Determining the likelihood of profiting from investments requires careful analysis of a company's current financial position and history. A basic understanding of the company's industry will help you interpret the data as financial indicators differ by industry. Acquiring the ability to successfully perform analysis can take years, and even the most seasoned professionals occasionally make mistakes -- the process is more of an art than a science. Still, some basic procedures can help you make an informed decision about the worthiness of an investment.

## Financial Analysis

Gather the balance sheets, cash flow statements, income statements and shareholder equity statements for the past three to five years. Use annual reports or search the EDGAR database maintained by the U.S. Securities and Exchange Commission.

Compare balance sheets. Look for large differences between specific items from year to year. If you see a large jump, find out why. For example, if you see a substantial increase in fixed assets or revenues, find out if a new division was acquired, and find out how much the company paid for the additional assets or income stream: sometimes the increases can appear to be very impressive, but they don't add much value to the company if the price paid for them was exorbitant. Examine the notes that accompany the financial statements for additional insight.

Look for trends on the income statement. Prepare a graph showing the rise or decline of revenues and net income. Smooth, consistent growth indicates stability more than erratic swings. Calculate key expenses as they relate to revenues by dividing expenses by revenues for the year. For example, divide each of the amounts listed for research and development, the cost of goods sold and general and administrative expenses by the amount listed for revenues. A high percentage for research and development compared to the percentage for general and administrative expenses could indicate the company is spending most of its revenues on new innovations.

Use cash flow statements to determine the source of cash and where it is going. In contrast to the income statement, which shows non-cash gains and expenditures, the cash flow statement looks at cash alone.

Analyze liquidity by calculating current and quick ratios. Calculate the current ratio by dividing total current assets by total current liabilities. Calculate the quick ratio by subtracting inventories from the total current assets before dividing by the total current liabilities. Higher ratios indicate the company has more liquidity and should be a low risk on short-term loans.

Evaluate debt by calculating leverage ratios, interest coverage and cash flow coverage. There are two ways to calculate leverage ratios. Dividing total debt by total equity yields the debt-to-equity ratio, which shows reliance on outside financing. Dividing total debt by total assets yields the debt-to-assets ratio and identifies reliance on outside financing of assets. While low leverage ratios indicate low debt, they also may indicate the company is playing it safe and missing opportunities for growth.

Divide earnings before interest and taxes by annual interest expense to determine interest coverage ratio, which helps show whether the company can afford its interest charges based on current earnings.

Calculate net cash flow by adding or subtracting non-cash items from net income. For example, add depreciation and amortization expenses and subtract equity income from the net income. Determine the cash flow coverage ratio by dividing net cash flow by annual interest expense. If you identify low cash flow and high profits, conduct more research before deciding the company is a worthy investment.

Look at profitability in past years. Calculate net profit margin by dividing profit after taxes by sales. Divide profit after taxes by total assets to identify the return-on-assets ratio. Calculate return on equity by dividing profit after taxes by book value of shareholders' equity. Subtract preferred dividends from profits after taxes and divide by the number of outstanding common shares to calculate the earnings per common share. Divide cash dividends by net income to determine the payout ratio.

Analyze efficiency by calculating ratios that show how well assets are managed. Divide cost of goods sold by average inventory to determine how quickly inventory moves. High ratios indicate the company does not keep items in inventory, thus minimizing inventory investment. Dividing 365 by inventory turnover tells you how many days the company keeps items in inventory. Divide sales by the average total assets to determine total assets turnover. Higher ratios show the company is performing well by generating sales for its investment dollars. Calculate accounts receivable turnover by dividing annual credit sales by average receivables and average collection period by dividing total sales by 365 and then dividing average accounts receivable by the answer. These two ratios show if the company has timely collections.

Divide current market price per share by after-tax earnings to obtain the price-to-earnings ratio. Determine dividend yield by dividing annual dividends per share by current market price per share. These ratios can show how other investors feel about a company's worth and may not reflect the true value of the company. For example, during the Internet stock boom, technology companies had high P/E ratios and low profits. When the tech bubble burst, investors realized that the cost of the stocks had been high because of demand rather than actual value.

#### Tip

- Consult an investment professional if you are unsure about your conclusions.

#### Warning

- High liquidity can indicate the company is missing investment opportunities to retain cash, according to the University of Missouri.

#### References

- University of Georgia: The Balance Sheet
- Ohio State University: The Profit and Loss Statement - What Does it Mean?
- Iowa State Universtiy: Understanding Cash Flow Analysis
- James Madison University: Financial Ratio Analysis
- Jacksonville State University: Statement of Cash Flows
- University of Missouri Extension: Financial Ratios

#### Photo Credits

- Hemera Technologies/AbleStock.com/Getty Images