How to Look at Financial Statements to Invest in Stocks

by Francesca Lee

The numbers can mystify, and all those financial reports are stuffed with terms that ring familiar but we can't quite grasp: gross margin, net revenues, amortization. To top it off, companies have several different financial statements that link together and must be taken as a whole to give a complete picture of the future earnings stream of a business. Here's a hint: You don't need an accounting degree. But you should know how to interpret the "story" in the numbers -- top line to bottom line -- before you shell out any cash on the stock.

Get a copy of the quarterly report, or the 10-Q. Hands down, this corporate filing, which covers three months (one quarter) of the fiscal year, is used as a critical forecasting barometer. Quarterly reports are issued four times per year. The earnings section receives the lion's share of attention -- whether the company makes its projection or gets ripped by analysts for underperforming. After you subtract all the expenses and operational costs, you have the company's net loss and net income, also referred to as the net profit, for the past quarter.

Look at the Income Statement -- the profit and loss account under "Financial Statements and Supplementary Data" in the 10-Q. Strong revenue growth (sales) and the gross margin results (also known as gross profit) drive this report. The gross margin is the percentage of every sale that makes a profit. How many widgets do they sell and how much do they cost to make? How much do they spend to earn a buck?

Calculate the risk-to-reward of a company by examining its balance sheet. Let's take a look the fictional company RapidClimb, a tech stock buzzing with promise. It has little cash, lots of debt (liabilities) a high percentage of illiquid assets (equipment, real estate) paltry accounts receivables and zero dividend. In other words, it sports a high-risk bulls eye painted in red. A growth investor might take this bet. If you're looking for value (but you like the sector) compare a company with more revenue, less debt, decent but steady growth. And perhaps, a dividend.

Head straight for the "cash" line on the cash flow statement. Cash also appears in the balance sheet as a short-term asset, one that's liquid and converts fairly quickly, like money market funds or checking accounts. Remember the saying: the cash flow statement doesn't lie. It tells you exactly, in numbers, the movement of money in and out of a business. Spending more than you take in creates a deficit, it's as simple as that.

Tip

  • For advanced analysis, read the Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A;), also known as the "notes." It's included the SEC filings and it's dense, highly specialized material. But you'll learn the methods the company used to crunch its numbers and forecast future earnings.

Warning

  • If you can't rattle off with ease how the company makes money, its competitors and its particular edge (if any) in the market, you have a weak case for investment.

Resources

About the Author

Francesca Lee has more than 12 years of experience as a business writer, specializing in personal finance and education. Her articles have appeared online at Wave Newspapers, Turning Point Magazine and Facsnet. Lee studied political science at the University of California, Berkeley.

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