When analyzing a stock, you have a choice to make.
You can use technical analysis… or you can focus on the fundamentals.
These two approaches are completely different. Technical analysis relies on charts to determine the best time to buy and sell. Fundamental analysis requires you to look at a company’s financial statements to assess a company’s investment potential.
Either method is fine. In fact, many investors use both.
But today, we’ll focus on fundamental analysis. I’ll show you how to use financial statements in your research… and highlight the most important numbers for investors to focus on.
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What are financial statements?
Financial statements are business records that show a company’s activities and financial performance. The three main financial statements are the balance sheet, income statement, and cash flow statement.
While a financial statement may look complicated, you don’t need to understand the entire thing.
Here are the most important numbers to check on each of the three statements…
A balance sheet gives you a snapshot of a company’s financial condition. The three main sections on a balance sheet are assets, liabilities, and shareholder’s equity. Assets are what a company owns, liabilities are what a company owes (like debt), and shareholder’s equity is simply the difference between assets and liabilities.
As investors, our main concern is making sure a company’s debt is manageable. If a company’s debt is too high, it could be spending too much paying the interest on the debt. Plus, rising interest rates could cause the interest expense to rise over time. In a worst-case scenario, the company could go bankrupt if it can’t pay off its debt as it comes due.
The two most important ratios to check are the current ratio and debt ratio. A current ratio, also called the liquidity ratio, is a company’s current assets divided by its current liabilities. If the current ratio is less than 1, a company may struggle to meet its obligations. So, we want to make sure the stock has a current ratio above 1.
Let’s use Microsoft (MSFT) as an example. We can find its balance sheet on Yahoo! Finance by clicking on the Financials tab (then click on Balance Sheet and choose Quarterly).
First, we look for current assets, which are listed under total assets. Microsoft has current assets of $165.6 billion. Next, we look for current liabilities, which you’ll find under total liabilities. Microsoft has current liabilities of $72.2 billion. Now that we have these two numbers, let’s calculate the current ratio…
Current ratio = $165.6 / $72.2 = 2.3
As you can see, Microsoft has a current ratio of 2.3. This is well above 1, which tells us the company has no problem paying its bills.
The debt ratio measures a company’s leverage. You can calculate it by taking total debt and dividing it by total assets. A debt ratio of 1 means a company has an equal amount of assets and debt. Lower is better… we want to see a debt ratio of less than 1.
Let’s stick with our Microsoft example. Its total debt is $67.3 billion and its total assets are $308.9 billion. To get the debt ratio, we simply divide the debt number by the assets…
Debt ratio = $67.3 billion / $308.9 billion = 0.22
As you can see, Microsoft has a debt ratio of 0.22, which is way below 1. That means its assets are worth nearly 5x its debt. Along with its current ratio of 2.3, it tells us Microsoft has a strong balance sheet.
Next up is the income statement. This statement tells us how much revenue (or sales) a company made and how much profit it earned after subtracting expenses. Revenue is a “top line” number, which means you’ll find it at the top of the income statement. As you work your way down, you’ll see the company’s costs. Near the bottom, you’ll find net income (or profit). That’s why you’ll often see profit called a “bottom line” number.
As investors, we want to know if a company is growing. Specifically, is it growing both revenues and profits? Successful companies continue to grow both their top and bottom lines.
When looking at an income statement, it’s best to focus on revenue and net income. First of all, we want to make sure that a company’s net income is positive.
Sticking with Microsoft, we can go to Yahoo! Finance to find its income statement. Again, we’ll stick with quarterly results for our example.
If we look at net income, we see $15.5 billion. That tells us Microsoft is making a massive quarterly profit.
Next, we want to make sure the company is growing its revenue. The best way to determine this is to look at its current revenue and compare it to revenue in the same quarter of last year. For the quarter ending March 31, 2021, Microsoft had revenue of $41.7 billion.
For the same period last year, revenue was $35 billion. As you can see, Microsoft definitely grew revenue this past quarter ($41.7 billion / $35 billion – 1 = 19.1% growth).
Now, let’s check to see if Microsoft’s profits are growing. Above, we already found the current net income ($15.5 billion). We need to compare this number to the result from the same quarter a year ago.
For the quarter ending March 31, 2020, Microsoft had a net income of $10.8 billion. That means the company’s profit grew 43.5% this quarter. So again, Microsoft shows impressive growth.
Based on these measures, Microsoft has a fantastic income statement.
Statement of cash flows
Lastly, we have the statement of cash flows. This financial statement shows how much cash is flowing into and out of a company. It’s divided into three main categories: operating activities, investing activities, and financing activities. There’s a lot of detail here to help analysts get a closer look at the business.
As investors, we only need to focus on two numbers: end cash position and free cash flow (FCF). The end cash position is what it sounds like: a company’s cash at the end of a quarter. FCF tells us how well a company is doing in terms of generating cash. If both figures are positive, it’s a good sign. It means a company has enough cash money to grow its business, add new facilities, invest in research, or pay a bigger dividend to its investors.
Sticking with our Microsoft example, we need to go back to Yahoo! Finance and click on “Cash Flow” and then choose the quarterly view. We can see Microsoft had an end cash position of $13.9 billion, which is a huge number.
Next, we’ll check to see if FCF is growing. Ideally, we want to see this number growing, but it’s not a deal breaker if it’s flat or slightly down over the past year. Microsoft’s FCF March 31, 2021 was $17.1 billion. A year ago, it was $13.7 billion. Let’s calculate the growth rate…
FCF growth = ($17.1 billion / $13.7 billion) = 24.8%
So, Microsoft’s cash flow statement looks great. It has a huge cash position and solid growth in FCF.
While financial statements may seem confusing to most, we only really need to look at a few different numbers to get started.
On a balance sheet, we want to check a company’s debt to make sure it can cover its obligations. If not, you should avoid the stock.
On an income statement, we want to make sure net income is positive, and that revenue and income are growing. If not, we don’t want to buy it.
Finally, we want to check the cash flow statement to make sure a company has a solid cash position. We also want to check FCF to make sure it’s positive. And, ideally, we want to see this number growing.
Before you go out and buy a stock, make sure to look at its financial statements and make sure everything looks great. The value of your portfolio may depend on it.