A very common piece of investing advice is that you should conduct your own research and analysis instead of fully relying on somebody else’s recommendations. But how do you do this? When it comes to investing in stocks, the key is to evaluate and analyse the financial statements of the company you are looking at.
Companies in India, the US, and most major economies around the world follow what are known as Generally Accepted Accounting Principles (GAAP) to create and maintain their financial records. This involves three crucial statements — the income statement, balance sheet, and cash flow statement.
On the basis of the data in these vital financial statements, you can conduct three essential types of analysis to better understand the relevant company’s performance and value: vertical analysis, horizontal analysis, and ratio analysis. In this article, we’ll present the basics of how you, as an investor, can begin analysing companies so as to make informed decisions.
Financial statements: The Big Three
Let’s take a quick look at what the three statements mentioned above are, what exactly they convey, and what you should focus on when you examine them.
Income statement
When you’re potentially interested in investing in a company, perhaps the first few financial data points you will want to know are its revenue and profit. And it’s precisely this information that you are going to find in the income statement, also known as the profit and loss statement. The revenue, costs, gross profit, operating profit, and net income are some of the key elements in an income statement that you should examine closely.
Also Read: I am an NRI in Canada. My ancestral property is being sold in India. What can I do to save tax?
Balance sheet
A balance sheet is a snapshot of three important things — the assets, liabilities, and shareholders’ equity of a company on a given date. This statement is central to evaluating a company’s overall financial health, as it provides insights into its stability, capital structure, debt obligations, liquidity, and more. As a general rule, the total assets must equal the liabilities plus the shareholders’ equity, and this gives the book value of the company.
Cash flow statement
This statement provides information about a company’s cash inflows and outflows due to three types of activities — operating activities, investing activities, and financing activities. By indicating the sources of cash generation and utilisation, the cash flow statement allows you to evaluate how efficient the company is in utilising its resources, what its cash position and liquidity are like, and how sustainable the company is financially.
Evaluating and analysing financial statements
Now that you know the basics of the most important corporate financial statements, let’s see how you can analyse them effectively:
Vertical analysis
When you conduct this type of analysis, you analyse different items of a financial statement for a given period in relation to another. Here, each item of a financial statement is expressed as a percentage of another item, which is chosen as the base figure.
For instance, when conducting a vertical analysis of an income statement, each line item can be expressed as a percentage of gross sales. If you consider the balance sheet, you can express each asset as a percentage of the total assets. For instance, inventory represents 15% of the total assets, while machinery and equipment represent 30%.
Through such a comparative analysis, you can evaluate the relative significance of different items of a financial statement and understand the strengths, weaknesses, and composition of a company’s finances.
Horizontal analysis
This type of analysis is also known as trend analysis, as it compares the items of a given type of financial statement across different periods. Every financial statement is created for a specific accounting period, such as a financial year or a quarter. Horizontal analysis allows investors to understand the changes, direction of growth, and trends in a company’s performance over time.
The simplest way to conduct horizontal analysis is to look at the differences between the figures of a statement from two different periods. For instance, you could compare the revenue of a company in FY2021 and FY2022. Another way to look at such differences is in the form of percentage changes instead of changes in the dollar/rupee value.
Horizontal analysis will help you evaluate a company’s revenue growth, profitability, expense management, dividend trends, cash flow trends, and more. This type of analysis is also used by company management for decision-making, as being aware of various kinds of trends allows them to better utilise their resources and drive growth.
Ratio analysis
Ratio analysis is an important part of analysing a company’s financial performance over different periods and in comparison to its peers in the industry. It can also help estimate future performance. There are several financial ratios that can provide insight into a company’s profitability, liquidity, operational efficiency, solvency, and cash flows.
For instance, if you want to assess a company’s liquidity, you should look at its current ratio and the so-called quick ratio. For operational efficiency, there are the inventory turnover ratio and accounts receivable turnover ratio. As an investor, looking at ratios like price-to-earnings, earnings per share, return-on-equity, and debt-to-equity can provide useful insights.
When undertaking ratio analysis, it’s important to note that different industries have different standards that you should be aware of for a meaningful analysis. For instance, FMCG companies tend to have a lower debt-to-equity ratio compared to companies in capital-intensive industries. This is because FMCG companies usually have a shorter cash conversion cycle and low capital expenditure requirements.
Also Read: Why did household savings fall in FY23? SBI Research shares the ‘real’ reason
Investing to maximise returns
When you want to maximise your returns, evaluating a company’s financial statements is crucial. But so is understanding your financial position and choosing the right investment platform.
By assessing your risk tolerance, financial goals, and investment horizon, you can pick the right type of investment and aim for asset allocation that is ideal for you. Once you have aligned your needs with the right investments, you should carefully choose an investing platform suitable for you.
This column has been written by Subho Moulik, Founder and Chief Executive Officer of Appreciate, a SEBI and IFSCA registered fintech platform for Savings and investments. Views expressed are personal.