How do I Evaluate Stock Investments by Using Financial Statement Analysis?

Stock investors can learn an incredible amount from analyzing a company’s financial statements. The company's income statement, balance sheet and statement of cash flows are especially useful to understanding how a company functions, its stability and how much its stock is worth.

Open the company’s most recent financial statements. Publicly traded stocks provide financial statements on a quarterly basis to the Securities and Exchange Commission as 10-Q and 10-K filings. These filings are available at the SEC's website and can be searched by using a stock’s ticker symbol. These records are also available at the “Investors” or “Investor Relations” section of the company website.

Locate the income statement in the filing and check for trends in top-line sales, major expenses and bottom line income. Growing sales and earnings are excellent, but declining sales, declining earnings and increasing expenses suggest the company is struggling. Review footnotes for nonrecurring items and determine for yourself if similar losses or gains are likely in the future.

Analyze the balance sheet. Notice whether the company paid down or increased its debt or if any items declined substantially in value. You should also note how much book value is assigned to intangible assets and goodwill. If these are large numbers, double-check the footnotes to make sure they could be useful to the firm in the future.

Analyze the cash flow statement. For operating cash flows, consider whether each past source or use of cash could be repeated in the future. Unsustainable sources and uses of cash should not be used to make future cash flow projections. Calculate free cash flow to investors by summing cash flows from operations and capital expenditures (an item in investing cash flows). Investors should be attracted to firms with the potential to produce positive free cash flows. Consider investing and financing cash flows as well. Verify whether the firm needed to cover investing and operating cash flows by borrowing or issuing shares, and try to determine if it will do it again in the future.

Adjust historical accounting values to make them reflect today's economic reality. Items listed as nonrecurring items or those likely to continue should be added back to net income. Adjust balance sheet items to reflect their economic values if they are different from their accounting values.

Calculate or look up valuation ratios. Valuation ratios reveal how dear a stock is to investors and include the price-to-book ratio, price-to-earnings ratio and price-to-sales ratio. These ratios divide the market capitalization of a company by the book value (equity listed on the balance sheet), earnings (net income on the income statement) and sales (the top line of the income statement).

Calculate other financial ratios. Liquidity ratios reveal whether a company is capable of paying its creditors. The current ratio is calculated by dividing current assets by current liabilities. The quick ratio is calculated by dividing current assets minus inventory by current liabilities. Current ratios under 1.5 and quick ratios under 1 are cause for concern and might indicate that a firm could have trouble paying creditors.

Make comparisons. Financial ratios can be compared between peer firms that use the same accounting conventions and operate in the same industry. They can also be used to compare a stock's current valuation and performance against its historical valuation and performance.