It is advisable and an advantage for investors to have an understanding of financial statements. It enables investors to draw their own conclusions about the company and possibly survive in challenging markets. However, it is not a simple task. Thus, it is probably easier to assess a company by using basic yardsticks.
Analyzing the business of a company provides an understanding about how well positioned the company is in the industry and also the potential growth of the industry itself.
You should understand and identify what type of business and industry the company is in, what and where the risks could come from and what is the market segment of the business.
Good people will run a good company. In fact, most goodwill built over the years is largely due to good management. The honesty, integrity and commitment of the people are a crucial determinant of the success of a business. Dishonesty and mismanagement can easily bring about the downfall of even large multinational companies like Enron, WorldCom and the National Australia Bank.
To provide an estimation of how well the company is doing, investors should assess the nature, quality and predictability of future revenue streams, as well as earnings before interest, tax and depreciation.
The earnings of a good company if not growing, should be sustainable. The earnings of a company should justify the capital employed as in the long term; investors would withdraw their support if profits of the company do not justify their investment value.
Most analysts will consider a company’s cash flow as the best way to determine the company’s health. Cash could come from three sources; operating activities, investing activities and financing activities.
The cash flow statement provides detail of all incoming and outgoing cash from each of the three sources. Revenue from the operating activities is consists of cash items only. Cash flow from investing activities includes the purchase and sale of property, plant and equipment. Cash flow from financing would show any monies raised or paid out to shareholders (including the dividends payment).
For a company that does have a dividend policy, it’s good to know whether it employs a constant dividend growth policy, residual method or none. For a profitable company with a lack of investment opportunities, it would be wise to return part of the profits as dividend to its shareholders. In most cases, profitable cash generating companies in mature or slow growth industries are the common dividend distributors. By knowing a company’s past dividend distribution and the management’s intentions, a good gauge of future distributions can be made. Popular models to value dividend paying companies are to discount the future dividends using either a constant or multiple period growth rates.
To determine the value of an investment requires ascertaining whether a current price reflects sufficient growth to allow an investor to generate a return that meets their cost of capital. Clearly, all the above have to be considered collectively for a fair assessment of a company’s valuation.
By learning to recognize the tell tale signs, you are better prepared to protect your interests. If you can interpret the information, you able to determine the magnitude of any underlying problems.