When it comes to investing in stocks, it's always wise to choose a financially stable company. But it is easier said than done. Analyzing the financial health of a company is not easy. It is a thing that must be learned.
Generally speaking, investors must focus on buying stocks of a quality business. The quality of a company stands on these three legs: (1) quality of management, (2) future growth prospects, and (3) financial health.
This time we will focus on the financial health aspect of the company and financial statement analysis.
When you’re evaluating whether to invest in a company (stock), financial health is a key factor. Financial health refers to the strength of a company’s balance sheet and its ability to operate within set boundaries. It measures how much equity a company has, how much debt it has, what its cash flow is like, and more.
Financial health directly impacts your ability to make informed business decisions. If you aren’t sure if an investment or partnership will be worth it in the long run, analyzing the company’s financial health factors is essential. Each one of these indicators will give you insight into how well a company is doing financially and determine whether or not you should trust them with your money.
🔵 Profit and Loss Statement
The income statement, commonly referred to as the profit and loss statement, displays a company's revenue, expenses, and profit for a specific period, such as a quarter, 6 months, or a year. The statement begins with revenue at the top and subtracts costs as it progresses, ultimately arriving at the profit, also known as income or earnings.
The income statement displays a company's earnings and expenses. Analyzing income statements from various time periods can provide insight into a company's growth or decline. A common preference is for companies that exhibit steady growth.
🔵 Cash Flow
Understanding cash flow is crucial for assessing a company's financial health. It measures the amount of cash coming in versus going out. A negative cash flow indicates that the company may not be sustainable. Unfortunately, cash flow isn't always included on a balance sheet, so it's important to estimate it.
One way to do this is by examining the operating cash flow, or EBITDA, which stands for earnings before interest, taxes, depreciation, and amortization. This metric includes non-cash charges and is a more reliable indicator of a company's ability to generate cash than net income.
🔵 Earnings
A company's earnings are the amount left after all expenses have been paid and are sometimes used instead of cash flow, especially for non-cash charges like research and development. If there is a significant difference between earnings and cash flow, it could mean that the company's financial statements are misleading.
You can locate a company's earnings on its income statement, and the earnings per share (EPS) is also important, as it reflects the value of each share of the company's stock. A decreasing EPS is a sign that the company is struggling, while a steady or alternating growth and decline of EPS is worth reviewing.
🔵 Equity
When you’re deciding whether to invest in a company, one important consideration is how much equity the company has. Equity refers to the invested money that isn't guaranteed to be repaid, and it's a great indicator of investor confidence.
A financially healthy company typically has a significant amount of equity, showing that investors trust and believe in its potential success. It's important to monitor whether the equity is increasing or decreasing, as this indicates the level of investor trust and involvement. Companies with a substantial amount of equity and strong cash flow are likely to be stable and successful in the long run.
🔵 Debt
When examining a company's debt, you are essentially measuring the amount of money it owes. While debt is a common way for companies to finance their operations, too much debt can be risky. A company that has a significant amount of debt must repay it. If the company is unable to generate enough cash flow from its operations to pay back the debt, the creditors can take over the company, or the company may go bankrupt.
The easiest way to determine how much debt a company has is by looking at its debt-to-equity ratio. Additionally, it's important to check the interest rate on the debt to determine if it's reasonable. If a company has a large amount of debt, it's crucial to see if the interest rate is reasonable and if the debt is short or long-term.
🔵 Financing
When a company is not making a profit or is experiencing a cash burn, it can be a risky situation to be in. However, if there is a high chance of obtaining financing for its operations, the company's overall health can be considered somewhat improved. Naturally, having financing readily available is the strongest sign of excellent health.
Indicators of a Company's Financial Health
When you’re evaluating a company’s financial health, it’s important to look at all of these indicators. It's not necessarily a cause for concern if one indicator appears negative, but it should encourage further investigation.
Altogether, they highlight the details of #financialhealth that otherwise remain hidden. But it is also important to note that in order to judge financial health, one cannot compare companies of different sectors. Technically, sector comparison can be done, but the interpretation will be erroneous.
Companies with robust financial health are generally safer investments than those with substantial debt or low equity. Furthermore, a company that is thriving and has healthy finances is often indicative of a promising future outlook.
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