5 Easy tips to Understanding the Financial statements!

Updated: Oct 10, 2021

After my wife read one of my article, she suggest to me that I need to teach people how to read financial statements if I truly want them to be successful at trading stocks...


My immediate thought was...


My readers don't need me to spoon feed them how to read financial statements...


That is the basics of becoming a good stock trader...


And yet, here I am, giving my thoughts about how to read financial statements.

You can easily obtain a financial statement like these from Yahoo finance... or some other pay websites like Morningstar.com that offer these information at $20 a month subscription.

(No I don't get any referral fee from them)


The really important things is... what to look for in the financial statement...


In my humble opinion, if you truly want to be a good investor, and you are serious about stocks... learn everything on the financial statement... I mean every, single, item...


But I know for a fact, most of you won't...


Most of you just want a quick and easy 5 steps to understand the financial statement!


So... Here we go...


1. First, and the most important of them all...

Profit

Ask the following questions when you look at profits...


Does this company make consistent profit for the last 5 years?


Is it growing?


Is the growth too rapid?


Was the growth from acquisition?


Profit is king!


A company can lie and buy their way into the stock market, as long as the company is not making a profit, it's going to go bust sooner or later.


2. Asset

If you are not an accountant, you are probably dying from financial jargon headache...


But, bare with me...


All you need to know is to think of a company like a person...


And answer the following questions...


Does this person have a lot of assets?


Can these assets be turn back into money?


Are these assets growing or depreciating?


If you are borrowing money to this person, how likely is he/she going to pay you back?


If you still feels good about this company after these questions, it's a good sign...



3. Debt

Just like making new friends, if your new friend have a ton of debt... it is a red flag...


However, not all debt is bad debt...


Part of being a good company is the ability to manage debt well...


Most start up tech company starts with a huge debt, but soon paid them off...


It is healthy for a company to have some debt, but be cautious when the debt is more than 50% of its asset. (because, how can a company pay these debts without selling its assets?)


Take an extra note...


High earnings can be an exceptions here.


Here's why: If a company have $100mil in asset, $50mil debt(50%), but makes $40mil in earnings each year...


This company can pay off its debts in 1-2 years... the debt seems small compare to the high earnings capability...


So debt is very tricky...


One good sign is that a company begin to reduce it's debt, and start to pay it off. That can mean the company is doing better, and it is capable to reducing its debt further.


4. Cash

Anyone who owns a business would tell you how important cash is to a business, even to us individuals.


Cash is not the most important thing to a company, but it is still really important.


Here is why...


Cash is a good indicator of a company's health, it's like the body temperature of a company.


A company with a lot of cash could mean it's saving up for a big project, or it has so much cash coming in, it doesn't know where to spend them. However, it can also be an indicator that the management is bad at cash allocation, and not putting these cash into good use.


To us investors, having a ton of cash is a really good sign... one of the reason being that the company have enough reserve to make mistakes... which is in evitable to any company...


A large pool of cash also means the company is capable of making large purchases when necessary.


On the other hand, having little to no cash is a really bad sign...


When a company is really cash poor, it doesn't mean it is doomed, but it is definitely a red flag...


Let's say X company, who have very little cash, over 80% in debt, and it has not invested in expensive acquisitions recently. Unless it has a great excuse, otherwise we shouldn't bring friends like these into our private portfolio.


Y company who have very little cash, but recently paid their debt down to 10%, and have invested in new machineries, is a good excuses for having little bit of cash.



5. Cash flow

No, Cash flow is different from cash... for those of you who want to say I already talked about cash at tip number 4...

FCF or Free Cash Flow is the utmost important thing to us investors...


Cash flow means the total volume of money flowing in and out of this business, but FCF is what is left from all the operations.


After paying salary, rent, production, shipping, and all the necessary expenses...


This can be stated as the total productivity of the company after all the expenses.


A consistently growing FCF is a must for good companies. Therefore, if you see a messy FCF data... it should trigger your alarms...


In conclusion...


While Financial statement can help you understand a company better, and to make wiser investment choices.


Most investors understand that, and public companies knows that.


That's why sometimes public companies tend to manipulate these data so more people would invest.


So, make sure the company is run by people with integrity. Otherwise, you are no different than buying a beautifully forged financial statement with thousands of dollars of your hard earned money.


Let's finished with one of Warren Buffet's quote!


"You have to understand accounting and you have to understand the nuisance of accounting. It is the language of business, and it's an imperfect language, but unless you are willing to put in the effort to learn accounting, how to read and interpret a financial statement, you really shouldn't select stocks yourself."
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