Investing in a company is a huge and often long-term decision that will have a lasting effect on both the investor and the business. Before an investor is ready to make that call and invest in a company, they need to assess its finances and quantify them.
In this article, we’ll go over the financial statements and key ratios that investors should be aware of. These are often available through public data, but they also require investors to assess companies independently and use third parties.
How to Analyze a Company Before You Invest?
Understanding the Three Key Financial Statements
There are three key financial statements that a business needs to produce and that the investor needs to study in order to understand the financial state of the business. These aren’t comprehensive, but they are a basis for any future decisions.
Income Statements
Income statements are the first financial statement to take into account when choosing to invest in a company. These include:
- Revenue: total income or sales
- Expenses: Cost of running a business in its entirety
- Net Income: The difference between the two
Investors should look for steady revenue growth or at least revenue that doesn’t fluctuate that much over time, as well as manageable expenses, which indicate a healthy business.
Balance Sheet
Balance sheets are used to showcase the company’s financial standing at a specific moment in time. The information is divided into three sections:
- Assets: This is everything the company owns, including cash, inventory, and property.
- Liabilities: This is everything the company owes, loans and accounts to be paid.
- Shareholders’ Equity: The net value left to the shareholders, once liabilities are subtracted from the assets.
A company should have more assets than liabilities. Sometimes information about these features is reported in publications following the industry, such as Cryptomaniaks, and sometimes, they are a result of an investigation by the investor.
Cash Flow Statement
Cash flow statements are made to follow the cash coming in and out of a business. They are divided into:
- Operating Activities: Cash from regular business operations
- Investing Activities: Cash from buying and selling assets
- Financing Activities: Cash from issuing company stock, borrowing, or repaying debt
Investors should look for a positive cash flow, indicating healthy business practices. In general terms, a business worth investing in should have positive balances on all three statements we mentioned.
Key Financial Ratios
There are a few ratios that paint a picture of how a business is doing. They can be used to quickly spot a red flag in a business and avoid it in terms of investing. Good ratios, on the other hand, don’t always indicate that the business is worth investing in, but that it deserves further consideration.
Profitability Ratio
There are three ways to measure a profitability ratio:
- Net profit margins: How much profit a business makes per dollar of sales.
- Return on assets: how efficiently the company uses its assets.
- Return on equity: How a company uses the money it has to make a profit.
High ratios point out how efficient a business is and how it utilizes its assets.
Liquidity Ratio
The liquidity ratio is measured by subtracting current liabilities from current assets. There’s also a quick ratio when current liabilities are subtracted from the value of the inventory. A good liquidity ratio shows that a company can pay off its current liabilities as soon as needed.
Leverage Ratio
This metric refers to how much debt the company has compared to the value of the shareholder equity. Another important ratio to add to that is the interest coverage ratio, which indicates how easily the company can service its debts.
This metric very clearly indicates how risky the company is to take on, and if these ratios aren’t in favor of paying debts, investors should stay clear.
Efficiency Ratio
Efficiency ratio indicates how a business uses assets at its disposal to make profits and, therefore, how well it operates. It’s measured in terms of inventory turnover, indicating how long it takes to sell all of the inventory, and in terms of asset turnover, indicating how long it takes for an asset (a machine or a vehicle) to pay for itself.
Valuation Ratios
- Price to earnings ratio refers to how much the investor is willing to pay for one $1 of earnings.
- Price to book ratio refers to the difference between the market and book value of a company.
These ratios help the investor decide if the value of the company stock is overvalued or undervalued compared to the potential for growth and earnings. It’s important to note that some of the metrics don’t have a precise number behind them and that they depend on the investor’s sentiment.
Qualitative Factors to Consider
There are also factors that can’t be measured and presented as figures that very much go into how much a company is worth and whether it is worth investing in. These, too, need to be taken into account by investors, and this is where their abilities to assess a company come into play more than with ratios and financial statements.
Company management is one of the most important assets it has, and it can’t be measured and expressed as a number. Quality leadership can make or break a company, especially when it’s going through times of crisis. The investors should learn about the team running the company, but also their managerial style and approach to delegating tasks.
A comparative advantage refers to the unique feature, ability, product, or asset that a company has and that can’t be copied. For instance, experts from Cryptomaniaks often write about altcoins that provide a unique benefit to their users. It’s these kinds of features that can drive the price of a company beyond the cost of its measurable elements.
To Sum Up
An investor needs to assess the value of a company they plan to invest in, and they have a variety of metrics at their disposal to do so. Most of these are available in public statements and data that anyone can access, but knowing which metrics to focus on requires a skill investors develop over time.
An investor should be aware of the assets the company has at its disposal, its income and revenue, as well as its debts, liabilities, and shareholder equity. However, the company is more than these facts , some qualities can’t be measured, such as the quality of management, a forward-looking approach, and the company’s reputation.