Investing in stocks can generate a rapid return on your investment, but it also carries a great deal of risk. One way to minimize this risk is to analyze a company's financial statements, using a few basic metrics to evaluate a company and choose good investments. The income statement shows how much money a company has made or lost, and the balance sheet shows its assets (how much it owns) and its liabilities (how much it owes).
One of the reasons to invest in a company is to collect dividend payments. The income statement lists dividends that were paid out, and those dividends can consist of distributions of cash or additional shares of stock to shareholders. This will be listed towards the bottom of the income statement, below the section on net income. Looking over several prior income statements will give you an idea of how often a company pays dividends. While a series of past dividend payments does not guarantee future payouts, it is a good indicator.
An income statement can also be used to calculate a company's profit margin. The net profit margin is calculated by dividing net income by the sales figure. For example, if a company had revenue of $500 million and net income of $100 million, the net profit margin would be 20 percent (100 divided by 500 equals 20 percent). This calculation tells you how much money from sales a company "pockets" after it pays its expenses. A higher net profit margin means a company will be better able to handle increased expenses, such as an increase in the price of raw materials.
The balance sheet can be used to calculate the amount of working capital a company has. Working capital is calculated by subtracting current liabilities from current assets. Current liabilities are defined as liabilities or debts that are due within one year; current assets are defined as assets that can be converted into cash or used up within one year. A company with more working capital will be better able to fund investments that can grow the company.
When a company purchases its own shares and holds onto them, it's called treasury stock. A company purchasing its own shares can increase the value of the stock. If a company owns treasury stock, it will be listed toward the bottom of the balance sheet, in the stockholders' equity section. Check the last several balance sheets to see if they list treasury stock. If a company has a history of owning treasury stock, that shows the company is willing to purchase its own shares to keep the stock value high.
Analyzing financial statements is all about comparison. It's important to look at several prior financial statements to spot trends and to compare a company to other companies in the same industry. Different industries have different profit margins; banks, for example, typically have higher profit margins than airlines. Lastly, when examining the income statement, try to find out what analysts' expectations were. If net income increased over the last quarter, but analysts had expected more of an increase, the stock may drop in value.
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