Back to the Basics
When deciding on a company to invest in, especially when you are looking to hold on to the shares for the long haul, one of the first things you should always do is your due diligence.
Due Diligence is: “the investigation or audit of a potential investment. It refers to the care a reasonable person should take before entering into an agreement or transaction with another party.”
This is so as to make sure that your potential investment’s financial house is in order. The main reason why it’s so important to conduct this analysis is because a company’s financials tell the story about their business health and sustainability.
Start with the Financial Statement
To get started, you must look up the financial statement (also called a company’s financials) on the company you want to investigate. These financial statements can be obtained from:
1. The Annual Report is released at the end of each fiscal year. It’s a comprehensive report prepared by the company’s management for their shareholders. The report paints a high level picture of the keys things that stakeholders should know about that had impacted the business over the last year. The financial statements can be found in the back pages of the report.
2. The 10K gives a more detailed look into a company’s business. The report is also released annually and contains the same financial statements as the Annual Report. Publicly traded companies are required by law to file a 10K. There is a section of the report where management formally states that they acknowledge the report’s information to be correct and true. The report also contains important information investors should know about such as details on the company’s business (i.e. what they do and how they make money), potential risks, legal issues, and of course, financial statements.
3. The 10Q is very similar to the 10K except that it is filed quarterly, at the end of January, June, September, and December.
Investigating a Company’s Financials
There are several ways to make a corporate valuation by analyzing a company’s financials. The most fundamental way is to take a look at their financial statements. The four financial statements are:
1. The Balance Sheet is a snap shot of where a company stands at a certain period of time. It tells you what the company is really worth and what kinds of potential risks that they may face. It contains three key parts: Assets, Liabilities, and Equity.
More specifically: Assets = Liabilities + Equity.
2. The Income Statement tells the results of a company’s operations over a certain duration of time. It could be over a year, one quarter, to one month. The income statement also contains three key parts: Revenue, Expenses, and Net Income.
More specifically: Net Income = Revenue – Expenses.
3. Statement of Retained Earnings provides the investor with information on what a company does with their profits. It is a compilation of a company’s retained earnings (i.e. Net Income or what the company gets keeps for itself, after all expenses are paid and liability payments are made to the company’s creditors) from the beginning to the end of the year. You will also find how much of a company’s Net Income was used to pay investors in the form of dividends and how much of their Net Income was used for internal growth (i.e. buying a new machine or opening another factory).
4. Statement of Cash Flows traces a company’s cash movement (inflows and outflows). Cash flow can also be separated into three sections: Cash Flow from Operating Activities, Cash Flow from Investing Activities, and Cash Flow from Financing Activities.
One of the key things to look for in this statement is to see whether or not a company is able to generate, well, Cash. As we say in finance, Cash is king. Whether a company has enough Cash tells you whether or not they can carry out their day to day operations, make future growth, pay off their liabilities, and thus whether or not the company is profitable!
It’s very important that you go through the forensics—aka the “details”—of each of these statements so that you can figure out whether a company is actually as good as it claims to be or whether it really is as bad as they say. The analysis allows you to get a sense of whether or not a company matches your investment style and overall, whether or not it is a good investment.