Ever wonder what makes one company more financially stable than another company? The answer lies in the company’s financial statements. The financial statements provide information on a company’s profitability, equity, available cash, and other financial data that illustrate how well a company is doing. You can use financial statements to assess the financial condition and stability of any particular company.
Before we analyze financial statements, let’s first look at how an expert defines financial stability in business. Warren Buffet, the second richest man in America (Forbes Magazine, “400 Richest Americans,” 2009) and a highly successful investor, researches and identifies financially stable and profitable companies by analyzing their “durable competitive advantage.”
Buffet identifies companies with “durable competitive advantage” by asking the following: Does the company sell a unique product or service? Is the company the low-cost buyer or seller of a product or service that people consistently need? Examples of such companies include Coca-Cola and Kraft, which sell unique products, and companies like Wal-Mart and Costco, which are low-cost buyers and sellers of popular consumer goods. Buffet invests in durable companies that manufacture competitive products on a consistent basis (e.g., Kraft has been in the food business since 1903 when it first sold cheese) that yield consistent profits. Buffet also likes to invest in companies on a long-term basis rather than for short-term gain.
Let’s say that you use Buffet’s “durable competitive advantage” strategy to select companies for potential investment. Your next step is to review the companies' financial statements to assess their financial condition.
One way you can obtain a publicly-traded company’s financial statements is through the U.S. Securities and Exchange Commission’s website. Under its “Filings & Forms” section, you can access the EDGAR database by selecting “Search for Company Filings,” then “Company and Fund Name,” which will prompt you to enter the name of the company you’re researching. You’ll need to select the document called “10K” from the list of various reports. The 10K is the company’s annual report which features financial statements.
Once you’ve downloaded the 10K, you should review the “Income Statement,” “Balance Sheet,” and “Cash Flow Statement.” Keeping Buffet’s emphasis on “consistency” in mind, try using his criteria to identify a financially stable and profitable company: A company should have consistent earnings and earnings growth; consistent high gross margins; consistently carry little or no debt; and consistently not have to spend large amounts of money on research and development. It's best to analyze a company’s financial statements over the past five to ten years to get a better sense of the company’s overall performance.
In addition to reviewing financial statements, investors like Buffet also like to perform ratio analysis to quickly assess the financial health of a company. Yahoo! Finance features a research tools website that explains how to calculate asset management, profitability, liquidity and leverage ratios using data from financial statements. These ratios are quite helpful in determining the financial stability of a company.