Evaluating a company by examining its financial statements is called financial statement analysis. It is a skill learned in a classroom or on-the-job and honed over many years. The primary tools used to assess a company's financial health are the balance sheet, also called the statement of condition; the income statement or profit and loss statement and the cash flow statement. These three reports will reflect the financial condition, profitability and cash generating ability of a business under review.

Things You Will Need

  • Financial statements

  • Calculator

  • Pad and Pencil

Audited Financials

Obtain the latest financial statements. If the statements are audited look for the auditor's "standard unqualified opinion." Pricewaterhouse Coopers advises that the opinion statement should state that the "financial statements, taken as a whole, “present fairly, in all material respects” the financial position, results of operations and cash flows of the company in accordance with the appropriate financial reporting framework (e.g., U.S. GAAP)." Based on his findings, the independent auditor may issue a modified opinion or refuse to render an opinion. Company evaluations based on unaudited financial statements or "no opinion" audits may not accurately portray the company's financial position.

Examine the company's balance sheet. What percentage of total assets is financed by debt as opposed to stockholder equity and retained earnings. The higher the ratio of debt/equity the greater the risk of default if earnings projections are not achieved. Next, measure business activity by comparing total sales on the income statement to the turnover of receivables and inventory. Rapid turnover means customers are buying the company's goods and paying in a timely manner.

Test the company's ability to raise cash in excess of its current obligations by subtracting current liabilities from current assets to derive working capital. Because working capital is composed of cash and receivables, along with inventory that hasn't been sold yet, a better determinant of liquidity, ready cash, is the quick ratio, which drops inventory out of the working capital calculation. A healthy working capital ratio of two to one or better means the company is generating cash from business activities to fund current operations. Cash flow statement analysis can confirm the availability of operating funds.

Perform a profitability analysis by first calculating profit margin, which is net income as a percentage of sales. Measure the return on assets (ROA) and the return on equity (ROE). The analyst wants to learn how efficient the company is in producing income from its assets and how well the stockholders will be rewarded for their risk investment. ROA is the percentage that net income bears to total assets. ROE is found by dividing net income by total equity.

Compare the results of the company's evaluation with data from similar companies of comparable size. Look behind the numbers at management. Have there been any significant changes in the top brass? Does the company reward innovation to remain competitive? Is the organization pursuing new markets for its product and services? Companies don't operate in a vacuum. Their long-term success often depends on events over which they have little control, such as the direction of the economy or the availability of credit to finance growth. While the financial statement is central to the evaluation of a company, analysts must incorporate many other factors that may impact future performance.