Reading Financial Statements Before Investing
Reading Financial Statements Before Investing
The investment landscape to buy stocks and bonds has become quite a challenge over the last 15 years for do it yourself investors as well as financial professionals within the investment industry. In the past, many retail investors would rely on their stockbroker or investment advisor to pick a particular stock or bond without the end investor even looking at the company's financial statements. Many times their stockbroker would just pick the investment for them. Only on rare occasions would an end investor ask their stockbroker or investment advisor if they could view the financial statements. Laws have been created so that every investor must receive financial documents prior to buying either a stock or a bond in a company. Before an investor buys a security from any entity they should understand what the entity does, the company's financial condition and maybe read what opinion either a rating agency or an investment firm has on the company's securities that they are buying.
There have been numerous scandals over the last 15 years such as Enron, Lehman Brothers, Bear Stearns, Local Municipalities, WorldCom, Aurther Anderson, Tyco International, Fannie Mae and Freddie Mac are to name a few. Some of these firms were the result of "cooked books" which would be false or doctored financial statements. While other firms had very high debt ratios and when time came due to pay their debts they were unable to meet their obligations. Some companies had continued losses on their income statements which resulted in a drop in their stock price creating losses for investors. As someone who reads financial statements from municipality's everyday it is so important that we look at for example the balance sheet and see if a municipality is too over leveraged and are riddled with debt, are they able to meet their debt service payments?
There are two examples that I use the state of California and Nassau County, New York. The state of California is a biggest economic state in the United States and the state have the 8th largest GDP in the entire world. The state brings in enough revenues but their biggest problem is their high liabilities. The same goes for Nassau County NY, which is located in Long Island and home to some of the wealthiest people in the Unites States. Their problem just like California is that they spend too much money and have high debt levels. If you are an investor whether a retail or professional it is so important to look at their financial states and say to yourself can these issuers meet my obligations if I were to buy their bonds? Are they able to pay interest payments when they are due? These are very important question and buy simply looking at the balance sheet and income statement of these issuers you can make your own informed investment decision.
When looking at a balance sheet, to me the biggest item I look at is a total asset versus total liabilities. If the financial entity's asset to debt ratio is too low than that means the financial entity has less liquidity, questions as the whether they can pay their debt and are not able to have flexibility in the markets. What I mean buy that is if let's say a company like Microsoft wanted to buy Facebook but they were too leveraged with liabilities this would make it difficult to achieve. Using a current ratio of current assets over current liabilities is always helpful in indicating if the company has enough liquidity.
The income statement of a financial entity let's us know whether company if profitable or not over a particular period of time. Obviously profitability is extremely important when looking at a company, if their net sales do not exceed the cost of goods sold then they may not be able to stay in business if this continues. When analyzing a stock the earnings per share of common stock outstanding is a very important item to look at when making your decision.
The statement of cash flows shows an investor the owners' equity and explains the changes that occurred in the components of the owners' equity. This financial statement is necessary because it tells the investor the sources and uses of cash for a particular year. This report helps us understand the financial entity in a more detailed way.
As a financial professional, who works in the financial industry it is imperative that we read all the available updated financial statements before making an investment decision. As a person who works in the municipal bond market we routinely relied on what the credit agencies (Standard and Poor's, Moody's and Fitch) had said about a particular municipality. It use to be common practice to say oh Standard & Poor's rates this issuer triple-A so the debt should be good. However taking a look at the financial statements of an issuer forces us to form our own opinion from rating agencies to allow us to make a sound and quality decision as to whether or not to buy of sell a particular security.
The rating agencies are still helpful but their creditability had been damaged because they rated many securities, whether it was mortgage backed bonds, corporate bonds or municipal bonds way too high not anticipating that we would have a financial meltdown like we did in 2007-2008.
In summary, I'd like to continue to stress no matter what level expertise you have the important of trying to understand and read the balance sheet and income statement of any investment that is purchased. It is important to look at past history to see what the firm has done, for instance one negative year out of ten may not be too much of a concern but let's say five of six years of losses may affect your decision to invest in the financial entity.
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