Financial statements of an organization provide potential investors with a more detailed insight about the organization as opposed to the casual glimpses of the organization’s stock market prices. For an investor who is interested in investing in a particular organizations stock, and has the financial records of the organization in question at his disposal, then the first five areas to review before investing would be as follows:
- Liquidity Position: The balance sheet presents a broader overview of the organization’s financial position. From balance sheet data, it is possible to calculate the current ratio which reveals the general liquidity of the organization and serves as an indicator as to how quickly an organization can meet its short-term liabilities.
- Profitability: Any investor will want to invest his money where there is value. The statement of operations serves as an indicator of annual profits made by an organization. An organization that makes in high profits is likely to continue doing well in the future.
- Cash flow: An organization should have enough cash at hand to cater for immediate expenses and to secure assets. A cash flow statement serves as an indicator of whether the organization generates cash over a certain financial period. The footnotes section gives an insight to the taxes paid by the organization and the accounting standards used.
- Organizations debt: The greater the debt an organization has compared to its total assets, the riskier it would be to invest in such an organization. It always a good idea to identify a certain percentage beyond which not to invest, e.g. 50% debt to asset ratio.
- Confidence: The auditor’s opinion letters serve to reassure investors that the financial records about an organization are valid, conform to the laid down standards in their preparation, and are free of any manipulation. They, therefore, provide confidence that they reflect the true position of the organization.
- Profitability ratios are used to measure the performance of the company over a given financial period. Margin ratios indicate the ability of a company to make a profit from sales e.g. a 10% net profit margin indicates a profit of 10 cents for every dollar sale. Returns ratios, on the other hand, represent the ability of the company to generate returns e.g. a high percentage of the Returns on Investment ratio indicates that the company is effectively managing its assets to generate returns.
- Liquidity ratios represent the ability of a company to meet its short-term financial obligations. The current ratio, for example, measures the capacity of the company to settle liabilities not exceeding one year, with its current assets. The higher the liquidity ratio, the more likely a company is, to settle short term liabilities.
- A company is solvent if it possesses more than it owes. Solvency ratios represent the ability of a company to meet its long-term obligations in the future. A high debt-to-equity ratio for example signifies high interest rates while a high debt-to asset ratio means that most of the company’s assets have been acquired through debt and this poses a major risk.
- The asset turnover ratio is a measure of how well a company uses its assets to generate revenue. A high asset turnover ratio is a significant indicator that the company is generating more revenue per asset. A low asset turnover, on the other hand, is a strong indicator that the company is experiencing poor sales.
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Khan, M. Y., & Jain, P. K. (2007). Financial management (5th ed.). New Delhi: Tata McGraw-Hill.