Most traders spend time using technical analysis to track trends in the stock market. However, taking time to analyze the fundamentals of a stock can put you one step ahead of the rest. Financial information about a company’s activities and its financial success and failures is valuable information in making trading decisions.
Analyzing the Balance Sheet
The balance sheet shows the net worth of the company buy comparing the assets and liabilities at a particular point in time. A balance sheet shows three sections: assets, liabilities, and shareholder’s equity. Assets are listed according to their liquidity (how easily they can be converted to cash).The assets and liabilities sections are divided by current (withing 1-year) and long-term (more than 1-year). Equity accounts include outstanding preferred and/or common stocks and retained earnings (the profits that are reinvested in the company rather than paid out to owners or shareholders).
It’s important to compare the information and ratios obtained from the balance sheet with that of other companies in order to properly evaluate the potential investment.
In analyzing assets, you want to look at how quickly a company is collecting on its accounts receivable and how quickly inventory is sold. The faster a company collects on accounts or sells its inventory, the better that company is doing in managing its assets.
Analyzing LiabilitiesIn analyzing liabilities, you want to look at 2 primary ratios: the current ratio and the acid or quick ratio.The current ratio shows whether a company can make its payments. A current ratio that’s lower than most other companies in the industry can indicate the company having problem paying its short-term debts. This could mean bankruptcy is around the corner. You want to look for companies with current ratios that are close to the industry average.To find the acid test ratio, inventory value amounts are subtracted from current assets before dividing the result by current liabilities. This is an important ratio for financial institutions considering a short-term loan to a company. A company that has problems getting short-term debt is likely to have problems meeting its short-term obligations in the future. The market will soon recognize this problem and the company’s share price is likely to drop.