1. Examining a Company's Liquidity Before Investment
2. Checking the Income Statement
3. Examine Return on Assets
4. Don't Forget Operating Cash Flow

Updated October 9,2020:

Understanding how to evaluate a company for investment is actually fairly simple. Basically, you need to examine four important factors about the company: balance sheet liquidity, earnings growth on the income statement, return on assets, and operating cash flow.

Examining a Company's Liquidity Before Investment

Before you invest your money in a company, it's important that you measure a few of the company's key financial metrics. To evaluate a company's finances, there are three financial statements that you must carefully examine:

  • Balance sheet
  • Income statement
  • Cash flow

The best place to start when evaluating a company is looking for liquidity on the balance sheet in cash form. Essentially, you're looking to see if the company has enough money to cover their expenses. You should also be checking to see if the company's short-term debts will cause them to exhaust their cash before the year's end.

To determine a company's liquidity on the balance sheet, you need to look for something called a current ratio, which is a measurement of the working capital that the company possesses. You can calculate the current ratio of a company, comparing its current assets that can be turned into cash and its current liabilities that must be paid in the upcoming year. Ideally, a company will have a 2:1 ratio of assets to liabilities.

Some companies can have a lower ratio if they are well run, meaning that they are effectively controlling your cash. Companies in slow-growth industries also may not need as much liquidity as companies in rapidly growing industries. Most companies, however, should have a 2:1 ratio.

Checking the Income Statement

After you've determined a company's liquidity, you should move on to the income statement. This document will include several financial metrics that can help you decide whether to invest in a company. In particular, you need to check the growth of earnings and the growth of net income.

Checking these metrics can help you to determine if the company is actually growing. Look at the bottom and top lines of the income statement going back 10 years. Do the numbers on the top line continue to grow over those 10 years? Preferably, the top and bottom growth lines will be parallel.

When these lines are parallel, it means that both the sales growth rate and the net earnings growth rate are rising at the same rate. If the lines are not parallel, it may mean that the company's earnings are growing while revenue is going down.

Examine Return on Assets

The next financial metric that you need to examine is the company's return on assets. There are three different measurements that you can check to determine what a company is accomplishing with its earnings compared to how much the company is spending to bring in those earnings:

  • Return on assets
  • Return on equity
  • Return on capital

Companies worth investing in will have strong returns. Generally, a good company will have a 30 percent return annually. Examining a company's return on assets will reveal its profitability, as well as how effective the company is at using its assets to bring in revenue.

Don't Forget Operating Cash Flow

The fourth and final factor that you should examine before investing in a company is operating cash flow, which you can find on the cash flow statement. Looking at this metric will help you to discover if the company is generating real cash. You need to determine exactly how the company is generating cash. Does the cash come from borrowing money and selling of stock and business assets? If so, then putting your money into this business is likely not a wise investment.

On the cash flow statement, you need to look for operating cash flow. Subtract the money that the company used to purchase equipment, known as capital expenses, from the operating cash flow. What's left is the company's real cash flow. Basically, real cash flow is the money that can either be reinvested into the company or paid to the company's owner. This money is important, as it speaks to a company's ability to grow. You want to see real money coming in on the operating cash flow line.

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