How to Evaluate Financials Before Investing Or Trading

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How to Evaluate Financials Before Investing Or Trading

When it comes to trading, investing, or to of placing your own hard earned money into a company’s common stock in any way, it’s incredibly important to be able to read and understand that company’s recent financials. If you trade blindly, without at least glancing at recent financial filings, you’ll likely blow through your portfolio so fast you’d be better off burning it. 

Of course, the parts of the company’s financials to focus on does change based on the type of trading you’re doing, or the market you’re investing in. Below, in explaining what I consider some of the more important financial aspects, I will comment on their importance level based on whether you’re investing or trading, and whether you’re playing big boards, such as NASDAQ or NYSE, or the OTC market. 

Before we start looking at individual components of company finances, I’ll leave here a quick summary of the basic accounting equation, also known as the balance sheet equation.

Assets = Liabilities + Stockholder’s Equity

Assets: What a company owns (Property, Cash, Etc.)

Liabilities: What a company owes to others (Debt)

Stockholder’s Equity: The difference left (Negative is bad)

Essentially, what you want here in evaluating a company, is a large relative value for assets, a liability value that is less than assets, and hopefully a stockholder’s equity value that is positive and similar to, or larger than, the value for liabilities. (This is explained more below.)

Debt to equity ratio:

The debt to equity ratio is a simple formula used to quickly evaluate the financial state of a company. Basically, it is just the company’s total liabilities, (or debt), divided by the total stockholder’s equity. Companies saddled with heavy debt are susceptible to trouble if the economy tanks or their business hits rough waters. A ratio of less than 1 is considered a base number for investing, however, some experts like to see the idea ratio for investing at about 0.3. (What this means in simple terms, is that the stockholder’s equity value is larger than the total liabilities value.) A ratio of 2 or more, (or any negative value), is extremely worrisome because the company ownership is severely diluted. Too low of a ratio could mean the company management is too conservative and missing out on more potential growth. Essentially, the more debt per equity, the riskier the investment. 

The importance of the debt to equity value:

If you are looking to invest long term, this value is extremely important to evaluate before investing in the company. If you are simply looking to trade the stock short term, it is not as important, yet it should still not be ignored. Thirdly, if you are trading in the OTC market, this number is likely very high, or negative. As is such, trade with caution, the OTC market is for starter companies with little to no revenue coming in, so in many cases it is normal to see a negative number here. One way to use this number in the OTC is to see the Debt/Equity ratio over time: if it is trending towards positive, then it may be okay to trade. One more caution, however: the OTC is for trading only, DO NOT invest here, you’ll likely become stuck with valueless stock.

Dividends

A dividend is a pre determined cash payment made to all shareholder’s of a company’s stock, and is a company’s way of showing their commitment to increase the value of their shareholder’s investments. It is important to look at how often dividends have been distributed, for how much, (best to look at the dividend amount compared to the total share price, and then convert to a percentage), and which class of share receives them (sometimes dividends are distributed only to a preferred class of shares, other times to preferred and common share owners). It is very important to take into account dividend payments to determine the potential growth and periodic return of one’s investment in any company.

The importance of dividends:

Dividends are something to greatly consider when looking for a long term investment in a NASDAQ or other big market stock, and some company’s pay dividends that greatly increase investment value over time. However, if you are looking for a short term investment, or just to trade, it is totally acceptable to ignore dividend history, as you likely won’t be around long enough to receive one. Similarly, when trading OTC stocks, you can pretty much ignore the possibility of a dividend, as they are extremely rare occurrences. 

Management turnover

This is something that most people tend to ignore when looking for an investment, or trade. However, it can actually be extremely insightful into the stability of the company. A very low management turnover shows the stability of the company, and conversely, numerous upper level management changes is not a good sign. All corporations are required to report management changes with an 8-K form, filed with the SEC, so it is very easy to track management turnover, even if you are a beginner investor.

The importance of evaluating management turnover:

Again, this is something that becomes more important as your length of investment increases. It can be helpful to look into the history of each member of the management board, taking into account their history with other companies. When only trading, especially in the OTC, before buying, look into the history of the current management members, to see if they are prone to drive companies into the ground. Also beware of 8-K forms that are filed, as these can affect stock price.

Share structure

Share structure is a factor you must consider before doing any sort of investing in a company. Since an entire article could be written on share structure alone, I will keep it simple. There are three numbers you should immediately look for in the share structure of a company: The Authorized Shares, the Outstanding Shares, and the Float. The authorized shares are the amount of shares the company is authorized to issue: to increase this number, the company management, or board of directors must vote, and a form 8-K must be filed with the SEC. If a company increases its authorized share count too often, it could be a sign of financial trouble, and is typically not a good sign. Note: authorized share count is not used to determine the market capitalization of the company. The outstanding share count is the amount of shares that have been issued and are outstanding. This is how you determine market capitalization, and is the number you should use to determine the value of the company. Thirdly, the float is the amount of shares that exist in free trading, it’s basically all the outstanding shares that aren’t restricted or owned by insiders. 

You also need to look into how many classes of shares the company has and the rights of each share class, or their attributes. Who owns the shares; important individuals, insiders, or other corporations, is also important. Although there are many different classes of shares a company could hypothetically issue, it is normal to see a preferred class of shares (sometimes preferred class A and preferred class B), and a common class of shares. Almost always, in a case such as that, only the preferred class of shares will have voting rights on company matters. Thus, share classes are used for business purposes: if numerous types of shares exist for a company, without a valid business purpose, it should be seen as a red flag.

The importance of share structure:

Share structure is one of the first things you must consider before investing or trading. When investing long term, be sure to look at the history of authorized and outstanding share increases, too often of an increase is not a good sign. When trading in the OTC, the single most important factor is the outstanding share number. Since dilution is so prevalent in the OTC, be sure it’s not occurring at an alarming rate. An outstanding share count that has doubled in a few months is a tale of what is to come, STAY AWAY. Even if you are only planning on holding a stock for a day or two, be careful to watch for 8-K filings indicating an authorized share increase, typically when that happens there well be a sell off, and price will drop drastically. I will say once more, share structure is VITAL.

Stock price fluctuation

Splits: It is important to look into whether the company you’re thinking of investing in has had stock splits, forward or reverse, or other types of stock manipulations, such as dilution or share class conversions. When it comes to stock splits, you need to determine whether the splits were due to growth or if they were manipulation for pump and dump schemes (usually only seen in the OTC market.) To show a couple examples of this: forward splits are usually seen as a good thing, as when a share price becomes too high, a company may decide to do a split to increase trading liquidity, and to attract more traders with a lower share price. They may split on a 1/3 basis, so that for every one share issued, there will now be three. The other side of this, of course, is a reverse split, and in most cases, these are seen as a bad thing. OTC market stocks are most prone to reverse split, as if the share price becomes too low, or their outstanding share count becomes far too bloated, the company may be forced to reverse in some fashion, such as a 100/1 split, where for every 100 shares, there will now only be one. Be careful of too many splits in a company’s history.

Class Conversions: Another factor that can influence share price is one class of shares converting. Sometimes companies will issue preferred shares to insiders, with a holding period. Once the holding period is over, those insiders may decide to liquidate some or all of their shares, and when this happens, it can dilute the value of common shares, causing a drop in share price—this is seen far more often in OTC stocks, so be careful to watch for insiders unloading their shares, it’s usually not a good sign.

Dilution: This is by far the biggest factor that hurts share price in OTC market stocks. Dilution occurs when company’s issue shares in exchange for a financing. Once a holding period is over, the shares will be converted, and the stock price will suffer. Although dilution can occur in big board stocks, it’s far more common in OTC stocks, and it is the single most important factor to look into before trading the the OTC market.

The importance of evaluating price fluctuations:

As noted above, it is important to investigate the history of share splits before investing long term in a company, but price fluctuations such as reverse splits, dilution, and conversions are more important to note when trading in the OTC. When trading OTC stocks, you need to be certain that dilution or conversions are not occurring currently, and be careful with impending reverse splits. All of those will drive share price down, and you will lose most of the value of your investment. The dilution schedule can usually be estimated by looking into when notes become due, (this is usually six months or a year after the note issuance date). Preferred shares also have a holding period, so you can determine when insiders will be allowed to convert their shares. 

Type of debt

Before investing, it is important to look into the types of debt a company has, and the details of those debts: terms, interest rate, when they are due, current vs long term—all are factors on determining liquidity and financial health. Due to the amount of depth this topic can be taken to, I will leave it as basic as possible for the time being. As was noted in the share price fluctuation section, debt through share issuance is one type of debt of particular importance to trading in the OTC, so be sure to watch out for that type of debt, (many times this is called toxic debt, so watch out for that term). It is also vital to look into the amount of debt a company has, too much debt in a small company with low revenues may be too much to overcome, but large amounts of debt in companies with quickly growing revenues may not be such a problem.

The importance of company debt:

As always, before investing long term, you must take into account all the debt a company has before buying. When trading for the short term, it is safe to look at only short term debt. When trading OTC stocks, short term debt is again what is most important, and I will note again, that it is the toxic debt through dilution that is most important to watch out for. Extreme due diligence is required for making sure dilution is not occurring, so don’t pass over this section lightly if you plan to be successful.

Growth

Company growth is something that can be evaluated based on financials. What you want to look for is increasing revenues, acquisitions of other companies, increases in assets and equity, and higher or steadily increasing profits. How the company has been growing or devolving steadily over the last 5 years is very indicative of the future, and is a sufficient timeline to evaluate whether it is a good investment or not. Steady growth is a good sign of a healthy company, whereas slowing growth or regressing is a sign of a company struggling, or heading towards stormy waters.

The importance of growth:

Growth is most important to take into account when you’re looking for a long term investment. Investing long term with success requires choosing only companies that have a long history of steady growth, so be sure to choose wisely. When it comes to trading in the OTC, most companies don’t have a long enough history to look very far back, so it is best to look back through the quarterly financial statements, and look to see if the company’s revenues are increasing by quarter. Also, be careful to make sure that the company isn’t experiencing increasing costs of revenues at a higher rate than the increased revenues, as this means they’re adding to their operating deficits, which is not a good sign.

Profitability and revenue

When investing, or trading, you want to make sure the company is profitable and has steady or increasing yearly revenues. You also want to consider if the company has had positive and consistent net income. Typically, you want to look at the past 3 years at a minimum. If a company has a growing profit margin, this is usually a sign of a well managed company. Growing revenues are key, you do not want to see a company who has slowing or decreasing revenues, this may mean other market competitors are taking more control, or the company may be having financial issues. Also be sure that costs of revenues or expenses are not increasing faster than revenues, that’s a sign of trouble. Again, since profitability could consist of an entire article, I’ll keep it to that: look for steady or increasing profits and revenues. It would be a smart idea as a new investor to understand this concept more, and look into the different Profitability Ratios, such as return on equity, discussed earlier.

The importance of profitability and revenue:

When choosing a long term investment, this is one of the most important factors to consider. You want to make sure you investment will succeed long term, and there is no better place to ensure that than with a company with increasing revenue and profit. When looking for a short term trade, or when trading the OTC market, make sure the company has at least some revenue, and make sure that revenue is at least steady. If it is decreasing, stay away, it’s as simple as that. In the OTC, it is common to see companies that are not profiting; since you should only be short term trading in the OTC, just make sure that their operating deficit and lack of profit is not so high that even holding a day or two could be detrimental to your money. Again, this topic requires more research than is explained here, but I’ll keep it to that for now. 

Accounts receivable and payable

This is something that is rarely given too much attention, so I’ll just make a quick comment on the basics. If the accounts receivable is increasing, and some accounts are growing older, it could be concerning for the company, as it may not be collecting its receivables. This trend could not be sustained be for an extended period of time: also look at the percentage of bad debts. 

On the flip side, if the accounts payable is growing and getting older it could be a sign of a lack of liquidity and could have grave consequences, the suppliers of financing or goods may stop delivery, etc, and the related interest expense to the company could start to capitalize.

The importance of AR and AP:

As noted, this is a lesser looked at aspect of company finances. Take a look at this closely if planning on investing in a company long term. If only planning to trade, it would be okay to focus more on other aspects of the financials.

Retained earnings (or accumulated deficit)

Retained earnings are the money a company has saved over the years. It is essentially the portion of net income, or profit, retained every year after dividend payments. You want to look closely at this, because some companies deal with retained earnings differently. Some reinvest the money back into the company with acquisitions or other purchases, some will distribute some of the retained earnings back to the shareholders through increased dividends, and others will simply keep the profit on the books. The best companies tend to do a combination of these things. Look into if the RE has steadily increased over the years: steady growth is a good sign. But also look at it in conjunction with the dividends pay-out, as it could be the board of directors has been distributing profits primarily back to shareholders. This may limit how the money is reinvested, but may not be a bad sign for investments. Also, as noted before, remember to look at what class of shares has been receiving the dividends.

The flip side of retained earnings is an accumulated deficit. This occurs when a company is not making enough money to cover all expenses. If this continues over a long period of time, being able to continue as an operating company will become a going concern, as they will likely need restructuring, or they will eventually go bankrupt. (You will see a going concern section, or disclaimer, in most financial filings of OTC companies, as most have accumulated a deficit.)

The importance of retained earnings:

Retained earnings are of particular importance when finding a company to invest long term in. This is again related to growth, as for your investment to grow, retained earnings for the company will need to grow as well. When it comes to trading in the OTC, it is unlikely the company will have any retained earnings at all. What you need to watch out for is the accumulated deficit. If this number is steadily growing larger at an alarming rate, best to steer clear. If the deficit is shrinking, or staying close to the same, it is likely safer to trade.

Auditors report

One more thing to note about financials before investing in or trading a stock is the auditor’s report. It is basically a formal report, or disclaimer, written by an internal auditor, or an independent external auditor as a result of an internal or external audit of a company’s financials. The auditor’s report is very important in ascertaining if the company's financials are accurate and dependable. These auditor’s reports can usually be found within the financial statements, and there are a few different types of auditor’s reports. A financial statement without an accompanying auditor’s report is not nearly as insightful, as it cannot be stated with certainty that all the information included is correct.

The importance of the auditor’s report:

Auditor’s reports are very useful when looking for long term investments and also for trades, as they confirm that the financials are accurate and won’t be up for dispute. When trading OTC stocks, many times the company financials may be questioned, so look closely to make sure the auditor’s report is positively stated and present within the financial statements.

Factors extraneous to financial statements:

The last thing I will mention here isn’t as closely related to financial statements as everything above, but is vital nonetheless. Factors extraneous to financials, such as the public opinion of a stock, news rumors, or actual mergers, acquisitions, or consolidations, can greatly affect the stock price. It is crucial to look into all rumors and news, as well as taking into account public opinion of a company before investing in it.

The importance of extraneous factors:

This is something that needs to be taken into account for all types of investing and trading alike. However, I will note that this is something that can have an even larger influence on OTC stocks as compared to others. Many times, because OTC stocks have such a small share price, they are more prone to have large price fluctuations that can be greatly influenced by news rumors. Before trading an OTC stock, make sure to carefully look into rumors, and determine whether the stock’s price has taken into account the rumor or not. Not doing so can have dire consequences, so make sure to be VERY careful with this.

So, what should you take from all of this? 

It should be fairly clear by now, that to invest efficiently and profitably, an incredible amount of research is required, and shortcuts should not be taken. Since every investor trades differently, determining which parts of the financials to weigh more heavily in importance will be something that defines you as an investor and trader. The more time you spend researching company financials before investing, the better, and as you gain experience as an investor, it will become easier to make your decisions, and you will be able to do so faster. Yet, the financials will never lose their importance. 

Whether you plan to invest primarily long term, or whether you plan on trading OTC market stocks on a daily basis, the importance of financials will not change. Hopefully, this short summary of some of the most important pieces to company financials will provide a base as to where to start researching. Good luck!

Credit - Written for CHEDSBLOG by Nate Smith, December 10 2015

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