Should you read a balance sheet?
For many people it is about how much they or somebody else likes the company, about the great gadgets the company sells, or how popular the company is with friends.
But there is an important side to this. Just like if you really like a design of a car, you should look into the engine before buying. It is similar with companies..
To illustrate what this engine is about — let me first tell you a story about the first stock I ever bought.
I saw a TV report about this cool green tech company about two decades ago. It was in the middle of some oil crisis and the company was promising a magic product — they will make oil from light using some special cloned algae.
I suddenly believed this was the thing the world needed. There was so much demand for oil and there were difficulties buying it combined with decreasing reserves — a clear ‘investor’ situation. I was sure to reap a fairy-tale profits.
I was thrilled when I found the company trading in a broker’s app. I bought into it. I did not look up the company, and I did not bother to read their balance sheet either. I just bought.
For a while it did quite ok, but then the stock started to fall sharply. I tried to read the news, but they just said the company needed more money to build their product. So I bought a bit more, this time a bit weary. The company held for a while and then the price dropped completely. It think it is not listed in the exchange anymore.
Just a bit later I found out that the company was actually not making much money and spending through all the cash they had.
Had I read their balance sheet, and understood it, I could have saved myself this trouble and invested in something that would actually make money. I would have found out that the revenues of the company were too low to support the market value, there was very little growth in revenues to expect the value to increase soon and most importantly the company could not support itself from the money it was making, by burning through its cash it would soon get into trouble.
My point is — read and get an idea of the balance sheet. It is like the health of a company, it does not tell the whole story, but it says something about how likely is the company to hang on there and possibly thrive.
So why are you buying a company share? — Most probably it is for the opportunity to increase your wealth and gain income from dividends.
Which companies pay dividends? Usually those that make revenue, pay all the costs to produce products, pay operating costs, pay other costs they have and still have some leftover cash to distribute to shareholders.
Where can you find out how much money did the company make and how much cost it had to pay in order to produce the revenue? — yes, in the financials of the company (balance sheets, income, cash flow statements..).
Which companies increase in value, i.e. have the price of their stock increased? This is a bit more complicated, but you will sleep better, if the company has finances in good order, even if you just expect to flip the company to someone who will just pay more. Companies with better financials have better chances to stay longer in business and grow.
Let’s go through an examples.
First, let’s take the marvel of today’s stock market — Amazon.
We can see the revenue growing nice for past over 10 years:
On top of this the company is generating cash:
You can see operating the cash flow growing extremely well. Around $20 billion in free cash flow for 2019 and positive net change in cash.
This means that the company has money leftover after subtracting direct costs of what it sold, also its operating costs, and also other costs like investments, interests etc.
What is nice, the company has cash leftover to pay for its own investments:
If we have a look at the balance sheet, the company seems to have a healthy position with just about $23 billion in long term debt, which is not much compared to its revenues.
With such amazing numbers, no wonder Amazon stock is growing fast.
As you can see even a basic analysis of a balance sheet and cash flow can give you an overview of how well the company’s engine is humming. Financials are the engine of every company and the better they look the more power the company has to grow.
However, before investing your real money, I recommend to look deeper into financials, and read annual reports and other information as well.
At bullandbearlist.com we build tools for regular people to search for such high potential companies. Please note that all investments entail risk and these are just my opinions, not a professional financial advice. I am not a professional financial advisor. I may or may not hold positions in mentioned companies.