Investing in stocks can result in financial freedom through the consistent inflow of dividend income. However, before making any investment decision, there are some fundamental financial concepts you should know to make huge gains. Moreover, these are vital principles that pro investors contemplate before betting on their best stock.
So, without further ado, let’s get started.
The Three Statement Trio
Financial statements let you decide whether or not a company is a better choice for investment purposes. Before spending a single dime on stocks, it’s beneficial to analyze the company’s financial statements in which you aspire to invest. Since the company is listed on a stock exchange, the law binds the management to get their financial statements audited by an audit firm, ensuring there is no space for any errors.
Following are the three primary financial statements that you need to inspect before spending your hard-earned money:
- Statement of Financial Position, aka Balance Sheet
- Statement of Comprehensive Income, aka Profit and Loss Account
- Cashflow Statement
Let’s learn what financial concepts these statements have to offer one by one.
Statement of Financial Position (SOFP)
An SOFP tells you the current position of a company’s assets and liabilities. In any given circumstances, the asset side of SOFP has to be congruent with the summation of equity and liabilities.
Assets = Liabilities + Equity
SOFP proves resourceful because it lets you make an informed decision on whether or not the company has sufficient assets to meet its liabilities. It compels you to know if the company has taken significant loans to fund its operations. You can check if the company has creditors to pay off or receive an amount due from debtors against sales at the year-end.
It’s a statement showing the company’s accumulated assets and liabilities as of the current year-end. This is generally described as: “SOFP as of 31 December 2022.” This line on top of SOFP represents that this statement is not for a particular year, but accumulated company results right from its incorporation year.
This statement proves handy, but to fully unleash your decision-making power and dominate the stock world, you must also assess the other two statements.
Statement of Comprehensive Income (SOCI)
The financial term “SOCI for the year ended 2022” differentiates it from SOFP. Unlike SOFP, SOCI reflects a company’s results for a particular year. The financial concepts in SOCI dictate to show whether or not the company is profitable for the year. If it’s not, the management will reflect loss for the year instead of profit.
It lets you make an entire decision if the company is worthy of your investment. But, it’s not like you cannot invest merely based on the current year status of the company. You need to view the historical data and check if the company was profitable in prior years. You can still invest in that company’s stock even if it reflects a loss this year.
There are several other factors involved in making that critical investment decision. Perhaps, the business is at a loss during the current year. This might be your chance to invest in that business because its stock price might be at its bottom, which can grow exponentially in the coming years. Holding the stock makes you eligible to withdraw dividend income and sell it at a high price later when the share price stabilizes.
Cashflow Statement (CFS)
As seen in the name of this statement, it shows the cash flow during the year. A mere glance at the CFS will tell you how the business has spent its money during the year. It is the movement of cash during the year. It has three sections:
- Cash flows from operating activities
- Cash flows from investing activities
- Cash flows from financing activities
A company’s operating activities are the primary activities through which it generates its income. Investing activities reflect the investments made by the company during the year, and financing activities reveal if the company has obtained a loan and how much it has paid back during the year.
The investing section of the statement is crucial because it manifests the management’s intentions. If the company is spending cash on some project, it will be shown in this section, based on which you can anticipate if the company will be significant in the coming years. If capital expenditure is being made, it’s a clear sign that the company is up to something.
#Bonus Strategy
There is also another financial concept, aka bonus step, that pros undertake before deciding to invest. Remember the listed companies are legally bound to get their financial statements audited?
This is the point where pros differentiate themselves from noobs. The auditor issues an audit report when the company’s financials are audited. Reading that report can make your investment decision ten times better.
The auditors will state facts in their report if there’s a potential threat to the company’s existence. Perhaps, the company’s manufacturing plant caught fire during the year, and it is now reluctant to meet its commitments. This information might not be evident from financial statements, but when you read the audit report, you will find it there.
Conclusion
Practicing these financial concepts before purchasing stocks can increase your chances of becoming profitable. The key is to analyze all three financial statements first. Then make your analysis better by scrutinizing the audit report for any critical information that can grow or hamper a company. Implementing these little-known tactics before purchasing shares on a trading platform is the secret of any successful investor. Since now you know them, you too will become a better investor.