How to analyse a stock?

Let us discuss this again with a few analogies and examples. Suppose you have a sister at home, and your parents want to search for an appropriate life partner for her. What are the things which you would be keeping in mind while taking up this task? When you look for a groom, you define a certain criteria for it. These criterias are based on your family, the bride to be and other priorities in life. Correct? and you evaluate the person on the basis of those criteria,  to see whether the chosen man is good for your sister or not. For stock selection and investing also, we need to decide on certain criterias. If those criterias are fulfilled, then we consider it for investment. 

When we look for a life partner, we look and we want to know certain things about him.

Things like his current financial condition, and what he earns and how much he can earn in the future. It's a simple thought. Now, if we apply the same things to a company, the thought process of evaluating a company becomes very simple.

To evaluate a company, we have to 1st evaluate its three financial statements. 

• Balance Sheet
• Profit and Loss account 
• Cash Flow Statement

What is a balance sheet and what does it depict?

A balance sheet will tell us the current situation or the financial health of the Life Partner you want to choose. 

What are his assets? Does he have a house to live in? Or the appropriate amount of money? What are his liabilities? Which assets does he own on EMI? What are the future liabilities if he starts a business? You will require a complete picture of his assets and liabilities to find out his current financial situation.

The same concept, the balance sheet helps us find out the current situation or the financial health of the company. The picture of assets and liabilities in the company will tell you about what amount of money the shareholders will get, if the company decides to liquidate. 

This is also called the book value of the company. 

What is a profit and loss account and what does it depict?

The Profit and loss statement answers some very important questions for an investor, when considered for investment. How much business is the company doing today? What is the cost of doing the business, and how much the company is earning from doing the business. 

The P&L statement objectively gives us crisp information on:

• The revenue of the company for the given period (yearly or quarterly),
• The expenses incurred to generate the revenues,
• Taxes,
• The final earnings.

It helps a businessman to evaluate the performance of a company and provides a basis for forecasting future performance. The Profit & Loss account throws light on various business activities such as revenues and expenses, which is insightful in assessing the probability of a certain level of income in the near future. 

When we compare it to our analogy of finding a suitable groom, you need to know what is the boy earning today, whether in salary or a business, and what does he save?

What is the actual income?

Earnings are an important criteria which everyone has to evaluate.

What is a cash flow statement and what does it depict?

Apart from the earning, or salary of the boy, the question arises as to how much cash is he bringing home? This means that the profit and loss statement shows us the earnings the company is making during a particular period but when we see the cash flow statement, we understand whether the company is earning via selling on credit or not, how much payment is outstanding? What is the net cash in hand which the company has, at its disposal. These pointers are reflected by the cash flow statement.

To evaluate the financial health and the performance of the company, these three financial statements are extremely important. It tells us about the current financial situation.

Importance of Management 

Another important aspect to be seen is knowing the future earning potential of the company. The management of the company tells us about how good the future outlook of the company is. How do they see the business outlook and performance of the company in the coming days? What may be the challenges? And what are the growth prospects of the company? 

Today you can estimate that everything is going well, but periodically, you have to meet and ask the company management if everything is going well or not. This happens when the quarterly results are released, the company declares results every 3 months,the company, along with its results, tells us about its current situation, about what's going on now, and what does the future hold.