How to Perform Financial Statement Analysis to Identify Great Stocks

Financial statement analysis is essential in selecting the best stocks, as it provides insights into a company's financial health, profitability, and growth potential. This article outlines a comprehensive approach to financial statement analysis, utilizing key metrics and Financial Modeling Prep (FMP) API endpoints to access valuable data.

Understanding the Basics of Financial Statement Analysis

Financial statement analysis involves reviewing and interpreting financial reports to evaluate a company's overall performance. There are three primary financial statements:

- Income Statement. Shows revenue, expenses, and profit over a period.

- Balance Sheet. Reflects assets, liabilities, and equity at a specific date.

- Cash Flow Statement. Details cash inflows and outflows, focusing on operating, investing, and financing activities.

Each statement provides different insights, and a well-rounded analysis requires examining all three.

1. Setting Up Your Financial Analysis Framework

To get started with analyzing stocks, follow these steps:

- Select a Sector or Industry. Narrowing down sectors helps identify industry-specific growth and value metrics.

- List Target Companies. Choose companies based on stock types. For example, defensive stocks do not depend on economic cycles. Cyclical stocks rise faster when the economy is booming. Income stocks generate a stream of income as they pay dividends. If you expect the economy to boom, choose cyclical stocks. If you expect the stock market to take a flat trajectory, choose defensive stocks. For detailed stock types read the article on “what stocks should you buy”

Use the FMP Symbol List API endpoint to fetch a comprehensive list of stocks with details like symbol, name, and exchange.

2. Analyzing Profitability Ratios

Profitability ratios reveal how well a company generates profit from its revenue. Calculated from the Income statement (if you want to calculate manually or use FMP endpoint, listed below). Essential ratios include:

- Gross Profit Margin. Indicates the percentage of revenue left after covering the cost of goods sold.

- Operating Margin. Shows operating income as a percentage of revenue, reflecting efficiency.

- Net Profit Margin. Shows net income as a percentage of revenue, indicating the overall profitability. This margins should be compared to company closest peers using the Stock Peers API endpoint. Margins should be stable and should not be very volatile. And they should be higher than of closest peers. Now lets talk about how to extract those ratios.

Using FMP for Profitability Ratios

To obtain profitability ratios, use the Ratios API endpoint. This endpoint returns data for key ratios, including gross profit margin, operating margin, and net profit margin.

3. Evaluating Liquidity and Solvency Ratios

Liquidity and solvency ratios help assess a company's financial stability, particularly its ability to meet short-term and long-term obligations. Calculated from the Balance sheet statement (if you want to calculate manually or use FMP endpoint, listed below).

- Current Ratio. Measures current assets relative to current liabilities, indicating liquidity. A ratio above 1 is generally considered good as it means the company has enough current assets to cover its short-term liabilities. A higher current ratio suggests better liquidity, but an excessively high ratio may indicate that the company is not effectively using its assets.

- Quick Ratio. Similar to the current ratio but excludes inventory, offering a more stringent liquidity measure. A quick ratio above 1 is also seen as favorable, indicating that the company has sufficient liquid assets to meet its short-term obligations without relying on inventory sales. This is particularly important for companies with slow-moving inventory, as it highlights financial resilience.

- Debt-to-Equity Ratio. Compares total debt to shareholders' equity, reflecting financial leverage. A debt-to-equity ratio above 1 indicates the company has more debt than equity, which can imply higher risk but may also signify aggressive growth financed by debt. Typically, a lower debt-to-equity ratio is considered more stable.

Using FMP for Liquidity Ratios

Retrieve these ratios using the Ratios API endpoint.

4. Growth Analysis.

Growth analysis is critical for evaluating a company's potential. Key growth metrics include:

- Revenue Growth. Measures the annual growth in revenue, highlighting demand for the company's products or services.

- Earnings Growth. Indicates annual growth in net income, reflecting improved profitability.

- Dividend Growth. Shows the growth of dividend payments, indicating stability and shareholder value. Compare this data to the company's closest peers to find the company with the highest growth. The higher the growth, the better it is for the future stock price because it creates a higher probability that investment analysts will increase stock target prices. Now lets see how to access this data.

Using FMP for Growth Data.

To assess growth, you can use the Financial Growth API endpoint

5. Assessing Valuation Ratios

Valuation ratios indicate whether a stock is undervalued or overvalued relative to its earnings, book value, and cash flow. These are some of the basic ratios:

- Price-to-Earnings (P/E) Ratio: Shows how much investors pay for each dollar of earnings.

- Price-to-Book (P/B) Ratio: Compares the market value to the book value of the company.

- Price-to-Sales (P/S) Ratio: Measures stock price relative to revenue per share.

If you are interested in calculating stock target price based on valuation ratios, you can read the article on “How to Calculate Fair Value of a Stock with the Price-Income Model”. And please don't rely heavily on basic ratios when analyzing your selected company. I've written a detailed guidance on how to use valuation ratios correctly.

Using FMP for Valuation Ratios

For accessing those ratios you can use the Ratios API endpoint.

6. Cash Flow Analysis

Cash flow analysis assesses how well a company generates cash from operations and manages its cash across investing and financing activities. This data can be found in the Cash Flow Statement.

- Operating Cash Flow. Cash generated from core business operations. Positive operating cash flow is a sign of a healthy business. Consistent growth in OCF suggests the company's operations are profitable and generating enough cash to cover operating expenses and other obligations. A declining or negative OCF may indicate operational inefficiencies or declining demand, which could lead to liquidity issues.

- Investing Cash Flow. Investing cash flow represents the cash used or generated by a company's investing activities, such as purchasing equipment, acquiring other businesses, or selling long-term assets. Negative investing cash flow is typical for growing companies as they reinvest in their business. However, persistent negative cash flow from investing without growth in operating cash flow could be concerning. Positive cash flow from investing may indicate asset sales, which can be favorable or unfavorable, depending on the context (e.g., selling assets to cover debts is often a red flag).

- Financing Cash Flow. Financing cash flow includes cash transactions related to debt, equity, and dividends. It reflects a company's financing activities, such as issuing or repurchasing stock, taking on or repaying debt, and distributing dividends. Positive financing cash flow typically suggests that the company is raising capital through debt or equity issuance. Negative financing cash flow often indicates repayment of debt or payment of dividends. While paying dividends is a positive sign, a company heavily relying on debt for financing may be over-leveraged, which could lead to riskier financial positioning.

- Free Cash Flow. Free cash flow is the cash available after deducting capital expenditures (CapEx) from operating cash flow. It represents the cash that a company can use to pay dividends, reduce debt, or reinvest in growth opportunities. Positive free cash flow is a strong indicator of financial flexibility. High and stable FCF enables a company to pursue growth, pay down debt, and distribute dividends to shareholders. Conversely, consistently negative FCF may suggest that a company is heavily investing or struggling to generate enough cash after covering essential costs. FCF directly affects company valuations. A steadily growing cash flow may result in a consistently improving stock target price.

Using FMP for Cash Flow Data

Use the Cashflow Growth API endpoint to see how company cash flow is changing over time specified.

7. Making an Investment Decision

Once you've gathered data and performed comparative analysis (with closest company peers), it's time to decide if the stock is worth investing in. Look for:

- Consistency in Growth: Strong and steady revenue, earnings, and cash flow growth.

- Financial Health: Low debt, high liquidity, and solid cash reserves.

- Attractive Valuation: Favorable P/E, P/B, and P/S ratios compared to industry peers.

Financial statement analysis provides a thorough understanding of a company's financial position and growth prospects, allowing investors to make more informed decisions. With Financial Modeling Prep's API, you can seamlessly access the data needed to perform robust stock analysis and potentially identify excellent investment opportunities.