Stock Market Definition
The stock market is the market where financial instruments such as stocks, bonds, or other securities are issued, bought and sold. As a result of the different securities available in the stock market, stock market provides you opportunity to guide against risks through the allocation of your funds across different securities. Before you continue reading this article, let me quickly clarify some terms. In case you come across the words “equity market” in this article or elsewhere, it is the same thing as stock market. The two words can be used interchangeably. The activities involving buying and selling of stocks in the stock market is referred to as stock trading. Just like any other market, there should be people who are willing to sell before buyers can find something to buy. The interaction between sellers and buyers is what set the tune for the market forces. When sellers are more than buyers, price ends to go downward and when people who are willing to buy are more than sellers, prices go up. This is just the law of demand and supply in any free market. For the purpose of beginners who may know little or nothing about stock market, I will try as much as possible to simply everything. That is why I will like to explains some basics in this article.
Stock Exchange Definition
As a beginner investor, I know one of the questions you may like to ask is “what is the difference between stock market and stock exchange?” Well, the two terms seem the same; they are quite different. Instead of giving you an academic definition of stock exchange, let me try to be more practical in my approach. I believe you understand that a market is where things can be sold and bought. So let’s assume that you just bought a new washing machine for your wife. Now you want to share the good news with your wife. You will probably say; “My dear, see the new washing machine I bought for you”. Your wife will be happy of course. Later, your wife may want to ask you more information about the machine. Supposing she asks you, “where did you buy the machine?” And you responded, “I bought it from the market”. Well, you are right but she wants you to be more specific by mentioning where exactly you bought the market from. This is just the analogy about the relationship between stock market and stock exchange. Stock market can be referred to as a place where stocks, bonds, or other securities are issued, bought and sold. Stock exchange on the other hand can be defined as an organization or institution that provides a medium for the buying and selling of stocks, bonds, or other securities. If you say that you bought shares from the stock market; that will too vague and general. But if you say that you bought stocks from New York Stock Exchange for instance, that is more specific Therefore, stock exchange can be said to be more specific about where exactly securities are traded. There are many stock exchanges around the world where investors can buy and sell stocks, bonds and other derivatives. Below is the list of some of the stock exchanges around the world.
- New York Stock Exchange
- London Stock Exchange
- Tokyo Stock Exchange
- Shanghai Stock Exchange
- Honk Kong Stock Exchange
- Toronto Stock Exchange
- Shenzhen Stock Exchange
- Frankfurt Stock Exchange
- Bombay Stock Exchange
- National Stock Exchange
What are Stocks?
I will explain this in a layman language. I want to believe that you are reading this article because you are interested or planning to buy stocks. If this is true, we can then ask the same question in a different way. What does it mean to buy stocks? When you buy a stock, you are simply buying into the ownership of a company. The number of stocks you buy determines your share in the ownership of the company. That is why stocks can be referred to as “shares”. Essentially, companies sell their shares in order to raise capital. This type of capital is called equity capital. If you want to be a part owner of a company, this can be achieved by buying the shares of the company. The more shares of any company you buy, the more your claims on the assets and earnings of the company. For instance, if a company has issued capital of 500,000 shares and you buy 50,000 shares of the company, this will give you rights to 10% of the assets and earnings of the company. Supposing you buy additional 50,000 shares of the same company, this will increase your shareholding to 100,000 shares. This will automatically increase your ownership to 20% supposing the total number of the outstanding shares remains at 500,000 units. I don’t want you to get confused. You may want to know how you can increase your shareholdings from 50,000 units to 100,000 units if the company does not issue additional new shares. It is possible. In stock market, you will find different categories of people. You will find people who want to sell and people who want to buy. Some people may not be interested in buying or selling. They are simply holding on to what they have already bought, waiting for the right time for them to sell. So, you can increase the number of your shares by buying from other investors that want to sell. However, stock investing is not without risks. The same way the shares you buy in a company gives you rights to lay claims on the assets and earnings of the company, you can lose the money you invested if the company fails. That is why it is important that you ensure that you only invest in a company that you believe will be profitable.
How do you make money in the stock market?
Anybody that engages in a business will definitely have a profit motive. Stock market is actually a good platform for wealth creation. But it is not automatic that everyone that invests in stocks will profit from it. If you want to make money investing from the stock market, you can achieve this through the following:
- Dividends: If you invest in a company and the company makes good profits, it can decide to distribute part of the profits to its shareholders. The dividends you receive serve as income to you. You can decide to use the dividends to meet your expenses. On the other hand, you can choose to reinvest the dividends to buy more stocks. Remember that the number of stocks you own in the company will determine the proportion of the profits that will be distributed to you. For some retirees who may not have other sources of income, they usually like investing in companies that pay dividends.
- Capital appreciation: Another way you can make money from stock market is through capital appreciation. This happens when the price of the stocks you buy increases. That is, you buy at low price and then sell the stocks when its price has increased.
- Bonus issue: I believe you are familiar with the word “bonus”. If you buy something and the seller decides to give you free item which you don’t need to pay for, you simply get bonus. It works the same way in the stock market. When you buy stocks from a company, the company may decide to issue free stocks to its shareholders instead of distributing dividends to them. The bonus shares are usually in proportion to the shareholders’ current holdings in the company. For example, a company may issue bonus share of one for five. This means that for every five shares a shareholder owns, he will get additional one. For someone having 5,000 shares, he will be entitled to additional 1,000 units of shares. This will increase his total shareholding in the company to 6,000 shares. Companies issue bonus shares for different reasons. It may be that the company doesn’t have enough cash to pay as dividends or it has capital projects to finance. So instead of the company to pay dividends and then start looking for ways of raising fresh funds to finance the project, it may decide to reward its shareholders by issuing bonus shares to them.
Stock Market Players
There are principally four categories of players in the stock market. Understanding who these players are and the roles they play may help you have confidence in stock trading. The reason I want to discuss this is to clear the doubt that some people have about stock market. They believe that stock market is just for certain people or that the activities of the market can be easily manipulated to the benefits of some few ones. Below are the main players in the stock market
- Regulatory authority: The activities in the stock market are highly regulated. The body responsible for the regulation of the stock market is Securities and Exchange Commission(SEC) Securities and Exchange Commission ensures that the interests of investors in stocks are protected. There are laws governing the listing of stocks which all the companies that want to list their stocks must comply with. This includes the filing of their reports. Securities and Exchange Commission is empowered by the Federal Securities Laws to suspend trading in any stock for up to ten trading days when the SEC determines that a trading suspension is required in the public interest and for the protection of investors. Specifically, SEC may suspend trading in a stock for the following reasons:
- A lack of current, accurate, or adequate information about the company, for example, when a company is not current in its filings of periodic reports;
- Questions about the accuracy of publicly available information, including in company press releases and reports, about the company’s current operational status, financial condition, or business transactions;
- Questions about trading in the stock, including trading by insiders, potential market manipulation, and the ability to clear and settle transactions in the stock. Therefore, investors can be confident that any stocks listed in the stock markets are genuine and the company involved has met the requirements stipulated by the laws. SEC also promotes the development of the stock market.
- Companies issuing shares: Without companies whose stocks will be traded, stock market will just be like an investors’ forum for debates and exchange of ideas. For stock trading to take place, there must be companies whose shares will be listed in the stock market. The size of a company and the amount of money the company plans to raise will determine the number of its shares that will be made available to the public. You need to understand that when a company is coming to the stock market for the first time, its shares are sold in the primary market. This will be done through the Initial Private Offer (IPO). In most cases, it is the institutional investors such as banks, insurance companies and pension funds that buy the larger part of the shares at this stage. The portion that is usually released to the individual investors to buy is not that significant. The essence of Initial Private Offer is for the issuing company to raise funds to finance its expansions, investment in research or working capital. The company through the advice of the investment banks determines the price at which its shares will be sold during the Initial Private Offer. However, once the stocks are listed in the secondary market, the stocks will be available to all classes of investors whether institutional investors or individual investors. At this point, the price of the stock will no longer be determined by the company. The stock price will be influenced by the force of demand and supply, the performance of the company and the available information about the company among other factors. Another distinguishing feature between when shares are sold at the primary market and when sold at the secondary market, is that the proceeds from the sales of stocks sold in the secondary market do not go to the issuing company. The proceeds go to the investors making the sales. If the company wants to raise additional funds, it will need to issue fresh shares for sale.
- Stockbrokers: The only people authorised by law to trade stocks directly in the stock market are stock brokers. Before a person can become a stock broker, he must have passed all his stockbroking professional examinations and has to be licensed to practice. In order for stockbroking firms to conduct trades in the stock market; they must do it through licensed stockbrokers. Stock brokers can buy and sell stocks for investors or for themselves to make profits. In summary, stockbrokers act as intermediaries between the stock exchange and investors or traders. Besides stockbrokers, there are other professionals who plays advisory roles to investors. These include financial planners and financial advisers. But these people don’t trade on the floor of the stock exchange except they double as stockbrokers.
- Traders and Investors: These are people that invest in stock market for money making opportunities and/or as an avenue to grow their wealth. There are individual investors and institutional investors such as banks, insurance companies, mutual funds and pension funds. Individual investors or institutional investors can be stock traders or investors. The two terms may look the same to beginner investors but they are quite different. Let me explain the difference briefly. When a stock trader buys shares, he is just waiting for a quick opportunity to sell the stocks so that he can make his profits. Stock traders may hold stocks for short or medium terms but they never intend to hold stocks for a long period. They need to continuously monitor the market. If they miss the right time, that may result to a loss. If stock traders buy a particular stock and its price does not increase as expected, they don’t mind selling it even at a loss. They can do this in order to take advantage of other stocks that are relatively cheap so that they can quickly sell and realise gains when the prices increase. On the other hand, investors have long term perspective. They don’t just buy stocks, they buy into the company. Therefore, before they buy any stocks, they ensure that company has good fundamentals. They invest in stocks of companies that have potential to generate massive earnings. Even, if the price of the stocks falls, they have a belief that the price will still bounce back. While it may seems that stock traders makes quick gains on their investments, the fees they pay each time they buy and sell stocks tend to reduce the gains. Therefore, stock investors can be described as patient dogs that eat the fattest bones. Over time, stock investors are able to enhance their gains by reinvesting their dividends to buy more stocks thereby making compound interest work to their advantage.
How to buy stocks
I know this is the part that will interest most of the readers of this article. I have my reason why I didn’t start with it. If I had started telling you about how to invest in stock, probably, you must have missed some points. Nevertheless, I need to tell you that there is more to stocks investing than buying and selling stocks. The points I will raise under this section may not be comprehensive. It is just to give you a tip. I believe that if you are armed with relevant information about how stock market operates; you won’t find it difficult knowing how you can buy stocks. After this section, you will still find a lot of useful resources underneath. Therefore, it will be good if you can read the entire article.
How can you buy stocks? The process is simple. The difficult aspect there is how to know which stocks to buy. Let’s continue.
Open an account: If you want to trade in the stock market, the starting point is for you to open a brokerage account. You can do this by either walking into a stockbroking firm or you open an online brokerage account. For beginners, it is actually good to choose a stockbroker you can relate with physically. He will be able to guide you and provide you with useful information that can help you invest in right stocks. If you think you are comfortable with online brokerage account, there are lots of online brokerage firms around. The popular ones are Ameritrade, E*Trade and Merrill Edge among others. Some of the advantages of online brokerage account are access to research, real time online trading platform, margin account and access to international stocks. You should ascertain that your choice brokerage firm will provide you the features you desire. Other critical factors you need to consider before you chose a brokerage firm are the fees you may be asked to pay and the account opening restriction. Some firms will require that you open your account with a certain minimum amount. To open a brokerage account, you will need to provide your basic personal information (such as name, address and telephone number), your Social Security number, Signature card, W-9 form, forms of identification and your initial deposit.
Read Also: How to Choose a Right Stock Broker
It is important that you don’t use all your money as deposit for the purpose of investing in stock market. You need to set enough money aside as emergency fund. This fund will be your nest net in time of emergency. Situations may arise when you will need to spend money you did not plan for. Such spending may be unexpected medical bills, pet medical care, car repairs, burial expenses or unplanned trip. If you don’t have enough funds set aside for these purposes, you may end up selling off your investment at the wrong time. This may result to a loss. It is actually risky to invest all your money in the stock market. It is usually advised that you have money that will cover at least your six months expenses in your emergency fund. In addition, if you have debts, it will be better to them off first. If you can’t wait till the time you have finished paying off your debts before you start investing in the stock market, you should at least pay off the debts with high interest rates.
Define your investment goals: You should have goals for investing in stock market. Your reasons may be to save towards your retirement, plan to buy a house, save for children school fees, start a business, plan for wedding or to buy a car. It is better to document your goals. Having your goals documented makes it more real to you. It will give you a sense of responsibility. You will also be able to measure your actual performance against the written goals.
Buy right stock: If you have ever been to the market where they sell clothes, you will agree with me that one can easily get confused of the one to buy except you have already made up your mind about what you are going to the market to buy. The same thing applies to stock market. There are many types of stocks in the stock market. You need to understand that stocks are not the same. The earlier you understand this, the better. That is one of the reasons you need to have a clear investment goal. Your investment goal will guide you on the type of stocks that is right for you. Stocks can be categorised based on ownership, risks, market capitalization, dividend payments, fundamental and price trends. Regardless of how stocks are classified, you may find one particular stock appearing under two or three categories. That is why I will choose to explain the types of stocks listed below without grouping them.
Read Also: When is the right time to buy stocks?
- Common Stocks: When people say that they buy stocks from the stock market, they may be referring to common stocks. This type of stocks gives you rights to the ownership of the company. If you buy common stocks, you will enjoy a share of the profits of the company. You also have voting rights when it comes to decision making on vital issues such as declaration of dividends, appointment of directors and appointment of company’s auditors. Common stocks carry the highest risks too. The shareholders will only be paid dividends if the company makes enough profits. If the company fails, the shareholders may lose all their investments. The stocks rank last in case of company’s liquidation. If you want to reduce your risk, you can achieve this by investing in different companies possibly within different industry. You should also ensure that you invest in companies with strong fundamentals.
- Preferred Stocks: Preferred stocks almost share the same attributes with common stocks. The main differences are; preferred stocks do not have voting right. The investors enjoy guaranteed fixed dividends. This means that whether the company makes profit or not, the investors will still need to be paid dividends as promised. However, this advantage may turn out to be a disadvantage. If the company performs exceptionally very well, the preferred stocks investors don’t enjoy additional or increased dividends. In case of bankruptcy, preferred stocks are ranked higher than common stocks. Preferred stocks are good for investors who want to enjoy dividends but don’t want to carry risks.
- Penny stocks: These are low priced stocks. Their price usually trade below $5. This type of stocks is usually issued by small or new companies. The risks attached to penny stocks are so high as some of the companies in this category may end up not doing well. But if the company succeeds, the rate of returns on the investment can be very exponential. Penny stocks are good for people who have little money to invest and a great appetite for risks. Penny stocks are susceptible to pump and dump scheme. Pump and dumb scheme is a situation whereby hypes are created around a particular stock by a group of investors, usually institutional investors. They do this in order to make the stocks look attractive. This makes people to rush into buying the stocks, thereby forcing the price of such stocks to go up. When the price has reached a satisfactory level, the investors quickly offload their stocks. This will make the price of the stocks to plummet to the detriment of other individual investors.
- Growth stocks: Growth stocks are companies that have a high potential to achieve great success, but they can also be very risky investments because they are not well established. Growth stocks may not pay dividends even though the companies record high profits. They usually reinvest their profits. This normally makes the price of growth stocks to rise. Investors in growth stocks are those who have good source of income which makes them less dependent on dividends. Instead, they look forward to capital appreciation. One distinguishing feature about growth stocks is the high price earnings ratio. Their prices tend to grow faster than their earnings as people invest mostly into the future of the companies. Growth stocks are not good for people looking for a secondary source of income.
- Income stocks: Income stocks do not only pay high dividends. They are known for consistent payments of dividends. The companies in this category are usually stable with good earnings and cash flow. These stocks are attracted to people who are looking for passive income as secondary source of income. Dividend yield is a good indicator to help you determine whether a company is an income stock. Companies with consistent records of high dividend payout ratio can also be classified as income stocks companies. A retiree will prefer a stock with high dividend yield. The higher the dividend yield, the more income for investors. Dividend yield is the dividend per share expressed as a percentage of the share price.
- Blue chip stocks. Blue chip stocks are stable and less risky. They represent high quality companies with good track records of high earnings and payment of dividends. The companies in this category are large already. Therefore, their growth rate is generally low. The prices of blue chip stocks don’t fluctuate as such. This makes it good for investors who are risk averse and those who are interested in preserving their capital.
- Small-cap stocks: Stocks of companies that have less than $2 billion in market capitalization are classified as small cap stocks. They are perceived to be risky when compared to blue chip companies. The reason is that small cap companies don’t have much resource to compete in the market place. They may not pay dividends as the companies will like to use the available resources to finance their growth. Notwithstanding, they usually out-perform blue chip companies in the stock market. I think this validates the guiding principle about investing that says “the higher the risks, the higher the likely returns”. For people who can withstand price volatility and don’t expect immediate dividend income, small cap stocks have potential to grow very fast. It can generate high gains to investors in the long run.
- Cyclical stocks: This category of stocks is more affected by economic situation per time. They tend to rise quickly when the economy is good and fall quickly when the economy is bad. Cyclical stocks don’t enjoy much trading in the stock market during economy recession. If the economic recession is prolonged, these stocks may find it difficult to bounce back.
- Defensive stocks: Contrary to cyclical stocks, the prices of defensive stocks are not likely to fall because they are in stable market sectors. They are not affected by economic cycles because the companies produce necessities such as food and drugs. You will agree with me that people will always eat regardless of the situation of the economy. Also, there is no time that people will not need medical attention. You can buy defensive stocks for protection against potential losses in more speculative investments.
- Value stocks: Value stocks are toast for value investors. They are stocks that are believed to be undervalued. This is manifested through their low price earnings ratio or low price to book ratio. If you don’t understand what these ratios mean, I will still explain them later. Why would stocks be valued below their worth? This can happen as a result of general fall of stock prices in the stock market. It can also be caused by temporary decline in earnings of the company compared to the previous years. Negative news about a company can also cause negative reactions from investors thereby causing its stock price to fall. Don’t forget that one of the factors that determines the share price in the stock market is the news made available to the public. Valued investors may like to seize this as an opportunity to buy the stocks while the price is low so that they can sell when the price goes up. Of course, this comes with risks. There is no guarantee that the price of the stocks will rise again.
- Foreign Stocks: If you are aiming at international investments for the purpose of diversifying your investments, foreign stocks will help you achieve this. What are foreign stocks? For investors in US, foreign stocks will be stocks of companies located outside United States. For people outside US, foreign stocks will be stocks of companies that are based outside the country where you live.. This is relevant to people that open online brokerage account.
Whatever types of stocks you want to buy; it is always good to buy at the right price. Experienced investors make most of their profits when they buy their stocks.
Read Also: Penny Stocks and How to Profit from Them
Types of Stock Market Investment strategies
Now that you know that stocks are not the same, you may need to have your own investment strategy. It is your strategy that will guide you in the selection of stocks to buy in order to reach your investment goals. While developing your investment strategy, you should be able to match your risk tolerance with the returns you expect from your investment. For instance, if you expect high returns, you should be prepared to take some levels of risks. However, in order to reduce the risks, there may be need for you to carry out thorough analysis of the stocks before you make any buying decision. Every good investor knows the importance of investment strategies. No stock will carry an emblem of growth stock or income stocks. It is the behaviour of the stocks and the result of the analysis you carry out that will help you conclude that a particular stock will be a good buy. There are many investment strategies but I will discuss few of them here.
- Value Investing
- Active Investing
- Passive Investing
- Buy and Hold
- Growth Investing
- Dollar Cost Averaging
- Balanced Investment Strategy
Value Investing: Value investors usually look for good stocks that are believed to be under-priced and buy them. In most cases, investors over-react to information that is available to them. A little negative information about a good company can force the price of its stocks down. However, if you want to be a value investor, it is not enough to look at historical data. The fact that you buy a stock that its price has fallen considerably does not make you a value investor. The key point is buying stocks at the price that is cheaper than what they are worth. You can easily recognise stocks that are trading below their intrinsic value by comparing their current price with their book value. A value investor will prefer to buy stocks with low price to book ratio. Another good yardstick is the price earnings ratio. Buying stocks of a company with low price earnings ratio means that you can easily recoup your investment within a short period. But you should understand that not all companies pay out their earnings as dividends. Therefore, if your focus is on the dividend income you will generate from the stocks, you may need to look further by considering the dividend yield of the company. Stocks of companies with high dividend yields will be a good buy for value investors. Warren Buffet is an acclaimed value investor and this has actually worked for him.
Active Investing: Active investing involves buying and selling stocks in quick successions with the aim of achieving higher profits. You can refer to active investors as stock traders. They spend most of their times monitoring activities in the stock market. They will buy or sell stocks at a slightest opportunity depending on the trend of price movement. Active investors will rather focus on short term profits than long term trends. If you want to adopt active strategy, you should prepare to spend more time monitoring the activities in the stock market.
Passive Investing: Investors in this category believe in “buy and hold” for a long time. Unlike active investors, passive investors will like to do proper analysis of stocks and buy the ones that they believe will give them appreciable capital appreciation over long term period. Passive investors will not sell stocks at the dictate of price fluctuation in the stock market. The fact that they don’t sell their stocks too often, they are able to save transactions costs involved in buying and selling of stocks.
Growth Investing: If you have read about growth stocks as explained above, you won’t have problem understanding growth investing. This strategy focuses on investing in new or emerging markets companies with high earnings and growth potential. The emphasis of growth investors is on capital appreciation. Most of good stocks to buy for people pursuing growth investing strategy will likely have high price earnings ratio.
Dollar Cost Averaging: This strategy involves buying stocks usually in equal portions on a regular basis regardless of the fluctuation in prices. Instead of buying stocks at once, investors use dollar cost averaging strategy to spread purchase over time. This strategy has the advantage of reducing risks that might arise from buying stocks when the price is at peak. At the same time, this can turn out to be a disadvantage as it tends to reduce average returns on investment.
Balanced Investment Strategy: This is just as the name implies. Investors use this strategy in an attempt to balance risks and returns by spreading their investments between high-risk and low-risk assets. For instance, you may not want to take too much risk by investing in growth stocks only. Instead, you may invest your money in fixed income securities and equities. This provides a certain level of diversification. You can enjoy both income and capital appreciation. But if the investment in equities fails to perform, you can be sure of income from the other investment in fixed income securities. However, you need to understand that there is nothing like risk free investment. Even your investment in fixed income securities can be impacted by changes in interest rates.
Stock Trading Methodologies
The same way investors may have different strategies, they can also approach investment in the stock market in different ways. The two main approaches investors use in approaching stock market are through technical analysis and fundamental analysis
Technical Analysis: Technical analysis involves the use of charts in analysing the historical price, trading volumes and industry trading trends of stocks in order to predict their future movements. It is believed that history always repeat itself. Those people that are familiar with the stock market understand that the prices of certain stocks usually follow particular trends over a period of time. With this, it can be easier to predict which direction the stock price will go. Investors that are into active stock trading usually adopt this methodology. They rely on trend and play down on intrinsic value. The main drawback of technical analysis is that it may not be useful in analysing the stocks that have just been listed in the stock exchange.
Fundamental Analysis: This involves the use of economic factors and company’s financial data in determining whether to invest in the stocks of a company or not. Investors that want to take a long position in stocks usually use this approach to analyse stocks. Investors rely on the information on the company’s financial statements in order to analyse its stocks. Fundamental analysis can be time consuming. It also requires good understanding of financial analysis.
Understanding Financial Statements
It is mandatory for all companies listed in the Stock Exchange to publish their audited financial statements. They have to file the financial statements with the Securities and Exchange Commission and also make it available to the general public. The objective of financial statements is to provide information about the financial position and performance of the reporting entity. Shareholders and prospective investors rely on the information in the financial statements to make investment decisions. For example, shareholders will like to assess the risks and returns of their investment in the company while prospective investors will like to assess the viability of investing in stocks of particular companies. This is where financial analysis skill plays a vital role. When information contained in the financial statements is properly interpreted, it helps investors understand the current financial condition, problems and possibilities of a company. If you actually want to make money in the stock market, you need to understand how to read and interpret financial statements.
Components of Financial Statements
Financial Statement is made up of the following:
- Statement of Financial position
- Statement of comprehensive income
- Cash flow statement
- Notes to the account
- Five year financial summary
Statement of financial position
Statement of Financial position or Balance Sheet is a quantitative summary of a company’s financial condition at a specific point in time, including assets, liabilities and net worth. It shows what a company owns and what it owes at a fixed point in time. Essentially, it measures the cumulative result of business efforts. Balance Sheet is divided into two namely Assets; Liabilities and Networth. Networth can also be referred to as Shareholders’ fund. A company’s assets have to equal the sum of its liabilities and networth, hence the words Balance Sheet. The simple Accounting equation is:
Assets = Liabilities + Shareholders Funds.
The above equation can be expressed in another form as follows:
Assets – Liabilities = Shareholders Funds.
Assets are things that a company owns that have value. They can either be sold or used by the company to make products or provide services that can be sold. Assets are normally debit balances. They are divided into two groups namely current assets and fixed assets.
Fixed Assets: Fixed assets are called long term assets because they are more permanent in nature. They are not intended for resale. Fixed assets are usually recorded at cost less accumulated depreciation. Examples are: land and building, motor vehicle, plant and machinery.
Current Assets: Current assets are things a company expects to convert to cash or used within one year. Examples are cash and bank balances, short term investments, receivables and inventories.
These are your obligations to others which arise during the course of business operations. Liabilities are further classified into long term and short term liabilities.
Long Term Liabilities: They are obligations which are not due for payment within a year. A good example is bank loan.
Current Liabilities: These are obligations due and payable within one year e.g. Trade creditors, bank overdraft and wages payable.
Networth or Shareholders’ Funds:
Networth is the portion of a company’s assets that the shareholders own, as opposed to what they’ve borrowed. It is all the money belonging to the company’s shareholders which includes the share capital contributed and all profits retained in the company.
Statement of comprehensive income
Income statement is a report that shows how much revenue a company earned over a set period. Unlike the balance sheet, the income statement is a temporary statement. It accumulates information over a (usually quarterly or yearly) at the end of which its numbers are reset to zero in order to start tracking activity of the next period. It also shows the costs and expenses associated with earning that revenue. It tells you whether the company made profit or loss over the period.
Components of Income Statement include the following:
Sales: This is the total revenues earned during the accounting period. Sales are usually recorded as net of returns, allowances and discounts. It includes both cash and credit sales. Sales on credit will only create paper profits if the debts are not recovered from the customers. This means that amount which has earlier been reported as profits can reduce or be wiped away by reason of bad debts. You can determine whether a company have a sizeable market share by comparing sales figures in the income statement to sales of other companies within the same industry. Besides, as an investor, you should be interested in the sales trend. You will like to see if the company is making more sales.
Cost of goods sold: These are all the direct costs related to the product or rendered service sold and recorded during the accounting period. Matching the revenues earned during an accounting period with the cost associated with the period to ascertain the result of the business concern is very crucial. This is the only way by which accurate profit for a period which can be safely distributed to the shareholders can be ascertained.
Operating expenses: These include all other expenses that are not included in Cost of goods sold but are related to the operation of the business during the specified accounting period. This account is most commonly referred to as administrative expenses. This includes expenses such as salaries, selling and marketing, maintenance, administrative and other office expenses including depreciation and amortization, etc.
Other revenues & expenses: These are all non-operating expenses such as interest earned on cash or interest paid on loans.
Income taxes: This account is a provision for income taxes for reporting purposes.
A statement of changes in equity: This breaks down changes in the shareholders’ interest in the organization and in the application of retained profit or surplus from one accounting period to the next. Line items typically include profits or losses, dividends paid, redemption of stock, and any other items credited to retained earnings.
Cash Flow Statement
Cash flow statement reports a company’s inflows and outflows of cash. It shows details about the cash that moved through the business during the tracking period—how it came in, and how it left. While an income statement can tell you whether a company made a profit, a cash flow statement can tell you whether the company generated cash.
Cash flow statements are divided into three main parts:
- Operating activities;
- Investing activities; and
- Financing activities.
Operating activities include the production, sales and distribution to the customers of the company’s product. It also includes collection of payments from its customers. This activity could include purchasing raw materials, inventory and advertising of the product. It analyses the changes in the working capital of a company. Adjustments are usually made for items that do not involve the movement of funds. Such items include depreciation, amortization and interest income.
Investing activities are activities that relate to the purchase of long term assets in order to ensure that the business of the company continues. Investing cash flows are the cash flows arising from the purchase or disposal of non-current assets. Cash can also be generated from the sales of fixed assets or divestment.
Financing activities include resources obtained from lenders and owners of the enterprise, loan repayment as they become due and payment of returns to the providers of resources e.g. Interest and dividends.
Notes to the Accounts
The statement of financial position and income statement may not give you the details of the figures in the accounts. For you to have a better understanding of what the figures entail, you will need to look at the Notes to the Accounts. You will find this immediately after the cash flow statement.
Five Years Financial Statements
This gives you an abridged summary of the company’s statement of financial position, income statement and some vital financial ratios over a five years period. This section should interest all investors. You will be able to see the trend of the company’s performance and financial health status. You will be able to carry out a comparative analysis of the company’s financial performance over a certain period of time.
Other important information
Director’s report and Auditors’ report are also important parts of financial statements. Ensure you read these reports. For instance, from the director’s report, you will have a better understanding of the activities of the company. You can have access to useful information about the project which the company is planning to embark on that can impact on the price of its stocks.
Read Also: Understanding Mutual Funds Investing
Analysis of Financial Statements
It is not enough to read financial statements. As an investor, you need to understand the information that is contained therein before it can become a tool in your hand for investment decision making. You should be able to know the linkage of figures in the financial statements. The analysis of financial statement is usually done by the use of ratios. These ratios can be grouped under the following headings:
- Shareholders’ Investment Ratios
- Profitability ratios
- Liquidity ratios
- Leverage Ratios
Shareholders’ Investment Ratios
- Earnings Per Share: Profit after tax divided by number of outstanding shares. It measures profits attributable to each unit of shares of the company. Diluted Earnings per Share is more accurate. It iincludes preference shares, unexercised stock options and convertible debts
- Price Earnings Ratio: This is the current price of a company’s share divided by the earnings per share of the company. Investors use this ratio to determine the value of a stock. It reveals how much the market the market is willing to pay for company’s earnings. A stock with low price earnings ratio may signify that the stock is under-priced. If the price earnings ratio of a stock is too high, it can signify that the stock is expensive. Growth investors will not mind investing in stocks with high price earnings ratio
- Dividend per Share. Dividends divided by number of outstanding shares. It represents the dividend payable on each unit of shares of the company.
- Dividend Cover: Earnings per share divided by dividend per share. The represents the number of times the profit attributable to shareholders can pay the dividends. A company that pays almost all its profits as dividend will have low dividend cover. A growth stock company will like to retain significant part of the profits in the business. This fund can be used for the expansion of the business or for the purchase of fixed assets since there will not be any pressure for repayment.
- Dividend Payout Ratio: This is the amount of dividends a company pays to its shareholders in relation to its earnings. The amount not paid out as dividend is known as retained earnings. Income stocks usually have high dividend payout ratio. Therefore, companies with high dividend payout ratio will be attracted to people seeking secondary source of income from the stock market.
- Dividend yield: This is the amount of dividends a company pays to its shareholders in relation to its current share price.
Ratios under this group are the following:
- Returns on capital employed: Profit before interest and tax divided by capital employed. It measures the returns on the capital invested in a company. The higher the ratio the better. A company with new investment in fixed assets may initially experience low returns on capital investment. But if the return of investment remains low probably at the level below expectation or industry standard over a long period of time, it may signal under-utilization of assets.
- Assets Turnover: Turnover divided by capital employed. It measures how effective the company is able to utilize its assets to generate sales. Investors who are interested in growth potential of a company will like to look for information concerning how the company obtained its resources and how it uses them. A good company should seek to record an improved assets turnover over the previous year. This improvement can be achieved by generating more sales.
- The gross profit margin: Gross profit divided by sales. It lets you know how much profit is available as a percentage of sales to pay payroll costs, advertising, sales expenses, office bills, etc. The higher this ratio, the more profit a company has to pay overheads.
- The net profit margin: Net profit divided by sales. It tells you how much money a company makes for every dollar in revenue. Companies with higher net profit margins can often offer better benefits, more attractive bonuses, and fatter dividends. Achieving higher net profit is possible by either increasing your gross margin or reducing your overheads.
- Current Ratio: Current assets divided by current liabilities. It measures the ability of a company to meet its current obligations. It is normal for current assets to be more than current liabilities.
- Quick Ratio: Current assets less inventories divided by current liabilities. This measures the ability of a company to meet its current obligations with near cash assets.
- Account Receivables Collection Period: It measures the number of days it takes to collect debts from customers. The shorter the days the better the working capital position of the company. A company that sells its products on cash basis will have zero account receivable collection period.
- Account Payables Payment Period: It calculates the number of days it takes the company to pay its suppliers. If the account payables payment period is shorter than the account receivables collection period, this means that the company is paying its suppliers much earlier than it collects debts from customers. This creates a liquidity gap which has to be filled by sourcing for other short term sources of finance such as overdraft. If the situation persists for too long time, it can lead to cash crisis. Such company will find it difficult to pay dividends.
- Debt Ratio: Total debts divided by total assets. It measures the proportion of debts to the assets of the company. If this ratio is higher than one, it simply means than the company is carrying too much debts more than what its assets can cover if sold.
- Debt – Equity Ratio: This is total debts divided by the shareholders’ equity. A company having too high debt –equity ratio is largely financed by debt and this means that greater part of its income will be going for debt servicing. This type of situation can make profitable ventures to become unprofitable as a result of high interest payments
- The interest coverage ratio is an important financial ratio for companies that use a lot of debt. It is profit before interest divided by interest charges. It lets you know how much money is available to cover all of the interest expense a company incurs on the money it owes each year. That is, the number of times profits can pay the interest charges. Having a low debt profile will increase your interest coverage.
You will agree with me that anybody that really want to make money from the stock market has a lot to learn. I can say that this is just elementary. But the good thing is that stock market usually rewards those who are willing to pay the price to educate themselves. Though investing in the stock market involves risks, you can reduce the risks by first investing in yourself.