As many in the business world are at least vaguely aware, traders, or stock traders as they’re also called, buy and sell securities on the stock market. To do this, they analyze movements in the market to locate and make trades that they calculate have an excellent prospect of generating profits.
Stocks or ‘equities’ are portions of a company’s assets, and they often fluctuate. So the data the trader evaluates always relate to two questions: will this stock increase or decrease in value, and will I make a profit by buying or selling now?
They’re continually reviewing a series of market indicators signposting the level of supply and demand for these stocks, including the productivity of the firms they’re monitoring and the salient conditions for economic growth, stasis, or contraction.
One of the critical factors they weigh up is risk: what risk accompanies this equity? And to do this, they research the financial performance of the business in question alongside the fluctuations it’s encountered in the market.
In other words, traders keep a vigilant eye on a company’s financial reporting, including any news or updates that might cause the stock to rise or fall in value.
Let’s take a closer look at the kind of financial information upon which they base their decisions. Clue: they keep the metrics included in a firm’s financial reporting documents under constant surveillance.
How traders evaluate a company’s strength through its financial statements
It may come as a surprise to entrepreneurs operating today to find that there was once no legal obligation to disclose their finances publicly. The great crash of 1929, which sent shockwaves around the world, put paid to that. The government was keen to prevent such a disaster from happening again and enacted legislation to ensure investors had the data they needed to make sound investments, never again “flying blind” when making investment decisions as they had done in the years preceding the crash.
Publicly traded companies were suddenly obliged by law to disclose details of their financial health and operations. In particular, the three metrics mandated by law for public disclosure are those found in a company’s income statement, balance sheet, and cash flow statement.
Of course, for a long time, smaller companies were at a disadvantage, lacking the resources of their large corporate rivals to hire dedicated professional financial and reporting teams. But thanks to the rise of cutting-edge, cloud-based accounting software in recent years, that disadvantage has become a relic of the past. Available in the form of tiered subscription services from expert providers, the technology allows modestly-sized companies to dispense with the employee costs of a dedicated team of finance staff, automating and regularly updating time-consuming and labor-intensive manual data entry tasks. As Forbes recently noted:
“The use of technology can help reduce errors, add a layer of visibility to key executives, add scale to the process and enable companies to use a best-of-breed approach developed by Fortune 500 companies.”
The significance of Income Statements for traders
This statement makes public any inflows of new assets and all expense outflows a business has incurred during a specific quarter or year in the quest to generate revenue. The oft-used term “bottom line” comes from the layout of income statements, which start (at the top of the page) with the firm’s income and proceed downward to subtract all costs and expenses (including taxes) before reaching the “bottom line”: the company’s net profit (i.e., before dividend payouts).
Crucially, there are essential entries below the so-called “bottom line.” These reveal the average number of common shares of the firm’s stock that investors hold, followed by earnings per share (i.e., net dividend income divided by the number of shares). That is what the firm pays out per share to its stockholders.
The significance of the balance sheet
Income statements cover a period; balance sheets, by contrast, give a “snapshot” of all the funds coming into and leaving a firm at a specific point, giving investors a view of the firm’s assets (what it owns) and its liabilities (what it owes). The difference between the two is effectively the book value of its stockholders’ stake in the business.
The significance of Cash Flow Statements
These documents show where a firm’s cash has come from and how it’s been deployed to fund operations over a specified period. By tracking how a firm has managed its money, they give a fuller picture of its liquidity (meaning its ability to pay bills and finance future expansion) than either the balance sheet or income statements.
Conclusion
These reports help traders to gauge the financial health of the companies whose stocks they’re trading. Stock prices, of course, climb and fall in response to a wide array of reasons. But when companies more or less consistently perform well financially, the usual outcome is that they “earn” higher stock values over time.
That is why traders seem to “obsess” over the financial reporting statements of companies. Even those who focus chiefly on technical analysis (using data in charts to forecast probable future stock price changes) tend to study financial statements, concentrating their attention on firms that demonstrate strong or improving fundamentals.
