Calculating a company’s potential revenue is one of the most important steps when researching stocks. Investors can use internal data to evaluate the profitability of an individual business, which can help determine entry or exit points in stock ownership.
To that end, one of the most reliable ways to forecast revenue is by examining an organization’s prior financial performance. Here are some tips on how to calculate revenue potential using common financial statements.
What Is Revenue Potential?
Revenue potential evaluates a business entity’s ability to generate a profit. In stock trading, revenue potential is a vital part of fundamental analysis — the method by which investors measure the inherent value of a stock.
Fundamental analysis can include qualitative measures such as the performance of the industry as a whole. Alternatively, it can be conducted by considering the impact of a new product line or leadership change.
However, the most reliable method of revenue forecasting uses a company’s internal data to predict future performance. So as long as current trends remain consistent, examining a business entity’s financial statements will provide insight into its stock’s revenue potential.
How to Calculate Potential Revenue Using Financial Statements
Financial statement analysis will give you the most accurate picture of a stock or security’s revenue potential. Taking a deep dive into a company’s past financial performance will help you make investment decisions based on clear, objective data. Here are tips for evaluating each type of financial statement.
Balance Sheet
Think of the balance sheet as a snapshot of a company’s financial position at any given time. A balance sheet will provide an overview of an organization’s:
- Assets: The resources a company uses in its operations
- Liabilities: Debts and financial obligations
- Shareholders’ Equity: The money flowing into the business from shareholders
Both assets and liabilities can be short or long-term. Short-term assets are those that can be easily converted into cash within a year. Long-term liabilities are debts and obligations that are expected to endure beyond a year.
By analyzing a balance sheet, you’ll be able to determine some of the following metrics:
- The amount of debt the company has compared to its equity
- A company’s short-term liquidity
- The time it takes to receive payments from customers
- The time it takes to pay vendors and suppliers
- The time it takes to sell the company’s existing inventory
Since a balance sheet is only a snapshot of a particular moment in time, insights are limited. Nevertheless, a company’s balance sheet will provide an overview of an organization’s short-term and long-term assets and liabilities.
The balance sheet can also show you how liquid a company is — in other words, how readily it can convert its tangible assets into cash. These factors provide an overview of a business entity’s financial position, which can be a predictor of how well it will be able to generate future revenue.
Income Statement
If the balance sheet provides a snapshot of a company’s financial position, the income statement evaluates its performance over a designated period. The income statement assesses a company’s revenue, expenses, and profits earned.
An income statement will record the revenue earned for the time period before subtracting the cost of goods sold to determine the gross profit. The income statement also subtracts all other operating expenses (payroll, rent, utilities, etc.), which determines the earnings before interest and taxes.
Once the company subtracts interest and taxes, the income statement records the net profit. What can you learn from an income statement? Use an income statement to determine things like:
- How revenue is rising or falling during a given accounting period
- A company’s gross profit margin
- The percentage of revenue that leads to net profit after deducting expenses
- How well a business is handling its interest payments, taxes, and debt
A company can also return its net profits to shareholders in the form of dividends. An income statement will reveal the amount of profits distributed to shareholders and how much the organization is reinvesting in its own operations.
Cash Flow Statement
Cash flow refers to the amount of money actually flowing into or out of the business. A cash flow statement will therefore record the cash flowing in and out of the company during the designated accounting period.
Viewing the cash flow statement will give investors the clearest picture of how a company actually spends its cash. The cash flow statement will show how an organization receives and uses cash, categorizing its usage into operating, financing, and investing activities.
A cash flow statement will therefore provide insight into the following:
- Whether a company’s cash flow has increased or decreased
- How much cash a company has to invest in future operations
- The company’s main sources of cash
- How liquid a company is
Unlike income statements, a cash flow statement informs you of the actual cash an entity spends or receives. This can provide a more accurate picture of how the company handles its resources. A business with strong cash flow may have more liquid assets to invest in growth, which can be a sign of strong revenue potential.
Tips for Analyzing Financial Statements
How can you make the most out of analyzing financial statements? Here are some tips for leveraging this data to make well-informed investment decisions.
Focus on Key Ratios
Financial statements will provide you with a lot of raw data. But you can start organizing this information by evaluating key relationships between different numbers. For example, you might focus on key ratios such as:
- Earnings per Share: The ratio of a company’s profit to the number of shares
- Price-to-Earnings Ratio: The ratio of the share price to its per-share earnings
- Debt-to-Equity Ratio: The amount of debt relative to the amount of equity
- Current Ratio: The ability of a business to meet its short-term obligations
- Return on Equity: A company’s ability to leverage equity to earn profit
- Return on Assets: The ability of a business to leverage assets to earn profit
By becoming familiar with these basic metrics, you’ll be better equipped to compare similar-sized companies within the same industry. This can be a crucial step when you’re selecting stocks of a similar type.
Track Business Metrics Over Time
Financial statements may be helpful, but they can only provide you with data for the designated accounting/reporting period. Calculating potential revenue based on a single accounting period can be misleading, especially for industries that experience cyclical patterns of growth, such as tourism or the automobile industry.
Instead, try to track financial data over time. Reviewing historical data can give you a more comprehensive overview of how a company operates, as well as how it navigates cyclical markets or shifting economic conditions.
Use Consistent Data
When you are forecasting profit potential, it’s important to use consistent data. This means you should evaluate the same types of financial statements when tracking a stock’s performance. In other words, when calculating potential revenue, don’t compare one company’s balance sheet to another’s cash flow statement.
Using the same financial metrics will ensure that you’re tracking data accurately over time. And when you compare companies, using the same metrics will present a more fair comparison for better decision-making.
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