Understanding Financial Reports: Easier than you Think
It's been a year since I discussed financial statements with you (see the June 27, 2006, issue of Financially Fit), but two recent events prompt me to reengage this subject:
The first is that the market is reaching new highs almost daily and many investors wonder whether they should exit their stocks, while those who didn't join in this latest bull trend wait on the sidelines, pondering the question of whether it's too late to cast their lot with the market.
As you know, I am a bottoms-up investor. I believe that it's the company that counts - overall - and that a long-term investor without an intimate knowledge of the companies in which he invests is not going to be a successful investor.
And part of that tool kit is the ability to understand the financial reports of your current holdings or potential investments. This is essential knowledge that is the first building block required to determine when to cash out or when to jump into a stock. A few minutes spent perusing a company's financial statements will give you a very good idea of the company's historical performance, as well as its future prospects - much more important data in the long-run than the cyclical maneuverings of the stock market.
The second event that underscores the importance of understanding financial statements is the fact that this is going to be a record year for mega private-equity deals, with more than $81 billion in deals announced in May alone! Savvy investors who understand financial reports may more easily scour the market for companies demonstrating the potential to be bought out, perhaps earning some nice premiums to add to your investment coffers.
I realize that reading page after page of legalese and small print is not exciting to most people, but the information contained in these reports can make the difference between being a mediocre investor, or a successful one. Becoming familiar with just a few basic principles may mean thousands of dollars in your pocket. So, isn't that worth a few minutes of your time?
In my report to you last June, I suggested that you begin your education with the 10-K - the annual summary of a firm's performance that the Securities and Exchange Commission (SEC) requires every public company to submit 60-90 days after the end of its fiscal year.
The 10-K combines the company's pretty, glossy annual report with additional data that will come in handy for a thorough analysis of the company's investment potential.
If you are not receiving the 10-K directly from the companies in which you invest, you can easily access them - for free - either through the companies' own websites (generally, in the Investor Relations section) or through the SEC at http://www.sec.gov/edgar.shtml.
In my investing seminars, I always tell my audience that one quarter or one year of financial data is not enough, so I recommend that you compare the data in at least two to three years of 10-K reports. Don't worry - once you've figured out one year, the next few come pretty easily!
Last June's issue of Financially Fit breaks down the four sections of the 10-K, so I won't belabor those points. Instead, I want to focus on Part IV, which highlights the three most important financial statements that you need to understand.
The Income Statement is also called the profit and loss statement and it depicts the results of operations over a period of 12 months. Results of the two years prior are included for comparative purposes.
Here are the major accounts found on the Income Statement:
- Net Sales includes revenues net of returns, breakage allowances, freight-out and discounts.
- Cost of Goods Sold reflects the cost of buying raw materials and producing finished goods.
- Depreciation is a noncash expense, an amortization of fixed assets, to allocate their cost over their depreciable life.
- Selling, General and Administrative Expenses are all expenses associated with the normal operations of the business that were not included in cost of goods sold. Ex. salaries, rent, utilities, and advertising.
- Net Operating Profit is what is left over after deducting cost of goods sold, depreciation and SG&A expenses from net sales; tells you the company's profit on an operating basis without taking into account any unusual items of income or expense or interest and taxes.
- Other Income or Expenses are any unusual income or expense items such as gains or losses from investments or the sale of fixed assets. Interest expense is sometimes included in this category.
- Earnings Before Income Taxes nets out all pretax income and expense items.
- Provision for Income Taxes is the company's tax liability for the period in question.
- Net Income equals the bottom line - how much the company has earned - after netting out all expenses except for dividends.
In order to understand if the relationship between a company's income and expenses is healthy, it is beneficial to calculate each account as a percentage of sales, and then determine if the account has increased or decreased relative to sales over a period of time.
Try to decipher the reasons for the change; is the growth or reduction acceptable to you? Be on the lookout for significant growth or decreases in particular accounts, especially expense accounts such as interest. Can the company easily cover its interest expenses?
Also, if companies are in the biotech or computer technology industries, growth or reductions in R&D can be a telling sign of the company's future intent.
Determine if income is growing because of increased sales, lowered expenses (including taxes), or both.
The Balance Sheet, also called statement of condition or statement of financial position, shows the status of the company's assets (what they own), liabilities (what they owe), and owners' equity (how much they have left over) on a given date, usually the close of a quarter or a year. It is a snapshot, not a motion picture, and must be analyzed in comparison with prior period statements as well as operating statements.
The fundamental equation of the balance sheet is: Assets = Liabilities + Stockholder’s Equity - in other words, it balances!
The major accounts found on the Balance Sheet are as follows:
· Current Assets include cash, accounts receivable, inventory and other assets that are likely to be converted into cash, sold, exchanged or expensed in the normal course of business - usually within a year. These items may also include marketable securities, prepaid expenses, coins, or short-term investments like Treasury bills, and negotiable Certificates of Deposit.
- Net Fixed Assets consist of property, plant and equipment - relatively permanent assets that are used in the production of income, listed net of depreciation.
- Other Assets are miscellaneous assets that may include minority stock ownership in other companies, unconsolidated subsidiaries, intangibles such as goodwill, research and development costs, patents, trademarks, etc.
- Current Liabilities include accounts payable, notes payable, accrued liabilities, current portion of long-term debt, dividends payable - any debt or other obligations coming due within a year.
- Long-term Liabilities consist of debt obligations due after one year, including term loans, mortgages, debentures (unsecured bonds), capital lease obligations, pension liabilities and estimated liabilities under long-term warranties.
- Shareholders' Equity is ownership interest - the value of assets after all creditors have been paid. Includes preferred stock, common stock, capital surplus and retained earnings.
To analyze the Balance Sheet, look for significant growth or reduction in particular assets and liabilities, as well as overall growth or decrease in company size. You will want to review the changes in inventories, accounts receivables and payables, which will give you a good sense of the company's efficiency. Run a keen eye over the firm's debt levels. Is short-term debt growing too quickly and staying in place too long? Do goodwill and intangibles look reasonable?
The Statement of Consolidated Cash Flows has one primary purpose - to show you where the company received cash and how it spent it. It focuses on liquidity rather than just on increased cash, displaying operating results on a cash basis. The Financial Accounting Standards Board (FASB) requires analysis in three separate categories: cash flows from operating activities, investing activities, and from financing activities.
Uses and sources of cash are indicated as either increases or decreases in each account:
Uses:
Assets - positive (increase)
Liabilities - negative (decrease)
Sources:
Assets - negative (decrease)
Liabilities - positive (increase)
The most important line is Cash Flow from Operations. This is the cash that a company takes in from its day-to-day business. If it sells washing machines, the cash is from merchandise sales. Is this number positive; is it trending positive, from year-to-year? It's great if a firm is raking in money from its investments or even in real estate (although that's a lot harder to come by these days!), but the majority of its cash should be derived from the business in which it is in business to do.
Again, one quarter or one year of financial statements will not give you a complete picture of a company's health. An example I refer to frequently is an amusement company I have moved into and out of my portfolio. The company's flagship park is located in Ohio, and its first-quarter cash flow is always negative. After all, who would ride a roller coaster in Ohio in January? Consequently, if you based your analysis of this company on its negative cash flow in that particular quarter - you would have missed out on years of fabulous returns!
Simply stated, a company's financial statements are akin to looking at a diagnostic printout of your automobile - they are a pretty complete picture of not only what the company looks like right now, but also what you can expect in the future in terms of management strategy and performance. Combined with news and statistics on industry, company, economic and market events, these statements will provide you the tools you need to analyze any company.
And once you get your feet wet with a report or two, the going gets much easier. Just look at the 10-K as a book filled with information key to your success as an investor, and it won't be long before you are rubbing your hands together, anticipating the edge that information will give you.
Happy Investing!
About the Author
Nancy Zambell, Contributing Editor to BrokerAdviser.com's Financially Fit, has enjoyed a diversified career in the financial services industry.
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