It takes surprisingly little to do well in investing and meet your financial goals. Keeping to a few basic commandments like diversification and avoiding behavioral traps, you can count on your portfolio to grow at an expected rate over your lifetime. If you want to find the real money though you will have to do some deep analysis and that means learning how to read financial statements.
What do analysts really do?
An army of Wall Street analysts work around the clock reading and decoding the mandatory financial statements published by publicly-traded companies. These documents, required by the Securities and Exchange Commission (SEC), include an alphabet of codes like 10-Q, 8-k and S-8. The most important document is the 10-K, the company’s annual report.
Within the annual filing, you will find three primary statements, footnotes and the management’s discussion of the year’s business. The three statements, described below, are where you will spend most of your time. The footnotes give important meaning to some of the statement data and management’s discussion can sometimes clue you to hidden opportunities.
The Balance Sheet
This is a record of all the company’s assets, liabilities and equity on the last day of the quarter or year. Assets include things like cash, property, unsold inventory and other items with value like patents and trademarks. Liabilities are the loans and other debt-like promises that the company owes. Stockholder’s equity is the difference between the company’s assets and liabilities and is the value owned by shareholders.
The Income Statement
This is the profit and loss statement of the company’s business over the period. Starting with sales (revenue), it subtracts different costs, interest on debt and taxes to arrive at the net income available to shareholders. Unfortunately, there are a lot of ways for management to manipulate the income statement from inflating sales to waiting to recognize costs in later periods. The income statement offers a lot of good information but it must be used with the other two statements as well.
The Statement of Cash Flows
This statement is the favorite of many investors because it shows just how management is using cash to run the business. Since an investment’s value is ultimately the source of future cash flows, investors are intently focused on how current cash is being used. The statement separates cash sources and uses into three primary topics; operations, investment and financing. Cash flow from operations is the Holy Grail for many because it is the actual cash generated, or used, through the business. Cash used for investment is important because it can help to increase or maintain future operational cash flow. Cash flows from financing include share issuance or buybacks, dividend payments and loans.
So if Wall Street analysts spend their nights and days decoding these statements, can’t I just read their reports?
The problem is that the second these reports hit the market, the company’s stock price reacts immediately. To find the real opportunities, you have to decode the statements before the rest of the market.
Making the most of limited time
Careers are spent learning the intricacies of financial statement analysis and you shouldn’t expect to be an expert in a short amount of time. Most investors with little time to commit are well-served by sticking to some basic ratios and red flags.
- Days sales outstanding (DSO) is the average days that a company takes to collect on past sales made on credit. It is the accounts receivables line of the balance sheet divided by the amount of credit sales, multiplied by the number of days in the period. The ratio is important because a company taking longer and longer to collect might be extending its credit terms too far and may not actually see the cash for past sales. The McAfee Company, now owned by Intel (INTC), overstated sales between 1998 and 2000 and was eventually sued by the SEC.
- Liquidity ratios like the cash ratio – are measures of the company’s ability to pay its short-term liabilities. This is important for companies that are facing short-term challenges or if you think the economy might take a turn for the worse. If the company is already on shaky ground, weak sales ahead may be the tipping point into bankruptcy. The cash ratio, total cash divided by short-term liabilities, is generally the most conservative of the liquidity ratios since it does not include inventory or receivables.
- Free cash flow is a powerful measure used by many investors. It is the cash leftover from operations after spending on projects to maintain the business. It is the operating cash flows minus capital expenditures, generally much of the amount spent on property, plant and equipment.
Red flags are warning signals that could tip an investor off to some kind of management fraud or operational weakness. The rate of change in cost of goods sold, receivables and payables should all be comparable to the rate of change in sales. If any one of these changes significantly from the overall trend, it may signal that management is changing the way it accounts for the item. Payables growing faster than sales may mean that management is trying to inflate income by holding off on paying suppliers and labor. A significant drop in cost of goods sold may indicate a cheaper quality product being made.
One important red flag is the growth rate in net income versus that of operating cash flow. Because of accounting rules, management can manipulate net income much more easily that the actual cash coming in or out of the company. If net income constantly grows faster than the cash produced by the business, then management might be inflating its performance to look better. The Xerox Corporation (XRX) doubled net income in 2004 though its cash flow from operations actually decreased. Investors were not fooled and the stock languished for the better part of three years.
The vast majority of investors do not have the time available to pour through every financial statement released by every company in their portfolio. With a short list of ratios, red flags and measures you can catch some big opportunities every once in a while. Devote most of your portfolio to investing off of the basic rules from this website, leaving a small chunk available to take advantage of opportunities when they come along through financial statement analysis.