Examining Financial Statements (The Investor’s Way)

Examining Financial StatementsA company’s financial statements are invaluable for investors. Using the financial statements alone you can determine the health of the company and make educated predictions about future appreciation and dividend growth. On Wall Street perhaps more than anywhere else, knowledge is power, which is why insider trading is illegal—insiders know way too much to play a fair game. As an outsider, however, you want to know as much about the industry, the company, and its stock as possible so you can make a wise purchase decision, maximize your return, and minimize your exposure to risk.

Publicly traded companies are required by law to publish reports that tell current and prospective investors how well (or not so well) the company is doing. You can obtain a company’s most recent annual report by visiting its Web site or contacting the company and requesting a copy. Companies also typically release their balance sheets and income statements in press releases when they announce their quarterly earnings. You can find press releases on the company’s Web site or on financial Web sites such as Yahoo! Finance or Google Finance.

When you buy shares in a company, you’re not just buying pieces of paper—you’re buying ownership of that company. It’s sort of like loaning money to a relative who’s looking to start a business. If his idea for a business sounds wacky and unprofitable, his home is in foreclosure, and he can’t manage his own life let alone a business, you’d probably be reluctant to loan him any money, aren’t you?

Just like you consider the financial soundness of your relative, you want to make sure that a company you’re thinking about investing in is financially sound and that management seems to have its act together. You make this determination by examining the following three document: Balance sheet; Income statement; and Cash flow statement. The numbers on these statements are the company’s fundamentals—things like revenues and expenses. In the next page, I describe each of these documents in greater detail and even show you how to decipher them.

This post guides you how to examine financil statement for investing purpose. This a broad topic. For faster page-load, this post is broken down into two pages as follows:

Page-1. Company Financial Statements (with examples) – Three major financial reports and its are explained from investor’s point of view. Inside, you will learn:

  • Balance Sheet (Company’s Financial Snapshot)
  • Income Statement (Company’s Profits and Losses)
  • Cash Flow Statement (The Cash Stream)

 

Page-2. Measuring Healthiness of Company Target – I will guide you to understand the followings:

  • Calculating a Dividend’s Relative Strength
  • What is Yield (Dividend Yield)?
  • How to Calculate Dividend Per Share
  • How to Compute The Indicated Dividend Per Share
  • Figuring Out The Yield
  • How Pricing Affects Yield
  • Utilizing The Price-To-Earnings (P/E) Ratio
  • Determining Earnings Per Share
  • Calculating the P/E Ratio
  • Comparing P/E Ratios
  • Calculating The Payout Ratio
  • Calculating Return On Equity
  • Determining A Peek At The Quick Ratio

 

After you understand the fundamentals, you can compare these metrics against others to calculate ratios specific to dividend investing. These calculations help you determine the health of the company and make educated predictions about future appreciation and dividend growth. I give you the lowdown on some of these ratios later in this post.

Company reports measure past performance, but a stock’s value depends entirely on what people expect it to do in the future. Because of this discrepancy, stock analysis pretty much consists of predicting future performance based on current conditions and past performance.

Although past performance is all you have to go on, it’s no guarantee of future results; last year’s big winner may be this year’s big loser, and vice versa. If it sounds like trying to predict the weather, it is, and even the best meteorologists and stock analysts get it wrong sometimes. At the end of the day, staying on top of stocks is like keeping tabs on the weather: You can see most storms from miles away if you take the time to look, and you’d rather be ready for a storm than surprised by one.

 

Balance Sheet (Company’s Financial Snapshot)

Basically there are two forms of balance sheet: Stapled (as I often use) and T-form (as most European companies use). Whatever the form is, basically, a balance sheet presents a financial snapshot of what the company owns and owes at a single point in time, typically at the end of each quarter. It’s essentially a net worth statement for a company.

Here is an example:

Financial Statement For Investors - Balance Sheet

You’re right; it’s called a balance sheet because each side must equal the other. Assets equal liabilities plus shareholder equity. In other words, whatever assets aren’t being used to pay off the liabilities belong to the shareholders.

The top or left side of the balance sheet lists everything the company owns: its assets, also known as debits. As you can see on the next balance sheet example, the right or lower side lists the claims against the company, called liabilities or credits, and shareholder equity.

Liabilities may not seem like credits to you, but that’s not a typo. In accounting lingo, a credit is a loan. A credit brings cash in that the firm can use to purchase an asset. However, this credit is a liability, a debt that must be paid back at a later date.

The followings delve into some of the balance sheet’s information:


A. Assets

Assets are items of value that the company owns. The major components that make up the asset side of the balance sheet include current assets, fixed assets, investments, and intangibles. Here’s a breakdown:

1. Current Assets: All liquid assets — cash or anything that can easily be turned into cash:

  • Cash equivalents – Highly liquid, short-term investment securities with a high credit quality. These assets are typically low-risk, low-return instruments, such as bank accounts, money market accounts, and marketable securities, including U.S. Treasury bills and corporate commercial paper (short-term debt instrument) that matures within 24 hours.
  • Accounts receivables – Funds owed to the company. These assets represent unsettled bills customers have yet to pay on goods or services already delivered.
  • Inventory – The value of everything the firm is ready to sell.

 

2. Investments: Stocks, bonds or derivatives. Some are long-term investments, but any investment that can be sold for quick cash goes under current assets.

3. Fixed Assets: Tangible, permanent items necessary for the business to operate. Fixed Assets include real estate, buildings, vehicles, and equipment. These assets typically have a long life.

4. Intangibles: Anything that has value but isn’t involved in the actual production of the good or service. Intangibles include copyrights, patents, trademarks, licenses, and goodwill (the company’s standing in the community, based on the company’s relationship to customers and suppliers and people’s view of the company’s brand name).

Together, these items add up to total assets. Ideally, assets create income, which pays for future dividends.

 

B. Liabilities

Liabilities are sort of like IOUs — together, they represent the total cash value of what the company owes to other entities. Liabilities aren’t necessarily a bad thing. After all, companies have to spend money to make money. They only become a problem when a company is consistently spending more than it’s earning and has no clear and viable strategy to reduce that trend.

Here’s how liabilities typically break down:

1. Current Liabilities: All short-term debt that must be paid back within the next 12 months, such as:

  • Accounts Payable – Unpaid bills for goods already received from the company’s suppliers. These debts typically require payment within 90 days.
  • Current Long-Term Debt – Any long-term debt that will be retired in the next 12 months and its interest payments.

2. Long-Term Debt: Any borrowed money that the company will pay back over a time period longer than 12 months. Long-term debt includes bonds, loans from banks, and mortgages.

3. Other Liabilities: Everything else the company owes.

Note: Add current liabilities to long-term debt and other liabilities to calculate total liabilities.

 

C. Shareholder Equity

Subtract total liabilities from total assets, and you end up with the company’s net worth, also known as shareholder equity — the shareholders’ ownership stake after all the debts are paid. (That’s why stocks are also called equities.)

Common stock, preferred stock, and retained earnings comprise the three major parts of shareholder equity. These items may not be listed in the annual report or press releases, but they can be found in the 10-Q and 10-K SEC filings (if you are in the U.S.) They ultimately determine how much each share receives in dividends:

  • Common stocks – The number of common shares outstanding.
  • Preferred stock – The number of preferred shares outstanding.
  • Retained Earnings – The profits left over after dividends have been paid.

 

Also called “undistributed profits or earned surplus“, “retained earnings” provide the funds to make investments and purchase new assets.

If you an investor, a company’s balance sheet is only one item to consider when deciding where to invest your money. You also need to look at the other facts and figures, along with how the sector (industry) is doing as a whole and the company’s outlook as compared to that of other companies you’re investigating.

 

Income Statement (Company’s Profits and Losses)

The income statement (also known as the profit-and-loss or P&L statement) details all of the company’s revenues and expenses —how much the company receives in sales and how much the company spends to make those sales. After all the additions and subtractions, the final tally tells you whether the company earned a profit or suffered a loss and how much.

Here is a comparative Income Statement from the ABC Corp:

Income Statement Example For Investors

 

The income statement contains the fundamental equation for every business:

Sales – Expenses = Net Income

 

A positive net income indicates the company is profitable. Zero means it broke even. A negative number shows the company lost money. That’s all pretty straightforward, but the income statement usually contains more detail, covering the following items (among other things):

1. Revenues – Total dollar amount brought in from sales. Called the top line because it’s the top line of the income statement, revenues record the company’s total (gross) sales of products and services.

2. Costs of Goods Sold – Also called cost of revenue and cost of goods sold, this figure represents the costs of buying raw materials and producing the finished products.

3. Gross profit – Deduct the cost of products sold from the total revenues to arrive at gross profit. (The first benchmark comes right here, the gross margin or profit margin, also known as the return on sales. Divide gross profit by revenues to get profit margin. When it comes to dividend stocks, a profit margin of 50 percent of total revenues keeps me interested. Less that 50 percent and I toss it.)

4. Selling, general, and administrative expense – This category includes all costs to maintain the business:

  • Selling costs include all expenditures to sell the product, such as marketing and travel.
  • Administrative includes salaries and other services such as accountants and lawyers.
  • General costs encompass the costs to maintain plants and equipment.

 

5. Operating income – The difference between gross profit and selling, general, and administrative expenses. Operating income represents the total amount of profits that came from the actual performance of the company’s business.

6. Earnings before interest, taxes, depreciation and amortization – These earnings, often referred to as EBITDA, combine operating income with income from investments. (EBITDA is useful in giving a view to profits before non-cash accounting calculations, such as depreciation and amortization, are deducted. However, EBITDA is not an official number under the Generally Accepted Accounting Principles (GAAP), so it can be manipulated to suit management’s goals.)

7. Interest expense – The interest paid on debt.

8. Non operating income – Any income that doesn’t come from the company’s operations, such as the sale of assets or investment income.

9. Earnings from continuing operations – Profits from the company’s current businesses.

10. Earnings from discontinued operations – Profits from any businesses the company closed or sold this quarter.

11. Net Income – The true profit after every other possible expense has been paid. The profit is the bottom line, because it’s the last line on the income statement and what really matters at the end of each quarter. In the end, does this company make a profit or loss, and how big is it?

Another key number to check on an income statement is “earnings per share (EPS)”. In this example, even though the net income fell in the first quarter of 2009 to $2.6 million, compared with $2.7 million in the first quarter in 2008, earnings per share actually grew to 88 cents from 87 cents. That happened because ABC Corp. bought back some shares, lowering the number of shares available for sale on the stock market to $3,104,600 from $3,301,200. Fewer shares can boost earnings per share even when net income falls.

Earnings per share and net income are different ways to measure the same thing—profits. If they move in different directions, wonder why. Whenever you notice discrepancies like this one, you need to investigate. When a company buys back its own shares, it lowers the number of shares outstanding, which means the profits are spread out among fewer shares.

Did management lower the number of shares outstanding to artificially boost earnings per share and give investors a false impression about the company’s health?

Quite possibly. But that’s not the only possible reason for a buyback. Buybacks and insider purchases are often signs that management believes the company’s share prices will soon rise. In this case, the company bought back the shares because it felt they were under-priced. ABC Corp., a provider of consumer products, saw profits fall because of problems in the economy, not inside the company.

 

The recession and stock market crash of 2008 and 2009 caused consumers to reduce their spending, and share prices of ABC Corp. fell too.

Realizing the company was worth more than the stock market was pricing it, management decided the shares were selling at a bargain price and bought some back. Any time you see a number in parentheses, it means that’s a negative number, or outflow of money. If the net income figure is in parenthesis, the company recorded a net loss for the quarter.

Income statements compare the most recent quarter to the same quarter a year earlier. Some businesses are cyclical. For instance, retailers make a lot more money during the winter holidays than the first three months of the year. So, to compare the January-to-March quarter to the October-to-December quarter wouldn’t be a fair comparison.

 

Cash Flow Statement (The Cash Stream)

The cash flow statement is like the company’s checkbook register. It records the actual movement of all the cash in the company, showing which activities generated the money coming in and what was actually paid for in that quarter.

The balance sheet and income statement summarize how much, but the cash flow statement provides more details about where the cash came from, what it was spent on, and (perhaps most importantly) whether the company spent more money than it generated.

The cash flow statement measures the movement of money from three different activities—operations, investments, and financing. See below example:

Cash Flow Statement Example For Investor

 

1. Operating activities – The cash flow statement starts with the net income from the income statement, making it the top line. It then adds back in depreciation (an accounting device in which no actual cash moves), other operating expenses that don’t involve cash, and gains from the sale of assets. These items add up to the net cash generated from operating activities.

2. Investing activities – Any money spent on the purchase of new assets such as machinery, plants, or land gets classified as a capital expenditure, or Capital Expenditure (CapEx.) These new assets go to the future production of income. Companies invest in capital expenditures to maintain and grow the business. Cash flow from investing activities subtracts capital expenditures from all income generated by these assets.

3. Financing activities – It records the financing of the company’s operations, including the payment of dividends, the sale or purchase of stock, and the net amount the company has borrowed.

 

Although seeing the change in total cash flow over the time period listed is good, the more important take-away number is called free cash flow. Here’s the formula:

Free Cash Flow = Net Cash from Operating Activities – Capital Expenditures

 

For ABC Corp. in above figure, the free cash flow ends up being $4.283 million – $737,000 = $3.546 million. To cover unexpected costs, a healthy company’s free cash flow should be at least enough to exceed the sum of dividend payments and interest payments. A good rule of thumb is to look for companies with a free cash flow about three times greater than the current dividend.

Negative free cash flow doesn’t automatically mean the company is in trouble. It may be making huge investments for future earnings growth. However, it’s not a good sign for the dividend investor. Companies need to have cash on hand to pay dividends. If they don’t have enough cash on hand, they need to take on debt to make the payments or simply stop paying dividends. Borrowing funds to pay dividends isn’t sustainable, so free cash flow gives a clear look at how secure the dividend is.

Continue reading:

Inside Page-2. Measuring Healthiness of Company Target – I will guide you to understand the followings:

  • Calculating a Dividend’s Relative Strength
  • What is Yield (Dividend Yield)?
  • How to Calculate Dividend Per Share
  • How to Compute The Indicated Dividend Per Share
  • Figuring Out The Yield
  • How Pricing Affects Yield
  • Utilizing The Price-To-Earnings (P/E) Ratio
  • Determining Earnings Per Share
  • Calculating the P/E Ratio
  • Comparing P/E Ratios
  • Calculating The Payout Ratio
  • Calculating Return On Equity
  • Determining A Peek At The Quick Ratio

Author: Lie Dharma Putra

Putra is a CPA. His last position, in the corporate world, was a controller for a corporation in Costa Mesa, CA. After spending 15 years as a nine-to-five employee, he decided to serve more companies, families and even individuals, as a trusted business advisor. He blogs about accounting, finance and tax, during his spare time, and helps accounting students (around the globe) to understand the subject matter easier , faster. Follow him on twitter @LieDharmaPutra or add him to your circle at Google Plus Lie+

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