HOW IS
THE COMPANIES BALANCE SHEET ?
A Companies
stocks if purchased by an investor, skilled investors, go through the various
hidden factors about the stock also.
While
matching a Boy( Bride) with a Girl( Bridegroom) for a Marriage, then
(i) Their Age,
(ii) Educational qualification
(iii) Complexion,
(iv) Height,
(v) Weight,
(vi) Their
Horoscopy matching, etc are considered for a celebration.
Moreover in
some cases we have heard of “X” Ray, Scan, E.C.G, Cardiogram, are taken if
required.
Like the above
a companies internal health must also be assessed.
Introduction to Financial
Statements
The massive amount of numbers in a company's
financial statements can be bewildering and intimidating to many investors. On
the other hand, if you know how to analyze them, the financial statements are a
gold mine of information.
Financial statements are the medium by which a
company discloses information concerning its financial performance. Followers
of fundamental analysis use the quantitative information
gleaned from financial statements to make investment decisions. Before we jump
into the specifics of the three most important financial statements - income statements, balance sheets and cash flow statements - we will briefly introduce each financial statement's
specific function, along with where they can be found.
THE MAJOR STATEMENTS
THE BALANCE SHEET
The Snapshot of Health
The balance sheet, also
known as the statement of financial condition, offers a snapshot of a company's
health. It tells you how much a company owns (its assets), and how much it owes
(its liabilities). The difference between what it owns and what it owes is its equity,
also commonly called "net assets" or "shareholders equity".
The balance sheet tells investors a lot about a company's fundamentals: how much debt the company has, how much it needs to
collect from customers (and how fast it does so), how much cash and equivalents
it possesses and what kinds of funds the company has generated over time.
Investors often overlook
the balance sheet. The
balance sheet represents a record of a company's assets, liabilities and equity
at a particular point in time. Assets and liabilities aren't nearly as
sexy as revenue and earnings. While earnings are important, they don't tell the
whole story.
The balance sheet is named by the fact that a business's financial
structure balances in the following manner:
Assets = Liabilities +
Shareholders\' Equity
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Assets represent the resources that the business owns or
controls at a given point in time. This includes items such as cash, inventory,
machinery and buildings. The other side of the equation represents the total
value of the financing the company has used to acquire those assets. Financing
comes as a result of liabilities or equity.
Liabilities represent debt (which of course must be paid back), while equity
represents the total value of money that the owners have contributed to the
business - including retained earnings, which is the profit made in previous
years.
The Balance Sheet's Main
Three
Assets,
liability and equity are the three main components of the balance sheet.
Carefully analyzed, they can tell investors a lot about a company's
fundamentals.
Assets
There are two main types of assets: current assets and
non-current assets. Current assets are likely to be used up or converted into
cash within one business cycle - usually treated as twelve months. Three very
important current asset items found on the balance sheet are: cash, inventories andaccounts receivables.
Investors normally are attracted to companies with plenty of cash on their
balance sheets. After all, cash offers protection against tough times, and it
also gives companies more options for futuregrowth. Growing cash reserves often signal
strong company performance. Indeed, it shows that cash is accumulating so quickly
that management doesn't have time to figure out how to make use of it. A
dwindling cash pile could be a sign of trouble. That said, if loads of cash are
more or less a permanent feature of the company's balance sheet, investors need
to ask why the money is not being put to use. Cash could be there because
management has run out of investment opportunities or is too short-sighted to
know what to do with the money.
Inventories are finished products that haven't yet sold. As an investor, you
want to know if a company has too much money tied up in its inventory.
Companies have limited funds available to invest in inventory. To generate the
cash to pay bills and return a profit, they must sell the merchandise they have
purchased from suppliers. Inventory turnover (cost
of goods sold divided
by average inventory) measures how quickly the company is moving merchandise
through the warehouse to customers. If inventory grows faster than sales, it is
almost always a sign of deteriorating fundamentals.
Receivables are
outstanding (uncollected bills). Analyzing the speed at which a company
collects what it's owed can tell you a lot about its financial efficiency. If a
company's collection period is growing longer, it could mean problems ahead.
The company may be letting customers stretch their credit in order to recognize
greater top-line sales and that can spell trouble later on, especially if
customers face a cash crunch. Getting money right away is preferable to waiting
for it - since some of what is owed may never get paid. The quicker a company
gets its customers to make payments, the sooner it has cash to pay for
salaries, merchandise, equipment, loans, and best of all, dividends and growth
opportunities.
Non-current assets are defined as anything not classified as a current asset.
This includes items that are fixed assets, such as property,
plant and equipment (PP&E).
Unless the company is in financial distress and is liquidating assets,
investors need not pay too much attention to fixed assets. Since companies are
often unable to sell their fixed assets within any reasonable amount of time
they are carried on the balance sheet at cost regardless of their actual value.
As a result, it's is possible for companies to grossly inflate this number,
leaving investors with questionable and hard-to-compare asset figures.
Liabilities
There are current liabilities and non-current liabilities. Current
liabilities are obligations the firm must pay within a year, such as payments
owing to suppliers. Non-current liabilities, meanwhile, represent what the company
owes in a year or more time. Typically, non-current liabilities represent bank
and bondholder debt.
You usually want to see a manageable amount of debt. When debt levels are
falling, that's a good sign. Generally speaking, if a company has more assets
than liabilities, then it is in decent condition. By contrast, a company with a
large amount of liabilities relative to assets ought to be examined with more
diligence. Having too much debt relative to cash flows required to pay for
interest and debt repayments is one way a company can go bankrupt.
Look at the quick ratio. Subtract inventory from current
assets and then divide by current liabilities. If the ratio is 1 or higher, it
says that the company has enough cash and liquid assets to cover its short-term
debt obligations.
Quick Ratio =
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Current Assets -
Inventories
Current Liabilities
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Equity
Equity
represents what shareholders own, so it is often called shareholder's equity.
As described above, equity is equal to total assets minus total liabilities.
Equity = Total Assets
– Total Liabilities
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The two important equity items are paid-in capital and retained earnings. Paid-in capital is the amount
of money shareholders paid for their shares when the stock was first
offered to the public.
It basically represents how much money the firm received when it sold its
shares. In other words, retained earnings are a tally of the money the company
has chosen to reinvest in the business rather than pay to shareholders.
Investors should look closely at how a company puts retained capital to use and
how a company generates a return on it.
Most of the information about debt can be found on the balance sheet - but some
assets and debt obligations are not disclosed there. For starters, companies
often possess hard-to-measure intangible assets. Corporate intellectual property (items such as patents, trademarks, copyrights and business
methodologies), goodwill and brand recognition are all common assets in today's
marketplace. But they are not listed on company's balance sheets.
There is also off-balance
sheet debt to be aware
of. This is form of financing in which large capital expenditures are kept off
of a company's balance sheet through various classification methods. Companies
will often use off-balance-sheet financing to keep the debt levels low.
The Cash Flow Statement
The cash flow statement shows how much cash comes in and goes
out of the company over thequarter or the year. At first glance, that
sounds a lot like the income statement in that it records financial
performance over a specified period. But there is a big difference between the
two.
What distinguishes the two is accrual accounting, which is found on the income
statement. Accrual accounting requires companies to record revenues and
expenses when
transactions occur, not when cash is exchanged. At the same time, the income
statement, on the other hand, often includes non-cash revenues or expenses,
which the statement of cash flows does not include.
Just because the income statement shows net income of $10 does not means that
cash on the balance sheet will increase by $10. Whereas when the bottom of the
cash flow statement reads $10 net cash inflow, that's exactly what it means.
The company has $10 more in cash than at the end of the last financial period.
You may want to think of net cash from operations as the company's "true" cash profit.
Because it shows how much actual cash a company has generated, the statement of
cash flows is critical to understanding a company's fundamentals. It shows how the company is able
to pay for its operations and future growth.
Indeed, one of the most important features you should look for in a potential
investment is the company's ability to produce cash. Just because a company
shows a profit on the income statement doesn't mean it cannot get into trouble
later because of insufficient cash flows. A close examination of the cash flow
statement can give investors a better sense of how the company will fare.
Three Sections of the Cash Flow
Statement
Companies produce and consume cash in different ways, so the cash flow
statement is divided into three sections: cash flows from operations, financing and investing. Basically, the sections on operations
and financing show how the company gets its cash, while the investing section
shows how the company spends its cash.
Cash Flows from Operating Activities
This section shows how much cash comes from sales of the company's goods
and services, less the amount of cash needed to make and sell those goods and
services. Investors tend to prefer companies that produce a net positive cash
flow from operating activities. High growth companies, such as technology
firms, tend to show negative cash flow from operations in their formative
years. At the same time, changes in cash flow from operations typically offer a
preview of changes in net future income. Normally it's a good sign when it goes
up. Watch out for a widening gap between a company's reported earnings and its
cash flow from operating activities. If net income is
much higher than cash flow, the company may be speeding or slowing its booking
of income or costs.
Cash Flows from Investing Activities
This section largely reflects the amount of cash the company has spent
on capital expenditures, such as new equipment or
anything else that needed to keep the business going. It also includes
acquisitions of other businesses and monetary investments such as money market
funds.
You want to see a company re-invest capital in its business by at least the
rate of depreciationexpenses each year. If it doesn't
re-invest, it might show artificially high cash inflows in the current year
which may not be sustainable.
Cash Flow From Financing Activities
This section describes the goings-on of cash associated with outside financing
activities. Typical sources of cash inflow would be cash raised by selling
stock and bonds or by bank borrowings. Likewise, paying back a bank loan would
show up as a use of cash flow, as would dividend paymentsand common stock repurchases.
Cash Flow Statement Considerations:
Savvy investors are attracted to companies that produce plenty of free cash flow (FCF).
Free cash flow signals a company's ability to pay debt, pay dividends, buy back
stock and facilitate the growth of business. Free cash flow, which is
essentially the excess cash produced by the company, can be returned to
shareholders or invested in new growth opportunities without hurting the
existing operations. The most common method of
calculating free cash flow is:
Ideally, investors would like to see that the company can pay for the investing
figure out of operations without having to rely on outside financing to do so.
A company's ability to pay for its own operations and growth signals to
investors that it has very strong fundamentals.
Statement of Cash Flows
The statement of cash flows represents a record
of a business' cash inflows and outflows over a period of time. Typically, a
statement of cash flows focuses on the following cash-related activities:
- Operating Cash Flow (OCF): Cash generated from
day-to-day business operations
- Cash from investing (CFI): Cash
used for investing in assets, as well as the proceeds from the sale of
other businesses, equipment or long-term assets
- Cash from financing (CFF): Cash
paid or received from the issuing and borrowing of funds
The cash flow statement is important because it's very
difficult for a business to manipulate its cash situation. There is plenty that
aggressive accountants can do to manipulate earnings, but it's tough to fake
cash in the bank. For this reason some investors use the cash flow statement as
a more conservative measure of a company's performance.
Other Important Sections Found in Financial Filings
The financial
statements are not the only parts found in a business's annual and quarterly
SEC filings. Here are some other noteworthy sections:
Management Discussion
and Analysis ( MD& A )
As a preface to the financial statements,
a company's management will typically spend a few pages talking about the
recent year (or quarter) and provide background on the company. This is
referred to as the management discussion and analysis (MD&A).
In addition to providing investors a
clearer picture of what the company does, the MD&A also points out some key
areas in which the company has performed well.
Don't expect the letter from management to delve into all the juicy details
affecting the company's performance. The management's analysis is at their
discretion, so understand they probably aren't going to be disclosing any
negatives.
Here are some things to look out for:
- How candid and accurate are
management's comments?
- Does management discuss
significant financial trends over the past couple years? (As we've already
mentioned, it can be interesting to compare the MD&As over the last
few years to see how the message has changed and whether management
actually followed through with its plan.)
- How clear are management's
comments? If executives try to confuse you with big words and jargon,
perhaps they have something to hide.
- Do they mention potential risks
or uncertainties moving forward?
Disclosure is the name
of the game. If a company gives a decent amount of information in the MD&A,
it's likely that management is being upfront and honest. It should raise a red
flag if the MD&A ignores serious problems that the company has been facing.
The Auditor's Report The auditors' job is to express an opinion on whether the financial statements are reasonably accurate and
provide adequate disclosure. This is the purpose behind the auditor's report, which is sometimes called the
"report of independent accountants".
By law, every public company that trades stocks or bonds on an exchange must
have its annual reports audited by a certified
public accountants firm. An auditor's report is meant to scrutinize the
company and identify anything that might undermine the integrity of the financial statements.
The typical auditor's report is almost always broken into three paragraphs and
written in the following fashion:
Independent Auditor\'s Report
Paragraph 1
Recounts the responsibilities of the auditor and directors in general and
lists the areas of the financial statements that were audited.
Paragraph 2
Lists how the generally
accepted accounting principles (GAAP)
were applied, and what areas of the company were assessed.
Paragraph 3
Provides the auditor\'s opinion on the financial statements of the company
being audited. This is simply an opinion, not a guarantee of accuracy.
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While the auditor's report won't uncover any financial bombshells, audits give
credibility to the figures reported by management. You'll only see unaudited
financials for unlisted firms (those that trade OTCBB or on the Pink Sheets).
While quarterly statements aren't audited, you should be very wary of any
annual financials that haven't been given the accountants' stamp of approval.
The Notes to the Financial Statements
Just as the MD&A serves an introduction to the financial statements, the
notes to the financialstatements (sometimes
called footnotes) tie up any loose ends and complete the overall
picture. If the income statement, balance sheet and statement of cash flows are the heart of the financial statements, then
the footnotes are the arteries that keep everything connected. Therefore, if
you aren't reading the footnotes, you're missing out on a lot of information.
The footnotes list important information that could not be included in the
actual ledgers. For example, they list relevant things like outstanding leases,
the maturity dates of
outstanding debt and details on compensation plans, such as stock options, etc.
Generally speaking there are two types of
footnotes:
Accounting Methods - This type of footnote identifies and explains the major
accounting policies of the business that the company feels that you should be
aware of. This is especially important if a company has changed accounting
policies. It may be that a firm is practicing "cookie jar accounting" and is changing
policies only to take advantage of current conditions in order to hide poor
performance.
Disclosure - The second type of footnote provides
additional disclosure that simply could not be put in the financial statements.
The financial statements in an annual report are
supposed to be clean and easy to follow. To maintain this cleanliness, other
calculations are left for the footnotes. For example, details of long-term debt
- such as maturity dates and the interest rates at which debt was issued - can
give you a better idea of how borrowing costs are laid out. Other areas of
disclosure include everything from pension plan liabilities for existing
employees to details about ominous legal proceedings involving the company.
The majority of investors and analysts read the balance sheet, income statement
and cash flow statement but, for whatever reason, the footnotes are often
ignored. What sets informed investors apart is digging deeper and looking for
information that others typically wouldn't. No matter how boring it might be,
read the fine print - it will make you a better investor.
The Income Statement
While the balance sheet takes a snapshot approach in
examining a business, the income statement measures a company's performance
over a specific time frame. Technically, you could have a balance sheet for a
month or even a day, but you'll only see public companies report quarterly and
annually.
The income statement presents information about revenues,
expenses and profit that was generated as a result of the business' operations
for that period.
The income statement is
basically the first financial statement you will come across in an annual
report or quarterly Securities
And Exchange Commission (SEC) filing.
It also contains the numbers most often discussed when a company announces its results - numbers such as revenue, earnings and earnings
per share. Basically, the income statement shows how much money the
company generated (revenue), how much it spent (expenses) and the difference
between the two (profit) over a certain time period.
When it comes to analyzing fundamentals, the income statement
lets investors know how well the company's business is performing - or,
basically, whether or not the company is making money. Generally speaking,
companies ought to be able to bring in more money than they spend or they don't
stay in business for long. Those companies with low expenses relative to
revenue - or high profits relative to revenue - signal strong fundamentals to
investors.
Revenue as
an investor signal
Revenue, also commonly known as sales, is
generally the most straightforward part of the income statement. Often, there
is just a single number that represents all the money a company brought in
during a specific time period, although big companies sometimes break down
revenue by business segment or geography.
The best way for a company to improve profitability is by increasing sales
revenue. For instance, Starbucks Coffee has aggressive long-term sales growth
goals that include a distribution system of 20,000 stores worldwide. Consistent
sales growth has been a strong driver of Starbucks' profitability.
The best revenue are those that continue year in and year out. Temporary
increases, such as those that might result from a short-term promotion, are
less valuable and should garner a lower price-to-earnings multiple for a
company.
What are the Expenses?
There are many kinds of expenses, but the two
most common are the cost
of goods sold (COGS)
and selling, general and administrative expenses (SG&A). Cost of goods sold is the
expense most directly involved in creating revenue. It represents the costs of
producing or purchasing the goods or services sold by the company. For example,
if Wal-Mart pays a supplier $4 for a box of soap, which it sells to customers
for $5. When it is sold, Wal-Mart's cost of good sold for the box of soap would
be $4.
Next, costs involved in operating the business are SG&A. This category
includes marketing, salaries, utility bills, technology expenses and other
general costs associated with running a business. SG&A also includes depreciation and amortization. Companies must include the cost of
replacing worn out assets. Remember, some corporate expenses, such as research
and development (R&D)
at technology companies, are crucial to future growth and should not be cut,
even though doing so may make for a better-looking earnings report. Finally,
there are financial costs, notably taxes and interest payments, which need to
be considered.
Profits = Revenue - Expenses
Profit, most simply put, is equal to total revenue minus total expenses.
However, there are several commonly used profit subcategories that tell
investors how the company is performing. Gross profit is calculated as revenue
minus cost of sales. Returning to Wal-Mart again, the gross profit from the
sale of the soap would have been $1 ($5 sales price less $4 cost of goods sold
= $1 gross profit).
Companies with high gross margins will
have a lot of money left over to spend on other business operations, such as
R&D or marketing. So be on the lookout for downward trends in the gross
margin rate over time. This is a telltale sign of future problems facing the
bottom line. When cost of goods sold rises rapidly, they are likely to lower
gross profit margins - unless, of course, the company can pass these costs onto
customers in the form of higher prices.
Operating profit is equal to revenues minus the cost of
sales and SG&A. This number represents the profit a company made from its
actual operations, and excludes certain expenses and revenues that may not be
related to its central operations. High operating margins can mean the company
has effective control of costs, or that sales are increasing faster than
operating costs. Operating profit also gives investors an opportunity to do
profit-margin comparisons between companies that do not issue a separate
disclosure of their cost of goods sold figures (which are needed to do gross
margin analysis). Operating profit measures how much cash the business throws
off, and some consider it a more reliable measure of profitability since it is
harder to manipulate with accounting tricks than net earnings.
Net income generally represents the company's profit after all expenses,
including financial expenses, have been paid. This number is often called the
"bottom line" and is generally the figure
people refer to when they use the word "profit" or
"earnings".
When a company has a high profit margin, it usually
means that it also has one or more advantages over its competition. Companies
with high net profit margins have a bigger cushion to protect themselves during
the hard times. Companies with low profit margins can get wiped out in a
downturn. And companies with profit margins reflecting a competitive advantage
are able to improve their market share during the hard times - leaving them
even better positioned when things improve again.
Conclusion
You can gain valuable insights about a company by examining its income
statement. Increasing sales offers the first sign of strong fundamentals.
Rising margins indicate increasing efficiency and profitability. It's also a
good idea to determine whether the company is performing in line with industry
peers and competitors. Look for significant changes in revenues, costs of goods
sold and SG&A to get a sense of the company's profit fundamentals.
