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In stock investing, it is important to base your decisions on sound analysis of the company’s performance and growth prospects. This is not possible without going through the nitty-gritty of a company’s financial statement. For instance, you need to know if it is generating revenues from its core businesses operation or if it has enough cash to cover dividend payment since dividends are usually paid in cash. This is best analyzed by looking at cash flow statements. If you are wondering just how much profit a company has made in its income report over a period of time, you have to refer to its income statement.
There are four main types of financial statements that you need to understand. These are the balance sheets, income statements, cash flow statements, and statements of shareholders’ equity. You don’t actually need to take a complete accounting course to understand these, unless you want to make a living out of it, but knowledge on the basics is essential. This article provides a crash course on how to read a financial report.
1) Balance Sheet
This is an example of a balance sheet statement from Catepillar Inc:
If you want to have a quick look at what the company owns and owes at a given time, consult the balance sheet. The balance sheet, as the name implies, shows the company’s assets that have to balance with the sum of its liabilities and shareholder equity. It does not show the flows of money but rather a snapshot of these three items.
Assets are simply things that the company owns which have value and can be sold or used by the company to create products and services. The amounts of cash and investments the company owns are also assets. Assets can also be physical or intangible. Physical properties include plants, equipment, trucks, and inventory. The intangible assets refer to non-physical ones like patents or trademarks.
Assets are grouped in the balance sheet depending on how quickly they are converted to cash. Current assets refer to those that the company expects to translate into cash over a year’s duration such as inventory. Non-current assets like fixed assets take longer to turn into cash. Fixed assets, like office furniture and trucks, are things that are important in the business operations but which are not for sale.
Liabilities and Shareholder Equity
What the company owes to other companies or entities are called liabilities. These include loans from the bank, obligations to suppliers, rental fee for using a property, money to be paid to employees, tax duties to the government, and other obligations like providing goods or services to clients in the future. You would see that liabilities are listed based on the term or due dates. Current liabilities are those that have to be paid off in a year’s time. Long-term ones are those that will not mature within the year.
The company’s shareholder equity is what’s left if all the assets are sold and all liabilities are paid off. It’s the money that goes to the owners or shareholders. This money is also known as net worth or capital. This refers to the money that owners or shareholders have invested in the company stock; earnings should be added while losses, deducted. Sometimes earnings are not retained but instead distributed as dividends.
2) Income Statement
Take a look below at a typical company’s income statement:
The income statement should be able to tell you how much money the company had produced and spent over a certain period. It shows the net earnings or losses of the company. These are obtained based on revenues and costs or expenses data. You would also see the earnings per share (EPS) from the income statement. Should the company decide to give all its net earnings for a given period, the EPS would be the amount that shareholders receive for each share of stock owned. But companies do not distribute all the money it has made but rather reinvest it in its business.
The income statement is built like a set of stairs. You start off with the total amount the business has brought in from the sale of products or services and go down while deducting various kinds of costs. In the end, you should arrive at the net earnings or losses of the company for that particular period. This total amount you have simply refers to the sales or gross revenues. You call it gross since you would have to deduct expenses from it. After gross sales, you can find merchandise returns and sales discount. These are amounts that the company does not collect on sales it has made. After this, you should take out returns and allowances so you can get the net revenues. Next to the net revenues are the costs of sales. It is the amount used to produce products and services during the specified time. If you remove costs of sales from net revenues, you will get the gross profit or gross margin. It is already considered profit but there are things that you need to deduct first.
The next item in the income statement deals with operating expenses like salaries of administrative personnel, marketing costs, and research expenses. These expenses differ from the costs of sales because these are not directly connected to the production of goods and services that the company sells. In addition, you need to take out depreciation or the wear and tear of machinery, furniture, and tools among other assets that are normally used over a long period of time. Since the costs of these physical assets are spread over time, their costs in the income statement are only a fraction of their acquisition costs. When all these things are taken out, you will come up with the operating profit prior to deduction of interest and income taxes. This result is often called income from operations.
Next to this, you will arrive at the interest income and interest expense. Interest income refers to the amount of money the company makes from placing its cash in savings accounts that bear interest, money market funds, or such other funds. On the other hand, interest expense is the cost of borrowing money. Take note that some companies present these items separately while others combine them. After interest income and expense are taken into account, you would then come up with operating profit before income tax. Income tax is the last item to be deducted from the annual income report. After this, you will now have the bottom line which is either a net profit, also known as net income, or net losses.
One of the useful financial ratios obtained from the income statement that investor often use is the net profit margin, an indicator of profitability. The more profitable company between any two relatively similar companies presents a more attractive investment than the less profitable one. This shows that this company is able to control its expenses such that it can arrive at a higher profit out of its sales or revenues.
3) Cash Flow Statement
This is an example of a company’s cash flow statement (Microsoft in this case):
The movement of cash to and from the company over a period of time is shown in the cash flow statement. It is very critical that a company has enough cash in its pocket to easily purchase its needs and pay its expenses. By using information from the income statement and balance sheet, the cash flow statement should be able to tell you if the company has produced enough cash or not. Take note that this does not present absolute amounts in a given point in time but rather flows that change over a certain period or quarter in a quarterly report.
Usually, this part shows the cash flows associated with the net income or net losses. The amounts of actual cash that the business gets from its operations as well as that which is used to carry these out are made consistent with the net income. This is possible by adjusting the net income such that depreciation is added back and cash amounts used or generated by other assets and liabilities involved in operating activities are taken into account.
Investors should look at the cash from operating activities in comparison with the net income. The cash amount should always be larger than the net income. If this is the case, the earnings are considered high quality earnings. The opposite is considered a red flag because it means income it not turning into cash.
By its name, this part dwells on cash flows from the company’s investments like sales and acquisitions of long-term assets such as plant and equipment, properties, and investment securities. Cash used in buying machinery for instance is an outflow from investing activities. The proceeds from selling parts of an investment portfolio will turn up as a cash inflow.
The third part reports the flows of cash from various financing activities like the issuance and repurchase of bonds and stocks. Getting cash from banks through loans are also entered into this section. The payments made by the company to these loans are also included. This section will also show the payment of dividends.
You have to look deeper into each of these sections and how they matter to the overall cash position. A negative overall cash flow does not always mean that the company is not a good investment. What you should pay attention to is the flow from its core business activities, the result of the cash flow from operating activities. If this is positive, then the negative overall cash flow may have been due to some huge investment spending the company has made which is not necessarily a bad idea.
A consistently large amount of cash can also mean that the company is able to increase its dividend which is well-loved by dividend income-seekers. Such company is also able to buy back some of the stocks it had issued, lower its debt levels, or even buy another company which can increase its value in the future.
4) Statement of Shareholders’ Equity
Below is an example of a shareholders’ equity statement:
This financial statement simply presents the changes in the interests of the shareholders over a given period. This statement shows the changes in the balance sheet’s equity section. It includes retained earnings, value of shares, additional capital, and the like. The statement shows how these items are balanced out as well as the changes in them over time. Since these sets of information are about shareholders, they are worth a good look by any investor who is planning to invest in the company.
Understanding these financial reports is very essential in picking the right companies to invest in. Make sure that when you compare the reports of various companies, they are presented in the same fashion. Some companies can have quite different ways of presenting their financial statements depending on the nature of their business. You also have to remember that you can only compare companies of relative size in the same industry. This means that you are not comparing oranges to apples but rather orange with orange or apple versus apple.
Likewise, the huge amount of information you can get from these statement may not suffice if you are not familiar with how the company operates its business. Therefore, apart from these statements, you need to look into a company’s organizational structure and subsidiaries to gain a better understanding as to the nature and scope of its business operations. You can find these from its 10-K which is filed once per year to the Securities and Exchange Commission. If you want a more frequent picture, browse through the 10-Q which provide quarterly data.
You must remember that these financial statements are a record of the company’s past performances. As an investor, while the past performance is very important in choosing the best companies to invest in, the growth prospects are equally important. So in addition to going through a huge amount of numbers, grab a newspaper or do your own research on the Internet. Check out what is up with the companies you have in mind. Are the about to acquire another company? Are they planning some expansions? How important are these expansions to their future growth prospects?