12 Things You Need To Know About Financial Statements

April 01 2011| Filed Under » Investing Basics

Knowing how to work with the numbers in a company's financial statements is an essential skill for stock investors. The meaningful interpretation and analysis of

balance sheets, income statements and cash flow statements to discern a company's investment qualities is the basis for smart investment choices. However, the

diversity of financial reporting requires that we first become familiar with certain general financial statement characteristics before focusing on individual corporate

financials. In this article, we'll show you what the financial statements have to offer and how to use them to your advantage.

1. Financial Statements Are Scorecards

There are millions of individual investors worldwide, and while a large percentage of these investors have chosen mutual funds as the vehicle of choice for their

investing activities, a very large percentage of individual investors are also investing directly in stocks. Prudent investing practices dictate that we seek out quality

companies with strong balance sheets, solid earnings and positive cash flows.

Whether you're a do-it-yourself or rely on guidance from an investment professional, learning certain fundamental financial statement analysis skills can be very

useful - it's certainly not just for the experts. Over 30 years ago, businessman Robert Follet wrote a book entitled "How To Keep Score In Business" (1987). His

principal point was that in business you keep score with dollars, and the scorecard is a financial statement. He recognized that "a lot of people don't understand

keeping score in business. They get mixed up about profits, assets, cash flow and return on investment."

The same thing could be said today about a large portion of the investing public, especially when it comes to identifying investment values in financial statements.

But don't let this intimidate you; it can be done. As Michael C. Thomsett says in "Mastering Fundamental Analysis" (1998):

"That there is no secret is the biggest secret of Wall Street - and of any specialized industry. Very little in the financial world is so complex that you cannot grasp it.

The fundamentals - as their name implies - are basic and relatively uncomplicated. The only factor complicating financial information is jargon, overly complex

statistical analysis and complex formulas that don't convey information any better than straight talk." (For more information, see Introduction To Fundamental

Analysis and What Are Fundamentals?)

What follows is a brief discussion of 12 common financial statement characteristics to keep in mind before you start your analytical journey.

2. What Financial Statements to Use

For investment analysis purposes, the financial statements that are used are the balance sheet, the income statement and the cash flow statement. The statements

of shareholders' equity and retained earnings, which are seldom presented, contain nice-to-know, but not critical, information, and are not used by financial analysts.

A word of caution: there are those in the general investing public who tend to focus on just the income statement and the balance sheet, thereby relegating cash

flow considerations to somewhat of a secondary status. That's a mistake; for now, simply make a permanent mental note that the cash flow statement contains

critically important analytical data. (To learn more, check out Reading The Balance Sheet, Understanding The Income Statement and The Essentials Of Cash Flow.)

3. Knowing What's Behind the Numbers

The numbers in a company's financials reflect real world events. These numbers and the financial ratios/indicators that are derived from them for investment

analysis are easier to understand if you can visualize the underlying realities of this essentially quantitative information. For example, before you start crunching

numbers, have an understanding of what the company does, its products and/or services, and the industry in which it operates.

4. The Diversity of Financial Reporting

Don't expect financial statements to fit into a single mold. Many articles and books on financial statement analysis take a one-size-fits-all approach. The less-

experienced investor is going to get lost when he or she encounters a presentation of accounts that falls outside the mainstream or so-called "typical" company.

Simply remember that the diverse nature of business activities results in a diversity of financial statement presentations. This is particularly true of the balance sheet;

the income and cash flow statements are less susceptible to this phenomenon.

5. The Challenge of Understanding Financial Jargon

The lack of any appreciable standardization of financial reporting terminology complicates the understanding of many financial statement account entries. This

circumstance can be confusing for the beginning investor. There's little hope that things will change on this issue in the foreseeable future, but a good financial

dictionary can help considerably.

6. Accounting Is an Art, Not a Science

The presentation of a company's financial position, as portrayed in its financial statements, is influenced by management estimates and judgments. In the best of

circumstances, management is scrupulously honest and candid, while the outside auditors are demanding, strict and uncompromising. Whatever the case, the

imprecision that can be inherently found in the accounting process means that the prudent investor should take an inquiring and skeptical approach toward financial

statement analysis. (For related content, see Don't Forget To Read The Prospectus! and How To Read Footnotes - Part 2: Evaluating Accounting Risk.)

7. Two Key Accounting Conventions

Generally accepted accounting principles (GAAP) are used to prepare financial statements. The sum total of these accounting concepts and assumptions is huge. For

investors, a basic understanding of at least two of these conventions - historical cost and accrual accounting - is particularly important. According to GAAP, assets are

valued at their purchase price (historical cost), which may be significantly different than their current market value. Revenues are recorded when goods or services

are delivered and expenses recorded when incurred. Generally, this flow does not coincide with the actual receipt and disbursement of cash, which is why the cash

flow becomes so important.

8. Non-Financial Statement Information

Information on the state of the economy, industry and competitive considerations, market forces, technological change, and the quality of management and the

workforce are not directly reflected in a company's financial statements. Investors need to recognize that financial statement insights are but one piece, albeit an

important one, of the larger investment information puzzle.

9. Financial Ratios and Indicators

The absolute numbers in financial statements are of little value for investment analysis, which must transform these numbers into meaningful relationships to judge

a company's financial performance and condition. The resulting ratios and indicators must be viewed over extended periods to reflect trends. Here again, beware of

the one-size-fits-all syndrome. Evaluative financial metrics can differ significantly by industry, company size and stage of development.

10. Notes to the Financial Statements

It is difficult for financial statement numbers to provide the disclosure required by regulatory authorities. Professional analysts universally agree that a thorough

understanding of the notes to financial statements is essential in order to properly evaluate a company's financial condition and performance. As noted by auditors

on financial statements "the accompanying notes are an integral part of these financial statements." Take these noted comments seriously. (For more insight, see

Footnotes: Start Reading The Fine Print.)

11. The Auditor's Report

Prudent investors should only consider investing in companies with audited financial statements, which are a requirement for all publicly traded companies. Before

digging into a company's financials, the first thing to do is read the auditor's report. A "clean opinion" provides you with a green light to proceed. Qualifying remarks

may be benign or serious; in the case of the latter, you may not want to proceed.

12. Consolidated Financial Statements

Generally, the word "consolidated" appears in the title of a financial statement, as in a consolidated balance sheet. Consolidation of a parent company and its

majority-owned (more that 50% ownership or "effective control") subsidiaries means that the combined activities of separate legal entities are expressed as one

economic unit. The presumption is that a consolidation as one entity is more meaningful than separate statements for different entities.

Conclusion

The financial statement perspectives provided in this overview are meant to give readers the big picture. With these considerations in mind, beginning investors

should be better prepared to cope with learning the analytical details of discerning the investment qualities reflected in a company's financials.

Measuring Company Efficiency

July 12 2012| Filed Under » Accounting, Fundamental Analysis, Investment, Stocks

Analyzing a company's inventories and receivables is a reliable means of helping to determine whether it is a good investment play or not. Companies stay efficient

and competitive by keeping inventory levels down and speeding up collection of what they are owed. In this article, we'll take you through the process step by step.

SEE: The Working Capital Position

Getting Goods off the Shelf

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 - they can't

stock a lifetime supply of every item. To generate the cash to pay bills and return a profit, they must sell the merchandise they have purchased from suppliers.

Inventory turnover measures how quickly the company is moving merchandise through the warehouse to customers.

Let's look at U.S. retail giant Walmart, known for its super-efficient operations and state-of-the-art supply chain system, which keeps inventories at a bare minimum.

In fiscal 2011, inventory sat on its shelves for an average of 40 days. Like most companies, Walmart doesn't provide inventory turnover numbers to investors, but

they can be flushed out using data from Walmart's financial statements.

Inventory Days = 365 Days / (Average Cost of Goods Sold/Average Inventory)

Obtaining Average COGS

To get the necessary data, find its Consolidated Statements of Income on the company's website and locate cost of goods sold (COGS), or "cost of sales" found just

below the top-line sales (revenue). For the 2011 fiscal year, Walmart's COGS totaled US$315.29 billion.

Obtaining Average Inventory

Then look at the Consolidated Balance Sheet (the next page after Statements of Income). Under assets, you will find the inventory figure. For 2011, Walmart's

inventory was $36.3 billion, and in 2010, it was $32.7 billion. Average the two numbers ($36.3 billion + $32.7 billion / 2 = $34.5 billion), then divide that inventory

average, $34.5 billion, into the average cost of goods sold in 2011. You will arrive at the annual turnover ratio 9.1. Now, divide the number of days in the year, 365,

by the annual turnover ratio, 9.1, and that gives you 40.1. That means it takes Walmart about 40 days, or about a month and a half, to cycle through its inventory.

This number of inventory days is also known as the "days-to-sell" figure.

Broadly speaking, the smaller number of days, the more efficient a company - inventory is held for less time and less money is tied up in inventory. Using the same

calculations above, Walmart's numbers back in 2003 yielded 45 days, which goes to show that within that decade range, the company has increased its inventory

efficiency. Thus, money is freed up for things like research and development, marketing or even share buybacks and dividend payments. If the number of days is high,

that could mean that sales are poor and inventories are piling up in warehouses.

SEE: How To Evaluate A Company's Balance Sheet

Remember, however, that it's not enough to know the number at any specific time. Investors need to know if the days-to-sell inventory figure is getting better or

worse over several periods. To get a decent sense of the trend, calculate at least two years' worth of quarterly inventory sales numbers.

If you do spot an obvious trend in the numbers, it's worthwhile asking why. Investors would be pleased if the number of inventory days were falling because of

greater efficiencies gained through tighter inventory controls. On the other hand, products may be moving off the shelf more quickly simply because the company is

cutting its prices.

To get an answer, flip to the Income Statement and look at Walmart's gross margin (top-line revenue, or net sales, minus cost of sales). Check to see whether gross

margins as a percentage of revenue/net sales are on an upward or downward trajectory. Gross margins, which are consistent or on-the-rise offer an encouraging sign

of improved efficiencies. Shrinking margins, on the other hand, suggest the company is resorting to price cuts to boost sales. Looking back at the numbers, you will

find that Walmart's gross margins, as expressed as a percentage of net sales, went down 0.2% from 24.9% in 2010 to 24.7% in 2011 (gross margin = net sales -

COGS/net sales).

If inventory days are increasing, that's not necessarily a bad thing. Companies normally let inventories build up when they are introducing a new product in the

market or ahead of a busy sales period. However, if you don't foresee an obvious pick-up in demand coming, the increase could mean that unsold goods will simply

collect dust in the stockroom.

Collecting What's Owed - Soon!

Accounts receivable is the money that is currently owed to a company by its customers. Analyzing the speed at which a company collects what it is 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 - especially since some of what is owed may never be paid. The quicker a company gets its customers to make payments, the sooner it has

cash to pay for salaries, merchandise and equipment, loans and, best of all, dividends and growth opportunities.

Therefore, investors should determine how many days, on average, the company takes to collect its accounts receivable. Here is the formula:

Receivables Days = 365 Days / (Revenues/Average Receivables)

On the top of the Income Statement, you will find revenues. On the Balance Sheet under current assets, you will find accounts receivable. Walmart generated $418.9

billion in net sales in 2011. At the end of that year, its accounts receivable stood at $5 billion, and in 2010, it was $4 billion, yielding an average accounts receivable

figure of about $7 billion.

Dividing revenue by average receivables gives a receivables turnover ratio of 60. This shows how many times the company turned over its receivables in the annual

period. Three hundred and sixty-five days of the year divided by the receivables turnover ratio of 60 gives a receivables turnover rate of three days. On average, it

took about a week for Walmart to receive payment for the goods it sold.

SEE: Read This Before You Sell

Sizing-up Efficiencies

It's good news when you see a shortening of both inventory days and the collection period. Still, that's not enough to fully understand how a company is running. To

gauge real efficiency, you need to see how the company stacks up against other players in the industry.

Let's see how Walmart compared in 2003 to Target Stores, another large, publicly-listed retail chain. Dramatic differences can be seen. While Walmart, on average,

turned over its inventory every 40 days during that period, Target's inventory turnover took nearly 61 days. Walmart collected payments in just three days.

Meanwhile, Target, which relied heavily on slow-to-collect credit card revenues, required almost 64 days to get its money. As Walmart shows, using competitors as a

benchmark can enhance investors' sense of a company's real efficiency.

SEE: A Look At Corporate Profit Margins

Still, comparative numbers can be deceiving if investors don't do enough research. Just because one firm's numbers are lower than a rival's, doesn't mean that one

firm will have a more efficient performance. Business models and product mix need to be taken into account. Inventory cycles differ from industry to industry.

Keep in mind that these efficiency measures apply largely to companies that make or sell goods. Software companies and firms that sell intellectual property as well

as many service companies do not carry inventory as part of their day-to-day business, so the inventory days' metric is of little value when analyzing these kinds of

companies. However, you can certainly use the days' receivables formula to examine how efficiently these companies collect what's owed.

The Bottom Line

Finding out where a firm's cash is tied up in inventories and receivables can help shed light on its how efficiently it is being managed. Of course, it takes time and

effort to extract the information from company financial statements. However, doing the analysis will certainly help you find which companies are worthy of

investment.

Detecting Accounting Manipulation

February 10 2012| Filed Under » Accounting, Fundamental Analysis, Investment

There's more than one way to make financial statements look pristine when earnings season comes around. This article will take a look at two ways in which

companies can fool investors, so that you can learn to spot accounting manipulation: "one-time charges" and "investment gains."

SEE: Strategies For Quarterly Earnings Season

Some Background on GAAP

Generally Accepted Accounting Principles is a common set of accounting principles, standards and procedures set out by institutes and boards around the world.

GAAP is a combination of authoritative standards and accepted ways of doing accounting.

While GAAP is a good set of standards for companies to follow, it still leaves room for them to distort or pamper figures. The line between reflecting the true value of

a company and exaggerating it, is a blurry one for some GAAP techniques. One-time charges and investment gains are examples of such techniques, as they are legal

ways to represent figures, but can still have a tendency to fool investors into thinking things are better than they really are.

One-Time Charges

Many high-profile companies have been known to take one-time charges, sometimes known as the "big bath." One-time charges are expenses that the company

claims will not occur year after year, and, as such, are not recorded on the income statement but included in a separate charge. One-time charges are technically not

recurring and therefore not a true factor affecting the value of the company. So, earnings figures calculated with the one-time charges are usually reported

separately from the figures on the income statement, such as net income. (For more on one-time charges read The One-Time Expense Warning.)

Unfortunately, companies sometimes use these charges to bury unfavorable expenses or investments that went wrong, which should be recorded on the income

statement, where investors could clearly see the true negative effect on the company's net income. The problem with a one-time charge is that a company can too

easily justify it by claiming that it's necessary but not a usual part of the company's operations. But hiding management mistakes in a category of expense that, by

definition, does not have a true effect on earnings is a manipulation of the leeway allowed in accounting standards.

This isn't to say it's a bad thing every time a company writes down charges. The problem lies with those companies that continually write things down. Firms

sometimes use one-time charges to blame previous management for leaving problems. In truth, these charges may be an indication that something is fundamentally

wrong with the company. Also, watch out when companies use restructuring charges to improve future earnings and profitability. By taking huge restructuring

charges when times are bad, the company reduces depreciation in future periods and ultimately increases income.

What's an investor to do? These non-recurring, "one-time" charges should always be viewed with a degree of skepticism. The adjustments should reflect reality. If,

for example, the charges are really operating expenses, by all means, include these numbers into the bottom line of a company. If, on the other hand, the company is

writing down bad debts, you should question why it is lending money so freely to companies with credit problems - the answer could be vendor financing. (Read

Earnings Sustainability: The Key To Your Investing Future to learn how to analyze the sustainability of a company's earnings.)

Investment Gains

At the peak of the dotcom boom, when companies were throwing money at anything and everything, a lot of investment gains were showing up on financial

statements. This happens whenever things are going well in the markets. An investment gain is definitely better than a loss, but these gains are typically unsteady.

Take for example, Intel's experience. Its investment and interest gains during the second quarter of 2000 were just over $2.3 billion. One year later, in the second

quarter of 2001, they sank to a paltry $115 million. Intel's investment income declined at a faster rate than the Nasdaq, partly thanks to bad investments.

A company's aims for investment gains can pose another problem: when the company is having trouble meeting earnings expectations, it sometimes becomes

consumed with boosting investment income to meet predictions. This can mean that the core operations of the company are left behind. The moral of the story is to

not put too much faith into investment gains. Although they may reflect the company's ability to diversify revenue streams, watch out because these investments can

fluctuate widely. These gains flourish when the future looks bright, but shrink when the financial markets head south.

The Bottom Line

Next time you analyze the financial statements of a company, take a close look at the one-time charges and investment gains. Spotting these two accounting tricks

can help to tell the whole story behind a company - don't get fooled into thinking the picture is brighter than it really is. (For further reading see Creative Accounting:

When It's Too Good To Be True.)

Analyze Cash Flow The Easy Way

November 26 2012| Filed Under » Accounting, Fundamental Analysis, Stocks

If you believe in the old adage, "it takes money to make money," then you can grasp the essence of cash flow and what it means to a company. The statement of

cash flows reveals how a company spends its money (cash outflows) and where the money comes from (cash inflows). We know that a company's profitability, as

shown by its net income, is an important investment evaluator. It would be nice to be able to think of this net income figure as a quick and easy way to judge a

company's overall performance. However, although accrual accounting provides a basis for matching revenues and expenses, this system does not actually reflect the

amount the company has received from the profits illustrated in this system. This can be a vital distinction. In this article, we'll explain what the cash flow statement

can tell you and show you where to look to find this information.

Difference Between Earnings and Cash

In an August 1995 article in Individual Investor, Jonathan Moreland provides a very succinct assessment of the difference between earnings and cash. He says "at

least as important as a company's profitability is its liquidity - whether or not it's taking in enough money to meet its obligations. Companies, after all, go bankrupt

because they cannot pay their bills, not because they are unprofitable. Now, that's an obvious point. Even so, many investors routinely ignore it. How? By looking

only at a firm's income statement and not the cash flow statement."

The Statement of Cash Flows

Cash flow statements have three distinct sections, each of which relates to a particular component - operations, investing and financing - of a company's business

activities. For the less-experienced investor, making sense of a statement of cash flows is made easier by the use of literally-descriptive account captions and the

standardization of the terminology and presentation formats used by all companies:

Cash Flow from Operations

This is the key source of a company's cash generation. It is the cash that the company produces internally as opposed to funds coming from outside investing and

financing activities. In this section of the cash flow statement, net income (income statement) is adjusted for non-cash charges and the increases and decreases to

working capital items - operating assets and liabilities in the balance sheet's current position.

Cash Flow from Investing

For the most part, investing transactions generate cash outflows, such as capital expenditures for plant, property and equipment, business acquisitions and the

purchase of investment securities. Inflows come from the sale of assets, businesses and investment securities. For investors, the most important item in this category

is capital expenditures (more on this later). It's generally assumed that this use of cash is a prime necessity for ensuring the proper maintenance of, and additions to,

a company's physical assets to support its efficient operation and competitiveness.

Cash Flow from Financing

Debt and equity transactions dominate this category. Companies continuously borrow and repay debt. The issuance of stock is much less frequent. Here again, for

investors, particularly income investors, the most important item is cash dividends paid. It's cash, not profits, that is used to pay dividends to shareholders.

A Simplified Approach to Cash Flow Analysis

A company's cash flow can be defined as the number that appears in the cash flow statement as net cash provided by operating activities, or "net operating cash

flow," or some version of this caption. However, there is no universally accepted definition. For instance, many financial professionals consider a company's cash flow

to be the sum of its net income and depreciation (a non-cash charge in the income statement). While often coming close to net operating cash flow, this

professional's shortcut can be way off the mark and investors should stick with the net operating cash flow number.

While cash flow analysis can include several ratios, the following indicators provide a starting point for an investor to measure the investment quality of a company's

cash flow:

Operating Cash Flow/Net Sales

This ratio, which is expressed as a percentage of a company's net operating cash flow to its net sales, or revenue (from the income statement), tells us how many

dollars of cash we get for every dollar of sales.

There is no exact percentage to look for but obviously, the higher the percentage the better. It should also be noted that industry and company ratios will vary

widely. Investors should track this indicator's performance historically to detect significant variances from the company's average cash flow/sales relationship along

with how the company's ratio compares to its peers. Also, keep an eye on how cash flow increases as sales increase; it is important that they move at a similar rate

over time.

History of Free Cash Flow

Free cash flow is often defined as net operating cash flow minus capital expenditures, which, as mentioned previously, are considered obligatory. A steady, consistent

generation of free cash flow is a highly favorable investment quality - so make sure to look for a company that shows steady and growing free cash flow numbers.

For the sake of conservatism, you can go one step further by expanding what is included in the free cash flow number. For example, in addition to capital

expenditures, you could also include dividends for the amount to be subtracted from net operating cash flow to get to get a more comprehensive sense of free cash

flow. This could then be compared to sales as was shown above.

As a practical matter, if a company has a history of dividend payments, it cannot easily suspend or eliminate them without causing shareholders some real pain. Even

dividend payout reductions, while less injurious, are problematic for many shareholders. In general, the market considers dividend payments to be in the same

category as capital expenditures - as necessary cash outlays.

But the important thing here is looking for stable levels. This shows not only the company's ability to generate cash flow but it also signals that the company should

be able to continue funding its operations.

Comprehensive Free Cash Flow Coverage

You can calculate a comprehensive free cash flow ratio by dividing the comprehensive free cash flow by net operating cash flow to get a percentage ratio - the higher

the percentage the better.

Free cash flow is an important evaluative indicator for investors. It captures all the positive qualities of internally produced cash from a company's operations and

subjects it to a critical use of cash - capital expenditures. If a company's cash generation passes this test in a positive way, it is in a strong position to avoid excessive

borrowing, expand its business, pay dividends and to weather hard times.

The term "cash cow," which is applied to companies with ample free cash flow, is not a very elegant term, but it is certainly one of the more appealing investment

qualities you can apply to a company with this characteristic.

The Bottom Line

Once you understand the importance of how cash flow is generated and reported, you can use these simple indicators to conduct an analysis on your own portfolio.

The point, like Moreland said above, is to stay away from "looking only at a firm's income statement and not the cash flow statement." This approach will allow you

to discover how a company is managing to pay its obligations and make money for its investors.

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