Chapter 16

Ten Tips for Reading a Financial Report

In This Chapter

Judging profit performance

Bumping into extraordinary gains and losses

Differentiating cash flow from profit

Looking for signs of financial distress

Recognizing the limits of financial reports

You can compare reading a business’s financial report with shucking an oyster: You have to know what you’re doing and work to get at the meat. You need a good reason to pry into a financial report. The main reason to become informed about the financial performance and condition of a business is because you have a stake in the business. The financial success or failure of the business makes a difference to you.

Shareowners have a major stake in a business, of course. The lenders of a business also have a stake, which can be major. Shareowners and lenders are the two main audiences of a financial report. But others also have a financial stake in a business. For example, my books are published by John Wiley & Sons (a public company), so I look at its financial report to gain comfort that my royalties will be paid.

In this chapter, I offer practical tips to help investors, lenders, or anyone who has a financial stake in a business glean important insights from its financial reports. These tips also help anyone else with an interest in the financial reports of a business. See the sidebar “Sorting out financial report readers.”

Get in the Right Frame of Mind

So often I hear non-accountants say that they don’t read financial reports because they are not “numbers” people. You don’t have to be a math wizard or rocket scientist to extract the essential points from a financial report. I know that you can find the bottom line in the income statement and compare this profit number with other relevant numbers in the financial statements. You can read the amount of cash in the balance sheet. If the business has a zero or near-zero cash balance, you know that this is a serious — perhaps fatal — problem.

Therefore, my first bit of advice is to get in the right frame of mind. Don’t let a financial report bamboozle you. Locate the income statement, find bottom-line profit (or loss!), and get going. You can do it — especially having a book like this one to help you along.

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Decide What to Read

Suppose you own stock shares in a public corporation and want to keep informed about its performance. You could depend on articles and news items in The Wall Street Journal, The New York Times, Barron’s, and so on that summarize the latest financial reports of the company. Also, you can go to websites such as Yahoo! Finance. This saves you the time and trouble of reading the reports yourself. Generally, these brief articles and websites capture the most important points. If you own an investment portfolio of many different stocks, reading news articles that summarize the financial reports of the companies is not a bad approach. But suppose you want more financial information than you can get in news articles?

The annual financial reports of public companies contain lots of information: a letter from the chief executive, a highlights section, trend charts, financial statements, extensive footnotes to the financial statements, historical summaries, and a lot of propaganda. And you get photos of the top brass and directors (whoopee do!). In contrast, the financial reports of most private companies are significantly smaller; they contain financial statements with footnotes, and not much more.

So, how much of the report should you actually read?

You could read just the highlights section and let it go at that. This might do in a pinch. I think you should read the chief executive’s letter to shareowners as well. Ideally, the letter summarizes in an evenhanded and appropriately modest manner the main developments during the year. Be warned, however, that these letters from the top dog often are self-congratulatory and typically transfer blame for poor performance on factors beyond the control of the managers. Read them, but take these letters with a grain of salt.

Many public businesses send shareowners a condensed summary version in place of their much longer and more detailed annual financial reports. This is legal, as long as the business mentions that you can get its “real” financial report by asking for a hard copy or by going to its Web site. The idea, of course, is to give shareowners an annual financial report that they can read and digest more quickly and easily. And, condensed financial summaries are more cost effective.

In my view, the scaled-down, simplified, and shortened versions of annual financial reports are adequate for average stock investors. They are not adequate for serious investors and professional investment managers. These investors and money managers should read the full-fledged financial report of the business, and they perhaps should study the company's annual 10-K report that is filed with the Securities and Exchange Commission (SEC). You can go to the website www.sec.gov and navigate from there.

Improve Your Accounting Savvy

Financial statements — the income statement, balance sheet, and statement of cash flows — are the core of a financial report. To make sense of financial statements, you need at least a rudimentary understanding of financial statement accounting. You don’t have to be a CPA, but the accountants who prepare financial statements presume that you are familiar with accounting terminology and financial reporting practices. If you’re an accounting illiterate, the financial statements probably look like a Sudoku puzzle. There’s no way around this demand on financial report readers. After all, accounting is the language of business. (Now where have I heard that before?)

The solution? Read this book. And when you’re done, consider reading another book or two about reading financial reports and analyzing financial statements. Without undue modesty I can recommend my book How To Read A Financial Report, 7th edition (John Wiley & Sons).

Judge Profit Performance

A business earns profit by making sales and by keeping expenses less than sales revenue, so the best place to start in analyzing profit performance is not the bottom line but the top line: sales revenue. Here are some questions to focus on:

How does sales revenue in the most recent year compare with the previous year? Higher sales should lead to higher profit, unless a company’s expenses increase at a higher rate than its sales revenue. If sales revenue is relatively flat from year to year, the business must focus on expense control to help profit, but a business can cut expenses only so far. The real key for improving profit is improving sales. Therefore, stock analysts put first importance on tracking sales revenue year to year.

What is the gross margin ratio of the business (which equals gross profit divided by sales revenue)? Even a small slippage in its gross margin ratio can have disastrous consequences on the company’s bottom line. Stock analysts would like to know the margin of a business, which equals sales revenue minus all variable costs of sales (product cost and other variable costs of making sales). But external income statements do not reveal margin; businesses hold back this information from the outside world (or they don’t keep track of variable versus fixed expenses.)

  Based on information from a company’s most recent income statement, how do gross margin and the company’s bottom line (net income, or net earnings) compare with its top line (sales revenue)? It’s a good idea to calculate the gross margin ratio and the profit ratio for the most recent period and compare these two ratios with last period’s ratios. If you took the time to compare these two ratios for a variety of businesses; you may be surprised at the variation from industry to industry. By the way, very few businesses provide profit ratios on the face of their income statements — which is curious because they know that readers of their income statements are interested in their profit ratios.

One last point: Put a company’s profit performance in the context of general economic conditions. A down economy puts downward pressure on a company’s profit performance, and you should allow for this in your analysis (although this is easier said than done). In an up economy, a company should do better, of course, because a rising tide lifts all boats.

Test Earnings Per Share (EPS) Against Change in Bottom Line

As you know, public companies report net income in their income statements. Below this total profit number for the period, public companies also report earnings per share (EPS), which is the amount of bottom-line profit for each share of its stock. Figure 13-1 shows an example. Strictly speaking, therefore, the bottom line of a public company is its EPS. Private companies do not report EPS; however, the EPS for a private business is fairly easy to calculate — divide its bottom-line net income by the number of ownership shares held by the equity investors in the company.

The market value of ownership shares of a public company depends mainly on its EPS. Individual investors obviously focus on EPS, which they know is the primary driver of the market value of their investment in the business. The book value per share of a private company is the closest proxy you have for the market value of its ownership shares. (I explain book value per share in Chapter 13.) The higher the EPS, the higher the market value for a public company. And, the higher the EPS, the higher the book value per share for a private company. Now, you would naturally think that if net income increases, say 10 percent over last year, then EPS would increase 10 percent. Not so fast. EPS — the driver of market value and book value per share — may change less than 10 percent, or perhaps more than 10 percent.

Individual investors should compare the percent increase/decrease in total bottom-line profit over last year with the corresponding percent increase/decrease in EPS. Why? Because the percent changes in EPS and profit can diverge. For public companies use its diluted EPS if it’s reported. Otherwise, use its basic EPS. (I explain these two critical profit ratios in Chapter 13.) Suppose, for example, that profit (bottom-line net income) increased 10 percent over last year. EPS may not increase the full 10 percent. The business may have issued additional stock shares during the year, or it may have issued additional management stock options that get counted in the number of shares used to calculate diluted EPS. The profit pie may have been cut up into a larger number of smaller pieces. How do you like that? In doing this test you may find just the reverse. EPS may increase more than the 10 percent increase in bottom-line profit. The business may have bought back some of its own shares, which decreases the number of shares used in calculating EPS. This could be a deliberate strategy for increasing EPS by a higher percent than the percent increase in net income.

In summary, EPS doesn’t necessarily move in sync with the profit performance of a business. A deviation in the change in EPS compared with the change in profit can hamper or boost market value or book value per share. Be prudent: Check the percent change in profit against the percent change in EPS. But be warned: You have to do this on your own because neither public nor private companies volunteer this comparison. Evidently they don’t want to call attention to any disparity between the change in profit versus the change in EPS.

Tackle Extraordinary Gains and Losses

Many income statements start out normally: sales revenue less the expenses of making sales and operating the business. But then there’s a jarring layer of extraordinary gains and losses on the way down to the final profit line. (I discuss extraordinary gains and losses in Chapter 4.) For example, a business may shut down and abandon one of its manufacturing plants and record a huge loss due to asset write-downs and severance compensation for employees who are laid off. A business may suffer a large loss from an uninsured flood. Or a business may lose a major lawsuit and have to pay millions in damages. The list of extraordinary losses (and gains) is a long one.

In these situations, there are two bottom lines: one for profit from normal, ordinary, ongoing operations; and a second for the effect from the abnormal, extraordinary, nonrecurring gains and losses. The final profit line is the net result of the two components in the income statement. (EPS is reported before and after the unusual items.) What’s a financial statement reader to do when a business reports such gains and losses?

There’s no easy answer to this question. You could blithely assume that these things happen to a business only once in a blue moon and should not disrupt the business’s ability to make profit on a sustainable basis. I call this the earthquake mentality approach: When there’s an earthquake, there’s a lot of damage, but most years have no serious tremors and go along as normal. Extraordinary gains and losses are supposed to be nonrecurring in nature and recorded infrequently, or one-time gains and losses. In actual practice, however, many businesses report these gains and losses on a regular and recurring basis — like having an earthquake every year or so.

Extraordinary losses are a particular problem because large amounts are moved out of the mainstream expenses of the business and treated as nonrecurring losses in its income statement, which means these amounts do not pass through the regular expense accounts of the business. Profit from continuing operations is reported at higher amounts than it would be if the so-called extraordinary losses were treated as regular operating expenses. Unfortunately, CPA auditors tend to tolerate this abuse . . . well, up to a point. Investment managers complain in public about this practice. But in private they seem to prefer that businesses have the latitude to maximize their reported earnings from continuing operations by passing off some expenses as extraordinary losses.

Check Cash Flow Beside Profit

The objective of a business is not simply to make profit, but to generate cash flow from making profit as quickly as possible. Cash flow from making profit is the most important stream of cash inflow to a business. A business could sell off some assets to generate cash, and it can borrow money or get shareowners to put more money in the business. But cash flow from making profit is the spigot that should always be turned on. A business needs this cash flow to make cash distributions from profit to shareowners, to maintain liquidity, and to supplement other sources of capital to grow the business.

The income statement does not — I repeat does not — report the cash inflows of sales and the cash outflows of expenses. Therefore, the bottom line of the income statement is not a cash flow number. The net cash flow from the profit-making activities of the business (its sales and expenses) is reported in the statement of cash flows. When you look there, you will undoubtedly discover that the cash flow from operating activities (the official term for cash flow from profit-making activities) is higher or lower than the bottom-line profit number in the income statement. I explain the reasons for the difference in Chapter 6.

Businesses seldom offer any explanation of the difference between profit and cash flow. What you see in the statement of cash flows is all you get — no more. You’re pretty much on your own to interpret the difference. There are no general benchmarks or ratios for testing cash flow against profit. I couldn’t possibly suggest that cash flow should normally be 120 percent of bottom-line profit, or some other ratio. However, one thing is clear: Growth penalizes cash flow — or, more accurately, growth sucks up cash from sales because the business has to expand its assets to support the higher level of sales.

Cash flow from operating activities could be a low percent of profit (or even negative). This situation should prompt questions about the company’s quality of earnings, which refers to the credibility and soundness of its profit accounting methods. In many cases cash flow is low because accounts receivable from sales haven’t been collected and because the business made large increases in its inventories. The surges in these assets raise questions about whether all the receivables will be collected and whether the entire inventory will be sold at regular prices. Only time will tell. Generally speaking, you should be more cautious and treat the net income that the business reports with some skepticism.

Look for Signs of Financial Distress

A business can build up a good sales volume and have very good profit margins, but if the company can’t pay its bills on time, its profit opportunities could go down the drain. Solvency refers to the prospects of a business being able to meet its debt and other liability payment obligations on time. Solvency analysis asks whether a business will be able to pay its liabilities, looking for signs of financial distress that could cause serious disruptions in the business’s profit-making operations. Even if a business has a couple billion bucks in the bank, you should ask: How does its solvency look?

Frankly, detailed solvency analysis of a business is best left to the pros. The credit industry has become very sophisticated in analyzing solvency. For example, bankruptcy prediction models have been developed that have proven useful. I don’t think the average financial report reader should spend the time to calculate solvency ratios. For one thing, many businesses massage their accounting numbers to make their liquidity and solvency appear to be better than they are at the balance sheet date.

Although many accountants and investment analysts would view my advice here as heresy, I suggest that you just take a quick glance at the company’s balance sheet. How do its total liabilities stack up against its cash, current assets, and total assets? Obviously, total liabilities should not be more than total assets. Duh! And obviously, if a company’s cash balance is close to zero, things are bad. Beyond these basic rules, things are a lot more complex. Many businesses carry a debt load you wouldn’t believe, and some get into trouble even though they have hefty cash balances.

The continued solvency of a business depends mainly on the ability of its managers to convince creditors to continue extending credit to the business and renewing its loans. The credibility of management is the main factor, not ratios. Creditors understand that a business can get into a temporary bind and fall behind on paying its liabilities. As a general rule, creditors are slow to pull the plug on a business. Shutting off new credit may be the worst thing lenders and other creditors could do. Doing so may put the business in a tailspin, and its creditors may end up collecting very little. Usually, it’s not in their interest to force a business into bankruptcy — doing so is a last resort.

Recognize the Risks of Restatement and Fraud

In 2007, the CEO of one of the Big Four global CPA firms testified before a blue-ribbon federal government panel on the state of auditing and financial reporting. He said that one out of every ten financial reports issued by public companies is revised and restated at a later time. If that’s true, there’s a 10 percent chance that the financial statements you’re reading are not entirely correct and could be seriously misleading. An earlier study of financial restatements arrived at a much lower estimate. You’d think that the incidence of companies having to redo their financial reports would be extremely rare, but I have to tell you that financial restatements continue with alarming regularity.

When a business restates its original financial report and issues a new version, it does not make restitution for any losses that investors suffered by relying on the originally reported financial statements. In fact, few companies even say they’re sorry when they put out revised financial statements. Generally, the language explaining financial restatements is legalistic and exculpatory. “We didn’t do anything wrong” seems to be the underlying theme. This attitude is hard to swallow.

All too often the reason for the restatement is that someone later discovered that the original financial statements were based on fraudulent accounting. Frankly speaking, CPAs don’t have a very good track record for discovering financial reporting fraud. What it comes down to is this: Investors take the risk that the information in financial statements they use in making decisions is subject to revision at a later time. I suppose you could go to the trouble of searching for a business that has never had to restate its financial statements, but, of course, there’s always a first time.

Remember the Limits of Financial Reports

There’s a lot more to investing than reading financial reports. Financial reports are an important source of information, but investors also should stay informed about general economic trends and developments, political events, business takeovers, executive changes, technological changes, and much more. Undoubtedly, the information demands required for investing have helped fuel the enormous popularity of mutual funds; investors offload the need to keep informed to the investment managers of the mutual fund. Many advertisements of financial institutions stress this point — that you have better things to do with your time.

When you read financial statements, keep in mind that these accounting reports are somewhat tentative and conditional. Accountants make many estimates and predictions in recording sales revenue and income, and expenses and losses. Some soft numbers are mixed in with hard numbers in financial statements. In short, financial statements are “iffy” to some extent. There’s no getting around this limitation of accounting.

Having said that let me emphasize that financial reports serve an indispensable function in every developed economy. We really couldn’t get along without financial reports, despite their limits and problems. People wouldn’t know which way to turn in a financial information vacuum. Even though the financial air is polluted, we need the oxygen of financial reports to breathe.