IN THIS CHAPTER

Judging profit performance

Bumping into unusual gains and losses

Distinguishing 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 substantial. 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.

Note: In Chapter 10, I explain the basic ratios that investors and lenders use for judging the profit performance and financial condition of a business. I don’t repeat that discussion in this chapter, so my first tip is to read or reread that chapter. The following ten tips assume you know the ratios.

Get in the Right Frame of Mind

So often I hear nonaccountants say that they don’t read financial reports because they aren’t “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 when you have a book like this one to help you along.

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 isn’t 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. (I discuss the variety of information in financial reports in Chapter 9.) 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 take the time to 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 release a condensed summary version in place of their much longer and more detailed annual financial reports. Apple does, for example. 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 website. The idea, of course, is to give shareowners an annual financial report that they can read and digest more quickly and easily. Also, 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 aren’t 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 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’re 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 and apply the information in 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 the book How to Read a Financial Report, 8th Edition (Wiley), coauthored by me and my son Tage, Tracy.

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’s? 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? Even a small slippage in its gross margin ratio (which equals gross profit divided by sales revenue) 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 take 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 5-1 shows an example. Strictly speaking, therefore, the bottom line of a public company is its EPS. Private companies don’t have to 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 10.) 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 more or less than 10 percent:

• Less than 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?
• More than the 10 percent: 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.

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 a public company, use its diluted EPS if it’s reported. Otherwise, use its basic EPS. (I explain these two critical profit ratios in Chapter 10.)

In summary, EPS doesn’t necessarily move in perfect 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. 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. Most likely, they don’t want to call attention to any disparity between the change in profit versus the change in EPS.

Tackle Unusual 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 unusual gains and losses on the way down to the final profit line. (I discuss unusual gains and losses in Chapter 5.) 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. What’s a financial statement reader to do when a business reports such unusual, nonrecurring gains and losses in its income statement?

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. Unusual gains and losses are supposed to be nonrecurring in nature and recorded infrequently. 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.

Unusual 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 unusual losses were treated as regular operating expenses. Investment managers complain in public about the special treatment of unusual gains and losses in financial reports. 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 unusual, infrequent losses when, in fact, these gains and losses occur more frequently than you would expect.

Check Cash Flow From 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’ll 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 7.

Businesses seldom offer any narrative or footnote 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 such relationship. However, one thing is clear: Growth penalizes cash flow — or more accurately, growth sucks up cash because the business has to expand its assets to support the higher level of sales.

Cash flow from operating activities could be a low percentage 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 all the 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 a business’s prospects of being able to meet its debt and other liability payment obligations on time, in full. Solvency analysis looks 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? Is there any doubt it can pay its bills on time?”

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 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 shouldn’t 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 Possibility of Restatement and Fraud

A few years ago, 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 later revised and restated. Assuming 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. I’m sure future studies will show variation in the rate of restatements. 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 doesn’t 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 the 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 there’s always a first time for fraud.

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 recording 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.