The balance sheet breakdown

The balance sheet is separated into assets (usually the first half of the balance sheet) and liabilities and shareholders’ equity (usually the second half). These two sides must equal each other. Academic textbooks often present assets on the left-hand side of a page and liabilities and shareholders’ equity on the right-hand side. In real life, expect to see liabilities and shareholders’ equity below the assets section.

Assets are items a company owns that provide some future benefits — like cash, inventory, or plant and equipment. They’re further divided into current and long-term assets:

• Current assets are those assets that are expected to be converted into cash within one year. Items you’ll find in the current assets section of a balance sheet include cash, inventory, and accounts receivable (credit the company is expecting to convert into cash). You want to see that a company has a good amount of current assets relative to its current liabilities (which I get to shortly).
• Long-term assets refer to items that are expected to be used for more than one year. Expect to see items such as land, plants and equipment, and long-term investments. There’s no good absolute number you want to see in this arena. Some industries are capital intensive and require lots of long-term assets. Others, like technology companies, have few long-term assets (except for perhaps patents). Within the same industry, a firm that achieves more profits per total assets is often valued higher than a firm that achieves fewer profits per total assets.

On the liabilities portion of the balance sheet, you find items the company owes others. Like assets, liabilities are divided into two categories: current and long-term.

• Current liabilities are expenses the company is expected to pay over the next year (short-term debt, salaries, expenses, and the like). You want a firm’s current assets to be at least 1.5 times its current liabilities when you buy shares in a company, generally, to remove major risk that the company may face a liquidity problem in the coming year.
• Long-term liabilities are those debts due beyond one year. Long-term debt is usually the most important long-term liability. Compare long-term debt to shareholders’ equity. Ideally, a company should have little long-term debt relative to equity — say less than 30 percent. The more debt a company has, the riskier the company is.

Finally, shareholders’ equity (sometimes presented as owners’ equity) is the difference between total assets and total liabilities. This is what’s left over for equity/stock shareholders after meeting the obligations of debt holders. Shareholders’ equity includes share capital and the amount of earnings the company has accumulated over time.

How to properly assess a balance sheet

You can develop a feel for a company’s financial health by looking at balance sheets and surmising whether the company is in good, average, or poor shape. Use these guidelines to help you:

• Cash is king. The more cash a company has relative to its debts, the better. The less cash a company has relative to its debts, the worse off it is.
• Compare current assets to current liabilities. A ratio of 1.5 or higher is usually a sign that the company isn’t going bankrupt in the next 12 months. A ratio below 1 may signal real problems ahead.
• Compare long-term debt to shareholders’ equity. The higher the percentage, the more leveraged a company is. Stick to buying companies with debt levels below 30 percent.
• Large increases in accounts receivable are a red flag. If a company’s accounts receivable grow faster than sales, it may mean the company is extending loose credit terms to increase sales. And that can spell trouble if the company is unable to recover all amounts owed to it.
• Large increases in inventory levels are a red flag. If inventories rise faster than sales, the company may be on the cusp of a slowdown as it works to sell off inventory. This problem is more pronounced in the technology sector where inventory values quickly decline due to technology advancements.

Figure 7-1 brings these concepts to life with the balance sheet of a publicly traded company, Amazon.com (symbol: AMZN). Identify the key parts of the balance sheet: current assets, long-term assets, current liabilities, and long-term liabilities. (You won’t know every line item that appears in this example. Further research can help you understand those items that I don’t cover.)

Glancing quickly over the balance sheet, you should notice that Amazon has more current assets than current liabilities as of September 30, 2018: $59.9 billion versus $55.3 billion. The current ratio is therefore 1.08. I prefer to see a current ratio above 1.50. However, I’m not overly concerned because I see that $6 billion of current liabilities are marked as unearned revenue. Unearned revenue refers to revenues you receive cash payments for without having provided the product or service. In that sense, it’s a liability to Amazon until it delivers the goods. Unearned revenues are a good liability unlike an account payable or debt. If you remove this $6 billion from Amazon’s current liabilities and recalculate the current ratio, the current ratio rises to a more respectable 1.21.

Something else that should jump out at you is the leverage Amazon employs. Long-term debt ($24.68 billion) relative to shareholders’ equity ($39.12 billion) is a high 63 percent. Companies with high leverage can face difficulties when the economic cycle turns. I’m not worried about Amazon given its ample cash reserves ($20.43 billion), which could pay the majority of the company’s debt.

The amount of research you conduct beyond the cursory examination presented here depends on the type of swing trader you are. More work can help you make better decisions, but there isn’t enough time in one day to closely examine several companies. One shortcut is to look for balance sheet ratios (provided, for example, on Reuters finance website), which can quickly tell you a company’s debt and liquidity position. Figure 7-2 shows an example for American Eagle (symbol: AEO).

Remember that as a swing trader, you have to allocate your time in the most efficient way possible. Spending half of your time on a single company isn’t going to be appropriate when your time horizon is measured in days or weeks. You can’t pore over hundreds of pages of SEC filings to discover details that may, or may not, influence your decision to swing trade the stock. Instead, make sure you understand the basics and use resources that can reduce the amount of time you spend on each candidate, allowing you to quickly reject the stock (which should happen most often) or put it into a bucket for further consideration.

The income statement breakdown

Revenues is a fancy way of saying sales. In Europe, revenues are often called turnover. Whatever term you use, this financial statement represents a company’s lifeline. Without sales, you can’t make profits. Growth-oriented companies can grow sales at double (and even triple) digit rates in times of economic expansion.

After revenues, an income statement lists a firm’s gross profit (the amount of profit left over after a company subtracts all direct costs related to making a product or providing a service — called cost of goods sold). An example best illustrates these terms: If Dummies Corporation reports sales of $10 million in 2019 (due, no doubt, to the success of Swing Trading For Dummies), the firm’s cost of goods sold would include the cost of printing the book, hiring yours truly to write it, paying editors to proofread it, and more. These are all direct costs. You wouldn’t include any indirect costs, like the salary of the CEO, in the calculation of the cost of goods sold because they aren’t directly attributable to the cost of the book.

Gross profit is often calculated as a percentage of sales. The higher the ratio, the more profitable the firm. Often companies receive higher valuations because of higher gross profit margins.

After gross profit, the next main heading in the income statement is the operating income. Operating income is what’s left over after taking out all indirect costs from the gross profit figure. Indirect costs include selling, general, and administrative costs. Marketing, for example, is considered an indirect cost. The costs of electricity and office desks are also indirect. Subtracting these items from gross profit yields operating income.

Finally, a few more subtractions are made from operating income to arrive at net income — the bottom line. Subtract interest expense (like interest payments on debt) and taxes and you get net income. Net income is usually presented in dollars and as a per share figure. That is, companies divide net profit by the number of shares the company has outstanding in order to calculate income per share.

How to properly assess an income statement

Keep these suggestions in mind to stay on your game and spot strength and weakness in income statements:

• Compare sales growth rates (year over year) to net income growth rates (year over year). Ideally, you want to see net income rise at a faster pace than sales.
• Keep an eye on the trend of gross profit as a percentage of sales. A rising ratio is a healthy sign, whereas a declining ratio is a red flag.
• Keep an eye on the trend of operating income as a percentage of sales. Again, a rising ratio is a healthy sign and a declining ratio is a red flag.
• Compare sales and earnings to year-ago periods. Comparing either figure to prior quarters rather than the prior year may lead you to incorrect conclusions regarding the company’s health.
• Track net profit margins over time. Determine whether net profit margin (net income divided by sales) is increasing, decreasing, or stable over time. Net profit margin expansion is often coupled with P/E ratio expansion (meaning investors will pay a higher price or higher multiple for a company with rising or high net profit margins than for one with low or falling net profit margins).
• Watch for growth in outstanding shares. This growth can be a red flag that the company is issuing more shares and thereby diluting existing ones.

Figure 7-3 shows the income statement of Apple for the 12 months ending in 2018, 2017, and 2016. Identify the key parts of the income statement: revenues, gross profit, operating income, net profit, and net income per share (earnings per share, or EPS).

Apple posted revenues of $265.595 billion in the year ending September 30, 2018. Looking at annual figures, you can compare Apple’s revenues over time, which wouldn’t be possible if you were looking at a quarterly income statement and compared, say, Apple’s fourth quarter with its third quarter. Why? Because in many businesses, seasonality exists. For example, a toy manufacturer will experience a steep drop in sales after the holiday shopping season. Therefore when you compare quarters, make sure you compare one quarter to the year-ago period and not to the previous quarter.

In Apple’s case, you can see that revenues grew by 15.9 percent in 2018 versus 2017. That’s impressive — especially for a company Apple’s size. Of course, investors care most about the future, not the past. So Apple’s expected performance will drive shares.

Gross profit as a percentage of sales basically remained unchanged from 2017 (at 38.5 percent) to the 2018 (38.3 percent). (Comparing items that are a percentage of sales across quarters isn’t as problematic as comparing sales or earnings across quarters.) You would want to be alert if gross profit margins rose or dropped considerably; although you want to see growth, you also want to understand what’s causing that growth.

Operating income as a percentage of sales fell from 27.8 percent in 2016 to 26.70 percent in 2018. This decline isn’t concerning for two reasons (1) the absolute number of the decline is small, and more importantly, (2) the reason for the decline isn’t a bad reason: Apple increased its spending on research and development (from 4.66 percent of sales in 2016 to 5.36 percent of sales in 2018). Research and development is an investment in the future, and therefore the small decline in profit margins isn’t overly concerning because Apple is investing for its future.

Finally, you can see that Apple’s net income profit margin rose from 21.2 percent in 2016 to 22.4 percent in 2018. The increase isn’t significant, but it’s a positive sign that Apple has maintained its pricing power and cost discipline. Apple’s shares outstanding declined from $5.47 billion in 2016 to $4.96 billion in 2018. This is a positive trend and reflects Apple using its cash to buyback shares.

The cash flow statement breakdown

The first section of this financial statement details cash flows used in or generated from operating activities. It starts with net income and makes various adjustments to tally up how much cash was generated or used during the period — ending with cash flow from operating activities. What kinds of adjustments are made? An increase in inventories reflects a use of cash and therefore should be subtracted from net income. On the other hand, a company adds back non-cash expenses taken out of net income in the income statement. Non-cash expenses are costs a company recognizes on its income statement that aren’t actually paid out. For example, if a company owns a car used for business, it may recognize a $5,000 non-cash expense in one year to reflect the car’s loss of value. That expense lowers net income but doesn’t actually reflect a $5,000 cash payment. For that reason, depreciation expenses are added back to the net income in the cash flow statement.

As a swing trader, don’t get too caught up in the details. The most important item of this section is cash flow from operating activities — the bottom line. This shows whether the company actually generated cash from its business during the period. A company can report strong net income and have negative cash flow if a majority of sales are on credit, for example. Look for cash flow from operations to be consistent with net income (that is, they should rise together and fall together).

The second section of the cash flow statement is the cash flow from investing section. The most important item here is usually capital expenditures, or the costs incurred to maintain, upgrade, or acquire physical assets. Generally, the smaller the level of capital expenditures relative to sales, the better.

The third and final section of the cash flow statement is the cash flow from financing activities section. This part of the statement shows any dividends paid and any issuance or payment of debt or stock. Ideally, a company can sustain its operations from the cash it generates internally, but sometimes a company looks outside itself to fund growth. It may borrow money or issues shares of stock. Issuing stock dilutes the value of other shareholders’ equity, and borrowing money may saddle the company with a debt burden that’s difficult to bear.

How to properly assess a cash flow statement

Always look at a cash flow statement with these points in mind so you can more easily spot a company’s strengths and weaknesses:

• Compare cash flow from operations to net income. Net income rising with cash flows declining is a negative sign. Falling net income with rising cash flows may reflect a high level of non-cash expenses.
• Keep an eye on capital expenditures (in the cash flows from investing activities) relative to sales. The higher the ratio, the less cash is available for dividends, share buybacks, research and development, and so on. Some capital expenditures are necessary for any business, but firms with low capital expenditures can generate higher growth rates and returns for shareholders.
• Look at the methods the company depends on for its cash. Does it generate its own cash from operations and not need to borrow money? Or is the company issuing stock and heavily borrowing to make ends meet? Answering “yes” to the first question is a good thing; “yes” to the second question is not.
• Look for major changes in the cash flow from the financing activities section. A large amount of debt issuance may be a red flag. Payment of debt, on the other hand, is a good sign that a company is deleveraging itself.
• Watch for large items or breaks in historical levels of cash flows. Both can signal major events like an acquisition or payment of debt. Paying down debt is generally a good thing, whereas acquisitions can be good or bad. Unless acquisitions are a part of a firm’s strategy, I’m often weary of them. A recent KPMG study found that 70 percent of mergers and acquisitions actually reduce shareholder value.

Check out Figure 7-4, the cash flow statement of Twitter.

Notice that Twitter reported net income of $950.293 million in the nine months ending September 30, 2018, but generated cash from operations of $1.0 billion. Capital expenditures were $409.9 million during the nine months, consuming 40 percent of the cash generated from operations. The main drag on cash flows from investing activities is a large investment in “marketable securities” of $4 billion. Because of the gap between cash flow generated from operations and cash flows used in investing activities, Twitter borrowed $1.15 billion (listed as “proceeds from issuance of convertible notes”); the net cash flows provided by financing activities for the nine-month period ending September 30, 2018, was $989.23 million.