Chapter 14
Now Comes the Financial Stuff
Once you’ve taken a close look at a company, checking out its product or service, market share, customers, size, age, and other factors, you’ll need to take some time to check out its finances.
Looking at a company’s balance sheet, income statement, and cash flow statement will help you get a handle on how profitable it is, what sort of debt it’s dealing with, what its assets are, and so forth. Studying a company’s financial information is the most basic aspect of fundamental analysis, which we introduced in Chapter 12.
This chapter will fill you in on what sort of financial information to look for, and tell you how to use the financial reports mentioned above to assess an organization’s financial health. Before you start moving into a company’s annual reports or other financial information, however, you should take a few minutes to check out the financial information found on an analyst’s stock report.
Getting an Initial Overview of a Company’s Finances
Before you delve into a company’s income and cash flow statements or its balance sheet, all of which contain a lot of important information, find yourself an analyst stock report. You can find these online from companies like Standard & Poor’s (S&P) or Morningstar, and they’re easy to read and loaded with interesting information.
An S&P stock report rates the strength of a stock from zero to five stars, gives it a letter grade, tells what industry and sector the stock falls into, lists the firm’s major competitors, and provides a risk assessment. The report also provides an explanation for why the stock received the rating it did, along with key statistics and financial information. You can read a corporate overview, corporate strategy, find out who runs the company, where it’s located, how many employees and stockholders there are, and much more.
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Always look for “As” or “Bs” for stock grades on analyst reports. Look to see how the stock is doing compared to the S&P 500 index and if the sales of the company are increasing. This information will give you a snapshot of the company and let you know if it’s worth investing more of your time.
The value of looking at a stock report before knuckling down to assess financial information is that if the analyst’s report tells you that the XYZ Company is a horrible investment, gives it zero out of five stars as a recommendation, and clearly spells out its rationale for that advice, you can save yourself some time and effort and move on to a different company.
To access a report, simply go to S&P or another rating service website and enter the name of the company in which you’re interested. You have to register in order to get access to the reports, but it’s free and easy to do so.
Getting Serious with Balance Sheets
If the report on the stock you’re interested in is favorable, it’s time to move on to an examination of the company’s balance sheet. Companies are required by the government to provide balance sheets for shareholders on a regular basis in order to give them an overview of the company’s financial health.
Prospective investors can also get access to a company’s balance sheet from the Securities and Exchange Commission (SEC) and its EDGAR website at www.sec.gov/edgar.shtml. From the EDGAR site you can access a company’s 10-K and 10-Q reports, which contain information from its balance sheets. The 10-K report can give you the balance sheet for an entire fiscal year, while the 10-Q provides quarterly reports of balance sheet information.
Checking out a company’s balance sheets will give you a look at the direction in which the company has come, and that in which it is headed. You’ll be able to compare assets and liabilities from quarter to quarter and year to year to assess its overall financial health. Let’s have a look at just what a balance sheet is and what it contains.
What Is a Balance Sheet?
A balance sheet is simply a record of a company’s assets and liabilities. It provides the value of what a company owns or expects to own soon, and what it owes or expects to owe soon. When you know the values of assets and liabilities, you can figure out equity, which is explained in the next section.
Balance sheets have three main parts: assets, liabilities, and equity. In Chapter 3, you learned about determining your net worth by adding up all your assets, and then subtracting the total of all your liabilities from that number. Balance sheets work the same way, and companies do them for the same reason that you might complete the Net Worth Worksheet in Chapter 3.
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When you’re studying a company’s financials, keep in mind that all publicly held companies use accrual accounting when reporting their earnings. Accrual accounting is different from cash accounting, which is the system most individuals use, in that it records financial transactions (income and expenses) at the point at which they actually occur, rather than at the time payment is received or made. A company, for instance, subtracts charges for its electric bill throughout the month instead of simply paying off a bill at the end of the month. Accrual accounting provides a more realistic, “real time” picture of a company’s financial picture than cash accounting.
Assets for a company are the same as for an individual—anything a company owns that has value. Liabilities are also the same for companies and individuals; they’re anything the company owes. When assets and liabilities are listed on a balance sheet (hence the name), the total value of a company’s assets must equal the combined value of its liabilities and equity. For instance, if a company has assets worth $10 million and liabilities worth $5 million, its equity must also be $5 million in order to balance the value of the assets.
Balance sheets vary in appearance from company to company, but normally contain the same general information. Generally, the first category is assets, which are broken down into several groups:
• Current assets. These include cash; accounts receivable or debts that are owed to the company; inventory and supplies; and prepaid expenses, such as insurance premiums that have been paid in advance.
• Property and equipment. These assets include land, land improvement, equipment, and buildings. Depreciation must be considered when figuring the total of these assets.
• Intangible assets. These are a little murky, and include things like the values of patents; trade names; and goodwill, which is value added to a company for its good reputation and a satisfied p ,ool of customers.
The second category of the balance sheet, liabilities, is also broken down into a couple categories:
• Current liabilities. These include expenses such as wages; interest; taxes; warranties; unearned revenues, which is money received for products or services not yet delivered; and accounts payable, which is money the company owes to suppliers or others.
• Long-term liabilities. These can include payments due on long-term loans, such as leases, or bonds that the company has issued.
The third category of a company’s balance sheet is shareholder equity. This number tells you how much money is left over to divide among shareholders once all the assets have been added up and the liabilities subtracted from their total.
Why Is It Important?
The balance sheet is a simple concept, but an extremely important document for investors and prospective investors. Comparing the assets of a company to the liabilities provides a picture of the company’s equity, which tells you if a company is financially sound.
DEFINITION
Equity is the value attached to a company, determined by subtracting liabilities from assets.
A company that is in good financial shape will have a good supply of liquid assets, or assets that can quickly be turned into cash. That’s important to investors because a company that has more cash than it needs to fund future growth can use the extra cash to pay dividends to investors or to buy back stock.
By examining a company’s balance sheet, you can see if the company will be able to keep expanding without borrowing huge sums of money or issuing more stock in order to do so. You can view how much it owes, what kind of income it generates, what it owns, and much more. A balance sheet is essentially the financial overview of a company, and an important tool to use when deciding whether or not to buy its stock.
Earnings, Earnings, Earnings
Another of a company’s trio of major financial statements is its income statement, which measures how well a company did financially over a specific period of time, normally a quarter or a fiscal year.
Income statements are broken down into two sections: operating and nonoperating. The operating section reveals financial information related directly to the day-to-day operations of the business. If you’re looking at an auto manufacturing company, for instance, the operating section of the income statement would report on all revenues and expenses that result directly from the manufacture of cars.
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An income statement is also known as a profit and loss statement, statement of operations, statement of earnings, or statement of income. Some financial types refer to it as “the P&L,” referring to profit and loss statement. However, an income statement by any other name still reports on income.
The nonoperating section reports on revenues and expenses that result from nonoperating activities, such as the sale of a factory or equipment. Again, the amount of detail contained in an income statement depends on the complexity of the company and other factors. Some of the information often found on income statements includes the following.
• Net sales. These are the revenues a company realizes from the sales of goods or services, and they’re an important factor in its ability to grow. Sales should be on the increase if you’re considering buying shares of the company.
• Cost of goods and services (COGS). These are expenses a company incurs for materials, manufacturing overhead, and labor. COGS also includes depreciation, although that’s listed separately.
• Gross profit. This is the amount you get when you subtract the COGS from the net sales. The greater the gross profit of a company, the better its bottom line will be. Compare the current year to the last several, because you should look to invest in companies that have increased profits.
• Selling, general, and administrative expenses (SG&A). These are costs incurred to sell the product or service such as rent, insurance, payroll taxes, utilities, advertising, delivery expenses, salaries and benefits, and credit card fees. Many of these expenses are considered to be controllable and an indicator of the effectiveness of management.
• Operating income. This is the amount you get when you subtract SG&A from a company’s gross profit, and it reflects the earnings realized from day-to-day operations.
• Pretax income. What a company pays in taxes affects its bottom line. If a company is able to reduce or avoid taxes, it will report more income than a company that isn’t able to shave off some taxes. Some investors prefer to look at pretax income as a more reliable indicator of earnings.
• Net income. This is where most investors look first when reading an income statement, and the figure most often used to determine a company’s profitability (or lack of profitability).
For an income statement to be of real value, you need to be able to compare a current statement with past statements. You can look at an income statement and think a company is great because its net income is $6 million. If its net income from the previous year was $8 million, however, you probably want to rethink investing in the company.
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Income statements that show earnings for more than one year are called comparative income statements. They allow investors and potential investors to gain perspective on a company’s earnings over time, and are normally considered to be more useful than those that show earnings from just one year.
In addition to comparing earnings of previous years when looking at a company’s income statement, you’ll want to look for reductions in COGS. If earnings increase while COGS decrease, the company will have more gross income, which is an indicator of financial health.
Also, check to make sure that operating expenses appear to be under control by comparing them to those of previous years. If sales have increased while expenses have stayed the same or decreased, it’s a good sign that the company is well managed and financially on the right track.
Cash Flow
A company’s cash flow statement is the third of the major financial statements you’ll want to look at when analyzing a company. It’s important to investors because it indicates how much cash on hand a company has, and how much it will be able to invest back into the business to further increase productivity and profit.
Some investors don’t consider cash flow as an aspect of fundamental analysis, but you should always check a company’s cash flow statement when deciding whether or not to buy its stock. A company can be generating a profit, but if it doesn’t have enough money on hand to pay its bills, you don’t want to invest in it.
A cash flow statement is divided into three sections, each of which applies to one area of a company’s business:
• Operations. Its operations are the primary way in which a company generates cash. This is cash that’s generated from within the company, as opposed to outside of the company, as with investing and financing activities. This part of the cash flow statement takes into account net income and operating assets and liabilities.
• Investing. Cash flow from investing includes payouts the company makes when it buys property or equipment, investment securities, expansion from acquiring other businesses, and income obtained from selling its assets, such as investment securities, property, equipment, or even parts of the business. Investors are interested in a company’s investment cash flow because it indicates whether the company is using its cash to maintain facilities and equipment so that it can continue operations.
• Financing. Stockholders want to make sure a company they’re invested in has money with which to pay out dividends. If a company has to pay out too much cash to repay debt and interest, and isn’t realizing income from selling more stock, its investors begin to fear that dividends will be cut or discontinued, which isn’t a good thing.
Analyzing cash flow is a little trickier than looking at other financial statements because it’s more open to interpretation. Still, it’s an important part of a company’s overall financial situation and helps to indicate stability and prospects for its future.
Understanding Ratios
Ratios are important tools when analyzing a company’s financial situation. Getting a handle on some basic ratios allows you to compare one company against another in the same industry or sector, or contrast a company’s current performance with past performance.
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Don’t be tempted to compare ratios of companies that are in different industries. Comparing ratios of a soft drink company with those of a software company is like comparing apples and oranges.
Many people are intimidated by the thought of ratios and shy away from using them as analytical tools, but they’re really not that difficult to understand. There are five categories of ratios, each of which applies to one financial area. Within each category of ratios there are subratios. You can buy entire books dealing with ratios, but for our purposes, we’ll be considering the five broad categories of:
• Operating ratios
• Profitability ratios
• Liquidity ratios
• Valuation ratios
• Solvency ratios
Let’s take a look at what each category entails and what it means to the financial health of a company.
Operating Ratios
Operating ratios, which sometimes are called asset management ratios, indicate how well a company manages its capital and other assets in order to realize a profit. They’re based on factors such as the amount of inventory the company has or the amount of accounts receivable it takes to support a specified portion of the business.
Operating ratios are calculated by comparing operating expenses to net sales. They are a company’s operating expenses divided by its operating revenues. In other words, operating ratios help you to know how much the company you’re analyzing spends in order to produce its products or services, and how much revenue it generates from the sale of those products or services.
Common operating ratios include sales to receivables, net profits to gross income, operating expenses to operating income, net profit to net worth, return on equity, and return on assets.
Profitability Ratios
As the name indicates, profitability ratios help you to look at how profitable a company is. Remember that profit is different from income. A company might have a lot of income, but not be making much profit.
Common profitability ratios include profit margin, return on assets, and return on equity. Remember that a company’s profits can vary from season to season, so be careful how you compare them. It makes more sense to compare its profitability with that of another company in the same industry and year to year, or with a previous time period that is comparable within the company you’re analyzing.
If the company’s profits are decreasing from year to year, that should raise a red flag that it may be facing stronger competition or that its market is falling. If its profit is much lower than that of its competitors, that’s another reason for concern, as is a much higher profit, which could indicate conditions or operating circumstances that won’t last.
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An analysis tool popularly used in some industries is Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). EBITDA isn’t a ratio but a process of converting net income to a number that’s computed by starting with net income and subtracting interest, taxes, depreciation, and amortization. The theory behind EBITDA is that interest, taxes, depreciation, and amortization don’t reflect the philosophies or business practices of current management, but are functions of laws, such as tax codes, or decisions made by prior managers. Generally, the use of EBITDA makes a company’s financial ratios more attractive, so if you encounter this tool, consider it with a grain of salt.
Liquidity Ratios
Liquidity ratios indicate how easily and quickly a company can convert its assets into cash. A company could need to raise cash for various purposes, such as buying additional assets or expanding, repaying creditors, or for some type of emergency situation.
Examples of liquidity ratios include the current ratio, quick ratio, working capital turnover, inventory turnover, and receivables turnover ratio.
These ratios indicate whether a company has enough cash to pay its bills, both under normal and difficult circumstances; whether the company is able to collect money that is owed to it; how much of its working capital the company is spending; and how susceptible the company might be to high interest rates.
Valuation Ratios
Valuation ratios refer to how the price of a company’s stock relates to the performance of the company. They are important to investors who are thinking about buying the stock, because they indicate whether or not the stock is a good value.
The most widely used valuation ratio is the price-to-earnings ratio, also known as the P/E ratio, which compares the price of a company’s stock to the amount of earnings generated on a per-share basis. The P/E ratio gives investors an idea of how much income a company will generate in the future, and whether the current stock price is overly expensive or a good value.
The P/E ratio is calculated by dividing the current price of the stock by the earnings. It’s important to compare the firm’s P/E with others in the same industry, as well as with the overall P/E of the S&P 500. The P/E ratio is high for tech stocks and low for consumer staple stocks, making it irrelevant to compare the ratios of companies within those industries.
Investors who look for stock that is priced low are called value investors, as you read about in Chapter 7. Other valuation ratios include price to sales, price to book, and price to cash flow.
Solvency Ratios
Solvency is simply a matter of whether or not a company is able to stay afloat financially. Solvency ratios help to determine that by comparing what a company owns to what it owes. They indicate the long-term health of a company by looking at its financial obligations and how it might generate assets in the future.
Investors, of course, favor companies that aren’t drowning in debt, either short or long term. The total debt to total assets ratio is an important solvency ratio because it indicates the percentage of a company’s assets for which the company has debt.
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When analyzed and put together, ratios provide a wide range of information about a company, including how well it’s doing compared to competitors and industry averages, overall financial health, strength of operations, liquidity, its ability to borrow money and pay off debt, profitability, and other factors. All of these are important in deciding whether or not to invest.
The closer to “0” this solvency ratio comes, the better, because that indicates low debt. If a company has two or three times more debt than assets, investors should look elsewhere. A total debt to total assets ratio of one is sometimes acceptable for young companies that haven’t yet had time to pay off debt. Other solvency ratios include working capital, times interest earned, and free cash flow.
Coming to Terms with Ratios and Other Financials
You can find all the information you need with which to calculate ratios in a company’s financial statements. Check the company’s website, a stock report site like S&P, or the company’s financial information on the SEC’s EDGAR site (www.sec.gov/edgar.shtml. ).
Once you’ve located the information you need, consider using a financial analysis form to record it and provide you with an overview of a company’s financial information. You can make your own form as a spreadsheet or chart. The form doesn’t need to be anything fancy; just come up with a format that works for you. It should include all of the information contained on a stock report, and any other information you might find to be helpful, including the following:
• Earnings per share
• P/E ratio
• Total debt
• Company name
• Products or services
• Company risk (such as legal problems)
• Management team
• Ticker symbol and stock exchange
• Investor relations contact person and number
You should also include your impressions of a company and its financial health on your financial analysis form. Collecting all of this type of information on one form will be extremely helpful when you want to review it later.
Predicting the Success of a Company
Once you’ve studied a company’s financial information, you can put that together with information you’ve already gathered about what the company does, its products or services, its market share and competition, its size, and the other factors described in the previous chapter. All of this information, when combined and viewed as a package, provides the fundamental analysis you need in order to decide whether or not to invest in a company.
Take a little time to review all the information you’ve acquired, putting it together so that you’re relating a company’s financials to the state of the overall economy, the financial health of the company’s industry or sector group, the strength of its management team, how well its competition is doing, and other factors.
While financial information is vital to your analysis of a company, it cannot on its own provide the whole picture of how well a company is doing or what success it will experience in the future, since all public information available is historical. If the financial information is favorable, however, and your research regarding other aspects of the company had favorable results, you probably could feel good about buying its stock.
A big-picture approach is necessary when determining what stock to buy, along with ongoing vigilance concerning events that might affect its performance. You’ll need to continue to watch for conditions and events, both within the company and outside of it, that could affect its financial well-being.
The Least You Need to Know
• Analyst stock reports are easy to obtain and provide valuable information about a company.
• Financial information can be obtained from a company’s balance sheet, income statement, and cash flow statement.
• Financial ratios provide insight into many areas of a company’s finances.
• Carefully researching financial and other information regarding a company will allow you to predict its success.
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