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How to Read (and Understand!) a Financial Statement

April 24, 2017, 4:05 pm

I go through extensive research when sizing up a new company, and thought it might be helpful to share my process with you, especially when it comes to financial statements. These number-heavy documents can be overwhelming, so I’ve simplified the process with a handy guide that you can use when researching any prospective names for your own portfolio.

Some of the terms and explanations are likely to be familiar to you, especially if you’ve been investing for a while. Others you may not be as familiar with, and I hope it gives you some helpful food for thought.

Please note that not every company displays every characteristic listed below. This is simply a guideline for choosing healthy business entities that have the wherewithal to continue growing. I want you to be able to look beyond the conventional P/E ratios, press reports or rumors when picking stocks. It’s important to understand what the numbers in a financial statement tell you – and it’s equally important to know that companies change over time, so their trends can change, too. When you know what to look for, you can continue to evaluate the worth of a stock on an ongoing basis.

The Income Statement

1) Revenues: Simply put, these are the sales that a company makes during a given period, quarterly or annually. Keep in mind that sales are recorded on an accounting basis and do not represent cash that is being earned. (More on this later when we discuss the cash flow statement.) I do like to see annual sales growing at least a high single-digit rate. And I especially like to see double-digit growth rates year-over-year, since that’s an even better indicator that a company is gaining traction among existing customers and/or growing their customer base.

2) Margins: There are two margin lines I like to look at: gross margins and operating margins (or EBIT, which stands for earnings before interest and taxes). Gross margins are equal to revenues minus the cost of goods sold, or COGS for short. COGS includes the cost of making a product, from software to machines to clothes, that a company sells to its customers. This line item typically includes material costs and direct labor costs. It does not include expenses like salaries, research and development, etc. It’s always good to see gross margins on the rise, because it means that a company is showing pricing power, controlling its production costs, or both.

Operating margins are one of the more important income statement line items because they take into account not just the direct costs of making a product, which are captured in gross margin, but also the impact of all the operating expenses a company must carry, including research and development, staff salaries and the like. I generally like to see double-digit operating margins on a longer-term trend of growth.

In some cases, though, operating margins may be negative. Newly-established companies just out of the gate often incur heavy start-up and operating costs before they see much in the way of sales or profits. Some industries show this trend more than others, particularly the biotech sector. In looking at biotechs, I want to see some real promise in the novel therapies being developed, their specific targeting of disease and advantages over existing treatments. This will translate into strong revenues, and eventually the company will generate some real profit and cash flow strength.

3) Net Income: This is the “bottom line,” which means the money that is left over to stock investors after all expenses are deducted. Net income is usually presented on a financial statement after one-time items – such as special charges for, say, a product recall, a win or loss in a lawsuit (with damages paid) or even failure of some equipment or due to a tornado or other weather-related event.

There are a million reasons why such special items may show up on an income statement, but they can have the effect of making net income turn into a net loss, or vice versa. So even though Wall Street looks at the bottom line perhaps more than any other place on an income statement, net income can be a misleading metric at times. Make sure you know what the earnings power of a business is before these items. Analysts and investors typically look at the tax-effective operating income when judging the success of a quarter’s earnings result.

4) Balance Sheet: This is a snapshot of a company’s financial position at a given point in time, whether at the end of a quarter or the end of the year. When I look at a balance sheet I generally want to see a rising cash and investments position, which indicates that a company is growing its business. I also want to see a quick ratio above one. The quick ratio lets us know that a company can cover its liabilities in a pinch. You can calculate this ratio on your own by dividing current assets by current liabilities. Ideally, the result will be at least 1.

There are also varying opinions about debt, but it really depends on the industry. In some cases, debt is a necessary cost of doing business. Biotechs and even some energy companies, for example, must get funding in place before they can get operations up and running – particularly if their products have yet to hit the marketplace.

5) Cash Flow Statement: There’s an old saying in the investment world that “cash is king.” That’s because a company must generate cash to sustain its operations. However, it’s also because over the past several years some unscrupulous management teams have manipulated income statements and balance sheets to hide deteriorating financial performance (Enron, anyone?). You MUST look at the cash flow statement in order to judge the financial soundness of a company during your due diligence.

In my experience, the most important part of the cash flow statement includes the first of the three sections typically listed on the financial statement, known as the operating cash flow segment. This shows how an accounting convention, net income, gets turned into cash. A simple rule of thumb is to look for increasing and positive operating cash, and then to subtract a line item from the next section, the cash flow from investing activities. This line typically reads “purchase of property, plant and equipment.”

That’s also known as capital expenditures (capex), or the cash that is being reinvested into the business through buying or building new production plants or even buying other companies in order to grow. Operating cash flow minus the capex equals free cash flow, or what is “left over” to fund future activities. The greater the free cash flow, the more likely it is that the company will see even better growth in the future as it has the resources to compete against peers.

I hope this helps to give you a better understanding of what I look for and the financials you should check out before investing in a new company. Keep these numbers in mind during your research, and you’ll be on your way to finding the right stocks that are worth your money!

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