Financial Statement Basics

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Before you invest your hard earned money, put the company under the microscope.

I received a request from a reader on how to read financial statements and do some basic company research. I thought it was an excellent idea for a post!

Below is a very brief summary of places and methods to find information on companies along with a description of how to read financial statements.

Accounting statements aren’t something that generates “clicks,” which is why some of these basics are hard to come by on a basic google search. I wish I had a little summary like this when I started out.

Types of Financial Statements

I throw around terms on this blog like “enterprise value,” “net current asset value” like everyone knows what they are. Of course, not everyone does, so I hope this helps.

If you want to go more in-depth than the summary I’m giving here, there are some books you can check out to learn about financial statements. The Interpretation of Financial Statements by Ben Graham is probably your best bet. It’s a concise, quick read. Stig Broderson and Preston Pysch (who host my favorite podcast) also wrote an excellent book on financial statements: Warren Buffett Accounting.

As a brief recap of Accounting 101, here are the three financial statements and their purpose:

Balance sheet – The balance sheet is a statement of a company’s assets and liabilities at a fixed point in time.

Income statement – This is a snapshot of how much money a company made over a period of time.

Cash flow statement – This is a breakdown of how a company’s cash position changed over a period of time. The statement of cash flows wasn’t required for a company to post until the 1970s.

Where to obtain financial statements

Google Finance was my go-to source for financial statements. It had a very nice summary of financial statements, with accompanying charts. For some reason, they decided to dump it. Their “financials” section is currently a few critical ratios on the company.

These days, there are a few places you can obtain free financial statements. Morningstar is an excellent source and offers free financial statements and valuation ratios. They also show relative valuations, which is nice when you want to compare a company to others in the same industry. Just go to the website, type in the ticker, and go to financials.

Yahoo Finance is also an excellent alternative to Google Finance. In their “statistics” section they even break down EBITDA and Enterprise Value, which is something that Google never did. On the downside, the website isn’t as clean and fast as Google used to be.

Why, Google, why?

K’s and Q’s

The gold source for financial statements is company filings with the SEC. When I am interested in a company, I usually start my search with free services like Yahoo. If I like the numbers, I will then go to the SEC website and delve deeper.

Because it’s possible that the free service (Yahoo, Google, Morningstar, etc.) may have input the wrong #’s into their online financial statements, I always double check their work by going straight to the 10-K and make sure that the numbers match up.

You can find 10-K’s for free at the SEC website. Scroll down on the homepage and search any ticker:

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The output of this search looks exceptionally intimidating.

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Don’t be intimidated. The documents you want to focus on are the K’s and Q’s. 10-Q’s are quarterly statements. 10-K’s are annual reports.

When you click on a K or Q, you’ll receive another batch of documents. The only doc you need is the first one. That will contain the financial statements and management commentary.

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The 10-Q will start off with the consolidated financial statements. This is the financial statement for the entire company. If you scroll down in the 10-Q, it will break out separate financial statements for each division along with commentary. For our purposes, you only need to concentrate on the first financial statements that you see, the consolidated financial statements.

My recommendation is that you check out the consolidated statements on the free sites. If you like what you see, double check Yahoo and Morningstar’s work by going to sec.gov and double checking the numbers for yourself.

Typically, my focus on the 10-Q is the financial statements.

Once I’ve checked the numbers, and I like what I see, the next step is reading the 10-K. I recommend reading the recent 10-K for every stock that you buy. The 10-K will provide financial information, but it will also summarize all of the company’s activities more robustly than you’ll find on the quarterly statements.

In my opinion, the most critical section of a 10-K is called “risk factors,” and it is generally near the beginning of the report. This is the section where management is legally required to disclose anything that they deem to be a risk to the business. In other words: while much of the 10-K is management’s opportunity to gloss over and obscure problems facing the company (it’s like a job interview – they are going to give you 110% and their only weakness is that they work too damn hard), the risk factor section is one where they are legally required to cut through the B.S. and tell you what they’re worried about.

The SEC: A watchdog and fountain of information

The SEC is one of the main reasons that I only buy individual stocks in the United States. The SEC isn’t the perfect watchdog, but it’s the best in the world. With the SEC website, you have every public company’s financial statements at your fingertips. Moreover, you have an enforcement agency to keep these companies honest. I’m fine with buying a massive basket of 50 companies in one country, but I simply don’t trust other enforcement agencies enough to buy individual foreign stocks. I also can’t easily find financial statements the way that I can in the U.S. As a guy with a full-time job for whom investing is a hobby, I also don’t have the time to dig around to find foreign financial statements. Reading everything available for a US companies takes up enough time!

The Balance Sheet

As stated earlier, the balance sheet is a statement of a company’s financial position at a given point in time. The focus here is on assets and liabilities.

The balance sheet is broken up into three sections: assets, liabilities, equity. Equity is a confusing term in finance because it is used to describe different things. Equity can mean an ownership interest in a company. On a balance sheet, equity is merely the difference between assets and liabilities.

The balance sheet equation is simple: Assets – Liabilities = Equity

When we talk about book value, we’re talking about equity. That’s the accounting asset value of the entire company.

Assets

Assets

Assets are broken out into current assets and long-term assets. The order of items begins with the most liquid and liquidity decreases as you go down the list of assets. Current assets are assets that can be liquidated in a time period less than a year, so they are listed at the top. The most obvious asset is at the top: cash and cash equivalents.

The second section is longer-term assets. Property, plant, and equipment is pretty basic. That’s the big stuff that the company owns. Buildings, smokestacks, etc.

Goodwill is a kind of accounting fiction. When a company acquires another company, they usually pay more than the true accounting value of the new company’s assets. They’re buying the company for its long-term cash generating ability, not merely the value of the stuff that it owns. This excess amount is treated as an “asset” and is on the books as goodwill.

Goodwill also comes into play on the income statement. Goodwill is expensed over time, an event that is called “amortization of goodwill”. This is why income estimates like free cash flow or “Earnings Before Interest, Taxes, Depreciation, and Amortization” are designed to exclude items like this. It’s not a direct cash expense.

Intangible assets are things like patents and copyrights. Basically, they’re real assets that aren’t easily liquidated into cash.

Deferred taxes are assets that the company expects to recoup at a later date in the form of a tax refund. This is not liquid because the company can’t just sell this or obtain it immediately. They have to wait until the appropriate time to include this expense.

When we calculate tangible book value we are stripping away goodwill and intangible assets. In contrast, book value treats all assets equally. Tangible book value focuses on assets that you can actually turn into cash. Tangible book value = Tangible Assets – Total liabilities.

Ben Graham’s Balance Sheet Approach

Ben Graham’s focus was on net current asset value, which is even more conservative than tangible book value. Ben didn’t even give value to property, plant, and equipment or longer term assets. His goal was to focus on what the company could sell for as scrap. He thought that asset value should focus entirely on current assets. Net current asset value = Current Assets – Total Liabilities.

When Ben took the metric to an even more conservative extent, he focused on working capital, which was the current asset value which only assigned 75% of value to receivables and 50% of value to inventory. The idea was to get a rough approximation of a conservative liquidation valuation. In a liquidation, inventory would be unloaded at fire-sale prices and not all of our customers would pay the company back due to impending doom. This is the most conservative estimate of a company’s value. Company’s that sell below this value are essentially worth more dead than alive.

It was net current asset value and net working capital stocks that Ben Graham used to generate 20% returns for his investors in the 1930s through the 1950s. Warren Buffett used this method in the 1950s, but abandoned it because he became too large to employ it effectively.

Today, these opportunities mostly exist abroad. They are available infrequently in extreme situations (one stock I own is a net-net – Pendrell) during normal times. They are only available in large numbers in the United States during times of economic stress. Even then, they are in a micro-cap universe that most investors can’t take advantage of (this is a good thing!) They were available in large quantities during the dot-com crash in the early 2000s and after the 2008 crash. Like cicadas, they only emerge once every decade or so.

I’m patiently awaiting the next opportunity to buy a lot of them.

Liabilities

liabilities

Most value investing ratios treat all liabilities equally to ensure maximum conservatism when assessing value.

Like the assets section, the liabilities section is listed in order of the time in which the payments are due. Current liabilities are debts that the company needs to pay in a year. Accounts payable are short-term bills due. Further down the liabilities section is long-term debt, which are long-term items like bank loans and mortgages on properties.

Deferred income taxes, in contrast to deferred taxes in the assets section, are income taxes that the company will owe in the future.

When we talk about the debt to equity ratio, we are talking about long-term debt divided by equity. This is an excellent rough metric to measure how leveraged the company is. Current liabilities aren’t included in this metric because current liabilities may be a simple part of the business’s operation and aren’t a long-term risk. Graham recommended a debt/equity ratio below 100%. In my backtesting, I’ve found that debt/equity ratios below 50% tend to work best.

equations

Enterprise Value

Enterprise Value is a term that value investors throw around a lot. Traditionally, investors focused on the total market value of a company’s stock (per share price times the number of shares) – also known as “market capitalization.”

Enterprise value goes beyond simple market cap and tries to calculate the total cost of the entire business to an acquirer. If we were to buy the whole company, we wouldn’t merely have to pay the market price. We would also become responsible for all of the company’s debts. We would also have to pay out holders of preferred equity. Additionally, we would have full access to the company’s cash on hand for whatever we want. The enterprise value is the sum of all of these components to arrive at the true cost of buying the company.

This is important because a company can have a low market capitalization, but a massive amount of other liabilities. Valuation ratios using the enterprise value try to take the entirety of a company’s size into the valuation equation.

You can calculate enterprise value by using the relevant balance sheet items and then adding it to the market capitalization.

Enterprise Value = Market capitalization + Debt + Minority Interest + Preferred Equity – Cash

Income Statements

The statement of income attempts to sum up how much money the company made over a set period of time.

As a general rule, the items at the top of the income statement are more reliable than the items at the bottom. It’s hard to fake sales, for instance. It’s easy to play games with taxes and depreciation. A typical income statement looks like the below:

income

The income statement is reasonably self-explanatory. You start with sales and you take away the cost of sales (also called “cost of goods sold”, or expenses directly tied into what you’re selling) and you arrive at gross profit. After gross profit, you take away “selling expenses” (all of your expenses that aren’t directly tied to what you’re selling).

If we were running a lemonade stand, sales are the total amount of money that we received from patrons for lemonade. Cost of sales would be cups, lemons, water, and sugar. Selling and administrative expenses are what we’re paying our lemonade stand employees.

You then take out depreciation and amortization. The full cost of an asset (i.e., our pitchers for the lemonade and wood to make the lemonade stand) isn’t expensed up front, it’s spread out over a period of time. For each period, this is the cost in the form of depreciation. Amortization usually refers to the “amortization of goodwill,” which is expensing how much we paid up for the business over its accounting value.

This then takes us down to “operating income”. When we’re talking about “earnings before interest and taxes“, this is what we’re talking about. The reason that many value investors focus on this metric of income is simple: (1) The further you move up the income statement, the less likely the numbers are to be manipulated, so it’s better to focus on an item closer to the top of the income statement. (2) If we’re using enterprise value in the denominator of the valuation ratio, we are already assuming that we’re paying off all of the company’s debts. This allows us to take away the interest expenses. In other words, it provides us with a rough-and-dirty way to compare the relative valuation of companies that have entirely different capital structures.

We then take out taxes, include money made from interest, and take out money spent on interest — this then brings us to net income.

From net income, to arrive at earnings per share, we subtract dividends paid to investors and other distributions. We then have “earnings per share”. This is the E in P/E. When looking at P/E ratios, it is important to examine the earnings and make sure that they are all “real”. If the trailing twelve-month earnings are boosted by some goofy accounting trick in tax expenses or amortization/depreciation, then the P/E can be artificially low.

Usually, when you see quoted values for operating income and earnings per share, it is referred to as “TTM” or “trailing twelve months.” This simply means that they are adding up the numbers over the last four quarters to show you a trailing year of earnings and income.

Most investors use “forward” P/E ratios, or a P/E based on estimated future earnings. Forward earnings estimates are relatively worthless. The backtesting proves this. There is no value ratio that tests as bad as forward P/E’s.

Cash Flows

The statement of cash flows summarizes the change in a company’s cash position from one period to another. The total change in cash on the statement should tie into the change in “cash and equivalents” from one quarter to another on the balance sheet.

The statement of cash flows wasn’t required until the 1970s, after many company blow-ups that weren’t detected on the income statement. If a company is generating tons of sales and income, but they’re burning cash, it’s going to be difficult for them to stay in business over the long-run.

Warren Buffett contends that the real value of a company is the cash flow it can generate for the owner over time.

cash flows

The statement of cash flows is broken down into three sections:

Cash flows from operating activities – This is the section that focuses on the cash that is actually being generated from the business. This is the section that most value investors hone in on. It begins with net income and subtracts all non-cash expenses like depreciation and amortization (because they aren’t real cash expenses). Ideally, the number should be positive, demonstrating that the company is actually generating cash for its owners.

Cash flows from investing activities – This shows you how much cash the company generated from its investing activities. If you were to go out and buy a stock or a bond, it would be a negative number on the statement. If you sold stock, it would be a positive number on the statement. It doesn’t show if the asset was sold for a profit. It simply shows how much cash your investing activities generated. A negative number here isn’t necessarily a bad thing. It simply means that the company bought financial assets more than it sold them. A positive number isn’t necessarily a good thing because it doesn’t tell you if the company sold the asset for a profit.

Cash flow from financing activities – This is cash flow related to the activities of the company outside of normal operations and investing activities.

Cash that the company paid out in dividends to the owners or used to purchase back stock would be a negative number for this. Money borrowed from a bank would be a positive number because that’s cash coming into the company.

The net effect of all three sections will show you the net change in a company’s cash position in a quarter or a year. This change should tie into the “cash and equivalents” section that is on the balance sheet.

High positive cash flows are not necessarily a good thing. If the company is bringing in cash through debt issuance or issuing new shares (diluting your ownership stake), it is not good for investors.

A term that value investors use frequently is free cash flow. This is what you want to focus on when examining the statement of cash flows. Warren Buffet refers to this as “owner’s earnings.” Free cash flow is simply: Cash Flows From Operating Activities – Capital Expenditures. You can find the capital expenditures as a line item in “cash flows from investing activities”. For the above example, they list it as “purchases of property, plant and equipment”. In other words, free cash flow excludes all of the other investing and financing activities conducting by the company.

Free cash flow focuses solely on cash generated by the operating business minus the money spent to keep the business operating.

If you were to buy the business in its entirety, free cash flow is the money that you would have as the owner to (1) pay yourself in the form of dividends or share buybacks, (2) invest to generate more cash flow in the long-run.  Free cash flow is the cash available to you, the owner of the business.

free cash flow

Summary

I hope you find this brief summary useful. I know I could have definitely used this breakdown years ago when I got started investing in individual companies. It’s not as hard or intimidating as it appears on the surface.

Investors frequently lose sight of what a share of stock is. A stock isn’t a ticker symbol and a number. It’s not a line on a chart that bounces around that you can find hidden meaning in. A share of stock is an ownership interest in a company. You are a part owner of a company. Before you lay down a dime, you should find out what that company does and understand its financial position.

If this homework sounds too hard, then you shouldn’t go out and buy stocks in individual companies. If you are willing to put in the work, then give it a shot.

There is obviously much more to learn about financial statements and company research, but I hope this is an excellent basic summary that you can use as a springboard to learn more.

Accounting is boring, but it is the language of business, and it’s essential that you know it before you go out and buy an individual company’s stock.

This has nothing to do with investing. I just love it. 🙂

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

One thought on “Financial Statement Basics”

  1. Great summary – and a good lesson about doing homework – one we often overlook and just run on speculation and rising prises. I have a resources page and will be sure to add some of these terms to it as well. Once again, very useful and well explained!

    Like

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