Understanding Financial Statements

In my investing seminars, I make it a point to ask my audience for a show of hands to find out if they actually read the financial statements sent to them by the companies in which they invest. The answer is invariably about 3%-5% of the attendees. That is an abysmal percentage, yet completely understandable.

Just the thought of reading and comprehending the small print, convoluted charts and the seemingly-endless gobbledygook of the legalese contained in the pages of 10-Ks and annual reports can put a glaze over the eyes of even the most avid of investors.

However, the rapidly-changing, instant-information, highly-competitive age that we live in today necessitates that astute investors gain a thorough understanding of their investments. And financial reports—although historical in nature—are very important barometers for gauging just how well, or poorly, your companies are coping today, as well as good indicators of future performance. Consequently, you should learn to read them for one very important reason: to become a better and more profitable investor.

In the pages of these reports, you will find numerous tidbits that will give you a wealth of information about your company’s most recent, current, and future strategies, actions, and results. And armed with that information, you can make much better investing decisions, which will hopefully translate into increased portfolio returns.

I hope to convince you of two critical points: the importance of staying on top of the financial health of the companies in which you invest, and how easy it is to do that. Now, you may be surprised, but I promise you, once you get the hang of knowing just where to look and which parts are important, you will be breezing through the thickest of financial reports in less than an hour. So, where do you start?

Very simply, at the beginning—with the 10-K—the summary of a firm’s performance that the Securities and Exchange Commission (SEC) requires every public company to submit 60-90 days after the end of its fiscal year.

The 10-K incorporates the data from that nice, shiny-paged, colorful annual report that most investors receive from the companies in which they hold stock. If your companies don’t mail them to you, you can easily access them—for free—either through the companies’ own websites (generally, in the Investor Relations section) or through the SEC at:

https://www.sec.gov/edgar.shtml

Before you start your exploration, you need to know that the financial statements for just one year won’t give you a very complete picture of the company’s status. For a thorough review, you really do need to compare at least 2-3 years’ worth of data. So, pull up a 10-K, relax, and let’s go investigating:

The easiest way to tackle a seemingly-complex task is to break it down into manageable tasks. Fortunately, the 10-K is already divided into four primary sections:

Part I includes Business; Risk Factors; Unresolved Staff Comments; Properties; and Legal Proceedings.

This section will provide details on the company’s revenues, marketing plans, major products, competition, and risk factors. If you compare it from year to year, you will be amazed at just how much you can learn about the changes in the firm’s strategies, product lines, and where it stands among its competitors and its marketplace.

You will also want to keep a keen eye on the firm’s legal proceedings. In today’s world, it’s not unusual for a business to be involved in lawsuits. What you need to know is how much the proceedings could potentially cost or earn them, and if that amount will have a material effect on the company. If a business doesn’t or can’t answer those questions, you may want to reconsider your investment.

Part II includes Market for Registrant’s Common Equity and Related Stockholder Matters; Selected Financial Data; Management’s Discussion and Analysis of Financial Condition and Results of Operation; Quantitative and Qualitative Disclosures about Market Risk; Financial Statements and Supplementary Data; Changes in and disagreements with Accountants on Accounting and Financial Disclosure; Controls and Procedures; and Other Information.

The most important part of this section is management’s discussion of the most recent reporting period, as compared to prior years. Here, the company will provide details of the major events affecting its operations, such as divestitures and acquisitions, which, when compared to previous years’ reports, will give you a good sense of the firm’s ongoing growth strategies. Any restatements of financial statements will also be noted here, and you’ll want to make sure that will not create an ongoing problem for the business, nor is it a regular occurrence.

Next, you get to the heart of the report—the financial performance summary of the company and the events that affected it, good or bad. This will include an analysis of income and expenses, margins, changes in debt, liquidity, capital, leases, taxes, pension plans, accounting changes, related-party transactions, and executive compensation.

Here, you will want to watch for out-of-the-ordinary changes that may have a major impact on the company’s bottom line. Are expenses, as a percentage of revenues out of line? Are margins steady and growing? If the company has taken on large quantities of debt, is it funding growth of sales and earnings, or is it just creating more interest payments?

Pay special attention to the pension section to make sure the company is on top of its funding and hasn’t squandered the pension monies of its retirees. If it falls behind, one day it will have to play catch-up. Related-party transactions can also be of importance, to ascertain if a company’s shifting money among subsidiaries is on the up-and-up or suspicious. You may also find out if the firm is making unwarranted and unethical loans to upper management or directors.

Lastly, executive compensation needs to be reasonable. You will have to consult the company’s Proxy statement for complete details, but it’s a worthwhile task. Just ask yourself, is the executives’ pay (including options) in line with the revenues and earnings the company is producing?

Part III includes Directors and Executive Officers of Registrant; Executive Compensation; Security Ownership of Certain Beneficial Owners and Management; Certain Relationships and Related Transactions; and Principal Accountant Fees and Services.

Take a good look at your company’s directors and officers. Is there a revolving door at the firm? If so, it could mean tumult in the management suite or board room and may create havoc in the company’s finances. Or has the company’s management been around too long—fat and happy—without the drive and ambition to continue making the company successful?

It’s always interesting to see the level of, and changes, in management and beneficial owners’ shares. Are they buying or selling? How many shares do they have left? Is management putting its money where its mouth is? Beware of companies whose key management members do not invest in its shares.

Next, does the company change auditors frequently? This is a potential red flag and could possibly portend doom and gloom for the financial health of the business. Note that this information may not be complete in Part III; you may be referred to the company’s proxy statement or an exhibit accompanying the 10-K.

Part IV includes Exhibits, Financial Statement Schedules.

In this section, you will find detailed financial statements. Please read them and compare them, year-over-year. Look to see how the individual accounts have changed. On the income statement, pay attention to changes in operating income, including cost of sales, and increases or decreases in selling and administrative and operating expenses, as a percentage of sales. Can the company easily cover its interest expenses? Is income growing because of increased sales, lowered expenses (including taxes), or both?

On the balance sheet, review the changes in inventories, accounts receivables and payables, which will give you a good read of the company’s efficiency. Again, run a keen eye over the firm’s debt levels. Is short-term debt growing too quickly and staying in place too long? Do goodwill and intangibles look reasonable?

The cash flow statement has one primary purpose—to show you where the company received cash and how it spent it. The most important line is Cash Flow from Operations. This is the cash that a company takes in from its day-to-day business. If it is an amusement park, the cash is from ticket, merchandise and food sales. Is this number positive; is it trending positive, from year to year? It’s great if a firm is making money from real estate sales or investments, too, but the bulk of its cash should be derived from the business for which it is in business.

Although a company’s 10-K is much more comprehensive than space allows me to review here, these pointers will considerably aid you in your search for good investments.

And I hope this information will encourage you to become regular readers of your companies’ financial statements. This process will give you greater insight into their current strategies as well as future possibilities. Once you have read a handful of these reports, you will begin to have a much better understanding of what makes a good company good and a bad company bad.

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