Make no mistake; investors who understand how to gauge a company’s financial health have an edge in the market.
It is a skill that top managers and entrepreneurs use all the time in their strategic decisions, as well as to consistently identify latent opportunities and to avoid unnecessary risks.
And whereas these people are trained to read these documents and retain information with only a glance, a new investor may not even know where to begin.
So, to guide you, lets go over the following:
·The Annual Report
·The Balance Sheet
·The Income Statement
·The Cash Flow Statement
By knowing how to read these documents and, especially, what to look for in each of them, you will surely get the full picture of the company you are planning to invest in.
So, without further ado, let’s dig in, shall we?
The Annual Report
A company’s annual report is a public document that describes both their operational and financial situation.
The report allows for current and potential investors to understand where the company is headed and how is it planning to get there.
It is often divided into two different sections.
The first part features letters from key figures from inside the company (usually C-level executives) and is basically a narrative on how the company performed and what their outlook is shaping up to be.
Keep in mind that annual reports also serve as marketing collateral, so it is not uncommon for storytelling elements to be present as to provide ample vision into the company’s mission and goals, as well as industry insights, accounting policies, management’s analysis (MD&A), and other investor information.
The second section is where you can sink your teeth into the company’s numbers.
The Annual Report VS The 10-K Report
The annual report will summarize financial data by the inclusion of the company’s income statement, balance sheet, and cash flow statement.
Even so, the US Securities and Exchange Commission (SEC) still mandates that public companies, in tandem with their annual report, publish their 10-K report: a document which must follow SEC guidelines and includes information in much greater detail about the company’s current fiscal and market activities, their corporate agreements, their executive compensation, and their risk and opportunities.
By taking the narrative of the annual report and combining it with the details provided in the 10-K report, an investor can thus get a much clearer vision of the company’s inner workings and future plans.
The Balance Sheet
In simple terms, the balance sheet is a snapshot of the company’s performance at a given point in time.
Its purpose is trifold: while internal reviewers (stakeholders) will look for insight over the company’s successes or failures and act accordingly upon each of those cases, external reviewers (potential investors) will want to look reasons for which to invest or stay clear of the company, and lastly, auditors may peer into the balance sheet as to look for the company’s compliance to rules and regulations.
When read correctly, it will offer investors critical insight on the company’s financial health as well as convey them its “book value” by tallying up all of its assets (anything the company owns and can be of quantifiable value), liabilities (debt, payroll expenses, rent, taxes, etc. Basically, the opposite of an asset) and equity (its net worth).
The Balance Sheet Equation
The balance sheet equation is as follows:
Assets = Liabilities + Owners’ Equity
It’s probably an obvious statement to make but the equation must always, well… balance. If you find that it doesn’t, then it is likely to have been reported incorrectly.
Without getting into too much detail, Assets can be divided into two: Current Assets and Noncurrent Assets
The difference between them is where they stand in the timeline the company has traced in terms of converting them to cash. Current assets are expected to be converted into cash within a year, whereas Noncurrent are set to do so on a larger time frame.
The same logic applies to the company’s liabilities, as they too can be divided into Current (such as payroll or rent) and Noncurrent (such as long-term obligations or debt).
As for the Owner’s Equity (or shareholders ’ equity), the math is simple as it is equal to assets minus liabilities.
While the balance sheet is a powerful tool, it doesn’t account for all factors.
As such, a look into other statements is much needed as to fully understand a company’s financial position.
The Income Statement
Commonly known as the Profit and Loss Statement (or P&L), the income statement will tell you the company’s financial performance over a period of time through the impact of its revenue, gain, expense, and loss transactions.
The Profit and Loss Statement differs from the balance sheet as the first will tally income and expenses and the latter records assets, liabilities, and equity.
What’s in it
The most common elements to be featured on a company’s income statement are the company’s revenue, its expenses, COGS (or cost of goods sold), its gross profit (which equals revenue minus COGS), its operating income, income before taxes, net income, the company’s depreciation (assets lose value over time), its EPS (earnings per share, which equals net income divided by outstanding shares) and EBITDA (earnings before interest, taxes, depreciation and amortization).
The document will often display financial trends and comparisons over different set periods.
What to look for
By reading the Profit and Loss Statement, investors are able to get the full picture (or at least the financial one) of the company in terms of its value and efficiency as they can gather information about the company’s profitability, the money which is needed to make a product, how much cash reserves it has, and so forth.
It also works as a basis of comparison between the company’s expectations and actual performance.
The document will also give investors financial insight over trends as, from there, they can pinpoint when (or if) costs tend to get higher or lower, giving investors an edge regarding future opportunities.
How to find information: the vertical and the horizontal analysis
By running a vertical analysis, investors can keep track of how individual lines will relate to one another as the percentages displayed will work as both a performance metric and a relative indicator between different companies operating in the same industry.
A horizontal analysis, on the other hand, when comparing the company’s financial statements, will let investors see the exact changes that happened and which key elements might be related to its financial performance.
The Cash Flow Statement
A cash flow statement is an investor’s best friend when trying to understand what exactly has happened with the company’s cash during an accounting period (a set window in time).
Cash flow statements provide information on a company’s operating activities (the regular delivery of goods and/or services with revenue and expenses), investing activities (the purchase and selling of assets), andfinancing activities (related to debt and equity).
By reading it, investors can gather information on how much cash is going in and out of the company and which activities generate it, which, in turn, tells volumes on the company’s financial stability, potential growth and its ability to operate on both short- and long-term scenarios.
How is it calculated
There are basically two ways of doing so: the direct and the indirect method.
While the direct method draws from transactional information (all cash collections from operations minus its disbursements), the indirect method works on the back of accrual accounting (meaning that the adjustments made will cause cash from the company’s operating activities to be different from its net income).
What to look for: positive and negative cash flows don’t always mean what they mean
Cash flows can speak volumes about what stage a company is currently in, as by looking at the numbers, investors, managers, and entrepreneurs can understand if it is growing, maturing, transitioning into something else entirely, or even declining.
A company which brings in more money than is spending (positive cash flow) will be able reinvest that money in either itself or by paying debt, whereas a company with negative cash flow might signal that some adjustments might need to be made.
However, it is very important to understand that a positive cash flow may not correlate with being profitable, and a negative cash flow might also indicate that the company is expanding or investing in something.
This highlights the importance of comparing several different statements in order to get the full picture.
Wrapping up
There is investing and there is intelligent investing.
Intelligent investors will dig into a company’s statements to gauge its financial heath, its current and potential performance, and its underlying risks.
As Sir Arthur Conan Doyle, the creator of the character Sherlock Holmes, once said:
“It is a capital mistake to theorize before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to suit facts.”
By looking at all these reports, you will also be able to look and interpret the company’s data clearly while avoid having it cherrypicked or spun by anyone.
So, pick a company, start digging in and happy investing.