readingfinancialreports.pdf

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Money & Business

Reading Financial ReportsSpot the next Enron a mile away.

Even the most experienced investor can get lost in the jungle o a companys

inancial statements. But basic knowledge o the balance sheet, cash low

statement, and income statement go a long way. With just a little eort , you can:

Navigate through the sections o an annual report

Calculate basic ratios to measure proftability, liquidity, and solvency

Make better, more inormed investment decisions

published byBarnes & N

Financial Report BasicsFinancial reports, or nancial statements, are documents

that summarize a companys nancial perormance. All

publicly traded U.S. companies that have more than 500

investors and $10 million in net assets, or that are listed

on a major national stock exchange such as the New York

Stock Exchange (NYSE) or the NASDAQ, are required by

law to issue nancial statements on both a quarterly and

annual basis. This regulation is enorced by the Securities

and Exchange Commission (SEC), the U.S. government

agency that regulates the investment industry.

Financial reports are meant to create transparency and

accountability by making companies nancial results vis-

ible to investors and the market as a whole. The reports

are standardized, meaning that the annual and quarterlyreports rom various companies contain comparable (though

not necessarily the same) nancial inormation.

How Investors Use Financial ReportsReading a nancial report is the only way or most inves-

tors to get a good picture o a companys perormance and

nancial situation. Learning to read and analyze nancial

reports can help you understand a companys nancial

perormance in detail and, in turn, make more inormed

investment decisions. By reading and analyzing nancial

reports, you can begin to invest based on a companys un-

damentals, or nancial statisticsan ess ential step toward

becoming a condent, successul stock investor.

Annual Reports (10-Ks)An annual report (in SEC lingo, a 10-K) covers a public com-

panys perormance during the previous scal year. Private

companies dont le 10-Ks. The report contains two basic parts.

Narrative Summary

The narrative summary is a written synopsis that gives

investors some insight into the companys vision and strate-

gies. It includes the ollowing components:

Letter to shareholders

Management bios and compensation data

Managements discussion and analysis (MD& A)

Auditors statement

Financial Statements

The annual report also contains three nancial statements

that provide hard data on the companys nancial peror-

mance over the previous year.

Balancesheet: A snapshot o the companys nancial

condition at a specic point in time, including assets

(cash, items owned by the company, and money

owed to the company); liabilities (debts and nancial

obligations); and equity (assets minus liabilities).

Incomestatement: A breakdown o the companys

revenue (income) and expenses (costs) over a specic

period o time. The income statement shows whether

the company has earnings, also known as prots or

net income. Earnings are the cash that remains ater

all expenses have been taken into account.

Cashowstatement: A detailed list o all cash

infows (money coming in) that a company receives

rom its ongoing operations and external investment

sources, as well as all cash outfows (money going out)

that pay or business activities and investments.

Notes

Every nancial statement includes a set o accompanying

ootnotes in small print at the end o the nancial state-

ments section. These notes, also known as ootnotes,

serve as annotations to the statements themselves and

oten include the juiciest, most revealing bits o inorma-

tion in the entire annual report. For example, i a company

recently purchased a new private jet or its executives, that

minor detail (which could cost tens o millions o dollars)

would likely be stipulated in the notes and nowhere else.

Companies also oten bury their nancial problems, such as

the cause o a drop in sales or a spike in debt, in the notes.

The Financial Highlights Section

Along with their actual nancial statements, companies

oten include a user-riendly summary o their nancial data.

Typically reerred to as nancial highlights, this section o

the annual report is neither required nor ormally regulated.

As a result, the nancial highlights are not always presented

in accordance to accounting rules. Thereore, you should

never trust the nancial highlights accuracy. Reer to the

actual nancial statements instead.

Quarterly Reports (10-Qs)A quarterly report (in SEC lingo, a 10-Q) is similar to an

annual report, with two important dierences:

Timeframe: Quarterly reports cover only the three

most recent months o a companys perormance.

Theyre issued three times per year (the ourth-quarter

report is included in the annual report). So i its June

and youre reading an annual report that was published

in January, be sure also to review the more recent

nancial data contained in the latest quarterly repo

Mostlyjustnancials: Quarterly reports dont con

as much narrative commentary as annual reports.

may have a brie introduction but otherwise contai

just the nancial statements.

The Best Sources or Financial DataMost publicly traded companies publish their quarterly

annual reports online or ree. Reports are t ypically avai

in the ollowing locations:

Companywebsite: Look or links to the investor

relations section o the website.

SECwebsite: www.sec.gov/edgar.shtml

Yahoo!Finance: nance.yahoo.com

You can oten get a paper copy o the annual repor

calling the company directly and requesting one rom

investor relations department.

How to Read the NarrativeSummary o an Annual Report

The narrative summary provides a glimpse into how

company views its own prospects and also gives s

insight into the companys management and strategie

narrative summaries o annual reports contain our pa

Letter to shareholders

Management bios and compensation data

Managements discussion and analysis (MD &A)

Auditors statement

When reading the narrative summary, keep in mind tha

company is using it in large part to try to present itsel i

best possible light, even i its annual nancial results

weak. Read between the lines, with skepticism.

Letter to ShareholdersAll annual reports begin with a message thats osten

rom the companys top executives but more likely wr

by the companys public relations department. This l

to shareholders is typically designed to highlight the

tive aspects o the companys year but should also add

negative results. Though you should read this letter to

sense o the companys current overall message, never

on it when determining whether to buy a companys st


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www.quamut.com Reading Financial Rep

Management Bios and Compensation DataFollowing the letter to shareholders, the annual report typi-

cally contains sections that provide biographical and com-

pensation inormation about the companys management

teamthe group o top executives who run the company.

Managementbios: Inormation about the educational

and business background o each management team

member. The bios can help you assess whether the

companys executives are appropriately qualied. I

youre thinking o investing in a sotware company, or

example, you want executives with strong background

in the sotware business, not the pet care business.

Compensationdata: Specics about salary, stock,

and other compensation awarded to the management

team. This data can help you assess how airly the

company pays its executives. For instance, i recent

nancial results are weak, the company shouldnt

award executives exorbitant compensation packages.

I a companys management strikes you as underqualied or

overcompensated relative to management at other, similar

companies, you may want to avoid the companys stock.

Managements Discussion and AnalysisThe managements discussion and analysis, oten

reerred to as the MD&A, is the portion o the annual reportin which the companys management expresses its views

on the companys past year o perormance and its uture

prospects. Read the MD&A closely to get a sense o how

closely managements views align with the companys

actual nancial results contained in the balance sheet, in-

come statement, and cash fow statement.

Overall Contents o the MD&A

The MD&A covers our aspects o a companys business:

Liquidity: The companys cash position and ability to

cover its expenses on a short-term basis

Capitalresources: The companys debts and its plans

or using debt, such as expansion, acquisitions, and

other major capital expenses

Resultsofoperations: A summary o nancial results,including earnings, prots, and taxes

Markettrends: A review o external trends and events

in the marketplace, such as weather or energy prices,

that may impact the companys perormance

Specifc Disclosures in the MD&A

The MD&A contains many specic data points, called dis-

closures, that can help you get a sense o the companys

nancial standing. The specic disclosures you should read

most closely are:

Revenuerecognition: Species when a company

books revenue or a sale, as opposed to when it

actually receives revenue or a sale. You should be

wary o companies whose revenue recognition policies

allow them to book revenue ar in advance o actually

receiving the revenue: these policies can create the

illusion that a company generates much more revenue

than it ever actually receives.

Allowancefordoubtfulaccounts: The companys

expected losses as a result o unpaid accounts

receivable. The losses that result rom doubtul

accounts can reduce or erase a companys earnings.

A notable increase in doubtul accounts over several

quarters can signal a problem with the companys

accounts receivable strategy or a general breakdown in

the industrys liquidity.

Environmentalandproductliabilities: The

companys risk o being sued or held responsible or

paying nancial claims made by other organizations or

individuals. Companies with a high degree o potential

liability, such as chemical transporters or cigarette

manuacturers, can see their earnings diminished or

erased by litigation ees and judgments.

Restructuringcharges: The companys disclosure o

costs it expects to incur as a result o restructuring,

such as shutting actories or relocating parts o the

business. These charges can be recurring or conned

to one event. One-time charges are less worrisome

than recurring charges, though either type can

signicantly cut into earnings.

Stock-basedcompensation: Specic details o stock-

based compensation packages awarded to employees.

In general, stock-based compensation should refectthe companys perormance. Be wary o companies

oering stock-based compensation that seems

excessive, especially i company perormance has

recently been lackluster.

Pensionplans: Companies with employee pension

plans (company-paid employee retirement plans)

must disclose how they plan to meet the plans

nancial obligations. Be especially wary o very large

corporations, as they may have vast pension plan

obligations that can threaten earnings.

Auditors StatementThe SEC requires companies to pay third-party auditors

to veriy the reliability and accuracy o nancial reports.

The auditors create a nal assessment, called an auditors

statement, that usually appears just beore or ater thenancial statements contained in the annual report.

What Auditors Do

Auditors dont check every single transaction a company

makes. Instead, they perorm a battery o tests that provide

reasonable assurance against material misstatements

errors that can signicantly impact a companys nancial

position. These tests provide some protection against bla-

tant raud but should not be considered oolproo.

Contents o the Auditors Statement

An auditors statement typically contains an introductory

paragraph, a scope paragraph, and an opinion paragraph.

Introductoryparagraph: Basic inormation regarding

the audit and nancial data it covers, such as the time

period the audit covers and the names o the auditors.

This paragraph is meant to limit the auditors liabilit

by stating that the audit is merely an opinion about

nancial data and that the companys management

responsible or the contents o the nancial reports

Scopeparagraph: A description o the standard se

guidelines or nancial accounting, called the Gene

Accepted Accounting Principles (GAAP), that the

auditors ollowed to conduct the audit. The paragra

states the rules accountants must ollow in recordi

and summarizing transactions and in preparing na

reports. GAAP standards stipulate that the main go

the audit is to ensure that the nancial report is re

material misstatements.

Opinionparagraph: The auditors conclusions bas

on the companys nancial reports. I the auditors

ound no major problems, theyll say so in the opini

paragraph. An auditors statement that uncovers n

major problems is called an unqualied auditors

statement or a standard auditors opinion. An

auditors statement that does uncover major proble

is called a qualied auditors statement. In such

cases, the auditors will use the opinion paragraph t

speciy the problems they uncovered.

Qualifed Auditors Opinions

Auditors issue qualied opinions or many reasons. S

are minor and technical in nature; others may indicate mtrouble, such as impending bankruptcy. Among the

serious reasons or issuing qualied opinions are:

Going-concernissues: Auditors issue going-conce

qualications when they have substantial doubt tha

a company will be able to und its operations, pay

its debts, and remain a going concerni.e., stay in

business. Problems that might lead to this qualica

include stang issues, disputes with suppliers, ong

losses without the prospect o near-term protabili

and so on.

Businessu ncertainties: Some uncertainties in the

companys uture could lead to substantial losses,

which could in turn prevent the company rom

remaining a going concern. These can include a

possible merger that seems likely to all through ora major deal with a shady supplier. I an uncertainty

merits inclusion in an auditors opinion, its likely a

major threat to the companys uture.

Questionableaccountingpractices: When

signicant dierences arise between the way audit

and company management handle the accounting

o a major item, such as a sizeable business deal,

the auditors will mention the discrepancy in their

statement. This qualication can signal unscrupulo

management behavior and may be a major red fag

Auditors may also issue qualied opinions i theyre un

to obtain the inormation or resources they need in ord

issue an unqualied opinion. For example, i the com

withholds inormation rom the auditors, the auditors

issue a qualied opinion even i the available nancial

is veriable and accurate.


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www.quamut.com Reading Financial Repo

How to Read a Balance Sheethe balance sheet is a summary o a companys current nancial standing based on assets,

abilities, and equity.

Assets: Cash, items owned by the company, and money owed to the company by

other parties

Liabilities: Any debt owed to people or organizations outside the company, including

bank loans, wages, and ees owed to suppliers

Equity: Total assets plus retained earnings (prots generated by the company that

were reinvested into the company) minus total liabilitiesalso reerred to as owners

equity or shareholder equity

he most undamental equation that investors use to evaluate a companys nancial health

called the balance equation or accounting equation:

liabilities + equity = assets

vestors reer to the balance sheet to nd the three components o this equation and see

ow they relate. Investors tend to avor companies whose assets exceed their liabilities,

aking their equity value positive.

As a company grows and its assets increase, its liabilities and equity tend to increase as

ell. For example, or a company to build a new actory, it must either reduce current assets

r increase liabilities and/or equity. Namely, it must do at least one o the ollowing:

Useexistingassets: By spending cash or liquidating an asset (converting it to cash,

usually by selling)Acquirealiability: By taking out a loan rom bank or some other lender

Takeonmoreequity:Typically by soliciting urther investment rom the companys

current shareholders or by oering stock or sale to the public

A Sample Balance Sheethis sample includes the most important line items, or specic elds, youll nd on most

ompanies balance sheets. The remainder o this section explains how to read and analyze

he line items. Please note that on nancial statements, parentheses indicate entries with

egative values.

ypes o Assetss you can see on the sam-

e balance sheet, compa-

es have two main types

assets:

Currentassets: Any

assets that are cash or

can be converted into

cash within a year

Long-termassets:

Assets (such as

buildings or land) that

require more than a year

to convert to cash

urrent Assets

ay close attention to cur-

ent assets, as they und

he companys day-to-day

perations, short-term debt

xplained below), interest

ayments, and dividends.

a companys current as-

ets all short, unds must

e raised either through

orrowing (taking on more

ability) or seeking addi-

onal investment (taking

n more equity). The most

ommonly reported current

sset categories included on

alance sheets are:

Cashandcashequivalents: The cash in a companys checking and savings accounts,

plus any other assets that can be converted to cash almost immediately. Assets with

maturities shorter than 90 days, such as short-term bonds and certicates o deposit

(CDs), also all into this category. Investors look or companies whose current assets

are composed mainly o cash and cash equivalents, as these give the company the

highest degree o security and fexibility i it needs to acquire more assets or reduce

liabilities (by paying down a loan) or equity (by buying back its own shares).

Accountsreceivable: Money that customers owe the company or products or

services theyve already received. Investors compare a companys accounts receivab

amounts over several quarters to assess how eective the company is at collecting

money its owed. I the total accounts receivable increase each quarter, but the cash

balance remains the same or decreases, investors might be wary o investing in the

company because its ailing to collect on money owed.

Short-terminvestments: Stocks, bonds, CDs, and other investments that the

company can convert to cash within the next 12 months (not including cash

equivalents). Investors consider short-term investments second only to cash and cas

equivalents since theyre easily liquidated, or converted to cash, in the near term.

Short-term investments are also reerred to as marketable securities.

Inventory: Saleable products the company owns. Inventory on the balance sheet is

valued at its cost to the company, not the price at which the company hopes to sell t

product. Investors dont value inventory as avorably as short-term investments and

cash, as its never certain that the company can convert its inventory to cash by selli

it at a prot in the marketplace.

Long-Term Assets

Though long-term assets are dened as assets convertible to cash ater periods o one ye

or more, companies rarely hold these assets with the intention o converting them to ca

Two types o long-term assets appear m ost oten on corporate balance sheets:

Fixedassets: All o the land, buildings, urniture, and machinery that the company

owns. Rather than speciy an assets current value, balance sheets show the original

cost o the asset minus depreciationthe amount o an assets original value lostover time due to use or some other cause. I the asset has increased in value, or not

depreciated, the balance sheet includes the original value only. For instance, the

company on the sample balance sheet owns a building it bought or $300,00 0. I the

buildings current value is $1 million due to price appreciation in the real estate marke

the company holds a hidden asset worth $700,000 more than the amount in the

balance sheet. Investors dont pay much attention to the current value o xed asset

because companies rarely convert these assets to cash. But its worth noting the

current value o xed assets, because at times the assets may be sold or reorganize

Intangibleassets: Nonphysical long-term assets, rights, and licenses that the

company owns or controls. A common intangible asset is goodwill, which puts

an approximate dollar value on a companys overall brand, longevity, and esteem.

Investors tend to value intangible assets only in terms o the price a company might

command in an acquisition, when the acquiring company would have to compensate

the company or the intangible assets, such as goodwill, that it has built up over time

Types o LiabilitiesBeore deciding to invest in a company, its crucial to know how the companys assets copare to its liabilities. I a companys liabilities threaten to consume most or all o its asse

the company aces the prospect o bankruptcy, which typically causes stock prices to plu

met. Like assets, liabilities are typically classied as current or long-term.

Current Liabilities

Current liabilities are debts that a company must pay during the next 12 months. Investo

pay particularly close attention to current liabilities because these debts usually are p

with current assets, which must be either cash or be easily convertible to cash within

months. I a company cant pay down current liabilities with cash, it will have to take o

loans, raise more equity, or go bankrupt. The most common current liabilities include:

Short-termdebt: Lines o credit used to pay current liabilities. Since these loans car

high interest-rate charges, investors tend to avor companies with low short-term de

A high amount o short-term debt can indicate that the company cant secure long-

term debt (at lower rates) to meet its cash needs. Short-term debt is also reerred to

notes payable.

Accountspayable : Fees the company owes or services, supplies, and so on. A quic

(though not conclusive) way to gauge a companys nancial health is to compare its

accounts payable to its accounts receivable amountsthe latter should be higher.

Accruedexpenses: Expenses or bills not part o accounts payable, such as operat

expenses, which can include advertising, payroll, utilities, or taxes.

Currentportionoflong-termdebt: Portions o long-term debt, such as mor tgages

that must be paid within the next 12 months. These are classied as current liabilities

Long-Term Liabili ties

Long-term liabilities are long-term loans, such as mortgages, loans used to buy machine

or equipment, or bonds, which must be repaid at some point more than 12 months ro

the current date. Long-term liabilities typically dont concern investors as much as sho

term liabilities because they dont pose an immediate bankruptcy threat. Investors wit

long-term view, however, tend to be wary o companies with signicant long-term liabilit

because these debts can cause big problems down the road.

a sample balance sheet


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Equity (a.k.a. Owners Equity or Shareholders Equity)The equity section details the claims that shareholders have on a companys assets. A

companys equity is equal to its total assets minus its total liabilities. Investors tend to avor

companies with positive equity numbers, which means the companys assets total more

than its liabilities. The t wo components o equity are stock and retained earnings.

Stock

Each share ostock that the company has sold to the public is valued on the balance sheet

at its initial offering price, not at its current market value. Since gains and losses in the com-

panys share price impact the shareholders, not the company, dont interpret a companys

share price fuctuations as proo that the company is making or losing money.

Retained Earnings

Prots not paid out to shareholders as dividends at the end o the year are classied as

retained earnings. Many businesses, especially younger companies, orgo dividends and

reinvest prots to und new product launches and other business expansion. Investors must

thereore consider the context o a companys decision to retain earnings. A companys

decision not to pay dividends isnt necessarily a sign that the company cant afford to pay

dividendsthe company may simply want to invest its prots in new opportunities.

How to Read an Income StatementThe income statement shows a companys overall nancial results, including prots, loss-

es, and expenses, during a particular period. The income statement has our key parts :

Revenue: Money the company received rom sales o its products, goods, or services

to its customersalso called sales or gross incomeCostofgoodssold: Costs incurred to make or purchase the goods or services that

the company sells to customersalso c alled cost o sales

Grossprot: The net dierence between sales and cost o sales or a period. I sales

are greater than cost o sales, the company has earned a gross prot. Gross prot is

calculated beore expenses, such as taxes, are taken into account. These prots are

also called earnings. Gross prot minus operating expenses, such as utilities and

supplies, is called operating income or operating prot.

Expenses: The amount the company spent on costs related to operating the business.

These may include administration, marketing, payroll, and so on

Netprot: A companys total revenue minus total expensesalso called net income,

net earnings, or the bottom line

A Sample Income StatementThe example below shows the specic line items included on most income statements. The

remainder o this section explains all o the line items included in this example.

RevenueThe point at which a company considers its revenue earned, called revenue recognition,

can vary greatly bet ween companies. Its critical that you know how a company recognizes

revenue beore deciding to buy its stock because manipulative revenue recognition is one

o most common ways executives can window-dress company earnings. In particular,

manipulating revenue recognition can help:

Infate the prots a company actually achieves in order to appease investors

Reduce the revenues a company claims to have made in order to lower its tax burden

Investors tend to avor companies that recognize revenue when they actually get paid

not when they close a deal or simply book the revenue based on expected uture

The income statement alone wont tell you how the company recognizes revenue: lo

that inormation in the notes that accompany the nancial statements. I you cant

call the companys investor relations department and ask them directly.

Cost o Goods Sold (Cost o Sales)Companies dont oten include a detailed breakdown ocost o goods sold (COGS) in

income statement. Typically, though, the category includes the ollowing costs:

Rawgoods: The cost o buying supplies and raw materials required to make the

companys products or to acilitate oering its services

Labor: The cost o the workers the company used to produce its products or serv

(this gure does notinclude payroll wages paid to the companys regular sta )

Inventory: The cost o all products the company has produced but not yet sold

For a company to be protable, its COGS must be signicantly less than its total rev

as that revenue must cover not only COGS but also the companys various other exp

as well.

Gross ProftGross prot shows the dierence between the amount a company paid to manuactu

products and the amount it received or selling those products. Gross prot gives inv

a sense o whether a company is selling enough products or services to cover its COG

gross prot alone doesnt indicate denitively whether a company is covering its COGS

doesnt take into account all the companys expenses. The ormula or gross prot is

revenue (sales) COGS = gross prot

Generally speaking, investors may be inclined to avoid buying stocks o companie

negative gross prot, as a negative number can signal a lack o demand or the comp

goods or services, problems with product pricing, or other serious issues.

EBITDA

In addition to gross prot, income statements also oten include a line item called EB

which stands or earnings beore interest, taxes, depreciation, or amortization (the gr

paying o o a liability, such as a mortgage). Investors use EBITDA as a star ting point to

pare companies because only EBITDA shows the protability o a company based e

sively on its operations. Even so, EBITDA cannot be considered denitive, as interest,

depreciation, and amortization c an dramatically reduce net prots, which matter mo

Expenses

Companies have various types o expenses, each o which typically appears in a spplace on the income statement. For example, operating expenses typically appea

deduction rom the gross prot line on the income statement. The our most common

o expenses are:

Expense Description LocationonStatem

Operating Administration, advertising, research

and development (R&D), royalties,

sales, and so on

Gross prot section

Interest Interest paid on loans and other debts EBITDA section

Depreciation Depreciation on buildings, equipment,

and other property

Gross prot or EBITDA

section

Taxes Tota l amount company paid in taxes EBITDA section

Net ProftThe net prot is called the bottom line or good reason: its typically the last line ite

an income statement. Its also the line item that arguably matters most because it

sents whether the company has made money ater all expenses have been subtracted

the total amount o revenue. Companies with negative net prot numbers have incu

loss. Though investors sometimes buy the stocks o companies with no net prots, o

losses, this type o speculation can be risky and is not appropriate or all investors. A

conservative strategy or beginning investors is to invest in companies that have had

sistent positive net prots over an extended period o timeve years or more.

How to Read a Cash Flow StatementThe cash fow statement shows investors the details about the cash that the com

currently has on its balance sheet. More specically, it indicates the sources o cash

ing into the company and the recipients o cash fowing out o the company. The cas

statement is divided into sections based on three dierent types o cash transac

operating activities, investing activities, and nancing activities.

a sample income statement


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A Sample Cash Flow StatementThis sample includes the specic

ine items youll nd on most

companies balance sheets.

The remainder o this section

explains each item in detail.

Operating ActivitiesThis section o the cash fow

statement provides a summary

o cash transactions resulting

rom the companys day-to-day

operations. Here, the term day-

to-day operations reers to all

the companys regular business

activities, including paying its

sta, paying or supplies, and

producing, marketing, and sell-

ng products or services. This

section includes depreciation

by adding it back to income.

Depreciation is a noncash ex-

pense, so it doesnt represent

any actual cash fow out o the

company and is merely an ac-

counting expense.)

Investors examine this parto the cash fow statement to determine whether a company generates enough cash based

on day-to-day operations to cover its expenses. I the company ails to generate enough

cash rom operations, it will have to rely on investing or nancing activities. Investors may

avoid investing in a company in this situation because that company isnt making enough

money on its own to support itsel.

Investing ActivitiesThis section summarizes the companys capital expenditures, or the investments that the

company has made with cash. These expenses typically involve:

Paying or mergers and acquisitions (joining orces with or buying another company)

Purchasing marketable securities (stocks or bonds)

Purchasing buildings, land, or equipment

Repairing and improving existing buildings, actories, or equipment

nvestors examine this section o the cash fow statement to assess whether the companys spending its cash wisely. Investors tend to be particularly wary o expenditures, such as

the purchase o a residence or a company executive, that dont seem likely to contribute

to the companys net prots. Companies typically bury the explanation or large capital ex-

penditures that dont relate directly to the companys business in the notes that accompany

the companys nancial statements.

Financing ActivitiesThis section covers cash on the balance sheet used to und nancing activities that involve

debts, dividend payments, or the companys issuance or purchase o its own s tock. Inves-

tors look or the ollowing specic activities in this section o the cash fow statement:

Stockbuybacks: Companies buy back shares o their own stock when they believe

the stock is undervalued or, less requently, i they need stock to meet internal

obligations, such as stock option grants. Investors typically view stock buybacks as

a avorable sign that a company believes in its own uture enough to bank on it. In

addition, stock buybacks reduce the number oshares outstanding, which investors

oten see as a avorable move.

Dividendcutsorincreases: Companies have the option to increase or decrease the

dividend payments they oer to shareholders. For companies that do issue dividends,

investors tend to view dividend increases as a sign o a companys strength and

dividend cuts as a sign o nancial problems.

Debt: Companies can pay down existing debt or take on new debt to und operations

or capital expenditures. Investors typically consider a companys decision to pay down

debt as a sign o nancial strength. How investors view the decision to take on more

debt depends on the amount and the purpose o the debt. I investors consider the

debt excessive or unnecessary, the companys stock may all out o avor.

Change in Cash and Cash EquivalentsThe nal section expresses the companys net cash position. A positive number indicates

positive cash fow, which means the company took in more money than it spent. A negative

number indicates negative cash fow, which means the company spent more than it took

n. The nal number equals the sum o total operating, investing, and nancing activities.

How to Assess ProftabilityTo try to determine whether a companys stock is worth its current share price, inves

use a variety oratios. These ratios help put a companys protability in context by com

ing the company to its peers in the same industry. For example, i you know the Coca-C

Company is protable, you also need to know how its protability compares to that o o

beverage companies, such as PepsiCo Inc. and Cadbury Schweppes PLC. Among the m

popular ratios and statistics investors use to analyze protability are the price/earn

ratio, the return on sales ratio, the payout ratio, and various prot margins.

Price/Earnings Ratio (P/E Ratio)The P/E ratio divides the companys share price by its earnings per share (EPS) , or the t

earnings divided by the total number oshares outstanding (shares held by investors)

market value per share o stock / EPS = P/E

A company with a share price o $20 per share and an EPS o $2 has a P/E o 10.

Using the P/E Ratio

Though the average P/E ratio or all stocks historically alls between 15 and 25, the sig

cance o the ratio depends on the companys particular industry and on overall econo

conditions at a given time. For example:

A P/E o 30 may be typical in the tech industry because investors tend to pay more

or the shares o tech companies with high growth prospects, giving those s tocks h

prices relative to their earnings.

A P/E o 5 may be typical in the shipping industry because growth rates are muchslower than in the tech industry.

One eective way to get a sense o whether a tech or shipping company oers good va

or example, is to compare its P/E to that o its direct competitors or, better yet, to the a

age P/E ratio o the entire industry. One way to nd out an industrys average P/E is by us

the Yahoo! Finance Industry Browser, at biz.yahoo.com/ic.

Return on Sales Ratio (ROS)The return on sales (ROS) ratio is used as a measure o a companys operational ecie

By analyzing the income statement numbers using ROS, you can gauge how much p

a company brings in or every dollar o sales it makes. Tocalculate ROS, consult the c

panys income statement to nd its net prot and the total amount the company pai

taxes. Add the amount the company paid in taxes to total net prots and divide the re

by sales (revenue) to get the ROS:

net prot beore taxes / sales = ROS

Using the ROS Ratio

As with the P/E ratio, the best way to get a sense o the signicance o a companys ROS i

compare the ROS to that o direct competitors or to the average ROS o the entire indus

When comparing two companies in the same industry, the company with the higher

number has a higher degree o operational eciency.

Payout RatioThe payout ratio measures the percentage o earnings that a company distributes to sh

holders as cash dividends. To calculate the payout ratio, consult the income statemen

nd the total amount the company spent on cash dividends, then divide by net prots.

cash dividends / net prots = payout ratio

Using the Payout Ratio

The payout ratio can help investors asses s how a companys dividend payouts compar

other companies in the same industry. Investors use this inormation to assess a compa

protability and overall nancial well-being. For example, i two companies in the sa

industry have vastly dierent payout ratios, investors might be wary o the company w

the lower ratio. More specically, they would investigate why that company has cho

to retain the cash that other companies in the industry pay out to investors as dividen

Unless they uncover a good reason or the discrepancysuch as signicant capital exp

ditures that will boost the companys uture protsthey might suspect that the compa

protability is too low to cover expenses and dividend payments together. Like all nan

statistics, the payout ratio alone doesnt suce as support or investment decisions. It m

always be considered in the context o the companys other core undamentals.


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Proft MarginsA prot margin expresses, as a percentage, the dierence

between what a company pays or a product or service and

what it receives or selling that product or service. A com-

panys overall prot margin is equal to its net prot divided

by its sales during a specic period o time. Though the over-

all prot margin gives a sense o how eciently a company

converts sales into prots, investors use the ollowing three

more ocused versions o the prot margin to evaluate a

companys protability: the gross margin, operating margin,

and net margin.

Gross Margin

The gross margin is a prot margin based only on sales and

the cost o producing those sales. It divides gross prot by

net sales (total sales, or revenues, minus expenses related

to returns or discounts, i any):

gross prot / net sales = gross margin

nvestors use gross margin to assess a companys eciency

n producing and distributing its products or services. A ter

determining the gross margin, compare it to that o other

companies in the same industry. A higher gross margin

ndicates a greater degree o eciency.

Operating MarginThe operating margin helps investors evaluate how well a

company controls costs by actoring in expenses, such as

distribution and R&D, notdirectly related to the production

and sales o a product. To calculate operating margin:

operating prot / net sales = operating margin

Companies with an operating margin above the industry

average are typically better at controlling their cost o sales

and operating expenses, which gives them advantages such

as pricing fexibility during dicult economic times.

Net Margin

The net margin measures a companys overall eective-

ness at realizing net prots rom sales. To calculate net

margin, divide net prot by net sales or revenues:

net prot / net sales (revenues) = net margin

Net margin is helpul in comparing companies within the

same industry (the higher the margin, the better) and in

assessing a companys protability year to year. Companies

that maintain high net margins relative to the competition

over a period o a years arent just luckytheyre consis-

tently more eective at generating prots rom sales.

How to Assess LiquidityA companys liquidity reers to how much cash a company

has and how easily the companys other current assets

can be converted to cash. Investors consider other liquid-

ty crucial to a companys nancial well-being because

companies must have cash or highly liquid assets to pay

debts. Companies that own mostly illiquid assets, such as

actories, may have to take out loans or sell more stock to

raise unds and pay their bills quickly. Investors use three

ratios to assess liquidity: the current ratio, the quick ratio,

and the debt-to-capital ratio.

Current RatioA companys current ratio divides current assets by cur-

rent liabilities:

current assets / current liabilities = current ratio

Using the Current Ratio

To cover current liabilities, a company must have a current

ratio o at least 1.0. Though the standard varies by industry,

most investors look or a current ratio o at least 1.5, pre-

erably higher. Some investors, however, believe that the

current ratio doesnt accurately predict a companys ability

to pay debts because it includes assets, such as inventory,

that may be dicult to convert to cash.

Quick RatioThe quick ratio solves some o the problematic aspects o

the current ratio by actoring in only quick assetsassets

that can be quickly converted into cash (typically within 90

days). To calculate the quick ratio, consult the companys

balance sheet to nd the total quick assets (cash plus

accounts receivable), then divide by total current liabilities:

quick assets / total current liabilities = quick ratio

Using the Quick Ratio

Investors generally look or companies whose quick ratios

exceed 1.0. Typically, investors tolerate a quick ratio under

1.0 only rom companies in the retail industry because re-

tailers tend to have most o their current assets tied up in

inventory, which the quick ratio ignores.

Debt-to-Capital RatioThe debt-to-capital ratio measures the portion o a com-

panys capital that comes rom debt nancing. In this case,

capital reers to the companys total debts (liabilities) plusits equity, both o which you can nd on the balance sheet.

To calculate the debt-to-capital ratio:

Find the companys total debt (current liabilities + long-1.

term liabilities).

Find the companys capital (total debt + equity).2.

Divide total debt by capital.3.

Using the Debt-to-Capital Ratio

Investors avor companies with debt-to-capital ratios o

0.351.00. Ideally, the ratio should stay below 0.50. Compa-

nies with debt-to-capital ratios above 0.50 tend to have to

pay higher interest rates on loans because lenders consider

them to be riskier borrowers than companies with more

avorable debt-to-capital ratios. Dierent industries have

dierent standards or debt-to-capital ratios, so investorsgenerally consider a company in the context o its competi-

tors ratios.

How to Assess SolvencySolvency reers to a companys ability to pay its xed

long- and short-term liabilities, such as mortgage pay-

ments and utility bills. Investors use three ratios to assess

solvency: the cash debt coverage ratio, current cash debt

coverage ratio, and cash fow coverage ratio. All the data

needed to calculate these ratios appears in the cash fow

statement.

Cash Debt Coverage RatioThe cash debt coverage ratio measures a companys ability

to repay its liabilities using cash generated rom day-to-day

operations. To calculate the cash debt coverage ratio:

(cash rom operating activities dividend payments) /

total liabilities = cash debt coverage ratio

Using the Cash Debt Coverage Ratio

The cash debt coverage ratio looks at a companys ability

to pay all o its debts. A negative number indicates that

the company could become insolvent, or unable to pay

its debts.

Current Cash Debt Coverage RatioThe current cash debt coverage ratio helps investors

assess a companys ability to repay its short-term debts.

The ormula or the current cash debt coverage ratio is:

cash rom operating activities / average current liabilitie

current cash debt coverage ratio

Average current liabilities, which is required in the orm

above, is calculated as ollows:

average current liabilities = (current liabilities rom this y

+ current liabilities rom previous year) / 2

Using the Current Cash Debt Coverage Ratio

As with the cash debt coverage ratio, investors look

companies with high current cash debt coverage ratios r

tive to their competitors.

Cash Flow Coverage RatioThe cash fow coverage ratio helps investors ass

whether a company generates enough cash to cove

capital expenditures, pay its stock dividends, and pay

debts. To calculate the cash fow coverage ratio:

Calculate the companys cash requirements. To do s1.

add the ollowing together:

Capital expendituresA.

Cash dividends paidB.

Current portion o long-term debtC.

Interest expensesD.

Then calculate the cash fow coverage ratio. This is2.calculated as:

cash romoperating activities / cash requirements

Using the Cash Flow Coverage Ratio

The higher the cash fow coverage ratio, the better. A r

greater than 1.0 indicates that a company generates m

than enough cash to und capital expenditures, dividen

and debts.

Summary o Formulas in this GuidThe table below summarizes this guides important orm

or reading nancial reports.

Description FormulaTotal assets liabilities + equity

Total liabilities assets equity

Total equity assets liabilities

Gross prot revenue COGS

P/E ratio share price / EPS

ROS ratio net pretax income / revenue

Payout ratio cash dividends / net income

Gross margin gross prot / net revenue

Operating

margin

operating prot / net revenue

Net margin net prot / net sales or revenues

Current ratio current assets / current liabilities

Quick ratio quick assets / current liabilities

Debt-to-capital

ratio

total debt / capital

Cash debt

coverage ratio

(cash rom operating activities

dividend payments) / total liabilities

Cash current

debt coverage

ratio

cash rom operating activities /

average current liabilities

Average

current

liabilities

(current liabilities rom this year + c

rent liabilities rom previous year) /

Cash fow

coverage ratio

cash rom operating activities /

cash requirements

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