By Brad Stark, MS, CFP®
Founder and Chief Compliance Officer
Since the economic meltdown, there has been more discussion than ever regarding corporate and government financials. If you are like most, the jargon can be overwhelming. Even for the astute, reviewing and understanding financial statements can be a challenge unless you work in that profession (such as an accountant, banker, or investment manager). Here are some tips in reviewing financials whether for investment, business purposes, cocktail party discussions or maybe a student taking a finance course.
The three main components of a financial statement are the balance sheet, income statement and cash flow statement. Once you get a handle on what you are looking for, then you can apply “ratios” to help put some context to the figures.
You should always start your analysis with the balance sheet. It is simply a snapshot view of the assets and liabilities of the company at a particular point in time. I like to take a comparative look at the company over the past few years. You can easily find this data for any publicly traded company on the financial section of mainstream search and news websites.
Start your review at the top of the balance sheet where the most liquid assets are located. Are the assets increasing or shrinking? Pay particular attention to “goodwill,” this is a figure which can be grossly overstated (the lower it is the better).
Let’s assume assets are increasing, is that due to the assumption of more debt in the lower section, liabilities? Or is it due to more sales? In today’s environment, you are more apt to see debt reducing. Then you want to get a handle on the types of debt they are incurring - is it short or long term? Once you are comfortable with this area, go back up to the asset section to see how they are positioned to pay the current debts owed. Do they have cash on hand for the accounts payable vs. having to sell a “truck,” for example, to cover payroll?
Turning to the income statement, this is where you will see revenues, expenses and net income over a period of time. Think about this for yourself: You earn money, then you pay expenses and hopefully you have something left over (unless you are the government, of course). One confusing element here is that you can have “noncash” items such as depreciation expenses. To fix that issue, many focus on EBITDA (earnings before interest, taxes, depreciation and amortization) to get a real net income number that cancels out differing tax and capital structure issues. The name of the game is net income - the higher the better.
The next place to look is the cash flow statement. This is where you can see how management is handling the money, such as cash in, cash out, investments, liability reduction, liability increase, dividend payments, and others. How are they generating cash flow - operations, investing or financing? The more cash flow from operations the better. The more cash flow generated from debt, generally the worse. Some companies may be self liquidating by selling property, plants and equipment. This is a situation that may look good on the income statement but is not a good reflection on the true health of the company.
So now you have a good handle on the general operations of the company, but wonder what to do next? You should turn to “ratios” so that you can compare this business to others. Financial ratios are a powerful tool which will allow you to compare any size business to another. But be careful to only compare “like” businesses if you want to get an accurate read on the situation. For example, you should not compare a manufacturer to a high technology firm (the ratios will and should be vastly different).
If you are lending money, liquidity and solvency ratios should be the focus. If you are internal management, you may want to focus on asset utilization and inventory turnover. Everyone should be interested in the profitability ratios and for investors; the focus is generally on the market metrics (e.g., price to earnings ratio, price to sales, and market to book).
One ratio unto itself is a measure. You have to take a look at a number of them to get a good grasp on how the company is operating. It is best to compare the ratios to its “peer”or “peer group.” This will give you the best insight to how the company is doing overall, including the underlying strength of the business and management skill.
There are dozens if not thousands of ways to interpret the data. But make it simple. Is the company getting stronger or weaker? Are they taking on more debt, and if so, are they profitable? Are they generating earnings from operations or by simply liquidating assets or making one-time adjustments to create the money? In regard to their peer group, do their financial ratios on debt, profitability and price to earnings look better or worse?
Like anything new, it takes time to get accustomed to the jargon and the data. Spend a little effort to gain familiarity with the basics and you will be light years ahead of most.
Previously published in the Daily Sound.
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