How to Analyze Financial Reports
If you think that the accounting practices permitted under GAAP — generally accepted accounting principles — are established and consistent, you can certainly be forgiven. The very name, containing as it does the innocuously conservative-sounding phrase “generally accepted,” seems to offer assurances. Unfortunately, GAAP contains far more leeway than it might seem, and many public companies take full advantage of what can be generous limits in order to make their financial pictures look as rosy as possible. Conversely, in some cases GAAP-compliant financial statements make a company look weaker than it actually is.
All too often, investors consider a single “headline” number — with earnings per share or EPS leading the pack — and make a decision on that basis. EPS tends to be heavily reported in the financial news media exactly because it is a single easily understood data point with an obvious trend from quarter to quarter and year to year.
Doing so is, to be blunt, a horrible idea. You need only stop to consider that numerous companies have taken advantage of the unusually and frankly abnormally low price of credit to buy back their own stock. Why put money toward risky capital investment, research and development, or new products or services to boost the company’s earnings when instead you can reduce the float (number of shares available for trading) and automatically increase EPS even when earnings are flat or declining?
This is but one simple example of how a company can manipulate its financials to portray overly flattering results. The sad fact is that there are many, many ways to subtly distort financial reporting. The even sadder fact is that often companies don’t even work that hard to conceal those distortions.
Let’s consider the poster child (or whipping boy, more accurately) for shady financial reporting: Enron. While today the widely held public view is that Enron’s malfeasance was obvious, in fact federal prosecutors worried as they sought to build cases against senior executives such as chairman Ken Lay and CEO Jeffrey Skilling. Writing for the New York Times in 2006, Alexei Barrioneuvo and Kurt Eichenwald revealed that “some prosecutors privately worried that they would never even be able to charge Mr. Lay with any crimes.”
The reason is that, as Harvey Silverglate describes in his 2011 book Three Felonies a Day: How the Feds Target the Innocent, Enron had disclosed its “aggressive” accounting practices, including the transfer of non-performing assets into the infamous off-balance-sheet “special-purposes entities,” in the footnotes to its financial statements. Jonathan Weill of The Wall Street Journal examined Enron’s accounting practices in July 2000 and discovered how much of Enron’s reported income was “unrealized.” Financier James Chanos, motivated by Weill’s reporting, also took a closer look and decided to short Enron’s stock. Even as far back as 1998, six Cornell business students had analyzed Enron as a class project and concluded that the company was badly overpriced, recommending it as a “sell.”
In other words, even the ugly truth about Enron was there years before the company imploded for those patient enough to dig into the financial statements and perform some analysis.
Unfortunately, we don’t have the space here to examine the many different analysis points that can be applied to a company’s financials. What we can do is (1) provide a summary of the major indicators in five different functional areas and (2) dig more deeply into one very significant indicator that is among the most difficult to distort.
The Key Financial Analysis Numbers
A company’s three financial statements (income statement, balance sheet, and cash flow statement) provide data for about 40 key performance indicators. They are listed here by functional area with a very brief description of how to calculate and evaluate them.
It is very important to understand that ratios should be compared only within the same industry and that relative, not absolute, performance is important. (Comparing Ford to General Motors — absolutely. Comparing Ford to Verizon — not a good idea.) Also, never take an indicator from a single point in time. Instead, evaluate the trailing three to five years (three is generally sufficient since market and macroeconomic conditions can change significantly) and consider the trend. If you were to look at just one year and happened to pick an unusually good or unusually bad one, you would get a distorted result.
Most stock research resources such as those provided by online brokerage services will put much of the information you need in one place. For example, the screenshot below shows some of the key operating profitability measures for Ford compared to the average for its industry (Automobiles, in this case).
|Gross profit margin||(Revenue – Cost of Goods Sold) ÷ Revenue||Higher is better; measures relative productivity|
|Operating profit margin||Operating Income ÷ Net Sales||Higher is better; measures how well a company controls costs of routine operations|
|Net profit margin||Net Profit ÷ Revenue||Higher is better; measures profits from both ordinary and extraordinary items|
|Cash return on assets||Cash Flows from Operations ÷ Total Assets||Higher is better; less subject to distortion from accounting methods|
|Return on common equity||(Net Income – Preferred Dividends) ÷ Common Equity||Higher is better; modifies return on equity to remove any distortion from preferred stock|
|Return on debt||Net Income ÷ Long-Term Debt||Less commonly used by investors; mostly for evaluating leveraged buyouts|
|Return on capital employed||Earnings Before Interest and Taxes ÷ (Total Assets – Current Liabilities)||Measures profitability and capital use efficiency; better than ROE for capital-intensive industries|
|Return on retained earnings||(∆ Profit ÷ (Total EPS – Total Dividends Paid per Share)) × 100%||Normally calculated over 5-10 year horizon; Total EPS is usually diluted normalized EPS|
Annual Revenue ÷
Average Cash Balance
Lower is generally better, but easily distorted; look specifically at how company is using cash
Days cash on hand
Cash and Cash Equivalents ÷ ((Operating Expenses – Noncash Expenses) ÷ 365)
Higher is better but also easily distorted or misunderstood; usually not a good investor metric
Total Cost of Goods Sold ÷ Average Inventory
Higher is better; shows how quickly a company moves its inventory; only finished goods inventory is used (not raw materials)
Days inventory outstanding
(Average Inventory ÷ Cost of Goods Sold) × 365
Lower is better; indicator of how much cash is tied up in inventory; uses finished goods, work in progress, and raw materials inventories
Accounts receivable turnover
Net Credit Sales ÷ Average Accounts Receivable Balance
Higher is better, but often not possible to calculate since companies do not have to report net credit sales
Days sales outstanding
(Average Accounts Receivable ÷ Net Credit Sales) × Days in Period
Lower is better; under 45 is very good and around 60 is average
Accounts payable turnover
Total Purchases ÷ Average Accounts Payable Balance
Not a perfect measure since total purchases will be represented by COGS, which not every company has
Days payables outstanding
(Avg. Accounts Payable Balance ÷ Cost of Goods Sold) × Days in Period
Significantly higher value can indicate cash flow issues causing company to pay A/P later
Working capital turnover
Sales ÷ Average Working Capital
Higher is better; working capital is current assets minus current liabilities
Days working capital
(Average Working Capital × Days in Period) ÷ Period Sales
Extremely high or extremely low value is negative
Fixed asset turnover
Net Sales ÷ Average Net Book Value of Fixed Assets
Higher is better; shows how much revenue company generates with its fixed assets
Total asset turnover
Net Sales ÷ Average Total Assets
More opportunity for distortion since calculation uses total assets
Current Assets ÷ Current Liabilities
Preferable to see ratio of 1.1 or higher, but for fast cash flow businesses, slightly under 1.0 is acceptable
Acid test ratio
(Cash & Cash Equivalents + Accounts Receivable) ÷ Current Liabilities
More rigorous and thus normally lower than current ratio
Cash & Cash Equivalents ÷ Current Liabilities
More rigorous than acid test because it excludes A/R
Current cash debt coverage
Net Cash from Operating Activities ÷ Average Current Liabilities
Higher is better; looks at how well cash flow covers current debt maintenance and A/P
Cash to working capital
Cash & Cash Equivalents ÷ (Current Assets − Current Liabilities)
Shows how much of a company’s working capital is in cash; extremes (high or low) are not good
Inventory to working capital
Inventory ÷ (Current Assets − Current Liabilities)
Shows how much of working capital is in inventory; lower is generally better
Total Debt ÷ Total Equity
Lower is better; most common leverage ratio
Net debt to EBITDA
(Total Liabilities – Cash & Cash Equivalents) ÷ EBITDA
Lower is better; approximates how long a company would require to repay its debt with current earnings
((Total Assets – Intangible Assets) – (Current Liabilities – Short-Term Debt)) ÷ Total Debt
Lower is better; shows how much debt a company could repay by liquidating its assets
Cash flow to debt
Net Cash Flow from Operations ÷ Average Current Liabilities
Higher is better; shows how quickly current cash flow could repay debt
Earnings Before Interest & Taxes ÷ Interest Expense
Higher is better (at least 1.5); not ideal because depreciation and amortization are non-cash but still included
Price to sales (P/S)
Market Capitalization ÷ Total Sales
Share Price ÷ Sales per Share
Higher is more favorable; this measurement is superior to P/E because sales are harder to manipulate via accounting than earnings
Price to earnings (P/E)
Share Price ÷ Earnings Per Share
Should be calculated using diluted normalized EPS; cannot be negative; must be considered relative to industry and market
Price to cash flow (P/CF)
Share Price ÷ Cash Flow per Share
Can be negative; must be considered on a trend basis
Price to book (P/B)
Price per Share ÷ ((Total Assets − Total Liabilities) ÷ Shares Outstanding)
Can be applied to company with negative earnings (unlike P/E) but not negative book value; can be distorted by high research and development costs
Price earnings to growth and dividend yield (PEGY)
(Price ÷ Earnings per Share) ÷ (Earnings Growth Rate + Dividend Yield)
Expansion of price to earnings growth (PEG) to incorporate dividends (if paid); is only as reliable as the accuracy of the earnings growth projection
Earnings per share (EPS)
(Net Income − Dividends on Preferred Stock) ÷ Shares Outstanding
Not inherently industry-specific and therefore widely used but easily manipulated through accounting
Annual Dividend per Share ÷ Earnings per Share
Only applies to companies that pay dividends
Net Income ÷ Dividends Paid
Higher is better; value under 1.0 means company is borrowing or using cash reserves to pay dividends
Cash Flow: The Place to Find Truth
To reiterate, when looking at something as complex as a public company’s financials, there is no one simple ratio or number (or even a few numbers) that will tell the entire story. (If that were the case, investing would be every so much easier.) However, there is one financial statement and one aspect of a company’s financial results that is harder to distort and provides the best insight into its performance and prospects.
Perhaps you’ve heard the express “Cash is king.” There’s a good reason for that. A company can manipulate profits with aggressive accounting, and there are even ways to play some games with sales, but cash in hand is cash in hand.
Let’s consider some examples. We’ll start with Sprint (S), the most troubled of the large wireless carriers. As the income statement extract below shows, for the most recent reported quarter (Q1 FY 2020 ended 6/30/19), Sprint had a net loss after taxes of $114 million on revenue of $8.142 billion.
However, Sprint actually burned through $2.111 billion in cash in the quarter.
Operations (that is, Sprint’s normal business) produced $2.244 billion in cash (highlighted in blue below), mostly because depreciation (in green) is a non-cash item and so is added back to net income (in yellow).
However, Sprint invested $2.705 billion in fixed assets (predominantly network buildout, highlighted in yellow below) and paid off debt of $1.858 billion (in green), so investing and financing activities respectively used up $2.468 billion and $1.887 billion, producing the net negative change in cash of $2.111 billion.
Let’s look next at Boeing (BA). Over the last four quarters, the company has seen net income (in yellow) decline significantly. It has spent heavily on inventory (usually raw materials in the case of a manufacturer like Boeing) (in green), which in concert with other factors has caused its total cash from operations (in blue) to suffer. It is likely that Boeing has continued contractually obligated purchases of materials from its suppliers even as orders have slowed thanks to the controversy over the 737 MAX.
Net change in cash (highlighted in blue below) has steadily improved, but closer examination shows that this is because Boeing has shifted from paying off debt (nearly $12 billion net in Q4 2018 and nearly $3 billion net in Q1 2019, in yellow) to borrowing, issuing almost $20 billion in debt for Q3 2019.
One lesson you should take away from these illustrations is that even a headline cash flow number can be misleading. Looking at nothing but Boeing’s net change in cash for the trailing four quarters would show steady improvement, but the truth is that net income from operations dropped off a cliff in Q3 2019, and net cash flow was strong only because the company borrowed nearly $20 billion.
In the case of Sprint, while weak cash flow is not a good sign, the one positive is that Sprint is investing in its network, which is a competitive necessity. It is also paying off debt, and while that is generally a good thing, given the need to expand 5G coverage it would be better to see Sprint borrowing to build out more quickly. Looking closely at its long-term debt issued and retired, it becomes clear that Sprint is engaged in relatively short term borrowing to cover its maturing debt, which begs the question of whether the company is able to borrow at competitive rates.
Financial statement analysis requires time, patience, and critical thinking. As we demonstrated, even with a financial black hole like Enron, the evidence of the company’s actual financial condition was there for anyone ready to dig deeply enough. Understanding what numbers can be manipulated and where on the financial statements those manipulations will appear, as well as keeping in mind the importance of examining trends, will take you a long way down the path toward skilled financial analysis.
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