Earnings and the Financials
In this Section
Earnings and their Problems
So far in this guide we’ve talked a lot about earnings and eluded to earnings per share (EPS). Unfortunately for investors, earnings are not completely precise, especially earnings per share. Earnings are often subject to “financial engineering” by a company’s management (remember Enron?) For this reason, investors have recently placed less significance on EPS. However, an investor can still use earnings for a quick analysis of a company just as long as she remembers the earnings and EPS are not precise. Later on in this section you will learn about another method to calculate profits.
The Income Statement
The income statement starts with revenue or sales on the top line and work likes a schedule or your checkbook adding in other revenues and subtracting out expenses until you reach profits. When calculating past growth rates for earnings (and you learned about the danger of earnings in the previous paragraph) we use pre-tax profits/income. The reason for this is that often time’s taxes can blur the actual performance of the business through different deductions and changing rules. Other useful information on income statement includes general and administrative expenses (G&A expenses) as well at the number of shares outstanding. G&A expenses are expenses that are outside normal expenses such as raw materials or employee compensation. Using G&A expenses, you can tell how well a company is keeping costs in check. Obviously, a fast growing company is going to have to increase G&A expenses as the company grows, but if they outpace the growth of sales or profits you might have a company that is wasting shareholder money. If you see a problem here, check the annual report for an explanation. This brings me to another important point: always study the income statement, balance sheet, and cash flow statement from the annual and quarterly reports. Often times the reports from the companies have more detailed information then you’ll find in the generic statements from Yahoo Finance or your broker.
The Balance Sheet
The balance sheet is where you determine the financial strength of a company. Through the balance sheet you can determine if a company has strength to make it through tough times and the resources to take of future opportunities. At StockBoxFinancial, we don’t spend more than a couple minutes with a balance sheet. First, start on the top part of the balance sheet with “Current Assets.” Under this category you should see a line labeled something like “Cash and Equivalents” and another line called “marketable securities.” All balance sheets have a cash and equivalents line, but some companies lump their marketable securities with the cash and equivalents. Adding these items together gives you the company’s overall cash position. This number is basically the amount of cash (in dollars) that has company has. Next, we look at the amount of long term debt. To find the company’s net cash position you subtract the overall cash position from the long term debt. If net cash is positive then the company is in great shape. If not, then a little more work needs to done to determine the firm’s financial strength.
Another great way to find the financial strength of the company is to use the long term debt to equity ratio. The following simple formula allows you to calculate the long term debt to equity ratio:
long term debt to equity ratio =
(long term debt)/(long term debt + equity)
Both long term debt and the shareholder’s equity are found on the balance sheet. According to Peter Lynch, the average corporate balance sheet has 85 percent equity and 15 percent debt (a long term debt to equity ratio of 0.85). You can tell a company’s financial strength by studying the percentage of equity; the higher the better.
Digression: More Problems with Earnings
When you look at the income statement one of the most important numbers is net income. However, thanks to modern accounting practices this number is not as useful as investors would like. This number includes accounts receivable. To illustrate this we’ll look at an example with a fictitious company ABC Inc. ABC sells TVs and gives customers an option of paying next year (let’s say with zero percent interest to make things simple). ABC has $1500 dollars of costs and sells 20 TVs worth $100. So, ABC has revenue of $2000 and costs of $1500 for net income of $500. Wait! We forgot to incorporate those people that will pay next year. If five people are going to pay next year then ABC’s revenue this year will drop by $500 (5 times 100) to $1500. With costs of $1500, ABC’s net income for this year drops to $0! To sort this matter out we’ll turn to the cash flow statement which we’ll talk about in the next section.
The Cash Flow Statement
The cash flow statement has become a favorite of investors recently. This schedule connects the income statement and the balance sheet. At the top of the cash flow statement you find net income (from the income statement). As you learned above, this number isn’t all that seems and is not the “cash” that the company makes from operations. After this line you’ll find many cash items added back in or subtracted out from net income such as account receivables. The next major item you need to see after this is called Net Cash from Operations or Total Cash from Operations, but you will most often hear this called Operating Cash Flow. This number can be seen as the amount of money that a company brings in from operations and often times can be a better representation of profit than the net income value seen on the income statement. The last line on the cash flow statement is the total change in cash the cash position for the firm for a given period. This number makes the connection to the balance sheet. For example, if we are looking at the cash flow statement for 2007, then the last line, the change in the cash position for that year, will equal the difference in on the balance between 2006 and 2007.