Financial Statements Explained
[...] reading financial statements is the foundation for analyzing companies.
The balance sheet [...] tells you how much a company owns (its assets), how much it owes (its liabilities), and the difference between the two (its equity). Equity represents the value of the money that shareholders have invested in the firm [...].
"Cash and equivalents" usually contains money market funds or anything that can be liquidated quickly and with minimal price risk, whereas "short-term investments" is similar to cash – usually, bonds that have less than a year to maturity and earn a higher rate of return than cash but would take a bit of effort to sell.
[...] accounts receivable are bills that the company hasn't yet collected but for which it expects to receive payment soon.
Comparing the growth rate of accounts receivable with the growth rate of sales is a good way to judge whether a company is doing a good job collecting the money that it's owed by customers.
You'll often see an "allowance for doubtful accounts" just after accounts receivable on the balance sheet. This is the company's estimate of how much money it's owed by deadbeat customers, and which it's consequently unlikely to collect.
There are several types of inventories, including raw materials that have not yet been made into a finished product, partially finished products, and finished products that have not yet been sold.
Inventories are especially important to watch in manufacturing and retail firms, and their value on the balance sheet should be taken with a grain of salt. Because of the way inventories are accounted for, their liquidation value may very well be a far cry from their value on the balance sheet.
Inventories soak up capital – cash that's been converted into inventory sitting in a warehouse can't be used for anything else. The speed at which a company turns over its inventory can have a huge impact on profitability because the less time cash is tied up in inventory, the more time it's available for use elsewhere. You can calculate a metric called inventory turnover by dividing a company's cost of goods sold by its inventory level.
Noncurrent assets are assets that are not expected to be converted into cash or used up within the reporting period. The big parts of this section are property, plant, and equipment (PP&E); investments; and intangible assets.
The most common form of intangible assets is goodwill, which arises when one company acquires another. Goodwill is the difference between the price the acquiring company pays and tangible value – or equity – of the target company.
[...] the value of goodwill that shows up on the balance sheet is very often far more than the asset is actually worth.
Accounts payable: These are bills the company owes to somebody else and are due to be paid within a year.
Noncurrent liabilities are the flip side of noncurrent assets. They represent money the company owes one year or more in the future.
Retained earnings is a cumulative account; therefore, each year that the company makes a profit and doesn't pay it all out as dividends, retained earnings increase. Likewise, if a company has lost money over time, retained earnings can turn negative and is often renamed "accumulated deficit" on the balance sheet. Think of this account as a company's long-term track record at generating profits.
Be sure to check the "revenue recognition policies" buried in the financial statements so you know what you're looking at – companies can record revenue at different times depending on the business that they're in.
Cost of sales, also known as cost of goods sold, represents the expenses most directly involved in creating revenue, such as labor costs, raw materials (for manufacturers), or the wholesale price of goods (for retailers).
Gross profit is simply revenue minus cost of sales. Once you have gross profit, you can calculate a gross margin, which is gross profit as a percentage of revenue. Essentially, this tells you how much a company is able to mark up its goods.
[...] the more differentiated a company's products are, the more it can mark up its good over what it costs to manufacture them.
Selling, General, and Administrative Expenses (SG&A), also known as operating expenses, includes items such as marketing, administrative salaries, and, sometimes, research and development. (Research and development is usually broken out as a separate line item, as is marketing for firms that spend large amounts on advertising.) You'll often see a relationship between SG&A and gross margin – firms that are able to charge more for their goods have to spend more on salespeople and marketing. You can get a feel for how efficient a firm is by looking at SG&A as a percentage of revenues – a lower percentage of operating expenses relative to sales generally means a tighter, more cost-effective firm.
Depreciation and Amortization: When a company buys an asset intended to last a long time, such as a new building or a piece of machinery, it charges off a portion of the cost of that asset on its income statement over a series of years. This number is occasionally broken out separately on the income statement, but it's usually rolled into operating expenses. It's always included in the cash flow statement, though, so you can look there to see how much a company's net income was affected by noncash charges such as depreciation.
Nonrecurring Charges/Gains is the catch-all area where companies put all the one-time charges or gains that aren't part of their regular, ongoing operations, such as the cost of closing a factory or the gain from selling a division. Ideally, you'd want to see this area of the income statement blank most of the time.
Operating Income is equal to revenues minus cost of sales and all operating expenses. Theoretically, it represents the profit the company made from its actual operations, as opposed to interest income, one-time gains, and so forth. In practice, companies often include nonrecurring expenses (such as write-offs) in figuring operating income, and you have to add back one-time charges (or subtract one-time gains) yourself.
Interest Income/Expense represents interest the company has paid on bonds it has issued or received on bonds or cash that it owns.
Net Income represents (at least theoretically) the company's profit after all expenses have been paid. [...] Although net income is the number you'll most often see companies tout in their press releases, don't forget that it can be wildly distorted by one-time charges and/or investment income.
Number of Shares (Basic and Diluted) represents the number of shares used in calculating earnings per share; it represents the average number of shares outstanding during the reporting period. Basic shares include only actual shares of stock, and you should pretty much ignore it – the fact that it's still recorded in financial statements is more of a historical legacy than anything else. Diluted shares, however, include securities that could potentially be converted into shares of stock, such as stock options and convertible bonds. Given the amount of egregious granting of stock options that has occurred over the past several years, it's the diluted number that you'll want to look at, because you want to know the degree to which your stake in the firm could potentially be shrunk (or diluted) if all those option-holders convert their options into shares.
The cash flow statement strips away all the abstract, noncash items such as depreciation that you see on the income statement and tells you how much actual cash the company has generated. [...] The cash flow statement is divided into three parts: cash flows from operating activities, from investing activities, and from financing activities.
If you can't understand how a dollar flows from a company's customers back through to shareholders, something's amiss. Either the company's business model is too confusing or you need to do more digging before committing any of your money.
When you're evaluating a company's liabilities, remember that debt is a fixed cost. A big chunk of long-term debt can be risky for a company because the interest has to be paid no matter how business is doing.
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