Guide to financial statements

In this section of the guide, these educators and experienced investors explain how they look at financial statements. In a few paragraphs, each suggests ways to read financial statements and critical areas to study.

Note: In this guide, financial statement names are statement of earnings, statement of financial position, and statement of cash flows. For synonyms, visit the glossary.

Business school dean

Dr. Al Hartgraves is senior associate dean and professor of accounting at Goizueta Business School, Emory University. He teaches corporate financial reporting to MBA students; to corporate executives in executive MBA programs; and corporate management development programs. He has co-authored two books on management accounting and published numerous articles in professional and academic journals.

Business executive

Nathaniel Alexander is chief executive officer and a member of the board of directors of IVEX Corporation, a privately held corporation that designs, develops, and manufactures visual systems for flight simulation. He has started new businesses; acquired and divested companies; managed turnaround and pre-bankruptcy situations, restoring profitability; and worked with stockholders, banks, and financial institutions. He has been an investor in stocks for more than thirty years.

High school economics teacher

Carol Penland, a former "state high school economics teacher of the year" and the founding president of her state's association of economic educators, has been teaching for more than twenty years. She currently teaches at Campbell High School in Smyrna, Georgia. She coached three winning state championship teams in the National Council of Economics Education Stock Market Game and two winning state championship teams in the Chicago Board of Trade Commodity Challenge Game.

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General suggestions
Before I talk about the statements, let me explain what I do in general as an investor. When I buy shares of an established company - public at least ten years - I look at trends for five numbers. These include net sales, net earnings, net cash provided by operating activities, price-earnings ratio (P/E ratio), and backlog, preferably over the last four years. The first three items are easily found in the financial statements; the P/E ratio and backlog figures may require additional research.

When it comes to young companies, particularly technology, I speak to friends who understand the technology or market. I also read reports from brokers who make a market, or specialize, in trading that stock. Novice investors can contact a reputable broker whose research department will happily mail out research on stocks the firm follows or helped bring public.

Comments on statement of earnings

The first number I look at is net sales and ask: Was there an increase over the last four years at a pace substantially above the inflation rate? If the answer is yes, that is a good sign. The U.S. government periodically reports inflation rates, and you can find this information in the papers and on radio and TV. (Check also the Internet links to the U.S. Department of Commerce and to the Bureau of Labor Statistics in Resources). Remember, this rate varies from year to year. If you are an international investor, remember it varies from country to country.

A second number I look at is net earnings and ask: Did net earnings increase over the same period, at least at the same percentage rate as net sales? If the answer is yes, that is another good sign. If net earnings are lower in one year than in previous years, I try to determine why. Sometimes there are valid reasons for a slump in earnings. For example, intense competition may force cuts in prices. Or the cost of utilities may rise because of unusually severe weather. Other times, a drop in net earnings is a sign for caution.

Comments on statement of cash flows
On this statement, I focus on the number for net cash provided by operating activities. Learning whether the business generates cash is important because eventually, a business must generate cash from its core activities. This cash covers payroll, rent, utilities, and so on.

During some periods in its life, particularly growth spurts, a business may not generate sufficient cash to buy extra material for inventory and to hire more people. In these periods, the business can borrow from banks. But if the business does not ultimately generate cash, it goes bankrupt.

The line usually labeled "cash and cash equivalents" is also important, but it includes financing and investing activities. In the end, the cash generated by operating activities is crucial because the company invests for the future using cash provided by operations.

Comments on P/E ratio and backlog
A fourth number I look at is the price-earnings ratio (P/E ratio) for a company's stock. As I mentioned before, not all financial statements contain this figure, so finding it may require additional research. This information is quoted daily in the stock tables. Sometimes, an annual report includes the P/E ratio at the end of the fiscal year. Investors should compare a company's price-earnings ratio to the ratios of its major competitors.

The price-earnings ratio can change daily as the price of the stock moves up or down, so be sure to compare ratios from different companies at the same times.

[For content of an annual report, see "Guide to Annual Reports". For addresses of Web sites that provide information on industry ratios, see Resources.]

The last number I look at is a year-end figure and is usually called backlog (again, finding this number may require additional research). This number is the dollar value of unshipped orders available for delivery in the next year, ultimately resulting in net sales. For manufacturing companies, the backlog at the end of the year is a good indicator of what might happen in the next year.

Having a backlog means orders come in faster than a company can ship them. Customers expect and understand some delay. Too long a delay means customers get frustrated and place their orders elsewhere.

Frequently, a company will give its perspective on backlog in the management discussion section in the annual report. Also, checking the notes to the statement of financial position, for example, might reveal details on inventories to fill back orders.

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General suggestions

When my students are considering an investment in a company, I encourage them to start research in three places: the statement of earnings, statement of financial position, and statement of cash flows.

The statement of earnings will give them an overall picture of the company's revenue, its costs, and the resulting profit.

The statement of financial position will give them a cumulative performance of the company over time, showing assets versus liabilities and net worth.

The statement of cash flows will tell how much money came in and how much went out. It may give insight into how the company is being managed, ultimately answering the question: Is management making wise use of resources?

However, these numbers by themselves should not be used to make decisions about investing in a company. I do not put a great deal of significance on numbers alone because they can be manipulated, and oversight and enforcement may not be 100% effective at all times. You must look inside the company for answers.

Comments on statement of earnings

If a company shows a profit on the statement of earnings, I tell my students to find out why - even if it means calling and asking a company official or reviewing the company's Web site. Asking the right questions can identify the reasons for a profit. Has the company introduced a new product that boosted sales? Has the company's management changed tactics, such as increasing efficiency or entering new markets? Has the competition changed, causing the company to gain new customers? If a profit resulted because the answers to these questions are yes, it can indicate a healthy, growing company.

On the other hand, a profit on paper can sometimes result from practices that are not good for the company's long term health. For example, although cost-cutting is often desirable, it can have serious consequences. If cost-cutting brings about a greater efficiency without sacrificing quality, the company may be a sensible investment. However, if a company cuts costs by reducing product quality, it will probably lose sales in the future. If you are investing your hard-earned money, you want to feel confident a "financial wizard" has not been manipulating numbers that will mislead you.

I also tell my students that a loss on the statement of earnings does not always indicate a weak company. A company showing a loss might be investing heavily in research and development to perfect future products, which could result in greater future profits. A company could be experiencing temporary losses due to bad decisions. A stockholder must ask: Are these decisions irreversible or just temporary setbacks?

If a loss has caused a company's stock price to fall, stockholders must ask: Is this stock "on sale" (a bargain investment that will increase in value) or "down the drain" (a losing investment that will continue to decline)? The answers to these questions will not be found in the standard financial statements. These statements are simply starting points for further research.

Comments on statement of cash flows
A company is in business to make money. If the company shows a negative cash flow on the statement of cash flows, it is spending more than it makes. As a potential investor, you must ask: How long can the company survive following its current practices? Is this a "temporary" negative cash flow that's part of a bigger overall plan for a more profitable future? Or is the situation one which the company can not turn around?

Comments on statement of stockholders' equity
This statement can help give a clearer picture of what is going on inside a company. The statement should contain information on how the profits are being dispersed. If a large percentage of the profit is being declared in dividends, it could indicate the company is not planning for expansion and innovations. Such practice could result in a decrease in the value of the stock in the future. Accepting a financial page at face value could be a big mistake.

Make sure you always do your homework to understand that information in the bigger picture.

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General suggestions

With any financial statement, you should first look at the changes from year to year - both in the raw numbers and in the percentage changes in the numbers. These comparisons may indicate "trends" and are very helpful in assessing a company.

It is hard to generalize about a good rate of change - it depends on the line item you are looking at and the rates of change in prior years. If a company's sales rose 15 percent in each of the past three years, and rose only 10 percent this year, it would not be good. However, if the past years' rates of increase had been only five percent, and this year's rate is 10 percent, it would be quite good.

Most large companies include data for three years, but I recommend looking at longer periods of time if possible.

The financial statements represent a good starting point in judging a company's financial strength, but they are only a starting point. To complete the picture, you must acquire more information about the company's products, people, technology, and other resources that may give it a competitive advantage in the marketplace. One of the best sources of supplemental information is the non-financial section of the annual report. This section, usually in front, often tells a lot about top management's views on the company's future and ability to compete.

Comments on statement of earnings

On this statement, one of the figures I look at is the total operating income and its ratio to total revenue (net sales):

total operating income
total revenue

Ideally, I would like to see operating income growing, both as an absolute number and as a percentage of total revenue. That would usually mean a company is growing its operating income and becoming more efficient over time in managing its costs and operating expenses. There is no "ideal percentage" because the target percentage varies from industry to industry.

Comments on statement of financial position

On this statement, two things I look for are the figure for total stockholders' equity and the ratio of total liabilities to total stockholders' equity:

total liabilities
total stockholders' equity

Generally, a lower ratio of liabilities to equity means a lower risk for a company's creditors and lower costs when the company borrows money. Yet, how much debt a company carries compared with stockholders' equity varies widely according to the norms for the industry and the company's financial strategy. Just because a company has a high debt ratio is not a signal of weakness, if the ratio is in the ballpark for the industry.

With the statement of financial position, it is important to remember that most companies try to shine the spotlight on assets, not on liabilities. For instance, this statement typically provides a number for total assets and total stockholders' equity but not for total liabilities (to obtain total liabilities, subtract total stockholders' equity from total assets). An anonymous writer once said, "The needs of man are few - to get food, find shelter, and keep debt off the balance sheet [statement of financial position]". Keep this in mind and train yourself to seek out liabilities reported indirectly as well as directly.

Be sure to check the notes too, for liabilities you might find there. Look into note titles such as "Debt", "Other Liabilities and Environment", "Interest on Debt", "Commitments and Contingencies", "Leases", "Pensions" and "Post-Retirement Obligations".

Financial information is useful, but not every asset and liability can be measured in accounting terms. Statements of financial position often omit assets that are hard to measure or do not result from specific past events. For example, Coca-Cola does not report the company trademark - estimated to be worth more than $50 billion - on this statement. Also, Boeing's statement of financial position does not include the value of its vast workforce of engineers and aeronautics experts. These intangible assets can make the market value of a successful company's stock much greater than the statement reports.

Comments on statement of cash flows

On this statement, I look at the figure for cash provided, or used, by operating activities (operations). Without a doubt, this number is the most critical on this statement. These activities represent the basic business of the company. If a company consistently fails to make money at its basic business, it will have a hard time surviving. In a healthy mature company, operating activities normally result in positive cash flows.

The other ways a company receives or spends cash - investing and financing - are more difficult to interpret. For example, negative investing cash flows may indicate only that the company is growing and buying assets that enable it to manufacture more products. Financing cash flows are affected by a company's borrowing and the amount paid in dividends during the year. To interpret these numbers, you need more information on the company's strategies.

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