thoming inncil Sttements

Fathoming Financial Statements

Financial data isn't as black and white as you might think. Accounting rules are as open to interpretation as laws are. Although the Securities and Exchange Commission (SEC) requires companies to report information in specific formats and at specific times, companies have some leeway in how they present their financial data—and they use that leeway to portray their performance in the best possible light. Data providers analyze the data that companies report and tweak it in various ways to better reflect company performance or to make it easier to compare competitors—all in an effort to add value for their clients and earn their subscription fees.

After the 1929 stock market crash and the Great Depression, Congress stepped in to try to prevent similar catastrophes. The Securities Act of 1933 requires companies to publish financial information about the securities they sell to the public. The Securities Exchange Act of 1934 directs the operation of securities markets and brokerage firms, defines the rules for purchasing securities on margin, and outlines access to financial information. These two acts are the basis for the contents, disclosure requirements, and frequency of reporting for today's financial statements.

The SEC oversees compliance with these acts. Companies must provide unaudited financial information for each quarter, called 10-Qs, within 45 days of the end of the quarter. Annual reports, called 10-Ks, must be audited by independent third parties and are due within 90 days of the end of the fiscal year.

Three financial statements work together to paint a picture of company performance: the income statement, the balance sheet, and the statement of cash flows. Quarterly and annual reports include more than financial statements, as you'll learn in Chapter 4, but the financial statements provide key information about company performance.

1 The Income Statement

The income statement covers a period of time, typically a quarter or an entire year, and shows how a company makes money, how it spends money, and how much is left over at the end. This financial report is the source for information about growth over time—both for revenue as well as expenditures. Look at a company's income statement and find that it begins with revenues at the top, as demonstrated by an EdgarScan income statement in Figure. Revenues are whittled away by various expenses until you're left with net income at the bottom.

Numbers might seem black and white to you, but accountants can be quite creative (really!) to produce the most favorable picture of a company's net earnings.

An income statement shows income and expenses for a period of time

First, a company subtracts items like the cost of sales and selling, general, and administrative (SGA) expenses. These are the costs for the company to manufacture the products it sells, to operate its stores, to pay salaries to its employees, and to pay the rent each month. These fixed costs are the company's direct operating expenses; the money that's left over is its operating profit.

Next, the company subtracts non-cash items such as depreciation and amortization, which don't appear in the simplified income statement in Figure. For example, depreciation is an accounting convention that enables companies to obtain a tax break as their equipment and facilities age and become less productive. Further down the income statement, the company deducts any interest paid on its debts as well as taxes. Eventually, you reach the company's net income.

Net income, before any extraordinary expenses, is usually carried forward to the first line of the cash flow statement, listed as "Cash flows from operating activities."

2 The Balance Sheet

The balance sheet is a snapshot, typically at the end of a quarter or a year, of what a company owns and owes, illustrated with an EdgarScan spreadsheet in Figure. The property a company owns is an asset, and may include equipment, land, product inventory, accounts receivable, cash, or other items of this nature. The money a company owes to others is a liability, and may include debt, accounts payable, unpaid expenses, estimates of future expenses, such as pensions, or money received for services that haven't been provided yet. When you subtract liabilities from assets, you obtain the amount of equity that shareholders hold in the company.

The balance sheet shows a snapshot of assets, liabilities, and shareholders' equity

Shareholders' equity is the corporate equivalent of the equity you hold in your house. When you purchase a house, you pay a specific price for it, which is initially comprised of your down payment and the mortgage you obtain. At any given time, your equity in the house is the current value of the house minus the balance on your mortgage. Similarly, shareholders' equity is the monetary value that remains after you subtract company liabilities from company assets. It has nothing to do with how much money shareholders actually pay to buy their shares in the company. This financial report is called a balance sheet, because the amount of total assets balances with the sum of total liabilities and shareholders' equity.

Balance sheets don't always paint a perfect picture of a company's financial situation. Because these reports don't show the fair market value of assets and liabilities, some items can be grossly over- or understated. For example, land might appreciate dramatically in value over time, but that increase in value doesn't appear until the land is sold and its value is measurable. The often-significant value of a brand name doesn't appear on a balance sheet, which might understate a company's worth. Conversely, the potential obligations from lawsuits, such as those in the tobacco industry, might lead to an overly optimistic picture of company worth.

3 The Statement of Cash Flow

Because of the creativity of accountants and the idiosyncrasies of balance sheets, the income statement and balance sheet reports can hide important information. Therefore, many experts prefer cash flow as the most telling measure of corporate health. The concept of cash flow is easy to understand. For example, your personal balance sheet might look good—a million in assets, such as your home and retirement plan, and $400,000 in liabilities for your mortgage and car loan. That's $600,000 in net worth! However, if you don't have readily accessible cash to pay your mortgage, you have a cash flow problem.

The purpose of the statement of cash flow is to follow the cash coming into and flowing out of a company—which is hard to fake with any amount of legal accounting creativity [Hack #39]. The statement of cash flows starts with the net income from a company's income statement and ends with the cash on the balance sheet. This is illustrated in Figure with a statement of cash flow from the Reuters Investor web site.

The statement of cash flow isn't as susceptible to accounting creativity

Cash comes from three different sources. Cash from operating activities is the money that a company generates from its business operations. When a company generates cash from its ongoing operations, the business is sustainable. Cash from investing activities represents transactions, such as buying or selling buildings, or investing company cash in the stock market. On an income statement, selling an asset shows up as a gain or loss, which temporarily enhances or reduces the company's earnings. Cash from financing activities represents cash from outside sources, such as debt borrowed from banks or money raised by selling more shares to investors.

A company can finance investments (read: borrow money) [Hack #29], which is great when those investments help a company grow. Young companies often have no other source of cash. However, when mature companies raise cash to pay for ongoing operations by borrowing money, watch out. That could be a red flag that the company can't generate enough cash from operations to maintain financial stability.

Company cash isn't quite the same as greenbacks in your wallet. With the advent of discounted cash flows and leveraged buyouts, accounting rules now disconnect revenues and expenses from cash. In effect, a dollar of revenue does not equal a dollar of cash. To sort out this tangle of ephemeral finance, here are some questions you can ask to evaluate a company's health based on its statement of cash flow:

Does the net income on the income statement closely equal the cash from operating activities?

If it does, the company's earnings are primarily from operations, and the business can support itself.

Are net income and cash from operations growing at about the same rate?

When cash from operations grows slower than net income growth, cash flow problems may arise.

Are accounts receivable [Hack #31] increasing faster than sales?

This indicates that a company can't collect what it is owed, which not only hurts cash flow, but may indicate problems with product quality or obsolescence.

Are inventories [Hack #31] growing faster than sales or cost of goods sold?

Buying supplies and producing inventory require cash, so increasing inventory decreases cash flow and may indicate problems with products.

Did cash increase or decrease?

Decreasing cash might lead to additional financing activities, which eventually negatively impacts the value of stock shares.

Is cash flow from operations negative over time?

Negative cash flow may indicate a rapidly growing company—without financing, the company can grow only as fast as it can generate cash from operations. However, it's a bad sign when a company isn't growing quickly but still can't generate cash.

Although taking on debt to fuel growth is a reasonable strategy for a company, it's risky for shareholders. If the fast growth stalls and the company falters, the debt holders get paid before shareholders receive any money.

Is the company increasing cash by selling assets?

This can be a double whammy. First, selling assets to raise cash might mean a company can't borrow money anymore, which means banks don't like what they see. Second, assets often produce growth, so selling assets means the company will be less able to generate cash in the future.

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