Financial statements are some of the best insights into a company a value investor has when conducting research. All financial statements of US companies, and many foreign companies, are reported under the GAAP accounting body. This gives the reader a good level of confidence that the figures in them can be trusted. Furthermore, most large companies are audited by the big four account firms: PriceaterhouseCoopers, Ernst&Young, Deloitte, and KPMG, giving another layer of trust. However, even with strict guidelines, companies can still manipulate figures, and so some level of skepticism is always needed.
How to read a balance sheet for value investing
What is the balance sheet?
The balance sheet is the bedrock of a company. It shows the financial strength by listing all of the assets and liabilities at a single point in time, usually at the end of a fiscal quarter or year. It is found on the quarterly (10-Q), and annual (10-K) statements that are filed with the SEC and available on EDGAR. For foreign listed stocks, the information is normally found with the country’s government regulatory agency. The income, expenses, and cash flow that enter and leave a business are not shown; it is the overall effect of the transactions at a specific date.
There are three main segments to a company’s balance sheet: assets, liabilities, and shareholder’s equity. The statement gets its name because it must balance; assets equals liabilities plus shareholder’s equity. Assets are any company-owned or controlled resources to produce economic value. They represent ownership of value that can be traded for cash. Liabilities represent what is owed to another entity. They are obligations that require future payment in return for a benefit today. Shareholder’s equity is what would be returned to shareholders if the company sold all its assets and settled its liabilities. For example, if you had assets such as equity in a home worth $150,000, a car worth $20,000, and retirement savings worth $30,000, along with liabilities such as a mortgage of $50,000, credit card debt of $10,000, and some utility bills totaling $1,000, your shareholder’s equity would be $139,000 ($200,000 worth of assets minus $61,000 of liabilities).
Assets and liabilities naturally occur during business operations; a company may issue bonds (liability) in order to build a factory (asset). Both the factory and the bonds are recorded in the corresponding place on the balance sheet. Most companies report an itemized list of:
- Current assets (assets that can be sold within a year) – such as cash, short-term investments, accounts receivable, inventory, prepaid expenses, and other current assets
- Long-term assets (assets that cannot be easily converted into cash and are not expected to be sold within a year) – such as long-term investment; property, plant, and equipment; intangible assets; and other long-term assets
- Current liabilities (liabilities to be settled within a year, long-term liabilities (liabilities to be paid longer than a year)- such as accounts payable, accrued expenses, unearned revenue, notes payable, and income tax payable
- Shareholder’s equity- such as common stock, additional paid-in capital, and retained earnings
Assets
Current Assets
Current assets are classed as very liquid or readily convertible to cash and are expected to be used over the next year. On the balance sheet, they are listed in order of liquidity, with cash (such as money market funds and short-term Treasury bills) being the most liquid and prepaid expenses (such as rent, utility bills, and salaries) being the least. Asset-heavy industries, such as utility companies, are expected to have more cash on the balance sheet in order to pay for high Capex costs. In contrast, asset-light sectors, such as technology, do not need as much money. Cash levels can also be compared to other companies in the same industry to gauge strength in their particular environment. Too little cash may signal trouble, and too much may indicate that management does not know how to deploy capital effectively. Investors can use the current ratio (current assets minus current liabilities) to find the true level of money a company has on hand.
Accounts receivable is the amount other businesses owe in the form of credit to the company. If the figure is high, it may mean the company has relaxed credit terms or is having trouble collecting payments. Furthermore, if they are increasing rapidly, it may be a sign that they are relaxing their standards to boost sales. However, if accounts receivable is low, it may mean the company has short terms for its credit or is very efficient at collecting payments. Levels of accounts receivable can differ by sector; companies that produce high ticket items such as machinery will often have high accounts receivable, whereas cash-based sectors, such as restaurants, will generally have low accounts receivables.
Inventory refers to the goods and materials that a business holds for utilization, production, or resale. For example, steel is needed to make cars or cleaning supplies to clean an office. Inventory is required for companies to be able to operate and meet the demand of customers. If inventories are low, a business may be unable to produce a product or service, leading to lost sales. If inventories are too high, a company risks being unable to convert the inventory into sales and will therefore have value locked up and not being utilized. Balancing this level is particularly important in fast-moving industries, such as technology hardware, as the technology can quickly become out-of-date and unsellable. Too low, and the company will not fully maximize the opportunity.
Prepaid expenses are goods and services paid in advance, such as rent. On the balance sheet, they are first recorded as an asset, and then, as they are realized over time, the figure is recorded as an expense. For example, if a company pays for 12 months of rent for a building upfront, the whole 12 months’ rent is an asset. In the middle of the 12-month period, six months have been used and are therefore an expense, and six months have yet to be used and are therefore recorded as an asset.
Other current assets are often restricted cash (cash held for a specific purpose and not available for immediate use) and short-term loans.
Long-Term Assets
Long-term assets are not expected to be used or sold within the next 12 months. Long-term investments are stocks, bonds, or royalties the company intends to hold for longer than a year. Plant, property, and equipment are fixed assets that a company owns in order to operate. Their value is usually recorded as the original cost minus depreciation, which is written off as a non-cash expense over its estimated useful life. Each asset has its own rate of depreciation; for example, the life of a mobile phone is much shorter than the life of a factory. The management can also influence the rate of depreciation. Businesses may aggressively depreciate assets, raising expenses lowering profits, and therefore reducing the amount of tax owed. They may also take a slower depreciation rate to appear more profitable than they really are.
Again, long-term assets vary depending on the industry. Capex-heavy industries such as manufacturing will have many fixed assets, whereas a software company would be asset-light. Intangible assets are assets that are not physical, such as intellectual property and patents, which often have an expiration date and will lose value as they approach their expiration. Goodwill is the amount paid over the value of an asset. For example, if you were to buy Apple, you would pay vastly more than all its fixed assets because its brand adds enormous value to the company. However, because it is difficult to put a precise number on a brand’s value, goodwill can often be over or understated.
Total Assets
Total assets are just the sum of current and long-term assets. The figure is used in calculations such as a company’s book value (assets minus liabilities) and returns on assets (net income divided by total assets)
Liabilities
Liabilities represent what is owed to another entity. They are obligations that require future payment in return for a benefit today.
Current Liabilities
Current Liabilities are obligations that are due within 12 months. The most common current liability accounts payable; is the credit extended to the company by other companies, such as suppliers. The credit is reduced as goods and services are sold, and the proceeds are applied to the obligation. Accounts payable and shares should roughly rise and decline together. If accounts payable are increasing faster than goods and services sold, it could be a sign that the company is struggling to pay its bills.
Accrued expenses are expenses that have accumulated but have not yet been paid. The most common accrued expenses are rent and salaries. Unearned revenue is the revenue collected from an order for a good or service that is yet to be fulfilled. It is a liability because the business is required to fulfill the order within a pre-determined time. Notes payable is the short-term financing borrowed from lenders. Income tax payable is what is owed to the government, and the current portion of long-term debt is the long-term debt to be paid back that year. Companies must have enough current assets to cover current liabilities, or they will default or have to borrow more.
Long-Term Liabilities
Long-term liabilities are not expected to be paid within the next 12 months. Long-term liabilities include deferred income tax, pension obligations, and long-term debts such as bonds. The most common long-term liability is from the company issuing its own bonds that have scheduled interest payments. How the debt is used is vital to the health of the company. If it is efficiently allocated to sustainable profit-generating investments, it is an excellent use of a liability and does not dilute shareholders’ equity. If it is carelessly used, the company may not be able to generate enough cash flow to pay for the interest payments. Deferred income tax is the difference between the two methods of depreciation mentioned in “Long-term assets” and is recorded under long-term liabilities.
Total Liabilities
Total liabilities are just the combination of short and long-term liabilities. If the figure is equal to or more than total assets, it would mean the shareholders have no equity.
Stockholder’s Equity
Stockholder’s equity is what is left over after subtracting total liabilities from total assets. It can also be viewed as the company’s net worth, just as your total assets minus total liabilities equals your net worth. Common stock represents the shareholder’s equity, additional paid-in capital is the difference between the issuance of new stock (normally at market value) and what the shareholders paid for their shares. Retained earnings are earnings generated by the company, not returned to the shareholders through dividends. They are typically reinvested back into the business. Preferred stock is a hybrid between a stock and a bond. The share owner owns the company and receives a dividend but has limited voting power. However, in the event of liquidation, preferred stock has priority over common shareholders but after bond holders.
How to read an Income Statement for Value Investing
What is an income statement?
The income statement is the most closely studied statement of all financial reports. It reports earnings (the net proceeds from business operations) which institutional and individual investors follow to determine how successful a company is. A company’s value is based on its ability to generate cash flow. Stock prices generally follow earnings. The income statement reports financial data over a specific period, usually a quarter or one year. It includes the gross and net revenue, expenses (cost of goods sold; Selling, general, and administrative; other expenses), and cash flow during the stated period. The basic premise of the statement is to show what is left over from the revenue after expenses have been deducted. The statement is in order of events and is meant to be read from top to bottom, where total revenue is at the top (“top-line”), and net income is at the bottom (“bottom-line”).
Types of accounting for tracking income
There are two methods of accounting that can be used to create the income statement. Accrual method of accounting records revenues and expenses when they are earned, regardless of when the cash is sent or received. For example, a manufacturing company would record revenue when they have made the widgets for a credit sale, not when they receive the payment. The credit sale is recorded in accounts receivable under assets on the balance sheet and under revenues on the income statement. Accrued expenses are recorded as a liability on the balance sheet and expenses on the income statement. It is best for matching expenses with revenues and is the most widely used form of accounting. Cash-based accounting records revenues and expenses as the money is actually sent or received. It is a better way of tracking cash flows.
There are different ways an income statement can be formatted, by most commonly used is the five-step format. It divides the statement into five steps: revenue, gross income, operating income, income before taxes, and net income. It helps the reader to distinguish how income and expenses are tracking over time.
Revenue
Revenue is always at the top of an income statement. It represents the total amount of goods and services that have been delivered to customers. For the transaction to be official, the risk and reward of owning the product or service must be transferred to the purchaser. The company includes an appropriate percentage of returns that are not recorded as revenue. Net revenue is the company’s revenue minus revenue for accounts with a high probability of not paying. Sometimes revenue is not recorded on the income statement even though payment has been received. Revenue from multi-year licenses, such as those common with software, is recorded as the license is used. The remaining revenue is recorded as unearned revenue. However, the expenses associated with the sale is recorded as it occurs.
Gross Income
Gross income is the amount a company earns by selling its products or services minus the cost of goods sold (COGS). COGS are the expenses a business incurs by creating the product—for example, the raw materials and labor needed in manufacturing. Industries with high Opex costs will have high COGS and often lower margins. There are two ways to record COGS; first-in-first-out (FIFO) or last-in-first-out (LIFO). FIFO records the oldest inventory as sold first and is useful in times of high inflation, as the lower cost inventory are recorded first. LIFO records the newest inventory as sold first and is more useful if a company wants to lower profits (due to the higher cost of newer items) and, therefore, taxes. Gross margin (gross profit divided by revenue) is a valuable tool to determine a company’s ability to generate a profit and track its trend. Increasing expenses will eat into company profits and therefore should be watched closely.
Operating Income
Operating income is the company’s revenue before interest, taxes, depreciation, non-operating expenses, and extraordinary charges. It is calculated by subtracting operating expenses (selling, general, and administrative expenses (SG&A), R&D expenses, depreciation, and amortization) from gross income. SG&A is normally listed first in expenses and is often further divided by selling costs, such as marketing, and general administration costs, such as salaries, insurance, utility bills, etc. Operating expenses can not be traced to specific products or services, whereas COGS can be. Depreciation is the division of costs into the number of years based on depreciated expected lifespan. For example, a building is depreciated for 30 years. It is used to spread out the recognition of the expenses over the life span of the investment instead of having one large expense at the beginning. As a result, it reduces the value of an asset fixed assets on the balance sheet.
There are two main depreciation methods: Straight-line depreciation, which reduces the value of an asset evenly each, and accelerated depreciation, which will reduce the value of an asset at a faster rate at the beginning of an asset’s life span. Accelerated depreciation is often used to increase expenses and, therefore, lower taxes. Amortization is the decline in the value of intangible assets, such as intellectual property and patents, over their life span. Operating income and margins offer vital insight into the core business functionality, how it is performing over time, and how it is doing compared to other companies in the same industry. Earnings before interest, tax, depreciation and amortization (EBITDA) are often cited as how much cash a company generates. However, investors should mostly ignore EBIDTA as depreciation is an expense and can significantly skew a company’s actual earnings.
Interest expense is the interest paid on debt taken out by the company to finance growth. It is a form of non-operating expense and is recorded as a financing expense. Companies with large amounts of cash may earn interest, which is recorded as a non-operating income, as can the proceeds from selling equipment. Combining operating and non-operating expenses and subtracting them from gross income creates income before taxes.
Net Income
Net income is the income after expenses, including taxes, available to shareholders. Adjustments to income, which can be income or expenses, are not part of the normal operations in any given year. They are often recorded under extraordinary gain or loss, discontinued operations gain or loss (such as closing down a section of a business), non-recurring items, and the cumulative effect of change in accounting (such as when a company adopts a new accounting practice).
Earnings per Share
Earnings per share (EPS) is the most anticipated data point investors look for when new financial statements are released. It is created by dividing the net income by the number of shares outstanding after preferred dividends have been taken out. It simply states how much did each share earn during the reporting period. Diluted earnings per share are the same as EPS, except stock options, warrants, and convertible bonds are included. It is what would be available to shareholders if all stock options, warrants, and convertibles were exercised. Sometimes income statements also include retained earnings, the net earnings that are paid out as dividends, and what is retained for company growth.
EPS may appear higher if the company has been buying back its shares (the earnings are divided between fewer outstanding shares), or if a company has been issuing shares, the EPS may be lowered. Keep an eye on the number of shares outstanding. If earnings are growing and the number of shares outstanding are the same or have increased, it is a good sign that the company has increased earnings.
Revenue growth
Revenue growth is critical in determining a company’s strength. Growing revenues are a strong signal that the company is gaining market share and is more likely to fend off competition. It is important to remember that revenues can be seasonal, such as retailers selling more during the Christmas period, so it is more important to compare year-to-year quarterly revenues and not consecutive quarterly revenues. Also, expect smaller companies to have higher growth rates due to their base effect and larger companies to have slowing revenues as their market becomes saturated. Furthermore, high-profit margins will attract competition, potentially decreasing profitability, so the strength of the company’s moat is vital to its survival. Companies with small margins will be more sensitive to changes in input costs and may find it difficult to pass any increased production costs to their customers.
How to Read a Cash Flow Statement for Value Investing
What is a cash flow statement?
Cash flows are the lifeblood of a company; without them, they die. Cash flows differ from earnings in that earnings are based on the accrual accounting method (matching expenses with revenues whether or not the cash has been sent or received). Because accrual accounting does not necessarily report when cash is exchanged, it opens up to interpretation by the managers. For example, higher revenue may not directly convert to cash flow if accounts receivable are allowed to increase. The cash flow statement provides a clearer picture of how much and where the cash flow is coming from. It connects the income statement to the balance sheet. The cash flow statement is similar to a checking account; once a transaction occurs and the cash has been spent, it is no longer with the company. The purchase is not spread out over several years based on the life of the product or service; it is transferred instantly. The cash flow statement allows the reader to see if the business generated more cash than it used in a given period. If they gained more cash than they spent, it is a good sign that the company is profitable. If it used more cash than earned, it might need to issue more stock or take on more debt. The cash flow statement is divided into three sections: cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities.
Cash Flow From Operating Activities
Cash flow from operating activities shows whether a company’s general business activity produced or decreased cash. If the net cash flow provided by operations is positive, the business generates more cash than it uses on regular operations to provide its goods and services. If it is negative, it uses more cash than it produces. Furthermore, if it is negative, the company will need to issue stock, diluting shareholders’ ownership (the company’s net worth will be divided by more shareholders), or it will need to take on more debt, which increases interest payments. However, it is common for new companies to exhibit negative operating cash flows as it is investing in expansion.
There are two ways cash flow from operating activities can be determined: direct and indirect. The direct method registers all significant cash flows from payments and receipts, with cash received from customers being the most significant. To calculate cash flow from operating activities, payments for operating expenses and inventory costs are deducted from cash received from customers. The indirect method begins with net income and then adds or subtracts differences resulting from non-cash expenditures to calculate cash flow from operating activities. Most companies use the indirect method. The net income figure is taken from the income statement and is placed at the top. Then, depreciation and amortization are the first to be listed as it is a non-cash expenses. They are recognized over their life span in order to match revenues with expenses. Both depreciation and amortization decrease net income and shareholder’s equity, but as they do not affect the actual cash of the business, they are added back to net income. Then, normally accounts receivable, inventory, and accounts payable are listed after depreciation and amortization.
Changes in working capital (the difference in net working capital between periods) must be adjusted to follow the changes in the flow of cash. For example, if accounts receivable increase, it is fair to assume payment will likely be received in the future. However, cash has yet to be received, so to account for this, the increase in accounts receivable is subtracted from net income. Other non-cash items, such as prepaid expenses, also are listed on the cash flow statement. Prepaid expenses are balance sheet assets that do not decrease net income or shareholder’s equity but do reduce cash. Unearned revenue is similar to accounts payable in that it is a liability. Also, its increase does not affect net income but does increase cash as payment has been received for goods or services to be delivered in the future. Deferred taxes is the difference between book tax and actual income tax. Finally, net cash flow is the sum of all the parameters mentioned above. It is normal to see new and expanding companies have negative operating cash flow while they pile resources into growth. However, for more mature companies, it is vital for cash flows to be positive.
Cash Flow from Investing Activities
Cash flow from investing activities states what the business has invested in itself, such as capital expenditures (Capex), which are usually in the form of plant, property, and equipment. The amount is usually negative as most companies are allocating capital for growth. Still, it can be positive if the company generates more revenue from the sale of assets than it is spending. Capex is normally long-term and its expense is divided up into the lifetime of the asset’s usable life. However, the actual cash used to purchase the asset is used all at once, instantly causing a significant cash outflow and not the asset’s useful life. It is essential to look into what the company is spending its money on and whether it will increase company earnings. Capex should be rising at the same rate as earnings; too fast and the company can run out of money; too slow could signal the company does not know where to allocate capital efficiently. It is also normal to see differences in industry; manufacturing is Capex-heavy and requires much heavy investment, and tech is asset-light as it is mostly software based.
Investments in other companies, acquisitions, and divestitures of subsidiaries are also stated in the cash flow from investing activities. Commodity hedges for companies that heavily rely on commodities, currency hedges for international business, and significant investments in marketable securities are all listed under “Other cash flows from investing activities.” Net cash from investing activities combines Capex, long-term investments, and other cash flows from investment activities. The most robust businesses will have a negative net cash figure as it is a sign that the company can use its cash flow to reinvest back into itself.
Cash Flow From Financing Activities
Cash flow from financing activities includes the company’s own stock, debt, and dividend transactions. When a company issues stock, cash is received in return for the sale of the stock and shareholder ownership is diluted. Issuing stock can be a good decision if the capital raised can be put to good use; however, over-issuance can be a sign that the company is in trouble. Alternatively, the repurchase of shares when the company can buy them at a discount to intrinsic value may be the most suitable capital allocation at the time. However, repurchases decrease cash holdings. Cash flows can also be from company bonds (debt) issuance. When issued, the business receives cash that needs to be repaid later or a cash outflow. The interest payments are included in operating activities as they are a part of normal business operations.
Dividend payments to shareholders are outflows of cash and commonly increase year over year as the company generates more net income. However, a dividend decrease may be a sign that the company is in trouble. Dividends are more common in well-established industries that experience slower growth. It is common for new and rapidly growing companies to not distribute any dividends as they can allocate capital more effectively. Net cash provided by financing activities is the sum of long-term debt issued, increase(decrease) in common stock, and dividends paid.
Currency Translation
If a company is international, it may also include a currency translation line item. Multinational companies may generate revenue in different currencies and are adjusted by the “cumulative effect of exchange rate changes.”
Net Change in Cash
The net change in cash is the sum of cash flows from operating, investing, and financing activities. The amount should be the difference between the cash the company had at the beginning of the period (normally per quarter or year) and the amount at the end of the period. Ideally, cash flow should come from operations, as this is how the business will generate revenue in the future. A positive figure means the company generated more cash than it used, and a negative figure means it used more than it earned. It is essential to look at how the cash was used, not if the net change is positive or negative. It is all about how much invested cash will return. If a company can use its cash flow to generate high returns from reinvestments, pay down high-interest rate debt, or repurchasing shares at the right time, then it may make sense to have a negative net change in cash.
Analysis of Cash Flows
Cash flows, especially from operating activities, are often compared to net income. Cash flows from operating activities fail to account for future earned revenues and future payments for accrued liabilities. Furthermore, it does not provide a clear picture for young, fast-growing companies as they often reinvest most of their cash to purchase assets to drive growth. As mentioned, this can cause operating cash flows to be negative for several years until profitability stabilizes. Alternatively, net income is based on accrual accounting, which ignores the effects of non-cash items. Non-cash items are somewhat subjective in their valuation and can differ depending on the company. Accrual-based accounting also allows managers some discretion on when revenues are recognized.
Free Cash Flow
Free cash flow is cash flow from operating activities minus Capex and dividends. Free cash flow is the cash that is left over after all expenses. It is what the company’s management can use at their discretion. It is vital for a company’s survival to be able to generate cash over long periods of time. How the cash is allocated is key to its growth. A company must continue to upgrade equipment, expand R&D efforts, and expand into new areas to increase earnings. The nature of each industry must be considered, and each company must be compared to other companies in the same sector to get a clear picture of which are great and which are weak.
