Financial Statements

What Are Financial Statements And Why Should You Care?

As an investor, you will have to understand the basics of accounting to be able to identify financially strong companies and avoid companies which experience financial troubles. In this lesson I will try my best to explain this topic in an easy to follow, non-boring way.

Summary:

  • You have to understand the basics of accounting to be able to identify financially strong companies and avoid companies which experience financial troubles

  • Accountants keep track of the money flows and product flows within a company and document every transaction a company makes

  • Financial statements are the documents in which these transactions are recorded

  • If you do not understand the basics of financial statements, you cannot apply a value investing strategy, because value investing is based on thorough financial statement analysis

  • Accounting and financial statements are not difficult, but they can be confusing at first because of the specialized vocabulary

  • There are three main financial statements: the balance sheet, the income statement and the cash flow statement

  • The balance sheet shows you an overview of what a company owns today, its assets, how much the company owes today, its liabilities, and how much a company is worth today, its shareholders’ equity.

  • On the income statement you find how much a company sold in a given period, sales, how much money it had to pay, costs, and finally how much money was left after paying these costs, net income.

  • The cash flow statement tracks the movement of cash throughout the business, so where the company gets cash and where that cash goes.

  • Income is not the same as cash, and even a highly profitable company might still be unable to pay its bills if it runs out of cash

  • The balance sheet, income statement and cash flow statement all work together to show you a complete picture of a company’s financial position, but they all have their own specific purpose

Useful Financial Ratios

Financial ratios are what you get when you combine some figures from the financial statements in smart ways. This lesson will cover some of the most important financial ratios for value investors.

Summary:

  • Financial ratios allow you to compare companies and get a better idea of how well they are performing

  • Earnings per share shows you how much profit a company is making for each stock it has issued

  • The Price/Earnings ratio is a valuation ratio, or multiple, which shows you how much investors are willing to pay for a stock per dollar of income

  • P/E in itself does not say much about whether or not a company is undervalued with respect to its intrinsic value

  • The net margin tells you what percentage of total sales is translated into bottom line profits

  • Both P/E and net margin differ greatly per industry, which makes them unsuitable to compare companies across industries

  • Return on equity shows you how much net income a company earns per dollar of equity, or in other words, how efficient a company uses its equity to generate profits

  • While book value is often inaccurate, the growth of book value per share over time gives you a general sense of whether a company is creating value or destroying value

  • The debt to equity ratio indicates how much debt a company has in relation to equity

  • High levels of debt are dangerous, because the interest payments can bankrupt a company

  • The current ratio is a liquidity ratio which measures a company's ability to pay its short-term obligations

The Power Of Free Cash Flow

In today’s lesson we are going to cover a very important, yet often overlooked metric called Free Cash Flow, or FCF.

Summary:

  • Free cash flow is the amount of cash a company has left after is has paid for all of its expenses and investments required to keep the business running

  • Free cash flow can be used for repaying debts, paying dividends to shareholders, buying back shares, or to facilitate the growth of its business

  • Free cash flow is not reported in the financial statements. You have to calculate it yourself by taking cash from operating activities and then subtracting capital expenditures

  • The absolute value of free cash flow does not tell you the whole story, you have to dig a bit deeper

  • Ask where the cash is coming from. Is a company generating these cash flows from their own earnings or do they rely on debt?

  • Ask what the company is spending its cash on. Are they investing in future growth, paying dividends, buying back shares, paying off debt, or are they simply spending it on maintenance costs?

  • If a company consistently reports negative cash flows while reporting increased earnings, this is a big warning sign, because this is unsustainable in the long run and could indicate earnings manipulation

  • Negative free cash flow might also indicate that a company does not have the liquidity to stay in business, at least not without taking on additional debt

  • Falling free cash flows are a warning sign as well, because it could indicate that a company is experiencing a slowdown in business which means future earnings may not be able to grow

  • Just as you can calculate a P/E ratio, you can also calculate a Price/Free Cash Flow ratio. However, these ratios both share the same limitations.

  • Also check whether a company is growing its cash reserves or burning through its cash reserves

  • Finally, always put these figures into perspective. They never tell you the complete story, you will have to dig a bit deeper to find out how a company is actually performing.

Detecting Earnings Manipulation & Avoiding Value Traps

In this lesson you will learn why managers manipulate earnings in the first place, how they do it, what the dangers are for you as an investor, and how you can identify and avoid these so called “value traps”, which is one of the most difficult aspects of stock picking.

Summary:

  • To determine whether or not a company is financially healthy, we have to look at their financial statements, but management sometimes manipulates these statements to make a company look more profitable than it actually is

  • No matter how sophisticated your fundamental analysis and your intrinsic value estimates, if they are based on misstated information they are essentially worthless

  • Managers manipulate earnings to keep the stock price high and to meet analyst expectations

  • The GAAP allow several legal ways to manage earnings to a certain extend, which are sometimes misused

  • A value trap is a stock which appears to be a great investment at first, but is actually experiencing serious fundamental problems which are permanent in nature

  • The price of a true value investment is low because of irrational price movements, often caused by emotional reactions to temporary and solvable problems. TR

  • Even the best value investors in the world regularly buy value traps, because it is very difficult to identify them

  • There are two major scientific models to identify companies which might experience financial troubles in the near future: the Altman Z-score and the Beneish M-score. They are both useful, but not perfect

  • Hewitt Heiserman developed a method of creating two alternative income statements which counter the flaws of a company’s reported earnings: the defensive income statement and the enterprising income statement

  • Shareholder friendly management is important, because honest management is less likely to manipulate earnings

  • Finally, always read the footnotes of a company’s financial reports, because they can reveal important details

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