don’t skip the notes.
by ed mendlowitz
77 ways to wow!
how do you start reviewing a financial statement? like any good book, you must start at the beginning.
more on advisory: when an audit is a great thing | how to read a financial statement | the kpi an absentee manager needs | which kpis do you need? | 77 thoughts about client needs
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but where is the beginning? and how can you do it in only seven minutes? here is how …
1. start with the statement of operations and look at the sales and net income. the top line and bottom line. the top line gives you an immediate feeling of the size of the company. the bottom line tells you if they’ve been profitable and to what extent.
2. the next step is to look at the balance sheet and check out the stockholders’ equity. this tells the “book value.” immediately you have a sense of the financial strength of the company. now check out the working capital – the excess of the current assets over the current liabilities. compare this to the book value. how much of the book value is comprised of working capital? the more the better.
still with the balance sheet. look at the long-term debt and compare it to the book value. what is the debt-to-equity ratio? the lower, the better. the lower it is, the greater stake the stockholders have in the company as compared to creditors.
however, some people think this is not so great because the company lacks leverage because the company could only make money on its own money. with debt you can make money with other people’s money. and you can make it faster. one problem is you can lose it faster also. and you become dependent on the interest rate and general economic situation, and the possibility the creditors can call or reduce their loan with the company. you also might be subject to creditor oversight, which can be good and bad. good because it makes the owners accountable to explain some of their actions and has them accessible to people who might be more knowledgeable in certain areas; bad because it can be a pain in the rear.
3. you may also want to check out how much cash is in the bank; the number of days of sales that are tied up in the accounts receivable; and the number of days’ cost of sales that is in the inventory. i also like to compare the accounts payable to the accounts receivable and inventory. it should be much lower and is part of the working capital amount, but i like to look at this anyway.
4. now you should turn to the first page and see what kind of report and opinion the cpa firm issued. this tells you the degree of credibility that can be placed on the financial statement. it will also tell you whether there is anything unusual you should be aware of.
5. now go back to the statement of operations. look at the gross profit or gross margin percentage, and the percentage of net income to sales. the higher both numbers are the better. a high gross margin means the direct costs of sales are low, leaving room for accelerated profits as sales increase. a high net income percentage indicates the profitability and how much is left at the end of the year for the owners. you can also do a quick check of the percentage of income taxes to profits and see that it is a realistic rate and certainly not more than 30 percent.
compare the net income to the stockholders’ equity. what is the rate of return on the company’s net assets, i.e., net worth? if you are reviewing a public company compare the net income to the market value or market capitalization. this shows the return on market equity. (note that this is reflected in the pe ratio, and you can also get this percent by dividing 1 by the pe ratio.)
6. turn next to the statement of cash flows. a quick glance down the page can tell you about any unusual transactions affecting cash. while there, look at how much cash was received from or applied to operations. check over the investing section and see how much new equipment was acquired or other investments made. then review the financing activities – what new loans were taken, or old loans repaid and other capital transactions, but these are more thoroughly covered in the statement of stockholders’ equity.
7. look over the statement of stockholders’ equity to see what capital transactions there were that affected the company’s equity. was any money invested into the company and money paid out, either for stock buybacks, dividends, or stock options and benefits to employees?
8. the statement of other comprehensive income deserves a look because losses reported here reduce stockholders’ equity without being reflected in the statement of operations and included in net income for the year. the cumulative amount of negative other comprehensive income represents a dollar-for-dollar reduction of book value and in my opinion “undisclosed” losses. not so good!
9. one of the liabilities i suggest looking at is the deferred income tax liability. any rate reduction would reduce this liability and cause a corresponding profit and increase in book value. if the company has a deferred tax asset, any decrease in tax rates would reduce this asset, resulting in a loss and a reduction of book value, and the loss of expected tax refunds at some point. not good!
10. when you are finished with the above – about three to four minutes’ worth – you should spend the rest of your time perusing the notes to financial statements. read the first note and look at any big items in the other notes plus the note for commitments and contingencies. this will tell you what you may have missed. you may have to refer frequently back to the balance sheet or other statements while looking at the notes.
you now should have a good handle on the business. seven minutes!
this process will not make you an expert in the company but can clearly indicate if you should forget about investing in it, or if it looks promising, and whether you should commit to additional examination and efforts. have fun!