Understanding Financial Reports Easier than you Think

Three most important financial statements that you need to understand.
The Income Statement is also called the profit and loss statement and it depicts the results of operations over a period of 12 months. Results of the two years prior are included for comparative purposes.

Here are the major accounts found on the Income Statement:
• Net Sales includes revenues net of returns, breakage allowances, freight-out and discounts.
• Cost of Goods Sold reflects the cost of buying raw materials and producing finished goods.
• Depreciation is a noncash expense, an amortization of fixed assets, to allocate their cost over their depreciable life.
• Selling, General and Administrative Expenses are all expenses associated with the normal operations of the business that were not included in cost of goods sold. Ex. salaries, rent, utilities, and advertising.
• Net Operating Profit is what is left over after deducting cost of goods sold, depreciation and SG&A expenses from net sales; tells you the company's profit on an operating basis without taking into account any unusual items of income or expense or interest and taxes.
• Other Income or Expenses are any unusual income or expense items such as gains or losses from investments or the sale of fixed assets. Interest expense is sometimes included in this category.
• Earnings Before Income Taxes nets out all pretax income and expense items.
• Provision for Income Taxes is the company's tax liability for the period in question.
• Net Income equals the bottom line - how much the company has earned - after netting out all expenses except for dividends.
In order to understand if the relationship between a company's income and expenses is healthy, it is beneficial to calculate each account as a percentage of sales, and then determine if the account has increased or decreased relative to sales over a period of time.

Try to decipher the reasons for the change; is the growth or reduction acceptable to you? Be on the lookout for significant growth or decreases in particular accounts, especially expense accounts such as interest. Can the company easily cover its interest expenses?

Also, if companies are in the biotech or computer technology industries, growth or reductions in R&D can be a telling sign of the company's future intent.

Determine if income is growing because of increased sales, lowered expenses (including taxes), or both.

The Balance Sheet, also called statement of condition or statement of financial position, shows the status of the company's assets (what they own), liabilities (what they owe), and owners' equity (how much they have left over) on a given date, usually the close of a quarter or a year. It is a snapshot, not a motion picture, and must be analyzed in comparison with prior period statements as well as operating statements.

The fundamental equation of the balance sheet is: Assets = Liabilities + Stockholder’s Equity - in other words, it balances!

The major accounts found on the Balance Sheet are as follows:

• Current Assets include cash, accounts receivable, inventory and other assets that are likely to be converted into cash, sold, exchanged or expensed in the normal course of business - usually within a year. These items may also include marketable securities, prepaid expenses, coins, or short-term investments like Treasury bills, and negotiable Certificates of Deposit.
• Net Fixed Assets consist of property, plant and equipment - relatively permanent assets that are used in the production of income, listed net of depreciation.
• Other Assets are miscellaneous assets that may include minority stock ownership in other companies, unconsolidated subsidiaries, intangibles such as goodwill, research and development costs, patents, trademarks, etc.
• Current Liabilities include accounts payable, notes payable, accrued liabilities, current portion of long-term debt, dividends payable - any debt or other obligations coming due within a year.
• Long-term Liabilities consist of debt obligations due after one year, including term loans, mortgages, debentures (unsecured bonds), capital lease obligations, pension liabilities and estimated liabilities under long-term warranties.
• Shareholders' Equity is ownership interest - the value of assets after all creditors have been paid. Includes preferred stock, common stock, capital surplus and retained earnings.

To analyze the Balance Sheet, look for significant growth or reduction in particular assets and liabilities, as well as overall growth or decrease in company size. You will want to review the changes in inventories, accounts receivables and payables, which will give you a good sense of the company's efficiency. Run a keen eye over the firm's debt levels. Is short-term debt growing too quickly and staying in place too long? Do goodwill and intangibles look reasonable?

The Statement of Consolidated Cash Flows has one primary purpose - to show you where the company received cash and how it spent it. It focuses on liquidity rather than just on increased cash, displaying operating results on a cash basis. The Financial Accounting Standards Board (FASB) requires analysis in three separate categories: cash flows from operating activities, investing activities, and from financing activities.

Uses and sources of cash are indicated as either increases or decreases in each account:

Uses:
Assets - positive (increase)
Liabilities - negative (decrease)

Sources:
Assets - negative (decrease)
Liabilities - positive (increase)

The most important line is Cash Flow from Operations. This is the cash that a company takes in from its day-to-day business. If it sells washing machines, the cash is from merchandise sales. Is this number positive; is it trending positive, from year-to-year? It's great if a firm is raking in money from its investments or even in real estate (although that's a lot harder to come by these days!), but the majority of its cash should be derived from the business in which it is in business to do.

Simply stated, a company's financial statements are akin to looking at a diagnostic printout of your automobile - they are a pretty complete picture of not only what the company looks like right now, but also what you can expect in the future in terms of management strategy and performance. Combined with news and statistics on industry, company, economic and market events, these statements will provide you the tools you need to analyze any company.

And once you get your feet wet with a report or two, the going gets much easier. Just look at the book filled with information key to your success as an investor, and it won't be long before you are rubbing your hands together, anticipating the edge that information will give you.

Happy Investing!