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Money & Business
Reading Financial ReportsSpot the next Enron a mile away.
Even the most experienced investor can get lost in the jungle o a companys
inancial statements. But basic knowledge o the balance sheet, cash low
statement, and income statement go a long way. With just a little eort , you can:
Navigate through the sections o an annual report
Calculate basic ratios to measure proftability, liquidity, and solvency
Make better, more inormed investment decisions
published byBarnes & N
Financial Report BasicsFinancial reports, or nancial statements, are documents
that summarize a companys nancial perormance. All
publicly traded U.S. companies that have more than 500
investors and $10 million in net assets, or that are listed
on a major national stock exchange such as the New York
Stock Exchange (NYSE) or the NASDAQ, are required by
law to issue nancial statements on both a quarterly and
annual basis. This regulation is enorced by the Securities
and Exchange Commission (SEC), the U.S. government
agency that regulates the investment industry.
Financial reports are meant to create transparency and
accountability by making companies nancial results vis-
ible to investors and the market as a whole. The reports
are standardized, meaning that the annual and quarterlyreports rom various companies contain comparable (though
not necessarily the same) nancial inormation.
How Investors Use Financial ReportsReading a nancial report is the only way or most inves-
tors to get a good picture o a companys perormance and
nancial situation. Learning to read and analyze nancial
reports can help you understand a companys nancial
perormance in detail and, in turn, make more inormed
investment decisions. By reading and analyzing nancial
reports, you can begin to invest based on a companys un-
damentals, or nancial statisticsan ess ential step toward
becoming a condent, successul stock investor.
Annual Reports (10-Ks)An annual report (in SEC lingo, a 10-K) covers a public com-
panys perormance during the previous scal year. Private
companies dont le 10-Ks. The report contains two basic parts.
Narrative Summary
The narrative summary is a written synopsis that gives
investors some insight into the companys vision and strate-
gies. It includes the ollowing components:
Letter to shareholders
Management bios and compensation data
Managements discussion and analysis (MD& A)
Auditors statement
Financial Statements
The annual report also contains three nancial statements
that provide hard data on the companys nancial peror-
mance over the previous year.
Balancesheet: A snapshot o the companys nancial
condition at a specic point in time, including assets
(cash, items owned by the company, and money
owed to the company); liabilities (debts and nancial
obligations); and equity (assets minus liabilities).
Incomestatement: A breakdown o the companys
revenue (income) and expenses (costs) over a specic
period o time. The income statement shows whether
the company has earnings, also known as prots or
net income. Earnings are the cash that remains ater
all expenses have been taken into account.
Cashowstatement: A detailed list o all cash
infows (money coming in) that a company receives
rom its ongoing operations and external investment
sources, as well as all cash outfows (money going out)
that pay or business activities and investments.
Notes
Every nancial statement includes a set o accompanying
ootnotes in small print at the end o the nancial state-
ments section. These notes, also known as ootnotes,
serve as annotations to the statements themselves and
oten include the juiciest, most revealing bits o inorma-
tion in the entire annual report. For example, i a company
recently purchased a new private jet or its executives, that
minor detail (which could cost tens o millions o dollars)
would likely be stipulated in the notes and nowhere else.
Companies also oten bury their nancial problems, such as
the cause o a drop in sales or a spike in debt, in the notes.
The Financial Highlights Section
Along with their actual nancial statements, companies
oten include a user-riendly summary o their nancial data.
Typically reerred to as nancial highlights, this section o
the annual report is neither required nor ormally regulated.
As a result, the nancial highlights are not always presented
in accordance to accounting rules. Thereore, you should
never trust the nancial highlights accuracy. Reer to the
actual nancial statements instead.
Quarterly Reports (10-Qs)A quarterly report (in SEC lingo, a 10-Q) is similar to an
annual report, with two important dierences:
Timeframe: Quarterly reports cover only the three
most recent months o a companys perormance.
Theyre issued three times per year (the ourth-quarter
report is included in the annual report). So i its June
and youre reading an annual report that was published
in January, be sure also to review the more recent
nancial data contained in the latest quarterly repo
Mostlyjustnancials: Quarterly reports dont con
as much narrative commentary as annual reports.
may have a brie introduction but otherwise contai
just the nancial statements.
The Best Sources or Financial DataMost publicly traded companies publish their quarterly
annual reports online or ree. Reports are t ypically avai
in the ollowing locations:
Companywebsite: Look or links to the investor
relations section o the website.
SECwebsite: www.sec.gov/edgar.shtml
Yahoo!Finance: nance.yahoo.com
You can oten get a paper copy o the annual repor
calling the company directly and requesting one rom
investor relations department.
How to Read the NarrativeSummary o an Annual Report
The narrative summary provides a glimpse into how
company views its own prospects and also gives s
insight into the companys management and strategie
narrative summaries o annual reports contain our pa
Letter to shareholders
Management bios and compensation data
Managements discussion and analysis (MD &A)
Auditors statement
When reading the narrative summary, keep in mind tha
company is using it in large part to try to present itsel i
best possible light, even i its annual nancial results
weak. Read between the lines, with skepticism.
Letter to ShareholdersAll annual reports begin with a message thats osten
rom the companys top executives but more likely wr
by the companys public relations department. This l
to shareholders is typically designed to highlight the
tive aspects o the companys year but should also add
negative results. Though you should read this letter to
sense o the companys current overall message, never
on it when determining whether to buy a companys st
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Copyright 2007 Qu
All rights rese
Quamut is a registered tradema
Barnes & Noble
10 9 8 7 6 5 4 3
Printed in the United S
Writer: Megan Kam
www.quamut.co
The inormation contained in this and every Quamut guide is intended only or the general interest o
its readers and should not be used as a basis or making medical, investment, legal or other important
decisions. Though Quamut makes eorts to create accurate guides, editorial and research mistakes can
occur. Quamut cannot, thereore, guarantee the accuracy o its guides. We disclaim all warranties, including
warranties o merchantability or tness or a particular purpose, and must advise you to use our guides at
your own risk. Quamut and its employees are not liable or loss o any nature resulting rom the use o or
reliance upon our charts and the inormation ound therein.
This chart and the inormation contained in this chart are or general educational and inormational uses
only. The chart is not a recommendation, solicitation, or oer to buy or sell any security, investment, or
und. The chart is not intended to provide you with any personalized legal, nancial, accounting, or tax
advice. The chart should not be used as a substitute or personal advice rom a legal, nancial, accounting,
or tax expert. This chart does not make any representations or warranties as to the accuracy, timeliness,
suitability, completeness, or relevance o any inormation contained therein.Photo Credits: Page 1: Royalty-Free/Corbis.
www.quamut.com Reading Financial Rep
Management Bios and Compensation DataFollowing the letter to shareholders, the annual report typi-
cally contains sections that provide biographical and com-
pensation inormation about the companys management
teamthe group o top executives who run the company.
Managementbios: Inormation about the educational
and business background o each management team
member. The bios can help you assess whether the
companys executives are appropriately qualied. I
youre thinking o investing in a sotware company, or
example, you want executives with strong background
in the sotware business, not the pet care business.
Compensationdata: Specics about salary, stock,
and other compensation awarded to the management
team. This data can help you assess how airly the
company pays its executives. For instance, i recent
nancial results are weak, the company shouldnt
award executives exorbitant compensation packages.
I a companys management strikes you as underqualied or
overcompensated relative to management at other, similar
companies, you may want to avoid the companys stock.
Managements Discussion and AnalysisThe managements discussion and analysis, oten
reerred to as the MD&A, is the portion o the annual reportin which the companys management expresses its views
on the companys past year o perormance and its uture
prospects. Read the MD&A closely to get a sense o how
closely managements views align with the companys
actual nancial results contained in the balance sheet, in-
come statement, and cash fow statement.
Overall Contents o the MD&A
The MD&A covers our aspects o a companys business:
Liquidity: The companys cash position and ability to
cover its expenses on a short-term basis
Capitalresources: The companys debts and its plans
or using debt, such as expansion, acquisitions, and
other major capital expenses
Resultsofoperations: A summary o nancial results,including earnings, prots, and taxes
Markettrends: A review o external trends and events
in the marketplace, such as weather or energy prices,
that may impact the companys perormance
Specifc Disclosures in the MD&A
The MD&A contains many specic data points, called dis-
closures, that can help you get a sense o the companys
nancial standing. The specic disclosures you should read
most closely are:
Revenuerecognition: Species when a company
books revenue or a sale, as opposed to when it
actually receives revenue or a sale. You should be
wary o companies whose revenue recognition policies
allow them to book revenue ar in advance o actually
receiving the revenue: these policies can create the
illusion that a company generates much more revenue
than it ever actually receives.
Allowancefordoubtfulaccounts: The companys
expected losses as a result o unpaid accounts
receivable. The losses that result rom doubtul
accounts can reduce or erase a companys earnings.
A notable increase in doubtul accounts over several
quarters can signal a problem with the companys
accounts receivable strategy or a general breakdown in
the industrys liquidity.
Environmentalandproductliabilities: The
companys risk o being sued or held responsible or
paying nancial claims made by other organizations or
individuals. Companies with a high degree o potential
liability, such as chemical transporters or cigarette
manuacturers, can see their earnings diminished or
erased by litigation ees and judgments.
Restructuringcharges: The companys disclosure o
costs it expects to incur as a result o restructuring,
such as shutting actories or relocating parts o the
business. These charges can be recurring or conned
to one event. One-time charges are less worrisome
than recurring charges, though either type can
signicantly cut into earnings.
Stock-basedcompensation: Specic details o stock-
based compensation packages awarded to employees.
In general, stock-based compensation should refectthe companys perormance. Be wary o companies
oering stock-based compensation that seems
excessive, especially i company perormance has
recently been lackluster.
Pensionplans: Companies with employee pension
plans (company-paid employee retirement plans)
must disclose how they plan to meet the plans
nancial obligations. Be especially wary o very large
corporations, as they may have vast pension plan
obligations that can threaten earnings.
Auditors StatementThe SEC requires companies to pay third-party auditors
to veriy the reliability and accuracy o nancial reports.
The auditors create a nal assessment, called an auditors
statement, that usually appears just beore or ater thenancial statements contained in the annual report.
What Auditors Do
Auditors dont check every single transaction a company
makes. Instead, they perorm a battery o tests that provide
reasonable assurance against material misstatements
errors that can signicantly impact a companys nancial
position. These tests provide some protection against bla-
tant raud but should not be considered oolproo.
Contents o the Auditors Statement
An auditors statement typically contains an introductory
paragraph, a scope paragraph, and an opinion paragraph.
Introductoryparagraph: Basic inormation regarding
the audit and nancial data it covers, such as the time
period the audit covers and the names o the auditors.
This paragraph is meant to limit the auditors liabilit
by stating that the audit is merely an opinion about
nancial data and that the companys management
responsible or the contents o the nancial reports
Scopeparagraph: A description o the standard se
guidelines or nancial accounting, called the Gene
Accepted Accounting Principles (GAAP), that the
auditors ollowed to conduct the audit. The paragra
states the rules accountants must ollow in recordi
and summarizing transactions and in preparing na
reports. GAAP standards stipulate that the main go
the audit is to ensure that the nancial report is re
material misstatements.
Opinionparagraph: The auditors conclusions bas
on the companys nancial reports. I the auditors
ound no major problems, theyll say so in the opini
paragraph. An auditors statement that uncovers n
major problems is called an unqualied auditors
statement or a standard auditors opinion. An
auditors statement that does uncover major proble
is called a qualied auditors statement. In such
cases, the auditors will use the opinion paragraph t
speciy the problems they uncovered.
Qualifed Auditors Opinions
Auditors issue qualied opinions or many reasons. S
are minor and technical in nature; others may indicate mtrouble, such as impending bankruptcy. Among the
serious reasons or issuing qualied opinions are:
Going-concernissues: Auditors issue going-conce
qualications when they have substantial doubt tha
a company will be able to und its operations, pay
its debts, and remain a going concerni.e., stay in
business. Problems that might lead to this qualica
include stang issues, disputes with suppliers, ong
losses without the prospect o near-term protabili
and so on.
Businessu ncertainties: Some uncertainties in the
companys uture could lead to substantial losses,
which could in turn prevent the company rom
remaining a going concern. These can include a
possible merger that seems likely to all through ora major deal with a shady supplier. I an uncertainty
merits inclusion in an auditors opinion, its likely a
major threat to the companys uture.
Questionableaccountingpractices: When
signicant dierences arise between the way audit
and company management handle the accounting
o a major item, such as a sizeable business deal,
the auditors will mention the discrepancy in their
statement. This qualication can signal unscrupulo
management behavior and may be a major red fag
Auditors may also issue qualied opinions i theyre un
to obtain the inormation or resources they need in ord
issue an unqualied opinion. For example, i the com
withholds inormation rom the auditors, the auditors
issue a qualied opinion even i the available nancial
is veriable and accurate.
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How to Read a Balance Sheethe balance sheet is a summary o a companys current nancial standing based on assets,
abilities, and equity.
Assets: Cash, items owned by the company, and money owed to the company by
other parties
Liabilities: Any debt owed to people or organizations outside the company, including
bank loans, wages, and ees owed to suppliers
Equity: Total assets plus retained earnings (prots generated by the company that
were reinvested into the company) minus total liabilitiesalso reerred to as owners
equity or shareholder equity
he most undamental equation that investors use to evaluate a companys nancial health
called the balance equation or accounting equation:
liabilities + equity = assets
vestors reer to the balance sheet to nd the three components o this equation and see
ow they relate. Investors tend to avor companies whose assets exceed their liabilities,
aking their equity value positive.
As a company grows and its assets increase, its liabilities and equity tend to increase as
ell. For example, or a company to build a new actory, it must either reduce current assets
r increase liabilities and/or equity. Namely, it must do at least one o the ollowing:
Useexistingassets: By spending cash or liquidating an asset (converting it to cash,
usually by selling)Acquirealiability: By taking out a loan rom bank or some other lender
Takeonmoreequity:Typically by soliciting urther investment rom the companys
current shareholders or by oering stock or sale to the public
A Sample Balance Sheethis sample includes the most important line items, or specic elds, youll nd on most
ompanies balance sheets. The remainder o this section explains how to read and analyze
he line items. Please note that on nancial statements, parentheses indicate entries with
egative values.
ypes o Assetss you can see on the sam-
e balance sheet, compa-
es have two main types
assets:
Currentassets: Any
assets that are cash or
can be converted into
cash within a year
Long-termassets:
Assets (such as
buildings or land) that
require more than a year
to convert to cash
urrent Assets
ay close attention to cur-
ent assets, as they und
he companys day-to-day
perations, short-term debt
xplained below), interest
ayments, and dividends.
a companys current as-
ets all short, unds must
e raised either through
orrowing (taking on more
ability) or seeking addi-
onal investment (taking
n more equity). The most
ommonly reported current
sset categories included on
alance sheets are:
Cashandcashequivalents: The cash in a companys checking and savings accounts,
plus any other assets that can be converted to cash almost immediately. Assets with
maturities shorter than 90 days, such as short-term bonds and certicates o deposit
(CDs), also all into this category. Investors look or companies whose current assets
are composed mainly o cash and cash equivalents, as these give the company the
highest degree o security and fexibility i it needs to acquire more assets or reduce
liabilities (by paying down a loan) or equity (by buying back its own shares).
Accountsreceivable: Money that customers owe the company or products or
services theyve already received. Investors compare a companys accounts receivab
amounts over several quarters to assess how eective the company is at collecting
money its owed. I the total accounts receivable increase each quarter, but the cash
balance remains the same or decreases, investors might be wary o investing in the
company because its ailing to collect on money owed.
Short-terminvestments: Stocks, bonds, CDs, and other investments that the
company can convert to cash within the next 12 months (not including cash
equivalents). Investors consider short-term investments second only to cash and cas
equivalents since theyre easily liquidated, or converted to cash, in the near term.
Short-term investments are also reerred to as marketable securities.
Inventory: Saleable products the company owns. Inventory on the balance sheet is
valued at its cost to the company, not the price at which the company hopes to sell t
product. Investors dont value inventory as avorably as short-term investments and
cash, as its never certain that the company can convert its inventory to cash by selli
it at a prot in the marketplace.
Long-Term Assets
Though long-term assets are dened as assets convertible to cash ater periods o one ye
or more, companies rarely hold these assets with the intention o converting them to ca
Two types o long-term assets appear m ost oten on corporate balance sheets:
Fixedassets: All o the land, buildings, urniture, and machinery that the company
owns. Rather than speciy an assets current value, balance sheets show the original
cost o the asset minus depreciationthe amount o an assets original value lostover time due to use or some other cause. I the asset has increased in value, or not
depreciated, the balance sheet includes the original value only. For instance, the
company on the sample balance sheet owns a building it bought or $300,00 0. I the
buildings current value is $1 million due to price appreciation in the real estate marke
the company holds a hidden asset worth $700,000 more than the amount in the
balance sheet. Investors dont pay much attention to the current value o xed asset
because companies rarely convert these assets to cash. But its worth noting the
current value o xed assets, because at times the assets may be sold or reorganize
Intangibleassets: Nonphysical long-term assets, rights, and licenses that the
company owns or controls. A common intangible asset is goodwill, which puts
an approximate dollar value on a companys overall brand, longevity, and esteem.
Investors tend to value intangible assets only in terms o the price a company might
command in an acquisition, when the acquiring company would have to compensate
the company or the intangible assets, such as goodwill, that it has built up over time
Types o LiabilitiesBeore deciding to invest in a company, its crucial to know how the companys assets copare to its liabilities. I a companys liabilities threaten to consume most or all o its asse
the company aces the prospect o bankruptcy, which typically causes stock prices to plu
met. Like assets, liabilities are typically classied as current or long-term.
Current Liabilities
Current liabilities are debts that a company must pay during the next 12 months. Investo
pay particularly close attention to current liabilities because these debts usually are p
with current assets, which must be either cash or be easily convertible to cash within
months. I a company cant pay down current liabilities with cash, it will have to take o
loans, raise more equity, or go bankrupt. The most common current liabilities include:
Short-termdebt: Lines o credit used to pay current liabilities. Since these loans car
high interest-rate charges, investors tend to avor companies with low short-term de
A high amount o short-term debt can indicate that the company cant secure long-
term debt (at lower rates) to meet its cash needs. Short-term debt is also reerred to
notes payable.
Accountspayable : Fees the company owes or services, supplies, and so on. A quic
(though not conclusive) way to gauge a companys nancial health is to compare its
accounts payable to its accounts receivable amountsthe latter should be higher.
Accruedexpenses: Expenses or bills not part o accounts payable, such as operat
expenses, which can include advertising, payroll, utilities, or taxes.
Currentportionoflong-termdebt: Portions o long-term debt, such as mor tgages
that must be paid within the next 12 months. These are classied as current liabilities
Long-Term Liabili ties
Long-term liabilities are long-term loans, such as mortgages, loans used to buy machine
or equipment, or bonds, which must be repaid at some point more than 12 months ro
the current date. Long-term liabilities typically dont concern investors as much as sho
term liabilities because they dont pose an immediate bankruptcy threat. Investors wit
long-term view, however, tend to be wary o companies with signicant long-term liabilit
because these debts can cause big problems down the road.
a sample balance sheet
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Equity (a.k.a. Owners Equity or Shareholders Equity)The equity section details the claims that shareholders have on a companys assets. A
companys equity is equal to its total assets minus its total liabilities. Investors tend to avor
companies with positive equity numbers, which means the companys assets total more
than its liabilities. The t wo components o equity are stock and retained earnings.
Stock
Each share ostock that the company has sold to the public is valued on the balance sheet
at its initial offering price, not at its current market value. Since gains and losses in the com-
panys share price impact the shareholders, not the company, dont interpret a companys
share price fuctuations as proo that the company is making or losing money.
Retained Earnings
Prots not paid out to shareholders as dividends at the end o the year are classied as
retained earnings. Many businesses, especially younger companies, orgo dividends and
reinvest prots to und new product launches and other business expansion. Investors must
thereore consider the context o a companys decision to retain earnings. A companys
decision not to pay dividends isnt necessarily a sign that the company cant afford to pay
dividendsthe company may simply want to invest its prots in new opportunities.
How to Read an Income StatementThe income statement shows a companys overall nancial results, including prots, loss-
es, and expenses, during a particular period. The income statement has our key parts :
Revenue: Money the company received rom sales o its products, goods, or services
to its customersalso called sales or gross incomeCostofgoodssold: Costs incurred to make or purchase the goods or services that
the company sells to customersalso c alled cost o sales
Grossprot: The net dierence between sales and cost o sales or a period. I sales
are greater than cost o sales, the company has earned a gross prot. Gross prot is
calculated beore expenses, such as taxes, are taken into account. These prots are
also called earnings. Gross prot minus operating expenses, such as utilities and
supplies, is called operating income or operating prot.
Expenses: The amount the company spent on costs related to operating the business.
These may include administration, marketing, payroll, and so on
Netprot: A companys total revenue minus total expensesalso called net income,
net earnings, or the bottom line
A Sample Income StatementThe example below shows the specic line items included on most income statements. The
remainder o this section explains all o the line items included in this example.
RevenueThe point at which a company considers its revenue earned, called revenue recognition,
can vary greatly bet ween companies. Its critical that you know how a company recognizes
revenue beore deciding to buy its stock because manipulative revenue recognition is one
o most common ways executives can window-dress company earnings. In particular,
manipulating revenue recognition can help:
Infate the prots a company actually achieves in order to appease investors
Reduce the revenues a company claims to have made in order to lower its tax burden
Investors tend to avor companies that recognize revenue when they actually get paid
not when they close a deal or simply book the revenue based on expected uture
The income statement alone wont tell you how the company recognizes revenue: lo
that inormation in the notes that accompany the nancial statements. I you cant
call the companys investor relations department and ask them directly.
Cost o Goods Sold (Cost o Sales)Companies dont oten include a detailed breakdown ocost o goods sold (COGS) in
income statement. Typically, though, the category includes the ollowing costs:
Rawgoods: The cost o buying supplies and raw materials required to make the
companys products or to acilitate oering its services
Labor: The cost o the workers the company used to produce its products or serv
(this gure does notinclude payroll wages paid to the companys regular sta )
Inventory: The cost o all products the company has produced but not yet sold
For a company to be protable, its COGS must be signicantly less than its total rev
as that revenue must cover not only COGS but also the companys various other exp
as well.
Gross ProftGross prot shows the dierence between the amount a company paid to manuactu
products and the amount it received or selling those products. Gross prot gives inv
a sense o whether a company is selling enough products or services to cover its COG
gross prot alone doesnt indicate denitively whether a company is covering its COGS
doesnt take into account all the companys expenses. The ormula or gross prot is
revenue (sales) COGS = gross prot
Generally speaking, investors may be inclined to avoid buying stocks o companie
negative gross prot, as a negative number can signal a lack o demand or the comp
goods or services, problems with product pricing, or other serious issues.
EBITDA
In addition to gross prot, income statements also oten include a line item called EB
which stands or earnings beore interest, taxes, depreciation, or amortization (the gr
paying o o a liability, such as a mortgage). Investors use EBITDA as a star ting point to
pare companies because only EBITDA shows the protability o a company based e
sively on its operations. Even so, EBITDA cannot be considered denitive, as interest,
depreciation, and amortization c an dramatically reduce net prots, which matter mo
Expenses
Companies have various types o expenses, each o which typically appears in a spplace on the income statement. For example, operating expenses typically appea
deduction rom the gross prot line on the income statement. The our most common
o expenses are:
Expense Description LocationonStatem
Operating Administration, advertising, research
and development (R&D), royalties,
sales, and so on
Gross prot section
Interest Interest paid on loans and other debts EBITDA section
Depreciation Depreciation on buildings, equipment,
and other property
Gross prot or EBITDA
section
Taxes Tota l amount company paid in taxes EBITDA section
Net ProftThe net prot is called the bottom line or good reason: its typically the last line ite
an income statement. Its also the line item that arguably matters most because it
sents whether the company has made money ater all expenses have been subtracted
the total amount o revenue. Companies with negative net prot numbers have incu
loss. Though investors sometimes buy the stocks o companies with no net prots, o
losses, this type o speculation can be risky and is not appropriate or all investors. A
conservative strategy or beginning investors is to invest in companies that have had
sistent positive net prots over an extended period o timeve years or more.
How to Read a Cash Flow StatementThe cash fow statement shows investors the details about the cash that the com
currently has on its balance sheet. More specically, it indicates the sources o cash
ing into the company and the recipients o cash fowing out o the company. The cas
statement is divided into sections based on three dierent types o cash transac
operating activities, investing activities, and nancing activities.
a sample income statement
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A Sample Cash Flow StatementThis sample includes the specic
ine items youll nd on most
companies balance sheets.
The remainder o this section
explains each item in detail.
Operating ActivitiesThis section o the cash fow
statement provides a summary
o cash transactions resulting
rom the companys day-to-day
operations. Here, the term day-
to-day operations reers to all
the companys regular business
activities, including paying its
sta, paying or supplies, and
producing, marketing, and sell-
ng products or services. This
section includes depreciation
by adding it back to income.
Depreciation is a noncash ex-
pense, so it doesnt represent
any actual cash fow out o the
company and is merely an ac-
counting expense.)
Investors examine this parto the cash fow statement to determine whether a company generates enough cash based
on day-to-day operations to cover its expenses. I the company ails to generate enough
cash rom operations, it will have to rely on investing or nancing activities. Investors may
avoid investing in a company in this situation because that company isnt making enough
money on its own to support itsel.
Investing ActivitiesThis section summarizes the companys capital expenditures, or the investments that the
company has made with cash. These expenses typically involve:
Paying or mergers and acquisitions (joining orces with or buying another company)
Purchasing marketable securities (stocks or bonds)
Purchasing buildings, land, or equipment
Repairing and improving existing buildings, actories, or equipment
nvestors examine this section o the cash fow statement to assess whether the companys spending its cash wisely. Investors tend to be particularly wary o expenditures, such as
the purchase o a residence or a company executive, that dont seem likely to contribute
to the companys net prots. Companies typically bury the explanation or large capital ex-
penditures that dont relate directly to the companys business in the notes that accompany
the companys nancial statements.
Financing ActivitiesThis section covers cash on the balance sheet used to und nancing activities that involve
debts, dividend payments, or the companys issuance or purchase o its own s tock. Inves-
tors look or the ollowing specic activities in this section o the cash fow statement:
Stockbuybacks: Companies buy back shares o their own stock when they believe
the stock is undervalued or, less requently, i they need stock to meet internal
obligations, such as stock option grants. Investors typically view stock buybacks as
a avorable sign that a company believes in its own uture enough to bank on it. In
addition, stock buybacks reduce the number oshares outstanding, which investors
oten see as a avorable move.
Dividendcutsorincreases: Companies have the option to increase or decrease the
dividend payments they oer to shareholders. For companies that do issue dividends,
investors tend to view dividend increases as a sign o a companys strength and
dividend cuts as a sign o nancial problems.
Debt: Companies can pay down existing debt or take on new debt to und operations
or capital expenditures. Investors typically consider a companys decision to pay down
debt as a sign o nancial strength. How investors view the decision to take on more
debt depends on the amount and the purpose o the debt. I investors consider the
debt excessive or unnecessary, the companys stock may all out o avor.
Change in Cash and Cash EquivalentsThe nal section expresses the companys net cash position. A positive number indicates
positive cash fow, which means the company took in more money than it spent. A negative
number indicates negative cash fow, which means the company spent more than it took
n. The nal number equals the sum o total operating, investing, and nancing activities.
How to Assess ProftabilityTo try to determine whether a companys stock is worth its current share price, inves
use a variety oratios. These ratios help put a companys protability in context by com
ing the company to its peers in the same industry. For example, i you know the Coca-C
Company is protable, you also need to know how its protability compares to that o o
beverage companies, such as PepsiCo Inc. and Cadbury Schweppes PLC. Among the m
popular ratios and statistics investors use to analyze protability are the price/earn
ratio, the return on sales ratio, the payout ratio, and various prot margins.
Price/Earnings Ratio (P/E Ratio)The P/E ratio divides the companys share price by its earnings per share (EPS) , or the t
earnings divided by the total number oshares outstanding (shares held by investors)
market value per share o stock / EPS = P/E
A company with a share price o $20 per share and an EPS o $2 has a P/E o 10.
Using the P/E Ratio
Though the average P/E ratio or all stocks historically alls between 15 and 25, the sig
cance o the ratio depends on the companys particular industry and on overall econo
conditions at a given time. For example:
A P/E o 30 may be typical in the tech industry because investors tend to pay more
or the shares o tech companies with high growth prospects, giving those s tocks h
prices relative to their earnings.
A P/E o 5 may be typical in the shipping industry because growth rates are muchslower than in the tech industry.
One eective way to get a sense o whether a tech or shipping company oers good va
or example, is to compare its P/E to that o its direct competitors or, better yet, to the a
age P/E ratio o the entire industry. One way to nd out an industrys average P/E is by us
the Yahoo! Finance Industry Browser, at biz.yahoo.com/ic.
Return on Sales Ratio (ROS)The return on sales (ROS) ratio is used as a measure o a companys operational ecie
By analyzing the income statement numbers using ROS, you can gauge how much p
a company brings in or every dollar o sales it makes. Tocalculate ROS, consult the c
panys income statement to nd its net prot and the total amount the company pai
taxes. Add the amount the company paid in taxes to total net prots and divide the re
by sales (revenue) to get the ROS:
net prot beore taxes / sales = ROS
Using the ROS Ratio
As with the P/E ratio, the best way to get a sense o the signicance o a companys ROS i
compare the ROS to that o direct competitors or to the average ROS o the entire indus
When comparing two companies in the same industry, the company with the higher
number has a higher degree o operational eciency.
Payout RatioThe payout ratio measures the percentage o earnings that a company distributes to sh
holders as cash dividends. To calculate the payout ratio, consult the income statemen
nd the total amount the company spent on cash dividends, then divide by net prots.
cash dividends / net prots = payout ratio
Using the Payout Ratio
The payout ratio can help investors asses s how a companys dividend payouts compar
other companies in the same industry. Investors use this inormation to assess a compa
protability and overall nancial well-being. For example, i two companies in the sa
industry have vastly dierent payout ratios, investors might be wary o the company w
the lower ratio. More specically, they would investigate why that company has cho
to retain the cash that other companies in the industry pay out to investors as dividen
Unless they uncover a good reason or the discrepancysuch as signicant capital exp
ditures that will boost the companys uture protsthey might suspect that the compa
protability is too low to cover expenses and dividend payments together. Like all nan
statistics, the payout ratio alone doesnt suce as support or investment decisions. It m
always be considered in the context o the companys other core undamentals.
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Proft MarginsA prot margin expresses, as a percentage, the dierence
between what a company pays or a product or service and
what it receives or selling that product or service. A com-
panys overall prot margin is equal to its net prot divided
by its sales during a specic period o time. Though the over-
all prot margin gives a sense o how eciently a company
converts sales into prots, investors use the ollowing three
more ocused versions o the prot margin to evaluate a
companys protability: the gross margin, operating margin,
and net margin.
Gross Margin
The gross margin is a prot margin based only on sales and
the cost o producing those sales. It divides gross prot by
net sales (total sales, or revenues, minus expenses related
to returns or discounts, i any):
gross prot / net sales = gross margin
nvestors use gross margin to assess a companys eciency
n producing and distributing its products or services. A ter
determining the gross margin, compare it to that o other
companies in the same industry. A higher gross margin
ndicates a greater degree o eciency.
Operating MarginThe operating margin helps investors evaluate how well a
company controls costs by actoring in expenses, such as
distribution and R&D, notdirectly related to the production
and sales o a product. To calculate operating margin:
operating prot / net sales = operating margin
Companies with an operating margin above the industry
average are typically better at controlling their cost o sales
and operating expenses, which gives them advantages such
as pricing fexibility during dicult economic times.
Net Margin
The net margin measures a companys overall eective-
ness at realizing net prots rom sales. To calculate net
margin, divide net prot by net sales or revenues:
net prot / net sales (revenues) = net margin
Net margin is helpul in comparing companies within the
same industry (the higher the margin, the better) and in
assessing a companys protability year to year. Companies
that maintain high net margins relative to the competition
over a period o a years arent just luckytheyre consis-
tently more eective at generating prots rom sales.
How to Assess LiquidityA companys liquidity reers to how much cash a company
has and how easily the companys other current assets
can be converted to cash. Investors consider other liquid-
ty crucial to a companys nancial well-being because
companies must have cash or highly liquid assets to pay
debts. Companies that own mostly illiquid assets, such as
actories, may have to take out loans or sell more stock to
raise unds and pay their bills quickly. Investors use three
ratios to assess liquidity: the current ratio, the quick ratio,
and the debt-to-capital ratio.
Current RatioA companys current ratio divides current assets by cur-
rent liabilities:
current assets / current liabilities = current ratio
Using the Current Ratio
To cover current liabilities, a company must have a current
ratio o at least 1.0. Though the standard varies by industry,
most investors look or a current ratio o at least 1.5, pre-
erably higher. Some investors, however, believe that the
current ratio doesnt accurately predict a companys ability
to pay debts because it includes assets, such as inventory,
that may be dicult to convert to cash.
Quick RatioThe quick ratio solves some o the problematic aspects o
the current ratio by actoring in only quick assetsassets
that can be quickly converted into cash (typically within 90
days). To calculate the quick ratio, consult the companys
balance sheet to nd the total quick assets (cash plus
accounts receivable), then divide by total current liabilities:
quick assets / total current liabilities = quick ratio
Using the Quick Ratio
Investors generally look or companies whose quick ratios
exceed 1.0. Typically, investors tolerate a quick ratio under
1.0 only rom companies in the retail industry because re-
tailers tend to have most o their current assets tied up in
inventory, which the quick ratio ignores.
Debt-to-Capital RatioThe debt-to-capital ratio measures the portion o a com-
panys capital that comes rom debt nancing. In this case,
capital reers to the companys total debts (liabilities) plusits equity, both o which you can nd on the balance sheet.
To calculate the debt-to-capital ratio:
Find the companys total debt (current liabilities + long-1.
term liabilities).
Find the companys capital (total debt + equity).2.
Divide total debt by capital.3.
Using the Debt-to-Capital Ratio
Investors avor companies with debt-to-capital ratios o
0.351.00. Ideally, the ratio should stay below 0.50. Compa-
nies with debt-to-capital ratios above 0.50 tend to have to
pay higher interest rates on loans because lenders consider
them to be riskier borrowers than companies with more
avorable debt-to-capital ratios. Dierent industries have
dierent standards or debt-to-capital ratios, so investorsgenerally consider a company in the context o its competi-
tors ratios.
How to Assess SolvencySolvency reers to a companys ability to pay its xed
long- and short-term liabilities, such as mortgage pay-
ments and utility bills. Investors use three ratios to assess
solvency: the cash debt coverage ratio, current cash debt
coverage ratio, and cash fow coverage ratio. All the data
needed to calculate these ratios appears in the cash fow
statement.
Cash Debt Coverage RatioThe cash debt coverage ratio measures a companys ability
to repay its liabilities using cash generated rom day-to-day
operations. To calculate the cash debt coverage ratio:
(cash rom operating activities dividend payments) /
total liabilities = cash debt coverage ratio
Using the Cash Debt Coverage Ratio
The cash debt coverage ratio looks at a companys ability
to pay all o its debts. A negative number indicates that
the company could become insolvent, or unable to pay
its debts.
Current Cash Debt Coverage RatioThe current cash debt coverage ratio helps investors
assess a companys ability to repay its short-term debts.
The ormula or the current cash debt coverage ratio is:
cash rom operating activities / average current liabilitie
current cash debt coverage ratio
Average current liabilities, which is required in the orm
above, is calculated as ollows:
average current liabilities = (current liabilities rom this y
+ current liabilities rom previous year) / 2
Using the Current Cash Debt Coverage Ratio
As with the cash debt coverage ratio, investors look
companies with high current cash debt coverage ratios r
tive to their competitors.
Cash Flow Coverage RatioThe cash fow coverage ratio helps investors ass
whether a company generates enough cash to cove
capital expenditures, pay its stock dividends, and pay
debts. To calculate the cash fow coverage ratio:
Calculate the companys cash requirements. To do s1.
add the ollowing together:
Capital expendituresA.
Cash dividends paidB.
Current portion o long-term debtC.
Interest expensesD.
Then calculate the cash fow coverage ratio. This is2.calculated as:
cash romoperating activities / cash requirements
Using the Cash Flow Coverage Ratio
The higher the cash fow coverage ratio, the better. A r
greater than 1.0 indicates that a company generates m
than enough cash to und capital expenditures, dividen
and debts.
Summary o Formulas in this GuidThe table below summarizes this guides important orm
or reading nancial reports.
Description FormulaTotal assets liabilities + equity
Total liabilities assets equity
Total equity assets liabilities
Gross prot revenue COGS
P/E ratio share price / EPS
ROS ratio net pretax income / revenue
Payout ratio cash dividends / net income
Gross margin gross prot / net revenue
Operating
margin
operating prot / net revenue
Net margin net prot / net sales or revenues
Current ratio current assets / current liabilities
Quick ratio quick assets / current liabilities
Debt-to-capital
ratio
total debt / capital
Cash debt
coverage ratio
(cash rom operating activities
dividend payments) / total liabilities
Cash current
debt coverage
ratio
cash rom operating activities /
average current liabilities
Average
current
liabilities
(current liabilities rom this year + c
rent liabilities rom previous year) /
Cash fow
coverage ratio
cash rom operating activities /
cash requirements