Graham Witcomb, Analyst at Intelligent Investor
How to read financial statements for investing?
Start by asking yourself what it is that you’re trying to achieve. Every annual report should be read with a mission in mind.
If you’re coming to the company for the first time, it might be worth skipping the income statement and balance sheet until you have a firm idea of what the company actually does. You can find this information on the company website, and the ‘operating segments’ section usually gives a quick explanation of each division. Until you can explain to a 10-year old how a company makes money, the numbers are meaningless.
If it passes the ‘simple business’ test, it’s time to figure out how the company is doing. But before you open the first page, make a few notes of what you expect to see.
If you’re dealing with an infrastructure asset that you expect to earn stable, recurring revenues – and it doesn’t – ask why the business isn’t as consistent as you thought. If you’re looking at a manufacturer, and its margins are over 20%, ask why customers are willing to pay a premium for its product? It’s often the anomalies when it comes to returns on capital and margins that show off competitive advantages.
So, what are the most important numbers when reading a report?
Ratios and numbers can mean different things depending on the industry, so there are no set rules. Ratios are often used best when comparing an company to it’s peers and to the benchmark of an industry.
There are, however, two figures that are important to monitor no matter what business you’re looking at. The first is the borrowings detailed on the balance sheet. Often they’ll be called something else (e.g ‘Interest-bearing liabilities’) and often they’ll be split between current (due within a year) liabilities and long term. If you’re feeling generous you might deduct any cash the company holds (in current assets) – presuming that it could use the cash to pay back the debt. If the ‘net debt’ figure that results is large in relation to the company’s net assets (or shareholders’ equity) then it may be a red flag. Companies with net debt-to-equity ratios above 50% or interest coverage ratios below 5.0 are more likely to get into trouble in times of crisis, so the less debt the better.
The second thing you need to know is whether profits are turning into cash, which can be used to grow the business or be distributed to shareholders as dividends and share buybacks. If free cash flow consistently trails net profit, it may be a sign that this is a low-quality, capital-intensive business.
Don’t stop at this year’s annual report. Ultimately what you want to figure out is how the business has performed over time and where it will be in five or 10 years. Download the annual report from a few years ago and compare the ratios to today – are margins widening or shrinking, is debt going up or down?
Take home message
No matter which company you’re looking at, or how glossy the numbers, you have to ask the question: ‘is management acting in my best interests?’
You may want to look for a high level of insider ownership under the ‘director interests’ and ‘key management personnel disclosures’. Executive compensation based on earnings per share growth, not net profit, is also a big one.
Though more subjective, also keep any eye out for overly promotional language scattered throughout the report, which might suggest that management is trying to mislead you. Phrases like ‘exponential growth opportunity’ and ‘you can’t make this stuff up’ should ring alarm bells.
Reading an annual report isn’t about plugging numbers into your calculator or checking that net profit rose this year. You’re not sitting down to read a novel – it’s a good idea to arm yourself with a pen and paper, and write down follow-up questions as you go. If you owned this business in its entirety, what would you want to ask the manager running it for you?
About Graham Whitcomb
Graham has a degree in Psychology from the University of Sydney and is a Chartered Financial Analyst (CFA) charterholder. He previously worked for one of the world’s most successful professional gamblers and joined the research team at Intelligent Investor in early 2013 after spending several years in Canada completing the Chartered Financial Analyst program.