8.1. How to Read Financial Statements?
A company’s financial statements are a quantitative picture of the company’s operating performance and financial position. They consist of three different statements: 1) the income statement, 2) the balance sheet and 3) the cash flow. The income statement shows how much money a company has made in a given time period (one full year for an annual income statement). The balance sheet shows financial position including all the items a company owns and all the debts it is obligated to pay. The cash flow statement shows cash coming into the company and cash going out of the company. This is important because it can differ from the income statement. It is also useful because it is more difficult to manipulate a cash flow statement through accounting methods only – actual cash flows would have to change to change a cash flow statement. Finally, at the end of this section, we discuss the Dupont Analysis and also say something about forecasting financial statements.

8.2. Income Statement

REVENUES
Revenues are the total sales that a company earns in a given period. This is the sum of the money which the company has earned selling its products and services during the period equivalent to the quantity of products and services multiplied by the average selling price of those products and services.

COST OF GOODS
Cost of goods are the total costs associated with providing the products and services which earned revenues during a given period. For a manufacturing company, this would encompass the costs of the raw materials and also the cost of the labor used to make its products. It would also include a depreciation charge for the plant and equipment used to make its products.

SG&A
SG&A stands for Selling, General and Administrative. This item encompasses all the other costs associated with providing a product or service that is not included in the costs of goods. These include costs associated with marketing a product, including advertising and the cost of salesmen. General overheads such as the costs associated with a central finance and accounting department and certain managerial functions are also part of SG&A.

GROSS MARGIN
A gross margin is calculated by taking gross profit (what is left after subtracting cost of goods from revenues) and dividing by revenues. Gross margins are usually expressed in percentage terms. A high gross margin indicates that a product or service can be sold for much more than it cost to produce, indicating a higher chance of overall profitability for the company.

OPERATING MARGIN
Operating margin is calculated by taking operating profit (gross profit less SG&A costs) and dividing by revenues. Operating margins are also usually expressed in percentage terms. An operating margin is probably an even more important statistic than gross margin as it is an indicator of core profitability of a business taking into account not only direct costs of producing a product or service but also the associated costs of managing the business and trying to get the product sold. Sometimes a company may have a high gross margin but a low operating margin because the costs associated with getting its products sold are too high. If operating margin is high, it is likely that the company is a good business.

NET MARGIN
Net margin is calculated by taking net profit (operating profit less all non-operating expenses) and dividing by revenues. Net margins are usually expressed in percentage terms. Net margin indicates the total accounting earnings of a company in a given time period (this can differ from cash earnings of a company as explained in more detail below). Oftentimes net margins can be distorted in a given year if there are unusual non-operating items. Restructuring charges can often reduce net profits from their normal levels in the years that such charges are taken. Unusual tax charges or credits can also alter the net margin picture. Net margins and operating margins are both important. However, interpreting net margins generally requires more work and care.

8.3. Balance Sheet

ASSETS
Assets represent all of the things that a company owns or is owed by others. These include property, plant and equipment. Also inventory, accounts receivables, cash and investments. Note that these assets can have loans on them (as property might) or be money owed to the company but not actually in the company’s possession (as accounts receivable are).

LIABILITIES
Liabilities are what a company owes others. This can include bank loans. Loans, in turn, can be mortgages (as on property) or they can also be more general lines of credit which a company uses to have more cash to conduct its business. Accounts payable, which is money owed to its suppliers for products and services already received, also count as liabilities.

EQUITY
Equity is what’s left over after subtracting liabilities from assets. This can be seen as a representation of the company’s net worth. If the accounting in a company is accurate, equity may be a good estimate of what a company’s owners could expect to receive for the company if the company ceased operation and was liquidated. Quite often, however, the equity account is not equivalent to this figure as some assets may not be listed at market value. This is due to the fact that accounting conventions do not always result in a company’s assets being recorded at the value they could really be sold at in the market. However, a high equity value relative to a company’s market value is usually a source of reassurance that a company’s valuation is reasonable (see the section on price/book value).

DEBT/EQUITY RATIO
The debt to equity ratio is the sum of all of a company’s bank loans divided by its equity. A debt/equity ratio usually does not include all of a company’s liabilities. It generally includes those liabilities that are used solely for financing purposes rather than arising as a course of the company doing business. This generally means both short and long-term bank loans are included. However, accounts payable are generally not included. A company’s debt/equity ratio can give an indication of how risky a company’s financial position is. A relatively higher debt/equity ratio (over 2X) may indicate that the company may have more difficulty servicing its debts if it goes through a bad patch. Sometimes debt can enhance the profitability of a business if the business can earn a higher return on money than it costs the business for that money in interest expense. However, too much debt may put the business at risk for insolvency or bankruptcy if it is unable to service the debt. Also, the nature of some businesses is to have a very high amount of debt (i.e. the utility industry).

NET DEBT/EQUITY RATIO
Sometimes a company may be holding a large amount of cash which distorts its debt/equity picture. As a result, the net debt/equity ratio is another measure which can be used to measure a company’s financial risk. Net debt is total debt less a company’s cash position. To be more useful, cash that is needed for the ongoing operations of the business should be excluded from the net debt calculation. However, in practice this is usually not done as operating cash needs are quite difficult to estimate. If a company simultaneously has a lot of debt and a lot of cash, its debt/equity and net debt/equity ratios may be quite different. In such a case, more analysis of the reasons for this variance are necessary. It is possible in such cases that a high debt/equity ratio does not signal a risky investment.

RETURN ON ASSETS
Return on assets (ROA) is net profit divided by total assets, usually expressed in percentage terms. This figure indicates how efficiently a company uses its assets. For a manufacturing firm, this may measure how efficiently the company can generate profits from its factories (property, plant and equipment). The higher the ROA, the better. ROA can also be seen as a measure of how capital intensive a business is. A low ROA combined with a large amount of assets usually indicates a business is capital intensive. In such cases, the company’s financing strategy becomes especially important.

RETURN ON EQUITY
Return on Equity (ROE) is net profit divided by total equity, usually expressed in percentage terms. This is a key figure in financial analysis. The difference between ROA and ROE is generally related to the capital structure of the company. A high debt/equity ratio will result in a larger gap between ROA and ROE. If the debt is financing high profitability business (or at least business that generates more than the interest expense associated with the debt), ROE is likely to be higher than ROA. The converse is also true. At any rate, a high ROE is the mark of a good business. It means that the original capital invested in the business by the owners of the business is able to generate a good return.

8.4. Cash Flow

DIFFERENT TYPES OF CASH FLOW
Cash flow statements are usually split into three sections which show operating, investing and financing cash flow. Operating cash flow is cash received or paid by a company in the course of its regular business during a specific time period. Operating cash flow items will usually have a correspondence to items in the company’s income statement. Investing cash flows are cash received or paid out by the company associated with investment items. These can be investments in publicly traded securities, investments in other companies or investments in assets such as property or factories. Oftentimes, investing cash flows will not have a corresponding item on a company’s income statement but the changes should show up on a company’s balance sheet. Financing cash flows shows money received or paid out by the company associated with its capitalization. These items can be related to debt payments or new debt. Dividend payments would show up here. Stock buybacks or the issuance of new stock would also show up here. Most of these items would be unlikely to show up on a company’s income statement (although interest payments would) but would show up on the balance sheet.

DIFFERENCES BETWEEN ACCOUNTING AND CASH EARNINGS
If one looks at a company’s income statement and its cash flow statement, it is highly unlikely that total income is equal to total cash received in a given period. This is partly due to the fact that a company receives or pays out money that is not directly related to its ongoing business. Investing and financing activities often fall into this category. Accounting conventions are also responsible for some of the differences.

Accounting conventions have been developed to accurately portray what a company has earned in a given time period. However, this portrayal often results in timing differences between when things are recorded on an accounting basis and when the money related to the accounting records is actually paid or received. For instance, revenues are often recorded in the income statement although a customer may not have paid yet. Accounting convention records revenues when a product is sold, not when the company is paid.

Depreciation charges, which are part of cost of goods sold, are another example of timing differences. Depreciation, from an accounting standpoint, records the cost of a long-term asset as the charge associated with using that asset for a given period. Thus, a company may build a new factory in the year 2000. It must pay for the entire factory when it is built. However, accounting conventions result in the cost of the factory being recorded in the income statement gradually over the whole life of the factory. Thus, a depreciation charge may show a charge of 1/20th of the cost of the factory each year until 2020. However, this depreciation charge would be a non-cash charge since the factory was already paid for. The cash flow statement would adjust for this.

EBITDA.
Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) is a simplified combination measure of a company’s operating profitability and cash flow. It can be seen as a way to standardize a short-hand representation of operating cash flow. Non-operating charges such as financing costs (interest) and taxes are excluded. At the same time, to more accurately portray cash earnings, rather than accounting earnings, depreciation and amortization charges are also excluded from the calculation. One way to calculate this figure would be to take operating earnings and add back depreciation and any amortization due to operating factors.

FREE CASH FLOW
Free cash flow (FCF) is a figure that is used to show the operating cash generated by a company that is available to be used in a discretionary way. Free cash flow starts from operating cash flow and subtracts those items necessary for the business to be run as an ongoing business entity, namely capital expenditures. A more standardized calculation for free cash flow would be net income plus amortization plus depreciation plus change in cash due to working capital changes less capital expenditures. Capital expenditures are included because this spending is necessary to keep a company’s equipment up-to-date – either for maintenance or for equipment renewal and capital expenditures are also necessary to allow the company to grow. What’s left over after capital expenditures is generally what can be used for other purposes – either dividend payments or perhaps debt payment if the company is to be re-capitalized.

8.5. Further Income Statement Analysis

DUPONT ANALYSIS
When analyzing a company’s financial statements, there are some techniques that can be used to glean extra information. The Du Pont analysis is one of these. It breaks down a company’s ROE into component parts so that the source of a company’s ROE can be more readily analyzed. The Du Pont analysis consists of the following formula:

ROE = net profits/equity
= (net profits/sales) × (sales/assets) × (assets/equity)
= profitability × capital efficiency × leverage

Thus, ROE is broken down into three component parts: net margin measures profitability, sales over assets measures capital efficiency and assets/equity measure the effect of leverage.

8.6. How to Forecast Earnings?
To forecast a company’s earnings in a detailed manner, you would build a financial model which forecasts each item in its income statement. Forecasting each line item would allow you to calculate a net profit figure for future years and this figure would be your earnings forecast. However, the time and effort required to forecast a full income statement is substantial. As a result, it might be helpful to develop more simple methods to forecast earnings.

One way to do this is to not forecast every line item. For instance, you could forecast revenues, operating margin and non-operating items. In a previous section on company analysis we described some of the things to take into account when forecasting revenues and company profitability. You could take these items into account to estimate revenue growth and changes in operating margin. With this, you can calculate an operating profit. You could then try to estimate taxes which the company would pay based on what it has paid in previous years (say the past five years), if taxes have been relatively stable. You could then look in previous years and see which non-operating items are likely to be repeated and which are one-off items. Those items that are likely to be repeated (such as interest expense) could then be taken into account and you can calculate a net profit figure by making the appropriate adjustments to your operating income forecast above.

If you have a serious interest in forecasting or in detailed financial analysis, it may make sense to invest time in learning how to use a spreadsheet program, such as Microsoft Excel. These programs are powerful and flexible but the time investment needed to get full use of the program could be quite substantial. You need to weigh the time and effort you are willing to put in to do more detailed financial analysis and/or forecasting against the benefit and enjoyment you would get out of it.