Analyzing a Financial Statement

Analyzing a Financial Statement

Every publicly traded company annually issues Form 10-K which contains their financial statement and considerable analytical data. 10-Ks are usually well written, clear, logical and informative. However, to really understand them I submit it would take a minimum of three days and upwards of a week for most of them, and considerably longer for some of the larger high market cap companies.

I know this because I am teaching an MBA course this semester in understanding, analyzing, interpreting and using financial statements and I have gone through over 75 10-Ks looking to glean data I could teach from. My class is also set up with almost each student using a different company’s report and I get at least fifteen responses for each topic covered.

While the teaching is made more interesting because of the range of issues, analyzing the statement as an investment would be much harder. For example difficulties are created because some companies have negative working capital or stockholders’ equity; lack inventory, property and equipment or deferred income taxes; no profits; unintelligible other comprehensive income or out of sight debt to equity ratios. Many of the companies’ segment data looks good, but is incomplete; some provide non-GAAP earnings, free cash flow from operations or EBITDA making it appear their net income is not really the right measure; some make payments for dividends and stock buybacks greater than what they earn leaving nothing to reinvest in their own growth; many have cash flow generating assets that are not valued at all on their financial statements but which values are somewhat reflected in their stock prices and market cap. Some well-known names have substantial cash hoards they brag about but they neglect to mention the long term debt they incurred to acquire that cash and while much of the cash is outside the United States, the debt is domestic.

Further the financial statements are lagging measures usually released more than two months after the year end. Investors use the data, or should use the data, to determine the sustainability of the company’s cash flow and the potential for growth. Using months’ old numbers seems to thwart that purpose. Also, while a decision to invest might be made it would have to be monitored on a regular basis to make sure there are no major changes in the initial assessment, and that too would be with using months’ old information. In addition to the company’s financial information as a source of information, many analysts issue their own investment reports which provide added insights; however many times the analysts contradict each other. Remember for every buyer thinking he is getting a bargain there is a seller thinking the stock maxed out. Also, you cannot be right all the time.

I am good at this stuff but I believe the time necessary to do a decent analysis is far too long for anyone to be able to construct a reasonable portfolio for themselves. A takeaway from what I have been doing for my class is to forget about buying individual stocks and sticking to mutual and index funds.

However, my students will be learning how to really get a good handle on the financial statements and the course will be capped off the last session with my “Seven Minute Financial Statement Analysis” technique. This is an easy method to determine if you should skip that company or go forward committing to the “3 days” of analysis. This gives a great start to grasping the essence of the statement, enabling the elimination of many companies from consideration, but by no means is a way to “bet” on winners.