Reading Financial Reports For Dummies
If you’re looking at a business with an interest in investing in it, you need to read its financial reports. Of course, when it comes to the annual report, you don’t need to read everything, just the key parts. Combining the annual report with some of the financial reports a corporation files with the Securities and Exchange Commission (SEC) can help you figure profitability and liquidity ratios and get a better sense of cash flow.
Key Parts of an Annual Report
Reading a corporation's financial report is never the easiest thing to do, and annual reports can be especially daunting. You may be relieved to know that you don’t actually need to scour every page. The following parts best serve to give you the big picture:
Auditor’s report: Tells you whether the numbers are accurate and whether you should have any concerns about the future operation of the business
Financial statements: The balance sheet, the income statement, and the statement of cash flows; where you find the actual financial results for the year
Notes to the financial statements: Details about potential problems with the numbers or how the numbers were derived
Management’s discussion and analysis: The higher-ups’ breakdown of the financial results and other factors that impact the company’s operations
The rest is fluff.
Key Securities and Exchange Commission Reports
If you read financial reports on a regular basis, you know that the reports an organization files with the government are more extensive than the glossy reports it sends to shareholders. Although many different types of forms must be filed with the Securities and Exchange Commission (SEC), you can get most of the juicy information from just a few:
10-K: Annual report that provides a comprehensive overview of the corporation’s business
10-Q: Quarterly report that describes key financial information about the prior three months
8-K: Shows any major events that could impact the financial position of the company
Forms 3 to 5: Reflect changes in ownership of stock by directors, officers, and major stockholders, giving you an idea of the view from the inside
Reading Financial Reports for Profitability Ratios
You read financial reports to get a sense of a company’s financial position and how viable it is in the marketplace. You can test a company’s money-making prowess by using the following important formulas:
Price/earnings ratio compares the price of a stock to its earnings. A ratio of 10 means that for every $1 in company earnings per share, people are willing to pay $10 per share to buy the stock.
Price/earnings ratio = Market value per share of stock ÷ Earnings per share of stock
Dividend payout ratio shows the amount of a company’s earnings that are paid out to investors. Use it to determine the actual cash return you get by buying and holding a share of stock.
Dividend payout ratio = Yearly dividend per share ÷ Earnings per share
Return on sales tests how efficiently a company is running its operations by measuring the profit produced per dollar of sales.
Return on sales = Net income before taxes ÷ Sales
Return on assets shows you how well a company uses its assets. A high return on assets usually means the company is managing its assets well.
Return on assets = Net income ÷ Total assets
Return on equity measures how well a company earns money for its investors.
Return on equity = Net income ÷ Shareholders’ equity
The gross margin gives you a picture of how much revenue is left after all the direct costs of producing and selling the product have been subtracted.
Gross margin = Gross profit ÷ Net sales or revenues
The operating margin looks at how well a company controls costs, factoring in any expenses not directly related to the production and sales of a particular product.
Operating margin = Operating profit ÷ Net sales or revenues
Reading Financial Reports for Liquidity Ratios
If a company doesn’t have cash on hand to cover its day-to-day operations, it’s probably on shaky ground. As you read the financial report, use the following formulas to find out whether a company has plenty of liquid (easily converted to cash) assets.
Current ratio gives you a good idea of whether a company will be able to pay any bills due over the next 12 months with assets it has on hand.
Current ratio = Current assets ÷ Current liabilities
Quick ratio or acid test ratio shows a company’s ability to pay its bills using only cash on hand or cash already due from accounts receivable. It doesn’t include money anticipated from the sale of inventory and the collection of the money from those sales.
Quick ratio = Quick assets ÷ Current liabilities
Interest coverage ratio lets you know whether a company is bringing in enough money to pay interest on whatever outstanding debt it has.
Interest coverage ratio = EBITDA ÷ Interest expense
Reading Financial Reports for Cash Flow
You’re interested in a company, so you’re reading its financial reports. Part of the test of a viable operation is having enough cash to keep the company going. The following formulas give you various tests of a company’s cash position:
Free cash flow shows you how much money a company earns from its operations that can actually be put in a savings account for future use.
Free cash flow = Cash provided by operating activities – Capital expenditures – Cash dividends
Cash return on sales looks specifically at how much cash is being generated by sales.
Cash return on sales = Cash provided by operating activities ÷ Net sales
Current cash debt coverage ratio lets you know whether a company has enough cash to meet its short-term needs.
Current cash debt coverage ratio = Cash provided by operating activities ÷ Average current liabilities
Cash flow coverage ratio finds out whether a company has enough money to cover its bills and finance growth.
Cash flow coverage ratio = Cash flows from operating activities ÷ Cash requirements