How to Read Financial Reports
You can compare reading a business’s financial report with shucking an oyster: You have to know what you’re doing and work to get at the meat. You need a good reason to pry into a financial report. The main reason to become informed about the financial performance and condition of a business is because you have a stake in the business.
The financial success or failure of the business makes a difference to you.
You don’t have to be a math wizard or rocket scientist to extract the essential points from a financial report, so don’t let a financial report bamboozle you. Locate the income statement, find bottom-line profit (or loss!), and get going.
Decide what to read and what to skip
Suppose you own stock shares in a public corporation and want to keep informed about its performance. You could depend on articles and news items in The Wall Street Journal, The New York Times, Barron’s, and so on that summarize the latest financial reports of the company.
And you can go to websites such as Yahoo! Finance. This saves you the time and trouble of reading the reports yourself. But suppose you want more financial information than you can get in news articles?
The annual financial reports of public companies contain lots of information: a letter from the chief executive, a highlights section, trend charts, financial statements, extensive footnotes to the financial statements, historical summaries, and a lot of propaganda. In contrast, the financial reports of most private companies are significantly smaller; they contain financial statements with footnotes, and not much more. So, how much of the report should you actually read?
Many public businesses send shareowners a condensed summary version in place of their much longer and more detailed annual financial reports. This is legal, as long as the business mentions that you can get its “real” financial report by asking for a hard copy or by going to its website.
The idea, of course, is to give shareowners an annual financial report that they can read and digest more quickly and easily. And, condensed financial summaries are more cost effective.
The scaled-down versions of annual financial reports are probably adequate for average stock investors, but they are not adequate for serious investors and professional investment managers. These investors and money managers should read the full-fledged financial report of the business, and also study the company’s annual 10-K report that is filed with the Securities and Exchange Commission (SEC). You can go to the website and navigate from there.
Judge profit performance
A business earns profit by making sales and by keeping expenses less than sales revenue, so the best place to start in analyzing profit performance is not the bottom line but the top line: sales revenue. Here are some questions to focus on:
How does sales revenue in the most recent year compare with the previous year? Higher sales should lead to higher profit, unless a company’s expenses increase at a higher rate than its sales revenue. If sales revenue is relatively flat from year to year, the business must focus on expense control to help profit, but a business can cut expenses only so far. The real key for improving profit is improving sales.
What is the gross margin ratio of the business (which equals gross profit divided by sales revenue)? Even a small slippage in its gross margin ratio can have disastrous consequences on the company’s bottom line. Stock analysts would like to know the margin of a business, which equals sales revenue minus all variable costs of sales (product cost and other variable costs of making sales). But external income statements do not reveal margin; businesses hold back this information from the outside world (or they don’t keep track of variable versus fixed expenses.)
Based on information from a company’s most recent income statement, how do gross margin and the company’s bottom line (net income, or net earnings) compare with its top line (sales revenue)? Take the time to compare these two ratios for a variety of businesses; you may be surprised at the variation from industry to industry.
One last point: Put a company’s profit performance in the context of general economic conditions. A down economy puts downward pressure on a company’s profit performance, and you should allow for this in your analysis (although this is easier said than done). In an up economy, a company should do better, of course, because a rising tide lifts all boats.
Tackle extraordinary gains and losses
Many income statements start out normally: sales revenue less the expenses of making sales and operating the business. But then there’s a jarring layer of extraordinary gains and losses on the way down to the final profit line. For example, a business may shut down and abandon one of its manufacturing plants and record a huge loss due to asset write-downs and severance compensation for employees who are laid off.
A business may suffer a large loss from an uninsured flood. Or a business may lose a major lawsuit and have to pay millions in damages. The list of extraordinary losses (and gains) is a long one. What’s a financial statement reader to do when a business reports such gains and losses?
There’s no easy answer to this question. You could blithely assume that these things happen to a business only once in a blue moon and should not disrupt the business’s ability to make profit on a sustainable basis.
This is the earthquake mentality approach: When there’s an earthquake, there’s a lot of damage, but most years have no serious tremors and go along as normal. Extraordinary gains and losses are supposed to be nonrecurring in nature and recorded infrequently, or one-time gains and losses. In actual practice, however, many businesses report these gains and losses on a regular and recurring basis — like having an earthquake every year or so.
Extraordinary losses are a particular problem because large amounts are moved out of the mainstream expenses of the business and treated as nonrecurring losses in its income statement, which means these amounts do not pass through the regular expense accounts of the business. Profit from continuing operations is reported at higher amounts than it would be if the so-called extraordinary losses were treated as regular operating expenses.
Unfortunately, CPA auditors tend to tolerate this abuse . . . well, up to a point. Investment managers complain in public about this practice. But in private they seem to prefer that businesses have the latitude to maximize their reported earnings from continuing operations by passing off some expenses as extraordinary losses.
Check cash flow beside profit
The objective of a business is not simply to make profit, but to generate cash flow from making profit as quickly as possible. Cash flow from making profit is the most important stream of cash inflow to a business. A business could sell off some assets to generate cash, and it can borrow money or get shareowners to put more money in the business. But cash flow from making profit is the spigot that should always be turned on.
The income statement does not report the cash inflows of sales and the cash outflows of expenses. Therefore, the bottom line of the income statement is not a cash flow number. The net cash flow from the profit-making activities of the business (its sales and expenses) is reported in the statement of cash flows. When you look there, you will undoubtedly discover that the cash flow from operating activities (the official term for cash flow from profit-making activities) is higher or lower than the bottom-line profit number in the income statement.