Financial Statements: Conclusion
  1. Financial Statements: Introduction
  2. Financial Statements: Who's In Charge?
  3. Financial Statements: The System
  4. Financial Statements: Cash Flow
  5. Financial Statements: Earnings
  6. Financial Statements: Revenue
  7. Financial Statements: Working Capital
  8. Financial Statements: Long-Lived Assets
  9. Financial Statements: Long-Term Liabilities
  10. Financial Statements: Pension Plans
  11. Financial Statements: Conclusion

Financial Statements: Conclusion

By David Harper
(Contact David)

Let's summarize the ideas discussed throughout this tutorial according to a few major themes:

Let the Business Model Shape Your Focus Areas
The average 10-K annual report is stuffed with dozens of dense footnotes and adjusted numbers offered as alternatives to the recognized numbers contained in the body of the income statement and balance sheet. For example, companies often disclose six or eight versions of earnings per share, such as the "as reported," "adjusted," and "pro forma" versions for both basic and diluted EPS. But the average individual investor probably does not have the time to fully assimilate these documents.

Therefore, it may be wise to first look at industry dynamics and the corresponding company business model and let these guide your investigation. While all investors care about generic figures, such as revenue and EPS, each industry tends to emphasize certain metrics. And these metrics often lead or foreshadow the generic performance results.

The table below illustrates this idea by showing some of the focus areas of a few specific industries. For each industry, please keep in mind that the list of focus areas is only a "starter set"--it is hardly exhaustive. Also, in a few cases, the table gives key factors not found in the financial statements in order to highlight their shortcomings:

Selected Industries: Nature of Business Model: Selected Focus Areas:
Business Services (for example, temporary help, advertising and consulting.)
  • People are key assets.
  • Much of the company value is likely to be intangible (not on the balance sheet).
  • Revenue recognition.
  • Recurring sources of revenue (for example, long-term contracts).
  • Gross margin (1 – cost of goods as % of revenue) since it tells you about "pricing power" with customers.
Computer Hardware
  • Rapid price deflation (decrease in price-to-performance).
  • Rapid inventory turnover.
  • Rapid innovation and product obsolescence.
  • Revenue breakdown into no. of units x avg. price per unit (how many units are selling?).
  • Cash conversion cycle (days inventory + days receivable – days payable).
  • Quality of research and development (R&D) spending and joint ventures.
Consumer Goods
  • Brand value is critical.
  • Companies require efficient inventory because it is often perishable.
  • Industry sees relatively low margins.
  • Cash conversion cycle and inventory turnover.
  • Gross margin.
  • Operating margin (for example, EBIT or EBITDA margin).
  • Key factors not in statements: new product development and investment in the brand.
Industrial Goods (materials, heavy equipment)
  • Cyclical.
  • If commodities, then market sets price.
  • Heavy investment in long-term assets.
  • High fixed costs.
  • Long-term assets and depreciation methods.
  • Asset turnover (sales/assets) and asset utilization (for example, return on capital).
  • Key factors not in financial statements: market pricing trends and point in business cycle.
  • Economies of scale are typically important.
  • Requires significant investment.
  • Convergence is "blurring the line" between industries.
  • Revenue recognition, especially for subscriptions and advertising.
  • Free cash flow, especially for cable and publishing.
  • Pension plans as many companies are "old economy."
  • Key factors not in financial statements: regulatory environment and joint/ventures alliances.
Retail (for example, apparel or footwear)
  • Intense competition against fickle fashion trends.
  • Inventory management, which is critical.
  • Low margins.
  • Revenue breakdown in product lines and trends--one product can "make or break."
  • Cash conversion cycle.
  • Gross margin.
  • Operating margin - low employee turnover will keep this down.
  • High "up front" investment but high margins and high cash flow.
  • Complicated selling schemes (channels, product bundling, license arrangements).
  • Revenue recognition, which is absolutely essential in software industry.
  • Gross margin trends.
  • Stock option cost/dilution because, of all industries, software grants the most options.
  • High fixed investment (capital intensive).
  • Changing regulatory environment.
  • Long-term assets and depreciation.
  • Long-term debt (for instance, many companies are highly leveraged).

Cash Flows Help to Determine the Quality of Earnings
While some academic theories say that cash flows set stock prices, and some investors appear to be shifting their attention toward cash flows, can anyone deny that earnings (and EPS) move stocks? Some have cleverly resolved the cash flow-versus-earnings debate with the following argument: in the short run, earnings move stocks because they modify expectations about the long-term cash flows. Nevertheless, as long as other investors buy and sell stocks based on earnings, you should care about earnings. To put it another way, even if they are not a fundamental factor that determines the intrinsic value of a stock, earnings matter as a behavioral or phenomenal factor in impacting supply and demand.

Throughout this tutorial, we explore several examples of how current cash flows can say something about future earnings. These examples include the following:

Cash Flows That May Impact Future Earnings Why the Cash Flows May Be Predictive
Changes in operating accounts, which are found in the statement of cash flows, sometimes hint at future operational deterioration:
  • Increase in inventory as percentage of COGS/sales (or decrease in inventory turnover).
  • Unless company is stocking up ahead of anticipated demand, the increase in inventory could indicate a slackening demand.
  • Increase in receivables as percentage of sales (or decrease in receivables turnover).
  • Customers may be taking longer to pay; there may be an increase in collection problems.

  • Decrease in payables as percentage of COGS/sales (or decrease in payables turnover).
  • Company may be losing leverage with vendors.
If "cash collected from customers" grows less than revenues, there may be future revenue problems. Reported revenue may be getting a temporary (current) boost by end-of-year incentives.
If free cash flow to equity (FCFE) (which equals cash flow from operations minus cash flow from investments) is growing more than earnings, it may be a good sign. (Conversely, a FCFE that grows less than earnings may be a bad sign.) In the long-run, it is unlikely that divergence between the two can be sustained--eventually, earnings will probably converge with the cash flow trend.
The funded status of a pension plan, which equals the fair value of plan assets minus the projected benefit obligation (PBO), tends to impact future earnings. Unless trends reverse, under-funded (over-funded) pension plans will require greater (fewer) contributions in the future.

Red Flags Theme
The red flags emphasized in this tutorial stem from this single principle: the aim in analyzing financial statements is to isolate the fundamental operating performance of the business. In order to do this, you must remove two types of gains that may not be sustainable:
  1. Non-Recurring Gains - These include gains due to the sale of a business, one-time gains due to acquisitions, gains due to liquidation of older inventory (that is, liquidation of the LIFO layer), and temporary gains due to harvesting old fixed assets, where lack of new investment saves depreciation expense.
  2. Gains Due to Financing - These are important because, while they are real gains, they are often random variables that depend on market conditions and they may be reversed in future years.
The sources of financing gains include special one-time dividends or returns on investments, early retirement of debt, hedge or derivative investments, abnormally high pension plan returns (including an upward revision to expected return on plan assets, which automatically reduces pension cost) and increases to earnings or EPS simply due to a change in the capital structure. For example, an increase in EPS due to an equity-for-debt swap.

Green Flags Theme
In regard to green flags, the key principle as far as financial statements are concerned is that it is important to see conservative reporting practices. In regard to the two most popular financial statements, conservatism is implied by the following:
  1. In the Income Statement: Conservative revenue recognition is shown by things like no barter arrangements, no front-loaded recognition for long-term contracts, a sufficient allowance for doubtful accounts (that is, it is growing with sales), the choice of LIFO rather than FIFO inventory costing method and the expensing of rather than capitalizing of R&D expenditures.
  2. In the Balance Sheet: Conservative reporting practices include sufficient cash balances; modest use of derivative instruments that are deployed only to hedge specific risks such as interest rate or foreign currency exchange; a capital structure that is clean and understandable so those analyzing the statements don't have to sort through multiple layers of common stock, preferred stock and several complex debt instruments; and a debt burden that is manageable in size, not overly exposed to interest rate changes, and not overly burdened with covenants that jeopardize the common shareholders.
Final Note
This series is designed to help you spot red and green flags in your potential stock investments. Keep in mind the limitations of financial statements: they are backward-looking by definition, and you almost never want to dwell on a single statistic or metric.

Finally, U.S. accounting rules are always in flux. At any given time, the Financial Accounting Standards Board (FASB) is working on several accounting projects. You can see the status of the projects at their website. But even as rules change and tighten in their application, companies will continue to have plenty of choices in their accounting. So, if there is a single point to this tutorial, it is that you should not accept a single number, such as basic or diluted earnings per share (EPS), without looking "under the hood" at its constituent elements.

  1. Financial Statements: Introduction
  2. Financial Statements: Who's In Charge?
  3. Financial Statements: The System
  4. Financial Statements: Cash Flow
  5. Financial Statements: Earnings
  6. Financial Statements: Revenue
  7. Financial Statements: Working Capital
  8. Financial Statements: Long-Lived Assets
  9. Financial Statements: Long-Term Liabilities
  10. Financial Statements: Pension Plans
  11. Financial Statements: Conclusion
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