When gathering information about a company whose shares you are interested in, one of your first references should be the company's annual financial report, which includes its income statement, cash flow statement and balance sheet. This week, as part of our series on how to manage your money, we tell you what you should look for in these documents and how to read them.
Stock exchanges around the world require the companies that list on them to release audited financial results regularly. In the case of the JSE, companies have to publish both interim (half-year) and annual results.
All JSE-listed companies have to publish their financial results on the Securities Exchange News Service (also known as Sens) and post copies of their annual report to all shareholders.
Some companies also publish their results in business newspapers such as our sister newspaper, Business Report.
If you are considering investing in a company, you can obtain a copy of its latest annual report by asking the company's investor relations department to post you a copy. Most companies' annual reports are also available on their websites.
When you analyse financial statements, you should bear in mind that they contain historical information. They cannot predict future events, such as a downturn in the economy, that could affect the company's performance.
Annual reports usually consist of the chairman's report, the chief executive officer's report, the auditor's report, the income statement, the balance sheet and the cash flow statement.
The chairman's report and the chief executive's report usually include information about how the economy has affected the company's performance and the outlook for the year ahead. These two reports will give you an insight into anticipated opportunities for the company, possible problems and management's planning.
The auditor's report will tell you whether the company's accounts have been prepared according to international accounting standards and are in line with local regulations.
Auditors also check that the information in the annual report is factually correct and that the company's financial transactions have been recorded properly.
However, an auditor's report should not lull you into a false sense that all is well with a company. For example, respected accounting firm Arthur Andersen was the auditor for Enron, which turned out to be a disaster for investors.
The income statement, balance sheet and cash flow statement should all include financial data for the previous year so that you can see whether a company's performance is improving or declining.
Income statement
The income statement will tell you whether the company is making a profit. Most income statements start by listing revenue, which tells you how much money the company made from sales over the past year. Revenue is not the same as the actual cash received by a company, because it may include orders or invoices that had not been paid by the end of the period covered by the report.
You will also find the following information in the company's income statement:
- Gross profit - the company's sales less all expenses directly related to those sales, such as the costs of manufacturing and buying raw materials.
- Expenses - these include manufacturing costs, the cost of buying raw materials from suppliers and employees' salaries.
- Operating profit - also known as earnings before interest and taxes (Ebit), this refers to the company's earning power from ongoing operations. If you divide the operating profit by the company's revenue, this gives you the company's operating profit margin. A company with a lower operating profit margin can still show operating profit growth if it substantially increases its revenue. This usually occurs when a company cuts prices to achieve higher sales volume growth or enters a new market or country which has margins lower than the parent company. For example, generic pharmaceuticals manufacturer Aspen Pharmacare entered the antiretroviral market some years ago. This market has good revenue growth but lower profit margins than the other markets the company focuses on.
- Net income - what the company earned after accounting for all operating expenses, interest received or paid, and taxes and payments to minority shareholders. A company can choose to pay the entire amount to shareholders as dividends, or pay part of it as dividends and use the rest to fund expansion.
- Headline earnings per share (Heps) - earnings per share excluding the effects of any "extraordinary items" that would normally not appear on the income statement, such as the sale of a subsidiary or the acquisition of another company.
Heps is used to calculate the price-earnings (PE) ratio of a share. The PE ratio is obtained by dividing the share price by the year's Heps, and tells you how long, at a company's current level of earnings, it will take you to recover your investment. A trailing PE ratio shows you the relationship between a share's current price and its earnings over the past year. Most analysts concentrate on a forward PE ratio, using projected earnings for the coming year.
Cash flow statement
The cash flow statement tells you the actual amount of cash that flowed in and out of the company over the past year. It shows you whether a company is in good shape or whether the earnings in the income statement have possibly been manipulated to paint a rosy picture that is not entirely realistic.
Cash flow from operating activities will reveal whether the company's order book is being matched by payments from clients. A large order book will reflect favourably on the income statement - under "revenue" - but until clients have actually paid for the orders, the order book merely reflects money owed to the company.
You should also look at the "changes in working capital". Working capital is the value of the stock plus what the company is owed minus what it owes.
Big changes in working capital warrant further attention. They could mean that the company has given its clients extended credit terms (it has less cash in hand) or that its creditors are insisting on being paid upfront because the company has been a slow payer or because it is viewed as a poor credit risk.
The cash flow statement is also important because it shows you how much the company has borrowed, how much debt it has paid off, and how much capital has been spent. Remember to look at the operating cash figure because a company could have decreased its capital or increased its borrowing to make its end-of-year cash flow appear higher.
Balance sheet
The balance sheet can be described as a snapshot of the business as it was at year end or half way through the year. You will find the assets (the value, in monetary terms of what the company owns), liabilities (what it owes) and capital in the balance sheet. A basic principle of accounting is that a company's assets must balance or be equal to the capital (owners' equity) plus liabilities.
Assets and liabilities are both listed under two headings: current and long-term.
- Current assets are those assets that can quickly be converted to cash, such as money in the bank. Long-term assets are generally those that are held for more than a year and can refer to manufacturing equipment or subsidiary companies.
- Current liabilities are items such as the company's bank overdraft. Long-term liabilities are debts that are not payable in the year ahead.
The balance sheet can tell you at a glance whether or not the company is able to fund its own growth.
If the current assets are substantially higher than the current liabilities, the company is in a good position and can either declare a high dividend or use the money for growth. On the other hand, if the current liabilities outweigh the current assets, this is a sign of trouble - the company will need to borrow money or may find itself having to raise capital by issuing more shares.
It's worthwhile to compare the level of stock a company holds with its sales figures. If stocks are piling up and sales are slow, it could indicate that the company is not meeting the needs of its target market, or the market is saturated, or there is simply less demand for the company's products.
CALCULATIONS YOU CAN USE
There are a number of indicators apart from the PE ratio that analysts use to determine whether a company is a good buy or not. Make sure you analyse all the company's financial details and don't base your decisions on one indicator. Common indicators include the following:
- Owner earnings:
Investment guru Warren Buffett favours the use of what is called owner earnings as a tool when deciding whether to invest in a company.
Owner earnings is the amount of cash that can be taken out of a business after depreciation and capital expenditure have been taken into account.
Depreciation is a decrease in the value of assets with time and use. Capital expenditure is the cost of long-term improvements to the company's assets, such as building alterations or the purchase of new manufacturing equipment.
You calculate owner earnings by adding depreciation to the net income after tax and then subtracting the company's capital expenditure.
Buffett believes that owner earnings can give you a more accurate picture of a company's earning power than the earnings figure reported in the income statement. The owner earnings figure tells you how much free cash a company can create year after year for you, the shareholder.
- Return on equity:
This ratio is calculated by dividing net income by shareholders' equity.
You should look for businesses that consistently show a
high return on equity.
- Dividend yield:
The percentage of the purchase price that is paid back to you in the form of a dividend.
To calculate dividend yield, you divide the dividend paid per share by the current share price.
- Dividend cover:
This ratio tells you how many times the dividend is covered by earnings.
You calculate dividend cover by dividing earnings per share by the dividend per share. The lower the dividend cover, the higher the percentage of earnings paid out to shareholders in dividends.
- Gearing or debt-equity ratio:
This is a reflection of the company's debt in relation to the shareholders' money or equity. The higher the gearing, the higher the proportion of borrowing. You should look for companies with low debt-equity ratios.
- Liquidity ratio:
This refers to the ability of the company to meet its debt obligations if they fall due immediately.
You can calculate a company's liquidity by dividing its current assets by its current liabilities.
A high liquidity ratio means the company has sufficient easily-disposable current assets to meet its current liabilities. However, watch out for a very high liquidity ratio, because this could mean the company is not making good use of its current assets. In extraordinary circumstances, though, such as the current economic downturn, this could be an advantage.