For the purpose of this article, “investments” will refer to financial investments, such as stocks, bonds, mutual funds, etc. Other investments such as real estate are beyond the scope of our discussion.
Successful investing is necessary to reach financial goals, whether they are modest (extra income, secure retirement) or ambitious (financial freedom, becoming very wealthy).
The problem from the layperson’s point of view is that she lacks the financial literacy and knowledge to distinguish a good investment from a bad one. She therefore relies on advisers to assist her in making investment decisions, and due to conflicts of interest or just plain incompetence, they may make recommendations that are not in her best interest.
The most common source of investment advice comes from financial advisers who are employed at banks, brokerages and insurance companies. These advisors are typically compensated in two ways:
- Advisers who sell mutual funds are typically compensated through trailing commissions that are siphoned out of the management fees fund companies charge investors who own their products. Investors are often oblivious to trailing commissions.
- If the adviser also manages your investment portfolio, you will also be charged a fee equal to approximately 1 per cent of your account assets under management each year.
For example, your adviser might encourage you to invest in a mutual fund that may be considered risky for your investment profile because he can earn a significant commission from selling it to you. This would be an obvious conflict of interest.
Moreover, the risks of investing in this manner are one-sided in the adviser’s favor: if the value of your investments go up, your adviser is paid his commission and management fee. If the value of your investments go down, the adviser is still paid his commission and management fee. That is: you win, he wins. You lose, he still wins!
LEARNING TO READ FINANCIAL STATEMENTS
This is why learning how to read financial statements is such a worthwhile investment of time. If you are able to read financial statements, you will be able to make the distinction between a good investment versus a bad one. Having such knowledge is therefore crucial when investing in the stock market, where this ability is most often applied.
Ideally, you would like to have 2 basic questions answered before investing in a company:
- Is the company profitable?
- Is the company safe to invest in?
A review of a company’s financial statements will answer these questions.
Financial statements are comprised of two basic components: (1) the income statement; and (2) the balance sheet.
In the end, the income statement and balance sheet tell us whether a company’s stock is worth buying. We shall examine each of these components in turn.
What is an income statement?
The income statement is often called the profit & loss statement. It is divided into two main sections: revenues and expenses.
Within the revenue category are sales figures for the company’s products and services. Expenses include the cost of producing the goods or services, overhead expenses, depreciation, taxes and other costs of doing business.
Below is the income statement of the Coca Cola Company (listed as “KO” in the New York Stock Exchange) for the three month period ending on 3 April 2009.
We can see that during the first quarter of 2009, KO had a net profit of $1,815,000,000 after income taxes. We can also see that net income per share was 58 cents per share.
From an investor’s point of view, the income statement informs you whether a company is profitable. KO was clearly profitable during the first quarter of 2009.
However, is KO a safe investment? An income statement cannot really answer this question. To determine if an investment is safe, we must turn to an examination of the balance sheet.
What is a balance sheet?
A balance sheet is a financial snapshot, clicked at a specific moment in a corporation’s life, being the end of an operating period such as a quarter or a fiscal year. Reviewing it tells us what assets are owned by the corporation and how the acquisition of these assets were financed.
A company is considered a safer investment if it uses less debt and more of the shareholder’s equity (i.e., the investors’ money) to finance the acquisition of its assets
Below is the balance sheet of KO as at 3 April 2009. On this date, KO had $43,103,000,000 in assets, financed by $21,108,000,000 of Shareholders’ Equity, and $21,995,000 in Liabilities (i.e., credit given to KO by its creditors to finance the acquisition of its assets).That is:
Assets ($43,103) = Shareholders’ Equity ($21,108) + Liabilities ($21,995)
The above equation illustrates an extremely important point: the ” balance sheet” is so called because it must always balance. Total assets will always equal total liabilities plus total equity. Thus, if a company’s assets increase from one period to the next, you know for sure that the company’s liabilities and equity increased by the same amount.
When you think about this point and apply the same reasoning to your own personal “balance sheet” it makes perfect sense. Let’s say you purchased a home for $200,000. To purchase it, you either: (1) had the money; (2) borrowed the money; or (3) used a combination of both.
You likely purchased the home with your own money, (that is, your down payment – say $50,000) and a $150,000 loan from the bank in a form of a mortgage. Your down payment is your “equity” in the home and the mortgage is the liability. The balance sheet equation would hold true in your case as well:
Assets (home of $200,000) = Equity (down payment of $50,000) + Liabilities (mortgage of $150,000)
What does the Balance Sheet tell me?
For an investor assessing whether a company is a good investment, the balance sheet informs you of a company’s financial stability, and thus the safety of investing in it. By reviewing the balance sheet, you can determine: (1) the worth and quality of its assets; (2) the amount of debt it has taken on.
Reviewing the assets
Let’s look at KO’s balance sheet again. First, we can see that it has $14,714,000,000 in “current assets”. Current assets are those assets that can be turned into cash within one year. This is important – if a company doesn’t have cash readily available, it won’t be able to meet its financial obligations during the normal course of business. That is, it won’t be able to pay its employees, suppliers and other creditors.
Going further down the balance sheet, we also see that KO has investments in various subsidiaries, mainly bottling companies in other countries. These investments total $5,757,000,000, and are considered “long-term” investments since they cannot be easily be liquidated and turned into cash.
Further down, we see that KO has assets consisting of Property, Plant & Equipment as well as Trademarks and other assets. Again, these assets are considered long-term assets since they cannot be easily turned into cash in a short period of time. This is just common sense: KO wouldn’t be able to operate in the normal course of business if it sold its property, plant, equipment and trademarks.
Reviewing the liabilities
Once an investor has contemplated the nature of a company’s assets, one must determine if the amount of debt it has taken on is manageable.
Continuing our review of KO’s balance sheet, we see that it has $13,169,000,000 in “current liabilities”. These are obligations that must be paid by KO within one year. Fortunately, as we have seen above, KO has $14,714,000,000 in current assets, so it can easily meet its current obligations.
Going further down the balance sheet, we see that KO has long-term debts of $5,017,000,000. The debts are called “long-term” because the don’t have to be paid for at least another 12 months from the balance sheet date (3 April 2009). KO also has relatively small amounts owing for Other Liabilities and Deferred Income Taxes.
Now that we’ve reviewed the balance sheet, we’re now in a position to analyze KO’s financial health by using a series of financial ratios. The most common ones employed are:
Current ratio = current assets / current liabilities
1.117 = $14,714 / $13,169
This ratio calculates the ability of a company to pay its current obligations in the ordinary course of business. A sound company should have a current ratio of 2 – that is, it should have $2 of current assets for every $1 of current liabilities. The higher the ratio, the more likely a company will be able to meet its current obligations as they become due. KO falls short in this regard.
Debt to equity ratio = total liabilities / shareholder equity
1.042 = $21,995 / $21,108
This ratio measures the amount of debt a company has incurred to finance the acquisition of its assets. Ordinarily, a company should have an approximate ratio of 50 percent. A high debt/equity ratio generally means that a company has either been: (1) aggressive in financing its growth with debt, which can result in volatile earnings as a result of the additional interest expense; or (2) aggressively buying back its stock from shareholders.
In fact, KO had been on an aggressive stock repurchasing program for the past few years. The effect of this was to return cash to the shareholders in return for shares that were canceled. This had the effect of decreasing the amount of equity in the company relative to is liabilities, explaining KO’s relatively high debt to equity ratio.
As we have seen, financial statement analysis can be an extremely valuable tool in determining the quality of an investment. However, financial statement analysis is purely quantitative. Qualitative issues such as the competence and integrity of company management and future business prospects must also be reviewed.
Using KO to illustrate this point, under the strong leadership of its CEO Muhtar Kent, KO has successfully expanded its market share in soft drinks globally. This has resulted in an increase in KO’s profits and share price since April 2009. Therefore, notwithstanding its relatively high debt to equity ratio, KO’s share buy back program and expansion plans have been very good for investors in its shares.
© Copyright Fong and Partners Inc., 2011.