If the thought of sifting through financial statements as daunting, know YOU ARE NOT ALONE! There are often 100-300 pages of strange terms and loads of numbers. Well before we even get to that I was sent a shocking statistic by Ryann (an analyst), about peoples financial knowledge: (https://www.theatlantic.com/international/archive/2014/05/the-danger-of-financial-ignorance-do-you-understand-money/361851/?utm_source=atlfb)
First thing you need to understand is what you don't understand!
So given I have done fairly well, thought let me share five (5) things I look at in annual financial statements (after the big picture - industry, economy, understanding the company).
Not something I look at, but rather something I understand from auditing locally and internationally. First realise that financial statement are drawn up by management! Management, who want to keep their jobs and want people to think they are doing well (often to get bonuses)! Yes they are audited (mostly correct) but the points management want you to focus on are emphasized, and what they don't want you to know are well disguised.
1. Firstly I start with the statement management can't manipulate! Statement of Cash flows! Your bank account can't lie, if you making cash going to see it. So go to the operating cash flow section and see whether they are making cash.
- Do a little calculation - market cap over cash flow from operations (after interest). This gives me a cash PE estimate. If this number is low, this has a big influence in whether I would buy the share or not.
If it is high I don't necessarily rule it out, I just investigate the expenses to see if there is anything "unusual". If the company has been spending money of marketing, research, rebranding, expansions etc. These costs would come down eventually and profits go up. (See the blog "value in cycles - ... " for more on that.
2. Next thing I am interested in is revenue. What makes up the revenue and is it growing. If revenue is growing substantially then that is a good start, BUT need to understand what drives the growth. Is this organic or acquisitions?
- Long and the short, finance research shows that the acquiring firm generally under performs for a bit after an acquisition. (Obviously exceptions) An important way of thinking about it is:
The person who knows the most about the business (seller) is happy to sell it at this price, which means they likely believe they are getting a good deal (i.e. the buyer a bad deal).
If growth is organic this may be bad for short term cash flows (investment in PPE, capacity, training etc), however when the growth stops will have a big jump in earnings a year or two later.
3. Working capital! (Inventory, creditors, receivables other operating current assets and current liabilities). When I teach finance I tell people this is the most under taught section in finance. Working capital is he cash invested in your day-to-day operations. If your working capital is growing faster then sales (likely you inflating revenue or not doing that well). If working capital is fairly stable in relation to sales or improving (lower net working capital = current operating assets - current operating liabilities). Also why working capital is important as it shows how much of the income statement is non-cash! Working capital is where management hide the lies ;-) - I see you!
4. The actual cash balance. If there is no cash unless they spending it all on expansions (investing cash flows) or paying big dividends this is a concern.
5. Non-current assets - Non-current assets are the drivers of operations, without looking after those your business will suffer. Also tangible (assets you can touch) asset could be an investment in itself.
Might seem simplistic, but this is my starting point from this I would basically decide if I am interested. After that becomes a little more complex - maybe get to a blog on that someday! However, as someone starting off this is maybe a good place to start looking.