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Fool On The Hill

Tuesday, February 23, 1999

An Investment Opinion
by Warren Gump

Financial Analysis Is Worth the Effort

Financial analysis often gets the short-shrift when evaluating stocks. Many investors find a product or company that they like and just purchase the stock without reviewing the company's financial statements. I am a big believer in using consumer experience as a starting point for investment ideas, but I also strongly encourage you to dig a little deeper into the financial underpinnings of a company's existence before making an investment.

Perhaps you have never looked at a financial statement and have been a successful investor for the past fifteen years. To you, it might seem like a waste of energy to dig into the financial statements. You just buy companies you know such as Coca-Cola (NYSE: KO), Microsoft (Nasdaq: MSFT), and Proctor & Gamble (NYSE: PG) and reap the rewards of holding on over time.

Fortunately for investors, many big, well-known companies have strong financial managers who ensure that a company's business model is as strong as its brand name. These people try to make sure that company's operations result in high cash flow, earnings, and a strong balance sheet. You shouldn't take it for granted, however, that a company with a well-known brand name has strong financial characteristics. You should investigate financial statements to gain perspective on how the company is managed.

I was looking at some athletic shoe and apparel retailers the other day and the importance of strong financials was reemphasized for me, particularly when an industry hits a downturn. Almost all of these companies are struggling because of a dramatic slowdown in demand (too many new stores didn't help the situation). Although stock performance is most directly related to operational performance, the balance sheet also plays a key role. Here are four industry players and their performance over the past year:

                               Debt/Equity     1 year
Ratio price change
Venator (NYSE: Z) 0.88 -81%
The Sports Authority (NYSE: TSA) 1.05 -52%
Just For Feet (Nasdaq: FEET) 0.45 -26%
Footstar (Nasdaq: FTS) 0.26 -11%

Two of the leading companies in the industry, Venator (operator of chains like Foot Locker and Champs Sports) and Sports Authority, have been the worst performers. Not coincidentally, they also have much higher leverage in their balance sheets. Because of their high levels of debt, many investors are concerned that the companies will not be able to quickly address their operating problems. Beyond their balance sheet problems, these two companies have the ugliest earnings projections, with Sports Authority expected to have a loss in fiscal 1999 and Venator expected to be just above break-even.

Just For Feet and Footstar, operator of Footaction and shoe stores within Kmart (NYSE: KM), on the other hand, have more flexibility to address the problems facing the industry. Because of their relatively unleveraged balance sheets, they can access capital to refurbish stores, implement new advertising campaigns, and address other operational issues. Having a lower debt level also means more operating cash flow can be reinvested in the business with less going to bondholders.

Another advantage of a strong balance sheet is that it allows a company to be opportunistic. When companies are struggling and desperate for cash, they are often willing to sell out at bargain basement prices. Competitors with strong balance sheets, like Just For Feet and Footstar, can take advantage of these situations. Last year, in fact, Just For Feet made such a move by picking up the Sneaker Stadium chain to expedite its move into Northeastern markets.

The evaluation of a company need not boil down entirely to financial analysis. Using a qualitative approach to appraise items such as brand strength, management depth, and organizational structure can prove invaluable. Due to its subjective nature, however, sufficient information to form an opinion on such subjects is not always available. If you are able to obtain it, you will be better positioned to develop an informed investment opinion.

On the other hand, you always have access to financial statements of publicly traded domestic companies. The SEC requires every one of them to file an income statement, balance sheet, and cash flow statement on a quarterly basis. You can access this information freely via the Internet. Quarterly information is filed in the creatively titled form 10-Q, while annual information is filed in a 10-K. (You can obtain SEC filings via the Fool. This link will take you to our quote/data page. After entering a ticker symbol and pulling up a quote, click on "SEC" under the "Info" heading to get a listing of recent filings.)

Taking the time to learn about the balance sheet, income statement, and cash flow statement will help you out in evaluating companies. If you are confused by some unusual jargon (it's not everyday that you throw around terms like "Additional Paid In Capital"), jump over to our "Reading Financial Statements" message board and ask your question. You might also want to post your question on the message board related to the company you're analyzing. Other Fools who are familiar with that company can help bring you up to speed on what's happening. Spending a little time looking at financials could add a lot of value to your portfolio in the future.

Comments on this column? Post them on the FOTH message board.

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