Welcome back! We're in Part 2 of our Craft of Rule Maker series, in which we're covering the financial basics of Rule Maker investing. Yesterday, in Part 1, we introduced the pros and cons of our investing approach. Today, we'll take a broad overview of the financial statements any investor needs to analyze Rule Makers.
The hunt for financial information starts with two forms: the 10-Q, or the quarterly report, and the 10-K, the annual report. These reports, which contain the financial statements, provide all the numbers you need to apply the Rule Maker's quantitative criteria, plus pages and pages about the company's business, industry, cash position, off-balance sheet activities, legal proceedings, and contingent liabilities. The 10-K is base camp for any investor.
Investing in a company without carefully reading the financial statements is like climbing a mountain without any idea how to use a rope. You can borrow your buddy's rope, let him flake it out, tie all the figure-eight knots, and yell at you for standing on it when he's climbing, but you're relying entirely on someone else's judgment. Face it, you're just along for the ride.
It takes time to really understand how to read financial statements, but you can pick up enough to get started quickly. (By the way, if you don't know anything about reading income statements, balance sheets, and cash flow statements, you might want to start where I did -- by reading Understanding Financial Statements by Lyn Fraser and Aileen Ormiston. What a great book -- slim for an accounting text and easy to reference. You'll be surprised how quickly you can understand the basics of accounting -- the language of business.)
There are actually four financial statements a company must prepare: the income statement, the balance sheet, the statement of retained earnings, and the statement of cash flows. Companies prepare four financial statements because they can't fit all the relevant financial information on a single statement, so investors who read only the income statement are missing three-fourths of the picture. With a little practice, you can understand how the primary financial statements are linked. For example, the way a company accounts for inventory on the balance sheet affects the cost of goods sold (and therefore net income) on the income statement. It's all tied together.
Let's start with the income statement, which measures a firm's operating performance over a specific period. Go to Freeedgar.com to find the most recent full set of financial statements. Type in the company's name or ticker symbol -- I'm using Cisco (Nasdaq: CSCO) as an example -- delete the annoying pop-up, and click the View Filings hotlink. With this complete, you should be looking at a long list of confusing form types, the government's way of saying there's a rule for everything. Just scroll down to the most recent 10-Q. The forms are in reverse chronological order so it should be the first 10-Q you come across. In Cisco's case, it was filed on Dec. 12. Click the associated link (10-Q) and look at the index in the left-hand margin, then click income statement.
This statement reports a company's revenues, expenses, and net income for a given period, as well as earnings per share and diluted earnings per share. From the income statement we know how much product Cisco sold in its first fiscal quarter, the cost of those products, and operating expenses such as research and development, and sales and marketing. One thing to note is that for Cisco all figures are represented in millions of dollars. This can vary depending on the company.
By taking a single line item, such as research and development, and dividing it by net sales, we learn what percentage of sales Cisco is spending on R&D. In this case, it's 14.5%. We can then take this number and compare it to R&D as a percent of sales a year ago -- 13.8% -- giving us a year-over-year trend.
I mention this because comparison is what financial analysis is all about -- comparison with competitors and with the same firm from earlier periods. This is why every financial statement contains a comparison set of numbers from an earlier period; without context, the numbers are meaningless. It's also why the annual report is so useful. Not only is it audited by an outside party, but it gives you a full year's results and compares it with results from previous years. Click on Cisco's most recent 10-K (filed on Sept. 29, 2000) and you'll see three years' worth of income statements and cash flow statements.
Let's move to the balance sheet, which gives us a look at what a company owes and owns. It's called a balance sheet because the two sides of the statement are equal: Assets = Liabilities + Shareholders' Equity. Assets are owned by the firm and represent items that will provide a future benefit, such as a machine that will produce revenue over time. Liabilites represent obligations, or claims against a company's assets. For example, accounts payable represents money the company owes to suppliers.
Investors must pay a lot of attention to the balance sheet since it contains so much useful information: how much debt the company has, how much money it needs to collect from customers and how fast it does so, how much cash and equivalents a company has, and what kind of funds a company has generated over time.
By moving the balance sheet equation around a bit, we can see how the relationships work: Assets - Liabilities = Shareholders' Equity. Shareholders' equity represents stockholders' claims against a company's assets. One of the most important accounts in shareholders' equity is retained earnings. Retained earnings represent all the money a company has earned since inception minus dividends. This isn't a pile of cash sitting in the bank, but it is a record of money the company has chosen to reinvest in the business rather than pay to shareholders. Shareholders have every right to expect a decent return on that investment, and the balance sheet keeps a running tally for us.
Retained earnings comes from net income. Looking again at Cisco (which doesn't pay a dividend) take the difference between the retained earnings accounts from the two periods: $9,156 - $8,358. That $798 million difference is the net income figure on the current income statement.
Lastly, it's important to know that the balance sheet is just a snapshot of one point in time. These accounts change daily. The income statement and cash flow statement are a record of changes over an entire period, kind of a motion picture view.
Let's wrap up with the cash flow statement, which tells us how operating, investing, and financing activities affect cash flows during an accounting period. We talk about the importance of cash flow in the Rule Maker for two primary reasons. First, cash flow isn't as easily manipulated as net income. Since cash on the cash flow statement actually represents funds moving in and out of the company (as opposed to income on the income statement, which isn't necessarily cash the company has already received), we look for companies that generate strong cash flow from operating activities.
Second, companies are valued on future cash flows. There's a bit more to it than this, but investors should understand that a business' value is based on how much cash it's expected to produce -- not on how many great partnerships it has, or how many new stores it's opening, or how much you love its products. Keep your eye on cash and you'll stay on the right track.
Click on Cisco's cash flow statement and scroll down to the last line: cash and cash equivalents, end of period. The $5,538 of cash at the end of the period is the same amount of cash and equivalents the company reports on the top of its balance sheet. The cash flow statement will show you exactly what the company did to end up with this amount of cash at the end of the period.
Spend some time working your way through your favorite company's financial statements. It's an eye-opening climb. Tomorrow, we'll dig deeper into the income statement and discuss the importance of sales growth.
Don't forget that this Craft of Rule Maker series is just a warm-up for our upcoming 2001 Rule Maker online seminar, The Art of Rule Maker ($49). During the seminar, which begins in March, we'll show you how to identify sustainable competitive advantages, spot great management, evaluate expanding possibilities, and assess a stock's valuation. We think you'll find that an understanding of both the quantitative and qualitative aspects of Rule Maker analysis work in tandem to make you a better investor. We'll also offer up our 25 favorite Rule Maker investment ideas, with concise, tell-it-how-it-is analysis of each one. And as with all Fool services, if you don't love the experience, we'll happily give you your money back. We hope you'll join us.
Have a great day.
Part 3: Why Growth Matters ï¿½
Richard McCaffery, a co-manager of the Rule Maker Portfolio, lives near the horse-racing track in Laurel, Maryland with his wife Linda. You can view his stock holdings in his online profile. The Motley Fool is investors writing for investors.