So you're an investor. But what kind? There are a wide range of possibilities: day trader, momentum buyer, value investor, income seeker, or blue chipper. No matter which kind you are, it behooves you to know and study financial statements. Master investor Warren Buffett, a kingpin of value investing, is even known to memorize hundreds each year. Only by knowing what's on the books can you find the best ideas in the market.
That's easier said than done, though. Still, it can be done. Permit me to offer a brief introduction to the three main financial statements.
The balance sheet
A balance sheet is a snapshot of a company's financial condition at a single point in time. For your own personal balance sheet, you'd list all your assets, subtract your debts and obligations, and end up with your net worth. Companies essentially do the same thing, and you can gain valuable insights into a firm's financial strength by studying this document.
The balance sheet has three main parts: assets, liabilities, and shareholder's equity. Shareholder's equity, a measure of net worth, is simply assets minus liabilities.
Take a gander at assets. In this category, you'll find items such as "cash and cash equivalents" and "short-term investments." That's how much unused gunpowder the company has. These assets are good, but most other assets are not as good. Consider "accounts receivable." That's money the company hasn't yet received from customers and therefore can't use. "Inventory" reports how much product is in various stages of preparation. It's cash tied up in materials that haven't yet been sold. Not so good. Other balance sheet assets may include investments, "prepaid expenses" (such as insurance that's paid ahead of time), and "property, plant, and equipment" (PP&E).
Liabilities are likely to include short-term (also called "current") debt and long-term debt. Debt is not necessarily a bad thing, although we generally don't like to see much long-term debt. Debt can be good when it represents cash that the company is putting to work effectively, but it can be crippling when a firm's performance is ebbing. Glance at Krispy Kreme's (NYSE:KKD) balance sheet for the past few years, and you'll see a general upward trend, from $4 million in long-term debt in 2002 to $146 million in 2004, accompanied by a downward trend for the stock. "Accounts payable" is unpaid invoices, money owed to creditors (such as parts suppliers) for goods and services.
Finally, shareholder equity is the portion of the company that stockholders can claim. Simply put, it's the difference between assets and liabilities. By studying a balance sheet, you can evaluate a company's current condition and also see whether its financial health is improving or failing. Look for generally promising trends, such as falling debt, rising cash, and inventory and accounts receivable levels growing no faster than sales. (Sales are reported on the income statement.)
The income statement
The income statement (sometimes called the statement of operations) summarizes sales and profits over a period of time, such as three months or a year. It usually offers information for the year-ago period, too, so you can compare and spot growth trends -- crucial to finding a company on the rise.
Consider PepsiCo's (NYSE:PEP) income statement for 2004. At the top, as with every income statement, you'll find net sales (sometimes called revenues). For Pepsi, they were $29.3 billion for 2004.
Working our way down the income statement, various costs will be subtracted from the revenues, leaving different levels of profit. The item you'll find just under revenues is "cost of goods sold" (abbreviated as COGS and sometimes called cost of sales), representing the cost of producing the products or services sold. For Pepsi, it's $13.4 billion. Subtract the COGS from revenues, and you'll get a gross profit of $15.9 billion.
To find the gross margin, which reflects the costs of production compared to sales, simply divide Pepsi's gross profit by revenues. Dividing $15.9 billion by $29.3 billion yields a gross margin of 54%. It's often illuminating to compare the results with those of industry peers. For example, Coca-Cola's (NYSE:KO) gross margin is 65%.
Next, the remaining costs involved in operating the business -- such as support staff salaries, utility bills, and advertising expenses -- are subtracted, leaving operating profits. Pepsi's operating profit was $5.6 billion. Dividing this by revenues yields an operating margin of 19%, revealing the profitability of the company's principal business. Crunching older numbers reveals that Pepsi's operating margin has held steady over the past several years -- a good sign (though rising margins are more exciting).
Finally, after items such as taxes and interest payments are accounted for, we come to net income, near the bottom of the statement. Pepsi's was $4.2 billion. Dividing that by revenues yields a net profit margin of 14%. This number reflects how much of every dollar of sales a company keeps as profit.
Compare all these margins with those from previous years. Increasing margins indicate increasing efficiency and profitability. Check out the margins of the company's competitors. Is the firm more efficient than its peers? Look for significant changes in revenues, SG&A (selling, general, and administrative) expenses, and costs of goods sold.
Also look at growth rates to see how quickly items such as revenues and net income are increasing (or -- gasp -- decreasing).
Finally, remember that margins vary widely by industry. Software companies such as Microsoft (NASDAQ:MSFT), for example, tend to have high margins (a recent net profit margin of 27%, for example), while retailers tend to have low ones. Wal-Mart (NYSE:WMT), with its net profit margin near 4%, is proof that a company can do rather well for itself and its investors despite low margins. It just makes up for them with high volume. Even its 4% net margin is impressive for a retailer. Well-respected competitor Costco (NASDAQ:COST) has a net profit margin closer to 2%.
The statement of cash flows
Of the three main financial statements that each investor should be familiar with, the statement of cash flows is the least understood. Yet it's a key stash of information for Fools. It shows how much cash a company's operations are generating, and it shows how it's investing and borrowing funds.
The statement breaks cash inflows and outflows into three categories: operations, investments, and financing. Some operating activities include purchases or sales of supplies, and changes in payments expected and payments due. Investing activities include the purchase or sale of equipment, buildings, property, companies, and securities such as stocks or bonds. Financing activities include issuing or repurchasing stock and issuing or reducing debt.
If the bottom-line number is positive, the company is "cash-flow positive." That's a good thing. But this is not the only thing you should look at on this statement. Check to see where most of the moolah is coming from. You'd rather see more greenbacks generated from operations than financing. Cash flow from operations is arguably the most important bottom line on this statement.
A common way to examine cash flow statements is to calculate a company's "free cash flow." That's done by subtracting capital expenditures (often called "purchase of property, plant, and equipment" on the cash flow statement) from cash flow from operations. This tells you how much money a company's operations generate, and it can be used to buy back shares, pay a dividend, or purchase other companies.
Examine the various line items on this statement to see how they have changed compared to past years. You may notice, for example, that "payments of debt" double or triple from one year to another. This shows that the firm is increasingly paying off debt. "Purchase of company stock" would reflect a company buying back some of its own shares to increase the value of the remaining shares -- something shareholders generally smile at. If you're thinking of investing in any company, the more you know about it, the better ... and scouring the cash flow statement can be a very profitable thing to do.
Profit by learning
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Selena Maranjian's favorite discussion boards include Book Club , Eclectic Library , and Card & Board Games . She owns shares of PepsiCo, Coca-Cola, Costco, Wal-Mart, and Microsoft. Coca-Cola is a Motley Fool Inside Value recommendation. Costco and Krispy Kreme are Motley Fool Stock Advisor picks.
For more about Selena, view her bio and her profile. You might also be interested in these books she has written or co-written: The Motley Fool Money Guide and The Motley Fool Investment Guide for Teens . The Motley Fool is Fools writing for Fools.
