Each April, flimsy paperback "books" wrapped in plastic flood investor mailboxes. Hidden within these darkly covered annual reports is where the rubber meets the road in terms of profitable investing.
Earnings season offers us a deep look into the views of management. We have thousands of Form 10-Ks, which all publicly traded companies file with the SEC, at our disposal. By reading these annual reports, you can uncover awesome opportunities. Equally as important, they can give you clear indicators of when to sell a stock.
A lot of people glaze over when these large packages arrive. But it's actually an excellent use of time to review these documents carefully. Investors that closely monitor these reports can end up having a substantial advantage over those that merely listen to friends for the latest investment tip.
Here's what to look for…
The Secret to Analyzing a 10-K
First, start with the letter to shareholders. Written by the CEO, here lies the company spin. While the numbers buried in the 10-K tell the real story, the letter to shareholders can give you a snapshot of the biggest trends in the business.
Honest CEOs will share the challenges along with the triumphs, but expect to find mostly the company line. A public relations firm usually writes this letter, and most investors stop reading at this point.
Next, jump to the balance sheet, right away you can evaluate the liquidity and solvency of the firm.
The balance sheet contains a list of the company's assets – what the company owns. Against those assets are charged the liabilities. Liabilities are what the company owes – the financing by debts. The balance sheet also lists the shareholder's equity, which is the "net worth" of the company. It is often listed as the common stock plus "retained earnings" and any additional paid-in capital.
This simple equation should balance, hence the name balance sheet. The equation is:
Assets = Liabilities + Shareholder's Equity
The balance sheet reveals the overall structure of the company. First, it shows the short-term assets: cash, inventory, receivables, etc. Then we see the long-term assets: property, plants and equipment, or fixed assets.
Look closely at the assets.
Have the long-term and short-term debts increased or decreased? What about the accounts payable, have they increased or decreased? Are the assets liquid, if they need to be sold quickly?
Remember, liquidity is evaluated by assessing the "current" and the "quick" ratio.
The current ratio is an indication of a company's ability to pay short-term debt obligations.
The higher the ratio, the more liquid the company's position is. Current ratio is equal to current assets divided by current liabilities. If the current assets of a company are more than twice the current liabilities, then that company is generally considered to have good short-term financial strength. If current liabilities exceed current assets, then the company may have problems meeting its short-term obligations.
For example, if company X's total current assets are $10,000,000, and its total current liabilities are $8,000,000, then its current ratio would be $10,000,000 divided by $8,000,000, which is equal to 1.25. Company X would be in relatively good short-term financial standing.
The quick ratio is a measure of a company's ability to pay its obligations…
This is the acid-test ratio measuring liquidity. It is calculated by subtracting inventories from current assets and then dividing by current liabilities. The quick ratio reveals a company's financial strength or weakness. Think in these terms: The higher the number, the stronger the finances; the lower the number, the weaker the finances.
For example, if current assets equal $21,000,000, current inventory equals $12,000,000 and current liabilities equal $3,000,000, then the quick ratio is: $21,000,000 - $12,000,000 divided by $3,000,000, or 3.
Since we subtracted current inventory, it means that for every dollar of current liabilities, there are three dollars of easily liquidated assets.
Understanding the Debt-to-Equity Ratio
Pay attention to the company's solvency too. Solvency is measured by the "debt-to-equity" ratio, which measures a company's leverage. This ratio is equal to long-term debt divided by common shareholder's equity.
Investing in a company with a higher debt/equity ratio is riskier in times of rising interest rates. Additional interest is paid to service this debt as rates increase. For example, if a company has long-term debt of $30,000 and shareholder's equity of $120,000, then the debt/equity ratio would be 30,000 divided by 120,000 = 0.25. It is important to realize that if the ratio is greater than 1, the majority of assets are financed through debt. If it is smaller than 1, assets are financed through equity.
After a company passes my tests in these areas, I look to evaluate how efficient management is in deploying capital. From the balance sheet, we can move on to the income statement and make an assessment about profitability.
Finally, I go to the cash flow statement to help me understand where the cash was spent and made during the year. This is the "show me the money" report that every investor should understand.
In short, open up those annual reports when they come in the mail! Examining them gives you a better understanding of the complete financial picture of any company. And you'll get a big leg up on the average investor.
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