You are on page 1of 14

# The Art of the Annual Report: Making It

Meaningful (Part 2)
Starting to make sense of the numbers
General suggestions
With any financial statement, you should first look at the changes from year
to year both in the raw numbers and in the percentage changes in the
numbers. These comparisons may indicate "trends and are very helpful in
assessing a company.
It's hard to generalize about a good rate of change it depends on the line
item you're looking at and the rates of change in prior years. If a company's
sales rose 15 percent in each of the past three years and rose only 10 percent
this year, it would not be good. However, if the past years' rates of increase
had been only 5 percent, and this year's rate is 10 percent, it would be quite
good.

## Looking at the Change from Year to Year

Horizontal & Vertical analysis
Horizontal Analysis

## Study of percentage changes in comparative financial statements.

Two steps
Compute the dollar amount of the change for, the base (earlier) period to the later
period.
Divide the dollar amount of the change by the base-period amount.

2

## How do you interpret this?

Vertical Analysis

Analysis of a financial statement that reveals the relationship of each statement item
to the total, which is 100%.

## How do you interpret this?

Most large companies include data for three years, but I recommend looking at even
longer periods of time if possible.
The financial statements represent a good starting point in judging a company's
financial strength, but they are only a starting point. To complete the picture, you
and other resources that may give it a competitive advantage in the marketplace. One
of the best sources of supplemental information is the non-financial section of the
annual report. This section, usually in front, often tells a lot about top management's
views on the company's future and ability to compete.

## Calculating ratios for a company for ONE year is

relatively meaningless!

Before I talk about the statements, let me explain what I do in general as an investor.
When I buy shares of an established company public at least ten years I look at
trends for five numbers. This is the trend analysis in action. These include net

## sales, net earnings, net cash provided by operating activities,

price-earnings ratio (P/E ratio) , and backlog , preferably over the
last four years. The first three items are easily found in the financial statements; the
P/E ratio and backlog figures may require additional research.

## Comments on the Statement of earnings (a.k.a. P & L, Income Statement)

On this statement, one of the figures to look at is the total operating income and its
ratio to total revenue (net sales):
Total operating income
Total revenue
Ideally, you like to see operating income growing, both as an absolute number and as a
percentage of total revenue. That would usually mean a company is growing its operating
income and becoming more efficient over time in managing its costs and operating
expenses. There's no "ideal percentage" because the target percentage varies from
industry to industry.
What numbers do I look at this statement?
The first number to look at is net sales and ask: Was there an increase
over the last four years at a pace substantially above the inflation rate? If the
answer is yes, that's a good sign. The U.S. government periodically reports
inflation rates, and you can find this information in the papers and on radio and
TV. [Check also the Internet links to the U.S. Department of Commerce and to
the Bureau of Labor Statistics in Resources]. Remember, this rate varies from
year to year.
The second number to look at is net earnings and ask: Did net earnings
increase over the same period, at least at the same percentage rate as net
sales? If the answer is yes, that's another good sign. If net earnings are lower in
one year than in previous years, try to determine why. Sometimes there are valid
reasons for a slump in earnings. For example, intense competition may force cuts
in prices. Or the cost of utilities may rise because of unusually severe weather.
Other times, a drop in net earnings is a sign for caution.
A next number to look at is the price-earnings ratio (P/E ratio) for a
company's stock. Not all financial statements contain this figure, so finding it
may require additional research. This information is quoted daily in the stock
tables. Sometimes, an annual report includes the P/E ratio at the end of the fiscal
year. Investors should compare a company's price-earnings ratio to the ratios of
its major competitors.
The price-earnings ratio can change daily as the price of the stock moves up or
down, so be sure to compare ratios from different companies at the same

times.

Trend
A pattern in a company's financial performance over time. For example, if a company's sales have
been increasing over many months or years, analysts would describe this pattern as a sales growth
trend.
Net sales
A company's total sales less returned merchandise and discounts. Listed on the statement of
earnings.
Net earnings
A company's total revenue less total expenses, showing what a company earned (or if lost, called
net loss) for a set period, usually one year. Listed often literally as the "bottom line" on the
statement of earnings. Also called net income and net profit.
Price earnings ratio (P/E ratio)
A ratio used to evaluate the relationship between a company's price per share and the earnings per
share (EPS). For example, if a company's stock is selling for \$12 per share and the earnings per
share is \$2, the P/E ratio is 6 (12 2 = 6).

## Measuring the companys profitability

Use the Decision Guidelines

Take Aim
Lets try out these ratios

## Comparing Target and Walmart

Some simple horizontal analysis
Analysis: Statement of Earning (Income Statement)
Gross profit
2007

2006

2005

05 vs '06

06 vs '07

Increase or
(Decline)

Increase or
(Decline)

Target
(in millions)
Walmart
(in millions)
05 vs '06
Operating Income
2007

2006

2005

Increase or
(Decline)

2005

06 vs '07
%

Increase or
(Decline)

05 vs '06

06 vs '07

Increase or
(Decline)

Increase or
(Decline)

Target
(in millions)
Walmart
(in millions)

Net Earnings
2007

2006

Target
(in millions)
Walmart
(in millions)

05 vs '06
EPS
2007

2006

2005

Increase or
(Decline)

06 vs '07
%

Increase or
(Decline)

Target
(in millions)
Microsoft
(in millions)

## Comments on the Statement of financial position (Balance Sheet)

On this statement, two things to look for are the figure for total stockholders' equity and
the ratio of total liabilities to total stockholders' equity or Debt to Equity Ratio:
total liabilities
total stockholders' equity
Generally, a lower ratio of debit to equity means a lower risk for a
company's creditors and lower costs when the company borrows money. Yet, how much
debt a company carries compared with stockholders' equity varies widely according to
the norms for the industry and the company's financial strategy. Just because a company
has a high debt ratio is not a signal of weakness, if the ratio is in the ballpark for the
industry.
With the statement of financial position, it's important to remember that most

## companies try to shine the spotlight on assets, not on liabilities. For

instance, this statement typically provides a number for total assets and total stockholders'
equity but not for total liabilities. (To obtain total liabilities, subtract total stockholders'
equity from total assets). An anonymous writer once said,
"The needs of man are few to get food, find shelter, and keep debt
balance sheet [statement of financial position]."

off the

Keep this in mind and train yourself to seek out liabilities reported indirectly as well as
directly.

Backlog
The amount of a company's unfilled orders at the end of the year. When the company fills the orders the
following year, it records the revenue on the statement of earnings. Frequently, a company will give its
perspective on backlog in the management discussion section in the annual report.

10

## Measuring the companys Liquidity

Use the Decision Guidelines

Current ratio
Indicates the ability to pay current liabilities as they mature, providing the ratio of
current assets to current liabilities. As a general rule, a current ratio of 1.5 or greater
is normally sufficient to meet near-term operating needs. A current ratio that is too
high can suggest that a company is hoarding assets instead of using them to grow
the business -- not the worst thing in the world, but potentially something that could
impact long-term returns. You should always check a company's current ratio (as
well as any other ratio) against its main competitors in a given industry. Certain
industries have their own norms as far as which current ratios make sense and which
do not. For instance, in the auto industry a high current ratio makes a lot of sense if
a company does not want to go bankrupt during the next recession

## Acid Test (Quick) ratio

The quick ratio is simply current assets minus inventories divided by current
liabilities. By taking inventories out of the equation, you can check and see if a
company has sufficient liquid assets to meet short-term operating needs.
Most people look for a quick ratio in excess of 1.0 to ensure that there is enough cash on hand to pay the
bills and keep on going. The quick ratio can also vary by industry. As with the current ratio, it always pays
to compare this ratio to that of peers in the same industry in order to understand what it means in context.
Net working capital
Indicates the business ability to meet short-term obligations, reporting the excess of
current assets over current liabilities.
The best way to look at current assets and current liabilities is by combining them into something called
Working Capital. Working capital is simply current assets minus current liabilities and can be positive or
negative. Working capital is basically an expression of how much in liquid assets the company currently
has to build its business, fund its growth, and produce shareholder value. If a company has ample positive
working capital, then it is in good shape, with plenty of cash on hand to pay for everything it might need to
buy. If a company has negative working capital, then its current liabilities are actually greater than their
current assets, so the company lacks the ability to spend with the same aggressive nature as a working
capital positive peer. All other things being equal, a company with positive working capital will always
outperform a company with negative working capital.

11

## Measuring the companys Solvency

Use the Decision Guidelines

Debt to Equity
Indicates the balance between total equity ownership (common and preferred
stockholders) and long-term debt. The greater the percentage, the more leveraged
is the company.
Debt ratio
Indicates the balance between total equity ownership (common and preferred
stockholders) and long-term debt. The greater the percentage, the more leveraged
is the company.
Risk Management Association determined that the acceptable range for the debt ratio is 0.57 to 0.67.
Higher ratios indicate a company that is highly leverages, lower ratios indicate a more stable organization

Lets try out these ratios
Comments on the Statement of cash flows
On this statement, look at the figure for cash provided, or used, by operating
activities (operations). Without a doubt, this number is the most critical on this
statement. These activities represent the basic business of the company. If a company
consistently fails to make money at its basic business, it will have a hard time surviving.
In a healthy mature company, operating activities normally result in positive cash flows.
The other ways a company receives or spends cash investing and financing are
more difficult to interpret. For example, negative investing cash flows may indicate only
that the company is growing and buying assets that enable it to manufacture more
products. Financing cash flows are affected by a company's borrowing and the amount
paid in dividends during the year. To interpret these numbers, you need more information
on the company's strategies.

12

Efficiency ratios
MIXED STATEMENT RATIOS

## Inventory turnover ratio

An alternative measure of how quickly inventory is sold.

## Number of days sales in inventory

An indicator of the amount of inventory maintained relative to the companys sales
(as measured by the cost of goods sold).

## Receivable turnover ratio

An alternative, but equivalent, measure of the efficiency of the companys
receivables collection efforts. If the company also makes sales for cash, total credit
sales should be substituted for total sales.

Collection period
Measures the number of days sales that are uncollected in average accounts
receivable, providing an idea of how successful the firm is in collecting its customer
debt.

## ONE MORE TIME

Lets look at these ratios in relation Target

13

## Can you trust financial statement?

Unfortunately people actually do cheat on their financial statements! Even in the good
ole days there was financial statement chicanery. In 1720 two stockbrokers in England
formed a company called the South Sea Company. This company had exclusive trading
rights from England to the New World. To keep the company going, fresh cash was
needed to pay the bills. Since the trading business wasnt going so well the company, the
companys owners decided that the best source of new money continued to be selling
more stock. To encourage more demand for its stock, the company allowed investors to
buy on an installment plan which helped drive up the stock price.
Investors forgot or ignored that its the flow of current and future profits that makes a
company an attractive investment. Although the South Sea Company had trouble making
profits, it was very good at printing stock certificates. The share price went from 100 in
January, 1720 to 1,000 by July of that year.
As with all scams, the directors of the company (as well as royalty and government
officials) knew when to cash in, and when they did so the bottom fell out. Among the
more famous investors was Sir Isaac Newton who said I can calculate the motions of the
heavenly bodies, but not the madness of people.
So who do you believe?
There are two groups of people you can turn to for some assurance that the financial
statements are materially correct (remember that doesnt mean 100% accurate). The first
is top management of the company. The Sarbanes-Oxley Act of 2002 requires the CEO
and CFO of all publicly traded companies to attest to the accuracy of the statements and
the strength of the internal controls. The second group is the external auditors. These are
independent accountants who test the transactions that make up the statement to
determine if the transactions were recorded properly. Remember auditors can handle
review of statements several different ways, each providing a different level of assurance:
1. If the statements are audited, the accountants have tested the bookkeeping
procedures and confirmed that the assets on the balance sheet really exist.
Procedures are also performed to try to be certain that all of the liabilities are
listed on the balance sheet. Therefore the readers of the financials can be
reasonably assured that the financial statements are materially correct.
2. If the accountants letter indicates that the financial statements are reviewed, the
reader of the financials knows that an independent accountant has at least stuck
their nose into the companys record keeping, so there is a good chance that the
statements are materially correct.
3. If the accountants letter indicates that the financial statements are compiled, the
independent accountant may have done little more than take the numbers that they
were given and put the figures into a format that complies with GAAP.

14