There's plenty of information in a company's financial statements that can help determine the company's prospects. Here are the things accountants, analysts, and other financial sleuths focus on in their reviews.
THE EARNINGS PRESS RELEASE 1. This is a document to be read with great caution. If an earnings number is flagged in the headline, it may or may not be calculated according to conservative rules. Because these statements are not reviewed by regulators, they are largely public relations efforts. If management has included a pro forma number, be sure to read carefully for information about the charges a company is choosing to ignore. "We never use pro forma numbers," warns investor Cliff Asness of AQR Capital. "I believe `pro forma' is usually just a fancy word for lying." But announcements of other news may be very useful. A change in auditor, outside legal counsel, or the CFO makes analyst Howard Schilit's list of "10 excellent clues to detect shenanigans."
THE STATEMENT OF OPERATIONS 2. Here's where you will find earnings as calculated by CPAs--net income. Also, there are useful line items such as "investment income," which highlight how much money a company earned on its investment portfolio. Depending on the company, this may or may not be central to their success. Although investors tend to focus on the bottom line, the first item on the income statement--revenue--can sometimes be the most important. If it's hard to get a handle on the quality of a company's earnings, it may be easier to ascertain whether its revenue growth is slowing or increasing.
THE STATEMENT OF CASH FLOWS 3. This is rarely tacked on to the press release and usually can be found only in the quarterly report filed with the SEC about a month later. It's the most conservative measure of a company's health--how much cash its operations are creating every quarter. "Short of fraud, cash flow is much less vulnerable to manipulation" than earnings, says RL Renck's Robert Renck. It's broken into operating cash flow (money in the door), cash invested in the business, and cash from financing activities, such as issuing stock or debt.
THE BALANCE SHEET 4. "People need to be looking at something they haven't been looking at for the past few years--the balance sheet," says former SEC chief accountant Lynn Turner. The balance sheet is prepared according to GAAP and highlights a company's cash on hand as well as what it has borrowed (liabilities), what it has yet to be paid for (receivables), and how much inventory it has on hand. If receivables or inventory are growing much faster than revenue, it's a warning sign that demand may be weakening. A company with plenty of ready cash can invest in its future growth, perhaps by making an acquisition or funding research and development.
THE FOOTNOTES 5. These can be found in SEC filings, some only in the annual report. Look for the footnote on the pension fund to see how much of net income may have come from its gains. In the bull market of the late '90s, that was an inflator at companies such as GE (GE
) and IBM (IBM
). Now, the issue may be shortfall. There's also a special note devoted to restructurings and how much money has been spent on layoffs and facility closings. Look for the word "reversals." This indicates that the company overestimated how much it would have to spend and has fed that excess back into earnings.
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