Course 1 Part 2rev - 2008

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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 thenumbers. These comparisons may indicate "trends” and are very helpful inassessing a company.

It's hard to generalize about a good rate of change — it depends on the line

item you're looing at and the rates of change in prior years. If a company'ssales rose ! percent in each of the past three years and rose only !# percentthis year, it would not be good. $owever, if the past years' rates of increase

had been only percent, and this year's rate is !# percent, it would be %uitegood.

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Looking at the Change from ear to ear !ori"ontal # $erti%al anal&sis

Horizontal Analysis

&tudy of percentage changes in comparative financial statements.

Two steps

ompute the dollar amount of the change for, the base (earlier) period to the later

period.

*ivide the dollar amount of the change by the base+period amount.

!o' o &ou interpret this

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*ut 'ait+ If t'o &ears are goo, 'ouln-t . &ears be better


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Vertical Analysis

nalysis of a financial statement that reveals the relationship of each statement item

to the total, which is !##/.


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1ost 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 2udging a company's

financial strength, but they are only a starting point. To complete the picture, youmust ac%uire more information about the company's products, people, technology,and other resources that may give it a competitive advantage in the maretplace. 3neof the best sources of supplemental information is the non+financial section of theannual report. This section, usually in front, often tells a lot about top management'sviews on the company's future and ability to compete.

Cal%ulating ratios for a %ompan& for /01 &ear is

relatiel& meaningless+

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4efore I tal about the statements, let me e5plain what I do in general as an investor.When I buy shares of an established company — public at least ten years — I loo 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 !"# ratio$ , and backlog , preferably over thelast four years. The first three items are easily found in the financial statements6 the789 ratio and baclog figures may re%uire additional research.

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%omments on the &tatement of earnings aka ! ( ), *ncome &tatement$

3n this statement, one of the figures to loo at is the total operating income and itsratio to total revenue net sales$;

Total operating incomeTotal revenue

Ideally, you lie 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 operatingincome and becoming more efficient over time in managing its costs and operatinge5penses. There's no "ideal percentage" because the target percentage varies fromindustry to industry.

+hat numbers do * look at this statement

The first number to loo at is net sales and as; +as there an increaseover the last four years at a pace substantially above the inflation rate If theanswer is yes, that's a good sign. The hec also the Internet lins to the

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1rend

pattern in a company's financial performance over time. Bor e5ample, if a company's sales have been increasing over many months or years, analysts would describe this pattern as a sales growth

trend.

2et sales company's total sales less returned merchandise and discounts. ?isted on the statement of

earnings.

2et earnings

company's total revenue less total e5penses, showing what a company earned (or if lost, callednet loss) for a set period, usually one year. ?isted often literally as the "bottom line" on the

statement of earnings. lso called net income and net profit.

!rice earnings ratio !"# ratio$

ratio used to evaluate the relationship between a company's price per share and the earnings per share (97&). Bor e5ample, if a company's stoc is selling for E! per share and the earnings per

share is E, the 789 ratio is : (! F G :).

Measuring the %ompan&-s profitabilit&

4se the 5e%ision 6uielines

Take Aim

)et3s try out these ratios

H

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Comparing Target and Walmart

Some simple horizontal analysis

Analysis: Statement of Earning (Income Statement)

05 s !0" 0" s !0#

$ross profit Increase or Increase or

%00# %00" %005 (&ecline) ' (&ecline) '

Target

(in millions)

Walmart

(in millions)

05 s !0" 0" s !0#

perating Income Increase or Increase or

%00# %00" %005 (&ecline) ' (&ecline) '

Target

(in millions)

Walmart

(in millions)

05 s !0" 0" s !0#

et Earnings Increase or Increase or

%00# %00" %005 (&ecline) ' (&ecline) '

Target

(in millions)

Walmart

(in millions)

05 s !0" 0" s !0#

E*S Increase or Increase or

%00# %00" %005 (&ecline) ' (&ecline) '

Target

(in millions)

+icrosoft

(in millions)

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%omments on the &tatement of financial position 4alance &heet$

3n this statement, two things to loo for are the figure for total stocholders' e%uity andthe ratio of total liabilities to total stockholders' e5uity or .ebt to #5uity atio;

total liabilities

total stocholders' e%uity

Jenerally, a lower ratio of debit to e5uity means a lower risk for acompany's creditors and lower costs when the company borrows money. Ket, how muchdebt a company carries compared with stocholders' e%uity varies widely according tothe norms for the industry and the company's financial strategy. Lust because a companyhas a high debt ratio is not a signal of 'eakness, if the ratio is in the ballpark for theinustr&7

With the statement of financial position, it's important to remember that most

companies try to shine the spotlight on assets, not on liabilities. Borinstance, this statement typically provides a number for total assets and total stocholders'e%uity but not for total liabilities. (To obtain total liabilities, subtract total stockholders'e5uity from total assets). n anonymous writer once said,

6The nees of man are fe' 8 to get foo, fin shelter, an keep ebt off the

balan%e sheet 7statement of financial position86

Meep this in mind and train yourself to see out liabilities reported indirectly as well asdirectly.

!1LP34L 513I0ITI/0S A05 CALC4LATI/0S

4acklog

The amount of a company's unfilled orders at the end of the year. When the company fills the orders thefollowing year, it records the revenue on the statement of earnings. Bre%uently, a company will give its

perspective on baclog in the management discussion section in the annual report.

!#

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Measuring the %ompan&-s Li9uiit&


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 toohigh 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 companys current ratio !as

well as any other ratio" against its main competitors in a given industry. #ertainindustries have their own norms as far as which current ratios make sense and which

do not. $or 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 ne%t recession

Acid Test (Quick) ratio

&he 'uick ratio is simply current assets minus inventories divided by current liabilities. (y taking inventories out of the e'uation, you can check and see if a

company has sufficient li'uid assets to meet short-term operating needs.

1ost people loo for a %uic ratio in e5cess of !.# to ensure that there is enough cash on hand to pay the bills and eep on going. The %uic ratio can also vary by industry. s with the current ratio, it always paysto compare this ratio to that of peers in the same industry in order to understand what it means in conte5t.

Net working capitalIndicates the business) ability to meet short-term obligations, reporting the e%cess of

current assets over current liabilities.

The best way to loo at current assets and current liabilities is by combining them into something calledWoring apital. Woring capital is simply current assets minus current liabilities and can be positive ornegative. Woring capital is basically an e5pression of how much in li%uid assets the company currentlyhas to build its business, fund its growth, and produce shareholder value. If a company has ample positiveworing 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 woring capital, then its current liabilities are actually greater than theircurrent assets, so the company lacs the ability to spend with the same aggressive nature as a woring

capital positive peer. ll other things being e%ual, a company with positive woring capital will alwaysoutperform a company with negative woring capital.

!!

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Measuring the %ompan&-s Solen%&


Debt to EquityIndicates the balance between total e'uity ownership !common and preferred

stockholders" and long-term debt. &he greater the percentage, the more *leveraged+ is the company.

Debt ratio

Indicates the balance between total e'uity ownership !common and preferred stockholders" and long-term debt. &he greater the percentage, the more *leveraged+

is the company.

@is 1anagement ssociation determined that the acceptable range for the debt ratio is #.D to #.:D.

$igher ratios indicate a company that is highly leverages, lower ratios indicate a more stable organiNation

Ready to try??????

)et3s try out these ratios

%omments on the &tatement of cash flows

3n this statement, loo at the figure for cash provided, or used, by operatingactivities (operations). Without a doubt, this number is the most critical on thisstatement. These activities represent the basic business of the company. If a companyconsistently fails to mae 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 — aremore difficult to interpret. Bor e5ample, negative investing cash flows may indicate onlythat the company is growing and buying assets that enable it to manufacture more products. Binancing 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 informationon the company's strategies.

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1ffi%ien%& ratios

MI15 STAT1M10T RATI/S

Inventory turnover ratio

An alternative measure of how 'uickly inventory is sold.

Nuber o! days" sales in inventory An indicator of the amount of inventory maintained relative to the company)s sales

!as measured by the cost of goods sold".

#eceivable turnover ratio

An alternative, but e'uivalent, measure of the efficiency of the company)sreceivables collection efforts. If the company also makes sales for cash, *total credit

sales+ should be substituted for *total sales.+

Collection period

easures 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

)ets look at these ratios in relation 1arget

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Can you trust fnancial statement?

Documents

Course 1 Part 2rev - 2008