Money & Business
Reading Financial Reports
Spot the next Enron a mile away.
Even the most experienced investor can get lost in the jungle of a company’s
financial statements. But basic knowledge of the balance sheet, cash flow
statement, and income statement go a long way. With just a little effort, you can:
Financial Report Basics
Financial reports, or financial statements, are documents
that summarize a company’s financial performance. All
publicly traded U.S. companies that have more than 500
investors and $10 million in net assets, or that are listed
on a major national stock exchange such as the New York
Stock Exchange (NYSE) or the NASDAQ, are required by
law to issue financial statements on both a quarterly and
annual basis. This regulation is enforced by the Securities
and Exchange Commission (SEC), the U.S. government
agency that regulates the investment industry.
Financial reports are meant to create transparency and
accountability by making companies’ financial results vis­
ible to investors and the market as a whole. The reports
are standardized, meaning that the annual and quarterly
reports from various companies contain comparable (though
not necessarily the same) financial information.
How Investors Use Financial Reports
Reading a financial report is the only way for most inves­
tors to get a good picture of a company’s performance and
financial situation. Learning to read and analyze financial
reports can help you understand a company’s financial
performance in detail and, in turn, make more informed
investment decisions. By reading and analyzing financial
reports, you can begin to invest based on a company’s fun-
damentals, or financial statistics—an essential step toward
becoming a confident, successful stock investor.
Annual Reports (10-Ks)
An annual report (in SEC lingo, a 10-K) covers a public com­
pany’s performance during the previous fiscal year. Private
companies don’t file 10-Ks. The report contains two basic parts.
Narrative Summary
The narrative summary is a written synopsis that gives
investors some insight into the company’s vision and strate­
gies. It includes the following components:
• Letter to shareholders
• Management bios and compensation data A quarterly report (in SEC lingo, a 10-Q) is similar to an
• Management’s discussion and analysis (MD&A)
• Auditors’ statement
Financial Statements
The annual report also contains three financial statements
that provide hard data on the company’s financial perfor­
mance over the previous year.
• Navigate through the sections of an annual report
• Calculate basic ratios to measure profitability, liquidity, and solvency
• Make better, more informed investment decisions
• Balance sheet: A snapshot of the company’s financial
condition at a specific point in time, including assets
(cash, items owned by the company, and money
owed to the company); liabilities (debts and financial
obligations); and equity (assets minus liabilities).
• Income statement: A breakdown of the company’s
revenue (income) and expenses (costs) over a specific
period of time. The income statement shows whether
the company has earnings, also known as profits or
net income. Earnings are the cash that remains after
all expenses have been taken into account.
• Cash flow statement: A detailed list of all cash
inflows (money coming in) that a company receives
from its ongoing operations and external investment
sources, as well as all cash outflows (money going out)
that pay for business activities and investments.
Notes
Every financial statement includes a set of accompanying
footnotes in small print at the end of the financial state­
ments section. These notes, also known as footnotes,
serve as annotations to the statements themselves and
often include the juiciest, most revealing bits of informa­
tion in the entire annual report. For example, if a company
recently purchased a new private jet for its executives, that
minor detail (which could cost tens of millions of dollars)
would likely be stipulated in the notes and nowhere else.
Companies also often bury their financial problems, such as
the cause of a drop in sales or a spike in debt, in the notes.
The “Financial Highlights” Section
Along with their actual financial statements, companies
often include a user-friendly summary of their financial data.
Typically referred to as financial highlights, this section of
the annual report is neither required nor formally regulated.
As a result, the financial highlights are not always presented
in accordance to accounting rules. Therefore, you should
never trust the financial highlights‘ accuracy. Refer to the
actual financial statements instead.
Quarterly Reports (10-Qs)
annual report, with two important differences:
• Timeframe: Quarterly reports cover only the three
most recent months of a company’s performance.
They’re issued three times per year (the fourth-quarter
report is included in the annual report). So if it’s June
and you’re reading an annual report that was published
published by Barnes & Noble
in January, be sure also to review the more recent
financial data contained in the latest quarterly report.
• Mostly just financials: Quarterly reports don’t contain
as much narrative commentary as annual reports. They
may have a brief introduction but otherwise contain
just the financial statements.
The Best Sources for Financial Data
Most publicly traded companies publish their quarterly and
annual reports online for free. Reports are typically available
in the following locations:
• Company website: Look for links to the investor
relations section of the website.
• SEC website: www.sec.gov/edgar.shtml
• Yahoo! Finance: finance.yahoo.com
You can often get a paper copy of the annual report by
calling the company directly and requesting one from the
investor relations department.
How to Read the Narrative
Summary of an Annual Report
The narrative summary provides a glimpse into how the
company views its own prospects and also gives some
insight into the company’s management and strategies. All
narrative summaries of annual reports contain four parts:
• Letter to shareholders
• Management bios and compensation data
• Management‘s discussion and analysis (MD&A)
• Auditors’ statement
When reading the narrative summary, keep in mind that the
company is using it in large part to try to present itself in the
best possible light, even if its annual financial results were
weak. Read between the lines, with skepticism.
Letter to Shareholders
All annual reports begin with a message that’s ostensibly
from the company’s top executives but more likely written
by the company’s public relations department. This letter
to shareholders is typically designed to highlight the posi­
tive aspects of the company’s year but should also address
negative results. Though you should read this letter to get a
sense of the company’s current overall message, never rely
on it when determining whether to buy a company’s stock.
 www.quamut.com Reading Financial Reports

Management Bios and Compensation Data
Following the letter to shareholders, the annual report typi­
cally contains sections that provide biographical and com­
pensation information about the company’s management
team—the group of top executives who run the company.
• Management bios: Information about the educational
and business background of each management team
member. The bios can help you assess whether the
company’s executives are appropriately qualified. If
you’re thinking of investing in a software company, for
example, you want executives with strong background
in the software business, not the pet care business.
• Compensation data: Specifics about salary, stock,
and other compensation awarded to the management
team. This data can help you assess how fairly the
company pays its executives. For instance, if recent
financial results are weak, the company shouldn’t
award executives exorbitant compensation packages.
If a company’s management strikes you as underqualified or
overcompensated relative to management at other, similar
companies, you may want to avoid the company’s stock.
Management’s Discussion and Analysis
The management’s discussion and analysis, often
referred to as the MD&A, is the portion of the annual report
in which the company’s management expresses its views
on the company’s past year of performance and its future
prospects. Read the MD&A closely to get a sense of how
closely management’s views align with the company’s
actual financial results contained in the balance sheet, in­
come statement, and cash flow statement.
Overall Contents of the MD&A
The MD&A covers four aspects of a company’s business:
• Liquidity: The company’s cash position and ability to
cover its expenses on a short-term basis
• Capital resources: The company’s debts and its plans
for using debt, such as expansion, acquisitions, and
other major capital expenses
• Results of operations: A summary of financial results,
including earnings, profits, and taxes
• Market trends: A review of external trends and events
in the marketplace, such as weather or energy prices,
that may impact the company’s performance
Specific Disclosures in the MD&A
The MD&A contains many specific data points, called dis-
closures, that can help you get a sense of the company’s
financial standing. The specific disclosures you should read
most closely are:
• Revenue recognition: Specifies when a company
books revenue for a sale, as opposed to when it
actually receives revenue for a sale. You should be
wary of companies whose revenue recognition policies
allow them to book revenue far in advance of actually
receiving the revenue: these policies can create the
illusion that a company generates much more revenue
than it ever actually receives.
• Allowance for doubtful accounts: The company’s
expected losses as a result of unpaid accounts
receivable. The losses that result from doubtful
accounts can reduce or erase a company’s earnings.
A notable increase in doubtful accounts over several
quarters can signal a problem with the company’s
accounts receivable strategy or a general breakdown in
the industry’s liquidity.
• Environmental and product liabilities: The
company’s risk of being sued or held responsible for
paying financial claims made by other organizations or
individuals. Companies with a high degree of potential
liability, such as chemical transporters or cigarette
manufacturers, can see their earnings diminished or
erased by litigation fees and judgments.
• Restructuring charges: The company’s disclosure of
costs it expects to incur as a result of restructuring,
such as shutting factories or relocating parts of the
business. These charges can be recurring or confined
to one event. One-time charges are less worrisome
than recurring charges, though either type can
significantly cut into earnings.
• Stock-based compensation: Specific details of stock-
based compensation packages awarded to employees.
In general, stock-based compensation should reflect
the company’s performance. Be wary of companies
offering stock-based compensation that seems
excessive, especially if company performance has
recently been lackluster.
• Pension plans: Companies with employee pension
plans (company-paid employee retirement plans)
must disclose how they plan to meet the plan’s
financial obligations. Be especially wary of very large
corporations, as they may have vast pension plan
obligations that can threaten earnings.
Auditors’ Statement
The SEC requires companies to pay third-party auditors
to verify the reliability and accuracy of financial reports.
The auditors create a final assessment, called an auditors’
statement, that usually appears just before or after the
financial statements contained in the annual report.
What Auditors Do
Auditors don’t check every single transaction a company
makes. Instead, they perform a battery of tests that provide
reasonable assurance against material misstatements—
errors that can significantly impact a company’s financial
position. These tests provide some protection against bla­
tant fraud but should not be considered foolproof.
Contents of the Auditors’ Statement
An auditors’ statement typically contains an introductory
paragraph, a scope paragraph, and an opinion paragraph.
• Introductory paragraph: Basic information regarding
the audit and financial data it covers, such as the time
period the audit covers and the names of the auditors.
This paragraph is meant to limit the auditors’ liability
by stating that the audit is merely an opinion about the
financial data and that the company’s management is
responsible for the contents of the financial reports.
• Scope paragraph: A description of the standard set of
guidelines for financial accounting, called the Generally
Accepted Accounting Principles (GAAP), that the
auditors followed to conduct the audit. The paragraph
states the rules accountants must follow in recording
and summarizing transactions and in preparing financial
reports. GAAP standards stipulate that the main goal of
the audit is to ensure that the financial report is free of
material misstatements.
• Opinion paragraph: The auditors’ conclusions based
on the company’s financial reports. If the auditors
found no major problems, they’ll say so in the opinion
paragraph. An auditors’ statement that uncovers no
major problems is called an unqualified auditors’
statement or a standard auditors’ opinion. An
auditors’ statement that does uncover major problems
is called a qualified auditors’ statement. In such
cases, the auditors will use the opinion paragraph to
specify the problems they uncovered.
Qualified Auditors’ Opinions
Auditors issue qualified opinions for many reasons. Some
are minor and technical in nature; others may indicate major
trouble, such as impending bankruptcy. Among the most
serious reasons for issuing qualified opinions are:
• Going-concern issues: Auditors issue going-concern
qualifications when they have substantial doubt that
a company will be able to fund its operations, pay
its debts, and remain a going concern­— i.e., stay in
business. Problems that might lead to this qualification
include staffing issues, disputes with suppliers, ongoing
losses without the prospect of near-term profitability,
and so on.
• Business uncertainties: Some uncertainties in the
company’s future could lead to substantial losses,
which could in turn prevent the company from
remaining a going concern. These can include a
possible merger that seems likely to fall through or
a major deal with a shady supplier. If an uncertainty
merits inclusion in an auditors’ opinion, it’s likely a
major threat to the company’s future.
• Questionable accounting practices: When
significant differences arise between the way auditors
and company management handle the accounting
of a major item, such as a sizeable business deal,
the auditors will mention the discrepancy in their
statement. This qualification can signal unscrupulous
management behavior and may be a major red flag.
Auditors may also issue qualified opinions if they’re unable
to obtain the information or resources they need in order to
issue an unqualified opinion. For example, if the company
withholds information from the auditors, the auditors will
issue a qualified opinion even if the available financial data
is verifiable and accurate.

The information contained in this and every Quamut guide is intended only for the general interest of
its readers and should not be used as a basis for making medical, investment, legal or other important
decisions. Though Quamut makes efforts to create accurate guides, editorial and research mistakes can
occur. Quamut cannot, therefore, guarantee the accuracy of its guides. We disclaim all warranties, including
www.quamut.com
warranties of merchantability or fitness for a particular purpose, and must advise you to use our guides at Copyright © 2007 Quamut
your own risk. Quamut and its employees are not liable for loss of any nature resulting from the use of or
All rights reserved.
reliance upon our charts and the information found therein.
Quamut is a registered trademark of
This chart and the information contained in this chart are for general educational and informational uses Barnes & Noble, Inc.
only. The chart is not a recommendation, solicitation, or offer to buy or sell any security, investment, or 10 9 8 7 6 5 4 3
fund. The chart is not intended to provide you with any personalized legal, financial, accounting, or tax
advice. The chart should not be used as a substitute for personal advice from a legal, financial, accounting,
Printed in the United States
or tax expert. This chart does not make any representations or warranties as to the accuracy, timeliness,
Photo Credits: Page 1: Royalty-Free/Corbis.
suitability, completeness, or relevance of any information contained therein. Writer: Megan Kaminski
 www.quamut.com Reading Financial Reports

highest degree of security and flexibility if it needs to acquire more assets or reduce its
How to Read a Balance Sheet liabilities (by paying down a loan) or equity (by buying back its own shares).
The balance sheet is a summary of a company’s current financial standing based on assets, • Accounts receivable: Money that customers owe the company for products or
liabilities, and equity. services they’ve already received. Investors compare a company’s accounts receivable
amounts over several quarters to assess how effective the company is at collecting
• Assets: Cash, items owned by the company, and money owed to the company by money it’s owed. If the total accounts receivable increase each quarter, but the cash
other parties balance remains the same or decreases, investors might be wary of investing in the
• Liabilities: Any debt owed to people or organizations outside the company, including company because it’s failing to collect on money owed.
bank loans, wages, and fees owed to suppliers • Short-term investments: Stocks, bonds, CDs, and other investments that the
• Equity: Total assets plus retained earnings (profits generated by the company that company can convert to cash within the next 12 months (not including cash
were reinvested into the company) minus total liabilities—also referred to as owners’ equivalents). Investors consider short-term investments second only to cash and cash
equity or shareholder equity equivalents since they’re easily liquidated, or converted to cash, in the near term.
Short-term investments are also referred to as marketable securities.
The most fundamental equation that investors use to evaluate a company’s financial health • Inventory: Saleable products the company owns. Inventory on the balance sheet is
is called the balance equation or accounting equation: valued at its cost to the company, not the price at which the company hopes to sell the
product. Investors don’t value inventory as favorably as short-term investments and
liabilities + equity = assets cash, as it’s never certain that the company can convert its inventory to cash by selling
it at a profit in the marketplace.
Investors refer to the balance sheet to find the three components of this equation and see
how they relate. Investors tend to favor companies whose assets exceed their liabilities, Long-Term Assets
making their equity value positive. Though long-term assets are defined as assets convertible to cash after periods of one year
As a company grows and its assets increase, its liabilities and equity tend to increase as or more, companies rarely hold these assets with the intention of converting them to cash.
well. For example, for a company to build a new factory, it must either reduce current assets Two types of long-term assets appear most often on corporate balance sheets:
or increase liabilities and/or equity. Namely, it must do at least one of the following:
• Fixed assets: All of the land, buildings, furniture, and machinery that the company
• Use existing assets: By spending cash or liquidating an asset (converting it to cash, owns. Rather than specify an asset’s current value, balance sheets show the original
usually by selling) cost of the asset minus depreciation—the amount of an asset’s original value lost
• Acquire a liability: By taking out a loan from bank or some other lender over time due to use or some other cause. If the asset has increased in value, or not
• Take on more equity: Typically by soliciting further investment from the company’s depreciated, the balance sheet includes the original value only. For instance, the
current shareholders or by offering stock for sale to the public company on the sample balance sheet owns a building it bought for $300,000. If the
building’s current value is $1 million due to price appreciation in the real estate market,
A Sample Balance Sheet the company holds a hidden asset worth $700,000 more than the amount in the
This sample includes the most important line items, or specific fields, you’ll find on most balance sheet. Investors don’t pay much attention to the current value of fixed assets
companies’ balance sheets. The remainder of this section explains how to read and analyze because companies rarely convert these assets to cash. But it’s worth noting the
the line items. Please note that on financial statements, parentheses indicate entries with current value of fixed assets, because at times the assets may be sold or reorganized.
negative values. • Intangible assets: Nonphysical long-term assets, rights, and licenses that the
company owns or controls. A common intangible asset is goodwill, which puts
Types of Assets an approximate dollar value on a company’s overall brand, longevity, and esteem.
As you can see on the sam­ a sample balance sheet Investors tend to value intangible assets only in terms of the price a company might
ple balance sheet, compa­ command in an acquisition, when the acquiring company would have to compensate
nies have two main types the company for the intangible assets, such as goodwill, that it has built up over time.
of assets:
Types of Liabilities
• Current assets: Any Before deciding to invest in a company, it’s crucial to know how the company’s assets com­
assets that are cash or pare to its liabilities. If a company’s liabilities threaten to consume most or all of its assets,
can be converted into the company faces the prospect of bankruptcy, which typically causes stock prices to plum­
cash within a year met. Like assets, liabilities are typically classified as current or long-term.
• Long-term assets:
Assets (such as Current Liabilities
buildings or land) that Current liabilities are debts that a company must pay during the next 12 months. Investors
require more than a year pay particularly close attention to current liabilities because these debts usually are paid
to convert to cash with current assets, which must be either cash or be easily convertible to cash within 12
months. If a company can’t pay down current liabilities with cash, it will have to take out
Current Assets loans, raise more equity, or go bankrupt. The most common current liabilities include:
Pay close attention to cur­
rent assets, as they fund • Short-term debt: Lines of credit used to pay current liabilities. Since these loans carry
the company’s day-to-day high interest-rate charges, investors tend to favor companies with low short-term debt.
operations, short-term debt A high amount of short-term debt can indicate that the company can’t secure long-
(explained below), interest term debt (at lower rates) to meet its cash needs. Short-term debt is also referred to as
payments, and dividends. notes payable.
If a company’s current as­ • Accounts payable: Fees the company owes for services, supplies, and so on. A quick
sets fall short, funds must (though not conclusive) way to gauge a company’s financial health is to compare its
be raised either through accounts payable to its accounts receivable amounts—the latter should be higher.
borrowing (taking on more • Accrued expenses: Expenses for bills not part of accounts payable, such as operating
liability) or seeking addi­ expenses, which can include advertising, payroll, utilities, or taxes.
tional investment (taking • Current portion of long-term debt: Portions of long-term debt, such as mortgages,
on more equity). The most that must be paid within the next 12 months. These are classified as current liabilities.
commonly reported current
asset categories included on Long-Term Liabilities
balance sheets are: Long-term liabilities are long-term loans, such as mortgages, loans used to buy machinery
or equipment, or bonds, which must be repaid at some point more than 12 months from
• Cash and cash equivalents: The cash in a company’s checking and savings accounts, the current date. Long-term liabilities typically don’t concern investors as much as short-
plus any other assets that can be converted to cash almost immediately. Assets with term liabilities because they don’t pose an immediate bankruptcy threat. Investors with a
maturities shorter than 90 days, such as short-term bonds and certificates of deposit long-term view, however, tend to be wary of companies with significant long-term liabilities
(CDs), also fall into this category. Investors look for companies whose current assets because these debts can cause big problems down the road.
are composed mainly of cash and cash equivalents, as these give the company the
 www.quamut.com
Equity (a.k.a. Owner’s Equity or Shareholder’s Equity)
The equity section details the claims that shareholders have on a company’s assets. A
company’s equity is equal to its total assets minus its total liabilities. Investors tend to favor
companies with positive equity numbers, which means the company’s assets total more
than its liabilities. The two components of equity are stock and retained earnings.
Stock
Each share of stock that the company has sold to the public is valued on the balance sheet
at its initial offering price, not at its current market value. Since gains and losses in the com­
pany’s share price impact the shareholders, not the company, don’t interpret a company’s
share price fluctuations as proof that the company is making or losing money.
Retained Earnings
Profits not paid out to shareholders as dividends at the end of the year are classified as
retained earnings. Many businesses, especially younger companies, forgo dividends and
reinvest profits to fund new product launches and other business expansion. Investors must
therefore consider the context of a company’s decision to retain earnings. A company’s
decision not to pay dividends isn’t necessarily a sign that the company can’t afford to pay
dividends—the company may simply want to invest its profits in new opportunities.
How to Read an Income Statement
The income statement shows a company’s overall financial results, including profits, loss­
es, and expenses, during a particular period. The income statement has four key parts:
• Revenue: Money the company received from sales of its products, goods, or services
to its customers—also called sales or gross income
• Cost of goods sold: Costs incurred to make or purchase the goods or services that
the company sells to customers—also called cost of sales
• Gross profit: The net difference between sales and cost of sales for a period. If sales
are greater than cost of sales, the company has earned a gross profit. Gross profit is
calculated before expenses, such as taxes, are taken into account. These profits are
also called earnings. Gross profit minus operating expenses, such as utilities and
supplies, is called operating income or operating profit.
• Expenses: The amount the company spent on costs related to operating the business.
These may include administration, marketing, payroll, and so on
• Net profit: A company’s total revenue minus total expenses—also called net income,
net earnings, or the bottom line
A Sample Income Statement
The example below shows the specific line items included on most income statements. The
remainder of this section explains all of the line items included in this example.
a sample income statement
Revenue
The point at which a company considers its revenue earned, called revenue recognition,
can vary greatly between companies. It’s critical that you know how a company recognizes
revenue before deciding to buy its stock because manipulative revenue recognition is one
of most common ways executives can “window-dress” company earnings. In particular,
manipulating revenue recognition can help:
• Inflate the profits a company actually achieves in order to appease investors
• Reduce the revenues a company claims to have made in order to lower its tax burden
Reading Financial Reports
Investors tend to favor companies that recognize revenue when they actually get paid in full,
not when they close a deal or simply “book” the revenue based on expected future sales.
The income statement alone won’t tell you how the company recognizes revenue: look for
that information in the notes that accompany the financial statements. If you can’t find it,
call the company’s investor relations department and ask them directly.
Cost of Goods Sold (Cost of Sales)
Companies don’t often include a detailed breakdown of cost of goods sold (COGS) in their
income statement. Typically, though, the category includes the following costs:
• Raw goods: The cost of buying supplies and raw materials required to make the
company’s products or to facilitate offering its services
• Labor: The cost of the workers the company used to produce its products or services
(this figure does not include payroll wages paid to the company’s regular staff)
• Inventory: The cost of all products the company has produced but not yet sold
For a company to be profitable, its COGS must be significantly less than its total revenue,
as that revenue must cover not only COGS but also the company’s various other expenses
as well.
Gross Profit
Gross profit shows the difference between the amount a company paid to manufacture its
products and the amount it received for selling those products. Gross profit gives investors
a sense of whether a company is selling enough products or services to cover its COGS. But
gross profit alone doesn’t indicate definitively whether a company is covering its COGS, as it
doesn’t take into account all the company’s expenses. The formula for gross profit is:
revenue (sales) − COGS = gross profit
Generally speaking, investors may be inclined to avoid buying stocks of companies with
negative gross profit, as a negative number can signal a lack of demand for the company’s
goods or services, problems with product pricing, or other serious issues.
EBITDA
In addition to gross profit, income statements also often include a line item called EBITDA,
which stands for earnings before interest, taxes, depreciation, or amortization (the gradual
paying off of a liability, such as a mortgage). Investors use EBITDA as a starting point to com­
pare companies because only EBITDA shows the profitability of a company based exclu­
sively on its operations. Even so, EBITDA cannot be considered definitive, as interest, taxes,
depreciation, and amortization can dramatically reduce net profits, which matter most.
Expenses
Companies have various types of expenses, each of which typically appears in a specific
place on the income statement. For example, operating expenses typically appear as a
deduction from the gross profit line on the income statement. The four most common types
of expenses are:
Expense Description Location on Statement
Operating Administration, advertising, research Gross profit section
and development (R&D), royalties,
sales, and so on
Interest Interest paid on loans and other debts EBITDA section
Depreciation Depreciation on buildings, equipment, Gross profit or EBITDA
and other property section
Taxes Total amount company paid in taxes EBITDA section
Net Profit
The net profit is called the “bottom line” for good reason: it’s typically the last line item on
an income statement. It’s also the line item that arguably matters most because it repre­
sents whether the company has made money after all expenses have been subtracted from
the total amount of revenue. Companies with negative net profit numbers have incurred a
loss. Though investors sometimes buy the stocks of companies with no net profits, or with
losses, this type of speculation can be risky and is not appropriate for all investors. A more
conservative strategy for beginning investors is to invest in companies that have had con­
sistent positive net profits over an extended period of time—five years or more.
How to Read a Cash Flow Statement
The cash flow statement shows investors the details about the cash that the company
currently has on its balance sheet. More specifically, it indicates the sources of cash com­
ing into the company and the recipients of cash flowing out of the company. The cash flow
statement is divided into sections based on three different types of cash transactions:
operating activities, investing activities, and financing activities.
 www.quamut.com Reading Financial Reports

A Sample Cash Flow Statement

This sample includes the specific How to Assess Profitability
line items you’ll find on most To try to determine whether a company’s stock is worth its current share price, investors
companies’ balance sheets. use a variety of ratios. These ratios help put a company’s profitability in context by compar­
The remainder of this section ing the company to its peers in the same industry. For example, if you know the Coca-Cola
explains each item in detail. Company is profitable, you also need to know how its profitability compares to that of other
beverage companies, such as PepsiCo Inc. and Cadbury Schweppes PLC. Among the most
Operating Activities popular ratios and statistics investors use to analyze profitability are the price/earnings
This section of the cash flow ratio, the return on sales ratio, the payout ratio, and various profit margins.
statement provides a summary
of cash transactions resulting Price/Earnings Ratio (P/E Ratio)
from the company’s day-to-day The P/E ratio divides the company’s share price by its earnings per share (EPS), or the total
operations. Here, the term day- earnings divided by the total number of shares outstanding (shares held by investors).
to-day operations refers to all
the company’s regular business market value per share of stock / EPS = P/E
activities, including paying its
staff, paying for supplies, and A company with a share price of $20 per share and an EPS of $2 has a P/E of 10.
producing, marketing, and sell­
ing products or services. This Using the P/E Ratio
section includes depreciation Though the average P/E ratio for all stocks historically falls between 15 and 25, the signifi­
by adding it back to income. cance of the ratio depends on the company’s particular industry and on overall economic
(Depreciation is a noncash ex­ conditions at a given time. For example:
pense, so it doesn’t represent
any actual cash flow out of the • A P/E of 30 may be typical in the tech industry because investors tend to pay more
company and is merely an ac­ for the shares of tech companies with high growth prospects, giving those stocks high
counting expense.) prices relative to their earnings.
Investors examine this part • A P/E of 5 may be typical in the shipping industry because growth rates are much
of the cash flow statement to determine whether a company generates enough cash based slower than in the tech industry.
on day-to-day operations to cover its expenses. If the company fails to generate enough
cash from operations, it will have to rely on investing or financing activities. Investors may One effective way to get a sense of whether a tech or shipping company offers good value,
avoid investing in a company in this situation because that company isn’t making enough for example, is to compare its P/E to that of its direct competitors or, better yet, to the aver­
money on its own to support itself. age P/E ratio of the entire industry. One way to find out an industry’s average P/E is by using
the Yahoo! Finance Industry Browser, at biz.yahoo.com/ic.
Investing Activities
This section summarizes the company’s capital expenditures, or the investments that the Return on Sales Ratio (ROS)
company has made with cash. These expenses typically involve: The return on sales (ROS) ratio is used as a measure of a company’s operational efficiency.
By analyzing the income statement numbers using ROS, you can gauge how much profit
• Paying for mergers and acquisitions (joining forces with or buying another company) a company brings in for every dollar of sales it makes. To calculate ROS, consult the com­
• Purchasing marketable securities (stocks or bonds) pany’s income statement to find its net profit and the total amount the company paid in
• Purchasing buildings, land, or equipment taxes. Add the amount the company paid in taxes to total net profits and divide the result
• Repairing and improving existing buildings, factories, or equipment by sales (revenue) to get the ROS:

Investors examine this section of the cash flow statement to assess whether the company
is spending its cash wisely. Investors tend to be particularly wary of expenditures, such as
the purchase of a residence for a company executive, that don’t seem likely to contribute
to the company’s net profits. Companies typically bury the explanation for large capital ex­
penditures that don’t relate directly to the company’s business in the notes that accompany
the company’s financial statements.
Financing Activities
This section covers cash on the balance sheet used to fund financing activities that involve
debts, dividend payments, or the company’s issuance or purchase of its own stock. Inves­
tors look for the following specific activities in this section of the cash flow statement:
• Stock buybacks: Companies buy back shares of their own stock when they believe
the stock is undervalued or, less frequently, if they need stock to meet internal
obligations, such as stock option grants. Investors typically view stock buybacks as
a favorable sign that a company believes in its own future enough to bank on it. In
addition, stock buybacks reduce the number of shares outstanding, which investors
often see as a favorable move.
• Dividend cuts or increases: Companies have the option to increase or decrease the
dividend payments they offer to shareholders. For companies that do issue dividends,
investors tend to view dividend increases as a sign of a company’s strength and
dividend cuts as a sign of financial problems.
• Debt: Companies can pay down existing debt or take on new debt to fund operations
or capital expenditures. Investors typically consider a company’s decision to pay down
debt as a sign of financial strength. How investors view the decision to take on more
debt depends on the amount and the purpose of the debt. If investors consider the
debt excessive or unnecessary, the company’s stock may fall out of favor.
net profit before taxes / sales = ROS
Using the ROS Ratio
As with the P/E ratio, the best way to get a sense of the significance of a company’s ROS is to
compare the ROS to that of direct competitors or to the average ROS of the entire industry.
When comparing two companies in the same industry, the company with the higher ROS
number has a higher degree of operational efficiency.
Payout Ratio
The payout ratio measures the percentage of earnings that a company distributes to share­
holders as cash dividends. To calculate the payout ratio, consult the income statement to
find the total amount the company spent on cash dividends, then divide by net profits.
cash dividends / net profits = payout ratio
Using the Payout Ratio
The payout ratio can help investors assess how a company’s dividend payouts compare to
other companies in the same industry. Investors use this information to assess a company’s
profitability and overall financial well-being. For example, if two companies in the same
industry have vastly different payout ratios, investors might be wary of the company with
the lower ratio. More specifically, they would investigate why that company has chosen
to retain the cash that other companies in the industry pay out to investors as dividends.
Unless they uncover a good reason for the discrepancy—such as significant capital expen­
ditures that will boost the company’s future profits—they might suspect that the company’s
profitability is too low to cover expenses and dividend payments together. Like all financial
statistics, the payout ratio alone doesn’t suffice as support for investment decisions. It must
always be considered in the context of the company’s other core fundamentals.

Change in Cash and Cash Equivalents

The final section expresses the company’s net cash position. A positive number indicates
positive cash flow, which means the company took in more money than it spent. A negative
number indicates negative cash flow, which means the company spent more than it took
in. The final number equals the sum of total operating, investing, and financing activities.
 www.quamut.com Reading Financial Reports

Profit Margins
A profit margin expresses, as a percentage, the difference
between what a company pays for a product or service and
what it receives for selling that product or service. A com­
pany’s overall profit margin is equal to its net profit divided
by its sales during a specific period of time. Though the over­
all profit margin gives a sense of how efficiently a company
converts sales into profits, investors use the following three
more focused versions of the profit margin to evaluate a
company’s profitability: the gross margin, operating margin,
and net margin.
Gross Margin
The gross margin is a profit margin based only on sales and
the cost of producing those sales. It divides gross profit by
net sales (total sales, or revenues, minus expenses related
to returns or discounts, if any):
gross profit / net sales = gross margin
Investors use gross margin to assess a company’s efficiency
in producing and distributing its products or services. After
determining the gross margin, compare it to that of other
companies in the same industry. A higher gross margin
indicates a greater degree of efficiency.
Operating Margin
The operating margin helps investors evaluate how well a
company controls costs by factoring in expenses, such as
distribution and R&D, not directly related to the production
and sales of a product. To calculate operating margin:
operating profit / net sales = operating margin
Companies with an operating margin above the industry
average are typically better at controlling their cost of sales
and operating expenses, which gives them advantages such
as pricing flexibility during difficult economic times.
Net Margin
The net margin measures a company’s overall effective­
ness at realizing net profits from sales. To calculate net
margin, divide net profit by net sales or revenues:
net profit / net sales (revenues) = net margin
Net margin is helpful in comparing companies within the
same industry (the higher the margin, the better) and in
most investors look for a current ratio of at least 1.5, pref­
erably higher. Some investors, however, believe that the
current ratio doesn’t accurately predict a company’s ability
to pay debts because it includes assets, such as inventory,
that may be difficult to convert to cash.
Quick Ratio
The quick ratio solves some of the problematic aspects of
the current ratio by factoring in only quick assets—assets
that can be quickly converted into cash (typically within 90
days). To calculate the quick ratio, consult the company’s
balance sheet to find the total quick assets (cash plus
accounts receivable), then divide by total current liabilities:
quick assets / total current liabilities = quick ratio
Using the Quick Ratio
Investors generally look for companies whose quick ratios
exceed 1.0. Typically, investors tolerate a quick ratio under
1.0 only from companies in the retail industry because re­
tailers tend to have most of their current assets tied up in
inventory, which the quick ratio ignores.
Debt-to-Capital Ratio
The debt-to-capital ratio measures the portion of a com­
pany’s capital that comes from debt financing. In this case,
capital refers to the company’s total debts (liabilities) plus
its equity, both of which you can find on the balance sheet.
To calculate the debt-to-capital ratio:
1. Find the company’s total debt (current liabilities + long-
term liabilities).
2. Find the company’s capital (total debt + equity).
3. Divide total debt by capital.
Using the Debt-to-Capital Ratio
Investors favor companies with debt-to-capital ratios of
0.35–1.00. Ideally, the ratio should stay below 0.50. Compa­
nies with debt-to-capital ratios above 0.50 tend to have to
pay higher interest rates on loans because lenders consider
them to be riskier borrowers than companies with more
favorable debt-to-capital ratios. Different industries have
different standards for debt-to-capital ratios, so investors
generally consider a company in the context of its competi­
tors’ ratios.
How to Assess Solvency
cash from operating activities / average current liabilities =
current cash debt coverage ratio
Average current liabilities, which is required in the formula
above, is calculated as follows:
average current liabilities = (current liabilities from this year
+ current liabilities from previous year) / 2
Using the Current Cash Debt Coverage Ratio
As with the cash debt coverage ratio, investors look for
companies with high current cash debt coverage ratios rela­
tive to their competitors’.
Cash Flow Coverage Ratio
The cash flow coverage ratio helps investors assess
whether a company generates enough cash to cover its
capital expenditures, pay its stock dividends, and pay its
debts. To calculate the cash flow coverage ratio:
1. Calculate the company’s cash requirements. To do so,
add the following together:
A. Capital expenditures
B. Cash dividends paid
C. Current portion of long-term debt
D. Interest expenses
2. Then calculate the cash flow coverage ratio. This is
calculated as:
cash from operating activities / cash requirements
Using the Cash Flow Coverage Ratio
The higher the cash flow coverage ratio, the better. A ratio
greater than 1.0 indicates that a company generates more
than enough cash to fund capital expenditures, dividends,
and debts.
Summary of Formulas in this Guide
The table below summarizes this guide’s important formulas
for reading financial reports.
Description Formula
Total assets liabilities + equity
Total liabilities assets − equity
Total equity assets − liabilities

assessing a company’s profitability year to year. Companies Solvency refers to a company’s ability to pay its fixed Gross profit revenue − COGS
that maintain high net margins relative to the competition long- and short-term liabilities, such as mortgage pay­ P/E ratio share price / EPS
over a period of a years aren’t just lucky—they’re consis­ ments and utility bills. Investors use three ratios to assess
tently more effective at generating profits from sales. solvency: the cash debt coverage ratio, current cash debt ROS ratio net pretax income / revenue
coverage ratio, and cash flow coverage ratio. All the data Payout ratio cash dividends / net income
needed to calculate these ratios appears in the cash flow
How to Assess Liquidity statement.
Gross margin gross profit / net revenue

A company’s liquidity refers to how much cash a company Operating operating profit / net revenue
has and how easily the company’s other current assets Cash Debt Coverage Ratio margin
can be converted to cash. Investors consider other liquid­ The cash debt coverage ratio measures a company’s ability
Net margin net profit / net sales or revenues
ity crucial to a company’s financial well-being because to repay its liabilities using cash generated from day-to-day
companies must have cash or highly liquid assets to pay operations. To calculate the cash debt coverage ratio: Current ratio current assets / current liabilities
debts. Companies that own mostly illiquid assets, such as Quick ratio quick assets / current liabilities
factories, may have to take out loans or sell more stock to (cash from operating activities – dividend payments) /
raise funds and pay their bills quickly. Investors use three total liabilities = cash debt coverage ratio Debt-to-capital total debt / capital
ratios to assess liquidity: the current ratio, the quick ratio, ratio
and the debt-to-capital ratio. Using the Cash Debt Coverage Ratio Cash debt (cash from operating activities –
The cash debt coverage ratio looks at a company’s ability coverage ratio dividend payments) / total liabilities
Current Ratio to pay all of its debts. A negative number indicates that
Cash current cash from operating activities /
A company’s current ratio divides current assets by cur­ the company could become insolvent, or unable to pay
debt coverage average current liabilities
rent liabilities: its debts.
ratio

current assets / current liabilities = current ratio Current Cash Debt Coverage Ratio Average (current liabilities from this year + cur­
The current cash debt coverage ratio helps investors current rent liabilities from previous year) / 2
Using the Current Ratio assess a company’s ability to repay its short-term debts. liabilities
To cover current liabilities, a company must have a current The formula for the current cash debt coverage ratio is:
Cash flow cash from operating activities /
ratio of at least 1.0. Though the standard varies by industry, coverage ratio cash requirements