How To Read A Firm Like A Book

Foreword from ShareInvestor

This article “How To Read A Firm Like A Book” by Alvin Foo was first published in The Sunday Times on 17 Mar 2013 and is reproduced in this blog in its entirety.

Investors can glean valuable information about a company by learning what to
look for in its financial statement

Making sense of a listed company’s financial statement may seem like rocket science to some investors, especially if trawling through pages of numbers and corporate jargon is not your cup of tea.

Yet these public documents contain nuggets of information which could be crucial to the making or breaking of your stock investments.

They offer key insights into a company’s financial well-being and possible future performance.

“Financial statements provide investors with a scorecard of a company’s financial health,” said DBS group research analyst Ho Pei Hwa.

“It’s also important to look at the historical performances of the company.”

Typically, financial statements comprise three key components – the income statement, balance sheet and cash flow statement.

The income statement reveals how much a company earned and spent, the balance sheet unveils what a company owns and owes, while the cash flow statement shows the money stream moving in and out of a company.

Equity and accounting experts list the top 10 items to note when reading these statements, and how to identify red flags.

1 Profit

The chief attention-grabbing figure in the sea of numbers is usually net profit, or what a company earns after accounting for costs.

Typically, this is the first port of call which market experts head to.

“Sales and net profit as well as growth are probably the sexiest lines that capture our eyes when we first look into a company’s financial statements,” said DBS’ Ms Ho.

This is before diving into the margins and other cost items, she added.

Investors should find out whether net profit – also known as earnings – meets market expectations and identify possible reasons.

They should also look out for one-off items, such as a sale of assets or a debt write-off, which could result in abnormal earnings, said remisier Wang Han Hui.

These items should be excluded to ascertain the company’s core profits, he added.

2 Revenue

Another major number is revenue, or the total amount of money received by the company for goods sold or services provided.

“The ultimate long-term driver of growth for a company is its revenues, and hence this is the key item to focus on,” said Mr Hartmut Issel, head of Asia-Pacific wealth management research at UBS.

Comparing this number to historical figures will show if the company is winning or losing market share.

Investors may also look at the company’s revenues by segment to identify the performance of various business units, said Ernst & Young assurance partner Yee Woon Yim.

How a company recognises revenue may differ from sector to sector.

“For example, companies that are involved in long-term contracts such as construction of buildings and ships tend to recognise revenue as and when the construction progresses,” said PricewaterhouseCoopers (PwC) partner Kok Moi Lre.

3 Dividends

Investors will be most keen to see the proposed dividend, if there is one, and especially if they are shareholders, as it shows the attractiveness of the company in paying out regular returns. They should also look at the consistency of the dividend payout and the firm’s ability to continue paying the dividend, said Mr Wang.

DBS’ Ms Ho said: “A mature company’s willingness and ability to pay steady dividends over time, better still to increase them, provides good clues about its fundamentals.”

A dividend cut could signal the need to conserve funds or an inability to maintain its past dividend track record, said OCBC investment research head Carmen Lee.

One keenly followed ratio is dividend yield, which is the dividend distribution a share divided by the stock’s current price. This is especially so for sectors such as real estate investment trusts and telcos.

Investors should compare this yield for a company to that of its peers in the industry.

4 Debt

Key questions investors should consider are whether debt is rising, what it is being used for, and whether the company is able to afford its interest expenses.

“Higher debt is not necessarily a bad sign, especially if additional debt is being deployed to clearly identified rowing business or funding its business expansion,” said OCBC’s Ms Lee.

Investors should also look out for interest cover – a measure of a company’s creditworthiness – to ensure that its debt service ability is healthy, said Ernst & Young’s Mr Yee.

A closely watched figure by analysts is the gearing ratio, the ratio between a company’s borrowed funds and its capital or assets. The higher this ratio, the more risk the company is exposed to.

5 Cash Flow

Cash is king, especially during turbulent times.

Hence, a company’s cash flow statement is crucial, as it reveals how a company spends its money and where its liquidity comes from.

“Sometimes, a company fails not because of a bad product it sells; rather it’s because it does not manage its cash flow well,” said PwC’s Ms Kok.

A significant segment to watch is cash flows from operating activities.

“It tells us whether the business is generating enough positive cash flows to fund its capital expenditure and investment, repayment of bank loans, and have enough to pay dividends,” Ms Kok said.

6 Valuation Ratios

Investors should use the data contained in the financial statements to compute two widely used ratios used to measure a company’s stock value.

The first is the price-to-earnings (PE) ratio – the ratio of the company’s stock price to its earnings per share. A high PE suggests that investors are expecting sharper earnings growth in the future compared to companies with a lower PE.

“It is necessary to compare PE ratios relative to other companies within the same industry,” said DBS’ Ms Ho.

The second is the price-to-book value, which is the ratio of the company’s stock price to its book value, that is, what the company is said to be worth overall.

If a company is trading at less than its book value, it normally means either the market believes the asset value is overstated or the company is earning a very poor return on its assets.

“It’s a tried-and-tested method for finding low-priced stocks that the market has neglected,” Ms Ho added.

7 Costs

A surge in some costs could erode a company’s competitiveness and point to a rocky road ahead.

“A rise in sales and marketing cost will give a hint towards increasing competition, which in turn leads to pressure on profit margins,” said UBS’ Mr Issel.

A sudden increase in operating costs could signal hiccups in a company’s processes or a change in industry trends.

8 Outlook

Financial statements typically contain views from the management concerning its earnings prospects.

This usually provides a general indication of how the management expects the company and industry to perform.

“One should also look into the outlook commentary for a basic understanding of the company’s outlook, but more research on a company’s growth prospects and industry trend is absolutely critical,” said DBS’ Ms Ho.

Some firms may also issue profit warnings, an early indication that its earnings in the coming quarter will decline.

9 Changes To Senior Management

Sound corporate governance is a key indicator of a healthy company.

Thus, investors should be alert to changes in the senior management, such as the chief executive officer and chairman.

“Regular resignations of key executives could point to unclear strategies for the company or that the company could be headed for more troubles,” said OCBC’s Ms Lee.

A frequent change in the chief financial officer should raise alarm bells, especially for a company with a short track record of operations and listing history, noted DBS’ Ms Ho.

10 Auditors’ Report

The auditors’ report is an essential part of every financial statement, as it indicates the auditor’s opinion following its evaluation of the company.

It is closely watched for warning signs.

OCBC’s Ms Lee said: “A change in auditors or an adverse opinion report from auditors could also be indications of troubles ahead.”

Auditors may issue a red flag over a company’s future by indicating that it may not continue as a going concern, which means that the company could soon be dissolved or become bankrupt.