A line-by-line guide to reading financial statements

Anybody who reads financial statements without a calculator in hand, or a spreadsheet open, is missing a trick. You don't need to build a huge financial model and forecast ten years into the future to get value out of it. But I think you do need at least two, preferably three or four years' reports, and a good dose of pragmatism. This isn't about working out the 'right' number in the way accounting students do, with multiple adjustments - it's more about getting a good feel for the trends.

I am often asked how I navigate financial results statements. Which are the key metrics I look for? What numbers do I value the most and why do they matter?

Reading and interpreting company financial results is something that I used to do on an almost daily basis and I used start by printing off the key pages of the report and highlighting the most important numbers.

And the first pages I would look at were the income statement (which runs through the sales and costs, profit and loss for the period under review), the cash flow statement (which shows the amount of actual cash the company has made and spent) and the balance sheet (which gives a snapshot of the financial position of the company at its period end).

Now I am not saying that printing is strictly necessary, but I would recommend you look at these financial statements before you read the management-selected highlights higher up the report. Working through these statements line by line and comparing the numbers to previous years is a useful exercise.

Here are some of the key lines that you should know how to interpret.

Income statement

Revenue: Sometimes known as ‘sales’ or ‘turnover’, this top line of the income statement shows the amount of money generated from the sale of good or services. You’ll want to see an increase in this number year-on-year and it’s worth checking in the notes of the report to see which segments of the business helped to drive the revenue performance.

Costs: Basic business costs are reported in the income statement in two chunks: the ‘cost of sales’ and ‘operating costs’. Some businesses (like those in the software world) have very low sales costs, but have to spend a lot more money on product development (an operating cost). Others (like retailers) have to spend quite a lot of money for each item they sell, meaning their sales costs tend to be higher.

Operating profits: There are many different lines of profit in the income statement: gross profit, which comes after the cost of sales have been extracted; operating profits, which come after all the costs of operating the business have been accounted for; pre-tax profits, which account for interest payments on debt and one-off charges. I like to look at operating profit because it provides a pretty robust picture of elements of the business growth that are actually within its control.

I never, ever read a results statement without calculating the operating margins and, if I'm looking at a retailer or reseller, the gross margins. If you have a revenue growth story with declining operating margins - forget it. (That kept me out of a number of bad tech stocks during the internet boom years.)

Operating margins are a key figure for comparing companies in the same sector (though adding back depreciation and amortisation gives a more useful result if the companies' policies are very different). This can sometimes be useful not just for spotting recovery stocks, but for assessing their potential value.

Suppose I find a company which is making just 3% return on sales, but its competitors are making 8-10% with the same business model. If management can get margins up to 8% within two years, then I can work out what that would be on flat sales (or sales slightly down, if they're aiming to cut out unprofitable lines of business), and estimate what earnings per share would be at that level of operating margin.

Net profits: Lower down the income statement you’ll find various finance items which account for costs like interest paid on debt and business taxes. The bottom line of the income statement shows the net profit after all of these items have been taken out.

Earnings per share (EPS): Dividing the net profits by the number of shares in issue leaves you with the EPS figure, or the amount of profit available for each individual unit of the company.

Cash Flow Statement

Moving onto the cash flow statement which is presented in three chunks: operating, investing and financing cash flows. While the income statement tends to capture more headlines around company reporting season, it’s the cash flow statement that you’ll find the real meaty information about the company’s performance.

Operating cash flow: This line shows the amount of cash that has entered the business from its day-to-day operations, after taking into account any cash costs. You’ll want to look for operating cash inflows that are higher than company operating profits. That shows a business which is efficiently converting its profits to actual, usable cash.

Capital expenditure: The cash-accounted investment in things that are needed to keep the company’s operations ticking along. Some companies (those with a lot of assets) require a high amount of ongoing capital expenditure, other asset light businesses don’t need to invest so much in capital expenditure.

Investing cash flows: This is normally a negative number as it reflects the amount the company has spent on its investments including ongoing capital expenditure and one-off expenses like acquisitions. You might see a positive investing cash flow number if the company has sold a part of its business.

Free cash flow: The amount of cash left over after taking into account all the cash costs of operations and ongoing cash requirements from capital expenditures. Be warned, this figure isn’t always reported in the cash flow statement and it is different to the net change in cash (represented at the bottom of the cash flow statement) as it doesn’t take into account all the investing or finance cash flows. Free cash flow can be calculated by taking capital expenditure from operating cash flow. You’ll want to see a free cash inflow that is growing and is higher than the company’s net profit figure. For a more detailed description of free cash flow, Ed Croft delves deeper into this metric as part of our multibaggers series here.

How to read the balance sheet

The balance sheet differs from the income or cash flow statements because it provides a simple snapshot of a company’s financial position on a certain date. It is separated into two segments (assets and liabilities) which are in turn separated into ‘current’ and ‘non-current’ segments. The current segment accounts for assets that can readily be turned into cash or liabilities which are owed within one year.

It’s called a balance sheet because the company’s assets and liabilities ‘balance’ to match the value of its equity, or, the value of the business that ordinary shareholders have claim to. The balance sheet will show you how much cash (a current asset) the company has on its books and also the total value of its debt (split into current and non-current liabilities).

It’s worth keeping an eye on both of these metrics - a company that is too reliant on borrowings could be in difficulty, while a company with too much cash on its balance sheet isn’t being terribly efficient.

I also like to use the balance sheet to work out a company’s working capital position. Take the current assets away from current liabilities and you’ll get a picture of the money needed by the business to operate from day to day.

There is actually a whole bunch of financial wizardry that can be conducted with the help of the balance sheet. For example, you can use the accounts receivable line (which reflects the amount of money that the company has billed for but hasn’t yet received the cash for) to work out how long it takes for a business to get paid by its customers. And the accounts payable line (the money that the company owes) to work out how long it tends to take to pay its suppliers.

It’s another area of stock analysis which can end up consuming a surprisingly long time. You sit down with your balance sheet and your spreadsheet and by the time you’ve emerged from your web of numbers, the day is almost over and you don’t feel like you’re any nearer to understanding if the company is in good financial shape.

Here are three key ratios which can help make it easier for you:

Net debt as a proportion of equity: Divide the net debt by the total equity figure to understand how reliant the company is on borrowings. Anything less than 50% is fine.

Working capital: Take the current assets away from the current liabilities. As long as the figure isn’t rising at a faster rate than the revenue growth, there’s nothing to worry about.

Current ratio: Divide the current assets by the current liabilities to assess to show how if the company is in a financial position to meet its immediate financial obligations. If the number is more than 1, there’s no need to worry.

A lot of companies say 'we have £xm cash in our balance sheet' and conveniently don't mention that they also have bank borrowings. I'm not interested in gross cash, particularly as no business can run its operations without some cash in hand - and businesses that take deposits have large amounts of cash that don't really belong to them. It's the net cash, or net debt, that I care about, and that isn't shown on the balance sheet - you have to work it out.

I have to stress that this is not rocket science. It is all fairly simple stuff. Getting the ratios just requires a little application and a bit of time. I should also stress that the ratios will not tell you whether a company is a good investment or a bad one. They will simply show you that, let's say, it is less profitable than another company in the same sector. Up to you to find out why. (Bad management? A low cost, bottom end of the market operator? Strategy to increase market share at the short-term expense of profits?)

But doing the ratios properly does show you the questions you should be asking. And it's also a way of evaluating management and checking that what they are saying in the discussion of operations doesn't put a spin on the truth, or distract you from underlying problems.

Profitability and Efficiency

I also look at a number of ratios that compare the balance sheet and the profit and loss account - relating profit to the capital the company uses to generate it. (These are figures that always seem to be missed out of even quite educated reporting.) You can use return on assets, return on capital employed, or return on equity. ROA has the advantage of cancelling out the advantages any company gains from gearing up, so it shows basic operational efficiency; on the other hand ROCE shows the efficiency with which the company is using its shareholders' funds, and that obviously affects the actual return you're getting.

The importance of these figures is that they show you what returns the company is getting from investing in its business - and if that's less than inflation, or less than the interest rate you could get on the funds, then that should tip you off that it's a poor investment. In 1998, quite a few telecoms companies in Russia were making ROCE of 4%, while the interest rate was above 18% - that if nothing else should have told you the Russian economy wasn't a great investment (and it tumbled later that year).

Some people also use the asset turnover ratio - basically how much in sales a company manages to make for each pound of assets. However, I've found it isn't really as useful as the profit-related figures, except in one special case. When a company is losing money in a profitable industry, the asset turnover ratio will tell you whether it's because the company is not selling enough product - or whether it's because it's selling lots of product but at a loss. The management action needed in each case is, of course, different - in the first case, a marketing drive is needed, and you need to ask how well the company can compete against its rivals (is its product dated or unattractive?) - in the second case, cost cutting is what's needed, or perhaps increased prices.

Now operating margin and ROCE/ROA will tell you whether the company is doing well. But there are also a number of ratios you ought to look at to see the stress factors that can pull a company down. The working capital ratios are the leaders here. For instance you'd naturally want to know how many days' inventories the company has money tied up in - a build up of stocks can indicate slower sales, and if the stock becomes obsolete, the company's got a real problem.

The same goes for receivables. One of the best bits of investment advice I was ever given came from a friend who worked in IT consulting. “If a company has more than 60 days' receivables,” he said, “forget it. Thirty days to invoice, thirty days to pay, that's sixty, and if they have any more, they're going to have problems getting that money out of their customers.” That doesn't work in all sectors - in construction, for instance, stage payments for major projects are normal, and that may mean receivables days are extended - but if the ratios are lengthening continually, that's a sure sign of financial stress.

Oh yes. One last thing you need to do with a spreadsheet before you're finished - and this one has got me out of three or four stocks six months ahead of a really bad result. Just check the half-year on half-year comparisons. Because we don't have quarterly reporting, most people just look at the full year results against last year's. However, it can often be surprising what happens when you calculate the second half and look at the progression of revenue and profit growth for each six month period. A company that's apparently growing quite nicely year-on-year at the interims may actually be a long way behind its second half performance last year - and you can bet it's not all seasonality.