I started investing without really bothering looking at the financial reports. When I started looking at stocks, I looked at the company’s name and evaluate whether the products that the company is selling are popular. My rationale is simple: As long as the product is popular, profit streams will be continuous.
What I failed to realize is that a good product does not really translate to profits. There are many companies who have good products but still end up losing money. One of the reasons could be higher cost of producing the product, or probably an unexplainable high cost of running the operations.
To avoid investing in those kind of companies, there are financial reports that an active investor need to study. A publicly listed company is required to file these reports online on a quarterly and annual basis. I use the portal Rocket Financial to look at these reports. You type in the company’s name in the search box and you’ll get the latest SEC filings on the front page of the company you have searched.
These financial reports would include:
Profit and Loss Statement
Cash Flow Statement
Notes to Financial Statements
Management’s Discussion and Analysis
Don’t worry, we will not discuss each statements on this article but allow me to give you an overview of how I go through each of these reports.
Some investors advice that they start with the notes to Financial Statements first all the way to the balance sheet. The reason is that majority of the investor never really bother to read the notes. Although I don’t recommend doing this, reading the notes is as crucial to reading the main financial reports itself. There are nuggets of information hidden in the notes.
Actually before I dig down the reports, I usually look at the business model of the company. If I can’t explain the business model to a 10-year old kid, I won’t bother looking at the reports. I’d like to draw the business model in diagram – right from the manufacturing of the product down to the selling to end-users. If I can’t do that, the investment is a pass.
My next step is to read the balance sheet. The balance sheet gives you an overview of the company’s assets, liabilities and net worth. What I would really like to look at before investing in the company is its capital structure. In most cases, I don’t like companies funded mostly by debt. When I see a company with that profile, I don’t bother looking at the other financial statements. It’s a good screen for investors who don’t like bankruptcy risk.
If I am comfortable with the balance sheet, I’ll go to the cash flow statements. The cash flow statement tells you how much cash the company is generating, how much the company is spending and where the source of the company’s cash aside from its operating cash flow. What I would love to see is a positive cash flow from operations and litle capital spending. If it’s negative, I would take note of it for further research.
Another thing that I would love to look at is the financing cash flow. I don’t want a positive financing cash flow. It would mean that the company relies mostly on other people’s money to fund its operations. If it’s consistently positive, I would consider it a red flag.
I don’t really put too much emphasis on the profit statement. What I would like to see is cash generated from the business. After all, cash is fact and income an opinion.
After a quick view of the profit statement, I would go to the notes to the financial statements. The notes to financial statements is supplementary to the balance sheet, cash flow statement and profit statement. Although it’s supplementary, I believe it gives a big margin of safety for risk-averse investors.
A quick checklist on the notes would include hidden liabilities, possibility of loss or regulatory and special purpose vehicles. However, my assessment of the notes would not end these. I would look at how the company records its revenues, etc. If there are any change in accounting policies or estimates. These are dirts that the company would like to hide from investors.
By this time, I would have already idea on the issues that the company is facing. I would then validate these concerns through the management’s discussion and analysis. This section gives you an overview on the company’s strategy and direction. I love looking back at past management’s discussion to see whether the management has actually executed its plans. Even without meeting the management in person, this will give you an idea of what kind of management are you dealing.
After this, I’ll take my research to the next level. I will go through over the issues that I have found from my quick view of the financials. I will also read these reports over and over again to give me confidence that I haven’t really missed anything.
How about you? What’s your process of reading these financial reports? In the next posts, I would be happy discussing you specific points on each of the financial reports. Happy investing!