My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a tax partner and the managing partner of Cunningham LLP in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog do not reflect the position of Cunningham LLP. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned.

Monday, March 21, 2011

Reading Financial Statements For Dummies

Today I will discuss some simple tips to utilize when reading financial statements (that clicking sound you just heard are the other readers hitting the escape button when they saw reading and financial statements used in the same sentence). For the two of you still here,"Dummies" is of course used in the popular culture context; however, in the case of reading financial statements, I often feel like one and I am an accountant.
If you are a non-accountant, what should you look for when reviewing a company’s financial statements? I will assume you do not have the background to review such technical items as the accounting policies to determine how revenue is recognized or such; so here are a few simple things non-accountants can look for in the financials:

1. Cash is always king, so always include a review of the statement of cash flows, especially in the case of mature companies. None other then Warren Buffett says "it’s good to compare how much different cash flow is from net income: if the latter is substantially higher than the former, you could have some aggressive accounting to worry about" (see Larry MacDonald's blog Buffet on accounting manipulation for further Buffett comments).

2. For those with a sense of accounting adventure, you can try and calculate the Current Ratio and Debt Ratio:
The current ratio measures liquidity, (a sense of a company's ability to meet its short-term liabilities with liquid assets) and is calculated by dividing Current Assets by Current Liabilities. A ratio of 1:1 implies adequate coverage and the higher above 1:1 the better. If it is relatively low and declining, that is not a good sign.
A company's debt ratio is calculated by dividing Total Liabilities by Total Assets (or alternatively, Total debt divided by Total Assets). This ratio tells you the extent by which a company’s assets have been financed with debt. For example, a debt ratio of 40% indicates that 40% of the company's assets have been financed with borrowed funds. Debt can be good or bad. In times of economic stress or rising interest rates, companies with high debt ratios can experience financial problems. During good times, debt can enhance profitability by financing growth at a lower cost.

3. If you have always wished for a "Coles Notes" summary of the financial statements you are in luck. Effective for all periods ending on or after December 15, 2010 new audit standards in Canada will result in changes to the auditor’s report, which will make it far simpler for investors of any sophistication to determine the key issues in the statements. One major change is the requirement for an “Emphasis of Matter” paragraph in the auditor's report. Companies will now be required to highlight matters that are disclosed in the financial statements that are of such importance, they are fundamental to the users’ understanding of the financial statements. The issues noted in the Emphasis of Matter discussion are disclosed elsewhere in the financial statement notes, but the new paragraph prevents companies from being able to hide these issues in the many pages of notes.

4. The notes to the financial statements are ignored by many novice investors, but the notes often have important nuggets of information. One of the first notes on any set of financials are the accounting policies and accounting estimates notes. For most non accountants, trying to follow and understand the accounting policies and estimates will be futile, however, if these notes disclose a change, try your best to understand the impact of the change on the F/S which should be disclosed in the case of a change in policy. You should also always read the “Subsequent Events” note to determine if anything of a substantial nature has changed for the company that is not reflected in the financial statements. The commitments note will inform you of any required outlays over the next several years and finally the contingency note, which will inform you of potential lawsuits and such. Some of these items may not be disclosed in the Emphasis of Matters note discussed in #3 above.

5. Most public company financial statements reveal how many fully diluted shares are outstanding. I like to see what constitutes that number, so I add together the common shares issued, stock options outstanding and warrants issued. Then I review the terms of the the warrants and options to get a feel for the stock price at which maximum dilution would occur.

6. If you are looking at anything less than a “large cap” company, potential financings must always be considered. I have been sideswiped on several occasions by a private placement or financings at a discount to the current stock price that have deflated a stock on the move. I like to see enough cash on the balance sheet to sustain the business for at least 18-24 months so the company is not hand to mouth each month, although for some small cap stocks, it may be closer to 12 months. For these type companies, the Management Discussion and Analysis will often provide the burn rate for the company. If the burn rate is provided, divide the total of the actual cash on hand, plus short term investments, plus the accounts receivable (a little tricky, but assume A/R is a fairly consistent number) less the accounts payable by the burn rate and you will have a crude idea of how many months of cash the company has available.

The above are just some simple review steps that even non-accountants should be able to undertake to gain a better insight into the companies they have stock ownership in.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.

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