How to Read a Financial Report: Wringing Vital Signs Out of the Numbers
by John A. Tracy, published 2009
There isn’t too much to say about John A. Tracy’s “How To Read A Financial Report: Wringing vital signs out of the numbers”. It’s a basic guide to understanding the income statement, balance sheet and statement of cash flows that all businesses, public and private, rely on to internally control their business as well as report the condition of their business to other investors and third parties.
It’s set up in a wide (versus standard tall) format and goes step-by-step through the various financial statements, their sub-sections and sub-accounts and the way specific items on each financial statement interact with other items on other financial statements. There are a number of tables and figures for illustrative purposes.
Below, I have summarized some of the most important takeaways to serve as a quick reference for myself going forward.
Sales Revenue and Accounts Receivable (A/R)
The average sales credit period determines the size of accounts receivable.
Accounts Receivable Turnover Ratio = Sales Revenue / Accounts Receiveable
The accounts receivable turnover ratio is most meaningful when it is used to determine the number of weeks (or days) it takes a company to convert its accounts receivable into cash.
Cash Conversion Cycle in Weeks (Days) = 52 Weeks (365 Days) / ARTR
Excess accounts receivable means that excess debt or excess owner’s equity capital is being used by the business.
Cost of Goods Sold (COGS) and Inventory
The average inventory holding period determines the size of inventory relative to annual cost of goods sold.
Inventory Turnover Ratio = COGS / Inventory
Dividing this ratio into 52 weeks (365 days) gives the average inventory holding period expressed in weeks (days).
Average Inventory Holding Period in Weeks (Days) = 52 Weeks (365 Days) / ITR
If the holding period is longer than necessary, too much capital is being tied up in inventory. The company may be cash poor because it keeps too much money in inventory and not enough in the bank. If overall inventory is too-low, stock-outs may occur.
Accounting issues: the inventory asset account is written down to record losses from falling sales prices, lower replacement costs, damage and spoilage, and shrinkage (shoplifting and employee theft). Losses may be recorded in the COGS expense account.
Inventory and Accounts Payable
One source of accounts payable is from making inventory purchases on credit. A second source of accounts payable is from expenses that are not paid immediately.
Sellers that extend credit set their prices slightly higher to compensate for the delay in receiving cash from their customers. A small but hidden interest charge is built into the cost paid by the purchasers.
Operating Expenses and Accounts Payable
The recording of unpaid expenses does not decrease cash.
Operating Expenses and Prepaid Expenses
The prepayment of expenses decreases cash.
Accounting issues: a business may be on the verge of collapse and its prepaid expenses may therefore have no future benefit and may not be recoverable (so, a large prepaid expense account should maybe be discounted to 0 in an NCAV analysis). A business may not record prepaid costs; instead it could simply record the prepayments immediately to expense. A business could intentionally delay charging off certain prepaid expenses even though the expenses should be recorded in this period.
The allocation of the cost of a long-term operating asset to expense is called depreciation. In financial statement accounting depreciation means cost allocation.
Accelerated depreciation results in depreciation over a period of time which is considerably shorter than the actual useful life of the asset. Accelerated means front-loaded; more of the cost of a fixed asset is depreciated in the first half of its useful life than in its second half. If useful life estimates are too short (the assets are actually used many more years), than depreciation expense is recorded too quickly.
Book value represents future depreciation expense, although a business may dispose of some of its fixed assets before they are fully depreciated. Chances are that the current market replacement costs would be higher than the book value of the fixed assets– due to general inflation and the use of accelerated depreciation methods.
An expense is recorded when there is a diminishment in value of a company’s intangible assets.
Accounting issues: if the business adopts a sales pricing policy for recapturing the cost of a fixed asset over X years, then an X-year depreciation life would be most appropriate.
Accrued Liabilities and Unpaid Expenses
Typical accrued expenses:
- accumulated vacation and sick leave pay owed
- partial-month telephone and electricity costs incurred but not billed
- property taxes charged to the year, but not billed
- warranty and guarantee work on products sold in the year, so future expenses related to current sales are matched in the present period
Accounting issues: if a business is seriously behind in paying interest on its debts, the liability for unpaid interest should be prominently reported on its balance sheet to call attention to this situation.
Net Income and Retained Earnings; Earnings Per Share (EPS)
Retained earnings is not an asset and certainly is not cash.
Retained Earnings = Net Income – Dividends Paid to Shareholders
Cash Flow From Operating (Profit-Making) Activities
Cash Flow From Operating Activities (CFO) is best thought of as cash flow from profit.
Drivers of cash flow:
- A/R – an increase hurts CFO; extending customers credit uses cash
- Inventory – an increase hurts CFO; buying inventory uses cash
- Prepaid expenses – an increase hurts CFO; paying for expenses uses cash
- Depreciation – an increase helps CFO; depreciation is a non-cash expense
- A/P – an increase helps CFO; using credit from suppliers frees up cash
- Accrued A/P – an increase helps CFO; delaying the payment of accrued expenses conserves cash
- Income Tax Payable – an increase helps CFO; not paying the full tax burden conserves cash
Summary for the seven cash flow adjustments:
- Increases in operating assets cause decreases in cash flow from operations; decreases in operating assets cause increases in cash flow from operations.
- Increases in operating liabilities help cash flow from operations; decreases in operating liabilities result in decreases in cash flow from operations.
Profit generates cash flow; cash flow does not generate profit.
Cash Flow From Investing and Financing Activities
The second section of the statement of cash flows summarizes investments made by the business during the year in long-term operating assets. It also includes proceeds from disposals of investments (net of tax). These are assumedly one-time cash flows, not recurring like cash flows from operations.
The third section of the statement of cash flows reports the cash flows of what are called financing activities. These are cash flows generated outside the business (new equity sales, new borrowings) or cash flows paid to parties outside the company (stock buybacks, debt repayments, dividends to shareholders).
Profit can be viewed as the internal source of cash flow and is the only renewable, recurring one if the business is in good health as a going concern.
The important question to ask is, “What did the business do with its cash flow from profit?”
The other important question is, “Can the business support its other cash flows (investing, financing) with cash from operations?” If not, the business will not remain solvent and liquid in the long-run.
Impact of Growth and Decline on Cash Flow
Cash flow can be higher or lower than net income for the period. There are three main reasons:
- depreciation and other noncash expenses and losses
- changes in operating assets
- changes in operating liabilities
Growth should be good for profit next year, but growth almost always puts a dent in cash flow for the year.
A business could speed up cash flow from profit if it were able to improve its operating ratios, such as holding a smaller stock of products in inventory. If anything, however, it may allow these ratios to slip a little by offering customers more liberal credit terms to stimulate sales, which would extend the A/R credit period. Or, the business may increase the size and mix of its inventory to improve delivery times to customers and to provide better selection.
Businesses with lower fixed costs have more flexibility to swiftly respond to business declines by reducing costs, thereby improving margins.
A huge net loss for the year may be due to huge write-downs of assets (or by recording a large liability).
The total cash outlays for expenses could be more than total cash inflow from sales revenue, even after the depreciation add back is considered. This is called negative cash flow. In this situation, a business is using up its available cash at the burn rate, which can be used to determine how long a business can live without a major cash infusion.
Financial Statement Ratios
Cash Flow as % of Net Income = CFO / NI
Cash Flow per Share = CFO / Shares Out
Current Ratio = Current Assets / Current Liabilities
The Current Ratio measures short-term liquidity of the business and should be 2 or higher.
Acid Test Ratio = Cash + ST Investments + A/R / Current Liabilities
Also called the quick ratio, should be 1 or higher.
Debt to Equity Ratio = Total Liabilities / Total Stockholders Equity
Debt-to-Equity is an indicator of whether debt is being used prudently.
Times Interest Earned Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense
TIE tests the ability of the business to pay interest from earnings.
Return on Sales Ratio = Net Income / Sales Revenue
Also known as net margin, return on sales measures the ability of the company to earn profit per $1 of sales. It is a sales efficiency ratio.
Return on Investment = Profit / Capital Invested
This is a standard formula with several variants, measuring the profit generated from a particular amount of capital invested. Also,
Return on Equity = NI / Stockholders Equity
Return on Assets = EBIT / Total Assets
The ROA is compared with the annual interest rate on the company’s borrowed money. You want the difference between these two values (spread) to be higher rather than lower. An ROA – Interest Rate > 1 represents gain on financial leverage.
Asset Turnover Ratio = Sales Revenues / Total Assets
Represents the rate at which assets are being converted into sales revenue.
Massaging the Numbers
Businesses can play many games to manipulate their reported financial numbers.
Discretionary expenses, such as repair and maintenance costs, employee training and development, advertising expenditures. Managers have a lot of control over when and how these expenses are recorded by pushing up or delaying such actions.
Stuffing the channels occurs when the manager accelerates sales by shipping more sales to the company’s captive dealers even though they haven’t ordered the products.
Window dressing, whose purpose is to make the short-term solvency and liquidity of the business look better than it really was at the end of the year.
For reporting profits soon, the CEO instructs accountants to choose accounting methods that accelerate sales revenues and delay expenses. To be conservative, the accountants can be instructed to use accounting methods that delay the recording of sales revenue and accelerate the recording of expenses.
If reported earnings are backed up with steady cash flow from operations, the quality of the earnings may be deemed as high.
A quick litmus test for judging a company’s financial performance:
If sales increased by X%, did profit increase X% as well? Did A/R, inventory and long-term operating assets increase by X%?
For example, suppose inventory jumped by 50%, even though sales revenues increased only 10%. This may result in an overstocking of inventory and lead to write-downs later.