Business

Financial statement analysis 101 — What the numbers indicate

SSL In The Money

with Sutanya Chedda

Wednesday, November 24, 2010    

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WHETHER you watch the Business Review or read articles in the Jamaica Observer, you will constantly hear experts enforce the importance of "doing your homework" before investing in a company and this can be done via a number of measures including effective interpretation of financial statements as discussed in our article last week. However, separate and apart from using ratio analysis, an understanding of line items on key financial statements and what they indicate are useful.

A financial statement is a formal record of the financial activities of a company presented in a structured manner. It is essentially a historical document, relaying what transpired during a particular period or at a point in time. Investors, however, are typically concerned about what will happen in the future as it relates to earnings and dividends. Financial statements are a good start, but it is the fundamental analysis of these statements that determines the intrinsic value of a company's stock. It is important for investors to have a working knowledge and understanding of balance sheets, income statements and cash flow statements to discern a company's investment quality as this is the basis for smart investment choices.

Prudent investment practices encourage investors to look for companies with strong balance sheets, solid earnings and positive cash flows over a period of time. The income statement shows the difference between a company's revenues and expenses over a period of time. This statement is analogous to a set of stairs - You begin at the top with the total amount of sales made in the period, then each step down represents deductions in the form of expenses or other costs. Profit is realised at the foot of the staircase (the bottom line). Generally speaking, companies ought to be able to bring in more money than they spend for sustainability. companies with low expenses relative to revenue, or high profits relative to revenue signal strong fundamentals to investors.

Since profit is equivalent to revenue net of expenses, the best way for a company to improve profitability is by increasing revenue. For instance, Caterpillar Inc (NYSE: CAT) has produced consistent revenue growth and has also set aggressive long-term goals that include a 2012 sales expectation in the range of US$55 billion to US$60 billion. Consistent revenue growth should help to boost a Company's bottom line and thus result in a lower Price to Earnings (P/E) multiple. It is important to note that from an analyst standpoint when we speak of revenues we refer to sales generated from the company's core operations. For example, Carreras Ltd (CAR) posted a 31 per cent increase in Net Profit for both its fiscal second quarter and year-to-date (YTD) period as its core business regained momentum in spite of continued challenges.

While expenses related to rising oil prices are accepted as inevitable, an income statement that reveals more staff related costs whilst the number of employees remains the same requires investigation. Expenses such as these are particularly debilitating for companies, especially if prices cannot be raised to cover the excess as an upward trajectory of expenses reduces the Company's profitability. However, increased expenses associated with business expansion are understandable as this is necessary to accommodate increased working capital levels, but also, increased revenue growth.

While an analysis of the income statement is beneficial, investors should also recognise that cash flow statements are a "must read" item, reason being "cash, not profit, is king". Accurate assessment of this statement will reveal cash flow problems, financial arteries and trends; it will differentiate the company that is steering up new trade from the one that is struggling to meet payments. The bottom line of the cash flow statement shows the net increase or decrease in cash for the period. A healthy cash flow has enabled National Commercial Bank of Jamaica Ltd (NCBJ) to reward shareholders with dividends, generally on a quarterly basis. The stock's current dividend yield stands at 7.72 per cent. Positive cash flows have also enabled International Business Machines Corp (NYSE: IBM) to repurchase billions of its shares year after year.

Turning the focus to the company's financial position, the balance sheet provides detailed information on assets, liabilities and net worth (shareholder's equity). Net worth represents the funds that would be left if all of its assets were sold to meet all of its obligations. The balance sheet shows whether assets or liabilities are "tilting" the company's scales. In the first couple years of a business venture it is acceptable and expected that its liabilities will outweigh its assets, however, if a negative trend persists, the investment is not worthwhile. For example with a book value of $50.73 billion, Scotia Group Jamaica Ltd (SGJ) has a strong Return on Equity (ROE) of 20 per cent.

In keeping with the above, Stocks & Securities Ltd (SSL) continues to recommend that investors focus on fundamentally sound companies with track records of consistent revenue and earnings growth, and positive cash flows. A few stocks to include in your portfolio are Jamaica Broilers Group Ltd (JBG), Carreras Ltd (CAR), General Electric Co (NYSE: GE) and Goldman Sachs Group Inc (NYSE: GS).

Sutanya Chedda is Research Administrator at Stocks & Securities Ltd. She can be contacted at schedda@sslinvest.com.

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