Decoding Financial Statements 101: How To Identify Threats And Opportunities Below The Surface

Decoding Financial Statements
How To Identify Threats And Opportunities Below The Surface
By Mitch Kummetz, CFA

There's a lot of information that can be gleamed from financial statements. As a sell-side analyst covering footwear and apparel companies, financial statement analysis is part of what I do, and I want to share with you some of the things I look at. But let me caution you that this is just a sampling of some of our analysis, and financial statement analysis should also be accompanied by fundamental research.

Illustration: John Antoski

Since public companies are required to file a slew of information with the SEC, the first thing to discuss is which filings to look for. The ones we care most about are a company's 10-Qs and 10-Ks. The 10-Q is a company's quarterly financial report, and the 10-K is its annual financial report.

Within a 10-Q/K there are a variety of financial statements, and a good place to start is with the income statement. The first thing you'll probably want to know about a company is whether or not its sales are growing. Year-over-year (y-o-y) sales growth can be calculated from the revenue numbers provided at the top of the income statement. But we don't just look at y-o-y sales growth for one quarter or year; we look at growth over a longer period to see if it is accelerating or decelerating. Let me also mention that it is always a good idea to read the managements discussion and analysis (MD&A) of a 10-Q/K, as this gives a fairly detailed qualitative description of the data presented in the financial statements.

You can also use the income statement to determine a company's profitability. There are two primary measures of profitability that we look at. The first is gross margin, which is the profit a company receives from selling its goods after subtracting all of the costs incurred in producing the goods. The second is operating margin, which is the profit received after also subtracting the operating costs of running the company. Gross margin is calculated by dividing a company's gross profit by its sales, and operating margin is a company's operating profit divided by its sales. We look at the y-o-y changes in these profitability metrics and how these changes trend over time.

Now let's turn to the company's balance sheet. There's a lot one can do with the balance sheet to help assess a company's financial well-being, but I'll just mention a few things. First, we look at the company's net-debt position, which is its total debt minus cash. This comes in handy when valuing a company relative to its peers. Second, we look very closely at inventory, as this is something that can factor into a company's future profitability. We look at the y-o-y change in inventory relative to a company's anticipated rate of sales growth. Third, we look at receivables. "Red flags" here could suggest that a company is stuffing the channel or that a company could have a hard time collecting from its customers.

Lastly, let's look at the statements of cash flows. What we're most interested in here is seeing if a company is generating free cash flow, which is the cash generated after operating expenses, investments, and dividends. There are a number of ways to calculate free cash flow, but the simplest is to take net income and add back depreciation and amortization, and subtract capital expenditures and dividends. Free cash flow is important for paying down debt, buying back stock, or making acquisitions.

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Mitch Kummetz, CFA, is an analyst for Robert W. Baird & Co. specializing in the apparel market. In 2009, Kummetz was named the No. 5 Best Brokerage Analyst in the apparel industry by Forbes. Volcom, Quiksilver, and VF Corporation, which owns Reef, Vans, and The North Face, are among the brands Kummetz covers. He can be reached at (303) 270-6371 or mkummetz@rwbaird.com.