First up are some filings every investor should be able to read and know how to use to find a good company. There are 3 main filings that investors use the most, including the Income Statement, Balance Sheet, and Statement of Cash Flows. There is a fourth used in accounting and which is needed for the others, which is the Statement of Stockholders' Equity. At the bottom I put some info from Warren Buffett on how important these filings are and how to use them.
All publicly traded companies have to file these documents (some yearly, some quarterly), and they can be found on free websites such as Sec.gov under the filings.
Income Statement
This is a financial statement that reports a company’s revenues and expenses over an interval of time. It shows whether the company was able to generate enough revenue to cover the expenses of running the business. If revenues exceed expenses, then the company reports net income, if they do not the company reports a net loss.
Take this Starbucks income statement for example. The income statement lists revenues at the top (Starbucks has 3 categories) and then expenses underneath to calculate net income.
Company stores - The Starbucks stores we go to in town.
Licensed stores - Starbucks inside of target or other stores.
Other - Selling their branded coffee, cups, and other products.
Some of the main expenses any business, not just Starbucks, have to pay for include...
Cost of Goods Sold (COGS) - All the incurred costs to get to a final product. Starbuck's would include coffee beans, the labor, the cup, and all the other costs needed to get to the final cup of coffee sold to the customer. This is how you get gross profit (how much they make on each cup).
Sales and Marketing - Such as Starbucks running an ad campaign on TV or billboards.
Research and Development (R&D) - Where companies spend million and sometimes billions to find the next big thing in their industry. This is where Starbucks would put the cost to develop a new drink for Christmas time.
General and Administrative - Expenses generated for running the business, such as paying workers' salaries.
Cash Flow statement
This is where a company posts where they spent and made cash from. This differs from the income statement because it also shows cash inflows and outflows, such as investments in stock or, in Starbucks' case, new buildings. The CFS acts as a sort of bridge between the IS and the balance sheet.
The CFS is broken down into 3 sections -
Investing - Includes the acquisition/disposal of non-current assets and other investments not included in cash equivalents. Typically include cash flows associated with buying or selling property, plant, and equipment (PP&E), other non-current assets, and other financial assets.
Operating - Operating activities are the principal revenue-producing activities of the entity. Cash flow from operations typically includes the cash flows associated with sales, purchases, and other expenses.
Financing - Cash flow from financing activities results from changes in a company’s capital structure. Includes cash flows associated with borrowing and repaying bank loans or bonds, issuing or buying back shares, and the payment of a dividend.
Indirect - Starts with Net Income
Companies can choose to report these 3 sections in an Indirect or Direct CFS
Indirect - Cash flow statement begins with net income on an accrual basis and subsequently adds and subtracts non-cash items to reconcile to actual cash flows from operations. This account tries to take purchases on credit and other deferred revenue into consideration. This is the method most companies use.
Direct - Cash flow from operating activities is presented as actual cash inflows and outflows on a cash basis, without starting from net income on an accrued basis. (means there is a line item for each in-flow and outflow). This is very time consuming and not many companies use this.
Stockholders' Equity
The statement of stockholders’ equity is a financial statement that summarizes the changes in stockholders’ equity over an interval of time. Stockholders’ equity arises from two primary sources—common stock and retained earnings.
Stockholders’ Equity = Common Stock + Retained Earnings
Net income comes from Income Statement
Accountants use parenthesis to show a negative number. Meaning this is subtracting dividends.
Common stock (CS) (external source of equity) represents amounts invested by stockholders (owners) when they purchase shares of stock. The change in common stock over the period is shown as:
Beginning CS + New Issuances of shares = Ending CS
Retained earnings (RE) (internal source of equity) represent all net income minus all dividends over the company's life. The change in retained earnings over the period is shown as:
Beginning RE + Net Income – Dividends = Ending RE
Balance Sheet
The balance sheet is a financial statement that presents the financial position of the company on a particular date. The financial position of a company is summarized by the accounting equation -
Assets = Liabilities + Stockholders’ Equity
Assets are the resources of the company, and liabilities are amounts owed to creditors. Equity funding is needed because assets surpass liabilities, meaning funding must come from somewhere else, which is why a company issues stock.
Assets
Any item or resource with monetary value that company owns.
Current - Convert to cash in 1 year.
Noncurrent - Longer term where you cannot recognize true value until after 1 year.
Cash and cash equivalent - short term and super safe investments that can be easily turned into cash.
Marketable securities - similar to C&CE (such as bonds)
Accounts receivable - Amount of money owed to company by credit purchases.
Inventories - Completed and ready to be sold but have not been sold.
Property, plant, equipment (PPE) - Assets company will own for 1 year+ (cars).
Liability
Something the company owes
Current - Expected to be paid off in 1 year
Noncurrent - Companies expect to have for more than 1 year
Accounts payable - Money owed for products/services already received
Deferred revenue - Money paid but product/ service is not complete yet (subscription)
Commercial paper - short-term debt (about a month, such as loan payments)
Warren Buffett and Financial Statement Interpretation
Buffett has gone as far to say that the financial statements of a company are the language of business, and that if you do not understand them, do not invest in individual stocks. These statements may not have the glamour of other informational sites, but they can be fun to read and provide everything you need to know about the business.
Consistency
Buffett says the best amount of time to hold a stock is forever. Stocks such as Coca Cola have been Dividend kings and revenue machines for decades. Companies like that do not seem to have an end in sight as not a lot of companies can compete at that level. This means consistently growing revenues and EPS, consistently lowering debt and expenses, and being great at 1 or a few things, rather than good at a lot of things.
When you have a specialized niche, you can lower COGS, marketing costs, equipment costs, and can build a solid brand name because you use, and do, the same things for decades.
What Buffett looks for in the Income Statement
Looks for growing Net income consistently and compares margins, such as Net margin and Gross margin, over the years to other companies to see how your company lines up.
Balance Sheet
Buffett has said he likes looking at the retained earnings of a company, as this number can change depending on if a company is reinvesting net income or not. Steady growth in RE shows good reinvestment and steady income growth. Then after seeing how a company chooses to spend its income, you can look at Return on Equity (ROE) to see how efficient this company is when they reinvest.
Cash Flow Statement
When analyzing a CFS and looking at all the ins and outs of money for the company pay attention to what the company is spending on. So, if Capital expenditures rise over a 1–2-year period, see if new building or equipment were purchased and how this new capital will help the business grow.
Buffett also looks at dividends paid, and share buy backs. Making sure companies have enough cash to pay for these actions is important for long term growth.