ON BUSINESS || Seven Financial Statement Basics and Six Cash Flow Trends to Evaluate a Company's Financial Health
Q2 earnings reports are dropping daily, and if you aren’t an active investor, you may be thinking, what’s the big deal?
If you’re relatively new to the world of reading financial statements, you could treat reading quarterly earnings reports (and the more detailed annual reports) as an exercise to help you learn and get better at evaluating a company's financial health.
You may have seen stock traders sharing a technical analysis of graphs and charts of stock prices on social media. I lean more towards the Warren Buffet way of investing, where we take the time to find out if the company is running a sustainable, good business, where we’re happy to go along on the ride for a few years.
“If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.”
If you share this approach towards investing and business, you should learn the financial statement basics below to lay a foundation for understanding the numbers behind a business. Here are seven financial line items to get you started.
Revenue: Revenue is the total amount of money that a company brings in from selling its products or services—the most basic line item and also a good measure of the company's size and growth potential.
Cost of goods sold (COGS): COGS is the cost of the materials and labour that go into making the company's products or providing its services. It is a good measure of the company's profitability.
Gross profit: Gross profit is the difference between revenue and COGS. It is a good measure of the company's ability to make a profit after paying for the cost of its products or services.
Operating expenses: Operating expenses are the costs that a company incurs to operate its business. They include things like rent, utilities, salaries, and marketing.
Net income: Net income is the company's profit after all expenses have been paid. It is a good measure of the company's overall financial health.
Free cash flow: Free cash flow is the amount of cash that a company has available after paying for its operating expenses and capital expenditures. It is a good measure of the company's ability to generate cash and invest. In other words, does the company know how to make money profitably?
Debt: Debt is the amount of money a company owes to its creditors. It is a good measure of the company's financial leverage. If you want to dig a bit deeper into the debt line items, you want to assess the timeline of when different debts come due. For example, if the company has a massive amount in current liabilities that need to be repaid soon but their cash reserves won’t cover it, you’d want to think twice about investing.
Given that we are in a recessionary market, here are six trends to watch for that would indicate the first signs of a company in financial trouble:
Negative free cash flow. Free cash flow is the amount of cash a company generates after paying for its operating expenses and capital expenditures. A negative free cash flow indicates that a company is spending more money than it is bringing in, which can signify financial trouble.
Declining revenue. A decline in revenue is a red flag for any company, but it is especially concerning during a recession. When revenue declines, it can be difficult for companies to cover their costs and make debt payments.
Increased debt. As companies struggle to generate cash, they may take on more debt to finance their operations. This can lead to a vicious cycle, as the increased debt payments further strain the company's cash flow.
Decreasing profit margins. Profit margins measure how much profit a company makes on each dollar of revenue. When profit margins decrease, the company has to spend more money to generate each dollar of revenue. This can be a sign of trouble, as it means that the company is less profitable and has less money to invest in its future.
Increased inventory levels. When companies struggle to sell their products or services, they may build up inventory levels. This can lead to increased costs and decreased cash flow.
Decreasing asset values. As the economy slows down, the value of assets such as real estate and stocks can decline. This can hurt companies' balance sheets and make it more difficult for them to borrow money.
While it’s essential to understand each of the line items in a financial statement, it’s more important to be able to interpret what they are telling you as a whole. For example, higher cash levels may not always indicate that the company is doing well, especially in inflationary times like now, where the inflation rate is devaluing cash in the bank. Higher earnings in the most recent quarter may not indicate the company is doing better. It may simply reflect seasonality in the business. A ski resort doing better in Q1 and Q4 is because it’s ski season. Understanding the business will give you more depth in reading financial statements in a meaningful and valuable way.
