To verify the validity of the financial information, the reader can apply tests of "capital strength, profitability, and growth potential--whether these key factors are highlighted in the material that the company choose to show you or not" (p. 2). Therefore, the author answers his initial question with an emphatic 'no'. By educating the reader on basic accounting principles, focusing on the subtleties of the annual report footnotes and its organization, and explaining the manipulations of auditors, the author attempts to increase of transparency of these compliance documents.
Annual reports represent the final stage of a three-step accounting process, bookkeeping, decision making, and reporting. Thomsett concentrated on three reports, the balance sheet, summary of operations (income statement), and the statement of cash flows.
Three areas of financial statements, working capital, capitalization, and profitability, employ ratios.
"1. Working capital
The current ratio compares current assets and liabilities
The quick assets ratio is similar to the current ratio, but without inventory
Inventory turnover compares inventory and direct costs.
2. Capitalization
The debt ratio shows the sources from which operations are funded
3. Profitability
Gross margin compares gross profit to revenues
Expense level is a study of expenses as a percentage of revenue.
Net return compare earning to revenue" (p. 55).
"In addition to the ratio in thee three classification, you can learn a lot by checking dividend yield and the consitency of dividend paid over time, the well known P/E ratio, and some technical indicator, such a the 52-week price range and a review of the trading range" (p. 55).
The working capital ratio indicates the size of a company's pool of cash, its liquidity needed in order to function--pay debts, meet payroll, buy inventory, expand.
Formula Current assets
Current liabilities = x to y
"A general standard for the current ratio is 2 to 1. A company is considered to be in good shape if its current ratio is 2 to 1 or better" (p. 56).
The quick asset ratio, a variation of the current ratio, excludes inventory. "The general standard defining a 'good' level for the quick asset ratio is 1 to 1. So if the quick assets are equal to or higher than the total current liabilities, that is acceptable" (p. 58).
Another dimension of working capital, inventory turnovers, reflects an average based on average inventory levels.
Formula Direct costs of goods sold
Average Inventory = Turns
"There is no single standard for an 'acceptable' number of turns. However, by studying a corporation's inventory turnover over time, you can spot trends . . . in the best of all worlds, turnover would remain steady even when revenues grow substantially. However, there is a tendency for turnover to slow down with greater volume" (p. 60).
"Captialization is simply the funding of a company. It comes from two general sources. Equity is provided by investors, who expect dividends and stock price appreciation. Debt comes from lenders, who expect periodic interest payments and repayment of the amount loaned" (p. 61).
Formula long-term debt to equity ratio
Long-term debt
Long-term debt + stockholders' equity = long-term debt to equity ratio
"Outcomes are not always what they seem. It is possible to conclude that working capital is healthy without realizing that the ratio has been created by growth in long-term debt. Invariable, apparent trends have to be confirmed by also checking other, related trends.
Profitability
Formula Gross Margin Gross profit
Revenues = Gross Margin
"Gross margin becomes meaningful only if and when an established level changes . . . it should remain constant" (pp. 65-66).
Formula Expense level Expenses
Revenues = Expense level
Formula Net operating profit
Revenue = Net return
Formula Earnings per Share Net operating Profit
Total shares outstanding = EPS
Formula Dividend Yield Dividend paid
Share price = Dividend yield
"Dividend yield is meaningful only in relation to the price you pay for stock. After that, changes in the yield don't affect you.
Formula P/E ratio Share price
EPS = P/E
"The P/E ratio can be very unreliable unless it users current information for both sides of the equation" (p. 71).
Technical Indicators
Thomsett defined fundamental and technical indicators as follows, "the financial, also called fundamental, indicators include revenues, earnings, capitalization, and dividends declared and paid . . . the nonfinancial, also called technical, indicators include high and low stock prices during the year and the year-end stock price per share" (p. 72). In his 'Key point' box, the author made the following point, "the 52-week high/low can mislead you and cause you to reach an inaccurate conclusion. You should also review a 52-week price chart to spot the trend within that trading range"m (p. 73). He listed these reasons to question the technical indicator, the trading range might include a nonrecurring spike . . . the price might be showing an upward trend . . . the price might be showing a downward trend . . . volatility in price might make it impossible to spot a trend" (p. 73).
