How to evaluate a Stock by reviewing Financial Information

While reading the book, Financial Intelligence, A Manager's Guide to Knowing What the Numbers Really Mean, I had the annual report of Intrepid Potash in front of me. Because I had paid more than what the stock currently sells for, I wanted to assess whether my belief in its long term potential justified keeping it. For a non-financial analyst, this book offers the basic principles in a readable, easily comprehensible way.

 Having worked for a software company that manufactured accounting applications for Fortune 500 and smaller companies, I have an understanding of accounting principles and month-end, and year-end processing, the balance sheet, and income statements.  What I lacked was how to digest efficiently quarterly and annual financial report information and how to spot quickly the ways companies can distort the numbers to improve bottom-line results. The authors of Financial Intelligence claimed as their philosophy, "that everyone in a company does better when they understand how financial success is measured and how they have an impact on the company's performance" (p. xi) and its first chapter is entitled, You can't always trust the numbers.

In that chapter the authors list a couple of ways a company blatantly 'doctors' its numbers:
1. "One time charge" mechanism: when a company accumulates many charges and
lumps them into one quarter, improving the financials of future quarters instead of recording the charges when they in fact occurred.
2. Financial shell game: Moving expenses from one account to another to improve the bottom line.
3. Retiree benefit accruals: Lowering the numbers even though the commitment remains at the higher rate (this generated, according to the authors, a front page article in the Wall Street Journal.)
4. Determining when to recognize revenue: Although FASB has some rules regarding when companies in some industries can recognize revenue, the authors noted: "According to a 2007 study by the Deloitte Forensic Center, 41 percent of fraud cases pursued by the Securities and Exchange Commission between 2001 and 2006 involved revenue recognition" (p. 8). Options that companies have used include "When a contract is signed, When the product or service is delivered, When the invoice is sent out, When the bill is paid" (p. 8).
5. Accrual, allocation, and depreciation estimated and subjective amounts.

 Part 2 of the book, The (Many) Peculiarities of the Income Statement, covers the components of the income statement--revenue, sales, deferred revenue, earning per share, cost of goods sold, operating expenses, depreciation and amortization,  and one-time charges. The last two items I previously mentioned as areas for financial statement manipulation. Given that focus, the authors begin this part of the book with the chapter, Profit is an Estimate. They elaborate on the topic of profit by discussing it in it many variations, gross profit, operating profit (EBIT), and net profit. To this mix, the authors add contribution margin, "sales minus variable costs. It shows the profit you are earning on what you sell before you account for fixed costs" (p. 81). Part 3, The Balance Sheet Reveals the Most, delved into the sections of that financial statement. According to the authors, the balance sheet constitutes "a statement of what a business owns and what it owes at a particular point in time" (p. 90). Assets reflect what a business owns and liabilities, what it owes.

Part 4, Cash is King, demonstrates by the title the importance that the authors put on this one item.
The authors cite Warren Buffet as an investor that examines the cash position of companies most closely. The authors compress his laser vision on cash by isolating his three practices: "First, he evaluates a business on its long-term rather than its short-term prospects.  Second, he always looks for businesses he understands. . . . And third, when he examines financial statements, he places the greatest emphasis on a measure of cash flow that he calls owner earnings" (p. 125). Obviously, any cash flow that results in owners earnings derives from inflows rather than outflows. Of the cash flows, operating activities, investing activities, and financing activities cause movement. The first and most important cash flow, operating activities, clearly displays the financial health of the firm; it makes more than it spends or vise versa. The second, discloses the amount of money the company spends on future investments. The last, documents how much the business depends on outside financing for its survival. Therefore, an investor needs to examine the connection between profit and cash and where the firm obtains cash to generate its profit.

Part 5, Learning what the numbers are really telling you, documents the various types of ratios investors can use to analyze statements--profitability ratios, leverage ratios, liquidity ratios, and efficiency ratios. For an investor, the authors list five measures--revenue growth by year, earnings per share, EBITDA, free cash flow, return on total capital or return on equity. For the business owner, the authors zero in on the percent of sales figure.

No financial management book would be complete without a discussion of return on investment (ROI) to evaluate capital purchases. This book presents the three methods of calculating RIO, the payback method, the net present value method, and the internal rate of return method.

Finally, the authors advocate educating employees, family, and friends on financial literacy to improve company and personal financial management performance.