I really liked this article by my colleague Tim. Tim du Toit is the editor and owner of Eurosharelab. He has more than 20 year of institutional and personal investing experience. Tim is based in Hamburg, Germany. More of his articles can be found at http://www.eurosharelab.com
I asked Tim if I could re-post the article here, and he was kind enough to grant me permission. My favorite section of the article is at the end where Tim talks about what words to search for while reading SEC financial statements. The list consists of twelve words that when discovered, should be investigated at greater length. I like print books, I never read e-books; however, when reading 10-Ks, Qs, proxies etc. I find it very useful to use a computer because I can search for specific words like the ones Tim describes in the fillings.
Some of these words could be read flags that need to be examined, such as; “change in revenue recognition”, which can have a huge effect on the top line or bottom line. It also makes you wonder why is the company switching. Are they trying to make a certain quarter have bad earnings or good earnings?
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Others like capitalized expenses, while not necessarily a red flag, need to be examined. Why is the company capitalizing costs instead of listing them as expenses? Capitalized expenses are used to meet the matching principle, but can also be used to inflate the prices of assets on the balance sheet. If there is a signifcant amount of expenses being capitalized, the issue must be examined in greater depth.
Below is the full article:
Do you have a list of the most important points to consider when analysing a company or more specifically reading the annual report?
I have developed one over time and I think it is something you can benefit from.
When investing in a company there are thousands of things that can go wrong. Some of these you can anticipate but most of them not. So it is not really something you can incorporate into your analysis.
What you however have a high degree of control over, is the state of the company when you invest. You read the annual reports, analyse ratios and possibly talk to customers and competitors.
The future is uncertain, but at least you can determine that the current state of the company is stable and healthy before investing.
Here are my top questions you should ask yourself when analysing a company.
Be sure to read through to the end of the article as I have included a handy shortcut for you.
Do you understand the annual report?
One of the simple things that I have learned about investing is that if you have difficulty understanding how a company makes money the investment is best avoided.
Most businesses are relatively simple, they buy or manufacture something, add value of some sort, sells the product or service and earns a profit.
If you cannot understand a business in these simple terms from reading the annual report it would be in your best interest to invest your money elsewhere.
An example for me would be an investment in a large investment bank like Goldman Sachs or Morgan Stanley. The businesses of these companies are so complex, and if you add on their own trading and risk taking it is beyond my understanding.
Is the operating cash flow higher than or equal to earnings?
If the operating cash flow (also called cash from operations) the company generates is not equal to or larger than net profit the company generates it is a definite warning sign to investigate further as it means that the company is not making cash profits.
Contrary to the popular belief, it is not the lack of profits but rather cash flow that drags a company under.
Depreciation is a non-cash deduction from net income but not from operating cash flow, with the result that operating cash flow should normally be higher than earnings except when the company is investing heavily into working capital (inventory and accounts receivable).
If the company is growing it usually means increased investment in working capital is required. It is then perfectly understandable that operating cash flow will be lower than earnings.
As long as the days of inventory outstanding or they days accounts receivable outstanding is not increasing at an alarming rate it is acceptable.
Have there been changes in accounting policies?
It is definitely worthwhile having a look at the company’s accounting policies to determine if there have been any changes in the current financial year.
Most of the time it is nothing to be worried about as accounting policies have to be adjusted because of new accounting rules but be careful if the company makes adjustments on their own.
Changes may be perfectly legitimate due to changing business conditions but make sure that management is not trying to artificially inflate the profitability of the company by for example, changing the recognition of sales or capitalizing expenses to the balance sheet that should really be in the income statement.
Has there been a restatement of past financial periods?
Any restatement of past financial figures is also worth looking into.
This goes along with the previous point of changes in accounting policy, which may be the reason to restate previous financial periods.
Most of the time restatements simply relate to legitimate accounting policy changes and is nothing to be worried about.
However be careful when the company restates results to make it look more profitable especially if there is no clear reason for them to be doing so.
Just a simple commonsense test is more than you’ll ever need. Ask yourself what management is trying to achieve with these changes and if it makes good logical sense. If not, it’s a warning signal.
Are there recurring extraordinary expenses?
If a company, year after year, has quite high amounts grouped under extraordinary expenses in its income statement it is a sign to be weary.
If it relates to a truly once-off event it is perfectly legitimate to have an extraordinary expense, but year after year is highly unlikely.
What I have also found is that a lot of companies attempt to list normal expenses as extraordinary with the hope that investors will ignore these expenses when evaluating the company, thus inflating profitability.
For example, why would a retail company list lease payments due to store closures as extraordinary when its business is the opening and closing of retail stores? I would argue it’s not extraordinary.
Any related party transactions?
This is the one item in the annual report I always look at.
The ideal would of course be that there are no transactions between the company and its management or directors, directly or indirectly.
Related party transactions immediately give me the impression that management is trying to profit personally at the expense of shareholders.
Here is a recent experience I had.
As Germany did not participate in the worldwide property bubble that developed from 2005 and 2008 I started looking at property companies in Germany that were at the time, trading at less than 50% of book value and had a quite attractive dividend yields.
Closer investigation however revealed that most of the companies had a laundry list of related party transactions where management, usually also a relatively large shareholder, develops properties and sell them to the property company. And this happened year after year in quite a few cases.
This gave management the ideal opportunity to profit at the expense of shareholders.
It simply looked too dodgy for me to invest.
Is the tax rate unusually low?
Most developed economies have company tax rates of 35% to 40%.
As soon as the company you are looking at has a tax rate that deviates substantially from this number is worth investigating.
The company may have assessed losses which is keeping its tax rate low but watch out when these run out as earnings will then decline by up to 40%.
Any large “other income” and “other expense” amounts?
Large amounts in the income statement with heading “Other Income” or “Other Expenses” should make you curious as it may mean management is trying to hide something.
Under “Other Income” they may be trying to hide a deterioration of the company’s operating performance or may be looking for a way to boost its profitability with large once off items not related to the company’s main business.
Under “Other Expenses” management may be trying to hide expenses that they would rather not name by name.
Are there large directors and management payments?
It is always worthwhile having a look at directors and management compensation.
I look at the numbers in total to see they are reasonable compared to the profitability of the company.
If they look large or excessive the company has to be very undervalued for me to invest.
Also be careful of consulting fees paid to directors, retired management or existing management this is usually an item that shows that management and directors do not have the best interests of shareholders at heart.
Now for the shortcut I mentioned.
I usually read through the last three annual reports of the company I am analysing but I also use a time saving shortcut to zoom into the areas where problems may lie.
As annual reports are now available electronically it is very easy to find specific words or phrases.
To quickly identify if and where potential problem areas may lie I have put together a list of phrases I search for in the annual report.
Here is my list:
“bill and hold”
“percentage of completion”
“change in revenue recognition”.
“materially and adversely affected”
You may want to want to copy the list and have it handy when you read through the next annual report.
Keep in mind that the accounting terms vary from country to country and, depending on the country you invest in, may have to change the search terms somewhat.
Not all the phrases will bring up something important but should they come up it is usually something that deserves your attention.
Tim du Toit