Insights Upon Financial Statements

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Okay, we now know what the three types of financial statements are and how to read them. This article is around the insights or clues one can infer upon them. The mentioned are just some of the many potential ones.

In general terms, financial statements show a business performance and how fragile or solid is it and has been. Paying close attention to what a company reports can be of extreme help. Investing is about trying to maximize future return while minimizing risk and a great way to minimize risk is, for instance, by avoiding buying companies at the edge of bankruptcy.

In logical terms, a company has the risk of bankruptcy when it cannot pay off the debt it has in the short term. That’s widely known, however, financial statements are what can help an investor spot such potential cases. Imagine you are researching a company that has one billion in current debt, has 0 to no cash and equivalents nor any current assets, loses money at an operative level and has historically shown a floor CapEx for it to maintain business.

Going back to what Annie Duke taught of thinking probabilistically, this is a company that in many future scenarios either goes bankrupt or raises capital through stock issuance and dilutes investors. Both scenarios don’t favor us. Therefore, we calmly let this stock pass and continue aiming for companies with higher chances of succeeding or, at least, not going to 0.

This may sound stupidly easy or absurdly obvious, but if an investor doesn’t look at the company’s financial statements, he/she will not know this and may commit a mistake.

Now let’s imagine a company records one billion in sales and 300 million in free cash flow, which seems fantastic, that’s a 30% fcf margin. This means that for every dollar a company makes in sales, 0.3 cents are actual cash the firm makes. Well, now imagine you look at the cash flow statements and spot a Stock-based Compensation of 350 million dollars. That’s an actual operating cost that inflates the company’s free cash flow. Once the SBC is taken into account, the company’s profitability is now questioned. If it starts paying full in cash, the free cash flow margin turns negative 5% and the overall appreciation of the business drastically changes.

More insights can surge from looking at the interest paid on debt taken, on comparing the current assets to the current liabilities to check for further financial fragility and some more can help determine whether a management has good capital allocation skills or not.

Furthermore, it’s from financial statements where one of the most relevant indicators of a company’s financials show, margins. Margins represent a business’ profitability at the different levels at which it could be analyzed. This piece of information widely impacts the appraisal the financial community has over a certain company, generally shown in multiples. It’s not the same for a company to have a net income margin of 30% as a company having a 5% margin. The reason for this is that for every dollar the first company gets to grow, it generates a utility of 30 cents, whereas the second one, 5 cents , that´s a 6x difference. Margins allow an investor to tell how efficient is a company at any level, how profitable is it and how many dollars, product of future growth, will the company keep.

Personal Commentary

Financial statements are extremely helpful for investors, they are a key resource, which we must take advantage of. These are only some of the outtakes one can have while reading them. Many of the insights I could have spoken about are theme of future articles, which means it made no sense covering them today. Anyway, hope you enjoyed!

On Wednesday at 5PM, I’ll be publishing the second part of Microsoft’s Research, covering its industry, MOAT, financials, management and thesis.