Now that we are “experts” in our company’s operations, products, offerings, management, etc., we can now get into probably the most challenging piece: analyzing the financial statements.
Now, I have to keep this section relatively brief as you could write an entire college textbook on this section. Given that, I will keep this quite high level. But I recommend that you spend the time to understand the basics of some key accounting concepts, such as accrual accounting, determining carrying values of assets and liabilities, etc. These will come in time, and I’ll get into them briefly, but these are crucial to your understanding of a company’s financials.
So, in general, this guide will focus more on what to look for and how to analyze financial statements rather than the nuts and bolts of accounting.
I will break this step into four parts:
- Income Statement
- Balance Sheet
- Cash Flow Statement
For each of the above steps, I will give a very brief breakdown of each financial statement along with some analysis techniques for judging performance, financial health, etc. I will then end the article with some red flags.
The income statement is the financial statement which estimates the company’s profit or loss for a single period, typically done over three-month and twelve-month periods. I use the word “estimates” because for any company using accrual accounting, which is basically every company you will see, it is not just cash received minus cash spent in a period.
In basic terms, it is simply revenue recognized minus expenses recognized.
Now, we’ll get into a breakdown of the income statement. We can generally break it down as such:
- Cost of Sales
- Gross Profit
- Operating Expenses
- Operating Income
- Other Income / Expense
- Pre-Tax Income
- Tax Expense
- Net Income
Revenue is listed as your top-line amount and is the sum of your recognized revenue over the period. Revenue is recognized based on strict accounting principles under US GAAP, IFRS, etc. In general, revenue is recognized whenever a service and/or product is delivered to a customer, not when you receive the order.
For example, if you manufacture pencils and you received an order for one million pencils at a dollar a pencil, you expect to receive one million dollars. For accounting purposes, you will not recognize that revenue (typically) until those pencils ship to your customer and they become the customer’s legal possession. And remember, you might do those pencils in batches. So you might recognize 250k one month, 300k the next month, etc.
Services work a similar way. There are a few ways to estimate services provided. Sometimes it is done on a rolling basis based on completion of a project. For example, say you’re doing a bit construction job with multiple steps that the customer was quoted separately, but pays at once. As you finish each step, you recognize a portion of that revenue. Another way, and the most conservative way, is to just wait until the job is done.
Remember, when you are paid is something separate.
As a final point, sometimes revenue is broken down between gross and net revenue. Gross revenue is the revenue you would receive before accounting for discounts, rebates, and returns (primarily). So net revenue can almost never be greater than gross revenue. The number we want to focus on is net revenue as that should equal your expected cash intake assuming you didn’t sell to people with terrible credit ratings! Most companies only report net revenue, but I wanted to point this out.
Cost of Sales
Cost of sales, sometimes referred to as cost of services or cost of goods sold, are your direct costs related to providing said product or service to a customer. For a manufacturer, this is your cost of inventory which includes all of your manufacturing costs, depreciation on your fixed assets, labor wages, etc. For a service provider, this is generally just the wages of your employees directly providing the service, any depreciation for fixed assets utilized, and direct expenses like internet, phone plans, etc.
Gross profit is simply defined as net revenue minus your cost of sales. The idea is that you earn revenue for your sale, but you also incur direct costs to provide the service. The resulting difference is your gross profit, which you obviously expect to turn a hefty profit.
But wait a second, we’re missing costs, aren’t we? That we are, which brings me to…
Where cost of sales is defined as your direct cost for providing a service, operating expenses, also called “SG&A” or “selling general & administrative”, are your remaining expenses. These include primarily your costs incurred for salespeople, marketing, accounting, HR, IT, etc. But remember, it’s nothing related to the direct costs I mentioned above, we don’t double count.
Think of these costs as your indirect or non-core costs. For a manufacturer, these are all of the expenses you incur to keep the business running in the background but are generally unrelated to the actual manufacture of a product.
Now, the distinction between cost of sales and operating expenses is a bit of a gray area. As long as you are not double counting, it really doesn’t matter that much which items go where for our purposes. As long as you understand the difference that’s all that really matters. The most important item is our next one.
Operating income is defined as your gross profit minus operating expenses. For most companies, operating income is the most important number to judge basic business performance. We can plainly see how much a company earned and how much it cost them to do it from a pure business perspective.
Now, a business incurs other expenses which are generally seen as “unrelated” to your business activities. Let’s get into those…
Other Income / Expense
Now, we all know that business also have certain other income and expenses periodically which have nothing to do with direct business operations. These are generally bucketed as something called “other income / expense”. What are these?
For a non-bank or financial institution, this income/expense is almost exclusively related to cash and the financing your entity has received. Let’s give a few examples of what goes down here:
- Interest – this is a big one for most companies. The interest you are charged is unrelated to your core business operations unless you are a financial institution. Conversely, if a company earns some interest on its cash on hand, that is considered income.
- Foreign exchange gains or losses – if your company operates in multiple countries or buy/sells in foreign currencies, you will always have some amount of foreign exchange gain or less to the company. These are technically income or expenses attributable to shareholders, so we must put them in the income statement.
- Change in liability fair values – this is very common in the OTC with derivative liabilities such as convertible debt, etc. If the company has to revalue its derivative liabilities, any gain/losses in the valuation are considered income or expenses attributable to shareholders.
Pre-tax income, earnings before tax, or “EBT” is just your operating income less all of these other non-operating items outlined above. This is basically all of the profit or loss attributable to common shareholders before Uncle Sam (and not me 😊) takes his cut.
This number is a little deceptive. You may have had a stellar operating result in operating income, but once you factor is interest expense, FX losses, etc., you may end up in a pre-tax loss. The opposite can be true too.
This is why we first focus on operating income to assess the actual business performance, then we move down to pre-tax income to get a better sense of the financial health of a company.
Tax expense is equal to any direct taxes paid on your pre-tax profits. This is generally your corporate income tax. This does not include indirect taxes which are expensed, such as customs duties, property taxes, employer taxes, etc. This could also be a tax benefit if your company utilized a deferred tax asset, etc.
Net income is therefore then your final, bottom line, income attributable to shareholders after taking into account your income taxes. This is typically what investors use as their “first pass” in determining profitability because it is, in essence, the estimated profit attributable to your common shareholders. But it is not the be-all-end-all as we’ve seen.
There’s probably hundreds of methods to judge how a company is doing. So I recommend you do some research online on more. But some of the most common are:
- Is the company’s revenue growing over time?
- Is revenue steadily increasing or is it choppy and unstable?
- Is revenue growth exceeding costs growth or vice versa?
- Is operating margin increasing over time, what about gross margin?
- If a company is in losses at an operating level, why is it? Will more scale increase profit or is the business just not a good one.
Generally, with any company I analyze, I want to see steady and consistent revenue growth quarter over quarter. Even if it’s still the growth stage, I still need to see that they are able to consistently expand the business. If results are too choppy or stagnant, I tend to avoid.
On the profitability end, with a growth stage company I am less concerned about current profitability. But what I do want to see is expenses growth, over time, being less than revenue growth. For a more mature company, probability stability is key. If we aren’t going to see high revenue growth, the company needs to turn a consistent profit.
The balance sheet is a somewhat more straightforward, but also tricky. The balance sheet is a financial statement which details the assets, liabilities, and equity accounts of a company. These are:
- Assets are financial, tangible, or intangible assets which have some inherent value and are expected to provide some future benefit to a company.
- Liabilities, conversely, are defined as some amount which is expected to result in a future outflow for the company.
- Equity is simply defined as your assets less liabilities. This is the net book value of your equity accounts, generally common shares. For example, if you have 100 in assets and 90 in liabilities, equity is worth 10. So all of the common shares have a book value of 10.
Below I’ll briefly discuss each of these.
Assets are some sort of property of the company which is intended to generate a benefit. These typically take three forms:
- Financial Assets – these are things like accounts receivables and cash. You can use your receivables and cash to generate future benefit through reinvesting in the business.
- Tangible Assets – these are typically your inventory, property, plants, and equipment (“PP&E”). Inventory is quite straightforward in that you are expecting to sell it for a profit. But fixed assets like PP&E are generally used in manufacturing which brings a benefit to the company. They could also theoretically be sold or leveraged for debt.
- Intangible Assets – these are almost exclusively acquired intangible property (not internally developed) which benefits the company. For example, purchasing a patent to a product to then manufacture it.
Assets should generally tell you what sort of company you’re analyzing. If it’s a service provider, expect to not see a ton of tangible assets and to mostly see financial assets and/or intangible assets. For a manufacturer, you should see large assets on the books for PP&E (assuming it’s not leased), inventory, etc.
Liabilities are the opposite of an asset and consist of a quantifiable future outflow to the business. The most common liabilities are your accounts payable and debt. Accounts payable are items you’ve already expensed and consumed but have not paid for yet. Think of buying something with a credit card but not paying for it until 30 days later.
Debt, quite straightforward, is carried at a particular value which is generally equal to the amount of principal and accrued interest owed to a lender. The company will have to pay this back one day, so it must record it as a liability.
Equity is basically just your assets minus liabilities. In my head I think of it like this. If you liquidated the company today and sold all of your assets at your carrying value to pay off all of your liabilities at their carrying value, how much is left for the common shareholders? That is equity.
If it’s negative, a company is technically insolvent. This means it cannot pay off its liabilities using its assets on the books. This means a company generally must raise more money through common stock issuances, or manage to become much more profitable.
This is a very nuanced account on the balance sheet and how it is presented for book value purposes. So to keep yourself sane, just think of it like this for now. We’ll get into this more later.
The balance sheet, much like the income statement, is very ratio heavy when it comes to analysis. The most common to look at are:
- Current Ratio = Current Assets / Current Liabilities. This tells you if the company can meet its current liability obligations (in the next 12 months) without needing more cash by using cash on hand and accounts receivables.
- Cash Ratio = Cash on Hand / Current Liabilities. Basically, can the company pay its 12 months of liabilities using only cash currently in the bank.
- Debt / Equity. This tells us how much debt the company is currently burdened with.
- Assets / Equity. This is a simple leverage ratio which tells us how leveraged a company is in general, rather than just focusing on debt.
- Return on Assets = Net Income / Total Assets. For an asset intensive business, this details how much profit a company earns for deploying its assets.
- Return on Equity = Net Income to Common Shareholders / Book Value of Equity. This tells us how much profit a company is earning versus its book value of equity and is a standard measure for how company performance from the perspective of common shareholders.
Cash Flow Statement
I am going to keep this short, but essentially a cash flow statement breaks down how much cash the company received or paid for three categories. We then see the net cash change for the period at the end.
We see it as:
- Cash from operating activities.
- Much like our operating items from the income statement, this reconciles how much actual cash was paid and received from operating activities.
- Cash from investing activities.
- This details how much cash was spent on things like capital expenditures, prepaid inventory, companies acquired, etc.
- Cash from financing activities.
- This section tells you how much the company paid for things like debt repayments, preferred dividends, or common dividends. This also tells you how much the company received from issuing new debt, common shares, etc.
What we want to look for here with a mature company is to see if the company is actually generating positive cash flow. If it is not generating cash flow, why not? Is it generously recognizing revenue and not collecting cash? Is it paying off accounts payables to clean up its balance sheet? Things like that you should think about.
For a growth stage company, we want to see what their cash burn is and how the company is reinvesting their capital raised. Is it going towards debt repayments and dividends? Or is it reinvested through capital expenditure?
I’ve already gotten into this above some, but I wanted to get down my biggest red flags I see time and time again browsing filings. Note, I could write a book on red flags in the OTC at this point, so these are just the biggest I see on a daily basis.
When revenue is recognized, you book a receivable on your balance sheet. When you receive the cash, the accounts receivable balance is offset by the cash you received. Easy peasy. But what happens if you never get paid?
If you recognize revenue but are never paid, the way it works is like this. You still recognize that revenue from back several months ago or whatever, say Q1. By Q3 you find out you’re never getting paid. So instead of booking negative revenue for Q3, you instead include a bad debt expense on the income statement equal to the exact amount owed i.e. your previously recorded revenue.
When you look back then at the full year, you’re back at net zero at an income level, but you still recorded some amount of topline revenue which is canceled out in your expenses.
This can be very deceptive if you don’t know what you’re looking at. If all you focus on is topline revenue, you may miss that revenue recognized six months ago has been written off. But that topline revenue is still there.
In the OTC, I’ve seen many a company plays games with this. A lot of times its frontloading revenue they know won’t be collected on around a quarter or year-end. It’s then written off six months later when, surprise surprise, it’s uncollectable. Be very careful with this. You can usually see it quite plainly if you search for “allowance” which typically brings you to a note on “allowances for uncollectable accounts”. This generally has a discussion of receivables that have been partially or completely written off.
I suggest that you look back at a minimum of two years of annual reports and/or 10Q’s and check to see how much revenue has actually been collected over that time period. Your average blue-chip company tends to collect more than 95% of its receivables, usually even more. So in the OTC, if you start seeing things like 20+ % unrecoverable consistently, that’s a big red flag.
Related Party Transactions
Generally, an OTC company’s CEO is usually the founder, and many times is the majority owner of the company. These CEO’s and other high up management tend to have other side businesses and ventures. Many times it’s consulting firms, investment management, lawyers, other small businesses, etc.
You will sometimes see that the CEO or whoever in management will have their side business provide services to the publicly traded OTC company. Sometimes it’s very cheap, like a couple thousand of dollars a year for legal fees, etc. But sometimes, you’ll see unprofitable small companies paying a related party like that hundreds of thousands of dollars which is insane. Always check the related party transactions section to make sure that the fees the CEO is effectively paying themselves is reasonable.
Many times you’ll see a company absolutely hemorrhaging money at an operating income level, but magically have extremely high levels of “other income” which results in a quasi-profitable period. These are temporary items and you should always be weary when a company touts how they “HAD OUR FIRST PROFITABLE QUARTER WOOO!!” but it’s really because they received 5 million dollars in PPP loans that were forgiven.
Most common examples are:
- Gains on derivative liabilities
- PPP loan forgiveness (recently)
- Gains on debt extinguishment
All of the above cases are temporary benefits that have little bearing on how the actual business performed. Yes, the company may have had a 5-million-dollar net benefit by restructuring debt, but if it’s still cranking out huge losses at an operating level it doesn’t really matter.
You should now be able to have a basic understanding of the income statement, balance sheet, and cash flow statement. You should also be able to point out some red flags as well as perform some basic performance analysis on these financial statements. I plan to expand this step regularly given that it is so dense. I would love to write a whole series of articles on red flags as well. Either way, I hope you all enjoyed and I look forward to finishing this series!
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DISCLAIMER – THIS ARTICLE IS NOT FINANCIAL ADVICE AND IS INTENDED ONLY FOR EDUCATIONAL PURPOSES. I AM NOT A FINANCIAL ADVISOR. DO YOUR OWN RESEARCH.