Financial Statement Analysis Blog #1 – why, what, how?
“Before you can really start setting financial goals, you need to determine where you stand financially.”
Investment opportunities are different from each other. One dollar invested in Caterpillar’s stock will yield different returns than one dollar invested in John Deere’s stock – even as the two companies continue to operate in the heavy machinery industry. Why the difference, you ask? Well, the two companies are managed by two different groups of people, adopted different strategies and execution approach, and have different styles when it comes to governance, social responsibility, and ethics.
The different yields and approaches present investors with a dilemma: there are many (too many?) choices for an investor when it comes to investing. Among the many companies out there, which one should an investor invest in? Each choice comes with an opportunity cost. Even passive-style investing like mutual funds (through Vanguard, Fidelity, etc.) still require active portfolio managers who design the funds and buy and sell stocks and bonds for the funds on behalf of their clients. Whether you are a direct investor who pick your own bonds and stocks, or a portfolio manager who pick bonds and stocks on behalf of clients, it helps to have a list of investment criteria to winnow down the investment choices available to you. Such list might have:
The industry that you are interested in investing in
The general company strategy (cost leadership vs. product differentiation vs/ core competencies)
Governance structure (for public company)
Social responsibility and ethical standards observed (if they matter to you)
Past financial performance (a good predictor for future performance usually)
Growth potential
Accuracy and trustworthiness of past financial performance reporting
The list above is by no means exhaustive. One thing is for certain for any investors: they want their money back, and back with returns. This reason is why it is important to understand companies’ past financial performance when selecting stocks and bonds – an understanding that can only be fully achieved through financial statement analysis.
Financial statement analysis if the exercise of analyzing companies’ past financial performance using their financial statements. Regardless of its public or private status, any company produces financial statements. A public company is required to file their financial statements to the Securities and Exchange Commission (SEC) who makes these documents available to the general public. The results of a financial statement analysis will provide an investor with insights into how the company has generated and spent its revenue as well as structure its capital and assets base in the past. While the past is not a perfect indicator of the future, it does provide a potential direction on where the company is heading. It is worth noting that, although our discussion is framed in the context of an investment, the same financial statement analysis technique can be used for other business purposes: acquisitions due diligence, joint ventures partner diligence, divestitures preparation, and more.
The financial statement analysis starts with collecting the needed information about the company:
The latest 10-K
The latest Annual Meeting Proxy Statement
The latest Annual Meeting Proxy Statement from a competitor (John Deere is used in our example)
Hoovers report on the company’s industry
Mergent Online report on the company
Of course, there are other sources of information that can be used for this analysis. Value Line, S&P Capital IQ, Bloomberg report, etc. Each with different cost and content. The key is to find reports that are most relevant to the company being analyzed.
In this series of 11 blog posts regarding financial statement analysis, we will focus on public companies’ filings as they are more readily available publicly. We will also review how industry reports, such as those from Hoovers and Mergent Online, can be used to supplement the exercise. Lastly, we will continue to use Caterpillar (stock ticker CAT) as an example in this series of blog posts.