What a company’s financial statements mean

Looking at a company’s annual reports will tell you a lot about the business. Essentially, what you want is a business with little or no debt that is generating high returns on equity. Keep that in mind as we take a tour through the three statements that form the core of a company’s financial reporting.

The balance sheet

Rule No.1 in investing is: don’t lose your capital. The balance sheet is where you can start to get a feel for whether a company is destined for failure. When things turn sour a heavily indebted company can quickly find that it’s unable to meet its obligations.

A common way to measure the “gearing” of a business is by dividing total debt (say, net of cash) by the total value of the assets (or sometimes the equity) on the balance sheet.

How much debt a company can manage depends on how reliable its earnings are, but for your standard, industrial-type company a ratio of less than 50 per cent debt to total assets is a good starting point.

You can also judge a company’s ability to meet its obligations by turning to the income statement to measure its “interest cover”, which is operating earnings before interest and tax divided by the total interest payments. A cover of four times is solid.

Rising debt could mean the company can’t generate enough cash to fund itself – not a good sign. Similarly, falling debt could mean the opposite.

Income statement

This is where you’ll find the company’s profit. However, be aware that tax rates, writeoffs, acquisitions, one-off sales and cost-cutting can serve to obscure the true, underlying performance of the business.

This is why many analysts prefer to look at the statement of cash flow, which is harder to manipulate.

Nevertheless, tracking the trajectory of operating revenue – “top-line” growth – will give you a good feel as to whether the business is expanding.

Of course, the company could just be raising more and more shareholder equity to fund that growth, which is bad news from an investor’s point of view.

That makes return on equity (ROE) a crucial figure. It’s calculated as the earnings per share (before “extraordinary” or one-off items) divided by the total number of shares outstanding.

All these figures should be disclosed by the company. An ROE above 15 is very good, and one above 20 is excellent.

Cash flow statement

Cash flow is the lifeblood of a business. A business with no profit can live to fight another day; one with no cash flow cannot.

Companies can generate cash from their daily business operations, by selling large fixed assets or by borrowing or raising capital.

Obviously what you want is a company that’s generating a lot of cash through the course of its normal operations, and at a rate above what it needs just to operate.

That leaves it with enough cash to be able to distribute some to investors via dividends or share buybacks, or to reinvest in the business for growth.

Patrick Commins Smart Investor