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So i have just completed a beginners course on understanding financial statements. As part of the final assignment, we are supposed to pick a real company, study its financial statements and conclude some meaningful information about the trends going inside the company, risk assessment etc. etc. and we have to do it in a language as laymen as possible. Now i know how to study financial statements but i have no clue how i should be using that data to come down to meaningful judgements. Also, i am a rookie at this so i need your help as to where i should start, what would be some ideal companies to look at ?? and where should i go from there on? Statements to focus on are B/S; C/F and Income statements. Please advise.

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closed as off-topic by Helin, Alex C, skoestlmeier, LocalVolatility, Bob Jansen May 6 at 13:10

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    $\begingroup$ I'm voting to close this question as off-topic because this is not within the scope of quantitative finance. I'd recommend any corporate finance textbook (e.g., Bodie's Investments). $\endgroup$ – Helin May 5 at 21:24
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Choose John Deere. Some firms provide minimal disclosures, other firms are very good at making investors aware of every detail. Deere provides excellent and complete disclosures, well beyond what the law requires. It is a great firm to teach and learn with.

As to what should you look for, that depends on the industry. Consider the electric utility industry. It has zero ability to control its revenues. It cannot offer coupons or weekend sales. People do not receive text messages saying that if they flip on a light, their power company will only charge four cents per kWh for that additional light.

As such, revenue related measures mean nothing for electric utilities, but their costs are in their control to some extent.

On the flip side, consider a high-end retailer, one that is a great competitor under monopolistic competition. It has tremendous influence over its revenue and optimal solutions imply they must never minimize their costs. Measures of turnover, inventory levels and so forth are critical.

To determine what is important depends entirely on the firm. As this is a learning exercise, I won't tell you the things that drive Deere's business, but you had them in your microeconomics and macroeconomics courses.

If you choose Deere, pick up their annual report as presented to investors because that tells you how management wants to project itself to the world. Read the 10-k, proxies, addenda incorporated by attachment and 10-Qs. Learn the company inside and out. If you suddenly inherited the entire company from a rich uncle and had to run it, what would you need to know?

Financial statements, because they are approximately uniform, cannot tell you what is important unless you read all the other content. If each industry were permitted to create their own set of financial statements, they would each emphasize the variables uniquely important to them and nothing would look alike. Indeed, that is part of why GAAP exists. Financial statements used to be so different that you could not compare them at all across firms.

Remember that there are no absolute rules. To provide an example, "high debt levels are bad" is not a good rule for financial institutions. While an industrial concern might be healthy at 1.5:1 debt-to-equity a life insurance firm doesn't become healthy until it reaches around 25:1 debt-to-equity as it has underutilized assets otherwise. Likewise, a firm with incredibly negative current assets may be exceedingly healthy. To have extreme current account deficits would require a financial institution to underwrite you and as they are so conservative, that would imply they are not worried. For another firm, high net current assets are necessary for survival.

Learn the firm, learn the industry, learn the industry that the firm services.

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    $\begingroup$ Great practical advice! $\endgroup$ – Bob Jansen May 6 at 13:13
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I will try to provide a complete answer, although valuation can get way too far. So let's stick to the essentials.


Balance Sheet

  • Cash & Cash Equivalents: Cash in bank and short-term securities, that can be used to settle short-term liabilities. Can be used to quantify liquidity risk (e.g Cash Ratio)

  • Tangible and Intangible assets: What is their portion as a percentage of Total Assets? Is the company capital-intensive? Also, note that these assets are subject to depreciation and amortization, respectively. This enables firms, to adjust and project their expenses, by imposing certain depreciation methods (Although, they are limited by accounting standards, which pose restrictions on annual depreciation rates). Also, note that deprecation serves as a tax-shield, by lowering taxable income.

  • Equity and Debt: What is the leverage of the firm (Percentage of Debt to Total Assets). A high leveraged firm, has increased risk to default. That affects, firms WACC and cost of debt.
  • Short-term and Long-term debt: If firm issues more short-term debt, then it restricted by creditors, compared to a firm who issues more long-term debt.
  • Deferred Income/Liability Taxes: Very useful to understand how firm treats taxation. Refers to future Tax Income/Expense.
  • Retained Earnings/Accumulated Losses: Depending on the sign, provides information about firm's past performance and earnings distribution. A firm who capitalizes earnings is more likely to be expanding, reinvesting profits. However, this is not necessary, as retained earnings could be used for share repurchases.

Income Statement

  • Sales and Cost of Sales: Examine firms profitability. You can calculate the gross profit margin. Sales are the main source of income. A gross profit margin indicates a healthy company, with low-cost production.
  • EBITDA: Stands for Earnings Before Interest, Tax, Depreciation and Amortisation. EBITDA measures firm's "real" operating profitability, after removing operating and other expenses. It is used among practitioners, as it is not affected by non-operating activities and accounting treatment (or Creative accounting!). To examine operating profitability, calculate EBITDA Margin, and for firm valuation purposes the EV/EBITDA ratio (measures enterprise value per dollar of EBITDA).
  • EBIT: Similar to EBITDA. Important if firm is capital-intensive and depreciation takes a significant part of total expenses
  • Net Profit and EPS: Important since from the Net Profit, dividends are determined. EPS is the most popular indicator of profitability, and firms give a huge attention on it (They even try to inflate it!)

Notes:

  1. These are the most important accounts. From these you can construct many indicators to get a clearer image (A simple Google Search on Profitability, Liquidity, Efficiency and Productivity ratios would be instructive)
  2. These accounts might not be appropriate for high leveraged firms, such as banks which require different type of analysis. Banks are characterized by extremely high leverage, low portion of fixed assets and high interest income/expenses.

I recommend a company that is listed on NYSE/AMEX or NASDAQ, due to availability of data. For instance, General Electric or Boeing.

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