What does an SEC 10K really tell you?

What does an SEC 10K really tell you?

By Kathleen Kerwin, UNDERSTANDING FINANCIALS LLC

INTRODUCTION

The interpretation and evaluation of SEC filed 10K’s and 10Q’s is accomplished by Financial Analysis or Fundamental Analysis. The process chosen is based on the viewpoint and goals of the principal completing the analysis. The following is a review of the differences between Financial Analysis, Fundamental Analysis and Technical Analysis that helps put into perspective their characteristics.
 
Financial Analysis is the examination of a company’s financial statements by creditors or bankers to determine its debt management (both long term solvency and short term liquidity) and ability to repay current and future debts. Financial ratios are derived from the financial data to further understand the relationships between the financial statements and economic reality. Internal Trend Analysis is performed to identify how the company’s performance has changed over a period of time. An external Comparative Analysis is conducted, in the form of matching the financial numbers and ratios to industry benchmarks, to further measure the company’s performance relative to its competitors within its industry. Ratio Analysis of financials helps to identify the relationship between management strategy and its results.

Fundamental (referring to Market Fundamentals) Analysis reviews the same methodology used by Financial Analysts but with different goals based on the needs of current and potential investors. Both quantitative and qualitative studies are conducted with a focus on understanding what the intrinsic value of the company is compared to the market value. Is the company under, over or fairly valued? The quantitative analysis researches the company financials. The qualitative analysis seeks to understand the business itself, management effectiveness, its future prospects within the industry, and industry trends given the macro economic conditions including inflation.

Technical Analysis, on the other hand, presumes to predict the timing of the market. It is a sort of behavioral analysis that assumes that all aspects of both Financial and Fundamental analysis are already known quantities.

USING FUNDAMENTAL ANALYSIS TO DETERMINE ECONOMIC GAIN

The reason to invest is for economic gain. A company’s gain comes through maintaining or improving positive earnings, revenue growth, or by increasing market share. An investor needs to know the current value of the equity stock and its intrinsic value (based on earnings estimates) in order to make a sound decision on whether to invest. According to Ben Graham an investor needs a “sound intelligent framework for making decisions… (and) … keep emotions from correcting the framework (Benjamin Graham, 1934)”. A good foundation in understanding Fundamental Analysis will give you the tools to make a more informed decision.

What is the intrinsic value of a stock? This is the key question that makes Fundamental Analysis more of an art than a science. Many attempts have been made to apply a formula to providing this answer. First you have to subscribe to the assumption that there is an intrinsic value (apart from its market price) that incorporates all of its future financial prospects and that eventually the stock will reach this value. When you buy the stock you are buying the future product capability of its assets entrusted to the management team to produce earnings in the future. The future stream of predicted earnings is the real value, or intrinsic value, of the stock. These earnings (predicted future cash flow) are discounted to the present market value of the stock. Stocks that appraise well using Fundamental Analysis generally have had more consistent earnings and growth prospects. A strong foundation in understanding Market Fundamentals enables you to make a more sound decision.

Financial Statements give you only past performance on the financial numbers and are therefore limited in what they can reveal. For the details on what the financial numbers mean you need to look in the text portion of the financials. For forward looking projections to evaluate the intrinsic value of a company, you’ll need a good source of projected earnings estimates (which are only as good as the reputation of the company).

The bottom line is identifying growth and value stocks (priced at a lower than their price-to-book value) through the evaluation process. Then buy at a discount to its intrinsic value and sell at its peak price. Sounds simple enough but the devil is in the details. In fact during the evaluation process you’ll often find yourself asking “where am I or what does it all mean” due to the complexity of the relationship of the mountains of numerical data that represent accounting points in time that measure the on-going business.

A fundamental premise of valuation is that price does not equal value since the stock market is irrational. There are two means of identifying good investments: by the value method or concentrating on growth. Both taking valuation into the grey area of the unknown away from the science of accounting rules (notwithstanding a rather flexible list based on GAAP principles) from which financials are documented and therein lays the art. Whether you choose a company by the value method or for growth, you need to know what a company is worth.

The goal of investors is to entrust their money to strong companies with good earnings prospects that will increase market value and their own portfolio value. A Fundamental Analysis Framework places each ratio in a category based on certain criteria: Efficiency, Liquidity, Solvency, Profitability and Valuation. Then sub categories further define what to look for from the ratio. This goal oriented means of understanding ratios gives you the background and perspective from which to base your analysis of a company’s financial strength.

A NOTE ABOUT STANDARDS

FASB, the Financial Accounting Standards Board, has established Financial Accounting guidelines and standards which include ratio analysis. However, how ratios and financial data is used everyday (by those not accountable to regulatory agencies) is not standardized and you can not be guaranteed about the source of the financial data numbers or which composite fields were used to create the ratio results unless your data resource states this explicitly. At minimum interpretation requires result comparison for different reporting periods such as updating frequencies (most recent quarter (mrq), trailing twelve months (ttm), or fiscal yearend. Other issues are differences in composite fields or labeling. The good news is that the quality of online financial data has significantly improved in the last year. Most likely this is due to the greater accountability required in the financial services market not only to stay in business but to stay out of the focus of SEC scrutiny and minimize legal liability. The presentation and formatting of ratio data between data resources appears to be the most common point of difficulty you’ll have to transcend in order to compare ratio result data.

An example of composite field variation:

The Quick Ratio is a good example of the issue of composite fields. Accounting textbooks commonly define the Quick Ratio as (Current Assets – Inv / Current Liabilities). Most commonly found Quick Ratio numbers from online resources substitute Quick Assets for Current Assets [(cash + short term investments + receivables) / Current Liabilities].

Understanding which composite fields are used can help you look deeper into the financials and make more complex connections. Knowing that a different mix of composite fields can be used makes you a more discriminate consumer and will trigger you to ask more questions about the data source in order to more completely evaluate the reliability of the resource. The value is not the ratio itself but in the composite fields that are used to arrive at the result.

An example of ratio result and updating variations:

Comparing ratio results of different reporting periods simply takes practice. Although there are differences in the ratio results most can be accounted for within minimum percentage difference that most likely will not change your interpretation or evaluation.

Of course the quality of data used should not be overlooked. Free data comes with no guarantees of accuracy. Identify the sources of your ratio results. Are they trustworthy and up-to-date? Pin point the date ranges that they cover in order to put them into perspective.

Regarding the sources of financial data, identify and verify that the financial numbers are taken from 10K’s and 10Q’s filed with the SEC. The 10K sources are the preferred resource since their financials are audited and signed off by the company CEO.The formulas for ratio equations can be simple for educational purposes.

The same equation can become quite complex when accounting realities are accurately measured.

RANGES AND UNITS

Although industry norms and averages of ratio results are primarily used to compare companies, a list of numerical results from ratios is difficult to evaluate until you know that the results have a Baseline Range (minimum and maximum) and a typical range that helps you gain a perspective.

A good example is Working Capital (WC = Current Assets – Current Liabilities). The result measures how much money is available to pay short term bills. Bills have to be paid in cash so there has to be at least enough money (CA) to cover bills (CL) or the company has to take out a loan or use up credit. The minimum Baseline result is that [WC >= 0]. This may not seem important on the surface, however, if [WC < 0] the company is at greater risk because the cash to pay the bills doesn’t exist and needs to be found somewhere.

The results Range is the entire set of possible numbers. The Baseline Range is the minimum and maximum requirements and are taken from a list of non-industry specific acceptable numbers (such as the baseline range of WC >= 0) or those commonly referenced by standard Finance and Accounting textbooks of non-industry specific numbers (such as Current Ratio = 2). A typical range is also useful to help you gain perspective when interpreting ratios. For example a ratio with Day Units may use a 30, 60 or 90 day typical range based on a monthly billing or accounting period. Identifying these typical ranges helps new analysts to more quickly gain interpretive knowledge.

The Unit value is critical as well because it gives you knowledge of what you are measuring. The WC Units are in Dollars which again may not seem important to know when comparing a list of ratios, however, the choices are Dollars, a pure Ratio relationship with Units canceling out such as [(nominator in $’s)/(denominator in $’s)], Percent (Ratio * 100), Times, and Days. Without applying the specific Unit value to each ratio you evaluate it just becomes the difference between lists of numbers. But a number of what?

The Unit values can be somewhat interchangeable such as a Ratio relationship (nom/denom) and Percent (Ratio * 100). If you can quickly do the math it’s not a problem except that the developer of the ratio list can make any decision they wish interchanging a Ratio relationship or Percent. There is no standard. It’s a matter of the form the public expects to see the ratio result or how the ratio developer does. Comparing ratio results can be quite confusing when the result form is mixed in a long list of company ratios. Comparing the results between multiple data sources with mixed result forms is even more challenging. Although Liquidity Ratios (Current Ratio, Cash Ratio and Quick Ratio) are commonly in the Ratio relationship form, Profitability (ROE, ROA and Margin Ratios) and Solvency (Debt Ratio and Debt to Equity) are interchangeably in the Ratio relationship or Percent form. The difference is simply a decimal point but requires an additional evaluation step for each ratio in question in an already complex interpretation process.

TREND ANALYSIS

Numerical Trend Analysis is based on several periods of observations from past performance. It can be as simple as measuring the percentage change of the financial numbers from one period to another or it can be a more complex in-depth analysis.

You get the Percentage Change of a number when it is then compared to a base year multiplied by 100. Compare a selected year against Percentage Change of the previous or future years.

Percentage Change comparisons can be made for internal company Trend Analysis, externally among industry competitors forming a Competitive Analysis using industry benchmarks, and across industries using common size statement for Comparative Analysis.

HOW TO START YOUR ANALYSIS

A good place to start is by reviewing the balance sheet for Efficiency, Liquidity and Solvency. Then continue to the income statement for Profitability and Valuation. The Cash Flow statement helps you understand where the cash was spent and made during the year. The interconnectivity of the financials helps provide a check from where you can better understand the complete financial picture.

REVIEW THE BALANCE SHEET

The balance sheet lists the company’s Assets which were financed by debt (Liabilities) or Stockholder’s Equity (common stock, retained earnings and additional paid-in capital). Therefore Assets = Liabilities + Stockholder’s Equity. The Assets are listed in order of Liquidity and Liabilities in order of immediacy (i.e., those that have the most senior claim on a firm’s assets are listed first).

Assets: What the company owns.
Liabilities: What the company owes.
Shareholder’s Equity: Is “net worth” of the company.

Take the Assets and sell the Liabilities to get the Net worth or Stockholders Equity (Assets — Liabilities = Stockholders Equity) aka Book Value.

Assets:
Review the balance sheet for the overall structure of the company. What are the short-term assets (cash, inventory, receivables etc anticipated to be turned into cash within 1 year or operating cycle)? What are the long-term (Property, Plant and Equipment) fixed assets? If the assets don’t fit with the main operating activities of the company ask why. The operating activities define the company.

Whatever goods the company makes or services that it sells are the primary operating activities. If the company makes and sells goods, the result of the operating activities is inventory that is sold either for cash or credit (receivables). Review inventory and receivables management. For example, if the inventory is growing faster than sales, look at whether the inventory is obsolete or outdated. Why is it growing and why is it not selling. How many times is the receivables account turning over per year? If the receivables account is older then the terms in the credit policy then there is a collection problem. For example if the receivables turn over every 72 days and the credit policy states 60 days you need to look closer. Perhaps the credit and discount policy need to be reviewed. A more liberal discount policy can encourage customers to pay on time. Late fees in the credit policy provide motivation to pay on time.

Liabilities:
How are the assets capitalized, by debt of equity? The long-term assets should be financed by long-term debt. What is the capital structure %? Have the long-term and short-term debt increased or decreased? Has the accounts payable increased or decreased? If yes, ask why.

REVIEW INCOME STATEMENT

The Income Statement is a summarized list of inflows (revenues) and outflows (expenses) over a period of time (Qtr or Year). The difference between Revenues and Expenses is the Net Income (Loss) bottom line. The statement provides information whether the company is making money and is profitable or operating at a loss. Ratios built upon the operating activities measure performance. The Key items are Revenues, Operating Income and Net Income (Loss).
 
 
The Income Statement is read using a step wise approach (EBITDA being the exception unless the stepwise approach includes the successive steps for EBITDA, EBIT then EBT) reaching Net Income after subtotals are calculated after each major expense line item is subtracted, see below:

Gross Profit = Revenue — Cost of Revenue with depreciation (COGS)
Operating Income = Gross Profit — All Operating Expenses
Net Income = Operating Income — Interest and Taxes

The EBITDA is then added somewhere in this successive list of subtractions breaking the pattern. A novice analyst should be able to quickly take the pattern into perspective therefore understanding the Income Statement as a straight forward successive calculation ignoring EBITDA. After which review the EBITDA calculation separately.

EBITDA = Operating Income + Depreciation + Amortization

BIBLIOGRAPHY

Graham, Benjamin & Dodd, David. (1934). Security Analysis. (5th ed.). Indiana: McGraw Hill.

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