Deconstructing The Paper Wall
Painstakingly sifting through a company's SEC filings is almost nobody's idea of a good time. But understanding the prospects for a company's stock begins with knowing your way around its balance sheet, as well as its income and cash-flow statements. There are valuable warning signals flashing in the accompanying narrative information, like the auditor's report, the management discussion and analysis, and even the humble footnotes. Reports to the SEC can be seen on the Web at Edgar and also at 10Kwizard.com.
Anything out of the ordinary about the auditor's report may be cause for alarm. A straightforward audit is about one page long and indicates that an outside review of the company's financials has been performed and the information presented by management is in accordance with generally accepted accounting principles (GAAP). If the auditors are concerned, they will include a "subject to" paragraph in the middle of this statement, as in: subject to the resolution of certain problems, the company looks okay. That's serious, but even worse is an opinion that questions the company's status as a "going concern."
Next, review the narrative statements in 10-K and 10-Q reports under Management Discussion and Analysis. This is packed with good information because it's where they tell you why revenue wasn't as good this year as last year. SEC rules require company executives to highlight and explain business changes that occurred in the past year, including sharp drops in revenue, acquisitions, and divestitures.
Pay special attention to the section labeled Liquidity and Capital Resources. A company must have enough current or liquid assets as collateral in order to borrow money to pay short-term debts. Otherwise, the company may not be able to distribute dividends, pay suppliers and creditors, or, if money is really tight, meet its own payroll.
The footnotes are another treasure trove of potential red flags. Footnotes are most often found at the end of a 10-K or an annual report. One kind refers to accounting methods and may reveal questionable or aggressive practices or that the company has changed methods, usually a warning sign. But most investors will have an easier time deciphering the other footnotes, which offer disclosures not found in the main body of the financial statements.
For example, the cost of stock options issued to employees is excluded from income statements. Yet when employees exercise those options, their gains are taxable salary on which the companies owe Social Security tax. Companies often subtract this liability from net income as a special item because it's based on unknowns such as market fluctuations and employee decisions to exercise. But investors shouldn't be quick to dismiss that amount. It's a real cash expense, however, the income statement will show a hypothetical, or "pro forma" income, with a reference to the footnotes, explaining that the options expense has been excluded.
Pro forma income can be a red flag in itself. It refers to how much a company earned after excluding onetime events such as a big restructuring charge or a large gain due to the sale of a division, or stock option liabilities. Therefore, you should be skeptical about what items companies put in and take out to arrive at that pro forma figure.
Other one time occurrences often detailed in the footnotes, frequently inflate earnings. The sale of an asset may prop up income, but it can't be relied on for future gains. If a company touts profits based on anything other than its main business, that's a major red flag. Then at that point you have to ask, "Where do revenues and earnings come from, and are they of quality?" Onetime events can also pump up cash positions.
Serious legal problems may also surface in the footnotes. But investors have to realize that many lawsuits are expected in certain businesses. Tobacco companies, for example, have been disclosing lawsuits for years - most of which, until recently, didn't have much impact on the tobacco industry.
Finally, check out a much neglected footnote called Subsequent Events. This is where auditors insert anything important that happens in the period between the close of a given quarter and the date that the report is actually filed. The subsequent events section is often one of the last footnotes in a filing, and unfortunately, many people don't bother to read the footnotes.
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Anything out of the ordinary about the auditor's report may be cause for alarm. A straightforward audit is about one page long and indicates that an outside review of the company's financials has been performed and the information presented by management is in accordance with generally accepted accounting principles (GAAP). If the auditors are concerned, they will include a "subject to" paragraph in the middle of this statement, as in: subject to the resolution of certain problems, the company looks okay. That's serious, but even worse is an opinion that questions the company's status as a "going concern."
Next, review the narrative statements in 10-K and 10-Q reports under Management Discussion and Analysis. This is packed with good information because it's where they tell you why revenue wasn't as good this year as last year. SEC rules require company executives to highlight and explain business changes that occurred in the past year, including sharp drops in revenue, acquisitions, and divestitures.
Pay special attention to the section labeled Liquidity and Capital Resources. A company must have enough current or liquid assets as collateral in order to borrow money to pay short-term debts. Otherwise, the company may not be able to distribute dividends, pay suppliers and creditors, or, if money is really tight, meet its own payroll.
The footnotes are another treasure trove of potential red flags. Footnotes are most often found at the end of a 10-K or an annual report. One kind refers to accounting methods and may reveal questionable or aggressive practices or that the company has changed methods, usually a warning sign. But most investors will have an easier time deciphering the other footnotes, which offer disclosures not found in the main body of the financial statements.
For example, the cost of stock options issued to employees is excluded from income statements. Yet when employees exercise those options, their gains are taxable salary on which the companies owe Social Security tax. Companies often subtract this liability from net income as a special item because it's based on unknowns such as market fluctuations and employee decisions to exercise. But investors shouldn't be quick to dismiss that amount. It's a real cash expense, however, the income statement will show a hypothetical, or "pro forma" income, with a reference to the footnotes, explaining that the options expense has been excluded.
Pro forma income can be a red flag in itself. It refers to how much a company earned after excluding onetime events such as a big restructuring charge or a large gain due to the sale of a division, or stock option liabilities. Therefore, you should be skeptical about what items companies put in and take out to arrive at that pro forma figure.
Other one time occurrences often detailed in the footnotes, frequently inflate earnings. The sale of an asset may prop up income, but it can't be relied on for future gains. If a company touts profits based on anything other than its main business, that's a major red flag. Then at that point you have to ask, "Where do revenues and earnings come from, and are they of quality?" Onetime events can also pump up cash positions.
Serious legal problems may also surface in the footnotes. But investors have to realize that many lawsuits are expected in certain businesses. Tobacco companies, for example, have been disclosing lawsuits for years - most of which, until recently, didn't have much impact on the tobacco industry.
Finally, check out a much neglected footnote called Subsequent Events. This is where auditors insert anything important that happens in the period between the close of a given quarter and the date that the report is actually filed. The subsequent events section is often one of the last footnotes in a filing, and unfortunately, many people don't bother to read the footnotes.
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posted by Bob Moser at
8:02 PM
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