Deconstructing the 10-K: Part II of II
In the first half of the two-part series, we loaded our proverbial dinner plate with a hearty discussion covering the anatomical craft of analyzing securities through their annual reporting, commonly known as a Form 10-K. Be that as it may, if your insatiable appetite for discovering high-quality investments was not adequately satisfied, do not fear—dessert is on its way. Besides, the proof is always in the pudding, right? Well, if you were to ask an Investment Banking Analyst, they’d likely tell you two things; i) that they are an Investment Banking Analyst, and ii) that the proof actually lies in the three financial statements. No pudding for us, unfortunately. They’d also tell you that the key element of assessing a companies’ health in a way that is both holistic and data-validated would be to conduct a rigorous probe of the financial statements enclosed within the 10-K.
As a reminder, this editorial from Senior Editor Benjamin Kavanagh, is intended to provide an entry-level probe into corporate & financial statement analysis (specifically the Form 10-K, filed with the SEC of the U.S.) and offers a framework that aims to give relief from the laboriousness’ of reading copious amounts of reticent financial statements and notes—in what is usually a small window of time.
The Source of Truth
At this time, one may be left wondering what remains to be seen within the statements, considering the extensive account of business performance that is described in the MD&A and Business Description, and so on. And it’s a fair assumption. Truthfully, relative to the average day trader, you have already taken massive strides in informing your investment selection by taking the time to understand what management values and where they see the business developing in the near-term. However, if your end goal is outperformance, believing everything that management forecasts for their business is hardly a judicious strategy. In this instance, it’s a matter of reframing your perspective as an investor to be a cautious pragmatist; someone who makes decisions steeped in fact and observation. Like anything in life, employing a healthy balance of skepticism and optimism is essential in forming a critical opinion. Ultimately, in a world that can be clouded by opinions and biased, the three financial statements (“3FS”) remain steadfast, as an unwavering source of truth that students, analysts, and anyone interested in securities analysis can rely on as a beacon of integrity to inform investment choices.
Income Statement
Before jumping into things, it’s important to disclose the role of this article, as a quick “Rule of Thumb” guide which aims to ameliorate the often-lengthy process of picking apart a companies’ financial statements line-by-line. Essentially, if you are somewhat experienced in corporate finance, but have yet to find a framework that ensures you are keeping good pace in your analysis, or maybe you are a newcomer student who possesses basic accounting knowledge but hasn’t learned how to extrapolate from the numbers, this guide is made for you!
Revenue
This section of the Income Statement is often as straightforward as it looks, and if you are finding it too complicated to understand, chances are it’s not a worthwhile investment. When conducting your diligence, note the following four questions and develop clear answers;
I. How does the company make money?
II. Which revenue streams make up the highest share of revenue?
III. What is driving the growth of each of these revenue streams?
IV. What are the assumptions underpinning this growth?
Naturally, there will be a high degree of variance in your extrapolation of these learnings, depending on the industry. For example, if you are dealing with a subscription model, you may find yourself double clicking on how long the contracts are, the value per contract and its trajectory over recent years, and the costs of acquiring a recurring customer. Whereas, if you are looking at a commodity-driven business, you may want to understand the sensitivity of earnings to whatever fluctuations are occurring in that respective market.
Cost Of Goods Sold / Gross Margin
When delving into cost structure, the following questions can help guide your understanding of how profitable various aspects of the business are, and which are subjected to the highest amounts of risk:
I. What are the main drivers of COGS?
II. How do they relate to each product line/service?
III. Are there specific lines that require higher COGS, and thus have a lower GM?
IV. Are these driving the growth, or are the high margin lines driving growth?
A reasonable way to look at these figures with a second layer of thinking would be to then compare these figures against comparable peers who offer a similar product, service, etc., and draw conclusions as to why your business operates at a higher/lower margin. Ultimately, you want to know if the business has fat to cut out, or alternatively, if there are any material drivers that would change their margins in the near future.
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)
EBITDA is very frequently used as a valuation metric as it removes external accounting factors and non-operating expenses from view, focuses on the operating performance of the business and takes into consideration an approximate value of company cash flow. Oftentimes you will notice that analysts and industry-members alike will use EBITDA multiples to value businesses, meaning its importance should not be understated. Here are some helpful things to keep in mind as you address EBITDA:
Pragmatic investment analysts should ask several key questions about EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) to gain a clear understanding of a company's financial performance and assess its investment potential. Given its importance, and the fact that it is a non-GAAP figure, it also warrants the most scrutiny when conducting your diligence. Here are some important entry-level questions to consider:
I. What is the EBITDA Margin?
II. Why is EBITDA being used?
III. How does EBITDA compare to other financial metrics?
IV. Are there any unusual or non-recurring items in EBITDA?
V. How stable is EBITDA over time?
In confirming these, you can determine a general proxy for cash flows (which will be discussed), agnostic of scale or capital structure. Consequentially, the all-too-frequent ‘adjustments’ to EBITDA require severe scrutiny as well, as they offer a proxy of the companies’ ability to inflate their performance artificially to secure stronger valuations.
Keeping pace in mind, if there aren’t any substantial changes between EBITDA and Net Income reported, you can typically shift gears to the next statement with assurance. If therein lies a major jump, double click on it and carefully analyze what may be affecting the bottom line.
Cash Flow Statement
Cash Flow Statement (CFS) is a financial statement that exhibits cash transactions during a specific period, providing critical data to gauge a company's financial health. CFS categorizes cash activities into Operating, Investing, and Financing activities, enabling readers to assess how efficiently a company allocates its cash resources. Whereas when reading the income statement provides the profit of a business, those profits might not necessarily be converted into cash. It is cash that is the lifeblood of the business—not profit.
Cash From Operating Activities
To obtain operational cash flow in the company (cash generated or used from or in normal operating activities), you start with net income (bottom line of the income statement) and work up the income statement making adjusting for non-cash transactions that affected net income. The goal of looking at the cash flow from operating activities is to work out whether a company can trade in a manner that is self-sustainable. A company can generate a lot of profit but burn cash. Without ample cash, the business may lack working capital, and this can cast a dark shadow on day-to-day operations. A sign of a company turning itself around could be improved cash generation and therefore no longer reliant on equity diluting fundraising in order to keep the lights on. It is important to look at profit also, but companies that have the liquidity to be self-sustaining rather than burning cash can be a sign to investigate further into the business, and a sign of an intelligent management team at the helm.
Cash From Investing Activities
This section is straightforward, in which you obtain the cash generated or spent from investing in itself. Good examples of investing activities can include the purchase of tangible or intangible assets, investments in listed or unlisted businesses, or the sale of assets including tangible assets, securities, and so on. Typically, you can analyze this segment of the CFS to gain footing on the level of investment the business is putting in itself, which is most influential when juxtaposed with the years preceding. A company that has a considerable amount of ongoing capital expenditure (Maintenance Capex) required for its assets to function effectively will find it troublesome to grow or expand, for example. The opposite is true as well, with companies who don’t require much reinvestment being capable of leveraging their capital base to make expansionary plays.
Cash From Financing Activities
This section of the CFS highlights the net cash inflows and outflows of capital that are used to fund the company. In this section you may find that a company recycled their own shares to raise proceeds, or maybe paid down the principal of lease payments. Ultimately, for the purposes of a quick spot check, you really want to ensure that your equity position isn’t being diluted heavily by new issuances. Viewing the CFS from arm’s length, you can run an effective spot check with the following three questions:
Is the business generating positive operating cash flow?
Are there substantial amounts of depreciation of fixed assets, or amortization of intangibles?
Is the company struggling to collect cash and paying debtors quicker than it is coming in?
Balance Sheet
The CFA Institute offers what I consider to be a concise and effective description of a Balance Sheet and how it works:
“The balance sheet discloses what an entity owns (assets) and what it owes (liabilities) at a specific point in time. Equity is the owners’ residual interest in the assets of a company, net of its liabilities. The amount of equity is increased by income earned during the year, or by the issuance of new equity. The amount of equity is decreased by losses, by dividend payments, or by share repurchases.”
At the entry-level, there may be some incremental value-additive outcomes to carefully probing each line item, chances are you can ‘sniff test’ the balance sheet strength with a few quick and dirty ratios:
I. Return on Invested Capital (NOPAT / Invested Capital)
II. Net Leverage Multiple (Net Debt / EBITDA)
III. Inventory Turnover (COGS / Avg. Inventory @ Selling Price)
IV. Debt to Equity (Total Debt / Total Shareholders’ Equity)
V. Interest Coverage Ratio (EBIT / Interest Expense)
Calculating these metrics should offer a helpful snapshot of the companies’ ability to meet its short and long-term obligations, as well as their efficiency in utilizing their capital.
Notes to the Financial Statements
Chances are, even if you took the time to read line-by-line for each statement tenfold, you are likely still left with unaddressed questions concerned with adjustments, driver rationale, and non-GAAP reporting subjectivity. This is an inevitability in this line of work. Fortunately, you can (must) refer to the ‘Notes to Financial Statements’ section of the 10-K frequently when conducting your diligence. It’s not foolproof but being a footnote hawk is a best practice that separates the alpha generators from the index players. These will vary from company to company, but it undoubtedly requires more attention than each of the statements themselves combined.
By now, I’ve rambled plenty enough on this subject and you’re having war flashbacks of COMM111 lectures. Or perhaps you are still disappointed about the lack of pudding. Either way, somewhere in the middle I hope that you took away from this that the fundamental prerequisite for analyzing a company through its annual reporting is to adopt a cautious pragmatists’ mindset, and not grow too excited nor too weary of what a company tells you it’s going to do. Rather, carefully evaluate each anatomical element we’ve discussed in Parts I and II and consider the sum of these parts to be the value of the whole.