Comparisons with Past Financial Reports

A financial statement is valuable as a single document only for testing of certain fundamentals. For example, if you accept the commonly held belief that current ratios should be 2-to-l or better, it is easy to check that at a glance. However, for the more individualized forms of fundamental analysis, in which you are looking for trends and changes over time, you need to compare today's financial statements to those of the past.

Published statements include the latest two years of balance sheets and three years of other financial statements. Quarterly reports usually include comparisons only to results from the prior fiscal year's comparable quarters. This is adequate for a level of preliminary analysis; but when you own shares of stock in a company, your trend analysis should be ongoing, and should involve tests over as many years as you hold your stock. Two years represent only the two latest entries in a continuing trend.

Your task in the preliminary analysis of a financial statement is to quickly identify declining trends (when monitoring your portfolio) or favorable reversals (if you are thinking of buying the stock). These are not always easy to spot; however, some declining trends are obvious from a surface review. Some turnarounds do not become obvious until the opportunity has come and gone. In other words, there is always a degree of risk in interpreting trends. Declining sales, reduction in earnings per share, lowered dividend declaration or a missed dividend payment, and reduction in working capital (such as that expressed by the current ratio) are all examples of easy-to-spot declining trends. Dramatically improving sales over two or more periods, improvements in working capital, and improved net margin all are indicators of a potential turnaround in previous negative trends.

KEY POINT

The comparison of two years is a good starting point, but a real trend requires more. Remember that the latest information is simply an entry in a longer history.

Be especially aware of the relative changes in working capital (current assets compared to current liabilities). This is where bigger problems often associated with expansion often appear first. As companies expand, good planning and management lead to the maintenance of minimum requirements in working capital. Growth occurring too quickly or without proper controls is reflected in declining working capital.

A second area to search for problems—especially when watching balance sheet ratios and trends over time—is in the relative makeup of capitalization. As dependence on debt increases, interest costs rise as well. That in itself is not a problem as long as profit margins are maintained and a higher dollar volume of profits is made possible. Such a situation demonstrates that management is using borrowed funds well while controlling net margin. Debt is appropriate when the dollar amount of profits increases enough to cover interest within the same margin, and it generates enough cash flow to repay the principal portion of borrowed money.

You can also look for declining trends on the statement of income. The most obvious will be net margin and earnings per share. Be cautious, however, in a year-to-year comparison of earnings per share. If additional common shares were issued during the year, then earnings per share cannot be tracked accurately. Likewise, if the company repurchased its own shares in large volume, retiring those shares to treasury stock, that distorts the comparison of earnings per share from one year to the next. Because treasury stock earns no dividends, that artificially raises the dividends for other stock. And finally, be aware of the dividends paid to preferred stockholders. Use the payout ratio rather than a more simplified earnings per share calculation to find any masked trends in this area.

One ratio to watch carefully tests dividend payments. Many investors like to watch the dividend rate over time. However, simply tracking the dividend rate may not tell the whole story. A more revealing way to track dividends is through the dividend payout ratio (see Figure 5.4). This ratio also reports the percentage of dividends paid on common stock, but it adjusts for any dividends declared and paid on preferred stock. This provides you with an accurate tracking device for common stock dividends (which most stockholders receive), especially if the rate on preferred stock changes significantly on comparable profits. The formula involves dividing common stock dividends paid by adjusted net profits (net profits minus dividends paid on preferred stock); the result is expressed as a percentage.

FIGURE 5.4 Dividend Payout Ratio (rounded to one decimal)

In the example, the adjusted payout is 4.4 percent. A simple calculation of common stock dividends without excluding preferred dividends would not change this percentage. However, if the rate of payment on preferred stock were to change in the future, it would impact the common stock payout. Also if the corporation were to issue a large number of preferred stock shares and then declare and pay dividends, the payout would be affected. The payout ratio allows you to accurately track common stock dividends over time.

The dividend payout ratio reveals one important trend—how management pays dividends to shareholders after allowing for adjustments for preferred shareholders. This, in combination with careful monitoring of sales trends, forms the basis for a sound program of fundamental analysis.

KEY POINT

The dividend payout ratio is useful in identifying the real payout trend, after adjusting for potentially changing management policies regarding preferred shareholders.

While sales volume by itself should never be a decisive fundamental indicator, sales are important for purposes of comparison in ratio form. Thus, when sales decline from one period to another, it should raise questions. First, how have declining sales affected other important ratios, such as earnings per share and net margin? Why have sales declined? Is the decline a one-time event or part of a trend? If the company is ceding industry leadership to another corporation, do declining sales represent lost market share?

Equally as important as sales volume trends is the gross margin. This is the percentage that gross profit (sales less direct costs) represents when compared to sales.

Gross margin is an important fundamental test for the statement of income. The formula for gross margin is shown in Figure 5.5.

Gross margin should remain fairly constant, regardless of how sales rise or fall. Thus, in periods of rapid expansion, a deteriorating rate of gross margin is one indicator that profits will tend to erode. Management should carefully control its gross margin because direct costs should change directly in relationship to sales.

KEY POINT

Sales volume trends have always been popular indicators, although they do not tell the entire story. Use sales as a part of your broader statement of income analysis.

FIGURE 5.5 Gross Margin (rounded to one decimal)

KEY POINT

Gross margin often Is ignored as a fundamental indicator. The ability or inability of management to maintain a consistent level of gross margin during times of rapid expansion is a valuable indicator.

The most important of the balance sheet trends will be profitability—not only the amount of net profit, but the margin as well. The amount of net profit should be a reflection of sales volume. As volume increases, so should the amount of profit. However, it is possible to have higher dollar amount profit with lower net margin. This indicates that a company is producing more sales revenue, but lower rates of return, a negative trend. Some analysts look for ever-growing margins, which is not practical. However, a healthy growth period is characterized by stable net margins. That means that the dollar amount of profits rises with higher sales, but also that the percentage margin remains constant within an acceptable range. This is the case because it is unlikely that a corporation will be able to improve its net margin indefinitely.

An exception to this rule occurs when a company in one primary line of business acquires a subsidiary operation or merges with a corporation in a different product or service line, especially one with a significantly different level of net margin. As the two operations are combined, the mix of business will dictate what constitutes normal margins. In watching the profitability trend over time, be aware of the effect of mergers and acquisitions of dissimilar lines, and adjust the trend expectation accordingly.

KEY POINT

Net margin should remain consistent within a reasonable range, and can be expected to change only when a corporation dramatically changes its mix of business, for example, through acquisitions.