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A good Management Discussion and Analysis will give you
details you need to understand items on income statement. You should get segmented sales data, cost drivers, etc. in this section. If you can’t make sense of MD&A, that should set off alarm bells in your head. If you don’t find information you need in MD&A, you should…
4. Look at Notes to Consolidated Financial Statements (Footnotes)
The footnotes tend to be more difficult to understand than MD&A, but you get really detailed information here. The footnotes are where management hides dirty laundry. And when you’ve got guys making today’s corporate salaries that laundry pile can get pretty big. Here’s where you’ll likely find what you couldn’t in MD&A, it’s just that in notes you may have to do some putting of two and two together.
Take your time sifting through this section, and try to identify income statement items that relate to footnotes you’re reading. You can do it other way around, as well, and look for footnotes that relate to income statement item.
If you still can’t figure out what company is doing, after going through MD&A and footnotes, you may want to consider looking at another company. This one may be too complicated (or too devious) for your abilities. Don’t feel bad about not understanding business, either. Even great Warren Buffett admits that he doesn’t understand some businesses, and he never lets his ego run away from him. If he can’t understand it, he won’t invest in it. I recommend you do same thing.
5. Look at segmented data
I always like to look at segmented sales and profit figures to determine which product lines, or operating businesses, are growing sales faster than others. This information is usually in MD&A. If you can, try to find operating profit for each business segment as well. Then look at profit margins for each segment of business.
You may be surprised at different profitability levels of each business segment. Compare segment with fastest growing sales versus segment with highest operating profit. If these are same segment, that’s good news. If they aren’t, that’s okay too.
You do want to watch out for companies that have lowest operating profit in their fastest growing segment. This could cause a decline in company’s overall profitability as sales grow faster than profits. For example, a segment that’s growing 5% a year, but has a 10% margin, will contribute more to total operating profit growth than a segment growing at 20% a year with a 1% margin.
I hope you find these tips helpful. Of course, there are plenty of other analysis tools that you can use to evaluate financial statements. It's important that you keep looking for more and better ways to analyze company data, because constant learning will make you a consistently better investor.
Chris Mallon is the editor and publisher of the Undervalued Weekly, a free personal finance and investment newsletter, published every Saturday.
To sign up for the Undervalued Weekly, send e-mail to underval@hot-response.com, or sign-up through the website at www.dynamicinvestors.net/index8.html.
