Anda di halaman 1dari 15


The purpose of the income statement. The income statement's purpose is to provide investors the most accurate description of the company's profitability over a set period of time, usually a fiscal quarter (three months), or a fiscal year (12 months). This includes an estimate of the firm's sales, costs, increase or loss in intangible value, taxes, outstanding shares, and ho the resulting net profit is divvied up to shareholders. !t's important to emphasi"e that the income statement is an estimate of these figures. #ome items, such as the value of good ill, or depreciation expense, are essentially arbitrary. $ven seemingly concrete figures, such as revenues, are estimates as some companies ill boo% sales based on commitments hich may later be amended or even terminated. The income statement is full of accounting assumptions. &hen e discuss the cash flo statement, e ill see ho these assumptions translate into cold, hard cash. &e'll use the financial statements of a recent (although not current) 'agic (ormula stoc% that everyone should be familiar ith) !ntel *orporation (!+T*). !ntel has a fairly easy to understand business, and also has most of the line items an investor ill encounter hen investigating a stoc%. ,ere is !ntel's fiscal 2--. income statement (all values are in millions of dollars). *olumns ith grey bac%grounds are a calculated (not reported) value, and those ith light blue bac%grounds are calculated metrics. /alues in parenthesis represent costs. Revenues Cost of Sa es Gross !rofit Gross Mar"in Research an# Deve opment Mar$etin"% Genera an# A#ministrative Amorti&ation of Intan"i' e Assets Operatin" Income Operatin" Mar"in Net Interest Income(E)pense Restructurin" an# Asset Impairment Gains on E*uit+ Investments Income Ta) !rovision Net Income Net Mar"in Shares Outstan#in" Earnin"s !er Share 01,002 (11,20-) 13,3-2 41.35 (4,.44) (4,2-1) (16) 1,.02 22.15 .30 (416) 14. (2,13-) 6,3.6 11.25 4,306 1.11

7et's ta%e each of these line items one8by8one and explain them briefly)

Revenues. This is simply the amount of money !ntel earned in 2--. from selling their processors, chipsets, and memory to customers, primarily electronics manufacturers. Cost of Sa es. These are the direct costs of producing the processors, chipsets, and memory products. Things included in this number ould be manufacturing employee salaries, the cost of silicon and other materials to build the chips, electricity and other utilities to run the fabs, pac%aging materials, and so forth. Gross !rofit. 9ross profit is simply (:evenues 8 *ost of #ales). Gross Mar"in. 9ross margin is (9ross ;rofit < :evenues). This gives an idea of ho much of each dollar of sales the company earns from selling its products. 'ost commodity industries earn lo gross margins (2-5 or lo er), hile highly differentiated products can earn very high gross margins (4-5 or more). Research an# Deve opment. !n order to consistently produce faster and smaller chips, !ntel has to spend a lot of money on development labs, engineering resources, prototype products, etc. Those expenses are recorded here. Mar$etin"% Genera an# A#ministrative. :emember the =lue 'an 9roup commercials ha %ing !ntel chips> Those and other advertising expenses are recorded here. 9eneral and ?dministrative costs include executive salaries, stoc% options, and any other costs that cannot be grouped else here. Amorti&ation of Intan"i' e Assets. !ntangible assets ill be discussed more in the balance sheet article, but in general they are assets li%e brand names, exclusivity contracts, or patents that provide competitive advantage but are difficult to place a price tag on. !n this line, !ntel is applying a pre8defined schedule for degrading the value of these. This is one of those accounting assumption that does not involve any cash, @ust the paper value of the company. Operatin" Income. Aperating income is (:evenues 8 ?ll Aperating *osts). This is the golden number on the income statement. These are the profits !ntel earned from its day8to8day business in the fiscal year. Operatin" Mar"in. *alculated by (Aperating !ncome < :evenues). Aperating margin is very useful for comparing companies ith the same general business. ,igher operating margins bet een competitors usually indicate hich company has the stronger business. Net Interest Income(E)pense. !ntel o es its bondholders interest on the B2 billion in debt it has issued, but also collects interest on the nearly B12 billion of cash and other investments. #ince !ntel collects more interest than it pays, this value is positive.

Restructurin" an# Asset Impairment. &hen a company decides to cut costs by announcing layoffs, usually the cost of laying off these or%ers (for severance pay and so forth) is expensed right a ay. ?sset impairment is often related to equity investments the company holds. &hen it believes that the investment ill no longer be orth its boo%ed value ithin a reasonable amount of time, it ill record an CimpairmentC to a lo er level. ?gain, this is an accounting assumption that may or may not turn out to be accurate, for better or orseD Gains on E*uit+ Investments. !ntel holds significant equity sta%es in !' (lash Technologies and *lear ire, the latter of hich trades on the +?#E?F 9lobal #elect. The change in value of this investment over the fiscal year is recorded here. Ance again, this is not a cash item and really has no effect on the day8to8day business of the company. Income Ta) !rovision. 7i%e all of us, !ntel has to pay Gncle #am. The accountants calculate hat they believe the tax rate ill be and set aside a portion of profits in this line item (another assumptionD). Net Income. +et income is simply (:evenues 8 ?ll *osts). This is the bottom line profit number. Net Mar"in. +et margin is (+et !ncome < :evenues). This represents the percentage of each dollar that falls through to profits. !ntel's 115 figure is exceptional. +et margin, li%e operating margin, is most useful hen comparing t o competitors in the same industry. Shares Outstan#in". This is the average number of common shares outstanding through the period. !f you are a shareholder, some of these shares are yours. Earnin"s !er Share. #imply (+et !ncome < #hares Autstanding). This is the amount of profit the company earned for each one of your shares. #o that's the income statement. +ext e'll examine the balance sheet, follo ed by the cash flo statement. Then e'll finish up ith a list of accounting Cred flagsC to loo% for hen examining a company's statements.


The purpose of the 'a ance sheet. The balance sheet's purpose is to provide a detailed listing of the company's assets and liabilities. !t is not unli%e a personal credit report. !f you thin% about your o n financial net orth, you probably have a number of assets such as a home, a vehicle, a stoc% portfolio, cash in a savings account, and so forth. Hou also li%ely have a list of liabilities or debts, such as a mortgage, a car loan, electric or telephone bills that have not yet been paid, etc. This concept is directly analogous to a company, and the balance sheet lists out all of these. 7i%e the income statement, an investor needs to be a are of the potential accounting assumptions made for the balance sheet. Abviously, some line items are unambiguous. (or example, the orth of cash in the ban% is a pretty straightfor ard value. ,o ever, the orth of a 4 year old computer, or an undeveloped piece of land, is less concrete. (or most of these %inds of items, a company ill boo% their value at hatever as paid for it. &hile items that depreciate, li%e computers, are usually de8valued over a period of time, that piece of land ill li%ely appreciate over time, and the current value may not be reflected on the balance sheet. This can ma%e the company more valuable than it appears (some value investors refer to these as Casset playsC). (or financial companies, a ton of assumptions are made on the balance sheet. The actual value of a loan is very difficult to calculate due to variable interest rates, ris% of default, ris% of early payment, etc. Ta%e that reality and multiply it by the millions of loans a large ban% has outstanding, and you begin to see hy investing in ban%s is such a difficult and ris%y endeavor. ,o ever, since the 'agic (ormula thro s out financial stoc%s, e on't discuss that in much detail here. Ane other thing to be generally a are of is that both assets and liabilities are categori"ed as either CcurrentC or Clong8termC. The line items falling into the CcurrentC category are assets that the company expects to be converted into cash ithin the next 12 months, or liabilities that are expected to be paid off over the next 12 months. C7ong8termC assets and liabilities have a longer time hori"on for being liquidated or covered, respectively. To understand the balance sheet, ill continue ith our previous example, !ntel (!+T*). ,ere is it's year end 2--. balance sheet. ?gain, gray columns are calculated values, and light blue columns are calculated metrics. ?ll values are in millions of dollars, and items in parenthesis represent liabilities. The balance sheet often has line items that are specific to a line of business or a company, so some of these you on't generally see, hile others are pretty common. Cash . E*uiva ents/ Short0term Investments/ Tota Cash E*uiva ents/ Accounts Receiva' e/ Inventories/ .,0-. 4,2312,.3. 2,4.6 0,0.-

Tra#in" Assets/ Deferre# Ta) Assets/ Other Current Assets/ Tota Current Assets/ !ropert+% ! ant% E*uipment% Net/ Goo#1i / Mar$eta' e E*uit+ Securities/ Other -on"0term Investments/ Other Assets/ Tota Assets/ Accounts !a+a' e/ Accrue# Compensation an# ,enefits/ Accrue# A#vertisin"/ Deferre# Income on Shipments/ Other Accrue# -ia'i ities/ Income Ta)es !a+a' e/ Short0term De't/ Tota Current -ia'i ities/ -on"0term De't/ -on"0term Income Ta)es !a+a' e/ Deferre# Ta) -ia'i ities/ Other -on"0term -ia'i ities/ Tota -ia'i ities/ Tota E*uit+/ De't0to0E*uit+ Ratio/ Current Ratio/ ? brief explanation of each line item)

2,466 1,116 1,0320,114 16,311 0,316 31. 2,031 4,42. 44,641 (2,061) (2,21.) (.23) (624) (1,301) (003) (122) (1,4.1) (1,31-) (.14) (211) (1,122) (12,113) 22,.62 2.365 2.35

Cash . E*uiva ents. Iust hat it sounds li%e. This is very liquid cash in a ban% account, or an investment that can be sold quic%ly at a %no n price. Short0term Investments. Aften classified bond ith a maturity under 12 months. ith cash. $xamples of these ould be a *E or

Tota Cash E*uiva ents. #imply the above t o added together. (or analysis purposes, these assets can be liquidated at the stated value at any time.

Accounts Receiva' e. ?mount o ed to the company for products, but not yet received. ?n example of this ould be hen a computer ma%er li%e Eell (E$77) buys !ntel parts on credit but has not yet paid off the balance. !ntel is o ed this balance, and it is boo%ed here. Inventories. /alue of processors, chipsets, and memory that have been manufactured but not yet sold to customers. This is an important number to atch for a company li%e !ntel, because the value of this inventory declines rapidly as ne er chips are rolled out. Tra#in" Assets. This is a line item you don't generally see. !n this case, they represent short8 term debt instruments (bonds) that !ntel has invested some of its cash in to earn a higher return. Deferre# Ta) Assets. ?n accounting by8product. :emember in the income statement article that e mentioned that tax provisions ere an assumption of ho much the company ould o e in taxes> Aften those assumptions turn out to be a bit off, and the company either o es more or less taxes than it set aside. #ince these are assets, at some point in the past !ntel overestimated its tax liability, and is carrying the difference on the balance sheet. This account can be used to ma%e up the difference on the do nside in the future ( hich !ntel expects to do, as it's listed as a current asset to be used in the next 12 months). Other Current Assets. ? catch8all line item. (or most companies, you need to go into the footnotes to get the details here. This is especially important if it's a large value, as all %inds of dirty secrets can be hidden in the CotherC line items. (or !ntel, the bul% of this number (over B1 billion) as due to a pre8payment on a stoc% buybac% authori"ation, hich as neatly offset by a B1 billion accrued liability. Tota Current Assets. ?ll of the above added together. These are the assets !ntel expects to convert to cash ithin the next 12 months. !ropert+% ! ant% E*uipment 0 Net. The value of all of !ntel's factories, administrative buildings, computers, chip ma%ing equipment, and so on. #ometimes the balance sheet ill sho an Cat8costC figure and then Caccumulated depreciationC. &henever a company buys equipment, it ill set up a depreciation schedule and degrade the value in set intervals. The net figure is Cat8costC minus Caccumulated depreciationC. Goo#1i . &hen a company (acquirer) purchases another company (acquiree), the amount paid over the Total $quity of the acquiree is carried as good ill on the balance sheet of the acquirer. The idea is that this premium represents the intangible assets and future earnings po er of the acquiree. This is an accounting phantom 8 this number has no tangible value and is often ritten do n (impaired) if the acquired assets prove not to be as valuable as expected. #ince it is essentially a made8up asset, strategies li%e the 'agic (ormula disregard it totally and assign it no orth. Mar$eta' e E*uit+ Securities. #ome cash rich companies li%e !ntel ill invest a portion in equities, much li%e you or ! ould invest our excess cash in a stoc% portfolio. !ntel holds stoc% in companies li%e /'&are (/'&) and 'icron ('G), both of hom are part of @oint ventures ith !ntel. !t is fairly rare to see public companies hold a significant amount of equity assets on the open mar%et.

Other -on"0term Investments. These represent minority sta%es in other companies that ere not purchased on the open mar%et. !n 2--., this value mainly represented !ntel's minority sta%e in +A: flash ma%er +umonyx and &i'?J ma%er *lear ire. Other Assets. ?nother CotherC category that you need to dig into the footnotes to understand. (or !ntel, these include other non8mar%etable equity investments, derivatives for managing foreign exchange ris%, estimated value of intangible assets, and direct investments in @oint ventures (!' (lash Technologies ith 'icron, for example). Tota Assets. The cumulative value of all current and long8term assets. Accounts !a+a' e. 'oney that !ntel o es to suppliers but has not yet paid in cash. Accrue# Compensation an# ,enefits. This is money !ntel o es it's employees for hours or%ed, earned but unpaid bonuses, and benefits such as unused paid time off. Accrue# A#vertisin". 'ost companies lump their advertising contract obligations in ith accounts payable, but !ntel has a separate line item specifically for it. This is money the company o es advertising outlets but has not paid off in cash. Deferre# Income on Shipments. This is money that has been paid to !ntel by customers, but that !ntel has not yet shipped. !t is carried as a liability to represent the obligation !ntel has to actually ship the product that has been paid forD This concept can be applied for any company's Cdeferred incomeC liabilities. Other Accrue# -ia'i ities. ?nother catch8all CotherC line item. 'ost of it is the aforementioned prepaid share buybac%. ,edging portions of the derivative contracts and equity holdings are included here, but there are not many hard details on these in the 1-8K (annual #$* filing). Income Ta)es !a+a' e. $stimated tax liabilities that !ntel year. ill have to pay ithin the next

Short0term De't. Gsually a ban% credit line that needs to be paid off in a short amount of time (not unli%e a credit card). 'any companies also have a C*urrent ;ortion of 7ong8term EebtC line item, hich reflects ho much of their long8term bonds are maturing ithin the next 12 months. Tota Current -ia'i ities. ? sum of all the above liabilities. These are all due to be paid off in ithin the next year. -on"0term De't. The total face amount of outstanding long8term bonds issued by the company, plus the expected interest due to be paid on them. -on"0term Income Ta)es !a+a' e. This differs from deferred tax items in that !ntel has already been charged ith this amount of tax. Deferre# Ta) -ia'i ities. #ee above CEeferred Tax ?ssetsC. The same idea, except for this line item, !ntel underestimated the tax they ould have to pay.

Other -on"0term -ia'i ities. Het another CotherC categoryD !ntel lumps a lot of things in here, mainly uncertain tax liabilities and interest payment obligations. Tota -ia'i ities. ?ll current and long8term liabilities summed up. Tota E*uit+. *alculated as (Total ?ssets 8 Total 7iabilities). This is !ntel's Cnet orthC 8 the amount of assets left over for common shareholders li%e us after all liabilities are paid off. Theoretically, this is the liquidation value of the company. De't0to0E*uit+ Ratio. *alculated as ((#hort8term Eebt L 7ong8term Eebt) < Total $quity). This is a financial health statistic. &e don't ant to see a high percentage of debt to equity, because this debt has to be serviced by profits and that ta%es out our cut as shareholders. !n some cases, the debt interest requirements can be higher than profits, or even orse, debt coming due in the next 12 months may not be able to be paid off ith cash flo and cash reserves, leading to potential ban%ruptcy. ?s a rule of thumb, e loo% for a number here less than .-5, although it varies by business. !ntel's is under 45, so debt burden is not a concern here. Current Ratio. *alculated as (*urrent ?ssets < *urrent 7iabilities). This is another financial health measure that tests the CliquidityC of a company, or it's ability to cover it's short term liabilities. The higher the better here. ?ny number under 1--5 should be scrutini"ed, as this could mean that the company ill not be able to pay it's liabilities in the near term. 1245 is a decent number to loo% for, but ris%ier companies should be required to have a higher figure (1.45 or better). !ntel's 2.35 figure is outstanding. That as a long oneD =ut the balance sheet is extremely important in determining ho financially sound a company is. !t also sho s you ho much capital the company needs to generate it's profits, hich is critical to calculate return on capital. &e'll discuss both of these in our red and green flag articles that sho ho to use the information discussed above. !n the third part of this series, e ill ta%e a loo% at the cash flo statement.


The purpose of the cash f o1 statement. The cash flo statement has 2 primary purposes. Ane, it indicates to the investor ho much cash money flo ed into or out of the business over a period of time, usually a year or a 08month quarter. #econd, it reconciles the other t o financial statements 8 income statement and balance sheet. (or the income statement, it reconciles the accounting assumptions ith the actual cold, hard cash the business earned. (or the balance sheet, the cash flo statement sho s the differences in the level of assets or liabilities from the previous reporting period. Ane ma@or difference bet een the cash flo statement and it's siblings is that there are no accounting assumptions or estimations on the cash flo statement. The income statement contains many accounting assumptions for things li%e depreciation and taxes. 7i%e ise, the balance sheet estimates the orth of acquired businesses (good ill) and intangibles li%e patents or brand names. The cash flo statement values are very real 8 this is the MexactM amount of cash coming in and going out of the business. #ince creating cash from assets is the basic function of any business, the cash flo statement has a ell earned reputation amongst value investors for being the most important of the 0 reports. *ash flo statements are organi"ed into 0 sections. The first, cash from operations, is the most important. This is the section that reconciles reported net income from the income statement and adds bac% non8cash costs, as ell as accounting for the change in or%ing assets li%e inventory, and so forth. The second, cash from investin" activities, is here the company lists out items li%e capital expenditures, acquired businesses, and purchase<sale of equity or bond holdings. The third, cash from financin" activities, is here dividend payouts, stoc% repurchases, cash received from bond issues, and debt repayments are listed. ?s before, e'll loo% at !ntel's (!+T*) fiscal year 2--. cash flo statement, and then briefly explain each item. ?ll values are in millions of dollars, and parenthesis represent negative values (cash going out). !n order to %eep this some hat brief, some line items have been grouped together. Net Income/ Depreciation/ Share ,ase# Compensation/ Asset Impairment/ Ta) ,enefit from Share ,ase# !a+ments/ Amorti&ation of Intan"i' e Assets/ Gains on E*uit+ Investments/ Gains on Divestitures/ Deferre# Ta)es/ Chan"es in 3or$in" Assets an# -ia'i ities/ Net Cash from Operations/ A##itions to !ropert+% ! ant% E*uipment 4Capita E)pen#itures5/ Ac*uisitions% Net of Cash Ac*uire#/ !urchases of Avai a' e0for0sa e Investments/ 6,3.6 2,426 342 462 (111) 242 (14.) (21) (220) .2 12,624 (4,---) (.6) (11,.21)

Maturities an# Sa es of Avai a' e0for0sa e Investments/ Investments in Non0mar$eta' e E*uit+ Instruments/ Net !rocee#s from Divestitures/ Other Investin" Activities/ Net Cash from Investin" Activities/ Decrease in Short0term De't/ !rocee#s from Government Grants/ E)cess Ta) ,enefit from Share0'ase# !a+ments/ A##itions to -on"0term De't/ !rocee#s from Sa es of Shares to Emp o+ees/ !urchase an# Retirement of Common Stoc$/ !a+ment of Divi#en#s/ Net Cash from 2inancin" Activities/ Net Chan"e in Cash Ho #in"s/ 2ree Cash 2 o1/ Divi#en# !a+out Ratio/ 2ree Cash 2 o1 Mar"in/ 2ree Cash to Earnin"s Ratio/ ? brief explanation of each line item)

1,-11 (1,243) 02 232 (3,326) (03) 16111 124 0,-42 (2,.11) (2,611) (1,33-) .-3 1,-.3 02.25 21.15 1115

Net Income. The net income line from the income statement. *ash is reconciled against this starting point. Depreciation. Eepreciation expenses in the income statement do not affect cash. (or a personal example, thin% of the depreciation in your vehicle's value each year. ?lthough it diminishes your net orth by reducing the amount you could sell the car for, it does not affect your cash holdings. Share ,ase# Compensation. Tech companies li%e !ntel often re ard employees by granting them stoc% or stoc% options. The estimated final value of these must be expensed on the income statement, but issuing stoc% or options does not require cash, so the amount expensed is added bac% here. Asset Impairment. The value of assets on the balance sheet are in most cases estimated. !ntel's accountants decided that, due to ea% demand, the value of some assets as lo er than as being carried on the balance sheet. The resulting rite8do n affected the balance sheet value, but did not affect cash holdings, so it is added bac% here. This line item also contained employee severance charges that ere expensed in the current period, but not yet paid out in cash.

Ta) ,enefit from Share ,ase# !a+ments. &hen employees exercise their stoc% options, the amount of profit they receive can be ritten off !ntel's tax bill, as employee compensation is tax deductible. An the cash flo statement, this value is subtracted from operating cash and added to cash from investments as a re8classification exercise. Amorti&ation of Intan"i' e Assets. #imilar to Eepreciation or ?sset !mpairment, !ntel has set up a schedule to degrade the balance sheet value of some of it's intangible assets over a period of time. &hile this affects the balance sheet and is counted as an expense on the income statement, it does not affect cash and is added bac% in here. Gains on E*uit+ Investments. ?s mentioned in the balance sheet article, !ntel holds equity positions in a fe companies it or%s ith, notably /' are (/'&) and 'icron ('G). 7i%e your personal portfolio, unrea i&e# gains and losses affect net orth, but not cash balances. Therefore the gain recorded in the income statement is subtracted bac% out here. Deferre# Ta)es. ?s mentioned in the balance sheet revie , deferred taxes represents over or under8estimated tax payment carry8for ards. ?gain, this is a carrying account, only for trac%ing tax balancesN changes in it are strictly for accounting purposes and do not involve cash. Chan"es in 3or$in" Assets an# -ia'i ities. !ntel's accounts receivable, inventory, accounts payable and other or%ing capital balances obviously fluctuate on a daily basis. T o things to loo% for here are accounts receivable rising (!ntel not able to collect it's o ed cash payments), and inventory rising as a percentage of revenues. These represent ea%ness in !ntel's customer base, and rising inventory is a big concern as technology products degrade in value very quic%ly. Aver time, this line item should or% out to about brea%8even. *onsistent negative values here indicate poor management of collection and demand forecasting. Net Cash from Operations. The sum of all of the above line items. This is the amount of cash !ntel earned over the reported period, one of the most important pieces of data available. A##itions to !ropert+% ! ant% an# E*uipment 4Capita E)pen#itures5. ?ny items the company purchases for business that have a useful life over one year are considered Ccapital expendituresC. These are not expensed in the income statement, but are charged off gradually through depreciation. (or !ntel, these are things li%e ne chip8ma%ing equipment, office furniture, computers, and so forth. Ac*uisitions% Net of Cash Ac*uire#. This is the cash !ntel spent purchasing other businesses. !urchases of Avai a' e0for0sa e Investments. *ash !ntel put into purchasing equity and<or bonds for the purpose of earning a higher return. C?vailable8for8saleC means these are usually done on the open mar%et. Maturities an# Sa es of Avai a' e0for0sa e Investments. The inverse of the above. ;roceeds from equity and<or bonds that matured or ere sold in the period.

Investments in Non0mar$eta' e E*uit+ Instruments. *ash spent for a considerable equity investment that as done off8the8mar%et. !n this particular case, !ntel invested nearly B1.4 billion for a @oint venture sta%e in !' (lash Technologies. Net !rocee#s from Divestitures. *ash received from the sale of various assets and businesses the company no longer deemed strategic. 7oo%ing over the 1-8K, this includes optical net or%ing components group, media and signaling businesses, and several others. Other Investin" Activities. The catch8all for investing8based items that don't fit any here else. These consist of a number of items spread all over the 1-8K, hich ! on't list here. Net Cash from Investin" Activities. ?ll of the investing based items (here, the previous .) added together. Decrease in Short0term De't. *ash !ntel used to pay off some of it's short8term debt balances. !rocee#s from Government Grants. There is not much detail on this in the 1-8K. ;resumably !ntel received a nominal amount of cash from some government agency. E)cess Ta) ,enefit from Share0'ase# !a+ments. #ee the similar entry under the operating cash section. A##itions to -on"0term De't. *ash received from selling corporate bonds. !rocee#s from Sa es of Shares to Emp o+ees. 'ost tech companies, and many other companies as ell, have employee share purchase programs here employees can purchase equity at reduced prices. The amount of cash !ntel's employees paid the company for these shares is recorded here. !urchase an# Retirement of Common Stoc$. The amount !ntel spent to buy bac% and retire it's o n shares. !a+ment of Divi#en#s. Iust dividends. hat it seems 8 the cash paid out to shareholders in the form of

Net Cash from 2inancin" Activities. ?ll of the financing based items (here, the previous .) added together. Net Chan"e in Cash Ho #in"s. *alculated as (+et *ash from Aperations L +et *ash from !nvesting L +et *ash from (inancing). This is the amount of cash added to or subtracted from !ntel's balance sheet during the period. !n this case, !ntel increased it's cash balance by B.-3 million dollars over the fiscal year. 2ree Cash 2 o1. (ree cash flo can be calculated t o ays. *lassically it's (+et *ash from Aperations L Eepreciation 8 *apital $xpenditures). Ioel 9reenblatt in The Little Book that Beats the Market calculates it as (+et *ash (rom Aperations 8 Eepreciation). (ree cash flo is the cash available for the company to invest in gro th or pay bac% to shareholders through share buybac%s or dividend payments. &e use depreciation as this is a more accurate vie of

Cmaintenance capital expendituresC. The traditional calculation can include capital expenditures used for gro th (for example, buying ne property or buildings), hich unfairly s%e s the free cash flo calculation for quic%ly gro ing companies. Divi#en# !a+out Ratio. *alculate as (Eividends ;aid < (ree *ash (lo ). This percentage sho s you ho much of free cash flo is being paid out in dividends. Too high of a percentage (over 6-8.-5) could indicate an unsustainable dividend. 2ree Cash 2 o1 Mar"in. *alculate as ((ree *ash (lo < :evenues). This is the amount of every dollar of sales that is converted into free cash flo . The higher the better here. 7oo% for at least 45. !ntel's very high 215 figure is @ust another indication of the top quality nature of the company. 2ree Cash to Earnin"s Ratio. *alculate as ((ree *ash (lo < +et !ncome). ? big red flag is hen this is consistently less than 1--5. &e ill discuss this more in the red<green flag articles.

These red flags can indicate that a company may not present an attractive investment based on the three main pillars) gro th potential, competitive advantages, and strong financial health. *onversely, a company ith fe or none of these red flags is probably orth consideration.

The red flags, in no particular order, are) 6. A severa +ear tren# of #ec inin" revenues. &hile a company can improve profitability by eliminating asteful spending, cutting unnecessary headcount, improving inventory management, and so forth, long term gro th is dependent on sales gro th. ? company ith 0 or more consecutive years of declining revenues is a questionable investment 8 any cost efficiencies can usually be reali"ed over that period of time. 'ore often, declining revenues is indicative of a declining business 8 rarely a good investment. 7. A severa +ear tren# of #ec inin" "ross% operatin"% net% an#(or free cash f o1 mar"ins. Eeclining margins may indicate that a company is becoming bloated, or that management is chasing gro th at the expense of profitability. This one has to be ta%en in context. ? declining macro8economic picture or a cyclical company can lo er margins ithout indicating any intrinsic decline in operations. !f you can't reasonably attribute margin ea%ness to outside factors, be are. 8. E)cessive + risin" outstan#in" share count.

&atch out for companies ho's share count consistently rises more than 2805 per year. This indicates that management is giving a ay the company and diluting your sta%e through options or secondary stoc% offerings. The best case here is to see share count #ec inin" 1825 per year, sho ing that management is buying bac% stoc% and increasing your sta%e in the enterprise. 9. Risin" #e't0to0e*uit+ an#(or fa in" interest covera"e ratios. =oth of these are an indication that the company is ta%ing on more debt than it's operations can handle. ?lthough there are fe hard targets in investing, ta%e a closer loo% if debt8to8equity is over 1--5 or interest coverage ratio is 4 or less. Ta%e an even closer loo% if this red flag is accompanied by falling sales and<or falling margins. !f so, this stoc% may not be in very good financial health. (!nterest coverage is calculated as) net interest payments < operating earnings). :. Risin" accounts receiva' e an#(or inventories% as a percenta"e of sa es. The purpose of a business is to generate cash from assets 8 period. &hen accounts receivable are rising faster than sales, it indicates that customers are ta%ing longer to give you cash for products. &hen inventories rise faster than sales, it indicates that your business is producing products faster than they can be sold. !n both cases, cash is tied up in places here it cannot generate a return. This red flag can indicate poor supply chain management, poor demand forecasting, and too loose credit terms for customers. ?s ith most of these red flags, loo% for this phenomenon over a several year period, as short8term issues are sometimes due to uncontrollable mar%et factors (li%e today). ;. 2ree cash to earnin"s ratios consistent + un#er 6<<=. This is closely related to the above red flag. !f free cash flo is consistently coming in under reported earnings, some serious investigation is needed. Gsually, rising accounts receivable or inventory is the culprit. ,o ever, this red flag can also be indicative of accounting tric%s such as capitali"ing purchases instead of expensing them, hich artificially inflates the income statement net profit number. :emember, only the cash flo statement sho s you discrete cash values 8 everything else is sub@ect to accounting CassumptionsC. >. ?er+ ar"e @Other@ ine items on the income statement or 'a ance sheet. These include Cother expensesC on the income statement, and Cother assetsC<Cother liabilitiesC on the balance sheet. 'ost firms have these, but the value given to them is small enough to not be a concern. ,o ever, if these line items are significant as a percentage of total business, dig deep to find out hat's included. ?re the expenses li%ely to recur> !s any part of these CotherC items shady, such as related party deals or non8business related items> 7arge CotherC items can be a sign of management trying to hide things from investors. &e ant transparency, not shadiness. A. -ots of non0operatin" or one0time char"es on the income statement.

9ood companies have very easy to understand financial statements. An the other hand, firms that are trying to play tric%s or hide problems often bury charges in the aforementioned CotherC categories, or add numerous line items for things li%e CrestructuringC, Casset impairmentC, Cgood ill impairmentC, and so forth. ? several year pattern of these Cone8timeC charges is a concern. 'anagement ill tout their improving non89??;, or pro8forma, results 8 but in truth there has been little improvement. These charges are a ay of confusing investors and trying to ma%e things loo% better than they are. &atch the cash flo statement instead. B. Current ratio un#er 6<<=% especia + for c+c ica companies. This is another financial health measure, calculated as (current assets < current liabilities). This measures a company's liquidity, or their ability to meet their obligations over the next 12 months. ? current ratio under 1--5 is not a huge concern for firms that have a stable business and generate lots of cash (thin% ;roctor and 9amble (;9)). =ut for very cyclical companies that could see 245 of their revenues disappear in one year, it's a huge concern. *yclical L lo current ratio O recipe for disaster. 6<. !oor return on capita 1hen a##in" in "oo#1i . This one is specifically geared to 'agic (ormula investors. Ioel 9reenblatt's The Little Book that Beats the Market removes out good ill for the purposes of calculating return on capital. ,o ever, if gro th is financed by overpaying for acquisitions, return on capital ill loo% great because the amount of overpayment is not accounted for. &e al ays loo%s at both measures, ith and ithout good ill. !f the C ith good illC number is lo , the high '(! return on capital is a mirage.