Financial statements are the key to evaluating companies, and that was the central theme of chapter 4 in Ian Wyatt’s 2009 book, “The Small-Cap Investor: Secrets to Winning Big With Small-Cap Stocks.”
As he pointed out, the statements allow investors to understand the top and bottom-line performance of a company. That top and bottom-line performance can then be compared with other companies and with the company’s own history.
As the title of the book suggests, Wyatt’s focus is on small-cap stocks, but essentially investors look for positive signals that apply to all capitalizations. Overall, he wants to see:
- Consistent revenue growth.
- Consistent growth of net income.
- Expanding profit margins.
- Comprehensible footnotes.
- Little difference between net earnings and “core net earnings” (the latter is a concept from Standard & Poor's, showing income from only a company’s core activities – somewhat similar to Ebitda).
Wyatt gets into more detail about these signals later. But, before diving into the financial statements, investors should recognize the role of Generally Accepted Accounting Principles (GAAP). It is the gold standard of accounting for corporate activity, a set of rules and best practices, and driven by major accounting organizations. As Wyatt observed, it offers consistency and objectivity when comparing one company with another.
Three types of financial statements exist:
- Balance sheet: It shows the ending balances of assets and liabilities when a quarter or a year is finalized.
- Income statement: This shows how much the company brought in as revenue, how much it spent to earn that revenue and the profit earned.
- Cash flow statement: This shows how money moved in and out of the company and is associated with the results shown in the income statement.
Wyatt warned investors that they should appreciate the connections among the three statements and not focus on the income statement alone. As he put it, “The balance sheet and statement of cash flows are important checks on the financial health of a business, beyond the review of revenues, expenses and income.”
He led into the 10 key metrics by pointing out small-cap investors looking for bargains may have to work with minimal data from the financial statement. The goal is to find small companies that have just begun operating profitably, recently turned around their fortunes, or gone to market with an innovative new product. With that context in mind, he offered his 10 key metrics:
- Revenues: These should be regularly increasing and enjoying a steady or increasing rate of growth.
- Net income: Again, look for growth and increases in the rate of growth. Wyatt noted that Walmart (WMT) consistently grew its earnings when it was a small cap.
- Growth, revenue and net income: The company must have increasing revenues with steady rates of return and track the rate of growth of both revenue and earnings from year to year. They should “move along a similar scale.”
- Gross margin: Margins will vary among industries and sectors, but the gross margin should be consistent from year to year.
- Current ratio: This is calculated by dividing the current assets by current liabilities; the standard is two or higher, but Wyatt said that may drop to as low as one for some industries, such as those that invest heavily in inventory.
- Debt ratio: This shows how much of the firm’s capitalization comes from equity and from debt (long-term loans and bonds). Only choose companies that have a steady or falling debt ratio over several years. Wyatt said General Motors (GM, Financial) almost collapsed in 2008, when its debt ratio was above 100%, because it kept borrowing to fund consistent losses.
- Combined current ratio and debt ratio: Called by Wyatt “the most important working capital test,” the current ratio is a measure of liquidity, of a firm’s ability to pay off its current (short-term) liabilities with current assets. The debt ratio compares total debt with total assets (not just current assets and liabilities). Combining the two provides a measure of a firm’s ability to take care of both its current and long-term debt.
- Executive compensation: If you see a company with growing revenues and exceptional net earnings, then see a levelling of those earnings, there is a good possibility management is rewarding itself ahead of shareholders. This data is in the "General & Administrative" line of the income statement.
- Dividend history: It is unusual to see dividends from small caps, yet there may be some that have been operating for several years and now appear ready to break out. In these cases, a solid dividend history is a good sign.
- Core earnings versus net income: How much is the company earning from its core business, and how much from other businesses? Wyatt advised, “You will notice that the less volatile, steadily growing companies also tend to have little or no core earnings adjustments.”
As noted, the chapter also issues 10 red flags that indicate there are likely problems:
- Unusual growth in accounts receivables: More specifically, if accounts receivables are growing faster than sales, the firm is likely making sales to companies that aren’t paying their bills.
- Abnormal deferrals on the balance sheet: Watch for entries in the assets section titled “Prepaid Assets” or “Deferred Assets.” It could be an accounting irregularity, a fraudulent manoeuvre, or simply a special circumstance — push hard to find satisfactory answers.
- Falsifying the actual amount of revenue earned: For example, a company may receive the proceeds of a loan and report it as income rather than a liability. Another example: A company sells investments and puts the full proceeds down as current income, rather than reporting just the net investment income.
- Capitalizing the current year expenses: Wyatt wrote, “Once a company starts artificially increasing net earnings, it tends to only get worse over time. It is not normal to set up expenses and amortize them over many years.”
- Sugar bowling: This refers to the process of deferring some revenue into the future, after a successful year. Also called “cookie jar accounting,” it is a form of manipulation.
- Early reporting of expenses: The flip side of sugar bowling, this involves reporting current year expenses in advance. Such manipulation can be found under the heading “special charge” in the liability section.
- Off-balance sheet subsidiaries: A favorite of Enron, Wyatt said this type of manipulation is hard to find, as in being not disclosed at all or being buried in the footnotes. Results can be fudged by faux transfers with the parent company and covered up with journal entries.
- Converting reserves into income: This might involve reserves for bad debts or similar provisions. Companies with large credit balance reserves can turn them into income by reclassifying them, in full or in part.
- Writing off assets over a longer period: For example, net earnings can be manipulated higher by writing off an asset over 10 years instead of the more appropriate five years.
- Odd changes to accounting policies: Big and sudden changes in gross profit may indicate the company has changed its accounting practices. For example, a firm might revise the way it values its inventory. Any such changes should be justified with a GAAP-based accounting opinion.
Summing up, in chapter 4 of “The Small-Cap Investor: Secrets to Winning Big with Small-Cap Stocks,” Wyatt explained the three types of financial statements and offered 10 key metrics and 10 red flags.
This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
