Annual reports can provide valuable investment insights

Looking to purchase a particular long-term stock investment? With many biased recommendations coming from Wall Street, a good place to begin your research is with a company's annual report.

First, review the basics. Since stock represents ownership in a corporation, it's important for investors to research and monitor a company's operating performance and financial condition. In fact, highly profitable and efficient companies with strong finances are often great investments.

Focus your research on the three main sections of the annual report: 1. the balance sheet 2. the income statement and 3. the statement of cash flows.

The balance sheet. The balance sheet reports major categories and amounts of assets, liabilities and stockholders' equity, and their interrelationships at a specific point in time. The basic relationship is:

Assets = Liabilities + Shareholders' equity

Assets are defined as probable benefits obtained or controlled by a particular firm. Liabilities are defined as probable sacrifices of benefits due to present obligations to transfer assets or provide services to other firms. Equity is therefore the amount of net assets remaining after deducting liabilities.

?Current assets and liabilities. Accountants arbitrarily define any asset or liability that will turn into cash within one year as current and all other assets and liabilities as long-term.

Cash and cash equivalents, marketable equity securities, receivables, inventories and prepaid expenses are considered current assets. Short-term debt, current portion of long-term debt, capitalized leases, accounts payable to suppliers, accrued liabilities, interest and taxes payable are classified as current liabilities.

?Analyzing the balance sheet. Ratio analysis is a quick way to analyze the balance sheet of a firm. Two widely used ratios are the current ratio and the debt-to-equity ratio.

Current Ratio = Current Assets / Current Liabilities

The current ratio is a quick measure of a company's ability to pay its financial obligations. Like all ratios, this ratio should be compared with recent trends and industry averages before determining its strength. However, a current ratio of two or higher is considered strong for most industries.

Debt-to-Equity Ratio = Total Liabilities/ Shareholders' Equity

One of the most common measures of financial leverage is the debt-to-equity ratio. A ratio of 60 percent means that creditors supply 60 cents for every dollar supplied by shareholders.

Firms with a high debt-to-equity ratio are undertaking considerable financial risk and should be watched closely. This ratio can vary widely among industries, but as a rule of thumb 30 percent and lower is considered strong.

The income statement. The income statement reports on the performance of the firm. The measurement of accounting earnings involves two steps: 1. identifying revenues for the period and 2. matching the corresponding expenses to revenues. It's important to recognize that revenue is not the same as cash received.

Revenues are inflows from delivering or producing goods, rendering services or other major ongoing activities. Expenses are outflows from delivering or producing goods, rendering services or carrying out other major ongoing activities.

Not included in revenues and expenses are gains and losses, defined as increases (decreases) in equity (net assets) from supplementary transactions. Gains and losses are, therefore, nonoperating events. An example is the gain or loss from an asset sale.

?Analyzing the income statement. Examine the revenue-recognition policies of a firm. Make sure the firm provides all or substantially all of the required product or service before revenue recognition occurs. Also, make certain that collectibility is reasonably assured.

Revenues not accompanied by cash inflows should be considered suspect, especially when the disparity persists for a long time period.

Examine how expenses are recognized as well. Be wary of firms that capitalize expenditures that appear to be current period expenses, especially when capitalization is based on optimistic assumptions. Capitalized expenditures often inflate reported earnings.

Ratio analysis can also be used to analyze parts of the income statement. Two commonly used ratios are the net profit margin and return on assets.

Net Profit Margin = Net Income/Revenue

The net profit margin is the amount of net earnings from each dollar of sales. For example, with a net profit margin of 40 percent, Microsoft earns 40 cents for every dollar of sales.

This measure of profitability is most informative when compared with industry competitors.

Return on Assets (ROA) = Net Income/Total Assets

Return on assets is a measure of efficiency with which a company allocates and manages its resources. With an ROA of 16 percent, Merck & Company earns 16 cents for every dollar invested in assets.

An ROA of 15 percent or higher is excellent, however, it can vary widely due to the capital intensity of the industry in which the firm is operating. As a result, ROA should be compared with competitors to determine its strength.

The statement of cash flows. The statement of cash flows reports the cash receipts and outflows during the specified reporting period. The statement is broken down into three activity areas operating, investing and financing activities.

Cash from operations is the net cash effect from the revenue-producing activities of the firm.

More specifically, cash inflow is from the revenues generated by selling the firm's product or service. Cash outflows include items such as product material costs, labor, interest on loans and income taxes.

Investing cash flows are the net effect of capital sales less capital expenditures. Items include the purchase or sale of plant, property and equipment