Fundamentals of a Financial Statement

Financial statements from companies can seem very intimidating at times. I have a theory that some companies do that simply to keep us small investors from seeing the big picture. Wonder if I could write a program that evaluated companies based on the simplicity of their annual report...I'm only half joking there.

Anyway, let’s start with some basics. Companies release quarterly reports, which basically report a subset of information found in the Annual Report. We're just going to focus on the Annual Report today. Within the annual report, you find three main sections:

1. Statement of earnings(aka Income Statement): Presents the companies business results for the year. It shows how much product they sold, how much it cost them to do it, and the bottom line on how much they made for the year.
2. Statement of financial position (aka Balance Sheet): Lists what the company has for assets and what they owe to other people.
3. Statement of cash flows: Measures the flow of cash into and out of the company

Annual reports are not just about the numbers. A lot of times there's a lot of good information from the companies leadership in which they summarize the year and give some good vision on what they see ahead. These of course are always going to paint pretty rosy messages but there's a lot then can be read between the lines.

Lets use the 2005 Garmin report for our example. There are lots of numbers in this document but page 63 is the best place to start.

The key numbers I always like to look at initially are the Net Sales, Costs of Goods, Total Operating Expenses, and Net Earnings.

• Net Sales: Total amount of money the company received selling it's product.

• Costs of Goods: How much it cost the company to manufacture the product
• Raw Material
• Salaries
• Other production costs.
• Total Operating Expenses: Other costs which are broken into two broad categories
• Advertising and other administrative type costs.
• Research and Development.
• Net Earnings: This is the bottom line, after all costs and taxes, this tells you how much money the company made for the year.

Other things to note are the Other Income, Income Tax Provision, and Operating Income fields. Other Income is income received (or lost) through company investments and other miscellaneous endeavors. Income Tax Provision is just what the company had to pay in taxes for the year. Operating Income is just the amount the company made before factoring in Other Income and Taxes. The Garmin financial statement actually gives you these numbers for the current year and the previous 4 years (making it even easier to do comparison).

With just these numbers, you as an investor, can begin to get a feeling for a company. Are the Net Sales going up each year? How much is the Cost of Goods going up in relation to Net Sales? Is the margin between the two increasing or decreasing. A decreasing margin can imply many things, from an increase in cost of raw material to stiffer competition. How about the Total Operating Expenses, are those increasing/decreasing at the same rate as the Net Sales? The efficiency of a company becomes very important as it grows. And of course, the Net Earnings, are they consistently going up each year? What's the percentage increase from year to year? Always be careful when analyzing Net Earnings. A common move by large companies is to increase Net Earnings by reducing Operating Expenses, and not necessarily increasing sales. This of course is still good for the investor, but can mislead some into thinking the company is growing more then they really are. Also, a reduction in Operating Expenses sometimes comes by reducing R&D efforts which may help the current quarter, but have detrimental impacts to the future.

There are of course dozens of calculations that can be done to formalize some of the things I mention above but for now we're just focused on fundamentals. Things you do within your head when you first look at a company’s annual report.

These are of course all things I should have done before purchasing Garmin....but my value side just couldn't avoid the deal I got on 11/3. The good part is that so far, it's looking like a pretty good company :)