ANALYST  DOUG  ROGERS  REVIEWS  CORPORATE  FINANCIAL  STATEMENTS

Editors Note: 

Over the last few months, StockUpTicks has brought you the timely insight of analyst Doug Rogers of ManageSource Research as part of our ongoing efforts to keep our readers on top of the ever-changing investment business. Today, we’ve fulfilled the requests of many of our members who wanted to tap into Doug’s know-how in regard to Corporate Financial Statements.

Doug breaks down the jargon and explains the loopholes and often confusing or contradictory entries. With the New York Attorney General investigating six of the top firms on Wall Street for their business practices, we can think of no better time to bring you Doug's series on financial documents and corporate operations. 

And just in case you’re new to StockUpTicks or missed a previous installment of any of Doug’s insightful and exclusive articles, take a quickclick to any of the links below: 

How the NASDAQ really works  (click here)
Understanding the Small-Cap market (click here) 
Digging into Corporate filings (click here)

Last time out, Doug answered questions submitted by our readers regarding the analysis of stocks, the fundamental financial structures of corporations, and more  (click here). 
 

And now, today’s installment ... 
 
 

*** CORPORATE   FINANCIAL   STATEMENTS ***

An in-depth look by analyst Doug Rogers

In the last article, we began a series dedicated to identifying and understanding certain elements within a company’s corporate financial statements.  We started wit the balance sheet and today I’d like to discuss the statement of operations and how it can help investors gain visibility into the into the financial operations of a company.  The macro concept of the statement of operations is to provide visibility into a company’s operational efficiency on two levels: 1) revenue, and 2) costs.  The revenue breakdown obviously provides a sense of market viability and earnings potential.  The costs, however, shows me what the profitability potential of the company is, but also how effective management is at controlling the internal operations of the company. 

I’ll go through a standard statement of operations in the manner that I went through the balance sheet last week to demonstrate my points and the methodology behind my analysis.  The first item is the company’s total revenue generated for the period being reported.  This is critical for two important reasons.  First, the absolute value of the number really shows me the success and market potential of the company’s products and services, but also the stage in the company’s lifecycle.  If revenues were $15,000 for a quarter, I’d sure hope that I was looking at a development stage company that hasn’t fully commercialized, for example.  I also want to see that gross revenue has grown Y-Y by a moderate, if not substantial, amount.  Obviously, a Y-Y contraction in sales could indicate a serious problem or could merely be due to a shift in core focus or economic contraction.  Basically, I want to at least see ongoing revenue being generated and I want to see Y-Y progress. 

One critical, yet often overlooked, point to understand is where the company generates its revenue.  If I’m looking at a software company that indicates a significant amount of its gross sales revenue is generated from “investing activities”, “other”, or some area that isn’t related to the company’s core products and services, then this is a major red flag.  Revenues like this are unsustainable and don’t work to further the company’s mission.  They show a flaw or other problem with the company’s core focus.  Whatever the particular problem may be, a company should generate the majority of its revenue from its core business.  If it cannot, then beware!

The next item up is the cost of sales.  The cost of sales can vary drastically from company-to-company and industry-to-industry and even product-to-product or location-to-location.  So, instead of attempting to convey some kind of rule of thumb for analyzing a company’s cost of sales, Id’ say that I want to see that their gross profit (gross sales – cost of sales / gross sales) is at least in the double digits.  Again, look for out of the ordinary items that don’t, in your mind, complement the core focus of the business.  If you see “CEO’s Ferrari” listed, then I’d say that that’s a problem!  I don’t suspect that you’ll ever see that, but you get the idea.

“Selling, general and administrative” expense is, in my mind, a very critical item and one that I weigh heavily when analyzing a company.  It provides me with the greatest visibility into management’s ability to effectively control internal costs and ongoing operational costs.  Remember, SG&A contains marketing and advertising expenditures, promotional items, rents and leases, payroll, travel and entertainment expenses, legal and accounting, professional services, etc., etc., etc.  You will almost never see an itemized accounting of SG&A, so it’s difficult to ascertain whether or not there are a substantial amount of frivolous items contained within.  The good news, however, is that the majority of companies that you or I would be interested in are run by competent and honest individuals.  So, what am I looking for?  Consistency.

I have just completed an analysis of a telecom company that, despite consistently increasing gross sales for almost every quarter since inception, has been extremely successful at controlling their internal costs.  This is evidenced by relatively flat SG&A results throughout their history.  The point that I’m trying to enunciate is that SG&A expenses remaining relatively flat while sales and revenues consistently expand shows management’s ability and commitment to containing internal operational costs and therefore creating shareholder value by being able to retain greater revenues and report higher earnings for a given period.

The remainder of the operations statement is primarily accounting and simple calculations.  Interest expenses should be in line with the amount of debt previously identified on the company’s balance sheet and income taxes should be in line with revenues.  The weighted average number of shares outstanding (WANO) will be computed by collaboration between the company’s registrar, attorneys and accountants.  WANO changes from period to period and should not raise any concerns as long as isn’t drastically different from the prior reporting period.  If WANO is, you must determine whether a stock split, reverse split, a major buy-back, major issuance, or major conversion took place and why.  Once the driving force is identified, you can determine whether it was a reasonable initiative that will ultimately help the company’s market value and future potential, or whether it points to a potential or existing problem for current and potential shareholders.

I hope that I have provided a concise overview of the “statement of operations” that will help you identify financially healthy companies as well as potential problems that could have a negative impact on a company’s ability to manage operations. 
 

*** NEXT WEEK ***

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