Two companies can trade at the same P/E and be completely different businesses. One of them may be running on borrowed money. Three free documents tell you which.
Learning objectives. After this week you can (1) say what question each of the three financial statements answers; (2) compute net margin, ROE and debt-to-equity; and (3) find these figures for a company you hold.
Remember this: read ROE next to debt. Borrowed money can make an ordinary business look brilliant.
1) Three statements, three questions
- Income statement: how did the period go? Revenue sits at the top, costs come off in layers, and net income (the profit Week 3's EPS divides by shares) is the bottom line.
- Balance sheet: what does the firm own and owe right now? A snapshot.
- Cash flow statement: where did the cash actually move? It has three sections: operating (running the business), investing (buying or selling assets) and financing (borrowing, repaying, issuing shares, paying dividends).
Assets = Liabilities + Shareholders' Equity
Everything a firm owns is paid for by lenders (liabilities) or owners (equity). Every listed company's statements are free on the Financials tab of Yahoo Finance or Google Finance. The source is the 10-K, the audited annual report every U.S. public company files with the SEC, free on its EDGAR website.
2) Three ratios
Net Margin = Net Income ÷ Revenue × 100 · ROE = Net Income ÷ Equity × 100 · Debt-to-Equity = Total Debt ÷ Equity
Net margin is how much of each sales dollar survives as profit. ROE (return on equity) is how hard the owners' money is working. Debt-to-equity is how much of the firm is borrowed. Compare them with the same firm's past years and with direct competitors: a 12% margin is excellent for a grocer and weak for a software company.
3) One firm, a full pass
Revenue $50B, net income $6B, total debt $24B, equity $30B, liabilities $50B, 3B shares:
| Ratio | Computation | Result |
|---|---|---|
| Net margin | 6 ÷ 50 × 100 | 12% |
| ROE | 6 ÷ 30 × 100 | 20% |
| Debt-to-equity | 24 ÷ 30 | 0.8 |
| EPS (Week 3) | $6B ÷ 3B shares | $2.00 |
Assets are $50B + $30B = $80B. Now a competitor: net income $2.5B on equity $10B is an ROE of 25%, but with $30B of debt its D/E is 3.0. Its higher ROE comes from a thin slice of equity under a lot of debt, not better management. Debt magnifies good years and bad ones alike.
Quick self-check
(a) Net income $4B, revenue $40B, equity $16B. Net margin and ROE? (b) Assets $120B, liabilities $75B. Equity? (Answers: 10% and 25%; $45B.)
Common mistakes
- Comparing across industries. Compare a bank with banks, a retailer with retailers.
- Trusting one great year. Look at two or three years; the trend beats the level.
- Treating profit as cash. A firm can report profit while its operating cash flow is negative.
This week in the arena
Pick your largest stock holding and open its Financials tab on Yahoo Finance or Google Finance. From the latest annual figures, compute its net margin, ROE and debt-to-equity. Then check one direct competitor's ROE and debt-to-equity and see whether the business you own is the stronger one, or just the more familiar name.