Finding and Interpreting Key Facts

Once you have the information in hand, the next step is to decide exactly what information you will want to review. Future chapters provide you with detailed examples for all of the tests and ratios that you can perform on financial statements. The following is a review of the primary points of interest. These may be used to quick-check a company and, perhaps, to eliminate a company from your list of possible investments. For example, you may set some basic rules for yourself. You may decide to not invest in companies that have never shown a profit; those whose P/E ratio is too high; companies that do not pay dividends; or companies whose bonds are rated below investment grade. These are only examples of some of the elimination points you could employ. Here is a quick-checklist you can use to review the numbers as reported on the financial statements, without needing a detailed review:

1. Comparison of sales, costs, expenses, and profits. The most basic and obvious test is the test of earnings. Look at the statement of operations, not just for this year but for previous years as well. If the company has many divisions, look for breakdowns by operating unit (this is usually located in the footnotes). Also study the important attributes making up sales growth or decline. For example, in the retail sector, study the year-to-year changes in retail space and numbers of stores opened or closed. Are sales growing? And if so, are profits growing as well? The big danger signal is found when sales are flat or declining, but expenses keep rising; that is a sign of a poorly managed company. Even when sales are rising, if profits are falling at the same time, there could be problems.

The sign of a well-controlled, well-managed company is one in which sales increase each year—not erratically but steadily— and costs remain at the same approximate percentage of sales. At the same time, expenses may be expected to rise somewhat during periods of growth, but not at the same rate as sales. Net profits should remain at approximately the same percentage of sales each year, while the dollar amount of net profits rises. That is the basic operating standard.

2. Dividends declared and paid. Corporations declare and pay dividends and those that raise their dividends each year also tend to be well-managed companies. This does not mean a company that does not pay dividends is not well managed; the dividend test is only one of many basic tests worth applying. You may also decide to limit your search to corporations that have increased their dividend every year. An excellent subscription service for those interested in tracking dividend records is Dividend Achievers (http://www.dividendachievers.com), a service published by Mergent Corporation. A quarterly publication lists those companies that have increased dividends for at least 10 years.

Corporations with erratic earnings and large net losses cannot always afford to pay dividends because their cash flow tends to suffer along with the volatile earnings outcomes. A volatile operating record is a sign of problems, but companies with less fundamental volatility tend to also have better cash flow; consistent profits; and a better, more consistent dividend record.

3. DRIPS program offered. Rather than cash, many corporations allow stockholders to take dividends in additional partial shares. This is the most efficient way to reinvest dividends and achieve a compound rate of return. These dividend reinvestment programs (DRIPs) are valuable for anyone interested in accumulating value rather than receiving cash.

fundamental volatility the degree of change from one year to the next in reported sales, costs, expenses, and earnings, as well as inconsistency in other fundamental trends, dividend payments, and ratio tests.

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