Part 2

1. The Five rules for successful
stock investing - Part 2
By Pat Dorsey

2. Chapter 5 – Financial Statement Explained
In this chapter we’ll look at each of the three main financial statements in detail. Here we
must introduce some additional complexity if we want to analyze real companies, in this
chapter we’ll look at some real-world companies to see what their financial statements can
tell us about how their businesses are functioning.
Since this is a summary so we’d assume that the person reading this will be having the
book.
We’ll start with the balance sheet, move to the income statement and finish with the
statement of Cash Flow.

3. The Balance Sheet
• Sometimes it is also called a “statement of financial position” – tells you how much a co. owns (in assets), how much
the co. owes (in liabilities), and the difference between total asset and total liabilities, Equity represents the value of
the money that the shareholders have invested in the firm, and if that sounds odd, think of it just like your mortgage
– your equity in home is the home’s value minus the mortgage . stockholder’s equity in a co. is the value of the firm’s
assets minus its liabilities.
• The basic equation is Assets – Liabilities = Equity, so we can mold this formula to find either if this equation’s
components.
• The key thing to understand about a balance sheet is simply that it must always balance, hence the name. An
increase in liabilities – issuing a bond, for example causes increases in assets – the cash received from the sale of the
bond. If a firm generates huge profits that drives an increase in assets, equity also increases, this makes sense
because the value of shareholder’s investment in the firm rises if that firm makes a lot of money.

4. The Balance Sheet
BREAKING OF BALANCE SHEET;
Asset accounts:
Current assets - This is defined as those likely to be used up or converted into cash within one business cycle, usually
defined as one year. The major portions of this category are cash and equivalents, short term investments, accounts
receivables, inventories.
o Cash and Cash equivalents and short term investments; This usually holds low risk fairly risky investments. This investments contains
money market funds or anything that can be liquidated quickly and with minimal price risk, whereas short term investments is similar
to cash usually bonds that have less than a year maturity and earn higher rate of return than cash but would take a bit of effort to sell.
In some cases you can lump this in cash when considering how much firm has on hand to meet immediate need.
o Accounts Receivable. ; Bills that the company hasn’t yet collected but for which it expects to receive payments soon. If account
receivable are rising much faster than sales, the firm is booking a large amount of revenue for which it has not yet received the
payment. This can be a sign of trouble because it may mean that the firm is offering looser credit terms to increase sales remember
that the firm can record a revenue as soon as it has shipped the product, but sometimes it has less likelihood of receiving the cash it
owed. You will often see “allowance for doubtful debts” just after the accounts receivable on the balance sheet. That term explains
how much money it’s owed by the customer who aren’t going to repay.
o Inventories; There are several types of inventories including raw materials that have not yet been made into a finished products,
partially finished products and finished products that have not yet been sold.
Inventories are especially important to watch in manufacturing and retail firms, and their value on the balance sheet should be taken
with a grain of salt. Because of the way inventories are accounted for, their liquidation value may very well be different from their
balance sheet. More importantly inventories soak up capital, cash that’s been converted into inventory sitting in a warehouse can’t be
used for anything else, The speed at which the co. turns over its inventory can have a huge impact on profitability because the less
time the cash is tied up in inventory, the more it’s available for use elsewhere. There is also a metric called inventory turnover ratio
(COGS/average inventory), it tells us how much inventory is being converted into finished goods which is sold.

5. The Balance Sheet
BREAKING OF BALANCE SHEET;
Asset accounts:
Non current asset -Noncurrent assets are assets that are not expected to be converted into cash or used up within the reporting
period. The big parts of this section are property plants & equipment, investments, and intangible assets.
o Property plant and equipment; These are long term assets from infrastructure of the co. such as land, buildings, factories,
furniture, equipment, and so forth. If we compare these numbers with the firm’s total assets, we can get a feel for how a co. is
capital intensive business.
o Investments; This is money invested in either long term bonds or in the stock of other companies, ranging from a token
amount to a substantial stake. It’s not nearly as liquid as cash and might be worth on the market than the amount shown on
the balance sheet. You’ll need to dig around in the notes to the financial statements to see what exactly is in this account and
with how much skepticism you should view this value.
o Intangible assets; The most common form of intangible asset is goodwill, which arises when one co. acquires another,
goodwill is the difference between the price the acquiring company pays and tangible value (equity) of the target company.
Essentially, goodwill represents the value of all the other stuffs the co. gets when one co. acquires the other. Ex. The majority
value of the Coca-Cola’s value is not the firm’s buildings and equipment; it’s in the powerful brand that the coke has built up
over the past several decades, If some firm were to buy coke it would have to pay more than the book value of the coke’s
equity, and the extra amount is called goodwill. You should view this account with extreme skepticism because most
companies tend to overpay for their targets, which means the value of goodwill that shows up on the balance sheet is very
often far more than the asset is worth.

6. The Balance Sheet
• Liability accounts : let us look at the other side of the coin that is what the co. owes,
• Current liabilities - Money the co. expects to pay out within a year. You should focus on accounts payables, short term borrowings
or payables.
• Accounts Payable: These are the bills that the co. owes to somebody else and are due to be paid within a year, large co.’s that
have a lot of leverage over their suppliers can push out some of their payables, which means they hold on to cash longer and
that’s good for cash flow.
• Short term borrowings - This refers to companies have borrowed for less than a year, usually to meet short term need. It’s
often a lone of bank credit that the firm has temporarily drawn down, though it might be a portion of long-term debt that’s
due within the next year. This line item becomes especially important for companies in financial distress because the entire
amount of this must be paid back quickly.
Noncurrent liabilities - They represent money the company owes one year or more in the future. Though you’ll sometimes see a
variety of line items under this, the most important one is long term liabilities. This represents money that the co. has borrowed
(usually by issuing bonds, though sometimes from a bank, that doesn’t need to be paid back for a few years.)
Stockholder’s Equity - Remember that the equity’s formula is Total Asset – Total Liabilities, and it represents that the part
of the co. owned by the shareholders. This can be the most confusing section of any firm’s financial statement because
it’s filled with many outdated line items that have little practical relevance.
The only account worth looking here is the retained earnings, which basically records the amount of capital a co.
generated over its lifetime – dividends and stock buybacks (which represents the funds that have been already returned
to shareholders). Think of this account as a co.’s long term track record at generating profits.

7. The Income Statement
• Starting with income statement, let us understand the meaning and what does it comprises of, Income statement is basically how much
money are we earning (or losing), and in the annual report it is sometimes named as “consolidated statement of income” or “consolidated
statement of earnings”.
• Revenue - Also known as ‘Sales’, is simply how much money the co. has brought in a year or a quarter. Larger companies sometimes
break down revenue on the income statement according to a business sector, geographic region, product versus services. Always
make sure to check “Revenue Recognition” policies which is in the annual report under financial statements so that we know what are
we looking for. Companies can record revenue at different times depending on the business they’re in.
• Cost of Sales - Also known as cost of goods sold, this number represents the expenses used in creating the goods which we are selling,
such as labor costs, raw materials (for manufacturing) or the wholesale price if goods (for retailers). large companies That combine
manufacturing and services sometimes break down this number into cost of goods sold and cost of services.
• Gross Profit - This line item doesn’t really appear in the income statement, but the simple formula for this is Revenue – Cost of sales.
Once you have gross profit, you can calculate Gross Margin, which is Gross profit as a Percentage of revenue. The more differentiated
the products of the co. higher the gross profit. As in the book there are examples given where software has very high gross margins.
• Selling, General and Administrative expense - This line item is also known as operating expense, includes marketing, administrative
salaries and sometimes research and development. Usually, Research and development is broken down into separate line item as is
marketing for firms that spend large amount on advertising. You’ll see a relationship between SG&A and Gross margin firms that are
able to charge more for their goods must spend more on salespeople and marketing. You can judge how efficient is the firm is by
looking at SG&A as a percent of revenue (a lower percentage of operating expense relative to sales means a tighter, more cost-
effective firm). If it’s rising fast, watch out, firm is spending more on the expenses without reaping the benefit of higher sales.
• Depreciation & Amortization - When a co. acquires an asset intended to last long, such as new building or machinery, it charges off
portion of the cost of that asset on its income statement over a series of year. This number is occasionally realized separately in
income statement, but it’s usually realized under operating expenses.

8. The Income Statement
• Nonrecurring charges/Gains - This line item is an area where co. put all the one-time charges or gains that aren’t part of
their regular, ongoing operations, such as the cost of closing a factory or the gain from selling a division. Ideally, you’d want
to see this line-item blank most of the time. You should view one-time expenses with skepticism. Companies have gotten
the habit of placing many costs that really part of doing business into charges, firms that are serial chargers (they seem to
take some kind of hit every year are much more difficult to analyze because all kinds of expenses can be buried in one-time
charges). Always take a notes section where all the details are provided there for this particular line item.
• Operating Income - We can calculate operating income as revenue – cost of sales – operating expenses. This represents the
profit the company made from its actual operations, as opposed to one-time gains, interest income and so forth. In
practice, co.’s often includes one-time gains or one time charges (such as write offs) in figuring operating income and you
have to add back one time charges (or subtract one-time gains) yourself. It excludes one time items as well as income from
nonoperational sources.
• Interest Income and Expenses - Sometimes interest income and interest expenses are listed separately, and sometimes
they’re combined into net interest income (or expense). In either case, this number represents interest the co. has paid to
bondholders of their bonds or received on bonds or cash it owns. You can get information about the financial health of a co.
by looking at the earnings before interest and taxes relative to its interest expense also called Interest coverage ratio.
• Interest Income and Expenses. - Sometimes interest income and interest expenses are listed separately, and sometimes
they’re combined into net interest income (or expense). In either case, this number represents interest the co. has paid to
bondholders of their bonds or received on bonds or cash it owns. You can get information about the financial health of a co.
by looking at the earnings before interest and taxes relative to its interest expense also called Interest coverage ratio.

9. The Income Statement
• Taxes - The government must get paid and taxes is usually the last expense listed before net income. Unfortunately,
corporate tax rate is separate topic because the co. must submit a different set of financial statement to the government for
the tax purpose than the ones we see filed with the SEC. In general the tax rate for U.S. Corporation is 35%. If the tax rate
for a company is lower than this, find out why, find out whether the tax advantage is likely to permanent or temporary. In
addition look at the tax rates of the firm you’re analyzing over time. If it bounces from around year to year, the firm is
generating earnings by playing with tax loopholes rather than selling more goods or services.
• Net Income - This number represents the co.’s profit after all the expenses has been paid. It’s the number most companies
highlight in their quarterly earnings releases. Net income is not the good representation of the amount of cash the
company has generated, for that we need to the statement of cash flow. Although Net income is the number, you’ll most
often see in the companies advertise press releases, don’t forget it can wildly include one-time charges or investment
income.
• Number of shares (Basic/Diluted) - This figure represents the number of shares used In calculating earnings per shares, it
represents the average number of shares outstanding during the reporting period (a quarter or a year). Basic shares include
actual shares of the stock, and we should ignore it (the fact it is recorded in the financial statement is more of a historical
legacy than anything else). Diluted shares include securities that could potentially be converted into shares of a stock, such
as stock options and convertible bonds. The granting of stock options that has occurred the past several years, we should be
more focused on diluted shares, because we want to know the degree to which our stake in the firm could potentially be
shrunk (or diluted) if all those option holders convert their options into shares.
• Earnings Per Share - EPS formula is Net income divided by number of shares, it gets more attention when the company
reports yearly or quarterly figures. It’s not the only figures to look at, in fact without looking at the cash flow statement and
many other factors it is meaningless. So when in the Annual report or Quarterly report we see that the firm did not
calculate EPS, find out the reason why?

10. The Cash Flow statement.
• This statement is the true representation of value creation because it shows how much cash a co. is generating from year to
year, and cash is what counts. As per the author in this chapter, in this section of the cash flow statement he would
recommend FIRST we should start our analysis by looking at the cash flow statement to see how much cash it’s throwing
off, then look at the balance sheet to see the financial strength and then look at the income statement to check margins.
• The cash flow statement doesn’t count noncash items such as depreciation you see in the income statement and tells you
how much actual cash the co. has generated.
• The cash flow statement is divided into 3 parts :
o Cashflow from Operating Activities
o Cashflow from Investing Activities
o Cashflow from Financing Activities
let us look at each of these cash flow statement:
o Cashflow from Operating Activities - This section tells us how much ash the company is generating through its business,
this is the area to focus most of your attention on because of the cash generating power of business we’re most interested
in.
o Cashflow from Investing Activities - These are activities involved in acquisition or disposal of PP&E, corporate acquisitions
and any sale or purchase of investments.
o Cashflow from Financing Activities - These are activities involved with the company’s equity owners or creditors. Items that
are typically show up in this section are briefly described.
Conclusion - Here what we have learned is something very valuable, in this chapter we have learnt enough about how to
analyze financial statements.

11. Chapter 6 – Analyzing the company (The
basics)
• In this chapter we will learn how to understand the co., piece by piece and it
contains a process of 5 steps :
1. Growth – How fast has the co. grown? What about the sources of its growth and how
sustainable the growth is to be ?
2. Profitability – what kind of return the co. generates ?
3. Financial health – How solid is the firm’
4. Risk/Bear case – what are the risks to your investment case? There are excellent reasons
not to invest in even the best-looking firms. Make sure we look at the full story of the firm
and we investigate the negatives as well as the positives.
5. Management – who is running the show? Are they running the co. for shareholder’s
benefit or for themselves? (Discussion about this point will be on the next chapter)

12. • Let us look at each of this point in a more descriptive manner :
• Growth : When you’re evaluating growth rate of a company’s, don’t get swept away by strong historical growth. Make
sure you find the source of the growth of the company and how it can be sustained over time.
• The Four Sources - In the long run sales growth drives earning growth. Although profit growth can outpace sales
growth for a while if a company is able to do an excellent job cutting costs or fiddling with the financial statements,
this type of situations aren’t sustainable in the long run. There’s a limit to how much a firm could cutcosts and there
are only so many financial tricks that the co. can use to boost the bottom line. Sales growth stems from one of the four
areas:
1. Selling more goods and services : The easiest way to grow is to do whatever you’re doing better than your
competitor, sell more products than they do, and steal the market share from them.
2. Raising Prices : It takes strong brand or captive markets to be able to raise price and boost the co.’s top line.
3. Selling new goods or services : If there isn’t much more market share to be taken or you’re your customers
are very price sensitive, you can expand your market by selling products that you hadn’t sold before.
4. Buying another company – The acquisitions deserves a special attention. Acquisitive firms must keep
buying bigger and bigger firms to keep growing at the same rate, and the bigger the target firm is the
harder it is to check out thoroughly, which increases a risk of buying a diamond out of lump of coal. One
study showed that buying a small, related business, succeeded only about half the time. You must know
how fast the co. Would have grown without acquisitions, if you don’t know then don’t buy the shares. .
Remember the goal of the shareholder is to buy great businesses, and not successful merger & acquisitions
machines.

13. • Questioning Quality - Unfortunately, there are plenty of other ways of making growth look better than it really is, especially
when we turn out to earnings growth than the sales growth. Sales growth is much difficult to fake. Although there are lists
of tricks that companies use to boost earnings growth even as the sales growth takes much longer, there are few basic areas
to watch out for : Changing tax rates, changing shares counts, pension gains, one-time gains (often from selling off
businesses), rampant cost cutting are the most common one.
• Profitability - This is the second part of process and the most crucial part of the entire process. How much profit is the
company generating relative to the amount of invested in the business? This is the real key thing separating great
companies from average ones. For understanding this we need to look at various ratios and many comparisions.
Return on equity = ROA x financial leverage.
ROE is also calculated as Net Margin x Asset Turnover x Financial Leverage.
Financial leverage essentially is a measure of how much debt company carries relative to shareholders equity. This ratio is
something we need to watch carefully. As with any kind of debt a sensible amount can boost returns, too much can lead to
disaster.
A firm could have three levels that can boost ROE – Net margins, Asset turnover, Financial leverage. A company can be bad on
either two and be good at one which can increase the ratio.
• Free Cash Flow - In the previous chapter there was a term called CFO, which measures how much cash that a co. generates,
as useful as the term is it doesn’t consider the money that a firm has to spend on Capital expenditure. To do this we need to
subtract capital expenditure, which is money used to buy fixed assets. Free Cash Flow = CFO – Capital Expenditure.
• Putting Return on Equity and Free Cash Flow together.
One good way to think about returns a company is generating is to use the profitability matrix, which looks at a company’s
ROE relative to the amount of Free Cash Flow it’s generating.
• Return on Invested Capital Return on invested capital is a sophisticated way of analyzing return on capital that adjusts for
some peculiarities of ROA & ROE. Higher ROIC is preferred to lower one.

14. • Financial Health - When a company increases its debt, it increases its fixed costs as a percentage of the total cost. In years
when a business is good, a company with high fixed costs can be extremely profitable, because once the costs are covered
any additional sale the co. makes will fall directly into the bottom line. When the business is bad, however the cost of debt
push the earnings even lower. A common measure of leverage is simply the financial leverage ratio that we used in
calculating the ROE equal to asset divided by the equity. In addition to financial leverage make sure to examine few other
key metrics when assessing a company’s financial health. Also there are ratios such as Debt/Equity, Current ratio & Quick
ratio.
• The Bear Case -After you’ve assessed growth, profitability and financial heath, your next task is to look at the bear case for
the stock you’re analyzing. Start by listing all the potential negatives, from most obvious to least likely. Ask questions like :
• What could go wrong with the investment thesis?
• Why might someone prefer to be a seller of the stock than a buyer?
Your bear case will be a great reference point even if we want to buy the company. You’ll know in advance what signs of
trouble to watch for, which will help you make a better decision when bad news comes in future, having already
investigated the negatives, you’ll have the confidence to hang on the stock during a temporary rough patch as well as the
shrewdness to know when the rough patch will really be a serious problem.