Here are all five parts of our series on how to analyze an earnings report

0 18

One thing that separates fledgling investors from the pros is reading financial statements. For amateurs, comparing the so-called headline numbers — sales and earnings — to estimates is the full extent of research into a company, whereas in more experienced hands, they are just a starting point. If you want to become a better investor, make like a pro and digest the financials. It’s the best way to truly understand a company’s performance. In the lead up to the start of earnings season later this month, we’ve put together a five-part series to help Club members better understand all the tables and charts and how to analyze them. Here are all five parts Part 1: Income statement Part 2: Balance sheet Part 3: Cash flow analysis Part 4: The ratios Part 5: AMC case study Part 1: Income statement In the financial statements that companies report to the Securities and Exchange Commission and shareholders on a quarterly and annual basis, there are three main sections: the income statement, the balance statement and the cash flow statement. They are all important for different reasons. While the cash flow statement shows how much actual money a company brought in or used to run its businesses and the balance sheet displays its overall financial health, the income statement sums up a company’s revenues and expenses over a period of time. Here, we’ll walk through how to read and interpret the latter. The income statement gives us our best view of management’s performance. How efficiently is the team running its business? How is it handling risk? Adjusting to economic headwinds? It also helps us to better analyze the top (sales) and bottom (profits) lines. Consider: A company may beat expectations on sales, but look a little deeper and you might discover it had to slash prices — increase “promotional activity” — to get there. Or a company reports better-than-expected earnings, but cut its research and development (R & D) budget to do it, thus imperiling future innovation. These are not high-quality beats. On the other hand, a company could deliver weaker earnings because it needed to invest more to ramp up production to meet strong demand. This miss isn’t as bad as it looks, since the company is setting up to increase longer-term profits. At the Investing Club, we’ll take that over an earnings beat at the cost of investing in the business to grow even more in the future. In terms of presentation, income statements can vary slightly company to company, but they all have the same key metrics. We’ll use the recent statement from Club holding Apple (AAPL) as an example. The best way to read the statement is top to bottom. The top part focuses on sales — the money brought in — while the middle focuses on costs and expenses. The bottom is where you find earnings, which alone can’t give you a clear view of management’s performance. All three parts need parsing. Sales The top line represents the total dollar amount of goods and services sold in the period. Most companies will also provide some breakdown by operating segments. Apple goes a step further by breaking the sales figure into products and services, since those are the two primary sources of revenue for the company. Why you should care : There are many things a company can do to improve the bottom line. But it’s often at the cost of longer-term growth, such as cutting spending on R & D or marketing. Sales, on the other hand, are harder to engineer and so speak directly to the demand for a company’s products. Cost of goods sold The “COGS” line shows the direct cost to create, store and deliver products or services . The greatest input here is generally the cost of materials (and in some cases may also include an estimate of warranty costs). Why you should care : This can help us estimate how profitable a company could become as efficiencies below this line item (in the operating expense section of the income statement) improve. The greater the gross profit margin, the more flexibility a company has for other expenses — such as marketing or R & D — or to lower costs in the pursuit of greater sales volume. Gross margin This is the percentage of sales left over after accounting for COGS . In Apple’s most recent earnings report, the company generated total sales of $82.96 billion and COGS came in at $47.07 billion. Subtracting the COGS from the sales, we get gross margin dollars of $35.89 billion. To calculate a gross margin, we would divide the gross margin dollars by total sales. Apple’s gross margin is 43.26% (simple math: divide $35.89 by $82.96, then take the answer and move the decimal point two places to the right to represent it in percentage terms). Why you should care : This key metric of profitability can be used to monitor a company’s efficiency in sourcing raw goods or, in some cases, the cost of logistics to get goods to customers. Since it includes the cost of the raw goods (found in COGS), which fluctuate from product to product, the margin also highlights the sales mix (the different streams of revenue). If the margin fluctuates, then the sales mix is something to listen for on an earnings conference call. For example, luxury products typically have higher gross margins because consumers are paying up for brand recognition. But if the margins comes down, it may mean consumers are tightening their belts and more likely to spend discretionary income on lower-priced goods. Operating expenses These costs are made up of R & D and selling, general and administrative (SG & A) costs . (Note, here is one example where we may see some variance from company to company. Club holding Amazon (AMZN), for example, explicitly states fulfillment costs as it is more relevant to understanding that business. That said, the SG & A and R & D categories are quite standard across companies.) We always want to see a healthy R & D budget because while it’s an expense in a given quarter, it’s the engine that drives innovation and helps a company stay competitive. SG & A may include items such as salaries, advertising, rent, utilities, marketing, legal costs, office supplies and so on — the basic expenses to keep the lights on. Also included here will be depreciation and amortization expenses. Why you should care : A good management team operates to increase efficiency and productivity. Operating expenses are the expenses most directly within their control. A team only has so much power over the cost of things like raw goods (which are related to COGS), but the items that go into operating expenses are directly within their control. By studying these expenses, especially as a percentage of revenue (SG & A divided by sales or R & D divided by sales), we can get a sense of how much operating leverage the team is getting. For example, if SG & A expenses as a percentage of sales are increasing over time, it could indicate that the return on those expenditures is diminishing and management is losing operating leverage. On the other hand, if SG & A as a percentage of revenue holds constant it tells us that we are getting similar returns on that spend, which may justify spending more as every dollar increase here leads to a proportional increase in sales. If the percentage is going down over time, then we are seeing operating leverage improve as the team is spending less per dollar of revenue on SG & A, an indication that efficiency is improving and therefore so is potential earnings power. Operating income Once we remove operating expenses from gross margin dollars , we are left with what is known as operating income. Some may also refer to this as a company’s “EBIT” margin, which stands for earnings before interest and taxes. Similar to what we did with gross margin dollars, we can take this operating income, divide it by total sales and calculate the company’s operating margin. In Apple’s case, we would take operating income of $23.08 billion divided by sales of $82.96 billion (remember to move that decimal over) to get an operating margin of 27.82%. Why you should care : An analysis of the operating margin can tell us how efficiently management is running a company against historical standards or against others in the industry. While changes in the margin are expected from quarter to quarter, or year to year, the why behind the change is crucial. Some questions to be considered: Is too much being spent on marketing? Is enough being spent on R & D? Are fixed costs too high versus peers? Have depreciation and amortization dynamics changed? Did a company hire too many people? Some companies will report a line item before reporting operating income referred to as “EBITDA,” which stands for earnings before interest, taxes, depreciation and amortization . The reason we don’t find it on Apple’s income statement is because EBITDA is not a GAAP measurement and Apple reports on a GAAP (generally accepted accounting principles) basis. Opinions on the usefulness of this metric are mixed. Depreciation and amortization are very real expenses. They may not require a cash outlay to realize, but eventually an asset must be replaced and that is a very real cash cost. The metric is widely used by companies and analysts and can move stock prices. We certainly use it for the Club. How much weight an investor should give to it is up for debate. On the one hand, it does provide a good means of comparing a company to peers because it can provide insight into the strength of a company’s operating profitability before non-cash expenses. This helps generate a better apples-to-apples comparison across an industry to see which companies are more efficiently managing items above the EBITDA line, such as the cost of goods (COGS), SG & A, and R & D. On the other hand, it somewhat clouds the profitability profile because it attempts to focus investor attention on a profit metric without including the cost of depreciation or amortization. Other income/expenses This includes interest and dividend income, interest expenses, and other non-operating related income/expenses, such as realized gains or losses on currency hedges used to protect against swings in foreign exchange rates. Remove this from operating income or “EBIT” and we are left with “EBT” (earnings before taxes), which Apple refers to intuitively as “income before provision for income taxes.” Why you should care : While less attention is usually placed on the interest and taxes part of the income statement since as it is not a major indicator of operating performance, it is worth a quick look just to ensure there are no surprises. Additionally, if there is a large fluctuation in taxes it may be worth a closer inspection just to ensure there has not been a material change in the tax burden going forward. Net income From there, we have the tax line and once we remove taxes , we are left with net income. Of course, seeing as we trade stocks based on earnings-per-share, we want a per-share number. This is simply calculated as net income divided by shares outstanding. In Apple’s case, this would be $19.44 billion divided by 16.26 billion shares outstanding (in general we want the diluted share count as it incorporates any dilution that may occur from items such as convertible debt or employee compensation plans), which results in earnings of $1.20 per share. Why you should care : The primary objective of a business is to generate profits. Without a profit, the business is simply not sustainable. Moreover, earnings-per-share are used to value a business. If earnings go up, then the stock can appreciate sustainably as the multiple (calculated by dividing the price of the stock by forward next 12 months earnings estimates) placed on those earnings need not expand. Remember, stock appreciation via price-to-earnings multiple expansion is less favorable and riskier than stock price appreciation based on earnings growth. Bottom line Reading an income statement can give you an edge when it comes to determining the quality of an earnings release or when comparing a company against its peers. If you know how to read an income statement, cash flow statement, balance sheet and listen to an earnings call, after a while, you can pretty much anticipate what Wall Street analysts will say about the quarter, especially if you know what they were looking for coming into the print. Part 2: Balance sheet If the income statement, which we covered in Part 1 , is akin to a report card, the balance sheet is most like a physical exam: Here we discover just how healthy — or sick — a company is at the end of each quarter. This check-up includes the good (assets and equity) along with potential risk factors (liabilities). It’s one of three main sections — the other two are the income sheet and the cash flow statement — included in the earnings reports companies file with the U.S. Securities and Exchange Commission on a quarterly and annual basis. Let’s run through what’s in most balance sheets and, more importantly, how understanding how to read one can help make you a better investor. First, some basics: All balance sheets are divided into three main parts: assets, liabilities and equity (assets minus liabilities). Additionally, assets and liabilities are segmented into short term (referred to as “current”) and long term (referred to as “non-current”): Short term refers to those assets or liabilities intended to be held for a year or less, while long term refers to assets or liabilities with a lifespan greater than a year. As with our discussion on reading an income statement, we’ll use Club holding Apple (AAPL) as our example. Here’s what we see in Apple’s most recent quarterly report. Current assets Cash and cash equivalents : Nothing to unpack here. This first line is cash and other things treated as cash — like short-term Treasurys. Apple puts “highly liquid investments with maturities of three months or less” here, considering bonds of longer maturities as marketable securities. Why you should care : Cash is the ultimate form of liquidity and allows companies to invest in growth and innovation without the need to raise funds by some other means, such as taking on additional debt or issuing additional shares. Marketable securities : These are extremely liquid securities that can quickly be converted to cash if needed. Examples of marketable securities include stocks, longer maturity bonds, derivatives, and other similar investments. But while they may be viewed as similar to cash, they’re also more susceptible to market volatility so should be considered a shorter-term investment. Why you should care: Many analysts will include the marketable securities alongside cash and cash equivalents when thinking about how much readily available funds are on the balance sheet. Accounts receivable : This represents sales made on credit. When you buy an iPhone with a credit card, the company doesn’t actually receive any cash at the time of purchase. As a result, Apple can’t list the proceeds of that sale as cash on the balance sheet. Think of this as an IOU. Eventually, this moves over to the cash line once payment is actually collected. But until then, there is going to be some credit risk. Why you should care: In theory this represents cash to come in the future. That said, it is important to monitor fluctuations here. A rapid increase in receivables indicates that more sales are being made on credit and, if so, an investor must ensure that the company has not reduced the quality of credit it demands to sell goods or services, as this increases the risk that the cash is never actually received and the receivables are written down. Inventories : Apple can’t sell you what they don’t have. That’s why the company keeps an inventory of its products. This line represents the total dollar value of that inventory. Since it isn’t broken down by product, we don’t have any detail on the mix. While that’s normal, you might learn a bit more detail on the earnings call. Why you should care: Comparing inventory levels against history can tell us a bit about management’s demand expectations. If management is bullish on demand, they may seek to build up inventory (such as before a holiday selling season). On the other hand, if inventory is trending lower, it may speak to concerns about near-term demand. For all companies — but especially Apple and other names that need to keep innovating with products — managing inventory appropriately is absolutely crucial to financial performance. If there isn’t enough product to meet demand, the company misses out on sales. If there’s too much inventory, management will be forced to cut prices to clear the shelves and make way for the next product iteration. Vendor non-trade receivables : This is a line item a bit more unique to Apple and a good reminder to Club members: When there is a line item on a financial statement that is unusual, the best thing to do is look for an explanation in the company’s 10-K, the annual report all companies must file with the SEC. A quick search of Apple’s 10-K informs us that this line item represents components that Apple purchases directly from suppliers and then sells to its manufacturing vendors for assembling into the final products for the company. Why you should care: This line item is a bit more opaque, but similar to inventories can provide some insight into future expectations of demand since it is a gauge of manufacturing activity. Given that this speaks to supplies provided to manufacturers to assemble products, like the inventory line, it may indicate future sales expectations or product ramps. Other current assets : This is a catch-all for anything considered to be an asset that falls outside the other major categories. Why you should care: On its own this isn’t the most informative line item. However, it adds to the total current assets value — and as we will see later in our analysis of important financial ratios, the level of total current assets plays into crucial ratios that signal liquidity levels. Non-current assets Marketable securities : These are no different than the marketable securities listed under current assets, except that Apple plans to hold these as investments for more than one year. Once the status of these holdings change — Apple plans to hold for less than a year — the value moves to current assets. Why you should care: When Apple discusses the amount of cash, cash equivalents and marketable securities on the balance sheet during earnings calls, the team usually adds this non-current portion to the value of “cash” on the balance sheet. Property, plant and equipment (PP & E) : This represents the total value of hard assets such as land, buildings, machinery, equipment and internal-use software. Why you should care: In a vacuum, the the value of this line item offers little information. But by analyzing the value against past releases, we can get a sense of how much money Apple spends on hard assets. This is especially important from a cash flow perspective as many companies define free cash flow (a non-GAAP metric) as “operating cash flow less expenditures on property, plant and equipment.” So if the company doesn’t provide the cost of PP & E explicitly (Apple does not provide a spend amount on PP & E in a given quarter, nor does it provide a free cash flow line since that is not a GAAP metric), we can calculate the difference in value between one period and the next (after adjusting from any depreciation realized during the period) to determine capital expenditures in the period. GAAP stands for generally accepted accounting principles. Other Non-Current Assets : Another catch-all, but adds to total value of non-current assets. Current liabilities Accounts Payable : Whereas receivables represent money owed to Apple, payables represent money Apple owes to others. Why you should care: A company must be able to meet its financial obligations, or risk litigation or, even worse, bankruptcy. Payables represent those obligations that are most front and center. However, unlike commercial paper or term debt (below), which represent debt taken on in exchange for cash, payables represent a liability due to purchases made on credit. Other Current Liabilities : Similar to “other current assets,” this is a catch-all for anything considered to be a liability that falls outside the other major categories. Why you should care: While it may not provide much detail on these liabilities, they are earmarked as current and, therefore, represent an obligation that must be met within the next year. Deferred Revenue : This represents money that has been collected for sales, but the product or service hasn’t been delivered yet. For example, when a service is sold, the money is collected up front but the product (think music streaming) is delivered over the course of a month. That revenue is only realized as the service is delivered. Consider: Apple collects $15 for 30 days of access to Apple Music; it may index $15 to deferred revenue at the time of collection and then realize $0.50 per day as the service delivered, thereby realizing the full $15 over the 30-day period. Why you should care: This represents the value of sales that Apple can realize over time (the timing is generally available within the company’s 10-Q or 10-K). As a result, deferred revenue provides some indication of sales — depending on cancelation policies — that have been locked in. They rely solely on Apple delivering the associated product or service. Importantly, seeing as this is an obligation to deliver goods/services, it is important to keep in mind that it does not require a cash outlay. So if deferred revenue is a high percentage of liabilities, it may determine which financial ratios — such as cash versus liabilities without the deferred revenue included — are best for valuing the company. Commercial Paper : This refers to debt taken on with a payback period of less than one year. Why you should care: This is a line worth taking note of, especially in relation to liquid assets on the balance sheet, as it speaks to an upcoming need for cash — and therefore, the company’s liquidity. We’ll discuss these relationships between assets and liabilities when we review financial ratios every investor should be familiar with. Term Debt : This refers to debt with a payback period of greater than a year, but when listed under current liabilities represents the portion of longer-term debt that is coming to maturity within the next year. In this way, it is similar to commercial paper; the difference is that when initially issued, this debt has a payback period greater than one year. Why you should care: This can pretty much be grouped in with commercial paper as far as an investor is concerned because, like commercial paper, it represents an upcoming need for cash and further highlights the company’s liquidity. Non-current liabilities Term Debt : As noted above, this refers to debt with a payback period of greater than a year. The difference between term debt listed as non-current versus current is that the former still has greater than a year remaining before the maturity date is reached. Why you should care: This provides an indication of what must eventually be paid back to borrowers and, shedding light on the company’s future cash requirements. Importantly, this line item does not indicate when the debt must actually be paid back. If the number is high versus the company’s liquid assets — indicating that more cash is ultimately needed to pay it back, either via cash flow or additional borrowing and equity offers — further investigation is required. To do this, hop over to the company’s 10-K annual report. On the first page of the report you will find all registered securities associated with the company, including the equity shares (and any associated classes) and all debt notes outstanding. A little more digging and you can find a better description of the outstanding debt securities, which will provide an indication of how much money — and when — the company is required to payback. For exact amounts, one must go even deeper and look for the financial statement schedule, where you’ll find links to the 8-K “current report” associated with each issue and the exact amounts and terms. Other Non-Current Liabilities : Once again, this is a catch-all for anything considered to be a liability that falls out of the other major categories with an expected holding period longer than one year. Equity Equity is equal to total assets less total liabilities. Here we can find a count of the total shares outstanding, which are used in the calculation of earnings-per-share, which is simply net income divided by shares outstanding. Retained earnings: This represents net income minus money paid out to investors via dividends and stock buybacks. It is important to note that this is a running calculation. We start with the prior period’s ending retained earnings value, add net income for the period, and then subtract dividend and share purchases done during the reported period. Why you should care: This isn’t the most telling number in terms of how a company is doing in the here and now, but it can provide some insight into a company’s history of generating profits and losses. There is also an argument to be made that in the earlier stages of a company, the more importance one should place on this number. For example, when a company decides to go public, we may get a few years of financial data, but it’s this line item that gives us a grand total of how much money may have been lost to get to this point, indirectly indicating how efficient management is when it comes to allocating capital. Accumulated other comprehensive income/(loss) : This represents unrealized gains or losses unrelated to daily operations. For example, Apple may utilize currency hedges to protect against swings in foreign exchange rates. The value of those hedges will fluctuate and the unrealized gain or loss will be recorded here. Eventually, when the gain or loss is realized, they will be reclassified into earnings and be reflected on the income statement under other income/(expense). Why you should care: In general, there won’t be enough information here for an investor to work off, however, it is worth a look because if the number is out of whack versus historical norms, it may be worth looking for an explanation in the 10-Q or 10-K, which are filings required by the government. Total shareholders’ equity : As noted previously, this is simply the result of total assets less total liabilities. Right underneath this we will always see “total liabilities and shareholders’ equity,” which is simply a double check of the accounting. It should always be equal to total assets. If it isn’t, we know something went wrong somewhere in the calculation of either assets or liabilities. (This should never be the case, as management should catch this blatant error before ever publishing their financials.) Bottom line While it may not be the most exciting thing in the world, knowing how to read a balance sheet is one of the most important skills an investor can have. Whereas the income and cash flow statements provide insight into performance over a three-month period, the balance sheet is like something of a “financial physical.” It provides insight into both a company’s ability to invest in growth and innovation in the future, as well as its ability to weather any potential storms on the horizon. Part 3: Cash flow analysis The cash flow statement is the middle child in a financial report — it gets overlooked. And for good reason: It’s the least straightforward of the three main parts, which includes the income statement and the balance sheet — covered in Part 1 and Part 2, respectively — and can, therefore, be the most confusing. But cash flow should get more attention, because it’s arguably the most important section. It’s all about quality control, and explains the real strength (or weakness) of a company’s earnings. Profits backed by actual cash are higher quality than those backed by what are essentially IOUs. Another way of looking at the cash flow statement is as a polygraph, or lie detector: it reveals the truth. The cash flow statement is divided into three sections: operating cash flow (represented in red: cash generated in the course of a company’s normal operations), investing cash flow (represented in blue: funds used for investments) and financing cash flows (represented in black: money pulled in to run the company). While all three sections are important, the operating section is arguably the most crucial of the three as it demonstrates the company’s ability to generate cash internally. Once again, we’ll use Apple’s recent earnings report as an example. We will be reviewing what is known as the “indirect method,” which is what most companies use. It involves backing into free cash flow by starting with net income and making adjustments for income and balance sheet items that did, or did not, require the use of cash. One thing to keep in mind: Companies pay for and sell things via credit or cash but in the end, cash is how all debts must be settled. As a result, generating positive cash flow is of the utmost importance to the long-term sustainability of a business. Final cash flow matters most, everything else is simply part of the equation. As an investor, the more you understand the better, but you don’t need to have a forensic accountant level of understanding to make smart decisions. As you review the financials of your holdings, try not to lose yourself in the weeds. Keep an eye on the big picture total cash flows; an emerging company may be forgiven for burning cash to grow, but eventually must generate positive cash flow to survive without constantly taking on more debt or selling equity (and diluting existing investors). The other thing to watch out for is large fluctuations from period to period after accounting for normal seasonality; for example, a large uptick in inventory is normal ahead of the holiday shopping season. Largely consistent numbers are ideal. Operating cash flow This is net income that is adjusted for items on the income and balance sheets that did not involve spending or receiving actual cash. Apple breaks the operating cash flow into two categories, “adjustments to reconcile net income to cash generated by operating activities” (income statement) and “changes in operating assets and liabilities” (balance sheet). Let’s start with ” adjustments to reconcile net income to cash generated by operating activities .” Depreciation and Amortization : These expenses reduce net income, but they are not expenses that come in the form of a cash outlay. Instead, this represents the gradual decline in an asset’s value, similar to how one’s car loses value over time. Given that it reduces net income but does not require a cash outlay, we add it back to net income. Why you should care: While the cash may not be laid out every period, depreciated assets must eventually be replaced and that does require cash. These are very real expenses. Additionally, this is a line item that investors should especially pay attention to when companies report metrics not used under the Generally Accepted Accounting Principles (GAAP). Often management teams will attempt to focus on earnings before interest, taxes, depreciation & amortization (EBITDA), rather than operating income (EBIT). And to be clear, we often will focus on EBITDA when companies report because it’s the metric the market uses to value companies. For example, the Street often uses enterprise value-to-EBITDA. Share-based compensation expense : This is wages paid in stock rather than actual cash. While this expense would be included in the selling, general and administrative (SG & A) expense line of the income statement, because it is not an actual cash outlay, it is added back to net income. Why you should care: This is certainly one to take note of when companies report “adjusted non-GAAP” earnings because one of those adjustments may very well be to exclude stock-based compensation. Again, while we will focus on those adjusted figures because that is simply what the market has determined acceptable (and, as a result, what the stock tends to trade on), it likely impacts the bottom line. This is not the case with Apple or any other company that only reports and trades on GAAP numbers. Investors may be inclined to accept this as an expense to be adjusted out, but there are two important factors to consider. First, every time payment is made with stock, it dilutes existing shareholders. Second, if a company is conducting buybacks, they won’t be as meaningful to reducing the share count if the company is buying back shares from the open market with its left hand and paying employees in stock with its right. Deferred income tax expense/(benefit) : Income taxes that were charged on the income statement but the cash has not yet been laid out. Had this been the use of a tax benefit — a case in which the company was able to reduce taxes in a way that resulted in a net benefit to income — it would be a negative on the cash flow statement because it increases income without any actual cash being received. Other : A catch all that incorporates any miscellaneous items that impacted the bottom line but did not include cash transactions, Next, let’s take a look at the effect of ” changes in operating assets and liabilities .” For those of you doing the math, you may notice that the numbers here may not add up exactly to the changes seen in the balance sheet. They are close, but not always exact. The reason for this is due to minor fluctuations that impact the individual line items. For example, a quick look at Apple’s 10-Q notes that the “accounts receivables” line item in the balance sheet is adjusted to reflect an allowance for credit losses; at the same time, the 10-Q notes that the inventory line of the cash flow statement relates only to those inventories “associated with underlying transactions that are classified as operating activities.” Why you should care: Generally, this is not a cause for alarm. But it does make clear the importance of a fully audited annual report. In Apple’s case, a quick look at its 2021 10-K (under the section titled “Report of Independent Registered Public Accounting Firm”) tells us that the company’s independent auditor, Ernst & Young, provided an “unqualified opinion,” which said the statements provided are fairly and appropriately reported, without exception, and comply with GAAP. Accounts receivable, net : When sales are made on credit, the company will record the full amount as a sale. But cash has not actually been received and as a result is logged as a receivable on the balance sheet. Because no cash has been received, we would subtract this amount if receivables have increased, and add this amount if receivables have decreased. Because the company is constantly receiving cash from sales made on credit while making new sales on credit, it is the net number that is important. For example, if net receivables increased, it tells us that more new sales were made on credit than total cash collected from prior sales made on credit; put another way, the bottom line saw a greater benefit than cash actually received. The reverse is also true. If more cash from old credit sales was received than new sales were made on credit, then receivables would decrease and we would see this number added back into the equation. More cash was actually pulled in than what the income statement would indicate. Inventories : If cash is used to purchase inventory, then it means cash flowed out and inventory came in. On the balance sheet, that may not indicate any change in the level of assets. For example a $100 decrease in cash and $100 increase in inventory would leave total assets unchanged. However, it does mean that actual cash has flown out from the company and that change is reflected here. Vendor non-trade receivables : As noted in our review of the balance sheet, vendor non-trade receivables represent components that Apple purchases directly from suppliers and then sells to its manufacturing vendors for assembling into the final products. So this line is simply telling us how much of that activity was actually conducted with cash. Other current and non-current assets : A catch-all for any balance sheet asset fluctuations that involved cash that do not fit the definitions of the other line items. Accounts payable : This is almost the exact opposite of the accounts receivable line item noted above. Recall, Apple may purchase inventory on credit. When that happens, the accounts payables line item of the balance sheet (a current liability) would increase because it is a payment Apple must make in the next year. That purchase would read as an expense on the income statement. However, given that the purchase was made with credit, no cash has actually left the company. In this case, we would see payables increase and the cash flow statement add back that increase to net income to represent that no cash was used on that expense. On the other hand, when that payable is ultimately settled, cash has indeed left, and the payables line item decreases to reflect the reduction of that debt. In this scenario, the reduction is subtracted from the cash flow equation to indicate a cash outflow. Deferred revenue : As noted in our study of the balance sheet, deferred revenue represents money that has been collected in advance of a product or service being delivered. While that future sale may not have been recorded on the income statement — which only represents sales actually made and delivered on in the period — it does represent an inflow of cash. That inflow is reflected here. Other current and non-current liabilities : A catch-all for any balance sheet liability fluctuations that involved cash that do not fit the definitions of the other line items. Once we add up all of these figures (after starting with net income), our end result is the net total amount of cash that Apple has either pulled in or paid out in the period. Why you should care: Before moving on to investing and financing cash flows, we want to address a popular non-GAAP metric that investors should be aware of that we do place a high level of importance on: Free cash flow. While there are a few ways to calculate this metric, most companies will simply define it as operating cash flow (the number we just backed into) less capital expenditures — typically expenses for items including property, plant and equipment (PP & E), a line item we will see in our analysis of investing cash flows. Here’s why we care about this number: While expenditures on PP & E may not be categorized as an operating expense because they do not relate directly to operations in the period in question, without these investments a company would find itself hard pressed to continue operations going forward. After all, as we alluded to above, once an asset used in day-to-day operations is fully depreciated it must be replaced. Good luck creating future iPhones with outdated plants and equipment. Investing cash flow This is much more straightforward than operating cash flows, where we indirectly backed into the number by starting with net income and adjusting for non-cash expenses or fluctuations in balance sheet assets and liabilities. Here we simply see a recording of cash used in activities that are not part of the company’s core operations. As most of these are self-explanatory, we will keep it as brief as possible. In general, given that these items represent investments, the end result is a cash outflow; after all, investing is all about exchanging cash for assets one expects to appreciate over time. Purchases of marketable securities : As noted in our study of the balance sheet, in addition to actual cash, companies will hold extremely liquid non-cash securities that can quickly be converted into cash if needed, such as stocks, bonds, derivatives and other similar investments. When those securities are purchased, cash moves out of the cash line item of the balance sheet and the value of the purchased asset moves into the marketable securities line item. In that instance, while the total asset value may be unchanged, cash has decreased. That outflow is recorded here. Proceeds from maturities of marketable securities : Where as the line item above calls out “purchases,” here we see “proceeds,” simply indicating the exact opposite activity; cash is coming in. We also see the term “maturities,” which indicates that these flows relate to securities that have reached their maturity dates, such as corporate paper, bonds or some form of derivative. When these securities mature, the marketable securities line item of the balance sheet (which includes all marketable securities, stocks included) would decrease while cash increases, in which case we would see an inflow here. Proceeds from sales of marketable securities : This is very similar to the above line item but since these sales are not the result of maturing securities, we can assume that equity holdings sold for cash would be recorded here, as well as any other securities sold prior to maturity. Why you should care: For all three of the above line items, an easy way to picture the dynamic is to think of your own investing account. When you first started, it was funded with cash, you then exchanged your cash for securities (be they stocks, bonds , or some derivative instrument such as options or futures contracts). With every purchase, cash diminished while the value of these “marketable securities” increased. The only way you got your cash back was to sell the securities, or in the case of bonds and derivatives, let them mature (if not sold prior to maturity). The same thing is happening here. Payments for acquisitions of property, plant and equipment : These are the cash outlays made in the period for the purchase of property, plant and equipment. That doesn’t necessarily mean the assets were purchased (think expensed) in the period, but represents any cash outlay associated with those purchase during the period. Payments made in connection with business acquisitions, net : Here we see any cash paid out or pulled in as a result of mergers and acquisitions. Other : A catch-all for any investments involving cash that do not fit the definitions of the other line items. Why you should care: Adding all of these line items up provides us with a net total of all cash pulled in or used in investing activity for the period. Financing cash flow Payments for taxes related to net share settlement of equity awards : Essentially cash tax payments related to equity-based compensation. Payments for dividends and dividend equivalents : Cash dividend payments made to shareholders. Repurchases of common stock : Those juicy buybacks we love so much? Here we see the cash outflow related to them. Proceeds from issuance of term debt, net : Cash pulled in due to the selling of debt with a maturity more than a year out. Repayments of term debt : Cash outlays related to the repayment of debt that initially has a maturity of greater than one year, either due to the repurchase of that debt prior to maturity or as a result of that debt maturing. Proceeds from commercial paper, net : Cash pulled in due to the selling of debt with a maturity of less than one year. Other : A catch-all for any financing activity involving cash that does not fit the definitions of the other line items. Why you should care: Adding all of these line items up provides us with a net total of all cash pulled in or used in financing activity for the period. Decrease in cash, cash equivalents and restricted cash : The sum total of operating cash flow, investing cash flow and financing cash flow, which on a net basis will increase or decrease the total cash level of the balance sheet. Bottom line While these statements can be intimidating when viewed as a whole, they’re much easier to digest line by line. We encourage all members to keep the big picture in mind and not be overly concerned should a line here or there be particularly confusing. If you have at least a decent understanding of what these statements are saying, you are well on your way to becoming a more knowledgeable investor. We encourage members to keep this series handy and review them every earnings season in conjunction with the quarterly analysis we provide for each of our holdings. While we do our best to highlight the most important dynamics in any given quarter, it is simply not possible to provide members with a line-by-line analysis of all financial statements (nor is it necessary every quarter). However, this guide equips members with a fine-toothed comb to use as they would like. Lastly, as a reminder, if ever you have a question or desire to dig even deeper, a company’s annual report (10-K for U.S. companies) is a great place to look. Moreover, in every annual report is a section called “Management’s Discussion and Analysis of Financial Condition and Results of Operations” that provides a great context for the data seen in these financial statements. We highly encourage members to take the time to review it alongside their review of these statements. Part 4: The ratios Now that you have a better understanding of the income , balance and cash flow statements — parts 1, 2, and 3, respectively — let’s go over how to use them to get a complete picture of a company’s financial health. That means using some key financial ratios. What follows is not an exhaustive list, but a good starting point for most investors, which includes many of the most important measures used by the Club. Current ratio The current ratio, which compares current assets to current liabilities, is a great first metric. As members will recall, current assets include cash, assets that can quickly be converted to cash (such as marketable securities), and those assets expected to be converted to cash within less than a year (such as receivables and inventory). Current liabilities are debts that must be repaid within the next year. Ideally, we want to see a ratio of greater than 1, which indicates sufficient current assets to cover current liabilities. If we take a look at Club holding Apple ‘s (AAPL) balance sheet statement for the third quarter of this year, we see current assets of $112.29 billion (represented on the release in millions as $112,292) and current liabilities of $129.87 billion. The former divided by the latter yields a ratio of about 0.865. (To represent that as a percentage, move the decimal point two places to the right.) That’s not great. But there are a few reasons why we’re not concerned with it comes to Apple. First and foremost, remember that Apple categorizes a significant amount of marketable securities as non-current assets. Simply adding this line item to the assets side of the equation would put us well over the 1 ratio threshold. That’s a rather straightforward and appropriate adjustment to consider given those marketable securities are still highly liquid assets. Apple’s management factors them into their calculation when discussing cash and equivalents on its earnings calls. Second, Apple generates a significant amount of free cash flow (roughly $21 billion expected in the upcoming quarter alone). Finally, Apple’s overall strong balance sheet and top-tier credit rating mean that they could always roll over some debt by selling longer-dated bonds to help pay off some nearer-term obligations. While the simple equation — current assets divided by current liabilities — is how you calculate the current ratio, we encourage members to think critically about the inputs and possibly consider making adjustments that seem logical. For example, one adjustment we like to consider here is to exclude deferred revenue from the current liabilities. Recall that deferred revenue is a liability that will be fulfilled by delivering a service, such as Apple Music. It’s a liability because Apple already collected the cash. That doesn’t require a cash outlay and, as a result, is something we can exclude from the equation. In Apple’s case, this would reduce current liabilities by $7.73 billion and lead to a modified current ratio of about 0.92, which is much closer to 1. The gap between current assets and current liabilities also falls to around $9.85 billion from around $17.58 billion, easily made up by one quarter’s free cash flow. Another consideration is how to handle term debt and commercial paper. You definitely do not want to exclude these two line items. But remember that companies, especially ones with as strong a reputation as Apple, can always sell more debt to pay off maturing debt. For example, Apple could always choose to sell long-term debt to pull additional funds in now. Keep this in mind if the ratio falls below 1. Some high-quality companies may run current ratios below 1, but can remedy that with debt or equity sales. The current ratio also doesn’t take into account cash flow generation, which companies can also use to meet near-term obligations. Quick ratio The quick ratio focuses only on current assets that can quickly be converted to cash. This usually means removing inventories, but some investors go a step further and remove any other current assets they deem less liquid and include only cash, cash equivalents, marketable securities and accounts receivables. The idea is to determine liquidity if we had to convert current assets to cash and pay off current liabilities quickly without worrying about the need to sell inventory, the value of which depends on consumer demand that can fluctuate. Current liabilities are left unchanged. When it comes to Apple, we start with current assets of $112.29 billion and remove the $5.43 billion in inventory we see on the balance sheet (again, see above, this is represented in millions as $5,433). This results in current assets less inventory of $106.86 billion. Dividing that by current liabilities yields a result well below 1. However, we could also opt to remove deferred revenue from the liabilities side to get a better picture of how large the gap is between what Apple has on hand and what it owes over the next 12 months. And again, in Apple’s case, a significant amount of marketable securities are categorized as noncurrent despite their liquidity. It’s important to consider at least a portion of these securities when thinking about the company’s liquidity position, along with its high free cash flow. This consideration of noncurrent marketable securities and cash flow profile is not meant to be an excuse for a poor ratio, but rather demonstrates why diligent investors must think beyond just mindlessly plugging numbers into a predetermined equation. That said, we reiterate that a result less than 1 for either the current ratio or quick ratio absolutely warrants further investigation. Net debt-to-EBITDA Of the leverage ratios, net debt-to-EBITDA is the main one. This involves taking the net debt (which is essentially total debt minus cash and cash equivalents) and dividing it by a full year’s earnings before interest, tax, deprecation and amortization (EBITDA). Corporations have the ability to take on debt to fund investments. As investors, we want profitable companies to lever up, to an extent, because strong management teams can make good use of that debt to provide strong long-term returns. The net debt-to-EBITDA ratio helps us determine appropriate debt levels given a company’s EBITDA generation. What the appropriate level is will be highly dependent on the industry and company in question. As a result, the best way to think through this metric is by researching historical levels and levels across the industry. In Apple’s case, this isn’t really a ratio of concern because Apple actually has negative net debt as a result of having more cash equivalents (including current and non-current marketable securities) than outstanding debt. We previously raised the point ( in Part 1 of our series in the operating income section) that some investors may not prefer the use of EBITDA since it factors out the real cost of depreciation and amortization. But it does make more sense in this equation because, in a worst-case scenario, a company could look to pay off debts before replacing depreciated equipment, for example. Dividend payout ratio This ratio measures the portion of earnings being paid out in dividends. A ratio north of 1 is simply unsustainable as a company cannot pay out more cash to investors than it generates in net income. That would be like giving your kids an allowance that is greater than your take-home pay. Apple’s third-quarter statement showed dividend payments of $3.81 billion (in millions as $3,811 on the release) and net income of $19.44 billion. If we divide the payout by the net income, we get a payout ratio of about 0.196. Clearly, Apple will have no issue sustaining these payouts. However, when you see a shockingly high dividend yield, it’s important to consider whether or not it’s a fluke — an “accidental high yielder,” which is what we refer to as a stock that yields a lot simply because the shares became oversold despite a perfectly sustainable payout. Cash conversion ratio Another important ratio that ties into earnings is the cash conversion ratio. Investors may look to use operating cash flow or free cash flow for this equation. In our view, because free cash flow removes payments for capital expenditures, it is the more conservative of the two. This ratio compares earnings to actual cash received. Earnings that are backed by cash are of a higher quality because, after all, you can’t pay dividends, buy back shares or invest in growth with IOUs. Ideally, we want a ratio as close to 1 as possible, which indicates that earnings are entirely backed by cash. Return on equity Return on equity (ROE) calculates the ratio of net income to shareholder equity — net income divided by shareholder equity, or total assets minus total liabilities. It tells us how many dollars the company makes for every dollar of shareholder equity. The higher the ratio, the more efficiently the company is making use of its equity, which is essentially shareholders’ stake in the business after netting out assets and liabilities. Another way to calculate ROE is through what is known as the DuPont equation. The extended version is calculated by multiplying five individual ratios. While these ratios ultimately cancel out to yield a simple ROE equation (net income divided by equity), this breakdown allows one to better understand the individual components impacting a company’s ROE. To better understand the utility of this equation, let’s consider what it looks likes for two rival companies, Club holding Advanced Micro Devices (AMD) and Intel . (We will use numbers pulled from FactSet for the 2021 calendar year; the numbers are represented in millions.) AMD clearly offers a significantly better ROE than Intel, a result of lower tax and interest burdens. The company also makes more efficient use of its assets. Finally, we see that AMD has less leverage. Less debt also means less future obligations and a stronger balance sheet, which is especially favorable in an economic slowdown. All of these positives for AMD serve to more than offset Intel’s superior operating (EBIT) margin. While calculating ROE is the goal — and we could have gotten the answer by simply dividing net income (found on the income statement) by shareholder equity (found on the balance sheet) — this breakdown allows us to better understand what is driving that ROE. Bottom line So, there we have it, a review of some noteworthy financial metrics. We hope this will help members better use the financial statements companies provide and allow them the ability to do even more due diligence on the companies in which they are invested or are thinking about taking positions. Part 5: AMC case study Throughout our series on reading financial statements, we’ve used earnings reports from Apple (AAPL) for a reason: The tech giant has one of the most bulletproof financial positions in the world. However, we think it’s helpful to also take a look at a company that has a shaky financial position. This will help us better spot red flags. Our pick is the highly controversial meme stock AMC Entertainment (AMC). We know lots of folks love this company. Perhaps, it’s the nostalgia of going to movie theaters or maybe it’s AMC’s charismatic CEO, Adam Aron. But our intention is to take a cold, hard look at the financials to determine the worthiness of AMC stock as an investment because, just like on “Mad Money,” we are not about friends — and Aron has been on “Mad Money” many times — we’re about making money. In this Part 5 case study, we can apply some of what we covered in Part 1 : The income statement; Part 2 : The balance sheet; Part 3 : Cash flow analysis; and Part 4 : The ratios. We’ll begin our AMC analysis by taking a look at the last eight income statements from the company. We could obviously go back further, but eight provides a good amount of data to understand the path the company is on — from the depths of the Covid-19 pandemic though the gradual reopening. We will briefly reference pre-pandemic numbers for comparisons. To simplify, we reformatted the financial statements using excel and added some additional information such as profit margin percentages and growth rates. So what do we see? For starters, we see a significant bounce back in admissions to movie theatres since the height of the pandemic, with $651 million tickets sold in the second quarter of 2022 (represented in millions as $651 in the release). It’s indicated by the annual revenue growth rates, with Q2 revenue of $1.17 billion. But that growth is clearly decelerating, and how much more revenue upside is left remains a key question for any potential investor. We see a nice rebound from the first quarter to the second quarter in 2021, as indicated by the sequential growth rate. But that may be due more to seasonality than anything else, as AMC’s first quarter appears to have a tendency to be weaker following a strong fourth-quarter movie release season. This is something we saw digging back through pre-pandemic statements, too. Overall sales look good, but they are not yet not back to pre-pandemic levels. Whether they ever will be is for the individual investor to determine. The incredible ramp up of streaming content is a major headwind for movie theaters. Another consideration is the potential for a recession. Going to the movies is a discretionary expense — and costly, especially when you consider the relative value of all sorts of streaming services that you can watch in the comfort of your home with your own popcorn and candy. Sales are only one headline number. In the case of AMC, it’s the expenses that are of primary concern. Operating costs and expenses of $1.18 billion in Q2 outweighed total revenue, meaning that the cost of operating the company is higher than the company’s total sales — an obviously unsustainable dynamic. On the other hand, AMC management is on the verge of breaking even on an operating profit basis, with just a $16.1 million loss in the second quarter. Put another way, they could get a bit more leverage on marketing, cut structural operating costs, or perhaps simply enhance the margin by charging more for food and beverages. AMC could eke out an operating profit, if demand remains strong. Still interested? The next step is to analyze what management is saying on conference calls and at investor events to determine whether the strategy has merit, or is simply wishful thinking. One nice thing about AMC is that CEO Adam Aron has been an open book when it comes to the path ahead and appears ready to consider every opportunity. Unfortunately, operating expenses are only part of the expense story. The “other” expenses must also be considered, especially — in AMC’s case — interest expense. AMC has a lot of debt, costing it about $80 million per quarter just to service it. We find this by looking at the “corporate borrowings” line item. Then there’s also expenses related to investment opportunities, slightly more discretionary but highly important given that AMC must grow revenue in order to survive. Management still has to get to operating profitability before they can even think about being profitable on a net income basis. And that’s the only basis that matters in the long run. Looking at net income, we can clearly see that the business as it stands today is a money loser, with a net loss before income taxes of $121 million in Q2. However, as was the case with operating profit, we are seeing a trend toward profitability as indicated by the net profit margin over time. Again, it’s on the investor to make a decision about where the business goes from here, and if it is a good gamble. This is not the income statement of a sustainable business. While losses may be acceptable for a rapidly growing business with large addressable market opportunities, the concern with movie theaters is that it’s an old business in decline as streaming catches on. How long can AMC last? Just how long AMC can survive at these loss rates will depend on how much cash it has on hand (a balance sheet question), its cash burn (a cash flow statement question) and management’s ability to raise additional funds, if needed, via debt and/or equity offerings. The cost of additional debt will not come cheap given the already-high debt burden, and with every equity offer comes more dilution for existing shareholders. With those thoughts in mind, let’s hop over to the balance sheet, pulled from AMC’s 10-Q. For this, we are only going to concern ourselves with the most recent release, since we are most concerned with the current financial health of the company. The cash and debt figures from a year ago are of little importance when thinking about the future. The first red flag is the current ratio (current assets divided by current liabilities, or $1.21 billion divided by $1.62 billion) stands at about 0.75. A ratio less than 1 means AMC does not have enough liquid assets on hand to cover upcoming liabilities. AMC’s current ratio can get closer to 1 if we adjust the liabilities by removing the impact of deferred revenue and income, as it won’t involve a cash outlay. This figure is likely related to movie tickets that were already sold for screenings not yet attended. After doing this, we’re not quite at a 1 ratio. But closer, and close enough that management may be able to make up the difference by stringing together a few positive quarters. It could also sell more equity, to the detriment of current shareholders. Additionally, the company recently said it has access to “undrawn revolver lines,” though added that it “does not anticipate the need to borrow under the revolver lines during the next twelve months.” Liquidity vs. solvency The current ratio is all about liquidity — and shows AMC needs to figure out a way to come up with cash to pay near-term obligations, be it an equity sale or debt offering. But since total debt also outweighs total liabilities, we also have a solvency issue. That means there are questions about the company’s ability to continue operating in the future as a so-called going concern. The difference between liquidity and solvency is that the former is simply a question of being able to raise cash quickly to meet near-term obligations, whereas the latter relates to a company’s ability to pay off debts in the long term. A company that can meet near-term obligations may be considered liquid, but if it can’t meet large obligations in the future it may become insolvent. As it stands now, shareholders are in an equity deficit. If the company liquidated right now there would not be enough cash or monetizable assets available to make good on the company’s financial obligations. In the event of bankruptcy, not only would equity holders get nothing, but lower-tier debt holders may not see a dime either. How AMC added liquidity Management has attempted to address their liquidity issue in the past, taking advantage of 2021’s meme-mania by selling 8.5 million shares to Mudrick Capital, which quickly flipped them for a profit for $27.12 per share — raising about $230.5 million. In a brilliant move, AMC offered 11.55 million shares at an average price of approximately $50.85 per share, raising an additional $587 million near the peak of the mania (on a closing basis, shares topped out at $59.26 on June 18). Over $800 million isn’t bad, however, it was nowhere near enough to address the company’s debt- and cash-burn rates. Of course, if the equity dilution wasn’t enough to convince you that shares may have been overpriced back in 2021, Aron also sold 625,000 in what he said was an “estate planning move.” The shares were sold at an average price of $40.53, totaling roughly $25 million. He then proceeded to sell additional shares through the end of 2021, bringing the grand total to roughly $42 million before announcing that he was done selling. At the time, he still had over 2.3 million shares, nearly all of which were unvested. We can’t fault Aron for making the sales, as he told investors he would ahead of time and has been as transparent a CEO as any retail investor could ask for throughout the mania. Perhaps the real moral of the story here is that when you have a balance sheet this bad, do what the insiders are doing. More recently, management was forced to up their creativity after shareholders said enough to the equity dilution. The solution? To offer up AMC Preferred Equity (APE) Units. Initially, the APE offer, despite representing a different class of stock with its own ticker, was done in the form of a dividend pay out to existing shareholders. This impacted the stock in a similar way that a 2-for-1 stock split would, with AMC shares falling by over 50% in the days leading up to, and through, the day of the distribution. The decision to offer up a new class of stock is not unheard of, however, it is a bit questionable in AMC’s case. Unlike the preferred shares of other companies that may provide unique characteristics such as different voting rights or a larger dividend, AMC’s APE units were designed to have the same economic value and voting rights as shares of Class A common stock. In the event of bankruptcy, preferred unit holders should have a higher priority claim on assets than common shareholders. However, as it stands now, it’s doubtful anything would be left over after the bondholders would finish making their claims. Regarding any future conversion to AMC common, such a move would require the board to make a proposal and shareholders to approve it. That gives us some insight as to why these APE units were even developed to begin with. Prior to the APE announcement, AMC tried and failed to gain wide shareholder support to authorize the sale of additional common stock. However, since these APE units are not technically AMC common stock — despite their similarities — they did not require shareholder approval, effectively providing management a with a new avenue to raise funds. Importantly, the initial distribution did not provide new funds or dilute existing holders since they went to the existing holders (again, similar to a sock split) as a dividend. However, while a grand total of 516.82 million APE units were distributed in August (1for each share of common outstanding), 1 billion APE units were actually authorized. Indeed, shortly after the initial APE dividend payment, management filed that they had entered into an equity distribution agreement to allow for the sale of the remaining APE units (425 million in total after holding some back for compensation). Management has said this distribution agreement was made in an effort to raise cash to pay off its debts. But while it may not be technically dilutive, AMC common shareholders have another class of equity coming in higher up in the capital structure. For a shareholder, the positive is that this plan gives AMC ample liquidity to meet its near-term obligations and buys management time to figure out how to get to profitability. The negative is that the authorization of 1 billion shares opens up the equity base to dilution when those shares that were not distributed as a dividend are sold, even without a vote to authorize additional shares. Solvency remains a longer-term issue and the main concern for those holding equity or low-seniority debt. What is the AMC brand worth? Another line item of concern is assets attributed to “goodwill.” Goodwill is an intangible asset: it’s not cash, it’s not receivables, and it’s not really something that can readily be converted into a liquid asset. It’s management’s best guess at what the AMC brand is worth. As of Q2, it was $2.35 billion. If the business prospects decline — sales fall short of expectations — management may be forced to reduce goodwill via what is referred to as an impairment charge to reflect the loss of brand value. The balance sheet takes a one-two punch: Cash levels come in lower-than-expected (because actual results didn’t match up to expectations) and goodwill (and, therefore, total assets) is reduced. This negatively impacts financial ratios. Indeed, we saw “goodwill non-cash impairment charges” of roughly $2.3 billion taken in the year ended Dec. 31, 2020, due to the impact the pandemic had on the “the enterprise fair values” of the Domestic Theatres and International Theatres reporting units. That may not have been a cash hit, but the negative impact it has on shareholder equity could certainly lead to higher borrowing costs. As to the $80 million in corporate borrowing interest payments we noted in our review of the income statement, we can see that the actual debt load causing these costs is about $5.36 billion in total corporate borrowings. Until management can make a dent in this principle, investors should expect those interest payments to continue at around the same rate. Call it somewhere in the range of $300 million to $350 million per year. While some of that debt was necessary just to survive the pandemic, whether management can pay it down, and how quickly, will depend heavily on the team’s ability to reach operating profitability and sustainably generate cash. So after considering the income statement and balance sheet, we are looking at a company that is losing money and does not have the ability to meet its financial obligations. That is the reality, as indicated by the most recent financial statements. The only reason AMC is even standing right now is because of the meme-mania we saw during the pandemic, a hysteria that allowed the company’s management to both sell equity into a buying frenzy and raise debt in a world where the cost to borrow was very low. We are no longer in that world. Borrowing costs have increased significantly and the buyers that fueled the stock’s prior price surges appear to have given up on AMC, or have run out of money. AMC’s cash flow Let’s finish by taking a look at the cash flow statement. Rather than analyze each individual line item — though members may do so here , as management must provide the statement in full on their 10-Q filing — we will instead focus on the consolidated statement on the operating, investing, financing and free cash flow totals over the most recent four quarters. The investing cash outflow (line one) is to be expected, as management is putting money to work to ensure growth and to get to profitability. The financing cash outflow (line two) shows a slow paying down of the massive debt load that’s weighing on the company’s balance sheet. What we really want to focus on is operating cash flow (line three), followed by capital expenditures and then free cash flow. AMC has not been able to consistently generate positive cash flow from operations. This means it must either sell assets or look to the bond and/or equity markets in order to find cash. Even in the fourth quarter, it didn’t generate enough cash flow to cover the investing and financing outflows, not to mention capital expenditures. Once again, we have an unsustainable financial dynamic: a company simply cannot survive if it is unable to generate cash internally. The individual investor has to determine if management has a plan to turn the ship around and get the company back on track. If you believe they do, then that’s the bet. Otherwise, there are no fundamental reasons to take a position in the name. Looking at the operating cash flow alone, AMC needs to make significant changes or it will eat away at cash on the balance sheet. Fortunately, current FactSet estimates do anticipate AMC having positive operating cash flow in 2023. But the projections still don’t cover the projected investing and financing cash outflows. Estimates are for another $6 million to flow out in the back half of 2022 ($81 million out in Q3 and $75 million back-in in Q4) and another $154 million and $201 million to flow out in fiscal years 2023 and 2024, respectively (not accounting for any effect that exchange rates may have on cash balances). The takeaway: Cash levels should be expected to decline for the foreseeable future. Bottom line Based on our analysis of AMC’s financial statements, the company is in trouble. Its stock price has fallen 76% year-to-date and the cost to borrow is climbing. Options to raise cash externally have become severely limited. Aron was smart enough to leverage the investor frenzy during the pandemic and the then-low borrowing costs to load up the balance sheet. Based on current burn rates and the roughly $965 million in cash, management has a couple years to figure things out. That’s still an optimistic take. In the most recent 10-Q, AMC shows a $525.6 million payment due in 2023. The company said it is currently negotiating terms of new debt intended to refinance and extend the maturity of that money owed, but “there are no assurances that the Company will be able to do so.” If AMC is unable to refinance these amounts, the principal amounts will be reported as current maturities, which may increase the uncertainty around the company’s ability to pay its debts. This renegotiation should be on the radar of every AMC investor and prospective investor. A failure to make do on a new debt agreement will mean a significant cash hit in 2023, and reduce the time on the clock for AMC to turn things around. The next big challenge will be the $3.36 billion in maturities due in 2026. We can cross that bridge when (and if) we come to it. Unless you believe that the movie theater business is about to reignite and the trend we have seen in recent years of viewers trading in the theater experience and $20 popcorn for some Disney+ and microwave popcorn, then there is little reason to be involved with AMC. We would love to see management pull this turnaround off, reinvent the company and provide consumers with an experience they’ve never seen before. But we have our doubts about management’s focus on the core business, given past moves such as investing in the completely unrelated business of a gold mining company . Understand that any position taken in AMC at this point is entirely a bet on management and Aron’s vision. To be clear, though we don’t predict a bright future for AMC based on its financial position and our own view of the changing consumer preference toward at-home streaming services, we find little fault with Aron. This is not a good hand he is playing with, but he appears ready, willing, and able to do anything and everything he can to save the theater chain. Some may argue that he took advantage of a generation of meme-stock investors. In our view, his transparency throughout the timeline going back to the early days of the pandemic negates that narrative. Instead, we think Aron acknowledged that his shareholder base is majority retail and opted to view and treat that base as members of a club, seeking to listen to what they wanted to see management do with the company — be it showing concerts or selling nonfungible tokens — and then see what financial means the company had at its disposal to do something, anything to get the company back on a path to profitability. (Jim Cramer’s Charitable Trust is long AAPL and AMD. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust’s portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.

The sign for Wall Street is seen with U.S. flags outside the New York Stock Exchange.
Yuki Iwamura | Afp | Getty Images

One thing that separates fledgling investors from the pros is reading financial statements. For amateurs, comparing the so-called headline numbers — sales and earnings — to estimates is the full extent of research into a company, whereas in more experienced hands, they are just a starting point. If you want to become a better investor, make like a pro and digest the financials. It’s the best way to truly understand a company’s performance. In the lead up to the start of earnings season later this month, we’ve put together a five-part series to help Club members better understand all the tables and charts and how to analyze them.

Leave A Reply

Your email address will not be published.