How to Read a Stock’s Financials (Avoid Excessive Risk)

In this article, I will show how to read a stock’s financials so you can avoid excessive financial risk. I’ll show you a simple financial statement analysis with a case study from equity research.

What you’ll learn to avoid is the risk of bankruptcy, which will make your investment go to zero.

Unfortunately, many individual investors skip financial statement analysis because the accounting seems complicated. To make matters worse, most videos on financial statements only explain formulas and things like balance sheet ratios, which don’t mean anything on their own.

When you look at a financial statement, you might think:

• I don’t understand the accounting terms.
• There are too many financial metrics!

You know it’s important but don’t know where to start. It is much easier to look at a stock chart and skip this step. Using the stock price to evaluate a business will lead to mistakes.

The problem with skipping financial statement analysis is…

You may take excessive financial risk.

The worst financial risk is when a company runs out of money, which usually happens in three steps:

1. The company’s operations lose money or negative earnings
2. The company’s has negative free cash flow
3. The company runs out of cash (or defaults on its debt)

Which leads to bankruptcy.

You can spot this risk by reading the financials. It’s essential for stock research.

The education company Corinthian is a classic example. Corinthian was the largest for-profit college in the US when the sector was booming (2008-2011). The federal government cracked down on the industry in 2011. 

In four years, this once high-flying company went bankrupt.

Here’s how to analyze the financial statements¹ to spot financial risk:

Step 1: Check the earnings on the income statement

Income statement: Are earnings (net income) negative?

Here’s how it works:

• The income statement records the transactions of the business.
• It’s where you assess if the company is performing well (and making money).
• The first sign of trouble is when the company cannot turn a profit. 
• If earnings are negative, it usually means its operations are using up cash.

In 2012, the federal government restricted student loans to for-profit colleges. Corinthian’s revenues then declined. It started its own student loan program, which created additional costs. As a result, its earnings were wiped out.

Here’s how to read this statement:

• Net revenues (tuitions): $1.75B to $1.60B
• Other (expense) income net (loan costs): $3.4m to $(23.8)m
• Net loss (earnings): $(111)m to $(1.7)m

Now, most of the net loss is from impairment and severance charges. These are one-time charges and non-cash expenses. So let’s remove them:

• Net loss (adjusted earnings): $108m to $1.9m

That’s a massive drop in earnings.

Since earnings are barely positive, you’ll want to examine its cash flows.

Step 2: Check cash flows on the cash flow statement

Cash flow statement: Is free cash flow negative?

Here’s how it works:

• The cash flow statement records the movements of cash across its operations, investments, and financing.
• It’s where you assess if the business is producing cash (or using it up). 
• On the cash flow statement, take the cash from operations minus capital expenditures to get free cash flow.
• Free cash flow represents the cash the business generates after reinvestments.
• When free cash flow is negative, this is a sign the business is burning cash.

Corinthian managed to improve its free cash flow in 2012. It took student tuition payments in advance (prepaid tuition), which increased cash flow (net cash provided by operating activities). It also cut capital expenditures (payments for capital expenditures). 

However, the Department of Education delayed the payment of student funds to Corinthian in 2013. Without these funds in advance, its cash flow from operations dropped again in 2013.

Corinthian’s free cash flow turned negative.

Here’s how to read this statement:

• Net cash provided by operating activities: $15m to $41m
• Payments for capital expenditures: $(110)m to $(44)m
• Free cash flow (calculated): $(95.6)m to $(2.5)m
• End of period cash: $107m to $46.6m

The statement shows that the company also paid down its debts (various cash flows from financing activities).

It suggests there are lots of financial obligations using up its cash. This is why the net change in cash is negative each year.

Since the business is burning up cash (dramatically), the next step is to check cash levels.

Step 3: Check the cash on the balance sheet

Balance sheet: Cash balance – can this cover the business needs?

Here’s how it works:

• If the business does not have the cash to cover its financial obligations, it’s a bankruptcy risk.
• The balance sheet records what the business owes and owns.
• Use this statement to check whether the business can meet its obligations.

Corinthian is clearly in an unhealthy situation. Its operations are not making money, and it is using up its cash. The question now is, can it survive? The problem Corinthian has is its debt. 

Here’s how to read this statement:

• Cash balance: $46.6m
• Long-term debt (net of current portion): $122.8m
• Debt owed for next year (current portion): $4.1m

💡Tip: Check the long-term liabilities for the debt amount. Then, look in the 10K filing notes for the debt section for details of when it is due.

Most of Corinthian’s debt is from a credit facility, a pre-approved bank loan. The loan was due on July 1, 2015. Corinthian needed to generate $120m in cash from its operations or from financial partners by this time.

How Bankruptcy Happens in Practice

Over the next two years, its business trends did not improve, and earnings worsened. No bank or investor wanted to partner with Corinthian. The bank also cut off access to its loans because it violated its loan covenants, which required Corinthian to have a minimum equity on its balance sheet.

Corinthian needed cash to repay its debt, but it did not have the cash. 

The company became a “going concern risk” (in accounting terms), meaning it could no longer meet its financial obligations. Corinthian filed for bankruptcy in 2015. 

Once the bankruptcy became clear, the stock dropped to zero. Stocks lose almost all value in bankruptcy because stockholders are the last to recover any funds (usually, there is nothing to recover).

Seeing the financial risk can help you avoid buying stocks like Corinthian well ahead of this time.

The stock looked “cheap” on the chart but then headed to zero.

The Steps to Watch for Bankruptcy Risk

To protect yourself from the worst financial risk, check the company’s earnings, cash flow, and cash.

Pay attention to these negative trends:

• Negative earnings
• Negative free cash flow
• Declining cash balance

When combined with debt, you are likely looking at a company facing bankruptcy risk.

I hope this helps you read the financials! You can learn more about the fundamental process here.

Footnotes

1. Corinthian’s financials (10K Filing) https://www.sec.gov/Archives/edgar/data/1066134/000104746913008803/a2216385z10-k.htm#fa43301_item_8._financial_statements_and_supplementary_data ↩︎