Evaluating financial statements–few important metrics

I have burnt my fingers few times by blind reliance on analyst reports or my own intuition. Today I will like to discuss few financial metrics that I have found of immense help in navigating through maze of financial numbers and analyst reports. These metrics allow me to view financial numbers in perspective and identify areas that need further exploration.

Before I delve further into what I know so far, I must caution that these metrics are empirical & should be used only for guidance. They should not be treated as an absolute statement on a stock’s worthiness. 

First metric that I find very useful is Beneish M-Score. This number, devised by Professor Messod Beneish, highlights probability of earning manipulation. This number, in its larger form, is based on a weighted sum of eight factors (called indexes) that are derived by comparing past and current financial statements. Another version of this number uses five of those indexes. Professor Beneish’s analysis showed that there is a very high probability of manipulation in financial statements if Beneish number is greater than -2.22. One should analyze financial statements with much caution and further dig into each of 8 factors if Beneish analysis raises an alert. It is also important to do this analysis over several years to identify a pattern and to check any possibility of financial manipulation in past. Further details of 8 factors are available from multiple sources on internet.

Second metric that I like is Altman Z score. This score measures financial health of a company and indicates probability that a firm will go into bankruptcy within two years. This score depends on four or five business ratios. There are few variants of Altman-Z formula for different industry segments. In general, a score above 3 indicates that a company is unlikely to enter bankruptcy. A score below 1.8 indicates a highly likelihood of financial distress within next two years.

Third metric that I will like to discuss is Piotroski F-score. This score measures relative financial health of firms. It is based on 9 factors. A score of 0 or 1 is assigned to each of these factors and total of all 9 factors if F-score for the firm. For example, Net income is one of the Piotroski factors. It will get a score of 1 if net income for that year is positive. A score of 7 or more indicates a financially strong company.

Three metrics written above should be used during preliminary analysis to identify areas that need deeper investigation. One should look at those factors of these scores that indicate any kind of distress. Ideally, these scores should be calculated over several years. These scores, coupled with other financial ratios are helpful in weeding out risky companies.

In near future I will share my spreadsheet tool that I created for my own use. Till then,  Arivederchi!

PS: Following is result on an analysis I did on September 27 2012