(This report is part of our occasional Other Voices format, as we run across interesting investment ideas or practices from outside our firm. Today’s piece is written by David Zion, founder of the Zion Research Group, an independent research firm focused on accounting and tax issues, and his colleagues Ravi Gomatam and Ben Wechter. It is excerpted from Zion’s annual 10-K Checklist, which includes tricks of the trade, potential red flags, questions to ask and common-sense tips to help you navigate the 10-K filings.)

Few investors other than Warren Buffett, perhaps, enjoy reading SEC documents, but they are crucial to a complete understanding of the company whose shares you are considering.  Buying a stock without reading the 10-K is like driving to an unknown destination without a map.  You can do it, but it’s better with navigation. Zion Research Group is expert at deciphering corporate SEC filings.  To help you navigate this thicket, we are running excerpts from Zion’s reports about 10-Ks. This is the second of three.

Financial Statement Analysis, Just Do It.   When the team at Zion Research Group are doing a Deep Dive on a company, they’ll read the 10-K from start to finish. If you want to narrow your focus, old fashioned financial statement analysis is a good place to start (e.g., common size financial statements, free cash conversion, working capital trends, etc.).

Zion uses a variety of tools to evaluate earnings quality. But they always start with their Red Flag Finder. Give them a shout if you’d like to see it for your portfolio or coverage universe. Look for changes in financial statements (out with the bad in with the good). Did a line item suddenly appear or disappear? Keep an eye out for reclassifications. Are bad things getting shifted out of the line items that the Street pays attention to while good things are getting shifted in?

Name that auditor. A change in auditor is a potential red flag, especially if the company is just shopping around for a better audit opinion. Remember, auditors now file Form AP (Auditor Reporting of Certain Audit Participants) with the Public Company Accounting Oversight Board (PCAOB). The form discloses the name of the engagement partner for audit reports of public companies and information about other firms that helped-out on the audit. So, the next time you see a company run into some accounting trouble, find out who signed that audit report. He/she may have also done work on the audit of a company in your portfolio.

Critical audit matters (CAM) will make their debut for most large accelerated filers in the 2019 10-K’s. As discussed in their September 6, 2019 blog post, Critical Audit Matters: CAMtastic Stuff Coming Soon to an Audit Report Near You, CAMs are matters communicated to the audit committee that “relate to accounts or disclosures that are material to the financial statements and involve especially challenging, subjective or complex audit judgment.”

Zion suggests comparing CAMs to the company’s disclosures (e.g., critical accounting estimate); differences could be red flags.

Balance Sheet   Looking for a high-quality balance sheet. In Zion’s view, a high-quality balance sheet is when the assets and liabilities are fairly stated, the company has enough liquidity, manageable asset/liability mismatches, a straightforward capital structure and not too much leverage. Simple ratios like the current ratio (current assets / current liabilities) and debt to equity are a good start.

✓ Asset/liability mismatches can be a problem. Zion suggests monitoring them especially when no one else is. For example, short-duration liabilities funding long duration assets may not cause too many problems during a normal economic environment but come crisis time, they could be crippling (if you know about a mismatch beforehand, you can be nimble and act accordingly before crisis strikes). Quant alert: Growing liabilities (debt). The new lease rules resulted in balance sheet growth in 2019, as both assets (right to use leased asset) and liabilities (lease obligation) landed on balance sheet. A bit further down the road (in 2022), the FASB’s project to “simplify” accounting for converts will increase the amount of debt on the balance sheet and reduce interest expense (bringing it closer to cash interest but further from economic cost); see Accounting Ch-Ch-Changes.

Income Statement   Earnings quality is key. High quality earnings are sustainable and generated by the core business (low quality are not). Look out for disconnects, like earnings growing faster than cash flows, receivables growing faster than sales, gross margins falling but operating margins are growing, earnings not being converted into cash, etc.

✓ Higher quality = higher multiple. Is the market paying more/less for the earnings stream relative to peers, does that reflect higher/lower quality earnings? If you adjust earnings to better reflect economic reality (e.g., strip out the impact of more aggressive accounting), what type of multiple does the stock price imply? Does the stock still look cheap?

Cash Flow Statement   Focus on cash flow quality. Are the cash flows driven by recurring operating activities core to the underlying business or is it non-operating, non-recurring stuff? For example, is the cash flow growth coming from selling more widgets or is the company just putting off paying its bills or has it stepped up receivable sales (there’s only so long that can last)?

✓ Sources and uses of cash. Zion would prefer that companies provide direct method cash flow statements where you would see sources and uses of cash by different types of business activity. That might provide a better view of whether or not the cash flows are being generated by those areas where the company has a competitive advantage. While you’re waiting for a direct method cash flow statement (don’t hold your breath), you need to do some work to get at the real operating cash inflows and outflows (e.g., strip out financing and tax related items that currently show up in cash flow from operations).

✓ Will the real free cash flow please stand up? What’s the real free cash flow after adjusting for stock comp related buybacks and acquisition spend? What appears to be strong free cash flow on the surface may look quite a bit weaker after making a few adjustments.

Statement of Changes in Shareholder’s Equity     It’s the forgotten financial statement. Use it to track changes in the underlying components of equity (i.e., book value), like additional paid in capital, retained earnings, treasury stock, accumulated other comprehensive income (AOCI), etc. ✓ But look elsewhere. If you want more information on share buybacks, check out Item 5 (Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities) under Part II of the 10-K.