The Motley Fool: Financial statements are worthwhile reading

Financial statements can help you evaluate the quality of a company’s management. In its annual report or latest earnings report, look at the balance sheet. Is there more long-term debt than cash? Many companies carry a lot of debt successfully, but others borrow more than they can pay. You’ll often find the interest rates that companies are paying in footnotes.

Review the income statement (aka the statement of operations) and compare numbers over the past few years. Have sales and earnings been growing consistently? A smooth upward trend suggests that management has been planning well, encountering few surprises. Growing profit margins are another sign of high quality.

To boost margins, management has to run its business more efficiently, decreasing expenses such as the cost of supplies, marketing or salaries. Rising operating margins show that the firm is working on wringing more and more profit from each dollar of sales. In a period of slowing sales growth, savvy managers can maintain earnings growth momentum by increasing margins.

A good barometer of management excellence is a company’s return on equity (ROE). It measures how well the company is using its reinvested earnings to generate additional income. You’ll find ROE listed in online profiles of stocks, such as at http://quote.fool.com and http://finance.yahoo.com. ROE varies by industry, so compare a firm’s ROE with those of its peers. And review several years’ worth, as one good year does not a great company make.

Other ways to discern management quality are to look for executives who own big stakes of the company stock and to read (and listen to) company communications, to get a feel for how candid the bigwigs are.

Invest in companies only after you make sure their highly compensated executives are earning their keep.

Ask the Fool

Q: Pottery Barn doesn’t seem to be a publicly traded stock. Am I out of luck regarding investing in it? – P.T., Syracuse, N.Y.

A: Nope. Do a little digging online (or just call the company and ask), and you’ll learn that Pottery Barn is part of Williams-Sonoma, trading under the ticker symbol WSM. Many companies are divisions of other companies. Gap, for example, owns the Gap, Banana Republic, Old Navy, Forth & Towne and Piperlime names. T.J. Maxx owns T.J. Maxx, Marshalls and HomeGoods stores. Yum! Brands owns Taco Bell, Pizza Hut, KFC, Long John Silver’s and A&W Restaurants. Berkshire Hathaway owns Dairy Queen, See’s Candies, GEICO, Benjamin Moore, Fruit of the Loom and The Pampered Chef, among many other companies.

Q: What are “trading curbs”? – W.S.P., via e-mail

A: They were imposed just a few weeks ago, when the Dow swooned by some 400 points.

Program trading curbs were instituted by the New York Stock Exchange (NYSE) after the crash of 1987 to temporarily restrict all or some trading during periods of volatility. Program trading was blamed, at least in part, for that crash.

According to investopedia.com, program trading is “computerized trading used primarily by institutional investors typically for large-volume trades. … Program trades are usually executed if index prices sink or rise to a certain level. This tends to create very volatile situations.”

More powerful are “circuit breakers,” which halt trading on the NYSE entirely for an hour, two hours or the rest of the day whenever the Dow Jones industrial average drops, respectively, by 10 percent, 20 percent or 30 percent.

My dumbest investment

Back in the late 1990s, my brother’s broker recommended a little company called Qualcomm. I decided instead to invest in a small company called Computer Warehouse, which I felt was pretty good, based on my limited research (I was still a bit green on investing then).

Over the next year, Qualcomm went from about $14 to something like $400 or $500, and Computer Warehouse went bankrupt. I learned a great deal from this situation about digging deeper into a company and getting to know the business. I can’t say I would have bought Qualcomm, but I sure wish I had, as my measly $900 would have become about $39,000 in 10 months, which would have been a tax problem I could have lived with.

Whatever you do, do your homework. – Jason Humble, Beaverton, Ore.

The Fool Responds: Like many other companies, Qualcomm took a big dive in the early 2000s. Those doing their homework might have bailed out before the crash, though, sensing that it was overvalued.