Understanding of Financial Statements
Financial statements are a structured representation of a group or company’s financial position and performance at a point or period of time. Financial statements are a good starting point to help us know more about the state of a company’s affairs.
Each financial statement has 5 core elements:
Revenue and expenses earned over a period of time (i.e. during a quarter, half-year, or full-year);
Assets and liabilities at a specific point in time, in which the difference between the two is the shareholder’s equity;
Cash flow statement
Changes in cash flow for operating, investing and financial activities;
Statement of changes in equity
Changes in the interests of shareholders’ over time; and
Notes to financial statement
Additional information, such as general company information, significant accounting policies, explanations for items contained in above statements, going concern issues, etc.
Make use of financial ratios to test a company’s profitability, stability and efficiency.
Listed companies are subject to strict reporting requirements, and additional information is disclosed. It may include: corporate governance practices; management discussion and analysis; biographies of directors and senior management; board committees; environment, social and governance performance, etc.
Audited financial statements will have an Auditor’s Report, which gives an opinion on whether the financial statement provides a “true and fair” view of the state of company.
Profitability margins look at a company’s ability to generate profit per dollar of sales. This includes gross margin, operating margin and net income margin. Gross margin is the ratio of gross profit (total sales less cost of goods sold) to total sales. Operating margin is the ratio of operating profit (gross profit less operating expenses) to total sales. Finally, net income ratio is net income (operating profit less interests and taxes) to total sales.
Solvency ratios, such as debt-to-asset and debt-to-equity, are a good indicator of a company’s financial stability. Companies with poor solvency ratios may have cash flow problems when interest rates rise or business deteriorates, resulting in going concern problems.
Efficiency ratios tell us how quickly the company turns inventory into sales. An example is inventory turnover, which is the ratio of cost of goods sold to inventory.
Earning before interest and tax
Earning before interest and tax (“EBIT”) shows a company’s performance without accounting for tax expenses or capital structure that may impact profit. We can use EBIT to compare two companies in the same industry but with substantially different tax rates. EBIT can also be used to analyze companies that are capital intensive (such as automobile, chemical and oil refinery industry), which have higher debt levels to finance property, plant and equipment. If debt levels are managed properly, the company will thrive despite high levels of interest. EBIT may be more meaningful in these circumstances.
Financial statements provide a wealth of information. However, it only demonstrates what the company has achieved in the past (i.e. in a specific time frame or time period). This may not be indicative of present or future performance. To fully understand a company, we should not only analyze the financial statements, but also read the news, research reports, and publications from other stakeholders, like banks and regulators.