Hi all, today I will be continuing with Part 2 of Dissecting the Annual Report. In part 1, I shared about some ways to dissect the annual report in order to find the information that you need. For those who missed it, you can read Part 1 here. Today, I will be going more in depth into the financial statements portion of the annual report. The financial statements in the annual report is an important piece of document that shed light on how the company is doing and challenges that the company may face.
The financial statements in the annual report always consist of 1) the Balance Sheet, 2) the Income Statement, 3) the Cash Flow statement and 4) the Statement of Equity. We will focus on the first 3 as the statement of equity is used less frequently.
Whenever I look into the financial statements of any company, I do it for 2 reasons. It’s either to identify if the company is fundamentally sound to invest or to evaluate the financial health of a company after every earnings report season that I am already vested in.
When deciding if a company is fundamentally sound, I would look for stability of earnings, debts level and their cash flow which I wrote about here. After, confirming that the company is a fundamentally sound company, I will scrutinise their financial statements further for any abnormal figures. This can come in the form sudden increase when compared to previous year’s figures or extremely high figures. As for companies that I am already vested, I always try to look out for abnormal figures when compared to the previous year.
By doing so, I am able to detect any drastic change that may happen to a company. This is because any abnormal figures usually have a huge impact on the company. For instance, when the company suddenly register a 50% decrease in Cash & Cash Equivalents in their balance sheet, you must find out what did the company spent the money on. Is it for expansion or paying down debts? Will this affect their operations etc etc. Hence it is important to always find out about abnormal figures that may puzzle you when you read their financial statements.
Alright, with that aside, we shall dive deeper into the financial statements. I will share with you the important things to look at and some basic calculations you can make to better understand the financial health of the company.
1) Income Statement
Let’s start with the income statement. The income statement is basically a summary of profit and loss for the company. It documents the revenue and expenses for the specific accounting period.
The above is an example of the income statement of a company.
Things to know:
- Revenue – a gauge of the amount of sales (look for stable or increasing revenue)
- Gross Profit – this is obtained after subtracting costs of goods from their revenue.
- Gross Profit Margin – this is obtained from dividing the gross profit by the revenue (High GPM shows that the company have some form of competitive advantage over their rivals)
- Operating Expenses – which consists of all expenditures that are not directly associated with the production of the good or services. Expenses like R&D costs, depreciation, amortization etc (Companies with durable competitive advantage have consistent operating expenses)
- Earnings Per Share — EPS is based on net profit attributable to shareholders after deducting any provision for preference dividends and then divided by total shares outstanding. (An increasing or consistent EPS is always preferred)
The income statement is important in telling me if the company’s business have a form of moat around it and also if the company have been able to keep costs low.
2) Balance Sheet
The balance sheet documents the assets, liabilities and the shareholders’ equity of a business at a particular point of time.
Things to note in a balance sheet:
- total assets = total liabilities + total equity
- Current assets refer to assets that can be liquidated into cash within a year
- Current liabilities refer to the money to be paid in less than a year
- Non-current assets refer to assets that takes more than a year to be converted to cash. For eg, property, factory buildings etc
- Non-current liabilities refer to the money payable after 1 year.
- Shareholders’ equity refer to the net worth of the company
- Current Ratio calculates the company’s abilities to meet their short term obligations. (Current Ratio = Current assets divided by Current Liabilities)
- Cash & Cash Equivalents > Total Debts – I always try to ensure that the company have enough cash on hand to pay off their total debts. An over-leveraged company is a troublesome company.
- Current Ratio > 1.5
For me, the balance sheet is important in telling me if the company will have a problem of paying their dues.
3) Cash Flow Statement
The cash flow statement records the cash inflow and outflow of a business. The cash flow statement shows how changes in the balance sheet and the income statement affects the cash and cash equivalents.
It consists of 3 parts. 1) Cash flow from Operating Activities which records the net cash into or out of the business from their main operations. 2) Cash flow from investing activities which records the cash movement from the company’s investment. For instance, purchase or sale of a property, subsidiary etc. 3) Cash flow from financing activities records the cash movement of financing activities in the company.
Cash Flow from Operating Activities
A positive cash flow from operating activities means that cash is flowing into the company from their business. This means that net of all the expenses, the company is receiving cash from the products they sell. This is important as you want a company to take in cash from the products they sell. A company with consistent negative cash flow from operating activities is burning through cash fast and may need to take on debt in the future to finance their expenses. Hence, we would want a company to have positive cash flow from operating activities.
Cash Flow from Investing Activities
Purchase of assets, company investing their money in the market etc. These are all counted as cash outflow from investing activities. Sale of an asset etc will be register as an inflow. This section can tell you if the company is spending money to expand their current infrastructure or expanding capacity through higher capital expenditures.
Cash Flow from Financing Activities
Financing activities include payment of dividends to shareholders, paying off debts, money used in share buyback etc. In this section, you will be able to find out what the cash is used for in their financial activities. For instance, a negative cash flow from financing activities can mean that the company is paying off its debt. A positive cash flow from financing activities could mean that the company is raising money through selling new shares in the market etc.
The sum of all three sections above will give the net change in cash and cash equivalents which will be added to the amount of cash they have at the beginning of the year. By understanding the functions of the different sections of the cash flow statement we can better understand what the company is doing with their cash.
Not all companies’ financial statements follow to the template I describe above. A lot of them have to be evaluated in the context of their business. For instance, although I emphasised a lot on positive cash flow from operating activities,.property developers would register most of their cash flow in the investing portion than operating activities when they sell a completed property project. Hence, the financial statement should be read in context with the industry the company is in.
the financial statement is a powerful tool to better understand a company. In fact, I am also still in the process of further deepening my understanding of the financial statements. The management may coat investors with nice narratives about the brilliance of the company but you can always cross check what the company is saying with their financial statements to gauge their reliability. Understanding the financial statements will definitely level up your investing many folds! 🙂