Financial Statements
- Assessment, Key Performance Indicators
Understand & Interpret Financial Statements
Understanding a financial statement and being able to spot the key potential benefits and hidden risks are key elements for anyone who intends to learn about a business. The financial statements comprise five different segments – the Balance Sheet (or Statement of Financial Position), Income Statement (or Statement of Financial Performance), Cash Flow Statement, Statement of Equity, and a set of accompanying disclosures. By aggregating the relevant information as presented in the financial statements, advanced users who can professionally interpret the documents will benefit from gaining an in-depth understanding of a company’s historical and current financial results, the variation in financial position, cash flow healthiness, and other key information of the company.
Parties who are frequent users of financial statements include but are not limited to investors, analysts, banks, regulatory bodies such as the tax office and/or governing bodies of publicly-held companies, and many more. Each party has different objectives to attain from reading the financial statements. For instance, investors reading financial statements may need to make a critical decision, such as whether to invest in or lend money to an organization, or in some cases, to acquire a targeted business. If so, it is essential to extract as much information as possible from the financial statements to aid in making the decision. For companies that issued financial statements, the financial statements represent a primary means of communicating with the users, and therefore, executive members and management are recommended to highly prioritize the task of determining what types of key messages will be circulated among different user communities in the market. Our Accounting and Finance Team have acquired relevant expertise to assist with how to do so. Although interpreting financial statements should be viewed as a whole to draw an overall valid conclusion, some specific aspects of our guidance in assisting with interpreting the financial statements comprise the following.
Cash and Investments
Cash and investment items are normally the first two separate items commonly found in the balance sheet. It is denoted as the current cash balance and cash invested in financial instruments of high liquidity. Under its high liquidity nature, amounts contained in these items are essentially the immediate source of liquidity for a business. Our specialized team could assist with sharing relevant issues related to these two line items as well as other related aspects that enable the users to obtain a broader perspective in determining whether the company has a sufficient amount of cash on hand or highly liquid assets.
Receivables
The receivable line item on the balance sheet contains the summary of amounts owed to the company by its customers as a result of extending credit to its customers, representing a common practice in most companies. The receivables area must be examined closely as it directly impacts the liquidity of a business since it comprises cash not yet collected, and some may be long overdue or have become uncollectible.
Inventory
Inventory for certain businesses such as the manufacturer, retailer, wholesaler, and those which dealt with the exchange of goods, is potentially one of the largest asset items on the balance sheet. Embedded underneath inventory items contain the different types of inventories that are within the possession of the business. Inventory asset is a key aspect of doing business for a certain business. For example, a wholesaler is usually heavily stocked with inventories to fulfill customer orders. Likewise, a manufacturer may maintain a certain level of inventory such as raw materials to ensure the continual production process. In other words, maintaining a significant inventory level for certain businesses is not an option but a key requirement of its business model. Maintaining a high level of inventories will potentially expose the company to a series of risks, such as aging problems and obsolescence. Furthermore, a low inventory turnover will also mean a significant amount of working capital of the company is tied down in inventory which could potentially lead to liquidity issues. Therefore, given the significant risks, the inventory-related problem will be a notable risk if not closely monitored.
Fixed Assets
For a company that operates in an asset-intensive industry, this line item is usually the largest investment for the company. As suggested by its name denoted as fixed, this line item of asset is generally harder to convert to cash at a reasonable price. Therefore, any investment in this area should be closely monitored. Common key conclusions to be drawn from the financial analysis of fixed assets include an understanding of the reasonableness of a company’s investment in this area, how fixed assets affect the profitability of the business or return on fixed-asset investment, and other aspects comprising the choice of accounting methods that could alter the outcome of the reported fixed assets.
Other Assets
The common asset items embedded underneath the Other Assets line item are usually the Prepaid Expense account and Goodwill account. They are relatively easier to analyze even though certain accounting adjustments of these assets, in particular the Goodwill account, which is a theoretical asset in essence but any major adjustment such as impairment will have a significant impact on the balance sheet and income statement. Both asset items required a reduced level of analysis but they are good indicators of other issues of a business.
Current Liabilities
Current liabilities summarize all financial obligations of the company that are due within 12 months. Parties to which the company owed the payable obligations include a broad of parties, ranging from suppliers, lenders, and government to employees and possibly customers too. Since it represents the financial obligations of a company, it provides valuable insights into the financial condition and possibly the liquidity of the company. For users to fully extract information from this section, it requires interpretation in multiple aspects including the presentation, measurements, and some notable issues relating specifically to current liabilities.
Debt
Debt is a watchful area that users need to fully interpret. Debt is a double-edged sword, if it is used properly, it may be the primary key supporting factor to corporate growth. However, a poorly controlled use of debt funding coupled with undertaking an excessive amount of debt could mean the company is at the edge of bankruptcy. Furthermore, the debt level needs to be constantly monitored because the business’s ability to continuously support the debt may change in a short timeframe. Therefore, similar to Current Liabilities, to fully extract information from this section requires an in-depth interpretation in several aspects including the presentation, measurements, and specific issues in association with debt.
Equity
Shareholders’ equity essentially reports the investors’ investments in the business, deducting any dividends or profit distributed to investors and aggregating any profit that has been historically accumulated or deducting any cumulative losses. For businesses engaged in a broad array of fundraising activities via equity funding, there is a crucial input in this section.
Sales
Needless to say, sales or revenue is probably the first line item in the income statement most parties will be looking at. Sales are closely monitored by all parties as it is the prime success indicator of any organization attracting new customers while obtaining more sales from existing customers. Typically, the sales concept is interpreted as an increase in assets or decrease in liabilities in tandem with sales of products and/or the provision of services to customers. Special attention is to be drawn to the difference between gross sales and net sales. Net sales are generally the end output of gross sales, after deducting any sales return and/or sales discount. As sales contain a significant amount of useful information, in particular when it is interpreted together with other information in the financial statement such as operating cash flow, segmental reporting, and other supporting disclosures, parties must analyze sales from a broad perspective, covering sales presentation in the income statement and other specific issues to form a valid conclusion on the overall sales performance during the reporting periods.
Cost of Sales and Gross Margin
Generally, the cost of sales concept refers to the cost of sales for services provision and/or cost of goods sold to customers. In other words, the cost of sales is the direct costs that correlate to generated sales. The more complex version of the cost of sales is the cost of goods sold, which comprise direct labor, costs of materials, and related overhead incurred. Upon subtracting the Cost of Sales from Net Sales, the outcome is Gross Margin which represents the subtotal of profitability of a company before deducting any operating expenses. Comparing gross margin with the same historical line items gives parties critical information such as whether the gross margin increases or decreases over the comparative periods. Gross margin is not only a subtotal that shows how much money was made before additional operating expenses deductions, but also it demonstrates how effective and profitable is the primary operating activities and business model of the company. To gain a full perspective of the line items, parties are recommended to be aware of the contents of costs of goods sold or cost of sales, the reasons that support the changes in the relevant expenses, and most of all, in what situations should the parties rely on gross margin analysis.
Operating Expenses
Operating expenses refer to all costs other than direct expenses as outlined in the cost of services or cost of goods sold line item, and its presence is crucial to sustaining the operation of the company. Generally operating expenses comprise selling and marketing costs, costs related to financing, accounting, research & development, and corporate and other related costs. The operating expenses are generally classified as Selling and Marketing, General and Administrative, and Finance Costs in the Financial Statements.
Other Income, Taxes, and Profits
Upon examining the abovementioned line items, there are several residual line items situated at the bottom of the income statement. One of which is frequently subjected to scrutiny is Other Income. The income tax expense represents the corporate income tax liabilities of the company but despite its importance, it is often ignored by casual readers who perceived the income tax as merely a simple percentage of earnings. On the contrary, the amount of income tax expense may deviate significantly from the assumed percentage of earnings, and many factors are causing this deviation that is not apparent to inexperienced readers. Parties should not overlook these residual line items in the income statements and are recommended to understand the implications of the relevant changes to the amounts as well as their relationships with other line items in the financial statements.
Cash Flow
The relevant cash flow line items as presented in the Statement of Cash Flow provide valuable information to all parties, in particular the assessment of the liquidity healthiness of the company. Cash flows remove the accounting accrual effects as shown in the income statements. Under the accrual accounting approach used in preparing the income statement, a certain company sometimes may have reported significant profits, but its bank account balances have been drained. Therefore, it is highly crucial for users to fully understand the cash flow performance of the company, probably more in-depth than its profitability assessment. There are different activities in the statement of cash flow, which generally categorize cash flow activities into three main categories – Operating, Investing, and Financing activities. Although cash flow activities generally comprise a series of activities ranging from paying employees and suppliers, buying securities, and cash collection from accounts receivable to cash receipt from loans and/or selling the company’s shares, the main focus in most companies is the cash flow line items related to operating activities, as it demonstrates how strong is the existing business model of the company in generating cash flow from its core operations. Naturally, if the company is generating sufficient cash flows which are higher than its cash flow balance at the beginning of the accounting reporting date, cash flows are considered to have a positive cash flow. Attributable to the significant nature of cash flows, parties are recommended to thoroughly understand the implications of the relevant changes to the amounts as well as their relationships with other line items in the financial statements.
Other Analysis
The main emphasis of our services encompasses the close examination and scrutiny of individual line items in the financial statements some of which were mentioned above, as well as the deployment of ratio analysis on respective line items. In addition to these analyses and line item examinations, there is other information that is valuable to users, such as analyses that relate to breakeven, working capital, dividend performance, and many more. Furthermore, there are different types of audit opinions and each of these opinions refers to different risks in using the financial statements.
Additional Public Company Information
If a business is a publicly-held entity, the amount of information available is vastly greater than just the financial statements since relevant regulatory bodies usually require a massive amount of additional reporting and contain different reporting deadlines. According to the general norms of these requirements, the additional information comprises the following:
• Annual Financial Report. Although both private and publicly-held entities require to issue an Annual Financial Report in most countries, the level of depths of the reporting requirements is far more than private entities, and private entities are not required to publicly disclose their annual financial reports. Analysts and market researchers commonly regard the Annual Financial Report of publicly-held entities as their primary input source for their research and analysis.
• Half-Yearly or Quarterly Financial Report. Half-Yearly or Quarterly financial report is essentially the half-yearly or quarterly version of the Annual Financial Reports. Depending on regulatory governing bodies of the stock exchanges, some stock exchanges only require to issue half-yearly financial reports and others may require quarterly financial reports. Generally, the “shorter duration” versions of the financial reports have lesser filing requirements than Annual Financial Reports. However, it has tremendous value since it provides users with current updates of the core information that is found in the Annual Financial Reports.
• Special disclosures and Filing. For publicly-held companies, there are additional disclosure requirements for material events that will significantly impact the company. For example, in most stock exchanges, there are special disclosures and additional filings that relate to the shareholding of existing major shareholders, ownership changes, filings required when a company intends to sell a registered stock, major mergers, and acquisitions exercise, takeover, reverse takeover, and many more. Again, this information has great value to existing shareholders and new investors in their portfolio consideration, and therefore, in-depth disclosures and filings are required.
We could assist with setting up a financial statement reviewing system for both the users and the companies, making proposals or corrective suggestions regarding key analyses that can be extracted from these reports and disclosures.
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