“If you get interested in a company and you read the annual report, you will have done more than 98% of the people on Wall Street. And if you read the footnotes in the annual report you will have done more than 100% of the people on Wall Street” – Jim Rogers
The Annual Report of a company provides information about the performance of a company’s business over a year’s time. It’s like our credit report where bank uses to assess our credibility for a loan or credit card applications to be approved. Howard Marks, in his book “The Most Important Thing”, mentioned that investors can only achieve above average return either by having sheer luck or superior insights about a particular company. Obviously, sheer luck are not going to give us consistent returns. As such, we must have superior insights and one of the way to achieve this is to read the Annual Report.
The Annual Report contains two key information, 1) Chairman Statement/ Management Discussion & Analysis; and 2) Financial Statements. We will be focusing on the latter because we understand that reading the financial statement is particularly difficult for people without accounting background (maybe that’s why it deters people from reading it). This post and the next three posts aim to provide you a simple guide to understand the Financial Statements. Hopefully, it helps you in your investment journey.
The 3 Key Financial Statements You Need To Know
There are a total of 4 financial statements but we only need to focus on 3 out of the 4 statements. All these Financial Statements are built on several accounting principles but as far as reading the Financial Statement is concern, you just need to understand the two most important concepts which is the “Prudence Concept” and “Accrual Accounting”.
As the name suggest, all Financial Statements should be prepared in a conservative (another word for prudence) manner where revenue and assets should not be overstated while expenses and liabilities should not be understated. Based on this concept comes the Accrual Accounting.
Under the accrual concept, revenues are recorded in the Income Statement when goods has been delivered to customers not when cash is received. Similar to expenses where it is recorded in the Income Statement when orders has been committed not when cash is paid to suppliers.
The implication of accrual accounting is that certain items in the Income Statement may not reflect the real cash movement in the business such as the purchase of goods from supplier. The amount committed may not be paid now but at a later date. Despite this, expenses will still be recorded in the Income Statement.
Now that you understand these two accounting concepts, let me give you an overview of the 3 key Financial Statements:
1. Income Statement (a.k.a. Statement of Profit or Loss & Other Comprehensive Income)
As the name suggests, it shows how income is generated from a business and its expenses incurred for generating such income. Ultimately, it gives us an idea of how profitable the business is. The figure above shows the typical sections that you will see in a company’s income statement.
To understand each category, let’s imagine you as a corporate professional (see below):
The revenue is equivalent to your monthly salary earned from working in a corporate firm from 9am to 5pm every Monday to Friday while expenses is equivalent to the monthly bills that you required to pay such as car loan instalments, phone bills, credit card bills and tax. The surplus amount is your savings.
2. Balance Sheet (a.k.a. Statement of Financial Position)
A Balance Sheet shows the net worth of a company and it is present based on the basic accounting equation of “ASSETS = LIABILITIES + EQUITIES”:
What the equation means is the Assets own by the company is finance by Equity (a.k.a. shareholders’ equity) and Liabilities (i.e. borrowings). This is similar to your personal net worth statement where it shows what assets you own (i.e. real estates, shares, cash in bank, etc.) and these assets you owned is funded by either your savings (Equity) or loans (Liability) or both.
3. Statement of Cash Flows
The Cash Flow Statement shows how the money flows into the business and out of the business. The picture above simplifies what you will see in a Cash Flow Statement.
Operating Cash Flow
This refers to the cash inflow or outflow due to the operation of business activities (i.e. purchasing of inventories, payment to suppliers, receiving of cash from customers, etc.).
Investing Cash Flow
This refers to the cash inflow or outflow due to investment made by the business (i.e. purchase of property, plant or equipment for business purpose, placement of cash into unit trust or fixed deposits, etc.).
Financing Cash Flow
This refers to the cash inflow or outflow due to the capital used to finance the business (i.e. repayment of borrowings, dividend paid to shareholders, issuance of shares, proceeds from undertaking loans, etc.).
If you look carefully, all 3 sections are inter-related. Let’s say you have a café business, the cash you received from selling food or beverages is called operating cash inflow. When you use these cash to purchase a coffee machine, this is known as purchase of machinery hence, it’s a form of investing cash outflow. If you purchase the coffee machine using funds from bank borrowings, this is a financing cash inflow because you borrow money from the bank.
How the 3 Key Financial Statement is connected
The diagram above illustrates how the 3 key financial statements are inter-linked:
Before starting any business
#1: You will need capital to purchase assets and this is funded either through your savings (Equity) or borrow from banks (Liabilities). The cash received from borrowings or your savings will be reflected under “Financing Cash Flow”.
#2: You probably need to buy some assets using the cash you just received from borrowings or your savings. This will be reflected under “Investing Cash Flow”.
Once business is opened
#3: The purchased assets will be use to generate “Revenue” and “Net Profit” after deducting all “Expenses” incurred including tax. The cash movement is when you receive cash from selling the goods and buying ingredients to make the goods ready for selling. This will be reflected under “Operating Cash Flow”.
#4: The “Net Profit” generated will goes to “Equity” if you choose to reinvest into your business.
Do you see the relation between these 3 Key Financial Statements? I hope you do. In the next 3 posts, we will examine each of this Financial Statement further using a café business as an example and also some real Malaysian companies to help you understand better. Stay tuned!
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