The Annual Report of a company provides information about the performance of a company’s business over a year’s time. It contains two key information, 1) Chairman Statement/ Management Discussion & Analysis; and 2) Financial Statement. In this post, I will guide you on how to read the financial statement. This is because it can be difficult for people without accounting background.
“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
Financial Statement is like our credit report where bank uses to assess our credibility for loan or credit card applications. There are a total of 4 financial statements in an Annual Report. You only need to focus on 3 out of the 4 statements. Before we dive deep into each statement, you must know that they are built based on several accounting principles.
But as far as reading the Financial Statement is concern, you need to understand the two most important accounting concepts:
As the name suggest, all Financial Statements should be prepared in a conservative (another word for prudence) manner. This means you should not overstate the revenue and assets and also understate the expenses and liabilities. Based on this concept comes the Accrual Accounting.
Under this concept, revenues are recorded in the Income Statement when goods has been delivered to customers not when cash is received. Similarly, expenses are recorded in the Income Statement when orders has been committed not when cash is paid to suppliers.
The implication of this is that certain items in the Income Statement may not reflect the real cash movement in the business. For example, the purchase of goods from supplier. Companies usually record this amount committed first in its Income Statement and pay at a later date. This is known as credit purchasing.
It’s like you buy an iPhone using credit card. The amount will show in your statement but it does not mean that you have paid for it. There is no real cash movement here. This is what accrual accounting means.
Now that you understand these accounting concepts, here’s an overview of the 3 key Financial Statements that you need to know:
#1: Income Statement
More commonly known as Statement of Profit or Loss and Other Comprehensive Income. It shows how a business generates income and expenses. This is important because 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.
Your monthly salary earned from working in a corporate firm is equivalent to revenue of a business. While your monthly phone bills or credit card bills is the expenses of a business. And finally, any surplus amount is your savings.
#2: Balance Sheet
More commonly known as Statement of Financial Position. This is important because it shows the net worth of a company. Usually, it is present based on the basic accounting equation, “ASSETS = LIABILITIES + EQUITIES”.
The above equation means that Assets are 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. For example, your house can be funded either through your savings (Equity) or loans (Liability) or both.
#3: Statement of Cash Flows
The Cash Flow Statement shows how the money flows within the business. The picture above simplifies what you will see in a Cash Flow Statement.
Operating Cash Flows
This refers to the cash inflow or outflow due to operation of business activities. For example, purchasing of inventories or payment to suppliers.
Investing Cash Flows
This refers to the cash inflow or outflow due to investment made for the business. For example, purchasing of property, plant or equipment.
Financing Cash Flows
This refers to the cash inflow or outflow due to the capital used to finance the business. An example would be repayment of borrowings.
How the 3 Key Financial Statements is connected
If you look carefully, all 3 sections are inter-related. Let’s say you have a café business, the cash you received from selling F&B is called operating cash inflow. When you use these cash to purchase a coffee machine, it’s a form of investing cash outflow. If you purchase the coffee machine using bank borrowings, this is a financing cash inflow.
The diagram above illustrates how the 3 key financial statements are inter-linked:
Before starting any business
- You need capital to purchase assets. You can fund this either through your savings (Equity) or borrow from banks (Liabilities). This will be reflected under “Financing Cash Flow”.
- You probably need to buy some assets using the cash you just received from borrowings or your savings. This will then be reflected under “Investing Cash Flow”.
Once business is opened
- 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”.
- 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? If you do, let’s go deeper into each of this Financial Statement. Click on the following link to read more:
|1||How to read Income Statement|
|2||How to read Balance Sheet|
|3||How to read Cash Flow Statement|
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