Tuesday, 15 May 2018

Education Series - Financial Statement: A Layman Overview

I will be having a talk on market outlook and investment insights, on 25 May (Fri), 730pm. I will also share stocks in my watch list, and how to structure a resilient stock portfolio. Register your attendance here

95% of investors, or my clients, shun financial statements like some kind of poison.

The truth is successful investment cant run away from Financial Statements. As Warren Buffet puts it, accounting is the language of business, presented in the form of Financial Statements. They are important documents that communicate to us investors, how well the business is doing.
But reading financial statements need not be such a painful experience. We do not need to know how statements are prepared, just like we don't have to know how a car engine works in order to drive one. With a little effort and some common sense, we can understand the gist of it, and interpret key numbers that illustrate the health of a business. 

In this article I would try to give an overview, a primer, on the Financial Statements, using plain simple English for a layman's understanding. 

Income Statement 
Think of it as a student's quarterly report card after term exam. This is the first statement an investor should look at.

This is also known as Profit and Loss Statement (P&L).

Companies sell products or services, bring in revenue (topline). In the process, it incurs expenses: raw material, machines, hardware, factory rental, marketing costs, workers salary etc. Taking away all these, gets you the earnings (bottom line). 

For those companies which require much raw materials in for goods production, the raw material cost would usually be grouped under Cost of Goods Sold. These are the expenses most directly related to production.

Other cost components that are not directly linked to production, but equally important in the company's operation, are termed as operation cost. Examples are marketing, advertising, rental, manpower.  

Sometimes a company can be huge, with many subsidiary and associates. The profit or loss of these subsidiaries are also consolidated under Income Statement. 

Balance Sheet
Think of it as a report documenting all the items in your home after a huge spring-cleaning. These items can be self-owned, or borrowed from friends.

Now apply this idea to a company. Similarly, Balance Sheet represents what the company owns and owes.

The gist of Balance Sheet is that Assets equal Equity plus Liability which is Accounting 101. It would be helpful if we think about these from the perspective of company.

As a company, you would have two sources/forms of funding to purchase all the required materials and equipment to start operation. You can either get loans from bank, or seek funding from shareholders which include individuals or other entities.

All the items bought using bank loans are liability, because technically the company does not own them. The bank does.

All items bought using shareholders' money are equity, owned by shareholders.

Putting both together, all things are assets that the company can make use of to get its business running. Thats the reason Assets always equal to Equity plus Liability - either purchased using bank loan or shareholders' money. 

Cashflow Statement
Most layman have big big question mark when it comes to Cashflow Statement. Why do we have P&L yet cashflow statement exist?  

One main reason is timing of payment or debt collection. As most of a company's business is done on credit terms, meaning customers do not pay immediately upon receiving an invoice, but instead make payment 1 mth or 3 mths later. Hence there is a time lag between recognising the revenue at point of invoicing, and receiving the payment (cash inflow) 3 mths later.

There are many other reasons but they are not within the scope of this article. And I would not want to bore readers with accounting terms. 

So the cashflow statement aims to provide a more accurate picture to the health of a company, from the cashflow perspective. After all, cash is king. 

What we should pay attention to in the Cashflow Statement is the Net Cashflow from Operations, ie actual amount of cash that company brings in through its day-to-day operating activities.

There are other parts such as Net Cashflow from Investing and Financing. Lets leave them for future pieces when we delve deep into each statements. 

There you go. a very brief but layman description of the three Financial Statements.


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