Tuesday, June 23, 2009

How to Interpret the Financial Statement of a Company


The recent global financial crisis and its attendant effect, calls for a deeper understanding of the financial statement of companies before investing your hard earned money with them. I have always advised that there is no better time to invest in the stock market than now. However, while embarking on such investments, there are certain fundamental analyses of company’s results which you should be independently familiar with. This does not however suggest that you should ignore the advice of an expert in investment matters. Once you purchase the shares of a company, you are by law a shareholder of the company and as such entitled to all benefits and privileges accruing to members of the company. As a shareholder, you are entitled to your opinion in the decision making process of the company. Access to financial information of the company cannot be restricted to you.

It has been observed that as a result of people’s inability to analyze a company’s financial statement; they more often than not ‘invest blindly’. In effect, people buy into companies not knowing its going concern ability. This is largely due to poor understanding and interpretation of financial records. In most cases also, people that can analyze financial statements do not take the pain to do the necessary home work before investing. They use various techniques which cannot be proved to take investment decisions. Sometimes, people loose their monies as a result of bad investment decision.

The financial statement of a company usually comprises of the balance sheet and profit & loss account. The balance sheet is technically defined as a financial statement that summarizes a company's assets, liabilities and shareholders' equity at a specific point in time. It is a snapshot of what a company owns and owes at any point in time. These three balance sheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by the shareholders. It follows therefore that the two sides of a balance sheet must balance out. This is so because a company has to pay for all the things it has (assets) by either borrowing money (liabilities) or getting it from shareholders (shareholders’ equity). Each of the three segments of the balance sheet will have many accounts within it that document the value of each. Accounts such as cash, inventory and property are on the asset side of the balance sheet, while on the liability side there are accounts such as accounts payable or long-term debt. The exact accounts on a balance sheet will differ by company and by industry, as there is no one set template that accurately accommodates for the differences between different types of businesses. It is set out in a number of possible standard formats.
Balance Sheet Formula:

Assets = Liabilities + Shareholders' Equity
Assets – They re assets owned by the company. It is divided into Fixed and Current Assets.

Fixed Assets such as buildings, machinery and equipments are the assets that generate wealth for the business over time.

Current Assets are the assets that are used up in generating daily revenues for the business. They are assets that could be turned into cash in the short period.
Liabilities – This is what the business owes. It is divided into:

Long-term and short-term liabilities depending on the payment period. The creditors due within one year (short-term liabilities) must be paid within, in most cases, one year while creditors due after more than one year (long-term liabilities) e.g. mortgage loan, takes a longer period.

On the other hand, the Profit & Loss Account (P&L) is a report of the company's profit on the sale of their goods or the provision of their service over a trading period, normally one year. It shows at a glance the income (sales) and cost of sales (expenses incurred) for a particular period, usually one year. It is made up of the following three parts:

1. The Trading Account – This records the money received (revenue) and costs of the business as a result of the business trading activities, i.e. buying and selling. It might be buying raw materials and selling finished goods etc.

2. The Profit and Loss Account – Ordinarily, it starts with the Gross Profit derived from the Trading Account. Other revenues and expenses are added and deducted appropriately. Thereafter, a Net profit is or loss is obtained.

3. The Appropriation Account – This shows how the profit is appropriated or divided during a particular period.

It is advisable to obtain the financial statements (audited accounts of a company) for the previous 5 years so as to arrive at an objective investment decision. In arriving at the decision it is necessary to understand the computation of the following:

Return on Capital Employed (ROCE) – This is a measure of the efficiency of the use of resources.
= Profit before Interest and Taxation X 100
Capital Employed

Current Ratio – This ratio gives a measure of the short-term safety of the firm. The current assets are those that could be turned into cash in a short period of time and the current liabilities are those liabilities which might have to be repaid at short notice. Therefore, the higher the level of current assets in relation to current liabilities the less likely it is that the firm will be unable to meet its short-term liabilities.
= Current Assets
Current Liabilities

Acid Test Ratio – It is also called Quick ratio. It is the ratio of current assets less inventories, accruals, and prepaid items to current liabilities.
= Current Assets – Stock
Current Liabilities

Usually, liquidity is measured by current and acid test ratios which reflect the ability of the company to meet its current liabilities as at when due. A current ratio of 2:1 and acid test ratio of 1:1 is generally considered healthy in most instances.
Net Assets Turnover = Sales
Net Assets

Fixed Assets Turnover – This is a ratio that measures the efficiency of the firm. The higher the level of sales generated by each 'unit' of fixed assets the more efficient the firm might be thought to be.
= Sales
Fixed Assets

Debtors Collection Period = Average Debtors X 365
Credit Sales

Stock Turnover = Cost of Sales
Average Stock

Gearing Ratio – This is also referred to as leverage ratio. It shows the relative amounts of capital provided by shareholders (equity) and those lending money to the firm in the form of credit of one type or another (debt). Ordinarily, firm is said to be highly geared it has a high level of debt and a relatively low level of equity. Conversely, if a firm has low gearing it will have financed its assets mainly from equity and will only have a little debt. As debt is usually cheaper than equity, it is profitable to have some debt in the firm as this means that the funds required can be raised a little more cheaply. Therefore, low gearing ratios could mean that the firm is paying too much for the money it is raising to finance its assets. Maybe it should be borrowing some 'cheap' debt to purchase assets rather than use more expensive equity. However, high gearing ratios mean that the firm has a lot of debt. In this case, if interest rates rise and profits fall the firm might not make enough money to pay its interest payments. Thus, high gearing is seen as being somewhat risky. Also, the risk of defaulting on interest payments increases as gearing rises.

= Long Term Debts
Shareholder’s Equity

The above analysis of the company’s financial statements notwithstanding, it is also necessary and advisable to consider the opinion expressed by the External Auditors of the company, usually contained as part of the financial statement, as to the going concern ability of the company. A going concern concept assumes that the business unit will operate in perpetuity, i.e. the business is not expected to be liquidated in the foreseeable future. The business is capable of earning a reasonable net income and there is no intention or threat from any source to curtail significantly its line of business in the foreseeable future.