Beginner’s Guide To Investing
HOW TO READ A FINANCIAL STATEMENT
When you start analyzing a company, you have got to know some basic accounting. We are not talking about being about to do double entry on a ledger but we would at least need to be able to read a financial statement.
You can easily access a company financial statement from its investor relationship website. Most companies would have such a site. You can search for it on Google by typing “COMPANY NAME Investor Relations”.
For example, a search for CapitaLand Investor Relations on google will bring me to this page: http://capitaland.listedcompany.com/
A search on Google.
You can then download the annual reports from the website to find out more about the company and its financials.
The three main financial statements you would need to be able to read are:
- Balance Sheet
- Income Statement
- Cash Flow Statement
The balance sheet is a snapshot of the health of the company at a specific point in time. Therefore, you can think of the balance sheet as a photograph. It is a photograph of what the company owns and owes at that point in time. This is a sample balance sheet of Lenovo Group, the largest computer manufacturer in the world.
Source: Lenovo Group Annual Report
These are assets that the company owns that are not planned to be liquidated into cash in the near future. As a rule of thumb, most company records assets that as non-current assets if it is to be kept as its current form for more than one year.
Property, plant and equipment
These are the hard asset investment made by the company. This includes its properties such as offices or factories. Its renovation, cars, computers, and other equipment that help the company in its operations.
Prepaid Lease Payments
The money that the company has prepaid for its leases.
Property, plants and equipment that is currently under construction.
Assets like goodwill, software, rights, concession and other intangibles.
Interests in Associates and Joint Ventures
Investments in associates or joint venture companies.
Deferred Income Tax Assets
Tax assets that the company could potential claim back.
Available-For-Sale Financial Assets
Financial assets such as equities or bonds the company bought as investments
Assets of the company that could readily be converted back to cash, typically within a span of one year.
Finished items or work-in-progress that will be sold in the future.
Receivables from customers that have been billed but payment have not been collected.
Other receivables from investments.
Derivatives Financial Assets
Value of the short-term hedging or speculative instruments.
Deposits, Prepayments and other receivables
As the name suggest.
Cash & Cash Equivalents
The Balance Sheet of Lenovo Group (HKG:0992)
Let’s take a look at the liabilities and equity side of a balance sheet.
The invested capital from its shareholders.
Value of equity typically generated from profits.
Equity attributable to owners of the company
The book value to shareholders.
Other non-common share equity holders of the company, such as preference shares.
Equity owned by non-shareholder of the companies.
The long term liabilities such as debt, bonds and other liabilities of the company that would need to be pay back after a few years, typically over one-year period.
Long term bank loans or bonds of the company.
Warranty liabilities for its products.
Collected but unearned revenue.
Retirement Benefit Obligations
Long-term employees’ benefits that have not been paid out.
Deferred Tax Liabilities
Possible tax liabilities that the company would need to pay in the future.
Liabilities that are due within a year.
Amount owning to suppliers of the company.
Outstanding payment that need to be paid out to bond holders within the next year.
Provision for losses or warranty in the near future.
Income Tax Payable
Unpaid current year income tax.
From the balance sheet, we are able to tell the health of the company at that point in time. We can see if the company have enough assets to cover its liabilities, and that it has the funds to survive in the next year or so.
The income statement records what the company has done over the past financial year from how much sales it has made to its expenses for the year to the net profit of the company. Here is a line-by-line description of an income statement.
Lenovo Group’s Income Statement for FY2016.
This is the sales that the company has made over the year. Bear in mind this does not represent the “cash” collected by the company, but rather just the billed amount.
Cost of Sales
These are the direct cost of the product and services that were sold. This might include inventory cost or direct labour cost.
Gross profit = Revenue – Cost of Sales. This is the profit generated by the sales minus off its cost of sales.
This include other income that are not generated from the core business. Income can be things like rental, government grants and maybe rebates from suppliers.
Selling and Distribution Expenses
This is the cost related to the operating expenses of selling and shipping out the product or services.
This is the administrative expenses of running the company.
Research and Development Expenses
This is the research and development expenses incurred during the year. Typically, R&D cost are not allowed to be capitalized unless you have proven that the technology or product developed has monetary value.
This is the operating profit of the company. You can calculate this by using:
Gross Profit minus all the line items before Operating Profit.
This is the income generated from its cash investments.
It is the cost associated with its debts and other borrowings.
Share of Profits/(Loss) of Associates and JV
This is the profit or loss share of the company from its associates or Joint Ventures.
Accounting Tax for the year. This might be different from the actual tax paid during the year.
This is the final profit figure for the company net of all expenses during the year.
Earnings Per Share
This is the net income figure translated to a Per Share basis for shareholders.
Cash Flow Statement
Moving on to the Cash Flow Statement of a company, this is the statement that shows the actual cash movement within a company. You will be able to use this statement to view how much cash is generated from the business, how much it has reinvested in its business or how much the company has repaid or took on new loans. More important, it is an essential financial statement to calculate the free cash flow of a company.
Cash Flow Statement of Lenovo Group for FY2016
Cash Flows Generated From Operating Activities
It is the cash collected by the company from its operations during the financial period.
Cash Flows From Investing Activities
This segment show how the cash is moving for the company in term of its investments. This can include capital expenditure, sales of assets, buying or selling or short term assets and even dividends and interests from its stocks and bond investments.
Purchase of Property, Plant and Equipment
Additional cash payment for property, plant and equipment during the year.
Purchase of Prepaid Leases
Additional cash payment for prepaid leases during the year.
Sales of PPE and Prepaid Leases
Sales proceed from selling its property, plant and equipment or prepaid leases during the year.
Interests Acquired in Associates and Joint Ventures
New investment into associates and joint venture companies.
Net Proceed from Disposal of An Associate or Joint Venture
Cash proceed from selling interests in an associate or joint venture.
Payment for Construction-In-Progress
Cash payment for buildings under construction.
Payment For Intangible Assets
Cash payment for buying intangible assets like goodwill, I.P. or software.
Purchase of Available-For-Sale Financial Assets
Cash purchase of financial assets.
Dividend and Interests Received
This is the cash received from its financial assets’ dividend or bond interest payment.
Cash Flows From Financing Activities
This portion shows how the cash movement of the company due to its financing needs and payoff.
The cash dividend paid out to shareholders over the year.
Issue of Perpetual Securities
The cash proceed the company received from issuing new securities.
Proceed of Borrowing.
This is the cash proceed from taking on more borrowings.
Repayment of Borrowing.
This is the cash repayment of its borrowing.
Effect of Foreign Exchange Rate Changes
This is the changes due to just the fluctuation of foreign exchange rate during the year.
When we add up all the sum of the cash flow from the three segment, we should be able to see how the cash balance from last financial year change to the cash balance of this financial year.
Common Financial Ratios To Take Note Of
From the financial statement, we are able to view all sort of data about a company. Many of them are done through the help of financial ratios. Some of the common financial ratios allow us to see:
- Profitability Ratio: how profitable the company is.
- Solvency Ratio: How strong is the company’s balance sheet
- Liquidity Ratio: Does it have enough liquid assets to meet its liabilities
- Efficiency Ratio: How well it is utilizing its assets
Gross Margin: Gross Profit / Revenue
This shows the markup of the product between its selling price and its cost to produce. For each, if a widget is sold for $100 but cost $50 to make, we say that the widget has a gross margin of ($100-$50)/($100) = 50%.
Operating Profit Margin: Operating Profit / Revenue
This is the measure of how profitable is the business after deducting for its operating expense as well. Going back to the previous example, if the company has a gross profit of $50 but need additional $30 in operating expenses such as sales and distribution, administrative expenses to run the business, then its operating profit will only be $20. That means that its operating margin will be $20 / $100 (Revenue) = 20%.
Return on Assets
As the name suggested, return on assets is a measure of how profitable a company is based on how much assets have been invested to generate that profit. The formula for return on assets is:
ROA = Net Income / Average Total Assets
The average total assets is the average of beginning and ending balance sheet assets during that financial year. A company with a ROA of 5% would mean that the company is able to generate $5 of profit for every $100 of assets it invested into.
Typically, the higher the ratio means the better return the company is generating.
Return on Equity
Return on equity is a measure of how profitable a company is based on how much equity is being invested in. The formula for ROE is:
ROE = Net Income / Average Shareholder’s Equity
Again, the average equity is just the average between the beginning and ending equity figures of the company during the period. If the company made $5 in profit but has $50 in shareholder’s equity. This means that the company has an ROE of 10% during the period. Generally, the higher ROE is better for the shareholders.
Leverage is a way to gauge how stressed is the company’s balance sheet. It is to show how much of the company assets are being financed by its equity. The formula for leverage ratio is:
Leverage = Total Asset / Total Equity
A company is deemed as less risky or financially less stressed is a large portion of its assets are being financed by its equity.
If a company has a leverage ratio of 2, it means that for every dollar of equity the company has, it is used to finance $2 of assets. Typically, the higher the number, the more risky the company is financially.
Debt To Equity Ratio
Another more direct method to measure solvency is through its debt to equity ratio. Instead of measuring the entire asset base of a company, we only look at its debt to its equity. This is because debt holders are place higher legally to the rights of the company’s assets. So if a company faces bankruptcy, the debt holders will be paid first before the equity holders. As an investor, we would want a company to have a lower debt to equity ratio to ensure our rights to the company is not threaten in the event of a crisis.
A company with a debt to equity ratio of 1 means that for every dollar of equity, the company also raised one dollar of debt.
Liquidity Ratio is a measure of how prepared a company is to fulfilled its short-term liabilities obligations.
Current ratio helps investors determine if a company has enough current assets to cover its current liabilities. The formula is:
Current Ratio = Current Assets / Current Liabilities
A company with a current ratio of less than 1.0 means that it has current liabilities obligations that is larger than all its current assets. Thus, such a company might run into a risk of having not enough liquidity to cover all its short-term cost.
Quick Ratio takes the idea of current ratio one step future. This is because for some companies, their current assets might include items that are relatively illiquid in nature. This means it is hard to transform these current assets into liquid cash to meet the company’s obligation.
Thus, quick ratio only take into account assets that are easily convertible into cash and see if the company has enough liquid assets to cover its current liabilities.
The formula for Quick Ratio is:
Quick Ratio = Cash + Short-Term Investment + Current Receivables
The quick ratio will exclude items such as inventory and prepaid expenses as these items might not be easily converted to cash in a time of needs.
Similarly, if a company has a quick ratio of less than 1.0, then it might indicate the company does not have enough liquid assets to meet its liquidity needs in the short-term.
Efficiency Ratio is used to measure how well the company is managing its resources and the company.
Account Receivable Turnover Days
Account Receivable Turnover Days is a measure of how long does the company takes to collect back its account receivable on average.
The formula is:
Account Receivable Turnover Days = 365 x (Account Receivables / Total Sales)
For the financial year, we can take the average account receivables for the period divide it by the total sales during that period and multiple that figure by the term of the financial year (365 days).
If a company has an account receivable turnover days of 90 days, it means that the company was only able to collect back its account receivables after 90days on average.
Typically, a smaller figure here means the company is more efficient in managing its account receivables.
Account Payable Turnover Days
Account Payable Turnover Days is a measure of how long does the company takes to pay back its account payable on average.
The formula is:
Account Payable Turnover Days = 365 x (Account Payable / Total Cost of Sales)
For the financial year, we can take the average account payable for the period divide it by the total cost of sales (Total purchase) during that period and multiple that figure by the term of the financial year (365 days).
If a company has an account payable turnover days of 90 days, it means that the company was only able to pay back its account payable after 90days on average.
Typically, a larger figure here means the company has more pricing power over its suppliers. However, we would not want to see an extremely large figure here as that might mean the company could have liquidity issue in paying back its suppliers.
Inventory Turnover Days
Inventory Turnover Days is a measure of how long does the company takes to sell off all its inventory within a year.
The formula is:
Inventory Turnover Days = 365 x (Ending Inventory / Total Cost of Sales)
For the financial year, we can take the ending inventory for that period divide it by the total cost of sales (Total purchase) during that period. Then we can multiple that figure by the term of the financial year (365 days).
If a company has an inventory turnover days of 90 days, it means that the company was only able to sell off all its inventory after 90days on average.
Typically, a smaller figure here means the company is more efficient in managing its inventory.
Cash Conversion Cycle
The Cash Conversion Cycle (CCC) is a measure of how efficiency is money flowing within the company and if the company would need a large or small working capital to run its operations.
The formula for CCC is:
Cash Conversion Cycle = Account Receivable Turnover Days + Inventory Turnover Days
– Account Payable Turnover Days
Basically, CCC is the sum of how long the company take to sell off its inventory and collect back the cash from its customers. But we need to subtract that sum from the number of days the company can delay paying its suppliers. The result is the number of days the company takes to generate new cash into the business.
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