Summary of "Financial Reporting is a Storybook".
Financial reports are the starting point for investors to understand how a company is doing. Anyone interested in stock investment should know the basics of financial reporting and how to read it. Although this is an old saying, there are still many people who only care about the news when they buy stocks, or who only read the so-called technical analysis without looking into the company's operation. The author of "Financial Reporting is Like a Storybook", Shun-Jen Liu, is a professor at the Department of Accounting, National Taiwan University. He is a professor at the Department of Accounting, National Taiwan University. He explains accounting knowledge related to financial reporting in great detail, which is very helpful for beginners who want to learn the meaning behind financial reporting figures. Especially in this book in each chapter before and after the insertion of some stories naturally into the theme, so that the hard definition of financial statements seem to read a little more human flavor, is my very favorite point.
The following is a brief summary of financial reporting expertise.
What is financial reward?
Financial reporting generally refers to five statements: income statement, comprehensive income statement, balance sheet, statement of equity and statement of cash flow. There are five types of statements: a comprehensive income statement, a balance sheet, a statement of equity, and a statement of cash flow.
There are three main types of activities in a business:
- Market share activities: The activities that determine the growth of revenue and profitability, which are referred to as operating activities in financial reporting.
- Strategic planning activities: Proper planning determines future growth and is referred to as investing in financial reporting.
- Logistics Support Activities: For a business, this is cash flow. It is related to financing activities in financial reporting.
What the financial report tries to present is the status of the enterprise in these three major activities. By observing a series of financial reports and continuously dismantling the contents, we can see the character, business model, growth status of an enterprise, and understand the future development possibilities and potential risks.
These statements are a collection of financial figures designed to reflect the underlying economic nature of a company. Since figures are measured and estimated, there are errors in measurement and room for manipulation. Therefore, financial figures are in fact the result of the influence of these three elements:
Figures = Economic Nature + Measurement Error + Manipulation
When we look at financial reports, we need to bear in mind that there are measurement errors and possibilities of human manipulation, and analyze them in depth in order to have a more comprehensive understanding of a company's situation.
Generally Accepted Accounting Principles (GAAP)
The principles that govern the preparation of these statements are known as accounting standards. There is more than one organization that sets accounting standards, the FASB in the U.S., and the IASB, known as IFRS, which is the accounting standard followed internationally, including in Taiwan, with reference to accounting theory, and to a lesser extent by governmental regulations and industry pressures.
Income statement
There are three reasons for stock price growth: profit growth, profit growth, and profit growth.
The income statement is used to explain how a business's wealth has changed over the financial reporting period and to measure whether and how it has generated a net profit or a net loss. By looking at the growth in revenues and profits, we can see how competitive a company is. To get a quick overview of operating performance, you must look at the income statement.
The income statement as a whole is based on the following formula:
- earning = revenue - expense
Revenues are usually based on net sales, fees, and the like.
The following fees are common:
- Cost of sales: The acquisition cost of selling goods or labor.
- Operating, selling and administrative expenses: including, for example, transportation costs, administrative salaries, etc.
- Interest expense: Interest on short-term promissory notes, long-term debt, etc.
- Income tax expense
In some financial statements, there are other expenses, and the footnote should explain each item in detail. Basically, the company will list the items that are important to them, and from what items are listed, we can tell something about the characteristics of the company.
Measurement of income and expenses is now done on an "accrual basis", which is not the same as the commonly used method of "cash basis". On a cash basis we only recognize income or expenses when money is received or paid, whereas on an accrual basis income or expenses should be recognized whenever there is an entitlement to receive or an obligation to pay. This is because the use of a cash basis is more likely to be manipulated because it can change the financial figures due to changes in the date of payment. Therefore, revenues and expenses are usually estimated amounts and there is room for error (and still manipulation).
Revenues minus each of the expenses give you these figures:
- gross profit: Net sales less cost of goods sold.
- Gross margin: Gross profit/net sales
- operating income: Gross profit on sales less operating, selling and administrative expenses.
= Revenues - cost of goods sold - operating, selling and administrative expenses - profits from continuing operations: operating profit - interest and income tax
= Revenues - cost of goods sold - operating, selling and administrative expenses - interest expense - income tax expense - net income (also known assurplusearning): income minus all expenses
Based on the net profit, we can also calculate the earnings per share (EPS):
- EPS = (Net Income - Preferred Stock Dividends)/Average Shares Outstanding
Another useful figure is the asset turnover rate, defined as:
- Asset Turnover = Revenue/Total Assets
A higher asset turnover rate means that the same amount of asset generates income faster.
A good company's revenue and profitability are highly stable and sustainable. Generally speaking, profitability should be synchronized with revenue growth, and if it is not, the reason should be analyzed.
In analyzing the causes of changes in profitability, we often have to observe the changes in various data, income or expenses over time or compare them with those of the same industry, so as to find out the company's status and relative competitiveness. Furthermore, different companies may adopt different methods of calculating various items according to the industry, laws and regulations, or for reasons of their own choosing. Of course, the more we know about these methods, the better, but I am not going to talk about them in this article.
Comprehensive income statement
Shows that in addition to the net income shown in the income statement, other market fluctuations have an indirect impact on the company, such as changes in foreign exchange rates, interest rates, securities prices, and commodity prices, which are mainly related to the environment and cannot be controlled by the operating team. In contrast, the items in the income statement are basically created by operating activities.
The consolidated statement of income is the result of adjusting the net income of the income statement by a number of items to produce a consolidated net income figure. These items are just a few examples:
- currency translation: Gains or losses arising from the recalculation of exchange rates on the amount of assets and liabilities of a multinational enterprise.
- net investment hedge: In order to avoid exchange rate fluctuations in the price paid, a company may purchase hedge contracts that change the net value of these contracts.
Often the way items are measured on a consolidated income statement is so variable and difficult to understand that many people choose not to look at them. For investors, it is important to at least observe, if not scrutinize, whether there are unusual variations and, if so, why they occur.
Balance sheet
The balance sheet describes the condition of the assets, liabilities and owners' equity of a business at a particular point in time. A balance sheet always satisfies the following conditions:
- Assets (assets) = liabilities + equity
On the left hand side, assets are economic resources owned by a company that can be used to generate future cash inflows or reduce future cash outflows. For example, cash, inventory, land, and equipment can increase future revenues, while prepayments are items that can decrease future cash outflows. The left side of the balance sheet shows the uses of funds. We often see asset items such as:
- Current assets: These are assets that can be converted to cash within one year.
- Cash and cash equivalents: Includes cash, cash that can be received within one week, and short-term investments.
- Receivables: Amounts that are more than one week old.
- Allowance for uncollectible accounts: Because some of the accounts receivable may not be collected, the company needs to make an estimate of the value of the assets to be used as an allowance.
- Inventory: This is the total cost of inventory of goods available for sale.
- Property, plant and equipment (property, plant and equipment): also known as fixed assets (fixed assets), refers to land, plant and equipment, the amount of money, including the acquisition price and taxes, as well as the amount of money must be maintained.
- accumulated depreciation: a deduction used to represent depreciation of the value of long-lived assets.
- Property under capital lease: A long-term asset that is leased and meets one of the following three conditions (if the conditions are not met, it is expensed as an operating lease).
- Acquisition of assets upon lease expiration or right to purchase at a favorable price
- Lease term over available years 75% or more
- accumulated amoritization: Similar to depreciation, but a deduction for impairment of the value of a capital leasehold property.
- Goodwill: Recognition of intangible assets. Goodwill is recognized as part of the amount paid for the shares of another company that exceeds the carrying value of that company.
On the right hand side, liabilities and shareholders' equity represent the sources of capital. Liabilities are the company's external financial obligations, the most common of which are.
- Current liabilities: Debt due within one year.
- commercial papers: Financial papers issued to raise short-term funds.
- accounts payable: accounts payable that have not yet been paid.
- Accrued liabilities: Items for which there is an obligation to pay, but which have not yet been paid, such as interest payable, salaries, and utilities.
- accrued income taxes: Taxes payable as of the end of the period.
- long term debt due within one year: the portion of a long-term debt that will mature within one year.
- long term debt: Debt that is due in more than one year.
- long term obligations under capital lease: Future rentals outstanding under a long-term capital lease.
- deferred income tax: The amount of deferred tax that can be paid on some taxes.
Shareholders' equity (or net assets) is the residual interest of the company's shareholders, so it is assets minus liabilities. It is often broken down into several components.
- common stock: The book value of outstanding shares of common stock. This refers to the par value, not the current share price.
- capital in excess of par value: The portion of the listed price received in excess of par value at the time of issuance.
- retained earning: Earnings accumulated over the years that have not been returned in the form of dividends.
- Accumulated other comprehensive income/loss: Comprehensive income/loss accumulated on a yearly basis.
The figures on the balance sheet are prepared from a fair value perspective and should be presented in such a way as to represent current market prices.
Uses of Balance Sheet and Common Indicators
The balance sheet can be used to determine the company's layout and whether there are any hidden losses or liabilities, key observations include:
- Liquidity: Measures the ability to meet short-term liabilities. A commonly used indicator is the current ratio, which is generally expected to be >1.
- Current Ratio = Current Assets/Current Liabilities
- Financial Structure: Measurement of the proportion of sources of available assets, usually compared to past operations or peers, to see if there are any anomalies, and compared to the statement of cash flows, to see if the current financial structure can support the burden of paying liabilities. It can be viewed in terms of gearing ratio or stockholders' equity ratio.
- Gearing ratio = liabilities/assets
- Shareholders' equity ratio = Shareholders' equity/assets
- Observe if assets are overvalued: For example, if the net value per share is higher than the stock price, it is possible that the intangible assets are overvalued by the company and the market does not consider them to be worth that much. Goodwill must be tested annually for impairment and a loss should be recognized if there is an impairment due to changes in the environment.
- Observing whether liabilities are undervalued: whether the manager is likely to hide liabilities
Statement of changes in equity (statement of equity)
This statement explains how owners' equity changed during the period as a result of operating gains and losses and dividend payments. The principles of the statement of changes in equity are.
- Shareholders' equity t = Shareholders' equity t-1 + Net income t - Cash dividends t + Cash capital increases and stock subscription activities t - Repurchase of corporate shareholders t + Other adjustments
Here t represents the current period and t-1 represents the prior period. If there is no capital increase or stock buyback, the increase in stockholders' equity is the remainder of the previous period's stockholders' equity plus net income earned, less dividends paid. If there is a cash capital increase, stockholders' equity will increase. If the company spends money to reduce capital, stockholders' equity decreases.
There are three types of capital reduction.
- Treasury stock reduction: A company buys back treasury stock to reduce its capital. This practice reduces the capital stock because the bought back capital will be eliminated, so it may increase the EPS.
- Cash Reduction: Eliminating shares and returning the equivalent amount of capital to shareholders is also a way to increase EPS.
- Capital Reduction to Cover Losses: This type of capital reduction reduces the amount of capital stock per share, and the amount of the reduction is used to cover losses, resulting in a significant reduction in stock for the shareholders.
Uses of the statement of changes in equity and common indicators
Changes in shareholders' equity are paired with market information, which can be used to interpret a company's governance structure and distributional characteristics.
- Retained Earnings to Stockholders' Equity Ratio: If the ratio is high, it means that most of the wealth has been accumulated through past earnings. On the other hand, it means that more of the wealth has been accumulated through cash.
- Equity multiple: A company's market capitalization/shareholders' equity, the level of which reflects the market's perception of the company's future growth. A high ratio indicates that the market believes the company will create more value in the future.
- Dividend to Net Income Ratio: A company's cash dividend should generally be stable, and if it begins to decline, it is usually considered a sign of weakness.
Statement of cash flow
This statement explains the change in cash over a specific period. Uninterrupted cash flow is a basic requirement for continuing operations.
There are three broad categories of activities that result in changes in cash, including operating activities, investing activities, and financing activities.
- Operating activities: all activities that affect the income statement (sales, payroll...).
- Investment activity: The activity of disposing of or acquiring long-term assets.
- Financing activities: loan repayment, dividend payment, stock repurchase, capital increase, etc.
The cash flow statement formula is a variation of the balance sheet:
- Change in cash = Change in liabilities + Change in shareholders' equity - Change in non-cash assets
At present, most companies use the indirect method to prepare the cash flow statement. The difference between the indirect method and the direct method lies in the impact on the cash flow statement.Cash from operating activitiesThe indirect method of presentation. The indirect method of net operating cash inflow (or outflow) is derived from the net profit amount in the income statement, and adjustments are made to the relevant items to produce a net operating cash inflow (or outflow) figure. Examples of such adjustments are
- Recovery of depreciation expense: Depreciation is added back to net income because it is not a true cash outlay.
- Add back the loss on disposal of assets: Again, no cash outlay was incurred.
- Deduct the increase in accounts receivable: If accounts receivable increase, it means that cash has not yet been received, but it has been recognized in net income, so it should be deducted. If receivables decrease, it means that cash has been received compared to the previous period, so this amount should be added.
- Deducting Increase in Inventory: If there is an increase in inventory, the increase is the same as not receiving cash and should be deducted from net income. If there is a decrease in inventory, it means that it has been sold, and the corresponding amount will be added to the net income.
- Add back increase in accounts payable: Contrary to the previous two items, the increase in accounts payable is unpaid and therefore has to be added to net income to be expressed as cash.
As for the recording of investing activities and financing activities, both the indirect and direct methods are the same, with inflows and outflows recorded directly.
Uses and Common Indicators of Cash Flow Statements
The cash flow statement is mainly used to observeNet operating cash inflowandobtain benefitsThe relationship between free cash flow and free cash flow can be analyzed to determine whether there are any abnormalities. Free cash flow (free cash flow) is positive or not and its size can be used as an indicator to determine.
- Free cash flow = Cash flow from operating activities - Capital expenditure
Capital expenditures are investments made for long-term growth, such as the purchase of plant and equipment or equity investments. If free cash flow is positive, it means that the company is able to support its growth with the money it earns. If the cash flow from operating activities is large, it means that the company has greater financial flexibility.
In addition, the three major activity flows of the statement of cash flows can indicate the type of business.
- Growth: Rapid growth in net income and net cash inflow from operating activities, significant increase in cash from investing activities, and increase in long-term liabilities with no cash inflows.
- Stable: Smaller growth in net income and net cash inflow from operating activities, cash inflow from operating activities greater than expenses from investing activities, large stock buybacks or dividends.
- Declining: simultaneous decline in net income and net cash inflow from operating activities, decline in cash from investing activities, may not be able to maintain stable dividends
If any of the following apply, be aware that it may be a landmine company with poor financial discipline:
- Net Income Growth, Net Cash Outflow from Operating Activities
- Cash from investing activities still increased from the above position
- Significant increase in short-term borrowings
- Significant decrease in interbank payables (possibly due to reluctance of interbanks to extend further credit)
Common ways of determining asset value
Asset value is defined in terms of the future cash flows that will be generated. When investing, we often see terms that express the expectation of future profitability:
- P/E ratio: This is the ratio of stock price to net income and is often used in conjunction with EPS to determine a reasonable stock price for an investment. For example, if EPS is $4 and P/E ratio is 15, then the stock price is estimated to be $60, which is a reasonable stock price. However, this is only an estimate and is subject to error, so we can only say that if it is significantly lower than $60, it is a good price to start. It is also important to note that the P⁄ E ratio will change over time, so you can't just rely on one single piece of data to make an investment.
- intrinsic value: the value of an asset after discounting the net cash flows that it will generate over its lifetime, the formula is not discussed here, but is simply attached.Reference LinksThe estimate of intrinsic value is compared to the market price. Estimates of intrinsic value compared to market prices can also be used to determine investment interest.
Return on Equity (ROE) and Financial Report Analysis
Buffett thinks:
Successful management performance is about achieving a higher rate of return on shareholders' equity, not just a sustained increase in earnings per share.
Return on Equity (ROE) is defined as:
- ROE = Net Profit/Average Shareholders' Equity
In financial report analysis, ROE can be decomposed based on the DuPont formula as:
- ROE = Net Profit/Average Shareholders' Equity
= Net Income/Revenue * Revenue/Total Assets * Total Assets/Average Shareholders' Equity
= Net Profit Margin * Asset Turnover * Gearing Ratio
Gearing can be translated into debt ratio. In order to control financial risk, it is important to note that increasing ROE should not be based on increasing leverage. From the investor's point of view, we must analyze the factors that cause changes in ROE to determine the changes and do a comprehensive analysis, rather than looking at one factor alone. From a manager's point of view, to increase ROE, we can set targets for leverage, net income ratio, and asset turnover ratio to formulate a plan. In addition, ROE should not be regarded as the only management objective. If ROE is the only concern when the scale of operation is large, it may create blind spots and slow down the expansion, which may cause other problems such as the aging of the organization.
Surplus Quality
As I mentioned earlier, there is an element of artificial control and estimation in financial reports. Enterprises may use various legal or illegal means to manage the surplus figures on their books. Therefore, besides looking at the figures, we should also pay attention to the quality. The quality of earnings reflects the competitiveness of the enterprise, and there are five conditions for high earnings quality:
- Sustainability
- Predictability: Using past surplus history, we can accurately predict future surplus development.
- Stability: The stability of the surplus value indicates the management ability and business model.
- Possibility of conversion to cash: Earnings are derived from the income statement, based on accruals, and do not focus on whether cash is received or not. Whether it is actually converted to cash is also an important indicator.
- Low potential for human manipulation
Short-term profitability does not necessarily mean competitiveness, but continuous and steady profitability does mean competitiveness.
About Integrity
Not only must you be aware of the risks arising from the growth and decline of your organization's competitiveness, but you must also be mindful of artificial distortions in your financial statements.
The most common way for short-selling organizations to make profits is by producing distorted financial reports. Sooner or later, financial reports that are not based on integrity will be reflected in the operation of the company. For investors, apart from reading financial reports, observing the market sentiment also helps to indirectly judge the integrity of a company. After all, it is better to believe everything than nothing. If the financial report is a storybook, we have to pay attention to the truthfulness of the story.
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