How To Understand Financial Statements

Financial statement analysis is an art, hidden behind the mystery of enterprises.

To understand financial statements, besides having basic knowledge of financial accounting, we should also grasp the following aspects to see clearly the hidden secrets behind the financial statements:

Browse the report to see if the company is significant.

To get a business report, first of all, it is not to do some complex ratio calculation or statistical analysis, but to read through three reports, that is, profit statement, balance sheet and cash flow statement, to see whether there are abnormal subjects or abnormal amount of subjects, or whether it is abnormal from the distribution of the amount of different subjects in the table.

For example, in domestic accounting practice, "receivable and payable is a basket, anything can be installed inside".

Other large receivables often mean that the funds of the enterprise are occupied or even occupied by other enterprises or people for a long time. Such occupation may not interest or may become bad debts.

In the analysis and evaluation, we should eliminate the part that accounts receivable may turn into bad debts and reflect it as the bad debt expense in the current period, so as to reduce profits.

To study the long-term trend of corporate financial indicators to identify whether there are any problems.

The performance of a continuous profit company is generally less than that of a previous 3 years, and this period is reliable.

Our research on Listed Companies in China shows that the performance of a listed company must be over 5 years before it can be seen clearly. If the rate of return on equity is used as a performance indicator to assess a listed company, there will be a rule that the index of listed companies will fall by more than 50% over the average level of the 3 years before listing, and the subsequent years will no longer be restored to the level before the listing.

There is only one explanation: the packaging before the listing is too severe.

Compare whether the profit level of a company is consistent with its cash flow level.

Some enterprises reflect a very high level of operating profit in the profit statement, but they are poor in the cash flow generated by their business activities. Then we should raise the question: "why profit has not been converted into cash? Is there any problem in the quality of the profits?" silver Guangxia's profitability in the year before its exposure is far more than the average level of the same industry. However, the net cash flow generated by its business activities is relatively poor compared with the operating profit level. After that, it proved that the company was using its wholly owned import and export subsidiary in Tianjin to make customs declarations and then inflated profits in the way of accounting receivable and sales revenue.

And the so-called accounts receivable that are not true can never be converted into cash in operation. It is no wonder that the cash flow generated by their business activities is so poor.

Comparison between enterprises and their peers

Comparing the performance of enterprises with the standards of the same industry indicators may bring us a broader picture of enterprises: a company may have made quite progress compared with itself, for example, sales have increased by 20%, but at the level of the whole industry, there may be different conclusions: if the average sales growth level of the industry is 50%, then the slower running enterprises will eventually lose their competitors.

Watch out for the "whitewash" in the report.

Some methods of whitewashing statements and making bubbles in financial statements are prone to deviate or even make mistakes in the evaluation of enterprise decision performance.

To disguise the shortage or loss of main business profits by non recurring business profits.

Non recurring business profits refer to the profits generated by business activities which are not often happened or happen by accident, which usually occur in subjects such as investment income, subsidy income and extra business income.

If we find that the net profit after deducting non recurring business gains and losses is far below the total net profit of enterprises, such as less than 50%, then we can be sure that the profits of enterprises are not from their main products or services, but from the business which occurs frequently or accidentally. Such a profit level can not be sustained, nor does it reflect the results of business managers' improvement in operation and management.

{page_break}

Capitalization of earnings or period costs to overestimate profits.

This is the common practice of Chinese and foreign enterprises to "whitewash" profits, such as the balance sheet items that should be included in the current profit expense account items as prepaid expenses or long-term deferred expenses.

In the domestic real estate development industry, we can often see that enterprises will sell the expenses, management fees and interest expenses during the development of real estate projects arbitrarily and long time to "debit" in the long term prepaid expenses, so that the profits of these enterprises will be seriously overestimated.

Improving business performance through related party pactions

The classic example of adopting this technique is the "Qiong min yuan" company, which no longer exists at present.

In order to conceal the situation of loss, it is necessary to sell land to its subsidiaries to realize current profits, and the trick of buying land back from the subsidiary next year has been severely punished by the Ministry of Finance and the securities and Futures Commission.

Therefore, in our analysis, we should pay attention to the situation of related party pactions, study the proportion of sales, purchases, loans and profits of enterprises, and examine whether the prices of these pactions are unfair.

Increasing profits through mergers and acquisitions

Some enterprises adopt the means of merging other profitable enterprises to increase the profits of their consolidated statements when the products or services are not yet profitable.

The accounting masters of these enterprises make use of the accounting standards which are not yet consolidated in the accounting statements and the loopholes in the current interim provisions of consolidated statements, and merge the annexed enterprises' annual profits into the consolidated statements unsuitable.

In the analysis, we should pay special attention to the acquisition date of the enterprise. The profit level of the annexed enterprise before takeover has the exception of abnormal items except income tax and minority shareholders' income between the total profit and net profit of the consolidated profit statement.

To whitewash cash flow through internal funds.

In some enterprises, the cash flow generated by the activities of supply, production and marketing is insufficient, and the financing of related enterprises should be used, and the inflow of these funds should be listed as "cash received by other business related activities", so that the cash flow generated by business activities in the cash flow table looks better.

The analysis of financial statements will help us to fully grasp the company's financial situation and evaluate the performance of decision making, but we should also soberly recognize the limitations of financial statement analysis:

First, the cost of product sales in the assets and profit statements of an enterprise is recorded on the basis of the amount paid for the acquisition of assets or inventories, so the assets and sales costs are not reflected in the current value of assets or inventories.

In the case of inflation, it is possible to overestimate the rate of return on assets or the rate of return on equity.

In addition, the principle of historical cost also leads to the difficulties of new and old enterprises in the same industry.

For example, assuming that a and B two enterprises produce exactly the same products, the same sales capacity is the same as this year's sales revenue. They are all 100 million yuan, and the enterprise is set up 10 years ago, because the fixed assets purchase and construction is relatively early, so the original cost is relatively cheap, and the depreciation value of the fixed assets is relatively low. The book value of fixed assets is lower than that of 20 million yuan, while B enterprise is just 3 years' enterprise. The cost of fixed assets purchase and construction is higher, and the accumulated depreciation is less, so its account value is higher, which is 60 million yuan.

We calculate the fixed assets turnover rate of a and B enterprises: one is 10000/2000=5 (second) and the second is 10000/6000=1.67 (second).

If we compare the turnover rate of the two enterprises, we will get the turnover rate of the enterprises of the second grade, which is only 1/3 of the enterprises.

However, such a conclusion is obviously unfair.

The way to solve this limitation is to use the current value of assets to measure the value of assets in the internal assessment of enterprises. For example, in the comparison of a and B enterprises, we can replace the book value according to the replacement cost of fixed assets.

Secondly, accounting method selection and accounting estimation exist universally.

Financial accounting standards and systems often allow for one of the multiple options to be taken for the same business. Even if the same type of fixed assets are depreciated by straight line method, the estimation of the value (residual value) of the assets that can not be sold on the market in different enterprises may be different.

The ways to overcome these problems are: first, before the performance appraisal of the enterprise group, we should reduce or even prohibit the different accounting treatment methods for the same economic business according to the unified accounting system of enterprises.

Second, as an analyst, some elimination should be adopted because of the inconsistency of accounting policies on financial indicators.

In addition, financial indicators also have limitations.

Whether the internal control procedure of an enterprise is effective and how the enterprise as an organization's innovation and learning ability can not be reflected or fully reflected by the financial indicators must be evaluated by other non-financial indicators, or even indicators which are difficult to quantify.