12 Things You Need to Know About Financial Statements
Here are 12 things you need to know and look out for when reading Financial Statements.
12 Tips To Note
1. View a Financial Statement as the scorecard for how well a business is performing.
2. Don’t neglect the Cash Flows. There might be cash in the bank account, but if it’s from selling assets rather than from selling goods/services, then the business might have a problem.
3. Learn what the business does and whether it should have a lot of assets, or a lot of debt. Then compare this to what you would expect to see and what you are actually seeing.
4. Don’t be alarmed when the Financial Statements don’t look like the ones you’ve seen in the past. Many different businesses have different ways of presenting different information, e.g. a company with many subsidiaries may have a breakdown of each subsidiaries accounts, or a mining company may have information about each type of mineral it mines.
5. Accountants are known to have jargon that most people have never heard of. If you don’t get it, Google it (or ask us).
6. Be prudent. You may find big amounts which influence the net profit of a company, or change the balance of assets, these may be purely accounting entries. An example is a Fair Value Adjustment of an investment, it may increase making the results of the company look incredible, but once you strip that away, the company could be making a loss.
7. Historical Cost and Accrual Basis of Accounting are a necessity to understand. One must know that the value of assets of the SOFP might be higher in the market, so there could be underlying value not recorded. Accrual Accounting is basically saying that if you receive money but haven’t delivered the goods, you will record a Liability (bad) rather than show the cash and sale. This concept makes it important to look at the Cash Flows.
8. Economic Data plays a huge role in the success of a company. An example is the price of Gold, as it decreases, the value of the assets the mining companies had valued their mines at will decrease. (Use the knowledge of financial statements even when you don’t have them in front of you).
9. Ratios are important. Ratios like Price Earnings (PE) are derived from Financial Statements. Knowing the Financial Statements helps you know the importance of the ratios.
10. Note: Notes to the Financial Statements are basically a break-down/explanation of certain line items. If you want more information regarding interest expense, follow the trail to the note and you shall find the details you were looking for.
11. Audit Reports prelude any set of Financial Statements and are a reasonable guide to whether what you are about to read is correct or incorrect.
12. Don’t let Consolidated Financial Statements trick you. When a company controls (owns over 50% of) a company, the books of the 2 are combined into one. Now the Income Statement will reflect the true profit owing to the Parent/Holding Company, however the SOFP will indicate that the parent has 100% of the assets of the subsidiary even though it only owns 50%. To avoid confusion, study up on Consols if indeed the company you’re researching has subsidiaries. (Most do)
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