Understanding Financial Statements

Accounting is the language of business and the financial statements are tools used to communicate the financial information to the stakeholders. As an investor and shareholder, you need to educate yourself with basic accounting knowledge so you can interpret the financial statements.

The information about the performance and financial health of a company can be found in 3 financial statements known as Income Statement, Balance Sheet, and Statement of Cash Flows. These financial statements could be found in the annual report, 10-K and 10-Q filings.

Income Statement

This is a sample Income Statement of FinanceMind Inc. The income statement tells you about the financial performance of a company for a specified period.

Sample Income Statement of FinanceMind Inc. for the year ended Dec 31, 2007
	$	$
Revenue
Gross Sales		251,000
Sales Returns and Allowance		(12,000)
Rebates and Discounts		(25,400)
Net Sales		213,600
Cost of Sales
Opening Inventory	45,100
Purchases	87,100
Freight	13,500
Inventory Write-off	4,400
Closing Inventory	(48,300)
Cost of Sales		(101,800)
Gross Profit (Loss)		111,800
Operating Expense
Advertising and Marketing	21,200
Bad Debt Write-off	800
Depreciation	6,400
Printing and Stationery	1,400
Provision for Bonus	3,000
Salaries and Wages	42,500
Travelling	7,000
Utilities	3,800
Operating Expense		(86,100)
Earnings Before Interest and Tax (EBIT)		25,700
Interest Expense		(8,700)
Earnings Before Tax (EBT)		17,000
Taxation		(4,500)
Net Income (Loss)		12,500
Earnings Per Share (assume 100,000 shares)		0.125

Net Sales

Net sales is the actual sales after netting off the sales returns, rebates and discounts. Net sales is more realiable than Gross sales because this figure doesn’t include any sales value achieved by using marketing gimmicks.

Cost of Sales

This includes any costs directly incurred to produce the products or services that is sold by the company.

Gross Profit (Loss)

The gross profit or loss line measures the difference between your income and your cost of sales. The gross margin (which is the gross profit over net sales) is an important measure because it measures how profitable your product is.

Net sales and Cost of sales are driven by quantities or volume sold. If the company's gross margin is 40%, this means that for every $100 value of sales generated, $40 is the incremental profit. If the company has already recovered all the operating expenses from earlier sales, then this $40 will flow down directly to the Earnings Before Tax (EBT) line increasing it by $40.

Operating Expense

Operating expense is also known as the Selling, General and Admin Expense (SGA). This is the company's overhead in running the business and any other costs indirectly incurred to produce the company's products. The operating expense could be fixed (eg. rental) or step cost (eg. salaries).

Earnings Before Interest and Tax (EBIT)

The EBIT is a measure of the company's operating profitability. Interests is considered a financing expense and therefore excluded from operating expense.

Net Income (Loss)

Net profit or loss is whatever leftover for the business owners after deducting for all expenses.

Balance Sheet

This is a sample Balance Sheet of FinanceMind Inc. The balance sheet tells you about the financial health of a company for at a specific date. It is a snapshot of the company on the date 31st Dec 2007 only. This is different from the Income Statement which tells you the performance from Jan 1st to Dec 31st, 2007.

The assets of a company is financed by capital, retained earnings and borrowings. Capital and Retained earnings are collectively known as the Shareholders' Equity

Sample Balance Sheet of FinanceMind Inc. as at
	Dec 31, 2007	Dec 31, 2006
	$	$
ASSETS
Non Current Assets
Property, Plant and Equipment (PPE)	16,000	22,400
Goodwill	0	0
Research and Development	2,000	1,500
Total Non Current Assets	18,000	23,900
Current Assets
Inventories	48,300	45,100
Trade and Other Receivables	15,000	10,000
Prepayments	300	500
Cash and Cash Equivalents	8,000	900
Total Current Assets	71,600	56,500
TOTAL ASSETS	89,600	80,400
EQUITY AND LIABILITIES
Capital and Reserves
Issued Capital	25,000	25,000
Reserves	8,100	8,100
Retained Earnings	27,000	14,500
Total Capital and Reserves	60,100	47,600
Non Current Liabilities
Interest Bearing Borrowings	11,100	17,300
Deferred Tax	1,200	800
Retirement Benefit Obligations	1,000	1,000
Total Non Current Liabilities	13,300	19,100
Current Liabilities
Trade and Other Payables	3,200	2,000
Current Portion of Interest Bearing Borrowings	6,000	7,000
Short-Term Borrowings	2,000	2,700
Other Current Liabilities (provisions)	5,000	2,000
Total Current Liabilities	16,200	13,700
TOTAL EQUITY AND LIABILITIES	89,600	80,400

Non-Current Assets

Assets with an economic useful life of more than 1 year are termed as Non-Current Assets. These are usually the assets with longer life span such as equipment, machinery, building and the likes.

Intangible assets such as goodwill, brand value and patents are also termed as non-current assets because the benefits of these assets last for many years.

Current Assets

Assets that will be consumed within 1 year in (eg. prepayments) or assets that are expected to be converted to cash within 1 year (eg. inventoties and trade receivables) are known as current liabilities.

Capital and Reserves

Capital and reserves are also known as Shareholders' Equity. This is the residue value to the shareholders after paying off all its liabilities.

Using a house and a mortgage as an example, you own a house with a value of $250,000. The mortgage outstanding on this house is $180,000. If you sell your house and pay off the mortgage, you will pocket $70,000. The difference between value of your house (Asset) and the mortgage (Liability) is your equity.

Non-Current Liabilites

Financial obligations which will mature in more than 1 year's time are termed as non-current liabilities. Examples are long-term loans, hire purchase and corporate bonds.

Current Liabilities

Financial obligations that mature within 1 year are termed as current libilities. Examples are trade payables and revolving credit.

Statement of Cash Flows

The Statement of Cash Flows tells you how much cash is generated from operations and how the cash is used by the company.

Some people believe that the information contained in the statement of cash flows is more important that the information in the income statement. The reason is because the income statement is built upon some assumptions such as recognition of revenue which are removed in the statement of cash flows. This makes it difficult to manipulate the numbers in the statement of cash flows.

Sample Statement of Cash Flows of FinanceMind Inc. for the year ended Dec 31, 2007.
	$	$
Cash Flow from Operating Activities
Earnings Before Tax		17,000
Adjustments for:
Depreciation	6,400
Interests	8,700
Provision for Bonus	3,000
		18,100
Operating Profit before working capital changes		35,100
Adjustments for Changes in Working Capital
Increase in Inventories	(3,200)
Increase in Trade Receivables	(5,000)
Decrease in Prepayments	200
Increase in Trade Payables	1,200
Decrease in Short-term Borrowings	(700)
		(7,500)
Cash Generated from Operations		27,600
Interest paid	(8,700)
Income Taxes paid (deferred tax not inclusive)	(4,100)
		(12,800)
Net Cash From Operating Activities		14,800
Cash Flow from Investing Activities
Research and Development	(500)
Net Cash used in Investing Activities		(500)
Cash Flow from Financing Activities
Repayment of Borrowings (long-term)	(6,200)
Repayment of Borrowings (short-term)	(1,000)
Net Cash used in Financing Activities		(7,200)
Net Increase in Cash and Cash Equivalents		7,100
Cash and Cash Equivalents at beginning period		900
Cash and Cash Equivalents at end period		8,000

Adjustments to Earnings Before Tax

The statement of cash flows starts with earnings before tax and is adjusted for non-cash items. If there is a non-cash expense, then the expense is added back to the earnings. Similarly, if there is a non-cash income such as gain on disposal of assets or forex gain, these will be deducted from the earnings.

The earnings is further adjusted for any changes in working capital. For example, if the receivables increased by $5,000 this means my cash is reduced by $5,000.

Cash Generated From Operations

This measures the cash generated by the business operations. It tells you if the business is a bottomless pit or a cash cow.

Net Cash From Operating Activities

This measures the net cash generated by the business after paying for all its operating cash outflows. If you use this figure over net sales, you will know how efficient the company is in generating cash. $14,800 / $213,600 x 100 = 6.9%. This means that for every $100 of net sales, the company is able to covert $6.90 into surplus cash.

Net Cash From Investing Activities

This section tells you how much a company is spending on expanding, maintaining or downsizing its business. Acquiring and disposal of property, plant and equipment (PPE) falls into this section. Generally, a company that acquires PPE is preparing for future growth while a company that disposes its assets are more likely downsizing its business operations.

Net Cash From Financing Activities

This section tells you how the company raises the capital to finance its operations and investing activities. It also tells you if the company is retiring any loans or buys back any stock.

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