Comprehending some basic Accounting principals is not just for accountants - all investors should have some essential accounting information that will help in the share-picking process. The balance sheet gives a look of a company's financial location on a particular day. That snapshot shows you what the company's assets, liabilities and its net worth (assets minus liabilities) are. (The net worth is reflected as shareholder funds or net asset value (NAV) in the balance sheet.)
A balance sheet on its own will only give you with restricted information, so you should compare it to the company's past results. To judge the financial potency of a company, ask at least the following four basic questions:
o Has the worth of the company's assets increased from six months ago, a year ago or two years ago? By comparing the present asset base to that of the past two financial years, you will be able to see if a company is increasing in both size and financial strength.
o How do the single items compare with those in the previous periods? In particular you should look at the expansion in line items such as accounts receivable to ensure that debtors are being well managed.
o Look at the liabilities and ask how they (especially debt and accounts payable) are growing relative to assets. A company could experience a cash flow crunch if accounts payable grows faster than accounts receivable for some time. Debt that grows faster than the items on the other side of the balance sheet can be a red flag of pending financial problems.
o Is the company's NAV or shareholders' funds (equity) greater than the previous year's? In a financially healthy company, NAV will increase as earnings grow. The income statement's purpose is to show the company's profit (or earnings or net income or bottom line) for the entire accounting period. Profit is simply the amount of money that's left over once all expenses (including operating costs, interest payments and taxes) have been subtracted from sales.
Investors should always compare this year's profit to last year's. A strong company should show consistent profit growth over time.
Investors should ask the following questions when they examine a company's income statement:
o Are operational earnings growing? Operational earnings are the portion of the bottom line that's made from the company's core activity. In other words, ascertain that the key contributor to a company's profit is its "real business" and not non-recurring items such as profit on the sale of assets.
o Are sales growing and why?
o Are expenses growing at a reasonable rate? Pay attention to one-off charges (such as a large
bad debt write-off and determine whether they make sense).
o Is the company's tax payment in line with the corporate tax rate (of 30%) or are earnings inflated by the use of past tax losses?
If you only have time to look at one financial statement, it should be the cash flow statement because it shows how a company is managing its resources. A company could be profitable yet can go out of business if it manages its resources poorly - for example if it doesn't collect its accounts receivable, it may not be able to pay its bills and be forced into liquidation.
The cash flow statement shows all receipts and payments of cash. It's split into three key sections: cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. It shows how the balance sheet line items have changed over the accounting period.
Cash flow from operating activities is, arguably, the most important section as it shows the underlying cash performance of the company's operations. Consistent negative operating cash flow can warn of future financial problems.
Cash flow from investing activities shows the money the company spends on investments, including capital expenditure and acquisitions. Cash receipts from sales of assets will also reflect in this section. Investors should check that a company is investing adequately to maintain its productive capacity - in other words that it's not artificially inflating profit now at the expense of its future earnings. One quick and easy way is to check that capital expenditure is at least equal to depreciation over a number of years.
Cash flow from financing activities reflects all cash flow of a capital nature, including equity injections, debt raised and debt repaid.
These three financial statements are not all. Investors can glean important extra information from both the Value-Added Statement and the Statement of Changes in Equity. Don't forget to read the notes to the financial statements, if anything this is even more important than reading the financial statements themselves. The notes contain the small print that you need to evaluate the balance sheet, income statement and cash flow statement.
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