Understanding Financial Reports - Part I

Financial reports: certainly not one of the more glamorous elements of trading. In Wall Street, Gordon Gekko never seemed to be trawling through hundreds of numbers in an attempt to get some overview of a company’s financial condition. But unfortunately, it’s usually essential to have at least a basic grasp of financial reports to become a successful trader.

In Part I of this introduction to financial reports, I’m going to look at the basics of company financial statements and how they can be interpreted. With these basic tools at your disposal, hopefully you will become a more educated trader, which is always more profitable in the long run.

Financial Reporting Is Important To Trading
Now I know what you’re thinking; accounting is boring. And it is. But it can make you a lot of money, which is more important. Company share prices regularly move up or down 10% depending on what profit figure they release. If you’re on the right side of that move, it can be very lucrative. The richest guy in the world, Warren Buffett, is a fundamental investor who uses financial reports as his primary tool. He trawls through hundreds of accounts before deciding on an investment. Forbes listed his wealth in 2008 at $62 billion.

All that scouring of company accounts and research is a lot of work, so in Part II I’ll show you how you can skip that whole part and just look out for the key figures. But that’s Part II. We need to build a bit of an accounting base before we get to that.

The Major Statements In Financial Reports

In the US, companies release their financial reports on a quarterly basis, hence reference to Quarter 1, Q2 etc. In Ireland and the UK though, it’s more common for companies to only report twice a year, hence interim and final. Whether quarterly or biannually, there are three major statements in set of financial reports:

(1) Profit And Loss
(2) Balance Sheet
(3) Cash Flow

Let’s have a look at each of them.

(1) Profit And Loss
The Profit and Loss account communicates how much revenue the company generated during a period and what costs it incurred in connection with generating that revenue. The difference is the profits. There are many different profit figures in a Profit and Loss account instead of a simple “profit” figure. This does add a layer of complexity, but there are two main profit figures that traders should be aware of:

(A) Operating Profit aka Earnings before Interest and Tax (EBIT)
(B) Net Profit aka the “bottom line”

Net Profit = Operating Profit - Net Interest - Net Taxes + Minority Interest + Income from Discontinued Operations.

Most of the time, these two profit figures will be relatively similar. But they can diverge quite a bit and we traders must be aware of this. News outlets often add to the problem by picking the most sensational profit figure and using that as the “profit” figure. With regards to Irish Life & Permanent 2008 results, BreakingNews.ie headline was “Irish Life & Permanent announces €433m loss”, reporting the Net Profit figure for the whole of the company.

In contrast, RTÉ’s first line included “operating profits at Permanent TSB bank fell by 86% to €30m.” RTÉ are only talking about the operating profits at Permanent TSB division of the bank. You have to dig much deeper to find “after-tax loss of €433m” in the middle of the piece. Both figures are important - what’s key is that traders realise that they are telling two different figures and need to be interpreted differently.

(2) Balance Sheet
The Balance Sheet is a snapshot of what a company’s assets, liabilities and equity are at a specific point in time. There is a key formula that is the basis of the Balance Sheet:

Assets = Liabilities + Equity

Equity is the source of funding for the company and is the amount initially invested in the company plus retained earnings. So this equation says that the things that companies own must equal its financial obligations and the amount of money available to finance its operations. Rather neatly, the two sides of the Balance Sheet equation must always balance each other out.

Assets and Liabilities are the two more important elements of the equation. Both of these can be broken down into short term and long term. Often analysts check to make sure that a company’s short term assets cover their long term assets. This is liquidity.

Another check that analysts are increasingly looking at is whether total assets cover total liabilities. This is solvency. What’s important is a whether a company’s solvency is improving or not. For many, it’s the latter and that is a big contributor to crashing share prices. For example, banks all around the world have been announcing huge write-downs in their assets, which is causing their assets and equity to fall heavily. But liabilities remain the same, which is resulting in many banks’ solvency falling sharply. Without the widespread government bailouts, pumping in money to increase assets and equity, there would have been a whole host of banks going insolvent and having to declare bankruptcy.

(3) Cash Flow

Cash flow is simply a measure of the amount of net money coming into the company. The cash flow statement is used to give an understanding of how a company operates. From this, traders can ascertain how a company spends its money and where it is coming from.

The cash flow statement is broken down to three main areas
(A) Operating (cash generated from the company’s main operations)
(B) Investing (cash dealings involving assets, investments and hedging)
(C) Financing (cash transactions in debt, dividends and loans)

The cash flow statement is probably the most honest of the three statements in financial reports because it’s the most difficult one for a company to “manage”. You see, publicly traded companies are under intense pressure to constantly meet financial projections. They make it a priority to at least meet, if not exceed, estimates. If not, their share prices get decimated. Over the years, companies have become adept at managing Profit And Loss and Balance Sheet statements to the point that they can be untrustworthy. The controversy over Irish Life & Permanent’s “deposit” in Anglo Irish Bank is but one example. This managing of accounts isn’t really possible with the more honest cash flow statement, so traders often give it a good weighting in their company analysis.

That’s enough to digest for Part I. The basics behind any set of financial reports are covered. It does get a good bit more complicated than the simple examples I’ve presented above. But luckily for us, we don’t need to get stuck into complicated accounting. In Part II, I’ll look at how we can track professional analysts, who do all the accounting for us.

Subscribe by RSS Subscribe by Email