Applying Common Sense to Financial Statements – Part 1

Financial statements are basically summaries of income, assets and liabilities of a company presented in difficult accounting jargon. A lay investor finds understanding the statements quite taxing and feels uncomfortable. The two-part series, “Applying common sense to financial statements” will address the uneasiness of such lay investors by telling them how to understand financial statements. But, before we jump into the financials themselves, here are nine guidelines on how to build a basic psychological grounding in order to handle the understanding the financial statements:

1. Don’t close the report: When you make the effort to read a company report and do not understand, you may feel discouraged to read further. You may draw blank and close the report. The mantra is: Don’t close the report. Instead, take a pause and get back. If you still find it difficult, distract yourself with other tasks and then get back to it.
2. Begin from the beginning: Begin reading the director’s report of the company. He will discuss the company highlights including performance and financials, company operations and future insight. The report will give you a feel for the company and its industry.
3. Take a quick glance: If figures give you jitters, simply take a glance at the financial statements. Net income will be recorded in bold font. If you see it as a positive figure, it is a positive year for the company. If the figure is in brackets, it is a negative and unhealthy sign. It is possible, at this stage that you may be able to correlate some figures in the director’s report to the financial statements. If you feel confident about proceeding further, it is better to get some basic understanding of the financial statements.
4. Do a bit of homework: Every company is part of an industry. Research on the industry, the company belongs to. Some industries are capital-intensive. Their gestation period may be longer. They need huge capital to build the infrastructure required for the company. Their break-even may take longer. Some industries survive only on equity. Their debts are nil. Outline the economic growth of the country in which the company exists.
5. Research statistics and strategy: It will be interesting to know the competitors of the company, if not in detail, at least the names. You can find out the size of the company and its market share. The more the competitors, the lesser the market share and revenues. Explore its products/services, customers and suppliers. The company will have a USP (unique selling proposition) to score over its competitors. Find it. Explore its brand power and positioning.
6. Learn basic financial terms and their applications: Understand the difference between the two major financing: Equity and Debt. Know their rates of return. Learn the basic ideology behind accounting; that is, the dual accounting and how dual transactions get reflected in the balance sheet.
7. Read the accounting assumptions: Every company will have its accounting policies and assumptions. These will be found in the notes to the financial statements.
8. Ask: If you feel that you do not understand its financials, do not hesitate to ask. As an investor/stockholder, you are entitled to explanations. Make a phone call or email or write to the investor relations department of the company.
9. Analyze: Now that you have a grasp of the basics of the company, ask questions about its past and present performance, growth and expansion. Analyze its future prospects. How is the company going to secure and grow in future? Is product development or diversification or acquisition its strategy? How will it beat competition?

When you have recorded sufficient background information, you may now want to take a peek into the financial statements, particularly the balance sheet of a company. In the second part of the topic, the balance sheet will be discussed in detail.