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| Sunday, 31 October 2004 |
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| News Business Features Editorial
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Understanding Financial statements by Ravi Abeysuriya, CFA, Managing Director, Amba Research Lanka (Pvt.) Ltd. Basics Be it that you are depositing money in a financial institution or investing in a company stock or debt instrument it makes sense to verify the financial health of that institution. Financial statements are an indispensable source of information about institutions' financial health and its prospects for the future. Depositors and investors should learn to make use of the information they contain as a report card of that institution's management performance and accountability and as an early indicator of the institution's future success or potential failure. This is why regulators such as the Central Bank of Sri Lanka and the Securities and Exchange Commission require public deposit taking institutions and listed companies respectively to make public their financial statements. Even if you have no clue about accounting, with a little bit of effort you can learn to interpret financial statements. Understanding a company is very much the same process as understanding your own personal finances. As we analyze our own finances, we typically start looking at how much cash we received and how much cash we paid and ultimately our net worth (how much money we are left with after we add all moneys owed to us and subtract our debt. This is usually "the truth" of how we really spent our money and how much money we have. How we look at corporate financial statements is very much the same. These financial statements are called (1) the statement of cash flows, (2) the statement of income (profit & loss), and (3) the balance sheet. One should start with the Cash Flow Statement, to get "the truth", a sense of where does cash come from (source of cash) and where does it go (use of cash)? The Cash Flow Statement has three parts; however, the components may vary depending on the type of business and the company engages in: (1) Cash flow from operations (CFFO) - describes cash coming in and out from a company's day-to-day business. (2) Cash flow from / used in investment activities - describes cash coming in and out from longer-term purchases, asset sales or investment accounts. (3) Cash flow from / used in financing activities - describes additional sources of cash coming in or going out from interest paid, interest received, loans, bonds sold or stock issued. Accounting choices affect whether cash flows are classified under operating, financing or investing activities. The Statement of Income communicates the profitability of a company over a specified period. A company's profit or net income is equal to its revenues and gains minus its expenses and losses. The measurement of accounting earnings involves two steps: (1) identifying revenues for the period and (2) matching the corresponding costs to revenues. It is important to recognize that revenue is not the same as cash received. According to the accrual principal of accounting, revenue is recognized as soon as "the effort required to generate the sale is substantially complete and there is a reasonable certainty that payment will be received". According to the matching principal of accounting, the capital expenditure, need to be spread over the useful life to match with the revenue. Company's' are given great latitude in how they recognise their revenue and identify their expenses and CFFO under the accounting principals (which leads to all the cooking!). The Balance Sheet presents a snapshot of a company's resources (i.e. its assets) and the claims against those resources (i.e. its liabilities and owners' equity or capital) at a specific point in time. The asset position of the balance sheet reports the effects of all of a company's past investment decisions. The liabilities and owners' equity position reports the effects of all of the company's past financing decisions. Capital is obtained from both short and long-term creditors and from owners. The critical equation to remember is: "Assets = Liabilities + Owners' Equity" A balance sheet is very much like a bikini. What it reveals is interesting, what it conceals is vital. |
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