The Attributes of Money: 23 Steps to Understand Financial Reports of Enterprises

The final summary of learning financial statements is to extract high-quality companies from listed enterprises through the 23-step method, which is a key step in stock investment.

Before summarizing, it is necessary to understand some key financial indicators, which are listed here.

The above key financial indicators are auxiliary tools for understanding enterprises and need to be understood in detail.

23-Step Method:#

Three Major Financial Statements [Balance Sheet, Income Statement, Cash Flow Statement]
There are three main financial statements: the balance sheet, the income statement, and the cash flow statement. Let's look at them one by one.
Balance Sheet
Assets: Resources owned by the company, including current assets (such as cash, accounts receivable) and fixed assets (such as real estate, equipment), etc.
Liabilities: The company's debts and obligations, including current liabilities (such as accounts payable) and long-term liabilities (such as bonds), etc.
Owner's Equity: The company's net assets, which is total assets minus total liabilities.

The balance sheet of an enterprise has many items,#

but the main content is divided into two major parts.

Where does the company's money come from? Where does the funding come from? VS Where does the company's money go?

(1) Where does the company's money come from? That is, the company's liabilities and owner's equity:

The company's assets (source of the company's money) = company's liabilities + owner's equity.

Company liabilities: Liabilities are what the company borrows from others and needs to repay, which is the focus of research (clarifying the reasons and urgency of the company's borrowing): Why does the company need to borrow money, from whom, how much, and how much interest needs to be repaid.

Shareholder equity: The company can raise funds from investors by issuing stocks. Stocks represent ownership in the company, and shareholders have the right to share in the company's profits. Shareholder equity is the company's net assets, including common stock and preferred stock.

(2) Where does the company's money go?#

That is the asset items:
First, look at whether total assets have increased or decreased compared to the previous year (overall impression), and then look at specific project expenditures:

Fixed Assets: Include long-term assets owned by the company for production or operation, such as land, buildings, machinery, and equipment. The company may invest in purchasing, updating, or maintaining these fixed assets.

Current Assets: Include assets that the company can convert to cash or use within one year, such as cash, inventory, accounts receivable, etc. Funds may be used to manage and increase these current assets.

Intangible Assets: Include non-physical assets such as patents, trademarks, software, etc. The company may spend funds to purchase or develop these intangible assets.

Investments: Include equity, bonds, real estate, and other investments held by the company. Funds may be used to purchase, hold, or sell these investments.

Accounts Receivable: Money owed to the company for goods sold or services provided that has not yet been received. Funds may be used to manage and recover accounts receivable.
Inventory: Products or raw materials held by the company for sale. Funds may be used to procure, manage, and sell inventory.

Company Activities: Research and Development: Funds may be used for research and development activities for new products or services. Human Resources: Funds may be used to hire, train, and maintain employees. Marketing and Advertising: Funds may be used to promote and advertise products or services. Operating and Administrative Expenses: Include various expenses required for the company's daily operations and management, such as rent, utilities, salaries, etc.

2. Income Statement [Reflecting Operating Results]#

The income statement summarizes the sales, costs, and profits of the company over a specific period. Main parts:

Operating Revenue: Total income obtained by the company from selling products and services.
Cost Expenses: Expenses related to production and sales, including production costs, sales expenses, and administrative expenses, etc.
Net Profit: Operating revenue minus cost expenses, which is the company's net profit over a specific period.

Focus on where the company's earnings come from, such as the main channel of operating revenue, minus cost expenses to obtain the company's gross profit.

Operating Income (mainly reflects the company's operating status and future development situation:
In addition to looking at the value of operating revenue, also look at the source of income. There are three ways for the company's operating revenue to grow:

Growth in potential demand
(This indicates natural market demand growth; generally, the entire industry will develop well);
Expansion of market share
(This proves that the company has a certain competitiveness among peers, but it may encounter sustained competition, so the subsequent profit growth situation needs to be monitored and evaluated);
Price increases (which may sacrifice consumer interests, leading consumers to reduce consumption or seek alternatives).

Investors generally prefer companies with potential demand growth, and various factors can affect the increase in potential demand: energy/market/culture/policy, etc. For example, the current new energy market and chip electronics market are beneficiaries of natural demand growth. Secondly, check whether the growth rate of the company's operating revenue is higher than the industry average. In a generally prosperous industry, only companies with an operating revenue growth rate higher than the industry average growth rate indicate that the company is a strong player in the industry.

(2) Company Expenses.

Mainly three aspects:

Sales expenses, administrative expenses, and financial expenses.

Companies with excessively high sales expenses may have lower product competitiveness, requiring significant marketing costs to drive sales. However, it also needs to be viewed dialectically, considering the ratio of sales costs to sales profits. If the value is high, it indicates that the company's marketing efforts exceed the product's value.
Administrative expenses should generally grow less than the growth of operating revenue. If administrative expenses suddenly increase, there may be certain issues, as listed companies often use administrative expenses to adjust income.
Investing in companies with excessively high R&D expenses requires caution. The uncertainty of developing new technologies is high; if a company needs to continuously invest large amounts in R&D to maintain competitiveness, once the new technology development fails, the company may face significant problems.

3. Cash Flow Statement [The Blood, Reflecting Cash Inflows and Outflows]#

The cash flow statement summarizes the inflows and outflows of cash and cash equivalents of the company over a specific period. Main parts:

Cash Flow from Operating Activities: Cash inflows and outflows related to daily business operations.

Cash Flow from Investing Activities: Cash inflows and outflows related to asset investments and disposals.

Cash Flow from Financing Activities: Cash inflows and outflows related to shareholder equity and debt.

The cash flow statement reflects the source and use of cash for the company,

(1) Cash flow from operating activities:#

Operating cash flow is the center of the cash flow statement, reflecting the company's operating ability. There are two key numbers:

One is "Net Cash Flow from Operating Activities";

The other is "Cash Received from Sales of Goods and Providing Services".

"Net Cash Flow from Operating Activities": If the cash flow from operating activities is greater than zero and greater than depreciation expenses, it indicates that the company is not only operating normally but can also compensate for asset depreciation expenses, allowing the company to continuously update machinery and expand production;

If it is less than zero, the company is facing operational difficulties. The net cash flow from operating activities can also be cross-verified with the net profit in the income statement. If the net cash flow from operating activities is greater than net profit, it indicates that the company's profits have basically turned into cash; if the net cash flow from operating activities is far greater than net profit, it indicates that the product is in short supply, and customers are paying in advance (but there are exceptions, such as pre-sales of properties under construction, where the comparative results may not be reliable).

Cash Received from Sales of Goods and Providing Services: This can be compared with operating revenue; if this value is greater than operating revenue, it indicates that the vast majority of sales payments have been received in cash, and the company's operating condition is good; if the value is far less than operating revenue, it indicates that many debts are owed, and the company's competitiveness is weak, requiring cautious investment.

(2) Cash flow from investing activities:
Look at the company's return on investment; if the return on investment is lower than the average return level of social funds, it indicates that the company's management's investment ability is poor, requiring cautious investment.
Look at whether the company has sold a large amount of fixed assets or other long-term assets; if cash inflow from investing activities comes from asset sales, it may indicate that the company's operating performance is declining and is not sustainable.
Analyze the source of funds for the company's investments. Company investment funds sourced from itself are more reliable, while funds sourced from financing carry greater risks.

Summary:#

The lower level of financial statement analysis is to understand the company's assets, liabilities, and profit situation, while the highest level of analysis is a comprehensive and holistic financial performance evaluation, including analysis of the company's financial condition, profitability, cash flow situation, and financial stability.

Financial Leverage: Examine the company's capital structure and debt level, understand the company's financial leverage situation, and the impact of debt on profitability and cash flow.

Operational Efficiency: Evaluate the company's operational efficiency and asset utilization through indicators such as operating profit margin and total asset turnover.

Risk Management: Examine the various risks faced by the company, including market risk, financial risk, operational risk, etc., to assess the company's risk tolerance and management level.
Industry Comparison and Trend Analysis: Compare the company's financial indicators with those of peer companies or industry averages, while paying attention to whether the company's financial performance has improved or declined over a period.

Financial Forecasting and Planning: Based on past financial performance, develop future financial forecasts and plans, considering market trends and macroeconomic factors affecting the company.

Corporate Governance and Transparency: Examine the company's governance structure, internal controls, and the transparency of financial reporting to assess the quality of management and the level of transparency.

Step 1: Prepare the annual reports of relevant companies#

■ We need to download the annual reports of the target company for the past 5-10 years; the more periods, the better.

■ It is best to also download the prospectus.

■ Additionally, download the annual reports of the top three companies in the same industry as the target company for the past 5-10 years.

For example, the top three companies in the A-share seasoning industry by market value are:

Step 2: First, look at the most recent annual report of the target company#

■ Open the most recent annual report of the target company.

■ Search for "Consolidated Balance Sheet" and start by looking at the "Consolidated Balance Sheet".

Step 3: Review each item in the consolidated balance sheet and mark any abnormal items#

■ Quickly review each item in the balance sheet, marking any items with a year-on-year increase or decrease greater than 30%.

Return to focus on these and investigate the reasons. Let's take a look at the abnormal items of Haitian Flavoring:

The items within the red boxes above are abnormal items.

Step 4: Search for abnormal items and investigate the reasons#

■ After discovering that an item has abnormal changes, we need to investigate the reasons.

■ And analyze whether this change is beneficial or harmful to the company.

In 2016, "Prepayments" amounted to 0.17 billion, an increase of 143% compared to 0.07 billion in 2015, which is a significant increase.

■ However, we find that the 0.17 billion "Prepayments" only account for 0.13% of the total assets of 134.64 billion.

■ Items with a total asset ratio of less than 3% that experience significant abnormal changes can also be ignored, as their impact on the company is extremely limited.

We can see that among the items with a total asset ratio exceeding 3%, only "Other Current Assets" and "Advance Receipts" have abnormal changes.

It can be seen that the significant increase in "Other Current Assets" is due to Haitian Flavoring purchasing 1.125 billion in short-term bank financial products in 2016 compared to 2015, which is part of Haitian Flavoring's cash management.

■ We know that Haitian Flavoring has 5.197 billion in cash, and managing cash is a normal situation.

■ The significant increase in "Advance Receipts" is mainly due to distributors making early payments at the end of the year, which reflects Haitian Flavoring's strong competitiveness. The large increase in this item is a good thing. Note:

■ If there are abnormal changes in accounts such as notes receivable, accounts receivable, other receivables, prepayments, inventory, construction in progress, and long-term deferred expenses, students need to pay attention. These items are high-risk areas for financial fraud.

■ If there are abnormal changes in liabilities such as short-term loans, notes payable, accounts payable, and other payables, it is also necessary to look at the abnormal items of Haitian Flavoring.

We can see that there are no abnormal items in Haitian Flavoring's income statement, but there are abnormal items in the cash flow statement.

We will search these two items separately to check the reasons. Through the search, we can find the following content.

We can see that the significant increase in "Other Current Assets" is due to Haitian Flavoring purchasing 1.125 billion in short-term bank financial products in 2016 compared to 2015, which is part of Haitian Flavoring's cash management.

■ We know that Haitian Flavoring has 5.197 billion in cash, and managing cash is a normal situation.

■ If there are abnormal changes in liabilities such as short-term loans, notes payable, accounts payable, and other payables, it is also necessary to pay attention.

■ Debt crises often start from these items.

■ We can see that these items of Haitian Flavoring are still very normal.

■ After completing Step 4, for companies with no issues, we can continue to move forward.

■ Companies with problems but cannot find credible explanations.

Step 5: Look at total assets to assess company strength and expansion capability#

Generally speaking, companies with large total asset amounts are stronger, and companies with rapid year-on-year growth in total assets have stronger expansion capabilities.

■ The above shows the total assets of Haitian Flavoring, Zhongju Gaoxin, and Jiajia Foods for 2016 and 2015.

■ From the scale of total assets, Haitian Flavoring's total assets are much greater than the combined total assets of Zhongju Gaoxin and Jiajia Foods.

■ From the year-on-year growth rate of total assets, Haitian Flavoring grew by 17%; Zhongju Gaoxin grew by 8.6%; Jiajia Foods grew by 5.7%.

■ It is clear which company has the strongest strength and expansion capability: Haitian Flavoring's debt-to-asset ratio.

Step 6: Look at the debt-to-asset ratio to assess the company's debt risk#

A company with a debt-to-asset ratio greater than 60% has a higher debt risk. Eliminate.

Calculating Zhongju Gaoxin's debt-to-asset ratios for 2016 and 2015 yields 37% and 38%, respectively. Jiajia Foods' debt-to-asset ratios for 2016 and 2015 are 32% and 32%, respectively.

■ We can see that Zhongju Gaoxin and Jiajia Foods have relatively stable and low debt-to-asset ratios, indicating low debt risk.

■ However, compared to Haitian Flavoring, Haitian Flavoring's risk is still lower. Step 7: Look at interest-bearing debt and cash to eliminate debt repayment risk.

Step 7: Look at interest-bearing debt and cash to eliminate debt repayment risk#

For companies with a debt-to-asset ratio greater than 40%, we need to check whether their cash exceeds their interest-bearing debt.

■ Companies with cash less than interest-bearing debt are eliminated. Haitian Flavoring's interest-bearing debt and cash.

■ Companies with cash less than interest-bearing debt are eliminated.

Haitian Flavoring's interest-bearing debt and cash:

We can see that Haitian Flavoring has zero interest-bearing debt and 5.197 billion in cash.

■ Haitian Flavoring has no risk of debt default.

Step 8: Look at "Receivables and Payables" and "Prepayments and Advance Receipts" to assess the company's industry position. Retain companies with strong industry positions and eliminate those with weak positions. Let's look at Haitian Flavoring's industry position.#

We can see that Haitian Flavoring's total amount of "Receivables" and "Prepayments" is 0.17 billion; the total amount of "Payables" and "Advance Receipts" is 23.84 billion.

■ The difference between the latter and the former is 23.67 billion. This is the amount of interest-free loans provided to Haitian Flavoring by its upstream suppliers and downstream distributors.

■ This means that Haitian Flavoring has the ability to "eat from both ends." Haitian Flavoring's industry position is very strong.

■ Regarding the judgment of industry position, we cannot only look at one year's data. We should look at at least five years of data.

Let's take a look at more years of data for Haitian Flavoring.

We can see that from 2012 to 2015, the total amount of "Receivables" and "Prepayments" for Haitian Flavoring was: 0.37 billion, 0.21 billion, 0.22 billion, and 0.07 billion; the total amount of "Payables" and "Advance Receipts" was: 19.64 billion, 22 billion, 26.21 billion, and 17.04 billion.
■ The differences between the latter and the former were: 19.27 billion, 21.79 billion, 25.99 billion, and 16.97 billion.
■ Through historical comparison, we can see that Haitian Flavoring has maintained a high industry position over the past five consecutive years. Let's look at Zhongju Gaoxin's industry position.

We can see that Zhongju Gaoxin's total amount of "Receivables" and "Prepayments" is 1.1 billion; the total amount of "Payables" and "Advance Receipts" is 4.86 billion.

■ The difference between the latter and the former is 3.76 billion. This is the amount of interest-free loans provided to Zhongju Gaoxin by its upstream suppliers and downstream distributors.

■ This means that Zhongju Gaoxin also has the ability to "eat from both ends," which is also good. However, Zhongju Gaoxin's industry position is clearly not as strong as Haitian Flavoring's.

Let's look at Jiajia Foods' industry position.

We can see that Jiajia Foods' total amount of "Receivables" and "Prepayments" is 1.75 billion; the total amount of "Payables" and "Advance Receipts" is 5.33 billion.
■ The difference between the latter and the former is 3.58 billion. This is the amount of interest-free loans provided to Jiajia Foods by its upstream suppliers and downstream distributors.

■ This means that Jiajia Foods also has the ability to "eat from both ends," and its industry position is similar to Zhongju Gaoxin's, which is also good. However, it is clearly not as strong as Haitian Flavoring's.

Step 9: Look at fixed assets to assess whether the company is asset-heavy or asset-light.#

■ Companies with a ratio of (Fixed Assets + Construction in Progress + Engineering Materials) to Total Assets greater than 40% are asset-heavy companies.

■ Asset-heavy companies have higher costs to maintain competitiveness and face greater risks. When we encounter asset-heavy companies, it is safer to eliminate them. Let's see if Haitian Flavoring is an asset-light or asset-heavy company.

■ We can calculate that Haitian Flavoring's ratio of (Fixed Assets + Construction in Progress + Engineering Materials) to Total Assets is 33%.

■ Haitian Flavoring is an asset-light company. Let's see if Jiajia Foods is an asset-light or asset-heavy company.

■ We can calculate that Jiajia Foods' ratio of (Fixed Assets + Construction in Progress + Engineering Materials) to Total Assets is 60%.

■ Jiajia Foods is an asset-heavy company.

■ Although they are in the same industry, Jiajia Foods' costs to maintain competitiveness are significantly higher than Haitian Flavoring's. Jiajia Foods also faces higher risks than Haitian Flavoring.

Step 10: Look at investment-type assets to assess the company's focus.#

■ Companies with investment-type assets unrelated to their main business accounting for more than 10% of total assets are not focused enough. Eliminate.

Let's look at Haitian Flavoring's investment-type assets:

We can see that the total amount of investment-type assets unrelated to the main business is 5.4145 million, accounting for only 0.04% of the total assets of 134.64 billion, which can be ignored.

■ Haitian Flavoring is a company focused on its main business. Let's look at Zhongju Gaoxin's investment-type assets.

■ We can see that the total amount of investment-type assets unrelated to the main business is 472 million, accounting for 9.6% of total assets of 4.91 billion.

■ Zhongju Gaoxin is not a company focused on its main business.

Step 11: Review each item in the income statement and cash flow statement and mark any abnormal items.#

■ After passing the balance sheet, we need to look at the income statement and cash flow statement.

■ If the balance sheet does not pass, there is no need to look at the income statement and cash flow statement.

■ Quickly review each item in the income statement and cash flow statement, marking any abnormal items. Return to focus on these and investigate the reasons.

Let's look at the abnormal items of Haitian Flavoring.

Haitian Flavoring's abnormal items:

■ We can see that there are no abnormal items in Haitian Flavoring's income statement, but there are abnormal items in the cash flow statement. After discovering abnormal changes in items, we need to investigate the reasons.

■ And analyze whether this change is beneficial or harmful to the company. Companies with issues that cannot find reasonable explanations should be eliminated.

Search for net cash flow from operating activities.

Search for year-on-year changes in cash flow.

We can see that there are no issues with these two abnormal items of Haitian Flavoring, and they are beneficial to the company.

Step 13: Look at operating revenue to assess the company's industry position and growth capability.#

■ We assess the company's industry position through the amount and quality of operating revenue; we assess the company's growth capability through the growth rate of operating revenue.

■ Companies with large operating revenue amounts and a ratio of "Cash Received from Sales of Goods and Providing Services" to "Operating Revenue" greater than 110% have high industry positions and strong product competitiveness.
■ Companies with an "Operating Revenue" growth rate greater than 10% have good growth potential.

■ Companies with a "Sales Revenue" growth rate less than 10% or a ratio of "Cash Received from Sales of Goods and Providing Services" to "Operating Revenue" less than 100% should be eliminated.

We can see that Haitian Flavoring's operating revenues for 2016 and 2015 were 12.459 billion and 11.294 billion, respectively, which are relatively large amounts. ■ The ratio of "Cash Received from Sales of Goods and Providing Services" to "Operating Revenue" was 122% and 109%, indicating high quality of operating revenue. The year-on-year growth rate of operating revenue was 10%, indicating good growth potential. Regarding operating revenue, we also need to look at at least five years of data from 2012 to 2016:

■ The year-on-year growth rates of Haitian Flavoring's operating revenue were: 19%, 17%, 15%, 10%.

■ The ratios of "Cash Received from Sales of Goods and Providing Services" to "Operating Revenue" were: 129%, 118%, 120%, 109%, 122%. ■ This indicates that Haitian Flavoring is a company with a high industry position, strong competitiveness, and rapid growth. Let's look at Zhongju Gaoxin's situation.

■ Zhongju Gaoxin's operating revenue for 2016 was 3.158 billion, which is average in scale.

■ The ratio of "Cash Received from Sales of Goods and Providing Services" to "Operating Revenue" was 117%, indicating high quality of operating revenue.

■ The year-on-year growth rate of operating revenue was 14%, indicating good growth potential. This indicates that Zhongju Gaoxin is a company with a relatively high industry position, strong competitiveness, and good growth potential.

Let's look at Jiajia Foods' situation:

■ Jiajia Foods' operating revenue for 2016 was 1.887 billion, which is average in scale. The ratio of "Cash Received from Sales of Goods and Providing Services" to "Operating Revenue" was 116%, indicating high quality of operating revenue.

■ The year-on-year growth rate of operating revenue was 7.5%, indicating average growth potential. This indicates that Jiajia Foods is a company with a relatively high industry position, strong competitiveness, and average growth potential.

Comparison:#

We can see that the combined operating revenue of Zhongju Gaoxin and Jiajia Foods is less than half of Haitian Flavoring's, and their operating revenue quality is also not as high as Haitian Flavoring's. Through the above comparison, it is clear which company has a high industry position, strong competitiveness, and good growth potential.

Step 14: Look at gross profit margin to assess the competitiveness of the company's products.#

■ Generally, a gross profit margin greater than 40% indicates that the company's product competitiveness is strong.

■ Companies with high gross profit margins have relatively low risks. Companies with gross profit margins less than 40% should be eliminated. Let's look at Haitian Flavoring's gross profit margin:

■ Haitian Flavoring's gross profit margins from 2012 to 2016 were: 37%, 39%, 40%, 42%, 44%.

■ We find that Haitian Flavoring's gross profit margin has been increasing every year over the past five years, indicating that Haitian Flavoring's product competitiveness is strengthening. Let's look at Zhongju Gaoxin's gross profit margin:

■ We can calculate that Zhongju Gaoxin's gross profit margin for 2016 was 37%, indicating that Zhongju Gaoxin's product competitiveness is average. Let's look at Jiajia Foods' gross profit margin:

■ Jiajia Foods' gross profit margin for 2016 was 28%, indicating that Jiajia Foods' product competitiveness is average.

■ We find that Haitian Flavoring's gross profit margin in 2016 was 7% higher than Zhongju Gaoxin's. Since Haitian Flavoring maintains the top position in the industry, it is normal for its gross profit margin to be 7% higher than Zhongju Gaoxin's.

If we find that Zhongju Gaoxin's gross profit margin is higher than Haitian Flavoring's, we should be cautious, as there may be fraud.

In practice, many companies' financial fraud is exposed in gross profit margins. If a company with an average industry position has a gross profit margin higher than that of the industry leader, it is likely that this company is committing fraud.

Step 15: Look at expense ratios to assess the company's cost control ability.#

■ High gross profit margins and low expense ratios are necessary for good operating results.

■ Excellent companies typically have an expense ratio to gross profit margin ratio of less than 40%.

■ Companies with an expense ratio to gross profit margin ratio greater than 60% should be eliminated. Let's look at Haitian Flavoring's expense ratio.

We can calculate that Haitian Flavoring's expense ratio for 2016 was 17%, and the ratio of expense ratio to gross profit margin was 39%, indicating that Haitian Flavoring has strong cost control ability. Let's look at Zhongju Gaoxin's expense ratio.

We can calculate that Zhongju Gaoxin's expense ratio for 2016 was 22%, and the ratio of expense ratio to gross profit margin was 59%, indicating that Zhongju Gaoxin's cost control ability is average.

Let's look at Jiajia Foods' expense ratio.

We can calculate that Jiajia Foods' expense ratio for 2016 was 16%, and the ratio of expense ratio to gross profit margin was 57%, indicating that Jiajia Foods' cost control ability is average.

Step 16: Look at operating profit to assess the company's profitability and profit quality.#

■ Operating profit is the main source of profit for a company; companies with operating profit less than 0 do not need to be further examined and should be eliminated.

■ Companies with gross profit margins greater than 40% should have operating profit margins of at least 15%. Companies with operating profit margins less than 15% should be eliminated.

■ Additionally, excellent companies should have a ratio of "Operating Profit" to "Total Profit" of at least greater than 80%.

■ Companies with a ratio of "Operating Profit" to "Total Profit" less than 80% should be eliminated.

Let's look at Haitian Flavoring's situation.

We can conclude that Haitian Flavoring's "Operating Profit Margin" for 2016 was 26%, indicating strong profitability.

■ The ratio of "Operating Profit" to "Total Profit" was 96%, indicating very high profit quality. We should also look at at least five years of data for operating profit.

■ Haitian Flavoring's ratios from 2012 to 2016 were:

■ Operating Profit Margins were: 21%, 22%, 24%, 25%, 26%.

■ The ratios of "Operating Profit" to "Total Profit" were: 99%, 95%, 95%, 95%, 96%.
■ We can see that Haitian Flavoring has maintained strong profitability and very high profit quality over the past five years. Let's look at Zhongju Gaoxin's situation:

■ Through calculations, we can conclude that Zhongju Gaoxin's "Operating Profit Margin" for 2016 was 14%, which is relatively low.

■ The ratio of "Operating Profit" to "Total Profit" was 88%, indicating average profit quality.

Step 17: Look at net profit to assess the company's operating results and quality.#

We can conclude that Haitian Flavoring's "Operating Profit Margin" for 2016 was 26%, indicating strong profitability.

■ The ratio of "Operating Profit" to "Total Profit" was 96%, indicating very high profit quality. We should also look at at least five years of data for operating profit:

■ Haitian Flavoring's ratios from 2012 to 2016 were:

■ Operating Profit Margins were: 21%, 22%, 24%, 25%, 26%.

■ The ratios of "Operating Profit" to "Total Profit" were: 99%, 95%, 95%, 95%, 96%.

■ We can see that Haitian Flavoring has maintained strong profitability and very high profit quality over the past five years. Let's look at Zhongju Gaoxin's situation:

■ Through calculations, we can conclude that Zhongju Gaoxin's "Operating Profit Margin" for 2016 was 14%, which is relatively low.

■ The ratio of "Operating Profit" to "Total Profit" was 88%, indicating average profit quality.

Step 18: Look at net profit attributable to shareholders to assess the company's ability to generate returns on equity.#

■ Using "Net Profit Attributable to Shareholders" and "Shareholder Equity," we can calculate the company's return on equity, also known as ROE.

■ Excellent companies generally have an ROE that continuously exceeds 15%. Companies with an ROE less than 15% should be eliminated.

■ ROE should also be examined over at least five years. ROE can be calculated by oneself; we will not calculate it here.

Let's directly search for "Return on Equity" to find Haitian Flavoring's ROE over the past few years.

We can see that from 2011 to 2016, Haitian Flavoring's ROE was at least 32% or higher. This is very high.

■ This indicates that Haitian Flavoring has a strong ability to generate returns on its equity.

Step 19: Look at net cash flow from operating activities to assess the company's ability to generate cash.#

■ The greater the net cash flow from operating activities, the stronger the company's ability to generate cash. Excellent companies generally have strong cash generation capabilities.

Excellent companies meet the condition that net cash flow from operating activities > depreciation of fixed assets + amortization of intangible assets + interest on loans + cash dividends.

■ Companies with "Net Cash Flow from Operating Activities" consistently less than (depreciation of fixed assets and amortization of intangible assets + interest on loans + cash dividends) should be eliminated. Let's see if Haitian Flavoring meets this condition:

■ Haitian Flavoring's "Net Cash Flow from Operating Activities" for 2016 and 2015 was 4.074 billion and 2.195 billion, respectively.

■ Through calculations, we find that Haitian Flavoring's "Depreciation of Fixed Assets and Amortization of Intangible Assets + Interest on Loans + Cash Dividends" for 2016 and 2015 was 2.005 billion and 1.631 billion, respectively.

Haitian Flavoring's "Net Cash Flow from Operating Activities" > depreciation of fixed assets + amortization of intangible assets + interest on loans + cash dividends.

■ This indicates that Haitian Flavoring can meet the demand for expansion through its own cash generation capability. Haitian Flavoring has strong cash generation capabilities.

Step 20: Look at "Cash Paid for Purchase of Fixed Assets, Intangible Assets, and Other Long-term Assets" to assess the company's future growth potential.#

■ The larger the amount of "Cash Paid for Purchase of Fixed Assets, Intangible Assets, and Other Long-term Assets," the stronger the company's future growth potential.

■ Companies with strong growth potential generally have a ratio of "Cash Paid for Purchase of Fixed Assets, Intangible Assets, and Other Long-term Assets" to "Net Cash Flow from Operating Activities" between 10% and 60%.

■ Companies with this ratio continuously above 100% or below 10% for two years should be eliminated.

Let's look at Haitian Flavoring's situation.

Haitian Flavoring's ratios of "Cash Paid for Purchase of Fixed Assets, Intangible Assets, and Other Long-term Assets" to "Net Cash Flow from Operating Activities" for 2015 and 2016 were 34% and 19%, respectively.

■ This ratio is within a reasonable range, indicating that Haitian Flavoring's future growth potential remains strong.

Step 21: Look at "Cash Paid to Ordinary Shareholders and Restricted Stock Holders" to assess the company's quality.#

■ Companies that consistently pay high dividends have a low probability of financial fraud. Excellent companies should pay dividends every year, and the dividend payout ratio should generally exceed 30% of net profit.

■ Companies with a dividend payout ratio below 30% either have issues with their capabilities or quality.

Companies with a dividend payout ratio below 30% should be eliminated.

Let's look at Haitian Flavoring's dividend payout ratio by searching for "Cash Dividend Amount."

By searching for "Cash Dividend Amount":
■ Haitian Flavoring's dividend payout ratios for 2014, 2015, and 2016 were: 61.17%, 64.7%, and 64.7%.

■ It can be seen that Haitian Flavoring's dividend payout ratio is very high, indicating that Haitian Flavoring is generous to its shareholders.

Step 22: Look at the combination types of the three major cash flow activities to select the best type of company.#

■ Excellent companies are generally of the "positive-negative-negative" and "positive-positive-negative" types.

■ Companies that have been of other types for two consecutive years should be eliminated.

Let's look at Haitian Flavoring's type:

■ Haitian Flavoring was of the "positive-negative-negative" type in both 2015 and 2016.

Step 23: Look at "Net Increase in Cash and Cash Equivalents" to assess the company's stability.#

■ Companies with a "Net Increase in Cash and Cash Equivalents" consistently less than 0 find it difficult to maintain their existing competitiveness.

■ Excellent companies generally have a "Net Increase in Cash and Cash Equivalents" that is continuously greater than 0.

■ Companies with a "Net Increase in Cash and Cash Equivalents" less than 0 after removing dividends should be eliminated.

Let's look at Haitian Flavoring's "Net Increase in Cash and Cash Equivalents":
■ Haitian Flavoring's "Net Increase in Cash and Cash Equivalents" from 2013 to 2016 was only -0.91 billion in 2013, with the rest being positive.

■ If we exclude the 747 million cash dividend in 2013, the "Net Increase in Cash and Cash Equivalents" would be 656 million, which is also good.

Conclusion:#

Through the above 23 steps, we can comprehensively understand a company.#

■ If we apply these 23 steps to examine the more than 3,300 listed companies in A-shares, at least 99% of the companies will be eliminated.

■ The remaining less than 1% of companies are generally very excellent companies. This is called "survival of the fittest."

■ We can first select companies that meet the criteria through financial indicators. Then, by following these 23 steps, we can greatly improve efficiency.

Everyone should remember that financial reports are used for falsification, not for verification. As long as there are doubts, they can be excluded.#

Financial fraud carries the risk of delisting, and our purpose in learning is to select those good companies that have not committed fraud. Therefore, this is also the necessity of learning financial reports, as some companies may embellish their financial statements.

General Outline#

In investing, safety is the first priority.
With the risk manual in hand, both principal and returns are secured.

Mnemonic#

Cash funds must be real; financial returns must be clear.

Accounts receivable should not be frequent; accounts receivable should not be left behind.

A sharp increase in inventory should be cautious; biological assets should not be taken lightly.

Prepayments must be clear; other receivables must be examined carefully.

Construction in progress must be converted to fixed assets; goodwill impairment must be examined during acquisitions.

How to check related transactions? It is recommended to use Tianyancha.

Cash flow should look at balances; the correlation must not be overlooked.

Operation Manual#

Cash funds must be real.

Checking method:

Search for "cash funds" in the financial report, which will match many search results. Directly jump to the details of cash funds in the consolidated financial statement notes, check the amount of bank deposits, and write it down, assuming the amount is X.

Note: The notes are divided into consolidated financial statement notes and parent company financial statement notes; do not confuse them. It is often easy to mix them up. It would be better to number each note from beginning to end and then fill in the numbers in the report.

Search for "financial expenses," which will also match many results. Directly jump to the "financial expenses" in the consolidated financial statement notes, check the interest income amount in the detailed items, and see if this amount and cash funds are in a normal ratio, generally between 1% and 3% is relatively normal. If it is below 1%, be cautious and continue to check whether this value is normal in quarterly or semi-annual reports. This standard is not fixed and should be considered in conjunction with the industry and business model. However, if it is lower than the current interest rate, the authenticity of cash funds is highly questionable, indicating that the funds do not stay on the company's books for long.
Financial returns must be clear.

Checking method:

Search for "other current assets," and similarly jump to the notes to check the amount of bank financial products.
Search for "investment income," jump to the notes to check the amount of bank financial income, and then divide the income amount by the amount of bank financial products to see if this ratio is in a reasonable range, with 3% to 5% being relatively normal.
Accounts receivable should not be frequent.

The author has seen a company where the amount of accounts receivable remained unchanged for several accounting periods. Later, the Securities Regulatory Commission inquired, and it turned out to be expired notes, and it was unclear whether the auditing accountant genuinely did not discover it or pretended not to. According to China's commercial bill regulations, the acceptance period for commercial bills cannot exceed six months.
Therefore, if you find that accounts receivable maintains an unchanged value for a long time, be cautious.

Accounts receivable should not be left behind.

This is simple. Add accounts receivable to commercial acceptance bills, then divide by revenue; the smaller this ratio, the better. If there is a sudden sharp increase in a certain accounting period, be cautious, as it often indicates bad news, indicating that business is difficult, and in severe cases, there is a possibility of inflated revenue.

A sharp increase in inventory should be cautious.

Even more alarming than a sudden large increase in accounts receivable is a sudden large increase in inventory, which means that even credit sales cannot be sold off, and large inventory write-downs will eventually need to be recognized. However, there are very few exceptions, such as monopolistic products like Moutai liquor, where the issue is not high inventory but supply and demand. For the vast majority of companies, high inventory is not a good thing.

Biological assets should not be taken lightly.

The agriculture, forestry, fishery, and animal husbandry industries do not pay taxes, and the cost of fraud is zero, making them high-risk areas. Companies with significant biological assets must be cautious. The natural attributes of biological assets make them easy to falsify. For example, how many scallops are in the sea or how many turtles are in the lake cannot be counted, and they can easily claim large asset impairments with a simple statement like "the scallops have all died." My solution is to avoid such companies altogether.

Prepayments must be clear.

It is essential to examine the outflow of economic benefits carefully. If a company spends money like water but receives no returns, be cautious. For example, Hengtong Optoelectronics has recently been questioned about prepayments of 3.3 billion, most of which are paid to the same company every year, which is worth investigating.

Calculate the ratio of prepayments to total assets; if it is too high, check the notes to see who the prepayment recipients are, and dig deep to see if the prepayments are reasonable and whether the recipients are genuinely supplying raw materials or services to the company.

Other receivables must be examined carefully.

Like prepayments, this other receivables item can also be a place to hide dirt. Normal business-related debts should be placed in accounts receivable or notes receivable; some inexplicable cash outflows may be placed in other receivables, such as funds being misappropriated by major shareholders or lent to related parties. Therefore, check the detailed items in the notes to see which companies these funds are flowing to and what the relationship is with the company.

Of course, in some industries, such as real estate, it is normal to have more non-sales-related funds due to cooperative development projects, but for the vast majority of industries, this item should not have excessive amounts.

Construction in progress must be converted to fixed assets.

Construction in progress does not require depreciation; once it is converted to fixed assets, depreciation must be recognized each year, affecting profits. Therefore, in some asset-heavy industries, to make profits look better, they may delay converting completed construction in progress to fixed assets.

The checking method is to search for "construction in progress" in the financial report, jump to the notes to see the detailed situation, total budget? Cumulative investment? Current period investment? Completion progress? This is also quite important, as it determines when production capacity can be released. For changes or delays in construction in progress, it is essential to clarify the reasons.

Goodwill impairment should be examined during acquisitions.

At the end of last year and the beginning of this year, goodwill became a topic of concern, with frequent occurrences of goodwill impairments. Simply put, goodwill is the price paid to acquire a company that exceeds the identifiable net assets of the acquired entity, indicating that the acquirer has a strong outlook on the acquired target company and is willing to pay a high price, believing that the target company will earn back this price difference in the future.

Some acquisitions involve benefit transfers, where the buyer knows the price is not justified but is still willing to buy, which is even more concerning.

Previously, goodwill was handled by amortization, but it has since changed to impairment testing. If no impairment signs are found after testing, there is no need to deduct expenses. However, this remains a hidden danger, as a large impairment could occur one day, leading to a significant drop in profits or even losses.

The key is to examine the quality of the acquisition target. First, look at the industry; acquiring a company in a sunset industry is certainly riskier than acquiring one in a sunrise industry. Then, examine the financial statements of the acquisition target. Companies will announce significant acquisition transactions, disclosing the financial statements and audit reports of the acquisition target, which should be carefully reviewed to check the quality of these companies.

In some industries, such as Aier Eye Hospital, although goodwill accounts for more than 20% of total assets, there is not much to worry about, as this is a blue ocean field in an upward phase, and the likelihood of underperformance is relatively low. However, in recent years, many LED companies diversified and acquired companies in lighting or outdoor advertising, which raises questions.

How to check related transactions? It is recommended to use Tianyancha.

If the financial report writers intend to conceal related transactions, it is challenging to detect them solely from the financial report. Therefore, other tools should be used. According to the financial report disclosure rules, the names of the counterpart companies must be disclosed, so by searching for these company names, we can investigate their equity structure and legal representatives, tracing the connections between enterprises. I recommend an app called "Tianyancha," which provides detailed information about company ownership structures and legal representatives, making it very useful.

The recent widely circulated article questioning Hengtong Optoelectronics' large prepayments and other receivables involving related transactions was authored by someone who used "Tianyancha" to identify related companies.

Cash flow should look at balances; correlation must not be overlooked.

For the cash flow statement, we generally focus on net amounts, especially the net cash flow from operating activities. However, it should be noted that cash flow situations can also be manipulated, so it is essential not only to look at net amounts but also to check the correlations with the other two statements. "Correlation" is a term in accounting that refers to the correspondence of financial data between the three major statements. Specifically, the following points should be noted:

Check the amount X of "Cash Received from Sales of Goods and Providing Services" in the cash flow statement, the amount A of operating revenue in the income statement, the increase B in accounts receivable and notes receivable (i.e., the ending balance minus the beginning balance), and the increase C in advance receipts (now referred to as "contract liabilities" under the new accounting standards).

Then X should roughly equal (A - B + C).

Check the amount X of "Cash Paid for Purchase of Goods and Receiving Services" in the cash flow statement, the amount A of operating costs in the income statement, the increase B in inventory on the balance sheet, the increase C in accounts payable and notes payable, and the increase D in advance payments.

Then X should roughly equal (A + B - C + D).

The "Net Increase in Cash and Cash Equivalents" in the cash flow statement should roughly equal the ending balance of "Cash Funds" in the balance sheet minus the beginning balance.

Remember the above mnemonics, and check them one by one while reviewing financial reports. Many companies with unhealthy financial data can be avoided, significantly reducing the probability of encountering risks.