A step-by-step guide to reading financial reports

According to the thematic reading method in "How to Read a Book," I am preparing to spend three months studying financial statements. The first book that is relatively easy to start with is "A Hands-On Guide to Reading Financial Statements," and I will continue to update and improve it.

Basic Knowledge

1.1 Financial Statement Disclosure Timing#

Annual Report: Within 4 months after the end of the year (highest credibility)
Semi-Annual Report: Within 2 months after the end of the first half
Quarterly Reports: Within 1 month after the end of the quarter

1.2 Three Main Financial Statements#

The financial report mainly consists of three statements: the balance sheet, the income statement, and the cash flow statement. These three statements include consolidated statements and parent company statements.

The parent company's balance sheet, income statement, cash flow, and statement of changes in equity show the operating conditions of the listed company's headquarters.

In the statements, we mainly focus on the consolidated statements. The consolidated statement is not a real legal entity; it consolidates the operating conditions of the listed company and its subsidiaries and offsets their investments.

1.2.1 Balance Sheet#

The balance sheet is the sum of assets, liabilities, and equity.

On the right side of the balance sheet is the source of funds: debt or shareholder investment. It is divided into liabilities and equity, arranged according to the urgency of repayment, with the most urgent at the top.
Liabilities indicate how much money is borrowed.
Equity indicates how much is shareholder money.
On the left side of the balance sheet is the use of funds: the company's assets. Assets are arranged according to liquidity. The most liquid is cash, while the least liquid includes fixed assets, intangible assets, goodwill, etc.

1.2.2 Income Statement#

The income statement is the easiest to manipulate, rooted in the accrual basis of accounting. Money not received can be counted as income; money not paid may be recorded as costs; received money does not count as income; paid money is not recorded as costs.

Operating profit is the core profit of the company, and companies with a large proportion of non-operating income and expenses should be particularly noted.

1.2.3 Cash Flow Statement#

The cash flow statement shows the inflow and outflow of cash. The most accurate figures in the statement are the beginning cash balance, ending cash balance, and the difference between the two.

Cash-related activities of the company are divided into three categories: operating activities, investing activities, and financing activities.

Operating Activities: Cash income from selling goods or providing services and corresponding cash expenditures.
Investing Activities: Expenditures for internal and external investments and the situation of receiving returns on previous investments.
Financing Activities: Cash received from stock buybacks, dividend distributions to shareholders, borrowing, or issuing stocks, along with related costs.

1.3 Commonly Used Financial Report Websites#

Giant Tide Information: http://www.cninfo.com.cn
Shanghai Stock Exchange: http://www.sse.com.cn
Shenzhen Stock Exchange: http://www.szse.cn

1.4 Important Reminders#

The content in the important reminders section, opinions issued by accounting firms are quite important. Any firm unwilling to issue a "standard unqualified opinion" should be considered problematic. If the accountant does not issue this standard phrase, please ignore the company directly.

Three must-watch items in the financial report: financial accounting report, board of directors report, and important matters. Secondary content: changes in shares and shareholder situations, directors, supervisors, senior management personnel, and employee situations.

First, exclude companies with ROE (Net Profit / Net Assets) < 15%.

This raises an interesting point: by comparing the number of shareholders at the end of each financial statement, the number of shareholders disclosed in the 5 days prior, and the stock price at that time, one can draw interesting conclusions.

Balance Sheet

The asset section of the balance sheet is arranged according to liquidity. It is mainly divided into current assets and non-current assets.

As an investor, Old Tang's classification:

Cash
Operating-related assets
Production-related assets
Investment-related assets

2.1 Cash#

Only the consolidated statement data needs to be focused on for cash. The cash in the parent and subsidiary statements is merely internal allocation and does not need to be looked at. The "prepayments" in the parent company statement have no observational significance.

Behind cash, the second column of notes shows (1), indicating an explanation of the cash item, which can be found in the notes of the consolidated statement. It can be located using the search function.

2.1.1 Classification of Cash and Cash Equivalents#

Cash on hand
Bank deposits
Other cash
Reserves deposited with the central bank that can be withdrawn at any time
Interbank placements
Interbank borrowings
Securities purchased under resale agreements between banks
Investments held by enterprises that are short-term (generally referring to those maturing within three months from the date of purchase), highly liquid, easily convertible into known amounts of cash, and with minimal risk of value change.

2.1.2 Sources of Cash#

(1) Issuing stocks or borrowing;
(2) Selling assets or business units;
(3) Continuous cash inflow from operating activities exceeding cash outflow.

2.1.3 Principles for Analyzing Cash#

Cash needs to match short-term debt (the company's ability to repay debt) and operational needs (the ability to utilize funds).

(1) Cash balance is much smaller than short-term liabilities;
(2) Cash is abundant, but there are many interest-bearing or even high-interest debts;
(3) Many fixed deposits, a lot of other cash, but severely lacking in working capital;
(4) Other cash amounts are huge but lack reasonable explanation.

(1) may represent a short-term debt crisis for the company; (2), (3), and (4) may indicate fabrication, freezing, or that the major shareholder has already occupied the funds.

For companies involved in value-added tax, accounts receivable, notes receivable, and cash received all include value-added tax collected on behalf of the tax bureau. Therefore, the tax payable item in the balance sheet also includes the value-added tax collected. However, the operating income in the income statement does not record value-added tax.

2.2.1 Notes Receivable#

For the seller, sales generate notes receivable; for the buyer, liabilities create accounts payable.

Notes receivable are divided into:

Bank acceptance bills (cashable by banks), which are equivalent to cash
Commercial acceptance bills.

You can check the composition of notes receivable in the financial report to understand the company's sales policies and market position. Moutai's notes receivable are all bank acceptance bills, indicating Moutai's strong position.

2.2.2 Accounts Receivable: Goods are taken first, payment later.#

Pitfalls:

(1) Accounts receivable increase significantly, exceeding the growth of revenue, and collection speed is below the industry average;
(2) Accounts receivable account for more than 30% of revenue, and a large portion is over one year old;
(3) Accounts receivable are very low. The longer accounts receivable are overdue, the higher the chance they become bad debts.

Making provisions for bad debts on accounts receivable, then recovering them through the next collection to gain profits, is also a means of manipulating financial statements.

If a company with long-term accounts receivable suddenly resolves the accounts receivable issue with a large sum of money, please be cautious.

2.2.3 Prepayments#

Prepayments are payments made to suppliers for goods or construction projects. If a company frequently makes large prepayments to suppliers, it indicates a weak position.

2.2.4 Other Receivables#

This is a catch-all for receivables unrelated to the main business. Excellent listed companies have very small amounts of other receivables and payables.

2.2.5 Long-term Receivables#

Refers to receivables generated from financing leases and installment payments using deferral methods.

2.2.6 Inventory#

Inventory consists of goods held for sale, products in the production process, and related raw materials, mainly composed of raw materials, labor costs, and manufacturing expenses.

Inventory valuation methods:

First-in, first-out
Last-in, first-out
Weighted average
Individual valuation

2.2.7 Productive Biological Assets, a high incidence area for fraud.#

Production-related assets include:

Fixed assets
Construction in progress
Engineering materials
Intangible assets
Goodwill
Long-term deferred expenses
Deferred tax assets (liabilities)

2.3.1 Fixed Assets#

Non-monetary assets held by the company for operation with a useful life of more than one year, including buildings, machinery, vehicles, and other equipment related to production and operation.

Fixed assets must (1) be depreciated; (2) undergo impairment testing; (3) depreciation policies can be straight-line, units of production, double declining balance, or sum-of-the-years'-digits; (4) depreciation counts as an expense and must be deducted from the income statement; (5) depreciation does not mean the asset has actually incurred a loss.

2.3.2 Construction in Progress and Engineering Materials#

Construction in progress refers to projects under construction, consuming engineering materials while creating fixed assets.

2.3.3 Intangible Assets#

Patent rights
Trademark rights
Copyrights
Land use rights
Licenses
Copyrights
Non-patent technology

2.3.4 Goodwill#

If a company's profitability exceeds the normal earning capacity of identifiable net assets, the excess is attributed to another type of asset called "goodwill."

2.3.5 Long-term Deferred Expenses#

Expenses already incurred by the company but lasting more than one year. The larger the amount, the worse the quality of the company's assets.

Trading financial assets, held-to-maturity investments, available-for-sale financial assets, purchased resale financial assets, long-term equity investments, and investment properties.

2.4.2 Trading Financial Assets#

The company intends to hold them short-term for price differences. They cannot be transferred to other accounts, and the fair value changes during the holding period are recorded as current profits and losses, affecting the company's current profits. Listed companies holding stocks of other companies will list them in the board report or important matters, usually referred to as holding stocks of other listed companies.

Transaction costs for purchasing trading financial assets are directly deducted from the current income statement.

Items affecting the income statement:

Fair value changes
Dividends or interest

2.4.3 Held-to-Maturity Investments#

Generally various bonds. Interest received annually is directly recorded in the investment income section of the income statement.

Items affecting the income statement:

Investment income calculated at the effective interest rate
Impairment

2.4.4 Available-for-Sale Financial Assets#

Measured at fair value.

2.4.5 Long-term Equity Investments#

Classification of investments in other companies:

Control: Holding more than 50%
Joint venture: Contractually agreed
Associate: Holding proportionally agreed, usually 20%-50%
Others: Generally holding below 20%

Dividends or changes in operating activities of the companies held affect the company's income statement.

2.5 Liabilities and Owner's Equity#

2.5.1 Liabilities are also Equity#

They are the creditors' equity. Divided into current liabilities and non-current liabilities based on whether the maturity is within one year.

2.5.2 Liabilities can be divided into two types#

One is based on the source of liabilities, divided into operating liabilities, distribution liabilities, and financing liabilities; the other is based on whether they bear interest, divided into interest-bearing liabilities and non-interest-bearing liabilities.

(1) Operating liabilities: Accounts payable, taxes payable, and prepayments;
(2) Distribution liabilities: Dividends payable, income taxes payable;
(3) Financing liabilities: Short-term and long-term loans.

Investors are most concerned about whether the company's cash and cash equivalents can cover interest-bearing liabilities, followed by the proportion of interest-bearing liabilities to total assets.

(1) Loans from the central bank, deposits, and interbank placements: Mainly the privilege of financial institutions, most listed companies do not have this.
(2) Payable employee compensation: Employee salaries, funds, insurance, provident funds, etc. Salaries paid to frontline employees are included in production costs; those paid to workshop managers are included in manufacturing expenses; those paid to corporate managers are included in management expenses; those paid to sales personnel are included in sales expenses; those paid to construction personnel are included in construction projects.
(3) Special payables: Funds invested by the government for special or specific purposes.

2.5.3 Owner's Equity#

Also known as shareholder equity or net assets, calculated by subtracting total liabilities from total assets.

Paid-in capital
Capital reserve
Surplus reserve
Undistributed profits

Paid-in capital, also known as share capital, is the registered capital on the business license. The par value is generally 1 yuan. The amount of paid-in capital represents how much share capital the company has.

Capital reserve is the portion of share capital premium when issuing stocks, which can be converted into share capital but cannot be distributed.

Surplus reserve and undistributed profits. The order of profit distribution:

First, to cover previous losses;
Second, to extract statutory surplus reserve fund at 10% of the current year's after-tax profit (can stop extracting after exceeding 50% of registered capital);
Third, shareholders decide whether to extract and how much discretionary surplus reserve;
Finally, decide whether to distribute to shareholders.

Companies can use surplus reserves or undistributed profits to issue bonus shares, and after the issuance, surplus reserves must not be less than 25% of registered capital.

2.6 Quick Reading of the Balance Sheet#

First look at liabilities and owner's equity. By looking at "Total Liabilities and Owner's Equity," you can know how much the company has, then look at "Total Owner's Equity" to know how much is its own and how much is borrowed.

Liabilities: Why borrow, from whom, for how long, and what is the interest? If the numbers are questionable, you can search for relevant explanations.

Tangible assets (production assets) include fixed assets, construction in progress, engineering materials in the balance sheet, and intangible assets like land.

Production assets / Total assets: A high proportion is called a heavy company, a low proportion is called a light company.

Or you can use the current year's pre-tax profit / production assets to get a ratio higher than twice the bank loan interest rate.

Proportion of receivables to total assets: Is it too large? Accounts receivable divided by average monthly operating income to see if it is too large.

Proportion of cash to interest-bearing liabilities: See if the company has a debt crisis.

3 Income Statement#

3.1 Key Points of the Income Statement#

3.1.1 Income Statement#

Also known as the profit and loss statement, stock prices are related to price-earnings ratios and earnings per share.

Earnings per share calculated based on existing share capital.

Diluted earnings per share: Earnings per share calculated based on existing share capital plus potential share capital (such as outstanding warrants, stock options, convertible bonds, etc. that may increase the company's share capital).

3.1.3 Classification#

Consolidated income statement. The consolidated income statement shows the operating activities of the headquarters plus its controlling subsidiaries, offsetting all profits after internal transactions. The main focus is still on the consolidated statement's "Net Profit Attributable to Parent Company Owners" item.
Parent company income statement. The parent company income statement shows the operating profit of the headquarters and the dividends declared by controlling subsidiaries for the year.

Minority interests refer to the rights of other shareholders in subsidiaries.

3.1.4 Process of Generating Net Profit#

First, the process from operating income to operating profit;
Second, the process from operating profit to net profit.

3.2 The Process of Creating Profit#

Profit does not equal making money because actual cash has not been received.

Accounting methods are divided into:

Cash basis: Revenue and expenses are defined by cash received and paid.
Accrual basis: Revenue and expenses are determined by the occurrence of rights and responsibilities (can be unrealized).

3.2.1 Total Operating Income#

Refers to the total inflow of economic benefits formed during the company's daily operations, such as selling goods, providing services, and transferring asset usage rights.

Classification:

Main business income
Other business income

Total operating income = Main business income + Other business income or Total operating income = Product sales volume (or service volume) * Product unit price (or service unit price)

Sales revenue from main and by-products (or different grades of products) should all be included in operating income; income from different types of services should also be included in operating income.

Operating income is the revenue obtained from main or other businesses. It refers to the monetary income obtained by commercial enterprises from selling goods or providing services within a certain period.

The principle of recognizing operating income: Search in the financial report for "recognized when the following conditions are met" to find the income recognition principle.

Investors should pay attention to the ratio of operating costs to main business income.

3.2.2 Gross Profit Margin#

Gross profit margin is the ratio of gross profit to main operating income.

When analyzing, compare gross profit margins over several years, analyze the reasons for changes, and consider whether the changes are reasonable.

The final profit of a company is determined by three factors:

Gross profit margin, Moutai model
Turnover rate, Walmart model
Operating leverage size, bank model

3.2.3 Total Operating Costs#

Costs and expenses in the income statement must be incurred during the period to obtain revenue, known as the matching principle.

Total operating costs:

Operating costs (operating costs)
Business taxes and surcharges
Operating expenses
Selling expenses
Management expenses
Financial expenses
Asset impairment losses

Changes in selling expenses and management expenses should align with changes in operating income.

Operating costs are also known as business costs or operating costs. They refer to the costs of goods sold or services provided by enterprises.

Asset impairment losses may arise from equity, fixed assets, intangible assets, goodwill, inventory, bad debts, available-for-sale financial assets, held-to-maturity investments, etc.

Impairment losses on inventory, accounts receivable, and debt investments are important means for companies to manipulate profits. If they are large, please analyze the issues.

Net profit must be compared with the "Net Cash Flow from Operating Activities" in the cash flow statement; it can also be used as Net Cash Flow from Operating Activities / Net Profit, with a ratio greater than 1 representing a cash printing machine.

3.3 Quick Reading of the Income Statement#

Key points to focus on in the income statement: operating income, gross profit margin, expense ratio, operating profit.

3.3.1 Operating Income#

The first priority for a company should be to grow in the past, present, and future. There are three ways to achieve revenue growth: potential demand growth, market share expansion, and price increases.

3.3.2 Gross Profit Margin#

A high gross profit margin indicates that the company has a strong competitive advantage, with fewer substitutes or high costs of substitution. Avoiding low gross profit margin companies significantly reduces the probability of failure.

3.3.3 Expenses#

This is also used to exclude companies. Expenses, also known as the three expenses, include selling expenses, management expenses, and financial expenses.

(1) Companies with high selling expenses indicate that they lack strong sales power and must rely on high expenses to complete sales.
(2) The growth rate of management expenses should generally align with the growth of operating income; if there are significant changes, it is advisable to study them.

Expense ratios can also be calculated by dividing expenses by total operating income or by dividing expenses by gross profit; if expenses can be controlled within 30% of gross profit, it is considered an excellent company.

R&D expenses: Kelly formula. (Learning)

Operating profit margin is the most core number in the financial report. For companies like Moutai, with a gross profit margin of 90% and operating profit of 70%.

Changes in operating profit margin should not only look at the numbers but also consider whether they are due to price increases, cost reductions, or effective expense control. It is necessary to think specifically about the entire industry, whether it is one-time, and the same behavior of competitors.

Determine whether cash returns to the company. The method is to use the "Net Cash Flow from Operating Activities" in the cash flow statement divided by the net profit in the income statement; if greater than 1, it represents a good company.

4 Cash Flow Statement#

4.1 Breakdown of the Cash Flow Statement#

The cash flow statement is responsible for showing the changes in the "Cash and Cash Equivalents" item in the balance sheet, truly reflecting the source of cash.

The balance sheet only shows the beginning and ending changes in cash; whether the company's money is borrowed or earned.

The income statement shows whether the company's money is earned.

Investors should only care about the consolidated cash flow statement.

The cash flow statement is divided into:

Cash flow from financing activities
Cash flow from investing activities
Cash flow from operating activities

4.1.1 Cash Flow from Operating Activities#

Inflows#

Cash received from sales of goods and services. Records cash received from sales of goods, cash recovered from previous sales, and new prepayments minus cash paid for returns during the period (including VAT collected).
Cash received from tax refunds. Records cash received from tax refunds.
Cash received from other operating-related activities. Reflects cash received from other operating-related activities, such as rent received from operating leases, interest from own funds, etc.

Outflows#

Cash paid for purchasing goods and receiving services: Reflects cash paid for purchases during the period and payments for previous payables, minus cash received from returns during the period.
Cash paid to employees and for employees: Reflects actual cash paid to employees for salaries, bonuses, various allowances, and subsidies during the period.
Taxes paid.
Cash paid for other operating-related activities: Reflects cash expenditures related to operations, such as rent for operating leases, travel expenses, business entertainment fines, etc.

Important numbers in operating cash flow:

Net cash flow from operating activities
If negative, the company is in financial trouble.
If equal to 0, the company is barely surviving.
If greater than 0 but less than depreciation, the company lacks the ability to upgrade.
If greater than 0 and equal to depreciation, the company can maintain the status quo.
If greater than 0 and greater than depreciation, it indicates potential growth.
Net cash flow from operating activities / net profit, a ratio greater than 1 indicates an excellent company, the larger the better.
Cash received from sales of goods and services
If "Net Cash Flow from Operating Activities" divided by operating income is greater than 1.17, it indicates that the company has basically received all the sales payments.
If far less than 1, it proves that a large amount of money has not been received and is still owed.

4.1.2 Cash Flow from Investing Activities#

Inflows#

Cash received from recovering investments: Reflects cash received from selling, transferring, or recovering various investments.
Cash received from investment income: Reflects cash dividends and interest received from various investments.
Cash received from the net amount of fixed assets, intangible assets, and other long-term assets disposed of: The net amount of money from selling assets minus expenses.
Cash received from insurance compensation after disasters is also included here.
Cash received from disposing of subsidiaries and other operating units.
Cash received from other investment-related activities: Reflects cash inflows related to investment activities other than the above items.

There are two situations for cash inflows from investment activities: one is selling assets, and the other is dividends or interest from investments.

Outflows#

Cash paid for purchasing fixed assets, intangible assets, and other long-term assets: Reflects cash spent on purchasing or constructing assets. However, for fixed assets purchased in installments, the down payment is counted here, while subsequent payments are counted as financing cash outflows.
Cash paid for investments: Reflects cash paid for various types of investments and related expenses.
Cash paid for acquiring subsidiaries and other operating units: Cash paid for acquiring companies or business units, minus the cash on the acquired company's or business unit's books.
Cash paid for other investment-related activities.

There are two situations for cash outflows from investment activities: one is investing in oneself to form fixed assets; the other is investing outwards, purchasing stocks and bonds from others, or establishing subsidiaries and joint ventures.

(1) Negative net cash flow from investment activities indicates that the company is in a spending expansion phase; conversely, it is generally in contraction.

(2) Whether the return on investment is higher than the average return on social funds.

4.1.3 Cash Flow from Financing Activities#

Inflows#

Cash received from investment: Cash income from selling stocks minus issuance costs.
Cash received from borrowing: Reflects cash received from various short-term and long-term loans.
Cash received from issuing bonds: Cash income from issuing bonds minus issuance costs.
Cash received from other financing-related activities: Reflects cash inflows related to financing activities other than the above items.

Outflows#

Cash paid to repay debts: Reflects cash used to repay the principal of debts.
Cash paid for distributing dividends, profits, or paying interest.
Cash paid for other financing-related activities: Reflects cash outflows related to financing activities other than the above items, such as donations, financing lease fees, loan interest, and subsequent cash for installment purchases of assets.

4.1.4 Deriving the Cash Flow Statement#

The cash flow statement is derived from the income statement and balance sheet.

The derivation of the cash flow statement is divided into two types:

One is derived from "cash received from sales of goods and services," called the direct method. The cash flow statement prepared using the direct method is used to analyze the sources and uses of cash from operating activities and predict the future cash flow of the enterprise.
The other is derived from net profit, called the indirect method (this table is in the notes). The cash flow statement prepared using the indirect method facilitates comparing net profit with net cash flow from operating activities, understanding the reasons for discrepancies between net profit and cash flow from operating activities, and analyzing the quality of net profit from a cash flow perspective.

Deriving net cash flow from operating activities from net profit:

Step 1: Add back all expenses deducted from net profit that did not actually incur cash expenditure during the period, such as asset impairment provisions, depreciation, and asset disposal losses.
Step 2: Subtract all income not related to operating activities from net profit, such as investment income, interest income from funds raised in special accounts (financial expenses in the table, introduced on page 85 of the financial report).
Step 3: Subtract cash expenditures not included in costs from operating activities, such as overpaid taxes (deferred tax assets), increased inventory, increased receivables, and paid payables.

Free cash flow refers to the money earned from operating activities, minus the amount that must be reinvested to maintain the company's profitability. In simpler terms, it is calculated as net cash flow from operating activities minus net cash outflow from investment activities.

4.2 Portrait of Corporate Cash Flow#

4.2.1 Positive Net Cash Flow from Operating Activities#

(1) Net cash flow from operating activities (+) Net cash flow from investing activities (+) Net cash flow from financing activities (+), indicates a strong company; pay attention to what the financing activities are used for and the planned investment projects.
(2) Net cash flow from operating activities (+) Net cash flow from investing activities (+) Net cash flow from financing activities (-), indicates a stable company with low PE and high dividend yield; whether the net cash flow from investing activities is derived from asset sales.
(3) Net cash flow from operating activities (+) Net cash flow from investing activities (-) Net cash flow from financing activities (+), indicates a strong company; focus on project prospects and funding support. This company invests operating funds and financing funds into investment activities.
(4) Net cash flow from operating activities (+) Net cash flow from investing activities (-) Net cash flow from financing activities (-), indicates a stable company; investment is expanding, and the company is also repaying debts. Focus on sustainability.

4.2.2 Negative Net Cash Flow from Operating Activities#

(5) Net cash flow from operating activities (-) Net cash flow from investing activities (+) Net cash flow from financing activities (+), not recommended for investment.
(6) Net cash flow from operating activities (-) Net cash flow from investing activities (+) Net cash flow from financing activities (-), not recommended for investment.
(7) Net cash flow from operating activities (-) Net cash flow from investing activities (-) Net cash flow from financing activities (+), gambler type, no construction investment.
(8) Net cash flow from operating activities (-) Net cash flow from investing activities (-) Net cash flow from financing activities (-), refuse to participate.

4.3 Quick Reading of the Cash Flow Statement#

Key point: Focus on the consolidated cash flow statement.

4.3.1 Abnormal Phenomena in Operating Cash Flow#

Continuous negative net cash flow from operating activities;
Positive net cash flow from operating activities, but mainly due to increases in accounts payable and notes payable;
Net cash flow from operating activities far lower than net profit.

4.3.2 Abnormal Phenomena in Investing Cash Flow#

Expenditures for purchasing fixed assets, intangible assets, etc., continuously higher than net cash flow from operating activities, indicating that the company is borrowing money to maintain investment behavior;
A large amount of cash inflow from investment activities is obtained from selling fixed assets or other long-term assets.

4.3.3 Abnormal Phenomena in Financing Cash Flow#

Cash received from borrowing is far less than cash paid to repay loans;
The company pays obviously higher interest or intermediary fees for financing, reflected in "cash paid for distributing dividends, profits, or paying interest" and "cash paid for other financing-related activities." Search for details.

4.3.4 Selecting Quality Companies through the Cash Flow Statement:#

Net cash flow from operating activities > net profit > 0
Cash received from sales of goods and services ≥ operating income
Net cash flow from investing activities < 0, and mainly for expansion rather than maintaining existing production capacity
Net increase in cash and cash equivalents > 0, which can be relaxed to exclude dividend factors, this item > 0
Ending cash and cash equivalents balance ≥ interest-bearing liabilities, which can be relaxed to ending cash and cash equivalents + bank acceptance bills in receivables > interest-bearing liabilities.

4.3.5 Analysis through the Three Statements:#

Comparison of cash flow from operating activities and net profit
Comparison of cash received from sales of goods and services and operating income
Comparison of cash balance, investment expenditure, cash dividends, and interest-bearing liabilities

5 Comprehensive Reading and Analysis of Financial Reports#

5.1 Overview of the Three Major Statements#

5.1.1 Interconnected Three Major Statements#

The balance sheet reflects the financial condition of the enterprise, including its assets and liabilities.
The income statement reflects the operating results of the enterprise over a period, demonstrating the process and ability of the enterprise to create value and achieve profitability using controlled resources.
The cash flow statement reflects the process of cash inflows and outflows, demonstrating the enterprise's ability to raise and manage funds.

Net profit in the income statement = ending surplus reserve in the balance sheet + ending undistributed profits - beginning surplus reserve - beginning undistributed profits + dividends implemented during the period.

Most companies that commit fraud will inflate assets.

5.1.2 Analyzing Company Accounts in Four Steps#

Step 1: Browse the balance sheet and income statement items, focusing on any abnormalities. For example: in the balance sheet, investors should focus on accounts receivable, notes receivable, other receivables, and long-term deferred expenses for significant growth; on the liabilities side, pay attention to notes payable, accounts payable, other payables, and short-term loans for significant growth. In the income statement, check for significant changes in operating profit; whether the sum of fair value changes, investment income, and asset impairment losses has a significant change in proportion to operating profit; whether the ratio of operating profit to net profit remains basically stable.
Step 2: Conduct historical analysis of financial indicators. Look at financial statements for over 5 years and compare with history.
Step 3: Compare the trends of changes in company profits and cash flow. The quality of profits is an important responsibility of the cash flow statement. Over several years, the company's net profit issues should maintain a stable ratio with the net cash flow from operating activities, and preferably, the net cash flow from operating activities should exceed net profit. If cash flow is poor, consider why profits have not been converted into cash.
Step 4: Compare the company with competitors. Comparing the company with competitors or industry benchmarks can provide a broader perspective.

5.2 Financial Indicator Analysis#

5.2.1 Safety Analysis#

This refers to whether the company can timely repay short-term debts (current liabilities) when needed. Common indicators include two types: current ratio and quick ratio.

Current Ratio = Current Assets / Current Liabilities.
Quick Ratio = Quick Assets / Current Liabilities.
Cash and cash equivalents / interest-bearing liabilities ≥ 1 or (cash + net value of financial assets) / interest-bearing liabilities ≥ 1.

A current ratio around 2 and a quick ratio around 1 are ideal states for a company.

5.2.2 Profitability Analysis#

Look at it from two angles:

One is from the perspective of operating income, i.e., how much of each unit of operating income can be converted into profit;
The other is from the asset perspective, i.e., how much profit can be generated from each unit of shareholder investment plus borrowed interest-bearing liabilities.

From the perspective of income, look at profitability:#

Operating profit margin = (Operating income - Operating costs - three expenses) / Operating income
Gross margin = (Operating income - Operating costs) / Operating income
Net profit margin = Net profit / Operating income

Gross margin shows the competitiveness of the company's products;

Operating profit and net profit add expense information.

From the asset perspective, use return on equity (ROE) to measure the company's profitability:#

Return on equity (ROE) = Net profit / Average net assets
Return on total assets = Net profit / total assets

5.2.3 Growth Analysis#

Can be viewed from both income and asset perspectives.

From the income perspective, focus on operating income growth rate and operating profit growth rate;
From the asset perspective, focus on total asset growth rate and net asset growth rate.

From the income perspective, focus on operating income growth rate and operating profit growth rate:#

Operating income growth rate = (Current operating income - Previous operating income) / Previous operating income
Operating profit growth rate = (Current operating profit - Previous operating profit) / Previous operating profit

From the asset perspective, focus on total asset growth rate and net asset growth rate.#

Total asset growth rate = (Current total assets - Previous total assets) / Previous total assets
Net asset growth rate = (Current net assets - Previous net assets) / Previous net assets

5.2.4 Management Capability Analysis#

Mainly observe accounts receivable turnover, inventory turnover, fixed asset turnover, total asset turnover, etc.

Accounts receivable turnover = Operating income / Average accounts receivable
Average accounts receivable = (Beginning accounts receivable total + Ending accounts receivable total) / 2
Inventory turnover = Operating costs / Average inventory balance
Average inventory balance = (Beginning inventory total + Beginning inventory total) / 2
Fixed asset turnover = Operating income / Net fixed assets
Total asset turnover = Operating income / Average total assets

5.2.5 Overall Analysis (Common DuPont Analysis System)#

Return on equity = Net profit / Net assets can be modified to:

Return on equity = (Net profit / Sales revenue) × (Sales revenue / Average total assets) × (Average total assets / Net assets)

This analysis breaks down the net profit into three parts:

Product net profit margin (Net profit / Sales revenue)
Total asset turnover (Sales revenue / Average total assets)
Leverage ratio (Average total assets / Net assets)

Through this analysis, it can be determined whether the company relies on high net profit margins (product net profit margin), operational capabilities (total asset turnover), or whether the company uses sufficiently large leverage (leverage ratio).

5.3 Using Financial Data for Valuation#

Three methods to evaluate a company:

Discounted cash flow method, calculating the present value of all future free cash flows the company can generate to determine its value;
Liquidation value method, calculating the cash value remaining after selling all assets and settling all debts;
Market value method, predicting a company's value based on its trading price in the stock market.

6 Statement of Changes in Owner's Equity and Financial Report Notes#

6.1 Statement of Changes in Owner's Equity#

Gains come from changes in asset values or incidental events. The difference from income is that income comes from daily operations.

Gains are divided into two parts:

Gains and losses included in current profits and losses
Asset impairment losses;
Fair value changes;
Investment income;
Aggregate income;
Non-operating income and expenses.
Gains and losses not included in current profits and losses
The difference between the fair value of available-for-sale financial assets and book value;
The difference between the fair value and book value on the reclassification date of financial assets;
The difference between the fair value and original book value when converting self-used or inventory real estate to fair value accounting for investment properties;
Changes in owner’s equity of the investee other than net profit, calculated based on the shareholding ratio under the equity method;
The fair value corresponding to the equity contained in convertible bonds.

6.2 Financial Report Notes#

The notes to the financial report contain the richest information.

Part Seven (Explanation of Consolidated Report Items) and Part Thirteen (Explanation of Main Items in Parent Company Financial Statements) are the most important contents.

7 Management Report#

7.1 Board of Directors Report#

Analysis and discussion of operating conditions

Main business analysis
Industry, product regional operation analysis: various classified products
Asset-liability analysis
Investment situation analysis

7.2 Important Matters#

8 Fraud and Anti-Fraud#

8.1 Common Three Methods#

8.1.1 Fictitious Income#

Exaggerating income through one-time actions
Transforming the sale of business units or assets into operating income; converting acquisition expenses into operating income
Bundling losses into one company or department, then selling to cover losses
Engaging in swap trades to exaggerate income
Recognizing income in advance
Recognizing income for products or services not yet provided
Recognizing income when the buyer has not explicitly assumed payment obligations
Recognizing income exceeding the completion percentage

8.1.2 Manipulating Expenses#

Pushing current expenses into the future
Concealing costs or losses
Washing the big bath: making the company's operating conditions deteriorate all at once

8.1.3 Manipulating Cash Flow#

Increasing cash inflows from operating activities
Reducing cash outflows from operating activities
One-time actions delivering net cash flow from operating activities

8.1.4 Manipulating the Income Statement#

Actively accruing bad debt provisions to reduce current profits
Reversing collections in the next period to achieve profit growth in financial reports

8.2 Detecting Signs of Manipulation#

8.2.1 Income Statement#

According to the accounting identity "Assets = Liabilities + Owner's Equity + Income - Expenses," beautifying the changes in owner's equity brought by income and expenses must ultimately be reflected through adjustments to asset and liability items.
Increasing operating income: Intentionally increasing sales revenue of high-margin products, raising prices, or lowering raw material costs. Check freight and handling costs.
Sales and management expenses: Significant increases or decreases in sales and management expenses.
Non-operating expenses and one-time expenses.
Asset impairment losses.

8.2.2 Cash Flow Statement#

Net cash flow from operating activities
Cash outflows from investing activities
Cash received from other operating-related activities
Interest expenses in financing cash flows

8.2.3 Balance Sheet#

Significant increases in accounts receivable
Large amounts of other receivables
Prepayments
Accounts payable and notes payable
Inventory
Construction in progress
Long-term deferred expenses
Intangible assets and goodwill
Payable employee compensation
Bad debts
Outside the financial report

The following are important points summarized based on the book's content.

9 Considerations for Analyzing Financial Reports#

9.1 Important Reminders:#

Three must-watch items in the financial report: financial accounting report, board of directors report, and important matters.
Prioritize excluding companies with ROE (Net Profit / Net Assets) < 15%.
Operating profit is the core profit of the company; companies with a large proportion of non-operating income and expenses should be particularly noted.
The financial report mainly consists of three statements: balance sheet, income statement, and cash flow statement, primarily focusing on consolidated statements.
An important method for reading financial reports: comparing with peers, looking at the differences in proportions of various assets, especially notes receivable, accounts receivable, accounts payable, prepayments, and the proportions of costs, taxes, and expenses relative to income.
Operating profit is the core profit of the company; companies with a large proportion of non-operating income and expenses should be particularly noted.
The board of directors report and important matters must be read carefully.
Any accounting firm unwilling to issue a "standard unqualified opinion" should be ignored.
If a company changes its accounting policy, consider the reasons and implications.
Surplus reserves: After a company makes a profit, it must extract 10% from the parent company's net profit for retention. Once it exceeds 50% of registered capital, the board of directors decides whether to continue extracting. This can only be used to cover losses or distribute bonus shares. At the same time, if bonus shares are distributed, surplus reserves must still be greater than 25% of registered capital.
Bonus shares: Using undistributed profits or surplus reserves to distribute shares is called distributing bonus shares; using capital reserves to distribute shares is called increasing share capital.

9.2 Report Trap Analysis#

9.2.1 Balance Sheet#

Impairment losses on inventory, accounts receivable, and debt investments are important means for companies to manipulate profits. If they are large, please analyze the issues.

Cash#

Cash needs to match short-term debt (the company's ability to repay debt) and operational needs (the ability to utilize funds).

Cash balance is much smaller than short-term liabilities;
Cash is abundant, but there are many interest-bearing or even high-interest debts;
Many fixed deposits, a lot of other cash, but severely lacking in working capital;
Other cash amounts are huge but lack reasonable explanation.

Accounts Receivable#

Significant increases in accounts receivable, exceeding revenue growth, and collection speed below the industry average;
Accounts receivable account for more than 30% of revenue, and a large portion is over one year old;
Accounts receivable are very low. The longer accounts receivable are overdue, the higher the chance they become bad debts.

Other Receivables#

This is a catch-all for receivables unrelated to the main business. Excellent listed companies have very small amounts of other receivables and payables.

Signs of Manipulation#

Significant increases in accounts receivable
Large amounts of other receivables
Prepayments
Accounts payable and notes payable
Inventory
Construction in progress
Long-term deferred expenses
Intangible assets and goodwill
Payable employee compensation
Bad debts
Outside the financial report

9.2.2 Income Statement#

Profit does not equal making money because actual cash has not been received. The income statement is the easiest to manipulate, rooted in the accrual basis of accounting. Money not received can be counted as income; money not paid may be recorded as costs; received money does not count as income; paid money is not recorded as costs.

Total Operating Income#

The principle of recognizing operating income: Search in the financial report for "recognized when the following conditions are met" to find the income recognition principle.

Investors should pay attention to the ratio of operating costs to main business income. Impairment losses on inventory, accounts receivable, and debt investments are important means for companies to manipulate profits. If they are large, please analyze the issues.

Signs of Manipulation#

According to the accounting identity "Assets = Liabilities + Owner's Equity + Income - Expenses," beautifying the changes in owner's equity brought by income and expenses must ultimately be reflected through adjustments to asset and liability items.
Increasing operating income: Intentionally increasing sales revenue of high-margin products, raising prices, or lowering raw material costs. Check freight and handling costs.
Sales and management expenses: Significant increases or decreases in sales and management expenses.
Non-operating expenses and one-time expenses.
Asset impairment losses.

9.2.3 Cash Flow Statement#

Operating Cash Flow#

Important numbers in operating cash flow:

Net cash flow from operating activities
If negative, the company is in financial trouble.
If equal to 0, the company is barely surviving.
If greater than 0 but less than depreciation, the company lacks the ability to upgrade.
If greater than 0 and equal to depreciation, the company can maintain the status quo.
If greater than 0 and greater than depreciation, it indicates potential growth.
Net cash flow from operating activities / net profit, a ratio greater than 1 indicates an excellent company, the larger the better.
Cash received from sales of goods and services
If "Net Cash Flow from Operating Activities" divided by operating income is greater than 1.17, it indicates that the company has basically received all the sales payments.
If far less than 1, it proves that a large amount of money has not been received and is still owed.
Continuous negative net cash flow from operating activities;
Positive net cash flow from operating activities, but mainly due to increases in accounts payable and notes payable;
Net cash flow from operating activities far lower than net profit.

Investment Cash Flow#

Cash received from recovering investments: Reflects cash received from selling, transferring, or recovering various investments.
Cash received from investment income: Reflects cash dividends and interest received from various investments.
Cash received from the net amount of fixed assets, intangible assets, and other long-term assets disposed of: The net amount of money from selling assets minus expenses.
Cash received from insurance compensation after disasters is also included here.
Cash received from disposing of subsidiaries and other operating units.
Cash received from other investment-related activities: Reflects cash inflows related to investment activities other than the above items.

Financing Cash Flow#

Cash received from investment: Cash income from selling stocks minus issuance costs.
Cash received from borrowing: Reflects cash received from various short-term and long-term loans.
Cash received from issuing bonds: Cash income from issuing bonds minus issuance costs.
Cash received from other financing-related activities: Reflects cash inflows related to financing activities other than the above items.

Conclusion#

The financial report is a comprehensive reflection of a company's performance and potential. By carefully analyzing the balance sheet, income statement, and cash flow statement, investors can gain insights into the company's financial health and make informed investment decisions.