How to read an Annual Report
(Continued from last week)
Annual reports are a corporate ‘work of art’ and should not be
read like a normal book. Through this weeks article CSE continues with
the guidelines on how to read an Annual Report.
Balance Sheets
The second financial statement that you’ll encounter in the annual
report is the balance sheet. The basic concept underlying a balance
sheet is simple enough: total assets equal total liabilities plus
equity.
A lot of investors tend to focus on the income statement, but the
balance sheet is just as important a source of information. You can use
the balance sheet to determine the firm’s liquidity, to see how
leveraged the company is, or just to see all specific assets and
liabilities of the company.
The following list will teach you how to read a balance sheet and use
the information from it to find out the company’s current financial
standing.
Current Assets are fixed assets on the balance sheet. Current assets
are defined as assets that can or will be converted into cash quickly
(generally within one year). Current assets include, of course, cash and
cash equivalents (money market accounts, etc.), but it also includes the
company’s inventories (unsold stock) and its accounts receivable
(uncollected bills from its debtors). Current Liabilities are the
opposite of current assets.
They are the money that the company expects to pay out within the
next year. Current liabilities include accounts payables (bills the
company must pay), interest on long term debt, taxes, and dividends.
Non-Current Assets and Liabilities are assets that cannot be turned into
cash quickly or liabilities that are not due for over a year,
respectively. This includes assets such as the company’s plants,
property, and equipment, and liabilities like long-term loans.
Ratios and Other Calculations can be calculated to analyse the
balance sheet, just like you can calculate several different types of
margins to help you analyse a company’s income statement.
Debt Equity Rate: The debt/asset ratio can show you what percentage
of the company’s assets are financed through debt. You can calculate it
by taking total liabilities and dividing by total assets. If the ratio
turns out to be less than one, then that means that most of the
company’s assets are financed through equity. If the ratio turns out to
be greater than one, then the company is financing most of its assets
through debt. Companies that have high ratios are said to be ‘highly
leveraged’. This means that they are carrying excessive amounts of debt
and could be in danger if creditors start to demand repayment.
Current Ratio (depending on the industry): The current ratio is the
opposite of the debt/asset ratio: it takes the total number of current
assets owned by the company and divides by its total current
liabilities. If this number is greater than one, then the company has
enough current assets to cover its short term liabilities.
A number that is much higher than one, however, might indicate that
the company is hoarding its assets instead of putting them to use. A
number less than one indicates that the company may experience problems
with liquidity.
Shareholder Equity: Shareholder equity is equal to total assets minus
total liabilities. This number shows you what part of the company is
owned by the shareholders after all of its obligations have been met.
Working Capital: Working capital is calculated by subtracting the
firm’s current liabilities from its current assets. This number shows
you how much in liquid assets the company has available to build its
business.
The number can be positive or negative, depending on how much debt
the company is carrying. In general, companies that have lots of working
capital will be more successful since they can expand and improve upon
their operations. Companies with negative working capital may lack the
funds necessary for growth.
Turnover Ratio: The turnover ratio is used to determine how many
times a company “turns over” its inventory in a given year. It is
calculated by taking the cost of goods sold and dividing by the average
inventory for the period.
A high turnover ratio is looked upon favorably because it is a sign
that the company is producing and selling its goods or services very
quickly. A low turnover ratio indicates that the company has large
warehouses of inventory going unsold for long periods of time.
Leverage: Financial leverage is a measure of how much debt the
company has assumed in order to finance its assets. It is calculated by
dividing the amount of long-term debt carried by the company by the
company’s total equity. Companies that are highly leveraged may be at
risk of bankruptcy if they are unable to make payments on their debt;
they may also be unable to find new lenders in the future. The important
thing is to be able to differentiate between a healthy amount of debt
for good purposes and too much debt for questionable purposes.
Cash Flow Statements
The cash flow statement is similar to the income statement, except
that it dispenses with some of the abstract items found on the income
statement (such as depreciation) and focuses on actual cash.
Most of the information found on the cash flow statement is contained
in either the income statement or the balance sheet, but here it is
organised in such a way that it is difficult for companies to use
accounting tricks to obscure the facts. The cash flow statement is
broken down into three parts:
Cash Flows from Operating Activities: Here you’ll find how much money
the company received from its actual business operations.
This does not include cash received from other sources, such as
investments. To calculate the cash flow from operating activities, the
company starts with net income (from the income statement), then adds
back in any depreciation expenses, deferred taxes, accounts payable and
accounts receivables, and charges.
Cash Flows from Investing Activities: This section shows how much
money the company has received (or lost) from its investing activities.
It includes money that the company has made (or lost) by investing
its excess cash in different investments (stocks, bonds, etc), money the
company has made (or lost) from buying or selling subsidiaries, and all
the money the company has spent on its physical property, such as plants
and equipment.
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