Do you:
– Hate Numbers?
– Find Financial Statements Overwhelming?
– But yet, want to make Consistent Profits from Stock Investing?
If you are, don’t fret.
Please be rest assured that you’re not alone.
As I write, there are millions of people who couldn’t read financial statements. Please bear in mind that a huge chunk of these people are professionals, highly qualified and very intelligent. Thus, if you couldn’t interpret financial statements, there’s no shame in it.
In this article, I’ll share what financial statements are, why they are produced and how you can read them with ease like a pro. If you are one of those who are really bad in maths, please don’t be surprise if you find the below written fairly easy to comprehend.
So, what are financial statements?
Financial statements tell us whether a person is rich or poor. They can be prepared on a personal level, corporate level and government level. Basically, a complete set of financial statements has three documents.
They are:
– Balance Sheet
– Income Statement
– Cash Flow Statement
Why are they prepared?
It depends who are the users of financial statements. Here, I’ll be writing in the context of a stock investor as I’m one.
To me, financial statements are the most important documents as I use them to separate stocks that are rich (financially sound) from stocks that are poor (financially unstable). This enables me to invest in stocks that are profitable and avoid making bad investments in stocks that are making losses.
Let’s start with the Balance Sheet
A balance sheet tells you:
– What you owned (Asset)
– What you owed (Liabilities)
– Your net worth (Equity)
It’s a snapshot of your belongings and debt at a specific point of time. For instance, as at July 31, 2017, your balance sheet looks like:
Figures in RM
No. | Assets | Amount | No. | Liabilities | Amount |
1 | House | 500,000 | 1 | Mortgage | 300,000 |
2 | Car | 50,000 | 2 | Car Loan | 30,000 |
3 | Cash | 50,000 | Total Liabilities | 330,000 | |
4 | Receivables | 1,000 | Your Net Worth | 271,000 | |
| Total Assets | 601,000 | Liabilities + NW | 601,000 | ||
A balance sheet is ‘balanced’ as the total assets that you owned equals to your outstanding liabilities and your net worth.
With this knowledge, you should aim to increase your net worth by increasing assets while reducing liabilities. How fast can you do so? That’s when we look into your income statement.
Now, the Income Statement
An income statement tells you:
– How much income did you bring in? (Sales)
– How much expenses did you incur? (Expenses)
– What’s left? (Profits)
Let us say, you have two jobs. On weekdays, you are a school teacher who makes RM 5,000 in fixed salary. On weekends, you are a freelance editor. In the month of July, you received and completed two freelancing works worth RM 2,000 and RM 1,000 respectively. Also, during the month, you’ve spent RM 4,000 in living expenses. Thus, your income statement looks like:
Figures in RM
No. | Item | Amount |
1 | Salary | 5,000 |
2 | Freelance Work 1 | 2,000 |
3 | Freelance Work 2 | 1,000 |
Total Income | 8,000 | |
4 | Total Expenses | (4,000) |
| 5 | Your Savings (Profits) | 4,000 |
Finally, the Cash Flow Statement
A cash flow statement tells you:
– How much cash did you actually bring in?
– How much cash was flowing out?
– Did you receive more cash into your pocket?
– Or, did more cash flow out from your pocket?
– Your current cash position
Wait a minute!
Isn’t the income statement good enough? Why do we need to prepare the cash flow statement? Good question.
Let’s use the example above where you’ve completed two freelancing works. In July, you’ve received the full payment of RM 2,000 from Freelance Work 1 but haven’t receive the payment of RM 1,000 from Freelance Work 2. In this case, your cash flow statement looks like:
No. | Item | Amount |
Cash Position on June 30, 2017 | 47,000 | |
1 | Salary | 5,000 |
| 2 | Freelance Work 1 | 2,000 |
3 | Freelance Work 2 | 0 |
Total Cash Inflows | 7,000 | |
4 | Total Cash Outflows | (4,000) |
5 | Actually, You Brought in | 3,000 |
| Cash Position on July 31, 2017 | 50,000 | |
So, how do we account for the RM 1,000 which is to be received?
It’s known as receivables. That’s why, in the balance sheet, there’s RM 1,000 in the column of receivables.
No. | Assets | Amount | No. | Liabilities | Amount |
1 | House | 500,000 | 1 | Mortgage | 300,000 |
2 | Car | 50,000 | 2 | Car Loan | 30,000 |
3 | Cash | 50,000 | Total Liabilities | 330,000 | |
4 | Receivables | 1,000 | Your Net Worth | 271,000 | |
Total Assets | 601,000 | Liabilities + NW | 601,000 | ||
For corporations (stocks), the concept is the same. There are stocks that do credit-based sales. This means, they do works for clients and would receive money in 60, 90 or 120 days after works are performed. This is why cash flow statements are prepared separately from an income statement.
Simple Enough?
Hopefully, you’ve found the above simple to comprehend.
Obviously, this article covered the basics. If you are keen to learn more, there is more to discover. Recently, KC Lau has recorded an 1-Hour Session to help you understand a company’s financial statements better. It should be helpful. By the way, he’s an engineering graduate (not an accountant). This means, you can learn this stuff too.
Link:
