The Basics of Understanding Financial Statements by Mariusz Skonieczny is a good primer on how to read financial statements with an eye toward ascertaining the financial well-being of the company. The author begins the presentation by explaining that managers of publicly traded companies communicate with shareholders about the success or failure of a business operations through the prism of financial statements.
The presentation provides examples of simple balance sheet, income statement and cash flow statements. The more complex concepts of comprehensive income and accumulated other comprehensive income are not explained. In addition, municipal accounting statements are not referenced. The financial statements presented show losses with a minus sign instead of a bracket.
Comprehensive income is the sum of net income and other items that are not on the income statement because they haven’t been realized. These types of items include unrealized holding gains or losses from available for sale securities and foreign currency translation gains or losses. These items are not part of net income per se. They are important enough to be included in comprehensive income. As a result, the financial statement user has a more expansive portrayal of the organization as a whole. Items included in comprehensive income, but not net income are reported under the accumulated other comprehensive income section of shareholder’s equity.
Comprehensive income (CI) attempts to measure the sum of all operating and financial events that have changed the value of an owner’s interest in an enterprise. The amount is measured on a per-share basis to capture the effects of dilution and options. CI negates the impact of equity transactions where the owner would be indifferent. i.e. dividend payments, share buy-backs and share issues at market value.
Comprehensive Income (CI) is calculated by reconciling the book value per-share from the start of the period to the end of the period.
Shareholders’ Equity, beg. of period (per share)
less Dividends paid (per share)
plus Shares issued (premium over book value per share)
less Share buy-backs (premium over book value per share)
plus Comprehensive Income (per share)
= Shareholders’ Equity, end of period (per share)
The author explains the necessity of putting cash to work or returning it to the shareholders in the form of dividends or share buy backs. The presentation on accounts receivable is pertinent because some companies report increments in sales yet uncollectibles rise disproportionately. Generally, a company earns more in proportion to the number of fixed assets owned; however, obsolescence can be a major factor in some companies and industries. A prime example would be cell phones. The newer models are lighter with much greater functionality.
The author explains that low gross profit margins may result from cutting prices to remain more competitive. Another important aspect is to analyze the sources of cash to determine whether or not the source is from increased selling or the sale of fixed assets, borrowings or the issuance of stock.
The Basics of Understanding Financial Statements is a good introduction to financial statements for novice investors. This book alone is not enough. There are other factors which impact the purchases of stock; such as, market variability measurable by the VIX index and intermarket events like the difficulties Greece is having with its large debt.
Even a top stock like Apple can lose up to 40% of its value in a major or unforeseen market downturn. Novice investors must be aware of these market influences. Traditionally, portfolios can be protected with stop loss orders or the artful use of covered calls by more sophisticated investors.