Advice on Learning from a Reader/Accountant, Agewisdom

agewisdom

As an accountant, I can understand some of the predicament that many non-accountants are facing. Three years to get a professional qualification and another 4 years in auditing and I still get a bit of headache digesting some information on financial statements. So, even though its’ daunting, please don’t get discouraged.

There’s been a lot of great discussion and tips by everyone here (great community) but I’d like to add my top 3 tips to help in understanding financial statements.

1. Start with the familiar.

Basically, I am sure everyone is familiar with some sort of business. You may be an engineer, so you’d be familiar with an engineering business. Or your family may run a stationery shop, so you’d be familiar with that sort of business.  After reading the basic books on financial statements, stop and get a copy of financial statements of businesses that you are familiar with.

Then from there, look at the figures, preferably for the past 3-5 years. You see, what is important to understand is that the financial statements with the notes over a 3-5 year period tells its’ own story. It’s like a novel, except with more figures and some explanatory notes. If you understand the business well, you’ll find that financial statements actually make a lot of sense and quantifies what you know in your gut-feeling. Further, the type of financial statement in every industry is sometimes vastly different. Financial statements in a trading business is vastly different from that of an insurance co, for example.

2. Understand the principles and Hot Areas

If possible, try to understand the underlying reasons why accountants prepare certain financial statements in a certain way. For instance, an understanding of the principle of deferred taxation would allow you to make the firm judgment call that any deferred tax asset in the Balance Sheet should be ignored. Why? I’d leave you to find out. Further, be aware of certain danger areas such as Contingent Liabilities and Special Purpose Vehicles (SPVs). Yes, it’s difficult reading but knowing these areas are quite crucial in assisting in making a firm judgment call.

3. Follow the money or http://www.youtube.com/watch?v=OaiSHcHM0PA

As with all things, cash is KING! So the cash flow statement is the most important part of the financial statements. It doesn’t matter if the company is making HUMUNGOUS profits if its’ cash flow is NEGATIVE. So, a company that is the darling of everyone but is hemorrhaging cash quarterly is a dangerous one. Coincidentally, Enron never prepared cash flow statements on the basis it was too complicated. We all know what happened next.

Enron Case Study: http://wp.me/p1PgpH-2U

7 responses to “Advice on Learning from a Reader/Accountant, Agewisdom

  1. Thank you for the great advice. It reinforces Buffett’s ‘Circle of Competence’ principle. As an engineer and accounting beginner I will stick with manufacturing companies initially because I think the accounts are easier to grasp (for me). It makes perfect sense to become very familiar with a similar style of accounts instead of jumping from trading companies to financial companies etc.

  2. Dear V4Value,

    That’s would be the best way to start of things. Even better would be to get the financial statement of the co. you are working with. Then you can see how the narrative jives with the numbers, so to speak. E.g., if the manufacturing company introduced a new product or entered a new market, see how this is reflected in the financial statements.

    Happy Learning 🙂

  3. Thank you for sharing your thoughts agewisdom.

    With regards to tip #3. I learned in a book that I downloaded here, creative cash flow reporting by Charles Mulford, early stage growth companies exhibit fast growth in earnings but might report negative cash flows due to increasing inventories and accounts receivable.

    How will I know that a company is a legitimate growth company and did not just increased their revenue through creative accounting?

    • Dear Curious,

      Now that’s a good question! The most straightforward way would be to approach it via two different approach, i.e. quantitative and qualitative manner.

      A. Quantitative Manner
      This would be through a more detailed perusal of the financial statements. It’s assumed that we would have at least 1-2 years worth of data, so there would be at least 4-8 quarters to work on.

      Let’s go on a common sense basis first. If the company is growing substantially, you would expect the following:
      1. Sales increases substantially quarter on quarter
      2. Trade debtors or receivables increases only proportionate to the sales. That is, the Average Days to Collect Trade Debts remains the same. This is a simple ratio to calculate.
      3. Inventories should not increase substantially. If it’s such high growth, the stuff they’re making should be flying off the shelves!
      4. Whilst cash may be negative, we’d expect to see the substantial cash received from sales to be used in expanding plant and machinery and other productive assets.

      Now, a lot of times, the OPPOSITE occurs. Although sales increase:
      1. Inventories increase substantially
      2. Trade receivables increase substantially
      3. Cash received is used to pay bonuses, salaries and other non-productive items e.g. entertainment expenses
      4. Trade Payables or Amount due to creditors is increasing

      See, the difference? What usually happens is that the Co. doesn’t have a gee-whiz product that everybody wants. Instead to boost sales, they often loosen standards by giving trade debtors an extremely long credit period or shoving goods out to door to whoever wants it without even vetting whether these customers can pay. In extreme cases, they even send out goods that’s not even ordered, telling the customer, they can return it later.

      As a result, sales is boosted temporarily. Over the long term however, trade receivables start to get bloated and often turn into bad debts. The problem in cash collections results them delaying payment to trade creditors. At the same time, inventories start to pile up cos’ they’re producing goods that they don’t really have a market for. The death spiral would come sooner or later.

      B. Qualitative Manner
      Although analyzing financial statements is fine, nothing beats seeing where the product is sold and asking some customers on their opinion. Heck, you could even try the product yourself if it’s applicable. Often, a little bit of common sense on whether the product is a gee-whiz, I must have it or whether it’s a dud will tell you whether the co. is a legit one or not.

      Hope I’m clear. If not, feel free to ask.

  4. Wow! Very enlightening agewisdom!

    You got this 100% right:
    “Now, a lot of times, the OPPOSITE occurs. Although sales increase:
    1. Inventories increase substantially
    2. Trade receivables increase substantially
    3. Cash received is used to pay bonuses, salaries and other non-productive items e.g. entertainment expenses
    4. Trade Payables or Amount due to creditors is increasing”

    Thank you very much!

    • Dear Curious,

      You’re welcome. We’re all learning and sharing here, thanks to John’s great blog. 🙂

      Kind rgds

  5. Dear Agewisdom,

    Have you tried investing in turnaround situations?

    regards

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