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