Financial statements are the main source of information for a long-term investor, who wants to understand, how successful is a public company. Based on these data, it is possible to determine the growth rate. (Fall?) Business, its profitability, level of debt burden, sources of income, as well as the amount of profit, owed to shareholders in the form of dividends. Analysis of the reports suggests, how fair is the current market valuation of the business and whether it is worth thinking about acquiring shares of this issuer in your portfolio.
At the same time, financial documentation is one of the main fears for novice investors., who are just immersed in the world of self-investment. Financial statements can really look confusing and incomprehensible. However, this document is not so difficult to study., as it seems at first glance. Reports are made by and for people, and one of their key tasks is to show a clear and objective picture of the financial situation of the business..
Nevertheless, to learn how to read reports, you will have to learn basic accounting terminology and understand the meaning of each line. Besides, you need to have enough free time, to practice studying the reports of different issuers. After all, despite the general principles of formation, reports of different companies differ. Understanding comes with experience, therefore, it is important to read and re-read, even if not immediately everything will be easy.
I will highlight five mistakes, which are most often done by novice investors when studying financial statements.
Ignore low base effect
Comparing current and previous periods, it is important not to become a hostage to the low base effect, when a multiple growth of indicators is not so much associated with business success, how many with a small starting value.
As an example, let's analyze the results of the telecommunications company PJSC "Science-Svyaz" for 2018 year. The net profit of the issuer during this period soared almost eleven times. Such strong growth can turn the head of an untrained investor, ready to believe, that he found a real diamond – a fast-growing business, who is about to lead the telecommunications sector in Russia.
Rice. 1. A source: financial statements under IFRS "Science-Svyaz" for 2018 godRis. 1. A source: financial statements under IFRS "Science-Svyaz" for 2018 year
However, such strong growth was caused by the effect of the low base. IN 2018 G. indicator recovered after failure 2017 G., when the net profit became almost zero. Over a longer distance, multiples of growth 2018 the year does not look so impressive any more and turns out to be very far from its historical maximums.
Rice. 2. A source: financial statements "Science-Svyaz" according to IFRS Rice. 2. A source: financial statements "Science-Svyaz" under IFRS
Do not understand the reasons for the growth and fall of financial indicators
Figures in reports without context can give little information to investors. Assessing the dynamics of certain financial indicators, it is worth looking for the reasons for the changes, to answer a series of questions.
- Changes are caused by internal factors (increase in production capacity, improving business efficiency, creation of a new competitive product and so on) or external (rise/fall in prices for raw materials or products on the world market, fluctuation of national currency, change of legislation, introduction of time restrictions for business and others)?
- Factor, affecting financial performance, is long-term or short-term?
- How timely and effectively the company responds to changes in the business environment compared to its key competitors?
Do not adjust the results to take into account one-time and non-cash items
Often the growth or fall in profits is associated with a one-time effect, which is unlikely to happen again. For example, the company sells a large asset and immediately receives a significant amount of cash. If the asset was not profile, yes, and the sale price was profitable, is an undoubted positive for shareholders, especially if management decides to share part of the profit in the form of dividends. However, the same asset cannot be sold twice, and next year there will be no such effect from the sale..
Besides, non-cash items due to revaluation of assets or exchange rate differences may also affect financial performance. For example, pork prices rose, and meat producers overestimated the market value of unsold hogs, having received a substantial income from this activity. but, until the meat is sold at settlement prices, earnings exist only on paper. Another example. On the balance sheet the company has shares of another company, and their value has increased tenfold - this will be reflected in the financial statements in the form of paper income received.. but, until the securities are sold, the issuer did not earn real money. At the same time, quotes may decrease and lead to a reverse revaluation..
To smooth out the impact of one-off and non-cash items, the investor should adjust the profit for those factors, that have an effect only once or do not lead to the receipt / loss of real money by the business.
As an example of this,, how different adjustments affect the final outcome, PhosAgro's consolidated financial statements for 2020 year. Excluding adjustments, the company's net profit for the reporting period decreased almost three times compared to 2019 G. with 49,4 to 16,9 RUB billion. Taking into account the adjustments, the situation is reversed - net profit increased by 26% — with 37,1 billion to 46,8 RUB billion.
Don't read the explanations
There are three important sections in the financial statements: Balance sheet, statement of financial results and statement of cash flows. This is the base, with whom the investor-analyst works.
However, do not ignore the explanations, which go below. It usually contains very valuable information., which will help you understand the processes, inside the company, and disclose individual financial items.
Additional information can also be obtained from the company's press releases on the results of financial results or from the MD document.&A, in which top management gives its own analysis of the financial position and results of the issuer's work.
Do not pay attention to the items with the "asterisk"
Another important factor, which is dangerous to ignore, — adjustment of indicators of the previous period. It happens, that the business for some reason revises last year's results - and sometimes the changes are so significant, that turn the situation upside down.
As a vivid illustration, we can consider the financial results of PJSC Aeroflot.
In the consolidated financial statements for 2018 year the company reflected net profit in the amount of 5,7 RUB billion. It was much less, than for the same period of the previous year, nevertheless, the business remained profitable..
Rice. 3. A source: financial statements according to IFRS of PJSC Aeroflot for 2018 godRis. 3. A source: financial statements according to IFRS of PJSC Aeroflot for 2018 year
However, in 2019 G. Aeroflot switches to new IFRS accounting standards 16, in accordance with which the rules of lease accounting have changed. Due to the specifics of the business, the company operates a large fleet of aircraft, a significant part of which is leased.
In connection with the transition to IFRS 16, in 2019 G. the issuer was forced to recalculate the financial indicators for 2018 year, according to the new accounting rules. This led to the fact that, that instead of net profit in the amount of 5,7 RUB bn., the company reflected a loss on the results 2018 G. in size 64,4 RUB billion. As they say, feel the difference.
Rice. 4. A source: financial statements according to IFRS of PJSC Aeroflot for 2019 godRis. 4. A source: financial statements according to IFRS of PJSC Aeroflot for 2019 year
That's why it's so important to read the asterisk notes and understand, how different accounting rules can affect the final result.
Analysis of financial statements is closer to art, than to exact science. Therefore, it is dangerous for the investor to approach this process formally., because the cost of wrong conclusions can be too high.
