Reading financial statements: Interpreting the story behind 2 comments

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Reading a financial statement for the first time, complete with all the figures and descriptions, is daunting for even those trained in accounting. Yet if one sees it as a chance to obtain details of the company's progress, understand more about its key strengths and risks, and corroborate one's understanding of its outlook, he should relish it.

The investor should already have built a good picture of his investee company beforehand, through self-sourced sector updates, broker reports, company announcements etc. If he chooses his stock right (ie. reasonable scale of operations, good broker/institutional coverage, strong sector player and hence well-geared to sector developments) such updates should be pretty regular and relevant to his company.

After looking at Hong Kong financial reporting format, which are deficient in key areas including balance sheets and cash flows, I have learnt to appreciate the Singapore reporting template. Key information that allows "story interpretation" are all there.

General issues that the investor looks for are available: earnings momentum (P&L), earnings quality (cash flow), and company asset management and financial position (balance sheet). Depending on his skill in interpreting the numbers, he will pick out key evidence that serve to confirm his ideas about the stock, as well as identify key risks that he might not have observed earlier. For example, the company's strong reported earnings growth might corroborate his earlier expectations based on sector updates, while weaker than expected earnings momentum might suggest that the company is not sufficiently exposed to the sector momentum. High receivables which had been observed as a possible risk (potential bad debts) from the previous balance sheet might warrant further investigation if they persist into the current reporting period. High working capital as shown in the cash flow statement might signal a difficulty in inventory clearance which could disprove earlier reports that the product is selling well (such as Creative's MP3 players). Seen in this context, the regular financial statements can be seen as extremely valuable in providing company-specific information that is complementary to the regular news updates.

Then there are the specific issues that the investor has highlighted as important to the context of the stock. Using Peter Lynch's classification of stocks, for asset plays the investor might zoom in to the balance sheet for closer examination; for growth stocks he focuses on toplines and profit margins; for cyclicals he looks for evidence of cycle peaking or bottoming; for stalwarts he looks for dividend growth; for turnarounds he looks for financial strength and key segment performances. Again he tries to pick out details to augment his picture of the company.

And finally, the management outlook for the coming period is one of the most valuable pieces of jigsaw that is better than any other separate announcement. While the numbers above give a report card of the past, management forecast tries to analyse and identify key opportunities and threats in the future. It is so valuable to providing a picture of how the sector is likely to perform that I often read the outlooks section in the reports of peer companies of my actual investee stock just to corroborate my view of the sector in general. Either alarm lights or money signs flash before my eyes as I obtain a consolidated "average" picture of the sector outlook for the future through the actual participants' eyes.