A step-by-step guide to reading financial reports

According to the thematic reading method in "How to Read a Book," I plan to spend three months studying financial statements. The first book that is relatively easy to start with is "A Hands-On Guide to Reading Financial Statements," which will be continuously updated and improved.

Basic Knowledge

1.1 Financial Statement Disclosure Timing#

Annual Report: Within 4 months after the end of the year (highest credibility)
Semi-Annual Report: Within 2 months after the end of the first half
Quarterly Reports: Within 1 month after the end of the quarter

1.2 Three Main Financial Statements#

The main financial statements include the balance sheet, income statement, and cash flow statement. These three statements have both consolidated and parent company reports.

The parent company's balance sheet, income statement, cash flow, and statement of changes in equity show the operating conditions of the listed company itself.

In the statements, we mainly focus on the consolidated statements. The consolidated statement is not a legally existing entity; it consolidates the operating conditions of the listed company and its subsidiaries and offsets their investments against each other.

1.2.1 Balance Sheet#

The balance sheet is the sum of assets, liabilities, and equity.

On the right side of the balance sheet is the source of money: debt or shareholder contributions. It is divided into liabilities and equity, arranged according to the urgency of repayment, with the most urgent at the top.
Liabilities indicate how much money is borrowed.
Equity indicates how much is shareholder money.
On the left side of the balance sheet is the destination of money: the company's assets. Assets are arranged according to their liquidity. The most liquid is cash, while the least liquid includes fixed assets, intangible assets, goodwill, etc.

1.2.2 Income Statement#

The income statement is the easiest to manipulate, rooted in the accrual basis of accounting. Money not received can be counted as income; money not paid may be recorded as costs; received money does not count as income; paid money is not recorded as costs.

Operating profit is the core profit of the company, and companies with a large proportion of non-operating income and expenses should be paid special attention.

1.2.3 Cash Flow Statement#

The cash flow statement shows the inflow and outflow of cash. The most accurate figures in the statement are the beginning cash balance, ending cash balance, and the difference between the two.

Cash activities of the company are divided into three categories: operating activities, investing activities, and financing activities.

Operating Activities: Cash income from selling goods or providing services and corresponding cash expenditures.
Investing Activities: Expenditures for internal and external investments and the situation of receiving returns on previous investments.
Financing Activities: Cash received from stock buybacks, dividend distributions to shareholders, borrowing, or issuing stocks, along with related costs.

1.3 Commonly Used Financial Statement Websites#

Giant Tide Information: http://www.cninfo.com.cn
Shanghai Stock Exchange: http://www.sse.com.cn
Shenzhen Stock Exchange: http://www.szse.cn

1.4 Important Reminders#

The content in important reminders, especially opinions issued by accounting firms, is quite significant. Any firm unwilling to issue a "standard unqualified opinion" should be considered problematic. If the accountant does not use this standard phrase, simply ignore the company.

Three must-watch items in financial statements: financial accounting reports, board reports, and important matters. Secondary content includes changes in shares and shareholder situations, as well as information on directors, supervisors, senior management, and employees.

First, exclude companies with ROE (Net Profit / Net Assets) < 15%.

This raises an interesting point: by comparing the number of shareholders at the end of each financial statement period, the number of shareholders disclosed in the 5 days prior, and the stock price at that time, one can draw some interesting conclusions.

Balance Sheet

The asset section of the balance sheet is arranged according to liquidity. It is mainly divided into current assets and non-current assets.

As an investor, Old Tang's classification:

Cash and cash equivalents
Operating-related assets
Production-related assets
Investment-related assets

2.1 Cash and Cash Equivalents#

Only the consolidated statement data needs to be focused on for cash and cash equivalents. The cash and cash equivalents in the parent company and subsidiary statements are merely internal transfers and need not be considered. The "prepayments" in the parent company statement have no observational significance.

Behind cash and cash equivalents, the second column of notes shows (1), indicating an explanation for the cash and cash equivalents item, which can be found in the consolidated statement notes. It can be located using the search function.

2.1.1 Classification of Cash and Cash Equivalents#

Cash on hand
Bank deposits
Other cash equivalents
Reserves held at the central bank that can be withdrawn at any time
Interbank placements
Interbank loans
Securities purchased under resale agreements
Investments held by the enterprise that are short-term (generally referring to those maturing within three months from the date of purchase), highly liquid, easily convertible to known amounts of cash, and with minimal risk of value fluctuation.

2.1.2 Sources of Cash and Cash Equivalents#

(1) Issuing stocks or borrowing;
(2) Selling assets or business units;
(3) Continuous cash inflow from operating activities exceeding cash outflow.

2.1.3 Principles of Cash and Cash Equivalents Analysis#

Cash and cash equivalents need to match short-term debts (the company's debt repayment ability) and operational needs (the ability to utilize funds).

(1) The balance of cash and cash equivalents is much smaller than short-term liabilities;
(2) Cash and cash equivalents are abundant, yet the company has borrowed a lot of interest-bearing or even high-interest debt;
(3) There are many time deposits, many other cash equivalents, but a severe lack of working capital;
(4) Other cash equivalents are substantial but lack reasonable explanation.

(1) may indicate a short-term debt crisis for the company, while (2), (3), and (4) may suggest fictitious, frozen, or already occupied by major shareholders.

For companies involved in value-added tax, accounts receivable, notes receivable, and cash received all include the value-added tax collected on behalf of the tax bureau. Therefore, the tax payable item in the balance sheet also includes the value-added tax collected on behalf of the tax bureau. However, the operating income in the income statement does not record value-added tax.

2.2.1 Notes Receivable#

For the seller, sales generate notes receivable; for the buyer, liabilities create accounts payable.

Notes receivable are divided into:

Bank acceptance bills (cashable by the bank), which are equivalent to cash;
Commercial acceptance bills.

Notes receivable composition can be queried in the financial report to understand the company's sales policy and market position. Moutai's notes receivable are all bank acceptance bills, indicating Moutai's strong market position.

2.2.2 Accounts Receivable: Goods are taken before payment.#

Pitfalls:

(1) A significant increase in accounts receivable, exceeding the growth of income during the same period, with collection speed below the uneven industry level;
(2) Accounts receivable accounting for more than 30% of income, with a large portion being over a year old;
(3) Very low accounts receivable. The longer accounts receivable are overdue, the higher the chance they become bad debts.

Making provisions for bad debts on accounts receivable and then recovering them through subsequent collections to gain profits is also a means of manipulating financial statements.

If a company with long-term accounts receivable suddenly resolves the accounts receivable issue with a large sum of money, proceed with caution.

2.2.3 Prepayments#

Prepayments refer to the purchase payments made to suppliers or prepayments for construction projects. If a company frequently makes large prepayments to suppliers, it indicates a weak position.

2.2.4 Other Receivables#

This is a catch-all for receivables unrelated to the main business. Excellent listed companies have minimal amounts in other receivables and payables.

2.2.5 Long-Term Receivables#

Refers to receivables generated from financing leases and those collected in installments using a deferred method.

2.2.6 Inventory#

Inventory consists of goods held for sale, products in the production process, and related raw materials, primarily composed of raw materials, labor costs, and manufacturing expenses.

Inventory valuation methods:

First-in, first-out (FIFO)
Last-in, first-out (LIFO)
Weighted average
Specific identification

2.2.7 Productive Biological Assets, a high-risk area for fraud.#

Production-related assets include:

Fixed assets
Construction in progress
Engineering materials
Intangible assets
Goodwill
Long-term deferred expenses
Deferred tax assets (liabilities)

2.3.1 Fixed Assets#

Non-monetary assets held by the company for operation with a useful life exceeding one year, including buildings, machinery, vehicles, and other equipment related to production and operation.

Fixed assets must (1) be depreciated; (2) undergo impairment testing; (3) have depreciation policies such as straight-line, units of production, double declining balance, and sum-of-the-years'-digits; (4) depreciation counts as an expense and must be deducted from the income statement; (5) depreciation does not mean the asset has truly incurred a loss.

2.3.2 Construction in Progress and Engineering Materials#

Construction in progress refers to projects under construction, consuming engineering materials while creating fixed assets.

2.3.3 Intangible Assets#

Patents
Trademarks
Copyrights
Land use rights
Licenses
Copyrights
Non-patented technology

2.3.4 Goodwill#

If a company's profitability exceeds the normal earning capacity of identifiable net assets, the excess is attributed to another asset known as "goodwill."

2.3.5 Long-Term Deferred Expenses#

Expenses already incurred by the enterprise but lasting more than one year. The larger the figure, the poorer the quality of the company's assets.

Trading financial assets, held-to-maturity investments, available-for-sale financial assets, purchased resale financial assets, long-term equity investments, and investment properties.

2.4.2 Trading Financial Assets#

The company intends to hold these for a short time to gain price differences. They cannot be transferred to other accounts, and the fair value changes during the holding period are recognized as current gains and losses, affecting the company's current profits. Listed companies holding stocks of other companies will list them in board reports or important matters, usually referred to as holding stocks of other listed companies.

Transaction costs for purchasing trading financial assets are directly deducted from the current income statement.

Items affecting the income statement:

Fair value changes
Dividends or interest

2.4.3 Held-to-Maturity Investments#

Generally refers to various bonds. The interest received each year is directly recorded in the investment income section of the income statement.

Items affecting the income statement:

Investment income calculated at the effective interest rate
Impairment

2.4.4 Available-for-Sale Financial Assets#

Measured at fair value.

2.4.5 Long-Term Equity Investments#

Classification of investments in other companies:

Control: Holding more than 50%
Joint venture: Contractually agreed
Associate: Contractually agreed holding, usually 20%-50%
Other: Generally below 20%

Dividends or operational changes from held companies affect the company's income statement.

2.5 Liabilities and Owner's Equity#

2.5.1 Liabilities are also Equity#

They are the creditors' equity. Divided into current liabilities and non-current liabilities based on whether the due date is within one year.

2.5.2 Liabilities can be divided into two types#

One is based on the source of liabilities, divided into operating liabilities, distribution liabilities, and financing liabilities; the other is based on whether interest is incurred, divided into interest-bearing and non-interest-bearing liabilities.

(1) Operating liabilities: Accounts payable, taxes payable, prepayments;
(2) Distribution liabilities: Dividends payable, income taxes payable;
(3) Financing liabilities: Short-term and long-term loans.

Investors are most concerned about whether the company's cash and cash equivalents can cover interest-bearing liabilities, followed by the proportion of interest-bearing liabilities to total assets.

(1) Loans from the central bank, deposits, and interbank placements: Mainly the privilege of financial institutions, most listed companies do not have this.
(2) Employee compensation payable: Salaries, funds, insurance, provident fund, etc. Salaries paid to frontline employees are included in production costs; those paid to workshop managers are included in manufacturing expenses; those paid to corporate managers are included in management expenses; those paid to sales personnel are included in sales expenses; those paid to construction personnel are included in construction in progress.
(3) Special payables: Funds invested by the government for specific or designated purposes.

2.5.3 Owner's Equity#

Also known as shareholder equity or net assets, calculated by subtracting total liabilities from total assets.

Paid-in capital
Capital reserve
Surplus reserve
Undistributed profits

Paid-in capital, also known as share capital, is the registered capital on the business license. The nominal value is generally 1 yuan. The amount of paid-in capital represents how much share capital the company has.

Capital reserve is the portion of share capital premium at the time of issuing stocks, which can be converted into share capital but cannot be distributed.

Surplus reserve and undistributed profits. The order of profit distribution:

First, cover previous losses;
Second, 10% of the current year's after-tax profits should be allocated to statutory surplus reserves (after exceeding 50% of registered capital, it can be stopped);
Third, shareholders decide whether to allocate and how much to allocate from discretionary surplus reserves;
Finally, decide whether to distribute to shareholders.

Companies can use surplus reserves or undistributed profits to issue bonus shares, and after the issuance, surplus reserves must not be less than 25% of registered capital.

2.6 Quick Reading of the Balance Sheet#

First look at liabilities and owner's equity. By looking at the "total liabilities and owner's equity," you can know how much the company has, then look at "total owner's equity" to see how much is its own and how much is borrowed.

Liabilities: Why borrow, from whom, for how long, and what is the interest? If there are doubts about the numbers, you can search for relevant explanations.

Tangible assets (production assets) include fixed assets, construction in progress, engineering materials, and intangible assets in the balance sheet.

Production assets / Total assets: A large proportion is called a heavy company, while a small proportion is called a light company.

Alternatively, you can use the current year's pre-tax profit / production assets to derive a ratio higher than twice the bank loan interest rate.

Proportion of receivables to total assets: Is it too large? Accounts receivable divided by average monthly operating income to see if it is too large.

Proportion of cash and cash equivalents to interest-bearing liabilities: To see if the company has a debt crisis.

3 Income Statement#

3.1 Key Points of the Income Statement#

3.1.1 Income Statement#

Also known as the profit and loss statement, stock prices are related to price-to-earnings ratios and earnings per share.

Earnings per share calculated based on existing share capital.

Diluted earnings per share: Earnings per share calculated based on existing share capital plus potential share capital (such as outstanding warrants, stock options, convertible bonds, etc. that may increase the company's share capital).

3.1.3 Classification#

Consolidated income statement. The consolidated income statement shows the operating activities of the parent company plus its controlling subsidiaries, offsetting all profits after internal transactions. It mainly looks at the consolidated statement's "net profit attributable to owners of the parent company."
Parent company income statement. The parent company income statement shows the operating profit of the parent company and the dividends declared by controlling subsidiaries for the year.

Minority interests refer to the equity belonging to other shareholders of the subsidiary.

3.1.4 Process of Generating Net Profit#

First, the process from operating income to operating profit;
Second, the process from operating profit to net profit.

3.2 The Process of Creating Profit#

Profit does not equal making money because actual cash has not been received.

Accounting methods are divided into:

Cash basis: Defines income and expenses based on cash received and paid.
Accrual basis: Determines receivables and payables based on the occurrence of rights and responsibilities (can be unrealized).

3.2.1 Total Operating Income#

Refers to the total inflow of economic benefits formed during the daily business activities of selling goods, providing services, and transferring asset usage rights.

Classification:

Main business income
Other business income

Total operating income = Main business income + Other business income or Total operating income = Product sales volume (or service volume) * Product unit price (or service unit price)

Sales income from main and by-products (or different grades of products) should all be included in operating income; income from different types of services should also be included in operating income.

Operating income is the income obtained from main or other business activities. It refers to the monetary income obtained from selling goods or providing services within a certain period.

The principle of recognizing operating income: Search in the financial report for "recognized when the following conditions are met" to find the income recognition principles.

Investors should pay attention to the ratio of operating costs to main business income.

3.2.2 Gross Profit Margin#

Gross profit margin is the proportion of gross profit to main operating income.

When analyzing, compare gross profit margins over several years, analyze the reasons for changes, and consider whether the changes are reasonable.

The final profit of a company is determined by three factors:

Gross profit margin, Moutai model
Turnover rate, Walmart model
Size of operating leverage, bank model

3.2.3 Total Operating Costs#

Costs and expenses in the income statement must be incurred during the period to obtain income, which accountants refer to as the matching principle.

Total operating costs:

Operating costs (operational costs)
Business taxes and surcharges
Operating expenses
Selling expenses
Management expenses
Financial expenses
Asset impairment losses

Changes in selling expenses and management expenses should align with changes in operating income.

Operating costs, also known as business costs, refer to the costs of goods sold or services provided by the enterprise.

Asset impairment losses may arise from equity, fixed assets, intangible assets, goodwill, inventory, bad debts, available-for-sale financial assets, held-to-maturity investments, etc.

Impairment losses on inventory, accounts receivable, and debt investments are important means for companies to manipulate profits. If the amount is large, please analyze the issue.

Net profit must be compared with the "net cash flow from operating activities" in the cash flow statement, and the ratio of net cash flow from operating activities / net profit greater than 1 indicates a cash printing machine.

3.3 Quick Reading of the Income Statement#

Key points to focus on in the income statement: operating income, gross profit margin, expense ratio, operating profit.

3.3.1 Operating Income#

The first priority for a company should be to grow in the past, present, and future. There are three ways for a company's revenue to grow: potential demand growth, market share expansion, and price increases.

3.3.2 Gross Profit Margin#

A high gross profit margin indicates that the company has a strong competitive advantage, with fewer substitutes or high costs of substitution. Avoiding low gross profit margin companies greatly reduces the probability of failure.

3.3.3 Expenses#

This is also used to exclude companies. Expenses, also known as the three expenses, include selling expenses, management expenses, and financial expenses.

(1) Companies with high selling expenses indicate that they do not have strong sales power and must rely on high expenses to complete sales.
(2) The growth rate of management expenses generally aligns with the growth of operating income; if there is a significant change, it is advisable to study it.

Expense ratios can also be calculated by dividing expenses by total operating income or using expenses divided by gross profit; if expenses can be controlled within 30% of gross profit, it is considered an excellent company.

R&D expenses: Kelly formula. (Learning)

Operating profit margin is the most core number in the financial report. For companies like Moutai, with a gross profit margin of 90% and operating profit of 70%.

Changes in operating profit margin should not only look at the numbers but also consider whether it is due to price increases, cost reductions, or effective expense control. Specific thoughts should be given to the entire industry, whether it is one-time, and similar behaviors of competitors.

Determine whether cash returns to the company. The method is to use the "net cash flow from operating activities" in the cash flow statement divided by the net profit in the income statement; if greater than 1, it indicates a good company.

4 Cash Flow Statement#

4.1 Breakdown of the Cash Flow Statement#

The cash flow statement is responsible for showing the changes in "cash and cash equivalents" in the balance sheet, truly reflecting the source of cash.

The balance sheet only shows the beginning and ending changes in cash; whether the company's money is borrowed or earned.

The income statement can show whether the company's money is earned.

Investors should only care about the consolidated cash flow statement.

The cash flow statement is divided into:

Cash flow from financing activities
Cash flow from investing activities
Cash flow from operating activities

4.1.1 Cash Flow from Operating Activities#

Inflows#

Cash received from sales of goods and services. Records cash received from the sale of goods and services during the period, cash recovered from previous sales, and new prepayments, minus cash paid for returns during the period (including value-added tax collected).
Tax refunds received. Records cash received from tax refunds.
Other cash related to operating activities received. Reflects other cash received related to operating activities, such as rent received from operating leases, interest on own funds, etc.

Outflows#

Cash paid for purchasing goods and accepting services: Reflects cash paid for purchases during the period and cash paid for previous payables, minus cash received for returns during the period.
Cash paid to employees and for employees: Reflects cash actually paid to employees for wages, bonuses, various allowances, and subsidies during the period.
Paid taxes.
Other cash paid related to operating activities: Reflects cash expenditures related to operations, such as rent for operating leases, travel expenses, and business entertainment fines.

Important numbers in operating cash flow:

Net cash flow from operating activities
Negative: The company is in deficit
Zero: The company barely survives
Greater than 0, less than depreciation and amortization: The company lacks the ability to upgrade
Greater than 0, equal to depreciation and amortization: The company can maintain the status quo
Greater than 0, greater than depreciation and amortization: Indicates potential growth
Net cash flow from operating activities / net profit, a ratio greater than 1 indicates an excellent company, the larger the better
Cash received from sales of goods and services
If "net cash flow from operating activities" divided by net profit in the income statement is greater than 1, it is an excellent company; equal to 1 is also acceptable; less than 1 indicates concerns about net profit quality.
Cash received from sales of goods and services
Divided by operating income, greater than 1.17 indicates that the company has basically received all sales amounts;
Much less than 1 indicates that a large amount of money has not been received and is still owed.

4.1.2 Cash Flow from Investing Activities#

Inflows#

Cash received from recovering investments: Reflects cash received from selling, transferring, or recovering various investments.
Cash received from investment income: Reflects cash dividends and interest received from various investments.
Net cash received from disposing of fixed assets, intangible assets, and other long-term assets: Cash from selling assets minus expenses.
Insurance compensation received after disasters is also included here.
Cash received from disposing of subsidiaries and other operating units.
Other cash received related to investing activities: Reflects other cash inflows related to investing activities, excluding the above items.

There are two situations for cash inflows from investing activities: one is selling assets, and the other is dividends or interest from investments.

Outflows#

Cash paid for purchasing fixed assets, intangible assets, and other long-term assets: Reflects cash spent on purchasing or constructing assets. However, for fixed assets purchased in installments, the down payment counts here, while subsequent payments are counted as cash outflows from financing activities.
Cash paid for investments: Reflects cash paid for various types of investments and related expenses.
Net cash paid for acquiring subsidiaries and other operating units: Cash paid for acquiring companies or business units, minus the cash on the acquired company's or business unit's books.
Cash paid for other investing activities.

There are two situations for cash outflows from investing activities: one is investing in oneself to form fixed assets; the other is investing outwards, purchasing stocks and bonds from others, or establishing subsidiaries and joint ventures.

(1) Negative net cash flow from investing activities indicates that the company is in a spending expansion phase; conversely, it is generally in a contraction phase.

(2) Whether the return on investment is higher than the average return on social funds.

4.1.3 Cash Flow from Financing Activities#

Inflows#

Cash received from investment: Cash income from selling stocks minus issuance costs.
Cash received from borrowing: Reflects cash received from various short-term and long-term loans.
Cash received from issuing bonds: Cash income from issuing bonds minus issuance costs.
Other cash received related to financing activities: Reflects other cash inflows related to financing activities, excluding the above items.

Outflows#

Cash paid to repay debts: Reflects cash used to repay the principal of debts.
Cash paid for distributing dividends, profits, or paying interest.
Other cash paid related to financing activities: Reflects other cash outflows related to financing activities, such as donations, financing lease fees, loan interest, and later cash for installment purchases of assets.

4.1.4 Deriving the Cash Flow Statement#

The cash flow statement is derived from the income statement and balance sheet.

The derivation of the cash flow statement is divided into two types:

One is derived from "cash received from sales of goods and services," called the direct method. The cash flow statement prepared using the direct method is used to analyze the sources and uses of cash from operating activities and predict the future cash flow of the enterprise.
The other is derived from net profit, called the indirect method (this table is in the notes). The cash flow statement prepared using the indirect method is convenient for comparing net profit with net cash flow from operating activities, understanding the reasons for differences between net profit and cash flow from operating activities, and analyzing the quality of net profit from a cash flow perspective.

Deriving net cash flow from net profit:

Step 1: Add back any expenses deducted from net profit that did not actually incur cash outflows during the period, such as asset impairment provisions, depreciation, and asset write-off losses.
Step 2: Subtract any income not related to operating activities from net profit, such as investment income, interest income from funds raised in special accounts (financial expenses in the table, introduced on page 85 of the financial report).
Step 3: Subtract cash expenditures not included in costs from operating activities, such as overpaid taxes (deferred tax assets), increased inventory, increased receivables, and paid payables.

Free cash flow refers to the money earned from operating activities, minus the amount that must be reinvested to maintain the company's profitability. Simply put, it is calculated as net cash flow from operating activities minus net cash outflow from investing activities.

4.2 Portrait of Corporate Cash Flow#

4.2.1 Positive Net Cash Flow from Operating Activities#

(1) Positive net cash flow from operating activities (+) + net cash flow from investing activities (+) + net cash flow from financing activities (+): This indicates a strong company; attention should be paid to what the financing activities are used for and the planned investment projects.
(2) Positive net cash flow from operating activities (+) + net cash flow from investing activities (+) + net cash flow from financing activities (-): This indicates a mature company with low PE and high dividend yield; whether the net cash flow from investing activities comes from asset sales.
(3) Positive net cash flow from operating activities (+) + net cash flow from investing activities (-) + net cash flow from financing activities (+): This indicates a strong company; attention should be paid to the outlook for investment projects and funding support. This company has invested operating cash and financing cash into investing activities.
(4) Positive net cash flow from operating activities (+) + net cash flow from investing activities (-) + net cash flow from financing activities (-): This indicates a normal company; investment is expanding, and the company is also repaying debts. Attention should be paid to sustainability.

4.2.2 Negative Net Cash Flow from Operating Activities#

(5) Negative net cash flow from operating activities (-) + net cash flow from investing activities (+) + net cash flow from financing activities (+): Not recommended for investment.
(6) Negative net cash flow from operating activities (-) + net cash flow from investing activities (+) + net cash flow from financing activities (-): Not recommended for investment.
(7) Negative net cash flow from operating activities (-) + net cash flow from investing activities (-) + net cash flow from financing activities (+): This indicates a gambler type; no investment in construction.
(8) Negative net cash flow from operating activities (-) + net cash flow from investing activities (-) + net cash flow from financing activities (-): Refuse to participate.

4.3 Quick Reading of the Cash Flow Statement#

Focus: Pay attention to the consolidated cash flow statement.

4.3.1 Abnormal Phenomena in Operating Cash Flow#

Continuous negative net cash flow from operating activities;
Positive net cash flow from operating activities, but mainly due to increases in accounts payable and notes payable;
Net cash flow from operating activities far below net profit.

4.3.2 Abnormal Phenomena in Investing Cash Flow#

Expenditures for purchasing fixed assets, intangible assets, etc., continuously exceeding net cash flow from operating activities, indicating that the company is borrowing money to maintain investment behavior;
A large amount of cash inflow from investing activities is due to the sale of fixed assets or other long-term assets.

4.3.3 Abnormal Phenomena in Financing Cash Flow#

Cash received from borrowing is far less than cash paid to repay loans;
The company pays obviously higher interest or intermediary fees for financing, reflected in "cash paid for dividends, profits, or interest" and "cash paid for other financing activities." Search for details.

4.3.4 Selecting Quality Companies through the Cash Flow Statement:#

Net cash flow from operating activities > net profit > 0
Cash received from sales of goods and services ≥ operating income
Net cash flow from investing activities < 0, and mainly for new projects rather than maintaining existing production capacity
Net increase in cash and cash equivalents > 0, which can be relaxed to exclude dividend factors, this item > 0
Ending balance of cash and cash equivalents ≥ interest-bearing liabilities, which can be relaxed to ending cash and cash equivalents + bank acceptance bills in receivables > interest-bearing liabilities.

4.3.5 Analysis through Three Statements:#

Comparison of cash flow from operating activities and net profit
Comparison of cash received from sales of goods and services and operating income
Comparison of cash balance, investment expenditure, cash dividends, and interest-bearing liabilities

5 Comprehensive Reading and Analysis of Financial Statements#

5.1 Overview of the Three Major Statements#

5.1.1 Interconnected Three Major Statements#

The balance sheet reflects the financial condition of the enterprise, including its assets and liabilities.
The income statement reflects the operating results of the enterprise over a period, demonstrating the process and ability of the enterprise to create value and achieve profitability using controlled resources.
The cash flow statement reflects the inflow and outflow of cash, demonstrating the enterprise's ability to raise and manage funds.

Net profit in the income statement = ending surplus reserve in the balance sheet + ending undistributed profits - beginning surplus reserve - beginning undistributed profits + dividends implemented during the period.

Most companies that commit fraud will inflate assets.

5.1.2 Analyzing Company Accounts in Four Steps#

Step 1: Browse through the balance sheet and income statement items, focusing on any abnormalities. For example: In the balance sheet, investors should focus on whether accounts receivable, notes receivable, other receivables, and long-term deferred expenses have increased significantly; on the liabilities side, pay attention to whether accounts payable, notes payable, other payables, and short-term loans have increased significantly. In the income statement, check whether operating profit has changed significantly; whether the sum of fair value changes, investment income, and asset impairment losses has changed significantly in proportion to operating profit; whether the ratio of operating profit to net profit remains stable.
Step 2: Conduct historical analysis of financial indicators. Look at financial statements over 5 years or more and compare them with history.
Step 3: Compare the trends of profit and cash flow changes in the company. The quality of profit is an important responsibility of the cash flow statement. Over several years, the company's net profit issues should maintain a stable ratio with the net cash flow from operating activities, and it is best if the net cash flow from operating activities exceeds net profit. If cash flow is poor, consider why profit has not been converted into cash.
Step 4: Compare the company with competitors. Comparing the company with competitors or industry benchmarks can provide a broader perspective.

5.2 Financial Indicator Analysis#

5.2.1 Safety Analysis#

This refers to whether the company can repay short-term debts (current liabilities) in a timely manner when needed. Common indicators include two types: current ratio and quick ratio.

Current Ratio = Current Assets / Current Liabilities.
Quick Ratio = Quick Assets / Current Liabilities.
Cash and cash equivalents / interest-bearing liabilities >= 1 or (cash + net value of financial assets) / interest-bearing liabilities >= 1.

A current ratio around 2 and a quick ratio around 1 are ideal states for a company.

5.2.2 Profitability Analysis#

Look at it from two angles:

One is from the perspective of operating income, i.e., how much of each unit of operating income can be converted into profit;
The other is from the asset perspective, i.e., how much profit can be generated from each unit of shareholder investment plus borrowed interest-bearing liabilities.

From the perspective of income, profitability can be viewed as:#

Operating profit margin = (Operating income - Operating costs - three expenses) / Operating income
Gross profit margin = (Operating income - Operating costs) / Operating income
Net profit margin = Net profit / Operating income

Gross profit margin shows the competitiveness of the company's products;

Operating profit and net profit add expense information.

From the asset perspective, use return on equity (ROE) to measure the company's profitability:#

Return on equity (ROE) = Net profit / Average net assets
Return on total assets = Net profit / Total assets

5.2.3 Growth Analysis#

Can be viewed from both income and asset perspectives.

From the income perspective, focus on the growth rate of operating income and operating profit;
From the asset perspective, focus on total asset growth rate and net asset growth rate.

From the income perspective, focus on the growth rate of operating income and operating profit:#

Operating income growth rate = (Current operating income - Previous operating income) / Previous operating income
Operating profit growth rate = (Current operating profit - Previous operating profit) / Previous operating profit

From the asset perspective, focus on total asset growth rate and net asset growth rate.#

Total asset growth rate = (Current total assets - Previous total assets) / Previous total assets
Net asset growth rate = (Current net assets - Previous net assets) / Previous net assets

5.2.4 Management Capability Analysis#

Mainly observe accounts receivable turnover, inventory turnover, fixed asset turnover, total asset turnover, etc.

Accounts receivable turnover = Operating income / Average accounts receivable
Average accounts receivable = (Beginning accounts receivable + Ending accounts receivable) / 2
Inventory turnover = Operating costs / Average inventory balance
Average inventory balance = (Beginning inventory + Ending inventory) / 2
Fixed asset turnover = Operating income / Net fixed assets
Total asset turnover = Operating income / Average total assets

5.2.5 Overall Analysis (Common DuPont Analysis System)#

Return on equity = Net profit / Net assets can be modified to:

Return on equity = (Net profit / Sales income) * (Sales income / Average total assets) * (Average total assets / Net assets)

This analysis breaks down the net profit into three parts:

Product net profit margin (Net profit / Sales income)
Total asset turnover (Sales income / Average total assets)
Leverage ratio (Average total assets / Net assets)

Through this analysis, it can be determined whether the company relies on high net profit margins (product net profit margin), operational capability (total asset turnover), or whether the company uses sufficiently large leverage (leverage ratio).

5.3 Using Financial Data for Valuation#

Three methods to evaluate a company:

Discounted cash flow method, calculating the present value of all future free cash flows that the company can generate to determine its value;
Liquidation value method, calculating the remaining cash value after selling all assets and paying off all liabilities;
Market value method, predicting a company's value based on its trading price in the stock market.

6 Statement of Changes in Owner's Equity and Financial Statement Notes#

6.1 Statement of Changes in Owner's Equity#

Gains come from changes in asset values or incidental events. The difference from income is that income refers to daily operating activities.

Gains are divided into two parts:

Gains and losses included in current profits and losses
Asset impairment losses;
Fair value changes;
Investment income;
Aggregate income;
Non-operating income and expenses.
Gains and losses not included in current profits and losses
The difference between the fair value of available-for-sale financial assets and book value;
The difference between the fair value and book value on the reclassification date of financial assets;
The difference between the fair value on the conversion date of self-used or inventory real estate to fair value mode accounting and the original book value;
The changes in owner’s equity of the investee, excluding net profit, calculated according to the shareholding ratio under the equity method;
The fair value corresponding to the equity contained in convertible bonds.

6.2 Financial Statement Notes#

The notes to the financial statements contain the richest information.

Part Seven (Explanation of Consolidated Statement Items) and Part Thirteen (Explanation of Major Items in Parent Company Financial Statements) are the most important contents.

7 Management Report#

7.1 Board Report#

Analysis and discussion of operating conditions

Main business analysis
Industry, product regional operation analysis: various classified products
Asset-liability analysis
Investment status analysis

7.2 Important Matters#

8 Fraud and Anti-Fraud#

8.1 Three Common Methods#

8.1.1 Fictitious Income#

Exaggerating income through one-time actions
Transforming the sale of business units or assets into operating income; converting acquisition expenses into operating income
Bundling losses into one company or department, then selling to cover up losses
Conducting swap trades to exaggerate income
Recognizing income in advance
Recognizing income for products or services that have not yet been provided
Recognizing income when the buyer has not explicitly assumed payment obligations
Recognizing income exceeding the completion percentage

8.1.2 Manipulating Expenses#

Pushing current expenses to the future
Covering up costs or losses
Washing the big bath: making the company's operating conditions deteriorate all at once

8.1.3 Manipulating Cash Flow#

Increasing cash inflow from operating activities
Reducing cash outflow from operating activities
One-time actions delivering net cash flow from operating activities

8.1.4 Manipulating the Income Statement#

Actively accruing bad debt provisions to reduce current profits
Reversing collections in the next period to achieve profit growth in financial reports

8.2 Detecting Manipulation Signs#

8.2.1 Income Statement#

According to the accounting equation "Assets = Liabilities + Owner's Equity + Income - Expenses," beautifying the changes in owner's equity brought by income and expenses must ultimately be reflected by adjusting asset and liability items.
Increasing operating income: Deliberately increasing sales revenue of high-margin products, or raising prices, or reducing raw material costs. Check freight and handling costs.
Sales and management expenses: Significant increases or decreases in sales and management expenses
Non-operating expenses and one-time expenses
Asset impairment losses

8.2.2 Cash Flow Statement#

Net cash flow from operating activities
Cash outflow from investing activities
Other cash received related to operating activities
Interest expenses in financing cash flow

8.2.3 Balance Sheet#

Significant increase in accounts receivable
Large other receivables
Prepayments
Accounts payable and notes payable
Inventory
Construction in progress
Long-term deferred expenses
Intangible assets and goodwill
Employee compensation payable
Bad debts
Outside the financial report

The following are important points summarized based on the content of the book.

9 Important Considerations for Analyzing Financial Reports#

9.1 Important Reminders:#

Three must-watch items in financial statements: financial accounting reports, board reports, and important matters.
Prioritize excluding companies with ROE (Net Profit / Net Assets) < 15%.
Operating profit is the core profit of the company; companies with a large proportion of non-operating income and expenses should be paid special attention.
Financial reports mainly consist of the balance sheet, income statement, and cash flow statement, with a primary focus on consolidated statements.
An important method for reading financial reports: compare with peers to see how different asset proportions vary, especially accounts receivable, notes receivable, accounts payable, prepayments, and the respective proportions of costs, taxes, and expenses to income.
Operating profit is the core profit of the company; companies with a large proportion of non-operating income and expenses should be paid special attention.
The board report and important matters must be read carefully.
Any accounting firm unwilling to issue a "standard unqualified opinion" should be directly ignored.
If a company changes accounting policies, consider the reasons and impacts.
Surplus reserves: After a company makes a profit, it must retain 10% from the parent company's net profit. After exceeding 50% of registered capital, the board decides whether to continue retaining. This can only be used to cover losses or issue bonus shares. Additionally, if issuing bonus shares, surplus reserves must still be greater than 25% of registered capital.
Bonus shares: Using undistributed profits or surplus reserves to issue shares is called issuing bonus shares; using capital reserves to issue shares is called increasing share capital.

9.2 Report Trap Analysis#

9.2.1 Balance Sheet#

Impairment losses on inventory, accounts receivable, and debt investments are important means for companies to manipulate profits. If the amount is large, please analyze the issue.

Cash and Cash Equivalents#

Cash and cash equivalents need to match short-term debts (the company's debt repayment ability) and operational needs (the ability to utilize funds).

The balance of cash and cash equivalents is much smaller than short-term liabilities;
Cash and cash equivalents are abundant, yet the company has borrowed a lot of interest-bearing or even high-interest debt;
There are many time deposits, many other cash equivalents, but a severe lack of working capital;
Other cash equivalents are substantial but lack reasonable explanation.

Accounts Receivable#

Significant increase in accounts receivable, exceeding the growth of income during the same period, with collection speed below the uneven industry level;
Accounts receivable accounting for more than 30% of income, with a large portion being over a year old;
Very low accounts receivable. The longer accounts receivable are overdue, the higher the chance they become bad debts.

Other Receivables#

This is a catch-all for receivables unrelated to the main business. Excellent listed companies have minimal amounts in other receivables and payables.

Signs of Manipulation#

Significant increase in accounts receivable
Large other receivables
Prepayments
Accounts payable and notes payable
Inventory
Construction in progress
Long-term deferred expenses
Intangible assets and goodwill
Employee compensation payable
Bad debts
Outside the financial report

9.2.2 Income Statement#

Profit does not equal making money because actual cash has not been received. The income statement is the easiest to manipulate, rooted in the accrual basis of accounting. Money not received can be counted as income; money not paid may be recorded as costs; received money does not count as income; paid money is not recorded as costs.

Total Operating Income#

The principle of recognizing operating income: Search in the financial report for "recognized when the following conditions are met" to find the income recognition principles.

Investors should pay attention to the ratio of operating costs to main business income. Impairment losses on inventory, accounts receivable, and debt investments are important means for companies to manipulate profits. If the amount is large, please analyze the issue.

Signs of Manipulation#

According to the accounting equation "Assets = Liabilities + Owner's Equity + Income - Expenses," beautifying the changes in owner's equity brought by income and expenses must ultimately be reflected by adjusting asset and liability items.
Increasing operating income: Deliberately increasing sales revenue of high-margin products, or raising prices, or reducing raw material costs. Check freight and handling costs.
Sales and management expenses: Significant increases or decreases in sales and management expenses
Non-operating expenses and one-time expenses
Asset impairment losses

9.2.3 Cash Flow Statement#

Operating Cash Flow#

Important numbers in operating cash flow:

Net cash flow from operating activities
Negative: The company is in deficit
Zero: The company barely survives
Greater than 0, less than depreciation and amortization: The company lacks the ability to upgrade
Greater than 0, equal to depreciation and amortization: The company can maintain the status quo
Greater than 0, greater than depreciation and amortization: Indicates potential growth
Net cash flow from operating activities / net profit, a ratio greater than 1 indicates an excellent company, the larger the better
Cash received from sales of goods and services
If "net cash flow from operating activities" divided by net profit in the income statement is greater than 1, it is an excellent company; equal to 1 is also acceptable; less than 1 indicates concerns about net profit quality.
Cash received from sales of goods and services
Divided by operating income, greater than 1.17 indicates that the company has basically received all sales amounts;
Much less than 1 indicates that a large amount of money has not been received and is still owed.

9.3 Analyzing Company Accounts in Four Steps#

Step 1: Browse through the balance sheet and income statement items, focusing on any abnormalities. For example: In the balance sheet, investors should focus on whether accounts receivable, notes receivable, other receivables, and long-term deferred expenses have increased significantly; on the liabilities side, pay attention to whether accounts payable, notes payable, other payables, and short-term loans have increased significantly. In the income statement, check whether operating profit has changed significantly; whether the sum of fair value changes, investment income, and asset impairment losses has changed significantly in proportion to operating profit; whether the ratio of operating profit to net profit remains stable.
Step 2: Conduct historical analysis of financial indicators. Look at financial statements over 5 years or more and compare them with history.
Step 3: Compare the trends of profit and cash flow changes in the company. The quality of profit is an important responsibility of the cash flow statement. Over several years, the company's net profit issues should maintain a stable ratio with the net cash flow from operating activities, and it is best if the net cash flow from operating activities exceeds net profit. If cash flow is poor, consider why profit has not been converted into cash.
Step 4: Compare the company with competitors. Comparing the company with competitors or industry benchmarks can provide a broader perspective.

9.4 Financial Indicator Analysis#

9.4.1 Safety Analysis#

This refers to whether the company can repay short-term debts (current liabilities) in a timely manner when needed. Common indicators include two types: current ratio and quick ratio.

Current Ratio = Current Assets / Current Liabilities.
Quick Ratio = Quick Assets / Current Liabilities.
Cash and cash equivalents / interest-bearing liabilities >= 1 or (cash + net value of financial assets) / interest-bearing liabilities >= 1.

A current ratio around 2 and a quick ratio around 1 are ideal states for a company.

9.4.2 Profitability Analysis#

Look at it from two angles:

One is from the perspective of operating income, i.e., how much of each unit of operating income can be converted into profit;
The other is from the asset perspective, i.e., how much profit can be generated from each unit of shareholder investment plus borrowed interest-bearing liabilities.

From the perspective of income, profitability can be viewed as:#

Operating profit margin = (Operating income - Operating costs - three expenses) / Operating income
Gross profit margin = (Operating income - Operating costs) / Operating income
Net profit margin = Net profit / Operating income

Gross profit margin shows the competitiveness of the company's products;

Operating profit and net profit add expense information.

From the asset perspective, use return on equity (ROE) to measure the company's profitability:#

Return on equity (ROE) = Net profit / Average net assets
Return on total assets = Net profit / Total assets

9.4.3 Growth Analysis#

Can be viewed from both income and asset perspectives.

From the income perspective, focus on the growth rate of operating income and operating profit;
From the asset perspective, focus on total asset growth rate and net asset growth rate.

From the income perspective, focus on the growth rate of operating income and operating profit:#

Operating income growth rate = (Current operating income - Previous operating income) / Previous operating income
Operating profit growth rate = (Current operating profit - Previous operating profit) / Previous operating profit

From the asset perspective, focus on total asset growth rate and net asset growth rate.#

Total asset growth rate = (Current total assets - Previous total assets) / Previous total assets
Net asset growth rate = (Current net assets - Previous net assets) / Previous net assets

9.4.4 Management Capability Analysis#

Mainly observe accounts receivable turnover, inventory turnover, fixed asset turnover, total asset turnover, etc.

Accounts receivable turnover = Operating income / Average accounts receivable
Average accounts receivable = (Beginning accounts receivable + Ending accounts receivable) / 2
Inventory turnover = Operating costs / Average inventory balance
Average inventory balance = (Beginning inventory + Ending inventory) / 2
Fixed asset turnover = Operating income / Net fixed assets
Total asset turnover = Operating income / Average total assets

9.4.5 Overall Analysis (Common DuPont Analysis System)#

Return on equity = Net profit / Net assets can be modified to:

Return on equity = (Net profit / Sales income) * (Sales income / Average total assets) * (Average total assets / Net assets)

This analysis breaks down the net profit into three parts:

Product net profit margin (Net profit / Sales income)
Total asset turnover (Sales income / Average total assets)
Leverage ratio (Average total assets / Net assets)

9.5 Using Financial Data for Valuation#

Three methods to evaluate a company:

Discounted cash flow method, calculating the present value of all future free cash flows that the company can generate to determine its value;
Liquidation value method, calculating the remaining cash value after selling all assets and paying off all liabilities;
Market value method, predicting a company's value based on its trading price in the stock market.

10 Statement of Changes in Owner's Equity and Financial Statement Notes#

10.1 Statement of Changes in Owner's Equity#

Gains come from changes in asset values or incidental events. The difference from income is that income refers to daily operating activities.

Gains are divided into two parts:

Gains and losses included in current profits and losses
Asset impairment losses;
Fair value changes;
Investment income;
Aggregate income;
Non-operating income and expenses.
Gains and losses not included in current profits and losses
The difference between the fair value of available-for-sale financial assets and book value;
The difference between the fair value and book value on the reclassification date of financial assets;
The difference between the fair value on the conversion date of self-used or inventory real estate to fair value mode accounting and the original book value;
The changes in owner’s equity of the investee, excluding net profit, calculated according to the shareholding ratio under the equity method;
The fair value corresponding to the equity contained in convertible bonds.

10.2 Financial Statement Notes#

The notes to the financial statements contain the richest information.

Part Seven (Explanation of Consolidated Statement Items) and Part Thirteen (Explanation of Major Items in Parent Company Financial Statements) are the most important contents.

7 Management Report#

7.1 Board Report#

Analysis and discussion of operating conditions

Main business analysis
Industry, product regional operation analysis: various classified products
Asset-liability analysis
Investment status analysis

7.2 Important Matters#

8 Fraud and Anti-Fraud#

8.1 Three Common Methods#

8.1.1 Fictitious Income#

Exaggerating income through one-time actions
Transforming the sale of business units or assets into operating income; converting acquisition expenses into operating income
Bundling losses into one company or department, then selling to cover up losses
Conducting swap trades to exaggerate income
Recognizing income in advance
Recognizing income for products or services that have not yet been provided
Recognizing income when the buyer has not explicitly assumed payment obligations
Recognizing income exceeding the completion percentage

8.1.2 Manipulating Expenses#

Pushing current expenses to the future
Covering up costs or losses
Washing the big bath: making the company's operating conditions deteriorate all at once

8.1.3 Manipulating Cash Flow#

Increasing cash inflow from operating activities
Reducing cash outflow from operating activities
One-time actions delivering net cash flow from operating activities

8.1.4 Manipulating the Income Statement#

Actively accruing bad debt provisions to reduce current profits
Reversing collections in the next period to achieve profit growth in financial reports

8.2 Detecting Manipulation Signs#

8.2.1 Income Statement#

According to the accounting equation "Assets = Liabilities + Owner's Equity + Income - Expenses," beautifying the changes in owner's equity brought by income and expenses must ultimately be reflected by adjusting asset and liability items.
Increasing operating income: Deliberately increasing sales revenue of high-margin products, or raising prices, or reducing raw material costs. Check freight and handling costs.
Sales and management expenses: Significant increases or decreases in sales and management expenses
Non-operating expenses and one-time expenses
Asset impairment losses

8.2.2 Cash Flow Statement#

Net cash flow from operating activities
Cash outflow from investing activities
Other cash received related to operating activities
Interest expenses in financing cash flow

8.2.3 Balance Sheet#

Significant increase in accounts receivable
Large other receivables
Prepayments
Accounts payable and notes payable
Inventory
Construction in progress
Long-term deferred expenses
Intangible assets and goodwill
Employee compensation payable
Bad debts
Outside the financial report

The following are important points summarized based on the content of the book.

9 Important Considerations for Analyzing Financial Reports#

9.1 Important Reminders:#

Three must-watch items in financial statements: financial accounting reports, board reports, and important matters.
Prioritize excluding companies with ROE (Net Profit / Net Assets) < 15%.
Operating profit is the core profit of the company; companies with a large proportion of non-operating income and expenses should be paid special attention.
Financial reports mainly consist of the balance sheet, income statement, and cash flow statement, with a primary focus on consolidated statements.
An important method for reading financial reports: compare with peers to see how different asset proportions vary, especially accounts receivable, notes receivable, accounts payable, prepayments, and the respective proportions of costs, taxes, and expenses to income.
Operating profit is the core profit of the company; companies with a large proportion of non-operating income and expenses should be paid special attention.
The board report and important matters must be read carefully.
Any accounting firm unwilling to issue a "standard unqualified opinion" should be directly ignored.
If a company changes accounting policies, consider the reasons and impacts.
Surplus reserves: After a company makes a profit, it must retain 10% from the parent company's net profit. After exceeding 50% of registered capital, the board decides whether to continue retaining. This can only be used to cover losses or issue bonus shares. Additionally, if issuing bonus shares, surplus reserves must still be greater than 25% of registered capital.
Bonus shares: Using undistributed profits or surplus reserves to issue shares is called issuing bonus shares; using capital reserves to issue shares is called increasing share capital.

9.2 Report Trap Analysis#

9.2.1 Balance Sheet#

Impairment losses on inventory, accounts receivable, and debt investments are important means for companies to manipulate profits. If the amount is large, please analyze the issue.

Cash and Cash Equivalents#

Cash and cash equivalents need to match short-term debts (the company's debt repayment ability) and operational needs (the ability to utilize funds).

The balance of cash and cash equivalents is much smaller than short-term liabilities;
Cash and cash equivalents are abundant, yet the company has borrowed a lot of interest-bearing or even high-interest debt;
There are many time deposits, many other cash equivalents, but a severe lack of working capital;
Other cash equivalents are substantial but lack reasonable explanation.

Accounts Receivable#

Significant increase in accounts receivable, exceeding the growth of income during the same period, with collection speed below the uneven industry level;
Accounts receivable accounting for more than 30% of income, with a large portion being over a year old;
Very low accounts receivable. The longer accounts receivable are overdue, the higher the chance they become bad debts.

Other Receivables#

This is a catch-all for receivables unrelated to the main business. Excellent listed companies have minimal amounts in other receivables and payables.

Signs of Manipulation#

Significant increase in accounts receivable
Large other receivables
Prepayments
Accounts payable and notes payable
Inventory
Construction in progress
Long-term deferred expenses
Intangible assets and goodwill
Employee compensation payable
Bad debts
Outside the financial report

9.2.2 Income Statement#

Total Operating Income#

The principle of recognizing operating income: Search in the financial report for "recognized when the following conditions are met" to find the income recognition principles.

Signs of Manipulation#

According to the accounting equation "Assets = Liabilities + Owner's Equity + Income - Expenses," beautifying the changes in owner's equity brought by income and expenses must ultimately be reflected by adjusting asset and liability items.
Increasing operating income: Deliberately increasing sales revenue of high-margin products, or raising prices, or reducing raw material costs. Check freight and handling costs.
Sales and management expenses: Significant increases or decreases in sales and management expenses
Non-operating expenses and one-time expenses
Asset impairment losses

9.2.3 Cash Flow Statement#

Operating Cash Flow#

Important numbers in operating cash flow:

Net cash flow from operating activities
Negative: The company is in deficit
Zero: The company barely survives
Greater than 0, less than depreciation and amortization: The company lacks the ability to upgrade
Greater than 0, equal to depreciation and amortization: The company can maintain the status quo
Greater than 0, greater than depreciation and amortization: Indicates potential growth
Net cash flow from operating activities / net profit, a ratio greater than 1 indicates an excellent company, the larger the better
Cash received from sales of goods and services
If "net cash flow from operating activities" divided by net profit in the income statement is greater than 1, it is an excellent company; equal to 1 is also acceptable; less than 1 indicates concerns about net profit quality.
Cash received from sales of goods and services
Divided by operating income, greater than 1.17 indicates that the company has basically received all sales amounts;
Much less than 1 indicates that a large amount of money has not been received and is still owed.

9.3 Analyzing Company Accounts in Four Steps#

Step 1: Browse through the balance sheet and income statement items, focusing on any abnormalities. For example: In the balance sheet, investors should focus on whether accounts receivable, notes receivable, other receivables, and long-term deferred expenses have increased significantly; on the liabilities side, pay attention to whether accounts payable, notes payable, other payables, and short-term loans have increased significantly. In the income statement, check whether operating profit has changed significantly; whether the sum of fair value changes, investment income, and asset impairment losses has changed significantly in proportion to operating profit; whether the ratio of operating profit to net profit remains stable.
Step 2: Conduct historical analysis of financial indicators. Look at financial statements over 5 years or more and compare them with history.
Step 3: Compare the trends of profit and cash flow changes in the company. The quality of profit is an important responsibility of the cash flow statement. Over several years, the company's net profit issues should maintain a stable ratio with the net cash flow from operating activities, and it is best if the net cash flow from operating activities exceeds net profit. If cash flow is poor, consider why profit has not been converted into cash.
Step 4: Compare the company with competitors. Comparing the company with competitors or industry benchmarks can provide a broader perspective.

9.4 Financial Indicator Analysis#

9.4.1 Safety Analysis#

This refers to whether the company can repay short-term debts (current liabilities) in a timely manner when needed. Common indicators include two types: current ratio and quick ratio.

Current Ratio = Current Assets / Current Liabilities.
Quick Ratio = Quick Assets / Current Liabilities.
Cash and cash equivalents / interest-bearing liabilities >= 1 or (cash + net value of financial assets) / interest-bearing liabilities >= 1.

A current ratio around 2 and a quick ratio around 1 are ideal states for a company.

9.4.2 Profitability Analysis#

Look at it from two angles:

One is from the perspective of operating income, i.e., how much of each unit of operating income can be converted into profit;
The other is from the asset perspective, i.e., how much profit can be generated from each unit of shareholder investment plus borrowed interest-bearing liabilities.

From the perspective of income, profitability can be viewed as:#

Operating profit margin = (Operating income - Operating costs - three expenses) / Operating income
Gross profit margin = (Operating income - Operating costs) / Operating income
Net profit margin = Net profit / Operating income

Gross profit margin shows the competitiveness of the company's products;

Operating profit and net profit add expense information.

From the asset perspective, use return on equity (ROE) to measure the company's profitability:#

Return on equity (ROE) = Net profit / Average net assets
Return on total assets = Net profit / Total assets

9.4.3 Growth Analysis#

Can be viewed from both income and asset perspectives.

From the income perspective, focus on the growth rate of operating income and operating profit;
From the asset perspective, focus on total asset growth rate and net asset growth rate.

From the income perspective, focus on the growth rate of operating income and operating profit:#

Operating income growth rate = (Current operating income - Previous operating income) / Previous operating income
Operating profit growth rate = (Current operating profit - Previous operating profit) / Previous operating profit

From the asset perspective, focus on total asset growth rate and net asset growth rate.#

Total asset growth rate = (Current total assets - Previous total assets) / Previous total assets
Net asset growth rate = (Current net assets - Previous net assets) / Previous net assets

9.4.4 Management Capability Analysis#

Mainly observe accounts receivable turnover, inventory turnover, fixed asset turnover, total asset turnover, etc.

Accounts receivable turnover = Operating income / Average accounts receivable
Average accounts receivable = (Beginning accounts receivable + Ending accounts receivable) / 2
Inventory turnover = Operating costs / Average inventory balance
Average inventory balance = (Beginning inventory + Ending inventory) / 2
Fixed asset turnover = Operating income / Net fixed assets
Total asset turnover = Operating income / Average total assets

9.4.5 Overall Analysis (Common DuPont Analysis System)#

Return on equity = Net profit / Net assets can be modified to:

Return on equity = (Net profit / Sales income) * (Sales income / Average total assets) * (Average total assets / Net assets)

This analysis breaks down the net profit into three parts:

Product net profit margin (Net profit / Sales income)
Total asset turnover (Sales income / Average total assets)
Leverage ratio (Average total assets / Net assets)

9.5 Using Financial Data for Valuation#

Three methods to evaluate a company:

Discounted cash flow method, calculating the present value of all future free cash flows that the company can generate to determine its value;
Liquidation value method, calculating the remaining cash value after selling all assets and paying off all liabilities;
Market value method, predicting a company's value based on its trading price in the stock market.

10 Statement of Changes in Owner's Equity and Financial Statement Notes#

10.1 Statement of Changes in Owner's Equity#

Gains come from changes in asset values or incidental events. The difference from income is that income refers to daily operating activities.

Gains are divided into two parts:

Gains and losses included in current profits and losses
Asset impairment losses;
Fair value changes;
Investment income;
Aggregate income;
Non-operating income and expenses.
Gains and losses not included in current profits and losses
The difference between the fair value of available-for-sale financial assets and book value;
The difference between the fair value and book value on the reclassification date of financial assets;
The difference between the fair value on the conversion date of self-used or inventory real estate to fair value mode accounting and the original book value;
The changes in owner’s equity of the investee, excluding net profit, calculated according to the shareholding ratio under the equity method;
The fair value corresponding to the equity contained in convertible bonds.

10.2 Financial Statement Notes#

The notes to the financial statements contain the richest information.

Part Seven (Explanation of Consolidated Statement Items) and Part Thirteen (Explanation of Major Items in Parent Company Financial Statements) are the most important contents.

7 Management Report#

7.1 Board Report#

Analysis and discussion of operating conditions

Main business analysis
Industry, product regional operation analysis: various classified products
Asset-liability analysis
Investment status analysis

7.2 Important Matters#

8 Fraud and Anti-Fraud#

8.1 Three Common Methods#

8.1.1 Fictitious Income#

Exaggerating income through one-time actions
Transforming the sale of business units or assets into operating income; converting acquisition expenses into operating income
Bundling losses into one company or department, then selling to cover up losses
Conducting swap trades to exaggerate income
Recognizing income in advance
Recognizing income for products or services that have not yet been provided
Recognizing income when the buyer has not explicitly assumed payment obligations
Recognizing income exceeding the completion percentage

8.1.2 Manipulating Expenses#

Pushing current expenses to the future
Covering up costs or losses
Washing the big bath: making the company's operating conditions deteriorate all at once

8.1.3 Manipulating Cash Flow#

Increasing cash inflow from operating activities
Reducing cash outflow from operating activities
One-time actions delivering net cash flow from operating activities

8.1.4 Manipulating the Income Statement#

Actively accruing bad debt provisions to reduce current profits
Reversing collections in the next period to achieve profit growth in financial reports

8.2 Detecting Manipulation Signs#

8.2.1 Income Statement#

According to the accounting equation "Assets = Liabilities + Owner's Equity + Income - Expenses," beautifying the changes in owner's equity brought by income and expenses must ultimately be reflected by adjusting asset and liability items.
Increasing operating income: Deliberately increasing sales revenue of high-margin products, or raising prices, or reducing raw material costs. Check freight and handling costs.
Sales and management expenses: Significant increases or decreases in sales and management expenses
Non-operating expenses and one-time expenses
Asset impairment losses

8.2.2 Cash Flow Statement#

Net cash flow from operating activities
Cash outflow from investing activities
Other cash received related to operating activities
Interest expenses in financing cash flow

8.2.3 Balance Sheet#

Significant increase in accounts receivable
Large other receivables
Prepayments
Accounts payable and notes payable
Inventory
Construction in progress
Long-term deferred expenses
Intangible assets and goodwill
Employee compensation payable
Bad debts
Outside the financial report

The following are important points summarized based on the content of the book.

9 Important Considerations for Analyzing Financial Reports#

9.1 Important Reminders:#

Three must-watch items in financial statements: financial accounting reports, board reports, and important matters.
Prioritize excluding companies with ROE (Net Profit / Net Assets) < 15%.
Operating profit is the core profit of the company; companies with a large proportion of non-operating income and expenses should be paid special attention.
Financial reports mainly consist of the balance sheet, income statement, and cash flow statement, with a primary focus on consolidated statements.
An important method for reading financial reports: compare with peers to see how different asset proportions vary, especially accounts receivable, notes receivable, accounts payable, prepayments, and the respective proportions of costs, taxes, and expenses to income.
Operating profit is the core profit of the company; companies with a large proportion of non-operating income and expenses should be paid special attention.
The board report and important matters must be read carefully.
Any accounting firm unwilling to issue a "standard unqualified opinion" should be directly ignored.
If a company changes accounting policies, consider the reasons and impacts.
Surplus reserves: After a company makes a profit, it must retain 10% from the parent company's net profit. After exceeding 50% of registered capital, the board decides whether to continue retaining. This can only be used to cover losses or issue bonus shares. Additionally, if issuing bonus shares, surplus reserves must still be greater than 25% of registered capital.
Bonus shares: Using undistributed profits or surplus reserves to issue