Reviewing the financial review section of an annual financial report helps to assess various aspects of the business performance and risk from a quantitative perspective. This blog outlines the main questions investors or readers should ask when reading a company’s financial statements.
1. Did the net profit rise or fall?
When assessing the financial position of a company, you always need to see improvements in sales and margins of all levels. It is a good sign if net profit increases as a result of increase in sales, recurring gains of operating margin.
2. Is the cash-cycle rising or falling? Why?
If the cash cycle is rising, inventory and receivables might be piling up too fast, which means cash is locked up fora longer term. A decrease or steady cash cycle is preferable because the company is able to convert to cash quicker and hence is more effective in their operation and management.
3. Is operating cash flow healthy?
Normally, if the company is not growing fast, then a negative operating cash flow is a red flag because it raises the question of where the cash has been used.
If accounts receivable is increasing faster than sales, the company is having a hard time collecting their cash. The same thing goes with inventories, if the number is increasing faster than sales then the company is having trouble turning their products to cash. Both scenarios may be the reason that leads to decreasing operating cash flow, an indicator of an unhealthy cash flow.
4. Is gearing too high?
In common practice, a company with higher levels of financial leverage (normally Net Gearing > 50%) is considered to be more vulnerable to downturns in the business cycle than those that have a low net gearing because it has to service its debts regardless of how bad sales are. However, it should be noted that financial leverage levels are industry specific.
5. Is Return on Equity (ROE) improving or declining?
When analysing ROE, if there is a rise in earnings with a steady decline in ROE, a red flag should be noted. On the contrary, if ROE is improving, there is a good sign that the company is doing great in making profits.
6. Is shareholders’ equity rising or falling?
Is actual dividend pay-out steady, rising or falling?
- Dividends per share rising faster than earnings per share: often indicates slowing growth prospects
- Earnings per share rising faster than dividends: indicates growing opportunities are still good
Investors should also beware of high retained earnings without clear accompanied investment plans.
In our next blog entry, we will go over the remaining sections of an annual financial report, which provide important non-financial information. In the meantime, download the second part of our whitepaper for more details on how to calculate different elements of the financial statement.