Reading a company's financial statements

What this cluster is for

Almost everybody who buys shares has never opened the annual report of a company they own.

That is not laziness. It is a reasonable response to how the subject is taught. Accounting is presented as a body of knowledge to be learned first and applied later, which means the learning takes 200 pages and the applying never happens. Most people quit somewhere around depreciation.

These 7 lessons are built the other way round. Each one ends with something you do inside a real annual report, for a company you actually hold, in between 10 and 25 minutes. You will use a browser, the company's own filing, and a calculator. Nothing else.

By the end of this cluster you will be able to:

• Find the 3 statements in any annual report or 10-K and say what each one answers
• Confirm a balance sheet balances, and know exactly why that proves nothing
• Convert receivables and inventory into days, and compare this year against 3 years ago
• Find the obligations that are not on the balance sheet at all, and that no screener shows you
• Say how much of a company's equity is money shareholders put in and how much the business earned
• Walk 12 lines of a balance sheet in 6 minutes and know which 6 questions to ask
• Compare 3 years of profit against 3 years of cash, and find the line that explains the difference

Nothing here is a tip. Nothing here names a company to buy. Everything here will still work in 2036 on a company that does not exist yet.

The one idea

If you take a single sentence out of this cluster, take this one.

Profit is an opinion. Cash is a fact.

Profit is calculated. Getting to it requires dozens of judgements: when a sale becomes a sale, how fast a machine wears out, whether a customer will pay, whether a cost is an expense this year or an asset for 10 years. Every one of those is decided by management, inside rules that permit a range.

Cash is counted. A bank balance is there or it is not.

The gap between the 2 is where nearly every corporate failure in this cluster was visible, in published documents, for years before the share price noticed. The gap is not hidden. It is printed in the same report, about 8 pages apart, and almost nobody puts the 2 pages side by side.

Every article here returns to that sentence and gives you a different way to test it on a company you own.

The reading order

The articles build on each other. Read them in order the first time.

The map

1. Why read financials, and what the three statements each answer — the balance sheet is one day, the income statement is a year, the cash flow statement is the bank statement. And profit is an opinion, cash is a fact.

The balance sheet, piece by piece

1. What a balance sheet is, and the equation behind it — assets equal liabilities plus equity. It cannot break, so balancing is evidence of nothing.
2. Understanding assets — sort them by how fast they turn into cash, not by size. Receivable days and inventory days do the work.
3. Understanding liabilities — timing beats size, and the obligations that end companies are usually in a note, not on the page.
4. Understanding equity, and what is actually yours — split it into money put in and money earned. The split is the story.

Putting it together

1. How to read a balance sheet, line by line — 12 lines, 2 columns, 5 ratios, 6 warning signs. Consolidated first, always.
2. The income statement and the cash flow statement — did the company make money, or make it look that way? The operating section of the cash flow statement itemises the answer.

The checklist

Every article ends in an action inside a real annual report. Collected here, they are one long afternoon on your largest holding, and they are the most valuable thing in this cluster. Tick them off as you go.

Once, on your largest holding — the full pass

• Open the annual report. Find the 3 statements. Note whether you are looking at standalone or consolidated. (1, 6)
• Add total liabilities to total equity. Confirm it equals total assets, in both years' columns. (2)
• Write the balance sheet date down before any number. It is one day. (2)
• Fill a 16-row table: 10 balance sheet lines, 4 income statement lines, 2 from the notes — both years. (6)
• Calculate the 5 ratios: current, debt to equity, receivable days, inventory days, interest coverage. (6)
• Compare standalone borrowings against consolidated borrowings. If the gap is large, count the subsidiaries. (6)

The conversion check — the one that matters most

• Write down profit after tax and cash from operations for the same year. (1)
• Do it for 3 years. Add both columns. Divide operating cash by profit. (7)
• If the ratio is below 0.6 across 3 years, read the operating section and name the line that explains it. (7)
• Subtract capital expenditure from operating cash. That is free cash flow. (7)

Asset quality

• Receivable days, this year against 3 years ago. (3)
• Inventory days, this year against 3 years ago. (3)
• Multiply the increase in receivable days by revenue, divide by 365. Compare that to a full year of profit. (3)
• Goodwill and intangibles as a percentage of total assets. Has any of it ever been impaired? (3)
• Open the receivables ageing table. How much is more than 1 year old? (3)

What the company owes

• Find the contingent liabilities note. Divide the total by total equity. (4)
• Inside it, find guarantees given for subsidiaries and associates. (4)
• Add short-term borrowings and current maturities of long-term debt. Compare to a year of operating cash. (4)
• Read the related party transactions note in an Indian report, or Item 3 Legal Proceedings in a 10-K. (4, 6)

What is actually yours

• Split equity: share capital plus securities premium against retained earnings. Which is bigger? (5)
• Share count today against 3 years ago. (5)
• Book value per share, both years. Did it rise as fast as total equity did? (5)
• Check for a revaluation reserve. If equity grew because of one, nothing happened. (5)

Habits that take 2 minutes each

• Count how many of the last 3 years contain an exceptional item, and what it did to reported profit. (7)
• Read diluted earnings per share, never basic. (7)
• Read the auditor's report first, not last: the opinion, the key audit matters, and what CARO says. (6)
• In a 10-K, read this year's Risk Factors against last year's and note what was added. (6)

India and the United States, equally

Every article covers both markets at the same depth, and then says where they genuinely diverge and what that difference tells you.

The divergences here are not cosmetic. They change the numbers.

India's system assumes the risk is a controlling promoter moving money and obligations between connected companies. So it responds with structured data: Schedule III fixes the format of every balance sheet, ageing tables for receivables and construction projects are prescribed, related-party disclosure is detailed, and CARO forces the auditor to answer a long list of named questions in writing.

The American system assumes the risk is management telling a misleading story. So it responds with narrative and personal liability: management must explain its own results and its own liquidity position in MD&A, list what could go wrong in Risk Factors, and have the chief executive and chief financial officer certify the filing personally.

The practical consequence is that you read the 2 documents in a different order. In an Indian report, start with the tables and the notes, then read the management discussion and see whether it matches. In an American filing, start with the narrative, then check whether the numbers support it.

And 3 accounting divergences change the figures themselves: US GAAP permits LIFO inventory valuation and Ind AS does not; Ind AS permits upward revaluation of property and US GAAP does not; Ind AS requires development costs to be capitalised once tests are met while US GAAP expenses most research and development. Comparing an Indian company to an American competitor without checking those 3 policies is a guess, not a comparison. All 3 are stated in the accounting policies note and reading it takes 4 minutes.

Where to get the documents

Both countries publish everything free.

India. The company's own website has an Investors or Investor Relations page with annual reports going back many years. The BSE and NSE websites carry filings, quarterly results and the shareholding pattern, which shows promoter holding and promoter shares pledged to lenders.

United States. The SEC's EDGAR database holds every filing. The annual report is the 10-K, the quarterly report is the 10-Q, and material events go on an 8-K.

You do not need a subscription to anything to do a single exercise in this cluster.

A note on what this is not

These lessons are free, and they will stay free. They are the text version of the ideas in our video course, written for anybody who cannot spend money on learning right now.

They will take you longer than the videos would. But the goal is the same one it has always been: fewer people in the 95%.

Related

• Ratios, valuation and business quality — what to do with these numbers next
• What a company is, and what owning one means
• ← All 22 topics
• The tools