In ancient times you would peer into the entrails of animals to discern the future. Or sneak into a cave and stare at the squiggly writing on the walls to figure out the past.
How we live in different, sophisticated times. These days companies produce thick annual reports using highly paid accountants and software which often Joe Public stares at to figure out what the numbers mean. Ok so perhaps nothing has really changed!
But the contents of these reports are hugely important to almost everyone; shareholders, employees, suppliers, customers etc. Sometimes companies cook the books to make revenues, profits etc look good. But I am ahead of myself. Before we delve into all that here is a primer on financials.
The annual report is really four separate (but connected) pieces of key information; the Financial Statements, the Footnotes, Management Discussion and Analysis, and the Audit Report.
Let’s take the first. For our purpose, the financial statements are the Statement of Comprehensive Income (aka P & L statement), the Statement of Financial Position (aka Balance sheet) and the Statement of Cash Flows.
Before we go any further its key to grasp that all companies follow something called Accrual Accounting; lack of clarity on this has led to many a major confusion. Simply put, all revenues are accounted when earned, not when the cash comes in. Similarly, all expenses are accounted when incurred, not when the cash is paid. The opposite (aka cash accounting) is what your corner Grocer follows.
This has a massive impact on financials. If you sold on credit, its still Revenue although cash may come in (Inshallah!) a few months later. If you bought on credit its still a Cost although you may pay the vendor later. If you haven’t paid your staff at months end its still a Cost.
Let’s take the case of a fictitious Property Developer called Highly Dodgy Developer (HDD)
The P & L says how much revenue HDD earned, how much cost it incurred and the net profit during a period (month, quarter, year etc.). Revenue is the sale of villas and apartments during the period and it’s the single most crucial item on the P & L (more about that exciting topic later!).
The costs are many. The cost of sales is the cost of building these villas and apartments and varies with the volume of sales. If you knock of this from the Revenue you get the Gross Profit. Then comes the overheads aka Selling, General and Admin expenses. Now this is the payroll, rent, advertising, utilities etc, most of which are fixed and don’t vary with the volume of sales. Another item is Depreciation on fixed assets. The profit left after deducting the Overheads and Depreciation from Gross Profit is the Operating Profit. If HDD has debt there will be interest expense and if you deduct this from the Operating Profit you get the Net Income.
The size and trend of revenues and profits are of course critical. But equally important is the quality of these (more about this fascinating topic later!)
Key point: Net income is NOT cash. Because many of the items you see on a P & L are a mix of cash and credit or just a book entry, like depreciation. So if HDD has AED 2 billion of Net Income it is highly unlikely it will have made AED 2 million of cash during the period.
Then comes the Balance Sheet. Its a list of all asset and liabilities of HDD. Assets included cash, receivables from buyers of properties, fixed assets and villas and apartments (both under construction and finished but unsold). Trade Payables and bank loans are typical liabilities. For HDD the money collected from clients for off plan sales is also a liability since the deposits are refundable if the property is not delivered (well.. on paper at least!).
The third item is Equity which is actually assets minus liabilities. These are the moneys payable to the shareholders. And this is made up of what the shareholders initially put plus accumulated profits (remember all the profits belong to the owners). If HDD pays dividends or buys back shares or incurs losses Equity is reduced. Equity gets destroyed fully or partially if HDD racks up massive losses. Equity is important- it shows how strong the company is and drives how much it can borrow- bankers typically won’t give you money unless you show you have enough!!
But the statement I like the most is the cash flow. Its even simpler- a summary of cash inflows and cash outflows during the period. This is shown as Operating, Investing and Financing cash flows.
The operating cash flows are the most important as they show how much was collected from customers, cash paid to suppliers, to staff and for interest. This is the core activity of the company and the company cannot survive for long if it bleeds money! The investing cash flows are mainly cash paid for fixed assets and investments and cash from sale of these. And the cash flows from financing is all cash transactions with shareholders and lenders such as issue of capital, loans taken, loans repaid and dividend paid.
Just as profits are NOT cash, cash is NOT profit. So HDD may be flush with cash pocketed from customers’ deposits but it can’t record any profits till it delivers the apartments, hopefully a few years down the line!
All this is part of International Financial reporting Standards (IFRS) and in the UAE all listed companies have to follow IFRS (Just to reassure you that I am not making up any of this stuff)
In the next piece we will discover the fascinating world of accounting tricks that are used to make revenue; profits and the balance sheet not just look good but stunning!!
Jargon Buster
• Topline: Revenue recorded during the period
• Bottom line: Net Profit for the period
• Earnings Per Share: Net Profit divided by no of common shares
• Shareholders Equity/Net Worth: Initial investment plus accumulated profits minus accumulated losses minus dividends
Binod Shankar is a CFA charter holder and Chartered Accountant.He is a financial trainer and speaker and runs Genesis Institute, a financial training company based in the UAE
