Personal Money Management 101

How to Read a Financial Statement

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Financial Statements
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  • This section introduces the key concepts of accounting for investors. Its intention is to better enable investors to understand and interpret the financial statements of businesses they might invest in.
  • Accounts provide a (hopefully) objective analysis of the state and performance of a business.
  • Accounts of listed companies must be prepared according to both the law and Generally Accepted Accounting Principles (GAAP). Listed companies must have their accounts audited by qualified, independent, auditors to verify the accounts conform to the law and GAAP.
    • Look closely at the auditor's statement. Any hint of concern here should be cause for alarm.
  • The four basic accounting principles are accruals, prudence, consistency, and viability.
    • Accruals - Items are recorded when their income (or expenditure) arises, not when it is actually received or paid.
    • Prudence - Figures must be shown in a conservative (pessimistic) way.
    • Consistency - Accounting methods can vary from company to company, however, for a given company the methods used must remain consistent from year to year. If a company changes its accounting methods, this change must be reported.
    • Viability - Accounts are prepared on the assumption that the company will remain in business.
  • Because companies can legitimately adopt different accounting methods it is not always possible to directly compare the accounts of one company with another. However, because of the consistency principle, it is possible to monitor a particular company's performance over time from its financial statements.
  • Financial statements usually include letters from the chairman and board of directors. These will usually serve to tell you what a great job the management team have done, but can sometimes provide useful hints as to likely future initiatives.
  • The three key financial statements are the Profit and Loss Account, the Balance Sheet, and the Cash Flow Statement.
  • Also described are some of the key financial ratios that may be derived from these statements.