When we look at a financial report, we usually pay attention to the numbers. Numbers can represent prosperity or poverty, but they can also give us signals about unusual problems in a company. In this article, we will explore some suspicious signs of a company based on the analysis of the financial report.

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How to read a Financial Report?

Before we can identify areas of concern in a financial statement, we need to be able to read a financial statement. Many people simply open it and look for metrics like revenue, profit, or cash flow – this is not enough.

However, the Financial Report also has other parts that we should know. Basically, it includes the following 4 components:

1. Audit Report: This is a report prepared by the auditor giving their opinion on the Financial Statements based on what the auditor has gathered.

Many people when reading Financial Statements often skip the Auditor's Opinion section, while... this is the first important part that we need to pay attention to!!! Why? The figures on the Financial Statements will be meaningless if the auditor is not sure about its truthfulness.

Let's see what the Auditor's opinion is on the company's report here?

There are 4 levels or opinions of auditors about the honesty of a report. They are:

• Full acceptance
• Except
• Not accepted
• Refuse.

2. Financial Statements: The Financial Statements themselves are a collection of smaller reports that provide a complete picture of the cash flow within a company and its financial position over a given period of time. The smaller reports included in the Financial Statements are the balance sheet, income statement, and cash flow statement.

3. Notes to Financial Statements: Important documents to help us read Financial Statements. Notes to Financial Statements will clearly explain important transactions in the company or more details about accounting accounts.

4. Management comments and analysis: Similar to a summary, this is a note from management that includes information or topics that management wants to communicate to shareholders or readers of the report. These management notes are often conclusions from a section of the report, and are placed in a separate section, as they may not necessarily be easy for readers to understand. This section provides invaluable information to help us determine the profitability, liquidity, and cash flow of the company; all of these signs are important to us in understanding the health of the company.

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Start your journey to find the Sign

Now that we have an idea of how to read a Financial Statement, here are 6 signs that could be “black spots” on a company’s Financial Statement.

1. Debt to equity ratio is increasing: This shows that the company is using more debt than it has.

2. Revenues consistently decline over the years: If a company has three or more years of declining revenues, it is a sign that the company is not doing well. While cost-cutting measures, such as eliminating wasteful spending and cutting staff, can offset the decline in revenues, the company needs to make changes in its business within three years or the cuts will not deliver long-term value.

3. Unusually large “Other expenses” on the balance sheet: Companies often have “other expenses” items that fluctuate or are too small to quantify, which is normal on the income statement and balance sheet. However, if the “other expenses” item is unusually high, we should find out what caused the “other expenses” item to be so high. And we can predict whether this item will appear in the future.

4. Unstable cash flow: Cash flow is a good sign of the health of the company, cash flow is like a stream running, up and down. Items on the cash flow statement show transactions being processed but they do not tell us about transactions that will occur in the future. Conversely, a lack of cash can be a sign of under-billing/over-billing of the company's business situation.

5. Increase in receivables and inventories relative to sales: Money in receivables or in inventories is money that does not generate profits. While it is important to have enough inventory to meet orders, a company does not want receivables to eat up sales or to hold unsold inventory because it ties up working capital and reduces the company's liquidity.

6. Declining gross profit margin: This is a measure of a company's profitability calculated by dividing the profit earned by the revenue over a given period of time. A declining gross profit margin is something to watch out for.

The profit margin represents the direct cost of producing a good or service and the profit margin must be sufficient to cover operating expenses such as debt service. Applying this ratio to each product is a prerequisite for setting pricing policies. It should also be used in negotiating raw material purchase costs with suppliers.

A business with a large competitive advantage and an efficient organization will maintain a high profit margin for many years. A competitive advantage will help a business maintain a high price compared to the cost of goods sold because when there is a competitive advantage, a business's price increase will not affect the customer's demand too much.

• If the Gross Profit Margin is greater than 30%, the business has a long-term sustainable competitive advantage.
• If Gross Profit Margin is less than 30%, competition from other competitors can erode the business's profit margin.
• If the Gross Profit Margin is less than 10%, it is likely that the business has no competitive advantage.

From an analyst’s perspective, “reading” numbers to dissect the meaning behind them is a prerequisite to becoming a successful analyst. But don’t look at these numbers in isolation, but put them together with industry analysis and business model analysis to build a deeper analysis.

References:

1. Financial Statement Analysis - Fernando Alvarez, Martin Fridson, Ho Chi Minh City Economic Publishing House, 2011.

2. Financial Report Analysis, Associate Professor, Dr. Nguyen Ngoc Quang, Finance Publishing House, 2016.

3. Financial Reports - Step-by-Step Guide to Understanding and Preparing Financial Reports, Thomas R.ITTELSON, Hong Duc Publishing House, 2018.

4. Financial Report - Forecasting and Valuation Analysis, Dr. Pham Thi Thuy, National Economics University Publishing House, 2018.

5. Financial Statement Analysis Textbook, Prof. Dr. Nguyen Van Cong, National Economics University Publishing House, 2019.

MSc. Nguyen Thi Thanh Xuan – Lecturer of Faculty of Accounting