Tips for reading financial statements

Tips for reading financial statements


Investors are more concerned about fraudulent financial statements of listed companies following the damage caused by the Stark Corporation allegations.

The recent allegations of fraud at Stark Corporation has caused severe damage to investors.

Most of the time, the alleged fraud involves the company’s owner, management or auditor.

After twice postponing submission of the company’s 2022 financial results, the listed wire and cable manufacturer Stark issued restated financial results showing it incurred a net loss the past two years and its liabilities exceeded its assets.

Last month, Stark defaulted on some of its 39 billion baht in liabilities. Trading of its shares were suspended on the Stock Exchange of Thailand (SET) after sinking 99% this year.

Stark is being probed by the Department of Special Investigations and the Economic Crime Suppression Division.

On Thursday, the Securities and Exchange Commission (SEC) filed charges of financial misconduct against 10 offenders, including Stark Corp and Vonnarat Tangkaravakoon, the company’s largest shareholder and acting chief executive. The same day Stark informed the SET Mr Vonnarat resigned from all his positions at the company.

WARY INVESTORS

Stark, once worth nearly US$2 billion and known for its aggressive expansion beyond Asia, is under a criminal investigation and faces a class action lawsuit following revelations of accounting irregularities.

“The scandals surrounding Stark made investors concerned about whether listed companies’ financial statements are trustworthy,” said Arpaporn Sawaengpak, vice-president of DBS Vickers Securities.

To avoid investing companies such as Stark, Sombat Narawuthichai, secretary-general and director of the Investment Analysts Association (IAA), advises investors on how to read financial statements to reduce risk.

Investors should carefully read the auditor’s opinion report and look at the company’s growth of revenue and net profit, as well as its assets, said Mr Sombat. Potential investors should also check the net profit margin and return on equity (ROE), he said.

Financial risks and the company’s liquidity can help to explain the health of the company, in addition to accounts receivable and inventories, said Mr Sombat.

Financial statements are part of the information used for stock analysis, as well as economic data and an overall picture of the business and industry, he said. Analysts have to interview executives to understand their vision and intention, as well as their capacity to manage the company, he said.

Analysts then make projections for future financial statements and stock valuations, said Mr Sombat.

Research by analysts offers a glance of a company’s financial statement and their opinion, which investors should read, he said. The financial statements of listed companies can be found on the SET and Settrade websites, except for companies that do not submit statements.

Companies that have low debt, a large portion of capital and a sound financial structure usually have low risk.


MUST-READ INFORMATION

First is the auditor’s opinion report, which is often long, but investors are recommended to read it because the auditor interviewed the executives who are responsible for the company’s budget.

The most important phrases are usually declared in this section, such as “the financial statements are fair in all material respects in accordance with Thai Financial Reporting Standards”, “nothing has been found that would cause us to believe the financial information is inaccurate”, and “prepared in accordance with accounting standards”.

If you read the statement, “I cannot express an opinion on the company’s financial statements”, investors should avoid any trades related to this company, said Mr Sombat.

In the auditor’s report, investors should also look for a “remark”. This is an opportunity for the auditor to point out anything it regards as unusual, and investors should read these closely, he said.

To get a quick summary of an auditor’s opinion, go to the “Factsheet” on the Settrade website.

Second on the list is growth of revenue and net profit. Investors should look at a five-year summary of the company’s financial results on the SET and Settrade websites. General businesses that are not cyclical stocks should have a visible growth trend, though the Covid crisis may have upset this trend, said Mr Sombat.

Sorting the data for 2-3 years is insufficient to determine a growth trend, especially in highly cyclical stocks such as petrochemicals, oil, metals, agricultural products and airlines, he said.

For highly cyclical stocks, product prices and profits are normally volatile. The price and profit can rise sharply for two years during an uptrend, then nosedive the following two years.

Look closely at revenue and normalised profit from operation, excluding one-time special items such as land sales or profits from debt restructuring, said Mr Sombat.

PROFIT MARGIN

Investors should also investigate figures that indicate whether a company has a healthy profit margin.

Earnings per share is usually stated at the bottom of the income statement, and is definitely worth a look, he said.

Investors are also recommended to check net profit margin (net profit divided by total revenue) and ROE (net profit divided by equity).

A healthy business should have a high profitability that did not decline the prior five years. A higher level of comparison involves checking the profitability of the company’s competitors in the same industry, said Mr Sombat.

In some cases, a company will post a net profit, but net cash from operations is negative. If you are still interested in this stock, he said more homework is required. For example, check accounts receivable and see if the debt is unreasonably overdue, or why the stock of raw materials and products went up. Mr Sombat said ask yourself, “Is it because the product cannot be sold?”

Investors and analysts should also consider the history and behaviour of executives, directors and major shareholders. In particular, if any of these people have a record of reporting false numbers by producing fake proof of sales or tax receipts, the stock should be avoided, he said.

Risks and financial liquidity should be another concern for investors, said Mr Sombat. Companies that have low debt, a large portion of capital and a sound financial structure usually have low risk, he said, with the strength to withstand an economic slowdown or recession quite well.

In terms of debt-to-equity (D/E) ratio, a low number means low financial risk. However, it does not mean a business is healthy and growing well. Mr Sombat said a company may need to expand and if loan interest rates are high, a good company could have 1.5 times or even 2 times for a D/E ratio.

A business with poor profits and a D/E level of 3-4 times should be avoided as it carries a high financial risk compared with its ability to generate profit to pay back the debt, he said.

If the D/E ratio is high, investors may need to look at short-term liquidity and the current ratio, said Mr Sombat. On a balance sheet, divide the current assets by current liabilities. This number should not exceed one times to ensure the company has the ability to turn over the debt in a one-year period.

BUYER BEWARE

The next items to check are receivables and inventories. If these numbers look unusual, it often indicates these stocks are starting to have problems, he said.

Many numbers rise in line with sales growth, perhaps a little faster or slower. But investors should beware when there is a sudden increase in accounts receivables or inventories, said Mr Sombat.

For example, if sales increased by 10% but accounts receivable rose by 70%, is there a reasonable explanation for this? If not, investors should be wary.

He said investors should try calculating accounts receivable for days and months in terms of sales. When dividing the total accounts receivable by the monthly sales, if the number is unusually high, investors should be cautious, said Mr Sombat. Compare the figure with the previous year to see if the number is increasing. It could indicate a problem with debt, he said.

Investors should also look at inventory figures to check for irregularities. In general, goods should be sold no longer than 2-3 months after production, depending on the nature of the business.

“These techniques to read financial statements will help investors to screen stocks to see if they are good enough for their portfolio,” said Mr Sombat.

Mr Sombat advises investors to carefully read auditor’ opinion report and look into the company’s growth of revenue and net profit, as well as its assets.

Investors are advised to read the fundamental analysis by licensed analysts on securities companies. This information is provided for about 300 stocks, sent by the IAA and the SET, and listed under “Analyst Opinion Survey” (IAA Consensus) on the Settrade website.

BOND SELECTION

SCB Chief Investment Office (SCB CIO) highlights four key criteria before making investment decisions on bonds.

“The first factor involves evaluating the credit rating of debentures, which should be conducted by an approved credit rating agency supervised by the SEC,” said Sornchai Suneta, executive vice-president of SCB CIO and product function at Siam Commercial Bank. “In addition to the interest offered, investors are advised to assess the issuer’s ability to repay debt as this significantly affects risk associated with the investment. A one-notch decrease in the issuer’s rating doubles the risk of default on debt payment compared with the original rating,” he said.

Second, consider the different risks and repayment orders associated with each debenture type, advised SCB CIO.

“Secured bonds provide the right to asset repayment ahead of other creditors, making them suitable for investors seeking lower risk. Unsecured bonds possess the same asset rights as ordinary creditors, but carry a higher level of risk compared with secured debentures,” said Mr Sornchai.

Third, corporate governance of the debenture issuer is a crucial consideration for investors seeking to mitigate risk, avoiding investment in companies that engage in financial misrepresentation or internal fraud, said SCB CIO.

Shares of STARK were suspended after sinking 99% this year.

“SCB CIO believes that future assessments of corporate governance scores for listed companies will become more rigorous. Investors should consider how important companies consider stakeholders to be such as creditors, shareholders, employees and society. The backgrounds of executives are also crucial considerations,” he said.

Finally, preliminary analysis of financial statements involves examining balance sheets, income statements, cash flow statements, and assessing financial ratios.

“Investors should read balance sheets for any abnormalities, such as unusually rapid asset growth, significant increases in trade account receivables, or longer debt repayment periods, while considering the proportion of liabilities. Higher proportions indicate increased risk,” said Mr Sornchai.

“Pay attention to any unusual increases in revenue or profit, and assess whether the explanations provided are logical, or could suggest artificial manipulation of financial figures.”

Cash flow statements are important as they indicate cash generated from operations. Even if a bond issuer appears highly profitable, a negative cash flow statement can signal a lack of liquidity to meet debt repayment obligations, he said. For example, total liabilities divided by shareholders’ equity measures D/E, with lower values being more favourable, though a comparison with industry peers is essential.



Source link

Scroll to Top