How do I understand financial statements?

Recently, many companies have successively released their first-quarter financial reports—dozens of pages long—leaving readers utterly bewildered. In fact, professionals don’t read them word for word. This article teaches you how to decipher the financial statements of listed companies. First, to evaluate whether a company is sound, analysis should focus on three key aspects: 1. Profitability—how much money it can earn; 2. Financing capability—how much capital it can raise; 3. Operational efficiency—how quickly cash flows in. Therefore, information in financial statements related to these three dimensions is of paramount importance. The DuPont Analysis method enables efficient extraction of such information and helps interpret the underlying meaning conveyed by the data. 【科普】DuPont Analysis: DuPont, an unconventional American research company, prefers simplifying complex problems rather than complicating simple ones. DuPont Analysis is a classic financial methodology that evaluates corporate performance—particularly profitability and return on shareholders’ equity—by examining interrelationships among key financial ratios. Although ‘net assets’ and ‘total assets’ differ by only one character, they are not comparable in weight: net assets represent the portion of capital contributed by shareholders—also known as owners’ equity. ROE (Return on Equity) = Net Profit ÷ Net Assets—i.e., the return generated for shareholders on their invested capital. ROE clearly reflects a company’s profitability. Yet, based solely on this formula, how can we assess its financing capability (‘how much capital it can raise’) or operational efficiency (‘how quickly cash flows in’)? In fact, ROE possesses a ‘Transformers-like’ adaptability! From the diagram above, four key insights emerge: 1. A higher net profit margin on sales indicates stronger profitability. If operating scale expands but the net profit margin fails to grow accordingly, management should receive a yellow card—prompting cost-control measures. 2. Higher ROE is generally better, with no upper limit. Companies consistently achieving ROE above 15% are typically excellent investment candidates—though their stock prices tend to be correspondingly high. 3. If a company’s ROE falls below the one-year fixed deposit interest rate… then perhaps it’s best to save your energy. Spending effort without commensurate returns warrants presenting the company with a banner: ‘What use are you?!’ 4. High ROE must be sustainable—not volatile like a rollercoaster, which would not only disturb your mood but also destabilize your stock portfolio balance. What other data reflect a company’s operational health?

Key points when reading financial statements

I. Balance Sheet For a company, there are typically three sources of monetary funds: (1) issuing shares or taking on debt; (2) selling assets or business divisions; and (3) sustained positive net cash inflow from operating activities (i.e., operating cash inflows exceeding outflows). Companies meeting the third condition usually possess some form of sustainable competitive advantage. When analyzing monetary funds, adhere to one fundamental principle: monetary funds must align with short-term debt obligations and operational needs. Alignment with short-term debt reflects solvency; alignment with operational needs reflects capital utilization efficiency. If monetary funds are too low, it may signal insufficient solvency or operational strain. If monetary funds are excessively high, it may indicate weak capital utilization—or potentially questionable fund nature. Applying this principle, investors should watch for the following four red-flag scenarios in practice: (1) Monetary funds significantly lower than short-term liabilities; (2) Ample monetary funds coexisting with substantial interest-bearing (even high-interest) debt; (3) Large amounts of time deposits and other monetary funds, yet severe shortages of working capital; (4) Huge balances in ‘other monetary funds’ without reasonable explanation. As the saying goes: ‘When something appears abnormal, something sinister is likely at play.’ Scenario (1) may indicate an imminent short-term solvency crisis; scenarios (2), (3), and (4) suggest that seemingly abundant monetary funds could be fictitious, frozen, or already appropriated by major shareholders—temporarily returned to the company’s account just before reporting, only to vanish again afterward. Regarding accounts receivable: if a company’s accounts receivable surge dramatically—outpacing同期 revenue growth—and its collection speed falls below industry averages or shows a clear downward trend—it often signals one of two possibilities: (a) the company has temporarily relaxed its credit policy and expanded credit sales, or (b) it has prematurely recognized—or even fabricated—revenue. Moreover, if accounts receivable constitute a large proportion of revenue—and especially if over 30% consists of receivables overdue by more than one year—investors should question the authenticity of reported revenue. Another scenario demanding investor vigilance—often overlooked by casual financial statement readers—is unusually low accounts receivable. Points to note regarding liabilities and equity: 1. Examine the proportion, interest rates, and maturities of interest-bearing liabilities; 2. Monitor ratios such as production assets / total assets, accounts receivable / total assets, monetary funds / interest-bearing liabilities, and non-core assets / total assets. II. Income Statement (prepared under the accrual basis) Focus on four key items: revenue, gross margin, expense ratio, and operating profit margin. Pay attention to whether revenue growth matches profit growth, and examine the ratio of net profit to net operating cash inflow—i.e., whether profits have genuinely materialized as cash in the company’s bank account. From a revenue perspective, profitability is assessed via operating profit margin, gross margin, and net profit margin—with operating profit margin being the most critical. Operating Profit Margin = (Revenue − Cost of Goods Sold − Three Major Expenses) ÷ Revenue Gross Margin = (Revenue − Cost of Goods Sold) ÷ Revenue Net Profit Margin = Net Profit ÷ Revenue Gross margin reflects product competitiveness; operating and net profit margins incorporate expense-related information. From an asset perspective, investors should monitor Return on Equity (ROE) and Return on Total Assets (ROA).