When we look at analysing a company for its inherent merits and demerits, the focus is quite often on the three financial statements; income statement, balance sheet and cash flows. The more discerning investors also look at the Management discussion and Analysis (MDA) as well as the Director’s report for the more futuristic signals. But what a lot of us tend to miss out is the Notes to Accounts. At the end of the balance sheet and the income statement, the annual report provides detailed Notes to Accounts where a lot of explanatory variables are provided. What is the importance of notes to financial statements? If you look at some of the notes to financial statements examples, then it covers everything from break up of borrowings to the depreciation policy. What is disclosed in the notes to the financial statements is far more important and incisive than the pure numbers of flows and stock. Here are 10 things you must look at in the Notes to the financial statements of the company.
10 things to look at in the Notes to Accounts of Financial Statements
Focus on the accounting policies used for revenue recognition, employee benefits etc. Normally companies use the accrual system of accounting which is based on incomes and expenses due rather than what is paid in cash. Be more cautious if the company has been consistently shifting its accounting policies and valuation methodologies.
Check out how the asset impairment is recorded in the financial statements. Good account policy is that whenever carrying amount is not recoverable in case of assets, then the impairment is immediately recorded in the income statement. This is a good conservative policy.
See how intangible assets like goodwill and patents are recognized. An intangible should be accounted for only if it is clear that the future economic benefits can be quantified and attributed to that particular asset. It is quite common to overstate or understate this aspect and hence one need to be cautious.
See how derivative transactions are accounted for. Quite often derivative transactions are used as a means of off balance sheet financing as it does not impact the balance sheet ratios. However, these are contingent liabilities and you must ensure that they are properly and fully accounted for as contingent liabilities.
Notes clearly disclose how much of the foreign currency exposure of the company is hedged and how much is not hedged. That gives you an idea of the risk that the company runs in case of extreme events like a sharp rise in oil prices or a sharp depreciation in the value of the rupee etc.
When it comes to financials and banks, make sure that the investment values are depicted appropriately. How is the company’s policy for classifying current and long term investments since long term investors have to be shown at cost or fair value whichever is lower? Make sure that the financial company makes adequate provisions for interest rate risks and default risk.
Check the capital structure of the company which is disclosed in detail in the notes to accounts. Be cautious of a capital structure where the number of sub components is too many as they can confuse the valuation of the firm. Also check that the company has been conservative in classifying reserves as free reserves as they have large implications for capital base and for ROE calculations.
See how the company is account for foreign currency translation of losses and profits. The policy must be consistent and conservative. It is quite common for companies to shift policies when it is suitable. That should be a red flat for you as an analyst looking at notes to accounts.
Look at the break up of borrowings. Look at the mix of secured and unsecured borrowings that is disclosed in the Notes to accounts. Also focus on the split between long term borrowings and short term borrowings. Ensure that cash flow is sufficient to take care of loan repayments coming up in the next one year. The notes will also tell you if the borrowing cost is high, medium or low as it impacts your decisions based on the interest coverage ratio.
A lot of doubtful transactions take place under the loans and advances section. This is disclosed in detail in the Notes section. Check if there are too many inter group loans and advances. You can trade the audit trail of group companies through the MCA database.
In addition, the Notes to accounts also give you useful insights about the trade receivables management and the trade payables management of the company. IN short, Notes offer a wealth of information and insights to even the most casual reader of the balance sheet.