How to Interpret Financial Reports? Understanding This Article is Enough!
There are countless accounting books on financial reports, and there’s no need for me to add more. However, most of the details are too complex for the average investor and unnecessary to fully grasp unless you plan to work in accounting or auditing. This article will discuss financial reports from a simple and practical perspective, focusing on what’s useful. If reading this article helps you quickly and happily master the skills of reading corporate annual reports, my goal will be achieved.
Three Forms of Business Organizations
Before diving into corporate financial reports, we need to cover some foundational knowledge. This knowledge will help us understand how the current system evolved and what problems it aims to solve.
Any publicly traded company is first and foremost a business. There are three main forms of business organizations: sole proprietorships, partnerships, and corporations. A sole proprietorship is owned by an individual or a family, where the company’s assets and liabilities are the owner’s personal assets and liabilities. The owner bears unlimited liability for the business. For example, a villager opens a small supermarket at the village entrance. The profits from the supermarket are equivalent to the owner’s personal income, and the supermarket’s debts are the owner’s personal debts. If the supermarket maliciously defaults on payments, a judge can order the owner to surrender personal assets. Most restaurants fall into this category—the restaurant’s profits are the owner’s profits. Many large corporations started as sole proprietorships, changing their structure as they grew. However, restaurants often remain sole proprietorships indefinitely.
A partnership is similar to a sole proprietorship, except it has multiple owners who jointly own the assets and liabilities of the business. Typically, partners have a written agreement outlining profit-sharing and loss-bearing responsibilities. Sometimes, these businesses may also have limited liability partners. For example, Zhang San and Li Si are good friends. Zhang San is a skilled cook, while Li Si excels in operations, so they decide to open a restaurant together. Unfortunately, they lack sufficient funds and borrow money from Wang Wu. The three agree that Wang Wu’s contribution counts as an investment. Since Wang Wu isn’t involved in the restaurant’s daily operations, he’s a limited liability partner, while the other two bear unlimited liability. One day, disaster strikes—the restaurant experiences a large-scale food poisoning incident. The police arrest Zhang San and Li Si but only question Wang Wu briefly.
Corporations differ from the above two forms. A corporation is a legal entity separate from its owners. You can think of a corporation as a person responsible for its own actions, unable to shift blame to others. A corporation can own assets and liabilities, enter contracts with other companies or individuals, and can sue or be sued. The laws governing corporations are vastly different from those for other business forms. Many know the English word “company” comes from the Latin “companion,” meaning partner. In other words, a company is a collective of business partners.
The corporate system emerges inevitably when a business reaches a certain scale. Consider this: the smallest family workshop is a sole proprietorship. When it gains a few partners, it becomes a partnership. As it grows further and acquires many shareholders, it transforms into a corporation. Shareholders elect a board of directors, which decides who manages the company—sometimes the chairman takes the role, while other times an external hire is made.
Corporations have three main advantages. First, shareholders enjoy limited liability. Imagine a company you invested in goes bankrupt, owing creditors a large sum. If creditors could come to your home and take your TV, fridge, and furniture, would you dare to invest? With limited liability, the worst-case scenario is losing your initial investment, capping your risk and encouraging investment. Second, corporate ownership can be easily bought and sold without disrupting operations, as ownership and management are separate. Shareholders don’t need to manage the company, and managers don’t need to own shares. Finally, a corporation exists independently. Even if its founders pass away, the company continues to operate, with its health tied solely to performance.
Most large businesses worldwide are corporations. Some corporations have ownership concentrated in a few hands—these are private companies. Others have ownership spread among thousands—these are public companies, including all publicly traded ones. A company’s name often indicates its type. For example, “Inc.” stands for “incorporated,” meaning a corporation. In the UK, “PLC” denotes a public limited company, while “LTD” signifies a private limited company. In Japan, the term “株式会社” (kabushiki kaisha) is used, where “株式” means shares and “会社” means company, together forming “stock company” or corporation.
