(Yicai Global) Aug. 25 -- Analyzing Chinese internet companies' earnings reports pose complex challenges, mostly involving their innovative business models.

Hidden risk factors are hard to spot by reading internet companies' financial reports as the firms tend to have unique profit models and the sector's ecosystem is completely different from the manufacturing industry.

Three Challenges: Outdated Rules

The challenges can be divided into three categories. 

First, financial reporting rules were formed in the industrial age of big machines and equipment. Thus, the techniques are designed for the manufacturing industry. With these outdated methods, it is difficult to make sense of the scale and significance of new tech companies' income and costs, as well as their research and development expenses.

Take the example of Tencent Holdings. The Shenzhen-based firm is mainly known for operating social media applications WeChat and QQ, but these apps do not generate most of the company's revenues. The firm earns most of its money by selling virtual items on video games, as well as social network memberships.

In comparison, Facebook’s social media platforms Instagram, Facebook, Messenger, and WhatsApp are free to use, but over 97 percent of the company's revenue comes from advertising.

New Theory 

The second problem is that mankind’s understanding of the internet industry is still at an early stage. The development of relevant theories lags far behind practice. This is why it is hard to form a foundation for analyzing financial reporting.

Lastly, the sector has a special driving force. The manufacturing industry relies on capital, a gauge that helps analysts form their judgment about companies' financial health. But the rapid growth of internet firms is mainly driven by technology and business innovation as well as human resources. That makes some of the usual factors, such as the ratios of asset turnover, inventory turnover, accounts receivable turnover, inapplicable. They should be replaced by other indicators such as the number of monthly active users and customer acquisition costs.

Monetization

What makes internet companies' business models so unique and diversified is that their development potential is continuously being expanded by monetizing user traffic. And that encourages these firms to pass the money on to grow even bigger together. In the new click-happy era, many platforms have added equity investment to their main scopes of business, as well as formed joint ventures and alliances.

For instance, the scale of Tencent’s equity investments exceeds its operating assets. The WeChat owner's equity assets equal more than half of its total assets. The fair value of Tencent's assets in listed companies tallied more than CNY1.2 trillion (USD184.9 billion) by December 2020.

Other Chinese tech titans, including Alibaba Group Holding, JD.Com, Baidu, Xiaomi, Meituan, and ByteDance Technology, also have considerable equity investments.

However, that adds to the pile of topics that require upgraded interpretation tools. Changes in the cost, ownership, and fair value of equity assets are some of the key factors that should be considered when analyzing internet companies' financial reports.

Editor: Emmi Laine, Xiao Yi