Overview of Financial Statements

A financial statement is a collection of business’s financial information. One can form conclusions about business’s financial health through financial statement analysis and organization. Statements include line-by-line items as well as total amounts of what one is looking at.
• Financial Statements are important for anyone who wants to invest in shares.
• All sorts of people analyse financial statements. From small-time investors to Chief Financial Officers (CFO’s) of big businesses.
• For investors, a company’s financial statements help determine financial condition (liquidity situation, cash generation, debt levels etc) of the company

Types of financial statements

1. Income Statement (IS) (also called as Profit and Loss Statement)
2. Balance Sheet (BS)
3. Cash flow Statement (CS)

1.Balance Sheet (BS)

The balance sheet shows the value of a business at a point in time; usually the year end. The balance sheet shows a company’s:
• Assets: things it owns that generate revenue.
• Liabilities: what it owes in debt.
• Equity: its assets minus its liabilities.

Assets

1. Assets don’t need to be ‘things.’ They can also be intangible assets like the brand names of Coca-Cola or Tata. Intangible assets are hard to value.
2. Assets are split into current assets (like products for sale and cash in the bank) and non-current assets (like brand names, property and office equipment).

Liabilities

1. Most companies need to borrow money from investors to grow their businesses. They do this by issuing equity/bonds to investors.
2. Liabilities are split into current liabilities (debt that needs to be paid back within a year) and non-current liabilities (the rest).

Equity

Equity is equal to all the assets minus all the debt.

2.Income Statement (IS)

The Income Statement lists all the income and expenses of a company over a period of time, usually every quarter. Profit equals income minus expenses. The more profit the better.

3.Cashflow Statement (CS)

As the name suggests, the CS shows a company’s cash inflows and outflows over a period of time. Cash doesn’t lie so it’s hard to manipulate. It is the simplest of all financial statements to read and understand.

It has three sections, Cash from Operations, Cash from Investing activities and Cash from Financing Activities.

Cash from Operations – Highlights the cash generated by a company from its operations (business). Best run business will have this value almost equal to net profit

Cash from Investing Activities – Highlights the net inflow/outflow from company’s investments and also sale/purchase of assets.

Cash from Financing Activities – Highlights the net inflow/outflow covering new debt raised/debt repaid/dividends paid

What do good financial statements look like?

It sounds obvious, but good financial statements should show that a company is in good financial health. If you are looking for simple ways to check financials of a stock, then see if the following helps.

1. Profit and Loss Statement
a. Sales should double every 5 years
b. Net Profit should more than double every 5 years
c. Operating Margin should be improving historically
2. Balance Sheet
a. No debt is ideal
b. Even if debt is there, it should be decreasing over the years
c. Sundry debtor and Sundry creditor is proportionally increasing with respect to sales, nothing to worry.
3. Cash Flow
a. Cash from Operations should be increasing and should be a positive figure
b. Cash from investing should be negative (meaning company is investing to growth business further)
c. Cash from financing should be negative (meaning company is paying their debt and/or giving away dividends)

These simple points should be enough to screen a company at high level. Also compare these factors of the company’s competitors as well. For example, if you are checking Berger Paints, check these with Asian Paints.

Don’t fall for trap in financial statements

Those who actually check these statements are less among retail investors. Even those who check, they evaluate these statements independently without linking each other. Here is an example of how a company can conceal their bad state.

Income Statement – It contains both revenue and profit. Here Profit means not actual cash collected but recorded profits. These are on papers. A company may send their products to distributors and record their value as revenue, irrespective of whether they managed to collect “cash” from the distributors. So by looking at Income Statement alone, won’t be sufficient.

Balance Sheet – Most just do a quick glance on debt levels. Generally it is sufficient, but inventory levels, trade payables and trade receivables also need to be checked. A company who is unable to collect cash for the products sold, will have higher levels of trade receivables.

Cash Flow – This will reveal anything a company tends to hide. Unfortunately, most small investors do not check this statement at all. Cash from Operations need to be in line with Net Profit. When this is very less compared to net profits, then company is having cash crunch.

So a company that is unable to collect cash will go through following,
• Continue to report good Net Profit
• Trade receivables will keep increasing
• Cash from Operations will be low
• Company will start taking working capital loans from banks followed by NBFC
• Promoters will start to pledge their shares
• Lenders will eventually unload pledged shares on open market due to margin pressure as stock price will go down

Conclusion

Learn to have a quick look at financials to understand the condition of the company before making any investment decision. This is a must thing to do by all investors. This article aimed to give a shortcut for those who are not from accounting background to quickly interpret financial statements with simple steps.