If you want to invest successfully in the stock market, you need to learn how to read and understand the financial reports of a company. Financial statements are tools to evaluate the financial health of the company. In this post, we are going to discuss the basics of how to read financial statements of a company. Here you’ll learn how to read the balance sheet, income statement, and cashflow statement of a company.
To be honest, you won’t find this post very interesting. Many of the points might sound complex and boring. However, it’s really important that you learn how to read financial statements of a company for achieving success in your investing journey. Reading and understanding the financials of a company is what differentiates an investor from a speculator.
As Warren Buffett used to say “Risk comes from not knowing what you are doing.”. And you can find the risk and potentials of a company through its financial reports. Without wasting any further time, Let’s get started.
How to get the financial statements of a company?
Before we start analyzing the financial statements of a company, the first thing that you need to know is where exactly to find them. Where can you see or download the financial statements of a company that you’re researching?
Well, you can find the financial statements of a company in any of the following sites: 1) BSE/NSE Website, 2) Investor relation page on Company’s website 3) Financial websites (like screener, money control, investing, etc)
In India, Securities exchange board of India (SEBI) regulates the financials announced by the company and try to keep it as fair as possible. Further, if you are using any other non-reputed website, make sure that the reports are correct and not tempered.
Three Core Financial Statements of A Company
Now, let us understand the different financial statements of a company. The financials of a company are split into three key sections. They are:
- Balance sheet
- Income statement (Or Profit & loss statement)
- Cash flow statement.
The balance sheet shows the assets and liabilities of a company i.e. what it owns and owes. Second, the income statement shows how much profit/loss the company has generated from its revenues and expenses. And finally, the Cash flow statement shows the inflows and outflows of cash from the company.
It’s essential that you know how to read all of these financial statements. Let’s understand each statement one-by-one.
How to read financial statements of a company?
1. Balance Sheet
A balance sheet is a financial statement that compares the assets and liabilities of a company to find the shareholder’s equity at a specific time. The balance sheet adheres to the following formula:
Assets = Liabilities + Shareholders’ Equity
Here, do not get confused by the term ‘shareholder’s equity’. It is just another name for ‘net worth’ of the company. In other way, the above formula can be also written as:
Shareholder’s Equity = Assets – Liabilities
Quick Note: You can easily understand this with an example from day to day life. If you own a computer, car, house, etc then it can be considered as your asset. Now your personal loans, credit card dues, etc are your liabilities. When you subtract your liabilities from your assets, you will get your net worth. The same concept is applicable to companies. However, here we define net worth as the shareholder’s equity.
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Why are balance sheets important?
The balance sheet helps an investor to judge how a company is managing its financials. The three balance sheet segments- Assets, liabilities, and equity, give investors an idea as to what the company owns and owes, as well as the amount invested by shareholders.
Key elements of a Balance Sheet
Assets and liabilities are two key elements of a balance sheet. However, both assets and liabilities further comprise of different elements. Let’s define both of these to understand them in details:
1) Assets: It is an economic value that a company controls with an expectation that it will provide a future benefit. Assets can be cash, land, property, inventories, etc. Further, assets can be broadly categorized into:
- Current (short-term) assets: These are those assets that can be quickly liquidated into cash (within 12 months). For example cash and cash equivalents, inventories, account receivables, etc.
- Non-Current (Fixed) assets: Those assets which take more than 12 months to convert into cash. For example- Land, property, equipment, long-term investments, Intangible assets (like patents, copyrights, trademarks), etc.
The sum of these assets is called the total assets of a company.
2) Liabilities: It is an obligation that a company has to pay in the future due to its past actions like borrowing money in terms of loans for business expansion purposes etc. Like assets, it can also be broadly divided into two segments:
- Current liabilities: These are the obligations that need to be paid within 12 months. For example payroll, account payable, taxes, short-term debts, etc.
Non-current (Long-term) liabilities- There are those liabilities that need to be paid after 12 months. For example long-term borrowings like term loans, debentures, deferred tax liabilities, mortgage liabilities (payable after 1 year), lease payments, trade payable, etc.
Now, let us understand these segments with the help of the balance sheet of a company from the Indian stock market. Here is the balance sheet of ASIAN PAINTS for the fiscal year 2016-17. I have downloaded this report from the company’s website here.
Please note that there are always at least 2 columns on the balance sheet for consecutive fiscal years. It helps the readers to monitor the year-on-year progress.
2. Income Statement
This is also called the Profit and loss statement. An income statement summarizes the revenues, costs, and expenses incurred during a specific period of time (usually a fiscal quarter or year). The basic equation on which a profit & loss statement is based is:
Revenues – Expenses = Profit
In simple words, what a company ‘takes in’ is called revenue and what a company ‘takes out’ is called expenses. The difference in the revenues and expenses is net profit or loss.
The fundamental structure of an income statement:
– Cost of goods sold (COGS)
= Gross Profit
– Operating expenses
= Operating Income
– Interest expense
– Income taxes
= Net Income
Note: The revenue is called TOPLINE and net income is called the bottom line in the income statement.
Most of the investors check the income statement of a company to find its earning. Moreover, they look for growth in their earnings. It’s preferable to invest in a profit-making company. A company cannot grow if the underlying business is not making money.
3. Cashflow statement
This is the third key part of a company’s finances. Cash flow statement (also known as statements of cash flow) shows the flow of cash and cash equivalents during the period under report and breaks the analysis down to operating, investing, and financing activities. It helps in assessing the liquidity and solvency of a company and to check efficient cash management.
Three key components of Cash flow statements
- Cash from operating activities: This includes all the cash inflows and outflows generated by the revenue-generating activities of an enterprise like sale & purchase of raw materials, goods, labor cost, building inventory, advertising, and shipping the product, etc.
- Cash from investing activities: These activities include all cash inflows and outflows involving the investments that the company made in a specific time period such as the purchase of new plant, property, equipment, improvements capital expenditures, the cash involved in purchasing other businesses or investments.
- Cash from financial activities: This activity includes inflow of cash from investors such as banks and shareholders by getting loans, offering new shares, etc, as well as the outflow of cash to shareholders as dividends as the company generates income. They reflect the change in capital & borrowings of the business.
In simple words, there can be cash inflow or cash outflow from all three activities i.e. operation, investing, and finance of a company. The sum of the total cash flows from all these activities can tell you how much is the company’s total cash inflow/outflow in a specific period of time.
Through this post, we tried to explain the three core financial statements of a company. It is important to read and understand all the three financial statements of a company as they show the health of a company from different aspects.
- The balance sheet shows the assets and liabilities of a company.
- The income statement shows how much profit/loss the company has generated from its revenues and expenses.
- Cash flow statement shows the inflows and outflows of cash from the company.
While investing in a company, you should pay special attention to all these financial aspects of a company. As a thumb rule, invest in a company with high-income growth, large assets compared to its liabilities and a high cash flow.
That’s all! This is how to read financial statements of a company. Although it’s not enough, however, this post aims to give a basic idea to the beginners about the financial statements of a company.