A company’s financial statements are a window into its financial health. No wonder studying them is an integral part of fundamental analysis.
The balance sheet, profit-and-loss statement, as well as the cash-flow statement contain the data necessary to guide investors looking to invest in a company.
Ratios used in analysing stocks are impossible to obtain without figures and data contained in these statements.
While analysts dig into financial statements and try to unearth the not-so-obvious aspects of a company’s financials, understanding basic financial statements should suffice for an investor in most cases.
An Explanation of the Major Financial Statements
There are three major financial statements: the balance sheet, profit-and-loss statement and cash-flow statement.
The balance sheet tells you about the assets and liabilities of a company. The profit-and-loss statement tells you about a company’s profitability. And the cash-flow statement is about the flow of cash into and out of a company.
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The balance sheet shows the assets that a business owns, the liabilities that it owes and the funds contributed by its shareholders.
The balance sheet is so called because it always balances according to this equation:
Assets = Liabilities + Owners’ equity.
A balance sheet that doesn’t balance is simply wrong.
Assets include land, equipment, inventory, goodwill, patents, brand value, etc. Liabilities include debt (long-term and short-term) and any other payables that a business has. Shareholder funds are in the form of equity and reserves.
Strong v Weak Balance Sheets
A weak balance sheet is one that is saddled with debt. When a business has a strong balance sheet, it has more assets and equity than liabilities.
In order to know the balance-sheet strength, you need not actually see the balance sheet; you can just look at the debt-equity ratio.
As its name suggests, the P&L statement tells you about the profitability of a company. The simple formula to calculate profits is
Profit (loss) = Revenue – Expenses.
The head revenue generally has two entries: revenue from sales and other income.
Other income is the revenue from sources other than the core area of the company’s operations. For instance, it could be income from investments, dividends, royalties, etc.
The head expenses constitutes the categories of expenditure such as cost of raw materials, employee costs, etc. On subtracting the total costs from the total revenues, we get the operating profit, which is nothing but a company’s profit from its core operations.
In order to arrive at the final profit figure, any miscellaneous income or loss is to be added to or subtracted from the operating profit. Finally, net profit is obtained after deducting the tax applicable.
A cash-flow statement provides a true picture of a company’s financial health. While businesses can misstate their profits through creative accounting, they can’t fake the movement of hard cash.
The cash-flow statement shows the movement of cash in a business. The cash-flow statement is of limited use for banks and finance companies, but it is important for investors.
How to read a Cash Flow Statement
The cash-flow statement has three components: cash flows from operating activities, from financing activities and from investing activities. The statement also mentions the current cash holding of the business.
What you need to check in the data is whether flows from operating activities are positive or not. If they are positive, it means that the company is able to generate cash from its operations. If they are negative, it means that the company is losing money. While it may show profits in its P&L statement, negative flows from operations should ring an alarm.
Cash flows from financing activities show the money raised for the company’s operations or the money paid towards debt repayment. The former will be a positive number on the statement, while the latter will be a negative number.
Cash flows from investing activities capture the cash used in investments. For instance, a business that has generated surplus cash may park it in a bank fixed deposit. Next year it may withdraw cash from that Fixed Deposit. The former will be a negative number on the statement, while the latter will be a positive number.
All these statements may be found in the annual reports of companies as well as online. A simple web search should unearth the information.
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