How to read financial statements of a company?
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, I am going to teach you the basics of how to read financial statements of a company.
To be honest, you won’t find this post very interesting. Many of the points might sound complex.
However, it’s really important that you learn how to read financial statements of a company. Reading and understanding the financials of a company differentiates an investor from a speculator.
So, let’s get started.
First of all, few things that you need to know.
Where can you get the financial statements of a company?
You can find the financial statements of a company in any of the following sites:
Further, if you are using any other source, make sure that the reports are correct and not tempered.
In India, Securities exchange board of India (SEBI) regulates the financials announced by the company and try to keep it as fair as possible.
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 (Also called profit & loss statement)
- Cash flow statement.
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’. The above formula can be also written as:
Assets – Liabilities = Shareholder’s Equity
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 is applicable to companies. However, here we define net worth as the shareholder’s equity.
Now, 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 the key elements of a balance sheet. Let’s define both of these to understand them in details:
It is an economic value that a company controls with an expectation that it will provide future benefit. Assets can be cash, land, property, inventories etc
Assets can be broadly categorized into:
- Short-term (or current) assets: These are those assets that can be quickly liquidated (within 1 year). For example cash in hand, inventories etc
- Fixed assets: Land, property, equipment etc
- Other assets: Financial investments and intangible assets like patents, copyrights, trademarks etc.
The sum of these assets is called total assets of a company.
It is an obligation that company has to pay in future due to its past actions like borrowing money in terms of loans for business expansion purpose etc
Like assets, it can also be broadly divided into three segments:
- Short term (or current) liabilities: These are the obligations that need to be paid within a year. For example payroll, account receivables, taxes etc.
- Non-current (Long-term) liabilities- Example long-term borrowings, trade payables etc
- Other liabilities: Example- deferred income taxes etc
Now, let us understand these segments with the help of the balance sheet of a company from 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.
Although the balance sheet looks complicated, however, once you learn the basic structure, it’s easy to understand how to read financial statements of a company.
Few points to note from the balance sheet of Asian Paints:
- There are three segments in the balance sheet of Asian paints: Assets, equity, and liability.
- It adheres the basic formula of the balance sheet: Assets = Liabilities + Shareholder’s equity. Please note that the first column of asset (TOTAL ASSETS = 9335.60) is equal to the second & third column of equity and liabilities (TOTAL EQUITY & LIABILITY = 9335.60).
Although there are much more points to cover in balance sheet topic, however, it’s not possible to explain everything in a single blog post.
You can learn in great depth about balance sheet in my online course- HOW TO PICK WINNING STOCKS? Check it out now.
Now, let us move to the second important financial statement of a company.
2. Income Statement:
This is also called 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.
Most of the investors check the income statement of a company to find its earning. Moreover, they look for the growth in the earnings.
It’s preferable to invest in a profit-making company. A company cannot grow if the underlying business is not making money.
Here is the Income statement of Asian paints for the Year 2016-17:
Here are few points that you should note form the income statement of Asian Paints:
- The operating costs like cost of materials, purchases of stock-in-trade, excise duties etc are included in expenses.
- The difference in total income and total expenses gives EBITDA. This is also called operating profit.
- When you reduce interests, taxes, depreciation, and amortization from EBITDA, you will get the net profit for the year.
For Asian paints, net profit is increased from the fiscal year 2015-16 to the fiscal year 2016-17. This can be taken as a healthy sign for the company.
3. Cashflow statement:
Last part of a company’s finances is its cash flow statement.
Cash flow statement shows the flow of cash and cash equivalents during the period under report. It helps in assessing liquidity and solvency of a company and to check efficient cash management.
Three key components of Cash flow statements:
- Cash from operating activities: Revenue generating activities of an enterprise. For example, sale & purchase of goods and services.
- Cash from investing activities: Sale and purchase of fixed assets (machinery, equipment and improvements) and long-term investments.
- Cash from financial activities: Change in capital & borrowings (short term and long term) of the business.
In simple words, cash from operating profit can be considered as ‘cash in’. And the cash from investing activities and financial activities can be considered as ‘cash out’.
For a healthy company, cash inflows should be positive and high.
Here is the Cash flow statement of Asian paints for the fiscal year 2016-17.
Quick note: In financial statements, people do not use the negative sign. For example, if the expense is to be deducted, it is not written as -40. When writing minus sign, accountants use parentheses (—). For the same example, it will be written as (40), not -40.
From the Asian paints cashflow statement, we can notice that the net increase in cash and cash flow equivalents is low compared to the last fiscal year. However, the cash and cash equivalents by the end of the year (31st March) has increased for the year 2016-17, which can be considered decent enough for the company.
It’s 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 inflow.
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.
If you want to learn (in details) about where to find the financial statements of an Indian company and how to effectively study the reports, feel free to check out my online course on HOW TO PICK WINNING STOCKS here. I have explained everything about financial statements in this course.
Further please comment if you have any questions. I’ll be happy to help you out.
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