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Understanding financial statements

Studying a company's financial statement is an integral part of fundamental analysis. Learn the basics here

Understanding financial statements

A company's financial statements are a window into its financial health. No wonder studying them is an integral part of fundamental analysis. While analysts dig deeper 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.

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.

Balance sheet
The balance sheet is so called because it always balances according to this relation: Assets = Liabilities + Owners' equity.

A balance sheet that doesn't balance is simply wrong. The balance sheet shows the assets that a business owns, the liabilities that it owes and the funds contributed by its shareholders.

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.

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.

Profit-and-loss statement
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.

Cash-flow statement
The cash-flow statement shows the movement of cash in a business. While businesses can misstate their profits through accounting jugglery, they can't fudge the movement of hard cash. Hence, a cash-flow statement provides a true picture of a company's financial health. However, for banks and finance companies, the cash-flow statement is of limited use as they follow a different business model than other types of businesses.

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 FD. The former will be a negative number on the statement, while the latter will be a positive number.

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 also require figures and data contained in these statements, without which a thorough analysis is impossible. All these statements may be found in the annual reports of companies as well as online. On Value Research, these statements can be found on any stock page under 'Financials'.