Understanding financial statements and ratios

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

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, for an investor, understanding basic financial statements should suffice 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 the company.

Balance sheet
The balance sheet is called so 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 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. What's that? More on it soon.

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 as follows:
Profit (loss) = Revenue - Expenses

The head 'revenue' generally has two entries: revenue from sales and other income. Other income is the revenue from the 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 these businesses have 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 see among these data is whether the 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. 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, if a company buys some fixed asset such as some machinery, the cash outflow will be recorded as a negative number under the cash flows from operating activities. If it sells some fixed asset, the number will be positive.

Financial ratios
If you are not one who likes to dig deep into a company's financial statements but still wants to make sense of its financials, financial ratios come to your rescue. They are readymade tools to interpret what's happening in a company. Most financial ratios can be derived from the three major financial statements: balance sheet, profit-and-loss statement and cash-flow statement.

In order to put a company's ratios in perspective, compare them with the industry trend and peers' ratios. Again, good analysis goes beyond ratios, and you shouldn't make your investment decision just in terms of ratios.

Here is a summary of the major financial ratios and what they mean. You can find these (and more) for any Indian listed company on VRO. Just type in a company's name in the search bar. On the company page, click on the 'Financials' tab and scroll down. You will find the 'Ratios' section, which has many popular ratios.

Debt to equity: Companies take debt to run their business operations. Their shareholders also put money, called equity, in the business. The debt-to-equity ratio tells us about this balance. A high debt-to- equity is not desirable. But to know what is ideal, you must see the industry-wide trend. As a rule of thumb, avoid companies where the debt-equity ratio exceeds one.
Return on net worth (RONW): Also called the return on equity (ROE), this ratio tells us what returns a company is generating on its equity part. A high RONW is desirable. Good companies have more RONW than their peers.
Operating margin: This ratio tells us how much a company makes from its core operations. It is derived by dividing the operating profit by the total revenues. A high operating margin is a good sign, but do see the industry trend.
Revenue growth: This ratio indicates how fast a company is growing its revenues over a period of time. A high revenue growth is a positive sign and shows that the company is expanding.
EPS growth: This is a tool related to earnings and tells us the growth of earnings per share (EPS) over a period of time. For instance, if the EPS of a company this year has gone up from `10 to `12, the EPS growth is 20 per cent. Good companies show higher earnings growth than their peers in a sector. A shrinking EPS, on the other hand, should ring an alarm.