Financial statements and stock investing

Today I am going to blog on a topic which is very close to my heart. I love this subject and every time now and then, whenever I get time, I try to read about this topic and try to gain more knowledge about it.

When I was comparatively young, I used to think about this topic which is very complicated and which is known to very few people in this world. Since those days I always had this dream and passion of knowing about this subject.

Gradually I developed a strong affinity for this topic and it didn’t took me long to develop a habit of reading on this subject.

I talking about none other than the topic of stock analysis. I know lot of people in this world want to know about stocks analysis because people do fantasise and they do like stock investing.

But many would realise that stock investing is not a very easy thing to do. It is not easy to make money in stocks. And people who do make money has very strong knowledge of stock analysis.



The same was true for me as well. I wanted to invest money in stocks, but I had very little knowledge about stock analysis. As a result I decided to gain more knowledge about this subject.

While I was trying to understand about stocks, how to invest in them, how to analyse a good stocks, I started become aware of one parameter which completely dominates stock investing.

Financial statements

All good strong investors practice this habit of reading and analysing financial statement of companies. It will not be wrong to say that, if person does not know how to read and analyse financial statements, it will be like impossible for them to invest profitably in stocks.

This was a surprise for me, but it also came as a big bolt, because I am not a finance guy, forget about how to read financial statement of companies.

Financial statements and stock investing

In my good old days when I was very young, when I joined one of the big corporate house as a graduate trainee, in those times we were give some training, some insights on these financial statements. Needless to say that in those times it looked like impossible to read and understand those statements.

But later on in my life when I developed this affinity for investment, particularly for stock investment, I realised that unless and until I learn to read and analyse financial statements, it will be very difficult for me to invest in stocks very profitable.

So I had very little choice left. I decided to start my education on financial statements.

Frankly speaking, in those days there were very less good examples on internet which can explain to a layman the skill of reading financial statements of companies. So, I was left on my own. At that time I had to decide that either I give up stock investing completely or I have to find a way out. I must learn to read Balance sheets, Profit & Loss A/c and Cash Flow Statements.

That was a challenge. From that day onwards when I decided that I will not give up stock investing, instead I will try to learn more about financial statements, I started roaming around the market. I was looking for good reference books.

Initially the books that I found on the book shelf of shops were too complicated and didn’t helped the purpose of a beginner. I wanted something which was simple, which could give a head start, so that I could know at least what is a balance sheet, what is a profit and loss a/c, what the hell is this cash flow statement?

Why companies have three financial statements?

And why companies prepare these three reports? They can prepare a single report. That will be much easier for them as well to read and understand. Why at all they are preparing these there reports?

So this was the first question that came to my mind that why companies prepare three reports. Today I understand that how important it is for companies to have these three reports.

One report, which is the balance sheet tells a investor that how rich is the company. In a layman language if we want to understand how rich is a company, we have to see its balance sheet.

The second report, which is profit and loss account, tells us that how profitable is the company.

So the two reports, balance sheet which tells how rich the company is and the second report tells you how profitable the company is and the third report which is the cash flow report tells the investor that if the company is generating enough cash or not. Because in a business term the cash is kind. A company which may be very profitable but it is not able to generate enough cash it will ultimately die because of liquidity crunch.

A company may not be very profitable but if it is generating enough cash for itself, it can sustain for a very long time in the market. Of course profitability is also important, but cash is king.

So, more or less the first thing that I understood about the three financial report was the starting point for me in the field of stock investment.

So even today when I want to pick and good stocks, I ask to myself, How rich is this company? And to answer this i have to see its balance sheet.

Once I know how rich is the company, the second question that I ask to myself about the company is; Is this company profitable enough? Maybe, it may happen that in the past the company has done good business, it done a very profitable business in the past, but is it profitable even today?

And this question is answered when I see companies profit and loss account.

So these are the two main financial reports that I look at before buying any stock even today.

Balance sheet and income statement has some interlinking?

So talking about my good old days, at that time another questions that puzzled me for a very long time. Only in last few years I began to solve this puzzle. It always always struck to me, whenever I used to read a balance sheet and profit and loss account, it always clicked in my mind that how these two reports are linked to each other. I always used to ask my self, are these two reports completely independent of each other, or there is any link between these two reports?

And if at all there is any link how it helps me as a stock investor. I will not lie to that I solved this puzzle very quickly. It took me lot of time to solve this puzzle. But now I know that there is a very clear link between a balance sheet and profit and loss account. And the link that I established between these two reports helped me grow as a stock investor. Now I can see the two reports, I can glance if between the two reports, and on fist looks say if this company is worth investing or not.

So let me explain you how there two reports are linked and then we will go into more details.

PAT

The profit and loss accounts, as  said before, it is nothing but a report which tells the investor that how profitable is the company. And how we make out this conclusion?

If you can see a typical profit and loss account, you can see that in the beginning of the report all the expenses of the company are listed. Before the expenses, the sales turnover and total income of the company is indicated.

So, how to arrive at a profit? Total income minus total expense is the profit of the company. And in finance term total income minus total expense is called gross profit.

On gross profit, company pays interest, taxes and duties and does other adjustments. So after paying all the interest, taxes and duties to the government, what is left is net profit.

For an average investor, this net profit figure, which is also called as Profit After Tax (PAT) is extremely important.

If I could suggest to beginner, what they should look for in a profit and loss account of a company, I would say that they should look into the historical net profit figures. Historical net profit figures means? At least they should see net profit (PAT) for the last 5 to 10 years. And what you have to see? Just give a glance and see if the profit, 10 years back, has grown in these last 10 years or not.

The idea for doing a business is to make profit, and to make that profit grow year after year. We all know the concept of inflation. The price of goods and services are increasing every year. If fact it increases at a very fast rate. In India the average inflation figure at present is hovering around 6-7% .

So a company which is doing business in India should be able to increase its net profit at least at the rate of inflation. A company which is not able to grow its profits atlas at this rate is probably not worth investing in.

So this realization about the net profit of a company was very important for me as a novice investor. When I started investing around 10 years in stocks, I sued to watch closely these net profit figures. But very soon I realized that looking only at net profit of company is not advisable. And why it is so? Because I realized that there is something more important in the profit and loss account than PAT. And what was that which are more important? It is called Earning Per Share.

EPS

The earning per share is nothing but the net profit of the company is nothing but net profit of the company (PAT) dividend by the number of shares outstanding in the market. SO what I suggest always in my blog posts, instead of looking only and net profit figures, investor must look at earning per share.

It is very important for people to see a pattern in EPS. Like I suggested people to look and historical net profit figures, again I suggest the same think for EPS. Have a look at last 10 years EPS, and try to understand if EPS is continuously growing? If it is growing fast enough? Or if there is a complete volatile movement in EPS?

A company which is able to increase its EPS consistently is surely a good stocks to invest in.

Even today I look at the earning per share of company, historical earning per share of companies, to make a first impression about that company. If I want to buy a stocks, it should definitely show me a continuously growing EPS is last 10 years. No matter how big is the brand name, no matter how high is the marked capitalization of that stock, but unless and until I see a constant growth patter in their EPS, I don’t even take the pain of analyzing that stock. This is step 1 for me even today. Of course, I also look at PAT, but earning per share figure is absolutely important for me.

Dividend per share

The profit and loss account also gives me another very interesting value. And that value is the dividend that company pays from its profits. As a value investors, I always like investing in those stocks which not only show a consistent growth in their EPS, but it should also pay me decent dividends.

When company makes profit, it also likes to dividends to its shareholders. Of course not every company pay dividends, but most of the cash rich companies who are also making good profits do belief in sharing profits with their shareholders. And how do they share profits? They share profits in the form of dividends.

So the next thing that I look into companies profit and loss account is dividend history. A company which has been able to continuously grow is EPS should also grow its dividend per share.

A consistently growing dividend per share makes me very exited about the company. I generally see last 10 years dividend per share history of the company, and if the dividend is consistently increasing with its profits, it gives me a clear hint that the company must be doing something excellent.

So coming back to our point that how profit and loss account and balance sheet is interlinked to each other.

Reserves

So now what we have see that, there is net profit of a company, which is reflected in their profit and loss account, there is a dividend which has been paid out of the companies profit. So suppose and company makes 100 crores of profit. Out of this 10 crore, it pays 20 crore as dividend. So what is balance is 80 crores. Hundred crore profit minus 20 crore dividend, the rest which remains is 80 crores. This balance 80 crores is transferred to companies balance sheet.

So this profit which goes into the companies balance sheet creates a link between profit and loss a/c and balance sheet. Actually this is that value that which makes a company richer.

Profit that remains with the company after it has paid dividends goes into the balance sheet as surplus and reserves. if you turn to balance sheet, in the shareholders fund line, you can see that there is share capital and there is reserve and surplus. You can look into money control and find what I am saying. If you can see it with your eyes you will remember it more clearly.

You can see, for a good company like TCS, the reserve and surplus figure has only increased every year in last 10 years. And how these reserves and surplus are increasing? From where the money is coming? The money is actually coming from the profit and loss account.

The balance profit which remains with the company after paying dividends to shareholders is transferred to this balance sheet. So when I say how balance balance sheet tells me how rich is the company, it gives me this answer when I look into the shareholders funds.

More particularly, I like looking into the reserves and surplus figure in the balance sheet. The bigger is the reserves and surplus, more excited I become. And again I do the same exercise. I see at that last years10 figures of that reserves and surplus in the balance sheet.

If I see pattern that every year the reserves and surplus figures are increasing, it means that the company is getting richer and richer.

Final words…

So enough for today. I have some insights about how to start your journey of stock analysis. So what we have discussed today that it is very important for an average investor to learn the skill of reading financial statements of companies to invest profitably in stocks. And what you will look into the financial statements? You will have to look at the net profit, earning per share and dividend per share. An where you will find these figures? You will find it in the profit and loss account. Once you are done with profit and loss account you must open the balance sheet and see the surplus and reserves figures of last 10 years.

Just by looking at these 4 things in the companies financial report. you will gain a lot of insight about the company. A company which is able to increase its net profit, EPS, dividend per share, reserves and surplus continuously fro last 10 years is bound to be tagged as a good stock.

So go ahead and try to practice what I have just suggested in my audio blog. Go to moneycontrol,  open any company say it is TCS, Reliance Industries, Infosys, Wipro…any company. Open their balance sheet, open their profit and loss account, and see what I have told you just now.

I can assure you, it may be little cumbersome for you in the beginning, but try to develop a habit of looking into companies profits, earning per share, dividend per share, reserves and surplus. Try to see these figures of as much company as you can. Develop this knack of looking into these figures of companies. Very soon you will realize that you are beginning to like it.

A stock investor who loves reading companies balance sheet and profit and loss accounts he surely is going to make lot of money in the stock market.



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Disclaimer: All blog posts of getmoneyrich.com are for information only. No blog posts should be considered as an investment advice or as a recommendation. The user must self-analyze all securities before investing in one.

About the Author

Mani
I am a Blogger with a passion for investment education. I started blogging in 2007-08. Blogging didn’t happened to me as a coincidence, it was a conscious decision. The idea with which I started blogging still stands true. In my starting days my finances remained tight. I was reading heavily about how to manage finance. One day I got hold of a book which my father gifted me in 2003. It was stacked below my graduation books. It was a small-thin book with its cover named "Rich Dad Poor Dad".....more

3 Comments on "Financial statements and stock investing"

  1. Gopalakrishnan B Chettiar | August 26, 2017 at 11:13 am | Reply

    Knowledge gaining article for newbies on financial statements and stock investing. I feel, if the beginners have to this article as opt in, explaining with examples to deduce to decide in which stock to invest, appropriately, by comparing the parameters.

  2. Thanks Iam doctor and zero in maths and finance this really helps.

    Mani sir,in one of your post “basics of stocks,” you mentioned how to read overvalued and undervalued companies.I couldn’t figure it out.
    Can you please let me know where is that thread?
    Thanks again.

  3. Thank you Mani. This is very helpful insight into gaining knowledge on stock picking.

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