How to Understand Financial Statements?

Different companies has different line of business. Some make fast foods, some make software’s, some make cars etc. But the reason behind why all companies are doing business is for ‘profit making’. All managers working in a company contributes in their own ways towards profits that ‘grows every year’. In case of private companies, profits are tracked very closely. In government companies, focus on profit is not as stringent but to keep the company running, they too track their spending’s very closely.

Irrespective of the fact that whether a person is an employee of private or government company, understanding of financial statements will be very useful for them. Understanding financial statements can make people realize the importance of cost reduction and sales growth.

Both these parameters has a big importance in the formulation of financial statements. You must have noticed yourself that how much your top managers harps about ‘wastage’s’ and ‘invoice billing’. These are only other words for ‘cost reduction’ and ‘sales growth’.

Understanding financial statements helps people realize that how important it is for a company to maximize the efficiency of its assets. Suppose a company buys a desktop computer (asset) but no body uses it. In this case the utilization of companies asset is zero. Suppose the same desktop computer is assigned to a person who can develop 10 software’s in a week. In this case the utilization of desktop computer has been substantially increased. Suppose the same desktop is assigned to a person who develop only 2 software’s in a week. This way the utilization/efficiency of the asset (computer) has gown down by 80%. Knowing how to read & analyze financial statements helps people to realize the importance of ‘asset efficiency’ for companies long term prosperity. In short, people who can read and understand financial statements can contribute more for a company.

For investors it is essential to master the skill of financial statements analysis. Understanding financial statements will help investors to answer: what is the financial health of a company? How good or bad company is spending its money? How profitable is the company? How company is generating its cash? And where company is utilizing its cash? Such intricate details about companies operations are available in their financial statements. A financial statement is made up of 3 documents, the profit & loss a/c, the balance sheet, and the cash flow statement. For companies which are listed in stock market, all 3 financial documents are available online. The documents can be used by shareholders and potential investors to know about financial health of a company.

Utility of Financial Statements

There is a fixed format for all 3 financial documents. All companies use this format to report their financials. This uniform reporting format helps shareholders, investors to compare one company with the other. The guidelines for the format of financial statements is provided in GAAP (Generally Accepted Accounting Principles).

Accural Accounting used in Financial Statements

There is a cash-basis accounting and accural accounting in practice. Very small companies may opt for cash-basis accounting. But as company grows in size they switch to accural accounting. In accural accounting the ‘sales and expenses are booked when they are incurred’. A sale which is incurred today may receive the payment after 3 months. But such sale will be recorded in financial statement as on today (will not wait for 3 months). Similarly, an expense may be incurred today (booking on invoice of vendor) but they are recognized in the same period as their associated sale. In cash-basis accounting the transactions are counted on the date when actual cash flow occurs.

Profit & Loss A/c

Investors likes to buy stocks of companies like Apple, Microsoft, Berkshire Hathaway, Exxon Mobil etc. What makes these companies so likable? No matter how big is the company, no matter how renowned is the its CEO, no matter how technologically advanced are its products, but if companies is not making profits its not good for investing. The profit & loss a/c tells us if the company is making profit or loss. Generally, profit and loss a/c of company talks about its profit/loss over last one year. [Companies also publish their quarterly and semi-annual financial reports]

But how do profits of companies reported in P&L a/c? The first thing that is recorded in P&L a/c is sales turnover. The next thing that is recorded is companies expenses. The expense are like: cost of manufacturing of goods, administrative costs, storage costs, depreciation of plant & equipment, interest costs, taxes and duties etc. All these costs are added up and then deducted from sales turnover. What’s left is called the ‘net income’ of the company. If the net income is positive, it means company is making profit. If the income is negative, it means company has made a loss.

UNDERSTANDING FINANCIAL STATEMENT - PROFIT & LOSS AC

Cost of Goods Sold: Is the cost of manufacturing of a product. This cost includes the raw material cost and direct labor associated with manufacturing of product.

Operating Expense: Is the cost linked with administrative expense of company. This includes salaries of all employee who are not directly linked with manufacturing of products (like sales & marketing). It also includes cost like payment of bills, rents etc.

Depreciation: All assets devalues over time. It is essential for companies to make-up for this devaluation. Lets take an example. Suppose a company has a Forklift used for internal transportation of raw material etc. The life of that forklift is say 5 years. It means, after 5 years the company should procure a new forklift. Suppose the cost of forklift is $ 20,000. Over a period of 5 years, this principal will get adjusted as depreciation. In first year depreciation expense will be $4000, second year it will be $4000 and so on. At the end of 5th year, after depreciation adjustment, the asset (forklift) is worth zero dollars for a company. A company must make a provision for cash so that after end of the 5th year they have cash to buy a new forklift. Accounting for depreciation is one financial tool which companies use to make provision for potential next capital purchase. As here there is no actual cash out flow (no actual depreciation expense), company can record depreciation as an expense, but can keep the cash as savings.

Interest Expense: This expense is related to loans the company has taken to mage its working capital. The interest paid on loans is recorded separately in profit and loss a/c.

Income tax: Government tax all companies on its PBT. The income tax paid by companies to government is recorded seperately in profit and loss a/c.

Balance Sheet

Financial health of a compay is reflected in its Balance Sheet. This is perhaps the most important financial documents that investors and shareholders must learn to analyze. In order to understand financial statement like balance sheet, people must read one such reports each week.

How to Understand Financial Statements- Balance Sheets

Owners equity is also known as shareholders capital. It can be calculated as a sum of share capital and accumulated reserves. Share capital is the money of the investors. Accumulated reserves is the remaining profit transferred to balance sheet from P&L a/c at end of every financial year. Liability is represents the borrowed money like bank loans etc. Unlike share capital where company is not obliged to pay any fixed returns, funds raised through debt costs interest expense to company. Company raises funds in form of owners equity & liability. These funds in turn is utilized to buy assets. These assets in turn helps company to do business. Example of asset are land, factor, equipment’s, inventory, receivables, cash & cash equivalents etc.

How to Understand Financial Statements - Balance Sheet

Cash Flow Statement

Reading and understanding Cash flow statement is like looking into bank statement of a company. It tells the investors from where the cash is coming-in and where the cash is going-out. A company which is able to keep its cash flow positive (always) can remain in business forever. In a large company cash flow is not a big concern as its easier for such companies to get loan. But for a small company cash flow is like blood running in vain. The life will come to an end as soon the flow stops. Profits recorded in P&L account is one thing, converting those profits into cash is another thing. A company which is able to collect faster will have more cash in hand to manage its working capital.

How to Understand Financial Statements - Cash FLow Statement

Conclusion

Balance sheet, profit & loss account and cash flow statement highlights three different perspective about the companies “Financial Performance”. In order to know “how well a company is doing financially” one needs to read and analyze its three financially statements. (1) Profit and loss accounts highlights the bottom line of the company (net profit/loss) generated over last 4 quarters. It says whether company is making profit or not. (2) The balance sheet highlights the financial position of company at that point in time – its asset, liabilities and equity. It talks about how well the company is utilizing its assets to generates profits. It also talks about how much the company is relying on liabilities to do business. (3) The cash flow statements highlights from where the cash is coming and going out. It tells whether company is able to convert its profits into cash. The information provided by each financial statement is highly interrelated. A positive /negative change in one will certainly effect the other report. One of the best ways to analyze the three highly interrelated financial statements is use of financial ratios.


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.

2 Comments on "How to Understand Financial Statements?"

  1. It is very interesting and informative.

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