How to read financial statements of a company?

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.

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.

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:

1. BSE/NSE Website
2. Company’s website
3. Financial websites (like screener, money control, investing etc)

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:

1. Balance sheet
2. Income statement (Also called profit & loss statement)
3. Cash flow statement.

Let’s understand each statement one-by-one.

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 detail:

Assets:
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:

• Current (short-term) assets: These are those assets that can be quickly liquidated into cash
(within 12 months). For example cash and cash equivalents, inventories, account receivables etc.

• Non-Current (Fixed) assets: Those assets which take more than 12 months to converted into cash.
For example- Land, property, equipment, long-term investments, Intangible assets (like patents,
copyrights, trademarks) etc.

The sum of these assets is called the total assets of a company.

Liabilities:
It is an obligation that a 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 two segments:

• Current liabilities: These are the obligations that need to be paid within 12 months. For example
payroll, account payable, taxes, short-term debts etc.

• Non-current (Long-term) liabilities- There are those liabilities that need to be paid after 12
months. For example long-term borrowings like term loans, debentures, deferred tax liabilities,
mortgage liabilities (payable after 1 year), lease payments, trade payable etc.

Now, let us understand these segments with the help of the balance sheet of a company from
the 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:

1. There are three segments in the balance sheet of Asian paints: Assets, equity, and liability.
2. 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).

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.

The fundamental structure of an income statement:

Revenue
– Cost of goods sold (COGS)
——————————————-
= Gross Profit
– Operating expenses
——————————————-
= Operating Income
– Interest expense
– Income taxes
——————————————–
= Net Income

Note: The revenue is called TOP LINE and net income is called the bottom line in the income
statement.

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 a few points that you should note form the income statement of Asian Paints:

1. The top line (revenue) increased by 8.04% in the fiscal year 2016-17.
2. On the other hand, the bottom line (net profit) increased by 11.84% (Rs 1802.76 Cr –>
Rs 2016.24 Cr) in the from the fiscal year 2015-16 to the fiscal year 2016-17.
3. This shows that the management has been able to increase the profits are a better
pace compared to the sales. This is a healthy sign for the company.

For Asian paints, the diluted EPS also increased from Rs 18.19 in the year 2015-16 to Rs 20.22
in year 2016.17. This is again a positive sign for the company.

3. Cashflow statement:
Last part of a company’s finances is its cash flow statement.
Cash flow statement (also known as statements of cash flow) shows the flow of cash
and cash equivalents during the period under report and breaks the analysis down to
operating, investing and financing activities. . 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: This includes all the cash inflows and outflows generated by the
revenue-generating activities of an enterprise like sale & purchase of raw materials, goods, labor
cost, building inventory, advertising, and shipping the product etc.

• Cash from investing activities: These activities include all cash inflows and outflows involving the
investments that the company made in a specific time period such as the purchase of new plant,
property, equipment, improvements capital expenditures, cash involved in purchasing other
businesses or investments.

• Cash from financial activities: This activity includes inflow of cash from investors such as banks
and shareholders by getting loans, offering new shares etc, as well as the outflow of cash to
shareholders as dividends as the company generates income. They reflect the change in capital &
borrowings of the business.

In simple words, there can be cash inflow or the cash outflow from all three activities i.e.
operation, investing and finance of a company. The sum of the total cash flows from all
these activities can tell you how much the company’s total cash inflow/outflow in a
specific period of time is.

Here is the Cash flow statement of Asian paints for the fiscal year 2016-17.
From the Asian paints cashflow statement, we can notice that the net cash from operating
activities has declined from Rs 2,242.95 Crores to Rs 1,527.33. This may be little troublesome
for the company as the net cash from operating activities shows how much profit the
company is generating from its basic operations.

As a thumb rule, an increase in the net cash from operating activities year over year is
considered a healthy sign for the company. However, while comparing also look at the data
for multiple years.

Quick note: In financial statements, generally accountants 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.

Summary:
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.
 1. The balance sheet shows the assets and liabilities of a company.
2. The income statement shows how much profit/loss the company has generated from its
revenues and expenses.
3. 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 flow.

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.