Lesson #12: Analyzing Financial Statements
The primary goal in financial reporting is the dissemination of financial statements that accurately measure the profitability and financial condition of a company.
So there is no way you can invest your hard earned money in a business whose financial condition you don’t understand.
The financial health of a company is depicted by following three statements-
- Balance Sheet
- Income Statement
- Cash Flow Statement
Let’s begin with the analysis of Balance Sheet.
In simple terms, the balance sheet discloses what a business owns and what it owes at a specific point in time. It is thus also referred to as the statement of financial position.
The financial position of a business is described in terms of its assets, liabilities, and equity:
- Assets (A) are resources controlled by the company as a result of past events and from which future economic benefits are expected to flow to the company (like land, machines, plants, offices, brands, future receivables from customers, cash, investments etc.)
- Liabilities (L) represent obligations of a company arising from past events, the settlement of which is expected to result in an outflow of economic benefits from the company (like bank borrowings and future payment to suppliers of raw materials etc.)
- Equity (E) Commonly known as shareholders’ equity or owners’ equity, is determined by subtracting the liabilities from the assets of a company, giving rise to the accounting equation: A = L + E or A – L = E. Equity can be viewed as a residual or balancing amount, taking assets and liabilities into account.
To simplify the concept of a Balance Sheet, assume you buy a house property worth Rs 100. Your father is willing to provide you Rs 20 of his own funds, and you borrow the remaining Rs 80 from a bank.
Here is how your personal Balance Sheet will look like in this case…
The first major head in a typical balance sheet is “Equity and Liabilities”. Equity here is usually represented by “Shareholders’ Funds”, while Liabilities are shown split into “Non-Current Liabilities” and “Current Liabilities”.
Equity is again sub-divided into Share Capital and Reserves and Surplus.
Let me explain this with an example.
Suppose a company were to issue 500 new shares in an IPO. The shares have a face value of Rs 5 and an IPO issue price of Rs 100. After the company issues these shares, here is how the addition is made into its Equity –
- Rs 5 of Face Value x 500 shares = Rs 2,500 will be added to its Share Capital
- Rs 95 of Share Premium (i.e., Rs 100 minus Rs 5) x 500 shares = Rs 47,500 will be added to its Reserves and Surplus.
So, while Rs 2,500 in Share Capital will always remain with the company, it is free to choose what to do with the premium amount of Rs 47,500 that lies in its Reserves & Surplus under the sub-head “Share Premium Reserves”.
In all, Equity of a company is increased by contributions by the owners (in terms of new equity funds infusion) or by profits (including gains) made during the year and is decreased by losses or withdrawals in the form of dividends.
The key purposes of Equity are to provide stability and to absorb losses, thereby providing a measure of protection to creditors in the event of liquidation.
Non-Current Liabilities include Long-Term Liabilities (due more than one year into the future like redemption of debentures), Deferred Tax Liabilities (arising due to difference in depreciation rates by Companies Act and Income Tax act), Long Term Provisions (employee benefits etc.) and Long-term Borrowings (long term bank loans).
One thing that value investors should watch out for is Long-term borrowings as compared to the equity. Excessive use of debt signals potential danger if things don’t turn out the way a company expects them to.
Current Liabilities are liabilities for which payment is due normally in less than a year. This item includes things like Trade Payables (amounts a business owes its vendors), Other Current Liabilities (security deposits and advances from dealers, unclaimed liabilities etc.), Short Term Provisions (short term employee benefits, warranties on products, proposed dividend etc.) and Short Term borrowings (short term loans to mean working capital requirements).
One final item on the Equity & Liabilities side of the Balance Sheet is called Minority Interest. This is found only in the “Consolidated” Balance Sheets (that combines the accounts of a company and its subsidiaries).
Here is a video where I explain same concepts, using the example of Opto Circuits’ Balance Sheet.
No let’s go through the Assets side of the Balance Sheet and see what lies within.
The Assets side of the Balance Sheet is made up of two broad categories – Non-Current Assets and Current Assets
Non-current assets are assets that are not easily convertible to cash or not expected to become cash within the next year. This item includes following things –
1. Fixed assets – Tangible items like land, building, equipment etc. Intangible items like goodwill, patents, copyrights, trademarks etc. The third key item under Fixed Assets is Capital Work-in-Progress which are the assets that are in progress of being built.
2. Long-Term Investments – Such investments can range from anything from buying a minority stake at another company to investing in equity shares and debt securities (for a period more than one year).
3. Long-Term Loans & Advances – Any loans and advance payments that the company has granted to employees, suppliers, and government, and which are to be received by the company in a period beyond one-year.
These are assets expected to be realized or intended for sale or consumption in the business’s normal operating cycle, or within one year. This includes current investments (that a company makes for a short period of time), inventories and trade receivables, “cash and cash equivalents” (cash in a company’s bank accounts, plus highly liquid short-term investments), and short term loans and advances.
Here are two videos where I explain the Assets side of the Balance Sheet that I’ve discussed above.
So broadly speaking, the Balance Sheet tells about a company’s liquidity, financial strength, and efficiency.
An important way to analyze the strength of a Balance Sheet is by way of ratio analysis, which will help you investigate the liquidity (the ability to cover short-term liabilities with short-term assets), solvency (the ability to finance long-term debt with profits) and how shareholder capital is being managed. We will study ratio analysis in future lessons.
Balance Sheet is a static indicator, a snapshot of the health of the business. It doesn’t tell about the quality of operations of the company or how the cash is being generated and deployed in the business.
So let’s turn our attention to the Income Statement, which showcases a company’s earning potential.
The Income Statement presents information on the financial results of a company’s business activities over a period of time. It communicates how much revenue the company generated during a period (quarter or year) and what costs it incurred in connection with generating that revenue.
Let’s look at the important parts of an income statement
Revenue from Operations
This is the revenue or income a company earns from the operations of its core business. It includes Revenue from Sale of Products and Other Operating Revenue.
This includes interest income on bank deposits and other investments, and dividend income. When a company sells an investment during the year, any gain or loss from the sale of such an investment is also recorded in Other Income.
As the term suggests, it includes the money a company spends to operate its business. It includes the cost of the raw materials consumed, employee expenses, interest paid on company’s borrowings, sales and marketing expenses and depreciation.
Profit before Tax
his is the profit the company generates every year (or quarter) before paying income tax to the government.
Net Profit and EPS
Net profit is the result of PBT minus Tax, and EPS can be calculated by dividing Net Profit by No. of shares outstanding.
To properly interpret financial statements, you need to understand the links between the statements, but the links aren’t easy to see. As you become more skilled in reading the financial statement, these links will become increasingly obvious. So don’t feel overwhelmed. Just like any other skill, reading financials requires practice and patience.
As far as company’s financial health and strength of operations is concerned, balance sheet and income statement should suffice. So why do we need cash flow statement?
Because of the way depreciations works, the reported earnings and the actual earnings of a business are different. Which means that the actual cash that passes hands is different from what’s depicted in the income statement. The real cash flow is very important to investors because they need to be ensured that the business can pay its bills on time.
You will find businesses that generate a lot of cash flows, even when they may not be earning profits.
I have a friend who runs a company that did not make profit for five years in a row. But my friend never missed his yearly trip to the US, and he bought a high end car every two years. His employees were also paid well.
You may wonder, “But how he did it?”
The answer is – Great cash flow.
He was absolutely brilliant at timing income with outflow. When one product was selling great, he’d move the cash into product development. When nothing was happening, he’d slow down for a while and cut back on expenses.
He also had a smart accountant who knew how to spread losses around, as well as a few other tricks – all legal – for reducing the profit.
Now, if his company was listed, I may not have invested in it given the charismatic nature of the promoter ? , and high levels of uncertainty in his business and cash flows. A lot of listed companies are in fact like that – who cover up their sins by occasionally managing their cash flows well.
But a business that sustains a good positive cash flow performance year after year without manipulating expenses and profits is what you as an investor must look out for.
So let’s now turn attention to the most-confusing, most-misunderstood, but most-important statement of them all – the Cash Flow Statement (CFS).
Cash Flow Statement
Here’s a video I’ve prepared for my Mastermind Value Investing Course, where I explain the working of a company’s cash flow statement.
For starters, a cash flow statement shows where the company’s cash came from (sources of cash) and where it went (uses of cash) during a given period (mostly a year).
Finally, if you were to remember one thing about the CFS, it must be that if a company’s cash outflow exceeds its cash inflow for long period of time, it may lead to the business’s downfall.
Cash is so very important, after all!
I think we have covered a lot of ground as far analyzing a company’s financial statements are concerned.
I would like to reiterate, don’t get overwhelmed with the jargons and details we have discussed in this lesson. It’s all a matter of time and practice. The more annual reports you read and analyze, easier it becomes.