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Making sense of financial statements

Last updated on: June 15, 2009 10:15 IST

Sanjana (name changed) is an avid stock market investor who likes to track her equity portfolio minute by minute. However if you ask her to read the financials of any of her equity investments, she is put off.

As with Sanjana, the crunching of numbers to read a financial statement and cull information about a company or its growth prospects sounds dull and boring to many. Especially when 'pink' papers give indepth stock analysis, research analysts provide reports and friendly brokers/advisors provide handy 'stock tips.'

Yet, reading a financial statement is a necessary 'evil.' It is important for the simple reason that you should know the company in which you have invested or plan to invest in.

Publicly listed companies are obliged to release their basic financial information regularly. The three main statements released are the balance sheet, the profit and loss account and the cash flow statement. It is important that investors know how to use, analyse and read these.

Financial statements tell investors how good the company is at making money, what they own and owe, and how they're paying for their operation and future growth.

A balance sheet is a snapshot of a company's financial position at a point in time. It is divided into two parts, one being assets and the other, the liabilities and shareholder funds, and the two sides must always equalise.

In other words, assets, or the means used to operate the company, are balanced by a company's financial obligations, along with the share capital brought into the company and its retained earnings.

Assets are what a company uses to operate its business, while its liabilities and shareholder's funds are two sources that support these assets. Owners' funds, referred to as shareholders' funds in a publicly traded company, is the amount of money initially invested into the company, plus any retained earnings, and it represents a source of funding for the business.

An increase in shareholders' funds could be due to increase in retained earnings or issue of fresh capital. Increase in fixed assets means the company is expanding business. Increase in loan capital means it has borrowed money for business purposes. The loans could be short or long term.

After understanding the balance sheet, let us look at the profit and loss account. It gives the net earnings of the company during the stated time period. It shows the income, expenditure, tax, net profit, distributed profits and retained earnings of the company.

 

While analysing income, you may check if operating income has increased, as that is an indication of business growth. In case non-operating income has increased, it may not be a healthy sign, as it may be non-recurring in nature.

Expenditure is the expense on raw materials, wages, salaries, administrative expenses, advertisements and publicity, charges for power consumption and so on. The item 'interest' refers to the interest the company pays on its loans. Depreciation refers to the wear and tear on the equipment used.

A higher increase in expenditure as compared to income shows that the operating margin has gone down. The difference between total income and total expenditure is profit before tax. After deduction of tax, we get profit after tax.

Remember that profits by themselves carry little meaning. You will always have to compare profit in a particular period with those in the preceding period to arrive at any conclusions.

Schedules to accounts provide break-ups of income, expenditure and other items. For instance, you may want to know what components constitute 'other income,' particularly if it has been a significant contributor to profits that year. The item-wise split of the components classified under 'other income' will help you decipher how much of the non-operational income is recurring in nature.

You are also provided with segmental information -- both geographic and business. Similarly, schedules elaborate on balance sheet items such as long-term and short-term loans. Many a time, it provides finer details of how accounting treatment has been done. It can throw out information of any 'adjustments' made by the company.

The cash flow statement measures the liquidity of a company, by providing a better picture to investors on its ability to pay off its bills, creditors, and finance growth. In fact, a company can be profitable and yet run out of money.

A lack of liquidity may result in financial difficulty and potentially lead to bankruptcy. A cash flow statement also helps investors to answer the questions, 'Where did the money come from?' and 'Where did it go?'

The statement is important because cash flow isn't as easily manipulated as reported earnings. You either have cash or not, and the cash flow statement tells investors the whole story.

A positive cash flow tells investors the company was able to generate enough cash from operations to fund business growth without additional financing. A negative cash flow would tell investors the company had to get cash from other sources, such as financing by way of loans or selling investment or properties or fixed assets to meet the operational requirements.

Analyse the financial statement with ratios

To analyse the information within the balance sheet and profit and loss account, financial ratio analysis is used. The main types of ratios that use information from the financial statements are financial strength ratios, activity ratios and profitability ratios.

Financial strength ratios, such as the working capital and debt-to-equity ratios, provide information on how well the company can meet its obligations and how they are leveraged. This can give investors an idea of how financially stable the company is and how the company finances itself.

Activity ratios focus mainly on current accounts to show how well the company manages its operating cycle (which include receivables, inventory and payables).

The main activity ratios are debtors turnover ratio and inventory turnover ratio. These ratios provide insight into the operational efficiency of the company.

Profitability ratios such as net profit margin, earnings per share, return on equity and return on assets provide information on a firm's overall economic performance.

Financial analysis (though it requires a bit of number crunching!) can be a productive starting point for assessing financial strengths and weaknesses, credit worthiness and other attributes of a firm based on past performance.

The essence of savvy investing is to research your investments carefully and make use of all the information available. The view of media houses may not always be right and research reports have been way off the mark a number of times.

Hence, understanding financial statements is a must. CFO's of public limited companies should make the financial statement easy and lucid for investors such as Sanjana to read and understand.

Ashish Pai in Mumbai
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