Financial Statements Simplified

We all know equities and what they represent. But when it comes to participating in the market we are surrounded by an avalanche of choices from all the companies available in the market for investing. If you are also overwhelmed by the number of companies and don’t know how to select companies to invest don’t worry. Stick on to this post to learn about it.

In this post, we are going to learn how to evaluate a company, based on the data available to the common public. These data are the financial statements of the company, these documents are required to be published mandatorily by the company according to the regulatory body of that market.

So what are financial statements?

Financial statements are essential documents that provide a comprehensive overview of a company’s financial health. They are typically used by investors, creditors, and financial analysts to assess a company’s performance, financial position, and cash flows. There are three key financial statements.

Income Statement

They are also known as Profit and Loss statement. It summarizes a company’s revenues and expenses over a specified period, usually quarterly and yearly, resulting in net income or loss. The data is summarized under different heads which is a standard format. The different heads of the statement are as follows:

1. Revenue/Sales: This is the income received from selling goods or services before any expenses are deducted. It’s usually listed at the top of the statement. Increasing Sales is a good/positive sign as it indicates the company is gaining more ground in the market.
2. Cost of Goods Sold (COGS): These are the direct costs attributed to the production of the goods sold by a company. Subtracting COGS from revenue results in Gross Profit. Decreasing the Cost of Goods is a good/positive sign as it can lead to an increase in profit margin.
3. Operating Expenses: These include selling, general, and administrative expenses that are necessary to run the business but are not directly tied to the production of goods or services. Decreasing operating expenses is a good/positive sign.
4. Operating Income: Also known as Earnings Before Interest and Taxes (EBIT), it’s calculated by subtracting operating expenses from gross profit. Increasing operating income is a good/positive sign.
5. Other Income: This represents income from other sources apart from the main business of the company. Increasing other income is a good/positive sign, but if the other income constitutes a significant part of the Total income it becomes a red flag for the investor.
6. Net income: This is the final profit or loss after all expenses, including taxes and interest, have been deducted from the total revenue. Increasing net income is a good/positive sign.

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Cash Flow Statement

This statement summarizes cash inflow and outflow for a company over a specific period, such as quarterly or yearly. It is one of the three main financial statements. As with the Income statement Cash Flow Statement also has a standard format and is divided into three main sections:

1. Cash flow from operating Activities: This section shows the cash generated or used by the company’s core business operations. it includes receipts from sales, payments to suppliers, wages to employees, and other operating expenses. Cash flow from operating activities should ideally be large as compared to other heads in this statement as the company is expected to generate most of its revenue from its main business.
2. Cash flow from Investing Activities: This part details the cash used for or generated from investments, like the purchase or sale of assets, equipment, or securities.
3. Cash flow from Financing Activities: This section reflects the cash flow related to financing activities, including borrowing, repaying debts, issuing stock, and paying dividends.

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This statement is essential to understand how the company manages its cash, how it funds its operations, and how it handles its financial obligations. It’s particularly useful for assessing a company’s ability to generate cash and remain solvent.

Balance Sheet

This statement provides a snapshot of a company’s financial position at a specific point in time. It details the company’s assets, liabilities, and shareholders’ equity according to the following equation: Assets = Liabilities + Shareholder’s Equity.

If you want to read more about Assets and Liabilities you can read it here.

1. Assets: These are the resources owned by the company that have economic value and can be converted into cash. Assets are usually categorized as either current (expected to be converted into cash within a year) or non-current (Long-term). These include land, buildings, machinery, equipment, inventory, trade receivables, and cash equivalents.
2. Liabilities: These are obligations the company owes to outside parties, such as loans, accounts payable, and mortgages. Liabilities are also divided into current (due within a year) and long-term. These include Long-term and short-term borrowings, lease liabilities, trade payables, and advances from customers.
3. Shareholder’s Equity: Also known as owner’s equity, this represents the residual interest in the assets of the company after deducting liabilities. it includes funds invested by shareholders and retained earnings.

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Insight

These statements are governed by accounting principles like Generally Accepted Accounting Principles (GAAP) in the US or international Financial Reporting Standards (IFRS) internationally. Understanding these documents is crucial for making informed financial decisions and strategic business moves.

These financial statements alone won’t make so much sense. To make sense of these statements they have to be seen in tandem with the product of the company and the market it operates in. For better decision making the statements should be compared with other companies in the same industry.

However, it is to be noted that evaluating a company through statements only helps us make a decision about whether the company fits our investment strategy or not but does not tell us whether it is the right time to buy it. For this, we have to do some more studying which I will cover in the upcoming posts.

This is all for this post. Let me know your thoughts in the comments. Don’t forget to follow my Facebook and Instagram pages for regular updates. See you in the next post. Till then keep learning.