Financial Statements: A Guide for Investors

Financial statements are a business's blueprints. Just as architects use blueprints to visualise a building's structure, investors rely on financial statements to understand a company's financial health. These documents offer a detailed roadmap of a company's past performance, present condition, and future prospects. By deciphering the numbers and ratios within these statements, investors can make informed decisions about where to allocate their capital.

What are Financial Statements?

Financial statements are reports that summarize a company's financial activities and overall financial condition. Think of them as a business report card showing how well they're performing financially. These documents are typically prepared regularly – often quarterly and annually – to give investors, lenders, and other interested parties a clear picture of the company's financial situation.

The main purpose of financial statements is to provide accurate and reliable information about a company's:

1. Financial position (what it owns and owes)
2. Performance (how much money it's making or losing)
3. Cash flows (how money is moving in and out of the business)

This information helps investors assess the company's financial health, profitability, and potential for future growth.
 

How do Financial Statements Work?

Financial statements work together to comprehensively view a company's financial activities. They're like different pieces of a puzzle that, when put together, create a complete picture of the company's financial situation.

Here's a simple breakdown of how they work:

• The balance sheet shows what a company owns (assets) and owes (liabilities) at a specific point in time.
• The income statement reveals how much money the company made or lost over some time.
• The cash flow statement tracks how cash moves in and out of the business during that period.

Investors can get a good sense of a company's overall financial health and performance by looking at these statements together. For example, a company might show strong profits on its income statement, but if the cash flow statement reveals it's struggling to collect customer payments, that could be a red flag for potential cash flow problems.
 

Types of Financial Statements

There are four main types of financial statements that investors should be familiar with:

Balance Sheet

The balance sheet provides a snapshot of a company's financial position at a specific point in time. It shows:

• Assets: What the company owns (e.g., cash, inventory, equipment)
• Liabilities: What the company owes (e.g., loans, accounts payable)
• Shareholders' Equity: The difference between assets and liabilities (essentially, the company's net worth)

The Income Statement

Also known as the profit and loss statement, shows a company's revenues, expenses, and profitability over a specific period (usually a quarter or a year). Key components include:

• Revenue: Money earned from selling goods or services
• Expenses: Costs associated with running the business
• Net Income: The bottom line (profit or loss) after all expenses are subtracted from revenue

Cash Flow Statement 

This statement tracks how cash moves in and out of the business over a specific period. It's divided into three sections:

• Operating Activities: Cash generated from day-to-day business operations
• Investing Activities: Cash used for long-term investments (e.g., buying equipment)
• Financing Activities: Cash from investors or lenders, and payments to shareholders

Statement of Changes in Equity 

This statement shows how a company's equity (net worth) changes over time. It includes:

• Beginning equity balance
• Net income or loss for the period
• Dividends paid to shareholders
• Other changes in equity (e.g., issuing new shares)

Understanding these different types of financial statements and how they work together is key to understanding a company's financial health.
 

Financial Ratios

Financial ratios are tools investors use to analyse and compare a company's financial performance. They're calculated using numbers from the financial statements we just discussed. Here are some important ratios to know:

Profitability Ratios

• Gross Profit Margin: This shows a company's profit after accounting for the cost of goods sold. Formula: (Revenue - Cost of Goods Sold) / Revenue
• Net Profit Margin: Reveals how much profit a company keeps from its total revenue. Formula: Net Income / Revenue

Liquidity Ratios

• Current Ratio: Measures a company's ability to pay short-term obligations. Formula: Current Assets / Current Liabilities
• Quick Ratio: Similar to the current ratio, but excludes inventory (which can be harder to turn into cash quickly). Formula: (Current Assets - Inventory) / Current Liabilities

Efficiency Ratios

• Inventory Turnover: This shows how quickly a company sells its inventory. Formula: Cost of Goods Sold / Average Inventory
• Accounts Receivable Turnover: Indicates how efficiently a company collects payments from customers. Formula: Net Credit Sales / Average Accounts Receivable

Solvency Ratios

• Debt-to-Equity Ratio: Compares a company's total debt to its shareholders' equity. Formula: Total Liabilities / Shareholders' Equity
• Interest Coverage Ratio: Measures how easily a company can pay interest on its debt. Formula: Earnings Before Interest and Taxes (EBIT) / Interest Expense

Valuation Ratios

• Price-to-Earnings (P/E) Ratio: Compares a company's stock price to its earnings per share. Formula: Stock Price / Earnings Per Share
• Price-to-Book (P/B) Ratio: Compares a company's market value to its book value. Formula: Stock Price / Book Value Per Share

These ratios can help investors compare companies of different sizes and industries. However, it's important to remember that ratios should be used alongside other analysis tools and not in isolation.
 

How to Read Financial Statements?

Reading financial statements might seem daunting at first, but with practice, it becomes easier. Here's a simple approach:

• Start with the basics: Familiarise yourself with the main components of each statement.
• Look for trends: Compare current numbers with previous periods to spot patterns.
• Analyse ratios: Use financial ratios to investigate the company's performance.
• Consider the context: Consider industry trends, economic conditions, and the company's situation.
• Read the footnotes: These often contain important details that aren't obvious from the main statements.

Now, let's break down how to read each of the main financial statements:
 

How to Read a Balance Sheet?

The balance sheet follows a simple equation: Assets = Liabilities + Shareholders' Equity. Here's how to read it:

Assets

Start by looking at the company's assets, typically listed in order of liquidity (how quickly they can be turned into cash).
●    Current Assets: These can be converted to cash within a year (e.g., cash, accounts receivable, inventory).
●    Non-Current Assets: These are long-term assets (e.g., property, equipment, investments).

Liabilities

Next, look at what the company owes.
●    Current Liabilities: Debts due within a year (e.g., accounts payable, short-term loans).
●    Non-Current Liabilities: Long-term debts (e.g., long-term loans, bonds payable).

Shareholders' Equity

This represents the owners' stake in the company.
●    Common Stock: The value of issued shares.
●    Retained Earnings: Profits that have been reinvested in the business.

Example: Let's look at a simplified balance sheet for XYZ Company as of December 31, 2023:

Assets:

1. Cash: ₹100,000
2. Accounts Receivable: ₹50,000
3. Inventory: ₹150,000
4. Property and Equipment: ₹500,000 Total Assets: ₹800,000

Liabilities:

• Accounts Payable: ₹75,000
• Short-term Loans: ₹100,000
• Long-term Debt: ₹300,000 Total Liabilities: ₹475,000

Shareholders' Equity:

• Common Stock: ₹200,000
• Retained Earnings: ₹125,000 Total Shareholders' Equity: ₹325,000

Total Liabilities and Shareholders' Equity: ₹800,000

This balance sheet shows that XYZ Company has ₹800,000 in total assets, balanced by ₹475,000 in liabilities and ₹325,000 in shareholders' equity. The company has a solid asset base with significant property and equipment. However, it also has substantial debt, which investors would want to monitor.
 

How to Read an Income Statement?

The income statement shows a company's revenues, expenses, and profitability over a specific period. Here's how to read it:

• Revenue: Start at the top with the company's total sales or revenue.
• Cost of Goods Sold (COGS): The direct cost of producing the goods or services sold.
• Gross Profit: Revenue minus COGS.
• Operating Expenses: These are the costs of running the business (e.g., salaries, rent, marketing).
• Operating Income: Gross profit minus operating expenses.
• Other Income/Expenses: This includes interest, expenses, and one-time gains or losses.
• Net Income: The bottom line shows the company's profit or loss after all revenues and expenses.

Example: Here's a simplified income statement for XYZ Company for the year ended December 31, 2023:

• Revenue: ₹1,000,000 Cost of Goods Sold: ₹600,000 Gross Profit: ₹400,000
• Operating Expenses:

         a. Salaries: ₹150,000
         b. Rent: ₹50,000
         c. Marketing: ₹75,000 Total Operating Expenses: ₹275,000

• Operating Income: ₹125,000
• Interest Expense: ₹25,000
• Net Income Before Taxes: ₹100,000 Income Tax Expense: ₹30,000
• Net Income: ₹70,000

This income statement shows that XYZ Company had ₹1 lakh in revenue and a net income of ₹70,000 after all expenses. The company's gross profit margin is 40% (₹400,000 / ₹1,000,000), which could be compared to industry averages to assess performance.
 

How to Read a Cash Flow Statement?

The cash flow statement shows how cash moves in and out of the business. It's divided into three sections:

1. Cash from Operating Activities:

• Starts with net income
• Adjusts for non-cash expenses (like depreciation)
• Shows changes in working capital (e.g., inventory, accounts receivable)

2. Cash from Investing Activities:

• Shows cash used for long-term investments (e.g., buying equipment)
• Shows cash received from selling long-term assets

3. Cash from Financing Activities:

• Shows cash received from issuing stock or borrowing money
• Shows cash paid out for dividends or repaying debt

Example: Here's a simplified cash flow statement for XYZ Company for the year ended December 31, 2023:

4. Cash from Operating Activities: Net Income: ₹70,000 Adjustments:

• Depreciation: ₹50,000
• Increase in Accounts Receivable: (₹10,000)
• Decrease in Inventory: ₹20,000 Net Cash from Operating Activities: ₹130,000

5. Cash from Investing Activities:

• Purchase of Equipment: (₹100,000) Net Cash used in Investing Activities: (₹100,000)

6. Cash from Financing Activities:

• Repayment of Long-term Debt: (₹50,000)
• Dividends Paid: (₹20,000) Net Cash used in Financing Activities: (₹70,000)

Net Increase in Cash: (₹40,000) Cash at the Beginning of Year: ₹140,000 Cash at the End of Year: ₹100,000

This cash flow statement shows that while XYZ Company had positive cash flow from operations (₹130,000), it used more cash for investments and financing activities, resulting in a net decrease in cash of ₹40,000 for the year.

How to Read an Annual Report?

An annual report is a comprehensive document that includes the company's financial statements along with additional information about the company's performance, strategy, and future outlook. Here's how to approach reading an annual report:

1.  Letter to Shareholders: Start with the CEO's or management's letter. This often provides an overview of the company's performance and future plans.
2. Business Overview: Read about the company's main products, services, markets, and competitive position.
3. Management's Discussion and Analysis (MD&A): This section provides management's perspective on the company's financial results, risks, and future outlook.
4. Financial Statements: Review the balance sheet, income statement, and cash flow statement (as discussed earlier).
5. Notes to Financial Statements: These provide important details and explanations about the numbers in the financial statements.
6. Auditor's Report: This gives an independent opinion on whether the financial statements fairly represent the company's financial position.
7. Corporate Information: Look for details about the company's board of directors, executive team, and corporate governance practices.

Example: Let's say you're reading the annual report of ABC Tech, a software company. Here's what you might find:

• Letter to Shareholders: The CEO discusses launching a new cloud-based product and its positive impact on revenue growth.
• Business Overview: ABC Tech operates in the enterprise software market, focusing on cybersecurity solutions.
• MD&A: Management explains that while revenue grew by 15%, expenses also increased due to higher R&D spending on new products.
• Financial Statements: The income statement shows revenue of ₹500 lakh, up from ₹435 lakh the previous year. Net income is ₹75 lakh, compared to ₹65 lakh last year.
• Notes: One note explains that ₹20 lakh of revenue came from a multi-year contract, with some revenue deferred to future years.
• Auditor's Report: The independent auditor states that the financial statements represent ABC Tech's financial position fairly.
• Corporate Information: You learn that the company recently added a new board member with expertise in artificial intelligence.

Reading these sections gives you a comprehensive view of ABC Tech's financial performance, strategic direction, and governance structure.

Limitations of Financial Statements

While financial statements provide valuable information, they do have some limitations:

• Historical Data: Financial statements typically show past performance, which may not always indicate future results.
• Accounting Methods: Companies may use different accounting methods, making comparisons challenging.
• Non-Financial Factors: Financial statements don't capture important non-financial information, such as brand value, customer satisfaction, or employee morale.
• Timing Issues: Some financial impacts may not be immediately reflected in the statements.
• Potential for Manipulation: In rare cases, companies may attempt to present their financials in an overly favourable light.
• Complexity: Some financial statements, especially for large corporations, can be complex and difficult for non-experts to interpret.

Despite these limitations, financial statements remain a crucial tool for investors when used alongside other sources of information and analysis.
 

How to Analyse Financial Statements?

Analysing financial statements involves more than just looking at the numbers. Here's a step-by-step approach:

• Understand the Business: Before examining the numbers, consider the company's business model, industry, and competitive landscape.
• Review Multiple Periods: Look at financial statements from several periods to identify trends and patterns.
• Compare with Peers: Compare the company's financial ratios and performance metrics with those of similar companies in the same industry.
• Analyse Ratios: Use financial ratios (as discussed earlier) to assess profitability, liquidity, efficiency, and solvency.
• Read the Footnotes: Don't skip the notes to the financial statements – they often contain important details and explanations.
• Consider Non-Financial Factors: Look beyond the numbers to factors like market trends, technological changes, and regulatory environment.
• Check Cash Flow: Pay special attention to cash flow, as it can reveal potential issues that are not apparent from the income statement alone.
• Look for Red Flags: Look for warning signs such as declining revenues, increasing debt, or unusual accounting practices.
• Seek Additional Information: Supplement your analysis with other sources, such as earnings call transcripts, industry reports, and news articles.
• Stay Objective: Try to maintain an unbiased perspective and be willing to challenge your assumptions.
• Remember, financial statement analysis is both an art and a science. It takes practice to become proficient, but with time and experience, you'll better interpret the stories that numbers tell about a company's financial health and prospects.
   

Conclusion

Financial statements are powerful tools that provide valuable insights into a company's financial health and performance. By understanding how to read and analyse balance sheets, income statements, and cash flow statements, investors can make more informed decisions about where to put their money.
Remember, while financial statements are crucial, they're just one piece of the puzzle. Consider them alongside other factors like industry trends, competitive landscape, and overall economic conditions. With practice and patience, you'll become more confident in decoding financial statements and using them to guide your investment decisions.