What are financial statements?
Simply put, financial statements are written records that express how well a company is/ isn’t doing. But why should you know all of this? With the world’s finances going unpredictable day by day and the living expenses skyrocketing because of inflation, more and more people are trying to build a safety net by means of investing.
Therefore, to invest in a company, you should know how well they are doing. And the most reliable indicator of a company’s performance is its financial statements.
Financial statements not only uncover the current financial footing of the company but also gives you an overview of its earning potential in the future. Hence it serves as a valuable tool for any investor to make informed decisions about where to put their money.
Investors or Company
Understanding financial statements are not only important for investors but also for companies. As per section 210 of the Companies Act 1956, it is mandatory on the part of all companies to prepare their final accounts and present them before the shareholders for their sanction at every annual general meeting of the company. A company’s financial statements can ultimately help decide the shareholders whether to raise or withdraw their investments to cut further losses.
But for someone who does not understand financial jargon all that well, reading and analysing a financial statement might prove challenging. If you are one such person, then look no more. This article will provide you with a general idea about what to look out for in any financial statement. But remember this is just a guide to understanding all the basic elements of a financial statement and analysing them.
If you are willing to take a deep dive into the rabbit hole of financial statement analysis, you can check out the various courses available online that can be of help. One such course is Henry Harvin’s financial analysis course, which gives a comprehensive understanding of financial analysis with easy-to-understand, specifically designed modules to help you navigate your investing decision.
What should it include?
Every financial statement should include the following:
Profit and loss statement/ income statement: this indicates the financial performance of a company by showing the net result i.e, profit earned or loss incurred during the accounting period.
A Balance sheet: this indicates a company’s financial position by expressing its assets, liabilities and equity (shareholder’s funds)at any given point in time. This shows what the company possess and what it owes.
Cash Flow Statement (CFS): this indicates all the cash inflows that the company receives from its operations and external investments.
Elements of financial statements:
- Investment by owners
- Distribution to owners
- Comprehensive income
- Cash flow from operations
- Cash flow from investments
- Cash flow from finances
Everything that the company owns which has a monetary value can be considered an asset. Based on how long it is going to take for an asset to turn into cash they are divided into Current assets and Non- Current assets. Even in the balanced sheet, the assets are categorised based on how temporary they are. For example, current assets usually precede non-current assets as they are turned into cash than non-current assets.
These assets are intended for sale or consumption in the company’s normal operating cycle. These are held primarily for trading and are expected to be turned into cash or cash equivalents within 12 months from the date on the balance sheet.
Current assets include:
- Current investments
- Trade receivables
- Cash and cash equivalents
- Short-term loans and advances.
Non-current assets are those assets which are held by the company not with the purpose of sale but with the purpose to increase the earnings of the business in the long run. These include
Those assets which have a physical existence are known as tangible assets. Some examples of tangible assets include buildings, machinery etc.,
These include assets which do not have a physical existence and are known as intangible assets. Examples of such assets include brands/ trademarks, copyrights and other intellectual property rights.
Other non-current assets include:
- Investments in property, mutual funds and partnership firms etc.,
- Deferred tax assets
- Long-term loans and advances.
Liabilities reflect all the money that a company owes to others. It is an obligation between parties that is expected to be paid in any form, in an agreed-upon time.
Just like assets, liabilities are also classified based on their temporality. The two classification includes Current and Non-Current liabilities.
Liabilities that have to be repaid within 12 months from the date of the balance sheet are classified as current liabilities. Such liabilities are further classified as,
- Short-term borrowings: examples of this include overdraft or cash credit from banks, deposits, and loans from other parties.
- Trade payable: this includes the amount payable against the purchase of goods or services that are taken in the normal course of business, such as payable bills.
- Short-term provisions: this includes provisions against which liabilities may arise within the next financial year. Such provisions include provisions for bad and doubtful debts, taxes, expenses etc.
Other current liabilities may include:
- Current maturities of long-term debts
- Unpaid dividends
- Provident fund payable
These liabilities include all those that are company is expected to pay off in the distant future and not within the 12 months from the date mentioned on the balance sheet.
Non-current liabilities are further classified into,
- Long-term borrowings include loans that are repayable after the operating cycle. Debentures, loans, public deposits and other loans and advances are categorised as long-term borrowings.
- Contingent liability: in this type, the liability may or may not occur based on the outcome of an unfortunate incident in the future.
- Warrant liability: it is the estimated amount of money and time spent repairing damaged goods. This can arise for companies that offer long-term warranties for their products such as automobiles.
- Post-employment benefits: this entails the benefits that an employee or their families receive after their retirement. This can’t be overlooked with the increasing health care and deferred compensation.
Equity refers to the value that the shareholders gain when a company is liquidated and all of its debts settled. It is also a representation of the interest of ownership of the company in the form of stocks. This is one of the most common elements of financial statements that will help analyse the financial performance of the company.
Equity is calculated by the subtraction of the company’s total liabilities from its total assets. Owning equity entails capital gain and dividends for the shareholders. Possessing equity ownership will also make the shareholders eligible for voting in on corporate decisions.
A shareholder’s equity can either be positive or negative. When it is positive, it means that the company’s assets are more than its liabilities. When it is negative, it shows that the company has more liabilities than assets.
Types of equity:
This happens when the company’s evaluation such as its share price is not traded publicly. Equities in the private placement are often offered to garner investors that specialise in direct investments in private companies or those in leveraged buyouts.
Some types of private equity financing may include venture capitalist funding and PIPE(private investment in a public company).
The amount of ownership one has in their residence subtracting the mortgage can be represented by home equity. This can be used as a great source of collateral to secure a loan.
Big corporations may hold reputation and brand name as intangible assets. This might hold an inherent value through years of advertising and building a loyal customer base. This is termed brand equity.
Equity can always be used as a benchmark for investors to determine whether the purchase they made is justifiable.
4. Investment by owners
An owner investment also known as the owner’s contribution capital is the asset or monetary support that the owner provides to the company.
It can either be to start the business or to keep it running. The owner uses a temporary equity account to make his contributions which are closed at the end of each year, increasing his capital. This means that the more contributions that the owner makes, the more stake he holds in the company.
Owners contribute to their businesses in two ways. The first is cash and the second is assets. Cash is often needed by a company during its initial establishment or to fund a new project or to help in its expansion. Contributions in the form of assets such as vehicles or equipment are also taken into account.
5. Distribution to owners
Owner withdrawals or distributions mean the money the owner took out of the company’s accounts for personal expenses. These are called withdrawals in partnerships and sole proprietorships and in S corporations these are referred to as distributions.
Whenever the owner cashes out money from the company’s fund, the company takes it out of his share of capital.
It is the money generated from the sales of products or services that the company has to offer. It is the gross income from which amounts are deducted to arrive at net income. For any company to increase its earnings per share for its shareholders, it should focus on increasing its revenues and cutting out its expenses. Revenue can be divided into operating revenue and non-operating revenue.
Operating revenue describes the sales from the company’s core activities.
Non-operating revenue describes revenue from sources that are unpredictable and non-recurring such as the sale of an asset or payment through litigation. Non-operating revenue is often referred to as one-time gains. Revenues are also categorised based on divisions that generate them and also based on tangible and intangible product lines.
Revenue is an important element of the financial statement that cannot be overlooked as it is a major deciding factor of EPS or earning per share of the company’s shareholders.
Gains, also known as other income indicate the money made from non-core company activities such as selling a long-term asset, old transportation van, unused land or a subsidiary company. This can also be obtained by investing in financial instruments and winning lawsuits, all of which are the company’s non-primary activities. This is also a form of revenue.
Expenses include the cost a company requires to keep its optimal functioning and to turn a profit. They are important for a company as they can be written off as tax returns provided that they meet the IRS guidelines. They are further classified into
- Primary activity expenses
- Secondary activity expenses
Primary activity expenses:
All expenses that are necessary to generate a normal operating revenue for the business are termed primary activity expenses. These include
- Cost of goods sold
- Research and development expenses
- Employee wages
- Sales commission
- Utility expenses such as electricity and transportation.
Secondary activity expenses:
Any expenses that can be linked to non-primary business activities are termed secondary activity expenses. This may include interest paid on a loan amount.
These are realised when the company loses money in non-primary activities. These may include inferring a loss in a financial investment or instances wherein the company is ordered to pay money when losing a lawsuit. A company’s management of its secondary expenses denotes its expertise in handling non-core activities. This can provide insight into how the company may pan out in the future.
9. Comprehensive income
This involves providing a comprehensive view of the company’s income that is not fully captured in the income statement. It includes all the unrealised income and expenses incurred by the company during the financial year through a hedge or financial investments.
Usually, a comprehensive income statement(CIS) is added under a separate heading at the bottom of the income statement or included as footnotes. In the CI statement, the net income is added and adjustment is done to account for non-owner activities and is added under “ accumulated other comprehensive incomes.”
A comprehensive income statement contains two major sections:
- Net income (derived from the income statement)
- Other comprehensive income (such as hedges)
10. Cash flow from operations(CFO)
This is a part of an important element of the financial statement known as the cash flow statement. Cash flow statements are regarded as the most intuitive element of a financial statement because it follows the cash generated by the company.
The cash flow statement provides consolidated data regarding all the money flow that the company receives from operating activities and external investments. The three categories of the cash flow statement will help an investor assess the company’s stock value or its value as a whole.
CFO includes the cash inflow and outflow of the company from its operational businesses. These activities include buying and selling the company’s inventory and supplies and paying salaries and wages to employees. Other activities such as investments, dividends and debts.
A company should generate enough cash flow from its activities to promote operational growth. If it is not generated, then there arises a need to secure financing for expansion and external growth.
This section can also include
- Amounts payable
- Revenues or expenses with no associated cash flow.
11. Cash flow from investments
This section of the cash flow statement summarises the result of investment gains and losses. Monetary expenses on property, plant and equipment are also included in this section. Financial analysts peruse this section to find capital expenditure, commonly known as capex.
When capex increases, it means that the cash flow is reduced. But this does not necessarily mean a bad sign. Because it means that the company is investing in endeavours that would mean growth in the future.
12. Cash flow from financing
This is the last part of the cash flow statement. It provides an overview of the company’s cash dwelling in business financing. CFF does the measurement of cash flow between a company, its owners and creditors in the form of debts and equity. The reports of this are annually provided to the shareholders.
Analysts especially use this section to determine how much money the company has paid out in dividends and also how much cash it has raised for operational growth.
When the cash flow from finances is a good number, it is a good indicator that the company has more money coming in than flowing out.
Benefits of financial statements
Elements of financial statements are important in showing
- How a business operates
- How much revenue it is generating
- How efficient is the business in managing cash
- And what its assets and liabilities are
This is a clear indicator of the performance of a company. Before investing in a company it is important to go through the financial statements of at least the past 5 years to incur an idea about its growth pattern and operational stability.
Even though financial statements provide an abundance of information on a company, it still has their limitations. The statements are open to interpretation which leaves multiple, vastly different conclusions about the company’s performance for each interpreter.
These interpretations mostly depend on an individual’s needs. For example, one person may not mind a company’s debt status, while for another it might be an issue. Similarly, one investor may prefer short-term stock repurchases while another may be interested in investing in long-term assets.
Hence, the inference drawn from the statement may widely depend on the investors’ necessities. Therefore, it becomes imperative to compare statements from multiple periods to determine the trends and also to compare a company’s results with its peers in the same industry.
Financial statements are important factors that provide information about a corporation’s financial health, performance, operations and cash flow. An important factor that helps investors break down the enormous financial data provided by each company is financial ratio analysis. They help in determining the profitability and operational efficiency of the company.
All elements of the financial statement should be analysed in tandem with each other as each can be interpreted differently by each analyst. In any case, one can always avail the help of available online courses such as Henry Harvin’s financial analysis course to make important investing decisions.
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Answer: Financial statements are written records of transactions that express the financial activities of a company. It is a formal and very detailed report card of a company that helps the investors to decide whether or not they should invest in that company.
Answer: Financial statements are required to be produced and presented to the shareholders annually.
Answer: All the elements of the financial statement are important as each of them represents a significant detail of the company’s financial performance. But as an investor, keep an eye out for earnings per share, operational margin, and dividend payout ratio.
Answer: The four main financial statements would include a balance sheet, income statement, cash flow statement and shareholder’s equity.
Answer: Henry Harvin is an online education portal that provides a range of courses. One such course is the financial analysis course provided by the academy. It gives an overview of the structure of financial statements and also equips the learners with analysing tools that can help profitably assess them. They also offer job opportunities, internships and boot camp sessions along with complimentary modules.
Answer: Not necessarily. A company having a negative capital expenditure can also be an indicator of its spending money on future investments. Hence, if you’re looking to invest in the company for a longer term, negative capital expenditure may not be a bad thing.
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