By: Rupesh Oli
Pre-1929 market crash, the majority of businesses had no legal obligation to reveal their financial statements due to which the investors had a hard time deciding whether the companies were financially sound to invest or not. However, post-1929 market crash, the story completely turned around as the companies were obliged to disclose their operations and financials on a regular basis—to prevent such a disaster from occurring any time soon as the government enacted the legislation.
Hereafter, publicly traded companies need to compulsory release their financial statements—the balance sheet, income statement, and cash flow statement. These financial statements help investors evaluate the financial strength of the company and determine whether the particular company is favorable for investment or not. Such transparency aided investors to surge up their investment confidence towards the company they were keen to invest in.
The data unveiled on each of the financial statements are used to calculate the financial ratios that help investors compare the different companies based on the outcome of those ratios. Each of the statements—the balance sheet, income statement, and cash flow statement—provides unique financial details to be explored further, however, they are all interconnected and the data from one financial statement can be used alongside the data from the other statements to calculate a ratio. For instance, the return of assets (ROA) is calculated by dividing the net income by the total assets of a particular company, whereby the value of net income is taken from the income statement and the total assets from the balance sheet. Therefore, the inner elements of each of the statements can be cross-referenced back and forth when trying to propose a financial ratio—significant for a deeper analysis of a company.
An individual, when becomes competent to read and analyze the financial statements, can make effective investing decisions and hunt out varied ways to book the profit in the financial markets. Businesses get insights into where they stand financially—as of now—among their competitors. They can figure out whether they have the amount to reinvest or grow their businesses which helps them efficiently deal with the cash flow management. When financial statements are prepared on a regular basis, it not only benefits the contemporary situation but also the future projections based on available financial data.
In the context of Nepal, all these statements are prepared on a quarterly—every 3 months, and annual basis providing a comprehensive overview of how the company financially performed in the previous year.
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1. Balance Sheet
What is a balance sheet?
A balance sheet is a financial statement that displays a company’s assets—what it owns, liabilities—what it owes, and shareholders’ equity—shareholders’ investment in a company at a specific point in time, wherein the total assets of a company must equal the liabilities plus equity. The balance sheet reflects the true worth of a company. It aids an auditor in comprehending the company’s financial position. Various ratios namely quick ratio, asset turnover ratio, receivable turnover days, debt to equity, and debt to assets are taken into account for gauging the efficiency of the company’s balance sheet.
What does a balance sheet constitute of?
As aforementioned, a balance sheet constitutes of three elements: assets, liabilities, and shareholder equity.
Assets refer to the items of economic value that a company owns. It can be considered as all the value that a company has on hand be it cash, equipment, or inventory, or even those that might not be in the company’s hand yet such as the account receivables or payments that are due to receive. In addition, intangible assets like patents or trademarks also fall under the asset section of the balance sheet.
Liabilities are simply the debt a company owes that costs business the money over the haul. When you subtract the liabilities from the assets, you get an idea of how much value the company is left with. Liabilities such as business debt loans are considered to be long-term loans whereas short-term liabilities like accounts payable are paid off by the company each month.
The value of the company after settling down all the debts and liabilities is considered the shareholders’ equity. It is also referred to as stockholder equity or owner’s equity. Simply, it refers to the amount that has been sunk into the company wherein the capital refers to the initial investment, and retained earnings refer to the profit held by the company. In other words, it reflects how much money the owners have invested in the company or retained the earnings over the haul.
Significance of a balance sheet
- It helps stakeholders evaluate the business performance and the liquidity position of the company.
- Balance sheet helps in analyzing whether the company is funding its operations from the profit or the debt.
- It is an essential statement to be submitted to the banks for obtaining any sort of loan.
- Comparing data from the balance sheet over the years helps in measuring the growth of a company.
- Investors, creditors, and other stakeholders can use it as one of the tools to gain insights into the financial health of the company.
- It is a significant statement in itself as it fluctuates with every transaction, hence, analysis of the balance sheet is a must.
How to read a balance sheet?
As an investor, one needs to know the fundamentals of the balance sheet so that s/he could read the statement with ease. As stated above, you need to be mindful of three elements in the balance sheet: assets, liabilities, and shareholder equity. Assets such as inventory, receivables, cash on hand, and property; liabilities such as long-term debt, current liabilities, non-current liabilities, and shareholders’ equity namely common stock, and retained earnings fall under the balance sheet. One needs to know what each of these terms refers to so that s/he could comprehend the balance sheet that could impact his/her investment decisions to an extent—positively.
When reading a balance sheet, it is suggested to select the company that possesses high shareholder equity as it reflects the company’s assets are higher than the liabilities—a positive trait for any investor. Also, the quarter-over-quarter or the year-over-year changes can be considered to see how the company’s value has altered over time. Growth in assets and reduction in liabilities of a company—if reflected in the balance sheet—is highly recommended to be taken into account for investment purpose.
2. Income Statement
What is an income statement?
An income statement, also known as profit and loss statement, is a financial statement that provides insights into the revenue earned by the company alongside the expenses incurred in the operating activities over a period of time. It offers a great deal of transparency into the company’s operating activities. The major reason behind analyzing the income statement by the analysts is to gauge the profitability of the company. Some of the key ratios such as operating margin, gross margin, interest coverage, tax ratio efficiency, and net margin are taken into account when analyzing the income statement of the company.
It is the first financial statement to be prepared because the balance sheet and cash flow statement will be incomplete without the insertion of information from the income statement. Therefore, you would perform the necessary calculations in the income statement and then plug them into your balance sheet and cash flow statement.
What does an income statement constitute of?
Several key financial elements are used to prepare an income statement as illustrated below.
It constitutes of all the amount that a company earns by selling the products or services—the operating revenue alongside the revenue earned through non-core business activities—the non-operating revenue.
Cost of Goods Sold (COGS)
These are the costs associated with generating the sales revenue be it developing the products or services or deploying them to foster the reach of products in the market.
These are the expenses not linked to products or services provided by the company but rather include expenses such as rent, utilities, and office supplies that are essential to operate the company’s operating activities.
As we know that the value of products depreciates over time, hence depreciation is too considered in the income statement of the company as the goods bought by the company lose the value over the haul. In addition, the value of depreciation varies based on the industry where the company is operating.
Earnings before taxes
As the name signifies, these are the income of the company before paying any taxes.
Gross Profit is calculated by subtracting the cost of goods sold from the revenue generated by the company.
Also known as the net profit, it is the total amount that a company has earned after the deduction of all the expenses including taxes and interest from the gross profit.
Significance of an income statement
- It aids in tracking the profitability of the company and the stakeholders can acquire the company’s financial standing in terms of the profitability showcased in the income statement.
- Income statement is vital along with other statements—the balance sheet and cash flow statement—to calculate the tax liability of the company.
- A company can determine whether to push sales, increase production or shut down or open a new department based on the insights from an income statement.
- It is a vital tool to compare the company’s performance in the past and amongst the other competitors in the industry providing insights into where the company stands amongst the competitors.
- Business owners can make better and wise decisions regarding the transactions of the company based on past performance for better forecasting.
How to read an income statement?
An income statement should be read from top. Starting with the revenues—called the top-line, then the expenses and the cost incurred are subtracted followed by the taxes, reaching the company’s net income or net profit before paying any sort of dividends—the bottom-line.
3. Cash Flow Statement
What is a cash flow statement?
A cash flow statement is a financial statement that reflects a company’s financial activity over the haul, particularly where a company’s cash comes from and how allocated cash is further utilized be it investing or paying for the operation of a company. Hence, it basically illustrates the inflow and outflow of cash for the company. It depicts a company’s overall liquidity by illustrating cash transaction activities. It is broken down into three parts: operating, investing, and financing cash flow. Taking an insight into a cash flow statement, investors can easily determine the net change in the cash balance from the start to the end of the period. Some of the key ratios such as cash flow coverage ratio, cash flow margin ratio, price to cash flow ratio, and cash interest coverage ratio are taken into account when analyzing the cash flow statement of the company.
What does a cash flow statement constitute of?
A cash flow constitutes three main components briefed below.
Cash flow from operating activities
It includes core activities of the business. For instance, the sales of products and services, income tax payments, salary payments, etc.
Cash flow from investing activities
It includes the activities related to the acquisition and disposal of long-term assets investment—not included in cash equivalents. For instance, patents, physical property, non-physical property, vehicles, etc.
Cash flow from financing activities
It includes all those activities related to the financing of the company. For instance, dividend payments, raising a loan, paying interest to service debt, issuing and buying back of shares, etc.
Significance of a cash flow statement
- It provides holistic insights into the spending activities of the business.
- Businesses get data about the cash inflow and outflow; thus, they can utilize such data to increase cash inflow into the company and determine the activity leading to high cash outflow providing them the room for improvement and becoming more efficient in terms of controlling cash outflow.
- Businesses can analyze whether they have an excess or deficit of funds and act accordingly.
- Businesses can efficiently utilize the working capital so that it becomes easier for them to improve their operations to preserve cash and improve the inflow numbers.
- Cash flow statements are extremely significant to businesses for the short-term planning to meet contemporary obligations such as managing the operating costs and paying wages.
- Not only does the cash flow statement help the financial managers with short-term planning but also aids them with effective long-term planning as it helps financial managers to understand what activities need to be prioritized for achieving the long-term goal.
How to read a cash flow statement?
There exist two basic methods of accounting: cash accounting and accrual accounting. The majority of small companies do not use cash flow statements. But if the company has adopted the accrual method of accounting, it is a must as cash flow statements are essential for measuring the financial health of such companies. Expenses and the income are recorded on the books when they incur, not relying on when the actual transaction through the inflow or outflow of money occurs when adopted the accrual method of accounting.
Basically, an investor read a cash flow statement in terms of positive cash flow or negative cash flow. Positive cash flow implies a greater inflow of money in comparison to the outflow opening greater opportunities for reinvesting the cash in business growth. Conversely, negative cash flow implies the company has spent more money than what it generated over a period. It might not necessarily signify a bad indicator as the investment might have been done for future growth. However, negative cash flow for the successive quarters might indicate a red flag—the financial risk.
The Final Takeaway
The three financial statements—the balance sheet, income statement, and statement of cash flow—must be properly studied by investors before selecting the company for investment. It is because these statements provide insights into the companies that possess strong fundamentals not only through the key financial elements present in the statement but also through the various financial ratios that can be calculated by incorporating the key elements from each of the statements. Even in the bad time—the financial market turmoil—the companies selected through the thorough study of the aforementioned statement help investor stay on the safe side without panicking about such events as it offsets the risk—hedging—that you would have otherwise encountered by randomly selecting the stocks without proper study of financial statements.
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