The core responsibility of any company is to generate profits for and benefit its shareholders. While shareholders are the company’s owners, it is managed by a third party, the Board of Directors, and their duty is primarily towards the company and the shareholders. The shareholders are not involved in the day-to-day operations of the company. So how will they know if the company’s management is working in their best interests? This is where the financial statements of a company come into the picture. But how to understand them? Discussed hereunder is the meaning and how to interpret or understand the financial statements of a company.
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What are financial statements and why are they important?
A company’s financial statements are the first point of reference for the shareholders and other stakeholders like the creditors, investors or potential investors, lenders, etc. It is a detailed record of the financial activities of the company that can be studied to reflect the performance of the company over the years.
Every company is required to maintain a set of financial statements that have to be signed by all the board of directors before being presented to the shareholders for approval. If the company is required to be audited as power the provisions of the Income Tax Act, of 1961, the auditors need to review the financial statements and form an opinion on the same whether they present the true and fair picture of the company. The auditor’s report forms part of the financial statements in such cases and has to be presented to the shareholders too.
The purpose of the financial statements as mentioned above is to showcase a true and fair view of the company. This means that any cases of fraud, errors, or misrepresentations on part of the management or the company as a whole has to be brought forward and rectified by taking necessary steps. The intention of these financial statements is to provide the necessary information to all the stakeholders regarding the current status and the direction in which the company is going so they can make optimum use of resources as well as take strategic decisions for the better future of the company as well as the stakeholders like shareholders, credits, investors, etc.
How to read components of financial statements?
We have established that the financial statements are the record of the performance of the company at any point in time. But to understand the true position of the company, it is important to understand the available data and the implications of the same. The three main components of the financial statements are the Balance sheet, Profit and Loss Statement, and Cash Flow Statement. The details of these statements and their implications are mentioned below.
- Balance Sheet
A balance sheet is a record of the assets and liabilities of a company on a particular date, usually the last date of the financial year or quarter in the case of an interim balance sheet. The funds of the company are segregated on the basis of the owner’s funds and borrowed funds. The owner’s funds are the investment made by the shareholders and promoters in the company while the borrowed funds represent the long-term or short-term liabilities of the entity. The borrowed funds should not be too excessive that the company is unable to finance the debt and has to simply borrow to fulfill such obligations. Investors should also look at the current ratio of the company by comparing the current assets and the current liabilities of the company. The ideal ratio for every industry is different but a current ratio of 2:1 and a quick ratio of 1:1 is widely accepted to be a sign of a healthy company.
Read more: What is current ratio and how do you interpret it ?
The second part of a financial statement is the profit and loss statement or the income and expenditure statement of a company. It is a record of the income or the revenue as well as all expenses (cash and non-cash) of the company that are incurred during the financial year (or an interim period for which the statement is prepared). This statement is broadly divided into a few key headings namely, revenues, cost of goods sold, gross profit, operating profit, interest and taxes, profit after tax, or net profit. Revenue is the top line of the company while net profit is the bottom line. If the top line of the company is favourable but the bottom line is adverse or decreasing, it calls for further introspection with respect to areas like excessive operating expenditure, excessive interest costs or taxes, etc.
- Cash Flow Statement
The cash flow statement is another key component of the financial statements. It is a record of the flow of cash in the business during the financial period or the interim period for which it is made. The cash flow statement is divided into three categories to understand the various sections of the company where the cash is coming and going to. The details of these are mentioned below.
- Cash flow from operating activities
Under this category, the cash flow generated from the operating activities like the sale and purchase of goods or raw materials, cost of labour, overheads, etc. is included. This will help in understanding the concentration of expenses towards the operating activities and the income from the same.
- Cash flow from investing activities
The funds allocated for the investments and related activities of the company are included in this portion. Some of the examples of cash flown to be included in this category are funds used for the purchase of any plant and machinery, purchasing shares of a company, sale proceeds from liquidating any investment, etc.
- Cash flow from financial activities
The cash flow from the financial activities of the company is included in this category of cash flow statement. Any changes in the capital or the debt portion of the company are deemed to be a financial activity. Some examples of cash flown from financial activities are dividends paid by the company, interest paid on loans, closing of a short-term or long-term debt, etc.
A consistent increase in the cash inflow from operating activities can be considered to be a sign of a healthy business. On the other hand, a consistently huge cash outflow for servicing the debts under the financial activities should be reviewed and actions need to be taken to correct the same.
Conclusion
Financial statements are an accurate mirror of the position of a company with respect to the industry that they belong to as well as in comparison to their past performance. Therefore. The ability to read financial statements and understand their true meaning is what separates a good investor from the average one.
FAQs
Some of the key ratios that can be drawn from the financial statements of a company are PE ratio, EPS, PB ratio, Debt-Equity ratio, Net Profit ratio, Dividend payout ratio, current ratio, quick ratio, asset turnover ratio, etc.
Some of the common ways to analyze financial statements are carrying out a fundamental analysis of the company, analyzing the financial ratios of the company, cost-benefit analysis of the company’s product, etc.
The core financial statements to be analyzed are the balance sheet of the company, the profit and loss statement of the company and the cash flow statement of the company.
The key pointers for poor financial statements of a company are falling net profit margin, negative cash flows, consistent loss of revenues, excessive operating costs as compared to industry standards, excessive debts in the company, etc.
