Understanding Financial Statements
Financial Statements of a Company
Financial statements are reports prepared by a company’s management to present the financial performance and position at a point in time. A general-purpose set of financial statements usually includes a Profit and Loss Statement, a Balance Sheet and a Statement of cash flows. Financial statements are the main source of financial information for most decision makers. That is why financial accounting and reporting places such a high emphasis on the accuracy, reliability, and relevance of the information on these financial statements. Companies can be evaluated on the basis of past, current, and projected performance. The particular importance of financial statements and its analysis comprise the following:
- Management:The complexities and the size of the business make it necessary for the management to have up to date, accurate and detailed information of the business and the financial position. The financial statements help the management in understanding the performance of the company in comparison to the other businesses and the sector. Providing management with accurate information enables them to form proper policies for the companies and take correct decisions. The performance of management is ranked by these statements, the performance of these statements helps management justify their work to all the parties involved in the business
- Shareholders: Shareholders are the owners of the business but do not take part in making decisions and day to day activities. However, these results are shared with the shareholders as quarter and annual updates. These statements enable the shareholders to understand how the company has been performing. It also allows them to judge the present and future performance. Financial statements are the most important source of information for current and prospective investors.
- Creditors and the Lenders: Factors like liquidity, debt, profitability is all judged by the essential metrics in the financial statements. Creditors and Lenders are mostly concerned about the company’s debt and liquidity position. Analyzing these statements help them decide if they want to continue providing goods and se and determine the future course of action.
- Government and Regulatory Authorities: The government and regulatory authorities use these financial statements for taxation and regulatory purposes. Also, these financial statements help authorities assess the business performance of these companies in various sectors to assess the economy’s performance as well.
Profit & Loss Statement
Statement of profit and loss captures the Revenues and expenses a company has incurred from both Operating and Non-Operating activities over a specific period of time, usually a month, quarter or a given financial year. It is also called Income Statement, and captures the basic elements of the following equation:
Profits = Revenues – Costs
P&L statements are additive in nature (unlike Balance Sheets). The revenues/costs/profits for a financial year is equal to the sum of revenues/costs/profits for all the quarters within the financial year. This statement is based on the accrual method of accounting i.e. revenues and expenses are recognized as and when they are incurred (movement of cash is immaterial). To better understand, consider the following example:
A businessman Ramesh procures computer parts from his supplier Ganesh, assembles them into computers and sells them to a customer Suresh every month. As per terms of the contract, Suresh pays Ramesh on a quarterly basis and Ramesh pays Ganesh once Suresh has made payments (Quarterly) i.e. all the payments are settled at the end of every quarter. In the Cash method of accounting, all the revenues/costs/profits would be recorded at the end of the quarter, when all the payments take place. But in the Accrual method of Accounting (generally followed practice), all the revenues/costs/profits would be recorded as and when incurred.
Major heads within a P&L statement:
All P&L statements typically follow the same format whereby first revenues are described followed by expenses
- Net Revenue/Net Sales: Net Revenues or Net Sales are the sales made by the company in a given accounting period after accounting for returns or warranty replacements/ trade discounts. Typically, this includes revenues from main line of business.
- Cost of Goods Sold (COGS)/Cost of Sales: Cost of goods sold (COGS) refers to the direct costs of producing the goods sold or services provided by a company. This amount includes the cost of the materials and labor directly used to create the good or provide the service. It excludes indirect expenses, such as distribution costs and sales force costs.
- Gross Profit: Gross profit is the profit a company makes after deducting the costs associated with making and selling its products, or the costs associated with providing its services. It is derived by reducing COGS from Net Sales. It helps investors realize the production efficiency of the company.
- Other Income: This head typically includes income from ancillary activities of the company or one-time profits that may be incurred due to income from interest, dividends, miscellaneous sales, rents, royalties, and gains from the sale of capital assets etc.
- Operating and Direct Expenses: This represents expenses beyond procurement of goods such as Selling Expenses (Commissions given to agents selling products), Packaging Costs, Transport Costs, etc. These expenses are directly attributable to the cost of goods being sold or the services being provided.
- General and Administrative Expenses (G&A): General and administrative expenses are incurred in the day-to-day operations of a business and may not be directly tied to a specific function or department within the company. These include overheads such as Office Rent, Electricity, Water Charges, Maintenance Charges, Municipal Charges, Rent, Facilities for employees such as Tea, Coffee, etc.
- Employee Benefit Expenses: Employee benefits are defined as a form of compensation paid by employers to its employees. Employee benefits come in many forms and are an important part of the overall compensation package offered to employees. It includes expenses incurred for wages, bonuses and retirement benefits of company employees.
- Other Expenses: Other expenses are those expenses that non-operating in nature that does not have any relation with the main business operations and include expenses like impairment and restructuring costs, etc. It is a line item to record any unexpected losses unrelated to the normal course of business. It could include a loss from the disposal of equipment.
- Operating Profit/Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA): Operating Profit is the profit from a company’s core business operations excluding deductions of interest, Depreciation & Amortization expenses, and taxes.
Mathematically,EBITDA is calculated by adding Other Income to Gross Profit and deducting Operating, Direct, G&A, Employee, Other expenses. EBITDA is a measure that helps analysts understand the profitability of a company from core activities of the business.
- Depreciation and Amortization: Amortization and depreciation are two methods of calculating the value for business assets over time. Amortization is the practice of spreading an intangible asset’s cost over that asset’s useful life. Depreciation is the expensing of a fixed asset over its useful life. These expenses typically represent the charge of using assets of the company such as Plant & Machinery, Furniture and fixtures, equipment, etc.
- Profits/Earnings before Interest and Taxes (EBIT): Mathematically, EBITDA + Non-operating Income – Depreciation and amortization expense = PBIT. PBIT measures the profit a company generates from its operations. By ignoring taxes and interest expense, PBIT focuses solely on a company’s ability to generate earnings from operations, ignoring variables such as the tax burden and capital structure. EBIT removes the benefits from the tax cut out of the analysis. PBIT is helpful when investors are comparing two companies in the same industry but with different capital structure and tax rates.
- Interest Expenses: This includes Interest expense incurred on bank loans, credit facilities, etc. Since non-payment of interest can result in serious consequences for a company or even leading to liquidation of assets, investors analyse the Interest paying capacity of the company by looking at the current interest expenses of the organization.
- Profit/Earnings Before Taxes (PBT): Profit before tax is a measure of a company’s profitability that looks at the profits made before any tax is paid. It matches all the company’s expenses, which include operating and interest expenses, against its revenues but excludes the payment of income tax. It helps investors analyse whether company is profitable as a whole. PBT is helpful when investors are comparing two companies in the same industry but with different tax rates.
- Taxes: This represents taxes levied by the government on profits of the company. This does not include indirect taxes levied by government such as GST.
- Profit After Tax (PAT): Profit after tax or a gain after tax is essentially the amount of money that remains with the taxpayer after all the necessary deductions have been made. It is like a barometer that tells you how much profit a business has really earned. Calculated by deducting taxes from PBT.
A balance sheet is a financial statement that reports a company’s assets, liabilities and shareholders’ equity at a specific point in time, and provides a basis for computing rates of return and evaluating its capital structure. It is a financial statement that provides a snapshot of what a company owns and owes, as well as the amount invested by shareholders.
In simple words, the Balance Sheet adheres to the following equation:
Total Assets = Total Liabilities + Shareholders’ Equity
Major heads within a Balance Sheet:
Total Assets: Assets are resources that are owned by the company both legally and economically. There are two main classes of assets. They are current and noncurrent assets.
- Non-Current Assets – Noncurrent assets are a company’s long-term investments that have a useful life of more than one year. Noncurrent assets cannot be converted to cash easily. They are required for the long-term needs of a business and include things like land and heavy equipment. Noncurrent assets are reported on the balance sheet at the price a company paid for them, which is adjusted for depreciation and amortization and is subject to being re-evaluated whenever the market price decreases compared to the book price. It may also include land, property, trademarks, long term investments etc. Classifications as follows:
- Property, plant and equipment: Property, plant, and equipment assets are also called fixed assets, which have a useful life assigned to them, which means they have a set number of years the assets will have economic value to the company. Fixed assets also have a salvage value, which is the value remaining at the end of the asset’s life. Fixed assets undergo depreciation, which divides the cost of fixed assets, expensing them over their useful lives. Depreciation also helps spread the asset’s cost out over a number of years allowing the company to earn revenue from the asset.
- Intangible assets: Intangible assets are assets that are not physical in nature but hold monetary value. Goodwill, brand recognition and intellectual property, such as patents, trademarks, and copyrights, are all intangible assets.
- Non-Current Investments: Long-term investments hold a section on the asset’s side of a company’s balance sheet that represents the company’s investments that a company intends to hold for more than a year, including stocks, bonds, Mutual Funds, Long-term Advances, Investments in other subsidiaries etc.
- Current Assets – Current assets are considered short-term assets because they generally are convertible to cash within a firm’s fiscal year, and are the resources that a company needs to run its day-to-day operations and pay its current expenses. Current assets are generally reported on the balance sheet at their current or market price. It may include cash and cash equivalents, inventory, accounts receivables etc.
Total Liabilities – Liabilities are obligations of a company which they owe to other businesses or individuals and the owners of the company. Liabilities are shown classifying them into:
- Owner’s Equity – Owner’s equity is the obligation of the business to its owners. The term owners’ equity is mostly used in the balance sheet of sole proprietorship and partnership form of business. In a company’s balance sheet, the term “owner’s equity” is often replaced by the term “shareholder’s equity” or “shareholder’s fund”. Equity is important because it represents the value of an investor’s stake in a company, represented by their proportion of the company’s shares. These equity ownership benefits promote shareholder’s ongoing interest in the company. Shareholder’s equity can be either negative or positive. If positive, the company has enough assets to cover its liabilities. If negative, the company’s liabilities exceed its assets; if prolonged, this is considered as balance sheet insolvency. Typically, investors view companies with negative shareholder equity as risky or unsafe investments.
- Non-Current Liabilities – The liabilities which are payable after one year from the date of the balance sheet or after an operating cycle whichever is longer are called long-term liabilities. Noncurrent liabilities generally arise due to availing of long-term funding for the business. Apart from funding of day to day operations, businesses also need to raise funds for various capital expenses from time to time. These include acquisition of fixed assets and property. These capital expenses are generally funded through non-current liabilities such as bank loans, public deposits, long term notes payable, lease, pension, and gratuity fund, etc.
- Current Liabilities – Liabilities payable within a short period of quickly changeable are called current liabilities. The liabilities which are payable within the next year from the date of the balance sheet or within an operating cycle whichever is longer are called current liabilities. Current liabilities are typically settled using current assets, which are assets that are used up within one year. They include Accounts payable, notes payable, expense payable, dividend payable, unearned revenue, bank loan, interest payable etc.
Cash Flow Statement
Major heads within a Cashflow Statement:
Cash flow statement shows inflow and outflow of cash and cash equivalents from various activities of a company during a specific period under three main heads:
- Operating Activities – Operating activities are the activities that comprise of the primary or the main activities of an enterprise during an accounting period. These are the principal revenue generating activities of the enterprise. For example – for a garment manufacturing company, operating activities include procurement of raw material, sale of garments, incurrence of manufacturing expenses, etc.
Cash inflows from operating activities shall include cash receipts by sale of goods, from fees, royalties etc.
Cash outflow from operating activities shall include cash payments to suppliers for goods and services and payments of income tax etc.
- Investing Activities – Cash flow from investing activities includes the movement in cash flows owing to the purchase and sale of assets. It relates to purchase and sale of long-term assets or fixed assets such as machinery, furniture, land and building, etc.
Cash inflows from investing activities shall include cash receipts from disposal of assets, dividend receipts from investments etc.
Cash outflow from investing activities shall include cash payments to acquire fixed assets or shares, cash advances to third parties (other than by way of operating activities) etc.
- Financing Activities – Financing activities are activities that result in changes in the size and composition of the owners’ capital and borrowings of the enterprise. It includes financing activities related to long-term funds or capital of an enterprise. For example – cash proceeds from issue of equity shares, debentures, raising long-term loans, repayment of bank loans, etc.
Cash inflows from financing activities shall include cash proceeds from issuing shares, debentures, short-term or long-term borrowings etc.
Cash outflow from financing activities shall include cash repayments of borrowed amounts, dividend on equity and preference capital etc.
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