What comprises analysis of Financial Statements

You must have heard some statements like, 90% of people lose money in the stock market. Shocking right? More than an average number of people invest in the stock market based on tips, rumours and whatnot. 

But the other thing is, No one, I repeat NO ONE knows what will happen in the world of stocks. Just take a look at the COVID19 crisis. Hardly anyone would have predicted it. Or the 2008 Global Recession. 

This clearly means that certain things are not in our control.

On the other hand, there are certain things that are in our control, such as following some ground rules before investing in a stock, and one of the ground rules all of us should follow is to go through the companies financials before investing in its stock. 

Today, Let’s look at the statements you should be going through before analysing any stock.  

What is Financial Statement Analysis?

Financial statement analysis is the one go-to analysis you should do before investing in any company. It is used by shareholders as well as stakeholders to evaluate the business for better decision making to understand the overall health of the company. 

It is the process of analysing and assessing the Profit & Loss, Balance Sheet and Cash Flow statement of the company. Before investing in any stock, it is a good practice to judge it based on its financials. So, today we bring you some good insights into these statements. Let’s get started.

Understanding Financial Statements

As discussed above, Financial statements are divided into three categories, Profit & Loss Statement, Balance Sheet & Cash Flow Statement. Let us explain each one to you one by one.

Profit & Loss Statements

The statement of P&L gives a good picture of the Profitability of a company.

P&L statement showcase all the expenses incurred and revenue generated during a financial year. 

Thus, the statement is divided into two sections, namely INCOME & EXPENSES.

Income includes revenue generated from operations and any other income as seen in the image below. 

Where other income has income from interest such as banks, dividend income and more. As far as revenue from operations is concerned, it is the income generated from the core business of the company.

For, e.g. for a software company, the selling software licence is the main activity, then all the revenue coming from that comes under income from operations. 

As far as Expenses are concerned, this section includes all the costs associated with production, salaries, interest expenses etc., as seen in the image below. 

Apart from this, the expenses section includes Exceptional items, which include those that are not included in the ordinary course of business, such as profit and loss from discontinued business. 

It also includes Tax expenses, as the company has to pay corporate taxes. The profit derived after all this is known as PAT, Profit after tax. 

Balance Sheet

After preparing the profit & loss statement, you move forward to the Balance Sheet, which shows the financial position of the company in a given financial year. 

It is divided into segments, namely, Shareholder funds, Assets & Liabilities. 

The essence of the balance sheet is that it always Tallies, and the equation goes like this, Shareholder’s fund + Liabilities=Assets.  

Let's understand these elements a little bit more in detail. 

Shareholder’s fund

It is the sum of money a company owes to its shareholders. That means this is the number of funds that have been raised from outside the company in the form of shares. 

Shareholder funds compromise three different elements, Equity Share Capital + Preference share capital + Other equity. 

Assets 

Assets are the resources owned and controlled by a business. These Assets are expected to generate revenues for the business. Further, they are divided into two categories namely Current Assets and Non-Current Assets.

Current Assets includes cash or cash equivalents. These items are typically converted into cash easily or, to be specific, within one year.

On the other hand, Non-current Assets are the ones that can not be converted into cash within a year. It is a combination of tangible and intangible assets such as plant & machinery, goodwill etc. 

Liabilities

Liabilities are the total sum of money the company is liable to pay to its creditors. Like Assets, these can be further classified into Current, non-current liabilities & Financial liabilities. 

Where Current Liabilities are expected to be paid within a year, non-Current Liabilities are expected to be paid after the period of one year, and Financial Liabilities are the debts taken to fund the projects of the company. 

These three items are the crux of a Balance Sheet. The last and final statement is the Cash Flow Statement. 

Cash Flow Statement

The income statement and balance sheet do not show a clear picture of where the cash comes from. Its depicted in a very organised way in the cash flow statements.

The cash flow statement is divided into 3 sections, Operating activity, Investing activities, Financing activities. Let's understand them one by one. 

Cash flow from Operating Activities

As the name suggests, it shows the inflow and outflow of cash generated from the main activities of the business. As shown in the image below.

All the expenses that do not involve actual cash outflow, such as depreciation, is added back to the PAT. Also, any loss on sale of property, plant or equipment does not involve any cash outflow. The expenses incurred for the raising of capital such as interest expenses are deducted from cash from operations. 

After making these adjustments, we get the cash generated from operations before working capital changes. And working capital is current assets - current liabilities. Thus, some adjustments have to be made in current assets & liabilities before including them in the cash flow statement. And the thumbnail rule to do these adjustments is: 

Cash flow from Investing Activities

The cash flow that happens due to buying and selling of fixed assets, or income from any kind of investment done or loan given comes under cash flow from investing activities. A negative cash flow from investing activity would mean that the company is expanding. 

Cash flow from Financing Activities 

The cash flows used to finance the activities of the company such as the issue of shares, repayment of loans, the dividend paid all come under cash flow from financing activity. If the company has negative cash flow, it implies that they have been repaying debts. 

Conclusion

You see, Financial Statement is a broad topic and due to time and word limit (as usual 😋) we were unable to explain to you various line items involved in these statements but to do needful we have got the amazing course called, Financial Statement Analysis in Quest. 

The biggest reason why only 4% of the total Indian population invest in the stock market is that the scams & frauds that happened in the past have made people fearful. The correct knowledge before investing in any company is very essential isn’t it?

The course will also let you learn about valuation techniques so that you can save your money from fraudulent companies.