Understanding the Basics of Financial Statement

27 Apr 2020  Read 2864 Views

A company's financial statements are a window to its financial health. It is no wonder that studying them is an integral part of fundamental analysis. While analysts delve into financial statements and try to discover the not-so-obvious aspects of a company's finances, understanding the basic financial statements in practice is sufficient for an investor in most cases.

There are three main financial statements: the income statement, the balance sheet, and the cash flow statement. The balance sheet informs about the assets and liabilities of a company. The profit and loss statement informs about a company's profitability. And the cash flow statement is about the cash flow entering and leaving a company.

Balance sheet

The balance sheet is called as"Balance Sheet" because it is always balanced according to this relationship: Assets = Liabilities + Shareholders' Equity.

A balance that does not balance is simply wrong. The balance sheet shows the assets a company has, the liabilities it has, and the funds contributed by its shareholders.

Assets include many heads like land, equipment, inventory, goodwill, patents, brand value, etc. Liabilities include debt (long and short term) and any other accounts payable that a company has. Shareholders’ funds are in the form of equity and reserves.

A weak balance sheet is one that is burdened with debt. When a company has a strong balance sheet, it has more assets and equity than liabilities. To know the strength of the swing, you don't need to see it; you can just look at the debt/equity ratio.

Profit and Loss Account

As its name suggests, the profit and loss statement informs about a company's profitability. The simple formula for calculating profits is Profit (loss) = Revenue - Expenses.

The 'revenue' header usually has two entries: sales revenue and other revenue. Another revenue is revenue from sources other than the central area of ​​the company's operations. For example, it could be investment income, dividends, royalties, etc.

The heading 'expenses' constitute the categories of expenses, such as raw material costs, employee costs, etc. By subtracting total costs from total revenue, we get 'operating profit', which is nothing more than a company's profit from the core operations.

To reach the final result, any miscellaneous income or loss must be added to or subtracted from operating profit. Finally, net income is obtained after deducting the applicable tax.

Cash flow statement

The cash flow statement shows the cash flow in a business. Although companies can distort their profits through accounting juggling, they cannot falsify the movement of cash. Therefore, a cash flow statement provides a true picture of a company's financial health. However, for banks and financial companies, the cash flow statement is of limited use, as it follows a different business model from other types of business.

The cash flow statement has three components: cash flows from operating activities, financing activities, and investment activities. The statement also mentions the company's current financial stake.

What you need to check in the data is whether the flows of operating activities are positive or not. If they are positive, it tells that the company can make cash from its activities. If they are negative, it tells that the company is losing money from the activities. While it may show profits in its income statement, negative flows from operations should sound an alarm.

The cash flows from financing activities show the money raised for the company's operations or the money paid for the payment of the debt. The first will be a positive number in the statement, while the last will be a negative number.

Cash flows from investing activities confine the cash used and payments made in investments. For example, a company that has generated surplus money can park it in a fixed bank deposit. Next year, you can withdraw money from that FD. The first will be a negative number in the statement, while the last will be a positive number.

The balance sheet, income statement, and cash flow contain the necessary data to guide investors who wish to invest in a company. The indices used in the stock analysis also require numbers and data contained in these statements, without which a complete analysis is impossible.

 So basically if you know about these three statements you can understand and calculate how the company is running and working. Its stability, its profitability, its assets, and its liability is all you need to know to prepare and work out these statements. So now I am ending this article with the hope that this article will be helpful for you all.  

About the Author: Ausaf Ahmed | 19 Post(s)

Ausaf is a 2nd-semester student who is pursuing Accountancy Honours. He has a joyful character and is a very curious boy who always tents to learn new things especially in travel and finance background. 

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