A Beginner's Guide to Reading Financial Statements

For any investor, learning to read a company’s financial statements is like a doctor learning to read a patient’s medical reports. They tell you the story of a company’s financial health, its performance, and its ability to generate cash. In India, all listed companies are required to publish their financial statements every quarter and annually, giving you a regular peek into their performance.

This guide will walk you through the three most important financial statements: the Balance Sheet, the Income Statement, and the Cash Flow Statement.

Key Takeaways

• Three Core Statements: The Balance Sheet, Income Statement, and Cash Flow Statement are the three pillars of financial analysis.
• Interconnected Story: These statements are linked and should be analyzed together for a complete picture. For instance, the net income from the Income Statement flows into the Balance Sheet’s reserves and is the starting point for the Cash Flow Statement.
• Cash is King: Profit is important, but a company needs cash to survive. The Cash Flow Statement reveals the real cash a company is generating. A big difference between profit and cash flow can be a red flag.

The Balance Sheet: A Snapshot of Financial Position

The Balance Sheet, also known as the Statement of Financial Position, gives you a snapshot of a company’s financial health at a single point in time. It follows a fundamental equation:

Assets = Liabilities + Shareholders’ Equity

This means that a company’s resources (Assets) are funded by either borrowing money (Liabilities) or by the money invested by its owners (Shareholders’ Equity).

Assets

Assets are the resources owned by the company that have future economic value. They are broadly divided into:

• Non-Current Assets: Long-term assets that are not expected to be converted into cash within a year. This includes Property, Plant, and Equipment (PPE), intangible assets like patents and trademarks, and long-term investments.
• Current Assets: Short-term assets that are expected to be converted into cash within a year. This includes cash, inventory, and accounts receivable (money owed by customers).

Liabilities

Liabilities are a company’s financial obligations or debts to others.

• Non-Current Liabilities: Long-term debts that are not due within a year, such as long-term bank loans and bonds.
• Current Liabilities: Short-term obligations due within a year, like accounts payable (money owed to suppliers), short-term loans, and provisions for expenses.

Shareholders’ Equity

This represents the owners’ claim on the company’s assets after all liabilities have been paid. It includes:

• Share Capital: The initial capital invested by the founders and other shareholders.
• Reserves and Surplus: Accumulated profits that the company has retained over time. This is a key link to the Income Statement, as the net profit earned each year gets added to this section.

What to look for: A strong balance sheet will have manageable debt levels and sufficient current assets to cover its short-term liabilities.

The Income Statement: Gauging Profitability

The Income Statement, also called the Profit and Loss (P&L) statement, shows a company’s financial performance over a period of time (a quarter or a year). It tells you how much revenue a company generated and how much profit it made after accounting for all its expenses.

Key Components of an Income Statement:

1. Revenue (or Sales): The total amount of money generated from the sale of goods or services.
2. Cost of Goods Sold (COGS): The direct costs associated with producing the goods sold by a company.
3. Gross Profit: Revenue - COGS. This shows how efficiently a company is producing its goods.
4. Operating Expenses: Costs not directly related to production, such as salaries, marketing, and rent.
5. Operating Income (or EBIT): Gross Profit - Operating Expenses. This is a measure of a company’s core business profitability.
6. Interest and Taxes: The cost of borrowing money and corporate taxes paid to the government.
7. Net Profit (or Profit After Tax - PAT): The final profit left for shareholders after all expenses, interest, and taxes have been paid. This is often referred to as the “bottom line.”

What to look for: Consistent growth in revenue and net profit over several quarters and years is a positive sign. Also, watch the profit margins (like gross margin and net margin) to see if the company is becoming more or less profitable over time.

The Cash Flow Statement: Tracking the Cash

The Cash Flow Statement (CFS) tracks the movement of cash both into and out of a company over a period. A company can be profitable on paper (according to the Income Statement) but still face a cash crunch if its customers aren’t paying on time. The CFS provides a more accurate picture of a company’s liquidity.

The CFS is divided into three main activities:

1. Cash Flow from Operating Activities (CFO): This is the cash generated from a company’s main business operations. It starts with Net Income and adjusts for non-cash expenses (like depreciation) and changes in working capital. A consistently positive CFO is a strong sign of financial health.
2. Cash Flow from Investing Activities (CFI): This includes cash used for or generated from buying and selling long-term assets, such as property, plant, and equipment (Capex), and other investments.
3. Cash Flow from Financing Activities (CFF): This shows the cash flow between a company and its owners and creditors. It includes issuing or buying back shares, and taking on or repaying debt.

What to look for: A healthy company typically has a positive cash flow from operations. A negative cash flow from investing can be a good sign if the company is investing in future growth.

How the Three Statements Are Linked

No single statement tells the whole story. They are all interconnected:

• Net Income from the Income Statement is the starting point for the Cash Flow Statement and also flows into the Reserves & Surplus on the Balance Sheet.
• The ending cash balance on the Cash Flow Statement is the cash asset on the Balance Sheet for that period.
• Changes in Balance Sheet items like inventory or accounts payable are reflected in the Cash Flow Statement.

Basic Red Flags and Positive Signs

When you start analyzing financial statements, here are a few things to watch out for:

Red Flags 🚩

• Widening Gap Between Profit and Cash Flow: If a company reports high profits but has negative or low cash flow from operations, it could be a sign of aggressive accounting or trouble in collecting payments.
• Rising Debt Levels: A consistently increasing debt-to-equity ratio can be a warning sign, especially if the company’s profits are not growing.
• Frequent Changes in Accounting Policies: This could be an attempt to manipulate financial results.
• Inconsistent Financial Reporting: Drastic fluctuations in revenue or profits without a clear reason should be investigated.

Positive Signs ✅

• Consistent Revenue and Profit Growth: A company that is steadily growing its top and bottom lines is generally a good sign.
• Strong and Positive Cash Flow from Operations: This shows that the core business is healthy and generating enough cash to sustain itself.
• Manageable Debt: A company with low or manageable levels of debt is less risky.

By taking the time to understand these three financial statements, you can move beyond just looking at the stock price and make more informed investment decisions based on a company’s fundamental strength.

This article is only for information purposes and is not investment advice. Before investing, do your own research.