How to Read and Understand Financial Statements

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The ability to understand Financial Statements and accordingly analyse the financial health of companies is one of the most important skills that must be learned by investors, businessmen, managers and advisors so that they can make strategic decisions and create wealth for themselves or guide others in their financial journey.

Financial Statements refer to written records that depict the business activities and the financial performance of a company. They are used to assess taxation, financing and understanding the amounts for investing purposes.

There are three basic financial statements that one must learn to read and understand before investing in a company: Balance Sheet, Income Statement and Cash Flow Statement.

  • Balance Sheet refers to the financial position of a company at a specific point of time. A balance sheet is divided into two sections. One side represents the business’s assets and the other shows its liabilities and shareholders' equity.
  • Income statements depict a company’s financial performance over a reporting period, such as quarter or year. It shows the profitability of the company from an accounting point of view. An Income Statement is a statement of operation or profit and loss and starts with the revenue mentioned at the top and after deducting expenses, the net income figure is derived.
  • Cash Flow Statement illustrates the cash position of the company and answers various questions like how much of the company’s cash goes to the creditors and shareholders, how much amount does the company have for investment and growth.

It mainly consists of three components- Cash from Operations, Cash Used in Investing and Cash from Financing.

How to Read a Balance Sheet?

A balance sheet tells us the value one has in hand, i.e., the assets while how much money one owes to others (like banks and creditors) is called liabilities. A Balance Sheet basically conveys the “book value” of a company.

Assets include cash, accounts receivables, patents, trademarks, stock, machinery, accrued income, investments and equipment. On the other hand, liabilities include accounts payable, accrued expenses, debt like mortgages, loans, etc. While assets refer to the value you have in hand, liabilities cost you money.

Subtracting assets from liabilities gives you an approximate figure how much value the company has. In other words, a positive figure implies a good position but if the liabilities are more than the assets, the company owes more money to outsiders.

Another important figure in the balance sheet is Owner’s Equity. It refers to the amount that the owner has invested in the business. Equity consists of capital which is the initial investment made by the business to get the business up and running and Retained Profits refer to the profits that the business possesses. Drawings refer to the amount one pays to themselves from their business.

A Balance Sheet provides information that can be used to assess rates of return and evaluate capital structure by using the following formula-

Assets = Liabilities + Owner’s Equity

How to Read an Income Statement?

An Income Statement, also referred to as a Profit and Loss (P&L) Statement gives a picture of the cumulative impact of revenue, gain, expense and loss transactions for a particular period. An Income Statement is often shared as a part of quarterly, half-yearly and annual reports of a company. It shows the financial trends, business activities and comparisons over a particular period of time.

Income Statements cover the information of the company which includes its Revenue, Expenses, Cost of Goods Sold, Gross Profit, Operating Income, Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA), Depreciation Net Profit and Earnings Per Share (EPS,

This information is used by accountants, investors, financial advisors and other business professionals to understand a company’s performance, profitability, expenses and future growth. This information also helps in understanding the financial trends, costs of the company and the industry scenario according to which companies perform.

How to Read a Cash Flow Statement?

A Cash Flow Statement provides a detailed picture of the business’s cash during a specific duration of time. It shows a company’s ability to operate during an accounting period by assessing the amount of cash that flows into and out of it. In a Cash Flow Statement, one can see the type of activities that generate cash and use the information to make financial decisions.

It is very important to understand the difference between Cash Flow and Profit. Cash Flow is the cash that flows into and out of a company. On the other hand, profit is what remains after all the expenses of a company have been deducted from its revenues.

Also, it should be understood that a positive cash flow does not demonstrate that a company is profitable. One must also simultaneously study the Balance Sheet and Income Statement of a company to get an accurate Financial Position of a Company.

Reviewing and understanding Financial Statements can provide valuable insights about a company regarding its debts and liabilities, profits and losses, operational expenses, level of investment, growth of the company and other aspects of finance and business of the company. Having an understanding of Financial Statements is highly beneficial for investors who wish to create wealth in the long-term. Also a very good idea before investing into a company is to go through its annual report on the whole, it can very easily give you an idea about the current workings and future plans of a company.

Hence, if you do not have a financial background, you must take help of a financial advisor to build your financial literacy and get an understanding of Financial Statements so that you can make wise investment decisions.

Disclaimer: This blog is for information purpose only.