Lesson 5 – Understanding Financial Statements
In this lesson you will understand what financial statements are and why they are important in stock investing decisions.
- Profit & Loss Statement
- Balance Sheet Statement
- Cash Flow Statement
In prior lessons you studied qualitative aspects of investing. In this lesson you will start with the quantitative aspects of stock investing.
In this lesson, I have shared the financial statements of Supreme Industries which is a leading plastics manufacturer. This is purely for illustrative purposes. I have covered Supreme Industries in a detailed note at Capital Orbit earlier.
Profit & Loss Statement
Please spend some time looking at the profit and loss statement first. You will find it easy to understand even if you have not looked at financial statements before.
Let us go step by step.
What are revenue and expenditure respectively?
Revenue from operations is what the company earns by selling products or services. It spends money on expense heads such as salaries, raw materials, marketing, administrative expenses and other overheads.
Other income usually is any income that is not the core income of the company. Take a case where a company sells of a piece of land which was once far away from the city but is now within city limits. It might make sense to relocate the factory further out and make some money in the process. It can also be money made from investments in mutual funds.
See the first five heads in Expenditure.
- Cost of Materials Consumed
- Purchase of traded goods
- Change in Inventories of Finished Goods and Work-in-progress and traded goods
- Employee Benefits Expense
- Other expenses
These are operating expenses. They are directly linked to the plastics manufacturing activity.
What is EBITDA?
Earnings before Interest, Tax and Depreciation & Amortisation or EBITDA is the profit left after deducting operating expenses from total revenue.
EBITDA is a nice word that you can now start using. One, it takes less effort, and two, you can brag a bit about your knowledge. Alright, I am kidding.
In the Supreme Industries statement they have used the word Profit instead of Earnings.
What are finance costs?
If a company takes a loan from a bank or an institution it has to pay interest on the loan as per an agreed schedule. Interest goes into the finance cost head. Please note that this does not include principal repayment.
What is depreciation?
Any company usually owns plant and machinery (P&M), buildings, furniture and vehicles. It usually owns land on which the manufacturing plant or an office respectively is set up. These are assets. More specifically, fixed assets in accounting lingo.
You will agree that if we keep land aside, all the other items like P&M and buildings get worn out with time. They have a finite life.
Accounting says that we need to deduct a certain charge from the cost of the assets like P&M and buildings. Let us assume that we buy a particular machine for Rs. 100,000 today. Assume that the life of this machine is 8 years.
The depreciation you will charge to the Profit & Loss Statement will be Rs. 12,500 if we divide the cost (Rs. 100,000) over the life of this machine (8 years).
How are taxes paid?
Profit before tax (PBT) is EBITDA minus the Finance costs and the Depreciation items. Tax payable is calculated on PBT.
PBT minus Taxes leads us to profit after tax (PAT).
What is PAT?
PAT or net profit is a very important figure for a shareholder (you) because this is what is left after taking care of all the expenses payable to employees, labour, suppliers, banks, government and any external entity you can think of.
That is all there is to a Profit & Loss Statement (P&L). If it seems like a lot, don’t worry. You are starting off. Once you start reading more financial statements you will get completely comfortable with these terms.
Remember, you are already better off than most other investors if you have come this far. Many “investors” do not bother to check on the financials of a company even though they are so important.
Before we start off, let us first understand what assets and liabilities are.
What are assets and liabilities?
Assets are what the company owns. You have already seen examples of fixed assets when you read about the P&L statement.
Liabilities are what the company owes to others.
Assume you buy a home for Rs. 30 lakh and take a home loan of Rs. 16 lakh. If the home is all you have in this world, you have assets of Rs. 30 lakh and a liability of Rs. 16 lakh. Your net worth is Rs. 14 lakh.
In accounting terms, share capital plus reserves and surplus is net worth.
What does current and non-current mean?
If you have understood assets and liabilities, the next step is the distinction between current and non-current items.
Current as the name suggests is ongoing. In accounting lingo we use this word with a time period of one year or less. So, a current liability is to be paid by the company within the next one year. A current asset is cash or an item that will come to the company as cash within the next one year.
Fixed assets are also called non-current assets. Long-term loans would come under non-current liabilities.
What are current assets?
The important heads within current assets are debtors or account receivables, inventory and cash. You may see other heads in different companies’ balance sheets.
A company might make a sale on credit period of 1 month and not receive the cash immediately from a customer. This will show up as an account receivable. At the end of 1 month the customer will pay cash. The account receivable for this customer will become zero.
What are current liabilities?
One company’s account receivable is another company’s account payable. This item may also be called creditors in the balance sheet.
What is working capital?
Working Capital equals Current Assets minus Current Liabilities. Working Capital (WC) is a very important factor in understanding business strength.
Cash is the lifeblood of a company. If a company can collect cash on time from customers (less account receivables) and pay suppliers with a relative delay (higher account payables) and keep less raw materials or finished goods in the warehouse (low inventory) it means that it is a cash-efficient company.
Such companies usually have strong businesses. If you come across a company like this, consider it a good candidate for investment.
Cash Flow Statement
As you saw the example, a company might record a sale when it raised an invoice on a customer. This does not bring in the cash. Cash is needed to transact with suppliers. Cash is needed to pay the electricity bills. Cash is needed to pay employees. Cash is needed to set up a new factory.
You get the drift.
We need to understand the impact of all the company’s activities on the cash position. This is what the cash flow statement does.
It has three sections,
What is Cash Flow from Operations?
We covered PAT in the P&L statement. This is what is left in the company’s hands after all expenses. But this is not equal to cash from operations.
You studied depreciation in this lesson. Remember that is a notional item. A company does not pay this amount to anyone. It deducts this amount itself from the fixed assets item.
Cash flow from operations statement is broadly built by adding such non-cash items back to PAT.
We also account for changes because of Working Capital. Remember that WC is composed of cash or items which will convert to cash within one year.
Now, the company has cash generated from operations.
What is Cash Flow from Investing?
Common sense tells you that the company can choose to invest this cash in new capacity, plant expansions, acquiring companies or making investments. This covers the investing part.
What is Cash Flow from Financing?
In the financing part, we broadly deal with its interactions with the debt-holders and the equity holders. If for any reason, the company needs more cash then it possesses, it will have to raise more loans or equity.
If the company has taken a loan, it has to make principal repayments. Remember, I mentioned that in P&L we only take interest. Principal repayments come here.
A company that does an IPO and raises equity capital will have a positive flow under the cash flow from financing in that year to that extent.
This broadly covers the financing part.
- Please look at VST Industries Annual Report for FY12.
- Read VST’s financial statements which start on page 42.
- Focus on becoming familiar with the structure of financial statements in general.
- Spot the key items that you have studied in this lesson.
- Start making Annual Reports your investing friends. Try to understand the broad heads of information.
- I do not expect you to understand the complete Annual Report today but you will find them easy to understand if you keep at it.
Refer this E-Course to your friends if you have benefited from it
If you like this E-Course, share it with friends who will benefit. You can have better discussions on investing with them if they too read what you are reading. It is useful to get views and counter-views on any investment idea!
You can refer your friends or colleagues by using this referral page.
I am new to this E-Course. How do I sign up?
You reached this lesson via an email forward from someone you know.
Do you want to sign up for this E-Course? Understand more about this course by clicking here.