If you want to read just one article on Financial Statements, go for this one!
Shreya, a friend of mine called up last weekend to discuss her business concerns.
Shreya has an apparel business that runs on an Instagram page. The page has over 25K subscribers and is doing well on the sales front.
However, the concern is that she was running out of cash. I then quickly asked a couple of questions related to cash status, inventory holding days, inventory at hand, etc., to which she couldn’t answer and was hinting at talking to her CA who prepares the financial statements.
This somehow didn’t seem to be fine with me, though the CA will be able to answer all my queries as a business owner you should know about financials.
To which her answer was pretty obvious “I am a software engineer who also runs an apparel business”, I don’t understand much about financials. That’s not my domain.
I then quickly got into a call with the CA and understood that the issue is with the amount of inventory at hand. A huge quantity of inventory is at hand which is creating a cash crunch despite making decent sales.
After going through her concern, I’ve realized that this might be the issue for a lot of small entrepreneurs who find it extremely difficult to understand financial statements.
So, I decided to write a quick beginner’s guide on financial statements wherein I will address all the aspects that you would need to know.
What are Financial Statements:
To start with the obvious, what are financial statements? I would call it a scorecard or a report card of a company. Just like a student gets a report card at the academic year-end as a performance summary company also has a report card that explains the financial performance.
Broadly Financial Statements can be divided into 3 parts:
1. Balance Sheet
2. Profit/ Loss Statement and
3. Cash Flow Statement
Why should you understand FS?
I want to clear this bug right at the beginning. You might be wondering I am a student/ a software professional why should I need to know about Financial Statements? This isn’t my expertise.
I resonate with you but at the same time in the day and age we live in having a basic understanding of financial statements is inevitable.
Let me explain how; Say as a student you get a job in XYZ company. You would need to understand what is the prospects of the company, Is it in a position to pay me a salary regularly which can be evaluated by looking at the cash flow statement?
For an employee also it becomes crucial to understand the financial position of the company, it is going to continue shortly or is on the verge of liquidity.
Objectives of Financial Statements (FS):
Every report has an objective behind its preparation. Along similar lines, financial statements also have a set of objectives which broadly include:
1. Providing information on the financial performance of a company to the employees, shareholders, and general public. It gives information like what is the profit for the year, the value of assets, liabilities held with the company, etc.
2. Financial Statements should aim at providing a true and fair view of the company’s performance. All the information stated as part of the statements must be true and fair. There should not be any scope for misstatements/ inconsistencies in the figures reported
3. It helps investors make decisions based on liquidity, cash position, assets at hand, etc.
4. Information on earning potential of the company
Now, that the basics are in place, let’s understand each of these financial statement components in detail.
Balance Sheet (BS):
BS is a summary of the company’s performance; it gives you a glimpse of the company’s assets and liabilities.
A simple equation in accounting is: Assets — Liabilities = Net Worth
The major aspect that one would look at BS is the net worth i.e., what is the net assets the company holds after paying all the liabilities.
A higher net worth indicates a better financial position.
Objectives of a BS:
a) To provide a comprehensive view of the health of a company in terms of how the assets are performing
b) BS forms an important document to obtain loans from any financial institution
c) It shows the areas where improvement is needed say cash balance is on the lower side, higher money is spent on fixed assets such as buildings, etc. which might not be required for the business model.
How to evaluate the Balance Sheet of a company:
Financial ratios come in handy to understand the performance of a BS, here are a couple of financial ratios to evaluate:
1. Debt-Equity (D/E) Ratio: Debt/ Equity
Debt indicates the value of loans/ borrowings of the company. Equity on the other hand is the investment by the shareholders/ owners. Debt/ equity indicates the % of debt to equity. A Higher D/E ratio indicates that loans are higher than funds invested by owners. This doesn’t speak good about the company because anybody would trust a company where owners have invested higher. Generally, 0.5:1 is considered to be a decent DE ratio
2. Assets Turnover Ratio: Sales/ Total Assets
This indicates how effectively the company is utilizing its assets to generate the required revenue. A higher Assets turnover ratio is suggested to be a good indicator of a company’s performance.
3. Return on Capital employed: Earnings before interest & Tax/ Capital employed
This ratio indicates the amount of return/ profit a company earned on the capital invested (incl. debt funds). A higher return on capital indicates that the company can generate returns on the existing capital and additional capital might not be required for growth.
4. Free Cash Flow (FCF):
FCF= Net profit + non-cash expenses such as depreciation/ amortization
It indicates the amount of cash a company holds after meeting all the required expenses.
Higher FCF means the company can generate higher returns which in turn flow for the growth of the company/pay to shareholders
5. Cash Conversion Cycle (CCC):
It takes three major aspects of a company’s performance into account i.e., sales, payables, and inventory. This ratio is a combination of the following questions:
a) How many days does it takes to recover from the customers?
b) In how many days can I pay vendors?
c) How many days am I holding inventory after production and before the sale?
A combination of these questions hits on the working capital of a company.
Working capital is the money required to manage day-to-day operations in other words it is the gap between current assets such as cash, inventory, and liabilities.
CCC trend for over last 3–5 years indicates the direction of working capital. The lower the CCC the better it is because it indicates that you take lesser time to recover from customers and inventory is also quickly converted to sales.
Profit/ Loss Statement (P/L Statement):
In simple words, it indicates the Profit/ Loss generated through its operations for a given period generally 1 year. All the income sources and expenses are included in the statement to arrive at the final Profit/ Loss from operations.
Objectives of a P/L Statement:
· To capture all the expenses and income streams for a given period
· To evaluate the earning capabilities of a company
· Understand the major income streams & expenses, and the probability of occurrence in the future. For example, there are 3 income streams of which 1 constitutes over 60% and is expected to discontinue in the future. This is alarming information for the stakeholders since this source is not going to generate revenue in the years to come
How to evaluate the P/L Statement of a company:
1. Evaluate the company’s performance year on year to understand sources of revenue and how it has grown over time. This shall help in understanding the future prospectus of the company
2. Net Profit Ratio:
Net profit is the profit arrived at after meeting product-related expenses and general expenses. Net Profit/ Sales indicates the profit earned from the business. Comparing the same with the competitors and previous years helps in understanding how the company is performing
3. Seasonality of the business; say ice cream business will generate higher revenue during the summer season when compared to the winter season. Therefore, it is important to evaluate if the business is seasonal and the impact of the same on sales volume
4. Cost of goods sold: It is the direct expenditure required to manufacture a product. Say, Raw material cost: 4 Rs and employee cost: Rs 3 Rs then 7 Rs is the cost of goods sold. The higher cost of goods sold indicates a lower gross profit margin. Therefore, every company must work towards minimizing the cost of goods sold
Cash Flow Statement (CFS):
CFS indicates the cash position of a company in terms of how much cash is available at the end of an accounting period. Generally, the profit earned by the company is not the cash available.
Let me explain why.
There are generally 2 accounting methods:
1. Accrual accounting wherein an expense is recorded in the period in which it is supposed to be paid and not when it is paid.
Say, Salary for Mar’22 is to be paid by end of Mar’22. If cash is not available the same can be paid in Apr/ May’22 however the same is recorded in the books in Mar’22 and not Apr/ May’22 under the accrual form of accounting. This is generally followed by most companies.
2. Cash accounting wherein an expense is recorded when it is paid and not when it is supposed to be paid. In the earlier example, the salary is recorded in Apr/ May’22 and not in Mar’22
In the above scenario where accrual accounting is followed, the Profit/ Loss statement includes this as expenditure however there is no actual cash outflow in Mar’22 leading to a difference between these two statements. On similar lines, non-cash expenses such as depreciation also create differences.
How to evaluate the Cash Flow Statement of a company:
Bifurcate the cash flow under the following heads:
a. Cash Flow from Operations
b. Cash Flow from Investing
c. Cash Flow from Financing
This helps in understanding the cash position under each of the above heads.
Say, cash flow from operations is higher than in the previous period which means that the company is performing well on the operations front.
Say, cash flow from Investing is declining which means that the investment decisions of the company are not deriving sufficient returns and there is a need to reevaluate the investment strategy.
Now that all the 3 major pillars of financial statements are covered, I’ll move on to address a couple of general questions in your mind.
FQA’s on Financial Statements:
1. Is it mandatory to prepare Financial Statements for any company?
Absolutely! Every company has to prepare financial statements. To look at it from a layman’s perspective when you have a business, you would need to know if you are making a profit or loss from the venture.
2. Are financial statements required for a Non-Profit organization?
Not exactly, the objective of non-profit organizations is not to make a profit. Therefore, the financial statements required are slightly different. It broadly includes:
a) Statement of Financial position
b) Statement of Activities
c) Statement of Cash Flow
3. Are financial statements required to be audited?
Well, be it a Startup/ private/ Public company it is mandatory to get the financial statements audited. Audit means getting the statements vetted by an independent Chartered Accountant
4. What are book value shares and how is it different from Market price?
Book value of shares is arrived at by dividing the total value of equity shares/ No. of shares of the company.
On the other hand, Market price is the actual share price at which one would purchase the share from the market. It is dependent on the demand and supply of the share.
A higher market price, when compared to book value, indicates that investors value the share at a higher rate than its original value.
5. Is it possible to get the Financial Statements of a company for the last 5 years?
Oh yes! You can download the financial statements of any company from its official website by just click of a button.
6. Why are projected Financial Statements prepared?
Projected financial statements are required to be submitted to the financial institutions for the issue of funds. Generally, these financial institutions look for future income sources, liquidity positions, and the capability to refund the loan shortly.
7. Is it possible to have a positive cash position but loss as per the Profit/ Loss statement?
Absolutely Yes! The profit/ Loss statement includes accrued expenses (say, salaries payable but not yet paid) and non-cash items such as depreciation which might lead to a loss however the same does not have any cash outflow leading to a positive cash position
Conclusion:
Today with the growing number of Startups, more regulations are expected to be enforced in preparation for Financial Statements. You as a potential business owner/ Stakeholder/ Investor are obliged to understand and interpret the same.
Without understanding how the company is performing, is it a good idea to continue/ invest might be difficult and you might end up making a wrong decision.
I hope with this you got a detailed understanding of financial statements and broad parameters to look for.
In case you have any queries please feel free to post in the comments section.
