Number crunching can get boring. However, reading the details is important, especially if you have invested in the company’s stock or plan to do so.
It is the time of the year when companies publish and send their shareholders, the annual performance report. Most of us don’t read into the financials of the companies we invest in. Crunching numbers to read the nuances of a financial statement, culling information about a company’s growth prospects sounds boring. Yet, reading a financial statement is a necessary ‘evil’. It is important for the simple reason that we need to know the company in which we have already invested or plan to invest in.
What’s in it?
The annual report includes the profit and loss statements and balance sheet. Apart from these, the chairman’s address to shareholders, gives a synopsis of segment-wise performance, key initiatives in the year, achievements and a financial snapshot.
The annual report also contains management discussion and analysis. It gives an industry overview, factors affecting prospects, impact of the past and possible policy changes, potential threats and opportunities and, finally, the company’s own initiatives to exploit those opportunities or combat challenges. Often, there is a discussion on future plans, too.
Publicly listed companies are required to release their financial information annually. The three main statements released are the balance sheet, the profit and loss account and the cash flow statement. Investors should know how to use, analyse and read these. Financial statements provide information to investors on how good the company is at making money, what they own and owe, and how they’re paying for their operation and future growth.
A balance sheet is divided into two parts, one being assets and the other the liabilities and shareholder funds. The two sides must always equalise. In other words, assets, or the means used to operate the company, are balanced by a company’s financial obligations, along with the share capital brought into the company and its retained earnings.
Assets are what a company uses to operate its business, while its liabilities and shareholders’ funds are two sources that support these assets. Owners’ funds, referred to as shareholders’ funds in a publicly traded company, is the amount of money initially invested in the company, plus any retained earnings, and it represents a source of funding for the business.
After understanding the balance sheet, you can look at the Profit and Loss Account. It gives net earnings during the stated time period. It shows the income, expenditure, tax, net profit, distributed profits and retained earnings of the company. While analysing income, you may check if operating income has increased, since it is an indication of business growth. In case non-operating income has increased, it may not be a healthy sign, as it may be non-recurring.The difference between total income and total expenditure is profit before tax. After deduction of tax, we get profit after tax. Remember that profits by themselves carry little meaning. You will always have to compare profit in a particular period with those in the preceding period to arrive at any conclusions.
Schedules to accounts provide break-ups of income, expenditure and other items. For instance, you may want to know what components constitute other income, particularly if it has been a significant contributor to profits that year. The item-wise split of the components classified under ‘other income’ will help you decipher how much of the non-operational income is recurring in nature.
Cash flow statement measures the liquidity of a company, by providing a better picture to investors on its ability to pay off its bills, creditors and finance growth. In fact, a company can be profitable and yet run out of money. A lack of liquidity may result in financial difficulty and potentially lead to bankruptcy.
The cash flow statement is important because it cannot be manipulated easily. You either have the cash or not. A positive cash flow tell investors the company was able to generate enough cash from operations to fund business growth without additional financing. A negative cash flow would tell investors the company had to get cash from other sources, such as financing by way of loans or selling investment or properties or fixed assets to meet the operational requirements.
Analyse with ratios
To analyse the information within the balance sheet and profit and loss account, financial ratio analysis is used. The main types of ratios that use information from the financial statements are financial strength ratios and profitability ratios.
Financial strength ratios, such as the working capital and debt-to-equity ratios, provide information on how well the company can meet its obligations and how it is leveraged. This can give investors an idea of how financially stable the company is and how the company finances itself. Profitability ratios such as net profit margin, earnings per share, return on equity and return on assets provide information on a firm’s overall economic performance.
Companies have now become conscious of the importance of pursuing good corporate governance. It is no longer a rigid set of guidelines; it has now become an integral part of companies’ functioning and progress. Compliance is a process towards establishing and maintaining the principles of integrity, transparency, accountability and fairness.No longer is it, mere adherence to regulations.
Investors wanting to make a headstart in reading financial reports could do so with those of top listed companies.Information technology companies such as Infosys, Wipro, TCS; pharma companies like GlaxoPharma; Power companies like Tata Power; those in banking and finance like HDFC , Bank of Baroda and so on, produce good reports.
Financial readings can be a good starting point for assessing the strengths of a company, credit worthiness and other attributes based on past performance.The essence of savvy investing is to research your investments carefully and make use of all the information available.
The author is a freelance writer