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INTRODUCTION TO FINANCIAL STATEMENTS

More about cash flows.

If there is one investor who watches the flow of cash closely- thats Mr. Warren
Buffet, one of the worlds richest stock market investor. Theres lot of books and
videos explaining his method of investing, the way he analyses a company and
about his investing philosophy. But if you watch closely, what buffet does is quite
fundamental
He targets long term investment appreciation
He invests in businesses he understands
He takes a closer look on cash flow.
Understanding Cash flow statements

Profit is an estimate. Cash is a fact.


Cash flow statement-Thats last of the three types of financial statements.
I hope the very first sentence in this article has given you an idea about cash
flows. The cash flow statement reports the actual solid cash generated and
used during the time interval specified in its heading, unlike profit and loss
statement which gives an estimate based on certain rules and assumptions, after
deducting certain expenses like deprecation which does not require any cash
outflow.
The whole idea of cash flow statement is to show you from where the company
got its cash whether its from its business operations or by sale of assets or
issue of shares and how it used up those funds. This data is important because
business needs cash like a car needs fuel. If there is no regular generation of cash
from the day-to-day operations, the business will need to resort to debt and share
issues to survive.

Cash flow statement. An introduction.


CASH FLOW STATEMENTS.
The Cash flow statement is the final component of a companys annual report.
It throws light on the cash generating ability of a company. The statement records
the actual movements in cash in an accounting period. All cash received (inflows)
by the company, and spent (outflows) by the company will be shown in this
statement.
Cash flow statements may be a little bit difficult to understand than balance
sheets and income statements.
Balance sheet components: Liabilities and Equity.

We said earlier that the balance sheet shows what the company owns and owes.
What the company owns are called assets and we have seen the various types of
assets that a company holds. Now what the company owes is categorized into
two (1) Liabilities and (2) equity. So in another way, the total of what the
company owes shows how the company found money to buy the assets!!. Lets
dig into the topic:
Section 2- Equity and Liabilities. What the company owes is classified into
Equity and Liabilities. Fine. But whats the difference between the two? The

difference is Equity is that part of funds that the company raised by issuing
shares. It also includes that amount the profits that has been made in all the past
years and kept accumulated without paying it to the shareholders.

So, you and I, who gives money to the company by subscribing to its IPO
forms the Equity. To that extend, we are the owners of the company. The equity
ownership that we get can be sold in the secondary market if there are takers for
it. That organized place where we sell equity ownership is called the stock
market.

Liabilities are outside borrowings, usually listed on the balance sheet from
the shortest term to the longest term, so the very layout tells you something
about whats due to be paid and when.

Anything a company owes to people or businesses other than its owners is


considered a liability. There are two types of liabilities Current liabilities and long
term liabilities. In general, if a liability must be paid within a year, it is considered
current. This includes bills, money you owe to your vendors and suppliers,
employee payroll and short-term loans. A long-term liability is any debt that
extends beyond one year, such as a mortgage loan or a term loan availed by the
company to purchase machinery.

Apart from long term and short term liabilities theres one more category
called contingent liability. Contingent liabilities are estimated payments that the
company may have to make if a future event takes place. For instance, suppose
the excise authorities have imposed a heavy levy on the company, which has
been disputed by the company on some justifiable grounds, but the authorities
have gone on appeal against the company, it is a contingent liability. In the
normal course, the company does not expect the liability to crystallize, but if the
court verdict ultimately goes against the company, it will have to meet the
liability. This is a contingent liability.

Contingent liabilities are not actual liabilities and hence will not be
displayed in the balance sheet figures. It will be shown as a note below the
balance sheet. Thats why notes to balance sheet assume lot of importance to
an analyst.
So, logically, Equity (+) liabilities should be equal to Total assets. This will be true
at any point of time. How and why it will always happen is something an
accounting student should be learning, not you. Since your aim is to study and
analyse the balance sheet to make investment decisions, a thorough knowledge
of the frame work given in this session should be sufficient.
Balance sheet components: Assets

The hardest thing about the balance sheet is deciphering the vocabulary on it.
Once you learn what a few things mean, the sheet is much easier to read. Before
you can understand the individual accounts in each section, it is important to
understand the three main sections on the balance sheet.

Section 1 Assets (these may be again classified in the balance sheet as


fixed assets and current assets). But for the time being, lets see what assets areAssets are what the company owns. Example land, buildings, factories,
machinery, vehicles, computers, furniture, cash, bank balance in companys
account etc.. , it also includes receivable amounts from customers, tax
authorities, government and other entities.

A company can also have fixed deposits in banks. Thats not all, it can have
deposits for various purposes like rent deposit, advance given to suppliers etc , it
can invest in shares, mutual funds and bonds.. These amounts also form part of
the companys assets.

A company may also hold finished goods which are meant for sale. In some
cases, work may be in progress. For example , lets take a car factory. As on the
balance sheet date, the company will have finished cars ready for sale as well as
partly finished cars. These are collectively called inventories. The value of
finished goods (Fully made cars) and work-in progress (partly made cars)
forms part of the assets of the company.

Prepaid assets are another category of asset that may be seen in a balance
sheet. In the course of every day operations, businesses will have to pay for
goods or services before they actually receive the product. For example rent may
have to be paid in advance for a year. Sometimes companies may decide to
prepay taxes, salaries, utility bills, or the interest on their debt. These would all be
pooled together and put on the balance sheet under the heading pre-paid
expenses or pre-paid assets. By their very nature, Prepaid Expenses are a
small part of the balance sheet. They are relatively unimportant in your analysis
and shouldnt be given too much attention.

Theres one more class of assets intangible asset i.e., assets which
appear in the balance sheet in the form of a value but which cannot be seen ,
touched or felt. These include copy rights, trademarks, intellectual property,
patents goodwill etc..
So thats it for the first component in the balance sheet Assets. Add them all up
and you get the total assets owned by the company. Simple.
ASSET VALUE: MORE OF ESTIMATES AND ASSUMPTIONS

One important point to take note here is that, the value of most of the asset
components discussed above as shown in the balance sheet is derived based on
certain estimates and assumptions. For example Property, plant and machinery,
computers , furniture and fittings and all those equipments that the company use
to operate business are accounted in the balance sheet at the purchase price in
year one and in the subsequent years , a fixed rate of depreciation is charged on
it and the balance is shown as the value. But in reality, nobody knows how much
the companys real estate or equipment might be worth in the open market. The

fact that companies must rely on purchase price to value their assets can create
some anomalies. Lets discuss some examples here:
You started a company 25 years back and bought land For 25 lakhs. The
land could be worth 5 or 6 crores today but it will still be shown at 25 lakhs in
the balance sheet. Since land does not wear out, depreciation is not charged on
land each year.
In the case of machinery and other fixed assets, depreciation is charged at
a fixed rate by the accountants. So , when you buy machinery worth 25 lakhs, its
shown in the balance sheet after charging a depreciation of say, 10% or 15%. Two
years down, this machinery may not have a reliazable value at all due to various
reasons for example technological obsolescence but, may still appear in the
balance sheet at cost (25 lakhs) less depreciation charged (say at 15% for two
years) at 18.06 lakhs.
A company may have intangible assets (goodwill, intellectual property,
customer base , strategic strength, brand image etc..). These are assets which
exists but you cannot touch or spend. Most of these assets are created over
time and are not found on the balance sheet of the company unless an acquiring
company pays for them and records them as goodwill.
Your company launched a major advertising campaign. All the work is done
in January and the cost comes to around 25 lakhs. The accountants may
now decide that the benefit from this ad campaign will benefit the company for 2
years . So they will record an expense of 12.50 lakhs in the first year and show
the balance 12.50 lakhs as prepaid asset. The value of 12.50 lakhs prepaid
asset is actually an estimate since the company may receive the benefit of ad
campaign for several years or the ad may not click at all !
Now its time to move on to the other side of the balance sheet where we have
two separate components to discuss- Liabilities and Equity. More about that in our
next lesson.
Balance sheet : what is it?

Balance sheet is a statement that shows what a business owns and owes AT a
particular point of time. (Remember, the income statement shows revenues and
related expenses FOR a period of time , usually a year).

ALL COMPANIES are statutorily required to come out with a final statement
of accounts every year. The final statement of accounts consist of the balancesheet, the profit and loss (P&L) account, supporting schedules, the auditors
report, a statement of accounting policies and additional notes on account. The
balance-sheet and P&L account are designed to give a birds eye view of the state
of affairs of a company.
Schedule VI of the Companies Act details the format and typical contents of
the balance-sheet and P&L account. Companies are given the option to have their
statements in either the `horizontal or `vertical format. Most companies follow
the latter.
Companies are also given the freedom to have the figures published in
thousands, lakhs or Crores of rupees depending upon the scale and magnitude of
operations.

A typical vertical balance-sheets design is like this- The company gets its
sources of funds from shares issues, loans borrowed etc.. And applies the funds
to run the business in fixed assets, investments, stock etc..
Logically, at any point of time, the total of sources of funds would be equal
to the total of application of funds.
But law in India (Companies ACT) requires companies to disclose more facts
about the deployment of funds and not just a summary. So, a typical balance
sheet is accompanied by schedules, notes, bifurcations, tables, disclosures.. And
hence, the whole things looks complicated at the beginning for a newbie.
Balance sheet is also called statement of financial position

Conclusion
The balance sheet of a company reflects its financial position at a particular point
of time. It shows what the company owns and owes after doing business for a
year. So, analysis of balance sheet of a company becomes vital for an investor. To
do that, you need to know what are the components of the balance sheet. More
about that in our next lesson.
The income statement: Revenues an important figure.

Sales or revenue is the value of all the products or services a company sold to its
customers during a given period of time. Profits of the company are based largely
on the volume of this figure.
Why this figure is important.
More revenues means more profits. An increase in profits year on will have a
positive impact in the stock price. So companies are always eager to show
increased revenues in the profit and loss account. And, the sales figure is one of
the easiest figure to manipulate.
How do companies manipulate sales?
Method 1. Sales to related parties The Company may sell its products to
another company which may be owned by a director or any one who has
substantial influence in the company.
Method 2. Record fraudulent sales using fake bills. For example It was
discovered that Mr. Raju of satyam computers created as many as 7,561 fake
invoices during the period from April 2003 to December 2008.
Method 3. Very Flexible terms for payment for the buyer by providing
such a facility the company may boost up the revenues temporarily, but in the
long run such arrangements pose an increased risk of the payment never being
realized!
Method 4. Including one time revenues like income from sale of fixed
assets like unwanted machinery or scraped assets or even loan amount received
in the sales figure and thus boosting the figure and profits.
Method 5. Companies can adjust reported net earnings simply by
changing accounting policies. These tend to be quite complex and difficult to
understand, but the details are going to be found in the footnotes. For example, a
company may change the way it values inventory, which in turn could have a big
effect on calculation of the cost of goods sold and gross profit.
Method 6. Converting reserve profits to income. This may also be difficult
to understand for a newbie. Reserves are profits earned in the past years, kept

aside for future expansion activities. Companies carrying large balance in


reserves can manipulate current year outcome by simply reclassifying all or part
of the reserve balance to income.
Well, i am not here to list out fraudulent practices. that list goes on and on from
least complex ones to complicated accounting tricks. The question is how to
analyse a companys quality of revenues.

HERES YOUR SIX POINT CHECKLIST.


How can a company continue to earn profits year after year? By selling
more and more every year. So, the first question to be answered is Does the
company have a history of increasing revenues every year?
Now the second question to be answered is Are the Revenues increasing
at par or above the other competitors in the industry?
Does the company have a unique product-line that will sell fast? You have
to invest in companies whose products and business model you understand.
Does the company have a unique branded product to sell? Branded
products are easy to sell and if consumers love the brand, they do not mind
paying a premium for its products & services. For example Maruti. Moreover, a
company with a brand value can easily diversity into other sectors and instantly
become successful For example Titan. They have diversified successfully into
the eye wear and diamond jewelry sectors.
Take the current assets section in the balance sheet. The amount of
unrealized sale from customers will be given under the head accounts
receivables or sundry debtors. Check if the receivables are showing a sudden
jump. Co-relate with the revenue figure and see that the revenues and
receivables are growing at the same pace. For example if you see the revenues
growing moderately but receivables showing a sudden jump, thats a red flag! You
need to be careful. You have to look for companys disclosures regarding related
party transactions, sale to sister concerns , change in the assessment of
customers ability to pay , extended payment terms offered to any particular
client etc..
Calculate the price /sales ratio. Calculating the price/sales ratio is a simple matter
of performing the maths. Lets assume that the company we are using as an
example had revenue of 300 million rupees over the last four quarters. If we take
the current market capitalization of 150 million rupees and divide it by the
revenue of 300 million rupees, we arrive at a P/S ratio of 0.5. As with the P/E ratio,
the lower this ratio is, the better the odds that this will prove to be a good
investment.
The Income statement :Understanding Depreciation

Depreciation
One of the things that analysts and investors frequently look for while analyzing a
company is the amount of depreciation written as expense in the profit and loss
account. It is a term frequently used in finance that describes the loss of value
over time. Depreciation is an expense; hence less of this expense would mean
higher profits! Similarly, a steep rise in the depreciation would result in the
companys earnings falling below the expected levels, however profitable their

operations
are.
Depreciation is calculated as Cost (minus) estimated residual value / Life of the
asset. A change in any one of these measures cost, residual value or life will
result in a change in the amount charged as depreciation.
There are also two methods of calculating depreciation straight line method and
written down value method. a change in the depreciation policy can also bring
in huge difference in the profits either positively or negatively.
As an investor you need not dig deep into this topic. What you need to
understand is the following points:
Depreciation is an expense
It is a non cash expense. That is, there is no outflow of cash from the
company.
The choices that a company makes in deciding how to amortize and
depreciate and by what amounts will affect its overall appearance of
financial health. The amounts will play probably a large part in determining the
figures on the companys balance sheet. They will also affect the profit figures on
the income statement. These two documents are enormously important in
determining everything from shareholder/investor returns to credit worthiness.
An increase in depreciation also means that the company has acquired new
assets. High growth oriented companies, which are on an expansion spree may
acquire lot of assets in the form of machinery and other fixed assets. So, to that
extent its also a positive sign.
A fall in profits due to increased depreciation expense cannot be taken as a
negative sign if the increase depreciation figure is due to acquisition of fixed
assets
However, if the depreciation figures show material change due to factors
like charging different depreciation rates or due to changes in the method of
calculating depreciation etc You may better be careful.
Since depreciation is an expense that depends on lot of factors, investors
consider the Profit Before Deprecation and Taxes for valuation purposes.
Amortization and depletion are other expenses similar to depreciation thats
non cash in nature.
Amortization is a process that is exactly same as depreciation, for an
intangible asset. We said in our earlier chapters that the business may have
tangible assets like machinery or intangible assets like patents and goodwill.
When tangible assets are written off at a specific rate, its called depreciation and
when intangible assets are written off, its called amortization.
Depletion refers to the allocation of the cost of natural resources over
time. For example, an oil well has a finite life before all of the oil is pumped out.
Therefore, the oil wells setup costs are spread out over the predicted life of the
oil well.
Being non cash expense, these three items decreases the earnings figures
of the company but helps in increasing the cash flow of the company.
It can also have significant effects on tax burden. The less a company
claims as depreciation/amortization, the more profitable the company seems and

therefore the more it will be taxed. Choosing higher depreciation amounts can
provide short-term tax relief.
Where to look
The best place to find information on all this is the schedules to the balance sheet
and notes to accounts in the companys annual report or quarterly results. The
schedule on Significant Accounting Policies will give the method and rates of
depreciation, along with other accounting treatment specifically followed by the
company. The notes to accounts explain the accounting treatment to
The income statement: Difference between earnings and revenues

Lets catch up with the terms Earnings and Revenues- two totally different
terms which may baffle a naive financial analyser.
EARNINGS
Earnings means Profits. Its that simple.
Now, in business, there are different names for it. The most popular being
bottom Line and net income. Its similar to the term net pay or net
income or net earnings or net salary or take home pay on your pay slips.
Just like your take home pay, earnings are the take home pay of a business. It
represents how much money the company has left over, if any, after its paid the
costs of doing business payroll, raw materials, taxes, interest on loans, etc.
Earnings are arguably the ultimate measure of growth of a business. Analysts
want to find companies that are growing their earnings because this is what they
keep after theyve paid their bills. Thats why earnings results reports each
quarter are eagerly awaited by stock investors.
REVENUES
Revenues means The total amount of money a company receives from sale of
goods and services (i.e. receipts BEFORE deducting all expenses). Its also called
top-line or Total sales or gross income. Its similar to the term gross pay
or gross earnings on your salary slip. If you take an income statement,
revenues or sales will be displayed on the left hand side of the statement
(Horizontal format) or on top of the statement (vertical format). When you deduct
all the expenses from revenues the resultant figure is called earnings. Arguably,
top-line growth is more important, but also a more misleading figure than bottomline growth. Its more important in the sense that any earnings growth is going to
have to come from revenues. But its misleading because on its own it doesnt tell
you what the company is actually making in profits. (Since the numbers dont
reflect what the business has to pay out in expenses).
FORMS OF EARNINGS
We discussed earlier about earnings. Its a companys profit. The real issue is
what goes into that income number. There are many flavors: EBT is earnings
before taxes, EBIT is earnings before interest and taxes, EBDIT is earnings before
depreciation ,interest and taxes, EAT is earnings after taxes and EBDITA means
earnings before interest, taxes, depreciation and amortization. In other words,
incomes before those costs have been subtracted.
MEASUREMENT OF EARNINGS -EPS

EPS is earnings per share, or the part of the companys profit that is attributed to
each individual share of stock. EPS is a good indicator of a companys
profitability, and is a very important ratio to look at while evaluating a certain
stock.
HOW IS IT CALCULATED?
The formula for EPS is below.
(Net income Dividends on Preferred Stock) / (Average Outstanding Shares)
In Beginners lessons- Fundamental analysis we have given the formula (Net
income Dividends on Preferred Stock) / Outstanding Shares).You may wonder
why average outstanding shares is used as denominator instead of
outstanding shares . The reason is that EPS is reported over a certain period of
time, and the number of outstanding shares will likely fluctuate in that period, so
you can get a more accurate result by using the average number of outstanding
shares.
WHY IS IT IMPORTANT?
EPS is considered by most investors to be the single most important ratio to use
when evaluating a stock. However, some aspects of EPS can be misleading when
comparing two different companies. For example, one company could use twice
as much capital to generate the same amount of profit as another, but it is
obviously not utilizing its capital as efficiently as the other company. However,
these numbers are not reflected in the EPS, so it is important to remember that
EPS alone doesnt tell the whole story.

POINTS TO NOTE
When you analyse a company for its EPS, keep these points in mind:
You should always compare earnings growth relative to previous years /
quarters. A steady increase in earnings per share is a good indicator of genuine
growth and reduces the possibility that the company just had one great quarter
which might not be sustained in the future.
Current quarterly earnings per share Earnings must be up at least 1020%.
Annual earnings per share These figures should show meaningful growth
for the last five years.
With that we complete our discussion on the difference between earnings and
revenues. I said that quarterly earnings results influence stock prices. But Why?
Why do results for a single quarter cause so much mayhem?
To know the answer, you have read one more simple article: More about earnings
quarter.
Bye for now, have a nice day!
The Income statement: Profits

So far we know that sales less all type of expenses results in profit. We know a
little bit more we know that sales less direct expenses results in Gross profit and
Gross profit less indirect expenses ( including taxes ) results in net profit. In this

lesson we will introduce two more variations of net profit the PBIT , PBT and PAT.
( Profit before interest and tax , Profit before tax and profit after tax)
Gross profit
Companies need to generate a healthy gross profit to cover up indirect expenses,
taxes, financing cost (all indirect costs) and net profit. But how much is healthy?
That varies from industry to industry and from company to company. To analyse a
companys
gross
profit
,
you
need
to
do
two
things
:
1. Compare the Gross profit ratio with competitors in the industry and
2. Compare the Gross profit ratio with the past 5 years ratio.
Comparison with the peers will give you an idea about how competitive the
company is and by comparing the last 5 years ratio will tell you whether the
company is headed up or down.
Operating profit or EBIT
Gross profit minus operating expenses results in operating profit. This operating
profit is also know by another name EBIT. I.e., earnings before interest and tax
(Pronounced as EE-bit). Some companies may write the same as PBIT (Profit
before Interest and taxes). What has not been deducted is interest and taxes.
Why? Because operating profit is the profit a business earns from the business it
is in- from operations. Interest expense depend on whether the company has
taken a bank loan or not and taxes dont really have anything to do with how well
you are running the company. The EBIT will be displayed in the income statement
of any company.
EBT-or Earnings before taxes.
Or profit before taxes (PBT). The term implies operating profit after deducting
interest expense.
PAT/EAT.
Now lets get to the bottom line: Net profit. (Also called Profit after tax (PAT) / or
Earnings after tax (EAT)]. PAT is what is left over after everything is subtracteddirect expenses, indirect expenses, interest and taxes. When the analyst says
the companys bottom line has shown considerable growth what he means to
say is that the companys PAT has gone up. Some of the key ratios used to
fundamentally analyse a company such as Earning Per share and Price earnings
ratio are based on this PAT.
To analyse a companys PAT, you need to the same routine as you did in Gross
profit analysis:
1 Compare the PBT ratio with competitors in the industry and
2 Compare the PBT ratio with the past 5 years ratio.
Comparison with the peers will give you an idea about how competitive the
company is and by comparing the last 5 years ratio will tell you whether the
company is headed up or down.
EBDITABefore we close this section we need to look at one more important version of
profit called EBDITA or Earnings before depreciation, interest, taxes and
amortization.( Amortization is something we havent explained. For the time

being understand that its non cash expenditure.) Some people think that EBDITA
is a better measure of a companys operating efficiency because it ignores non
cash charges such as depreciation.
How to calculate these ratios have been given in the Fundamental analysis
section. For you as an investor , its enough that you take out the EBDITA, PAT and
PBIT figures. A comparison of these figures with the peers a for the past 5 years
would give you a first hand impression about the company.
The Income statement: Understanding the components.

THE 5 COMPONENTS
Towards the end of the last post we wrote that the income statement has only 5
components, they are
1. Sales ( or revenue or income )
2. Direct cost
3. Gross profit (or it could be gross loss)
4. Indirect cost
5. Net profit (or it could be net loss)
So the question that remained to be answered was Why does the income
statement looks complicated if there are only 5 components? We will try to find
the answer in this post. Before we explain that, we need to remember that
Sales direct costs = gross profit
Gross profit indirect costs = net profit.
So, among the five elements, gross profit and net profit are single figures and will
be displayed as such in the revenue statement. That leaves us with three figures
sales, direct cost and indirect costs. The Sales figure should be less complicated
when compared to direct and indirect costs. These statements look complicated
due to the complex nature of businesses done by big business houses.
For example a company like reliance has income from various sources like oil
production business, oil refining and marketing business, petrochemicals etc.
These different segments may be separately shown in their revenue statement
and hence, the first item in their revenue statement sales would show four
different figures and also the grand total of the four segments. When these
figures are shown separately, it looks complicated. Such separate disclosure is
essential for the reader to understand the proportion of income from different
products. Separate disclosure can also be made based on geographical locations
or any other viable separator. There will not be separate disclosure for credit
sales and cash sales. (Recall the matching principle)
COSTS AND EXPENSES
There are two types of expenses.
(1) Directly related to the sale and
(2) Indirect expenses.
All expenses direct or indirect will be deducted from the revenues. By directly
related we mean that such costs are normally directly proportional to the volume
of sales. Direct costs are also known as costs of sales or cost of goods sold.
This figure will be shown separately in the income statement as a deduction from
the Total revenues or total sales figure.

The resultant figure after deduction is termed as gross profit. From the gross
profit that the company has made, it needs to meet all its operational expenses
like advertisement, salary to staff, rent etc.These expenses , which are not
directly proportional to the sales are called indirect expenses. They are also
known as overheads or operating expenses.
Both direct costs and indirect cost also follow the matching principle and hence,
those figures may not represent money actually paid.
CASH AND NON-CASH EXPENSES
At this point it is important for you to understand two more terms which are
required to understand the profit and loss statement completely. They are: (1)
cash expense and (2) non cash expense. Cash expense are expenses which are
payable in cash. Non cash expenses are expenses for which there is no outflow of
cash, but it will still be recorded as an expense. Thats because as far as an
accountant is concerned the term expense has wider meaning and includes
outflow of cash or outflow of other valuable assets or decreases in economic
benefits or depletions of assets
Regardless of whether an expense is cash or non-cash in nature, it will be shown
as deduction from the gross profit in an income statement. So if asset like
machinery is used in business, the proportionate cost of machinery will be
deducted as expense. Technically its called depreciation. Its an expense.
Precisely, its a non cash expense since there is no cash outflow.
Expenses is it good or bad?
If a revenue statement shows too much expenses which affects the profitability of
the company, thats a bad sign. Its important for the management to find out
areas where they can save costs and expenses so that it improves the companys
profitability. Any such steps (for example spotting unnecessary down time in a
manufacturing process) taken by a company is a positive sign.
We now know that expenses can be classified as direct and indirect or as cash
and non cash expense. Expenses can also be classified in many other ways for
example it can be classified on the basis of controllability as controllable and un
controllable expense or based on variability- as fixed and variable expenses.
In a revenue statement, instead of showing all the expenses as one figure,
accountants would show it in maximum detail as possible so that the users,
especially investors, can get further insights into the way in which the company is
operating.
Now we hope you have understood why an income statement looks complicated
at the beginning. Its because, additional details are provided for clarity and
transparency. At the end, any income statement can be trimmed down to just
those five elements.
The Income statement : Understanding the matching principle.

Matching principle is one of the fundamental accounting principles followed by


accountants worldwide. To understand matching principle, we will look at two
business transactions first Transaction 1-

You run a whole sale super market. There is a 20% profit in every sale you make.
There are many retailers who buy in bulk, mostly on credit. One such customer
buys goods worth 5 lakhs on credit, on March 31 (last day of the financial year).
Definitely, you have made a sale. Goods have gone from your go down and the
stock reports will show goods worth 5 lakhs dispatched. Fine. But, on the other
hand, the customer has not paid anything and hence the 5 lakhs sale will not
bring in a penny to your bank account. There is also a probability that the
customer can delay or default in his payments. In such a scenario, can we
consider this as a sale in this financial year? If this is recorded as a sale, your
revenue statement will show an additional 1 lakh as profit for which you are
supposed to pay income tax. Whereas in reality, you have not got a penny.
Transaction 2
On the very same day (March 31st) salary for the month is to be paid. There is a
total of Rs 50,000 to be paid. It is an expense to be deducted from the profits of
that accounting year. But, since salary is always paid on the 5 th of every month,
the amount remains in your bank. Nothing has been paid. Should we add this as
an expense of this year? If this is recorded as an expense, your expense will
increase but at the same time you have not paid a penny from your bank
account.
Whats the right decision?
In the first case, it is a sale and the transaction should be recorded. Thats
because, if we look closely, we will understand that the profit has been already
made although there is a delay in realizing the money. This sale was made due to
the effort of your employees in the month of March. Hence, the second
transaction should also be recorded in this financial year. The salary of 50,000
payable in March is an expense (payment delayed because due date is on 5th)
against the profit of Rs 1 lakh made ( receipt delayed due to the credit policy of
the company) . You actual profit is Rs 50,000, for which you have to pay tax.
If we do not record both these transactions this year, there are two side effectsfor the year ending march 31 , your records will show no sale or profit but at the
same time, your stock records will show an outflow of goods worth 5 lakhs. Next
month, even if you do not make a single sale and close down your business, your
accounts will still show a receipt of Rs 5 lakhs and an expense of Rs 50,000. If this
carries on, your accounts will finally become a jungle of complications.
So, Accountants dont mind if the customer has actually paid the cash or not.
They dont mind if an expense like salary is actually paid in cash or not. If it
pertains to a particular period, they record it in that period itself. In the balance
sheet ( where all receivables (assets)and payables (liabilities) of the company are
recorded for the year) the accountant will show Rs 5 lakhs as an asset (cash)
receivable and the unpaid salary as a liability to be payable.
Now the picture becomes clear for anyone who goes through the revenue
statement and balance sheet. The company has made a sale of 5 lakhs ( will be
shown as revenue from sales in the income statement) against which 20% is the
profit. So the balance 80% is the purchase cost which will be first deducted from
Rs 5 lakhs to arrive at Rs 1 lakh as gross profit. But as they can see in the balance

sheet, the entire 5 lakhs is pending to be received. An expense of 50,000 will be


shown against this profit. At the same time, the balance sheet will show the
expense as a liability payable. Subject to this, the company has made a profit of
50,000 for the year.

Why do accountants do like that?


The reason lies in a concept called matching principle. Matching principle says
that appropriate costs should be matched to the sales for the period represented
in the income statement. Knowledge of this concept is necessary to understand
how accountants arrive at the profit of a business.
Lets take another example. My business performs consulting service for a client
and has billed Rs 50,000 in December 2010 and he pays my bill 3months later on
April 2011. I do not have Rs 50,000 as my income because when I perform the
service, I also incur some expenses in the form of salary, printing, electricity etc
Lets assume that my expenses are Rs 15,000 in total. My profit for the year 2010
is Rs 35,000 and I have to pay tax for that amount- irrespective of the fact that
my client has paid me Rs 50,000 in April 2011!!
This might seem to be strange for Newbies. Think and youll understand. If I dont
match my expenses of 2010 to revenues of 2010, my financial statements
would never show the right picture in any year. It will show a loss of Rs 15,000 in
2010 and a profit of Rs 50,000 in 2011. Although I know the reason, nobody
looking at my financial statement would be able to understand why I incurred a
loss in one year and a huge profit in the next year.
The above is case a very simplified example. Imagine what would be the result
when you have huge volume of bills and number branches all over India? Even I
may not understand what has caused too much volatility.
The above discussion brings us to some realitiesThe sales or revenues or operating income you see in the income
statement is the value of goods sold or services rendered in a particular year. For
example sale revenue of Rs 300 Crores means that the company has actually
sold or rendered services worth Rs 300 Crores. It doesnt mean that the
company has received 300 Crores in their bank account. Some of the customers
may have paid a portion of it.
The profit shown in the financial statements is based on the above sales
figure of Rs. 300 Crores after deducting the expenses incurred. Lets assume that
the expenses (salary etc.) incurred by the company to generate Rs 300 Crores is
Rs 140 Crores. The company has made a profit of Rs 160 Crores in papers. But in
reality, since their clients have paid the whole amount, the profit thats displayed
at the end of the revenue statement is basically an estimate. ( we said that
earlier in our post components of financial statements that profit is an estimate).
The customers have not paid yet, so the profit shown in the statements does not
reflect real money. So, a company can be very profitable and still run out of cash!!
Later, the profit shown in papers will turn into real cash when the customers
start paying.
Lets see one more application of the matching principle If the company
buys a truck in 2010 that it plans to use for 5 years, the full cost of the truck will

not be shown as expense in 2010 itself. Thats because, the company is availing
the benefit of the truck for the next 5 years and hence, the cost of the truck has
to be spread over the next 5 years and should be deducted from the sale
proceeds of these 5 years equally.
The profit and loss account, in fact, tries to measure whether the products
or services that a company provides are profitable when each and every expense
(whether paid or not) is considered. It has nothing to do with the companys
actual cash inflow and outflow.
CONCLUSION
thats matching principle for you. Now we proceed to discuss about the
components of income statement. There are basically only 5 components in an
income statement. These are 1. sales 2. Direct expenses 3. Gross profit 4. Indirect
expenses 5. Net profit. If there are only 5 components, then why does an income
statement look very complicated with lots of figures in it? Well try to understand
all that in our next lesson.
The Income statement: Basics

MANY NAMES OF INCOME STATEMENT


We know that the income statement shows revenues, expenses and profit for a
period of time, such as month, quarter or year. Accountants call these statements by
different names
1.

Profit and loss account or just P & L

2.

Income statement

3.

Trading and profit and loss account

4.

Statement of income/revenues

5.

Statement of operations

6.

Operating results statement

7.

Statement of operating results

8.

Statement of earnings

9.

Earnings statement

10.

P & L statement

11.

Statement of financial performance..etc

WHATS IN A NAME?
We cannot say that its the accountants call to put any name he likes. These
statements assume different names according to the nature of business of the
company. For example a company that has no trading activity ( buying and selling of
goods) or a company involved in service oriented industry, will not have a trading
and profit and loss account simply because, there is no trading activity involved. So a
company like Infosys will have an income statement or a statement of revenues or a
profit and loss account and a company like Reliance will have a trading and profit and
loss account.
In any case, the income statement displays the profit made. However, in the case of
companies involved in trading, it makes two types of profits called -

Gross profit and


Net profit.
Gross profit is the profit made from sales before deducting running expenses. The
only item deducted from sales is the purchase cost of goods that was sold. The
purpose of tracking gross profit is to know the actual trading margin in the business.
Its important for companies to see that the percentage of gross profit never falls.
Net profit is what the company makes after deducting all types of expenses. So, if the
net profit falls, that means that somewhere the cost of operating the business has
increased.
In the case of companies not involved in trading, the Gross profit element will be
missing in the income statement. Only the net profit will be shown. In fact, there is no
gross profit for them since their business do not involve buying something for a
lesser price and selling it at a margin.
So, income statement will be prepared according to the nature of business and an
appropriate name will be given that matches with the nature of business. In the case
of a trading company, the income statement will show the gross profit and net profit
separately.
MANY FEATURES OF INCOME STATEMENT

thats not all. The income statement has many more features. Heres a point wise
collection will help you to understand the income statement better.
The format can be vertical or horizontal: Generally, the income statement is
drawn in a vertical or horizontal format. In whichever way its drawn, the first item in
it would be revenues or sales. This sales figure appearing on top of the statement
is also called top line of the business. (Hope youve heard of analysts taking about
the increase/decrease in topline of the company). In vertical format, each and every
expense is deducted from the revenue figure and finally the net profit is arrived at.
This net profit is also called bottom line in financial lingo since it appears as the last
item in the income statement. In the horizontal format, the sales or revenues are
shown on the right side and categorized expenses are shown on the left side and the
difference between the two will be shown on the right side (loss) or left side
( profit).Charitable organizations / clubs / non profit making voluntary organizations /
association of persons that exist for the welfare of the society etc- may not have an
income statement or revenue statement since they do not exist for making revenues.
However, these organizations do have money flowing in the form of contributions.
Hence, they prepare a statement called receipts and payment account and the
resultant surplus money will be termed as excess of revenue over
expenditure.Which ever way its presented, the basic idea of a revenue statement is
to arrive at the profit. The form is not important.
The time period you cannot draw a revenue statement unless you decide
about the time period for which it is drawn. For example you can find the revenues,
deduct all the expenses and arrive at the net profit for a year, for six months, for a
quarter, for a month or even for a week. The time period has to be decided.
Corporates prepare revenue statement for all quarters and of course, the official
annual report.

Projected and estimated statements: Accountants also prepare projected


financial statements which shows the expected revenues and expenses in
the coming years if the current trend continues. Accounting projections may be made
for 5 or even 10 years forward depending on the use intended. Estimated financial
statements are sometimes prepared to know the expected profits for the current year
if the current trend continues. Projections are basically estimates.
Stand alone and consolidated statements : Big companies (For example Tata
group) which has many subsidiary companies under its control may publish
consolidated financial statements to show the consolidated figures from all its
businesses. Such business conglomerates will also have stand alone statements for
each of their firms.
Provisional and audited statements: In India, The companies Act and the
Income tax Act requires companies to get their financial statements audited by
professional accountants. A financial statement thats not audited is
called provisional financial statements and the one thats audited is called audited
statements. Whats important for an investor is to look at the audited financial
statements. Audited financial statements are included in the annual report and that
is the final official- legal profit and loss statement of the company. The audited
financial statements will be made available to the share holders of the company. The
audited statements of all the companies listed in the stock exchange are available in
the stock exchanges website or various financial sites and newspapers.
CONCLUSION
The income statement is one of the three statements that a stock market investor
should be familiar with. Whats important for an investor is to have a look at the
audited financial statements. Projections, estimates or provisional statements are
made for different purposes and involves a lot of assumptions.
Even the actual financial statement we are talking about is not free from assumptions
and estimates. To understand how income statements are made , we need to look at
an important concept in accounting- called the matching concept.
More about matching concept in out next post.

The components of financial statements

THE COMPONENTS OF FINANCIAL STATEMENTS


In the last article we said that financial statements are prepared on monthly /
quarterly /half yearly and annual basis. Now, irrespective of the time period,
financial statements (or financials as it is called in common parlance) basically
consists of three parts:
1. Income statement or Profit and Loss account

2. Balance Sheet
3. Cash flow statement
Most of the figures shown in the annual financial statements will be in a
summarized form since for example the total of all the assets like machinery,
buildings, plant, tools, vehicles, computers etc will be shown in the balance sheet
as fixed assets. If you want to know about the details of fixed assets, you may
have to refer to the schedule of fixed assets attached with the balance sheet. A
big company may have many more schedules like the one mentioned above.

Introduction to financial
statements
From the last two articles we know that financial statements are part of a broad
report call annual report. Now we proceed to understand what financial
statements are. Law requires corporate entities to keep correct financial records
of all the transactions. This is because; the company does business with the
money of the public (shareholders).In order make sure that these funds are
utilized properly, law makes it mandatory for companies to keep systematic
record of all financial transactions. From these financial records, the annual profit
or loss from the business is ascertained by an independent qualified auditor. This
audited statement forms part of the annual report.
FIRST THINGS FIRST
The very first point you have to understand is that apart from annual financial
statements, these are also prepared on monthly, quarterly and half yearly basis
so that the management has absolute control over whats happening and they
are up-to-date with the financial position of the business. Quarterly statements
will be published every three months, half yearly statements after the end of six
months of operation and the final statement for the whole year will be published
after twelve months of business. Out of these, the full year official audited
statements (or annual financial statements) are the most important ones since,
as said above, it presents the grand summary of business done in a year and its
is also checked and certified by an independent financial auditor.
This doesnt mean that quarterly and half yearly statements have no importance
to the investor. They are important too. Since Quarterly / half yearly statements
provide a summary of what has happened in the last 3/6 months, these figures
are used by analysts to judge whether the companys performance is up to the
mark as expected. Analysts may also make projected or estimated figures using
these statements and predict about the probable performance of the company.
Another important use of these quarterly statements is that it is possible to
compare the performance from quarter to quarter. Such comparisons may reveal
certain important aspects of the business- for example, the seasonal nature of
the business. A companys ability to hit the estimates expected by the investors
every quarter also affects the market price of its shares. For example If the

quarterly financial result of a company exceeds investors expectations, you can


witness a jump in its share price. So all these statements has its own importance.
A WORD OF CAUTION: as said above, analyzing quarterly or half yearly
statements are good. However, it doesnt not mean that you can rely on it totally.
Thats because, its possible that a company that has shown promising results in
the first quarter may face difficulties going forward. Uncertainty is a big factor in
business. Predictions of all the market experts and brokers can go wrong. Why
should we say about brokers? Those CEOs themselves can go wrong in certain
cases.
Now that youve got an idea about financial statements in general, our next
article will explain the components of financial statements in detail.
How to read an Annual report.

An annual report, as mentioned in the last article, contains a wealth of


information on any event that has a material impact on the company. We also
said that you will have to read it carefully in order to dig out those negative
remarks since; it will be generally written in a positive tone. The positive tone in
which it is presented is not meant to deceive the shareholders or the general
public in any way. But, thats the way it is presented amplifying the positive
facts and muting the negative aspects. This piece of advice should be there in the
back of your mind while going through annual reports. The form, layout, pictures,
graphs and colour of the annual report are of less importance. Whats to be
collected is the content those figures, ratios, notes and other bits and pieces of
information that youll be able to gather. If you know how to put everything
together and fish out meaningful information, youre bang on target.
Must reads in an annual report.
You do not have to read the report cover to cover. Thats not practical also. The
first few pages are colourful and it presents a non-technical overview of the
companys objective and how well it is meeting them.
The front section will probably also tell you about the companys strategies,
products and competitive positioning. The chairmans statement or message to
shareholders will also be included here.
The back portion of the annual report is usually filled with financial information
about the company. The real meat of an annual report is in the financial
statements and notes to accounts found in this portion.
The balance sheet, income statements along with auditors comments and notes
to accounts are must reads. Apart from these, the Directors address gives an
overview of your companys operational and segment-wise performance, key
initiatives undertaken during the year, achievements and a financial snapshot.
The Directors report will give an overview of the initiatives taken during the year,
other achievements, awards and a snapshot of whatever milestones the company
could achieve in the past one year.
Many items of expenditure or income may be disclosed in the financial
statements in abstract figures for which break up will be given in the schedules.

There will be a long list of schedules accompanying the balance sheet and income
statements.
The management will also discuss in detail about the industry, factors affecting
the companys prospects, impact of policy changes by the management or the
government, strengths, opportunities, threats, competitors and how well the
company tackles all this.
Other bits and pieces.
A detailed study of the notes to financial statements, allow you to go beyond the
numbers to understand some of the assumptions and accounting policies that
underlie them. For this purpose, we must refer to the notes to accounts, given as
an appendix to the balance-sheet and profit and loss account.
Remuneration given to directors and other managerial personnel, dealing with
sister concerns of the company etc may also find place in the notes to accounts.
Notes can be divided into two parts. The first part describes the basis of
accounting and presentation. It briefs you on estimates used and where foreign
exchange earnings are involved, the basis of conversion. Some of the key points
of information contained in the notes include the position of cash and cash
equivalents, collateral given to various lending institutions and investments in
sister concerns.
The second part provides information on the assets and liabilities position. Here,
related party transactions that show companys dealings with group companies
and associates, are key sources of information.
For manufacturing concerns, the production figures assume significance. The
production figures compared with installed capacity could give you an idea of the
efficiency at which the company is operating .This information is particularly
pertinent if the company is planning further expansion
For newly listed companies, the utilization of the IPO proceeds are disclosed in the
annual report.
Since financial statements are prepared by matching principle an analysis of
the cash flow statement will show the actual flow of cash.
So, next time you get an annual report, look beyond numbers. The financials are
just one part of it. To get the bigger picture, consider reading and analyzing the
above mentioned points.
Understanding Annual reports.

What is an annual report?


An annual report is a summary of all thats happened in the business in a
financial year growth in revenues, new contracts, new milestones, changes in
management team, new appointments of key personnels, future plans etc. It is
prepared by the management and distributed to the shareholders, promoters,
government authorities, general public and to anybody whos interested in the
affairs of the company. Most annual reports are in the form of a book. It runs into
many pages starting from a chairmans message to future plans and prospects.
An annual report is presented in the annual general meeting.

What is a financial year? A financial year is a period of twelve months or less


ending on 31st march in India. It could be any other date-for example, for most of
the European countries, financial year ends on 31st December.
What does an annual report contain?
Typically an annual report would kick off with the letter to the shareholders from
the Chief Executive Officer. It will also contain a list with contact numbers of all
the key board members, auditors, company secretary etc
Then, in the next pages, detailed financial reports like balance sheet, income
statement, supporting schedules, a general report on companys operations, an
independent auditors report etc are given. It will also contain details regarding
the share holding pattern of the company, along with historical share prices
highs and lows, a lot of pictures and graphs, displaying in visual form all the
milestones and achievements the company has made.
You will have to read his report with a shrewd mind because, generally, an annual
report may amplify the positive aspects of the business and give less attention to
the negative aspects. The chairmans report may indirectly contain apologies for
targets missed. The best way to read the annual report is to read it in comparison
with the previous one. When you connect the present report with the previous
ones youll straight away get an idea about what targets have been missed
during the year. That way, youll also get the first impression about the
managements performance.
It may take some expertise and patience to read and understand an annual report
thoroughly. As an investor, it will be very beneficial for you to go through these
reports since; it will give you more insights into that companys operations.
Contents of an annual report:
You should be able to find the following information from an annual report:
Letter from the CEO
Summary of the operations-milestones, achievements, prospects.
Past Annual summary of all financial figures.
Management discussion and analysis of the performance of the company
The directors report.
The balance sheet
The income statement
Auditors report
Subsidiaries, brands, addresses, registered office, head quarters etc..
Names of directors
Stock price history
Conclusion
Annual reports are a collection of important informations that may be vital for the
investor. Our next article would tell you on how best to read them and what to
look for.