It is said that ‘never judge a book by its cover’. However, a company can always be judged by its financial statements. The financial statements of a company are like a window to all its happenings. They not only present profitability as well as working status but also highlight the future goals and aspirations. Hence, the first judge to the success of any company shall always be its financial statements.
Financial statements basically comprise of three statements: Balance sheet, Income statement and cash flow statement. Apart from these, other additional statements that are also a part of the group are Changes in equity and Notes to Accounts.
Discussing the three main statements in more length below –
The balance sheet of a company, on broad terms, basically talks about the assets and liabilities existing for a given financial year. The first and only rule of the Balance sheet is, the total of both the sides should always match i.e. Assets = Liabilities.
Assets basically mean the resources of any company which can be used for business and help in the generation of cash. Assets can be bifurcated into Tangibles and Non Tangibles.
– Tangible asset means any asset which can be touched and is in a physical form. This includes Fixed Assets such as Land, Building, Both tangibles and fixed include fixed assets of the company such as land & building, machinery, and equipment, etc.
– Non-tangibles, on the other hand, shall include intangible assets such as goodwill, patent, copyright and Current Assets such as debtors, bills receivables, bank, cash, etc. Since these are not in physical form, these are either purchased or valued as per market or trade conditions.
Liabilities mean all the obligations or the debts a company owes because of any transactions undertaken in the past. The liability side of the balance sheet is opposite to the asset side.
It can be further segregated into Shareholder’s Equity, Long Term Liabilities and Current Liabilities.
Shareholder’s Equity shall be the combination of Share Capital of the company (when the shares are issued) or simply Capital (brought in by the entrepreneur or partners) for laying the foundation of the company as well as Retained Earnings.
Long Term Liabilities include obligations which are not payable in a year’s time such as Bank Loan, Mortgages, Debentures issued, etc.
Current Liabilities are those obligations which are repayable within a year such as creditors, bills payable.
Working Capital is another major component which should be looked upon in a balance sheet as it states the day to day working conditions of a company.
Working Capital is equal to Current Assets – Current Liabilities. Positive working capital is mostly desired. A negative working capital reflects liquidity crunch as well as hindrances being faced to carry on everyday business activities.
The income statement of a company talks about all the major expenses and incomes incurred and are usually repetitive in nature. Expenses and incomes include both notional as well as actual since the accrual system is followed for preparation of financial statements.
Major components under the Income side would be Gross Income. All the revenue earned from the primary activities of the company shall be reported under this head. This shall form a subhead namely Income from Primary Activities.
Any other kind of income earned from sources other than primary sources i.e. secondary sources shall be reported under the subhead Income from Secondary Sources. For example, dividend received, rent received, etc.
Another subhead shall be Gains in case of situations where any shares or land, building, equipment are sold at profit. There are other heads too forming a part of income statement but can be specific to large scale companies as compared to small scale industries which are fairly simple in reporting as well as functioning.
The complete opposite is the Expenses sides. It can be segregated as per primary and secondary activities and losses incurred. All the expenses which are actually incurred as well as which are notional in nature shall be reported here.
Cash Flow Statement is the last major segment in financial statements. The main purpose here is to report the generation of cash and where it is being used. It is like a cash ledger however, the activities are divided into three categories i.e. Operating, Investing and Financing.
Operating activities include all the day to day activities where the cash is used and is required for business operations. All notional expenses which are non-cash in nature but are recurring shall also be taken into consideration.
Investing activities include asset purchases such as land & building, machinery, equipment, etc. It also includes selling of these assets as they bring in cash.
Financing activities involve issuing and buyback of shares, dividends received or paid or any other activities undertaken for financing the business.
In the end, the net balance from all the three heads is added up to find the cash balance at the end of the financial year.
Thus, summing this up, financial statements give us a three-dimensional view of a company’s existing status and is a report card for its performance.
This is the first article in a series of ‘Understanding the financial statements in detail’ series. In the next article, we will look into the Income Statement along with examples.