Understanding Basic financial statements.

I decided to write this article because many of my friends and contacts always ask me how there can start buying stocks and how they can understand what they are buying. I believe knowing how to read a financial statement is the first step in understanding what you are buying. I believe anyone that reads this article will have something to gain as no knowledge is a waste, at that same time I encourage you to share with friends, especially those with a very little background in Equity. Financial Statements are very crucial to businesses because that is how to know activities going on in the business and the performance of the business. Normally, the law requires public companies to release their financial statements to the public quarterly and annually in most cases. This article is going to be mainly for those with little or no understanding of the statements and how to make use of them while making investment decisions.

According to Wikipedia, Financial statements (or financial reports) are formal records of the financial activities and position of a business, person, or other entity. Let me explain what they mean. most times, you cannot really determine what is happening inside a company except if you are an insider (someone that is part of the company with a high-value position). Sometimes, even when you are part of the business, you can only manage to know some things that are happening outside your department. Investors and shareholders depend on the financial statements as well to make their decisions on whether to be part of business ownership. These statements are what allow you to understand if a company is making a profit or if it is losing and if the company is using their money wisely. Normally, financial statements are prepared using standards that accountants adhere to and it is normally audited to ensure credibility.

We have three major financial statements, the balance sheet, profit and loss statement and the cashflow statement. The three are equally important to investors and carry different information you can fuse together to generate important information about a company’s financial status. We will go ahead to discuss the three important financial statements and what a value investor is looking for in them.

1.     Balance sheet:

The balance sheet typically shows you the financial position of the company, it contains the assets (what the company owns), liabilities (what the company owes) and equity (which is the difference between the assets and liabilities). Equity on the other hand also represents the ownership of the company or the investor’s stake. Discussing the balance sheet alone can take a whole article to do, but I will try to point out the important sections and what you should be looking out for in the balance sheet. In the asset section of the balance sheet, we have what we call the Current and non-current assets. I will use the VitaFoam balance sheet for an easier illustration of the things I will be pointing out.

If you look closely, you will see the non-current and the current side of the balance sheet. You will notice that things like inventories and Cash are on the current side of the balance sheet. It illustrates the definition of the current asset as assets that can be easily liquidated or converted to cash. While non-current assets are the opposite. There is also the liability side of the part of the balance sheet that contains the current and non-current liabilities as shown below. Equity is also considered to be part of the liabilities side of the balance sheet. As I said earlier, adding the equity and liabilities together should always equal the company’s assets.

Now, what should a value investor be looking out for in a balance sheet? I will point out some of them below.

The first is how much capital the business needs to run. you can find out by looking at their working capital and as well as they fixed assets. Secondly, where the capital is coming from? It is important to know where most of the capital come from, the source can be debt (the money the company borrowed at interest). Debt can be a good thing since most businesses leverage debt capital to undertake new projects. However, it can be a red flag as well, especially if the company has a high debt with no justifiable investment to account for the borrowing. Some Executives borrow money to pay themselves huge bonuses as well, so is a good thing to be very keen on understanding a particular debt situation. Another source of capital can be through equity, a company can raise fund through the public through the IPO process and secondary offers is another good way of raising funds too. Finally, companies can get float capital too. That is money coming from customers, employees or the government as well. In addition, the balance sheet can also be handy in calculating inventory turnover which is how often you are using your inventory to generate revenue. Although it requires you to combine inventory from the balance sheet and the cost of goods sold from the profit and loss statement. There is other information you can derive from the company’s balance sheet, which is important as well. I have only compiled those I felt is very valuable for many stock investors.

2.     Income Statement (profit and loss statement).

The income statement shows how much the company makes over a period of time. That is all the revenue coming into the company and also the cost that is associated with generating that revenue over that period of time. The cost can be in form of depreciation (loss of value), in form general expenses and the cost of acquiring raw materials. Let us say a business produces bread in Nigeria, we are talking of the cost of buying flour, buying fuel for electricity, paying staff etc.

From the Vitafoam income statement, you can see their revenue over the year period increased reasonably. Things you should note include the fact that their revenue grew by an impressive 49% for the company. At the same time, the cost of sales increased by 68%, which means that their cost of production is growing faster than their revenue, if it continues like that it will at some point eat up the revenue. Which in most cases is not a good thing, except there is a particular macroeconomic reason for the occurrence. Also, the gross profit is gotten by subtracting the Cost of sales from the revenue. Also, when you take out R&D cost, marketing cost and depreciation from the gross profit, you will get the operating profit. The final earning (net profit) is gotten by removing taxes and interest from the operating profit.

Some important use of the income statement includes seeing the trend in revenue and profit growth. It also helps to evaluate if a business has operating leverage. Operating leverage in the sense that the profit is growing faster than the revenue. In such a situation, it means that the business is optimizing its operations and that the management is efficient. We also have the earnings per share, which is dividing the profit by the number of shares the company has. Normally you should compare it to the industry average to know if the company is underperforming or overperforming. It can also help you in estimating the value of the business. There is other important information about taxes and interest that you can also lift from the income statement as well.

3.     The Cashflow Statement.

The cash flow statement normally shows the movement of cash in the company. It can help you understand when a company is posting an audio revenue. When I say audio, what I mean is that the company might be posting revenues for goods sold on credit (the company is yet to receive payment). A cash flow statement is a very confusing statement but to put it in simple terms, it is the statement that tells you why the increase in cash is not equal to net income.

If you look closely at the cash flow statement, you will see things like the cash from the operation, cash from investing activities and cash from financing activities. The cash flow from operations shows you how much the company is generating from its operation. You will see if the company is investing or carrying out a capital-intensive project by looking at its cash flow from investing activities. Then have the free cash flow, which is the cash the company has after settling everything and even making investments. A company with enough free cash is a good thing because it allows the business to pursue new opportunities. However negative free cash sometimes can mean that the company is making a huge investment which is impacting its cash flow. But generally, companies with enough free cash are more desirable.

I must add that there are some important ratios you can also calculate from these financial statements like the Price to Earnings ratio, Acid ratio and the rest which are also helpful in understanding business performance. I believe the information here is already a lot for a beginner. I will appreciate your feedback on this article and will also appreciate that you share it with your friends too.

Uchenna Jochez.