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How to read a profit loss statement and understand the financial statements or balance sheet of a company
The financial statements of a company
are a mirror of its financial health. It is not surprising that studying them
is an integral part of fundamental analysis. While analysts scrutinize the
financial statements deeply and try to find out the real aspects of the
financial aspects of the company, understanding the basic financial statements
should in most cases be necessary for an investor. Here we are going to tell you how to read a profit loss statement.
Financial statements contain three
major financial statements.
1. Balance sheet,
2. Profit and loss statement
3. Cash-flow statement.
The balance sheet gives you an idea
of the assets and liabilities of any company. The profit-loss statement makes
you aware of the profitability of the company. And the cash-flow statement
describes the flow of cash in and out of a company.
Balance Sheet
The balance sheet is called important
because it always balances according to this relationship: Assets = Liabilities
+ Owner's Equity. A balance sheet that is not in a balanced state is incorrect.
The balance sheet shows all the assets that a business owns, liabilities that
it owes and funds that are contributed by its shareholders.
Assets include land, equipment,
goodwill, inventory, patents, brand value, etc. Liabilities include both
long-term and short-term debt and any other liabilities that a business has.
The shareholders in the balance sheet are always in the form of fund equity and
reserves.
A weak balance sheet is one in which
the company is debt-ridden. Whenever a business has a strong balance sheet, it
has more assets and equity than liabilities. To know the balance-sheet
strength, you don't really need to see the entire balance sheet, you can only
look at the debt-equity ratio.
Profit and Loss Statement
Before knowing how to read a P&L statement, we need to know what is a profit and loss statement. So let's start understanding P&L and balance sheet. As its name suggests, the profit and
loss statement tells you about the profitability of a company. The simple
formula to calculate profit is profit or loss = total revenue - total
expenditure. There are generally two types of entries in revenue: revenue from
sales and other income. Other income is revenue received from sources other
than the main area of operation of the company. For example, it may be other
income from investments, dividends, royalties, etc.
The head 'expenses' constitutes the
categories of expenditure such as cost of raw materials, employee costs,
transportation etc. When we subtract total costs from total revenue, we get
'operating profit', which is nothing but profit from the company's main
operations. To arrive at the final profit figure, we must add or subtract any
miscellaneous income or loss from operating profit. Finally, net profit is
obtained after the currently applicable tax deduction.
Cash Flow Statement
The best tool to understand financial statements is cash flow statement and we will now talk to you how to read a cash flow statement. The cash-flow statement refers to the
movement of cash in a company. While businesses can misstate their profits
through hacking-panky, they cannot stop the movement of hard cash. Therefore,
the cash-flow statement provides accurate information about the financial
health of any company. However, for banks and finance companies, the cash-flow statement is of limited use because they follow a different business model than
other types of businesses. The current cash holding of the business is also
mentioned in the statement of any company.
The cash-flow statement has three
components:
1. Cash flow from operating
activities,
2. Cash flow from financing
activities, and
3. Cash flow from investment
activities.
You need to check in the data whether
the flow from operating activities is positive or negative. If they are
positive, this means that the company is capable of generating cash through its
operations. If they are negative, it means that the company is losing its
money. While it may show profits in its P&L statement, negative flows from
operations should sound a warning alarm. Cash flows from financing activities
represent funds raised for the operations of the company or paid for debt
repayment. On the former statement, it will be a positive number, while in the
latter it will be a negative number.
Cash flow from investment activities
captures the cash used in investment. For example, a business that has
generated surplus cash may place it in bank fixed deposits. Next year it can
withdraw cash from that fixed deposit. On the former statement, it will be a
negative number, while in the latter it will be a positive number.
The balance sheet, profit-loss a statement, as well as the cash-flow statement, contain essential data for
investors wishing to invest in a company. The ratios used in analyzing a
company's stock also require the data and data contained in these statements,
without which in-depth analysis is impossible. All these statements can be
found online along with the annual reports of the companies.
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