Financial Statements: Demystifying the Basics
Some things in life appear more difficult than they actually are. Analyzing a company's financial performance is simply one of them. Many a time we come across people who completely depend on others for their investment decisions, which can have far serious implications. Although it looks like an uphill task to many, company analysis is actually no rocket science. A little understanding of the fundamentals and an elementary logic is all it takes to identify the potential of the companies.
Firstly, you should be aware of the business of the company you have invested your money in or intend to invest. Its history, vision, products and services and its business model will give you necessary details regarding the functioning of the company. A thorough study of its introduction in the annual report, company's website and of course the internet will easily furnish you loads of information. So, if you are unable to forgive the way the company operates or its growth prospects, it is better to stay away from the stock. Herd mentality is definitely not advisable for a long-term investment.
Once you have a sound understanding of the company's operations and revenue earning methodology, turn to its financial statements. Again, this can easily be accessed from the company's website. There are three financial statements which are the Comprehensive Income statement, Balance Sheet and Cash Flow.
The Income Statement shows the revenue earned for the period, the expenses incurred for earning the revenue and the resultant after meeting statutory obligations is known as the net profit / retained earnings or loss. It is on this amount that the company declares a dividend to the shareholders. The comparative analysis with past period statement helps you to analyze how the company is performing. The most important areas of focus in the statement are the ratio between net profit and sales (also known as the net margin) as well the gross profit and sales (also known as the gross profit margin). The higher they are, the better it is. Furthermore, other areas that deserve a check are the direct cost components, which are the major costs driving the business. This will differ for each company, according to the industry it operates.
Then it's the Balance Sheet, which is a statement of the sources and application of funds as on the last day of the period. As a rule of thumb, the sources of funds must be equal to the application. You can ascertained the financial position of the company by examining various ratios like the Debt-Equity ratio and Debt-Asset ratio. A high proportion of debt implies that the company is financing its growth by borrowing aggressively. This is only justified if the revenue of the company also shows a significant growth. More debt also charges increased interest expense, so the quantum of growth in revenue should be more than that of interest, or else it will less the earnings. Also, this ratio depends on the sector which the company belongs to. Manufacturing companies usually are more leveraged than service oriented companies. Meanwhile, the ratio between the current assets and current liabilities, ascertains the liquidity of the company.
The last one is the Cash Flow Statement. Showing the movement of cash for the period, this statement is divided into three sections which are cash from operating activities, cash from investing activities and cash from financing activities. You can very easily comprehend the cash position of the company with respect to the three main activities. The strong company derives more cash flow from operations than from investment or financing activities. The operational cash is the direct indication of the organic growth of the company.
Lastly, it is imperative to compare the financials of the target company with other companies in the same industry. Only then will you have a lucid idea about the performance of the company. Whether the change in financials is due to industry related factors or specific to the company can be easily determined.
While, there are other parameters to judge the overall performance of the company, a strong hold on its financial performance is the first and major step in this direction. By unearthing the stories behind these numbers you can really empower yourself to judge the prospects of your portfolio.
