Financial Reports- The place where it all begins
In the previous blog, we discussed how we should go about interpreting the fundamentals of the company and what inference we should draw from them to make sound and informed investment decisions. However, while making decisions we need to find the correct data to analyze and interpret. Identifying correct sources of data is detrimental to an investor’s ability to keep making correct decisions and keep his performance a factor of data analysis rather than pure luck. Now, the question arises how does one find correct sources of data to make all the decisions we referred to in our previous blogs? The answer to that lies in the financial reports of the company.
Financial reports are the documents filed by the companies to the regulators and the investors. They contain all the financial information of the company during a particular period and hence provide the necessary data to the investor to make more informed decisions. Financial reports are certified by the auditors of the company. To check the authenticity of the financial statements one must read the auditor’s report. If the auditor reports state that the statements are correct, by and large in almost 95% of the cases, the investor can trust the authenticity of the reports.
The 3 basic financial reports that contain most of the information for the investor to analyze are:
- Balance Sheet- The balance sheet contains information about the assets and liabilities of the company. Assets are what the company owns that have some current or future economic value. Examples of assets include buildings, land, debtors, investments, and cash. The other side of the balance sheet contains what the company owes to its shareholders and creditors. This site is known as liabilities and capital. Note the distinction between the two. The liabilities side contains what the company owes to its creditors and the capital side contains what the company owes to the owners i.e. the shareholders and the people who have invested in the company. The balance sheet provides basic information about the company’s financial situation. Usually, you would prefer that the liabilities of the company are lower than the capital of the company. Here you can judge the capital structure of the company to identify whether it has more or it owes more.
- P&L Statement– The P&L Statement contains all the details about the revenue and expenses of the company. Revenue refers to the money that a company earns from its various activities while the expenses show the amount company spends to maintain its day-to-day activities and to earn the revenue. As an investor, you would always prefer a company whose revenue exceeds the expenses. Now in revenue, there are various sub-categories. The one that the investor should most focus upon is the revenue from operations as it focuses on the business activity of the organization. Revenue from operations must form the bulk of total revenue generated as it indicates the business is reliant on revenues generated from its core activity. The rate of revenue growth must always be higher than expenses and the same must be viewed as a sign of competent management. One can also assess the quality of the business by looking at the total profit and total revenue. The higher the percentage of profit in revenue the greater is the quality and durability of the business.
- Cash Flow Statement- The cash flow statement is perhaps the most important financial statement and holds the greatest relevance for investors eyeing durable businesses to hold for long periods. It measures the cash generated by the business over a particular period. Here cash and profit are different terms. We will be going more into detail about these terms in our upcoming blogs. For now, the investor must understand that cash and profit are different terms due to a difference in measuring them due to accounting principles. A business that generates a lot of cash is an ideal investment for the long-term investor and such companies can be viewed as attractive potentials for building a long-term portfolio. The cash flow statement is also used to analyze management competency, business quality, and the overall health of the enterprise. Due to the depth of info, it provides to the investor the cash flow statement is the most wholesome financial statement and the one to study with the greatest detail.
While the investor analyses the above reports one must also keep in mind that all these reports are generated from the art of accounting. Accounting is affected by management bias, principles, and sometimes the selfish interest of the promoters. There are subtle limitations to each financial statement and hence none of the statements must be viewed in isolation. An investor must use all the 3 financial statements to see if one thing confirms the other. For example, a rise in profit should be accompanied by almost a similar magnitude of the rise in the cash generated. It is by using the 3 financial statements that the investor can make a sound and potentially rewarding investment division.
Due to the inherent complexity in the financial statements, we will be discussing each of them in detail in our upcoming blogs. In the next blog, we will discuss the balance sheet in detail.
Until next time!
By- Akshay Vyas