Financial statements are written records that give an idea about a company’s overall financial performance and health. They are guiding lights for an investor, lender, or any other stakeholder who wants an insight into how the business is doing. And hence, it is important to understand how to analyze financial statements to make a proper decision. There are three financial statements, namely, Profit and Loss Statement, Balance Sheet, and Cash Flow Statement. Now, we’ll take a look at what each of these means.
Profit and Loss Statement
Every business either manufactures a product or provides a service. For this, it incurs various costs such as raw material costs, employee salaries, fuel and power costs, among many other costs. But ultimately, businesses are about earning profit for the shareholders. By selling the product or service, a business generates revenue or income. A profit and loss statement is basically a record of these incomes and expenses. When you subtract the expenses (costs) from the income, what you get is the net profit of the company. Let’s take a look at the Profit and Loss Statement of Infosys Limited, an IT services firm, for financial year ended March 31, 2019. Now, what does it mean? Basically, it’s the record of the income generated and costs incurred throughout the financial year that ended on March 31, 2019.
You can see that the total income generated is ₹ 73,107 Cr;
And the total expenses (excluding tax expense) are ₹ 56,032 Cr.
When we subtract these expenses from total income, we get
Profit Before Tax (PBT) = Total Income – Total Expenses
= ₹ 73,107 Cr – ₹ 56,032 Cr
= ₹ 19,927 Cr
We all know that everyone has to pay income taxes and businesses are no exceptions. After subtracting the tax amount, we finally arrive to the value of net profit of the company.
Net Profit or Profit After Tax (PAT) = PBT – Tax Expense
= ₹ 19,927 Cr – (₹ 5,189 Cr + ₹ 36 Cr)
Net Profit = ₹ 14,702 Cr
This statement is indicative of the financial performance of the company i.e. how well has the company managed its resources to generate profits.
To understand what a balance sheet is, let’s think of a company that manufactures automobiles. To manufacture the automobiles the company will require land, a factory, machinery and other equipment. These are the assets that a company owns which are essential for generating income for the company. But quite obviously, to purchase these assets, the company will require huge sums of money. So where do the companies get the money from? They either borrow from lenders (by issuing bonds or through loans from banks) or seek money from the business owners. Eh, Wait!! But why would companies seek investments from the business owners? Well, that’s because in accounting practices, a business and a business owner are considered separate entities.
Now, let’s come back. Eventually, these lenders would want their money back and the business owners would want high returns on their investments. So, the company is under an obligation to repay the debts and generate high returns for the owners i.e. shareholders. The money borrowed from lenders is termed as liabilities and money invested by owners is called as the equity capital or shareholders’ equity.
The balance sheet is nothing but the record of these assets, liabilities and shareholders’ equity. Assets can also be called as “what the company owns” or “application of funds”, whereas, liabilities and shareholders’ equity are known as “what the company owes” or “sources of funds”. The liabilities and shareholders’ equity are used to fund the assets; therefore, it is imperative that the sum of all assets be equal to sum of all liabilities and shareholders’ equity.
Assets = Liabilities + Shareholders’ Equity
Let’s take a look at Tata Motors’ balance sheet. You can notice that the value of total assets of the company is equal to the value of total equity and liabilities.
As on 31st March, 2019,
Total assets = ₹ 60,909.63 Cr, and;
Total Liabilities = Non-current Liabilities + Current Liabilities
= ₹ 15,806.30 Cr + ₹ 22,940.81 Cr
Total Liabilities = ₹ 38,747.11 Cr
Note that, Equity = ₹ 22,162.52 Cr
Now, when we add total liabilities and equity, we see that the value is ₹ 60,909.63 Cr, same as the value of total assets. Also, notice that the balance sheet is recorded as on March 31, 2019, which means that it shows the cumulative value of assets and liabilities since the inception of the company till March 31, 2019.
Cash Flow Statement
A cash flow statement indicates the ability of a company to generate cash to fund its operating expenses, repay its debt obligations and fund investments. You might be thinking, we just calculated profit in the profit and loss statement which can be used to fund all these requirements, why do we need another financial statement? That’s because profit and cash are not the same thing in accounting. Profit is arrived at after subtracting non-cash expenses from the total income. Non-cash expenses are expenses that do not result in outflow of actual money from the company. Depreciation is one of the non-cash expenses. Confusing, right?
Remember that we came across assets in the balance sheet. So, when a company buys an asset, say a machine, it does not record the money that goes out of the company as an expense because, the machine will continue its role in production for years. Therefore, it is illogical to record its cost at once in the profit and loss statement. So, we depreciate the value of the machine every year i.e. reduce its value by a certain amount. The amount by which the machine’s value is reduced is called as depreciation which is recorded as an expense. However, it is only an accounting entry and cash does not actually go out of the company, as the machine has already been paid for.
Due to these reasons, profit is different from cash flow. Cash flow represents the actual cash generated by the company i.e. the amount obtained after non-cash expenses are added to net profit.
Cash Flow = Net Profit + Non-Cash Expenses
Now, let’s come back to cash flow statement. The cash flow statement comprises of cash flow from three types of activities, namely, operating, financing and investment activities.
Cash flow from operating activities: It is the cash flow generated from the company’s operations i.e. by running the business and selling its products or services.
Cash flow from financing activities: It is the cash flow generated from the company’s financing activities such as borrowing from banks, owners.
Cash flow from investment activities: It is the cash flow generated from investment activities such as sale or purchase of fixed assets, loans repaid by customers and investments in merger and acquisitions.
Take a look at the cash flow statement of Tata Motors below.
The total cash flow of a company can be mathematically, written as:
Total Cash Flow = Cash from Operating Activities + Cash from Investing Activities + Cash from Financing Activities
Let’s substitute the values of various cash flows in the aforementioned formula.
Total Cash Flow = ₹ 18,890.75 Cr + (₹ 19,711.09 Cr)* + ₹ 8,830.37 Cr
[*Note that the brackets represent outflow of cash, so the value will be subtracted]
After, doing the arithmetic, we get,
Total Cash Flow = ₹ 8,010.03 Cr
A positive cash flow is a positive sign, it means that the company may be able to run the business in the future.