Sunday, June 25, 2006

How to read financial statements - the very basics

A company's financial statements consist of three separate statements that attempt to describe how the company has performed during its fiscal year. The three statements are

1) the balance sheet (BS)
2) the profit and loss statement or the income statement (P&L)
3) the cashflow statement (CF)

The balance sheet lists out what the company owns: its assets, what the company owes to other entities: its debt, and what is left after its assets are subtracted by its debt: the shareholders' equity, or the book value.

The P&L statement starts with sales or revenue and deduct all sorts of cost from revenue until we arrive at net income, which ultimately goes into shareholders' equity on the balance sheet.

The cashflow statement describes how cash has actually been received and deducted from the company, which is usually different from actual profit gained and loss incurred. It links the P&L to what has changed in the balance sheet. One major item that affects cashflow and income differently is depreciation. Depreciation is treated as a cost in the income statement, but it has no actual cashflow impact.

To use a Singaporean household as an example, the BS will list down the household's assets, liabilities and equity. Assets are HDB flat, car, cash savings, surgically enhanced waistline, chin, double eyelids etc. Liabilities are mortgage, renovation loan, study loan, credit card debt, children, pets etc, and equity is what is left. Sad to say, 70% (my own guess) of Singaporean households probably have no equity to speak of, because our liabilities (mortgage, car loans) are usually much more than our assets (value of our flat, car etc).

The P&L statement of the household will be salary on the top (sales for companies though), followed by all the expenses (food, transport, utilities, deduction to NKF, parking fines, Toto etc), until we arrive at net income, which could be added to the BS at the end of the month or year (i.e. any money left after all expenses goes into savings = equity for the household).

The cashflow statement would be actual cash movement, i.e. salary that was transferred to our bank (cash inflow), how we have spent the cash on food, pirated DVDs, useless souvenirs from tours etc (cash outflow).

To analyse a company, all three statements are important and it will be very helpful to be well versed in reading them. I will be posting on how to read each statement in the future, watch this space!

See also P&L Statement
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