
In our 2nd part of How to Read Financial Statement Series, we will further discuss about What to understand from Financial Statements and How to Read Financial Statements?
To understand the fundamentals of Financial Statements, Click on the link mentioned below https://www.advisorprabhash.com/post/do-you-know-how-to-read-financial-statements
We can draw a lot of information from the financial statements as there is so much depth to study. By studying and analyzing the revenue part in profit and loss account, one can analyze many ways like year-to-year total revenue trend, and segment-wise revenue analysis. Now these segments may be location-wise or product-wise, quarter-to-quarter revenue analysis, profit or loss-making segment analysis, and so on. Therefore, here we have identified 6 key components which should be understood by a common man while reading financial statements and these are -
1. Financial Health of the Company: Financial statements provide insights about the financial health of a company. Financial condition or health may be understood by reading and analyzing Balance Sheet along with notes to account such as:
a. Identifying source of fund: A company may source fund for its business either by issuing shares, debentures or by borrowing secured or unsecured loans.
b. Identifying application of fund: The fund sourced by the company may be utilized for different purposes like acquisition of fixed assets, investments, repayment of debt, and working capital management etc.
2. Valuation of a Company: Financial statements provide significant help to determine the value of a company. Financial statements provide the relevant data to use a variety of valuation method such as Asset-based valuation, Income-based valuation, Market-based valuation, Discounted cash flow (DCF) analysis.
These method use:
Data of assets and liabilities from balance sheet,
Revenue, expenses, gross and net profit from profit and loss account.
Cash inflow and outflows from cash flow statements
Other relevant data from the notes to account including business plan and future prospective of the company.
3. Growth of the Company: By comparing the revenue/ turnover of the company for past 3-5 years from the profit and loss account, a trend in the growth of the company may be understood. If revenue is growing, then it is a good sign of growth of the company and it can further be analysis by segment report to understand which segment is growth and how company is doing with the competitive segment.
4. Profitability of the Company: Generating profit is a good sign of increase in value of the company as profit either distributed to the shareholders in the form of dividend or retained as general surplus which increases the value of owner’s equity and company. Profit of a company can be taken from the profit and loss statement to compare with the previous year’s profit and understand a tread.
5. Liquidity of the Company: Liquidity refers to the ability of a company or organization to turn its assets into cash, as and when needed. Liquidity is important for a company because it allows it to meet its short-term financial obligations, such as paying its bills and salaries.
There are a number of ratios that can be used to measure a company's liquidity such as –
a. Current ratio: The current ratio measures the company's ability to meet its short-term debts. It is calculated by dividing the company's current assets by its current liabilities. A current ratio of at least 1 means that the company has enough assets to cover its short-term debts.
b. Quick ratio: The quick ratio is similar to the current ratio, but it excludes inventory from the calculation. It is calculated by dividing the company's current assets (excluding inventory) by its current liabilities. A quick ratio of at least 1 means that the company has enough assets to cover its short-term debts, even if it cannot sell its inventory.
c. Cash ratio: The cash ratio is the most conservative liquidity ratio. It measures the company's ability to meet its short-term debts with cash and cash equivalents. It is calculated by dividing the company's cash and cash equivalents by its current liabilities. A cash ratio of at least 1 means that the company has enough cash and cash equivalents to cover its short-term debts.
6. Financial Leverage and Solvency of the Company: Financial leverage is the use of debt to finance a company's operations. Debt can be a useful tool for businesses, as it can allow them to grow faster and achieve greater profits. However, debt can also be risky, as it can increase a company's financial exposure. Solvency is the ability of a company to meet its long-term debts and financial obligations. It is a measure of a company's financial health and its ability to continue operating in the future. Financial leverage and solvency can be measure using the ratios such as
a. Debt-to-equity ratio: This ratio measures the amount of debt a company has relative to its equity. A high debt-to-equity ratio is a sign that the company may be having trouble meeting its debts. Ideal debt-to-equity ratio depends upon the industry and the company's specific circumstances, generally, debt-to-equity ratio of 1 or less is considered to be healthy.
b. Interest coverage ratio: This ratio measures the company's ability to cover its interest payments with its earnings. A high interest coverage ratio is a sign that the company is generating enough cash flow to repay its debt obligations.
c. Debt-to-assets ratio: This ratio measures the amount of debt a company has relative to its assets. A high debt-to-assets ratio is a sign that the company is using a lot of debt to finance its assets.
To sum it up, you can get a better understanding of a company's financial health and performance by understanding the information in financial statements and using financial ratios. This information can be helpful for making investment decisions or assessing a company's creditworthiness.
This is not an exhausting way of either reading financial statement or taking key notes from these, as we discussed earlier there is so much depth to study and we will be discussing these in detail in our upcoming blogs.
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