Introduction to Financial Statements

Financial reporting refers to the way companies report their financial performance to investors/shareholders, creditors, and other interested parties. A more colloquial way to describe financial statements is the way a business communicates with all its interested and potentially interested stakeholders.

Financial statement analysis plays a vital role in fundamental analysis as it helps provide a picture of the workings of the business and aid in critical decision-making. Investors, creditors and even tax authorities rely on these financial documents to assess the business and take critical decisions. Examples of decisions include whether to invest a company’s securities or whether they should be recommended to investors.

Financial statements also act as a reality check - whether promises made by the management are reflected and can be verified by the numbers. Analysts use all the available data, past and present, and from each of the financial statements to try and assess the company - its strength in the market, its ability to earn profits, generate cash flows, weather business cycles, etc

Three key financial statements every analyst must learn to understand in great detail are - the income statement (also called the Profit & Loss statement), the Balance Sheet, and the Cash Flow.

Before we dive into the income statement, let’s take a quick look at what each of these statements helps us understand.

1. Income statement: Helps assess the overall profitability of the company. Investors can understand the overall business generated by a company over the year and the necessary costs incurred to produce those revenues
2. Balance Sheet: Helps understand the financial position of a company as on a particular date. Unlike its peer statements, balance sheets are as on a particular date (the other two are for a period). They present a collective picture of the business, including what the business owns (assets) and what the business owes (liabilities) as on a particular date.
3. Cash Flow: The cash flow statement similar to the income statement, helps understand the kind of cash profit the business generates from its various activities. Unlike the income statement, it excludes non-cash items like depreciation and focuses only on the inflow and outflow of cash in the business. Beyond operations, it also looks at the flow of money in and out of the business via investing and financing activities.

Finally, let’s look at a very basic, albeit important financial statement analysis framework.

1. Outline the objective of the analysis: Are you an investor looking to invest for the long term or a creditor who is looking to fund a short term working capital loan?
2. Gather data: Beyond annual reports, company presentations, quarterly/half yearly management earnings calls and investor presentations offer a vast universe of data to not just get started but continuously augment your understanding of the company
3. Process the data: Make appropriate adjustments to make sure you are comparing like-for-like information
4. Analyse and interpret: Form conclusions with the data at hand. Even more importantly, if there are gaps in your understanding, make it point to check and fill them before taking any next steps
5. Update analysis: Basis conclusions formed from the aforementioned steps, investors should look to either create a detailed analysis or update their current investment thesis, so as to make an investment decision.

With this, let’s dive into the first financial statement - the income statement in the next chapter