Introduction to Financial Statements

More about cash flows.

If there is one investor who watches the flow of cash closely- that’s Mr. Warren Buffet, one of the world’s richest stock market investor. There’s lot of books and videos explaining his method of investing, the way he analyses a company and about his investing philosophy. But if you watch closely, what buffet does is quite fundamental –

  • He targets long term investment appreciation
  • He invests in businesses he understands
  • He takes a closer look on cash flow.

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Understanding Cash flow statements

“Profit is an estimate. Cash is a fact.”

Cash flow statement-That’s last of the three types of financial statements.

I hope the very first sentence in this article has given you an idea about cash flows.  The cash flow statement reports the “actual solid cash” generated and used during the time interval specified in its heading, unlike profit and loss statement which gives an estimate based on certain rules and assumptions, after deducting certain expenses like deprecation which does not require any cash outflow.

The whole idea of cash flow statement is to show you from where the company got it’s cash – whether it’s from it’s business operations or by sale of assets or issue of shares  and how it used up those funds. This data is important because business needs cash like a car needs fuel. If there is no regular generation of cash from the day-to-day operations, the business will need to resort to debt and share issues to survive.

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Cash flow statement. – An introduction.

CASH FLOW STATEMENTS.

The Cash flow statement is the final component of a company’s annual report. It throws light on the cash generating ability of a company. The statement records the actual movements in cash in an accounting period. All cash received (inflows) by the company, and spent (outflows) by the company will be shown in this statement.

Cash flow statements may be a little bit difficult to understand than balance sheets and income statements.

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Balance sheet components: Liabilities and Equity.

We said earlier that the balance sheet shows what the company owns and owes. What the company owns are called assets and we have seen the various types of assets that a company holds. Now what the company ‘owes’ is categorized into two – (1) Liabilities and (2) equity. So in another way, the total of what the company ‘owes’ shows how the company found money to buy the assets !!. Let’s dig into the topic:

  • Section 2- Equity and Liabilities. What the company owes is classified into Equity and Liabilities. Fine. But what’s the difference between the two? The difference is – Equity is that part of funds that the company raised by issuing shares. It also includes that amount the profits that has been made in all the past years and kept accumulated without paying it to the share holders.
  • So, you and I, who gives money to the company by subscribing to it’s IPO forms the ‘Equity’. To that extend, we are the owner’s of the company. The equity ownership that we get can be sold in the secondary market if there are takers for it. That organized place where we sell equity ownership is called the stock market.
  • Liabilities are outside borrowings, usually listed on the balance sheet from the shortest term to the longest term, so the very layout tells you something about what’s due to be paid and when.
  • Anything a company owes to people or businesses other than its owners is considered a liability. There are two types of liabilities – Current liabilities and long term liabilities. In general, if a liability must be paid within a year, it is considered current. This includes bills, money you owe to your vendors and suppliers, employee payroll and short-term loans. A long-term liability is any debt that extends beyond one year, such as a mortgage loan or a term loan availed by the company to purchase machinery.
  • Apart from long term and short term liabilities there’s one more category called ‘contingent liability’. Contingent liabilities are estimated payments that the company may have to make if a future event takes place. For instance, suppose the excise authorities have imposed a heavy levy on the company, which has been disputed by the company on some justifiable grounds, but the authorities have gone on appeal against the company, it is a contingent liability. In the normal course, the company does not expect the liability to crystallize, but if the court verdict ultimately goes against the company, it will have to meet the liability. This is a contingent liability.
  • Contingent liabilities are not ‘actual liabilities’ and hence will not be displayed in the balance sheet figures. It will be shown as a ‘note’ below the balance sheet.That’s why ‘notes to balance sheet’ assume lot of importance to an analyst.

So, logically, Equity (+) liabilities should be equal to Total assets. This will be true at any point of time. How and why it will always happen is something an accounting student should be learning , not you. Since your aim is to study and analyse the balance sheet to make investment decisions, a through knowledge of the frame work given in this session should be sufficient.

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