Introduction to Financial Statements

The Income statement : Basics

MANY NAMES OF INCOME STATEMENT

we know that the income statement shows revenues, expenses and profit for a period of time, such as month, quarter or year. Accountants call these statements by different names –

  1. Profit and loss account or just ‘P & L’
  2. Income statement
  3. Trading and profit and loss account
  4. Statement of income/revenues
  5. Statement of operations
  6. Operating results statement
  7. Statement of operating results
  8. Statement of earnings
  9. Earnings statement
  10. P & L statement
  11. Statement of financial performance..etc


WHAT’S IN A NAME?

We cannot say that it’s the accountants call to put any name he likes. These statements assume different names according to the nature of business of the company. For example a company that has no trading activity ( buying and selling of goods) or a company involved in service oriented industry, will not have a trading and profit and loss account simply because, there is no trading activity involved. So a company like Infosys will have an income statement or a statement of revenues or a profit and loss account and a company like Reliance will have a trading and profit and loss account.

In any case, the income statement displays the profit made. However, in the case of companies involved in trading, it makes two types of profits called -

  • Gross profit and
  • Net profit.

Gross profit is the profit made from sales before deducting running expenses. The only item deducted from sales is the purchase cost of goods that was sold. The purpose of tracking gross profit is to know the actual trading margin in the business. It’s important for companies to see that the percentage of gross profit never falls.

Net profit is what the company makes after deducting all types of expenses. So, if the net profit falls, that means that somewhere the cost of operating the business has increased.

In the case of companies not involved in trading, the Gross profit element will be missing in the income statement. Only the net profit will be shown. In fact, there is no gross profit for them – since their business do not involve buying something for a lesser price and selling it at a margin.

So, income statement will be prepared according to the nature of business and an appropriate name will be given that matches with the nature of business.In the case of a trading company, the income statement will show the gross profit and net profit separately.

MANY FEATURES OF INCOME STATEMENT

That’s not all. The income statement has many more features. Here’s a point wise collection will help you to understand the income statement better.

  • The format can be vertical or horizontal: Generally, the income statement is drawn in a vertical or horizontal format. In which ever way it’s drawn, the first item in it would be ‘revenues’ or ‘sales’. This sales figure appearing on top of the statement is also called ‘top line’ of the business. (Hope you’ve heard of analysts taking about the increase/decrease in ‘topline’ of the company). In vertical format, each and every expense is deducted from the revenue figure and finally the net profit is arrived at.  This net profit is also called ‘bottom line’ in financial lingo since it appears as the last item in the income statement. In the horizontal format, the sales or revenues are shown on the right side and categorized expenses are shown on the left side and the difference between the two will be shown on the right side ( loss) or left side ( profit).Charitable organizations / clubs / non profit making voluntary organizations / association of persons that exist for the welfare of the society etc- may not have an income statement or revenue statement since they do not exist for making revenues. However, these organizations do have money flowing in the form of contributions. Hence, they prepare a statement called ‘receipts and payment account’ and the resultant surplus money will be termed as ‘excess of revenue over expenditure’.Which ever way it’s presented, the basic idea of a revenue statement is to arrive at the profit. The form is not important.
  • The time period – you cannot draw a revenue statement unless you decide about the time period for which it is drawn. For example – you can find the revenues, deduct all the expenses and arrive at the net profit for a year, for six months, for a quarter, for a month or even for a week. The time period has to be decided. Corporates prepare revenue statement for all quarters and of course, the official annual report.
  • Projected and estimated statements: Accountants also prepare ‘projected financial statements’ which shows the expected revenues and expenses in the coming years if the current trend continues. Accounting projections may be made for 5 or even 10 years forward depending on the use intended. Estimated financial statements are sometimes prepared to know the expected profits for the current year if the current trend continues. Projections are basically estimates.
  • Stand alone and consolidated statements : Big companies (For example – Tata group) which has many subsidiary companies under it’s control may publish ‘consolidated financial statements’ to show the consolidated figures from all it’s businesses. Such business conglomerates will also have stand alone statements for each of their firms.
  • Provisional and audited statements: In India, The companies Act and the Income tax Act requires companies to get their financial statements audited by professional accountants. A financial statement that’s not audited is called ‘provisional financial statements’ and the one that’s audited is called audited statements. What’s important for an investor is to look at the audited financial statements. Audited financial statements are included in the annual report and that is the final –official- legal – profit and loss statement of the company. The audited financial statements will be made available to the share holders of the company. The audited statements of all the companies listed in the stock exchange are available in the stock exchange’s website or various financial sites and newspapers.

CONCLUSION

The income statement is one of the three statements that a stock market investor should be familiar with. What’s important for an investor is to have a look at the audited financial statements. Projections, estimates or provisional statements are made for different purposes and involves a lot of assumptions.

Even the actual financial statement we are talking about is not free from assumptions and estimates. To understand how income statements are made , we need to look at an important concept in accounting- called the ‘matching concept’.

More about matching concept in out next post.

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The components of financial statements

THE COMPONENTS OF FINANCIAL STATEMENTS

In the last article we said that financial statemenst are prepared on monthly / quarterly /half yearly and annual basis. Now, irrespective of the time period, financial statements ( or ‘financials’ as it is called in common parlance) basically consists of three parts:

  • Income statement or Profit and Loss account
  • Balance Sheet
  • Cash flow statement

Most of the figures shown in the annual financial statements will be in a summarized form since – for example the total of all the assets like machinery, buildings, plant, tools, vehicles, computers etc will be shown in the balance sheet as ‘fixed assets’. If you want to know about the details of fixed assets, you may have to refer to the schedule of fixed assets attached with the balance sheet. A big company may have many more schedules like the one mentioned above.

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Introduction to financial statements


From the last two articles we know that financial statements are part of a broad report call annual report. Now we proceed to understand what financial statements are. Law requires corporate entities to keep correct financial records of all the transactions. This is because; the company does business with the money of the public (shareholders).In order make sure that these funds are utilized properly, law makes it mandatory for companies to keep systematic record of all financial transactions. From these financial records, the annual profit or loss from the business is ascertained by an independent qualified auditor. This audited statement forms part of the annual report.

FIRST THINGS FIRST

The very first point you have to understand is that apart from annual financial statements, these are also prepared on monthly , quarterly and half yearly basis so that the management has absolute control over what’s happening and they are up-to-date with the financial position of the business. Quarterly statements will be published every three months, half yearly statements after the end of six months of operation and the final statement for the whole year will be published after twelve months of business. Out of these, the full year official audited statements (or annual financial statements) are the most important ones since, as said above, it presents the grand summary of business done in a year and it’s is also checked and certified by an independent financial auditor.

This doesn’t mean that quarterly and half yearly statements have no importance to the investor. They are important too. Since Quarterly / half yearly statements provide a summary of what has happened in the last 3/6 months, these figures are used by analysts to judge whether the company’s performance is up to the mark as expected. Analysts may also make projected or estimated figures using these statements and predict about the probable performance of the company.

Another important use of these quarterly statements is that it is possible to compare the performance from quarter to quarter. Such comparisons may reveal certain important aspects of the business- for example, the seasonal nature of the business. A company’s ability to hit the estimates expected by the investors every quarter also affects the market price of its shares. For example – If the quarterly financial result of a company exceeds investor’s expectations, you can witness a jump in its share price. So all these statements has its own importance.

A WORD OF CAUTION: as said above, analyzing quarterly or half yearly statements are good. However, it doesn’t not mean that you can rely on it totally. That’s because, it’s possible that a company that has shown promising results in the first quarter may face difficulties going forward. Uncertainty is a big factor in business. Predictions of all the market experts and brokers can go wrong. Why should we say about brokers? Those CEOs themselves can go wrong in certain cases.

now that you’ve got an idea about financial statements in general, our next article will explain the components of financial statements in detail.

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How to read an Annual report.

An annual report, as mentioned in the last article, contains a wealth of information on any event that has a material impact on the company. We also said that you will have to read it carefully in order to dig out those negative remarks since; it will be generally written in a positive tone. The ‘positive tone’ in which it is presented is not meant to deceive the shareholders or the general public in any way. But, that’s the way it is presented – amplifying the positive facts and muting the negative aspects. This piece of advice should be there in the back of your mind while going through annual reports. The form, layout, pictures, graphs and color of the annual report are of less importance. What’s to be collected is the content – those figures, ratios, notes and other bits and pieces of information that you’ll be able to gather. If you know how to put everything together and fish out meaningful information, you’re bang on target.

Must reads in an annual report.

You do not have to read the report cover to cover. That’s not practical also. The first few pages are colorful and it presents a non technical overview of the company’s objective and how well it is meeting them.

The front section will probably also tell you about the company’s strategies, products and competitive positioning. The chairman’s statement or message to shareholders will also be included here.

The back portion of the annual report is usually filled with financial information about the company. The real meat of an annual report is in the financial statements and ‘notes to accounts’ found in this portion.

The balance sheet, income statements along with auditor’s comments and notes to accounts are must reads. Apart from these, the Director’s address gives an overview of your company’s operational and segment-wise performance, key initiatives undertaken during the year, achievements and a financial snapshot.

The Director’s report will give an overview of the initiatives taken during the year, other achievements, awards and a snapshot of whatever milestones the company could achieve in the past one year.

Many items of expenditure or income may be disclosed in the financial statements in abstract figures for which break up will be given in the schedules. There will be a long list of schedules accompanying the balance sheet and income statements.

The management will also discuss in detail about the industry, factors affecting the company’s prospects, impact of policy changes by the management or the government, strengths, opportunities, threats, competitors and how well the company tackles all this.

Other bits and pieces.

A detailed study of the notes to financial statements, allow you to go beyond the numbers to understand some of the assumptions and accounting policies that underlie them. For this purpose, we must refer to the notes to accounts, given as an appendix to the balance-sheet and profit and loss account.

Remuneration given to directors and other managerial personnel, dealing with sister concerns of the company etc may also find place in the notes to accounts.

Notes can be divided into two parts. The first part describes the basis of accounting and presentation. It briefs you on estimates used and where foreign exchange earnings are involved, the basis of conversion. Some of the key points of information contained in the notes include the position of cash and cash equivalents, collateral given to various lending institutions and investments in sister concerns.

The second part provides information on the assets and liabilities position. Here, related party transactions   that show company’s dealings with group companies and associates, are key sources of information.

For manufacturing concerns, the production figures assume significance. The production figures compared with installed capacity could give you an idea of the efficiency at which the company is operating .This information is particularly pertinent if the company is planning further expansion

For newly listed companies, the utilization of the IPO proceeds are disclosed in the annual report.

Since financial statements are prepared by “matching principle” an analysis of the cash flow statement will show the actual flow of cash.
So, next time you get an annual report, look beyond numbers. The financials are just one part of it. To get the bigger picture, consider reading and analyzing the above mentioned points.

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