Whenever we talk about investment then the first question that comes to mind is ‘Where should we invest?’
Everyone would tell you that if you make an investment, then you will get a 12% or 15% return.
But we will only get that return if we choose a good company. Something more important than choosing a good company is to ignore a bad company.
Because if you choose a bad company your money can be ruined.
So how can we analyze which company is good and which is bad for the stock market? And how can we read financial statements in a layman and simple way?
Today we’re going to talk about how we should read which financial statement. And how we can make a good investment decision by reading a financial statement. And how we can select a good company for our investment decision.
So, friends, in this article we are going to cover mainly three topics.
- What a profit and loss statement is? and how we can read it.
- What a balance sheet is? and how a good balance sheet can be read and how a good balance sheet can help us make a good investment?
- The very important point which is Cash flow statement
Cash flow statements are ignored by most retail investors and don’t pay much attention to them. Because they don’t understand its importance.
But today, I’m going to tell you why cash flow statements are the most important.
Because a lot of financial analysts believe that among the three financial statements, the cash flow statement is the most important.
So, I’m also going to tell you how a cash flow statement can be read?
Profit and loss statement
Now if a company is running then it must be earning profit from somewhere or the other.
And many retail investors like us, like you and me.
First see how much profit a company has earned. And whether their profit in that quarter or annual year, has increased from the previous quarter or annual year or not.
So, friends, the biggest question is, where does the company earn their profit from. Was the profit earned from their business operation or from somewhere else?
And at what point should we see where the company’s profit is coming from.
So, friends, in profit and loss, the first thing you will get to see is revenue
What is revenue?
Whenever a company does its sales, it’s called revenue.
The total sales of a company is known as revenue, that the company made that many sales in a financial year.
Now for the amount of sales that a company makes, it also requires some amount of raw materials.
Now for example if the company sells the mobile phone.
Before selling the phone the company would’ve had to make the phone also. Now to make that phone the raw material that was used and apart from the raw material. They also have employee expenses.
In this way a company has different types of expenses.
So all the expenditure that the company had in that year will come under the company’s expense.
So friends, you now know about revenue and expenses.
And when you subtract revenue from expenses, you get Operating profit.
That is, when the company carried out its operations and spent money on it, how much profit did the company earn. This parameter is extremely important for any company.
Because this tells us the profit earned by the company by carrying out its business operations. And if we convert this into percentage we get a parameter known as Operating profit margin.
When you read the financial statement of a company?
You have to, very carefully, see its operating profit margin.
Because this tells us how well the company’s operations were carried out in that annual year.
And if the company’s operating profit margin increases,.
Then the company has utilized its raw materials very well.
And if the company’s Operating profit margin is declining, for some reason.
Then you must investigate the reason behind why their Operating Profit margin declined.
Because if it is declining, then either the cost of their raw materials has increased.
Or a problem has come up in their business and business is not as efficient as compared to last year.
When you read the profit and loss statement of a company.
If a company’s sales have drastically increased in a year.
So, as an investor, you shouldn’t necessarily be happy.
You should first see that if the sales have increased, how much have the expenses increased.
And most importantly you must see where the operating profit margin is.
Has its percentage increased or decreased.
If the company’s sales have increased then its operating profit margin has also increased.
Which means that the company has performed well.
So, you should very carefully pay attention to these parameters before making an investment decision.
So, friends, after this, there is another row which is very important and a lot of people don’t pay attention to this row.
And that row is the Other income row.
Other income is the income that the company receives but not by its business.
If I give you an example in very simple terms,.
I have a Mobile phone making factory and business but I sold one of the machines in the factory because of which I got some money.
So the money I received from that was not from my business but from my other income.
The money that is not received by my core business goes into other income.
So if the company’s net profit has drastically increased in that year,.
But a lot of the amount in the net profit comes from the other income.
Then you should pay attention as to why the company is not receiving money from its business.
And why the company has to show the money from its other income to increase its net profit.
So, friends, I always tell you that when we invest in a company,.
We invest for the business. So when you see the company’s net profit,.
You must notice whether a lot of the company’s income is coming from other income.
Or from its core business.
So, a lot of the company’s income must come from its core business and not from its other income.
So, in the profit and loss statement there is another important row, which is called depreciation.
Now you must be thinking what the meaning of this big term is.
I will explain this in very simple terms.
Take for example, I have made a factory worth 1 crore rupees.
And in the factory, the value of the machines in one year have decreased by 10%.
So, in one year the 1 crore value has decreased by 10 lakhs.
Because the machine that I bought there became damaged and its value depreciated.
So, the 10 lakh value that went down, has to be booked as a loss in the Profit and loss statement.
And I have to subtract that from my profit.
Some companies, to make their net profit seem more,.
Show that their depreciation was lesser than it actually was.
There are a lot of ways that a company shows how it calculated its depreciation in a financial year.
So, as a retail investor we should always note that.
If, in that year, to increase their net profit, did the company change their depreciation method.
And by changing it they deliberately made their depreciation look lesser to make their profit look more.
So, as a retail investor you should always keep in mind that.
As compared to the previous year how has the company portrayed its depreciation to be.
And in this case the company can make a fool out of its investors by showing its depreciation to be lesser than its income.
So, now, after removing all these expenditures we get Profit before tax.
As the name suggests, it means that the company hasn’t paid its tax.
And the money left after the tax is paid is known as the company’s net profit.
And us, retail investors without reading the entire statement, directly read the net profit.
And on that basis decide whether the company has performed well or not.
So, if in the future, you are going through the profit and loss statement of a company.
Then don’t look into it with too much detail but don’t ignore such things.
Firstly, you have to see how much the other income is.
Secondly, you have to see how much the operating profit margin is.
To see how efficiently the company is performing.
Third, you have to see what the depreciation of the company is.
And if there wasn’t much change in the depreciation and if there was a change, what is the reason behind it.
Which you will find out by reading the company’s financial report.
About how the company calculated its depreciation.
And only after seeing all these things should you decide.
If the company’s net profit is good or not.
If I tell you about the second financial statement.
Then that is called a Balance Sheet.
I will tell you about every row in a balance sheet.
Which is very important from the investment perspective.
The first thing is Debt/Borrowing. So what are these?.
This is the loan or the money that a company takes from a third party to run their business.
Or to expand their business. So as an investor what should we see?.
If a company has a lot of debt, then should we ignore that company?.
No, friends, having debt doesn’t necessarily mean it’s a bad thing.
But having debt at the wrong time is a bad thing.
So, I will tell you this in simple terms.
If this year a company has taken a debt to expand their business,.
And next year, instead of their company expanding, it starts to decline.
And the company takes on more debt under the pretext that they will expand their company.
Then at that point you should become alert that something is going wrong in the company.
That the company is increasing its debt but it isn’t making a difference in the company’s business.
Neither is the company expanding itself.
Neither is it optimizing its operations.
Nor is it putting its money to good use.
This is why you should be alert and exit the company at the correct time.
There is another row in Balance sheet which is known as Trade Payables.
It is written in the name itself ‘Trade payables’.
The money with which you have to pay for trade.
I will explain this again in very simple terms.
Take for example I have a factory and in this factory I make and sell mobile phones.
But to make these mobile phones, I need to buy plastic from somewhere.
And I got this plastic from a vendor.
And with the plastic, I make the mobile phones and sell them to the customers.
And I give the money back to the vendor in 30 or 40 days depending on my agreement with the vendor.
So a balance sheet in trade payables tells us that, at that point,.
How much money does the company have to give its vendors or third party which is related to its trade.
And if this amount keeps increasing, then that is a red flag as well.
Because the company isn’t paying the third party the amount that its supposed to pay at the right time.
Now, there is another row which we call Reserves. Now what are Reserves?.
I have already explained how a company’s net profit is made.
Take for example, that a company has earned a net profit of 100 Rupees.
Now out of this 100 Rupees, the company decided to give a dividend of 40 Rupees to the people because they have invested in the company.
So, after sharing the dividend, the company is left with 60 Rupees.
Out of that 60 Rupees, the company decided that they will again invest 30 Rupees in the company.
To expand the company.
So the company included that 30 Rupees investment in the company’s expansion.
Now the company is left with 30 Rupees.
That 30 Rupees goes in the company’s reserves.
Reserves is the money that the company has left after it performs all its duties, that money goes in the company’s reserves.
Having too much money in the reserves is a good as well as a bad thing.
Reserves tell us how much money the company has in the case of a contingency.
If I talk about ITC then their reserves is a lot.
Because they have a lot of profit and apart from that their dividend.
And even after the expansion costs, they have a lot of money left which they add to the reserves.
If I tell you about this year then ITC has more than 55000 crores worth of reserves.
There is another row in the balance sheets which is also very important and is known as assets.
Which tells us the amount of assets that a company has.
There is a sub-category under assets which is known as investments.
Now, what are investments? Where will a company invest?.
Investments tell us where a company has made its investments.
In which investment instruments has the company made its investments.
And how much their investment is at that point of time.
If the company has a lot of money left.
They put some money in reserves and some in investment as well.
So that they get good returns.
Or, when need be, they can remove their money.
So this is what is called investments.
Now, there is another important row in assets which is known as Fixed Assets.
The name ‘Fixed Assets’ itself gives a lot of clarity that tells us how much money the company has put in fixed assets.
For example, I have a factory and to build that factory I made an investment of 1 crore Rupees.
Which means that the value of the machines in the factory is 1 crore rupees.
So all this comes under fixed assets in the balance sheet.
It is not necessary that every company’s fixed assets must be high.
Because if I talk about some IT companies,.
They have a very small investment in fixed assets.
Because they don’t need fixed assets as much as they need employees.
Now, let us talk about the third financial statement which is known as Cash Flow Statement.
Cash flow statement tells us how much money the company received and lost from its perspective.
Under the cash flow statement there are three main sub-categories.
First, cash flow from operations, second, cash flow from investing and third, cash flow from financing activities.
Now I will tell you what these mean and what their significance is.
And in a lot of situations it is negative, so should it be negative or positive.
First I will talk about cash flow from operating activities.
Cash flow from operating activities or cash flow from operations tells us that.
In the company’s operations, how much money was received and how much was lost.
So if I tell you in simple terms, then normally this has to be positive.
Because until the company doesn’t properly create money from its business,.
And if its not able to make its cash properly, then there is a problem.
If the cash flow is negative for sometime, then it’s fine.
But in the long run, if a company’s cash flow from operating activities is negative.
Then there is a problem and you have to investigate properly.
If in any year a company’s cash flow from operating activities is negative, what is the reason behind that.
Now I will talk about cash flow from investing activities.
What does investing mean?
Take for example that I have invested somewhere this year then the money has gone out of the company.
So, actually, it has to be negative.
So, if I properly observe a company and its making its investments in the right place.
Then that company’s cash flow from investing activities should be negative.
But, if it is positive.
Then it means the company has sold some of its assets.
Which is why the company’s cash flow from investing activities is positive.
So, if you look at this as an investor,.
You should see that if the company is in expansion mode,.
Then its cash flow from investing activities should normally be negative.
Now we come to a very important parameter, cash flow from financing activities.
What are financing activities?.
It is the money you take from someone to run your business.
Take for example, I have a company and to run it I took a loan of 100 Rupees.
So, my cash flow becomes positive, because money came into the company.
But now , imagine that I have a 100 Rupees debt and I earned a good amount this year.
And I paid back the money to some bank.
My cash flow from financing activities becomes negative.
So, if I ever talk about cash flow from financing activities.
It should normally be negative for one company.
Because when a company pays a debt off, its cash flow from financing activities becomes negative.
But, if any company’s cash flow from financing becomes continues to be positive.
Then it means that the company is taking money from somewhere.
Because of which, this parameter of theirs continues to be positive.
So, friends, of all these financial statements, I told you that the Cash flow statement was very important.
And we normally ignore this.
So why is it important?.
So, friends, as I told you that if I want to increase my net profit in that year,.
I can make changes in other things to make the profit seem more.
I can reduce the depreciation or I can show my other income to make the profit seem more.
From this we can infer that a company portraying that they have a high net profit is not a big deal.
But if I talk about cash flow statements,.
Then cash flow tells us how much the company received and lost.
In this case, the company cannot make any manipulations.
Making manipulations in the cash flow statement is next to impossible.
Or it is very difficult for companies to do.
So if any analyst is observing a company, we should first see its cash flow statement.
Because a cash flow statement always gives us the right picture.
That, from financing, in the case of a debt, we can find out how much money the company received and gave.
In the case of investing we can find out how much money the company gave out and took in during investment.
And in the third case, from operating, we find out that in the company’s operations,.
How much cash the company earned and how much it lost.
So, these three parameters are very important, because of which.
The cash flow statement of the three financial statements becomes the most important.
So, friends, if after today you plan on making an investment decision in any company,.
You should first look into the financial statements of the company.
And in the financial statements, like I told you,.
Look carefully into every parameter and investigate thoroughly.
And question everything. Like if net income has increased, why did it increase?.
The answer to that question will be found in the annual report because the company has to mention why something has increased or decreased.
In the same way if a company has increased its investments in a year.
Then you should question that also, as to why the company increased its investments.
If the debt increases, then why did it increase and where was the money used.
So a retail investor, like an intelligent investor, must question everything.
And for the questions if you get them then you can make the investment decision.