Understanding Financial Statements

Financial Statements (i)

Why assets are always equal to liabilities

Financial statements are used to gauge the health of a company. It’s always good habit to learn about a company before investing in the same. Financial statements can give us a quick snapshot of how much profit the company has been making over the years; how much of that profit has been returned to investors in the form of dividends; what are the liabilities and whether the assets are sufficient to fulfill these liabilities? Let’s discuss more about income statement and balance sheet, the two most important financial statements of a company. Let’s try to understand everything through an example.

Let’s assume you want to set up an auto parts manufacturing plant and need some money for the same. You have three options to raise funds:

Option 1: Take a loan at a fixed rate of interest from the local bank

Option 2: Take money offered by your dad’s friend and bring him on board as an investor/shareholder

Option 3: A mix of the above two options

Let’s say you opt for the third one. Your total initial requirement is Rs 1,00,000. You have decided to take a loan of Rs 50,000 from the bank and borrow the remaining Rs 50,000 from your dad’s friend. You intend to use the funds for the following purposes: Rs 40,000 for machines, Rs 40,000 for building & other infrastructure and Rs 20,000 for raw materials.

At this point, let’s define some basic terms. All the tools, machines, infrastructure, building and other things acquired by you for manufacturing auto parts are called assets. More precisely, everything bought and owned by you using the money you raised, is classified as an asset. Assets are created when funds are utilised to buy articles that are going to help generate cash in the future. In this case, machines are acquired using the funds you raised and will help you generate cash in the future.

Assets can be further broken down into fixed, tangible & immovable assets and movable current assets. Plant and machinery will be classified as fixed, tangible and immovable assets because they are relatively immovable and have a very long life. Raw materials will be classified under movable current assets, as they have a very short life span and will be required to replenish at regular intervals.

Whereas assets are sourced by using funds, liabilities are the source of funds. As discussed, we have two sources of fund: banks and your dad’s friend. Total liability is Rs 1,00,000. The most important thing to understand here is assets are always equal to liabilities. The amount you borrowed from bank needs to be repaid over the next few years and will be classified as long term liability. Money you raised from your dad’s friend is not a loan but an investment in your company. Thus it is classified as shareholder’s equity and your dad’s friend will be a shareholder of the company.

So to conclude and summarise, assets are obtained by using funds and liabilities represent sources of funds. Hence assets are always equal to liabilities.

Financial Statements (ii)

Understanding capital structure of a firm

In our previous post, we discussed the basics of financial statements and learnt about two basic items in a balance sheet: assets and liabilities. We also understood how assets and liabilities of a company are always equal. In this article, we will continue with our earlier example where we were trying to setup an auto parts manufacturing plant.
Let’s say you decide to name your firm ABC Inc. As discussed in the previous article, total assets of ABC Inc. is worth Rs 1,00,000 and total liability is also equal to Rs 1,00,000. We further classified assets into current assets and fixed & immovable assets. Liabilities were classified as shareholder’s equity and long term bank liability. Please refer to the table below to understand basic structure of ABC Inc’s balance sheet.

AssetsLiabilities (incl equity)
Total1,00,000Total1,00,000
Fixed AssetsShareholder Equity
Plant Building40,000Friends of father50,000
Machines40,000
Current AssetsLiability
Raw Material20,000Bank Loan50,000

Assets are sourced by using funds, liabilities are the source of funds. As discussed earlier and as can be seen from the above table assets are always equal to liabilities. Lets now discuss few other few commonly used terms: debt, equity and leverage.

Debt is a liability and refers to the the amount of loans raised by the company on which it is has to pay interest every financial year. In our example ABC Inc. this is equal to the amount of Rs.50,000 taken as loan from the bank. Equity refers to the initial investment put in by different investors/shareholders. In this case, it would be equal to Rs 50,000 investment put in by your dad’s friend. A company can raise more funds through equity route by issuing new shares. In such a scenario equity will increase by a proportionate  amount. Leverage is the ratio of debt to debt plus equity (debt/(debt+equity). In ABC’s case leverage is 50% (=50000/100000). Hence ABC is 50% levered. The debt/equity ratio of 1:1 or 50%:50% in this case, is also known as the capital structure of the firm. It tells us how much debt company has borrowed, compared to equity.

The above explanation completes our discussion on basics of balance sheet. Read on to learn about income statements.

Financial Statements (iii)

A company's salary slip

In this article, we will be covering the other important financial statement of a company, called Income Statement.
Balance sheet gives us an idea about the assets and liabilities of a company, as of a specific date. All the items defined in a balance sheet are as of a specific date. On the other hand, items covered in the income statement give details about what has happened over a specific period of time. We will revisit this issue after understanding basics of income statement. Please refer to the below table to understand the basic structure of ABC Inc’s income statement

ItemAmount (in INR)Description
Sales Revenue (a)1,00,000Amount of units sold in a year multiplied by the price per unit (1000*100)
COGS (b)70,000Amount of units sold multiplied by the cost in making each unit (1000*70)
Gross Profit (c=a-b)30,000
SG&A (d)10,000General costs incurred in day to day operations: rent, utilities, insurance etc
EBIT (e=c-d)20,000Earning before Interests and Taxes are paid
Interest (@10%)(f)5,000Interest paid to the bank at the rate of 10% (0.1*50,000)
PBT (g=e-f)15,000Profit before taxes are paid
Tax (@20%) (h)3,000Taxes paid to the government @20% (0.2*PBT)
PAT (i=g-h)12,000Net income generated by ABC Inc in the given financial year
Dividends (j)2,000Dividends distributed to shareholders (friends of Dad)
Retained earnings (k=i-j)10,000Income reinvested in ABC Inc to expand the business

As can be seen in the above table, our starting point is total sales / revenue generated by the company over a specific time period, one full year in ABC Inc.’s case. Various costs incurred by the company during this period are subtracted from the sales number to arrive at profit after tax / net income.

A company can utilize profit after tax in 3 different ways:

  1. Entire amount can be distributed to shareholders. In ABC Inc.’s case this would be your dad’s friend and you who are the owners/shareholders of the company.
  2. Some part is distributed as dividend and some part is invested back into the company, for research and expansion purpose.
  3. Entire profit amount is invested back into the company.

Early stage companies tend to retain most of the earnings as they have enormous potential to grow and capture market share. On the other hand, mature companies who have already grown a lot tend to distribute most of the income to shareholders in the form of dividends, due to lack of growth opportunities.

This clarifies how income statement includes items which give details of what has happened over a specified time period. For example, one cannot declare what is the revenue as of a particular date, because revenue is generated over a period of time. It is important to specify over how what period period this revenue is generated. On the other hand, one can always specify the amount of assets as of a particular date.    

Read our next chapter to understand how to quickly deduce important information from financial statements using key ratios.