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Understanding Financial Statements

Key sections of an annual report:

• Management discussion & analysis

• Auditor’s report
• Balance sheet
• Profit & loss account
• Cash flow statement
• Notes forming parts of the Financial Statements

1. Management discussion & analysis

This is a section used to understand the company’s perspective of their performance. It

outlines the management’s view of the business.

2. Auditor’s report
The auditors’ report is an independent verification of certain financial aspects, relating to the
business.

3. Profit & loss account

It summarizes all income and expenditure, pertaining to the relevant period.

Accrual Concept: Income and expense are recognized/recorded when a transaction occurs,
not when cash changes hands.

Broad sections of a profit and loss account are:

• Operating Income:
 This section considers revenues that are recurring in nature and accrue from
actual operations – i.e. they will stop if the production/operation process is
stopped.

• Cost of Goods Sold (COGS):

 The COGS takes into account only those costs that are related to the production
of the goods sold by the company.
 COGS covers: purchase of finished goods, consumption of raw materials, other
direct costs & increase/decrease in inventory

• Gross profit: It is the profit made considering the Operating Income less the costs
related to production i.e. COGS.

• Other Income: It refers to the non operating income of the company. It could include
items like profit on sale of assets, forex gains and other sources that will not necessarily
recur year on year.

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• Cash operating expenses: These are indirect expenses that are still operating (recurring
and for production) in nature. It includes employee remuneration, lease payments on
machinery used in operations etc.

• EBITDA: It stands for Earnings before Interest, Taxation, and Depreciation &
Amortization. EBITDA is an important measure of the fundamental operating strength
and profitability of the company.

• Adjusted EBITDA: It excludes non-operating income.

• Depreciation: represents the wear and tear on the machinery that is used by the
company.

• Amortization: It is the reduction in value for intangible assets.

• EBIT: ‘EBIT’ refers to Earnings Before Interest and Taxes. It gives the amount of
earnings available, from the lender’s perspective, to pay the interest burden of the
company.

• Net interest costs: It refers to the net capital cost of the company i.e. interest expense –
interest income.

• Exceptional or extraordinary income/expense: It stands for any income or expense that

is one-off in nature and not expected to recur.

• Profit before Tax (PBT): It represents the profits of the company before paying off
taxes.

• Tax: The company can pay two types of taxes:

 Current Taxes – For the current financial year
 Deferred Taxes – A company may pay taxes in advance due to difference in
the accounting and tax periods.

• PAT/ Net Profit: It is the final figure after all deductions. This is an important figure, as
this reflects the actual return for the equity share holder.

4. Balance sheet
The Balance Sheet is the snapshot of a business as on a particular date.

Balance sheet has two main sections:

Liabilities & Assets

Assets and liabilities are also known as uses of funds and sources of funds respectively.

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Liabilities section contains:

1. Capital and Reserves
2. Long Term Liabilities
3. Current Liabilities

Assets section contains:

1. Fixed Assets
2. Current Assets
3. Non–current Assets
4. Intangible Assets & Miscellaneous Expenditure

Assets:
1. Fixed assets
These are all those assets that are held by the company to generate revenues.
It includes: Land and Building, Plant and Machinery & Sundries.

Capital Work-in-Progress
It refers to any work-in progress in respect of plant or capital equipment. This often shows the
progress of any expansion plans.

2. Current assets
It refers to those assets that are short term in nature. Their value changes due to the
increase/decrease in activity within the company.

3. Non-current assets
These are assets that have a tenor longer than one year, but which cannot be classified into the
fixed assets category.

4. Intangible Assets and Miscellaneous Expenditure

Intangible assets are assets that do not exist in physical form. For example - goodwill.

Miscellaneous expenditure is, expenses incurred at the time of a public issue or any other equity
issue. For example - shares issued at discount.

Liabilities

1. Capital & Reserves

Paid-up Capital - This represents the amount of equity that has been invested by owners/
shareholders of the company.

Preference Share Capital - This refers to any preference capital that has been invested into the
company, and is not redeemable in the next financial year.

General Reserves & Surplus - This refers to the reserves accumulated in the company over
time.

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Revaluation Reserves - This represents any surplus amount that has been included in the
balance sheet through revaluation of assets.

Loss Brought Forward - Any cumulative losses that are brought forward from previous years are
recorded here.

2. Long Term Liabilities

Long-term liabilities are liabilities which are due for repayment, after one year.

3. Current Liabilities
Current Liabilities are liabilities that need to be repaid immediately, or within a year.

5. Cash flow statement

This determines the actual cash generated by the business from financing, investment and
operating activities.
Cash balance for the business = PAT + Non cash expenses – Non cash incomes

Cash flows for a business can be further sub-divided on the basis of broad activities of a
business.

1. Cash Flow from Financing (CFF): The cash flow arrived at by financing activities such
as borrowing money, getting capital from owners, and repaying both.

2. Cash Flow from Investing (CFI): The cash flow arrived at by investment activities
such as purchasing or selling stocks and bonds or machinery.

3. Cash Flow from Operations (CFO): The cash flow arrived at by operating activities:
sales and expenses. This cash flow is of prime importance for a lender as it ensures ongoing
repayment capacity.

6. Schedule & notes to account

This section details the main numbers that have been stated in the summary financial
statements.

Notes to account section, details some underlying data relating to the statements & this section
is where you will get, some drill down information to any financial statement.

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