Monday, February 13, 2012

Step by Step Guide to Unlocking the secrets of Financial Statements !

Lets face it, there are lots of people for whom understanding financial statements is an unfamiliar terrain.

I know what you are thinking "Why should I read these so called financial statements? I am not a finance guy"

Even if you are not a finance guy, almost everyone at some point in their life wants to invest. What if I tell you that by the end of this blog you will be one step closer to becoming a good investor, isn't that a big enough incentive. I promise this is not rocket science.

From this point on it is going to be all about explaining financial statements in the most simplest of ways.

Types of Financial Statements
a) Balance Sheets
b) Income Statements
c) Statement of Owner's Equity
d) Statement of Cash Flows

In this blog I am going to explain about Balance Sheets. Lets get started !

What is a Balance Sheet ?
Think of it as a snapshot which portrays the financial position of the company at a specific point in time.

What does it look like ?
This particular balance sheet shows the financial position of XYZ Company (Look at Top Left of the Sheet) at 02/10/2012 that is 2nd Feb, 2012 (see top far right).

There is so much data in it ? Please simplify what it consists of ?
Sure, it consist of just two halves:
a) Assets
b) Liabilities and Owner's Equity (Told you it isn't rocket science)

Assets are goods and property owned by the company.
Liabilities is the debt owed to outside parties. Owner's as the name suggest are owners of the company (those who invest in the company), and equity in simple terms are basically stocks. So owner's equity(value of the company) = Anything that the company has(assets) - Anything that they owe (debt).

Lets start by explaining subsection of Assets.
1)Current Assets - Current Assets include cash and those assets which can be converted into cash within a year of balance sheet.
Note: The order in which these assets are listed depends on the time its going to take for these assets to get liquidated. By liquidated I mean converted into cash.
Types of Current Assets :
Cash - Money deposited in bank or cash in hand
Marketable Securities - Excess or idle cash that is not needed immediately may be invested in marketable securities.
Go on ask me. What is Security ?
Security in this context is a contract between the lender and the borrower that is assigned a value and traded.
So marketable securities are basically your investments. You can invest your money in two type of securities, namely :-
a) Trading Securities : Debt and Equity securities that are brought and sold frequently to generate short term profits. For example - If I trade in stock market, buy a share of a company and after two weeks I sell the stock. I am doing short-term trading.
b) Held-To-Maturity Securities : debt securities that the company has the ability and intent to hold to maturity. “Maturity” is the date when debt instruments, those issued by government, such as Treasury bills, are due and payable.
Accounts Receivable - Amount due from customers that have not been collected yet. Suppose I start a company which says buy now and pay after 4 days. You bought the item for $500 and another customer
bought for $600.So in accounts receivable, company would have $1100.
Inventory - In simple terms inventory is the cost of manufacturing a product and/or purchasing a product for sale to customers. Sale to customers is very important word here and that is what makes an inventory an asset. How does a company decide the worth of an inventory. So two parameters are compared : the cost of producing the goods and the market value, whichever is lower in price determines the value of the inventory.
Prepaid Expenses - As the name suggest it is the prepaid expense a company incurs (in advance) for a right to use the service later on. A good example is Insurance. You pay a monthly expense (prepaid) in order to use a service some time in the future.

The sum of all of these form the total current asset. These are also called "liquid cash". Thus they can and will, in the near term be converted to cash and can be used to pay company debt.

2)Fixed Assets
Long Term Investments - For example- If I buy government bonds today whose Maturity Date is 15 years from now. Thus if I keep the government bonds till 15 years , these securities would be classified as Long Term Investments.
Property, Plant and Equipment
These are assets not for sale. These can be land, building machinery etc.
Then comes the Depreciation part. Simple decline in the useful value of an asset over time. I have a perfect example for you. As soon as iphone 4s was launched the price of the previous iphone's dropped. So the person who had the old iphone faced what we call depreciation in balance sheets.

3)Other Assets

Intangible Assets - As the name suggests, intangible is something that cannot be touched or grasped (something that does not have physical existence). So intangible assets are those that have no physical existence, yet have substantial value to the firm. One of the most important intangible asset is Goodwill.
How the hell is goodwill measured ?
Suppose XYZ company acquires ZYX company. Goodwill is the amount by which Price of ZYX company exceeds the value of the related assets. This is somewhat intuitive. So goodwill can be reputation, customer base, intellectual capability.

All these assets combined together make up the figure "Total Assets" that is 33,500 in our balance sheet.

In the next blog I will be explaining the other half of Balance Sheets that is Liabilities and Owner's Equity.
Hope you got the big picture after reading my blog.

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