Understanding Financial Statements:
Why is it important for a transcriber or an editor to understand Financial Statements?
Basically Financial Statements are records of a company’s financial activities. It gives an overview of the financial health of the company, both short- and long-term, and is presented in a structured manner, which is easy to understand. It is this information that is discussed by analysts and corporate executives in a conference.
At first glance, Financial Statements will merely look like a list of cold, unrelated numbers. But if you know the basic structure of the financial statements and its components, it has a story of its own to tell, a message that needs to get delivered. To be able to read this story, you need to be conversant with the language.
Example: Assets are written on the left and liabilities on the right side. But, there is nothing left on the right and nothing is right on the left.
Here if you don’t know what Assets and Liabilities means, then it would be very difficult to understand what it conveys or to relish the play of words here. By the way, Balance Sheet is the document where assets are written on the left and liabilities on the right.
Well it doesn’t mean that one who wants to understand and read financial statements should take a course in double entry bookkeeping and should know how to construct a balance sheet. After all, you don’t have to be an artist to appreciate a piece of art. One needs to just familiarize oneself with the general layout of financial statements, and that’s what we would try to do here.
Types of Financial Statements:
There are four basic financial statements that a company provides:
1) Balance Sheet: This is also referred to as statement of financial position or conditions, which reports on assets, liabilities, and net equity of a given firm at a point in time.
2) Profit & Loss (P&L) Statement or Income Statement: This reports on a company’s income, expenses, and profits or loss over a given time period. It provides information on the operations of the company.
3) Statement of Retained Earnings: This report explains the changes in a company’s retained earnings over the reporting period.
4) Cash Flow Statements: This report reports on a company’s cash flow activities; particularly its operating, investing, and financing activities.
These statements are very complex and very often include Notes to Financial Statements and MD&A (Management Discussion and Analysis). These notes describe each item on the financial statements in greater detail, and are very useful to transcribers and editors while working on a call.
Note: The two most basic reports of a company are its Balance Sheet and Profit & Loss Account. Hence, we would try to deal with these two reports here.
Balance Sheet:
A balance sheet is the fundamental report of a company’s asset, liabilities, and capital invested. Before making any investment an investor uses the balance sheet to see whether the firm can meet its financial obligations, how much money has been invested in the company, the indebtedness of the company, the kind of assets purchased by the company, etc.
The basic concept behind Balance Sheet:
For a company to acquire assets, it should be paid for by either debt (liabilities) or invested capital (shareholders’ equity). Hence…
Assets = Liabilities + Shareholders’ Equity
Heading | Amount |
Total Liabilities | $38,000 |
Shareholders’ Equity | $52,000 |
Total Assets | $90,000 |
Pro forma Balance Sheet:
Vertical Ltd. | |||||
Balance Sheet as at March 31, 2009 | |||||
Schedule No. | Figures as at the end of the current financial year | Figures as at the end of the current financial year | |||
I. | Sources of Funds | ||||
1. Shareholders' Funds: | |||||
a) Capital | |||||
b) Reserve and Surplus | |||||
2. Loan Funds: | |||||
a) Secured Loans | |||||
b) Unsecured Loans | |||||
TOTAL | |||||
II. | Application of Funds | ||||
1. Fixed Assets: | |||||
a) Gross Block | |||||
b) Less: Depreciation | |||||
c) Net Block | |||||
d) Capital Work-in-Progress | |||||
2. Investments | |||||
3. Current Assets, Loans and Advances: | |||||
a) Inventories | |||||
b) Sundry Debtors | |||||
c) Cash and Bank Balance | |||||
d) Other Current Assets | |||||
e) Loan and Advances | |||||
Less: Current Liabilities and Provisions: | |||||
a) Liabilities | |||||
b) Provisions | |||||
Net Current Assets | |||||
4 | a) Miscellaneous Expenditure to the extent not written off or adjusted | ||||
b) Profit and Loss Account (Deficit Balance) | |||||
TOTAL | |||||
Note: Balance Sheet can be presented in two format, i.e., Vertical and Horizontal. The above mentioned pro forma balance sheet is in vertical format. In Horizontal format, the account is divided into two parts, Assets are written on the left side and Liabilities on the right side.
Now let’s try to learn a few components of balance sheet!
Sources of Funds: Every industrial and commercial enterprise must have capital to finance and conduct its business. This capital can be owned, i.e., “shareholders’ funds,” or borrowed from financial institutions, banks, or general public, i.e., “loans and advances.”
Shareholders’ Equity (Capital): The required capital is raised by splitting the capital amount into a number of parts called “shares” which is sold to any person who wishes to be part owner (shareholder) of the company. Each share has the same “par” or “face” value, which is printed on each share certificate.
If more capital is required later, a further number of shares having the same face value is offered for sale, at par or at premium. Any issuance of shares has to be authorized by the “Article of Association” of the company. If necessary the limit on issuance of shares by the Article of Association can be increased through an amendment to the Article of Association.
A company can demand the full value of the shares at the time of issuance. However more commonly, only a portion is demanded to start with and the balance is recovered in equal installments called “Calls.” As long as the full value of the shares is not called-up, they remain “partly-paid” but become “fully paid” when the full value is called-up and paid. The company has the right to forfeit shares, if calls are unpaid even after repeated demand, by giving due notice, and can reissue the shares at a future date.
Shares can be classified into two basic categories:
a) Ordinary or Equity Shares: If the shares issued by a company have the same rights regarding sharing gains and losses and participation in the management of the company, then such shares are called Ordinary or Equity Shares.
b) Preference Shares: Companies can also issue shares called Preference Shares. The holders of Preference Shares don’t have any say in the management except in matters affecting their rights. On account of loss of voting power, the holders are compensated by giving preferential position in respect of receipt of dividend and repayment of capital on the winding-up of the company. Rate of dividend is fixed and is only paid if there are profits available. If no profit is available then dividend is not paid or deferred to the next year.
Reserves: The excess of Assets over Liabilities, including share capital is called Reserves. Reserves are shown directly after the share capital as such excess or surplus however derived belong to the owners of the company and forms a part of their equity. Basically, reserves are retained profits that are accumulated over the years.
They generally fall into two categories depending upon their source of origination:
a) Revenue Reserves: Retained profits derived from the normal trading operations of the business.
b) Capital Reserves: Retained profits that are non-revenue in nature, i.e., derived from non-trading operations of the company. These are not regarded as free for distribution in the form of dividends.
Loan Funds: When a company needs to raise additional capital, raising funds through issuance of shares not only takes time, but also involves expenditures which can be quite large in proportion to the amount of capital required to be raised. In such a scenario, the company approaches banks or financial institutions for loans. Alternatively, the company can also raise loan by issuing debenture bonds to existing shareholders, financial institutions, or the general public.
Types of Loans: Loans no matter from which source they are obtained can be classified into Secured Loans and Unsecured Loans.
a) Secured Loans: These loans are secured against the mortgage of land, buildings, plant, machinery, equipment and other assets basic to the company’s operation, i.e., immovable property.
b) Unsecured Loans: These loans are taken without providing for any security, but the repayment of such loans is guaranteed by one or more directors.
Debenture Bonds: These are basically certificates issued under the seal of the company acknowledging the debt and promising repayment of the loan on expiry. These are secured loans and represent a mortgage on fixed assets of the company issuing them. They carry a fixed rate of interest, which is payable on specific intervals regardless of profit or loss of the company.
Current Liabilities: All liabilities that have to be settled by the company within a relatively short period of time, usually within one year from the date of the balance sheet, is called Current Liabilities.
The most common Current Liabilities are:
1) Bank overdrafts and cash credits.
2) Fixed deposits from the public.
3) Installments due on long-term loans.
4) Notes payable and trade acceptances.
5) Sundry creditors for goods and supplies.
6) Accruals.
7) Deposits against orders.
8) Advance Payments.
9) Unclaimed dividends.
10)Provisions.
Provisions: Liabilities that are known to exist when drawing the balance sheet, but the exact amount of which is uncertain or undeterminable, need to be provided for in accounting. Provisions are amounts written-off by the company by way of providing for such liabilities. The commitments for which provisions are normally created are: depreciation, taxation, bad debts, gratuity, pension fund or retirement benefits, contingencies, dividends and contingent liabilities.
Fixed Assets: Assets like land and building, plant and machinery, tools and equipments, furniture and fixtures, cars, trucks, et cetera owned by a company are called Fixed Assets. They are owned by company for the purpose of production and normally are not available for sale. They are permanent in nature, and constantly used to carry on the business.
Depreciation: Depreciation is the decrease in the value of an asset caused by wear and tear through constant use.
Capital Work in Progress: Assets which are under construction stage. Since the nature of the investment is long-term, it is called Capital Work in Progress.
Investments: These represent investment of cash not immediately required for current operations or money sunk in some business, or property that has nothing to do with the working of the main business for generating future benefits. Eg.: Government or Trustee securities, Stocks and shares of companies, shares of subsidiary companies, time deposits with banks, et cetera.
Current Assets: Assets that can be easily exchanged for cash are called Current Assets. They are listed on the balance sheet in the reverse order of the easy with which they can be converted into cash. They are generally divided into five groups:
1) Inventories: Inventories or Stocks are the physical part of the current assets like stock of raw materials, stores, spare parts and tools, work in progress, finished goods, and goods in transit.
2) Sundry Debtors: This represents amounts due to a company by its customers for goods sold to them on credit.
3) Cash and Bank Balance: This represents the amount of cash in hand and in savings and current accounts with banks.
4) Other Current Assets: This represents those investments which are of a short-term nature and are readily marketable at any time.
5) Loans and Advances: This include advances and loans to subsidiaries/partnership firms in which the company or its subsidiary is a partner, bills of exchange held, advances recoverable in cash or kind for value to be received, et cetera.
Miscellaneous Expenditure: These represent expense items of a non-recurring nature and not arising out of the current operations of the business. They are usually written off against profits.
Profit and Loss Account (Deficit balance): Sometimes accumulated deficit to the P&L account appears at the end of the assets side of the balance sheet and continues to appear till it is absorbed in future profits.
Profit & Loss Account:
A Profit & Loss Account is a schedule that lists out the income from and expenses of running a business over a period of time, usually one year, and then gives a final figure which represents the amount of profit earned or loss sustained by the business.
Pro forma Profit & Loss Account:
Vertical Ltd. | |||||
Profit & Loss A/c for the year ended 20__ | |||||
Schedule No. | Current Year | Previous Year | |||
INCOME | |||||
Sales | |||||
Other Income | |||||
Increase/Decrease in Work in Progress | |||||
Finished Stock | |||||
TOTAL | (A) | ||||
EXPENDITURE | |||||
Cost of Raw Materials and Spares | |||||
Excise Duty | |||||
Employees Remuneration and Benefits | |||||
Other Expenses | |||||
Interest | |||||
Depreciation | |||||
TOTAL | (B) | ||||
PROFIT BEFORE TAXATION & EXTRAORDINARY ITEMS | (A – B = C) | ||||
Extraordinary Items | (D) | ||||
PROFIT BEFORE TAXATION | (C – D = E) | ||||
Provision for Taxation | (F) | ||||
PROFIT AFTER TAX | (E – F = G) | ||||
Balance of profit B/F from the previous year | (H) | ||||
TOTAL AVAILABLE FOR APPROPRIATIONS | (G + H = I) | ||||
APPROPRIATIONS | (J) | ||||
Proposed Dividend | |||||
Corporate Dividend Tax | |||||
Debentures Redemption Reserve | |||||
General Reserve | |||||
Any Other Statutory Reserves | |||||
BALANCE C/F TO NEXT YEAR | (I – J = K) | ||||
A few components of Profit and Loss Account:
Sales or Revenues: This is amount of money realized from the sale of goods or services by a company. It should be stated gross with deductions for returns, allowances, rebates, discounts and commissions, and excise duty shown separately. The resulting figure is Net Sales.
Other Income: Revenue earned by a company other than through the sales of goods or services is termed as Other Income. These include income by way of rent for let out premises, interest and dividend on investments, gains on foreign exchange transactions, royalty, etc.
Work in Progress: This is a part of a stock that is currently being worked upon. Since it is no longer raw material because it has undergone some processing it is called Work in Progress.
Finished Stock or Finished Goods: The stock of goods readily available for sale by the company is called Finished Stock or Finished Goods.
Raw Materials: Any material used for the production of goods manufactured by the company is called Raw Material.
Excise Duty: It is basically a tax charged on the production or sale of goods.
Employee Remuneration or Benefits: Salary of Employees, benefit provided to employees in the form of dearness allowance, company car, house rent allowance, incentives, et cetera.
Other Expenses: All expenses which are non-operational in nature, i.e., not required for the day-to-day working of the business are Other Expenses. Eg.: Interest on loans, loss on foreign exchange transactions, miscellaneous non-operating expenditure, et cetera.
Interest: It is basically price paid for borrowed money. A company sometimes borrows money in various different forms from financial institutions, banks, bond holders, et cetera. The interest paid on such borrowed money is an expense to the company.
Depreciation: Depreciation is the decrease in the value of an asset caused by wear and tear due to constant use. The cumulative depreciation is written in the P&L account.
Extraordinary Items: These are usually one-time items and are not expected to re-occur in the normal course of business. They affect profit or loss of the company, but are not non-operational in nature, like sale of subsidiary, legal expenses on a lawsuit, et cetera. This is generally deducted from Profits Before Taxation & Extraordinary Items in case of extraordinary gains, and vice versa in case of extraordinary losses.
Eg.: Company XYZ has a profit of $300,000. But on closer examination of the P&L account, you come to know that the company had sold its subsidiary for $400,000 to LMN Ltd. Now to arrive at the correct profit & loss figure, you have to deduct the extraordinary gain received from the sale of subsidiary from the gross profit of the company, thus you will arrive at the correct net loss amount of $100,000.
Provision for Taxation: This is provided for at the standard tax rate applicable on the total income for the year inclusive of any extraordinary gains or losses recorded during the year.
Balance of Profit B/F: Generally a business does not spend all the profit earned in a particular year. This accumulated profit is called retained profit. The balance is brought forward from previous year to the current year accounts in the P&L statement.
Appropriation: This is basically the distribution of profits or loss of a company for various specific purposes, such as dividend, reserves, et cetera.
Dividend: This is basically distribution of profits among the company shareholders. It is declared after being decided up on in the Annual General Meeting. Dividend is paid pro rata depending on the number of shares each shareholder owns, and is based on a percentage of the face value of the shares.
Reserves: The excess of Assets over Liabilities, including share capital is called Reserves. Reserves are shown directly after the share capital as such excess or surplus however derived belong to the owners of the company and forms a part of their equity. Basically, reserves are retained profits that are accumulated over the years.
Balance C/F to Next Year: This is basically the net retained profits of a company after extraordinary items, taxation, appropriation, which will be carried over to next years accounts as Balance B/F from Previous Year.
Note: Now that you have a basic idea of what it is that you are going to listen in a conference call, let’s try to familiarize ourselves with a few common financial terms that you are most likely to come across during a conference call. Please click here:
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