Basics of financial statements

Ashish Agarwal
A free video tutorial from Ashish Agarwal
Corporate Finance Expert, Ex McKinsey, Ex BlackRock
4.3 instructor rating • 16 courses • 39,749 students

Lecture description

In this lecture, we introduce the financial statements and explain how we read and interpret the income statement

Learn more from the full course

Financial analysis: Compare performance of companies

Learn financial analysis skills - Performance measurement and evaluation of companies using an objective scorecard

01:10:51 of on-demand video • Updated March 2020

  • Ratio analysis on financial numbers
  • Framework for performance comparison between companies
  • Operating health metrics of a company
  • Financing health metrics of a company
  • Scorecard framework to evaluate the performance of companies
English The next question we want to understand is what are the basic accounting statements. There are three basic accounting statements that every company is required to follow or prepare, But we are going to look at two of them in today's lecture. The first statement is the Income Statement. The Income Statement is a statement of how much profits that your business make in any particular year. It is made for every financial year of the business. In this statement you show all the sales made by the business, and the corresponding cost incurred to make the sales. Such that when you subtract that the two you derive, how much profit is the business made? Let's see the structure of any typical Income Statement. It starts with the revenues of the company. Revenues is the total amount of sales the company has made during any Financial year. From these revenues, we remove the Direct and Indirect costs associated with realizing those revenues. Direct costs of a company are those costs that are directly associated with the manufacture of the product. For example in an Iron and Steel business, the cost of extraction of the Ore would be direct cost of producing the steel. Indirect costs relate to that general selling and administrative cost associated with the running of the overall business. The cost of maintaining an Office, Advertisement costs, Fuel costs etc., would be classified under this head. When we subtract these direct and indirect costs from the revenues we get the EBITDA for the company. EBITDA stands for the Earnings Before Interest Tax Depreciation and Amortization costs. This typically refers to the cash operating profit of the company since most of the items that are used for this calculation are in cash terms. Next comes Depreciation costs. Depreciation costs refer to the general "Wear and Tear" of the machinery used in the business. Although this is not a cash cost but it is still an economic cost associated with the running of the business, and hence we need to subtract that as well, to find out my profit. After subtracting the depreciation costs, we're left with a measure of economic profit of the company called EBIT. EBIT which stands for Earnings Before Interest and Taxes. After EBIT We have to pay the Interest cost for the borrowings, we may have taken from the bank and outsiders. Interest cost is the Financing cost of running the business. When we subtract Interest cost we get EBT or Earnings Before Taxes. Finally we have to pay taxes to the government for the profits to that business has made. This is typically prescribed in the regulations on what is the tax rate that is applicable for different businesses. Subtracting the taxes we are left with the actual profit of the company called, Profits After Taxes. This therefore lays out in a short and precise way, what the typical Income Statement of any company would look like. We will look at this in more detail with the help of an example later on. The next statement that we would generally prepare is the Balance Sheet of the company . The Balance Sheet of the company is a record of all the assets and the liabilities of the company. Assets refer to the what company owns and the liabilities refer to what the company owes. Let us look at the assets side of the Balance Sheet first. We start with the fixed assets of the company. Fixed assets are the long term assets of the company, they typically include big investments that the company typically needs to run the business. Generally fixed assets include Plant, Machinery, Land etc., Most of these fixed assets have a long life and are also referred to as the long term assets of the company. Along with the fixed assets there are also a few short term assets that the company requires. These assets are required to run the day to day business of the company. They generally include 1) inventory of raw materials or finished products, 2) account receivables from the customers who have not yet paid for the goods and services they have used, and 3) that cash that the business needs to hold on, all of this together gives us the asset side of the balance sheet. Let us move to the liability side of the Balance Sheet now. The current liabilities, or the short-term liabilities is what the business owes, to the creditors for a short period of time. The business or the company needs to pay this back. Typically this includes one accounts payable to the vendors whom we have not yet paid for the goods and services we have used from them. And two, a short term debt that we owe to the bank or to outsiders used for the near term financing of the business. All of this money needs to be paid back and is therefore in the liability side of the balance sheet. Beyond the short term liabilities there are also long term liabilities in the business. This includes the long term debt to the bank or outsiders use for the long term financing of the business. Besides long term debt there is the Owners Capital called the shareholders equity. This is the money that the owners of the business have invested or retained in the business when we When we add up the current liabilities and the long term liabilities, We get the total off the liability side of the balance sheet. The two side of the balance sheet, always needs to match eventually. Whatever is the asset side of the balance sheet, should be equal to the liability side of the balance sheet. Because the assets need to be ultimately financed by something on the liability side and hence you will see that in the accounting statement or the Balance Sheet that companies report the Balance Sheet the two side of the Balance Sheet always matches. This is also what we will see with an example in the next section.