Financial Literacy: How to read Balance sheet, Cash Flow and Income Statements

Meaning of Financial Literacy:

Financial Literacy can be defined as the ability to know how money works, how it is earned and spent, how it is invested to increase the capital, overall how it is managed. Financial literate is an individual who has the ability to make informed judgments and take effective decisions with regards to the use and management of the money.

The four well known principles that one must follow to become finally literate are:

• Understand the difference between Assets and Liabilities: The best way to define it is, that an asset is anything that puts money in your pocket and a liability is anything that takes money out of your pocket.
• Clear the concept of cash flow vs. Capital gains: Invest for cash flow rather than capital gains, but that will only come through strong financial education to take the right decisions.
• Learn the technique to use debt and taxes to make money: One needs to master the technique of using good debt and making money through taxes which comes only through financial intelligence.
• One should take own financial decisions: One should have the knowledge to act upon and make money on their own caliber.

What has one to be literate about?

Every individual should be competent enough to manage his/her personal funds. Besides that, with regards to making investments, one can get all the relevant information through the different financial reports. This consists of being literate about how to read the essential financial statements namely the Income Statements, Balance Sheet and Cash Flow Statements.

What is the importance of financial literacy?

Financial literacy is something that is useful in all stages of life. From the day to day spending to long term planning, all needs sound financial knowledge. In order to figure out which investing strategy works for an individual sometimes can be intimidating, as the investments chosen do not always help determine whether or not one will achieve their financial goals. This is where financial literacy plays an important role.

Key notes to reading an Income Statement

One needs to identify the parts of an income statement and know what they mean in order to understand their implications.

Example:

In the above example, we need to know the different heads and their importance to understand the overall income statement.

Heading:

The heading of the income statement indicates the business and the time period summarized by the statement.

Content:

In the above example, the financial report is to be read from the top line (sales revenue), proceeding down to the bottom line (net income). In each step down, the income statement involves the deduction of an expense.

In the presence of an Income Statement, there has to be clarity on what is deducted and what is added to the main line items as there are no minus signs depicted. (sometimes parentheses are put to indicate deductions). That is why one needs to be clear on the deductions in the income statement.

The gross margins (also called gross profit) are obtained by the deduction of the cost of goods sold (cost to the company to buy or create the products it sold to the customers) from the sales revenues. This is the profit before the deduction of the other expenses.

All the other expenses are deducted from the gross profit to get the operating profit of the business. Further to this, deduction of interest, depreciation, and taxes gives the net income / net profit/bottom line of the business.

Operating costs consist of a wide variety of costs of operating the business and making sales, including labor costs, insurance premiums, marketing, and advertising and different legal costs.

In addition to sales revenue from selling products and/or services, a business may have income from other sources. For instance, a business may have earnings from investments in marketable securities. In the income statement, these kinds of earnings are taken on a separate line and not combined with sales revenues. These are to be taken as one-off earnings and not considered as recurring earnings through operations.

Key notes to reading a Balance Sheet

Example:

The balance sheet can be defined as the financial snapshot of what the company owns and owes at a single point in time. It is also called the net worth statement for a company. The left or top side of the balance sheet lists everything the company owns: its assets, while the right or lower side lists the claims against the company, called liabilities and shareholder equity.

It’s called a balance sheet because each side must equal the other. Assets equal liabilities plus shareholder equity.

Assets:

Assets are what the company owns. Assets include current assets, fixed assets, investments and intangibles. Current assets include cash and cash equivalents (bank accounts, marketable securities), accounts receivables and inventory. Other assets include investments like stocks and bonds and fixed assets, like real estate and vehicles. Copyrights, trademarks, licenses, patents and the company’s goodwill are counted as assets, too, and they’re called intangibles.

Liabilities:

Liabilities are also called credits as in accounting a credit is a loan. Credit brings cash to the firm that can be used to purchase an asset. However, one should keep in mind that this credit is a liability, a debt that must be paid back at a later date. They represent what the company owes to other entities. Liabilities aren’t necessarily a bad thing. After all, companies have to spend money to make money. They only become a problem when a company is consistently spending more than it’s earning and has no clear and viable strategy to reduce that trend. Liabilities include current liabilities, like accounts payable, long-term debt, like mortgages. One should analyze the liabilities to see what goes into generating revenues.

Shareholder equity:

Total liabilities deducted from the total assets gives the company’s net worth, also known as shareholder equity. Common stock, preferred stock, and retained earnings comprise the three major parts of shareholder equity. They ultimately determine how much each share receives in dividends.

Individually when each component of the balance sheet is analyzed one can gauge the liquidity, operational efficiency, debt repaying capacity and overall financial capability of a business.

Key notes to reading a Cash Flow Statement

Cash Flow Statement shows how the company is paying for its operations and future growth, by detailing the “flow” of cash; where positive numbers represent cash flowing in, while negative numbers represent cash flowing out.

There are three sections in the cash flow statement namely Operating, Financing and Investing. Operating and Financing segments show how the company gets cash while investing indicates how the company spends cash and invests for future growth and expansion. One should see how the company pays for the investing head from the operating figure without turning to finance. One needs to keep in mind that Financing does cause problems: like issuing new stocks could lower the value of every individual share; issuing bonds commits to making interest payments which together could affect future earnings.

The Company has a healthy cash flow when the cash provided by operations is sufficient to cover the cash used for investing.

In the representation of a Cash Flow Statement, in the Operating section, depreciation is an expense but added (It is already taken out of the earnings). This is done as the net earnings from the income statement are adjusted by removing the components that don’t entail flow of actual money.

Example:

Conclusion

The level of financial literacy affects the quality of life significantly. It affects the ability and attitude towards money and investments. Financial literacy enables people to understand what is needed to achieve a lifestyle that is financially balanced, sustainable, ethical and responsible. From the business point of view, it helps entrepreneurs leverage other people’s money for business to generate sales and profits. Hence, from the Personal to Business level, Financial Literacy plays a key role in taking appropriate financial decisions for one and all