Today's topic is "Financial Statement Analysis" We are not going to do a deep analysis like Warren Buffet or Benjamin Graham. But at high level, lets see how we can measure a business using financial statements. This is not required for normal investors at all. As we saw in "Stocks Portfolio" episode, index funds by itself is good enough. That is why this is going to be in Yellow category rather than the usual Green category. But still, if we know how to read a financial statement, it helps us to prepare ourselves for either running our own business or buying business. So use what I am sharing here to expand your financial knowledge. Do not use it for making a decision. For that you need a professional accountant's guidance.
Phew – standard disclaimer is over. Lets get into the episode now. Lets start with a "Quarter". No. No. This is not the quarter (alcohol) you are thinking. This is calendar quarter. Jan – March, Apr – June etc. each of these 3 months make a quarter. If a company is trading publicly, they are required to share their financial results every quarter. Because, if we are the shareholders of the company, the only visibility we have on the business is their financial health. So the only way to know whether the business is growing or losing is only by looking at their quarterly results. If we are a shareholder, we should be capable of understanding their quarterly financial results. If only we can understand that, we will know whether that business is making money or losing money. Lets take a look at an example financial report and see how we can read it. Here we are looking at the financial report for Apple on Reuters site. There are three parts to each financial statement. The first is the income statement that shows the income and expenses.
The next one is the balance sheet that shows the assets and the debts. The third one is the cash flow statement that shows the movement of cash. Lets take a look at the income statement first. We can know the earnings and expenses from an income statement. There are 2 sections on the side – Annual and Quarterly. Under the quarterly section, we can see the recent quarterly statements released by Apple. The latest quarterly statement we see is for the one that ended in Sep 2020. We can see that they have published their quarterly results every 3 months in March, June and Sep. Under the annual section, we can see the company's fiscal year results. Each company has their own fiscal year.
Most of the companies have January to Dec as fiscal year. But Apple has October to September as their fiscal year. The numbers we are seeing under Sep-20 are the total income and expenses for the whole year from Oct 2019 to Sep 2020. This is basically a sum of all the individual quarters in that fiscal year. Don't get scared with all the numbers here. The ones we need are just three. Revenue. Expenses. And Profit. We can see that the first line itself is revenue. That is the most important number among others. That is why it is at the top. Many mention "Top Line Growth" when talking about a business.
The top line growth they refer is this Revenue. So what is revenue? It is basically all the sales that happened during that period. i.e. The income from selling all the iphones, macbooks, itunes etc. during last fiscal year makes up the revenue – 274 Billions. All the sales including the Rs. 1 Lakh you paid for your iphone is accounted here in the revenue. So basically all the money that came inside the cash register is revenue. Lets take a look at expenses now. All the expenses that incurred last year is what we are seeing as "Total Operating Expenses". 208 Billions. They have reported the total expenses as three different line items. Cost of Revenue – this is the cost that Apple has to incur for making iphones, macbooks etc that it sold last year. Last year it was 169 Billions. They have made products for 169 Billions and sold it for 274 Billions. Wonderful business right? Other than this, general admin expenses is 20 Billions. These expenses are to run the company. Employee salaries, electricity bill etc will come under this.
Then Research and Development – 19 Billions. They do have to research and innovate on next product to the market right? Recently they have introduced M Chips. Expenses like those come under R&D. Now we have seen Income and expenses. What do we get when we subtract expenses from Income? We get the Profits. We are seeing that profit as "Operating Income" here. Last year, apple has seen a profit of 66 Billions. They also have lot of cash in their hand. Including the interest for that, Apple had a total profit of 67 Billions. We are saying it as Profit in simple terms.
But in financial terms, some call it as "Net Income Before Taxes" as here. Some call it as EBIT – Earnings Before Interest and Tax. Some call is as EBITDA – Earnings Before Interest Tax Depreciation and Amortization. For our purpose, its just profit. That is all. The profits after paying taxes on it is called as Net Income or "Net Profits". Apple's last year net profit is 57 Billion Dollars.
So for an income statement, just these 3 numbers – Revenue, Expenses and Profits – are important. We should be able to identify them immediately. If you know just these, you are half analyst. 😉 Lets check out the Balance Sheet now. A balance sheets shows the networth of the company. What is networth? As we saw in Financial Freedom video, Assets – Liabilities is Networth. In a balance sheet, we can see how many assets and how much debt the company carries. When an income statement shows the business health of a company, the balance sheet shows the financial health of it. The two important numbers that we have to check for in a balance sheet is "Total Assets" and "Total Liabilities". We can clearly see that there are two sections in the balance sheet. One for Assets and another for Liabilities. Apple had a total assets of 323 Billions by end of Sep 2020. Just the cash and cash equivalents alone are 38 Billions. Then including all the other extra ones, they have a total of 323 Billions of Assets.
Total Liabilities is 258 Billions. In personal finance, we add all our debt for liabilities. In business, it is actually a broader term. In addition to debt, it has few other items as well. If we see this "Accounts Payable" – it is 42 Billions. This is also a part of liabilities. "Accounts Payable" means – Apple has to make a payment for someone's services. But they have not paid yet.
For example, all the iphones manufactured in China could have been shipped to USA thru a cargo flight. But they might not have paid for that service and the payment could be still pending. Pending payments like that are called as "Accounts Payable". The number we need in this liabilities section is "Total Debt". This shows the total debt carried by Apple. We are seeing 113 Billions as total debt. If we see the cash and short term investments, they are close to 91 Billions. Then you must be wondering why they have a debt for 113 Billions? Do a google search and enter your findings in comments below. Now we know Assets and Liabilities. When we subtract liabilities from assets, that is the Networth. Here they don't call it as "Networth". But as "Shareholders Equity". That is, if we sell all the assets owned by Apple today and pay off all the debts, what would they be left with? That is called as shareholders equity.
Apple's shareholders equity is 65 Billions. If that is true, the marketcap of Apple should have been just 65 Billions right? Why is it over 2 Trillions? Lets say that we have a Golden egg laying goose. Would we calculate its value based on the one golden egg in its stomach or would we calculate based on all the future golden eggs that it could lay in the future? We would definitely value it based on its future potential. That is exactly the same reason Apple is trading at a market cap that is many folds higher than its Total Equity.
Lets check out Cash Flow statement next. Cash Flow is very important for running a business successfully. Just assets alone is not going to help much. We can understand a company's business health better thru its cash flow. Basically in a cash flow statement, we can see how much money came in and how much money went out. All the cash flow in a company comes under 3 categories. Cash from Operating Activities. Cash from Investing Activities. And Cash from Financing Activities.
The sum of these 3 is the "Net change in Cash". Cash from Operating activities is the cash flow from normal day to day operations. All day to day operations like Cash received from customers, cash paid to suppliers, cash paid for tax etc. will be accounted here. In a good business, operating cash will be positive. Apple has brought in 80 Billion dollars thru their operating activities. Cash from investing activities show how the cash has changed because of future investments by the company. Lets say that Apple is building a new manufacturing plant, the expense for that will come under this investing activities. Usually, it will be negative for all the companies. Because, investment is a cash outflow.
So it will be negative. 4 Billion dollars has gone out of Apple's account from investing activities. Cash paid for dividends, Stock repurchases, Bonds maturity, and cash received for stocks issuance, bonds issuance – all that cash flow related to financing comes under Cash from financing activities. Apple has issued dividends and repurchased its stocks a lot and so its financing activities is at negative 86 billions for last year. Usually if this value is negative, it is means that the company is doing well without getting any new debt and sharing its profits with share holders.
At the bottom, we are seeing the total of these 3 activities – "Net Change in Cash". For Apple, a total cash of 10 Billions has gone out of its account. But they have close to 90 Billions as cash equivalents. So for a situation like that, the negative net cashflow is not of any concern. Till now, we saw the data for annual statement. The same data is release for quarterly period as well. We can see them under quarterly section. Here, instead of seeing the income/expenses for the whole year, we are seeing them only for that specific 3 months quarter. That is all the difference. These quarterly statements help us to keep a close eye on business health. Now we know how to read a financial statement at high level.
We will see how we can leverage this knowledge to identify a good business in the next episode. Thank You.