Knowing accountancy and understanding the basics is a pre-requisite for investing in direct equity. However, some people believe that this is ENOUGH. Sadly, this is not so. Once you start understanding accountancy you will appreciate that numbers taken in isolation do not work.

You will realize that “avoid companies with debt” or “company should have a high RoCE” are perhaps good things to hear but one also has to see whether the company is growing, increasing market share, able to attract talent, has a grip on the technology that it uses or is supposed to use. It is not easy. There are people who masquerade as ‘teachers of investing’ but may not have their achievements int he public space. So to pick an Asian paints and say “it has good accounting practices” is easy. The challenge lies in picking Kajaria ceramics when it was languishing at Rs. 40 and be able to say “it has reasonably clean accounting practices” and ride that nice journey from 40 to Rs. 1000.

Here, start with the basics…

There are four main financial statements which are important in the ANNUAL REPORT that a company sends you. Missed it? No problems. Go to the company website and have a look. Too lazy to do that? Invest in mutual funds – Index fund – and then start the process of learning!

The  important statements are (1) balance sheets;

(2) income statements, popularly known as the Profit and Loss account;

(3) cash flow statements; and

(4) Director’s Report and

(5) Management Discussion and Analysis

Balance sheets show what a company owns and what it owes at a particular point in time. Profit and Loss accounts show how much money a company earned and spent over a period of time. Cash flow statements show from where the money came and where it went – over a period of time.

Let’s look at each of these statements in more detail.

Balance Sheets

A balance sheet provides detailed information about a company’s what the company owns (assets), and how it was funded (liabilities).

What are the things that a company uses to make products or render services? Assets. These are the  things that a company owns that have value. This largely means that they can either be sold, rented, leased or used by the company to make products or provide services. Assets include physical property, such as plants, trucks, equipment, buildings, factories and inventory. It includes things that cannot be touched but exist and have value, such as trademarks, goodwill, and patents. Also includes cash, investments, etc. which may be kept in a form different to be used in a different point in time. Also remember that some awesome assets – relationships with clients, systems, people, self developed assets, self created brands, etc. – which substantially contribute to the sales and profits – do not appear in the balance sheet!

The balance sheet also tells you how these were funded.  The other side are the liabilities are amounts of money that a company owes to others. This includes all kinds of obligations – to the owners and to the lenders. The money borrowed from a bank to buy a factory, the money they got from the shareholders to buy assets, set up new products, hire people, fund the company when it is not yet earning money, launch a new product, rent for use of a building, money owed to suppliers for materials, etc. etc. Liabilities also include obligations to provide goods or services to customers in the future (aka advances from clients).

Assets minus outsider’s liabilities is called ‘net worth’ of the company.

This leftover money belongs to the shareholders, or the owners, of the company.