by Susantha Nanayakkara

Created on: October 11, 2009   Last Updated: October 13, 2009

Understand a financial statement of a business

Warren Buffett, the richest investor in the stock market in the world, always says when we invest in share market, it is imperative to understand the underlying business of a particular company before buying shares. Analysis of the financial statements of past years is the way to study the performance of a business. But more than 95% of investors buy and sell shares based on their prices and disregard underlying business activities. Many psychological factors affect such investors since they are ignorant about the reality of the business.Therefore, they fail to stay confident about future performances of the company over a long term.

When we see a financial statement, it has three divisions namely; the balance sheet, the income statement and the cash flow statement.They all show where is money of the business.

Balance sheet shows company's asserts, liabilities and share holder's equity. An asset is a product or service that generates money or once sold gives money to the company. For instance, inventory, machines, buildings and cash in hand can be considered as company assets. In contrast, a liability is taking money away from the company as with loans, rents and employee's payments. The value that we get after the liabilities subtract from the asserts is share holders equity, in other words, net worth or book value of the company. When shareholders equity divide by number of common shares, we get equity per share or book value per share.

In the income statement, we observe data on income and expenses on producing goods and services, taxations, interest payments on their loans and eventually, the net profit. It facilitates us to understand whether the company is making profits or losses. When we divide net profit from number of issued common shares, we get earning per share(EPS).

When we analyse, we calculate 'return on equity' that is the result taken by dividing net profit from share holder's equity. On average, a good performing American company has over 12% 'return on equity' (ROE). If we analyse a series of financial statements over the past years, we can see whether the ROE is almost constant or not which is an important observation.Thereafter, we search for whether the company is constantly capable of enhancing the share holders equity. If those two basic criteria are satisfied then we make a decision that company is performing averagely well or even above average.If the price of the business share is agreeable,

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