Introduction
Financial statements are the backbone of IPO analysis. They reveal the company's financial health, profitability, and cash generation capabilities. This guide helps beginners understand how to read and interpret the key financial statements in an IPO prospectus.
The Three Core Financial Statements
1. Income Statement (Profit & Loss Statement)
Shows revenue, expenses, and profit over a period (usually 3-5 years in IPO prospectus).
Key Components
| Item | What It Shows |
|---|---|
| Revenue/Sales | Total money earned from business operations |
| Cost of Goods Sold (COGS) | Direct costs of producing goods/services |
| Gross Profit | Revenue - COGS |
| Operating Expenses | Salaries, rent, marketing, R&D, etc. |
| Operating Profit (EBIT) | Gross Profit - Operating Expenses |
| Interest Expense | Cost of debt/borrowings |
| Depreciation | Non-cash expense for asset wear |
| Tax Expense | Income tax paid |
| Net Profit | Final profit after all expenses |
What to Look For
- Revenue Growth: Is it increasing year-over-year?
- Margin Trends: Are gross and operating margins improving?
- Expense Control: Are expenses growing slower than revenue?
- Profitability: Is the company consistently profitable?
2. Balance Sheet
A snapshot of company's financial position at a point in time.
Key Components
Assets (What the company owns)
- Current Assets: Cash, receivables, inventory (convertible to cash within 1 year)
- Non-Current Assets: Property, plant, equipment, intangibles
Liabilities (What the company owes)
- Current Liabilities: Payables, short-term debt (due within 1 year)
- Non-Current Liabilities: Long-term loans, bonds
Shareholders' Equity
- Share capital + Retained earnings
- Represents shareholders' stake in the company
The Balance Sheet Equation
Assets = Liabilities + Shareholders' Equity
What to Look For
- Current Ratio: Current Assets / Current Liabilities (should be > 1)
- Debt Levels: Total debt relative to equity
- Cash Position: Adequate cash for operations
- Asset Quality: Nature and age of fixed assets
3. Cash Flow Statement
Shows how cash moved in and out of the company.
Three Sections
Operating Cash Flow (CFO)
- Cash from core business operations
- Most important for assessing sustainability
- Should generally be positive and growing
Investing Cash Flow (CFI)
- Cash spent on/received from investments
- Includes capital expenditure, acquisitions
- Usually negative for growing companies
Financing Cash Flow (CFF)
- Cash from/to investors and lenders
- Includes borrowings, share issues, dividends
- Positive when raising money, negative when repaying
What to Look For
- CFO vs Net Profit: CFO should be close to or higher than net profit
- Free Cash Flow: CFO - Capital Expenditure (ideally positive)
- Cash Burn: For loss-making companies, how fast is cash depleting?
Key Financial Ratios to Calculate
Profitability Ratios
| Ratio | Formula | Interpretation |
|---|---|---|
| Gross Margin | Gross Profit / Revenue × 100 | Higher is better; shows pricing power |
| Operating Margin | Operating Profit / Revenue × 100 | Shows operational efficiency |
| Net Margin | Net Profit / Revenue × 100 | Overall profitability |
| ROE | Net Profit / Shareholders' Equity × 100 | Return generated on equity; 15%+ is good |
Liquidity Ratios
| Ratio | Formula | Interpretation |
|---|---|---|
| Current Ratio | Current Assets / Current Liabilities | Should be > 1; measures short-term ability to pay |
| Quick Ratio | (Current Assets - Inventory) / Current Liabilities | More conservative; should be > 0.8 |
Leverage Ratios
| Ratio | Formula | Interpretation |
|---|---|---|
| Debt-to-Equity | Total Debt / Shareholders' Equity | Lower is safer; < 1 generally comfortable |
| Interest Coverage | EBIT / Interest Expense | Higher is better; should be > 3 |
Trend Analysis
Look at data over 3-5 years to identify trends:
- Is revenue growing consistently?
- Are margins improving or declining?
- Is the company becoming more or less leveraged?
- Is cash flow improving?
Common Financial Red Flags
- Net profit much higher than operating cash flow
- Sudden improvement in margins before IPO
- Growing receivables faster than revenue
- Frequent changes in accounting policies
- Large "other income" contributions to profit
- Qualified auditor opinion
Where to Find Financial Data in Prospectus
- Financial Information: Contains audited statements
- Restated Financials: Statements restated per SEBI requirements
- MD&A Section: Management discussion of financials
- Financial Ratios: Key ratios often provided in summary
Practical Tips for Beginners
- Start with the financial summary/highlights
- Calculate year-over-year growth rates
- Compare ratios with industry peers
- Focus on trends, not just absolute numbers
- Read MD&A to understand what drove changes
- Don't ignore cash flow statement
Conclusion
Reading financial statements becomes easier with practice. Start with the summary, understand the trends, calculate key ratios, and compare with peers. Remember, financial statements tell the story of a company's past – use them to assess whether that story is likely to continue positively. Combined with understanding the business and industry, financial analysis forms the foundation of sound IPO investment decisions.