Stay on Top of Your Business: Reading Financial Statement

Why is it important to properly learn how to read financial statements?

The purpose is to gain a deep understanding of your business’s financial health and performance. This knowledge empowers you to make informed decisions that foster growth, improve profitability, and ensure long-term success.

Types of Financial Statements:

Balance Sheet: Provides a snapshot of a company’s financial position at a specific point in time, detailing its assets, liabilities, and equity. It shows what the company owns, what it owes, and the value remaining for shareholders.

Profit & Loss Statement: Summarizes a company’s financial performance over a specific period, detailing its revenue, expenses, and profits. It reveals how effectively the business generates income and manages costs, ultimately reflecting profitability.

Cash Flow Statement: Monitors the movement of cash in and out of a business, categorizing activities into operating, investing, and financing sections. This statement provides valuable insights into the company’s liquidity, helping assess its ability to meet obligations and fund future growth.

Statement of Shareholders' Equity: Illustrates the changes in a company’s equity over time, detailing factors such as retained earnings, stock issuance, and dividends paid. This statement provides insights into how the company’s financial decisions impact shareholder value and ownership interests.

What’s in the Balance Sheet?

In the balance sheet should be your assets. Your current assets which include cash, accounts receivable, and inventory and your non-current assets consist of property, equipment, and long-term investments.

In it should also be your liabilities. Your current liabilities are short-term debts, accounts payable, and taxes due and your non-current liabilities include long-term debt, leases, and bonds.

Also, included in the balance sheet should be your equity. Owner’s equity, or shareholder equity, represents the ownership interest in the company after all liabilities are paid.

Your Balance Sheet Key Performance Indicators

The balance sheet is a fundamental tool for evaluating a company's financial health, stability, and operational efficiency. It provides a snapshot of the company’s assets, liabilities, and shareholders' equity at a given time, helping assess its ability to meet obligations, fund growth, and generate returns. By analyzing balance sheet ratios, stakeholders can gain insights into liquidity, solvency, and efficiency, all of which are crucial for effective financial management. Here are some key balance sheet ratios to monitor:

1. Liquidity Ratios - These ratios indicate the company’s ability to meet short-term liabilities, providing a measure of financial flexibility and short-term financial health.

• Current Ratio: Assesses if current assets are sufficient to cover current liabilities.

• Quick Ratio (Acid-Test Ratio): A stricter test of liquidity, excluding inventory from current assets.

2. Leverage Ratios - Leverage ratios measure the degree to which a company relies on debt to finance its assets, shedding light on long-term financial risk.

• Current Ratio: Assesses if current assets are sufficient to cover current liabilities.
• Quick Ratio (Acid-Test Ratio): A stricter test of liquidity, excluding inventory from current assets.

3. Efficiency Ratios - Efficiency ratios gauge how effectively the company utilizes its assets to generate revenue, crucial for assessing operational productivity.

• Asset Turnover Ratio: Reflects how efficiently assets generate sales revenue.
• Inventory Turnover Ratio (if inventory is applicable): Measures how quickly inventory is sold.

4. Profitability Ratios - Profitability ratios assess the company's capacity to generate earnings relative to various balance sheet elements, indicating the effectiveness of asset and equity use.

• Return on Assets (ROA): Measures profit relative to total assets.
• Return on Equity (ROE): Evaluates profitability generated from shareholders' equity.

5. Solvency Ratios - Solvency ratios assess long-term financial stability and the company’s capacity to meet long-term debt obligations.

• Interest Coverage Ratio: Indicates how easily a company can cover interest expenses with earnings.
• Equity Ratio: Shows the percentage of assets financed by equity.

Monitoring these balance sheet ratios shows if a company can meet short-term needs, manage debt, use assets efficiently, and stay profitable. Together, these ratios give a full view of financial health, helping with smart decisions, investor trust, and planning.

What should be in the Profit and Loss Statement?

Here are some of the details that must help you understand your income statement:

• Revenue refers to the total sales or income generated by the business.
• Cost of Goods Sold (COGS) represents the direct costs associated with producing goods.
• Gross Profit is calculated by subtracting COGS from revenue.
• Operating Expenses are the costs incurred for running the business, which include salaries, rent, and marketing.
• Operating Income is the profit earned before deducting interest and taxes, also known as EBIT.
• Net Income is the final profit remaining after all expenses, taxes, and interest have been deducted.

Key Performance Indicators of your Profit and Loss Statements

In most service-based businesses, gross profit is a critical metric, often targeted to fall between 30-50%, though this can vary by industry. For service businesses, gross profit typically represents the revenue minus the direct costs associated with delivering the service—such as labor, materials, and direct overhead.

Reviewing the Cash Flow Statement

First, you must examine your operating activities. This represents the cash generated from the core operations of the business, including revenue from sales and payments made to suppliers and employees. This section reflects the company’s ability to generate cash through its primary business functions.

Next thing you need to look into are your investing activities. This refers to the cash utilized for investments in property, equipment, and securities. This section highlights the company’s commitment to growth and expansion, showcasing how it allocates resources to enhance its long-term asset base.

Most importantly, you need to know more about your financing activities which involves cash transactions related to borrowing, repaying debts, and issuing or repurchasing stock. This section reflects how a company manages its capital structure and finances its operations, highlighting its approach to securing funding and returning value to shareholders.

Why is it important to interpret the Statement of Shareholders' Equity?

The key components of the statement of shareholders' equity include retained earnings, common stock, and dividends. Retained earnings represent the cumulative profits that have been reinvested in the business, common stock reflects the ownership interest held by shareholders, and dividends indicate the distribution of profits back to shareholders.

The statement of shareholders' equity illustrates how equity fluctuates over time due to profits, losses, and dividend payments. It provides insights into how a company’s financial performance and distribution decisions affect the ownership interests of its shareholders.

Here are more tips for reading financial statements:

• Focus on trends over time, not just individual numbers.
• Compare financials to industry benchmarks for context.
• Identify red flags such as declining profits or increasing liabilities.
• Use the information to make informed decisions about business strategy.

Reading financial statements is crucial for business owners as it provides a comprehensive understanding of their company's financial health. By regularly analyzing these statements, owners can make informed decisions, monitor cash flow, evaluate profitability, identify trends, enhance strategic planning, attract investors and improve accountability.

Learn about how we can guide you on how to read your financial statements. Schedule a free call with our expert today!