How to Analyze Financial Statements like a Pro
Financial statements are not easy to decipher if you have little to no background in Accounting. You’ll see a series of numbers and computations that will overwhelm you if you don’t know what they mean and how they relate to your business. Good thing, you can learn to analyze financial statements by knowing how to define essential terminologies first.
What are Financial Statements?
Financial statements are business reports containing the summary of financial transactions of an organization. It provides a clear overview of the financial health of a company.
The process consists of tracking all cash outflow and inflow transactions, including the expenses, payments received, accounts and notes payable, assets acquired, debts, expenses, and capital. An accountant organizes all these items in a general ledger to compute by the end of a month, quarter, or a year.
To put it in simple terms, financial statements allow you to know where the cash, services, and goods go.
Financial statements typically have three main kinds, all of which have different purposes for the business. Namely, these are balance sheets, income statements, and cash flow statements.
1. The Balance Sheet
The balance sheet presents the company’s current assets, liabilities, and shareholders’ equity the time the financial statement was produced. A bookkeeper may prepare this balance sheet depending on your business—it could be annually, quarterly, or monthly.
The basic formula to see the clear picture of how the business stands is, Assets + Liabilities + Shareholders’ Equity.
Assets refer to anything that the company owns, which can be measured. This includes both tangible and non-tangible properties. These consist of cash on hand, cash in transit, cash receivable, note receivable, equipment, land, building, furniture, vehicles, unsold inventory, patents, trademarks, etc.
Liabilities are all the debts a company owes to people or businesses. These are what the business costs money, and subtracting it from assets will show you the estimated value of how much the business has. Liabilities include accounts payable, notes payable, credit card debts, mortgages, rent, utilities, taxes, salaries, etc.
This is the value of the company after subtracting the liabilities from all assets the business has. The owners or shareholders of the company own this sum of money left, assuming all assets sold and debts paid.
2. The Income statement
This financial statement is the generated report that shows how much money was earned over a given time. It also provides a clear picture of what was spent to arrive at your net profit. In short, this income statement shows you how the business performed over a particular time.
It is also commonly called a profit and loss statement or statement of operations. It follows the formula of Revenue – Costs and Revenues = Net Profit/Loss.
Here’s a definition of some of its terms:
Cost of Goods Sold (COGS)
The total costs to make or produce goods or services.
Revenue – COGS = Gross Income
The total costs of operating the business, excluding the COGS.
Gross profit – Operating expenses = Net income
The quantified measure of an asset (like vehicles, equipment, buildings, etc.) that reduces its value over time.
Earnings per share (EPS)
Net income / outstanding shares = EPS
3. The Cash Flow Statement
It is the financial statement detailing the cash inflows and outflows of the company. It is an essential part of identifying a business’s financial health as it shows the amount of cash you had worked with and how much is left after a period of time.
The cash flow statement shows the ability of the business to continue operating in long- and short-terms. Most investors use this financial statement to decipher the company’s financial standing, whether it’s good or bad.
The three sections included in the cash flow statement consist of:
Cash flow from operating activities
This details the cash flows made in running the business. This includes what you spend and earn during normal operations.
Cash flow from investing activities
These cash flows refer to the money used to invest in assets which the company will use for a long time. This includes the acquisition and disposal of properties like equipment, vehicles, and land.
Cash flow from financing activities
This cash flow refers to the money used in investing for the business, including loan procurements and repayments. It also includes the interests earned for loans and other debts. The capital contributions of shareholders also go here.
Financial statement analysis
Now that you have a comprehensive introduction to what consists of financial statements, it’s time to walk you through learning to analyze financial statements. Here are three common analysis methods used in financial statement analysis.
1. Ratio Analysis
The ratio analysis allows you to get a glimpse of the company’s capability to cover debts and how much profit it earns.
When ratios are computed for a given time, you can use it to compare against other periods to identify the business’s overall performance.
Here are some of the common kinds of ratios to know:
This lets you see how the business fully utilizes its assets. Some efficiency ratios include inventory turnover, accounts receivable turnover, accounts payable turnover, and asset turnover.
This aims to decipher the capacity of the business to continue operations. Some of its ratios include cash coverage ratio, quick ratio, and current ratio.
This shows an overview of how the company relies on debts to maintain the operations. Some of its ratios include debt to equity ratio, fixed charge coverage, and debt service coverage ratio.
This aims to show how profitable the business is. The profitability ratios include return on equity, gross profit ratio, return on net assets, and break-even point.
2. Vertical Analysis
This refers to the process of analyzing a single column in the financial statement. It makes it easy to identify how individual items relate to another item in the given column. It provides the results of the income statement and balance sheet as the percentages of sales and assets.
3. Horizontal Analysis
Also known as “trend analysis,” horizontal analysis is reading the current financial statement to compare it to previous reports. This allows you to see the differences and progresses made in each different period. This way, it’s easy to spot any drastic change that occurred in a year, quarter, or a month. This is usually used in analyzing income statements and balance sheets.
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