How to Read Financial Statements

How to Read Financial Statements

To truly get your small business on its feet, you’ll first have to master the art of managing your finances. Depending on the size and scope of your business, the difficulty of this could vary — but in any case, you should develop a keen understanding of what it takes to leverage your available resources effectively.

That means not only keeping a close eye on your books but developing an ability to read and understand financial statements. In the business world, these documents are key indicators of an organization’s standing, and they serve many purposes in retaining and acquiring more business over time.

On its most basic level, a financial statement demonstrates how a business has utilized the funds it has received from stockholders and lenders. In this way, these statements speak volumes about the executive strategy and offer a sense of transparency for those who have infused their own funds into the business’ mission.

Of course, financial statements also pull the curtain back on a business’ financial status. To make it easier for you to read this critical document, let’s take a closer look at what information it includes and what this shares about business operations.

Breaking Down Financial Statements

While the exact contents of a financial statement may include other sections, these three fundamental parts are almost universally represented. You’ll need some background on what each one is and how it speaks to your business. Here’s a quick rundown:

Balance Sheet

This section is an overview of your business assets and liabilities. The balance sheet summarizes your financial situation in a relatively brief way, providing a glimpse at your net worth (and general financial standing) at a particular point in time. In many cases, balance sheets are generated at the end of a fiscal year and can help contextualize your performance and plans for the future.

To determine your net worth, your balance sheet calculates your assets by breaking down the combination of liabilities and stockholders’ equity. Since this is a way of equalizing assets, this equation uncovers the true amount of assets at your disposal. Assets are then listed by their liquidity and liabilities by the order in which you will pay for them, with short-term listings due to be paid within a period of one year.

Income Statement

This one seems pretty self-explanatory, and for the most part, it is. However, its significance in the overall financial statement cannot be overstated. The income statement hones in on the net income of your business over a period of time, rather than focusing on a snapshot like the balance sheet does. You might opt for quarterly or annual financial statements, for instance, at which point the income statement will cover the net income spanning that entire period.

Within the income statement — also known as the profit and loss account — you’ll find a detailed breakdown of revenue, expenses, and earnings that ultimately leads you to the net income of your business. You can learn a lot from this particular facet of your financial statement, especially if it incorporates older data from previous years. Such an approach can really highlight the differences in your business’ performance over time and show where any drastic changes might provide a boost.

Cash Flow Statement

Having a stable cash flow is an essential part of maximizing your business’ success, and a cash flow statement helps illuminate the realities of this part of your operation. Quite simply, this section of your financial statement lists the cash levels flowing in and out of your business throughout a specific period of time.

In this way, the cash flow statement represents a perfect combination of your balance sheet and income statement. When your net income and cash flow drift apart, the cash flow statement emerges to set the record straight. It includes the most basic activities that comprise your business dealings, including:

  • Day-to-day operations, including revenue and expenditures
  • Investments involving buying and selling assets
  • Financing matters

No matter which facet of your business needs your attention, your cash flow statement will pinpoint any trouble spots for you, allowing your business analysts to take action and improve your financial standing in the coming year.

A Few More Integral Sections

Though the balance sheet, income statement and cash flow statement make up the lion’s share of your financial statement, this document still has a few goodies in store for you. Here are some other important areas to pay close attention to.

Footnotes

Business documents are known for being on the dry side. So it’s easy for footnotes to slip through the cracks, considering their small print and marginalized placement on most pages. But there’s a lot of wisdom to be gleaned from the footnotes of your financial statement.

Businesses often include key accounting practices amidst their financial statements, which can be particularly telling of their financial operations. Moreover, the footnotes are where you’ll find details on a company’s income taxes and what factors influenced its rate.

If you’re looking for information on a business’ pension and other retirement plans, this too will be listed among the footnotes. Specifically, financial statements will delve into the assets and costs associated with these programs and reveal their comparative funding levels. Finally, if a company offers stock options to any employees (including officers), this will be listed in the footnotes as well.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

All the charts and figures in a financial statement can be overwhelming. So if you’re looking for a simple narrative explanation of a company’s financial status, this is where you need to turn. An MD&A presents a quick review of a business’ condition largely for the benefit of investors, describing what the financial statement says about its standing as well as the trends and/or risks that play into it.

In fact, the Securities and Exchange Commission requires that businesses list any ongoing trends, risks and impactful events within their MD&A in the interest of keeping investors informed. With this data, companies are expected to paint a detailed enough picture of their financial condition to give investors context that may drive their own decision-making.

Ratios and Calculations

While many figures are not spelled out in a financial statement, you can often devise any number of ratios and calculations from the information it contains. Which ones you choose to use will likely depend on your industry, but it’s never a bad idea to crunch some numbers as you interpret a company’s financial statement for yourself.

Here are some examples of ratios that can be useful:

  • Inventory turnover ratio: Cost of sale over average inventory
  • Operating margin: Operations income over net revenues
  • Price-to-earnings ratio: Price per share over earnings per share (also known simply as the P/E ratio)
  • Working capital ratio: Current assets minus liabilities

Again, only you can determine which of these ratios applies to your interest and will factor into your own investment in a company. You might even want to try calculating your own business ratios to gain a better perspective of how others see your operation.

Robert Yaniz Jr. has been a professional writer since 2004, including print and online publications. Much of his experience centers on the business world, including work for a major regional business newspaper and a global law firm.
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