You don’t have to be a CPA or rocket scientist to decipher the information on financial statements. If you have been intimidated or reluctant to take the time to learn to read your company’s financial statements, now is a great time to learn.
Below are a few quick and easy steps to untangle the web of financial reports like income statements, balance sheets and cash flow statements.
Income statements can be used to make key decisions, such as whether to extend credit to new accounts; increase or decrease an existing line of credit; offer certain terms or discounts; and, most importantly, whether a company will get paid.
The income statement records a company’s performance over a set period of time and starts with net operating income, sales or revenue, and ends with the net income. The net income is what the company earns after deducting expenses like the cost of goods sold, overhead and interest.
Key metrics to look at on the income statement include the interest coverage ratio and gross profit margin. The interest coverage ratio or times-interest-earned ratio lets you know if the company has enough money to cover the cost of its debt. The gross profit margin shows the company’s relationship between revenue and the cost of goods sold. You can use the percentages to gauge whether a company is incurring insufficient volume or excessive purchasing or labor costs.
You want both the interest coverage ratio and the gross profit margin to be high so that your company is not carrying too much debt and there is enough money to pay expenses.
A balance sheet captures a company’s financial position at a specific point in time. This shows the company’s total assets such as cash, short-term investments, inventories and equipment; total liabilities like accounts and notes payable; and shareholders’ or owners’ equity. The quick ratio and the debt-to-equity ratio are important to note in the balance sheet.
Quick ratios are considered to be a more conservative measurement than the current assets ratio because inventories are excluded. Inventories are “less liquid” than cash, and if a company needed to sell its inventories to pay debt, it could be difficult to arrange a quick sale.
A high debt-to-equity ratio could indicate a company has aggressively financed its growth with debt. On the up side, if the borrowed money assisted with increased or improved operations, the company might generate more earnings.
Each industry is different, and it is essential to compare to its peers. Some industries have low gross margins which could be considered bad, but if it is an industry norm and the fixed costs are low, it should be less of a concern.
Cash flow statement
Cash flow statements tell where a company is getting cash and how they are using it. Cash flow statements are divided into three sections: operating, investing and financing activities. Some key information contained in cash flow statements comes from income statements and balance sheets.
Operating activities — cash and non-cash
The first line item is consolidated net income. You can add certain line items like depreciation and non-cash transactions to net income and subtract other items, such as deferred income taxes, to calculate how much cash a company has generated during a specific time period.
Investing activities — inflows or deposits
A cash flow statement’s investing activities section details a company’s property, plant and equipment purchases, sales of short-term investments, or the acquisition of a business during a specific time period.
Financing activities — outflows or payments
Understanding significant changes in a company’s cash flow can help you make informed decisions. You want to know whether your company’s cash is increasing or decreasing. Gains may signal an organization financed its debt and investments and had more money remaining than in the prior period. Similarly, if a company’s cash flow is decreasing, the organization may experience future cash flow management problems.
While you may still need to hire a professional to help you maintain your financial statements and documents, it is always good to have a general understanding of what each financial statement is used for. As a business owner, it is important to know the financial trends to determine if the numbers are increasing, declining or staying flat. Then you can be proactive and steer you company in the correct financial direction.