How to Analyze Financial Statements

As a business owner, it is important to understand how to analyze financial statements and how to verify if the information is correct. This allows you to assess your financial ratios and to understand your current liabilities, total assets, stockholders' equity, and so on.

You can probably never be completely certain all data are correct, but with a scientific approach, you can check your strategies. From here, you can correct your future statements if you notice any issues or areas of concern.

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What are financial statements?

You may use three basic financial statements in your business: a balance sheet, an income statement, and a cash flow statement. 

A financial ratio measures a company's financial performance in different categories, such as how well it covers its debts or how much profit it makes.

These ratios are calculated by plugging financial information into formulas. Based on which financial statement you're analyzing, you can use various formulas, i.e., different ratios.

Investors, CPAs, and corporate annual reports authors may perform extremely high-level calculations for their clients. We will, however, discuss the most straightforward, essential ratios that business owners use to analyze their financial statements and make decisions on a daily basis.

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How to Read a Balance Sheet

The balance sheet shows how much you own (assets) and how much you owe (liabilities). A company's assets can include cash, accounts receivable, equipment, inventory, or investments. Accounts payable, accrued expenses, and long-term debt such as mortgages and other loans can be considered liabilities.

Parts of a Balance Sheet

Assets

Assets are all the things you own. The money can be either cold hard cash or it can be less liquid, such as inventory or equipment. There may even be some you don't have yet, such as accounts receivables or unpaid invoices.

Liabilities

You lose money when you have liabilities. By removing them from your assets, you can get an idea of how much value your business has to work with. Accounts payable, which typically include payments to vendors or contractors, can be considered a short-term liability; you'll probably pay them off each month. Liabilities like business loans have a longer life.

Owner's Equity

A business owner's equity is the amount of money they have invested in the company. Capital refers to your initial investment. It is the money you used to start up your business. Retained earnings are profits your business has retained. The owner's draw, or drawing on your business, refers to the money you pay yourself from it. The retained earnings of your company should not be used as a personal spending account for reasons of tidy accounting and liability.

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How to Read an Income Statement

Over the course of a financial year, the income statement shows how much money your business has spent and how much it has earned. The bottom line is your net profit.

Net profit is at the bottom of your income statement, which is why it's called the bottom line. Each line item in your income statement becomes more specific as you work down your income statement.

Parts of an Income Statement

The top line, or sales revenue, represents all the money that has come into the business during the month, before any expenses.

The cost of goods sold (COGS) is the amount the business spent in order to make sales revenue.

The gross profit is the owner's income after subtracting COGS, but excluding general expenses.

The general expenses category includes money the business spends on a monthly basis to run its business and make sales. Certain expenses, such as rent, are constant. Others, such as utilities and office supplies, may fluctuate.

EBITDA (Expenses Before Interest, Taxes, Depreciation, and Amortization) is the overall amount the owner takes home after subtracting expenses from revenue, but before adding taxes or interest on debt.

For each reporting period, income tax expense is the amount of estimated income tax paid or owed. In addition to interest payments, this is covered in EBITDA.

A business's net profit is the amount it earned after deducting all expenses, including taxes and interest.

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Six Steps to Analysing Financial Statements

Financial statements are formal reports detailing your company’s financial health. Having regular and detailed financial statements can improve your company’s accountability, as well as your company’s reliability in front of investors, shareholders, and banks. This reliability can be severely damaged if the statements were created in a sloppy way, or if they contain bad data.

Thankfully, there are several steps you can take to ensure your statements are factual and to preserve the trust your business partners and financial institutions have in your management.

1. Check the Quality of the Company’s Financial Statements

You will need to familiarise yourself with current accounting standards and you will need to review the financial statements for their quality. The most important question should be the integrity of the balance sheet and whether it represents the complete picture of the company’s financial situation. Additional essential parts to evaluate should be items such as classification, valuation, and recognition. Finally, check the cash flow of your business to assess liquidity and compare it with the financial operations that were conducted by the company.

2. Check the Value of Your Company

The most important issue for your shareholders and any future investors is your company's steady increase in value. This increase may be measured in many ways, one of which is the comparison between your equity statements, your debt-to-equity ratio, and your cash flow account, showing the precise amounts of free cash flow. This analysis will help you in several ways, as it can show mistakes and issues that came up. It can also become a way to communicate your company’s financial health to the stakeholders, as well as shareholders' equity, so as to ensure their future trust.

 Helpful Resource: What is a Cash Flow Statement?

3. Devise Better Strategies

It is seldom easy to predict the future. Nevertheless, you will need to make strategies to predict the movements of your company and the market as a whole. For that, you will need the reliability of the data inside your financial statements. Try to account for as many factors as possible and use various techniques, such as the Percentage of Sales (PoS) approach. Once you have a detailed plan, you can analyze how the financial statements you have made compare to the situation and revise your positions accordingly.

4. Clear Picture of Your Industry

You should analyze the complete production chain of your company and the impact various industries and markets have on your business process. There can be multiple factors in your supply chain that can seriously impact your business and you will need to know how they are portrayed in the financial statements to have a better idea of future actions. To do this, you can utilize several techniques like Porter’s Five Forces or consult with your accountant on the best way to approach this issue.

5. Analyze Profits and Liabilities

This point can truly benefit your company and add a lot of value for both the stakeholders and the financial statements themselves. The usual approach is to assess critical reports, such as ratios that relate to profitability, liquidity, asset management, and the management of risk and debt.

You will need to make sure to analyze these issues, both from the managerial perspective — regardless of the source of financing — as well as from a shareholder perspective; he or she will definitely be interested in the overall profitability of the company. Additionally, these statements should be compared to those from an earlier period so as to determine trends and tendencies within the company.

6. Have Regular Audits

Regular audits provide an extra pair of eyes to check your quality of reporting and your company’s financial health. Moreover, they can help you assess the reliability of the data you are working with, so you gain a more in-depth insight into your company’s financial health. Consequently, it will be easier for shareholders, investors, banks and tax services to trust you and your financial management skills.

You can always do a comparative analysis of the financial statements, current assets, shareholders' equity reports and the auditing reports and compare them with earlier editions in order to determine if problems are being solved, as well as whether the strategies that you have developed in the past are yielding the expected results.

 

The Importance of Financial Statements

You can never be entirely confident that all your statements will always be impeccable. However, you should do everything in your power as a business owner or manager to keep your records trustworthy. This will assist both you and your team in improving your quality of work and will improve your relations with the stakeholders in your company. Additionally, don’t hesitate to ask for help from an external accountant, who can offer a fresh perspective on your company’s financial health.