How to Read and Analyse Financial Statements

May 28, 2024

Simon Madziar
Simon Madziar

How to Read and Analyse Financial Statements

 

Key Highlights

  • Financial statements, such as the income statement, balance sheet, and cash flow statement are essential tools for understanding a company's financial performance.
  • Net income, gross profit, and cash flow are key indicators of a company's financial health and overall performance.
  • Understanding and analysing financial statements can help businesses make informed decisions, identify areas for improvement, and track their financial progress.
  • Financial statements provide valuable insights into a company's revenue, expenses, assets, liabilities, and equity, allowing stakeholders to evaluate its financial stability and profitability.
  • By following a step-by-step guide to reading financial statements, business owners can gain a better understanding of their company's financial position and make more informed decisions.
  • Analysing financial ratios, such as the current ratio, debt-to-equity ratio, and net profit margin, can provide further insights into a company's financial performance and help identify areas for improvement.

Introduction

Financial statements are crucial tools for understanding and analysing a company's financial performance. They provide a comprehensive overview of a company's revenue, expenses, assets, liabilities, and equity, allowing stakeholders to evaluate its financial health and profitability. By understanding and interpreting financial statements, businesses can make informed decisions, identify areas for improvement, and track their financial progress.

The three main types of financial statements are the income statement, balance sheet, and cash flow statement. The income statement provides information about a company's revenues, expenses, and net income, while the balance sheet provides a snapshot of its assets, liabilities, and equity. The cash flow statement shows the inflows and outflows of cash during a specific period, providing insights into a company's liquidity and cash management.

Analysing financial statements involves examining various financial ratios and metrics to assess a company's financial performance. These ratios can help identify strengths and weaknesses, measure profitability, and assess a company's ability to meet its financial obligations. By understanding and using financial statements effectively, businesses can make better financial decisions, manage their resources efficiently, and strive for long-term success.

The Importance of Financial Statements for Your Business

Financial statements play a crucial role in understanding a company's financial health and performance. They provide a comprehensive overview of a company's financial activities, including its revenue, expenses, assets, liabilities, and equity. By analyzing these financial data, businesses can make informed decisions about resource allocation, budgeting, and investment. Financial statements also help stakeholders, such as investors, lenders, and regulators, evaluate a company's financial performance and assess its ability to meet its financial obligations. By understanding and using financial statements effectively, businesses can enhance their decision-making processes and improve their overall financial performance.

Understanding the Role of Financial Statements

Financial statements are essential for financial reporting and provide a snapshot of a company's financial position and performance. They serve as a tool for business owners to monitor and evaluate their company's financial health. The statement of financial position, also known as the balance sheet, provides a summary of a company's assets, liabilities, and equity at a specific point in time.

By analysing the statement of financial position, business owners can assess their company's liquidity, solvency, and overall financial stability. It helps them understand how much the company owns (assets), how much it owes (liabilities), and the value that belongs to the owners (equity). This information is crucial for making informed decisions, such as determining the company's financial health, applying for loans or financing, and attracting potential investors.

Overall, financial statements provide valuable insights into a company's financial position and performance, empowering business owners with the knowledge they need to manage their finances effectively and make sound business decisions.

How Financial Statements Impact Decision Making

Financial statements play a vital role in decision making for businesses. They provide crucial information about a company's operating activities, financial performance, and overall financial health. By analysing financial statements, businesses can make informed decisions that impact their bottom line.

For example, the income statement helps business owners understand their revenue and expenses, allowing them to identify areas of high profitability or potential cost savings. This information can guide decisions related to pricing, cost management, and resource allocation.

The balance sheet provides insights into a company's assets, liabilities, and equity, helping business owners evaluate their company's financial stability and overall financial health. By understanding their financial position, business owners can make decisions about investments, expansion plans, and managing debt.

The cash flow statement shows how cash flows in and out of a company, providing insights into its liquidity and ability to meet financial obligations. By analyzing cash flow patterns, businesses can make decisions about cash management, budgeting, and liquidity management.

Overall, financial statements provide crucial information that impacts decision making at every level of a business. By using this information effectively, businesses can make informed decisions to drive growth, profitability, and long-term success.

Getting Started with Financial Statements

Getting started with financial statements involves understanding the three main types: the income statement, balance sheet, and cash flow statement. These statements provide a comprehensive overview of a company's financial performance, position, and cash flow.

The income statement showcases a company's revenue, expenses, and net income over a specific period. It helps business owners understand their profitability and identify trends in revenue and expenses.

The balance sheet provides a snapshot of a company's assets, liabilities, and equity at a specific point in time. It helps business owners assess their company's financial position and evaluate its liquidity and solvency.

The cash flow statement tracks the inflow and outflow of cash during a specific period. It helps business owners understand their company's cash position and cash flow patterns.

By understanding and utilising these financial statements, business owners can gain valuable insights into their company's financial performance, position, and cash flow, enabling them to make more informed decisions and achieve financial success.

What You Need to Begin

To begin understanding and using financial statements, business owners need to familiarise themselves with the basics of financial accounting and key accounting principles. This foundation will help them interpret the information presented in financial statements accurately.

Financial accounting involves the recording and reporting of a company's financial transactions and activities. By following generally accepted accounting principles (GAAP), businesses ensure consistent and reliable financial reporting.

Key accounting principles, such as the accrual basis of accounting, revenue recognition principle, and matching principle, guide the recording and reporting of financial transactions. Understanding these principles is essential for accurate financial statement analysis.

Additionally, business owners should be familiar with common financial statement components, such as revenue, expenses, assets, liabilities, and equity. Administrative expenses, such as rent, utilities, and salaries, are examples of items that may appear on an income statement.

By having a solid understanding of financial accounting and accounting principles, business owners can confidently navigate and interpret financial statements, enabling them to make informed decisions about their company's financial performance and position.

Basic Terminology and Concepts

To effectively read and analyse financial statements, it is crucial to understand some basic terminology and concepts commonly used in financial reporting.

Net income, also known as the bottom line or profit, represents the amount of money a company earns after deducting all expenses from its revenue. It is a key indicator of a company's profitability.

Gross profit is the difference between revenue and the cost of goods sold. It represents the profit generated from a company's core operations before considering other expenses.

Operating expenses are the costs incurred to run a business, such as salaries, rent, utilities, and marketing expenses. They are deducted from gross profit to arrive at operating income.

By understanding these basic terms and concepts, business owners can gain a better understanding of the information presented in financial statements. This knowledge allows them to analyse a company's financial performance, identify areas for improvement, and make informed decisions about resource allocation and strategy.

Step-by-Step Guide to Reading Financial Statements

Reading financial statements can seem overwhelming at first, but by following a step-by-step guide, business owners can gain a better understanding of the information presented in these statements. Business owners can gain a better understanding of their company's financial performance, position, and cash flow, enabling them to make informed decisions and drive financial success.

Step 1: Start with the Balance Sheet

When analysing financial statements, it is essential to start with the balance sheet. The balance sheet provides a snapshot of a company's financial position at a specific point in time.

One important aspect to consider on the balance sheet is current liabilities, which represent the company's obligations that are expected to be settled within one year. Examples include accounts payable and short-term debt.

Total assets on the balance sheet represent everything a company owns, including cash, accounts receivable, inventory, and property. It reflects the company's total resources.

Shareholder equity represents the residual interest in the company's assets after deducting liabilities. It represents the value that belongs to the owners of the company.

Step 2: Move on to the Income Statement

After analysing the balance sheet, the next step is to review the income statement. The income statement provides information about a company's revenue, expenses, and net income over a specific period.

Net sales represent the revenue earned from the sale of goods or services. It represents the top line of the income statement and reflects the company's ability to generate revenue.

The cost of goods sold (COGS) represents the direct costs associated with producing or delivering the goods or services. It includes the cost of materials, labor, and overhead directly related to production.

Gross profit margin is the percentage of revenue remaining after deducting the cost of goods sold. It measures the profitability of a company's core operations before considering other expenses.

Analysing the income statement helps business owners understand their company's profitability, identify trends in revenue and expenses, and assess the overall financial performance of the company.

Step 3: Analyse the Cash Flow Statement

In addition to the balance sheet and income statement, the cash flow statement is an essential financial statement to analyse. It provides insights into a company's cash flow and cash management.

Cash equivalents are highly liquid assets that can be easily converted into cash. They include short-term investments, treasury bills, and money market funds.

Operating activities on the cash flow statement represent the cash inflows and outflows from a company's core operations, such as revenue, expenses, and working capital changes.

Financial activities on the cash flow statement represent the cash inflows and outflows from a company's financing activities, such as issuing or repaying debt, issuing or buying back shares, or paying dividends.

Analysing the cash flow statement helps business owners understand their company's liquidity, cash management, and ability to meet financial obligations. It provides insights into the company's cash flow patterns and allows for better cash flow management.

Step 4: Consider Other Financial Statements

In addition to the balance sheet, income statement, and cash flow statement, there are other financial statements and reports that business owners should consider for a comprehensive analysis.

The annual report is a comprehensive document that provides detailed information about a company's financial performance, strategy, and operations. It typically includes financial statements, management discussion and analysis, and other relevant information.

Equity financing represents the funds raised by a company through the sale of shares or other equity instruments. It can provide valuable insights into a company's financial structure and ownership.

Intangible assets represent non-physical assets that have value but do not have a physical presence, such as intellectual property, patents, and copyrights. These assets can contribute to a company's overall value and competitive advantage.

Considering these additional financial statements and reports can provide a more comprehensive analysis of a company's financial performance, position, and value. It allows business owners to gain a deeper understanding of their company's overall financial health and make informed decisions.

Deep Dive into the Balance Sheet

The balance sheet is a vital financial statement that provides insights into a company's financial position at a specific point in time. A deep dive into the balance sheet involves analysing key components and ratios to assess a company's financial health.

Liquid assets, such as cash and short-term investments, are easily convertible into cash and represent a company's ability to meet short-term financial obligations.

Total liabilities represent a company's outstanding debts and obligations. They include both short-term and long-term liabilities.

The equity ratio compares a company's total equity to its total assets. It measures the proportion of a company's assets that are financed by owners' equity.

Analysing these aspects of the balance sheet helps business owners assess their company's financial stability, debt obligations, and overall financial health. It provides insights into a company's ability to meet its financial obligations and the value of the company's equity.

Understanding Assets, Liabilities, and Equity

To gain a better understanding of the balance sheet, it is essential to understand the concepts of assets, liabilities, and equity.

Assets represent a company's resources, including cash, accounts receivable, inventory, property, and equipment. They provide value and generate future economic benefits.

Liabilities represent a company's obligations and debts, including accounts payable, loans, and long-term debt. They represent amounts owed to creditors and other parties.

Owner's equity, also known as shareholders' equity, represents the residual interest in the company's assets after deducting liabilities. It represents the ownership value and the net worth of the company.

Analysing these components of the balance sheet helps business owners assess their company's financial position and stability. It provides insights into the company's resources, obligations, and ownership value.

Example of a Balance Sheet Analysis

A balance sheet analysis involves understanding the company's financial position at a specific point in time. This analysis can be done using vertical analysis and horizontal analysis.

Vertical analysis compares each line item on the balance sheet as a percentage of the total assets, liabilities, or equity. This allows for a better understanding of the proportion of each category.

Horizontal analysis compares the balance sheet over multiple periods to identify trends or changes in the company's financial position. It helps analyse the growth or decline of assets, liabilities, and equity.

For example, let's look at the balance sheet of Company XYZ:

Year 1Year 2
Assets$500,000$600,000
Liabilities$200,000$250,000
Equity$300,000$350,000

Using vertical analysis, we can calculate the percentage of each category in relation to total assets. In Year 1, liabilities accounted for 40% of total assets, while equity accounted for 60%. In Year 2, the percentage increased to 41.67% for liabilities and 58.33% for equity.

Horizontal analysis would involve comparing the changes in each category over the two years. In this case, assets increased by $100,000, liabilities increased by $50,000, and equity increased by $50,000.

Analysing a balance sheet involves understanding key financial ratios that provide insights into a company’s financial health. Let’s explore three essential ratios:

1. Current ratio

The current ratio assesses liquidity by determining how readily current assets can be turned into cash to settle short-term debts; the higher the ratio, the more liquid the assets.

To calculate the current ratio, use this formula:

Current Ratio = Current Assets / Current Liabilities

2. Quick ratio

The quick ratio, also known as the acid test ratio, evaluates the ability of a business to settle its debts by focusing on readily available liquid assets like cash or assets that can be quickly converted into cash.

To calculate the quick ratio, use this formula:

Quick Ratio = (Cash and Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities

As long as your quick ratio is 1:1 or above, you are in good shape; you have sufficient assets that can be easily converted to cash to pay off your debts.

3. Debt to equity ratio

The debt to equity ratio tells you how much your business depends on equity versus borrowed money.

To calculate your debt-to-equity ratio, use this formula:

Debt to Equity Ratio = Total Debt / Owner or Shareholders’ Equity

Exploring the Income Statement

The income statement provides a snapshot of a company's financial performance over a period of time, usually a year or a quarter. It shows the company's total revenue, expenses, and net profit or loss.

Total revenue represents the amount of money generated from sales or services provided. Net profit is the amount left after subtracting all expenses from the total revenue. Operating expenses include costs like salaries, rent, and utilities.

Analysing the income statement helps assess the company's profitability, efficiency, and operating performance.

Revenue vs. Expenses Breakdown

The income statement breaks down the revenue and expenses to provide a detailed view of a company's financial performance.

Revenue, also known as the top line, represents the total amount of money generated from sales or services. It is the starting point for calculating profit.

Expenses, on the other hand, are the costs incurred to generate revenue. These can include operating expenses, such as salaries, rent, and utilities, as well as non-operating expenses like interest and taxes.

The difference between revenue and expenses is the net profit or loss, also known as the bottom line. It reflects the company's overall financial performance.

One important metric derived from the income statement is the profit margin, which measures the company's ability to generate profit from its revenue. It is calculated by dividing net profit by total revenue and is expressed as a percentage. A higher profit margin indicates better profitability.

Example of an Income Statement Analysis

Analysing an income statement can provide insights into a company's performance and profitability. One way to do this is by calculating key financial ratios such as net profit margin and gross profit margin.

Net profit margin measures the percentage of each dollar of revenue that is converted into net profit. It is calculated by dividing net profit by total revenue. A higher net profit margin indicates better profitability and efficiency.

Gross profit margin measures the percentage of revenue that is left after deducting the cost of goods sold. It is calculated by dividing gross profit by total revenue. A higher gross profit margin indicates better cost management and pricing strategy.

By comparing these ratios over time or against industry benchmarks, investors and analysts can assess a company's financial performance and profitability.

1. Gross profit margin

Your gross profit margin indicates the amount of money your company earns for each dollar generated, considering only the cost of goods sold. To boost this margin, you can reduce COGS by cutting expenses on the wholesale prices of products and services or by increasing prices.

To calculate gross profit margin, use this formula:

Gross Profit Margin = (Sales Revenue – COGS) / Sales Revenue

2. Operating profit margin

Your operating profit margin is similar to your gross profit margin, but taking general expenses into account as well. You can increase this profit margin by raising prices, lowering COGS, or lowering operating expenses and overhead.

To calculate operating profit margin, use this formula:

Operating Profit Margin = Operating Earnings (EBITDA) / Sales Revenue

Typically, the focus is on increasing the operating profit margin to generate more profit, while interest and tax expenses are often beyond your control.

3. Net profit margin

The net profit margin is the relationship of your bottom line to your sales revenue; it’s the total amount you keep after taking every expense into account.

You calculate your net profit margin like this:

Net Profit Margin = Net Income / Sales Revenue

Unpacking the Cash Flow Statement

The cash flow statement provides information about a company's cash inflows and outflows during a specific period. It is divided into three sections: operating activities, investing activities, and financing activities.

Operating activities include cash flows from day-to-day business operations, such as sales and payments to suppliers. Investing activities include cash flows from buying or selling assets, such as equipment or investments. Financing activities include cash flows from raising capital or repaying debt.

Analysing the cash flow statement helps assess a company's liquidity, cash generation, and ability to fund its operations and investments.

Operating, Investing, and Financing Activities

The cash flow statement is divided into three main sections: operating activities, investing activities, and financing activities.

Operating activities include cash flows generated from the company's day-to-day operations. This can include cash received from customers, payments to suppliers, and operating expenses.

Investing activities include cash flows related to the purchase or sale of long-term assets or investments. This can include cash spent on acquiring property, plant, and equipment, or cash received from the sale of investments.

Financing activities include cash flows related to raising capital or repaying debt. This can include cash received from issuing shares or borrowing money, as well as cash spent on repaying loans or paying dividends.

Analysing these cash flow activities helps assess a company's ability to generate cash, fund investments, and manage its financial obligations.

Example of a Cash Flow Statement Analysis

Analysing a cash flow statement can provide insights into a company's cash generation and financial health. For example, let's look at the cash flow statement of Company XYZ:

Line ItemAmount ($)
Beginning Cash Balance 10,000
Sales/Revenue15,000
Cash at End of PeriodInterest and Dividends 500
COGS(8,000)
Operating Expenses (3,000)
Interest Paid(200)
Income Taxes Paid(1,000)
Net Cash Flow 2,300
Ending Cash Balance 12,300

Analysing these figures helps assess a company's ability to generate cash and make wise investment decisions over a given period of time.

1. Current liability coverage ratio

The current liability coverage ratio tells you how much cash flow you have for a specific period versus how much debt you need to pay in the near future—typically, within one year’s time.

In order to utilise this equation, you must determine your existing average liability. This liability amount may vary each month due to debt principle payments; computing an average considers these fluctuations to provide an approximate estimation.

To do this, add your current liabilities at the start and end of an accounting period, then divide the total by 2.

Here’s the formula for calculating your current average liability ratio:

Current Average Liability Ratio = Net Cash from Operating Activities / Average Current Liabilities

If a company has a current liability coverage ratio of less than 1:1, it indicates that the business is not producing adequate cash to meet its short-term debts.

2. Cash flow coverage ratio

Similar to the current liability coverage ratio, the cash flow coverage ratio evaluates your ability to settle debts using cash. Unlike the former, this ratio considers all types of debt, regardless of their duration. A strong cash flow coverage ratio signals financial stability and the capacity to meet financial obligations, which can attract investors, facilitate loan approvals, and enhance the marketability of your business. Unlike monthly assessments, cash flow coverage is calculated annually.

Cash Flow Coverage Ratio = Net Cash Flow from Operations / Total Debt

Typically, specialists advise maintaining a cash flow coverage ratio above 1.0 to appeal to investors

3. Cash flow margin ratio

The cash flow margin ratio tells you how much cash you earned for every dollar in sales for a reporting period.

You calculate the cash flow margin ratio with this formula:

Cash Flow Margin = Net Cash from Operating Activities / Net Sales

Financial Ratios and What They Reveal

Financial ratios are powerful tools for analysing a company's financial health and performance. They provide a way to compare different financial metrics and assess the company's strengths and weaknesses.

Ratio analysis involves calculating and interpreting various financial ratios to gain insights into a company's profitability, liquidity, solvency, and efficiency. These ratios can be compared to industry benchmarks and historical data to assess the company's performance.

By using financial ratios, investors and analysts can make informed decisions about investing in or lending to a company.

Conclusion

Understanding and utilising financial statements is crucial for making informed business decisions. By delving into balance sheets, income statements, and cash flow statements, you gain insights into your business's financial health. Assessing key ratios and analysing these statements regularly can guide your strategic planning and financial management. Remember, financial statements are not just numbers; they tell a story of your business's performance and potential. Stay informed, review them frequently, and avoid common mistakes in analysis to leverage the power of financial data effectively for your business growth.

Frequently Asked Questions

 

How Often Should I Review My Financial Statements?

It is recommended to review your financial statements regularly, such as monthly or quarterly. This allows you to track your company's financial performance, identify trends, and make informed business decisions. Business owners and financial advisors can help guide you to the appropriate reporting period based on your specific needs and goals.

What Are Common Mistakes When Analysing Financial Statements?

Common mistakes when analysing financial statements include not following accounting principles, misinterpreting financial information, focusing too much on profit, and only looking at good news. It is important to consider the full picture and analyse financial statements in the context of the company's goals and industry standards.

How best can a financial statement be analysed?

Financial statements can be analysed in several ways to gain insights into a company's financial health and performance. Here are some key steps to analyze a financial statement effectively:

  • Horizontal Analysis: Compare financial data over several periods to identify trends and changes.
  • Vertical Analysis: Evaluate each line item as a percentage of a base figure (often total revenue or assets) to understand the relative size of components.
  • Ratio Analysis: Calculate and interpret key financial ratios like liquidity ratios, profitability ratios, efficiency ratios, and solvency ratios to assess different aspects of the company's financial position.
  • Common Size Statements: Prepare common-size financial statements to standardise the balance sheet and income statement items, making it easier to compare companies of different sizes or within the same industry.
  • Cash Flow Analysis: Review the cash flow statement to assess how well the company generates cash to pay its obligations and fund operations.
  • Benchmarking: Compare the company's financial performance with industry peers or competitors to identify strengths, weaknesses, opportunities, and threats.

By utilising these methods in combination, stakeholders can develop a comprehensive understanding of a company's financial performance and make informed decisions based on the analysis results.

 

Looking for help with your accounting, bookkeeping or taxes? Mahler Advisory can help! Click below to call or schedule a online appointment with us.

*Please note that the above information is general advice only. We recommend you seek advice from a specialist relevant to your personal situation. This information is correct at the time of publishing and is subject to change*

Tax laws and regulations can change over time, so it is important to stay informed about any updates or amendments that may affect your tax obligations. The Australian Taxation Office (ATO) is the authoritative source for the most up-to-date information regarding tax requirements and regulations in Australia.

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