Most people have little experience or know-how when it comes to reading a financial statement. For some, it seems a foreign language; for others, a task best left to someone else.
At some point, almost everyone in the business world will need to read and understand a financial statement or, more accurately, a set of financial statements.
With a few pointers and a little practice, you too can make sense of all the numbers.
When reading a set of financial statements, you may see:
- Independent accountant’s report
- Balance sheet
- Income statement
- Statement of cash flows
- Statement of stockholders’ equity
- Statement of comprehensive income
- Notes to financial statements
- Supplemental schedules
The balance sheet and income statement are the two areas people typically focus on and should be considered together. These two statements hold the key to a balanced set of statements.
Each statement tells only part of the story. In the case of the balance sheet – the assets and liabilities of an organization are presented as of a specific date. The income statement presents revenues and expenses for a set period of elapsed time.
Before things get too complicated, let’s focus on the basics. Don’t get intimidated by the titles at the top of each page or the number of sheets of paper involved.
Sort through to locate the opinion, balance sheet, income statement and footnotes. The best defense is a good offense, so before you begin reading, have a few expectations.
First, the opinion. One typically expects to see an unqualified opinion, sometimes referred to as a clean opinion. There may be legitimate reasons for qualifications, so don’t be shy about asking for and understanding the reasons.
The balance sheet comes next. Beyond the cash, accounts receivable and payable balances and outstanding debt, the balance sheet offers insight into current ratio, liquidity and retained equity or assets.
Total assets in excess of total liabilities is a good indicator to look for. Liquidity is determined based on the excess of current assets over current liabilities. This is important because a business should have cash left over after the trade payables are satisfied.
The income statement shows revenue, often by category less expenses. Expenses are typically split between what is known as “cost of sales” and selling, general and operating expenses. One should look for gross profit (hopefully, not a loss) as well as earnings per share.
The footnotes hold a trove of often overlooked data. By reading the notes, you can learn what a company does, what significant balances and transactions are reflected in the financial statements and how key transactions are recorded. Many assets and liabilities are not measured for recording in the financial statements and appear only in the footnotes, so be sure to read carefully – and ask questions.
Earnings per share is a key indicator for publicly traded issues. The concept still applies for closely held entities – just think “return on investment.” Most business owners think about cash return on investment, which can be very different, so don’t be confused.
Ratios are key analysis factors. Banks and lending institutions use a variety of ratios to determine ability to cash flow debt and viability for new loans.
A low ratio of debt to equity indicates a reduced risk for the company’s creditors. This factor varies by industry, so the measurement is certainly not one-size-fits-all.
A high ratio of debt to equity is not a signal of weakness if the ratio is in the ballpark for the industry. Indeed, the use of debt may make sense if the cost of debt is less than the return on stockholders’ equity.
As you can imagine, we have only scratched the surface on how to read a financial statement. The basic statements and the accompanying notes hold information, which when analyzed and compared to like companies, prior periods and industry standards, provide diligent readers with a basis for informed decision making.
The wisest advice is to consult with your CPA – to better understand your financial statements and those of the companies in which you intend to invest.