Not too many people have know-how when it comes to reading a financial statement. Many think it’s a task best left to someone else.
But, 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.
Someone who wants to invest in a business or, perhaps, has been recently appointed to a company’s board of directors may not be familiar with financial statements and the information they can reveal. With a few pointers and a little practice, almost everyone can make sense of all the numbers.
What financial statements contain
When reading a set of financial statements, you may see the following items:
- Independent accountant’s/auditor’s report
- Balance sheet
- Income statement
- Statement of cash flows
- Statement of stockholders’ equity
- Statement of comprehensive income
- Notes to financial statements
- Supplemental schedules
Don’t be 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 notes.
In an audit, the independent, or external, auditor expresses an opinion on whether an organization’s financial statements present fairly, in all material respects, the financial position of the organization in accordance with the stated method of accounting.
Typically, you can expect 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
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.
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 information is important because a business should have cash left over after the trade payables are satisfied.
The income statement
The income statement presents revenues and expenses for a set period of elapsed time.
Revenue is shown often by category, less expenses. Expenses are typically split between what is known as “cost of sales” and selling, general and operating expenses. You should look for gross profit for the financial health of the operations and net income for the overall financial performance.
The cash flow statement
The cash flow statement provides an analysis of where cash is generated and where it is spent during the same period as the income statement.
This statement provides information on the net cash flows from operating, investing and financing activities. A key focus should be on cash flow from operations. A positive operational cash flow indicates that the entity is generating cash from its operation.
Notes to the financial statements
The notes to the financial statements 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 contingent assets and liabilities are not measured for recording in the financial statements and appear only in the notes, so be sure to read carefully – and ask questions.
Ratios – why they’re important
Ratios are key analysis factors. Banks and lending institutions use a variety of ratios to determine ability to repay debt and viability for new loans.
Return on assets provides information on how efficient capital is used to generate income. The gross profit ratio is a good indication of financial health. Without adequate gross profit, an entity will be unable to pay its other expenses. Both ratios can be compared to peer data.
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.
If you have questions about how to read a financial state, please contact our firm.