Tips for reading financial statements

As the year comes to an end, many business owners are taking a look at their financial reports the first time. Financial reports are necessary tools for businesses but are often ignored because of uncertainty about what they are telling you. The ability to read and comprehend your financial statements is key to developing and growing your business. A few statements that are critical to understand are your balance sheet, profit and loss, and cash flow. If you are using accounting software, these statements are most likely already prepared for you and you just need to know how to read them to get the most information from them.

Balance Sheet

The formula behind the balance sheet is Assets = Liabilities + Owners’ Equity. Balance sheet accounts are permanent and roll forward year to year so you are viewing balances as of a given date. The balance sheet gives you the following information:

  • Business Assets – “What do we have?” Not only what you have but also what you have control of. This includes items such as cash, fixed assets, investments, inventory, and accounts receivable.
  • Liabilities – “What do we owe?” Liabilities can include loans, credit cards, payroll taxes, and accounts payable.
  • Owners’ Equity – “What is left over for the owners’?”

Tips for reading the Balance Sheet:

  1. Analyze with ratios- Choose a few key ratios to run on a recurring basis. Some helpful ratios include:
    • Current Ratio = Current Assets / Current Liabilities
    • Working Capital = Current Assets – Current Liabilities
    • Debt to Equity Ratio = Total Liabilities / Owners’ Equity
  1. Read your balance sheet regularly. The more familiar you are with your reports, the better you will become at spotting good and bad trends and how to address them.
  2. Current assets = short term resources. Current items are usually considered cash or items that can be converted to cash within that fiscal year. The main current asset accounts are cash, accounts receivable, and prepaid expenses.
  3. Current liabilities = short term obligations. These obligations are debts that must be paid within the year. Current liability accounts include accounts payable, payroll tax liabilities, and short term notes.

Profit and Loss

The Profit and Loss is the statement that you most likely use on a regular basis, but it is not telling you everything you need to know about your company’s financial health. Unlike the balance sheet, the profit and loss does not roll forward year to year. It starts at a zero balance at the beginning of each year.

Tips for reading the Profit and Loss:

  1. Analyze with ratios- Choose a few key ratios to run on a recurring basis. Some helpful ratios include:
    • Gross Profit = Revenue – COGS
    • EBITDA=Earnings before interest, tax, depreciation, and amortization
  1. Watch for trends. You can compare by month, quarter, or year to date.
    • Increasing Sales and Declining Profits- Is there a way to increase margins?
    • Increased COGS – Is the increase industry wide or do you need to review your suppliers?
    • Increasing non-variable expenses (such as utilities, salaries, and rent) – You may be able to switch providers or locations and cut costs without reducing revenue.

Cash Flow

The cash flow statement gives you the information you need to analyze if your business has the necessary cash to stay afloat. Cash flow statements have three distinct sections, operating, investing, and financing.

  1. Analyze with ratios- Choose a few key ratios to run on a recurring basis. Some helpful ratios include:
    • Operating Cash Flow/Net Sales. This percentage tells you how many dollars of cash you get for every dollar of sales. The higher the percentage, the better.
    • Free Cash Flow = Cash flow provided by operating activities – Capital Expenditures. This ratio tells you how much cash is left over from operations after the company pays for its capital expenditures.