Understanding Financial Statements of a Company
'If you don't have regular and accurate financial statements, you're driving your business 100 miles an hour down a one-way street, the wrong way, at night, in the fog, without lights'. - Jim Blasingame
Would you like to do business without an idea of where it's going? It's like shooting without aiming. Even if you believe that your business is doing great, and your earnings are going up, you need financial statements. The objective of financial statements is to provide a clear picture of your company's financial position. Also, well-kept financial statements help you compare the performance of your business with competing businesses. Stakeholders including financial institutions, investors, shareholders, and government base their important decisions on a company's financial statements.
The importance of financial statements for a company cannot be denied. However, merely preparing financial statements for the heck of it is not enough. A clear understanding of financial statements and budgeting will help you make the right decisions at the right time, and steer your business towards profits. In this article, we've listed out ways in which you can analyze your financial data better.
Important Financial Statements:
Income Statement - The purpose of an Income Statement, or Profit and Loss statement is to determine whether a business is making profits or incurring losses. Typically, an income statement is prepared to arrive at the net income earned during a period, which is the difference between the revenue and the operating expenses.
Balance Sheet - The Balance Sheet is a statement of a company's assets, liabilities, and capital at the end of a period. A company's assets are what it owns, it's liabilities are what it owes, and the capital is the amount that its shareholders have invested. In contrast to the Income Statement, the Balance Sheet shows the financial position at the end of a period, say, at the end of the financial year.
Cash Flow Statement - The Cash Flow statement is a systematic record of the cash and cash equivalents entering and leaving the business during a period. The purpose of a Cash Flow Statement is to determine the inflow an outflow of cash through operating, investing, and financing activities in a year. The closing balance is the exact value of cash or cash equivalents left with the company at the end of the period.
A combination of the Income Statement, Balance Sheet and the Cash Flow Statement presents a complete picture of the financial position, and the overall performance of a business.
How Can You Understand Your Financial Statements?
Fixed Assets Vs Current Assets - A company's balance sheet shows its assets and liabilities. Assets are typically a blend of fixed assets and current assets. While fixed assets are usually property, plant and machinery, current assets comprise of cash, inventory, receivables etc.
Even if the position of assets looks great in your balance sheet, it is important to know which assets are higher in value. If you've got a lot of valuable inventory in stock, and a huge amount in the receivables, it indicates lack of sales, and incompetent recovery of amount from debtors.
Current Liabilities Vs Long-Term Liabilities - Current liabilities are amounts payable by your business within 12 months. Long-term liabilities are moneys due to outsiders for a longer period. These include long-term loans, debentures, bonds, etc.
In contrast to assets, a business is considered to be well off if it's current liabilities are greater in proportion to long-term liabilities. A proper understanding of current and long-term liabilities helps understand the risk associated with the business.
Understanding the P&L Statement - The income statement is a statement of expenses incurred and revenues earned by a business in a year. There are two primary types of expenses; operating, and non-operating. Operating expenses are the expenses incurred to carry out the main business activity, for example, manufacturing a product. On the other hand, the non-operating expenses are fixed expenses, outside of the main business operations, for example interest, depreciation, taxes, etc.
Regardless of whether a business is making profits or losses, it should always try to reduce its operating expenses. Minimum operating expenses are the true indicators of the good financial health of a business.
Ratio Analysis - Ratio analysis is an effective way to analyze a company's financial statements. A financial statement ratio is a ratio between any two elements from the financial statements. There are some standard ratios used to evaluate the overall performance of a business. For instance, activity ratio, inventory turnover ratio, current ratio, quick ratio, cash ratio, gross profit ratio, net profit ratio, debt-to-equity ratio, debt-to-assets ratio, and so on.
Financial ratios are key indicators of a company's efficiency and weaknesses. They also help to compare the current position with previous years, as well as with other companies.
Financial Auditing - Another great way to analyze a company's financial statements is to get the financial statements and reports audited by an external auditor, financial advisor, or expert. The primary purpose of financial audits is to give regulators, investors, directors, and managers reasonable assurance that financial statements are accurate and complete.
Financial auditing also helps a business owner understand the actual performance of his business, and make better business decisions in future. A business should get his financial records audited at least once a year.
The primary objective of preparing financial statements at the end of a financial year is to track the financial performance of a business. However, financial statements can sometimes be very technical, or ambiguous. These are some ways in which the financial statements can be deciphered. A clear understanding of the financial statements is the most important activity for any business, because that's how the future business decisions, financial planning and operational activities will be carried out.