Want to know how to read financial statements? You can not acquire all the facts regarding the financial condition of your organization without all the details. The problem is that there is plenty of data out there, and it can be stressful to gather all the data in one place. These data are required to perform some much-needed analysis.
That is where financial statements come in place. Financial statements offer an insightful window into your organization’s performance. However, there are different types of financial statements and each of them is designed to tell you something different about your organizational performance.
So, if you are much interested to know more about Financial statements then this article is for you. Here, in this article, I am going to wrap together an overview of financial statements, understanding the balance sheet, analyzing key ratios derived from the balance sheet, analyzing the income statement, and evaluating the cash flow statement, and financial statements step by step guide.
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Overview Of Financial Statement
investors and financial analysts rely on the financial data of an organization to analyze the overall performance. Thus, from these data, they can make future predictions on which way the organization seems to be going. One of the most reliable resources of financial statements is an annual report, which contains the organization’s financial statement.
Financial statements are used by employers, market analyzers, and creators to analyze its overall growth and performance. The three major financial statement reports are the balance sheet, income statement, and cash flow statements.
1. Balance Sheet
The first type of financial statement is called a balance sheet. A balance sheet is a table that must show you all of the available resources of your organization and how they have been financed up to a certain date. Additionally, it should also tell you all the company’s assets, owner’s equity, or Shareholder’s equity and liabilities.
The balance sheet should tell you the book value of your business. It tells what your company owns, what it owes, and what has been invested through shareholders. balance sheets are also useful if you want to figure out your organization’s rate of return. If you want to evaluate your capital structure, the balance sheet helps you in the way around. All the data that you require to perform this financial analysis is there in the Balance Sheet.
2. Income Statement
An organization’s income statement is a summary of all its revenue, expenses, losses, and profits over a specific time. An income statement is also referred to as a profit-loss statement. Income statements are critical for accountants and investors as they can evaluate how the company is doing in terms of incoming and outgoing.
They often are included in quarterly reports or annual reports since income statements paint a basic picture of how a company’s business activities are performing during a time frame. Income statements also enable organizations to spot any emerging financial trend that is necessary to react.
3. Cash Flow Statement
A cash Flow Statement is useful if you want a more detailed overview of your organization of how your company’s cash position has changed over a certain time frame. If this term is new to you, a cash flow statement is a fancy way to describe the total amount of cash inflow and cash equivalent being transferred to and from your organization over a certain period.
cash Flow Statement can be divided into three different parts, including
- Cash Flow from operative activities
- Cash Flow from investment activities
- Cash Flow from financing activities
Companies like to evaluate cash flow statement since it provides a transparent picture of whether the business has enough money to operate in the short term and the long term. However, this is all based on how much cash moves in and out.
Understanding the Balance Sheet
Explanation of Balance Sheet Components
The term Balance Sheet refers to a financial statement that reports a company’s assets, liabilities, and shareholder equity at a particular point in time. balance Sheet provides the basis for computing rates of return for investors and it evaluates a company’s capital structure.
There are three components of a Balance Sheet: Assets, liabilities, and Shareholder Equity.
1. Assets
Accounts within the assets segment are listed from top to bottom in order of their liquidity. This is the procedure through which they can be converted into cash. Further, they are divided into current assets, it can be converted into cash within 1 year or less. Another one is non-current assets that cannot be converted into cash.
2. Liabilities
Liability is any money that a company owes to outside parties, from invoices it has to pay to the suppliers to interest on bonds, utilities, and salaries, to creditors to rent. Current liabilities are due within one year on the other hand, long-term liabilities are due at any point after one year.
3. Shareholder Equity
Shareholder equity is the money ascribable to the owners of a business or its shareholders. It is also referred to as net assets since it is equivalent to the total assets of a company minus the debts it owes to non-shareholders.
Analyzing Key Ratios Derived From Balance Sheet
To provide a complete interpretation of an organization quantitatively, balance sheet ratios are used. Balance sheet ratios are used to compare two items on the balance sheet. The balance sheet ratios also analyze other items of a balance sheet. balance sheet ratios are a great means for analyzing the financial standing of an organization.
Various types of balance sheet ratios are Efficiency, Solvency, Liquidity, and Profitability ratios.
1. Current Ratio
The current ratio falls under the Liquidity ratio. It represents the efficiency with which you liquidate your current assets to pay off your current liabilities or present debts. The current ratio tells you how your current assets and liabilities are related. current ratios are the valuable possessions that your company can convert to cash within one year.
Divide the current assets by your current liabilities to get your current ratio. the optimal current ratio is greater than 1:1.
current Ratio=Current assets/ Current liabilities
2. Debt-to-Equity Ratio
The debt-to-equity ratio is the financial metric that represents how much debt and shareholder equity are accessed to finance the assets of a company. The ratio is directly connected to leveraging. The ratio is often known as risk, gearing, or leverage.
Simply, the debt-to-equity ratio denotes the amount of equity available to the company for repaying its debt obligations.
Debt-to-Equity Ratio=Total long-term debt/ Shareholders fund
3. Return On Equity
Return On Equity is the profitability measure that contrasts a company’s profits with the value of Shareholder’s equity. Return on Equity is represented as a percentage and is computed as net income divided by Shareholders equity.
Return On Equity= Net Income/ Shareholder’s Equity
Analysing Income Statement
Explanation of Income Statement’s Components
No two income statements look the same, but they all possess a common set of data. These include total revenue, total expenses, and net income.
1. Revenue
It is the amount of money you are taking in.
2. Total Expense
It includes everything your business spends. Also includes your cost of Goods sold. It specifically refers to how much it costs to make each part of what your business sells.
3. Net Income
It is your bottom line after all your expenses are taken out. Your net income can be shown on an income statement in various ways, including:
Earning before taxes, Earning before interest and Taxes, earning before interest, taxes, depreciation, and amortization.
Analyzing Key Ratios Derived From Income Statements
The following financial ratios are derived from the income statement and used to compare different companies within the same industry. These include:
1. Gross Profit margin
Gross profit margin represents how much money a company makes after accounting for the costs of doing business. The ratio is the percentage of the sales revenue available and also known as the gross margin ratio.
Gross profit margin can be calculated in two ways either by dividing gross profit by net sales or by subtracting the costs of goods sold from the company’s net sales.
2. Operating Profit Margin
A company’s net operating profit margin equals operating income divided by net sales. This is used to represent how much revenue is left over after paying variable costs including raw materials, and wages. This operating Profit Margin is the same as a company’s return on sale and shows how well the return has been managed.
3. Net Profit margin
A profit margin ratio is the most common ratio used to determine the profitability of a business’s activities. It represents the profit per sale after all the expenses are deducted. It indicates how many cents a company generates in profit for each dollar sales.
So, if a company indicates a 30% profit margin, it means its net income was 30 cents for every dollar generated.
To generate the profit margin, you need to divide the net income after tax by net sales.
Evaluating Cash Flow Statement
Whether you are a financial analyzer or an investor, when it comes to reading financial statements, you must remember that a cash flow statement offers a bit of insight into a company’s financial health. A Cash flow statement is divided into operating, investing, and financial activities. Just have a look at its elements.
Overview of Cashhlow Statement Elements
1. Operating Activities
The cash flows from the company’s primary business activities are shown in the cash flow statement area. This part must be examined to determine whether the business is generating positive cash flows from its operations, it is typically a favorable sign.
2. Investing Activities
The cash flows that are produced by the company’s investing activities are also displayed in the area of the statement of cash flow. These investing sections include the purchase or sale of assets. You must examine this area to determine whether the company is purchasing the assets that are anticipated to produce income in the future or selling the assets to grow money.
3. Financial Activities
A company’s cash flow from financial activities is displayed in the area of the cash flow statement. These financial activities include issuance or repayment of debt, or the issuance or purchase of stocks. You need to evaluate this section to explore whether the company is sensibly repaying debts or is manipulating its stock price through stock buybacks.
Key Metrics To Consider From The Cash Flow Statement
1. Operation Cash Flow
Operation cash flow can be simply described as the measure of the cash a business produces through its core business operations within a specific time frame. You can calculate the operation cash flow by subtracting the Operating expense from the Total Revenue.
Operation Cash Flow= Total Revenue-Operating Expense
2. Free Cash Flow
The Free Cash Flow is the money that a company has left over after paying its Operation expenses and capital expenditure. The more free Cash Flow a business has, the more the company can allocate to its dividends, and paying down debts.
You can generate Free Cash Flow by subtracting Capital Expenditure from Operation Cash Flow.
Free Cash Flow= Operation Cash Flow-Capital Expenditure
3. Cash Flow Adequacy
The Cash Flow Adequacy ratio determines whether a company’s Operation Cash Flow is enough to cover its ongoing expenses. The concept of Cash Flow Adequacy is important. You can derive the Cash Flow Adequacy by dividing the Cash Flow from Operations by the sum of capital expenditure + Mandatory Expenses+Dividends.
Cash Flow Adequacy= Cash Flow From Operations/(Capital Expenditure + Mandatory Expenses + Dividends)
Financial Statement Step-By-Step Guide
There are 5 steps that you need to follow to prepare a Financial Statement for your business. These include:
Step 1: Identifying and Gathering Financial Data
The first step of preparing a financial statement is identifying and gathering relevant financial data. You can gather these data from the company’s account records. This step involves collecting information on transactions such as sales, borrowings, investments, and expenses. Systematically organize these data.
Step 2: Adjusting and Classifying Transactions
After collecting financial data, you need to adjust and classify all the transactions. You should do it according to the appropriate accounting principles. Classifying transactions involves adjusting similar items in appropriate categories such as assets, liabilities, revenues, and expenses.
Step 3: Preparing Financial Statement Components
While all the transactions have been classified, the next step is to prepare the individual components of Financial Statements. These include a balance sheet, income statement, cash flow statement, and statement of the Stockholder’s Equity.
Step 4: Consolidation of Financial Statement: (if applicable)
If a company has subsidiaries or other related entities, it may be required to prepare a consolidation of the Financial Statement. This process involves pairing the financial information of the parent company and its subsidiaries to generate a unified view of the entire corporate group’s financial condition.
Step 5: finalizing and Displaying Financial Statement
After preparing the Financial Statement’s components and consolidation of the Financial Statement (if applicable) the last step is to review and present the Financial Statement.
This process ensures that all the information is accurate, and compliant with the relevant accounting standard.
Wrap Up
To realize a company’s financial condition, you need to review and analyze various financial statements, including balance sheets, income statements, and cash flow statements. Here, in this article I have provided every detail of how to read financial statements, hope this guide will help you to analyze your business’s financial condition.
The investors use the Financial Statement of a business to evaluate the company’s profitability, growth potential, and financial stability.