How To Read Financial Statements

Financial statements are an important part of any business or organization. They give an overview of the company’s financial health. These documents provide insights to investors and stakeholders, aiding informed investment decisions.

In this post, we’ll explore the basics of financial statements and offer tips on how to read them. You’ll have the knowledge to invest or understand your business better.

The Importance Of Financial Statements 

Financial statements give an overview of a company’s financial performance and position. They serve as the foundation for evaluating the health and stability of a business. They’re also important for tax authorities. For example, programs like What is Making Tax Digital? It’s a system that requires taxpayers to manage taxes digitally.

Financial statements are important for businesses in a few ways:

1. Tax Accuracy. Financial statements help businesses accurately report their taxes. When business owners and managers understand financial statements, it’s easier to see areas for improvement, create plans, and manage taxes.
2. Improvement and Planning. Financial statements allow owners and managers to find areas that need improvement. After analyzing the numbers of recognise revenue, they can make informed decisions and develop strategies for growth.
3. Stakeholder Significance. Financial statements are crucial for stakeholders like investors, creditors, and potential business partners. These statements offer information for investors to make decisions about where to invest their money. Creditors also rely on financial statements to assess a business’s creditworthiness before offering loans.

Financial statements play a role in ensuring tax accuracy, identifying areas for improvement, and providing important information to stakeholders.

Types Of Financial Statements

There are three main types of financial statements, each serving a unique purpose:

• Balance Sheet: The balance sheet provides a snapshot of a company’s financial position. It presents the company’s assets, liabilities, and shareholders’ equity. Assets represent what the company owns. Liabilities show what the company owes. Shareholders’ equity represents the ownership interests in the company. With the balance sheet, stakeholders can assess a company’s liquidity, solvency, and net worth.
• Income Statement: Also known as the profit and loss statement or statement of operations. The income statement offers information about revenue, expenses, gains, and losses over a specific period of time. It helps check the company’s ability to generate profit by comparing revenue with expenses.
• Statement Of Cash Flows: The statement of cash flows tracks the cash inflows and outflows of a company. It divides cash flows into operating activities: (day-to-day business operations), investing activities (purchases or sales of assets), and financing activities (borrowing or repaying funds). This statement lets stakeholders assess a company’s ability to generate and manage cash.

When you understand the purpose and content of each financial statement, it’s easier to read the available financial information.

How to Read Financial Statements

It’s easier to read financial statements when you understand the basics. Here’s everything you need to know about interpreting the main types of financial statements:

The Balance Sheet

Let’s start with the balance sheet. It comprises three main components: assets, liabilities, and equity. Let’s explore each of these in detail:

• Assets: Assets are things that a person or a company owns that have value. They can include things like money in the bank, buildings, equipment, and even things like patents or copyrights. In simpler terms, assets are like the valuable possessions a person or a company has.
• Liabilities: Liabilities are debts or things that a person or a company owes to others. This can include things like loans, bills to be paid, or money owed to suppliers. Liabilities are like the money you owe to other people, like when you borrow money from a friend and need to pay them back.
• Equity: Equity represents the ownership of a person or a company in something. In the context of a balance sheet, it refers to the owner’s or shareholders’ claim on the assets of the company. The money left after subtracting all the debts (liabilities) from the value of your stand and its equipment (assets) is your equity. It’s how much of the business is truly yours.

Reading a balance sheet requires the use of financial ratios and metrics. Here are three common types of ratios used to assess different aspects of a balance sheet:

• Liquidity ratios help us see if a company has enough money to pay its short-term bills. For example, we can use the current ratio to compare the company’s assets that can be turned into cash (like money in the bank) with its short-term debts. If the ratio is good, it means the company can cover its debts.
• Solvency ratios help us understand if a company is financially stable in the long run. We look at the debt-to-equity ratio to see how much of the company’s funding comes from borrowing compared to what the owners have invested. The interest coverage ratio helps us know if the company’s earnings are enough to pay the interest on its loans. These ratios show if the company can handle its long-term financial responsibilities.
• Efficiency ratios show how well a company uses its resources to make money. The asset turnover ratio looks at how much sales the company generates per dollar of assets it has. The inventory turnover ratio tells us how quickly the company sells its inventory. These ratios help us see if the company is making the most of its assets and managing its inventory effectively.

To better understand how a balance sheet works, let’s look at a sample balance sheet from one of wise.com’s free balance sheet templates:

In this example, we can see that the sample company has a total of USD$308,259 in assets for the current year (2023). These assets are funded by USD$52,271 in liabilities and USD$255,988 in equity. By looking at the balance sheet, stakeholders can understand how financially stable the company is. They can assess its ability to pay its debts in the short and long check how well it manages its assets.

When interpreting a balance sheet, it’s important to analyze and consider various factors. To gain insights and make informed decisions, it’s helpful to compare the company’s balance sheet to previous periods or industry benchmarks.

The Income Statement

Next is the income statement. It comprises components like: 

• Revenue, also known as sales, shows how much money a company makes from selling goods or services. It’s important because it tells us how well the company attracts customers and brings in income.
• Expenses are all the costs a company has to pay to run its business, like employee salaries, rent, utilities, marketing, and raw materials. We subtract these costs from the revenue to find the company’s net income.
• Net Income, also called net profit or net earnings, is what’s left after we subtract expenses from revenue. It shows if the company is making a profit (positive net income) or a loss (negative net income). It helps us understand the overall profitability of the business.

When analyzing an income statement, we use different ratios and financial metrics to understand how profitable a company is. Profitability ratios compare the company’s profit with its revenue or investment. Here are some examples of profitability ratios:

• Gross Profit Margin. This ratio shows the percentage of revenue that is left after subtracting the cost of goods sold. It tells us how profitable a company’s main operations are. The formula for gross profit margin is (Revenue – Cost of Goods Sold) / Revenue.
• Operating Profit Margin. This ratio measures the percentage of revenue that remains after deducting both the cost of goods sold and operating expenses. It helps us understand how efficiently a company is running its day-to-day operations. The formula for operating profit margin is (Operating Income / Revenue) x 100.
• Net Profit Margin. This ratio reveals the percentage of revenue that remains as net income after accounting for all expenses, including taxes and interest. It gives us an overall view of a company’s profitability and efficiency. The formula for net profit margin is (Net Income / Revenue) x 100.

Now, let’s look at an example of an income statement and how to interpret it.

In this example, the sample company generated USD$74,000 in revenue for year 3, with a gross profit of USD$55,000. After deducting operating expenses and interest expenses, the company had an operating income of USD$24,250. After accounting for income taxes, the company’s net income for the year was USD$23,250.

Statement Of Cash Flows

Finally, the statement of cash flows. It’s divided into three main sections:

• Operating Activities: This category includes the cash flows that come from the day-to-day operations of a business. It includes cash received from customers, cash paid to suppliers and employees, and payments for taxes and interest. Positive cash flows mean that the company is generating enough cash from its activities to support its operations, investments, and dividends.
• Investing Activities: These cash flows are about investments in long-term assets or the sale of such assets. Examples include buying or selling equipment and property. As well as acquiring or divesting subsidiaries. Positive cash flows here suggest that the company is investing in growth opportunities.
• Financing Activities: This category covers the cash flows from financial operations. Such as issuing or repurchasing stocks and bonds, paying dividends, or borrowing money. Positive cash flows here show that the company is successfully raising capital for its operations and growth.

Cash flow ratios are the most common metrics used in understand a statement of cash flows. They measure a company’s ability to generate cash or take in cash from its operating, investing, and financing activities. Here are a few examples of these ratios:

• Operating Cash Flow Ratio. This ratio shows how well a company can cover its current liabilities using the cash generated from its day-to-day operations. The formula is Operating Cash Flow / Current Liabilities.
• Free Cash Flow. Free cash flow measures the amount of cash that remains after paying for operating expenses and long-term investments. It represents the cash available to creditors and equity investors. The formula is Operating Cash Flow – Capital Expenditures.
• Cash Debt Coverage Ratio. This ratio assesses a company’s ability to repay its total debts by looking at its cash flow from operating activities. The formula is Operating Cash Flow / Total Debt.

Here’s an example of a statement of cash flows and how to interpret it:

In this example, the company made $147,900 in cash from its day-to-day operations. It spent $41,400 on investments and received $87,000 from financing activities. After all these transactions, the company’s cash increased by $19,500, resulting in a final cash balance of $35,200.

The statement of cash flows complements other financial statements like the balance sheet and income statement. It offers a complete picture of a company’s financial health, liquidity, and financial management.

Wrap Up

Financial statements are important documents that give us valuable information about a company’s finances. These statements include the balance sheet, income statement, and statement of cash flows. Looking at these statements we can assess a company’s financial well-being and make smart choices based on that information.

The interpretation of statements presents some challenges. However, the rewards of financial statement analysis far outweigh the efforts to read them. Management of financial information becomes easier by using budgeting software. These apps come loaded with templates, easy calculations, and automations that simplify dealing with financial statements.