Making the Most of Your Company’s Financial Statements
A company’s financial statements typically comprise its balance sheet, income statement, and statement of cash flows. Each of these reports can reveal much about the financial position, health and performance of your business. By carefully analyzing these statements, you may be able to uncover potential money-management problems or even fraudulent activity.
The Balance Sheet
The balance sheet summarizes your company’s assets, liabilities and net worth to create a snapshot of your company’s financial health as of a specific point in time. The balance sheet reports what the company owns (assets), what the company owes (liabilities or claims on the company’s assets) as well as the amount invested by the shareholders (equity). Current assets (such as cash) mature within a year, while long-term assets (such as plant and equipment) have longer lives. Similarly, current liabilities (such as accounts payable) come due within a year, while long-term liabilities are payment obligations that extend beyond the current year or operating cycle.
Net worth or owners’ equity is the extent to which assets exceed liabilities. Because the balance sheet must balance, assets must equal liabilities plus net worth. If the value of your liabilities exceeds the value of the assets, your net worth will be negative. Net worth is a common financial metric used to determine the financial health of a company.
There are a number of balance sheet ratios that are important to regularly monitor. Examples include:
- Growth in accounts receivable compared to the growth in sales – If receivables are growing faster than the rate at which sales are increasing, customers may be taking longer to pay. They may be running into financial trouble or finding quality issues with the products or services. When accounts are starting to become past term, it may be time to start having discussions with slow paying customers and time to start charging interest.
- Growth in inventory vs. the growth in sales – When inventory levels increase at a faster rate than sales, the company is producing or acquiring products faster than they’re being sold. This can tie up your cash. Moreover, the longer inventory remains unsold, the greater the likelihood it will become obsolete.Growing companies often must invest in inventory and accounts receivable, so increases in these accounts don’t always signal problems. Typically, jumps in inventory or receivables should correlate to rising sales.
- The ratio of current assets to current liabilities – This ratio, known as the current ratio, is a common financial metric used to measure the company’s liquidity or availability of current assets to cover current liabilities as they become due. If this ratio falls below 1, the company may struggle to pay bills coming due. Some business experts believe a current ratio of less than 2:1 is problematic. Monitoring the current ratio may give you advance warning of cash flow issues.
The Income Statement
Unlike the balance sheet which covers a specific date in time, the income statement reports revenues, expenses and related profit or loss generated for a certain period of time. A commonly used term when discussing income statements is “gross profit,” or the income earned after subtracting the cost of goods sold from revenue. The gross profit metric shows how well your company allocates and uses its resources. Cost of goods sold includes the cost of labor, materials and related overhead required to make a product. Another important term is “net income,” which is the income remaining after all expenses (including taxes) have been paid.
Also reflected on the income statement are sales, general and administrative expenses (SG&A). These expenses reflect functions, such as marketing, that support a company’s production of products or services. The ratio of SG&A costs to revenue may tend to be relatively fixed, no matter how well your business is doing. If these costs constitute a rising percentage of revenue, business may be slowing down.
The income statement can reveal other potential problems, too. It may show a decline in gross profits, which means production expenses are rising more quickly than sales. Common causes of this include hiring more employees than you really need and doing an excessive proportion of low- or no-margin business.
Another profit metric calculated based on information reported on the income statement is “gross margin” which is derived from the gross profit number by dividing gross profit by revenues. When analyzing profit metrics like gross profit or gross margin, you should look for trends within industries and market sectors for comparison to your company’s competition.
Statement of Cash Flows
Complementing the balance sheet and the income statement, the cash flow statement shows all the cash flowing into and out of your company. For example, your company may have cash inflows from selling products or services, borrowing money and selling stock. Outflows may result from paying expenses, investing in capital equipment and repaying debt. These activities as reported on the statement of cash flows are classified into three different categories: operating, investing and financing, depending on the source and use of the funds.
Ideally, a company will derive enough cash from operations to cover its expenses. If not, it may need to borrow money or sell stock to survive.
Although this report may seem similar to an income statement, its focus is solely on cash. For instance, a product sale might appear on the income statement, even though the customer won’t pay for it for another month. But the money from the sale won’t appear as a cash inflow until it’s collected. To remain in business, companies must continually generate cash needed to pay creditors, vendors, and employees. So you’ve got to watch your statement of cash flows closely.
Key Performance Indicators
The most successful business owners and executives constantly monitor key financial performance indicators such as ratios and trends revealed in their financial statements to assist in measuring their business’ health. If you pay regular attention to the three key reports therein, you’ll stand a better chance of catching potential trouble before it gets out of hand.
Katie A. Allender?>
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