How to Read and Analyze Financial Statements?
The financial statements of a company reflect the financial performance of the company. The finance experts and accountants derive these statements by collecting, recording, and summarizing critical transaction data around the year. The financial statements prepared every year by a company include a balance sheet, income statement, and cash flow statement. However, these are mere numbers that, without adequate interpretation, bear no meaning for a layman. The financial ratio analysis is a technique that the experts use to guide the stakeholders to make appropriate decisions.
The ratio analysis involves using the information from the financial statements by putting them into formulas and analyzing its effect on a particular aspect. For example, the current ratio uses the number of existing assets and liabilities from the balance sheet to reflect the company’s liquidity ratio. Financial advisors and consultants apply advanced-level calculations to make the most out of the financial information. However, we have curated a guide displaying the method of reading and analyzing financial statements using essential ratios and their formulas for every business with no proficiency in using such ratios.
Studying Balance Sheet:
The balance sheet is the most vital statement of the company that clearly distinguishes between the long and short-term assets and liabilities. Assets show the money in hand ( in different forms apart from cash) and what you owe to other parties (liabilities). Together, it forms a position statement signifying where the company stands financially.
- Assets include cash, inventory, highly liquid receivables, and non-current, including machinery, property, furniture, long-term investments, etc.
- Liabilities that the companies have to pay within a year include payables, outstanding expenses, and non-current involves loans, etc.
- Owner’s equity symbolizes the money invested by stakeholders as equity, preference, share capital, and the company retained earnings.
Current ratio: It measures the ease in converting assets into cash to pay off the liabilities. A standard 2:1 is desirable. Its formula is:
Current ratio= Current assets/ Current liabilities
Quick ratio: Like the current ratio, it also tells the liquidity position of the company. However, it uses only highly liquid assets. A 1:1 ratio is considered healthy:
Quick ratio= Quick assets (Current assets- Stock and Prepaid expenses)/ Current liabilities.
Debt to equity ratio: It signifies whether the business uses its money or borrowed money to carry out its operations. It is better to have a low debt to equity ratio. The formula:
Debt to equity= Total current and non-current debt/ Shareholder’s equity
Studying Profit and Loss Statement:
The income statement provides the revenue and expenses incurred in a particular period. The balance is either net profit (income > payments) or net loss (income < expenses). It includes:
Revenue from the sale of products or services the business deals in
Cost of goods (COGS) sold shows the money spent on acquiring or manufacturing the product or service offered to end-users
Gross profit = Sales- COGS
General and administrative expenses help keep the business running like rent, utilities, etc.
Operating earnings is the income before accounting for taxes and interest on debts.
The net profit comes by subtracting the tax and interest amounts.
Financial Ratios Analysis to Interpret Income Statement Involves:
Gross profit ratio:
It measures the amount earned by the business by only taking COGS into account. You can boost this ratio by increasing the sale price or reducing expenses. Higher is always desirable.
Gross profit ratio= Gross profit/ Sales
Net profit ratio:
It shows the final amount left after incurring every possible expense in the year. You can enhance this ratio by curbing unnecessary costs and increasing revenue possibilities.
Net profit ratio= Net income/ Sales
Studying Cash Flow Statement:
A cash flow statement shows the inflows and outflows of cash in a particular period and the company’s current cash position. It involves adding incomes and subtracting money operating, investing, and financing items to get a closing cash balance.
The Financial Ratio Analysis Involved Here Include:
Current liability coverage ratio: It determines the cash position of the company to pay current and upcoming liabilities. Higher than one is impressive, whereas lower than one shows the need for improvement.
Current liability coverage ratio= Net cash from operating activities/ Average current liabilities
Cash flow coverage ratio: It measures the company’s ability to pay off investors’ funds in cash and displays financial health. Companies must strive to keep this ratio above one to attract investors.
Cash flow coverage ratio= Net cash flow from operating activities/ Total debt.
Conclusion:
The ratio analysis of a company provides a simple, easy-to-understand interpretation of the complex financial numbers that many people might not know or qualify. Reading and analyzing financial statements using this process expedites the decision-making process of the business. If you struggle to find time to conduct this activity, you can hire accounting outsourcing services. It will free your money, time, and energy to invest in better opportunities.