How To Interpret Financial Statements

Financial statements provide a look into the financial life of a company. They show how money flows through the company, and reveals its financial health. For small business owners seeking investment opportunities or seeking to attract investors, it is beneficial to know how to create and evaluate these reports.

When it comes to establishing financial statements, decide on the reporting period or how often the statements will be created: monthly, quarterly, or annually. You can use accounting software, which can make creating these reports much easier, or seek professional accounting help if you need it.

Key Parts of a Financial Statement

In this article, you will learn about three types of financial statements: balance sheets, income statements (also called profit and loss or P&L statements), and cash flow statements.

“By definition, the balance sheet speaks to the company’s health. However, not being a good steward over the P&L and cash flow statements would be the equivalent of a diabetic never monitoring their glucose levels. It can lead to irreversible tragedy,” said George Dandridge Jr., EA, NTPIF, CTC, President of Elite 8 Tax and Financial Services. Dandrige works extensively with small businesses to establish sound accounting practices.

“My experience has been that most business owners wait too late to address the P&L and do not have a cash flow statement. The cash flow statement is a great indicator of if a company is profitable in most cases,” he told The Balance.

Interpreting the Balance Sheet

A balance sheet provides the financial snapshot of your business. It is the first thing investors and banks want to see if you’re looking to raise additional capital, and typically what they rely on heavily to give you money.

“If a company’s balance sheet has too much debt or too few assets, it will be difficult to secure a bank loan or surety bonding,” said Dandridge.

Components of a Balance Sheet

Assets are valuable properties, cash, investments, patents, or trademarks owned by a company. Assets can be current (can be liquidated within a year) or noncurrent (will take longer than a year to sell). Some noncurrent assets are fixed, or not sellable, because they are needed to operate the business, such as vehicles or office furniture.

Liabilities are debts the company owes for supplies, business loans, rent on a property, payroll, and other obligations. Liabilities can also be current or long term.

Shareholders’ equity, also called capital or net worth, is the cash value of the company if all assets were to be sold and all liabilities paid off. Shareholders’ equity is the amount owners invested in the company’s stock plus or minus the company’s earnings or losses since its inception.

Financial Ratios

To investigate the financial health of a company, investors often use “ratios” to analyze two or more components of a financial statement. For balance sheet reports, these include:

• Quick sheet ratio: A quick sheet ratio is what investors use to measure a company's short-term liquidity. It shows if the company has access to enough cash to meet short-term financial obligations. Companies with high quick sheet ratios are well-equipped to cover their current liabilities.
• Debt-to-equity ratio: This ratio measures how much debt a company is taking on in comparison to the amount of money owners are investing in the company.
• Current ratio/Working capital ratio: If a company uses its current assets to pay off all its current liabilities (those that must be paid within a year of the date of the balance sheet), any money left would be working capital.

Interpreting the Income Statement

Income statements report how much revenue a company profited or lost over the reporting period. The report also includes earnings per share (EPS), which details how much money the company’s shareholders could expect to receive if the company made a distribution of all its net earnings for the period.

Components of an Income Statement

The report starts with the “gross revenue,” or the total amount of revenue earned through the sale of products or services. “Gross” indicates that this total is not final, as it does not reflect the whole story because expenses have not been addressed.

After stating the revenue earned, the statement will list and deduct the amount of money the company cannot collect from the sales it made (due to such things as returns or discounts). The “net” revenues, or the amount of money remaining after the deductions, will be stated.

Several expenses then are taken from the net revenue. These deductions vary, but usually start with the cost of making sales. The total after deducting these expenses is called the “gross profit” or “gross margin.” Once again, “gross” indicates that the figure is not final as more deductions for expenses are to come. Operating expenses such as marketing costs, staff salaries, and product research are then deducted from the total.

Following these deductions, the income statement will list “income from operations” or the operating profit before income tax or interest expenses are taken. Both “interest expenses” (the interest a company paid for loans) or “interest income” (money the company earned through investments) are then either subtracted from or added to the operating profit. Finally, income taxes are deducted to determine the net profit (also called net income or net earnings) or net losses. At this point, it is clear if the company earned a profit or sustained losses over the accounting period.

“The income statement is one of the most valuable tools in making short-term decisions while also revealing the results of past decisions,” said Dandridge. “Understanding specific revenues and the expenses and generating them will illustrate what products or services your company may need to remove or double down on.”

Income Statement Ratios

Some income statement ratios are:

• Gross profit margin: This financial ratio is used by company owners and investors to measure how efficiently a company produces the products it sells. Results should be compared to other time frames and competitors in the industry to be accurate.
• Operating income: Refers to a company’s income after deducting its operating expenses, but before subtracting interest and income taxes. Operating income is also called earnings before interest and taxes (EBIT), operating profit, recurring profit, and operating earnings.
• Operating profit margin: Operating profit generally refers to the money a company controls after all its expenses have been deducted.
• Net profit margin: This expresses how much of the income earned by a company ends up as profit.
• Return on assets: This ratio measures how productively a company uses its assets to make money.
• Return on equity: This is an important indicator of a company’s profitability as it shows the income a company possesses after paying taxes and in relation to shareholder equity.
• Accounts receivable collection: This examines how and when a company collects and pays accounts receivables.

Interpreting the Cash Flow Statement

A cash flow statement reports the company’s inflow and outflow of cash. It shows the net increases or decreases in cash for the reporting period from operating activities, investing activities, and financing activities.

“Business owners tend to always miss accounting for cash spent, and some tend to not record cash received,” said Dandridge. “This puts everything out of balance. For small businesses, co-mingling is an Achilles heel, especially if they are ever audited.”

There are three types of cash detailed in these reports:

• Cash from operations: Cash flow earned from the delivery of goods and services and which includes expenses and revenue
• Cash from investing: Cash flow from selling off assets or purchasing physical and non-physical assets with cash, not credit
• Cash from financing: Cash flow from equity or debt financing, such as taking a loan

The Bottom Line

Most U.S. public companies are required to file their financial information with the U.S. Securities and Exchange Commission (SEC).  The companies are required to file Form 10-K for annual information, and Form 10-Q is required after the company's first through third fiscal quarter. While the SEC sets disclosure requirements, it does not evaluate the accuracy of the reports. The reports are viewable by the public on the SEC's EDGAR website.

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