Reading financial statements involves analysing three major components – the balance sheet, the income statement, and the cash flow statement.

You can identify ways to make more money, expand your firm, or catch problems before they arise if you know how to analyse your financial statements. Let’s take a look at each of these by one, using examples to help us in understanding these financial statements. Then we’ll look at some fundamental financial numbers to determine how well your company is doing.

What are financial ratios, and what do they mean?

An important aspect of Reading Financial Statements is the use of ratios. Financial ratios depict your company’s financial success in several categories, such as its ability to service its debts or the amount of profit it generates.

These ratios are calculated by entering your financial data into algorithms. Depending on which financial statement you’re looking at, you can employ different formulas—that is, different ratios.

Financial counsellors, investment gurus, CPAs, and corporate annual report authors may use Einstein-level mathematics to assist their clients in making financial decisions. However, we’ll focus on the most basic, important ratios that business owners use to assess their financial accounts and make day-to-day business choices in this article.

What is the best way to read a balance sheet?

Your balance sheet shows you how much money you owe and how much money you have on hand (assets) (liabilities). Cash, accounts receivable, equipment, inventory, and investments are all examples of assets. Accounts payable, accrued expenses, and long-term debt, such as mortgages and other loans, are all examples of liabilities.

A balance sheet’s components: 

ASSETS are all of your valuable possessions. Some of it is real money. Some of it, such as equipment or inventory, is less liquid. Accounts receivable, or payments owing to you, may not even be in your possession yet.

LIABILITIES are costly. By subtracting them from your assets, you may get an estimate of how much value your company has to work with. Accounts payable, for example, which often refers to payments to suppliers or contractors, could be considered a short-term obligation because you’ll most likely pay them off each month. Other obligations, such as business loan debt, last longer.

OWNER’S EQUITY is the money that you, the owner, have sunk into the business. Capital is your initial investment, the money you used to get up and running. Retained earnings are the profit your business has held onto. And drawing, or owner’s draw, is the money you pay yourself from your business.

Using financial ratios to analyse a balance sheet

These three financial ratios allow you to perform a basic balance sheet analysis.

Current Ratio

The current ratio assesses your liquidity, or how readily your current assets may be converted to cash to meet short-term obligations. Your assets will be more liquid if the ratio is higher.

Use the following formula to compute the current ratio:

Current Assets / Current Liabilities = Current Ratio

Here’s a helpful tip to read financial statements – You shouldn’t let your current ratio fall below 2:1; if it does, you don’t have enough current assets on hand to cover your short-term commitments, and you’re in trouble. The higher your ratio, the more likely you are to be able to cover your liabilities.

Quick Ratio

The quick ratio (also known as the acid test ratio) is similar to the current ratio in that it assesses your company’s ability to repay its obligations. It solely considers highly liquid assets, such as cash or assets that can be rapidly converted to cash—in other words, money that can be obtained immediately.

Use the following formula to compute the quick ratio:

Quick Ratio = Current Liabilities / (Cash and Cash Equivalents + Marketable Securities + Accounts Receivable)

Here’s a helpful tip to read financial statements-  The company is doing well if your quick ratio is 1:1 or greater; you have enough liquid assets to cover all of your debts.

Debt to equity ratio

The debt-to-equity ratio indicates how much of your company’s capital is derived from its resources rather than borrowed funds.

Use the following formula to establish your debt-to-equity ratio:

Total Debt / Owner or Shareholders’ Equity = Debt to Equity Ratio

How to Read a Profit and Loss Statement

An important tip to read financial reports is to not ignore the income statement. Throughout a financial reporting period, your income statement will show you how much money your company has spent and how much it has received. This allows you to figure out your net profit, or bottom line.

Because net profit is at the bottom of your income statement, it’s called the bottom line. As you work your way down the income statement, more and more expenses are applied to your revenue, resulting in a more specific income line item.

What is a cash flow statement and how can I read one?

No understanding of financial statements is complete without the cash flow statement. Cash flow statements aren’t used by every small business. However, if you utilise the accrual method of accounting, you’ll need a statement of cash flows to track your financial health.

Expenses and income are recorded on the books when they are incurred, not when the money changes hands, as is the case with the accrual system. For example, if you place a $1,000 order with a vendor, you’ll record it as a $1,000 expense right away, even if you won’t pay the vendor until after you receive an invoice.

Similarly, you may invoice a client $1,000 and keep track of it as $1,000 accounts receivable, which is an asset. However, you don’t have the money yet, so if you tried to use it to make a $1,000 purchase, you wouldn’t be able to.

A cash flow statement reverses transactions where you don’t have cash on hand, giving you a more accurate picture of how much cash you have to work with over time. In conclusion, understanding financial statements are not as easy as it sounds. Use Finlearn Academy’s Guide to Understanding Financial Statements to become a successful investor.