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. Collectively, they tell the story of your business’ financial position and financial performance. Moreover, by carefully analyzing them, you may be able to uncover potential money management irregularities or even fraudulent activity.
The Balance Sheet
The balance sheet presents a snapshot of your company’s assets owned, and liabilities due, as of a particular point in time. Current assets are either cash or assets that can be converted into cash within twelve months. An example is accounts receivable from customers. Current liabilities are obligations of your company that must be paid within twelve months, such as accounts payable.
Working capital is the difference between current assets and current liabilities. A positive working capital is a sign of liquidity.
Property assets are those that have a useful life that exceeds one year. These assets are recorded at cost less depreciation accumulated over the years. Depreciation is an annual expense that recognizes the economic benefit generated by the property assets over their estimated useful lives.
Long-term debt represents the portion of the principal payments of notes payable that are due beyond one year.
Net worth or owners’ equity is the amount the business’ assets exceed liabilities. If liabilities exceed assets then your company is in a deficit position.
There are a number of balance sheet ratios worth monitoring. Examples include:
Turnover of receivables: this calculation finds the ratio between the net sales for the period and the average balance in accounts receivable. The resulting ratio is a measure of how many times accounts receivable are collected (or turned over) during the period being examined. For example, a ratio of 6 indicates that accounts receivable, on average, were completely collected 6 times over the past year, or every two months.
Inventory turnover: this ratio measures the number of times your company sells (or turns) its inventory during the year. Although, a high inventory turnover is usually regarded as a good sign, a rate that is high in relation to that of similar companies in your industry may indicate lost sales by failing to maintain an adequate stock of goods to serve customers promptly. Low inventory turnover could indicate poor liquidity, possible overstocking or obsolete inventory.
The Income Statement
While the balance sheet can be thought of as a snapshot, the income statement is similar to a video camera which is typically turned on the first day of your business’ fiscal year and shuts off on the last day. It shows the revenue and expenses over a specific period of time. A commonly used term, gross profit, is the income earned after subtracting the revenue, the cost of the goods sold that produced the revenue. Cost of goods sold includes the cost of labor and materials required to make a product. Net income equals the gross profit minus the remaining company expenses (including income taxes). These remaining expenses include sales, general and administrative expenses.
There are a number of income statement ratios worth monitoring as well. Examples include:
Gross margin or gross profit percentage: the ratio of gross profit to net sales is an indication of the company’s operating efficiency. For example, if the company’s percentage is decreasing, it may indicate the company is not passing its increasing costs to its customers.
Operating margin: this ratio of the net income from operations to net sales expands on the issues identified by analyzing the operating expense ratio and is often used as a measure of management’s ability to control its operating expenses.
Statement of Cash Flows
This statement summarizes the cash flowing into and out of your company into three categories: cash from operations, cash from financing and cash from investing. For example, your company may have cash inflows from selling products or services, borrowing money and selling its corporate stock. Outflows may result from paying expenses, investing in capital equipment and repaying long-term debt. 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 continue as a going concern.
Ratios and Trends
The most successful business owners and executives constantly monitor ratios and trends revealed in their financial statements. If you pay regular attention to the three key reports therein, you’ll stand a better chance of identifying potential financial difficulties.
Sidebar: What’s the Difference Between LIFO and FIFO?
You can report inventory in your financial statements in two ways. Your choice will impact both the inventory account on the balance sheet and the cost of goods sold on the income statement. (See main article.) Here are the methods:
- Last-in, first-out (LIFO). This method assumes the last units produced are the first ones sold. Because costs typically rise, the newer (and presumably higher costing) inventory would be sold first, driving up the cost of goods sold and reducing the inventory account on the balance sheet.
- First-in, first-out (FIFO). Inventory bought first is assumed sold first. When costs are increasing, and older, less expensive items are sold first, the cost of goods sold will be lower. The newer, more expensive inventory units remain on the balance sheet.
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