How to decode financial statements

In any business, chief executives often focus on the product or service being offered and rely on others to manage the finances. Bank balances, receipts and payments are easily understood, but things like accrual basis accounting, ratios and working capital can be confusing to non-accountants.

Certain financial statement indicators can alert management to potential issues that need to be addressed:

  • Ongoing losses
  • Aged and possibly uncollectible receivables
  • Slow-moving or obsolete inventory
  • A reduction in gross profit as a percentage of sales
  • Liabilities that exceed assets
  • Increased overhead
  • Loan covenant violations
  • The need to refinance long-term debt or obtain additional sources of financing

To have a complete picture of the company’s financial situation, accrual-basis financial statements are necessary – unless the company does not have significant receivables or payables.

Full accrual financial statements include the following as assets:

  • Accounts receivable from customers
  • Payments for future periods, such as rent or insurance
  • Inventory purchased but not yet sold

Accrual-basis liabilities include:

  • Accounts payable to vendors
  • Accruals for unpaid vacation and wages
  • Unpaid interest on debt
  • Payments for goods or services not yet provided (deferred revenue)
  • Retirement plan contributions owed but not yet paid

Essentially, accrual-basis financial statements provide a more complete picture of financial position than the amount of cash in the bank at any given time.

At a minimum, the two basic accrual-basis financial statements that should be reviewed monthly are the balance sheet and the income statement.

  • The balance sheet effectively shows what the company owns and what it owes at a point in time, with the difference being the owners’ equity in the company.
  • The income statement shows operating results for a period of time, broken down by revenue line items and expense line items.

In reviewing the financial statements, management should first ensure that the accounts have been properly reconciled and adjusted so that the information is reliable.

The balance sheet should be classified, separating current assets and liabilities from long-term assets and liabilities. Current amounts include anything that is expected to be converted into cash within a year.

In reviewing the balance sheet, items to consider include:

  • Whether all receivables are collectible
  • Whether the value of inventory is overstated due to obsolescence
  • Whether all amounts owed are reflected as liabilities

Working capital should be calculated, defined as the excess of current assets over current liabilities. It is a measure of whether the company has the means to pay obligations as they come due. Negative working capital is an indicator of financial problems.

Working capital can be expressed as a ratio of current assets to current liabilities and can be calculated over time to highlight negative trends that should be addressed. Seasonality may also affect working capital and the need to draw down on a line of credit.

There are industry-specific ratios, such as accounts receivable turnover, inventory turnover and debt to equity that should be calculated if meaningful to the company. Some ratios may need to be monitored as part of loan covenants. In addition, consideration should be given to whether there are enough reserves to prevent deferred maintenance or whether there is insufficient investment back into the company.

In reviewing the income statement, the obvious first consideration is net income – the excess of revenues over expenses. Losses – the excess of expenses over revenue – should be addressed to mitigate long-term negative effects on the company.

There should also be a comparison of budgeted or expected operating results to actual, for both the current period and year to date, with explanations for deviations from expectations.

The balance sheet and the income statement are interrelated. Assets are typically increased by profits, and liabilities are typically decreased. Net income directly increases equity in the company, while losses reduce equity.

The final financial statement that may be useful is the statement of cash flows. It basically consists of three parts:

  • Operating activities – cash inflows and outflows from operating the business
  • Investing activities – cash inflows and outflows from buying and selling fixed assets, purchasing or selling investments or making loans
  • Financing activities – cash inflows and outflows from loan proceeds, repayment of debt principal, capital contributions and distributions to owners

The financial statement can be misleading if not considered in conjunction with the balance sheet and income statement. The reason is that, when additional cash is collected or a payment is made, the financial statement can change significantly.

Other considerations in reviewing the financial results of a company include:

  • Comparing operating results to industry benchmarks
  • Trending operating results over a period of five years
  • Modeling financial scenarios to plan for the future

These analyses help to stop negative trends that a company can address before it’s too late. They can help to modify or cut unprofitable segments of the business and to manage cash flow. When necessary, the company can also use the analyses to determine financing needs.

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