Analyzing a financial statement may seem like a daunting task for some. But for many small business owners, generating and then accordingly analyzing such statements is critical. When it comes to making economic decisions for the company, for instance, you are going to want a comprehensive picture of where the company stands. In reviewing your financial statement, you gain a clearer understanding of the company's cash flow position as well as operating results. A financial statement can also give you insights into whether or not you can handle additional debt, and it enables you to more effectively communicate with your shareholders regarding the future of the firm. So how do you undertake a financial statement analysis…In this article, we will look at common types of financial statements as well as the protocol for analyzing them.
Understanding Financial Statement Analysis
In making any decision about your company, you are going to want to have a pretty comprehensive view of where things stand financially. So for example, if you are considering developing a new product, you want to make sure that from an economic standpoint this is feasible before spending a great deal of money on this kind of endeavor. A financial statement allows you to keep track of the business's performance during a given period. In this way too, you can gauge how well your company is meeting its objectives and initiatives.
As mentioned, there are a few different types of financial statements. Each answers a certain question. The information found within these will differ according to the purpose of the document. Among the most common kinds of financial statements: balance sheets, cash flow statements, shareholder equity statements, and income statements.
A balance sheet is an accounting of a business's assets, liabilities, and shareholder equity. This is a good way for investors to see how a company is performing. Especially if they are considering investing more money, they will want an overview of where things stand at a given time. As far as the formula is used with a balance sheet: assets equal liabilities plus shareholder equity.
So an asset here is that which a company owns that has value. Any equipment, for example, real estate, current inventory, stocks, and bonds; this can also include more intangible property such as a patent or a trademark. Liabilities are what the company currently owes to creditors and/or suppliers. Rent and utility payments also fall under this category. Payroll expenses, taxes, and of course any debts are all a part of a company's liability.
As far as shareholders' equity, this is essentially what the company is worth. So once all liabilities are subtracted from the assets, whatever is left (meaning that which could be paid back to shareholders upon liquidation of a company/) is the value of the business.
Cash Flow Statement
This shows what is coming in and what is going out of the business. To remain in operation a business needs to have money to cover its expenses. Often a lender will look at a cash flow statement to determine whether or not a company would be able to repay a loan without going into default.
Cash flow statements tend to show, among other things, revenue generated as a result of goods/services sold. Cash flow comes in as a result of investment activities. And the money generated by debt/equity financing.
Shareholders' Equity Statement
Regardless if shareholders are private or public investors, this statement shows the changes in any equity held by your shareholders. It will detail the value of the stock and additionally show whether or not the company bought back any of the stock.
Income statements present a snapshot of how much a company has made in a certain period—be it quarterly or annually most often. Among other information provided on an income statement, you will generally find a break down of operating expenses, asset depreciation, and net income over a specific period.
Conducting A Financial Statement Analysis
There are a couple of different methods when it comes to financial statement analysis. Most often used are verticalhorizontal analysis and also, ratio analysis. Let's take a look at what each of these entails.
While these are related, they also differ in a few key ways. They refer to how you go about reading the actual statement. These are often used together as both types help management gain much-needed insight into the overall health of the business. As the names suggest, vertical means that you are reading down a single column. With this method, you are getting a better understanding of how items relate to one another as well as how they relate to items in another report. With horizontal analysis, you are looking more in terms of a broader view. That is to say, you're considering one reporting period as it relates to a previous reporting period. This then helps you to identify key changes over time. You can see for instance, if sales between Q2 and Q3 have gone up or down. Again, both methods taken together provide a comprehensive approach as far as financial statement analysis. And can offer different insights into where a company stands.
Ratio analysis is yet another method used to read a financial statement. In this process, you are analyzing the information presented in a statement in terms of how it might relate to another piece of information in the same report. Ratios can be broken down in a multitude of ways. For example, you might look at profitability ratios to see whether or not the company is profitable. This involves taking into consideration the break-even point, return on equity, and gross profit ratio. You could also review leverage ratios to see exactly how much your firm is dependent on debt to keep running; this entails looking into debt to equity ratio among other items. Liquidity ratios can also give you important information regarding the financial health of your organization. How liquid your company is can be extremely important as far as how sustainable it is. With this type of analysis, you will calculate the various ratios and then compare these against previous statements. This shows you how your business has been performing over time.