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Understanding a company’s financial health is vital for entrepreneurs, investors, or anybody related directly to the financial department. While hiring expert accountants to read financial statements is a practical approach, a business owner must understand finances better. Investors also need to know how to read financial statements before investing in a profit-making company.
There are three fundamental financial statements one must read to analyze a company’s financial health. These are:
Let us find out how to read these financial statements to clear the basic concepts of financial accounting.
Businesses make a cash flow statement to get a vivid picture of what happened with the company’s cash during a specific period. Most companies prefer following a monthly or quarterly cash flow statement to be on top of their finances.
The cash inflow and outflow exhibit the company’s ability to operate within a short-term or long-term period. It all depends on how much cash is flowing in and out of your business.
Cash flow statements have three sections:
Operating activities exhibit the cash flow that generates when the business starts to deliver regular goods and services. These include revenues and expenses. Simply put, it consists of the cash inflows and outflows that occur due to revenue-generating activities. For example, purchasing raw materials, building inventory, shopping for products, and more.
Investing activities refer to cash flow from purchases and sales of assets. These usually are in the form of tangible property like vehicles for transportation or real estate. The intangible forms are patents, copyright, and so on. Purchasing other business ventures or investments in your existing business, all come under this.
Financial activities include cash inflows from investors. These could be shareholders offering new shares and banks or other financial institutions in the form of loans. Outflow under financial activities includes cash paid as dividends or loan repayment. These help you read the changes in the company’s capital and borrowings.
Here is a basic structure to help you understand how a cash flow statement is prepared:
| Month | August |
| Opening balance | 20,000 |
| Cash In | |
| Sales | 25,000 |
| Total | 25,000 |
| Cash Out | |
| Raw Materials | 7,500 |
| Marketing | 5,000 |
| Wages | 10,000 |
| Total | 22,500 |
| Cash flow | 2,500 |
| Closing balance | 22,500 |
The income statement, also known as the profit & loss statement, helps you understand the total profit or loss during a specific period. The total revenue is subtracted from the total expenditures, and the result is either a profit or a loss. The basic formula is:
Total revenue – Total expenses = Net Profit
To make it simple, revenue is the amount that a business makes/earns, whereas expenses refer to the amount that a company pays out. If the total costs exceed the amount compared to the total revenue, it marks a loss.
Most investors check the recent income statements of a business to understand average earnings. They also tally previous income statements to analyze growth and profits. It prevents them from investing in a company that is likely to make losses.
| Revenue | ||
| Net sales | 25,000 | 25,000 |
| Expenses | ||
| Cost of goods sold | 10,700 | |
| Wages | 2,250 | |
| Supplies expense | 500 | 13,450 |
Net Income | 11,550 |
To read an income statement in-depth, you need to follow the structure below:
Reading a balance sheet will help you analyze the book value of a business. It exhibits the available resources and how they were financed.
To understand a balance sheet, you need to read the following:
Assets provide an economic value to a business with the expectation of a viable future benefit. It can be in the form of cash, inventories, properties, and so on. Assets can either be long-term or short-term.
Long-term assets are fixed assets that can take around 12 months or more to materialize into cash. Such assets include tangible assets like land, investment, and intangible ones like trademarks, patents, etc.
Short-term assets are likely to be quickly liquidated into cash. Such examples are inventories, cash equivalents, etc.
The summation of both long-term and short-term assets defines the total assets of a company.
Liabilities are the obligations a business needs to pay to ensure its significant growth. These can be wages, loans, and so on. Liabilities can be segregated as long-term and short-term.
Long-term liabilities are payables for which you get at least 12 months. These can include long-term borrowings, trade payables, lease payments, and so on.
Short-term liabilities are obligations to pay within 12 months. These can be payroll, monthly loan repayments, taxes, and so on.
A balance sheet compares the assets and liabilities of the business to find out the owner’s equity. The assets are equal to the summation of liabilities and owner’s equity. So, the formula is:
Total Assets = Total Liabilities + Owner’s Equity
Owner’s equity can also be referred to as shareholders’ equity. To make it easily understandable, this portion refers to the net worth of the company. So, the other formula to read the balance sheet is:
Net worth = Total Assets – Total Liabilities
Here is a basic structure of a balance sheet to understand the net worth of a business:
| Assets | Amount | |
| Cash & Cash equivalents | 52,000 | |
| Inventory | 57,400 | |
| Short-term investment | 150,000 | |
| Total Assets | 2,59,400 | |
| Liabilities | ||
| Accounts Payable | 55,000 | |
| Short-term debt | 25,000 | |
| Total Liabilities | 80,000 | |
| Owner’s Equity | 1,794,00 |
It is essential to understand that the cash flow and profit & loss statements are not the same. Cash flow analysis exhibits the money flowing into and out of business. At the same time, profit refers to gains made by a company from its total revenue.
A cash flow statement format helps you analyze the types of activities your business makes. It will help you make better financial decisions in the future. Ideally, the cash from operating incomes must exceed the net income. It will indicate a healthy cash flow and exhibit financial stability. However, a positive cash flow might not mean that your company has sufficient profits to sustain. Thus, it is essential to analyze the P&L statement and balance sheet to have a clear picture.
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