What You Need To Know About Reading Financial Statements
October 8, 2016
In order to maximize the success of your business, you’ll need to learn how to read financial statements. There are three key financial statements – the balance sheet, the income statement and the cash flow statement – and each of them offers a slightly different view of the health your company.
The Balance Sheet
By looking at a balance sheet, you can tell at a glance whether a company is in good operating condition. On the “Assets” side of the balance sheet, you can tell whether a company has big reserve of cash to get through hard times and pay off suppliers. On the “Liabilities” side of the balance sheet, you can see how much debt a company has taken on in order to finance future growth. Finally, you can get a quick read on a company’s overall business condition by comparing the “due to” and the “due from” receivable accounts. As a rule of thumb, companies should have more orders coming in than orders going out.
Putting all this together, you can say that a company has a “strong” balance sheet if it has lots of cash and cash equivalents, if it has minimal debt that it needs to pay off, and if the accounts receivable are in good condition. You can go one step further and see what kinds of assets a company owns. If it’s a manufacturing company, for example, it may have high-value capital goods (i.e. equipment) that it can unload at fire-sale prices if business dries up. That’s especially important for potential lenders, who may want to use those assets as collateral to pay back debts.
The Income Statement
You’ve probably heard people talk about “bottom line” thinking in business. This refers to the literal “bottom line” of the income statement – the final number that tells you how much money you made or lost in the previous reporting period, calculated by subtracting expenses from revenues. Obviously, the bigger the number, the better it looks.
However, it’s not always the case that you need to be reporting a bottom-line profit to impress investors. In fact, many Wall Street analysts prefer to look at factors like “net operating income” or EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). Investors will also check out your margins – it may be the case that you’re making a lot of money, but if the margins are razor-thin, they may prefer to go with a competitor that has a more effective way of making money with “fat margins.” Usually, the more premium your product is, the higher the margins.
The Cash Flow Statement
The cash flow statement is perhaps the least understood of all three of the financial statements. Many people mistakenly just think that it tells you how much cash you have in the bank. But a cash flow statement actually tells you how you are making cash from all of your operating, investing and financing activities. You can think of the cash flow statement as a synthesis of your balance sheet and income statement, showing exactly how changes in your balance sheet and income impact the amount of cash that your company generates.
As a rule of thumb, companies don’t go bankrupt if they’re generating plenty of cash. That’s because cash flow is a proxy for the liquidity of your company. If you have enough cash, you can pay employees, pay the rent and keep the lights on at night. If you don’t have enough cash – that’s when you face a “cash squeeze” and may have to tell lenders that you’re having trouble making debt payments.
As you can see, it’s possible to get a very sophisticated view of the financial health of your company by taking into account all three of these financial statements. Within every industry, there are certain financial metrics – both official and unofficial - that investors and stakeholders use to compare rival companies.
Over time, the healthiest companies are able to manage the expectations of investors and stakeholders, guiding them to the most salient facts of the financial statements that may be buried deep in the footnotes. Once you understand the structure of your industry, you’ll become accomplished at knowing what analysts are looking at, and how to describe the financial health of your company in terms they will understand.