Financial Statements Demystified
November 24, 2022
Business owners from all industries and walks of life have one thing in common: in order to make better informed decisions, they need to have a solid understanding of their financial health. And the best way to gain this understanding is through a regular review of their financial statements. Financial statements give a point-in-time snapshot of your organization’s financial picture and business performance.
What Is Included in Financial Statements?
For most businesses, a monthly financial statement will suffice. Smaller organizations who don’t have employees and have a low volume of transactions may even be able to get away with reviewing their statements on a quarterly basis.
Financial statements include the following four elements:
1. Balance sheet: A balance sheet is like a picture of your businesses financial strength on a specific date. The balance sheet will list current assets (like cash and accounts receivable), fixed assets (including, potentially, real estate and equipment), current liabilities (accounts payable, accrued expenses), long-term liabilities, and shareholders equity. Total assets will equal the same amount as total liabilities plus shareholders equity.
2. Income statement: An income statement is like a video telling you what happened in the business for a period of time. The income statement details revenue, broken out by different revenue streams, and cost of goods sold in order to determine gross profit. Operating expenses are then deducted from the gross profit to get to the net income or net loss for the period.
3. Cash flow statement: This statement reflects how money has moved through your organization during the period.
4. Statement of retained earnings: This document shows a company's cumulative income and expenses since inception, as well as the retained earnings (net income) at the end of each period. It summarizes how much money has been brought in and how much has been kept within the company.
And finally, there is usually a page of notes to the Financial Statements, where any assumptions or supplementary information is documented. Common notes include references to accounting policies, details on accounts payable and accounts receivable, and a revenue breakdown by region or segment.
Key Financial Ratios
Ratios are a key part of financial analysis and can be used to measure the performance and health of a business. While there are several financial ratios available, there are three primary ratios that I typically focus on with my clientele: current ratio, return on assets, and debt to equity.
The current ratio is the easiest and most impactful of the financial ratios; it measures a company's ability to cover its short-term liabilities with its available short-term assets. A higher current ratio can indicate that a company has access to enough cash or liquid assets to pay its bills on time; conversely, a lower ratio could mean that a business may not have adequate funds for short-term needs, such as payroll. Ideally an organization’s current ratio is at least 1.25 – where current assets are just slightly above current liabilities. Once an organization hits a 2.0 current ratio, they should look to utilize that excess money in some way, either by reinvesting in the company, or by drawing some funds out.
Return on Assets
Return on assets is a key indicator of business performance because it reflects how efficiently a company is using its resources to generate profit. It's essential for business owners to be aware of this, since they're the ones who will have to make decisions about allocating capital and evaluating potential investments.
5% is typically considered a good return on asset ratio and 20% is an excellent ratio.
Debt to Equity
This ratio measures how much debt the business has compared to its shareholder’s funds. A higher ratio can indicate that a business is over-leveraged and may struggle to pay back its debts, while a lower ratio can suggest that there are sufficient funds on hand to cover those liabilities. A bank will take this ratio under advisement when determining whether to lend funds. A 2:1 debt to equity ratio is generally considered to be a decent ratio.
Common Oversights on Financial Statements
Three things come to mind when considering common errors on financial statements.
- Inventory – many organizations don’t update or report their inventory properly
- Work in progress – likewise, this is commonly accounted for incorrectly
- Leases – these can be confusing as it can vary depending on the type of lease; sometimes it belongs on the balance sheet and sometimes it doesn’t.
Knowledge is power. The rich insights that financial statements can provide can be a gamechanger for organizations. Working with your accountant to ensure that you have an accurate view of your financial health can reduce risk and present opportunities for growth and diversification. Make the most out of your relationship with your accountant by meeting to review balances and compare forecasts with reality and to openly discuss areas of concern or opportunity so that you can take logical, informed steps forward rather than relying on hunch-based decision-making.
About the Author
Graham Thiessen is a Partner and Co-Founder with SummitPath LLP. Graham is passionate about educating his clients, enjoys being a sounding board for them, and is deliberate about asking the right questions to show them a different way to look at their business. Graham’s driving purpose is to leverage his client relationships to make a positive difference in the lives of others.
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