There are many ways to gauge a company’s financial health, but none are quite as eye-opening as analyzing financial statements. These documents tell you everything you need to know about your organization’s financial fitness, highlighting areas for improvement. But how exactly do you make sense of them? Read on to find out.

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Understanding the Balance Sheet

The balance sheet gives a snapshot of a company’s financial condition at a specific point in time. It is divided into three main sections.

Assets

Assets are everything a company owns or controls that has measurable value. These can be tangible (like cash or property) or intangible (think patents and trademarks). Assets are typically classified as current (short-term) or non-current (long-term). Current assets are expected to be converted into cash or used within a year, whereas non-current assets have a longer shelf life.

Liabilities

These are obligations owed to external parties––in other words, debts. They include everything from loans to accounts payable. Like assets, liabilities are divided into current and non-current. Current liabilities are generally those owed within a year, like unpaid invoices. Bonds and long-term loans would fall under the non-current category.

Equity

Equity represents the residual interest in the company after all liabilities are settled. To determine your equity, simply subtract total liabilities from total assets. Equity includes retained earnings, common stock, and any additional paid-in capital. It reflects ownership value and serves as a helpful measure of your company’s strength.

Decoding the Income Statement

The income statement, also known as the profit and loss statement, outlines a company’s financial performance over a specific period, typically a quarter or a year. It includes the following.

Revenue

Revenue is pretty straightforward. It’s the total amount of money your company earns from its core business activities and is usually obtained through the sale of goods and/or services. 

Expenses

Your expenses include the cost of goods sold (COGS), which is directly tied to production, and operating expenses like salaries, rent, and marketing. You can determine your COGS with the following formula:

Beginning inventory + inventory costs – ending inventory = cost of goods sold

It’s important to manage your expenses effectively to ensure profitability. Rising expenses without a corresponding increase in revenue can erode profit margins. Accurately categorizing expenses is also important for stakeholders to assess where the company is spending its resources.

Net Income

This represents your “bottom line.” Net income is the amount of profit remaining after all expenses, taxes, and interest have been subtracted from revenue. It’s really the number one indicator of a company’s profitability. A positive net income signals that the business is earning more than it spends, whereas a negative net income (a loss) suggests the opposite. 

Key Metrics to Watch in Financial Statements

There are a few key metrics to analyze when viewing a financial statement. These offer a deeper understanding of your company’s performance beyond raw numbers. The most important metrics to watch are gross profit margin, operating margin, and earnings per share (EPS).

Gross Profit Margin

Gross profit margin is a measure of profitability that shows the percentage of revenue remaining after deducting the COGS. Use this formula to calculate your gross profit margin:

(Revenue – COGS) / revenue = gross profit margin

For example, if you start with $100,000 in revenue, subtract a COGS of $20,000, you would end up with $80,000. You would then divide that number by your starting revenue ($100,000) to get 0.8, or 80%. This metric is important because it highlights the efficiency of your company’s production process and pricing strategy. Higher profit margins indicate greater efficiency. 

Operating Margin

Operating margin measures the percentage of revenue left over after covering COGS and operating expenses. It’s calculated like this:

Operating earnings / revenue = operating margin 

This metric reflects a company’s ability to generate profit from its core business operations before interest and taxes are deducted. A higher operating margin suggests strong management control over operating expenses.

Earnings Per Share

Earnings per share (EPS) is one of the most widely used metrics for determining an organization’s profitability. It measures the portion of a company’s profit allocated to each outstanding share of common stock. The formula for EPS is:

(Net income – preferred dividends) / weighted average shares outstanding = EPS

Stakeholders look at EPS to compare companies and see who generates the most profit on a per-share basis.

The Importance of a Cash Flow Statement

The cash flow statement provides insights into how a company generates and uses its cash. You can divide this financial statement into three sections:

  • Operating Activities: This section shows the cash generated or used in the core business operations. It includes cash received from customers and cash paid to suppliers and employees.
  • Investing Activities: Investing activities highlights cash spent on or generated from investments, such as the purchase or sale of assets like property and equipment.
  • Financing Activities: This part details cash flows related to borrowing and repaying debts, issuing shares, and paying dividends.

Positive cash flow indicates that a company is generating more cash than it is spending, which is a sign of financial health. Companies with strong cash flow management are better positioned to invest in growth opportunities and weather economic downturns.

Make the Most Out of Your Financial Statements

Don’t be intimidated by the amount of information on your cash flow statements. By knowing what to look for, you can better understand your business activities and make the changes necessary to improve your financial health. In doing so, you can position your business to perform well in the market and sustain long-term growth.

 

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