Understanding Financial Statements

Foggy bridge - Coast Women in Business

Guide to Understanding and Using Your Business’s Financial Statements

by Jeremiah (Jerry) Murphy

Outline of this presentation:

  • What Are Financial Reporting Objectives?
  • What Do You Need to Be Aware of?
  • Financial Statements
  • Your Balance Sheet
  • Your Income Statement
  • Using Information-Ratios and Such

What Are Financial Reporting Objectives?

There are 3 primary objectives of financial reporting:

  • Provide information that’s useful to investors, creditors, and other users in making rational decisions
  • Help investors, creditors, and others to assess the amounts, timing, and uncertainty of prospective net cash inflows to the entity
  • Identify the economic resources of a business, claims to those resources, and effects that transactions and events have on those resources

What Do You Need to Be Aware of?

The ability to read financial statements requires an understanding of the basic accounting equation:

assets = liabilities + owner equity

What are assets What are liabilities? What’s owner equity?

What are the components of owner equity?

+ owner investment – owner drawings of profit + revenue – expenses

Accounting Method

You need to understand what accounting method is used for your financial statements:

  • Cash method – transactions are recorded as cash comes in or is paid out
  • Accrual method – transactions are recorded when income is earned and when liabilities are incurred

Financial Statements

  • Balance sheet – This sheet shows the balances, at a particular time, of each asset, each liability, and the owner equity. The balance sheet proves the accounting equation (A=L+E).
  • Income statement – This statement lists revenues and expenses and calculates the company’s net income or net loss for a specified time period.
  • Statement of cash flows (note: not presented for this example) – This statement tracks the movement of cash during a specific accounting period. It assigns all cash exchanges to one of three categories: operating, investing, or financing.

Your Balance Sheet

Review the heading for your balance sheet and notice:

  • Company name
    • This is important to get your bearing on what the financial statements are going to be talking about
  • Name of financial statement
    • It should indicate that this is a balance sheet, but is it comparative? Or is other information presented with the balance sheet?
    • If the information is presented using a method of accounting other than accrual, you’ll usually be able to tell by the name of the financial statement.
  • Date of information presented
    • The date is important because the balance sheet presents information as of a specific date, a point in time, and not for a period of time

Your Income Statement

Review the heading for your income statement and notice:

  • Company name
    • This should be the same as the name of the company on the balance sheet
  • Name of financial statement
    • Profit and loss statement or income statement
    • The name should tell you that it’s an income statement or something similar like a profit and loss statement. If the statement is presented as a comparative income statement, then the additional information presented as comparative is described.
    • If the information is presented using an accounting method other than accrual, you’ll usually be able to tell from this line
  • Date of information presented
    • The income statement presents the results of operations for a period of time, and this line will describe the period involved; if the statement is comparative, the additional period is also described

Using Information-Ratios and Such

Horizontal and Vertical Analysis

Comparative balance sheets:

  • Easy comparison of two periods, side by side
  • You can quickly see and assess the chane in your business financial condition from one period to the next
    • frequently done at year-end
    • ask the question: are we better off now than we were a year ago?

Comparative income statements:

  • Easy comparison of two periods, side by side
  • Did sales increase or decrease? By how much?
  • Did net income increase or decrease? By how much? Is the percent change similar to the change in sales?

Profitability Ratios

Ratios to measure your company’s performance include gross margin ratio and net profit ratio. A third ratio in this family includes return on equity ratio.

  • Gross margin
  • Net profit
  • Return on equity

Liquidity Ratios

This set of ratios measures your company’s ability to meet its current obligations.

  • Current ratio
  • Quick ratio
  • Days receivable outstanding

Leverage Ratios

This family of ratios measures your company’s ability to meet its long-term debt obligations.

  • Debt ratio
  • Debt-to-equity ratio

Discovering Trends

By comparing several years’ worth of ratios, you can discern trends in your business.

  • 5 years of current ratios will show your business’s improvement or the degradation of your current financial strength

By comparing your ratios with benchmark ratios, you can understand how your business is doing as compared to your specific industry.

  • For instance, RMA’s Annual Studies subscription reports ratios for each industrial classification of business
  • Also see your trade group of professional organization for statistics

Summary

Here is what we learned:

  • Financial reporting’s 3 primary objectives
  • Accounting equation
  • Accounting method
  • Basic financial statements are:
    • Balance sheet
    • Income statement
    • Statement of cash flows
  • How to use information in financial statements:
    • Horizontal and vertical analysis
    • Ratios

Now that you’ve gained understanding financial statements are, how about using them to learn about your business?


About the Author

Jeremiah K. (Jerry) Murphy is a Certified Public Accountant (CPA). He opened his CPA firm in Fort Bragg, California, in September 1976 and has been serving the Mendocino Coast since then. He recently sold his business and started his new company, Polaris Consulting.

Jerry concentrates on providing his clients with excellent information that they need to keep their business running smoothly and successfully. He also works as an advisor the West Business Development Center. Jerry specializes in advising clients on tax issues as well as Quickbooks and other accounting and internal control issues.

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