Published on: Jan 07, 2025 by Nancy Mehlberg, CVB, EA
Updated on: January 7, 2025
Being able to read financial statements properly helps you understand and predict the health and performance of your company, in turn facilitating better decision-making now and in the long term.
Financial statements offer a view of your company’s performance, financial health, and prospects. Understanding how to read financial statements can help you make more informed, timely choices, better strategic decisions, and even predict potential risks or opportunities.
In this blog, I break down the components of financial statements and highlight the areas I emphasize when guiding clients through the process of understanding their financial performance, identifying opportunities for improvement, and developing a plan to achieve their goals.
These days, it’s all about the data. How well do you understand the data in your financial statements? Let’s take a deep dive into the various aspects of financial statements and review the specific areas you need to be aware of.
When it comes to financial data, the balance sheet is the star. Your balance sheet provides a snapshot of your company's financial position at a specific point in time, with insights into your assets, liabilities, and equity. But to truly understand your balance sheet, you need to dive deeper into financial ratios.
Ratios reveal the story behind your numbers, helping you interpret the raw data to get a clearer picture of your company's financial health and performance. Ratios can uncover potential problems, highlight strengths, and guide you towards making more informed business decisions.
Make sure you don't forget about your equity. Your equity is the part of your company that you own, and it can be an indicator of your company's overall financial health. You want your equity to grow over time, so it’s important to keep an eye on this area.
Income statements show you how your business is performing over a specific period. I recommend using accrual-based financial statements for a more accurate picture of your business's financial health.
Cash-based financial statements can also be used; however this is a direct reflection of when you receive cash or pay bills, and might not give you a true picture of company performance. A cash basis financial statement records revenue expenses when cash is received or paid out, rather than when it was incurred or earned.
Understand and pay close attention to your gross profit margin when you’re analyzing financial statements. Gross profit margin is calculated by subtracting your cost of goods sold from your revenue and dividing the result by your revenue. It tells you how much money you're keeping after the costs of producing your products or services.
It's also important to understand how your gross profit margin compares to the industry average. This is where working with SVA professionals can be especially helpful. For example, if I'm working in an industry where most companies have a gross profit margin between 30-35%, but one company is only at 20%, that's a clear sign they're not pricing their products or services appropriately.
By using your income statement as a starting point for analysis of financial statements, you can identify where you can make changes to improve your profitability, whether it’s adjusting your pricing, cutting costs, or finding other ways to increase revenue.
While it may not be a line item on a financial statement, a budget that outlines expected revenues, expenses, and financial goals acts as a benchmark against actual financial performance. While you can glean the health of your business from financial statements, it’s important to know how the business performed compared to the budget.
If actual performance deviates significantly from the budget, you can investigate the causes and make informed decisions to address any issues.
It’s important to understand the significance of cash flow in your company. Many people focus solely on their income statement, believing they're having a successful year based on those numbers. However, without analyzing the cash flow statement, they may be missing essential information about where their cash is going.
I've met many business owners who are confused about why they don't have cash despite their seemingly profitable year. The answer often lies in the cash flow statement, which reveals the movement of cash in and out of your business, including transactions that aren't reflected on the income statement.
For example, prepaid expenses, paying down debt, or distributions to shareholders can significantly affect your cash balance without showing on the income statement.
When analyzing financial statements to make better business decisions, several formulas and metrics come to mind that are important for business owners to know.
One of the most important metrics is your gross profit margin, which measures the percentage of revenue that remains after subtracting the cost of goods sold. Understanding your gross profit margin and how it compares to the industry average can provide valuable insights into your pricing strategy and cost management.
Another important metric is the percentage of net income, which shows how much of your revenue translates into profit after accounting for all expenses. This can help you identify areas where you may be able to cut costs or increase efficiency to improve your bottom line.
It's also important to keep an eye on big-ticket items like rent, utilities, labor expenses, and advertising costs, as they also affect your profitability.
Regularly watching these key formulas and metrics provides a deeper understanding of your business's financial health to make data-driven decisions. Whether you're looking to expand into new markets, invest in new equipment, or simply achieve and maintain a healthy cash flow, these metrics are a foundation for sound financial management.
Days in Accounts Receivable (AR) is also an important ratio to consider. This ratio measures how quickly your customers are paying their invoices. A high number of days in AR can show that you're having trouble collecting payments, which could lead to cash flow issues down the line.
Inventory turnover is another place I often focus on with clients. Low inventory turnover might show that you're holding on to too much inventory, which can lock up cash that could be used elsewhere.
When analyzing your inventory turnover ratio, some businesses benefit from a just-in-time (JIT) inventory management system, which helps reduce inventory-holding costs by ordering and receiving goods only as they are needed in the production process, reducing overstock and freeing up cash that’s tied up in excess inventory.
Your Current Ratio, which compares your current assets to your current liabilities, is also important. A high Current Ratio suggests that you have enough liquid assets to cover your short-term obligations, while a low Current Ratio could show that you're at risk of running out of cash.
Banks and other lenders will often look at these ratios when considering a loan application, so it's important to keep them in mind if you're planning to seek financing.
While every business is different, here are several best practices and tips that can help you get the most out of your financial statement analysis.
Look for trends and changes in your financial performance over time. This can help you find areas of improvement or potential issues that need to be addressed.
Compare your financial ratios and metrics to industry averages, which can give you insight about where you may be underperforming or overperforming.
Financial statements don't tell the whole story. Consider other factors that are affecting your financial performance, like changes in the market, new competitors, or shifts in customer purchases.
While there are many financial ratios and metrics to consider, focus on the ones that are most relevant to your business and industry. This may include gross profit margin, operating margin, or return on investment.
Regularly comparing your budget to actual performance is a critical practice for maintaining financial health. It enables you to stay on top of your finances, make informed decisions, and drive your business towards its financial objectives.
Pay attention to any significant differences (positive or negative) between budgeted and actual figure and analyze why these variances may have occurred so you can make any adjustments needed.
Stay on top of economic trends that may impact your business. For example, if you're a food distributor that hasn’t raised prices despite nationwide increases in food costs, you may be putting your profitability at risk. Being aware of these trends and reacting quickly can help you stay ahead of the curve.
Analyzing financial statements should lead you to use the insights you’ve uncovered to make better business decisions. Financial statements are like an onion — if the first layer smells bad, you need to keep peeling until you get to the source of the problem.
This may require looking beyond the financials and examining issues like production processes or operational inefficiencies. Once you figure out the problem, put a plan in place to solve it.
Part of analyzing financial statements is to keep asking questions, stay curious, and proactively find and address issues before they become major problems. Focusing on continuous improvement allows you to use your financial statement analysis as a powerful tool to drive business success.
If you're not feeling confident about analyzing your financial statements, our SVA professionals can help. With our wide-ranging experience across various industries, we can assess your business, compare it to industry benchmarks, and guide you to effectively analyze your financial statements, empowering you to make better, more informed decisions.
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Nancy is a Principal with SVA Certified Public Accountants and helps clients improve their company profitability and protects their interests by clearly understanding their future goals. She works closely and proactively with clients with an emphasis in business and income tax planning and financial reporting.
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