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Everything You Need to Know About Reading and Understanding Financial Statements for Your Business

Everything You Need to Know About Reading and Understanding Financial Statements for Your Business

One of the most important skills to learn regarding accounting for small business owners is understanding financial statements.

This is the essential guide to understanding your financial statements.

In this guide you’ll learn:

·     The background information you need to understand financial ratios

·     What ratios are and how to calculate them

·     What the ratios mean for YOUR business

Let’s dive right in.

Background

The three most relevant financial statements for most small business owners are the income statement, balance sheet, and the cash flow statement.

Your Income Statement shows the revenue, expenses, and profit or loss for your business. Even though the income statement resets to zero each month, and the running total resets at the end of the year, your accounting software will allow you to see aggregate data for specific time periods as well. Some common time periods are quarterly and yearly.

Your Balance Sheet shows what you own, what you owe, and your owners’ equity (what’s left if you decide to sell all of your assets and pay all of your liabilities). Your balance sheet doesn’t reset. It is a running total for the life of the business. At the end of the year net income is added to the retained earnings account.

Although the balance sheet can be run at any time, it is most commonly run at the same time as the other financial reports.

The Cash Flow Statement tells you how much cash you have and shows you how your cash position has changed over time. This report is most useful under the accrual basis for accounting. For cash basis accounting, your income statement and your cash flow statement will be very close.

However, under accrual accounting, the cash flow statement is an indispensable tool for understanding your cash position since revenue is not cash. For instance, you will recognize revenue for a sale as soon as you have earned it, but you may not get paid for that revenue for a month or more.

Ratios

Financial ratios are equations used to gain powerful insights into Key Performance Indicators (KPIs) important to your business. The KPIs are chosen based on your strategic plan and data is taken directly from your financial statements. This is why it is critically important that your accounting data is accurate.

These KPIs can be used strictly internally to measure the success of strategic goals or, if you have industry data, can be used to see how your company is doing compared to the rest of the industry.

Balance Sheet Ratios

Debt to Equity (AKA Risk Ratio)

Debt to equity ratio = Total Debt (All Liabilities)/Owner’s Equity

Appropriate ratios vary by industry, but a general benchmark is 2.0 or below.

Current Ratio Current Ratio = Current Assets/Current Liabilities

Appropriate ratios are generally between 1.5 and 3.0.

Quick Ratio

Quick Ratio = (Cash/Cash Equivalents + Marketable Securities + Accounts Receivable)/Current Liabilities

Any number above 1.0 is considered good.

Income Statement Ratios

Gross Profit Margin

Gross Profit Margin = (Sales Revenue – Cost of Goods Sold)/Sales Revenue

A good Gross Profit Margin varies widely by industry. For instance, Law Firms may have a 27% margin. However, Printing companies regularly have a 42% margin and railroads have a 90% margin. Many industry margins are available online.

Net Profit Margin

Net Profit Margin = Net Income/Sales Revenue

Determining a good net profit margin is also highly variable by industry. Regardless of industry standards, you may have your own profit margin goal.

Operating Profit Margin

Operating Profit Margin = EBITA/Sales Revenue

Again, this will vary by industry. However, one strategy is to compare how your margin stacks up to the S&P 500 Index.

Cash Flow Statement Ratios

Cash Flow Margin

Cash Flow Margin = Net Cash from Operating Activities/Net Sales

Check your industry benchmarks. However, higher is better.

Current Liability Coverage Ratio

Current Liability Coverage Ratio = Cash Flow From Operations/Average Current Liabilities

1.0 is considered comfortable. Higher is better.

Cash Flow Coverage Ratio

Cash Flow Coverage Ratio = Net Cash Flow from Operations/Total Debt

OR

Cash Flow Coverage Ratio = (Net Earnings + Depreciation + Amortization)/Total Debt

Aim to be above 1.0.

What the ratios mean for YOUR business

Debt to Equity (AKA Risk Ratio)

This ratio gives you an idea about how much risk you’re taking on through your borrowing.

If you borrowed money to help fund revenue growth, this can help you decide if the financed activity is actually adding to your earnings. If the boost in earning is less than the interest payments, then it wasn’t effective.

This ratio is also used by creditors when deciding to offer financing.

Current Ratio

This ratio is an indicator of your ability to pay your short-term debts.

The current ratio is also used by creditors when deciding to offer financing.

Quick Ratio

This ratio tells you how quickly you can pay your current liabilities (Accounts Payable, Accrued Liabilities, Short-term Debt) with current assets (cash, cash equivalents, marketable securities, current A/R). The quick ratio also helps you determine how solvent your company is.

This is another ratio that creditors may use when making lending decisions.

Gross Profit Margin

Your gross profit margin tells you how efficient you are at producing your product or executing your services.

It can also be a useful tool when you are doing market research so that you can see how your performance stacks up against your competitors.

Net Profit Margin

This is the most fun ratio for most business owners because it tells you how much money you have made at the end of the period after paying expenses.

Operating Profit Margin

Operating profit is another ratio useful for comparing your results to your competitors or industry averages. If you are falling behind your competitors, you should start with a review of your expenses.

Cash Flow Margin

The cash flow margin shows you how efficiently your sales turn into cash.

Current Liability Coverage Ratio

This ratio indicates whether your company has the cash to cover debts owed within a year. When this goes below 1.0, it means that urgent action may be needed to improve cash flow.

Cash Flow Coverage Ratio

The cash flow coverage ratio can help you determine the resilience of your company if revenue slowed for a short time.

If this stays below 1.0 for more than a short time, the company may be headed to bankruptcy in the next couple years.