How to Interpret a Financial Statement

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Ratios are commonly used to interpret financial statements.
Ratios are commonly used to interpret financial statements. (Image: graph bars image by Tomislav from Fotolia.com)

Financial statement analysis is based on the comparison of assets, liabilities, equity, income and expenses from one year to the next as well as industry benchmarks. Proper interpretation of financial statements assists in identifying a company’s strengths and weaknesses. Financial statements are comprised of a balance sheet, an income statement and a statement of cash flow. Oftentimes, financial statements that have been audited, reviewed or compiled by a Certified Public Accountant will include supplementary schedules, such as detailed general and administrative expenses or, in the case of construction contracts, a schedule of work in progress.

Create common sized balance sheets by calculating each asset, liability and equity account as a percent of total assets. Create common sized income statements by calculating each income and expense account as a percent of total revenue before discounts, returns and allowances. Prepare common sized balance sheets and income statements for each year they are available.

Compare the common sized balance sheets and income statements. Identify unusual or unexpected fluctuations. If no plausible explanation exists, ask management about the variation. For example, if cash decreased $50,000 from December 31, 2008 to December 31, 2009 and the company purchased equipment for $45,000 during the year, the reason for the dramatic decrease is largely substantiated. However, if cash decreased $50,000 and auto expense increased $45,000, you may want to inquire about the purchase of a vehicle and if it was a business necessity.

Create an Excel spreadsheet for ratio analysis. Ratios are used to interpret a company’s profitability, liquidity, activity and solvency. Commonly used ratios include current ratio (current assets divided by current liabilities), gross profit ratio (gross profit divided by total sales times 100), working capital turnover ratio (cost of goods sold divided by working capital), debt to equity ratio (total debt from outside lenders divided by total equity) and operating profit ratio (net profit divided by total sales times 100). Working capital is calculated by subtracting total current liabilities from total current assets.

Analyze the ratios calculated over time and compare to industry benchmarks. Develop hypotheses regarding the company and its performance over time. Use the ratio analysis to support these ideas. For example, if a company’s gross profit decreased from 75 percent to 65 percent, and union costs skyrocketed during that same time, the reason for the decrease can be substantiated. However, if gross profit decreased from 75 percent to 65 percent, and materials, labor and other job costs remained approximately the same, further analysis would be warranted.

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