How to Analyze and Read Between Lines of Financial Statements
A financial statement provides interesting information about a company's past and present performance, but the data must be reviewed and analyzed in more detail to present a true picture of the health of the business and to predict future trends. While you may not have gone into business to analyze financial statements, you can easily learn how to look further into the information presented as a tool in good business decision-making.
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Financial Statement Review
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Review the complete set of financial statements. This includes the balance sheet and income statements, as well as the cash flow statement. Check to be certain that they have been verified and the company has periodic audits performed to be certain that the information the statements contain is completely accurate. Assemble the statements from the same time period in previous years for comparison.
Gross Profit Changes
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Compute the gross profit margin for the business. This number may be shown as a percentage on the income statement. If not, calculate it by subtracting the cost of goods sold from the total sale, which gives the gross profit in dollars. Convert it to a percentage by dividing the gross profit by the total sale and then multiply by 100. Calculate the margin form the prior years the same way. If the margins are rising compared to previous years, it means that the business is able to sell its goods for higher amounts or control its cost of goods sold, indicating good financial health. Decreasing profit margins are a cause for concern.
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Liquidity
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A company must have enough cash coming in to pay its bills and meet its payroll. A good indicator of this is the ratio between current assets and current liabilities. Current refers to how quickly these items are converted to cash or due to be paid. A current item's time frame is less than one year. The minimum ratio for good financial health is 1-to-1, but a higher ratio is desirable whenever possible.
Debt to Equity Ratio
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An indication of how much of a business is financed from borrowing and the portion that is contributed by investors will show how heavily leveraged the company is. A higher leveraged company may be at a higher risk of default on its loans. In some industries, however, higher leverage may be a positive, as the business is making the most of other people's money. A debt to equity ratio can be expressed as a percentage by dividing the total liabilities of a business by the total equity and multiplying by 100. A 2-to-1 ratio, or 200 percent, is considered by many to indicate a solid business, and it should show growth over the years.
Accounts Receivable
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A business that is experiencing growth in receivables without a corresponding growth in sales could be in trouble. The accounts receivable to sales ratio is calculated as a percentage by dividing the total receivables by the total sales for the period and multiplying by 100. A 20 percent increase in this ratio, for example, from 20 percent to 24 percent, indicates potential trouble with the business collecting its money or too many sales financed on credit.
Comparisons
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While the comparison between different years in the same business is helpful, it may not completely tell the story of the health of the business. Peer-group analysis can be helpful in these cases. Some trade organizations publish composite financial statements of different businesses of the same type, and show the values as percentages of sales or total expenses. These percentages can be compared on a level playing field, even for businesses that experience significantly different amounts of total sales or expenses. If you find a value that is outside of the average of a peer group, that category may need further analysis to determine why.
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