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How to Read and Understand Financial Statements: A Guide to What They Are and How to Manage Them

Financial statements are a critical part of understanding the financial health of any business, but for many people, they can be intimidating and difficult to decipher. However, once you understand the basics, financial statements become an essential tool that can help you make informed decisions about your business. In this article, we’ll explore the essential components of financial statements, their significance, and how to analyze them effectively. 

Whether you are an entrepreneur looking to evaluate your company’s performance or an investor looking to make informed decisions, from this guide, you’ll get valuable insights into how to read and interpret financial statements like a pro and learn what tool to use for their effective management.

Understanding financial statements

Financial statements are reports that show the financial performance of a business over a specific period. They include information about a company’s assets, liabilities, equity, revenue, expenses, and cash flow. 

The primary financial statements that businesses use are the balance sheet, income statement, and cash flow statement. These statements provide different  types of information about a company’s finances and are used to evaluate various aspects of a business.

The Importance of financial statements

Financial statements are an essential part of running a business as they allow you to see how much money a company is making, how much it owes, and how much it’s invested. Financial statements can help investors make informed decisions about whether to invest in a company, while creditors can use them to determine whether to lend money to a business.

Business owners can use financial statements to track their company’s performance over time, identify areas of weakness, and make informed decisions about the future. They can also use financial statements to evaluate the effectiveness of their financial strategies and make adjustments as needed.

Types of financial statements

There are three primary financial statements that businesses use to report their financial performance: the balance sheet, income statement, and cash flow statement, each one reflecting a different aspect of a company’s performance. 

Balance sheet

The balance sheet provides a picture of a company’s financial position at a specific point in time. It shows the liabilities, assets, and equity of a business. Assets include things like cash, inventory, and property, while liabilities include things like loans and accounts payable. And equity is the difference between a company’s assets and liabilities, and it represents the value of the company’s assets that are owned by the shareholders.

The balance sheet is important because it shows whether a company has enough assets to cover its liabilities. If a company’s liabilities are greater than its assets, it may be in financial trouble. However, if a company has a significant amount of equity, it may be a sign that the company is financially healthy.

Learn more about the balance sheet from a business owner’s perspective

Income statement

The income statement, also known as the profit and loss (P&L) statement,  shows a company’s revenues, expenses, and net income over a specific period, typically a quarter or a year. Revenues include sales and fees, while expenses are things like salaries and rent. Net income is the difference between revenues and expenses, and it represents the company’s profit or loss.

The significance of the income statement for a business lies in the fact that it shows how much money a company is making and how much it’s spending. It can help investors and creditors determine the company’s profitability and financial health, while business owners can use the income statement to evaluate the effectiveness of the chosen business strategy and change it if required.

Click here for more information about the income statement.

Cash flow statement

The cash flow statement shows how much cash a company has coming in and going out over a particular period of time. It includes information about cash from operations, investing activities, and financing activities. Cash from operations comes from sales, and cash from a company’s investing activities stands for the money from buying or selling assets. Financing activities are about borrowing money or repaying loans.

The cash flow statement is of vital importance to a business as it depicts how much cash a company has available to pay its bills and invest in its business. It’ll show potential and existing investors and creditors if a company is generating enough cash to cover its expenses and invest in its future. Business owners can use the cash flow statement to evaluate their company’s ability to generate cash and make sensible decisions about their financial future.

Find out more about  the difference between the income (P&L) statement, the balance sheet and the cash flow statement.

FYI: Strictly speaking, there’s one more type of  financial statement –  the statement of retained earnings, or an equity statement, or a statement of owner’s equity, which focuses on the changes in equity, like shares, payment of dividends, and profit and loss of a business for a given period. But it’s only required for the audited package of the company.

Interpreting financial statements

Interpreting financial statements can be challenging, but there are several financial ratios that you can use to evaluate a company’s financial performance. Financial ratios are calculations based on a company’s financial statements that compare two or more financial elements to provide insights into a company’s financial health.

  • Current Ratio: This ratio reflects comparison of a company’s current assets to current liabilities. It shows whether a company can pay its bills in the short term. The generally accepted healthy current ratio for a business is 2:1 or higher.
  • Debt-to-Equity Ratio: This ratio compares a company’s debt to its equity. It compares a company’s debt to its equity. A ratio that equals to or lower than 1:1 is healthy.
  • Gross Margin Ratio: This ratio compares a company’s gross profit to its revenue. It shows how much money a company is making after accounting for the cost of goods sold. It’s best when the ratio is higher.
  • Return on Equity (ROE): This ratio compares a company’s net income to its equity. It reflects the amount of profit a company brings to its shareholders. The higher the ratio, the better.

These ratios are just a few examples of the many financial ratios that you can use to evaluate a company’s financial performance. By using these ratios, you can gain valuable insights into a company’s financial health and make informed decisions about whether to invest in the company or lend it money.

Analyzing financial statements

Analyzing financial statements requires a deep understanding of the financial data and the ability to interpret that data accurately. Here are some tips for how to do it effectively:

  • Look for trends: Look for trends in a company’s financial data over time. Are revenues increasing or decreasing? Are expenses rising or falling? Identifying trends can help you evaluate a company’s financial performance and make informed decisions about its future.
  • Compare to industry standards: Compare a company’s financial data to industry standards to see how it stacks up against its competitors. If a company is underperforming compared to its peers, it may be a sign that it needs to make changes to its business strategy.
  • Use financial ratios: Use financial ratios to evaluate a company’s financial health. By comparing different financial elements, you can gain valuable insights into a company’s profitability, liquidity, and solvency.
  •  Automate this process: Use Synder, state-of-the-art software that can generate financial reports enabling you to accurately and timely assess your company’s financial health. This software has outstanding functionality. It gathers all information about your transactions – invoices, bills, checks, sales receipts – any financial data available on the connected sales channels and payment gateways, and generates necessary financial reports without the need for manual intervention. Synder takes care of all the daunting P&L math for you, like calculating COGS, operating expenses and revenue, obtaining net income, and more. It also  gives you tremendous relief when it comes to calculating your balance sheets. Synder calculates your liabilities and equity, assesses your assets, and checks the results. And all these operations are running automatically in the background requiring little to no attention from you. 

Ready to trust these challenging tasks to professional Synder software? Hop on a free 15-day free trial with no commitments or credit card required, or book office hours to see how Synder can ease the life of your business. 

Conclusion

Financial statements are an essential tool for evaluating the financial health of any business. By understanding the elements of financial statements and how to analyze them effectively, you can make informed decisions about your business’s financial strategy. Whether you are an entrepreneur, investor, or creditor, financial statements provide valuable insights into a company’s financial performance and can help you make strategic decisions about its future. So, take the time to master financial statements and unlock the secrets of the financial part of your business.

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