An ability to understand the financial health of a company is one of the most vital skills for entrepreneurs, business owners and managers to develop. Armed with this knowledge you can better identify promising opportunities while avoiding undue risk and make more strategic business decisions.
Financial statements offer a window into the health of a company, which can otherwise be difficult to gauge. While accountants and finance specialists are trained to read and understand these documents, many business professionals are not. The effect is an obfuscation of critical information.
Traditional financial statements, like the Balance Sheet, Profit & Loss, and Income Statement have been around a long time. They must be working well! However it is the interpretation which makes the data valuable. A good starting point is the performance of the previous month and year-to-date. Next would be to compare this to what was expected (the forecast) and to look at any variance from last year over the same period.
How to read a Balance Sheet
A balance sheet conveys the “book value” of a company. It allows you to see what resources it has available and how they were financed as of a specific date. It shows its assets, liabilities, and owners’ equity (essentially, what it owes, owns, and the amount invested by shareholders, a snapshot of your business finances as it currently stands).
How to read an Income Statement
Whist the balance sheet is a snapshot of your business’s financials at a point in time, the income statement (sometimes referred to as a profit and loss statement / P&L ) shows you how profitable your business is over a given period, such as a month, quarter, or year, it summarises the cumulative impact of revenue, operating expenses and cost of goods sold (cost component of what it takes to make whatever a business sells) for a given period. The document is often shared as part of monthly and annual report. It shows financial trends, business activities, gross, operating and net profit, and compares these over set periods.
Profitable products doesn’t mean your business is profitable. You could be making a killing on every item / service, but spending so much on advertising that you walk away with nothing.
How to read a Cash Flow Statement
Cash flow can never be ignored, even cash-rich businesses should keep an eye on this and understand how they will fund operations going forward.
The purpose of a cash flow statement is to provide a detailed picture of what happened to a business’s cash during a specified period. It demonstrates an organisation’s ability to operate in the short and long term, based on how much cash is flowing into and out of it.
Cash flow statements are broken into three sections:
Cash flow from operating activities, cash flow that’s generated once the company delivers its regular product or services and includes both revenue and expenses
Cash flow from investing activities, cash flow from purchasing or selling assets
Cash flow from financing activities, cash flow from both debt and equity financing.
It’s important to note there’s a difference between cash flow and profit. Whilst cash flow refers to the cash that's flowing into and out of a company, profit refers to what remains after all of a company’s expenses have been deducted from its revenues.
Both are important numbers to know.
Ideally, cash from operating income should routinely exceed net income, because a positive cash flow speaks to a company’s financial stability and ability to grow its operations. However, having positive cash flow doesn’t necessarily mean a company is profitable, which is why you also need to analyse balance sheets and income statements.
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