One of the essential qualities for potential investors, managers, and founders is assessing a company’s financial health. Equipped with this information, investors can unravel potential opportunities while quantifying risks or uncertainties.
Financial statements provide a glimpse into a company’s health that sometimes may be tough to determine by using other forms or means. Although finance professionals and accountants are qualified to comprehend such documents, most of the entrepreneurs and founders are not. The result is a blur of vital data.
Understanding of financial statements
Every person in business must learn to study and evaluate the financial statements, i.e. income statement, balance sheet, cash flow statement, and annual report and notes to the accounts.
- 1. Balance sheet
A balance sheet expresses the “book value” of an organisation. It enables an individual to get an idea about the availability of resources and how they have been supported on a given date. It shows liabilities, assets and owner’s equity (basically, what it owns, owes, and the shareholders investment).
The balance sheet contains data that can be useful to measure the rate of return and determine the composition and usage of capital, using the accounting equation:
| Assets= Liabilities + Owners equity |
- Assets are something of measurable value that a business owns.
- Liabilities refers to money owed, such as unpaid payroll costs, interest, rent, utilities, and taxes.
- Owners equity is known as a company’s net worth.
The balance sheet alone does not include trend information; that’s why an individual must review the rest of the financial statements to fully understand the financial condition, namely, cash flow and income statement.
- Income Statement
As the name suggests, it shows the net profit or loss made by the business during a particular time. It is also popularly referred to as a profit and loss (P&L) account under UK FRS (Financial Reporting Standards), statement of comprehensive income under the IFRS (International Financial Reporting Framework). As part of annual and quarterly reports, the document is also shared and displays financial patterns, company operations (revenue and expenditure), and contrasts over defined periods.
Usually, income statements contain the below-mentioned information:
- Revenue or Income: Total sales made during the period.
- Costs of goods sold: The price of parts needed to make something that a company sells.
- Administrative expenses: Expenses like rent, staff salaries, advertising expense.
- Other income: Income that is not revenue- like profit on the sale of business assets.
- Taxes: corporate and other taxes payable
- Cash Flow Statement
A cash flow statement aims to give a clear image of a company’s cash (inflow and outflow) over a given period known as the accounting period. It shows how cash has been received or spent in a given time.
Statement of cash flow includes cash flow from operating, investment, and financing activities.
Cash flow generated from its routine operations, that is, selling product or services minus purchases, is detailed in the operating activities.
Cash flow from selling or buying assets is an investment activity, generally in physical property, like vehicles, and non-physical property, such as patents. Financing activities shows a detailed inflow and outflow of cash from debt as well as equity.
It’s essential to know that profit and cash flow is different. Cash flow is all about the inflow and outflow of cash into the business. On the other hand, P&L is about the leftover after all expenses are subtracted from income or revenue. Both of them are valuable numbers to be aware of. For example, profit and loss also includes non-cash items like depreciation, bad debts, provision for any legal costs and accruals
An individual can analyse the kinds of activities that generate cash with a cash flow statement and implement that data to make better financing decisions.
Annual Report
It is a report published alongside public limited companies’ financial statements at the end of the year. Its target audience is broader, including investors, shareholders, bondholders, debt holder, market analysts, employees, etc.
In the form of images or a letter from the Chairpersons/ CEO to describe corporate activities, benchmarks, and achievements, annual reports often incorporate editorial and storytelling. In comparison with individual financial statements, they provide investors, shareholders, and staff with better insight into a corporation’s objectives and vision. An annual report also describes financial data and includes the income statement, balance sheet, and cash flow declaration.
Wrapping-up
Analysing and reviewing the financial records can give valuable insights about an organisation, such as:
- Debts and the ability to pay them back.
- Profit and loss (for a year or quarter).
- Variance analysis- comparison of the last year’s number with current year to identify trends.
- Investment level needed to hold or expand the company.
- Operational expenses, in comparison to the revenue generated by such type of expenses.
Investors, shareholders, and accountants must be aware of an organisation’s financial health. Moreover, employees can also get an advantage from knowing balance sheets, cash flow and income statements, and annual reports.
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