Comprehensive financial statements can help tell the story of your organization’s financial health. Together, a balance sheet, income statement and statement of cash flows can be powerful diagnostic tools to help evaluate its financial well-being. Moreover, by carefully analyzing them, you may be able to uncover potential money-management problems or even fraudulent activity.
Assets vs. liabilities — The balance sheet
A balance sheet provides a snapshot of a company’s financial health at a moment in time. One side shows the assets owned by a company, such as cash, accounts receivable and inventory. The other side contains liabilities or claims on the assets, including accrued expenses, accounts payable and equipment loans.
Current assets (such as receivables) mature within a year, while long-term assets (such as plant and equipment) have longer lives. Similarly, current liabilities (such as payables) come due within a year, while long-term liabilities are payment obligations that extend beyond the current year or operating cycle.
Net worth or owners’ equity is the extent to which assets exceed liabilities. Because the balance sheet must balance, assets must equal liabilities plus net worth. If the value of your company’s liabilities exceeds the value of its assets, net worth will be negative.
A focus on profits — The income statement
The income statement reports revenue, expenses and profits earned (or losses incurred) over a given period. A commonly used term when discussing income statements is “gross profit,” or the income earned after subtracting the cost of goods sold from revenue. Another important term — “net income” — describes income remaining after all expenses (including taxes) have been paid.
Sales, general and administrative expenses (SG&A) are also indicated on income statements, reflecting business functions, such as marketing, that support a company’s production of products or services. The ratio of SG&A costs to revenue tends to be relatively fixed — no matter how well your business is doing. If these costs constitute a rising percentage of revenue, business may be slowing down.
The income statement can reveal other potential problems. It may show a decline in gross profits, as expenses rise quicker than revenue. Common causes include hiring more employees than needed or doing an excessive proportion of low- or no-margin business. In today’s business environment, many companies are reporting lower gross margins due to rising labor and materials costs — unless they’ve managed to pass along these cost increases to customers through higher prices.
Cash is king — The statement of cash flows
The statement of cash flows shows all the cash coming in and out of a company. Your company may have cash inflows from selling products or services, borrowing money and selling stock. Outflows may result from paying expenses, investing in capital equipment and repaying debt. Ideally, a company will derive enough cash from operations to cover its expenses. If not, it may need to borrow money or sell stock to survive.
The statement of cash flows shows changes in balance sheet items from one accounting period to the next. It’s organized into cash flows from three primary sources:
- Investing activities
- Financing activities
To complicate matters, non-cash investing and financing transactions are reported at the bottom of the statement of cash flows. These transactions don’t involve direct cash exchanges. For example, a machine that’s purchased directly with loan proceeds would be reported here.
Although this report may seem similar to an income statement, its focus is solely on cash. A product sale might appear on the income statement, even though the customer won’t pay for it for another month. But the money from the sale won’t appear as a cash inflow until it’s collected.
To remain in business, your company must continually generate cash to pay creditors, vendors and employees, watching your statement of cash flows closely.
Ensuring tip-top financial shape
Financial statements can be valuable for many purposes — whether you’re evaluating the financial results of your own business or one that you’re considering acquiring, lending to or investing in. An experienced professional can help you assess your company’s financial health, including potential risks and areas of improvement.