How to analyze financial statements

Understanding your company's financial statements might be confusing, especially if you're not familiar with accounting or finance. 

This article will help you make sense of the basics of analyzing financial statements. Use the tips to better understand the health of your business and identify ways to improve it.

The importance of accurate financial statement analysis

Proper financial statement analysis reveals valuable information about your company's financial situation. It can tell you how efficiently you're using cash and help you identify problems that impact earnings.

Reviewing your balance sheet, income, and cash flow statements is good practice for benchmarking financial performance. Understanding how to calculate and interpret ratios is critical to your analysis. You can use ratios to evaluate your company's solvency, profitability, liquidity, and operational efficiency.

Key components of financial statements

There are three financial statements used to analyze business performance. They include the balance sheet, income statement, and statement of cash flows.

Balance sheets identify the assets, liabilities, and equity of your company. Performing balance sheet analysis helps you evaluate the liquidity and efficiency of your organization.

The income statement shows your company's revenues and operating expenses for a period. Income statement analysis helps you identify opportunities for growth or cost-cutting. Two methods to help you analyze your income statement are horizontal and vertical analysis. Both techniques allow you to compare performance across different periods.

Cash flow analysis pinpoints the sources of incoming cash and where you're spending it. It can tell you if there is a monetary shortfall or if you have excess funds available.

Common financial ratios and metrics

There are four main types of financial ratios: liquidity, solvency, profitability, and efficiency.

• Liquidity ratios evaluate financial stability. They tell you whether you have enough money available to pay off short-term debts should they become immediately due. A few examples of liquidity ratios can be the current ratio and quick ratio.
• Solvency ratios are similar to liquidity ratios in that they evaluate a company's ability to pay off debt. However, solvency ratios look at long-term obligations instead of short-term ones. Instances of solvency ratios include the debt-to-equity ratio and interest coverage ratio.
• Profitability ratios tell you how well your company generates revenues from its existing assets, liabilities, and equity. Return on equity and profit margin are two types of profitability ratios.
• Efficiency ratios examine your internal performance, such as how quickly you collect outstanding receivables or turn over inventory. Efficiency ratios encompass things like fixed asset turnover and accounts receivable turnover.

Steps to analyze financial statements

It's good practice to analyze your company's financial statements regularly. Most companies review their statements monthly, quarterly, and yearly. Here are five steps to get you started.

1. Gather and review financial statements

Your first step is to gather your balance sheet, income statement, and cash flow statement for the period. You'll want to review them before you start the analysis process. Look for any anomalies that signify mistakes in your statements. For instance, if you see a significant unexpected revenue shift, your income statement may be incorrect.

The analysis process won't yield correct results if your financial statements are inaccurate. Make sure you're working with a complete statement before you dive in.

2. Calculate financial ratios

Your next step is calculating financial ratios for each statement. It's a good idea to select a variety of liquidity, solvency, profitability, and efficiency ratios. Not every ratio will be appropriate for your business. For instance, if you don't have any long-term debt, there's no need to calculate the interest coverage ratio because you don't have to pay any interest.

Some accounting software will calculate your financial ratios for you. Automated calculations can save you time and improve accuracy. However, if your financials are complex, you may still need to perform some analysis manually.

3. Compare ratios and industry benchmarks

It's a good idea to compare ratios across different periods. Start with a monthly comparison, then look at quarterly and yearly differences. Comparing ratios allows you to identify patterns that may be important to your business.

You can also compare your business performance to your industry's. You can find industry averages from various sources, including your bank. Banks use industry ratios to evaluate company performance for lending purposes. Your banker may share ratios if you ask for the data.

Dun & Bradstreet publishes ratios for over 800 industries, which you can access with a subscription. Some public libraries allow you to access their publication for free. You can check with your library to determine if it's available.

If you have competitors that publish their financial statements, you can use them to compare your company's performance. You may be able to find their current financials on their company website, which you can use for benchmarking. However, remember that differences in operating structures and company size may make comparison difficult.

4. Identify trends over time

Once you begin analyzing your financial statements, you'll want to track performance over time. Keep a record of all your ratios, and compare results monthly, quarterly, and yearly. You'll likely see trends and patterns that help you better understand your company's performance. Evaluating trends can help you pinpoint financial or operational efficiency shifts that need further analysis.

Remember, financial ratios come directly from your financial statements. You will need to look at underlying transactions to learn more about their meaning. Your accountant or financial analyst can help you decipher your transactions and how they impact your ratios.

5. Interpret findings and draw conclusions

When you have a solid set of financial ratios, you can interpret their meaning. You'll use your results to determine where your company is doing well and where improvements might help. To do so, you'll need to understand what each ratio signifies.

You can use your ratios to set goals for your business. For instance, if your current ratio is low, you may have difficulty paying your short-term debts. You can improve your current ratio by paying off obligations or increasing assets.

Keep in mind that ratio results will differ depending on many factors. Your company's financing structure and industry both impact your results. Don't assume your business is in trouble based on a single ratio. Instead, look at your business from a holistic perspective. If you recently took on debt, your solvency ratios may be lower than you like. However, the debt might be necessary for future business growth.

Leverage financial analysis for informed decision-making

Analyzing your business financial statements eliminates confusion around your company's performance. You'll feel much more comfortable knowing you have a solid grasp of your organization's operations. By calculating your profitability, liquidity, efficiency, and solvency ratios, you'll discover information that helps you make knowledgeable business decisions.  

Consider speaking with a professional if you need help analyzing your financial statements. Experienced financial analysts can identify financial ratios critical to your business. They'll also help you interpret their meaning and help you set goals for improvement.

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