A Primer on Financial Statements and Financial Ratios

• How keeping detailed records can help you assess the financial health of your business
• A look at the balance sheet, income statement, and cash flow statement
• View sample statements to view how this information is presented

By Kempton Coady and Denis Jakuc

Let’s look first at financial statements. There are three types.

• The balance sheet shows the company’s assets and liabilities and owners’ equity, as of a specific reporting date. The information it shows does not cover a span of time.
• The income statement, also called the profit and loss statement (P&L), shows the results of the company’s operations and financial activities for a specific reporting period. It includes revenues, expenses, gains, and losses. It’s a great tool to measure the financial, operating, and marketing performance of individual business segments, products, and services.
• The cash flow statement shows changes in the company’s cash flows during a specific reporting period. Cash flow is normally calculated by simply adding back depreciation to net profit, but there’s more to it than that (see below). The cash flow statement contains the most important information for a small business owner, because it measures how much cash the company has on hand to pay its bills.

Let’s take a closer look at how these statements work.

Balance sheet

The balance sheet is the presentation of the company’s financial position, broken down into assets, liabilities, and equity.

Balance sheets serve two purposes. First, based on the balance sheet, company management and investors can make better decisions about the health of the company and what specific actions may need to be taken. For example, a balance sheet might show the company has too much debt, or its goodwill calculations are too large.

Secondly, when a balance sheet is reviewed externally by investors, it can give insight into what resources are available and how they were financed, to help decide whether it would be wise to back the company.

The balance sheet is calculated: Assets = Liabilities + Owners’ Equity

Assets

Assets must be categorized in the balance sheet.

Current assets typically include anything a company expects it will convert into cash within a year, such as:

• Cash and cash equivalents
• Prepaid expenses
• Inventory
• Marketable securities
• Accounts receivable

Noncurrent assets typically include long-term investments that are not expected to be converted into cash in the short term, such as:

• Land
• Patents
• Trademarks
• Brands
• Goodwill
• Intellectual property
• Equipment used to produce goods or perform services

Liabilities

While an asset is something a company owns, a liability is something it owes. Liabilities are financial and legal obligations to pay an amount of money to a person or another entity.

Current liabilities typically refer to any liability due to the debtor within one year, which may include:

• Payroll expenses
• Rent payments
• Utility payments
• Debt financing
• Accounts payable
• Other accrued expenses

Noncurrent liabilities typically refer to any long-term obligations or debts which will not be due within one year, which might include:

• Leases
• Loans
• Bonds payable
• Provisions for pensions
• Deferred tax liabilities
• Obligations to provide goods or services in the future (for example, a newspaper which has been paid for a subscription for the next 12 months)

Owners’ equity

Owners’ equity refers to what belongs to the owners of a business after all the liabilities are accounted for. If you add up all the resources a business owns (its assets), and subtract all the claims from third parties (its liabilities), the residual left over is the owners’ equity.

This includes two key elements. The first is the money contributed to the business as an investment in exchange for a degree of ownership (typically represented by shares of stock). The second is the earnings the company generates over time and retains along with other financial documents that speak to a company’s health.

Income Statement or Profit and Loss Statement (P&L)

An income statement, or profit and loss (P&L) statement, is the easiest to understand and most important financial statement for a small business. This financial statement allows you to look at your business overall — and when applied to business segments or product/service lines, to understand their contribution in the business mix.

This financial statement, along with cash flow calculations, allows you to better run your business. The P&L can also be used to analyze your business’s financial trends over time and do forecasting.

The income statement summarizes all income and expenses over a given period, including the cumulative impact of revenues, gains, expenses, and losses. Income statements are shared as quarterly and annual reports, showing financial trends and comparisons over those time periods.

The income statement shows a company’s (or business segment’s, or product/service line’s) financial performance over a period of time. It tells the financial story of a business’s activities. Within an income statement, you will find all revenues and expenses accounted for a particular period.

Business owners, accountants, and investors regularly review income statements to understand how well a business is doing in relation to expected or industry standard performance, and use that information to adjust their decision making and actions. Without accurate income statements, a company is flying blind.

Developing an income statement

An income statement is one of the most important documents a company’s management team and its investors can review, because it includes a detailed breakdown of income, costs, expenses, and profitability over time. It includes:

• Revenue: The amount of money a business takes in during a reporting period
• Expenses: The amount of money a business spends during a reporting period
• Costs of goods sold (COGS): The cost of the component parts it takes to make whatever it is the business sells
• Gross profit: Total revenue less COGS
• Operating income: Gross profit less operating expenses
• Income before taxes: Operating income less non-operating, or overhead, expenses
• Net income: Income less taxes
• Earnings per share (EPS): Net income divided by the total number of outstanding shares
• EBITDA: Earnings before interest, taxes, depreciation, and amortization
• Depreciation, and local, state, and federal taxes
• Net profit

Breaking down the P&L to look at business segments, product lines, and services, can give you a better understanding of those businesses.

ViVA Skin Care Comparative P&L January 2006 vs January 2005

Cash flow statement

Cash flow calculations can involve three different components:

1. Cash recognized because of adding back non-cash items like depreciation to your net profit
2. Cash generated because of investments
3. Sales of assets to generate cash

Cash Flow Statement Direct Method

This method, often referred to as a cash basis cash flow statement, records the transactions that impacted cash during the reporting period. To calculate the operations section using the direct method, take all cash collections from operating activities, and subtract all cash disbursements.

Cash Flow Statement Indirect Method

The second way to prepare the operating section of the statement of cash flows is often called the indirect, or accrual, method. This method uses accrual accounting, in which revenues and expenses are recorded at times other than when cash was paid out or received. These accrual entries and adjustments result in the cash flow from operating activities differing from the net income.

An example of this kind of cash flow accounting is a newspaper whose cash from an annual subscription is reported as cash coming in monthly over 12 months. The expenses of producing the daily paper are also reported monthly.

Interpreting a Cash Flow Statement

Positive Cash Flow

Positive cash flow indicates that a company has more money flowing into the business than out of it over a specified period. This is an ideal situation to be in, because having an excess of cash allows the company and its shareholders to reinvest, settle debt payments, and find new ways to grow the business.

Negative Cash Flow

Having negative cash flow means your cash outflow is higher than your cash inflow during a specific period. A negative cash flow may be caused by a mismatch of expenditures and income. This can happen, for example, when a company is expanding its business.

Financial Ratios

Financial ratios are mathematical comparisons of accounts or categories on financial statements. Calculating these relationships between financial statement accounts helps business owners, investors, creditors, and company management understand how well a business is performing, and the areas that need to be improved or shut down.

Some of the most important financial ratios to look at are:

• Gross Margin % (Gross Profit/Sales x 100)
• Pretax Margin % and After-Tax Margin %
• Return on Assets (ROA) % (Net Profit/Total Assets x 100)
• Return on Investment (ROI) % (Net Profit/Total Investment x 100)

Other financial ratios can be looked at as well.

Presenting important financial ratios

Important financial statement ratios are generally made to industry standards and are presented as a percentage and a monetary contribution. Here are some of the more important figures and what information they convey to managers or investors:

• Gross Margin: Does the product or service make enough money?
• Operating Margin: Are operating expenses too high?
• Pretax Margin: After all the overhead expenses, do we make enough money?
• Cash Flow (net profit and depreciation): Is cash flow sufficient to contribute to expanding a business?
• Return on Assets (cash flow/assets): Are we making enough return on the assets we’ve invested?

Conclusions

The purpose of all these financial statements and financial ratios are:

• To determine the ability of a business to generate cash, and the sources and uses of that cash
• To determine whether a business has the capability to pay back its debts
• To track financial results on a trend line, to spot any looming profitability issues
• To use financial ratios derived from the financial statements that can indicate the condition of the business
• To investigate the details of certain business transactions, as outlined in the disclosures that accompany the statements

For example, here’s how businesses use income (P&L) statements. You prepare an income statement by calculating your revenue, determining the cost of goods sold, calculating the gross margin, and including operating expenses. You then calculate your income, including an allowance for depreciation, then include income taxes to calculate net income.

This income statement is then used to measure the one-time results of the company, a product, or service. It can also be used to measure performance over time, and as a way to compare your company, product, or service performance to industry standards. Finally, income statements can be used to do specialized analyses of a business, product, or service, to determine its viability.

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