We have been blogging all month on the topic of financial statements and their benefits and have noticed that even the best ones can be incredibly difficult to read and understand. Today, we will discuss a few simple tricks to remember when reading financial statements. You don’t have to be an accountant, bookkeeper, or even a billionaire venture capitalist to need a financial statement. Since misreading one can be a huge financial mistake, here are the top things to remember when thinking of financial statements for dummies.
1. Types of Financial Statements for Dummies
As we previously discussed here, there are 4 main types of financial statements and they include:
- The Income Statement- A recounting of the income of a business in sales, products sold, services, provided, etc. This statement is also coupled with a recounting of the operating expenses the business has taken on from rent to payroll and beyond.
- The Statement of Financial Position – Also known as the balance sheet, it tallies the assets and expenses/liabilities for a business and calculates the difference in totals. The remaining difference can tell you if the business is in the black or the red.
- The Cash Flow Statement – This represents the flow of cash over a certain period of time so readers can see where the money is going.
- The Equity Changes Statement – If the business has had a change in leadership, ownership, or other related area, this statement will show it.
2. How Much Cash on Hand
Before you get involved in a business, one of the best things to know is how much cash is in their balance. The cash flow financial statement is the one that will best show you this number, especially if the company has a few years under its belt. As mega investor Warren Buffett has said “it’s good to compare how much different cash flow is from net income.” This line of thinking is due to the fact that if the net income is much higher than the cash flow, then there may be a serious problem/ This problem can be in the accounting practices of the business or some illegal activity may be at foot – Bernie Madoff anyone?
3. Know the Net Income
Yes this business may do $10 million in sales, but if there are $15 million in total operating expenses, it’s in the red for $5 million. Getting the net income will tell you how much profit a business turns after all bills have been paid. One way to calculate the net income is displayed in this example.
- $50,000 in total sales.
- $25,000 in cost of goods sold.
- A gross margin of $25,000.
- $10,000 in expenses related to administrative, sales, and general areas.
- $15,000 in earnings from operations.
- $500 in expenses from interest.
- $14,500 in earnings before taxes.
- $4,000 in taxes.
- There there is $10,500 in net income.
Of course the numbers for revenue, margins, etc will differ from business to business.
4. Current Liquidity to Debt Ratio
Those of you who do have experience in accounting, bookkeeping, or similar knowledge can give this one a try. The liquidity of a business is its ability to meet its short-term expenses and liabilities with liquid assets. It is calculated by dividing the current assets by the current liabilities. A ratio of one to one (or if both numbers equal the same amount) denotes that the business is adequately prepared to operate day to day. If the assets are higher than the liabilities, aka $2 million over $1 million, this means the business is doing well. It is not only prepared to cover its expenses, it has more than enough assets to expand into further ventures. Those businesses with liabilities that are higher than their assets, aka $1 million over $2 million, are in trouble when it comes to keeping their doors open. They may have to resort to dangerous practices such as taking out high interest loans, selling assets, firing staff, taking a hit on their credit, or other action that could have negative financial consequences.
For more information on financial statements for dummies, check out the Official Dummies page on it.
Financial Statements for Dummies in Houston
And if you are in need of preparing or reading financial statement services and live in Houston or the surrounding area, please contact us to see how we can help make sense of it all.