Do you truly understand your company’s financial statement? If you have a good handle on its three components — the balance sheet, income statement and statement of cash flows — you should be equipped to make wise business decisions.
Behold the balance sheet
On this report, you tally your company’s assets, liabilities and net worth to create a snapshot of its financial health.
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 liabilities exceeds the value of the assets, your net worth will be negative. There are a number of balance sheet ratios worth monitoring, including:
Growth in accounts receivable compared to the growth in sales. If receivables are growing faster than the rate at which sales are increasing, customers may be taking longer to pay. They may be running into financial trouble, or finding quality issues with the products or services.
Growth in inventory vs. the growth in sales. When inventory levels increase at a faster rate than sales, the company is producing products faster than they’re being sold. This can tie up your cash. Moreover, the longer inventory remains unsold, the greater the likelihood it will become obsolete.
Growing companies often must invest in inventory and accounts receivable, so increases in these accounts don’t always signal problems. Typically, jumps in inventory or receivables should correlate to rising sales.
The ratio of current assets to current liabilities. If this ratio falls below 1, the company may struggle to pay bills coming due. Some business experts believe a current ratio of less than 2:1 is problematic.
Enter the income statement
The income statement shows sales, expenses, and the income or profits earned after expenses 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. Cost of goods sold includes the cost of labor and materials required to make a product. Another important term is “net income,” which is the income remaining after all expenses (including taxes) have been paid.
Like the balance sheet, the income statement can reveal potential problems. It may show a decline in gross profits, which means production expenses are rising more quickly than sales.
Next: The statement of cash flows
This statement shows all the cash flowing into and out of your company. For example, 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.
Although this report may seem similar to an income statement, its focus is solely on cash. For instance, 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, companies must continually generate cash needed to pay creditors, vendors and employees. So you should watch your statement of cash flows closely.
Each of the reports described above can reveal much about your business’s financial position and performance. Moreover, by carefully analyzing your financial statement, you may be able to uncover potential money-management problems.