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Navigating your financial statements

What is the purpose of enterprise? That is the question I normally start every finance course with. The easy answer, at least for most businesses, is to make money. That is not to say that businesses have profit making as their sole purpose. However, providing a fair return on capital is mission critical for business. In fact, even for governments and non-profit organizations, the ability to operate in a financially sustainable manner is critical to long-term survival, and hence success. So finance is important.

Here’s the other important observation. Every management decision will eventually show up in the financials. In over two decades of teaching executives, that is a statement that no one has ever disagreed with.

Which, of course, brings us to the next matter: How do you know you’re making good decisions if you don’t understand your financial statements?

So that is our topic for the week, financial analysis 101.

Components and overview

For our purposes this week, we will just focus on what are usually called the GAAP statements. These are the ones prepared in accordance with generally accepted accounting principles and are the ones that are submitted to the Securities and Exchange Commission.

A full set of financial statements will have the following: Balance Sheet, Income Statement, Statement of Cash Flows, Statement of Stockholder’s Equity, and Notes. For many managers, the most important components of the financial statements are the Balance Sheet and the Income Statement, and the referenced notes. The referenced notes explain the details of items in the statements.

The balance sheet presents the financial position of the company at a single point in time. The balance sheet essentially shows the company’s assets (what it owns) and the components of total capital.  Assets include current assets such as cash and other items of working capital such as inventory and accounts receivable; and long-term assets which are typically building, furniture and equipment.  Total capital comprises the two general categories of debt and owner’s equity.  Essentially what this means is that all of the capital needed to support operations come either from the owner or from borrowings. Owner’s equity includes the owner’s original capital brought in and any earnings not paid out as dividends, called retained earnings.

Generally, the income statement shows the results of operations over a reporting period, typically one year. Any changes in net assets are shown in a sub-statement showing comprehensive income. In business, three large items comprise the income statement: revenue, expense and earnings (also called profit). When managers speak of the top line, the middle line and the bottom line, these are what they refer too.

Quick review

When looking at financial statements, one of the first questions that can be answered is the question of size. Typically, the size of a business can be evaluated based on total assets and total revenue.

The second question that can be answered by a quick review of the financial statement is trends. Are assets growing? Are revenues growing? How fast? Are expenses growing? Are they growing faster than revenue? Are accounts receivables growing? Are they growing faster than revenue? This comparison of financial statements over time is called a horizontal analysis. 

When looking at trends over time, managers typically want to see that a business is growing. Usually, managers want to see businesses growing at least as fast as competition.  There are other benchmarks for growth, of course. For example, general economic growth would be one benchmark. Also, managers want to look at relative growth rates. Expenses should not grow faster than revenue. Accounts receivables and inventory are expected to grow with revenue but typically should not grow faster than revenue. The assets needed to generate revenue are expected to grow with but not faster than revenue.

The third question that can be answered by a first review of the financial statements is composition, often called vertical analysis.   How much of assets are liquid? How much of capital is debt versus equity? What is the composition of revenue? What is the composition of expenses? How much of expenses is cost of goods versus fixed overhead? What portion of revenue is gross profit? What portion of revenue is net income?

Ratios

Finally, a quick financial analysis will end with calculating and evaluating a few ratios. There are generally four kinds of ratios: profitability ratios, efficiency ratios, liquidity ratios, and leverage ratios.

Many managers would begin with the profitability ratios. There are many profitability ratios. The four that are the most used are: gross margin, net margin, return on assets and return on equity. 

The margins are the numbers most managers are familiar with. The gross margin is simply gross profit as a percentage of revenue. Gross profit, in turn is simply revenue minus the cost of goods and any commissions or trade discounts. Essentially, this is the amount that is left to cover overhead expenses. If the gross margin is negative, no amount of additional selling or controlling of overhead will allow a company to make a profit. A reasonable gross margin is the first goal. The gross margin is the amount every CEO or entrepreneur must have a quick handle on.  Total revenue and gross margin together make up the living pulse of the business.  The net margin is simply net income divided by revenue. A slim margin means that the company is extremely sensitive to slight disruptions and could end up in the read with slight changes in market situation. A comfortable net margin means that the business has the resilience to weather tough times.

Return on assets (ROA) is the ratio of net income to assets. An easy way to think about this is to understand that net income represent the amount of money the owner earns from engaging in the business. Assets represent the total amount of capital that needs to be left in the business in order for the net income to be earned. In that sense, ROA represents the return on total investments in the company. 

Return on Equity (ROE) is the ratio of net income to equity. If net income is the amount the owner earns from owning the business, equity is the amount of capital the owner has in the business. Hence, ROE represents the owner’s return on investments. Of course, if the owner has paid more than book value for his ownership in the business, as is often the case with listed companies, there is a different, more appropriate calculation.

So that’s it Finance 101, part 1.

 

Readers can email Maya at [email protected]  Or visit her site at http://integrations.tumblr.com.

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