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How to Correctly Interpret Your Business Financial Statements


Interpret Your Business Financial Statements

To operate a successful business, you must have a robust understanding of your business’ financial statements because these forms inform all your managerial decisions. In the next section, we’ll take a closer look at three fundamental financial statements also discuss how you should read and analyze them to understand your company’s performance better.

Interpreting Business Financial Statements

Business Financial statements are significant aspects of financial reporting. Business Accountants use these documents to depict a business’s financial performance accurately—these records ensure C.P.A.s provide precise accounting and business tax services.

Understanding Financial Ratios

To analyze your business financial statements, you’ll need to calculate the financial ratio, i.e., a numerical representation of your company’s performance in terms of debts and profits.

How to Read and Interpret a Balance Sheet

A balance sheet provides an accurate portrayal of your assets, the amount you owe (liabilities), and your equity. All balance sheets adhere to the equation below.

Assets = Equity + Liabilities

A balance sheet provides a snapshot of your company’s finances at a specific date. Therefore, to understand your company’s performance, you must examine previous balance sheets. Also, you ought to compare these records with those of other companies working in the same industry.

Calculating your current financial ratio could also help you gauge whether your company is cash strapped. The current ratio formula is as follows:

Current ratio = Current Assets/ Current Liabilities

Example: Current ratio = 40,000/15,000 = 2.66

Note that the recommended current ratio is 2:1. Anything below that number means that your assets are not enough to cover your liabilities. Also, to know whether your business can run using your earnings (equity), your company’s balance sheet should not exceed a debt-to-rate ratio of 2:1.

How to Read and Analyze an Income Statement

Your income statement conveys your company’s expenses and earnings over a specific accounting period. To interpret your income statement, you must understand these essential financial ratios.

Gross profit margin

The gross profit margin relies on the cost of goods sold (COGS) to calculate how much money your business is making.

Gross Profit Margin = (Sales Revenue – COGS) / Sales Revenue

Gross Profit Margin = (7,000 – 4,000) / 7,000= 0.42

Here, the gross profit margin is 0.42, meaning that a business keeps 0.42 US dollars for every dollar as gross profit.

Operating profit margin

Your operating profit margin takes into account both the COGS and other expenses. Here’s the formula:

Operating Profit Margin = Operating Earnings / Sales Revenue

To become a profitable business, you should work on increasing the operating profit margin. The best way to do this is by keeping track of your daily business expenses.

How to Read and Interpret a Cash Flow Statement

Analyzing your cash flow statement should be a priority task when undertaking any business finance operation. A cash flow statement reveals how your company raised funds and how it spent them over a particular period. It also measures your business’ ability to cover expenses.

Ideally, your company should bring in more money than it is spending. There are three main elements of a cash flow statement: operations, investment, and finance.

As a business owner, you’ll come across two ways of recording transactions, namely cash basis and accrual accounting—usually, the former works for small and medium enterprises that don’t take inventory. Cash basis accounting only recognizes actual income and not in its abstract form. In comparison, accrual accounting records all expenses and earnings regardless of whether or not they’ve hit the bank account.

Businesses use these three formulas to determine their cash flows

Current debt coverage ratio

This ratio gives you a clear picture of how much cash debt you owe and whether the net business income can cover such liabilities. See the formula below:

Current debt coverage ratio = net income from operations / average current liabilities

Example: Let’s say your company generated 65,000 USD from operating activities in 2019. The current liabilities at the start and end of the financial year are 55,000 USD and 70,000 USD. Your current liability coverage ratio would be:

(55,000+70,000)/2= 62,500

65,000/62,500= 1.04

Therefore, the ratio will be 1.04:1 (A higher ratio depicts that your business is at a better liquidity position)

Cash flow coverage ratio

This financial ratio also examines whether your business can pay off its debt. The key difference is that this ratio considers the entire debt and not just for a specific period. Here’s the formula:

Cash Flow Coverage Ratio = Net Cash income from Operations / Entire Debt

Cash flow margin ratio

The cash flow margin ratio determines how much your business made for every dollar earned during a particular reporting period. See the formula below:

Cash Flow Margin ratio = Net income from Operations / Net earnings

Let F.M.A., C.P.A. In Clearwater Handle All Your Business Financial Statements’ Needs

Understanding your business financial statements is a core element of business finance. F.M.A., C.P.A. has extensive financial knowledge to provide business advisory services in Clearwater. Not only do we help businesses prosper, but we also work with individuals. Our services include personal tax filing and retirement planning services.  For more information and to schedule a no-cost consultation, call us at 727-530-0036 today!

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