Accurate financial reporting is a vital tool to reveal insights into your business’s health and potential. This means that the ability to understand and effectively manage your business’ financial information isn’t just a skill, it’s a necessity.
But what if you can’t decipher the story your financial statements tell? And how do you use this information to align your business strategies with financial realities? Do you know how to use your reports to attract investors and maintain compliance?
Understanding your balance sheet, income statement and cash flow statement does more than just keep your accounting in check. It helps you unlock the strategic value hidden in these documents. That way, you can leverage your financial reporting to ensure continued business success and growth.
Understanding Key Financial Statements
The three key financial statements of any business are a balance sheet, income statement, and cash flow statement.
The Balance Sheet
Your balance sheet reports assets, liabilities, and shareholder equity at a given time. Altogether, it’s the basis for calculating your business’ capital structure and financial health, in order to evaluate performance. By comparing your balance sheets over time, you can also track business growth.
Assets
Assets are tangible items of value, and are usually classified as current and noncurrent. The former can be converted to cash within 12 months and offers flexibility and solvency. This includes cash and inventory. On the other hand, non-current assets are long-term investments that can’t be converted easily, like land owned by your company.
Liabilities
You must settle liabilities before your company can create profits. As with assets, liabilities are current or noncurrent, based on whether they are obligations that need to be fulfilled within a year, or over a longer term.
Shareholder equity
This is your company’s net worth, or the difference between total assets and total liabilities.
The Income Statement
Income statements track income and expenses on a monthly or quarterly basis, to indicate profits or losses. Also known as profit & loss statements, they guide you on where to cut costs and increase revenue.
These statements help track business performance for you to make informed decisions. That way, your team can spot and remedy small financial problems before they escalate.
Expenses
Expenses are your business’ cost of operating and creating profits. They can be categorized by activity.
Primary activity expenses link to the primary activity of your business, including wages, utilities, and cost of goods sold (COGS). Secondary activity expenses are not linked to core business activities, like interest paid on loans.
Revenue and gains
Revenue is categorized by source. For that reason, income from primary business activities is called operating revenue. Usually, it is generated from sales of goods or services. Non-operating revenue comes from other sources, for example, interest earned on capital or revenue from royalty payments.
Also known as sundry income, gains refer to money your company generates from one-time non-business activities, such as the sale of long-term assets.
However, revenue shouldn’t be confused with receipts. While both refer to income generated by your company, revenue is accounted for in the period when sales are made. Receipts are the actual cash amounts received for goods or services. For this reason, revenue can come from multiple streams, and may affect your accounting, especially if it is deferred.
The Cash Flow Statement
This statement tracks your company’s cash flow, to determine performance. As such, it helps with short-term forecasting and planning, as it provides a clear view of how your business is doing.
A positive cash flow can lead to a more stable business model, and save you penalties or late fees on payments. Alternatively, a negative cash flow could affect your reputation and discourage potential investors.
The main components of a cash flow statement are operating, investing, and financing activities.
Operating activities relate directly to the sale of products or services, through accounts receivable and accounts payable. This dictates whether or not your business has enough money coming in to cover operating expenses.
Investing activities track cash flow from a business’ investments. That includes any changes to equipment or assets, like vendor loans, or mergers and acquisitions payments.
Financing activities include cash to and from investors and banks, or shareholders.
How to Read Financial Statements
Interpreting the Balance Sheet
Financial ratio analysis helps you interpret a balance sheet and make sense of your assets and liabilities. However, there are several different ratios to consider. These include:
- Debt-to-equity (D/E): This provides information about profitability, by dividing total liabilities by total shareholders equity. Generally speaking, a D/E ratio under 2.0 is a good sign.
- Liquidity: This measures a company’s ability to pay off current liabilities with current assets, by dividing assets by liabilities. The higher the ratio, the better your liquidity position.
- Solvency ratios indicate whether your cash flow is sufficient to meet long-term liabilities. These ratios vary by industry.
- Activity ratios are used to determine the efficiency of your company’s operations, through its ability to convert different accounts in its balance sheets into cash. They can be broken down into different activities, each with its own formulas.
Understanding shareholder equity
Shareholder equity determines the real return your company is generating for investors. If your assets are worth more than liabilities, your business has positive net equity. If not, your shareholder equity will be negative.
On a balance sheet, shareholder equity is divided into four categories:
- Preferred shares: These are issued to investors as proof they have paid into a company, and are issued with specific terms of payment, usually in the form of dividends.
- Common shares: Like preferred shares, these are usually paid out as dividends, but are paid after preferred shares.
- Paid-in shares: This is the amount of cash or assets shareholders have paid in exchange for shares or stock.
- Retained earnings: These are a percentage of net earnings not paid to shareholders as dividends.
Analyzing the Income Statement
A number of financial ratios can help you analyze your income statement to assess your company’s profitability.
Despite this, profitability ratios depend on your gross profit (net sales – COGS), operating profit (gross profit – operating costs), and net profit (operating profit + other income – additional expenses and income taxes).
Profitability ratios
A high gross profit margin ratio indicates that your company has a high profit compared to product or service costs. This ratio must be stable for continued business success. Here’s how to calculate this ratio:
Gross Profit Margin Ratio = (Gross Profit ÷ Sales) × 100
Operating profit ratios are directly linked to efficiency. When making this calculation, consider your company’s operating income, or earnings before interest and taxes (EBIT). EBIT identifies your business’s ability to generate enough earnings to be profitable.
The operating profit margin is calculated as follows:
Operating Profit Margin Ratio = (Operating Income ÷ Sales) × 100
The net profit ratio accounts for earnings and taxes, and thus demonstrates how much profit you make from total sales. The formula is:
Net Profit Margin Ratio = (Net Income ÷ Sales) × 100
These ratios not only show investors and stakeholders how successful your business is, but can be used to see where it’s possible to cut costs and boost revenue.
Understanding the Cash Flow Statement
Even though this tracks cash coming into and out of your business, it does not track profits.
Cash flow statements track the movement of money over a given period, while profit is what remains of your revenue after costs are deducted. Thus, the former gives you a view of your company’s financial outlook, while profits show its immediate success. It’s possible to have a profitable business with a poor cash flow.
Identifying cash flow trends and what they indicate
A cash flow analysis determines your working capital, or money your business has available to run operations and complete transactions. This means you can identify cash flow trends for insights into your business’s financial health and future performance.
That way, your business can meet its short-term and long-term goals. After all, long-term negative cash flows could indicate a potential future bankruptcy, while a positive cash flow suggests the opposite.
The Vital Role of Financial Reporting
Accurate financial reporting offers numerous business advantages. In addition to performance and profitability assessment, reporting allows for informed analysis and decision-making.
For instance, you can compare reports to establish trends, and identify weak spots and areas for cost reduction. In addition, your reports allow you to plan future strategies for goal setting and growth through effective resource allocation.
When you compare financial statements with competitors in your industry, you’ll be able to benchmark your business’ efficiency and profitability. That could help you make more informed decisions about investments, pricing, and business strategy.
Financial reporting also plays a large role in attracting investors. Clear financial statements mean easy evaluation of your company’s profitability, and therefore return on investment. When investors can rely on your financial statements, they’ll be confident about establishing a relationship with your company.
Moreover, it’s important that all your financial statements are compliant with current financial and legal regulations, and that you maintain transparency.
Tips for Maintaining Transparency and Compliance
Regular financial reporting is like a warning system, helping you to spot financial issues and address them before they escalate. Transparent reporting is thus important to foster trust in stakeholders. Providing accurate and complete financial information proves that your business is committed to ethical practices and discourages fraud and financial mismanagement.
Best Practices for Compliance
To start with, identify the financial and legal regulations applicable to your business. A CPA or tax attorney can assist you with this, and offer advice on local and international regulations.
Thereafter, create a comprehensive compliance process outlining how your business will meet those requirements. Next, conduct regular internal audits and reviews. That way, you can ensure that your business’s financial statements are credible, error-free, and compliant.
Also, staff training and education are important. Everyone involved in financial reporting should be aware of current regulations, processes, and best practices.
Leveraging Technology
Finally, another way to ensure compliance and transparency in financial reporting is by using reliable accounting software, with tools customized for accurate reporting. Your chosen software should be able to collect, process, analyze, and present financial data with ease. With software options like QuickBooks or NetSuite, you can also automate many aspects of financial reporting, while integrating your accounting system with other business systems.
The importance of financial reporting in business is undeniable. However, when you master this reporting, you ensure the accuracy and strategic impact necessary for good financial health.
If you need help maximizing your financial reports, schedule a Discovery Call with one of our CPAs.
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