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An ability to understand how to read, analyze, and create financial statements is one of the most vital skills for aspiring entrepreneurs, new investors, and executives to develop. You get a full and precise understanding of your finances. Armed with this knowledge, a business owner and investors can better identify promising opportunities and professionals of all levels can make more strategic business decisions.

Individuals can also keep track of their personal finances. Financial statements basically gives an understanding of the income coming in, and the expenses going out at a certain period. You will be able to know how much money the operation has stored away and how much debt is owed.

While financially informed people read and understand these documents, many business owners do not. It makes you lose out on critical information.The Financial Statements comprises Balance Sheet, Income Statement, and the Cash Flow Statement and are better reviewed together.

I have put this together to serve as an anchor that helps you read and understand the information contained in financial statements, especially if you have to make some important decisions with them.

1. Understanding the Balance Sheet

This is denoted as Statement of Financial Position (SOFP) in International Financial Reporting and conveys the “book value” of a business. It reports a company’s financial position by showingwhat resources it has available and how they were financed as of a specific date. It comprises of assets (what it owes), liabilities (what it owns), and owners’ equity (amount invested by shareholders).

The balance sheet can provide other important information, using the popular accounting equation:

Assets = Liabilities + Owners’ Equity

Assets are anything a company owns with quantifiable valueand/or future benefit.It includes machinery, patent, car, investments, building, inventory, receivables, etc.

Liabilities are owed by the business.All debts, outstanding bills and payables belong to this category.

Owners’ equity is the ‘net worth’ of a company. It is the amount of money that is left if all assets were sold and all liabilities paid and belongs to the shareholders, who may be private owners or public investors.

Many of the ratios and figures that Analysts use when discussing the financial health of a company are calculated from the balance sheet.

2. Understanding the Income Statement

An income statement has a more detailed version known as Statement of Comprehensive Income (SOCI). It summarizes the cumulative impact of revenue, gain, expense, and loss transactions for a given period. The document shows financial trends, business activities (revenue and expenses), and comparisons over set periods.

Accountants, investors, and other business professionals frequently review the Income Statements:

– To understand how well their company is doing: How much money is spent to produce a product? Is it profitable?

– To determine the cash to invest back into the business?

– To establish financial trends: When are costs highest and when are they lowest?

The statement typically contain the following information (briefly explained):

• Revenue: The amount of money a business receives;
• Expenses: The amount of money a business spends;
• Costs of goods sold (COGS): The cost of component parts of what it takes to make whatever it sells;
• Gross profit: Total revenue less COGS;
• Operating income: Gross profit less operating expenses;
• Income before taxes: Operating income less non-operating expenses;
• Net income: Income after taxes;
• Depreciation: The extent to which assets (for example, aging equipment) have lost value over time;
• EBITDA: Earnings before interest, depreciation, taxes, and amortization (used in complex businesses).

3. Understanding theStatement of Cash Flow

This statement provides a detailed picture of what happened to a business’ cash during the accounting period. Broken into three sections, it demonstrates a business’ ability to operate in the short and long term, based on how much cash is flowing in and out of it. With a Statement of Cash Flow, you can easily see the types of activities that generate cash and use that information to make sound financial decisions.

• Cash flow from Operating activities: This reflects cash flow that is generated once the business delivers its regular goods or services, and includes both revenue and expenses;

• Cash flow from Investing activities: Cash flow from purchasing or selling assets—typically in the form of property such as real estate, vehicles etc. form the investing activities;

• Cash flow from Financing activities:Financing activities detail cash flow from both debt and equity financing in the business.

The Cash flow and Profit are both important numbers to know in your business. While cash flow refers to the cash that’s flowing in and out of a company, profit refers to what remains after all of a company’s outflows (Expenses) have been deducted from its inflows (Revenues).

A Critical Skill

Reviewing and understanding financial documents can provide you with valuable insights about a business entity, including:

• Debt structure and ability to repay them;
• Profits and/or losses for a given period;
• If profit has increased or decreased compared to past accounting periods;
• The level of funds/investment required to maintain or grow the business;
• Operating expenses, especially compared to the revenue generated from those expenses

A positive cash flow speaks to a company’s financial stability; it also shows its ability to grow its operations. However, having positive cash flow doesn’t necessarily mean a company is profitable, which is why you need to analyze the accounts together.

Bottom Line

If you are going to be a business owner, manager, investor, or shareholder any day or you are already one, you will do yourself a world of good to understanding the Financial Statements. Be keenly aware of the financial health of the business even if you are just an employee.

Like I have always encouraged, building your financial literacy and skills doesn’t need to be difficult.