Report Analysis – How to Read the Statements

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Learning toReports read and analyze financial statements is crucial to the success of the business.  If the owner can decipher the information and make good decisions, the company will improve. But to make good decisions, the owner has to be able to understand what they are reading. This section teaches the business owner how to read the financial statements.

These articles are in-depth and are educational in nature.  If you are looking for some quick lesson, this isn’t the site for you.  It took me seven years of education and 17 years on the job to develop the necessary skills to truly understand financial statements.  I can’t teach you nor anyone in 10 minutes or less.  I’ve kept the information simple and easy to understand.  If you have questions, contact me via the ‘My Services’ page in the footer below.

FEATURE ARTICLES:

  • Price to Sales Ratio: A Poor Indicator of Value

    The price to sales ratio is a marginal valuation ratio at best.  It is really an offshoot of an antiquated concept of valuing a business. In the past, one of the more common methods to value a business deal was to use a multiplier of sales. The price to sales ratio used with business ratios ...
  • Performance Ratios

    Performance RatiosThe most common thought among business owners, consultants, investors and students is the ‘bottom line’.   The proper word is of course ‘PROFIT’.  In business, the single number one reason to operate is to make a profit. 
  • Leverage Ratios

    Financial LeverageLeverage refers to the ability to lift a heavier load using a fulcrum and a lever.  The common image is a board on a triangular pivot point with a heavy weight (M1) on one end and a lighter weight (M2) on the other.   As the lever shifts towards the lighter load it starts to lift the ...
  • Price to Cash Flow

    Price to Cash Flow RatioThe price to cash flow ratio is a valuation tool used to assist buyers and sellers of stock in determining timing of purchases or the disposition of shares.   Unlike the other valuation ratios, this particular ratio utilizes the cash flows statement in determining the outcome.   The formula is simple: Price to Cash Flow = $Market Price ...
  • Activity Ratios

    The majority of activity ratios measure the ability of the company to turn assets into earnings.   All businesses utilize a simple principle, buy an asset at a low price and sell it at a higher price.   Even service based businesses do this.  Labor is purchased for a certain value and then sold for a much ...
  • Job Costing Reports – Introduction (Part 1)

    Job Cost ReportsJob costing reports are management tools used to evaluate project or production performance against a known or estimated standard.   They are used in many business sectors and their respective industries.   The primary purpose of job costing reports is to identify discrepancies or beneficial results, usually in the form of financial values.   They can be used ...
  • Liquidity Ratios

    Liquidity RatiosLiquidity ratios are a group of ratios used to measure the ability of a business operation to meets its current obligations.   Liquidity ratios are similar to the initial medical tests a patient receives at a doctor’s visit.   Doctors take blood pressure, temperature, and pulse rate.   The doctor wants assurance that the primary indicators of health ...
  • Return on Equity

    Return on EquityAnother performance ratio used in business is return on equity.  It is similar to return on assets except return on equity uses one section of the bottom half of the balance sheet.
  • Operating Cash Ratio – Formula and Understanding

    Operating Cash Ratio - Formula and UnderstandingFar and above the most valuable liquidity ratio is the operating cash ratio.  Unlike the other liquidity ratios that are balance sheet derived, the operating cash ratio is more closely connected to activity (income statement based) ratios than the balance sheet.
  • Operating Profit Margin – Formula and Understanding

    Operating Profit Margin - Formula and UnderstandingOperating profit margin refers to the value earned as a percentage of net sales.   The operating profit is often referred to as earnings before interest, taxes, depreciation and amortization, (EBITDA).   This is a misleading reference as operating profit is actually defined differently by industry sector.   EBITDA is used primarily in valuing businesses.
  • Total Assets Turnover Rate – Formula and Analysis

    Total Assets Turnover RateWithin the group of activity ratios, the total assets turnover rate is the broadest in scope.   Similar to other activity ratios, it utilizes net sales as the numerator.  However the denominator doesn’t focus in on a single balance sheet asset group like the working capital turnover or fixed assets turnover rates, it includes all assets.
  • Debt Ratio

    Debt RatioEvery business buys on account whether it is a traditional vendor account like that found in retail or simply using a credit card.   A third party provides credit which creates debt for the business.    The debt ratio reflects the percentage of assets covered by debt. 
  • Fixed Assets Turnover Rate

    Fixed Assets Turnover RateThe fixed assets turnover rate is another activity ratio whereby an income statement financial characteristic is compared to a balance sheet asset section.    In this case, comparing adjusted sales against historical cost of fixed assets.   This financial business ratio is only effective for business operations that are fixed asset intensive.  So with service based industries ...
  • Working Capital Turnover

    Working Capital TurnoverThe activity ratios measure performance of a current asset on the balance sheet against a corresponding area of the income statement.  The working capital turnover is the most encompassing of all the activity ratios; in effect, it is the most general of the activity ratios.   This particular ratio measures the ability of management to efficiently ...
  • Cash Ratio

    Cash RatioOne of the liquidity ratios used in business is the cash ratio.  It is a much more effective tool for small business than the traditional current or quick ratio.  Although the cash ratio is more difficult to manipulate in small business, most entrepreneurs miscalculate the result
  • Accounts Receivable Turnover Ratio

    Accounts Receivable Turnover RateOne of the activity ratios in business is the receivables turnover ratio or rate.   This ratio measures the frequency of collecting the entire balance of accounts receivable during a standard accounting year.   The ideal turns rate is twelve with a higher value indicating an aggressive collection process.   A lower value is a warning about accounts ...
  • Net Profit

    Net ProfitNo other business term is so misunderstood, misstated, misleading or deceiving as the words ‘net profit’.  Accounting defines net profit as the amount earned after all associated costs and expenses are subtracted from the associated sales.   The larger or more public the company the more reliable the dollar value as stated on the bottom ...
  • Current Ratio

    Current RatioThe current ratio is an inappropriate relationship to use or rely on in small business.  The ratio is best suited for large publicly traded organizations.  This article explains the basic formula for the current ratio, how to identify the ratio in reading financial statements, its purpose and the many drawbacks for its use with small ...
  • Business Ratios (Introduction)

    Percentage of CompletionRatios are used in business to compare companies of different sizes within the same industry. The goal is to discover the best investment for return on your stock purchase.  Business ratios essentially equalize different size companies within the same industry.  A common mistake is to compare two different industries within the same sector (explained below).
  • Interest Coverage Ratio

    The last of the leverage ratios isn’t really a pure leverage indicator but augments the debt ratio.  Debt requires the payment of interest and so an indicator of the ability to pay this interest is needed.  This is the interest coverage ratio.
  • Gross Profit Margin

    Gross Profit MarginThe difference between the sales price and the cost of the product or service rendered is known as gross profit margin in business.  It is traditionally the amount identified on the income statement or a tax return as the amount earned after cost of sales a.k.a cost of goods sold, cost of services rendered, etc. ...
  • Debt to Equity Ratio

    Another leverage ratio used to evaluate the financial integrity of a business is the debt to equity ratio.  It is strictly a bottom half balance sheet ratio.  Its result explains the relationship of volume of debt and corresponding equity to finance the operations of a business, i.e. the purchase of assets.
  • Net Profit Margin

    Net Profit MarginThe net profit margin reflects the profitability of the company as a percentage of net sales.  It is one of the performance ratios used in evaluating business.  Interestingly, some consider it the most important ratio.  These users of business ratios take a very simplistic approach towards business evaluation. 
  • Return on Assets

    Return on AssetsOne of the performance ratios used in business identifies the overall ability of management to efficiently utilize resources to generate a profit.   Corporate resources include human knowledge/skills and the balance sheet assets of the business.   The labor component is unquantifiable in terms of dollars, but assets with a dollar value associated with them are reflected ...
  • Accounts Payable Turnover Rate (Ratio)

    Accounts Payable Turnover RateThe accounts payable turnover rate is a business activity ratio measuring the frequency of the company’s ability to pay its vendors and suppliers.  The numerical value is customarily reported as an annual value.  The higher the number, the more often the payables are cleared (paid).  A ’12’ would indicate that all payables are paid every month ...
  • Inventory Turnover Rate

    Inventory Turnover RateOne of the many ratios used in business, the inventory turnover rate is often misunderstood, miscalculated and misused.  The traditional business course in academia explains that ideally the inventory turnover ratio (rate) is the highest number possible.  This higher value means the business operation is selling the product as fast as possible.  This in turn ...
  • Fixed Assets To Debt Relationship

    Fixed Assets to Debt RelationshipEvery business owner, especially young entrepreneurs, must understand how long-term debt  is used to finance the purchase of fixed assets . It is a basic principle especially for start-ups. There is a relationship that exists between the two. If created correctly, profitability is enhanced and cash flow is maximized.
  • Profit and Loss Statement Using Class Accounting

    Class AccountingClass accounting breaks down sales and the associated cost of sales into functional groups.  Whether you use divisions or departments or product/service lines class accounting allows you to identify those more profitable areas of operations.  This is just one of the many different financial reports used in small business.
  • Financial Statements for the Small Business

    Financial StatementsFinancial statements serve the purpose of presenting economic activity and status related to a particular date and over a particular time frame.  Accountants record monetary transactions and via financial reports present the information in an easy to understand format.  The financial statements for a small business do not have to comply with those of publically ...
  • Retained Earnings – How it Works

    Retained EarningsIn the equity section of the balance sheet there is an account that tallies the lifetime earnings net of dividends for the company.  The value identifies the total amount retained by the company for operational purposes.  This account is referred to as the Retained Earnings of the business.
  • Long Term Debt – Financial Statement Presentation

    Long-Term DebtLong Term Debt is one of the multiple forms of capitalizing a business.  It includes bonds, secured notes and mortgage notes.  In the world of small business, the most common form of long term debt is secured notes, most likely with recourse.  As an owner of a business you need to understand how this information ...
  • Returns, Allowances and Discounts in Accounting

    ReturnsIn the revenue section of every income statement (profit and loss statement) is an adjustment group to sales.  This group reflects the value related to the actual sale of the product or services.  This adjusting group is comprised of three significant types of adjustments to sales.
  • Trial Balance – Purpose and Interpretation

    Debits and CreditsThe trial balance is an accountant’s report used to identify issues with the respective ledger accounts.  In general, the trial balance sums all the debits and credits in the footer section and the accountant verifies that the total debits equal total credits.  This confirms proper entry in the dual entry accounting system.
  • Dividends and Distributions – Use in the Proper Context

    Dividends and Distributions - Use in the Proper ContextDividends and distributions refer to the payment of cash to investors.  So why are there two separate terms?  Well, the term is tied back to the type of entity that makes the payment.  Simply stated, regular corporations, i.e. C-Corporations as identified in the Internal Revenue Code use the term ‘Dividends’ and S-Corporations (Small Business Corporations) ...
  • Quick Ratio – Definition, Explanation and Proper Use

    Quick RatioThe quick ratio is a formula used in business to identify the ability of a business to pay its current liabilities.  It is also known as the ‘Acid Test’ formula (ratio).  In the large markets this formula is one of the financial industry ratios used to value the stock of a corporation.  In the arena ...
  • Accelerated Depreciation – An Explanation

    Accelerated DepreciationWhen it comes to depreciation, no two businesses are alike. Unlike traditional straight line depreciation where the asset value is costed out to depreciation expense in equal increments over a given life expectancy, accelerated depreciation expenses the cost at higher values during the earlier accounting periods and at a lower amount towards the last half ...
  • Current Liabilities Section of the Balance Sheet

    Current LiabilitiesThe current liabilities section of the balance sheet identifies those amounts due to third parties within the current year.  These include accounts payable, credit card accounts, accrued payroll, taxes, unearned revenue, deposits and those amounts due within one year related to debt instruments.
  • The Fixed Assets Section of the Balance Sheet

    Fixed Assets SectionThe fixed assets section of the balance sheet is one of the easiest sections to read and understand.  This article is written to describe and illustrate some simple examples of the fixed assets section. 
  • Accrued Payroll – An Explanation

    Accrued PayrollAccrued payroll is a current liability comprised of four sections.  The first is the amount of payroll earned by staff and not yet processed or paid.  The second is the dollar value of personal time off accumulated for each employee aggregated into one number.  The third consists of payroll taxes owed to the respective governmental ...
  • An Explanation of Current Assets

    Current AssetsCurrent assets carry the most value to the small business entrepreneur because of the cash conversion aspect.
  • The Various Forms of Depreciation

    depreciation definitionThere are various forms of depreciation used in the small business world.  In general, depreciation is not required but it is advisable.  So a small business owner should understand depreciation and the various forms of how to calculate the deduction. 
  • How to Read a Balance Sheet – Equity Section (Simple Format)

    StockThe equity section of the balance sheet equals assets minus liabilities.  Traditionally the equity section is referred to as the net worth of the company.  If you were to dispose of all the assets through a sale and pay off liabilities, the money left over would be available for distribution to the shareholders.  The shareholders ...
  • What is Amortization?

    AmortizationNon-physical assets are expensed to the income statement or profit and loss statement via a method called amortization.  It is most commonly used in the mortgage industry to refer to the monthly payment made to pay interest and the principle (the amortizable portion) on a debt instrument. 
  • The True Cost of Labor

    Cost of LaborI laugh at the definition of labor costs because in my opinion the so called experts only have it half right.  Labor costs are more than just gross wages and benefits.  It should include the costs of insurance, employer taxation, human resources management and incentives.  All of the costs associated with delivering the human element ...
  • How to Read a Balance Sheet – Simple Format

    AssetsReading a balance sheet is instrumental in understanding the business’s financial position.  This particular financial report is a snapshot of a moment in time.  It can change dramatically in a minute so understanding the perspective of the report and its respective sections will help you to be better informed.
  • Depreciation – This is Weird Accounting

    DepreciationIn the world of accounting, there are two types of expenses on the reports widely misunderstood.  They are depreciation and amortization.  I will try to help the novice gain an understanding of depreciation in this article.

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