Skip to main content. Financial Statements, Taxes, and Cash Flow. Search for:. Introducing Financial Statements. Learning Objectives Define the purpose of a financial statement. The balance sheet reports a point-in-time snapshot of the assets, liabilities and equity of the entity. The cash flow statement reports the flow of cash in and out of the business, dividing cash into operating, investing and financing activities. Key Terms liabilities : an obligation of an entity arising from past transactions or events, including any type of borrowing equity : The residual claim or interest to investors in assets after all liabilities are paid.
If liability exceeds assets, negative equity exists and can be purchased through stock. Assets : economic resources that represent value of ownership that can be converted into cash although cash itself is also considered an asset. Uses of the Financial Statement Financial statements are used to understand key facts about the performance and disposition of a business and may influence decisions.
Learning Objectives Explain how financial statements are used by different entities. Key Takeaways Key Points Owners and managers use financial statements to make important long-term business decisions. Prospective investors use financial statements to perform financial analysis, which is a key component in making investment decisions. A lending institution will examine the financial health of a person or organization and use the financial statement to decide whether or not to lend funds.
Key Terms financial analysis : Financial analysis also referred to as financial statement analysis refers to an assessment of the viability, stability, and profitability of an organization or project. Limitations of Financial Statements Financial statements can be limited by intentional manipulation, differences in accounting methods, and a sole focus on economic measures.
Learning Objectives Summarize the common limitations found in financial statements. Financial ratio analysis analyzes specific financial line-items within a company's financial statements to provide insight as to how well the company is performing. Ratios determine profitability, a company's indebtedness, the effectiveness of management, and operational efficiency. It's important to consider that the results from financial ratios are often interpreted differently by investors.
Although financial ratio analysis provides insight into a company, they should be used in tandem with other metrics and evaluated against the overall economic backdrop. Below are some of the most common financial ratios that investors use to interpret a company's financial statements. Profitability ratios are a group of financial metrics that show how well a company generates earnings compared to its associated expenses.
However, investors should take care not to make a general comparison. Instead, they will get a better sense of how well a company is doing by comparing ratios of a similar period. For example, comparing the fourth quarter of this year with the same quarter from last year will net a better result. Return on equity , or ROE, is a common profitability ratio used by many investors to calculate a company's ability to generate income from shareholders' equity or investments.
Companies issue shares of stock to raise capital and use the money to invest in the company. Shareholders' equity is the amount that would be returned to shareholders if a company's assets were liquidated, and all debts were paid off. The higher the return or ROE, the better the company's performance since it generated more money per each dollar of investment in the company. Operating profit margin evaluates the efficiency of a company's core financial performance.
Operating income is the revenue generated from a company's core business operations. Although operating margin is the profit from core operations, it doesn't include expenses such as taxes and interest on debt.
As a result, operating margin provides insight as to how well a company's management is running the company since it excludes any earnings due to ancillary or exogenous events. For example, a company might sell an asset or a division and generate revenue, which would inflate earnings.
Operating margin would exclude that sale. Ultimately, the operating profit is the portion of revenue that can be used to pay shareholders, creditors, and taxes. Liquidity ratios help shareholders determine how well a company handles its cash flow and short-term debts without needing to raise any extra capital from external sources, such as a debt offering.
The most commonly used liquidity ratio is the current ratio , which reflects current assets divided by liabilities, giving shareholders an idea of the company's efficiency in using short-term assets to cover short-term liabilities. Short-term assets would include cash and accounts receivables , which is money owed to the company by customers.
Conversely, current liabilities would include inventory and accounts payables , which are short-term debts owed by the company to suppliers. Higher current ratios are a good indication the company manages its short-term liabilities well and generates enough cash to run its operation smoothly.
The current ratio generally measures if a company can pay its debts within a month period. It can also be useful in providing shareholders with an idea of the ability a company possesses to generate cash when needed.
Debt includes borrowed funds from banks but also bonds issued by the company. Bonds are purchased by investors where companies receive the money from the bonds upfront.
When the bonds come due—called the maturity date —the company must pay back the amount borrowed. If a company has too many bonds coming due in a specific period or time of the year, there may not be enough cash being generated to pay the investors.
In other words, it's important to know that a company can pay its interest due on their debt, but also it must be able to meet its bond maturity date obligations. The debt-to-equity ratio measures how much financial leverage a company has, which is calculated by dividing total liabilities by stockholders' equity. A high debt-to-equity ratio indicates a company has vigorously funded its growth with debt.
However, it's important to compare the debt-to-equity ratios of companies within the same industry. Some industries are more debt-intensive since they need to buy equipment or expensive assets such as manufacturing companies. On the other hand, other industries might have little debt, such as software or marketing companies. The interest coverage ratio measures the ease with which a company handles interest on its outstanding debt.
A lower interest coverage ratio is an indication the company is heavily burdened by debt expenses. Efficiency ratios show how well companies manage assets and liabilities internally. Investors accept short-term losses, but they want to see a profit and a return on their investment sooner rather than later. Your break-even point says what is needed to make this happen. Often, the break-even point is a specific sales target that will cover your expenses and get you to profitability.
You may also build on other assumptions, such as economies of scale, improved production efficiency or reduced marketing expenses, as long as you can explain them in a way that's acceptable to investors. You deserve sweat equity for the hard work it took to get your business running, but many investors will want to see that you've made a financial equity investment as well. If you have money at stake, investors believe that you'll do what it takes to protect it. If you're not at risk of losing financial capital, investors may fear that you'll view them as a blank checkbook and burn through cash without enough focus on protecting their investments.
You can discuss the specific ratios that apply in each category of analysis with your controller services. Even if you're not ready to seek investment, finding ways to improve can help the overall health of your business.
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