Financial statements prepared under U.S. Generally Accepted Accounting Principles (GAAP) include three reports: the balance sheet, income statement and statement of cash flows. Together these reports can be powerful diagnostic tools to help evaluate the financial well-being of a business. Moreover, by carefully analyzing them, you may be able to uncover potential money-management problems or even fraudulent activity.
The Balance Sheet provides a snapshot of a company’s financial health at a moment in time. One side shows the assets owned by the company. The other side contains liabilities or claims on the company’s assets. Current assets mature within a year, while current liabilities come due within a year. Long-term assets and liabilities extend beyond the current year.
The Income Statement shows revenue, expenses and profits earned (or losses incurred) over a given period. A commonly used term when discussing income statements is “gross profit,” or the income earned after subtracting the cost of goods sold from revenue. Cost of goods sold includes the cost of labor and materials required to make a product. Another important term is “net income,” which is the income remaining after all expenses (including taxes) have been paid.
Also reflected on the income statement are selling, general and administrative expenses (SG&A). These expenses reflect functions, such as marketing, that support a company’s production of products or services. If these costs constitute a rising percentage of revenue, business may be slowing down.
The income statement can reveal other potential problems, too. It may show a decline in gross profits, which means production expenses are rising more quickly than revenue. In today’s business environment, many companies are reporting lower gross margins due to rising labor and materials costs — unless they’ve managed to pass along these cost increases to customers through higher prices.
The Statement of Cash Flows shows all the cash coming in and out of your company. For example, your company may have cash inflows from selling products or services, borrowing money and selling stock. Outflows may result from paying expenses, investing in capital equipment and repaying debt.
Although this report may seem similar to an income statement, its focus is solely on cash. For instance, a product sale might appear on the income statement, even though the customer won’t pay for it for another month. But the money from the sale won’t appear as a cash inflow until it’s collected. To remain in business, companies must continually generate cash to pay creditors, vendors and employees. So business owners must watch their statement of cash flows closely.
Financial statements tell a story about a company’s financial performance. This information can be valuable for many purposes — whether you’re evaluating the financial results of your own business or one that you’re considering acquiring, lending to or investing in. An experienced professional can help you evaluate a company’s financial health, including potential risks and areas of improvement.