Analysing Financial Statements

February 12, 2020

Analysing and understanding financial statements is a must for any business owner, investor, accountant, entrepreneur or student that wishes to be successful. Financial statements clearly understood can help identify potential areas of weakness and strength within a company. They can also help set and measure business goals. 

 

In this post, you will learn how to analyse a company's financial statements, namely; the profit and loss statement and the balance sheet. 

 

Understand the basics

 

To obtain the ability or skill to analyse financial statements, you first need to know the basics of accounting. This includes understanding debits and credits, assets and liabilities, and the basics of profit and loss statements and balance sheets. 

 

If you need to learn these basics or need a quick refresher, I suggest taking my free bookkeeping course and my free accounting course. Both are free and no registration is required. 

 

Who needs to analyse financial statements?

 

Lot's of people! But to be more specific, here is a handy list...

 

- Business owners

- Entrepreneurs

- Private capital investors 

- Stock traders and investors 

- Accountants, financial controllers, finance managers and bookkeepers 

- Business students and accounting students 

- Company directors and shareholders 

 

 

 

 

Why are financial statements so important? 

 

Unfortunately, most people just use financial statements to see how much profit (or loss) a company made, have a quick glance at sales performance and see how much tax is due... Financial statements can tell us so much more than these items though. From analysing a simple company profit and loss statement and balance sheet, you can tell the following...

 

- If the company is profitable

- If sales revenue is improving or decreasing 

- The company's profit margins i.e how much gross and net profit on average is being made with each sale

- Areas where profits can be increased 

- If the company is likely to meet it's financial obligations to it's creditors 

- What the company owns

- What the company owes

- Average customer payment days 

- Average suppliers payment days 

- Return per share 

- Dividends paid

- If the company is holding too much stock

- Average days that stock is held within the company warehouse 

- How many days it takes the company to sell and re-stock inventory 

- And much more...

 

Fundamental formulas and ratios for financial statement analysis

 

Below are the most basic (and common) formulas used for analysis. At the bottom of this post, is a full list of formulas that can be used.

 

Gross profit margin - evaluates how much gross profit is generated from sales

Gross profit margin = gross profit/total sales

Gross profit margin as percentage = (gross profit/total sales)*100

 

Net profit margin - evaluates how much gross profit is generated from sales

Net profit margin = gross profit/total sales

Net profit margin as percentage = (gross profit/total sales)*100

 

Current ratio - analyses the company's ability to pay-off short-term liabilities with the company's assets 

Current ratio = current assets/current liabilities 

 

Acid test ratio - analyses the company's ability to pay-off short-term liabilities with the liquid assets 

Acid test ratio = liquid assets/current liabilities 

 

Days sales outstanding (DSO) - measures the average number of days it takes for the company to collect payment from credit sales. Can also be referred to as collection period or receivable turnover is days. 

DSO = (debtors balance/total credit sales)*365

 

Days payable outstanding (DPO) - measures the average number of days it takes for the company to pay it's credit suppliers. Can also be referred to as payment period or accounts payable turnover in days

DPO = (creditors balance/total credit purchases)*365 

 

Video Explanations

 

Now watch these videos, they will help greatly...

 

 

 

 

 

All formulas for financial statement analysis

 

Financial formulas for profitability

 

Gross profit margin - evaluates how much gross profit is generated from sales

Gross profit margin = gross profit/total sales

Gross profit margin as percentage = (gross profit/total sales)*100

 

Net profit margin - evaluates how much gross profit is generated from sales

Net profit margin = gross profit/total sales

Net profit margin as percentage = (gross profit/total sales)*100

 

Return on assets - also known as return on investment. Used to evaluate the company's efficiency to generate sales from it's assets 

ROA = net profit/total assets 

 

Return of shareholders equity - measures the income derived from shareholders equity 

Return of shareholders equity = net profit/shareholders equity 

 

Financial formulas for liquidity

 

Current ratio - analyses the company's ability to pay-off short-term liabilities with the company's assets 

Current ratio = current assets/current liabilities 

 

Acid test ratio - analyses the company's ability to pay-off short-term liabilities with the liquid assets 

Acid test ratio = liquid assets/current liabilities 

 

Cash ratio - analyses the company's ability to pay-off short-term liabilities with company cash 

Cash ratio = cash/current liabilities 

 

Net working capital - determines if a company can meet it's current liabilities with it's current assets 

Net working capital = current assets - current liabilities 

 

 

**** If you want to be a financial analysis expert, we highly suggest 'Financial Statement Analysis: A Practitioner's Guide'. UK link - click here. US link - click here ***

 

 

 

Financial formulas for management efficiency

 

Days sales outstanding (DSO) - measures the average number of days it takes for the company to collect payment from credit sales. Can also be referred to as collection period or receivable turnover is days. 

DSO = (debtors balance/total credit sales)*365 

 

Inventory turnover - measures how many times inventory is sold and replaced

Inventory turnover ratio = cost of sales/inventory 

 

Days inventory outstanding - measures how many days inventory is in the warehouse before sale

Days inventory outstanding = 365/inventory turnover 

 

Days payable outstanding (DPO) - measures the average number of days it takes for the company to pay it's credit suppliers. Can also be referred to as payment period or accounts payable turnover in days

DPO = (creditors balance/total credit purchases)*365 

 

Operating cycle - calculates the amount of days it takes the company to complete 1 full operating cycle i.e pays for purchases, sells them and collects the revenue from the sale

Operating cycle = days inventory outstanding/days sales outstanding

 

Financial formulas for leverage

 

Debt ratio - measures the amount of company assets that are financed by debt 

Debt ratio = total liabilities/total assets 

 

Equity ratio - measures the amount of company assets that are financed by owners equity 

Equity ratio = total equity/total assets 

 

Financial formulas for valuation and growth

 

Earnings per share(EPS) - shows the rate of earnings per company share

EPS = (net profit-dividends)/company shares 

 

 

Want to learn more about financial statements? Need help understanding financial statements?

 

Subscribe to my accounting mentor program and receive 6 online training sessions with me (the Bookkeeping Master)!

 

Would you like me to analyse your company's financial statements? Send me an email - info@bpfs-online.com 

 

I wish you all the best with your accounting!

 

The Bookkeeping Master

 

@thebookkeepingmaster
info@bpfs-online.com 

 

P.S If you are ready to take accounting more seriously, take my Ultimate Bookkeeping & Accounting Course

 

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