9 Things You Need To Know About Financial Statements

Financial StatementEvery business owners, company investors and board of directors would like to see how their company performing financially. A need for preparing financial statements becomes a routine part for any organization. These financial statements tell business owners, companies board of directors a true picture about the health of their organization. Therefore, interpreting and understanding these financial statements becomes important on the part of investors, owners and companies board of directors.

What is Financial Statements?

Financial statements are formal record of the financial activities and position of a business, person, or any organization or a legal entity. The financial activities are presented in a structured manner which is easy to read and understand by any individual. The key financial information’s are recorded either on:

  • Income Statement
  • Balance Sheet
  • Statement of Cash Flow

In this article, I will explain you what the financial statements have to offer and how to use them to work in your favor.

  1. Business Investor and Financial Analyst all use Balance Sheet, Income statement and Statement of cash flow before making any financial decision. These statements truly reflect the financial health of any organization. The other statements such as statement of owner equity, retained earnings are important too but not critical. Investors can refer them also to make their financial decision.
  2. The financial statements are widely used to develop a score card to help business owner to compare the score card with actual and make any decision if there is any variance between the score card and actual results. Financial Analyst prepares this score card based on the historical financial information presented by the company in the form of Financial Statements.
  3. The financial statements are widely used by financial analyst to calculate various financial ratios which tend to show an indicator of company present performance and where company is heading in the future. These financial ratios are often presented to board of directors or investors for review.
  4. An active investor likes to see these statements before investing in to company. The auditor of company uses these financial statements to prepare his audit report. The audit report can either be unaudited which is based on mid-year financial statement and final auditor report which is normally completed after the company financial reporting period ends.
  5. If the company owns several other subsidiaries companies, the financial statements can also be prepared as consolidated financial statement where it includes financial information of both parent company and all its subsidiaries companies.
  6. GAAP (generally accepted accounting principles) rules followed by majority of large companies which allow the company to prepare their financial statements according to GAAP. There are basically two conventions, one of historical cost and other one accrual accounting, according to GAAP, the assets are valued at their historical cost whereas revenues and expenses are recoded when they are incurred. Therefore, the investor should really need to understand the statement of cash flow of any organization to see health of the company performance.
  7. Income statement is another statement that cannot be overlooked by any investor. Income statement normally reveals the ability of a business of how much business generates a profit. On the other hand, it does not reflect how much of assets and liabilities business required to generate a profit.
  8. Investor or financial analyst can perform a variance analysis if they have the financial information’s to see some powerful indicator such as profitability trend, sales trend and revenue trend. These variance analyses help the investors to make their financial decisions.
  9. Cash flow statement is the most important financial statement for any business mainly because it focuses solely on changes in cash inflows and outflows over a period of time. This report presents investors a more clear view of a company’s cash flows than the income statement, which can sometimes present skewed results, especially when accruals are required to be maintained according to GAAP


An overview of the above financial statement helps the readers to see a bigger picture of the company. However, the beginning investor should also prepare to learn more about investment qualities before they invest in the companies.

Still confused about financial statement? Connect with online accounting tutor to understand more about financial statements and improve learning before investing.

15 Financial Ratios Every Business Owners Needs to Know

Financial Ratios, Balance Sheet, Income StatementFinancial ratios or accounting ratios are most commonly used by every businesses and companies to determine or evaluate the overall financial health of the business and companies. These ratios are frequently used by financial analyst, managers, shareholders, creditors to find out about the strength and weaknesses of the any organization.

The data used in calculating financial ratios comes from either income statement, profit and loss account, cash flow statement or company balance sheet. These financial ratios allow the companies to compare its financial strength between companies, industries, different time period for one company. These rations are measured always against benchmark set by a company. Without benchmark, these ratios are not so useful. Company have to have some kind of industries benchmark set to compare against its financial ratios.

Most publicly traded companies are required by law to use generally accepted accounting principles (GAAP) for their home country. However, the private companies such as LLC, partnership, private companies are not required to use GAAP method.

There are primarily four main categories of financial ratios that all business used to analyze its data:

  1. Profitability Ratios
  2. Liquidity Ratios
  3. Debt Ratios
  4. Activity Ratios

Let’s elaborate further about all the above financial ratios:

1: Profitability Ratios: These ratios allow companies to measure its ability to make adequate return on sales, total assets and invested capital. In other words, these ratios measure how effectively a company utilizes its resources. Some of the profitability ratios are as follows:

Profit margin ratio: profit margin ratio is calculated by dividing the net income by sales over a reporting period. For example: if company earns net income for $25,000 in a reporting period and its sales amounted to $250,000, the profit margin ratio can be calculated as follows:

Profit Margin Ratio:    Net Income/Sales

Profit Margin:             $25,000/$250,000

= 10%

Return on Investment Assets: Return on investment can be arrived by dividing the Net Income by Total Assets. For example if company Total Assets are $200,000, its return on assets ratio will be as follows:

Return on Assets:   Net Income/Total Assets

ROI:              $25,000/$200,000

= 12.5%

Return on Equity: Return on equity ratio is calculated as dividing the Net Income by Net equity. In other words if company Net equity is worth at $100,000, its Return on Equity ratios will look like as follows:

Return on Equity:   Net Income/ Net Equity

=   $25,000/$100,000

= 25%

Gross Margin Ratio: Gross Margin Ratio can be calculated by dividing the Gross profit by Net Sales. For example: If company gross profit is $50,000 and its net Sales are $250,000. The Gross Profit Margin ration will look like as follows:

Gross Profit Margin Ratio:     Gross Profit/ Net Sales

=    $50,000/$250,000

=     20%

2.Liquidity Ratios: Liquidity ratios determined the company ability to pay it short term obligations normally due within 12 months. There are mainly four liquidity ratio that business or companies would like to find out if they have enough cash to pay its short term debt:

Current Ratio: Current ratio is also known as working capital ratio. The current ratio is calculated by dividing the current assets to current liabilities. For example: If Company net current assets are $150,000 and its net current liabilities are $75,000, The company current ratio will look like as follows:

Current Ratio:         Current Assets/ Current Liabilities

= $150,000/$75,000

= 2 Times

Quick Ratio: Quick ratio is calculated by subtracting Inventory from Current Assets divided by Current Liabilities. For Example: Company Inventory in hand at the end of reporting period amounted to $75,000.

Quick Ratio: Current Assets-Inventory/ Current Liabilities


= 1:1

Cash Ratio: Cash ratios are calculated adding Cash and Marketable Securities divided by Current Liabilities. For Example: If company balance sheet shows cash in hand equal to $100,000 and Its marketable securities on books amounted to $50,000, the its cash ratio should look like this:

Cash Ratio: Cash + Marketable Securities/ Current Liabilities

$100,000 + $50,000/$75,000

= 2 times

Operating Cash Flow: Operating cash flow ratio is calculated as dividing the Operating Cash Flow by Total Debts. For example: company operating cash flow shows $150,000 and Total debt shows $75,000, its operating cash flow ratio should look like this:

Operating Cash Flow: Operating Cash Flow/Total Debts


= 2 Times

3. Debt Ratios: Debit ratios are also known as leveraging ratios. The ratio is defined as the ratio of total debt to total assets expressed as percentage. These ratios can be interpreted as the proportion of total company’s assets that are financed by company’s debt. The higher of these ratios represent that the company is more leveraged with its debt associated with more financial risk. There are mainly four debt ratios Companies would like to know:

Debit Equity Ratio: Debt equity ratio represent the shareholders equity and the debt used to finance company’s assets. The debt equity ratio can be interpreted as proportion of long term debt plus Value of Leases divided by Total Assets.

Debit Equity Ratio:    Total Liabilities/ Shareholder Equity

For Example: If a company has its total liabilities of $200,000 and total shareholders’ equity of $800,000. Its debt to equity ratio will look this:

Debt Equity Ratio:     $200,000/$800,000

= .25

Total Debt Ratio: Total debt ratio represent the company total liabilities to total assets. The lower the ratio means the company is less dependent on its leverage. In other words, the higher the ratio, the more risk company is taking.

For Example: Let’s assume company total assets at the end of reporting period amounted to $900,000 on the balance sheet. So the total debt ratio will look like this:

Debt Ratio:         Total Liabilities/Total Assets

Debit Ratio:    $200,000/$900,000

= 22%

Interest Coverage Ratio: Interest coverage ratio is commonly used by companies to determine if it can pay interest expenses on its outstanding debt. The ration is calculated by dividing the company earnings before interest and taxes (EBIT) by the total interest expenses. The lower the ratio, the more the company is burdened by its debt expenses. The ratio of less than 1.5 is considered risky as company ability to pay interest expenses will be questionable.

For Example: ABC LTD has its earnings before interest and taxes amounted to $200,000 and Interest expenses amounted to $28,000.

Interest Coverage Ratio:  Earnings before Interest and Taxes/ Interest Expenses

Interest Coverage Ratio: $200,000/$28,000

= 7.14

This represent that the company has good margin of safety to cover its interest expenses.

Cash Flow to Debt Ratio: The cash flow to debt ratio is calculated by dividing the company operating cash flow by total debit. The ratio tell the business owner if they have the ability to cover their debit from its operating cash flow earning. The higher the ratio is, the chances that better the business owner to carry its total debt.

For Example: The Company ABC Ltd. have total operating cash flow amounted to $100,000 and its total debt at the end of reporting period are $130,000. The cash flow to debt ratio will  look this:

Cash Flow to Debt Ratio:         Operating Cash Flow/Total Debt


Cash Flow to Debt Ratio:     $100,000/ $130,000

=   .77

4. Activity Ratios: Activity ratios are those ratios that all business owners like to know if they have the ability to convert different accounts of balance sheet in to cash or sales. These ratios widely used to measure the relative efficiency of a company assets, leverage or other balance sheet items. There are mainly three activity ratios that businesses would like to know:

Stock Turnover Ratio: Stock turnover ratio can be calculated by dividing the cost of goods sold by average inventory. Generally the stock turnover ratio can also be calculated by dividing the sales by Inventory. A low turnover is normally considered a bad sign because products value tend to deteriorate as they sit in the warehouse for longer than average period of time.


Stock Turnover Ratio:           Sales/ Inventory


Stock Turnover Ratio:     Cost of Goods Sold/ Average Inventory

For Example: If a company shows its sales at the end of reporting period amounted to $500,000 and its inventory shows total to $200,000, then stock turnover ratio should look like as follows:


Stock Turnover Ratio             $500,000/$200,000

= 2.5

Assets Turnover Ratios: Assets turnover ratio is calculated by dividing the sales or Revenues by Total assets. Generally speaking, the higher the ratio, the better it is as company generating more revenue per dollar of assets.

For Example: ABC LTD. has total sales at the end of reporting period amounted to $500,000 and its total assets appears on balance sheet at the end of reporting period amounted to $750,000. Then assets turnover ratio can be calculated as follows:


Assets Turnover Ratio:   $500,000/$750,000

= 67%

Inventory Conversion Ratio: Inventory conversion ratio is calculated by total inventory to cost of sales divided by 365. The inventory conversion is measured as against the time required to acquire raw materials for a product, manufacture and then sell it.

Inventory Conversion Ratio        Inventory/Cost of Sales/365

In addition to helping management and owners of business in diagnosing the financial health of their company or business, ratios can also helpful for managers to make decisions about investments or projects that the company is considering to take, such as acquisitions, or expansion.

Still confused or need to brush up your knowledge on financial ratios? Connect with our Online Accounting Tutor and get the help right away.

Key Difference Between Income Statement, Cash Flow Statement & Balance Sheet

An effective business management needs three very important financial statements that include income statement, cash flow statement and balance sheet. Indeed, all these three financial statements are typically produced with accurate financial information in order to make trustworthy & sound business decisions. Usually, these financial reports reflect the critical info about the different business activities like cash management, effects of business transaction during a particular period, revenues and expenses of a company, equity shares as well as the events on an entity. Each type of statement plays a significant role in a company; in fact these are the essential decision-making tools.

Let’s have a look at the key difference among these significant financial statements:

Income Statement

The statement that depicts financial sustainability assists to represent the current value of the business as well as describes the total profit over the costs of earning of a company for a given period of time. Indeed, income statement is a statement of operations that represent overall income, profit and loss of a business entity. The “Statement of Financial Performance” provides information relating to the sufficiency of the selling prices as well as the adequacy of the profit related to the business owner’s net investment. Along with the profitability, it also indicates how the company’s revenues are transformed into the net income.

Generally, this P&L statement (Profit and Loss Statement) is directly associated to the cash flow statement, balance sheet along with statement of changes in equity. One section of this statement includes details about the revenues & gains and another section includes details about the expenses and losses. The income statement shows a net profit, if gains & revenues are greater than losses & operating costs. On the other hand, in case of greater expenses and losses of the company, the income statement will show a net loss.

 income statement

Cash Flow Statement

The statement of cash flow shows the details of cash funds that a company has taken in or disbursed to or from any another source over a specific period of time. In fact, it describes the source as well as application of received and distributed money or funds throughout the reporting period by comparing the opening balances with the closing balances on cash or cash equivalent accounts. Essentially, the cash flow statement includes all the details from the balance sheet and the income statement in order to give a summary of cash inflows and outflows related to the financing activities, operating activities and investing activities.

Indeed, this statement informs about the movement of cash funds in a specific period of time to the decision makers. By including details of all the cash activities during that period of time, cash flow reports are prepared at the end of an accounting period. In fact, the statement of cash flow is a mirror image of business or a company owner’s ability to pay its bills or invoices in the future.

Read more – What is the difference between Cost accounting, financial accounting and Management accounting?

Balance Sheet

The “statement of financial position” or a balance sheet identifies the financial strength of a company or business at a particular moment in a time. In financial accounting, it is a summary of the financial balances of a corporation, a sole proprietorship, a business partnership or other business organization.

A balance sheet is an essential statement that shows the real picture or snapshot of a company’s financial position and the exact value of the assets that an organization owns at a particular point in time. It is prepared either monthly or quarterly at the end of an accounting period.

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The key purpose of all these three aforementioned financial statements is to provide different types of details & appropriate information to financial decision makers that essential to run a company successfully. With the help of this unique, necessary and accessible information, the internal and external decision makers need to make decisions about the distribution of resources within their control. In this way, all the statements assist decision makers choose the most advantageous resource allocation option for their business or a company.