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How to Use Financial Statements and Ratios

Posted in 2. Double Entry Transactions, 5. Financial Statements, 6. Operations by Erin Lawlor on the September 24th, 2008

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This post talks about how to make use of the information in Financial Statements.  Those statements are really the results of past operations.  It is important to use this information to be proactive and look to the future to predict results and to set goals, expectations and budgets based on the evidence provided from the past.

Time analysis is the most important tool you will use in analyzing your Financial Statements.  It is essential in managing and securing resources because it can quickly pinpoint changes that indicate errors or fraud as well as the unexpected changes that might require adjustments to cash planning and/or operations.

The first Statement to look at is the Comparison Trial Balance.  This Statement is very important, it shows the amounts posted to each account month by month complete with totals at the end.  The month to month analysis is extremely important for verifying your numbers before you start with ratio analysis.

You can either show all accounts on this Statement or you can limit it to Income Statement Accounts. I choose to include both types of Accounts so I can track the changes in Financial Position provided by the Balance Sheet Accounts.

I’ve added a few entries to the Comparison Trial Balance Report from posts # 7 and 9.   You can see that the monthly changes in Rent Expense for Oct and Nov will catch your attention.

Account Description Jun Jul Aug Sept Oct Nov Dec Total
1000 Checking -$3,000 $-3,000 $-3,000 -$3,000 -$3,000 -$3,000 -$3,000 $-21,000
2000 Accounts Payable $0 $0 $0 $0 -$3,000 $3,000 $0.
7000 Rent $3,000 $3,000 $3,000 $3,000 $6,000 $0 $3000 $21,000
Totals $0 $0 $0 $0 $0 $0 $0 $0

**This example starts with June because of space limitations here.  The additional entries for all months except September are not included in the Income Statement or Balance Sheet, I’ve only added them here for illustration.

Let’s start with Financial Ratios by looking at the Income Statement and its ratios.

Income Statement:

The Income Statement gives you a good overview of your Expenses in relation to your Revenue.  It can also help to pinpoint potential problems.

As the dollar value of Sales changes, the dollar values of Costs of Goods and Expenses should also change.   By tracking the changes in dollar values in terms of percentages of sales, you can more easily evaluate whether changes in dollar amounts are reasonable.

The percentages are based on a Percentage of Sales.  So, Gross Profit Margin = Gross Margin/Sales, Net Profit Margin = Net Income(Profit)/Sales etc.

Know your percentages. Watch your trends over time, both as they accumulate throughout the fiscal year, and as they compare month to month and year to year. Percentages can also be compared to industry ratio standards to measure your results against others in your industry.

Some expenses like wages and payroll taxes, or general office expenses are more meaningful when grouped together to find a percentage of the group rather than as a single line item.

This is the Income Statement that developed through the progressive post entries.

Income Statement % of Sales
Sales $50,000
Cost of Goods Sold $0 0%
————
Gross Margin $50,000 100% Gross Profit Margin %
Rent $3,000 6%
Office Supplies $150
Subscriptions $300
Utilities $125
Fuel $275
Repairs & Maintenance $500
Credit Card Interest $50
———–
Operating Expenses $4,400 9%
———–
Operating Income $45,600 91% Operating Profit Margin %
Other Revenues and Expenses $0
Net Income $45,600 91% Net Profit Margin %

This is a very limited Income Statement Example built from very few entries, but even with the information available, it gives useful information.  There is also obviously a problem with this Income Statement, it has no Cost of Goods Sold to relate to Sales.  In this case, we’re either missing information or we’re violating the Revenue Principle and recording Sales before they’ve been earned.  (Pinpointed Problem)

Gross Margin is also called Gross Profit or even Gross Profit Margin and the terms Income and Profit are also often used interchangeably.  Just be consistent in your terminology so that users will not be wondering if there is a difference in meaning if you use a different term.

**Comparing your business against other businesses in your industry is called Benchmarking.  There are a number of free or fee based benchmarking services online.

Remember that the Income Statement is a Yearly Statement, all its accounts are reset to zero at the end of each year and the difference (Net Income) is transferred to the Equity section of the Balance Sheet as either Retained Earnings (for Corporations) or as Owners Capital (for all other types of entities).

Balance Sheet Ratios:

The Balance Sheet gives you a good overview of your financial position at any point in time.  The Balance Sheet is not a Yearly Statement, it is a cumulative statement whose accounts retain their balances from the beginning to the end of the entity.

All Assets and Liabilities on the Balance Sheet should contribute to increasing the value of the entity.  If they are not contributing, they might need to be liquidated.

The “Current” sections of the Balance Sheet are important to keep track of because it will be Current Assets which will pay off Current Liabilities, you want to make sure you have at least as many Current Assets as Current Liabilities.  The items in the Current Sections are considered to be the most liquid, that is, they are the most likely to be able to convert to cash at (or close to) their stated value.

Two Assets to pay particular attention to are Accounts Receivable and Inventory.  Receivables are an essential tool in doing business, they finance purchases for your customers but it is important to watch their aging and balances to make sure you are not extending credit to customers who are unable to pay.  Watch Inventory turnover to make sure you that your inventory is selling and that you are not carrying obsolete or otherwise unsellable items.

Purchases that your Vendors finance for you are liabilities called Payables.  Payables and other Liabilities are essential for financing current operations and growth but keep close track of their related interest and fees to make sure their costs do not exceed their benefits.

Balance Sheet
Assets
Current Assets
1000 Checking Account $44,350
Fixed Assets
1500 Office Equipment $1,300
1520 Office Furniture $1,650
————
Total Fixed Assets $2,950
————
Total Assets $47,300
Liabilities and Equity
Current Liabilities
2000 Accounts Payable $1,700
————
Total Liabilities $1,700
Equity
Net Income $45,600
————
Total Liabilities and Equity $47,300

Some important financial ratios to keep track of are:

Current Ratio which is Current Assets/Current Liabilities this ratio should always be at least 1

Quick Ratio = Current Assets - Inventory/Current Liabilities this ratio removes Inventory from Current Assets because Inventory is usually the least liquid of the Current Assets.

The next ratios are approximations, they give you a good idea about what they are measuring.  They are general enough to give you an idea about where to look for trouble items but they are not specific enough to be fool proof.

Inventory Turnover = Sales/Inventories this ratio gives you a rough idea of how many times your inventory is sold and restocked.  Of course, it does not specifically identify inventory items so there may be items that are not selling but it does tell you how well your sales are covering your costs.

Days Sales Outstanding = Receivables/(Sales/360) this ratio gives you a number that represents aging of your receivables.  If your terms are net 30 days and this ratio gives you a number of 45 or more, then it is a good indicator that you should watch your collections carefully.

Fixed Asset Turnover = Sales/Net Fixed Assets (Fixed Assets - Accumulated Depreciation) this ratio provides an idea of how effectively your Fixed assets are contributing to operations.   This ratio can be slightly misleading because Assets are carried at book value rather than market value which might scew this ratio depending on the age of the Assets.

Total Assets Turnover = Sales/Total Assets this ratio provides an idea of how effectively your total assets contribute to operations and increases in entity value.  Although this ratio will have the same problems as the Fixed Asset Turnover ratio both of these ratios are still important to recognize and watch for trends.

As I said at the beginning of this post, know your percentages (ratios) watch them carefully.  You should use them to your advantage for predictions, corrections and budgets for your current and future operations and policies.

© 2008 - 2010 Erin Lawlor

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**disclaimer: All information posted on this blog is from my own experience and training. The guidelines I present are general and in my experience, standard practice. I do not write with authority from any Accounting Standards Boards.

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