Recognising the business a financial strength is vital for investors, lender and company owner. One must start with the 3 financial statements that lay the foundations of corporate financial reporting — the income statement, the balance sheet and the cash flow statement. Those are the main financial statements that help assess how an organisation has performed over time (past and present) along with a view of future growth.
Through these documents, you get insights into financial performance metrics that help you make better investment, credit, or operational improvement decisions. In this blog, we define each of these fundamental financial statements in the context of your financial report analysis, and why these are essential reflections of a business’ strength and areas for growth.
Income statement: the overview for profitability
The income statement (profit and loss statement) is about their revenues, costs, and expenses over a specific time period (usually a quarter or year). This financial statement, provides the financial performance metrics of gross profit, operating income, and net income.
What It Says About Department Strength
The income statement shows a company is profitable or losing money. Long run successful costs, inflated sales, at the same time as bills are well-managed suggest there is correct operational potency and that the marketplace is well-receptive to the corporate’s product or carrier.
A healthy income statement usually shows:
- Revenue growth in a year-on-year manner
- The high gross margins (due to cost controls)
- High net income (indicating bottom-line profitability)
Such measurements enable stakeholders to measure the financial strength and earnings trend and cost management through the strength of the company. It usually means you are doing something right when revenue is growing faster than expenses, a sign of scalable operations and good management (from a financial standpoint).
Income statement ratios you should track
- Gross Profit Margin = (Revenue — Cost of Goods Sold)/Revenue
- Operating margin = Operating profit / Revenue
- Net Profit Margin = Net Income/Revenue
These ratios have different perspectives in the capacity of generating profit in terms of company activity. An above-average gross profit margin indicates that the company has either good pricing power or an efficient process for production; a respectable net profit margin indicates that a business is handling overhead and interest costs well.
Balance Sheet: Financial Health Snapshot
The income statement measures performance over a period of time while the balance sheet shows the financial position of a company at a moment in time. It has assets, liabilities and shareholder’s equity based on the basic accounting equation:
Assets = Liabilities + Equity
Importance of the Balance Sheet
This balance sheet directly represents the financial strength of the company and shows what the company owns (assets), what are its liabilities (obligation), and the residual interest in the assets of the entity (equity). A healthy balance sheet indicates a business has the funds to cover their short- and long-term debt obligations, capitalise on opportunities, and survive economic disruptions.
Here are some indicators of strength on the balance sheet:
- Substantial liquid assets, including cash and marketable securities
- Positive Debt / Equity Ratio
- Strong retained earnings
Key Financial Performance Indicators from the Balance Sheet
- Current Ratio = Current Assets / Current Liabilities (a measure of short term liquidity)
- Debt-to-Equity Ratio = Total Liabilities / Shareholder Equity (financial leverage ratio)
- ROA (Return on Assets) = Net Income / Total Assets (indicates how efficient a company is at using its assets to generate earnings)
Investors use these figures in financial report analysis to understand whether the company is overleveraged, how effectively it uses its assets, and whether it can service its debts.
Real-World Application of Balance Sheet
Assume, for example, that a firm has $500 million in assets and $300 million in liabilities, then the firm has $200 million in equity. If the same firm simultaneously claims that it has large cash reserves and low levels of long-term debt, it is typically perceived as financially sound and low-risk by the investors and creditors.
Statement of Cash Flows: Liquidity and Cash Management
A company can be running like a well-oiled machine and still struggle or fail because it is not managing its cash flow correctly. The cash flow statement reports the moving of cash in and out during a specific period and includes three sections:
- Cash from Operating Activities — cash generated from its core operations
- Vertical Bars Investing Activities — cash used for or received from investments (ex. real estate, or acquisitions)
- Financing Activities — cash received from or paid to investors and creditors
Cash Flow: The Must-Have Metric for Company Strength
One of the best aspects of a company possesses the potential of positive cash flow from operation. Although net income from the income statement may be impacted by non-cash items (for example depreciation), cash flow represents the real cash the firm has available.
Cash flow statement helps in assessing:
- If company operations operate like a self-sustaining entity
- As far as there is liquidity available to pay debt, to reinvest and dividends
- The consequence of the investment and financing decisions taken up on the cash balance of the firm
Cash Flow Metrics to Monitor
- Free Cash Flow = Operating Cash Flow – Capital Expenditures
- Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities
- Cash Flow Margin = Operating Cash Flow / Net Sales
Ideal for non-comparative analysis of financial reports, such as financial companies in capital-intensive industries or firms that are experiencing rapid growths.
Combining the 3 Financial Statements for a Full Picture
To precisely assess firm financial strength, it is important to evaluate the 3 statements as a whole. All of these windows shine a different light on one document:
- Profitability as seen on the income statement
- Financial stability and leverage on the balance sheet
- The cash flow statement shows Liquidity and Cash Efficiency
Full, proper financial report analysis can only be performed when insight from all three is combined. For example, a business can demonstrate relatively high net income, and at the same time, it shows poor cash flow — perhaps because of lax credit conditions or inventory stuffing. Or maybe it’s great on the balance sheet, but has such a high debt ratio that any economic headwinds could be threatening.
Steps for analysing a financial statement
- Use the income statement first: Identify trends in terms of revenue, margins, and ratios of expenses. Take note of any abnormal, or unusual behaviours.
- Examine the Balance Sheet: Assess the asset and liability mix. Keep an eye on leverage, solvency and retained parking
- Cash Flow Statement Analysis: Check if the company generates cash in its main areas of business. Verify that capital investments are sustainable and that financing activities are aligned with long-term goals.
- Use Ratio Analysis: Link data across the three major financial statements to compute ratios for measuring the company against industry norms.
- Look beyond the Numbers: Review notes to the financial statements, management discussion and industry outlook to obtain the context behind the numbers.
Final thoughts
The 3 financial statements are more than merely an accountant tool; they are strategic documents that drive stakeholder measurement into company financial strength as they visually depict financial performance metrics and ultimately guide decision-making. If you are an investor thinking of a new opportunity, or a lender assessing the creditworthiness of a borrower, or a business owner requesting loans or investments, then it absolutely necessary to master these 4 key cash flow statements.
A well-considered and comprehensive financial report analysis will tell you not only the position of a company today but more importantly, its journey tomorrow.
