Financial statements contain lots of crucial information about the health of your business.
But if you’re not sure how to interpret them they can look more like a bleary sea of lines and numbers – especially after a long day of working hard at your business.
In this article we tap the expertise of Keith Peters, Assistant Vice President & Manager, Commercial Portfolio Management, for a primer on gleaning insights from your balance sheet, income statement, and cash flow statement.
“While I’d consider the cash flow statement to be the most important of the three, most small-to-mid-size businesses don’t prepare a cash flow statement monthly – they generally do that annually,” says Peters. “So, cash flow statement aside, reviewing the income statement and determining the business’ ongoing EBITDA each month would be the most crucial for business owners. At the end of the day, the business needs to generate sufficient cash flow to meet all its daily requirements. That includes everything from employee wages, to paying suppliers, to paying business loans.”
What your statements can tell you about the health of your business
Balance Sheet: Two key things your balance sheet will tell you are company liquidity and the overall leverage on the company.
Company liquidity – This is a company’s ability to pay its current liabilities over the course of the year, such as payables and loan payments. It’s measured by looking at the Current Ratio, which is Current Assets divided by Current Liabilities. The lower the liquidity, the more risk there is that the business could face a cash crunch in the near term.
Overall leverage on the company – This is measured by the Total Debt divided by Shareholder Equity. The higher the leverage, the more risk there is that the company could be unable to make its loan payments.
Income Statement: Two key things your income statement will tell you are gross profit and cash flow or EBITDA.
Gross Margin – This gives you an indication of what the company is earning on its sales after taking into account the cost of the good or service you’re selling. It’s calculated by dividing gross profit by total revenue.
Cash Flow or EBITDA – Cash flow tells you how much cash the business is generating from its operations and how much cash is available to make all its loan payments and interest expense during the year. EBITDA stands for (and is calculated as) Earnings Before Interest, Taxes, Depreciation, and Amortization. It’s a measure of corporate performance that shows earnings before accounting and financial deductions come into play.
Cash Flow Statement: A cash flow statement will tell you where the business is generating its cash from – and where it’s spending it. This statement typically has three sections: Cash Flow from Operating Activities, Investing Activities and Financing Activities.
The story behind the numbers
Reading the numbers on a statement is one thing. Understanding what those numbers are telling you is another.
“Looking at ratios and tracking how they change from period to period can tell you a lot, including identifying issues of concern before they get too bad – as well as opportunities,” says Peters. “For example, if gross margin percentage has been declining from period to period, then seeing that trend could prompt you to look closer at the underlying issues and what you can do to improve things. On the flip side, a company with consistently strong ratios might be able to take on more financing to acquire another business or competitor, or perhaps get additional equipment or expand to a bigger location.”
Below are some table stakes ratios and strategies for spotting trends – and taking action.
How to calculate: Current Assets divided by Current Liabilities.
What it tells you: This is a measure of the business’ ability to pay its short-term liabilities, which is important for the longevity of the business. A low Current Ratio indicates that the business is more likely to have issues making its ongoing payments. “Banks typically look at a ratio of 1.25 or higher as being a strong Current Ratio,” says Peters. This can be calculated on your balance sheet on a monthly basis.
Debt to Tangible Net Worth Ratio
How to calculate: Total Debt divided by Shareholder Equity.
What it tells you: This is a measure of the level of debt the company has compared to how much of an investment the owners have made in the business. “Typically, a ratio of 2.50x or lower is considered good,” says Peters. This can be calculated on your balance sheet on a monthly basis.
Cash Flow Coverage Ratio
How to calculate: EBITDA divided by the total principal and interest payments made in a certain period.
What it tells you: This is a measure of the company’s ability to make its loan payments and interest expense on all its debt. “A ratio of 1.25x or higher is generally considered good,” says Peters, adding that while your bank typically does this calculation annually, a business owner can also calculate it on a monthly basis.
“What makes the ratios particularly useful is when you look for trends month to month, quarter to quarter, and especially when you compare how the business has done from one year to the next,” says Peters.
For example, you could look at the current year’s first quarter results against the previous year’s first quarter to see what’s changed on the financial statements. You could do the same with year end statements.
“Has Gross Margin percentage gone up or down from one year to the next? Have operating expenses gone up or down? What’s causing it? Identifying what’s happened and why the changes have occurred will help you understand what’s going on with the business,” says Peters.
Bringing it all together
Your balance sheet, income statement, and cash flow statement can tell you a lot about the health of your business. Applying some table stakes ratios and analyzing for trends in the numbers can put you in a position to act early on both issues and opportunities. And, as always, cash is king.
“Be careful not to focus so much on your balance sheet and assets that you’re neglecting your income statement and how much cash flow the business is generating,” says Peters. “While it’s important to have sufficient assets to secure loans, what’s key is for the business to generate enough cash flow to meet all of its obligations.”