Interpreting and inferring financial statements can be intimidating, especially when you have not undertaken a formal course of finance yet. The numbers and ratios, however, are indispensable when you as an entrepreneur are looking to partner, merge, acquire or simply do business with a firm.
Financial literacy is a must if you are running your shop. Financial statements offer great insight and are extensively used by the stakeholders such as employees, the board of directors, investors, shareholders, customers, management, suppliers, bankers, and other related stakeholders for different purposes.
Assets, Liabilities, Equity, Revenues, and Expenses, may look complex to start with. Once you understand and learn to interpret, you can uncover many things about your firm, competing start-ups and other businesses. Here is your ultimate guide on what these mean
What is an Asset in business terms?
Assets are what business owns which generates economic benefit throughout the accounting period. A building, manufacturing equipment, patents, cash or land, etc all fall under the category of assets since they stay with the firm for a long duration and can benefit the firm in economic terms.
What are liabilities?
Are they good or bad? A liability is an obligation arising from the past events and its settlement typically result in an outflow from entity resource reflecting economic benefit. Liabilities are obligations which have to be paid to a person, business or government. For example taxes payable, wages payable and accounts payable are all different kinds of liabilities.
What is equity and how does it impact assets/liabilities?
An owner’s equity in his/her investment in terms of money in the company, plus the retained earnings, which is the money which the company makes and does not spend or distribute as dividends. Equity is defined as the residual interest in the assets of an entity after deducting all its liabilities. Equity increase or decrease depends on the movement of assets and liabilities. So, if assets are increasing and liabilities are stable then equity increases, on the contrary, if the assets are stable and liabilities are increasing then equity decreases.
Revenue and Expenses
Revenues and expenses, and layers below them to gauge how a company is doing.
Revenue is an economic benefit during the accounting period in the form of inflows or increase of assets or decrease of liabilities which increases equity. Revenue is the total income a company generates during the period covered by the financial statement. A company could have operating revenues and non-operating revenues. Operating revenues come from the selling of goods or services whereas non-operating revenues come from other sources like the return from investments.
Two principles can be used to record revenues:
Cash basis and Accrual Basis. Cash basis is the income recognized once cash is received and Accrual basis is the income recognized at the time when the reward is transferred from sellers to buyers.
Expenses are the operational costs recorded in the financial statements in the period they occur. According to the official definition, an expense is a decrease in economic benefits in the form of outflows or depreciation of assets or an increase in liabilities which results in a decrease of an equity.
Expense is money a company spends to do business. For example rent, utilities and wages can all be categorized as an expense. The depreciation in the cost of an equity’s value is also an expense. According to accrual basis, an expense must be reported as soon as an individual owes them money, whereas, in the cash basis reporting, the expense is reported when the bill is paid.
Financial numbers listed above mean nothing when they are referred to as stand-alone. Financial numbers make sense only when they are viewed with each other and compared to the number of other business, industries. Key ratios can be used to depict the current financial condition of a company. The key ratios data can be taken from the subject company’s financial statements like balance sheet, income statement, and statement of cash flows. Companies having superior ratios are the ones who are doing good. Items on the financial statements of the company are compared with other items and produce ratios which represent the key aspects of the company’s financial picture like liquidity, profitability, earning strength and debt.
What are the key financial ratios an entrepreneur must know?
Net profit margin
The ratio depicts the efficiency of a company and its ability to keep costs under control. Higher the net profit, more efficient is the company at converting revenue into profit. Using this ratio, you can compare two companies in the same industry or similar businesses.
Debt to Equity Ratio
The ratio depicts the proportion of equity and debt used by a company to help in financing its assets. The ratio is computed estimated by dividing the total liabilities by stockholder’s equity.
Cash ratio, cash asset ratio, and liquid ratios help estimate the firm’s ability to pay back short term obligations or debts in time.
The ratio is also referred to as the acid test ratio or quick asset ratio. The ratio helps estimates the short term liquidity of a company and is helpful to measure the company’s short term debts situation compared to its most liquid assets.
Return on Equity
The ratio estimates the profitability of a company by computing the amount of profit generated with the money invested by the shareholders.
Working Capital Ratio
The ratio is extremely important for start-ups since most work nimbly. The ratio indicates whether a firm has enough assets to cover its debts. Small firms must never move their eyes off this ratio, else they might face troubled times. The ratio is computed as current assets /current liabilities.
Many other ratios can be computed and looked at to gauge the financial health of an organization. An ample number of short online courses are available, that can be leveraged to ace interpreting financial statements. The Filings can help you decipher all these terms with ease and provide complete compliance support. Connect with us: 044-46315959 | [email protected] or visit our website: www.thefilings.in