How to analyze a financial statement

It's obvious financial statement have a lot of numbers in them and at first glance it can seem unwieldy to read and understand. One way to interpret a financial report is to compute ratios, which means, divide a particular number in the financial report by another. Financial statement ratios are also useful because they enable the reader to compare a business's current performance with its past performance or with another business's performance, regardless of whether sales revenue or net income was bigger or smaller for the other years or the other business. In order words, using ratios can cancel out difference in company sizes.

There aren't many ratios in financial reports. Publicly owned businesses are required to report just one ratio (earnings per share, or EPS) and privately-owned businesses generally don't report any ratios. Generally accepted accounting principles (GAAP) don't require that any ratios be reported, except EPS for publicly owned companies.

Ratios don't provide definitive answers, however. They're useful indicators, but aren't the only factor in gauging the profitability and effectiveness of a company.

One ratio that's a useful indicator of a company's profitability is the gross margin ratio. This is the gross margin divided by the sales revenue. Businesses don't discose margin information in their external financial reports. This information is considered to be proprietary in nature and is kept confidential to shield it from competitors.

The profit ratio is very important in analyzing the bottom-line of a company. It indicates how much net income was earned on each $100 of sales revenue. A profit ratio of 5 to 10 percent is common in most industries, although some highly price-competitive industries, such as retailers or grocery stores will show profit ratios of only 1 to 2 percent.

Types of Costs

Direct costs are those costs that cann be directly attributed to a product or product line, or to one source of sales revenue, or one business unit or operation of the business. An example of a direct cost would be the cost of tires on a new automobile.

Indirect costs are very different and can't be attached to any specific product, unit or activity. The cost of labor or benefits for an auto manufacturer is certainly a cost, but it can't be attached to any one vehicle. Each business has to devise a method of allocating indirect costs to different products, sources of sales revenue, business units, etc. Most allocation methods are less than perfect, and generally end up being arbitrary to one degree or another. Business managers and accounts should always keep an eye on the allocation methods used for indirect costs and take the cost figures produced by these methods with a grain of salt.

Fixed costs are those costs that stay the same over a relatively broad range of sales volume or production output. They're like an albatross around the neck of business and a company must sell its product at a high enough profit to at least break even.

Variable costs can increase and decrease in proportion to changes in sales or production level. Variable costs vary proportionately with changes in production/

Relevant costs are essentially future costs that could be incurred, depending on what strategic course a business takes. If an auto manufacturer decides to increase production, but the cost of tires goes up, than that cost needs to be taken into consideration.

Irrelevant costs are those that should be disregarded when deciding on a future course of action. They're costs that could cause you to make a wrong decision. Whereas relevant costs are future costs, irrelevant costs are those costs that were incurred in the past. The money's gone.

What is a sole proprietorship?

A sole proprietorship is the business or an individual who has decided not to carry his business as a separate legal entity, such as a corporation, partnership or limited liability company. This kind of business is not a separate entity. Any time a person regularly provides services for a fee, sells things at a flea market or engage in any business activity whose primary purpose is to make a profit, that person is a sole proprietor. If they carry on business activity to make profit or income, the IRS requires that you file a separate Schedule C "Profit or Loss From a Business" with your annual individual income tax return. Schedule C summarizes your income and expenses from your sole proprietorship business.

As the sold proprietor of a business, you have unlimited liability, meaning that if your business can't pay all it liabilities, the creditors to whom your business owes money can come after your personal assets. Many part-time entrepreneurs may not know this, but it's an enormous financial risk. If they are sued or can't pay their bills, they are personally liable for the business's liabilities.

A sole proprietorship has no other owners to prepare financial statements for, but the proprietor should still prepare these statements to know how his business is doing. Banks usually require financial statements from sole proprietors who apply for loans. A partnership needs to maintain a separate capital or ownership account for each partners. The total profit of the firm is allocated into these capital accounts, as spelled out in the partnership agreement. Although sole proprietors don't have separate invested capital from retained earnings like corporations do, they still need to keep these two separate accounts for owners' equity - not only to track the business, but for the benefit of any future buyers of the business.

Balance sheet

A balance sheet is a quick picture of the financial condition of a business at a specific period in time. The activities of a business fall into two separate groups that are reported by an accountant. They are profit-making activities, which includes sales and expenses. This can also be referred to as operating activities. There are also financing and investing activities that include securing money from debt and equity sources of capital, returning capital to these sources, making distributions from profit to the owners, making investments in assets and eventually disposing of the assets.

Profit making activities are reported in the income statement; financing and investing activities are found in the statement of cash flows. In other words, two different financial statements are prepared for the two different types of transactions. The statement of cash flows also reports the cash increase or decrease from profit during the year as opposed to the amount of profit that is reported in the income statement.

The balance sheet is different from the income and cash flow statements which report, as it says, income of cash and outgoing cash. The balance sheet represents the balances, or amounts, or a company's assets, liabilities and owners' equity at an instant in time. The word balance has different meanings at different times. As it's used in the term balance sheet, it refers to the balance of the two opposite sides of a business, total assets on one side and total liabilities on the other. However, the balance of an account, such as the asset, liability, revenue and expense accounts, refers to the amount in the account after recording increases and decreases in the account, just like the balance in your checking account. Accountants can prepare a balance sheet any time that a manager requests it. But they're generally prepared at the end of each month, quarter and year. It's always prepared at the close of business on the last day of the profit period.

What are partnerships and limited liability companies?

Some business owners choose to create partnerships or limited liability companies instead of a corporation. A partnership can also be called a firm, and refers to an association of a group of individuals working together in a business or professional practice.

While corporations have rigid rules about how they are structured, partnerships and limited liability companies allow the division of management authority, profit sharing and ownership rights among the owners to be very flexible.

Partnerships fall into two categories. General partners are subject to unlimited liability. If a business can't pay its debts, its creditors can demand payment from the general partners' personal assets. General partners have the authority and responsibility to manage the business. They're analogous to the president and other officers of a corporation.

Limited partners escape the unlimited liability that the general partners have. They are not responsible as individuals, for the liabilities of the partnership. These are junior partners who have ownership rights to the profits of the business, but they don't generally participate in the high-level management of the business. A partnership must have one or more general partners.

A limited liability company (LLC) is becoming more prevalent among smaller businesses. An LLC is like a corporation regarding limited liability and it's like a partnership regarding the flexibility of dividing profit among the owners. Its advantage over other types of ownership is its flexibility in how profit and management authority are determined. This can have a downside. The owners must enter into very detailed agreements about how the profits and management responsibilities are divided. It can get very complicated and generally requires the services of a lawyer to draw up the agreement.

A partnership or LLC agreement specifies how profits will be divided among the owners. While stockholders of a corporation receive a share of profit that's directly related to how many shares they own, a partnership or LLC does not have to divide profit according to how much each partner invested. Invested capital is only of the factors that are used in allocating and distributing profits.

Quasar software

Accounting has become more and more complex as have the businesses that use accounting functions. Fortunately, there are several excellent software packages that can help you manage this important function. Quasar is one such package.

All versions of Quasar offer comprehensive inventory controls. In its most basic use, the inventory module allows a business owner to track the locations and quantities of all inventory items. Additionally, the inventory capabilities go beyond simple record-keeping. Manufacturers and wholesalers can assemble kits using component items; whenever a kit is assembled, the inventory representing its component items are adjusted accordingly. Items can be grouped into various categories and the groups can be nested many levels deep. Vendor purchase orders can be generated for items whose quantities are below a preset level. Costs and selling prices for items can be set and discounted in a myriad of different ways. Finally, these items can be reported upon to show such things as profits, margins, and sales per item.

Sales and purchasing are another strength of Quasar. Customer quotes can be easily converted to invoices to be paid. Promotions can be created and discounts can be given based on date, customer, or store location. Margins can be reported upon for traits such as individual items, individual customers, or individual salesperson. Likewise, a purchase order can be created and converted to a vendor invoice, which can be paid in a number of different ways, including printing a check. Quasar can keep track of miscellaneous fees such as container deposits, freight charges, and franchise fees.

The intelligent design of Quasar's user interface allows for quick and easy data entry. Some programs you may encounter are not optimized for keyboard use. These programs require you to move your hand to the mouse to select frequently needed options. While some of Quasar's menu options are only mouse-accessible, the bulk of Quasar's user interface is designed in such a way that you can keep you hands on the keyboard by using special shortcuts. This allows for faster data entry, which can save time (and therefore money) in the long run.

Managing the Bottom Line

If you don't keep track of how much money you're making, you have no idea whether your business is successful or not. You can't tell how well your marketing is working

And I don't just mean you should know the amount of your total sales or gross revenue. You need to know what your net profit is. If you don't, there's no way you can know how to increase it.
If you want your business to be successful, you need to make a financial plan and check it against the facts on a monthly basis, then take immediate action to correct any problems. Here are the steps you should take:

* Create a financial plan for your business. Estimate how much revenue you expect to bring in each month, and project what your expenses will be.
* Remember that lost profits can't be recovered. When entrepreneurs compare their projections to reality and find earnings too low or expenses too high, they often conclude, "I'll make it up later." The problem is that you really can't make it up later: every month profits are too low is a month that is gone forever.
* Make adjustments right away. If revenues are lower than expected, increase efforts in sales and marketing or look for ways to increase your rates. If overhead costs are too high, find ways to cut back. There are other businesses like yours around. What is their secret for operating profitably?
* Think before you spend. When considering any new business expense, including marketing and sales activities, evaluate the increased earnings you expect to bring in against its cost before you proceed to make a purchase.
* Evaluate the success of your business based on profit, not revenue. It doesn't matter how many thousands of dollars you are bringing in each month if your expenses are almost as high, or higher. Many high-revenue businesses have gone under for this very reason -- don't be one of them.

About GAAP

While many businesses assume that accountants are bound by generally accepted accounting practices and that these are inviolate, nothing could be further from the truth. Everything is subject to interpretation, and GAAP is no different. For one thing, GAAP themselves permit alternative accounting methods to be used for certain expenses and for revenue in certain specialized types of businesses. For another, GAAP methods require that decisions be made about the timing for recording revenue and expenses, or they require that key factors be quantified. Deciding on the timing of revenue and expenses and putting definite values on these factors require judgments, estimates and interpretations.

The mission of GAAP over the years has been to standardize accounting methods in order to bring about uniformity across all businesses. But alternative methods are still permitted for certain basic business expenses. No tests are required to determine whether one method is more preferable than another. A business is free to select whichever method it wants. But it must choose which cost of good sold expense method to use and which depreciation expense method to use.

For other expenses and for sales revenue, one general accounting method has been established; there are no alternative methods. However, a business has a fair amount of latitude in actually implementing the methods. One business applies the accounting methods in a conservative manner, and another business applies the methods in a more liberal manner. The end result is more diversity between businesses in their profit measure and financial statements than one might expect, considering that GAAP have been evolving since 1930.

The pronouncement on GAAP prepared by the Financial Accounting Standards Board (FASB) is now more than 1000 pages long. And that doesn't even include the rules and regulations issued by the federal regulatory agency that jurisdiction over the financial reporting and accounting methods of publicly owned businesses - the Securities and Exchange Commission (SEC).