Why is understanding financial statements important

Liabilities are said to be either current or long-term. Current liabilities are obligations a company expects to pay off within the year. Long-term liabilities are obligations due more than one year away. Sometimes companies distribute earnings, instead of retaining them. These distributions are called dividends. It does not show the flows into and out of the accounts during the period. An income statement is a report that shows how much revenue a company earned over a specific time period usually for a year or some portion of a year.

An income statement also shows the costs and expenses associated with earning that revenue. This tells you how much the company earned or lost over the period. This calculation tells you how much money shareholders would receive if the company decided to distribute all of the net earnings for the period. Companies almost never distribute all of their earnings.

Usually they reinvest them in the business. To understand how income statements are set up, think of them as a set of stairs. You start at the top with the total amount of sales made during the accounting period. Then you go down, one step at a time. At each step, you make a deduction for certain costs or other operating expenses associated with earning the revenue. At the bottom of the stairs, after deducting all of the expenses, you learn how much the company actually earned or lost during the accounting period.

At the top of the income statement is the total amount of money brought in from sales of products or services. This top line is often referred to as gross revenues or sales. This could be due, for example, to sales discounts or merchandise returns. Moving down the stairs from the net revenue line, there are several lines that represent various kinds of operating expenses.

Although these lines can be reported in various orders, the next line after net revenues typically shows the costs of the sales. This number tells you the amount of money the company spent to produce the goods or services it sold during the accounting period.

The next section deals with operating expenses. Marketing expenses are another example. Depreciation is also deducted from gross profit. Depreciation takes into account the wear and tear on some assets, such as machinery, tools and furniture, which are used over the long term. Companies spread the cost of these assets over the periods they are used.

This process of spreading these costs is called depreciation or amortization. After all operating expenses are deducted from gross profit, you arrive at operating profit before interest and income tax expenses. Next companies must account for interest income and interest expense. Interest income is the money companies make from keeping their cash in interest-bearing savings accounts, money market funds and the like.

On the other hand, interest expense is the money companies paid in interest for money they borrow. Some income statements show interest income and interest expense separately. Some income statements combine the two numbers. The interest income and expense are then added or subtracted from the operating profits to arrive at operating profit before income tax. Finally, income tax is deducted and you arrive at the bottom line: net profit or net losses.

Net profit is also called net income or net earnings. This tells you how much the company actually earned or lost during the accounting period. Although operating margin is the profit from core operations, it doesn't include expenses such as taxes and interest on debt.

As a result, operating margin provides insight as to how well a company's management is running the company since it excludes any earnings due to ancillary or exogenous events. For example, a company might sell an asset or a division and generate revenue, which would inflate earnings. Operating margin would exclude that sale. Ultimately, the operating profit is the portion of revenue that can be used to pay shareholders, creditors, and taxes.

Liquidity ratios help shareholders determine how well a company handles its cash flow and short-term debts without needing to raise any extra capital from external sources, such as a debt offering. The most commonly used liquidity ratio is the current ratio , which reflects current assets divided by liabilities, giving shareholders an idea of the company's efficiency in using short-term assets to cover short-term liabilities. Short-term assets would include cash and accounts receivables , which is money owed to the company by customers.

Conversely, current liabilities would include inventory and accounts payables , which are short-term debts owed by the company to suppliers. Higher current ratios are a good indication the company manages its short-term liabilities well and generates enough cash to run its operation smoothly.

The current ratio generally measures if a company can pay its debts within a month period. It can also be useful in providing shareholders with an idea of the ability a company possesses to generate cash when needed.

Debt includes borrowed funds from banks but also bonds issued by the company. Bonds are purchased by investors where companies receive the money from the bonds upfront.

When the bonds come due—called the maturity date —the company must pay back the amount borrowed. If a company has too many bonds coming due in a specific period or time of the year, there may not be enough cash being generated to pay the investors. In other words, it's important to know that a company can pay its interest due on their debt, but also it must be able to meet its bond maturity date obligations.

The debt-to-equity ratio measures how much financial leverage a company has, which is calculated by dividing total liabilities by stockholders' equity. A high debt-to-equity ratio indicates a company has vigorously funded its growth with debt. However, it's important to compare the debt-to-equity ratios of companies within the same industry. Some industries are more debt-intensive since they need to buy equipment or expensive assets such as manufacturing companies.

On the other hand, other industries might have little debt, such as software or marketing companies. The interest coverage ratio measures the ease with which a company handles interest on its outstanding debt. A lower interest coverage ratio is an indication the company is heavily burdened by debt expenses. Efficiency ratios show how well companies manage assets and liabilities internally. They measure the short-term performance of a company and whether it can generate income using its assets.

The inventory or asset turnover ratio reveals the number of times a company sells and replaces its inventory in a given period. The results from this ratio should be used in comparison to industry averages. Low ratio values indicate low sales and excessive inventory, and therefore, overstocking. High ratio values commonly indicate strong sales and good inventory management.

Price ratios focus specifically on a company's stock price and its perceived value in the market. The dividend yield ratio shows the amount in dividends a company pays out yearly in relation to its share price.

The dividend yield provides investors with the return on investment from dividends alone. Dividends are important because many investors, including retirees, look for investments that provide steady income. Dividend income can help offset, at least in part, losses that might occur from owning the stock.

Essentially, the dividend yield ratio is a measurement for the amount of cash flow received for each dollar invested in equity. There is no one indicator that can adequately assess a company's financial position and potential growth. That is why financial statements are so important for shareholders and market analysts alike. These metrics along with many others can be calculated using the figures released by a company on its financial statements.

Tools for Fundamental Analysis. Did those expenses result in the net income you were targeting? Moving forward, you can learn from your mistakes and double down on investments that paid off. Financial statements are also useful when managing and planning budgets.

Keeping the broader health of your organization in mind is vital when managing your team. When setting team goals, leverage financial statements to provide context for why specific benchmarks were targeted and the thought process behind your plans for reaching them.

Instill in employees your same big-picture mindset and the knowledge that their efforts make a tangible difference to the company. Bolstering your financial knowledge can enable you to make the best use of the resources available to you and become a finance-driven manager.

Are you interested in using finance to become a better manager?