What are the steps to analyze financial statements?

If a balance sheet is a snapshot in time, the income statement is like a movie showing your total revenue and expenses for the year. You want to try to keep as much revenue as possible by minimizing your non value added expenses so that more revenue turns into gross margin and ultimately net income.

1- Purpose: Define the analysis goal. 2- Gather Data: Obtain key financial statements. 3- Horizontal Analysis: Spot trends by comparing current vs. past data. 4- Vertical Analysis: Check each item's proportion in the statement. 5- Ratios: Evaluate liquidity, solvency, profitability. 6- Cash Flows: Assess sources of cash inflows/outflows. 7- Benchmark: Compare with industry norms/competitors. 8- External Factors: Consider market conditions, leadership, industry trends. 9- Draw Conclusions: Use insights for decision-making. 10- Reassess: Periodically review for updates.

To me it's important to compare to other periods of time. While an income statement can tell you your revenue and expenses for that period of time, it's important to know whether they are an improvement or not. Did we earn more than last quarter, last year, last month, the same period last year and so on. Are we managing our expenses well or have they gone up and why? These are the ways that we need to look at our financial statements to get real value from them. It's important to look holistically as well as line by line.

For non- finance professionals I often explain it this way. Your profit and loss statement contains stuff that has not happened yet (that is expected to be spent or collected in the future) and some accounting stuff like depreciation that is not a real cash transaction. Your balance sheet is the repository of these future transactions and non cash items. It’s where you keep track of them in your business. When you analyse both your profit and loss and the various changes in each account on your balance sheet (the non cash and future stuff), this process allows you to get a much more clear view of the cash that really came in and went out of your business. Both financial statements are important to get a clear view of your business.

A balance sheet is a snapshot of your business at a specific point in time, showing your assets and liabilities. As a business owner, lender, potential investor, you can get a feel for how healthy the business is by doing ratio analysis: - Current Ratio (Current Assets / Current Liabilities) measures how you can liquidate current assets to pay off current liabilities. - Quick Ratio (Current assets - Inventory / Current Liabilities) is the same as current ratio but backs out inventory - Working Capital (Current Assets less Current Liabilities) - Explains how much you have to run operations - Debt to Equity - How much of your business is funded via debt vs. owner's equity

This is extremely important information to know and have a basic understanding. Cash flow is the lifeline of all businesses.

It's all about the cash flow. This is the most important financial statement. ?? It's great if you can show positive income for book purposes, but you need cash inflows to ultimately stay in business.

There may be other important ratios that may need to be considered based on other agreements. For example, certain banks may have certain ratios, such as a debt service coverage ratio (unique in each agreement), that need to be calculated.