Financial Analysis may sound like a daunting task to some people, especially if the subjects have never really been explained to them in a common sense way. I had an opportunity to teach a Finance student of mine what I like to call Common Sense Financial Analysis in 20 hours, and within that 20 hours, I’m confident he learned more than in four years at our prestigious local University.
Essentially we reviewed the three critical financial statements, the components of each, why those components were important, when a company reported, to whom they reported to, and essentially, what information you could get out of the numbers you were given. Sure there are a million ratios and terms to make things sound fancy (like the beloved weighted average cost of capital) but common sense is where you start, and ironically, once you understand basics, the rest comes relatively easy.
Boiled down Financial Analysis:
An Income Statement tells you whether or not a company (through selling its goods or services) is making money or not. Extended analysis will shed light on revenue trends, expense management, margins, consistency etc, but essentially it’s called a Profit and Loss statement because that’s exactly what it tells you: during a period of time, did this company experience a profit or a loss.
A Balance Sheet tells you at any given point in time, what a company owns, what it owes, and the difference, which is what it’s worth. If your house was on a balance sheet, what you own (your asset) is worth say $100k. What you owe (your liability) is $80k, and what you own (your equity) is $20k. What you own, less what you owe, is what you are worth. Assets- Liabilities = Equity. Or on a balance sheet Assets = Liabilities + Equity. They must equal so the sheet balances, hence the name. Extended ratios from the balance sheet will tell you if a company is too leveraged (borrowing more than they should), has a good cash cycle (A/R and A/P analysis), Liquidity (can they pay their short term bills) and insights into ownership structures (is the company financed through stock, borrowing, owners capital etc).
Our third statement, a Cash Flow Statement essentially tells you, again over a period of time, what inflows (sources) of cash you had over that time, and what outflows (uses) of cash you had. The interesting thing about a cash flow statement is it is created by the change of the balance sheet from one period to the next. So, changes in what you own (buying or selling) would be uses or sources of cash. Changes in what you owe (borrowing or paying off) would also be sources or uses of cash. Changes in equity (selling stock, buying stock, and investing capital for example) are also sources and uses of cash.
As you can see, this is not rocket science, but you would be amazed at the number of financial and non financial people that can’t make these simple connections to their work and businesses. The really cool thing about business financial statements is that they can be applied at a personal level as well. You can calculate your personal ‘profit or loss’ for a given year, your personal net worth on your balance sheet, and your personal cash flow statement (changes in your balance sheet) over time.
Not understanding your financials is like driving with your eyes closed. Sure you may be able to make it down the street, but I wouldn’t recommend the highway.