Previously, we introduced readers to the third and final of the three major financial statements, the statement of cash flows, and produced the above-referenced example for our fictitious ABC Corporation.  Now it is time to do some financial analysis to see what the statement of cash flows has to tell us about the all-important cash position of a business.

At the conclusion of our previous post we mentioned that one of the entries on the statement of cash flows may very well be the most important figure on any of the financial statements.  So without further ado, let’s reveal what that figure is and why it is so important.  The object of our scrutiny is: net cash provided by operating activities. 

While you might thank that net income (i.e. profits) would be more important as it is the famous “bottom line” number from the income statement—and a favorite of the press when discussing a company’s financial results—savvy investors­, and business owners, prefer to focus on net cash provided by operating activities.

Net income can be subject to distortions—either intentional or unintentional—through tactics like not properly recognizing bad loans or misrepresenting the value of assets.  Because it is much harder to misstate profits and working capital, it always pays to look at net cash provided by operating activities, which reflects the effects of changes in working capital on a firm’s net income.  There are many examples of companies that have reported positive net income even when they are on the brink of declaring bankruptcy; in almost all of these cases though, net cash from operating activities began to deteriorate much earlier, providing an early clue that the firm was in trouble.

In the case of ABC Corp. we can see that while it had a positive net income of $23,000, its operating activities provided a negative $2,000 of cash flow.  This should cause us some concern as we continue to work our through the rest of the statement.

At the bottom of the next section, we see that ABC’s investing activities also resulted in a negative cash flow, in this case the figure is $6,500.  And in the last section we finally see some positive cash flow, to the tune of $3,500, as a result of ABC’s financing activities. The end result of all of this is that ABC saw its cash balance decline by $5,000 during the course of the year.

So what are we to make of all of this?  ABC’s operating activities drained it of $2,500 in cash yet it spent $8,500 on new fixed assets (a long-term investment), and it covered part of these costs by increasing its debt load (the $3,500 in additional notes payable).

The situation at ABC is clearly not sustainable and this is reflected in the fact that its cash balance at the end of year declined by 42% ($5,000/$12,000).  If ABC keeps on this same path for too much longer, it will eventually run out of cash.  In order to remedy the situation, ABC needs to take a hard look at refining its core operating activities, in addition to determining whether it has the right mix of assets to support its business, and whether or not its debt load is sustainable.  And of course, if you start to see your company’s cash position weakening, it is time to think about all of these things before the situation gets too dire.

So that concludes our series on the major financial statements that most firms produce, and that most lenders and investors want to see.  We once again remind readers that this series is intended as an introduction to financial statements and a beginning look at their analysis.  We hope that you are now better armed to analyze and make decisions about your firms’ financial matters, and encourage you to read further on these topics in a financial management textbook.

In our previous post we presented readers with the income statement of the fictitious ABC Corporation duplicated above.  In that entry we gave a brief explanation of each of the items on the income statement that may be helpful to review before proceeding further into this post, which is aimed at teaching you to analyze the income statement for information about the financial situation of a business.

Let’s start our income statement analysis by calculating a very important financial ratio, gross profit margin (also known as gross margin).  The math here is about as easy as it gets, gross profit margin is equal to gross profit divided by total revenue.  In ABC’s case we come up with a gross profit margin of 0.60 or 60% ($90,000/$150,000).  Gross profit margin can be thought of as a measure of efficiency, it tells us how much money is left over from sales after accounting for the cost of the goods sold.  While average profit margins vary greatly from industry to industry, as a general rule a higher gross profit margin indicates a more efficient company within its field.

The next figure we want to calculate is operating income or operating profit, as it is sometimes referred to.  Once again, the math is simple: operating income is equal to gross profit minus operating expenses ($90,000 – $5,000 – $45,000 = $40,000 in our example).  Operating income puts a dollar figure on the amount of money that a business is generating from its core activities and is closely watched by lenders and investors as a gauge of a firm’s ability to repay loans or pay dividends to investors.  If a business is experiencing growth in its operating revenues, then it will have more money available for expansion, debt repayment, or any other management initiatives.  The converse is also true of course, so if your business’s operating income has been steadily declining this should give some cause for concern.

Now let’s go ahead and calculate ABC’s operating margin, which is equal to operating income divided by total revenue ($40,000/$150,00) or 26.67%.  Operating margin tells us how much a company keeps from each dollar of sales, before it has to pay interest and taxes.  As with profit margins averages will vary among different industries, but the higher the figure, the better.  Looking at your company’s operating margins over time, by comparing different years’ income statements, can be an effective tool to measure how effective your firm is at keeping what it earns in sales revenue.  If your revenues are increasing but your margins are shrinking, it may be time to assess whether those additional revenues are worth the money it costs to acquire them.

So hopefully now you have an idea of what the income statement can tell you about your business and how to calculate some simple, yet important, ratios that will also be of interest to lenders and investors. As with our discussion of balance sheets, this series on the income statement is not meant to have been an exhaustive analysis.  We have left out a discussion of some of the more complex items that can appear on the income statements of large corporations, such as amortization and depreciation, although we may cover these in future posts. In any event you should now have the tools to understand a good deal about your own company’s income statement, and if you wish to read further, we’d once again recommend an introductory undergraduate or MBA-level financial management textbook.

In our previous HBS entry, we introduced readers to the balance sheet of the fictitious ABC Corporation presented above.  At the time, we gave a brief explanation of each of the items on the balance sheet that you may want to review before diving into this post, which is aimed at informing you how to “read” a balance sheet for information on the financial condition of a business.

Before we get into the nitty-gritty of balance sheet analysis let’s revisit something we raised at the end of our prior post: the fact that for all businesses total assets are equal to total liabilities plus equity.  Now that you know what is meant by assets, liabilities, and equity, this equation should make intuitive sense.  If ABC Corp. were to sell off all of its assets it would receive $50,000; if ABC pays off all of its liabilities it will have to shell out $38,000 leaving it with $12,000, which is equal to the company’s total common equity.  Thus we see that assets minus liabilities equal common equity, and some simple math then tells us that total assets are equal to total liabilities plus equity. Common equity is what is left when liabilities are subtracted from assets and is therefore sometimes referred to as the net worth of a company.

So what exactly can a balance sheet tell a small-business owner?  It can help you to gauge the financial health of your company and to analyze trends that may be occurring over time.  It is also one of the cornerstones of financial reporting that lenders and investors will want to analyze before deciding whether or not to provide funding to your business.

One very important figure we can calculate is the current ratio, which is equal to current assets divided by current liabilities; in our example $35,000/$18,000 equals a current ratio of 1.94.  Because the current ratio measures a company’s ability to pay its short-term liabilities, it is a favorite of banks and other lenders. While current ratios will vary from industry to industry, a rule of thumb for small businesses is that lenders like to see a current ratio of at least 2.0.

Because inventory typically represents the least liquid of a firm’s current assts, we also want to gauge short-term financial health without relying on converting inventory into cash.  We accomplish this by looking at the quick ratio, which is equal to current assets minus inventories, divided by current liabilities. A company’s quick ratio (in our case ($35,000-$10,000)/$18,000 = 1.39) will obviously be lower than its current ratio but it will hopefully be greater than 1.0, meaning that it can pay off its current liabilities without having to worry about selling its inventory.

Because it represents a picture of a company’s financial situation at a specific moment in time, a single balance sheet is not useful for analyzing trends.  In order to do this though, we simply have to look at two or more balance sheets and see how things have changed over time.  For example, are your inventories growing much faster than your revenues?  If so, this may be a sign that you are stockpiling too much product at the expense of more liquid assets like cash.

You’ll also want to keep a close eye on how your receivables change over time.  If they are increasing faster than your revenues, then you may need to improve your collections process and take a realistic look at who owes you money and how likely they are to pay it back.  If you find that you have one or two problem customers, it may be time to have a talk with them.

Hopefully you now have an idea of what your company’s balance sheet is all about and how to read if for clues as to the health of your finances.  While our discussion has been by no means comprehensive, it should have left you with an understanding of some of the most important information that a balance sheet contains.  For even more detailed analysis, a college or MBA level financial management textbook can be a great resource.