The main reason to become informed about the financial performance and condition of a business is because you have a stake in the business. The financial success or failure of the business makes a difference to you. And the good news is you don’t have to be an accountant to interpret financial reports.
There are easier ways to do so here are a few tips on how to interpret financial report.
Be familiar with accounting terminology and financial reporting practices.
When issued to users, the preceding types of financial statements may have a number of footnote disclosures attached to them. These additional notes clarify certain summary-level information presented in the financial statements, and may be quite extensive. Their exact contents are defined by the applicable accounting standards.
Be in the know with worldly affairs
Put a company’s profit performance in the context of general economic conditions. Investors also should stay informed about general economic trends and developments, political events, business takeovers, executive changes, technological changes, and much more. You should read the chief executive’s letter to shareowners as well. Ideally, the letter summarises in an evenhanded and appropriately modest manner the main developments during the year. You could read just the highlights section and let it go at that too.
Judge profit performance
A business earns a profit by making sales and by keeping expenses less than sales revenue, so the best place to start is analysing sales revenue. Here are some questions to focus on:
- How does sales revenue in the most recent year compare with the previous year’s?
- What is the gross margin ratio of the business?
- Based on information from a company’s most recent income statement, how do gross margin and the company’s bottom line (net income, or net earnings) compare with its top line (sales revenue)?
Check cash flow from profit
The objective of a business is not simply to make profit but to generate cash flow from making profit as quickly as possible. A business needs this cash flow to make cash distributions from profit to shareowners, to maintain liquidity, and to supplement other sources of capital to grow the business.
Therefore the net cash flow from the profit-making activities of the business its sales and expenses is reported in the statement of cash flows. When you look there, you’ll undoubtedly discover that the cash flow from operating activities the official term for cash flow from profit-making activities is higher or lower than the bottom-line profit number in the income statement.