Knowing how to read financial statements is one of the most vital skills you can possess in business, and an essential one for a consultant. Financial statements are the tools used to assess the overall financial health of any organization. They give you a report card on a variety of crucial factors such as income, debt, expenses, and assets. Whether you’re an aspiring consultant, investor, entrepreneur, or manager, knowing how to read financial statements gives you the ability to identify promising opportunities, avoid risks and make strategic decisions. This article will provide you with the basic tools you need to get started!
What Are The Four Basic Financial Statements?
There are four basic types of financial reports you will typically see:
These all serve different purposes and are typically directed towards different audiences, i.e. investors, shareholders, or owners/employees. Balance sheets are static snapshots showing what is owned and owed by an organization at any given point in time. The Income Statement shows net profits by breaking out income and expenses over a period of time. Cash Flow statements show the money that flows in and out of the company for a defined period of time. It helps predict future surpluses/shortages. Finally, the Annual Report is produced specifically for shareholders to update them on the operational and financial conditions of the company.
Can you guess which financial statement consultants interact with most often? If you guessed the income statement, well done! Consultants are most interested in optimizing current operations and directing future strategy. Therefore, they spend the most time digging into the income statement. As long as cash flows are positive, management consultants don’t spend too much more time digging into the cash flow statement. And after a cursory look, they leave the balance sheet to the bankers, since that is a much more useful tool for valuations.
How To Read Financial Statements
Now that you have a handle on the different types of financial statements, let’s take a closer look into how to read them! In order to fully grasp the financial position of any company, you need to be able to review and analyze the following reports.
How to Read a Balance Sheet
Balance sheets are used as a quick way to capture the equity in a company by looking at both assets and liabilities. Knowing how to read a balance sheet is not difficult - they are one of the simplest financial statements. The balance sheet is set up as a basic equation.
ASSETS + (LIABILITIES) = EQUITY
Assets include anything the company owns that has value. This includes physical things such as property or equipment, as well as intangible assets like trademarks and patents. Liabilities are what the company owes to other entities i.e. debt, rent, payroll owed to employees, or taxes.
A good way to think of equity is as a company’s net worth. Equity is the value the company would receive if it sold all its assets and paid off all liabilities. When reading a balance sheet, you can simply look at the bottom line to see the equity. This information is useful, but it only gives you a piece of the picture. For operational details, you need to turn to the Income Statement or Cash Flow Statement.
How to Read an Income Statement
In order to understand how to read an income statement, you need to be aware that this report shows you how profitable a business is over any given period of time. The frequency of reporting is generally weekly, monthly, or yearly. Consultants (and others) regularly check income statements to understand whether a company is profitable. They also use them to see how much money is spent to produce a product. Here is the information that is typically included in an income statement:
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- Revenue: The amount of money taken in
- Cost of goods sold (COGS): The total amount it costs to make a product
- Gross profit: Total revenue minus COGS
- Operating Expenses: The cost of operational activities not directly tied to the cost of producing what the company sells
- Operating Income: Gross profit minus operating expenses
- Net income: Income after subtracting operating expenses from gross profit and removing taxes owed
- Earnings per share (EPS): This takes the net income and divides it by the number of outstanding shares
- Depreciation: Subtracts the extent to which the assets of the company (such as production equipment) have lost value
- EBITDA: Earnings before interest, taxes, depreciation, and amortization
If you can familiarize yourself with these terms, you are well on your way to knowing how to read a profit and loss statement - another name for the income statement. As you look at this information, you can determine trends and whether or not a business is truly profitable. Knowing this information gives you the ability to pivot, as well as forecast and plan for the future.
How to Read a Cash Flow Statement
Simply put, cash flow statements help you understand how much cash is moving in or out of a business during a specified time period. This is important because it gives you an idea of the company’s ability to operate effectively (both short and long term) based on how much is coming in and going out.
Cash flow statements aren’t utilized by every type of business, but they are important for businesses that use an accrual accounting method. Accrual accounting includes revenue and expenses that may not have been received or paid by the business yet but are promised.
Knowing how to read a cash flow statement begins with understanding the three sections typically represented:
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- Cash Flow from Operating Activities: cash flow that comes from delivering your product or service – both revenue and expenses
- Cash Flow in Investing Activities: This is cash flow from selling or purchasing assets – usually physical assets
- Cash Flow from Financial Activities: This section shows details from financing both debts and equity
The benefit of the cash flow statement is that it provides a snapshot of the business that the balance sheet and income sheet don’t give. It shows you the cash you have on hand at any given moment.
How to Read an Annual Report
Finally, we’ll discuss how to read an annual report. The SEC requires public corporations to publish an annual report that shows stakeholders the current state of the company – both operational and financial. As you’ll find, annual reports are much glitzier than their financial statement cousins – these documents are part financial statement, part marketing collateral.
Annual reports incorporate all the other statements along with additional editorial information that tells the story of the company. This could be in images, statistics about achievements or performance, a description of corporate activities, and sometimes a letter from the CEO.
Essentially, the annual report answers the question, “What were we trying to achieve this year, and did we achieve it?” Furthermore, the annual report tries to convince stakeholders to keep or increase their shares in the company.
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Understanding Financial Statements
No matter what role you play in a business or corporation – employee, investor, consultant, or owner – it is critically important to be able to understand financial statements. They give you the information and the tools to make wise decisions about the future. Knowing how to read, understand and analyze various financial statements will equip you to be a more well-rounded leader, entrepreneur, or consultant. You will be well on your way to standing out among your peers as someone who is able to make well informed decisions and lead others to do the same!
Additional Reading:
- Case Interview: Complete Prep Guide
- Investment Banking Financial Models vs. Consulting Financial Models
- Consulting Exit Opportunities: 28% of Management Consultants Pursue Finance
- Financial Terms Guide