3 Reasons Why You MUST Understand Financial Statements

"Financial Statements? Naah! They're not for me. They're too complicated, full of jargon and don't make any sense, except to bankers or stockbrokers. Who needs to understand them anyway?"

Well, YOU DO!

Here's 3 reason's why you MUST understand Financial Statements: -

1. Knowing the 'stories' behind the numbers

Being able to understand Financial Statements (i.e. The Balance Sheet, Profit & Loss Statement and Cash Flow Statement) is extremely important as the numbers in the  Financial Statements tell a 'story' about the financial "health", profitability and the cash flows of a business or company.

It also allows you to track the performance of one company over a few years as well as compare the performance of two companies over the same year. So remember, Financial Statements are not only published for the 'entertainment' of bankers and stockbrokers! You should use them too!

2. Making informed business decisions

If you are a business owner, understanding Financial Statements not only allows you to know how your business is doing (e.g. is it making profit or losing money), it also allows you to assess the current situation of the business and decide on the future plans to improve it. For example you might like run some cost cutting measures or control your business' finances.

Many business owners tend to shy away from understanding their Financial Statements, but they must realise that it is actually the key to understanding your business.

3. Investing based on facts, not feelings

Many stock investors enter into investing decisions (buy, sell or hold stock) based on news or rumours they've heard in the marketplace, or based on their own "gut feeling". Investing this way may sometimes bring huge profits but it may also bring huge losses, and clearly not sustainable in the long run. 

Warren Buffett was once asked "How do you know what stock to buy?" He answered "I read the financial statements!".

A very important part of every stock investor's research is using financial statement data and doing the something called "Fundamental Analysis". "Fundamental Analysis" is a technique that attempts to determine a stock's value by focusing on underlying factors that affect a company's actual business and its future prospects. Part of this technique involves Financial Ratio Analysis.

Are you a busines owner who wants get a feel of how "healthy" your busines or company is?

Are you a stock investor who needs a simple but effective tool to supplement your Fundamental Analysis?

"The DIY Financial Ratio Analysis Template" is designed to assist you in calculating and assessing the "health" of a company through financial ratio analysis.

The Template will allow you to: -

1. Calculate and assess 16 key financial ratios split into 4 categories: -

• Liquidity & Solvency ratios
• Efficiency ratios
• Profitability ratios
• Cash Flow Ratios

2. View key ratios in graphical format for easy visualisation

3. Assess the overall financial "health" of a company by assigning one of the following ratings: -

• Very Strong
• Strong
• Average
• Weak

4. Compare the assessment and ratings of up to 3 companies at the same time

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3 Reasons Why You DON'T Need To Hire An Accountant

If you own a small business and someone asks you to prepare your own accounts and financial statements, what thoughts would go through your mind?

"I don't think accounting is for me, it's too complicated and I don't understand it!"

"I don't want to get involved in all those messy numbers and figures!"

"I don't want to learn all those Debits and Credits, what a waste of time!"

"I don't have time for this!"

So what do you do? You go out and hire an accountant to prepare your accounts for you. The accountant then charges you a fee, which is an extra cost to your business.

But wait! Is there another way?

Well, YES!

You actually DON'T need to hire an accountant and here's 3 reasons why: -

1. Your business is small and simple

If you own a small and simple business, then there's a strong chance that you don't need to hire an accountant because you can easily prepare your accounts and financial statements on your own. Small businesses tend to have a limited number of transactions per month which can be easily recorded and self-managed. You can literally DIY it!

2. Be in control of your own business finances

Preparing your own accounts and financial statements will give you a great overview of your business and allows you to be in control of your business finances. You will know the financial impact of every transaction and be able to make the right business decisions. Why give all that information to someone else, like say, an accountant, when you can DIY it?

3. Save money

Accountants may charge a substantial fee just to prepare a simple set of accounts and financial statements for your business. This cost may not justified as you could save that money and reinvest it to grow your business. If your business is small and simple, then preparing accounts shouldn't cost you a fortune. DIY it and watch the savings come through!

"Great! I don't need an accountant to prepare my accounts! I will DIY it! But where do I start?"

Everyone knows that to build a piece of furniture, you'll need the right tools (hammer, nails, screwdriver etc). Likewise, to prepare your accounts and financial statements, you'll need the right tools!

"The DIY Accounting Template" is designed to assist owners of small and simple businesses (for example, buying and selling trendy clothes on the Internet, selling tasty hot dogs at a food stand, selling unique paintings at a flea market, baking and selling custom-made cakes etc) in preparing their accounts and financial statements.

You may purchase this spreadsheet for only a fraction of the cost of hiring an actual accountant.

The Template will allow you to: -

1. Prepare and record a monthly transaction list - No worrying about double entries or DEBITS and CREDITS, it's all done automatically!

2. Keep track and manage your stock balances - How much stock do I have left?

3. Keep track and manage your customer balances - Who owes me money?

4. Keep track and manage your supplier balances - Who do I owe money to?

5. Get an overview of your sales by customer - Who are my top 5 largest customers by sales value?

6. Get an overview of my business expenses - Where did I spend most of my expenses on?

7. Generate your year end financial statements - The Balance Sheet and Profit & Loss Statement, all done automatically!

You will also receive online support via email from a qualified accountant, who will guide and assist you if you have any questions.

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Lesson #15 - Financial Ratios - How "Healthy" Is A Company Or Business?

Ever wondered how "healthy" a company or business is?

Just like a medical healthcheck has various indicators like heart rate, blood pressure, cholesterol levels etc, Financial Ratios are the indicators for a company or business. Ratios tell us whether the company or business is in great health or has critical health issues.

It also gives us a better overview of how the company or business is actually performing. In short, it helps us see the "Bigger Picture".

Great! So, where do I start?

Your starting point is knowing what Financial Ratios are, how to calculate the Ratios and what 'stories' these Ratios tell us.

The beauty of it is - All the figures required for calculating these ratios can be found inside the 'BIG 3' Financial Statements - The Balance Sheet, The Profit And Loss Statement and The Cash Flow Statement!

Tell me! Tell me! What are these "Ratios"?

Financial Ratios can be divided into 4 broad categories. These categories are presented below, together with the Ratios that sit within them. The purpose of each Ratio is then explained.

Liquidity & Solvency Ratios

Current Ratio

Current Ratio = Current Assets / Current Liabilities

It shows the company's ability to meet its short-term obligations. The higher the ratio, the better.

Quick Ratio

Quick Ratio = (Current Assets - Inventory) / Current Liabilities

Similar to the Current Ratio. It shows the company's ability to meet its short-term obligations but using its most 'liquid' assets (i.e. near cash or quick assets, excluding inventory which usually takes longer to be converted into cash). The higher the ratio, the better.

Wow! That was quick!

Debt To Equity Ratio

Debt To Equity Ratio = Total Liabilities / Shareholders' Equity

It shows how the company is funded i.e. by Debt or by Equity and used as a standard for judging a company's financial standing. Too much debt may be a problem as it ties the company to interest payments and repayment of its loans and borrowings. A good balance of Debt and Equity is recommended.

Debt Ratio

Debt Ratio = Total Liabilities / Total Assets

Similar to the Debt To Equity Ratio. It shows how much the company relies on Debt to finance its Assets. The lower the ratio, the better.

Interest Coverage Ratio

Interest Coverage Ratio = Operating Profit / Interest Expense

It shows how easily a company can pay interest on outstanding Debts (i.e. loans and borrowings). The higher the ratio, the better.

Efficiency Ratios

Days Sales Outstanding (DSO)

DSO = Trade Receivables / Revenue x 365

It shows how many days a company takes to collect cash from customers, after a sale has been made. The lower the number of days, the better.

Days Inventory Outstanding (DIO)

DIO = Inventory / Cost of Goods Sold x 365

It shows how many days a company takes to sell its inventory. The lower the number of days, the better.

Days Payables Outstanding (DPO)

DPO = Trade Payables / Cost of Goods Sold x 365

It shows how many days a company takes to pay its suppliers. The higher the number of days, the better.

Cash Conversion Cycle (CCC)

CCC = DIO + DSO - DPO

It shows the combined effectiveness of the company to collect cash from customers, convert inventory into cash and to pay its suppliers. The lower the number of days, the better.

Profitability Ratios

Revenue Growth

Revenue Growth = Current period Revenue / Prior period Revenue

It shows how much revenue has grown in the current period compared to the prior period. The higher the ratio, the better.

Return On Assets

Return On Assets = Net Income / Total Assets

It shows how effective the company is at using its assets to generate profits. The higher the ratio, the better.

Return On Equity

Return On Equity = Net Income / Shareholders' Equity

It shows how effective the company is at using the money invested by shareholders to generate profits. The higher the ratio, the better.

Net Profit Margin

Net Profit Margin = Net Income / Revenue

It shows how much each dollar of revenue earned is translated into profits. The higher the ratio, the better.

Cash Flow Ratios

Operating Cash Flow

Operating Cash Flow = Cash Flows From Operating Activities / Revenue

It shows how many dollars of cash you get for every dollar of sales. The higher the ratio, the better.

Asset Efficiency

Asset Efficiency = Cash Flows From Operating Activities / Total Assets

It shows how well the company uses its assets to generate cash flow. The higher the ratio, the better.

Cash Generating Power

Cash Generating Power = Cash Flows From Operating Activities / [Cash Flows From Operating Activities + Cash Flows From Investing Activities (Total of inflows only) +

Cash Flows From Financing Activities (Total of inflows only)]

This is a complex ratio but probably one of the most powerful, hence its name!

It shows the company’s ability to generate cash purely from operations compared to the total cash inflow (i.e. ignoring cash outflows).

Note that instead of using both cash inflows and outflows
from Investing activities and from Financing activities, only cash inflows are used. Cash outflows are excluded. The higher the ratio, the better.

On that note, let's take you back to the 90's with a song called "The Power" by Snap!

Enjoy!

Lesson #14 - The Third Statement - THE CASH FLOW STATEMENT

The Cash Flow Statement shows us the inflows and outflows of cash that a business or company made over a period or duration of time, e.g. a year (12 months), a quarter (3 months) or a month.

It shows us how much Cash the business or company generated, where the Cash comes from and how the Cash was spent.

The Cash Flow Statement is probably the most important Statement as a business cannot survive without Cash. Although Profits are important and may usually be the focal point, the core engine behind a business is actually Cash.

Cash creates Profits. Profits do not create Cash! As the saying goes - "CASH IS KING!"

The Cash Flow Statement, as its name suggests, is made up primarily of Cash (which is 'obviously' an ASSET).

The Cash Flow Statement is divided into 3 main parts: -

Part 1 - Operating Activities
This part shows the cash inflows generated by and the cash outflows used in relation to activities performed as part of the main principal activities or day-to-day operations of the business.

Part 2 - Investing Activities
This part shows the cash inflows generated by and the cash outflows used in relation to purchase and sale of fixed assets (e.g. machinery, tools, equipment etc) as well as purchase and sale of investments (e.g. shares in the stock market, bonds, treasury notes etc).

Part 3 - Financing Activities
This part shows the cash inflows generated by and the cash outflows used in relation to debt (e.g. loans, bank borrowings) or equity (e.g. cash raised through issuance the company's shares in the stock market).

Here's an example of a Cash Flow Statement.

To wrap it up, here's "All 'Bout the Money" by Meja.

Enjoy!!!

Lesson #13 - The Second Statement - THE PROFIT AND LOSS STATEMENT

The Profit And Loss Statement (also known as The Statement of Financial Performance or The Income Statement) shows us how much profit or loss the business made over a period or duration of time, e.g. a year (12 months), a quarter (3 months) or a month.

In other words, did the company or business make money or lose money?

The Profit And Loss Statement made up of REVENUE and EXPENSES.

So, here's another equation for you: -

Profit or Loss = REVENUE - EXPENSES

If REVENUE > EXPENSES = Profit!

If EXPENSES > REVENUE = Loss!

Here's an example of a Profit And Loss Statement.

Unlike the Balance Sheet which gives a "snapshot" of ASSETS, LIABILITIES and EQUITY at a fixed point in time, the Profit and Loss Statement gives an overview of the REVENUE and EXPENSE "flows" over a duration of time (just like a river flowing into a lake).

As REVENUE and EXPENSES flow just like a river in The Profit And Loss Statement, let's listen to Billy Joel's "River of Dreams".

Enjoy!!!

Lesson #12 - The First Statement - THE BALANCE SHEET

The Balance Sheet (also known as The Statement of Financial Position) shows us the position or net worth of the company or business at a particular point in time (e.g. a year, a quarter or a month). A snapshot!

I'm sure I look better without that cowboy hat on!

The Balance Sheet is made up of ASSETS, LIABILITIES and EQUITY, where the elements are presented true to THE ACCOUNTING EQUATION.

If you recall, the ACCOUNTING EQUATION is as follows: -

EQUITY = ASSETS - LIABILITIES

When you spin it around, the following equation is also true...

ASSETS = LIABILITIES + EQUITY

Here's an example of a Balance Sheet.

Remember - The Balance Sheet is always in balance, and never out of balance. In other words, there should be no differences arising.

Let's allow The Wallflowers to solidify this with a song called "The Difference".

Enjoy!!!

Lesson #11 - The 3 Financial Statements That You MUST Know - An Introduction

You may have heard of something called "Financial Statements".

If you ever wondered how a company or business is doing financially, how well or profitable it is, or how healthy it is then the Financial Statements is a good place to start.

They show you how well the money of a company or business is managed, where the money came from, how the money was spent and where the money is now.

In a nutshell, they "SHOW YOU THE MONEY!!!"

There are 3 main Financial Statements, let's call them the "BIG 3".

They are:

1. The Balance Sheet

2. The Profit and Loss Statement

3. The Cash Flow Statement

If you recall the 5 Accounting Elements in the earlier posts, the Elements "live" inside these Statements. Think of each of the Statements as a "house" and the Accounting Elements as its "bricks".

1. The Balance Sheet contains ASSETS, LIABILITIES and EQUITY.

2. The Profit and Loss Statement contains REVENUE and EXPENSES.

3. The Cash Flow Statement contains only CASH (which is actually an ASSET).

We'll talk more about each of these statements in detail later on but in the meantime, let's listen to a song called "Money" by Pink Floyd.

Enjoy!!!