How to Prepare Financial Statement and Balance Sheets
A formal record of a company, organization, or individual's financial activities and position is referred to as a financial statement. It summarizes financial transactions, performance, and financial health over a specific period. Financial statement analysis involves a comprehensive examination of a company’s financial statements, including the income statement, balance sheet, and cash flow statement. In order to assess a company's financial health and performance, analysts look at revenue, earnings, assets, liabilities, and cash flow.
Types of financial statements
The cash flow statement, the balance sheet, and the income statement are the three primary financial statements.
The Balance Sheet
One of the most fundamental financial statements, a balance sheet depicts a company's financial situation at a particular time. It describes a business's assets (liabilities), debts (assets), and shareholders' equity (the difference between assets and liabilities). It shows how much a company owns compared to how much it owes, providing a snapshot of the company's current financial health. The balance sheet is used by investors, creditors, and analysts to evaluate a company's ability to pay its debts, overall financial strength, and growth potential. It helps in comparing a company’s performance over time or against competitors within the same industry The balance sheet assessment reveals a company’s liquidity through current and quick ratios. A company's ability to meet its financial obligations may be indicated by a strong liquidity position, which indicates sufficient current assets to cover short-term liabilities. Companies with healthy liquidity positions might be considered more favorable for investment due to their ability to navigate short-term challenges. Balance Sheet indicates the amount of debt a company carries. Low debt may indicate financial stability, while high debt may indicate danger. Whether investors are looking for long-term growth, short-term gains, or a balanced investment portfolio, balance sheet analysis enables them to make informed decisions regarding a company's financial health and performance. Investors examine the adequacy of current assets to cover short-term obligations using leveraging ratios like the current ratio to assess liquidity from the balance sheet. The debt structure, its impact on the company's risk profile, and the debt-to-equity ratio should all be closely examined given the weight that debt levels carry. Additionally, investors analyze asset quality, seeking insights into the composition and efficiency of assets in generating revenue. Liquidity, Solvency, Efficiency, and Valuation ratios are all derived from a balance sheet. Assessments of a company's short-term financial health are aided by liquidity ratios like the current and quick ratios, which provide insight into the company's capacity to meet short-term obligations. Leverage ratios such as the debt-to-equity and debt ratio highlight a company’s reliance on debt financing, aiding in gauging financial risk. Efficiency ratios like the asset turnover ratio reveal how effectively a company utilizes its assets to generate revenue, while profitability ratios such as ROA and ROE unveil its ability to translate these assets into profits. A stock's undervaluation or overvaluation in relation to its book value can be determined using valuation ratios like the P/B ratio. These ratios, which are taken from the balance sheet, provide investors with crucial insights into the performance, risk exposure, and potential returns of a company. They are the foundation for making well-informed investment decisions. keeping track of changes over time and comparing them to industry norms is a further evaluation that, in the end, guides their investment decisions. Financial Statement An income statement, also known as a profit and loss statement, is a financial report that summarizes a company’s revenues, expenses, and profits (or losses) over a specific period.
The income statement
It provides valuable insights into a company’s financial performance, indicating its ability to generate profit, manage expenses, and operate efficiently over a specific period. This statement is used by investors, analysts, and stakeholders to evaluate the profitability and financial health of the business. Income Statements provide a snapshot of a company’s financial performance by detailing its revenues, expenses, and overall profitability over a specific period.
Investment decisions are guided by ratios derived from the income statement, which provide crucial insights into a company's financial health. Metrics like profit margin unveil a company’s efficiency in generating profits from sales, influencing investor confidence. The profit Margin ratio shows the company’s profitability by indicating how much profit is generated from each dollar of sales. A higher profit margin indicates better cost management efficiency and increased earnings potential, both of which can have a positive impact on investment decisions. Return on Assets (ROA) measures how effectively a company uses its assets to generate profit. It shows how effectively the company uses its resources. A higher ROA is generally favored by investors because it indicates better asset management to generate profits. A company's ability to profit from shareholder equity is measured by its ROE (Return on Equity). It demonstrates the company's efficiency in reinvesting shareholder funds. Higher ROE is often seen as a sign of efficient utilization of shareholders’ investments and can positively influence investment decisions. Earnings Per Share (EPS) reflects the company’s profitability on a per-share basis. It’s a crucial metric for investors as it indicates how much profit a company makes for each outstanding share. Higher EPS can make a company more attractive to investors seeking profitable opportunities. The price-earnings (P/E) ratio compares a company’s current share price to its earnings per share. It helps investors assess the company’s valuation. A higher P/E ratio might indicate that investors expect higher earnings growth in the future, while a lower P/E ratio might suggest undervaluation. Operating margin measures the proportion of revenue that remains after covering variable costs of production. It demonstrates how effectively the business manages its operating costs. Investors generally prefer a higher operating margin. The debt-to-equity ratio compares a company’s total debt to its shareholders’ equity. It suggests that the business relies on debt financing. A lower debt-to-equity ratio is often preferred, suggesting lower financial risk and better financial health. A company's performance, profitability, efficiency, and financial health can all be evaluated using these ratios.
Cash Flow Statement
A cash flow statement is a financial report showing the cash inflow and outflow within a company over a specified period. Because it reveals a company's capacity to manage debt, invest in growth, generate cash from operating activities, and provide returns to shareholders, cash flow analysis is an essential component of fundamental analysis. It offers insights into the company’s cash position, which is vital for its sustainability. Companies exhibiting stronger financial health and better cash flow management are often preferred in investment decisions. The CFS helps evaluate a company’s ability to meet its short-term obligations. Investors can assess how the company manages its cash flow from operating, investing, and financing activities. Negative trends or inconsistencies in cash flow can signal underlying problems within the company, such as issues with sales, high debt, or inefficient operations. Consistent positive cash flow from operations indicates a healthy and sustainable business model.
Cash flow can be divided into three sections based on their sources and uses of cash: operating activities, investing activities, and financing activities. The operating section reveals the cash generated or utilized by the core business operations, encompassing sales, expenses, and taxes. In the meantime, the investing section provides insight into the cash flow generated by asset investments like equipment or property. Last but not least, the financing section explains how capital structure-related cash moves through things like stock issuance, dividend payment, and loan acquisition. This statement is crucial for investors and stakeholders because it reveals a company's capacity to generate cash and meet its financial obligations in addition to profitability. For investment strategies, ratios derived from the Cash Flow Statement (CFS) are helpful.
• Operating Cash Flow Ratio:
Assesses a company’s ability to generate cash from its core operations, often calculated as Operating Cash Flow divided by Total Debt. A higher ratio indicates a better capability to cover debt obligations from operating activities.
• Free Cash Flow (FCF) Yield:
FCF Yield measures the cash generated after accounting for capital expenditures. It’s calculated as FCF divided by Market Capitalization. A company's potential value to investors is indicated by a higher FCF Yield, which indicates that the business generates a lot of cash in relation to its market value.
• Interest Coverage Ratio and Debt Service Coverage Ratio
Interest Coverage Ratio and Debt Service Coverage Ratio are two Cash Flow Coverage Ratios that evaluate a company's capacity to cover various obligations. Interest Coverage Ratio is measured by Operating Cash Flow divided by Interest Expense. It indicates how easily a company can cover interest payments. Debt Service Coverage Ratio is determined Operating Cash Flow divided by Total Debt Service. It gauges the ability to service all debt obligations.
What to include in an income statement? The profit and loss statement, also known as the income statement, is typically regarded as the most significant. It gives investors and management a clear picture of your profitability over time and can help them evaluate your employees' performance. Said simply, income statements build confidence by surfacing trends and financial health metrics.
This statement looks at metrics that provide a holistic assessment of the company's financial performance (think revenue and profitability). It's helpful in evaluating specific strategies implemented during the reporting period.
1. Determine your trial balance
A trial balance is a critical part of your accounting system. It lists the balances of all general ledger accounts at a specific point in time.
Typically prepared at the end of an accounting period, the trial balance helps ensure accounting entries are recorded accurately and verifies the equality between debits and credits.
Since the adjusted trial balance serves as the foundation for creating income statements, make any necessary adjustments.
2. Select the reporting period
First, choose the length of your reporting period. Depending on your objectives, you should create a monthly report if you want to make short-term changes. But a yearly report is better if you want to look at long-term trends or get a high-level overview of the company's finances.
3. Find out the gross profit
Gross profit tells you how efficiently you produce the products you sell. Subtract COGS from net sales (the total sales made during the period) to determine gross profit.
4. Determine the cost of selling the goods
Cost of goods sold (COGS) refers to the cost of producing products sold by your business. You need to calculate COGS to understand the actual profit you're earning.
Payroll costs for employees who are directly involved in production, production-related materials, and overhead related to location and equipment are all included in this metric. Again, if you want your income statement to focus on a specific business segment, only include relevant costs.
5. Determine the costs
Operating expenses include standard costs like rent, supplies, and other overhead. It would not include anything directly related to producing the goods you sell—that would be included in COGS.
6. Determine revenue
Add up revenue for the given period. This includes operating income (i.e., income that comes from core business operations, like sales revenue) and non-operating income (i.e., revenue from external sources, like rentals or interest earned on your bank balance).
Your entire operation is not required to be evaluated in income statements. If you want your income statement to focus on a specific business segment, only include financial data related to that segment.
7. Find net income
To complete your income statement, you'll need your net income—the bottom-line item.
8. Determine taxes and interest
Total income is what the company takes home before accounting for taxes and interest payments. As a result, that figure is also known as the EBIT (earnings before interest and taxes). Now, we need to get a picture of your income that is more accurate. Take into account local, state, and federal income taxes, as well as any interest you owe on debt during the reporting period.
9. Estimate your total earnings
To calculate total income, simply subtract your operating expenses from your gross profit.
Since many of the metrics we've looked at in the past are used to calculate net income, it makes sense to do so last. Your company's ability to convert revenue into net profit can be seen in your profit and loss statement. To determine net income, take the income you calculated in step seven and subtract the taxes and interest you calculated in step eight. The result shows how much money your company has left over for the reporting period.
How to prepare a balance sheet
A company's financial health is shown in a balance sheet. It shows the relationship between what the company owns (assets) and what it owes (liabilities). This financial statement also includes the shareholders' equity in the business.
Here is an illustration of a balance sheet. Yours, of course, will look different than this, but the fundamental sections are there.
A closely related metric that's also included is retained earnings, or earnings that are not distributed as dividends to shareholders. Instead, they are put back into the business to boost growth, pay off debts, and other things. This helps maintain a healthy credit balance and supports the company's long-term financial stability.
1. Add up liabilities
Liabilities include accounts payable, wages, and accrued expenses, to name a few. Similar to assets, you should separate current liabilities (such as accounts payable and short-term loans) and long-term liabilities (such as bonds) in this section.
2. Add up the assets
Make a list of all your assets, including inventory, marketable securities, accounts receivable, cash and cash equivalents, and less liquid assets like property or machinery. Current assets (cash, accounts receivable, inventory), fixed assets (property, plant, and equipment), and other assets (investments, intangible assets) should be displayed in different categories for clarity's sake.
3. Determine shareholders' equity
The final section of your balance sheet will need retained earnings and shareholders' equity. The formula for shareholders' equity is as follows:
Total assets divided by total liabilities is shareholder equity. The balance sheet is called the balance sheet because the relationship between assets, liabilities, and equity must be "balanced." This is best represented by the famous accounting equation:
Assets = Liabilities + Shareholders' Equity
The shareholders' equity equation is the opposite of the accounting equation, as you probably noticed. Take a look at the balance sheet from the previous reporting period to determine the retained earnings. Find the retained earnings there, and add your net income for this reporting period. Subtract dividends, and you'll have your retained earnings for your new balance sheet.
What to include in a cash flow statement? The cash flow statement shows inflows and outflows of cash over a specific period, showing how cash is generated, used, and invested within the business.
1. Calculate cash flow from financing activities
Add up cash from sources such as issuing equity, borrowing funds, or capital contributions.
Next, add cash paid for purposes such as loan repayments, repurchasing company shares, or divided payments.
Subtract total cash outflows from total cash inflows to get your net cash flow from financing activities.
2. Determine the operating activities' cash flow
There are two options available when attempting to calculate cash flow from operating activities, also known as the cash flow generated by day-to-day core operations. The indirect method is a lot easier than the direct method. The income statement's net income serves as your starting point. Then, you add non-cash expenses (like depreciation and amortization) and subtract non-cash revenues (like gains on the sale of assets). Last but not least, you take into account changes in balance sheet accounts like inventory, accounts payable, and accounts receivable. In contrast, the direct method precisely records the actual cash flows into and out of specific operational activities. You would examine each individual cash payment and receipt. It can be a painstaking process since it looks at every transaction made in the reporting period.
3. Determine your initial cash balance
Helping to determine the company's current cash position is one of the primary purposes of cash flow statements. That said, knowing cash flows isn't very useful unless you're determining an ending balance; for that, you need your starting cash balance. It can be found at the very end of your prior cash flow statement.
4. Determine your final balance
To arrive at your final balance, add the outcomes for each kind of cash flow to the starting balance. By comparing each ending balance to the one before it, you can see how your cash flow has changed over time. This is useful.
5. Determine the cash flow from investments
Add up cash received from the sale of long-term assets, the sale of investments, and loans received from others.
Then, determine outflows by adding up cash paid for the purchase of long-term assets, purchase of investments, and loans made to others.
Your cash flow from investing activities will be calculated by subtracting the total cash outflows from the total cash inflows. In conclusion financial statements are critical for driving the insights needed to make intelligent, data-driven decisions that benefit the business. A simple and quick way to begin properly preparing effective financial statements is to follow the above steps. While financial statements can be created manually, the right accounting software can make it much easier to pinpoint the data you need and build financial statements from the ground up.