Category: Internet Business

How to analyze a financial statement

It’s obvious financial statement have a lot of numbers in them and at first glance it can seem unwieldy to read and understand. One way to interpret a financial report is to compute ratios, which means, divide a particular number in the financial report by another.

Financial statement ratios are also useful because they enable the reader to compare a business’s current performance with its past performance or with another business’s performance, regardless of whether sales revenue or net income was bigger or smaller for the other years or the other business. In order words, using ratios can cancel out difference in company sizes.

There aren’t many ratios in financial reports. Publicly owned businesses are required to report just one ratio (earnings per share, or EPS) and privately-owned businesses generally don’t report any ratios. Generally accepted accounting principles (GAAP) don’t require that any ratios be reported, except EPS for publicly owned companies.

Ratios don’t provide definitive answers, however. They’re useful indicators, but aren’t the only factor in gauging the profitability and effectiveness of a company.

One ratio that’s a useful indicator of a company’s profitability is the gross margin ratio. This is the gross margin divided by the sales revenue. Businesses don’t discose margin information in their external financial reports. This information is considered to be proprietary in nature and is kept confidential to shield it from competitors.

The profit ratio is very important in analyzing the bottom-line of a company. It indicates how much net income was earned on each $100 of sales revenue. A profit ratio of 5 to 10 percent is common in most industries, although some highly price-competitive industries, such as retailers or grocery stores will show profit ratios of only 1 to 2 percent.




Making Your Accounting Principles Acceptable




It would be very easy for an employee to expect fair treatment from professionals within the company s/he’s employed with. To expect them to act within the precepts of the Golden Rule: “Do Unto Others as You Would Have Them do Unto You” which, if company management were to engage in such honorable behavior, workers would have little or nothing to worry about. But that’s not the case and therefore principles and systems must be employed.

If everyone involved in the process of accounting followed their own system, or no system at all, there would be no way to truly tell whether a company was profitable or not. Most companies follow what is commonly referred to as GAAP (Generally Accepted Accounting Principles), and there are huge tomes in libraries and bookstores devoted to just this one topic.

Unless a company states otherwise, anyone reading a financial statement can make the assumption that company has used GAAP. If GAAP is not the set of principles used for preparing financial statements, then a business needs to make clear which other form of accounting they have used and are bound to avoid using titles in its financial statements that could mislead the person examining it.

GAAP is the gold standard for preparing financial statements and/or a financial report. Not disclosing that it has used principles other than GAAP makes a company legally liable for any misleading or misunderstood data. These principles have been fine-tuned over decades and have effectively governed accounting methods and the financial reporting systems of businesses.

Different principles have been established for different types of business entities, such as for-profit and NFP (Not For Profit) companies/organizations, governments and other enterprises. GAAP is not cut and dried, however. They’re guidelines and, as such, are often open to interpretation. Estimates have to be made at times, and they require good faith efforts towards accuracy.

You have probably heard the phrase “creative accounting,” which is when a company pushes the envelope a little (or a lot) too far to make their business look more profitable than it might actually be. This is also known as massaging the numbers, a practice that can spiral out of control and quickly turn into accounting fraud (or cooking the books). The results of these practices can be devastating and ruinous to hundreds and thousands of lives, as in the cases of Enron, Rite Aid and others.