What are the financial records and how to analyse them?

A business keeps financial records to monitor and control its performance. Financial records are a legal requirement for limited liability companies and are used to calculate any taxes to be paid by a business. In this article, I discuss the financial records, tips to improve performance and the financial ratios to analyse these records.

What are the financial records?

Financial records include the income statement, balance sheet and the cash flow statement. The income statement shows the profit or loss made by a business during a specific period, usually over one fiscal year and provides evidence of the performance and efficiency of the business. The income statement lists revenues, expenses and profit or loss made. The balance sheet shows the net worth of a business on a particular date, and the net worth of the company represents the end balance of equity after deducting any liabilities. Moreover, the balance sheet comprises the current assets, current liabilities, fixed assets, loans and equity and provides details of what a business owns and owes on a particular date. Cash flow statement shows the movement of money both in, i.e. The sources of cash, and out, i.e. The uses of cash, of the company. These sources of cash flow include profit, sold inventory, collected receivables or sold assets. Whilst the uses of cash flow can be in the form of paid expenses, building up inventory, increasing receivables, buying equipment or paying suppliers. The cash flows of a firm come from the operation of the business, investment, financing and equity. Cash flow from operation shows cash flow sourced or used in the operating accounts, and cash flow from investments is made up of buying or selling assets or investments. Cash flow from the finance represents loans received and repayments, and cash flow from the equity shows issuing or buying out ordinary shares or paying dividends to shareholders.

Tips for improving cash flows and profitability

There are many ways to improve cash flows including, increasing net profit, reducing the working capital, controlling debts and managing the equity. Increasing profit includes growing revenues and controlling expenses, and reducing the working capital involves shortening credit facilities offered to customers, decreasing inventory or increasing credit terms on payments to creditors. Controlling debts involves setting bars for the level of the leverage ratio, deciding on the most economical deals of loans funding and agreeing on a suitable paying schedule. Moreover, managing equity can help to improve cash flows by issuing common shares, purchasing back of common shares and distributing dividends. Besides, improving productivity and efficiency of the enterprise can lead to improving cash flows and this process can be achieved by training and leadership of staff and reducing wastes through better management of resources.

Ratio analysis

This is a quantitative analysis of a business’s performance and involves using data from current and historical financial statements. A company conducts a ratio analysis to compare its performance over time and discover its strengths and weaknesses. For example, a company assesses its performance to see, whether it is improving or deteriorating. A company also compares its performance with the industrial sector and other companies. There are many sets of ratio groups including liquidity, solvency, profitability, efficiency and market prospect ratios. Liquidity ratios measure the company’s ability to pay off its short-term debts using current or quick assets and include the current ratio, quick ratio, and working capital ratio. While, solvency ratios compare the company’s debts with its assets, equity, and earnings and check the company’s ability to pay its long-term debt and interests. They include the debt-equity ratio, debt-assets ratio and interest coverage ratio. Profitability ratios show how well a company can generate profits from its operations, and include profit margin, gross margin, return on assets and return on equity. Efficiency ratios evaluate how well a company uses its assets and liabilities to generate sales and maximize profits. Key efficiency ratios are the asset turnover ratio, inventory turnover and days’ sales in inventory. Market prospect ratios determine earnings and predict the market value of stocks and include dividend yield, Price/Earning P/E ratio, earnings per share and dividend payout ratio. Ratios can be judged against the industry benchmarks and business targets.

Final note

This article is extracted from my new book- Mastering Enterprise Skills for Potential Entrepreneurs, which can be found on www.amazon.co.uk. If you want to receive more information about the book and our activities, you can register in our newsletter by using this link.