Let’s walk through each of these statements piece by piece, using examples. Then, we can use some basic financial ratios to see how your business is performing.
What are financial statements?
There are three basic financial statements your business might use: the balance sheet, the income statement, and the cash flow statement. If you’re brand new to financial reporting, check out our comprehensive article on financial statements—then head back here to learn how to analyze them with financial ratios.
What are financial ratios?
Financial ratios represent your company’s financial performance in different categories—for instance, how well it can cover its debts, or how much profit it’s earning.
You use these ratios by plugging your financial information into formulas. There are different formulas—meaning, different ratios—you can use according to which financial statement you’re analyzing.
Financial advisors, investment gurus, CPAs, and authors of corporate annual reports may employ Einstein-level calculations to help their clients plan how to spend money. But in this guide, we’ll look at the most straightforward, essential ratios business owners use to analyze their companies’ financial statements and make day-to-day business decisions.
How to read a balance sheet
Your balance sheet tells you how much value you have on hand (assets) and how much money you owe (liabilities). Assets can include cash, accounts receivable, equipment, inventory, or investments. Liabilities can include accounts payable, accrued expenses, and long-term debt such as mortgages and other loans.
Example balance sheet
Parts of a balance sheet
ASSETS include all the value you have on hand. Some of it is cold hard cash—like the business bank account line item in the example above, which holds $20,000. Some of it is less liquid, like equipment or inventory. And some may not even be in your hands yet—accounts receivable, or payments you’re due to receive.
LIABILITIES cost you money. Subtracting them from your assets gives you a rough idea of how much value your business really has to work with. In the example above, accounts payable—typically payments to vendors or contractors—could be considered a short term liability; you’ll probably pay them off each month. Other liabilities, like business loan debt, stick around longer.
OWNER’S EQUITY is the money that you, the owner, has sunk into the business. Capital is your initial investment, the money you used to get up and running. Retained earnings is the profit your business has held onto. And drawing, or owner’s draw, is the money you pay yourself from your business. (For the sake of tidy accounting and liability, you shouldn’t use your company’s retained earnings as a personal spending account.)
Analyzing a balance sheet with financial ratios
These three financial ratios let you do a basic analysis of your balance sheet.
- Current ratio
To calculate the current ratio, use this formula:
Current Ratio = Current Assets / Current Liabilities
If we use the example above, the calculation looks like this:
Current Ratio = 36,000 / 11,000 = 3.27
Meaning a ratio of 3.27:1 (assets:liabilities).
Your current ratio shouldn’t dip far below 2:1; if it’s less than 1:1, you don’t have enough current assets on hand to cover your short-term debts, and you’re in a tight position. The higher your ratio, the better able you are to cover liabilities.
- Quick ratio
The quick ratio (also called the acid test ratio) is like the current ratio—it measures how well your business can pay off its debts. However, it only looks at highly liquid assets, such as cash or assets that can easily be converted to cash—that is, money you can get your hands on quickly.
To calculate the quick ratio, use this formula:
Quick Ratio = (Cash and Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
Using the example above, the total number of cash and cash equivalents, plus accounts receivable, is $24,000. (Chelsea’s Ceramics doesn’t have any marketable securities.)
We don’t include the equipment line item in these assets, because selling off equipment isn’t a quick way to raise cash.
So, the formula looks like:
Quick Ratio = 24,000 / 11,000 = 2.18
Or a ratio of 2.18:1 (quick assets:liabilities).
So long as your quick ratio is 1:1 or higher, you’re doing well; you’ve got enough easy-to-liquidate assets to cover all your debts.
- Debt to equity ratio
The debt to equity ratio tells you how much your business depends on equity versus borrowed money.
To calculate your debt-to-equity ratio, use this formula:
Debt to Equity Ratio = Total Debt / Owner or Shareholders’ Equity
Using the example above, we include the long-term debt, but not accounts payable, in the calculation.
So, our formula looks like this:
Debt to Equity Ratio = 10,000 / 25,000 = 0.4
Or a ratio of 0.4:1 (debt:equity).
In this case, Chelsea’s doing well. A 4:1 debt:equity ratio is considered acceptable. With all her retained earnings, Chelsea is able to run her business largely using her own money.
How to read an income statement
Your income statement tells you how much money your business has spent, and how much it has earned, over a financial reporting period. That lets you calculate your net profit—the bottom line.
The reason it’s called the bottom line is because net profit is at the bottom of your income statement. As you work down your income statement, more and more expenses get applied to your revenue, meaning your income line item becomes more and more specific.
Example income statement
Parts of an income statement
Sales revenue, the top line, is all the money that has come into the business during the month, before taking any expenses into account.
Cost of Goods Sold (COGS) is the money Erin spent in order to earn her sales revenue. For a retail business like Erin’s, that’s typically the wholesale cost of products.
Gross profit is Erin’s income, after subtracting COGS, but without taking general expenses into account.
General expenses includes money Erin has to spend on a monthly basis to keep her business running and making sales. Some of these, like rent, will be the same month to month. Others, like utilities and office supplies, may fluctuate.
Operating earnings (or EBITDA—Expenses Before Interest, Taxes, Depreciation, and Amortization)—equals the total amount Erin takes home after subtracting expenses from her revenue, but before taking into account any taxes or interest on debt she needs to pay.
Income tax expense is the cost of estimated income tax paid or owed for the reporting period. Along with interest payments (which Erin doesn’t have), this is part of the IT in EBITDA.
Net profit is the total amount the business has earned, after taking all expenses into account, including tax and interest.
Further reading: Gross Profit vs. Net Profit: Understanding Profitability
Analyzing an income statement with financial ratios
There are three key financial ratios you can use to analyze your income statements. All of them calculate different profit margins—the relationship between revenue and expenses.
- Gross profit margin
Your gross profit margin is how much money your business makes per dollar earned, only taking into account COGS. You can increase this margin by lowering COGS—saving money on the wholesale cost of goods and services—or by raising prices…
To calculate gross profit margin, use this formula:
Gross Profit Margin = (Sales Revenue – COGS) / Sales Revenue
Using the example above, we get:
Gross Profit Margin = (9,000 – 4,000) / 9,000 = 0.55, or 55%
Erin’s gross profit margin is 55%, meaning she keeps $0.55 of every dollar earned as gross profit.
- Operating profit margin
Your operating profit margin is similar to your gross profit margin, but taking general expenses into account as well. You can increase this profit margin by raising prices, lowering COGS, or lowering operating expenses and overhead.
To calculate operating profit margin, use this formula:
Operating Profit Margin = Operating Earnings (EBITDA) / Sales Revenue
For Erin, that looks like this:
Operating Profit Margin = 2,750 / 9,000 = 0.31, or 31%
So, for every dollar she earns, Erin takes home $0.31, after taking EBITDA into account.
Typically, it’s the operating profit margin that you’ll focus on increasing in order to earn more profit. Interest and tax expenses aren’t usually something you can control. After all, Congress sets tax rates and interest rates are set by lenders. But EBITDA is determined by your own day-to-day operations—so your operating profit margin is the ratio you have the greatest control over.
- Net profit margin
The net profit margin is the relationship of your bottom line to your sales revenue; it’s the total amount you keep after taking every expense into account.
You calculate your net profit margin like this:
Net Profit Margin = Net Income / Sales Revenue
For Erin, that looks like this:
Net Profit Margin = 1,850 / 9,000 = 0.21, or 21%
So, for every dollar she earns, Erin takes home $0.21.
How to read a cash flow statement
With the accrual method, expenses and income are recorded on the books when they’re incurred, not when the money actually changes hands. For instance, you may place a $1,000 order to a vendor; in that case, you’d immediately record it as a $1,000 expense—even if you won’t send money to the vendor until later, after you get an invoice.
Similarly, you may invoice a client $1,000, and record that as $1,000 accounts receivable, an asset. But you don’t actually have the money on hand yet—so, if you were to try and use it for a $1,000 purchase, the money wouldn’t be there.
A cash flow statement reverses those transactions where you don’t actually have cash on hand, so you get a real idea of how much cash you have to work with during a period of time.
Example cash flow statement
Parts of a cash flow statement
Keep in mind that numbers in brackets are subtractions of cash—you can read them as negative numbers. Numbers without brackets are additions.
Cash, beginning of period is the cash Suraya had on hand at the beginning of the month.
Net income is her total income for the month. Some or all of that income may be subtracted on the cash flow statement, depending how much of it is in accounts receivable (not paid) or in the bank (paid).
Additions to cash reverse expenses that are listed on the books, but haven’t been paid out yet. For instance, the $500 in accounts payable is money Suraya owes, but hasn’t paid. And the $200 depreciation is symbolic, for accounting purchases—she already paid out that $200 as part of the total cost of the asset she’s depreciating.
Subtractions from cash reverse any transactions that were recorded as revenue for the month, but not actually received. In this case, it’s $1,000 in accounts receivable.
Suraya’s net cash from operating activities is $700, meaning $700 cash came into her business during the month.
Cash flow from investing activities covers assets like real estate, equipment, or securities. Suraya bought a $500 sewing machine this month—an investment. This is recorded on the books as a $500 increase to her equipment account. However, she spent $500 cash to get it—meaning, the total cost needs to be subtracted.
Cash flow from financing activities lists money earned collecting interest on loans, credit, and other debt. It can also include draws or additional capital contributions from the business owner.
Cash flow for month ending March 31, 2020 is $200. That’s Suraya’s total cash flow from operations ($700) minus the cash she spent on equipment ($500). In total, she had $200 cash come into her business this month.
Cash at end of period is $2,200—her starting cash amount, plus the money she earned this month.
Analyzing a cash flow statement with financial ratios
Financial ratios for cash flow can tell you how much cash you have on hand to cover debt, as well as how much of your income you earned during the month was in the form of cash. Here are three formulas to help you do that.
- Current liability coverage ratio
The current liability coverage ratio tells you how much cash flow you have for a specific period versus how much debt you need to pay in the near future—typically, within one year’s time.
To use this formula, you need to calculate your current average liability. Your current liability can change month to month as you pay down the principle on a debt; calculating an average takes that into account, so you can get a ballpark figure.
Do that by taking all your current liabilities at the beginning of an accounting period, all your current liabilities at the end of a period, adding them together and dividing by 2.
Let’s say Suraya’s balance sheet shows total current liabilities of $1,000 at the beginning of March, and $900 at the end.
(1,000 + 900) / 2 = 950
So, her current average liability is $950.
Here’s the formula for calculating your current average liability ratio:
Current Average Liability Ratio =
Net Cash from Operating Activities / Average Current Liabilities
For Suraya, that would look like this:
Current Average Liability Ratio = 200 / 950 = 0.21, or 21%
A current liability coverage ratio of less than 1:1 shows the business isn’t generating enough cash to pay for its immediate obligations… In this case, Suraya’s business has room for improvement.
- Cash flow coverage ratio
Similar to the current liability coverage ratio, the cash flow coverage ratio measures how well you’re able to pay off debt with cash. However, this ratio takes into account all debt, both long term and short term.
It’s important for bringing on investors, getting a loan, or selling your company—a good cash flow coverage ratio shows your business is financially healthy and able to cover its debts.
Cash flow coverage is calculated on a large scale—yearly, rather than monthly. So, Suraya would add up operating cash flow from all her monthly cash flow statements for the year in order to get her annual cash flow.
For the sake of simplicity, we’ll say Suraya’s cash flow from operations was exactly $700 every month. So her total cash flow for the year is $8,400.
The formula looks like this:
Cash Flow Coverage Ratio = Net Cash Flow from Operations / Total Debt
Let’s say that, in addition to $1,200 credit card debt, Suraya has $5,000 left on a loan she took out to start her business. That’s $6,200 total debt.
For her, the equation would be:
8,400 / 6,200 = 1.35
Generally, experts recommend you keep your cash flow coverage ratio above 1.0 to attract investors.
- Cash flow margin ratio
The cash flow margin ratio tells you how much cash you earned for every dollar in sales for a reporting period.
You calculate the cash flow margin ratio with this formula:
Cash Flow Margin = Net Cash from Operating Activities / Net Sales
Let’s say Suraya made $1,200 net sales for the month of March. Her cash flow margin ratio would look like this:
700 / 1,200 = 0.58, or 58%.
So, for every dollar Suraya earned in sales revenue during March, she got $0.58 in cash.
Further reading: Financial Statements 101