How to Read a Financial Report. John A. Tracy
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of the balance sheet is to disclose such information about the ownership of the business entity and the sources of its equity capital.
The stockholders expect the managers of the business to earn a reasonable annual return on their $23,125,000 equity ownership in the business. In its most recent annual income statement the business reports $2,642,000 bottom-line profit, or net income. This profit equals 11 percent on the company’s year-end stockholders’ equity. The stockholders, as well as the company’s managers and its lenders, want to know more than just bottom-line profit. They want to see the whole picture of how profit is earned. Therefore, the income statement reports totals for revenue and expenses for the period as well as bottom-line net income.
The ability of managers to make sales and to control expenses, and thereby earn profit, is summarized in the income statement. Business investors and lenders pay particular attention to the profit yield from revenue. Earning profit is essential for survival and it is the business manager’s most important financial imperative. But the bottom line is not the end of the manager’s job—not by a long shot!
To earn profit and stay out of trouble, managers must control the financial condition of the business. This means, among other things, keeping assets and liabilities within appropriate limits and proportions relative to each other and relative to the sales revenue and expenses of the business. Managers must prevent cash shortages that would cause the business to default on its liabilities when they come due, or not be able to meet its payroll on time.
Business managers really have a threefold financial task: 1) earning enough profit, 2) controlling the company’s assets and liabilities, and 3) generating cash flows. For all businesses, regardless of size, a financial statement is prepared for each financial imperative—one for profit performance (the income statement), one for financial condition (the balance sheet), and the statement of cash flows.
Earning adequate profit by itself does not guarantee survival and good cash flow. A business manager cannot fully manage profit without also managing the assets and liabilities of sales revenue and expenses. In our business example, the changes in these assets and liabilities cause cash flow to be higher than the profit for the year. In other situations, the changes can cause cash flow from profit to be lower—perhaps much lower—than profit for the period (and can cause negative cash flow in extreme situations).
Business managers use their income statements to evaluate profit performance and to ask a raft of profit-oriented questions. Did sales revenue meet the goals and objectives for the period? Why did sales revenue increase compared with last period? Which expenses increased more or less than they should have? And there are many more such questions. These profit analysis questions are absolutely essential. But the manager can’t stop at the end of these questions.
Beyond profit analysis, business managers should move on to financial condition analysis and cash flows analysis. In large business corporations, the responsibility for financial condition and cash flow is separated from profit responsibility. The chief financial officer (CFO) of the company is responsible for financial condition and cash flow. The chief executive officer (CEO) and board of directors oversee the CFO. They need to see the big picture, which includes all three financial aspects of the business—profit, financial condition, and cash flow.
In smaller businesses the president or the owner/manager is directly involved in controlling financial condition and cash flow. There’s no one to delegate these responsibilities to, although, consultants and advisors can be hired for advice.
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