A 5 Minute Tutorial on How to Read Financial Statements

For most people I know, reading financial statements sounds daunting and complex. Then I found this quote: “If you can read a nutrition label or a baseball box score, you can learn to read basic financial statements”. I completely agree with it! You don’t need to be an accountant to read financial statements, the same way you don’t need to know how to make a car to drive one. This article focuses on key elements you should know when you look at an organization’s financial statements and what they mean. You may even have fun reading!

In case you are just getting started, you should know the following about financial statements:

  • Financial statements provide you with a snap shot at a specific point in time of the financial health of an organization. That is why it is so important for financial statements to have a date.

  • The balance sheet shows the value of assets, liabilities and equity accounts as of the statement’s date. Total value of assets will always equal the sum of all liabilities + equity. These accounts balance each other out…hence the clever name “balance sheet”.

  • The income statement, lists all revenues and expenses to calculate the profit (or deficit) for the year. By the way, accountants like to put negative numbers in (brackets).

  • The statement of cash flows shows the inflow and outflow of cash for the period. You usually don’t want to see a bracket around the number at the bottom of the list.

Income Statement and Cash Flow Golden Rule

Generally, an organization is doing well if the income statement and cash flow balances are positive. It means that the organization is making more revenue than it is spending, and that it has cash in its bank account to operate. For not-for-profit organizations, the income statement may have a $0 balance. This is positive news, as it means that the organization spent exactly the amount received to deliver its programs and operations. No profit was made on contributions/revenue generated which the title not-for-profit implies.

Too easy? Ok, the real fun begins with the balance sheet. Here are key points you should look for:

 

Liabilities > Assets = Generally Bad

Assets are resources controlled by the organization that can or will be converted to cash (e.g. a building, bank account(s), accounts receivable). Liabilities are obligations that the organization owe to others (e.g. accounts payable, loans and debts). So, if liabilities (amounts owned) are higher than assets (value of possessions), then the organization does not have enough resources to cover its obligations. That’s potentially bad news! There are some exceptions to this such as deferred revenue or contributions but we will ignore those for now.

 

Negative Equity or Net Assets = the organization is experiencing repeated deficits

Equity is essentially the balancing account between assets and liabilities. It is composed of shareholder’s equity and retained earnings (aka accumulated profit and loss from the current and past years). Typically, a negative equity balance would be attributed to a series of deficits resulting in negative retained earnings balance.

In the non-profit world, there is often no equity account, as there are no owners or shareholders. The replacement will often be called “Net Assets”, which is the accumulated net surplus or deficit for the year. Similarly to the retained earnings, a negative net asset balance indicates that the organization recognized a series of deficits for the year and incurred more expenses then it generated revenues. There can be more lines in the Net Asset balance including endowment, restricted assets, unrestricted assets etc. but the total balance is the most important number here.

 

Large Accounts Receivable = Not terrible, but not ideal

Accounts receivable is the value others (e.g. members, donors) owe to the organization. Therefore it represents the promise of money to be received. Whether the balance is large or small is not as relevant as the aging of receivable amounts. If amounts have been owed for under a month, there is still a good chance of seeing your bank account balance increasing in the near future. However, if receivables are over 90 days old, it may be a sign that the payee(s) cannot or will not provide the funds to cover the amount they owe you.

An aged accounts receivable balance also poses a cash flow risk, as the organization is incurring expenses and may need to use its line of credit if funds are not received in a timely manner.

To help determine if the aging accounts receivable balance is an issue, look at the cash balance. If it is low, the organization may be facing cash flow issues.

 

Accounts Payable > Cash = Can’t pay short term debt

Accounts payable are short term debts, such as invoices due to suppliers or other organizations. Generally these amounts are paid within 30 days if the organization wants to avoid late payment penalties. Again, check the cash balance to ensure there is sufficient cash on hand to cover the accounts payable balance.

If you see an accounts payable balance that is higher than the bank account balance, then the organization may be experiencing cash flow issues and will need to either use credit to pay bills or wait for some of the accounts receivable to come in so that there is enough cash to pay. Either way, this may result in interest or penalty fees, which is no fun (except if you’re a bank!).

 

Value of Capital Assets vs. Value of Accumulated Depreciation

As mentioned earlier, assets are resources controlled by the organization that have value and theoretically can be converted into cash. Some of these assets are capital in nature and, over time, as the capital assets are used, they lose their value and the organization “depreciates” or “amortizes” them on their books (note: amortization is just another word for depreciation – although don’t tell that to your accountant or economist – they may blow a fuse!). The depreciated amounts are recorded and added in the Accumulated Depreciation account on the asset side of the balance sheet. The net capital asset value is calculated by subtracting the accumulated depreciation balance from the capital asset balance. Don’t worry, they do the math for you!

Capital Asset Value – Accumulated Depreciation = Net Capital Asset Value

What does that mean and why is this important? Well you may want to consider upgrading or replacing your capital assets if your Net Capital Asset Value is getting too low. This is more important in some organizations (manufacturing) than it is in others (service).

 

There are a few other ratios and analysis you can do while reading financial statements such as the current and quick ratios but I will save those for another time. The elements described here provide enough information to help you quickly assess the financial health of any organization in just a few minutes. There you go! Reading financial statements has become quick and easy, just like reading the nutrition information on a cereal box!