Reading financial statements may not be like leisurely reading a good novel, but when it comes to your own company, your investments, or potential investments, you have money at stake in being able to read and understand these statements. They just may contain more information than you thought. You can find out a lot about a company by reading between the lines and doing some analysis.
The balance sheet and income statement are fundamental to any business. They could be thought of as a "report card" on the performance of the business for the period. But what do they really tell you, other than the bottom line result? Once the financial statements have been prepared for your own business, how can you use them and learn from them to help you manage your business? Or, if you are considering making an investment in a company’s stock, how can you use its financial statements to help you decide whether it might be a good investment? One of the tools you can use is ratio analysis.
Ratio analysis as an evaluation tool
Obviously there are many different aspects and factors involved in evaluating a business, including management capability, innovations in products and technology, shifts in market demands, and general economic conditions, among others. But one of the advantages of using financial statements is that they provide you with objective, concrete data with which to perform analysis. Ratio analysis by itself is just one tool you can use in evaluating your own business, or a potential investment opportunity. For example, comparisons of balance sheets and income statements from one period to another can be very effective in detecting changes, trends and shifts. Calculating ratios based on the current period balance sheet and income statement can be very useful, and when combined with a comparative analysis from period to period, it becomes a very dynamic way of gauging performance.
How you use the insights you gain from your analytical work will of course depend on your purpose in reading the financial statements. If you are looking at a company in which you already have an investment, or in which you are thinking about investing, you may use the results of your analysis to either buy or sell, or to increase or decrease your holdings of that stock. If you are looking at your own company, you can use your analysis to see where your business is strong, and where it could use some adjustments or improvements. This will help you make financial decisions about your business operations.