How to: read a financial statement (2° part)

The top three items to check

Do production costs outweigh earnings? Is it worth investing in the company? Is the company able to pay its suppliers? 

In the first part of this article, we left off with these questions. Let's now take a look at the first items to check in a balance sheet to get an impression of the health of a company.

Is the business profitable?

To understand whether a business is profitable, let's first look at the sales revenues in the income statement to check whether they increased over time. A company's analysis should never be based on the latest annual report alone, but it should always analyze the trend over time.

Sales revenues should  then be compared to the production costs. Just scroll down to EBIT, which reveals the margin the company earns from the sale of its products/services. A negative value indicates the company's core business is loss-making, although it can still generate profits. The profit/loss for the period also includes income and expenses from financial transactions, which can affect the result for the year.

How heavily indebted is the company?

To answer this question, let's look at the total liabilities, which aggregate the company's financing from external sources. The value should be compared with equity, which represents the internal financing source of the company. If the result is equal to 1, the financing resources are equally divided into equity and liabilities. If the ratio is greater than 2,  debts double equity. 

We then need to examine whether liabilities consist mainly of medium- to long-term debts (non-current liabilities) or short-term debts (current liabilities). The latter includes the debts the company has to pay within the next financial year, including those to its suppliers.

Is the company able to pay its suppliers?

To pay its short-term debts, the company needs cash.

Let's look at current assets; this includes the company's cash resources and those expected to be converted into cash within a year, such as customer receivables, inventories, and any securities or interests held in other companies. As a general rule, current assets should be at least one and a half current liabilities.

The analysis could go further, but with these first three points, you can already guess whether the economic asset management is well balanced. 

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