How to read a statement of financial position

Also known as the balance sheet, the statement of financial position is one of the essential financial statements for every business or organization. The elaboration of this financial report allows the different users to have a global vision of the financial health of their economic activity before putting in place the adequate strategic orientation. In this article, we explain the usefulness of the statement of financial position as well as the accounting tools you need to master to perform an effective financial analysis.

What is a statement of financial position?

The statement of financial position is an accounting document that summarizes a company's assets, liabilities and equity over a given period and a comparative period. In other words, it shows what the company owns and how its assets are financed. The balance sheet also shows the net book value of the company.

Assets

Assets are all the resources or property available to the company that will provide future economic benefits. Two types of assets can be distinguished in the final report of the statement of financial position: current and non-current assets.

Current assets:

Current assets represent assets that provide current benefits, i.e., less than one year. It includes inventories, accounts receivable and cash on hand.

• Inventories: the inventory of raw materials, finished goods available for sale, merchandise, etc.
• Accounts receivable: The money that the company is entitled to, following the sale of goods or services to its customers.
• Available money: liquid and semi-liquid securities in the bank, which the company can use easily.

Non-current assets:

Fixed assets include assets that generate economic benefits over more than one year. They include, in particular:

• Intangible assets: these are non-tangible assets that have no physical form such as goodwill, certain research and development costs, software, transactional websites, trademarks, patents, etc.
• Tangible assets: these are physical assets such as vehicles, industrial equipment, furniture, buildings, etc.
• Financial assets: these are investments that are not accessible in the short term, including investments in bonds and affiliates.

Liabilities

The liabilities that are frequently found in a company are all its debts to its creditors. In the statement of financial position, different types of liabilities can be distinguished, depending on their classification.

Equity includes shareholders' equity, contributed surplus and retained earnings. The equity, also called the net worth of the company, shows how much the owners have invested in their company and how much profit the company has generated to date, without distributing it to shareholders in the form of dividends.

Accounting is not as boring as it seems

What are the components of financial statements?

In addition to the statement of financial position, there are other information tables to prepare:

• Income statement
• Statement of cash flows
• Statement of retained earnings

The income statement

As the name implies, the income statement shows whether the company's fiscal year in a given period is profitable or not. The main components of the income statement are:

• Income (turnover)
• Cost of goods sold (COGS)
• Operating expenses
• Net income
• Earnings per share

Cash flow statement

The cash flow statement describes the management of financial flows (cash inflows and outflows) by giving a more precise idea of its capacity to generate money. We are talking about money here rather than profits.

We can distinguish 3 types of cash flows:

• Cash flow from operations;
• Cash flow from investing activities;
• Cash flow from financing activities.

Statement of retained earnings

The statement of changes in equity provides the link between the income statement and the statement of financial position. It shows the amount of net income transferred to the company's retained earnings account, since net income must be zero at the beginning of each new accounting period.

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How important is it to know how to read a statement of financial position?

Understanding a statement of financial position, and particularly the balance sheet, is essential for reliable financial management and strategic planning of the company. This information is useful for the organization's internal and external stakeholders:

For accountants and managers:

• Track the financing of assets (by liabilities or equity);
• Track the change in the value of the company over time;
• Assess the financial strength of the company and its ability to meet its obligations.

For the eventual buyer of a company:

• The balance sheet is used to demonstrate the financial health and the financial potential of the company to generate profits.

For investors and funding agencies:

• The statement of financial position provides a clear view of the solvency and financial performance of the company in the eyes of investors and creditors.

Difference between compilation engagement, review engagement and audit

Tips for reading and interpreting a statement of financial position

Here are some tips for reading and interpreting a statement of financial position:

1. Understand the hierarchy of the table
2. Identify the first indicators
3. Determine working capital
4. Use a powerful accounting software

1. Understand the hierarchy of the table

The balance sheet table is read from left to right (asset columns and then the liability column), but mostly from top to bottom. The assets are classified from top to bottom, from the most liquid to the most permanent. Similarly, liabilities are classified in order of maturity, from short-term to long-term debt.

2. Identify the first indicators

A high level of receivables reflects a potential default in the settlement of short-term obligations. A high level of inventory in relation to a company's business volume is an indication of inventory obsolescence and a problem in the marketing of the goods. It presents a risk of depreciation of the stock value.

The ratio (financial debt/equity) reflects the financial dependence of the company on external creditors and potentially an interest burden that is not sustainable in the long term.

The accounts payable ratio determines the average number of days it takes the company to pay its suppliers. Ideally, the company collects money from its customers in a shorter period of time than it takes to pay its suppliers. This ratio is calculated as follows:

Days included in the fiscal year (generally 365 days) x average accounts payable/purchase balances

3. Determine working capital

Working capital is a measure of a company's short-term liquidity and its ability to pay its bills on time. It also corresponds to the money that the company needs on a permanent basis to finance its operations.

Working capital (WC) = current assets - current liabilities

Accountants can also calculate:

Working capital ratio = current assets / current liabilities

Most companies target a working capital ratio above 1.5, but this varies greatly depending on the industry and short-term needs.

Here are some tips to increase your company's working capital:

• Ensure the collection of accounts receivable to pay your short-term debts;
• Financing your short-term debt with long-term debt;
• Sell the stock quickly to settle your obligations.

4. Use an efficient accounting software

In order to speed up the process of calculating the various ratios from the statement of financial position, it is recommended that you turn to the use of accounting software such as QuickBooks Online and Xero. They allow you to prepare and analyze all the details of your financial statements, regardless of the volume of data.

In the same vein, Stamped offers a collaborative platform that connects you with our CPAs and your accountants in a secure and accounting standard compliant manner. Stamped is always striving to optimize its digital tools, as is convinced that the artificial intelligence (AI) based approach will be the key solution in the coming years to make financial statement services simpler and more efficient.

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