Effective CEOs Understand These Financial Statements
Updated: Aug 4
As CEO, it is essential to have a good understanding of your company's financial numbers, and this includes understanding financial documents such as the balance sheet, income statement, cash flow statement, and statement of retained earnings, as well as key performance indicators (KPIs) related to revenue, expenses, profit margins, and other financial metrics.
Having a solid grasp of your company's financial situation allows you to make informed decisions about allocating resources, managing expenses, investing in growth opportunities, and ensuring the financial stability and growth of the company.
The principal accounting documents that a CEO should be familiar with and review on a monthly, quarterly, and annually are:
Balance Sheet: This document shows the company's assets, liabilities, and equity at a specific point in time. It is a snapshot of the company's financial position and can be used to assess liquidity, solvency, and financial stability.
The balance sheet is a snapshot of a company's financial position at a specific point in time. It helps to assess liquidity, which is the ability of the company to meet its short-term obligations, solvency, which is the ability of the company to meet its long-term obligations and financial stability, which is the ability of the company to continue operating in the future. The balance sheet is divided into two sections: assets and liabilities, and equity.
Assets are resources that the company owns and expects to provide future economic benefit.
Liabilities are obligations the company owes to others.
Equity represents the residual interest in the entity's assets after deducting liabilities. The balance sheet equation is Assets = Liabilities + Equity, which means that the total assets of a company are always equal to the total liabilities plus the equity. It is not enough to produce the Balance Sheet; you have to understand what you are reading so you can make the necessary business decisions.
Here's how you read it
Start with reviewing the assets. Assets are listed in order of liquidity, meaning that the most liquid assets that can be converted to cash quickly are listed first. Typical assets include cash and cash equivalents, accounts receivable ,inventory, and property. Property is referring to land, structures, and equipment in this case.
You want to look at your liabilities. Liabilities are listed in order of maturity, meaning that the debts due soonest are listed first. Common liabilities include accounts payable, short-term debt, and long-term debt.
Equity represents the residual interest in the entity's assets after deducting liabilities. The common types of equity are;
Common Stock: businesses may raise additional equity by selling new shares of stock to investors.
Retained Earnings: the portion of the company's profits that have been reinvested in the business rather than distributed as dividends to shareholders.
Treasury Stock: when a company repurchases its own stock, those shares become "treasury stock" and are essentially removed from public circulation.
Owner's Investments: The funds the owner(s) have contributed to the business to help start or grow it.
Other equity instruments: Small businesses may issue different types of equity instruments, such as stock options or warrants, to employees or investors.
Compare the total assets to the total liabilities to see if they are equal. If they are not, you have identified an accounting issue that needs to be corrected.
Use the information in the balance sheet to analyze the company's liquidity, solvency, and financial stability. Look for trends in the data, such as whether assets or liabilities are increasing or decreasing. Compare the company's balance sheet to other companies in the same industry or to the company's own historical balance sheets to see any notable changes or trends.
Income Statement: This document shows the company's revenues, expenses, and net income for a specific period. It is used to assess the company's profitability and efficiency.
The income statement, also known as the profit and loss or P&L statement, shows a company's revenues, expenses, and net income over a specific period, such as a month, quarter, or year. A CEO needs to understand their company's Profit and Loss (P&L) statement because it provides a detailed overview of its financial performance over a specific period. Specifically, understanding the P&L statement can help CEOs:
Evaluate profitability: The P&L statement shows a company's revenue and expenses, allowing CEOs to determine the business's profitability. By understanding which products or services generate the most revenue and which have the highest costs, CEOs can make informed decisions about where to allocate resources and how to increase profitability.
Identify trends: By comparing P&L statements over time, CEOs can identify trends in revenue and expenses and track the effectiveness of initiatives designed to improve financial performance. For example, if income is consistently increasing while expenses remain stable, it may be a sign that the company is growing and becoming more efficient.
Make informed decisions: The P&L statement provides a detailed breakdown of expenses, allowing CEOs to identify areas where costs can be reduced or eliminated. This information can inform budgeting, pricing, and other financial decisions.
Communicate with stakeholders: The P&L statement is a critical tool for communicating with investors, lenders, and other stakeholders. By understanding the P&L statement, CEOs can effectively communicate the company's financial performance and outlook to these groups.
Here is how you read it:
Review the revenues: The P&L statement will show the total revenues earned by the company over a specific period. Revenues are typically broken down by source, such as sales of products or services.
Review the costs of goods sold (COGS): COGS are the direct costs of producing the goods or services sold. These costs include things like materials, labor, and manufacturing overhead.
Review the operating expenses: Operating expenses are all the indirect costs of running the business, such as rent, utilities, and administrative expenses. These expenses are usually grouped together and listed in one section of the P&L statement.
Review the profit or loss: The P&L statement will show the company's net income, which is calculated by subtracting total expenses from total revenues. If the total expenses are greater than the total revenues, the company will have a net loss.
Analyze the data: Use the information in the P&L statement to analyze the company's profitability and efficiency. Compare the company's revenues and expenses to those of other companies in the same industry or to the company's own historical P&L statements to see if there are any notable changes or trends.
Look for Non-operating income and expenses: Some P&L statements may also include non-operating income and expenses. These are income or expenses that are not related to the company's core operations, such as interest income or gains or losses on investments.
Cash Flow Statement: This document shows the inflow and outflow of cash over a specific period. It is used to assess the company's ability to generate cash and manage its cash resources.
A CEO should read a cash flow statement to understand the inflow and outflow of cash for the company. A cash flow statement provides information on a company's ability to generate and manage its cash resources, which is essential for maintaining the financial stability and growth of the company. It is used to assess the company's ability to generate cash and manage its cash resources. Cash flow is crucial because it affects a company's solvency, operations, investment opportunities, financial planning, and credibility with stakeholders. A company with strong and positive cash flow is better positioned for long-term success and financial stability.
Reviewing your cash flow statement is straightforward. Here is how to approach it:
Operating Cash Flow: Cash generated or used by the company's core operations. A positive operating cash flow indicates that the company's core business is generating cash, while a negative operating cash flow may indicate that the company is not generating enough money to sustain its operations.
Investing Cash Flow: The cash flow related to the company's investments in property, facilities, equipment, and other long-term assets. Positive investing cash flow may indicate that the company is investing in growth opportunities, while negative investing cash flow may indicate that the company is divesting or selling assets.
Financing Cash Flow: This section shows the cash flow related to the company's financing activities, such as issuing or repurchasing stock, paying dividends, or borrowing money. Positive financing cash flow may indicate that the company is obtaining financing to fuel growth or pay dividends, while negative financing cash flow may mean that the company is paying back debt or buying back stock.
Net change in cash: This section shows the overall change in the company's cash balance over the reporting period. It is an essential indicator of the company's overall cash position and liquidity.
Review the net change in cash:This section shows the overall change in cash for the period being reported on and can indicate whether the company has generated or used cash.
Compare the cash flow from operating activities to the company's net income, and examine the trends in cash inflows and outflows over time. Look for any unusual changes or fluctuations in the cash flow, and consider their potential impact on the company's financial position. Use the information in the cash flow statement to analyze the company's cash position and its ability to generate cash.
Compare the company's cash flow to those of other companies in the same industry or to the company's own historical cash flow statements to see if there are any notable changes or trends.
When reviewing the cash flow statement, CEOs should pay close attention to any significant changes in these critical areas, as well as any negative cash flow trends that may indicate potential financial challenges. They should also look for opportunities to optimize cash flow, such as reducing expenses, improving collections, and managing inventory levels more effectively. The statement ends with the cash balance at the end of the period.
In summary, a cash flow statement is a significant financial document that provides information on a company's ability to generate and manage its cash resources. By reviewing this statement, a CEO can better understand the company's cash flow trends and patterns and make informed decisions about managing its cash resources for the benefit of the company and its stakeholders.
Statement of Retained Earnings: This document shows the changes in retained earnings (a component of equity). It tracks the company's accumulated profits and dividends paid to shareholders.
The Statement of Retained Earnings can provide valuable information to business owners and stakeholders by showing how the company's profits are being retained and used for future growth. By reviewing this statement, business owners can make informed decisions about reinvesting profits, paying dividends, or taking other actions to improve the financial performance and stability of the company.
Reading a statement of retained earnings can be done by following these steps:
Review the beginning retained earnings balance: This is the retained earnings balance at the beginning of the period being reported on. It is typically taken from the retained earnings balance on the previous period's statement of retained earnings.
Review the net income or loss: This is the company's net income or loss for the reported period, as shown on the income statement.
Review the dividends declared: This is the amount of dividends that the company has declared and paid to shareholders during the period being reported on.
Review the ending retained earnings balance for the reported period: It is calculated by adding the beginning retained earnings balance, net income or loss, and dividends declared and then subtracting any dividends paid to shareholders.
Analyze the data: Use the information in the statement of retained earnings to analyze the company's profitability and dividend policy. Compare the company's retained earnings to those of other companies in the same industry or to the company's own historical statements of retained earnings to see if there are any notable changes or trends.
Keep in mind that retained earnings is a component of shareholders' equity, what's left over for the owners of the company after all debts and obligations have been settled. It helps to understand how the company is generating and allocating its profits.
Financial documents can tell a story about a company's performance and financial position over a certain period. By analyzing financial statements such as the income statement, balance sheet, and cash flow statement, one can gain insight into a company's revenue and expense trends, liquidity, solvency, profitability, efficiency, and cash flow.
For example, an income statement shows how much revenue a company generates and how much it spends on expenses. It can reveal whether a company is profitable and how much it is earning or losing.
A balance sheet shows the company's assets, liabilities, and equity, and it can indicate the company's liquidity and solvency.
A cash flow statement shows a company's cash inflows and outflows over a certain period of time and can indicate the company's ability to generate cash.
The statement of retained earnings helps a CEO make informed decisions about how to best allocate earnings for the company's and its stakeholders' benefit.
Together, these financial documents can provide a comprehensive view of a company's financial performance and position. It is essential to read and analyze financial statements over time to identify trends and changes and to compare them to industry averages or to the company's historical financial statements. By reading and analyzing them, you can gain insights into a company's revenue and expense trends, liquidity, solvency, profitability, efficiency, and cash flow.