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How to Read Financial Statements (Step by Step Guide to Reading Financials)

I’m going to introduce you to the SMART system. So what this is going to do is give you a step-by-step system for how you should go about reading financial statements. So regardless of whether it’s an income statement or a balance sheet or if it’s just an internal budget report that you’re receiving, there’s a certain system that can help you read those financials faster and actually get a lot more insight out of it. But before I walk you through what each of the steps mean, I need you to come back in time with me and I want you to remember your days in Kindergarten. So, maybe you had Mrs. Taylor and she taught you phonics and step-by-step and she probably also taught you how you actually go about reading where you would take a piece of paper and you always start at the top and you work your way to the bottom. And you read line by line, side to side to side and that served you very well. Obviously, you’ve gotten you this far along that it’s doing something right. But the reality is you are going to face hundreds and hundreds and hundreds of financial statements between now and the rest of your career. And if you don’t have a system for reading them, you’re at huge risk of just looking at them and missing the main points or doing what a lot of people do, which is glaze over them and really not get any insights out of it at all.

Okay so, right now I’m going to walk you through what every letter in SMART stands for. And no it’s not the same as, “SMART Goals”, I’m sure you’ve all heard of that. So step one is, “Scope”. And you can think of this as the journalist step. So this is when you’re trying to figure out the “who”, “when”, “where”, “what” and “why” of the specific statement that you’re looking at. This is really important to get yourself oriented and this is not necessarily a really long step but you need to know an orientation of what the document is purporting to show before you actually start reading it and drawing conclusions. Because that information is going to shape a lot of the ways that you approach the following steps. If you pick up a piece of paper, you get emailed a document and it has numbers on it, the first thing I want you to do is mentally pause for even 10 seconds and walk yourself through each of the five W’s.

Materiality is the second component of reading financial statements in a SMART way. But what I want to start doing is training your eye to scan the schedule for the biggest dollar amount. That’s not always going to be what you’re going to want to focus on but you need to get that anchored. So there’s a really big risk that you end up just reading all the way through in the order the information is coming through. You need to learn how to orient yourself and sequence what you’re looking at based on materiality. Anytime you’re looking at a set of information, you’re gonna have follow-up questions. There’s going be there’s things that you’re gonna either need to refer back to the disclosure notes to get more information. Maybe you have to go back to someone in the accounting department to seek more clarification. Maybe you have a budget variance explanation in there but it’s really not quite fully satisfying what it is that you’re looking for. So there’s a certain process that we’re gonna go through to compile the information that you need to ask largely driven by the scope of materiality above.

“R” is relative. So not family relatives but relative. This is probably the most important step if I were to say that there would be any. But any information on a budget report, on a balance sheet. What makes it important and what makes it significant is what you’re comparing it against. So you want to be thinking through a very systematic way of doing that.

And then “T” is transaction. So this is where we’re going to make sure that we go one layer deeper. You’re going to be thinking what source system do they come from. You know who’s the supplier and what are they supplying? Or who are the customers and what are they representing? This is really where you’re gonna start to see that what’s usually presented on a financial statement is just the tip of the iceberg. So you need to have some level of understanding of everything that fits below the iceberg.

So that is essentially the 5-step SMART system. I just want you to promise me one thing and that is that you will never, ever, ever, ever again pick up a financial schedule and just mindlessly read it top to bottom and corner to corner. Please, please, please promise me you will stop doing that and I promise you you are going to get so much more out of your insights. So, let’s start diving in and let’s start making these financial schedules really come to life.

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