Comprehensive financial statements prepared under U.S. Generally Accepted Accounting Principles (GAAP) include three reports: the balance sheet, income statement and statement of cash flows. Together these reports can be powerful diagnostic tools to help evaluate the financial well-being of a business. Moreover, by carefully analyzing them, you may be able to uncover potential money-management problems or even fraudulent activity.
Balance Sheets Show Assets vs. Liabilities
The balance sheet provides a snapshot of a company’s financial health at a moment in time. One side shows the assets owned by the company, such as cash, accounts receivable and inventory. The other side contains liabilities or claims on the company’s assets. Examples include accrued expenses, accounts payable and equipment loans.
Current assets (such as receivables) mature within a year, while long-term assets (such as plant and equipment) have longer useful lives. Similarly, current liabilities (such as payables) come due within a year, while long-term liabilities are payment obligations that extend beyond the current year or operating cycle.
Net worth or owners’ equity is the extent to which assets exceed liabilities. Because the balance sheet must balance, assets must equal liabilities plus net worth. If the value of your company’s liabilities exceeds the value of its assets, net worth will be negative.
When benchmarking financial results over time or against competitors, there are a number of balance sheet ratios worth monitoring. Examples include:
Growth in accounts receivable vs. the growth in revenue. If receivables are growing faster than the rate at which revenue is increasing, customers may be taking longer to pay. This might indicate that customers are running into financial trouble or finding quality issues with the products or services.
Growth in inventory vs. the growth in revenue. When inventory levels increase at a faster rate than revenue, the company is producing products faster than they’re being sold. This can tie up your cash. Moreover, the longer inventory remains unsold, the greater the likelihood it’ll become obsolete.
Growing companies often must invest in inventory and accounts receivable, so increases in these accounts don’t always signal problems. However, increases in inventory or receivables should typically correlate to rising revenue.
Current ratio. The ratio of current assets to current liabilities is used to gauge short-term liquidity. If this ratio falls below 1, the company may struggle to pay bills coming due. Some business experts believe a current ratio of less than 2:1 is problematic. But the optimal ratio varies depending on your industry, economic conditions and other factors.
Income Statements Focus on Profits
The income statement shows revenue, expenses and profits earned (or losses incurred) over a given period. A commonly used term when discussing income statements is “gross profit,” or the income earned after subtracting the cost of goods sold from revenue. Cost of goods sold includes the cost of labor and materials required to make a product. Another important term is “net income,” which is the income remaining after all expenses (including taxes) have been paid.
Also reflected on the income statement are sales, general and administrative expenses (SG&A). These expenses reflect functions, such as marketing, that support a company’s production of products or services. The ratio of SG&A costs to revenue tends to be relatively fixed, no matter how well your business is doing. If these costs constitute a rising percentage of revenue, business may be slowing down.
The income statement can reveal other potential problems, too. It may show a decline in gross profits, which means production expenses are rising more quickly than revenue. Common causes of this include hiring more employees than you really need and doing an excessive proportion of low- or no-margin business. In today’s business environment, many companies are reporting lower gross margins due to rising labor and materials costs — unless they’ve managed to pass along these cost increases to customers through higher prices.
Cash Is King
The statement of cash flows shows all the cash coming in and out of your company. For example, your company may have cash inflows from selling products or services, borrowing money and selling stock. Outflows may result from paying expenses, investing in capital equipment and repaying debt. Ideally, a company will derive enough cash from operations to cover its expenses. If not, it may need to borrow money or sell stock to survive.
The statement of cash flows shows changes in balance sheet items from one accounting period to the next. It’s organized into cash flows from three primary sources:
- Investing activities, and
- Financing activities.
To complicate matters, noncash investing and financing transactions are reported at the bottom of the statement of cash flows. These transactions don’t involve direct cash exchanges. For example, a machine that’s purchased directly with loan proceeds would be reported here.
Although this report may seem similar to an income statement, its focus is solely on cash. For instance, a product sale might appear on the income statement, even though the customer won’t pay for it for another month. But the money from the sale won’t appear as a cash inflow until it’s collected. To remain in business, companies must continually generate cash to pay creditors, vendors and employees. So business owners must watch their statement of cash flows closely.
We Can Help
Financial statements tell a story about a company’s financial performance. This information can be valuable for many purposes — whether you’re evaluating the financial results of your own business or one that you’re considering acquiring, lending to or investing in. Contact your financial advisor to get the most from these reports. An experienced professional can help you evaluate a company’s financial health, including potential risks and areas of improvement.
Footnote Disclosures Provide Critical Details
Audited and reviewed financial statements are required to include footnote disclosures. In addition, companies that issue compiled financial statements often voluntarily disclose information to support their numerical results. Footnotes provide greater detail to line items on the financial statements and explain business operations, risk factors and external market conditions. This information is designed to help people who rely on the company’s financial statements better understand its financial health.
To get the most out of your financial statement review, read the footnotes carefully. Here are some disclosure topics that might warrant additional due diligence.
Companies may give preferential treatment to, or receive it from, related parties. This term refers to individuals or companies with the ability to influence one another’s financial transactions.
These transactions are often associated with small businesses. For example, a family business owner might lease space from her parents at below-market rental rates or pay above-market salaries to her son. But large companies can also engage in related-party transactions. For instance, an executive or board member may have an undisclosed financial interest in one of the company’s suppliers.
Footnotes should disclose all related parties with whom the company and its management team conduct business. It’s important to critically evaluate related-party transactions to determine whether they’re at “arm’s length” — and whether significant risk factors exist.
Accounting Method Changes
A company’s choice of accounting methods can shape its financial results. For instance, under the cash-basis method, companies report revenue only as it’s received and expenses only as they’re paid. Under the accrual method, income is recorded at the time of sale, regardless of when payment is received. And expenses are recorded only when goods or services are received.
Companies must disclose changes in accounting methods, estimates, principles and practices if the change materially affects their financial statements. The disclosure should also explain the justification for a change in accounting principle or method, as well as the change’s effect on their financial statements. The reason for a change should be valid, such as a regulatory mandate. Dishonest managers can use accounting changes in, for instance, depreciation or inventory reporting methods to manipulate financial results.
Footnotes also should disclose significant events that could materially impact future earnings or impair business value. Examples include the loss of a major customer, uninsured business interruption from a natural disaster or stricter regulatory oversight next year.
Business owners and investors should stay atop industry trends to avoid being blindsided by emerging trends in the business environment. Interim financial reports can sometimes help catch undisclosed events early.
Footnotes may also reveal contingencies, such as pending litigation, an IRS inquiry, an environmental claim and uncertain tax positions. If significant, these items could impair a company’s future performance and value. However, managers tend to downplay these issues, so you might need to read between the lines and ask questions to better understand the potential risks and expected losses.
A broad range of environmental, social and governance (ESG) issues may affect a borrower’s financial condition and performance. Examples include the size of the company’s carbon footprint, efforts to replace fossil fuels with renewable energy sources, and overall use of natural resources, as well as workplace, health and safety, and consumer product safety risks.
ESG reports aren’t mandatory in the United States, but public companies increasingly are required by the Securities and Exchange Commission to disclose information related to such issues as climate change and the use of conflict minerals in their financial reports. Many private companies have joined the bandwagon to prove to lenders and other stakeholders that they’re environmentally responsible, cost conscious and creditworthy.