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The books are closed and all account balances are reconciled.
You're justifiably proud of the resulting financial statements, and
you're comfortable that every number is accurate. Will someone
outside your company get a favorable impression from reviewing these
documents?
Who reads your financial statements?
Obviously, your company managers read the financial statements
carefully and do further analysis on the numbers included. They were
most likely the audience you had in mind as you prepared the
statements.
But it's important for you to step back and see the financial
statements in the way that a person outside the company might see
them. To do this, you must first understand who these outsiders are
and why they would be interested in your financial statements. There
are several categories of outsiders.
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Investors
* Decide whether and at what price to commit, or continue to
commit, resources to your company.
* Potential to gain a share in future profits.
* Risk/ Loss of their own money and loss of investment income from a
better investment.
-
Creditors
* Decide whether your company can pay back current or future
debt, either from expected future income or from the sale of assets.
* Potential gain
by colleting fees for lending resources.
* Risk/ Loss of their own money and loss of investment income from a
better investment.
-
Customers
* Decide whether your company can meet their needs for product
delivery. Understand the value of their business to your company and
review the price that they are paying.
* Potential gain through the growth of their own business.
* Risk/ Dependency
that you could cause their company to fail.
-
Suppliers
* Decide whether to sell their product to you. Understand the
value of their product to your company and review the price that
they are charging.
* Potential gain for Income for their own business.
* Risk/ Loss of income from you and loss of income from a better
customer.
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Auditors
* Decide whether to provide a favorable opinion on both the
accuracy of the numbers and the ongoing viability of your company.
* Potential gain
through charging Fees for rendering opinion and enhanced
professional reputation.
* Risk/ Damage to reputation and potential lawsuits if opinion proves
incorrect.
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Industry analysts and fund managers
* Decide whether to endorse your company as a good investment
for their customers.
* Potential gain from enhanced reputation, new customers, and higher
commissions. Risk/ Loss of reputation and customers.
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Government regulators
* Determine whether your statements comply with the regulations
for companies that sell their stock publicly.
* Potential gain is on your side: You are allowed to
continue to market your stock.
* The risk is also yours: Failure to comply means denial of
trading and, potentially, stiff penalties.
Although some of these outsiders have access to you or other members
of company management and can ask questions to help fill in the
blanks in their analysis, other readers have to make conclusions by
using only the information in the statements.
What are they looking for?
As you can see, there are many different reasons that outsiders
might read your financial statements. Some of the answers that these
readers seek are available directly from the statements, but finding
other answers might require additional effort.
Analysis methods depend on a reader's goals, approach to financial
analysis, and personal preferences, as well as your company's
various businesses and circumstances. There are, however, some
common tasks that outsiders perform, including:
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Looking for changes over time and trends in those changes. The
easiest way to accomplish this goal is to lay side by side the
financial statements for consecutive periods. (Remember that a set
of financial statements is a snapshot in time — only by comparing
several snapshots do you get a true picture of where the numbers are
heading.)
-
Comparing some line items as percentages of others. For example,
outsiders might look at general and administrative expenses as a
percent of sales to determine whether your operations are becoming
more efficient as production grows. Or they might look at accounts
receivable as a percent of total assets to see if you are paying
attention to the income collection side of the business.
-
Evaluating your company's trends against others in your industry.
Readers calculate standard ratios to measure return on investment,
safety and liquidity, and operating efficiency, and then compare
your ratios to your competitors'. If there's a significant
difference, they try to determine the reason.
How many financial statements will be included in this comparison
process?
That depends on your company's business and circumstances.
In most cases, a 5 to 10-year period is good. However, recent changes in
the company or the industry may make this historical data less
helpful.
What are readers looking for on each financial statement?
- Balance sheet
How liquid is the company? Liquid assets are cash and other assets
that can be quickly and easily converted into cash.
How well is the company set up to meet cash needs? For payments
required in the next year, this question is answered by determining
liquidity. For longer-term obligations, the outsider needs to know
when payments are due.
How much are your key assets really worth? Fixed assets are included
in your balance sheet at cost and not market value. In some
businesses, the value of the company is based on the value of a few
key assets. Outsiders need to know the information that helps them
value these assets.
How thin is your remaining equity? The equity section of the balance
sheet shows how much remains of earlier investments in your company.
Operating losses and distributions may have depleted this
investment. The remaining equity is the funding your company could
use for further expansion.
- Income statement
Since your income statement shows a net profit, you were certain
that anyone reading the statements would come away with a favorable
impression. You now understand that the outsider is not looking at
the income statement for this period alone.
Can the income from this period be compared with the income reported
in earlier periods? Income can be thought of as a combination of
revenue and other gains.
* Revenue is the income from your operations. It's the money you
collect from the delivery or manufacture of a product or from
providing a service.
* Other gains are inflows from sources other than operations, such
as capital gains and losses.
Be sure to clearly separate these two income categories on your
income statement.
Also state separately any unusual income amounts from operations
included this period. For example, you might have charged your
existing customers a one-time license fee.
Are there different business segments in your company? For example,
you might have two very different products. Outsiders want to see
income and expenses broken out by segment, particularly if there are
differences in net profit or in potential for growth between these
products.
Statement of cash flow
How many dollars have to be invested to get a dollar of revenue? The
cash flow statement describes the company's sources of cash and uses
of cash. These numbers detail how the company reconciles its
beginning and ending cash balance.
Other information in financial statement package
There are other, more general pieces of information that outsiders
want to see, such as:
* Certainty level for all measurements. If you reported some income
that has not yet been collected, how certain are you that the amount
you booked will be collected?
* Known or expected changes that will affect future performance.
These could be changes in your industry, changes in market
conditions, or changes within your company.
* Information to build a management report card. How close are these
results to projections?
Can you make your financial statements better?
Having viewed the data through an outsider's lens, you may find that
your confidence in your financial statements has turned to concern.
What can you do now?
It's too late to make changes that can immediately affect the
profitability of your business. Obviously, you can't go back and
"cook the books." But you can use the information that you just
gained to correct any operational shortcomings in the next business
cycle.
And you can still enhance your financial statements package. Do the
analysis described above. Sit down with a representative of each
reader category and watch them analyze your financials. Note
questions they ask.
There's also a good chance that you can add information that, if
read at the same time as the financial data, could lessen readers'
concerns. For example, you can:
* Provide detail on segments of your business.
* Clearly separate operating income and expense items from other
sales and related expenses.
* Because these statements will be reviewed side by side with
earlier statements, make sure that you categorize items
consistently.
* Separate the effect of unusual and nonrecurring income and expense
items from recurring items.
You can add these details by inserting line items in the statements
or by including notes with the statements.
Also, consider adding supplementary investment analysis information
to your financial statements package. You will have the opportunity
to provide this package as a presentation to outsiders. You may
present it directly, post it on your Web site, or mail it.
Think of your financial statement package as part of your company's
public image. The outsiders who read the package are key to your
continued success. Be as concerned with addressing their needs as
you are with taking care of your company's customers.
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