Show me the Money
This is not only a famous line from the movie Jerry Maguire but also an excellent interpretation of what financial statements do. Show you just where a company’s money comes from, where it goes and where it is right now.
Reading a Balance Sheet
One of the most important items to thoroughly understand is the balance sheet. The balance sheet consists of:
- Current assets – Items expected to convert into cash within 12 months including inventory and money owed by customers paying on credit
- Non-current assets – Items expected to last longer than a year, eg: land or equipment
- Liabilities – Money a company owes or will have to pay in the future. Current liabilities are due within the next 12 months where non-current liabilities are only due after the next 12 months.
- Equity – What is invested in a business by the owners, plus any remaining retained earnings (accumulated profits or losses).
In the balance sheet we look at the net asset value, which should preferably indicate that a company’s retained earnings is a positive amount, with assets exceeding liabilities. But just what do your assets and liabilities constitute? For example if your Net Asset Value is increasing due to your debtors’ balance increasing, then there is a risk of not receiving this money from the debtors which can likely cause cash-flow constraints.
Loans to and from shareholders
Sometimes a company can be technically insolvent with loans payable to shareholders that have been subordinated, which would then mean these loans would not be factored in when calculating the net asset value.
Investors would however also like to see that the shareholders have also invested in the entity and that they also have interest in the entity’s affairs.
Where a company has inventory then the number of times this is turned over during a year would also be looked at. High turnover would indicate better liquidity or superior merchandising. On the other hand it could also indicate a shortage of needed inventory for the level of sales. Low turnover could also indicate poor liquidity, overstocking or having become obsolete.
There are also several factors that can affect the inventory balance, such as a big purchase just before year end increasing the inventory balance, which would not be a true reflection of the year’s business.
What needs to be understood here is that the profit figure shown on the face of the income statement is not necessarily actual cash received during the year. There are also non-cash items included in the income statement. For a manufacturing company with a high value of PPE there will be a large amount of depreciation included in the operating expenses which isn’t actual cash-flow.
Obvious examples are debtors and creditors. The revenue amount will include money owed by debtors, as well as operating expenses/cost of sales, including creditors who have not been paid.
The income statement will also look at earnings before interest and tax (EBIT) as tax contains many variables and a portion of the tax expense as well as finance cost or interest earned having not yet been paid.
Cash flow statement
This shows what movements on the balance sheet were actual cash – that went through the bank account. The cash flow statement measures how well a company manages its cash position, meaning how well the company generates cash to pay its debt obligations and fund its operating expenses.
The cashflow statement is broken down into three sections as follows:
- Cash flow from operating activities. This includes any sources and uses of cash from business activities. In other words, it reflects how much cash is generated from a company’s products or services.
- Cash flow from investing activities. This includes any sources and uses of cash from a company’s investments for example purchases or sales of assets, loans advanced, or any payments related to mergers and acquisitions are included in this category. In short, changes in equipment, assets, or investments relate to cash from investing.
- Cash flow from financing activities This includes the sources of cash from investors and banks, as well as the way cash is paid to shareholders. This includes any dividends, payments for share buy-backs, and repayment of debt principal (loans) that are made by the company.
It’s important to remember not just to look at one aspect in the financial statement, as the ratio analysis applicable to your industry is also important. You need to not only understand the ratios but what is factored into them.
The small amount of time spent understanding financial statements will pay off in the long run and help you navigate your way around your business’s finances.
Partner, PKF VGA