Financial Statements for Dummies

Financial Statements for Dummies

As a Chartered Accountant in public practice, I have provided assurance on approximately 500 sets of financial statements over the last 10 years. In the process, I have analyzed statements to assess the ongoing viability of different businesses and I have seen what happens when companies fail to act on what their statements are telling them. I will try to sum up the most valuable points of financial statement analysis in this “Financial Statements for Dummies” blog.

Financial statements are typically prepared for a 12 month period. They provide a record of all the transactions that occur during that period, including the payment of related income taxes. There are adjustments to reflect transactions that occur with no cash transacted.

First Step – level of work:

The first thing you should do when you look at a set of financial statements is check if the company in question was audited or reviewed. This information should be clearly stated on the report that accompanies the statements. If there is no report with the statements, you can assume the statements were not audited or reviewed and therefore, there is no objective party providing assurance that the statements accurately reflect the company’s operations.

When accountants conduct a review engagement, they assess the ‘plausibility’ of the financial statements through analysis , inquiry and discussion. An audit includes the same analysis, inquiry and discussion, plus additional substantive work and review of controls to assess the ‘reasonability’ of the financial statements. An audit provides a higher level of comfort that the financial statements fairly represent the company’s operations and it is the standard for public companies , whereas a review provides a lower level of assurance.

Take a close look at the review or audit report to make sure the company has an unqualified opinion, meaning that the external accountant performed their work and the statements are not materially misstated.

Second Step – accounting standard:

The next item I would review is the basis of accounting meaning what accounting standard is the company following. In Canada, private companies will typically be using Accounting Standards for Private Entities (ASPE) for December 31, 2011 year-ends going forward and public companies will be using International Financial Reporting Standards (IFRS). The basis of accounting is important because if you are comparing two sets of financial statements, you want to ensure the accounting policies are the similar.

Also pay close attention to the financial statement notes. Look for issues such as Going Concern, Risks and Contingencies as any one of these can allude to significant issues in the company.

Third Step –analysis:

I have learnt over the years that users look at financial statements for different reasons and therefore different parts of the financial statements are important to each of us. Financial statements are generally prepared for general use to allow for different user requirements. As a result, in preparing this article, I will touch upon some of the more common areas of financial statement analysis.

Comparative analysis
This is an amazing tool if used correctly. Comparing sales, expenses or other balance sheet items year over year can identify many critical issues. Be careful to look at the year over year dollar change as well as percentage change. The dollar change may look small, but percentage-wise it can be significant. For example, if your gross profit (revenue less cost of sales) decreases from 12% to 10% the following year, it may seem like an insignificant 2% change year over year. In reality, the gross profit has decreased by 17% (2%/12%) year over year. This seemingly small change can be indicative of significant issues such as fraud, rising input costs that are not being passed on the customer, downward pressure on prices which is shrinking your revenue or a host of other issues.

Ratio analysis
Financial statement ratio analysis can be used to evaluate a company’s liquidity, efficiency, long-term solvency, profitability and more.

Liquidity ratios look at a company’s ability to meet its short-term obligations. The current ratio looks at current assets : current liabilities. A current ratio below 1 means that the current liabilities exceed the current assets. Clearly this is not good and it could indicate that the company will have trouble meeting its liabilities.

Inventory turnover is used to assess a company’s efficiency. It can tell you how many times inventory is turning over and how long inventory is sitting on the shelves. The longer inventory sits, the longer it takes for the company to make money. The same goes for accounts receivable (AR) turnover, if AR turns over twice per year, it essentially means it takes about half a year to collect AR.

Ratios can be compared year over year or compared to some industry standard. If the ratios are drastically different from one year to the next, or if they are different than the norm for the industry, you need to find an explanation.

Net worth
The net worth of a company is the assets minus the liabilities and it represents what is left for the owner once all assets are liquidated and liabilities are settled. This is an area that is commonly looked at in a purchase and financing arrangements.

Cash flow statement
The cash flow statement provides details as to where cash was used and received throughout the year, and if analysed correctly, can uncover significant matters. For example when reviewing the cash flow, you may see large non-cash items received throughout the year. In this situation the income may look great, but if much of the income was non-cash, it may have no real benefit to the company.

Fourth Step –Intangibles:
The financial statements may include items that are considered intangible, i.e. goodwill, leasehold improvements or intangible assets. Often times these assets are ignored by the banks and outside investors because they carry no tangible value, are not readily saleable and are typically part of an overall valuation of the company.

In conclusion, financial statements can be very useful if you know what you are looking for. If your objectives are simple, then the review of the financial statements can be as quick as just looking at the net income and moving on, but if your objectives are more involved, then following the process above would be appropriate.

-- David Hertzog

Capitalizing my business?

Outside of tax planning and operational issues, how to better capitalize is one of the most common discussions I have with my auto dealer clients. Clearly one of the better ways to capitalize your business is by way of retaining internal cash flow in the business, but often this is not possible and as a result the owner must entertain offers for external financing. I have found that obtaining new financing and re-financing existing credit facilities is much more challenging as a result of the recent economic downturn as banks are more risk averse, especially in the auto retail business.

It is still possible to obtain financing in today’s market, but a well-structured plan is in order. The plan should consist of a strategic message to the bank as to why the financing is required and how the funds will be used. If the financing is simply to fund current and prior year losses, it is more likely than not that the bank will decline. However, if the funds are used to purchase additional inventory, pay off previous management or acquire new equipment, the bank is more apt to provide financing.

Business owners are sometimes so surprised that the bank is willing to provide financing, and so focused on the interest rate and loan-to-value ratio of capital property, that they forget to read the fine print on their credit facility agreement. Often there are significant terms in the credit facility that are overlooked by the business owner until it is too late. Commonly overlooked terms address personal guarantees, postponements, financial covenants, audited financial statements, and significant security.

Personal guarantees come into play when a business can no longer continue to operate and the bank calls the loan. If you have an agreement with a personal guarantee and there is not enough cash to repay the bank loan, the bank can seize your personal assets (i.e. your house!) as repayment.

Postponements require that the company postpone repayment of debts in favour of repaying bank debt. This term can be detrimental if your business runs into trouble and you have personally put significant funds into the business.

Financial covenants also pose a risk in that sometimes they can be impossible to meet and 1-3 years after the facility agreement is signed, the covenants may be breached and the bank can call the loan.

The terms may indicate that you will be required to provide the bank with audited financial statements within a specific period following your company’s year end. Audits can be costly, and you may be able to negotiate to submit reviewed financial statement (lower assurance than audited statements) which can save your company some money in accounting fees.

Another problem I see is business owners who don’t explicitly ‘shop’ around to different banks and compare terms. It is important to create a chart to compare the terms offered by different banks because more often than not facility agreements, especially for auto dealers, have a significant number of terms that are not easy to compare in your head. I suggest you write out the differences and compare all the options to make a decision based on the facts. Some points of comparison may be qualitative in nature, such as the reputation of the bank or relationship with the banking representative.

This is just a taste of what I have dealt with over the last several years with regards to capitalizing your business and I plan to write further blogs on this topic.

-- David Hertzog

Are you paying attention to your financials?

With over 15 years of experience preparing, reviewing and analyzing financial statements for owner-managed clients, I can tell you unequivocally that 90% of the time, financial statements are not reviewed effectively.

Reviewing financial statements is like getting a physical at the doctor – it can point out ‘issues’ that you may not have been aware of so that you can address them before they get worse. To continue the analogy, just as a doctor assesses one system at a time looking for anything out of the ordinary, when reviewing your statements, it is important that you know what normal should be so you can identify and follow up on irregularities.

As part of the year-end audit for one of my auto dealership clients, I met the owner for a morning coffee meeting and we reviewed the dealership’s interim financial statements. After looking at the financial statements, I noticed that the margins on used vehicles were up significantly year-over-year. When I questioned the owner about this he said the used car manager must have been doing his job, however it appeared irregular to me, and after a little investigation I found that there were some accounting irregularities and the profits on used vehicles were not at all what the owner had thought.

As part of the month-end review of the financial statements, there should be a set checklist that you go through so that you know what you are looking for. Staring at the numbers and stating that everything is in line with expectations is just not enough. Comparing to prior month, prior month last year and budget are only some of the overall checklist items that should be investigated, but this is a good starting point because this review of fluctuations can raise some ‘red flags.’

The financial statement review is not just meant to find accounting irregularities. Much like an investor reviewing an initial public company offering or a banker reviewing annual compliance; financial statements can uncover so much more. It can help identify liquidity issues, operational issues and potentially fraud. 

Don’t rely on others to do your dirty work, pay attention to your financial statements because they tell the story of how your business is performing. If you find something that seems out of the ordinary, keeping digging until you are satisfied.

I will be focusing on specific financial statement line items and ratios in upcoming blogs.