If you sit on a board or are presented with a set of financial accounts, how do you review them?
I am not going to pretend that I can cover everything in this short article but at least give you some pointers and maybe arm you with some questions.
However, I must stress a fundamental principle of reviewing financial statements. You need to understand the business. Different business structures or industries look totally different and will have different financial challenges, KPIs, pain points and therefore should have different financial strategies. Do you understand these for the business?
I am going to assume that you know your way around the 3 key financial statements, shown in the graphic – their purpose and what each of them shows. (If not, please do reach out, you are not alone and we can help you with this).
So let’s look at areas you might examine on the Balance Sheet:
When reading a Balance Sheet, we recommend that you focus on the following:
Analysis of assets
- What evidence is there around the collectability of accounts receivable (i.e. will the amount shown actually be received);
- Do you know the difference between the market value of securities/investments and their recorded cost?
- Question if inventory on hand is saleable in the foreseeable future;
- Are you satisfied that all significant capital assets of the company are recorded on the balance sheet?
- Have you had discussions re whether the company plans to or needs to replace capital assets in the future? Are non-current assets on the increase?
- Read the notes to the financial statements to determine the detail re accounting policies, the treatment of revenue, depreciation rates, right of use assets etc.
Analysis of liabilities
- Compare current liabilities with current assets. The company should have sufficient current assets (the sum of cash, inventory, accounts receivable, etc.) to cover its current liabilities. If it does not, then you should question how the company will pay the amounts owing in the upcoming year. (See cash flow below – the cash flow forecast, an internal document, should be giving you reassurance on this point).
- Review the terms and conditions of loans and other debt to determine whether any large payments are due in the near future.
- Read the notes to the financial statements to determine whether there are any potential liabilities that could not be quantified as at the year end.
The Profit and Loss Account or Income Statement
When reading a P & L, we recommend that you focus on the following:
Analysis of revenue
- Review changes in revenue from last year to this year. Management should be able to explain significant changes if the reasons for those changes are not evident from the financial statements themselves.
- Review accounts receivable in conjunction with revenue. A significant increase in accounts receivable might indicate either problems with collectability of revenue or a significant increase in activity toward the end of the fiscal year.
Analysis of expenses
- Compare the change in expenses from last year to this year. Review the notes to see if explanations for significant differences are noted.
- Review the notes to the financial statements to determine whether there are potential expenses that have not been recorded because the amounts were not reasonably determinable at the year end.
The Cash Flow Statement
When reading a Cash Flow Statement, we recommend that you focus on the following:
Analysis of Statement of Cash flows
- Take net cash actually received or spent on operations from the statement of cash flows and compare it with the profit or loss for the year as recorded in the Income Statement. The two amounts should be similar unless liabilities or receivables have changed significantly over the year. If the two amounts do not closely correlate, then ask why. Understanding a discrepancy is especially important when a company with a healthy excess of revenue over expenses has received significantly less cash from operations. The discrepancy might indicate cash flow problems that could lead to financial difficulties.
- It would be unusual for a company making a profit to show a negative cash flow for operating activities.
- The cash flows from investing activities shows at a glance how much the company is investing in the future. Is it simply keeping up with depreciation or growing the business?