Health of a firm is not always in its bottom line
Whether you are considering purchasing, selling or investigating a company, or researching a competitor, analysing financial statements is often your first port of call.
Too often individuals rely solely on bottom line profit as a sign of any company’s financial performance. While a company’s long-term survival does, of course, rely on consistently being profitable, there are a number of other areas which are equally as important when assessing an organisation’s financial health.
Analysis of a number of key areas, in particular, will help a reader gain a more complete understanding of the underlying business performance, without the need to be an accounting expert.
These areas are:
• Cash flow statement — the age-old saying that ‘cash is king’ rings true in business.
Problems arise when outgoings are consistently more than income, making long-term prospects questionable.
By focusing on cash flows and comparing it with profit, one can quickly identify when reported profits are not really represented by cash generation.
• Net current assets — this represents the difference between an organisation’s current assets and current liabilities, and is a measure of the organisation’s ability to meet current liabilities as they fall due. Although common in some sectors, negative net current assets may indicate a company which is overly reliant on its bankers or creditors.
• Trend analysis — analysing financial statements for a one-year period will not be indicative of a company’s past or likely future performance.
Trend analysis spanning at least three years, together with an understanding of the business and its industry, will give a reader a greater sense of the business’s trading cycles, and may identify factors that could impact on future performance.
• Related party transactions — it is normal for organisations to have some level of related party transactions. Occasionally, such transactions are undertaken under non-commercial terms, for example a property may be rented to the company by a related or group company at below market rate.
Related party transactions will be disclosed in financial statements and it is important to understand the relationships and transactions between an organisation and its related parties in order to get a complete picture of the organisation’s operations, and the impact on underlying performance.
• Other balance sheet liabilities — ‘other liabilities’ are common within an organisation’s balance sheet.
Typically, these liabilities are so insignificant that management believes no further explanation is necessary.
Further investigation is advised when ‘other liabilities’ appear substantial, or where contingent liabilities, or financial commitments, are disclosed in the notes to the financial statements.
The above list is not exhaustive, but a quick guide of what to look out for over and above the obvious.
So, the next time you review financial statements, whether it be to spot a good investment or investigating a company, be vigilant and consider other key areas to gain a greater understanding of an organisation’s true financial performance.