Preparing Your Financial Statements
July 18th, 2007 Filed Under General
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.
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.
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.
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.
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:
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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