2.3. Gleaning Key Information from Financial Statements

The whole point of reporting financial statements is to provide important information to people who have a financial interest in the business — mainly its outside investors and lenders. From that information, investors and lenders are able to answer key questions about the financial performance and condition of the business. I discuss some of these key questions in this section. In Chapters 13 and 17, I discuss a longer list of questions and explain financial statement analysis.

2.3.1. How's profit performance?

Investors use two important measures to judge a company's annual profit performance. Here, I use the data from Figures 2-1 and 2-2 (the dollar amounts are in thousands):

• Return on sales = profit as a percent of annual sales revenue:

  $520 bottom-line annual profit (net income) ÷ $10,400 annual sales revenue = 5.0%

• Return on equity = profit as a percent of owners' equity:

  $520 bottom-line annual profit (net income) ÷ $2,470 owners' equity = 21.1%

Profit looks pretty thin compared with annual sales revenue. The company earns only 5 percent return on sales. In other words, 95 cents out of every sales dollar goes for expenses, and the company keeps only 5 cents for profit. (Many businesses earn 10 percent or higher return on sales.) However, when profit is compared with owners' equity, things look a lot better. The business earns more than 21 percent profit on its owners' equity. I'd bet you don't have many investments earning 21 percent per year.

2.3.2. Is there enough cash?

Cash is the lubricant of business activity. Realistically a business can't operate with a zero cash balance. It can't wait to open the morning mail to see how much cash it will have for the day's needs (although some businesses try to operate on a shoestring cash balance). A business should keep enough cash on hand to keep things running smoothly even when there are interruptions in the normal inflows of cash. A business has to meet its payroll on time, for example. Keeping an adequate balance in the checking account serves as a buffer against unforeseen disruptions in normal cash inflows.

At the end of the year, the business in our example has $1 million cash on hand (refer to Figure 2-2). This cash balance is available for general business purposes. (If there are restrictions on how it can use its cash balance, the business is obligated to disclose the restrictions.) Is $1 million enough? Interestingly, businesses do not have to comment on their cash balance. I've never seen such a comment in a financial report.

The business has $650,000 in operating liabilities that will come due for payment over the next month or so (refer to Figure 2-2). So, it has enough cash to pay these liabilities. But it doesn't have enough cash on hand to pay its operating liabilities and its $2.08 million interest-bearing debt (refer to Figure 2-2 again). Lenders don't expect a business to keep a cash balance more than the amount of debt; this condition would defeat the very purpose of lending money to the business, which is to have the business put the money to good use and be able to pay interest on the debt.

Lenders are more interested in the ability of the business to control its cash flows, so that when the time comes to pay off loans it will be able to do so. They know that the other, non-cash assets of the business will be converted into cash flow. Receivables will be collected, and products held in inventory will be sold and the sales will generate cash flow. So, you shouldn't focus just on cash; you should throw the net wider and look at the other assets as well.

Taking this broader approach, the business has $1 million cash, $800,000 receivables, and $1.56 million inventory, which adds up to $3.36 million of cash and cash potential. Relative to its $2.73 million total liabilities ($650,000 operating liabilities plus $2.08 million debt), the business looks in pretty good shape. On the other hand, if it turns out that the business is not able to collect its receivables and is not able to sell its products, it would end up in deep doo-doo.

One other way to look at a business's cash balance is to express its cash balance in terms of how many days of sales the amount represents. In the example, the business has an ending cash balance equal to 35 days of sales, calculated as follows:

$10,400,000 annual sales revenue ÷ 365 days =
            $28,493 sales per day

$1,000,000 cash balance ÷ $28,493 sales per day
                   = 35 days

The business's cash balance equals a little more than one month of sales activity, which most lenders and investors would consider adequate.

2.3.3. Can you trust the financial statement numbers? Are the books cooked?

Whether the financial statements are correct or not depends on the answers to two basic questions:

• Does the business have a reliable accounting system in place and employ competent accountants?

• Has top management manipulated the business's accounting methods or deliberately falsified the numbers?

I'd love to tell you that the answer to the first question is always yes, and the answer to the second question is always no. But you know better, don't you?

What can I tell you? There are a lot of crooks and dishonest persons in the business world who think nothing of manipulating the accounting numbers and cooking the books. Also, organized crime is involved in many businesses. And I have to tell you that in my experience many businesses don't put much effort into keeping their accounting systems up to speed, and they skimp on hiring competent accountants. In short, there is a risk that the financial statements of a business could be incorrect and seriously misleading.

To increase the credibility of their financial statements, many businesses hire independent CPA auditors to examine their accounting systems and records and to express opinions on whether the financial statements conform to established standards. In fact, some business lenders insist on an annual audit by an independent CPA firm as a condition of making the loan. The outside, non-management investors in a privately owned business could vote to have annual CPA audits of the financial statements. Public companies have no choice; under federal securities laws, a public company is required to have annual audits by an independent CPA firm.

Two points: CPA audits are not cheap, and these audits are not always effective in rooting out financial reporting fraud by high-level managers. I discuss these and other points in Chapter 15.

2.3.4. Why no cash distribution from profit?

In this example the business did not distribute any of its profit for the year to its owners. Distributions from profit by a business corporation are called dividends. (The total amount distributed is divided up among the stockholders, hence the term "dividends.") Cash distributions from profit to owners are included in the third section of the statement of cash flows (refer to Figure 2-3). But, in the example, the business did not make any cash distributions from profit — even though it earned $520,000 net income (refer to Figure 2-1). Why not?

The business realized $400,000 cash flow from its profit-making (operating) activities (refer to Figure 2-3). In most cases, this would be the upper limit on how much cash a business would distribute from profit to its owners. So you might very well ask whether the business should have distributed, say, at least half of its cash flow from profit, or $200,000, to its owners. If you owned 20 percent of the ownership shares of the business, you would have received 20 percent, or $40,000, of the distribution. But you got no cash return on your investment in the business. Your shares should be worth more because the profit for the year increased the company's owners' equity. But you did not see any of this increase in your wallet.