Financial Statement Analysis: Recognizing Debt Overload
This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.
Despite my undergraduate degree in finance and background in explaining numbers to non-financial managers, even my eyes start to glaze over when I think about financial statement analysis. Still, I am intrigued with the idea that the right kind of scrutiny could save a company from near-certain disaster.
Treasury and technology consultant Tom Marcoux, principal of Reserve Capital Value, LLC, told me that business owners can avoid "delayed realization" by recognizing unwieldy debt structures, which could destroy their companies. Aligning the purpose and timeframe of borrowing with debt terms is critical so that capital invested generates cash in a controlled manner.
Financial statements can illuminate short-term funding and long-term borrowing needs, particularly if reviewed along with strategic plans and annual budgets. In-depth analyses followed by discussions with key managers may make the case for accelerating A/R collections or renegotiating payment terms with vendors, rather than taking on high-rate credit-card debt to fund day-to-day operations.
Similarly, business owners may plan better for major purchases by setting aside capital reserves. They may also make sure that bank loan terms are matched with the useful lives of facilities and equipment to avoid dragging down cash flow with aggressive payment schedules.
Here are more tips on financial statement analysis:
Get a full picture.
Look at your profit and loss (P&L) statement, balance sheet, and cash flow statement to get a full picture of what's happening with your business. Your company may have booked thousands of dollars in sales, which renders a rosy-looking outlook for income. However, you may not be collecting your accounts receivable (A/R) on a timely basis. This will become more apparent when you review your A/R balance on the balance sheet or see that cash expended in inventory or payroll dollars isn't flowing back to the company as retail sales or monthly billings.
Detect trends.
Analyze statements compared to prior periods. See if your company is increasing its sales, growing profits at the same rate of sales increase, collecting payments faster, or reducing cost per unit shipped or project delivered.
Tom reminds me that financial statements are snapshots: valuable but not totally enlightening if reviewed in isolation.
Develop a frame of reference.
Understand that "different industries require different analytical frameworks" Tom advises. Typically, there are standards for financial ratios, profit margins, and average operating costs as a percentage of sales, etc. Trade associations, professional groups, and non-profit business organizations are potential sources of aggregated financial data. Ascertaining why your company deviates from the norm can reveal strengths and weaknesses in your business model, pricing, and efficiency.
Even if you can't pinpoint industry-specific financial figures, review actual versus budget comparisons. Consider how your company is progressing compared to expectations. Find out if underlying assumptions hold true and how economic or competitive conditions are influencing results.
Understand cash basis or accrual basis accounting.
Cash reports are relatively simple: Sales are recorded when cash is received and expenses documented when bills are paid. Accrual-basis statements can give a more accurate, complete picture of your company's financial standing. However, creating and tracking accruals can add complexity to the record-keeping process. Tom recommends that most companies adopt an "accrual basis as soon as possible after getting revenue up to pay owner's salary and hire staff." All statements should be prepared using the same basis.
Scrutinize operations.
Well before statements are prepared and analyzed, work with your accountant to establish policies for transferring and consolidating financial information among various business entities.
Decide on appropriate methods of valuing inventory, set interest at market rates, etc.
Make sure that information is captured and reported consistently so that comparisons with prior periods and budgets are meaningful. This approach can help avoid inflating the profitability of one company while under-reporting the value of another.
Pay close attention if partners are involved so that one entity doesn't get shorted in a transaction that is inconsequential when statements are consolidated but can seem fraudulent at a lower level of detail.
Figure out what's missing.
Financial statements should give a true picture of what's happening with your company. That's only possible if all the information has been captured, categorized, and presented correctly.
Comparing your company to its competitors can give you ideas on what areas may need greater detail and which ones might be combined. Other areas that might be overlooked are out-of-pocket expenses and reserve accounts for bad debt.
Notice if "one-time" write-offs are recurring.
One-time write-offs of obsolete inventory or bad debt can be reasonable charges against earnings. In some cases, this information may be omitted from the main portion of financial statements to make year-over-year and actual versus budget comparisons more reasonable. Pay attention to confirm that write-offs don't occur regularly. Instead, discover and deal with sources of problems, such as excessive purchases of seasonal inventory or lax credit policies.
No matter what you think your financial analysis is telling you, if you don't have enough money to pay your bills or yourself, then there's a problem. If you are paying your vendors and lenders on time, setting aside money for future obligations, and giving yourself (and your employees) well-deserved paychecks, then your financial health should be excellent.
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