Steve Harms

Thursday, April 28, 2011

FINANCIAL STATEMENTS: HOW AND WHY THEY ARE IMPORTANT

A. The value of a financial statement


A financial statement is the financial picture of a company at a particular point in time. It is exactly the same as taking a picture of your children. Within a few weeks, they changed, didn’t they? Within a month or so, there are generally significant changes, right? Within a year or two, your kids don’t look anything like they did a year ago. Well, financial statements are exactly the same. A current financial statement is the only good financial statement. An audited financial statement is better than an unaudited one. What am I talking about: a financial statement is the picture of assets and liabilities. An operating statement is the sales and profit/loss. Both are dated. For example, a financial statement may be dated December 31, 2006. That statement might be valuable to determine credit transactions for several months. An operating statement is over a span of time such as January 1, 2006 through December 31, 2006. Sales and profits for a year are posted. Again, audited financial statements are better than unaudited ones. Simply put, the audit carries the reputation of the certified public accounting firm that prepared it. Why aren’t all financial statements audited? Simply put, they are expensive.


B. The “useful” components of a financial statement when extending credit or assessing collectability.


For extending credit, a couple of ratios come to the forefront. First, the current ratio. The current ratio is current assets divided by current liabilities. If current liabilities exceed current assets, watch out. The ideal is current assets substantially in excess of current liabilities. What this means to you: the company has sufficient assets to cover its debts. Also, examine:


Quick ratio, which is quick assets divided by current liabilities. Quick assets are assets that are quick to liquidate such as cash, accounts receivables, certificates of deposit. Current assets which would not be included as quick assets would be slow moving inventory. Hopefully, quick assets are sufficient to cover current liabilities. What this means to you: the company has sufficient cash and receivables to cover its current liabilities which are all of its short term debt (debt which is less than a year old). Even here, there are problems. What if the accounts receivable are no longer collectible? Oh No.


Net working capital ratio is net working capital divided by total assets. The net working capital of a company is its current assets minus its current liabilities.


Don’t get carried away with these ratios. There are whole courses on studying financial statements such as that found at www.investopedia.com. There is a printable 74 page advanced financial statement analysis form available free, absolutely free, at that cite. Topics include Whose in Charge?, The System, Cash Flow, Earnings, Revenue, Working Capital, etc.


C. Popular Terms


If you looked up the phrase Cash Flow, you would get a thousand different definitions if you searched a thousand different web sites. Commonly speaking, cash flow is something that debtors say they don’t have enough of. The first step in generating cash flow is to create sales. Sales put the product out the door. Accounts receivable bring the money back in the door.


If the company is not generating sales, they can’t generate cash flow. If the company doesn’t collect its receivables, there is no cash flow either. Example: I have run into a number of construction companies which has done work for the Katrina Hurricane Relief in New Orleans. None of them have been paid a dime, according to their managers, and they thought they were working for the federal government (FEMA) and thought they would be paid right away. If you don’t collect your receivables, you might as well not sell your product.


Working capital is another popular phrase. Working capital is the money used to pay short term obligations, such as paying vendor bills. In that sense, it is just like cash flow: debtors always claim they don’t have enough working capital. Businesses which have heavily invested in fixed assets, long term debt, and inventory build up have a hard time generating a good level of working capital. Once again, we look at the quick asset ratio; they don’t have enough cash, receivables, certificates of deposits and other assets quickly liquid in order to satisfy debt which becomes due in 30 days such as vendor obligations.


Tons of Tips on Credit and Collections: THE book, Credit and Collections Kit

1 comment:

Janet Williams said...

Great article, financial statements are so vital and important pieces of information about a company. Thanks for sharing!

Janet
Collections Statements