isn’t much need for a summary of changes in owners’ equity. The financial statement reader can easily find profit in the income statement and cash distributions from profit (if any) in the statement of cash flows. For details, see the later section “Why no (or limited) cash distribution from profit?”
Gleaning Important 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 investors and lenders. From that information, investors and lenders are able to answer key questions about the financial performance and condition of the business. We discuss a few of these key questions in this section. In Chapters 11, 12, and 20, we discuss a longer list of questions and explain financial statement analysis, including using ratios to evaluate financial results.
How’s profit performance?
Investors use two important measures to judge a company’s annual profit performance. Here, we use the data from Figures 2-1 and 2-2 for the company. Of course, you can do the same ratio calculations for a product or service business. For convenience, the dollar amounts here are expressed in thousands:
Return on sales = profit as a percent of annual sales revenue:$4.482 million bottom-line annual profit (net income) ÷ $71.064 million annual sales revenue = 6.3%
Return on equity = profit as a percent of owners’ equity:$4.482 million bottom-line annual profit (net income) ÷ $15.959 million owners’ equity = 28.1%
Profit looks pretty thin compared with annual sales revenue. The company earns only 6.3 percent return on sales. In other words, 93.7 cents out of every sales dollar goes for expenses, and the company keeps only 6.3 cents for profit. (Many businesses earn 10 percent or higher return on sales.) However, when profit is compared with owners’ equity, things look much better. The business earns more than 28 percent profit on its owners’ equity. We’d bet you don’t have many investments earning 28 percent per year.
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 company in our example has $11.281 million cash on hand (refer to Figure 2-2). This cash balance is available for general business purposes. (If there are restrictions on how the business can use its cash balance, the business is obligated to disclose the restrictions.) Is $11.281 million enough? Interestingly, businesses do not have to comment on their cash balance. We’ve never seen such a comment in a financial report.
The business has $4.213 million in operating liabilities that will come due for payment over the next one to three months (see Figure 2-2). Therefore, it has enough cash to pay these liabilities. But it has just barely enough cash on hand to pay its operating liabilities and its $7.0 million interest-bearing debt. 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 look at the other assets as well.
Taking this broader approach, the business has $11.281 million in cash, $8.883 million in trade accounts receivables, and $1.733 million in inventory, which adds up to $21.897 million in cash and cash potential. Relative to its $11.213 million in total liabilities ($4.213 million in operating liabilities plus $7.0 million of debt), the business looks like it’s in pretty good shape. On the other hand, if it turns out that the business isn’t able to collect its receivables and isn’t able to sell its products, the business would end up in deep doo-doo.
$71.064 million annual sales revenue ÷ 365 days = $194,696 sales per day
$11.281 million cash balance ÷ $194,696 sales per day = 58 days
The business’s cash balance equals almost two months of sales activity, which most lenders and investors would consider adequate.
Can you trust financial statement numbers?
Whether the financial statements are correct depends on the answers to two basic questions:
Does the business have a reliable accounting system in place and employ competent accountants?
Has its management manipulated the business’s accounting methods or deliberately falsified the numbers?
Furthermore, there are lots 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 we have to tell you that in our 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’s 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 a 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.