How to Read and Better Understand Your Financial Statements
By Jim Lindell, CPA, CSP, CGMA, MBA
It is important to identify who is using the financial statements as well as what their specific interest is. Some users of financial statements are not very experienced and have no desire to become enlightened on reading the financials. Therefore, it is important that they are taught some key components of the financial statements and expect nothing more than that. The next priority is understanding what their particular interest is. Typically, CEOs and sales executives are interested in the top line. CEOs are also interested in the bottom line. COOs are interested in operational costs and the bottom line. HR professionals are typically interested in labor costs and staffing issues.
I believe that providing more context or background to the financial information presented is one of the most critical things for controllers and CFOs to do. A balance sheet, income statement or cash flow statement that just displays absolute dollar values may be meaningless because it does not provide anything to put the numbers in proper context. Context is one of the reasons that comparability from prior periods is so important. Additional context develops with the use of graphs, ratios, and specific metrics. Never forget the adage that a picture is worth 1000 words.
Consider the following example: Take the revenue history of an organization and graph that information against the G-17 industrial production numbers for the same industry. Also, include 3 and 12-month trailing averages and then it is possible to identify the business cycle of the industry as well as the organization. These lines allow us to make some assumptions as to the quality of the sales staff as compared to the overall industry. If the sales revenue numbers are not better than the industry average regarding the overall production, it tells us that the company is not doing as well as the rest of the industry. If the sales staff were performing well, the expectation would be for the trendlines to outperform the industry averages.
Keeping the same example, now envision the chart displays both industrial production for the industry and your company’s sales revenue history and then the background is color coded for the time periods of the corresponding recessions. The results now have the context of comparison to industry, economic times and inferences for pre- post- and current recessions! Now, this is valuable information provided by the CFO or controller which brings additional meaning to the financial statements. By the way, color coding the recession periods is accomplished with the use of the second Y-axis and data set for recession time periods. It is important for a company to identify key ratios for their organization. This author has always been a proponent of the Altman Z-score. Even though the Z-score was created as an indicator of bankruptcy, this author uses it as an overall indicator of the health of an organization similar to the way a physician would take the blood pressure of their patient. A company can also consider calculating the DuPont ratio, which is a return on equity calculation. The reason to consider both of these ratios is that they involve components from both your balance sheet and your income statement. Over time this author has learned that executives will put an overemphasis on the income statement because they do not understand the correlation with the balance sheet.
We also do a disservice to financial statement readers with the utilization of exceptions and extraordinary items. An organization should be concerned with the long-term health of the company as opposed to just current earnings. Expenses that wind up as extraordinary are the result of decisions made in the past that we believe shouldn't impact the current operations. When in fact an executive should be charged with all of the responsibilities of the decisions that have occurred regardless of the timeframe. Some of the author's recommended ratios are the current ratio, turnover ratios for accounts receivable and inventory as well as net sales to working capital. If the organization has loan covenants, then consider including those as part of the discussion.
Another tip for improved reading and understanding of financial statements involves the presentation of financial statement information to your executive team, managers or board of directors. The following example is a great trick the author learned from a vice president of a hospital. Whenever he presented his financial statements, he handed them out in traditional statement format and as a duplicate copy in Excel format with both the rows and columns identified. When he led the discussion, he would use the Excel format and would request the participants to focus on specific cells. For example, he would say, “Everyone, please look at cell A5. Do you see $1M? If so, please nod.” The VP would make comments about cell A5. After telling people a couple of times to nod, it was no longer necessary, and he had complete control of the conversation. If somebody interrupted him with a question, he could then ask the person to identify the cell. Then direct the rest of the participants in the meeting to the same area to discuss the question in more detail. As a consultant, this author has used this technique many times.
One time, the author was asked to lead the financial presentation to the board of one of his clients (the CFO fell ill) with only a couple of hours’ notice. The board members commented that this was the best presentation that they had ever received. The reason this approach works is that when financial statements are presented everybody looks at different areas related to their particular interest and may not listen to the presenter. Being able to steer the listeners to the exact section of the financial statement helps increase the focus of the user. When this occurs, relationships and context are identified, providing more meaning to the end users.
Jim Lindell, CPA, CSP, CGMA is a regular presenter for GSCPA events. He is a seven-time recipient of the AICPA’s Outstanding Discussion Leader award and writes the AICPA’s “Annual Controller Update.” Jim can be reached at email@example.com.