Financial statements are typically used to paint a picture of the financial health of the company. However, as credit professionals are well aware, numbers can sometimes be manipulated. Thus, it is important to have statements that are audited by an independent accounting firm. Financial statements come in three levels:
1. Audited statements are compiled by an independent accounting firm from company records. This is the preferred type of statement. The audit firm signs off on the statements when the audit is complete. They typically state that the accounting conforms to generally accepted accounting principles (GAAP). This is referred to as an unqualified and it is what credit managers ideally want to receive.
If the accounting firm disagrees with the way the company handled one or more transactions believing the issue does not conform to GAAP, it will give a qualified statement. Companies generally will go to extreme lengths to make sure that their auditors give an unqualified statement as many believe a qualified statement is a sign of bigger problems. It can also trigger an investigation from parties such as the Securities and Exchange Commission (SEC)—something virtually every company would like to avoid.
2. Reviewed statements are what they indicate. The audit firm reviews the numbers put together by the client, but the accountants have not audited the company’s procedures. 3. Compiled statements are put together on the basis of information provided by the company to the accountant. The accounting firm has no way of determining if the numbers are accurate or if the company has complied with GAAP.
The more current the statement, the more reliable the numbers will be to the credit manager using the information to complete a credit evaluation. Typically, the numbers may be as much as 18 months old. Here’s why. The accountants only audit once a year and this is done after the fiscal year-end. Thus, already some of the information is a year out of date. Then the company must complete the audit and prepare the financial statements. This can and usually does take several months. However, new statements should be available six to nine months after the end of the fiscal year. If they are not, it could be a sign of financial difficulties.
Additionally, credit professionals are well advised to look twice at customers who change their fiscal year-end.Very rarely is there a good business reason for making the change, often the change is done to hide something. Thus, whenever a change is noted, question the customer for the reasoning behind the change. What Is Included in Financial Statements? Several important documents are included in the general term financial statements.
Income Statement. The income statement is the starting point for most credit investigations. It tells the profit-and-loss story for the current fiscal year. Examine the statement closely for any unusual or nonrecurring items, such as the sale of a facility, a change in accounting methods, a large tax credit, or a write-off. If you find such items, recalculate the income statement, and then redo your ratio analysis based on the new numbers. After all, if the only reason a company showed a profit was that it sold a piece of real estate, this is a one-time gain that is unlikely to happen again.
Once you have the new ratios, compare them to industry standards to see if they are normal for the industry. If they do not fall within the accepted ranges, you will have to find out why the ratios are off. Also take a close look at the statement of stockholders’ equity to see if there have been any significant changes for the period the income statement covers. Again, if there were big changes, such as the owners making a capital contribution or the sale of new stock, you need to determine the reason for the change.
Balance Sheet. The balance sheet, sometimes called the statement of financial condition, shows the financial condition of the company. It reflects both long- and short-term assets and liabilities.
Statement of Cash Flow. Although traditionally the cash flow statement was not deemed to be that important, increasingly it is seen as vital to those analyzing the financial condition of a company. It shows the cash inflows and outflows of the customer. It is especially important to credit professionals who are very concerned about making sure the customer has adequate cash flow to pay all its short-term obligations, especially vendor obligations. Some even call cash flow the lifeblood of any organization.Anything that adversely affects it needs to be examined closely.
Footnotes. Some of the most important information about a company is hidden away in the footnotes. Long and complicated footnotes deserve extra attention. Again, they do not necessarily mean bad news, but they do need to be inspected closely. Additionally, they may provide invaluable information that is not included elsewhere in the financial statements.What kinds of information might you find? Details about lawsuits pending against the company, use of tax credits, the condition of the pension plan, and the status of leases and mortgages or deferred compensation commitments. Information about certain contingent liabilities will also be buried in the footnotes.
Most customers will not voluntarily offer this type of information to their creditors. You must find it. These facts can often have a negative bearing on a credit decision—provided you unearth them.
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