What Are Financial Reports And What Do They Reveal?

Financial Reports are typically associated with accountants.  This term can be found in the Corporations Act (“the Act”).  Section 295 of the Act specifies that an annual Financial Report consists of:

• the Financial Statements;
• the Notes to the Financial Statements; and
• the Directors’ Declaration about the Financial Statements and Notes.

When the Financial Reports are prepared in accordance with Australian Accounting Standards, they will include:

• the Profit and Loss Statement;
• the Balance Sheet; and
• the Statement of Cash Flows.

Technically speaking, there are other documents that need to be prepared in accordance with Accounting Standards.   Here, I want to specifically focus on the ‘Financial Statements’ of the ‘Financial Reports’ being the 3 key documents identified above and shed some light as to what they are designed to say and what they don’t say, especially when they have not been prepared in accordance with Accounting Standards.

The Profit and Loss Statement

This document may also be referred to as the Income and Expenditure statement and, as the name suggests, includes the income and expenses for the year to result in a profit or loss.  Most people intuitively understand that profits are good and losses are bad and that typically, in my experience, is where the interest starts and ends for those not familiar with and confident in reading Financial Statements.

Some Profit and Loss Statements can provide quiet detailed information which facilitate useful analysis relating to the computation of gross profits margins, contribution margins, interest cover ratios and may identify things such as abnormal items and/or extraordinary items.  Items such as tax expenses, profit distributions to owners and prior year losses should also be apparent.  However, there are many cases where all this type of useful information may not be obtainable from the Profit and Loss Statement.

One of the common misconceptions about what the Profit and Loss Statement reveals is information about how cash rich or cash poor the particular business is.  Profit and Loss Statements are generally prepared on an accruals basis which means that all income and expenditure for the relevant year should be included which may be very different from the actual cash receipts and outgoings for the year.  Also the Profit and Loss statement may include non-cash items relating to depreciation expenses, amortisation expenses and/or unrealised gains or losses.

The Balance Sheet

The Balance Sheet may be also referred to as the Statement of Financial Position.  In my experience, most business orientated people have a basic-level understanding that this document shows what assets and liabilities are held by the business.  However, beyond the mere inclusion of assets and liabilities, the Balance Sheet can be a tricky document to understand for some.

The Balance Sheet, by definition, must always ‘balance’ whereby:

• ‘total assets’  - ‘total liabilities’ = ‘equity’; or
• ‘total assets’ = ‘total liabilities’ + ‘equity’.

I have seen plenty of Balance Sheets over the years that do not actually ‘balance’, which is an instant sign that something is wrong.  It might help to view the Balance Sheet for a business as a pie of assets, of which, outsiders (liabilities) and owners (equity) each have an interest in eating a piece of that pie.

Unlike the other documents in the Financial Statements which reflect the recording of financial events over time, the Balance Sheet is a ‘snap shot’ of the business at a specific point in time.

The first and most obvious thing on the Balance Sheet that draws attention is whether there is a Net Asset position or a Net Liability position, the latter indicating that outsiders and owners potentially want more pie than what is available!

Working capital is usually the next thing that draws attention, however you have to calculate it.  This is usually simply worked out as the difference between ‘total current assets’ and ‘total current liabilities’.  This provides some information as to the liquidity of the business.

While the Balance Sheet provides useful information about the types of assets and liabilities held by the company, chances are some assets and liabilities have not been included on it and those which have, are recorded at a value which may have little relevance as to what they may be worth today.  So while the Net Asset or Net Liability position shown on the Balance Sheet is interesting, this particular value rarely equates to what the business may be worth.

The Cash Flow Statement

This document may also be referred to as the Statement of Cash Flows or Source and Application of Funds.  As these names may suggest, it reflects the business’ cash receipts and outgoings over the year.

Unfortunately, those businesses that are not legally obliged under the Accounting Standards to prepare such a document, most often do not voluntarily choose to do so, even though they might prepare a Profit and Loss Statement and Balance Sheet.

Within a Cash Flow Statement, there are three key headings:

• Net Cash Flows from Operating Activities.  This provides information about the business’ ability to generate cash from its core business relating to the sale of goods and services including the associated costs and taxes.  A profitable business may actually have negative operating cash flows which is very useful information to be aware of.
• Net Cash Flows from Investing Activities.  This generally provides information about the cash flows from purchase and sale non-current assets.
• Net Cash Flows from Financing Activities.  This generally provides information about the cash flows from non-current liabilities, eg loan draw downs and repayments and equity, eg payments of dividends.

The objective of the Cash Flow Statement is to show how the opening cash balance and the various net cash flows for the year agree to the cash balance shown on the Balance Sheet.

Summary

A common feature of all the documents included in the Financial Statements described above is that they are all historical in nature.  They are typically prepared months after the actual events happened so while the information contained in the Financial Statements are very useful to understand in respect of some of the history of the business, care is still required to interpret them as they may be subject to ‘creative’ accounting (which will be the topic of another blog).  Even greater care is required when analysing Financial Statements to inform about what the business might look like today or in the future.