Whether you’re an investor about to buy another business or a supplier wondering whether your big new client will be able to pay for the products they’ve ordered, getting under the skin of a company is vitally important.
Businesses, even small ones, are complex machines with many moving parts. That can be problematic for outsiders seeking insights into a company’s financial health and future prospects.
Fortunately companies are obliged to provide annual financial statements which can help us to look into the workings of their business. While enterprises vary enormously from industry to industry and from country to country, the way in which their financial picture is presented is broadly similar.
The three building blocks
There are three basic financial statements which combine to give an all-round view of a company.
- Balance Sheet: A summary of what a company owns and what it owes.
- Profit and Loss Account: A summary of the revenues generated by a business over a period of time and the costs incurred in making those sales.
- Cash-flow Statement: A summary of all cash received and paid out over a period of time.
There are dozens of ways in which these financial statements can be analysed and hundreds of insights to be derived from that analysis. But let’s take a practical example.
Checking out that new customer
You’ve received a large order from a new customer you have never dealt with before. That’s great, but only if the company actually pays you for the products which you are supplying.
Time to dive into the financial statements and do a little due diligence. Here are some of the things you could look at for starters.
- Is the company growing?
The Profit and Loss account will give you a sense of the size of the company and whether the order they have placed with you looks ‘normal’ in that context. Then a glance at the company’s revenues and profits over the last few years will tell you whether the company is growing or stagnant. Most suppliers feel more comfortable doing business with customers whose business is growing.
- Is the company taking longer to pay suppliers?
Turn to the balance sheet, which helpfully gives a figure for trade creditors, to see how much the company owes to suppliers for goods it has already received. If that amount has increased out of proportion to the size of the increase in its sales, that could be a sign of financial problems. Which means you might be waiting a long time to get paid.
- Is the company struggling for funds?
While you’re on the balance sheet, have a look at the company’s debts. If the amount of money they owe is rising sharply and particularly if the company has had to resort to short term overdrafts to fund their business, alarm bells should be ringing. When their bank is not willing to make long term loans to a company, that usually means something is wrong. Which means you might not get paid at all.
In future posts, we’ll show how you can go deeper into company financial statements and gain insights that can help you make sound decisions. But we can’t leave the subject without addressing two concerns people frequently raise when approaching a set of accounts.
Accounts aren’t worth the paper they’re written on
It’s true that company accounts aren’t perfect and can’t tell us everything we might like to know about a business. There are two main complaints:
Accounts are a snapshot taken at a point in time, limiting what they can tell us. True. But when compared with figures from previous years, trends can be identified which can reveal a lot about how a business is developing.
The numbers can be manipulated to convey a particular message. It’s certainly important to be aware of the choices that companies make in presenting key data and how that can change the picture that outsiders see. But financial statements are produced to standards set by independent bodies and then scrutinised by trained professionals. So while companies which deliberately set out to mislead do sometimes slip through the net, they are the exception rather than the rule.
For all their faults, company accounts provide a valuable snapshot at a point in time of the status of a business. And where else are you going to get that kind of insight?
Help! I’m not a trained accountant
The other concern for the un-initiated is that, like any area with its own specialist jargon, accounts can be a bit intimidating at first glance. However, once a few basic terms are defined and the relationships between the key numbers are understood, a world of information opens up.
A little knowledge goes a long way
Of course, if you want to track funds flows through complex financial structures built around opaque offshore shell companies, you’re going to need to hire a specialist. But with a little bit of basic knowledge and understanding of the numbers which companies report, anybody can get a good feel for what kind of business they are looking at. That’s something we’ll be exploring in future posts.