Preface: Many entrepreneurs vaguely appreciate, and typically do not gain adequate value from the quality assurance of their businesses financial statements, namely because they are unaware of how to synthesize and analyze the information in-depth. In this blog, we will highlight key areas of a financial statement, and provide advice to improve the value of the CPA’s work to the entrepreneur.
Financial Statements – Synthesis and Analysis – Part II
Statements of cash flows show the businesses liquidity, solvency and financial flexibility. A statement of cash flows shows sources and uses of cash in three classifications, i) operating ii) investing iii) financing. Operating cash flows begin with net income and adjust for changes in current assets and liabilities, including inventory, accounts receivable, accounts payable or say accrued wages. Operating cash flows show increases and decrease in operating balance sheet accounts. Investing activities show cash uses for equipment or investment purchased, or cash received from repayment of a note receivable. Financing cash flows show cash uses for repayment of debt, cash received from an increase in a line of credit or other financing activities.
What to look for on statement of cash flow? Decreases in accounts receivable and accounts payable indicate good collection efforts and adequate cash management. A decrease in accounts receivables is an increase in cash flow, and a decrease in accounts payable is a decrease in cash flow. Statements of cash flow most importantly, should always have increases in cash from operating activities. A decrease in cash from operating activity cash flows, indicates a deterioration in business operation activity for the period. If operating cash flow is negative for the fiscal year, or consecutive fiscal years, the business needs to take immediate action to determine causes, e.g. market shifts in key products or services, slack customer demand or lack of pricing power, or maybe even hidden fraud.
The statement of cash flow will tell you more about a businesses operating activities health than the income statement. Investing cash flows should most often include capital expenditure cash uses, if the business is growing, while still maintaining a net increase in cash on the statement. Should a manufacturing or construction business not consistently invest in capital expenditures, i.e. new equipment or machinery, the cash flow statement indicates the business is not planting for the future. Financing cash flows show requirements for debt payments or say discretionary owner’s draws. Financing cash flow uses should rarely exceed operating cash flow increases; and the higher net income, and the higher operating cash flows, the healthier the business. A high ratio of cash flows from operating activities to net income indicates strong internal cash flow.
Supplementary schedules in financial statements provide greater comprehension of the company’s historic financial data; and make ratio analysis easier. The real value in financial statement synthesis and analysis is in interpreting analytical procedures. Typically, CPAs preparing financial statements do not prepare analytical procedures, i.e. cash flow ratios, sufficiency ratios, efficiency ratios, liquidity ratios. If you’re serious about making the most sense of financial statements, on your business, or investment(s), you should begin tracking key ratios. Analytical procedures are beyond the text of this blog, but standard for the savvy financial manager.
Summary: Many entrepreneurs vaguely appreciate, and typically do not gain adequate value from the quality assurance of financial statements, namely because they are unaware of how to synthesize and analyze the information in-depth. Financial statements characteristically provide a minimum of three reports: i) a balance sheet ii) income statement iii) statement of cash flows. Tracking trends in financial statements is vital to monitoring the financial health of your business. Interpreting your financial statements is an important and honed skill. If you have CPA prepared financial statements, and they are not inexpensive, don’t neglect the extra step of making sense of that information. If your businesses CPA doesn’t take the time to prepare analytical procedures and interpret your financial statements to you, request that they do.