Expert Explains the Basics of Financial Statements

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One of the important skills business credit professionals must master is how to understand financial statements. Another valuable skill is to know what types of financial indicators can be used to gain valuable insight about a company’s financial status as presented in its financial statements. Attendees of an NACM teleconference on Feb. 21 got an opportunity to learn some of the basics of reading financial statements and performing various calculations. The presenter of the teleconference was D.J. Masson, Ph.D., CTP, Cert ICM.

Masson is President of The Resource Alliance, a training and consulting firm specializing in treasury management, electronic commerce, international finance, sales and sales management, retirement investments and planning and business process redesign. Over the past 20 years, he has been providing business and financial consulting and training services to a wide variety of corporations, financial institutions and not-for-profit organizations in the U.S., Canada and abroad. Masson has an extensive resume that includes teaching, speaking and writing articles and books on various financial subjects.

He mentioned that there were three types of accounting: managerial, tax and financial. In managerial accounting, the goal is to provide information to the company’s executives about the financial strengths and weakness of the organization. "It’s considered proprietary and internal to the company," Masson said. Tax accounting is done primarily "to minimize a company’s tax liability." Financial accounting is used to produce the books that are provided to the general public, to the investors and to the SEC. "Companies use different types of accounting for different purposes," he added. He provided the example of the depreciation of assets. For tax purposes, accelerated depreciation may be used to reduce the tax liability of the company in the first few years, while for investors, straight-line depreciation may be used.

There are two types of accounting methods, which are cash and accrual accounting. Masson said that cash accounting recognized expenses and revenues when cash is actually brought in or paid out, while accrual accounting recognizes these entries when they are booked. "In accrual accounting, we have a disconnect between cash flow with the accounting of that cash flow." Under Generally Accepted Accounting Principles (GAAP), Masson noted that flexibility is allowed in accrual accounting. He pointed out that cash flow analysis is used to try to understand the true cash position or liquidity of the company. "Liquidity of any company is its life’s blood."

The four types of financial statements required by GAAP are: income statements, statements of retained earnings, balance sheets and statement of cash flows. Masson said the income statement, or P&L (profit and loss), is a record of revenues and expenses showing the net change in shareholder equity from operations over a specified period. The statement of retained earnings shows how net income for the period was used. A balance sheet presents a snapshot of assets and liabilities, and the statement of cash flow reconciles all information back to what is the cash position of the business. In describing the difference between income and cash flow statements, Masson said the statement of cash flows provides an indication of cash flow and how it is being used while the income statement is an indication of performance.

There are various financial ratios and performance measures designed to reveal various aspects of the financial status of a company. The most common of these were presented and explained with accompanying examples. The most commonly used are liquidity, activity, debt, profitability and market ratios. Masson pointed out there are advantages and disadvantages offered by these ratios. Among the advantages are that they are easily computed, they are widely used, the information is easily obtained, they allow assessments of historical performance and they allow for comparisons between companies. Some of the disadvantages these financial indicators present are that they summarize accounting information and do not reflect economic value, they express static, not dynamic, relationships, they cannot reflect qualitative value such as managerial talent and other intangibles, they often miss variability of cash flows and are not necessarily indicative of future performance and their use of different accounting methods or "window dressing" can distort calculations.

In response to an attendee question on what financial ratios are the best predictors for bankruptcy, Masson pointed to the Z-score developed in 1968 by Dr. Edward I. Altman, a financial economist and professor at New York University’s Stern School of Business. The Z-score is a predictor of the likelihood that a company will go bankrupt in the near future. He also advised of comparing the current and quick ratios of a company to others in the industry. He also said, "You may just want to do a Google search." Other advice he offered regarding the possibility that a company may go bankrupt is to view rating companies, such as Standard & Poor’s and using credit scoring models to evaluate the creditworthiness of the firm.

Source: Tom Diana, NACM Staff Writer, and D.J. Masson

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