Lessons in Financial Health
The information age sparked from the 1990’s has created a false sense of total & complete knowledge over the masses in managerial circles. They fail to note that simple having access to information does not translate to having the tools to understand it.
Now more than ever; managers, investors and stakeholders need to start understanding how the numbers on the documents relate their concerned companies operations. They must also seek to comprehend financial reports. Without this knowledge, the next depression can neither be foreseen nor tackled.
The problem isn’t the quantity of information; it’s the lack of comprehension amid those who make use of financial statements. For starters, you can’t really get a clear picture of a company’s financial health from raw financial statements. For one thing, by the time a report is issue, the data is pretty much outdated. Secondly the metrics do not necessarily reflect developing trends and are highly subjective. Yet despite these assumptions, financial statements have value as long as one looks beyond the numbers.
A thorough read into the balance sheet, cash flow statement, P&L statement and footnote disclosures can reveal how well a company is managed, if at all. It’s the reader’s job to link the varying aspects of the report in order to analyze them as a single unit instead of as individuals.
I once worked with a company that generated a significant stream of sales revenue – which appears very impressive to the untrained eye – that is if attention is not paid to the cash flow statement & balance sheet; which reveals if any of those sales are collected. IF we simply studied the income statement, we’d assume it was doing well. A closer look showed otherwise. The accounts receivable (debtors) were noticeably high, but it was until the statement of cash flows was reviewed it was clear that while the company as recording sales, there was a failure in the collection of those associated payments.
The common misconception remains that rising sales translates to strong financial health in most Pakistani business circles. They fail to realize how the rise in sales corresponds to an increase in costs for variable costs in the form of production equipment, stocks and labor. In an effort to boost a company’s net equity and enable a safe expansion, companies need to start focusing on creating sustainable growth i.e. by increasing the profits and retaining some income for the company itself.
Per share prices are dragged down due to an excess of borrowing that disregard the equity level. It all starts tumbling down with the carrying costs.
While in this regard, sustainable growth formulas have a predictive value, they rely on ceteris paribus i.e. all factors remaining constant. If a company decides to change its game plan, the outcome changes but other than that, there’s a high degree of correlation.
Investors can expect some reassurance from an auditors report but in the end, there’s no substitute for being able to understand financial statements and speculate with the information accurately.