Financial statement literacy has become a managerial necessity
The prospect of reading an organization’s financial statements can make even the most experienced businessperson’s head spin.
The rows and columns of tiny numbers and the arcane terminology can seem daunting and confusing.
But whether it’s determining a client’s credit worthiness, evaluating a merger candidate or making process improvement recommendations, understanding the story a balance sheet, income statement and cash flow statement are telling is a mighty skill.
Keely Gohl, an adjunct professor at the Daniels College of Business, has been helping people overcome their fear of financial statements since 1998. She teaches the Daniels Executive Education “Finance for Non-Financial Managers” course with Dessa Bokides, another adjunct professor. The long-standing three-day workshop helps mid-level professionals, small business owners and consultants understand and analyze the three main financial statements.
The first step, Gohl says, is understanding what each of the statements is intended to do.
Balance sheet vs. income statement vs. cash flow statement
“A balance sheet captures the financial health of an organization—everything it owns (its assets) and everything it owes (its liabilities)—at a moment in time,” Gohl said. “It answers the critical question: ‘Does the organization have enough assets to cover its liabilities?’
“Income statements highlight the operating environment and answer questions such as, ‘Are we efficient in our operations?’ and, ‘What do our margins look like?’ And cash flow statements highlight the use of cash and its flow in and out of an organization.
“Putting it all together, for example, negative cash flow over an extended period should raise questions. But it’s not always bad,” she added. “For a startup, it could mean that investors are providing their cash flow. And that’s okay. It’s important to see where they’re generating cash and what is using cash. The three statements together tell that story by painting a holistic picture.”
Five tips for reading financial statements
Understanding the purpose of each statement is one thing. Interpreting them together is another. Gohl offers five tips for reading financial statements.
1. Know what you have in front of you
Financial statements can be prepared on a cash or an accrual basis. Which is it?
Much like a checkbook register, cash accounting follows cash income and expenditures in real time. Accrual accounting recognizes income and expenditures when a transaction occurs, rather than when a cash payment is made or received.
“As consumers, we typically don’t accrue things in our checkbooks. We follow the cash,” Gohl said. “Most small businesses run on cash until they do something, such as draw down on a line of credit, or there’s an end of a period and they catch up their accruals.
“Accrual accounting considers the event that gave rise to a transaction. You might have purchased something on credit. Or, you might have received a cash payment, but haven’t fulfilled your obligations. Accrual seeks economic reality and recognizes a transaction when the event giving rise to it occurs, rather than when it settles in cash.”
2) Look at the time frame
Organizations often choose a fiscal timeframe other than a calendar year to record their annual financial results.
“Organizations may opt for a non-calendar fiscal year to account for seasonality or unique timing attributes,” Gohl said. “It wouldn’t make sense for DU to have a Dec. 31 yearend. It’s dead center in the middle of the academic year. June 30—after the academic year has ended—makes more sense because it avoids having to record large unearned student balances. And many retailers use either Jan. 31 or Feb. 28 so they can allow for holiday returns.
“Knowing the fiscal timeframe and cut-off date helps you compare companies apples to apples,” she added. “This is especially important when significant events happen that could’ve impacted the numbers, like COVID.”
3) Pay attention to footnotes (if available)
Books and periodicals often use footnotes to document sources and are not intended to be read in their entirety. But financial statement footnotes can be critically important.
“Rather than placing information—such as certain types of debt or litigation judgements—in the face of documents, organizations often place them in footnotes,” Gohl said. “Debt covenants will appear in the footnotes. Accounting principles—how you’re recognizing revenue, how you determine, for example, your allowance for realizable or uncollectable receivables—is disclosed in the footnotes.
“Some experienced analysts go to the footnotes first because of the depth of information they provide.”
4) Understand the industry nuances of financial statements
Financial statements can vary by industry and economic sector.
“Not-for-profits have a statement of position instead of a balance sheet,” Gohl explained. “Their income statements are called statements of activities. The information is the same, but they use different names.
“In the for-profit sector, it makes sense to see costs of goods sold on a manufacturing company’s income statement. But a service industry company won’t have that,” she added.
“These are fundamental differences that apply by sector. Not understanding them makes analysis much more difficult.”
5) Use ratio analysis
Use of ratios can deepen an understanding of an organization’s financial condition.
“Liquidity ratios indicate how much cash or how many assets are on hand to cover liabilities. And, more fundamentally, do they cover liabilities?” Gohl said. “The Quick Ratio looks at current assets versus current liabilities. And there are leverage ratios to see what percentage of either assets or equity debt is.”
Gohl noted the utility of these ratios, but cautioned on using applicable ratios, noting that ratios also can vary by industry.
Gohl and Bokides will fully cover these and other fundamentals at the next “Finance for Non-Financial Managers” session, which takes place on three consecutive Thursdays—Feb. 29, March 7 and March 14, 2024, from 9 a.m.-4 p.m. on the DU campus.