Understanding Company Financials
Use financial statements to gauge the health of potential business partners.
Thinking about hiring a consultant, engaging a service provider or buying from a new supplier? Recommendations from satisfied friends and colleagues are important, of course, but for large expenditures your research should include a look at a company's financials.
This month I'll introduce a key concept behind financial statements and explain the two types of statements you should examine. Next month I'll explain how to use these statements to gauge a company's health.
Cash vs. Accrual
One purpose of financial accounting is to accurately document a company's financial status. To do this, a business must record income and expenses in one of two ways: They operate using the "cash basis" method or using the accrual method. It's important to understand the difference when reviewing financial records to evaluate suppliers, from consultants to large corporations.
Cash is King
Cash-basis accounting is the simpler of the two methods. It relies on recording a transaction whenever money changes hands. For example, when a company writes a check to pay a bill, an expense is incurred (and recorded). When a company bills (sends an invoice) for a service provided, there's actually no transaction. At the point when the company receives a check to pay that invoice, there's revenue. No payment, no transaction. It's easy to see why cash-basis accounting is often called checkbook accounting.
Sole proprietors (one-person shops) and small businesses with no inventory are typical users of cash-basis accounting. It's simple to implement and easy to understand. Unfortunately, it may give a false sense of a company's financial state.
Suppose, for example, you're evaluating the financial health of a consultant you're thinking of hiring. The consultant, a sole proprietor who uses the cash-basis method, founded Acme Consultants in January with $10,000 seed money. At the end of January, Acme bills a client for $2,500 for work performed, and writes checks for a few bills incurred (telephone, rent, business cards, and so on) totaling $1,000.
As the IT manager, you look at the company's financial records and see that Acme had expenses of $1,000 but received no income. If Acme has another $1,000 in expenses in February, bills out another $2,500, but its January invoice remains unpaid, how does Acme look to you now? The financial records show the company has $2,000 in expenses and no income. Acme doesn't look like a healthy business, does it?
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With the accrual method of accounting, financial records reflect everything that happens when it happens. Used by the vast majority of corporations and businesses, the accrual method provides a truer picture of a business' financial situation. The scenario above looks very different if Acme Consultants chooses the accrual method.
The $1,000 in expenses would still be recorded in January. However, the company also records the $2,500 it billed as an "Account Receivable" (A/R for short). This is literally an account in which a firm records money it reasonably expects to receive. A look at Acme's books at the end of February shows the same $2,000 in total expenses, but the records also show the company expects to receive $5,000 in revenue. This sounds like a much healthier consultancy.
Another benefit of the accrual method is that it lets you match revenues more closely to expenses. We'll discuss that next month.
Note that in both scenarios the company's financial situation is exactly the same. The difference is how the company's financial statements reflect the situation.
So what are these statements? You should be aware of two types of reports when evaluating a company—be it a consultant or a Fortune 1000 corporation.
The Balance Sheet and the Income Statement are generally included in a publicly traded company's Annual Report, which is readily available. You may wish to ask for a more current report, however, because a six-month-old report may not accurately reflect a company's current situation, especially in this economy. For non-public companies, you'll need to specifically ask for such statements. Most reports show figures for the current year and the previous year, enabling you to see the changes in a company's position.
Of the two reports, the Balance Sheet presents the financial status of a company at a point in time. Balance Sheets are typically prepared monthly for internal use; you should insist on the most current balance sheet available—one that's no more than six months old.
Incidentally, the reporting year need not be the typical calendar year; it could be for a fiscal year. Most U.S. retailers, for example, usually designate February 1 through January 31 as their reporting year.
The Balance Sheet includes a list of the company's assets (cash and financial holdings, plus resources it owns to help it generate income, such as equipment), shows what the company owes (liabilities) and owners' equity. Equity is what's "left over" after liabilities are subtracted from assets, and represents what remains for the company's owners (stockholders, if it's a publicly held entity).
The Income Statement
Unlike the Balance Sheet, an Income Statement presents a summary of a company's performance over a period of time, usually for a company's fiscal year.
Also known as the Profit and Loss Statement (P&L), the Income Statement details revenue (Acme's invoices for services), the cost of those sales, and expenses (Acme's salaries, office expenses, and so on) for the last 12 months.
Next month I'll explore these two reports further and show you what to look for when evaluating a company.