Reviewing Vital Connections
Business managers and investors read financial reports because these reports provide information regarding how the business is doing. The top managers of a business, in reviewing the annual financial report before releasing it outside the business, should keep in mind that a financial report is designed to answer certain basic financial questions.
Sales Revenue and Debtors
This business’s ending balance of debtors is five weeks of its annual sales revenue. The manager should compare this ratio to the normal credit terms offered to the business’s customers. If the ending balance is too high, the manager should identify which customers’ accounts are past due and take actions to collect these amounts, or perhaps shut off future credit to these customers. An abnormally high balance of debtors may signal that some of these customers’ amounts owed to the business should be written off as uncollectable bad debts.
Cost of Goods Sold Expense and Stock
This business’s ending stock is 13 weeks of its annual cost of goods sold expense. The manager should compare this ratio to the company’s stock policies and objectives regarding how long stock should be held awaiting sale. If stock is too large the manager should identify which products have been in stock too long; further purchases should be curtailed. Also, the manager may want to consider sales promotions or cutting sales prices to move these products out of stock faster
Sales, Administration and General (SA&G) Expenses and Prepaid Expenses
This business’s ending balance of prepaid expenses is three weeks of the total of these annual operating expenses. The manager should know what the normal ratio of prepaid expenses should be relative to the annual SA&G operating expenses (excluding depreciation expense). If the ending balance is too high, the manager should investigate which costs have been paid too far in advance and take action to bring these prepaid back down to normal.
Sales, Administration and General (SA&G) Expenses and Creditors:
This business’s ending balance of creditors is five weeks of its annual operating expenses. Delaying payment of these liabilities is good from the cash flow point of view but delaying too long may jeopardize the company’s good credit rating with its key suppliers and vendors. If this ratio is too high, the manager should pinpoint which specific liabilities have not been paid and whether any of these are overdue and should be paid immediately. Or, the high balance may indicate that the company is in a difficult short-term solvency situation and needs to raise more money to pay the amounts owed to suppliers and vendors.
Sales, Administration and General (SA&G) Expenses and Accrued Expenses Payable:
This business’s ending balance of this operating liability is eight weeks of the business’s annual operating expenses. This ratio may be consistent with past experience and the normal lag before paying these costs. On the other hand, the ending balance may be abnormally high. The manager should identify which of these unpaid costs are higher than they should be. As with creditors, inflated amounts of accrued liabilities may signal serious short-term solvency problems.
Statement of Changes in Owners’ Equity and Comprehensive Income
In many situations a business needs to prepare one additional financial statement – the statement of changes in owners’ equity. Owners’ equity consists of two fundamentally different sources – capital invested in the business by the owners, and profit earned by and retained in the business. The specific accounts maintained by the business for its total owners’ equity depend on the legal organization of the business entity. One of the main types of legal organization of business is the company, and its owners are shareholders because the company issues ownership shares representing portions of the business. So, the title statement of changes in shareholders’ equity is used for companies
Making Sure that Disclosure Is Adequate
The primary financial statements (including the statement of changes in owners’ equity, if reported) are the backbone of a financial report. In fact, a financial report is not deserving of the name if the primary financial statements are not included. But, as mentioned earlier, there’s much more to a financial report than the financial statements. A financial report needs disclosures. Of course, the financial statements provide disclosure of the most important financial information about the business.
You may wonder how different the company’s annual profits would have been if the alternative method had been in use. A manager can ask the accounting department to do this analysis. But, as an outside investor, you would have to compute these amounts. Businesses disclose which accounting methods they use but they do not have to disclose how different annual profits would have been if the alternative method had been used – and very few do.