Analysing Financial Statements: Linking Figures with Reality

Published on 7th November 2022

Financial statements are usually drawn after a given period (month, quarter, semester, year). Viewed in this light, all figures stated are historical, and nothing can be done to amend the performance that they translate. However, their analysis enables business drivers to take stock of what happened during the period under reference, and to take lessons from the past to determine measures to be taken for the future, with a view to correcting a bad performance or to improving upon an already good performance.

Looking at a financial statement, be it a balance sheet or a profit and loss account on its own gives only a static view of a business. True, these translate into accurate figures stating the performance during the past period and show a real picture of the financial structure at a certain date, but they still offer a static view which does not explain the past performance with regard to previous periods and does not reveal the evolution of the financial strength of the business over time. For this reason, any CFO or CEO must have a sliding view of the business, by comparing figures relating to at least two preceding periods. It does not suffice to note variations from one period (or from one date) to another. Meaningful lessons are only learnt by looking for the causes behind these variations and by trying to understand what specific events or operational measures have caused these variations, for the better or the worse.

The profit and loss accounts

If we place three yearly accounts side by side on a spreadsheet, we already have an idea how turnover, gross profit and main items of expenditure have evolved, and this will translate into the evolution of the bottom line from year to year, positively or negatively. But most items of income and expenditure are direct corollaries of the turnover (top line), and instead of looking at nominal rupees, each of these items of revenue and expenditure is best assessed when it is expressed as a percentage of turnover. Here are some lessons to be taken from a comparison of these percentages, year on year.

Gross profit

A growing percentage of gross profit is positive news because it means that the business is generating profit at a higher pace than the growth of the turnover. Gaining market share and gross profit margin at the same time is exceptional performance. It may indicate smarter marketing due to better communications (mainly advertising) or the building up of product image which enables it to command a premium selling price. A falling gross profit percentage may, in the opposite sense, mean difficulty in selling due to the product losing appeal. It may also be a case of the operators “buying sales” by sacrificing gross profit margins. This already suggests a necessity to step up marketing efforts by better communication of the product’s attributes and by promotional campaigns. It may also suggest that weak products in a portfolio must be discarded because they need as much effort, finance and management time as healthy products.

Operational expenses

Expenses are either fixed or variable. If it is normal to expect variable expenses (cost of sales, marketing expenses, energy consumption related to production and transport costs) to increase in line with the percentage increase in turnover (or ideally marginally lower), increasing administrative costs (staff costs, overseas travel, office expenses, rentals) indicate a system which is “growing fat” by taking on board additional expenses which are not directly related to sales. Paradoxically, this fattening usually happens in good years, when companies tend to be lax in their control and overspend for no useful reason, or worse, rather recklessly, in the comfort that turnover will continue increasing. It is a concrete illustration of loss of productivity. It is when turnover starts to stagnate (or reduce) or adverse external factors (reduction in overall demand, interest rate hikes, increase in cost of raw materials) appear that the full brunt of the additional expenditure taken on board in good years is felt. The struggle to keep heads out of water can be an uphill battle in adverse economic situations because cost cutting is not as easy sailing as cost increases.

Financial expenses

This item, which is directly related to bank indebtedness, if well analysed, may contain several useful lessons. Increases in interest paid usually result from a number of factors, namely

(1) increase in stock level due to reckless buying,
(2) obsolete stocks due to mismanagement
(3) laxity in collection of debtors,
(4) investment in land and buildings for no economic reason,
(5) fixed assets left idle
(6) reduction in level of supplier credits.

Usually there is a combination of several of these factors. As an analyst, it is the first item of expenditure which I look at and it gives, at a glance, the source of the problem of a falling bottom line, especially if the turnover is still rising. If this problem happens while the net profit after tax is increasing, the explanation often lies in the amount of cash generated not being in line with the level of profit achieved. In family businesses, a major occurring which leads to increased indebtedness and higher financial costs is the siphoning of the company’s cash to finance personal assets of shareholders or an over-liberal dividend policy which leaves no cash in the company to finance its growth, in which case, this must be financed by costly additional indebtedness.

Cost cutting is not as easy sailing as cost increases.

Buying assets outside the company’s balance sheet is more of a reality in Mauritius because of the unreasonable attitude of banks to include present and future assets in their floating charges. In case a company needs additional finance which its banker is unwilling to give, it is in a stalemate situation because all its assets are tied with the floating charge. Siphoning of family companies’ profits to buy land and buildings in the name of shareholders enable them to have a fall back to obtain finance from other banks should such need arise.

The balance sheet

Total assets and net worth

Systematically highlighting increases in total assets is pure vanity and an eye-wash, especially when profits are stagnating or reducing. Mathematically, total assets can be increased indefinitely by a parallel increase in borrowing. A much more meaningful figure is the increase in net worth, which is the differential between assets and liabilities, and indicative of an acquisition of value if this figure increases year on year.

There is a maxim which says: top line (turnover) is vanity, bottom line (profits) is sanity and cash is reality. Cash represents “les nerfs de la guerre” and there is no point in increasing profits when these profits have to be looked for, when they are needed, under a heap of obsolete stocks, uncollected debtors heading towards bad debts and idle fixed assets. Cash availability (or comfortable unused borrowing capacity) allows investment in growth, if not in cash, at least with a healthy gearing and allows a company to take advantage of business opportunities which require investment as and when they present themselves. Additionally, it makes the banker the servant of the company, and not its master, and gives the company an important psychological advantage over its banker, which can be leveraged whenever finance through borrowing is required, especially with regard to the cost of this finance.

Provisions

Provisions, unlike reserves, have a greater probability of being disbursed in the foreseeable future. Hence, it is good financial governance to make adequate provisions like provisions for bad debts, obsolete stocks, pilferage and unpredictable expenses. As a business driver, I would favour making healthy provisions, even going beyond what is strictly required in order to keep a safety margin. It is a fact that accountants do not like over-providing, which is what accounting standards term as “reserve accounting”. It is also true that tax authorities do not accept over provision or provisions whose likelihood of disbursement is not ascertained. But this is what management accounts are meant for, namely to present a financial situation, marginally pessimistic, on which a CEO can rely. There is no wisdom in producing management accounts which are the exact replica of final and audited accounts.

The same reasoning goes for depreciation charges which, ideally, should be calculated over a shorter active of the asset than that allowed by tax authorities because the base for its calculation is the price of acquisition, which becomes meaningless when adjusted for inflation and compared to the replacement value. There may also be a need, in exceptional circumstances, to renew productive equipment earlier than scheduled to keep pace with competition. Whether such provisions are acceptable or not to tax authorities is another matter, to be dealt with in the final and audited accounts.

Some meaningful ratios

Working capital

Working capital is a better indicator than the debt-to-equity ratio because the latter does not enter into the details of what the debts have financed between fixed (illiquid) and current (quasi-liquid assets). It just gives a measure of the dependence of the company on indebtedness and the amount of personal risk taken by the shareholders (through their equity) when compared to outside creditors. It does not take into account the realisability of the assets within reasonable time if this is required to repay the debts. Additionally, it does not suggest the effect that the sale of assets (fixed and current) in this scenario, can have on the future of the business, i.e., whether it can continue to operate by reducing its current assets or it has to be liquidated by the sale of its means of production, namely its plant and equipment.

Systematically highlighting increases in total assets in pure vanity and an eye-wash.

The working capital is calculated by the difference between current assets and current liabilities but its economic sense is better understood by the difference between shareholders’ funds (capital plus reserves and retained earnings) and total fixed assets. The two methods of calculation arrive at the same mathematical figure. It is the portion of shareholders’ funds left over to finance current assets after fixed assets have been paid for.

The working capital represents the security of lenders, and bankers in particular should be alive to it. A healthy, positive working capital means that the liquidation of part of the current assets alone is enough to repay all creditors, should they call back their credit. A negative working capital spells doom in case creditors have to be paid at short notice because it means that the total current debts can only be repaid by the disposal of part of the fixed assets over and above current assets. Fixed assets represent the production capacity of the business and their liquidation simply means cessation of business.

EBITDA

The term “Earnings before interest, tax, depreciation and amortisation” (EBITDA) is more and more used to measure the profit generating capacity of a business. It is a measure of earnings before interest, tax, depreciation and amortisation. It may, in strictly accounting terms, serve a purpose when EBITDA is compared over a number of financial exercises to find a trend. To a seasoned business driver who has a global and realistic view of any business, it does not make any sense at all. It gives an idea of the “operating performance” or of the capacity to generate profits but it is totally unreal. Interest, tax, depreciation and amortisation are concrete business realities. Hence, measuring the profitability of a business “if it had no interest, tax, depreciation and amortisation to cater for” belongs to the realm of dreams, because a business can never get rid of these items of expenditure or charges, whether they are disbursed immediately or not (as in the case of depreciation). It sounds more like a theoretical accounting exercise devoid of sense than anything meaningful in economic and realistic terms.

Debt servicing capability ratio

It is the number of years it would take to repay all medium and long-term debts if the totality of revenue (before depreciation, which is a non-cash expenditure) were used to this effect. It is particularly useful for bankers to know the repayment capacity of the borrower and to know what amount of revenue is left after debt servicing over the agreed number of years, to finance the needs in working capital as the business progresses in volume turnover, to finance any growth by new investments and to meet the debt servicing requirements of additional loans in future, when required. A duration of 3-4 years for medium term loans to be repaid using the totality of net revenue is considered to be healthy.

There are two ways of looking at this ratio. We can use either “profits after tax and dividends, before depreciation” (“Capacité nette d’autofinancement”) which is a realistic way of ascertaining the repayment capacity, or “profits after tax but before depreciation and dividends” (“Marge brute d’autofinancement”), which gives the potential repayment capacity in an optimistic scenario, when the shareholders are 100% behind their company to accompany its growth and forego their dividends.

My views may clash with puritan accounting practices, but they are the views of a hands-on CEO who needs to have a realistic and comprehensive view of his business and keep sufficient cushion for unpredictable expenses or a downturn in the sector of activity due to unfavourable economic situations and difficult years.

By Mubarak Sooltangos

Mubarak Sooltangos is an accredited business trainer, a marketing and strategy consultant and author of Business Inside Out (2018) and World Crisis – The Only Way Out (2020).

Courtesy - November-December 2022 issue of CONJONCTURE, the electronic journal of PluriConseil.


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