Analyzing through financial statements
Reviewing financial statements with a purpose of getting some insight about the firm is a typical task of financial statement analysis. These include the income statement, balance sheet, statement of cash flow, and statement of changes in equity. This process on its own in practice will involve comparing each entry or element between different periods of the same firm or by comparing them against a competitor, industry average, set of objectives, or a combination of all. Normally this sort of analysis is done by outside parties since it is expected that those within the firm have access to inside information and well before it is complied into statement and published. However, just as I say to many students from a variety of backgrounds, the real life is different from what the books say. In other words, the person that want to analyse ever though he or she may be working in the firm they may not have access to all information they need, or they may not trust the source of information. Typical there should questions about how this can happen in practice, since this is not specifically mentioned in the books, or in some other cases questions wold be raised about the authority asking for information. As mentioned above, since real life is different from how the books describe if, if is possible that although a position of authority asks for information, what is supplied to them or the form of information may not reflect the true substance of the firm’s well-being.
Assets, the more the better!
Firm’s aim is to maximize wealth for its owners. This is the main task, the first one on the list of priorities. It is of those tasks that does not allow for any compromise in order to move down the list of priorities. For example, a firm’s which losses money cannot claim any success even if it has a major impact in protecting environment. Therefore, assets first and foremost should be in the service of generating wealth. The higher the rate of return on assets the better. Therefore, for example, what if a firm has a collection of books, a library of their own, to be used by its employees, while the firm is operating in agriculture. These books will probably appear as assets on the balance sheet and they may be very valuable too. The real question is if the firm can use these books in a way that will generate wealth? Well, for an agriculture firm that would be very unlikely. In the same way would be treated the vast amounts of money executives spend on their offices and other perks, read self-indulgent. Most of these expenses although appear in the balance sheet as assets they not only are usable in the firm’s core activities but the amount of money to be recovered if need be would be minimal or at a fraction of what was originally paid for.
In a similar dubious quality are to be treated trade receivables. All these concerns are to be tackled by auditors’ reports, that is in an ideal world. In reality there are countless cases of auditors’ failures to identify such manipulations. On the other hand, it is an accepted opinion that if managers will intentionally want to show a certain situation despite auditors’ efforts it will very difficult to uncover such situations. This is exceptionally difficult in larger organisations where managers will collude in their intentions to present a situation different what it really is.
Even in smaller firms due to substantial levels of informality it will be very difficult for auditors to uncover such practices. In any case all this is made even more difficult if we are looking at a firm operating in such jurisdictions where rule of law and overall accountability are at a below satisfactory level. This is the reason why most valuable companies are rarely based in underdeveloped countries. On the other hand, contrary to popular belief in the long term strict upholding of law and order it directly benefits firms and ultimately their owners.
Lots of customers, no profit!
There are many firms that although they appear that they are very active they fail to make a profit and eventually are forced to close down operations. Let me make it clear that there may be many reasons for such scenario. However, so that we remain within the topic one of the reasons could be an exaggeration of overheads; incurring expenses which are not directly linked with business operations. There could also be the case of low returns for every $1 spent on overheads, on other words, low utilization of resources. Another factor typically in larger firms, is settling of trade payables before they are due. This will result in a need for external financing and ultimately high expenses. Low utilization will be reflected also on staff. It is very common to find on practice that larger firms operating in profitable industries with time become bureaucratic. On a day to day operations this would mean higher expenses for those involved in non-core activities than for those who actually bring money in. This is one of the reasons why monopolies fail in the long term. Their cost in non-core activities rise faster than revenues. All these failures. Low utilization of assets and staff will eventually reflect in the income statement in the form of depreciation, compensation, interest, and so on. In some other cases, gross margin on the price charged for unit sold does not equal the cost of goods sold (COGS) at the end of the reporting period, in fact there is a substantial difference. Some of the reasons could be; inadequate inventory control, bad sales practices, poor manufacturing standards, and so on.
These are just few reasons why although having the full authority to analyse and investigate, because of the size of the firm and very often managers who work in a collusion with a clear attempt to cover-up each other’s failings it will be difficult to enforce credible practices. On the other hand, sincerity and persistence of those on the top, the one with decision making power, will prevail. However, more often than not this will take time, and those who come in with promises to overturn everything within few months usually fail. The very fact that a firm operating as a monopoly is incurring losses is clear enough that problems are far more complex than changing few senior managers. From analysis point of view is the question of reliance on information received and ultimately how much can accounts and people preparing them are to be trusted.