The thought of reviewing a financial statement can be scary. While financial statements have similar elements, they are far from standardized and can be complicated to understand. Here are six tips to help simplify the scope of financial statement reviews.
Obtain Financial Statements
The first and easiest step in conducting a successful financial statement review is obtaining the financial statements.
Publicly Traded Companies are required to submit audited financial statements to the Securities and Exchange Commission (SEC) at least annually. The largest and most complex companies submit even more frequently. Often, these financial statements are published online and can be found with a quick web search. I find that searching "[Company Name] Financial Statements" or "[Company Name] Form 10-K" frequently turns up what I need.
Privately Held Companies are not required to publish financial statements. Due to the significant cost of having financial statements audited, small to mid-size companies may not even have audited financial statements. If the vendor in question is privately held and does not release financial statements, see if they can provide you with a declaration of financial stability. Believe it or not, this will provide the information you need.
Have Appropriate Expectations
You are not the vendor's financial auditor. While it may be tempting to want to read and understand every part of a financial statement, this is not an appropriate expectation. The purpose of reviewing financial statements is simply to prove stability. If you are pursuing or continuing a relationship with a vendor, you need to know the company with which you are partnering is financially stable. Anything beyond that is busy-work.
Find the Auditor's Report
Once your purpose is clear, you need to determine whether the statements are audited or not. If they are, this makes your job much easier. While financial statements can be complicated, the auditor's report uses standardized wording. If you are having a difficult time locating the auditor's report, try searching the document for some of these words:
- In Any Audited Statement: The financial statements fairly present the financial position of the company.
- Only In Form 10-K: The company maintained effective internal control over financial reporting.
The wording in these statements is standardized. If the auditor's report states the financial statements do NOT fairly present the financial position or they did NOT maintain effective internal controls, consider yourself warned.
Review the Financial Statements
There are three key financial statements to use when assessing a vendor's stability. A change in numbers from the previously reported year(s) to the current year could be a red flag. Here are the financial statements and numbers to look at in each statement. The story of the vendor's stability is told when you compare certain numbers, such as looking at total liabilities and total equity - or - current assets and current liabilities to know whether a vendor can pay off their debts.
The Balance Sheet shows what a vendor owns (assets), what the vendor owes others (liabilities), and investments in the vendor (equity). Important numbers to review include current assets, total assets, current liabilities, total liabilities, and total equity.
An Income Statement shows how the vendor makes money (revenue) and how the vendor spends money (expenses). Important numbers to review include total revenue, interest expense, total expenses, and gross income.
The Cash Flows Statement shows the changes in cash throughout the year. Important numbers to review include the balance at the beginning and end of the year.
Review the Notes to Financial Statements
The financial statement notes provide additional information from the vendor to clarify and disclose information regarding company processes, accounting procedures, and potential anomalies in the financial statements. Items you should look for include, but are not limited to, legal proceedings, new products or services, mergers and acquisitions, and changes in key positions (e.g., CEO, CFO, etc.).
Summarize the Results
Use the information you have learned from the review to make decisions. You can choose to proceed as normal, reviewing the vendor's financial statements on an annual basis. However, if the review drew attention to areas of concern, consider reviewing the vendor's financial statements more frequently or, in extreme cases, consider discontinuing services.
When reviewing financial statements, remember your goal is to determine the vendor's stability. Leave the rest of the number crunching to the auditors.
