Every company is required by the Companies Act to keep accounting records and prepare annual financial statements (AFS). These are often seen as the “end product” to an audit, review or compilation assignment performed by the auditors or professional accountants. The question is whether owners and management view these financial statements as part of the company’s essential records and decision making tools, or whether they are basically signed, filed and never looked at again.
The intention of this article is to highlight a few areas for consideration with regard to understanding the company’s AFS and the usefulness thereof.
What type of information is useful for owners and management to focus on in the AFS?
Financial gain
The purpose of a company, from a business ownership point of view, is to provide a vehicle for financial gain to flow to the owners, from net profit, dividends, interest on shareholder loan accounts (if considered a good investment), or an eventual sale of a business or its assets. These measures of financial gain, and the ability of the company to produce such financial gain to its owners, are measured and reflected in the AFS.
Financing and capital structure
When approaching a bank for financing, the latest AFS will inevitably be requested, as well as management accounts to date. The value in obtaining bank financing is to boost cash which, if made available for funding or expanding the operations of the company, could generate increased profitability. Although the bank may disregard certain “strictly accounting” type entries and disclosures, the AFS will form an integral part in determining whether financing will be granted or not.
With an owner managed business, very often the most important thing a potential financier will look at is the ratio between your current assets (bank, stock, debtors) and current liabilities (overdraft, creditors etc). This ratio is a very good measure of the ability of a company to pay its debts when due. What constitutes a good ratio varies from business to business. For a trading company with stock, the benchmark of a solid company is R2 of current assets for every R 1 of current liabilities. Service type companies can survive with a slightly lower ratio. Remember, liquidity is king. For owner managed businesses that are often under capitalised, cash flow is usually what brings your business down.
Keeping an eye on the measurement of the health of your company as reflected in the AFS, and as determined from the perspective of a third party (like a bank), is a great way to ensure the future existence and profitability of your company. Keeping a company desirable to a third party financier and/or buyer does not have to only be considered when financing is required, or when the sale of the company is being pursued.
The interrelationship between the AFS and the value of the company/business
The undistributed reserves are a good indicator of value to the company’s owners, as this represents the extent to which distributions can be made to the shareholders.
The historic results per the AFS will form an integral part of any valuation of the business or the company. When carrying out a formal valuation of the company, there may be various adjustments made to the net profit to arrive at a value that best represents the expected cash flows going forward, but this information is readily available from the AFS.
In addition, the prior years’ AFS help to create an understanding of how the business performs under various economic circumstances, which will form part of developing an expectation as to how the business will perform in the future, and therefore influence the current value of the company.
The value in having AFS available soon after the year end
The sooner after year end the AFS are available, the greater the extent to which the AFS can form part of current decision making tools. The ideal situation is where an internally prepared set of management accounts for the full financial period is available at year end, and these management accounts have historically proven to be accurate when compared to the final signed AFS prepared after year end.
The value in seeing the Financial Position as at year end,and seeing this soon after year end, is that financing decisions can be made in order to impact the full period of the new financial year.
The value in seeing the Financial Results (income statement and cash flow statement) for the full period to the year end, is that decisions can be made soon after year end regarding pricing, costings, sales volumes, operating expenditure, taxesand so on, with a few to considering changes that can impact on the next year ends’ full period results.
The big picture view
The above considerations serve to demonstrate some of the value that can be gleaned from a company’s AFS. It is often the “aerial view” that brings the greatest insight and, certainly in the area of accounting, finance and business at large, it is very easy to get bogged down in the detail and miss the bigger picture.
For all your annual financial statement needs, including interpretation thereof, feel free to contact us at Meredith Harington. We have many years of experience in the field and help you to view your annual financial statements in the way they should be – a valuable tool to understand its financial performance and financial position.