Importance of Accurate Financial Statements for a Business

For any business and for the people who run it, the importance of accurate
financial statements cannot be underestimated. Some of the most important
financial statements that are imperative for an organization of any scale are:
Income Statement, Balance Sheet, Statement of Stockholders’ Equity, Cash
Flow Statement and Statement of Comprehensive Income. The numbers
revealed through these financial statements play an immense role in making
decisions, planning strategies, determining success, estimating failures, and
telling the world the story of the company.
Importance of Accurate Financial Statements for Organizations
1. Financial Transparency:
Even the smallest numbers in a balance sheet can have a huge impact
on the business. Assets never have the same value that they did when
they were first purchased. A percentage has to be deducted from their
value for depreciation. A company might report a certain number as
revenue earned. But how much of it is actual cash and how much of it
is accounts receivable has to be accurately stated. Numbers like Profit
before Tax, Profit after Tax, and Profit after Interest, Depreciation and
Tax are all important numbers that tell shareholders and management
a lot.
2. Evaluate Tax Liability:
Corporate tax rates are quite high. When companies make a lot of profit,
the taxes they have to pay are equally high. The owners often get
astonished at how little they have left once they have paid taxes to the
government. Can they reduce their tax burden? If yes, then they will
need the most accurate financial numbers possible. Otherwise, all their
resources could be depleted in a very short time. Conversely, for the
government, accurate financial statements are essential because many
firms fudge their reports only to avoid paying tax.
3. Mitigate Errors:
Accurate financial statements are also essential to catch costly
mistakes or internal wrongdoing early on in the process. If any illegal
activity is taking place, there is no better way to catch it than through
discrepancies in the numbers. If an error has been made, reconciliation
 activities can find them. That is why companies spend a lot of time on
reconciling their books of accounts and checking each entry so that they
can find if anyone has tampered with any part of the business or an
accounting error has been made.
Investment banking especially has been prone to many accounting
misdeeds over the years to cover huge trading losses. The inefficiency
of the financial reporting systems allowed those losses to be hidden.
That is why regulators have started asking banks and other trading firms
to pay more attention to their internal accounting methods.
4. Build Trust:
More than anything else, accurate financial statements induce trust in
the company. Investors need a sign that a company is doing well and
they can put their hard earned money in its business. It is all very well if
the balance sheet shows a profit. But there have been times when the
balance sheet of many companies showed a profit, only to be found
later that they were actually hiding losses. Large-scale companies like
Enron and WorldCom and successful accounting firms like Arthur
Andersen had to be closed because of their role in fudging financial
statements. After experiences like that, it is little wonder then that the
world is more concerned about accurate financial statements than ever
before. Governments have made accounting and compliance rules
more stringent, so that companies do not feel tempted to misreport their
financial numbers.
5. Improved Payment Cycles:
In order to optimize the Accounts Payable and Accounts Receivable
cycles, accuracy of financial statements plays a key role. Other outgoing
payments include salaries and daily wages that need to be paid
(payroll), dividends need to be given to the shareholders, inventory
needs to be managed, and creditors need to be paid. All this cannot be
done unless the numbers are in order. If a loan is overdue then the
company needs to know how much interest has to be paid or received.
Mathematical calculations can only be done with the correct figures.
6. Better Decision Making, Planning and Forecasting:
Analysing financial statements is crucial when decisions are to be
made. A finance manager would look at the value of the assets that he
 currently holds and decide if he can afford to purchase more. When the
value of assets is severely depreciated, questions would arise if they
need to be sold off.
A company needs more funds to expand its business; the accountant would
look at the debts on the balance sheet, the shareholders capital, and other
loans they have taken and decide which type of financing they can afford.
When the time comes for the company to pay dividend, the CFO would look
at the profits that have been made, the debts that need to be paid off, the
provisions made for various reserves and decide what the quantum of
dividend can be.
Financial statements open a window for educated decision-making and
strategic planning. The working capital statements, fund flow statements,
cash flow statements, and trading account all have to be consulted every day
for evaluating how much money the company is making, how much money
they need, the reserves that they need to set aside, and how they propose
to increase sales and boost financing.
The above-mentioned points emphasize why it is imperative that companies
strive to maintain the accuracy of their financial statements. Following GAAP
or other applicable accounting standards to generate these statements is a
critical factor in ensuring they present the actual financial picture of the
business to management and external stakeholders.

CRITICAL WARNING SIGNS IN FINANCIAL STATEMENTS

Financial statements are a good way to know how well your business is
doing. These important reports enable your team to identify issues that need
to be addressed to put your business on the growth path.
In order to do this, you need to look for certain ‘red flags’ in your financial
statements. These would serve as warning signs which you might need to
address quickly to secure your business from possible trouble. Examine your
balance sheet, income statement and cash flow statement for performing this
analysis. These should span the last two or three years so that you can
identify year on year numbers.
The following are some of the warnings signs in financial statements that
might need your attention.
Urgent Warning Signs in Financial Statements
Excess or Insufficient Inventory :
If your business is based on a product rather than a service, you need to
take careful stock of your inventory. A higher inventory is permissible only if
your business is on the expansion mode. However, if you find your inventory
is increasing when you are not expanding, it could mean that your products
are not selling or that your customers are dissatisfied with the product and
are returning them after purchase. Whatever be the case, excess inventory
would result in your products getting obsolete or not suitable for use. Add to
this the fact that it costs money to store inventory and insure them.
In addition to excess inventory, insufficient inventory is also a warning sign.
Insufficient inventory would lead to loss of sales and increased costs. If you
run out of crucial raw materials, then your operating costs would go up. You
might have to pay overtime to employees if raw materials come in late. In the
worst possible situations, you could end up buying inventory at high prices.
How to spot:
First, identify your average inventory for the previous two years. To do this,
add the beginning inventory balance to the ending inventory balance. For
instance, if your company began the year with $500,000 of inventory and
finished with $480,000 of inventory, total the two to get $980,000. If you
divide this figure by two, you would get the average inventory. In this
example, divide $980,000 by two to get $490,000 as the average inventory.
You could use the ending inventory from previous year’s balance sheet as
the starting inventory for the current year. After this, divide average inventory
by the year’s sales. Compare this percentage over the years to see if your
inventory is increasing or decreasing.
High Number of Accounts Receivable Days:
You might think that having a large accounts receivable figure is good. It
might be, depending on how quickly you can convert it to cash. However, it
is far from easy to quickly collect money from your customers. Understand
that the further away your receivable is, the more likely it is that it might
become a default. So, actually, a growing receivables account could reveal
that you are not being effective at collecting what others owe you.
In this regard, the accounts receivable (AR) days can alert you if you are not
receiving payments from customers quickly enough. Generally, a lower
figure for AR days is beneficial, because it means you are getting cash
quickly. Though, this can vary from firm to firm, data from Sage works says
that for all industries, the average AR days is 39. A comparison over the
years and with competitors will give you an idea whether you are able to
manage AR well.
How to spot:
To arrive at the AR days figure, you need to divide accounts receivable by
sales (annual revenue) and then multiply it by 365 days. Do it for at least
three or four years. If you find that this figure is higher than it has been in
previous years, you can be sure that your receivables are piling up and you
need to do something about it.
If you want to investigate further, you could run an aging schedule as part of
your accounting software. This schedule will help categorize AR balances by
due date. If a large number of ARs are due, you might need to look at
speeding up collection or change collection terms. Also, note if the same
customers repeatedly show up as past due in the aging schedule. If this is
the case, you might need to re-evaluate whether you should continue doing
business with them. Other indicators include accounts receivable turnover,
credit policies and cash collection schedules.
Increasing Non-Operating Income:
Selling equipment whose performance is not up to the mark or that is not
needed for operations anymore is normal routine for any business. However,
selling fixed assets every now and then could mean that your business is
trying to raise cash to meet short term expenses or pay off debt. Unless the
money from such sale is reinvested in the business, your operating revenue
might be impacted in the long term. Some businesses might get income from
other one-off sources, such as money from sale of investments. These are
non-operating revenues and they are not as valuable because there is no
guarantee of getting income from the same sources in future.
How to spot:
Check your income statement for gains and losses from fixed assets.
Disposals might also be apparent on your balance sheet. You will know why
the assets were sold in the first place, so if the disposals are significant, list
down why you sold them and what you used the cash for. If the reasons are
to meet short term crunches, then the next step would be to analyze the
reason for the shortfall, such as long AR days cycle. Also, check the non-
operating income that is stated separately from operating income on your
income statement. Compare the proportion of operating income to non-
operating income over the preceding years. If this is decreasing, you might
have to focus on generating better revenues from your core operations.
Cash Flow Problems:
Having good profits is not an indication that your business is doing well. Only
if you manage your cash flows well, can you grow in the long term. If profits
are good but cash flows are not, it could be that you are not collecting
receivables quickly enough or you are struggling with repayment of your
loans, or even worse, you are exaggerating your revenues. A financially well-
run business should have an improving cash position at the end of every
month rather than every year. It is important to check your cash flow position
month on month, at the end of every quarter to quickly spot and rectify
problems.
How to spot:
The general rule is that your net cash should match your net income with
little difference. If you find that your net cash flow is low compared to the net
income, you can be sure that you are in a cash crisis. You must look at a
three-month projection as cash disappears quickly and unless swiftly
rectified, things might go out of the hand. For instance, if your sales have
increased 10%, but your cash flows are rapidly declining, you might be
collecting accounts receivable later than required. If it is the other way round,
with cash flows increasing and sales declining, a different problem arises.
This could mean that you are not marketing your products well.
The quicker you identify the problems in your business, the lower would be
subsequent losses. Losses not only mean money, they also include time and
resources that could have been used productively. So, pro activeness in
dealing with warning signs in financial statements is crucial for the growth of
your business.
4 Ways Inventory Management Affects Financial Statements

Inventory or stock is the goods and materials that a business holds for the
ultimate purpose of resale (or repair), and inventory management is a
science that specifies the shape and percentage of stocked goods. Inventory
could be in the form of raw materials, work in progress or finished or
completed goods.
Since inventory is an important part of any business, its management can
affect any of the financial statements. For instance, a low inventory level
could lead to delays in deliveries, while an excess in stock could adversely
affect your cash flow.
Different Methods of Accounting for Inventory
Your chosen method of valuing inventory is indicated as the inventory
footnote on your financial statement. The best-known methods for valuing
inventory are:

1. FIFO: The first-in-first-out (FIFO) method usually yields a higher gross

profit, higher taxable income, and lower cost of goods sold (COGS) due
to higher ending inventory.
2. LIFO: The last-in-first-out (LIFO) method does just the opposite wherein
everything would be higher except the COGS. The COGS is an
expense and will be subtracted from the income in the income
statement. The equation used to calculate COGS is: Cost of Goods Sold
= Beginning Inventory + Purchases or Goods Available – Ending
Inventory. Generally small businesses prefer the LIFO method. This is
because during periods of growth, the method yields lower income and
income tax payments, thereby enhancing the firm’s cash flows.

An inventory is most often listed as a current asset on financial statements.

Therefore, the way you value inventory would determine the total current
assets, total asset balances, and the actual inventory itself. When you sell,
COGS increases and it is shown as expense on your statement. Another
important point is that financial statements need to be error free – an
erroneous inventory can lead to several errors in your financial statements.
The COGS, profits and net income can be incorrect.
4 Ways in Which Inventory Management Affects Financial Statements
1. The Income/Profits:
If there are any errors in calculating inventory, there would be
cascading effects on COGS, profits and income. There are several
reasons why your inventory might be inaccurate. Some instances
include breakage during transit, not adding returned goods to
inventory and old goods which might have to be sold at a discount. In
all such cases, you need to adjust your inventory to an accurate value.
Understand that using LIFO will have higher COGS and would be
more representative of the current economic reality. Hence,
profitability will be more accurate, making it a better indicator for
forecasting.
Adjusting inventory cannot be an annual affair. This should be done
more often so that there are no major changes to the inventory value
during the time of change. For this, companies often use an inventory
reserve account, where obsolete or unusable inventory is recorded as
a percentage of the inventory value. The inventory reserve account is
a balance sheet account and would have a negative balance. If you pit
it against the inventory account, you would get an accurate idea of
your inventory.
2. Cash Flows:
If a business uses FIFO when prices are rising and inventories are
also rising, COGS would be low and net income would be higher. As a
result, the company would have to pay higher taxes. This would result
in a lower cash flow for the firm.
3. Balance Sheet:
Change in inventories and incorrect inventory balances affect your
balance sheet, the financial statement that is a snapshot of your
company’s worth based on its assets and liabilities. An incorrect
inventory balance can result in inaccurate reported value of assets
and owner’s equity on the balance sheet. However, it does not affect
liabilities.
4. Working Capital:
 Since working capital is defined as current assets minus current
liabilities, when inventory goes up in the income statement, the
working capital would also go up.
In conclusion, it is important to ensure that the inventory shown in your
financial statement is accurate. Understand that keeping your inventory from
being too high or too low can help you to make better financial forecasts.

Balance Sheet Ratios

Balance sheet ratios are financial metrics that determine relationships

between different aspects of a company’s financial position i.e. liquidity vs.
solvency. They include only balance sheet items i.e. components of assets,
liabilities and shareholders equity in their calculation.
Explanation
Balance sheet is the financial statement that provides a picture of a
company’s financial position by listing a company’s assets, liabilities and
shareholders equity. Income statement and cash flows statement provides
information about profitability and cash flows.
A financial ratio determines relationship between two components. These
may include:
 Two balance sheet components, i.e. assets, liabilities and shareholders’
equity
 Two income statement components, i.e. sales, gross profit, net income, etc.
 A balance sheet component and an income statement component
 An income statement component and a cash flows statement component
 A balance sheet component and a cash flows statement component
A balance sheet ratio belongs to the first category, i.e. it includes either two
classes of assets, assets and liabilities, assets and shareholders equity,
liabilities and shareholders equity.
Examples
Identify which of the following are balance sheet ratios:
 Debt ratio
 Debt to equity ratio
 Return on shareholders equity
 Current ratio
 Quick ratio
 Cash flows per share
 Equity multiplier
Solution
Debt ratio is a balance sheet ratio. It is calculated by dividing total liabilities
by total assets, both of which are balance sheet components.
Debt to equity ratio is a balance sheet ratio because it is calculated by
dividing total liabilities by total shareholders equity, both of which are
balance sheet items.
Return on shareholders equity is calculated by dividing net income by total
shareholders equity, one of which is income statement element. Hence, the
ratio is not a balance sheet ratio.
Current ratio = current assets/current liabilities, both of which are balance
sheet items and hence it is a balance sheet ratio.
Quick ratio is also a balance sheet ratio because the numerator (current
assets – inventories) and the denominator (current liabilities) are both
balance sheet items.
Cash flows per share (CFS) is not a balance sheet ratio because the
denominator is a cash flows statement component.
Equity multiplier total assets in numerator and total shareholders equity in
denominator and hence the ratio is a balance sheet ratio.
The majority of the ratios identified as balance sheet ratios are either
liquidity ratios (current ratio and quick ratio) or solvency ratios (debt ratio,
debt to equity ratio, equity multiplier).