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Family Business by the Numbers
How Financial Statements Impact Your Business
By Norbert E. Schwarz
Palgrave MacmillanCopyright © 2011 Family Business Consulting Group
All rights reserved.
What Are Annual Reports All About?
The pair certainly did not look like the owners of a hundred-million-dollar corporation. The woman could not have been more than five years out of college, and her long, straight hair, multi-colored clothes, and flamboyant jewelry suggested an artist. The man looked like a graduate student who, judging from his denim shirt and jacket, had just changed from blue jeans into a pair of wash pants.
The banker offered his hand. "We meet at last. I'm Bob Holmes."
"I'm Sue Monahan, and this is my cousin, Greg Ferris. We've come to talk to you about our family's business, FerMon Lamp Company."
Holmes ushered them to a round conference table, and they sat down. "Frankly, I expected to see you four years ago, after your parents died in that unfortunate accident. I was designated as your mentor to help you prepare for the day your trusts end—which, as I remember, is when you celebrate your 30th birthdays. However, I may not be as helpful now since I've been off the company's board of directors for three years. You may want to have someone still with the company mentor you on this."
"Frankly, Mr. Holmes, we wanted to consult with someone not currently with the company, and our parents' trust in you makes you the logical choice," Sue explained.
"Actually," Greg interrupted, "we've come to put Sue's mind to rest about the business. She seems to have picked up the notion that it's in some kind of trouble."
"Why do you think something is wrong?"
"Well, I don't know much about business, so I'm not sure. However, I have heard some disturbing remarks from people who work there, and I've noticed a few things that don't look right, like a lot of dusty cartons crowded into the finished-goods area.
"I'm a product designer and, until recently, I had seldom visited the plants. A couple of months ago, I thought I'd try my hand at designing a few lamps and was given a part-time position at the low-cost subsidiary as a trial. At the main plant, I was told that they pretty much stick to their 'classic' lines and, in any case, were all tied up in reconfiguring them. I eventually discovered that this meant finding ways of making the lamps more cheaply. Don't you think that could undermine a company built on its reputation for high quality, Mr. Holmes?"
"Well, that would depend upon how and why it was being done. Improved manufacturing techniques or the elimination of costly but unessential materials could make the lamps more competitive. On the other hand, making lamps that look cheap and don't work well would undermine the company's reputation for quality. It's hard to tell much from isolated facts."
"Exactly," Greg chimed in. "Look, Sue, we all know about old-line companies whose prices rose so high that nobody would buy their outdated products. If the executives want to make a few changes, I'm sure they know what they're doing. Our company's going steady as a clock—always pays our dividends on time."
"But they have gone down a lot the last couple of years."
"Well, we can't always expect outstanding years, and sometimes a company has to devote its profits to future growth. We're still getting plenty to live on."
"And that's what's important to Greg. It's paying his way through medical school and will let him set up his practice."
"And let you dabble in your artsy projects."
Holmes moved quickly to refocus the discussion. "Are there any other observations that disturbed you?"
"Well, a couple of people who have worked at the company for many years told me several things that started me worrying. For example, one of them said that most of the profits are coming from the subsidiary making cheaper lamps but that there are rumors about this division being sold. When I met the president and asked about this, he seemed a little evasive and asked where I'd heard that, which made me worry about compromising the people who'd confided in me. He said no such decision has been made but that one always has to consider every option for improving the overall business. I fail to see the wisdom in selling off the only part of the business that's making money.
"Another thing my source told me is that the company has begun borrowing significant amounts of money during the past two or three years. Our parents always took pride in being debt-free."
Numbers: Objective and Standardized Information
Holmes reflected on this for a moment. "These could be significant factors. It's hard to tell without further information. For example, borrowing money and selling assets to improve the company's other capabilities is an excellent, established way of keeping a company competitive and expanding it. On the other hand, raising money these ways simply to meet ordinary expenses and to pay dividends would eventually leave you with no equity—it would milk the business dry." He turned to Sue. "Thanks for sending me the annual reports I requested on the telephone. I have been able to compile them into five-year statements that we can examine after going over the financial statements for last year."
The cousins sighed, and Sue exclaimed, "Really, Mr. Holmes, I don't see how a bunch of abstract figures can tell you much about what people are doing in a complex company."
"Especially," Greg added, "when the numbers are all related to weird things like 'debentures' and 'accrued earnings.'"
Holmes chuckled. "Yes, financial experts have their special terminology, as do most professionals, including artists and doctors. And speaking of doctors, Greg, don't numbers play a central role in evaluating a patient's health? There are body temperature, blood pressure, all kinds of numbers from blood tests, and the graphs from electrocardiograms. Why do doctors reduce the complex operations of our bodies to numbers?"
Greg smiled. "I remember one professor who talked about how early doctors used to evaluate patients by estimating how pale or flushed they looked and how warm or cool they felt. The 'tests' consisted of evaluating the colors and degrees of warmth. It was pretty subjective."
Holmes nodded. "It's the same with evaluating the health of a business. Of course, numbers don't tell us everything. Just as the doctor has to observe, touch, and talk with the patient, so one has to observe what is going on in a business and talk to people there, as Sue has done. Nevertheless, the numbers that have been standardized for annual reports are a fast way of getting a pretty good overall picture of how a company is doing. It also enables us to compare its performance to that of other companies."
"Don't tell me we have to study reports from other companies, too!" Sue objected.
"Not usually, though you might want to if you were tracking down a specific problem, like excessive expenses or poor sales. Suppose profits suddenly fell one year. It would be helpful to know whether this happened in the economy as a whole or in your particular industry. Or suppose that one of your competitors suddenly started taking away a lot of business from you. You might want to not only examine its products but see from their report whether it has lowered its costs, increased its investments, and so on."
"You seem to be saying that these reports provide a shortcut to evaluating a company, but they don't seem very short," Sue commented.
"Yeah, why can't they just say how much the company is worth and how much money it's making?" Greg added.
"Because a simple statement would not tell you enough. For example, suppose a business had three million dollars in cash at the end of the year. Would you say it was doing well?"
"Sure," they said.
"But suppose that in one month it had to pay off five million dollars for loans and purchases?"
"Maybe not so well," Sue murmured.
"Suppose further that, in three months, some long-term investments would mature and pay four million dollars? Suppose we had to replace expensive equipment or a plant within a year? I could go on, but you can see that we need quite a few items of information before we can form an adequate picture of a business—or even fully understand the meaning of an individual number."
"A number is a number, isn't it?" Greg objected. "I mean, isn't that why we use numbers, because they are exact?"
"Yes, but their meaning can vary drastically. Is a very high blood-pressure reading always bad?"
"When you take it in a regular examination, yes. I suppose you mean that a high measurement would be expected, even good, right after a stress test."
"Exactly. Now, take 'Accounts Receivable'—money that customers owe for goods shipped to them. If this amount increases by 20% in the latest annual report, what does it mean?"
"I suppose it could mean that sales have gone up, which would be good," Sue offered. "Or it could mean that customers aren't paying their bills, which would be bad."
"You've got it. One way of testing this is to see whether Net Sales have gone up in the same way. By comparing various figures in the report, we can find out a surprising number of things about how well a company is doing."
The cousins groaned. "Do you mean to say that we not only have to go through all those figures but also have to make further calculations with them?" Greg demanded.
"I'm afraid so. I might as well give you the rest of the bad news: sometimes you will have to look up some more detailed information to clear up the questions you raise when going through the reports."
A Sense of Direction
"When I started riding lessons, my instructor said that I had to direct the horse with a few simple actions, like tugging the reins and exerting pressure with my legs and feet. The horse would then do all the work. However, if I didn't show the animal who is boss, then the horse might take me where I don't want to go.
"Similarly, you have executives and workers who will handle almost all of the work for you, but as owners, you will have to spend time going over reports, attending meetings, and visiting the plants to make sure the company is achieving its goals. I assure you, this is a lot easier than starting a new business like your grandparents did, or building it up as your parents did."
"I suppose," Sue said, "but that sounds so coldly calculating, almost exploitative—how much we can get out of others."
"It doesn't have to be. Making sure a company is running soundly also protects the livelihoods of all those who work for it and provides the means for any improvements you'd like to make for them."
Levels of Information
"Okay," Greg agreed, "but exactly how deeply do we have to dig into these reports, and how much research do we have to do? I hope we won't have to worry about how many paper clips the office is using."
"Not unless you hear of something like the Department of Defense paying $700 for an ordinary hammer," Holmes laughed. "Ordinarily, the bookkeepers take care of recording and totaling data like this. Trying to evaluate countless small items would prove exhausting and would leave one more confused than enlightened about what was going on in the overall business."
"Yeah," Greg agreed. "I mean, what would you conclude from finding out that we spent less on paper clips in March but more on pencils in August?"
"Exactly. Now, when we categorize these expenses, say, come up with totals like 'Office Supplies,' 'Office-Building Expenses,' and 'Office Salaries,' we have some information that begins to show the larger events in the company. We start with Data, which include the bookkeeping entries that are the foundation for developing the numbers on the financial statements. When the data are accumulated to meaningful statements and reports, we have Information. When we are able to understand the financial statements, we have Knowledge. When we are able to make intelligent decisions using the information we have, we achieve the last element in the financial decision-making process, Wisdom."
"True," Sue said, "but that's still a lot of detail to go through."
"That's why in the annual report we further consolidate this information into more inclusive categories, like 'Administrative Expenses,' or something ever broader, like 'Selling, General, and Administrative Expenses.' This and other broad categories like 'Net Sales' and 'Operating Expenses' give us a more manageable picture of the business."
Sue frowned in thought. "I can see how that kind of statement could work—whether sales are increasing enough to cover increasing expenses or whether one area of expenses is getting out of control."
"You have now arrived at knowledge, where you start working with information and arrive at a real understanding of what is happening in the company."
"And that kind of understanding tells you when you need more detailed information," Greg added. "If Administrative Expenses are getting too big compared with, say, Net Sales and Manufacturing Expenses, then one begins digging to find out why."
"Exactly. Hopefully, one will not have to go down to the level of paper clips, but one might discover that an older building is costing too much to maintain, or that people need better computers and software to work more efficiently, or that the officers are rewarding themselves too generously. Arriving at these insights and learning to deal with them is the highest, but hardest-to-reach, plateau of wisdom."
A Company's Annual "Physical"
Greg was running with an idea. "You might say that the annual report is kind of like a physical exam: it covers the major systems and when the results look abnormal, one orders further, more-detailed tests."
"I like that," Holmes said. "I'll have to use that analogy with some of my clients."
He paged through the reports Sue had given him. "Now that we have gone through the general ideas of what annual reports cover and how they are related to other information about a company, it is time to look at them in more detail. We'll start by looking at the big picture and see whether that shows anything corresponding to your suspicions, Sue."CHAPTER 2
Overview of the Annual Financial Statement
"I gather," Greg said, "that the Balance Sheet tells how much the company is worth and that the Income Statement tells how much money it is making. So which one do we begin with?"
Holmes nodded. "You're right about the general meaning of those two parts. There are also three other significant items—Cash Flow, Financial Analysis, and the notes to the financial statements, which, like other fine print, often contain very important information. For example, a note might explain an atypical source of profit or loss."
"Why should anything be easy?" Sue groaned.
Holmes smiled. "Oh, it's not that bad, especially for a medium-sized company like FerMon. However, before evaluating the evidence, we have to check on its reliability."
Greg rolled his eyes. "But that would mean redoing all the bookwork!"
"Some of it. Fortunately, we don't have to do this ourselves. That's what auditors are for."
"I remember them," Sue said. "When I was at work one day, I noticed a couple of people in a temporary office and was told they would be 'going over the books' for several weeks. I assumed they were putting together the annual report."
"Not writing it—that is normally done by the company. The auditors focus on the financial statements in the annual report, making independent checks to ascertain whether the information provided by management is factual and is presented in a standard, consistent manner."
"How do they do that without redoing the entire report?" Greg asked.
"By examining the books closely and taking judicious samples to verify the accounts. For example, they examine the inventory, do spot checks to see that income and expenses are appropriately recorded, check contractual obligations for accuracy and proper disclosure on the statements, and dig further into specific areas when questions arise."
"So auditors are supposed to keep management honest?" Sue asked.
"In part. They also make sure that the company's books and financial statements follow what are called Generally Accepted Accounting Principles, usually abbreviated as GAAP."
"To make sure everything is put into all those obscure accounting categories?" Greg grimaced.
"You'll be surprised at how quickly you'll become familiar with the most important terms. The key is standardization. For example, there is no way of ascertaining a company's profitability with a single figure."
"Can't you just subtract total costs from total sales?" Greg asked.
"Ultimately we do something like that, but a central question is what to count as 'costs.' Should one consider taxes as a cost? What about mortgage and loan payments? If we purchase major equipment and build a new plant to be used next year, should we count them as costs of the products we are selling this year? When we sell an item we made last year, do we count its cost as what we paid to make it last year or what we will have to pay to replace it in inventory this year?"
"I can see where carrying items from year to year complicates things," Sue conceded. "Do the standard methods specify how such things are handled?"
"There is often more than one 'approved' way of reporting costs, sales, and other items. Usually, however, a company has to pick one and stick to it. Otherwise, we could not compare the results from year to year in a meaningful way."
"Because we'd be comparing apples to oranges," Greg commented.
Excerpted from Family Business by the Numbers by Norbert E. Schwarz. Copyright © 2011 Family Business Consulting Group. Excerpted by permission of Palgrave Macmillan.
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Table of ContentsIntroduction
What Are Annual Reports All About?
Overview of the Annual Financial Statement
The Balance Sheet: Overview
The Balance Sheet: Assets
The Balance Sheet: Liabilities and Owners' Equity
The Balance Sheet: Five-Year Comparisons
The Statement: Five-Year Comparisons
The Cash Flow Statement
Financial Ratios and Analysis Tools
The Next Steps