Limitations of Financial Statements
Understanding your Financial Statements – Part 8
This series of articles has been an introduction to how to read your financial statements and how to use the information to improve your business. Financial statements provide very valuable insights, but they are not perfect and do not tell you everything.
In this final article, we look at 8 limitations of financial statements, and where to go from here to dig deeper for business improving information.
Here are some quick links to what we’re going to cover:
Information Provided
There’s an old expression used for data management systems: “rubbish in equals rubbish out”.
The quality of the output we get from our financial statements, and any other performance measuring system, can only be as good as the information fed into it.
To get reliable, useful financial statements, make sure you provide complete and correctly classified information to your accountant.
All business-relevant transactions, whether processed through the business bank accounts or not, should be included.
Financial Measures Only
You can argue that your financial statements present the end result of all business efforts. However, there is more to evaluating the health and prospects of a business than just the financial results.
How satisfied are your customers?
Are your staff developing their skills?
How is your firm’s reputation?
To run a business, you need both financial and non-financial measures with information from the accounting and other systems.
Internal Information Only
Financial Statements show the business’s results, but do not consider what is going on outside of the business.
A business manager needs to also look at environmental factors when making decisions such as economic conditions, law changes and competitor’s activities.
Looking Backwards
Your financial statements will tell you what happened in the last financial year. This provides a great learning opportunity. Those numbers are real. However, we want to take those lessons and use them when looking forward.
To improve your financial performance, you need to use the knowledge of what your actions to date have achieved, and projections of what will change in the future.
Forecasts can incorporate pending new contracts, or loss of contracts, plans for new services and other challenges that do not impact your financial statements.
No Intangible Assets
If a business spends money on marketing, developing skills or building its reputation, these costs are expensed. I.e., they reduce profit. However, they could be considered an investment.
If these business development efforts are effective, the business will be growing intangible assets as skills and brand reputation are real assets that improve future financial results. Due to the difficulty in valuing these assets, accounting rules require that we just write the costs off.
To get a true picture of the financial position, intangible assets must also be considered.
Historical Cost
Generally, financial statements record everything at historical cost meaning that the value all assets in the balance sheet are based on their original cost.
A more relevant picture of the financial health includes the current worth of assets.
This is especially relevant with assets like real estate and livestock where the valuation in the accounts may bear no resemblance to current values.
Owner’s Situation
Small business accounts include items that reflect the current owner’s individual situation.
Home office costs are determined by the owner’s level of mortgage debt or rent. Interest costs are determined by the financial structure chosen by the owner. Most significantly, the accounts may not include a market cost for the owner’s time.
To get a full picture you need to separate the owner’s own situation with the actual business operations.
That is why a potential purchaser of a business will adjust the existing accounts to find a profit figure that reflects the actual business operations they will be taking over.
Accounting Policies
Financial statements must follow rules. For small businesses, these are generally rules set by Inland Revenue and their purpose is to help determine tax payable. The rules do not always produce the most realistic measure of business performance.
For example, when you buy a fixed asset, we depreciate it (expense the cost) over the expected useful life of the asset, thus spreading its cost against the income it is used to generate. IRD provide a schedule of rates that we use for depreciating assets.
If you buy some computer equipment that will last you for five years, you could realistically recognise 20% of its cost each year. However, when following IRD tax rules, we write it off at 50% per year, overstating expenditure in the first couple of years of owning it.
So where can we look for more relevant or detailed information?
Management Accounts
Financial statements are prepared primarily for external users, such as IRD and potential investors, as opposed to business owners. They still provide valuable management information but are not specifically designed to inform management decisions.
Management accounts on the other hand are prepared specifically to help a manager make good decisions and are not bound by external rules. Business operators serious about growing and developing their investment want information focused on the key results that measure their progress. Management accounts, typically prepared monthly or at regular intervals, are part of this.
Management accounts can provide the following information that is generally not disclosed in annual financial statements.
Drilled-down information – While financial statements show overall revenue and profitability, to find out exactly where the profits are being made and lost, we need to dissect it. Management accounts can usually be drilled into to split profits by appropriate segments. This could be by product or service, client, type of client or business manager. Often there will be one or more areas of your business responsible for most of your success, while other areas are actually costing you.
Seasonal Trends – Financial statements show changes happening year to year but will not reveal the ups and downs during a year. To manage work loads and cash flow fluctuations, we need to plan on a monthly basis, not just a full year. Management accounts can be prepared in any time-frame, but typically will be monthly or quarterly.
Up to date – Financial statements show you what happened in the last financial year. Management accounts can show us what happened last month, within a few days of the month finishing.
Forward looking – By combining recent actual figures with forecast figures, we can get an accurate picture of how your current year is turning out.
Non-financial measures – By combining non-financial measures with financial measures, a management reporting package can provide a wider view of the business.
Conclusion
Financial statements are a great place to start analysing your business, especially as you are already paying to have them prepared. But, you get financial statements once a year, usually a while after the year has finished, and the information they provide has some limitations.
If you are serious about developing a successful business, you need regular, relevant information on which to base informed business decisions. This includes financial and non-financial measures, internal and external information, backward and forward focused.
If you’re unsure about anything in this article and have more questions, feel free to get in touch.
Next Steps
Robb MacKinlay is an accountant and business advisor to professionals and consultants, helping them convert their expertise into profitable business.
Contact us with your business questions.
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