So Your Sales Went Up? So What? (page 1 of 2)

He expounds upon this observation, illustrating it with examples in a six-week course titled "Using Financial Statements," which is designed to help managers, investors and other businesspeople comprehend financial reports and understand how the numbers on the documents relate to a company's operations. Along the way, Percival offers a formula called "sustainable growth" which mathematically predicts how far a company can expand without collapsing. Some of his observations sound counter-intuitive-for example, he says that sales growth doesn't always benefit a company--but more about that later.

At first glance, it might appear that a course about using financial statements is almost unnecessary. After all, prodded by watchdog organizations like the Financial Accounting Standards Board (FASB), which establishes and improves standards of financial accounting and reporting, and the Securities and Exchange Commission (SEC), which among other responsibilities ensures that investors have access to disclosure of all material information concerning publicly traded securities, issuers of financial statements tend to fill their reports with a great deal of detailed information.

In addition to profit and loss statements, and a summary of assets and liabilities, companies routinely disclose developments like material litigation. On the face of it, then, society is well served by financial statements. Indeed, the U.S. system of accounting and financial reporting, with all the disclosures, checks and balances, is routinely held up as a world model.

But Percival, who has served as a consultant to major corporations and organizations like AT&T, Bell South and the Federal Trade Commission, says the problem isn't the quantity of information. Instead, it's the comprehension, or lack of it, among those who use financial statements.

To begin with, he says, raw financial statements don't really present a picture of a company's health. At least two reasons account for this: One is that the metrics used, such as a year's worth of activity for a profit and loss statement, are somewhat arbitrary and may not reflect developing trends. Another is the fact that financial statements present historical data, which are already outdated by the time the report is issued.

But even with these limitations, financial statements have value, Percival asserts. The key, he says, is to look beyond the raw numbers.
"The first step is to understand what a financial statement does¡Vit links a business to certain numbers," he says. "Each component,,o the balance sheet, the P&L statement, the statement of cash flows, and footnote disclosures,,o can offer clues to how well a company is managed." The numbers will yield that information if you can tie the disparate reports together and analyze them as a single unit, rather than as discrete reports.

Percival offers a classic case study: A firm that generates significant sales, enhancing its balance sheet, but doesn't actually collect on those sales. "If you simply studied the income statement, you'd think that the company was doing well," he says. "If you just studied the balance sheet, you might notice that Accounts Receivable were unusually high, but you still couldn't be certain that something was wrong."

However, a review of the statement of cash flows, which reconciles sales (a P&L item) to cash (a balance sheet item), would make it clear that the company was recording sales but not collecting the associated payments.