What are financial statements?
What are financial statements? There’s no getting away from it, keeping an eye on financials is a prime responsibility for a board of directors, and at the centre of it all are financial statements.
It’s true that boards can (and should) be a diverse group of people with varying areas of expertise, but if a board doesn’t have an understanding of financials, there’s something wrong.
This, by the way, does not mean that bringing one accomplished accountant on board will solve everything. Ultimately, all board members need to know the ins and outs of financial reporting.
So let’s start at the basics.
What do financial statements do?
There are several types of commonplace financial statements. Together, they are records showing the financial position of a company, and they paint a concise picture of where it is now, how it got there, and where it expects to go in the future.
What financial statements should board members know?
There are three main statements that boards should not only know about but also be able to read and understand. None of the three are overly long or complex, so anyone who is totally new will get used to their formats quickly.
- An income statement (or a profit and loss statement) tracks a company’s income and expenditure over a given time, usually a year. Revenue from all sales and other incomes is recorded, totalled, and measured against all expenses. If the difference is a positive number, the statement shows a profit, if it’s negative, a loss.
- A balance sheet is a “financial screenshot”. It compares all assets (i.e. things a company owns that are worth something) against all liabilities (things expected to cost the company at some point in the future). It doesn’t measure progress over a given period the way an income statement does. Rather, it offers a window into the current financial state of the company. i.e. do assets outweigh liabilities?
- A cash flow statement tracks cash alone, forgoing other assets like property or equipment. It shows how money flows into and out of a business and for what purpose. This is important because a company needs to ensure it always has enough cash at its disposal to pay debts, no matter how valuable its other assets are.
A fourth type of financial statement – an equity statement – is also important, as it breaks down any changes in the company’s share capital, accumulated reserves, and retained earnings. Board members should familiarise themselves with these statements too, but the first three are what they will primarily focus on.
What should board members look out for when reading financial statements?
Nobody wants to find themselves on a board while the company is being steered towards financial disaster. That’s why it’s essential that when board members read the statements above, they understand the story being told. It’s simply not enough to see a figure that “looks right” and miss red flags or see a figure that looks worrying and not ask why it’s there.
Be aware of the following when it comes to financial statements:
Income statements. These aren’t just profit and loss records, these are an indication of a company’s strength in its own field.
Essentially, they show a company’s ability to manage its expenses, generate sales, and achieve meaningful profits.
Behind every income statement is a budget, and board members should always have this budget in mind when they look at the statement. After examining both, profits shouldn’t matter as much as variance.
For many companies, it’s okay to spend a few years with little to no profits. This is the case for many start-ups and high-tech firms. What matters is how much the actual profits vary from the profits the budget planned for. If there is variance, even in a good way, a board member’s first question should be “what happened?” then “how do we manage this next year?”
There are only two basic conclusions to be drawn from a balance sheet: either the company has more than it owes or the other way around.
If it’s the other way around, board members shouldn’t necessarily get scared, but they should instantly get curious. Was it part of a plan? Is there a long-game lens to consider? Has an unexpected shift in the market (like a pandemic) meant that this liability is unavoidable?
Answering those questions is key. If board members don’t have the know-how to get to the bottom of them, this should raise red flags.
Cash flow statements.
Board members should study these carefully. The other two statements deal with longer-term information or include fixed assets that can’t necessarily help in a financial emergency.
The cash flow statement is the only document that shows a firm’s ability to pay its debts in the short term. If it has more cash going out than coming in, it risks insolvency. Nobody should take a place on a board at risk of becoming insolvent.
What are the rules governing financial statements?
They vary from country to country. In federations like the United States or India, they can vary from state to state too.
No matter the jurisdiction, the first step in understanding rules is to find out who makes them. Ordinarily, rules for financial statements are made by:
- The national business/financial regulator
- The country’s central bank (or reserve bank).
- The government directly via the passing of new laws
Financial statements are important for a company’s progress in the marketplace, but internal staff aren’t the only ones interested in them. Often, government officials will be interested also, as a means of ensuring the company complies with the law.
As a result, board members should always be aware of whether the company will require an official inspection of its financial statements – more commonly known as an audit.
As a general rule, anyone looking to become a board member should assume that their company will need an audit by law.
There are exceptions, however, and the two most common reasons are:
- The company is too small to require an audit. What “small” means is different in each jurisdiction. Regulators will usually look for things like balance sheets, annual turnover, and employee numbers to be below a certain level, as set by law.
- The company hasn’t been active recently. Again, the meanings of “active” and “dormant” will differ across jurisdictions, mostly around the timings of income activity.
Financial statements do not need to be scary. They should be seen as informative, and a window into the potential successes and challenges that a company faces. All that’s needed is for those in charge to know how to read them.
The important takeaways are the three main statements relevant to the board (income, balance sheet, and cash flow), as well as knowing where to turn for rules regarding reporting and audits.