You know the old adage, “Financial statements don’t kill people, people kill people.”
While it’s true there can be misrepresentation and deception in a financial statement (FS), the document is not inherently bad, it is the poor intentions of the preparer or company that is to blame.
As credit analysts, we always review and rely on FSs when underwriting surety bonds. We know there may be attempts to mislead our judgement or even downright deception. But the need to evaluate the financial report is unavoidable. It is considered a valuable “report card on the quality of management.”
There are three levels of financial presentation by Certified Public Accounts (CPAs):
Compilation – a properly organized report where the numbers have not been verified or evaluated by the CPA
Review – includes some checking “Review” of key elements
Audit – is the highest level and includes the CPA’s statement that they have checked and believe the numbers are correct
The reader of the FS is entitled to certain expectations: A candid and complete presentation that informs the reader. Are they entitled to more than that? Does the reader sometimes expect too much?
The Balance Sheet
This shows assets and liabilities. It describes the dollars in the company (assets) and who owns them (liabilities and stockholder’s equity). You know many of the normal entries: Cash, accounts receivable, accounts payable, inventory, bank debt, the net worth / stockholder’s equity section, etc.
The balance sheet always has a date, such as 12/31/2017. It shows the status of these accounts on the one day. Credit analysts calculate the Working Capital aka Net Quick (NQ) which is considered a measure of short term financial strength. You find the NQ by subtracting current liabilities from current assets. When the bond underwriter has the NQ number, it can then be incorporated in the decision making.
“What size bonds will be approved for this applicant?” “How much total capacity can they be allocated?” The NQ figure becomes a benchmark that is used for the remainder of the year.
For many analysts, this one number carries a huge importance for the following 12-15 months.
Let’s move forward one day in time, to 1/1/2018. “Happy New Year!” and let’s check the bank account. Some money has come in! The accounts receivable and cash have changed. Other elements are also different and so, if we calculate the NQ based on the 1/1 balance sheet, the NQ will probably be different from 12/31. Again, that’s because the balance sheet shows the state of these accounts on ONE DAY. It is always changing!
The reality is that the working capital number is only correct for one day, then it is subject to revision. This is not to say the number is not important or relevant. And certainly decision-makers must have annual benchmarks and a method for their determinations. It is very important, but so are other elements.
Financial Statement Fraud
The most common FS fraud is not committed against us by others. It is the self-deception we commit by over relying on these “one-day numbers.” To do so is to miss the big picture!
Underwriters love to see a big cash account sitting on that top line (of the balance sheet). But that’s a one-day number. Isn’t it even more important to determine the average funds on deposit for the prior six months or year? Many analysts fail to ask for this.
Accounts Receivable and Payable – here is another key area where the “one-day number” can easily be given a historical perspective. Aged schedules of A/R and A/P are easy to obtain and they give a view over more than one day. These documents are not automatically included in FSs, and underwriters may fail to ask for them.
Another example: A broader understanding of the banking relationship is accomplished by looking beyond the balance sheet bank debt. A reference letter can reveal if the client has bounced checks, broken loan covenants or defaulted.
As readers of these documents and analysts, let’s not cheat ourselves by over relying on the balance sheet or thinking it is more than a one-day snapshot. It should be scrutinized and viewed in harmony with other key underwriting factors such as mid-year financial reports and supporting documents.
In this manner underwriters can make realistic, well-informed decisions.
Steve Golia is a long established surety bond provider and expert.
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