Podcast: Financial statements tell compelling stories about companies

June 06, 2007

Managers, markets, and the many players who must contract with a firm: all three groups need credible information about companies. The financial statement -- which includes the income statement, balance sheet and statement of cash flows -- tells a compelling story when read as a whole. Phil Drake, clinical professor of accountancy at the W. P. Carey School, talks about the information contained in the financial statement and who needs to know it. 12:29

Knowledge: Financial statements can paint a public company's entire financial picture -- if you know what to look for. Phil Drake, clinical associate professor of finance at the W.P. Carey School of Business, has details of what can be found in financial statements and who needs to know that information.

Phil Drake: There are a number of groups that would see the need for financial information. The most obvious group is going to be management. When I think of managers, they typically do three basic things. Number one, they plan the strategy. Two, they execute that strategy, then, three, there is feedback from the execution of the strategy.

That feedback then cycles back to more planning, more strategy, further executions and more feedback. You need information in that process to be able to decide if you are achieving your long-term as well as your short-term goals. Financial accounting is one aspect of the data that you need to be able to manage your company efficiently and effectively.

When you think about it from a manager's perspective, they have to satisfy a number of constituencies. They have, on one hand, their customers, and then on the other hand they have their vendors. On one hand they will have the owners, on the other hand they have the creditors.

They have to manage not only the employees, but they also have to deal with issues with the government and what it's asking of them. So managers are in a very difficult position, because they have to manage the needs of all these different constituencies, as well as trying to satisfy what they're trying to do with the organization.

So when you look at a firm, what you're finding is that it is where all these people come to transact business, whether it is the owners injecting capital, or whether it is a vendor selling their product, or a customer buying their goods and services. And the managers have got to be able to manage that entire process, and part of that is to have good information. So when you look at that, it's sort of like information is the grease that allows management to manage.

Of that information, financial accounting is one aspect. It is a very important aspect for what they are trying to do. "Are we charging the right prices for the customers? Are we paying the right price to our employees to keep them working and being effective? Are we meeting the needs of our shareholders and the demands that they have for the return on their capital?" So they have to manage all of those things, and accounting is part of that.

So that is one major group -- management.

The second major group would be the market.

When you are in the marketplace and your shares are publicly traded or even privately traded, the owners are looking for information that will help them value the organization. What is the worth of the company? The financial accounting is a way of providing feedback on how the capital that has been invested into the firm has been utilized, and is it getting the type of returns that the owners are looking for. So the markets are going to clearly have a need for financial information and financial accounting data.

Third is people who are in a contract with the company.

For example, when a bank gives you a loan there are usually going to be restrictions or covenants associated with a loan, and the loan covenants are sometimes going to be tied to accounting data.

The reason we like to tie covenants to accounting data is because financial accounting has a set of rules that everybody can see beforehand that happened in our account. Put it this way: we will know if you are meeting your restrictions or not. So you will see a lot of accounting used in loan covenants.

Secondly, you also see financial accounting used for managers, in the sense of stock options or restricted stock grants. Also, you will see accounting information used in bonuses. Again, it's a way of saying, "We've got a set of rules up front, and as a consequence we have all agreed that if these rules get results, you will be rewarded accordingly. You will get these options, you will get these stock grants, you will get this bonus."

So lots of groups, lots of parties, have an interest in financial accounting. So it's the management, the market, anybody that wants to contract with the firm, are people who demand to have credible information to be able to do business with the organization.

Knowledge: So what kind of information do you find in financial statements?

Drake: The kind of information that is embedded in financial statements are going to be, typically, of three different sources or three different characteristics.

One is going to have to do with operations. How is the firm doing? How is the firm performing? Are we doing well? Are we not meeting expectations?

Second is going to be investments. What are we taking, the money that we're having access to, how are we employing it? What are we investing in? Are we buying assets, are we paying off our liabilities? Or are we buying new companies, are we divesting of bad-performing units? So investing will be one aspect.

And then a third aspect will be financing. How are you raising money for the company? Are you borrowing money? Are you issuing stock? Are you selling off assets? Or, how are you using the money? Are you using it for financing purposes? Are you paying out dividends? Are you paying your debt on time? Are you buying back your stocks?

So when we think about the financial statement information, what we're looking for is information on how is the company financed. What did they take with that financing, how was it invested, and then based on those investments, how is the company operating with those investments?

It is kind of a little bit of a layer, and then within operations, if you look at one particular financial statement called an income statement, it's sort of like an onion. You're going to keep on peeling back and getting more information.

So when you look at an income statement, it's going to give you how much are you charging over the cost of your product or your service. It gives you a sense of your gross margin. How profitable are you from that? If you look at changes over time you can see questions about how you're managing a product or how your marketplace is affecting you.

Then the second layer is how successful are you at the operations. You look at the profits you're getting off of your product, goods and services, but you also factor in the cost of running your business. Are you still profitable?

Then the third layer will be all the ancillary -- not usual day-to-day -- operating activities, but things that just happen. For example, you may have interest earning money that you borrowed, or you may have unforeseen events that have an impact on the firm. So how profitable are you in that perspective?

And then the fourth and the final layer is, once you've taken out the cost of doing business in the form of taxes, how much is left over as profits for the owners?

So in an income statement, what we're seeing is different levels of operating activity, from very focused on the business at hand to all the way through the entire operation of the firm in its totality. So the type of information that you'll typically see in a financial statement are dealing with financing, investing, and operating activities.

Knowledge: How are the financial statements related to each other?

Drake: That's a good question, because there are three typical financial statements. There's the income statement, which tells you how profitable or unprofitable you've been. The balance sheet,  which is basically just a tally of the assets that you own and to whom are they owed, is basically the liabilities and the owner's equity. The owner's equity is what is left over after that liability has been paid.

Then the third primary financial statement is the statement of cash flows. And a statement of cash flows shows you the sources and uses of cash. How did cash come in? How did it go out by the three categories: operating, investing, and financing.

So when you look at them, they look like they're very dissimilar, disjointed, and not tied together at all. And once you have a chance to work with accounting, you start seeing some of the interplays. For example, accountants will typically see the world as a balance sheet, assets on one side, liabilities and equities on the other side. Whereas managers typically see the world in a series of flows, so they see profits coming in, and cash coming in and going out.

So what we need to have is a way of articulating those two points across. Why you want to articulate those points is to recognize that the income statement and statement of cash flows are the result of changes in the underlying balance sheet, while it may not be readily apparent.

But what we find is the balance sheet at one point in time as it changes over time. The reason it changes is because the company has been making money, or has been losing money, or the company has been bringing in new sources of cash through operations, investing or financing, or has been using cash along those three elements.

And you'll start seeing the interrelations between the income statement and the balance sheet and  the interrelations between the balance sheet and the statement of cash flows. It starts becoming much more of a unified approach.

One thing you have to be careful about is the notion between an income statement and a statement of cash flows. A lot of times people will view the net income or the profit of the company as the change in cash that's come in to the company or has been lost by the company.

In the short term, it's going to probably be a very distinct number. And the distinction between the profits and cash flows gives us a sense of how we're managing various aspects of the company. When we look through changes in the income statement and the statement of cash flows, it gives you a sense of how the management has managed its financial structure. And you can see how management is going through to try to work and show itself profitable as well as generate the cash that's necessary to run the business.

So while it appears that the three financial statements look very unique and very different, in reality they are truly integrated with one another, and they tell a compelling story when viewed as a whole.

Knowledge: I'm wondering, how did Sarbanes-Oxley change how you read these financial statements? Did it make an impact on that?

Drake: Sarbanes-Oxley has had a huge impact on financial statement presentation. The underlying notions haven't changed at all, but what Sarbanes-Oxley has done is gone back to one of the points you talked about before, and that is markets need credible, trustworthy information with which to work.

If I can't trust what a company is saying to me, I'm not going to give full value to its statements. I'm always going to say, "Well, maybe, maybe not. If you said you're profitable, maybe you really weren't. Maybe you're playing games."

What Sarbanes-Oxley has done has instilled a greater sense of credibility so that when a firm speaks, the market participants can now take greater confidence in those statements. And as a consequence, when I tell you I'm profitable, OK, you probably are more likely profitable than you were, say, five years ago. And I give that a lot more weight and as a consequence I'm willing to pay a higher premium for those statements because I can have greater confidence, greater trust in the assertions made by management.