How do financial statements work together?
I’ve written before how you need to look at the all the statements in order to get a good picture of a company’s financial health. But how are these reports tied together?
The common factor that ties together the balance sheet, the income statement, and the cash-flow summary is cash. Cash is the life-blood of a company. Without cash, companies go bankrupt. They may have the best product, processes, and people in the world, but if they can’t persuade customers to shift cash from their accounts to the company’s, the firm doesn’t have much future.
So how does cash move? Analysts talk about the cash cycle—sales lead to receivables, which are collected into cash, which goes into production and expense, which leads to more product in inventory, which leads to sales. As a company grows, these items on the financial reports also grow. But if something grows disproportionately—say, inventory spikes higher—that’s an indication that something’s out of whack. In the case of inventory spiking, there might be a problem with customer acceptance of a new product. Or if sales spike along with receivables, but the cash doesn’t grow, the company might be “channel stuffing” to pad its income statement. That happens when a company records premature sales, even though their distributor/customer hasn’t made the order. This sort of thing happens all the time, especially when companies are trying to hit a target on their income statement.
But an honest look at all the reports, and especially how cash flows through them, can give you a heads-up that something funny may be going on. Cash is king. And by following the money, canny investors should be able to see if a company’s managers treat their position as a trust—or as their own personal piggy bank.
Douglas R. Tengdin, CFA
Chief Investment Officer
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