Understand how financial accounts are related

Quality financial analysis depends on the analyst’s grasp of the interrelationship between accounts.

A good financial analyst will look line by line through a business' balance sheet and find changes that prompt further inquiry. An example may be the amount of cash on hand. If cash on hand drops 80% this year, questions arise about where they cash went. Again, a marginal change in profit this year may warrant further investigation. What explains that the growth of the company was substantial, but the profit is almost unchanged? These questions are invaluable for a business to answer and can unearth trends, decisions and inefficiencies that the business has an opportunity to correct.

A great financial analyst may look at each line of the balance sheet, but it’s the relationship of each account to the others which guides the analyst’s inquiry. It’s good enough to ask about the change in cash on hand; a great analyst wants to know who funded the cash and why a substantial amount was converted to inventory. A good financial analyst will be concerned that profit has not increased; a great analyst explores the relationship between sales, cost of sales, and indirect expenses to gage where to target questions about the business' health.

When a business seems to be healthy, managers can be satisfied with changes in individual accounts. If cash isn’t dwindling, a profit margin exists, and sales are growing managers are content to keep business as usual. This works well when the business is truly healthy and keeps managers focused on the conduct of quality operations and innovation to keep the business growing. Superficial analysis on the basis of individual accounts will not; however, give managers early warning signals when the business begins to drift off course. No alarm bells may sound when current liabilities begin to exceed current assets if managers are content that assets are growing and liabilities seem manageable. By the time managers awaken to the problem, the business may be too far along to correct without grinding its operations to a halt. If the bills become due when there isn’t enough cash to pay them, the business may be forced to sell inventory or take on loans in unfavorable circumstances that will set the business back.

Those managers who investigate the interrelationships between accounts will spot the warning signals in time to make corrections. A growth in inventory will not be assumed as business growth because the quick ratio will indicate that the business is risking insolvency. A decrease in liabilities will not be labeled a success if liabilities make up 95% of the source of funds, leaving almost no equity.

My review of the balance sheet and income statement is closer to good than great financial analysis. I begin to ask a few of the same questions Frampton and Robilliard list in their examples, but the correlations they make between accounts and the way they narrow down to specific concerns shows how much I have to learn. My initial thought when I saw the cash on hand dwindle and the inventory grow was that the business must be expanding fast to need so much inventory, and that growth is probably good. Even the growth in accounts receivable wasn’t a red flag, since it meant that many of the business' products must have been sold. This leads me to think that this book equips me to understand the basic interrelationships between assets, liabilities, equity, income, and expense, and a follow-on book about common practices in financial analysis will be both valuable and understandable. If anyone has suggestions, I’m all ears.

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