In financial statements, devil is in the details
Financial statements are the vital signs of a company. Any astute investor knows how to decipher at least the headlining indicators of a company’s health in financial statements — cash flow, debt load and operating expenses.
But often, some of the most interesting information is hidden away in a financial statement’s notes. Here is where you can often find interesting insights into a company’s related entities, tax credits or upcoming balloon payments on loans. Especially in audited financial statements, where a third-party auditor has verified the accounting accuracy and details of the statements, this information can be valuable for an investor seeking a more detailed view of a company’s financial outlook. Here are five things to look for in the notes of a financial statement of a company you are investigating as a potential investor:
• Cost and Nature of Debt
The notes to the financial statements will give an investor several layers of detail about a company’s debt load. It will show any long-term and short-term debt, interest rates, payment schedules and maturity. Delve into these details to calculate when debt will be repaid, when interest rates might rise, and see the company’s total yearly debt payments. Also, keep any eye out for nontraditional forms of debt, like convertible debt, that can affect the company’s ownership structure.
• Transactions with Related Parties
Companies often have complex relationships with related entities, and these can be more clearly understood through a careful reading of the notes under “transactions with related parties.” Does the company make payments to a related company or hold debt from related parties or people? Does the company invest in related entities? Are the companies of executives or large shareholders used as sub-contractors? Understanding these transactions and what effect they have on the financials and long-term health of the company is prudent due diligence for thorough investors.
• Restricted Cash
Financial statements, especially those for non-profit and governmental entities, will often show a certain amount of “restricted cash,” cash that is restricted to certain uses, on the balance sheets. The notes to the statement will give much more detail about that cash, giving insights into how the entity is planning for future expenses. If a for-profit company lists restricted cash, review the notes to see if it is being held for future debt payments, capital projects or acquisitions. For more insight into governmental entities or non-profits that your company is involved with, carefully dissect the details of restricted cash to see the long-term financial plan and get hints about large future decisions like new infrastructure projects, equipment purchases or restricted donations.
• Tax Liabilities/Credits
Taxes are often viewed as fixed or variable costs, but tax credits can flip this equation on its head. Look through the notes to see a clear explanation of any tax credits the company has amassed and how those might offset the company’s expected tax costs. The tax section of the notes can also raise some red flags like deferred tax liabilities, uncertain tax positions or open audit years which may signal new or unexpected future tax costs.
• Subsequent Events
Financial statements capture one snapshot in time, and as they are being compiled and audited or reviewed, the company carries on with its business. Sometimes this means that significant new financial information comes together as the financial statement is being completed. This information is often included in the “subsequent events” section of the notes. All investors should pay attention to any information in this section. It could include notes on ownership changes, reorganizations of the company’s structure or large financial transactions that occurred after the balance sheets were compiled. Knowing the contents of the subsequent events portion of the financial statement notes will spare you any unpleasant surprises following your investment decision.
Ryan Webber is an accountant with J.A. Solari & Partners. Learn more at jasolariandpartners.com.
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