With the explosion of the Internet and other computer-related technologies, the 1990s have logically been christened the Information Age. But simply having access to information should not be confused with understanding it, according to John Percival, an adjunct professor of finance at Wharton.
He expounds upon this observation, illustrating it with examples in a six-week course titled "Using Financial Statements," which is designed to help managers, investors and other businesspeople comprehend financial reports and understand how the numbers on the documents relate to a company’s operations. Along the way, Percival offers a formula called "sustainable growth" which mathematically predicts how far a company can expand without collapsing. Some of his observations sound counter-intuitive-for example, he says that sales growth doesn’t always benefit a company–but more about that later.
At first glance, it might appear that a course about using financial statements is almost unnecessary. After all, prodded by watchdog organizations like the Financial Accounting Standards Board (FASB), which establishes and improves standards of financial accounting and reporting, and the Securities and Exchange Commission (SEC), which among other responsibilities ensures that investors have access to disclosure of all material information concerning publicly traded securities, issuers of financial statements tend to fill their reports with a great deal of detailed information.
In addition to profit and loss statements, and a summary of assets and liabilities, companies routinely disclose developments like material litigation. On the face of it, then, society is well served by financial statements. Indeed, the U.S. system of accounting and financial reporting, with all the disclosures, checks and balances, is routinely held up as a world model.
But Percival, who has served as a consultant to major corporations and organizations like AT&T, Bell South and the Federal Trade Commission, says the problem isn’t the quantity of information. Instead, it’s the comprehension, or lack of it, among those who use financial statements.
To begin with, he says, raw financial statements don’t really present a picture of a company’s health. At least two reasons account for this: One is that the metrics used, such as a year’s worth of activity for a profit and loss statement, are somewhat arbitrary and may not reflect developing trends. Another is the fact that financial statements present historical data, which are already outdated by the time the report is issued.
But even with these limitations, financial statements have value, Percival asserts. The key, he says, is to look beyond the raw numbers.
"The first step is to understand what a financial statement does–it links a business to certain numbers," he says. "Each component¾ the balance sheet, the P&L statement, the statement of cash flows, and footnote disclosures¾ can offer clues to how well a company is managed." The numbers will yield that information if you can tie the disparate reports together and analyze them as a single unit, rather than as discrete reports.
Percival offers a classic case study: A firm that generates significant sales, enhancing its balance sheet, but doesn’t actually collect on those sales. "If you simply studied the income statement, you’d think that the company was doing well," he says. "If you just studied the balance sheet, you might notice that Accounts Receivable were unusually high, but you still couldn’t be certain that something was wrong." However, a review of the statement of cash flows, which reconciles sales (a P&L item) to cash (a balance sheet item), would make it clear that the company was recording sales but not collecting the associated payments.
In fact, according to Percival, rising sales are not necessarily the key to a company’s health. "Increasing a business’ sales carries a corresponding increase in costs for such things as production equipment, labor and inventory," he says. "Instead, a company should concentrate on sustainable growth, which is characterized by increasing profit (as opposed to sales) and retaining the earnings within the company."
Percival notes that this approach boosts a company’s net equity, enabling it to expand safely. "Simply borrowing money without regard to equity level is self-defeating," he says. "The carrying charges can strangle a firm. And you can’t issue stock indefinitely, without dragging down the per-share price."
Sustainable growth can be expressed as a mathematical formula, crunching a variety of financial data and expressing the relationships as a maximum rate that a company can grow without imploding, Percival explains. Applying the formula to historical data has confirmed its predictive value, he adds. Of course, he cautions, the formula assumes a relatively unchanging environment. "For instance, if the business recasts itself in a more efficient mold, then the outcome will change," he says. "But absent that, there’s a high degree of correlation."
Students, who include many corporate managers, say the Wharton Direct course offers real-world benefits. "I majored in accounting in college, so I knew how to create all the financial statements," says one former student, a programmer and analyst with an investment firm in Chicago. "But here I really learned how to analyze the numbers that go into the statements and what they mean for a company."
Percival’s analyses begin with the basic financial statements, and then enhance the numbers through careful review. But what if the basic numbers are wrong? "Many reporting issues remain open," he says, citing such practices as revenue and expense smoothing, recently targeted by the SEC, that may artificially flatten out differences in period-to-period profits and losses. "There’s a difference between reporting aggressively, but staying within the rules, as opposed to outright fraud. Sometimes, however, the difference may not be that great. While a reader can take some comfort from an auditor’s report, it’s still a limited comfort level. In the end, there’s no substitute for being able to understand a financial statement and use the information intelligently."