READING A FINANCIAL STATEMENT can be a mind-numbing exercise, but it is crucial if you really want to understand the financial condition of a prospective vendor. Here are a few tips from Peter Knutson, an accounting professor at the University of Pennsylvania Wharton School:
- First, look at the company’s liquidity?its ability to pay the bills?rather than at its assets. To do that, compare the amount of cash a vendor has on hand and its accounts receivables with the amount of money it owes. If the debt exceeds the cash, the company doesn’t have enough money in receivables to pay the bills, and that’s a bad sign.
- Carefully scrutinize the vendor’s cash flow statement. There are three sections of the cash flow statement. The first details the net cash generated by selling products or services that are also needed to run the business. The second reveals how much the company is spending on acquisitions or investing in future assets. The third states how the company is financing itself with outside capital. “Be wary of a company whose major source of cash is in the financing section,” Knutson says. “That means they are getting cash from borrowing money and issuing shares, as opposed to [getting cash from] operations.”
- Walk away from a company whose major source of cash flow is in securities. That means the company is issuing securities and borrowing money to run other companies without generating any cash. “That’s the worst of all situations,” he warns. “The company is spending all of its money buying other companies and operating them at a cash deficit rather than operating its own business. That’s the kind of company you want to avoid.”
- Check to see whether the cash generated from running the business matches over time with the income the company reports on the income statement. If a company reports revenue on the income statement but doesn’t collect that revenue from the customers, it ends up as receivables on the balance sheet and doesn’t become cash. “If they’re reporting a lot of income on the income statement but it doesn’t eventually show up on the cash flow statement as cash from operating activities, then you can ask if you’re really looking at income,” Knutson says. You’re probably not.
- Finally, check if the company has lengthened its collection periods. If so, that means customers are not paying up. “You wonder if the company will ever collect those receivables,” he concludes.