Last week, we looked at the individual] financial [statements][3. Being an expert on the individual pieces isn’t the same as knowing the total financial performance of your business. To show this, I’ll give an example of when something looks good but is actually bad, and one where something that looks bad is actually good.
Example #1: Good is actually bad. The first set of numbers that draw attention is the net profit on the income statement. What could be simpler, the higher the net profit, the better, right? The exception to this rule comes in the amount of inventory you build. The raw materials, labour, supervision and other variable costs that go into making your product will go to one of two places on your financial statements. If the product is sold, it goes in the income statement as cost of goods sold, and the costs are accrued. If the product is not sold, the associated costs go onto the balance sheet as inventory, an asset! This increased inventory will represent future costs that haven’t yet gone through the income statement. So, in a way, inventory represents future costs. The best way to not be trapped by this is to look at the cash flow statement and balance sheet to ensure some costs aren’t being hidden in inventory. Beware the inventory build!
Example #2: Bad is actually good. On the balance sheet, the retained earnings level can go down and it can be a good thing. The retained earnings level is calculated by adding net profit and subtracting dividend payments from earlier balances. If negative net profit is the cause of retained earnings going down, that is a bad thing. If it is due to dividend payments, it is an excellent thing. In fact, this is delivering on the promise the management team made to investors. Shrinking retained earnings can be a good thing!
These are only a couple of examples of how you need to see all parts of the statements to see the real picture. Anybody that won’t show them all to you could be trying to hide something from you. Seeing them all will give you the whole picture.