Finance Fundamentals - a Board-level Perspective
A high-performance Board of Directors is comprised of a variety of skills and experience. However, in order to effectively assess strategic decisions, a fundamental understanding of finance and accounting is required. The ability to read a financial report, and understand and evaluate key performance indicators and ratios is critical from a Board-level perspective.
Financial Statements often require Board approval and sign off, therefore Directors must understand the main elements and be able to detect errors or potential problems. The purpose of a financial statement is to convey the business activities and the financial performance of a company, and is often audited to ensure accuracy. The basic elements of financial reports include a Statement of Financial Position (Balance Sheet), Statement of Profit or Loss (Income Statement) and Statement of Cash Flow.
A balance sheet provides a snapshot of what a company owns and owes by summarising assets, liabilities and equity at a specific point in time. The following equation reflects the most fundamental principle of double entry accounting. The formula shows that a company has to pay for what it owns by borrowing money (debt) or funding from investors (equity).
ASSETS = LIABILITIES + EQUITY
Overvaluation of assets and undervaluation of liabilities are indicators of financial fraud, and Board members should compare the balance sheet against previous periods to understand trends over time.
The income statement shows how much money a company earned and spent over a specific period. Revenue from goods or services appears at the top (top line) followed by the deduction of costs of doing business including cost of goods sold, operating expenses, tax expenses and interest expenses. Net income is known as the bottom line and reflects the performance during the period. Some working capital elements on the balance sheet are not reflected in the income statement even though they affect the cash position such as inventory, accounts payable and accounts receivable. An income statement provides valuable insights into various aspects of a business, including management efficiency, problem areas that may be eroding profits, and whether the company is performing in line with industry peers. Board members should compare monthly/quarterly income statements to identify trends across revenue and expense categories and expect management commentary against any significant variances.
Cash flow statement
A cash flow statement reports a company’s cash inflows from ongoing operations and external investment sources, and cash outflows to pay for business activities and investments. While the balance sheet and income statement usually reflect accrual accounting, the cash flow statement is prepared on a cash basis. It reflects positive or negative cash flows and highlights the importance of ensuring there is enough cash on hand to pay expenses. Critically, profits do not correspond to cash. For example, depreciation affects profits but not cash while capital expenditure affects cash but not profits. To estimate cash flow, add back depreciation and amortisation to the profits and subtract the changes in working capital and capital expenditures. Board members should scrutinise cash flow statements carefully to ensure the organisation is able to generate sufficient positive cash flow for operational growth.