Knowing the basics of reading the numbers on a financial statement is essential to understanding the financial health of an association. Many people admit that accounting is not their area of expertise and therefore leave it to others (or the auditors) to explain what they are seeing on the financial statements. With a few simple lessons, you can learn what financial statements really tell you and how to use them to understand the true financial health of your association.
Definitions of the Most Commonly Used Financial Statement Terms
An income statement can also be referred to as a Profit and Loss Statement, or a Statement of Operations for not-for-profit organizations. It shows the revenue and expenses incurred by an association over a period of time.
The Balance Sheet, or a Statement of Financial Position, shows the amount of assets (what is owned), liabilities (what is owed) and capital, or the net assets for not-for-profit organizations (what is left over) of an association at one point in time.
Items on the balance sheet are usually broken down into short term and long-term categories, with the long-term period usually being a year or more. On the balance sheet the assets always equal to the liabilities plus the equity (or net assets in the case of a not-for-profit).
Statement of Cash Flows
The statement of cash flows is a financial statement that shows how changes in balance sheet accounts and income affect cash, and breaks the analysis down to operating, investing and financing activities.
Knowing What’s Behind the Numbers
Financial statements reflect real world events but aren’t always the whole story.
Things like market forces, the economy, and technology are not reflected in the financial statements so it is important to understand that they are just one piece of the puzzle when it comes to decision making.
The numbers are easier to understand if you have a solid understanding of what the association does and what it’s goals are. Financial statements can also be influenced by management estimates and judgement. Audits or review engagements are helpful to determine if the estimates being made are appropriate.
Working Capital Ratio – the liquidity of an association is a strong indicator of it’s health. Liquidity refers to how easily an association can turn assets into cash to pay any of it’s obligations. The working capital ratio is calculated by dividing current assets by current liabilities. The higher the working capital ratio the better, however ideally at least 1.0, but preferably greater.
Quick Ratio – similar to the working capital ratio, the quick ratio calculates the short-term liquidity of an association. It is calculated by first removing inventory from current assets and then dividing by current liabilities. The reason is that inventory often takes some time to sell. Again, the higher the ratio the more liquid the association. You wouldn’t want to see a quick ratio of less than 1.0.
Operating Margin – this ratio is calculated by subtracting expenses from revenues and dividing that sum by the revenues. This is an important forecasting ratio because it illustrates the associations ability to produce a surplus, which can be drawn on if needed in the future. Generally, an operating margin of 25% or higher is considered favorable.
Operating Reserve – the operating reserve addresses whether an associations resources are sufficient to support its goals. It compares net assets to total expenses. Not-for-profit organizations should aim to have an operating reserve ratio of 100% of its revenues, or enough to cover a least 12- months of their annual revenues.
Questions to Consider
When a board member or executive looks at the financial statements, some of the things they should consider are:
- What items are included in accounts receivable and accounts payable? When are they to be received/paid? Are they overdue? Is it possible they may never be collected?
- Compare the balance sheet with the previous year’s statement for the same time period. Look for any trends that may indicate a change to the health of the association.
- Is there enough or too much cash available and should some of it be invested?
- Are revenues higher than expenses and if not, why not?
- If not, does your association have a plan to increase revenue?
- Have investments increased or decreased and what is the reason? Has the market gone down?
- Are the actual amounts in line with the budget?
It is important to understand the role the auditor plays regarding the financial statements. It is a common misconception that if an audit has been done that every single item has been checked. To read more about the role of an audit, review engagement, or notice to reader, review our previous article on the subject https://strauss.ca/difference-audit-review-engagement/
The Board’s Responsibilities
The directors of an association have the responsibility to oversee the finances.
As a director (or executive), you do not need to be a financial expert; however, you do need to understand how financial information is presented. It is a reasonable expectation, to do regular reviews of the information prepared for that purpose by engaging in questioning and participating in discussions. In the end, it is the Board of Directors who are accountable for the financial affairs of your association—if you do not understand something presented in a set of financial statements, then it is your responsibly to ask questions and ensure that your question and the answer are included in the minutes of the meeting.