Why Audited Statements Do Not Tell the Whole Story

While you cannot rely exclusively on the audited financial statement, this does not mean that statements are useless. In fact, they are valuable in what they do reveal. The starting point for trend analysis should be found on financial statements, but along with that you also need to be able to spot emerging problems or questionable reported numbers. For example, if a company is reporting declining sales, increasing expenses, and ever-higher net losses, everyone will agree that the trend is negative. But what if, at the same time, the company's working capital remains strong and consistent from one year to the next? The numbers simply don't add up and something is wrong when this occurs.

Working capital is considered one of the most important financial aspects of corporate strength, a quick view of the company's effectiveness is managing cash flow. When a series of net losses occurs, you would expect to see working capital weaken. However, there is a way that corporations can bolster working capital to create the appearance that it is managing cash flow effectively, even when it loses money every year. By issuing new bonds or acquiring new long-term loans, companies can keep their cash balances up, thus keeping working capital at high levels. The problem with this practice is that it artificially creates a good ratio, deceiving those fundamental analysts who look only at the cash flow question.

The solution: In evaluating working capital, you also need to track total capitalization and to monitor the company's long-term debt (bonds and notes). If you discover that a corporation is creating effective working capital by increasing long-term debt, it is usually a highly negative sign for several reasons. First, the practice creates an artificially positive-looking outcome but it is deceptive. Second, as long-term debt is increased, it places an ever-increasing burden on future cash flow and robs stockholders of future dividends. Because the corporation will have to repay the long-term debt and make interest payments, the higher that debt and the less profits there are to continue funding working capital or to declare dividends.

working capital the funds available to a corporation to fund ongoing operations for the immediate future, and a test applied to test and compare cash flow. Working capital is the net difference between current assets and current liabilities.

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