Chapter 19
What financial statements don’t tell you

Financial statements tell you many things about a company once you know what to look for and how to read and interpret them. But there are also many things financial statements do not tell you. Chief among these are total actual value of the company as a whole or of its individual assets, the future prospects for the company, and strategic changes in the company’s operating environment. Nor do company financial statements say much about the owners, whose performance and resources may be critical to the company’s financial health.

Actual asset fair market value is rarely disclosed for listed assets, because financial statements are based on historical costs and built upon principles of conservatism. For some assets, such as stocks and bonds, a statement’s footnotes will disclose both the cost and the year-end value. But for equipment, land and many other types of assets, true values are rarely disclosed.

Suppose you founded a trucking company 25 years ago and built the shop and storage yard on the edge of town. You paid $1,000 per acre for 10 acres of farmland. Now the city has grown, the road has expanded to four lanes, and shopping centers are located on either side of your truck lot, with multifamily housing on the third side. The financial statements still show that 10 acres at a total cost of $10,000, but the current value may be $500,000 or more.

You won’t find the actual value of that land anywhere in the financial statements. All other things being equal, if the net equity on the balance sheet is reported at $1 million, there is nothing to tell you that it is really closer to $1.5 million.

Financial statements will not report the value even if there’s evidence to support it, such as an offer on the real estate from the local shopping-center tycoon. The reason is the accountants’ principle of conservatism and the difficulty in developing good standards for reporting fair market value.

Another example would be the value of your equipment. It’s relatively easy to appraise an entire fleet based on published prices being paid for used vehicles. But you probably will never see a fleet value report in financial statements, even in the footnotes. Instead, the fleet is carried at net book value — original cost minus accumulated depreciation.

Conservatism suggests that for assets the numbers should be under the mark rather than over. In short, what something could be sold for is not as trustworthy as what something was actually sold for in a real transaction.

Any final upward adjustment of the value of assets will occur only upon the closure of an actual sales transaction. Accountants are usually quite good at recording debts, because it’s easier to clearly determine those. But for assets, there is always the chance that the actual value will be higher than book value. That’s why companies’ balance sheets should always be reviewed for undervalued assets.

Overvalued assets are rare, but they can sometimes occur. Accounting standards may not require that they be written off or the accountants may decide they can stay on the books for one more year. A common example might be advances or loans to stockholders. It’s a common practice, especially with C corporations, to build up receivables by making advances to owners rather than declaring them as salary or dividends. This may occur because the controller or CPA is not diligent in getting the owner to comply with recommended practices. Once per year, they are discovered and booked as assets. Whatever the reason, the advances increase over the years. For every $100,000 in shareholder loans receivable, there might be an overvaluation of stockholders’ equity, because listing these advances as assets increases the net equity.

Or there may be advances to subsidiary companies or investments in new or joint ventures. The true value of these types of assets may take years to determine, as the new business struggles to get started. Until there’s compelling evidence that the asset’s carrying value has been impaired and is worth less than the book value, there is no write-down of these values. This, too, could overstate the net equity of the company.

Total company market value is another thing that financial statements do not tell you. As discussed in Chapter 15, companies are often worth more than the sum of their parts. Balance sheets conservatively state asset values, and a company’s people, products, customers, safety programs, and rights or competitive advantages in certain lanes or markets can’t be listed on balance sheets. These are intangibles — but good companies can use them to their advantage. These intangibles are often called goodwill. They are only recorded on the books of a company if another company acquires the company and pays cash. They are never recorded without an actual purchase transaction.

A company’s value is also in the eye of the beholder. There are two main classes of company buyer: financial and strategic. Financial buyers (discussed in Chapter 15) look at the company as if it were any other stock or bond, expecting a dividend or financial return. A strategic buyer, on the other hand, often values a company higher than a financial buyer because of what strategic advantage owning that company will bring to the buyer. Perhaps it gives him a foothold in a very profitable lane serving a customer he thinks he can grab. A financial statement cannot measure strategic value in any way.

Liquidation value is also not reported on financial statements, which are presented assuming that the company will continue operating. Should a company lose a key individual and become too small to be sold as a whole, the assets typically will be liquidated and the debts paid off. In addition, liquidation value may come into play when there are shareholder disputes that can only be resolved by a liquidation or division of assets. Given the time it takes to liquidate, there will be costs associated with the period of “wind down,” including legal, accounting and final payroll and taxes. The net equity finally distributed, if any, may be only a shadow of that reported on the last financial statement.

Future prospects of a company are not shown in financial statements, only historical results. The company may make many internal forecasts and projections, often several years into the future, but rarely are these documents given to anyone except bankers or company appraisers.

Financial statements do not measure the effects of gaining a new and valuable customer — or the effects of losing one. These will not show up until the actual revenues have risen or fallen.

Likewise, good financial results may be the result of the skills of a key manager or several key employees. Since financial statements do not measure or report “people assets,” there is no accounting for talent. Should one or several of these people leave, it may take years for the financial toll to be measured.

Strategic changes in the company’s operating environment are not disclosed, unless they are clearly disastrous to the company’s immediate financial health. If construction of a new pipeline, for example, threatens the revenues of a tanker fleet five years down the road, there is no requirement to disclose this threat. But if in the year the pipeline opened the company’s revenues dropped 50 percent and the losses caused the company’s working capital to disappear, the financial reports might disclose the uncertainly of the company’s ability to continue operating. The danger signs were evident four or five years before the fact, but it’s unlikely that the financial reports would have disclosed them.

Entry of major or new competitors are not disclosed or measured. Should a large, well-financed public company decide to target your lanes, the financial statements will not tell the reader that this is happening or is about to occur. Only after the revenues or profits start to decline will the financial results show the damage caused by this development.

Individual owners’ resources are separate from company assets and liabilities. It is impossible to know by looking at company financial statements if stockholders are personally financially sound. That’s why bankers require personal financial statements of anyone who signs or guarantees the bank debt. This information is necessary for lenders, owners, and potential investors to fully evaluate the health of the company.

In Summary
Financial statements are valuable and informative resources for certain information. But by design, reports don’t tell you many things, such as what your company and its individual assets are really worth or what dangers may lie ahead. Prudent users of financial statements should be aware of these limitations and find other ways to stay informed about such important matters.