Components of Audited Financial Statements
- Auditor’s Report: This is the official, signed opinion issued by an external auditor on a company’s financial statements. This section is actually ‘owned’ by the auditor, not the company.
- Financial Statements: These provide a quantitative picture of the current health of the company and consist three core statements: a balance sheet, an income statement and a statement of cash flows. Nomenclature may differ in certain industries.
- Notes to the Financial Statement: The notes section provides more of a qualitative picture about the company through supplemental disclosures and details. These can include disclosures related to the basis for accounting, long-term commitments, pending litigation and affiliated entities. There is a lot of information you can glean from the notes section.
4 Red Flags to Look for in Third-Party Financial Statements
1. Modifications to the Auditor’s Opinion.
You want your third-party to have a ‘clean’ (often referred to as unqualified or unmodified) audit opinion. A clean opinion means that the independent auditor has concluded the company’s financial statements are presented fairly in all material respects. An audit opinion that is not considered ‘clean’ is one that has been modified.
Auditors issue a modified audit opinion if they disagree with management about the financial statements. The auditors will also issue a modified opinion if they have not been able to carry out all the work they feel is necessary, or if they have been unable to gather all the evidence they need.
Auditors can also modify the audit report without modifying the opinion by adding additional paragraphs to draw users’ attention to specific significant matters. For example, if the auditors believe that there is some aspect of the financial statements that is subject to a material degree of uncertainty—even if fully disclosed—then they may draw attention to and emphasise this in the audit report. This is widely known as an emphasis of matter paragraph.
So a great place to start in your financial statement due diligence is with the audit report. If the auditors have made modifications to their report, you should bring in additional subject matter experts from your finance team to help evaluate the risks associated with the modifications and determine whether additional due diligence is required.
2. Declining Profitability.
3. Inability to Pay Near-Term Liabilities.
Being profitable is good, but the old adage says, “cash is king.” I’ve seen too many companies look like they are stable when in fact they are running out of money really fast. A good way to evaluate a vendor’s ability to cover its current liabilities is through liquidity ratios.
The three key ratios to help with analysis are current ratio, quick ratio and cash ratio. What you’re assessing here is the vendor’s ability to pay what it owes and keep the lights on in the near-term. A liquidity ratio that trends lower over time is a red flag the company may be running out of cash
4. Concerns with Long-Term Solvency.