Why Financial Information Alone Cannot Give a Complete Picture of a Business Performance

Financial information is a critical component in assessing the health and performance of a business. However, it is merely one piece of the puzzle. To achieve a comprehensive understanding of a company's performance, we must look beyond the numbers to consider the broader context. In this article, we will explore why financial information alone is insufficient and the steps one should take to gain a more complete picture.

Jonathan's Perspective

Jonathan, an experienced SEO expert, highlights that financial figures are a historical snapshot, giving an insight into a business's past performance at a specific point in time. He argues, however, that the future is far from certain, with numerous variables such as market changes, technological shifts, obsolescence, competition, and regulatory compliance — all of which introduce risks. Dealing with these risks requires adaptability and management skills, attributes that fall outside the scope of financial reporting.

Intangibles that Financial Information Ignores

Financial statements often fail to capture critical non-financial aspects of business performance. For example, they do not reflect working conditions, employee morale, or ethical behavior within the organization. In regions outside the Western world, these aspects can be even more stark. Practices such as the use of prison labor or child labor, which would not be legally sanctioned in the United States or Europe, can significantly impact the integrity and reputation of a company. Such practices can, if known, deter potential buyers and cast doubt on the morality of the business.

Manipulation and Due Diligence

Financial reports can also be manipulated, intentionally or unintentionally. A new owner might change accounting methods, reduce input quality, or lower the salaries of new hires all in an attempt to portray a better financial picture. After six to nine months, these changes might indeed make the company look much improved on paper. Yet, such alterations bypass the critical analysis of a comprehensive due diligence process.

The importance of due diligence cannot be overstated. Here are some steps to consider:

Verify the Auditors: Ensure that the auditors belong to the Big 4 or a reputable audit firm. Reputable auditors add credibility to the financial statements. Analyze the Board of Directors: Examine the relationships within the board to understand any conflicts of interest or related party transactions. Examine Cash Flow Statements: Understand the inflows and outflows within the cash flow statements to identify any irregularities or trends. Review Stock Price Performance: A significant reduction in stock price can indicate underlying issues within the company. Attend Annual General Meetings (AGMs): Observe the discussions and the composition of the management team. Investigate the financial standing and interests of the management. Check Vendor Relationships and Debts: Focus on the largest creditors and the reasons for any significant debts. Bank Borrowing and Creditors: Ensure that the creditors are unrelated to the board and have no vested interests in the company. Public Opinion: Consider the public view and opinion of the company through external reviews and media coverage.

Just as one wouldn't buy a house without inspecting it, a car without test-driving it, or get engaged without knowing the person, one must not buy a company based solely on financial figures. A thorough due diligence process is crucial in ensuring a company's true value and integrity are accurately reflected.

By following these steps and incorporating multiple angles into your assessment, you can avoid potential risks and make more informed decisions when evaluating a business's performance.