While many companies obtain audited financial statements from vendors as part of third-party due diligence, do the reviewers of those statements really know what they’re looking for?
A vendor’s financials are the most objective way to assess its overall health. As the old adage says, “numbers don’t lie.” Here’s a breakdown of the main components of a set of audited financial statements along with four red flags you should always be looking for.
Components of Audited Financial Statements
The audit is the highest level of assurance service that a Certified Public Accountant (“CPA”) performs, and is intended to provide the reader with comfort as to the accuracy of a company’s financial statements. The CPA performs procedures in order to obtain “reasonable assurance” (defined as a high but not absolute level of assurance) about whether the financial statements are free from material misstatement.
Audited financial statements are segmented into three key sections:
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
Reviewing financial statements is usually one part of your overall third-party due diligence. It would be easy to spend hours delving into a company’s financials, but most people don’t have that type of time. So if you don’t have that kind of time, I recommend focusing on these four areas to look for red flags.
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.
Declining Profitability. One of the first places most people look is the income statement to see whether the vendor is profitable. This is a good place to start as these ratios measure a company’s ability to earn an adequate return. However, when analyzing a company’s margins, it is always prudent to compare them against those of the industry through the use of profitability ratios such as profit margin and return on assets. A declining profitability ratio can be a red flag signaling that a company’s costs are rising faster than their revenues, or that a company is losing market share.
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.
Concerns with Long-Term Solvency. When evaluating the financial position of an organization from a long-term solvency point of view, Solvency Ratios are some of the best tools to use. They help you understand how a company uses debt to fund its operations and whether their debt is growing to a point where it will strain the company’s ability to pay it back. A solvency ratio that is trending higher over time may be a red flag that the company is adding too much debt.
Analyzing a company’s financial statements is a valuable part of due diligence. However, not every vendor requires a financial statement review. Always let your third-party risk assessment be your guide to determining the scope of your due diligence, including a financial statement review.