Financial Statement Insights in Light of a Recession
With the rise in interest rates to fight inflation, many experts agree there is a greater risk of a recession. However, whether or not a recession happens, there are important things to look out for on financial statements. These include the following:
- Total debt to total assets. Financial statements provide insight into a business and enable stakeholders to make informed decisions. A key metric for companies to know is their total debt to total assets. Simply put, this measures the amount of leverage used by a company. A higher ratio, generally greater than 1, means that a company is at a greater risk of defaulting on its loans. However, having a high total debt to total assets ratio doesn’t tell the whole story. A company may have long-term debt that matches the expected future cash flows of the company.
- Current maturities of debt. It’s important to know the current maturities of debt — debt that is due within 12 months of the balance sheet date. In many financing arrangements a loan will have a balloon payment due at maturity. Knowing the current amounts due and maturity date will be key during a recession since it can often be more challenging to obtain financing during economic uncertainty. So, be sure to have a complete understanding of the debt financing terms of a company.
- Cash flow. A recession can hit a company’s cash flow hard. Having strong working capital will help a business should inventory turnover slow down, customer receivables go beyond normal collections periods, margins shrink or debt become due as discussed above. A quick calculation of total current assets less total current liabilities will often highlight cash flow concerns.
- Concentrations. U.S. GAAP requires the disclosure of significant concentrations in financial statements. Reviewing these disclosures will provide insight if a concentration makes a company vulnerable to risk of short-term impact. For instance, having a high customer concentration may leave a company vulnerable should the customers experience financial difficulties themselves. In addition, having a concentration of supply or service from the vendor may leave a company vulnerable to price increases or shortages of supply. Other concentrations, such as concentrations in a geographic area, or labor subject to collective bargaining agreements, may have additional implications during a recession that need to be carefully considered.
- Commitments and contingencies. One last area to consider are disclosures for commitments and contingencies. These often do not show up on the balance sheet and can be overlooked. Commitments and contingencies, such as purchase commitments, employment agreements or pending litigation, can be recorded as a liability if certain conditions are met; however, they are often only a disclosure. These disclosures are just as important since they can affect future cash flows.
Many of these items can change depending on business trends, seasonality and economic conditions. So, if you notice any of these it’s not necessarily the end of the company, it just may be time to reassess and ask more questions.
Bill Beiermeister, CPA, is a partner at Wiss & Company, LLP. He is a member of the NJCPA.