Key takeaways
- An unqualified opinion says the financial statements are fairly presented in all material respects under the standards. It does not say the business is sound or low-risk.
- Correct financial statements can show a profit alongside negative cash and short-term debt that is about to fall due.
- In addition to audited financial statements, owners need forward-looking information and internal controls.
The owner receives financial statements signed by the auditor with no qualification, feels relieved and files them away. Three months later, a major customer pays late, cash runs short and the bank asks for a meeting. The owner is baffled: the statements passed only recently, so why is there a problem? The answer is that an audit is not designed to answer that question.
A normal health check reports your condition on the day of the check, for the items tested. It does not guarantee you will not fall ill tomorrow, and it does not tell you how to change your lifestyle. Audited financial statements are the same.
What the auditor says and does not say
What the opinion covers
- The financial statements are fairly presented in all material respects under the applicable framework
- Reasonable assurance, not absolute assurance
- An assessment of going concern in line with the standards
What it does not cover
- Whether the strategy is good or the price is worthwhile
- Examining every transaction, or guaranteeing there is no fraud
- How good next year's plan and budget are
- Whether management is working efficiently
Example: clean financial statements, high risk
A hypothetical example. The latest financial statements received an unqualified opinion, and no figure in the table breaches the standards. But a few extra calculations give a different picture from the profit line. Figures are in THB million.
| Item | Figure | Reads as |
|---|---|---|
| Net profit | 18.0 | The line everyone looks at |
| Operating Cash Flow | (6.0) | Profit of THB 1 against negative cash of THB 0.33 |
| Available cash | 12.0 | - |
| Monthly operating payments | 17.0 | Cash lasts about 21 days |
| Debt due within 12 months | 45.0 | Cash covers only 0.27 times |
| Share of receivables from the largest customer | 46% | Concentration risk |
These financial statements may be correct in every respect, and the short-term debt may already be disclosed in the notes. But no one in the company has picked up the figures to calculate and decide.
Seven questions the annual financial statements do not answer
| Questions | Where to look |
|---|---|
| Will there be enough cash over the next 13 weeks? | Cash Forecast |
| Are the major debtors still in good shape? | Aging and recent payment behaviour |
| Can the existing inventory be sold? | Inventory aging and movement |
| What is the margin by product or branch? | Management reports |
| When will the covenant be hit? | Covenant Forecast |
| Do the controls actually work? | Management letter and internal testing |
| Do the key risks have owners? | Risk Register |
Do not read only the auditor's opinion page. Read the notes on related-party transactions, commitments, debt falling due and subsequent events, as well as any emphasis of matter paragraph or material uncertainty related to going concern section.
Getting more from your auditor than a signature
Many owners know their auditor only through the fee and the filing date, even though the auditor sees the company's processes from an angle insiders may overlook. After the audit work ends, arrange a meeting and ask about matters beyond the figures in the financial statements: which areas required a high degree of judgement, which items came close to materiality, which issues recurred from the prior year, and which documents made the audit hardest.
It is also worth understanding that audit materiality is set for considering the financial statements as a whole. Something small to the financial statements may not be small to the owner. A modest monthly cash leak, or a branch that has lost money for years, may not affect the auditor's opinion yet directly affects the business's returns. This work belongs to management and should not wait for the auditor to point it out.
When you send financial statements to a bank or investor, prepare an explanation alongside them. If profit is good but cash is negative, explain whether it comes from building up inventory or expanding operations, and when you plan to bring the cash back. Experienced readers will spot the issue anyway, and explaining it first shows that management understands its own business. Hoping the auditor's signature will answer the question for you usually does not work.
Next steps
- Calculate operating cash flow against profit, cash days and coverage of short-term debt from the latest financial statements
- Read the notes to the financial statements on debt, commitments and related parties
- Request the management letter and arrange a direct meeting with the auditor once a year
- Ask the auditor what their biggest concern is this year
- Prepare forward-looking reports, at a minimum a cash forecast and a covenant forecast
- Create a one-page risk register that names owners and warning figures