Financial statements provide broad information about the financial position (balance sheet), results of operations (income statement), and cash flows (statement of cash flows) of a business. While these basic financial reports give a snapshot of the business at a given point in time, they fail to communicate much of a message to financial statement users. In fact, financials by themselves merely present figures, ratios, and charts that allow the reader to draw conclusions based on their interpretation of data.
Next, lets consider financial statement users (audience) and their needs. Within the small business arena, financial statement users can be grouped into three (3) primary categories, as follows:
- Lenders – the institutions that lend money to businesses so they can finance operations, facilities, equipment, etc. These users need financial statements to ensure compliance with loan covenants, verification of ability to service debt requirements, and ultimately, whether or not to provide financing.
- Investors – the individuals and institutions that share risk with businesses by purchasing ownership interests and lending money. These users require financial statements to evaluate the performance of management, identify intrinsic value, and ultimately, whether or not to provide investment capital.
- Managers – the individuals that operate businesses by employing capital from lenders and investors to accomplish objectives believed to increase shareholder value. These users analyze financial information to evaluate performance in meeting strategic objectives (among other things).
In summary, the purpose and use of financial statements can be combined as follows:
- To provide ambiguous information about a business that allows users to draw their own conclusions about whether or not to provide financing or investment capital
I don’t know exactly how that sits with other small business owners, but it literally scares the crap out of me! However, it is a realistic interpretation of the situation small business owners can find themselves in by providing users with basic financial statements that omit guidance that only they can provide. In other words, business owners should always prepare the Management’s Discussion & Analysis (MD&A) section of their annual report, and they should never submit financial information to creditors, lenders, or investors without this invaluable piece.
The MD&A section is not a required disclosure of small businesses, but it should be considered a mandatory component of financial statements that will be submitted to an audience such as identified above. This section gives management an opportunity to draft the narrative that explains strategy, objectives, challenges, and outcomes (i.e., balance sheet, income statement, statement of cash flows, etc.), and it should be used to provide context to financial information and guidance to users unfamiliar with the industry. The Management’s Discussion & Analysis allows for broadening user perspective over a period of several years or sharpening focus to intangible value that would otherwise be overlooked.
Summary of Content and Benefits