When reading financial statements, if you’re asked “Is this a good number or bad number?” the appropriate answer is “I don’t know; I don’t have enough information.”
In a moment I’ll explain why “I don’t know” is the appropriate answer, but first I want to warn you that you will have a difficult time employing this response to reading financial statements. I know this because it has been the most difficult concept for students to embrace during the 25 or so years that I’ve taught financial accounting.
Evidence
In my classes, I tell students that the appropriate response to “Is this a good number or a bad number?” is “I don’t know; I don’t have enough information.” Two minutes later, I’ll show them a ratio and ask “Is this a good number or a bad number?” The response I always get is either good or bad…even though I warned them not to make this kind of judgment.
Natural tendency
What makes it so hard for people to avoid making “good or bad” judgments about financial information is that they:
- Lack the financial education that would have shown them how dramatically numbers can change from good to bad or vice versa depending on the circumstances.
- Are told by their accountants what their industry standards are…without explaining that these standards are averages based on the reported results of companies using different accounting rules…and that at least some of the companies may be padding their results.
- Possess the same natural propensity for judgment that we all possess by virtue of our humanity.
I Don’t Know: The Appropriate Answer
The reason “I don’t know” is the appropriate answer is that numbers are meaningless without context. Here’s an example to illustrate my point:
A retailer’s financial statements showed a significant write down in inventory value which dramatically reduced their profits and earnings per share. The stock market reacted negatively to the news and the stock price dropped significantly.
That means that the readers of this retailer’s “numbers” had formed a judgment that this was a bad thing. In reality, the retailer discovered a problem that it had. Took their lumps for having made a mistake and had set in place practices to prevent this problem from recurring. In other words, their future was going to be brighter…and it proved to be so.
Stockholders who sold on the “bad” news paid a hefty price for not getting enough information to make an informed judgment.
In my financial accounting class, I use an exercise called “The Mystery Works Company.” As its name implies, the students don’t know what the company does. They can infer some things about the company, but they can’t determine with certainty what industry it’s in. I do this intentionally to make it easier to illustrate how important it is to get context before judging a number. Here’s an example to make it easier for you to visualize:
I show them that the average days’ sales outstanding (average age of the accounts receivable) is only 10 days, then ask “Is this a good number or a bad number?” They instantly look to the standard for this ratio and judge it to be a good number…well below the standard.
Then I ask: “What would make this a bad number?” Here are some of the realizations they get from this question:
- The company may have one customer that represents 90% of their business. This customer demands a low price and in exchange agreed to pay in 5 working days. This context shows the company to be at great risk. Losing that one customer could force the company out of business.
- The company’s credit department might be granting credit to only the most creditworthy customers, thus forgoing profit that could have been made by accepting a slightly higher credit risk.
- If the company’s terms were “payable upon receipt,” they shouldn’t have any accounts receivable.
These are a few examples to illustrate how important it is to have context before judging any number reported in any financial statement.
Takeaway
When reviewing financial information, do not judge any number without first asking questions about what the number represents and how it was arrived at.
If you’re reading year-end reports, read the footnotes first, they tell you what accounting rules are being employed and how those rules are impacting the numbers you’re seeing.
If you find that you simply can’t break yourself of judging numbers, immediately upon forming your judgment, ask yourself what would make this good number bad or what would make this bad number good.
Regardless of what approach you use, get context before making a final judgment. Over time you’ll find it easier to say “I don’t know; I need more information” which indicates that you’ve become a savvy reader of financial information.
If you’ve found this post helpful, please share it with your friends. It’s a great way to let them know how much you care.
If you’d like the leaders in your organization to learn how to use the numbers more effectively and dramatically improve the productivity of your workforce, contact me to learn more about these resources:
Resources
Making the EXCEPTIONAL Normal program helps you identify and nurture emerging leaders who elevate all around them to higher levels of performance and greater job enjoyment.
Financial Awareness & Strategy program where employees learn to identify opportunities to improve financial results and prioritize these opportunities on the basis of which produces the greatest impact with the least effort. Greater financial awareness = Better decisions.
Leave a Reply