What do users of private company financial statements want? Financial statements' primary purpose is to serve the needs of users. But there is a quandary as to who is a "user" and what users need, particularly for private companies. Financial Executives Research Foundation (FERF) examines these needs, from both the preparer and user perspectives.

Most, if not all, would agree that perhaps the primary objective of financial reporting is serving the needs of users. Broadly speaking, users of financial statements can be categorized as internal and external. Internal users can include company management, owners or directors. External users can be further categorized into two groups. The first includes commercial bankers, vendors/suppliers, rating agencies and others concerned with the company's collateral and/or credit-worthiness. The second category, external shareholders and equity-oriented investors, may be more concerned about share values, dividends and future earnings.

But, while the users of public company financial statements are more easily identifiable, the definition of "user" to a privately held company may vary. As a result, their needs may differ.

One type of user could read financial statements to evaluate business risks and profitability in order to determine a company's viability. Another may focus on a company's ability to generate cash flows and whether or not they are sufficient to meet its obligations.

Still another user may use components of the financial statements as inputs for models used to value collateral or determine liquidity and/or return on investment. Longer-term users may want to determine whether or not a company's ownership and succession plans ensure its long-term sustainability.

For private companies, then, who exactly uses financial statements and other relevant information? What are these users' needs? And, once needs are identified, how do they drive demands for financial information? In a series of interviews, Financial Executives Research Foundation (FERF) examines the answers to these questions from both the user and preparer perspective.

PinnOak Resources: Keeping It Simple

At PinnOak Resources LLC, a privately held coal producer, Vice President and Controller H. Richard Howie divides the company's financial statement users into four categories: investors, banks, insurance companies and all others. The latter groups are considered to be "standard" users and request the annual audited financial statements. Though the company does not always provide financials to all parties that request them, its insurers do receive its generally accepted accounting principles (GAAP) statements. "They are mainly interested in the financial strength of the company and how it may affect rates," Howie says.

The major users, Howie notes, are the company's outside investors, and they want monthly operational data, in addition to what is provided by the financials. Since the outside investor group owns 46.5 percent of the company, its primary focus is on how the company is meeting its financial goals. Consequently, it looks more closely at trend lines and year-over-year comparisons.

"Management prepares a PowerPoint presentation with graphs for the investors," Howie says. "The investors are interested in non-GAAP measures, such as earnings before interest, tax, depreciation and amortization (EBITDA), tons produced and sold, tons per man days, capital expenditures, working capital and production costs."

The company's bank group, on the other hand, wants audited GAAP financial statements, quarterly financial statements and measures of liquidity, which tie into debt covenant language provided in their agreement. Jerrod Freund, director at PinnOak's lead banker, UBS, elaborates: "The biggest thing for a lender is the cash flow and income statement. The ultimate goal is to make sure we will get paid back. Historically, we want to see the volatility in cash flow to ensure a company can service its debt, even in a down year."

For all of his clients, after looking at the cash flow and income statement, Freund looks at the balance sheet for existing obligations to determine what extent it is senior or subordinated to what may be owed to UBS. Finally, he looks at a company's hard asset base to determine what security can be provided to support obligations, and calculates the loan to value ratio. To Freund, GAAP financials are only a starting point.

"Since bankers are not auditors, GAAP financial statements provide more comfort that the accounting is correct--particularly for a smaller company that is thinly staffed," Freund says. "We don't look at something as GAAP or non-GAAP. We look at how a company will internally present to its board."

Though Freund typically sees more than the average user (as a banker, he is often bound by confidentiality agreements), he still places more importance on metrics that are specific to a particular business. Though he says GAAP financials are useful to some degree, they are not as meaningful. While he does use some of the financial statements and footnotes to identify risk, he does not need the detailed level currently required. "As a former accountant, now in banking, I agree with how complex it has gotten ... It's hard to keep up."

PME Companies: Cash is King

For PME Cos., a plastic injection mold, automotive parts and design-services company, its primary external financial statement users are bankers and leasing companies. In addition to annual audited financial statements, prepared in accordance with GAAP, PME's bankers also require monthly financial statements consistent with the annual statements. Mark Rusch, PME's CFO and partner, also provides the bank with detailed aged payables and receivables; inventory totals; monthly loan covenant calculations, which include debt-to-tangible net worth and current ratio calculations; collateral reports, with a breakdown of payables and receivables used in the calculations; and quarterly cash flow coverage.

The bank loads this financial information into its database to calculate ratios, Rusch explains. "They look for consistency. The bank can get some additional information from the footnotes, such as depreciation and amortization, but it gets most of its information from the financial statements."

Leasing companies, he says, "want to make sure that we are liquid so that we can meet current obligations. They will receive audited financial statements, and will learn much more from and ask about the footnotes." Rusch also notes that some of its larger customers are allowed to review financial statements, but do not retain copies. Instead of providing financial statements, Rusch calculates the company's Altman Z score and offers vendors a public accounting firm attestation to his calculation that is based on the information in the financial statements.

"An Altman Z score is a metric that runs financial statement information through a model to indicate the likelihood of bankruptcy," Rusch explains. A company with a Z score above 3.0 is considered safe; a company with a Z score between 2.7 and 2.99 is considered to be on alert, with caution; a company with a Z score between 1.8 and 2.7 could be bankrupt within two years.

Since PME has three partners, its major internal users are its owners. Internal financial statements are prepared in accordance with GAAP, though there is less interest in audited financials. Derivations of these financials are shared to varying degrees with the management team, and provided in different formats to people responsible for the various divisions. But they are not what Rusch calls "full disclosure financial statements" in compliance with GAAP.

For example, he says, those responsible for operations are provided with operating numbers on a weekly and monthly basis. "We make decisions more from a tax and cash-flow standpoint. We also look to minimize risk," he says. Further, he adds, "We're less concerned about the GAAP impact of a transaction. In the end, the bank just cares about cash flow and getting paid."

Rusch agrees, however, that GAAP provides consistency and comparability, and disagrees with bifurcating GAAP based on company size or status because financial statements would become meaningless. However, he points out it is impossible to tell the story of a business, whether it is doing well or poorly, using GAAP. He says his partners use financial dashboards. "I don't want to downplay GAAP, but information about operations is what is needed."

White Castle System: Information to Run the Business

Russell Meyer, CFO of White Castle System Inc., a privately held food and restaurant company, says the main users of its financials are its shareholders, bankers and insurance companies. For the company's shareholders, the audited financials add less value compared to the other internal reporting that takes place. He says his needs are really are at two levels--internal versus external. "The most important need is to generate financials for internal purposes so that we have good information for running the business. We generate an operations P & L that isn't pure GAAP, to avoid some distortions at the frontline business level. We roll that up into GAAP P & Ls for top management reporting."

For external purposes, he says, not much more is needed than cash flows, an overall understanding of business activity and profitability by major type of operation. Meyer describes the formal external audit as a "necessary process," and says the company's bankers like to see the audited numbers to be certain of consistency and accuracy. Their focus, however, remains concentrated on cash flow and fixed-cost coverage. "They ignore or add back what they call 'funny money'--items like minimum pension liabilities that have no immediate impact on cash flows," he adds.

From a courtesy standpoint, each accounting period, bankers receive a copy of the company's internal reporting "flash," which is a one-page overview of key performance metrics. Upon request, sales trends per store are given to offer some industry-wide comparison. The bankers and external auditors also receive a copy of the company's quarterly internal discussion and analysis of operations--to stay informed and save time. Additional information requests occur on an annual basis and consist of underwriting renewals and approvals.

White Castle's insurance companies ask for audited financials annually as part of its underwriting renewals in order to ascertain short- and immediate-term credit-worthiness for open insurance claims reserves outstanding. Like the company's bankers, they mostly ignore non-cash items.

Meyer agrees that GAAP is a common anchor point where the reader can compare his company's financials to others within the industry. He believes that GAAP provides a certain level of reliability to outside users' comfort level when reading the financial statements and accompanying footnotes. He says he prefers GAAP over some other basis of accounting--but only as long as it results in meaningful financials that are based on practical and common sense reporting versus more "theoretical" standards.

Still, Meyer says there is less need for lots of footnote disclosure for a private company. "Owners of private companies are typically more involved in the business, and are well aware of the true business and financial position of the entity," versus their public shareholder counterparts who may receive information only from filed periodic reports.

Cheryl de Mesa Graziano, CPA ([e-mail]), is Vice President-Research and Operations for Financial Executives Research Foundation (FERF). A more detailed research report on this topic will be available at the FERF bookstore: www.fei.org/rfbookstore.

RELATED ARTICLE: Users of Private Company Financials Want:

Internal Management

Financial and operating information for their division

Operating information that is provided on both a weekly and monthly basis

Investors

More information than is provided by GAAP financial statements

More operational data than financial data

Trend lines and year-over-year comparisons

Investment Bankers 

Audited annual financial statements for accuracy and comparability

Supplemental information beyond GAAP, such as a history of capital expenditures

A fair value appraisal for a company that is not liquid

Vendors

Financial statements, but only get financials if they are in a strong negotiating position

Insurance Companies

Annual audited GAAP financial statements

To primarily know about the financial health of companies

Banks

Annual audited GAAP financial statements for accuracy and comparability, and also quarterly financial statements

Other desired financial information may include:

* Detailed aged payables, receivables and inventory

* Monthly loan covenant calculations (debt to tangible net worth and current ratio calculations)

* Collateral reports

* Quarterly cash flow coverage information

Leasing Companies

Annual audited financial statements

Knowledge about liquidity

RELATED ARTICLE: takeaways

* The primary objective of financial statements is to serve the needs of users, both internal and external.

* Internal users include company management, owners or directors. External can include commercial bankers, vendors/ suppliers, rating agencies and shareholders.

* Identifying "users" for privately held companies is more difficult, and their needs differ from those of public company users.

* Those who use private company financials can include: internal management, investors, investment bankers, banks, insurance companies, leasing companies and vendors.