Here is a useful experience shared by Mr. Le Quang (Legal Manager at LOGIVAN). I have his kind permission to viral it.
Financial statement (“FS”) is commonly known as a valuable tool for assessment of a company’s fiscal status, which is prepared by auditors and finance team. Although it is not prepared by a legal team or an external legal professional firm; however, it is also an important piece of document that lawyers need to look at in certain cases. Either you are an in-house lawyer, or external counsel, you will definitely come through a FS in your career, if do not want to say a lot of time.
The questions are, how does a lawyer read a FS which is mostly fiscal informative, and what can we learn from it? Although this topic has been studied by an array of legal professionals, I would like to share my limited experience in exploring a FS from a lawyer’s perspective.
As discussed above, lawyers shall come across a FS in certain cases. So what are the cases and when are they? Below are circumstances which I myself have experienced, but I believe there are more to raise:
(i) When we (lawyers) need to assess the company’s operation and health in general. The outcome of the assessment could be used for an important decision to the company, e.g restructuring or doing M&A. Via the FS, lawyers can obtain an overview of the company’s equity, assets, liabilities, profitability, business orientation without looking at particular and segmented internal documents. However, of course, in order to obtain a deeper understanding of the company, further investigation will be required based on red flags obtained from the FS. This could be conducted by in-house lawyer prior to a restructuring decision of the company, so as to have a comprehensive advise to the BOD; or by a professional law firm under a legal due diligence process serving M&A purpose; and/or
(ii) When we need to assess a particular aspect of the company, e.g legality of assets’ ownership, loan transactions or related-party relationship… This could be conducted by a bank’ lawyer for assessment of the bankability from legal perspective, or in-house lawyer for engagement of his/her company with its partner in a commercial deal; or external counsel for an asset M&A deal…; and/or
(iii) When we have personal interest for an understanding of the company, e.g an in-house lawyer newly joining the company.
An audited FS is commonly divided into six (6) parts, which are:
(i) Report of BOD;
(ii) Report of independent auditors;
(iii) Balance sheet;
(iv) Income statement;
(v) Cash flow statement;
(vi) Notes to financial statement.
Of course, depend on the purpose of the lawyers who want to come across the FS (as mentioned above), we will know what to read, e.g for legality of assets, we will look at balance sheet, or for net income we will look at the income statement; or for investment capital we will look at the cash flow statement. Nevertheless, in this article I will provide short break down of information into groups. These groups of information do not locate in the sections divided by the drafters of the FS, but from those which may be useful for a lawyer.
2.1. Group 1: Corporate information
Under the auditing process, the auditors have to collect basic corporate information of the company via documents. As a consequence, the FS reflects a number of corporate information which come from various constitutional documents such as ERC, IRC, Charter, BOD appointment decisions, list of subsidiaries and affiliates…
The information can firstly be located in “Report of BOD”, or the first item of “Notes to FS”, which normally is the part about basic information. From such items, the lawyers can have an overview about the company, including but not limited to corporate form, equity, business lines and main business operation, BOD composition.
While the corporate information is important from legal perspective, the main business operation is crucial for interpretation of statistic as it explains the operation and orientation of the company. For instance, a manufacturing company tends to have financial loan bigger than a trading company, as it has a large demand of capital for the construction phase, and obtainment of production chain. On the other hand, a trading company usually has ratio of payable and receivable account at a relatively high rate, due to the nature of retail and wholesale model (paying for manufacturer and receiving from end users).
As a result, FS saves the lawyers ’s time to obtain such overview of the company information before getting deeper information.
2.2. Group 2: Operation information
These group of information provides readers with status of the company and its health, whether the company is in good condition, with proper operation. In general, the Group 2 can be sub-divided into the following items:
(i) Assets: there are a number of reasons why we need to look at the assets of the company, especially those having real properties. We may not need to clarify value of assets (if the FS is audited), but we need to ensure the legality of such assets. From FS, we may identify what kind of legal documents we need to collect for such purpose, a red book of a real property, or construction permit of a future fixed asset, or certificate of an intangible asset for instant. Absence of legal documents may have significant implication on the legality of the company, particular state owned enterprise. It is also important to look at investments of the company as long-term assets.
(ii) Debt and equity: the debt and equity ratio may vary depend on main business of the company, as mentioned above. However, it must be logical to such business. A trading company with a major financial debt is not logical for example. That is what we need to investigate. As a trading company without valuable assets is difficult to have big financial loan from credit institutions, such major debt may come from related-party transactions, or even convertible loans. For an investor, it is highly risky if they purchase a company without knowing there are creditors having right to hold the company’ shares by converting their loans to such company. Moreover, confirmation of equity status may also made via Balance sheet.
(iii) Quality of earnings: different to other lawyers, I personally think this is not a crucial aspect from a lawyer’s perspective, as it indicates proportion of income attributable to the core operating activities of a business, which is more valuable for financial assessment. However, it is one of the most important information delivered by a FS, saying the company’s business is healthy or not. As a result, it is not redundant for us to capture such information. This can mostly be found in Cash flow statement and income statement.
(iv) Business activities: it is commonly known that a company in Vietnam can register a number of business lines. However, in fact, it may only operate in one or several businesses. Therefore, having a business line does not mean that the company need to satisfy condition for performing such business. It is critical to identify the performing business of a company and thus track out the satisfaction of conditions for such businesses. On the other hand, conditions laid down by WTO Commitment are applicable whenever such business appears in the registration of the company, even if it is not practically operated. In addition, the business activities will also link to other statistic like debt and equity, quality of earnings.
2.3. Group 3: Red flags
In this group, I refer to those are not expressly indicated in the FS, but those contain implications requiring further investigation. Normally, it requires experiences of the lawyer to identify such information, which may be scattered throughout the FS. It can be an abnormal item as high value inventory, but the target is an IT company. On the other hand, it can be a normal item but contains legal implication like a related party transaction with regard to a significant asset.
In general, a common feature of these information is that requires further documents and reviewing, so as to ensure the legality. Such statistics do not say a thing if it stands alone.
To conclude, although FS is a financial document of a company, it is also valuable from a lawyer’s perspective. Despite what I mentioned in this article, I believe the best way to interpret a FS is to fully understand the statistics. Once we master it, we can be selective for picking up useful information for legal practitioners.