How To Use Financial Statements_pda

WISDOM IN A NUTSHELL

How to Use Financial

Statements

A Guide to Understanding the Numbers

By James Bandler McGraw-Hill, 1994 ISBN 078630197X 147 pages

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The Big Idea Reading and understanding Financial Statements has always been considered a difficult task to most. These days, financial statements are not solely for accountants, economists and businessmen. Knowing how to read and understand financial statements can help you know your company better, can help you plan investments, spot industry trends and can help you find a better job. You do not need to be an accountant to use the information on a basic statement. All you need are a few basic concepts. This book gives you a clear and simple way of reading and understanding financial statements. It puts complex ideas into plain and easy to understand language.

What Are Financial Statements and What Do They Tell Us Financial statements are necessary sources of information about a company. It is used to analyze a company’s past, present and future performance. Financial statements consist of three separate but interrelated topics: 1. Statement of financial position or balance sheet ƒ Gives a snapshot of the company’s financial position at any given time. ƒ Lists down the company’s assets against liabilities and owner equity. Assets should always equal liabilities plus owner equity. 2. Profit or loss or the income statement ƒ Shows how profitable a company is at any given time. ƒ Shows revenues minus expenses to come up with net profit. 3. Statement of cash flow ƒ Tells how much cash a company made, and where it went.

Who Uses Financial Statements and What Do They Look For Primary users of financial statements are: ƒ Owners/investors - places more emphasis on the profit side of the business; will focus most likely on the income statement ƒ Lenders - tends to give more importance to balance sheets and cash flow. ƒ Managers - uses financial statements to gauge the performance of the company or business. ƒ Suppliers - concerned with the ability of the company to make payments. They are inclined to look at cash flow and how “liquid” a company is.

ƒ Customers - looks into a company’s financial strength. ƒ Attorneys and litigants - interested in the client’s ability to pay. Financial statements are also used to determine who will be named in a law suit and how much to demand. ƒ Employees and jobseekers - employees need to know if the company can provide the job and employment security he needs.

An Introduction to Accrual Concept Financial statements are based on the concept of Accrual Accounting. It is important to understand this concept of recognizing revenue and expense when you read and analyze financial statements. Accrual accounting records revenue as it is earned and expenses as it is incurred, even if no money has changed hands. It matches revenues with expenses of a particular period regardless of cash involvement. Revenue is recognized upon completion of a sale or service which requires a client to make payment. Revenues may be earned before or after cash is received. Expenses are recorded at the time it is incurred or when a company receives supplies or services - regardless of whether cash payment had been made. Expenses are recognized when the company has an obligation to make payments. Accrual Accounting and Depreciation Matching of revenues and expenses can be found in the purchase of income generating assets such as property, plant and equipment. Instead of charging these assets at the time of purchase, resulting in a misrepresentation of company income, the cost of these assets is expensed over its useful life. The cost is matched against the revenue that will be generated over a particular period.

The Statement of Financial Position or Balance Sheet The balance sheet lists and totals the company’s assets, liabilities and the owner’s equity at the end of each operating period. An operating period can be 1 month, 3 months, 3 months or a year. It has three board categories and can be summarized as: Assets = Liabilities + Owner’s Equity A balance sheet, therefore, should always have equal assets to liabilities and owner’s equity. To get owner’s equity, you have to reorganize the equation as:

Owner’s Equity = Assets – Liabilities Items found in the balance sheet are as follows: ƒ Assets o Current Assets. Includes cash, things easily converted to cash, and things that enable a company to make products or render services that generate cash. It lists in order of liquidity (how it is easily converted to cash within a period of 1 year), beginning with cash itself. It may include accounts receivable, marketable securities, insurance or taxes. o Non-current Assets. This includes properties, plants, and equipment used in the production of products and services. ƒ Liabilities o Current Liabilities. Discloses amounts owed by the company, such as debt, unpaid bills, expenses not yet paid or yet to be paid within a period of one year. This typically includes payment for wages and salaries, rent and expenses, interest expense on debt and other account payables within one year. o Long-term debt. These are obligations not due for payment within the following year. ƒ Owner’s equity. This consists of both the funds contributed to the company for the purchase of ownership and the accumulation of profit not yet paid to the owners in the form of dividends or other capital distribution. The balance sheet can tell you the amount the company has in debt in relation to its owner’s equity. This is known as Leverage. A company is said to be highly leveraged if total liabilities are large in relation to owner’s equity. A company which has high owner’s equity in relation to its liabilities is low leveraged and is less risky than the former.

The Profit and Loss or Income Statement The income statement shows if the company is making profit or incurring losses. It subtracts the cost of doing business (i.e. the cost of production, operating expenses) from the revenue gained from the sales of products or services. An example of an income statement: Net sales Cost of goods sold Gross Profit Operating expenses: Selling, general & administrative Depreciation Total Operating expense

$10,000,000 7,000,000 3,000,000 1,600,000

200,000

(1,800,000)

Profit from operations Interest expense Income before taxes Provision for income taxes Net Profit

1,200,000 (200,000) 1,000,000 (400,000) $600,000

Revenues (net sales). These are products sold or various sales and services rendered regardless if cash was received. It can also come from rentals, interest earned, commissions, etc. Cost of goods sold. These are all cost allocated to inventory that was sold during the period. It includes labor, materials and overhead. Gross Profit. It is the difference between revenues and the cost of goods sold. Operating expenses. These are expenses incurred to keep the business running day to day. General and administrative cost includes salaries and wages, payment for utilities, insurance, rental and other expenses. Selling expenses includes all forms of advertising, cost of supporting sales function, salaries and commissions of sales personnel. Provision for income tax. This is the income tax expense and is based on the company’s income tax rate. Net income. This is also called the “bottom-line”. It is what is left after all cost of doing business is deducted from revenues earned. The income statement directly affects the balance sheet. Sales can lead to an increase in accounts receivable. Cost of goods sold can lead to a decrease in inventory. Operating expenses can affect a rise in accrual expenses or accounts payable. It can also decrease cash and prepaid expenses. Net profit leads to an increase of retained earnings or owner’s equity.

The Statement of Cash Flow The statement of cash flow essentially converts income statement into sources and uses of cash. Conceptual basis for determining cash flow Cash flow statement begins with net income and assumes that all transactions (revenues and expenses) are made in cash during the operating period. It then makes necessary change to show that it is not so.

An example of a cash flow statement: (based on the above income statement) Cash flow from operations Net profit 600,000 Depreciation 200,000 800,000 Changes to operating assets and liabilities Accounts receivable Inventory Accounts payable Accrued expenses Net cash provided by operations Cash flow from investing activities Additions to property, plant and equipment Net cash from financing activities Repayment of long-term debt Net cash provided (used)

(500,000) (300,000) 200,000 (100,000) 100,000 (1,000,000) (200,000) $(1,100,000)

Calculating cash flow Depreciation is not considered a cash outlay, so it is added back to net income. Accounts receivable and Inventory are deducted from cash flow as it is not yet cash during that period (no income made). Accounts payable are considered sources of cash since no payment was made during that operating period. Also deducted from cash are investment activities such as additions to property, plant and equipment. Cash from financial activities can increase or decrease cash flow. Payment of long-term debt reflects a decrease of cash flow while an increase of long term debt provides cash and is added to income. Alternative format for statement of cash flows This aims to show how much cash was made from sales, how much was utilized for production and how much was spent for operating expenses. It adjusts revenues earned or expenses incurred into cash received or cash paid. It is computed as: Cash revenue = accrual revenue + beginning accounts receivable - ending accounts receivable Cost of goods sold / production cost = beginning accounts payable + purchases - ending accounts payable Operating expense = total beginning accrual expenses - total ending accrual expenses.

Resulting cash flow statement looks like this:

Cash received from revenues Cash paid for production cost Cash paid for operating expenses Cash derived from operations Cash paid for property, plant & equipment Cash paid for debt reduction Net cash flow

$9,500,000

(7,100,000)

(2,300,000)

100,000

(1,000,000)

(200,000)

$(1,100,000)

Using the statement of cash flow For a meaningful analysis of cash flow, you should also focus on the individual components and not just the change in cash or net cash flow. The primary purpose of cash flow statement analysis is that a company should not tie up its funds in assets that are not able to generate cash for the company to meet its obligations. Analyzing cash flow of a company should be done over an operating period of several years and in detail.

Following a Transaction through the Financial Statements Important accounting issues and rules give additional meaning. Company transactions such as inventory purchase, payment or sale of inventory and collection of accounts receivable influence financial statements over an operating period. A growth or decline in a company’s business, its ability to create cash or meet its obligations, its efficiency and profitability can affect the balance sheet, income statement and cash flow.

Special Inventory Valuation and Depreciation Reporting Issues To effectively compare and analyze financial statements, it is imperative to take note of the specific methods used by the company. Two items that regularly appear are inventory valuation and depreciation of property, plant and equipment. Methods of valuation and depreciation are usually stated in the footnotes of financial statements. Inventory valuation alternatives First in - First out (FIFO). Reports as cost of sale the earliest acquisition cost of inventory. Last in - First out (LIFO). Reports as cost of sale the latest acquisition cost of inventory. Average cost method. Reports as cost of sale the average cost of its inventory.

Depreciation methods Straight line method. Applies a consistent rate of asset cost to each period Accelerated method. Applies a greater rate of depreciation in the earlier years of an asset’s life, and less in the later years. In computing depreciation, the following information is required: 1. Cost of asset. This should include the asset’s purchase price and all cost incurred to get the asset in the position and condition for operation / use. 2. Useful life. This estimates the serviceable or productive years of the asset. Normal wear and tear, obsolescence, and change in requirements should be taken into consideration. 3. Residual or salvage value. This approximates the amount the company can get from the sale of the asset at the end of its useful life.

Intangible Assets and Amortization These are assets lumped together in the category “other assets” seen on the balance sheets: 1. Intangible assets. These are assets that can not be seen nor felt but generate revenues. Patents, trademarks, copyrights and franchises are considered intangible assets. 2. Good will. This is the excess amount a company has paid over the book value assets of a company (subsidiary or affiliate) it has acquired. 3. Amortization. It is the cost of intangibles which are charged over the period they are expected to generate income.

Service Companies Service companies such as banks, public utilities, hotels, hospitals, data providers, travel agents differ from product or merchandise oriented companies in the way they report their financial statements. Service companies differ on how they generate revenues and other financial characteristics. They can be grouped into: 1. Financial Service Companies. These normally show large amount of loans and investment against owner’s equity. a. Banks. Loans are considered assets while deposits are liabilities. Income comes from interest earned from loans while interest paid is considered expenses. b. Insurance companies. Assets are in the form of marketable securities, common or preferred stocks and other investments. Liabilities are in the form of payment of claims. Revenues come from policy premiums and investments. Expenses are projected and actual policy claims.

c. Securities brokerage. Revenue comes from commissions from security traders and other agency fees. Commissions paid by the company to brokers are considered expenses. 2. Capital Intensive Companies. Revenues mainly come from property, plants and equipment. These companies invest heavily on property, plants and equipment to provide services and thus are capital intensive. Hospitals, hotels, airlines and other transportation companies, TV and cable companies, phone companies are some examples of these type of companies. 3. People Intensive Companies. These companies provide professional services. Law firms, accounting firms, consultancy agencies and employment agencies are under this category. People (or employees) are considered assets since they generate income.

What are the Rules that Preparers of Financial Statement Must Play By? To present the reader with an accurate and fair presentation of financial information, financial statements are prepared in accordance with the Generally Accepted Accounting Principles or GAAP. The GAAP standardizes how financial statements are prepared so that you can effectively compare a company with another in the industry. Most GAAPs are defined and served as guides for reporting and reading a financial statement. All information or disclosures needed by the reader to understand the financial statements, the company’s accounting practices as well as the auditor’s opinion can be found in the footnotes of a financial statement. Some of the disclosures commonly found are:

ƒ General. This reports the nature of a company’s business and its operating

and accounting principles. ƒ Summary of significant accounting policies o Principles of consolidation. States if the financial information of a company’s subsidiary are consolidated or mixed in with the parent company instead of showing it as a separate asset. o Revenue recognition. Tells how a company recognizes revenue for a better understanding of the statement. o Treatment of “excess of purchase price over net assets of business acquired”. This is also known as goodwill. It states how it is recognized (i.e. is it amortized? For how long?). o Property and equipment. Reports useful life of an asset and method of depreciation as well as net asset value of each. o Inventory. Tells what method (FIFO, LIFO, Average cost) of inventory valuation is used. Breakdown of inventory components are also included.

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o Research and development. Shows if R&D expenses are reported as assets (which benefits future periods) or as expenses for the current period. o Definition of cash equivalents. Most companies invest in short-term debt instruments instead of putting cash in banks. o Warranties of any other unusual terms of sale. States if there are unusual obligations or expenses arising from the sale of a company’s products or services. Description of credit facilities. States a company’s lending agreements with its creditors Description of terms and funding of employee’s benefits and retirement plans. Tells estimated cost for providing benefits and who are eligible for these benefits. Reconciliation of income tax expenses. Also known as provision for income tax. This tells what tax rate was used, the company’s tax credit, actual amount paid or due for taxes. Long term debt maturities. This is useful in determining future cash flow and financing needs as it reports how much debt must be paid and other future long-term obligations. Property and casualty insurance. Discloses if the company is insured against risk and losses and if it is within industry standard. Transactions with insiders or related entities. Reveals how the company conducts business with management or directors of company owned or controlled corporations. Major customers and suppliers. States the percentage of sales or purchases from parties and if the company is highly vulnerable to a loss of the major supplier or customer. Industry segment information. Discloses sales information by product line and geography. Current cost or replacement value of non-monetary assets. Contingent liabilities. States current development that might become future liability to the company (i.e. pending law suits). Events subsequent to the date of the financial statements. Discloses events that might affect the financial statement after it has been made. Opinion letters. An outside auditor’s opinion on the financial statement. It should state that the financial statement has been prepared in accordance with GAAP or that the statements fairly represent the financial conditions of the company. Opinion letters offer the highest level of assurance as they are made by independent auditors or accountants.

Some Basic Tools of Financial Analysis To be able to analyze a company’s success or failure, its strength and weakness as well as its future outlook, you need to understand the relationships of the data

presented in the financial statements. These relationships are analyzed by means of ratios. Some useful ratios and what they tell us 1. Leverage ratio. Tells if the company’s assets are adequate to cover claims of creditors and still present ample equity to owners. Leverage ratio = Total liabilities ÷ owner’s equity 2. Current ratio and quick ratio. Measures how liquid a company is. Quick ratio = total cash, short term marketable securities and accounts receivable ÷ current liabilities Current ratio = total current assets ÷ total current liabilities 3. Debt coverage ratio. Tells if a company’s cash flow before payment of debts is adequate to cover debt requirements. Debt coverage ratio = total of net income + non cash charge ÷ current maturities of long term debt 4. Accounts Receivable collection period. Discloses if the company is able to collect its account receivable on time (A/R) and long it collects A/R. Accounts Receivable collection period = Accounts receivable ÷ sales for the period x number of days for the period 5. Days inventory supply. Tells if the company is carrying enough in its inventory to meet demands of the market. Days inventory supply = inventory ÷ cost of goods sold for the period x number of days for the period. 6. Return on assets. A measure of profitability of assets. Tells if assets are producing sufficient income. ROA = net income ÷ total assets 7. Return on equity. Measures the return of investment of an owner or stock holder. Tells the profitability of owner’s investment ROE = Net income ÷ owner’s equity

The Limitations of Financial Statements Financial statements are merely historical measures of a company’s performance. Though it represents a fair representation of a company’s current condition, most data (except cash and other liabilities) are based on estimates, forecast and assumptions. Different methods (depreciation method, inventory, etc) used can distort a financial statement.