How to Read Financial Statements! Presented by Ed Knight! Conference Intentions! 1.  Become comfortable with financial information.! 2.  Participate in your organization.! 3.  Improve personal finance.! Todayʼs Agenda! Cash vs. accrual accounting! Key definitions to speak the language! Balance sheet, income statement, and cash flow! Break-even analysis! Ratios! Cash vs. Accrual Accounting! Accrual accounting:! •  Recognizes transactions when they occur! •  Recognizes income when goods are shipped or services are rendered! •  Recognizes an expense when the business is obligated to pay it! Cash vs. Accrual Accounting! Cash accounting:! •  Records transactions, sales, or payments when money actually changes hands! •  Recognizes income when money is actually received! •  Recognizes an expense when itʼs actually paid! Cash vs. Accrual Accounting! »  Why differences are important:! •  The accrual method shows the flow of business income and debts more accurately, but doesnʼt show cash reserves.! •  The cash method provides a more accurate picture of how much actual cash your business has, but may be misleading in terms of long-term profitability.! •  Cash accounting can distort a companyʼs accounting picture by incorrectly reflecting actual activity.! GAAP (Generally Accepted Accounting Principles)! GAAP:! •  Standard framework of guidelines for financial accounting! •  Accountants must follow in recording and summarizing transactions, and preparation of financial statements.! •  The terms theyʼre using, the way the financial documents are set up, and the rationale behind it! •  Emphasis on the term “general”! Key Definitions! Assumption sheet:! •  An attachment to any key financial document explaining the rationale behind numbers! Leverage:! •  The relationship between assets and the debt on those assets! Liquidity:! •  The relationship between assets owned and how quickly those assets can be converted to cash! Balance Sheet! Assets! Liabilities! The balance sheet shows: 1.  Assets 2.  Outstanding liabili8es 3.  Owners’ or shareholders’ equity Ownersʼ Equity! Balance Sheet! ht g u o h t be n a c t e she e c n a l a of a b ” h e p h a T r »  at a otog h h t l p “ a e a h cial of as n a n fi nyʼs a p m ime! t o c n i t n e ust m m o s t m e ass , given P A y.! A t i G u q o t e r ne ding w r o o c d c n A »  ies a t i l i b ge! a i a l r l e a v u e l q e nd a y t i lly d i a i u c q i e l p s s w l, e a c i t i r »  Sho c ar is .! e s y e f s o s e e n usi b l »  Tim a n o as with se Balance Sheet! Income Statement! It is sometimes called:! •  Statement of operations! •  Profit and loss (P&L) statement! •  Statement of activities! »  If a balance sheet is like a photograph, an income statement is like a video.! »  Usually done monthly! Income Statement! Income! Grants! Sales! Income Statement! Taxes! Donation! Income Statement! •  An income statement compares a relationship between income and outflow over a given period of time.! •  Always shown on an accrual accounting basis! Income Statement! Income Statement! Shows earned income only! Separates payroll and non-payroll expenses! Done monthly, quarterly, and at year-end! Indicates how the business is run day in and day out, month in and month out! Cash Flow Statements! Cash Flow Statements! »  Show actual money coming in and going out! »  Designed to maximize the use of money when we have it before we need it and minimize the cost of money when we need it before we have it! 3 Key Financial Statements! 1. Balance sheet! 2. Income statement! 3. Statement of cash flow! Calculating Payback! »  Use the payback method to determine whether the purchase of a new copier would be a good financial decision.! ASSET FACTS! ! Price = $15,000! Purch. Useful Life = 5 Years! Salvage Value = -0-! Cash Value = $8,000/Yr! (Generated Savings)! ! Annual! Depreciation! Payback ! Period! 3 Years! = = = $15,000 – 0! 5 Years! = $3,000! Total Cost of Investment! Annual Net Cash Flow! $15,000! $8,000 – $3,000! The copier would pay for itself in 3 years! The copier would pay for itself in 3 years!! Financial Ratios! Financial Ratios! Profitability:! Current ratio! Quick ratio! Financial Ratios! Current ratio:! •  Ideal ratio is better than 1:1! Current Assets! Current Liabilities! Current Ratio! Financial Ratios! Quick ratio:! •  Borrow short-term money! •  Will be lower than 1:1! Cash Marketable Securities + A/R! Current Liabilities! Quick Ratio! Financial Ratios! Debt to equity ratio:! •  Determines how solvent a business is! •  A ratio of more than 3 is considered highly leveraged.! Financial Ratios! Day sales outstanding (DSO):! •  If your standard terms are 30 days, but you calculate DSO of 45 or 50 days, then your average collection is 45 to 50 days, not 30 days.! Average A/R! Net Sales X 365! DSO Ratio! Financial Ratios! »  Inventory turnover ratio:! Cost of Goods Sold! Average Inventory! »  Asset turnover ratio:! •  How profitable your assets are! »  ROA and ROE:! •  Return on assets! •  Return on equity! Inventory Turnover Ratio! Financial Ratios! »  Gross profit margins and operating profit margins:! •  What are your product costs?! •  What are your overhead costs?! »  Return of sales (ROS) net profit margins! »  Ratios! In Conclusion! Important terms and definitions:! •  GAAP! •  Accrual vs. cash accounting! •  Leverage, liquidity, and assumption sheets! Understand the 3 key financial statements — balance sheet, income statement, and cash flow statement.! Look at the relationship between numbers, the ratios.! Welcome to How to Read Financial Statements Q&A! With Ed Knight! Thank you for joining us today!! Bonus Material: THE NONFINANCIAL MANAGERS’ FINANCE AND ACCOUNTING TOOL BOOK PRESENTED BY ROCKHURST WEB CONFERENCE SERIES, A DIVISION OF ROCKHURST UNIVERSITY CONTINUING EDUCATION CENTER, INC. Copyright 2011, Rockhurst University Continuing Education Center, Inc. Financial Glossary Account — A record in which the changes for a balance sheet or income statement item is recorded. Accrual accounting — Accounting for revenues in the period in which they are earned and for expenses in the period in which they are incurred. Asset — A valuable item that is owned or controlled by the entity and was acquired at a measurable cost. Assumption sheet — An attachment to any key financial document. The assumption sheet explains estimates, projections, the rationale behind the numbers, and reasons decisions were made. Balance sheet — A financial statement that reports the assets, liabilities, and equity of a company at one point in time. Cash accounting — Records of only cash receipts and cash payments. Cash flow statement — The cash flow statement measures how much cash comes in and stays in the bank compared with how much goes out to pay bills and payroll. Costs — Money spent making a product or providing a service. Dividend — The funds (money) generated by profitable operations that are distributed to shareholders. Entity — A business or other organization for which a set of accounts is kept. Equity — Capital (money) supplied by investors and profits reinvested into the business. Expenses — Money spent to develop, sell, account for, and manage the entire business process. GAAP — Generally Accepted Accounting Principles — The standard framework for financial accounting. It includes the standards, conventions, and rules accountants follow in recording and summarizing transactions. Income statement — A statement of revenues and expenses and the difference between them (net income) for an accounting period. Ledger — A group of accounts. Leverage — The relationship between assets and the debt on those assets. Liability — The claim that a business owes to creditors. Liquidity — The relationship between assets owned and how quickly those assets can be converted to cash. Monetary assets — The cash and promises by an outside party to pay the business a specified amount of money. NOA — The Net Operating Assets is the basis to calculate Return on Net Operating Assets. The NOA includes all assets used for the operational process of the company. Operating EBITDA — Operating Earnings Before Interest, Tax, Depreciation, and Amortization. WTFIN0908 2 Financial Glossary, continued Profitability ratios — A profitability ratio reflects the relation of the net income (loss) or of a subtotal of the income statement (e.g. operating profit) to the corresponding average capital employed (taken from the balance sheet). Retained earnings — The net income that is reinvested into the business and that increases equity. ROE —The Return on Equity is the quotient of net income and shareholder’s equity. ROI — The Return on total Investment measures the profitability of total assets employed. RONOA —The Return on Net Operating Assets is a financial indicator of performance of assets used for operating activities. It measures the operational profitability of a company. Revenue — The increase in owner’s equity resulting from operations during a period of time. Usually this is generated from the sale of goods or services. Transaction — An event that is recorded in the accounting records; it always has at least two elements. WTFIN0908 3 How to Calculate ROI (Return on Investment) ROI The Return on total Investment measures the profitability of total assets employed. It is a broader measure than ROE because total assets include debt as well as equity. Net Income (Loss) + Financial Expenses ROI = ———————————————————————————————————— x 100 Total Assets WTFIN0908 4 How to Perform a Payback Analysis Payback analysis evaluates the cost of an item by factoring in anticipated cash flow that the capital expenditure will generate and allows determination of how long it will take to be paid back for an investment. Calculating Payback Example: A copier for your area is purchased for $15,000. The formula needed to calculate payback is: Payback period = cost of investment annual net cash inflow It is important to eliminate the effect of non-cash expenses, which in most cases is represented by depreciation (use the items below). • The asset value = $15,000 • The asset’s useful life = 5 years • The asset’s salvage value = 0 Annual depreciation would be: $15,000 - 0 salvage value = $3,000 per year 5 years • The cash revenues = $8,000 • Annual expenses (which do not include depreciation expense) = $5,000 The payback for the machine would be: Payback period = $15,000 $8,000 – ($3,000 = $5,000) = 3 years If a company’s payback criteria is five years, the equipment would meet the criteria for a purchase. Note: Payback analysis may be easy, but it does not account for profitability and the present value of funds received in the future. It identifies the time to get out of the investment rather than the amount of return. Analyzing payback analysis in a plan or proposal may help get new ideas approved. This knowledge will demonstrate to management an understanding of the kind of return a company needs on its investments. WTFIN0908 5 Key Financial Ratios — What They Are and How to Calculate Them Name Method of Calculation Standard & Significance Current Ratio (Liquidity Ratio) Current Assets _________________ Current Liabilities Industry Average — Low: Possible cash flow problems High: May not be managing assets well Acid-Test or Quick Ratio (Liquidity Ratio) Cash + Marketable Securities + AR _________________ Current Liabilities At least 0.8 if company sells on credit Low: Cash flow problems High: May mean poor asset management Debt to Equity (Solvency Ratio) Total Liabilities _______________________ Total Shareholders’ Equity Industry Average — More than 3 is quite highly leveraged Days Sales Outstanding (DSO) (Efficiency Ratio) Avg. Accounts Receivables ________________________ Net Sales × 365 Industry Average 45-50 if company sells on net 30 terms Very low: Too restrictive credit policies High DSO: Hurts cash flow Inventory Turnover (Efficiency Ratio) Cost of Goods Sold _________________ Average Inventory Industry Average — Low: Problems with slow inventory that may hurt cash flow Very high: May run out of inventory Asset Turnover (Profitability Ratio) Sales/Revenue ______________ Total Assets The higher the better — How many times average assets are turned into net sales during the year Return on Assets (ROA) (Profitability Ratio) Net Income _________________ Average Total Assets The higher the better — The return on the assets invested in the business Return on Equity (ROE) (Profitability Ratio) Net Income ________________________ Total Shareholders’ Equity The higher the better — The return on the shareholders’ investment in the business Gross Profit Margin (Profitability Ratio) Gross Profits ____________ Net Sales Industry Average — The higher the better Operating Profit Margin (Profitability Ratio) Operating Profits ________________ Net Sales Industry Average — The higher the better Return On Sales (ROS) Net Profit Margin (Profitability Ratio) Net Profits ______________ Sales/Revenue Industry Average — The higher the better WTFIN0908 6