The Nonfinancial Manager’s Guide To Understanding Financial Statements
Larry Holmes Huston Texas
Separate your profession from your business.
The Cash Flow statement was created in 1988. Income statements are 500 years old.
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Investorwords.com – financial words.
Generally Accepted Accounting Principals: GAAP
Sales=Revenue
THE ACCOUNTING EQUATION:
Assets = liabilities + equity (capital)
Cash balance is found on the top line of a Balance Sheet.
The reason a business exists:
To maximize the profit of what is invested in the business.
Return on invested capital is the most important way to measure success of a business.
Securities and Exchange Commission(SEC): has 5 commissioners who serve 5 year terms. They are there to protect investors.
The difference between: Finance and Accounting.
Accountants have a different job than finance people. They record info.
Finance people take info accountants give them and put it to work. They analyze, plan and execute the financial health of an organization.
Your accountant doesn’t help you with financial planning because that’s different work.
Balance Sheet is a point in time.
Income Statement is more like a movie. It’s over a period of time. Can also be called a: P&L, Operating Statement.
Cash Flow Statement: Covers a period of time showing inflow and outflow of cash.
“Quality Earnings” –
Cash Basis: When the cash changes hands is when it is recorded. This gives you wild swings on your cash. Doctors use it. Small service businesses use cash basis.
Accrual Basis: We recognized revenue when it is earned and not when it is received. Recognized expenses when they are incurred and not when they are paid. Most people use accrual because it’s considered superior. It’s based on the “matching principal.”: I want to match my income and expenses when they happen.
“Full Disclosure Principal” When accountants are aware of something going on that might have a material financial impact on the organization, they will tell about it in the footnotes of a financial statement. So, read the footnotes.
Historical Cost: Assests on a balance sheet are carried at the original cost and not the market value of assets. This is more objective… who’s to say what the market value is.
Conservatism: Says accountants should not overstate or understate a situation. However, if they can error on one side or another… they will error on the convervative side.
Going Concern: I am going to assume you are going to be around for years.
Materiality: Accountants only have to correct mistakes that are material. What’s material? The size depends on the size of the company. “If a lender or investor knew about this, would it effect there decision?”
Industry Practices: If this is the way your industry does things, it will be acceptable.
If you aren’t doing things like discussed today: 1. you haven’t had your statements audited. 2. you have a industry practice that is different.
Cost/Benefit: The cost of providing financial information has to equate to the benefit it provides.
Balance Sheet
A Snap shot
It shows you on that day:
Assets must equal the Liabilites plus the Equity.
Assets = Liabilities + Equity
Assets are the wealth of the business:
Current Assets: Cash, Accounts receivable, inventory
Fixed Assets: Equipment, building, land
Prepaid Insurance Premiums
Intangible Fixed Assets: copyrights, patents, trademarks, goodwill (This is brand value, The premium you would have to pay for a business over and above the net market value of the assets on a balance sheet.
Liabilities
Assets – Liabilities = Equity
Balance Sheet:
If there is too much cash, you aren’t using it to grow your business.
What is too much cash
Look at it as a Percentage of total Assets: Guideline should be about 10%.
Compare cash as a percentage of annual revenue (about 5% of annual revenue).
For small businesses: Determine how much cash you need for current liabilities and interest on debt for about a year.
Accounts Receivable
Compare it with revenue on income statement.
Red Flag: A/R growing faster than revenue. When you see a big increase in A/R but not in revenue… they probably aren’t paying their bills.
Land, building, equipment on a balance sheet is the original cost.
Depreciate buildings and equipment.
You want to depreciate something for the length of time you are going to use it. “Straight line depreciation” depreciates the same amount every year.
When you buy something… you take that amount of money from “Cash” and add it to “Fixed Assets”.
Book Value This is the total stockholder equity. It’s usually a lot less than market value.
Net worth It implies how much that business is worth. It doesn’t consider good will, market value of assets.
Dividends
Common Stock has voting rights
Preferred Stock has no voting rights. They have a priority over owners in the payment of dividends and bankruptcy. If you can’t pay them, it is put in the footnotes as “dividends in arrears.”
Using a percentage of total assets let’s you quickly compare one period to another, and to compare 2 different sized companies.
“Common Size Analysis of a Balance Sheet”
You want to see 10% of total assets to be cash.
If your accounts receivable and inventory is too high and cash is too low… they might not be able to pay their bills.
2 things to know from a Balance Sheet:
Are they liquid and are they solvent?
Liquid: how much working capital they have: Current assets – Current liabilies
Are they solvent:
Debt to equity ratio
total liabilities divided by total stock holders equity
The percentage shows the percentage of liabilities they have.
An average is about 100% – about same amount of total liabilities as total stock holder equity.
Income Statement / Profit and Loss
Sales – COGS = Gross Profit
COGS can be inventory.
Service businesses: COS Cost of Sales.
Operating Expenses:
rent, travel, utilities, cars.
Key Elements
- Sales/Revenue
- COGS
- Operating Expenses: Selling, General & Administrative(S,G&A).
- Other Expenses
- Net Income (Net Profit, Earnings, Bottom Line)
Income Statement:
Sales
COGS
gives you Gross Profit
Operating expenses
Depreciation expenses
Interest Expense
Income tax expense
Other expense
Total Expense
Net Income
EBIT (operating income): EARNINGS BEFORE INTERest and taxes.
EBITDA: earnings before interest taxes depreciation and amortization. Used on the organization level.
Characteristics of a Captital Asset
- Physical substance
- Useful life over one year
- IRS Publication 946 will give you useful life.
- Minimum dollar threshold
- $500-$5000
- Know this for budgeting for capital assets.
- Not for resale
6 Elements included in a Capitalized Cost
- Net purchase price
- Plus installation cost.
- Plus Shipping cost.
- Plust insurance cost on shipping.
- Plus sales tax
- Plus Costs that extend its useful life. If you upgrade it, you should add that time to the life of the capital asset.
4 Elements Not Included
- Service contracts
- Start up
- Insurance after shipping
- Employee training.
Depreciation Methods:
Straight-Line Depreciation:
Equal periodic charges for depreciation less the anticipated salvage value.
Double Declining Balance – 200% declining balance.
Use double declining balance until straight line is more… then use double declining balance.
Sum-of-the-Years Digits
The years of the asset’s service life are added together.
Big companies use Straight Line on financial statements and Declining balance on their tax statement.
Declining balance looks better for tax purposes.
Zero Base Budgeting
The budget is based at zero. All expenses must be justified each new period. Go down every line item in budget:
- What can we eliminate?
- What can we fund at a reduced level?
- What should we fund at the same level?
- What would help us fulfill our mission to fund at a higher level?
Gross Profit Margin:
Gross profit divided by Sales… compare this from period to period.
Are you paying more or less for cost of goods sold. It also lets you compare two businesses… A higher profit margin means they are more efficient. If I have a higher profit margin I have a big competitive advantage… because I can cut my prices while my competitors can’t.
Net Profit margin – most industry specific margin.
Net Income / Net Sales
Software: 20%
Microsoft: 30%
Grocery: 2-3%Financial Class – Writely
Cash Flow Statement
The bottom line of the Income statement goes to the top line fo the Cash Flow statement
- An increase in assets decreases cash flow
- A decrease in assets increases cash flow
Oposite is true with liabilities:
- An increase in liabilities increases cash flow
- A decrease in liabilities decreases cash flow.
Most important aspect of this statement:
How much “Free Cash Flow” do they have:
CF from operating activities minus capital expenditures.
Cash flow from operating activities – land, building and equipment
This is the amount of cash they had complete discretion over.
You can’t have too much free cash flow.
Annual Reports
- A letter from the CEO… look for candor
- Sales and Marketing – Is it clear what buseinss they’re in?
- 10 year summary of financial figures – are they growing?
- Management Discussion and Analysis – is there a discussion of industry trends?
- Auditor Report
- Financial Statements.
- Subsidiaries.
- List of Directors and Officers and major shareholders.
- Stock Price History – what is the trend? Dividends?
SEC reports:
- 10-k – like an annual report but much more detailed.
- 10-Q – quarterly
- 8-k – for special events that happened at that company… bankrupticies, acquisitions, spins off a part of company.
www.sec.gov/edgarhp.htm
Liquidity Ratios
Current Ratio:
Current Assets / Current Liabilities
You might want to see 2:1
A 1:1 ratio means they can just meet their financial obligations.
- Low Current Ratios: restaurants: 1:1, soft drinks: 1:1
- High Current Ratios: Furniture: 1.9:1, general manufacturers: 2.4:1
- S&P Average: 1.3:1
Acid-test (Quick) Ratio – Service businesses should use this.
(Cash + Marketable Securities + Receivables) / Current Liabilities
This doesn’t include inventory.
- Low Quick Ratios: restaurants: .5:1, soft drinks: .6:1
- S&P Average: .9:1
Solvency Ratio
- Debt to Equity Ratio
Total Liabilities / Total Equity - Low Debt/Equity Ratios: software: .2:1, advertising: .1:1 – Don’t need debt. They have plenty of cash.
- High Debt/Equity: real estate: 3.3:1, banks: 2.3:1 – they are in the business of barrowing money.
- S&P: 1:1
Having a bad current Ratio witha bad Solvency ratio means these people are in trouble.
Profitability Ratios
- Gross Profit Margin
Gross Profit / Net Sales - Low GP Margin: construction supplies: 19.1%, computer hardware: 23.5%
- High GP Margin: software: 77.4%, major drugs: 74.6%
- S&P: 35.3%
- Net Profit Margin
Net Income / Net Sales - Low NP Margins: retail grocery: 2.2%, auto & truck manufacturers: 3.4%
- High NP Margins: banks: 17.1%, internet information: 21.4%
- S&P 10%
- Return on Assets
- Net Income / Total Assets – what kind of return they are getting on their resources.
- Low ROA: electric utilities: 3.5%
- High ROA: software: 18.8%, online schools: 20.4%
Return on Equity – most important
Net income / Total Equity
This is industry specific based on how the industry is doing.
- Low ROE: airlines: 9.8%, long-termcare: 7.5%
- High: oil & gas: 29.1%, personal computers: 46.9%
- S&P: 18.1%
Return on Invested capital: a better view of how well you are doing.
EBIT / (working capital + net fixed assets)
A good business will have 50%.
Efficiency Ratios:
- Days Sales Outstanding (DSO)
Accounts REceivable X 365 / Net Sales
This should be based on credit terms. - If you are too strict on who you give credit to, you are probably missing business.
- DSO should be about 10 days above credit terms.
- wholesale trade: 27 days
- personal service: 74 days
- S&P: 48 days
Inventory Turns
Cost of Goods Sold / Average Inventory
- Low inventory: computes: 5.1 days
- High inventory: appliance and tools: 60 days
Inventory Levels
Inventory Turns X Gross Profit Margin
Anything above 100 is usually to high of an inventory level.
If you know how to read the financial statements, and you know how to apply the ratios, you will be able to see your strengths and weaknesses.
- finance.yahoo.com
- reuters.com
- investing
- industries – his averages came from here.
- Moneycentral.msn.com
- stocks
- investing
- key ratios
- bizstats.com
- good for private company.
- magicformulainvesting.com
- for personal life.
- Shows: Highest return on invested capital
- Great book too.
IRS says a computer lasts 5 years. If you want to upgrade more often than that, you might want to lease. Cash conservation and technology are the biggest reasons to lease.
2 kinds of leases:
- Operating lease
- shows up as an operating expense and you give it right back to them after the lease. You want this: this wouldn’t effect debt to equity ratio and won’t effect barrowing power.
- Capital lease
- The value of the lease will show up on the balance sheet will be an asset…
- It’s a capital lease if any of these apply:
- The lessee owns it at the end of the lease
- The lessee has an option to buy that is a bargain price.
- The lease covers 75% or more of the useful life of the asset.
- The present value of lease payments is 90% or more of the fair market value
Capital Evaluation Analysis
Payback Period Method
- asset cost / annual quantifiable benefits
- $10,000/$2000 = 5 years
- It’s a very simple formula so it’s easily communicated.
- It doesn’t give you a rate of return to compare other things.
ROI
- annual quantifiable benefits / asset cost
- $2000 / $10000 = 20%
- It gives you a rate of return to compare other things.
Best Method: Net Present Value Analysis (discounted cash flow)
I’ll give you $2000 today or I’ll give you $2000 5 years from now. But you can’t spend it. Any amount of money you can expect to get in the future is that money less the interest rate they lost for that time period.
Excel Function: Net Present Value Analysis function: Have it go out the life time of the product. Use an interest rate that you think you can get for that money.
Break-even Analysis: Used in initial stages of making decisions… should we hire more people, should we get into another business, should we buy a building.
BE = Fixed Costs /Profit Margin Per Unit
$1000 / $2 = 500 hot dogs (page 25)
How many hot dogs do I have to sell to make a $500 profit
(FC + PG) / PM per unit
($1000 + $500) / $2 = 750
If we sell 400 hot dogs at $3 each we’ll loose money. How much do we have to charge to break even:
Break even price
FC / Units + VC per unit
$1000 / 400 + 1 = $3.50
total revenue equals your total cost (your fixed cost + variable costs)
This is a “what if” tool.
Anybody can be in any business as long as nothing goes wrong. It’s knowing what to do if something goes wrong.