Financial Statements for Management and Operations

Financial Accounting Management

Our Focus

The main focus of this course is to analyze and use financial statementsfor the purposes of:

Speaking with lenders Internal management Tax returns

The Basic Financial Statements

You should prepare and understand three basic financial statements:the balance sheet, which is a record of

assets, liabilities and capital at a specific point in time;

the income (profit and loss) statement, which is a summary of your earnings, expenses and net profit (or loss) over a given period of time; and

the cash flow projection, which shows the actual inflows and actual outflows of cash into and out of your business.

The Balance Sheet

The balance sheet is a snapshot of the company's financial standing at an instant intime. The balance sheet shows thecompany's financial position, what it owns(assets) and what it owes (liabilities and networth). The "bottom line" of a balance sheetmust always balance (i.e. assets = liabilities+ net worth). The individual elements of abalance sheet change from day to day andreflect the activities of the company.

The Balance Sheet

Assets represent the company's use of funds. The company uses cash or other funds provided by the creditor/investor to acquire assets. Assets include all the things of value that are owned or due to the business.

Liabilities represents a company's obligations to creditors while net worth represents the owner's investment in the company.

Current Assets

Current assets are those which mature in less than one year. They are the sum of the following categories:

Cash Accounts Receivable (A/R) Inventory (Inv) Notes Receivable (N/R) Prepaid Expenses Other Current Assets

Fixed Assets

Fixed assets represent the use of cash to purchase physical assets whose life exceeds one year. They include assets such as:

Land Building Machinery and Equipment Furniture and Fixtures Leasehold Improvements

Calculating Fixed Assets

When a fixed asset is purchased for use in theoperations of the business it is recorded at cost.As the asset wears out, an amount is charged toexpense and accumulated annually in a contra-account known as accumulated depreciation.

The gross fixed asset (purchase price) less theaccumulated depreciation equals the Net FixedAsset Value (also known as book value).

Gross Fixed Assets (Purchase Price) - AccumulatedDepreciation = Net Fixed Assets (Book Value)

Intangibles

Intangibles represent the use of cash to purchase assets with an undetermined life and they may never mature into cash.For most analysis purposes, intangibles are ignored as assetsand are deducted from net worth because their value isdifficult to determine.

Intangibles consist of assets such as:

Research and Development Patents Market Research Goodwill Organizational Expense

Current Liabilities

Current liabilities are those obligations that will mature and must be paid within 12 months.

Current liabilities consist of the following obligation accounts:

Accounts Payable -- Trade (A/P) Accrued Expenses Notes Payable -- Bank (N/P Bank) Notes Payable -- Other (N/P Other) Current Portion of Long term Debt

Non-Current Liabilities

Non-current liabilities are those obligations that will not become due and payable in thecoming year. There are three types of non-current liabilities, only two of which arelisted on the balance sheet:

Non-current Portion of Long Term Debt (LTD)

Subordinated Officer Loans (Sub-Off) Contingent Liabilities

Equity

Equity or Net Worth represents the owners‘share in the financing of all the assets. Itconsists of two types of equity; purchasedequity, and earned equity. Purchased equityconsists of:

Preferred Stock (P/S) Common or Capital Stock (C/S) Paid in Capital

The Income Statement

The Income Statement is also known as the “P&L” (Profit and Loss)

A company's income statement is a record of its earnings or losses for agiven period. It shows all of the moneya company earned (revenues) and all of themoney a company spent (expenses) duringthis period.

An Example

Income Statements for the Years Ending 2003 and 2004

Sales $800,000 $850,000Less Cost of Goods Sold (200,000) (250,000)Gross Profit on Sales 600,000 600,000Less General Operating Expenses (180,000) (200,000)Less Depreciation Expense (50,000) (50,000)Operating Income 370,000 350,000Other Income 60,000 90,000EBIT 430,000 480,000Less Interest Expense (50,000) (30,000)Less Taxes (50,000) (60,000)Net Earnings 330,000 390,000Less Dividends Paid (70,000) (80,000)Retained Earnings 260,000 310,000

Explanations

Gross Profit on Sales = Gross MarginGPS = NS – COGSOperating Income = GP – OE – DepreciationEBIT (Earnings Before Interest & Taxes) =

OE +/- OI(OL) +/- Extraordinary Income/Loss

Explanations

Net Earnings (Loss) = EBIT – Interest – TaxesRetained Earnings = Net Earnings -

Dividends

Statement of Cash Flow

Cash flow from an operating perspective ismost important for the businessmanager/owner in a small privately-heldcompany.

It is critical to operate "profitability" and notoperate with negative or break-even cash-flow. Therefore, managing cash-flow iscritical.

Statement of Cash Flows

The statement of cash flow reports the movementof cash into and out of a business in a given year.

Cash Flow Statements are broken down intothree sections:

Operating activities Investing activities Financing activities

Cash Receipts

Cash Receipts from Customers:

Net Sales + Beginning A/R (1/1/00) -Ending A/R (12/31/00) = CashReceipts from Customers

Cash Payments for Inventory

Cash Payments for Inventory:

Ending Inventory (12/31/00) -Beginning Inventory (1/1/00) +Beginning A/P (1/1/00)- Ending A/P(12/31/00) = Cash Paid for Inventory

Cash Paid for Operating Expenses

Cash Paid for Operating Expenses:

Operating Expenses – DepreciationExpenses + Ending Prepaid Expenses –Beginning Prepaid Expenses +Beginning Expenses Payable – EndingExpenses Payable = Cash paid forOperating Expenses

Cash Paid for Interest Expense

Cash Paid for Interest Expense:

Interest Expense per P&L + BeginningInterest Payable - Ending InterestPayable = Cash Paid for Interest Expense

Net Cash Provided (Used) by Operating Activities

A company generates cash from operating its business. A key number is net Cash provided from operating activities. This total includes some items fromthe statement of earnings; such as:

net earnings, showing the company’s profit (or loss); and

depreciation expense.

Net cash provided from operating activities also includes changes in someitems from the statement of financial position:

Inventory changes. (Increases in inventories use cash and reductions provide cash).

Changes in accounts receivable, the sales the company has not yet been paid for. (Increases use cash and decreases provide cash).

Changes in accounts payable. (Increases provide cash and decreases use cash).

The statement of cash flows adds the net cash from each type of operating activity and reports the company’s total net cash provided (or used) by all operating activities.

Net Cash Provided (Used) by Investing Activities

Net Cash Provided (Used) by Investing Activitiesmight include investments in property (land), plant(factories and assembly plants) and equipment(machines, trucks, computer systems, telephonesystems). Investing in such assets is a use of cash.selling them is a source of cash.

The Statement of Cash Flows adds the net cashFrom each type of investing activity and reports thecompany’s total net cash provided (or used) by allinvesting activities.

Working Capital

Working Capital = Current Assets –Current Liabilities.

Working Capital measures how much the Company has in liquid assets togrow its business.

Net Cash Provided (Used) by Financing Activities

Net Cash Provided (Used) by Financing Activitiesincludes the sources and uses of cash for financingactivities. Sources of cash include what a companyraises by selling stocks and bonds and by borrowingfrom banks.

The Statement of Cash Flows adds the net cashFrom each type of financing activity and reports thecompany’s total net cash provided (or used) by allfinancing activities.

Sources of Working Capital

Sources of additional working capital includethe following:

Existing cash reserves Profits (when you secure it as cash !) Payables (credit from suppliers) New equity or loans from shareholders Bank overdrafts or lines of credit Long-term loans

Some Ratios

Liquidity Ratios - a company's ability to meet its short-term obligations

Current Ratio = current Assets/current liabilities

Acid Test (Quick Ratio - no inventory) = current assets-inventory/current liabilities

Working Capital = current assets -current liabilities (how much cash is available to grow the company)

Some Ratios

There are many ratios that can be used to analyze acompany's financial position.

Profitability Ratios - the primary measure of acompany's success. These include:

Return on Equity = earnings after taxes/equity

Return on Assets = earnings after taxes/total assets

Return on Sales = earnings after taxes/total sales

More Profitability Ratios

A profit margin measures how much a company earnings relate to its sales.

A net profit margin measures earnings after taxes.The return on assets (ROA) is a snapshot of the

performance of the management of the company (not from a stockholder perspective).

The return on equity (ROE) is important from a stockholder perspective.

 

Leverage Ratios

How much debt is a company using to support its obligations? What is the debt to equity?

The debt to equity (debt or financial leverage) ratio indicates the extent to which the business relies on debt financing.Upper acceptable limits of the debt to equity (debt or financialleverage) ratio is usually 2:1; with no more than one-third ofdebt in long-term borrowings. A high financial leverage or debt to equity ratio indicatespossible difficulty in paying interest and principal whileobtaining more funding.

Make sure the leverage ratios are as low as possible.

Summary

The financial accounting principles in this course are importantto understand terminology and build a foundation tounderstanding financial statements.

It is important to understand a company's profitability, itsearning power and control over expenses. Is a companymanaging its operations correctly?

What is the current status of the cash flow management of thecompany and how does it relate to operations andmanagement?