Understanding, Analyzing and Using Financial

StatementsPresented by:

Wade Farquhar

Taking the Mystery out of Financial Statements

9:00 Seminar begins10:00 Break11:00 Break12:00 Lunch 1:00 Afternoon session begins 2:00 Break 3:00 Break 3:50Complete evaluations 4:00Dismiss

Today’s Schedule:

Link for this and other presentations:

www.LeanTeams.ca

Balance sheet.

What we will cover today:Key terms and core concepts for financials.

Financial ratios.

Income statement.Cash flow.

23456

1

Reporting standards and mechanisms.

Why do you want to know how to analyze and use financial

statements? 

Businesses that plan and track against their plan grow

30% faster. 

Basic Principles

What is GAAP?Generally Accepted Accounting Principles

A widely accepted set of rules, conventions, standards, and procedures for reporting financial information, as established by the Financial Accounting Standards Board.

Separate entity – activity is separate from owners or other business.Ongoing concern – the company is assumed to continue into the future.Money as a unit of measurement.

Basic Assumptions

Periodicity – activity is broken down into cycles of short duration.

Historical cost is verifiable and objective measurement.Revenue recognition takes place when an exchange transaction has occurred. The matching principle means that costs should be matched with related revenues in the same period.Full disclosure requires that information be sufficient for the user to make decisions.

Accounting Principles

Conservativism requires bad news to be recognized early and good news… late.

Accrual accounting records expenses when incurred (according to the matching principle) and revenues when the sale is made.

Materiality is the principle that judgement be used in determining how transactions are to be handled.

Objective evidence requires that interpretations be supported and verifiable.

Accounting Principles

Consistency requires that decisions (especially subjective interpretations) be consistent.

Credit rating.Contractual commitments.Quality of products.Effectiveness of R&D.

Non-Disclosed Items

Integrity of employees.Preparer’s biases.

The cost to produce a product or deliver a service.The sales price of a product or service.Gross and net margins on a product or service.Budgets.

Internal Uses

Variances.Whether to make or buy a product.

Investors.Vendors.Banks.Financial Analysts.

External Users

Government regulatory agencies (the SEC).

Financial AccountingVs.

Managerial Accounting.

Mainly concerned with aggregate numbers.Oriented towards outside parties.Tells the financial history of a company.Indicates general trends.Does not specify about how results were achieved.

Financial Accounting

Managerial accounting is proactive in nature, whereas many of the actions based on standard accounting are reactive in nature.

Managerial accounting provides information at the product, department, or business level.Managerial accounting provides real-time information to increase the speed of the feedback cycle.

Managerial Accounting

4 Key Financial Statements1

2

3

4

The Balance SheetThe Income Statement

Statement of Owners Equity

Statement of Cash Flow

Equity

Future benefit obtained or owned by a company.

Liabilities

Assets

Investment by ownersDistribution to ownersRetained earningsRevenuesExpensesGainsLosses

Future sacrifices arising from present obligations.

Decreases in net assets resulting from transfers from a company to an owner.

Increases in net assets resulting from transfers to a company by an owner.

Value that remains in a company after deducting its liabilities.

Changes in net assets from transactions from non-owner sources.

Increases in assets by delivering goods or services.

Increases in net assets from transactions other than revenues or investments by owners.

Asset outflows from delivering goods or services.Decreases in net assets from transactions other than expenses or distributions to owners.

The devil is in the details.

The Balance SheetAssets = Liabilities

+ Equity

How does a company purchase an item?

1One of two ways:

Purchased items are assets, therefore:

2Financing.It uses the owners money to make the purchase.

Assets = Liabilities + Equity

Intangible assets – items that have value but that have no physical existence.

Current assets – to be consumed or converted within one year.Fixed assets – long term investments that help a company generate profits for more than one year.

Other assets – tangible assets not used in the company’s ongoing operations.

Assets

Patents – lifespan of 17 years granted by government.Copyrights – the life of the author plus 50 years.Trademarks – not to exceed 40 years.Leases – when prepaid create an intangible asset.

Intangible Assets

Licenses – spread out over the cost of the license.Goodwill – no verifiable cost basis… except in the case of an acquisition.

Depreciation and Amortization

The beginning of the “art” of finance

Depreciate fixed assets, amortize intangible assets.

They are not the same thing… but they function in the same way.The cost of an item is allocated out in many chunks over a period of time.

Depreciation and amortization schedules are often defined by the biases of a company.

Depreciation and Amortization

Capitalized expenditure – an expense that is recognized over many periods rather than when cash is paid out.Salvage value – the expected (estimated) value of an item once it has used up its utility to a company.

Accumulated depreciation – the cumulative sum of all the years’ worth of wearing out that has occurred in an item.

Gross fixed asset – the purchase price of an item including all costs to put the item into service.

Key Terms

Book value – Purchase price minus accumulated depreciation, also known as Net Fixed Asset Value.

Depreciation is a deductible expense. Therefore increasing the amount decreases the taxable income.Startups often use it to reduce taxes in order to free up money for investment in future years.When items are purchased with loans, the tax savings can be used to make additional payments toward loan principals. These additional payments reduce the overall interest paid.

Why use accelerated depreciation?

Cash received sooner is more valuable than cash received later.

Companies can increase earnings by spreading out depreciation over a longer period of time.

This is a valuable tool for publicly traded companies that want to show high earnings to boost stock prices.

This effect is compounded by the fact that depreciated amounts are the same size over time, rather than larger up front.

Why use straight-line depreciation?

This is a commonly used tactic, in various forms, for publicly traded companies to commit fraud or drive the business into bankruptcy.

Liabilities+

Owners Equity

+

Current liabilities are satisfied within one year, generally from the sale of current assets or services.

Liabilities are the rights of others to the money, products or services of the company.There are two general types of liabilities:

Long-term liabilities will not be satisfied within one year.

Liabilities

Retained earnings are the accumulated earnings of a company that are not redistributed to owners.

Capital stock, sometimes called preferred stock is a broad description of the owners’ interest in a corporation.Additional amount paid in capital is the amount over and above the stock par value that owners put into the corporation.

Treasury stock is stock that has been re-acquired by the corporation and is being held.

Equity

Equity is the claim of owners on a company’s assets.Another way to look at it is that equity always equals a company’s assets minus its liabilities.

Equity

Master T Account

The Income Statement

A manager’s best friend

Discloses a company’s profit or loss during a specified period of time.

Can be called the Profit and Loss (P&L) or statement of operations.The person using the statement must be aware of the accounting basis used by the company.

What is profit?

Income Statement

Net income – gross profit minus operating expenses.

Profit is not total sales.

Gross profit – a company’s total sales minus direct costs.

EBITDA – Earnings before interest, taxes, depreciation, and amortization.

Profit

Profit is always an estimate.

Cash basis:Revenue is recorded when payment is

received and expenses are recorded when paid.

Accrual basis:Revenue is allocated to the period or periods it is earned, regardless of when it is collected.

Cash vs. Accrual

Expenses are applied to the period in which they are incurred rather than when they are paid.

SalesCost of goods sold (direct costs)Operating expensesOther income and expenses – income and expenses from sources other than the principal activity of the business.Net income

Key Elements

When a product or service is enjoyed it means that the “earning process is complete.”

Revenue is recognized when products or services are received by the buyer.Benefits from a product or service can be received or enjoyed all at once or over a period of time.

When the earning process is complete it means that there has been a “transfer of rights.”

Revenue Recognition

January February March April May June

Invoice for 6 mo.

of services

Service ExampleSix month service agreement

When is the revenue recognized?

January February March April May JuneInvoice

for 6 mo. of

servicesJournal entry

withdrawing 5

months

Journal entry

recognizing 1

month

Journal entry

recognizing 1

month

Journal entry

recognizing 1

month

Journal entry

recognizing 1

month

Journal entry

recognizing 1

month

Service ExampleSix month service agreement

When is the revenue recognized?

January February March April May June

Invoice for 1 mo.

of services

Invoice for 1 mo.

of services

Invoice for 1 mo.

of services

Invoice for 1 mo.

of services

Invoice for 1 mo.

of services

Invoice for 1 mo.

of services

Service ExampleSix month service agreement

When is the revenue recognized?

Activity February March April May June

IncomeSell

inventory item with markup

ExpensePurchase inventory

item

Product ExampleInventory part purchase and

resale

When is the expense recognized?

Activity February March April May June

IncomeSell

inventory item with markup

ExpensePurchase inventory

item

Product ExampleInventory part purchase and

resale

Net SalesGross Sales

- Sales Discounts- Sales returns and

allowances= Net Sales

Can include cost of services when labor is being resold.

Expenses to manufacture or purchase merchandise that has been sold.Takes into account materials costs, labor, and factory expenses.

Cost of Goods Sold (COGS)

Example$600,000 +

$700,000- $25,000_____________________

$1,275,000 -

$25,000_____________________$1,250,000

In selling prices.

Begin modeling different outcomes with changes:

In quantities of units sold.

In cost of goods as purchase units are increased/decreased.

Gross Profit Ratio

Administrative supplies costs.Office salaries (oftentimes all salaries).Depreciation expenses.Rent expenses.Insurance.Tax expenses.

Operating Expenses

Expense Allocation

Where the game is won… or lost

Revenues $1,000,000Cost of sales -750,000Gross margin 250,000Administration -100,000Profit before taxes 150,000Taxes -50,000Net Profit $100,000

Standard Income Statement

• This works if all the activities of the organization are similar in profitability.

• Assumes all costs will vary equally with changes in revenues.

• In complex situations it does not provide enough information for monitoring, planning or taking corrective action.

Issues:

Product Line A

Product Line B

Total

Revenue $750,000 $250,000 $1,000,000Cost of Sales $520,000 $230,000 $750,000

Gross margin $230,000 $20,000 $250,000

Administration

$100,000

EBITA $150,000

Taxes 50,000

Net profit $100,000

Product Line A

Product Line B

Total

Revenue $750,000 $250,000 $1,000,000Cost of Sales $520,000 $230,000 $750,000

Gross margin $230,000 $20,000 $250,000

Administration

$70,000 $30,000 $100,000

EBITA $150,000

Taxes 50,000

Net profit $100,000

New Construction Remodelling0%

20%

40%

60%

80%

100%

120%

COGS % to Income Earned

% of Total Income % COGS/Income

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Remod

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Remod

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$2,000.00

$4,000.00

$6,000.00

$8,000.00

$10,000.00

$12,000.00

$14,000.00

Gross Profit Analysis: Income to COGS

Income Cost

Statement of Owners Equity

Retained Earnings

Master T Account

Two PathsStay in the company

(investment)Exit the company

(distribution or dividend)

Earnings

EquityInvestments by owners

(stock)+ Retained earnings

= Total Equity

Statement of Cash Flow

Wait a second, we already talked about profit.

Profit is cash, right?

$300k

Startup

expenses

Cash in the

bank

Profitable Enterprise Inc.

February AprilJanuary March

Invoice all customers on 60 day terms.

$300k

Startup

expenses

Cash in the

bank

Profitable Enterprise Inc.

February AprilJanuary March

Invoice all customers on 60 day terms.

Money in, and Money out

Cash flow is:

Investing activities – purchases and sales of assets, other companies’ debts and equity.

Operating activities – Transactions related to providing goods and services and paying expenses to generate revenues.Financing activities – Issuance of capital stock, debt securities, dividend payments, debt repayment

3 Sources of Cash

Collections from customers

Money Out

Payments to employees

Other operating disbursements

Receipts of interest and dividends on investments

Operating

activities

Source: Bushee, Bryan. Introduction to Financial Accounting. Wharton School of Business Online, 2015.

Money In

Payments to suppliers

Payments of interest and tax

Divestitures

Money Out

Acquisitions of PP&E and intangiblesSale of

investments

Investing

activities

Source: Bushee, Bryan. Introduction to Financial Accounting. Wharton School of Business Online, 2015.

Money In

Acquisition of business

Purchase of investments

Sale of PP&E and intangibles

Issuance of new stock

Money Out

Purchase of treasury stockBorrowing

money

Financing

activities

Source: Bushee, Bryan. Introduction to Financial Accounting. Wharton School of Business Online, 2015.

Money In

Payment of dividends

Payment of principal on debt

Reissuing treasury stock

Statement of cash flow format:Net cash from operating activities.

+ Net cash from financing activities.+ Net cash from investing activities.

The Statement of Cash Flows

Non-cash transactions are also disclosed at the bottom of the statement.

Net change in cash balance.

The direct methodThe indirect method

Two ways to figure cash flow:

Rarely used for operating activities.

Lists all major operating cash receipts and payments by source/use of funds.Always used for financing and investing activities.

The Direct Method

Cash collected from customers (ARs).Interest and dividends received.Other operating receipts.Cash paid to employees and suppliers.Interest payments.Income tax payments.

The Direct Method Discloses

Begins with net income and reconciles that amount to net cash flow.Removes non-cash items from net income.

Only used for operating activities.

Adds in additional cash flows not included in net income.

The Indirect Method

Most companies use this method for calculating cash flows related to operating activities.

Deferrals of past operating receipts and payments.Accruals of expected future operating receipts and payments.

Non-cash gains and losses.

Changes in receivables, inventories, and other operating current assets and liabilities.

The Indirect Method Excludes

Operating cash minus cash for long-term investments.Which figure is used for “operating cash flow?”Cash from operations before

interestEBIT + DepreciationEBITDANet income adjusted for depreciation and other non-cash items – increase in working capital.

Free Cash Flow (FCF)

Financial Ratios.

Activity – operations efficiency.Leverage – how company uses debt.

Liquidity – important for lenders.

Profitability – important for investors.

Four Main Categories

Horizontal AnalysisCompares internal company results year over year.

Compares time period results as a percentage of net sales.

Vertical Analysis

Two Main Methods:

Ratios are comparisons of one number to another.Ratios must be compared to a benchmark.

Compare the same firm across time (time series).Compare a different firm or to the industry (cross-sectional analysis).

Ratios are contextual.Ratio analysis does not provide answers; it helps you ask better questions.Source: Bushee, Bryan. Introduction to Financial Accounting.

Wharton School of Business Online, 2015.

Ratios have multiple definitions.There is not GAAP standard for ratio analysis.You must use the same definition to make valid comparisons.

Choosing the appropriate benchmark is important.Major changes in the company make

time series comparisons difficult.Differences in strategy or structure distort cross-sectional analyses.

Misusing Ratios

Is $10 mil. in net profit a good or bad thing?It depends on the amount of capital invested to achieve that result.

ROE = Net return/average shareholders’ equity.The numerator shows how much return the company generated for shareholders. The denominator shows the shareholders’ investment. This is the best measure for ROI.

Return on Equity (ROE)

Operating performanceReturn on Assets (ROA) = Net income/Avg. assetsMeasures how effectively managers use company resources (assets) to make profit. Financial leverageHow much do managers use debt to increase the company’s assets for given level of investment.Leverage = Avg. assets/Avg. equity

Two Drivers of ROE

ProfitabilityHow much profit does the company earn on each dollar of sales.Return on sales (ROS) = Net income/sales

EfficiencyHow much sales does the company generate based on its available resources.Asset turnover (ATO) = Sales/Avg. assets

Two Drivers of ROA

Return on EquityOperating Performance X

Financial Leverage

ROE = Net income/assets

X Assets/equity

Benchmarking.

A tool to measure your business against your competitors within your region and industry.You can compare your revenues, costs, average days to collect, average days to pay, etc.

Have you ever wondered how your competitors operate?

To see the company website that provides this service click here.

Benchmarking

Businesses that plan and track against their plan grow

30% faster. 

Evaluating Capital Investments

How do you know when it is a good time to invest?

Net Present Value (NPV)Puts a value on tomorrow’s cash inflows from an investment in today’s dollars.

Calculates the interest rate below which an investment is a good idea.

Internal Rate of Return

Two Methods:

Net Present Value

Initial Cost

Value of Future

Revenues

Is it a good deal?

Annual Reports

Expense allocation.

Estimates and assumptions.

Revenue recognition.

Depreciation and amortization schedules (this includes salvage value and useful life estimates.

Annual Report Footnotes

Skim the highlights – written by the managers.Read the footnotes.

Skip the letter to shareholders.

Then go back to the financial statements and read them with a whole new set of eyes.

Reading an Annual Report

Accounting policies – choices made which would be important in interpreting results.Related party transactions – such as between the company and a shareholder, officer, or subsidiary.Subsequent events – relevant events that happened between when financials were prepared and report issued.Doubt concerning continued existence – any information contrary to “going concern” must be disclosed.Contingent liabilities – potential liabilities, such as a pending lawsuit not certain enough to record yet.Significant risks and uncertainties – nature of operations, use of estimates, high concentrations.

Disclosure Requirements

Unqualified opinionSometimes called a “clean” opinion, is that all material aspects are presented fairly in conformity with GAAP.

Will state the issues or disclosures that the auditor cannot grant an unqualified opinion. This could be as a result of non-conformity with GAAP.

Qualified opinion

Qualified vs. Unqualified

Earnings per share – Actual earnings on each share of stock. This is ROE/number of shares outstanding and helps see dilutive effects.Interim reporting – required when companies are required to report on a semi-annual or quarterly basis.

Segment disclosures – required so that the reader may become more aware of risks that management sees within the company.

Special Disclosures

MD & A – gives readers management’s opinion on the results of the company.

The Securities Exchange Act of 1934Public Utility Holding Company Act of 1935Trust Indenture Act of 1939Investment Company Act of 1940Investment Advisors Act of 1940Securities Investor Protection Act of 1970

The SEC Enforces:

1. Business2. Properties3. Legal Proceedings4. Submission of Matters to a Vote5. Market for Registrant’s Common Equity and

Related Stockholder Matters6. Selected Financial Data7. Management’s Discussion and Analysis

Form 10-K

8. Financial Statements and Supplementary Data

9. Changes in/Disagreements With Accountants

10.Directors and Officers of the Registrant11.Executive Compensation12.Security Ownership13.Certain Relationships & Transactions14.Exhibits/Financial Statement Schedules

Form 10-K, cont.

1. Financial Statements2. Management’s Discussion and Analysis3. Legal Proceedings4. Changes in Securities5. Defaults Upon Senior Securities6. Submission of Matters to a Vote of Security

Holders7. Other Information

Form 10-Q

Government Accounting

Regulated by the Government Accounting Standards BoardMany similarities between private and government accounting.Annual reports are different due to the external users of the report:

Citizenry – taxpayers, voters, and service recipients.Oversight bodies – commissions, councils, boards, and executives responsible for taking corrective action.Investors and creditors – municipal securities investors and underwriters, insurers, etc.

Government Accounting

Determining finance-related laws – bond covenants, grant restrictions, tax limits.Evaluating efficiency and effectiveness – service costs, efforts and accomplishments.

Comparing results with budgets – so that accountability can be maintained in the future.

Goals of Govt. Accounting

Assessing results – the entity’s financial position and ability to continue to provide services.

They are fiscal and accounting entities with a self-balancing set of accounts segregated for the purpose of carrying on specific activities or attaining certain objectives in accordance with special regulations, restrictions, or limitations.

Governmental accounting systems are organized and operated as “funds.”

Fund Accounting

Special Revenue Funds for specific revenue sources restricted to expenditures for specific purposes.Capital Projects Funds for acquiring or constructing major capital facilities.

General Fund for all financial resources except those in another fund.

Governmental Funds

Debt Service Funds for general long-term debt principal and interest.

Internal Service Funds for financing between agencies or departments of the government.

Enterprise Funds for operations similar to private businesses or where determination of revenue, expenses and/or net income is appropriate.

Proprietary Funds

Nonexpendable Trust Funds

Pension Trust Funds

Expendable Trust Funds

Agency Funds

Fiduciary FundsAssets held in a trustee capacity, including:

EncumbrancesAn encumbrance, which is unique to governmental accounting, is the reservation of a portion of an applicable appropriation that is made because a contract has been signed or a purchase order issued.

The encumbrance is usually recorded in the accounting system to prevent overspending the appropriation.

Audits.

1. Proposal2. Engagement letter3. The importance of internal controls4. Audit schedule:

• Physical inventory• Confirmation of receivables• Field work

5. Divide preparation of audit work-papers

Preparing for an Audit

Audited StatementsHere is what it means:

“An independent accountant has applied a variety of techniques to obtain evidential matter sufficient to express an informed opinion about whether the financial statements conform with GAAP. The accountant must comply with professional standards and conduct the examination in accordance with Generally Accepted Auditing Standards.”

Reviewed StatementsHere is what it means:“An independent accountant has performed inquiry and analytical procedures sufficient to provide a reasonable basis for expressing limited assurance that there are no material modifications that should be made to the statements in order for them to be in conformity with GAAP or, if applicable, with another comprehensive basis of accounting.”

Compiled StatementsHere is what it means:“An independent accountant presents in the form of financial statements for a nonpublic company, information that is the representation of management (or owners) of the client without the accountant undertaking to express any assurance on the statements.”

Audit risk and materiality

Reliance on internal controls

Errors and irregularities

Related party transactions

Illegal acts

Going concern

Audit Challenges

Title

Addressee

Introductory Paragraph

Scope Paragraph

Opinion Paragraph

Signature

The Auditor’s Report

Date

Internal AuditingPer the Institute of Internal Auditors and internal audit is “an independent, objective assurance and consulting activity designed to add value and improve an organization’s operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes.

Evaluate and improve the effectiveness of risk management, control, and governance processes.Evaluate emerging technologies.

Examine global issues.Analyze opportunities.

Assess risks, controls, ethics, quality, economy, and efficiency.

Internal Audit Goals

The reliability and integrity of information.

Compliance with policies and regulations.

Economical and efficient use of resources.Safeguarding of assets.

Operational goals and objectives.

Internal Auditor’s RoleReview:

Financial AuditsHave accurate financial statements as their objective.

Have compliance and/or operational improvements as their objective.

Operational Audits

Comparing Audits

… AND YOU’RE DONE!

Thank you.

Link to this presentation:www.LeanTeams.ca/

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Wade Farquhar

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