Introduction To Financial Statements

Valley Economic Development Center

Presented ByChase Morrison

Purpose of Course

• Learn how to read and create financial statements• Be able to identify the three primary statements• Learn basic characteristics of each statement• Gain a fundamental understanding of financial metrics• Develop ability to create your own financial

statements or projections• Learn how to apply what you learn using QuickBooks• Understand how financial statements are interrelated• Develop some basic benchmarking skills.

Who’s Your Instructor?• Chase Morrison• Over 25 years working for Fortune 300 companies• Significant financial planning & analysis experience• Worked in defense and medical device businesses• I am a partner with B2B CFO® (over 220 partners WW)• Provide CFO services to small and midsize businesses• Services include accounting oversight, financial

reporting, budgeting, forecasting, sales analysis, risk management, lender relationship maintenance, accounting system implementation, etc.

Why do you need financial statements?

• Secure a bank loan• Attract investors• Complete a tax return• Give you something to talk about with your

accountant• Impress your friends

• Financial statements are the primary tool you need to help a business generate a profit!!!

Understanding Balance Sheets

Categorizes what a company owns and what it owes

Assets -- The non-people related resources needed to generate revenue, including:

• Cash• Receivables • Inventory• Equipment• Intellectual Property

What a company owns

=

Liabilities – Third-party obligations:• Vendors (AP)• Lenders (Debt)• Employees (Accruals)

Equity – Stakeholder’s ownership in business• Owners• Shareholders• Partners

+

What it owes (& to whom)

Connecting things (or assets) to…

People (or investors, vendors, lenders & employees)

A few words about cash vs. accrual basis accounting• Cash basis accounting – GL only reflects actual receipt and

disbursement of cash. Advantages: i) simple, ii) aligns with taxes, iii) requires little

thought Disadvantages: i) mismatch of income and expense, ii) under-

states liabilities, iii) unreliable financial analysis tool.• Accrual basis accounting -- Revenue is recognized when

product or service is delivered (not on cash receipt) and expense is associated with benefiting period Advantages: i) truer representation of business position and

performance, ii) enables more reliable financial analysis, iii) has more validity with investors and lenders

Disadvantages: i) more complex, ii) requires more accounting knowledge, iii) more transactions, iv) will require more costly personnel to administrate

Source of Examples – QuickBooks Sample Files

Assets – What a Company Owns

• Resources needed to generate revenue

• Split into current (to be used in < 1 year) and long term (> 1 year)

• Ordered by liquidity• Asset test: Can you

convert item to cash?

ASSETSCurrent Assets

Checking & Savings 25,802Accounts Receivable 93,752Inventory 154,754Prepaids 0Other Current Assets 20,000

Total Current Assets 294,308

Long Term AssetsFixed Assets

Equipment 64,700Depreciation -923

Total Fixed Assets 63,777Other Assets 0

Total LT Assets 63,777

TOTAL ASSETS 358,084

More Liquid --- Less Liquid

Liabilities & Equity – Who a Company Owes

• Liabilities – Claims on company assets by outsiders– Like assets, split into current and

long term– Ordered by when payments are due

• Equity – Claims on company assets by stakeholders, after liabilities are paid– Two categories: Equity (or paid in

capital) and Retained Earnings– Paid in capital is the capital

investment made by the company’s owners

– Retained earnings is the accumulation of net income, net of any dividends. Since no dividends are paid, RE is the sum of the ITD net income.

LIABILITIESCurrent Liabilities

Accounts Payable 91,418Credit Cards 657Payroll Liabilities 1,306Line of Credit 3,739

Total Current Liabilities 97,121

Long Term LiabilitiesNone

EQUITYOwner's Equity 166,640Retained Earnings

Prior Year RE 5,634Current Year RE 88,690

Total Equity 260,964

TOTAL LIABILITIES & EQUITY 358,084

Two quick things we can learn from our balance sheet• Quick Ratio – Provides insight into immediate liquidity

problems:(Cash + Accts Receivable) / (AP + Other Current Liabilities) = QR

($25.8K + $93.8K) / ($91.4K + $4.7K) = 1.23This indicates that we have 1.23 in fairly liquid cash to pay our immediate debts, which indicates some modest cushion.

• Current Ratio – Provides insight into longer range solvency:(Cash + Acct Rec + Inventory + Other Assets) / (AP + Other Current

Liab) = Current Ratio($25.8K + $93.8K + $154.8K + $20.0K) / ($91.4K +$4.7K) = 3.03

A Current Ration of 3.03 means that there is $3.03 dollars per every $1.00 of current liabilities, which is a comfortable coverage range. Loan officers and bankers focus on this metric.

Understanding the Profit & Loss (P&L) Statement

• Also know as Income Statement, Statement of Earnings, and Statement of Operations

• The P&L tells you whether your company is profitable over a given period of time.

• Extremely useful for validating and managing your business model

• One may erroneously believe they are “making money” • Two part composition of business transactions (1:

promise to pay or revenue recognition, and 2: settlement or collection)

• The “making money” question is provided on a cash flow statement

So what information does a P&L provide?

• The P&L statement is indispensable because it answers the following question:

If we take the value of all the goods and services provided over a specific period of time and compare that to the costs that were incurred to produce those goods and services, even for costs that have yet to be paid, did the value received (or promise to pay) exceed the cost input?

• Assuming the answer is “yes”, and your customers settle all your transactions (or pay your invoices) then the business is going to make money.

Source of QB Profit & Loss Statement

Typical P&L CompositionIncome Statement

Revenue 486,526

Cost of Goods SoldStandard Cost 267,185Period Expenses 21,200Other Adjustment 924Total Cost of Goods Sold 289,309

Gross Profit 197,218GP Margin % 40.5%

Operating ExpenseAdvertising Expense 1,825Licenses & Fees 710Car & Truck Expense 13,810Conferences & Seminars 575

WagesSalary & Wages 28,725Employee Benefits 5,175Total Wages 33,900

Total Operating Expense 106,291

Total Operating Income/(Loss) 90,926Operating Margin % 18.7%

Other Income/ExpenseInterest Expense 2,236Total Other Income/Expense -2,236

Net Income 88,690Return On Sales % 18.2%

Revenue: Value of goods and services invoiced or billed

Cost of Goods Sold: Represents cost of goods or services delivered on revenue row. Includes material, labor and overhead.COGS: Net of revenue and cost of goods.

Operating Expense: Related business costs not directly associated with the product or service. Examples include distribution, selling, marketing, administrative and product development expenses.

Operating Income: Net of gross profit and operating expense.Other I/E: Income & Expense unrelated to revenue generating activitiesNet Income: Final income after all expenses, including tax

Basic P&L Analysis

Understanding Cash Flow Statement

• Reflects how effectively a business is able to convert profits into cash• CF statement displays changes that bridge beginning to ending cash

balance for some period, e.g. 2010 to 2011

• Split into three categories– Operating CF: Cash movement pertaining to day-to-day business

operations, such as collecting AR.– Investing CF: Cash movement pertaining to investing activities, such as

purchasing equipment.– Financing CF: Cash movement pertaining to financing activities, such as

acquiring debt.• Two types of CF statements—Direct & Indirect. Focus of this

presentation is Indirect method

ASSETSCurrent Assets YE 2010 YE 2011

Checking & Savings 77,638 25,802 CF Statement bridges $52K YOY use of cash

How to derive cash flow (Indirect) Prior CurrentPeriod Period Cash Flow Calculation

Net Income/(Loss) $CP +$CP Income/-$CP LossOperation CF Accts Receivable $PP $CP $PP - $CP Asset Increase = CF Use Inventory $PP $CP $PP - $CP Asset Increase = CF Use Accts Payable $PP $CP $CP - $PP Liability Decrease = CF Use Other Accruals $PP $CP $CP - $PP Liability Decrease = CF Use Total OCF $XXXXInvesting CF Fixed Assets $PP $CP $PP - $CP Asset Increase = CF Use Depreciation $CP +CP Add back (Non-Cash Expense)1

Total ICF $XXXXFinancing CF Debt $PP $CP $CP - $PP Liability Decrease = CF Use Equity Transactions $PP $CP $CP - $PP Liability Decrease = CF Use Total FCF $XXXX

TOTAL CASH FLOW CHANGE $XXXXNotes:Ignore retained earningsIgnore cash since the above will bridge the change in cash1Depreciation is a non-cash expense and is consequently added back to cash flow

Source of Cash Flow Data in QB

Typical Cash Flow StatementOCF + ICF + FCF = Periodic Cash Flow (Change in Cash)OrBeginning Cash + Change in Cash = Ending Cash

Principal Sources/Uses of Cash: 1) Operations, 2) selling/buying assets, 3) borrowing/paying back lenders and investors

OCF: Lenders want to see business generating or plan to generate OCF cash; otherwise there really is no business.

ICF: Growing companies may be consuming cash to purchase fixed assets. Eventually OCF must overtake ICF.

FCF: Reflects level of dependence on lenders and investors.

Putting it all together

Financial statements are interrelated:

Reference: Managing By The Numbers, C. Kremer, R. Rizzuto & J. Case: Page 68

Key Financial Metrics1 For Planning & Analysis

• Return on Sales – Net Income / Sales: Profitability Measure• Return on Assets – Net Income / Assets: Return on Assets

Measure• Return on Equity – Net Income / Equity: Return on Stakeholder

Investment Measure• Days Sales Outstanding – AR / Sales * 365 days: Measures

company’s ability to collect• Days Inventory On Hand – Inventory / COS * 365: Measures

company’s ability to manage inventory• Days Payable Outstanding – AP / Invoiced Expenses *365:

Measures company’s ability accounts payable• Cash Cycle – DSO + DIOH: Measures days from 1st check written

to inventory to invoice paid by customer 1More metrics & explanations in appendix

Understanding Efficiency

• Days Sales Receivable((Beg AR + End AR)/2) / Sales * 365

(($12K + $94K)/2) / $487K * 365 = 40 DSR• Days Inventory On Hand

((Beg Inv + End Inv)/2) / COGS * 365 = DIOH(($220K + $155K)/2) / $289K * 365 = 236 DIOH

• Days Payable Outstanding (Liability)((Beg AP + End AP)/2 / Invoice Exp * 365 = DPO

(($3K + $91K)/2) / $395K * 365 = 43 DPO• Cash Cycle

DSR + DIOH = 40 DSR + 236 DIOH = 276 Days

Creating Your Own Financial Statements = Financial Planning

• Why bother creating a plan?– Planning is the most powerful thing you can do– It allows you to see into the future – Can you have more power than the ability to predict and

influence the future?– This has the potential to become one of the most powerful tools

your company uses– It needs to be continuously updated and improved

• What you should have to get started– Context for your plan (goals & objectives)– Historical results and the metrics we’ve discussed– A financial model that closely replicates your business’

• Only create as much detail as will add value to financial management processes.

Financial Planning – Profit & Loss

• Methodologies for planning sales1) Increase prior-year total units by some % and adjust selling prices2) Use #1, but do it for each product3) Forecast sales by customer

• Methodologies for time phasing sales1) Divide by 122) Use last year’s monthly proportions (e.g. if 10% of sales were booked in

February then use that assumption.• Methodologies for cost of sales

1) Use prior-year % of cost of sales to sales2) Create standard unit costs and multiply product unit volumes from sales

plan• Methodologies for expenses

1) % of sales2) Fixed by month using prior year3) Expenses as % of another expense4) Expense by category using vendor detail from prior year

Financial Planning – Balance Sheet

• Methodologies for accounts receivable1) Use DSR methodology, basing projection on most recently quarterly

performance2) Use aging model (e.g. AR consists of 50% current sales, 30% of last month’s

sales and 20% of two months ago sales)3) Forecast AR by customer using either of the two approaches above

• Methodologies for inventory1) DIOH methodology, basing project on cost of sales plan2) Develop more complex model segregating RM, WIP & FG.

• Methodologies for fixed assets1) Need plan for acquiring new assets as well as the acquisition value of existing

assets. Add in straight line depreciation for new assets. • Methodologies for accounts payable

1) Use % applied to total cost of goods sold plus total expenses2) Actually identify invoiced expense and material, calculate the historical ratio

of AP to those costs and forecast future on that basis • Be creative in regards to planning other balance sheet accounts that

have a material impact.• Once P&L and balance sheet are created, cash flow plan

What a Financial Plan Looks LikeActual Plan

Year 2010 Year 2011 Year 2012 Year 2013 Year 2014Revenue $12 $487 $525 $573 $601

Cost of Goods $6 $289 $310 $344 $343Gross Profit $6 $197 $215 $229 $259Operating Expense

Wages $0 $34Insurance $0 $28Travel $0 $2Supplies $0 $3Professional Services $0 $4Facilities $0 $11Depreciation $0 $1All Other $0 $23

Total Op Expense $0 $106 $110 $109 $132Op Income $6 $91 $105 $120 $126

Other I/E $0 $2 $2 $2 $2Net Income $6 $89 $103 $118 $124 - YOY Revenue Growth -- 3919% 8% 9% 5% - Gross Profit 49% 41% 41% 40% 43% - Op Profit 47% 19% 20% 21% 21% - Return on Sales 47% 18% 20% 21% 21%

AssetsCash $78 $26 $40 $32 $92Accts Receivable $12 $94 $133 $288 $297Inventory $220 $155 $195 $215 $211Other Cur Assets $1 $20 $20 $20 $20

Current Assets $311 $294 $389 $555 $620Equipment $62 $65 $125 $135 $145Accum Depr $0 -$1 -$25 -$27 -$29

Total Assets $373 $358 $489 $663 $736Liabilities & Equity

AP $3 $91 $75 $81 $85Other Liabilities/Debt $63 $6 $50 $100 $45

Total Liailities $66 $97 $125 $181 $130Equity $302 $167 $167 $167 $167Retained Earnings $6 $94 $197 $316 $440

Total Liabilities + Equity $373 $358 $489 $663 $736 - DSO 40 100 200 189 - DIOH 236 230 228 225 - DPO 43 65 65 65

Operating CFNet Income $6 $89 $103 $118 $124Accts Receivable -$12 -$82 -$40 -$155 -$9Inventory -$220 $65 -$41 -$19 $3Other OCF Assets -$1 -$19 $0 $0 $0AP $3 $88 -$17 $6 $4Total OCF -$224 $142 $6 -$50 $123

Investing CFFixed Assets -$62 -$3 -$60 -$10 -$10Accum Depreciation $0 $1 $24 $2 $2Total ICF -$62 -$2 -$36 -$8 -$8

Financing CFDebt $63 -$57 $44 $50 -$55Investing/Draw $302 -$135 $0 $0 $0Total FCF $364 -$192 $44 $50 -$55

Change In Cash $78 -$52 $14 -$8 $60

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Benchmarking

• Benchmarking is a processed used to compare a company’s financial performance, typically to other competitors within its industry or possibly units within the same company.

• Significant variances between the company being evaluated vs. the benchmark companies provide opportunity for improvement.

Benchmark DataClient Company Wal-Mart J&J McDonalds Accenture

Fiscal Year ($K) 2008 2009 2010 2011 2010 2010 2010 2010Revenue $105 $250 $650 $725 $408,085 $61,587 $24,075 $23,094

1-year Growth #N/A 138.1% 160.0% 11.5% 1.7% -0.5% 5.8% -0.3%3-year CAGR #N/A #N/A #N/A 90.4% 5.8% 0.3% 1.8% 2.5%

Profitability/Operating EfficiencyGM % 27.6% 20.0% 30.8% 31.0% 25.4% 69.5% 40.0% 31.4%R&D % 19.0% 22.0% 11.5% 10.3% 0.0% 11.1% 0.0% 0.0%SG&A % 42.9% 26.0% 11.5% 11.7% 19.5% 30.9% 9.0% 18.8%Operating Income % -34.3% -28.0% 7.7% 9.0% 5.9% 27.5% 31.0% 12.6%OPAT % -39.0% -30.8% 4.5% 4.8% 5.4% 27.5% 29.1% 12.6%Net Income % -39.0% -30.8% 2.9% 3.2% 3.7% 21.7% 20.5% 8.9%Asset UtilizationOperating Cash Cycle (Days) 485 529 427 482 43 162 21 58

DSO (Days) 365 256 225 227 4 58 18 58DIOH (Days) 120 274 203 256 39 104 3 0

Operating Capital Turnover 0.84 1.43 1.63 1.16 NA NA NA NACapital Intensity (Fixed Asset Turnover) 10.50 1.67 2.60 4.14 3.99 4.23 1.09 34.99Asset Turnover 0.45 0.37 0.62 0.58 2.39 0.60 0.75 1.80Leverage 1.120 1.405 1.490 1.523 2.42 1.82 2.18 4.53Debt To Total Capital 0.0% 23.7% 28.1% 26.7% 34.1% 22.9% 44.0% 0.1%ReturnsROIC -19.6% -12.2% 2.0% 2.1% 14.0% 18.2% 18.9% 72.6%ROAE -17.5% -11.4% 1.8% 1.9% 8.8% 13.0% 15.5% 16.0%ROE -19.6% -16.0% 2.7% 2.8% 21.2% 23.6% 33.8% 72.6%

Benchmarking Example

A Deeper Dive – More layers off the onion

• What is the cost of acquiring a new customer or client?• How many leads do you average in a typical week?• How many leads turn into clients (conversion rate)?• On average, how many touches (email, phone, etc.) does it take to

close a sale?• If you operate on up sell or cross sell strategies, how often are you

successful?• Can you profile your average customer?• What % of your customers did you retain for 1 yr, 2 yrs, 3yrs?• What is your average dollar sale?• What were your top 3 advertising campaigns last year?• What % of your business can be attributable to those campaigns?• How frequently did we have to reissue and invoice due to an error?• How many manual payroll checks are issued monthly?• What is the average cost of “after product care” care (e.g. help desk

for a software product)?

Appendix -- A few useful financial ratiosMetric Formula Description

Current Ratio Current Assets / Current Liabilities Measure of overall liquidity

Quick Ratio (Cash + AR) / Current Liabilities Measure of liquid resources available to meet immediate

Days Inventory On Hand (DIOH) (Inventory/COGS) * 365 Measure of inventory turnover.

Days Sales Receivable (DSR) (AR/Sales) * 365 Measure of collections

Days Payables Outstanding (DPO) (Accts Payable/COGS) * 365 Measure of AP payments

Gross Profit Margin Gross Profit / Revenue Measure of revenue that is not paid out as direct spending (raw material, overhead, direct labor)

Net Profit Margin Net Profit Before Taxes / Sales Measure of how much profit is retained of each revenue dollar after deducting all expenses other than taxes.

Payroll To Sales (Direct Labor + G&A Payroll) / Sales Measure company payroll as a percentage of sales

Interest Coverage Ratio EBITDA / Interest Expense Measures company’s ability to service debt payments (EBITDA = Earnings before income taxes, depreciation and amortization)

Debt-To-Equity Ratio Liabilities / Total Equity Measures a company’s leverage ratio as a function of its total capitalization (balance of money owed to third parties and stakeholders used to fund assets)

Return on Equity Net Income / Equity Measures effective return of all stakeholders (owners, investors, partners)

Return on Assets (or Return on Assets Employed)

Net Income / Assets Measures company’s ability to produce profitable sales using the available assets.

Fixed Asset Turnover Sales / Gross Fixed Assets Asset management ratio measuring how well fixed assets are being used to “throw off” sales.