Understanding Financial Statements:

The Organizational Scorecard

Dan Chenoweth, MBA/CPA

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MILE HIGH CHAPTER

Premise• Every organization needs a “Scorecard”

to measure success• Financial Statements are the Scorecard• Two types of Accounting Records

• Textbook (“Accrual Basis”) Financial Statements

• Cigar Box (“Cash Basis”) Financial Statements

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Presentation ObjectivesTHE BASICS

• Overview of Accrual Basis Financials• Definition• Overview of the “Big 3” Financial Statements• Importance of Key Ratio Analysis

• Overview of Cash Basis Financials• Definition• Internal Controls

LATEST FINANCIAL REPORTING TRENDS

• Turning Data into Information: The Balanced Scorecard

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Accrual Basis Financials

DEFINITION: Financial Statements prepared in accordance with Generally Accepted Accounting Principles (GAAP):• Revenues recorded at time goods and services

are delivered, regardless of when customer pays• Expenses recorded at time goods and services

are purchased, regardless of when you pay the bill

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Accrual Basis FinancialsThe “Big 3”

Balance Sheet“A Snapshot in Time”

Income Statement“The Moving Picture”

Statement of Cash Flow “Cash is King”

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Balance SheetOverview

Purpose: A “snap shot” in time regarding organization’s financial position

Components: Assets = Liabilities + Owners’ Equity Assets – Liabilities = Owners’ EquityCurrent Assets: Current Liabilities:• Cash • Accounts Payable• Accounts Receivable • Accrued Expenses• Client Trust Funds • Short-Term Loans/Debt• Deposits & Prepaids Long-Term Loans/DebtFixed Assets (Net of Accum. Depr.) Capital & Draw (Owners’ Equity) • Partners’ Capital Contribution

• (Partners’ Draw / Distributions) • Retained Earnings

TOTAL ASSETS TOTAL LIABILITIES / CAPITAL & DRAW

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Balance SheetExample

Current Assets: Current Liabilities:• Cash $100 •Accounts Payable $200• Accounts Rec. 300 •Accrued Expenses 50• Client Trust Funds 500 •S-T Loans/Debt 250• Deposits & Prepaids 50 Total Current Liabilities 500 Total Current Assets 950 L-T Loans/Debt 600Fixed Assets (Net of A/D) 1050 Total Liabilities 1100TOTAL ASSETS $2000 Capital & Draw (Owners’ Equity) •Beginning Capital 780 •Partners’ Capital Contribution 20 •(Partners’ Draw / Distributions) (10) •Profit (Loss) ??? Total Capital & Draw ??? TOTAL LIABILITIES / CAP & DRAW $ ???

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Balance SheetAnswers

Current Assets: Current Liabilities:• Cash $100 •Accounts Payable $200• Accounts Rec. 300 •Accrued Expenses 50• Client Trust Funds 500 •S-T Loans/Debt 250• Deposits & Prepaids 50 Total Current Liabilities 500 Total Current Assets 950 L-T Loans/Debt 600Fixed Assets (Net of A/D) 1050 Total Liabilities 1100TOTAL ASSETS $2000 Capital & Draw (Owners’ Equity) •Beginning Capital 780 •Partners’ Capital Contribution 20 •(Partners’ Draw / Distributions) (10) •Profit (Loss) 110 Total Capital & Draw 900 TOTAL LIABILITIES / CAP & DRAW $ 2000

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Balance SheetKey Questions

Liquidity: Is Working Capital positive? That is, are there enough Current Assets to pay all Current Liabilities?

Solvency: Is Capital & Draw (Owners’ Equity) positive?

Debt vs. Equity: Who has more “skin in the game”? The partners or the bank?

How well is the firm doing in utilizing and managing its assets and leveraging its debt?

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Income Statement Overview

Purpose: A statement of income and expenditures over a specified time period to determine if profits or losses have been earned.

Components: Revenue – Expenses = Profit or LossRevenue:• Fees from Insurance Companies $2000 50%

• Fees from Private Clients 1800 45%• Other Income (Rental, Interest, etc.) 200 5% TOTAL REVENUE 4000 100%Expenses:Guaranteed payments, Payroll, Payroll Taxes, Fringe Benefits, Education,

Rents, Supplies, Depreciation, Entertainment, Dues, Insurance, Telephone 3850 96% Operating Profit or Loss 150 4%Interest Expense -40 1%

Net Income $ 110 3%

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Income StatementKey Questions

PROFITABILITY:• Did we earn a profit? What is our rate of return? INTERNAL BENCHMARKING / TRENDS:• Are revenues higher or lower than the last period?• Are expenses higher or lower than the last period?• How did we do this month vs. last month? This quarter vs. last quarter? This

year vs. last year?• How do our actual results compare to budget?EXTERNAL BENCHMARKING:• How do our firm’s financials compare to others in our industry?

Did we earn a reasonable profit commensurate with the risk assumed?

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Statement of Cash FlowOverview

Purpose: Explains movement of money in and out of the organization’s cash accounts during a particular time period. Provides explanation for changing amounts in the organization’s accounts.

Components: The “bridge” between the Balance Sheet and Income Statement as it contains elements of both. Must know both beginning AND end of period Balance Sheet amounts.

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Statement of Cash FlowExample

Begin Cash Balance (Per Prior Year’s B/S) $110

Cash Flow from Operating Activities• Net Income (Per Income Statement) 110• Add back Depreciation Expense (Per I/S) 20• Changes in Current Assets & Liabilities (Per B/S) -40 Net Cash Provided by Operating Activities 90Cash Flow from Investing Activities: • Purchase Fixed Assets (Per B/S) -50Cash Flow from Financing Activities: • Repay Bank Loans (Per B/S) -60• Partners’ Capital Contributions $20 less Draw $10 10Ending Cash Balance (Ending Balance per this year’s B/S) $100

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Statement of Cash FlowKey Questions

SOLVENCY: Did we have positive cash flow from operating activities? (If answer is “no,” indicator of big problems!)

CASH MANAGEMENT: How did we invest any excess cash? Did we reinvest in the business? Purchase CD’s?

FINANCING: • Did we have to borrow more money in order to finance operations or invest

in the business? Did the partners have to contribute more?• Did we generate enough cash that we could repay some or all of our bank

debt? Is there sufficient cash for partner draws / distributions?FORECASTING: Do we have sufficient cash on hand to cover normal

operating expenses for next few months?“Where does our money come from and

where does it go?”

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Key Ratio Analysis“Not everything that counts can be counted; not

everything that can be counted really counts.” Albert Einstein

“So now that we have all these numbers, what are we going to do with them?” Dan Chenoweth

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I earned $1 million in the stock market last year. Is that a good return?

Results to Resources RatioRRR

RRR DEFINED: What Resources were spent to achieve what Result?

• Resources: Time, space, equipment, people, budget, training, etc.

• Result: Did activity improve our profits?

RATIO = Numerator / Denominator RRR = Results / Resources

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Key Ratio Analysis(Examples - See Handout)

1. Liquidity Ratios: Indicator of short-term solvency

2. Profitability Ratios: Indicator of return on investment (i.e. return for resources expended)

3. Activity Ratios: Indicator of how well organization’s resources have been utilized

4. Leverage Ratios: Indicator of extent to which operations are financed with borrowed money vs. owners’ money

5. Other Ratios: Primarily associated with publicly held companies

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Key Ratio AnalysisBenchmarking

Internal Benchmarking / Trend Analysis: Compare yourself with yourself

• Current month vs. previous month• Current year vs. previous year

External Benchmarking: Compare your organization with others in the same industry.

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YourOrg.

Industry Avg.

Current Ratio: CA/CL $950/$500 1.90 2.00

ROI: NI / Total Assets $110/$2000 5.50% 5.68%

Avg. Collection Period: (Avg. A/R ) / (Revenues/365) 45 days 30 Days

Debt/Equity: $1100/$900 1.22 1.45

Cash Basis Financials“Cigar Box” Accounting

DEFINITION• Revenues recorded at time

cash is received from customers

• Expenses recorded at time cash is paid to vendors

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Internal ControlsQUIZ: How Weak Are Your Internal Controls?

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How to Improve Internal Controls

#1: Outside Audit

#2: “Checks and Balances”• Cash Receipts• Cash Disbursements

#3: Accounting Personnel• Integrity and Rotation

#4: Partners / Owners Financial Review• Involvement - Budget / Forecast• Understanding• Questioning

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Organization Stakeholders Successful organizations make decisions that

consider the best interests of four primary stakeholders

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CLIENTS

EMPLOYEES OWNERS

SOCIETY

Balance of Measures

• Quality• Cost• Delivery / Cycle Time• Safety / Morale• Reputation

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The Balanced Scorecard

• Associated with Kaplan and Norton at Harvard University.

• Choose key performance indicators (KPIs) based on critical success factors (CSFs):• Based on unique business strategy.• Measurables for companies in the same industry

should be different.

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The Balanced Scorecard

Financial

Learning & Growth

Customer

Operations

Strategy & Vision

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Learning & Innovation

Measurable examples:• Number of new services introduced• Service introduction lead-time• Training hours per person• Employee turnover• Employee satisfaction

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Operational

Measurement Examples:• Operational efficiency, e.g. lack of errors• Billable hours• Revenue per employee• Revenue per type of

service offered• Revenue per client

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Customer PerspectiveMeasurement examples:

• Customer Quality Ratings• Speed of Service• Repeat Customers• New Customer Acquisition• Market Share

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Financial Perspective

Measurement examples:• Profit• Shareholder value-added (SVA)• Debt/Equity• Return on investment• Return on assets

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Southwest Airlines

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Executive Education, Inc., © 2011 31

Executive Education, Inc.

Objectives

Measures Targets Initiatives

Financial $ Profit / # Seminar Days

Customer Average Knowledge, Presentation & Materials Scores (5-pt. scale)

4.7 Knowledge4.6 Presentation4.5 Materials

DL Knowledge Sharing

Operations

# Go Seminars / # Scheduled Seminars

Jan-Aug 90%Sept-Dec 95%

# People / #Seminars

25+ (average) PamphletsE-mail blasts

Learning % New Titles or Sections

25% New Material

Seminar Surveys

MS Word Style Analysis

0% Passives40 Readability12 Grade level

“Story” CasesNew Editing Standards

New Material

“Go” Rate

Registrations

High Participant Scores

High Quality Materials

Profitable Business

Repeat Attendees

Balanced Scorecard ExampleFrom Professional Services Firm

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ALLEN, LEACH & TUREK, PC

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Final Quiz

1. What are the “Big 3” Financial Statements?2. Which of these Financial Statements is the “bridge”

between the other two?3. What does “RRR” mean?4. Why is Key Ratio Analysis important?5. Which is better: Accrual basis accounting

or Cash basis accounting?6. Who are an organization’s four key stakeholders?7. What are the components of the “Balance of

Measures”? HINT: Q,C,D,S,M,R35

Conclusion “If you torture numbers long

enough, you can make them confess to anything.”

Former NM Senator Pete Domenici in discussing the Federal Government budgeting process

Don’t be a number torturer and don’t let numbers torture you! Instead, understand the critical elements in Financial Statements and know how to turn data into information!

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