Gain Confidence: Introduction to Financial Statement Analysis

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GAIN CONFIDENCEIntroduction to Financial Statement AnalysisMaine State Bar Association January 26, 2012


GAIN CONTROLGAIN CONTROL

OUR GOALS

• Understand the basic types of financial statements

• Understand how financial statements interact

• Identify different types of Accountants’ Reports and why that is relevant to you

• Understand why taxable income and net income are not created equal

• Determine some basic financial statement metrics

• Identify red-flags and accounting games

• Most importantly – Identify when you need some additional help

Our goal is to help you gain a better understanding of financial statements.

Today’s agenda:



NOT OUR GOALS• Talk debits and credits

• Do linear algebra

• Turn you into bean counters



The Basics

Setting the foundation to understand financial statements



• Assets = Liabilities + Equity– When people say the books are “in

balance”, this is what they mean– Think of equity as the leftover portion

when you take what you have (assets) and subtract what you owe (liabilities)

• Equity = Assets – Liabilities– If you owe more than you have, you

have negative equity

The Accounting Equation



Balance Sheet

• Snapshot of a company’s assets, liabilities, and equity as of a certain date

• Assets on the left-hand side (or first page)

• Liabilities on the right-hand side (or second page), followed by Equity

Assets Liabilities

Equity



Income Statement

• Movie about revenue and expenses over some period of time

• Titles and descriptions change, but the basic structure is the same

Revenue

(Cost of Goods)

Gross Profit

(Operating Expenses)

Profit from Operations

(Miscellaneous Items)(Interest)

(Taxes)

Net Income



Statement of Cash Flows

• Movie about cash over some period of time

• Three types of cash flow– Cash flow from Operations – generated (or

used) by normal activities

– Cash flow from Investments – generated by sale of assets or used by purchase of capital equipment

– Cash flow from Financing – generated by bank debt, equity sales or used for distributions



For-Profit Business Entities

• C-Corporation– Pay corporate-level taxes– Shareholders pay dividend

taxes on distributions– Also referred to as a “dual tax

entity” since there are two levels of taxes paid on distributions

• Everybody Else– S-Corps, Partnerships, LLCs*

– Taxes are paid by the members as ordinary income

– Also referred to as “pass through entities” since the tax liability is passed through to the member (or shareholder)

– *LLCs are commonly set up as partnerships, but can be S-Corps or C-Corps



Dual tax versus single taxC-Corp PTE

Pre-Tax Income 100.00$ Pre-Tax Income 100.00$ Corporate Taxes 40.50% (40.50) Corporate Taxes 0% -

Net Income 59.50 "Net Income" 100.00 Dividend Taxes 20.50% (12.20) Income Taxes 40.50% (40.50)

Cash-in-pocket 47.30$ Cash-in-pocket 59.50$

• Pass-Through Entities skip the dividend taxes, results in more cash for the owners upon distribution

• Distributions from PTEs to cover the tax liability are typical



Which is which?

C-Corp S-Corp Partner-ship

LLC

Public company Taxes in the income statement No taxes in the income statement Distributions proportional to ownership Tax Return is an:

1120 1120S 1065



Let’s Form a Company

• Easier to understand the interaction of financial statements with an example

• We contribute $100 for equity

• We borrow $900 from the bank

• We buy $1,000 in equipment



WidgetCoBalance Sheet as of

January 1, 2012Assets Liabilities

Cash - Loans $900

Inventory - Other commitments (see note __)

Total Current Assets - Equity

Equipment $1,000 Capital Stock 100

Depreciation - Retained Earnings

Net Fixed Assets 1,000 Total Equity 100

Total Assets $1,000 Total Liabilities & Equity $1,000

Opening Balance Sheet



Equity Section Details

• Three different kinds of equity– Common Stock

• The original capital contributed to the Company to satisfy par value

• $100 in out example

– Additional Paid in Capital (APIC)• Capital above par value

• Initial capital may be more than par value

• Fund losses or contributed for other purposes

– Retained Earnings• Prior year’s retained earnings plus net income minus any distributions



Let’s Sell Some Stuff

• We sell $1,000 worth of widgets• We have $400 in production expenses, $100 in

direct labor, and $200 in depreciation expense• We receive $60 of raw materials at year-end• We pay $100 in rent• We pay lawyers $10 and accountants $20• We pay interest of $45• We pay taxes of $55



Income Statement• Revenue is the

value of what was sold

• Cost of Goods Sold are the accounts directly linked to production

• Depreciation is a non-cash charge (which we will discuss later)

• Net Income is the “bottom-line”

• Let’s see how this impacts the balance sheet

WidgetCoIncome Statement

For the year ending December 31, 2012

Revenue $1,000

Production Expenses 400

Direct Labor 100

Depreciation 200

Total Cost of Goods Sold 700

Gross Profit 300

Operating Expenses (Rent, Legal, Accounting) 130

Operating Profit 170

Interest 45

Taxes 55

Net Income $70



A few simplifying assumptions

• All sales are for cash – no credit (yet)

• No additional equipment was purchased or sold

• All debt is interest only for the first five years

• No distributions are made to shareholders (yet)



WidgetCoBalance Sheet as ofDecember 31, 2012

Assets Liabilities

Cash $210 Loans $900

Inventory 60 Other commitments (see note __)

Total Current Assets 270 Equity

Equipment 1,000 Capital Stock 100

Depreciation (200) Retained Earnings 70

Net Fixed Assets 800 Total Equity 170

Total Assets $1,070 Total Liabilities & Equity $1,070

Year-End Balance Sheet

• Net Income is added to the shareholder equity in the form of retained earnings

• Fixed assets have been reduced by the depreciation expense



But wait a minute…

• Net Income is $70• How did we generate $210 in cash?• We find the answer in the

Statement of Cash Flows



Statement of Cash FlowsWidgetCo

Statement of Cash FlowsFor the year ending December 31, 2012

Net Income $70

Adjustments to Reconcile Net Income to Cash Flow from Operations

Inventory (60)

Depreciation 200

Net Cash Provided by Operations 210

Cash Flows from Investing Activities

Purchase of Equipment (1,000)

Net Cash Used by Investing Activities (1,000)

Cash Flows from Financing Activities

Borrowings 900

Capital Stock Issued 100

Net Cash Used by Financing Activities 1,000

Net Increase in Cash $210

Cash at Beginning of Year -

Cash at End of Year $210

• Links Income Statement (Net Income) to Balance Sheet (Cash)

• Best place to find non-cash expenses, like depreciation and amortization

• Reconciles beginning and ending cash

• Bankers love reconciling cash



Quick Review

• Assets = Liabilities + Owner’s Equity• Balance Sheet

– Must balance– Is a snapshot in time

• Income Statement– Boils down to Net Income– Movie of profits over time

• Statement of Cash Flows– Links Net Income (starting point) to Cash (ending point)– Movie of cash flows over time



Quick Review - continued

• Retained Earnings = Prior year’s retained earnings + Net Income – Distributions

• Taxes may or may not be paid at the corporate level, depending on entity-type

• Cash flow ≠ Net Income (more on this later)



Financial Reporting

Different types of reports and the distinction between taxable and net income



What is GAAP?

• Generally Accepted Accounting Principles (GAAP)• Accounting principles set forth over time by a variety

of authoritative and advisory bodies including,– Financial Accounting Standards Board (FASB)– Governmental Accounting Standards Board (GASB)– Securities & Exchange Commission (SEC)– Accounting Principles Board (APB)– International Accounting Standards Board (IASB)



Accountants’ Reports

• Four types of reports – and the level of assurance with respect to GAAP– Audit – positive assurance regarding material conformity– Review – negative assurance that nothing material

came to light– Compilation – no assurance. Simply compiled financial

information– Agreed-upon Procedures – no assurance beyond the

reporting of results from the application of certain procedures



Independent Auditors’ Report

• Clean opinion: Look for the following wording:

• In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Company as of December 31, 2008, and the results of its operations and its cash flows for the years then ended in conformity with U.S. generally accepted accounting principles.



Accountants’ Review Report

• Look for the following wording:

• Based on our review, we are not aware of any material modifications that should be made to the accompanying financial statements in order for them to be in conformity with U.S. generally accepted accounting principles.



Footnotes

• Referenced on bottom of each statement• “The rest of the story”• Many items reported as “net” on the financial

statement are detailed in the footnotes• Footnotes are particularly important with a

review or a compilation as “going concern” questions are not necessarily discussed in the report



Footnote Topics• Significant accounting policies• Components of inventory• Details of fixed assets• Income tax discussion & disclosure• Components of debt

• Leases, other commitments, and contingencies• Pension and profit sharing information• Fair value and derivative information• Subsequent events• Emphasis paragraph explanation from the accountants’ report• Related parties disclosures



No Financial Statements?

• Look to other sources of information:– Tax Returns– Internally generated statements of profit and

loss and financial position

• Financial Statements using GAAP as the foundation rely on accrual accounting– Revenue recognized when earned– Expenses recognized when incurred– Matching principle is extensively used

throughout GAAP



Tax Returns

• Tax returns are different from GAAP financials– Typically, revenues are recognized when received (not

earned) and expenses are recognized when paid (not incurred)

– Accounting estimates (allowances for doubtful accounts, inventory reserves) are not recognized

– Depreciation is based on statutory authority rather than estimated useful life

• The information has been presented to the IRS as true and accurate (if signed)



Internal Financial Statements

• May or may not be GAAP• May or may not be comprehensive• May or may not be accurate

• If there are no tax returns and no GAAP financial statements, the degree of confidence in internal financial statements is determined by other factors



• Looks like an income statement, but it isn’t

• Taxable income ≠ net income

Reconciling tax returns to financial statements



• Item 10 is Taxable Income• Item 1 is Net income (loss) per books• This table allows you to turn taxable income back into net income• If you have both financial statements and tax returns, doesn’t

hurt to check that the numbers are in fact the same

Reconciling tax returns to financial statements



Quick Review

• The hierarchy of quality of financial information:– Audited– Reviewed– Tax returns– Compiled– Agreed-upon Procedures– Internally generated

• Footnotes contain criticalcritical information• Taxable income ≠ net income

– Reconcile the taxable income through Schedule M1



Financial Statement Analysis

Extracting useful information from financial statements



Balance SheetExample C-Corp Balance Sheet as of December 31,

2005 2006 2007 2008 2009

Assets

Cash $30,000 $1,156,000 $4,071,000 $8,071,000 $12,001,000

Accounts Receivable 50,000 500,000 600,000 700,000 3,000,000

Inventory 100,000 150,000 1,000,000 2,000,000 6,000,000

Total Current Assets 180,000 1,806,000 5,671,000 10,771,000 21,001,000

Net Property Plant & Equip 1,091,000 2,100,000 2,100,000 2,100,000 2,100,000

Total Assets $1,271,000 $3,906,000 $7,771,000 $12,871,000 $23,101,000

Liabilities

Current Portion of Long Term Debt $100,000 $100,000 $100,000 $100,000 $100,000

Accounts Payable 50,000 55,000 60,000 70,000 80,000

Total Current Liabilities 150,000 155,000 160,000 170,000 180,000

Long Term Debt 1,000,000 900,000 800,000 700,000 600,000

Total Liabilities 1,150,000 1,055,000 960,000 870,000 780,000

Stockholder’s Equity

Common Stock 1,000 1,000 1,000 1,000 1,000

Additional Paid in Capital 20,000 20,000 20,000 20,000 20,000

Retained Earnings 100,000 2,830,000 6,790,000 11,980,000 22,300,000

Total Stockholder’s Equity 121,000 2,851,000 6,811,000 12,001,000 22,321,000

Total Liabilities and Stockholder’s Equity $1,271,000 $3,906,000 $7,771,000 $12,871,000 $23,101,000



Balance Sheet Analysis

• Common Size Balance Sheet– All line items as a percentage of Total Assets

• Working Capital– Current Assets – Current Liabilities

• Liquidity ratios– Current Ratio – Current Assets / Current Liabilities

– Quick Ratio – (Cash + A/R) / Current Liabilities

• Leverage ratios– How much debt to how much equity

• Coverage ratios– How many times can debt commitments be paid out of income



Common Size Balance SheetExample C-Corp Balance Sheet as of December 31,

2007 2008 2009

Assets

Cash $4,071,000 52.4% $8,071,000 62.7% $12,001,000

51.9%

Accounts Receivable 600,000 7.7% 700,000 5.4% 3,000,000 13.0%

Inventory 1,000,000 12.9% 2,000,000 15.6% 6,000,000 26.0%

Total Current Assets 5,671,000 73.0% 10,771,000 83.7% 21,001,000 90.9%

Net Property Plant & Equip 2,100,000 27.0% 2,100,000 16.3% 2,100,000 9.1%

Total Assets $7,771,000 100.0% $12,871,000 100.0% $23,101,000 100.0%

Liabilities

Current Portion of LTD $100,000 1.3% $100,000 0.8% $100,000 0.4%

Accounts Payable 60,000 0.8% 70,000 0.5% 80,000 0.4%

Total Current Liabilities 160,000 2.1% 170,000 1.3% 180,000 0.8%

Long Term Debt 800,000 10.3% 700,000 5.4% 600,000 2.6%

Total Liabilities 960,000 12.4% 870,000 6.7% 780,000 3.4%

Stockholder’s Equity

Common Stock 1,000 0.0% 1,000 0.0% 1,000 0.0%

Additional Paid in Capital 20,000 0.2% 20,000 0.2% 20,000 0.1%

Retained Earnings 6,790,000 87.4% 11,980,000 93.1% 22,300,000 96.5%

Total Stockholder’s Equity 6,811,000 87.6% 12,001,000 93.3% 22,321,000 96.6%

Total Liabilities and Equity $7,771,000 100.0% $12,871,000 100.0% $23,101,000 100.0%

• A/R almost tripled between ’08 and ’09

• Inventory almost doubled

• Cash is declining



Working Capital

• Current Assets – Current Liabilities

• Measures liquidity

Year 2005 2006 2007 2008 2009

Current Assets 180,000 1,806,000 5,671,000 10,771,000 21,001,000

Current Liabilities 150,000 155,000 160,000 170,000 180,000

Working Capital 30,000 1,651,000 5,511,000 10,601,000 20,921,000



Current Ratio

• Current Assets / Current Liabilities

• Measures liquidity

Year 2005 2006 2007 2008 2009

Current Assets 180,000 1,806,000 5,671,000 10,771,000 21,001,000


Current Ratio 1.2 11.65 35.44 63.36 116.67



Quick Ratio

• Cash + A/R / Current Liabilities

• More conservative measure of liquidity

Year 2005 2006 2007 2008 2009

Cash + A/R 80,000 1,656,000 4,671,000 8,771,000 15,001,000


Quick Ratio 0.53 10.68 29.19 51.59 83.34



Income Statement

Example C-Corp Income Statement for the Year Ending December 31,

2006 2007 2008 2009

Sales $15,000,000 $20,000,000 $25,000,000 $35,000,000

Cost of Sales 8,000,000 10,000,000 12,000,000 13,000,000

Gross Profit 7,000,000 10,000,000 13,000,000 22,000,000

Selling, General, & Admin 2,000,000 3,000,000 4,000,000 4,500,000

Operating Income 5,000,000 7,000,000 9,000,000 17,500,000

Interest Expense 450,000 400,000 350,000 300,000

Income before Income Taxes 4,550,000 6,600,000 8,650,000 17,200,000

Income Taxes 1,820,000 2,640,000 3,460,000 6,880,000

Net Income $2,730,000 $3,960,000 $5,190,000 $10,320,000

Reconciliation of Retained Earnings

Retained Earnings, Beginning of Year 100,000 2,830,000 6,790,000 11,980,000

Net Income 2,730,000 3,960,000 5,190,000 10,320,000

Less: Distributions - - - -

Retained Earnings, End of Year $2,830,000 $6,790,000 $11,980,000 $22,300,000



Income Statement Analysis

• Common Size Income Statement– Line items as a percentage of revenue

• Gross Margin – Percentage of revenue left after Cost of Goods Sold (COGS)– Demonstrates how much money is left after production

• Gross Profit– Same concept with dollars, rather than percentage

• Operating Margin– Percentage of revenue left after Operating Expenses and

COGS– Demonstrates how much money is left after production and

overhead• Operating Profit

– Same concept with dollars, rather than percentage



Common Size Income Statement


2006 2007 2008 2009

Sales $15,000,000 100.0% $20,000,000 100.0% $25,000,000 100.0% $35,000,000 100.0%

Cost of Sales 8,000,000 53.3% 10,000,000 50.0% 12,000,000 48.0% 13,000,000 37.1%

Gross Profit 7,000,000 46.7% 10,000,000 50.0% 13,000,000 52.0% 22,000,000 62.9%

Selling, General, & Admin 2,000,000 13.3% 3,000,000 15.0% 4,000,000 16.0% 4,500,000 12.9%

Operating Income 5,000,000 33.3% 7,000,000 35.0% 9,000,000 36.0% 17,500,000 50.0%

Interest Expense 450,000 3.0% 400,000 2.0% 350,000 1.4% 300,000 0.9%

Income before Income Taxes

4,550,000 30.3% 6,600,000 33.0% 8,650,000 34.6% 17,200,000 49.1%

Income Taxes 1,820,000 12.1% 2,640,000 13.2% 3,460,000 13.8% 6,880,000 19.7%

Net Income $2,730,000 18.2% $3,960,000 19.8% $5,190,000 20.8% $10,320,000 29.5%



Gross Profit / Gross Margin


2006 2007 2008 2009

Sales $15,000,000 100.0% $20,000,000 100.0% $25,000,000 100.0% $35,000,000 100.0%

Cost of Sales 8,000,000 53.3% 10,000,000 50.0% 12,000,000 48.0% 13,000,000 37.1%

Gross Profit 7,000,000 46.7% 10,000,000 50.0% 13,000,000 52.0% 22,000,000 62.9%





4,550,000 30.3% 6,600,000 33.0% 8,650,000 34.6% 17,200,000 49.1%

Income Taxes 1,820,000 12.1% 2,640,000 13.2% 3,460,000 13.8% 6,880,000 19.7%

Net Income $2,730,000 18.2% $3,960,000 19.8% $5,190,000 20.8% $10,320,000 29.5%



Operating Profit / Margin


2006 2007 2008 2009

Sales $15,000,000 100.0% $20,000,000 100.0% $25,000,000 100.0% $35,000,000 100.0%

Cost of Sales 8,000,000 53.3% 10,000,000 50.0% 12,000,000 48.0% 13,000,000 37.1%

Gross Profit 7,000,000 46.7% 10,000,000 50.0% 13,000,000 52.0% 22,000,000 62.9%





4,550,000 30.3% 6,600,000 33.0% 8,650,000 34.6% 17,200,000 49.1%

Income Taxes 1,820,000 12.1% 2,640,000 13.2% 3,460,000 13.8% 6,880,000 19.7%

Net Income $2,730,000 18.2% $3,960,000 19.8% $5,190,000 20.8% $10,320,000 29.5%



• Earnings Before Interest, Tax, Depreciation, and Amortization– Considered to be a measure of cash flow from

operations– Not subject to capital structure (interest), tax treatment,

or games people play with depreciation and amortization

– Start with Net Income (earnings) and add back:• Taxes• Interest• Depreciation and Amortization expense

– Often modified to exclude miscellaneous income or expense

– Does not cover fixed assets

What is EBITDA?



Statement of Cash FlowsExample C-Corp Statement of Cash Flows for the Year Ending December 31,

2006 2007 2008 2009

Cash Flows from Operations

Net Income $2,730,000 $3,960,000 $5,190,000 $10,320,000

Adjustments to Net Income

Depreciation 100,000 100,000 100,000 100,000

Accounts Receivable (450,000) (100,000) (100,000) (2,300,000)

Inventory (50,000) (850,000) (1,000,000) (4,000,000)

Accounts Payable 5,000 5,000 10,000 10,000

Net Cash Flows from Operations 2,335,000 3,115,000 4,200,000 4,130,000

Cash Flow from Investing

Purchase of Property, Plant & Equip (1,109,000) (100,000) (100,000) (100,000)

Net Cash Used by Investments (1,109,000) (100,000) (100,000) (100,000)

Cash Flow from Financing

Principal Payments on Long-Term Debt

(100,000) (100,000) (100,000) (100,000)

Distributions - - - -

Net Cash Used by Financing (100,000) (100,000) (100,000) (100,000)

Cash, Beginning of Period 30,000 1,156,000 4,071,000 8,071,000

Cash, End of Period $1,156,000 $4,071,000 $8,071,000 $12,001,000



Other financial statement metrics

• Cash Realized from Operations Ratio– Measures quality of earnings– Cash from Operations (CFFO) divided by

Net Income• Accounts Receivable Turnover / Days

Sales Outstanding– Measures how quickly A/R is collected– Average A/R divided by average day’s

sales• Inventory Turns / Days Sales in Inventory

– Measures how rapidly inventory turns over– Average inventory divided by averages

day’s sales



• Should approximate 1.0 over time

• Steep decline in 2008 to 2009

• Almost 0 for 2010?

Cash realized from operations



• How long does it take to collect accounts receivable on average?

• 365/DSO provides “turns” or number of times per year that A/R is collected

• Steep increase between 2008 and 2009

Day’s sales receivables (DSO)



• How long does it take to convert inventory into revenue?

• 365/days inventory provides inventory turns, or number of times per year that inventory is sold

• Continuously increasing curve – not good

Day’s sales in inventory



Quick Review

Term What is it?

Working Capital Used to fund ongoing operations (Current Assets – Current Liabilities)

Liquidity How much cash can be generated from current assets and liabilities

Gross Profit Money left after production (Revenue – COGS)

Operating Profit Money left after overhead (Gross Profit – Operating Expenses)

EBITDA Proxy for cash flow (Operating Income + Interest, Taxes, Depreciation, and Amortization)

Cash Flow from Operations

How much cash is generated from making and selling the product



Games People Play

• If the goal is to increase borrowing capacity, the following are prone to manipulation:– Assets

• Inventory• Accounts Receivable

– Liabilities• Off balance sheet liabilities• Reclassifying debts as equity (and vice versa)

– Equity• Revenue recognition to increase net income

– Current versus non-current classification



Games People Play

• If the goal is to make the Company appear worth less (or worthless), look for the following:– Related company transactions (commonly rent)– Management fees– Officer compensation– Relatives on the payroll– Loans to/from shareholders– Excess distributions



Contact Information

• Bill [email protected]

(207) 541-2208

• Seth [email protected]

(207) 541-2297



GAIN CONTROLWITH GROUNDED ADVICE


Documents

Gain Confidence: Introduction to Financial Statement Analysis