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Financial Statements andPerformance Analysis

Alan BarefieldAssociate ProfessorUniversity of TennesseeAgricultural Economics

Agricultural Extension ServiceThe University of Tennessee

Importance of Financial Management David Curlee (land developer) made a

fortune, then went bankrupt and is now consulting

He states that the entrepreneur must know: What is coming in versus what is going out Everything that is contained in the ledger

sheets All facets of business operations

Above all, don’t become too ambitious


Key Financial Statements Income or Profit & Loss Statement

Balance Sheet

Cash Flow Statement

Budget Forecast


Balance Sheet Details the financial position of a

business at a particular point in time Assets = Liabilities + Equity Tells the reader what the business

owns of monetary value and what the business owes to others.

Personal and business assets and liabilities are frequently reflected on the same statement


Components of theBalance Sheet Assets

Represents the monetary value of what the business owns

Are normally grouped into three categories denoting how soon they wear out or are sold• Current – Less than 1 year• Intermediate – 1 to 10 years• Long-term – Over 10 years


Current Asset Examples Cash Checking accounts Savings accounts Accounts

receivable Inventories Supplies WIP investments

Equity in hedging accounts

Tax refunds Unused tax credits Prepaid expenses

Payroll Insurance Rent


Intermediate Asset Examples Machinery Business vehicles Retirement accounts Cash value of life insurance Household goods Personal vehicles


Long-term Asset Examples Land

Buildings and structures

Personal residences

Nonbusiness real estate


Components of theBalance Sheet Liabilities

Represents the value of the debts owed by the business

Are normally grouped into three categories denoting how soon they fall due• Current – Less than 1 year• Intermediate – 1 to 10 years• Long-term – Over 10 years


Current Liability Examples Accounts payable Short term notes payable Current payments on intermediate

or long term notes Accrued expenses Contingent tax on sale of current

assets


Intermediate Liability Examples Loans to finance intermediate assets

less current payments

Contingent tax on sale of intermediate assets


Long-term Liability Examples Business and nonbusiness

mortgages less current payments

Other long-term notes

Contingent tax on sale of long term assets


Components of theBalance Sheet Net worth (also called net equity)

Net worth represents the difference between the total level of assets and the total level of liabilities

Net worth should be reported on an after-tax basis

If net worth is positive, the business is solvent (assets can be sold to retire liabilities). If net worth is negative, the business is insolvent


Structure of theBalance Sheet Assets

Current Assets Intermediate

Assets Long-term Assets

Liabilities Current Liabilities Intermediate

Liabilities Long-term

Liabilities

Net Worth


Purpose of theBalance Sheet The balance sheet indicates the

degree to which the business is liquid and solvent

Liquidity – Can the business’ current liabilities be retired if the current assets are converted to cash?

Solvency – Can the total liabilities of the business be retired if all assets are converted to cash?


Income or Profit & Loss Statement The income or profit and loss

statement summarizes the level of revenue and expenses for the business

Major components include: Revenues Expenses Taxes Extraordinary Items


Revenues Business revenue can be divided

into two categories Revenue from current operations –

Cash proceeds from the sale of inventory, noncash proceeds from sales, patronage dividends, insurance proceeds, noncash inventory adjustments

Expenses incurred in the production process should be deducted from revenues to yield a gross profit margin


Revenues Capital gains and losses – Gain or loss

realized from the sale of intermediate or long-term assets

Nonbusiness revenue – Income derived from nonbusiness employment, interest and dividend income from nonbusiness investments


Expenses Cash operating expenses – Includes

expenses paid in cash, expenses that have been incurred but not yet paid (accounts payable), interest expenses

Noncash expenses includes depreciation and any expenses paid from the last reporting period if the business is reporting on a cash basis


Taxes This section includes the specific tax

liabilities incurred during the reporting period. Only income and self-employment taxes are reported in this section. Payroll taxes, real estate and real property taxes, etc., are reported under the Expenses section of the income statement


Extraordinary Items This section includes “once-in-a-

lifetime” events that should not be included as a part of the firm’s regular financial activities

Includes insurance payments from a loss, agricultural disaster payments, etc.


Structure of theIncome Statement

RevenuesBusiness Revenue

+ Gain from sale of intermediate or LT assets+ Non Business Revenues+ Noncash revenue adjustments= Total revenue

- Cost of goods sold

= Gross profit margin


Structure of theIncome Statement

Gross profit margin- Cash operating expenses- Noncash operating expenses= Income from business operations+(-) Gain (loss) on depreciable assets= Net business income+ Nonbusiness revenue-Non business expenses= Income before taxes- Provisions for taxes= Net Income


Purpose of theIncome Statement Provides a summary of the revenues

and expenses associated with the period’s operating activities

Provide information to complete the business and personal income tax returns

Shows the profitability of the business for lenders and other interested parties


Cash Flow Statement Summarizes the levels of cash that

the business has available to meet current obligations

Generally divided into monthly or quarterly periods to show when excess cash is available or when borrowing needs to occur


Components of theCash Flow Statement Cash available

Beginning cash balance Cash revenues from sales and accounts

receivable Other sources of cash

• Proceeds from sale of equipment and other assets

• Nonbusiness wages• Interest and dividend income


Components of theCash Flow Statement Cash required

Operating expenses Income tax payments Intermediate and long-term payments Capital expenditures Family living expenses Cash gifts and donations


Components of theCash Flow Statement Borrowings

New loans to finance production and capital expenditures

Other Short term loan payments Savings – additions and withdrawals Ending cash balance for the period


Purpose of theCash Flow Statement Highlights the financing

arrangements necessary to cover cash requirements

Serves as a benchmark for budgeting activities

Analyzes the timing of financial borrowing activities


Budget Preparation Many persons assert that the budget

is simply a projection of the cash flow statement

However this is not correct The budget must incorporate all key

financial statements Forecasting statements are also

called pro forma statementsAgricultural Extension ServiceThe University of Tennessee

Key Budget Assumptions Expected selling prices Expected input prices Expected input productivity Pro forma operating budget

Production costs and sales objectives Pro forma financial budget

Cash receipts and disbursements Family living budgets


Financial Statement Analysis Ratio analysis

Alleviates the unit of measure problems incurred when comparing raw numbers

Four different types of ratios can be examined• Liquidity ratios – can current debts be met• Solvency ratios – can all debts be met• Efficiency ratios – how efficient is the

operation• Profitability ratios – how profitable is the

operationAgricultural Extension ServiceThe University of Tennessee

Keys to Ratio Analysis Ratios don’t mean anything by

themselves They must be compared over time

and with similar companies Look at industry standards through

trade magazines, Standard & Poore’s, RMA analysis, etc.


Liquidity RatiosCurrent Ratio Current assets divided by current

liabilities Interpretation

Relatively high ratio values mean that the business is liquid, but cash is not working

If the current ratio is greater than 1.0, the business is liquid

If the current ratio is less than 1.0, the business is illiquid


Liquidity RatiosCurrent Ratio


sLiabilitie Current Total AssetsCurrent Total

Ratio Current

Liquidity RatiosAcid Test Ratio Current assets minus inventories

divided by current liabilities Interpretation

Relatively high ratio values mean that the business is liquid, but cash is not working

If the current ratio is greater than 1.0, the business is liquid

If the current ratio is less than 1.0, the business is illiquid


Liquidity RatiosAcid Test Ratio

sLiabilitie Current TotalInventory - AssetsCurrent Total

Ratio Test Acid


Solvency RatiosLeverage Ratio Total liabilities divided by total net

worth Interpretation

The higher the value, the less solvent the business is

If less than 1.0, the business is solvent If greater than 1.0, the business is

insolvent


Solvency RatiosLeverage Ratio

WorthNet TotalsLiabilitie Total

Ratio Current


Solvency RatiosNet Capital Ratio Total assets divided by total

liabilities Interpretation

The higher the value, the more solvent the business

If greater than 1.0, the business is solvent

If less than 1.0, the business is insolvent


Solvency RatiosNet Capital Ratio

sLiabilitie Total AssetsTotal

Ratio Capital Net


Efficiency RatiosTurnover Ratio Value of production divided by total

average productive assets Interpretation

The higher the value, the more efficient the business

The lower the value, the less efficient the business


Efficiency RatiosTurnover Ratio

AssetsProductive TotalProduction of Value

Ratio Capital Net


Efficiency RatiosGross Ratio Total business expenses divided by

the value of production Interpretation

The lower the value, the more efficient the business

The higher the value, the less efficient the business


Efficiency RatiosGross Ratio

Production of ValueExpenses Business Total

Ratio Gross


Efficiency RatiosSales/Receivables Net sales divided by net accounts

receivables Interpretation

Measures the number of times receivables turn over during the year

The higher the turnover, the shorter the time between the sale and cash collection


Efficiency Ratios Sales/Receivables

sReceivable AccountsNetSales Net


Efficiency Ratios Days/Receivable Turnover 365 divided by the

Sales/Receivables Ratio Interpretation

Dividing the sales/receivables ratio into 365 provides the number of days between sales and collections

The higher the number, the longer it takes the business to collect accounts receivable


Efficiency Ratios Days/Receivable Turnover

Ratio ivablesSales/Rece365


Efficiency RatiosInventory Turnover Ratio Calculated by dividing cost of goods

sold by the dollar level of inventory Interpretation

Measures the number of times inventory is turned over during the year

High inventory can indicate better liquidity or superior merchandising


Efficiency RatiosInventory Turnover Ratio Interpretation (continued)

Conversely, high turnover can mean a shortage of needed inventory for sales

Low inventory turnover can indicate poor liquidity, possible overstocking, obsolescence, or a planned inventory buildup

Closely examine the reasons behind the value of this ratio with regard to your business


Efficiency RatiosInventory Turnover Ratio

InventorySold Goods of Cost


Efficiency RatiosDays Units Are In Inventory 365 divided by the inventory

turnover ratio Interpretation

Calculates the average number of days that units are in inventory

See explanations for high or low numbers in the interpretation for the inventory turnover ratio


Efficiency RatiosDays Units Are In Inventory

Ratio TurnoverInventory 365


Efficiency RatiosPayable Turnover Ratio Divide cost of goods sold by net

accounts payable Interpretation

Measures the number of times payables turn over during the year

The higher the turnover, the lower the time between purchase and payment


Efficiency RatiosPayable Turnover Ratio Interpretation (continued)

A low ratio can indicate:• Cash shortage• Invoice disputes with suppliers• Extended terms of payment provided by

suppliers• Expansion of trade credits with suppliers


Efficiency RatiosPayable Turnover Ratio

Payable AccountsNetSold Goods of Cost


Efficiency RatiosDays/Payables Turnover 365 divided by the payables

turnover ratio Interpretation

Calculates the average number of days that trade payables are outstanding

For possible explanations of a relatively large number of days, see the explanations for the payable turnover ratio


Efficiency RatiosDays/Payables Turnover

Ratio Turnover Payables365


Efficiency RatiosNet Sales/Working Capital Net sales divided by working capital Working capital is calculated by

subtracting current liabilities from current assets

Interpretation Measures how efficiently working

capital is employed


Efficiency RatiosNet Sales/Working Capital Interpretation (continued)

A relatively large ratio could mean that working capital is efficiently employed

Conversely, it could also mean that the firm is undercapitalized and is in danger of becoming non-liquid


Efficiency RatiosNet Sales/Working Capital

Capital WorkingSales Net

where

Working capital = Current Assets – Current LiabilitiesAgricultural Extension ServiceThe University of Tennessee

Profitability RatiosROR on Total Capital Income + loan interest obligations –

value of unpaid labor and management – business income taxes divided by total business assets

Interpretation The higher the value, the more

profitable the business


Profitability RatiosROR on Total Capital

AssetsBusiness TotalTaxes Business -

Labor Unpaid of Value

sObligation Interest Loan

Income


Profitability RatiosROR on Equity Capital Income – value of unpaid labor and

management – business income taxes divided by total business net worth

Interpretation The higher the value, the more

profitable the business


Profitability RatiosROR on Equity Capital

WorthNet Business TotalTaxes Business -

Labor Unpaid of Value

sObligation Interest Loan

Income


Economy & Finance

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