TiE Institute Session:Managing by the Numbers – Finance for Entrepreneurs

December 2012

Deciphering Financial Statements

and Ratios

© 2012 Deloitte Touche Tohmatsu India Private Limited 2

Agenda

• Financial Analysis

• Overview of Financial Statements

• Overview of Financial Ratios

• Performance Management

Introduction to Financial Analysis


Financial Analysis is an integral part of business …

Internal Analysis

Market/Competitor

Analysis

Strategic assessment of competitive environment

Strategic assessment of market potential

Summary of customer needs and demand drivers

Competitive cost analysis

Financial analysis and interpretation

Core competencies

Capability assessment

Key issues for consideration in strategy development

Identification and rapid implementation of savings opportunities

Option Development and Selection Scenario definition

and strategic vision

Scenario evaluations

Business case

development

Refined plans to

enhance short-term

value creation

Recommendations,

priorities, and guiding

assumptions

Action Planning

Strategy statement

Communication

process

Modification of current

initiatives/programs

and installation of

new programs

High-level action

plans

Performance target

setting

Diagnosis Strategy Development

Action Planning

Value Profiling

Total Shareholder Returns

Stock Price


Primary Financial objectives of Entrepreneurial Firms/New ventures

Profitability

A company’s ability to

make a profit

Liquidity

A company’s ability to

meet its short term

obligations

Efficiency

How Productively a

firm utilizes its assets

Stability

The overall health of

the financial structure

of the firm,

particularly as it

relates to its debt-to-

equity ratio

Many start‐ups are not

profitable during their first

one to three years while

they are training

employees and building

their brands

However, a firm must

become profitable to

remain viable and

provide a return to its

owners

Even if a firm is

profitable, it is often a

challenge to keep

enough money in the

bank to meet its routine

obligations in a timely

manner

However, a firm must

become profitable to

remain viable and

provide a return to its

owners

How productively a firm

utilizes its assets relative

to its revenue and its

profits

For a firm to be stable, it

must not only earn a

profit and remain liquid

but also keep its debt in

check

Sources: Premier in Entrepreneurship - University of Zurich


How does a business work in general?

Ultimately, the purpose of a business is to transform resources into cash.

Sources of funds to

acquire resources

(Liabilities)

Resources for creating

products (Assets)

Costs Revenues

Income

Financing

Inc

om

e D

istr

ibu

tio

n

Inc

om

e G

en

era

tion

To Creditors (interest

and principal payments)

To Owners (dividends

and capital gains)

From capital markets,

debt markets and

creditors

Turning assets into

revenue- generating

goods or services


Financial Analysis analyzes how well a business works

How efficiently is the company able to generate cash?

– How big is the company‟s cash flow “engine?”

– How efficiently can the engine generate cash? How many assets are required to generate a certain

amount of cash?

– Is the company getting better or worse at this over time?

How well is the company able to grow?

– What is the company‟s growth engine? Sustainable growth rate?

– How is growth being financed?

– What factors may limit growth? How much growth is „optimal‟?

How well is the company performing relative to peers or to the industry as a whole?

– Are Sales or COGS growing faster or slower than the industry/peers?

– How does the balance sheet look in comparison to peers?

– What level of profitability should be expected?

Overview of Financial Statements


Financial Statements: “The Big 3”

Reports the balance of assets, liabilities and equity at a

precise moment in time. Shows the financial condition

of the business.

Balance Sheet

Reflects the flow of funds received and paid out over a

period of time, typically one year. Shows changes in a

firm‟s investments and financial structure.

Cash Flow Statement

Summarizes revenues and expenses for a period of

time, typically one year. Reports the profit performance

of a business.

Income Statement

A financial statement is a written report that quantitatively describes a firm‟s financial health. The income

statement, the balance sheet, and the statement of cash flows are the financial statements entrepreneurs

use most commonly


Key Users of Financial statements In

tern

al U

se

rs

Exte

rna

l U

se

rs

Managers & Owners

Employees

Institutional Investors

Financial Institutions

Government

Vendors

General Mass & Media

Managers and owners need the financial reports essential to make business decisions

The financial statement is used to formulate contractual terms between the company and

other organizations

Immense use to the employees of the company for making collective bargaining

agreements

Such statements are used for discussing matters of promotion, rankings and salary hike.

Investors use the financial statements to assess the financial strength of a company

This would help them to make logical investment decisions

Key users are different financial institutions like banks and other lending institutions

Used for decision making to help the company with working capital or to issue debt

security to it

Organizations such as the Securities and Exchange Commission, government tax and

business licensing agencies

The financial statements of different companies are also used by the government to

analyze whether the tax paid by them is accurate and is in line with their financial strength

Major customers and suppliers, to evaluate the financial strength and staying power of the

company as a dependable resource for their business

The vendors who extend credit to a business require financial statements to assess the

creditworthiness of the business

The common people as well as media also make part of the users of financial statements

Rating agencies (such as Moody's, Standard & Poor's, and Dun & Bradstreet), to assign

credit ratings

Sources: Finance Maps of World


The Income Statement

The Income Statement shows how a company has performed over a given accounting period.

Sales

Gross

Profit

Cost of

Goods

Sold

Operating

Profit

(PBIT)

Expense

Net

Earnings

Interest & Tax

Retained

Earnings

Dividend

Reflects results of managing

the operations aspect of the

business

Retained for further

growth of the

company

Sales: The earnings of a company before any

costs or expenses are deducted. Includes all net

sales plus any other revenue associated with the

main operations

Costs and Expenses: Includes the cost of goods

sold (COGS); and salaries, commissions, and

travel expenses for executives and salespeople,

advertising costs, and payroll expenses (SG&A).

Operating Profit: Earnings before interest and

taxes (EBIT). Measures a company‟s earning

power from ongoing operations.

Interest expense: The expense incurred to cover

the interest on loans.

Net Earnings: Sales minus taxes, interest,

depreciation, and other expenses. Also called net

income, net profit, or bottom line.


Income statement Detail

Income Statement

(USD „000) 2011 2010 2009 Relationship to

Business Activities

Net Sales 5,450 5,273 4,847 Total sales, net of any returns or allowances

Cost of products sold 3,104 3,098 2,756 Number of units sold x cost per unit

Gross Profit 2,346 2,175 2,091 Profit before operating costs and expenses

Selling and administrative expenses 715 690 642 Sales and other overhead costs

Advertising costs 499 486 474 Sales & marketing costs

Research and development costs 114 111 108 R&D (investment in new technology/products)

Restructuring and asset impairment

costs

20 36 13 Restructuring costs – asset write-offs, relocation

expenses, severance costs, etc.

Interest expense 161 168 113 Payment for the interest on loans

Other expense (income), net 26 (9) (2) Miscellaneous income/expense

Earnings from continuing operations

before income taxes

811 693 743 Earnings before taxes

Income taxes on continuing operations 274 232 247 What the IRS takes

Earnings from continuing operations 537 461 496 Income from continuing ops

Earnings from discontinued operations - - 5 Income from discontinued ops

Net earnings 537 461 501 Net income

The 3 numbers namely net Sales, cost of sales and operating expenses (Advertising cost, administrative cost and

other expenses) receive the most attention when evaluating an income statement for an entrepreneurship firm


The Balance Sheet

The Balance Sheet presents a financial “snapshot.” It details where the company‟s money came from and

where it is deployed (at period end).

The balance sheet consists of Assets, Liabilities,

and Equity

– Assets always equal liabilities plus equity

Current Assets: The sum of cash and cash

equivalents, accounts receivable, inventory,

marketable securities, prepaid expenses, and

other assets that could be converted to cash in

less than one year.

Fixed Assets: includes Property, plant, and

equipment (PP&E)

Other Assets: Includes other assets such as

Intangibles

Current Liabilities: The sum of all obligations

owed by a company and due within one year.

Long-term: Debt not due to be paid within the

next year.

Shareholders equity: stock

Retained Earnings: Earnings not paid out as

dividends but instead reinvested in the core

business or used to pay off debt.

.

Current

Liabilities

Long-term

Liabilities

Shareholder‟s

Equity &

Retained

Earnings

Where the

money is

coming from

Where the

money is

going to

Current Assets

Fixed Assets

Other

Assets

Liq

uid

ity

Assets

Liabilities +

Shareholder

Equity

=


Balance Sheet Detail

Balance Sheet (USD „000) Cash and short-term equivalents

Net Receivables

Inventories

Other current assets

Total current assets

Property, plant, and equipment, net

Goodwill

Trademarks, net

Other intangible assets, net

Other assets

Total assets

Notes and loans payable

Current maturities of long-term debt

Accounts payable

Accrued liabilities

Income taxes payable

Total current liabilities

Long-term debt

Other liabilities

Deferred income taxes

Total liabilities

Stockholders‟ deficit

Total liabilities and stockholders‟ deficit

Current

Assets

Debt

Long -

Term

Assets

Declin

ing O

rde

r of L

iqu

idity

Uses of Working

Capital

Uses of Physical

and other Capital

Sources of

Working Capital

Sources of Long-

Term Capital

2010 214

505

384

150

1,253

960

1,658

560

123

158

$4,712

755

--

418

440

52

1665

2720

632

65

5,082

(370)

$4,712

2011 206

486

366

122

1,180

955

1,630

557

105

149

$4,576

421

577

381

472

86

1937

2151

640

23

4,751

(175)

$4,576


The Cash Flow Statement

The Cash Flow Statement is a statement presenting all of the cash received and paid during the year. It is

similar to a month‐end bank statement. It reveals how much cash is on hand at the end of the month as

well as how the cash was acquired and spent during the month

• These items primarily reflect the purchase and

disposal of assets used to generate revenues

• Useful for appraising the company‟s ability to pay

debts and dividends

Operating

Activities

Investing

Activities

Financing

Activities

Sources and Uses of Cash

• These items reflect sources of financing (e.g.,

debt and equity) as well as their repayment

• Useful for evaluating the company‟s requirements

for external financing

• Based largely on net income, these items reflect

money generated (and used) by operations

• Useful for assessing a company‟s ability to

generate future net cash inflows

Description Examples

Purchase of non-current

assets such as property and

equipment

Borrowing of funds (short- or

long-term) and sale of stock

Selling of and payment for

goods and services

The Cash Flow Statement helps us understand how much cash is available for future growth investments, after

operating expenses and financing obligations have been paid.


The Cash Flow Statement (contd.)

• The Cash Flow Statement is generated from the Income Statement and Balance Sheet

• The Cash Flow Statement adds a level of detail, however, including the following key items:

Depreciation

Working Capital

Amortization

Capital Expenditures

Dividends

Equity Repurchase /

Issuance

Debt Repayment /

Issuance

Net Income and Non-Cash Charges

(Income Statement) Cash Inflows / Outflows

(Cash Flow Statement)

Changes in Asset / Debt Levels

(Balance Sheet)

Operating Activities Investing Activities Financing Activities

Sale / Disposal of

Assets


Cash Flow Statement Detail

Cash from

Operations

Cash from

Investing

Cash from

Financing

Cash flow statement (USD „000) 2011 2010 2009

Operating activities

Net Earnings $ 537 $461 $501

Deduct: Earnings from discontinued operations - - 5

Earning from continuing operations 537 461 496

Depreciation and amortization 190 205 192

Share-based compensation 58 47 49

Deferred Income tax (1) (51) (19)

Asset Impairment cost 3 29 4

Changes in:

Receivables, net (2) (8) (15)

Inventories, net - (26) (8)

Other Current assets (4) 11 13

Accounts payable and accrued liabilities (40) 63 (30)

Income tax payable (6) (24) 11

Pension Contribution to qualified plans (30) - (10)

Net cash provided by operations 738 730 709

Investing activities

Capital expenditure (197) (170) (147)

Businesses Acquired - (913) (123)

Others - 1 2

Net cash used for investing activities (197) (1,082) (268)

Financing activities

Notes and Loan Payable, net (334) 681 (87)

Long-term debt borrowings 11 1,256 -

Long-term debt repayments - (500) (150)

Treasury stock purchased - (868) (155)

Cash dividends paid (258) (228) (183)

Issuance of common stock for employees stock plan and others 41 39 119

Net cash (used for) provided by financing activities (540) 380 (456)

Effect of exchange rate changes on cash and cash equivalents (9) 4 5

Net (decrease) increase in cash and cash equivalents (8) 32 (10)

Cash and cash equivalents: Beginning of year 214 182 192

Cash and cash equivalents: End of year $206 $214 $182


Financial Statement Linkages

Understanding the linkages between specific accounts first requires an understanding of the approach

of the core statements

Income

Statement

“Flow” of revenues and

costs over a period of time

Sums of transactions (e.g.,

net revenue, cost of goods

sold)

Period of time

(e.g., quarter, year)

Balance

Sheet

“Static snapshot” of

balances at a specific point

in time

Ending account balances

(e.g., cash, accounts

receivable)

Specific date

(e.g., quarter ending 3/31, year

ending 12/31)

Cash Flow

Statement

“Flow” of physical cash

over a period of time

Changes between beginning

and ending period balances

of each account (e.g., net

income, working capital)

Period of time

(e.g., quarter, year)

Statement Description Information Timing

Understanding how the core statements are intricately linked is necessary for performing financial analysis

Balance sheet at beginning of period plus/minus items on income statement leads to balance sheet at end of period

Cash flow statement shows net-income and non-cash charges from the income statement and changes in asset/debt

levels from period beginning and period ending balance sheets

Financial Ratios


Financial Ratios

Performance Ratios

• Return on Equity (ROE)

• Return on Net Assets (RONA)

• Gross Profit Margin, Operating Profit

Margin, Net Profit Margin

• Asset Turnover

• Inventory Turnover

• Receivables Turnover

• Days Sales Outstanding (DSO)

Also called Growth and Profitability metrics.

Used to set goals and measure performance against

them. Range from general indicators to industry-

specific ratios.

Measure a company‟s ability to earn a return on

investment and the company‟s efficiency in turning over

its assets.

Solvency Ratios

• Debt Ratio

• Debt to Equity Ratio

• LT Debt to Capitalization Ratio

• Interest Coverage Ratio

• Payables Coverage Ratio

Calculations that help to demonstrate the ability of a

firm to cover its liabilities as they come due.

Measure of how much a company is relying on

creditors to fund required asset levels at any point in

time.

Liquidity Ratios

• Current Ratio

• Quick Ratio

• Working Capital Ratio

• Cash Flow Ratio

Availability of cash or near-cash assets for the purpose

of meeting obligations.

Measure a company‟s ability to pay maturing

obligations.

Investment Ratios

• Earnings Per Share (EPS)

• Price/Earnings (P/E) Ratio

• Dividend Yield

• Dividend Cover

Also called Market Ratios, reflect performance of the

shareholders‟ investment in terms of stock price

performance and dividend activity.


Performance Ratios

Ratio Explanation Calculation Desired Value

Return on Equity Return generated on a shareholder‟s investment. NET INCOME

AVG TOTAL EQUITY

Return on Net Assets

(RONA) Percent return on money tied up in a business.

EBIT

AVG NET ASSETS

Gross Profit Margin

Indicates the proportion of sales that contribute to

fixed costs and profits, as opposed to variable

costs.

GROSS PROFIT

SALES

Operating Profit Margin Indicates margin for operating activities, not

including interest or tax expense.

EBIT

SALES

Net Profit Margin Calculates the total margin including all expenses. NET INCOME

SALES

Fixed Asset Turnover Indicates how well fixed assets are used to

generate sales.

SALES

AVG FIXED ASSETS

Total Asset Turnover Indicates how well a company uses all of its assets

to generate sales.

SALES

AVG TOTAL ASSETS

Inventory Turnover

Indicates how quickly a company sells its inventory

items. Measured in terms of how many times an

item is sold in a period (typically yearly).

COGS

AVG INVENTORY

Receivables Turnover Demonstrates company‟s ability to collect

receivables quickly.

SALES (on account)

AVG RECEIVABLES

Days Sales

Outstanding (DSO)

Shows both the average time it takes to turn the

receivables into cash and the age, in terms of

days, of a company's accounts receivable

RECEIVABLES * No. of Days

TOTAL CREDIT SALES


Solvency Ratios


Debt Ratio Calculates the percentage of the company‟s assets

that are financed by debt.

TOTAL LIABILITIES

TOTAL ASSETS

Debt to Equity Ratio

Indicates the amount of debt held by a company

relative to the funding provided by the

shareholders.

TOTAL LIABIILITIES

TOTAL EQUITY

LT Debt to

Capitalization Ratio

Separates long-term debt and compares it to

company‟s total capital.

LONG TERM DEBT

LTD + TOTAL EQUITY

Interest Coverage Ratio

Indicates the size of the interest expense relative

to earnings by showing the number of times that

earnings will “cover” interest expenses in a year.

EBIT

INTEREST EXPENSE

Payables Coverage

Ratio

Indicates the size of the payables expense relative

to earnings by showing the number of times that

earnings will “cover” payables.

EBIT

ACCOUNTS PAYABLE


Liquidity Ratios


Current Ratio

Indicates short-term liquidity by comparing

obligations due within one year with assets that will

turn into cash within one year.

CURRENT

ASSETS

CURRENT LIABILITIES

Quick Ratio

Similar to the Current Ratio, but a more

conservative view. The numerator here excludes

inventory.

QUICK ASSETS

CURRENT LIABILITIES

Working Capital Refers to capital available to address immediate

operating needs of the company.

CURRENT ASSETS

CURRENT LIABILITIES

Cash Flow Ratio

Compares average liabilities due within one year

to cash generated in the course of a year by

operations.

CASH + M/S + CFO

CURRENT LIABILITES


Investment Ratios


Earnings Per Share Provides a measure of firm profitability.

NI – PFD DIV

AVG # SHARES

(COMMON)

P/E Ratio

Used to understand the relationship of the market

price for a share of stock and the earnings

generated by the share.

MKT PRICE (COMMON)

EPS (COMMON)

Dividend Yield

Provides a view of the share performance in terms

of dividends paid versus the current market price

of the share.

DIVIDENDS

MKT PRICE

Dividend Cover

A measure of how much of the retained earnings

are being reinvested versus paid out to

shareholders.

EPS

DIVIDENDS PER SHARE


Financial Ratio Analysis: Five Caveats

1. Be selective in your choice of ratios. Know what you are measuring, and why that measure

is important to the company.

2.

Ratios may have more than one name and more than one definition. Return on Capital is

the same as Return on Net Assets; Accounts Receivable Days on Hand (ARDOH) is the same

as Average Collection Period. There are often different ways of calculating the same ratio.

3.

Take ratios at face value, but be aware that they may be subject to accounting

distortions. Pay attention to the financial footnotes and any irregular items that may or may

not have been included in the numbers.

4. Use ratios with care. Always compare “like” with “like,” and realize different industries may

have very different characteristics.

5.

Ratios, like financials, must not be looked at in isolation. Identifying trends or making

comparisons is where you get value and understanding. Individual ratios, with no frame of

reference, are meaningless.


Value framework for Performance Management


Illustrative Performance Metrics

Focus Area KPIs

Asset / Capital Efficiency

Cash Flow

Focus Area KPIs

Shareholder Return

People

Total Shareholder Return

ROIC

Cash Conversion Days

Income Statement Balance Sheet / Statement of Cash Flows

Other

Free Cash Flow

Employee Loss

Bench Strength1

11)

12)

13)

14)

15)

16)

Focus Area KPIs

Sales

1) Organic Sales Growth

2) Unit Volume Growth

3) Key Brand Sales Focus

Innovation

4) New Product Sales

Performance

5) New Product Pipeline Strength

Pricing Strength 6) Key Brand Price per Pound

Gross Profit 7) Gross Profit Margin

Consumer

Investment 8) Consumer Investment Level

SG&A 9) SG&A Efficiency

Operating Income 10) Operating Margin

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Economy & Finance

TiE Institute Session:Managing by the Numbers – Finance for Entrepreneurs