Introduction to financial statements - Chase Morrison
Introduction To Financial StatementsValley Economic Development Center Presented By Chase 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 SheetsCategorizes what a company owns and what it owes What a company owns What it owes (& to whom) Liabilities – Third-party obligations: Assets -- The non-people • Vendors (AP) related resources needed to • Lenders (Debt) generate revenue, including: • Employees (Accruals) • Cash = + • Receivables Equity – Stakeholder’s • Inventory • Equipment ownership in business • Intellectual Property • Owners • Shareholders • Partners Connecting things (or assets) People (or investors, vendors, to… lenders & employees)
A few words about cash vs. accrual basisaccounting• 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
Assets – What a Company Owns• Resources needed to ASSETS generate revenue Current Assets Checking & Savings 25,802 More Liquid --- Less Liquid• Split into current (to Accounts Receivable 93,752 Inventory 154,754 Prepaids 0 be used in < 1 year) Other Current Assets Total Current Assets 20,000 294,308 and long term (> 1 Long Term Assets year) Fixed Assets Equipment 64,700• Ordered by liquidity Depreciation -923 Total Fixed Assets 63,777 Other Assets 0• Asset test: Can you Total LT Assets 63,777 convert item to cash? TOTAL ASSETS 358,084
Liabilities & Equity – Who a Company Owes• Liabilities – Claims on company assets by outsiders LIABILITIES – Like assets, split into current and Current Liabilities long term Accounts Payable 91,418 – Ordered by when payments are Credit Cards 657 Payroll Liabilities 1,306 due Line of Credit 3,739 Total Current Liabilities 97,121• Equity – Claims on company assets by stakeholders, after Long Term Liabilities None liabilities are paid – Two categories: Equity (or paid in EQUITY capital) and Retained Earnings Owners Equity 166,640 – Paid in capital is the capital Retained Earnings investment made by the Prior Year RE 5,634 Current Year RE 88,690 company’s owners Total Equity 260,964 – Retained earnings is the accumulation of net income, net of TOTAL LIABILITIES & EQUITY 358,084 any dividends. Since no dividends are paid, RE is the sum of the ITD net income.
Two quick things we can learn from ourbalance 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) = 1.23 This 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.
Typical P&L Composition Income StatementRevenue 486,526 Revenue: Value of goods and services invoiced or billedCost of Goods Sold Standard Cost 267,185 Cost of Goods Sold: Represents cost of goods or Period Expenses 21,200 Other Adjustment 924 services delivered on revenue row. Includes material, Total Cost of Goods Sold 289,309 labor and overhead.Gross Profit 197,218GP Margin % 40.5% COGS: Net of revenue and cost of goods.Operating Expense Advertising Expense 1,825 Licenses & Fees 710 Car & Truck Expense 13,810 Conferences & Seminars 575 Operating Expense: Related business costs not directly associated with the product or service. Wages Examples include distribution, selling, marketing, Salary & Wages 28,725 Employee Benefits 5,175 administrative and product development expenses. Total Wages 33,900Total Operating Expense 106,291Total Operating Income/(Loss) 90,926 Operating Income: Net of gross profit and operatingOperating Margin % 18.7% expense.Other Income/Expense Interest Expense 2,236 Other I/E: Income & Expense unrelated to revenue Total Other Income/Expense -2,236 generating activitiesNet Income 88,690 Net Income: Final income after all expenses,Return On Sales % 18.2% including tax
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 ASSETS Current Assets YE 2010 YE 2011 Checking & Savings 77,638 25,802 CF Statement bridges $52K YOY use of cash• 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
How to derive cash flow (Indirect) Prior Current Period Period Cash Flow CalculationNet 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 $XXXXTOTAL 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
Typical Cash Flow Statement OCF + ICF + FCF = Periodic Cash Flow (Change in Cash) Or Beginning 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 togetherFinancial 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 customer1More 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 = FinancialPlanning• 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 sales 1) Increase prior-year total units by some % and adjust selling prices 2) Use #1, but do it for each product 3) Forecast sales by customer• Methodologies for time phasing sales 1) Divide by 12 2) 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 sales 2) Create standard unit costs and multiply product unit volumes from sales plan• Methodologies for expenses 1) % of sales 2) Fixed by month using prior year 3) Expenses as % of another expense 4) Expense by category using vendor detail from prior year
Financial Planning – Balance Sheet• Methodologies for accounts receivable 1) Use DSR methodology, basing projection on most recently quarterly performance 2) 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 inventory 1) DIOH methodology, basing project on cost of sales plan 2) Develop more complex model segregating RM, WIP & FG.• Methodologies for fixed assets 1) 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 expenses 2) 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 Like Actual Plan Year 2010 Year 2011 Year 2012 Year 2013 Year 2014 Revenue $12 $487 $525 $573 $601 Cost of Goods $6 $289 $310 $344 $343 Gross Profit $6 $197 $215 $229 $259 Operating Expense Wages $0 $34 Insurance $0 $28 Income Statement Travel $0 $2 Supplies $0 $3 Professional Services $0 $4 Facilities $0 $11 Depreciation $0 $1 All Other $0 $23 Total Op Expense $0 $106 $110 $109 $132 Op Income $6 $91 $105 $120 $126 Other I/E $0 $2 $2 $2 $2 Net 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% Assets Cash $78 $26 $40 $32 $92 Accts Receivable $12 $94 $133 $288 $297 Inventory $220 $155 $195 $215 $211 Other Cur Assets $1 $20 $20 $20 $20 Current Assets $311 $294 $389 $555 $620 Equipment $62 $65 $125 $135 $145 Balance Sheet Accum Depr $0 -$1 -$25 -$27 -$29 Total Assets $373 $358 $489 $663 $736 Liabilities & Equity AP $3 $91 $75 $81 $85 Other Liabilities/Debt $63 $6 $50 $100 $45 Total Liailities $66 $97 $125 $181 $130 Equity $302 $167 $167 $167 $167 Retained 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 CF Net Income $6 $89 $103 $118 $124 Accts Receivable -$12 -$82 -$40 -$155 -$9 Inventory -$220 $65 -$41 -$19 $3 Other OCF Assets -$1 -$19 $0 $0 $0 Cash Flow Statement AP $3 $88 -$17 $6 $4 Total OCF -$224 $142 $6 -$50 $123 Investing CF Fixed Assets -$62 -$3 -$60 -$10 -$10 Accum Depreciation $0 $1 $24 $2 $2 Total ICF -$62 -$2 -$36 -$8 -$8 Financing CF Debt $63 -$57 $44 $50 -$55 Investing/Draw $302 -$135 $0 $0 $0 Total FCF $364 -$192 $44 $50 -$55 Change In Cash $78 -$52 $14 -$8 $60
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.
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 ratios Metric 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 Net Income / Assets Measures company’s ability to produce profitable sales using the Assets Employed) available assets. Fixed Asset Turnover Sales / Gross Fixed Assets Asset management ratio measuring how well fixed assets are being used to “throw off” sales.