Financial Accounting Management Financial Statements for Management and Operations

Our Focus The main focus of this course is to analyze and use financial statements for the purposes of: Speaking with lenders Internal management Tax returns

The Basic Financial Statements You should prepare and understand three basic financial statements: the balance sheet, which is a record of assets, liabilities and capital at a specific point in time; the income (profit and loss) statement, which is a summary of your earnings, expenses and net profit (or loss) over a given period of time; and the cash flow projection, which shows the actual inflows and actual outflows of cash into and out of your business.

The Balance Sheet The balance sheet is a snapshot of the company's financial standing at an instant in time. The balance sheet shows the company's financial position, what it owns (assets) and what it owes (liabilities and net worth). The "bottom line" of a balance sheet must always balance (i.e. assets = liabilities + net worth). The individual elements of a balance sheet change from day to day and reflect the activities of the company.

The Balance Sheet Assets represent the company's use of funds. The company uses cash or other funds provided by the creditor/investor to acquire assets. Assets include all the things of value that are owned or due to the business. Liabilities represents a company's obligations to creditors while net worth represents the owner's investment in the company.

Current Assets Current assets are those which mature in less than one year. They are the sum of the following categories: Cash Accounts Receivable (A/R) Inventory (Inv) Notes Receivable (N/R) Prepaid Expenses Other Current Assets

Fixed Assets Fixed assets represent the use of cash to purchase physical assets whose life exceeds one year. They include assets such as: Land Building Machinery and Equipment Furniture and Fixtures Leasehold Improvements

Calculating Fixed Assets When a fixed asset is purchased for use in the operations of the business it is recorded at cost. As the asset wears out, an amount is charged to expense and accumulated annually in a contra- account known as accumulated depreciation. The gross fixed asset (purchase price) less the accumulated depreciation equals the Net Fixed Asset Value (also known as book value). Gross Fixed Assets (Purchase Price) - Accumulated Depreciation = Net Fixed Assets (Book Value)

Intangibles Intangibles represent the use of cash to purchase assets with an undetermined life and they may never mature into cash. For most analysis purposes, intangibles are ignored as assets and are deducted from net worth because their value is difficult to determine. Intangibles consist of assets such as: Research and Development Patents Market Research Goodwill Organizational Expense

Current Liabilities Current liabilities are those obligations that will mature and must be paid within 12 months. Current liabilities consist of the following obligation accounts: Accounts Payable -- Trade (A/P) Accrued Expenses Notes Payable -- Bank (N/P Bank) Notes Payable -- Other (N/P Other) Current Portion of Long term Debt

Non-Current Liabilities Non-current liabilities are those obligations that will not become due and payable in the coming year. There are three types of non- current liabilities, only two of which are listed on the balance sheet: Non-current Portion of Long Term Debt (LTD) Subordinated Officer Loans (Sub-Off) Contingent Liabilities

Equity Equity or Net Worth represents the owners‘ share in the financing of all the assets. It consists of two types of equity; purchased equity, and earned equity. Purchased equity consists of: Preferred Stock (P/S) Common or Capital Stock (C/S) Paid in Capital

The Income Statement The Income Statement is also known as the “P&L” (Profit and Loss) A company's income statement is a record of its earnings or losses for a given period. It shows all of the money a company earned (revenues) and all of the money a company spent (expenses) during this period.

An Example Income Statements for the Years Ending 2003 and 2004 Sales $800,000 $850,000 Less Cost of Goods Sold (200,000) (250,000) Gross Profit on Sales 600,000 600,000 Less General Operating Expenses (180,000) (200,000) Less Depreciation Expense (50,000) (50,000) Operating Income 370,000 350,000 Other Income 60,000 90,000 EBIT 430,000 480,000 Less Interest Expense (50,000) (30,000) Less Taxes (50,000) (60,000) Net Earnings 330,000 390,000 Less Dividends Paid (70,000) (80,000) Retained Earnings 260,000 310,000

Explanations Gross Profit on Sales = Gross Margin GPS = NS – COGS Operating Income = GP – OE – Depreciation EBIT (Earnings Before Interest & Taxes) = OE +/- OI(OL) +/- Extraordinary Income/Loss

Explanations Net Earnings (Loss) = EBIT – Interest – Taxes Retained Earnings = Net Earnings - Dividends

Statement of Cash Flow Cash flow from an operating perspective is most important for the business manager/owner in a small privately-held company. It is critical to operate "profitability" and not operate with negative or break-even cash- flow. Therefore, managing cash-flow is critical.

Statement of Cash Flows The statement of cash flow reports the movement of cash into and out of a business in a given year. Cash Flow Statements are broken down into three sections: Operating activities Investing activities Financing activities

Cash Receipts Cash Receipts from Customers: Net Sales + Beginning A/R (1/1/00) - Ending A/R (12/31/00) = Cash Receipts from Customers

Cash Payments for Inventory Cash Payments for Inventory: Ending Inventory (12/31/00) - Beginning Inventory (1/1/00) + Beginning A/P (1/1/00)- Ending A/P (12/31/00) = Cash Paid for Inventory

Cash Paid for Operating Expenses Cash Paid for Operating Expenses: Operating Expenses – Depreciation Expenses + Ending Prepaid Expenses – Beginning Prepaid Expenses + Beginning Expenses Payable – Ending Expenses Payable = Cash paid for Operating Expenses

Cash Paid for Interest Expense Cash Paid for Interest Expense: Interest Expense per P&L + Beginning Interest Payable - Ending Interest Payable = Cash Paid for Interest Expense

Net Cash Provided (Used) by Operating Activities A company generates cash from operating its business. A key number is net Cash provided from operating activities. This total includes some items from the statement of earnings; such as: net earnings, showing the company’s profit (or loss); and depreciation expense. Net cash provided from operating activities also includes changes in some items from the statement of financial position: Inventory changes. (Increases in inventories use cash and reductions provide cash). Changes in accounts receivable, the sales the company has not yet been paid for. (Increases use cash and decreases provide cash). Changes in accounts payable. (Increases provide cash and decreases use cash). The statement of cash flows adds the net cash from each type of operating activity and reports the company’s total net cash provided (or used) by all operating activities.

Net Cash Provided (Used) by Investing Activities might include investments in property (land), plant (factories and assembly plants) and equipment (machines, trucks, computer systems, telephone systems). Investing in such assets is a use of cash. selling them is a source of cash. The Statement of Cash Flows adds the net cash From each type of investing activity and reports the company’s total net cash provided (or used) by all investing activities.

Working Capital Working Capital = Current Assets – Current Liabilities. Working Capital measures how much the Company has in liquid assets to grow its business.

Net Cash Provided (Used) by Financing Activities includes the sources and uses of cash for financing activities. Sources of cash include what a company raises by selling stocks and bonds and by borrowing from banks. The Statement of Cash Flows adds the net cash From each type of financing activity and reports the company’s total net cash provided (or used) by all financing activities.

Sources of Working Capital Sources of additional working capital include the following: Existing cash reserves Profits (when you secure it as cash !) Payables (credit from suppliers) New equity or loans from shareholders Bank overdrafts or lines of credit Long-term loans

Some Ratios Liquidity Ratios - a company's ability to meet its short-term obligations Current Ratio = current Assets/current liabilities Acid Test (Quick Ratio - no inventory) = current assets-inventory/current liabilities Working Capital = current assets -current liabilities (how much cash is available to grow the company)

Some Ratios There are many ratios that can be used to analyze a company's financial position. Profitability Ratios - the primary measure of a company's success. These include: Return on Equity = earnings after taxes/equity Return on Assets = earnings after taxes/total assets Return on Sales = earnings after taxes/total sales

More Profitability Ratios A profit margin measures how much a company earnings relate to its sales. A net profit margin measures earnings after taxes. The return on assets (ROA) is a snapshot of the performance of the management of the company (not from a stockholder perspective). The return on equity (ROE) is important from a stockholder perspective.  

Leverage Ratios How much debt is a company using to support its obligations? What is the debt to equity? The debt to equity (debt or financial leverage) ratio indicates the extent to which the business relies on debt financing. Upper acceptable limits of the debt to equity (debt or financial leverage) ratio is usually 2:1; with no more than one-third of debt in long-term borrowings. A high financial leverage or debt to equity ratio indicates possible difficulty in paying interest and principal while obtaining more funding. Make sure the leverage ratios are as low as possible.

Summary The financial accounting principles in this course are important to understand terminology and build a foundation to understanding financial statements. It is important to understand a company's profitability, its earning power and control over expenses. Is a company managing its operations correctly? What is the current status of the cash flow management of the company and how does it relate to operations and management?