1. 1 Chapter Eleven Lecture Notes Financial Statement Analysis

2. 2 Financial Analysis n Financial analysis uses the financial statements and other sources of information to: - help managers and outsiders understand an organization's financial condition, - make decisions about the organization, and - compare an organization's financial performance to its peers. n Analysis of just financial statements rarely gives a final answer. Rather, it indicates where further analysis is needed!

3. 3 Financial Analysis Mission 1. Is the organization meeting its mission? 2. Doing too little or too much? 3. Does resource use match goals? 4. Is the organization effective? Viability 1. Liquidity? 2. Solvency? 3. Income Concentration? 4. Matched maturities for sources & uses of funds? 5. Efficiency? (Unit Costs) 6. Costs appropriate? 7. Other organization-specific considerations ? Financial Analysis tries to answer a series of questions about an organization's mission, financial stability, and operating results.

4. 4 The Financial Analysis Process n Read the auditor's opinion, the notes to the financial statements, and the financial statements themselves and extract as much information as possible. Look for potential problem areas! n Prepare the appropriate ratios and analyze. n Whenever possible get comparative data: - for the organization over time, - for the organization's peers, and - for the industry. n Organize the information and complete the analysis.

5. 5 Step One Read the Auditor's Opinion n The Auditor's Opinion: d escribes the type of work that the Certified Public Accountant did: – audits involve a statistical review of transactions and the systems that the organization uses;Boston – compilations involve the preparation of the statements; and – reviews involve checking management-prepared statements for form and accuracy. Chicago  Audit opinion may be unqualified, qualified, or adverse.  Pensacola, GM

6. 6 Step Two - Review the Notes n The notes to the financial statements are an integral part of the statements. They: -describe the accounting policies that the organization has used, -highlight any unusual and material event that may have occurred during the year, -provide further detail regarding material assets and liabilities, and -provide additional detail as required by GAAP (GAAP of full disclosure).

7. 7 Step Three - Analyze the Statements Review each financial statement to get a general sense of the types of accounts and the magnitude of each. BALANCE SHEET ASSETS20122011 Current Assets Cash$ 100$ 3,100 Marketable Securities3,000 Accounts Receivable, net55,00038,000 Inventory2,0004,000 Prepaid Expense 1,000 0 Total Current Assets$61,100$48,100 Long-term Assets Cash Restricted for LT Asset Acquisition$ 900 Fixed Assets Property40,000 Equipment, net35,00045,000 Investments 8,000 12,000 Total Long-term Assets$ 83,900$ 97,900 Total Assets$145,000$146,000

8. 8 Step Four - Calculate Ratios n What are ratios? Why are ratios used? n Ratio Cautions: - Ratios must be used together and with the financial statement data to develop a pattern. No one ratio is sufficient! - GAAP may make comparisons difficult across organizations. - Ratio analysis should be focused on potential problems. Ratios are not calculated for their own sake. - Ratios that are useful for health and not-for-profit organizations may not be appropriate for governments. - Use common sense! Focus on the order of magnitude of the ratio, rather than on carrying the calculation out many decimal places. - Think about what the ratio means. Should it be higher or lower than the average? Rising or falling? Ratios need to be compared to something; they do not exist in a vacuum!!

9. 9 Types of Ratios Common Size Ratios ~ vertical analysis Liquidity Ratios Asset Turnover or Efficiency Ratios Leverage and Coverage Ratios Profitability Ratios?? Functional Expense Ratios

10. 10 Common Size Ratios n Common Size Ratios compare all of the numbers on a financial statement to one key number. Why are common size ratios useful? Organization A Organization B Cash $10,000 too low?$100,000 too high? Cash 10,000 100,000 ----------------- = ---------- x 100% = 20% ----------- x 100%= 1% Total Assets 50,00010,000,000

11. 11 Common Size Ratios BALANCE SHEETPercent ASSETS2012of Total2011of TotalChange Current Assets Cash$ 1000.1%$ 3,1002.1%-96.8% Marketable Securities3,0002.1%3,0002.1%0.0% Accounts Receivable, net55,00037.9%38,00026.0%44.7% Inventory2,0001.4%4,0002.7%-50.0% Prepaid Expense 1,000 0.7% 0 0.0% NA Total Current Assets$ 61,10042.1%$ 48,10032.9%27.0% Long-term Assets Cash Restricted for LT Asset Acquisition$ 9000.6%$ 9000.6%0.0% Fixed Assets Property40,00027.6%$ 40,00027.4%0.0% Equipment, net35,00024.1%45,00030.8%-22.2% Investments 8,000 5.5% 12,000 8.2%-33.3% Total Long-term Assets$ 83,900 57.9%$ 97,900 67.1%-14.3% Total Assets$145,000100.0%$146,000100.0% -0.7%

12. 12 BALANCE SHEETPercent LIABILITIES AND NET ASSETS2012of Total2011of TotalChange Current Liabilities Wages Payable$ 2,0001.4%$ 3,0002.1%-33.3% Accounts Payable2,0001.4%3,0002.1%-33.3% Notes Payable6,0004.1%5,0003.4%20.0% Current Portion of Mortgage Pay. 4,000 2.8% 5,000 3.4% -20.0% Total Current Liabilities$ 14,000 9.7%$ 16,000 11.0% -12.5% Long-term Liabilities Mortgages Payable$ 12,000 8.3%$ 16,000 11.0% -25.0% Total Long-term Liabilities$ 12,000 8.3%$ 16,000 11.0% -25.0% Total Liabilities$ 26,00017.9%$ 32,000 21.9% -18.8% Net Assets Unrestricted$ 84,10058.0%$ 85,10058.3%-1.2% Temporarily Restricted4,9003.4%1,9001.3%157.9% Permanently Restricted 30,000 20.7% 27,000 18.5% 11.1% Total Net Assets$119,000 82.1%$114,000 78.1% 4.4% LIABILITIES AND NET ASSETS$145,000100.0%$146,000100.0% -0.7%

13. 13 ACTIVITY STATEMENT Changes in Unrestricted Net Assets 2012% ofTotalRev2011 % of Total % Change Revenues and Support Client Revenue$ 11,0005.8%$ 9,0005.0%22.2% City Revenue20,00010.5%16,0008.9%25.0% County Revenue10,0005.3%10,0005.6%0.0% Foundation Grants60,00031.6%50,00027.8%20.0% Annual Ball12,0006.3%11,0006.1%9.1% Contributions 65,000 34.2% 73,000 40.6%-11.0% Total Revenues and Support$178,000 93.7%$169,000 93.9% 5.3% Net Assets Released from Restrictions Satisfaction of Program Restrictions$ 10,0005.3%$ 10,0005.6%0.0% Satisfaction of Time Restrictions 2,000 1.1% 1,000 0.6%100.0% Total Net Assets Released from Restrictions$ 12,000 6.3%$ 11,000 6.1% 9.1% Total Unrestricted Revenue and Support$190,000100.0%$180,000100.0% 5.6% Expenses Meals$ 67,00035.3% $ 63,00035.0%6.3% Counseling35,00018.4%34,00018.9%2.9% Administration, Fund Raising and General75,00039.5%65,00036.1%15.4% Bad Debts4,0002.1%4,0002.2%0.0% Depreciation 10,000 5.3% 10,000 5.6% 0.0% Total Expenses$191,000100.5%$176,000 97.8% 8.5% Increase in Unrestricted Net Assets$ (1,000) -0.5%$ 4,000 2.2%-125.0%

14. 14 Liquidity Ratios Liquidity Ratios focus on whether an organization has enough cash and liquid resources to meet near-term obligations. Current Assets Current Ratio = ------------------------ Current Liabilities Can we meet our current obligations as they come due? What does a current ratio of 1.0 mean?

15. 15 Cash + Marketable Securities + A/R Quick Ratio = ------------------------------------------------ Current Liabilities Can we meet our current obligations out of liquid resources? How does the current ratio differ from the quick ratio?

16. 16 Cash + Marketable Securities Days of Cash on Hand = ------------------------------------------- (Operating Expenses- Depreciation)/365 Can we handle a collection crisis?

17. 17 Leverage and Coverage Ratios Leverage and Coverage Ratios focus on the use of debt and an organization's ability to pay that debt back. What is the difference between a leverage ratio and a coverage ratio? Why is debt a double-edged sword? Total Debt Debt to Assets =--------------------  Total Assets What portion of total assets were paid for with debt?

18. Increase in Net Assets Before Times Interest Expense Interest Earned = --------------------------------------- Interest Expense Revenue $800 Interest Expense 200 Other Expenses 400 Increase in Net Assets$200 Note that times interest earned is 2.0, not 1.0!!! Do we have enough money to pay interest expenses? 18

19. 19 Cash Flow from Operations + Interest & Rent Cash-Flow Coverage = -----------------------------------------------  Interest, Rent & Debt Payments Do we have enough cash flow to pay debt service and leases?

20. 20 Profitability Ratios Profitability Ratios compare the various measures of profit with revenue and support. Should not-for-profits focus on profitability? Perhaps more useful is to focus on the sources of revenue as ongoing versus one-time Also helpful to focus on functional expense breakdown

21. 21 Program Expense Ratio Program Services Expenses Program Exp. Ratio = --------------------------------------- Total Expenses What portion of our expenses are dedicated to operating programs? Hopefully a large proportion!

22. 22 Mgt. & General Expense Ratio Mgt & General Expenses Mgt. & General Exp. Ratio = --------------------------------------- Total Expenses What portion of our expenses are dedicated to “overhead”?

23. 23 Fund-raising Expense Ratio Fund-raising Expenses Fund-raising Exp. Ratio = --------------------------------------- Total Expenses What portion of our expenses are dedicated to fund-raising?

24. 24 Step Five - Get Comparative Data n Compare the ratios to: -the organization over time, (horizontal analysis) -comparable organizations, and -the industry. n Focus on trends: -should the ratio be higher or lower than average? -is it better for the ratio to be increasing or decreasing? n Remember that it is hard to find exact comparables. Use common sense!

25. 25 Step Six - Complete the Analysis n Identify red flags in the data! n When you think that you see a problem, ask why it is happening and find data to either support or refute your beliefs. n Organize the data to find patterns! n Periodically step back and summarize what you have found. n Focus your final analysis on the big picture. Don't get caught up in irrelevant details!

26. Budgeting Will be discussed separately! 26