MB105 Ch14 Understanding Financial Statements

3. DAY'S INVENTORY

= 365 Days/Inventory Turnover; Shows the actual number of day that the organization's products sit in inventory

1. DAYS RECEIVABLE

= Accounts Receivable/Average Day's Sales where AVERAGE DAY'S SALES = Net Annual Sales/365 Days; Shows the number of days it takes to convert accounts receivable to cash

1. CASH FROM OPERATIONAL ACTIVITIES

= Adjustments to net income to reflect the actual cash provided by operating activities

2. CAPITAL ASSET TRANSACTIONS

= Are decisions that managers make with respect to investment and divestment of capital assets (buildings, equipment, subsidiaries) that may be needed, or are no longer needed, as part of the organization's business system

DESIGNATED RESTRICTED ASSETS

= Assets that have been earmarked for a specific purpose and that are not available for managers to support organizational operating needs; such funds are not viewed as part of the organization's current asset base

2. INVENTORY TURNOVER

= Cost of Goods Sold/Average Inventory; Shows the ability of a company to turn its inventory into cash

1. CURRENT RATIO

= Current Assets/Current Liabilities; Shows the relationship between current assets and current liabilities

5. EARNINGS BEFORE INTEREST & TAXES (EBIT)

= Determined by subtracting general operating expenses from the gross profit margin

3. TIMES INTEREST EARNED RATIO

= Earnings Before Interest and Taxes (EBIT) / Interest Expense; Assesses the ability of the business to at least meet its interest obligation on the debt it has taken on

4. EARNINGS PER SHARE (EPS)

= Net Income/# of Shares Outstanding; Shows the return recognized by individual investors for each share they own

1. RETURN ON SALES (ROS)

= Net Income/Net Sales; Identifies the percentage of sales that actually represents profit

2. RETURN ON ASSETS (ROA)

= Net Income/Total Assets; Identifies how productive the deployment of assets was in producing income

3. RETURN ON EQUITY (ROE)

= Net Income/Total Equity; Shows the amount of income earned for each dollar of invested capital

2. DEBT TO EQUITY RATIO

= Total Liabilities/Total Equity; Calculates the amount of money borrowed to fund creation of the asset base against investor financing

3. CASH FROM INVESTING ACTIVITIES

= Uses of Cash flowing out of the organization from non-operating activities

2. QUICK (OR ACID TEST) RATIO

= [Cash + Marketable Securities + Accounts Receivable] / Current Liabilities; Determines the organization's ability to meet current obligations strictly from its immediate cash position

3. SOLVENCY RATIO

= [Net Income + Depreciation] / Total Liabilities; Assesses the organization's ability to meet its long term financial obligations; as a general rule, this ratio should be equal to or greater than .20 (varies by industry)

6. INTEREST EXPENSE

= The interest payments due on debt incurred

Components of the Balance Sheet

1. ASSETS 2. LIABILITIES

4. NET CHANGE IN CASH POSITION

= The net movement in the cash position of the organization based on operating, financing and investing activities

4. Absolute Analysis

- Examination of the specific dollar amount of financial resources available

Components of the Cash Flow Statement

1. CASH FROM OPERATIONAL ACTIVITIES 2. CASH FROM FINANCING ACTIVITIES 3. CASH FROM INVESTING ACTIVITIES 4. NET CHANGE IN CASH POSITION

1. Ratio Analysis

- The process by which relationships among the financial results shown on an organization's financial statements are assessed and interpreted

2. Leverage Analysis

- The process of assessing the impact of the amount of debt an organization has incurred in order to finance its asset base

3. Trend or Comparative Analysis

- Trends occurring over time are assessed by analyzing financial statements across multiple time periods

Common solvency and liquidity ratios include: (Analyze the financial obligations that an organization has against its financial resources in order to determine whether the organization possesses sufficient capital to meet its upcoming needs)

1. CURRENT RATIO 2. QUICK (OR ACID TEST) RATIO 3. SOLVENCY RATIO

Common activity ratios are: (Assist managers in assessing the efficiency and effectiveness of key components of an organization's operations; provides a sense of how effectively an organization is utilizing its asset base)

1. DAYS RECEIVABLE 2. INVENTORY TURNOVER 3. DAY'S INVENTORY

Three common debt ratios are: (Assist managers in assessing the efficiency and effectiveness of key components of an organization's operations; provides a sense of how effectively an organization is utilizing its asset base)

1. DEBT TO ASSET RATIO 2. DEBT TO EQUITY RATIO 3. TIMES INTEREST EARNED RATIO

The Three Primary Financial Statements

1. INCOME STATEMENT 2. BALANCE SHEET 3. CASH FLOW STATEMENT

In analyzing the current financial situation of a company, managers generally rely on three primary financial statements:

1. Income Statement 2. Balance Sheet 3. Cash Flow Statement

Two Fundamental Types of Business Transactions

1. OPERATIONAL TRANSACTIONS 2. CAPITAL ASSET TRANSACTIONS

There are four fundamental areas of ratio analysis:

1. Profitability 2. Solvency&Liquidity 3. Debt 4. Activity

Profitability Ratios include: ( Focus on assessing the amount of income the organization has earned in comparison to the operating activity that has taken place and the assets that have been used to support income generation)

1. RETURN ON SALES (ROS) 2. RETURN ON ASSETS (ROA) 3. RETURN ON EQUITY (ROE) 4. EARNINGS PER SHARE (EPS)

In conducting an analysis of an organization's financial health, management's focus is generally on four specific areas:

1. Ratio Analysis 2. Leverage Analysis 3. Trend or Comparative Analysis 4. Absolute Analysis

The importance of forecasting and budgeting is fourfold:

1. Requires the organization to think about changes in the market 2. Sets specific operational parameters for departments/divisions 3. Requires managers to make decisions about resource allocation measured against specific outcomes 4. Forecasts and budgets become benchmarks/targets against which actual results can be measured

Components of the Income Statement

1. SALES REVENUE 2. COST OF GOODS SOLD (COGS) 3. GROSS PROFIT MARGIN 4. GENERAL OPERATING EXPENSES 5. EARNINGS BEFORE INTEREST & TAXES (EBIT) 6. INTEREST EXPENSE 7. EARNINGS BEFORE TAXES (EBT) 8. NET PROFIT (INCOME) OR NET LOSS

The Balance Sheet ASSETS = LIABILITIES + OWNERS' EQUITY

1. Summarizes organization's financial position in terms of assets, liabilities, and owners' equity 2. Is a snapshot of the organization's position at a specific point in time 3. Provides a good barometer of an organization's capacity and liquidity

The income statement

1. Summarizes the operational transactions of an organization 2. Is a good barometer of a organization's efficiency and effectiveness 3. Shows the organization's profit (over a defined period) after expenses and taxes

The Cash Flow Statement

1. Summarizes the sources users of an organization's cash 2. Identifies the inflows and outflows money within a firm during a specified period of time 3. Provides insight into the current and projected liquidity position of the firm

3. CASH FLOW STATEMENT

= Provides managers with a full understanding of the total movement of cash from all sources into and out of the business -- Shows the full impact of all cash related decisions -- Is considered the best source of information relating to the firm's liquidity

ASOLUTE ANALYSIS (An understanding of financial resources in absolute terms, when combined with ratio analysis and using trend analysis, gives managers the best picture of the organization's health)

= Refers to an assessment of the actual dollar amount that organizations are generating and/or have at their disposal

1. OPERATIONAL TRANSACTIONS

= Represent the flow of money within the organization that is directly related to day-to-day business dealings; examples include revenue and expenses

1. ASSETS

= Resources that the organization has at its disposal and that it can utilize in the generation of business activity, and ultimately profit What the organization owns -- Current Assets - Resources the organization can convert to cash and/or consume within a short period of time (less than one year); includes cash, marketable securities, accounts receivable and inventory -- Non-Current Assets - Resources that are more fixed in nature and typically represent capital assets such as equipment, land, and buildings

TREND OR COMPARATIVE ANALYSIS

= Reviewing current results against prior year actual results and anticipated forecast results

RATIOS (Ratio analysis is a primary tool that managers use to assess the financial health of an organization; acts as a driver for the development of questions which the management team will seek additional information on in order to effectively manage the organization)

= Seek to define the relationship between critical components of information found on the financial statements

2. CASH FROM FINANCING ACTIVITIES

= Sources of cash flowing into the organization from non-operating activities

EFFICIENCY

= The ability of an organization to effectively manage its operations and allocate its resources

FINANCIAL CAPACITY

= The ability of an organization to generate revenue and to grow its revenue streams; relates to an organization's cash reserves and borrowing power

LIQUIDITY

= The ability of the company, on the basis of the cash it has on hand and the cash it is generating within its operations, to meet its ongoing financial obligations; the amount of assets an organization has that can easily be converted to cash

SOLVENCY

= The ability of the organization to meet its long term fixed expense obligations and to fund future growth; it is a longer-term assessment of the financial stability of the organization that focuses on the forward anticipated profitability of the firm and whether it can acquire sufficient capital to remain in business

FORECASTING AND BUDGETING

= The ability to project forward anticipated results for the up-coming quarter, year, or planning cycle period

LEVERAGE (Managers need to recognize this exposure and seek to utilize debt in a way that enhances profitable growth versus exposing the organization to significant liquidity and solvency issues by carrying too much debt)

= The amount of debt an organization uses in order to finance its asset base

7. EARNINGS BEFORE TAXES (EBT)

= The amount of earnings the operation has produced prior to paying federal and provincial income taxes

2. LIABILITIES

= The debts or financial obligations that an organization has incurred as a result of conducting its business What the organization owes -- Current Liabilities - Financial obligations coming due in the short term such as accounts payable, wages payable, and notes payable -- Long Term Liabilities - Debts that extend into the future (i.e. mortgages, bonds)

3. GROSS PROFIT MARGIN

= The difference between total revenue that an organization received and the direct expenses it incurs

1. SALES REVENUE

= The dollar amount the organization receives as a result of selling its products/services

2. COST OF GOODS SOLD (COGS)

= The expenses that are directly incurred in the manufacturing of a product or delivery of a service

2. BALANCE SHEET

= The financial statement that provides managers with an understanding of the resources the organization has at its disposal at a given point in time, and the financial obligations the business has incurred as a result of purchasing these resources - Shows the Accounting Equation: Assets = Liabilities + Owners' Equity

1. INCOME STATEMENT

= The financial statement that responds to the question of whether the business is earning a profit as a result of sales made versus expenses incurred in developing goods/services and delivering them to the marketplace -- Reflects a specific period of time (year, quarter, month) -- Identifies revenue received and subtracts expenses incurred in generating the revenue; the remainder is profit

4. GENERAL OPERATING EXPENSES

= The indirect expenses that an organization incurs and that must be paid from the gross profit margin

8. NET PROFIT (INCOME) OR NET LOSS

= The organization's profit or loss from the sale of products/services to customers

PROFITABILITY MARGIN

= The portion of an organization's revenue that is left after all operating expenses associated with its goods/services have been paid

OPERATING MARGIN

= The portion of an organization's revenue that is left over after the organization has paid the direct costs associated with its products/services

OWNERS' (OR SHAREHOLDERS') EQUITY

= The value of capital received from the owners of the business that is used to fund the start-up or ongoing operations of the business, as well as reflecting the value of the organization's retained earnings; the owners' equity stake in the company

1. DEBT TO ASSET RATIO

= Total Liabilities/Total Assets; Shows how much of the asset base has been created via debt financing; identifies the amount of financial leverage the organization has assumed

The Role of Financial Statements

An organization tracks the effectiveness of its decisions and product/service offerings with respect to growth, profitability, and asset productivity through analysis of its financial statements

Management Reflection - Keeping Your Finger on the Pulse of the Organization

Managers must be comfortable in preparing, reading, and interpreting financial statements; the ability to do this enables managers to "keep their finger on the pulse" of the organization

The Forecasting and Budgeting Process

Market analysis > Sales forecast and cost analysis > Development of preliminary pro-forma statements > Upcoming year finical resource assessment > Preparation of budgets > Comparison of budget against actual results

Simplified Cash Flow Statement

Net Results from the income statement + Net results from cash from operational activities + Net results from cash from investing activities + Net results from cash financing activities = Changes to cash position

Simplified Operating (Income) Statement

Sales Revenue Less: Product Costs (COGS) Equals: Gross Profit Margin Less: General Operating Expenses Equals: Earning Before Interest and Taxes Less: Interest Expense Equals: Earnings Before Income Taxes Less: Income Taxes Equals: Net Profit or Loss

A caution:

While ratio analysis provides many useful insights, ratios should not be the sole focus of the financial assessment process