Business Finance Analysis, Lecture notes of Business Finance

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Financial Statement Analysis

For

Small Businesses

A Resource Guide

Provided By

Virginia Small Business Development Center Network

( Revised for the VSBDC by Henry Reeves 3/22/2011 )

Contents

Topic Page

• Introduction
• Importance of Financial Statements
• Collecting and Managing Data
• The Income Statement
• The Balance Sheet
• Reconciliation of Equity or Statement of Changes in Stockholder Equity
• Statement of Cash Flows
• Notes to Financial Statements
• Financial Ratios – Explanation
• Key Terms and Concepts
• Financial Statements as a Management Tool
• Three Case Studies
• Figure 1: Summary Table of Financial Ratios
• Figure 2: K-L Fashions, Inc. Financial Statements
• Figure 3: Breakeven Analysis
• Figure 4. - Sample Cash Flow Statement (without numbers):
• Conclusion
• Sources of Financial Analysis Information

throughout the state. For the location of the Small Business Development Center nearest to you call visit www.virginiasbdc.org.

• Universities, community colleges, and public libraries have other books and publications on this topic.
• A tremendous amount of information is available on the Internet, using a search tool such as Google.

Importance of Financial Statements

Many business experts and accountants recommend that you prepare financial statements monthly; quarterly at a minimum. Some companies prepare them at least once a week, sometimes daily, to stay abreast of results. The more frequently a company prepares their financial statements, the sooner timely decisions can be made.

There are four types of financial statements; compiled, reviewed, audited, and unaudited:

• A compiled statement contains financial data from a company reported in a financial statement format by a certified public accountant (CPA); it does not include any analysis of the statement.
• (^) The reviewed statement includes an analysis of the statement by a CPA in which unusual items or trends in the financial statement are explained.
• An audited statement (also prepared by a CPA) contains any analysis which includes confirmation with outside parties, physical inspection and observation, and transactions traced to supporting documents. An audited statement offers the highest level of accuracy.
• An unaudited statement applies to a financial statement prepared by the company which has not been compiled, reviewed, or audited by a outside CPA..

Small business owners must be aware that they may be required to submit financial statements in nine circumstances:

1. Virtually all suppliers of capital, such as banks, finance companies, and venture capitalists, require these reports with each loan request, regardless of previous successful loan history. Banks may need CPA compiled or reviewed statements and, in some cases, audited statements. They may not accept company or individually prepared financial statements, unless they are backed by personal or corporate income. Typically, as a condition of granting a loan, a creditor may request periodic financial statements in order to monitor the success of the business and spot any possible repayment problems.
2. Information from financial statements is necessary to prepare federal and state income tax returns. Statements themselves need not be filed.
3. Prospective buyers of a business will ask to inspect financial statements and the financial/ operational trends they reveal before they will negotiate a sale price and commit to the purchase.
4. In the event that claims for losses are submitted to insurance companies, accounting records (particularly the Balance Sheet) are necessary to substantiate the original value of fixed assets.

5. If business disputes develop, financial statements may be valuable to prove the nature and extent of any loss. Should litigation occur, lack of such statements may hamper preparation of the case.
6. Whenever an audit is required--for example by owners or creditors--four statements must be prepared: a Balance Sheet (or Statement of Financial Position) , Reconcilement of Equity (or Statement of Stockholder’s Equity for corporations) , Income Statement (or Statement of Earnings) , and Statement of Cash Flows.
7. A number of states require corporations to furnish shareholders with annual statements. Certain corporations, whose stock is closely held, that is, owned by a small number of shareholders, are exempt.
8. In instances where the sale of stock or other securities must be approved by a state corporation or securities agency, the agency usually requires financial statements.
9. The Securities and Exchange Commission (SEC) requires most publicly held corporations (such as those whose stock is traded on public exchanges) to file annual and interim quarterly financial reports.

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Collecting and Managing Data

The language and principles of modern accounting have evolved from the centuries-old need for accurate record keeping. Today, the Financial Accounting Standards Board (FASB), the SEC, and the American Institute of Certified Public Accountants (AICPA) continue to refine and revise concepts and practices. Regardless of how complex a financial statement may seem, it is based on logic and practicality.

Collecting information for financial statements begins with the daily arithmetic of business and follows a continuing process called the audit trail. First, figures from original documents such as invoices are journalized, or recorded, daily in the book of original entry, which is called the journal. Today, these journals are maintained in electronic format. Items that are not normally recorded in the daily operations, such as those for depreciation and amortization, are called end-of-the-period adjustments and are calculated and journalized periodically. All of these detailed transactions are then posted to the general ledger. Amounts are balanced (credits must equal debits) and then used to prepare financial statements. In most computerized accounting systems the balancing is maintained in real-time, behind the scenes, allowing financial statements to be prepared at any time.

In a number of small businesses, bookkeepers or owners themselves prepare these reports. Frequently, they use textbook samples as models or standard bank forms provided by loan officers. But a growing number of small operations retain accountants on at least an occasional basis. Accountants typically tailor statements to a specific enterprise, so statement formats vary somewhat.

Micro businesses can use a very simple and basic system to collect the information that will ultimately be used to construct the financial statements. The business owner should put all receipts, cancelled checks, and credit card slips into a large envelope. Have one envelope for each month. The owner can then deliver these receipts to his or her bookkeeper, who will construct the financial statements. The envelopes

owner may need to prepare a second Income Statement based on the calendar year, if the fiscal year is different. Check with a tax advisor about Internal Revenue Code requirements.

The following terms are commonly found on an income statement:

1. Heading The first facts to appear on any statement are the legal name of the business, the type of statement, and the period of time reported, e.g., month, quarter, or year.
2. Column Headings If you include both current month and year-to-date columns on the Income Statement you can review trends from accounting period to accounting period and compare previous similar periods. Also, it is often helpful to show the dollar amounts as percentages of net sales. This helps you analyze performance and compare your company to similar businesses. Remember, you can choose any period of time to analyze.
3. Revenue All income flowing into a business for services rendered or goods sold comes under this category. In addition to actual cash transactions, the revenue figure reflects amounts due from customers on accounts receivable as well as equivalent cash values for merchandise or other tangible items used as payment.
4. Less Sales Returns and Allowances The value of returned merchandise and allowances made for defective goods must be subtracted from gross sales to determine net sales.
5. Cost of Goods Sold Cost of goods sold equals the amount of goods available for sale minus the inventory remaining at the end of the accounting period. (Total goods available = beginning inventory + cost of purchasing or manufacturing new merchandise during the accounting period). Cost of goods sold includes all costs directly related to the production of the product invoiced during the accounting period. Service businesses generally have no cost of goods sold.
6. Gross Profit Also called gross margin , this figure is the difference between the cost of goods sold and net sales (Net Sales - Cost of Goods Sold = Gross Profit). It is the business’s profit before operating expenses and taxes.
7. Operating Expenses The expenses of conducting business operations generally fall into two broad categories: selling and general administrative. Manufacturers normally include some operating expenses, such as machinery and labor depreciation, as part of cost of sales (Item 5).
8. Total (Net) Operating Income Total operating expenses are subtracted from gross profit to show what the business earned before financial revenue and expenses, taxes, and extraordinary items.
9. Other Revenue and Expenses

Income and expenses that are not generated by the usual operations of a business and that are not considered extraordinary (see Item 11) are recorded here. Typically included in this category are financial revenue, such as interest from investments, and financial expenses, such as interest on borrowed capital. (Loan principal is not considered an expense. It is a liability and is listed as such on the Balance Sheet).

10. Pretax Income To derive this figure, also called pretax profit, total financial revenue (minus total financial expenses) is added to total operating income. Taxes are subtracted from pretax income if the business is a ‘C’ corporation. Proprietorships, limited liability companies, and ‘S’ corporations do not pay business taxes on income; the income is reported on the owners’ personal returns. (For tax planning purposes, accountants estimate the annual taxes due, then project the monthly portion.)
11. Extraordinary Gain [Loss] Net of Income Tax [Benefit] Within the framework of an individual business type and location, any occurrence that is highly unusual in nature, could not be foreseen, is not expected to recur, and that generates income or causes a loss is considered an extraordinary item. The extraordinary gain or loss is shown after calculating tax liability (or tax benefit, as would be the case with an extraordinary loss) on the Income Statement. Examples: A court award to a business not previously involved in lawsuits would be an extraordinary gain; a major casualty would be an extraordinary loss.
12. Net Income Also called net profit, this figure represents the sum of all expenses (including taxes, if applicable). Net income or profit is commonly referred to as the bottom line.
13. Earnings per Share Total outstanding common stock (the number of shares currently owned by stockholders) is divided into net income to derive this figure. It is not applicable to proprietorships and limited liability companies, but must be shown on the Income Statements of all publicly held corporations.

The Balance Sheet

A Balance Sheet records the total assets, liabilities, and equity (net worth) of a business as of a specific day. This statement is divided to provide two views of the same business: what resources the business owns, and the creditor and owner investments that supplied these resources. These divisions are generally set up in the two-column account form, with assets on the left, liabilities and equity on the right. An alternative -- the one column statement form or report form -- lists assets on top, liabilities and equity below.

The backbone of the Balance Sheet is the fundamental accounting equation: Assets = Liabilities + Equity (transposed: Assets - Liabilities = Equity. This equation is based on the accounting principle that every business transaction, such as selling merchandise or borrowing capital, has a dual effect. Any increase or decrease on one side of the equation always requires a corresponding change to the other side of the equation. If the sides don’t balance, faulty arithmetic or inaccurate or incomplete records may be the cause.

The following is an example of the principle of balance: If a business owner purchases $2,000 worth of new merchandise on credit, assets are increased by the value of new inventory. Liabilities are increased

3. Current Assets Cash and resources that can be converted into cash within 12 months of the date of the Balance Sheet (or during one established cycle of operations) are considered current. Besides cash (money on hand and demand deposits in the bank, such as regular savings accounts and checking accounts), these resources include the items listed below. They are ranked in a generally accepted order of decreasing liquidity--that is, the ease with which the items could be converted to cash. - Accounts Receivable: The amounts due from customers in payment for merchandise or services. - Inventory: Includes raw materials on hand, work in process, and all finished goods either manufactured or purchased for resale. Inventory value is based on unit cost and is calculated by any of several methods (see Inventory Valuation below). - Temporary Investments: Interest- yielding or dividend-yielding holdings expected to be converted into cash within a year. Also called marketable securities or short-term investments , they include certificates of deposit, stocks and bonds, and time deposit savings accounts. According to accounting principles, they must be listed on the Balance Sheet at either their original cost or their market value, whichever is less. - Prepaid Expenses: Goods, benefits, or services a business pays for in advance of use. Examples are insurance protection, floor space and office supplies.

4. Long-Term Investments Also called long-term assets , these resources are holdings that the business intends to keep for a year or longer and that typically yield interest or dividends. Included are stocks, bonds and savings accounts earmarked for special purposes.

5. Fixed Assets Fixed assets, frequently called plant and equipment, are the resources a business owns or acquires for use in operations and does not intend to resell. Regardless of current market value, land is listed at its original purchase price, with no allowance for appreciation or depreciation. Other fixed assets are listed at cost, minus depreciation. Fixed assets may be leased rather than owned. Depending on the leasing arrangement, both the value and liability of the leased property may need to be listed on the Balance Sheet.

6. Other Assets Resources not listed with any of the above assets are grouped here. Examples include tangibles, such as outdated equipment which can be sold to the scrap yard, and intangibles, such as goodwill, trademarks and patents.

Liabilities This term covers all monetary obligations of a business and all claims creditors have on its assets.

8. Current Liabilities All debts and obligations payable within 12 months or within one cycle of operations are detailed here. Typically, they include the following, which generally are listed in the order due. - Accounts Payable: Amounts owed to suppliers for goods and service purchased in connection with business operations. - Short-Term Debt: The balances of principal due to pay off short-term debt for borrowed funds. - Current Portion of Long-Term Debt: Current amount due of total balance on notes whose terms exceed 12 months. - Interest Payable: Any accrued amounts due for use of both short-and long-term borrowed capital and credit extended to the business. - Taxes Payable: Amounts estimated by an accountant to have been incurred during the accounting period. For accounting purposes, this total may differ from the actual tax total required by the Internal Revenue Codes, since taxes payable are based on accounting income and not taxable income. ( Note: Income taxes are business obligations for corporations; proprietorships and partnerships do not pay income taxes; the income is reported on the owners’ personal returns.) - Accrued Payroll: Salaries and wages currently owed but not yet paid.
9. Long Term Liabilities Long-term liabilities are notes, payments, or mortgage payments due over a period exceeding 12 months or one cycle of operations. They are listed by outstanding balance (minus the Current Portion due).
10. Equity Also called net worth, equity is the claim of the owner(s) on the assets of the business. In a proprietorship or limited liability company, equity is each owner’s original investment, plus any earnings after withdrawals.

In a corporation, the owners are the shareholders--those who have invested capital (cash or other assets) in exchange for shares of stock. The corporation’s equity is the sum of contributions plus earnings retained after paying dividends. It is detailed as follows:

• Capital Stock: The total amount invested in the business in exchange for shares of stock at value up to the par value. Par is the per-share price assigned to the original issue of stock, regardless of subsequent selling prices.
• Capital Paid-In in Excess of Par: The amount in excess of par value that a business receives from shares of stock sold at a value above par.
• Treasury Stock: When a company buys back its own stock or when a closely held business buys out other owners. The value of the stock is recorded here and ordinarily does not receive dividends.
• Retained Earnings: The total accumulated net income minus the total accumulated dividends declared since the corporation’s founding. These earnings are part of the total

Service may require the information it provides. This statement can usually be produced by most accounting software applications.

Notes to Financial Statements

If an important factor does not fit into the regular categories of a financial statement, it should be included as a note. Also, anything that might affect the financial position of a business must be documented. Three major types of notes include:

1. Methodology Discussion of the accounting principles used by the company. For example, accrual basis of accounting vs. cash basis of accounting.
2. Contingent Liabilities Circumstances that have occurred as of the statement date and which represent potential financial obligations must be recorded by type and estimated amount. Example: A business owner cosigns a bank note. If the primary borrower should default, the business owner who cosigned would become liable.
3. Required Disclosures It is necessary that all significant information about the company be described in a disclosure statement. Example: If the business has changed accounting procedures since the last accounting period, the change must be described.

Financial Ratios

Financial ratios are a valuable and easy way to interpret the numbers found in statements. Ratio analysis provides the ability to understand the relationship between figures on spreadsheets. It can help you to answer critical questions such as whether the business is carrying excess debt or inventory, whether customers are paying according to terms, and whether the operating expenses are too high.

When computing financial relationships, a good indication of the company's financial strengths and weaknesses becomes clear. Examining these ratios over time provides some insight as to how effectively the business is being operated.

Many industries compile average (or standard) industry ratios each year. Standard or average industry ratios offer the small business owner a means of comparing his or her company with others within the same industry. In this manner they provide yet another measurement of an individual company’s strengths or weaknesses. RMA (Risk Management Association, formerly named Robert Morris & Associates) is a good source of comparative financial ratios. It can be found on the Internet at http://www.rmahq.org/

Following are the most critical ratios for most businesses, though there are others that may be computed.

1. Liquidity

Measures a company’s capacity to pay its debts as they come due. There are two ratios for evaluation liquidity.

Current Ratio - Gauges how able a business is to pay current liabilities by using current assets only. Also called the working capital ratio. A general rule of thumb for the current ratio is 2 to 1 (or 2:1, or 2/1). However, an industry average may be a better standard than this rule of thumb. The actual quality and management of assets must also be considered.

The formula is: Total Current Assets Total Current Liabilities

Quick Ratio - Focuses on immediate liquidity (i.e., cash, accounts receivable, etc.) but specifically ignores inventory. Also called the acid test ratio , it indicates the extent to which you could pay current liabilities without relying on the sale of inventory. Quick assets , are highly liquid--those immediately convertible to cash. A rule of thumb states that, generally, your ratio should be 1 to 1 (or 1:1, or 1/1).

The formula is: Cash + Accounts Receivable (+ any other quick assets) Current Liabilities

2. Safety Indicates a company’s vulnerability to risk--that is, the degree of protection provided for the business’ debt. Three ratios help you evaluate safety:

Debt to Worth - Also called debt to net worth. Quantifies the relationship between the capital invested by owners and investors and the funds provided by creditors. The higher the ratio, the greater the risk to a current or future creditor. A lower ratio means your company is more financially stable and is probably in a better position to borrow now and in the future. However, an extremely low ratio may indicate that you are too conservative and are not letting the business realize its potential.

The formula is: Total Liabilities (or Debt) Net Worth (or Total Equity)

Times Interest Earned – Assesses the company’s ability to meet interest payments. It also evaluates the capacity to take on more debt. The higher the ratio, the greater the company’s ability to make its interest payments or perhaps take on more debt.

The formula is: Earnings Before Interest & Taxes Interest Charges

Cash Flow to Current Maturity of Long-Term Debt - Indicates how well traditional cash flow (net profit plus depreciation) covers the company’s debt principal payments due in the next 12 months. It also indicates if the company’s cash flow can support additional debt.

4. Efficiency Evaluates how well the company manages its assets. Besides determining the value of the company’s assets, you should also analyze how effectively the company employs its assets. You can use the following ratios:

Accounts Receivable Turnover - Shows the number of times accounts receivable are paid and reestablished during the accounting period. The higher the turnover, the faster the business is collecting its receivables and the more cash the company generally has on hand.

The formula is: Total Net Sales Average Accounts Receivable

Accounts Receivable Collection Period - Reveals how many days it takes to collect all accounts receivable. As with accounts receivable turnover (above), fewer days means the company is collecting more quickly on its accounts.

The formula is: 365 Days Accounts Receivable Turnover

Accounts Payable Turnover - Shows how many times in one accounting period the company turns over (repays) its accounts payable to creditors. A higher number indicates either that the business has decided to hold on to its money longer, or that it is having greater difficulty paying creditors.

The formula is: Cost of Goods Sold Average Accounts Payable

Payable Period - Shows how many days it takes to pay accounts payable. This ratio is similar to accounts payable turnover (above.) The business may be losing valuable creditor discounts by not paying promptly.

The formula is: 365 Days Accounts Payable Turnover

Inventory Turnover - Shows how many times in one accounting period the company turns over (sells) its inventory. This ratio is valuable for spotting understocking, overstocking, obsolescence, and the need for merchandising improvement. Faster turnovers are generally viewed as a positive trend; they increase cash flow and reduce warehousing and other related costs. Average inventory can be calculated by averaging the inventory figure from the monthly Balance Sheets. In a cyclical business, this is especially important since there can be wide swings in asset levels during the year. For example, many retailers might have extra stock in October and November in preparation for the Thanksgiving and winter holiday sales.

The formula is: Cost of Goods Sold Average Inventory

Inventory Turnover in Days - Identifies the average length of time in days it takes the inventory to turn over. As with inventory turnover (above), fewer days mean that inventory is being sold more quickly.

The formula is: 365 Days Inventory Turnover

Sales to Net Worth - Indicates how many sales dollars are generated with each dollar of investment (net worth). This is a volume ratio.

The formula is: Total Sales Average Net Worth

Sales to Total Assets - Indicates how efficiently the company generates sales on each dollar of assets. A volume indicator, this ratio measures the ability of the company’s assets to generate sales.

The formula is: Total Sales Average Total Assets

Debt Coverage Ratio - An indication of the company’s ability to satisfy its debt obligations, and its capacity to take on additional debt without impairing its survival.

The formula is: Net Profit + Any Non-Cash Expenses Principal on Debt

Key Terms and Concepts

The following are brief descriptions and explanations of terms and concepts related to financial statements. (Items defined elsewhere in the text are not listed here.)

Accrual Basis of Accounting

By this long-established and widely used principle, revenue and expenses are recognized when a service is performed or goods are delivered, regardless of when payment is received or made. This method allows what accountants call the matching of revenues and associated expenses.

Revenue example - If a store sells $500 worth of radios in a day, $500 of revenue is earned and entered in the books even though the proceeds of the sale may not be collected for a month or longer.

Expense example - If the store clerk earns a $10 commission on the day of the radio sale, this expense to the business is recorded that day even though it may not actually be paid until the next payroll day.

Common-Size

A term applied to financial statements that use 100 percent of one category as the basis for determining the proportion that other statement items represent. Net sales is used as the basis figure for Income Statements, total assets for Balance Sheets. Since the total always sums to 100 percent, the statements prepared in this manner are referred to as “common-size.” This form of comparative statement enables the analyst to see at a glance the Balance Sheet trends and the proportionate changes taking place in the individual accounts form one statement period to the next.

Depreciation

A universal accounting assumption holds that all fixed assets--with the exception of land--deteriorate, wear out, or become obsolete.

This process represents a decline in value that is called depreciation. It is calculated by apportioning an asset’s original acquisition price, minus any expected salvage value, over the asset’s expected years of useful life. (For accounting purposes, land is always valued at its original purchase price.) On the Income Statement, depreciation incurred during the accounting period is detailed as an expense. On the Balance Sheet, depreciation is reflected by an asset’s listed net book or net carrying value (cost less accumulated depreciation).

The simplest and most common means of calculating depreciation is by the straight-line method. Using it, accountants divide the estimated useful life of an asset into its purchase price minus any applicable salvage value. Example: An $11,000 machine has a $1,000 salvage value and an expected useful life of 10 years. Annual depreciation = ($11,000 - $1,000) ÷ 10 = $1,000. In five years, straight-line accumulated depreciation would be $5,000.

There are other common calculation methods that allow more accelerated depreciation of fixed assets. These methods distribute the original acquisition cost more heavily during an asset’s early years. Accountants can show owners the various means to determine this depreciation, which is more complex than straight-line.

Depreciation computed according to the GAAP rules is not necessarily the same as that computed to comply with the Internal Revenue Code. For further information, consult a tax advisor.

Inventory Valuation

Because inventory units are usually purchased at varying prices, methods have been established to calculate the cost of goods sold and the value of remaining inventory. Three widely used methods are:

Average Cost - The total number of units of goods available is divided into the total manufacturing or acquisition cost (including freight charges to get the raw materials to the manufacturer's or supplier's location.)

FIFO - An acronym for “first in, first out.” This method is based on the assumption that the inventory acquired first is sold first. Consequently, the ending (remaining) inventory consists of the most recently purchased items. An advantage of this method of valuation is that it reflects recent costs of inventory on the Balance Sheet.

LIFO - An acronym for “last in, first out.” This method of valuation assumes that those items of inventory most recently acquired are sold before the older acquisitions. As a result, the ending inventory figure consists of the older purchases. Proponents of this valuation method argue that by representing current prices in the cost of goods sold, matching is more accurately accomplished.

Example: The first item in costs $100, the second costs $300, and the third costs $500. Two of these units are sold.

Calculated by average cost : $100 + $300 + $500 = $900 ÷ 3 = $300. Therefore, the cost of goods sold = $600 (2 units x $300); the remaining inventory is valued at $300.

Calculated by FIFO , the cost of goods sold is $100 + $300 = $400; the remaining inventory is valued at $500.

Calculated by LIFO , the cost of goods sold is $500 + $300 = $800; the remaining inventory is valued at $100.

Leverage

The concept of borrowing heavily for financing needs in order to minimize the capital investment and maximize the return on investment.

Liquidate

To convert non-cash assets into cash; also, to close the business by selling all assets and paying all debts.

Liquidity The ease with which items can be converted into cash without loss.

Negative Cash Flow

Cash receipts that are insufficient to meet ongoing costs and other cash needs, such as necessary investment in fixed assets or expanded inventory.

Working Capital

The difference between total current assets and total current liabilities; the resulting pool of resources readily available to maintain normal business operations.