Financial Statements and Performance Analysis

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Financial Statements andPerformance Analysis

• Alan Barefield
• Associate Professor
• University of Tennessee
• Agricultural Economics

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Importance of Financial Management

• David Curlee (land developer) made a fortune,
  then went bankrupt and is now consulting
• He states that the entrepreneur must know
• What is coming in versus what is going out
• Everything that is contained in the ledger sheets
• All facets of business operations
• Above all, dont become too ambitious

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Key Financial Statements

• Income or Profit Loss Statement
• Balance Sheet
• Cash Flow Statement
• Budget Forecast

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Balance Sheet

• Details the financial position of a business at a
  particular point in time
• Assets Liabilities Equity
• Tells the reader what the business owns of
  monetary value and what the business owes to
  others.
• Personal and business assets and liabilities are
  frequently reflected on the same statement

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Components of theBalance Sheet

• Assets
• Represents the monetary value of what the
  business owns
• Are normally grouped into three categories
  denoting how soon they wear out or are sold
• Current Less than 1 year
• Intermediate 1 to 10 years
• Long-term Over 10 years

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Current Asset Examples

• Cash
• Checking accounts
• Savings accounts
• Accounts receivable
• Inventories
• Supplies
• WIP investments

• Equity in hedging accounts
• Tax refunds
• Unused tax credits
• Prepaid expenses
• Payroll
• Insurance
• Rent

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Intermediate Asset Examples

• Machinery
• Business vehicles
• Retirement accounts
• Cash value of life insurance
• Household goods
• Personal vehicles

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Long-term Asset Examples

• Land
• Buildings and structures
• Personal residences
• Nonbusiness real estate

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Components of theBalance Sheet

• Liabilities
• Represents the value of the debts owed by the
  business
• Are normally grouped into three categories
  denoting how soon they fall due
• Current Less than 1 year
• Intermediate 1 to 10 years
• Long-term Over 10 years

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Current Liability Examples

• Accounts payable
• Short term notes payable
• Current payments on intermediate or long term
  notes
• Accrued expenses
• Contingent tax on sale of current assets

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Intermediate Liability Examples

• Loans to finance intermediate assets less current
  payments
• Contingent tax on sale of intermediate assets

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Long-term Liability Examples

• Business and nonbusiness mortgages less current
  payments
• Other long-term notes
• Contingent tax on sale of long term assets

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Components of theBalance Sheet

• Net worth (also called net equity)
• Net worth represents the difference between the
  total level of assets and the total level of
  liabilities
• Net worth should be reported on an after-tax
  basis
• If net worth is positive, the business is solvent
  (assets can be sold to retire liabilities). If
  net worth is negative, the business is insolvent

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Structure of theBalance Sheet

• Assets
• Current Assets
• Intermediate Assets
• Long-term Assets

• Liabilities
• Current Liabilities
• Intermediate Liabilities
• Long-term Liabilities
• Net Worth

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Purpose of theBalance Sheet

• The balance sheet indicates the degree to which
  the business is liquid and solvent
• Liquidity Can the business current liabilities
  be retired if the current assets are converted to
  cash?
• Solvency Can the total liabilities of the
  business be retired if all assets are converted
  to cash?

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Income or Profit Loss Statement

• The income or profit and loss statement
  summarizes the level of revenue and expenses for
  the business
• Major components include
• Revenues
• Expenses
• Taxes
• Extraordinary Items

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Revenues

• Business revenue can be divided into two
  categories
• Revenue from current operations Cash proceeds
  from the sale of inventory, noncash proceeds from
  sales, patronage dividends, insurance proceeds,
  noncash inventory adjustments
• Expenses incurred in the production process
  should be deducted from revenues to yield a gross
  profit margin

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Revenues

• Capital gains and losses Gain or loss realized
  from the sale of intermediate or long-term assets
• Nonbusiness revenue Income derived from
  nonbusiness employment, interest and dividend
  income from nonbusiness investments

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Expenses

• Cash operating expenses Includes expenses paid
  in cash, expenses that have been incurred but not
  yet paid (accounts payable), interest expenses
• Noncash expenses includes depreciation and any
  expenses paid from the last reporting period if
  the business is reporting on a cash basis

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Taxes

• This section includes the specific tax
  liabilities incurred during the reporting period.
  Only income and self-employment taxes are
  reported in this section. Payroll taxes, real
  estate and real property taxes, etc., are
  reported under the Expenses section of the income
  statement

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Extraordinary Items

• This section includes once-in-a-lifetime events
  that should not be included as a part of the
  firms regular financial activities
• Includes insurance payments from a loss,
  agricultural disaster payments, etc.

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Structure of theIncome Statement

• Revenues
• Business Revenue
• Gain from sale of intermediate or LT assets
• Non Business Revenues
• Noncash revenue adjustments
• Total revenue
• - Cost of goods sold
• Gross profit margin

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Structure of theIncome Statement

• Gross profit margin
• - Cash operating expenses
• - Noncash operating expenses
• Income from business operations
• (-) Gain (loss) on depreciable assets
• Net business income
• Nonbusiness revenue
• Non business expenses
• Income before taxes
• Provisions for taxes
• Net Income

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Purpose of theIncome Statement

• Provides a summary of the revenues and expenses
  associated with the periods operating activities
• Provide information to complete the business and
  personal income tax returns
• Shows the profitability of the business for
  lenders and other interested parties

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Cash Flow Statement

• Summarizes the levels of cash that the business
  has available to meet current obligations
• Generally divided into monthly or quarterly
  periods to show when excess cash is available or
  when borrowing needs to occur

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Components of theCash Flow Statement

• Cash available
• Beginning cash balance
• Cash revenues from sales and accounts receivable
• Other sources of cash
• Proceeds from sale of equipment and other assets
• Nonbusiness wages
• Interest and dividend income

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Components of theCash Flow Statement

• Cash required
• Operating expenses
• Income tax payments
• Intermediate and long-term payments
• Capital expenditures
• Family living expenses
• Cash gifts and donations

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Components of theCash Flow Statement

• Borrowings
• New loans to finance production and capital
  expenditures
• Other
• Short term loan payments
• Savings additions and withdrawals
• Ending cash balance for the period

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Purpose of theCash Flow Statement

• Highlights the financing arrangements necessary
  to cover cash requirements
• Serves as a benchmark for budgeting activities
• Analyzes the timing of financial borrowing
  activities

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Budget Preparation

• Many persons assert that the budget is simply a
  projection of the cash flow statement
• However this is not correct
• The budget must incorporate all key financial
  statements
• Forecasting statements are also called pro forma
  statements

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Key Budget Assumptions

• Expected selling prices
• Expected input prices
• Expected input productivity
• Pro forma operating budget
• Production costs and sales objectives
• Pro forma financial budget
• Cash receipts and disbursements
• Family living budgets

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Financial Statement Analysis

• Ratio analysis
• Alleviates the unit of measure problems incurred
  when comparing raw numbers
• Four different types of ratios can be examined
• Liquidity ratios can current debts be met
• Solvency ratios can all debts be met
• Efficiency ratios how efficient is the
  operation
• Profitability ratios how profitable is the
  operation

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Keys to Ratio Analysis

• Ratios dont mean anything by themselves
• They must be compared over time and with similar
  companies
• Look at industry standards through trade
  magazines, Standard Poores, RMA analysis, etc.

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Liquidity RatiosCurrent Ratio

• Current assets divided by current liabilities
• Interpretation
• Relatively high ratio values mean that the
  business is liquid, but cash is not working
• If the current ratio is greater than 1.0, the
  business is liquid
• If the current ratio is less than 1.0, the
  business is illiquid

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Liquidity RatiosCurrent Ratio
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Liquidity RatiosAcid Test Ratio

• Current assets minus inventories divided by
  current liabilities
• Interpretation
• Relatively high ratio values mean that the
  business is liquid, but cash is not working
• If the current ratio is greater than 1.0, the
  business is liquid
• If the current ratio is less than 1.0, the
  business is illiquid

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Liquidity RatiosAcid Test Ratio
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Solvency RatiosLeverage Ratio

• Total liabilities divided by total net worth
• Interpretation
• The higher the value, the less solvent the
  business is
• If less than 1.0, the business is solvent
• If greater than 1.0, the business is insolvent

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Solvency RatiosLeverage Ratio
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Solvency RatiosNet Capital Ratio

• Total assets divided by total liabilities
• Interpretation
• The higher the value, the more solvent the
  business
• If greater than 1.0, the business is solvent
• If less than 1.0, the business is insolvent

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Solvency RatiosNet Capital Ratio
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Efficiency RatiosTurnover Ratio

• Value of production divided by total average
  productive assets
• Interpretation
• The higher the value, the more efficient the
  business
• The lower the value, the less efficient the
  business

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Efficiency RatiosTurnover Ratio
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Efficiency RatiosGross Ratio

• Total business expenses divided by the value of
  production
• Interpretation
• The lower the value, the more efficient the
  business
• The higher the value, the less efficient the
  business

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Efficiency RatiosGross Ratio
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Efficiency RatiosSales/Receivables

• Net sales divided by net accounts receivables
• Interpretation
• Measures the number of times receivables turn
  over during the year
• The higher the turnover, the shorter the time
  between the sale and cash collection

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Efficiency Ratios Sales/Receivables
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Efficiency Ratios Days/Receivable Turnover

• 365 divided by the Sales/Receivables Ratio
• Interpretation
• Dividing the sales/receivables ratio into 365
  provides the number of days between sales and
  collections
• The higher the number, the longer it takes the
  business to collect accounts receivable

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Efficiency Ratios Days/Receivable Turnover
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Efficiency RatiosInventory Turnover Ratio

• Calculated by dividing cost of goods sold by the
  dollar level of inventory
• Interpretation
• Measures the number of times inventory is turned
  over during the year
• High inventory can indicate better liquidity or
  superior merchandising

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Efficiency RatiosInventory Turnover Ratio

• Interpretation (continued)
• Conversely, high turnover can mean a shortage of
  needed inventory for sales
• Low inventory turnover can indicate poor
  liquidity, possible overstocking, obsolescence,
  or a planned inventory buildup
• Closely examine the reasons behind the value of
  this ratio with regard to your business

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Efficiency RatiosInventory Turnover Ratio
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Efficiency RatiosDays Units Are In Inventory

• 365 divided by the inventory turnover ratio
• Interpretation
• Calculates the average number of days that units
  are in inventory
• See explanations for high or low numbers in the
  interpretation for the inventory turnover ratio

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Efficiency RatiosDays Units Are In Inventory
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Efficiency RatiosPayable Turnover Ratio

• Divide cost of goods sold by net accounts payable
• Interpretation
• Measures the number of times payables turn over
  during the year
• The higher the turnover, the lower the time
  between purchase and payment

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Efficiency RatiosPayable Turnover Ratio

• Interpretation (continued)
• A low ratio can indicate
• Cash shortage
• Invoice disputes with suppliers
• Extended terms of payment provided by suppliers
• Expansion of trade credits with suppliers

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Efficiency RatiosPayable Turnover Ratio
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Efficiency RatiosDays/Payables Turnover

• 365 divided by the payables turnover ratio
• Interpretation
• Calculates the average number of days that trade
  payables are outstanding
• For possible explanations of a relatively large
  number of days, see the explanations for the
  payable turnover ratio

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Efficiency RatiosDays/Payables Turnover
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Efficiency RatiosNet Sales/Working Capital

• Net sales divided by working capital
• Working capital is calculated by subtracting
  current liabilities from current assets
• Interpretation
• Measures how efficiently working capital is
  employed

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Efficiency RatiosNet Sales/Working Capital

• Interpretation (continued)
• A relatively large ratio could mean that working
  capital is efficiently employed
• Conversely, it could also mean that the firm is
  undercapitalized and is in danger of becoming
  non-liquid

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Efficiency RatiosNet Sales/Working Capital
where Working capital Current Assets Current
Liabilities
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Profitability RatiosROR on Total Capital

• Income loan interest obligations value of
  unpaid labor and management business income
  taxes divided by total business assets
• Interpretation
• The higher the value, the more profitable the
  business

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Profitability RatiosROR on Total Capital
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Profitability RatiosROR on Equity Capital

• Income value of unpaid labor and management
  business income taxes divided by total business
  net worth
• Interpretation
• The higher the value, the more profitable the
  business

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Profitability RatiosROR on Equity Capital