Financial Competency Study Guide for DEP Participants

Transcription

1 Directors Education Program (DEP) Financial Competency Study Guide for DEP Participants Bring even more to the boardroom table

2 contents INTRODUCTION 3 FINANCIAL STATEMENTS 3 General Overview 3 Responsibility for the Financial statements 4 The Balance Sheet 4 The Income Statement 6 The Cash Flow Statement 8 The Statement of Stockholder's Equity and 10 Statement of Retained Earnings FINANCIAL STATEMENT ANALYSIS 12 Tests of profitability Tests of liquidity Tests of Solvency CONCLUSION 13 SUGGESTED READINGS 13 Authored for the Institute of Corporate Directors (ICD) by: Ramy Elitzur Ph.D., CPA(USA), CMA(USA) The Edward Kernaghan Professor in Financial Analysis Rotman School of Management, University of Toronto The Institute of Corporate Directors (ICD), 2010

3 Introduction As a participant in the Directors Education Program (DEP) you will need to be familiar with some financial tools and concepts. As such, this document is intended to provide you with some basic tools and concepts of financial competency. If you feel that you need a stronger knowledge base there are a number of excellent books to read on the topic (please see the suggested readings at the end of this guide) and a number of financial courses available for non-financial executives available at business schools across the country. In addition, the ICD now offers a one-day Boardroom Financial Essentials course, for more details, please visit The guide begins by describing financial statements and their objectives. The responsibility for financial statements is then discussed, followed by a discussion of each financial statement accompanied by a recent example. The final section provides a general discussion of financial statement analysis. Financial Statements GENERAL OVERVIEW Financial statements are the major means of communicating financial information to external parties, whether it is a for-profit business organization, a governmental entity, or a not-for-profit organization. The discussion here aims to provide information for participants of the Directors Education Program (DEP) and thus focuses on public corporations, as opposed to private companies, governmental entities, or not-for-profit organizations. There are, in essence, two systems of accounting: financial accounting and managerial accounting. Financial accounting aims to provide information to external parties (such as, investors, creditors, regulators and so forth) and its final output is the financial statements (including notes). Managerial accounting, in contrast, serves internal decision makers within the organization, in essence, various levels of management. External and internal users of the accounting systems have very different informational needs and, consequently, the two systems have very different structures. Furthermore, as external users have no access to internal company records and, as such, suffer from an informational disadvantage (often referred to as asymmetrical information ) financial statements for public entities are covered by regulations and laws to ensure that their format, timing, and contents provide useful information for decision making to parties external to the entity. Managerial accounting, on the other hand, because its users are internal decision makers is not covered by laws or regulations and is flexible with respect to the reports in terms of their content, format and timing. The financial statements that entities report are the balance sheet, income statement, statement of cash flows, statement of shareholders' equity, and statement of retained earnings. Financial reports are released quarterly and annually. Quarterly statements are normally unaudited and summarized while the annual statements are audited by an external auditor and more detailed. 3

4 RESPONSIBILITY FOR THE FINANCIAL STATEMENTS The financial statements are the primary responsibility of the management of the corporation and, as such, it signs a statement of management responsibility for financial reporting. The Board of Directors reviews and approves the information contained in the financial reports of the corporation. The Audit Committee is appointed by the Board of Directors annually and is comprised of independent and financially literate directors 1. The Audit Committee meets regularly with management and the independent auditors, to ascertain that both of them properly fulfill their responsibilities, to review the financial statements and the independent auditors report and to discuss significant financial reporting issues and auditing matters. The Audit Committee reports its findings to the Board of Directors for consideration when approving the consolidated financial statements for issuance to the shareholders. The independent auditors audit the financial statements of the corporation in accordance with generally accepted auditing standards and provide an opinion on whether the financial statements present fairly, in all material respects, what they are supposed to present, in conformity with generally accepted accounting principles (GAAP). The Balance Sheet The balance sheet reports on the financial position of a company as at the last day of the quarter, or the year. As such, it provides a snapshot of the company s assets, liabilities and equity. Assets are economic resources that the company controls (for example, cash or inventory) and are classified as either current (those that will become cash or expire within a year) or non-current (those that will remain beyond a year). Liabilities are the debts and obligations of the company and, like assets, are broken into current and non-current liabilities based on whether they expire within a year or not Stockholders equity, also known as shareholders equity, is the amount of financing provided by shareholders (contributed capital) and operations (retained earnings). The balance sheet essentially provides the following equation: Assets = Liabilities + Stockholders Equity Where one side of the balance sheet (the assets) provides the amount of resources commanded by the organization the other side provides how these resources were financed, by debt (liabilities) and internal financing (stockholders equity). The following example provides a recent balance sheet of Bombardier Inc. Whenever a company owns subsidiaries, like in the case of Bombardier Inc., the financial statements of the parent and subsidiaries have to be consolidated. Exhibit 1 (page 5) shows that the total assets were about US$21.3 billion in January 31, 2009, financed by about US$18.8 billion of liabilities and US$2.5 billion of stockholder s equity. Note that the unit measure here is millions of US dollars. The exhibit shows that the balance sheet provides a snapshot of the financial position at a given date (January 31, 2009 and January 31, 2008) and that it obeys the equation above. Note that the balance sheet in the exhibit below contains several types of intangible assets (e.g., intangible assets of about US$1.4 billion and goodwill for US$2 billion on the most recent balance sheet). These assets lack any physical substance and, with the exception of goodwill, are amortized. Goodwill, in contrast, is not amortized but, like any other intangible assets, can be written down or off if found to be impaired 2. Goodwill reported can arise only as a result of an acquisition of another company and is defined as the difference between the price paid in an acquisition of a subsidiary and the fair market value of the net assets of the subsidiary. 1 According to the Canadian Securities Administrators National Instrument , Audit Committees, financial literacy is defined as the ability to read and understand a set of financial statements that present a breadth and level of complexity of the issues that can reasonably be expected to be raised by the issuer s financial statements. 4 2 Assets are considered to be impaired if they suffer from a permanent decline in value. This could happen due a physical event (e.g., fire), or due to the fact that expected future benefits from the asset are below what was originally expected.

5 Exhibit 1 Bombardier Inc s Balance Sheet Consolidated Balance Sheet (in millions of U.S. dollars) As at January Assets Cash and cash equivalents $ 3,470 $ 3,602 Invested collateral Note ,295 Receivables Note 4 1,981 1,998 Aircraft financing Note Inventories Note 6 5,522 5,092 Property, plant and equipment Note 7 1,568 1,732 Intangible assets Note 8 1,399 1,451 Fractional ownership deferred costs Deferred income taxes Note 20 1, Accrued benefit assets Note Derivative financial instruments Note Goodwill Note 9 2,010 2,533 Other assets Note $ 21,306 $ 22,120 Liabilities & Shareholders Equity Accounts payable and accrued liabilities Note 12 $ 6,988 $ 6,919 Advances and progress billings in excess of Related long-term contract costs 2,072 2,791 Advances on aerospace programs 2,991 2,926 Fractional ownership deferred revenues Long-term debt Note 13 3,952 4,393 Accrued benefit liabilities Note ,066 Derivative financial instruments Note 3 1, Preferred shares Common shareholders equity 2,197 2,771 $ 21,306 $ 22,120 5

6 The Income Statement The income statement reports on the results of operations for the year or the quarter (i.e., on the profitability of the company during that period). The income statement contains three categories: revenues, expenses, and either net income or net loss. Revenues are the earnings from the sale of goods or services and must meet two criteria in order to be recognized: n The performance of the company is virtually complete. Another way to describe this is that there was a transfer of risk and benefits from the seller to the buyer. This criterion is normally met when the goods or services are delivered. n Collectability is reasonably assured. Only if both criteria are satisfied can revenues be recognized. Note that revenues and cash receipts are not the same and when these two criteria are met revenues can be recognized even though cash was not yet received. Similarly, expenses are not synonymous with cash payments and represent usage of resources intended to generate income. Typical expenses include cost of sales, selling general and administrative expenses, research and development expenses, and so forth. The difference between revenues and expenses is the net income or net loss. When revenues exceed expenses the bottom line of the income statement is net income. If, on the other hand, expenses exceed revenues the bottom line is net loss. Exhibit 2 (page 7) shows an example of a recent income statement. Note that for the most recent year Bombardier Inc has total revenues of about US$19.7 billion (not including financing income), operating expenses of about US$18.3 billion, financing income of US$270 million, financing expense of US$408 million and income tax expenses of US$265 million. All of which result in net income of about US$1 billion. 6

7 Exhibit 2 Bombardier Inc s Statements of Income Consolidated Statements of Income (in millions of U.S. dollars, except per share amounts) For the fiscal years ended January Revenues Manufacturing $ 14,779 $ 12,508 Services 3, ,016 Other 1,825 1,982 19,721 17,506 Cost of sales Notes1, 6 16,049 14,607 Selling, general and administrative Note 1 1,558 1,408 Research and development Other income Notes 1,17 (23) (62) Amortization Special item Note ,310 16,766 Income before the following: 1, Financing income Note 19 (270) (225) Financing expense Notes 1, Income before income taxes 1, Income taxes Note Net income $ 1,008 $ 317 Earnings per share (in dollars) Note 21 Basic $ 0.57 $ 0.17 Diluted $ 0.56 $

8 The Cash Flow Statement Cash flow is the bloodline of any company and thus, as the statement of cash flow purports to achieve, it is crucial to understand what happened to the company s cash. The cash flow statement takes into account not just pure cash but cash equivalents (i.e., highly liquid and low risk cash like assets such as bank drafts and highly liquid government securities). Cash flows are broken into three types of activities as follows: n Cash flows from operating activities: Cash flows that show in this category include all cash flows related to earnings. As such, this category includes cash flow related to sales and expenses, such as collections from customers, payments to suppliers and employees, interest payments, interest and dividends receipts and tax payments. Note that interest payments show up in this category as they relate to interest expense. Similarly, interest and dividends cash received would be in this category as they relate to interest and dividend income. n Cash flow from investing activities: Cash outflows in this category include cash paid for buying property, plant and equipment or investment in other companies. Cash inflows in this category include all cash received from selling such assets. n Cash flow from financing activities: Cash inflows in this category include cash received from issuing shares or taking debt. Cash outflows in this category relate to payment of principal of debt, dividend payments, or repurchases of the company shares. The statement ends up with a reconciliation of cash flows. Essentially, the total of net cash flows from all three activities provide the net change in cash balance, which together with the beginning cash balance provide us with the ending cash balance. This bottom line of the cash flow statement, the ending cash balance, must be the same as both the amount shown on the balance sheet and the physical cash on hand and in the bank. Exhibit 3 (page 9) below provides an example of a recent cash flow statement. Note that, like the income statement, the cash flow statement refers to a period and not to a single date, in this year it refers to a whole year. Note that in both years the net cash flows from operating activities are positive and the net cash flows from investing activities and financing activities are negative. As such, this shows that the company generates cash from operations, invests in long term assets and is a net payer of financing. As is customary, the company also shows the effect of exchange rate changes on cash and cash equivalents. Together these activities resulted in a net decrease in the cash balance in the most current year (US$132 million), which together with the beginning balance (US$3.6 billion) resulted in an ending cash balance of US$3.47 billion, the same amount shown on the balance sheet in Exhibit 1 (page 5). Commonly, companies disclose, as Exhibit 3 (page 9) does, the amounts included in the operating cash flows that relate to interest payments (US$413 million in the most recent year, for example) and tax payments (US$98 million in the most year, for example). 8

9 Exhibit 3 Bombardier Inc s Statement of Cash Flows Consolidated Statements of Income (in millions of U.S. dollars, except per share amounts) For the fiscal years ended January Operating activities Net income $ 1,008 $ 317 Non-cash items: Amortization Deferred income taxes Note (25) Gain on Disposals of property, plant & equipment (28) (3) Stock-based compensation Note Special item Note Net change in non-cash balances related to operations Note 22 (746) 1,383 Cash flows from operating activities 909 2,380 Investing activities Additions to property, plant and equipment and intangible assets (621) (472) Disposals of property, plant and equipment Invested collateral Other (4) (117) Cash flows from investing activities (1 8 1) (534) Financing activities Repayments of long-term debt (166) (472) Purchase of Class B shares held in trust under the performance share unit plan Note 14 (54) (55) Issuance of shares, net of related costs 7 5 Dividends paid (147) (30) Other (6) - Cash flows form financing activities (366) (1,156) Effect of exchange rate changes on cash and cash equivalents (494) 264 Net increase (decrease) in cash and cash equivalents (132) 954 Cash and cash equivalents at beginning of year 3,602 2,648 Cash and cash equivalents at end of year $ $ 3,602 Supplemental information Cash paid for: Interest: $ $ 559 Income taxes $ 98 $ 108 9

10 Statement of Stockholders Equity and Statement of Retained Earnings The Statement of Stockholders Equity provides information on how the various components of stockholders equity change during the period. As such, the statement would report the beginning balance of, changes in, and the ensuing ending balance of contributed capital, retained earnings and the other components of the equity. An extract below from Exhibit 4 (page 11) provides a recent example of a statement of stockholders equity. The total of changes in each of the components of the most recent statement result in a decrease in equity from US$3.1 from last year to the current balance of about US$2.5 in the most recent year. Note that this amount is exactly the same as shown on the balance sheet in Exhibit 1 (page 5). In addition, some companies show a statement that reports the developments in retained earnings during the year. In the example shown in Exhibit 4 (page 11) this additional reporting is part of the statement of equity: Retained Earnings Balance at beginning of year $ 1,040 $ 753 Change in accounting policy Inventories Note 1 (268) - Fair value measurement Note 1 (66) - Net income 1, Dividends: Common shares (120) - Preferred shares (27) (30) Balance at end of year $ 1,567 $ 1,040 The above report shows that in the most recent year the beginning balance of retained earnings was about US$1 billion. Changes in retained earnings included changes in accounting policy (US$ 268 million and US$ 66 million), net income (about US$ 1 billion), and dividends (US$ 147 million in total), which led to an ending balance of retained earnings of US$1.567 billion. 10

11 Exhibit 4 Bombardier Inc s Statement of Shareholders Equity Consolidated Statements of Shareholders Equity For the fiscal years ended January 31 (in millions of U.S. dollars, except per share amounts) Number Amount Number Amount SHARE CAPITAL Note 14 (in thousands) (in thousands) Preferred Shares Series 2 9,465 $ 159 9,465 $ 159 Series 3 2, , Series 4 9, , , , Common Shares Class A Shares (Multiple Voting) Balance at beginning of year 316, , Converted to Class B (379) - (82) - Balance at end of year 316, , Class B Shares (Subordinate Voting) Balance at beginning of year 1,434,974 1,419 1,433,423 1,413 Issuance of shares 2, ,469 6 Converted from Class A ,437,520 1,428 1,434,974 1,419 Held in trust under the performance Note 14 share unit plan Balance at beginning of year (21,273) (89) (11,847) (34) Purchased (6,942) (54) (9,426) (55) Distributed 4, Balance at end of year (23,654) (130) (21,273) (89) Balance at end of year 1,413,866 1,298 1,413,701 1,330 Balance at end of year common shares 1,730,449 1,327 1,730,663 1,359 Total share capital $ 1,674 $ 1,706 CONTRIBUTED SURPLUS Balance at beginning of year $ 68 $ 35 Stock-based compensation Note Options exercised and shares distributed under the performance share unit plan (15) (1) Balance at end of year $ 104 $ 68 RETAINED EARNINGS Balance at beginning of year $ 1,040 $ 753 Change in accounting policy Inventories Note 1 (268) - Fair value measurement Note 1 (66) - Net income 1, Dividends: Common shares (120) - Preferred shares (27) (30) Balance at end of year $ 1,567 $ 1,040 ACCUMULATED OTHER COMPREHENSIVE INCOME, NET OF TAX Note 16 Balance at beginning of year $ 304 $ 174 Fair value measurement Note Other comprehensive income (1,112) 130 Balance at end of year $ (801) $ 304 Total shareholders equity $ 2,544 $ 3,118 11

12 Financial Statement Analysis As a participant in the DEP you will be required to perform some financial analysis. This guide is not intended to provide a deep understanding of financial statement analysis but rather offer a basic introduction to facilitate your effective participation in the DEP. Financial statement analysis has to be done in a context and thus can only be applied after understanding the economic environment of the business, its strategy, operations and business models. Furthermore, such analysis needs to take into account the ratios of the company and comparable companies over time. For example, the analysis of an oil and gas company would be quite different from an airline or a retailer because the economics of the industry and value drivers are quite different. As a result, the ratios which are important for an airline would not be the same for an oil and gas company, or a retailer. Furthermore, what is considered to be a good ratio in terms of value would differ among industries. Ratios usually fall into the following categories: Tests of Profitability: These ratios analyze the profitability of the company and include ratios such as net profit margin, return on assets, return on equity and so forth. In Exhibit 5 below an example of a profitability ratio is provided, the Net Profit Margin ratio, calculated as net income divided by sales. The Exhibit shows that in 2008 every $100 of sales resulted in $3.10 net income, while in 2009 the same sale would have resulted in a larger income of $10.10 Tests of Liquidity: These tests analyze the liquidity of the company and include measure such as net working capital, current ratio, quick (acid test ratio), inventory turnovers, accounts receivable turnovers and so forth. Bombardier Inc. does not distinguish in its balance sheet between current assets and noncurrent assets and, thus, the sample ratio that analyses liquidity in Exhibit 5 is Operating Cash Flow to Total Liabilities. The ratio targets the question of how well are liabilities covered by cash flows from operations (the higher the better). The calculation shows that there was a drop from 12.5% to 4.8%, explained mostly by the decrease in operating cash flows (see Exhibit 4) from US$ 2.4 billion to US$ 909 million. Tests of Solvency (also known as Capital Structure or Leverage Ratios): These ratios measure the long-term risk of the company, which is correlated with how levered the company is. Such tests include ratios such as debt to assets, debt to equity, interest coverage ratios and so forth. The sample ratio in Exhibit 5 below reveals that in 2008 around 85.9% of assets were financed by liabilities and in 2009 it increased slightly to about 88%. Exhibit 5: Sample Ratios Bombardier Inc Profitablility Ratio Net Profit Margin = Net Income/Sales 10.1% 3.3% Liquid Ratios Operating Cash Flows/Total Liabilities 4.8% 12.5% Solvency Ratios Debt/Assets = (Total liabilities/total assets) 88.1% 85.9% 12

13 Conclusion Every member of the audit committee in public companies by regulation has to be financially literate. While no such legal requirement falls on the other directors of a company, every director has a duty and responsibility for the oversight of the company s finances and financial statements and, as such, it is in every director s best interest to ensure that they are at minimum financially competent 3. During the DEP you will be exposed to various financial reports and analyses and participate in case discussions involving them with the goal of raising the financial competency of every DEP graduate. This guide is meant only to provide DEP participants with a baseline of knowledge to assist in your participation in the course. But even the course itself should not be treated as an end point in your financial competency growth. There will be great benefit to the director community and to organizations in Canada if all directors continually strive to advance their financial competency and literacy. 3 The term financially competent does not appear in any legal definition. We used it here to denote a level below that of financial literacy but one that would help you function and contribute as a board member, or as a DEP participant. Suggested Readings Basic Accounting and Reporting Libby, R., Libby, P.A., & Short, D. G. (2007). Financial Accounting. 5/e. McGraw Hill. ISBN: Easton P.D., Wild, J.J., Halsey R.F., & McAnally, M.L.(2010). Financial Accounting for MBAs, 4th Edition. ISBN: Pierre Bergeron. (2007). Finance for Non-Financial Managers, 6th Canadian Edition. ISBN-10: ISBN-13: Financial Statement Analysis Clyde P. Stickney, Paul Brown, James M. Wahlen. (2007). Financial Reporting, Financial Statement Analysis, and Valuation - A Strategic Perspective, Sixth edition, South-Western Publishing. ISBN-13: Lita Epstein. (2009). Reading Financial Reports For Dummies, 2nd Edition ISBN: