Reading Financial Statements to Aid in Business Decision-Making. Copyright 2015 by IndustriusCFO, A C-Leveled Company

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2 Copyright 2015 by All rights reserved. No patent liability is assumed with respect to the use of the information contained herein. Although every precaution has been taken in the preparation of this book, the publisher and authors assume no responsibility for errors or omissions. Nor is any liability assumed for damages resulting from the use of the information contained herein. Trademarks All terms mentioned in this book that are known to be trademarks or services have been appropriately capitalized. IndustriusCFO cannot attest to the accuracy of this information. Use of a term in this book should not be regarded as affecting the validity of any trademark or service mark. The Learning Company is a fictitious entity for the purpose of illustration and any similarity or resemblance to any company, real or imagined, is coincidental and unintended. Warning and Disclaimer Every effort has been made to make this book as complete and accurate as possible, but no warranty or fitness is implied. The information provided is on an as is basis. The authors and the publisher shall have neither liability nor responsibility to any person or entity with respect to any loss or damages arising from the information contained in this book. 2

3 Contents Financial Statements... 7 Introduction... 7 The Purpose of Financial Statements... 8 Overview of Financial Statements... 9 Balance Sheet... 9 Income Statement Cash Flow Statements Statements of Stockholders Equity Analysis of Financial Statements Why Analyze Financial Statements Types of Financial Statement Analysis Horizontal Analysis How to Create a Horizontal Analysis Vertical Analysis How to Create a Vertical Analysis How to Create a Common-Size Vertical Analysis Ratio Analysis Liquidity Ratios Activity Ratios Leverage Ratios Profitability Ratios Market Value Ratios Dividend Ratios Summary of Financial Ratios (Quick Reference Guide) Cash Flow Statement Analysis Financial Accounting Standards Board (FASB) Requirements Accrual Basis of Accounting In Conclusion

4 About the Authors Denise DeSimone Marianne Reid Anderson Acknowledgments and Sources We Want to Hear From You!

5 This book is written for business owners who need to use, read, and understand Financial Statements in order to more effectively run their business. 5

6 Financial Statements are the lighthouses of business, from a fiscal perspective. They warn of oncoming danger, show you where you can go full steam ahead and illuminate where and when you should proceed with caution. Denise DeSimone 6

7 Financial Statements Introduction Growing a business is a challenge; running one is impossible if you don t understand the language of money, specifically, accounting. In other words, if you cannot balance your own checkbook, you are going to have trouble managing, tracking and knowing how to control your business and its future development. Knowing how to create and understand Financial Statements helps a business to evaluate both its past and present, and help predict its future. This understanding is the key to prudent business decision-making; which is the key to success. Fortunately, the basics of reading Financial Statements is a science; but not rocket science. An entrepreneur need only master a few basic concepts and learn about a few standard reports to master his or her company. This ebook is designed to help you gain a basic understanding of how to read Financial Statements. It will not train you to be an accountant; but will help you master the basics of Financial Statements; thereby, giving you the confidence and basic knowledge to make sense of them for running your business. The goal of this book is to give you two skills: To help you understand your Financial Statements To help you analyze them. Therefore, the book is divided into two parts: Financial Statements (describes the what ) Analysis of Financial Statements (describes the how ) Let s begin by looking at the purpose of Financial Statements: 7

8 The Purpose of Financial Statements Generally, Financial Statements show you where a company s money came from, where it went, and where it is now. For example, did it come from Sales, investments, or loans? How was it spent? How much was spent, how much is available and how much is invested? Specifically, Financial Statements tell you where in your business your money is, so you can keep track of it and manage it effectively. For instance, through Financial Statements, you can see if your money is invested in stock, trapped in non-performing Fixed Assets or collecting dust in an outdated Inventory. Ultimately, well-organized, Financial Statements summarize what you need to know in a way that lets you quickly pick out key issues. One financial statement, that we will examine first, is called a Balance Sheet. It will clearly show an amount, for instance $100,000, is invested in overall Plant Assets, as of a specific date. You can see this amount instantly and then decide if this is sufficient and use other Financial Statements to determine if you have the means to invest in additional Plant Assets. Some Financial Statements are governed by a legal framework with international standards of accounting and auditing, and are generally prepared by a professional accountant or tax accountant. However, these are not necessarily the Financial Statements that you need to run a business. Instead, Financial Statements, reporting and analysis, sometimes referred to as management accounting is what you need for business decision-making and is the primary focus of this book. Fundamentally, the four main, standard Financial Statements and the type of information each provides is: 1. Balance Sheets a company s financial position (Assets, Liabilities and Net Worth) at the end of a time period such as for a quarter, for a year, over the past three years, and so forth. 2. Income Statements - Earnings (net income and expenses) for the period. 3. Cash Flow Statements - How and where Cash moved during the period. 4. Statement of Stockholders Equity - Comprehensive income (changes in Equity and value of ownership) for the period. Following is an overview of these Financial Statements. The final section will discuss analyzing Financial Statements. 8

9 Overview of Financial Statements As previously stated, here are the four standard Financial Statements that we will be examining: 1. Balance Sheets a company s financial position (Assets, Liabilities and Net Worth) at the end of a time period such as for a quarter, for a year, over the past three years, and so forth. 2. Income Statements - Earnings (net income and expenses) for the period 3. Cash Flow Statements - How and where Cash moved during the period 4. Statement of Stockholders Equity - Comprehensive income (changes in Equity and value of ownership) for the period Let s take a closer look at each statement, individually: Balance Sheet A Balance Sheet is a statement showing the Assets, Liabilities and Stockholders Equity of a business. It provides detailed information in a specifically defined format. As the name implies, a Balance Sheet must be in balance meaning: The total value of the Assets must be the same as the combined total value of the Liabilities and Stockholders Equity. In other words: BASIC ACCOUNTING EQUATION: Assets = Liabilities + Stockholders Equity Principle: A company s Assets must be equal to the sum of its Liabilities and Stockholders Equity. A Balance Sheet portrays the financial position of a company by showing what the company owns at a specific point-intime, like a snapshot. The point-in-time is the date stated in the heading of the Balance Sheet and every Balance Sheet is divided into the three sections that it represents: Assets Liabilities Stockholders Equity 9

10 By way of illustration, let s look at some sample Balance Sheets: Balance Sheets can be laid-out either horizontally or vertically. In a horizontal set up, the monetary value of left side is equal to the monetary value of right side. On the left side of the Balance Sheet, companies list their Assets. On the right side, they list their Liabilities and Stockholders Equity. The Learning Company Balance Sheet (In Thousands of Dollars) as of December 31, 2014 and Liabilities Particulars Assets Current Assets Cash Accounts Receivable Marketable Securities Inventory Current Liabilities Payroll Short- Term Debt Long- Term Liabilities Long- Term Debt Common Stock, $10 par value, 4500 shares Retained Earnings Total Non- Current Assets Total Stockholders' Equity Total Assets Total Current Assets Non- Current Assets Plant Assets Total Liabilities Stockholders' Equity Total Liabilities and Stockholders' Equity Note: Total Assets on the Left equals Total Liabilities and Stockholders Equity on the right. 10

11 In a vertical set up, the monetary value of the top portion is equal to the monetary value of the bottom portion. In the top portion of the Balance Sheet, companies list their Assets. In the bottom portion, companies list their Liabilities and Stockholders Equity. The Learning Company Balance Sheet (In Thousands of Dollars) as of December 31, 2014 and 2013 The particular point in time of a Balance Sheet is stated in the header Particulars Assets Previous year data given as comparison Current Assets The 3 sections of a Balance Sheet are: Assets Liabilities Stockholders Equity (a.k.a. Equity or Capital) means of Cash Accounts Receivable Marketable Securities Inventory Plant Assets Total Current Assets Non- Current Assets Total Non- Current Assets Total Assets Liabilities Current Liabilities Payroll Short- Term Debt Total Long- Term Liabilities Long- Term Debt Total Liabilities Stockholders' Equity Common Stock, $10 par value, 4500 shares Retained Earnings Total Stockholders' Equity Total Liabilities and Stockholders' Equity Whether it is laid out horizontally or vertically, a Balance Sheet still balances. 11 *MUST* = Liabilities As you can see, the Balance Sheet is divided into the three main sections and that it balances, meaning Total Assets = Total Liabilities + Stockholders Equity Assets + Equity

12 Let s take a closer look at each section and the Balance Sheet and this equation: Assets: Assets are defined as those things that a company owns and have value. Assets might include physical property like plants, cars, trucks, machines, and Inventory, but it may also include intangible things (things that do not exist in a physical sense, but which nevertheless have monetary value), such as trademarks and patents. Cash, in and of itself, is also considered an Asset, as are Accounts Receivable (the money due in from customers), securities and investments and any other item of value. Specifically, businesses use Assets, as shown on a Balance Sheet, in their day-to-day operations for earning money. This use typically means either a business can sell these Assets, or it can use them to make products for sale, or to render services. As in the illustration, Assets can be divided into Current and Non-Current Assets. The difference is how Liquid or readily-available the Asset is to use. For example, selling a security or investment for Cash makes the Asset Liquid and Current. Non-Current usually means Physical Assets such as buildings or equipment, which has value, maybe even considerable value, but is difficult to sell or turn into ready Cash. FYI: Many businesses have non-monetary Assets which include Intangible Assets such as trademarks, patents, goodwill, etc. which are difficult to set a specific value and are definitely part of the overall value of a company, but unfortunately, these cannot be transferred into ready Cash. Any item having no monetary value is irrelevant to the financial state of a company at a point-in-time and is therefore not taken into consideration on a Balance Sheet. Normally, if a non-monetary thing has a potential effect on items on a Balance Sheet, then this information is listed in the footnotes or documentation that accompanies the Balance Sheet or other Financial Statements. Generally, we list Assets in order of Liquidity, or how quickly they will be converted into Cash. Therefore, a breakdown of Assets into the categories of Current Assets (those that can be converted to Cash quickly) and Non-Current or Long-Term Assets (which take more time to convert to Cash) is necessary to place them on Balance Sheet at proper place. Current Assets and Non-Current or Long-Term Assets are, typically, subtotaled in the Asset list. As you can see in following illustration: 12

13 The Learning Company Balance Sheet (In Thousands of Dollars) as of December 31, 2014 and 2013 Particulars Assets Cash Accounts Receivable Marketable Securities Inventory Plant Assets Current Assets Note: The three main sections of Assets, Liabilities and Equity are Total Current Assets Non- Current Assets Total Non- Current Assets Total Assets Liabilities Current Liabilities further Payroll Short- Term Debt subdivided Long- Term Liabilities Long- Term Debt Total Liabilities Stockholders' Equity Common Stock, $10 par value, 4500 shares Retained Earnings Total Stockholders' Equity Total Liabilities and Stockholders' Equity Current Assets are things a company expects to convert to Cash within one period. Normally, this period is one year. A good example of Current Assets is Inventory. Most companies expect to sell their Inventory for Cash within one year. However, there may be situations where a company stocks nonperishable inventories as a part of their business strategy; in expectation that the Inventory will maintain or increase in value in the future. Non-Current Assets are things a company does not expect to convert to Cash within one year or that would take longer than one year to sell. This type of Asset includes Fixed Assets, and the Assets used to operate the business which are not available for sale, such as cars, office furniture, buildings and other property. 13

14 Liabilities: Liabilities can be thought of as money that a company owes and is obliged to pay to others to acquire Assets and to run a business. Liabilities include all kinds of obligations, such as money borrowed, rent for use of a building, money owed to suppliers, environmental cleanup costs, payroll, as well as, taxes owed to the government. Liabilities may also include obligations to provide goods or services to customers in the future. Therefore, to keep things in balance, if one thing on your Balance Sheet is an Asset or a positive item, then its opposite is a Liability. (Equity is a special type of Liability that we will cover later.) From an economic perspective, each dollar of Assets must be funded by a dollar of Liabilities or Equity. This principle is what we described earlier as in balance and is the standard way accountants and bookkeepers note a transaction, to verify that the accounts balance. (You can think of this as you would think of a quid pro quo or give & take transaction. For example, if you purchase something on credit, you receive it from the seller or manufacturer and it becomes an Asset to the business; but you also need to convey the Debt, or short-term Liability of the money that went to the seller or manufacturer. For every amount of value that you receive, you in turn, give an amount of value as payment, keeping the company s books in balance. Liabilities can also be divided into two categories based on their due date: Current Liabilities and long-term Liabilities. We list them on Balance Sheet based on their due dates, just as we list Assets in order of liquidity. Current Liabilities are obligations that a company expects to payoff within the year. On the Asset side, their counterparts are Current Assets. Long-term Liabilities are obligations due more than one year out. On the Asset side, their counterparts are the fixed Assets. The following illustration identifies the categories of Assets and Liabilities: 14

15 The Learning Company Balance Sheet (In Thousands of Dollars) as of December 31, 2014 and 2013 Categories of Assets and Particulars Assets Current Assets: in one year Convertible to Cash in more than one Current Liabilities: Payable in one year Long-Term Cash Accounts Receivable Marketable Securities Inventory Plant Assets Total Current Assets Non- Current Assets Total Non- Current Assets Total Assets Liabilities Current Liabilities Payroll Short- Term Debt Long- Term Liabilities Liabilities: Payable in more than one year 2013 Current Assets Convertible to Cash Non-Current Assets: 2014 Long- Term Debt Total Liabilities Stockholders' Equity Common Stock, $10 par value, 4500 shares Retained Earnings Total Stockholders' Equity Total Liabilities and Stockholders' Equity Capital or Stockholders Equity Stockholders Equity is also known as a company s Capital or Net Worth. This section lists the money that would be leftover if a company sold all of its Assets and paid off all of its Liabilities. Therefore, we use the word Net Worth. This leftover money belongs to the stockholders, or the owners, of the company. It can also accumulate over time because of a constantly profitable business. A positive Net Worth means you ve made a profit; negative means you ve lost money. A company may or may not distribute its earnings. Business circumstance and liquidity (Cash) needs dictate the decision to distribute earnings. When companies distribute earnings instead of retaining them, these distributions are called dividends. A full distribution of earnings seldom occurs. Generally, only a part of the earnings becomes a dividend. 15

16 In summary, one must strictly think of a balance as a snapshot. It is not like a movie that records the happenings of a company from the start to the end of a period; it only shows a snapshot of a company s Assets, Liabilities and Stockholders Equity at the end of the reporting period. It doesn t show the Flow into and out of the company s accounts during the reported period. For this information, businesses use Income Statements and Cash Flow Statements. Since Balance Sheets show the financial status at a specific point in time. Let s look at the Income Statement which shows how a company performed over a specified period of time. 16

17 Income Statement Income Statements are typically prepared at the end of a business period (such as a Fiscal Year or Quarter) to assess profit or loss. It can be thought of like a motion picture. It reports how a company performed during the period presented, and shows whether that company s operations have resulted in a profit or loss. Therefore, it shows how much money a company made and spent over the period. The period is shown in the header of the Income Statement. To state this another way, it is a financial report that shows how much revenue a company earned over a specific period (usually a year). An Income Statement also outlines the costs and expenses associated with earning the revenue. Typically, the final figure of this statement shows the company s net earnings or losses. This final figure tells you how much the company earned or lost over the period. Drawing an Income Statement To better understand how Income Statements are set up, it may be helpful to think of them as a set of stairs. The period of time is shown in the header Step 1: Step 2: Step 3: Step 4: Step 5: Step 6: The Learning Company Income Statement (In thousand of dollars) For the years Ended Dec 2014 and 2013 Particulars Sales Sales Returns and allowances Net Sales Cost of Goods Sold Gross Profit Operating Expenses Selling Expenses General Expenses Total Operating Expenses Income from Operations Non- Operating Income Income Before Interest Expense and Taxes Interest Expense Income Before Taxes Income Taxes (40% rate) Net Income We start at the top with the total amount of Sales made during the accounting period. Then we will go down, one step at a time. At each step, we make a deduction for costs or expenses associated with corresponding revenue. This means that each step will bring a revenue and an expense pair, or an expense item into the picture. At the last step, after deducting all expenses, we will learn how much the company earned or lost during the period. People often call 17

18 this the bottom line. It is the company s net earnings or loss. Let s take a closer look at each step: Step 1. At the top of the Income Statement is the total amount of money brought in from Sales of products or services. This is the gross revenue or Sales and often referred to as the top line. It s gross because we have not deducted expenses from it, therefore a gross or unrefined number. Similar to your pay stub from your paycheck, which starts out listing your gross pay, then lists all your deductions and taxes down to your net pay. Likewise we start with gross revenue or Sales and in each subsequent step, we will further refine it, approaching the net figure at the last step. Step 2. The next line lists money the company does not expect to collect on certain Sales. This could be, for instance, Sales discounts or merchandise returns or bad checks. Therefore, it is a deductible item because it is non-collectable. Since it is a loss of revenue, we subtract it from Sales to arrive at the company s net revenue or Net Sales. Step 3. This step typically shows the costs associated with the Sales also known as the Cost of Goods Sold. This is the amount of money spent to produce the goods or services sold during the period. By deducting the Cost of Goods Sold, we get Gross Profit or gross margin. It is gross because there are still additional expenses that need to be deducted to arrive at our last step. Step 4. The next step deals with Operating Expenses. It is a comparatively bigger step on the stairs, simply because there can be a great number of them. Operating expenses are the expenses that go toward supporting a company s operations for a given period. Operating expenses are different from the cost of Sales because operating expenses cannot be linked directly to the production of the products or services rendered. In our example, the operating expenses are divided into Selling Expenses and General Expenses. Selling expenses include those expenses spent to make a sale and can include marketing costs, travel, and commissions. General expenses can include salaries, research and development and depreciation or amortization. Note: Depreciation or Amortization takes into account the wear-&-tear on Assets such as machinery, tools and furniture, which are used over a long term or over a number of periods. Therefore, we also spread the cost of these Assets over the periods they are used. The depreciation deducted from Gross Profit in a period is determined as a fraction of the original cost of the Assets. This fractional amount is usually placed in a savings or depreciation account so that it is there to be used as a replacement cost at the end of the life of the equipment. 18

19 After all of the operating expenses are deducted from Gross Profit, we arrive at the figure of operating profit before interest and income tax expenses, also known as income from operations. In our example, Income from Operation equals Gross Profit minus Total Operating Expenses. Step 5. Next, we still need to account for interest income and interest expenses. Interest income is the money companies make from keeping their Cash in interest-bearing savings accounts or other investments. Interest expense is the money companies paid in interest for money they borrow. We add or subtract the interest income and expense to arrive at the figure of the Income Before Taxes. Step 6. In the final step, income tax is deducted and we arrive at the bottom line or the last step of the stair: net profit or net losses. Here we finally know about the profit or loss of a company. Specifically, whether or not the company made or lost money and, as in our example, whether they did better or worse than the previous year. FYI: Earnings per Share (EPS) - Some Income Statements also report Earnings per Share (or EPS ). This figure is the earnings per share of investment made in the company. Earnings per Share ratio is discussed and defined in the section on Analyzing Financial Statements. 19

20 Cash Flow Statements Cash Flow Statements - In many businesses, income and Cash Flow are not always the same, which leads to the need for a Cash Flow statement showing the exchange of money between a company and the outside world over a period. The Cash Flow statement reconciles opening balance of Cash (as opposed to non-cash items such as credit Sales) at the start of the period with the closing balance of Cash at the end of a period. Understanding Cash management is critically important for a person running a business. One must be a good manager of Cash to build a business successfully because Cash is vital to the operation of every business. The final information one looks for in the Cash Flow statement is the net increase or decrease in Cash for the period. This information is very important from a financial point of view. Financial analysts focus this information to judge the ability of a business to generate Cash. The information is also of vital importance for the person in business because it tells him/her about their business liquidity strength. The Cash Flow statement aids the businessperson to answer vital questions like: Where was money obtained? Where was money put and for what purpose? Additionally, the information contained in the Cash Flow statement is important to answer many critical questions, such as: Is my business growing, or simply maintaining its competitive position? Will my business be able to meet its financial obligations? Where did my business obtain funds? What use was made of net income? What is the internal capacity of my business to generate funds? How was the expansion in plant [do you mean plant expansion?] financed? Is my business expanding faster than it can generate funds? Is there a balance in the dividend policy and operating policy of my business? Is my business Cash position sound? The pattern of Cash utilization can determine a firm's success or failure. A businessperson must control his/her company's Cash Flow so that bills can be paid on time and extra money can be put into the purchase of Inventory and new equipment or invested to generate additional earnings. The Cash Flow Statements report on the company s Cash movements during a period, categorizing them into three areas that Cash Flows through a business from its operating, investing and financing activities. 20

21 Therefore, Cash Flow Statements generally have three main areas (Cash Flows): 1. Operating activities 2. Investing activities 3. Financing activities The Cash Flow statement discloses Cash in these specific categories. The most important of the Flow categories in a Cash Flow statement is Cash from operating activities. This category is the primary focus of the person operating the business. The Cash Flow from operations must be positive (net inflow) to make the business viable in the future and to make it an attractive investment for the person running the business. Each part reviews the Cash Flow from one there particular type of business activity. See the following Cash Flow Statement illustration: The Learning Company Statement of Cash Flows (in Thousands of Dollars) For the Year Ended December 31, 2014 Operating Activities Investing Activities Financing Activities Change over time Cash flows from operating activities Net Income Add/(deduct) to reconcile net income to net cash flow Depreciation Increase in accounts payable Increase in other liabilities Increase in Accounts Receivable Increase in Inventory Net cash provided by operating activities Cash flows from investing activities Cash paid to purchase fixed assets Sale of marketable securities Net cash provided by investing activities Cash flows from financing activities Decrease in notes payable Issuance of long- term- debt Sale of common stock Cash paid for dividends Net Cash used in financing activities Net decrease in cash and cash equivalents Cash and cash equivalents at beginning of the year Cash and cash equivalents at end of the year $ 182 $ 23 $ 9 $ 24 $ (35) $ (86) $ 117 $ (225) $ 28 $ (197) $ (36) $ 54 $ 78 $ (40) $ 56 $ (24) $ 51 $ 27 A Cash Flow statement such as this, categorized by three separate types of Cash Flow, gives a business a holistic view of total Flows into and out of the business. Cash Flow Statements are therefore fundamental tools to use when 21

22 making decisions about a company s Cash management. A Cash Flow statement is a Flow statement. It is not a snapshot like a Balance Sheet. It shows changes over time rather than an absolute dollar amount at a particular point in time. Information from a company s Balance Sheet and Income Statement is used to prepare a Cash Flow statement. It is reordering of information from a company s Balance Sheet and Income Statement in order to provide a different view of the business. Now, let s look at each section, specifically, Operating Activities Operating activities are defined as the company s primary business activities, for example the production and delivery of goods and services. They reflect the Cash effects of transactions, which are included in the final determination of net income. These activities basically include all activities not classified as either financing or investing activities. Cash Flow from operating activities is the first part of a Cash Flow statement. It analyzes a company s Cash Flow from net income or losses. Typically, this section of the Cash Flow statement reconciles the net income with the actual Cash the company received from or used in its operating activities. To do this, it adjusts net income for any non-cash items like depreciation expenses and adjusts for any Cash used or provided by other operating Assets and Liabilities. As discussed earlier, the most important aspect of Cash Flow in the statement is Cash from operating activities (a.k.a. Cash from operations). The Cash Flow from operations must be positive (net inflow) to make the business viable in the future and to make it an attractive investment for the person running the business. Investing Activities This is the second part of a Cash Flow statement. It shows the Cash Flow from all investing activities, which generally includes purchases or Sales of long-term Assets, such as plants, properties, and investment securities, etc. For example, if the Learning Company buys a piece of machinery, its Cash Flow statement would reflect this activity as a Cash outflow from investing activities. The Cash Flow is categorized as investing activity because it used Cash for investing in the business. Similarly, if the company decided to sell off some investments, it would also be considered an inflow from investing activities. This is because it provided the business with Cash. Financing Activities This is the third part of a Cash Flow statement. Financing activities show the Cash Flow from all financing activities. Financing activities include the activities relating to the receipt and repayment of funds provided by creditors and investors. Examples of this would be in the issuance of Debt or Equity securities, the repayment of Debt, and the distribution of dividends. This means the sources of Cash Flow include Cash inflow resulting from sale of stock and bonds or borrowing. Likewise, the repayment of a bank loan would generate Cash Out-Flow in this category. Businesspeople who intend on expanding their venture need Cash which can be done through Equity or borrowing 22

23 both are financing activities. When a company issues stock or borrows money, it receives Cash. As we stated above, the two Cash receipts are from financing activities. IMPORTANT: When you borrow from a bank, you will have to pay interest (i.e. Cash Out-Flow in future.) An unwise investment or use of these financed funds in a non-productive investment activity may trap a business in a future regular pattern of interest payments. In extreme situations, this may even result in bankruptcy. Statements of Stockholders Equity Statements of Stockholders Equity - The fourth financial statement, called a Statement of Stockholders Equity shows how shares, total Equity and ownership types have changed over time. It reconciles the activity in the Equity section of the Balance Sheet from period-to-period. The changes in Stockholders Equity represent company profits or losses, dividends and (or) stock issue. The specifics of Statements of Stockholders Equity can be extremely varied depending on the way any individual company is organized as it pertains to ownership, stock, preferred stock, paid-in-capital and how this capital is increased or diluted over time and explains what happened to cause any changes in each snap-shot of a Balance Sheet from moment-to-moment. Note: This statement is particularly important if you own stock in a company but do not have voting rights associated with that stock and therefore no control or say in the running of the business; particularly with respect to ownership, dilution of stock by issuing additional shares and so forth. Be sure you know your rights, before investing in the stock of a company. Columns list types of equity in company Balance on January 1 Issued Shares for Cash Purchase of Treasury Stock Net Income Cash Dividends Stock Dividends Balance on December 31 The Learning Company Statement of Stockholders' Equity For period ending January 31, 2015 Common Stock $10 Paid- In- Capital in par Excess of Par Retained Earnings $ 45,000 $ 39,600 $ 3,000 $ 12,000 $ 4,000 $ (1,500) $ 1,150 $ 4,000 $ (5,750) $ 49,150 $ 16,000 $ 36,350 Rows list how the equity changed over the year 23 Total Shareholders' Equity $ 84,600 $ 15,000 $ 13,000 $ 13,000 $ 4,000 $ (1,500) $ (600) $ 13,000 $ 114,500 Treasury Stock

24 As you can see in the illustration, when there is a change in Stockholders Equity over a year, the statement identifies what happened to the Equity over the period that caused the change. A Note about the Footnotes of Financial Statements A company s Financial Statements all come with a set of footnotes. It is very important to read the footnotes in the Appendix of a set of Financial Statements or statements. Because, the footnotes to Financial Statements give vital information. Here are some of the highlights which might be found in footnotes, as well as, why they are important: Significant accounting policies and practices - Companies are required to disclose the accounting policies which are most important to disclose in the company s financial condition and results. The company s management chooses its accounting policies. The choice of accounting policies often requires difficult, subjective and complex judgments by the management. Nonmonetary Assets describes any Assets such as Intangible Assets that cannot be converted into ready Cash but may still influence the overall valuation of a company. Income taxes - The footnotes also state detailed information about the company s current and deferred income taxes. Details include a break-down of total tax into federal, state, local and/or foreign taxes. Pension plans and other retirement programs - Footnotes may also discuss pension plans and other retirement or post-employment benefit programs. Stock options - Information about stock options granted to officers for performance improvement may be included in the footnotes. It would also state the effect of stock option plans on business results being reported on by the Financial Statements. Now that we have examined what Financial Statements are and what kinds of information they hold, let s look at how this information can analyzed to help the business decision-making process. 24

25 We analyze Financial Statements in order to take care of the money already invested, as well as, the money which is to be invested in the future. Denise DeSimone 25

26 Analysis of Financial Statements This section examines the following information to help you analyze your Financial Statements, Why analyze financial Statements The three common types of analysis How to compute each type of analysis Based on the results of the analysis, how to determine what the results mean to you and your company. Why Analyze Financial Statements Sometimes, as business owners, we are so busy with the day-to-day operations of running a business, we forget to take a step back and look at our business as whole. By analyzing Financial Statements, we can spot trends over time, identify the mix of Assets and Liabilities within a certain period of time and evaluate relationships among items to determine efficient operations. Ultimately, an analysis of Financial Statements is an evaluation of: A firm's past financial performance Its prospects for the future The points above relate to two very basic questions in running a business: How well my business is performing? What will happen to it in future? The search for answer to these questions begins with an analysis of the firm's Financial Statements. Formally defined, analysis of Financial Statements is the selection, evaluation, and interpretation of financial data, along with other pertinent information, to assist in investment and financial decision-making, as well as, indicate how and where to improve the overall performance of the business. In general, an analysis of Financial Statements is vital for a person running a business. This analysis tells this business owner where he or she stands in his/her financial environment. Business owners can use financial analysis both internally and externally. They can use them internally to evaluate issues such as employee performance, the efficiency of operations and credit policies, and they can use them externally to evaluate potential investments and the creditworthiness of borrowers, amongst other things. Analysis discloses both the external and internal financial situation and most importantly, it points to the financial destination of the business in near future, and to long-term trends. Analysis can also indicate the relative liquidity, Debt, and profitability of a firm, as well as, indicate how investors perceive the firm and can help detect emerging problems and strengths in a firm. 26

27 Besides analyzing the past performance, analysis helps determine the strategy of a company moving forward. For example, using financial ratios in conjunction with the budgeting process can be particularly helpful in determining costs or changes in process to increase savings and operate more efficiently. Thereby, achieving an objective of the budgeting process to determine the firm's game plan. Or, as in the case of the Sales to Inventory ratio. This ratio is a measure of the ability of a firm to turn Inventory into Sales. Generally, the higher the ratio, the more efficiently the business is using Inventory and turning over its Inventory without the cost of becoming obsolete. In addition to analyzing your company s own financials, you also need to analyze and compare your company s performance to industry peers, also known as, benchmarking. Industry data regarding your peers can be found through the IndustriusCFO system at Types of Financial Statement Analysis Typically, when Financial Statements are prepared they show past information so you can see the change over time. A business owner usually uses many instruments to evaluate the financial health of a business. Three of the most commonly-used evaluation instruments are: Horizontal Analysis analyzes the trend of the company financials over a period of time by showing each line item as a percentage from the previous period. Vertical Analysis compares the relationship between a single item on the Financial Statements to the total transactions within one given period, also indicated as a percentage. You can perform a Vertical Analysis on both an Income Statement and a Balance Sheet. Ratio Analysis analyzes financial ratios or numeric relationships based on a company s financial information and is used to compare a company s performance from one period to another (current year vs. last year). Analysis of Financial Statements is a great value to people running a business in order to accurately determine the strength of a business and where there is room for improvement. In the absence of analysis, such data may lead one to draw erroneous conclusions about the firm's financial condition and result in poor rather than strong decision-making. For example, an Assets to Sales ratio is a measure of a firm's productive use of Assets where a low percentage rate compared to the average for the industry usually indicates highly efficient use of Assets. Likewise, a high percentage rate indicates the need to improve the use of Assets. The following sections give a detail explanation of each type of analysis, how it is computed and what the results can mean: 27

28 Horizontal Analysis With a Horizontal Analysis, also, known as a trend analysis, you can more readily spot trends in your financial data over time. For example, a $2 million profit year looks very impressive following a $0.25 million profit year, but not after a $10 million profit year. Horizontal analysis stresses the trends in earnings, Assets and Liabilities over a period of time, such as, from year-to-year or over several years. For a business owner, this information about trends is useful in identifying areas of wide divergence. These identified areas become those areas of your business that require further attention, amending a course of actions, and for the fine-tuning of an adopted strategy. For instance, a large increase in Sales returns and allowances coupled with a decrease in Sales over two years would be cause for concern. The problem may be lower quality, or defective goods. If this is the case, you need to address and solve the problem or the company s reputation and future may be at stake. The ability to spot this trend over time, empowers you to intervene and be pro-active in solving the problem. No company lives in a bubble so it is also helpful to compare these results with those of competitors in order to determine whether the problem is industry-wide, or just within the company itself. If no problems exist industry-wide, one will observe a shortfall in Sales and rise in the dollar amount of Sales returns. Once a problem is identified, businesses can devise a strategy to cope with it. Therefore the key to analysis is to identify potential problems and areas of high efficiency to give the data necessary to legitimize change within the business. In a Horizontal Analysis, we state both the dollar amount of change and the percentage of change, because either one alone might be misleading. For example, although interest expense from one year to the next may have increased 100 percent, this probably does not require further investigation; because, the dollar amount of increase is only $1,000. Similarly, a large change in dollar amount might result in only a small percentage change which, ultimately, will not cause concern for the business owner. How to Create a Horizontal Analysis When Financial Statements are prepared, they often contain current data, as well as, the previous period so that the reader of the financial statement can compare to see where there was change, either up or down. With a Horizontal Analysis, this comparison goes one step further; it depicts the amount of change as a percentage to more readily show the difference over time as well as the dollar amount. The following illustration depicts a Horizontal Analysis: 28

29 The Learning Company Trend Analysis of the Balance Sheet (Expressed as a Percent) Dec. 31, 2014, 2013 and $ 2013 % $ 2012 % $ % Assets Current Assets Plant Assets Total Assets 463, , , % 50% 83% 210, , , % 35% 62% 100, , , % 100% 100% Liabilities Current Liabilities Long- Term Liabilities Total Liabilities 306, , , % 115% 117% 140, , ,000 92% 102% 97% 73,000 78, , % 100% 100% Stockholders' Equity Common Stock Retained Earnings Total Stockholders' Equity 120,000 62, ,000 9% 38% 17% 110,000 45, ,000 10% 55% 20% 100,000 29, , % 100% 100% Total Liabilities and Stockholders' Equity 828,000 83% 453,000 62% 280, % Note that the line-items are a condensed Balance Sheet, and that the amounts are shown as dollar amounts and as percentages and the first year is established as a baseline. A baseline is established because a financial analysis covering a span of many years may become cumbersome. It would require the arrangement and calculation of interlinked numbers and dates. Particularly, interlinks among the numbers make financial analysis tiresome and complex for a typical businessperson. A solution is to create comparative Financial Statements, which depicts the results of Horizontal Analysis and show the trends relative to only one base year. The baseline acts as a peg for the other figures while calculating percentages. For example, in this illustration, the year 2012 is chosen as a representative year of the firm s activity and is therefore chosen as the base. Each account of the baseline year is assigned an index of 100%. Once the baseline is established, the percentage for each respective account is found by: 1. Subtracting the previous year amount from the current year amount 2. Dividing the account's amount by the previous year amount 3. Multiplying by 100 to derive the percentage. 29

30 For example, if we let 2012 be the base year in the Balance Sheet of Learning Company, Current Assets would be given an index of 100%. Then for 2013, to derive the percentage of change, we look at each line item: In this case, Current Assets for 2013 are $210,000 subtract the baseline amount of $100,000: $210,000 - $100,000 = $110,000 Determines the difference of $110,000. Divide this difference by the baseline amount, so $110,000 / $100,000 = 1.1 Multiply by 100 to calculate the percentage: 1.1*100 = 110% And we can see that Current Assets grew by 110% from 2012 to To calculate 2014, we DO NOT go back to the baseline to do the calculations; instead 2013 becomes the new baseline, so we can see percentage growth from year-to-year. In our illustration, The calculation to determine the Current Assets 2014 percentage change becomes: $463,000 - $210,000 = $253,000 Determines the difference of 253,000. Divide this difference by the baseline amount, so $253,000 / $210,000 = 1.2 Multiply by 100 to calculate the percentage: 1.1*100 = 120% And we can see that Current Assets grew by 120% from 2013 to By seeing the trend, which is a remarkable growth of over 100% from one year to the next, we can also see that the trend itself, is not that remarkable of only 10% change from 2013 at 110% to 120% in Which could indicate, that 30

31 perhaps growth is starting to stagnate or level-off. Therefore, additional analysis is required. Vertical Analysis Vertical analysis is the comparison of various line items within a single period. It compares each line item to the total and calculates what the percentage or portion the line item is of the total. It can be done with the company s own Financial Statements or with the use of the Common Size statements. Both are described in this section: The following illustration shows a Vertical Analysis of a company s own Balance Sheet: The Learning Company Vertical Analysis of the Balance Sheet (Expressed as a Percent) Dec. 31, 2014, 2013 and $ 2013 % $ 2012 % $ % Assets Current Assets Plant Assets 463, ,000 56% 44% 210, ,000 46% 54% 100, ,000 36% 64% 828, % 453, % 280, % 306, ,000 47% 53% 140, ,800 47% 53% 73,000 78,000 48% 52% Total Liabilities 646, % 298, % 151, % Stockholders Equity Common Stock Retained Earnings 120,000 62,000 66% 34% 110,000 45,000 71% 29% 100,000 29,000 78% 22% Total Stockholders Equity 182, % 155, % 129, % Total Liabilities and Stockholders Equity 828, % 453, % 280, % Total Assets Liabilities Current Liabilities Long-Term Liabilities Note that in this illustration, each line item is shown as a percentage of the total for its category. For example, in 2012, Current Assets are 36% of Total Assets for that year; whereas in 2014, Current Assets are 56% of Total Assets. While you can still compare from one year to the next, the calculation to determine the percentage is within the same period i.e. down the column (unlike Horizontal Analysis where the calculation is 31

32 based on the difference in items from one year to the next). Also Note that in this illustration, the Balance Sheet is a condensed version. You may also want to do a Vertical Analysis on a full Balance Sheet to more clearly highlight potentially problematic areas. For instance, if you break out all Current Assets and see that the line item of Accounts Receivable is a large percentage of Total Assets, then you ll know that there is a problem with collections and that you need to look into ways of receiving payment in a more timely manner. How to Create a Vertical Analysis A Vertical Analysis can be completed on both an Income Statement and a Balance Sheet. Unlike Horizontal Analysis, a Vertical Analysis is confined within one year (or one vertical column of the Balance Sheet); so we only need one period of data to derived the percentages and complete the analysis. In our sample Balance Sheet, we want to determine the percentage or portion a line item is of the total category. For example, for 2014, to derive the percentage of Current Assets: Current Assets are $463,000 and Total Assets are $828,000 Divide Current Assets by Total Assets $463,000 / $828,000 =.56 Multiply by 100 to calculate the percentage:.56 * 100 = 56% And so we can see that Current Assets are 56% of Total Assets. This high percentage means most of your Assets are liquid and it may be time to either invest that money or use it to purchase additional Plant Assets. Likewise, to complete a Vertical Analysis of Current Liabilities: In 2014, Current Liabilities are $306,000 and Total Liabilities are $646,000 Divide Current Liabilities by Total Liabilities $306,000 / $646,000 =.47 Multiply by 100 to calculate the percentage.47 * 100 = 47% And so we can see that Current Liabilities are 47% of Total Liabilities. In this case, you may want to doublecheck if this is wise or if you are actually paying more interest than if you re-financed and move some of the Current Liabilities to Long-Term Liabilities for a better interest rate and a lower monthly payment. When creating a Vertical Analysis of an Income Statement, the amounts of individual items are calculated as a percentage of Total Sales. The following illustration depicts a Vertical Analysis of an Income Statement: 32