Chapter Fourteen Lecture Notes Financial Statement Analysis

Transcription

1 Chapter Fourteen Lecture Notes Financial Statement Analysis 1

2 Financial Analysis Financial analysis uses the financial statements and other sources of information to: - help managers and outsiders understand an organization's financial condition, - make decisions about the organization, and - compare an organization's financial performance to its peers. Analysis of just financial statements rarely gives a final answer. Rather, it indicates where further analysis is needed! 2

3 Financial Analysis Financial Analysis tries to answer a series of questions about an organization's mission, financial stability, and operating results. Mission 1. Is the organization meeting its mission? 2. Doing too little or too much? 3. Does resource use match goals? 4. Is the organization effective? 3 Viability 1. Liquidity? 2. Solvency? 3. Income Concentration? 4. Matched maturities for sources & uses of funds? 5. Efficiency? (Unit Costs) 6. Costs appropriate? 7. Other organization-specific considerations?

4 The Financial Analysis Process Read the auditor's opinion, the notes to the financial statements, and the financial statements themselves and extract as much information as possible. Look for potential problem areas! Prepare the appropriate ratios and analyze. Whenever possible get comparative data: - for the organization over time, - for the organization's peers, and - for the industry. Organize the information and complete the analysis. 4

5 Step One Read the Auditor's Opinion The Auditor's Opinion: describes the type of work that the Certified Public Accountant did: audits involve a statistical review of transactions and the systems that the organization uses; compilations involve the preparation of the statements; and reviews involve checking management-prepared statements for form and accuracy. Audit opinion may be unqualified, qualified, or adverse. 5

6 Step Two - Review the Notes The notes to the financial statements are an integral part of the statements. They: - describe the accounting policies that the organization has used, - highlight any unusual and material event that may have occurred during the year, - provide further detail regarding material assets and liabilities, and - provide additional detail as required by GAAP (GAAP of full disclosure). 6

7 The Meals for the Homeless Notes In their notes, Meals states that it: - treats all pledges as restricted until collected, - uses substantial volunteer labor and recognized $80,000 in 2012 and $72,000 in 2011 as both support and an expense, - uses LIFO for inventories, - uses straight-line depreciation, - accounts for investments at fair value and shows the composition of its investment portfolio. Meals also: - provided a short description of its operations and the volume of services that it delivered, - has a defined contribution rather than a defined benefit pension plan, - described its lease obligations, and - described the restrictions on its Temporarily Restricted Net Assets. 7

8 Step Three - Analyze the Statements Review each financial statement to get a general sense of the types of accounts and the magnitude of each. BALANCE SHEET ASSETS Current Assets Cash $ 100 $ 3,100 Marketable Securities 3,000 3,000 Accounts Receivable, net 55,000 38,000 Inventory 2,000 4,000 Prepaid Expense 1,000 0 Total Current Assets $61,100 $48,100 Long-term Assets Cash Restricted for LT Asset Acquisition $ 900 $ 900 Fixed Assets Property 40,000 40,000 Equipment, net 35,000 45,000 Investments 8,000 12,000 Total Long-term Assets $ 83,900 $ 97,900 Total Assets $145,000 $146,000 8

9 Step Four - Calculate Ratios What are ratios? Why are ratios used? Ratio Cautions: - Ratios must be used together and with the financial statement data to develop a pattern. No one ratio is sufficient! - GAAP may make comparisons difficult across organizations. - Ratio analysis should be focused on potential problems. Ratios are not calculated for their own sake. - Ratios that are useful for health and not-for-profit organizations may not be appropriate for governments. - Use common sense! Focus on the order of magnitude of the ratio, rather than on carrying the calculation out many decimal places. - Think about what the ratio means. Should it be higher or lower than the average? Rising or falling? 9

10 Types of Ratios Common Size Ratios Liquidity Ratios Asset Turnover or Efficiency Ratios Leverage and Coverage Ratios Profitability Ratios Program Expense Ratio 10

11 Common Size Ratios Common Size Ratios compare all of the numbers on a financial statement to one key number. Why are common size ratios useful? Organization A Organization B Cash $10,000 too low? $100,000 too high? Cash 10, , = x 100% = 20% x 100%= 1% Total Assets 50,000 10,000,000 11

12 Common Size Ratios BALANCE SHEET Percent Percent Percent ASSETS 2012 of Total 2011 of Total Change Current Assets Cash $ % $ 3, % -96.8% Marketable Securities 3, % 3, % 0.0% Accounts Receivable, net 55, % 38, % 44.7% Inventory 2, % 4, % -50.0% Prepaid Expense 1, % 0 0.0% NA Total Current Assets $ 61, % $ 48, % 27.0% Long-term Assets Cash Restricted for LT Asset Acquisition $ % $ % 0.0% Fixed Assets Property 40, % $ 40, % 0.0% Equipment, net 35, % 45, % -22.2% Investments 8, % 12, % -33.3% Total Long-term Assets $ 83, % $ 97, % -14.3% Total Assets $145, % $146, % -0.7% 12

13 BALANCE SHEET Percent Percent Percent LIABILITIES AND NET ASSETS 2012 of Total 2011 of Total Change Current Liabilities Wages Payable $ 2, % $ 3, % -33.3% Accounts Payable 2, % 3, % -33.3% Notes Payable 6, % 5, % 20.0% Current Portion of Mortgage Pay. 4, % 5, % -20.0% Total Current Liabilities $ 14, % $ 16, % -12.5% Long-term Liabilities Mortgages Payable $ 12, % $ 16, % -25.0% Total Long-term Liabilities $ 12, % $ 16, % -25.0% Total Liabilities $ 26, % $ 32, % -18.8% Net Assets Unrestricted $ 84, % $ 85, % -1.2% Temporarily Restricted 4, % 1, % 157.9% Permanently Restricted 30, % 27, % 11.1% Total Net Assets $119, % $114, % 4.4% LIABILITIES AND NET ASSETS $145, % $146, % -0.7% 13

14 ACTIVITY STATEMENT Changes in Unrestricted Net Assets 2012 % of Total 2011 % of Total % Change Revenues and Support Client Revenue $ 11, % $ 9, % 22.2% City Revenue 20, % 16, % 25.0% County Revenue 10, % 10, % 0.0% Foundation Grants 60, % 50, % 20.0% Annual Ball 12, % 11, % 9.1% Contributions 65, % 73, % -11.0% Total Revenues and Support $178, % $169, % 5.3% Net Assets Released from Restrictions Satisfaction of Program Restrictions $ 10, % $ 10, % 0.0% Satisfaction of Time Restrictions 2, % 1, % 100.0% Total Net Assets Released from Restrictions $ 12, % $ 11, % 9.1% Total Unrestricted Revenue and Support $190, % $180, % 5.6% Expenses Meals $ 67, % $ 63, % 6.3% Counseling 35, % 34, % 2.9% Administration, Fund Raising and General 75, % 65, % 15.4% Bad Debts 4, % 4, % 0.0% Depreciation 10, % 10, % 0.0% Total Expenses $191, % $176, % 8.5% 14 Increase in Unrestricted Net Assets $ (1,000) -0.5% $ 4, % %

15 Liquidity Ratios Liquidity Ratios focus on whether an organization has enough cash and liquid resources to meet near-term obligations. Current Assets Current Ratio = Current Liabilities Can we meet our current obligations as they come due? What does a current ratio of 1.0 mean? Rule of Thumb: 2 to 1 Trend should be: UP Ratio should be: ABOVE THE MEDIAN 15

16 Cash + Marketable Securities + A/R Quick Ratio = Current Liabilities Can we meet our current obligations out of liquid resources? How does the current ratio differ from the quick ratio? Rule of Thumb: 1 to 1 Trend should be: UP Ratio should be: ABOVE THE MEDIAN 16

17 Cash + Marketable Securities Days of Cash on Hand = (Operating Expenses - Bad Debts - Depreciation)/365 Can we handle a collection crisis? Rule of Thumb: Trend should be: Ratio should be: None UP ABOVE THE MEDIAN 17

18 18 Asset Turnover Ratios (Also Called Efficiency Ratios) Asset-Turnover Ratios focus on efficiency. How well do organizations convert resources into revenues and collect those revenues? They relate income statements (flows) to balance sheets (stocks). Revenue & Support - Cash Sales Receivables Turnover = Accounts Receivable How many times per year do we collect our A/R?? Rule of Thumb: Trend should be: Ratio should be: None UP ABOVE THE MEDIAN

19 365 Average Collection Period = Receivables Turnover How many days does it take to collect our A/R? Rule of Thumb: None Trend should be: DOWN Ratio should be: BELOW THE MEDIAN 19

20 Total Unrestricted Revenues and Support Total Asset Turnover = Total Assets How much revenue does each dollar of total assets support? Rule of Thumb: None Trend should be: UP Ratio should be: ABOVE THE MEDIAN 20

21 Cost of Inventory Used Inventory Turnover = Inventory How many times per year do we use up our inventory? Rule of Thumb: Trend should be: Ratio should be: None UP ABOVE THE MEDIAN 21

22 365 Average Holding Period = Inventory Turnover How many days of inventory do we have on hand? Rule of Thumb: Trend should be: Ratio should be: None DOWN BELOW THE MEDIAN 22

23 Total Unrestricted Revenues and Support Fixed Asset Turnover = Net Fixed Assets How much revenue does each dollar of fixed assets support? Rule of Thumb: Trend should be: Ratio should be: None UP ABOVE THE MEDIAN 23

24 Leverage and Coverage Ratios Leverage and Coverage Ratios focus on the use of debt and an organization's ability to pay that debt back. What is the difference between a leverage ratio and a coverage ratio? Why is debt a double-edged sword? Total Debt Debt to Assets = Total Assets What portion of total assets were paid for with debt? Rule of Thumb:.5 or less Trend should be: DOWN Ratio should be: BELOW THE MEDIAN 24

25 Total Debt Debt to Equity = Total Equity How much debt do we have in relation to equity? Rule of Thumb: 1.0 or less Trend should be: DOWN Ratio should be: BELOW THE MEDIAN 25

26 Increase in Net Assets Before Times Interest Expense Interest Earned = Interest Expense Revenue $800 Interest Expense 200 Other Expenses 400 Increase in Net Assets $200 Note that times interest earned is 2.0, not 1.0!!! Do we have enough money to pay interest expenses? Rule of Thumb: At least 1 to 1 Trend should be: UP Ratio should be: ABOVE THE MEDIAN 26

27 Cash Flow from Operations + Interest & Rent Cash-Flow Coverage = Interest, Rent & Debt Payments Do we have enough cash flow to pay debt service and leases? Rule of Thumb: At least 1 to 1 Trend should be: UP Ratio should be: ABOVE THE MEDIAN 27

28 Profitability Ratios Profitability Ratios compare the various measures of profit with revenue and support. Should not-for-profits focus on profitability? Can NFP organizations earn too much or too little? Should governments focus on profitability? Increase in Unrestricted Net Assets Operating Margin = Total Unrestricted Revenues and Support What are the unrestricted earnings per dollar of R&S? Rule of Thumb: None Trend should be: Judgment Call Ratio should be: Judgment Call 28

29 Increase in Net Assets Return on Net Assets = Net Assets What do we earn per dollar of net assets? Rule of Thumb: Trend should be: Ratio should be: None Judgment Call Judgment Call 29

30 Increase in Net Assets Total Margin = Total Unrestricted Revenues and Support What do we earn per dollar of revenue and support? Rule of Thumb: None Trend should be: Judgment Call Ratio should be: Judgment Call 30

31 Increase in Net Assets Return on Total Assets = Total Assets What do we earn per dollar of total assets? Rule of Thumb: Trend should be: Ratio should be: None Judgment Call Judgment Call 31

32 Program Expense Ratio Program Services Expenses Program Exp. Ratio = Total Expenses What portion of our expenses are dedicated to operating programs? Rule of Thumb: Trend should be: Ratio should be: None UP ABOVE THE MEDIAN 32

33 Step Five - Get Comparative Data Compare the ratios to: - the organization over time, - comparable organizations, and - the industry. Focus on trends: - should the ratio be higher or lower than average? - is it better for the ratio to be increasing or decreasing? Remember that it is hard to find exact comparables. Use common sense! 33

34 Step Six - Complete the Analysis Identify red flags in the data! When you think that you see a problem, ask why it is happening and find data to either support or refute your beliefs. Organize the data to find patterns! Periodically step back and summarize what you have found. Focus your final analysis on the big picture. Don't get caught up in irrelevant details! 34

35 Supplemental Notes The remaining pages in this set of notes are supplemental notes. These notes focus on the concept of leverage. 35

36 Leverage Suppose you invest $1,000 of the organization s money in a project that earns 20% on all dollars invested. A. No loan. B: $9,000 10% interest. $1,000 investment. $10,000 total investment. $1000 Total investment $10,000 Total investment x 20% Profit x20% Profit $ 200 Profit $ 2,000 Profit before interest Interest $ 1,100 Profit Leverage boosts the return on the organization s $1,000 from $200 to $1,100! 36

37 However, what if things go wrong? What if there is a 20% loss instead of profit? $1,000 $10,000 x -20% x -20% $ (200) Loss $(2,000) Loss before interest -900 Interest $(2,900) Loss In Case A, the organization loses $200 but still has $800 left. In Case B, the organization loses its entire $1,000 investment and still owes another $1,900 to the lender. This could result in financial disaster. Many attribute the great credit crisis of 2008 to excessive use of leverage in the financial services industry. 37