Financial Statement Overview Bankers Insight Group, LLC Jeffery W. Johnson Introduction Financial Statement Analysis is the Cornerstone of a Bank s credit decision making process They report on an economic entity s financial condition and operations Financial statements are used: To evaluate loan request Identify risk and properly structure credit facilities 1
Accounting Assumptions Economic Entity Assumption Revenue Recognition Principle Historical Cost Principle Matching Principle Full Disclosure Principle Money Measurement Continuity or Going Concern Periodicity Economic Entity Assumption An economic activity can be identified to a separate entity accountable for that activity. Businesses must keep their transactions separate from their owners, business units or other businesses transactions. Example, the business activities of the neighborhood coffee house are to be kept separate from the financial activities of its owners or managers. The financial statements for the coffee house will only reflect the revenue and expenses for the coffee house. It is possible to compare the financial statements of this coffeehouse with its competitors reports, since these statements should be reported separately under the economic entity assumption. 2
Revenue Recognition Assumption Revenue is to be recorded: when it is realized (or realizable), and when it is earned and not when it is received. Revenue is: realized when goods or services are exchanged, realizable when assets received can be converted to cash, earned when all necessary requirements are met entitling the company to the benefits represented by the revenue (e.g. services performed). Historical Cost Principle The historical cost principle deals with the valuation of both assets and liabilities. The value at the time of acquisition is used to value most assets and liabilities. If the coffee wholesaler purchased an office building in 1990 for $1.2 million, over time this asset has most likely appreciated in value. However, in accordance with the cost principle, the original (historical) price of the building is what is recorded as the cost of the building in the books of the business 3
Matching Principle Expenses of a business need to line up with its revenue. The expense or cost of doing business is recorded in the same period as the revenue that has been generated as the result of incurring that cost. In the case of the coffee wholesaler, when the 100 coffee mugs were delivered in July they changed from being a part of inventory (asset) to a cost of goods sold entry (expense) in the month that the revenue from the sale was recognized. At this point, the difference between the revenue and expense is determined as the gross profit from the sale. Full Disclosure Principle All past, present and future information that may have had an impact on the financial performance of the company needs to be fully disclosed. Examining the numbers does not always provide the entire financial picture of a company. Sometimes there are alternative situations that need to be reported. Pending or current lawsuits are one example of a transaction that could severely impact a company s bottom line. Incomplete financial transactions or any other conditions that could impact the company s performance must also be disclosed. Most of these transactions are disclosed in the footnotes to the financial statements. 4
Accounting Assumptions Continuity or Going Concern The entity is assumed to have an indefinite life unless strong evidence exists to the contrary Periodicity An entity s life can be subdivided into time periods for purposes of reporting its economic activities Accounting Assumptions Money Measurement Economic activity is initially recorded and reported in terms of a common unit of measure (US dollar) 5
Financial Statement Components Opinion Letter Balance Sheet Income Statement Statement of Retained Earnings Statement of Cashflows Financial Notes Interpretation of the Balance Sheet Current Assets Current Liabilities Fixed Assets Long Term Debt Other Assets Net Worth 6
Income Statement Sales Cost of Goods Sold Gross Profit Operating Expenses Operating Profit Non Operating Expenses / Income Net Income / Loss Before Taxes Taxes Net Profit / Loss Income Statement Balance Sheet Sales Accounts Receivable Cost of Goods Sold Inventory Accounts Payable Operating Expenses Accrued Expenses Interest Expenses Interest Payable Non Operating Expenses Other Liabilities Income Tax Expense Income Tax Payable Profits Retained Earnings Losses Retained Earnings Dividend Declared Dividend Payable 7
Cash Most liquid Asset May be restricted Companies need a minimum amount to operate Should not be used solely to make loan decision May be in the form of Near Cash Marketable Securities Next most liquid asset Usually convertible to cash within 30 to 90 days Includes investments such as: Listed & Marketable Stocks Bank Certificates of Deposits Money Market & Savings Accounts Commercial Paper & Repurchase Agreements 8
Accounts Receivable Amounts owed for a product or service sold Must consider size, type, age & validity Must consider Account Debtors ability to pay Must establish advance rates Company should set up allowance for bad debts Allowance for Doubtful Accounts Captures management s estimation of accounts that will not be collected Shown as a contra account on the asset section of the balance sheet Increased by debiting Bad Debt Expense each year Account is charged when a bad debt is written off and not charged against earnings 9
Inventory For manufacturers it consists of: Raw Material Work in Process Finished Goods Must consider how inventory is valued Must consider quality and age Prepaid Expenses Operating Expenses that are acquired in advance of its use When acquired, it is book as an asset because it represents the prepayment of an expense that will be used over time Examples include: Prepaid Rent, Insurance, Utilities, etc. When used, it becomes an expense that is reflected on the Income Statement and the asset is reduced by the same amount 10
Income Tax Refund Over payment of Income Taxes caused by a number of factors It will be collected within 90 days when the tax returns are filed Fixed Assets Consists of: Land Buildings & Improvements Machinery & Equipment Furniture & Fixtures Leasehold Improvements Capital Leases Valued at lower of cost or market Depreciates in value over time or usage Must consider effectiveness and efficiency Must consider age, location, technical ability, etc 11
Accumulated Depreciation Captures the depletion of assets value over time Shown as a contra account in the asset section of the balance sheet Is increased by annual depreciation expense Reflects varying methods of depreciation Intangible Assets Includes Assets such as: Goodwill Non Compete Agreements Trademarks, Copyrights, Patents, etc. Goodwill is created when the cost paid for an investment exceeds the acquisition cost of the asset Non Compete Agreements disallows individuals with competitive knowledge from operating a business in the same industry within a certain time frame and/or proximity of the company. It is usually a requirement from the acquirers of companies and executed by the sellers of the company Trademarks, Copyrights, Patents, etc., provide companies with exclusive rights to own, operate and distribute products and services that restricted to them only 12
Other Assets* Assets that are minor in value These assets are usually non operating assets, meaning that their existence will have little or no impact on the operations of the company Insure they represent less than 10% of the total assets of the company Notes Payable to Banks Borrowing to support Current Assets Usually a Line of Credit or Single Payment Note Must consider interest rate, terms and collateral 13
Notes Payable to Others Usually due to suppliers for inventory purchased If so, must inquire why inventory purchases are not paid within normal terms Could be due to other none operating purposes Must be thoroughly understood Accounts Payable Amount owed to suppliers for purchases Interest free financing usually for 30 days Must consider credit limits, age and relationship with suppliers 14
Accrued Expenses Expenses incurred but not yet paid Includes: Accrued Interest Accrued Taxes Accrued Wages, Profit sharing, bonuses & vacation Must consider timing of required payments Be cautious of Accrued Taxes beyond the current period Income Tax Payable* Taxes incurred in current or previous periods that have not been paid Be cautious of increasing amount and carryover from year to year Rule of thumb is that it should not exceed 25% of a current year s taxes 15
Interest Payable Interest Expense (or Finance Charges) incurred on borrower funds that were not paid as of the reporting date Dividend Payable Represents a declaration of dividend that has not been paid 16
Current Portion of Long Term Debt Principal portion of Long Term Debt due in the upcoming year Accounting rules requires to separate the current portion (due within 12 months) from the total Long Term Debt For cash flow purposes, use previous period CPLTD Long Term Debt Amounts owed over one year Must consider rate, terms, amortization with balloon payments and collateral Other long term debt may be due to stockholders or other creditors It should be thoroughly investigated 17
Net Worth Assets Minus Liabilities Equals Net Worth Usually composed of: Common or Preferred Stock Paid in Capital Retained Earnings Treasury Stock Sales/Revenue Revenue flowing into an entity as a result of selling a product or rendering a service Can be reported as Gross or Net Net Sales is Gross Sales minus Returns & Allowance, Discounts and Credit Memos Accounting method may change recognition of sales Be mindful of impact of Accrual vs. Cash Basis of accounting on sales Should be analyzed over several periods to determine management s decisions and trends 18
Cash Basis VS Accrual Basis Cash Basis Revenue, Cost and Expenses are recognized when cash is received or paid Accrual Basis Revenue and Expenses are recognized when incurred regardless of cash being received or paid Sales Recognition Long Term Projects Completed Contract: No revenue is recognized until the period in which the project is completed Percentage of Completion: Revenue is recognized based on the estimated stage of completion of a long term contract Completion of Production: Recognizes revenue at the completion of production or extraction. Used for many farm products and for certain precious metals. 19
Cost of Goods Sold Direct costs incurred for making product for manufacturers Direct costs incurred for buying products wholesalers and retailers These costs are usually uncontrollable Usually no COGS for service companies Usually no COGS for Farmers since all costs are shown of Sch. F Must know type of inventory valuation method used Must know depreciation method used Operating Expenses Costs not directly related to producing the product or buying the finished goods Costs are often controllable Should divide into variable and fixed category Should be measured as a percentage of sales 20
Thank You Bankers Insight Group, LLC Jeffery W. Johnson Jeffery.Johnson@Bankers Insight.com 21