Finance & accounting for non-financial energy professionals September 11, 2014
Objectives On completion of this training each participant should be able to: Understand basic financial statement analysis concepts Evaluate the footnotes included in the financial statements Read and interpret the portions of the 10-K and annual report required by the Securities and Exchange Commission (SEC) Describe how to analyse and compute historical financial information and key financial ratios 1
Agenda Financial statements General overview Primary financial statements Financial statement analysis Ratio analysis 2
Financial statements General overview Financial statements are the starting point in gaining a full understanding of the performance and prospects of an organization; understanding such reports is critical. Purpose of financial statements: Provide information in a standardized format that allows financial stakeholders to understand a business from an economic standpoint Comply with reporting requirements Publically held companies are governed by regulators who ensure financials comply with local reporting requirements Privately owned companies may not have any reporting requirements depending on its financial stakeholders Most companies headquartered in the US present their financials in accordance with US generally accepted accounting principles (US GAAP) Many countries have adopted the International Financial Reporting Standards (IFRS), which seek convergence in global financial reporting Local country GAAP 3
Financial statements General overview (continued) Who is required to have an audit? Generally companies with publicly traded securities Any receiver of bank financing SEC registrants are required to have an audit of internal controls over the financial reporting process to comply with Section 404 of the Sarbanes-Oxley Act What does is the purpose of an audit? An auditor concludes if the financial statements are presented in accordance with GAAP or other accounting standard, but is not performed to detect fraud 4
Primary financial statements Keep in mind when reviewing financials: Financial reports are not necessarily statements of unquestionable fact. Financial reports are very often subjective in nature; there is some latitude in their preparation. Primary financial statements should be seen in context with other sources of information. The three key sources of information regarding an organization: Financial statements themselves Financial statement notes and supplementary information Analyst reports 5
Supplementary sources of information Analysts do not focus exclusively on the primary financial statements. To form a true picture of the organization, other sources of information must be studied, including: Notes to the financial statements Auditor s report (letter to Board of Directors) Management s discussion and analysis (MD&A) (part of Form 10-K) Annual report Other items 6
Supplementary sources of information Notes to the financial statements Companies must ensure that users of statements have enough information to gain a fair view of the company s performance and financial position. Significant amounts of important data is disclosed in the accompanying notes rather than in the statements themselves. Corporations have been criticized for not being transparent in the disclosure of the substance of transactions. In the wake of high profile collapses such as Enron, the investor community is paying closer attention to presentation of data. The SEC regularly reviews questionable accounting practices for companies listed and traded on NASDAQ, AMEX, and NYSE. 7
Supplementary sources of information Notes to the financial statements (continued) Investors should pay particular attention to these key areas: Accounting policies of the company Regulatory disclosures Long-term capital commitments Contingent liabilities Environmental liabilities 8
Supplementary sources of information Auditor s report Auditors report on whether the financial statements are fairly presented. Unqualified opinion Issued if the auditor is satisfied that the financial statements are presented in accordance with GAAP Qualified opinion Issued if the financial statements contain an exception to the standard opinion that would not invalidate the statements as a whole Going concern opinion Issued if the auditor concludes substantial doubt exists about the entity s ability to continue as a going concern for a reasonable amount of time (1 year) 9
Supplementary sources of information Management Discussion & Analysis (MD&A) Found in the SEC Filing Form 10-K Discusses the issues facing the business, the performance record and the business risks relevant to the users of the financial statements. Gives the investor an opportunity to look at the company through the eyes of management and is written in plain English. Quarterly SEC Filings (Form 10-Q) require MD&A to provide specific information about: Results of Operations; Off-Balance Sheet Arrangements; Contractual Obligations; Liquidity and Capital Resources; and Known Trends, Events, Demands, Commitments, and Uncertainties. 10
Supplementary sources of information MD&A Results of operations should describe: Unusual or infrequent events or transactions; Significant components of revenue or expense; Known trends, events or uncertainties that have had, or are expected to have, a material impact on operations; Future changes in the relationship between costs and revenues; Extent to which material increases in sales or revenue are due to increased sales volume, introduction of new products or services, or increased sales prices; and Material impact of idle facilities. 11
Supplementary sources of information MD&A (continued) Off-balance sheet arrangements A public company must provide specific disclosures in a separate captioned section of MD&A for material off-balance sheet arrangements. Discussion of off-balance sheet arrangements must include: Nature and business purpose Financial importance Financial impact and exposure to risk Contingencies involving continued availability Contractual obligations Public companies (other than small business issuers, issuers of asset-backed securities, and registered investment companies) must include a tabular presentation of aggregate contractual obligations for the 5 succeeding years from the latest balance sheet date. Tabular presentation can be provided in any MD&A location deemed appropriate. 12
Supplementary sources of information MD&A (continued) Liquidity is the ability to generate adequate amounts of cash to meet both current and future needs. Discussion of liquidity is required to include: Indicators of the company s liquidity; Ability to generate adequate cash flows on both a long-term and short-term basis; Known trends, demands, commitments, events, changes in circumstances, or uncertainties that impact liquidity; Restrictions on subsidiaries to transfer funds to the parent; Plans to remedy any identified material deficiency in short or long-term liquidity; and Internal and external sources of liquidity, and any material unused sources. Capital resources section discusses equity, debt, and off-balance sheet financing arrangements and is required to include: Material commitments for capital expenditures as of the latest year; and Material trends, favorable or unfavorable, in the registrant s sources of capital. 13
Supplementary sources of information MD&A (continued) Known trends, events, demands, commitments and uncertainties that would cause reported financial information not to be indicative of future operating results or future financial condition. Discussion should include: Financial and non-financial information available to the company; Matters that would have an impact on future operations and have not had an impact in the past; and Matters that have had an impact on reported operations and are not expected to have an impact on future operations. 14
Supplementary sources of information Annual report Audited consolidated financial statements Selected financial data Supplementary financial information MD&A Changes in and disagreements with accountants Business description Segment information Director and executive officer information Common stock market prices and dividends Statement that Form 10-K, including financial statements and schedules Market risk disclosures 15
Supplementary sources of information Annual report (continued) Companies are required to disclose five years of selected financial data. The information required includes (presented on a consolidated basis): Net sales or operating revenues; Income (loss) from continuing operations; Income (loss) from continuing operations per common share; Total assets; Long-term obligations and redeemable preferred stock; Cash dividends declared per common share; Matters materially affecting comparability of information: Accounting changes Retroactive accounting changes Cumulative effect accounting changes Prospective accounting changes Discontinued operations. 16
Supplementary sources of information Annual report (continued) Supplementary Financial Information requires the disclosure of summarized quarterly financial data for the most recent two years (either in an unaudited footnote or outside the financial statements). The disclosure may be unaudited and must include: Net sales; Gross profit; Income (loss) before extraordinary items and cumulative effect of a change in accounting; Per share data (basic and, when applicable, diluted); and Net income (loss). 17
Supplementary sources of information Analyst and industry reports Analyst and industry reports provide good sources of company information. The reports normally come under three headings: Sector or industry reports: Normally assess and analyze prospects for a particular industry, for example, power and utilities, media, pharmaceuticals, technology, and retail. Company-specific reports: Cover analyst commentary on the performance and prospects. Credit risk or rating reports: Large companies often get investment ratings from ratings agencies to enable them raise money more cheaply on the money markets. Analysts can only be as accurate as the data they use to form their opinions. 18
Financial statement analysis Financial statement analysis involves analyzing financial and operational data as well as accounting methods to fully understand a company s financial performance. The primary objectives of financial statement analysis are to: Spot historical trends that may have significant impact on future financial results (e.g., working capital or profit trends) Allow accurate comparison between companies with different accounting policies (certain elections are available for revenue recognition, goodwill (if private can be amortized / not so for public), useful lives for assets etc.) to assist with peer comparison Identify areas of risk in a company that are not otherwise easily observable Aid in assessing loss given default for each counterparty in the credit analysis / scorecards 19
Financial statement analysis (continued) What to look for in the historical financials: Increasing or decreasing profitability Isolate where the change is taking place Depressed price environment Decreasing expenses is good unless it is trying to make up for a long term drop in gross margins (saving your way to profitability) Increasing/decreasing financial leverage Increasing/decreasing capital expenditures Increasing/decreasing access to capital markets Increasing/decreasing net working capital items Increasing/decreasing other assets or other liabilities Related income statement and balance sheet items growing at significantly different rates (sales and accounts receivable) 20
Financial statement analysis (continued) Consider how the historical trends will affect the future Is the revenue growth sustainable? Is price or volume driving historical growth? Given the operational leverage, how will COGS react to revenue increases? Are expenses fixed or variable? Are the expenses recoverable? Is the debt burden manageable? Will they exceed covenants if historical trends continue? Is the company collecting on its sales? Is the company continuing to invest in its future? To what extent are revenue increases lost to fund higher working capital? 21
Ratio analysis Ratios are a great way to: Spot historical trends Review the relative performance of company to its peer group Limitations Ratios are only as good as the underlying accounting data Over reliance on ratios Use your ratio analysis to: Compare and contrast to historical results How do your ratios compare to historical ratios? Compare and contrast to ratios of its peer group (what is normal for industry?) What does this tell you about the comparability of peer companies? 22
Ratio analysis (continued) Ratios 4 major types Liquidity ratios Measure an entity s short-run ability to pay its maturing obligations Activity ratios Measure how effective the enterprise is using the assets employed Profitability ratios Measure the financial performance of an entity over a period of time Coverage ratios Measure the degree of protection for long-term creditors and investors Operational ratios Measure operational performance of an entity over a period of time 23
Ratio analysis (continued) Liquidity Ratio Formula for Computation Computation 1. Current Ratio Current Assets Current Liabilities 2. Quick Test Cash, Market Securities, AR Current Liabilities Activity 1. Receivable Turnover Net Sales Avg. trade receivables (net) 2. Inventory Turnover COGS Avg. inventory 3. Asset Turnover Net Sales Avg. total assets 800k / 575k = 1.4 times 490k / 575k =.85 times 1,600K / ((350k +250k) / 2) = 5.33 times or every 64 days 1,000K / ((310k +250k) / 2) = 3.57 times every 102 days 1,600k / ((2,250k +2,100k) / 2) = 4.92 times or every 74 days 24
Ratio analysis (continued) Profitability Ratio Formula for Computation Computation 1. EBITDA Margin on Sales EBITDA Net Sales 2. Profit Margin on Sales Net Income 3. Rate of Return on Assets 4. Rate of Return on Common Stock Equity Net Sales Net Income Avg. total asset Net Income less pref d dividends Avg. stockholders equity 250k / 1,600k = 15.6% 150k / 1,600k= 9.4% 150k / ((2,250k +2,100k) / 2) = 6.9% 150k / ((950k + 867.5K) / 2) = 16.5% 25
Ratio analysis (continued) Ratio Formula for Computation Computation Coverage 1. Debt to total Assets Debt Total Assets 1,300k / 2,250k = 58% 2. Times Interest Earned EBIT Interest exp. 300k / 50k = 6 times 3. EBITDA Leverage Debt / EBITDA 1,300k / 250k = 1.2 years 4. Debt Coverage EBITDA / Debt 250k / 1,300k = 83% Operational 1. Sales Growth (Sales current Year / Sale Prior Year) - 1 Total Assets (1,600k / 1400k) - 1 = 14% 2. Gross Margin Sales COGS / Sales (1,600K - 1,000K) / 1600k = 38% 3. EBITDA Margin EBITDA / Sales 250k / 1,600k = 16% 4. Net Margin Net Income / Sales 150k / 1,600k = 9% 26
Qualitative Considerations Environment/Business Sector Economic environment Social and political environment Regulatory framework Business sector, prospect of changes in demand, dependence on economic cycles and technological changes, capital requirements, nature of intensity of competition Position Within Business Sector Size and market share Efficiency of plants Diversity and volatility of revenues by products Clients and geographies Business development strategies 27
Qualitative Considerations (continued) Repayment Capacity Ability to generate profits over a full cycle Debt service (Debt/EBITDA, interest coverage, and free cash flow) Quality and liquidity of assets Management Experience and effectiveness of managers Credibility of strategy Achievement of objectives Key staff turnover Quality of financial statements Financing Sources Access to diverse financial markets, banks and alternative sources of financing Availability of committed lines 28
Definition of a Derivative ASC 815 defines a derivative as an instrument or contract with all of the following criteria: Contains an underlying, notional, and payment provision No or minimal initial net investment The ability to net settle, which can be achieved through contract terms, market mechanisms, or delivery of an asset that puts the recipient in a position similar to net settlement. 29
Common Derivatives in the P&U Industry Futures (traded on an exchange) contracts are fixed as to commodity, quantity, and delivery month A NYMEX Natural Gas (Henry Hub) Physical Futures Contract for 10,000 mmbtu (standard quantity) for delivery in January 2015 (standard delivery month). Over the Counter (bilateral agreements between third-parties) contracts are customizable on all terms between the counterparties A contract between Midstream Supplier ABC and IPP XYZ to deliver 1,000 mmbtus at a specific delivery point on January 15 th, 2015 at NYMEX spot plus $0.10 per mmbtu. 30
Derivative Disclosure Examples General derivative accounting policies are included in the Summary of Significant Accounting Policies, typically located within the first couple footnotes. 31
Derivative Disclosure Examples (cont.) Hedging strategies discussion is a required disclosure within the derivatives footnote. 32
Derivative Disclosure Examples (cont.) Also included within the derivatives footnote are disclosures surrounding notional quantities open at the balance sheet date. 33
Derivative Disclosure Examples (cont.) In addition to the amounts and the values of derivatives on the face of the balance sheet, the derivatives footnote will disclose the gross value of the net amount presented on the balance sheet (based on market prices at the financial statement as of date) In this example, the $525k net amount of derivative assets may need to be backed out of the financial statement ratio analysis to get a more accurate picture given the potential volatility of the asset. 34
Derivative Disclosure Examples (cont.) Companies are required to disclose the impacts on the income statement of derivative activity. $621 of unrealized operating losses (not an earned number) may understate actual revenue depending on market volatility. 35
Derivative Disclosure Examples (cont.) Within MD&A, other disclosures such as derivative maturity, sensitivity analysis, etc. are outlined. 36
Derivative Disclosure Examples (cont.) Also included within MD&A are disclosures surrounding financial and credit risk, which often relate directly to the derivative positions held by the company. 37
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