Financial Statement Analysis for the Boardroom An Attorney s Guide September 13, 2017
Contact information For more information, please contact one of the following members of the engagement team: Marc Asbra Christina Carroll Paul Gurrola Managing Director Managing Director Managing Director +1.310.486.1854 +1.310.846.8897 +1.310.601.2566 masbra@stoutadvisory.com ccarroll@stoutadvisory.com pgurrola@stoutadvisory.com 2
Table of Contents I. Overview of Financial Statements II. Reading Financial Statements III.Analyzing Financial Statements IV. Applicable Examples 3
Overview of Financial Statements 4
Financial Statements Overview Financial Statements summarize the performance and financial position of an entity for a given period of time. Reporting standards The Securities and Exchange Commission has the authority to set and enforce accounting standards to be followed by public companies in the U.S. The Financial Accounting Standards Board ( FASB ) advises and provides input on generally accepted accounting principles ( GAAP ). Frequency of reporting Annually, quarterly, monthly May be used by a variety of decision makers Internal management, internal auditors, owners External lenders, investors, stockholders 5
Financial Statements Basic Types of Financial Statements: Balance Sheet What is the company s current financial status and solvency picture? Statement of Operations (Income Statement) What were the company s operating results for the period? Statement of Cash Flows How did the company generate and use cash during the period? Footnotes to the Financial Statements What are some of the details about the company s business and accounting policies? 6
Reading Financial Statements 7
Financial Statements Three Primary Statements: Balance Sheet Income Statement Cash Flow Statement Used by external sources to evaluate the financial health and position of an entity. Balance Sheet Income Statement Cash Flow Statement Information Reported Assets Liabilities Owners Equity Revenue Expenses Income Operating Investing Financing Time Reported Point in Time Period of Time Period of Time 8
Financial Statements A fourth statement exists: Statement of Shareholder s Equity Details changes to equity over a specified period. i.e. retained earnings, stock, additional investments by shareholders, dividends, etc. This information can be derived from both the balance sheet and income statement. 9
Balance Sheet The Balance Sheet Equation: Assets Liabilities Owners Equity This equation must always balance Nearly every transaction that occurs in an entity will be reflected in the Balance Sheet Displays the information for a specific point in time (a specific day) 13
Balance Sheet Indicators The Balance Sheet is an indicator of two key measures: Liquidity How fast an entity can turn its assets into cash (and therefore pay its debt and other obligations) The Balance Sheet is shown in order of declining liquidity Leverage How an entity is financed (debt vs. equity) Liabilities and Owners Equity shows how much of an entity relies on its debt versus equity from shareholders 14
Sample Balance Sheet ABC Company, Inc. Balance Sheet In U.S. Dollars As of As of 12/31/2016 12/31/2016 1 Cash and Cash Equivalents $ 15,000 12 Accounts Payable $ 50,000 2 Accounts Receivable, Net 20,000 13 Current Portion of Long-Term Debt 4,500 3 Inventories 5,000 14 Other Current Liabilities 5,000 4 Total Current Assets 40,000 15 Total Current Liabilities 59,500 5 Land 5,000 16 Long-Term Debt, Less Current Portion 10,000 6 Machinery and Equipment 50,000 17 Total Long-Term Liabilities 10,000 7 Less: Accumulated Depreciation (5,000) 8 Net Property and Equipment 50,000 18 Total Liabilities 69,500 9 Goodwill and Intangible Assets, Net 15,000 19 Common Stock (2,300) 10 Total Other Assets 15,000 20 Retained Earnings 37,800 21 Total Stockholders' Equity 35,500 11 Total Assets $ 105,000 22 Total Liabilities & Stockholders' Equity $ 105,000 Both sides must balance 15
Balance Sheet Caveats Shows accounts only at a single point in time Reflects assets at their historical cost basis Omits certain assets and liabilities 14
Income Statement Depicts the results of an entity s operating activities Displays sources of revenues and costs during the specific time period Shows how profitably (or not) a company able to convert its inputs to saleable outputs 14
Sample Income Statement ABC Company, Inc. Reported Income Statements In U.S. Dollars For the Fiscal Year Ended 12/31/2016 1 Total Net Sales $ 200,000 2 Less: Total Cost of Sales (95,000) 3 Gross Profit 105,000 4 Salary Expense 30,000 5 Rent Expense 5,000 6 Depreciation 1,000 7 Interest Expense 1,000 8 Office Supplies 5,000 9 Total Operating Expenses 42,000 10 Earnings Before Taxes 63,000 11 Income Tax Expense (25,200) 12 Net Income (Loss) $ 37,800 Transferred to Retained Earnings at the end of the Reporting Period 15
Income Statement Caveats Impacted by selected accounting policies Inventory recognition Depreciation and amortization periods Impacted by asset ownership Owned vs. leased properties Impacted by business model Perpetual sale vs. subscription sale Income can be materially different from cash 14
The Statement of Cash Flows Demonstrates an entity s ability to generate future cash flow and pay returns to its lenders (via debt service) and owners (via dividends) Three types of cash flow activities: Operating Investing Financing Operating Investing Financing Classification of Cash Flows Enters into the determination of net income Relates to the purchase/sale of securities, fixed assets, and other assets not generally held for resale, and making and collecting loans Identifies resources obtained from, or repaid to, owners and creditors 18
Inflows vs. Outflows on the Statement of Cash Flows Operating Investing Financing Inflows - Cash collected from sales - Realization of prepaid assets - Repayments received on loans made - Sale of capital assets - Debt borrowings - Stock sales Cash Pool Operating Investing Financing Outflows - Purchase of inventory - Payments to suppliers - Purchase of capital assets - Making a loan - Principal payments - Shareholder dividends 19
Sample Statement of Cash Flows ABC Company, Inc. Reported Statements of Cash Flows In U.S. Dollars For the Fiscal Year Ended 12/31/2016 1 Net Income (Loss) $ 37,800 2 Depreciation 1,000 3 (Increase) Decrease in Accounts Receivable 10,000 4 (Increase) Decrease in Inventories 2,500 5 Increase (Decrease) in Accounts Payable 10,000 6 Increase (Decrease) in Other Current Liabilities 1,000 7 Net Cash Provided by (Used in) Operating Activities 62,300 8 Proceeds from Sale of Equipment 5,000 9 Purchases of Equipment / Capital Expenditures (5,000) 10 Net Cash Provided by (Used in) Investing Activities 0 11 Proceeds from Borrowings 0 12 Principal Payments on Interest-Bearing Debt (15,000) 13 Distributions / Dividends (40,000) 14 Net Cash Provided by (Used in) Financing Activities (55,000) 15 Net Increase (Decrease) in Cash and Cash Equivalents 7,300 16 Cash and Cash Equivalents at Beginning of Year 7,700 17 Cash and Cash Equivalents at End of Year $ 15,000 Represents change in cash account (on B/S) over period 20
Tying the Three Statements Together Income Statement Net income appears in the form of retained earnings on the balance sheet and is also the first line on the operations section in the statement of cash flows Balance Sheet Ensures the balances of all accounts across all the financial statements Retained earnings is derived from the income statement, that is made up of net income Cash Flow Statement Net Income is the first line stated in the Operating Cash Flows section Ending cash balance flows to the cash account in the Balance Sheet 20
Tying the Three Statements Together Statement of Cash Flow Net Income Cash from Operating Cash from Investing Balance Sheet Cash from Financing Balance Sheet Cash Net Change in Cash Cash Other Current Assets Other Current Assets Net Fixed Assets Net Fixed Assets Long-Term Assets Statement of Owners' Equity Long-Term Assets Total Assets Preferred & Common Stock Total Assets Issue of Par Value Stock Current Liabilities Additional Paid-In Capital Current Liabilities Long-Term Liabilities Treasury Stock Repurchase Long-Term Liabilities Owners' Equity Retained Earnings (Net Income & Other) Owners' Equity Total Liabilities & Owners' Equity Net Change in Owners' Equity Total Liabilities & Owners' Equity Revenue Expenses Income Statement Net Income 21
Other Important Considerations Publicly held vs. privately held company financial statements The footnotes are an integral part of the financial statements and contain important information that should not be ignored Interim vs. year-end financial statements Cash basis vs. accrual basis financial statements 22
Notes to Financial Statements Provide/Disclose additional information that supplements the financial statements to offer clarity and understanding of the statements, including: Nature of the business Company organization (C-corp, S-corp, etc.) Accounting methods and related changes to revenue, inventory, leases, etc. Property and equipment detail Debt obligations Subsequent events Business segments Acquisitions/Sale of companies Partnership with companies Discontinued operations or related entities Material lawsuits or contingent liabilities 23
Level of Assurance How Reliable are the Financial Statements? Audit Review Compilation Management s Internal Statements 24
Other Important Considerations Internally vs. Externally-Prepared Financial Statements Internally-Prepared Financial Statements Management uses for periodic review of the operations of the company; May also be provided to investors or lenders No requirements on the format or content of the statements Examples include monthly financial statements, location-specific or product line financial statements, interim financial statements, and prospective financial statements Externally-Prepared Financial Statements Generally prepared in compliance with GAAP or other basis of accounting CPA prepared as a compilation, review, or audit engagement One can tell this by the opinion letter 25
Sample Opinion Letter Report of Independent Auditors To the Board of Directors ABC Company, Inc. We have audited the accompanying consolidated balance sheets of ABC Company, Inc. as of December 31, 2015 and 2016, and the related consolidated statements of operations, stockholders equity, and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company s management. Our responsibility is to express an opinion on theses financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company s internal control over financial reporting. Our audited included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of ABC Company, Inc. at December 31, 2016 and 2015, and the consolidated results of its operations and its cash flows for the years then ended in conformity with U.S. generally accepted accounting principles. 26
Analyzing Financial Statements 27
Basic Financial Statement Analysis - Vertical Vertical Analysis Measuring relationships between items within the statement Expressed as percentages Income Statement: Relationship of line item to Net Sales Balance Sheet: Relationship of line item to Total Assets, or to Total Liabilities and Stockholder s Equity In U.S. Dollars ABC Company, Inc. Reported Income Statements For the Fiscal Year Ended 12/31/2016 % 1 Total Net Sales $ 2,500,000 100.0% 2 Growth Rate 25.0% 3 Total Cost of Sales 1,700,000 68.0% 4 Gross Profit 800,000 32.0% 5 S,G&A Expenses 293,000 11.7% 6 Depreciation 58,000 2.3% 7 Total S,G&A Expenses 351,000 14.0% 8 Operating Income 449,000 18.0% 9 Other Income (Expense) 50,000 2.0% 10 EBIT 499,000 20.0% 11 Interest Expenses (20,000) -0.8% 12 Earnings Before Taxes 479,000 19.2% 13 Income Tax Expense 0 0.0% 14 Net Income $ 479,000 19.2% 28
Basic Financial Statement Analysis - Horizontal Horizontal Analysis Same items on comparative statements over two or more periods Describes changes over time Sales Gross Profit: Net Sales Cost of Goods Sold Net Income: Net Sales All Costs and Expenses EBITDA: Net Sales All Costs + Interest Expense + Income Taxes + Depreciation + Amortization ABC Company, Inc. Reported Income Statements In U.S. Dollars For the Fiscal Year Ended 12/31/2012 % 12/31/2013 % 12/31/2014 % 12/31/2015 % 12/31/2016 % 1 Total Net Sales $ 975,000 100.0% $ 1,000,000 100.0% $ 1,500,000 100.0% $ 2,000,000 100.0% $ 2,500,000 100.0% 2 Growth Rate n/a 2.6% 50.0% 33.3% 25.0% 29
Basic Financial Statement Analysis Vertical and Horizontal ABC Company, Inc. Reported Income Statements In U.S. Dollars For the Fiscal Year Ended 12/31/2012 % 12/31/2013 % 12/31/2014 % 12/31/2015 % 12/31/2016 % 1 Total Net Sales $ 975,000 100.0% $ 1,000,000 100.0% $ 1,500,000 100.0% $ 2,000,000 100.0% $ 2,500,000 100.0% 2 Growth Rate n/a 2.6% 50.0% 33.3% 25.0% 3 Total Cost of Sales 467,000 47.9% 500,000 50.0% 1,005,000 67.0% 1,300,000 65.0% 1,700,000 68.0% 4 Gross Profit 508,000 52.1% 500,000 50.0% 495,000 33.0% 700,000 35.0% 800,000 32.0% 5 S,G&A Expenses 166,000 17.0% 180,000 18.0% 224,000 14.9% 256,000 12.8% 293,000 11.7% 6 Depreciation 20,000 2.0% 20,000 2.0% 32,000 2.1% 44,000 2.2% 58,000 2.3% 7 Total S,G&A Expenses 186,000 19.1% 200,000 20.0% 256,000 17.1% 300,000 15.0% 351,000 14.0% 8 Operating Income 322,000 33.0% 300,000 30.0% 239,000 15.9% 400,000 20.0% 449,000 18.0% 9 Other Income (Expense) 12,000 1.2% 14,000 1.4% 24,000 1.6% 36,000 1.8% 50,000 2.0% 10 EBIT 334,000 34.3% 314,000 31.4% 263,000 17.5% 436,000 21.8% 499,000 20.0% 11 Interest Expenses (20,000) -2.1% (20,000) -2.0% (20,000) -1.3% (20,000) -1.0% (20,000) -0.8% 12 Earnings Before Taxes 314,000 32.2% 294,000 29.4% 243,000 16.2% 416,000 20.8% 479,000 19.2% 13 Income Tax Expense 0 0.0% 0 0.0% 0 0.0% 0 0.0% 0 0.0% 14 Net Income $ 314,000 32.2% $ 294,000 29.4% $ 243,000 16.2% $ 416,000 20.8% $ 479,000 19.2% 30
Basic Financial Statement Analysis Ratio Analysis Common Financial Ratios Liquidity Current: Current Assets/Current Liabilities Measures a company s ability to meet present obligations Leverage Debt ratio: Total Liabilities/Total Assets Provides information about protection of creditors from insolvency and ability to obtain additional financing Profitability Return on Assets: Net Income/Average Total Assets Measures the company s return on investment or income derived based on assets available Compare to benchmarks: Industry standards Prior operating years Management goals Competition Lending agreements 31