Rocco Sabino MBA, CPA

Rocco Sabino MBA, CPA Rocco.Sabino@Stonybrook.edu

Agenda: I. Understanding Financial Information Ø Financial Statements q Income Statement It s all about earning income How does Human Resource (HR) affect financial results? q Balance Sheet summary of value and ownership Review Major Accounts (Assets Liability = Owner s Equity) q Cash Flow Statements How Operations affect cash Sources and Uses of Funds 16-2

Agenda: Understanding Financial Information (continued) Ø Accrual Accounting and The Matching Principle Why is it important for HR to understand this principle? II. Reporting and Analyzing Financial Information q How do you Analyze Financial Results? Comparative and Trend Analysis q Financial Ratios Brief overview of ratios: how they help you understand the business 16-3

I. UNDERSTANDING FINANCIAL INFORMATION

Financial Statements Helps management answer questions like: q q q q q q q How much and what kind of debt is outstanding? Were sales higher this period than last? What assets do we have? What were our cash inflows and outflows? Did we make a profit last period? Are any of our product lines or divisions operating at a loss? Is our rate of return on assets increasing?

Financial Statements: Chart of Accounts a listing of all ledger account names used by the company to track all financial transactions Ø Arranged in the order in which they appear on the financial statements Account Number Account Description 1000 Cash 1100 Short-term Investments 1200 Accounts Receivable 1210 Allowance for Uncollectible Accounts 1500 Fixed Assets 1510 Land 1520 Building 1530 Machinery & Equipment 1540 Inventory 2000 Sales 3000 Materials 3100 Labor 3200 Overhead 4000 Rent 4100 Electric 16-6

Income Statement Ø Describes the performance of the company over a period of time (month, quarter, year). q Measures revenues (sales) and expenses (resources) used to achieve those sales q Profit = Sales Expenses q Also called a statement of operations or a profit and loss statement (P&L). q Most valued by CEOs, shareholders, bankers, and government regulators 16-7

Income Statement ABC Company Inc. Income Statement For the Period Ending December 31, 2016 Sales $ 500,000 Cost of Goods Sold 292,365 Gross Profit 207,635 Operating Expenses: Salaries & Benefits 76,280 Rent 40,000 Utilities 10,250 Depreciation 5,000 Advertising 25,000 Professional Fees 30,000 Total Operating Expenses 186,530 Operating Profit (EBIT) 21,105 Interest Expense (10,000) Earnings Before Tax (EBT) 11,105 Taxes (1,084) Net Income $ 12,189 LO 8

Income Statement Ø Sales or Revenues sale to customers of products and services that the company regularly offers for sale in normal course of business q Must be completed such as product shipped or service rendered ; customer is now required to pay Ø Cost of Sales cost to make or buy the product or service sold. Also includes cost of packaging or installation and training Ø Gross Profit first measure of profitability q Sales less Cost of Sales 16-9

Income Statement Ø Operating Expenses running the business q Salaries and Benefits or Compensation Expense normally approximately 40% - 50% of total operating expenses q q Advertising or Marketing Expense Professional Fees accounting, legal, consultants, recruiting Ø Operating Income profit that comes from doing what the company is in business to do. Or final result of the company s normal business activities q EBIT Earnings Before Interest & Taxes q EBITDA Earnings Before Interest, Taxes, Deprecation & Amortization 16-10

Income Statement Human Resource Expenses: Salaries Ø Exempt Ø Non Exempt Ø Bonus Fringe Benefits Ø Health Insurance Ø Group Life Insurance Ø 401K Plan Payroll Taxes Ø Employers Social Security tax (FICA 6.2%) Ø Federal Unemployment Tax (FUTA 6.0%) Ø Medicare Tax (1.45%) 16-11

Income Statement Human Resource Expenses: Training Costs Ø Travel Ø Conference & Workshop Fees Ø Training Materials Ø Tuition Reimbursement Employment Expenses Ø Recruiters Ø Employment Ads Ø Background Verification Ø Other Employment Expenses 16-12

Income Statement Some Observations: Ø If revenue is increasing but gross profit percentage is decreasing, company is probably gaining more business by reducing its selling price. Ø Operating expenses should increase more slowly than revenue. Ø If you see significant increase in salaries and benefits, company may be hiring in anticipation of new business (i.e. new store openings, new product launch). Ø Increase in employment expenses such as recruiting costs, should correlate with increase in hiring. 16-13

Balance Sheet Ø Represents the company s financial health. Consists of: q q Assets resources owned by the company Liabilities - company obligations to others q Stockholder s equity difference between assets and liabilities represents the ownership interest (What you own less what you owe = your equity) Ø A balance sheet helps us understand the following: q Company s ability to meet is obligations (liquidity) q It s financial strength: Can it secure resources to finance its future? Maintain and expand operations? Does it have the resources to support marketing and technology and improve profits 16-14

Balance Sheet Ø Evaluate company s asset management performance Inventory turnover Customer credit (accounts receivable) Ø Financial ratios can be calculated using balance sheet to compare company s performance against: Internal company standard (budget) Past history (trends) Other companies in a similar business or industry (benchmark) 16-15

Balance Sheet of a Merchandising Company

Balance Sheet Ø Current Assets assets that are cash or are expected to become cash within next 12 months. Main source of working capital q Cash and Cash Equivalents most liquid asset of all. Includes company checking accounts, cash reserves or savings, petty cash. q Accounts Receivable trade accounts or amounts due from customers as a result of sales made on credit. Anticipate customer will pay for sales within 30 to 60 days max. q Allowance for Bad Debts a reserve, an estimated amount the company provides for possibility that some customer balances will not be paid at all and will need to be written off. 16-17

Balance Sheet q Inventory production material or product purchases or manufactured and then held by the company for sale. Gross Inventory (Raw materials; Work in process; Finished goods) Direct Labor, Materials and Overhead Capitalized Engineering Inventory Reserves q Prepaid Expenses expenses paid in advance for services not yet rendered. Insurance policy paid at beginning of the policy. 16-18

Balance Sheet Ø Fixed Assets property, plant and equipment used for extended periods of time q Accumulated Depreciation reduction in value of the asset over time q Other Assets all other assets that cannot be categorized above (i.e. deposits) Note: Assets deteriorate over time or depreciate Example: A new car is worth $30,000 at time of purchase. If we determine that the car has a useful life of 10 years. After year 1, the value of the car declines to $27,000 ($30,000/10). In year 2, the value declines to $24,000 and the accumulated deprecation increases to $6000: Year 2 Auto $30,000 Accum. Deprec. (6,000) Net Book Value $24,000 Good will the value of a business entity not attributed to its assets and liabilities 16-19

Balance Sheet Ø Current Liabilities debts of the company expected to be paid within the next 12 months. q Accounts Payable account that includes all the bills yet unpaid from all the suppliers and service providers q Accrued Liabilities an expense for which the company received the benefit, but had not yet paid it (i.e. Accrued Interest) q Notes Payable and Other Bank Debt loans from banks and others that represent borrowed money; will be repaid within 12 months Ø Long-Term Liabilities borrowed capital that will be repaid over longer period of time; great than twelve months q q Lease Contracts such as lease equipment Long-Term Debt 16-20

Balance Sheet Ø Capital Stock and Contributed Capital amount paid into the company by investors to purchase stock Ø Retained Earnings an accumulation of net income and losses over the history of the company q Profits increase retained earnings, losses decrease it 16-21

Statement of Cash Flows Purpose of the Statement of Cash Flows To provide relevant information about the cash receipts and cash payments of an enterprise during a period. The statement provides answers to the following questions: 1. Where did the cash come from? 2. What was the cash used for? 3. What was the change in the cash balance? LO 4 Indicate the purpose of the statement of cash flows.

Statement of Cash Flows Ø Presents a detailed summary of all cash inflows and outflows, or the sources and uses of cash during the period q Information is presented in three sections: Cash flows provided by/used for operations Cash flows provided by/used for investments Cash flows provided by/used for financing Profit vs. Cash flow Ø Cash is the life blood of a business. It is more important to have cash flow than to be profitable Ø Transactions affect profit and cash flow differently due to timing (i.e. accruals). 16-23

Cash Inflow & Outflows

Statement of Cash Flows

Accrual Accounting and The Matching Principal Accountants use the matching principal : requires companies to match expenses with related revenues in order to accurately report profitability during a specified time period. Accrual Accounting: methodology whereby revenues are recorded when money is earned and expenses are recorded when the resource is consumed, without regard to when cash is received or paid out. Prepaid expense is an asset because the company makes a payment for a service (i.e. advertising) that it does not receive until ad begins next month for 12 months. When does it become an expense and how much should be expensed each month? 16-26

Accrual Accounting and The Matching Principal Accrued Payroll Expense all forms of compensation owed to employees that have not been paid to them. It represents a liability for the employer. Example John is paid $500 per week on Fridays. The last day of the month in November is on Wednesday. How much compensation is accrued on November 30 th? 16-27

Accrual Accounting and The Matching Principal Accrued Recruiting Expense costs incurred by the company for services performed by recruiter. Payment has not yet been made. Example Director of HR receives an invoice for $10,000 from a recruiter in January 2017 for an executive searched conducted in December 2016. What amount is recorded as an expense in December? January? 16-28

II. ANALYZING FINANCIAL INFORMATION

Statements in Comparative and Common-Size Form Dollar and percentage changes on statements An item on a financial statement has little meaning by itself. The meaning of the numbers can be enhanced by drawing comparisons. Common-size statements Ratios

Horizontal Analysis ABC CORPORATION Comparative Balance Sheets December 31 Increase (Decrease) This Year Last Year Amount % Assets Current assets: Cash $ 12,000 $ 23,500 $ (11,500) (48.9) Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200 Total current assets 155,000 164,700 Property and equipment: Land $12,000 $23,500 40,000 = 40,000 $(11,500) Buildings and equipment, net 120,000 85,000 Total property and equipment ($11,500 $23,500) 160,000 125,000 100% = (48.9%) Total assets $ 315,000 $ 289,700

Horizontal Analysis ABC CORPORATION Comparative Income Statements For the Years Ended December 31 Increase (Decrease) This Year Last Year Amount % Sales $ 520,000 $ 480,000 $ 40,000 8.3 Cost of goods sold 360,000 315,000 45,000 14.3 Gross margin 160,000 165,000 (5,000) (3.0) Operating expenses 128,600 126,000 2,600 2.1 Net operating income 31,400 39,000 (7,600) (19.5) Interest expense 6,400 7,000 (600) (8.6) Net income before taxes 25,000 32,000 (7,000) (21.9) Less income taxes (30%) 7,500 9,600 (2,100) (21.9) Net income $ 17,500 $ 22,400 $ (4,900) (21.9)

Horizontal Analysis Increase (Decrease) This Year Last Year Amount % Sales $ 520,000 $ 480,000 $ 40,000 8.3 Cost of goods sold 360,000 315,000 45,000 14.3 Gross margin 160,000 165,000 (5,000) (3.0) Operating expenses 128,600 126,000 2,600 2.1 Net operating income 31,400 39,000 (7,600) (19.5) Interest expense 6,400 7,000 (600) (8.6) Net income before taxes 25,000 32,000 (7,000) (21.9) Less income taxes (30%) 7,500 9,600 (2,100) (21.9) Net income $ 17,500 $ 22,400 $ (4,900) (21.9)

Common-Size Statements ABC CORPORATION Comparative Income Statements For the Years Ended December 31 Common-Size Percentages This Year Last Year This Year Last Year Sales $ 520,000 $ 480,000 100.0 100.0 Cost of goods sold 360,000 315,000 69.2 65.6 Gross margin 160,000 165,000 30.8 34.4 Operating expenses 128,600 126,000 24.8 26.2 Net operating income 31,400 39,000 6.0 8.2 Interest expense 6,400 7,000 1.2 1.5 Net income before taxes 25,000 32,000 4.8 6.7 Less income taxes (30%) 7,500 9,600 1.4 2.0 Net income $ 17,500 $ 22,400 3.4 4.7

Common-Size Statements ABC CORPORATION Comparative Income Statements For the Years Ended December 31 This Year s Operating Expenses This Year s Sales 100% Common-Size ( $128,600 $520,000 ) 100% = 24.8% Percentages This Year Last Year This Year Last Year Sales $ 520,000 $ 480,000 100.0 100.0 Cost of goods sold 360,000 315,000 69.2 65.6 Gross margin 160,000 165,000 30.8 34.4 Operating expenses 128,600 126,000 24.8 26.2 Net operating income 31,400 39,000 6.0 8.2 Interest expense 6,400 7,000 1.2 1.5 Net income before taxes 25,000 32,000 4.8 6.7 Less income taxes (30%) 7,500 9,600 1.4 2.0 Last Year s Operating Expenses Last Year s Sales 100% Net income $ 17,500 $ 22,400 3.4 4.7 ( $126,000 $480,000 ) 100% = 26.2%

Actual versus Budget Analysis Ø There are typically three types of variance explanations: q Business (rate, volume or both) q Timing q Error (actual result, budget, or both) Incorrect Budget assumption used ABC Company Budget Variance Report Current Month Year to Date Actual Budget Var $ Var % Actual Budget Var $ Var % Salaires 52,360 42,698 9,662 18.5% 365,982 236,498 129,484 35.4% Benefits 15,708 12,809 2,899 18.5% 109,795 70,949 38,845 35.4% Advertising - 16,985 (16,985) NA 23,895 47,905 (24,010) -100.5% Office Supplies 956 750 206 21.5% 13,043 5,000 8,043 61.7% Telephone 14,326 10,598 3,728 26.0% 35,987 22,000 13,987 38.9% Travel 995 1,989 (994) -99.9% 22,056 36,985 (14,929) -67.7% 16-36

Trend Analysis Employment Costs Account Description Jan Feb Mar Apr May Jun Jul Aug Sep Total 2016 Recruiters 20,000 10,000 4,000 - - - - - - 34,000 Employment Ads - 5,000 6,000 6,500 10,000 - - - - 27,500 Background Verification - - - 500 800 1,000 1,000 1,000 500 4,800 Total Employment Cost 20,000 15,000 10,000 7,000 10,800 1,000 1,000 1,000 500 66,300 What are some takeaways based on how employment costs are trending? 16-37

Financial Ratios Analysis Analysts and other interested parties can gather qualitative information from financial statements by examining relationships between items on the statements and identify trends in these relationships. Examples of the types of ratios that are analyzed by management are Liquidity and Profitability Ratios. 16-38

Financial Ratios Analysis Working Capital = Current Assets - Current Liabilities Current Ratio = Current Assets Current Liabilities $65,000 = $42,000 = 1.55 The current ratio measures a company s short-term debt paying ability. Too much working capital (high current ratio) is poor asset management. It is very expensive, can restrict cash flow and inhibit company growth

Acid-Test (Quick) Ratio Acid-Test Ratio = Quick Assets Current Liabilities Acid-Test Ratio = $50,000 $42,000 = 1.19 Quick assets include Cash, Marketable Securities, Accounts Receivable, and current Notes Receivable. This ratio measures a company s ability to meet obligations without having to liquidate inventory.

Days Sales Outstanding DSO = Accounts Receivable Total Credit Sales X # days = $350,000 $500,000 X 31 = 21.7 days This ratio measures the average number of days that a company takes to collect revenue after a sale has been made.

Return on Equity (ROE) ROE = Net Income Average Stockholders Equity $53,690 = = 25.91% ($180,000 + $234,390) 2 This measure indicates how well the company used the owners investments to earn income.

Profitability Ratios It measures the company s earnings performance. Focuses on: Ø Profitability achieved by management team Ø Assets invested in the business Ø Revenue achieved by the business Ø Funds that owners have invested in the business

Gross Margin Percentage Gross Margin Percentage = Gross Margin Sales $494,000 - $140,000 = = 71.6% $494,000 This measure indicates how much of each sales dollar is left after deducting the cost of goods sold to cover expenses and provide a profit.

Net Profit Margin Percentage Net Profit Margin Percentage = Net Income Sales $53,690 = = 10.9% $494,000 In addition to cost of goods sold, this ratio also looks at how compensation and benefits and other operating expenses influence performance.

Financial Analysis Exercise ABC Company Financial Ratio Analysis 2016 2015 2014 Sales Trend 128 115 100 Gross Margin 42% 35% 30% Net Profit Margin 8% 9% 10% Current Ratio 2.5 2.3 2.2 Acid - Test Ratio 0.8 1.1 1.5 Days Sales Outstanding 35.4 28.5 22.4 Inventory Turnover 6.5 7.2 8.0 1. Is the company making money on the products they manufacture? 2. Is it becoming easier or more difficult for the company to pay its bills? 3. Are customers paying their accounts at least as fast now as they were in Year 1? 4. Is total accounts receivable increasing, decreasing, or remaining constant? 5. Is the level of inventory increasing, decreasing or remaining constant? 6. Are operating expenses increasing, decreasing or remaining constant?