Finance Bootcamp for Non-Financial Managers Valerie M. Grubb, Principle Agenda 1. Basic Accounting Principles 2. Connecting Budgets to Financial Statements 3. Understanding Financial Statements 4. Critical Accounting Ratios to evaluate a Company s Health 1
GAAP Defined Generally Accepted Accounting Principles: GAAP provides a standardized system for recording financial events. Is GAAP a legal requirement? NO! Deviations from GAAP can jeopardize a firm s financial credibility. Cash vs. Accrual Accounting Cash-Basis Accounting Revenue or financial gain occurs when you receive $ and an expense happens when you pay out $ (i.e., when cash trades hands) Who uses cash-basis accounting? 2
Cash vs. Accrual Accounting Accrual Accounting Matching Principle: Revenues are recognized when they are earned. Expenses are matched with the time period when the services are used up. The Matching Principle is regardless of when cash changes hands! Cash vs. Accrual Accounting Cash-Basis vs. Accrual-Basis Accounting To conform to GAAP, a business must use -basis accrual accounting. 3
Cash vs. Accrual Accounting Final Thoughts Organizations use accrual accounting to determine their profits more accurately. This is necessary because expenses are often disbursed in a different time period from when revenues are collected. Accrual accounting does not measure the cash flow of a business! Agenda 1. Basic Accounting Principles 2. Connecting Budgets to Financial Statements 3. Understanding Financial Statements 4. Critical Accounting Ratios 4
The Company s Master Budget Sales & Revenue Forecast - Production & Expense Budgets = Financial Statements Company s Overall Health The Company s Master Budget Sales Budget Desired Inventory Ending Budget Production Budget Direct Material Direct Labor Factory Overhead Cost of Goods Sold Budget Selling Expense Budget Administration Exp. Budget Budgeted Income Statement Capital Budget Budgeted Balance Sheet Cash Budget 5
Creating your Budget WHERE to START??? Linking Goals to Budgeting Company Goals Department Goals Individual Goals Departmental Expense Budget Departmental CapX Budget Total Dept Budget 6
Operating vs. CapX Budgets Operating Expense VS. CapX Costs for running a department/company Costs which occur during the period (month, quarter or year) Services that are used up during the specified time period Short for Capital Expenditure Asset or project with a useful shelf life of greater than a year and over a dollar amount specified by the controller Linking Goals to Budgeting Documents the Plan/Activities Attaches a Monetary Value Monitors the $ Progress Tracks Performance Financially MATH 7
Bullet Proofing your Budget 1. Couple spend to company goals and improve profitability 2. Demonstrate ROI and cash efficiency of initiatives 3. Rank and Market initiatives by $ effect on the Bottom Line 4. Interview Dept Heads and model your budget based on their activities 5. Garner support from finance along the way 6. Detail value-added initiatives 7. Know what real concerns are driving your C-Suite Agenda 1. Basic Accounting Principles 2. Connecting Budgets to Financial Statements 3. Understanding Financial Statements 4. Critical Accounting Ratios 8
Key Financial Statements THE BIG THREE: 1. Income Statement 2. Balance Sheet 3. Statement of Cash Flows Key Financial Statements Statement Purpose Information Presented Income Statement (aka Profit & Loss Statement of P&L) Presents the organization s operating performance during a period of time. Revenues earned. Expenses incurred. Profit, Income or Loss which is the difference between revenues and expenses. Balance Sheet Reports to organization s financial condition at a point in time. Assets - what the organization owns. Liabilities - what the organization owes. Stockholders Equity - the difference between Assets and Liabilities (may be called Net Assets for a not-for-profit or government entity). Statement of Cash Flows Describes how cash came into the business and how it was used. Operating Cash Flow - the cash generated by the day-today operations of the organization. Investing Cash Flow - the cash reinvested in the business or generated by selling off pieces of the business. Financing Cash Flow - the cash generated by borrowing or selling stock to investors and the cash disbursed to pay off debt, buy back stock or pay dividends. 9
Key Financial Statements Income Statement (P&L) This is the major device for measuring the profitability of a company over a period of time (from a month to a year). It will tell you if a company is making a profit or operating at a loss. Accounting Principles Revenues Expenses = Net Income (Net Loss) Revenue $ the organization earns from selling its products and services $ from investments or sale of assets This is not necessarily the money collected during the year. Reduced for returns, discounts, customer credits. 10
Accounting Principles Revenues Expenses = Net Income (Net Loss) Expenses Costs the organization incurs to manufacture/sell goods AND run the company Must be matched when services are used up (accrual accounting principle). Not a reflection of money out the door. Income Statement Revenues = the Earnings Process Revenues are recognized when they are earned. Expenses = Costs incurred to generate revenues Expenses are recognized when they are incurred. Accrual Basis of Accounting (CRITICAL) Not when the cash is received or paid! 11
Income Statement When to recognize revenue and expense is up the accountants and can be an area of manipulating a company s books. Income Statement (P&L) Cost of Goods Sold (aka Cost of Sales) For a manufacturer, this represents the cumulative costs relating to products that were sold to customers during that year. It includes: Raw materials Direct Labor Factory overhead all other costs associated with the manufacturing facility such as indirect labor & supplies, depreciation, supervision, etc. 12
Income Statement (P&L) Cost of Goods Sold (aka Cost of Sales) For retailers, wholesalers and distributors, the Cost of Goods Sold represents what the company paid for those products that were resold to customers that year and the transportation associated with getting the products to the company s premises. For services providers, the equivalent of Cost of Goods Sold is called Cost of Services Provided. This reflects the cost of labor, supplies and other support that was needed for providing service. Income Statement (P&L) Calculating Income Statement: Total Sales - Cost of Goods Sold = GROSS PROFIT Gross Profit represents the difference between the cost to purchase or manufacture your goods and what you were able to sell them for. 13
Income Statement (P&L) Calculating Income Statement: Bob & Tom Candy Sales Retail Sales $2,200,000 Corporate Sales $1,000,000 Total Sales Revenue $3,200,000 Less Cost of Goods Sold $1,600,000 Gross Profit: $1,600,000 Income Statement (P&L) Operating Expense Includes all expenses (other than those that are part of Cost of Goods Sold) incurred in the day-to-day operations of the business including: Advertising/Marketing expenses General and Administrative (SG&A) Research and Development Depreciation of assets not used in a manufacturing process. 14
Income Statement (P&L) Calculating Income Statement: Total Sales - Cost of Goods Sold = GROSS PROFIT - Less operating expenses (EBITDA) - Depreciation expense Earnings before Interest & Taxes (EBIT) Income Statement (P&L) Bob & Tom Candy Sales Retail Sales $2,200,000 Corporate Sales $1,000,000 Total Sales Revenue $3,200,000 Less Cost of Goods Sold $1,600,000 Gross Profit: $1,600,000 Less Operating expense $ 800,000 EBITDA $ 800,000 Depreciation expense $ 42,500 Earnings before interest & taxes $ 757,500 (EBIT) THIS IS REFERRED TO AS OPERATING INCOME 15
Income Statement (P&L) OPERATING PROFIT Operating Profit shows if the Operations (i.e., the core business) is operating at a profit or loss. It s possible for a company to have a high Gross Profit (25-50%) but have a relatively low operating profit due to marketing the product and/or managing the Company. Think of Operating Profit as a measure of how efficient management is at generating revenues and controlling expenses. Income Statement (P&L) Other Income and Expense All encompassing category for what s left! These are costs that do not pertain to the continuing operations of the business. It includes: Interest income/expense Foreign currency gains/losses One-time events such as major write-offs of assets. One-time gains/losses resulting from the disposal of businesses and facilities. Income Taxes and Net Income 16
Income Statement (P&L) Bob & Tom Candy Sales Retail Sales $2,200,000 Corporate Sales $1,000,000 Total Sales Revenue $3,200,000 Less Cost of Goods Sold $1,600,000 Gross Profit: $1,600,000 Less Operating expense $ 800,000 EBIDTA $ 800,000 Depreciation expense $ 42,500 Earnings before interest & taxes $ 757,500 (EBIT) Less Interest expense $ 110,000 Earnings before income tax $ 647,500 Less income tax $ 300,000 Net Income $ 347,500 Income Statement (P&L) FROM THERE From NET INCOME, subtract Preferred Stock Dividend payments and that is the $ available to stockholders. Divide $ available to Stockholders by the Shares Outstanding That equals EARNINGS PER SHARE. 17
Income Statement (P&L) Has anyone seen the term pro forma on an Income Statement? Pro forma = projected HOWEVER! Pro forma can also mean an income statement that excludes any unusual or one-time charges! Income Statement (P&L) Revenues Expenses = Net Income (Loss) Operating Non-Operating Total Sales $ 2,600,000 Cost of goods sold 820,000 Gross profit (revenues) 1,780,000 Operating expenses 1,010,000 General and admin expenses 295,000 EBITDA Depreciation and amortization 715,000 137,500 Total operating expenses 1,442,500 Operating Profit (EBIT) 337,500 Interest expense (125,000) Interest income 11,400 Income before taxes 223,900 Provision for income taxes (75,000) Net Income $148,900 For the year ended December 31, 2008 18
The Bottom Line PROBLEM: Declining profits as shown by lower Net Income on the P&L Statement (aka Income Statement). Potential Solutions Reduce operating expenses: Increase sales revenues: Key Financial Statements THE BIG THREE: 1. Income Statement 2. Balance Sheet 3. Statement of Cash Flows 19
Balance Sheet Indicates how efficiently a company is utilizing its assets and managing its liabilities at a specific point in time. Indicates what a firm owns and how those assets are financed either through liabilities or ownership interest. Assets = Liabilities + Owners Equity The Accounting Equation Assets = Liabilities + Equity Assets = what the company owns Liabilities = what the company owes Equity the difference between what is owned and what is. owed Equity = Net Worth of a Company 20
Balance Sheet Assets = Liabilities + Owners Equity Three Components: Assets, Liabilities & Stockholders Equity CURRENT & FIXED ASSETS Listed in order of liquidity (ability to convert to cash): Cash (current) Marketable Securities (current) Accounts Receivable including Bad Debt (current) Inventory (current) Plant, Equipment and Furniture (long-term) Goodwill, Patents, Copyrights (long-term) Long-Term Assets Balance Sheet Those assets with a useful life of more than one year and over a certain minimum dollar amount. Long-term assets are also sometimes called capital assets. While an organization has some flexibility in deciding whether to expense or capitalize an item, it must do so in accordance with GAAP and the tax laws in the country where the asset is located. 21
Balance Sheet Long-Term Assets Capitalizing an Item The items becomes an asset on the balance sheet. Usually it is depreciated, depleted or amortized over time and gradually is converted to an expense. Expensing an Item The item is an expense on the income statement. It is not shown on the balance sheet. The organization appears to be more profitable in the short run because the cost of the item is spread over time. Tax benefits are realized over several years and must be claimed in accordance with the law for that particular asset. The organization is less profitable in the year the expense is incurred, but more profitable in subsequent years. The entire cost of the item is a tax deduction in the year the tax purchase occurred. Balance Sheet Assets = Liabilities + Owners Equity Three Components: Assets, Liabilities & Stockholders Equity CURRENT & LONG-TERM LIABILITIES Financial obligations broken in to current liabilities (due within one year) or long-term liabilities (1+ year away): Accounts or Notes Payable (current) Accrued Expenses (current) Bonds Payable (long-term) Deferred Income Taxes (long-term) Litigation Reserves (long-term) 22
Balance Sheet Assets = Liabilities + Owners Equity Three Components: Assets, Liabilities & Stockholders Equity TYPES OF STOCKHOLDERS EQUITY: Preferred Stock (paid first in full) Common Stock (paid with leftovers) Retained Earnings - cumulative earnings reinvested in the business since inception minus dividends and other adjustments (i.e., losses) Treasury Stock what the company paid when it repurchased its own shares previously issued. Sample Balance Sheet Assets = Liabilities + Owners Equity Assets Current Assets Total Cash $ 90,000 Short-term investments 200,000 Accounts receivable 60,800 Inventories 104,000 Prepaid expenses 50,000 Total Current Assets 504,800 Fixed Assets Property, plant & equipment 2,750,000 Less accumulated depreciation 325,000 Net Property, Plant, & Equipment 2,425,000 Goodwill Net 62,500 Total Assets 2,992,300 Liabilities & Owners Equity Current Liabilities Accounts payable 127,000 Current maturity of long-term debt 69,000 Accrued payroll 50,000 Income taxes payable 12,000 Other accrued expenses 8,000 Total Current Liabilities 266,000 Long-Term Liabilities Long-term debt 1,326,000 Total Liabilities 1,592,000 Owners Equity Common stock 1,000 Additional paid-in capital 1,350,000 Retained earnings 49,300 Total Owners Equity 1,400,300 December 31, 2009 Total Liabilities & Owners Equity $ 2,992,300 23
Balance Sheet Balance Sheet indicates a Company s NET WORTH Stockholders Equity Preferred Stock = NET WORTH or BOOK VALUE Total Assets - Total Liabilities = Stockholders Equity - Preferred Stock Obligation = Net worth available for Common Stock Outstanding Common Shares = Net worth, or book value, per share Balance Sheet Typically the 1 st financial statement an investor will review! Some basic questions: 1. Is the company solvent? 2. Can the company pay its bills? 3. Has owners equity been growing over time? 24
Key Financial Statements THE BIG THREE: 1. Income Statement 2. Balance Sheet 3. Statement of Cash Flows Statement of Cash Flows Demonstrates how cash came in and how it was used. Indicates if the company s cash flow is increasing or decreasing year-over-year. Includes cash equivalent : an item that can be converted into cash within 90 days (such as a money market fund). Translates income statement and balance sheet data into cash flow information. Cash Flow (Operating + Other) Cash Used = Change in Cash 25
Statement of Cash Flows Cash Flow from Operating Activities Cash Flow from Investing Activities Cash Flow from Financing Activities 1 2 3 Add Items 1, 2 and 3 together to determine net increase (or decrease) in cash Sample Statement of Cash Flows Cash Flow (Operating + Other ) Cash Used = Change in Cash Cash Flows from Operating Activities Cash Flows from Investing Activities Total Net income $ 148,900 Adjustments: Depreciation & amortization 137,500 Changes in assets and liabilities Accounts receivable (25,400) Inventories (9,000) Prepaid expenses (28,000) Accounts payable (49,000) Income taxes payable 4,000 Accrued payroll 12,000 Other accrued expenses (7,000) Net Cash From Operating Activities 184,000 Short term investments (172,000) Additions to property, plant & equip (850,000) Net Cash for Investing Activities (1,022,000) Cash Flows from Financing Activities Capital stock issue 950,000 Short-term debt 6,000 Long-term debt (63,000) Net Cash For Financing Activities 893,000 Net (decrease) increase in cash 55,000 Cash, beginning of year 35,000 For the year ended December 31, 2009 Cash, end of year $ 90,000 26
HR s Effect on the Bottom Line PROBLEM: Your company is having cash flow problems. Potential Solutions: Agenda 1. Basic Accounting Principles 2. Connecting Budgets to Financial Statements 3. Understanding Financial Statements 4. Critical Accounting Ratios to evaluate a Company s Health 27
Four important categories of ratios: 1. Profitability 2. Leverage 3. Liquidity 4. Efficiency Ratios Ratios Four important categories of ratios: 1. Profitability Shows a company s ability to generate profits/control expenses Gross Profit Margin = gross profit/revenue Operating Profit Margin = operating profit (EBIT)/revenue Net Profit Margin = net profit/revenue Return on Assets = net profit/total assets Return on Equity = net profit/shareholders equity 28
Ratios Four important categories of ratios: 2. Leverage Shows how and how extensively a company uses debt. Debt-to-Equity = total liabilities/shareholders equity Interest Coverage= operating profit (EBIT)/annual interest charge Ratios Four important categories of ratios: 3. Liquidity Tells you about a company s ability to meet its financial obligations. Current ratio = current assets/current liabilities Quick ratio = (current assets inventory)/current liabilities 29
Ratios Four important categories of ratios: 4. Efficiency Tells you how efficiently the company manages key balance sheet assets and liabilities. Days in Inventory (DII) = average inventory/(cogs/day) Inventory turn = 360 days/dii Days Sales Outstanding (aka average collection period) = ending A/R/(revenue/day) Days Payable Outstanding = ending A/P/COGS/day Total Asset Turnover = revenue/total assets A Call to Action Where do you go from here? What can you do to get involved? GREAT RESOURCE: Financial Intelligence: A Manager s Guide to Knowing What the Numbers Really Mean by Karen Berman and Joe Knight 30
A Call to Action QUESTIONS? Valerie M. Grubb (323) 229-2263 31