How to Read a Financial Statement

1. How to Read a Financial Statement Kimberly A. LoweAugust 20, 2009 *The law changes regularly. The information is current as of the date listed.

2. Overview • Basic Concepts • Financial Statement Details • Questions and Answers

3. Generally Accepted Accounting Principles • Standard for professional financial statement preparation • If not GAAP, then need to know how differ from GAAP • If the preparer cannot indicate how the statements differ from GAAP … • What does it all mean? • Cannot compare apples to apples • GAAP applies to all sorts of organizations • S-Corp • LLC • C-Corp • Non Profit • Cooperative

4. Financial Accounting • External financial statements – GAAP • Measures results and financial conditions so can compare similar businesses • Other types of accounting – purpose driven • Tax reporting – not GAAP • Regulatory reporting – not GAAP; not tax • Managerial accounting – Internal for management • Remember that type of entity does not matter

5. Trust? • Accountant’s Report • Audited • Less than audited • Nothing • Why do I care? • Validity of statements • Reliability of the accounting treatment

6. Audited Financial Statements • Assurances from accountants (CPA) … auditor report • “Present fairly in all material respects the financial position, results of operations and cash flows” of the company • Internal control system review • Test reliability of accounting • Auditors do not prepare the financial statements; they confirm that the financial statements present a true picture • Not an assurance that company is in good shape • Going concern opinion may be included as well

7. Unaudited Financial Statements • Accounting firm put together the financial statements from information provided by company (compilation) • Reviewed means the accountants some testing and inquiries but not as much as a full audit • Some companies cannot justify the cost of an audit nor is it necessary

8. Internal Financial Statements • Company did the financial statements themselves • May not be GAAP • Financial statements are the representation of management of a company • Internal financial statements are purely the opinion of management with no confirmation

9. Financial Statements • Balance Sheet • Statement of Condition • Statement of Financial Position • Income Statement • Statement of Cash Flows • Statement of Stockholder Equity

10. Balance Sheet • List of a company’s assets, liabilities and equity as of a specific date in time • Assets = Liabilities + Equity • Simple Example: • Building that cost $1,000,000 • Loan to buy building of $800,000 • Shareholders put down payment of $200,000 • ASSETS = LIABILITIES + EQUITY $1,000,000 = $800,000 + $200,000

11. Assets • Current Assets – assets that can be converted to cash within one year • Fixed Assets – long term assets • Goodwill • Prepaid Expenses • Listed in order of liquidity • Stated at historical cost

13. Current Assets • Cash – money in the bank • Cash Equivalents – easily converted to cash • Accounts Receivable • Amounts due from customers • Takes into account bad accounts which is estimated percentage of accounts that might be bad • Estimated amount ends up on income statement as an expense • Inventory – items company buys or makes to sell • Shown at cost • If it is sold during a period – cost of goods sold, cost of sales • Physical count of inventory critical because this needs to be accurate • Prepaid expense - already paid for; to be used in the future (move from cash to prepaid expense)

14. Fixed Assets • Property, Plant and Equipment • Depreciable Asset – purchased but will be used over time • Depreciation – spreads cost of asset over future accounting periods • Shown on balance sheet as historic cost of asset minus depreciation • Amount of depreciation is an expense on balance sheet • Straight line depreciation (same each year) • Accelerated depreciation (more in early years) • Amortization = depreciation for intangible assets • Depletion = depreciation for resources that are used up

15. Capitalizing versus Expensing • Capitalize (an asset) = record asset at amount paid (the expenditure) and recognize an expense in the form of depreciation over its useful life • Expense (an asset) = record entire amount of expense immediately • Not always obvious when an asset should be expensed or capitalized • Remember that choice impacts net income for periods

17. Liabilities • Amounts owed by the company • Current Liabilities – to be paid within one year • Note: Working capital = current assets over (less) current liabilities • Accounts payable are amounts the company owes to others for goods and services • Accrued expenses are expenses that need to be paid such as deferred compensation or some other amount that is owed • Income taxes – only time type of entity matters • Long Term Liabilities are amounts required to be paid more than a year in the future

19. Equity • Shareholder’s equity which is the assets less the liabilities is basically the book value of the company • Not market value of company or equity • Market value is based earnings, cash flow or some other measure

20. Elements of Equity • Stock/equity • What shareholders/members/partners/etc. paid for it? • Par Value is used to determine this value • Additional Paid in Capital • Owners investment • Amount of paid for stock in excess of par value recorded • Retained Earnings • All of the earnings of the company since its beginning that have not been paid out in the form of dividends or distributions. Not cash. It is an asset. • Increased by net income and decreased by net loss and dividends • Treasury Stock – company’s holdings in its own shares. • Reduction of equity • Un-issued shares that were previously issued

21. Income Statement • Measures profit (or losses) over a period of time • “Year ended” • Type of business changes some elements of the income statement • Manufacturing/Merchandising adds an additional level to derive income/gross profits.

23. Service Company Income Statement REVENUE Less: EXPENSES Equals: INCOME FROM OPERATIONS Less: INCOME TAX Less: EXTRAORDINARY ITEMS Equals: NET INCOME

24. Manufacturing Company Income Statement REVENUE FROM SALES Less: COST OF GOODS SOLD Equals: GROSS PROFIT Less: OPERATING EXPENSES Equals: INCOME FROM OPERATIONS Less: INCOME TAX Less: EXTRAORDINARY ITEMS Equals: NET INCOME

25. Sales/Income/Revenue • What company is getting paid for the services or goods it is selling • Service company it is just money for services. Legal services. • Merchandise or manufacturing it is what they sell the product for. • Internet company? • Lemonade Stand: • $1.00 a glass • Sells 100 glasses • Revenue/Sales = $100

26. Costs of Goods Sold • Cost of Goods sold links back to balance sheet with respect to the asset “inventory”. • Inventory on shelf waiting to be sold is an asset. • Service company does not have inventory. • Cost of goods sold is what the company paid to obtain that inventory so to determine its profit this amount needs to be reduced from the money it makes from selling this inventory • Lemonade Stand: • Costs $.20 to make one glass of lemonade: cup, powder mix/lemons, water • Sell 100 glass so Cost of Goods Sold = $20 • Reduce sales of $100 by $20 = $80 Gross Profit

27. Expenses/Operating Expenses • Any expense that a company has with respect to running the business: • Salaries • Marketing • Rent • PP&E • Capitalized Asset or expensed asset – reflected in the income statement • Etc. • Level of detail depends on nature of business. • Should be able to drill down into those details if necessary.

28. Above the Line/Below the Line • Above the line shows profitability of the Company. • Below the line includes items that are not generally in the control of the company • Taxes • Extraordinary Items are unusual or non-recurring events that cause a loss or gain – not part of ordinary operations. • Sale of property • Write down of assets or losses

29. Net Income • What there is left over to either distribute to shareholders or retain. • This is not a measure of profitability

30. Balance Sheet/Income Statement Connection

31. Statement of Cash Flow • Sources and Uses of cash during a specific period. • Not always included • Three categories: • Operations • Investing • Financing • Money goes in and out of the Pool of Cash available

33. Notes to Financial Statements • Important to read • A lot of details in the notes • If there are no notes then it is hard to figure out what went into creating the statements

34. EBITA • Earnings Before Interest, Taxes, Depreciation and Amortization • Good measure of financial health of a business • Exposes debt-free cash flow • Favors leveraged companies • Not net income