Financial Analysis : Statements, Overview and Walkthrough written by : William F Bryant The data I grabbed is from the same company that I have used throughout for any firm specific calculations. I won’t go into direct competitor comparison, but I will make mention of benchmarks and industry measures that are common measures for companies. Many business owners and managers go through financial statements and P&Ls, although I have never been fond of this generic assessment. A deeper understanding of some of the calculations that can be done with the statements and what is included in the accounting tallies for certain accounts can enlighten owners as to what the metrics and account tallies are actually revealing, and perhaps why I have always felt the P&L is too generic. The thing I always point out is that financial statements are the accounting department and accounting professionals’ tracking of capital. These numbers reflect past to the present-day book value of capital and the accountants have created methodologies for the most accurate monetary representations for these book valuations. The accounting professionals measure everything, however, cash and noncash, these folks are meticulous, but often the cash and noncash items get combined on the statements. This is where finance professionals tend to view the numbers in an additional way. Finance professionals tend to view cash flows and look to the future. We are taught to strip out the noncash from the account tallies, get to the cash flows and determine liquidity, current and into the future. Finance professionals then work with the actual cash flows. We determine future capital requirements for operations, strategic decisions and even investments. These determinations are then, often, valued and risk assessed from the future projections of cash flows in present terms evaluated against alternative strategies and these corresponding risks. I always like to say that we attempt to value the future decisions, the accountants track the past decisions and we meet in the present. Of course, this is light-hearted kidding, but it does reflect some accuracies in the way the statements are viewed and the differences in accounting and finance. Perhaps the noncash and cash topic is newer to you. I will attempt a quick explanation that will hopefully assist as you push forward through this paper. The most obvious choice for this explanation is depreciation. When you purchase certain items for your operations, such as equipment or facilities, you are required to depreciate the cost over time instead of listing the purchase as an expense. Depreciation attempts to track a real time value of the item as it is used over time. If you consider this transaction, you often pay out the full cost in cash at the time of purchase or within the allotted payables time period. This means that you no longer have this cash, the entire amount is withdrawn from your cash account. The item cost however, since it is not expensed all at once, is not reflected this way in the period’s income statement. Only a portion of the total cost is expensed and considered a part of the cost-of-goods-sold for that period and each period thereafter until the entire amount of the purchase is eventually expensed. If you think about the way depreciation is recorded, it should make sense that it’s tally and expensing is a noncash recording of a historic purchase and does not reflect current cash flows. While depreciation is an effective way to measure usefulness of equipment and facilities over time, it is not reflective of actual cash on-hand or gained for a period, even after you make your calculations down the income statement to arrive at net income. In fact, you will actually find that depreciation methods and considerations have an affect on other areas in terms of actual cash outflows and inflows such as deferred taxes. The more familiar you become with your financial statements, the more you will make sense of the cash and noncash concept, but a good indication of how accountants adapted to this issue was the creation of the Statement of Cash Flows. The Statement of Cash Flows divides up cash flows into three categories, Operations, Investing and Financing and calculates/records cash flows from each of these categories. One of the first things you will notice is that at the top of the statement, in the operations section, the depreciation is added back to the net income. Of course, there are other accounts being added in as well, including the other noncash account, but I simply wanted to make a point of considering that the financial statements are not always reflective, in themselves, of the potential for financing future strategic decisions and there are considerations to be made for components on the statements which are cash and noncash accounts. Future decisions need to be made from understanding actual cash flows. Even further, there is a distinction of the cash flows from the Statement of Cash Flows and free cash flows that would be used to project expanding operations. But, if you are needing a place to begin understanding the cash and noncash concept, depreciation and the Statement of Cash Flows is a good place to start. Proceeding to some statement data. Due to the fact that so much information can be gleaned from number trends and the understanding of the relationship of the accounts, without even getting into any calculations, I tend to like looking at more than five years of statement data. I will go back fifteen years if the data is available. First, statement data isn’t really overwhelming when you become accustomed to working with it. Second, C-suite trends, changes, and strategic decision changes can be seen over a fifteen-year period. If a company decided to go “asset-lite” you will see changes in depreciation, capital expenditures, operating and capital leases, financing and so on. If a company was having solvency issues or you need to distinguish preferred usage of cash, you can easily see this trending from the cash flows. There is a wealth of information to be gained from simply recognizing patterns over time. When you find the patterns, you can then dive deeper into calculations and ratios. As you get more familiar with the accounts, you can do this in the reverse order as well, spot discrepancies in the ratios and immediately jump to the statements and confirm your first impressions. Depending on what your end goal is, certain statement data may draw your attention first and this is probably where you would begin. I will make a brief mention of each starting with the balance sheet. Its also known as “the Snapshot”. I always remembered this sheet from the fact that it pertains to the balance equation, assets must equal liabilities plus equity. Accounts on this statement are listed in order of liquidity, most liquid to least. You might also note that its Assets, Liabilities and then Equity and remember this in terms of ownership and financing. The assets represent the productive capacity of the firm, liabilities fill in the gaps of capital needs to advance operations and are also first paid and finally equity is what’s leftover. That seems harsh but from a small business to a large corporation, creditors get dibs in times of liquidity problems. There are a few immediately noticeable observations before getting into any calculations and not looking over any of the other statements. The first is the change in cash. Companies know how much cash is needed for operations; they do not like to keep excess cash-on hand if it can be working for the company elsewhere unless it is stock-piled for a purpose. One could immediately think of major investments that cash would be used and an acquisition should come to mind. This is supported by the jumps in assets, AR and inventories, as well as AP, customer advances and, of course, a balancing with an increase in total equity. It would appear that the company is has now expanded its market share and an acquisition would accomplish this event. Balance Sheet: Some considerations from the balance statement: Accounts Receivable and Accounts Payable. These accounts are delayed cash flows. You can have a great, growing Accounts Receivable account and suffer solvency issues. Anytime an account represents a delayed cash flow you can think of it as terms of credit financing. An Accounts Receivable account is your firm offering purchase credit to your customers and an Accounts Payable account is your suppliers offering you purchase financing. These terms can be substantially advantageous if worked into your overall capital strategy. Inventory. This is another account that is designed to be representative of the value of inventory used in operations. You can see that inventory is even tracked through the process. However, inventory is recorded with criteria in mind, in monetary terms, the price of purchase and in timing of usage. The timing of usage is LIFO (Last In, First Out) and FIFO (First In, First Out). To visualize the usage, think of stocking a shelf with canned goods. You push the first can way to the back and stock the shelf to the front. Well, Last In, is the can closest to you and First In is the can you pushed all the way to the back. First Out should now make sense, you either grab the one in the back first (First In, First Out) or the one closest to you (Last In, First Out). If you are wondering why this matters, it is due to the change in prices over time and how to most accurately measure the costs of inventory used in production over this time. As an example, FIFO, during times of rising prices, means the first can in cost less than the last can in. When you use the first can first, the remaining cans’ average cost is now higher because you removed the cheapest can. This method would then impact total value of inventory, which would be higher than using the LIFO method. It also reflects a lower COGS and therefore profits would be higher. This is another good example toward supporting further understanding of accounts. Debt. There are a variety of debt options for a firm. Commercial paper, revolving credit lines, notes and bonds. Debt is either secured or unsecured and is ranked according to claims, senior, subordinated and so on. This is not necessarily needed for a basis analysis, it is just important to understand that the debt account can be expanded substantially in detail and it may become a factor when considering capital needs and how a firm chooses to attain capital. The income statement is the “Period Piece”. I always remembered this by linking it to the paycheck. A paycheck covers your income for the period and then you deduct all your expenses from it. As you can see from the statement below, this company does a great job of including significant detail in their statement. You will find that statements differ company to company. This firm goes so far as to include supplemental expense recordings on Depreciation, Interest, Rental and Stock-Compensation as well as several margin calculations. The income statement is period to period changes in operational efficiencies. Without looking at other statements, this statement, is most easily viewed in terms of relative percentages to revenues to see if there are any major changes in expenses. As a company finds its groove, it should maintain an optimal efficiency that can be seen in the margins. One of the points of note is that, the acquisition must not have had the same efficiencies as the acquirer given the closing of the margins in the year of purchase and one year after thus far. If we were to roll back a couple of years, we could get a quick look at trending margins for the parent company to see if this assumption is correct. Some considerations from the Income statement: Cost of Revenue & Cost of Goods. Cost of Revenue is the COGS, in addition to, additional direct costs outside of production that are needed to generate a sale. Distribution and Marketing costs for example. Keep in mind how this will affect any calculations with comparative companies if they use COGS. The way a company chooses to record costs immediately reveals something about the industry and its distribution. For reference COGS includes things such as raw material costs, packaging material costs, deposit costs, purchasing & receiving costs, manufacture labor & OH, brewing & processing costs, inspection costs (QA), inbound freight charges, depreciation expense (manufacture equipment/warehousing), warehousing costs (rent, labor, OH costs) Deferred Taxes. Several tax accounts can be found on the income statement and the deferred account, with the inclusion of cash taxes paid, may be found on the statement of cash flows. When it comes to taxes, companies may set aside anticipated taxes as a provisions, which is not necessarily what is paid, but differences also come from differences in depreciation methods of reporting income for tax purposes and to shareholders. As an example for tax purposes accelerated depreciation may be used, but for reporting purposes a straight-line method may be used. This becomes relevant in the noncash computations of free cash flows. Normalized Accounts. If you find that some accounts that follow the EPS section are referred to as “Normalized”, such as Normalized Net Income, this is simply restating the accounts without specific regards to the special items. Special items are not something that would occur in normal operations or on a regular basis and so they are given a separate account or a note on the income statement.
Some Considerations of the Statement of Cash Flows.
DDA. Depreciation, Depletion and Amortization. This, obviously, includes the approximate monetary value of the depletion of inventory used in beverage process. Deferred Taxes. These were previously mentioned. Working Capital: Capital usage toward operations over the period. (AR+Inc+Prepaid)-(AP+Accruals) Capital Expenditures. CAPEX. As seen from the statement, additional fixed assets are capital expenditures for expanding operations. This might also include maintenance and upkeep. Financing Activities. Choices on how to finance operations, capital structure, including additional considerations of interest payments, principal pay down and dividends.
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