Financial Statement Overview
Bankers Insight Group, LLC
Jeffery W. Johnson
Introduction
• Financial Statement Analysis is the Cornerstone of a Bank’s credit decision making process
• They report on an economic entity’s financial condition and operations
• Financial statements are used:
– To evaluate loan request
– Identify risk and properly structure credit facilities
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Accounting Assumptions
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Economic Entity Assumption
Revenue Recognition Principle
Historical Cost Principle
Matching Principle
Full Disclosure Principle
Money Measurement
Continuity or Going Concern
Periodicity
Economic Entity Assumption
• An economic activity can be identified to a separate entity accountable for that activity. • Businesses must keep their transactions separate from their owners’, business units’ or other businesses’ transactions. – Example, the business activities of the neighborhood coffee house are to be kept separate from the financial activities of its owners or managers.
– The financial statements for the coffee house will only reflect the revenue and expenses for the coffee house. – It is possible to compare the financial statements of this coffeehouse with its competitors’ reports, since these statements should be reported separately under the economic entity assumption. 2
Revenue Recognition Assumption
• Revenue is to be recorded:
– when it is realized (or realizable), and – when it is earned and not when it is received. • Revenue is:
– realized when goods or services are exchanged,
– realizable when assets received can be converted to cash, – earned when all necessary requirements are met entitling the company to the benefits represented by the revenue (e.g. services performed).
Historical Cost Principle
• The historical cost principle deals with the valuation of both assets and liabilities.
• The value at the time of acquisition is used to value most assets and liabilities.
• If the coffee wholesaler purchased an office building in 1990 for $1.2 million, over time this asset has most likely appreciated in value.
• However, in accordance with the cost principle, the original (historical) price of the building is what is recorded as the cost of the building in the books of the business
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Matching Principle
• Expenses of a business need to line up with its revenue.
• The expense or cost of doing business is recorded in the same period as the revenue that has been generated as the result of incurring that cost.
– In the case of the coffee wholesaler, when the 100 coffee mugs were delivered in July they changed from being a part of inventory (asset) to a cost of goods sold entry (expense) in the month that the revenue from the sale was recognized.
– At this point, the difference between the revenue and expense is determined as the gross profit from the sale.
Full Disclosure Principle
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All past, present and future information that may have had an impact on the financial performance of the company needs to be fully disclosed.
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Examining the numbers does not always provide the entire financial picture of a company. •
Sometimes there are alternative situations that need to be reported.
– Pending or current lawsuits are one example of a transaction that could severely impact a company’s bottom line.
– Incomplete financial transactions or any other conditions that could impact the company’s performance must also be disclosed. •
Most of these transactions are disclosed in the footnotes to the financial statements.
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Accounting Assumptions
• Continuity or Going‐Concern
– The entity is assumed to have an indefinite life unless strong evidence exists to the contrary
• Periodicity
– An entity’s life can be subdivided into time periods for purposes of reporting its economic activities
Accounting Assumptions
• Money Measurement
– Economic activity is initially recorded and reported in terms of a common unit of measure (US dollar)
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Financial Statement Components
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Opinion Letter
Balance Sheet
Income Statement
Statement of Retained Earnings
Statement of Cashflows
Financial Notes
Interpretation of the Balance Sheet
• Current Assets
• Current Liabilities
• Fixed Assets
• Long Term Debt
• Other Assets • Net Worth
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Income Statement
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Sales
Cost of Goods Sold
Gross Profit
Operating Expenses
Operating Profit
Non‐Operating Expenses / Income
Net Income / Loss Before Taxes
Taxes
Net Profit / Loss
Income Statement‐Balance Sheet
Sales
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Cost of Goods Sold
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Operating Expenses
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Interest Expenses
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Non‐Operating Expenses
Income Tax Expense
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Profits
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Losses
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Dividend Declared
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Accounts Receivable
Inventory Accounts Payable
Accrued Expenses
Interest Payable
Other Liabilities
Income Tax Payable
Retained Earnings
Retained Earnings
Dividend Payable
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Cash
• Most liquid Asset
• May be restricted
• Companies need a minimum amount to operate
• Should not be used solely to make loan decision
• May be in the form of “Near Cash”
Marketable Securities
• Next most liquid asset
• Usually convertible to cash within 30 to 90 days
• Includes investments such as:
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Listed & Marketable Stocks
Bank Certificates of Deposits
Money Market & Savings Accounts
Commercial Paper & Repurchase Agreements
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Accounts Receivable
• Amounts owed for a product or service sold
• Must consider size, type, age & validity
• Must consider Account Debtors’ ability to pay
• Must establish advance rates
• Company should set up allowance for bad debts
Allowance for Doubtful Accounts
• Captures management’s estimation of accounts that will not be collected
• Shown as a contra‐account on the asset section of the balance sheet
• Increased by debiting Bad Debt Expense each year
• Account is charged when a bad debt is written off and not charged against earnings
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Inventory
• For manufacturers it consists of:
– Raw Material
– Work in Process
– Finished Goods
• Must consider how inventory is valued
• Must consider quality and age
Prepaid Expenses
• Operating Expenses that are acquired in advance of its use
• When acquired, it is book as an asset because it represents the prepayment of an expense that will be used over time
• Examples include:
– Prepaid Rent, Insurance, Utilities, etc.
• When used, it becomes an expense that is reflected on the Income Statement and the asset is reduced by the same amount
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Income Tax Refund
• Over payment of Income Taxes caused by a number of factors
• It will be collected within 90 days when the tax returns are filed Fixed Assets
• Consists of:
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Land
Buildings & Improvements
Machinery & Equipment
Furniture & Fixtures
Leasehold Improvements
Capital Leases
• Valued at lower of cost or market
• Depreciates in value over time or usage
• Must consider effectiveness and efficiency
• Must consider age, location, technical ability, etc
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Accumulated Depreciation
• Captures the depletion of assets value over time
• Shown as a contra‐account in the asset section of the balance sheet
• Is increased by annual depreciation expense
• Reflects varying methods of depreciation
Intangible Assets
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Includes Assets such as:
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Goodwill is created when the cost paid for an investment exceeds the acquisition cost of the asset
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Non‐Compete Agreements disallows individuals with competitive knowledge from operating a business in the same industry within a certain time frame and/or proximity of the company. It is usually a requirement from the acquirers of companies and executed by the sellers of the company
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Trademarks, Copyrights, Patents, etc., provide companies with exclusive rights to own, operate and distribute products and services that restricted to them only
– Goodwill
– Non‐Compete Agreements
– Trademarks, Copyrights, Patents, etc.
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Other Assets*
• Assets that are minor in value • These assets are usually non‐operating assets, meaning that their existence will have little or no impact on the operations of the company
• Insure they represent less than 10% of the total assets of the company
Notes Payable to Banks
• Borrowing to support Current Assets
• Usually a Line of Credit or Single Payment Note
• Must consider interest rate, terms and collateral
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Notes Payable to Others
• Usually due to suppliers for inventory purchased
• If so, must inquire why inventory purchases are not paid within normal terms
• Could be due to other none operating purposes
• Must be thoroughly understood Accounts Payable
• Amount owed to suppliers for purchases
• Interest free financing usually for 30 days
• Must consider credit limits, age and relationship with suppliers
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Accrued Expenses
• Expenses incurred but not yet paid
• Includes:
– Accrued Interest
– Accrued Taxes
– Accrued Wages, Profit sharing, bonuses & vacation
• Must consider timing of required payments
• Be cautious of Accrued Taxes beyond the current period
Income Tax Payable*
• Taxes incurred in current or previous periods that have not been paid
• Be cautious of increasing amount and carryover from year to year
• Rule of thumb is that it should not exceed 25% of a current year’s taxes
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Interest Payable
• Interest Expense (or Finance Charges) incurred on borrower funds that were not paid as of the reporting date
Dividend Payable
• Represents a declaration of dividend that has not been paid
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Current Portion of Long‐Term Debt
• Principal portion of Long‐Term Debt due in the upcoming year
• Accounting rules requires to separate the current portion (due within 12 months) from the total Long Term Debt
• For cash flow purposes, use pervious period CPLTD
Long Term Debt
• Amounts owed over one year
• Must consider rate, terms, amortization with balloon payments and collateral
• Other long term debt may be due to stockholders or other creditors
• It should be thoroughly investigated
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Net Worth
• Assets Minus Liabilities Equals Net Worth
• Usually composed of:
– Common or Preferred Stock
– Paid in Capital
– Retained Earnings
– Treasury Stock
Sales/Revenue
• Revenue flowing into an entity as a result of selling a product or rendering a service
• Can be reported as Gross or Net
• Net Sales is Gross Sales minus Returns & Allowance, Discounts and Credit Memos
• Accounting method may change recognition of sales
• Be mindful of impact of Accrual vs. Cash Basis of accounting on sales
• Should be analyzed over several periods to determine management’s decisions and trends
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Cash Basis VS Accrual Basis
• Cash Basis
– Revenue, Cost and Expenses are recognized when cash is received or paid
• Accrual Basis
– Revenue and Expenses are recognized when incurred regardless of cash being received or paid
Sales Recognition
• Long‐Term Projects
– Completed Contract: No revenue is recognized until the period in which the project is completed
– Percentage of Completion: Revenue is recognized based on the estimated stage of completion of a long term contract
– Completion of Production: Recognizes revenue at the completion of production or extraction. Used for many farm products and for certain precious metals.
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Cost of Goods Sold
• Direct costs incurred for making product for manufacturers
• Direct costs incurred for buying products‐wholesalers and retailers
• These costs are usually uncontrollable • Usually no COGS for service companies
• Usually no COGS for Farmers since all costs are shown of Sch. F
• Must know type of inventory valuation method used
• Must know depreciation method used
Operating Expenses
• Costs not directly related to producing the product or buying the finished goods
• Costs are often controllable
• Should divide into variable and fixed category
• Should be measured as a percentage of sales
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Thank You
Bankers Insight Group, LLC
Jeffery W. Johnson
Jeffery.Johnson@Bankers‐Insight.com
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