Do You Understand Your Financial Statements? Let an Award Winning Pittsburgh CPA explain…

Financial statements help uncover problems and identify corrective action

Financial statements are important because they can help to both uncover problems and identify corrective action. The most important financial statements are the balance sheet, the profit and loss (income) statement, and the cash-flow statement.

A balance sheet is nothing more than a list of the accumulated assets and liabilities incurred by the business. The difference between the two represents the net worth of the business. The profit and loss basically answers the question, “How did we do?” and the cash-flow statement answers the question, “Where was the cash used?”

How does the Business Owner Benchmark & Evaluate Their Business?

• Net Income—5 to 10% of sales—However, you need to consider Owner’s Salary. Is the owner being paid an industry comparable salary?
• Comparative Analysis—This year versus last year. Look at $ and % of sales—Are you going in the right direction?
• Understand your Balance Sheet—What is Equity?—What is Retained Earnings?—What should be Capitalized, and what should be Expensed?
• Try to find some Common Benchmarks—Compare yourself; similar industry, size, geography & if applicable market (niche)—Salaries as a % of sales, Gross profit %, Food Cost as a % of Sales, Overhead as a % of sales, Direct labor as a % of Revenue.
• Are you properly matching Revenue & Expenses? Don’t post the expense in one month and the related revenue in another. Match the Revenue with the Expense.
• Customer satisfaction—Ultimately this leads to more Revenue.
• Are you winning all your Bids/Proposals?—Maybe you are under pricing your product.
• Ratios—Need proper classification of Asset & Liabilities—This is a Primary consideration when seeking Bank Loans OR additional Bonding Capacity.

Small Business Concerns

• There are Minimal published Benchmarks available for small business that are reliable enough, as most small business do not have audited financial statements, so there are a variety of posting & classification issues.
• Problem of Classification of Assets, Liabilities, Income & Expenses
• Other issues: Owners running questionable expenses through the books or not recording revenue (cash).
• Past Performance is no indicator of future performance—You need to keep a lot of irons in the fire—continue to experiment with the market.

Various Ratios Used in Industry

Liquidity

Liquidity measures a company’s capacity to pay its debts as they come due. There are two ratios for evaluating liquidity.

Current Ratio: The current ratio gauges how capable a business is in paying current liabilities by using current assets only. Current ratio is also called the working capital ratio. A general rule of thumb for the current ratio is 2 to 1 (or 2:1 or 2/1). However, an industry average may be a better standard than this rule of thumb. The actual quality and management of assets must also be considered.

The formula is:

Current Assets = Cash + Accounts Receivable + Inventory
Current Liabilities= Accounts Payable + Credit Card Debt + Short term Debt (need to separate Short Term Debt versus Long Term Debt (greater than one year)

Quick Ratio: Quick ratio focuses on immediate liquidity (i.e., cash, accounts receivable, etc.), but specifically ignores inventory. Also called the acid test ratio, it indicates the extent to which you could pay current liabilities without relying on the sale of inventory. Quick assets are highly liquid and are immediately convertible to cash. A general rule of thumb states that the ratio should be 1 to 1 (or 1:1 or 1/1).

The formula is: (Does not Include Inventory)

Working capital: Current Assets Less Current Liabilities

Safety

Safety indicates a company’s vulnerability to risk, e.g., the degree of protection provided for the business’ debt. Three ratios help you evaluate safety.

Debt to Equity: Debt to equity is also called debt to net worth. It quantifies the relationship between the capital invested by owners and investors and the funds provided by creditors. The higher the ratio, the greater the risk to a current or future creditor. A lower ratio means your client’s company is more financially stable and is probably in a better position to borrow now and in the future. However, an extremely low ratio may indicate that your client is too conservative and is not letting the business realize its potential.

The formula is:

EBIT/Interest: This assesses the company’s ability to meet interest payments. It also evaluates the capacity to take on more debt. The higher the ratio, the greater the company’s ability to make its interest payments or perhaps take on more debt.

The formula is:

Variation on this formula-EBITDA/All Principal + Interest Expense (Debt Service Coverage)

Cash Flow to Current Maturity of Long-Term Debt: Indicates how well traditional cash flow (net profit plus depreciation) covers the company’s debt principal payments due in the next 12 months. It also indicates if the company’s cash flow can support additional debt.

The formula is:

*Such as depreciation, amortization and depletion.

Profitability

Profitability ratios measure the company’s ability to generate a return on its resources. Use the following four ratios to help your client answer the question, “Is my company as profitable as it should be?” An increase in the ratios is viewed as a positive trend.

Gross Profit: Sales – COGS (Cost of Goods Sold)

Gross Profit Margin %: Gross profit margin indicates how well the company can generate a return at the gross profit level. It addresses three areas — inventory control, pricing and production efficiency.

The formula is:

Net Profit Margin: Net profit margin shows how much net profit is derived from every dollar of total sales. It indicates how well the business has managed its operating expenses. It also can indicate whether the business is generating enough sales volume to cover minimum fixed costs and still leave an acceptable profit.

The formula is:

Return on Assets: This evaluates how effectively the company employs its assets to generate a return. It measures efficiency.

The formula is:

Return on Equity: This is also called return on investment (ROI). It determines the rate of return on the invested capital. It is used to compare investment in the company against other investment opportunities, such as stocks, real estate, savings, etc. There should be a direct relationship between ROI and risk (i.e., the greater the risk, the higher the return).

The formula is:

Efficiency

Efficiency evaluates how well the company manages its assets. Besides determining the value of the company’s assets, you and your client should also analyze how effectively the company employs its assets. You can use the following ratios:

Accounts Receivable Turnover: This ratio shows the number of times accounts receivable are paid and reestablished during the accounting period. The higher the turnover, the faster the business is collecting its receivables and the more cash the client generally has on hand.

The formula is:

Accounts Receivable Collection Period: This reveals how many days it takes to collect all accounts receivable. As with accounts receivable turnover (above), fewer days means the company is collecting more quickly on its accounts.

The formula is:

Accounts Payable Turnover: This ratio shows how many times in one accounting period the company turns over (repays) its accounts payable to creditors. A higher number indicates either that the business has decided to hold on to its money longer or that it is having greater difficulty paying creditors.

The formula is:

Days Payable: This ratio shows how many days it takes to pay accounts payable. This ratio is similar to accounts payable turnover (above.) The business may be losing valuable creditor discounts by not paying promptly.

The formula is:

Inventory Turnover: This ratio shows how many times in one accounting period the company turns over (sells) its inventory and is valuable for spotting under-stocking, overstocking, obsolescence and the need for merchandising improvement. Faster turnovers are generally viewed as a positive trend; they increase cash flow and reduce warehousing and other related costs.

The formula is:

Days Inventory: This ratio identifies the average length of time in days it takes the inventory to turn over. As with inventory turnover (above), fewer days mean that inventory is being sold more quickly.

The formula is:

Sales to Net Worth: This volume ratio indicates how many sales dollars are generated with each dollar of investment (net worth).

The formula is:

Sales to Total Assets: This indicates how efficiently the company generates sales on each dollar of assets. A volume indicator, this ratio measures the ability of the company’s assets to generate sales.

The formula is:

Debt Coverage Ratio: This is an indication of the company’s ability to satisfy its debt obligations and its capacity to take on additional debt without impairing its survival.

The formula is: