Gain Confidence: Introduction to Financial Statement Analysis

GAIN CONFIDENCE Introduction to Financial Statement Analysis Maine State Bar Association January 26, 2012 GAIN CONTROL berrydunn.com

OUR GOALS Understand the basic types of financial statements Understand how financial statements interact Identify different types of Accountants’ Reports and why that is relevant to you Understand why taxable income and net income are not created equal Determine some basic financial statement metrics Identify red-flags and accounting games Most importantly – Identify when you need some additional help Our goal is to help you gain a better understanding of financial statements. Today’s agenda: GAIN CONTROL berrydunn.com

NOT OUR GOALS Talk debits and credits Do linear algebra Turn you into bean counters GAIN CONTROL berrydunn.com

The Basics Setting the foundation to understand financial statements GAIN CONTROL berrydunn.com

Assets = Liabilities + Equity When people say the books are “in balance”, this is what they mean Think of equity as the leftover portion when you take what you have (assets) and subtract what you owe (liabilities) Equity = Assets – Liabilities If you owe more than you have, you have negative equity The Accounting Equation GAIN CONTROL berrydunn.com

Balance Sheet Snapshot of a company’s assets, liabilities, and equity as of a certain date Assets on the left-hand side (or first page) Liabilities on the right-hand side (or second page), followed by Equity GAIN CONTROL berrydunn.com Assets Liabilities Equity

Income Statement Movie about revenue and expenses over some period of time Titles and descriptions change, but the basic structure is the same GAIN CONTROL berrydunn.com Revenue (Cost of Goods) Gross Profit (Operating Expenses) Profit from Operations (Miscellaneous Items) (Interest) (Taxes) Net Income

Statement of Cash Flows Movie about cash over some period of time Three types of cash flow Cash flow from Operations – generated (or used) by normal activities Cash flow from Investments – generated by sale of assets or used by purchase of capital equipment Cash flow from Financing – generated by bank debt, equity sales or used for distributions GAIN CONTROL berrydunn.com

For-Profit Business Entities C-Corporation Pay corporate-level taxes Shareholders pay dividend taxes on distributions Also referred to as a “dual tax entity” since there are two levels of taxes paid on distributions Everybody Else S-Corps, Partnerships, LLCs * Taxes are paid by the members as ordinary income Also referred to as “pass through entities” since the tax liability is passed through to the member (or shareholder) *LLCs are commonly set up as partnerships, but can be S-Corps or C-Corps GAIN CONTROL berrydunn.com

Dual tax versus single tax Pass-Through Entities skip the dividend taxes, results in more cash for the owners upon distribution Distributions from PTEs to cover the tax liability are typical GAIN CONTROL berrydunn.com

Which is which? GAIN CONTROL berrydunn.com C-Corp S-Corp Partner-ship LLC Public company  Taxes in the income statement   No taxes in the income statement    Distributions proportional to ownership  Tax Return is an: 1120   1120S   1065  

Let’s Form a Company Easier to understand the interaction of financial statements with an example We contribute $100 for equity We borrow $900 from the bank We buy $1,000 in equipment GAIN CONTROL berrydunn.com

Opening Balance Sheet GAIN CONTROL berrydunn.com WidgetCo Balance Sheet as of January 1, 2012 Assets Liabilities Cash - Loans $900 Inventory - Other commitments (see note __) Total Current Assets - Equity Equipment $1,000 Capital Stock 100 Depreciation - Retained Earnings Net Fixed Assets 1,000 Total Equity 100 Total Assets $1,000 Total Liabilities & Equity $1,000

Equity Section Details Three different kinds of equity Common Stock The original capital contributed to the Company to satisfy par value $100 in out example Additional Paid in Capital (APIC) Capital above par value Initial capital may be more than par value Fund losses or contributed for other purposes Retained Earnings Prior year’s retained earnings plus net income minus any distributions GAIN CONTROL berrydunn.com

Let’s Sell Some Stuff We sell $1,000 worth of widgets We have $400 in production expenses, $100 in direct labor, and $200 in depreciation expense We receive $60 of raw materials at year-end We pay $100 in rent We pay lawyers $10 and accountants $20 We pay interest of $45 We pay taxes of $55 GAIN CONTROL berrydunn.com

Income Statement Revenue is the value of what was sold Cost of Goods Sold are the accounts directly linked to production Depreciation is a non-cash charge (which we will discuss later) Net Income is the “bottom-line” Let’s see how this impacts the balance sheet GAIN CONTROL berrydunn.com WidgetCo Income Statement For the year ending December 31, 2012 Revenue $1,000 Production Expenses 400 Direct Labor 100 Depreciation 200 Total Cost of Goods Sold 700 Gross Profit 300 Operating Expenses (Rent, Legal, Accounting) 130 Operating Profit 170 Interest 45 Taxes 55 Net Income $70

A few simplifying assumptions All sales are for cash – no credit (yet) No additional equipment was purchased or sold All debt is interest only for the first five years No distributions are made to shareholders (yet) GAIN CONTROL berrydunn.com

Year-End Balance Sheet Net Income is added to the shareholder equity in the form of retained earnings Fixed assets have been reduced by the depreciation expense GAIN CONTROL berrydunn.com WidgetCo Balance Sheet as of December 31, 2012 Assets Liabilities Cash $210 Loans $900 Inventory 60 Other commitments (see note __) Total Current Assets 270 Equity Equipment 1,000 Capital Stock 100 Depreciation (200) Retained Earnings 70 Net Fixed Assets 800 Total Equity 170 Total Assets $1,070 Total Liabilities & Equity $1,070

But wait a minute… Net Income is $70 How did we generate $210 in cash? We find the answer in the Statement of Cash Flows GAIN CONTROL berrydunn.com

Statement of Cash Flows Links Income Statement (Net Income) to Balance Sheet (Cash) Best place to find non-cash expenses, like depreciation and amortization Reconciles beginning and ending cash Bankers love reconciling cash GAIN CONTROL berrydunn.com WidgetCo Statement of Cash Flows For the year ending December 31, 2012 Net Income $70 Adjustments to Reconcile Net Income to Cash Flow from Operations Inventory (60) Depreciation 200 Net Cash Provided by Operations 210 Cash Flows from Investing Activities Purchase of Equipment (1,000) Net Cash Used by Investing Activities (1,000) Cash Flows from Financing Activities Borrowings 900 Capital Stock Issued 100 Net Cash Used by Financing Activities 1,000 Net Increase in Cash $210 Cash at Beginning of Year - Cash at End of Year $210

Quick Review Assets = Liabilities + Owner’s Equity Balance Sheet Must balance Is a snapshot in time Income Statement Boils down to Net Income Movie of profits over time Statement of Cash Flows Links Net Income (starting point) to Cash (ending point) Movie of cash flows over time GAIN CONTROL berrydunn.com

Quick Review - continued Retained Earnings = Prior year’s retained earnings + Net Income – Distributions Taxes may or may not be paid at the corporate level, depending on entity-type Cash flow ≠ Net Income (more on this later) GAIN CONTROL berrydunn.com

Financial Reporting Different types of reports and the distinction between taxable and net income GAIN CONTROL berrydunn.com

What is GAAP? Generally Accepted Accounting Principles (GAAP) Accounting principles set forth over time by a variety of authoritative and advisory bodies including, Financial Accounting Standards Board (FASB) Governmental Accounting Standards Board (GASB) Securities & Exchange Commission (SEC) Accounting Principles Board (APB) International Accounting Standards Board (IASB) GAIN CONTROL berrydunn.com

Accountants’ Reports Four types of reports – and the level of assurance with respect to GAAP Audit – positive assurance regarding material conformity Review – negative assurance that nothing material came to light Compilation – no assurance. Simply compiled financial information Agreed-upon Procedures – no assurance beyond the reporting of results from the application of certain procedures GAIN CONTROL berrydunn.com

Independent Auditors’ Report Clean opinion: Look for the following wording: In our opinion , the financial statements referred to above present fairly, in all material respects, the financial position of Company as of December 31, 2008, and the results of its operations and its cash flows for the years then ended in conformity with U.S. generally accepted accounting principles. GAIN CONTROL berrydunn.com

Accountants’ Review Report Look for the following wording: Based on our review , we are not aware of any material modifications that should be made to the accompanying financial statements in order for them to be in conformity with U.S. generally accepted accounting principles. GAIN CONTROL berrydunn.com

Footnotes Referenced on bottom of each statement “ The rest of the story” Many items reported as “net” on the financial statement are detailed in the footnotes Footnotes are particularly important with a review or a compilation as “going concern” questions are not necessarily discussed in the report GAIN CONTROL berrydunn.com

Footnote Topics Significant accounting policies Components of inventory Details of fixed assets Income tax discussion & disclosure Components of debt Leases, other commitments, and contingencies Pension and profit sharing information Fair value and derivative information Subsequent events Emphasis paragraph explanation from the accountants’ report Related parties disclosures GAIN CONTROL berrydunn.com

No Financial Statements? Look to other sources of information: Tax Returns Internally generated statements of profit and loss and financial position Financial Statements using GAAP as the foundation rely on accrual accounting Revenue recognized when earned Expenses recognized when incurred Matching principle is extensively used throughout GAAP GAIN CONTROL berrydunn.com

Tax Returns Tax returns are different from GAAP financials Typically, revenues are recognized when received (not earned) and expenses are recognized when paid (not incurred) Accounting estimates (allowances for doubtful accounts, inventory reserves) are not recognized Depreciation is based on statutory authority rather than estimated useful life The information has been presented to the IRS as true and accurate (if signed) GAIN CONTROL berrydunn.com

Internal Financial Statements May or may not be GAAP May or may not be comprehensive May or may not be accurate If there are no tax returns and no GAAP financial statements, the degree of confidence in internal financial statements is determined by other factors GAIN CONTROL berrydunn.com

Looks like an income statement, but it isn’t Taxable income ≠ net income Reconciling tax returns to financial statements GAIN CONTROL berrydunn.com

Item 10 is Taxable Income Item 1 is Net income (loss) per books This table allows you to turn taxable income back into net income If you have both financial statements and tax returns, doesn’t hurt to check that the numbers are in fact the same Reconciling tax returns to financial statements GAIN CONTROL berrydunn.com

Quick Review The hierarchy of quality of financial information: Audited Reviewed Tax returns Compiled Agreed-upon Procedures Internally generated Footnotes contain critical information Taxable income ≠ net income Reconcile the taxable income through Schedule M1 GAIN CONTROL berrydunn.com

Financial Statement Analysis Extracting useful information from financial statements GAIN CONTROL berrydunn.com

Balance Sheet GAIN CONTROL berrydunn.com Example C-Corp Balance Sheet as of December 31, 2005 2006 2007 2008 2009 Assets Cash $30,000 $1,156,000 $4,071,000 $8,071,000 $12,001,000 Accounts Receivable 50,000 500,000 600,000 700,000 3,000,000 Inventory 100,000 150,000 1,000,000 2,000,000 6,000,000 Total Current Assets 180,000 1,806,000 5,671,000 10,771,000 21,001,000 Net Property Plant & Equip 1,091,000 2,100,000 2,100,000 2,100,000 2,100,000 Total Assets $1,271,000 $3,906,000 $7,771,000 $12,871,000 $23,101,000 Liabilities Current Portion of Long Term Debt $100,000 $100,000 $100,000 $100,000 $100,000 Accounts Payable 50,000 55,000 60,000 70,000 80,000 Total Current Liabilities 150,000 155,000 160,000 170,000 180,000 Long Term Debt 1,000,000 900,000 800,000 700,000 600,000 Total Liabilities 1,150,000 1,055,000 960,000 870,000 780,000 Stockholder’s Equity Common Stock 1,000 1,000 1,000 1,000 1,000 Additional Paid in Capital 20,000 20,000 20,000 20,000 20,000 Retained Earnings 100,000 2,830,000 6,790,000 11,980,000 22,300,000 Total Stockholder’s Equity 121,000 2,851,000 6,811,000 12,001,000 22,321,000 Total Liabilities and Stockholder’s Equity $1,271,000 $3,906,000 $7,771,000 $12,871,000 $23,101,000

Balance Sheet Analysis Common Size Balance Sheet All line items as a percentage of Total Assets Working Capital Current Assets – Current Liabilities Liquidity ratios Current Ratio – Current Assets / Current Liabilities Quick Ratio – (Cash + A/R) / Current Liabilities Leverage ratios How much debt to how much equity Coverage ratios How many times can debt commitments be paid out of income GAIN CONTROL berrydunn.com

Common Size Balance Sheet A/R almost tripled between ’08 and ’09 Inventory almost doubled Cash is declining GAIN CONTROL berrydunn.com Example C-Corp Balance Sheet as of December 31, 2007 2008 2009 Assets Cash $4,071,000 52.4% $8,071,000 62.7% $12,001,000 51.9% Accounts Receivable 600,000 7.7% 700,000 5.4% 3,000,000 13.0% Inventory 1,000,000 12.9% 2,000,000 15.6% 6,000,000 26.0% Total Current Assets 5,671,000 73.0% 10,771,000 83.7% 21,001,000 90.9% Net Property Plant & Equip 2,100,000 27.0% 2,100,000 16.3% 2,100,000 9.1% Total Assets $7,771,000 100.0% $12,871,000 100.0% $23,101,000 100.0% Liabilities Current Portion of LTD $100,000 1.3% $100,000 0.8% $100,000 0.4% Accounts Payable 60,000 0.8% 70,000 0.5% 80,000 0.4% Total Current Liabilities 160,000 2.1% 170,000 1.3% 180,000 0.8% Long Term Debt 800,000 10.3% 700,000 5.4% 600,000 2.6% Total Liabilities 960,000 12.4% 870,000 6.7% 780,000 3.4% Stockholder’s Equity Common Stock 1,000 0.0% 1,000 0.0% 1,000 0.0% Additional Paid in Capital 20,000 0.2% 20,000 0.2% 20,000 0.1% Retained Earnings 6,790,000 87.4% 11,980,000 93.1% 22,300,000 96.5% Total Stockholder’s Equity 6,811,000 87.6% 12,001,000 93.3% 22,321,000 96.6% Total Liabilities and Equity $7,771,000 100.0% $12,871,000 100.0% $23,101,000 100.0%

Working Capital Current Assets – Current Liabilities Measures liquidity GAIN CONTROL berrydunn.com Year 2005 2006 2007 2008 2009 Current Assets 180,000 1,806,000 5,671,000 10,771,000 21,001,000 Current Liabilities 150,000 155,000 160,000 170,000 180,000 Working Capital 30,000 1,651,000 5,511,000 10,601,000 20,921,000

Current Ratio Current Assets / Current Liabilities Measures liquidity GAIN CONTROL berrydunn.com Year 2005 2006 2007 2008 2009 Current Assets 180,000 1,806,000 5,671,000 10,771,000 21,001,000 Current Liabilities 150,000 155,000 160,000 170,000 180,000 Current Ratio 1.2 11.65 35.44 63.36 116.67

Quick Ratio Cash + A/R / Current Liabilities More conservative measure of liquidity GAIN CONTROL berrydunn.com Year 2005 2006 2007 2008 2009 Cash + A/R 80,000 1,656,000 4,671,000 8,771,000 15,001,000 Current Liabilities 150,000 155,000 160,000 170,000 180,000 Quick Ratio 0.53 10.68 29.19 51.59 83.34

Income Statement GAIN CONTROL berrydunn.com Example C-Corp Income Statement for the Year Ending December 31, 2006 2007 2008 2009 Sales $15,000,000 $20,000,000 $25,000,000 $35,000,000 Cost of Sales 8,000,000 10,000,000 12,000,000 13,000,000 Gross Profit 7,000,000 10,000,000 13,000,000 22,000,000 Selling, General, & Admin 2,000,000 3,000,000 4,000,000 4,500,000 Operating Income 5,000,000 7,000,000 9,000,000 17,500,000 Interest Expense 450,000 400,000 350,000 300,000 Income before Income Taxes 4,550,000 6,600,000 8,650,000 17,200,000 Income Taxes 1,820,000 2,640,000 3,460,000 6,880,000 Net Income $2,730,000 $3,960,000 $5,190,000 $10,320,000 Reconciliation of Retained Earnings Retained Earnings, Beginning of Year 100,000 2,830,000 6,790,000 11,980,000 Net Income 2,730,000 3,960,000 5,190,000 10,320,000 Less: Distributions - - - - Retained Earnings, End of Year $2,830,000 $6,790,000 $11,980,000 $22,300,000

Income Statement Analysis Common Size Income Statement Line items as a percentage of revenue Gross Margin Percentage of revenue left after Cost of Goods Sold (COGS) Demonstrates how much money is left after production Gross Profit Same concept with dollars, rather than percentage Operating Margin Percentage of revenue left after Operating Expenses and COGS Demonstrates how much money is left after production and overhead Operating Profit Same concept with dollars, rather than percentage GAIN CONTROL berrydunn.com

Common Size Income Statement GAIN CONTROL berrydunn.com Example C-Corp Income Statement for the Year Ending December 31, 2006 2007 2008 2009 Sales $15,000,000 100.0% $20,000,000 100.0% $25,000,000 100.0% $35,000,000 100.0% Cost of Sales 8,000,000 53.3% 10,000,000 50.0% 12,000,000 48.0% 13,000,000 37.1% Gross Profit 7,000,000 46.7% 10,000,000 50.0% 13,000,000 52.0% 22,000,000 62.9% Selling, General, & Admin 2,000,000 13.3% 3,000,000 15.0% 4,000,000 16.0% 4,500,000 12.9% Operating Income 5,000,000 33.3% 7,000,000 35.0% 9,000,000 36.0% 17,500,000 50.0% Interest Expense 450,000 3.0% 400,000 2.0% 350,000 1.4% 300,000 0.9% Income before Income Taxes 4,550,000 30.3% 6,600,000 33.0% 8,650,000 34.6% 17,200,000 49.1% Income Taxes 1,820,000 12.1% 2,640,000 13.2% 3,460,000 13.8% 6,880,000 19.7% Net Income $2,730,000 18.2% $3,960,000 19.8% $5,190,000 20.8% $10,320,000 29.5%

Gross Profit / Gross Margin GAIN CONTROL berrydunn.com Example C-Corp Income Statement for the Year Ending December 31, 2006 2007 2008 2009 Sales $15,000,000 100.0% $20,000,000 100.0% $25,000,000 100.0% $35,000,000 100.0% Cost of Sales 8,000,000 53.3% 10,000,000 50.0% 12,000,000 48.0% 13,000,000 37.1% Gross Profit 7,000,000 46.7% 10,000,000 50.0% 13,000,000 52.0% 22,000,000 62.9% Selling, General, & Admin 2,000,000 13.3% 3,000,000 15.0% 4,000,000 16.0% 4,500,000 12.9% Operating Income 5,000,000 33.3% 7,000,000 35.0% 9,000,000 36.0% 17,500,000 50.0% Interest Expense 450,000 3.0% 400,000 2.0% 350,000 1.4% 300,000 0.9% Income before Income Taxes 4,550,000 30.3% 6,600,000 33.0% 8,650,000 34.6% 17,200,000 49.1% Income Taxes 1,820,000 12.1% 2,640,000 13.2% 3,460,000 13.8% 6,880,000 19.7% Net Income $2,730,000 18.2% $3,960,000 19.8% $5,190,000 20.8% $10,320,000 29.5%

Operating Profit / Margin GAIN CONTROL berrydunn.com Example C-Corp Income Statement for the Year Ending December 31, 2006 2007 2008 2009 Sales $15,000,000 100.0% $20,000,000 100.0% $25,000,000 100.0% $35,000,000 100.0% Cost of Sales 8,000,000 53.3% 10,000,000 50.0% 12,000,000 48.0% 13,000,000 37.1% Gross Profit 7,000,000 46.7% 10,000,000 50.0% 13,000,000 52.0% 22,000,000 62.9% Selling, General, & Admin 2,000,000 13.3% 3,000,000 15.0% 4,000,000 16.0% 4,500,000 12.9% Operating Income 5,000,000 33.3% 7,000,000 35.0% 9,000,000 36.0% 17,500,000 50.0% Interest Expense 450,000 3.0% 400,000 2.0% 350,000 1.4% 300,000 0.9% Income before Income Taxes 4,550,000 30.3% 6,600,000 33.0% 8,650,000 34.6% 17,200,000 49.1% Income Taxes 1,820,000 12.1% 2,640,000 13.2% 3,460,000 13.8% 6,880,000 19.7% Net Income $2,730,000 18.2% $3,960,000 19.8% $5,190,000 20.8% $10,320,000 29.5%

Earnings Before Interest, Tax, Depreciation, and Amortization Considered to be a measure of cash flow from operations Not subject to capital structure (interest), tax treatment, or games people play with depreciation and amortization Start with Net Income (earnings) and add back: Taxes Interest Depreciation and Amortization expense Often modified to exclude miscellaneous income or expense Does not cover fixed assets What is EBITDA? GAIN CONTROL berrydunn.com

Statement of Cash Flows GAIN CONTROL berrydunn.com Example C-Corp Statement of Cash Flows for the Year Ending December 31, 2006 2007 2008 2009 Cash Flows from Operations Net Income $2,730,000 $3,960,000 $5,190,000 $10,320,000 Adjustments to Net Income Depreciation 100,000 100,000 100,000 100,000 Accounts Receivable (450,000) (100,000) (100,000) (2,300,000) Inventory (50,000) (850,000) (1,000,000) (4,000,000) Accounts Payable 5,000 5,000 10,000 10,000 Net Cash Flows from Operations 2,335,000 3,115,000 4,200,000 4,130,000 Cash Flow from Investing Purchase of Property, Plant & Equip (1,109,000) (100,000) (100,000) (100,000) Net Cash Used by Investments (1,109,000) (100,000) (100,000) (100,000) Cash Flow from Financing Principal Payments on Long-Term Debt (100,000) (100,000) (100,000) (100,000) Distributions - - - - Net Cash Used by Financing (100,000) (100,000) (100,000) (100,000) Cash, Beginning of Period 30,000 1,156,000 4,071,000 8,071,000 Cash, End of Period $1,156,000 $4,071,000 $8,071,000 $12,001,000

Other financial statement metrics Cash Realized from Operations Ratio Measures quality of earnings Cash from Operations (CFFO) divided by Net Income Accounts Receivable Turnover / Days Sales Outstanding Measures how quickly A/R is collected Average A/R divided by average day’s sales Inventory Turns / Days Sales in Inventory Measures how rapidly inventory turns over Average inventory divided by averages day’s sales GAIN CONTROL berrydunn.com

Should approximate 1.0 over time Steep decline in 2008 to 2009 Almost 0 for 2010? Cash realized from operations GAIN CONTROL berrydunn.com

How long does it take to collect accounts receivable on average? 365/DSO provides “turns” or number of times per year that A/R is collected Steep increase between 2008 and 2009 Day’s sales receivables (DSO) GAIN CONTROL berrydunn.com

How long does it take to convert inventory into revenue? 365/days inventory provides inventory turns, or number of times per year that inventory is sold Continuously increasing curve – not good Day’s sales in inventory GAIN CONTROL berrydunn.com

Quick Review GAIN CONTROL berrydunn.com Term What is it? Working Capital Used to fund ongoing operations (Current Assets – Current Liabilities) Liquidity How much cash can be generated from current assets and liabilities Gross Profit Money left after production (Revenue – COGS) Operating Profit Money left after overhead (Gross Profit – Operating Expenses) EBITDA Proxy for cash flow (Operating Income + Interest, Taxes, Depreciation, and Amortization) Cash Flow from Operations How much cash is generated from making and selling the product

Games People Play If the goal is to increase borrowing capacity, the following are prone to manipulation: Assets Inventory Accounts Receivable Liabilities Off balance sheet liabilities Reclassifying debts as equity (and vice versa) Equity Revenue recognition to increase net income Current versus non-current classification GAIN CONTROL berrydunn.com

Games People Play If the goal is to make the Company appear worth less (or worthless), look for the following: Related company transactions (commonly rent) Management fees Officer compensation Relatives on the payroll Loans to/from shareholders Excess distributions GAIN CONTROL berrydunn.com

Contact Information Bill Brown [email_address] (207) 541-2208 Seth Webber [email_address] (207) 541-2297 GAIN CONTROL berrydunn.com

GAIN CONTROL WITH GROUNDED ADVICE GAIN CONTROL berrydunn.com

Gain Confidence: Introduction to Financial Statement Analysis

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