Rocco Sabino MBA, CPARocco.Sabino@Stonybrook.edu

Agenda: I. Understanding Financial Information

Ø Financial Statements

q Income Statement – It’s all about earning income§ How does Human Resource (HR) affect financial results?

q Balance Sheet – summary of value and ownership§ Review Major Accounts (Assets – Liability = Owner’s Equity)

q Cash Flow Statements• How Operations affect cash • Sources and Uses of Funds

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Agenda:Understanding Financial Information (continued)

Ø Accrual Accounting and The Matching PrincipleWhy is it important for HR to understand this principle?

II. Reporting and Analyzing Financial Informationq How do you Analyze Financial Results?

� Comparative and Trend Analysisq Financial Ratios

� Brief overview of ratios: how they help you understand the business

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I. UNDERSTANDING FINANCIAL INFORMATION

Helps management answer questions like:

q How much and what kind of debt is outstanding?

q Were sales higher this period than last?

q What assets do we have?

q What were our cash inflows and outflows?

q Did we make a profit last period?

q Are any of our product lines or divisions operating at a loss?

q Is our rate of return on assets increasing?

Financial Statements

Financial Statements:Chart of Accounts – a listing of all ledger account names used by the

company to track all financial transactionsØ Arranged in the order in which they appear on the financial

statements

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AccountNumber Account Description

1000 Cash1100 Short-term Investments1200 Accounts Receivable 1210 Allowance for Uncollectible Accounts1500 Fixed Assets1510 Land 1520 Building1530 Machinery & Equipment1540 Inventory2000 Sales3000 Materials3100 Labor3200 Overhead4000 Rent4100 Electric

Income Statement Ø Describes the performance of the company over a period of time

(month, quarter, year).

q Measures revenues (sales) and expenses (resources) used to achieve those sales

q Profit = Sales – Expenses

q Also called a statement of operations or a profit and loss statement (P&L).

q Most valued by CEOs, shareholders, bankers, and government regulators

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Income Statement

LO 8

Sales 500,000$ Cost of Goods Sold 292,365 Gross Profit 207,635

Operating Expenses:Salaries & Benefits 76,280 Rent 40,000 Utilities 10,250 Depreciation 5,000 Advertising 25,000 Professional Fees 30,000 Total Operating Expenses 186,530

Operating Profit (EBIT) 21,105

Interest Expense (10,000) Earnings Before Tax (EBT) 11,105

Taxes (1,084) Net Income 12,189$

ABC Company Inc.Income Statement

For the Period Ending December 31, 2016

Income StatementØ Sales or Revenues – sale to customers of products and services

that the company regularly offers for sale in normal course of businessq Must be completed such as product shipped or service

rendered ; customer is now required to pay

Ø Cost of Sales – cost to make or buy the product or service sold. Also includes cost of packaging or installation and training

Ø Gross Profit – first measure of profitabilityq Sales less Cost of Sales

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Income StatementØ Operating Expenses – running the business

q Salaries and Benefits or Compensation Expense – normally approximately 40% - 50% of total operating expenses

q Advertising or Marketing Expenseq Professional Fees – accounting, legal, consultants, recruiting

Ø Operating Income – profit that comes from doing what the company is in business to do. Or final result of the company’s normal business activitiesq EBIT – Earnings Before Interest & Taxesq EBITDA – Earnings Before Interest, Taxes, Deprecation &

Amortization

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Income StatementHuman Resource Expenses:SalariesØ ExemptØ Non – ExemptØ Bonus

Fringe BenefitsØ Health InsuranceØ Group Life InsuranceØ 401K Plan

Payroll TaxesØ Employers Social Security tax (FICA – 6.2%) Ø Federal Unemployment Tax (FUTA – 6.0%)Ø Medicare Tax (1.45%)

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Income StatementHuman Resource Expenses:

Training CostsØ Travel Ø Conference & Workshop FeesØ Training MaterialsØ Tuition Reimbursement

Employment ExpensesØ RecruitersØ Employment AdsØ Background VerificationØ Other Employment Expenses

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Income Statement Some Observations:

Ø If revenue is increasing but gross profit percentage is decreasing, company is probably gaining more business by reducing its selling price.

Ø Operating expenses should increase more slowly than revenue.

Ø If you see significant increase in salaries and benefits, company may be hiring in anticipation of new business (i.e. new store openings, new product launch) .

Ø Increase in employment expenses such as recruiting costs, should correlate with increase in hiring.

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BalanceSheetØ Represents the company’s financial health. Consists of:

q Assets – resources owned by the company q Liabilities - company obligations to othersq Stockholder’s equity – difference between assets and liabilities

represents the ownership interest (What you own less what you owe = your equity)

Ø A balance sheet helps us understand the following:q Company’s ability to meet is obligations (liquidity)q It’s financial strength:

§ Can it secure resources to finance its future?§ Maintain and expand operations?§ Does it have the resources to support marketing and

technology and improve profits

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BalanceSheet

ØEvaluate company’s asset management performance§ Inventory turnover§ Customer credit (accounts receivable)

ØFinancial ratios can be calculated using balance sheet to compare company’s performance against:

• Internal company standard (budget)• Past history (trends) • Other companies in a similar business or industry

(benchmark)

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Balance Sheet of a Merchandising Company

BalanceSheet

Ø Current Assets – assets that are cash or are expected to become cash within next 12 months. Main source of working capitalq Cash and Cash Equivalents – most liquid asset of all.

Includes company checking accounts, cash reserves or savings, petty cash.

q Accounts Receivable – trade accounts or amounts due from customers as a result of sales made on credit. Anticipate customer will pay for sales within 30 to 60 days max.

q Allowance for Bad Debts – a reserve, an estimated amount the company provides for possibility that some customer balances will not be paid at all and will need to be written off.

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BalanceSheet

q Inventory – production material or product purchases or manufactured and then held by the company for sale.§ Gross Inventory (Raw materials; Work in process; Finished

goods)§ Direct Labor, Materials and Overhead§ Capitalized Engineering§ Inventory Reserves

q Prepaid Expenses – expenses paid in advance for services not yet rendered. § Insurance policy paid at beginning of the policy.

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Balance Sheet Ø Fixed Assets – property, plant and equipment used for extended periods

of timeq Accumulated Depreciation – reduction in value of the asset over timeq Other Assets – all other assets that cannot be categorized above (i.e.

deposits)

Note: Assets deteriorate over time or depreciateExample: A new car is worth $30,000 at time of purchase. If we determine that the car has a “useful life” of 10 years. After year 1, the value of the car declines to $27,000 ($30,000/10). In year 2, the value declines to $24,000 and the accumulated deprecation increases to $6000:

Year 2 Auto $30,000Accum. Deprec. (6,000)Net Book Value $24,000

Good will – the value of a business entity not attributed to its assets and liabilities

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Balance Sheet Ø Current Liabilities – debts of the company expected to be paid

within the next 12 months.q Accounts Payable – account that includes all the bills yet

unpaid from all the suppliers and service providersq Accrued Liabilities – an expense for which the company

received the benefit, but had not yet paid it (i.e. Accrued Interest)

q Notes Payable and Other Bank Debt – loans from banks and others that represent borrowed money; will be repaid within 12 months

Ø Long-Term Liabilities – borrowed capital that will be repaid over longer period of time; great than twelve monthsq Lease Contracts such as lease equipmentq Long-Term Debt

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Balance Sheet

Ø Capital Stock and Contributed Capital – amount paid into the company by investors to purchase stock

Ø Retained Earnings – an accumulation of net income and losses over the history of the companyq Profits increase retained earnings, losses decrease it

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To provide relevant information about the cash receipts and cash payments of an enterprise during a period.

The statement provides answers to the following questions:

1. Where did the cash come from?

2. What was the cash used for?

3. What was the change in the cash balance?

Purpose of the Statement of Cash Flows

LO 4 Indicate the purpose of the statement of cash flows.

Statement of Cash Flows

Statement of Cash FlowsØ Presents a detailed summary of all cash inflows and outflows, or the

sources and uses of cash during the period

q Information is presented in three sections:§ Cash flows provided by/used for operations§ Cash flows provided by/used for investments� Cash flows provided by/used for financing

Profit vs. Cash flowØ Cash is the life blood of a business. It is more important to have

cash flow than to be profitableØ Transactions affect profit and cash flow differently due to timing (i.e.

accruals).

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CashInflow&Outflows

Statement of Cash Flows

Accrual Accounting and The Matching Principal

Accountants use the matching principal : requires companies to match expenses with related revenues in order to accurately report profitability during a specified time period.

Accrual Accounting: methodology whereby revenues are recorded when money is earned and expenses are recorded when the resource is consumed, without regard to when cash is received or paid out.

Prepaid expense is an asset because the company makes a payment for a service (i.e. advertising) that it does not receive until ad begins next month for 12 months. When does it become an expense and how much should be expensed each month?

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Accrual Accounting and The Matching Principal

Accrued Payroll Expense – all forms of compensation owed to employees that have not been paid to them. It represents a liability for the employer.

Example – John is paid $500 per week on Fridays. The last day of the month in November is on Wednesday. How much compensation is accrued on November 30th?

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Accrual Accounting and The Matching Principal

Accrued Recruiting Expense – costs incurred by the company for services performed by recruiter. Payment has not yet been made.

Example – Director of HR receives an invoice for $10,000 from a recruiter in January 2017 for an executive searched conducted in December 2016. What amount is recorded as an expense in December? January?

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II. ANALYZING FINANCIAL INFORMATION

StatementsinComparativeandCommon-SizeForm

� Dollar and percentagechanges on statements

� Common-sizestatements

� Ratios

An item on a financial statement has little

meaning by itself. The meaning of the numbers

can be enhanced by drawing comparisons.

An item on a financial statement has little

meaning by itself. The meaning of the numbers

can be enhanced by drawing comparisons.

ABC CORPORATIONComparative Balance Sheets

December 31Increase (Decrease)

This Year Last Year Amount %Assets

Current assets: Cash 12,000$ 23,500$ (11,500)$ (48.9) Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200 Total current assets 155,000 164,700 Property and equipment: Land 40,000 40,000 Buildings and equipment, net 120,000 85,000 Total property and equipment 160,000 125,000 Total assets 315,000$ 289,700$

Horizontal Analysis

($11,500 ÷ $23,500) × 100% = (48.9%)

$12,000 – $23,500 = $(11,500)

HorizontalAnalysisABC CORPORATION

Comparative Income StatementsFor the Years Ended December 31

Increase (Decrease)This Year Last Year Amount %

Sales 520,000$ 480,000$ 40,000$ 8.3Cost of goods sold 360,000 315,000 45,000 14.3Gross margin 160,000 165,000 (5,000) (3.0)Operating expenses 128,600 126,000 2,600 2.1Net operating income 31,400 39,000 (7,600) (19.5)Interest expense 6,400 7,000 (600) (8.6)Net income before taxes 25,000 32,000 (7,000) (21.9)Less income taxes (30%) 7,500 9,600 (2,100) (21.9)Net income 17,500$ 22,400$ (4,900)$ (21.9)

Increase (Decrease)This Year Last Year Amount %

Sales 520,000$ 480,000$ 40,000$ 8.3Cost of goods sold 360,000 315,000 45,000 14.3Gross margin 160,000 165,000 (5,000) (3.0)Operating expenses 128,600 126,000 2,600 2.1Net operating income 31,400 39,000 (7,600) (19.5)Interest expense 6,400 7,000 (600) (8.6)Net income before taxes 25,000 32,000 (7,000) (21.9)Less income taxes (30%) 7,500 9,600 (2,100) (21.9)Net income 17,500$ 22,400$ (4,900)$ (21.9)

HorizontalAnalysis

Common-Size StatementsABC CORPORATION

Comparative Income StatementsFor the Years Ended December 31

Common-Size Percentages

This Year Last Year This Year Last YearSales 520,000$ 480,000$ 100.0 100.0 Cost of goods sold 360,000 315,000 69.2 65.6 Gross margin 160,000 165,000 30.8 34.4 Operating expenses 128,600 126,000 24.8 26.2 Net operating income 31,400 39,000 6.0 8.2 Interest expense 6,400 7,000 1.2 1.5 Net income before taxes 25,000 32,000 4.8 6.7 Less income taxes (30%) 7,500 9,600 1.4 2.0 Net income 17,500$ 22,400$ 3.4 4.7

ABC CORPORATIONComparative Income Statements

For the Years Ended December 31Common-Size Percentages

This Year Last Year This Year Last YearSales 520,000$ 480,000$ 100.0 100.0 Cost of goods sold 360,000 315,000 69.2 65.6 Gross margin 160,000 165,000 30.8 34.4 Operating expenses 128,600 126,000 24.8 26.2 Net operating income 31,400 39,000 6.0 8.2 Interest expense 6,400 7,000 1.2 1.5 Net income before taxes 25,000 32,000 4.8 6.7 Less income taxes (30%) 7,500 9,600 1.4 2.0 Net income 17,500$ 22,400$ 3.4 4.7

Common-SizeStatements

This Year’s Operating Expenses ÷ This Year’s Sales × 100% ( $128,600 ÷ $520,000 ) × 100% = 24.8%

Last Year’s Operating Expenses ÷ Last Year’s Sales × 100% ( $126,000 ÷ $480,000 ) × 100% = 26.2%

Actual versus Budget AnalysisØ There are typically three types of variance explanations:

q Business (rate, volume or both)q Timingq Error (actual result, budget, or both)

§ Incorrect Budget assumption used

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BudgetVarianceReport

Actual Budget Var$ Var% Actual Budget Var$ Var%

Salaires 52,360 42,698 9,662 18.5% 365,982 236,498 129,484 35.4%Benefits 15,708 12,809 2,899 18.5% 109,795 70,949 38,845 35.4%Advertising - 16,985 (16,985) NA 23,895 47,905 (24,010) -100.5%OfficeSupplies 956 750 206 21.5% 13,043 5,000 8,043 61.7%Telephone 14,326 10,598 3,728 26.0% 35,987 22,000 13,987 38.9%Travel 995 1,989 (994) -99.9% 22,056 36,985 (14,929) -67.7%

CurrentMonth YeartoDate

ABCCompany

Trend Analysis

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Employment Costs

2016

Account Description Jan Feb Mar Apr May Jun Jul Aug Sep Total

Recruiters 20,000 10,000 4,000 - - - - - - 34,000

Employment Ads - 5,000 6,000 6,500 10,000 - - - - 27,500

Background Verification - - - 500 800 1,000 1,000 1,000 500 4,800

Total Employment Cost 20,000 15,000 10,000 7,000 10,800 1,000 1,000 1,000 500 66,300

What are some takeaways based on how employment costs are trending?

Financial Ratios Analysis

Analysts and other interested parties can gather qualitative information from financial statements by examining relationships between items on the statements and identify trends in these relationships.

Examples of the types of ratios that are analyzed by management are Liquidity and Profitability Ratios.

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Financial Ratios Analysis

CurrentRatio

Current Assets Current Liabilities=

The current ratio measures a company’s short-term debt paying ability.

Working Capital = Current Assets - Current Liabilities

Too much working capital (high current ratio) is poor asset management. It is very expensive, can restrict cash flow and inhibit company growth

$65,000 $42,000= = 1.55

Acid-Test (Quick) Ratio

Quick Assets Current Liabilities=

Acid-TestRatio

Quick assets include Cash, Marketable Securities, Accounts Receivable, and current Notes Receivable. This ratio measures a company’s ability to meet obligations without having to liquidate inventory.

$50,000 $42,000

= 1.19=Acid-Test

Ratio

Days Sales Outstanding

DSO =Accounts Receivable X # days

Total Credit Sales

This ratio measures the average number of days that a company takes to collect revenue after a sale has been made.

X 31 = 21.7 days= $350,000 $500,000

Return on Equity (ROE)

ROE Net IncomeAverage Stockholders’ Equity=

$53,690($180,000 + $234,390) ÷ 2= = 25.91%

This measure indicates how well the company used the owners’ investments to earn income.

Profitability Ratios

It measures the company’s earnings performance. Focuses on:

Ø Profitability achieved by management team

Ø Assets invested in the business

Ø Revenue achieved by the business

Ø Funds that owners have invested in the business

Gross Margin Percentage

Gross Margin Percentage

Gross Margin Sales

=

This measure indicates how much of each sales dollar is left after deducting the cost of goods sold to cover expenses and provide a profit.

$494,000 - $140,000$494,000= = 71.6%

Net Profit Margin Percentage

Net Profit Margin Percentage

Net IncomeSales

=

In addition to cost of goods sold, this ratio also looks at how compensation and benefits and other operating expenses influence performance.

$53,690$494,000= = 10.9%

Financial Analysis ExerciseABC Company

Financial Ratio Analysis

2016 2015 2014Sales Trend 128 115 100Gross Margin 42% 35% 30%Net Profit Margin 8% 9% 10%Current Ratio 2.5 2.3 2.2Acid - Test Ratio 0.8 1.1 1.5Days Sales Outstanding 35.4 28.5 22.4Inventory Turnover 6.5 7.2 8.0

1. Is the company making money on the products they manufacture?

2. Is it becoming easier or more difficult for the company to pay its bills?

3. Are customers paying their accounts at least as fast now as they were in Year 1?

4. Is total accounts receivable increasing, decreasing, or remaining constant?

5. Is the level of inventory increasing, decreasing or remaining constant?

6. Are operating expenses increasing, decreasing or remaining constant?