Accounting Fundamentals--Summer 2000 1 Income Statement Classification Operating income Other income and expense Income from continuing operations Income,

Accounting Fundamentals--Summer 2000

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Income Statement Classification

• Operating income• Other income and expense• Income from continuing

operations• Income, gains & losses from

discontinued operations• Extraordinary gains and losses• Changes in accounting principles

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Statement of Cash Flows

• FASB 95--1987• Components

•Operating cash: Operations and working capital

• Investing cash: Non-current assets and investments

• Financing cash: L/T debt, equity and dividends

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Roots = Financing Activities

Trunk & Branches = Investing Activities

Fruit = Operating Activities

Businesses are like Fruit Trees

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Net Income vs. Cash Flow

Indirect Method• Net Income• +/- Non-cash Items• +/- Changes in Operating

Working Capital• = Cash Flow from Operations

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Indirect vs. Direct Method

• FASB prefers the direct method• FASB requires net income to cash

from operations reconciliation• Components:

• Cash from customers• Cash from dividends• Cash from interest income• Other operating cash receipts• Cash paid to suppliers• Cash paid to employees• Cash paid for taxes• Cash paid for interest• Other operating cash payments

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Economic Value Added

• Income from Capital- Cost of Capital= E V A

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Sources of Capital

• Debt (interest %)• Equity (interest % + 6%)

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Capital

• Working capital• Net tangible non-current

assets• Capitalized R & D• Capitalized Employee Devel.

Costs

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Adj. Operating Income

• Operating income• Plus:

•R & D• Emp. Devel. Costs

• Minus:•R & D Amort.• Emp. Devel. Cost Amort

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Keys to Success

• Make it a way of life• K I S S• CEO / Management buy-in• Gradual introduction• Thorough training

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Today’s Session• Financial Statement Analysis• The Goal

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Target Your Efforts

•Solvency assurance

•Wealth enhancement

•Performance improvement

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Start with the 3 P’s

•Planning

•Processing

•Presenting

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Include the Trifecta: Q-S-T

•Q: Quantitative analysis

•S: Strategic assessment

•T: Tactical feasibility

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Tools for Financial Statement Analysis

•Ratio analysis•Trend analysis•Common-size analysis•Base period analysis•Comparative analysis•Horizontal and vertical

analyses

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A Financial Statement Approach

•Look for key relationships•Focus on spending drivers•Don’t overlook the

Statement of Cash Flows•Remember to measure

trends•Tell a story

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Guidelines for a Presentation

•Clarity•Accuracy•Simplicity•Visually friendly•Limit page content

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Cash Flow Red-Flags

• Receivable and inventory growth rate exceeds sales growth rate

• Payables growth rate exceeds inventory growth rate

• Current liabilities grow faster than sales

• Sustained operating losses (negative net income)

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Cash Flow Red-Flags (cont’d)

• Negative operating cash flow• Capital expenditures exceed

operating cash flow• Sustained capital expenditures

reductions• Sustained sales of marketable

securities in excess of purchases• Substantial shift from long to

short term borrowing• Dividend reduction or elimination

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Cash Sufficiency Ratio

• Cash Flow From Operations + Interest + TaxesPPE + Debt Servicing + Taxes + Dividends

• Should be greater than 1• Can easily disaggregate• Different footprints for

different development stages

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Cash Conversion Cycle

•Cash conversion cycle•Days in payables ≥ DSO + Days in

inventory

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Typical Common Ratios

•Solvency & liquidity•Earnings•Performance

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Ratio Analysis

•General guidelines:•Be consistent•Ascertain contents of

numerator and denominator•Apply common sense…

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Trend Analysis

•Static analysis is virtually useless

•Trend direction is key•Combine with other

approaches

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Common-size Analysis

•Helpful for size discrepancies

•Keyed to sales or total assets

•Helpful for industry comparisons

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Base Period Analysis

•Combines trending and percentage analysis

•Select representative base year and set the index at 100

•Measure subsequent periods in terms of the base year

•Helpful for industry comparisons•Eliminates size bias

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Comparative Analysis Cautions

•Timing variances•GAAP variances•Conservative vs. Aggressive

GAAP•Management attitude…”win at

all cost!”•Size•Geographic venues

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Horizontal and Vertical Analysis

•The most basic…and most powerful analytical tool

•Key element in fraud detection

•Keeps the organization under control

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Horizontal Analysis

•Period versus period changes•Value changes•Percentage changes

•Look for irregularities

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Horizontal Analysis - Example

2009 2008 $ Change % Change

Current Assets $400 $300 $100 33%

Total Assets $2,500 $2,200 $300 14%

Current Liabilities $200 $150 $50 33%

Long-term Debt $1,600 $1,500 $100 7%

Equity $700 $550 $150 27%

Total Liabilities & Equity $2,500 $2,200 $300 14%

ABC CompanyPartial Balance Sheets

2008 and 2009

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Vertical Analysis

•Relationships within the same period:•Numerical relationships•Percentage relationships

•Look for irregularities

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Vertical Analysis - Example

$ % $ %

Current Assets $400 16% $300 14%

Total Assets $2,500 100% $2,200 100%

Current Liabilities $200 8% $150 7%

Long-term Debt $1,600 64% $1,500 68%

Equity $700 28% $550 25%

Total Liabilities & Equity $2,500 100% $2,200 100%

ABC CompanyPartial Balance Sheets

2008 and 2009

2009 2008

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Theory of Constraints

• The Concept• The Process• The Measures

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The Concept• Presented in Eliyahu Goldratt’s

The Goal• The goal of a business is to

make money…consistent with customer satisfaction

• Continuous flow• Avoid the “herbies”• Eliminate the bottlenecks first

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The Process

• Identify the constraints• Exploit the constraints (reduce

the bottlenecks)• Subordinate everything else• Elevate the constraints

(remove the bottlenecks)• Reiterate the process

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The Measures

• Throughput - Net income• Inventory - ROI• Ops. Expenses - Cash Flow