Understanding Financial Reports - Basic Course

Financial IntelligenceFinancial Intelligence

Ayman El-Najjar

Aiming to become Financially Intelligent person – Ayman El-Najjar

Outline• Introduction; the art of Finance and why it matters

• Income Statement; the many peculiarities of IS

• Balance Sheet; it reveals the most

• Cash Statement; cash is king

• Ratios; what the numbers are really telling

• Return on Investment; how to calculate ROI

• Working Capital Management; applied financial intelligence


What’s Financial Intelligence?

• Everyone in a company does better when they understand how financial success is measured and how they have impact on the company’s performance ...


• FI; set of skills that must be, and can be, learned

• For most senior executives, they come out of finance or pick up the skills during their rise to the top

• It’s tough to run a business unless you know what the financial folks are saying


4 skill Sets

• Understanding the foundation

• Understanding the art

• Understanding Analysis

• Understanding the big picture


• Financial intelligence need to be learned, practiced, and applied– Learn the Language– Ask Questions– Use the information

The Art of Finance & Why it MattersThe Art of Finance & Why it Matters


You can’t always trust the numbers!!

• Accounting and Finance, like all other business disciplines, really are as much art as they are science.

– When is a sale a sale? (revenue recognition game) …

• Xerox case – improperly recognized $6 billion!

– Determining whether a given cost is a capital expenditure or operating expenditure!


• If you don’t have a good working understanding of the financial statements and don’t know what those folks are looking at or why, you are at their mercy!!


Spotting Assumptions, Estimates, and Biases

Examples of the art of Finance

• Accruals

• Allocations

• Depreciation

• Valuation

Simple but critical Questions:

• What were the assumptions in this (االفتراضات)number?

• Are there any estimates in the (التقديرات)numbers

• What is the bias (الميل) those assumptions and estimates lead to?

• What are the implications ?(التضمينات)


Accruals• The portion of a given revenue or

expense item that is recorded in a particular time span

– e.g. Development Cost


Allocations• apportionment of costs to different

departments or activities within a company

– e.g. allocation of CEO salary to operating units


workshop – Group Discussion

• In June, you worked on a new product line, which was introduced in July. How much of your salary should be matched to product cost and how much to development cost … Imagine that The accountant determined that all your salary should go to development cost in June …


Depreciation (االستهالك)The method accountants use to allocate the cost of equipment and other assets to the total cost of products or services as shown on the income statement

At attempt to spread the cost of the expenditure over the useful life of the item


Example – for discussion• Accountants of Airline industry some

years back realized that their planes were lasting longer. So, they changed their depreciation schedules …

(assumptions, estimates, bias, implications)


Valuation (التقييم)• Methods of Valuation

– Price-to-Earning Ratio Method– Discounted cash flow Method– Asset Valuation Method

Each method entails a whole passel of assumptions and estimates


Why Increase your Financial Intelligence?

• To understand what the numbers really mean …

• As a leader, manager, employee, you need to understand what’s happening in the company from a financial perspective, and use that information to work and manage more effectively … simply stated, to improve your decision making


For you:– Increased ability to critically evaluate your company– Better understand the bias in the numbers– The ability to use numbers and financial tools to

make and analyze decisions

For the company: – better decisions, – greater alignment, – strength an balance throughout the organization


Roadblocks to Financial Savvy

• Hate Math!

• Finance and accounting department

• Your boss

• No Time!


The Players• Chief Financial Officer (CFO):

management and strategy of the organization from financial perspective. Oversees all financial functions

• Treasurer:

building and maintaining banking relationship, managing cash flow, forecasting, equity and capital-structure decisions, investors relations


• Controller:

Financial reports, general accounting, business analysis, financial planning, asset management, internal control


Part 1 - Recap

• We know “What’s Financial Intelligence?”

• Why we need to be financially intelligent?

• We learned about the art of Finance?

• We are ready to ask 4 simple but critical questions to spot assumptions, estimates, biases and their implications

Income StatementIncome Statement(( الدخل قائمة الدخل بيان قائمة ((بيان


• Income statement shows revenue (المبيعات), expenses (المصروفات), and profit (الربح) for a period of time, such as a month, a quarter, or year.

• It’s also called profit & loss statement ( بيانوالخسارة P&L, statement of earning ,(الربح

• The bottom line of the income statement is Net Profit ( الربح also known as net ,(صافيincome ( الدخل or net earning (صافي


Operating Expenses (Opex)

• Operating Expenses ( المصاريف are costs that are required (التشغيليةto keep the business going day to day.

– e.g. salaries, benefits, insurance costs, etc..

• Operating Expense shows up on the income statement and thus reduce profit


Capital Expenditures (Capex)

• Capital expenditure ( المصاريف is the purchase of an item (الرأسماليةthat’s considered a long term investment

– E.g. computer system, equipment, car

• Capex shows up on the balance sheet; only depreciation of a capital equipment appears on the income statement


• So, operating expenses reduces the bottom line immediately, and a capital expenditure spreads the hit out over several accounting periods


Profit (الربح)• “Profit is a sovereign criterion of an

enterprise” Peter Drucker

• Profit is not Cash; beware!

• Profit is an estimate! And you can’t spend estimates!

• It’s a promise to pay!

• Profit will turn into cash (hopefully!)


Matching principle• A fundamental accounting rule for

preparing an income statement

• It says “match the sale with its associated cost to determine profit in a given time”

• Accountants have to make assumptions and come up with estimates


The Purpose of the Income Statement

• In principle, it tries to measure whether the products or services are profitable when everything is added up.


A sample Income Statment• Revenue (مبيعات)

• Cost of Goods Sold ( المبيعات (تكلفة• Gross Profit ( الربح (إجمالي• Expenses (مصروفات)

• Operating Profit (EBIT)

• Taxes (ضرائب)

• Net Profit ( الربح (صافي

$100

50

50

30

20

5

$15


Revenue• Revenue recognition; when to record

or recognize a sale

– When a product delivered; a commonly used rule.

– Beware: this is an area for accountants judgment and thus manipulation

– Most common source of accounting fraud; revenue recognition!


Costs & Expenses• Cost of Goods Sold (COGS) or Cost

of Services (COS): to measure all costs directly associated with making the product of delivering the service

– The material. The labor.


Operating ExpensesOperating Expenses• Also referred to as “Overhead” or

“SG&A” i.e. Sales, General, & administrative expenses

– Utilities, rent, telephone, research, management, staff salaries, HR, accounting, IT, and so forth

– Depreciation is included … the way it’s calculated affects the bottom line


• Revenue $10,000

• COGS 5,000

• Gross Profit 5,000

• Expenses 3,000

• Depreciation* 1,000

• Net Profit $1,000

* 3 years depreciation

• Revenue $10,000

• COGS 5,000

• Gross Profit 5,000

• Expenses 3,000

• Depreciation* 3,000

• Net Profit - $1,000

* 1 year depreciation


Forms of Profits• Profit is the amount left over after

expenses are subtracted from revenue.


3 basic types of profitsGross Profit (GP) = Sales – COGS

GP can greatly be affected by decisions about when to recognize revenue and decisions about what to include in COGS


Operating Profit, EBIT ( العمليات من الربح(التشغيلية

= Gross Profit – operating expenses

• It’s the profit a business earns from the business it is in – from operations

• It measures both the overall demand for the company products (sales) and the company’s efficiency in delivering those products (costs)


Net Profit

Net Profit (the bottom line) ( الربح (صافي= Operating profit – (interest expense +

taxes, any other expenses not included in operating profit)


How to fix it?How to fix it?

1. Increase profitable Sales زيادةالربحية ذات المبيعات

1. Find new markets, or2. new prospects,3. Work through sales cycles, 4. So on so forth


2. Lower Production Cost and run more efficiently – i.e. reduce COGS بكفاءة … والعمل االنتاج تكاليف تخفيضأعلىTakes time; you need to study production processes, find inefficiencies, and implement changes


3. Cut Operating Expenses ( تقليصالتشغيلية (المصروفات

which almost always means cut the headcount! … layoffs! موظفين تسريحShort-term Solution! It makes earning looks better fast! نتائج له تظهر قد المدى قصير حل سريعة

But it backfires! ولو المرجوة النتائج عكس يعطيحين بعد


For most companies, it’s better to manage for the long haul and to focus on increasing profitable sales and reducing costs. Sure, operating expenses may have to be trimmed. But if that your focus, you’re probably postponing the day of reckoning!

Balance SheetBalance Sheet المركز المركز بيان بيانالماليالماليAssets = Liabilities + Equity


Understanding BasicsUnderstanding Basics• The balance sheet reflects the assets

( الموجودات أو أو ) liabilities ,(األصول المطلوباتأو ) and owner equity ,(المديونيات المالك حقوق .at a point in time (المساهمين

• It’s simply a statement of what a business owns and what it owes at a particular point in time. The difference represents equity

• All financial statements ultimately flow to the balance sheet


Equity • Equity is the shareholders’ stake in the

company.

* Equity = Assets – Liabilities* Equity = sum of all capital paid in by shareholders + profits earned – dividend paid out

• Increasing equity is a company’s goal.

• Profitability & Equity are related


What’s the relationship?• Profitability is like the grade you receive for a

course

• Equity is like your overall GPA

• Your GPA always reflects your cumulative performance at one point in time. Any grade affects it, but doesn’t determine it

• Over time, the equity section of the BS shows the accumulation of profits or losses


• Balance sheet (like income statement) in many respects is a work of art not only a work of calculation; understand the assumptions, decisions, and estimates that go into it


Assets• Assets are what the company owns;

– Cash & Cash Equivalent حكمه في وما النقد– Machinery & equipment ومعدات مكائن– Buildings مباني– Land أرض


• Current Assets المتداولة : الموجوداتanything that can be turned into cash in less than a year

• Long Term Assets طويلة الموجودات : المدىhave a useful life of more than a year


Types of Assets• Cash & Cash Equivalents

Money in banks & money-markets

• Accounts Receivable (A/R)

– Amounts customers owe the company. It’s like a loan form the company to its customers

– Important for managers to watch it closely


• Inventory; المخزون– Finished goods; ready to be sold– WIP goods; work-in-process– Raw materials Inventory

• Property, Plant, & Equipment (PPE)

– Includes buildings, land, machinery, trucks, cars, computers, etc

– Recorded at Purchase price


• Less: accumulated depreciation

– Land doesn’t wear out

• Goodwill الشهرة– Like land; not amortized!

• Intellectual property & other Intangible assets

– Patents, brand names, customer lists, strategic strength, employees, reputation, and so on.

– Most are not found on the balance sheet unless an acquiring company pays for them!

• Prepaid asset


Liabilities & Equity• The other side shows how the assets

were obtained


Liabilities• Current liabilities متداولة : مطلوبات

to be paid of in less than a year

• Accounts payable الدفع مستحقة ديون amounts the company owes للموردينits vendors

• Long-term liabilities طويلة ديون will come due over a longer time :األجلframe; mostly loans


Workshop Example• Pp 102-103


• A change in one statement nearly always has an impact on the other statements.

• The effect of Profit on Equity; net profit adds up to equity unless paid out as dividend

– See other examples pp 104-105

Cash StatementCash Statementالنقدية التدفقات النقدية قائمة التدفقات قائمة


Why cash?• It’s cash that keeps a business alive,

and cash flow is a critical measure of its financial health. You need people to run the business, you need a place, you need electricity, telephones, computers, supplies, etc. you can’t pay for all these things with profits because profits aren’t real money. Cash is!


• Profit is different than Cash

• Companies need both Profit & Cash

• Understanding the difference is a key to increasing your financial intelligence.


1st Scenario:Profit without Cash

Jan Feb Mar

Sales $20,000 $30,000 $45,000

COGS 12,000 18,000 27,000

Gross Profit

8,000 12,000 18,000

Expenses 10,000 10,000 10,000

Net Profit $(2,000) $ 2,000 $ 8,000


Jan Feb Mar

Beginning Cash

$ 10,000 0 ($22,000)

Cash in (Collection)

0 0 20,000

Cash out (vendors)

0 (12,000) (18,000)

Cash out (expenses)

(10,000) (10,000) (10,000)

Net Cash 0 ($ 22,000) ($ 30,000)


2nd Scenario:Cash without Profit

Jan Feb Mar

Sales $ 50,000 $ 75,000 $ 95,000

COGS 35,000 52,000 66,500

Gross Profit 15,000 22,500 28,500

Expenses 30,000 30,000 30,000

Net Profit $ (15,000) $ (7,500) $ (1,500)


Jan Feb Mar

Beginning Cash

$ 10,000 $ 30,000 $ 75,000

Collection (cash sales)

50,000 75,000 95,000

Payment (COGS)

0 0 (35,000)

Payment (expenses)

(30,000) (30,000) (30,000)

Net Cash $ 30,000 $ 75,000 $ 105,000


• Understanding this foundational concept opens up a whole window of opportunity to ask questions and make smart decisions


The language of Cash Flow• Cash from or used in operating activities

• Cash from or used in investing activities

• Cash from or used in financing activities

RatiosRatios


The Power of Ratios• They offer a quick shortcut to

understanding what the financial statements are saying

• Ratio indicate the relationship of one number to another


• Senior managers watch ratios such as gross margin to be aware of rising costs or inappropriate discounting

• Lenders examines ratios such as debt-to-equity to give them an idea of whether the company will be able to pay back a loan

• Credit managers assess potential customers’ financial health by inspecting the quick ratio


• The power of ratios lies in the fact that numbers in the financial statements by themselves don’t reveal the whole story

• Ratios offer points of comparison


• Compare Ratios with themselves over time (trend analysis)

• Compare Ratios with what was projected

• Compare Ratios with industry averages


• Is net profit of $ 10 million healthy for a company?


4 Categories of Ratios• Profitability Ratios

• Leverage Ratios

• Liquidity Ratios

• Efficiency ratios


Profitability RatioProfitability Ratio• The higher the better

• Evaluate a company’s ability to generate profits

• Are most of common of ratios


• Gross Profit Margin (or Gross Margin):

= Gross Profit / Revenue

Trend line in gross margin is important as it indicates potential problem. If it is heading down it means that the company is under sever price pressure or its raw material and labor are rising or both


• Operating Profit Margin (Operating Margin)

= Operating Profit (EBIT) / Revenue

A key metric indicating how well managers as a group are doing


• Net Profit Margin (net margin)

= net profit / revenue

To be compared with the company performance in the previous years & to similar companies in the same industry


• Return on Asset (ROA)

= net profit / total assets

ROA tells what percentage of every dollar invested in the business was returned to you as a profit. It shows how effective the company is at using those assets to generate profit


• An ROA considerably above industry average norm may indicate that the company is not renewing its asset base for the future – not investing in new machinery and equipment --- its long term prospect will be compromised

• Another possibility is that the company executives are playing fast and loose with the balance sheet, using accounting tricks o reduce the asset base to make ROA look better


• Return on Equity (ROE)

= net profit / shareholders’ equity

It tells us what percentage of profit we make for every dollar of equity invested


Leverage RatiosLeverage Ratios• ‘Leverage’ is the financial analyst’s word for

‘debt’. Two kinds of leverage:

• Operating leverage: the ratio between fixed costs and variable costs. Increasing operating leverage means adding to fixed costs with the objective of reducing variable costs

• Financial Leverage: the extent to which a company’s asset based is financed by debt


• Debt-to-Equity Ratio:

= Total Liability / Shareholders’ equity


• Interest Coverage

= Operating Profit / annual interest charges

The ratio shows how easy it will be for the company to pay its interest.


• What happens when either of these two ratios heads too far in the wrong direction (i.e. too high Debt-To-Equity and too low Interest Coverage)?


Liquidity Ratios• Current Ratio

measures the company’s current assets against its current liabilities

= ________________Current Assets

Current Liabilities


• Quick Ratio

known as the “Acid Ratio”

= __________________Current Assets - Inventory

Current Liabilities


Efficiency Ratios Efficiency Ratios (making the most of your assets)(making the most of your assets)

• Efficiency ratios help you evaluate how efficiently you manage certain key balance sheet assets and liabilities

• For instance, if you can reduce inventory and speed up collection of receivable, you will have a direct and immediate impact on your company’s cash position


Inventory Days and Turnover

• Days-in-inventory (DII)

= ____________________Average Inventory

COGS/360days


• Inventory Turns

= _______________360

DII


• Days Sales Outstanding (DSO)

known as “Average Collection period” and/or “Receivable Days”

• It is a measure of the average time it takes to collect the cash from sales (or it measures how fast customers pay their bills)

= ________________Ending A/R

Revenue / 360 days


• DSO is a key ratio for those doing a due diligence on a potential acquisition.

• High DSO may be a red flag

• Due diligence folks need to look at the aging of receivables, how old specific invoices are & how many there are


• Days Payable Outstanding (DPO)

it shows the average number of days it takes a company to pay its own outstanding invoices

= ___________________Ending A/P

COGS / 360 days


• Property, Plant, & Equipment (PPE) Turnover

It tells how many dollars of sales the company is getting for each dollar invested in PPE. It measures how efficient you’re in generating revenue from fixed assets.

= __________________Revenue

PPE


• Total Asset Turnover

It compares revenue to total assets not just fixed assets.

= _______________Revenue

Total Assets


Which Ratios are most important Which Ratios are most important to your Business?to your Business?• Depends on the industry, competition,

and company specific circumstances

• Example: Retailers watch Inventory turnover


Two things …

• The power of percent-of-sales figures to be tracked over time to establish trend lines

• Each line item of the income statement can be expressed as a percent of sales

• The percent-of-sales figure gives a manager more info than the raw numbers alone


Ratios Relationships• Example:

ROA (Return on Assets)= Net income/ total assets

• Expressed differently:

ROA= net income/revenue * revenue/assets

= net profit margin * asset turnover

Return on InvestmentReturn on Investment


Fundamentals • Time Value of Money simply says ‘a

dollar in your hand today is worth more than a dollar your expect in the future’

• Simply because of the risk involved. You may not collect it tomorrow.

• The longer time period, the higher the risk, the larger the interest charges are likely to be


• Three key concepts when analyze capital investment:

1) Present Value,

2) Future value,

3) required rate of return (or hurdle rate)


• Financial analyst figure a company’s Cost of Capital by

1. finding out the expected cost of its debt (interest rate),

2. estimating the return expected by the shareholders, and

3. taking a weighted average of the two.


• Example:

A company borrow at 4%, Shareholder expect a 16% return. It’s financed 25% by debt and 75% by equity.

What’s the cost of capital?


Figuring ROI• Capital expenditures, Cap-ex, Capital

Investments, Capital Budgeting, ROI … companies use these terms loosely or interchangeably to mean ..

• The process of deciding what capital investments to make to improve the value of the company.


The process of calculating ROI

1. Determine the initial cash outlay

2. Project the future cash flows generated from the investment

3. Evaluate the future cash flows; typically using 3 different financial methods; payback, NPV, IRR.


Learning the threee methods

• Payback Method:

It measures the time required for the cash flow form a project to return the original investment

= ___________________Initial Investment

Yearly cash flow


Payback MethodOn the Plus side:

• It’s simple to calculate ad explain.

• It provides easy and quick reality check. If the payback period is longer than he project life, then no need to look any further

• It’s a project used in meetings to quickly determine if a project is worth exploring.


Payback MethodOn the minus side:

• It doesn't tell you much.

• It doesn’t consider the cash generated beyond the breakeven

• It doesn’t give you an overall return

• It doesn’t consider the time value of money


Payback - Conclusion• Payback method should be used to

compare projects (those will recover their initial investment or reject projects (those that will never recover their initial investment)

• So, if payback looks promising, go on to the next method to see if the investment is really worth making


Net Present value (NPV)Net Present value (NPV)Net Present value (NPV):Net Present value (NPV):

It’s called Discounted Cash Flow (DCF) method It’s called Discounted Cash Flow (DCF) method

Pros:Pros:

It takes into account the time value of moneyIt takes into account the time value of money

It considers business cost of capital or other hurdle rateIt considers business cost of capital or other hurdle rate

It provides answer in today’s dollarsIt provides answer in today’s dollars


NPV – Acceptance Criterion

• If NPV of a project is greater than zero, it should be accepted because the return is greater than the company’s hurdle rate.


Internal Rate of Return (IRR)Internal Rate of Return (IRR)

• IRR calculates the actual return provided by the projected cash flows.

• That rate of return can then be compared with the company’s hurdle rate to see if the investment passes the test

• It can be looked at as the hurdle rate that makes NPV equals to Zero


IRR – cons • IRR doesn’t address the issue of scale.

• Example:

an IRR of 20% doesn’t tell anything about the dollar size of the return


IRR – Acceptance Criterion


• Example:

Initial Investment: $ 3,000

Cash flow by yearend: $ 1,300

Duration: 3 years


Comparing the Three methods• Example:

A company has $ 3,000 to invest, its hurdle rate is 9%, has three investments of the same risk level– Investment A: returns cash flow of $1000 per year for 3 years– Investment B: returns cash flow of $3600 at the end of year one– Investment C: returns cash flow of $4000 at the end of year 3

If you could select one of these investment, which would it be?


1. Payback method

1. A: PB=3 years2. B: PB=1 year 3. C: PB=3years

• NPV method• A: NPV= -$469• B: NPV= +$303• C: NPV=+$552

• IRR method• A: IRR= 0 %• B: IRR= 20%• C: IRR= 15%


• What’s the right decision?

if we go by IRR, B will be chosen. However, C has a higher NPV, which shows that C is worth more in today’s dollar than B.

With C, we get a lower return but we get it for three years at 15%, which is better than one year at 20%.


• An important step: revisit the cash flow estimates, make sensitivity analysis to check, for instance, the calculations using future cash flows that are 80% of original projections, and see if the investment still makes sense.


• Although the process entails a lot of calculating, you would be surprised how intuitive the whole process can be


A StoryJohn was running a financial review meeting for XYZ. A senior manager in a company suggested to invest $80,000 in a new machine center that could produce certain parts in-house rather than relying on an outsider. Before John could speak up, a shop floor technician asked the manager the following questions:


• Did you figure out the monthly cash flow return we will get on this new investment? $ 80,000 is a lot of money!

• Do you realize that we are in the spring, and the business is typically slow, and cash is tight during the summer?


• Have you figured in the cost of labor to run the machine? We are all pretty busy in the sop; you will probably have to hire someone to run this machine

• And are there better ways we could spend that cash to grow the business?

Working CapitalWorking Capital


Managing the Working Capital

• Learn to manage working capital better to impact the company’s profitability and cash position

• Working Capital =

Current Assets – Current Liability


• Elements of Working Capital

– Cash to buy Raw material to make goods (inventory) to sell (AR) which t be collected (Cash)


Cash Conversion Cycle• it’s the timeline relating the production

to the company’s investment in working capital

• How many days all this takes? How many days a company’s cash is tied up?


• Cash Conversion Cycle

= DSO + DII – DPO

This tells how fast a company recovers its cash, from the moment it pays its payable to the moment it collects its receivable


• The Cash Conversion Cycle gives you a way of calculating how much cash it takes to finance the business: you just take sales per day and multiply it by the number of days in the cash conversion cycle


• Example:

DSO = 54 days,

DII= 74 days,

DPO= 55 days

Sales per day = $ 241,360

How much working Capital this business would require to finance its operations?


• CCC = 54 + 74 – 55 = 73 days

• 73 days * 241,360 Sales/day

= 17,619,280


Financial Literacy• By introducing these concepts, it’s

aimed to increase your financial intelligence and helping you becoming a better manager.

• By understanding financial aspects of the business, we believe you will make more effective decision in your business and in your whole life


• There’s a simple antidote to politics; sunlight, transparency, and open communication

• When people understand a company’s objectives and work to attain them, it’s easier to create an organization built on a sense of trust and a feeling of community

Understanding Financial Reports - Basic Course

Documents

cash conversion cycle

returns cash flow

future cash flows

companys hurdle rate

whats financial intelligence

working capital

financial intelligence

gross margin