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Interpreting Financial Statements for Business Leaders

This Boardroom Briefing presented by Yatra Forudi, Associate Director, BDO delves into the topic of 'Interpreting Financial Statements for Business Leaders'. The fourth in a series on Enterpreneurial Leadership this session provides an introduction on how to use basic financial statements as a valuable management tool.

SEMINAR OUTLINE
•  Taking the Pulse of your Business
•  Demystifying Financial Statements
•  For a Closer Look: Management Accounts
•  What Financial Statements will and won’t tell you
•  What other information to consider
•  Vital Signs: What to look for
•  Optimising performance
•  Key messages
•  Where to find more information

TAKING THE PULSE OF YOUR BUSINESS
Why
•  Indicator of the financial health of your business (Historical and Forecast)
•  Fix any addressable issues as soon as they are diagnosed
•  More informed funding decisions
•  Take advantage of growth opportunities
•  Know the value of your business
•  Succession planning and exit strategy What
•  Financial Performance
•  Cash Flow
•  Working Capital
•  Funding
•  Lagging and Lead Indicators

How
•  Understand your financial statements and financial KPIs
•  Understand key value drivers
•  Create your own financial dashboard
•  Seek independent advice When
•  Now!
•  Monitor consistently and regularly

DEMYSTIFYING FINANCIAL STATEMENTS
A QUICK OVERVIEW

FINANCIAL STATEMENTS HANDOUTS
•  Profit and Loss Statement
•  Balance Sheet
•  Cash Flow Statement
•  Five Year Financial Summary (not usually part of financial statements)

KEY ISSUES IN THE ANALYSIS OF A PROFIT AND LOSS STATEMENT
•  What are the key ratios and how do they compare across time and with other entities?
•  What is your break even position? What is the normalised maintainable result?
•  What is the quality of the ‘core’ earnings?
•  What are the sources of revenue – are they sustainable – is there undue reliance on one source?
•  What are your key costs and the mix of fixed and variable costs and how do they compare to the industry sector?
•  Impact of accounting policies (cash v accruals)

KEY ISSUES IN THE ANALYSIS OF A BALANCE SHEET
•  What are the receivable, inventory and payable cycles of your business and how do they compare to the sector?
•  What are the largest balances on the Balance Sheet and is their valuation reasonable? Are there any intangible assets?
•  What are the key operating assets?
•  What is the mix of long term/short term balances (‘maturity analysis’)? Liquid / illiquid assets/liabilities? Core/surplus assets/liabilities?
•  What level of gearing do you utilise? Is it sustainable?

KEY ISSUES IN THE ANALYSIS OF A CASH FLOW STATEMENT
•  What are the differences between operating profit and cash flows from operations ? (Differences relate to non-cash items and should not be material)
•  Is cash flow from operations positive or negative and why? (this is generally the key source of cash for businesses)
•  What proportion of cash from operations is consumed towards financing obligations and long term investments versus reinvestment in the operations?
•  What is the trend of the cash flow generating capacity of the business and how does this compare with the earnings?

NOTES TO THE FINANCIAL STATEMENTS
-  Provide further detail about information presented in the financial statements
-  Provide qualitative and quantitative supporting information and insights to improve the readability of financial statements

FOR A CLOSER LOOK: MANAGEMENT ACCOUNTS
Handout Historical management accounts are tailored specific to the needs of your business P&L
-  Sales may be dissected into geographic, product, customer or other relevant groups
-  Expenses may be dissected into operational and functional groupings ie: by product, personnel and non-personnel, business segment, etc
-  A comparison to budget is usually included Balance Sheet
-  A dissection along relevant lines ie: by product, channel or segment may be presented. Forecasts - P&L and Balance Sheet forecast is also usually prepared in the above formats

WHAT THE FINANCIALS WILL TELL YOU
•  Historical and forecast profit/loss, net assets and cash flows of the business
•  Management accounts:
•  Channel, segment, product profitability
•  Revenue and cost concentration and mix
•  Enable trend and ratio analysis across periods
•  How the business is tracking against bank covenants
•  Provide majority of the information required to calculate:
•   the value of your business
•   the debt servicing ability of your business
•   whether your business is in financial distress

……AND WHAT THEY WON’T TELL YOU
•  An indication of ‘cash flow’ if only prepared on an ‘accruals’ basis
•  An indication of outlook if only historical data is prepared
•  Quality of ‘core’ maintainable earnings (unless you prepare an analysis of earnings)
•  Market value of assets if recorded at cost
•  How much income tax is payable unless you have tailored your accounts to calculate
•  Key customers and supplier analysis
•  Employee productivity unless you include analysis of this
•  Effectiveness of contractual relationships, status of trademarks/patents
•  Order / supply pipeline unless you prepare this information
•  How your business is tracking against competitors unless you include current / relevant benchmarks in your analysis
•  Contingencies and claims

WHAT OTHER INFORMATION TO CONSIDER
•  Seasonality, one-offs, differences between cash v accrual position
•  Sub ledgers from your accounting system including:
•  Debtor and creditor ageing reports
•  Top 10 customer and supplier details and historic trends
•  Inventory ageing report and top 10 items report
•  Employee productivity and leave records
•  Bank statements, loan account statements and correspondence
•  Customer and supplier order book and enquiries
•  Details of any disputes, ATO and legal correspondence
•  Unprocessed bills where accounting on a ‘cash’ basis
•  Records that measure effectiveness of marketing campaigns
•  Any valuations of assets
•  Upcoming asset purchases / refurbishments and funding commitment
•  Contracts, insurance policies and leases
•  Industry and ABS statistics, competitor data, business broker websites and contacts
(Note: This is not a comprehensive list!)

VITAL SIGNS: WHAT TO LOOK FOR
•  Trend analysis
•  Percentage mix
•  Variance to budget
•  Ratio analysis:
-  Profitability (including benchmarks)
-  Working capital
-  Cash flow
-  Leverage and debt servicing
-  Productivity and efficiency
•  Sensitivity analysis
•  Scenario analysis

VITAL SIGNS: WHAT TO LOOK FOR (CONTINUED)
- TREND ANALYSIS
Source: Woolworths 2010 Annual Report
- EBIT margin has steadily improved while growth rates have declined over time
- Return on equity has declined as the company has increased its debt as well as its equity
capital to open new stores and acquire businesses, whose incremental return appears to be
lower

VITAL SIGNS: WHAT TO LOOK FOR (CONTINUED) - RATIO ANALYSIS
Profitability
-  Gross and Net Margin v Industry
-  Price v Volume Contribution to Profit
-  Cost / Income
-  Return on Assets or Capital Employed
-  Return on Equity
-  Cash Flow Return on Equity
-  Financial Gearing Efficiency

Working capital
-  Debtor Days
-  Creditor Days
-  Inventory Days
-  Increase in working capital v increase in sales, purchases and COGS

Productivity and efficiency
-  Number of units per hour
-  Number of units per employee
-  Volume of raw material v finished product Cash flow
-  Operating, Financing and Investing
-  Operating cash flow v profit
-  Net increase or decrease
-  Tax cash flow Leverage and Debt Servicing
-  Interest cover
-  Debt service cover (cash flow v repayment) Sensitivity analysis Scenario analysis

OPTIMISING PERFORMANCE
•  Maintain a financial ‘dashboard’ or a KPI report of the key financial matters of relevance to your business
•  Be aware of your key value drivers and know how to work out the value of your business. At a minimum, know your business’:
•  Break even position, turnover, top 2 expenses and current margin
•  Working capital requirement, debtor, creditor and inventory days
•  Most and least profitable customers/products/employees
•  ‘Headroom’ over bank covenants
•  Continually monitor and action
•  Carry out ‘what if’ type sensitivity analysis to ‘flex’ or ‘stress test’ the drivers of your business under different scenarios ie: increased price, decreased volume, increased interest rates, new product line, etc

KEY MESSAGES
•  Financial statements and management accounts provide valuable information about the health of your business
•  One size does not fit all – ensure that your management accounts are tailored to the requirements of your business operations and strategy. Results for historical and forecast periods can then be monitored using dashboards and other reports and proactive action taken in a timely manner
•  A regular and critical examination of your business KPIs is invaluable:
•  In recognising trends and making tactical business decisions more confidently;
•  In maintaining and improving your competitive position and growth opportunities;
•  In supporting short and long term strategic plans that can be tracked;
•  In being ‘deal ready’ for any business purchase opportunity or offer for your business;
•  In supporting your negotiating position to obtain funding; and
•  In effective succession planning.
•  It is important to take a circumspect view of financial, economic, operational, commercial and sector specific data

WHERE TO FIND MORE INFORMATION
•  Qld Government Small Business Guides
•  Textbooks on Financial Statement Analysis and Ratio Analysis
•  Websites providing information on Financial Analysis and Financial Health Checks


YATRA FORUDI
ASSOCIATE DIRECTOR
BDO

DISCLAIMER The information provided in this presentation is for general information purposes only and reflects the views of the presenter. It does not necessarily reflect the views of BDO. The information is not intended to be and should not be used as specific advice in relation to any matter. BDO does not accept any responsibility for any decisions made in reliance on the general information provided in this presentation. Each business has unique factors which require consideration when determining its financial health which cannot necessarily be generalised. These factors require specific and separate consideration on a case by case basis.


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