Weekly Assignment
Chapter 3 Understanding Financial Documents
Learning Objectives
· To foster an understanding of how financial documents are used in entrepreneurial ventures
· To analyze the components of the basic accounting equation
· To understand the logic of an income statement
· To understand the relevance of the statement of cash flow
Case: Hostess Brands LLC
Little did the founders of the Continental Baking Company know in the 1920s that the company would go through two bankruptcy proceedings by 2013. Through a series of mergers, the company at one time was the largest commercial bakery in the United States, with its Wonder Bread and Hostess cake products becoming Hostess Brands LLC in 1930.
Despite having multiple owners, including International Telephone and Telegraph, Interstate Bakeries Corporation, Ralston Purina, Ripplewood Holdings, Silver Point Capital, Monarch Alternative Capital, and today Apollo Global Management LLC and Metropoulos & Co., the famous Twinkies brand has not had any significant change since invented by James Alexander Dewar in the Depression era of the United States.
Over the years, even though millions of Hostess products were being sold, the company was not keeping a close watch on the numbers, and the income statement of the company was in bad shape due mostly to the company's high fixed-cost structure. The labor unions had negotiated generous pensions and health care benefits not in line with the market. When sales declined in the 1980s and 1990s with people consuming fewer carbohydrates and no successful new product introductions, Hostess Brands LLC had $450 million in debt in 2004 when it filed for its first bankruptcy in September of that year.
During the years in bankruptcy, Hostess Brands LLC attempted to restructure its debt and its unfunded pension funds and had several purchase offers, including one for $580 million in 2007 from its biggest competitor, a part of the giant Mexican bakery firm Bimbo Bakeries USA, Grupo Bimbo. The company stayed intact and emerged from bankruptcy in 2009 by (1) obtaining a $130 million equity infusion for controlling interest by Ripplewood Holdings, a private equity firm; (2) debt providers, including Silver Point Capital and Monarch Alternative Capital, two hedge funds having about 30% of the debt, keeping their loans; and (3) the labor unions agreeing to reduce the number of jobs and salaries by $110 million.
Again, the numbers were not watched carefully; the company had 12 different unions with 15,000 members, 40 different pension plans, and $2 billion in pension liability, and again it was forced to file for bankruptcy in January 2012. As a result of not being able to reach an agreement with the unions and creditors, mismanagement, and not watching the numbers, the company stopped producing its brands of Twinkies, CupCakes, Ding Dongs, and Ho Hos in November 2012. The company sold its Wonder Bread brand to Flowers Foods and Hostess Brands LLC to Apollo Global Management LLC and Metropoulos & Co. Twinkies and Hostess CupCakes were back on the shelves for purchase on July 15, 2013. It is hoped that the numbers will be carefully watched this time to avoid a third bankruptcy.
Financial statements are extremely important for any business, regardless of size or industry, as they provide information on the operating, financing, and investment activities of the venture and help keep a company from filing for bankruptcy protection as occurred twice in the case of Hostess Brands LLC. They are a fundamental tool for raising capital and assessing the financial health of the venture. They allow projections, comparisons, and the evaluation of past performance and future cash flow. In a nutshell, financial statements are a necessary tool for assessing a venture's current and future earnings and associated cash flow. In this chapter, we will cover three basic financial documents: the balance sheet, the income statement, and the statement of cash flow. Chart 3.1 presents a schematic representation of the material covered in this chapter.
Chart 3.1 Schematic of Chapter 3
The Balance Sheet
The balance sheet allows venture owners to assess how healthy the business is in comparison with other past periods. It records what the company has in the form of assets, debt, and equity at the end of a month, fiscal quarter, or year. It is a “snapshot” of the firm's financial status at an instant in time. Table 3.1 provides an example of a balance sheet.
Assets are defined as the resources of the venture. Such assets were financed through liabilities or equity. Liabilities represent obligations the venture has to pay in the future, while equity defines the ownership interest of the venture. The relation between those three elements is the core of the balance sheet and is known as the accounting identity:
Assets
Assets represent the tangible and intangible property that the venture owns and has accounting value. It is important to note that assets can be both physical assets and intangible assets. Examples of physical assets are inventory, company cars, and real estate. Examples of intangible assets are patents, copyrights, trademarks, and goodwill. Assets are usually ordered in the balance sheet in order of their liquidity. The most liquid assets appear first on the balance sheet followed by the least liquid ones. Current assets represent the most liquid assets of a venture, meaning they can more easily be turned into cash. Examples of current assets are cash, marketable securities, and accounts receivable.
A venture's requirement for current assets is dependent on its operating cycle. The operating cycle is measured based on the time it takes to convert an investment in cash into inventory and then back into cash proceeds from its sale to customers. As a general rule, the longer the operating cycle, the larger the venture's need for liquidity (i.e., cash).
Noncurrent assets may not be readily converted into cash and are usually subject to wide swings in value. These assets are composed of buildings, land, mineral interests, and equipment (ranging from computers to furniture). Assets in this category are “depreciated” over time. Depreciation is the “expensing” or “writing off” of an asset over its economic life. Depreciation affects the value of such items on the firm's books. The value of the asset is and lowered by a certain amount each year. The annual amount of depreciation depends on the type of item. The depreciation amount appears on the income statement (which we will cover next) and reduces taxable income. Accumulated depreciation is the cumulative sum of depreciation for physical assets such as property and equipment.
Intangible assets are assets other than real or tangible property and have no physical existence. They may or may not be reported on the balance sheet. Intangible assets can be and usually are amortized over time.
Liabilities
Liabilities are usually presented in order of their due date and divided in two main sections: current liabilities and long-term liabilities.
Current liabilities are generally due within 1 year, with most items usually having a cycle shorter than 12 months. Several of the items in this category are associated with day-to-day operating expenses and are usually paid within 30 to 180 days depending on the country and culture. Current liabilities may consist of the following:
1. Accounts payable (payments due to other parties)
2. Wages and salaries (payments due to employees)
3. Current portion of long-term debt
4. Short-term loans (from banks or other sources)
Long-term liabilities are obligations that are due beyond 1 year. These can include the following:
1. Notes payable and bonds
2. Mortgages and capital leases
3. Deferred taxes (taxes that may have to be paid in the future)
Shareholders' Equity
Equity represents the shareholders’ stake in the firm. The book value of equity known as shareholders’ equity or stockholders’ equity is the portion of firm capital provided by its investors. This amount is the cumulative amount shareholders have invested in the venture, plus or minus cumulative earnings or losses, minus distributions to owners. This section of the balance sheet is composed of the following:
1. Par value (nominal amount per share of stock or stated value if the stock has no par value)
2. Capital surplus (amount paid for shares of stock by investors in excess of par or stated value)
3. Retained earnings (prior and current periods’ earnings and losses minus dividend payment)
4. Accumulated other comprehensive income or losses (accumulated unrealized gains and unrealized losses such as foreign currency hedges or unrealized pension costs)
Reaching a Balance
The basic accounting equation must always be maintained; total assets must equal total liabilities plus total shareholders’ equity. With some effort and interpretation, assets, liabilities, and equity can be used to generate a picture of the company's health at a particular moment in time. In the real world, the venture's balance sheet will undoubtedly be composed of more items than have been described here, but the format of the balance sheet will be similar to the one presented.
All entrepreneurs need to develop a clear understanding of accounting principles. The first accounting concept should be the balance sheet. The balance sheet represents a view of the firm at a particular point in time.
In Chapter 4, we will explore the balance sheet using ratio analysis. Analysis of the balance sheet can be very helpful in generating insights into management's capabilities, trends in the firm's performance over time, and the firm's performance vis-à-vis peer groups at a point in time.
The Income Statement
The income statement describes the results of a company's operations over a specific interval of time. This interval could be a month, quarter, or year. The purpose of the income statement is to describe how much revenue was generated and what the associated level of expenses was. With these two pieces of information, we can determine whether the company is making a profit or not (see Table 3.2). The basic formula for the income (i.e., profit and loss) statement is simple:
A second use of the income statement is to provide the basis for calculating various measures of profit and cash flow. Various measurements of profit and cash flow include pretax net profit, net income (NI), and earnings before interest, taxes, depreciation, and amortization.
Pretax operating income is the primary measurement of the total earnings generated by the firm without regard to taxes and net interest income (expense). This measurement is an intermediate measure of firm performance that helps describe the firm's economic results over a period of time (see Table 3.2).
Net income is the primary measurement of the after-tax total earnings of the firm. This measurement takes into account the firm's tax liability (see Table 3.2).
Earnings before interests, taxes, depreciation, and amortization (EBITDA) represent the profit generated after all expenses related to operations are paid. EBITDA is useful for comparison and valuation purposes as it paints a basic picture of the venture's operating capability as well as its ability to cover nonoperating payments such as taxes, interest payments, and principal (see Table 3.3).
Cash versus Accrual Accounting
Two main methods used in accounting are the cash accounting method and accrual accounting method. The cash accounting method records revenues when received and expenses when paid. The results can be difficult to understand and get a clear picture of the company as expenses may be registered several months before or after the associated revenue is made (see Table 3.4). Because of this poor matchup between revenue and expenses, this method is not good for larger, more complex firms with large inventories, but it is perfectly appropriate for small businesses with limited or no inventory.
The accrual accounting method registers revenues billed but not necessarily when the actual cash is received; similarly, this method registers expenses as incurred (accrued) but not necessarily as they are paid. The advantage of this method is that it provides a clear picture of a venture with respect to relating costs and revenues. On the other hand, this method does not give a precise picture of how the company is doing in terms of liquidity. To be more specific, it does not show whether the venture is about to run out of cash.
Revenues
Revenues represent the money received or billed for services or products sold. Revenues may also result from sources other than sales, such as returns on investments (interest earned), franchising fees, or even rental income from a property. When revenues are recorded in the income statement will depend on the accounting method chosen, as discussed previously.
Expenses
Expenses represent a cost associated with the selling of services and products. Expenses are composed of the cost of goods sold (COGS), operating expenses, financing expenses, and tax expenses. Again, expenses are recorded in the income statement depending on the accounting method chosen.
Cost of Goods Sold (COGS). The cost of goods sold (COGS) includes everything directly connected with the purchasing or production of the services or products that are ultimately sold. These expenses include the wages of the direct labor involved in the production of the product or service, the materials used, parts or components purchased, and repairs made to the equipment of the facility used for production of the product or service. These are expenses directly related to the venture's production of goods or services. If we subtract these expenses from revenue, the resulting sum is gross profit. Gross profit (when gross profit is measured as a percent of sales, it's called gross margin) is defined as the difference between sales of the company's goods and services and the cost of goods sold.
Operating Expenses. The operating expenses, also known as OPEX, represent a category of expenditure directly connected with operating the venture and not directly connected with the production of the product or service. This category includes accounting and legal services, advertising and marketing costs, insurance coverage, office equipment and supplies, office rent (factory rent for production may or may not be included in the COGS depending on the accountant), salaries not directly tied to the production process, utility bills (could also be classified in the COGS depending on the type of business), depreciation (allocation of the cost of a tangible asset spread throughout its economic life), and amortization (allocation of an intangible asset's cost over that asset's useful life).
Other Expenses. Other expenses cover financing expenses (interest paid on loans) and tax expenses associated with the company's profit.
The Statement of Cash Flow
The statement of cash flow describes the venture's cash flow. It analyzes cash flow, calculating cash flow attributed to three different activities: operations, investment activities, and financing activities. Questions include how much cash the company spent or where the cash came from. A simplified cash flow statement is shown in Table 3.5.
Cash flow from operations is defined as the cash generated or used by virtue of the day-to-day operations of the venture. Collected accounts receivable and cash from cash sales represent positive cash flow. Paid expenses related to generating those sales represent outflows of cash. The sum of these two flows is referred to as cash flow from operations, and this normally represents the bulk of the cash inflows and outflows that pass through the company.
Cash flow from investments includes cash generated or consumed by the purchase or sale of buildings, equipment, and marketable securities (stocks or bonds). It may also include loans advanced to suppliers or customers as well as payments related to acquisitions of parts of another venture.
Cash flow from financing activities includes cash generated or consumed by investments, investors, loans from banks, dividend payments, stock repurchases, and repayment of debt principal.
The firm's net cash flow is the cumulative sum of the above three subclasses of cash sources and uses. In short, the net cash flow equals cash sources minus cash uses. This computation is used to describe how the venture generates cash to fund operations, pay off liabilities, or pay dividends to investors. By analyzing the cash flow of a venture, it is possible to make conclusions about management's capabilities and the firm's overall efficiency. For example, if external financing from investors is the main source of cash for a large period of time, without significant inflows from operations, it is an alert that the firm could face upcoming financial challenges or is already experiencing difficulty in making and selling its product.
Summary
In this chapter, the three basic financial statements were presented and explained. Each of these statements provides information about the status and health of the venture. Later chapters will provide more tools for a deeper understanding of how to analyze and interpret each of the reports covered. The balance sheet is a comparison tool where the performance of the firm is assessed at a certain point in time. The income statement gives an overview of how much the company made and spent in a specific period of time. The statement of cash flow defines how much cash is generated and how it is used over a period of time.