Financial Statement Analysis

The learning objectives of this chapter are to:

¦ discuss the elements of financial statement analysis, including review of the financial statements, examination of the notes that accompany the financial statements, calculation of ratios, and final assessment;

¦ explain the parts of a financial statement review, including the audit opinion letter and the individual financial statements;

¦ explain the importance of examining the notes that accompany the financial statements and discuss the note that focuses on significant accounting policies, as well as other more specific notes;

¦ define ratio analysis and discuss the role that ratios play in assessing the financial situation of an organization;

¦ explain the importance of comparing the organization’s ratios with its own ratios over time, as well as those of comparable organizations, and the industry as a whole;

¦ provide cautions in the use of ratio analysis;

¦ define and explain a number of major classes of ratios and specific individual ratios that are of value in financial statement analysis; and

¦ discuss the importance of bringing all of the information together to make a final financial assessment of the organization.

INTRODUCTION

Chapters 9 to 13, Part IV of this book, focused on reporting results using financial accounting. The role of financial accounting is to gather, summarize, and report information about the financial history of the organization. The financial statements discussed in the preceding chapters are the vehicle used to communicate the results of operations and the financial position of the entity. The focus of this chapter and the next is on how that information can be analyzed to gain additional insight into the financial situation of the organization. This chapter focuses on a general framework for financial statement analysis. Chapter 15 focuses on special concerns in the analysis of the financial condition of governments.

The two chapters also consider other indirect sources and types of information that may be valuable in understanding the finances of an organization. For example, comparison of the organization’s financial results with those of similar organizations can be particularly enlightening. The same is true for comparisons with the organization’s industry as a whole.

There are many potential purposes of financial analysis. Managers must understand the financial situation of the organization to assess its ability to achieve its mission. They will want to understand their organization’s financial position and results so that they can make decisions that will maintain a satisfactory financial situation or improve an unsatisfactory one. Managers also want to compare the financial performance of their organization with similar organizations to learn if perhaps they could improve their organization’s performance.

Donors desire to evaluate organizations to which they are considering making a contribution. Vendors want to understand whether their customers will be able to pay for their purchases. Lenders want to consider the likelihood of an organization being able to repay loans. These represent just a few of the many uses of financial information.

Different users and different uses of information call for different types of information. Some users want an assessment of the likelihood of repayment of a loan due in 20 years. That requires some prediction of long-term solvency. Vendors may only be concerned with short-term liquidity: Will the organization be able to make payments next month for its purchases this month? Before investing in an entity, we may wish to know about its profitability. Before making a donation, we may wish to know how much of the money spent by the organization goes to program rather than support services. The goal of financial analysis is to use financial statements and other sources to gather the information needed to answer questions and make decisions.

For most organizations, the primary focus of financial analysis is on the audited financial statements. The statements themselves are reviewed, the contents of the notes that accompany audited financial statements are carefully considered, and a set of ratios are calculated. The notes to financial statements are critical because financial statements alone are often inadequate to convey all important financial information. The Generally Accepted Accounting Principle (GAAP) of full disclosure requires that notes be used to convey important financial information that the financial statements do not adequately disclose. Ratio analysis compares numbers from financial statements with each other to gain insight from the relationship between the numbers. Finally, all of the information gathered is brought together, and an assessment is made based on the information as a whole.

FINANCIAL STATEMENT REVIEW

A good place to commence a financial statement analysis is by carefully and thoroughly reading the financial statements and the accompanying notes. Ratios should then be calculated and comparative data should be obtained if possible. Finally, based on a review of all data, an assessment can be made about the financial status of the organization.

In reviewing the financial statements, three overriding concerns are as follows: (1) Is the organization accomplishing its mission? (2) Is the organization financially stable? and (3) Are the results of operations acceptable? By looking at the financial statements, we are not just looking for numbers; we are also trying to gain an insight as to what has happened to the organization and where it is today. The Certified Public Accountant’s (CPA’s) opinion letter and management’s discussion are other elements of an annual report that should be included in the review process.

Trend information often makes analysis easier and more fruitful. If possible, analysis should use financial statements that show more than one year of information. If such statements are not available, the individual annual financial statements from several preceding years can provide comparable data. In reviewing the statements, changes should be noted. If the changes appear significant in amount, one would want to try to investigate them to determine why they occurred and whether they represent a trend that is likely to continue.

The Audit and the Auditor’s Opinion Letter

A financial audit, or simply an audit, is a detailed examination of the financial statements and financial records of an organization. Audited financial statements are financial statements that have been examined by a CPA. The CPA issues an opinion letter, called the auditor’s report, providing expert opinion about whether the financial statements provide a fair representation of the organization’s financial position and the results of its operations. As an outsider, the auditor provides an independent review of the financial statements. The discovery of fraud is an occasional by-product but is not the primary focus of the audit. The primary focus is on whether the financial statements are in compliance with GAAP and are free of material misstatements.

Note that it is the accountant who is certified (by a state licensing board) and not the financial statements, although often people refer to audited financial statements as the “certified financials.”

In some cases, the auditor is hired to do something less than an audit. Small organizations, including many not-for-profits, are not required to have an audit by a CPA, which can be quite costly. Sometimes such organizations will employ a CPA to perform a compilation or review of financial statements. In a compilation engagement, the auditor is hired to develop a set of financial statements. The auditor takes the information that has been recorded by the organization during the year and summarizes that information into a set of financial statements that report the results of operations and the financial position of the organization. In a review engagement, the organization has prepared the financial statements, and the CPA reviews them for form and accuracy. However, in neither a compilation nor a review engagement does the CPA perform the extensive testing of records and detailed review that are part of an audit. The statements compiled or reviewed may not be referred to as audited or certified financials.

One of the major functions of an audit is to review not only specific transactions but also systems. It is too expensive to review every single transaction and find every error that has been made. Instead, auditors use sampling techniques to determine how often errors are occurring and how large they tend to be. If an unacceptable level of errors is occurring, the auditor works with the organization to improve its internal control systems (see Chapter 8). The auditor will send a letter, referred to as the management letter, to the organization’s management discussing its internal control weaknesses. That letter does not become part of the annual report issued to outsiders.

The management letter, written by the auditor, should not be confused with a separate letter called management’s discussion, which is written by the organization’s management and discusses their assessment of the organization’s performance.

In addition to the management letter, the auditor issues an opinion letter. This letter follows a standard format, with much of the same wording used for many different organizations. The following auditor’s opinion letter for The Fresh Air Fund is provided as an example:

Report of Independent Auditors1

To the Board of Directors of

The Fresh Air Fund

We have audited the accompanying statements of financial position of The Fresh Air Fund (the “Fund”) as of September 30, 2007 and 2006, and the related statements of activities, functional expenses, and cash flows for the years then ended. These financial statements are the responsibility of the Fund’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

1 Source: The Fresh Air Fund. Financial Statements: Years Ended September 30, 2007 and 2006 with Report of the Independent Auditors. Reprinted with permission of The Fresh Air Fund.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of The Fresh Air Fund as of September 30, 2007 and 2006, and the changes in its net assets and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.

Marks Paneth & Shron LLP

January 9, 2008

The first, introductory, paragraph explains what type of job the auditor was hired to do. Sometimes auditors do consulting or tax work, or are hired to perform a compilation or review. The paragraph indicates that in this instance an audit was performed and indicates the specific financial statements that were included in the audit process. For The Fresh Air Fund the CPA firm of Mark Paneth & Shron LLP2 audited the statements of financial position, as of September 30, 2007 and 2006, and the related statements of activities, functional expenses, and cash flows for the years then ended. Note that since a balance sheet shows the financial position at a moment in time, the letter refers to the statements of financial position as of a particular date, September 30 of each of the years covered by the audit. The other statements provide information on what has happened over a period of time. They are grouped together with an indication that they cover the “years then ended.”

The first paragraph of the letter points out that although the auditor can provide an expert opinion, management holds primary responsibility for the contents of the financial statements. In some organizations, the auditors, in practice, provide a substantial amount of help in compiling the financial statements as part of the audit. Nevertheless, managers must remember that if there are later problems with the information contained in the financial statements, it is the organization’s management, rather than the auditors, who bear the primary responsibility for their content. Regardless of who actually prepares the statements, managers should assure themselves that they understand their statements and agree with the estimates made and the contents of the statements.

The second, scope, paragraph of the audit letter explains the type of work the auditor did to ensure that the financial statements were in compliance with GAAP. Its purpose is to clarify that not every transaction was examined and that immaterial errors were not necessarily found and corrected. The types and extent of examinations that are undertaken as part of the audit are dictated by generally accepted auditing standards that CPAs follow in carrying out their audit.

The third, opinion, paragraph gives the auditor’s opinion on whether the financial statements provide a fair representation of the financial position and results of operations in accordance with GAAP. It is unusual and serious if the statements are not a fair representation (adverse opinion) in the opinion of the auditor. Some auditors condense the information from all three of these paragraphs into one paragraph.

2 LLP stands for Limited Liability Partnership. Generally the partnership business form, unlike corporations, does not limit the liability of its owners. LLP is a legal form of business organization that allows the business to operate as a partnership but provides legal liability protection to its owners.

The reader should also carefully examine any additional paragraphs beyond the standard three, or the one condensed paragraph. In the Fresh Air Fund letter, there are no additional paragraphs. In other instances, additional paragraphs might call the reader’s attention to a particularly important note, such as one regarding a major lawsuit against the organization.

The auditor’s letter often appears to be standard and contain nothing out of the ordinary. Nevertheless, it should always be reviewed as one of the first steps. If it does have anything out of the ordinary, it is worth giving it careful attention. Once the audit letter has been reviewed, the next step in financial statement analysis is to thoroughly review the financial statements. We begin with a discussion of the balance sheet.

The Balance Sheet

Exhibit 14-1 provides comparative statements of financial position (balance sheets) for the hypothetical Meals for the Homeless. (Note that this is a new example. The numbers in the Meals for the Homeless Financial Statements in this chapter are not the same as those in Chapters 10 and 11.) Comparative financial statements present financial information for more than one fiscal period. Each number on the balance sheet should be examined.

EXHIBIT 14-1

The first section of the balance sheet is current assets. Current assets are the most liquid of the firm’s resources. They generally represent resources that will become cash or will be used up within one year. In Exhibit 14-1, one of the first things we notice is that total current assets have increased from $48,100 to $61,100. At the same time, on the liability side of the balance sheet, we see that current liabilities, which will have to be paid in the near term, fell from $16,000 to $14,000. The increase in current assets during a period when there is a decrease in current liabilities, by itself, is a good thing.

It is important, however, to review critically all numbers rather than just summary ones. Although current assets increased, most of the increase is in accounts receivable. In fact, cash has declined from $3,100 to $100. Even though current assets seem adequate overall, one might question whether the $100 is adequate cash on hand to meet obligations as they come due. Furthermore, the increase in accounts receivable is a concern. If this is the result of increased revenues, then it is a positive sign. However, if revenues have not increased substantially, this is more likely to be indicative of problems collecting receivables. In that case, it may be a flag that a problem exists.

All assets that are not current assets fall into the general category of long-term assets. Prominent among the long-term assets are fixed assets, or property, plant, and equipment. Meals’ long-term assets have declined from $97,900 to $83,900. The largest element in this decline is a $10,000 reduction in equipment, net of depreciation. This indicates that the equipment of the organization is aging faster than it is being replaced. Depending on the specific circumstances of the organization, this might or might not be cause for concern. For example, if Meals had 10 delivery vans and a goal to replace two each year, the purchases of two new vans would offset the depreciation on the 10 vans. Given inflation, the new vans would cost more than the old ones, and we should see equipment gradually rise on the balance sheet each year. However, if Meals has only one van, it would not be surprising to see equipment, net of accumulated depreciation, decline from year to year until the year that the van is replaced.

We also note that investments declined from $12,000 to $8,000. Perhaps investments were sold to provide cash due to a shortfall from operations. If that is the case, it will show up on the cash flow statement. Alternatively, perhaps the market value of the investments has declined. We can look for more clues in the activity statement. Note that the first review of financial statements is a process that tends to raise more questions than it answers.

Long-term liabilities include any recorded liabilities that are not current liabilities. The only long-term liability for Meals is a mortgage. Note that the part of the mortgage that is due in the coming year is shown as a current liability. Overall, the mortgage for Meals has declined from the end of 2011 to the end of 2012. This is a positive indicator. It would be desirable, however, for the long-term liability reduction to be as great as the reduction in long-term assets. That was not the case for Meals.

The last thing we note in the case of the balance sheet for Meals is that although its total assets are approximately the same in both years and the total liabilities and net assets are approximately the same from 2011 to 2012 year-end, the net assets have increased by $5,000 from $114,000 to $119,000. A healthy, thriving organization generally requires at least a modest increase in net assets over time. In sum, Meals has performed reasonably in this area. The details of the increase will become apparent as we review the other financial statements.

The Activity Statement

The comparative activity statements (sometimes called operating statements, income statements, statements of revenues and expenses, or statements of revenues and expenditures) are shown in Exhibit 14-2. Revenues and support have increased by $9,000 from $169,000 to $178,000. This is a positive sign. However, it is not a large enough increase to explain the $17,000 increase in accounts receivable that was noted when reviewing the balance sheet. This change would therefore warrant further investigation. It is a potential sign of problems with management of the collections process.

Examination of the individual revenue and support items shows that foundation grants are up sharply, by $10,000. However, there is a disturbing decline in contributions to $65,000, down from $73,000. We would want to investigate and determine if this is a one-year aberration or the beginning of an unfavorable downward trend.

EXHIBIT 14-2

Meals for the Homeless Activity Statements For the Years Ending December 31, 2012 and 2011

2012

2011

Changes in Unrestricted Net Assets

Revenues and support

Client revenue

$ 11,000

$ 9,000

City revenue

20,000

16,000

County revenue

10,000

10,000

Foundation grants

60,000

50,000

Annual ball

12,000

11,000

Contributions

65,000

73,000

Total Revenues and Support

$178,000

$169,000

Net assets released from restrictions

Satisfaction of program restrictions (See Note 5)

$ 10,000

$ 10,000

Expiration of time restrictions (see Note 5)

2,000

1,000

Total Net Assets Released from Restrictions

$ 12,000

$ 11,000

Total Unrestricted Revenues and Other Support

$190,000

$180,000

Expenses

Meals

$ 67,000

$ 63,000

Counseling

35,000

34,000

Administration, fund-raising and general

75,000

65,000

Bad debts

4,000

4,000

Depreciation

10,000

10,000

Total Expenses

$191,000

$176,000

Increase/(Decrease) in Unrestricted Net Assets

$ (1,000)

$ 4,000

Changes in Temporarily Restricted Net Assets

Foundation grants

$ 10,000

$ 10,000

Contributions

5,000

2,000

Assets released from restrictions (Note 5)

(12,000)

(11,000)

Increase in Temporarily Restricted Net Assets

$ 3,000

$ 1,000

Changes in Permanently Restricted Net Assets Contributions

$ 3,000

$ 2,000

Increase in Permanently Restricted Net Assets

$ 3,000

$ 2,000

Increase in Net Assets

$ 5,000

$ 7,000

Net Assets at Beginning of Year

114,000

107,000

Net Assets at End of Year

$119,000

$114,000

The accompanying notes are an integral part of these statements.

Unrestricted net assets increased by $12,000 during 2012 due to release from restrictions. It is likely that most of this is the result of having spent money in compliance with restrictions. A note is often provided to explain net assets that are released from restrictions.

Although total unrestricted revenues and support have increased by $10,000 from $180,000 to $190,000, expenses have increased at an even faster pace. It is important to compare the organization with itself over time. The total $1,000 decrease in unrestricted net assets in 2012 is not a large amount. However, we note that the previous year there was a $4,000 increase. The implication is that we are possibly seeing a declining trend developing in the financial results of operations.

Overall, net assets increased by $5,000 in 2012. This is only $2,000 less than the increase the prior year. It is possible that the main change is that more of Meals’ contributions are coming with temporary and permanent restrictions. Note that while unrestricted contributions fell by $8,000 (from $73,000 to $65,000), temporarily restricted contributions rose by $3,000 (from $2,000 to $5,000), and permanently restricted contributions rose by $1,000 (from $2,000 to $3,000). While this helps reduce the sting of the reduction in unrestricted net assets, it is not totally reassuring. Restricted donations do restrict the organization’s use of resources. They do not provide the organization with the same degree of flexibility in directing resources where management believes they are most needed. Management might decide after reviewing these financial statements that a greater effort is needed to raise additional unrestricted contributions.

The Cash Flow Statement

The cash flow statement focuses on financial rather than operating aspects of the organization. The concern is not with specific revenues and expenses but rather with the general sources and uses of money. The statement provides less information about profitability than the activity statement and more information about viability. It is possible to go long periods without making a profit. However, negative cash flows can create immediate questions regarding continued survival. The cash flow statement can provide some early warning signs when viability problems start to arise.

Sometimes the overall change in cash may seem to be fine, but it turns out that the organization’s routine activities lose cash. Long-term assets are sold or money is borrowed to overcome an operating cash deficit. Unless annual cash deficits from operations can be reversed, the survival of the organization is not ensured. In Exhibit 14-3, we see comparative cash flow statements for Meals for the Homeless for 2012 and 2011. Operating activities in 2012 consumed $10,000 more of cash than they generated. This shortfall was partially made up by selling investments for $4,000 and by receiving contributions that are restricted to long-term investments. Overall cash decreased by $3,000.

The cash decline of $3,000 was only half as great as the decline for 2011, when the cash balance fell from $9,100 at the start of the year to $3,100 at the end. However, the implications are much worse. The 2011 cash decline was the result of acquiring a van, which required a $32,000 cash payment. We can see this in the “Cash Flows from Investing Activities” section of the statement. The purchase of the van required an increase in mortgages of only $9,000 (see the “Cash Flows from Financing Activities” section of the statement). Part of the acquisition was paid for by selling investments and part by lowering the cash balance. A substantial portion of the cash for the van, however, was generated by operations. In 2011, there was $15,000 more cash generated from operations than was used for operations. In 2012, the organization sold nearly as much of its stock investments as it did in 2011 but did not acquire any fixed assets. If the trend from 2011 to 2012 is allowed to continue, it will likely have severe consequences for the organization.

When routine operating activities generate a surplus of cash, the organization is more financially stable and viable than if operating activities consume more cash than they generate. There are times when cash deficits from operations cannot be avoided. Growing organizations often have this problem. Receivables and inventory grow faster than collections can keep up. Even when the deficit is the result of healthy growth, however, caution is needed. Rapid expansion will require, at a minimum, careful planning. There must be a determination of how much cash will be needed from sources other than operations. Agreements from banks or other sources must be obtained to ensure that a cash crisis does not occur. It is far easier to obtain financing while one still has cash than it is if one waits until one runs out of cash.

EXHIBIT 14-3

Meals for the Homeless Statements of Cash Flows For the Years Ending December 31, 2012 and 2011

2012

2011

Cash Flows from Operating Activities

Change in net assets

$ 5,000

$ 7,000

Add expenses not requiring cash Depreciation

10,000

10,000

Other adjustments

Add decrease in inventory

2,000

2,000

Subtract increase in receivables

(17,000)

(2,000)

Subtract decrease in wages payable

(1,000)

0

Subtract decrease in accounts payable

(1,000)

(2,000)

Subtract increase in prepaid expenses

(1,000)

0

Subtract contributions restricted to long-term investments

(4,000)

0

Subtract permanently restricted contributions

(3,000)

0

Net Cash Used for Operating Activities

$(10,000)

$ 15,000

Cash Flows from Investing Activities

Sale of stock investments

$ 4,000

$ 5,000

Purchase of delivery van

0

(32,000)

Net Cash from Investing Activities

$ 4,000

$(27,000)

Cash Flows from Financing Activities

Contributions restricted to endowment

$ 3,000

$ 0

Increase in notes payable

1,000

3,000

Contributions restricted to long-term investment

4,000

0

Increase in mortgages

0

9,000

Repayments of mortgages

(5,000)

(6,000)

Net Cash from Financing Activities

$ 3,000

$ 6,000

Net Increase/(Decrease) in Cash

$ (3,000)

$ (6,000)

Cash, Beginning of Year

3,100

9,100

Cash, End of Year

$ 100

$ 3,100

Supplemental Cash Flow Information Interest paid

$ 1,280

$ 1,600

The accompanying notes are an integral part of these statements.

The Statement of Functional Expenses

The comparative statements of functional expenses, shown in Exhibit 14-4 for Meals, provide a great deal of detailed information about the different expenses incurred by the organization. One can see the mix between salaries versus materials and the mix of expenses by type of program. One of the most critical relationships to explore on this statement is the relative program service expense versus the support service expense. For 2012, Meals spent $121,000 on program services ($83,000 for meals plus $38,000 for counseling) while it spent $70,000 on support services ($47,000 for management and general plus $23,000 for fund-raising). One must always question whether the support service expenses are too high relative to the program service expenses, which are more directly related to the organization’s mission.

EXHIBIT 14-4

Meals for the Homeless Statements of Functional Expenses For the Years Ending December 31, 2012 and 2011

Program Services

Support Services

Meals

Counseling

Management and General

Fund-Raising

Total

Expenses

For Year Ending 12/31/12

Salaries and benefits

$35,000

$35,000

$40,000

$17,000

$127,000

Food

17,000

17,000

Supplies and brochures

2,000

1,000

1,000

2,000

6,000

Office expenses

1,000

1,000

1,000

3,000

6,000

Rent

13,000

1,000

1,720

1,000

16,720

Interest

1,000

280

1,280

Professional fees

3,000

3,000

Bad debts

4,000

4,000

Depreciation

10,000

10,000

Total Expenses

$83,000

$38,000

$47,000

$23,000

$191,000

For Year Ending 12/31/11

Salaries and benefits

$33,000

$34,000

$36,000

$12,000

$115,000

Food

15,000

15,000

Supplies and brochures

2,000

800

1,000

2,000

5,800

Office expenses

1,000

800

1,000

3,000

5,800

Rent

12,100

1,000

1,700

1,000

15,800

Interest

1,300

300

1,600

Professional fees

3,000

3,000

Bad debts

4,000

4,000

Depreciation

10,000

10,000

Total Expenses

$78,400

$36,600

$43,000

$18,000

$176,000

The accompanying notes are an integral part of these state