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Breakout Session 1004 Juanita M. Rendon, MBA, CPA Instructor, Naval Postgraduate School

Tools for Assessing the Financial Health of a Contractor. Breakout Session 1004 Juanita M. Rendon, MBA, CPA Instructor, Naval Postgraduate School April 24, 2007 10:45 -11:45 AM. Learning Objectives.

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Breakout Session 1004 Juanita M. Rendon, MBA, CPA Instructor, Naval Postgraduate School

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  1. Tools for Assessing the Financial Health of a Contractor Breakout Session 1004 Juanita M. Rendon, MBA, CPA Instructor, Naval Postgraduate School April 24, 2007 10:45 -11:45 AM

  2. Learning Objectives • Understand the basic presentation of financial statements and their interrelationships. • Understand what financial statement ratios and tools to consider when analyzing the financial statements of a contractor’s business. • Gain an appreciation for the application of financial statement ratio analysis in assessing the financial health of a contractor’s business.

  3. WHY IS THIS IMPORTANT? • The contracting manager’s responsibilities are getting broader now. • The Federal Acquisition Regulations (FAR) Part 9 states that the contractor should “have adequate financial resources.” (FAR 9.104.1) • Contracting managers need basic tools to help them make sure that contractor qualifications are met before awarding a contract.

  4. WHAT IS ACCOUNTING? Accountingis an information system for the measurement and reporting of an organization’s business economic activities. Accounting is the language of business. The main objective is to provide useful information to decision-makers. (Williams, Haka, Bettner, & Carcello, 2008)

  5. Methods of Accounting Cash basis of accounting: an accounting method in which revenues are recognized when they are received, and expenses are recognized when they are paid. (Albright & Ingram, 2006)

  6. Methods of Accounting Accrual accounting: an accounting method in which revenues are recognized when they are earned and expenses are recognized when they are incurred. (Albright & Ingram, 2006)

  7. Accounting for Business Activities Accounting transactions are business activities (or economic events) that are measured in dollar values and recorded in accounts, which either increase or decrease depending on the event. (Albright & Ingram, 2006)

  8. Accounting for Business Activities • Examples of accounting economic events: • Purchase of equipment for business use increases equipment asset and decreases cash asset (if paid with cash). • Payment of rent expense decreases cash asset and increases rent expense account, which decreases RE, an equity account. • Receiving a long-term loan from a bank increases cash asset and increases notes payable (liability) account.

  9. Overview of Financial Statements Financial statements are reports that summarize the results of a company’s accounting transactions for an accounting period (calendar or fiscal). (Albright & Ingram, 2006)

  10. Overview of Financial Statements Most businesses prepare the following financial statements to report accounting information: • 1. Income Statement • 2. Balance Sheet • Statement of Cash Flows • Statement of Stockholders’ Equity (Links IS and BS) • Statement of Retained Earnings

  11. Overview of Financial Statements The preparation of financial statements in the U. S. is based on GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP). (Albright & Ingram, 2006)

  12. Overview of Financial Statements Standard Setting Organizations • Two authorities primarily responsible for establishing GAAP in the U. S. are: • The Securities and Exchange Commission (SEC) in the public sector. • The Financial Accounting Standards Board (FASB) in the private sector. (Albright & Ingram, 2006)

  13. Overview of Financial Statements Standard Setting Organizations The Governmental Accounting Standards Board (GASB)sets accounting standards for state and local governmental units. The U. S. Government Accountability Office (GAO; prior to 2004 was known as the General Accounting Office) is the agency that oversees accounting in the federal government. (Albright & Ingram, 2006)

  14. Overview of Financial Statements Standard Setting Organizations The International AccountingStandards Board (IASB) is an independent, privately-funded accounting standard setter. The Board is committed to developing, in the public interest, a single set of high quality, understandable, and enforceable global accounting standards. (Albright & Ingram, 2006)

  15. Overview of Financial Statements Sources of Accounting Regulations The Sarbanes-Oxley Act (SOX) was passed by Congress in 2002. This act affected the responsibilities of auditors, boards of directors, and corporate managers with respect to financial reporting. The primary purpose was to increase investor confidence . (Albright & Ingram, 2006)

  16. Corporate Annual Reports Include: • a discussion by management of the company’s performance • financial statements • notes to the financial statements • a statement of management responsibilities for the financial statements • an audit report (Albright & Ingram, 2006)

  17. The Auditors’ Report Anunqualified opinion states that the auditor believes that the financial statements fairly present the company’s actual economic events for the period covered by the audited statements. (Albright & Ingram, 2006)

  18. The Auditors’ Report Auditing standards include procedures used in conducting an audit to help auditors form an opinion about the fairness of the audited statements. (GAAS: Generally Accepted Auditing Standards) (Albright & Ingram, 2006)

  19. Overview of Financial Statements The Income Statement (Statement of Earnings) reports revenues and expenses for an accounting period as a means of determining how well a company has performed in generating profits for its owners. (Albright & Ingram, 2006)

  20. Company XYZZ Income Statement For the Year Ended December 31, 2006 Sales revenue $700,500 Cost of goods sold (450,200) Gross profit 250,300 Depreciation Expense (60,000) Selling, general, & administrative exp. (90,300) Operating income 100,000 Interest expense (5,000) Pretax income 95,000 Income taxes (40% tax rate) (38,000) Net income $ 57,000 Earnings per share Average number of common shares 4,000 $ 14.25

  21. Average Number of Shares Outstanding Company XYZZ issued 1,000 shares on January 1 and 9,000 shares on September 1. Jan. 1 to Aug. 31 = 8 months Sept. 1 to Dec. 31 = 4 months 1,000 x 8/12 = 667 10,000 x 4/12 = 3,333 Average 4,000

  22. $57,000 net income 4,000 average shares EPS = $14.25 EPS = Earnings per Share Earnings per share is a measure of the earnings performance of each share of common stock during an accounting period.

  23. Overview of Financial Statements A Balance Sheet (Statement of Financial Condition) identifies a company’s assets and claims to those assets by creditors and ownersat a specific date. (A = L + SE) (a snapshot)

  24. Company XYZZ Balance Sheet At December 31, 2006 Assets Current assets: Cash $ 12,600 Accounts receivable 9,600 Merchandise inventory 22,000 Supplies 800 Prepaid rent 1,000 Total current assets $ 46,000 Long-term (Fixed) Assets: Property and equipment, at cost 300,000 Less Accumulated depreciation (60,000) Total Long-term (Fixed) Assets $240,000 Total assets $286,000 Continued

  25. Liabilities and Stockholders’ Equity Current liabilities: Accounts payable $ 8,500 Unearned revenue 3,800 Interest payable 700 Notes payable, current portion 4,000 Total current liabilities $ 17,000 Long-term liabilities: Notes payable, long-term 80,000 Total liabilities$ 97,000 Stockholders’ equity: Common stock 150,000 Retained earnings 39,000 Total stockholders’ equity $189,000 Total liabilities and stockholders’ equity $286,000

  26. Must Equal Company XYZZ Balance Sheet At December 31, 2006 Assets: Total assets$286,000 Liabilities and Stockholders’ Equity Total Liabilities and Stockholders’ Equity $286,000

  27. Assets Liabilities Stock-holders’ Equity + = Economic Resources Owned by a Business Owners’ Claims on the Assets of a Business The Financial Obligations or Debts of a Business The Basic Accounting Equation (Albright & Ingram, 2006)

  28. Balance Sheet Stockholders’ equity includes: (1) amounts paid by owners to a corporation for the purchase of shares of stock and (2) retained earnings, profits reinvested (retained) in the corporation .

  29. Overview of Financial Statements The Statement of Cash Flows reports events that affected a company’s cash account during a fiscal period. It includes 3 sections: operating, investing, and financing. (Albright & Ingram, 2006)

  30. The Statement of Cash Flows GAAP permits the statement to be presented in either of two formats: direct or indirect. GAAP requires a schedule to reconcile cash flows from operating activities with net income when the direct format is used. (Albright & Ingram, 2006)

  31. The Statement of Cash Flows: Indirect Method The differences between the direct and indirect formats are in the operating section only. 99% of companies use the indirect method. (Albright & Ingram, 2006)

  32. The Statement of Cash Flows: Indirect Method Operating Activities Operating activities are transactions involving the acquisition or production of goods and services & the sale and distribution of these goods and services to customers. (Cash effects of events related to the company’s operations.) (Albright & Ingram, 2006)

  33. The Statement of Cash Flows: Indirect Method Depreciation and amortization expenses are not cash outflows so they are added back to net income in the indirect method. (Albright & Ingram, 2006)

  34. The Statement of Cash Flows Investing Activities Investing activities involve acquisition or sale of long-term assets and financial investments during an accounting period. (Albright & Ingram, 2006)

  35. The Statement of Cash Flows Financing Activities Financing activities are transactions between a company and its ownersor between a company and its creditors. (Albright & Ingram, 2006)

  36. From the income statement Company XYZZ Statement of Cash Flows For the Year Ended December 31, 2006 Indirect Operating Activities Net income $ 57,000 Depreciation exp. (noncash) 60,000 Increase in accounts receivable (CA) (20,000) Increase in merchandise inventory (CA) (32,000) Increase in supplies (CA) (1,200) Increase in prepaid rent (CA) (5,000) Increase in accounts payable (CL) 6,600 Increase in unearned revenue (CL) 3,000 Increase in interest payable (CL) 400 Net cash flow from operating activities $ 68,800

  37. Carried forward $ 68,800 Investing Activities Payments for purchase of equipment (231,700) Receipts from sale of equipment 500 Net cash flow for investing activities (231,200) Financing Activities Receipts from sale of common stock 150,000 Payment of dividends (20,000) Receipts from borrowing 60,000 Repayment of debt (15,000) Net cash flow from financing activities 175,000 Net increase in cash 12,600 Cash balance, December 31, 2005 0 Cash balance, December 31, 2006 $ 12,600

  38. Statement of Stockholders’ Equity Statement of Stockholders’ Equity CCRETotal Balance at Jan. 1, 2005 $ 0 $ 2,000 $ 2,000 + Common Stock Issued 150,000 150,000 + Net Income 57,000 57,000 - Dividends ______ <20,000><20,000> = Balance at Dec.31, 2006 $150,000 $39,000 $ 189,000 This statement links the income statement to the balance sheet. It describes how much NI was reinvested as part of RE. (Albright & Ingram, 2006)

  39. Statement of Retained Earnings Company XYZZ Statement of Retained Earnings For the Year Ended December 31, 2006 • Retained Earnings, Jan. 1, 2006 $ 2,000 • Net income for 2006 57,000 • Less: Dividends (Pmt. to owners) (20,000) 37,000 • Retained Earnings, Dec. 31, 2006 $39,000 This shows the amount of Net earnings (NI) retained by the company and the dividends distributed to shareholders. RE is part of the B/S. (Albright & Ingram, 2006)

  40. Overview of Financial Statements Title of Slide

  41. Financial Analysis 2006 100,800 900,800 2,148,800 3,150,400 1,800,000 899,400 900,600 4,051,000 2005 8,000 630,000 1,300,000 1,938,000 1,300,900 400,000 900,900 2,838,900 Triple C, Inc.: Balance Sheet Cash Accts./Rec. Inventories Total Current Assets Gross L-T Assets Less: Acc. Depreciation Net L-T Assets Total Assets (Brigham & Houston, 2007)

  42. Financial Analysis (Balance Sheet continued) Liabilities and Equity 2006 430,700 250,000 450,000 1,130,700 500,000 1,630,700 2,084,574 335,726 2,420,300 4,051,000 2005 530,100 600,800 490,000 1,620,900 800,000 2,420,900 387,500 30,500 418,000 2,838,900 Accts. payable Notes payable, current Unearned Revenue Total Current Liab. Long-term debt Total Liabilities: Common stock Retained earnings Total Stkhldrs Equity Total Liab. & Equity (Brigham & Houston, 2007)

  43. Financial Analysis Triple C, Inc.: Income statement 2006 7,000,600 (5,800,990) (500,000) 699,610 (110,900) 588,710 ( 80,000) 508,710 ( 203,484) 305,226 2005 6,000,000 (5,000,000) ( 500,900) 499,100 ( 100,900) 398,200 ( 130,000) 268,200 (107,280) 160,920 Sales COGS Other expenses EBITDA Depr. & Amort. EBIT Interest Exp. EBT Taxes (40% tax rate) Net income (Brigham & Houston, 2007)

  44. 2006 150,000 $2.035 $0.133 $12.57 $50,000 2005 100,000 $1.609 $0.120 $8.85 $50,000 Financial Analysis Triple C, Inc.: Other data No. of shares EPS DPS Stock price Lease pmts (Brigham & Houston, 2007)

  45. Financial Statement Analysis Methods • Vertical Analysis: involves measuring relationships between items for a single year. For example, % of sales on an income statement; % of total assets & % of total Liabilities & Stockholders’ Equity on a balance sheet • Horizontal Analysis: involves calculating the Dollar change and the Percent change for each line item on the Income Statement or Balance Sheet from the previous year to the current year. Current year – Previous year/Previous year x 100 = % change • Ratio Analysis:Various ratios (Brigham & Houston, 2007)

  46. Financial Analysis Why are ratios useful? • Ratios can standardize numbers and facilitate comparisons. • Ratios can be used to highlight weaknesses and strengths. • Ratio comparisons should be over a period of time and with competitors in the same industry • Trend analysis • Peer (or Industry) analysis (Brigham & Houston, 2007)

  47. Financial Analysis Five major categories of ratios: • Liquidity: Can the company meet its short-term obligations? • Asset management: Does the company have the right amount of assets vs. sales? • Debt management: Does the company have the right mix of debt and equity? • Profitability: Is the company consistently making a profit? Is the company controlling/managing its expenses? • Market value: Do investors like what they see? (Brigham & Houston, 2007)

  48. Financial Analysis: Liquidity Ratios Triple C Inc.’s forecasted current ratio and quick ratio for 2006: Current ratio = Current assets / Current liabilities = $3,150,400 / $1,130,700 = 2.79x Quick ratio = (CA – Inventories) / CL = ($3,150,400 – $2,148,800) / $1,130,700 = 1,001,600/1,130,700 = 0.89x (Brigham & Houston, 2007)

  49. Financial Analysis: Liquidity Ratios Comments on liquidity ratios • Measure short-run solvency—the ability of a co. to meet its short-term debt requirements as they come due. • For 2006, Co. had $2.79 of CA for $1 of CL; For 2006, Co. has $ .89 of cash & near cash assets for every $1 of CL. • Below industry average; Liquidity position is weak. • The higher the liquidity ratios, the better. (Brigham & Houston, 2007)

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