Financial Statements Explanations of Numbers Suggestions and Tips for Using the Reports

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1 Financial Statements Explanations of Numbers Suggestions and Tips for Using the Reports What s on This Report This report provides complete quarterly and annual financials for all four geographic regions for the prior year, including an income statement, a balance sheet, and a statement of cash flows. You may wish to print a copy of this report each year and retain it for your records, since the financial statements for each year just completed are always replaced by the financial statements for the following year as soon as the upcoming year s decisions are processed. Understanding the Income Statement Data The sales revenue numbers represent the combined net revenues (allowing for any promotional discounts) the company received from sales of both entry-level and multifeatured cameras in all geographic regions. Revenues are booked at the time of shipment, not at the time payments are received from retailers. The number for sales revenue per unit (calculated by dividing total sales revenues by the total number of cameras sold) represents, in effect, the weighted average net price for entry-level and multi-featured cameras this number will be the same for all years and the year provided the company did not make any quarterly changes in its wholesale prices for entry-level and multifeatured cameras (which could occur in the event that the quarterly decision option is activated by your instructor). The production cost numbers in the first column of each period represent total production costs (in 000s) of both entry-level and multi-featured cameras, as reported in more detail on the Production Cost Report. The adjacent number for unit production costs (calculated by dividing total production costs by the total number of cameras sold) represents, in effect, the weighted average production cost for entry-level and multi-featured cameras. Delivery costs are calculated by simply adding the delivery costs for all four geographic regions, as reported on the Operations Report for each region. As you can see by referring to the Operations Report for any region, delivery costs include both the $3 per camera shipping charge and the corresponding import duties of $5 per entry-level camera and $10 per multi-featured camera (unless you have received notification that import duties have changed for one or more regions). The adjacent number for delivery costs per unit (calculated by dividing total delivery costs by the total number of entry-level and multifeatured cameras sold) equals the weighted average delivery cost for both entry-level and multi-featured cameras per camera delivery costs for multi-featured cameras are always higher than for entry-level cameras because of the higher $10 import duty. Marketing costs, as reported on the income statement, represent the sum of retailer support costs, technical support costs, and advertising costs for the periods shown, across all four geographic regions. Marketing costs by region appear on the geographic Operations Reports. The adjacent number for marketing costs per unit (calculated by dividing companywide marketing costs by the total number of cameras sold) equals a weighted average marketing cost for both entry-level and multi-featured cameras across all geographic regions. Copyright 2009 GLO-BUS Software, Inc. Page 1

2 Administrative expenses are a companywide total for the period. The company s administrative expenses were $8 million annually ($2 million quarterly) as of Year 5 and have increased since at the annual rate of $3,000 per each additional 1,000-unit increase in the prior-year volume of cameras assembled and shipped (the combined number of entrylevel and multi-featured cameras). (Administrative expenses decline slightly by less than the $3,000 per 1,000-unit increase if and when camera volume declines in subsequent years). While the company s total administrative expenses are allocated to each region for the purpose of calculating profitability by geographic region on the four Operations Reports, the administrative expenses shown on the income statement are always the current companywide total (and, of course, equal the sum of the amounts allocated to each geographic region on the four Operations Reports for the corresponding period). The adjacent number for administrative expenses per unit (calculated by dividing companywide administrative expenses by the total number of cameras sold) equals a weighted average administrative cost for both entry-level and multi-featured cameras across all geographic regions. Operating profit equals sales revenues less all the above listed expenses. The per-unit number is calculated by dividing total operating profit by the total number of cameras sold during the corresponding period; it represents the average operating profit margin on each camera sold worldwide (and is a weighted average of the worldwide margin on entry-level cameras and the worldwide margin on multi-featured cameras). Operating profit margins on each type of camera in each geographic region appear on the regional Operations Reports. Net interest represents the current amounts paid to the World Community bank for loans outstanding on the company s line of credit less interest earnings on the company s quarterly cash balances in its checking account at the World Community Bank. Interest on loans outstanding is paid quarterly (on the amount of loans outstanding at the end of the prior quarter). The interest rate the company pays on loans against its line of credit is adjusted annually, based on the company s updated credit rating. Interest earned on cash balances is also paid quarterly, with interest earnings being equal to the ¼ of the annual rate paid on cash balances times the cash balance at the end of the prior quarter thus if a company had a cash balance of $10 million in its checking account and the World Community Bank s rate on cash balances was 2.5% annually, or 0.625% quarterly, then the company s interest earnings in the next quarter would be $62,500. It is possible at some point in the exercise that the company pays off most or all of its loans and accumulates sufficient cash such that interest income on its cash balances at the World Community bank exceeds its interest payments, in which case the number for net interest would appear in parentheses and represent an addition to pretax profits. Taxes equal 30% of companywide quarterly pretax profits (pretax profits are equal to companywide operating profits less interest expenses). No tax is owed if the company incurs a quarterly loss on worldwide operations, even though the company s accounting methodology results in Operations Reports that show the company earning a quarterly net profit in one or more geographic regions. Losses from prior quarters may not be carried forward to future quarters, for reasons of accounting simplicity. The company s net profit equals operating profits less interest expenses less any tax payments. Net profit (or loss) per camera equals the net profit divided by the corresponding number of cameras sold companywide for that period. Net profit per unit here represents the average net profit margin on each camera sold worldwide (and is a Copyright 2009 GLO-BUS Software, Inc. Page 2

3 weighted average of the worldwide margin on entry-level cameras and the worldwide margin on multi-featured cameras). Net profit margins on each type of camera in each geographic region appear on the regional Operations Reports. Understanding the Balance Sheet Data All entries on the balance sheet represent end of period numbers not beginning of period numbers. Cash on hand represents the company s ending cash balance for the period. When needed, the bank automatically loans the company sufficient money under its line of credit agreement to cover any negative cash balance. The accumulation of cash as an operating cushion should be viewed as positive and desirable. The World Community Bank pays the company an annual interest rate on cash balances equal to the prime rate it charges on loans to companies with an A+ credit rating less 2.5%; at the end of Year 5 the prime rate paid by A+ companies was 5%, meaning that prime less 2.5% equaled a 2.5% annual interest rate on cash balances. Accounts receivable are always equal to prior quarter sales of cameras (the company has no other type of accounts receivable). The number for accounts receivable on the year-end balance sheet is always equal to sales revenues in the 4 th quarter. Retailers pay for cameras the quarter following the one in which the cameras were ordered and shipped thus there is a one-quarter lag between the booking of sales revenues (which occurs in the quarter cameras are shipped) and the receipt of these revenues. This one-quarter lag means that your company cannot expect to generate more cash flow from additional sales in a particular quarter cash flows from additional sales in one quarter will occur the following quarter. Total current assets equal cash on hand plus accounts receivable. Gross fixed asset investment represents the amount the company has paid for its Taiwan facilities, workstations, other assembly-related equipment, and office furnishings and equipment in the both the corporate headquarters and the four regional sales offices. Gross fixed investment rises when $10 million facilities expansions are undertaken to provide space for an additional 50 workstations and when additional workstations are added (new workstations cost $75,000 each). There is also an automatic additional $5,000 investment in fixed assets for each 1,000-unit increase in prior-year companywide sales volumes. Accumulated depreciation equals the sum of all the amounts depreciated since the company commenced operations. The company s quarterly depreciation rate is 1% of gross fixed assets, which equates to 4% of gross fixed asset investment on an annual basis and an average fixed asset life of 25 years. Net fixed asset investment represents the still un-depreciated value of all of the company s fixed assets. Total assets are calculated by summing total current assets and net fixed asset investment. Accounts payable represents the amounts owed suppliers for components used in assembling cameras during the prior quarter. Invoices submitted by suppliers for components are pay at the end of 90 days. Copyright 2009 GLO-BUS Software, Inc. Page 3

4 Emergency loans payable can arise if a company is in deep financial trouble and must exceed its line of credit limit with the World Community Bank. The bank expects that all emergency loans will be repaid the following quarter, but further emergency loans may be granted if the company continues to be short of cash and requires another emergency loan. All emergency loans are granted at 2% above the regular interest rate charged on the company s line of credit, as per its current credit rating. Taxes payable are based on current quarter profits and are due and payable the following quarter. The taxes payable on the year-end balance sheet represent the taxes due on the company s 4 th quarter profits. Dividends payable are based on the size of the quarterly dividend declared the prior quarter. The total dollar amount for dividends payable equals the quarterly dividend declared times the number of shares outstanding in the quarter the dividend was declared (not the number of shares outstanding in the quarter in which the dividend is actually paid). Total current liabilities equals the sum of accounts payable plus emergency loans payable plus taxes payable plus dividends payable. Long-term debt is equal to the loans outstanding on the company s line of credit. These loans are long-term in the sense that they are repaid at the discretion of company management. There is no definite repayment schedule on the company s draw against its line of credit, although it is obviously advantageous to escape interest payments whenever possible. Each share of common stock outstanding carries a par value of $1 per share; thus, the amount appearing on the balance sheet for common stock always equals $1 times the current number of shares outstanding. Shareholder capital represents the total dollar amount that shareholders actually paid for all the shares outstanding above the par value of $1 per share. In effect, shareholder capital represents the amount the of equity capital raised by the company (above the par value) at the time the shares were first issued. All 10 million shares outstanding at the end of Year 5 were sold at a net price of $4 per share which, after subtracting the $1 par value, produced shareholder capital of $68 million. If your company s management has issued or repurchased any shares since the beginning of Year 6, then the numbers for shareholder capital on the balance sheet will be different from $68 million. Issuing new shares at say $35 per share will result in additions to shareholder capital of $34 per share (and a $1 per share addition to the common stock entry). Repurchasing shares at say $35 per share will reduce the shareholder capital account by $34 per share and the common stock account by $1 per share. Retained earnings represent all of the company s profits earned over all years of the company s operations that were not paid out to shareholders as dividends and thus were reinvested in growing the company s digital camera business. For example, the company earned $2 per share in Year 5 and paid out dividends of $1 per share, meaning that $1 per share was retained, creating total retained earnings of $10 million on the 10 million shares outstanding. However, retained earnings do not represent a pot of cash off to the side somewhere that you can later dip into and spend as needed all of the cash the company has is the amount reported on the first line of the balance sheet, and all cash on hand always resides in the company s checking account at the World Community Bank. Cash on hand is really unrelated to the amount of retained earnings. You should view retained earnings as merely an accounting entry on the balance sheet that Copyright 2009 GLO-BUS Software, Inc. Page 4

5 reports the company s cumulative reinvestment of net profits not paid out as dividends further, retained earnings are also adjusted downward by the amount of net losses the company reports. Total equity equals the sum of common stock plus shareholder capital plus retained earnings. It represents the net amount that shareholders have invested in the business since the company commenced operations. Total liabilities and equity is the sum of current liabilities plus long-term debt plus total equity. Understanding the Cash Flow Data The cash flow statement is presented in two pieces that make interpretation easy: Sources of Cash (or cash inflows) during the period and Uses of Cash (or cash outflows) during the period. Sources of Cash The beginning cash balance represents cash on hand left over from the previous quarter. It is available for use during the period. The beginning cash balance is never negative because your company's arrangement with Global Community Bank calls for the bank to automatically loan your company an amount sufficient to bring the cash balance to 0 at the end of any quarter in which your checking account is overdrawn. A beginning cash balance of 0 is a reliable signal that such an automatic loan was granted at the end of the prior quarter. Positive beginning cash balances are desirable and reflect better cash flow management. Moreover, the beginning cash balance is the amount on which your company will earn interest the Global Community Bank pays the company an annual interest rate on cash balances equal to 2.5% below the prime rate it charges on loans to companies with an A+ credit rating. Collection of accounts receivable represent cash flowing in from the sales of cameras the prior quarter. Retailers pay for cameras the quarter following the one in which the cameras were ordered and shipped thus there is a one-quarter lag between the booking of sales revenues (which occurs in the quarter cameras are shipped) and the receipt of these revenues. This one-quarter lag means that your company cannot expect to generate more cash flow from additional sales in a particular quarter cash flows from additional sales in one quarter will occur the following quarter. Common stock issues result in additional cash in the quarter in which the shares are issued. The cash inflow that results from issuing additional shares equals the number of shares issued multiplied by the issue price per share. New draws against the company s line of credit are an immediate source of cash. Your management team is authorized to draw against the line of credit at any time for any reason. The difference between the line of credit limit and the loans already outstanding against the limit represents the maximum amount of cash you can obtain from this source. Emergency loans are an immediate source of cash should you need to borrow more than the prevailing line of credit limit. However, emergency loans should be used sparingly, if at all they are really a last-resort source of cash, to be used only when it is not feasible to raise additional cash through issuing additional shares of stock. Copyright 2009 GLO-BUS Software, Inc. Page 5

6 From time-to-time extenuating circumstances may arise at your company such that your instructor sees fit to grant your company a refund. Should you qualify for a refund, then it will appear as a source of cash in the period the refund takes place. Total cash inflows available to your company in any one period equal the sum of all the sources of cash listed in the Sources of Cash section of the Cash Flow Statement. Uses of Cash Cash expenses for operations cover (1) payments to suppliers for components (cash outflows for this purpose are based on prior-quarter uses of materials since there is a onequarter or 90-day lag between the time components are delivered and the time these deliveries have to be paid for), (2) labor costs, (3) all other production-related expenses except depreciation (depreciation is not a cash expense), (4) shipping costs and duty fees, (5) marketing costs (retailer support costs, tech support costs, and advertising costs), and (6) administrative expenses. Cash outflows for new fixed asset investments for facilities and workstations occur in the quarter in which facilities are expanded or workstations are added. There is also an automatic additional $5,000 investment in fixed assets for each 1,000-unit increase in prioryear companywide sales volumes; such cash outlay occurs in quarter 1 of the year following such volume increases. The number shown represents all such expenditures. Cash outlays for interest payments on outstanding loans represent current interest owed adjusted downward for the amount of interest income received on prior-year cash balances at the World Community Bank. Interest payments on loans outstanding are determined by multiplying the quarterly equivalent of the company s annual interest rate by the priorquarter s outstanding loan balance. Interest earned on cash balances is also paid quarterly, with interest earnings being equal to the ¼ of the annual rate paid on cash balances times the cash balance at the end of the prior quarter. Thus cash outflows for interest payments equal interest owed minus interest income received. If interest income received exceeds interest payments, then this item on the cash flow will appear as a negative number (and will reduce cash outflows). Paydowns of your line of credit (and any emergency loans) obviously require cash; the amounts shown are a direct result of the decision entries made for paydowns of outstanding loans on the Finance Decisions screen, except if there are any emergency loans which are automatically repaid (without any action on management s part). Cash outlays for common stock repurchases are equal to the number of shares repurchased times the price per share at which the repurchase occurred (which appeared on the Finance Decision screen at the time the number of shares repurchased was entered). Cash outflows for tax payments are equal to 30% of prior-quarter companywide net profits. Current outlays for taxes payable always lag the earning of net profits by one quarter. Cash outflows for dividend payments are based on the size of the quarterly dividend declared the prior quarter times the number of shares outstanding in the quarter the dividend was declared (not the number of shares outstanding in the quarter in which the dividend is actually paid). Cash outlays for dividend payments due in the current quarter cannot be altered; however, the company can cut its declared dividend for current and future periods and thus cut future cash outlays for dividend payments. Copyright 2009 GLO-BUS Software, Inc. Page 6

7 From time-to-time, it is possible that your management team will violate certain rules and regulations prescribed by your instructor (such as not meeting the decision deadline); your instructor has the discretion to fine companies for out-of-bounds activities all such fines represent a cash outflow and appear in this line. The total of all cash payments your company is obligated to make in any one period equals the sum of all the cash payments listed in the Uses of Cash section of the Cash Flow Statement. Your company s ending cash balance in its checking account at the World Community Bank equals total cash available minus total cash outflows. Using the Financial Statement Data The information in the company s financial statements is an integral part of understanding the company s financial performance and revenue-cost-profit results. Studying the quarter-toquarter performance will help you understand the importance of the third quarter to the company s full-year performance and see how the quarterly performances add up to the annual performance. In evaluating the strengths and weaknesses of your company s financial performance, you should always make use of the financial and operating ratios that GLO-BUS calculates annually for your company (and all other companies) these are reported on the Comparative Financial Performances page of each year s issue of the Global Statistical Review. These ratios and how they compare to the ratios of rival companies will help you cut straight to the chase in determining how well your company is doing and what problems/issues need to be addresses in making decisions for the upcoming period. The definition and meaning of the financial and operating ratios and the measures of creditworthiness shown on the Comparative Financial Performances page of the GSR (page 6) are briefly presented below: Financial and operating ratios Low percentages of production costs to sales revenues are generally preferable to higher percentages because they signal a bigger margin for covering all other costs and earning a profit. The lower the percentage of production costs/costs of goods sold to net revenues the bigger a company s margin. Companies having the highest ratios of production costs to net revenues are likely to be caught in a profit squeeze, with margins too small to cover delivery, marketing, and administrative costs and interest costs and still have a comfortable margin for profit. Production costs at such companies are usually too high relative to the price they are charging (their strategic options for boosting profitability are to cut costs, raise prices, or try to make up for thin margins by somehow selling additional units). A low percentage of delivery costs to net revenues is preferable to a higher percentage, indicating that a smaller proportion of revenues is required to cover delivery costs (which leaves more room for covering other costs and earning bigger margins on each unit sold). A low percentage of marketing costs to net revenues relative to other companies signals good efficiency of marketing expenditures (more bang for the buck), provided unit sales volumes are attractively high. However, a low percentage of marketing costs, if coupled Copyright 2009 GLO-BUS Software, Inc. Page 7

8 with low unit sales volumes, generally signals that a company is spending too little on marketing. The optimal condition, therefore, is a low marketing cost percentage coupled with high sales, high revenues, and above-average market share (all sure signs that a company has a cost-effective marketing strategy and is getting a nice bang for the marketing dollars it is spending). A low ratio of administrative costs to net revenues signals that a company is spreading its fixed administrative costs out over a bigger volume of sales. Companies with a high percentage of administrative costs to net revenues generally need to pursue additional sales or market share or risk squeezing profit margins and being at a cost disadvantage to bigger-volume rivals (although a higher administrative cost ratio can sometimes be offset with lower costs/ratios elsewhere). A higher operating profit margin (defined as operating profits as a percentage of revenue) is a sign of competitive strength and cost competitiveness. The bigger the percentage of operating profit to net revenues, the bigger the margin for covering interest payments and taxes and moving dollars to the bottom-line. The bigger a company s net profit margin (its ratio of net profits to net revenues), the better the company s profitability in the sense that a bigger percentage of the dollars it collects from camera sales flow to the bottom-line. The net profit margin is sometimes called return on sales because it represents the percentage of revenues that end up on the bottom line. The current ratio (defined as current assets divided by current liabilities) measures the company s ability to pay its current liabilities as they become due. At the least, the current ratio should be a bit greater than 1.0; a current ratio in the 1.5 to 2.5 range provides a much healthier cushion for meeting current liabilities. Credit rating ratios and measures Three of the four measures of creditworthiness are based on the numbers in your company s financial statements debt-equity ratio, the times-interest-earned ratio, and debt-payback capability. The fourth, percentage of credit line used, deals with the degree to which your company relies on or is dependent on debt to finance operations. How these four factors weigh in to determine your company s credit rating and overall financial strength is something you should fully understand. The following explanation of the four credit rating measures should prove helpful: The debt-equity ratio is defined as long-term debt divided by total shareholders equity both are reported on your company s balance sheet. This ratio indicates the extent to which the company s long-term capital has been supplied by creditors versus shareholders. A debt-equity ratio of.33 is considered good. As a rule of thumb, it will take a 4-quarter average debt-equity ratio close to 0.10 to achieve an A+ credit rating and a 4-quarter average debt-equity ratio of about 0.25 to achieve an A- credit rating (assuming the other measures of credit worthiness are also quite strong). Debt-equity ratios above 0.50 (or 50%) are generally alarming to creditors and signal too much use of debt and creditor financing to operate the business. The times-interest-earned ratio is defined as annual operating profit divided by annual net interest payments. Your company s times-interest-earned ratio is used by credit analysts to measure the safety margin that creditors have in assuring that company profits from Copyright 2009 GLO-BUS Software, Inc. Page 8

9 operations are sufficiently high to cover annual interest payments. A times-interest-earned ratio of 2.0 is considered rock-bottom minimum by credit analysts. A times-interestearned ratio of 5.0 to 10.0 is considered much more satisfactory for companies in the digital camera industry because of quarter-to-quarter earnings volatility over each year, intense competitive pressures which can produce sudden downturns in a company s profitability, and the relatively unproven management expertise at each company. It usually takes a double-digit times-interest-earned ratio to secure an A- or higher credit rating. Your company s debt payback capability is defined as the number of years it will take to pay off the company s outstanding loans based on the most recent year s free cash flow (defined as net income plus depreciation minus total dividend payments). Net income is shown on the company s Income Statement, companywide depreciation costs are shown on the company s Production Cost Report and annual dividend payments are shown on the Cash Flow Statement. The number of years to pay off the company s outstanding debt equals the amount of long-term debt shown on the Balance Sheet divided by free cash flow. A short debt payback period (less than 3 years) is a much stronger sign of creditworthiness and financial strength than a long payback period (8 to 10 years or more) Credit analysts also like to see companies using only a small portion of their credit lines over the course of a year (there s no problem of borrowing more heavily to finance the typically double production levels of the third quarter so long as most of these borrowings are repaid in the fourth quarter when the cash from high third-quarter sales is received). What troubles credit analysts most is a company that calls upon 50% or more of its credit line quarter-after-quarter, year-after-year and seems constantly on the verge of struggling to debt outstanding. Companies that utilize only a small percentage of their credit lines are viewed as good credit risks, able to pay off their debt in a timely manner without financially straining their business. A Word About Using the Cash Flow Statement Studying the quarter-to-quarter performance will help you understand why and to what extent the company s net cash flows swing from the positive to negative on a quarterly basis, especially going from Q2 to Q3 and from Q3 to Q4. You should see why it is normal for the company to have to draw against its line of credit in the third quarter and then when cash inflows escalate in the fourth quarter have the positive cash flows to pay back most or all of the third-quarter borrowings. Copyright 2009 GLO-BUS Software, Inc. Page 9