May 19-22, 2014, Toronto ON Canada Understanding Balance Sheets & Financial Statements Oh My Presented by Frederick J. Esposito, Jr., CLM FM43 5/22/2014 3:30 PM - 4:30 PM The handouts and presentations attached are copyright and trademark protected and provided for individual use only.
Association of Legal Administrators 2014 Annual Conference & Exposition FM-43:Understanding Balance Sheets & Financial Statements Oh My! Presented by: Frederick J. Esposito, Jr., CLM Chief Financial Officer Rivkin Radler, LLP Thursday, May 22, 2014 3:30pm 4:30pm "In the beginning God created man...and the costs followed afterwards." - Unknown -Mark Twain
Why Understand Financial Statements? Understand your law firm better Use financial statements to improve business performance Make informed decisions on fact not fiction Assess the financial health of your firm Make it easier when applying for finance or refinancing of firm loans Generally Accepted Accounting Principals GAAP starts with a conceptual framework of standards that anchor financial reports to a set of principles, (such as materiality the degree to which the transaction is big enough to matter) and verifiability (the degree to which different people agree on how to measure the transaction) The basic goal is to provide users law firm management, investors, creditors, with information for making good decisions
Financial Statements Overview Balance Sheet Statement of financial health of the firm Income Statement Statement of profitability of the firm Statement of Cash Flows Statement of movement of cash flows in the firm Balance Sheet What is it? Asset Items of value owned by the firm Create future cash flows Liabilities Firm financial obligations that act as a source of support for the assets Require future cash flows Equity The amount owing from the firm to the shareholders or partners Another source of support for the assets Assets Liabilities = Equity
Balance Sheet What is it? Assets Examples Cash Accounts receivable Investments Prepaid expenses Equipment Notes receivable Current vs. Noncurrent Current Firm expects to convert to cash within one year Noncurrent Firm does not expect to convert to cash within one year Balance Sheet What is it? Liabilities Examples Accounts payable Accrued expense Deferred revenue Lines of credit Notes payable Current vs. Long-term Current Firm expects to pay off within one year Noncurrent Firm obligations with maturity dates greater than one year
Balance Sheet What is it? Equity Calculated as follows: The amount owners invested (+/-) Any additional contributions from owners (-) Any distributions or withdrawals made by owners If the above calculation is negative, the Firm will have a deficiency instead of equity Balance Sheet Classifications Current Assets All assets will be turned into cash within one year Current Liabilities All firm obligations that have to be repaid within one year Non Current Assets All assets other than current assets Non Current Liabilities All firm obligations other than current firm obligations
Assets = Liabilities + Equity
Balance Sheet Why Do We Care? The Balance Sheet provides law firm management with on the financial statement Quick Observations! Generally, if firm assets are large relative to liabilities, Conversely, just as you would be cautious loaning money to a friend who is burdened with large debts, a law firm with a large amount of liabilities relative to assets should be reviewed more carefully Balance Sheet - Example assets, liabilities and equity on that date
Financial Statements Income Statement -What is it? over a specific time frame and presents information about the revenues, expenses and profit that was period Components of the Income Statement include: Revenue How much the firm earned Expenses How much the firm has spent Net Income BEFORE and AFTER Tax (Profits of the firm) Income Statement Why Do We Care? The Income Statement answers the questions: Firms with low expenses and high profits relative to revenues are typically more desirable for investment because bringing in more dollars directly benefits the shareholders or partners
A Word About Profitability Profitability is a subtle and complex concept standards Your Law Firm Sets That Standard! Income Statement Take a Helpful Hint! Law Firms should regularly produce income statements and if not, WHY!
Income Statement Example An income statement as of 12/31/2010 represents the Financial Statements Cash Flow Statement Introduction Cash Flow Statement Very Important! Provides information about cash receipts and payments and provides information of cash on the basis of operating, investing and financing activities Ties All Three Basic Financial Statements Together!
Financial Statements Statement of Cash Flows The statement of cash flows represents a record of period of time It is the most intuitive of the statements and focuses on the following cash related activities: Operating Cash Flow Cash from Investing Cash from Financing It is very difficult to manipulate cash position; cash in the bank! Statement of Cash Flows Why Do We Care? The statement of cash flows is very important because it shows how much actual cash a law firm has generated The statement includes non-cash expenses, which the statement of cash flows excludes generate cash Shows movement of cash in the firm Can indicate if the firm is drawing too much cash!
Statement of Cash Flows Why Do We Care? statement but struggled later because of insufficient cash flows How is that possible? Profit without Cash?? Financial Statement Analysis Distinguish Profit from Cash Flow Remember - Income Statement shows Profit/(Loss) Profit/(Loss) does not show cash flow from profit making activities/performance Cash flow can be considerably higher than profit or considerably lower Cash flow can be negative when there is profit and vice versa There is no correlation between profit and cash flow
Financial Statement Analysis Distinguish Profit from Cash Flow What accounts for the cash flow differences? Depreciation expense is not a cash outlay in the period recorded; the cash outlay took place when the fixed assets being depreciated were acquired some years ago Total cash outlays for other expenses were $165K lower than the amount of expenses recorded earlier in the year Financial Statement Analysis Distinguish Profit from Cash Flow What accounts for the cash flow differences? Every Situation Can Be Different! -Suppose A/R remained flat? Cash flow would have been $100K higher. Need to monitor changes in the assets and liabilities that impact cash flow from profit.
Statement of Cash Flows Example A Statement of Cash Flows as of 05/31/2010 Financial Statements Bringing It All Together The three financial statements are all related The changes in assets and liabilities that are seen on the balance sheet are also reflected in the revenues and expenses that are seen on the gains or losses Cash flows provide more information about cash assets listed on the balance sheet and are related, but not equivalent, to net income shown on the income statement. No One Financial Statement Tells the Whole Story!
Financial Statements Reconciled Financial Statements Now What? Balance Sheet Statement of financial health of the firm Income Statement Statement of profitability of the firm Statement of Cash Flows Statement of movement of cash flows in the firm
Financial Statements The Benefits -Financial Statement Ratios Liquidity Ability of the law firm to pay bills as they fall due Solvency Ability of the law firm to meet all debt obligations Profitability Measure law firm performance and success of operations Balance Sheet How efficient the law firm is using assets and equity Financial Statements The Benefits -Financial Statement Ratios Liquidity Ratios Current Ratio Measures Financial Strength; the higher current ratio indicates the higher capability of a law firm to pay back its debts Quick Ratio Current Assets/Current Liabilities with its most liquid assets; higher the ratio, the better the position of the firm (Current Assets+AR+Short-term Investments) Current Liabilities
Financial Statements The Benefits -Financial Statement Ratios Solvency Ratios Leverage Indicates the degree of financial leverage being used by the law firm and includes both short and long term debt; rising ratio implies higher interest expenses; can more expensive to raise more debt Total Liabilities/Equity Debt to Asset Percentage of assets being financed by liabilities; higher the ratio, the higher degree of leverage and consequently, financial risk Total Liabilities/Total Assets Financial Statements The Benefits -Financial Statement Ratios Profitability Ratios Net Margin Percentage of firm revenues remaining after all expenses; generally 35-45% on average The higher the percentage, the more efficient the law firm is at concerting revenues to profit Net Profit/Firm Revenues
Financial Statements The Benefits -Financial Statement Ratios Balance Sheet Ratios Return on Assets How profitable a law firm is relative to its total assets; provides an indication as to how efficient management is at using its assets to generate earnings Net Income (Net Profit Before Taxes)/Total Assets Return on Investment Percentage of assets being financed by liabilities; higher the ratio, the higher degree of leverage and consequently, financial risk Total Liabilities/Total Assets Financial Statements The Benefits -Financial Statement Ratios Balance Sheet Ratios Return on Assets How profitable a law firm is relative to its total assets; provides an indication as to how efficient management is at using its assets to generate earnings Net Profit Before Taxes/Total Assets Return on Investment Measures the return on equity in the firm Net Profit Before Taxes/Total Equity
Financial Statements The Benefits -Financial Statement Ratios Other Ratios to Consider Debt to Equity leveraging; indicates the proportion of equity and debt used by the firm to finance its assets Total Liabilities/Total Equity Return on Equity Amount of net income returned as a percentage of equity; return on equity estimates the profitability of a firm by revealing the amount of profit generated by the firm with the cash invested by the owners Net Income/Total Equity Financial Statements/Analysis Take Another Helpful Hint! Financial ratio analysis will provide the all important business and financial problems before they destroy the firm
Financial Statements Two Financing Options: Debt Borrowing money, typically in the form of a loan from a bank or other financial institution to fund the Equity Bringing in investors or partners or shareholders who provide capital in exchange for a share of ownership in the firm me and I forget. Teach me and I remember. Involve me and I -Benjamin Franklin
Questions Thank you!