WIN FINANCE FOR LAWYERS Reading and interpreting financial statements Wednesday 25 February 2015 FINANCE FOR LAWYERS READING & INTERPRETING FINANCIAL STATEMENTS CHARLES BARNETT MARK MCCLUSKEY 25 FEBRUARY 2015 SESSION OBJECTIVES Demonstrate an understanding of accounting principles and understand how financial information is prepared Understand the composition of a set of financial statements, and be able to, at a high level, interpret a set of financial statements Understand the judgements or estimates that a preparer of a set of financial statements may have used and the impact these have By the end of today you should be able to AGENDA TIMINGCONTENT Introduction and Agenda 30 minsExplaining Accounting Principles 1 hourUnderstanding Financial Statements Composition 1 hourInterpreting Financial Statements Ratio analysis & KPIs Management estimates & judgements 10 minsWhat the future holds FINANCE FOR LAWYERS EXPLAINING ACCOUNTING PRINCIPLES ACCOUNTING: TURNING DATA INTO INFORMATION Accounting vs. book keeping Sources of requirements: EU and national law Accounting standards (UK GAAP & IFRSs) Rules vs. principles-based standards Underlying concepts and pervasive principles TYPES OF ACCOUNTING Accounting The process of identifying, measuring and communicating financial information which is useful for economic decision making Ultimately accounts provide a narrative on the performance and position of an organisation Management Accounting Provision of information for use within the organisation Financial Reporting Provision of information for external users mainly investors TYPES OF ACCOUNTING Management Accounting Internal use Designed to meet individual needs Both backward and forward looking Aids assessment of performance and facilitates planning Prepared regularly as needed Greater level of detail May be subject to internal audit in those entities that have that function and direction from management Financial Accounting External use Inflexible formats Regulatory compliance Historic: backward looking Aids assessment of performance and stewardship Annually prepared Some information aggregated Subjected to statutory audit (by external auditors such as BDO LLP) ACCOUNTING CONCEPTS How are financial statements created? Going Concern Prudence Separate entity Materiality Accruals RelevanceA true & fair view Understandable Consistency Substance over form WHAT ARE THE DIRECTORS RESPONSIBILITIES? In preparing these financial statements, the directors are required to: Select suitable accounting policies and then apply them consistently Make judgements and accounting estimates that are reasonable and prudent State whether applicable UK Accounting Standards have been followed, subject to any material departures disclosed and explained in the financial statements Prepare the financial statements on the going concern basis unless it is inappropriate to presume that the company will continue in business. FINANCE FOR LAWYERS FINANCIAL STATEMENT COMPONENTS PRODUCTION OF SET OF FINANCIAL STATEMENTS How are financial statements created? PRODUCTION OF SET OF FINANCIAL STATEMENTS How are financial statements created? In most clients, this will be performed by an accounting package Auditors will performing testing on this element and will raise audit adjustments Performed by the accounting function, FC, FD, CFO Approved by Board WHATS IN AN ANNUAL REPORT WHATS IN AN ANNUAL REPORT? Strategic Report Directors Report Report of Independent Auditors Directors Remuneration Report Corporate Governance Report STRGL / OCI Cash flow statement Profit & Loss Account / Income Statement Notes to the Financial statements Balance Sheet / Statement of Financial Position Statement of Changes in Equity UK GAAP AND IFRSs TERMINOLOGY DIFFERENCES UK GAAP Profit & loss account (P&L) Balance sheet Statement of total recognised gains & losses (STRGL) Turnover Interest payable Tax Fixed assets Debtors Creditors Creditors: amounts falling due within one year/ over one year IFRSs Income statement Statement of financial position Statement of comprehensive income Revenue Finance cost Income tax expense Non-current assets Receivables Payables Current liabilities/Non-current liabilities THE FINANCIAL STATEMENTS The primary statements Closing Statement of Financial Position (Balance Sheet) Financial position Solvency Available funds Opening Statement of Financial Position (Balance Sheet) Financial position Solvency Available funds Cash Flow Statement Liquidity Income Statement Performance Statement of Changes in Equity Transactions with shareholders Statement of Comprehensive Income Other gains and losses INCOME STATEMENT Note 000 Revenue4175,278166,517 Cost of sales(138,410)(131,579) Gross profit36,86834,938 Other operating income51,2831,203 Administrative expenses(9,164)(9,919) Distribution expenses(9,624)(10,101) Profit from operations619,36316,121 Finance expense9(584)(842) Finance income98251,491 Share of post-tax profits of associates Profit before tax20,56417,701 Tax expense10(2,782)(4,209) Profit from continuing operations17,78213,492 WHAT DOES A BALANCE SHEET TELL US? Shareholder Equity (i.e. what is owed to the shareholders as investors in the company) Assets to be utilised and safeguarded Liabilities and obligations incurred to date LESS Bottom half of balance sheet Top half of balance sheet EQUALS BALANCE SHEET A snapshot of the business at a particular point in time Balance sheet AS AT a particular date Provides a picture of the companys financial position What the company HAS less what the company OWES ASSETS - WHAT WE HAVE Right or other access to future economic benefits as a result of past transactions or events: Fixed Assets - Those held for continuing use in the business rather than for resale Current Assets - Acquired with the intention of use/disposal within a year ASSETS - EXAMPLES Fixed Land and buildings Plant and machinery Fixtures and fittings Motor vehicles Investments Current Stock (raw material, work-in-progress, finished goods) Debtors (trade, other, prepayments, accrued income) Short-term investment Cash at bank Cash in hand LIABILITIES - WHAT WE OWE An obligation to transfer economic benefits as a result of past transactions: Current liabilities - Amounts due for payment within one year Long-term liabilities - Amounts due for payment after more than one year Categorised by the Companies Act as Creditors LIABILITIES - EXAMPLES Current Bank overdraft Trade creditors (Owed for purchases) Accruals Lease payments/loan repayments due within one year Long-term Debenture loan stock Mortgages Lease payment/loan repayments due after more than one year BOTTOM HALF OF BALANCE SHEET CASH FLOW STATEMENT Areas of focus FINANCE FOR LAWYERS INTERPRETING FINANCIAL STATEMENTS WHO MIGHT READ THE ANNUAL REPORT AND WHY? Directors / Management Competitors Regulators (CRRP) Providers of finance Employees Shareholders Government (Tax) Lawyers Suppliers USING RATIOS Types of ratios WHY ARE RATIOS USEFUL?TYPES OF RATIOS 1. Identification of trends 2. Quick measurement 3. Overcomes problems of scale 4. Easy to calculate 5. Used with sector knowledge Profitability Efficiency Liquidity Investment/Gearing EXAMPLE RATIOS CONSIDER KEY PERFORMANCE INDICATORS (KPI) Performance -Turnover growth | Like for Like -Gross | operating | net margin -Earnings before interest, tax & depreciation (EBITDA) -Profit to cash conversion -Return on capital employed -Sector specific Interaction with financial covenants -Interest cover (EBITDA / Finance cost) -Senior debt cover (Net debt / EBITDA) -Cash flow available for debt service (CFADS / Finance cost) UNDERSTANDING THE BUSINESS Different focus? INCOMECAPITAL Performance Margin | EBITDA Working capital Operating - Retail, Professional service, Leisure & Hospitality Position Return on capital employed Gearing Leveraged - Real Estate, Natural Resources, Financial Services MANAGEMENT ESTIMATES & JUDGEMENT Impact of: Accounting principals: -True and fair -Substance over legal form Preparation of financial statements: -Post trial balance adjustments -Judgement areas Management motivations: -Attitude / perception of risk -Remuneration income or capital growth -Covenant headroom -Business aspirations Impact on the financial statements EXERCISE Working in your tables, consider the set of financial statements provided and discuss: What areas of the financial statements would you be interested in? What ratios or KPIs do you think are relevant? What levels of management estimate or judgement are included in the financial statements You have 15 minutes for this activity Understanding the business WHY DO PROFITABLE COMPANIES FAIL? Lack of cash CASH IS KING Surpluses do not equal cash Accruals Prudence Accounting non-cash entries (eg depreciation) Cash entries not recorded in the P&L (eg purchasing fixed assets). Does an entitys cash flows arise evenly over the year? AREAS OF POTENTIAL JUDGEMENT Keeping the cash moving Stock holding period Credit period given Credit period taken Buy inventory Pay our supplier Sell stock/ inventory Cash received from customer Funding period INDICATORS OF OVERTRADING Finance available cannot support level of trading Results indicate liquidity problems Current ratio declines Higher debtor days Higher creditor days Lower stock days Trend analysis relative to competitors/market What could tell us something is wrong? FINANCE FOR LAWYERS WHAT DOES THE FUTURE HOLD? THE SHAPE OF THINGS TO COME New UK GAAP Narrative reporting Directors report Strategic report Corporate governance (Going concern) Audit reporting (ISA 700) Changes to IFRSs Leases Revenue Financial instruments Recent and up-coming changes SESSION OBJECTIVES - REMINDER Demonstrate an understanding of accounting principles and understand how financial information is prepared Understand the composition of a set of financial statements, and be able to, at a high level, interpret a set of financial statements Understand the judgements or estimates that a preparer of a set of financial statements may have used and the impact these have By the end of today you should be able to THANK YOU Any further questions please contact us CHARLES BARNETT Partner Audit t: +44 (0) e: MARK MCCLUSKEY Director Audit t: +44 (0) e: WIN FINANCE FOR LAWYERS Reading and interpreting financial statements Wednesday 25 February 2015