Analyzing Financial Statements with Cindy Moorhead
Michael Platt: I want to thank everyone for joining us today. We are privileged to be joined by Cindy Moorhead, President of Moorhead Management Systems.
Cindy will be sharing with us her ideas on helping clients understand financial statements. And will also get us all to look at helping clients look at their customer’s numbers as well.
Cindy, the floor is yours....
Cindy Moorhead: Thanks Mike.
What I do is try to help my clients understand the financial trends on financial statements. When doing that I look at the year-to-year financial ratios as well as compare ratios to industry standards. Many times, the financial ratios will lead to additional questions that my clients can ask their customers about the financial activity of their company.
I think that looking whether you are looking at your client’s trends or your client's customer trends, you can be help them understand the same types of things. For instance, if you are looking at the inventory turnover trends. If inventory turnover is slower than what is normal in the industry averages, you might want to talk about what improving trends could mean in terms of dollars. If you are looking at your client's customer's statement and the customer is paying slowly and it seems like the inventory trends are slow, you might want to try to understand why.
Does everyone understand what can impact inventory trends? Possibly slow trends could be caused by old inventory. But slowing of inventory turns could also be caused by changing of product mix.
Michael Platt: What are some of the areas you have found that have the most impact?
Cindy Moorhead: I think the biggest areas to understand are the days receivables outstanding, the inventory turnover, the total debt to equity, the days payables outstanding and the income statement sections (such as gross margin).
David Balovich: Cindy how does valuation of the inventory play in determining whether the ratios from one year to the next are accurate?
Cindy Moorhead: If the company does not value their inventory accurately, it will throw the ratios off from year to year. If they undervalue their inventory one year, it will show faster turns. If they overvalue their inventory the next, it will slow down their turns...incorrectly. If a company has unaudited financial statements and you see swings in inventory turns, this could be one of the causes of the swings.
Ken Merwin: Cindy - I'm looking for good resources to share with Accounting students...as regards small business financial statement analysis...any leads?
Cindy Moorhead: Are you looking for resources on the Internet?
Ken Merwin: Yes...
Cindy Moorhead: Have you looked at my site?
Ken Merwin: Yes, just before we started so saw some things to revisit. Thanks.
Cindy Moorhead: There is also a company (you can send me an email and I'll track down) that has a free book on analyzing financial statements.
Michael Platt: Anyone else have any ideas on financial statement analysis websites??
Cindy Moorhead: I also just saw a note on an accounting discussion list that mentioned some analysis web sites. Send me a note and I can forward that information to anyone.
Michael Varisco: Cindy, how do you determine what ratios to include in an analysis?
Cindy Moorhead: I have a standard template that I use when I do my analysis. I look at this set of ratios and look for anything that is showing swings or is not in alignment with industry standards then I try to figure out why that is happening. What is different about this company to make this ratio trend up or down, or why is this company's ratio different than industry standards.
Wes Hammad: What is the most important part of a long-term forecast?
Michael Varisco: And how do you determine what the problems are?
Cindy Moorhead: It's a matter of digging.
Michael Platt: Some examples please Cindy...
Cindy Moorhead: Example: standard terms from vendors are 30 days. I see a days payables outstanding ratio of 60 days. But the customer is paying my client on time. I try to understand why.... I either pose the question to my client or (depending on the situation) call the customer on behalf of my client and start asking questions...are they getting extended terms from any of their suppliers?
I may recommend that my client make sure that they have current references on their customer. Variances in financial ratios will raise questions...they don't always answer the questions.
Wes Hammad: Do you start with analyzing sales & Cost of Goods Sold when you forecast the income statement?
Cindy Moorhead: Wes - what are you meaning when you say forecast the income statement? I usually analyze the income statement...I also, from time to time, review forecasted statements.
Cindy Moorhead: When I analyze an income statement, I do look, first at sales trends. Are the sales going up or down and how much.
Wes Hammad: Sometimes, an unrealistic sales figure causes the rest of the projections to be of questionable value.
Wes Hammad: Going up.
Cindy Moorhead: Yes, Wes...you are very correct. If you are analyzing forecasted statements, the sales basis is very important to understand. That is the key that builds the rest of the statement. What I do is look at any past history that I have. Many times I analyze retail stores.... I look at other store locations. I ask questions on how they came up with their basis for determining the sales levels. I try to make educated guesses on whether their sales levels makes sense. Many times I will ask my client to confer with their sales dept on whether those sales levels in that specific market makes sense. Then I look at the gross margins on sales forecasts.
Michalson, Matt E: How would you go about forecasting for an untested market with no past history?
Cindy Moorhead: That's a challenge. ...It involves making educated assumptions. What are similar markets doing? What is the competition in this market? I think the key is to try to decide what factors you do know and how you can make assumptions based on these factors.
Michalson, Matt E: We are all pretty brand new.
Michael Varisco: Cindy, are there any resource materials I can use to find out who the customers and suppliers of my customers are?
Cindy Moorhead: Ask them....
Michalson, Matt E: Which factors would you recommend?
Cindy Moorhead: Communicate with your customer...ask them who else they are buying from...who are their major vendors. Ask them who their largest customers are.
David Balovich: Michael, Dun & Bradstreet offers marketing information that will identify your customer’s suppliers.
Michalson, Matt E: Thank you both.
Cindy Moorhead: Excellent, David.
Some more samples of things that would stick out to me. If a company has a total debt to equity ratio of, say 3 to 1, find out what is going on. Are they making acquisitions which would cause their debt levels to be high? Talk to your customer and find out what sort of financing arrangements they have.
Michael Varisco: What do you consider to be the best way to calculate cash flow?
Ken Merwin: Cindy, Michael: I teach my students that cash flows statement is perhaps the most important; they learn about it even in first semester accounting.
Wes Hammad: Why banks closely examine the validity of the company's assumptions, making adjustments to the company's forecast statements as deemed necessary?
Cindy Moorhead: When I look at the statement of cash flow, I look at the major sections of it and try to understand the big picture of where the cash has come from and gone to. What is the cash provided by/used in operations, how much is spent on the purchase of fixed assets, how much is the pay down of loans (or increased borrowings, and did they pay dividends or have other type of equity activity). Many times I will start with the statement of cash flow to get a big picture activity of the company and then go to the other ratios...
Cindy Moorhead: Wes had a comment on the banks closely examining the validity of a company's assumptions and making adjustments. I think that makes perfect sense if they deem a company's assumptions are not conservative. Banks, when lending money, would want to look at the forecasts in a conservative manner. The forecast is meaningless if you don't understand the assumptions behind them.
Wes Hammad: Thank you Cindy
Michael Varisco: What are the ratios YOU use for cash flow?
Cindy Moorhead: Michael - I'm not quite sure of your question, but I do not use specific ratios for cash flow. My process is to look at the cash flow statement (if received) and analyze ratios on the balance sheet and income statements.
Michael Varisco: What I mean is, in your analysis, how do you explain cash flow to your customers?
Cindy Moorhead: I explain cash flow by discussing the big movements on the cash flow statement. You can explain to your clients how to improve their own cash flow by looking at specific ratios, like inventory turns or Days Sales outstanding, you can talk about improving these turns and how that can impact cash.
Ken Merwin: Cindy: Do you find that many accountants don't even understand the cash flows statement....particularly the newer staff?
Cindy Moorhead: Ken - each accountant is different. My background is that I used to prepare all of the cash projection and analysis, so I used to live it constantly. Everyone's background is different and their exposure to really understanding the impact of activity on cash is different. Does that make sense?
Ken Merwin: Yes, thanks. As I noted I really push my students to understand the importance of cash flows and to move beyond the basic Debit/credit stuff as quick as possible.
Cindy Moorhead: All company activity evolves around cash.
Michael Varisco: When writing an analysis, I typically use a 4-year spread of financials. Can I get enough trends from 4 years of financials?
Cindy Moorhead: I think so. I think you can get some idea from just two years, but the more years you can get the better.
Michael Platt: Cindy: What are some opportunities for accountants helping their clients understand THEIR customer's financial statements? How have you seen this level of financial statement analysis improve the CPA-client relationship?
Stuart Jones: I prepare a very simple cash flow statement for clients, having explained why they need cash rather than profits, and then place the known figures (capital repayments on loans etc.) in next years forecast and help the client fill in the gaps. I find
this helps the client understand what is required of them and their business.
Cindy Moorhead: That is excellent Stuart. One thing I have heard from people is that their accountant hands them their financial statements and never really explains what it means... I think that this is one area where CPA's can really provide extra benefit to their clients. Help them understand what their trends are....don't just hand them a sheet of paper. Go through things like inventory trends....tell them what they can do to improve their inventory trends and what, in terms of additional cash, improving a trend would be.
Stuart Jones: Thanks. It works and usually leads to more work for my firm.
Jacques Delisle: Do you use any software to do the number crunching on the ratios or graphs? We tried software called CA Analyst and we found it was not very useful.
Cindy Moorhead: I have thought of using canned software, but, truthfully, I find that excel spreadsheets works best for me.
Ken Merwin: Cindy: I stress value-added even for the staff; if they can not only prepare but articulate what the #'s mean they have to be worth much more than someone who can just crunch the #'s.
Cindy Moorhead: I agree Ken.... There is also software out there that spit out the ratios, but what is important is understanding what the ratios are saying about the company.
Mike Sheehan: When should an unsecured creditor be concerned that sales to working capital is too high?
Michael Varisco: We use Winfast, not only does it do the spreads, it also compares them to RMA averages.
Stuart Jones: I "sell" the idea of cash flows rather than profits to banks and find they like the emphasis as well as clients. It's good for referrals.
Ken Merwin: What are RMA averages, Michael?
Michael Varisco: Ken, RMA puts out an Annual Statement Studies guide each year that you can use to compare a companies financials and ratios to others just like around the nation.
Cindy Moorhead: Robert Morris Associates. They compile industry standards based on a database of financial statements.
Michael Platt: We've got just a couple of minutes remaining. Are there any other specific questions that anyone would like Cindy to address while we are together?
Ken Merwin: Thanks; sounds like a good resource.
Cindy Moorhead: The industry standards are segmented by SIC code. And by asset size.
Ken Merwin: Ok, SIC code would be the way to organize. Something else to teach my classes!
Jacques Delisle: Thanks sounds great, but are these RMA useful when dealing with small to medium sized businesses?
Cindy Moorhead: They give you ball park figures. For instance, they compile what the inventory turnover would be for like size companies. That doesn't mean they are gospel...it just gives you an idea if your client is in line. Say inventory turnover is 10 for the industry standard and your client's ratio is 3. You might want to try to understand why...But if your client's turnover is 9, then they are probably in the ballpark.
Michael Platt: The hour is just about up now -- you are welcome to remain on with Cindy for as long as she has available, or call her at 608-486-4497. I want to thank everyone for joining us in today’s workshop. We will be posting the transcripts on the site later today that you can go back and reference later. Please be sure to visit Cindy’s website at www.moorheadmgmt.com and sign up for her email newsletter. Cindy, we really appreciate your participation in today’s workshop. On behalf of everyone, THANK YOU! Cindy -- the last word is on you.
Cindy Moorhead: Thank you to everyone who attended. I hope you all found some value in our discussion.
Michael Varisco: Thanks to everyone for the info today!
Michael Platt: Reminder: If you would like to be alerted to future workshops, be sure to UPDATE YOUR PROFILE using the link on the navigation bar on the left.
Stuart Jones: Thanks Cindy, very useful.
Cindy Moorhead: Good...anyone with other questions, feel free to email me privately...I'd be more than happy to talk with you.
Michael Platt: Thanks Cindy. GREAT JOB!!
Cindy Moorhead: Thank you for having me.