Financial Statements for Dummies

Financial Statements for Dummies

As a Chartered Accountant in public practice, I have provided assurance on approximately 500 sets of financial statements over the last 10 years. In the process, I have analyzed statements to assess the ongoing viability of different businesses and I have seen what happens when companies fail to act on what their statements are telling them. I will try to sum up the most valuable points of financial statement analysis in this “Financial Statements for Dummies” blog.

Financial statements are typically prepared for a 12 month period. They provide a record of all the transactions that occur during that period, including the payment of related income taxes. There are adjustments to reflect transactions that occur with no cash transacted.

First Step – level of work:

The first thing you should do when you look at a set of financial statements is check if the company in question was audited or reviewed. This information should be clearly stated on the report that accompanies the statements. If there is no report with the statements, you can assume the statements were not audited or reviewed and therefore, there is no objective party providing assurance that the statements accurately reflect the company’s operations.

When accountants conduct a review engagement, they assess the ‘plausibility’ of the financial statements through analysis , inquiry and discussion. An audit includes the same analysis, inquiry and discussion, plus additional substantive work and review of controls to assess the ‘reasonability’ of the financial statements. An audit provides a higher level of comfort that the financial statements fairly represent the company’s operations and it is the standard for public companies , whereas a review provides a lower level of assurance.

Take a close look at the review or audit report to make sure the company has an unqualified opinion, meaning that the external accountant performed their work and the statements are not materially misstated.

Second Step – accounting standard:

The next item I would review is the basis of accounting meaning what accounting standard is the company following. In Canada, private companies will typically be using Accounting Standards for Private Entities (ASPE) for December 31, 2011 year-ends going forward and public companies will be using International Financial Reporting Standards (IFRS). The basis of accounting is important because if you are comparing two sets of financial statements, you want to ensure the accounting policies are the similar.

Also pay close attention to the financial statement notes. Look for issues such as Going Concern, Risks and Contingencies as any one of these can allude to significant issues in the company.

Third Step –analysis:

I have learnt over the years that users look at financial statements for different reasons and therefore different parts of the financial statements are important to each of us. Financial statements are generally prepared for general use to allow for different user requirements. As a result, in preparing this article, I will touch upon some of the more common areas of financial statement analysis.

Comparative analysis
This is an amazing tool if used correctly. Comparing sales, expenses or other balance sheet items year over year can identify many critical issues. Be careful to look at the year over year dollar change as well as percentage change. The dollar change may look small, but percentage-wise it can be significant. For example, if your gross profit (revenue less cost of sales) decreases from 12% to 10% the following year, it may seem like an insignificant 2% change year over year. In reality, the gross profit has decreased by 17% (2%/12%) year over year. This seemingly small change can be indicative of significant issues such as fraud, rising input costs that are not being passed on the customer, downward pressure on prices which is shrinking your revenue or a host of other issues.

Ratio analysis
Financial statement ratio analysis can be used to evaluate a company’s liquidity, efficiency, long-term solvency, profitability and more.

Liquidity ratios look at a company’s ability to meet its short-term obligations. The current ratio looks at current assets : current liabilities. A current ratio below 1 means that the current liabilities exceed the current assets. Clearly this is not good and it could indicate that the company will have trouble meeting its liabilities.

Inventory turnover is used to assess a company’s efficiency. It can tell you how many times inventory is turning over and how long inventory is sitting on the shelves. The longer inventory sits, the longer it takes for the company to make money. The same goes for accounts receivable (AR) turnover, if AR turns over twice per year, it essentially means it takes about half a year to collect AR.

Ratios can be compared year over year or compared to some industry standard. If the ratios are drastically different from one year to the next, or if they are different than the norm for the industry, you need to find an explanation.

Net worth
The net worth of a company is the assets minus the liabilities and it represents what is left for the owner once all assets are liquidated and liabilities are settled. This is an area that is commonly looked at in a purchase and financing arrangements.

Cash flow statement
The cash flow statement provides details as to where cash was used and received throughout the year, and if analysed correctly, can uncover significant matters. For example when reviewing the cash flow, you may see large non-cash items received throughout the year. In this situation the income may look great, but if much of the income was non-cash, it may have no real benefit to the company.

Fourth Step –Intangibles:
The financial statements may include items that are considered intangible, i.e. goodwill, leasehold improvements or intangible assets. Often times these assets are ignored by the banks and outside investors because they carry no tangible value, are not readily saleable and are typically part of an overall valuation of the company.

In conclusion, financial statements can be very useful if you know what you are looking for. If your objectives are simple, then the review of the financial statements can be as quick as just looking at the net income and moving on, but if your objectives are more involved, then following the process above would be appropriate.

-- David Hertzog

Choosing the right advisor

Auto dealerships and major sports franchises have at least one thing in common: for both, building the right team is essential to success. When everyone in your dealership is on the same page the business runs smoothly, opportunities are identified and exploited and you achieve optimal business performance. Internally most dealerships are structured with managers of individual departments reporting to a general manager who then reports to the president/owner, but team work goes far beyond the internal structure. There are outside advisors who are part of your extended team, such as your banker, lawyer and accountant. This extended team works on your behalf with your best interest in mind.

So how do you choose the right advisors? A good place to start is referrals from contacts who share your values and operate in a similar business environment. The advisors for your best friend’s online cupcake shop may not be well-versed in the world of car dealerships. Once you have some relevant recommendations, the next step is to schedule a meeting with the prospective advisor. Think of the initial meeting as a job interview; you are interviewing the potential advisor as much as he or she is interviewing you. Key elements that you should evaluate in an advisor are: your degree of comfort with the advisor, the advisor’s knowledge, and size of the advisor’s practice.

How do I relate to this advisor?

When you are meeting a potential advisor, be it a banker, lawyer or accountant; think about whether you could see yourself in a long term relationship with them. You are embarking on a marriage of sorts and divorce is tedious and painful. The more time you spend getting to know your advisor, the less likely it is that you will need to change advisors later. The two most important questions you need to ask when considering how you relate to a potential advisor are: 

1. Would I be comfortable communicating anything to this person? 
2. Would I trust them to tell me the truth? 

Your advisors have specialized knowledge, but they cannot provide effective advice without knowing the entirety of your situation. Would you be comfortable telling your advisor about business failures? A rough spot in your marriage? Sticky situations with your employees or children? Your relationships with your family and employees can play a role in your succession plan and other planning strategies and, in order to take full advantage of your advisor’s knowledge and expertise, you must be able to talk about them. Through face to face meetings, you can quickly get a sense of how genuine the advisor is and if your personalities sync.

Your advisor shouldn’t be the person you turn to for flattery. While your advisor may pay you a compliment from time to time, it is important that he or she is honest and straight forward. You want someone who will tell it to you like it is, take time to explain your options and consequences, and provide an opinion. You also want someone who is available to answer any questions you may have throughout the year. You shouldn’t be scared that your advisor will charge you for simple questions. Your advisor is a member of your team.

Does this advisor understand my business?

Your advisor should be knowledgeable and passionate about dealerships and the auto industry as well as all the laws, standards and regulations that affect your industry. Knowledge of business is key in providing the best service and opinions to clients.

During your interview with a prospective advisor you may want to ask them how many auto dealership clients they currently work with, how long they’ve been working with dealership owners and ask them how they feel about a recent industry development. An advisor who is passionate about dealerships would be more than happy to talk shop with you and you would quickly learn how well they know your business.

Does size really matter?

We all know that fit matters more than size, and it is no different with advisors. In the professional world there are small, medium, and large firms and each has advantages and disadvantages. Many people gravitate towards larger firms as they are familiar with the brand which creates a degree of comfort, however brand names typically come with premium price tags.

Consider the size of your business compared to the firms you are considering. If you will be a relatively small fish in that firm’s pond of bigger clients, you may experience better service with a firm that caters to businesses of your size. Mid-size firms may offer a different customer service experience because your business fits their niche. You may even find yourself in the fortunate circumstance of being a big fish in a mid-sized firm’s portfolio which can lead to better customer service and a greater investment in your business.

Auto dealership owners have a niche business, and there are firms that specialize in your industry. They can provide a competitive advantage over other practices as they are more knowledgeable about your business and can therefore offer more useful advice due to their experience.

Running a dealership is complicated; having advisors who understand your business is essential for making critical decisions.

-- Bryan Redinger

Service department let down!

I am going to talk about poor service I have both witnessed personally and heard about from family and friends to make recommendations that can help dealers be more competitive and successful. Many dealerships offer excellent service, so the recommendations below will not apply to everyone.

I have been a car owner for over 33 years and I have had a lot of experience dealing with auto dealership service departments. Years ago there were lots of options for car repairs, but the small auto repair shops located at local gas stations have been disappearing for the past decade and now dealerships are the most common choice for repair work. This is a fortunate circumstance for dealerships because the service department usually provides significant margins, but given the level of service I’ve seen lately, I wonder if some dealers aren’t taking this shift for granted.

Over the past 15 years or so I have switched from purchasing cars to leasing them, and consequently I moved my repairs from a local garage to the automobile dealership. I’m not your average Joe at a dealership waiting for repairs. I’ve been working with dealers for many years and I know what drives their bottom line, and I can tell you that service departments deserve more attention at some dealerships.

Recommendation 1 – Get customers in and out as efficiently as possible.

Service is a volume business meaning that a dealership needs to service a lot of customers to see good returns. Dealerships need to be prepared for high volume, and usually they are. I never just show up at a dealership for repair work. I call the day before, secure a time that works and make sure that I am not late for the appointment. And still, sometimes I have to wait a long time before anyone greets me and starts the service appointment. In a volume business, every customer counts. And, in the auto service business, which is a necessary evil to most people, making a customer wait is painful. They don’t want to be there and even though there is coffee and newspapers, they generally have something better to do. Your service department will take care of servicing cars, but you also need to make sure someone is servicing the customer. If your customer is going to wait for their car to be serviced, be sure to keep them informed if your promised delivery time changes. Have a dedicated employee greet and acknowledge incoming customers. Take their keys and let them go as soon as possible.

Recommendation 2 – Don’t make promises you can’t keep.

On countless occasions I have been promised that my car would be ready in an hour only to be let down when it wasn’t ready for 90 minutes. I understand that things can get hectic in the service bays, and there are unexpected situations and a million reasons for a service delay, but your customer doesn’t care. So, in all circumstances, recommend that they take advantage of your shuttle service or take a loaner and leave their car with you. It will take some stress off the service department because they will have more time with the car and it will avoid a situation where you are likely to upset the customer.

Recommendation 3 – Go the extra mile.

I can’t tell you how many times I have heard of people having to wait for their car because they were out of bounds for the service shuttle. This isn’t a pizza delivery service – these customers are paying you hundreds of dollars for a painful, mandatory service that offers them little personal value. Go the extra mile, literally, and do your customers a favour. They’re paying you for it and they’ll continue to pay you for it in loyalty and recommendations to their friends and family.

Recommendation 4 – Hire the right people and train and reward them.

Service staff can have attitude because they are rude or overworked and dealing with the customer takes them away from the long line of cars demanding their attention. You certainly don’t receive this type of service when you enter the sales area of the auto dealership. I know that the service department is a key profit center for the auto dealership, so why is there such disparity in the service provided in the service department? Your service department needs to service the customer as well as the car. Attention to customer service should be considered during the hiring process; is this person technically proficient and well-mannered? Would I want to introduce this person to my most valued customers? Once you’ve hired the right people, have you told them what you expect and trained them on how to deal with a long line? A frustrated customer? Have you rewarded them when you witnessed good behavior? You need to tell your employees what you want and reinforce it with monitoring and rewards.

Recommendation 5 – Walk the floor.

I believe the problem with service really rests at the top. Auto dealer owners are not spending enough time training, educating, rewarding and monitoring their service employees. When is the last time you walked the floor? Did you notice the bored customers flipping through the newspaper in the service department? Did you ask them about their experience? Did you watch your service department interact with your customers? Your attention to service will communicate volumes to your staff.

So, while dealerships are in the glory days of service with less competition from mom and pop shops, don’t be lulled into complacency. Chains of aftermarket service shops offer “Warranty Approved” services that threaten the dealership’s hold over the leased car maintenance market. In addition to threats from aftermarket shops, you can lose customers to the next dealership over when they start to shuttle to and from your area, promptly greet customers as they walk in and generally make service as painless as possible. The profits your dealership gains from service are far too precious to take a back seat.

-- Jeff Carbell

Capitalizing my business?

Outside of tax planning and operational issues, how to better capitalize is one of the most common discussions I have with my auto dealer clients. Clearly one of the better ways to capitalize your business is by way of retaining internal cash flow in the business, but often this is not possible and as a result the owner must entertain offers for external financing. I have found that obtaining new financing and re-financing existing credit facilities is much more challenging as a result of the recent economic downturn as banks are more risk averse, especially in the auto retail business.

It is still possible to obtain financing in today’s market, but a well-structured plan is in order. The plan should consist of a strategic message to the bank as to why the financing is required and how the funds will be used. If the financing is simply to fund current and prior year losses, it is more likely than not that the bank will decline. However, if the funds are used to purchase additional inventory, pay off previous management or acquire new equipment, the bank is more apt to provide financing.

Business owners are sometimes so surprised that the bank is willing to provide financing, and so focused on the interest rate and loan-to-value ratio of capital property, that they forget to read the fine print on their credit facility agreement. Often there are significant terms in the credit facility that are overlooked by the business owner until it is too late. Commonly overlooked terms address personal guarantees, postponements, financial covenants, audited financial statements, and significant security.

Personal guarantees come into play when a business can no longer continue to operate and the bank calls the loan. If you have an agreement with a personal guarantee and there is not enough cash to repay the bank loan, the bank can seize your personal assets (i.e. your house!) as repayment.

Postponements require that the company postpone repayment of debts in favour of repaying bank debt. This term can be detrimental if your business runs into trouble and you have personally put significant funds into the business.

Financial covenants also pose a risk in that sometimes they can be impossible to meet and 1-3 years after the facility agreement is signed, the covenants may be breached and the bank can call the loan.

The terms may indicate that you will be required to provide the bank with audited financial statements within a specific period following your company’s year end. Audits can be costly, and you may be able to negotiate to submit reviewed financial statement (lower assurance than audited statements) which can save your company some money in accounting fees.

Another problem I see is business owners who don’t explicitly ‘shop’ around to different banks and compare terms. It is important to create a chart to compare the terms offered by different banks because more often than not facility agreements, especially for auto dealers, have a significant number of terms that are not easy to compare in your head. I suggest you write out the differences and compare all the options to make a decision based on the facts. Some points of comparison may be qualitative in nature, such as the reputation of the bank or relationship with the banking representative.

This is just a taste of what I have dealt with over the last several years with regards to capitalizing your business and I plan to write further blogs on this topic.

-- David Hertzog

The first scratch is the hardest

In late 2004 I purchased my first new car, a 2004 Honda Civic SI sedan. My girlfriend was living in Montreal and I was in Toronto. She came to Toronto shortly after I picked up the car and I drove up to her parents’ house to show her my prized possession. On the way I decided to stop at an automatic car wash to make sure the car looked its best. I paid my money and drove into the bay. I will spare you the gory details as I am still sensitive about the incident, but let’s just say I paid for a touchless car wash and in the end I did not receive what I paid for. Even though the owner took responsibility, I still had to choose how I would get the damage fixed. Should I go to an independent body shop or take it back to the dealer?

I am lucky to have family in the business so I can get honest advice whenever I need it, but what is an average consumer to do? When I went through driving school they did not teach us what to do if an accident occurs. What documentation do I need? Where should I get the car towed to? How do I order a tow truck? Should I call the police? These are serious questions that many of us do not have the answers to.

The Toronto Automotive Dealers Association has addressed this problem with Renewit. Renewit can be offered to customers as a service they can use in case of a collision and it includes a mobile app that provides collision reporting templates, safety tips and traffic information. Bob Redinger, Co-Committee Chair Person at Renewit Inc., explains that if a customer is in an accident, they can contact Renewit and Renewit will assist the customer in bringing the car to the dealership of their choice for repair. Renewit can organize a tow truck to pick up the car, contact the dealer to let them know the car is coming in for repair and it can also help put the customer in touch with the right sources to get answers about insurance claims and repair coverage. In addition, the application allows dealers to contact their customers to inform them of specials, etc. This program is completely free to customers.

For dealers, the program is seen as a customer retention tool that provides customers with peace of mind that if they are ever in an accident they will have support from a knowledgeable and trustworthy source. Dealerships pay a monthly fee to be listed as a Renewit-approved dealer and the service can be offered to customers when they are purchasing a new or used vehicle or servicing a car through the dealership. In order for the dealership to get the full benefits of this program, employees should assist customers in installing the mobile application and setting up their personal profile.

It is a challenge to gain a competitive advantage in any industry, and this program allows dealerships to offer ongoing service to customers as well as providing an opportunity to get referrals through being listed as a preferred Renewit dealership.

Go to www.renewitnow.com for more information.

-- Bryan Redinger

Getting a new car? Should you lease or buy?

The discussion of lease vs. buy has been discussed in various publications over the years and I am not going to bore you with the basics of a lease vs. buy analysis. I just want to write a little bit about my experiences with buying a new vehicle and hopefully some of my readers can relate and provide some feedback.

I will attest that the starting point of acquiring any new vehicle should be based solely on choosing the car you want to drive for the next 4 years or so, not based on manufacturer rebates, cash incentives, 0% finance rates and so on. Making a decision on that basis will undoubtedly ‘get’ you into a car that you will likely regret 1-3 months after acquiring it. Focus on the car you want and then look for every possible avenue to acquire this vehicle, whether it’s new, used or certified.

From a purely financial point of view, it is easy to prove that purchasing a vehicle is more cost effective than consecutive leases if you plan to drive the car long-term and you do not encounter serious maintenance issues. However, I, along with many other buyers, look at variables that have nothing to do with finance when buying cars. There is also value in the option of driving a new vehicle every 3-4 years, not having to worry about paying for service costs and so on.

To provide a very simple example, I will compare the cost of leasing versus buying if you:

1. lease a vehicle that has a $20,000 MSRP for 3 consecutive terms of 4 years each, with a 50% residual at a 0% lease rate; or
2. purchase the same vehicle and drive it for 12 years. 

Under a lease you will pay $30,000 to drive the car for 12 years, and under a 0% finance arrangement you will pay $20,000 to drive the car for 12 years. I have not built in maintenance costs or fair market value (FMV) of the used vehicle after 12 years, but holding these factors equal, you have saved $10,000 in this example.

Clearly if you are looking to buy a car and drive it for 12 years you need to ensure you do some homework and buy a car with low maintenance costs and high reliability. If you are leasing a vehicle, these factors are not relevant because most likely all maintenance costs, with the exception of wear and tear will be covered by warranty in the lease period. Once you start to cloud the formula with interest rates, expected maintenance and so on, you may end up with a different answer.

Over the last 20 years or so I have owned approximately 10 different vehicles. When I add up the cost of what I paid for those 10 vehicles, it’s about 5 times higher than if I had driven each car for 10 years. It’s not uncommon to see cars on the road that are 10 plus years old and, if they are well-maintained, they can look almost brand new. Each time I leased or purchased a vehicle I knew that I was only going to drive it for 2-3 years before I got bored and wanted something new.

This is where the advantage of a short-term lease comes in. If you don’t plan on driving the car for more than 3 years, a lease is your most cost effective option because it allows you to walk away after 3 years versus having to sell the car to the dealer. The lease arrangement builds in a residual value that should approximate the FMV of the vehicle after 3 years, but based on my experience the residual is typically higher than the actual FMV and therefore you will pay less in the end than you would have if you bought the vehicle and sold it after 3 years.

To further complicate the matter, several manufacturers have discontinued the practice of leasing vehicles and are pushing customers into a strong finance arrangement. This comes back to my discussion earlier on with regards to first starting with the car you want and then looking at how to structure the deal. If you are adamant that you want to lease a car and the manufacturer does not offer a lease, there is always the option of leasing from a third party leasing company. This option will cost more, but it will give you the option of moving out of your car earlier.

-- David Hertzog

Car Shows and Marketing Opportunities for Dealerships

It is Summer, finally, which means it’s car show season. Last Monday I attended the Thornhill Cruisers Car Club’s weekly Monday night meet. I was very impressed with the turnout of both classic 50’s, 60’s, and 70’s cars as well as some 80’s and 90’s vehicles from my era,. Although these cars are mostly “drivers” they are still cool to look at to see how car styling and car sizes have changed over the years. I was very happy to see that a local car dealer had sponsored the event. I thought to myself, what a great marketing opportunity for the dealer.

This particular dealer is getting exposure every week, with very little effort on their part. Car shows are a great marketing tool to attract car enthusiasts into your dealership to see all the new models that you have to offer. They are also a great opportunity to give back to the community by raising money for charity. In today’s increasingly competitive environment, stretching marketing dollars and increasing your dealership’s reach is vital.

The birth and acceptance of the internet has changed business forever. Consumers are more knowledgeable and are able to compare competing brands as well as competing dealers among the same brand, at the click of a mouse. Competition between different brands is natural; however competition among dealers of the same brand is not. How does a dealer differentiate itself from a competing dealer of the same brand? Dealers must analyze what their competition is doing and determine how they can do it better. Exceeding customer expectations is a great way to get customers to talk about your dealership and the incredible experience they had with you. This increases word of mouth advertising and promotes positive feelings for your existing customers (securing future revenue) and increases the likelihood of referrals which will generate new business for your dealership.

Managing your online reputation is increasingly important as more customers flock to the internet to research everything from their doctor to their dealership. Is your dealership monitoring online comments and conducting regular searches to make sure any issues or complaints in online reviews are addressed? As of yesterday, there were 24 results when I searched for Toronto dealerships reviewed on yelp.com, including a review that opens with “Recommendation: Do not buy a car here!” Many customers will go to a less convenient dealership to purchase and service their car based on negative reviews.

In addition to focusing on customer service, community presence is also very important, by way of sponsoring community events. The goal of both of these initiatives is to create positive buzz about your dealership that will generate referrals. In addition to marketing via events and exceeding customer expectations, individual dealerships need to have online presence through social networking tools such as Facebook and Twitter and through active involvement in brand specific online car communities, or forums such as RX8club.com and the 8thcivic.com. These sites provide a great marketing opportunity to a captive audience who is enthusiastic about your brand.

Having your existing customers “Like” your dealership’s Facebook page will allow you to easily communicate with your customers by updating your corporate page as your updates will appear in the newsfeed for anyone who “Likes” your page. In addition, your page will be on your customer’s profile as a page they “Like” and all their contacts and friends will be able to see that they like you. This invites discussion and the “Like” begins to function as a recommendation of your dealership. Twitter functions in much the same way with your customers being able to follow you and gain access to your dealership updates. You may want to let customers know when new models come in, if there is a promotion on service or vehicles, if you are holding an event or anything else.

When marketing your dealership against dealerships of the same brand you need to think outside the box.

-- Bryan Redinger