how to read finanacial reports

8/10/2019 How to Read Finanacial Reports

1/48

This page is designed for thesole purpose of teaching someone how to readfinancial statements. While intended for those with little or now knowledge of finacialstatements, it can be a handy reminder even for the seasoned professional. This pageis very long so an outline is provided to help you get the information you desire.(SEEOUTLINE)

HOW TO READ A FINANCIAL STATEMENT

If you are a certified public accountant it is most unlikely that you can learnanything from reading this book. You don't need to be told the basics ofunderstanding what's presented in corporate annual reports. If you aren't a certifiedpublic accountant, and you find that annual reports are "over your head," this bookletcan help you to grasp the facts contained in such reports and possibly become a betterinformed investor. That is our principal aim in publishing this booklet, but we also

hope that it will be useful to other readers who want to understand how businessworks and to learn more about the companies that provide them with goods andservices or that offer them employment.

Most annual reports can be broken down into three sections: the Executive Letter,the business Review, and the Financial Review. The Executive Letter gives a broadoverview of the company's business and financial performance. The Business Reviewsummarizes recent developments, trends, and objectives of the company. TheFinancial Review is where business performance is quantified in dollars. This is thesection we intend to clarify.

The Financial Review has two major parts: Discussion and Analysis, and AuditedFinancial Statements. A third part might include information supplemental to theFinancial Statements. In the Discussion and Analysis, management explains changesin operating results from year to year. This explanation is presented mainly in anarrative format, with charts and graphs highlighting the comparisons. The Operatingresults are numerically captured and presented in the Financial Statements.

The principal components of the Financial Statements are the balance sheet; incomestatement; statement of changes in shareholders' equity; statement of cash flows; and

footnotes. The balance sheet portrays the financial strength of the company byshowing what the company owns and what it owes on a certain date. The balancesheet can be thought of as a snapshot photograph since it reports on financial positionas of the end of the year. The income statement, on the other hand, is like a motionpicture since it reports on how the company performed during the year and showswhether operations have resulted in a profit or loss. The statement of changes inshareholders' equity reconciles the activity in the equity section of the balance sheet
http://people.terry.uga.edu/akefalas/courses/mirrors_outline.htmhttp://people.terry.uga.edu/akefalas/courses/mirrors_outline.htmhttp://people.terry.uga.edu/akefalas/courses/mirrors_outline.htmhttp://people.terry.uga.edu/akefalas/courses/mirrors_outline.htmhttp://people.terry.uga.edu/akefalas/courses/mirrors_outline.htmhttp://people.terry.uga.edu/akefalas/courses/mirrors_outline.htm


2/48

from year to year. Common changes in equity result from company profits or losses,dividends, or stock issuances. The statement of cash flows reports on the movementof cash by the company for the year. The footnotes provide more detailed informationon the balance sheet and income statement.

This booklet will focus on illustrating the basic financial statements and footnotespresented in annual reports in accordance with current practice. It will also includeexamples of financial methods used by investors to better analyze financialstatements. In order to provide a framework for illustration, we will invent acompany. It will be a public company (one whose shares are freely traded on theopen market). The reason for choosing a public company is that it is required toprovide the most extensive amount of information in its annual reports in accordancewith guidelines issued by the Securities and Exchange Commission (SEC). Ourcompany will represent a typical corporation with the most commonly usedaccounting and reporting practices. We'll call our company Typical ManufacturingCompany, Inc.

A Few Words Before We Begin

Below are four samples of a Balance Sheet, Income Statement, Statement ofChanges in Shareholders' Equity, and a Statement of Cash Flows. These are thestatements we will discuss in the first section. To simplify matters, we did notillustrate the Discussion and Analysis nor did we present examples of the ExecutiveLetter or Business Review. In our sample statements, we've presented two years offinancial results on the balance sheet and income statement and one year of activity onthe statement of changes in shareholders' equity and statement of cash flows. Thiswas also done for ease of illustration. Were we to comply with SEC requirements, wewould have had to report the last three years of activity in the Income Statement,Statement of Changes in Shareholders' Equity, and Statement of Cash Flows. FurtherSEC requirements that we did not illustrate include: presentation of selected quarterlyfinancial data for the past two years, business segment information for the last threeyears, a listing of company directors and executive officers, and the market price ofthe company's common stock for each quarterly period within the two most recentfiscal years.

TypicalManufacturingCompany Inc.

Consolidated Balance Sheet


3/48

December 31,19X9 and 19X8 (dollars in thousands)

Assets 19X9 19X8

Current Assets

Cash $20,000 $15,000

Marketable securities at cost whichapproximates market value 40,000 32,000

Accounts ReceivableLess allowance for doubtful

accounts:19X9: $2,375, 19X8: $3,000

156,000 145,000

Inventories 180,000 185,000

Prepaid Expenses and other current assets 4,000 3,000

Total current assets 400,000 380,000

Property, plant and equipment

Land $30,000 $30,000

Buildings 125,000 118,500

Machinery 200,000 171,100

Leasehold improvements 15,000 15,000

Furniture, fixtures, etc. 15,000 12,000

Total property, plant, and equipment $385,000 $346,600

Less accumulated depreciation $125,000 $97,000

Net property, plant and equipment $260,000 $249,600

Intagibles(goodwill, Patents) - lessamortization

$2,000 $2,000

Total assets $662,000 631,600

Liabilities

Current liabilities

Accounts payable $60,000 $57,000

Notes payable 51,000 61,000

Accrued expenses 30,000 36,000

Income taxes payable 17,000 15,000


4/48

Other liabilities 12,000 12,000

Total current liabilities $170,000 $181,000

Long-term liabilities

Deferred income taxes $16,000 $9,000

12.5% Debentures payable 2010 130,000 130,000

Other long-term debt 0 6,000

Total libilities $316,000 $326,000

Shareholders Equity

Preferred staock $5.83 cumulative,

$100 par value authorized, issued andoutstanding60,000 shares

$6,000 $6,000

Common stock $5.00 par value,authorized 20,000,000 shares,19x9 issued 15,000,000 shares,19x8 14,500,000 shares 75,000 72,500

Additional paid-in capital 20,000 13,500

Retained earnings 249,000 219,600

Foreign currency translation adjustments 1,000 (1,000)

Less: Treasury stock at cost(19x9-1,000; 19x8-1,000 shares) 5,000 5,000

Total shareholders' equity $346,000 $305,600

Total liabilities and shareholders' equity $662,000 $631,600

TypicalManufacturing

Company Inc.

Consolidated Income Statement


19X9 19X8


5/48

Net sales $765,000 $725,000

Cost of sales 535,000 517,000

Gross margin $230,000 $208,000

Operating expensesDepreciation and amortization 28,000 25,000

Selling, general and administrative expenses 96,804 109,500

Operating income $105,196 $73,500

Other income (expense)Dividends and interest income 5,250 9,500

Interest expense (16,250) (16,250)

Income before income taxes and extraordinary loss $94,196 $66,750

Income taxes 41,446 26,250

Income before extraordinary loss $52,750 $40,500

Extraordinary item: Loss on early extinguishmentof debt (net of income tax benefit of $750) (5,000) ---

Net income $47,750 $40,500

Common shares outstanding $14,999,000$14,499,000

Earnings per common share before

extraordinary loss $3.19 $2.77Earnings per share--extraordinary loss (.33) ---

Net income (per common share) $3.16


Consolidated Statement of ChangesIn Shareholders' Equity


AdditionalForeign

Currency


6/48

Preferred

StockCommon

StockPaid-In

CapitalRetained

EarningsTranslation

AdjustmentTreasury

Stock Total

Balance, Jan. 1, 19X9 $6,000 $72,500 $13,500 $219,600 ($1,000) ($5,000) $305,600

Net income 47,750 47,750

Dividends paid on:

preferred stock (350) (350)

common stock (18,000) (18,000)

Common stock issued $2,500 $6,500 $9,000

Translation gain $2,000 $2,000

Balance, Dec.31, 19X9 $6,000 $75,000 $20,000 $249,000 $1,000 ($5,000) $346,000


Consolidated Statement of Cash FlowsDecember 31,19X9 and 19X8 (dollars in thousands)

Cash flows from operating activities:

Net income $47,750

Adjustment to reconcile net income tonet cash from operating activities:

Depreciation and amortization $28,000

Increase in marketable securities (8,000)

Increase in accounts receivable (11,000)

Decrease in inventory 5,000

Increase in prepaid expenses and other currentassets (1,000)

Increase in deferred taxes 7,000

Increase in accounts payable 3,000

Decrease in accrued expenses (6,000)

Increase in income taxes payable 2,000

Total Adjustments $19,000


7/48

Net Cash Provided by Operating Activities $66,750

Cash Flows from Investing Activities:

Purchase of fixed Assets ($38,400)

Net Cash Used in Investing Activities ($38,400)

Cash Flows from Financing Activities:

Decrease in notes payable ($10,000)

Decrease in other long-term debt (6,000)

Proceeds from issuance of common stock

Payment of dividends (18,350)

Net Cash Used in Financing Activities ($25,350)

Effect of Exchange Rate Changes on Cash $2,000

Increase in Cash $5,000Cash at beginning of year 15,000

Cash at end of year $20,000

Income tax payments totaled $3,000 in 19X9.Interest payments totaled $16,250 in, 19X9.See accompanying notes to consolidated financial statements.

The Balance Sheet

The balance sheet represents the financial picture as it stood on one particular day,December 31, 19X9, as though the wheels of the company were momentarily at astandstill. Typical Manufacturing's balance sheet not only includes the most recentyear, but also the previous year. This lets you compare how the company fared in itsmost recent years.

The balance sheet is divided into two sides: on the left are shown assets; on the

right are shown liabilities and shareholders' equity. Both sides are always inbalance. Each asset, liability, and component of shareholders' equity reported in thebalance sheet represents an "account" having a dollar amount or "balance." In theassets column, we list all the goods and property owned, as well as claims againstothers yet to be collected. Under liabilities we list all debts due. Under shareholders'equity we list the amount shareholders would split up it Typical were liquidated at itsbalance sheet value.


8/48

Assume that the corporation goes out of business on the date of the balancesheet. If that occurs, the illustration which follows shows you what typicalManufacturingshareholders might expect to receive as their portion of the business.

Total assets (Less: intangibles) $660,000

Amount required to pay liabilities 316,000

Amount remaining for the shareholders $344,000

Now, we are going to give you a guided tour of the balance sheet's accounts. We'll.define each item, one by one, and explain how they work.

Assets

Current Assets

In general, current assets include cash and those assets which in the normal courseof business will be turned into cash in the reasonably near future, i.e., generally withina year from the date of the balance sheet.

Cash

This is just what you would expect-bills and coins in the till (petty cash fund) andmoney on deposit in the bank.

1 Cash $20,000

Marketable securities

This asset represents investment of excess or idle cash that is not neededimmediately. In Typical's case it is invested in preferred stock. Because these fundsmay be needed on short notice, it is essential that the securities be readily marketableand subject to a minimum of price fluctuation. The general practice is to showmarketable securities at cost or market, whichever is lower.


9/48

2Marketable securities at cost which approximates mkt.value $40,000

Accounts receivable

Here we find the amount due from customers but not yet collected. When goodsdue are shipped prior to collection, a receivable is recorded. Customers are usuallygiven 30,60, or 90 days in which to pay. The amount due from customers is$158,375. However, experience shows that some customers fail to pay their bills,because of financial difficulties or some catastrophic event (a tornado, a hurricane, ora flood) befalling their business. Therefore, in order to show the accounts receivableitem at a figure representing expected receipts, the total is after a provision fordoubtful accounts. This year that debt reserve was $2,375.

3 Accounts receivable-less allowance for doubtful accounts of$2,375 $156,000

Inventories

The inventory of a manufacturer is composed of three groups. raw materials to beused in the product, partially finished goods in process of manufacture, and finishedgoods ready for shipment to customers. The generally accepted method of valuation

of the inventory is cost or market, whichever is lower. This gives a conservativefigure. Where this method is used, the value for balance sheet purposes will be cost,or perhaps less than cost if, as a result of deterioration, obsolescence, decline in prices,or other factors, less than cost can be realized on the inventory. Inventory valuationincludes an allocation of production and other expenses, as well as the cost ofmaterials

4 Inventories $180,000




10/48

Assets 19X9 19X8

Current Assets

1 Cash $20,000 $15,000

2 Marketable securities at cost whichapproximates market value 40,000 32,000

3 Accounts ReceivableLess allowance for doubtful accounts:19X9: $2,375, 19X8: $3,000 156,000 145,000

4 Inventories 180,000 185,000

5 Prepaid Expenses and other current assets 4,000 3,000

6 Total current assets 400,000 380,000

Property, plant and equipmentLand $30,000 $30,000

Buildings 125,000 118,500

Machinery 200,000 171,100

Leasehold improvements 15,000 15,000

Furniture, fixtures, etc. 15,000 12,000

7 Total property, plant, and equipment $385,000 $346,600

8 Less accumulated depreciation $125,000 $97,00

9 Net property, plant and equipment $260,000 $249,600

10 Intagibles(goodwill, Patents) - less amortization $2,000 $2,000

11 Total assets $662,000 $631,600

Prepaid expenses

Prepaid expenses may arise for a situation such as this: During the year, Typicalprepaid fire insurance Property, plant and equipment premiums and advertisingcharges for the next year. Those insurance premiums and advertising services are asyet unused at the balance sheet date, so there exists an unexpended item, which willbe used up over the next 12 months. If the advance payments had not been made, thecompany would have more cash in the bank. So payments made in advance fromwhich the company has not yet received benefits, but for which it will receive benefits


11/48

next year, are listed among current assets as prepaid expenses.

5Prepaid expenses and other current assets $4,000

Deferred chargesfor such items as the "introduction" of a new product to themarket, or for moving a plant to a new location, represent a type of asset similar topre-paid expenses. However, deferred charges are not included in current assetsbecause the benefit from such expenditure will be reaped over several years to come.So the expenditure incurred will be gradually written off over the next several years,rather than fully charged off in the year payment is made. Our balance sheet shows nodeferred charges because Typical has none. If it had, they would normally be included'us' before intangibles on the asset side of the ledger.

To summarize, the total current assets item includes primarily: cash,marketable

securities, accounts receivable, inventories, and prepaid expenses.

6 Total current assets $400,000

You will observe that these assets are mostly working assets in the sense that theyare in a constant cycle of being converted into cash. Inventories, when sold becomeaccounts receivable; receivables, upon collection, become cash; cash is used to paydebts and running expenses. We will discover later in the booklet how to make currentassets tell a story.

Property, Plant, and Equipment

Property, plant and equipment represents those assets not intended for sale that areused over and over again in order to manufacture, display, warehouse, and transportthe product. This category includes land, buildings, machinery, equipment, furniture,automobiles, and trucks. The generally accepted and approved method for valuation iscost minus the depreciation accumulated by the date of the balancesheet. Depreciation is discussed in the next section.

Property, plant, and equipmentLand $ 30,000

Buildings 125,000

Machinery 200,000

Leasehold Improvements 15,000

Furniture, fixtures, etc 15,000


12/48

7Total property, plant & equipment $385,000

The figure displayed is not intended to reflect market value at present orreplacement cost in the future. While it is recognized that the cost to replace plant andequipment at some future date might be higher, that possible cost is obviouslyvariable. For this reason, up to now, most companies have followed a general rule:acquisition cost less accumulated depreciation based on that cost.

Depreciation

Depreciation is the practice of allocating the cost of a fixed asset over its usefullife. This has been defined for accounting purposes as the decline in useful value of afixed asset due to wear and tear from use and passage of time.

The cost incurred to acquire the property, plant and equipment must be spread overthe expected useful life, taking into consideration the factors discussed above. Forexample: Suppose a delivery truck costs $10,000 and is expected to last five years.Using a straight-line" method of depreciation, $2,000 of the truck's cost is allocated toeach year's income statement. The balance sheet at the end of one year would show:

Truck (cost) $10,000

Less accumulated depreciation 2,000

Net depreciated value $ 8,000

At the end of the second year it would show:

Truck (cost) $10,000

Less accumulated depreciation 4,000

Net depreciated value $ 6,000

In our sample balance sheet, a figure is shown for accumulated depreciation. Thisamount is the total of accumulated depreciation for buildings, machinery, leaseholdimprovements, and furniture and fixtures. Land is not subject to depreciation, and itslisted value remains unchanged from year to year.


13/48

Less accumulated depreciation $125,000

Thus, net property, plant and equipmentis the valuation for balance sheet purposesof the investment in property, plant and equipment. As explained before, it consists ofthe cost of the various assets in this classification, less the depreciation accumulated tothe date of the financial statement.

9Net property, plant, and equipment $260,000

Depletion is a term used primarily by mining and oil companies or any of the so-called extractive industries. Since Typical Manufacturing is not in the miningbusiness, we do not show depletion on the balance sheet. To deplete means to exhaustor use up. As the oil or other natural resource is used up or sold, a depletion reserve isset up to compensate for the natural wealth the company no longer owns.

Intangibles

These may be defined as assets having no physical existence, yet having substantialvalue to the company. Examples? A franchise to a cable TV company allowingexclusive service in certain areas, or a patent for exclusive manufacture of a specificarticle. It should be noted, however, that only intangibles purchased from other

companies are shown on the balance sheet.

Another intangible asset sometimes found in corporate balance sheets is goodwill,which represents the amount by which the price of acquired companies exceeds therelated values of net assets acquired. Company practices vary considerably inassigning value to this asset. Accounting rules now require one firm that buys anotherto write off the goodwill over a period not exceeding 40 years.

10 Intangibles (goodwill, patents)less

amortization $2,000

All of these items added together produce the figure listed on the balance sheet astotal assets.


14/48

11 Total assets $662,000

Liabilities



Liabilities

Current liabilities

12 Accounts payable $60,000 $57,000

13 Notes payable 51,000 61,000

14 Accrued expenses 30,000 36,000

15 Income taxes payable 17,000 15,000

16 Other liabilities 12,000 12,000

17 Total current liabilities $170,000 $181,000

Long-term liabilities

18 Deferred income taxes $16,000 $9,00019 12.5% Debentures payable 2010 130,000 130,000

20 Other long-term debt 0 6,000

21 Total libilities $316,000 $326,000

Shareholders Equity

22Preferred staock $5.83 cumulative,$100 par value authorized, issued and

outstanding60,000 shares

$6,000 $6,000

23Common stock $5.00 par value,authorized 20,000,000 shares,19x9 issued 15,000,000 shares,19x8 14,500,000 shares 75,000 72,500

24Additional paid-in capital 20,000 13,500


15/48

25Retained earnings 249,000 219,600

26Foreign currency translation adjustments 1,000 (1,000)

27Less: Treasury stock at cost(19x9-1,000; 19x8-1,000 shares) 5,000 5,000

28 Total shareholders' equity $346,000 $305,600

29 Total liabilities and shareholders'

Equity$662,000 $631,600

Current Liabilities

This item generally includes all debts that fall due within 12 months. The currentassets item is a companion to current liabilities because current assets are the source

from which payments are made on current debts. The relationship between the two isone of the most revealing things to be learned from the balance sheet, and we will gointo that later. For now, we need to define the subgroups within current liabilities.

Accounts payable

The accounts payable item represents amounts the company owes to its regularbusiness creditors from whom it has bought goods or services on open account.

12 Accounts payable $ 60,000

Notes payable

If money is owed to a bank, individual, corporation, or other lender, it appears onthe balance sheet under notes payable as evidence that a promissory note has beengiven by the borrower.

13 Notes payable $ 51,000

Accrued expenses

Now we have defined accounts payable as the amounts owed by the company to itsregular business creditors. The company also owes, on any given day, salaries and


16/48

wages to its employees, interest on funds borrowed from banks and from bondholders,fees to attorneys, insurance premiums, pensions, and similar items. To the extent thatthe amounts owed and not recorded on the books are unpaid at the date of the balancesheet, these expenses are grouped as a total under accrued expenses.

14 Accrued expenses $ 30,000

Income tax payable

The debt due to the various taxing authorities such as the Internal Revenue Serviceis the same as any other liability under accrued expenses. But because of the amountand the importance of the tax factor, it is generally stated separately as Income taxespayable.

15 Income taxes payable $17,000

Other Liabilities

Simply stated, other liabilities includes all liabilities captured in the specificcategories presented.

16 Other liabilities $12,000

Total current liabilities

Finally, the total current liabilities item sums up all of the items listed under thisclassification.

17 Total current liabilities $170,000


17/48

Long-term Liabilities

In the matter of current liabilities, you will recall that we included debts due withinone year from the balance sheet date. Here, under the heading of long-term liabilitiesare listed debts due after one year from the date of the financial report.

Deferred income taxes

One of the long-term liabilities on our sample balance sheet is deferred incometaxes. The government provides businesses with tax incentives to make certain kindsof investments that will benefit the economy as a whole. Current and long-term debtare summed together to produce the figure listed on the balance sheet as liabilities.For instance, a company can take accelerated depreciation deductions for investmentsin plant and equipment. These rapid write-offs in the early years of investment reducewhat the company would otherwise owe in current taxes, but at some point in thefuture the taxes must be paid. Companies include a charge for deferred taxes in theirtax calculations on the income statement and show what taxes would be without theaccelerated write-offs. That charge then accumulates as a long-term liability on thebalance sheet.

18 Deferred income taxes $16,000

Debentures

The other long-term liability on our balance sheet is 12.5% debentures due in 2010.The money was received by the company as a loan from the bond-holders, who in turnwere given a certificate called a bond, as evidence of the loan. The bond is really aformal promissory note issued by the company, which in this case agreed to repay thedebt at maturity in 2010 and also agreed to pay interest at the rate of 12.5% peryear. Bond interest is usually payable semi-annually. Typical's bond issue is called a

debenture because the bonds are backed by the general credit of the corporation ratherthan by the company's assets. Debentures are the most common type of bond issuedby large, well-established corporations today.

Companies can also issue first mortgage bonds, which offer bondholder an addedsafeguard because they are secured by a mortgage on all or some of the company'sproperty. First mortgage bonds are considered one of the highest grade investments


18/48

because they give investors an undisputed claim on company earnings and the greatestsafety. If the company is unable to pay off the bonds in cash when they are due,holders of first mortgage bonds have a claim or 1ien before other creditors (such asdebenture holders) on the mortgaged assets, which may be sold and the proceeds usedto satisfy the debt.

19 12.5% Debentures payable 2010 $130,000

Other long-term debt

Other long-term debt includes all debt other than what is specifically reported on inthe balance sheet. In the case of Typical, this debt was extinguished in 1989.

20 Other long-term debt 0

Total liabilities

Current and long-term debt are summer together to produce the figure listed on thebalance sheet as total liabilities.

21 Total liabilities $316,000

Shareholders' Equity

This item is the total equity interest that all shareholders have in thiscorporation. In other words, it is the corporation's net worth after subtracting allliabilities. This is separated for legal and accounting reasons into the categoriesdiscussed below.

Capital Stock


19/48

In the broadest sense this represents shares in the proprietary interest in thecompany. These shares are represented by the stock certificates issued by thecorporation to its shareholders. A corporation may issue several different classes ofshares, each class having slightly different attributes.

Preferred Stock

These shares have some preference over other shares with respect to dividends andin distribution of assets in case of liquidation. Specific provisions can be obtainedfrom a corporation's charter. In Typical, the preferred stock is a $5.83 cumulative$100 par value, which means that each share is entitled to $5.83 in dividends a year,before any dividends are paid to the common shareholders. Cumulative means that ifin any year the dividend is not paid, it accumulates in favor of the preferredshareholders and must be paid to them when available and declared before anydividends are distributed on the common stock. Sometimes preferred shareholdershave no voice in company affairs unless the company falls to pay them dividends atthe promised rate.

22 Preferred stock $5.83 cumulative, $100 parvalue, authorized issued and outstanding

60,000 shares 6,000

Common Stock

Each year before common shareholders receive any dividends, preferred holders areentitled to $5.83 per share, but no more. Common stock has no such limit ondividends payable each year. In good times, when earnings are high, dividends mayalso be high. And when earnings drop, so may dividends.

23 Common stock $5.00 par valueauthorized 20,000,000 shares, issued

15,000,000 shares$75,000

Additional Paid-in Capital

This is the amount paid in by shareholders over the par or legal value of eachshare. Typical's common stock has a par value of $5.00 per share. In 1989, Typicalsold 500,000 shares of stock for a total of $9,000. The $9,000 was allocated on the


20/48

balance sheet between capital stock and additional paid-in capital. 500,000 shares at apar value of $5.00 for a total of $2,500 was allocated to common stock. Theremaining $6,500 was allocated to additional paid-in capital.

23 Common stock $5.00 par valueauthorized 20,000,000 shares issued

15,000,000 shares $75,000

24 Additional paid-in capital $20,000

Total of capital stock (common) and

additional paid-in capital $95,000

Retained Earnings

When a company first starts in business, it has no retained earnings. Retainedearnings accumulate as the company earns profits and reinvests or "retains" profits inthe company. In other words, retained earnings increase by the amount of profitsearned, less dividends declared to shareholders. At the end of its first year, if profitsare $80,000 and dividends of $30,000 are paid on the preferred stock but no dividendsare declared on the common, the balance sheet will show retained earnings of$50,000. In the second year, if profits are $140,000 and Typical pays $30,000 individends on the preferred and $40,000 on the common, the accumulated retainedearnings will be $120,000:

Balance at the end of the first year $ 50,000

Net profit for second year 140,000

$190,000

Less: all dividends 70,000

Retained earnings at the end of the second year $120,000

The balance sheet for Typical shows the company has accumulated $249,000 in

retained earnings.

25 Retained earnings $249,000

Foreign Currency Translation Adjustments


21/48

When a company has an ownership interest in a foreign entity and the entity'sresults are to be captured in the company's consolidated financial statements, thefinancial statements of the foreign entity must be translated to U.S. dollars. Generally,the translation gain or loss should be reflected as a separate component of

shareholders' equity called foreign currency translation adjustment. This adjustmentshould be distinguished from adjustments relating to transactions which aredenominated in foreign currencies. The gain or loss in these cases should be includedin a company's net income.

26Foreign currency translation adjustments $1,000

Treasury stock

When a company reacquires its own stock, it is reported as treasury stock and isdeducted from shareholder's equity. Of the cost and par methods of accounting, theformer method is more commonly applied to treasury stock. Under the cost methodthe cost of reacquired stock is deducted from share holders' equity. Any dividends onshares held in thetreasury should never be included as income.

27 Treasury Stock $5,000

The sum total of stock (net of treasury stock), additional paid-in capital, retainedearnings and foreign currency translation adjustments, represents the totalshareholder's equity.

28 Total shareholders' equity $346,000

Just what does the balance sheet show?


22/48

In order to analyze balance sheet figures, investors look to certain financialstatement ratios for guidance. One of their concerns is whether the business will beable to pay its debts when they come due. They are also interested in the company'sinventory turnover and the amount of assets backing corporate securities (bonds,preferred and common stock), along with the relative mix of these securities. In the

following section, we discuss various ratios used for balance sheet analysis

Net Working Capital

One very important thing to be learned from the balance sheet is net workingcapital or net current assets, sometimes called working capital. This is the differencebetween total current assets and total current liabilities. You will recall that currentliabilities are debts generally due within one year from the date of the balancesheet. The source from which to pay those debts is current assets. Thus, workingcapital represents the amount that is left free and clear after all current debts are paidoff. For Typical this is:

6 Current assets $400,000

17 Less: current liabilities 170,000

Working capital $230,000

If you consider yourself a conservative investor, you should invest only in

companies that maintain a comfortable amount of working capital. A company'sability meet obligations, expand volume, and take advantage of opportunities is oftendetermined by its working capital. Moreover, since you want your company to grow,this year's working capital should be larger than last year's.

Current Ratio

What is a comfortable amount of working capital? Analysts use several methods tojudge whether a company has a sound working capital position. To help you interpretthe current position of a company in which you are considering investing, the current

ratio is more helpful than the dollar total of working capital. The first rough test foran industrial company is to compare the current assets figure with the total currentliabilities. A current ratio of 2 to1is generally considered adequate. This means thatfor each $1 of current liabilities, there should be $2 in current assets.To find the current ratio, divide current assets by current liabilities. In Typical'sbalance sheet:


23/48

6Current assets $400,000

Current liabilities $170,000= 2.35 or 2.35 to 1

Thus, for each $1 of current liabilities, there is $2.35 in current assets to back it up.

There are so many different kinds of companies, however, that this test requires agreat deal of modification if it is to be really helpful in analyzing companies indifferent industries. Generally, companies that have a small inventory and easilycollectible accounts receivable can operate safely with a lower current ratio than thosecompanies having a greater proportion of their current assets in inventory and sellingtheir products on credit.

How Quick is Quick?

In addition to net working capital and current ratio, there are other ways of testingthe adequacy of the current position. What are quick assets? They're the assets youhave to cover a sudden emergency, assets you could take right away to the bank, ifyou had to. They are those current assets that are quickly convertible into cash. Thisleaves out merchandise inventories, because such inventories have yet to be sold andare not convertible into cash. Accordingly, quick assets are current assets minusinventories and prepaid expenses.

6 Current assets $400,000

4 Less: inventories 180,000

5 Less: prepaid expenses 4,000

Quick assets $216,000

Net quick assets are found by taking the quick assets and subtracting the totalcurrent liabilities. A well-fixed industrial company should show a reasonable excessof quick assets over current liabilities. This provides a rigorous and important test of acompany's ability to meet its obligations.

Quick assets $216,000


Net Quick Assets $46,000


24/48

The quick assets ratiois found by dividing quick assets by current liabilities.

17

$216,000 Quick assets

Current liabilities = 1.3 or 1.3 to 1

As you see, for each $1 of current liabilities, there is the same industry. $1.30 inquick assets available.

Debt to Equity

A certain level of debt is acceptable, but too much presents a hazardous signal toinvestors. The debt-to-equityratio is an indicator of whether the company is

excessively using debt for financing purposes. For Typical, the computed as follows:

21

28$316,000 Total liabilities

$346,000Total Shareholders Equity= .91

A debt-to-equity ratio of .91 means the company is using 91 cents of liabilities forevery dollar of shareholders' equity in the business. Normally, industrial companiesmaintain a maximum of a 1 to 1 ratio, to keep debt at a level which is less than the

investment level of the owners of the business. Utilities and financial companies canoperate safely with much higher ratios.

Inventory Turnover

How big an inventory should a company have? That depends on a combination ofmany factors. An inventory is large or small depending upon the type of business andthe time of the year. An automobile dealer, for example, with a large stock of autos atthe height of the season is in a strong inventory position, yet that same inventory atthe end of the season is a weakness in the dealer's financial condition.

One way to measure adequacy and balance of inventory is to compare it with salesfor the year to get inventory turnover. Typical's sales for the year are $765,000, andinventory on the balance sheet date is $180,000. Thus turnover is 4.25 times(765+180), meaning that goods are bought and sold out more than four times per yearon average. (Strict accounting requires computation of inventory turnover bycomparing annualcost of goods soldwith average inventory. This information is not


25/48

readily available in some published statements, so many analysts look insteadforsalesrelated to inventory.)

Inventory as a percentage of current assetsis another comparison that may bemade. In Typical, the inventory of $180,000 represents 45% of the total current assets,

which amount to $400,000. But there is considerable variation between different typesof companies, and thus the relationship is significant only when comparisons aremade between companies in the same industry.

Book Value of Securities

The balance sheet will reveal net book value(the value on the company's books)or net asset valueof the company's securities. This value represents the amount ofcorporate assets backing a bond or a common or preferred share. Here's how wecalculate values for Typical's securities.

Net Asset Value Per Bond

To state this figure conservatively, intangible assets are subtracted as if they haveno value on liquidation. Current liabilities of $170,000 are considered paid. Thisleaves $490,000 in assets to pay the bondholders. So, $3,769 in net asset valueprotects each $1,000 bond.


10 Less: intangibles 2,000

Total tangible assets $660,000


Net tangible assets available to meet

bondholders' claims$490,000

$490,000 =$3,769

130bonds oustanding

Net asset value per $1,000 bond

Net Asset Value Per Share of Preferred Stock

To calculate net asset value of a preferred share, we take total assets, conservativelystated at $660,000 (eliminating $2,000 of intangible assets). Current liabilities of$170,000 and long-term liabilities are con-sidered paid. This leaves $344,000 of assetsprotecting the preferred. So, $5,733 in net asset value backs each share of preferred.


26/48




17 Less: current liabilities $170,000

18,19, & 20 Long-term liabilities 146,000

Net assets backing the preferred stock$344,000

$344,000,000 = $5,73360,000

Shares of preferred stock oustanding

Net asset value per share of prefered

Net Book Value per Share of Common Stock

The net book value per share of common stock can be looked upon as meaning the

amount of money each share would receive if the company were liquidated, based onbalance-sheet values. Of course, the preferential shareholders would have to besatisfied first. The answer, $22.54 net book value per share of common stock, isarrived at as follows:




17 Less: current liabilities $170,00018,19, & 20 Long-term liabilities 146,000

22 Preferred stock 6,000

$322,000

Net assets available for the

common stock$338,000

$338,000,000 =

$22.54

14,999,000

shares of common

stock outstanding

Net asset value per share of

common stock

An alternative method of arriving at the common shareholders' equity--conservatively stated at $338,000 - is:

23 Common stock $ 75,000


27/48

24 Additional paid-in capital 20,000

25 Retained earnings 249,000

26 Foreign currency translation

adjustments1,000

27 Treasury stock (5,000)

$340,000

10 Less: intangible assets (2,000)

Total common shareholders' equity $338,000

$338,000,000 =

$22.5414,999,000

shares of preferred

stock oustanding

Net book value per share of common

stock

Do not be misled by book value figures, particularly of common stocks. Profitablecompanies often show a very low net book value and very substantial earnings.Railroads, on the other hand, may show a high book value for their common stock buthave such low or irregular earnings that the stock's market price is much less than itsbook value. Insurance companies, banks, and investment companies are exceptions.Because their assets are largely liquid (cash, accounts receivable, and marketablesecurities), the book value of their common stock is sometimes a fair indication ofmarket value.

Capitalization Ratio

The proportion of each kind of security issued by a company is the capitalizationratio. A high propor-tion of bonds sometimes reduces the attractiveness of both thepreferred and common stock, and too much preferred can detract from the common'svalue. That's because bond interest must be paid before preferred dividends, andpreferred dividends before common dividends.

To get Typical's bond ratiodivide the face value of the bonds, $130,000, by thetotal value of bonds, preferred and common stock, additional paid-in capital, retainedearnings, foreign currency translation ad-justments and treasury stock, less

intangibles, which is $474,000. This shows that bonds amount to about 27% ofTypical's total capitalization.

19 Debentures $130,000

22 Preferred stock 6,000

23 Common stock 75,000


28/48

24 Additional paid-in capital 20,000

25 Retained earnings 249,000

26 Foreign currency translation adjustments 1,000

27 Treasury stock (5,000)

10 Less: intangibles (2,000)Total capitalization $474,000

Thepreferred stock ratiois found the same way-divide preferred stock of $6,000by the entire capitali-zation of $474,000. The result Is about 1 %. The common stockratio will be the difference be-tween 1 00% and the total of the bond and preferredstock ratio-or about 72%. The same result is reached by combining common stock,additional paid-in capital, retained earnings, foreign currency translation adjustments,and treasury stock.

Amount Ratio

19 Debentures $130,000 27%

22 Preferred stock 6,000 1%

10 Common stock

&

23-

27(including additional paid-in capital, related

earnings, and foreign currency translation

adjustments less: treasury stock and

intangibles)338,000 72%

Total $474,000 100%

The Income Statement(dollars in thousands except per-share amounts)

Now, we come to the payoff for many potential investors. the income statement. Itshows how much the corporation earned or lost during the year. It appears earlier inthis page (Go there now). While the balance sheet shows the fundamental soundnessof a company by reflecting its financial position at a given date, the income statementmay be of greater interest to investors because it shows the record of its operatingactivities for the whole year. It serves as a valuable guide in anticipating how the


29/48

company may do in the future. The figure given for a single year is not nearly thewhole story. The historical record for a series of years is more important than thefigure of any single year. Typical includes two years in its statement and gives a ten-year financial summary as well, which appears further down this page (Go therenow).

An income statement matches the amounts received from selling goods andservices and other items of income against all the costs and outlays incurred in orderto operate the company. The result is a net incomeor a net lossfor the year. The costsincurred usually consist of cost of sales; overhead expenses such as wages andsalaries, rent, supplies, depreciation; interest on money borrowed; and taxes.

Net Sales

The most important source of revenue always makes up the first item on the income

statement. In Typical Manufacturing, it is net sales. It represents the primary source ofmoney received by the company from its customers for goods sold or servicesrendered. The net sales item covers the amount received after taking intoconsideration returned goods and allowances for reduction of prices. By comparing19X9 and 19X8, we can see if Typical had a better year in 19X9, or a worse one.

30 Net Sales $765,000 $725,000

Cost of Sales

In a manufacturing establishment, this represents all the costs incurred in thefactory in order to convert raw materials into finished products. These costs arecommonly known as product costs. Product costs are those costs which can beidentified with the purchase or manufacture of goods made available for sale. Thereare three basic components of product cost: direct materials; direct labor; andmanufacturing overhead. Direct materials and direct labor costs can be directly tracedto the finished product. For example, for a furniture manufacturer, lumber would be adirect material cost and carpenter wages would be a direct labor cost. Manufacturingoverhead costs, while associated with the manufacturing process, cannot be traceableto the finished p roduct. Examples of manufacturing overhead costs are costsassociated with operating the factory plant (plant depreciation, rent, electricity,supplies, maintenance and repairs, and production foremen salaries).


30/48

31 Cost of sales $535,000

Gross Margin

Gross Margin is the excess of sales over cost of sales, It represents the residualprofit from sales after consid-ering product costs.

32 Gross margin $230,000

Depreciation and Amortization

Each year's decline in value of non-manufacturing facilities would be captured here.Amortization is the decline in useful value of an intangible, such as a 17-year patent.

33Depreciation and amortization $28,000

Selling, General, and Administrative Expenses

These expenses are generally grouped separately from cost of sales so that thereader of an income statement may see the extent of selling and adminis-trative.co.sts.They include salesmen's salaries and commissions, advertising and promotion, traveland entertainment, executives' salaries, office payroll and office expenses.

34 Selling, general and administrative expenses $96,804

Subtracting all operating expenses from the net sales figure gives us the operatingincome.

35 Operating income $105,196

An additional source of revenue comes from dividends and interest received by thecompany from its investment in stocks and bonds. This is listed separately under an


31/48

item called other income (expense).

36Dividends and interest income $5,250

Interest Expense

The interest paid to bondholders for the use of their money is sometimes referred toas a fixed charge because the interest must be paid year after year whether thecompany is making money or losing money. Interest differs from dividends on stocks,which are payable only if the board of directors declares them.

Interest paid is another cost of doing business and is deductible from earnings inorder to arrive at a base for the payment of income taxes.

Typical Manufacturing's debentures, carried on the balance sheet as a long-termliability, bear 12.5% in-terest per year on $130,000. Thus, the interest expense in theincome statement Is equal to $16,250 per year. It shows up under other income(expense).

37 Interest expense $16,250

Income Taxes

Each corporation has a bas' tax rate, which depends 'II 31c on the level and natureof its income. Large corporations like Typical Manufacturing are subject to the top

corpo-rate income tax rate, but tax credits tend to lower the overall tax rate. Typical'sincome before taxes is $94,196; the tax comes to $41,446.

38 Income before provision for income taxes $94,196

39 Provision for income taxes 41,446


32/48

Income Before Extraordinary Loss

After we have taken into consideration all ordinary income (the plus factors) anddeducted all ordinary costs (the minus factors), we arrive at income before

extraordinary lossfor the year.

40 Income before extraordinary loss $52,750

Extraordinary Loss

Under ordinary conditions, the above income of $52,750 would be the end of thestory. However, there are years in which companies experience unusual andinfrequent events called extraordinary items. Examples of extraordinary items includedebt extinguishments, tax loss carry forwards, pension plan terminations, andlitigation settlements. In this case, Typical extinguished a portion of its debt early.This event's isolated on a separate line, net of its tax effect. Its earnings-per-shareimpact is also segregated from the earnings per share attribut-able to"normal"operations.

41 Loss on early extinguishment of debt(net of tax benefit of $750)

($5,000)

Net Income

Once all income and costs, including extraordinary items, are considered, we arrive atnet income.

42 Net income $47,750

Condensed, the income statement looks like this:

Plus factors:


33/48

30 Net sales $765,000

36 Dividends and Interest 5,250

Total $770,250

Minus factors:

31 Cost of sales $535,00033-

34Operating expenses 124,804

37 Interest expense 16,250

39 Provision for income taxes 41,446

Total $717,500

40 Net income beforeextraordinary loss

$ 52,750

41 Extraordinary loss (5,000)

42 Net income $ 47,750

Other Items

Two other items that do not apply to Typical could appear on an income statement.First, U.S. companies that do business overseas may have transaction gains or lossesrelated to fluctuations in foreign currency exchange rates.

Second, if a corporation owns more than 20% but less than 51 % of the stock of asubsidiary company, the corporation must show its share of the subsidiary's earnings-

minus any dividends received from the subsidiary on its income statement. Forexample, if the corporation's share of the subsidiary's earnings is $1,200 and thecorporation received $700 in dividends from the company, the corporation mustinclude $500 on its income statement under the category equity in the eamings ofunconsolidated subsidiaries. The corporation must also increase its investment in thecompany to the extent of the earnings it picks up on its income statement.

Analyzing the Income Statement

The income statement will tell us a lot more if we make a few detailedcomparisons. Before you invest in a company, you want to know its operatingmarginof profit and how it has changed over the years. Typical had sales of$765,000,000 in 19X9 and showed $105,196,000 as the operating income.


34/48

35

30$105,196 operating income

$765,000 sales= 13.8%

This means that for each dollar of sales $0.1380 remained as a gross profit fromoperations. This figure is interesting but is more significant if we compare it with theprofit margin last year.

35

30$ 73,500 operating income

$725,000 sales= 10.1%

Typical's profit margin went from 10.1 % to 13.8%, so business didn't just grow, itbecame more profitable. Changes in profit margin can reflect changes in efficiency,product line, or types of customers served.

We can also compare Typical with other companies in its field. If our company'sprofit margin is very low compared to others, it, is an unhealthy sign. If it is high,there are grounds for optimism.

Analysts also frequently use operating cost ratiofor the same purpose. Operatingcost ratio is the complement of the margin of profit. Typical's profit margin is 13.8%.The operating cost ratio is 86.2%. -

Amount Ratio

30 Net Sales $765,000 100.0%31,33,34 Operating Cost 659,804 86.2%

35 Operating Income $105,196 13.8%

Net profit ratiois still another guide to indicate how satisfactory the year's activitieshave been. In Typical Manufacturing, the year's net income was $47,750. The netsales for the year amounted to $765,000. Therefore, Typical's income was $47,750 on$765,000 of sales or:

42

30$47,750 net income

$765,000 sales= 6.2%

This means that this year for every $1 of goods sold, 6.20 in profit ultimately went to


35/48

the company. By comparing the net profit ratio from year to year for the samecompany and with other companies, we can best judge profit progress.

Last year, Typical's net income was $40,500 on $725,000 in sales:

42

30$40,500 net income

$725,000 sales= 5.6%

We can compare the U.S. Department of Commerce's latest available average profitmargins for all U.S. manufacturers to the profit margins calculated from Typical's 10-year summary further down the pag. (Go there now).

The margin of profit ratio, operating cost ratio, and net profit ratio, like all those we

examined in connection with the balance sheet, give us general information about thecompany and help us 'udge its prospects for the future. All these comparisons havesignificance for

Profit Margins (After Tax)

19X3 19X4 19X5 19X6 19X7

Average of U.S. Manufacturers 4.1 4.6 3.8 3.8 4.9

Typical 6.1 5.3 5.0 5.1 5.5

the long term, because they tell us about the fundamental economic condition of thecompany. One question remains: are the securities a good investment for you now?For an answer, we must look at some additional factors.

Interest Coverage

The bonds of Typical Manufacturing represent a very substantial debt, but they aredue many years in the future. The yearly interest, however, is a fixed charge, and wewant to know how readily the company can pay the interest. More specifically, wewould like to know whether the borrowed funds have been put to good use so that theearnings are ample and thus available to meet interest costs.

The available income representing the source for payment of the bond interest is$110,446 (operating profit plus dividends and interest). The annual bond interestamounts to $16,250. This means the annual interest expense is covered 6.8 times.


36/48

37$110,446 available income$16,250 interest on bonds

= 6.8%

Before an industrial bond can be considered a safe investment, most analysts say

that the company should earn its bond interest requirement three to four times over.By these standards, Typical Manufacturing has a fair margin of safety.

What About Leverage?

A stock is said to have high leverage if the company that issued it has a largeproportion of bonds and preferred stock outstanding in relation to the amount ofcommon stock. A simple illustration will show why. Let's take, for example, acompany with $10,000,000 of 4% bonds outstanding. If the company is earning

$440,000 before bond interest, there will only be $40,000 left for the common stockafter payment of $400,000 bond interest ($10,000,000 at 4% equals $400,000).However, an increase of only 10% in earnings (to $484,000) will leave $84,000 forcommon stock dividends, or an increase of more than 100%. If there is only a smallamount of common stock issued, the increase in earnings per share will appear veryimpressive.

You have probably realized that a decline of 10% in earnings would not only wipeout everything available for the common stock, but also result in the company's beingunable to cover its full interest on its bonds without dipping into accumulated

earnings. This is the great danger of so-called high-leverage stocks and also illustratesthe fundamental weakness of companies that have a disproportionate amount of debtor preferred stock. Conservative investors usually steer clear of them, although thesestocks do appeal to people who are willing to assume the risk.

Typical Manufacturing, on the other hand, is not a highly leveraged company. Lastyear, Typical paid $16,250 in bond interest and its net profit --before this payment --came to $56,750. This left $40,500 for the common stock and retained earnings. Nowlook what happened this year, Net profit before subtracting bond interest rose by$7,250, or about 13%. Since the bond interest stayed the same, net income after

paying this interest also rose $7,250, But that is about 18% of $40,500. While this iscertainly not a spectacular example of leverage, 18% is better than 13%.

Preferred Dividend Coverage


37/48

To calculate thepreferred dividend coverage(the number of times preferreddividends were earned), we must use net profit as our base, because federal, incometaxes and all interest charges must be paid before anything is available forshareholders. Because we have 60,000 shares of $100 par value preferred stock thatpays a dividend of $5.83 1/3, the total dividend requirement for the preferred stock is

$350,000. Dividing the net income of $47,750,000 by this figure we arrive atapproximately 136.4, which means that the dividend requirement of the preferredstock has been earned more than 136 times over. This ratio is so high partly becauseTypical has only a small amount of preferred stock outstanding.

Earnings Per Common Share

The buyer of common stock is often more concerned with the earnings per share ofa stock than with the dividend. This is because earnings per share usually influence

stock market prices. Although our income statement separates earnings per sharebefore and after the effect of the extraordinary item, the remainder of our presentationwill only consider earnings per share after the extraordinary item. In Typical's case theincome statement shows earnings available for common stock.

46 Earnings per share $3.16

But if it didn't, we could calculate it ourselves:

42Net profit for the year $47,750

Less: dividend requirements on preferred stock 350

Earnings available for the common stock $47,400

$47,400,00014,999,000

earnings available after preferred dividends

number of outstanding common shares= $3.16 earnings per

share of common

Typical's capital structure is a very simple one, comprised of common and preferredstock. It's earnings-per-share computation will suffice under this scenario. However, ifthe capital structure is more complex and contains securities which are convertibleinto common stock, options, warrants or contingently issuable shares, the calculationrequires modification. In fact, separate calculations must be performed. This is calleddual presentation. The calculations are primary and fully diluted earnings per commonshare.


38/48

Primary Earnings Per Common Share

This is determined by dividing the earnings for the year not only by the number ofshares of common stock outstanding but by the common stock plus common stock

equivalents if dilutive.

Common stock equivalents are securities, such as convertible preferred stock,convertible bonds, stock options, warrants and the like, that enable the holder tobecome a common shareholder by exchanging or converting the security. These aredeemed to be only one step short of common stock -- their value stems in large partfrom the value of the common to which they relate.

Convertible preferred stock and convertible bonds offer the holder either a specifieddividend rate or interest return, or the option of participating in increased earnings on

the common stock, through conversion. They don't have to be actually converted tocommon stock for these securities to be called a common stock equivalent. This isbecause they are in substance equivalent to common shares, enabling the holder at hisdiscretion to cause an increase in the number of common shares by exchanging orconverting. How do accountants determine a common stock equivalent? A convertiblesecurity is considered a common stock equivalent if its effective yield at the date of itsissuance is less than two-thirds of the then-current average Aa corporate bond yield.

Now, let's put our new terms to work in an example, remembering that it hasnothing to do with our own company, Typical Manufacturing. We start with the facts

we have available. We'll say we have 100,000 shares of common stock outstandingplus another 100,000 shares of preferred stock, convertible into common on a share-for-share basis. (Assume they qualify as common stock equivalents.) We add the twoand get 200,000 shares altogether. Now let's say our earnings figure is $500,000 forthe year. With these facts, our primary computation is easy:

$500,000 earnings for the year

200,000 adjusted shares outstanding= $2.50 primary

earnings per share

However, as mentioned earlier, the common stock equivalent shares are onlyincluded in the computation if the effect of conversion on earnings per share isdilutive. Dilution occurs when earnings per share decrease or loss per share increases.For example, assume the preferred stock paid $3 a share in dividends. Withoutconversion, the earnings per share would be $2, as opposed to $2.50 per share,because net income available for common after payment of dividends would be


39/48

$200,000 ($500,000 less $300,000) divided by the 100,000 common sharesoutstanding. In this case, the common stock equivalent shares would be excluded fromthe computation because conversion results in a higher earnings per share (anti-dilutive). Therefore, earnings per share of $2 will be reflected on the incomestatement.

Fully Diluted Earnings Per Common Share

The primary earnings per share item, as we have just seen in the preceding section,takes into consideration common stock and common stock equivalents. The purposeoffully diluted earnings per shareis to reflect maximum potential dilution in earningsthat would result if all contingent issuances of common stock had taken place at thebeginning of the year.

This computation is the result of dividing the earnings for the year by: commonstockand common stock equivalentsand all other securities that are convertible (eventhough they do not qualify as common stock equivalents).

How would it work? First, remember that we have 100,000 shares of convertiblepreferred outstanding, as well as our 100,000 in common. Now, let's say we also haveconvertible bonds with a par value of $10,000,000 outstanding. These bonds pay 6%interest and have a conversion ratio of 20 shares of common for every $1,000 bond.Assume the current average Aa corporate bond yield is 8%. These bonds are notcommon stock equivalents, because 6% is not less than two-thirds of 8%. However,

for fully diluted earnings per share we have to count them in. If the 10,000 bonds wereconverted, we'd have another 200,000 shares of stock, so adding everything up givesus 400,000 shares. But by converting the bonds, we could skip the 6% interestpayment, which gains us another $600,000 gross earnings. So our calculation lookslike this:

Earnings for the year $500,000

Interest on the bonds $600,000

Less: the income tax

applicable to deduction300,000

300,000

Adjusted earnings $800,000

$800,000 adjusted earnings

400,000 adjusted shares outstanding= $2 fully diluted

earnings per share


40/48

The only remaining step is to test for dilution. Earnings per share without bond

conversion would be $2.50 ($500,000 divided by 200,000 shares). Since earnings pershare of $2 is less than $2.50 we would assume debt conversion in our calculation offully diluted earnings per share.

Price-Earnings Ratio

Both the price and the return on common stock vary with a multitude of factors,One such factor is the relationship that exists between the earnings per share and themarket price. It is called theprice-eamings ratio, and this is how it is calculated: If astock is selling at 25 and earning $2 per share, its price-earnings ratio is 12 1/2 to 1,usually shortened to 12 1/2 and the stock is said to be selling at 12 1/2 times earnings.If the stock should rise to 40, the price-earnings ratio would be 20. Or, if the stock

drops to 12, the price-earnings ratio would be 6.

In Typical Manufacturing, which has no convertible common stock equivalents, theearnings per share were calculated at $3.16. If the stock were selling at 33, the price-earnings ratio would be 10.4. This is the basic figure that you should use in viewingthe record of this stock over a period of years and in comparing the common stock ofthis company with other similar stocks.

26

$33 market price

$3.16 earnings per share

= 10.4 : 1 or

10.4 times

This means that Typical Manufacturing common stock is selling at approximately10.4 times earnings.

Last year, Typical earned $2.77 per share. Let's say that its stock sold at the sameprice-earnings ratio then. This means that a share of Typical was selling for $28.80 orso, and anyone who bought Typical then would be satisfied now. Just remember, inthe real world, investors can never be certain that any stock will keep its same price-

earnings ratio from year to year. The historical P/E multiple is a guide, not aguarantee.

In general, a high P/E multiple, when compared with other companies in the sameindustry, means that investors have confidence in the company's ability to producehigher profits in the future.


41/48

Statement of Changes in Shareholders' Equity(dollars in thousands except per-share amounts)

This statement analyzes the changes from year to year in each shareholder's equityaccount. From this statement, we can see that during the year additional commonstock was issued at a price above par. We can also see that Typical experienced atranslation gain. The rest of the components of equity, with the exception of retainedearnings which we discuss below, remained the same.

Just as the income statement reflects the payoff for shareholders, retained earningsreflects the payoff for the company itself . It shows how much money the companyhas plowed back into itself for new growth. The Statement of Changes shows thatretained earn-ings increase by net income less dividends on pre-ferred and commonstock. Since we have already analyzed net income, we will now analyze dividends.

Dividends

Dividends on common stock vary with the profitability of the company. Commonshareholders were paid $18,000 in dividends this year. Since we know from thebalance sheet that Typical has 14,999,000 shares outstanding, the first thing we canlearn here is what may be the most important point to some potential investors -

dividends per share.

$18,000,000 common stock dividends14,999,000 shares

= $1.20 per

share

Once we know the amount of dividends per share, we can easi ly discover thedividendpayout ratio. This is Simply the percentage of net earnings per share that ispaid to shareholders.

46$1.20 dividend per common share$3.16 earnings per common share

= 38%

Of course, the dividends on the $5.83 preferred stock will not change from year to


42/48

year, The word cumulativein the balance statement description tells us that ifTypical's management someday didn't pay a dividend on its preferred stock, then the$5.83 payment for that year would accumulate. It would have to be paid to preferredshareholders before any dividends could ever be declared again on the commonstock.

That's why preferred stock is called preferred. It gets at any dividend money first.We've already talked about convertible bonds and convertible preferred stock. Rightnow, we're not interested in that aspect because Typical Manufacturing doesn't haveany convertible securities outstanding. Chances are its 60,000 shares of preferredstock, with a par value of $100 each, were issued to family members of Mr. IsaiahTypical, who founded the company back in 1923. When he took Typical public, hedidn't keep any of the common stock. In those days, the guaranteed $5.83 dividendwas more important to Isaiah, He was not interested in taking any more chances onTypical.

During the year, Typical has added $29,400 to its retained earnings. Even if Typicalhas some lean years in the future, it has plenty of retained earnings from which tokeep on declaring those $5.83 dividends on the preferred stock and $1.20 dividendson the com-mon stock.

There is one danger in having a lot of retained earnings. It could attract anothercompany -- Shark Fast Foods & Electronics, for instance -- to buy up Typical'scommon stock to gain enough control to vote out the current management. Then

Shark might merge Typical into itself. Where would Shark get the money to buyTypical stock? By issuing new shares of its own stock, perhaps. And where wouldShark get the money to pay the dividends on all that new stock of its own? FromTypical's retained earnings. So Typical's management has the obligation to itsshareholders to make sure that its retained earnings are put to work to increase thetotal earnings per share of the shareholders. Or else, the shareholders might cooperatewith Shark if and when it makes a raid.

25Retained earnings $249,000

Return on Equity

Seeing how hard money works, of course, is one of the most popular measures thatinvestors use to come up with individual judgments on how much they think a certainstock ought to be worth. The market itself-- the sum of all buyers and sellers-- makes


43/48

the real decision. But the investors often try to make their own, in order to decidewhether they want to invest at the market's price or wait. Most investors look forTypical's return on equity, which shows how hard shareholders' equity in Typical isworking. In order to find Typical's current return on equity, we look at the balancesheet and take the common shareholders'equity for last year--not the current year--and

then we see how much Typical made this year on it. We use only the amount of netprofit after the dividends have been paid on the preferred stock. For TypicalManufacturing, that means $47,750 net profit minus $350. Here is what we get:

$47,750 net income - $350 preferred stock

dividend $305,600 last year's stockholders' equity- $6,000

preferred stock value

$47,000 = 15.8%

$299,600Return on equity

For every dollar of shareholders' equity, Typical made more than $0.15. Is thatgood? Well, $0.158 on the dollar is better than Typical could have done by going outof business, taking its shareholders' equity and putting that $299,600 in the bank. SoTypical obviously is better off in its own line of work. When we consider putting ourmoney to work in Typical's stock, we should compare Typical's $0.158 not only towhatever Typical's business competitors make, but to Typical's investmentcompetitors for our money.For instance, the latest available average rate for all U.S.

industry, according to the U.S. Federal Trade Commission, was $0.16.

Just remember that $0.158 is what Typical itself makes on the dollar.By no meansis it what you will make in dividends on Typical's stock. What that return on equityreally tells you is whether Typical Manufacturing is relatively attractive as anenterprise, You can only hope that this attractiveness might be translated into demandfor Typical stock, and be reflected in its price.

Many analysts also like to see a company's annual return on the total capitalavailable to the company. To get this figure, we use all the equity, plus all availableborrowed funds. This becomes the total capital available. And for the total return onthis figure we use net income before income taxes and interest charges. This gives usa bigger capital base and a larger income figure. As shareholders, however, what we'remost interested in is how hard our own share of the company is working, and that'swhy we are more interested in return on equity.


44/48

Statement of Cash Flows

One more statement needs to be analyzed in order to get the full picture of Typical'sfinancial status. The Statement of Cash Flows examines the changes in cash resultingfrom business activities. Cash-flow analysis is necessary in order to make properinvesting decisions, as well as to maintain operations. Cash flows, although related tonet income, are not equivalent, This is because of the accrual concept of accounting.Generally, under accrual accounting, a transaction is recognized on the incomestatement when the earnings process has been completed or an expense has beenincurred. This does not necessarily coincide with the time that cash is exchanged. Forexample, cash received from merchandise sales often lags behind the time whengoods are delivered to customers. However, the sale is recorded on the incomestatement when the goods are shipped.

Cash flows are separated by business activity. The business activity classificationspresented on the statement include investing activities, financing activities, andoperating activities. First, we will discuss financing and investing activities. Operatingactivities basically include all activities not classified as either financing or investingactivities.

Financing activities include those activities relating to the generation andrepayment of funds prvided by creditors and investors. These activities include theissuance of debt or equity securities and the repayment of debt and distribution of

dividends. Investing activities include those activities relating to asset acquisition ordisposal.

Operating activities involve activities relating to the production delivery of goodsand services. They reflect the cash effects of transactions which are included in thedetermination of net income. Since many items enter into the determination of netincome, the indirect method is used to determine the cash provided by or used foroperating activities. This method requires adjusting net income to reconcile it to cashflows from operating activities. Common examples of cash flows from operatingactivities are interest received and paid, dividends received, salary, insurance, and tax

payments.

Qualifying and Certifying

Watch Those Footnotes


45/48

The annual reports of many companies contain this statement: "The accompanyingfootnotes are an integral part of the finacial statements." The reason is that the finacialreports themselves are kept concise and condensed. Therefore, any explanatory matterthat cannot readily be abbreviated is set out in greater detail in footnotes,

Some examples of approriate footnotes are:

Description of the company'spolicyfor depreciation, amortization, consolidation,foreign currency translation, and earnings per share.

Inventory valuation method. This footnote indicates whether inventories shown onthe blance sheet or used in determining the cost of goods sold on the income statementare valued on a last in, first out (LIFO) basis or a first in, first out (FIFO) basis. Lastin, last out means that the cost on the income statement reflect the actual cost ofinventories purchased most recently. First in, first out means the income statementreflects the cost of the oldest inventories. This is an extremely important considerationbecause a LIFO valuation reflects current costs and does not overstate profits duringinflationary times while a FIFO vlauation does.

Changes in accounting policy as a result of new accounting rules.

Non-reccuring items such as pension-plan terminations or sales of significantbusiness units.

Employment contracts, profit sharing, pension, and retirement plans.

Details of stock options granted to officers and employees.


46/48

Long-term leases. Companies which usually lease a considerable amount of selling

space must show their lease liabilities on a per-year basis for the next several yearsand their total lease liabilities over a longer period of time.

Details relating to issuance and maturities of long-temr debt.

Contigent liabilities representing claims or lawsuits pending.

Commitments relating to contracts in force that will affect future periods.

Inflation accounting adjustments. Certain companies must show the impact ifchanging prices in their finacial position by adjusting items that appear on the balancesheet and the income statement for current costs and the Consumer Price Index. FASBStatement Number 89 spells out the requirements for presenting inflation adjustedfiancial data.

Separate breakdowns of sales and gross profits must be shown for each line ofbusiness that accounts for more than 20% of a companies sales. Multinationalcorporations must also show slaes and gross income on a geographic basis bycountry.

Most people do not like to read footnotes because that may be complicated and

almost always hard to read. This is unfortunate, because footnotes are veryinformative. Even if they don't reveal that the corporation has been forced intobankruptcy, footnotes can still reveal many fascinating sidelights of the finacial story.

Independent Audits


47/48

The certificate from the independant auditors, which is printed inthe report, says,first, that the auditing steps taken in the process of verification of the account meet theaccounting world's approved standards of practice; and second, that the finacialstatements in the report have been prepared in conformity with generally acceptedaccounting principles (GAAP).

As a result, when the annual report contains finacial statements that have the stampof approval from independant auditors, you have an assurance that the figures can berelied upon as having been fairly presented.

However, if the independent auditors accounts' opinion contains words such as"except for," or "subject to," the reader should investigate the reason behind suchqualifications. Often the answer can be found by reading the footnotes that pertain tothe matter. They are usually referred to in the auditors opinion.

The Long View

We cannot emphasize too strongly that company records, in order to be very useful,must be compared. We can compare them to other company records, to industryaverages or even to broader economic factors, if we want.But most of all, we cancompare one company's annual activities to the same firm's results from other years.

This used to be done by keeping a file of old annual reports. Now, manycorporations include a ten-year summary in their financial highlights each year. Thisprovides the investing public with information about a decade of performance. That iswhy Typical Manufacturing included a ten-year summary in its annual report. It's nota part of the statements vouched for by the auditors, but it is there for you to see. Aten-year summary can show you:

The trend and consistency of sales The trend of earnings, particularly in relation to sales and the economy The trend of net earnings as a percentage of sales

The trend of return on equity Net earnings per share of common Dividends, and dividend policy.

Other companies may include changes in net worth, book value per share, capitalexpenditures for plant and machinery, long term debt, capital stock changes by way ofstock dividends and splits, number of em-ployees, number of shareholders, number ofoutlets, and where appropriate, information on foreign subsidiaries and the extent to


48/48

which foreign operations have been embodied in the financial report.

All of this is really important because of one central point: You are not only tryingto find out how Typical is doing now. You want to predict how Typical willdo, andhow its stock will perform.

Selecting Stocks

From the items we've studied in this booklet, Typical Manufacturing appears to bea healthy concern. Which should make Board Chairman Patience Typical, old IsaiahTypical's daughter, and her four nieces, who own most of the shares, happy. But itmakes us rather sad, since Typical is fictional, and we can't offer you shares of itsstock. When you decide to invest money In real stocks, please remember this:

Selecting common stocks for investment requires careful study of factors other than

those we can learn from financial statements. The economics of the country and theparticular industry must be considered. The management of the company must be

studied and its plans for the future assessed. Information about these other things is

rarely in the financial report. These other facts must be gleaned from the press or the

financial services or supplied by some research organizatlon. Merrill Lynch's Global

Securities Research and Economics Group stands ready to help you get the available

facts you need to be an intelligent Investor. Ask any Financial Consultant to put

Merrill Lynch to work for you.

how to read finanacial reports

Documents