this page is designed for the sole purpose of teaching someone how to read financial statements
TRANSCRIPT
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This page is designed for thesole purpose of teaching someone how to read
financial statements. While intended for those with little or now knowledge of
finacial statements, it can be a handy reminder even for the seasoned
professional. This page is very long so an outline is provided to help you get the
information you desire. (SEE OT!"#E$
HOW TO READ A FINANCIAL STATEMENT
"f you are a certified public accountant it is most unlikely that you can learn
anything from reading this book. %ou don&t need to be told the basics of
understanding what&s presented in corporate annual reports. "f you aren&t a
certified public accountant, and you find that annual reports are 'over your head,'
this booklet can help you to grasp the facts contained in such reports and
possibly become a better informed 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 business works and to learn more about the
companies that provide them with goods and services or that offer them
employment.
ost annual reports can be broken down into three sections) the E*ecutive
!etter, the business +eview, and the inancial +eview. The E*ecutive !etter
gives a broad overview of the company&s business and financial performance.
The -usiness +eview summaries recent developments, trends, and ob/ectives
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of the company. The inancial +eview is where business performance is
0uantified in dollars. This is the section we intend to clarify.
The inancial +eview has two ma/or parts) 1iscussion and 2nalysis, and
2udited inancial Statements. 2 third part might include information
supplemental to the inancial Statements. "n the 1iscussion and 2nalysis,
management e*plains changes in operating results from year to year. This
e*planation is presented mainly in a narrative format, with charts and graphs
highlighting the comparisons. The Operating results are numerically captured
and presented in the inancial Statements.
The principal components of the inancial Statements are the balance sheet3
income statement3 statement of changes in shareholders& e0uity3 statement of
cash flows3 and footnotes. The balance sheet portrays the financial strength of
the company by showing what the company owns and what it owes on a certain
date. The balance sheet can be thought of as a snapshot photograph since it
reports on financial position as of the end of the year. The income statement, on
the other hand, is like a motion picture since it reports on how the company
performed during the year and shows whether operations have resulted in a
profit or loss. The statement of changes in shareholders& e0uity reconciles the
activity in the e0uity section of the balance sheet from year to year. 4ommon
changes in e0uity result from company profits or losses, dividends, or stock
issuances. The statement of cash flows reports on the movement of cash by the
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company for the year. The footnotes provide more detailed information on the
balance sheet and income statement.
This booklet will focus on illustrating the basic financial statements and
footnotes presented in annual reports in accordance with current practice. "t will
also include e*amples of financial methods used by investors to better analye
financial statements. "n order to provide a framework for illustration, we will
invent a company. "t will be a public company (one whose shares are freely
traded on the open market$. The reason for choosing a public company is that it
is re0uired to provide the most e*tensive amount of information in its annual
reports in accordance with guidelines issued by the Securities and E*change
4ommission (SE4$. Our company will represent a typical corporation with the
most commonly used accounting and reporting practices. We&ll call our company
Typical anufacturing 4ompany, "nc.
A Few Words Before We Begin
-elow are four samples of a -alance Sheet, "ncome Statement, Statement of
4hanges in Shareholders& E0uity, and a Statement of 4ash lows. These are
the statements we will discuss in the first section. To simplify matters, we did not
illustrate the 1iscussion and 2nalysis nor did we present e*amples of the
E*ecutive !etter or -usiness +eview. "n our sample statements, we&ve
presented two years of financial results on the balance sheet and income
statement and one year of activity on the statement of changes in shareholders&
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e0uity and statement of cash flows. This was also done for ease of illustration.
Were we to comply with SE4 re0uirements, we would have had to report the last
three years of activity in the "ncome Statement, Statement of 4hanges in
Shareholders& E0uity, and Statement of 4ash lows. urther SE4 re0uirements
that we did not illustrate include) presentation of selected 0uarterly financial data
for the past two years, business segment information for the last three years, a
listing of company directors and e*ecutive officers, and the market price of the
company&s common stock for each 0uarterly period within the two most recent
fiscal years.
Typica
Man!fac"!ring
Co#pany Inc$
Consoida"ed Baance S%ee"
1ecember 56,6787 and 6789 (dollars in thousands$
Asse"s &'(' &'()
4urrent 2ssets
4ash :;
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accounts)
6787) :;,5?=, 6789)
:5,
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To"a c!rren" ia3ii"ies /&4+,+++ /&)&,+++
!ongBterm liabilities
1eferred income ta*es :6@,
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Typica
Man!fac"!ring
Co#pany Inc$
Consoida"ed Inco#e S"a"e#en"
December 31,19X9 and 19X8 (dollars in thousands)
&'(' &'()#et sales :?@=,
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benefit of :?=
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&'('
Ne"
inco#e>?,?=< >?,?=
preferred
s"oc9(5=
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4ash flows from operating activities)
#et income :>?,?= in"angi3es7 /11+,+++
A#o!n" re.!ired "o pay ia3ii"ies -&1,+++
A#o!n" re#aining for "%e
s%are%oders/-**,+++
#ow, we are going to give you a guided tour of the balance sheet&s accounts.
We&ll. define each item, one by one, and e*plain how they work.
Asse"s
C!rren" Asse"s
"n general, current assets include cash and those assets which in the normal
course of business will be turned into cash in the reasonably near future, i.e.,
generally within a year from the date of the balance sheet.
Cas%
This is /ust what you would e*pectBbills and coins in the till (petty cash fund$
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and money on deposit in the bank.
& Cas% /2+,+++
Mar9e"a3e sec!ri"ies
This asset represents investment of e*cess or idle cash that is not needed
immediately. "n Typical&s case it is invested in preferred stock. -ecause these
funds may be needed on short notice, it is essential that the securities be readily
marketable and sub/ect to a minimum of price fluctuation. The general practice is
to show marketable securities at cost or market, whichever is lower.
2
Mar9e"a3e sec!ri"ies a" cos" w%ic% appro?i#a"es
#9"$=a!e /*+,+++
Acco!n"s recei=a3e
ere we find the amount due from customers but not yet collected. When
goods due are shipped prior to collection, a receivable is recorded. 4ustomers
are usually given 5
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tornado, a hurricane, or a flood$ befalling their business. Therefore, in order to
show the accounts receivable item at a figure representing e*pected receipts, the
total is after a provision for doubtful accounts. This year that debt reserve was
:;,5?=.
- Acco!n"s recei=a3e:ess aowance for
do!3"f! acco!n"s of /2,-40
/&01,+++
In=en"ories
The inventory of a manufacturer is composed of three groups. raw materials to
be used in the product, partially finished goods in process of manufacture, and
finished goods ready for shipment to customers. The generally accepted method
of valuation of the inventory is cost or market, whichever is lower. This gives a
conservative figure. 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 realied
on the inventory. "nventory valuation includes an allocation of production and
other e*penses, as well as the cost of materials
* In=en"ories /&)+,+++
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Consoida"ed Baance S%ee"
1ecember 56,6787 and 6789 (dollars in thousands$
Asse"s &'(' &'()
4urrent 2ssets
& 4ash :;
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e.!ip#en"
) !ess accumulated depreciation :6;=,
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to preBpaid e*penses. owever, deferred charges are not included in current
assets because the benefit from such e*penditure will be reaped over several
years to come. So the e*penditure incurred will be gradually written off over the
ne*t several years, rather than fully charged off in the year payment is made. Our
balance sheet shows no deferred charges because Typical has none. "f it had,
they would normally be included &us& before intangibles on the asset side of the
ledger.
To summarie, the total current assets item includes primarily)
cash,marketable securities, accounts receivable, inventories, and prepaid
e*penses.
1 To"a c!rren" asse"s /*++,+++
%ou will observe that these assets are mostly working assets in the sense that
they are in a constant cycle of being converted into cash. "nventories, when sold
become accounts receivable3 receivables, upon collection, become cash3 cash is
used to pay debts and running e*penses. We will discover later in the booklet
how to make current assets tell a story.
8roper"y, 8an", and E.!ip#en"
Property, plant and equipment represents those assets not intended for sale that are
used over and over aain in order to manufacture, display, !arehouse, and transport the
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product" #his cateory includes land, buildins, machinery, equipment, furniture,
automobiles, and truc$s" #he enerally accepted and approved method for valuation is
cost minus the depreciation accumulated by the date of the balance sheet" Depreciation is
discussed in the ne%t section"
8roper"y, pan", and e.!ip#en"
Land / -+,+++
B!idings &20,+++
Mac%inery 2++,+++
Lease%od I#pro=e#en"s &0,+++
F!rni"!re, fi?"!res, e"c &0,+++
4To"a proper"y, pan" @
e.!ip#en"/-)0,+++
The figure displayed is not intended to reflect market value at present or
replacement cost in the future. While it is recognied that the cost to replace
plant and e0uipment at some future date might be higher, that possible cost is
obviously variable. or this reason, up to now, most companies have followed a
general rule) ac0uisition cost less accumulated depreciation based on that cost.
Deprecia"ion
1epreciation is the practice of allocating the cost of a fi*ed asset over its
useful life. This has been defined for accounting purposes as the decline in
useful value of a fi*ed asset due to wear and tear from use and passage of time.
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The cost incurred to ac0uire the property, plant and e0uipment must be spread
over the e*pected useful life, taking into consideration the factors discussed
above. or e*ample) Suppose a delivery truck costs :6
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Less acc!#!a"ed deprecia"ion /&20,+++
Thus, net property, plant and equipmentis the valuation for balance sheet
purposes of the investment in property, plant and e0uipment. 2s e*plained
before, it consists of the cost of the various assets in this classification, less the
depreciation accumulated to the date of the financial statement.
'
Ne" proper"y, pan", and
e.!ip#en" /21+,+++
1epletion is a term used primarily by mining and oil companies or any of the
soBcalled e*tractive industries. Since Typical anufacturing is not in the mining
business, we do not show depletion on the balance sheet. To deplete means to
e*haust or use up. 2s the oil or other natural resource is used up or sold, a
depletion reserve is set up to compensate for the natural wealth the company no
longer owns.
In"angi3es
These may be defined as assets having no physical e*istence, yet having
substantial value to the company. E*amplesF 2 franchise to a cable TG
company allowing e*clusive service in certain areas, or a patent for e*clusive
manufacture of a specific article. "t should be noted, however, that only
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intangibles purchased from other companies are shown on the balance sheet.
2nother intangible asset sometimes found in corporate balance sheets is
goodwill,
which represents the amount by which the price of ac0uired companies e*ceeds
the related values of net assets ac0uired. 4ompany practices vary considerably
in assigning value to this asset. 2ccounting rules now re0uire one firm that buys
another to write off the goodwill over a period not e*ceeding >< years.
&+ In"angi3es 6goodwi,
pa"en"s7ess a#or"ia"ion /2,+++
2ll of these items added together produce the figure listed on the balance
sheet as
total assets.
&& To"a asse"s /112,+++
Lia3ii"ies
Consoida"ed Baance S%ee"
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1ecember 56,6787 and 6789 (dollars in thousands$
Lia3ii"ies
4urrent liabilities
&2 2ccounts payable :@
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21oreign currency translation
ad/ustments6,
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No"es paya3e
"f money is owed to a bank, individual, corporation, or other lender, it appears
on the balance sheet under notes payable as evidence that a promissory note
has been given by the borrower.
&- No"es paya3e / 0&,+++
Accr!ed e?penses
#ow we have defined accounts payable as the amounts owed by the company
to its regular business creditors. The company also owes, on any given day,
salaries and wages to its employees, interest on funds borrowed from banks and
from bondholders, fees to attorneys, insurance premiums, pensions, and similar
items. To the e*tent that the amounts owed and not recorded on the books are
unpaid at the date of the balance sheet, these e*penses are grouped as a total
under accrued e*penses.
&* Accr!ed e?penses / -+,+++
Inco#e "a? paya3e
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The debt due to the various ta*ing authorities such as the "nternal +evenue
Service is the same as any other liability under accrued e*penses. -ut because
of the amount and the importance of the ta* factor, it is generally stated
separately as "ncome ta*es payable.
&0 Inco#e "a?es paya3e /&4,+++
O"%er Lia3ii"ies
Simply stated, other liabilities includes all liabilities captured in the specific
categories presented.
&1 O"%er ia3ii"ies /&2,+++
To"a c!rren" ia3ii"ies
inally, the total current liabilities item sums up all of the items listed under this
classification.
&4 To"a c!rren" ia3ii"ies /&4+,+++
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Long:"er# Lia3ii"ies
"n the matter of current liabilities, you will recall that we included debts due
within one year from the balance sheet date. ere, under the heading of longB
term liabilities are listed debts due after one year from the date of the financial
report.
Deferred inco#e "a?es
One of the longBterm liabilities on our sample balance sheet is deferred income
ta*es. The government provides businesses with ta* incentives to make certain
kinds of investments that will benefit the economy as a whole. 4urrent and longB
term debt are summed together to produce the figure listed on the balance sheet
as liabilities. or instance, a company can take accelerated depreciation
deductions for investments in plant and e0uipment. These rapid writeBoffs in the
early years of investment reduce what the company would otherwise owe in
current ta*es, but at some point in the future the ta*es must be paid. 4ompanies
include a charge for deferred ta*es in their ta* calculations on the income
statement and show what ta*es would be without the accelerated writeBoffs.
That charge then accumulates as a longBterm liability on the balance sheet.
&) Deferred inco#e "a?es /&1,+++
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De3en"!res
The other longBterm liability on our balance sheet is 6;.=C debentures due in
;
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&'&2$0 De3en"!res paya3e
2+&+/&-+,+++
O"%er ong:"er# de3"
Other longBterm debt includes all debt other than what is specifically reported
on in the balance sheet. "n the case of Typical, this debt was e*tinguished in
6797.
2+ O"%er ong:"er# de3" +
To"a ia3ii"ies
4urrent and longBterm debt are summer together to produce the figure listed
on the balance sheet as total liabilities.
2& To"a ia3ii"ies /-&1,+++
S%are%oders5 E.!i"y
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This item is the total e0uity interest that all shareholders have in this
corporation. "n other words, it is the corporation&s net worth after subtracting all
liabilities. This is separated for legal and accounting reasons into the categories
discussed below.
Capi"a S"oc9
"n the broadest sense this represents shares in the proprietary interest in the
company. These shares are represented by the stock certificates issued by the
corporation to its shareholders. 2 corporation may issue several different
classes of shares, each class having slightly different attributes.
8referred S"oc9
These shares have some preference over other shares with respect to
dividends and in distribution of assets in case of li0uidation. Specific provisions
can be obtained from a corporation&s charter. "n Typical, the preferred stock is a
:=.95 cumulative :6
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22 8referred s"oc9 /0$)- c!#!a"i=e,
/&++ par =a!e, a!"%oried iss!ed
and o!"s"anding 1+,+++ s%ares 1,+++
Co##on S"oc9
Each year before common shareholders receive any dividends, preferred
holders are entitled to :=.95 per share, but no more. 4ommon stock has no such
limit on dividends payable each year. "n good times, when earnings are high,
dividends may also be high. 2nd when earnings drop, so may dividends.
2- Co##on s"oc9 /0$++ par =a!e
a!"%oried 2+,+++,+++ s%ares,
iss!ed &0,+++,+++ s%ares
/40,+++
Addi"iona 8aid:in Capi"a
This is the amount paid in by shareholders over the par or legal value of each
share. Typical&s common stock has a par value of :=.
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capital.
2- Co##on s"oc9 /0$++ par =a!e
a!"%oried 2+,+++,+++ s%ares
iss!ed &0,+++,+++ s%ares
/40,+++
2* Addi"iona paid:in capi"a /2+,+++
To"a of capi"a s"oc9 6co##on7
and addi"iona paid:in capi"a
/'0,+++
Re"ained Earnings
When a company first starts in business, it has no retained earnings. +etained
earnings accumulate as the company earns profits and reinvests or 'retains'
profits in the company. "n other words, retained earnings increase by the amount
of profits earned, less dividends declared to shareholders. 2t the end of its first
year, if profits are :9
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Re"ained earnings a" "%e end of "%e
second year/&2+,+++
The balance sheet for Typical shows the company has accumulated :;>7,
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Treas!ry s"oc9
When a company reac0uires its own stock, it is reported as treasury stock and
is deducted from shareholder&s e0uity. Of the cost and par methods of
accounting, the former method is more commonly applied to treasury stock.
nder the cost method the cost of reac0uired stock is deducted from share
holders& e0uity. 2ny dividends on shares held in thetreasury should never be
included as income.
24 Treas!ry S"oc9 /0,+++
The sum total of stock (net of treasury stock$, additional paidBin capital,
retained earnings and foreign currency translation ad/ustments, represents the
total shareholder&s e0uity.
2) To"a s%are%oders5 e.!i"y /-*1,+++
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"n order to analye balance sheet figures, investors look to certain financial
statement ratios for guidance. One of their concerns is whether the business will
be able to pay its debts when they come due. They are also interested in the
company&s inventory turnover and the amount of assets backing corporate
securities (bonds, preferred and common stock$, along with the relative mi* of
these securities. "n the following section, we discuss various ratios used for
balance sheet analysis
Ne" Wor9ing Capi"a
One very important thing to be learned from the balance sheet is net working
capital or net current assets, sometimes called working capital. This is the
difference between total current assets and total current liabilities. %ou will recall
that current liabilities are debts generally due within one year from the date of the
balance sheet. The source from which to pay those debts is current assets.
Thus, working capital represents the amount that is left free and clear after all
current debts are paid off. or Typical this is)
1 C!rren" asse"s /*++,+++
&4 Less> c!rren" ia3ii"ies &4+,+++
Wor9ing capi"a /2-+,+++
"f you consider yourself a conservative investor, you should invest only in
companies that maintain a comfortable amount of working capital. 2 company&s
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ability meet obligations, e*pand volume, and take advantage of opportunities is
often determined by its working capital. oreover, since you want your company
to grow, this year&s working capital should be larger than last year&s.
C!rren" Ra"io
What is a comfortable amount of working capitalF 2nalysts use several
methods to /udge whether a company has a sound working capital position. To
help you interpret the 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 for an industrial company is to compare the current assets
figure with the total current liabilities. 2 current ratio of ; to6is generally
considered ade0uate. This means that for each :6 of current liabilities, there
should be :; in current assets.
To find the current ratio, divide current assets by current liabilities. "n Typical&s
balance sheet)
1
C!rren" asse"s
/*++,+++
C!rren" ia3ii"ies
/&4+,+++
2$-0 or 2$-0 "o
&
Thus, for each :6 of current liabilities, there is :;.5= in current assets to back it
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up.
There are so many different kinds of companies, however, that this test
re0uires a great deal of modification if it is to be really helpful in analying
companies in different industries. Denerally, companies that have a small
inventory and easily collectible accounts receivable can operate safely with a
lower current ratio than those companies having a greater proportion of their
current assets in inventory and selling their products on credit.
How !ic9 is !ic9
"n addition to net working capital and current ratio, there are other ways of
testing the ade0uacy of the current position. What are 0uick assetsF They&re the
assets you have to cover a sudden emergency, assets you could take right away
to the bank, if you had to. They are those current assets that are 0uickly
convertible into cash. This leaves out merchandise inventories, because such
inventories have yet to be sold and are not convertible into cash. 2ccordingly,
0uick assets are current assets minus inventories and prepaid e*penses.
1 C!rren" asse"s /*++,+++* Less> in=en"ories &)+,+++
0 Less> prepaid e?penses *,+++
!ic9 asse"s /2&1,+++
et quic$ assets are found by ta$in the quic$ assets and subtractin the total current
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liabilities" * !ell+fi%ed industrial company should sho! a reasonable e%cess of quic$
assets over current liabilities" #his provides a riorous and important test of a companys
ability to meet its obliations"
!ic9 asse"s /2&1,+++
&4Less> c!rren"
ia3ii"ies &4+,+++
Ne" !ic9 Asse"s /*1,+++
The quick assets ratiois found by dividing 0uick assets by current liabilities.
&4/2&1,+++ !ic9 asse"s
C!rren" ia3ii"ies &$- or &$- "o &
2s you see, for each :6 of current liabilities, there is the same industry. :6.5,67@3 the ta* comes to :>6,>>@.
-) Inco#e 3efore pro=ision for inco#e "a?es /'*,&'1-' 8ro=ision for inco#e "a?es *&,**1
Inco#e Before E?"raordinary Loss
2fter we have taken into consideration all ordinary income (the plus factors$
and deducted all ordinary costs (the minus factors$, we arrive at income before
extraordinary lossfor the year.
*+Inco#e 3efore e?"raordinary
oss/02,40+
E?"raordinary Loss
nder ordinary conditions, the above income of :=;,?=< would be the end of
the story. owever, there are years in which companies e*perience unusual and
infre0uent events called extraordinary items. E*amples of e*traordinary items
include debt e*tinguishments, ta* loss carry forwards, pension plan terminations,
and litigation settlements. "n this case, Typical e*tinguished a portion of its debt
early. This event&s isolated on a separate line, net of its ta* effect. "ts earningsB
perBshare impact is also segregated from the earnings per share attributBable
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to'normal' operations.
*& Loss on eary e?"ing!is%#en"
of de3" 6ne" of "a? 3enefi" of
/40+7
6/0,+++7
Ne" Inco#e
Once all income and costs, including e*traordinary items, are considered, we
arrive at net income.
*2 Ne" inco#e /*4,40+
-ondensed, the income statement loo$s li$e this.
Plus factors:
-+ Ne" saes /410,+++
-1Di=idends and
In"eres" 0,20+
To"a /44+,20+
Minus factors:
-& Cos" of saes /0-0,+++
--:
-*Opera"ing e?penses &2*,)+*
-4 In"eres" e?pense &1,20+
-' 8ro=ision for inco#e *&,**1
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"a?es
To"a /4&4,0++
*+ Ne" inco#e 3efore
e?"raordinary oss
/ 02,40+
*& E?"raordinary oss 60,+++7*2 Ne" inco#e / *4,40+
O"%er I"e#s
Two other items that do not apply to Typical could appear on an income
statement. irst, .S. companies that do business overseas may have
transaction gains or losses related to fluctuations in foreign currency e*change
rates.
Second, if a corporation owns more than ;
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The income statement will tell us a lot more if we make a few detailed
comparisons. -efore you invest in a company, you want to know its operating
marginof profit and how it has changed over the years. Typical had sales of
:?@=,
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2nalysts also fre0uently use operating cost ratiofor the same purpose.
Operating cost ratio is the complement of the margin of profit. Typical&s profit
margin is 65.9C. The operating cost ratio is 9@.;C. B
A#o!n" Ra"io
-+ Ne" Saes /410,+++ &++$+
-&,--,-* Opera"ing Cos" 10',)+* )1$2
-0Opera"ing
Inco#e/&+0,&'1 &-$)
et profit ratiois still another guide to indicate how satisfactory the year&s
activities have been. "n Typical anufacturing, the year&s net income was
:>?,?=
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*2
-+
/*+,0++ ne" inco#e
/420,+++ saes 0$1
We can compare the .S. 1epartment of 4ommerce&s latest available average
profit margins for all .S. manufacturers to the profit margins calculated from
Typical&s 6
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specifically, we would like to know whether the borrowed funds have been put to
good use so that the earnings are ample and thus available to meet interest
costs.
The available income representing the source for payment of the bond interest
is :66>@ (operating profit plus dividends and interest$. The annual bond
interest amounts to :6@,;=
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company with :6
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is about 69C of :>
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available for common stock.
*1 Earnings per s%are /-$&1
-ut if it didn&t, we could calculate it ourselves)
*2Ne" profi" for "%e year /*4,40+
Less> di=idend re.!ire#en"s on
preferred s"oc9 -0+
Earnings a=aia3e for "%e co##on
s"oc9/*4,*++
/*4,*++,+++
&*,''',+++
earnings a=aia3e af"er preferred
di=idends
n!#3er of o!"s"anding co##on s%ares
/-$&1 earnings
per
s%are of co##on
Typical&s capital structure is a very simple one, comprised of common and
preferred stock. "t&s earningsBperBshare computation will suffice under this
scenario. owever, if the capital structure is more comple* and contains
securities which are convertible into common stock, options, warrants or
contingently issuable shares, the calculation re0uires modification. "n fact,
separate calculations must be performed. This is called dual presentation. The
calculations are primary and fully diluted earnings per common share.
8ri#ary Earnings 8er Co##on S%are
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This is determined by dividing the earnings for the year not only by the number
of shares of common stock outstanding but by the common stock plus common
stock equivalents if dilutive.
4ommon stock e0uivalents are securities, such as convertible preferred stock,
convertible bonds, stock options, warrants and the like, that enable the holder to
become a common shareholder by e*changing or converting the security. These
are deemed to be only one step short of common stock BB their value stems in
large part from the value of the common to which they relate.
4onvertible preferred stock and convertible bonds offer the holder either a
specified dividend 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 to common stock for these securities to be called a
common stock e0uivalent. This is because they are in substance e0uivalent to
common shares, enabling the holder at his discretion to cause an increase in the
number of common shares by e*changing or converting. ow do accountants
determine a common stock e0uivalentF 2 convertible security is considered a
common stock e0uivalent if its effective yield at the date of its issuance is less
than twoBthirds of the thenBcurrent average 2a corporate bond yield.
#ow, let&s put our new terms to work in an e*ample, remembering that it has
nothing to do with our own company, Typical anufacturing. We start with the
facts we have available. We&ll say we have 6
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common on a shareBforBshare basis. (2ssume they 0ualify as common stock
e0uivalents.$ We add the two and get ;
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The primary earnings per share item, as we have /ust seen in the preceding
section, takes into consideration common stock and common stock e0uivalents.
The purpose of fully diluted earnings per shareis to reflect ma*imum potential
dilution in earnings that would result if all contingent issuances of common stock
had taken place at the beginning of the year.
This computation is the result of dividing the earnings for the year by) common
stockand common stock equivalentsand all other securities that are convertible
(even though they do not qualify as common stock equivalents) .
ow would it workF irst, remember that we have 6
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appica3e "o ded!c"ion
-++,+++
Ad;!s"ed earnings /)++,+++
/)++,+++ ad;!s"ed
earnings
*++,+++ ad;!s"ed s%ares
o!"s"anding
/2 f!y di!"ed
earnings per
s%are
The only remaining step is to test for dilution. Earnings per share without bond
conversion would be :;.=< (:=
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use in viewing the record of this stock over a period of years and in comparing
the common stock of this company with other similar stocks.
21/-- #ar9e" price
/-$&1 earnings per s%are
&+$* > & or
&+$* "i#es
This means that Typical anufacturing common stock is selling at
appro*imately 6 times earnings.
!ast year, Typical earned :;.?? per share. !et&s say that its stock sold at the
same priceBearnings ratio then. This means that a share of Typical was selling for
:;9.9< or so, and anyone who bought Typical then would be satisfied now. Just
remember, in the real world, investors can never be certain that any stock will
keep its same priceBearnings ratio from year to year. The historical AIE multiple is
a guide, not a guarantee.
"n general, a high AIE multiple, when compared with other companies in the
same industry, means that investors have confidence in the company&s ability to
produce higher profits in the future.
S"a"e#en" of C%anges in S%are%oders5 E.!i"y
(dollars in thousands e*cept perBshare amounts$
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This statement analyes the changes from year to year in each shareholder&s
e0uity account. rom this statement, we can see that during the year additional
common stock was issued at a price above par. We can also see that Typical
e*perienced a translation gain. The rest of the components of e0uity, with the
e*ception of retained earnings which we discuss below, remained the same.
Just as the income statement reflects the payoff for shareholders, retained
earnings reflects the payoff for the company itself . "t shows how much money
the company has plowed back into itself for new growth. The Statement of
4hanges shows that retained earnBings increase by net income less dividends on
preBferred and common stock. Since we have already analyed net income, we
will now analye dividends.
Di=idends
1ividends on common stock vary with the profitability of the company.
4ommon shareholders were paid :69,
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&*,''',+++ s%ares s%are
Once we know the amount of dividends per share, we can easi ly discover the
dividendpayout ratio. This is Simply the percentage of net earnings per share
that is paid to shareholders.
*1/&$2+ di=idend per co##on s%are
/-$&1 earnings per co##on s%are -)
Of course, the dividends on the :=.95 preferred stock will not change from
year to year, The word cumulativein the balance statement description tells us
that if Typical&s management someday didn&t pay a dividend on its preferred
stock, then the :=.95 payment for that year would accumulate. "t would have to
be paid to preferred shareholders before any dividends could ever be declared
again on the common stock.
That&s why preferred stock is called preferred. "t gets at any dividend money
first. We&ve already talked about convertible bonds and convertible preferred
stock. +ight now, we&re not interested in that aspect because Typical
anufacturing doesn&t have any convertible securities outstanding. 4hances are
its @
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days, the guaranteed :=.95 dividend was more important to "saiah, e was not
interested in taking any more chances on Typical.
1uring the year, Typical has added :;7,>
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Seeing how hard money works, of course, is one of the most popular
measures that investors use to come up with individual /udgments on how much
they think a certain stock ought to be worth. The market itselfBB the sum of all
buyers and sellersBB makes the real decision. -ut the investors often try to make
their own, in order to decide whether they want to invest at the market&s price or
wait. ost investors look for Typical&s return on e0uity, which shows how hard
shareholders& e0uity in Typical is working. "n order to find Typical&s current return
on e0uity, we look at the balance sheet and take the common
shareholders&e0uity for last yearBBnot the current yearBBand then we see how
much Typical made this year on it. We use only the amount of net profit after the
dividends have been paid on the preferred stock. or Typical anufacturing, that
means :>?,?=< net profit minus :5=
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putting our money to work in Typical&s stock, we should compare Typical&s
:
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One more statement needs to be analyed in order to get the full picture of
Typical&s financial status. The Statement of 4ash lows e*amines the changes in
cash resulting from business activities. 4ashBflow analysis is necessary in order
to make proper investing decisions, as well as to maintain operations. 4ash
flows, although related to net income, are not e0uivalent, This is because of the
accrual concept of accounting. Denerally, under accrual accounting, a
transaction is recognied on the income statement when the earnings process
has been completed or an e*pense has been incurred. This does not necessarily
coincide with the time that cash is e*changed. or e*ample, cash received from
merchandise sales often lags behind the time when goods are delivered to
customers. owever, the sale is recorded on the income statement when the
goods are shipped.
4ash flows are separated by business activity. The business activity
classifications presented on the statement include investing activities, financing
activities, and operating activities. irst, we will discuss financing and investing
activities. Operating activities basically include all activities not classified as
either financing or investing activities.
inancing activities include those activities relating to the generation and
repayment of funds prvided by creditors and investors. These activities include
the issuance of debt or e0uity securities and the repayment of debt and
distribution of dividends. "nvesting activities include those activities relating to
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asset ac0uisition or disposal.
Operating activities involve activities relating to the production delivery of
goods and services. They reflect the cash effects of transactions which are
included in the determination of net income. Since many items enter into the
determination of net income, the indirect method is used to determine the cash
provided by or used for operating activities. This method re0uires ad/usting net
income to reconcile it to cash flows from operating activities. 4ommon e*amples
of cash flows from operating activities are interest received and paid, dividends
received, salary, insurance, and ta* payments.
!aifying and Cer"ifying
Wa"c% T%ose Foo"no"es
The annual reports of many companies contain this statement) 'The
accompanying footnotes are an integral part of the finacial statements.' The
reason is that the finacial reports themselves are kept concise and condensed.
Therefore, any e*planatory matter that cannot readily be abbreviated is set out in
greater detail in footnotes,
Some e*amples of approriate footnotes are)
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1escription of the company&spolicyfor depreciation, amortiation,
consolidation, foreign currency translation, and earnings per share.
"nventory valuation method. This footnote indicates whether inventories shown
on the blance sheet or used in determining the cost of goods sold on the income
statement are valued on a last in, first out (!"O$ basis or a first in, first out
("O$ basis. !ast in, last out means that the cost on the income statement
reflect the actual cost of inventories purchased most recently. irst in, first out
means the income statement reflects the cost of the oldest inventories. This is an
e*tremely important consideration because a !"O valuation reflects current
costs and does not overstate profits during inflationary times while a "O
vlauation does.
4hanges in accounting policy as a result of new accounting rules.
#onBreccuring items such as pensionBplan terminations or sales of significant
business units.
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Employment contracts, profit sharing, pension, and retirement plans.
1etails of stock options granted to officers and employees.
!ongBterm leases. 4ompanies which usually lease a considerable amount of
selling space must show their lease liabilities on a perByear basis for the ne*t
several years and their total lease liabilities over a longer period of time.
1etails relating to issuance and maturities of longBtemr debt.
4ontigent liabilities representing claims or lawsuits pending.
4ommitments relating to contracts in force that will affect future periods.
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"nflation accounting ad/ustments. 4ertain companies must show the impact if
changing prices in their finacial position by ad/usting items that appear on the
balance sheet and the income statement for current costs and the 4onsumer
Arice "nde*. 2S- Statement #umber 97 spells out the re0uirements for
presenting inflation ad/usted fiancial data.
Separate breakdowns of sales and gross profits must be shown for each line
of business that accounts for more than ;
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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 the accounting world&s approved standards of practice3 and
second, that the finacial statements in the report have been prepared in
conformity with generally accepted accounting principles (D22A$.
2s a result, when the annual report contains finacial statements that have the
stamp of approval from independant auditors, you have an assurance that the
figures can be relied upon as having been fairly presented.
owever, if the independent auditors accounts& opinion contains words such
as 'e*cept for,' or 'sub/ect to,' the reader should investigate the reason behind
such 0ualifications. Often the answer can be found by reading the footnotes that
pertain to the matter. They are usually referred to in the auditors opinion.
T%e Long iew
We cannot emphasie too strongly that company records, in order to be very
useful, must be compared. We can compare them to other company records, to
industry averages or even to broader economic factors, if we want.-ut most of
all, we can compare one company&s annual activities to the same firm&s results
from other years.
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This used to be done by keeping a file of old annual reports. #ow, many
corporations include a tenByear summary in their financial highlights each year.
This provides the investing public with information about a decade of
performance. That is why Typical anufacturing included a tenByear summary in
its annual report. "t&s not a part of the statements vouched for by the auditors, but
it is there for you to see. 2 tenByear 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 e0uity
#et earnings per share of common
1ividends, and dividend policy.
Other companies may include changes in net worth, book value per share,
capital e*penditures for plant and machinery, long term debt, capital stock
changes by way of stock dividends and splits, number of emBployees, number of
shareholders, number of outlets, and where appropriate, information on foreign
subsidiaries and the e*tent to which foreign operations have been embodied in
the financial report.
2ll of this is really important because of one central point) %ou are not only
trying to find out how Typical is doing no!. %ou want to predict how Typical !ill
do, and how its stock will perform.
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Seec"ing S"oc9s
rom the items we&ve studied in this booklet, Typical anufacturing appears to
be a healthy concern. Which should make -oard 4hairman Aatience Typical, old
"saiah Typical&s daughter, and her four nieces, who own most of the shares,
happy. -ut it makes us rather sad, since Typical is fictional, and we can&t offer
you shares of its stock. When you decide to invest money "n real stocks, please
remember this)
"electing common stocks for investment requires careful study of factors other
than those !e can learn from financial statements# $he economics of the country
and the particular industry must be considered# $he 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# $hese other facts must
be gleaned from the press or the financial services or supplied by some research
organizatlon# %errill &ynch's lobal "ecurities esearch and *conomics roup
stands ready to help you get the available facts you need to be an intelligent
Investor# +sk any inancial onsultant to put %errill &ynch to !ork for you#