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  2. 2. HOW TO READ A FINANCIAL REPORT GOALS OF THIS BOOKLET “Management’s Discussion and Analysis” and “Audited Financial An annual report is unfamiliar terrain Statements.” It may also contain to many people. For those who are not supplemental financial information. accountants, analysts or financial planners, this booklet can help them to better under- In Management’s Discussion and Analysis stand such reports and possibly become (MD&A), a company’s management more informed investors. explains significant changes from year to year in the financial statements. Although present- This booklet was written and designed ed mainly in narrative format, the MD&A to help educate and guide its readers may also include charts and graphs highlight- so they might: ing the year-to-year changes. The company’s s Better understand the data included in operating results, financial position, changes financial reports and how to analyze it. in shareholders’ equity and cash flows are numerically captured and presented in the s Learn more about companies that offer audited financial statements. employment or provide investment opportunities. The financial statements generally consist of the balance sheet, income statement, state- A good starting point for achieving these ment of changes in shareholders’ equity, goals is to become familiar with the main statement of cash flows and footnotes. The components of a company’s annual report. annual financial statements usually are Please Note: Highlighted throughout this accompanied by an independent auditor’s booklet are key selected terms and defini- report (which is why they are called “audited” tions as a reference for readers. See also financial statements). An audit is a systematic the Glossary of Selected Terms in the examination of a company’s financial back of this booklet. statements; it is typically undertaken by a Certified Public Accountant (CPA). The audi- tor’s report attests to whether the financial COMPONENTS OF reports are presented fairly in keeping with AN ANNUAL REPORT generally accepted accounting principles, Most annual reports have three sections: (1) known as GAAP for short. The Letter to Shareholders, (2) the Business Following is a brief description or overview Review and (3) the Financial Review. Each of the basic financial statements, including section serves a unique function: the footnotes: s The Letter to Shareholders gives a broad overview of the company’s The Balance Sheet business and financial performance. The balance sheet, also called statement of financial position, portrays the financial s The Business Review summarizes position of the company by showing what a company’s recent developments, the company owns and what it owes at the trends and objectives. report date. The balance sheet may be thought of as a snapshot, since it reports s The Financial Review presents a the company’s financial position at a spe- company’s business performance in cific point in time. Usually balance sheets 1 dollar terms and consists of the represent the current period and a previous
  3. 3. HOW TO READ A FINANCIAL REPORT period so that financial statement readers A MODEL COMPANY CALLED can easily identify significant changes. “TYPICAL” The Income Statement To provide a framework for illustration, a fictional company will be used. It will On the other hand, the income statement be a public company (generally, one can be thought of more like a motion pic- whose shares are formally registered with ture, since it reports on how a company the Securities and Exchange Commission performed during the period(s) presented [SEC] and actively traded). A public com- and shows whether that company’s opera- pany will be used because it is required tions have resulted in a profit or loss. to provide the most extensive amount The Statement of Changes of information in its annual reports. The in Shareholders’ Equity requirements and standards for financial The statement of changes in shareholders’ reporting are set by both governmental equity reconciles the activity in the equity and nongovernmental bodies. (The SEC section of the balance sheet from period to is the major governmental body with period. Generally, changes in shareholders’ responsibility in this arena. The main equity result from company profits or nongovernmental bodies that set rules losses, dividends and/or stock issuances. and standards are the Financial (Dividends are payments to shareholders Accounting Standards Board [FASB]*, to compensate them for their investment.) the American Institute of Certified Public Accountants [AICPA] and the exchanges The Statement of Cash Flows the securities trade on. The statement of cash flows reports on This fictional company will represent the company’s cash movements during a typical corporation with the most com- the period(s) separating them by operating, monly used accounting and reporting investing and financing activities. practices. Thus, the model company will be called Typical Manufacturing Company, The Footnotes Inc. (or “Typical,” for short). The footnotes provide more detailed infor- mation about the financial statements. * The FASB is the primary, authoritative private- This booklet will focus on the basic sector body that sets financial accounting standards. From time to time, these standards change and financial statements, described above, new ones are issued. At this writing, the FASB and the related footnotes. It will also is considering substantial changes to the current include some examples of methods that accounting rules in the areas of consolidations, investors can use to analyze the basic segment reporting, derivatives and hedging, and financial statements in greater detail. liabilities and equity. Information regarding current, Additionally, to illustrate how these con- revised or new rules can be obtained by writing or calling the Financial Accounting Standards Board, cepts apply to a hypothetical, but realistic 401 Merritt 7, P.O. Box 5116, Norwalk, CT business, this booklet will present and 06858-5116, telephone (203) 847-0700. analyze the financial statements of a model company. 2
  4. 4. A FEW WORDS BEFORE BEGINNING The following pages show a sample of For example, the sample statements pre- the core or basic financial statements— sent Typical’s balance sheet at two year- a balance sheet, an income statement, ends; income statements for two years; a statement of changes in shareholders’ and a statement of changes in sharehold- equity and a statement of cash flows for ers’ equity and statement of cash flows for Typical Manufacturing Company. a one-year period. To strictly comply with SEC requirements, the report would have However, before beginning to examine included income statements, statements these financial statements in depth, the of changes in shareholders’ equity and following points should be kept in mind: statements of cash flows for three years. s Typical’s financial statements are illus- Also, the statements shown here do not trative and generally representative for include certain additional information a manufacturing company. However, required by the SEC. For instance, it does financial statements in certain special- not include: (1) selected quarterly finan- ized industries, such as banks, broker- cial information (including recent market dealers, insurance companies and pub- prices of the company’s common stock), lic utilities, would look somewhat dif- and (2) a listing of company directors and ferent. That’s because specialized executive officers. accounting and reporting principles Further, the “MD&A” will not be presented and practices apply in these and other nor will examples of the “Letter to specialized industries. Shareholders” and the “Business Review” s Rather than presenting a complete set be provided because these are not “core” of footnotes specific to Typical, this elements of an annual report. Rather, booklet presents a listing of appropriate they are generally intended to be explana- generic footnote data for which a reader tory, illustrative or supplemental in nature. of financial statements should look. To elaborate on these supplemental com- ponents could detract from this booklet’s s This booklet is designed as a broad, primary focus and goal: Providing readers general overview of financial reporting, with a better understanding of the not an authoritative, technical reference core or basic financial statements in an document. Accordingly, specific techni- annual report. cal accounting and financial reporting questions regarding a person’s personal or professional activities should be referred to their CPA, accountant or qualified attorney. s To simplify matters, the statements shown in this booklet do not illustrate every SEC financial reporting rule and regulation. 3
  5. 5. Typical Manufacturing Company, Inc. CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATED BALANCE SHEETS (Dollars in Thousands, Except Per-Share Amounts) December 31 19X9 19X8 Assets Current Assets: Cash and cash equivalents $19,500 $15,000 Marketable securities 46,300 32,000 Accounts receivable—net of allowance for doubtful accounts of $2,375 in 19X9 and $3,000 in 19X8 156,000 145,000 Inventories, at the lower of cost or market 180,000 185,000 Prepaid expenses and other current assets 4,000 3,000 Total Current Assets 405,800 380,000 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 Other Assets: Intangibles (goodwill, patents)— net of accumulated amortization of $300 in 19X9 and $250 in 19X8 1,950 2,000 Investment securities, at cost 300 — Total Other Assets 2,250 2,000 Total Assets $668,050 $631,600 See Accompanying Notes to Consolidated Financial Statements.* 4 * See pages 40-41 for examples of the types of data that might appear in the notes to a company’s financial statements.
  6. 6. Typical Manufacturing Company, Inc. CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATED BALANCE SHEETS December 31 19X9) 19X8) Liabilities and Shareholders’ Equity 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) Other liabilities 12,000) 12,000) Current portion of long-term debt 6,000) —) Total Current Liabilities 176,000) 181,000) Long-term Liabilities:) Deferred income taxes 16,000) 9,000) 9.12% debentures payable 2010 130,000) 130,000) Other long-term debt —) 6,000) Total Liabilities 322,000) 326,000) Shareholders’ Equity: Preferred stock, $5.83 cumulative, $100 par value; authorized, issued and outstanding: 60,000 shares 6,000) 6,000) Common stock, $5.00 par value, authorized: 20,000,000 shares; issued and outstanding: 19X9 - 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 (net of taxes) 1,000) (1,000) Unrealized gain on available-for-sale securities (net of taxes) 50) —) Less: Treasury stock at cost (19X9 and 19X8 - 1,000 shares) (5,000) (5,000) Total Shareholders’ Equity 346,050) 305,600) Total Liabilities and Shareholders’ Equity $668,050) $631,600) 5
  7. 7. Typical Manufacturing Company, Inc. CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATED INCOME STATEMENTS (Dollars in Thousands, Except Per-Share Amounts) Years Ended December 31, 19X9 19X8 Net sales $765,050) $725,000) Cost of sales 535,000) 517,000) Gross margin 230,050) 208,000) Operating expenses: Depreciation and amortization 28,050) 25,000) Selling, general and administrative expenses 96,804) 109,500) Operating income 105,196) 73,500) Other income (expense): Dividend and interest income 5,250) 10,000) Interest expense (16,250) (16,750) 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 earthquake destruction (net of income tax benefit of $750) (5,000) —) Net income $47,750) $40,500) Earnings per common share: Before extraordinary loss $3.55) $2.77) Extraordinary loss (.34) —) Net income per common share $3.21) $2.77) See Accompanying Notes to Consolidated Financial Statements CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY (Dollars in Thousands) Year Ended December 31, 19X9 Foreign Additional currency Unrealized Preferred Common paid-in Retained translation security Treasury stock stock capital earnings adjustments gain 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) Foreign currency translation gain 2,000) 2,000) Net unrealized gain on available-for-sale securities $50 $50) Balance Dec. 31, 19X9 $6,000 $75,000 $20,000 $249,000) $1,000) $50 ($5,000) $346,050) 6 See Accompanying Notes to Consolidated Financial Statements
  8. 8. Typical Manufacturing Company, Inc. CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATED STATEMENT OF CASH FLOWS (Dollars in Thousands) Year Ended December 31, 19X9 Cash flows from operating activities: Net income $47,750) Adjustments to reconcile net income to net cash from operating activities: Depreciation and amortization 28,050) Increase in accounts receivable (11,000) Decrease in inventory 5,000) Increase in prepaid expenses and other current assets (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 27,050) Net cash provided by operating activities 74,800) Cash flows from investing activities: Securities purchases: Trading (14,100) Held-to-maturity (350) Available-for-sale (150) Principal payment received on held-to-maturity securities 50 Purchase of fixed assets (38,400) Net cash used in investing activities (52,950) Cash flows from financing activities: Payment of notes payable (10,000) Proceeds from issuance of common stock 9,000) Payment of dividends (18,350) Net cash used in financing activities (19,350) Effect of exchange rate changes on cash 2,000 Increase in cash 4,500 Cash and cash equivalents at beginning of year 15,000 Cash and cash equivalents at the end of year $19,500 Income tax payments totaled $3,000 in 19X9. Interest payments totaled $16,250 in 19X9. See Accompanying Notes to Consolidated Financial Statements 7
  9. 9. THE BALANCE SHEET The balance sheet represents the financial s The Assets section includes all the picture for Typical Manufacturing as it goods and property owned by the stood at the end of one particular day, company, and uncollected amounts Dec. 31, 19X9, as though the company due (“receivables”) to the company were momentarily at a standstill. Typical’s from others. balance sheet for the previous year end is also presented. This makes it possible to s The Liabilities section includes all compare the composition of the balance debts and amounts owed (“payables”) sheets on those dates. to outside parties and lenders. The balance sheet is divided into s The Shareholders’ Equity section repre- two halves: sents the shareholders’ ownership inter- est in the company—what the compa- 1. Assets, always presented first (either ny’s assets would be worth after all on the top or left side of the page); claims upon those assets were paid. 2. Liabilities and Shareholders’ Equity Now, to make it easier to understand the (always presented below or to the composition of the balance sheet, each right of Assets). of its sections and the related line items within them will be examined one-by-one In the standard accounting model, the starting on page 9. To facilitate this walk- formula of Assets = Liabilities + Share- through, the balance sheet has been sum- holders’ Equity applies. As such, both marized, this time numbering each of its halves are always in balance. They are line items or accounts. In the discussion also in balance because, from an econom- that follows, each line item and how it ic viewpoint, each dollar of assets must be works will be explained. After examining “funded” by a dollar of liabilities or equity. the balance sheet, the income statement (Note: this is why this statement is called a will be analyzed using the same method- balance sheet.) ology. Then, the other financial statements Reported assets, liabilities, and sharehold- will be broken down element-by-element ers’ equity are subdivided into line items for similar analysis. or groups of similar “accounts” having a dollar amount or “balance.” A NOTE ABOUT NUMBERS AND CALCULATIONS Before beginning, however, it’s important to clarify how the numbers, calculations and numerical examples are presented in this booklet. All dollar amounts relating to the financial statements are presented in thousands of dollars with the following exceptions: (1) Per-share or share amounts are actual amounts; (2) actual amounts are used for accuracy of calculation in certain per-share computations; and (3) actual amounts are used in certain examples to illustrate a point about items not related to, nor shown in, the model financial statements. The parenthetical statement “(Actual Amounts Used )” will further identify amounts or computations where figures do not represent thousands of dollars. 8
  10. 10. THE BALANCE SHEET ASSETS CURRENT ASSETS Marketable Securities In general, current assets include cash and those Excess or idle cash that is not needed immediately assets that, in the normal course of business, will may be invested in marketable securities. These are be turned into cash within a year from the balance- short-term securities that are readily salable and sheet date. Current assets are listed on the balance usually have quoted prices. These may include: sheet in order of their “liquidity” or amount of time it takes to convert them into cash. s Trading securities — debt and equity securities, bought and sold frequently, primarily to generate Cash and Cash Equivalents short-term profits and which are carried at fair mar- This, just as expected, is money on deposit in the ket value. Any changes in such values are included bank, cash on hand (petty cash) and highly liquid in earnings. (Fair market value is the price at which securities such as Treasury bills. a buyer and seller are willing to exchange an asset in other than a forced liquidation.) 1 Cash and cash equivalents $19,500 CONSOLIDATED BALANCE SHEETS (Dollars in Thousands, Except Per-Share Amounts) December 31 19X9 19X8 Assets Current Assets: 1 Cash and cash equivalents $19,500 $15,000 2 Marketable securities 46,300 32,000 3 Accounts receivable—net of 156,000 145,000 allowance for doubtful accounts 4 Inventories 180,000 185,000 5 Prepaid expenses and other current assets 4,000 3,000 6 Total Current Assets 405,800 380,000 7 Total Property, plant and equipment 385,000 346,600 8 Less: accumulated depreciation 125,000 97,000 9 Net Property, Plant and Equipment 260,000 249,600 Other Assets: 10 Intangibles (goodwill, patents)— 1,950 2,000 net of accumulated amortization 11 Investment securities, at cost 300 — Total Other Assets 2,250 2,000 12 Total Assets $668,050 $631,600 9
  11. 11. THE BALANCE SHEET s Held-to-maturity securities — debt secu- Accounts Receivable rities that the company has the ability Here are found the amounts due from and intent to hold to maturity. “Maturity” customers that haven’t been collected as yet. is the date when debt instruments, such When goods are shipped to customers before as Treasury bills, are due and payable. payment or collection, an account receivable These securities are reported at amor- is recorded. Customers are usually given 30, tized cost (original cost adjusted for 60 or 90 days in which to pay. The total changes in any purchase discount or amount due from customers is $158,375. premium less any principal payments However, experience shows that some received). (Debt amortization is the customers fail to pay their bills (for example, practice of adjusting the original cost because of financial difficulties), giving rise of a debt instrument as principal pay- to accounts of doubtful collectibility. This ments are received and writing off any simply means it is unlikely that the entire purchase discount or premium to balance recorded as due and receivable will income over the life of the instrument.) be collected. Therefore, in order to show the s Available-for-sale securities — debt or accounts receivable balance at a figure rep- equity securities not classified as either resenting expected receipts, an allowance trading or held-to-maturity. They are for doubtful accounts is deducted from the recorded at fair value with unrealized total amount recorded. This year end, the changes in their value, net of taxes, allowance for doubtful accounts was $2,375. reported in stockholders’ equity. (Net of taxes means that the value or 3 Accounts receivable— $158,375) amount has been adjusted for the Less: allowance for effects of applicable taxes.) doubtful accounts (2,375) $156,000) In Typical’s case, it owns short-term, high-grade commercial paper, classified as “trading securities” and preferred stock, Inventory classified as “available-for-sale.” Typical, Inventory for a manufacturing company however, has no short-term “held-to-matu- consists of: (1) Raw materials—items to rity” securities (although it does have be used in making a product (for exam- an investment in publicly traded ple, the silk fabric used in making a silk mortgage bonds, a long-term “held-to- blouse); (2) work-in-process—partially maturity” debt security, which will be completed goods in the process of manu- discussed a bit later). facture (for example, pieces of fabric such as a sleeve and cuff sewn together during 2 Marketable securities: the process of making a silk blouse) and (3) finished goods—completed items ready Trading securities $46,100 for shipment to customers. Generally, the Available-for-sale 200 amount of each of the above types of inven- $46,300 tory would be disclosed either on the face 10
  12. 12. THE BALANCE SHEET of the balance sheet or in the footnotes. For 4 Inventories $180,000 Typical, inventory represents the cost of items on hand that were purchased Prepaid Expenses and/or manufactured for sale to customers. During the year, Typical paid fire insur- In valuing inventories, the lower of cost ance premiums and advertising charges for periods after the balance-sheet date. Since or market rule or method is used. This Typical has the contractual right to that generally accepted rule or method values insurance and advertising service after the inventory at its cost or market price, balance-sheet date, it has an asset, which whichever is lower. (Here market value, will be used after year end. Typical has or market price is the current cost of simply “prepaid”—paid in advance—for replacing the inventory by purchase or the right to use this service. Of course, manufacture, as the case may be, with if these payments had not been made, certain exceptions.) This provides a the company would have more cash in conservative figure. The value for balance- the bank. Accordingly, payments made for sheet purposes under this method which the company had not yet received usually will be cost. However, where benefits, but for which it will receive ben- deterioration, obsolescence, a decline efits within the year, are listed among cur- in prices or other factors are expected rent assets as prepaid expenses. to result in the selling or disposing of inventories below cost, the lower market 5 Prepaid expenses price would be used. and other current assets $4,000 Usually, a manufacturer’s inventories consist of quantities of physical products TOTAL CURRENT ASSETS assembled from various materials. To summarize, the “Total Current Assets” Inventory valuation includes the direct item includes primarily cash, marketable costs of purchasing the various materials securities, accounts receivable, inventories used to produce the company’s and prepaid expenses. products and an allocation (that is, an apportionment or dividing up) of the 6 Total Current Assets $405,800 production expenses to make those products. Manufacturers use cost These assets are “working” assets in the accounting systems to allocate such sense that they are “liquid”—meaning they expenses. (“Cost accounting” focuses on can and will, in the near term, be convert- specific products and is a specialized set ed into cash for other business purposes or of accounting procedures that are used to consumed in the business. Inventories, determine individual product costs.) when sold, become accounts receivable; When the individual costs for inventory receivables, upon collection, become cash; are added up, they comprise the inventory and the cash can then be used to pay the valuation. company’s debts and operating expenses. 11
  13. 13. THE BALANCE SHEET Property, Plant and Equipment jected period of time over which an asset is expected to have productive or Property, plant and equipment (often continuing value to its owner.) referred to as fixed assets) consists of Depreciation has been defined for assets not intended for sale that are used to manufacture, display, warehouse and accounting purposes as the decline in transport the company’s products and useful value of a fixed asset due to house its employees. This category “wear and tear” from use and the includes land, buildings, machinery, passage of time. equipment, furniture, automobiles and trucks. The generally accepted method The cost of acquired property, plant and for reporting fixed assets is cost minus equipment must be allocated over its the depreciation accumulated through the expected useful life, taking into date of the balance sheet. Depreciation consideration the factors discussed will be defined and explained further above. For example, suppose a delivery in discussing the next topic. truck costs $10,000 and is expected to last five years. Using the “straight-line Property, Plant and Equipment: method of depreciation” (equal periodic Land $30,000 depreciation charges over the life of the Buildings 125,000 asset), $2,000 of the truck’s cost is Machinery 200,000 charged or expensed to each year’s Leasehold improvements 15,000 income statement. The balance sheet at Furniture, fixtures, etc. 15,000 the end of one year would show: 7 Total property, plant (Actual Amounts Used) and equipment $385,000 Truck (cost) $10,000) The figure displayed is not intended Less: to reflect present market value or accumulated depreciation (2,000) replacement cost, since generally there Net depreciated cost $ 8,000) is no intent to sell or replace these assets in the near term. The cost to ultimately replace plant and equipment At the end of the second year it would at some future date might, and probably show: will, be higher. (Actual Amounts Used) Depreciation Truck (cost) $10,000) This is the practice of charging to, or Less: expensing against income, the cost of a fixed asset over its estimated useful accumulated depreciation (4,000) life. (Estimated useful life is the pro- Net depreciated cost $ 6,000) 12
  14. 14. THE BALANCE SHEET In Typical’s balance sheet, an amount Deferred Charges is shown for accumulated depreciation. Deferred charges are expenditures for This amount is the total of accumulated items that will benefit future periods depreciation for buildings, machinery, beyond one year from the balance-sheet leasehold improvements and furniture date; for example, costs for introduction and fixtures. Land is not subject to of a new product to the market or the opening of a new location. Deferred depreciation, and, generally, its reported charges are similar to prepaid expenses, balance remains unchanged from year but are not included in current assets to year at the amount for which it was because the benefit from such expendi- acquired. tures will be reaped over periods after one year from the balance-sheet date. 8 Less: accumulated (To “defer” means to put off or postpone to a future time.) The expenditure incurred depreciation $125,000 will be gradually written off over the future period(s) that benefit from it, rather than Thus, net property, plant and equipment is fully charged off in the year payment is the amount reported for balance-sheet pur- made. Typical’s balance sheet shows no poses of the investment in property, plant deferred charges because it has none. and equipment. As explained previously, Deferred charges would normally be it consists of the cost of the various assets included just before Intangibles in the Assets section of the balance sheet. in this classification, less the depreciation accumulated to the date of the financial Intangibles statement (net depreciated cost). Intangible assets (or “intangibles”) are assets having no physical existence, yet 9 Net Property, Plant having substantial value to the company. and Equipment $260,000 Examples are a franchise to a cable TV company allowing exclusive service in certain areas, a patent for exclusive manu- Depletion is a term used primarily by min- facture of a specific article, a trademark or ing and oil companies or any of the so- a copyright. called extractive industries. Since Typical Manufacturing is not in any of these busi- Another intangible asset often found nesses, depletion is not shown in its finan- in corporate balance sheets is goodwill, cial statements. To “deplete” means to which represents the amount by which the price of an acquired company exceeds exhaust or use up. As oil or other natural the fair value of the related net assets resources are used up or sold, depletion is acquired. This excess is presumed to be recorded (as a charge against income and the value of the company’s name, reputa- a reduction from its cost) to recognize the tion, customer base, intellectual capital and amount of natural resources sold, workforce (their know-how, experience, consumed or used to date. managerial skills and so forth.) 13
  15. 15. THE BALANCE SHEET Intangible assets reported on the balance 11 Investment securities, at cost sheet are generally those purchased from 8% mortgage bonds due others. Intangible assets are amortized 19Y4, original cost $350) (gradually reduced or written off, a process referred to as amortization) by periodic Less: principal prepayment charges against income over their estimat- in 19X9 (50) ed useful lives, but in no case for longer Investment securities than 40 years. The value of Typical’s intan- at amortized cost $300) gible assets, reduced by the total amount of these periodic charges against income However, this investment must also be (accumulated amortization), results in a reviewed to ensure that it is probable that figure for Typical’s net intangible assets. all contractually specified amounts are fully collectible. If not fully collectible, this 10 Intangibles investment would be considered perma- (goodwill, patents)— $ 2,250) nently impaired. If such permanent Less: accumulated impairment were found to exist, it would amortization (300) be necessary to write this investment down Net intangible assets $1,950) to its fair value. In this case, however, the issuer is in a strong financial condition. Investment Securities This is evidenced in two ways. First, the Investments in debt securities are carried issuer made an unscheduled prepayment at amortized cost only when they qualify of principal. Second, the property values as “held-to-maturity.” To so qualify, the have increased significantly where this investor must have the positive intent and well-maintained plant that secures these the ability to hold those securities until bonds is located. As such, there is no they mature. Early in 19X9, Typical pur- reason to suspect that all contractual chased on the New York Stock Exchange amounts will not be collected. Thus, mortgage bonds issued by one of its major there is no impairment, and no write suppliers. These bonds are due in full in down is necessary. five years and bear interest at 8% per year. In 19X9, the issuer made an unscheduled TOTAL ASSETS principal prepayment of $50. Since Typical intends to maintain a continuing relation- All of these assets (line items 1 to 11), ship with this supplier and to hold the added together, make up the figure for bonds until they mature—and appears the line item “Total Assets“ in Typical’s to have the financial strength to do so— balance sheet. this investment is classified as “held- to-maturity.” 12 Total Assets $668,050 14
  16. 16. THE BALANCE SHEET LIABILITIES AND SHAREHOLDERS’ EQUITY CURRENT LIABILITIES Accrued Expenses A current liability, in general, is an As discussed, accounts payable are obligation that is due and payable within amounts owed by the company to its 12 months. The “current liabilities” item regular business creditors for routine in the balance sheet is a companion to purchases. The company also owes, on “current assets” because current assets are any given day, salaries and wages to its the source for payment of current debts. employees, interest on funds borrowed The relationship between the two is from banks and bondholders, fees to revealing. This relationship will be attorneys and similar items. The total explored more closely a bit later. For amount of such items owed, but unpaid at now, however, the discussion will focus the date of the balance sheet, are grouped on the definition of the components of as a total under accrued expenses. current liabilities. 15 Accrued expenses $30,000 Accounts Payable Accounts payable is the amount the com- Income Taxes Payable pany owes to its regular business creditors Income taxes payable are the amounts from whom it has bought goods or ser- due to taxing authorities (such as the vices on open account. Internal Revenue Service and various state, foreign and local taxing agencies) within 13 Accounts payable $60,000 one year from the balance-sheet date. For financial-reporting purposes, they are Notes Payable treated the same as an accrued expense. If money is owed to a bank, individual, However, companies that owe a material corporation or other lender under a amount of taxes, as Typical does here, promissory note, and it is due within one often report income taxes payable as a year of the balance sheet date, it appears separate line item under the Current under notes payable. It is evidence that Liabilities caption in the balance sheet. the borrower named in the note is respon- sible for carrying out its terms, such as 16 Income taxes payable $17,000 repaying the loan principal plus any inter- est charges. Notes may also be due after one year from the balance-sheet date when they would be included in long- term debt. 14 Notes payable $51,000 15
  17. 17. THE BALANCE SHEET CONSOLIDATED BALANCE SHEETS (Dollars in Thousands, Except Per-Share Amounts) December 31 19X9 19X8 Liabilities and Shareholders’ Equity Liabilities: Current Liabilities: 13 Accounts payable $60,000 $57,000 14 Notes payable 51,000 61,000 15 Accrued expenses 30,000 36,000 16 Income taxes payable 17,000 15,000 17 Other liabilities 12,000 12,000 18 Current portion of long-term debt 6,000 — 19 Total Current Liabilities 176,000 181,000 Long-term Liabilities: 20 Deferred income taxes 16,000 9,000 21 9.12% debentures payable 2010 130,000 130,000 22 Other long-term debt — 6,000 23 Total Liabilities 322,000 326,000 Shareholders’ Equity: 24 Preferred stock, $5.83 cumulative, $100 par value; authorized, issued and outstanding: 60,000 shares 6,000 6,000 25 Common stock, $ 5.00 par value, authorized: 20,000,000 shares; issued and outstanding: 19X9 – 15,000,000 shares, 19X8 – 14,500,000 shares 75,000 72,500 26 Additional paid-in capital 20,000 13,500 27 Retained earnings 249,000 219,600 28 Foreign currency translation adjustments (net of tax) 1,000 (1,000) 29 Unrealized gain on available-for-sale securities (net of taxes) 50 — 30 Less: Treasury stock at cost (19X9 and 19X8 – 1,000 shares) (5,000) (5,000) 31 Total Shareholders’ Equity 346,050 305,600 32 Total Liabilities and Shareholders’ Equity $668,050 $631,600 16
  18. 18. THE BALANCE SHEET Other Current Liabilities benefit obligations. (Typical’s balance Simply stated, these are any other liabili- sheet does not show this obligation.) ties that are payable within 12 months, but which haven’t been captured in any of the Deferred Income Taxes other specific categories presented as cur- One of the long-term liabilities on the sample rent liabilities in the balance sheet. balance sheet is deferred income taxes. Deferred income taxes are tax liabilities a company may postpone paying until some 17 Other liabilities $12,000 future time, often to encourage activities for the public’s good. The opposite of deferred Current Portion of Long-Term Debt income tax liabilities are deferred income tax Current portion of long-term debt repre- assets. They are future income tax credits rec- sents the amount due and payable within ognized in advance of actually receiving 12 months of the balance-sheet date under them. Typical has not recorded any future all long-term (longer than one year) bor- income tax credit assets. rowing arrangements. In Typical’s case, this is the scheduled repayment of a The government provides businesses with tax $6,000 five-year note taken out by Typical incentives to make certain kinds of investments four years ago and due next year. If Typical that will benefit the economy as a whole. For had a long-term borrowing calling for instance, for tax-reporting purposes, a compa- monthly payments (on a mortgage, for ny can take accelerated depreciation deduc- example), the sum of the principal pay- tions on its tax returns for investments in plant ments due in the 12 months following the and equipment while using less rapid, more balance-sheet date would appear here. conventional depreciation for financial- reporting purposes. These rapid write-offs for tax purposes in the early years of investment 18 Current portion reduce the amount of tax the company would of long-term debt $6,000 otherwise owe currently (within 12 months) and defer payment into the future (beyond 12 months). However, at some point, the taxes TOTAL CURRENT LIABILITIES must be paid. To recognize this future liability, companies include a charge for deferred 19 Total Current Liabilities $176,000 taxes in their provision for tax expense in the income statement and show what the tax Finally, the “Total Current Liabilities” item provision would be without the accelerated sums up all of the items listed under this write-offs. The liability for that charge is classification. reported as a long-term liability since it relates to property, plant and equipment (a noncur- LONG-TERM LIABILITIES rent or long-term asset). [The classification of deferred tax amounts follows the classification Current liabilities include amounts due of the item that gives rise to it.] “within one year” from the balance-sheet date. Long-term liabilities are amounts due “after one year” from the date of the 20 Deferred income taxes $16,000 financial report, such as unfunded retiree 17
  19. 19. THE BALANCE SHEET Debentures Other Long-Term Debt The other long-term liability with a bal- Other long-term debt includes all debt ance on Typical’s 19X9 balance sheet is due after one year from the balance-sheet the 9.12% debentures due in 2010. The date other than what is specifically report- money was received by the company as a ed elsewhere in the balance sheet. In loan from the bondholders, who in turn Typical’s case, this debt is a $6,000, were given certificates called bonds, as single-payment loan made four years ago, evidence of the loan. The bonds are really which is scheduled for payment in full formal promissory notes issued by the next year. This loan was reported as long- company, which it agreed to repay at term debt at the end of 19X8 and, since maturity in 2010 and on which it agreed it is payable in full next year, and it no to pay interest at the rate of 9.12% per longer qualifies as a long-term liability, is year. Bond interest is usually payable reported as current portion of long-term semiannually. Typical’s bond issue is debt at the end of 19X9. called a debenture because the bonds are backed only by the general credit of 22 Other long-term debt — the corporation rather than by specific company assets. TOTAL LIABILITIES Companies can also issue secured debt (for example, mortgage bonds), which Current and long-term liabilities are offers bondholders an added safeguard summed together to produce the figure because they are secured by a mortgage reported on the balance sheet as “Total on all or some of the company’s property. Liabilities.” If the company is unable to pay the bonds when they are due, holders of mortgage 23 Total Liabilities $322,000 bonds have a claim or lien before other creditors (such as debenture holders) on the mortgaged assets. In other words, SHAREHOLDERS’ EQUITY these assets may be sold and the proceeds This item is the total equity interest that used to satisfy the debt owed the mortgage all shareholders have in this corporation. bondholders. In other words, it is the corporation’s net worth or its assets after subtracting all 21 9.12% debentures of its liabilities. This is separated for legal payable 2010 $130,000 and accounting reasons into the categories discussed on the following pages. 18
  20. 20. THE BALANCE SHEET Capital Stock Common Stock Capital stock represents shares in the own- Although preferred shareholders are enti- ership of the company. These shares are tled to dividends before common share- represented by the stock certificates issued holders, their entitlement is generally lim- by the corporation to its shareholders. ited (in Typical’s case to $5.83 per share, A corporation may issue several different annually). Common stock has no such classes of shares, each class having slightly limit on dividends payable each year. In different attributes. good times, when earnings are high, divi- dends may also be high. And when earn- Preferred Stock ings drop, so may dividends. Typical’s Preferred stock is an equity ownership common stock has a par value of $5.00 interest that has preference over common per share. In 19X9, Typical sold 500,000 shares with regard to dividends and the shares of stock for a total of $9,000. Of distribution of assets in case of liquidation. the $9,000, $2,500 is reported as common Details about the preferences applicable stock (500,000 shares at a par value of to this type of stock can be obtained from $5.00). The balance, $6,500, is reported provisions in a corporation’s charter. as additional paid-in capital, as discussed under the next heading. When added to In Typical’s case, the preferred stock is the prior year-end’s common stock bal- a $5.83 cumulative $100 par value. ance of $72,500, the $2,500 brings the (Par value is the nominal or face value common stock balance to $75,000. of a security assigned to it by its issuer.) The $5.83 is the yearly per-share dividend 25 Common stock, $5.00 par value, to which each preferred shareholder is entitled before any dividends are paid to authorized: 20,000,000 shares; the common shareholders. “Cumulative” issued and outstanding: means that if in any year the preferred 15,000,000 shares $75,000 dividend is not paid, it accumulates (con- tinues to grow) in favor of preferred share- holders. The total unpaid dividends must Additional Paid-In Capital be declared and paid to these sharehold- Additional paid-in capital is the amount ers when available and before any divi- paid by shareholders in excess of the par dends are distributed on the common or stated value of each share. In 19X9, stock. Generally, preferred shareholders paid-in capital increased by the $6,500 have no voice in company affairs unless discussed in the previous paragraph. the company fails to pay them dividends When this amount is added to last year’s at the promised rate. ending balance of $13,500, additional paid-in capital at Dec. 31, 19X9, comes 24 Preferred stock, $5.83 cumulative, to $20,000. $100 par value; authorized 26 Additional paid-in capital $20,000 issued and outstanding: 60,000 shares $6,000 19
  21. 21. THE BALANCE SHEET Retained Earnings are declared on the common, the balance When a company first starts in business, sheet will show retained earnings of it has no retained earnings. Retained earn- $79,900. In the second year, if profits are ings are the accumulated profits the com- $140,000 and Typical pays $200 in divi- pany earns and reinvests or “retains” in dends on the preferred and $400 on the the company. (In less successful compa- common, retained earnings will be nies where losses have exceeded profits $219,300. over the years, those accumulated net The Dec. 31, 19X9, balance sheet for losses will be reported as an “accumulated Typical shows the company has accumu- deficit. ) In other words, retained earnings ” lated $249,000 in retained earnings. The increase by the amount of profits earned, table below presents retained earnings less dividends declared to shareholders. from start-up through the end of 19X9.) If, at the end of its first year, profits are $80,000, dividends of $100 are paid on the preferred stock, and no dividends 27 Retained earnings $249,000 Calculation: Accumulated Retained Earnings Balance at start-up $0) Profit in year 1 80,000) Preferred dividends in year 1 (100) Retained earnings : End of year 1 79,900) Profit in year 2 140,000) Dividends in year 2: Preferred (200) Common (400) Retained earnings: End of year 2 219,300) Aggregate profits: Year 3 through 19X8 800,000) Aggregate dividends: Year 3 through 19X8 (799,700) Retained earnings: 12/31/X8 and 1/1/X9 219,600) Net income: 19X9 47,750) Dividends: 19X9 Preferred (350) Common (18,000) Retained earnings: 12/31/X9 $249,000) 20
  22. 22. THE BALANCE SHEET Foreign Currency Translation expense or benefit, as a separate compo- Adjustments (Net of Taxes) nent of shareholders’ equity. On Dec. 31, When a company has an ownership inter- 19X9, the total fair market value of these est in a foreign entity, it may be required securities exceeded their cost by $65. to include that entity’s results in the com- However, that gain would have increased pany’s consolidated financial statements. tax expense by $15, producing a net If that requirement applies, the financial unrealized gain of $50. If these securities statements of the foreign entity (prepared are sold, the difference between their in foreign currency) must be translated original cost and the proceeds from into U.S. dollars. The gain or loss resulting such sale will be a realized gain or loss from this translation, after the related tax included in the determination of net expense or benefit, is reflected as a sepa- income in that period. rate component of shareholders’ equity and is called foreign currency translation 29 Unrealized gain on available- adjustments. This adjustment should be for-sale securities (net of taxes) $50 distinguished from conversion gains or losses relating to completed transactions that are denominated in foreign curren- Treasury Stock cies. Conversion gains or losses are When a company buys its own stock included in a company’s net income. back, that stock is recorded at cost and reported as treasury stock. (It is called 28 Foreign currency translation treasury stock because after being reac- quired by the company, it is returned to adjustments (net of taxes) $1,000 the company’s treasury. The company Unrealized Gain on Available- can then resell or cancel that stock.) for-Sale Securities (Net of Taxes) Treasury stock is reported as a deduction from shareholders’ equity. Any gains or Unrealized gain/loss is the change in the losses on the sale of such shares are value (gain or loss) of securities classified reported as adjustments to shareholders’ as “available-for-sale” that are still being equity, but are not included in income. held. In Typical’s case, this represents the Treasury stock is not an asset. difference (a gain here) between the cost (or previously reported fair market value) of investment securities classified as 30 Less: treasury stock at cost ($5,000) “available-for-sale” held at the balance- sheet date and their fair market value at Total Shareholders’ Equity that time. Since Typical still holds these “Total Shareholders’ Equity” is the sum securities and has not yet sold them, such of stock (less treasury stock), additional differences have not been realized. As paid-in capital, retained earnings, foreign such, this unrealized amount is not includ- currency translation adjustments and ed in the determination of current income. unrealized gains on investment securities However, since these securities must be available for sale. reported at their fair market value, the changes in that fair market value since 31 Total Shareholders’ purchase (or the previously report date) are reported, after the related income tax Equity $346,050 21
  23. 23. JUST WHAT DOES THE BALANCE SHEET SHOW? To analyze balance-sheet figures, investors Current Ratio look to certain financial statement ratios What is a comfortable amount of working for guidance. (A financial statement ratio capital? Analysts use several methods to is the mathematical relationship between judge whether a company has adequate two or more amounts reported in the working capital. To interpret the current financial statements.) One of their con- position of a company being considered as cerns is whether the business will be able a possible investment, the current ratio may to pay its debts when they come due. be more useful than the dollar total of work- Analysts are also interested in the compa- ing capital. The first rough test is to compare ny’s inventory turnover and the amount of the current assets figure to the total current assets backing corporate securities (bonds liabilities. Although there is considerable and preferred and common stock), along variation among different types of compa- with the relative mix of these securities. nies, and the relationship is significant only The following section will discuss some when comparisons are made between com- ratios and calculations used for balance- panies in the same industry, a current ratio sheet analysis. of 2-to-1 is generally considered adequate. This means that for each $1 of current liabil- WORKING CAPITAL ities, there are $2 in current assets. One very important balance-sheet concept is working capital. This is the difference To find the current ratio, divide current between total current assets and total assets by current liabilities. In Typical’s current liabilities. Remember, current balance sheet: liabilities are debts due within one 16 Current assets $405,800 = 2.31 or 2.3 to 1 year of the balance-sheet date. The source from which those debts are 19 Current liabilities $176,000 1 paid is current assets. Thus, working Thus, for each $1 of current liabilities, there capital represents the amount of is $2.31 in current assets to back it up. There current assets that is left if all current are so many different kinds of companies, debts are paid. however, that this test requires a great deal For Typical this is: of modification if it is to be really helpful in analyzing companies in different industries. 6 Current assets $405,800) Generally, companies that have a small inventory and accounts receivable that are 19 Less: current liabilities (176,000) quickly collectible can operate safely with a Working capital $229,800) lower current ratio than companies having a greater proportion of their current assets in Generally, companies that maintain a inventory and that sell their products on comfortable amount of working capital extended credit terms. are more attractive to conservative investors. A company’s ability to meet HOW QUICK IS QUICK? obligations, expand volume and take In addition to working capital and the cur- advantage of opportunities is often deter- rent ratio, another way to test the adequacy mined by its working capital. Year-to-year of working capital is to look at quick assets. increases in working capital are a positive What are quick assets? They’re the assets 22 sign of a company’s growth and health. available to cover a sudden emergency—
  24. 24. JUST WHAT DOES THE BALANCE SHEET SHOW? assets that could be taken to the bank right DEBT TO EQUITY away, if necessary. They are those current A certain level of debt is acceptable, but assets that are quickly convertible into cash. too much is a sign for investors to be cau- This excludes merchandise inventories, tious. The debt-to-equity ratio is an indi- because such inventories have yet to be cator of whether the company is using sold and are not quickly convertible into debt excessively. For Typical, the debt-to- cash. Accordingly, quick assets are current equity ratio is computed as follows: assets minus inventories, prepaid expenses and any other illiquid current assets. 23 Total Liabilities $322,000 = .93 31 Total Shareholders’ Equity $346,050 6 Current assets $405,800) 4 Less: inventories (180,000) A debt-to-equity ratio of .93 means the 5 Less: prepaid expenses (4,000) company is using 93 cents of liabilities Quick assets $221,800) for every dollar of shareholders’ equity in the business. Normally, industrial com- The quick assets ratio is found by dividing panies try to remain below a maximum quick assets by current liabilities. of a 1-to-1 ratio, to keep debt at a level that is less than the investment level of the This means that, for each $1 of current liabili- owners of the business. Utilities, service ties, there is $1.26 in quick assets available. companies and financial companies often operate with much higher ratios. Quick assets $221,800 = 1.26 or 1.26 to 1 INVENTORY TURNOVER 19 Current liabilities $176,000 1 How much inventory should a company have on hand? That Net quick assets are found by taking the depends on a combination of quick assets and subtracting the total current many factors including the type of liabilities. A well-positioned company business and the time of the year. should show a reasonable excess of quick An automobile dealer, for example, assets over current liabilities. This provides a with a large stock of autos at the rigorous and important test of a company’s height of the season is in a strong ability to meet its obligations. inventory position; yet that same inventory at the end of the season Quick assets $221,800) represents a weakness in the 19 Less: current liabilities (176,000) dealer’s financial condition. Net quick assets $45,800) 23
  25. 25. JUST WHAT DOES THE BALANCE SHEET SHOW? One way to measure the Calculation 1:) adequacy and balance of 12 Total assets $668,050) inventory is to compare it 10 Less: intangibles (1,950) with the cost of sales for Total tangible assets 666,100) the year to determine the 19 Less: current liabilities (176,000) inventory turnover. This Net tangible assets available to tells us how many times a meet bondholders’ claims $490,100) year goods purchased by a (Actual Amounts Used) company are sold to its customers. Typical’s cost of $490,100,000 = $3,770 net asset value per sales for the year is 130,000 (bonds outstanding) $1,000 bond outstanding $535,000, which is divid- ed by average inventory for the year of Net Asset Value per Bond $182,500 (inventory at 12/31/X8 of To state this figure conservatively, intangi- $185,000 + inventory at 12/31/X9 of ble assets are subtracted as if they have $180,000, divided by 2) to determine no value on liquidation. Current liabilities turnover. Thus, turnover is 2.9 times of $176,000 are considered paid. This ($535,000 ÷ $182,500), meaning that leaves $490,100 in assets to pay the goods are bought, manufactured and sold bondholders. So, $3,770 in net asset out almost three times per year. (If this value protects each $1,000 bond. information is not readily available in (See Calculation 1 above.) some published statements, some analysts look instead for sales related to inventory.) Net Asset Value per Share “Inventory as a percentage of current of Preferred Stock assets” is another comparison that may be To calculate net asset value of a preferred made. In Typical’s case, the inventory of share, start with total tangible assets, con- $180,000 represents 44% of the total cur- servatively stated at $666,100 (eliminating rent assets, which amounts to $405,800. $1,950 of intangible assets). Current liabil- ities of $176,000 and long-term liabilities BOOK VALUE OF SECURITIES of $146,000 are considered paid. This Net book value or net asset value leaves $344,100 of assets protecting the is the amount of corporate preferred. So, $5,735 in net asset value assets backing a bond or a common or backs each share of preferred. preferred share. Intangible assets are (See Calculation 2 below.) sometimes included when Calculation 2:) computing book value. However, the following cal- 12 Total assets $668,050) culations will focus on the 10 Less: intangibles (1,950) more conservative net tan- Total tangible assets 666,100) gible book value. Here’s 19 Less: current liabilities (176,000) how to calculate values for 20, 21, 22 Long-term liabilities (146,000) Typical’s securities. (Refer Net tangible assets underlying to Calculations 1 to 4.) the preferred stock $344,100) (Actual Amounts Used) 24 $344,100,000 = $5,735 net asset value per 60,000 (preferred shares outstanding) preferred share
  26. 26. JUST WHAT DOES THE BALANCE SHEET SHOW? Book Value per Share of Common Stock Book-value figures, particularly of com- The book value per share of common mon stocks, can be misleading. Profitable stock can be thought of as the amount of companies may show a very low net book money each share would receive if the value and very substantial earnings, while company were liquidated, based on bal- mature companies may show a high book ance-sheet values. Of course, the bond- value for their common stock but have holders and preferred shareholders would such low or irregular earnings that the have to be satisfied first. The answer, stock’s market price is lower than its book $22.54 book value per share of common value. Insurance companies, banks and stock, is arrived at as follows. (See investment companies are often excep- Calculation 3 below.) tions. Because their assets are largely liq- uid (cash, accounts receivable Calculation 3:) and marketable securities), 25 Common stock $75,000) their common stock’s book 26 Additional paid-in capital 20,000) value is sometimes a fair 27 Retained earnings 249,000) indication of market value. 28 Foreign-currency translation adjustments 1,000) CAPITALIZATION RATIO 29 Unrealized gains on available-for-sale securities 50) 30 Treasury stock (5,000)The proportion of each kind of security issued by a company Total Common Shareholders’ Equity 340,050) is the capitalization ratio. A 10 Less: intangible assets (1,950) high proportion of bonds Total Tangible Common Shareholders’ Equity $338,100) sometimes reduces the attrac- (Actual Amounts Used) tiveness of both the preferred $338,100,000 = $22.54 book value per common share and common stock, and too 15,000,000 (common shares outstanding) much preferred can detract from the common’s value. An alternative method of arriving at the That’s because bond interest must be paid common shareholders’ equity, conserva- before preferred dividends, and preferred tively stated at $338,100, is shown in dividends before common dividends. Calculation 4 below. Typical’s bond ratio is derived by dividing the face value of Calculation 4:) the bonds, $130,000, by the 12 Total assets $668,050) total value of bonds, preferred 10 Less: intangibles (1,950) and common stock, additional Total tangible assets 666,100) paid-in capital, retained earn- 19 Less: current liabilities (176,000) ings, foreign currency transla- 20, 21, & 22 tion adjustments, unrealized Long-term liabilities (146,000) gains on available-for-sale 24 Preferred stock (6,000) securities and treasury stock, Net tangible assets available less intangibles, which is for common stock $338,100) $474,100. (See the Calculation on page 26.) This shows that (Actual Amounts Used) bonds amount to about 27% of $338,100,000 = $22.54 book value per common share Typical’s total capitalization. 15,000,000 (common shares outstanding) 25
  27. 27. JUST WHAT DOES THE BALANCE SHEET SHOW? 21 Debentures $130,000) The common stock ratio will be the 24 Preferred stock 6,000) difference between 100% and the total of 25 Common stock 75,000) the bond and preferred stock ratio—or 26 Additional paid-in capital 20,000) about 72%. The same result is reached by 27 Retained earnings 249,000) adding common stock, additional paid-in 28 Foreign currency capital, retained earnings, foreign currency translation adjustments, unrealized gains translation adjustments 1,000) on available-for-sale securities and trea- 29 Unrealized gains on sury stock, less intangibles, and dividing available-for-sale securities 50) the result by total capitalization. 30 Treasury stock (5,000) 10 Less: intangibles (1,950) Amount Ratio Total Capitalization $474,100) 21 Debentures $130,000 27% 24 Preferred stock 6,000 1% The preferred stock ratio is found the 10 & 25–30 same way—by dividing preferred stock Common Shareholders Equity of $6,000 by the entire capitalization of less intangibles 338,100 72% $474,100. The result is about 1%. Total $474,100 100% THE INCOME STATEMENT The most important report for many However, the income statement for a sin- analysts, investors or potential investors gle year does not tell the whole story. The is the income statement. It shows how historical record for a series of years is much the corporation earned or lost dur- more important than the figures for any ing the year. It appears with numbered single year. Typical includes two years in line items on page 27 of this booklet. its income statement and gives a 10-year financial summary as well, which appears While the balance sheet shows the funda- on pages 42 and 43. mental soundness of a company by reflect- ing its financial position at a given date, An income statement matches the rev- the income statement may be of greater enues earned from selling goods and ser- interest to investors: The reasons are vices or other activities against all the twofold: costs and outlays incurred to operate the company. The difference is the net income s The income statement shows the record (or loss) for the year. The costs incurred of a company’s operating results for the usually consist of: Cost of sales; selling, whole year. general and administrative expenses, such s It also serves as a valuable guide in as wages and salaries, rent, supplies and anticipating how the company may do depreciation; interest on money borrowed; 26 in the future. and taxes.
  28. 28. THE INCOME STATEMENT CONSOLIDATED INCOME STATEMENTS (Dollars in Thousands, Except Per-Share Amounts) Years Ended December 31, 19X9 19X8 33 Net sales $765,050) $725,000) 34 Cost of sales 535,000) 517,000) 35 Gross margin 230,050) 208,000) Operating expenses: 36 Depreciation and amortization 28,050) 25,000) 37 Selling, general and administrative expenses 96,804) 109,500) 38 Operating income 105,196) 73,500) Other income (expense): 39 Dividend and interest income 5,250) 10,000) 40 Interest expense (16,250) (16,750) 41 Income before income taxes and extraordinary loss 94,196) 66,750) 42 Income taxes 41,446) 26,250) 43 Income before extraordinary loss 52,750) 40,500) 44 Extraordinary item: Loss on earthquake destruction (net of income tax benefit of $750) (5,000) — 45 Net income $47,750) $40,500) 46 Earnings per share of common stock before extraordinary loss $3.55) $2.77) 47 Earnings per share—extraordinary loss (.34) —) 48 Net income per common share $3.21) $2.77) Net Sales 33 Net sales $765,050 The most important source of revenue is usually the first item on the income state- Cost of Sales ment. It represents the primary source of In a manufacturing establishment, cost of revenue earned by the company from its sales represents all the costs the company customers for goods sold or services ren- incurs to purchase and convert raw materi- dered. In Typical Manufacturing’s income als into the finished products that it sells. statement, it is shown as “net sales.” The These costs are commonly known as prod- “net sales“ item includes the amount uct costs. “Product costs” are those costs that reported after taking into consideration can be identified with the purchase or man- returned goods and allowances for price ufacture of goods made available for sale. reductions or discounts. By comparing net sales between 19X9 and 19X8, we see that There are three basic components of product sales increased in XXXX. cost: (1) Direct materials, (2) direct labor 27