HOW TO READ A FINANCIAL REPORTGOALS OF THIS BOOKLET “Management’s Discussion and Analysis” and “Audited FinancialAn annual report is unfamiliar terrain Statements.” It may also containto 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 Analysisstand such reports and possibly become (MD&A), a company’s managementmore 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&Ato help educate and guide its readers may also include charts and graphs highlight-so they might: ing the year-to-year changes. The company’ss 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 thes 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. Thecomponents of a company’s annual report. annual financial statements usually arePlease Note: Highlighted throughout this accompanied by an independent auditor’sbooklet 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 systematicthe Glossary of Selected Terms in the examination of a company’s financialback of this booklet. statements; it is typically undertaken by a Certified Public Accountant (CPA). The audi- tor’s report attests to whether the financialCOMPONENTS OF reports are presented fairly in keeping withAN 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 overviewReview and (3) the Financial Review. Each of the basic financial statements, includingsection 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 financials 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 reportss 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
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
A FEW WORDS BEFORE BEGINNINGThe 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 forTypical Manufacturing Company. a one-year period. To strictly comply with SEC requirements, the report would haveHowever, before beginning to examine included income statements, statementsthese financial statements in depth, the of changes in shareholders’ equity andfollowing 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’ss 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
TypicalManufacturing 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.
TypicalManufacturing 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
TypicalManufacturing 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
TypicalManufacturing 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
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
THE BALANCE SHEETASSETSCURRENT ASSETS Marketable SecuritiesIn general, current assets include cash and those Excess or idle cash that is not needed immediatelyassets that, in the normal course of business, will may be invested in marketable securities. These arebe turned into cash within a year from the balance- short-term securities that are readily salable andsheet 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 ittakes to convert them into cash. s Trading securities — debt and equity securities, bought and sold frequently, primarily to generateCash 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 includedbank, cash on hand (petty cash) and highly liquid in earnings. (Fair market value is the price at whichsecurities 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
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 face10
THE BALANCE SHEETof the balance sheet or in the footnotes. For 4 Inventories $180,000Typical, inventory represents the cost ofitems on hand that were purchased Prepaid Expensesand/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. Sinceor market rule or method is used. This Typical has the contractual right to thatgenerally accepted rule or method values insurance and advertising service after theinventory at its cost or market price, balance-sheet date, it has an asset, whichwhichever is lower. (Here market value, will be used after year end. Typical hasor market price is the current cost of simply “prepaid”—paid in advance—forreplacing 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 inconservative figure. The value for balance- the bank. Accordingly, payments made forsheet purposes under this method which the company had not yet receivedusually 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 ofinventories below cost, the lower market 5 Prepaid expensesprice would be used. and other current assets $4,000Usually, a manufacturer’s inventoriesconsist of quantities of physical products TOTAL CURRENT ASSETSassembled from various materials. To summarize, the “Total Current Assets”Inventory valuation includes the direct item includes primarily cash, marketablecosts of purchasing the various materials securities, accounts receivable, inventoriesused to produce the company’s and prepaid expenses.products and an allocation (that is, anapportionment or dividing up) of the 6 Total Current Assets $405,800production expenses to make thoseproducts. Manufacturers use cost These assets are “working” assets in theaccounting systems to allocate such sense that they are “liquid”—meaning theyexpenses. (“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 orof 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 thevaluation. company’s debts and operating expenses. 11
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
THE BALANCE SHEETIn Typical’s balance sheet, an amount Deferred Chargesis shown for accumulated depreciation. Deferred charges are expenditures forThis amount is the total of accumulated items that will benefit future periodsdepreciation for buildings, machinery, beyond one year from the balance-sheetleasehold improvements and furniture date; for example, costs for introductionand fixtures. Land is not subject to of a new product to the market or the opening of a new location. Deferreddepreciation, and, generally, its reported charges are similar to prepaid expenses,balance remains unchanged from year but are not included in current assetsto 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 thanThus, net property, plant and equipment is fully charged off in the year payment isthe amount reported for balance-sheet pur- made. Typical’s balance sheet shows noposes of the investment in property, plant deferred charges because it has none.and equipment. As explained previously, Deferred charges would normally beit 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 depreciationaccumulated to the date of the financial Intangiblesstatement (net depreciated cost). Intangible assets (or “intangibles”) are assets having no physical existence, yet9 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 oring and oil companies or any of the so- a copyright.called extractive industries. Since TypicalManufacturing is not in any of these busi- Another intangible asset often foundnesses, 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 exceedsexhaust or use up. As oil or other natural the fair value of the related net assetsresources are used up or sold, depletion is acquired. This excess is presumed to berecorded (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 andamount of natural resources sold, workforce (their know-how, experience,consumed or used to date. managerial skills and so forth.) 13
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 $668,05014
THE BALANCE SHEETLIABILITIES AND SHAREHOLDERS’ EQUITYCURRENT LIABILITIES Accrued ExpensesA current liability, in general, is an As discussed, accounts payable areobligation that is due and payable within amounts owed by the company to its12 months. The “current liabilities” item regular business creditors for routinein 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 itsthe source for payment of current debts. employees, interest on funds borrowedThe relationship between the two is from banks and bondholders, fees torevealing. This relationship will be attorneys and similar items. The totalexplored more closely a bit later. For amount of such items owed, but unpaid atnow, however, the discussion will focus the date of the balance sheet, are groupedon the definition of the components of as a total under accrued expenses.current liabilities. 15 Accrued expenses $30,000Accounts PayableAccounts payable is the amount the com- Income Taxes Payablepany owes to its regular business creditors Income taxes payable are the amountsfrom whom it has bought goods or ser- due to taxing authorities (such as thevices on open account. Internal Revenue Service and various state, foreign and local taxing agencies) within13 Accounts payable $60,000 one year from the balance-sheet date. For financial-reporting purposes, they areNotes Payable treated the same as an accrued expense.If money is owed to a bank, individual, However, companies that owe a materialcorporation 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 ayear of the balance sheet date, it appears separate line item under the Currentunder 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 $17,000repaying the loan principal plus any inter-est charges. Notes may also be due afterone year from the balance-sheet datewhen they would be included in long-term debt.14 Notes payable $51,000 15
THE BALANCE SHEET CONSOLIDATED BALANCE SHEETS(Dollars in Thousands, Except Per-Share Amounts) December 31 19X9 19X8Liabilities and Shareholders’ EquityLiabilities: 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 322,000 326,000Shareholders’ 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 346,050 305,60032 Total Liabilities and Shareholders’ Equity $668,050 $631,60016
THE BALANCE SHEETOther Current Liabilities benefit obligations. (Typical’s balanceSimply stated, these are any other liabili- sheet does not show this obligation.)ties that are payable within 12 months, butwhich haven’t been captured in any of the Deferred Income Taxesother specific categories presented as cur- One of the long-term liabilities on the samplerent liabilities in the balance sheet. balance sheet is deferred income taxes. Deferred income taxes are tax liabilities a company may postpone paying until some17 Other liabilities $12,000 future time, often to encourage activities for the public’s good. The opposite of deferredCurrent Portion of Long-Term Debt income tax liabilities are deferred income taxCurrent 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 receiving12 months of the balance-sheet date under them. Typical has not recorded any futureall 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 investmentsfour years ago and due next year. If Typical that will benefit the economy as a whole. Forhad 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 plantments due in the 12 months following the and equipment while using less rapid, morebalance-sheet date would appear here. conventional depreciation for financial- reporting purposes. These rapid write-offs for tax purposes in the early years of investment18 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 taxesTOTAL CURRENT LIABILITIES must be paid. To recognize this future liability, companies include a charge for deferred19 Total Current Liabilities $176,000 taxes in their provision for tax expense in the income statement and show what the taxFinally, the “Total Current Liabilities” item provision would be without the acceleratedsums up all of the items listed under this write-offs. The liability for that charge isclassification. 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 classificationCurrent liabilities include amounts due of the item that gives rise to it.]“within one year” from the balance-sheetdate. Long-term liabilities are amountsdue “after one year” from the date of the 20 Deferred income taxes $16,000financial report, such as unfunded retiree 17
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
THE BALANCE SHEETCapital Stock Common StockCapital 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 suchclasses of shares, each class having slightly limit on dividends payable each year. Indifferent attributes. good times, when earnings are high, divi- dends may also be high. And when earn-Preferred Stock ings drop, so may dividends. Typical’sPreferred stock is an equity ownership common stock has a par value of $5.00interest that has preference over common per share. In 19X9, Typical sold 500,000shares with regard to dividends and the shares of stock for a total of $9,000. Ofdistribution of assets in case of liquidation. the $9,000, $2,500 is reported as commonDetails about the preferences applicable stock (500,000 shares at a par value ofto this type of stock can be obtained from $5.00). The balance, $6,500, is reportedprovisions in a corporation’s charter. as additional paid-in capital, as discussed under the next heading. When added toIn 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 isentitled 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 $75,000dividend is not paid, it accumulates (con-tinues to grow) in favor of preferred share-holders. The total unpaid dividends must Additional Paid-In Capitalbe declared and paid to these sharehold- Additional paid-in capital is the amounters when available and before any divi- paid by shareholders in excess of the pardends are distributed on the common or stated value of each share. In 19X9,stock. Generally, preferred shareholders paid-in capital increased by the $6,500have 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’sat the promised rate. ending balance of $13,500, additional paid-in capital at Dec. 31, 19X9, comes24 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
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
THE BALANCE SHEETForeign 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 theseest 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 increasedpany’s consolidated financial statements. tax expense by $15, producing a netIf that requirement applies, the financial unrealized gain of $50. If these securitiesstatements of the foreign entity (prepared are sold, the difference between theirin foreign currency) must be translated original cost and the proceeds frominto U.S. dollars. The gain or loss resulting such sale will be a realized gain or lossfrom this translation, after the related tax included in the determination of netexpense or benefit, is reflected as a sepa- income in that period.rate component of shareholders’ equityand is called foreign currency translation 29 Unrealized gain on available-adjustments. This adjustment should be for-sale securities (net of taxes) $50distinguished from conversion gains orlosses relating to completed transactionsthat are denominated in foreign curren- Treasury Stockcies. Conversion gains or losses are When a company buys its own stockincluded in a company’s net income. back, that stock is recorded at cost and reported as treasury stock. (It is called28 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 companyUnrealized 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 orUnrealized gain/loss is the change in the losses on the sale of such shares arevalue (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’ Equitythat time. Since Typical still holds these “Total Shareholders’ Equity” is the sumsecurities and has not yet sold them, such of stock (less treasury stock), additionaldifferences have not been realized. As paid-in capital, retained earnings, foreignsuch, this unrealized amount is not includ- currency translation adjustments anded in the determination of current income. unrealized gains on investment securitiesHowever, since these securities must be available for sale.reported at their fair market value, thechanges 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
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 assets22 sign of a company’s growth and health. available to cover a sudden emergency—
JUST WHAT DOES THE BALANCE SHEET SHOW?assets that could be taken to the bank right DEBT TO EQUITYaway, if necessary. They are those current A certain level of debt is acceptable, butassets 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 usingsold 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 expensesand any other illiquid current assets. 23 Total Liabilities $322,000 = .93 31 Total Shareholders’ Equity $346,0506 Current assets $405,800)4 Less: inventories (180,000) A debt-to-equity ratio of .93 means the5 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 maximumquick assets by current liabilities. of a 1-to-1 ratio, to keep debt at a level that is less than the investment level of theThis means that, for each $1 of current liabili- owners of the business. Utilities, serviceties, 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 TURNOVER19 Current liabilities $176,000 1 How much inventory should a company have on hand? ThatNet quick assets are found by taking the depends on a combination ofquick assets and subtracting the total current many factors including the type ofliabilities. 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 therigorous and important test of a company’s height of the season is in a strongability to meet its obligations. inventory position; yet that same inventory at the end of the season Quick assets $221,800) represents a weakness in the19 Less: current liabilities (176,000) dealer’s financial condition. Net quick assets $45,800) 23
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
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 receivableCalculation 3:) and marketable securities),25 Common stock $75,000) their common stock’s book26 Additional paid-in capital 20,000) value is sometimes a fair27 Retained earnings 249,000) indication of market value.28 Foreign-currency translation adjustments 1,000) CAPITALIZATION RATIO29 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. A10 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 ofCalculation 4:) the bonds, $130,000, by the12 Total assets $668,050) total value of bonds, preferred10 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-sale24 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
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.
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 $765,050The most important source of revenue isusually the first item on the income state- Cost of Salesment. It represents the primary source of In a manufacturing establishment, cost ofrevenue earned by the company from its sales represents all the costs the companycustomers 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 thatreported 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 netsales between 19X9 and 19X8, we see that There are three basic components of productsales increased in XXXX. cost: (1) Direct materials, (2) direct labor 27
THE INCOME STATEMENT and (3) manufacturing overhead. Direct Selling, General and materials and direct labor costs can be Administrative Expenses directly traced to the finished product. For These expenses are generally grouped sep- example, for a furniture manufacturer, arately from cost of sales so that the reader lumber would be a direct material cost of an income statement may see the extent and carpenter wages would be a direct of selling and administrative costs. These labor cost. Manufacturing overhead costs, include expenses such as: sales agents’ while associated with the manufacturing salaries and commissions; advertising and process, cannot be traceable to the fin- promotion; travel and entertainment; exec- ished product. Examples of manufacturing utives’ salaries, office payroll; and office overhead costs are costs associated with expenses. operating the factory plant (rent, electrici- ty, supplies, depreciation, maintenance 37 Selling, general and and repairs and the salaries of production administrative expenses $96,804 supervisors). 34 Cost of sales $535,000 Operating Income Gross Margin Subtracting all operating expenses from the gross margin determines operating income. Gross margin is the excess of sales over cost of sales. It represents the actual direct profit from sales after considering product 38 Operating income $105,196 costs. Comparing period-to-period gross margin trends in absolute dollars is a use- Dividend and Interest Income ful analytical tool. So, too, is comparing An additional source of revenue comes from the gross margin percentage (computed dividends and interest received by the com- by dividing gross margin by net sales) from pany from its investment in stocks and bonds. year to year. 39 Dividends and 35 Gross margin $230,050 interest income $5,250 Gross margin percentage 30% ($230,050 ÷ $765,050) Interest Expense The interest earned by bondholders for Tangible Depreciation and the use of their money is sometimes Non-tangible Amortization referred to as a “fixed charge.“ That’s Each year’s decline in value would be because the interest must be paid year captured here. Amortization, as reported after year whether the company is making in this line item, represents the decline in money or losing money. Interest differs useful value of an intangible, such as a from dividends on stocks, which are 17-year patent. payable only if the board of directors declares them. Interest paid is another 36 Depreciation and cost of doing business, and is deductible amortization $28,050 from earnings in order to arrive at a base28 for the payment of income taxes.
THE INCOME STATEMENTTypical’s interest expense comes from three $52,750 would be the end of the story.sources: (1) Notes payable, (2) debentures However, there are years in which compa-and (3) other long-term debt (which nies experience unusual and infrequentbecame current portion of long-term debt events called extraordinary items. For exam-at this year-end). The notes payable, with ple, an extraordinary item would be cropan average outstanding balance for the destruction by a hail storm in an area whereyear of $56,000 at 7% interest, incur an hail storms are rare. In this case, one ofinterest charge of $3,920; the debentures, Typical’s manufacturing sites was destroyedbearing interest at 9.12% on the $130,000 by an earthquake. Since this event is notbalance, incur interest expense of expected to recur, it is isolated on a separate$11,856; and the $6,000 of other long- line, net of its tax effect. Its earnings per shareterm debt at 7.9% incurs interest of $474. impact is also separated from the earnings per share attributable to “normal” operations.40 Interest expense $16,250 44 Extraordinary item: lossIncome Taxes on earthquake destructionEach corporation has an “effective tax (net of tax benefit of $750) ($5,000)rate,” which depends on the level andnature of its income. Large corporations Net Income—the “Bottom Line”like Typical Manufacturing are subject to Once all income and costs, includingthe top statutory corporate income tax extraordinary items, are considered, netrate. However, tax credits, tax-free income income (or loss) is determined.and nondeductible expenses tend to 45 Net income $47,750change the overall tax rate. Typical’sincome before taxes and extraordinary loss Other Itemsis $94,196; its tax comes to $41,446. Three other items that do not apply to41 Income taxes $41,446 Typical could appear on an income state- ment. First, suppose Typical were heavilyIncome Before Extraordinary Loss involved in research and development“Income before extraordinary loss” for the (R&D) activities. In that event, Typicalyear is the amount by which all revenues would be required to include the amountexceed all expenses. Extraordinary gains of R&D costs in the income statement oror losses (as defined by GAAP ) are disclose it in the footnotes.excluded from this determination. Second, suppose Typical owned between 20% and 50% of another company. In that42 Income before case, Typical would have “significant influ- income taxes and ence” over that company, but not “control” extraordinary loss $94,196 it. As such, it would have to account for that investment using the equity method and43 Income before report its equity interest in that company in extraordinary loss $52,750 its financial statements. For example, suppose Typical’s share of that company’s earnings for the year were $1,200 and it received $700 inExtraordinary Items 29 dividends from the company during that year.Under usual conditions, the above income of
THE INCOME STATEMENT In that event, Typical would have to include by comparing operating income to net sales. $1,200 on its income statement under the To illustrate, in 19X9, Typical reported net category “equity in the earnings of uncon- sales of $765,050 and operating income solidated subsidiaries.” Typical would also of $105,196. be required to increase its investment in This means that for each dollar of 19X9 that company to the extent of the earnings sales, 13.8¢ remained as a profit from it picked up in its (i.e., Typical’s) income operations. This figure is interesting, but is statement. However, this would be reduced more significant when compared with the by any dividends received, in this case operating margin last year. $700, since the dividend represents a return of its investment. In this case, Typical‘s bal- Typical’s operating profit margin went ance sheet would show a net increase in its from 10.1% to 13.8%, so business didn’t investment in this company of $500. just grow, it became more profitable. Changes in operating margin can reflect Third, suppose Typical owned a “consoli- changes in volume, efficiency, product dated” subsidiary (more than 50% line or types of customers served. ownership), in which it had less than a 100% ownership interest. For example, say Typical can also be compared with other it owned 85% of that company. Any materi- companies in its field. If Typical’s operating al change in the related minority interest margin is very low compared to others, it is (15%), would have to be reported in the an unhealthy sign. If it is high, there is a income statement or footnotes. A corre- basis for optimism. sponding change in the cumulative minority interest would also have to be reported in the Analysts also frequently use “operating cost balance sheet, between long-term liabilities ratio” for the same purpose. Operating cost and stockholders’ equity. ratio is the complement of the operating margin. Typical’s operating margin is 13.8%. The operating cost ratio is 86.2%. ANALYZING THE INCOME STATEMENT Amount Ratio 33 Net sales $765,050 100.0% When used to make a few detailed com- 34, 36, & 37 parisons, the income statement will reveal Operating costs $659,854 86.2% a lot more information about a company’s 38 Operating 19X9 Operating margin: income $105,196 13.8% 38 $105,196 Operating income = 13.8% Net profit ratio is still another guide to indi- 33 $765,050 Net sales cate how satisfactory the year’s activities have been. In Typical’s case, the year’s net operating results. For example, a prospective income was $47,750. The net sales for the investor can determine the company’s oper- year amounted to $765,050. Therefore, ating margin and how it has changed over Typical’s income was $47,750 on $765,050 the years. This determination can be made of sales or: 19X8 Operating margin: 19X9 Net profit ratio: 38 $73,500 Operating income = 10.1% 45 $47,750 Net income = 6.2%30 33 $725,000 Net sales 33 $765,050 Net Sales
THE INCOME STATEMENTThis means that this year, for every $1 of expense on the other debt). The annualgoods sold, 6.2¢ in profit was ultimately debenture interest amounts to $11,856.earned by the company. By comparing the This means the debenture’s annual interestnet profit ratio from year to year for the expense is covered 8.9 times.same company and with other companies,profit progress can be evaluated. Number of times debenture interest earned:Last year, Typical’s net income was $106,052 Available income = 8.9$40,500 on $725,000 in sales: $11,856 Debenture interest19X8 Net profit ratio: For a corporate bond (debenture) to be45 $40,500 Net income = 5.6% considered a safe investment, most ana-33 $725,000 Net Sales lysts say that the company should earn its bond interest requirement three to fourThe operating margin, operating cost ratio times over. By these standards, Typical’sand net profit ratio—like the ratios examined debentures have a fair margin of safety.for the balance sheet—provide general infor-mation about the company and help assess its WHAT ABOUT LEVERAGE?future prospects. All these comparisons have a Financial leverage relates a company’slong-term significance because they provide long-term debt and preferred stock to theuseful information about the company’s fun- company’s common equity. Sometimes adamental economic condition. Another ques- stock is said to be highly leveraged. Whattion to ponder: Are Typical’s securities a good this simply means is that the companyinvestment? Consideration of some additional issuing the stock has a large proportion offactors can help provide an answer. bonds and preferred stock outstanding rel-INTEREST COVERAGE ative to the amount of common stock.Typical’s debentures represent a very substan- “High leverage” can work for or against atial debt, but they are due many years in the company depending on the earningsfuture. The yearly interest, however, is a fixed available to the common shareholders.charge. How readily the company can pay Generally speaking, however, analyststhe interest on this debt (i.e., the debt’s inter- consider highly leveraged companies to beest coverage) would be of great interest to an risk-prone. A simple illustration will showinvestor. (Interest coverage is number of why. Take, for example, a company withtimes the annual interest on a debt obligation $10,000,000 of 4% bonds outstanding. Ifis covered by income for the year without the company earns $440,000 before bondconsidering interest on the debt and taxes.) interest, there will only be $40,000 left forMore specifically, an investor would like to the common shareholders after payment ofknow if the borrowed funds have been put to $400,000 bond interest ($10,000,000 at 4%good use, so that the earnings are adequate equals $400,000). However, an increase ofand thus available to meet interest costs. only 10% in earnings (to $484,000) will leave $84,000 for common stock divi-The available income representing the dends, or an increase of more than 100%.source for payment of the debenture interest If there is only a small amount of commonis $106,052 (operating profit plus dividend stock issued, the increase in earnings per 31and interest income less the interest share will appear very impressive.
THE INCOME STATEMENT But in this instance, it is also apparent that a dividends were earned), net profit must be decline of 10% in earnings (to $396,000) used as the base. That’s because federal would wipe out everything available for the income taxes and all interest charges must common shareholders. Moreover, it would be paid before anything is available for also result in the company’s being unable to shareholders. Because the 60,000 shares cover the full interest on its bonds without of $100 par value preferred stock pay a per share dividend of $5.83, the total divi- dipping into its cash reserves and retained dend requirement for the preferred stock is earnings. This is the great danger of so- $350. Dividing the net income of called highly leveraged companies. It also $47,750, by this figure yields approxi- illustrates a fundamental weakness of compa- mately 136.4, which means that the divi- nies that have a disproportionate amount of dend requirement of the preferred stock debt. Conservative investors usually steer clear has been earned more than 136 times of highly leveraged companies, although they over. This ratio is so high primarily do appeal to people seeking a higher return because Typical has only a relatively small who are willing to assume the risk. amount of preferred stock outstanding. Typical Manufacturing, on the other hand, EARNINGS PER COMMON SHARE is not a highly leveraged company. In A buyer of common stock is often more 19X8, Typical incurred $11,856 in concerned with the stock’s earnings per debenture interest and its income before share than with its dividend. This is extraordinary loss and this expense came because earnings usually influence stock to $52,356 ($40,500 + $11,856 = $52,356). market prices. Although the income state- This left $40,500 for the common and pre- ment separates earnings per share before ferred stockholders and retained earnings and after the effect of extraordinary items, after recording this interest. the remainder of this presentation will only Now look what happened this year. Net prof- consider net income per common share it before extraordinary loss and debenture (net income after extraordinary item). In interest rose by $12,250 ([$52,750 + $11,856 Typical’s case, the income statement does = $64,606] - $52,356 = $12,250) or about not show income available for common 23%. Since the bond interest stayed the stock, so it must be calculated as follows: same, income before extraordinary loss and Typical’s capital structure is a very simple after recording this interest also rose $12,250. one, comprised of common and preferred But that is about 30% of $40,500. While this stock. As such, the earnings per share is certainly not a dramatic example of lever- computation above will suffice under this scenario. However, if the capital structure age, a 23% increase in pretax earnings is more complex and contains securities that generates a 30% increase in amounts avail- are convertible into common stock, options, able for dividends or retained earnings. warrants or contingently issuable shares, While this only illustrates the leverage effect the calculation requires modification. of the interest on the debentures, similar (Options and warrants each give the holder calculations could be made to show the the right to buy securities at a specified price. impact of the interest expense related to the Contingently issuable shares are shares of other borrowings and total interest expense. stock whose issuance depends on the occur- rence of certain events.) In fact, two separate PREFERRED DIVIDEND COVERAGE calculations are required. This is called dual32 To calculate the preferred dividend presentation. The calculations are basic and coverage (the number of times preferred diluted earnings per common share.
THE INCOME STATEMENTAs of December 15, 1997, as per Financial to common shareholders for the year (orAccounting Standard 128, publicly traded the period) by the average number ofcompanies are required to report both common and potential common sharesforms of earnings per share: basic earnings outstanding, if such potential commonper share and diluted earnings per share. shares are dilutive. Dilution occurs whenThis new standard replaced APB 15, earnings per share decreases or loss permaking simple, primary and fully diluted share increases.earnings per share obsolete. FAS 128 alsomakes the calculation of earnings per share The “adjustments” to earnings include:identical under U.S. and international • Dividends on convertible preferred stockaccounting standards. • After-tax interest expense on convertibleBasic Earnings per Common Share debtThis is determined by dividing the • Effect of the change in earnings fromearnings available to common shareholders other expenses (such as profit-sharingfor the year or the appropriate period by expense rising due to the increasedthe average number of shares of common income from the reduction of intereststock outstanding during the year. expense from the assumed conversion ofThe average calculation is simply the convertible debt)arithmetic mean of the shares outstanding,on a pro rata basis, for the reporting peri- The “potential” common shares consist ofod. Unexercised stock options, convertible other securities and contractual arrange-securities and contingently issuable shares ments that may result in the issuance ofare NOT included in the basic earnings common stock in the future, such as:per share calculation. • Options or warrantsSuppose, for example, that Complex • Convertible securitiesCapital Corp. has $300,000 in net income • Contingent stock arrangementsavailable to common shareholders and100,000 average common shares outstand- Convertible securities can be exchangeding for the year. Basic earnings per share or converted into common shares.would be $3.00 ($300,000/100,000). Examples are convertible preferred stock, convertible bonds and the like. Such secu-DILUTED EARNINGS PER rities are deemed to be only one step shortCOMMON SHARE of common stock. Their value stems inDiluted earnings per share is determined large part from the value of the commonby dividing the adjusted earnings available to which they relate.45 Net Income $47,750) Convertible pre- ferred stock and Less: dividend requirement on preferred stock (350) convertible Net income available for common stock $47,400) bonds offer(Actual Amounts Used) their holdersNet income per common share: some choices.$47,400,000 Net income available for the common stock = $3.21 A holder can14,750,000 Average number of outstanding common shares* elect either (1) a return at the 33*Shares outstanding at January 1 (14,500,000), plus shares outstanding at December 31 specified divi-(15,000,000), = 29,500,000, divided by 2 = 14,750,000 average shares outstanding for the year. dend or interest
THE INCOME STATEMENT rate, or (2) conversion into common stock share from stock options. All of the and participation in market appreciation proceeds from the conversion of the in- and dividends resulting from increased the-money (current share price is greater earnings on the common stock. However, than the exercise price) options are used the securities don’t have to be actually to repurchase common shares at the converted to common stock for them to average market price for the period. be called “potential common shares” For example, suppose the same Complex because they enable holders—in certain Capital Corp. used above also has 10,000 circumstances—to cause an increase in stock options outstanding with an average the number of common shares by exercis- strike price of $20 per share. The average ing, exchanging or converting. share price for the year was $50. The Each issue of potential common shares $200,000 in option proceeds (10,000 must be considered separately in options x $20 average exercise price) is sequence from the most dilutive (lower- assumed to repurchase common shares ing earnings per share the most) to the at $50 per share, therefore reducing com- least dilutive by examining the marginal mon shares by 4,000 ($200,000/$50). earnings per share impact. This is known The net dilutive effects of the options as antidilution sequencing. When calcu- would be an increase in 6,000 common lating diluted earnings per share, first shares (10,000 options less 4,000 compare the impact of the most dilutive repurchased), assuming the hypothetical security to basic earnings per share. If a conversion of the in-the-money options potential common share is antidilutive at the average share price for the period (therefore raising earnings per share), that under the Treasury Stock Method. security should NOT be included in the Therefore, the earnings per share would diluted earnings per share calculation. be diluted to $2.83 from the net effect Because antidilutive securities are not of options ($300,000 in net included in the diluted calculation, dilut- income/106,000 common shares, ed earnings per share must always be less including the net 6,000 options). than, or equal to, basic earnings per Let us now further examine the diluted share. Diluted earnings per share are usu- earnings per share calculation. Suppose ally less than basic earnings per share the following financial information for the due to the dilutive effects of potential same Complex Capital Corp. as above: common shares. • $300,000 net income available to Options and warrants are the most common shareholders common forms of potential common • 100,000 average common shares shares. As stated earlier, options and outstanding warrants each give the holder the right to • 10,000 stock options with an average buy securities at a specified price, known strike price of $20 as the “exercise price” or “strike price.” • Average share price for the year of $50 Let’s examine an example of the dilution • Convertible bonds with a par value of from the assumed conversion of options. $1,000,000, 6% interest rate, and a con- The Treasury Stock Method is a method of version ratio of 20 common shares for34 calculating the effect on earnings per every $1,000 bond
THE INCOME STATEMENTThe basic earnings per share are simply Diluted earnings per share calculation:$300,000 in net income divided by 100,000 Adjusted net income $336,000average common shares, or $3.00. The effect Adjusted common shares 126,000of options lowered earnings per share to$2.83. Let us now examine the effects of the = Diluted earnings per share $2.67potential common shares from the convert-ible bonds. Complex Capital Corp. would report both the basic and diluted numbers: Basic earn-If the 1,000 bonds were converted into com- ings per share of $3.00 and diluted earn-mon shares, there would be another 20,000 ings per share of $2.67. In most analyses,common shares (1,000 bonds x 20). But con- the diluted number is the most significantverting the bonds would save the $60,000 in figure. This reflects the dilution from allinterest payments ($1,000,000 x 6%), less the potential common shares. In fact, researchtax deduction of $24,000 on the interest earnings per share estimates are generallyexpense. Therefore, the conversion of the given as the expected diluted earnings perbonds would increase net income available share of the company.to common shareholders by $36,000($60,000 in interest expense less the $24,000 PRICE-EARNINGS RATIOtax deduction). Both the price and the return on common stock vary with a multitude of factors.Adjustments to net income assuming con- One such factor is the relationship thatversion of the bonds: exists between the earnings per share andNet Income available the market price. It is called the price-to common $300,000 earnings ratio (abbreviated P/E ratio).Plus: interest expense 60,000 This is how the P/E ratio is calculated. If a stock is selling at $25 per share and earningLess: tax deduction on $2 per share annually, its price-earningsinterest expense (24,000) ratio is 12.5-to-1, usually shortened toAdjusted net income $336,000 12.5. Put another way, the stock is said to be selling at 12.5 times earnings. If theAdditional common shares assuming stock should rise to $40, the P/E ratioconversion of the stock options and would be 20, or 20 times earnings. Or, ifthe bonds: the stock drops to $12, the P/E ratio would be 6, or six times earnings.Common shares outstanding 100,000 For Typical, which has no “potential com-Plus: options 10,000 mon shares,” net income per common shareLess: assumed shares repurchased was calculated at $3.21. If the stock wereunder Treasury Stock Method (4,000) selling at $33, the P/E ratio would be 10.3. This figure would be used to compare thisPlus: commons shares from stock over a period of years to itself and/orthe conversion of the bonds 20,000 to other similar stocks.Adjusted common shares 126,000 This means that Typical Manufacturing com- 35
THE INCOME STATEMENT P/E ratio: in the real world investors can never be cer- $33 Market price = 10.3: 1 tain that any stock will keep its same P/E 49 $3.21 Earnings per share or 10.3 ratio from year to year. The historical P/E times earnings multiple is a guide, not a guarantee. mon stock is selling at approximately 10.3 In general, a high P/E multiple, when com- times earnings. Last year, Typical earned pared with other companies in the same $2.77 per share. Assume that its stock sold at industry, means that investors have confi- the same P/E ratio then. This means that a dence in the company’s ability to produce share of Typical was selling for about higher future profits. $28.50, and anyone who bought Typical then would be satisfied now. Just remember, THE STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY This statement analyzes the changes nor are they deductible for tax purposes. from year-to-year in each component Common shareholders were paid $18,000 of shareholders’ equity. It shows that in dividends this year. Since the balance during the year, Typical issued additional sheet shows that Typical has 15,000,000 common stock at a price above par. It shares outstanding, the first thing to be also shows that Typical experienced a learned here may be an important point foreign currency translation gain and an to some potential investors—the dividend unrealized gain on investments classified per share. as “available-for-sale.” The other components of equity, with the Dividend per share: exception of retained earnings (Actual amount used) (see the paragraph below) remained the same. $18,000,000 Common stock dividends = $1.20 $15,000,000 Common shares outstanding Retained earnings reflects the cumulative earnings that the com- Once the dividend per share is known, it pany has invested for future growth. is easy to go on to the next step: comput- The statement of changes in shareholders’ ing the dividend payout percentage. This equity shows that retained earnings is simply the percentage of earnings per increased by net income less dividends share paid to shareholders. on preferred and common stock. Since net income has already been analyzed, dividends will now be examined. Dividend payout percentage: $1.20 Dividend per common share = 37% DIVIDENDS 48 $3.21 Net income per common share Dividends on common stock vary with the company. They do not36 enter into the determination of net income;
THE STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITYAnother statistic of great interest to many after paying dividends totaling $18,350.investors and analysts is the dividend Even if Typical has some lean years inyield, a percentage providing an estimate the future, it has plenty of retainedof the return per share on a given class of earnings from which to keep on declaringstock. Here, for example, the common those $5.83 dividends on the preferreddividend yield would be of great interest. stock and $1.20 dividends on theThis indicates the percentage return that common stock.the annual common dividend providesbased on the market price of the common There is one danger in having a lot ofstock. This is derived by dividing the retained earnings. It could attract anotherannual common dividend, in this case company, Great Giant Computers &$1.20, by the market price of the common Electronics for instance, to buy up enoughstock, earlier determined to be $33 per of Typical’s common to vote out theshare. This provides a “common dividend current management. Then Great Giantyield” of 3.6%, which is quite respectable might merge Typical into itself. Wherein today’s market. would Great Giant get the money to buy Typical stock? By issuing new shares of its own stock, perhaps. And where wouldDividend yield: Great Giant get the money to pay the$1.20 Dividend per common share = 3.6% dividends on all that new stock of its own?$33 Market price of the common stock The funds would come from Typical’s retained earnings. So Typical’s manage-Of course, the dividends on the $5.83 pre- ment has an obligation to its sharehold-ferred stock will not change from year-to- ers—to make sure that its retainedyear. The word “cumulative” in the bal- earnings are put to work to increaseance-sheet description indicates that if their total wealth. Otherwise, the share-Typical’s management didn’t pay a divi- holders might cooperate with Great Giantdend on its preferred stock, then the $5.83 if it conducted a raid on Typical.payment for that year would accumulate.It would have to be paid to preferred 27 Retained earnings $249,000shareholders before any dividends couldever be declared again on the common RETURN ON EQUITYstock. That’s why preferred stock is called Seeing how hard money works, of course,“preferred”; it gets any dividend money is one of the most popular measures thatfirst. Convertible bonds and convertible investors use to come up with individualpreferred stock were discussed earlier. judgments on how much they think a cer-However, Typical Manufacturing doesn’t tain stock ought to be worth. The markethave any convertible securities outstand- itself—the sum of all buyers and sellers—ing, so these are of no further interest right makes the real decision. But the investorsnow. Chances are its 60,000 shares of pre- often try to make their own decision onferred stock—with a par value of $100 whether they want to invest at the market’seach—were issued to family members. price or wait. Most investors look for Typical’s return on equity (also known asDuring the year, Typical Manufacturing “ROE”), which shows how hard share-has added $29,400 to its retained earnings 37 holders’ equity in Typical is working.
THE STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY How can an investor compute Typical’s Typical’s stock, an investor really needs ROE? To arrive at this figure, an investor to do two things. First, he or she needs would look at the balance sheet and com- to compare Typical’s 14.8% to returns pute the average common shareholders’ from Typical’s business competitors. equity for the year in order to calculate Second, he or she needs to compare how much Typical made on it. In making Typical’s return to the potential return that this calculation, the investor uses only the could be achieved from other types of amount of net profit after the dividends investment, such as certificates of deposit, have been paid on the preferred stock. corporate bonds, real estate or other com- For Typical Manufacturing, that means mon stocks. $47,750 net profit minus $350. (See the Calculation below.) Just remember, that 14.8% is what Typical itself makes. By no means is it For every dollar of shareholders’ equity, what an investor will make in dividends Typical made about 15¢. Is that good? on Typical’s stock. What ROE really Well, a 15% return to shareholders is reveals is whether Typical Manufacturing about twice the return Typical would have is relatively attractive as an enterprise. received had it invested instead in quality An investor can only hope that this attrac- corporate bonds. It is also several times tiveness will translate into demand for what it would have received from a sav- Typical’s stock and will be reflected in its ings account. The point is that in consider- market price. ing whether to put money to work in Calculation: $47,750 Net income less $350 preferred stock dividend = $325,825 Average 19X9 stockholders’ equity* less $6,000 preferred stock value $47,400 = 14.8% Return on equity $319,825 * Stockholders’ equity at January 1 ($305,600), plus stockholders’ equity at December 31 ($346,050) = $615,650, divided by 2 = $325,825 average 19X9 stockholders’ equity.38
THE STATEMENT OF CASH FLOWSOne more statement needs to be analyzed operating activities. Financing and invest-in order to get the full picture of Typical’s ing activities will be discussed first.financial status. The statement of cashflows presents the changes in cash result- Financing activities include those activitiesing from business activities. Cash-flow analy- relating to the receipt and repayment ofsis is necessary to make proper investing funds provided by creditors and investors.decisions and to maintain operations. These activities include the issuance of debt or equity securities, the repaymentCash flows, although related to net of debt, and distribution of dividends.income, are not equivalent to it. This is Investing activities include those activitiesbecause of the accrual method of relating to asset acquisition or disposal.accounting. Generally, under accrualaccounting, a transaction is recognized on Operating activities basically include allthe income statement when the earnings activities not classified as either financingprocess is completed, that is, when the or investing activities. They involve thegoods and/or services have been delivered company’s primary business activities, foror performed or an expense has been example, the production and delivery ofincurred. This does not necessarily coin- goods and services. They reflect the cashcide with the time that cash is exchanged. effects of transactions, which are includedFor example, cash received from merchan- in the determination of net income.dise sales often lags behind the time Since many items enter into the determi-when goods are delivered to customers. nation of net income, the indirect methodGenerally, however, when the goods are is used to determine the cash provided byshipped (service performed), the sale is or used for operating activities. Thisrecorded on the income statement and method requires adjusting net income toa related receivable is recorded on the reconcile it to cash flows from operatingbalance sheet. activities. Common examples of cashCash flows are also separated by business flows from operating activities are: Cashactivity. The business activity classifica- collected from customers; interest receivedtions presented on the statement include and paid; dividends received; salary;financing activities, investing activities and insurance; and tax payments. 39
ADDITIONAL DISCLOSURES AND AUDIT REPORTS Watch Those Notes s Asset impairment—disclosure of details The annual reports of many companies about impaired assets or assets to be contain this or a similar statement: “See disposed of. the Accompanying Notes to the Consoli- s Investments—information about debt dated Financial Statements” or “The and equity securities classified as “trad- Accompanying Notes are an Integral Part ing,” “available-for-sale” or “held-to- of the Financial Statements.” The reason is maturity.” that the financial statements themselves s Income tax provision—the breakdown simply report the balances in the various by current and deferred taxes and its accounts. Because there is no room on composition into federal, state, local the face of the statements for a complete and foreign tax, accompanied by a and adequate discussion relating to those reconciliation from the statutory income balances, additional required disclosures tax rate to the effective tax rate for the are provided in the notes. company. Some examples of appropriate footnote s Changes in accounting policy— data are: description of changes in accounting policy due to new accounting rules. s Description of the company’s policies—disclosure of the company’s s Nonrecurring items—details regarding policies for depreciation, amortization, nonrecurring items such as pension- consolidation, foreign currency plan terminations or acquisitions/dispo- translation, earnings per share, etc. sitions of significant business units. s Inventory valuation method—indicates s Employment and retirement which method is used to determine the programs—details regarding employ- cost of goods sold on the income state- ment contracts, profit-sharing, pension ment and on the balance sheet such as and retirement plans and postretirement last-in, first-out (LIFO), first-in, first- and postemployment benefits other out (FIFO) or average cost. LIFO means than pensions. that the costs on the income statement s Stock options—details about stock opt- reflect the cost of inventories purchased ions granted to officers and employees. or produced most recently. FIFO means the income statement reflects the cost s Long-term leases—disclosure of lease of the oldest inventories. This is an obligations on assets and facilities on a extremely important consideration per-year basis for the next several years because the LIFO method reflects the and total lease obligations over the most current costs in the income state- remaining lease period. ment and does not overstate profits dur- s Long-term debt—details regarding ing inflationary times, while the FIFO the issuance and maturities of long- valuation does. If not shown on the bal- term debt. ance sheet, the composition of the s Contingent liabilities—disclosures relat- inventories by raw materials, work-in- ing to potential or pending claims or process, finished goods and supplies lawsuits that might affect the company. should be presented.40
ADDITIONAL DISCLOSURES AND AUDIT REPORTSs Future contractual commitments— INDEPENDENT AUDITS terms of contracts in force that will The report from the independent auditors affect future periods. is often referred to as the auditor’s opin-s Regulations/restrictions—description ion, and is printed in the annual report. It of regulatory requirements and dividend should say three things, namely that: or other restrictions. 1. The audit steps taken to verify thes Off-balance sheet credit and market financial statements meet the auditing risks—details of off-balance-sheet credit profession’s approved standards of and market risk associated with certain practice. financial instruments. This includes interest rate swaps, forward and futures 2. The financial statements prepared by contracts and options contracts (often management are management’s respon- referred to as derivatives). “Off-balance- sibility and follow generally accepted sheet risk” is defined as potential for accounting principles. loss over and above the amount record- 3. There is no material misstatement. ed on the balance sheet.s Fair value of financial instruments As a result, when the annual report con- carried at cost—disclosure of fair tains financial statements accompanied market values of instruments carried by an unqualified (often referred to as at cost including long-term debt and “clean”) opinion from independent off-balance-sheet instruments, such auditors, there is added assurance that as swaps and options. the figures can be relied upon as being fairly presented.s Segment sales, operating profits and identifiable assets—information on However, if the independent auditor’s each industry segment that accounts for report contains the qualifying words more than 10% of a company’s sales, “except for,” the reader should be on the operating profits and/or assets. Multi- alert, cautious and questioning. The reader national corporations must also show should investigate the reason(s) behind sales and identifiable assets for each such qualification(s), which should be significant geographic area where sales summarily explained in that report and or assets exceed 10% of the related referenced to the footnotes. In addition, consolidated amounts. while the auditor(s) may not qualify theMost people do not like to read footnotes opinion, a separate paragraph, usually abecause they are complicated and are fourth, may be inserted to emphasize anrarely written in “plain English.” This is important item. Investors should carefullyunfortunate because the notes are very consider any matter so emphasized.informative. Moreover, they can revealmany critical and fascinating sidelights tothe financial story. 41
THE LONG VIEW It cannot be emphasized too strongly that ments verified for by the auditors, it is company reports must be compared if there for investors to read. A 10-year sum- they are to be useful. They can be com- mary can show the reader: pared to other dates and time periods, reports of other companies and to industry s The trend and consistency of revenues. averages. If desired, they can even be s The trend of earnings, particularly in compared to broader economic factors. relation to sales. But most of all, one company’s annual activities can be effectively compared to s The trend of net earnings as a percent- the same firm’s results from other years. age of sales. At one time this was done by keeping a s The trend of return on equity. file of old annual reports. Now, many cor- s Net earnings per common share. porations include a 5- or 10-year summary of their financial highlights in each year’s s Dividends and dividend trends. annual report. This provides the investing public with information about a decade of Other companies may include changes in performance. That is why Typical net worth; book value per share; capital Manufacturing has included a 10-year expenditures for plant and machinery; summary in its annual report. Although long-term debt; capital stock changes due the summary is not a part of the state- to stock dividends and splits; number of Ten-Year Financial Summary 19X9 19X8 19X7 19X6 Net sales $765,050 $725,000 $690,000 $660,000 Income before income taxes and extraordinary loss 94,196 66,750 59,750 54,750 Extraordinary loss (5,000) – – – Net income 47,750 40,500 37,700 33,650 Earnings per share before extraordinary loss 3.55 2.77 2.57 2.28 Net income per share 3.21 2.77 2.57 2.28 Dividend per common share 1.20 1.20 1.20 1.00 Working capital 229,800 199,000 218,000 223,000 Net plant and equipment 260,000 249,600 205,000 188,000 Long-term debt 130,000 136,000 136,000 6,000 Preferred stock 6,000 6,000 6,000 6,000 Common shareholders’ equity 340,050 299,600 275,800 254,700 Book value per common share 22.54 20.52 18.39 16.98 Note: Dollars in thousands, except per-share amounts.42
THE LONG VIEW employees; number of shareholders; and All of this is really important because of number of outlets. Where appropriate, the one central point: Investors and potential summary may also include information on investors not only are trying to find out foreign subsidiaries and the extent to how Typical is doing now, but they also which foreign operations have been want to try to predict how Typical and its embodied in the company’s financial stock will perform in the future. report. SELECTING STOCKS Given the items explored in this booklet, industry must be considered. The management Typical Manufacturing appears to be a of the company must be studied and its plans healthy concern. Since Typical is fictional, for the future assessed. Information about financial consultants can’t recommend the these “other things” is rarely contained in purchase of shares of its stock. When the financial report. These other facts must be investing money in real stocks, however, gleaned from the press or the financial services please remember this: Selecting securities provided by some research organization. for investment requires the careful study of Merrill Lynch’s ongoing research monitors factors other than those included in the basic this type of data and the available facts needed financial statements and related footnotes. The to help individuals and businesses become economics of the country and the particular informed investors. 19X5 19X4 19X3 19X2 19X1 19X0$600,000 $520,000 $500,000 $450,000 $350,000 $300,000 50,400 42,000 45,800 40,500 34,350 29,500 – – – – – – 29,850 27,300 30,360 25,975 21,000 18,100 2.00 1.83 2.20 1.93 1.69 1.43 2.00 1.83 2.20 1.93 1.69 1.43 1.00 1.00 1.00 .80 .80 .80 211,000 178,000 136,000 111,000 86,000 96,000 184,300 187,500 161,600 125,600 92,500 87,600 6,000 – – – – – 6,000 6,000 6,000 6,000 6,000 6,000 238,100 220,500 203,250 166,000 133,800 128,000 15.87 14.70 13.55 11.07 8.92 8.53 43
GLOSSARY OF SELECTED TERMS Page numbers in parentheses are page references in this booklet where the terms are first introduced or where additional information about the terms can be found. Accounts Payable (Page 15). not pay what they owe. Also Balance Sheet (Pages 1, 8-26). Amounts owed to creditors for called Provision for Doubtful A report showing the financial goods and services bought on Accounts, Reserve for Doubtful position or condition of a business credit; generally, they must be Accounts or Bad Debt Reserve. at a given date. Also called paid within 90 days. Statement of Financial Position or Amortization (Page 14). Statement of Financial Condition. Accounts Receivable (Page 10). Periodic charges to income to rec- Amounts due a business from cus- ognize the distribution of the cost Basic Earnings per Common Share tomers for goods and services sold of the company’s intangible assets (Page 33). on credit; generally they must be over the estimated useful lives of Income available to common paid within 90 days. those assets. shareholders for the period divided by the weighted-average number Accrual Method of Accounting Antidilution (to Earnings per of common shares outstanding for (Page 39). Common Share) (Page 35). the period. Method of accounting that recog- An increase in earnings (or nizes revenue when earned and decrease in loss) per common Bonds (Page 18). expenses when incurred in order to share that assumes that convertible Formal, secured or unsecured debt appropriately match income with securities were converted, stock obligations specifying interest and expenses in an accounting period. options and warrants were exer- repayment terms. cised or other shares were issued Accrued Expenses (Page 15). upon satisfaction of certain condi- Book Value per Share (Page 25). The obligation to pay business tions. When antidilution occurs, The adjusted shareholders’ equity expenses that were incurred, but not the per-share amount that it pro- for each class of stock divided by paid, during an accounting period. duces is not used as the reported the number of shares of each such per-share amount. class. Accumulated Amortization (Page 14). Antidilution Sequencing (Pages 34). Capitalization Ratio (Page 25). A deduction from intangible assets Examination of potential common The relationship that each security to show the total amount of peri- shares by order of most dilutive to (debt or equity) bears to total debt odic charges to income over the least dilutive. If the security lowers and equity, less intangible assets, estimated useful lives of those earnings per share relative to the expressed as a ratio. assets. Also called Reserve for base earnings per share, calculate Amortization. the earnings per share assuming Cash and Cash Equivalents the conversion of the security. (Page 9). Accumulated Depreciation Securities that are antidilutive are Generally, bank accounts and cur- (Page 13). not included in the diluted earn- rency on hand, and short-term, A deduction from fixed assets to ings per share calculation. highly liquid securities with a show the total amount of periodic maturity under 90 days, such as charges to income over the estimat- Asset (Pages 8, 9-14). U.S. Treasury bills. ed useful lives of those assets. Also Something owned by and having called Reserve for Depreciation. continuing value to its owner or a Cash Flows, Statement of business. (Pages 2, 39). Additional Paid-in Capital A report showing cash receipts (Page 19). Audit (of Financial and disbursements compiled and The total excess of the sharehold- Statements) (Page 1). totaled by operating, investing ers’ investment in the company A systematic examination of a and/or financing activities. over the par or stated value of its company’s financial statements to common and preferred stock. Also determine if the amounts and dis- Certified Public Accountant (CPA) called Paid-in Capital. closures in the reports are fairly (Page 1). stated and follow generally accept- Professional title granted to people American Institute of ed accounting principles. who pass a comprehensive test Certified Public Accountants on accounting, auditing and (AICPA) (Page 2). Available-for-Sale business law. CPAs usually perform The major professional public Securities (Page 10). audits of a company’s financial accounting group that sets stan- Securities not classified as held- statements. dards of practice for Certified to-maturity or trading. They are Public Accountants. carried at fair market value, with Changes in Shareholders’ any changes in the value (less Equity, Statement of (Pages 2, 36). Allowance for Doubtful applicable taxes) reported in A report providing the details, Accounts (Page 10). shareholders’ equity in the bal- by category, of all activity in all44 Amounts deducted from the total ance sheet. When sold, any gain components of shareholders accounts receivable balance to or loss will be realized and report- equity, for the period covered recognize that some customers will ed in the income statement. by the report.
Common Dividend Yield only by the general credit of to compensate them for their(Page 37). the issuer rather than certain of investment.Dividends paid on each share of its assets.common stock expressed as a per- Earnings per Common Sharecentage of the market price of those Debt Amortization (Page 10). (Page 33).shares. See also Dividend Yield. The practice of adjusting the origi- Net income reduced by preferred nal cost of a debt instrument as dividends and divided by the aver-Common Stock (Pages 19, 33). principal payments are received age outstanding number of com-The par or stated value of the and any purchase discount or mon shares during the accountingcommon stock (the basic owner- premium is written off to income period.ship interest in a corporation) over the life of the instrument.issued by a company as reported Estimated Useful Life (Page 12).in its balance sheet. Debt-to-Equity Ratio (Page 23). The period of time over which the The ratio of total debt (liabilities) to owner of an asset (physical orCommon Stock Ratio (Page 26). total shareholders’ equity. intangible) estimates that that assetThe percentage that common will continue to be of productivestockholders’ equity reduced by Deferred Charges (Page 13). use or have continuing value.intangible assets bears to total tan- Expenditures for items that willgible capitalization (the sum of benefit future periods beyond one Extraordinary Items (Page 29).shareholders’ equity and long-term year from the balance-sheet date. Nonoperating items that are bothdebt reduced by intangibles). unusual and occur infrequently. Deferred Income Taxes (Page 17).Compensatory Stock Options The obligation to pay income Fair Market Value (Page 9).(Page 33). taxes in future years generally The amount at which an itemSee Stock Options. arising from transactions involving could be exchanged between noncurrent assets and/or liabilities. willing unrelated parties, otherContingently lssuable Shares than in a forced liquidation. It is(Page 32). Depletion (Page 13). usually the quoted market priceShares of stock the issuance of The process of recognizing, by a when a market exists for the item.which depends on the occurrence charge against income, the reduc-of certain events. tion in the cost of a natural Financial Accounting resource (minerals, oil, gas) due to Standards Board (FASB) (Page 2).Convertible Securities (Page 33). its withdrawal and use or sale. The independent, private-sectorA debt or equity security that may organization designated to estab-under certain circumstances be Depreciation (Page 12). lish standards for financialexchanged for or converted into Periodic charges to income to accounting and reporting. It is theanother security, generally com- recognize the cost of “wear and body that issues GAAP, generallymon stock. tear” of a company’s fixed assets accepted accounting principles. over the estimated useful lives ofCost of Sales (Page 28). those assets. FIFO (Page 40).The total cost to purchase and/or Acronym for First-In, First-Out.manufacture all of the company’s Diluted Earnings per Common See First-In, First-Out.products that were sold during a Share (page 33)period. The amount of current earnings or Financial Leverage (Page 32). loss per share reflecting the maxi- See Leverage (Financial).CPA (Page 1). mum dilution (that is, the negativeSee Certified Public Accountant. impact) assuming the issuance of all Financial Statement Ratio potentially dilutive common shares. (Page 22).Current Assets (Page 9). A mathematical relationshipCash or other assets that will be Dilution (Page 33). between two or more amountsconverted to cash or consumed The reduction in common earnings reported in financial statements.within the normal operating cycle, per share (or increase in loss) if Financial statement ratios can pro-generally one year. convertible securities are converted, vide relative measures of, and stock options and warrants are exer- insights into, the health, conditionCurrent Liability (Page 15). cised or other shares are issued. and performance of a company.A liability that must be paidwithin the normal operating Dividend Payout Percentage First-In, First-Out (Page 40).cycle, generally one year. (Page 36). An inventory-costing method that Dividends per share divided by states inventory at its most currentCurrent Portion of earnings per share, expressed as cost while charging the cost ofLong-Term Debt (Page 17). a percentage. sales in the order the inventoryThe portion of long-term debt that was accumulated.is due within one year of the Dividend Yield (Page 37).balance-sheet date. The dividend paid on each share Fixed Assets (Page 12). of each class of stock as a percent- Another term for the property,Current Ratio (Page 22). age of the market price of those plant and equipment used in theThe relationship of current assets shares. See also Common operation of a business.to current liabilities, expressed as Dividend Yield.a ratio. Footnotes (Pages 2, 40). Dividends (Pages 2, 36). Additional details and disclosuresDebentures (Page 18). Payments, generally declared by about the figures and information 45Formal, unsecured debt obligations the Board of Directors, from contained in a company’s financial(bonds or notes) that are backed retained earnings to shareholders statements.
Foreign Currency Translation Income Taxes (Page 29). Long-Term Debt (Page 18). Adjustments (Page 21). The amount of income tax expense Borrowed funds due after one year The cumulative adjustment, report- reported for the period. It is often from the balance sheet date. See ed in the Equity section of the bal- referred to as the Tax Provision or Current Portion of Long-Term Debt ance sheet, resulting from the Provision for Income Taxes. and Other Long-Term Debt. translation of a foreign subsidiary’s local currency financial statements Income Taxes Payable (Page 15). Long-Term Liabilities (Page 17). into the currency of the parent The obligation to pay federal, for- Obligations that are due after one company. eign, state and local income taxes year from the balance-sheet date, that are due within one year from Generally Accepted Accounting the balance-sheet date. Lower of Cost or Market Rule. Principles (GAAP) (Page 1). (Page 11). The rules and standards followed Intangible Assets (Page 13). The rule is that inventory should in recording transactions and in Nonphysical assets with continuing be valued at its cost or market preparing financial statements. value, such as goodwill, copy- value, whichever is lower. The rights, trademarks and franchises. intent is to provide a conservative Goodwill (Page 13). figure in valuing a company’s An intangible asset that represents Interest (Page 29). inventory. See also Market Value. the excess of the amount paid for Payments by borrowers of funds to an acquired company over the fair compensate lenders for the use of Management Discussion and market value of the net assets of their funds. Analysis (MD&A) (Page 1). that company. Basically, it is the An SEC-required report in which value of the name and reputation Interest Coverage (Page 31). management provides selected of the acquired company. The number of times the annual financial data to highlight signifi- interest on debt obligations is cov- cant trends in the company’s finan- Gross Margin (Page 28). ered by income for the year before cial position or operating results. The excess of sales over cost of considering interest on the debt sales or the profit from sales before obligations and income taxes. Market Price (Page 11). considering operating, general and The price at which a good can be other expenses. Also called Gross Inventory (Pages 10-11). sold in the open market. See also Profit or Product Profit. The cost of goods on hand Fair Market Value. that were purchased and/or Gross Margin Percentage manufactured or that are being Market Value (Pages 9, 11). (Page 28). manufactured for sale to See Fair Market Value. Gross margin expressed as a per- customers. centage of sales. Also called Gross Marketable Securities Profit Percentage or Product Profit Inventory Turnover (Pages 23-24). (Pages 9-10). Percentage. The number of times the average Readily liquid securities (debt or inventory is sold during the year. equity) that can be converted into Held-to-Maturity Securities cash on very short notice. (Page 10). Investment Securities (Page 14). Debt securities that the holder/ Securities (debt or equity) held for Mortgage Bonds (Page 18). owner has the ability and intent to strategic purposes and/or long-term Formal, secured debt obligations hold to maturity. They are carried appreciation or income. that are backed by certain specific at amortized cost (original cost less assets of the issuer. Last-In, First-Out (LIFO). principal payments and premium (Page 40). Net Asset Value (Page 24). or discount amortization). An inventory-costing method that See Book Value. Highly Leveraged (Page 32). states inventory at its earliest cost while charging cost of sales Net Book Value (Page 24). A company with a large proportion at its latest cost (in the reverse See Book Value. of bonds and preferred stock out- standing relative to the amount of order that the inventory was accumulated). Net Income/Loss (Page 29). common stock. The final result of all revenue and Leverage (Financial) (Page 32). expense items for the period. Also Impairment (Permanent) of Loans Relates a company’s long-term called Net Profit or Loss. Often (Investments) (Page 14). debt to its capital structure. referred to as the “Bottom Line.” The probability that the lender (investor) will not collect all Also, it is the practice of obtaining Net of Taxes (Page 10). amounts in accordance with the capital using borrowed funds Term meaning the value or amount loan agreement. or preferred stock, rather than has been adjusted for the effects of common stock. applicable taxes. Income Statement (Pages 2, 26-36). Liability (Pages 8, 16-18). Net Profit Ratio (Page 31). Report summarizing the revenues An obligation to pay for assets or Net income expressed as a } and expenses and reporting the net goods or services acquired or to percentage of sales. income (or loss) of a business for repay borrowed funds. an entire accounting period. Also Net Quick Assets (Page 23). called the Statement of Earnings, LIFO (Page 40). The excess of quick assets over Statement of Profit and Loss, P&L Acronym for Last-In, First-Out. current liabilities.46 or Operating Statement. See Last-In, First-Out.
Notes Payable (Page 15). Property, Plant and Equipment Stock Option (Publicly Traded).*Short- or long-term obligation, (Page 12). A security bought and sold in theevidenced by a formal borrowing Assets not intended for sale that public securities markets that pro-agreement (such as a promissory are used to manufacture, display, vides the holder the right, but notnote), to repay borrowed funds. warehouse and transport the necessarily the obligation, to buy company’s products and house or sell a specified security in theOperating Income or Loss its employees. See also Fixed quantity, at the amount, and(Page 28). Assets. during the time period specifiedThe profit or loss generated by a in the option.company’s normal, recurring oper- Quick Assets (Page 22).ating activities before considering Assets that can be converted to Trading Securities (Page 9).nonoperating items, income taxes, cash quickly. Securities (debt or equity) boughtgains or losses from disposals of and sold frequently, principally toa segment of the business and Quick Assets Ratio (Page 23). generate short-term profits. Theyextraordinary items. The relationship between quick are carried at fair market value, assets and current liabilities, with any changes in the valueOperating Margin (Page 30). expressed as a ratio. reported in income.Operating income expressed as apercentage of sales. Retained Earnings (Page 20). Treasury Stock (Page 21). The total profit or loss of the The total cost of any of the compa-Other Long-Term Debt (Page 18). company less the total of all ny’s stock that has been repur-All debt due after one year from dividends paid, since the chased or otherwise reacquiredthe balance-sheet date that is not company’s startup. from shareholders and held in thereported elsewhere in the balance company’s treasury.sheet. Return on Equity (ROE) (Page 37). Net income for the period Treasury Stock Method (page 34).Paid-in Capital. expressed as percentage of average A method to calculate the effect onSee Additional Paid-in Capital. shareholders’ equity for the period. earnings per share of stock options and warrants. All option proceedsPar Value (Page 19). Securities and Exchange from the assumed conversion of in-The nominal or face value of a Commission (SEC) (Page 2). the-money options are assumed tosecurity assigned by the issuer for The main securities regulatory be used to repurchase shares (thatbalance-sheet reporting. It has no authority in the U.S. is, reacquired and held in the com-relation to market value. pany’s treasury) at the average stock Shareholders’ Equity price for the period.Permanent Impairment (Page 14). (Pages 8, 18-21).See Impairment (Permanent) of The total of shareholders’ invest- Unrealized Gain/Loss (Page 21).Loan (Investments). ments in the company and total The difference between the cost (or profits or losses since the start-up previously reported fair marketPreferred Dividend Coverage of the company, less all dividends value) of an asset held at the bal-(Page 32). and/or capital distributions, unreal- ance sheet date and its fair marketThe number of times the preferred ized gain on available-for-sales value at that date.dividend is covered (earned) by net securities and any foreign currencyincome. translation adjustments since the Warrant (Page 33). company’s start-up. A security, generally evidenced byPreferred Stock (Page 19). a certificate, giving the holder theAn equity security that entitles its Stated Value (Page 19). right to purchase securities, suchholders to certain preferences over The nominal or face value of a as common stock, at a specifiedcommon shareholders, such as div- security assigned by the issuer in price. Warrants are common stockidends, liquidation value and con- lieu of par value for balance-sheet equivalents and may dilute earn-vertibility into other securities, etc. reporting. It has no relation to ings per common share. market value.Preferred Stock Ratio (Page 26). Working Capital (Page 22).The percentage that preferred Statement of Cash Flows. The excess of current assets overstockholders’ equity bears to total See Cash Flows, Statement of. current liabilities.tangible capitalization (the sum ofshareholders’ equity and long-term Statement of Changes in *Note: This definition is not founddebt reduced by intangibles). Shareholders’ Equity. within this booklet. We have See Changes in Shareholders’Prepaid Expenses (Page 11). included the definition in the Equity, Statement of.Payments in advance for goods or glossary only to help better defineservices, which will be consumed Stock Option, Compensatory the differences between the twoand deducted from income during (on Unissued Stock) (Page 33). types of stock options.the future, normal operating cycle, An agreement, usually betweengenerally one year. an issuer and its executives/ employees, that grants the rightPrice-Earnings Ratio (Page 35). to purchase securities, such asThe comparison of the market common stock, at a specifiedprice of a share of stock to the price. Options are common stockearnings per share of that stock, equivalents and may dilute earn- 47expressed as a ratio. Also called ings per common share.the P/E ratio.
TABLE OF CONTENTS INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . INSIDE FRONT COVER HOW TO READ A FINANCIAL REPORT . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 A FEW WORDS BEFORE BEGINNING . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 CONSOLIDATED FINANCIAL STATEMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . 4 THE BALANCE SHEET . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 JUST WHAT DOES THE BALANCE SHEET SHOW? . . . . . . . . . . . . . . . . . . . . 22 THE INCOME STATEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 ANALYZING THE INCOME STATEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 THE STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY . . . . . . . . . . . . . 36 THE STATEMENT OF CASH FLOWS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 ADDITIONAL DISCLOSURES AND AUDIT REPORTS . . . . . . . . . . . . . . . . . . . 40 THE LONG VIEW . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 SELECTING STOCKS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 GLOSSARY OF SELECTED TERMS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44INTRODUCTIONKnown “from Wall Street to Main Street”—and worldwide—Merrill Lynch is a globalleader in the financial services industry. As a public service, Merrill Lynch wants to sharesome of its expertise in, and knowledge of, financial reporting through this booklet.We hope this booklet will serve as a valuable resource to help readers learn how to readand analyze a company’s annual report. Through it, readers can learn that an annualreport is not just a jumble of numbers and mind-numbing data. Read with understandingand analytical insight, the numbers and data in an annual report can tell an interesting,meaningful and fascinating story.