this page is designed for the sole purpose of teaching someone how to read financial statements

8/21/2019 This Page is Designed for the Sole Purpose of Teaching Someone How to Read Financial Statements

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This page is designed for thesole purpose of teaching someone how to read

financial statements. While intended for those with little or now knowledge of

finacial statements, it can be a handy reminder even for the seasoned

professional. This page is very long so an outline is provided to help you get the

information you desire. (SEE OT!"#E$

HOW TO READ A FINANCIAL STATEMENT

"f you are a certified public accountant it is most unlikely that you can learn

anything from reading this book. %ou don&t need to be told the basics of

understanding what&s presented in corporate annual reports. "f you aren&t a

certified public accountant, and you find that annual reports are 'over your head,'

this booklet can help you to grasp the facts contained in such reports and

possibly become a better informed investor. That is our principal aim in

publishing this booklet, but we also hope that it will be useful to other readers

who want to understand how business works and to learn more about the

companies that provide them with goods and services or that offer them

employment.

ost annual reports can be broken down into three sections) the E*ecutive

!etter, the business +eview, and the inancial +eview. The E*ecutive !etter

gives a broad overview of the company&s business and financial performance.

The -usiness +eview summaries recent developments, trends, and ob/ectives
http://www.terry.uga.edu/~akefalas/courses/mirrors_outline.htmhttp://www.terry.uga.edu/~akefalas/courses/mirrors_outline.htm


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of the company. The inancial +eview is where business performance is

0uantified in dollars. This is the section we intend to clarify.

The inancial +eview has two ma/or parts) 1iscussion and 2nalysis, and

2udited inancial Statements. 2 third part might include information

supplemental to the inancial Statements. "n the 1iscussion and 2nalysis,

management e*plains changes in operating results from year to year. This

e*planation is presented mainly in a narrative format, with charts and graphs

highlighting the comparisons. The Operating results are numerically captured

and presented in the inancial Statements.

The principal components of the inancial Statements are the balance sheet3

income statement3 statement of changes in shareholders& e0uity3 statement of

cash flows3 and footnotes. The balance sheet portrays the financial strength of

the company by showing what the company owns and what it owes on a certain

date. The balance sheet can be thought of as a snapshot photograph since it

reports on financial position as of the end of the year. The income statement, on

the other hand, is like a motion picture since it reports on how the company

performed during the year and shows whether operations have resulted in a

profit or loss. The statement of changes in shareholders& e0uity reconciles the

activity in the e0uity section of the balance sheet from year to year. 4ommon

changes in e0uity result from company profits or losses, dividends, or stock

issuances. The statement of cash flows reports on the movement of cash by the


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company for the year. The footnotes provide more detailed information on the

balance sheet and income statement.

This booklet will focus on illustrating the basic financial statements and

footnotes presented in annual reports in accordance with current practice. "t will

also include e*amples of financial methods used by investors to better analye

financial statements. "n order to provide a framework for illustration, we will

invent a company. "t will be a public company (one whose shares are freely

traded on the open market$. The reason for choosing a public company is that it

is re0uired to provide the most e*tensive amount of information in its annual

reports in accordance with guidelines issued by the Securities and E*change

4ommission (SE4$. Our company will represent a typical corporation with the

most commonly used accounting and reporting practices. We&ll call our company

Typical anufacturing 4ompany, "nc.

A Few Words Before We Begin

-elow are four samples of a -alance Sheet, "ncome Statement, Statement of

4hanges in Shareholders& E0uity, and a Statement of 4ash lows. These are

the statements we will discuss in the first section. To simplify matters, we did not

illustrate the 1iscussion and 2nalysis nor did we present e*amples of the

E*ecutive !etter or -usiness +eview. "n our sample statements, we&ve

presented two years of financial results on the balance sheet and income

statement and one year of activity on the statement of changes in shareholders&


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e0uity and statement of cash flows. This was also done for ease of illustration.

Were we to comply with SE4 re0uirements, we would have had to report the last

three years of activity in the "ncome Statement, Statement of 4hanges in

Shareholders& E0uity, and Statement of 4ash lows. urther SE4 re0uirements

that we did not illustrate include) presentation of selected 0uarterly financial data

for the past two years, business segment information for the last three years, a

listing of company directors and e*ecutive officers, and the market price of the

company&s common stock for each 0uarterly period within the two most recent

fiscal years.

Typica

Man!fac"!ring

Co#pany Inc$

Consoida"ed Baance S%ee"

1ecember 56,6787 and 6789 (dollars in thousands$

Asse"s &'(' &'()

4urrent 2ssets

4ash :;


5/77

accounts)

6787) :;,5?=, 6789)

:5,


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To"a c!rren" ia3ii"ies /&4+,+++ /&)&,+++

!ongBterm liabilities

1eferred income ta*es :6@,


7/77

Typica

Man!fac"!ring

Co#pany Inc$

Consoida"ed Inco#e S"a"e#en"

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

&'(' &'()#et sales :?@=,


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benefit of :?=


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&'('

Ne"

inco#e>?,?=< >?,?=

preferred

s"oc9(5=


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4ash flows from operating activities)

#et income :>?,?= in"angi3es7 /11+,+++

A#o!n" re.!ired "o pay ia3ii"ies -&1,+++

A#o!n" re#aining for "%e

s%are%oders/-**,+++

#ow, we are going to give you a guided tour of the balance sheet&s accounts.

We&ll. define each item, one by one, and e*plain how they work.

Asse"s

C!rren" Asse"s

"n general, current assets include cash and those assets which in the normal

course of business will be turned into cash in the reasonably near future, i.e.,

generally within a year from the date of the balance sheet.

Cas%

This is /ust what you would e*pectBbills and coins in the till (petty cash fund$


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and money on deposit in the bank.

& Cas% /2+,+++

Mar9e"a3e sec!ri"ies

This asset represents investment of e*cess or idle cash that is not needed

immediately. "n Typical&s case it is invested in preferred stock. -ecause these

funds may be needed on short notice, it is essential that the securities be readily

marketable and sub/ect to a minimum of price fluctuation. The general practice is

to show marketable securities at cost or market, whichever is lower.

2

Mar9e"a3e sec!ri"ies a" cos" w%ic% appro?i#a"es

#9"$=a!e /*+,+++

Acco!n"s recei=a3e

ere we find the amount due from customers but not yet collected. When

goods due are shipped prior to collection, a receivable is recorded. 4ustomers

are usually given 5


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tornado, a hurricane, or a flood$ befalling their business. Therefore, in order to

show the accounts receivable item at a figure representing e*pected receipts, the

total is after a provision for doubtful accounts. This year that debt reserve was

:;,5?=.

- Acco!n"s recei=a3e:ess aowance for

do!3"f! acco!n"s of /2,-40

/&01,+++

In=en"ories

The inventory of a manufacturer is composed of three groups. raw materials to

be used in the product, partially finished goods in process of manufacture, and

finished goods ready for shipment to customers. The generally accepted method

of valuation of the inventory is cost or market, whichever is lower. This gives a

conservative figure. Where this method is used, the value for balance sheet

purposes will be cost, or perhaps less than cost if, as a result of deterioration,

obsolescence, decline in prices, or other factors, less than cost can be realied

on the inventory. "nventory valuation includes an allocation of production and

other e*penses, as well as the cost of materials

* In=en"ories /&)+,+++


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Asse"s &'(' &'()

4urrent 2ssets

& 4ash :;


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e.!ip#en"

) !ess accumulated depreciation :6;=,


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to preBpaid e*penses. owever, deferred charges are not included in current

assets because the benefit from such e*penditure will be reaped over several

years to come. So the e*penditure incurred will be gradually written off over the

ne*t several years, rather than fully charged off in the year payment is made. Our

balance sheet shows no deferred charges because Typical has none. "f it had,

they would normally be included &us& before intangibles on the asset side of the

ledger.

To summarie, the total current assets item includes primarily)

cash,marketable securities, accounts receivable, inventories, and prepaid

e*penses.

1 To"a c!rren" asse"s /*++,+++

%ou will observe that these assets are mostly working assets in the sense that

they are in a constant cycle of being converted into cash. "nventories, when sold

become accounts receivable3 receivables, upon collection, become cash3 cash is

used to pay debts and running e*penses. We will discover later in the booklet

how to make current assets tell a story.

8roper"y, 8an", and E.!ip#en"

Property, plant and equipment represents those assets not intended for sale that are

used over and over aain in order to manufacture, display, !arehouse, and transport the


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product" #his cateory includes land, buildins, machinery, equipment, furniture,

automobiles, and truc$s" #he enerally accepted and approved method for valuation is

cost minus the depreciation accumulated by the date of the balance sheet" Depreciation is

discussed in the ne%t section"

8roper"y, pan", and e.!ip#en"

Land / -+,+++

B!idings &20,+++

Mac%inery 2++,+++

Lease%od I#pro=e#en"s &0,+++

F!rni"!re, fi?"!res, e"c &0,+++

4To"a proper"y, pan" @

e.!ip#en"/-)0,+++

The figure displayed is not intended to reflect market value at present or

replacement cost in the future. While it is recognied that the cost to replace

plant and e0uipment at some future date might be higher, that possible cost is

obviously variable. or this reason, up to now, most companies have followed a

general rule) ac0uisition cost less accumulated depreciation based on that cost.

Deprecia"ion

1epreciation is the practice of allocating the cost of a fi*ed asset over its

useful life. This has been defined for accounting purposes as the decline in

useful value of a fi*ed asset due to wear and tear from use and passage of time.


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The cost incurred to ac0uire the property, plant and e0uipment must be spread

over the e*pected useful life, taking into consideration the factors discussed

above. or e*ample) Suppose a delivery truck costs :6


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Less acc!#!a"ed deprecia"ion /&20,+++

Thus, net property, plant and equipmentis the valuation for balance sheet

purposes of the investment in property, plant and e0uipment. 2s e*plained

before, it consists of the cost of the various assets in this classification, less the

depreciation accumulated to the date of the financial statement.

'

Ne" proper"y, pan", and

e.!ip#en" /21+,+++

1epletion is a term used primarily by mining and oil companies or any of the

soBcalled e*tractive industries. Since Typical anufacturing is not in the mining

business, we do not show depletion on the balance sheet. To deplete means to

e*haust or use up. 2s the oil or other natural resource is used up or sold, a

depletion reserve is set up to compensate for the natural wealth the company no

longer owns.

In"angi3es

These may be defined as assets having no physical e*istence, yet having

substantial value to the company. E*amplesF 2 franchise to a cable TG

company allowing e*clusive service in certain areas, or a patent for e*clusive

manufacture of a specific article. "t should be noted, however, that only


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intangibles purchased from other companies are shown on the balance sheet.

2nother intangible asset sometimes found in corporate balance sheets is

goodwill,

which represents the amount by which the price of ac0uired companies e*ceeds

the related values of net assets ac0uired. 4ompany practices vary considerably

in assigning value to this asset. 2ccounting rules now re0uire one firm that buys

another to write off the goodwill over a period not e*ceeding >< years.

&+ In"angi3es 6goodwi,

pa"en"s7ess a#or"ia"ion /2,+++

2ll of these items added together produce the figure listed on the balance

sheet as

total assets.

&& To"a asse"s /112,+++

Lia3ii"ies



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Lia3ii"ies

4urrent liabilities

&2 2ccounts payable :@


23/77

21oreign currency translation

ad/ustments6,


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No"es paya3e

"f money is owed to a bank, individual, corporation, or other lender, it appears

on the balance sheet under notes payable as evidence that a promissory note

has been given by the borrower.

&- No"es paya3e / 0&,+++

Accr!ed e?penses

#ow we have defined accounts payable as the amounts owed by the company

to its regular business creditors. The company also owes, on any given day,

salaries and wages to its employees, interest on funds borrowed from banks and

from bondholders, fees to attorneys, insurance premiums, pensions, and similar

items. To the e*tent that the amounts owed and not recorded on the books are

unpaid at the date of the balance sheet, these e*penses are grouped as a total

under accrued e*penses.

&* Accr!ed e?penses / -+,+++

Inco#e "a? paya3e


25/77

The debt due to the various ta*ing authorities such as the "nternal +evenue

Service is the same as any other liability under accrued e*penses. -ut because

of the amount and the importance of the ta* factor, it is generally stated

separately as "ncome ta*es payable.

&0 Inco#e "a?es paya3e /&4,+++

O"%er Lia3ii"ies

Simply stated, other liabilities includes all liabilities captured in the specific

categories presented.

&1 O"%er ia3ii"ies /&2,+++

To"a c!rren" ia3ii"ies

inally, the total current liabilities item sums up all of the items listed under this

classification.

&4 To"a c!rren" ia3ii"ies /&4+,+++


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Long:"er# Lia3ii"ies

"n the matter of current liabilities, you will recall that we included debts due

within one year from the balance sheet date. ere, under the heading of longB

term liabilities are listed debts due after one year from the date of the financial

report.

Deferred inco#e "a?es

One of the longBterm liabilities on our sample balance sheet is deferred income

ta*es. The government provides businesses with ta* incentives to make certain

kinds of investments that will benefit the economy as a whole. 4urrent and longB

term debt are summed together to produce the figure listed on the balance sheet

as liabilities. or instance, a company can take accelerated depreciation

deductions for investments in plant and e0uipment. These rapid writeBoffs in the

early years of investment reduce what the company would otherwise owe in

current ta*es, but at some point in the future the ta*es must be paid. 4ompanies

include a charge for deferred ta*es in their ta* calculations on the income

statement and show what ta*es would be without the accelerated writeBoffs.

That charge then accumulates as a longBterm liability on the balance sheet.

&) Deferred inco#e "a?es /&1,+++


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De3en"!res

The other longBterm liability on our balance sheet is 6;.=C debentures due in

;


28/77

&'&2$0 De3en"!res paya3e

2+&+/&-+,+++

O"%er ong:"er# de3"

Other longBterm debt includes all debt other than what is specifically reported

on in the balance sheet. "n the case of Typical, this debt was e*tinguished in

6797.

2+ O"%er ong:"er# de3" +

To"a ia3ii"ies

4urrent and longBterm debt are summer together to produce the figure listed

on the balance sheet as total liabilities.

2& To"a ia3ii"ies /-&1,+++

S%are%oders5 E.!i"y


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This item is the total e0uity interest that all shareholders have in this

corporation. "n other words, it is the corporation&s net worth after subtracting all

liabilities. This is separated for legal and accounting reasons into the categories

discussed below.

Capi"a S"oc9

"n the broadest sense this represents shares in the proprietary interest in the

company. These shares are represented by the stock certificates issued by the

corporation to its shareholders. 2 corporation may issue several different

classes of shares, each class having slightly different attributes.

8referred S"oc9

These shares have some preference over other shares with respect to

dividends and in distribution of assets in case of li0uidation. Specific provisions

can be obtained from a corporation&s charter. "n Typical, the preferred stock is a

:=.95 cumulative :6


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22 8referred s"oc9 /0$)- c!#!a"i=e,

/&++ par =a!e, a!"%oried iss!ed

and o!"s"anding 1+,+++ s%ares 1,+++

Co##on S"oc9

Each year before common shareholders receive any dividends, preferred

holders are entitled to :=.95 per share, but no more. 4ommon stock has no such

limit on dividends payable each year. "n good times, when earnings are high,

dividends may also be high. 2nd when earnings drop, so may dividends.

2- Co##on s"oc9 /0$++ par =a!e

a!"%oried 2+,+++,+++ s%ares,

iss!ed &0,+++,+++ s%ares

/40,+++

Addi"iona 8aid:in Capi"a

This is the amount paid in by shareholders over the par or legal value of each

share. Typical&s common stock has a par value of :=.


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capital.

2- Co##on s"oc9 /0$++ par =a!e

a!"%oried 2+,+++,+++ s%ares

iss!ed &0,+++,+++ s%ares

/40,+++

2* Addi"iona paid:in capi"a /2+,+++

To"a of capi"a s"oc9 6co##on7

and addi"iona paid:in capi"a

/'0,+++

Re"ained Earnings

When a company first starts in business, it has no retained earnings. +etained

earnings accumulate as the company earns profits and reinvests or 'retains'

profits in the company. "n other words, retained earnings increase by the amount

of profits earned, less dividends declared to shareholders. 2t the end of its first

year, if profits are :9


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Re"ained earnings a" "%e end of "%e

second year/&2+,+++

The balance sheet for Typical shows the company has accumulated :;>7,


33/77

Treas!ry s"oc9

When a company reac0uires its own stock, it is reported as treasury stock and

is deducted from shareholder&s e0uity. Of the cost and par methods of

accounting, the former method is more commonly applied to treasury stock.

nder the cost method the cost of reac0uired stock is deducted from share

holders& e0uity. 2ny dividends on shares held in thetreasury should never be

included as income.

24 Treas!ry S"oc9 /0,+++

The sum total of stock (net of treasury stock$, additional paidBin capital,

retained earnings and foreign currency translation ad/ustments, represents the

total shareholder&s e0uity.

2) To"a s%are%oders5 e.!i"y /-*1,+++


34/77

"n order to analye balance sheet figures, investors look to certain financial

statement ratios for guidance. One of their concerns is whether the business will

be able to pay its debts when they come due. They are also interested in the

company&s inventory turnover and the amount of assets backing corporate

securities (bonds, preferred and common stock$, along with the relative mi* of

these securities. "n the following section, we discuss various ratios used for

balance sheet analysis

Ne" Wor9ing Capi"a

One very important thing to be learned from the balance sheet is net working

capital or net current assets, sometimes called working capital. This is the

difference between total current assets and total current liabilities. %ou will recall

that current liabilities are debts generally due within one year from the date of the

balance sheet. The source from which to pay those debts is current assets.

Thus, working capital represents the amount that is left free and clear after all

current debts are paid off. or Typical this is)

1 C!rren" asse"s /*++,+++

&4 Less> c!rren" ia3ii"ies &4+,+++

Wor9ing capi"a /2-+,+++

"f you consider yourself a conservative investor, you should invest only in

companies that maintain a comfortable amount of working capital. 2 company&s


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ability meet obligations, e*pand volume, and take advantage of opportunities is

often determined by its working capital. oreover, since you want your company

to grow, this year&s working capital should be larger than last year&s.

C!rren" Ra"io

What is a comfortable amount of working capitalF 2nalysts use several

methods to /udge whether a company has a sound working capital position. To

help you interpret the current position of a company in which you are considering

investing, the current ratio is more helpful than the dollar total of working capital.

The first rough test for an industrial company is to compare the current assets

figure with the total current liabilities. 2 current ratio of ; to6is generally

considered ade0uate. This means that for each :6 of current liabilities, there

should be :; in current assets.

To find the current ratio, divide current assets by current liabilities. "n Typical&s

balance sheet)

1

C!rren" asse"s

/*++,+++

C!rren" ia3ii"ies

/&4+,+++

2$-0 or 2$-0 "o

&

Thus, for each :6 of current liabilities, there is :;.5= in current assets to back it


36/77

up.

There are so many different kinds of companies, however, that this test

re0uires a great deal of modification if it is to be really helpful in analying

companies in different industries. Denerally, companies that have a small

inventory and easily collectible accounts receivable can operate safely with a

lower current ratio than those companies having a greater proportion of their

current assets in inventory and selling their products on credit.

How !ic9 is !ic9

"n addition to net working capital and current ratio, there are other ways of

testing the ade0uacy of the current position. What are 0uick assetsF They&re the

assets you have to cover a sudden emergency, assets you could take right away

to the bank, if you had to. They are those current assets that are 0uickly

convertible into cash. This leaves out merchandise inventories, because such

inventories have yet to be sold and are not convertible into cash. 2ccordingly,

0uick assets are current assets minus inventories and prepaid e*penses.

1 C!rren" asse"s /*++,+++* Less> in=en"ories &)+,+++

0 Less> prepaid e?penses *,+++

!ic9 asse"s /2&1,+++

et quic$ assets are found by ta$in the quic$ assets and subtractin the total current


37/77

liabilities" * !ell+fi%ed industrial company should sho! a reasonable e%cess of quic$

assets over current liabilities" #his provides a riorous and important test of a companys

ability to meet its obliations"

!ic9 asse"s /2&1,+++

&4Less> c!rren"

ia3ii"ies &4+,+++

Ne" !ic9 Asse"s /*1,+++

The quick assets ratiois found by dividing 0uick assets by current liabilities.

&4/2&1,+++ !ic9 asse"s

C!rren" ia3ii"ies &$- or &$- "o &

2s you see, for each :6 of current liabilities, there is the same industry. :6.5,67@3 the ta* comes to :>6,>>@.

-) Inco#e 3efore pro=ision for inco#e "a?es /'*,&'1-' 8ro=ision for inco#e "a?es *&,**1

Inco#e Before E?"raordinary Loss

2fter we have taken into consideration all ordinary income (the plus factors$

and deducted all ordinary costs (the minus factors$, we arrive at income before

extraordinary lossfor the year.

*+Inco#e 3efore e?"raordinary

oss/02,40+

E?"raordinary Loss

nder ordinary conditions, the above income of :=;,?=< would be the end of

the story. owever, there are years in which companies e*perience unusual and

infre0uent events called extraordinary items. E*amples of e*traordinary items

include debt e*tinguishments, ta* loss carry forwards, pension plan terminations,

and litigation settlements. "n this case, Typical e*tinguished a portion of its debt

early. This event&s isolated on a separate line, net of its ta* effect. "ts earningsB

perBshare impact is also segregated from the earnings per share attributBable


51/77

to'normal' operations.

*& Loss on eary e?"ing!is%#en"

of de3" 6ne" of "a? 3enefi" of

/40+7

6/0,+++7

Ne" Inco#e

Once all income and costs, including e*traordinary items, are considered, we

arrive at net income.

*2 Ne" inco#e /*4,40+

-ondensed, the income statement loo$s li$e this.

Plus factors:

-+ Ne" saes /410,+++

-1Di=idends and

In"eres" 0,20+

To"a /44+,20+

Minus factors:

-& Cos" of saes /0-0,+++

--:

-*Opera"ing e?penses &2*,)+*

-4 In"eres" e?pense &1,20+

-' 8ro=ision for inco#e *&,**1


52/77

"a?es

To"a /4&4,0++

*+ Ne" inco#e 3efore

e?"raordinary oss

/ 02,40+

*& E?"raordinary oss 60,+++7*2 Ne" inco#e / *4,40+

O"%er I"e#s

Two other items that do not apply to Typical could appear on an income

statement. irst, .S. companies that do business overseas may have

transaction gains or losses related to fluctuations in foreign currency e*change

rates.

Second, if a corporation owns more than ;


53/77

The income statement will tell us a lot more if we make a few detailed

comparisons. -efore you invest in a company, you want to know its operating

marginof profit and how it has changed over the years. Typical had sales of

:?@=,


54/77

2nalysts also fre0uently use operating cost ratiofor the same purpose.

Operating cost ratio is the complement of the margin of profit. Typical&s profit

margin is 65.9C. The operating cost ratio is 9@.;C. B

A#o!n" Ra"io

-+ Ne" Saes /410,+++ &++$+

-&,--,-* Opera"ing Cos" 10',)+* )1$2

-0Opera"ing

Inco#e/&+0,&'1 &-$)

et profit ratiois still another guide to indicate how satisfactory the year&s

activities have been. "n Typical anufacturing, the year&s net income was

:>?,?=


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*2

-+

/*+,0++ ne" inco#e

/420,+++ saes 0$1

We can compare the .S. 1epartment of 4ommerce&s latest available average

profit margins for all .S. manufacturers to the profit margins calculated from

Typical&s 6


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specifically, we would like to know whether the borrowed funds have been put to

good use so that the earnings are ample and thus available to meet interest

costs.

The available income representing the source for payment of the bond interest

is :66>@ (operating profit plus dividends and interest$. The annual bond

interest amounts to :6@,;=


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company with :6


58/77

is about 69C of :>


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available for common stock.

*1 Earnings per s%are /-$&1

-ut if it didn&t, we could calculate it ourselves)

*2Ne" profi" for "%e year /*4,40+

Less> di=idend re.!ire#en"s on

preferred s"oc9 -0+

Earnings a=aia3e for "%e co##on

s"oc9/*4,*++

/*4,*++,+++

&*,''',+++

earnings a=aia3e af"er preferred

di=idends

n!#3er of o!"s"anding co##on s%ares

/-$&1 earnings

per

s%are of co##on

Typical&s capital structure is a very simple one, comprised of common and

preferred stock. "t&s earningsBperBshare computation will suffice under this

scenario. owever, if the capital structure is more comple* and contains

securities which are convertible into common stock, options, warrants or

contingently issuable shares, the calculation re0uires modification. "n fact,

separate calculations must be performed. This is called dual presentation. The

calculations are primary and fully diluted earnings per common share.

8ri#ary Earnings 8er Co##on S%are


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This is determined by dividing the earnings for the year not only by the number

of shares of common stock outstanding but by the common stock plus common

stock equivalents if dilutive.

4ommon stock e0uivalents are securities, such as convertible preferred stock,

convertible bonds, stock options, warrants and the like, that enable the holder to

become a common shareholder by e*changing or converting the security. These

are deemed to be only one step short of common stock BB their value stems in

large part from the value of the common to which they relate.

4onvertible preferred stock and convertible bonds offer the holder either a

specified dividend rate or interest return, or the option of participating in

increased earnings on the common stock, through conversion. They don&t have

to be actually converted to common stock for these securities to be called a

common stock e0uivalent. This is because they are in substance e0uivalent to

common shares, enabling the holder at his discretion to cause an increase in the

number of common shares by e*changing or converting. ow do accountants

determine a common stock e0uivalentF 2 convertible security is considered a

common stock e0uivalent if its effective yield at the date of its issuance is less

than twoBthirds of the thenBcurrent average 2a corporate bond yield.

#ow, let&s put our new terms to work in an e*ample, remembering that it has

nothing to do with our own company, Typical anufacturing. We start with the

facts we have available. We&ll say we have 6


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common on a shareBforBshare basis. (2ssume they 0ualify as common stock

e0uivalents.$ We add the two and get ;


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The primary earnings per share item, as we have /ust seen in the preceding

section, takes into consideration common stock and common stock e0uivalents.

The purpose of fully diluted earnings per shareis to reflect ma*imum potential

dilution in earnings that would result if all contingent issuances of common stock

had taken place at the beginning of the year.

This computation is the result of dividing the earnings for the year by) common

stockand common stock equivalentsand all other securities that are convertible

(even though they do not qualify as common stock equivalents) .

ow would it workF irst, remember that we have 6


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appica3e "o ded!c"ion

-++,+++

Ad;!s"ed earnings /)++,+++

/)++,+++ ad;!s"ed

earnings

*++,+++ ad;!s"ed s%ares

o!"s"anding

/2 f!y di!"ed

earnings per

s%are

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

conversion would be :;.=< (:=


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use in viewing the record of this stock over a period of years and in comparing

the common stock of this company with other similar stocks.

21/-- #ar9e" price

/-$&1 earnings per s%are

&+$* > & or

&+$* "i#es

This means that Typical anufacturing common stock is selling at

appro*imately 6 times earnings.

!ast year, Typical earned :;.?? per share. !et&s say that its stock sold at the

same priceBearnings ratio then. This means that a share of Typical was selling for

:;9.9< or so, and anyone who bought Typical then would be satisfied now. Just

remember, in the real world, investors can never be certain that any stock will

keep its same priceBearnings ratio from year to year. The historical AIE multiple is

a guide, not a guarantee.

"n general, a high AIE multiple, when compared with other companies in the

same industry, means that investors have confidence in the company&s ability to

produce higher profits in the future.

S"a"e#en" of C%anges in S%are%oders5 E.!i"y

(dollars in thousands e*cept perBshare amounts$


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This statement analyes the changes from year to year in each shareholder&s

e0uity account. rom this statement, we can see that during the year additional

common stock was issued at a price above par. We can also see that Typical

e*perienced a translation gain. The rest of the components of e0uity, with the

e*ception of retained earnings which we discuss below, remained the same.

Just as the income statement reflects the payoff for shareholders, retained

earnings reflects the payoff for the company itself . "t shows how much money

the company has plowed back into itself for new growth. The Statement of

4hanges shows that retained earnBings increase by net income less dividends on

preBferred and common stock. Since we have already analyed net income, we

will now analye dividends.

Di=idends

1ividends on common stock vary with the profitability of the company.

4ommon shareholders were paid :69,


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&*,''',+++ s%ares s%are

Once we know the amount of dividends per share, we can easi ly discover the

dividendpayout ratio. This is Simply the percentage of net earnings per share

that is paid to shareholders.

*1/&$2+ di=idend per co##on s%are

/-$&1 earnings per co##on s%are -)

Of course, the dividends on the :=.95 preferred stock will not change from

year to year, The word cumulativein the balance statement description tells us

that if Typical&s management someday didn&t pay a dividend on its preferred

stock, then the :=.95 payment for that year would accumulate. "t would have to

be paid to preferred shareholders before any dividends could ever be declared

again on the common stock.

That&s why preferred stock is called preferred. "t gets at any dividend money

first. We&ve already talked about convertible bonds and convertible preferred

stock. +ight now, we&re not interested in that aspect because Typical

anufacturing doesn&t have any convertible securities outstanding. 4hances are

its @


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days, the guaranteed :=.95 dividend was more important to "saiah, e was not

interested in taking any more chances on Typical.

1uring the year, Typical has added :;7,>


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Seeing how hard money works, of course, is one of the most popular

measures that investors use to come up with individual /udgments on how much

they think a certain stock ought to be worth. The market itselfBB the sum of all

buyers and sellersBB makes the real decision. -ut the investors often try to make

their own, in order to decide whether they want to invest at the market&s price or

wait. ost investors look for Typical&s return on e0uity, which shows how hard

shareholders& e0uity in Typical is working. "n order to find Typical&s current return

on e0uity, we look at the balance sheet and take the common

shareholders&e0uity for last yearBBnot the current yearBBand then we see how

much Typical made this year on it. We use only the amount of net profit after the

dividends have been paid on the preferred stock. or Typical anufacturing, that

means :>?,?=< net profit minus :5=


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putting our money to work in Typical&s stock, we should compare Typical&s

:


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One more statement needs to be analyed in order to get the full picture of

Typical&s financial status. The Statement of 4ash lows e*amines the changes in

cash resulting from business activities. 4ashBflow analysis is necessary in order

to make proper investing decisions, as well as to maintain operations. 4ash

flows, although related to net income, are not e0uivalent, This is because of the

accrual concept of accounting. Denerally, under accrual accounting, a

transaction is recognied on the income statement when the earnings process

has been completed or an e*pense has been incurred. This does not necessarily

coincide with the time that cash is e*changed. or e*ample, cash received from

merchandise sales often lags behind the time when goods are delivered to

customers. owever, the sale is recorded on the income statement when the

goods are shipped.

4ash flows are separated by business activity. The business activity

classifications presented on the statement include investing activities, financing

activities, and operating activities. irst, we will discuss financing and investing

activities. Operating activities basically include all activities not classified as

either financing or investing activities.

inancing activities include those activities relating to the generation and

repayment of funds prvided by creditors and investors. These activities include

the issuance of debt or e0uity securities and the repayment of debt and

distribution of dividends. "nvesting activities include those activities relating to


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asset ac0uisition or disposal.

Operating activities involve activities relating to the production delivery of

goods and services. They reflect the cash effects of transactions which are

included in the determination of net income. Since many items enter into the

determination of net income, the indirect method is used to determine the cash

provided by or used for operating activities. This method re0uires ad/usting net

income to reconcile it to cash flows from operating activities. 4ommon e*amples

of cash flows from operating activities are interest received and paid, dividends

received, salary, insurance, and ta* payments.

!aifying and Cer"ifying

Wa"c% T%ose Foo"no"es

The annual reports of many companies contain this statement) 'The

accompanying footnotes are an integral part of the finacial statements.' The

reason is that the finacial reports themselves are kept concise and condensed.

Therefore, any e*planatory matter that cannot readily be abbreviated is set out in

greater detail in footnotes,

Some e*amples of approriate footnotes are)


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1escription of the company&spolicyfor depreciation, amortiation,

consolidation, foreign currency translation, and earnings per share.

"nventory valuation method. This footnote indicates whether inventories shown

on the blance sheet or used in determining the cost of goods sold on the income

statement are valued on a last in, first out (!"O$ basis or a first in, first out

("O$ basis. !ast in, last out means that the cost on the income statement

reflect the actual cost of inventories purchased most recently. irst in, first out

means the income statement reflects the cost of the oldest inventories. This is an

e*tremely important consideration because a !"O valuation reflects current

costs and does not overstate profits during inflationary times while a "O

vlauation does.

4hanges in accounting policy as a result of new accounting rules.

#onBreccuring items such as pensionBplan terminations or sales of significant

business units.


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

1etails of stock options granted to officers and employees.

!ongBterm leases. 4ompanies which usually lease a considerable amount of

selling space must show their lease liabilities on a perByear basis for the ne*t

several years and their total lease liabilities over a longer period of time.

1etails relating to issuance and maturities of longBtemr debt.

4ontigent liabilities representing claims or lawsuits pending.

4ommitments relating to contracts in force that will affect future periods.


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"nflation accounting ad/ustments. 4ertain companies must show the impact if

changing prices in their finacial position by ad/usting items that appear on the

balance sheet and the income statement for current costs and the 4onsumer

Arice "nde*. 2S- Statement #umber 97 spells out the re0uirements for

presenting inflation ad/usted fiancial data.

Separate breakdowns of sales and gross profits must be shown for each line

of business that accounts for more than ;


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The certificate from the independant auditors, which is printed inthe report,

says, first, that the auditing steps taken in the process of verification of the

account meet the accounting world&s approved standards of practice3 and

second, that the finacial statements in the report have been prepared in

conformity with generally accepted accounting principles (D22A$.

2s a result, when the annual report contains finacial statements that have the

stamp of approval from independant auditors, you have an assurance that the

figures can be relied upon as having been fairly presented.

owever, if the independent auditors accounts& opinion contains words such

as 'e*cept for,' or 'sub/ect to,' the reader should investigate the reason behind

such 0ualifications. Often the answer can be found by reading the footnotes that

pertain to the matter. They are usually referred to in the auditors opinion.

T%e Long iew

We cannot emphasie too strongly that company records, in order to be very

useful, must be compared. We can compare them to other company records, to

industry averages or even to broader economic factors, if we want.-ut most of

all, we can compare one company&s annual activities to the same firm&s results

from other years.


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This used to be done by keeping a file of old annual reports. #ow, many

corporations include a tenByear summary in their financial highlights each year.

This provides the investing public with information about a decade of

performance. That is why Typical anufacturing included a tenByear summary in

its annual report. "t&s not a part of the statements vouched for by the auditors, but

it is there for you to see. 2 tenByear summary can show you)

The trend and consistency of sales

The trend of earnings, particularly in relation to sales and the economy

The trend of net earnings as a percentage of sales

The trend of return on e0uity

#et earnings per share of common

1ividends, and dividend policy.

Other companies may include changes in net worth, book value per share,

capital e*penditures for plant and machinery, long term debt, capital stock

changes by way of stock dividends and splits, number of emBployees, number of

shareholders, number of outlets, and where appropriate, information on foreign

subsidiaries and the e*tent to which foreign operations have been embodied in

the financial report.

2ll of this is really important because of one central point) %ou are not only

trying to find out how Typical is doing no!. %ou want to predict how Typical !ill

do, and how its stock will perform.


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Seec"ing S"oc9s

rom the items we&ve studied in this booklet, Typical anufacturing appears to

be a healthy concern. Which should make -oard 4hairman Aatience Typical, old

"saiah Typical&s daughter, and her four nieces, who own most of the shares,

happy. -ut it makes us rather sad, since Typical is fictional, and we can&t offer

you shares of its stock. When you decide to invest money "n real stocks, please

remember this)

"electing common stocks for investment requires careful study of factors other

than those !e can learn from financial statements# $he economics of the country

and the particular industry must be considered# $he management of the

company must be studied and its plans for the future assessed# Information

about these other things is rarely in the financial report# $hese other facts must

be gleaned from the press or the financial services or supplied by some research

organizatlon# %errill &ynch's lobal "ecurities esearch and *conomics roup

stands ready to help you get the available facts you need to be an intelligent

Investor# +sk any inancial onsultant to put %errill &ynch to !ork for you#

this page is designed for the sole purpose of teaching someone how to read financial statements

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