HOW TO READ A FINANCIAL REPORT

The

Purpose of this presentation is to help you better understand the data included in financial reports and how to analyze it. Learn more about companies that offer employment or provided investment opportunities.

COMPONENTS OF AN ANNUAL REPORT

The Letter to Shareholders: This gives a broad overview of the companys business and financial performance. The Business Review: This summarizes a companys recent developments, trends and objectives. The Financial Review: This presents a companys business performance in $.

COMPONENTS OF AN ANNUAL REPORT

The Financial Review

Managements Discussion and Analysis: This section explains all significant changes from year to year in the financial statements. It also includes charts and graphs highlighting the year to year changes. Audited Financial Statements: Consists of the balance sheet, income statement, statement of changes equity, and cash flow.

THE BALANCE SHEET

The

balance sheet portrays the financial position of the company by showing what the company owns and what it owes at the report date. It is a snapshot, since it reports the companys financial position at a specific point in time.

The Income Statement

The

Income Statement can be thought of more like a motion picture, since it reports on how a company performed during the period(s) presented and shows whether that companys operations have resulted in a profit or loss.

The Statement of Changes in Shareholders Equity

The statement of changes in shareholders equity reconciles the activity in the equity section of the balance sheet from period to period. Changes in shareholders equity result for company profits or losses, dividends and/or stock issuances.

Statement of Cash Flows

The statement of cash flows reports on the companys cash movements during the period(s) separating them by operating, investing and financing activities.

The Footnotes

The footnotes provide more detailed information about the financial statements.

A Model Company Called Typical

To provide a framework for illustration, a fictional public company will be used. A public company will be used because it is required to provide the most extensive amount of information in its annual reports. The requirements and standards for financial reporting are set by both governmental and nongovernmental bodies.

A Model Company Called Typical

This fictional company will represent a typical corporation with the most commonly used accounting and reporting practices. Thus, the model company will be called Typical Manufacturing Company, Inc. (Typical, for short.)

A Model Company Called Typical

Before examining the financial statement in depth, the following points should be kept in mind:

Financial statement in certain specialized industries would look some what different from those of Typicals.

A Model Company Called Typical

Rather than presenting a complete set of footnotes specific to Typical, we will see a listing of appropriate generic footnote data for which a reader of financial statements should look. To simplify matters, the statements shown do not illustrate every SEC financial reporting rule and regulation.

A Model Company Called Typical

The goal of this presentation is to provide readers with a better understanding of the core or basic financial statements in an annual report.
The following slides are the consolidated financial statements for Typical Manufacturing Company, Inc.

Consolidated Balance Sheets, Assets

Assets Current Assets: Cash and cash equivalents Marketable securities Accounts receivable - net of allowance for doubtful accounts of $2,375 in 19X9 and #3,000 in 19X8 Inventories, at the lower of cost or market Prepaid expenses and other current assets Total Current Assets December, 31 19X9 19X8 $19,500 46,300 $15,000 32,000

156,000 180,000 4,000 405,800

145,000 185,000 3,000 380,000

Consolidated Balance Sheets, Property, Plant and Equipment

Property, Plant and Equipment: Land Building Machinery Leasehold improvements Furniture, fixtures, etc. Total property, plant and equipment Less: accumulated depreciation Net Property, Plant and Equipment 30,000 125,000 200,000 15,000 15,000 385,000 125,000 260,000 30,000 118,500 171,100 15,000 12,000 346,600 97,000 249,600

Consolidated Balance Sheets, Other Assets

Other Assets: Intangibles (goodwill, patents) net of accumulated amortization of $300 in 19X9 and $250 in 19X8 Investment securities, at cost Total Other Assets Total Assets

1,950 2,000 300 --2,250 2,000 $668,050 $631,600

Consolidated Balance Sheets, Liabilities

Liabilities and Shareholders' Equity Liabilities: Current Liabilities: Accounts payable Notes payable Accured expenses Income taxes Payable Other liabilities Current portion of long-term debt Total Current Liabilities Long-term Liabilities: Deferred income taxes 9.12% debentures payable 2010 Other long-term debt Total Liabilities December, 31 19X9 19X8 $60,000 51,000 30,000 17,000 12,000 6,000 176,000 16,000 130,000 --322,000 $57,000 61,000 36,000 15,000 12,000 --181,000 9,000 130,000 6,000 326,000

Consolidated Balance Sheets, Shareholders Equity

Shareholder' Equity: Preferred stock, $5.83 cumulative, $100 par value; authorized, issued and outstanding: 60,000 shares Common stock, $5.00 par value, authorized: 20,000 shares; issued and outstanding: 19X9 - 15,000,000 shares, 19X8 - 14,500,.000 shares Additional paid-in capital Retained earnings Foreign currency translation adjustments (net of taxes) Unrealized gain on available-for-sale securities (net of taxes) Less: Treasury stock at cost (19X9 and 19X8 - 1,000 shares) Total Shareholders' Equity Total Liabilities and Shareholders' Equity 6,000 6,000

75,000 20,000 249,000 1,000 50

72,500 13,500 219,600 (1,000) ---

(5,000) (5,000) 346,050 305,600 $668,050 $631,600

Consolidated Income Statement

Net Sales Cost of sales Gross margin Operating expenses: Depreciation and amortization Selling, general and administrative expenses Operating income Other income (expenses): Dividend and interest income Interest expense Income before income taxes and extraordinary loss Income taxes Income before extraordinary loss Extraordinary item: loss on earthquake destruction (net of income tax benefit of $750) Net income Years Ended December 31, 19X9 19X8 $765,050 $725,000 535,000 517,000 230,050 208,000 28,050 96,804 105,196 5,250 (16,250) 94,196 41,446 52,750 (5,000) $47,750 25,000 109,500 73,500 10,000 (16,750) 66,750 26,250 40,500 --$40,500

Consolidated Income Statement, continued

Earnings per common share: Before extraordinary loss Extraordinary loss Net income per common share

$3.55 (.34) $3.21

$2.77 --$2.77

Consolidated Statement of Changes in Shareholders Equity

Year Ended December 31, 19X9 Foreign Add'l currency Unrealized paid-in Retained trans security capital earnings adj gain 13,500 $219,600 47,750 (350) (18,000) 2,500 6,500 2,000 ($1,000) --Pref Stock Balance Jan. 1, 19X9 Net income Dividends paid on: Preferred stock Common stock Common stock issued Foreign currency translation gain Net unrealized gain on available-for-sale securities Com Stock Treas stock

Total

$6,000 $72,500

($5,000) $305,600 47,750 (350) (18,000) 9,000 2,000

$50 $20,000 $249,000 $1,000 $50

$50 ($5,000) $346,050

Balance Dec. 31, 19X9 $6,000 $75,000

Consolidated Statement of Cash Flows

Year Ended December 31, 19X9 Cash flows form operating activities: Net income Adjustments to reconcile net income to net cash from operating activities: Depreceation and amortization Increase in accounts receivable Decrease in inventory Increase in prepaid expenses and other current assets Increase in deferred taxes Increase in accounts payable Decrease in accrued expenses Increase in income taxes payable Total adjustments Net cash provided by operating activities $47,750

28,050 (11,000) 5,000 (1,000) 7,000 3,000 (6,000) 2,000 27,050 74,800

Consolidated Statement of Cash Flows, continued

Cash flows from investing activities: Securities purchases: Trading Held-to-maturity Available-for-sale Principal payment received on held-tomaturity securities Purchase of fixed assets Net cash used in investin activities Cash flows from financing activities: Payment of notes payable Proceeds from issuance of com stock Payment of dividends Net cash used in financing activities Effect of exchange rate changes on cash Increase in cash Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year (14,100) (350) (150) 50 (38,400) (52,950) (10,000) 9,000 (18,350) (19,350) 2,000 4,500 15,000 $19,500

The Balance Sheet

The balance sheet represents the financial picture for Typical Manufacturing as it stood at the end of one particular day, Dec. 31, 19X9, as though the company were momentarily at a standstill. Typicals balance sheet for the previous year end is also presented. This makes it possible to compare the composition of the balance sheets on those dates.

The Balance Sheet, continued

The balance sheet is divided into two halves:

Assets, always presented first

Liabilities and Shareholders Equity

In the standard accounting model, the formula of Assets=Liabilities + Shareholders Equity applies. Both halves are always in balance.

The Balance Sheet, continued

They are also in balance because, form an economic viewpoint, each dollar of assets must be funded by a dollar of liabilities or equity. Hence, the name balance sheet.
Reported assets, liabilities, and shareholders equity are subdivided into line items or groups of similar accounts having a dollar amount or balance.

The Balance Sheet, continued

The Assets section includes all the goods and property owned by the company, and uncollected amounts due (receivables) to the company from others.
The Liabilities section includes all debts and amounts owed (payables) to outside parties.

The Balance Sheet, continued

The Shareholders Equity section represents the shareholders ownership interest in the company--what the companys assets would be worth after all claims upon those assets were paid. To make it easier to understand the composition of the balance sheet, each of its sections and the related line items within them will be examined one-by-one.

The Balance Sheet, Assets, Current and Equivalents

Current Assets include cash and those assets that, in the normal course of business, will be turned into cash within a year from the balance sheet date.
Cash and Cash Equivalents is money on deposit in the bank, cash on hand and highly liquid securities such as Treasury bills.
1 Cash and cash equivalents $19,500

The Balance Sheet, Assets, Marketable Securities

Marketable Securities - Excess or idle cash that is not needed immediately may be invested in marketable securities.
These are short-term securities that are readily salable and usually have quoted prices.

The Balance Sheet, Assets, Marketable Securities, cont.

These may include: Trading securities - debt and equity securities, bought and sold frequently, primarily to generate short-term profits and which are carried at fair market value. Any changes in such values are included in earnings.

The Balance Sheet, Assets, Marketable Securities, cont.

Held-to-maturity securities- debt securities that the company has the ability and intent to hold to maturity. These securities are reported at amortized cost. Debt Amortization is the practice of adjusting the original cost of a debt instrument as principal payments are received and writing off any purchase discount or premium to income over its life.

The Balance Sheet, Assets, Marketable Securities, cont.

Available-for-sale securities - debt or equity securities not classified as either trading or held-to-maturity. They are recorded at fair value with unrealized changes in their value, net of taxes, reported in stockholders equity.

The Balance Sheet, Assets, Marketable Securities, cont.

In Typicals case, it owns short-term, highgrade commercial paper, classified as trading securities and preferred stock, classified as available-for-sale. Typical however, has no short-term held-to-maturity securities.
$46,100 200 $46,300

2 Marketable securities: Trading securities Available-for-sale

The Balance Sheet, Assets, Accounts Receivable

Accounts Receivable are the amounts due form customers that havent been collected yet. When goods are shipped to customers before payment or collection, an account receivable is recorded. Customers are usually given 30, 60, or 90 days in which to pay. The total amount due from customers is $158,375.

The Balance Sheet, Assets, Accounts Receivable, cont.

When customers fail to pay their bills it gives rise to accounts of doubtful collectibility.
In order to show the accounts receivable balance at a figure representing expected receipts, an allowance for doubtful accounts is deducted from the total amount recorded.

The Balance Sheet, Assets, Accounts Receivable, cont.

This year end, the allowance for doubtful accounts was $2,375.

3 Accounts receivable $158,375 Less: allowance for doubtful accounts (2,375) $156,000

The Balance Sheet, Assets, Inventory

Inventory for a manufacturing company consists of: Raw materials items to be used in making a product. Work-in-process partially completed goods in the process of manufacture. Finished goods completed items ready for shipment to customers.

The Balance Sheet, Assets, Inventory, continued

Generally, the amount of each of the above types of inventory would be disclosed either on the face of the balance sheet or in the footnotes.
For Typical, inventory the cost of items on hand that were purchased and/or manufactured for sale to customers.

The Balance Sheet, Assets , Inventory, continued

In valuing inventories, the lower of cost or market rule or method is used.

This rule values inventory at its cost or market price, whichever is lower. Market value is the current cost of replacing the inventory by purchase or manufacture.

The Balance Sheet, Assets , Inventory, continued

The market rule provides a conservative figure. The value for balance sheet purposes under this method usually will be cost. Where deterioration, obsolescence, a decline in prices or other factors are expected to result in the selling or disposing of inventories below cost, the lower market price would be used.

The Balance Sheet, Assets , Inventory, continued

A manufacturers inventories consist of quantities of physical products assembled form various materials.
Inventory valuation includes the direct costs of purchasing the various materials used to produce the companys products and an allocation of the production expenses to make those products.

The Balance Sheet, Assets , Inventory, continued

Manufacturers use cost accounting systems to allocate such expenses.

When the individual costs for inventory are added up, they comprise the inventory valuation.
4 Inventories $180,000

The Balance Sheet, Assets, Prepaid Expenses

During the year, Typical paid fire insurance premiums and advertising charges for periods after the balance sheet date.
Since Typical has the contractual right to that insurance and advertising service after the balance sheet date, it has an asset, which will be used after year end.

The Balance Sheet, Assets, Prepaid Expenses, continued

Typical has simply prepaid (paid in advance) for the right to use this service. If these payments had not been made, the company would have more cash in the bank.

The Balance Sheet, Assets , Prepaid Expenses, continued

Payments made for which the company had not yet received benefits, but for which it will receive benefits within the year, are current assets as prepaid expenses.
$4,000

5 Prepaid expenses and other current assets

The Balance Sheet, Assets, Total Current Assets

To Summarize the total Current assets item includes: Cash Marketable Securities Accounts receivable Inventories Prepaid Expenses
6 Total Current Assets $405,800

The Balance Sheet, Assets, Total Current Assets, cont.

These assets are working assets in the sense that they are liquid meaning they can and will, in the near term, be converted into cash for other business purposes or consumed in the business. Inventories, when sold, become accounts receivable; receivables, upon collection, become cash; and the cash can then be used to pay the companys debts and operating expenses.

The Balance Sheet, Assets, Property, Plant and Equipment

Property, plant and equipment consists of assets not intended for sale that are used to manufacture, display, warehouse and transport the companys products and house it employees.

The Balance Sheet, Assets, Property, Plant and Equipment

This category includes: Land Building Machinery Equipment Furniture Automobiles

The Balance Sheet, Assets, Property, Plant and Equipment

The generally accepted method for reporting fixed assets is cost minus the depreciation accumulated through the date of the balance sheet.
$30,000 125,000 200,000 15,000 15,000 $385,000

Property, Plant and Equipment: Land Buildings Machinery Leasehold improvements Furniture, fixtures, etc. 7 Total property, plant and equipment

The Balance Sheet, Assets, Property, Plant and Equipment

The figure displayed is not intended to reflect present market value or replacement cost, since there is no intent to sell or replace these assets in the near term.
The cost to ultimately replace plant and equipment at some future date might, and probably will, be higher.

The Balance Sheet, Assets, Depreciation, cont.

This is the practice of charging to, or expensing against, income the cost of a fixed asset over its estimated useful life.
Depreciation has been defined for accounting purposes as the decline in useful value of a fixed asset due to wear and tear from use and the passage of time.

The Balance Sheet, Assets, Depreciation, cont.

The cost of acquired property, plant and equipment must be allocated over its expected useful life, taking into consideration the factors discussed.

The Balance Sheet, Assets, Depreciation, cont.

For example, suppose a delivery truck costs $10,000 and is expected to last five years. Using the straight-line method of depreciation (equal periodic depreciation charges over the life of the asset), $2,000 of the trucks cost is charged or expensed to each years income statement.

The Balance Sheet, Assets, Depreciation, cont.

The balance sheet at the end of one year would show: $10,000
(2,000) $ 8,000

Truck (cost) Less: Accumulated depreciation Net depreciated cost

The Balance Sheet, Assets, Depreciation, cont.

At the end of the second year it would show:

Truck (cost) Less: Accumulated depreciation Net depreciated cost

$10,000
(4,000)

$ 6,000

The Balance Sheet, Assets, Depreciation, cont.

In Typicals balance sheet, an amount is shown for accumulated depreciation. This amount is the total of accumulated depreciation for buildings, machinery, leasehold improvements and furniture and fixtures. Land is not subject to depreciation and its reported balance remains unchanged from year to year at the amount for which it was acquired.

The Balance Sheet, Assets, Depreciation, cont.

8 Less: accumulated depreciation

$125,000

Thus, net property, plant and equipment is the amount reported for balance-sheet purposes of the investment in property, plant and equipment

The Balance Sheet, Assets, Depreciation, cont.

As explained previously, it consists of the cost of the various assets in this classification, less the depreciation accumulated to the date of the financial statement (net depreciated cost)

9 Net Property, Plant and Equipment

$260,000

The Balance Sheet, Assets, Depreciation, cont.

Depletion is a term used primarily by mining and oil companies or any of the extractive industries.
Since Typical Manufacturing is not in any of these businesses, depletion is not shown in its financial statements.

The Balance Sheet, Assets, Depreciation, cont.

To deplete means to exhaust or use up. As oil or other natural resources are used up or sold, depletion is recorded (as a charge against income and a reduction from it cost) to recognize the amount of natural resources sold, consumed or used to date.

The Balance Sheet, Assets, Deferred Charges

Deferred Charges are expenditures for items that will benefit future periods beyond one year from the balance-sheet date. For example, costs for introduction of a new product to the market or the opening of a new location.

The Balance Sheet, Assets, Deferred Charges, cont.

Deferred charges are similar to prepaid expenses, but are not included in current assets because the benefit from such expenditures will be reaped over periods after one year from the balance-sheet date. To defer means to put off or postpone to a future time.

The Balance Sheet, Assets, Deferred Charges, cont.

The expenditure incurred will be gradually written off over the future period(s) that benefit from it, rather than fully charged off in the year payment is made. Typicals balance sheet shows no deferred charges because it has none.

Deferred charges would normally be included just before Intangibles in the assets section of the balance sheet.

The Balance Sheet, Assets, Intangibles

Intangible assets (or intangibles) are assets having no physical existence, yet having substantial value to the company. Examples are: Franchise to a cable TV company allowing exclusive service in certain areas. A patent for exclusive manufacture of a specific article. A trademark or a copyright.

The Balance Sheet, Assets, Intangibles, cont.

Another intangible asset often found in corporate balance sheets if goodwill, which represents the amount by which the price of an acquired company exceeds the fair value of the related net assets acquired.
This excess is presumed to be the value of the companys name and reputation and its customer base, intellectual capital, and workforce.

The Balance Sheet, Assets, Intangibles, cont.

Intangible assets reported on the balance sheet are generally those purchased from others. Intangible assets are amortized(gradually reduced or written off, a process referred to as amortization) by periodic charges against income over their estimated useful lives, but in no case for longer than 40 years.

The Balance Sheet, Assets, Intangibles, cont.

The value of Typicals intangible assets, reduced by the total amount of these periodic charges against income (accumulated amortization), results in a figure for Typicals net intangible assets.
$2,250 (300) $1,950

10 Intangibles (goodwill, patents Less: accumulated amortization Net intangible assets

The Balance Sheet, Assets, Investment Securities

Investments in debt securities are carried at amortized cost only when they qualify as held-to-maturity.
To qualify, the investor must have the positive intent and the ability to hold those securities until they mature.

The Balance Sheet, Assets, Investment Securities, cont.

Early in 19X9, Typical purchased on the New York Stock Exchange mortgage bonds issued by one of its major suppliers.
These bonds are due in full in five years and bear interest at 8% per year. In 19X9, the issuer made an unscheduled principal prepayment of $50.

The Balance Sheet, Assets, Investment Securities, cont.

Since Typical intends to maintain a continuing relationship with this supplier and to hold the bonds until they mature and appears to have the financial strength to do so this investment is classified as held-tomaturity.

The Balance Sheet, Assets, Investment Securities, cont.

11 Investment securities, at cost 8% mortgage bonds due 19Y4, original cost $350 Less: principal prepayment in 19X9 (50) Investment securities at amortized cost

$300

However, this investment must also be reviewed to ensure that it is probable that all contractually specified amounts are fully collectible.

The Balance Sheet, Assets, Investment Securities, cont.

If not fully collectible, this investment would be considered permanently impaired.

If permanent impairment were found to exist, it would be necessary to write this investment down to its fair value. In this case, however,the issuer is in a strong financial condition

The Balance Sheet, Assets, Investment Securities, cont.

This is evidenced in two ways: The issuer made an unscheduled prepayment of principal.

The property values have increased significantly where this well-maintained plant that secures these bonds is located. As such, there is no reason to suspect that all contractual amounts will not be collected.

The Balance Sheet, Assets, Total Assets

All of these assets (line items 1 to 11), added together, make up the figure for the line item (12) Total Assets in Typicals balance sheet.
12 Total Assets $668,050

The Balance Sheet, Liabilities and

Shareholders Equity, Current Liabilities

A Current Liability is an obligation that is due and payable within 12 months. The current liabilities item in the balance sheet is a companion to current assets because current assets are the source for payment of current debts.

Liabilities and Shareholders Equity, Current Liabilities, Accounts Payable

The Balance Sheet,

Accounts Payable is the amount the company owes to its regular business creditors from whom it has bought goods or services on open account.
13 Accounts payable $60,000

Liabilities and Shareholders Equity, Current Liabilities, Notes Payable

The Balance Sheet,

If money is owed to a bank, individual, corporation or other lender under a promissory note, it appears on the balance sheet under notes payable.
It is evidence that the borrower named in the note is responsible for carrying out its terms,such as repaying the loan principal plus any interest charges.

Liabilities and Shareholders Equity, Current Liabilities, Notes Payable

The Balance Sheet,

While these particular notes are due within one year of the balance-sheet date, notes payable may also be due after one year from the balance-sheet date when they would be included in long-term debt.

14 Notes Payable

$51,000

Liabilities and Shareholders Equity, Current Liabilities, Accrued Expenses

The Balance Sheet,

As discussed, accounts payable are amounts owed by the company to its regular business creditors for routine purchases.
The company also owes, on any given day, salaries and wages to its employees, interest on funds borrowed from banks and bondholders, fees to attorneys and similar items.

Liabilities and Shareholders Equity, Current Liabilities, Accrued Expenses

The Balance Sheet,

The total amount of such items owed, but unpaid at the date of the balance sheet, are grouped as a total under accrued expenses. 15 Accrued expenses $30,000

The Balance Sheet, Liabilities and

Shareholders Equity, Current Liabilities, Income Taxes Payable

Income taxes payable are the amounts due to taxing authorities(Internal Revenue Service) within one year form the balancesheet date.
For financial-reporting purposes, they are treated the same as an accrued expense.

The Balance Sheet, Liabilities and

Shareholders Equity, Current Liabilities, Income Taxes Payable

However, companies that owe a material amount of taxes, as Typical does here, often report income taxes payable as a separate line item under the Current Liabilities caption in the balance sheet.
16 Income Taxes Payable $17,000

The Balance Sheet, Liabilities and

Shareholders Equity, Current Liabilities, Other Liabilities

These are any other liabilities that are payable within 12 months, but which havent been captured in any of the other specific categories presented as current liabilities in the balance sheet. 17 Other Liabilities $12,000

The Balance Sheet,

Liabilities, Current Liabilities
Current Portion of Long-Term Debt Represents the amount due and payable within 12 months of the balance-sheet date under all long-term(longer than 1 year) borrowing arrangements.

In Typicals case, this is the scheduled repayment of a $6,000 five-year note taken out by Typical four years ago and due next year.

The Balance Sheet,

Liabilities, Current Liabilities
Current Portion of Long-Term Debt, cont. If Typical had a long-term borrowing calling for monthly payments(on a mortgage), the sum of the principal payments due in the 12 months following the balance-sheet date would appear here.
18 Current portion of long-term debt $6,000

The Balance Sheet,

Liabilities, Total Current Liabilities
19 Total Current Liabilities

$176,000

Finally, the Total Current Liabilities item sums up all of the items listed under this classification.

The Balance Sheet,

Liabilities, Long-Term Liabilities

Current liabilities include amounts due within one year from the balance-sheet date. Long-term liabilities are amounts due after on year from the date of the financial report.

The Balance Sheet,

Liabilities, Long-Term Liabilities
Deferred Income Taxes

One of the long-term liabilities on the sample balance sheet is deferred income taxes. Deferred income taxes are tax liabilities a company may postpone paying until some future time, often to encourage activities for the publics good.

The Balance Sheet,

Liabilities, Long-Term Liabilities
Deferred Income Taxes, continued

The government provides businesses with tax incentives to make certain kinds of investments that will benefit the economy as a whole.

The Balance Sheet,

Liabilities, Long-Term Liabilities
Deferred Income Taxes, continued

For instance, for tax-reporting purposes, a company can take accelerated depreciation deductions on its tax returns for investments in plant and equipment while using less rapid, more conventional depreciation for financial-reporting purposes.

The Balance Sheet,

Liabilities, Long-Term Liabilities
Deferred Income Taxes, continued These rapid write-offs for tax purposes in the early years of investment reduce the amount of tax the company would otherwise owe currently (within 12 months)and defer payment into the future.(beyond 12 months)

However, at some point, the taxes must be paid.

The Balance Sheet,

Liabilities, Long-Term Liabilities
Deferred Income Taxes, continued

To recognize this future liability, companies include a charge for deferred taxes in their provision for tax expense in the income statement and show what the tax provision would be without the accelerated write-offs.

The Balance Sheet,

Liabilities, Long-Term Liabilities
Deferred Income Taxes, continued The liability for that charge is reported as a long-term liability since it relates to property, plant and equipment (a noncurrent or longterm asset). [The classification of deferred tax amounts follows the classification of the item that gives rise to it. 20 Deferred income taxes $16,000

The Balance Sheet,

Liabilities, Long-Term Liabilities
Debentures The other long-term liability with a balance on Typicals 19X9 balance sheet is the 9.12% debentures due in 2010.

The money was received by the company as a loan from the bondholders, who in turn were given certificates called bonds, as evidence of the loan.

The Balance Sheet,

Liabilities, Long-Term Liabilities
Debentures, continued The bonds are really formal promissory notes issued by the company, which it agreed to repay at maturity in 2010 and on which it agreed to pay interest at the rate of 9.12% per year.

Bond interest is usually payable semiannually.

The Balance Sheet,

Liabilities, Long-Term Liabilities
Debentures, continued Typicals bond issue is called a debenture because the bonds are backed only by the general credit of the corporation rather than by specific company assets.

Companies can also issue secured debt (mortgage bonds), which offers bondholders an added safeguard because they are secured by a mortgage on all or some of the companys property.

The Balance Sheet,

Liabilities, Long-Term Liabilities
Debentures, continued

If the company is unable to pay the bonds when they are due, holders of mortgage bonds have a claim or lien before other creditors (such as debenture holders) on the mortgaged assets.

The Balance Sheet,

Liabilities, Long-Term Liabilities
Debentures, continued

In other words, these assets may be sold and the proceeds used to satisfy the debt owed the mortgage bondholders. $130,000

21 9.12% debentures payable 2010

The Balance Sheet,

Liabilities, Long-Term Liabilities
Other Long-Term Debt Other Long-Term Debt includes all debt due after one year from the balance-sheet date other than what is specifically reported elsewhere in the balance sheet.

In Typicals case, this debt is a $6,000, single-payment loan made four years ago, which is scheduled for payment in full next year.

The Balance Sheet,

Liabilities, Long-Term Liabilities
Other Long-Term Debt This loan was reported as long-term debt at the end of 19X8 and, since it is payable in full next year, and it no longer qualifies as a long-term liability, is reported as current portion of long-term debt at the end of 19X9. 22 Other Long-Term debt ----

The Balance Sheet,

Liabilities, Long-Term Liabilities
Total Liabilities

Current and long-term liabilities are summed together to produce the figure reported on the balance sheet as Total Liabilities. 23 Total Liabilities $322,000

The Balance Sheet,

Shareholders Equity

This item is the total equity interest that all shareholders have in this corporation. It is the corporations net worth or its assets after subtracting all of its liabilities. this is separated for legal and accounting reasons into the categories discussed next.

Shareholders Equity, Capital Stock

The Balance Sheet,

Capital stock represents shares in the ownership of the company.

These shares are represented by the stock certificates issued by the corporation to its shareholders.

A corporation may issue several different classes of shares, each class having slightly different attributes.

Shareholders Equity, Preferred Stock

The Balance Sheet,

Preferred Stock is an equity ownership interest that has preference over common shares with regard to dividends and the distribution of assets in case of liquidation.
Details about the preferences applicable to this type of stock can be obtained from provisions in a corporations charter.

The Balance Sheet, Shareholders

Equity, Preferred Stock, cont.

In typicals case, the preferred stock is a $5.83 cumulative $100 par value.
Par value is the nominal or face value of a security assigned to it by its issuer. The $5.83 is the yearly per-share dividend to which each preferred shareholder is entitled before any dividends are paid to the common shareholders.

The Balance Sheet, Shareholders

Equity, Preferred Stock, cont.

Cumulative means that if in any year the preferred dividend is not paid, it accumulates in favor of preferred shareholders.
The total unpaid dividends must be declared and paid to these shareholders when available and before any dividends are distributed on the common stock.

The Balance Sheet, Shareholders

Equity, Preferred Stock, cont.

Generally, preferred shareholders have no voice in company affairs unless the company fails to pay them dividends at the promised rate.

24 Preferred Stock, $5.83 cumulative, $100 par value; authorized issued and outstanding: 60,000 shares $6,000

The Balance Sheet, Shareholders

Equity, Common Stock

Although preferred shareholders are entitled to dividends before common shareholders, their entitlement is generally limited (in Typicals case to $5.83 per share, annually).
Common stock has no such limit on dividends payable each year. In good times, when earnings are high, dividends may also be high.

The Balance Sheet, Shareholders

Equity, Common Stock, cont.

When earnings drop, so may dividends. Typicals common stock has a par value of $5.00 per share. In 19X9, Typical sold 500,000 shares of stock for a total of $9,000.

Of the $9,000, $2,500 is reported as common stock(500,000 shares at a par value of $5.00)

The Balance Sheet, Shareholders

Equity, Common Stock, cont.
The balance, $6,500, is reported as additional paid-in capital. When added to the prior year-ends common stock balance of $72,500, the $2,500 brings the common stock balance to $75,000.

25 Common stock, $5.00 par value, authorized: 20,000,000 shares; issued and outstanding: 15,000,000 shares

$75,000

The Balance Sheet, Shareholders

Equity, Additional Paid-In Capital
Additional paid-in capital is the amount paid by shareholders in excess of the par or stated value of each share. In 19X9, paid-in capital increased by $6,500, when this amount is added to last years ending balance of $13,500, additional paid-in capital at Dec. 31, 19X9, comes to $20,000. 26 Additional paid-in capital $20,000

The Balance Sheet,

Shareholders Equity, Retained Earnings

When a company first starts in business, it has no retained earnings. Retained earning are the accumulated profits the company earns and reinvests or retains in the company. In less successful companies where losses have exceeded profits over the years, those accumulated net losses will be reported as an accumulated deficit.

Shareholders Equity, Retained Earnings, cont.

The Balance Sheet,

Retained earnings increase by the amount of profits earned, less dividends declared to shareholders.

If, at the end of Typicals first year:

Profits are $80,000.

Dividends of $100 are paid on the preferred stock, and no dividends are declared on the common.

Shareholders Equity, Retained Earnings, cont.

The Balance Sheet,

The balance sheet will show retained earnings of $79,900.

In Typicals second year: Profits are $140,000. Preferred Dividends are $200. Common Dividends are $400. The balance sheet will show retained earning of $219,300.

Shareholders Equity, Retained Earnings, cont.

The Balance Sheet,

The Dec. 31, 19X9, balance sheet for Typical shows the company has accumulated $249,000 in retained earnings.
27 retained Earnings $249,000

The following table shows retained earnings from start-up through the end of 19X9.

Calculation: Accumulated Retained Earnings

Balance at start-up Profit in year 1 Preferred dividends in year 1 Retained Earnings: Profit in year 2 Dividends in year 2: Retained Earnings: Aggregate Profits: Aggregate dividends: Retained Earnings: Net Income: Dividends: Retained Earnings End of year 1 Preferred Common End of year 2 Year 3 through 19X8 Year 3 through 19X8 12/31/X8 and 1/1/X9 19X9 19X9 Preferred Common 12/31/X9 $0 80,000 (100) 79,900 140,000 (200) (400) 219,300 800,000 (799,700) 219,600 47,750 (350) (18,000) $249,000

Shareholders Equity, Foreign Currency Translation Adjustment

Net of Taxes

The Balance Sheet,

When a company has an ownership interest in a foreign entity, it may be required to to include that entitys results in the companys consolidated financial statements. If that requirement applies, the financial statements of the foreign entity(prepared in foreign currency)must be translated into U.S. dollars.

Shareholders Equity, Foreign Currency Translation Adjustment

The Balance Sheet,

The gain or loss resulting from this translation, after the related tax expense or benefit, is reflected as a separate component of shareholders equity and is called foreign currency translation adjustments.
The adjustment should be distinguished from conversion gains or losses relating to completed transactions that are denominated in foreign currencies.

Shareholders Equity, Foreign Currency Translation Adjustment

The Balance Sheet,

Conversion gains or losses are included in a companys net income.

28 Foreign currency translation adjustments(net of taxes)

$1,000

The Balance Sheet,

Shareholders Equity,
Unrealized Gain on Available-for-sale Securities

Unrealized gain/loss is the change in the value (gain or loss) of securities classified as available-for-sale that are still being held.

The Balance Sheet,

Shareholders Equity,
Unrealized Gain on Available-for-sale Securities

In Typicals case, this represents the difference (a gain here) between the cost (or previously reported fair market value) of investment securities classified as available-for-sale held at the balancesheet date and their fair market value at that time

The Balance Sheet,

Shareholders Equity,
Unrealized Gain on Available-for-sale Securities

Since Typical still holds these securities and has not yet sold them, such differences have not been realized. As such, this unrealized amount is not included in the determination of current income.

The Balance Sheet,

Shareholders Equity,
Unrealized Gain on Available-for-sale Securities

However, since these securities must be reported at their fair market value, the changes in the fair market value since purchase (or the previously report date) are reported, after the related income tax expense or benefit, as a separate component of shareholders equity.

The Balance Sheet,

Shareholders Equity,
Unrealized Gain on Available-for-sale Securities

On Dec. 31, 19X9, the total fair market value of these securities exceeded their cost by $65. That gain would have increased tax expense by $15, producing a net unrealized gain of $50.

The Balance Sheet,

Shareholders Equity,
Unrealized Gain on Available-for-sale Securities

If these securities are sold, the difference between their original cost and the proceeds from such sale will be realized gain or loss included in the determination of net income in the period. $50

29 Unrealized gain on available -for-sale securities(net of taxes)

Shareholders Equity, Treasury Stock

The Balance Sheet,

When a company buys its own stock back, that stock is recorded at cost and reported as treasury stock.
It is called treasury stock because after being reacquired by the company, it is returned to the companys treasury. The company can then resell or cancel that stock.

Shareholders Equity, Treasury Stock

Treasury stock is reported as a deduction from shareholders equity. Any gains or losses on the sale of such shares are reported as adjustments to shareholders equity, but are not included in income. Treasury stock is not an asset.

The Balance Sheet,

30 Less: Treasury Stock at Cost

($5,000)

Shareholders Equity, Total shareholders equity

The Balance Sheet,

Total Shareholders Equity is the sum of stock (less treasury stock), additional paidin-capital, retained earnings, foreign currency translation adjustments and unrealized gains on investment securities available for sale.
$346,050

31 Total Shareholders Equity

What Does The Balance Sheet Show?

To analyze balance-sheet figures, investors look to certain financial statement ratios for guidance.
A financial statement ratio is the mathematical relationship between two or more amounts reported in the financial statements.

What Does The Balance Sheet Show?

One of their concerns is whether the business will be able to pay its debts when they come due.

Analysts are also interested in the companys inventory turnover and the amount of assets backing corporate securities (bonds and preferred and common stock), along with the relative mix of these securities.

What Does The Balance Sheet Show? Working Capital

Working capital is the difference between total current assets and total current liabilities.
Remember, current liabilities are debts due within one year of the balance-sheet date. The sources from which those debts are paid is current assets.

What Does The Balance Sheet Show? Working Capital, cont.

Thus, working capital represents the amount of current assets that is left if all current debts are paid.
6 Current Assets 19 Less: Current Liabilities Working Capital $405,800 (176,000) $229,800

What Does The Balance Sheet Show? Working Capital, cont.

Generally, companies that maintain a comfortable amount of working capital are more attractive to conservative investors.
A companys ability to meet obligations, expand volume and take advantage of opportunities is often determined by its working capital

What Does The Balance Sheet Show? Working Capital, cont.

Year-to-year increases in working capital are a positive sign of a companys growth and health.

What Does The Balance Sheet Show? Current Ratio

What is a comfortable amount of working capital? Analysts use several methods to judge whether a company has adequate working capital.
To interpret the current position of a company being considered as a possible investment, the current ratio may be more useful than the dollar total of working capital.

What Does The Balance Sheet Show? Current Ratio, cont.

The first rough test is to compare the current assets figure with the total current liabilities.
A current ratio of 2-to-1 is generally considered adequate. This means that for each $1 of current liabilities, there are $2 in current assets.

What Does The Balance Sheet Show? Current Ratio, cont.

To find the current ratio, divide current assets by current liabilities.

16 Current Assets $405,800 2.31 19 Current Liabilities $176,000 1 or 2.3 to 1

Thus, for each $1 of current liabilities, there is $2.31 in current assets to back it up.

What Does The Balance Sheet Show? Current Ratio, cont.

There are so many different kinds of companies that this test requires a great deal of modification if it is to be really helpful in analyzing companies in different industries.

What Does The Balance Sheet Show? Current Ratio, cont.

Generally, companies that have a small inventory and accounts receivable that are quickly collectible can operate safely with a lower current ratio then companies having a greater proportion of their current assets in inventory and that sell their products on extended credit terms.

What Does The Balance Sheet Show? Quick Assets

In addition to working capital and current ratio, another way to test the adequacy of working capital is to look at quick assets.
Quick Assets are the assets available to cover a sudden emergency--assets that could be taken to the bank right away.

What Does The Balance Sheet Show? Quick Assets, cont.

They are those current assets that are quickly convertible into cash. This excludes merchandise inventories, because such inventories have yet to be sold and are not quickly convertible into cash.

What Does The Balance Sheet Show? Quick Assets, cont.

Accordingly, quick assets are current assets minus inventories, prepaid expenses and any other illiquid current assets. 6 Current Assets 4 Less: Inventories 5 Less: Prepaid Expenses Quick Assets $405,800 (180,000) (4,000) $221,800

What Does The Balance Sheet Show? Net Quick Assets

Net quick Assets are found by taking the quick assets and subtracting the total current liabilities. A well-positioned company should show a reasonable excess of quick assets over current liabilities.

What Does The Balance Sheet Show? Net Quick Assets, cont.

This provides a rigorous and important test of a companys ability to meet its obligations. $221,800 (176,000) $ 45,800

Quick Assets 19 Less: Current Liabilities Net Quick Assets

What Does The Balance Sheet Show? Quick Assets Ratio

The Quick Assets Ratio is found by dividing quick assets by current liabilities.
Quick Assets $221,800 126 . 19 Current Liabilities $176,000 1 or 1.26 to 1

This means that, for each $1 of current liabilities, there is $1.26 in Quick Assets available.

What Does The Balance Sheet Show? Debt to Equity

A certain level of debt is acceptable, but too much is a sign for investors to be cautious. The Debt-To-Equity Ratio is an indicator of whether the company is using debt excessively.

23 Total Liabilities $322,000 .93 31 Total Shareholders' Equity $346,050

What Does The Balance Sheet Show? Debt to Equity, cont.

A debt-to-equity ratio of .93 means the company is using 93 cents of liabilities for every dollar of shareholders equity in the business. Industrial companies try to remain below a maximum of a 1-to-1 ratio, to keep debt at a level that is less than the investment level of the owners of the business.

What Does The Balance Sheet Show? Debt to Equity, cont.

Utilities, service companies and financial companies often operate with much higher ratios.

What Does The Balance Sheet Show? Inventory Turnover

How much inventory should a company have on hand? That depends on a combination of many factors including the type of business and the time of the year. An automobile dealer with a large stock of autos at the height of the season is in a strong inventory position; yet that same inventory at the end of the season represents a weakness in the dealers financial condition.

What Does The Balance Sheet Show? Inventory Turnover, cont.

One way to measure adequacy and balance of inventory is to compare it with cost of sales for the year to determine inventory turnover.

What Does The Balance Sheet Show? Inventory Turnover, cont.

Typicals cost of sales for the year is $535,000. Which is divided by average inventory for the year of $182,500 to determine turnover. (inventory at 12/31/X8 of $185,000 + inventory at 12/31/X9 of $180,000, divided by 2) Turnover is 2.9 times ($535,000 / $182,500), meaning that goods are bought, manufactured and sold out almost three times per year on average.

What Does The Balance Sheet Show? Inventory Turnover, cont.

Inventory as a percentage of current assets is another comparison that may be made. In Typicals case the inventory of $180,000 represents 44% of the total current assets, which amounts to $405,800.

What Does The Balance Sheet Show? Inventory Turnover, cont.

But there is considerable variation between different types of companies, and thus the relationship is significant only when comparisons are made between companies in the same industry.

What Does The Balance Sheet Show? Book Value of Securities

Net book value or net asset value is the amount of corporate assets backing a bond or a common or preferred share. Intangible assets are sometimes included when computing book value. However, the following calculations will focus on the more conservative net tangible book value.

What Does The Balance Sheet Show? Book Value of Securities, cont.
Net Asset Value per Bond To state this figure conservatively, intangible assets are subtracted as if they have no value on liquidation. Current liabilities of $176,000 are considered paid. This leaves $490,100 in assets to pay the bondholders. So, $3,770 in net asset value protects each $1,000 bond.

Net Asset Value per Bond

12 total Assets 10 Less: Intangibles Total Tangible Assets 19 Less: Current Liabilities Net Tangible Assets Available to meet bondholders' claims $668,050 (1,950) 666,100 (176,000) $490,100

$490,100,000 =$3,770 Net Asset Value Per 130,000 1,000 Bond Outstanding

What Does The Balance Sheet Show? Book Value of Securities, cont.
Net Asset Value per Share of Preferred Stock To calculate net asset value of a preferred share, start with total tangible assets, conservatively stated at $666,100.

Current liabilities of $176,000 and long-term liabilities of $146,000 are considered paid.

This leaves $344,100 of assets protecting the preferred. So, $5735 in net asset value backs each share of preferred.

Net Asset Value per Share of Preferred Stock

12 total Assets 10 Less: Intangibles Total Tangible Assets 19 Less: Current Liabilities 20,21,22 Long-Term Liabilities Net Tangible Assets Underlying the Preferred Stock $668,050 (1,950) 666,100 (176,000) (146,000) $344,100

344,100,000 =$5,735 Net Asset Value Per 60,000 Preferred Share

What Does The Balance Sheet Show? Book Value of Securities, cont.
Book Value per Share of Common Stock The book value per share of common stock can be thought of as the amount of money each share would receive if the company were liquidated, based on balance-sheet values. The bondholders and preferred shareholders would have to be satisfied first. The answer, $22.54 book value per share of common stock, is arrived at as follows.

Book Value per Share of Common Stock

25 26 27 28 29 30 Common Stock Additional paid-in capitla Retained Earnings Foreign-Currency Translation Adjustments Unrealized gains on available-for-sale securities Treasury Stock Total Common Shareholders' Equity 10 Less: Intangible Assets Total Tangible Common Shareholders' Equity $75,000 20,000 249,000 1,000 50 (5,000) 340,050 (1,950) $338,100

$338,100,000 =$22.54 book value per common share. 15,000,000

What Does The Balance Sheet Show? Book Value of Securities, cont.
Book Value per Share of Common Stock

An alternative method of arriving at the common shareholders equity, conservatively stated at $338,100, is shown on the following slide.

Book Value per Share of Common Stock

Second Method
12 Total Assets 10 Less: Intangibles Total Tangible Assets 19 Less: Current Liabilities 20,21,22 Long-Term Liabilities 24 Preferred Stock Net Tangible Assets Available for Common Stock $668,050 (1,950) 66,100 (176,000) (146,000) (6,000) $338,100

$338,100,000 =$22.54 book value per common share 15,000,000

What Does The Balance Sheet Show? Book Value of Securities, cont.
Book Value per Share of Common Stock Book-value figures,particularly of common stocks, can be misleading.

Profitable companies may show a very low net book value and very substantial earnings, while mature companies may show a high book value for their common stock but have such low or irregular earnings that the stocks market price is lower than its book value.

What Does The Balance Sheet Show? Book Value of Securities, cont.
Book Value per Share of Common Stock

Because their assets are largely liquid their common stocks book value is sometimes a fair indication of market value.

What Does The Balance Sheet Show? Book Value of Securities, cont.
Capitalization Ratio The proportion of each kind of security issued by a company is the Capitalization Ratio. A high proportion of bonds sometimes reduces the attractiveness of both the preferred and common stock, and too much preferred can detract from the commons value.

What Does The Balance Sheet Show? Book Value of Securities, cont.
Capitalization Ratio Thats because bond interest must be paid before preferred dividends, and preferred dividends before common dividends.

What Does The Balance Sheet Show? Book Value of Securities, cont.
Capitalization Ratio Typicals bond ratio is derived by dividing the face value of the bonds, $130,000, by the total value of bonds, preferred and common stock, additional paid-in capital, retained earnings, foreign currency translation adjustments, unrealized gains on available-for-sale securities and treasury stock less intangibles, which is $474,100.

Capitalization Ratio
This shows that bonds amount to about 27% of Typicals total capitalization.
21 24 25 26 27 28 Debentures $130,000 Preferred Stock 6,000 Common Stock 75,000 Additional Paid-in Capital 20,000 Retained Earnings 249,000 Foreign Currency Translation Adjustments 1,000 29 Unrealized Gains on Available-for-Sale Securities 50 30 Treasury Stock (5,000) 10 Less: Intangibles (1,950) Total Captialization $474,100

What Does The Balance Sheet Show? Book Value of Securities, cont.
Preferred Stock Ratio

The Preferred Stock Ratio is found the same way--by dividing preferred stock of $6,000 by the entire capitalization of $474,100. The result is about 1%.

What Does The Balance Sheet Show? Book Value of Securities, cont.
Common Stock Ratio

The Common Stock Ratio will be the difference between 100% and the total of the bond and preferred stock ratio--or about 72%.

What Does The Balance Sheet Show? Book Value of Securities, cont.
Common Stock Ratio

The same result is reached by adding common stock, additional paid-in capital, retained earnings, foreign currency translation adjustments, unrealized gains on available-for-sale securities and treasury stock, less intangibles, and dividing the result by total capitalization.

Debenture, Preferred, and Common Ratios

21 Debentures 24 Preferred Stock 10 & 25-30 Common Shareholders Equity Less Intangibles 338,100 Total $474,100 Amount $ 130,000 6,000 Ratio 27% 1%

72% 100%

The Income Statement

The most important report for many analysts, investors or potential investors is the income statement. It shows how much the corporation earned or lost during the year.

The Income Statement, cont.

While the balance sheet shows the fundamental soundness of a company by reflecting its financial position at a given date, the income statement may be of greater interest to investors for the following reasons:

The income statement shows the record of a companys operating results for the whole year.

The Income Statement, cont.

It also serves as a valuable guide in anticipating how the company may do in the future. However, the income statement for a single year does not tell the whole story. The historical record for a series of years is more important than the figures for any single year.

The Income Statement, cont.

Typical includes two years in its income statement shown in the beginning of this presentation and gives a 10-year financial summary that will be shown and discussed later in this presentation.

The Income Statement, cont.

An income statement matches the revenues earned from selling goods and services or other activities against all the costs and outlays incurred to operate the company.
The difference is the net income (or loss) for the year.

The Income Statement, cont.

The costs incurred usually consist of: Cost of Sales Selling General and Administrative expenses such as wages and salaries, rent, supplies and depreciation Interest on money borrowed Taxes.

The Income Statement, Net Sales

The most important source of revenue is usually the first item on the income statement. It represents the primary source of revenue earned by the company from its customers for goods sold or services rendered. In Typical Manufacturings income statement, it is shown as Net Sales.

The Income Statement, Net Sales, cont.

The net sales item includes the amount reported after taking into consideration returned goods and allowances for price reductions or discounts. By comparing 19X9 and 19X8, it can be determined if Typical had a better year in 19X9, or a worse one.

33 Net Sales

$765,050

The Income Statement, Cost of Sales

In a manufacturing establishment, Cost of Sales represents all the costs the company incurs to purchase and convert raw materials into the finished products that it sells. These costs are commonly known as Product Costs, they are those costs that can be identified with the purchase or manufacture of goods made available for sale.

The Income Statement, Cost of Sales, cont.

There are three basic components of product cost: Direct Materials

Direct Labor

Manufacturing Overhead

The Income Statement, Cost of Sales, cont.

Direct materials and direct labor costs can be directly traced to the finished product. For example, for a furniture manufacturer, lumber would be a direct material cost and carpenter wages would be a direct labor cost.

The Income Statement, Cost of Sales, cont.

Manufacturing overhead costs, while associated with the manufacturing process, cannot be traceable to the finished product. Examples of manufacturing overhead costs are costs associated with operating the factory plant.

The Income Statement, Cost of Sales, cont.

Such as rent, electricity, suppliers, depreciation, maintenance and repairs and the salaries of production supervisors. 34 Cost of Sales $535,000

The Income Statement, Gross Margin

Gross Margin is the excess of sales over cost of sales. It represents the actual direct profit from sales after considering product costs. Comparing period-to-period gross margin trends in absolute dollars is a useful analytical tool.

The Income Statement, Gross Margin, cont.

Also, comparing the gross margin percentage from year to year. Gross Margin Percentage is computed by dividing gross margin by net sales.
35 Gross Margin $230,050 Gross Margin Percentage 30% ($230,050 / $765,050)

The Income Statement, Depreciation and Amortization

Each years decline in value of nonmanufacturing facilities would be captured in Depreciation and Amortization.
Amortization, as reported in this line item, represents the decline in useful value of an intangible, such as a 17-year patent.

36 Depreciation and Amortization

$28,050

The Income Statement, Selling, General, and Administrative Expenses

These expenses are generally grouped separately from cost of sales so that the reader of an income statement may see the extent of selling and administrative costs.

The Income Statement, Selling, General, and Administrative Expenses, cont.

These include expenses such as: Sales agents salaries and commissions Advertising and promotion Travel and entertainment. Executives salaries Office payroll and expenses. 37 Selling, General, and Administrative Expenses $96,804

The Income Statement, Operating Income

Subtracting all operating expenses from the net sales figure determines Operating Income.

38 Operating Income

$105,196

The Income Statement, Dividend and Interest Income

An additional source of revenue comes from dividends and interest received by the company from it investment in stocks and bonds. $5,250

39 Dividends and Interest Income

The Income Statement, Interest Expense

The interest earned by bondholders for the use of their money is sometimes referred to as a fixed charge.

Thats because the interest must be paid year after year whether the company is making money or losing money. Interest differs from dividends on stocks, which are payable only if the board of directors declares them.

The Income Statement, Interest Expense, cont.

Interest paid is another cost of doing business, and is deductible from earnings in order to arrive at a base for the payment of income taxes. Typicals interest expense comes from 3 sources: Notes Payable Debentures Other Long-Term Debt (which became current portion of long-term debt at this year end.

The Income Statement, Interest Expense, cont.

The notes payable, with an average outstanding balance for the year of $56,000 at 7% interest, incur an interest charge of $3,920.
The debentures, bearing interest at 9.12% of the $130,000 balance, incur interest expense of $11,856.

The Income Statement, Interest Expense, cont.

The $6,000 of other long-term debt at 7.9%, incurs interest of $474. 40 Interest Expense $16,250

The Income Statement, Income Taxes

Each corporation has an effective tax rate which depends on the level and nature of its income. Large corporations like Typical Manufacturing are subject to the top statutory corporate income tax rate.

However, tax credits, tax-free income and nondeductible expenses tend to change the overall tax rate.

The Income Statement, Income Taxes, cont.

Typicals income before taxes and extraordinary loss is $94,196.

Its tax comes to $41,446. $94,196 $41,446

41 Income before Income Tax and Extraordinary Loss 42 Income Taxes

The Income Statement, Income Before Extraordinary Loss

Income before extraordinary loss for the year is the amount by which all revenues exceed all expenses.

Extraordinary gains or losses ( as defined by GAAP) are excluded from this determination.

43 Income before Extraordinary Loss $52,750

The Income Statement, Extraordinary Items

Under usual conditions, the $52,750 income would be the end of the story. However, there are years in which companies experience unusual and infrequent events called Extraordinary Items.

For example, an extraordinary item would be crop destruction by a hail storm in an area where hail storms are rare.

The Income Statement, Extraordinary Items, cont.

In this case, on e of Typicals manufacturing sites was destroyed by an earthquake. This event is isolated on a separate line, net of its tax effect.

The Income Statement, Extraordinary Item, cont.

Its earnings per share impact is also separated from the earnings per share attributable to normal operations.

44 Extraordinary Item: Loss on earth quake destruction (net of tax benefit $750)

($5,000)

The Income Statement, Net Income

The Bottom Line Once all income and costs, including extraordinary items, are considered, Net Income (or Loss) is determined.

45 Net Income

$47,750

The Income Statement, Other Items

Three other items that do not apply to Typical could appear on an income statement.

The Income Statement, Other Items, cont.

First, suppose Typical were heavily involved in research and development (R&D) activities.
In that event, Typical would be required to include the amount of R&D costs in the income statement or disclose it in the footnotes.

The Income Statement, Other Items, cont.

Second, suppose Typical owned between 20% and 50% of another company. In that case, Typical would have significant influence over that company, but not control it. As such, it would have to account for that investment using the equity method and report its equity interest in that company in it financial statements.

The Income Statement, Other Items, cont.

For example, suppose Typicals share of that companys earnings for the year were $1,200 and it received $700 in dividends from the company during that year. In that event, Typical would have to include $1,200 on its income statement under the category equity in the earnings of unconsolidated subsidiaries.

The Income Statement, Other Items, cont.

Typical would also be required to increase it investment in that company to the extent of the earnings it picked up it is income statement. However, this would be reduced by any dividends received, in this case $700, since the dividend represents a return of its investment.

The Income Statement, Other Items, cont.

In this case, Typicals balance sheet would show a net increase in its investment in this company of $500.

The Income Statement, Other Items, cont.

Third, suppose Typical owned a consolidated subsidiary (more than 50% ownership), in which it had less than a 100% ownership interest. For example, if Typical owned 85% of that company. Any material change in the related minority interest (15%), would have to be reported in the income statement or footnotes.

The Income Statement, Other Items, cont.

A corresponding change in the cumulative minority interest would also have to be reported in the balance sheet, between longterm liabilities and stockholders equity.

The Income Statement, Analyzing the Income Statement

When used to make a few detailed comparisons, the income statement will reveal a lot more information about a companys operating results.
For example, a prospective investor can determine the companys operating margin and how it has changed over the years.

The Income Statement, Analyzing the Income Statement, cont.

This determination can be made by comparing operating income to net sales. To illustrate, in 19X0, Typical reported net sales of $765,050 and operating income of $105,196. 19X9 Operating Margin 38 $105,196 operating income = 13.8% 33 $765,050 Net Sales

The Income Statement, Analyzing the Income Statement, cont.

This means that for each dollar of 19X9 sales, 19.8 cents remained as a profit from operations. This figure is interesting, but is more significant when compared with the operating margin last year. 19X8 Operating Margin 38 $73,500 operating income = 10.1% 33 $725,000 net sales

The Income Statement, Analyzing the Income Statement, cont.

Typicals operating profit margin went from 10.1% to 13.8%, so business didnt just grow, it became more profitable.
Changes in operating margin can reflect changes in volume, efficiency, product line or types of customers served.

The Income Statement, Analyzing the Income Statement, cont.

Typical can also be compared with other companies in its field.

If Typicals operating margin is very low compared to others, it is an unhealthy sign. If it is high, there is a basis for optimism. Analysts also frequently use Operating Cost Ratio for the same purpose.

The Income Statement, Analyzing the Income Statement, cont.

Operating Cost Ratio is the complement of the operating margin.

Typicals operating margin is 13.8%. The operating cost ratio is 86.2%.
33 Net Sales 34,36,& 37 Operating Costs 38 Operating Income Amount $765,050 $659,854 $105,196 Ratio 100% 86.2% 13.8%

The Income Statement, Analyzing the Income Statement, cont.

Net Profit Ratio is still another guide to indicate how satisfactory the years activities have been.
In Typicals case, the year's net income was $47,750. The net sales of the year amounted to $765,050

The Income Statement, Analyzing the Income Statement, cont.

Therefore, Typicals income was $47,750 on $765,050 of sales or:

19X9 Net Profit Ratio: 45 $47,750 Net Income = 6.2% 33 $765,050 Net Sales

This means that this year, for every $1 of goods sold, 6.2 cents in profit was ultimately earned by the company.

The Income Statement, Analyzing the Income Statement, cont.

By comparing the net profit ratio from year to year for the same company and with other companies, profit progress can be evaluated.

Last year, Typicals net income was $40,500 on $725,000 in sales: 19X8 Net Profit Ratio: 45 $40,500 Net Income = 5.6% 33 $725,000 Net Sales

The Income Statement, Analyzing the Income Statement, cont.

The operating margin, operating cost ratio and net profit ratio provide general information about the company and help assess its future prospects.
All these comparisons have a long-term significance because they provide useful information about the companys fundamental economic condition.

The Income Statement, Analyzing the Income Statement, cont.

Another question to ponder: Are Typicals securities a good investment? Consideration of some additional factors can help provide an answer.

The Income Statement, Interest Coverage

Interest Coverage is the number of times the annual interest on a debt obligation is covered by income for the year without considering interest on the debt and taxes. Typicals debentures represent a very substantial debt, but they are due many years in the future. The yearly interest, however, is a fixed charge.

The Income Statement, Interest Coverage, cont.

How readily the company can pay the interest on this debt (i.e. the debts interest coverage) would be of great interest to an investor. More specifically, an investor would like to know if the borrowed funds have been put to good use, so that the earnings are adequate and thus available to meet interest costs.

The Income Statement, Interest Coverage, cont.

The available income representing the source for payment of the debenture interest is $106,052 (operating profit plus dividend and interest income less the interest expense on the other debt).
The annual debenture interest amounts to $11,856.

The Income Statement, Interest Coverage, cont.

This means the debentures annual interest expense is covered 8.9 times.

Number of Times Debenture Interest Earned: $106,052 Available Income = 8.9 $11,856 Debenture Interest

The Income Statement, Interest Coverage, cont.

For a corporate bond (debenture) to be considered a safe investment, most analysts say that the company should earn its bond interest requirement 3 to 4 times over.
By these standards, Typicals debentures have a fir margin of safety.

The Income Statement, What about Leverage?

Financial Leverage relates a companys long-term debt and preferred stock to the companys common equity.
Sometimes a stock is said to be highly leveraged, this means that the company issuing the stock has a large proportion of bonds and preferred stock outstanding relative to the amount of common stock.

The Income Statement, What about Leverage?, cont.

High leverage can work for or against a company depending on the earnings available to the common shareholders.
Analysts consider highly leveraged companies to be risk prone.

The Income Statement, What about Leverage?, cont.

For example, a company with $10,000,000 of 4% bonds outstanding. If the company earns $440,000 before bond interest, there will only be $40,000 left for the common shareholders after payment of $400,000 bond interest.

However, an increase of only 10% in earning to $484,000 will leave $84,000 for common stock dividends.

The Income Statement, What about Leverage?, cont.

If there is only a small amount of common stock issued, the increase in earnings per share will appear very impressive.
But in this instance, it is also apparent that a decline of 10% in earnings to $396,000 would wipe out everything available for the common shareholders.

The Income Statement, What about Leverage?, cont.

Moreover, it would also result in the companys being unable to cover the full interest on its bonds without dipping into its cash reserves and retained earnings. This is the great danger of so-called highly leveraged companies.

It also illustrates a fundamental weakness of companies that have a disproportionate amount of debt.

The Income Statement, What about Leverage?, cont.

Conservative investors usually steer clear of highly leveraged companies, although they do appeal to people seeking a higher return who are willing to assume the risk.
Typical Manufacturing, on the other hand, is not a highly leveraged company.

The Income Statement, What about Leverage?, cont.

In 19X8, Typical incurred $11,856 in debenture interest and its income before extraordinary loss and this expense came to $52,356 ($40,500 + $11,856).
This left $40,500 for the common and preferred stockholders and retained earnings after recording this interest.

The Income Statement, What about Leverage?, cont.

Now look what happened this year:

Net profit before extraordinary loss and debenture interest rose by $12,250 or about 23%. Since the bond interest stayed the same, income before extraordinary loss and after recording this interest also rose $12,250. But that is about 30% of $40,500.

The Income Statement, What about Leverage?, cont.

While this is certainly not a dramatic example of leverage, a 23% increase in pretax earnings generates a 30% increase in amount available for dividends or retained earnings.

The Income Statement, What about Leverage?, cont.

While this only illustrates the leverage effect of the interest on the debentures, similar calculations could be made to shoe the impact of the interest expense related to the other borrowings and total interest expense.

The Income Statement, Preferred Dividend Coverage

To calculate the preferred dividend coverage (the number of time preferred dividends were earned), net profit must be used as the base.
Thats because federal income taxes and all interest charges must be paid before anything is available for shareholders.

The Income Statement, Preferred Dividend Coverage, cont.

Because the 60,000 shares of $100 par value preferred stock pay a per share dividend of $5.83, the total dividend requirement for the preferred stock is $350. Dividing the net income of $47,750, by this figure yields approximately 136.4, which means that the dividend requirement of the preferred stock has been earned more than 136 times over.

The Income Statement, Preferred Dividend Coverage, cont.

This ratio is so high primarily because Typical has only a relatively small amount of preferred stock outstanding.

The Income Statement, Earnings Per Common Share

A buyer of common stock is often more concerned with the stocks earnings per share than with its dividend. This is because earnings usually influence stock market prices.

The Income Statement, Earnings Per Common Share, cont.

Although the income statement separates earnings per share before and after the effect of extraordinary items, the remainder of this presentation will only consider net income per common share (net income after extraordinary item).

In Typicals case, the income statement does not show income available for common stock, so it must be calculated as shown next.

The Income Statement, Earnings Per Common Share, cont.

45 Net Income Less: Dividend Requirement of Preferred Stock Net Income Available for Common Stock
Net Income Per Common Share: $47,400,000 Net Income Available for the Common Stock $3.21 14,750,000 Average Number of Outstanding Common Shares

$47,750
(350) $47,400

The Income Statement, Earnings Per Common Share, cont.

Typicals capital structure is a very simple one, comprised of common and preferred stock. Therefore, the earnings per share computation will suffice under this scenario. However, if the capital structure is more complex and contains securities that are convertible into common stock, option, warrants or contingently issuable share, the calculation requires modification.

The Income Statement, Earnings Per Common Share, cont.

Options and warrants each give the holder the right to buy securities at a specified price.
Contingently issuable shares are shares of stock whose issuance depends on the occurrence of certain events.

The Income Statement, Earnings Per Common Share, cont.

If a capital structures has convertible securities, two separate calculations are required:

Primary Earnings Per Common Share. Fully Diluted Earnings Per Common Share.

The Income Statement, Primary Earnings Per Common Share

This is determined by dividing the earnings for the year by the average number of shares of common stock outstanding during the year plus common stock equivalents if dilutive.

The Income Statement, Primary Earnings Per Common Share, cont.

Common Stock Equivalents are securities that enable their holders to become common shareholders by exercising a right to acquire common stock under that security(options or warrants) or exchanging or converting a security (convertible securities) into common shares.

The Income Statement, Primary Earnings Per Common Share, cont.

Examples are convertible preferred stock, convertible bonds and the like. Such securities are deemed to be only one step short of common stock. Their value stems in large part from the value of the common to which they relate.

The Income Statement, Primary Earnings Per Common Share, cont.

Convertible preferred stock and convertible bonds offer their holders some choices. A holder can elect either: A return at the specified dividend or interest rate. Conversion into common stock and participation in market appreciation and dividends resulting from increased earnings on the common stock.

The Income Statement, Primary Earnings Per Common Share, cont.

However, the securities dont have to be actually converted to common stock for them to be called a common stock equivalent because they enable holders in certain circumstances to cause an increase in the number of common shares by exercising, exchanging or converting.

The Income Statement, Primary Earnings Per Common Share, cont.

How do accountants determine a common stock equivalent? Stock options and warrants to acquire common stock are always considered common stock equivalents. A convertible security is considered a common stock equivalent if its effective yield at the date of its issuance is less than two-thirds of the current average Aa corporate bond yield.

The Income Statement, Primary Earnings Per Common Share, cont.

The following example is of how these new term might operate in a company entirely different form Typical Manufacturing. Assume there are 100,000 shares of common stock outstanding plus another 100,000 shares of preferred stock, convertible into common on a share-for-share basis. Assume they qualify as common stock equivalents.

The Income Statement, Primary Earnings Per Common Share, cont.

Add the two and get 200,000 shares altogether. Further, assume earnings are $500,000 for the year. With these facts, the computation-assuming the conversion of the preferred is: Earning Per Common Share Assuming Conversion of preferred: $500,000 Earnings for the year = $2.50 200,000 Adjusted Shares

The Income Statement, Primary Earnings Per Common Share, cont.

However, as mentioned earlier, the common stock equivalent shares are only included in the computation if the effect of conversion on earnings per common share is dilutive. Dilution occurs when earnings per share decreases or loss per share increases on the companys common stock.

The Income Statement, Primary Earnings Per Common Share, cont.

For example, assume the preferred stock paid $3 a share in dividends. Without conversion, the earnings per common share would be $2, as opposed to $2.50.

Earning Per Common Share: Net income for the year Less: Preferred Dividends Net Income Available for Common Shareholders Common Shares

$500,000 300,000 $200,000 100,000 = $2.00

The Income Statement, Primary Earnings Per Common Share, cont.

In this case, the common stock equivalent shares would be excluded from the computation. Thats because conversion results in the $2.50 per share amount computed previously, a higher (antidilutive) earnings per share. Therefore, primary earnings per share of $2 will be reflected on the income statement.

The Income Statement, Fully Diluted Earnings Per Common Share

The primary earnings per share item takes into consideration common stock and common stock equivalents.

The purpose of fully diluted earning per common share is to reflect maximum potential dilution in earnings that would result if all contingent issuances of common stock had taken place at the beginning of the year.

The Income Statement, Fully Diluted Earnings Per Common Share, cont.

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

The Income Statement, Fully Diluted Earnings Per Common Share, cont.

First, remember that for this earnings per share discussion there are 100,000 share of convertible preferred outstanding and 100,000 shares of common.
Assume there are also convertible bonds with a par value of $10,000,000 outstanding.

The Income Statement, Fully Diluted Earnings Per Common Share, cont.

These bonds pay 6% interest and have a conversion ratio of 20 shares of common for every one-thousand dollar bond. Assume the current average Aa corporate bond yield is 8%. These bonds are not common stock equivalents, because 6% is not less than two-thirds of 8%.

The Income Statement, Fully Diluted Earnings Per Common Share, cont.

However, for fully diluted earnings per share they must be included. If the 10,000 bonds were converted, there would be another 200,000 shares of stock, so adding everything up produces 400,000 shares.

The Income Statement, Fully Diluted Earnings Per Common Share, cont.

But by converting the bonds, the 6% interest payment, less the related $300,000 tax deduction, would be saved, adding another $300,000 to net income available to common shareholders.

The Income Statement, Fully Diluted Earnings Per Common Share, cont.

So the calculation is:

$500,000 $600,000 (300,000) 300,000 $800,000

Net income for the year Interest on the bonds Less: The income tax savings applicable to bond interest deduction Adjusted Earning

Fully Diluted Earnings Per Share: $800,000 Adjusted Earnings = $2 400,000 Adjusted Shares

The Income Statement, Fully Diluted Earnings Per Common Share, cont.

The only remaining step is to test for antidilution. The effect of antidilution would be the opposite of dilution; it would increase earnings per share or reduce loss per share.

The Income Statement, Fully Diluted Earnings Per Common Share, cont.

Earning per share without bond conversion would be $2.50 ($500,000 / 200,000 shares). Since earnings per share if $2 is less than $2.50, the $2 is used.

The Income Statement, Price Earnings Ratio

Both the price and the return on common stock vary with a multitude of factors. One factor is the relationship that exists between the earnings per share and the market price. It is call the price earnings ratio (abbreviated P/E ratio).

The Income Statement, Price Earnings Ratio, cont.

P/E ratio is calculated as follows:

If a stock is selling at $25 per share and earning $2 per share annually, its price earnings ratios 12.5 to 1, usually shortened to 12.5.

Put another way, the stock is said to be selling at 12.5 time earnings.

The Income Statement, Price Earnings Ratio, cont.

If the stock should rise to $40, the P/E ratio would be 20, or 20 times earnings.
If the stock drops to $12, the P/E ratio would be 6, or 6 times earnings. For Typical, which has no common stock equivalents, net income per common share was calculated at $3.21.

The Income Statement, Price Earnings Ratio, cont.

If the stock were selling at $33, the P/E ratio would be 10.3. This figure would be used to compare this stock over a period of years to itself and /or to other similar stocks.

The Income Statement, Price Earnings Ratio, cont.

P/E ratio: $33 market Price =10.3 : 1 49 $3.21 Earnings Per Share

This means that Typicals common stock is selling at approximately 10.3 times earnings.

The Income Statement, Price Earnings Ratio, cont.

Last year, Typical earning $2.77 per share.

Say that its stock sold at the same P/E ratio then. This means that a share of Typical was selling for $28.50 or so, and anyone who bought Typical then would be satisfied now.

The Income Statement, Price Earnings Ratio, cont.

In the real world investors can never be certain that any stock will keep its same P/E ratio form year to year. The historical P/E multiple is a guide, not a guarantee.

The Income Statement, Price Earnings Ratio, cont.

In general, a high P/E multiple, when compared with other companies in the same industry, means that investors have confidence in the companys ability to produce higher future profits.

The Statement of Changes in Shareholders Equity

This statement analyzes the changes from year-to-year in each component of shareholders equity.
It shows that during the year, Typical issued additional common stock at a price above par.

The Statement of Changes in Shareholders Equity, cont.

It also shows that Typical experienced a foreign currency translation gain and an unrealized gain on investments classified as available-for-sale.
The other components of equity, with the exception of retained earnings remained the same.

The Statement of Changes in Shareholders Equity, cont.

Retained earnings reflects the cumulative earnings that the company has invested for future growth.
The statement of changes in shareholders equity show that retained earnings increased by net income less dividends on preferred and common stock.

The Statement of Changes in Shareholders Equity, Dividends

Dividends on common stock vary with the profitability of the company.

They do not enter into the determination or net income nor are they deductible for tax purposes. Common shareholders were paid $18,000 in dividends this year.

The Statement of Changes in Shareholders Equity, Dividends, cont.

Since the balance sheet shows that Typical has 15,000,000 shares outstanding, the first thing to be learned here may be an important point to some potential investors, that is the dividend per share.

Dividend Per Share: $18,000,000 Common Stock Dividend = $1.20 15,000,000 Common Shares Outstanding

The Statement of Changes in Shareholders Equity, Dividends, cont.

Once the dividend per share is known, it is easy to go on to the next step: computing the dividend payout percentage.
The Dividend Payout Percentage is the percentage of earnings per share paid to shareholders.

The Statement of Changes in Shareholders Equity, Dividends, cont.

Dividend Payout Percentage: $1.20 Dividend Per Common Share = 37% 48 $3.21 Net Income Per Common Share

The Statement of Changes in Shareholders Equity, Dividends, cont.

Another statistic of great interest to many investors and analysts is the dividend yield, a percentage providing an estimate of the return per share on a given class of stock.

For example, the Common Dividend Yield would be of great interest.

The Statement of Changes in Shareholders Equity, Dividends, cont.

Common Dividend Yield indicates the percentage return that the annual common dividend provides based on the market price of the common stock.
This is derived by dividing the annual common dividend, in this case $1.20, by the market price of the common stock, earlier determined to be $33 per share.

The Statement of Changes in Shareholders Equity, Dividends, cont.

This provides a common dividend yield of 3.6%, which is quite respectable in todays market.

Dividend Yield: $1.20 Dividend Per Common Share = 3.6% $33 Market Price of the Common Stock

The Statement of Changes in Shareholders Equity, Dividends, cont.

Of course, the dividends on the $5.83 preferred stock will not change form yearto-year.
The word cumulative in the balance-sheet description indicates that if Typicals management didnt pay a dividend on its preferred stock, then the $5.83 payment for that year would accumulate.

The Statement of Changes in Shareholders Equity, Dividends, cont.

It would have to be paid to preferred shareholders before any dividends could ever be declared again on the common stock.

Thats why preferred stock is called preferred; it gets any dividend money first Chances are its 60,000 shares of preferred stock with a par value of $100 each were issued to family members.

The Statement of Changes in Shareholders Equity, Dividends, cont.

During the year, Typical has added $29,400 to its retained earnings after paying dividends totaling $18,350.
Even if Typical has some lean years in the future, it has plenty of retained earnings from which to keep on declaring those $5.83 dividends on the preferred stock and $1.20 dividends on the common stock.

The Statement of Changes in Shareholders Equity, Dividends, cont.

There is one danger in having a lot of retained earnings. It could attract another company, Great Giant Computers & Electronics for instance, to buy up enough of Typicals common to vote out the current management. Then Great Giant might merge Typical into itself.

The Statement of Changes in Shareholders Equity, Dividends, cont.

Where would Great Giant get the money to buy Typical Stock? By issuing new shares of its own stock, perhaps. And where would Great Giant get the money to pay the dividends on all that new stock of its own? The funds would come from Typicals retained earnings.

The Statement of Changes in Shareholders Equity, Dividends, cont.

So Typicals management has an obligation to its shareholders to make sure that its retained earnings are put to work to increase their total wealth.
Otherwise, the shareholders might cooperate with Great Giant if it conducted a raid on Typical.

27 Retained Earnings

$249,000

The Statement of Changes in Shareholders Equity, Return on Equity

Seeing how hard money works is one of the most popular measures that investors use to come up with individual judgments on how much they think a certain stock ought to be worth. The market itself--the sum of all buyers and sellers-- makes the real decision.

The Statement of Changes in Shareholders Equity, Return on Equity, cont.

But the investors often try to make their own decision on whether they want to invest at the markets price or wait.
Most investors look for Typicals Return On Equity (ROE), which shows how hard shareholders equity in Typical is working.

The Statement of Changes in Shareholders Equity, Return on Equity, cont.

How can an investor compute Typicals ROE? To arrive at this figure, an investor would look at the balance sheet and compute the average common shareholders equity for the year in order to calculate how much Typical made on it.

The Statement of Changes in Shareholders Equity, Return on Equity, cont.

In making this calculation, the investor uses only the amount of net profit after the dividends have been paid on the preferred stock.
For Typical Manufacturing, that means $47,750 net profit minus $350.

The Statement of Changes in Shareholders Equity, Return on Equity, cont.

Return On Equity: $47,750 Net Income Less $350 Preferred Stock Divident $325,825 Avg 19X9 Stockholders' Equity Less $6,000 Preferred Stock Value $47,400 14.8% Return on Equity $319,825

The Statement of Changes in Shareholders Equity, Return on Equity, cont.

For every dollar of shareholders equity, Typical made about 15 cents.

Is that good? A 15% return to shareholders is about twice the return Typical would have received had it invested instead in quality corporate bonds.

The Statement of Changes in Shareholders Equity, Return on Equity, cont.

It is also several times what it would have received from a savings account. The point is that in considering whether to put money to work in Typicals stock, an investor really needs to do two things. First, he or she needs to compare Typicals 14.8% to returns from Typicals business competitors.

The Statement of Changes in Shareholders Equity, Return on Equity, cont.

Second, he or she needs to compare Typicals return to the potential return that could be achieved from other types of investment, such as certificates of deposit, corporate bonds, real estate or other common stock.
Just remember, that 14.8% is what Typical itself makes.

The Statement of Changes in Shareholders Equity, Return On Equity, cont.

By no means is it what an investor will make in dividends on Typicals stock. What ROE really reveals is whether Typical Manufacturing is relatively attractive as an enterprise. An investor can only hope that this attractiveness will translate into demand for Typicals stock and will be reflected in its market price.

The Statement of Cash Flows

One more statement needs to be analyzed in order to get the full picture of Typicals financial status. The statement of cash flows presents the changes in cash resulting from business activities.

Cash flow analysis is necessary to make proper investing decisions and to maintain operations.

The Statement of Cash Flows, cont.

Cash flows, are related to net income, but are not equivalent to it. This is because of the accrual method of accounting.

Under Accrual Accounting, a transaction is recognized on the income statement when the earnings process is completed, that is, when the goods and/or services have been delivered or performed or an expense has been incurred.

The Statement of Cash Flows, cont.

This does not necessarily coincide with the time that cash is exchanged. For example, cash received from merchandise sales often lags behind the time when goods are delivered to customers. Generally, when the goods are shipped (service performed), the sale is recorded on the income statement and a related receivable is recorded on the balance sheet.

The Statement of Cash Flows, cont.

Cash flows are also separated by business activity. The business activity classifications presented on the statement include financing activities, investing activities and operating activities. Financing and investing activities will be discussed first.

The Statement of Cash Flows, cont.

Financing activities include those activities relating to the receipt and repayment of funds provided by creditors and investors.

These activities include the issuance of debt or equity securities, the repayment of debt, and distribution of dividends.
Investing activities include those activities relating to asset acquisition or disposal.

The Statement of Cash Flows, cont.

Operating activities basically include all activities not classified as either financing or investing activities. They involve the companys primary business activities, for example the production and delivery of goods and services.

They reflect the cash effects of transactions, which are included in the determination of net income.

The Statement of Cash Flows, cont.

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 requires adjusting net income to reconcile it to cash flows from operating activities.

The Statement of Cash Flows, cont.

Common examples of cash flows from operating activities are: Cash Collected from customers Interest received and paid Dividends received Salary Insurance Tax payments

Additional Disclosures and Audit Reports

Watch Those Notes The annual reports of many companies contain this or a similar statement: See the Accompanying Notes to the Consolidated Financial Statements. or The Accompanying Notes are an Integral Part of the Financial Statements.

Additional Disclosures and Audit Reports, Footnotes, cont.

The reason is that the financial statements themselves simply report the balances in the various accounts.
Because there is no room on the face of the statements for a complete and adequate discussion relating to those balances, additional required disclosures are provided in the notes.

Additional Disclosures and Audit Reports, Footnotes, cont.

Some examples of appropriate footnote data are: Disclosure of the companys policies for: Depreciation Amortization Consolidation Foreign Currency Translation Earnings Per Share

Additional Disclosures and Audit Reports, Footnotes, cont.

Inventory Valuation Method:

Indicates whether inventories shown on the balance sheet and used to determine the cost of goods sold on the income statement used a method such as Last-In, First-Out (LIFO), First-In, First-Out (FIFO), or Average Cost.

Additional Disclosures and Audit Reports, Footnotes, cont.

Inventory Valuation Method: LIFO & FIFO

LIFO means that the costs on the income statement reflect the cost of inventories purchased or produced most recently. FIFO means the income statement reflects the cost of the oldest inventories.

Additional Disclosures and Audit Reports, Footnotes, cont.

Inventory Valuation Method: LIFO & FIFO This is an extremely important consideration because the LIFO method reflects the most current costs in the income statement and does not overstate profits during inflationary times.

While the FIFO valuation does

Additional Disclosures and Audit Reports, Footnotes, cont.

Inventory Valuation Method: LIFO & FIFO

If not shown on the balance sheet, the composition of the inventories by raw materials, work-in-process, finished goods, and supplies should be presented.

Additional Disclosures and Audit Reports, Footnotes, cont.

Asset Impairment

Disclosure of details about impaired assets or assets to be disposed of.

Investments Information about debt and equity securities classified as trading, available-for-sale or held-to-maturity.

Additional Disclosures and Audit Reports, Footnotes, cont.

Income Tax Provision

The breakdown by current and deferred taxes and its composition into federal, state, local and foreign tax, accompanied by a reconciliation from the statutory income tax rate to the effective tax rate for the company

Additional Disclosures and Audit Reports, Footnotes, cont.

Changes in Accounting Policy Description of changes in accounting policy due to new accounting rules. Nonrecurring Items Details regarding nonrecurring items such as pension plan terminations or acquisitions/dispositions of significant business units.

Additional Disclosures and Audit Reports, Footnotes, cont.

Employment and Retirement Programs Details regarding employment contracts, profit-sharing, pension and retirement plans and post retirement and post employment benefits other than pensions. Stock Options Details about stock options granted to officers and employees.

Additional Disclosures and Audit Reports, Footnotes, cont.

Long Term Leases Disclosure of lease obligations on assets and facilities on a per year basis for the next several years and total lease obligations over the remaining lease period. Long Term Debt Details regarding the issuance and maturities of long term debt.

Additional Disclosures and Audit Reports, Footnotes, cont.

Contingent Liabilities Disclosures relating to potential or pending claims or lawsuits that might affect the company. Future Contractual Commitments Terms of contracts in force that will affect future periods.

Additional Disclosures and Audit Reports, Footnotes, cont.

Off-Balance Sheet Credit and Market Risks Details of off-balance-sheet credit and market risk associated with certain financial instruments. This includes: Interest rate swaps, forward and futures contracts and options contracts.

Off-balance-sheet risk is defined as potential for loss over and above the amount recorded on the balance sheet.

Additional Disclosures and Audit Reports, Footnotes, cont.

Regulations or Restrictions Description of regulatory requirements and dividend or other restrictions.

Fair Value of Financial Instruments Carried at Cost Disclosure of fair market values of instruments carried at cost including long term debt and off-balance-sheet instruments, such as swaps and options.

Additional Disclosures and Audit Reports, Footnotes, cont.

Segment Sales, Operating Profits and Identifiable Assets Information on each industry segment that account for more than 10% of a companys sales, operating profits and/or assets. Multinational corporations must also show sales and identifiable assets for each significant geographic area where sales or assets exceed 10% of the related consolidated amounts.

Additional Disclosures and Audit Reports, Footnotes, cont.

Most people do not like to read footnotes because they are complicated and are rarely written in plain English.
This is unfortunate because the notes are very informative. Moreover, they can reveal many critical and fascinating sidelights to the financial story.

Additional Disclosures and Audit Reports, Footnotes, cont.

Independent Audits The report from the independent auditors is often referred to as the auditors opinion, and is printed in the annual report. It should say these two things:

The audit steps taken to verify the financial statements meet the auditing professions approved standard of practice.

Additional Disclosures and Audit Reports, Footnotes, cont.

The financial statements prepared by management are managements responsibility and follow generally accepted accounting principles.

Additional Disclosures and Audit Reports, Footnotes, cont.

As a result, when the annual report contains financial statements accompanied by an unqualified (often referred to as clean) option from independent auditors, there is added assurance that the figures can be relied upon as being fairly presented.

Additional Disclosures and Audit Reports, Footnotes, cont.

However, if the independent auditors report contains the qualifying words except for, the reader should be on the alert, cautions and questioning.
The reader should investigate the reason(s) behind such qualification(s), which should be summarily explained in that report and referenced to the footnotes.

Additional Disclosures and Audit Reports, Footnotes, cont.

In addition, while the auditor(s) may not qualify the opinion, a separate paragraph may be inserted to emphasize an important item.
Investors should carefully consider any matter so emphasized.