Prentice Hall's one-day MBA in finance & accounting (8 page)

FINANCIAL STATEMENTS

The shareowners of a business are entitled to receive on a regular basis financial statements and other financial information about the business. Financial statements are the main means of communication by which the management of a business renders an accounting, or a summing-up, of their stewardship of the business entrusted to them by the investors in the business. The quarterly and annual financial reports of a business to its owners contain other information. However, the main purpose of a financial report is to submit financial statements to shareowners.

Generally accepted accounting principles (GAAP) and financial reporting standards have been extensively developed over the last half century. These guidelines rest on one key premise—the separation of management of a business from the outside investors in the business. In the formulation of GAAP it is assumed that financial statements are for those who have supplied the ownership capital to a business but who are not directly involved in managing the business. Financial statements are prepared for the “absentee owners” of a business, in other words. GAAP and financial reporting standards do not ignore the need for information by the lenders to a business.

41

F I N A N C I A L R E P O R T I N G

But the shareowners of the business are the main constituency for whom financial statements are prepared.

Federal law governs the communication of financial information by businesses whose capital stock shares are traded on public markets. The federal securities laws are enforced mainly by the Securities and Exchange Commission (SEC), which was established in 1934. Also, the New York Stock Exchange, Nasdaq, and other securities markets enforce many rules and regulations regarding the release and communication of financial information by companies whose securities are traded on their markets. For instance, a business cannot selectively leak information to some stockholders or lenders and not to others, nor can a business tip off some of them before informing others later. The laws and requirements of financial reporting are designed to ensure that all stockholders and lenders have equal access to a company’s financial information and financial statements.

A business’s financial statements may not be the first news about its profit performance. Public corporations put out press releases concerning their earnings for the period just ended before the company releases its actual financial statements.

Privately owned businesses do not usually send out letters about profit performance in advance of releasing their financial statements—although they
could
do this.

Financial Statements Example

Chapter 3 introduced the external income statement for a business, followed by the internal management profit report for the business. Now the
complete set
of financial statements for the business is presented, which consists of the following:

• Income statement for the year just ended (Figure 4.1)

• Statement of financial condition at the close of the year just ended and at the close of the preceding year (Figure 4.2)

• Statement of cash flows for the year just ended (Figure 4.3)

• Statement of changes in stockholders’ equity for the year just ended (Figure 4.4)

The income statement ranks first in terms of readability and intuitive understandability. Most people understand that profit equals revenue less expenses, although the technical jargon in
42

I N T E R P R E T I N G F I N A N C I A L S T A T E M E N T S

Sales revenue

$39,661,250

Cost-of-goods-sold expense

$24,960,750

Gross margin

$14,700,500

Selling and administrative expenses

$11,466,135

Earnings before interest and income tax

$ 3,234,365

Interest expense

$

795,000

Earnings before income tax

$ 2,439,365

Income tax expense

$

853,778

Net income

$ 1,585,587

Earnings per share*

$

3.75

*Privately owned business corporations do not have to report earnings per share; publicly owned corporations are required to disclose this key ratio in their income statements.

FIGURE 4.1
Income statement for the year just ended.

income statements is a barrier to many readers. The balance sheet (or statement of financial condition) ranks second.

Assets and liabilities are familiar to most people—although the values reported in this financial statement are not immediately obvious to many readers. The statement of cash flows is presented in a very technical format that makes the statement very difficult to read, even for sophisticated investors.

The
footnotes
that accompany the company’s financial statements are not presented here for the business. Footnotes often run several pages. Footnotes, although difficult and time-consuming to read through, contain very important information. Stock analysts and investment managers scour the footnotes in financial reports, digging for important information about the business. The footnotes are not needed for explaining financial statement ratios. (For a discussion of footnotes, see Chapter 16 in my book
How to Read a Financial
Report,
5th ed., John Wiley & Sons, 1999.) Publicly owned businesses present their financial statements in a format that compares the most recent three years (as required by SEC rules). The three-year comparative format makes it easier to follow trends, of course. Many privately
43

F I N A N C I A L R E P O R T I N G

Assets

At Close of

At Close of

Year Just

Preceding

Ended

Year

Cash

$ 2,345,675

$ 2,098,538

Accounts receivable

$ 3,813,582

$ 3,467,332

Inventories

$ 5,760,173

$ 4,661,423

Prepaid expenses

$

822,899

$

770,024

Total current assets

$12,742,329

$10,997,317

Property, plant, and equipment

$20,857,500

$18,804,030

Accumulated depreciation

($ 6,785,250)

($ 6,884,100)

Cost less accumulated depreciation

$14,072,250

$11,919,930

Total assets

$26,814,579

$22,917,247

Liabilities and Owners’ Equity

Accounts payable

$ 2,537,232

$ 2,180,682

Accrued expenses payable

$ 1,280,214

$ 1,136,369

Income tax payable

$

58,650

$

117,300

Short-term debt

$ 2,250,000

$ 1,765,000

Total current liabilities

$ 6,126,096

$ 5,199,351

Long-term debt

$ 7,500,000

$ 5,850,000

Total liabilities

$13,626,096

$11,049,351

Capital stock (422,823 and 420,208 shares)

$ 4,587,500

$ 4,402,500

Retained earnings

$ 8,600,983

$ 7,465,396

Total owners’ equity

$13,188,483

$11,867,896

TEAMFLY

Total liabilities and owners’ equity

$26,814,579

$22,917,247

FIGURE 4.2
Statement of financial condition at close of the year just ended
and at close of the preceding year.

owned businesses present their financial statements for two or three years, although practice is not uniform in this respect.

The company’s income statement (Figure 4.1) and statement of cash flows (Figure 4.3) are presented for the most recent year only. The statement of financial condition (Figure 4.2) is presented at the close of its two most recent two years. Finan-

cial statement ratios are calculated for each year. The ratios are calculated the same way for all years for which financial
44

Team-Fly®

I N T E R P R E T I N G F I N A N C I A L S T A T E M E N T S

Cash Flows from Operating Activities

Net income

$1,585,587

Changes in operating assets and liabilities:

Accounts receivable

($ 346,250)

Inventories

($1,098,750)

Prepaid expenses

($

52,875)

Depreciation expense

$ 768,450

Accounts payable

$ 356,550

Accrued expenses payable

$ 143,845

Income tax payable

($

58,650)

Cash flow from operating activities

$1,297,907

Cash Flows from Investing Activities

Investment in property, plant, and equipment

($3,186,250)

Proceeds from disposals of property, plant, and equipment $ 265,480

Cash used in investing activities

($2,920,770)

Cash Flows from Financing Activities

Net increase in short-term debt

$ 485,000

Increase in long-term debt

$1,650,000

Issuance of capital stock shares

$ 185,000

Cash dividends to stockholders

($ 450,000)

Cash from financing activities

$1,870,000

Cash increase during year

$ 247,137

Cash balance at beginning of year

$2,098,538

Cash balance at end of year

$2,345,675

FIGURE 4.3
Statement of cash flows for the year just ended.

statements are presented. As a general rule, only a few ratios are presented in most financial reports. Thus investors and lenders have to calculate ratios or look in financial information sources that report the financial statement ratios for businesses.

The business in this example is a corporation that is owned by a relatively small number of persons who invested the capital to start the business some years ago. The business has over $39 million annual sales (see Figure 4.1). Many publicly owned corporations are much larger than this, and most privately owned businesses are smaller. Size is not the point, however.

45

F I N A N C I A L R E P O R T I N G

Capital

Retained

Stock

Earnings

Beginning balances (420,208 shares)

$4,402,500

$7,465,396

Net income for year

$1,585,587

Shares issued during year (2,615 shares)

$ 185,000

Dividends paid during year

($ 450,000)

Ending balances (422,823 shares)

$4,587,500

$8,600,983

FIGURE 4.4
Statement of changes in stockholders’ equity for the year just
ended.

The techniques of financial analysis and the ratios discussed in the chapter are appropriate for any size of business.

LIMITS OF DISCUSSION

The chapter does not pretend to cover the broad field of
securities analysis
(i.e., the analysis of stocks and debt securities issued by public corporations that are traded in public marketplaces). This broad field includes the analysis of the competitive advantages and disadvantages of a business, domestic and international economic developments affecting a business, business combination possibilities, political developments, court decisions, technological advances, demographics, investor psychology, and much more. The key ratios explained in this chapter are the basic building blocks used in securities analysis.

The chapter does not discuss
trend analysis,
which involves comparing a company’s latest financial statements with its previous years’ statements to identify important year-to-year changes. For example, investors and lenders are very interested in the sales growth or decline of a business and the resulting impact on profit performance, cash flows, and financial condition. The chapter has a more modest objective—to explain the basic ratios used in financial statement analysis.

Only a handful of ratios are discussed in the chapter, but they are extremely important and widely used.

The business example does not include any
extraordinary
gains or losses
for the year.
Extraordinary
means onetime,
46

I N T E R P R E T I N G F I N A N C I A L S T A T E M E N T S

nonrecurring events. For example, a business may sell off or abandon a major segment of its operations and record a large loss or gain. A business may record a substantial loss caused by a major restructuring or downsizing of the organization to recognize the cost of terminating employees who will receive severance packages or early-retirement bonuses. A business may lose a major lawsuit and have to pay a huge fine or damage award. A business may write off most of its inventories due to a sudden fall in demand for its products. The list goes on and on. These nonordinary, unusual gains and losses are reported separately from the ongoing, continuing operations of a company.

Extraordinary gains and losses are very frustrating in ana-DANGER!

lyzing profit performance for investors, creditors, and managers alike. Making matters worse is that many businesses record huge amounts of extraordinary losses in one fell swoop in order to clear the decks of these costs and losses in future years. This is called “taking a big bath.” Quite clearly, many managers prefer this practice. In public discussions, the investment community wrings their hands and lambastes this practice, as you see in many articles and editorials in the financial press. However, I think many investors would admit in private that they prefer that a business take a big bath in one year and thereby escape losses and expenses in future years. The thinking is that taking a big bath allows a business to start over by putting bad news behind it, wiping the slate clean so that future years escape these charges.

PROFIT RATIOS

Owners take the risk of whether their business can earn a profit and sustain its profit performance over the years. How much would you be willing to pay for a business that reports a loss year after year? The value of the owners’ investment depends first and foremost on the profit performance of the business. Making sales and controlling expenses is how a business makes profit, of course. The profit residual from sales revenue is measured by a
return-on-sales ratio,
which equals a particular measure of profit divided by sales revenue for the period. An income statement reports several profit lines, beginning with
gross margin
down to bottom-line
net
income.