Reading Financial Reports for Dummies (17 page)

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Net assets:
This line shows what’s left for the company’s owners after all liabilities have been subtracted from total assets.

Figure 6-3 shows you what the financial position format looks like. (Keep in mind that
noncurrent assets
are long-term assets as well as assets that aren’t current but also aren’t long term, such as stock ownership in another company.) As investing becomes more globalized, you may start comparing U.S. companies with foreign companies. Or perhaps you may consider buying stock directly in European or other foreign companies. You need to become more familiar with the financial position format if you want to read reports from foreign companies. I take a closer look at regulations for foreign company reporting in Chapter 20.

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Current assets

$300

Less: current liabilities

$200

Working capital

$100

Plus: noncurrent assets

$200

Total assets less

Figure 6-3:

The finan-

current liabilities

$300

cial position

Less: long-term liabilities

$100

format.

Net assets

$200

Ogling Assets

Anything a company owns is considered an asset. This can include something as basic as cash or as massive as a factory. A company must have assets in order to operate the business. The asset side of a balance sheet gives you a summary of what the company owns.

Current assets

Anything a company owns that it can convert to cash in less than a year is a current asset. Without these funds, the company wouldn’t be able to pay its bills and would have to close its doors. Cash, of course, is an important component of this part of the balance sheet, but other assets are used during the year to pay the bills.

Cash

For companies, cash is basically the same thing you carry around in your pocket or keep in your checking and savings accounts. Keeping track of the money is a lot more complex for companies, however, because they usually keep it in many different locations. Every multimillion-dollar corporation has numerous locations, and every location needs cash.

Even in a
centralized accounting system,
in which all bills are paid in the same place and all money is collected and put in the bank at the same time, a company keeps cash in more than one location. Keeping most of the money in the bank and having a little cash on hand for incidental expenses doesn’t work for most companies.

For example, retail outlets or banks need to keep cash in every cash register or under the control of every teller to be able to transact business with their customers. Yet a company must have a way of tracking its cash and knowing exactly how much it has at the end of every day (and sometimes several
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times a day for high-volume businesses). The cash drawer must be counted out, and the person counting out the draw must show that the amount of cash matches up with the total that the day’s transactions indicate should be there.

If a company has a number of locations, each location likely needs a bank to deposit receipts and get cash as needed. So a large corporation is going to have a maze of bank accounts, cash registers, petty cash, and other places where cash is kept daily. At the end of every day, each company location calculates the cash total and reports it to the centralized accounting area.

The amount of cash that you see on the balance sheet is the amount of cash found at all company locations on the particular day for which the balance sheet was created.

Managing cash is one of the hardest jobs because cash can so easily disappear if proper internal controls aren’t in place. Internal controls for monitoring cash are usually among the strictest in any company. If this subject interests you, you can find out more about it in any basic accounting book, such as
Accounting For Dummies,
2nd Edition, by John A. Tracy (published by Wiley).

Accounts receivable

Any company that allows its customers to buy on credit has an accounts receivable line on its balance sheet.
Accounts receivable
is a collection of individual customer accounts listing money that customers owe the company for products or services they’ve already received.

A company must carefully monitor not only whether a customer pays but also how quickly she pays. If a customer makes her payments later and later, the company must determine whether to allow her to get additional credit or to block further purchases. Although the sales may look good, a nonpaying customer hurts a company because he’s taking out — and failing to pay for — inventory that another customer could’ve bought. Too many nonpaying or late-paying customers can severely hurt a company’s cash-flow position, which means the firm may not have the cash it needs to pay the bills.

Comparing a company’s accounts receivable line over a number of years gives you a very good idea of how well the company is doing on collecting late-paying customers’ accounts. Although you may see a company report very positive sales numbers and a major increase in sales, if the accounts-receivable number is also rising rapidly, the business may be having trouble collecting the money on those accounts. I show you how to analyze accounts receivable in Chapter 16.

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Marketable securities

Marketable securities
are a type of liquid asset, meaning they can easily be converted to cash. They include holdings such as stocks, bonds, and other securities that are bought and sold daily.

Securities that are bought by a company primarily as a place to hold onto assets until the company decides how to use the money for its operations or growth are considered
trading securities.
Marketable securities held as current assets fit in this category. A company must report these assets at their fair value based on the market value of the stock or bond on the day the company prepares its financial report.

A firm must report any
unrealized losses or gains
— changes in the value of a holding that hasn’t been sold — on marketable securities on its balance sheet to show the impact of those losses or gains on the company’s earnings. The amount you find on the balance sheet is the
net marketable value
, the book value of the securities adjusted for any gains or losses that haven’t been realized.

The balance sheet is the show for general consumption, but the notes to the financial statements are where you find the small print that most people don’t read. You find lots of juicy details in the notes that you shouldn’t miss. I talk more about the notes and their importance in Chapter 9.

Inventory

Any products held by a company ready for sale are considered
inventory.

The inventory on the balance sheet is valued at the cost to the company, not at the price the company hopes to sell the product for. Companies can pick from among five different methods to track inventory, and the method they choose can significantly impact the bottom line. Following are the different inventory tracking systems:

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First in, first out (FIFO):
This system assumes that the oldest goods are sold first, and it’s used when a company is concerned about spoilage or obsolescence. Food stores use FIFO because items that sit on the shelves too long spoil. Computer firms use it because their products quickly become outdated, and they need to sell the older products first.

Assuming that older goods cost less than newer goods, FIFO makes the bottom line look better because the lowest cost is assigned to the goods sold, increasing the net profit from sales.

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Last in, first out (LIFO):
This system assumes that the newest inventory is sold first. Companies with products that don’t spoil or become obsolete can use this system. The bottom line can be significantly affected if the cost of goods to be sold is continually rising. The most expensive goods that come in last are assumed to be the first sold. LIFO increases the cost of goods figured, which in turn lowers the net income from
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sales and decreases a company’s tax liability because its profits are lower after the higher costs are subtracted. Hardware stores that sell hammers, nails, screws, and other items that have been the same for years and won’t spoil are good candidates for LIFO.

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Average costing:
This system reflects the cost of inventory most accurately and gives a company a good view of its inventory’s cost trends.

As the company receives each new shipment of inventory, it calculates an average cost for each product by adding in the new inventory. If the firm is frequently faced with inventory prices that go up and down, average costing can help level out the peaks and valleys of inventory costs throughout the year. Because the price of gasoline rises and falls almost every day, gas stations usually use this type of system.

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Specific identification:
This system tracks the actual cost of each individual piece of inventory. Companies that sell big-ticket items or items with differing accessories or upgrades (such as cars) commonly use this system. For example, each car that comes onto the lot has a different set of features, so the price of each car differs.

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Lower of cost or market (LCM):
This system sets the value of inventory based on which is lower — the actual cost of the products on hand or the current market value. Companies that sell products with market values that fluctuate significantly use this system. For instance, a brokerage house that sells marketable securities may use this system.

You usually find some information about the type of inventory system a company uses in the notes to the financial statements. Any significant detail about inventory costs is discussed in the notes section or in the management’s discussion and analysis section.

After a company chooses a type of inventory system, it must use that system for the rest of its corporate life unless it files special explanations with its tax returns to explain the reasons for changing systems. Because the way companies track inventory costs can have a significant impact on the net income and the amount of taxes due, the IRS closely monitors any changes in inventory-tracking methods.

Long-term assets

Assets that a company plans to hold for more than one year are placed in the long-term assets section of the balance sheet. Long-term assets include land and buildings; capitalized leases; leasehold improvements; machinery and equipment; furniture and fixtures; tools, dies, and molds; intangible assets; and others. This section of the balance sheet shows you the assets that a company has to build its products and sell its goods.

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Land and buildings

Companies list any buildings they own on the balance sheet’s
land and buildings
line. Companies must depreciate (show that the asset is gradually being used up by deducting a portion of its value) the value of their buildings each year, but the land portion of ownership isn’t depreciated.

Many people believe that depreciating the value of a building actually results in undervaluing a company’s assets. The IRS allows 39 years for depreciation of a building, and after that time, the building is considered valueless. That may be true in many cases, such as factories that need to be updated to current-day production methods, but a well-maintained office building usually lasts longer. A company that has owned a building for 20 or more years may, in fact, show the value of that building depreciated below its market value.

Real estate over the past 20 years has appreciated (gone up in value) greatly in most areas of the country. So instead of a building’s value going down because of depreciation, it may actually increase in value because of market appreciation. You can’t figure out this appreciation by looking at the financial reports, though. You have to find research reports written by analysts or the financial press to determine the true value of these assets.

Sometimes you see an indication that a company holds
hidden assets
—

they’re hidden from your view when you read the financial reports because you have no idea what the true marketable value of the buildings and land may be. For example, an office building that was purchased for $390,000 and held for 20 years may have a marketable value of $1 million if it were sold today but has been depreciated to $190,000 over the past 20 years.

Capitalized leases

Whenever a company takes possession of or constructs a building by using a lease agreement that contains an option to purchase that property at some point in the future, you see a line item on the balance sheet called
capitalized
leases.
This means that at some point in the future, the company could likely own the property and would then add the property’s value to its total assets owned. You can usually find a full explanation of the lease agreement in the notes to the financial statements.

Leasehold improvements

Companies track improvements to property that’s leased and not owned in the
leasehold improvements account
on the balance sheet. These items are depreciated because the improvements likely lose value as they age.

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Machinery and equipment

Companies track and summarize all machinery and equipment used in their facilities or by their employees in the
machinery and equipment accounts
on the balance sheet. These assets depreciate just like buildings but for shorter periods of time, depending on the company’s estimate of their useful life.

Furniture and fixtures

Some companies have a line item for
furniture and fixtures,
whereas others group these items in machinery and equipment or other assets. You’re more likely to find furniture and fixture line items on the balance sheet of major retail chains that hold significant furniture and fixture assets in their retail outlets than on the balance sheet for manufacturing companies that don’t have retail outlets.