Reading Financial Reports for Dummies (18 page)

Tools, dies, and molds

You find
tools, dies, and molds
on the balance sheet of manufacturing companies but not on the balance sheet of businesses that don’t manufacture their own products. Tools, dies, and molds that are unique and are developed specifically by or for a company can have significant value. This value is amortized, which is similar to the depreciation of other tangible assets. I discuss depreciation and amortization in Chapter 4.

Intangible assets

Any assets that aren’t physical — such as patents, copyrights, trademarks, and goodwill — are considered
intangible assets.
Patents, copyrights, and trademarks are actually registered with the government, and a company holds exclusive rights to these items. If another company wants to use something that’s patented, copyrighted, or trademarked, it must pay a fee to use that asset.

Patents give companies the right to dominate the market for a particular product. For example, pharmaceutical companies can be the sole source for a drug that’s still under patent. Copyrights also give companies exclusive rights for sale. Copyrighted books can be printed only by the publisher or individual who owns that copyright or by someone who has bought the rights from the copyright owner.

Goodwill is a different type of asset, reflecting things like the value of a company’s locations, customer base, or consumer loyalty. Firms essentially purchase goodwill when they buy another company for a price that’s higher than the value of the company’s tangible assets or market value. The premium that’s paid for the company is kept in an account called “Goodwill” that’s shown on the balance sheet.

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Other assets

Other assets
is a catchall line item for items that don’t fit into one of the balance sheet’s other asset categories. The items shown in this category vary by company; some firms group both tangible and intangible assets in this category.

Other companies may put unconsolidated subsidiaries or affiliates
in this category. Whenever a company owns less than a controlling share of another company (less than 50 percent) but more than 20 percent, it must list the ownership as an
unconsolidated subsidiary
(a subsidiary that’s partially but not fully owned) or an
affiliate
(a company that’s associated with the corporation but not fully owned). I talk more about consolidation and affiliation in Chapter 10
.

Ownership of less than 20 percent of another company’s stock is tracked as a marketable security (see the section “Marketable securities,” earlier in this chapter). Long before a firm reaches even the 20 percent mark, you usually find discussion of its buying habits in the financial press or in analysts’

reports. Talk of a possible merger or acquisition often begins when a company reaches the 20 percent mark.

You usually don’t find more than a line item that totals all unconsolidated subsidiaries or affiliates. Sometimes, more detail is mentioned in the notes to the financial statements or in the management’s discussion and analysis section, but you often can’t tell by reading the financial reports and looking at this category what other businesses the company owns. You have to read the financial press or analyst reports to find out the details.

Accumulated depreciation

On a balance sheet, you may see numerous line items that start with accumulated depreciation. These line items appear under the type of asset whose value is being depreciated or shown as a total at the bottom of long-term assets.
Accumulated depreciation
is the total amount depreciated against tangible assets over the life span of the assets shown on the balance sheet. I explain depreciation in greater detail in Chapter 4.

Although some companies show accumulated depreciation under each of the long-term assets, it’s becoming common for companies to total accumulated depreciation at the bottom of the balance sheet’s long-term assets section.

This method of reporting makes it harder for you to determine the actual age of the assets because depreciation isn’t indicated by each type of asset, so you have no idea which assets have depreciated the most — in other words, which ones are the oldest.

Chapter 6: Balancing Assets against Liabilities and Equity
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The age of machinery and factories can be a significant factor in trying to determine a company’s future cost and growth prospects. A firm with mostly aging plants needs to spend more money on repair or replacement than a company that has mostly new facilities. Look for discussion of this in the management’s discussion and analysis or the notes to the financial statements. If you don’t find this information there, you have to dig deeper by reading analyst reports or reports in the financial press. For example, the toy companies Mattel and Hasbro both show their property, plant, and equipment on one line in the balance sheet, but you find a complete breakdown in the notes to the financial statements.

Looking at Liabilities

Companies must spend money to conduct their day-to-day operations.

Whenever a company makes a commitment to spend money on credit, be it short-term using a credit card or long-term using a mortgage, that commitment becomes a debt or liability.

Current liabilities

Current liabilities are any obligations that a company must pay during the next 12 months. These include short-term borrowings, the current portion of long-term debt, accounts payable, and accrued liabilities. If a company can’t pay these bills, it could go into bankruptcy or out of business.

Short-term borrowings

Short-term borrowings
are usually lines of credit a company takes to manage cash flow. A company borrowing this way isn’t much different from when you use a credit card or personal loan to pay bills until your next paycheck.

As you know, these types of loans usually carry the highest interest-rate charges, so if a firm can’t repay them quickly, it converts the debt to something longer-term with lower interest rates.

This type of liability should be a relatively low number on the balance sheet compared with other liabilities. A number that isn’t low could be a sign of trouble, indicating that the company is having difficulty securing long-term debt or meeting its cash obligations.

Current portion of long-term debt

Payments due on long-term debt during the current fiscal year are shown on this line item of the balance sheet. Any portion of the debt that’s owed beyond the current 12 months is reflected in the long-term liabilities section.

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Accounts payable

Companies list money they owe to others for products, services, supplies, and other short-term needs (invoices due in less than 12 months) in
accounts
payable.
They record payments due to vendors, suppliers, contractors, and other companies they do business with.

Accrued liabilities

Liabilities that are accrued but aren’t yet paid at the time a company prepares the balance sheet are totaled in
accrued liabilities.
For example, companies include income taxes, royalties, advertising, payroll, management incentives, and employee taxes that aren’t yet paid in this line item.

Sometimes a firm breaks out items individually, like income taxes payable, without using a catchall line item called accrued liabilities. When you look in the notes, you see more details about the types of financial obligations included and the total of each type of liability.

Long-term liabilities

Any money a business must pay out for more than 12 months in the future is considered a long-term liability. Long-term liabilities don’t throw a company into bankruptcy, but if they become too large, the company could have trouble paying its bills in the future.

Many companies keep the long-term liabilities section short and sweet and group almost everything under one lump sum, such as long-term debt.
Long-term debt
includes mortgages on buildings, loans on machinery or equipment, or bonds that need to be repaid at some point in the future. Other companies break out the type of debt, showing mortgages payable, loans payable, and bonds payable.

For example, both Hasbro and Mattel take the short-and-sweet route, giving the financial report reader little detail on the balance sheet. Instead, a reader must dig through the notes and management’s discussion and analysis to find more details about the liabilities.

You can find more details about what a company actually groups in the other liability category in the notes to the financial statements. (Guess you’re getting used to that phrase!)

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Navigating the Equity Maze

The final piece of the balancing equation is equity. All companies are owned by somebody, and the claims that owners have against the assets owned by the company are called
equity.
In a small company, the equity owners are individuals or partners. In a corporation, the equity owners are shareholders.

Stock

Stock
represents a portion of ownership in a company. Each share of stock has a certain value based on the price placed on the stock when it’s originally sold to investors. This price isn’t affected by the current market value of the stock; any increase in the stock’s value after its initial offering to the public isn’t reflected here. The market gains or losses are actually taken by the shareholders and not the company when the stock is bought and sold on the market.

Some companies issue two types of stock:

✓

Common shareholders:
These shareholders own a portion of the company and have a vote on issues. If the board decides to pay
dividends
(a certain portion per share paid to common shareholders from profits), common shareholders get their portion of those dividends as long as the preferred shareholders have been paid in full.

✓

Preferred shareholders:
These shareholders own stock that’s actually somewhere in between common stock and a
bond
(a long-term liability to be paid back over a number of years). Although they don’t get back the principal they pay for the stock, as a bondholder does, they do have first dibs on any dividends.

Preferred shareholders are guaranteed a certain dividend each year.

If for some reason a company doesn’t pay dividends, these dividends are accrued for future years and paid when the company has enough money. Accrued dividends for preferred shareholders must be paid before common shareholders get any money. The disadvantage for preferred shareholders is that they have no voting rights in the company.

If a firm goes bankrupt, the bondholders hold first claim on any money remaining after the employees and
secured debtors
(debtors who’ve loaned money based on specific assets, such as a mortgage on a building) are paid.

The preferred shareholders are next in line, and the common shareholders are at the bottom of the heap and are frequently left with valueless stock.

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Retained earnings

Each year, companies make a choice to either pay out their net profit to their shareholders or retain all or some of the profit for reinvesting in the company. Any profit not paid to shareholders over the years is accumulated in an account called
retained earnings.

Capital

You don’t find this line item on a corporation’s financial statement, but you’ll likely find it on the balance sheet of a small company that isn’t publicly owned.
Capital
is the money that was initially invested by the company’s founders.

If you don’t see this line item on the balance sheet of a small, privately owned company, the owners likely didn’t invest their own capital to get started, or they already took out their initial capital when the company began to earn money.

Drawing

Drawing
is another line item you don’t see on a corporation’s financial statement. Only unincorporated businesses have a drawing account. This line item tracks money that the owners take out from the yearly profits of a business. After a company is incorporated, owners can take money as salary or dividends, but not on a drawing account.

Chapter 7

Using the Income Statement

In This Chapter

▶ Getting acquainted with the income statement

▶ Considering different types of revenue

▶ Determining a company’s expenses

▶ Analyzing a company’s finances using profits and losses

▶ Figuring out earnings per share

Every businessperson needs to know how well his business has done over the past month, quarter, or year. Without that information, he has no idea where his business has come from and where it may go next. Even a small business that has no obligation to report to the public is sure to do income statements on at least a quarterly or (more likely) monthly basis to find out whether the business made a profit or took a loss.

The income statement you see in public financial statements is likely very different from the one you see if you work for the company. The primary difference is the detail in certain line items. In this chapter, I review the detail that goes into an income statement, but don’t be surprised if some of the detail never shows up in the financial reports you get as a company outsider. Much of the detail is considered confidential and isn’t given out to people outside the company. I include this detailed information in this chapter so you know what’s behind the numbers that you do see. If you’re a company insider, this additional information will help you understand the internal reports you receive.

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Introducing the Income Statement

The
income statement
is where you find out whether a company made a profit or took a loss. You also find information about the company’s revenues, sales levels, the costs it incurred to make those sales, and the expenses it paid to operate the business. The key parts of the statement are