Reading Financial Reports for Dummies (21 page)

How a firm chooses to raise money can greatly impact its bottom line. Selling equity has no annual costs if dividends aren’t paid. Borrowing money means interest costs must be paid every year, so a company will have ongoing required expenses.

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EBITDA gives financial report readers a quick view of how well a company is doing without considering its financial and accounting decisions. This number became very popular in the 1980s, when leveraged buyouts were common. A
leveraged buyout
takes place when an individual or company buys a controlling interest (which means more than 50 percent) in a company, primarily using debt (up to 70 percent or more of the purchase price). This fad left many businesses in danger of not earning enough from operations to pay their huge debt load.

Today, EBITDA is frequently touted by technology companies or other high-growth companies with large expenses for machinery and other equipment.

In these situations, the companies like to discuss their earnings before the huge write-offs for depreciation, which can make the bottom line look pretty small. EBITDA can actually be used as an accounting gimmick to make a company’s earnings sound better to the general public or to investors who don’t take the time to read the fine print in the annual report.

Firms can get pretty creative when it comes to their income statement group-ings. If you don’t understand a line item, be sure to look for explanations in the notes to the financial statements. If you can’t find an explanation there, call investor relations and ask questions.

Nonoperating income or expense

If a company earns income from a source that isn’t part of its normal revenue-generating activities, it usually lists this income on the income statement as
nonoperating income.
Items commonly listed here include the sale of a building, manufacturing facility, or company division. Other types of nonoperating income include interest from notes receivable and marketable securities, dividends from investments in other companies’ stock, and rent revenue (if the business subleases some of its facilities).

Companies also group one-time expenses in the nonoperating section of the income statement. For example, the severance and other costs of closing a division or factory are shown in this area, or, in some cases, a separate section on discontinuing operations is shown on the statement. Other types of expenses include casualty losses from theft, vandalism, or fire; loss from the sale or abandonment of property, plant, or equipment; and loss from employee or supplier strikes.

You usually find explanations for income or expenses from nonoperating activities in the notes to the financial statements. Companies need to separate these nonoperating activities; otherwise, investors, analysts, and other interested parties can’t gauge how well a company is doing with its core
Chapter 7: Using the Income Statement

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operating activities. The core operating activities line item is where you find a company’s continuing income. If those core activities aren’t raising enough income, the firm may be on the road to significant financial difficulties.

A major gain may make the bottom line look great, but it could send the wrong signal to outsiders, who may then expect similar earnings results the next year. If the company doesn’t repeat the results the following year, Wall Street will surely hammer its stock. A major one-time loss also needs special explanation so that Wall Street doesn’t downgrade the stock unnecessarily if the one-time nonoperating loss won’t be repeated in future years.

Whether a gain or a loss, separating nonoperating income from operating income and expenses helps prevent sending the wrong signal to analysts and investors about a company’s future earnings and growth potential.

Net profit or loss

The bottom line of any income statement is net profit or loss. This number means very little if you don’t understand the other line items that make up the income statement. Few investors and analysts look solely at net profit or loss to make a major decision about whether a company is a good investment.

Calculating Earnings per Share

In addition to net income, the other number you hear almost as often about a company’s earnings results is earnings per share.
Earnings per share
is the amount of net income the company makes per share of stock available on the market. For example, if you own 100 shares of stock in ABC Company and it earns $1 per share, $100 of those earnings would be yours unless the company decides to reinvest the earnings for future growth. In reality, a company rarely pays out 100 percent of its earnings; it usually pays out a very small fraction of those earnings.

You find the calculation for earnings per share on the income statement after net income, or in a separate statement called the statement of shareholders’

equity. The calculation for earnings per share is relatively simple: You take the number of outstanding shares (which you can find on the balance sheet) and divide it by the net earnings or net income (which you find on the income statement).

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Basically, earnings per share shows you how much money each shareholder made for each of her shares. In reality, this money doesn’t get paid back to the shareholder. Instead, most is reinvested in future operations of the company. The net income or loss is added to the retained earnings number on the balance sheet.

Any dividends declared per share are shown on the income statement under the earnings per share information. You find the amount of dividends paid on the statement of cash flows, which I talk about in Chapter 8. The company’s board of directors declares dividends either quarterly or annually.

At the bottom of an income statement, you see two numbers:

✓

The
basic earnings per share
is a calculation based on the number of shares outstanding at the time the income statement is developed.

✓

The
diluted earnings per share
includes other potential shares that could eventually be outstanding. This category includes shares designated for things like stock options (options given to employees to buy shares of stock at a set price, usually lower than the market price),
warrants
(shares of stock promised to bondholders or preferred shareholders for additional shares of stock at a set price, usually below the stock’s market value), and
convertibles
(shares of stock promised to a lender who owns bonds that are convertible to stock).

These numbers give you an idea of how much a company earns per share.

You can use them to analyze the company’s profitability, which I show you how to do in Chapter 11.

Chapter 8

The Statement of Cash Flows

In This Chapter

▶ Exploring the statement of cash flows

▶ Understanding operating activities

▶ Getting a grip on investments

▶ Figuring out the financing section

▶ Looking at other line items

▶ Finding net cash from all company activities

Cash is a company’s lifeblood. If a company expects to manage its assets and liabilities and to pay its obligations, it has to know the amount of cash flowing into and out of the business, which isn’t always easy to figure out when using accrual accounting. (You can find out more about accrual accounting in Chapter 4.)

The reason accrual accounting makes it hard to figure out how much cash a company actually holds is that cash doesn’t have to change hands for the company to record a transaction. The
statement of cash flows
is the financial statement that helps the financial report reader understand a company’s cash position by adjusting for differences between cash and accruals. (See Chapter 4 for more information on cash and accruals.) This statement tracks the cash that flows into and out of a business during a specified period of time and lays out the sources of that cash. In this chapter, I explore the basic parts of the statement of cash flows.

Digging into the Statement

of Cash Flows

Basically, a statement of cash flows gives the financial report reader a map of the cash receipts, cash payments, and changes in cash that a company holds, minus the expenses that arise from operating the company. In addition, the statement looks at money that flows into or out of the firm 108
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through investing and financing activities. As with the income statement (see Chapter 7), companies provide three years’ worth of information on the statement of cash flows.

When reading the statement of cash flows, you should be looking for answers to these three questions:

✓

Where did the company get the cash needed for operations during the period shown on the statement — from revenue generated, funds borrowed, or stock sold?

✓

What cash did the company actually spend during the period shown on the statement?

✓

What was the change in the cash balance during each of the years shown on the statement?

Knowing the answers to these questions helps you determine whether the company is thriving and has the cash needed to continue to grow its operations or the company appears to have a cash-flow problem and could be nearing a point of fiscal disaster. In this section, I show you how to use the statement of cash flows to find the answers to these questions.

The parts

Transactions shown on the statement of cash flows are grouped in three parts:

✓

Operating activities:
This part includes revenue the company takes in through sales of its products or services and expenses the company pays out to carry out its operations.

✓

Investing activities:
This part includes the purchase or sale of the company’s investments and can include the purchase or sale of long-term assets, such as a building or a company division. Spending on
capital
improvements
(upgrades to assets held by the company, such as the renovation of a building) also fits into this category, as does any buying or selling of short-term invested funds.

✓

Financing activities:
This part involves raising cash through long-term debt or by issuing new stock. It also includes using cash to pay down debt or buy back stock. Companies also include any dividends paid in this section.

Operating activities is the most important section of the statement of cash flows. In reading this section, you can determine whether the company’s operations are generating enough cash to keep the business viable. I discuss how to analyze this statement and make these determinations in Chapter 12.

Chapter 8: The Statement of Cash Flows
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The formats

Companies can choose between two different formats when preparing their statement of cash flows, both of which arrive at the same total but provide different information to get there:

✓

Direct method:
The Financial Accounting Standards Board (FASB; see Chapter 18) prefers the direct method, which groups major classes of cash receipts and cash payments. For example, cash collected from customers is grouped separately from cash received on interest-earning savings accounts or from dividends paid on stock owned by the company. Major groups of cash payments include cash paid to buy inventory, cash disbursed to pay salaries, cash paid for taxes, and cash paid to cover interest on loans. Figure 8-1 shows you the direct method.

✓

Indirect method:
Most companies (90 percent) use the indirect method, which focuses on the differences between net income and net cash flow from operations and allows firms to reveal less than the direct method, leaving their competitors guessing. The indirect method is easier to prepare. Figure 8-2 shows you the indirect method.

The direct and indirect methods differ only in the operating-activities section of the report. The investing-activities and financing-activities sections are the same.

Figure 8-1:

The direct

method.

Cash flows from operating activities

Net income (loss)

Adjustments to reconcile net income (loss) to net cash

provided by (used in) operating activities:

Depreciation and amortization

Provision for deferred taxes

Decrease (increase) in accounts receivable

Decrease (increase) in inventories

Figure 8-2:

Decrease (increase) in prepaid expenses

Increase (decrease) in accounts payable

The indirect

Increase (decrease) in other current liabilities

method.

Exchange (gain) loss

Net cash provided by (used in) operating activities

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Using the indirect method, you just need the information from two years’

worth of balance sheets and income statements to make calculations. For example, you can calculate changes in accounts receivable, inventories, prepaid expenses, current assets, accounts payable, and current liabilities by comparing the totals shown on the balance sheet for the current year and the previous year. If a company shows $1.5 million in inventory in 2007 and $1

million in 2008, the change in inventory using the indirect method is shown easily: “Decrease in Inventory — $500,000.” The statement of cash flows for the indirect method summarizes information already given in a different way, but it doesn’t reveal any new information.

With the direct method, the company has to reveal the actual cash it receives from customers, the cash it pays to suppliers and employees, and the income tax refund it receives. Someone reading the balance sheet and income statement won’t find these numbers in other parts of the financial report.

In addition to having to reveal details about the actual cash received or paid to customers, suppliers, employees, and the government, companies that use the direct method must prepare a schedule similar to one used in the indirect method for operating activities to meet FASB requirements. Essentially, companies save no time, must reveal more detail, and must still present the indirect method. Why bother? That’s why you’ll most likely see the indirect method used in the vast majority of financial reports you read.