Overview of Financial Statements

A company's financial statements are reproduced in Exhibit N on page 150. This is the same company example used in earlier chapters. The footnotes for these statements are not presented. (Chapter 16 discusses footnotes to financial statements.)

The company is owned by a small group of persons who started the business some years ago. (Three of the original shareholders have since died and left their stock shares to their sons and daughters.) Although the business has $10.4 million annual sales, the company would have to be much larger to be publicly owned. Size is not the point, however. The techniques of financial analysis and the ratios discussed in the chapter are appropriate for any size business, privately or publicly owned.

The chapter does not pretend to cover the broad field of securities analysis (i.e., the analysis of stocks and debt instruments issued by public corporations). This broad field includes the analysis of competitive advantages and disadvantages of a business, domestic and international economic developments, business combination possibilities, and much more. The key ratios explained in the chapter are basic building blocks in securities analysis.

Also, the chapter does not discuss the important topic of 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 flow, and financial condition.

The chapter has a more modest objective—to explain 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.

Upon opening a company's financial report probably one of the first things most investors do is to give the financial statements a once-over; they do a fairly quick scan of the financial statements, in other words. What do they look for? In my experience, they look first at the bottom line of the income statement, to see if the business made a profit or suffered a loss for the year.

As one sports celebrity put it when explaining how he keeps tabs on his various business investments, he looks first to see if the bottom line has ''parentheses around it.'' The business in our example does not; it avoided a loss. Its income statement reports that the business earned $718,200 net income for the year. Is this profit performance good, mediocre, or poor? Ratios help answer this question.

This company does not report any extraordinary gains or losses for the year, which are onetime, nonrecurring events. For example, a business may sell a major fixed asset and record a gain. Or a business may record a restructuring charge to record the cost of laying off employees who will receive severance packages. These nonordinary, unusual gains and losses are reported separately from the ongoing, continuing operations of a company. This topic would lead into a labyrinth of technical details. But be warned: These irregular gains and

EXHIBIT N—EXTERNAL FINANCIAL STATEMENTS OF BUSINESS (WITHOUT FOOTNOTES)

INCOME STATEMENT FOB YEAR

BALANCE SHEET AT END OF YEAR

CASH FLOW STATEMENT FOR YEAfl

INCOME STATEMENT FOB YEAR

BALANCE SHEET AT END OF YEAR

CASH FLOW STATEMENT FOR YEAfl

Sales Revenue

$10,400.000

Amts

C*ab Flows from Operating Activities

Cost of Goods So«

6,760,000

Cash

S 565,007

Net Income

S718,200

Gross Ma/girt

$ 3,640,000

Accounts Receivable

1,000,000

Accounts Receivable Incrensc

¡175,000]

Operating Expenses

2.080.000

inventory

1,690,000

Inventory Increase

(440,000)

Depreciation Expense

2 SO, 000

Prepaid Expenses

1 €0,000

Prepaid Owe-ase

25,000

Operating Earnings

$ 1.300,000

Total Current Assets

13.415.B07

Depreciation Expense

260,000

Interest Expense

103.000

Property, Plàftt & Equipment

3.000JOOO

Accounts Payable Increase

105,000

Earnings before Tax

$ 1,197,000

Accumulated Deprecia ton

(600.000)

Accrued Expenses Increase income Tax Payable Decrease

59,657 <12,060)

Income Tax Expense

475,800

Total Assets

fSjllSjOO^

Gas* Flow Irom Operating Actinies

S540.807

Net Income

i 7TS.2&0

Liabilities and Owners' Equity

Basic Earnings Per S^are

$3.59

Accounts Payable

$ 640.000

Cash Flows from InvMtfng Activities

STATEMENT OF CHANGES IH STOCKHOLDERS' EQUITY

STATEMENT OF CHANGES IH STOCKHOLDERS' EQUITY

Capital S1WK

Attained Earning?

Beginning daflances Wal ncnma lor Yea' Shares Issued during Ysar tJivideniH Paid (ftjftng V^nr

SaM5.il» 713,200

Shan-Tnrm Nwos PayiMa

T:1a! Curnsrtl Liabilities

LanO'Ts'm fiolsï Payable

SEDritfioWErE' Entity:

Capital Stocfc (200 OCC shares}

Retained Earning

Total OiWWl' Equi^

l,54i,1t)7 JSO.DM

775,QM

Perçusses flf P'OPfrflV, Pbfll 6 EqvQpnwiA <$750,GOT} Cash flows if5m Plnsndrvfl Acltfvftltt

Long-Term OeW &OiiOwng 150,000

Capital Stock iisw 50.030

DIvtdMdtHdSHcttnUin lioo.ptoi

Cash Irotri Fiflàfleirtfl Aeiiviûaâ $£5.000

IncraaSB iDecreasel r Cash rfcjrinfl Year TX"1;

losses complicate the evaluation and forecasting of the profit performance!

After reading the income statement, most financial statement readers probably take a quick look at the company's assets and compare them with the liabilities of the business. Are the assets adequate to the demands of the company's liabilities? Ratios help answer this question. Next, the readers take a look at the company's cash flows. As you see, the company's cash flow statement is included in Exhibit N. This is one of the primary financial statements of a business entity that must be included in its external financial reports. Nevertheless, I almost did not include it in the exhibit, which might surprise you.

None of the ratios discussed in this chapter involve the cash flow statement. Investors and creditors have yet to develop any benchmark ratios for cash flows. Still, cash flow gets a lot of ink in the financial press and in reports on corporations published by brokers and investment advisors. Cash flow from profit (operating activities) is considered a key variable for a business. The business in our example realized $540,807 cash flow from profit for the year just ended, which is considerably less than its $750,000 capital expenditures for the year. Its other sources and uses of cash provided only $25,000 cash for the year. Thus, the company's cash balance dropped $184,193 during the year.

Reading the cash flow statement in this manner provides a useful synopsis of where the business got its money during the year and what it did with the money. Notice that no ratios were calculated. We could divide cash flow from profit by net income to determine cash flow as a percent of net income. I think this is an interesting ratio. But it is not one of the benchmark ratios used in financial statement analysis.

We could divide cash flow from profit (operating activities) by the number of capital stock shares to get cash flow per share. But the Financial Accounting Standards Board (FASB) has specifically discouraged this ratio, which is most unusual. It is quite rare for the FASB to go out of its way to put the kibosh on a particular ratio.

Exhibit N introduces a new financial statement—the Statement of Changes in Stockholders' Equity. In some respects this is not really a financial statement; it's more of a supporting schedule that summarizes changes in the capital stock and retained earnings accounts. The business in our example probably would include this statement. However, this schedule is not all that necessary because the changes in its two stockholder equity accounts are easy to follow.

The business issued additional shares of capital stock during the year, as reported in its cash flow statement. So, the balance in its capital stock account increased. Net income for the year increased retained earnings, and the cash dividends paid to stockholders decreased the account.

The statement of changes in stockholders' equity is definitely needed when a business has a complex capitalization (ownership) structure that includes different classes of stock, and when a business repurchased some of its own capital stock shares during the year. Also, certain types of losses and gains are recorded directly to retained earnings and thus bypass the income statement. In these situations the statement of changes in stockholders' equity is essential to organize and report everything in one place.

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