Financial Statements Annual Report A report containing financial statements and management s summary of the current status of the

e firm and its future prospects.

The financial statements are: 1. Balance Sheet - A statement of the firm s accounting value at a specific point in time. 2. Income Statement - A statement of the firm s revenues and e!penses over the "uarter or year. #. Statement of Retained $arnings - A statement sho%ing ho% much of the firm s earnings %ere retained in the &usiness rather than paid out as dividends. '. Statement of (ash )lo%s - A statement of the firm s operating* investing and financing activities on cash flo%s over the "uarter or year. The Balance Sheet - Assets firm has on left. +ia&ilities on the assets on right. The assets are listed in order of decreasing li"uidity. The lia&ilities are listed in order of %hen they must &e paid. Assets 1. (urrent Assets - Assets %ith a life of one year or less* i.e.* can &e li"uid in 12 months less. e.g.: cash* short-term securities* accounts receiva&le* inventory. 2. )i!ed Assets - Assets %ith a long life. a. Tangi&le - Buildings* machines* etc. &. Intangi&le - ,atents* trademar-s* R . /* &rand loyalty* etc.

or

But to get these assets the firm had to &uy them usually %0 financing. This is usually done &y issuing stoc- 1e"uity2 or de&t 1&onds2* i.e.* +ia&ilities. +ia&ilities 1. (urrent +ia&ilities - +ia&ilities to &e paid %ithin the year. e.g.: accounts paya&le* notes paya&le* accruals 1%ages* ta!es* Social Security* %or-ers comp2 2. +ong-term +ia&ilities - /e&t not repaid in a year. e.g.: Bonds* loans* deferred ta!es* etc. Stoc-holder $"uity - Residual claim on the firm s assets* i.e.* %hat is left over if all assets %ere sold and lia&ilities paid off. By definition: Total Equity = Total Assets - Total Liabilities . Also called 3et 4orth $"uity is of t%o types: (ommon $"uity - (ommon stoc- issued &y the company %hose price and dividends change. ,referred $"uity - A hy&rid security li-e &oth stoc- and de&t* i.e.* the price changes &ut the dividend is fi!ed. 1

Therefore:

Assets - +ia&ilities - ,referred Stoc- 5 (ommon $"uity.

+et s loo- at an e!ample of Allied Food Inc.s Balance Sheet . an Income Statement: Balance Sheet (u!!ent Assets (ash . 6-t&le Securities Accounts Receiva&le Inventory Total 7 Fi)ed Assets 3et ,lant . $"uipment 7 Total Assets 7 2888 7 1;<8 Liabilities + Stoc,holde! s Equity (u!!ent Liabilities Accounts ,aya&le 3otes ,aya&le Accruals Total +ong-Term Bonds Total /e&t ,referred Stoc1'88= shares2 (ommon Stoc1:8 million shares2 Retained $arnings Total (ommon $"uity Total +ia&ilities . $"uity Income Statement 3et Sales (ost of ?oods Sold 7 %&&' ;8 118 1'8 #18 9:' 18;' '8 1#8 9;; <>; 2888 ecembe! "#$ %&&' $arnings Before Interest . Ta! 1$BIT2 +ess Interest 7 %&&* #8 ;8 1#8 228 :<8 <88 '8 1#8 918 <'8 1;<8 1888 7 <98 1888 7 <18 ecembe! "#$ %&&' Assets 7 %&&' 18 #9: ;1: 7 %&&* <8 #1: '1:

/epreciation Total @perating (osts 2

$arnings Before Ta! 1$BT2 Ta!es 1'8A2 3et Income Before ,referred ,referred /ividends 3et Income Availa&le to (ommon Stoc-holders (ommon /ividends Additions to Retained $arnings ,er Share /ata (ommon Stoc- ,rice $arnings ,er Share /ividends ,er Share Boo- Balue ,er Share

%&&' #888 2;1;.2 C 188 - 291;.2 2<#.< - << 1>:.< - 9<.# 119.: '. 11#.: :9.: :; 2# 2.29 1.1: 19.>2

%&&* 2<:8 2'>9 C >8 - 2:<9 2;# ;8 28# - <1 122 ' 11< :# ;: 2' 2.#; 1.8; 1;.<8

3ote: 3et 4or-ing (apital 5 (urrent Assets - (urrent +ia&ilitiesD net %or-ing capital sho%s %hether cash coming to the firm in the ne!t year is greater than or less than cash leaving the firm. etails About the Balance Sheet (onsolidated Balance Sheet - 4hen a parent company o%ns more than :8A of the voting stocof a su&sidiary* financial statements are com&ined. 4holly-o%ned Su&sidiary - ,arent controls 188A of voting shares. Assets 1. (urrent Assets - Assets generally %ith a life of 1 year or less* i.e.* li"uidated in less than or e"ual to 12 months. a. (ash . 6ar-eta&le Securities (ash plus securities %ith maturity less than or e"ual to 12 months. e.g.: T-&ills* certificates of deposit* notes . &onds* commercial paper 1unsecured promissory notes of large &usinesses2. &. Accounts Receiva&le #

(ustomer &alances outstanding on credit sales* reported net of allo%ance for dou&tful accounts. - The uncollecti&les are estimated for the year . realiEed losses are %ritten off the allo%ance account adFusted at end of year. - These dou&tful accounts affect &oth the current assets via accounts receiva&le* &ut also the &ad-de&t e!pense on the income statement. c. Inventories /ollars invested in ra% materials* %or- in process* and finished goods for sale. - )or most manufacturing firms inventory is the maFor source of revenue. In-ento!y = Total Assets %./ - *./

)or this reason %e need to loo- at different effects of ho% inventory is accounted for. - Inventory valuation is &ased on an assumption 1not reality2 that matches the cost of goods sold during an accounting period to the revenue generated from the sales during the year and then assign a value to the remaining inventory at end of year. Three 6ethods: 1. )I)@ - )irst units purchased* first sold. 2. +I)@ - +ast units purchased* first sold. #. Average (ost - Average cost over the year. e.g.: Assume a firm purchases : products for sale in the follo%ing order . price: 6achine ,urchase ,rice of Inventory 1 7 : 2 9 # < ' > : 11 - @&viously there are significant cost increases and0or inflation. - (ompany sells three of these machines at the end of the year. +et s see the impact on Inventory Baluation in Balance Sheet . (ost of ?oods sold in Income Statement %hen three items are sold: 0achine In-ento!y Sold 1emainin2 In-ento!y 1* 2* # 728 :* '* # Total (ost ! # : 2< Total (ost ! 2 : ' 12 2' 3oods Sold '* : 2* 1 1; (ost of 4aluation 7 28

0ethod )I)@ +I)@ Average (ost

So %hat effect does this inflation have on net income* earnings . assetsG In-ento!y Assets (ost of 3oods Sold 8et Income FIF5 FIF5 FIF5 FIF5 6 6 7 6 A-e!a2e (ost A-e!a2e (ost A-e!a2e (ost A-e!a2e (ost 6 6 7 6 LIF5 LIF5 LIF5 LIF5

3o% if %e too- the computer industry as an e!ample this %hole case %ould &e reversed* i.e. Assets (ost 8et Income . FIF5 FIF5 FIF5 7 6 7 LIF5 LIF5 LIF5

Although you do not have the information to calculate this* in the previous Balance Sheet Income Statement that company used )I)@* instead if they had used +I)@: %&&' FIF5 LIF5 In-ento!y *#. .9. i.e.: :"& mill diffe!ence In the Income Statement* (ost of ?oods sold %ould &e higher . earnings could &e do%n 71< mill. d. 3et ,lant . $"uipment )i!ed assets not consumed in annual &usiness operations* i.e.* tangi&le assets. - )i!ed assets other than land are depreciated 5H 3et is net of depreciation. - Assets are sho%n at Boo- Balue - original cost - accumulated depreciation. This has no relation to actual mar-et value. e;!eciation methods can also ma-e maFor differences in B.S. . I.S. entries. - 6ost companies have t%o sets of &oo-s: one using straight line for stoc-holders* the other using accelerated method for IRS. e.g. - :8*888 machine* : yr. life* 78 salvage. Fi!st <ea! e;!eciation St!ai2ht Line .&$&&& - & Sal-a2e = :#&$&&&=y! . Accele!ated > ouble- eclinin2 Balance 0ethod? .&$&&& - >& accumulated de;!eciation?>%).%? = :%&$&&& So this sho%s that dou&le declining &alance has much more depreciation in the first year than straight line. :

&y

/epreciation is an e!pense from ,lant . $"uipment in the B.S. . also in the I.S. St!ai2ht Line F.A. - e; 8et F.A. Accele!ated F.A. - e; B.S. .&$&&& #&$&&& I.S. 8et Sales -#&$&&& @&$&&& La!2e! EAS 8et Sales %&$&&& -%&$&&& e;. e);ense 8et F.A. "&$&&& Smalle! EAS +ia&ilities . Stoc-holders $"uity (laims against assets are of t%o types: 1. +ia&ilities - 6oney the company o%es. 2. Stoc-holders o%nership position* %hich is a residual Assets - Liabilities - A!efe!!ed Stoc, = (ommon Equity +ia&ilities (urrent +ia&ilities - must &e paid in one year or one operating cycle. a. Accounts ,aya&le - short-term o&ligations from credit e!tended &y suppliers for purchase of goods . services. - 3ote in B.S. a&ove these have dou&led: #8 5H ;8 should as- %hyG &. 3otes ,aya&le - short-term promissory notes to suppliers or financial institutions. - Again in B.S. a&ove it s gone from ;8 5H 118. c. (urrent 6aturities of +.T. /e&t - portion of principal of +.T. de&t paid during the upcoming year. d. Accrued +ia&ilities - e!penses in accounting records prior to actual payment of cash. Also from salaries* rent* insurance* ta!es* etc. +ong-Term /e&t - 3otes . Bonds %ith maturities &eyond one year - e.g.: notes* &onds* mortgages* leases* pension lia&ilities . long term %arranties. Stoc-holders $"uity - o%nership interests in the company %hich are residual assets after deducting lia&ilities. The (ommon $"uity Accounts have T%o ,arts: 1. (ommon $"uity . ,aid in Surplus or (apital ;

e;. e);ense

.&$&&&

discretion to issuance

are

Iave no fi!ed return &ut have voting privileges . dividends are at of directors. - The amount listed in B.S. is the par value of the stoc-* usually 71 72. - Also ,aid in Surplus - amount received &y the company at that is greater than par. e.g.: Stoc- issued at 7:0share* ,ar 5 1 (ommon Equity B Aaid in Su!;lus = # B @ = . - This item changes if ne% shares are issued or outstanding shares &ought &ac-. 2. Retained $arnings Accumulated value of every dollar the company has earned since its inception less any cash or stoc- dividends. 3ote* each year an amount is added to the cumulative* i.e. The (han2e in 1etained Ea!nin2s = 8et Income - di-idends These funds are not cash* &ut reinvested in the company.

@ther Things to +oo- @ut )or: 1. /iscretionary Items - Repair . maintenance* timing of certain payments* mar-eting . advertising* R./ and capital e!pansion are all at the discretion of management* &ut can &e very important. 2. 3onrecurring and 3on-operating Items - These items often should &e eliminated from earnings as a one-time event. e.g.: Selling an Asset 5H more cash and0or profits in a &ad year. Income Statement or Statement of $arnings ,resents revenues* e!penses* net income and earnings per share. - $arnings are measured on an accrual &asis* not cash. Accrual means that the revenue is recogniEed %hen the sale is made rather than %hen the cash is received. 3et Sales - Total sales revenue net of returns and allo%ances* i.e.* cancellation of a sale and deductions from the original sales invoice. - (an management turn sales into profitsG (ost of ?oods Sold The cost to the seller of products sold to customers. - Ieavily dependent on the type of inventory accounting* i.e.* +I)@ or )I)@. +oo-ing at the trend in costs. 3et Sales @perating $!pense - Selling . Administrative - salaries* rent* insurance* utilities - Advertising - can &e ; - 18A of net sales - +ease payments - /epreciation . amortiEation 9 (ost of Sales can tell ho% management is controlling

- Repairs . maintenance /epreciation - Allocation of costs of tangi&le assets. AmortiEation - (ost e!piration of intangi&le assets* i.e.: patents* copyrights* trademar-s* licenses* etc. $arnings Before Interest . Ta!es - ,rofit &efore interest and income ta! e!pense. Interest - @n de&t 6arginal vs. Average Ta! Rates Average Ta! Rate 5 Total Ta!es ,aid Total Income 6arginal Ta! Rate 5 JTa! JTotal Income i.e.* the ta! rate on an additional 7 earned.

Ta!es are figured on Ea!nin2s afte! Inte!est is ;aid. $,S - either primary or fully diluted* &oth are re"uired to &e presented if dilution %ould reduce $,S &y #A or more. /iluted earnings reflect %hat the earnings %ould &e in the event that all converti&le securities %ere converted to common stoc- and all options and %arrants %ere e!ercised. Ience the name* as the a&ove %ould cause more shares to &e outstanding %ith the same earnings. Statement of 1etained Ea!nin2s Balance of Retained $arnings 288; 7 918 Add: 3et Income +ess: /ividends to (ommon Stoc-holders Balance of Retained $arnings /ecem&er #1* 2889 9;;.88 Stoc- /ividends < 2889 11#.:8 2889 :9.:8 ecembe! "#$ %&&' /ecem&er #1*

Issuing more shares to e!isting shareholders. )or small dividends* i.e.* less than 28 - 2:A of the num&er of shares outstanding* retained earnings are decreased &y the mar-et value of the shares. )or large dividends* i.e.* greater than 2:A the retained earnings are decreased &y par value. - e.g.- 188*888 171 par2 shares outstanding and there is a 18A stoc- dividend %ith a mar-et value of 7#. Retained $arnings 1R$2 %ould &e decreased &y 7#8*888 5 1188*888 ! .12 ! #. - If a :8A stoc- dividend %ere declared R$ %ould &e decreased &y 7:8*888 5 1188*888 ! .:2 ! 1. )rom the stoc- holder s vie%* stoc- dividends represent nothing of tangi&le value. 4hen a cash dividend is declared* assets and retained earnings are reduced. A stoc- dividend represents only an adFustment %ithin the e"uity section of the &alance sheet: Retained $arnings is reduced and at the same time the common e"uity or e"uity plus paid in surplus is raised &y the same amount. This does not affect net asset values. (ash )lo% or 3et (ash )lo% /iffers from accounting profit mainly &ecause of accrual* i.e.* some revenues and e!penses on the I.S. %eren t paid in cash during the year. )rom the Identity: Assets 5 + C S$: (ash )lo% from Assets 5 (ash )lo% to (reditors C (ash )lo% to Stoc-holders (ash )lo% from Assets 5 @perating (ash )lo% - 3et (apital Spending - (hange in 3et 4or-ing (apital $BIT C /epreciation 1e!pense2 - Ta!es 2<#.< C 188 - 9<.# #8:.: $nding 3et )i!ed Assets - Beginning 3et )i!ed Assets C /epreciation 5 1888 - <98 C 188 5 2#8

@perating (ash )lo% 5 5 5 3et (apital Spending 5

J34( 5 $nd 34( - Beginning 34( 5 11888 - #182 - 1<18 - 2282 5 ;>8 - :>8 5 188 (ash )lo% Assets 5 #8:.: - 2#8 - 188 5 -2'.: (ash )lo% to (reditors 5 Interest ,aid - 3et 3e% Borro%ing 5 << - 19:' - :<82 >

5 << - 19' 5 -<; (ash )lo% to Stoc-holders 5 /ividends ,aid - 3et 3e% $"uity Raised 5 :9.: C ' - 8 5 ;1.: Therefore: (ash )lo% Assets 5 (ash )lo% to (reditors C (ash )lo% to Stoc-holders -2'.: 5 -<; C ;1.: 5 -2'.: (ommon SiCe Financial Statements Balance Sheet - all items stated as a percent of assets. Income Statement - all items stated as a percent of 3et or Total Sales.

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