Financial Statements

Introduction 4
The trick is to find a product that will boom, yet whose manufacturers stock is undervalued. If this sounds too easy, you are right. Lynch argues that once you have discovered a good product, there is still much homework to be done. This involves combing through the vast amount of financial information that is regularly provided by companies. It also requires taking a closer and more critical look at how the company conducts its businessLynch refers to this as kicking the tires. To illustrate his point, Lynch relates his experience with Dunkin Donuts. As a consumer, Lynch was impressed with the quality of the product. This impression led him to take a closer look at the companys financial statements and operations. He liked what he saw, and Dunkin Donuts became one of the best investments in his portfolio. This course will discuss what financial statements are and how they are analyzed. Once you have identified a good product as a possible investment, the principles discussed in these chapters will help you kick the tires. Suppose you are a small investor who knows a little about finance and accounting. Could you compete successfully against large institutional investors with armies of analysts, highpowered computers, and state-of-the-art trading strategies? The answer, according to one Wall Street legend, is a resounding yes! Peter Lynch, who had an outstanding track record as manager of the $10 billion Fidelity Magellan fund and then went on to become the bestselling author of One Up on Wall Street and Beating the Street, has long argued that small investors can beat the market by using common sense and information available to all of us as we go about our day-to-day lives. For example, a college student may be more adept at scouting out the new and interesting products that will become tomorrows success stories than is an investment banker who works 75 hours a week in a New York office. Parents of young children are likely to know which baby foods will succeed, or which diapers are best. Couch potatoes may have the best feel for which tortilla chips have the brightest future, or whether a new remote control is worth its price.

Doing your Homework with Financial Statements

A managers primary goal is to maximize the value of his or her firms stock. Value is based on the stream of cash flows the firm will generate in the future. But how does an investor go about estimating future cash flows, and how does a manager decide which actions are most likely to increase cash flows? The answers to both questions lie in a study of the financial statements that publicly traded firms must provide to investors. Here investors include both institutions (banks, insurance companies, pension funds, and the like) and individuals. The value of any business assetwhether it is a financial asset such as a stock or a bond, or a real (physical) asset such as land, buildings, and equipment depends on the usable, after-tax

cash flows the asset is expected to produce. Therefore, the chapter also explains the difference between accounting income and cash flow. Finally, since it is after-tax cash flow that is important, the chapter provides an overview of the federal income tax system. Much of the material in this chapter reviews concepts covered in basic accounting courses. However, the information is important enough to go over again. Accounting is used to keep score, and if a firms managers do not know the score, they wont know if their actions are appropriate. If you took midterm exams but were not told how you were doing, you would have a difficult time improving your grades. The same thing holds in business. If a firms managers whether they are in marketing, personnel, production, or financedo not understand financial statements, they will not be able to judge the effects of their actions, and the firm will not be successful. Although only accountants need to know how to make financial statements, everyone involved with business needs to know how to interpret them.

A Brief History of Accounting and Financial Statements

Financial statements are pieces of paper with numbers written on them, but it is important to also think about the real assets that underlie the numbers. If you understand how and why accounting began, and how financial statements are used, you can better visualize what is going on, and why accounting information is so important. Thousands of years ago, individuals (or families) were self-contained in the sense that they gathered their own food, made their own clothes, and built their own shelters. Then specialization begansome people became good at making pots, others at making arrowheads, others at making clothing, and so on. As specialization began, so did trading, initially in the form of barter. At first, each artisan worked alone, and trade was strictly local. Eventually, though, master craftsmen set up small factories and employed workers, money (in the form of clamshells) began to be used, and trade expanded beyond the local area. As these developments occurred, a primitive form of banking began, with wealthy merchants lending profits from past dealings to enterprising factory owners who needed capital to expand or to young traders who needed money to buy wagons, ships, and merchandise. When the first loans were made, lenders could physically inspect borrowers assets and judge the likelihood of the loans being repaid. Eventually, though, lending became more complex borrowers were developing larger factories, traders were acquiring fleets of ships and wagons, and loans were being made to develop distant mines and trading posts. At that point, lenders could no longer personally inspect the assets that backed their loans, and they needed some way of summarizing borrowers assets. Also, some investments were made on a share-of-the-profits basis, and this meant that profits (or income) had to be determined. At the same time, factory owners and large merchants needed reports to see how effectively their own enterprises were being run, and governments needed information for use in assessing taxes. For all these reasons, a need arose for financial statements, for accountants to prepare those statements, and for auditors to verify the accuracy of the accountants work. The economic system has grown enormously since its beginning, and accounting has become more complex. However, the original reasons for financial statements still apply: Bankers and other investors need accounting information to make intelligent decisions, managers need it

to operate their businesses efficiently, and taxing authorities need it to assess taxes in a reasonable way. It should be intuitively clear that it is not easy to translate physical assets into numbers, which is what accountants do when they construct financial statements. The numbers shown on balance sheets generally represent the historical costs of assets. However, inventories may be spoiled, obsolete, or even missing; fixed assets such as machinery and buildings may have higher or lower values than their historical costs; and accounts receivable may be uncollectable. Also, some liabilities such as obligations to pay retirees medical costs may not even show up on the balance sheet. Similarly, some costs reported on the income statement may be understated, as would be true if a plant with a useful life of 10 years were being depreciated over 40 years. When you examine a set of financial statements, you should keep in mind that a physical reality lies behind the numbers, and you should also realize that the translation from physical assets to correct numbers is far from precise. As mentioned previously, it is important for accountants to be able to generate financial statements, while others involved in the business need to know how to interpret them. Particularly, financial managers must have a working knowledge of financial statements and what they reveal to be effective. Spreadsheets provide financial managers with a powerful and reliable tool to conduct financial analysis, and several different types of spreadsheet models are provided with the text. These models demonstrate how financial principles taught in this book are applied in practice. Readers are encouraged to use these models to gain further insights into various concepts and procedures.

Financial Statements and Reports - The Annual Report

Of the various reports corporations issue to their stockholders, the annual report is probably the most important. Two types of information are given in this report. First, there is a verbal section, often presented as a letter from the chairman that describes the firms operating results during the past year and discusses new developments that will affect future operations. Second, the annual report presents four basic financial statementsthe balance sheet, the income statement, the statement of retained earnings, and the statement of cash flows. Taken together, these statements give an accounting picture of the firms operations and financial position. Detailed data are provided for the two or three most recent years, along with historical summaries of key operating statistics for the past 5 or 10 years. The quantitative and verbal materials are equally important. The financial statements report what has actually happened to assets, earnings, and dividends over the past few years, whereas the verbal statements attempt to explain why things turned out the way they did. For illustrative purposes, we shall use data taken from Allied Food Products, a processor and distributor of a wide variety of staple foods, to discuss the basic financial statements. Formed in 1978 when several regional firms merged, Allied has grown steadily, and it has earned a reputation for being one of the best firms in its industry. Allieds earnings dropped a bit in 2001, to $113.5 million versus $117.8 million in 2000. Management reported that the drop resulted from losses associated with a drought and from increased costs due to a three month

strike. However, management then went on to paint a more optimistic picture for the future, stating that full operations had been resumed, that several unprofitable businesses had been eliminated, and that 2002 profits were expected to rise sharply. Of course, an increase in profitability may not occur, and analysts should compare managements past statements with subsequent results. In any event, the information contained in an annual report is used by investors to help form expectations about future earnings and dividends. Therefore, the annual report is obviously of great interest to investors.

The Balance Sheet

The left-hand side of Allieds year-end 2001 and 2000 balance sheets, which are given in Table 2-1, shows the firms assets, while the right-hand side shows the liabilities and equity, or the claims against these assets. The assets are listed in order of their liquidity, or the length of time it typically takes to convert them to cash. The claims are listed in the order in which they must be paid: Accounts payable must generally be paid within 30 days, notes payable within 90 days, and so on, down to the stockholders equity accounts, which represent ownership and need never be paid off.

Table 2-1
ASSETS 2001 2000 LIABILITIES AND EQUITY 2001 2000

Cash and marketable securities Accounts receivable Inventories Total current assets Net plant and equipment

$ 10 375 615 $1,000 1,000

$ 80 315 415 $ 810 870

Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total debt Preferred stock (400,000 shares) Common stock (50,000,000 shares) Retained earnings Total common equity Total liabilities and equity

$ 60 110 140 $ 310 754 $1,064 40 130 766 $ 896 $2,000

$ 30 60 130 $ 220 580 $ 800 40 130 710 $ 840 $1,680

Total assets

$2,000

$1,680

NOTE: The bonds have a sinking fund requirement of $20 million a year. Sinking funds are discussed in Chapter 8, but in brief, a sinking fund simply involves the repayment of long-term debt. Thus, Allied was required to pay off $20 million of its mortgage bonds during 2001.The current portion of the long-term debt is included in notes payable here, although in a more detailed balance sheet it would be shown as a separate item under current liabilities.

Some additional points about the balance sheet are worth noting: 1. Cash versus other assets. Although the assets are all stated in terms of dollars, only cash represents actual money. (Marketable securities can be converted to cash within a day or two, so they are almost like cash and are reported with cash on the balance sheet.) Receivables are bills others owe Allied. Inventories show the dollars the company has

invested in raw materials, work-in-process, and finished goods available for sale. And net plant and equipment reflect the amount of money Allied paid for its fixed assets when it acquired those assets in the past, less accumulated depreciation. Allied can write checks for a total of $10 million (versus current liabilities of $310 million due within a year). The noncash assets should produce cash over time, but they do not represent cash in hand, and the amount of cash they would bring if they were sold today could be higher or lower than the values at which they are carried on the books. 2. Liabilities versus stockholders equity. The claims against assets are of two types liabilities (or money the company owes) and the stockholders ownership position.2 The common stockholders equity, or net worth, is a residual. For example, at the end of 2001, suppose assets decline in value; for example, suppose some of the accounts receivable are written off as bad debts. Liabilities and preferred stock remain constant, so the value of the common stockholders equity must decline. Therefore, the risk of asset value fluctuations is borne by the common stockholders. Note, however, that if asset values rise (perhaps because of inflation), these benefits will accrue exclusively to the common stockholders. 3. Preferred versus common stock. Preferred stock is a hybrid, or a cross between common stock and debt. In the event of bankruptcy, preferred stock ranks below debt but above common stock. Also, the preferred dividend is fixed, so preferred stockholders do not benefit if the companys earnings grow. Finally, many firms do not use any preferred stock, and those that do generally do not use much of it. Therefore, when the term equity is used in finance, we generally mean common equity unless the word total is included. 4. Breakdown of the common equity accounts. The common equity section is divided into two accountscommon stock and retained earnings. The retained earnings account is built up over time as the firm saves a part of its earnings rather than paying all earnings out as dividends. The common stock account arises from the issuance of stock to raise capital. The breakdown of the common equity accounts is important for some purposes but not for others. For example, a potential stockholder would want to know whether the company actually earned the funds reported in its equity accounts or whether the funds came mainly from selling stock. A potential creditor, on the other hand, would be more interested in the total equity the owners have in the firm and would be less concerned with the source of the equity. In the remainder of this chapter, we generally aggregate the two common equity accounts and call this sum common equity or net worth. 5. Inventory accounting. Allied uses the FIFO (first-in, first-out) method to determine the inventory value shown on its balance sheet ($615 million). It could have used the LIFO (last-in, first-out) method. During a period of rising prices, by taking out old, low-cost inventory and leaving in new, high-cost items, FIFO will produce a higher balance sheet inventory value but a lower cost of goods sold on the income statement. (This is strictly accounting; companies actually use older items first.) Since Allied uses FIFO, and since inflation has been occurring, (a) its balance sheet inventories are higher than they would have been had it used LIFO, (b) its cost of goods sold is lower than it would have been under LIFO, and (c) its reported profits are therefore higher. In Allieds case, if the company had elected to switch to LIFO in 2001, its balance sheet figure for inventories would have been $585,000,000 rather than $615,000,000, and its earnings (which will be discussed in the next section) would have been reduced by $18,000,000. Thus, the inventory valuation method can have a significant effect on financial statements. This is important when an analyst is comparing different companies.

6. Depreciation methods. Most companies prepare two sets of financial statementsone for tax purposes and one for reporting to stockholders. Generally, they use the most accelerated method permitted under the law to calculate depreciation for tax purposes, but they use straight line, which results in a lower depreciation charge, for stockholder reporting. However, Allied has elected to use rapid depreciation for both stockholder reporting and tax purposes. Had Allied elected to use straight line depreciation for stockholder reporting, its 2001 depreciation expense would have been $25,000,000 less, so the $1 billion shown for net plant on its balance sheet would have been $25,000,000 higher. Its net income and its retained earnings would also have been higher. 7. The time dimension. The balance sheet may be thought of as a snapshot of the firms financial position at a point in timefor example, on December 31, 2000. Thus, on December 31, 2000, Allied had $80 million of cash and marketable securities, but this account had been reduced to $10 million by the end of 2001. The balance sheet changes every day as inventories are increased or decreased, as fixed assets are added or retired, as bank loans are increased or decreased, and so on. Companies whose businesses are seasonal have especially large changes in their balance sheets. Allieds inventories are low just before the harvest season, but they are high just after the fall crops have been brought in and processed. Similarly, most retailers have large inventories just before Christmas but low inventories and high accounts receivable just after Christmas. Therefore, firms balance sheets change over the year, depending on when the statement is constructed.

The Income Statement

Table 2-2 gives the 2001 and 2000 income statements for Allied Food Products. Net sales are shown at the top of each statement, after which various costs are subtracted to obtain the net income available to common shareholders, which are generally referred to as net income. These costs include operating costs, interest costs, and taxes. A report on earnings and dividends per share is given at the bottom of the income statement. Earnings per share (EPS) is called the bottom line, denoting that of all the items on the income statement, EPS is the most important. Allied earned $2.27 per share in 2001, down from $2.36 in 2000, but it still raised the dividend from $1.06 to $1.15. Allied Food Products: Income Statements for Years Ending December 31 (Millions of Dollars, Except for Per-Share Data)

TABLE2-2 Net sales Operating costs excluding depreciation and amortization

Earnings before interest, taxes, depreciation, and amortization (EBITDA)

Depreciation Amortization Depreciation and amortization Earnings before interest and taxes (EBIT, or operating income) Less interest Earnings before taxes (EBT) Taxes (40%)

2001 3,000.0 2,616.2 383.8 100.0 0.0 100.0 283.8 88.0 195.8 78.3

2000 2,850.0 2,497.0 353.0 90.0 0.0 90.0 263.0 60.0 203.0 81.2

Net income before preferred dividends Preferred dividends Net income Common dividends Addition to retained earnings Per-share data: Common stock price Earnings per share (EPS)a Dividends per share (DPS)a Book value per share (BVPS)a Cash flow per share (CFPS)a

117.5 4.0 113.5 57.5 56.0

121.8 4.0 117.8 53.0 64.8

$23.00 $ 2.27 $ 1.15 $17.92 $ 4.27

$26.00 $ 2.36 $ 1.06 $16.80 $ 4.16

a There are 50,000,000 shares of common stock outstanding. Note that EPS is based on earnings after preferred dividends that is, on net income available to common stockholders. Calculations of EPS, DPS, BVPS, and CFPS for 2001 are as follows: b On a typical firms income statement, this line would be labeled net income rather than net income before preferred dividends. However, when we use the term net income in this text, we mean net income available to common shareholders. To simplify the terminology, we refer to net income available to common shareholders as simply net income. Students should understand that when they review annual reports, firms use the term net income to mean income after taxes but before preferred and common dividends.

Taking a closer look at the income statement, we see that depreciation and amortization are important components of total operating costs. Depreciation and amortization are similar in that both represent allocations of the costs of assets over their useful lives; however, there are some important distinctions. Recall from accounting that depreciation is an annual charge against income that reflects the estimated dollar cost of the capital equipment used up in the production process. Depreciation applies to tangible assets, such as plant and equipment, whereas amortization applies to intangible assets such as patents, copyrights, trademarks, and goodwill. Some companies use amortization to write off research and development costs, or the accounting goodwill that is recorded when one firm purchases another for more than its book value. Since they are similar, depreciation and amortization are often lumped together on the income statement. Managers, security analysts, and bank loan officers often calculate EBITDA, which is defined as earnings before interest, taxes, depreciation, and amortization. Allied currently has no amortization charges, so the depreciation and amortization on its income statement comes solely from depreciation. In 2001, Allieds EBITDA was $383.8 million. Subtracting the $100 million of depreciation expense from its EBITDA leaves the company with $283.8 million in operating income (EBIT). After subtracting $88 million in interest expense and $78.3 million in taxes, we obtain net income before preferred dividends of $117.5 million. Finally, we subtract out $4 million in preferred dividends, which leaves Allied with $113.5 million in net income available to common stockholders. When analysts refer to a companys net income, they generally mean net income available to common shareholders. Likewise, throughout this book unless otherwise indicated, net income means net income available to common stockholders. While the balance sheet can be thought of as a snapshot in time, the income statement reports on operations over a period of time, for example, during the calendar year 2001. During 2001 Allied had sales of $3 billion, and its net income available to common stockholders was $113.5 million. Income statements can cover any period of time, but they are usually prepared

monthly, quarterly, or annually. Of course, sales, costs, and profits will be larger the longer the reporting period, and the sum of the last 12 monthly (or 4 quarterly) income statements should equal the values shown on the annual income statement. For planning and control purposes, management generally forecasts monthly (or perhaps quarterly) income statements, and it then compares actual results to the budgeted statements. If revenues are below and costs above the forecasted levels, then management should take corrective steps before the problem becomes too serious.

Statement of Retained Earnings

Changes in retained earnings between balance sheet dates are reported in the statement of retained earnings. Table 2-3 shows that Allied earned $113.5 million during 2001, paid out $57.5 million in common dividends, and plowed $56 million back into the business. Thus, the balance sheet item Retained earnings increased from $710 million at the end of 2000 to $766 million at the end of 2001. Note that Retained earnings represents a claim against assets, not assets per se. Moreover, firms retain earnings primarily to expand the business, and this means investing in plant and equipment, in inventories, and so on, not piling up cash in a bank account. Changes in retained earnings occur because common stockholders allow the firm to reinvest funds that otherwise could be distributed as dividends. Thus, retained earnings as reported on the balance sheet do not represent cash and are not available for the payment of dividends or anything else.

Allied Food Products: Statement of Retained Earnings for Year Ending December 31, 2001 (Millions of Dollars) Table 2-3 Balance of retained earnings, December 31, 2000 Add: Net income, 2001 Less: Dividends to common stockholders Balance of retained earnings, December 31, 2001 $710.0 113.5 (57.5)a $766.0

COMPUTING A COMPANY'S TAXES

Taxes are a critical factor in making many financial decisions. The tax rules can be extremely complex, requiring a lot of specialized expertise to understand them. However for our purposes, we just need to understand how taxes are computed. To begin, we should ask, "Who is a taxpayer?" For the most part, there are three basic types of taxable business entities: sole proprietors, partnerships, and corporations. Sole proprietors report their income in their personal tax returns and pay the taxes owed. Partnerships report income from the partnership but do not pay taxes. Each partner reports his or her portion of the income and pays the corresponding taxes. The corporation, as a separate legal entity, reports its income and pays any taxes related to these profits. The owners (stockholders) of the corporation do not report these. Earnings in the personal tax returns except when all or a part of the profits are distributed In the form of

dividends. Because most firms of any size are corporations, we will restrict our discussion to corporate taxes.

ASSIGNMENT QUESTIONS
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. How do you value a business asset? How have financial statements evolved over the years? What is the annual report, and what are the two types of information are given in it? What four types of financial statements are typically included in the annual report? Why is the annual report of great interest to investors? What is the balance sheet, and what information does it provide? How is the order of the information shown on the balance sheet determined? Why might a companys December 31 balance sheet differ from its June 30 balance sheet? What is an income statement, and what information does it provide? Why is earnings per share called the bottom line? Differentiate between amortization and depreciation. What is EBITDA? Regarding the time period reported, how does the income statement differ from the balance sheet? What is the statement of retained earnings, and what information does it provide? Why do changes in retained earnings occur? Explain why the following statement is true: Retained earnings as reported on the balance sheet do not represent cash and are not available for the payment of dividends or anything else.

CLASS QUESTIONS

Q1.
Last year statement: Martin Motors reported the following income

Sales Cost of goods sold EBITDA Depreciation Operating income (EBIT) Interest expense Taxable income (EBT) Taxes (40%) Net income

$2,000,000 1,200,000 800,000 500,000 300,000 100,000 200,000 80,000 120,000

The companys CEO, Joe Lawrence, was unhappy with the firms performance. This year, he would like to see net income doubled to $240,000. Depreciation, interest expense and the tax rate will all remain constant, and the cost of goods sold will also remain at 60 percent of sales. How much sales revenue must the company generate to achieve the CEOs net income target?

Q2.

(Review of financial statements) Prepare a balance sheet and income statement for the Wood Corporation, given the following information: Accumulated depreciation $38,000 Long-term debt ?? Inventory 5,000 General and administrative expenses 1,000 Interest expense 1,200 Common stock 50,000 Cost of goods sold 6,000 Short-term notes 750 Depreciation expense 600 Sales 13,000 Accounts receivable 10,000 Accounts payable 5,000 Buildings and equipment 120,000 Cash 11,000 Taxes 1,300 Retained earnings 10,250

Q3.

(Review of financial statements) Prepare a balance sheet and income statement as

of December 31, 2003, for the Sharpe Mfg. Co. from the following information. Accounts receivable $120,000 Machinery and equipment 700,000 Accumulated depreciation 236,000 Notes payable 100,000 Net sales 800,000 Inventory 110,000 Accounts payable 90,000 Long-term debt 160,000 Cost of goods sold 500,000 Operating expenses 280,000 Common stock 320,000 Cash 96,000 Retained earnings-prior year ? Retained earnings-current year ?

Q4.

(Corporate income tax) Delaney, Inc. sells minicomputers. During the past year, the company's sales were $4 million. The cost of its merchandise sold came to $2 million, cash operating expenses were $400,000, depreciation expense was 100,000, and the firm paid $150,000 in interest on bank loans. Also, the corporation paid $25,000 in the form of dividends to its own common stockholders. Calculate the corporation's taxable income. Also calculate the tax liability according to the following slabs
Range 0-50k 51k-75k 76k-100k 101k -335k 335k
Q5.

Slab 15% 25% 34% 39% 40%

(Corporate income tax) Potts, Inc. had sales of $6 million during the past year. The

cost of goods sold amounted to $3 million. Operating expenses totaled $2.6 million and interest expense was $30,000. Determine the firm's tax liability. Use the slabs mentioned above.