Professional Documents
Culture Documents
FINANCIAL
REPORT
HOW TO READ A FINANCIAL REPORT
2
A FEW WORDS BEFORE BEGINNING
The following pages show a sample of For example, the sample statements pre-
the core or basic financial statements— sent Typical’s balance sheet at two year-
a balance sheet, an income statement, ends; income statements for two years;
a statement of changes in shareholders’ and a statement of changes in sharehold-
equity and a statement of cash flows for ers’ equity and statement of cash flows for
Typical Manufacturing Company. a one-year period. To strictly comply with
SEC requirements, the report would have
However, before beginning to examine included income statements, statements
these financial statements in depth, the of changes in shareholders’ equity and
following points should be kept in mind: statements of cash flows for three years.
■ Typical’s financial statements are illus- Also, the statements shown here do not
trative and generally representative for include certain additional information
a manufacturing company. However, required by the SEC. For instance, it does
financial statements in certain special- not include: (1) selected quarterly finan-
ized industries, such as banks, broker- cial information (including recent market
dealers, insurance companies and pub- prices of the company’s common stock),
lic utilities, would look somewhat dif- and (2) a listing of company directors and
ferent. That’s because specialized executive officers.
accounting and reporting principles Further, the “MD&A” will not be presented
and practices apply in these and other nor will examples of the “Letter to
specialized industries. Shareholders” and the “Business Review”
■ Rather than presenting a complete set be provided because these are not “core”
of footnotes specific to Typical, this elements of an annual report. Rather,
booklet presents a listing of appropriate they are generally intended to be explana-
generic footnote data for which a reader tory, illustrative or supplemental in nature.
of financial statements should look. To elaborate on these supplemental com-
ponents could detract from this booklet’s
■ This booklet is designed as a broad, primary focus and goal: Providing readers
general overview of financial reporting, with a better understanding of the
not an authoritative, technical reference core or basic financial statements in an
document. Accordingly, specific techni- annual report.
cal accounting and financial reporting
questions regarding a person’s personal
or professional activities should be
referred to their CPA, accountant or
qualified attorney.
3
Typical
Manufacturing
Company,
Inc.
CONSOLIDATED FINANCIAL STATEMENTS
December 31
19X9 19X8
Assets
Current Assets:
Cash and cash equivalents $19,500 $15,000
Marketable securities 46,300 32,000
Accounts receivable—net of allowance
for doubtful accounts of $2,375 in
19X9 and $3,000 in 19X8 156,000 145,000
Inventories, at the lower of cost or market 180,000 185,000
Prepaid expenses and other current assets 4,000 3,000
Total Current Assets 405,800 380,000
Other Assets:
Intangibles (goodwill, patents)—
net of accumulated amortization
of $300 in 19X9 and $250 in 19X8 1,950 2,000
Investment securities, at cost 300 —
December 31
19X9) 19X8)
Liabilities and Shareholders’ Equity
Liabilities:
Current Liabilities:
Accounts payable $60,000) $57,000)
Notes payable 51,000) 61,000)
Accrued expenses 30,000) 36,000)
Income taxes payable 17,000) 15,000)
Other liabilities 12,000) 12,000)
Current portion of long-term debt 6,000) —)
Total Current Liabilities 176,000) 181,000)
Long-term Liabilities:)
Deferred income taxes 16,000) 9,000)
9.12% debentures payable 2010 130,000) 130,000)
Other long-term debt —) 6,000)
Total Liabilities 322,000) 326,000)
Shareholders’ Equity:
Preferred stock, $5.83 cumulative,
$100 par value; authorized, issued
and outstanding: 60,000 shares 6,000) 6,000)
Common stock, $5.00 par value,
authorized: 20,000,000 shares;
issued and outstanding:
19X9 - 15,000,000 shares, 19X8 - 14,500,000 shares 75,000) 72,500)
Additional paid-in capital 20,000) 13,500)
Retained earnings 249,000) 219,600)
Foreign currency translation
adjustments (net of taxes) 1,000) (1,000)
Unrealized gain on available-for-sale securities
(net of taxes) 50) —)
Less: Treasury stock at cost
(19X9 and 19X8 - 1,000 shares) (5,000) (5,000)
5
Typical
Manufacturing
Company,
Inc.
CONSOLIDATED FINANCIAL STATEMENTS
The balance sheet represents the financial ■ The Assets section includes all the
picture for Typical Manufacturing as it goods and property owned by the
stood at the end of one particular day, company, and uncollected amounts
Dec. 31, 19X9, as though the company due (“receivables”) to the company
were momentarily at a standstill. Typical’s from others.
balance sheet for the previous year end is
also presented. This makes it possible to ■ The Liabilities section includes all
compare the composition of the balance debts and amounts owed (“payables”)
sheets on those dates. to outside parties and lenders.
The balance sheet is divided into ■ The Shareholders’ Equity section repre-
two halves: sents the shareholders’ ownership inter-
est in the company—what the compa-
1. Assets, always presented first (either ny’s assets would be worth after all
on the top or left side of the page); claims upon those assets were paid.
ASSETS
CURRENT ASSETS Marketable Securities
In general, current assets include cash and those Excess or idle cash that is not needed immediately
assets that, in the normal course of business, will may be invested in marketable securities. These are
be turned into cash within a year from the balance- short-term securities that are readily salable and
sheet date. Current assets are listed on the balance usually have quoted prices. These may include:
sheet in order of their “liquidity” or amount of time it
takes to convert them into cash. ■ Trading securities — debt and equity securities,
bought and sold frequently, primarily to generate
Cash and Cash Equivalents short-term profits and which are carried at fair mar-
This, just as expected, is money on deposit in the ket value. Any changes in such values are included
bank, cash on hand (petty cash) and highly liquid in earnings. (Fair market value is the price at which
securities such as Treasury bills. a buyer and seller are willing to exchange an asset
in other than a forced liquidation.)
1 Cash and cash equivalents $19,500
9
THE BALANCE SHEET
10
THE BALANCE SHEET
11
THE BALANCE SHEET
12
THE BALANCE SHEET
13
THE BALANCE SHEET
14
THE BALANCE SHEET
15
THE BALANCE SHEET
December 31
19X9 19X8
Liabilities and Shareholders’ Equity
Liabilities:
Current Liabilities:
13 Accounts payable $60,000 $57,000
14 Notes payable 51,000 61,000
15 Accrued expenses 30,000 36,000
16 Income taxes payable 17,000 15,000
17 Other liabilities 12,000 12,000
18 Current portion of long-term debt 6,000 —
19 Total Current Liabilities 176,000 181,000
Long-term Liabilities:
20 Deferred income taxes 16,000 9,000
21 9.12% debentures payable 2010 130,000 130,000
22 Other long-term debt — 6,000
23 Total Liabilities 322,000 326,000
Shareholders’ Equity:
24 Preferred stock, $5.83 cumulative,
$100 par value; authorized, issued
and outstanding: 60,000 shares 6,000 6,000
25 Common stock, $ 5.00 par value,
authorized: 20,000,000 shares;
issued and outstanding:
19X9 – 15,000,000 shares,
19X8 – 14,500,000 shares 75,000 72,500
26 Additional paid-in capital 20,000 13,500
27 Retained earnings 249,000 219,600
28 Foreign currency translation adjustments (net of tax) 1,000 (1,000)
29 Unrealized gain on available-for-sale securities
(net of taxes) 50 —
30 Less: Treasury stock at cost
(19X9 and 19X8 – 1,000 shares) (5,000) (5,000)
16
THE BALANCE SHEET
18
THE BALANCE SHEET
19
THE BALANCE SHEET
20
THE BALANCE SHEET
23
JUST WHAT DOES THE BALANCE SHEET SHOW?
Book Value per Share of Common Stock Book-value figures, particularly of com-
The book value per share of common mon stocks, can be misleading. Profitable
stock can be thought of as the amount of companies may show a very low net book
money each share would receive if the value and very substantial earnings, while
company were liquidated, based on bal- mature companies may show a high book
ance-sheet values. Of course, the bond- value for their common stock but have
holders and preferred shareholders would such low or irregular earnings that the
have to be satisfied first. The answer, stock’s market price is lower than its book
$22.54 book value per share of common value. Insurance companies, banks and
stock, is arrived at as follows. (See investment companies are often excep-
Calculation 3 below.) tions. Because their assets are largely liq-
uid (cash, accounts receivable
Calculation 3:) and marketable securities),
25 Common stock $75,000) their common stock’s book
26 Additional paid-in capital 20,000) value is sometimes a fair
27 Retained earnings 249,000) indication of market value.
28 Foreign-currency translation adjustments 1,000)
CAPITALIZATION RATIO
29 Unrealized gains on available-for-sale securities 50)
30 Treasury stock (5,000)The proportion of each kind of
security issued by a company
Total Common Shareholders’ Equity 340,050)
is the capitalization ratio. A
10 Less: intangible assets (1,950)
high proportion of bonds
Total Tangible Common Shareholders’ Equity $338,100)
sometimes reduces the attrac-
(Actual Amounts Used) tiveness of both the preferred
$338,100,000 = $22.54 book value per common share and common stock, and too
15,000,000 (common shares outstanding) much preferred can detract
from the common’s value.
An alternative method of arriving at the That’s because bond interest must be paid
common shareholders’ equity, conserva- before preferred dividends, and preferred
tively stated at $338,100, is shown in dividends before common dividends.
Calculation 4 below. Typical’s bond ratio is derived
by dividing the face value of
Calculation 4:) the bonds, $130,000, by the
12 Total assets $668,050) total value of bonds, preferred
10 Less: intangibles (1,950) and common stock, additional
Total tangible assets 666,100) paid-in capital, retained earn-
19 Less: current liabilities (176,000) ings, foreign currency transla-
20, 21, & 22 tion adjustments, unrealized
Long-term liabilities (146,000) gains on available-for-sale
24 Preferred stock (6,000) securities and treasury stock,
Net tangible assets available less intangibles, which is
for common stock $338,100) $474,100. (See the Calculation
on page 26.) This shows that
(Actual Amounts Used) bonds amount to about 27% of
$338,100,000 = $22.54 book value per common share Typical’s total capitalization.
15,000,000 (common shares outstanding) 25
JUST WHAT DOES THE BALANCE SHEET SHOW?
The most important report for many However, the income statement for a sin-
analysts, investors or potential investors gle year does not tell the whole story. The
is the income statement. It shows how historical record for a series of years is
much the corporation earned or lost dur- more important than the figures for any
ing the year. It appears with numbered single year. Typical includes two years in
line items on page 27 of this booklet. its income statement and gives a 10-year
financial summary as well, which appears
While the balance sheet shows the funda- on pages 42 and 43.
mental soundness of a company by reflect-
ing its financial position at a given date, An income statement matches the rev-
the income statement may be of greater enues earned from selling goods and ser-
interest to investors: The reasons are vices or other activities against all the
twofold: costs and outlays incurred to operate the
company. The difference is the net income
■ The income statement shows the record (or loss) for the year. The costs incurred
of a company’s operating results for the usually consist of: Cost of sales; selling,
whole year. general and administrative expenses, such
■ It also serves as a valuable guide in as wages and salaries, rent, supplies and
anticipating how the company may do depreciation; interest on money borrowed;
26
in the future. and taxes.
THE INCOME STATEMENT
19X9 19X8
33 Net sales $765,050) $725,000)
34 Cost of sales 535,000) 517,000)
35 Gross margin 230,050) 208,000)
Operating expenses:
36 Depreciation and amortization 28,050) 25,000)
37 Selling, general and administrative expenses 96,804) 109,500)
38 Operating income 105,196) 73,500)
Other income (expense):
39 Dividend and interest income 5,250) 10,000)
40 Interest expense (16,250) (16,750)
41 Income before income taxes and extraordinary loss 94,196) 66,750)
42 Income taxes 41,446) 26,250)
43 Income before extraordinary loss 52,750) 40,500)
44 Extraordinary item: Loss on earthquake
destruction (net of income tax benefit of $750) (5,000) —
45 Net income $47,750) $40,500)
46 Earnings per share of common stock before
extraordinary loss $3.55) $2.77)
47 Earnings per share—extraordinary loss (.34) —)
48 Net income per common share $3.21) $2.77)
Typical’s interest expense comes from three $52,750 would be the end of the story.
sources: (1) Notes payable, (2) debentures However, there are years in which compa-
and (3) other long-term debt (which nies experience unusual and infrequent
became current portion of long-term debt events called extraordinary items. For exam-
at this year-end). The notes payable, with ple, an extraordinary item would be crop
an average outstanding balance for the destruction by a hail storm in an area where
year of $56,000 at 7% interest, incur an hail storms are rare. In this case, one of
interest charge of $3,920; the debentures, Typical’s manufacturing sites was destroyed
bearing interest at 9.12% on the $130,000 by an earthquake. Since this event is not
balance, incur interest expense of expected to recur, it is isolated on a separate
$11,856; and the $6,000 of other long- line, net of its tax effect. Its earnings per share
term debt at 7.9% incurs interest of $474. impact is also separated from the earnings
per share attributable to “normal” operations.
40 Interest expense $16,250
44 Extraordinary item: loss
Income Taxes on earthquake destruction
Each corporation has an “effective tax (net of tax benefit of $750) ($5,000)
rate,” which depends on the level and
nature of its income. Large corporations Net Income—the “Bottom Line”
like Typical Manufacturing are subject to Once all income and costs, including
the top statutory corporate income tax extraordinary items, are considered, net
rate. However, tax credits, tax-free income income (or loss) is determined.
and nondeductible expenses tend to
45 Net income $47,750
change the overall tax rate. Typical’s
income before taxes and extraordinary loss
Other Items
is $94,196; its tax comes to $41,446.
Three other items that do not apply to
41 Income taxes $41,446 Typical could appear on an income state-
ment. First, suppose Typical were heavily
Income Before Extraordinary Loss involved in research and development
“Income before extraordinary loss” for the (R&D) activities. In that event, Typical
year is the amount by which all revenues would be required to include the amount
exceed all expenses. Extraordinary gains of R&D costs in the income statement or
or losses (as defined by GAAP ) are disclose it in the footnotes.
excluded from this determination.
Second, suppose Typical owned between
20% and 50% of another company. In that
42 Income before
case, Typical would have “significant influ-
income taxes and
ence” over that company, but not “control”
extraordinary loss $94,196
it. As such, it would have to account for that
investment using the equity method and
43 Income before report its equity interest in that company in
extraordinary loss $52,750 its financial statements. For example, suppose
Typical’s share of that company’s earnings for
the year were $1,200 and it received $700 in
Extraordinary Items 29
dividends from the company during that year.
Under usual conditions, the above income of
THE INCOME STATEMENT
In that event, Typical would have to include by comparing operating income to net sales.
$1,200 on its income statement under the To illustrate, in 19X9, Typical reported net
category “equity in the earnings of uncon- sales of $765,050 and operating income
solidated subsidiaries.” Typical would also of $105,196.
be required to increase its investment in
This means that for each dollar of 19X9
that company to the extent of the earnings
sales, 13.8¢ remained as a profit from
it picked up in its (i.e., Typical’s) income
operations. This figure is interesting, but is
statement. However, this would be reduced
more significant when compared with the
by any dividends received, in this case
operating margin last year.
$700, since the dividend represents a return
of its investment. In this case, Typical‘s bal- Typical’s operating profit margin went
ance sheet would show a net increase in its from 10.1% to 13.8%, so business didn’t
investment in this company of $500. just grow, it became more profitable.
Changes in operating margin can reflect
Third, suppose Typical owned a “consoli-
changes in volume, efficiency, product
dated” subsidiary (more than 50%
line or types of customers served.
ownership), in which it had less than a
100% ownership interest. For example, say Typical can also be compared with other
it owned 85% of that company. Any materi- companies in its field. If Typical’s operating
al change in the related minority interest margin is very low compared to others, it is
(15%), would have to be reported in the an unhealthy sign. If it is high, there is a
income statement or footnotes. A corre- basis for optimism.
sponding change in the cumulative minority
interest would also have to be reported in the Analysts also frequently use “operating cost
balance sheet, between long-term liabilities ratio” for the same purpose. Operating cost
and stockholders’ equity. ratio is the complement of the operating
margin. Typical’s operating margin is
13.8%. The operating cost ratio is 86.2%.
ANALYZING THE INCOME
STATEMENT Amount Ratio
33 Net sales $765,050 100.0%
When used to make a few detailed com-
34, 36, & 37
parisons, the income statement will reveal
Operating costs $659,854 86.2%
a lot more information about a company’s
38 Operating
19X9 Operating margin: income $105,196 13.8%
38 $105,196 Operating income = 13.8% Net profit ratio is still another guide to indi-
33 $765,050 Net sales cate how satisfactory the year’s activities
have been. In Typical’s case, the year’s net
operating results. For example, a prospective income was $47,750. The net sales for the
investor can determine the company’s oper- year amounted to $765,050. Therefore,
ating margin and how it has changed over Typical’s income was $47,750 on $765,050
the years. This determination can be made of sales or:
This means that this year, for every $1 of expense on the other debt). The annual
goods sold, 6.2¢ in profit was ultimately debenture interest amounts to $11,856.
earned by the company. By comparing the This means the debenture’s annual interest
net profit ratio from year to year for the expense is covered 8.9 times.
same company and with other companies,
profit progress can be evaluated. Number of times
debenture interest earned:
Last year, Typical’s net income was
$106,052 Available income = 8.9
$40,500 on $725,000 in sales:
$11,856 Debenture interest
19X8 Net profit ratio:
For a corporate bond (debenture) to be
45 $40,500 Net income = 5.6%
considered a safe investment, most ana-
33 $725,000 Net Sales lysts say that the company should earn its
bond interest requirement three to four
The operating margin, operating cost ratio
times over. By these standards, Typical’s
and net profit ratio—like the ratios examined
debentures have a fair margin of safety.
for the balance sheet—provide general infor-
mation about the company and help assess its WHAT ABOUT LEVERAGE?
future prospects. All these comparisons have a
Financial leverage relates a company’s
long-term significance because they provide
long-term debt and preferred stock to the
useful information about the company’s fun-
company’s common equity. Sometimes a
damental economic condition. Another ques-
stock is said to be highly leveraged. What
tion to ponder: Are Typical’s securities a good
this simply means is that the company
investment? Consideration of some additional
issuing the stock has a large proportion of
factors can help provide an answer.
bonds and preferred stock outstanding rel-
INTEREST COVERAGE ative to the amount of common stock.
Typical’s debentures represent a very substan- “High leverage” can work for or against a
tial debt, but they are due many years in the company depending on the earnings
future. The yearly interest, however, is a fixed available to the common shareholders.
charge. How readily the company can pay Generally speaking, however, analysts
the interest on this debt (i.e., the debt’s inter- consider highly leveraged companies to be
est coverage) would be of great interest to an risk-prone. A simple illustration will show
investor. (Interest coverage is number of why. Take, for example, a company with
times the annual interest on a debt obligation $10,000,000 of 4% bonds outstanding. If
is covered by income for the year without the company earns $440,000 before bond
considering interest on the debt and taxes.) interest, there will only be $40,000 left for
More specifically, an investor would like to the common shareholders after payment of
know if the borrowed funds have been put to $400,000 bond interest ($10,000,000 at 4%
good use, so that the earnings are adequate equals $400,000). However, an increase of
and thus available to meet interest costs. only 10% in earnings (to $484,000) will
leave $84,000 for common stock divi-
The available income representing the
dends, or an increase of more than 100%.
source for payment of the debenture interest
If there is only a small amount of common
is $106,052 (operating profit plus dividend
stock issued, the increase in earnings per 31
and interest income less the interest
share will appear very impressive.
THE INCOME STATEMENT
But in this instance, it is also apparent that a dividends were earned), net profit must be
decline of 10% in earnings (to $396,000) used as the base. That’s because federal
would wipe out everything available for the income taxes and all interest charges must
common shareholders. Moreover, it would be paid before anything is available for
also result in the company’s being unable to shareholders. Because the 60,000 shares
cover the full interest on its bonds without of $100 par value preferred stock pay a
per share dividend of $5.83, the total divi-
dipping into its cash reserves and retained
dend requirement for the preferred stock is
earnings. This is the great danger of so-
$350. Dividing the net income of
called highly leveraged companies. It also
$47,750, by this figure yields approxi-
illustrates a fundamental weakness of compa- mately 136.4, which means that the divi-
nies that have a disproportionate amount of dend requirement of the preferred stock
debt. Conservative investors usually steer clear has been earned more than 136 times
of highly leveraged companies, although they over. This ratio is so high primarily
do appeal to people seeking a higher return because Typical has only a relatively small
who are willing to assume the risk. amount of preferred stock outstanding.
As of December 15, 1997, as per Financial to common shareholders for the year (or
Accounting Standard 128, publicly traded the period) by the average number of
companies are required to report both common and potential common shares
forms of earnings per share: basic earnings outstanding, if such potential common
per share and diluted earnings per share. shares are dilutive. Dilution occurs when
This new standard replaced APB 15, earnings per share decreases or loss per
making simple, primary and fully diluted
share increases.
earnings per share obsolete. FAS 128 also
makes the calculation of earnings per share The “adjustments” to earnings include:
identical under U.S. and international
• Dividends on convertible preferred stock
accounting standards.
• After-tax interest expense on convertible
Basic Earnings per Common Share debt
This is determined by dividing the • Effect of the change in earnings from
earnings available to common shareholders other expenses (such as profit-sharing
for the year or the appropriate period by expense rising due to the increased
the average number of shares of common
income from the reduction of interest
stock outstanding during the year.
expense from the assumed conversion of
The average calculation is simply the convertible debt)
arithmetic mean of the shares outstanding,
on a pro rata basis, for the reporting peri- The “potential” common shares consist of
od. Unexercised stock options, convertible other securities and contractual arrange-
securities and contingently issuable shares ments that may result in the issuance of
are NOT included in the basic earnings common stock in the future, such as:
per share calculation. • Options or warrants
Suppose, for example, that Complex • Convertible securities
Capital Corp. has $300,000 in net income • Contingent stock arrangements
available to common shareholders and
100,000 average common shares outstand- Convertible securities can be exchanged
ing for the year. Basic earnings per share or converted into common shares.
would be $3.00 ($300,000/100,000). Examples are convertible preferred stock,
convertible bonds and the like. Such secu-
DILUTED EARNINGS PER
rities are deemed to be only one step short
COMMON SHARE
of common stock. Their value stems in
Diluted earnings per share is determined large part from the value of the common
by dividing the adjusted earnings available to which they relate.
rate, or (2) conversion into common stock share from stock options. All of the
and participation in market appreciation proceeds from the conversion of the in-
and dividends resulting from increased the-money (current share price is greater
earnings on the common stock. However, than the exercise price) options are used
the securities don’t have to be actually to repurchase common shares at the
converted to common stock for them to average market price for the period.
be called “potential common shares”
For example, suppose the same Complex
because they enable holders—in certain
Capital Corp. used above also has 10,000
circumstances—to cause an increase in
stock options outstanding with an average
the number of common shares by exercis-
strike price of $20 per share. The average
ing, exchanging or converting.
share price for the year was $50. The
Each issue of potential common shares $200,000 in option proceeds (10,000
must be considered separately in options x $20 average exercise price) is
sequence from the most dilutive (lower- assumed to repurchase common shares
ing earnings per share the most) to the at $50 per share, therefore reducing com-
least dilutive by examining the marginal mon shares by 4,000 ($200,000/$50).
earnings per share impact. This is known The net dilutive effects of the options
as antidilution sequencing. When calcu- would be an increase in 6,000 common
lating diluted earnings per share, first shares (10,000 options less 4,000
compare the impact of the most dilutive repurchased), assuming the hypothetical
security to basic earnings per share. If a conversion of the in-the-money options
potential common share is antidilutive at the average share price for the period
(therefore raising earnings per share), that under the Treasury Stock Method.
security should NOT be included in the Therefore, the earnings per share would
diluted earnings per share calculation. be diluted to $2.83 from the net effect
Because antidilutive securities are not of options ($300,000 in net
included in the diluted calculation, dilut- income/106,000 common shares,
ed earnings per share must always be less including the net 6,000 options).
than, or equal to, basic earnings per Let us now further examine the diluted
share. Diluted earnings per share are usu- earnings per share calculation. Suppose
ally less than basic earnings per share the following financial information for the
due to the dilutive effects of potential same Complex Capital Corp. as above:
common shares. • $300,000 net income available to
Options and warrants are the most common shareholders
common forms of potential common • 100,000 average common shares
shares. As stated earlier, options and outstanding
warrants each give the holder the right to • 10,000 stock options with an average
buy securities at a specified price, known strike price of $20
as the “exercise price” or “strike price.” • Average share price for the year of $50
Let’s examine an example of the dilution • Convertible bonds with a par value of
from the assumed conversion of options. $1,000,000, 6% interest rate, and a con-
The Treasury Stock Method is a method of version ratio of 20 common shares for
34 calculating the effect on earnings per every $1,000 bond
THE INCOME STATEMENT
The basic earnings per share are simply Diluted earnings per share calculation:
$300,000 in net income divided by 100,000 Adjusted net income $336,000
average common shares, or $3.00. The effect
Adjusted common shares 126,000
of options lowered earnings per share to
$2.83. Let us now examine the effects of the = Diluted earnings per share $2.67
potential common shares from the convert-
ible bonds. Complex Capital Corp. would report both
the basic and diluted numbers: Basic earn-
If the 1,000 bonds were converted into com-
ings per share of $3.00 and diluted earn-
mon shares, there would be another 20,000 ings per share of $2.67. In most analyses,
common shares (1,000 bonds x 20). But con- the diluted number is the most significant
verting the bonds would save the $60,000 in figure. This reflects the dilution from all
interest payments ($1,000,000 x 6%), less the potential common shares. In fact, research
tax deduction of $24,000 on the interest earnings per share estimates are generally
expense. Therefore, the conversion of the given as the expected diluted earnings per
bonds would increase net income available share of the company.
to common shareholders by $36,000
($60,000 in interest expense less the $24,000 PRICE-EARNINGS RATIO
tax deduction).
Both the price and the return on common
stock vary with a multitude of factors.
Adjustments to net income assuming con-
One such factor is the relationship that
version of the bonds:
exists between the earnings per share and
Net Income available the market price. It is called the price-
to common $300,000 earnings ratio (abbreviated P/E ratio).
Plus: interest expense 60,000 This is how the P/E ratio is calculated. If a
stock is selling at $25 per share and earning
Less: tax deduction on
$2 per share annually, its price-earnings
interest expense (24,000)
ratio is 12.5-to-1, usually shortened to
Adjusted net income $336,000 12.5. Put another way, the stock is said to
be selling at 12.5 times earnings. If the
Additional common shares assuming stock should rise to $40, the P/E ratio
conversion of the stock options and would be 20, or 20 times earnings. Or, if
the bonds: the stock drops to $12, the P/E ratio would
be 6, or six times earnings.
Common shares outstanding 100,000
For Typical, which has no “potential com-
Plus: options 10,000
mon shares,” net income per common share
Less: assumed shares repurchased was calculated at $3.21. If the stock were
under Treasury Stock Method (4,000) selling at $33, the P/E ratio would be 10.3.
This figure would be used to compare this
Plus: commons shares from stock over a period of years to itself and/or
the conversion of the bonds 20,000 to other similar stocks.
Adjusted common shares 126,000 This means that Typical Manufacturing com- 35
THE INCOME STATEMENT
This statement analyzes the changes nor are they deductible for tax purposes.
from year-to-year in each component Common shareholders were paid $18,000
of shareholders’ equity. It shows that in dividends this year. Since the balance
during the year, Typical issued additional sheet shows that Typical has 15,000,000
common stock at a price above par. It shares outstanding, the first thing to be
also shows that Typical experienced a learned here may be an important point
foreign currency translation gain and an to some potential investors—the dividend
unrealized gain on investments classified per share.
as “available-for-sale.” The other
components of equity, with the Dividend per share:
exception of retained earnings
(Actual amount used)
(see the paragraph below) remained
the same. $18,000,000 Common stock dividends = $1.20
$15,000,000 Common shares outstanding
Retained earnings reflects the
cumulative earnings that the com- Once the dividend per share is known, it
pany has invested for future growth. is easy to go on to the next step: comput-
The statement of changes in shareholders’ ing the dividend payout percentage. This
equity shows that retained earnings is simply the percentage of earnings per
increased by net income less dividends share paid to shareholders.
on preferred and common stock. Since net
income has already been analyzed,
dividends will now be examined. Dividend payout percentage:
$1.20 Dividend per common share = 37%
DIVIDENDS 48 $3.21 Net income per common share
Dividends on common stock
vary with the company. They do not
36 enter into the determination of net income;
THE STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY
Another statistic of great interest to many after paying dividends totaling $18,350.
investors and analysts is the dividend Even if Typical has some lean years in
yield, a percentage providing an estimate the future, it has plenty of retained
of the return per share on a given class of earnings from which to keep on declaring
stock. Here, for example, the common those $5.83 dividends on the preferred
dividend yield would be of great interest. stock and $1.20 dividends on the
This indicates the percentage return that common stock.
the annual common dividend provides
based on the market price of the common There is one danger in having a lot of
stock. This is derived by dividing the retained earnings. It could attract another
annual common dividend, in this case company, Great Giant Computers &
$1.20, by the market price of the common Electronics for instance, to buy up enough
stock, earlier determined to be $33 per of Typical’s common to vote out the
share. This provides a “common dividend current management. Then Great Giant
yield” of 3.6%, which is quite respectable might merge Typical into itself. Where
in today’s market. would Great Giant get the money to buy
Typical stock? By issuing new shares of its
own stock, perhaps. And where would
Dividend yield:
Great Giant get the money to pay the
$1.20 Dividend per common share = 3.6% dividends on all that new stock of its own?
$33 Market price of the common stock The funds would come from Typical’s
retained earnings. So Typical’s manage-
Of course, the dividends on the $5.83 pre- ment has an obligation to its sharehold-
ferred stock will not change from year-to- ers—to make sure that its retained
year. The word “cumulative” in the bal- earnings are put to work to increase
ance-sheet description indicates that if their total wealth. Otherwise, the share-
Typical’s management didn’t pay a divi- holders might cooperate with Great Giant
dend on its preferred stock, then the $5.83 if it conducted a raid on Typical.
payment for that year would accumulate.
It would have to be paid to preferred 27 Retained earnings $249,000
shareholders before any dividends could
ever be declared again on the common RETURN ON EQUITY
stock. That’s why preferred stock is called
Seeing how hard money works, of course,
“preferred”; it gets any dividend money
is one of the most popular measures that
first. Convertible bonds and convertible
investors use to come up with individual
preferred stock were discussed earlier.
judgments on how much they think a cer-
However, Typical Manufacturing doesn’t
tain stock ought to be worth. The market
have any convertible securities outstand-
itself—the sum of all buyers and sellers—
ing, so these are of no further interest right
makes the real decision. But the investors
now. Chances are its 60,000 shares of pre-
often try to make their own decision on
ferred stock—with a par value of $100
whether they want to invest at the market’s
each—were issued to family members.
price or wait. Most investors look for
Typical’s return on equity (also known as
During the year, Typical Manufacturing “ROE”), which shows how hard share-
has added $29,400 to its retained earnings 37
holders’ equity in Typical is working.
THE STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY
How can an investor compute Typical’s Typical’s stock, an investor really needs
ROE? To arrive at this figure, an investor to do two things. First, he or she needs
would look at the balance sheet and com- to compare Typical’s 14.8% to returns
pute the average common shareholders’ from Typical’s business competitors.
equity for the year in order to calculate Second, he or she needs to compare
how much Typical made on it. In making Typical’s return to the potential return that
this calculation, the investor uses only the could be achieved from other types of
amount of net profit after the dividends investment, such as certificates of deposit,
have been paid on the preferred stock. corporate bonds, real estate or other com-
For Typical Manufacturing, that means mon stocks.
$47,750 net profit minus $350. (See the
Calculation below.) Just remember, that 14.8% is what
Typical itself makes. By no means is it
For every dollar of shareholders’ equity, what an investor will make in dividends
Typical made about 15¢. Is that good? on Typical’s stock. What ROE really
Well, a 15% return to shareholders is reveals is whether Typical Manufacturing
about twice the return Typical would have is relatively attractive as an enterprise.
received had it invested instead in quality An investor can only hope that this attrac-
corporate bonds. It is also several times tiveness will translate into demand for
what it would have received from a sav- Typical’s stock and will be reflected in its
ings account. The point is that in consider- market price.
ing whether to put money to work in
Calculation:
$47,750 Net income less $350 preferred stock dividend
=
$325,825 Average 19X9 stockholders’ equity* less $6,000 preferred stock value
$47,400 = 14.8% Return on equity
$319,825
38
THE STATEMENT OF CASH FLOWS
One more statement needs to be analyzed operating activities. Financing and invest-
in order to get the full picture of Typical’s ing activities will be discussed first.
financial status. The statement of cash
flows presents the changes in cash result- Financing activities include those activities
ing from business activities. Cash-flow analy- relating to the receipt and repayment of
sis is necessary to make proper investing funds provided by creditors and investors.
decisions and to maintain operations. These activities include the issuance of
debt or equity securities, the repayment
Cash flows, although related to net of debt, and distribution of dividends.
income, are not equivalent to it. This is Investing activities include those activities
because of the accrual method of relating to asset acquisition or disposal.
accounting. Generally, under accrual
accounting, a transaction is recognized on Operating activities basically include all
the income statement when the earnings activities not classified as either financing
process is completed, that is, when the or investing activities. They involve the
goods and/or services have been delivered company’s primary business activities, for
or performed or an expense has been example, the production and delivery of
incurred. This does not necessarily coin- goods and services. They reflect the cash
cide with the time that cash is exchanged. effects of transactions, which are included
For example, cash received from merchan- in the determination of net income.
dise sales often lags behind the time Since many items enter into the determi-
when goods are delivered to customers. nation of net income, the indirect method
Generally, however, when the goods are is used to determine the cash provided by
shipped (service performed), the sale is or used for operating activities. This
recorded on the income statement and method requires adjusting net income to
a related receivable is recorded on the reconcile it to cash flows from operating
balance sheet. activities. Common examples of cash
Cash flows are also separated by business flows from operating activities are: Cash
activity. The business activity classifica- collected from customers; interest received
tions presented on the statement include and paid; dividends received; salary;
financing activities, investing activities and insurance; and tax payments.
39
ADDITIONAL DISCLOSURES AND AUDIT REPORTS
41
THE LONG VIEW
It cannot be emphasized too strongly that ments verified for by the auditors, it is
company reports must be compared if there for investors to read. A 10-year sum-
they are to be useful. They can be com- mary can show the reader:
pared to other dates and time periods,
reports of other companies and to industry ■ The trend and consistency of revenues.
averages. If desired, they can even be ■ The trend of earnings, particularly in
compared to broader economic factors. relation to sales.
But most of all, one company’s annual
activities can be effectively compared to ■ The trend of net earnings as a percent-
the same firm’s results from other years. age of sales.
At one time this was done by keeping a ■ The trend of return on equity.
file of old annual reports. Now, many cor-
■ Net earnings per common share.
porations include a 5- or 10-year summary
of their financial highlights in each year’s ■ Dividends and dividend trends.
annual report. This provides the investing
public with information about a decade of Other companies may include changes in
performance. That is why Typical net worth; book value per share; capital
Manufacturing has included a 10-year expenditures for plant and machinery;
summary in its annual report. Although long-term debt; capital stock changes due
the summary is not a part of the state- to stock dividends and splits; number of
SELECTING STOCKS
Given the items explored in this booklet, industry must be considered. The management
Typical Manufacturing appears to be a of the company must be studied and its plans
healthy concern. Since Typical is fictional, for the future assessed. Information about
financial consultants can’t recommend the these “other things” is rarely contained in
purchase of shares of its stock. When the financial report. These other facts must be
investing money in real stocks, however, gleaned from the press or the financial services
please remember this: Selecting securities provided by some research organization.
for investment requires the careful study of Merrill Lynch’s ongoing research monitors
factors other than those included in the basic this type of data and the available facts needed
financial statements and related footnotes. The to help individuals and businesses become
economics of the country and the particular informed investors.
43
GLOSSARY OF SELECTED TERMS
Page numbers in parentheses are page references in this booklet where the terms are first
introduced or where additional information about the terms can be found.
Accounts Payable (Page 15). not pay what they owe. Also Balance Sheet (Pages 1, 8-26).
Amounts owed to creditors for called Provision for Doubtful A report showing the financial
goods and services bought on Accounts, Reserve for Doubtful position or condition of a business
credit; generally, they must be Accounts or Bad Debt Reserve. at a given date. Also called
paid within 90 days. Statement of Financial Position or
Amortization (Page 14). Statement of Financial Condition.
Accounts Receivable (Page 10). Periodic charges to income to rec-
Amounts due a business from cus- ognize the distribution of the cost Basic Earnings per Common Share
tomers for goods and services sold of the company’s intangible assets (Page 33).
on credit; generally they must be over the estimated useful lives of Income available to common
paid within 90 days. those assets. shareholders for the period divided
by the weighted-average number
Accrual Method of Accounting Antidilution (to Earnings per of common shares outstanding for
(Page 39). Common Share) (Page 35). the period.
Method of accounting that recog- An increase in earnings (or
nizes revenue when earned and decrease in loss) per common Bonds (Page 18).
expenses when incurred in order to share that assumes that convertible Formal, secured or unsecured debt
appropriately match income with securities were converted, stock obligations specifying interest and
expenses in an accounting period. options and warrants were exer- repayment terms.
cised or other shares were issued
Accrued Expenses (Page 15). upon satisfaction of certain condi- Book Value per Share (Page 25).
The obligation to pay business tions. When antidilution occurs, The adjusted shareholders’ equity
expenses that were incurred, but not the per-share amount that it pro- for each class of stock divided by
paid, during an accounting period. duces is not used as the reported the number of shares of each such
per-share amount. class.
Accumulated Amortization
(Page 14). Antidilution Sequencing (Pages 34). Capitalization Ratio (Page 25).
A deduction from intangible assets Examination of potential common The relationship that each security
to show the total amount of peri- shares by order of most dilutive to (debt or equity) bears to total debt
odic charges to income over the least dilutive. If the security lowers and equity, less intangible assets,
estimated useful lives of those earnings per share relative to the expressed as a ratio.
assets. Also called Reserve for base earnings per share, calculate
Amortization. the earnings per share assuming Cash and Cash Equivalents
the conversion of the security. (Page 9).
Accumulated Depreciation Securities that are antidilutive are Generally, bank accounts and cur-
(Page 13). not included in the diluted earn- rency on hand, and short-term,
A deduction from fixed assets to ings per share calculation. highly liquid securities with a
show the total amount of periodic maturity under 90 days, such as
charges to income over the estimat- Asset (Pages 8, 9-14). U.S. Treasury bills.
ed useful lives of those assets. Also Something owned by and having
called Reserve for Depreciation. continuing value to its owner or a Cash Flows, Statement of
business. (Pages 2, 39).
Additional Paid-in Capital A report showing cash receipts
(Page 19). Audit (of Financial and disbursements compiled and
The total excess of the sharehold- Statements) (Page 1). totaled by operating, investing
ers’ investment in the company A systematic examination of a and/or financing activities.
over the par or stated value of its company’s financial statements to
common and preferred stock. Also determine if the amounts and dis- Certified Public Accountant (CPA)
called Paid-in Capital. closures in the reports are fairly (Page 1).
stated and follow generally accept- Professional title granted to people
American Institute of ed accounting principles. who pass a comprehensive test
Certified Public Accountants on accounting, auditing and
(AICPA) (Page 2). Available-for-Sale business law. CPAs usually perform
The major professional public Securities (Page 10). audits of a company’s financial
accounting group that sets stan- Securities not classified as held- statements.
dards of practice for Certified to-maturity or trading. They are
Public Accountants. carried at fair market value, with Changes in Shareholders’
any changes in the value (less Equity, Statement of (Pages 2, 36).
Allowance for Doubtful applicable taxes) reported in A report providing the details,
Accounts (Page 10). shareholders’ equity in the bal- by category, of all activity in all
44 Amounts deducted from the total ance sheet. When sold, any gain components of shareholders
accounts receivable balance to or loss will be realized and report- equity, for the period covered
recognize that some customers will ed in the income statement. by the report.
Common Dividend Yield only by the general credit of to compensate them for their
(Page 37). the issuer rather than certain of investment.
Dividends paid on each share of its assets.
common stock expressed as a per- Earnings per Common Share
centage of the market price of those Debt Amortization (Page 10). (Page 33).
shares. See also Dividend Yield. The practice of adjusting the origi- Net income reduced by preferred
nal cost of a debt instrument as dividends and divided by the aver-
Common Stock (Pages 19, 33). principal payments are received age outstanding number of com-
The par or stated value of the and any purchase discount or mon shares during the accounting
common stock (the basic owner- premium is written off to income period.
ship interest in a corporation) over the life of the instrument.
issued by a company as reported Estimated Useful Life (Page 12).
in its balance sheet. Debt-to-Equity Ratio (Page 23). The period of time over which the
The ratio of total debt (liabilities) to owner of an asset (physical or
Common Stock Ratio (Page 26). total shareholders’ equity. intangible) estimates that that asset
The percentage that common will continue to be of productive
stockholders’ equity reduced by Deferred Charges (Page 13). use or have continuing value.
intangible assets bears to total tan- Expenditures for items that will
gible capitalization (the sum of benefit future periods beyond one Extraordinary Items (Page 29).
shareholders’ equity and long-term year from the balance-sheet date. Nonoperating items that are both
debt reduced by intangibles). unusual and occur infrequently.
Deferred Income Taxes (Page 17).
Compensatory Stock Options The obligation to pay income Fair Market Value (Page 9).
(Page 33). taxes in future years generally The amount at which an item
See Stock Options. arising from transactions involving could be exchanged between
noncurrent assets and/or liabilities. willing unrelated parties, other
Contingently lssuable Shares than in a forced liquidation. It is
(Page 32). Depletion (Page 13). usually the quoted market price
Shares of stock the issuance of The process of recognizing, by a when a market exists for the item.
which depends on the occurrence charge against income, the reduc-
of certain events. tion in the cost of a natural Financial Accounting
resource (minerals, oil, gas) due to Standards Board (FASB) (Page 2).
Convertible Securities (Page 33). its withdrawal and use or sale. The independent, private-sector
A debt or equity security that may organization designated to estab-
under certain circumstances be Depreciation (Page 12). lish standards for financial
exchanged for or converted into Periodic charges to income to accounting and reporting. It is the
another security, generally com- recognize the cost of “wear and body that issues GAAP, generally
mon stock. tear” of a company’s fixed assets accepted accounting principles.
over the estimated useful lives of
Cost of Sales (Page 28). those assets. FIFO (Page 40).
The total cost to purchase and/or Acronym for First-In, First-Out.
manufacture all of the company’s Diluted Earnings per Common See First-In, First-Out.
products that were sold during a Share (page 33)
period. The amount of current earnings or Financial Leverage (Page 32).
loss per share reflecting the maxi- See Leverage (Financial).
CPA (Page 1). mum dilution (that is, the negative
See Certified Public Accountant. impact) assuming the issuance of all Financial Statement Ratio
potentially dilutive common shares. (Page 22).
Current Assets (Page 9). A mathematical relationship
Cash or other assets that will be Dilution (Page 33). between two or more amounts
converted to cash or consumed The reduction in common earnings reported in financial statements.
within the normal operating cycle, per share (or increase in loss) if Financial statement ratios can pro-
generally one year. convertible securities are converted, vide relative measures of, and
stock options and warrants are exer- insights into, the health, condition
Current Liability (Page 15). cised or other shares are issued. and performance of a company.
A liability that must be paid
within the normal operating Dividend Payout Percentage First-In, First-Out (Page 40).
cycle, generally one year. (Page 36). An inventory-costing method that
Dividends per share divided by states inventory at its most current
Current Portion of earnings per share, expressed as cost while charging the cost of
Long-Term Debt (Page 17). a percentage. sales in the order the inventory
The portion of long-term debt that was accumulated.
is due within one year of the Dividend Yield (Page 37).
balance-sheet date. The dividend paid on each share Fixed Assets (Page 12).
of each class of stock as a percent- Another term for the property,
Current Ratio (Page 22). age of the market price of those plant and equipment used in the
The relationship of current assets shares. See also Common operation of a business.
to current liabilities, expressed as Dividend Yield.
a ratio. Footnotes (Pages 2, 40).
Dividends (Pages 2, 36). Additional details and disclosures
Debentures (Page 18). Payments, generally declared by about the figures and information 45
Formal, unsecured debt obligations the Board of Directors, from contained in a company’s financial
(bonds or notes) that are backed retained earnings to shareholders statements.
Foreign Currency Translation Income Taxes (Page 29). Long-Term Debt (Page 18).
Adjustments (Page 21). The amount of income tax expense Borrowed funds due after one year
The cumulative adjustment, report- reported for the period. It is often from the balance sheet date. See
ed in the Equity section of the bal- referred to as the Tax Provision or Current Portion of Long-Term Debt
ance sheet, resulting from the Provision for Income Taxes. and Other Long-Term Debt.
translation of a foreign subsidiary’s
local currency financial statements Income Taxes Payable (Page 15). Long-Term Liabilities (Page 17).
into the currency of the parent The obligation to pay federal, for- Obligations that are due after one
company. eign, state and local income taxes year from the balance-sheet date,
that are due within one year from
Generally Accepted Accounting the balance-sheet date. Lower of Cost or Market Rule.
Principles (GAAP) (Page 1). (Page 11).
The rules and standards followed Intangible Assets (Page 13). The rule is that inventory should
in recording transactions and in Nonphysical assets with continuing be valued at its cost or market
preparing financial statements. value, such as goodwill, copy- value, whichever is lower. The
rights, trademarks and franchises. intent is to provide a conservative
Goodwill (Page 13). figure in valuing a company’s
An intangible asset that represents Interest (Page 29). inventory. See also Market Value.
the excess of the amount paid for Payments by borrowers of funds to
an acquired company over the fair compensate lenders for the use of Management Discussion and
market value of the net assets of their funds. Analysis (MD&A) (Page 1).
that company. Basically, it is the An SEC-required report in which
value of the name and reputation Interest Coverage (Page 31). management provides selected
of the acquired company. The number of times the annual financial data to highlight signifi-
interest on debt obligations is cov- cant trends in the company’s finan-
Gross Margin (Page 28). ered by income for the year before cial position or operating results.
The excess of sales over cost of considering interest on the debt
sales or the profit from sales before obligations and income taxes. Market Price (Page 11).
considering operating, general and The price at which a good can be
other expenses. Also called Gross Inventory (Pages 10-11). sold in the open market. See also
Profit or Product Profit. The cost of goods on hand Fair Market Value.
that were purchased and/or
Gross Margin Percentage manufactured or that are being Market Value (Pages 9, 11).
(Page 28). manufactured for sale to See Fair Market Value.
Gross margin expressed as a per- customers.
centage of sales. Also called Gross Marketable Securities
Profit Percentage or Product Profit Inventory Turnover (Pages 23-24). (Pages 9-10).
Percentage. The number of times the average Readily liquid securities (debt or
inventory is sold during the year. equity) that can be converted into
Held-to-Maturity Securities cash on very short notice.
(Page 10). Investment Securities (Page 14).
Debt securities that the holder/ Securities (debt or equity) held for Mortgage Bonds (Page 18).
owner has the ability and intent to strategic purposes and/or long-term Formal, secured debt obligations
hold to maturity. They are carried appreciation or income. that are backed by certain specific
at amortized cost (original cost less assets of the issuer.
Last-In, First-Out (LIFO).
principal payments and premium
(Page 40). Net Asset Value (Page 24).
or discount amortization).
An inventory-costing method that See Book Value.
Highly Leveraged (Page 32). states inventory at its earliest
cost while charging cost of sales Net Book Value (Page 24).
A company with a large proportion
at its latest cost (in the reverse See Book Value.
of bonds and preferred stock out-
standing relative to the amount of order that the inventory was
accumulated). Net Income/Loss (Page 29).
common stock. The final result of all revenue and
Leverage (Financial) (Page 32). expense items for the period. Also
Impairment (Permanent) of Loans
Relates a company’s long-term called Net Profit or Loss. Often
(Investments) (Page 14).
debt to its capital structure. referred to as the “Bottom Line.”
The probability that the lender
(investor) will not collect all Also, it is the practice of obtaining
Net of Taxes (Page 10).
amounts in accordance with the capital using borrowed funds
Term meaning the value or amount
loan agreement. or preferred stock, rather than
has been adjusted for the effects of
common stock.
applicable taxes.
Income Statement
(Pages 2, 26-36). Liability (Pages 8, 16-18).
Net Profit Ratio (Page 31).
Report summarizing the revenues An obligation to pay for assets or
Net income expressed as a }
and expenses and reporting the net goods or services acquired or to
percentage of sales.
income (or loss) of a business for repay borrowed funds.
an entire accounting period. Also Net Quick Assets (Page 23).
called the Statement of Earnings, LIFO (Page 40).
The excess of quick assets over
Statement of Profit and Loss, P&L Acronym for Last-In, First-Out.
current liabilities.
46 or Operating Statement. See Last-In, First-Out.
Notes Payable (Page 15). Property, Plant and Equipment Stock Option (Publicly Traded).*
Short- or long-term obligation, (Page 12). A security bought and sold in the
evidenced by a formal borrowing Assets not intended for sale that public securities markets that pro-
agreement (such as a promissory are used to manufacture, display, vides the holder the right, but not
note), to repay borrowed funds. warehouse and transport the necessarily the obligation, to buy
company’s products and house or sell a specified security in the
Operating Income or Loss its employees. See also Fixed quantity, at the amount, and
(Page 28). Assets. during the time period specified
The profit or loss generated by a in the option.
company’s normal, recurring oper- Quick Assets (Page 22).
ating activities before considering Assets that can be converted to Trading Securities (Page 9).
nonoperating items, income taxes, cash quickly. Securities (debt or equity) bought
gains or losses from disposals of and sold frequently, principally to
a segment of the business and Quick Assets Ratio (Page 23). generate short-term profits. They
extraordinary items. The relationship between quick are carried at fair market value,
assets and current liabilities, with any changes in the value
Operating Margin (Page 30). expressed as a ratio. reported in income.
Operating income expressed as a
percentage of sales. Retained Earnings (Page 20). Treasury Stock (Page 21).
The total profit or loss of the The total cost of any of the compa-
Other Long-Term Debt (Page 18). company less the total of all ny’s stock that has been repur-
All debt due after one year from dividends paid, since the chased or otherwise reacquired
the balance-sheet date that is not company’s startup. from shareholders and held in the
reported elsewhere in the balance company’s treasury.
sheet. Return on Equity (ROE) (Page 37).
Net income for the period Treasury Stock Method (page 34).
Paid-in Capital. expressed as percentage of average A method to calculate the effect on
See Additional Paid-in Capital. shareholders’ equity for the period. earnings per share of stock options
and warrants. All option proceeds
Par Value (Page 19). Securities and Exchange from the assumed conversion of in-
The nominal or face value of a Commission (SEC) (Page 2). the-money options are assumed to
security assigned by the issuer for The main securities regulatory be used to repurchase shares (that
balance-sheet reporting. It has no authority in the U.S. is, reacquired and held in the com-
relation to market value. pany’s treasury) at the average stock
Shareholders’ Equity
price for the period.
Permanent Impairment (Page 14). (Pages 8, 18-21).
See Impairment (Permanent) of The total of shareholders’ invest- Unrealized Gain/Loss (Page 21).
Loan (Investments). ments in the company and total The difference between the cost (or
profits or losses since the start-up previously reported fair market
Preferred Dividend Coverage of the company, less all dividends value) of an asset held at the bal-
(Page 32). and/or capital distributions, unreal- ance sheet date and its fair market
The number of times the preferred ized gain on available-for-sales value at that date.
dividend is covered (earned) by net securities and any foreign currency
income. translation adjustments since the Warrant (Page 33).
company’s start-up. A security, generally evidenced by
Preferred Stock (Page 19).
a certificate, giving the holder the
An equity security that entitles its Stated Value (Page 19). right to purchase securities, such
holders to certain preferences over The nominal or face value of a as common stock, at a specified
common shareholders, such as div- security assigned by the issuer in price. Warrants are common stock
idends, liquidation value and con- lieu of par value for balance-sheet equivalents and may dilute earn-
vertibility into other securities, etc. reporting. It has no relation to ings per common share.
market value.
Preferred Stock Ratio (Page 26).
Working Capital (Page 22).
The percentage that preferred Statement of Cash Flows. The excess of current assets over
stockholders’ equity bears to total See Cash Flows, Statement of. current liabilities.
tangible capitalization (the sum of
shareholders’ equity and long-term Statement of Changes in *Note: This definition is not found
debt reduced by intangibles). Shareholders’ Equity.
within this booklet. We have
See Changes in Shareholders’
Prepaid Expenses (Page 11). included the definition in the
Equity, Statement of.
Payments in advance for goods or glossary only to help better define
services, which will be consumed Stock Option, Compensatory the differences between the two
and deducted from income during (on Unissued Stock) (Page 33). types of stock options.
the future, normal operating cycle, An agreement, usually between
generally one year. an issuer and its executives/
employees, that grants the right
Price-Earnings Ratio (Page 35). to purchase securities, such as
The comparison of the market common stock, at a specified
price of a share of stock to the price. Options are common stock
earnings per share of that stock, equivalents and may dilute earn- 47
expressed as a ratio. Also called ings per common share.
the P/E ratio.
NOTES
48
NOTES
49
TABLE OF CONTENTS
SELECTING STOCKS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
INTRODUCTION
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report is not just a jumble of numbers and mind-numbing data. Read with understanding
and analytical insight, the numbers and data in an annual report can tell an interesting,
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