How to Read a Financial ReportThis booklet nas been repro— @ucea for tne purpose of the Engineering Economy course at McGill, with permission from the Montreal office of Merrill Lynen, Pierce, Fenner & smith Incorporatea- M.-L. Bilodeau September 1959 Rea a Financial Report How 10 Fn Eaton econ or 175 9 tne ienttyfen, teat Aine msowe. iManoe Secrts ines Pecten Conant FC)How to Read a Financial Report f you are a certified public accountant it is most unlikely that you can learn anything from reading this book. You don't need to be told the basics of understanding what's presented in corporate annual reports. If you aren't ‘an accountant, and you find that annual reports are “over your head,” this booklet can help you to grasp the facts contained in such reports and possibly to become a better informed investor. That is our principal aim in publishing this booklet but we also hope that it will be useful to other readers who want to understand how business works, to lear more about the companies that pro- vide them with goods and services, or that offer them employment. ‘Most annual reports have three elements: prose, pictures, and figures. On the whole, the prose is usually straightforward and understandable. And the pic- tures are useful in making the presentation more interesting. The figures are the part that is hardest for the average person to digest and they are the part we try to explain in this booklet—the income statement and the balance sheet. Basically, the income statement tells you how the company did this year com- pared to last year, whether it had a profit or a loss, and how much, and the balance sheet tells you how strong its finances are by showing you what the company owns and what it owes on a certain date, And then there are the foot- notes; they can tell you a lot of diferent things. But let's begin with a typical company, if there is such a thing. ‘Where can we find a good balance sheet, showing everything we want to show you? We're going to make one up. We'll make up a good company... fairly Simple... . corporation whose balance sheet is our model of clear reporting. Welll call our company Typical Manufacturing, and you'll se it throughout the book.Consolidated Balance Sheet ‘Total property, plant and equipmenta BEN tay ‘otal abilities Stockholders’ Equity See enedConsolidated Income Statement Dekada eel etek Accumulated Retained Sere ETON SeStatement Of Changes Tn Financial Position 1983 Rae EXC) rood Ae rec} BAe) Be 350 so} $ 56,750 Ser ea Parc) Ed ahd co) 1000 Beto Beta) (10,000) (Coo) Pd $(11,000) fcThe Balance Sheet specialized vocabulary. This book wil eine ‘2 S00" oF so these technical terms that you wil have fo get straight in your mind After tha, the whale tangled businass begins 0 olear up ‘The four preceding pages show a sample bal ‘ance sheet. an income and accumulated earnings Statement anda statement of changes in financial postion, These make up Typical Manulacturings {ota official annual statement. This particular report isnether the simplest that could be issued nor the ‘most complicated. 1's @ good sample ofthe kind of reportissued by an up-1-date company such as ‘Typical Manufacturing. To make the numbers easier {ofead, all dalar gues inthe nancial tables, ‘except per share dala, te expressed in thousands Of dala, including those in examples. The figues inthe prose sections are not abbreviated ‘The balance sheet represents the financial pic- teas stood on one particular day, December 31, 1984, as though the wheels ofthe company vere momentary aa standstil. Typical Manufacturing balance sheet not only inciudes the most recent eat but also the previous wear This lets you com- Pate how the company fare ints two latest years. ‘The balance sheets divided into two sides: on ‘tho left re shown assets on the right ae shown fa- A courte, he peels raw Assets ‘Current Assets In general, curt assets include cash and hase assets which inthe normal course of business willbe ‘med into cash inthe reasonably near future, gener ally within a year tom the date ofthe balance sheet Cash ‘Thsis just what you expect—bils and coins inthe i (petty cash fund} and money on deposit nthe bank Marketable socurtios ‘Ths aseet represents temporary investment f excess ride cash tals not neoded immediately is ust aly vested commetcia paper and shorttetm gov ferment secures. Because these funds may be biles anc stockholders aquiy. Both sides are ‘always in balance. inthe assets column, we ist all tha goods and property owned as wel as clams ‘against others yet o be collected. Under libities ‘wo list all debts due. Under stockholders equily we lstthe amount he stockholders would split up if Typical wore liquidated at its balance sheet valve ‘Assume thal the corporation goes out of busi ‘ness on the date of ne balance sheet Assume also (what is probably never so) tha the assets bring ‘exactly what is shown in the balance shee. that ‘ecurs, the fist ilustration sons you what Typical Manufacturings stockholders might expect toreceive as ther porton ofthe business. Total asses (Less: intangibles) $660,000 ‘Amount requied to pay lablites 316,000 ‘Amount remaining forthe - ‘stockholders ‘so4e.000 Non, we are going o give you a guided tour of the balance sheet’ parts. Well take entries, one by ‘one, and alscuss hav they are produced. Then ‘wel goon, tem by tem, to explain what ey mean ‘and how they work, ‘needed on shar nace, itis essential hat the socur- ties be reall marketable and subject oa minum ‘of price fluctuation. The general practice iso show marketable securtie at cost or market, whichever is tower Pa etn een Csr ne on) $40,000 ‘Accounts receivable Hote we ind the amount not et colected from cus tomers fo whom goods were shipped proto pay- ‘ment. Customers ao usualy given 30,60, or 30 days inwich to pay Te arrount due rom customers as shou inthe balance sheets $156 000,000. However, ‘experience shows that some customers af pay tharbils, etherbecause of franca dficutiesorsome catastoptic event (aiomado,ahuricane, ora flood betaling ther business. Therfoe, inorderto show the accounts receivable tem ata igure repe- senting aly the totals ator a provision for bad ‘obs, This year that debt reserve was $2,375 00. eee ereeeee ere) Et E id Inventories “Thairweniory ofa manufacturers composed of thee ‘goups: aw materials tobe used inthe product, par {aly finshed goods in process of manufactur, and {ished goods ready for shipmertto customers. The ‘general accepted metiod of valuation of the invert foxyis cost or market, whichever is ower Tis gies a ‘conservatives gue. Where his met is used, the \alve for balance sheet purposes willbe cost or pet haps less than cost if as aresut of deterioration, ‘bsclescence, decine in prices, cr aha actos, less than cost can be reaizadon the inventory ventory ‘valuation includes an allocation of proicion and ‘ther experses as wel as the cost of mali Ord Brot) ‘Coat nce ee co ene Prepaid expenses Prepaid expenses may aris roma svaton such as ths: During the year Typical prepa fire insurance [reriums and ackertsng charges forthe next year ‘Those insurance premiums and advertsng services ‘areas yet unused at th balance sheet dale, s thee essts an iter, which wll be used Up ‘ver the ne 12 months. the advance payers hhadnet been made, the company would have more ‘asin he bank 80, payments madi in advance from which ne company has not yet receved bene- fits, cut for which tv poate beneles nex year are Istod armeng current asses as prepaid expanses. Defered charges or such tems as the inroduction ‘fanen producto the marke, oor moving a plant to.anaw location, representa typeof asset similar to prepaid expenses, Honever, deferred charges ae not Included incuent assets because the bene rom such an expenditure wil be reaped over several years to come. Sothe expendi incited wll be gradually wien off ve the next several yeas, rather han fly, ‘charged afin the year payments mace Our ba [ance sheet shows no delered charges because “Typical has none. Hit, they woud normaly be incded just belo intanables on the asso side of ‘heledger “To summarize, the total curent assets tern includes pimarly cash, marketable secure, ‘accounts ecovadl,ientories, and prepaid ‘expenses. Cee $400,000 ‘You will obsene that these ascats are mocty werk Ing assets nthe sense that they arein a constant ‘je of being comerte ito cash. Inertores when ‘sold become accounts reevabe,eoetvabies upon ‘colection become cash cash is used to pay debs land tuning expenses, We will iscover ater cn ine ‘Book how 0 make cutent assets ela story Fixed Assets ‘The ned tem, ied asses, is sometimes refrtod teas propeny,plantand equipment. represents ‘hose assls not intended tr sale that are used over ‘andover again in order iomarulacu the product, ‘splay i, warehouse it tanspotit This category wilincude and, uidings, mactinery querer, furniture, automobiles and tucks, The generaly accepted and approved method fr valuations cost‘minus the depreciaton accumulated bythe date of ‘he balance sheet Depreciatonisciscussedn the ee section. oe er) ed Ptr crak) Ea) ec Machinery Cas ‘otal property plant & equipment $385,000 “The figure thus displayed is nctintended to reflect market value a present or eplacement cost inthe futur. Whie is ecognized tha he costo repiace plant and equipment at some future date may be Figher, that possible costs obviously vaiable. Fortis reason, up tony most companies have flowed a (general nie: acquisiion cost ess accumulated (depreciaion based an that cost Depreciation ‘Thishas been defined for accounting purposes as the dectine in useful value of a ited asset du to ‘wear and tear fom use and passage of time. Fixed ‘ascois may also suffer a decine in usetul value from ‘obsolescence because naw inventions and more ‘advanced techniques come to light that make he present equipment out of dato Tne Cost incurred 0 acquire the property, pant, land equipment must be spread over he expected Useful i, taking nto consideration the factors cis ‘cussed above. For exampie: Suppose a delivery ‘tuck costs $10,000 and s expected to last ve years, Using a staighine" method of deprecia- ‘ln, ts value wil decne at he rate of $2,000 each Year Te balance sect at tho oc fon year Truck (cost) $10,000 ‘Less accumulated depreciation 2,000 Net depreciated value. $8,000 [the end of the second year it would show: Truck cost) ‘$10,000 ‘Less accumulated depreciation _4,000 [Net depreciated value $6,000 In our sample balance sheet, heres shown a figure fr accumulated depreciation. This amount is the tla of accumulated depreciation for buildings, machinery and office fursture. Landis not subject to depreciation, and its listed value remains ‘unchanged fom year to year 10 Oe eee ae td ‘Thus, net ited assets isthe valuation fr bal ‘ance sheet purposes ofthe investment in property, Plant. anc equipment. As explained befor, tgen- fall consisis ofthe cost of the various assets in this Cassication ess the deprecation accumu- lated tothe date of ne financial statement er a $260,000 Depletion is aterm used primary by mining and oil companies or any ofthe So-called extractve indusines. Sine Typical Manufacturing s notin the ‘mining business, we donot show depletion on the balance sheet. To deplete means o exhaust or use Lp.AS the ol or other natural resource is used up, pletion reserve is set up fo compensate forthe ralura weath the company no longer owns, Intangibles “These ray be defined as esses having no physical auistonc. et having substan value he cor pany Examples” fanchisetoacable Ves Bary alowing excswe sarvceincetan areas, or “Toatot or etcswe maniacs cra space rice Consolidated alse Shet roy "oa ioee ipa deo MEBloy ersmmeieeet | tatO® Ponce ‘tom a0 Toalorartnons I)‘Another intangible asset sometimes found in oor porate balance sheetsis goodwill which epre- ‘Sens the ference between ha pice of acquired ‘companies and the related values of nel assets, ‘acquired, Company practices vary considerably in assigning vale to this asset. Accouning rules now requie one firm that buys ancther to wale of this ‘goodwill over 40 years. Sa Cet) $2,000 ‘Some companies have reduced the asset value ofthe intangible assets o a nominal $1. Ths ind ‘ates thal these assets do ens, butthe company has no way of quantifying them, ‘Allo these items added together produce the {igure listed on the balance sheet as fota assets 11 Total assets 662,000 Liabilities Current Liabilities ‘Tis tem generally includes ll debts tha fall due in the coming year. The current assets tem isa com- Panion to curren alies because curent assets ‘ate the source ftom which payments are made on ‘curent debts, The relationship between the two Is ‘one ofthe most revealing things o be learned irom the balance sheet and we wil go int that later on Ferow we need todsine fe sub grossa LECSSeRsGy | same) jaar comet Sam naw coum ee Salcee sam ete acces onay me Accounts payable ‘The accounts payable tem represents the amounts thatthe company owes fs regular business Cito from whom i has bought goods or ser Vices on open account Tac aa) Notes payable Ifthe money is owed to a bank or other lend it ‘appears on the balance sheet under notes pay- able, as evidence ofthe fact tha a written prom- issory note has been given by the borower. con "money owed by the company tis regular bus- ness creciors. The company also owes, on any ‘ven day, salaries and wages fois employoos, interest on funds bocrawe from banks and ram bondholders les io atlomeys, insurance pre- mums, pensions, and similar tems. Tothe extent thatthe amounts owed are unpaid atthe date othe balance sheet, ese expenses are grouped as a total under accrued expenses payable Se aed Federal income tax payable ‘The debt due othe Iniemal Revenue Service is the same as any cher laity under accrued‘expenses payable. But because ofthe amount and the importance ofthe tx actos tis generally slated separately as federal income faxes payable. SO cma ‘otal current liabilities Fal the total current ibilties tem sums up all ot the tems listed under this Cassticaton. Poca To) Long-term Liabilities In discussing curent bites, you will cal that ‘we included debis due within one year rom the bal- ‘ance enc! date, Here under the heading ollong- {erm labios are isted debis due after one year ‘tom the dato ofthe financial report Deterred income taxes ‘One of thelong-term abilies on our sample bal- ‘ane sheet deferred income taxes. The govern ment provides businesses wit fax incentives 1 ‘make certain kinds of investments that wil beneft Tie ecannrny ag a wixteForinalance, @ company ccantake accelerated depreciation deductions for investmens in plant and equipment. These rapid ‘wate off inthe early years of investment reduce ‘wha the company would oferwise owe in cutent taxes, but at some point inthe future te taxes must 'e paid. To smocth out wide iuctuations in earn ings, which would occur taxes varied significantly from year to year, companies include a charge for delerred taxes in the tax calculations on the income statement and show what taxes would be ‘without the acosleratod write ofs. That charge than accumulates asa longsterm labily onthe balance sheet Saeed Sra) Debentures ‘The ther long-term lablty on cur balance sheets the 121% debentures due in 2010. The money was received by the company as aloan trom the bond- halders, who in tum Were given a certificate caled ‘bond, as evidence af loan. The bonds really 2 ‘formal promissory not issued by he company. “which in his case agreed to repay the debt at mal fy in 2010 and agroed also to pay interest at the rate of 121% per year Bond inerests usualy pay- able semi-annually. Typicals bond issue is called ‘debenture because the bonds are backed by he (Qaneral credit ofthe corporation rather than by the ‘Company's assets, Debentures are he most com- ‘mantype of bond issued by large, wel-estabished Corporations today. ‘Companios can aso issue frst mortgage bonds, which oferbandhalders an added safeguard because they are sacured by a mortgage on allot ‘the companys property First morigage bonds are ‘considered one ofthe highest grade iwestens because hey give investors an undisputed cai ‘on company earings and the gratest safely. the ‘company is unable to pay off he bonds in cash when they ae due, holders of frst mortgage bonds havea claim or lien before cther editors (such ‘as debenture holders) on the mortgaged assets, “which may be sold and the proceeds used 1 sa ity the debt Eo}Stockholders’ Equity This item i the toal equity interest that al stock- holders have inthis corporation. In cther words, the Corporations net worth after subtracting allia- biltes. This is separatod for legal and accounting reasons into thee categories: capital stock, captal surplus, and accumulated retained earnings, Capital Stock Inthe broadest sense this represents shares inthe ‘roprietary interest in the company. These shares fare represented by the stock certficaes issued by the corporation tts shareholders. corporation ‘may issue several dierent classes of shares, each Class having sight diferent atrbutes. Profrred stock ‘These shares have some pretence over other shares with respect fo ditdends,andindistibuton asootsn case of iqudatn.Spectic provsens {an be obtained fom a corporaons charor In ‘pica the petored stock a $85.89 cumuiatve, 5100 par vale, which meas tat each shar is enitod a 85.83in dividends ayer bere any di- ‘Seni te pai iothe common slockolders. Cum {sive moana atin ary year ne vend isnt ‘8d, accumulates in aor of th prefered share- Folders and mustbe paid othe when avalabe and declared betore any Gvidends are csibved “onthe commoa soek Sometimes petered stock falders have novice in company af unless ‘he company fal o pay hom dhidends a tho promised ate Pee Cn ty Speier] oe cero Cones Eo) Common stock Each year bofore common stockholders receive any dividends, prefered holders are entitled to $3583 por state, butno more. Common stock has such limit on dividends payable each year. In ‘good times when eamings are high, dividends may false be high. And when earings drop. so may Gividends. Pome Cy acy Bruen outstanding 15,000,000 shares Aud Capital Surplus This isthe amount paidin by shareholders over the par or legal value ofeach share. For example: ‘ay the common stock has a par value of $5 a share {and Typical sold 15,000,000 shares of stock fora {exalt $91,000 000. The $91,000,000 willbe allo- cated on te balance sheet between capital stock ‘and capital surplus: 20 Common stock $5.00 par value, Pre Ei iaced erent tid aioe ua) 16,000 eee eee) Serer Ea ‘Recumulated Retained Eamings ‘Thistem's sometimes called eamed surplus, ‘When a company fist saris in business, has no accumulated retinad earings. Al the end ofits fist year if rots are $80,000 and dividends of $380,000 ae paid on the prefered stock bt no ‘lvdends are declared on the Common, then the balance shoot wil show accumulated retained teamings of $50,000. Inthe second year i pros are '3140,000 and Typical pays $80,000 n dividends on the prefered and $40,000 onthe common, te ‘accumulated retained earnings wil be $120,000: Balance atthe endffirstyear $50,000, Net profit for second year 140,000 “Tota +190,000 Less: al dividends 70,000 Accumulatedretained earnings $120,000 ‘The balance sheet for Typical shows the com- pany has accumulated $249,000,000 in retained earnings: Pye eo ro)Just what does the balance sheet show? Below we undertake to analyze the balance sheet ‘igures, a word on just whal an nvestor can expect toleam. A generation or more ago, belore present accounting standards and principles had gained wide acceptance, considerable imagination went int the preparation of balance sheets. This natu- rally made the public skeptical of nancial reports ‘As lime passes, however mor efot is berg spent tomake the figures in nancial statements moe reliable. The investor however is stil faced with the task of determining the signiteance ofthe ligues. As we have already seen, a number ofitems are based to alarge degree upon estimates, while obers are necessary somewiat arbitiany. ‘One mee generalization iin order here, Since ‘we all hope that Typical Manufacturing isa growing ‘Company, we can compari ast wo years to see iToeran tems nthe balance sheet shaw growth or shrirkage. Obviously, Because the balance sheet balances, assets will be equalled by lables and stockholders equi. But athough the two tla, always match, the preliminary nas can telus alot ‘bout the health of our company, Well point out these special areas as we go along. Net Working Capital (One very important thing tobe learned from the ba- ance shostisnet working capital or net curent ‘seis, sometimes called working capital. Tis is the diference between total curent assets and ftal Count abies. You wil recall that Curent abies are debis generaly due within one year fom the dato af the balance sheet. The source fem which 0 pay those debis is current assets. Thus, working Capital represents the amount thats et fee and clea i allcurent debis are paid of For “ypica, hiss: eee caer sey ered Sion} Exar) Peeters) you consider yoursel a conservative investor, you should vest only in companies that maintain ‘.comforiabie ameunt of working capital. Acom- pany ably to moot obligations, expand volume, ‘nd eke advantage of opportunities is oten dete ‘mined by ts working capital. Moreover, since you \want your company to gro this years working cap ital shouldbe larger than last yaar. “ Current Ratio ‘Whatis a comfortable amount of working capital? ‘Analysis use several methods fo judge whether a company has a sound working capital poston. To help you interpret the current positon af a company inwhich you are considering investing, the curent ratios more he'pfl nan the dolar total of working ‘capita. The fist rough test for an industrial com- pany isto compare the curent assets igure with ‘he total current labilties. While there are many ‘exceptions, analysts generally say that minmum ‘saloy requis current assets o be al leat wie as large as cure ables. This means tha foreach St of current ibis, tere should be $2 curent assets, “Ttind the cure rati, divide currant assets by current iabilies. In Typical balance sheet Cee SOR oe ae Cex So, foreach $1 of curent ibis, thee is $2.95 incurrent assets back kup. (Cesc lance Shot can fae 00 eins mt, ‘ie ti‘Thete ae so many ciferent kinds of companies, however, thal his test equies a great Geal of modi- fication itis tobe realy helpful in analyzing com. Panes in ferent industies. Generally. comparies that have a small inveniory and easily calectibie ‘accounis receivable can operale safely witha lover ‘curtent ratio than those companies having a greater proportion of heir current assets in inventory and seling heir products on cred How Quickis Quick? Inackdionto net working capa and cuenta, thor are oer nays of tesing he adequacy o he cure posten What ae queck asse8? Thayre he {coos Youn o cour asian emergent, 5205 cou ike ight avay oo bane, you ado They are those curr ase ha rb {que convene cash Teas cate chandse inentores, because such invenores have yttobe soe. Accorsingly quick asses a Cunt asets minus nvenoen. Net quick assets are found by taking the quick assets and subtracting the total cure iabilties. A \wel-ixe industrial company should snow a ea: sonable excess of quick asses ver current li billies. This provides a rigowus and important test of company’ ability 10 meets obligations. Quickassets poor Poe Cera fk) SET “The quick assets ratio is found by dividing the quick assets by the current labile ‘As you can see, or each $1 ofcurent labile, there s$1.30in quick assets avallabl, Inventory Turnover How big an inventory should a company have? That ‘depends on a combination of mary factors. An inventory stage or small depending upon the type ‘elusinass and the ima ofthe yearn atone. ‘eal fr example, wih large stock of aulos the eight othe season is ina tong inventory Postion; yet thal same inventory a the end of he ‘Seasons 8 weakness inthe dealer financial cconciton, ‘One way to measure adequacy and balance of inventory to compare twih sales forthe year fo ‘gt iwentory tumaver Typical sales forthe year ‘ate $765,000 000, and inventory onthe balance sheet daie is $180,000 000. Thus turnover is 4 25, times (765 ++ 180), meaning that goods are bought ‘9nd Sac out more than four times per year on vee ‘age. (Strict accounting requires computation of inventory tumover by comparing annual cost of (goods sold with average inventory Tis information 'Snot readily avaiable in published statements, so ‘many analysts look instead for sales elated to. iventory) Inventory as a percentage of ourent assets is ‘another comparison that may be made. In Typical, the irmentory of $180,000,000 represents 45% ofthe {ota cutent assets, which amount to $400,000,000. Butthere is considerable vation between ciflerent ‘types of companies, and thus the relationship is siicantonly when comparisons are made among companies ina similar industryBook Value of Securities Tre balance sheet wil veal net book value (the ‘value/on the companys books) ore asset valve of the company’s secures. This value represents the amount of corporate assets backing a bond ora ‘common or prolrred share. Heres how we calcu late values to Typicals secures, Net asset value per bond Toslate nie igure consacvaively, intangible assets are subtracted as they have no value on quid tion, Curent liabities of $170,000 000 ae consic- ‘ered paid. This leaves $490,000 000 in assets to pay the bondholders. So $3,603 n net asset value protec each $1,000 bond. Shoe Ea) es Er con) Berit) ‘otal tangible assets femehtoe Ss reer Perrone Poorer Seo Serio} Reo} Sea Peni) [Net asset value por share of proferred stock Tocalculate net asset value oa prelered share, wwe take total assets, conservalvaly stated at $$660,000,000 (eliminating $2,000,000 of intangible ‘assels) Curent abities of $70,000,000 and iong- term lables re considered paid. This leaves $$344,000,000 of assets protecting the pretered, So, $5,759 a net asset value backs each share of prefered eon reer} ur Total tangible assets Ero MNES} rates mal ania Sod Seay Prod ETE) ee) eens 344,000 Pero eae thE eT ro ed referred stock ‘Net book value per share of common stock “The net book value per share of common stock can be looked upon as meaning the amount of money ‘each share would receive the company were ekl- dled, based on balance-sheet values. Of course, ‘he preferental iquidation rights of Bondholders and prefered stockholders woul first have to be ‘salfied. The answer, $22.53 net book value per share of common stock is atved at as flows! Sheer Seay ‘otal tangible assets 46 Less: current roe rl Pe 19 preferred phe Ta) ray arc} Ee} eee ccd Der Eto) Retain) Eee td 15,000,000 ale oe peraend ‘Coon ee See me a "mame‘An aliemaive method of ativing atthe common stockholders equiy—conservatvely stated at $338,000.00 Prone Penny 22 Accumulated retained erie) 10 Less: intangible assets aed Pers oa) et RNs Sapna ore oss orang Donat be misled by book value figures, particu- lary ofcommon stocks. Poftable companies ten shaw a very low net book value and very substantial temings. Raloads, onthe cher hand, may show a high book vale forthe common buthave such low or regular earrings thatthe stocks market price is much ess than ts book value, Insurance Companies, banks, and investment companies are exceptions. Because hel assets ae largeyiguid (cash, accounts recetable, and marketable secur- 1s) the book value of ther common stock s some times afar incication of market value. Capitalization Ratios “The proportion of each kind of secuty issued by & ‘company ae the capitalization ratos. A high pro Porton of bonds sometimes reduces he atrac- tiveness ofboth the prefered and common stock, andtoo much preferred can detract am the com- ‘oni valve. Thats because bond interest must be ad befor prefered dividends. and preerred div: ‘dends before comman, To got Typicals bond ratio divide the face value ‘ofthe bonds, $136,000,000, bythe teal value of bonds, prefered and common stock, capital sur ps, and accumulated retained eamings less Intangibles, whichis $480,000,000. Tis shows bonds amount to about 25% of Typical total ceaptazaton. en ea ER inere 21 Capital surplus Sac) Cy cory sc) Paani ot) cca Sere eet ei er) The prefered stock ratios found the sarno way: calls per share [Now /ats drive nome the pont you should always keep in mind when reading annual reports: be sure to remember wha kind of earings per share you sae reading. Bazed on our examples neve, eamings ‘f $500,000 forthe year can mean several ciferent things to each share of common: ‘Before alowing forconversion: $# rimary earnings: $2.50 Fully luted earings: $2 2Price-eamings Ratio ‘Bath the price and the return on common stock vary wih a muriude of factors. One such facto isthe ‘elationshp that exsts between tre earnings per ‘hare and the market price. tis called Ine price ‘eamings rao, andithis is how itis calculated Ita ‘tock s soling at 25 and earring $2 per share, ts price-eamnings ratios 12¥t0 1, usually shortened to 12¥eand the stock ie said tobe soling at 12% times earings. ifthe stock should rise to 40, the fceearngsrato wai be 2, Oritho sock opto 12, he price-eamnings rao would be 6. In Typical Manviacturing, which has no cowvert- ‘ble common stock equivalents, the eamnings per share were calculated at $3.16. the stock wore seling a 3, the price-eamings rao would be 10.4. ‘Thisis the basic igure that you should use in view. ing the record hs stock over a period of years {andin compaing the cormman stock ofthis com- pany with ther similar siocks. eee rl ‘This means that Typical Manufacturing common stock's sling at approximately 10.4 times earings. ‘Last yea, Typical earned $2.77 per share. Lets say fhalis stock soldat the same price-earings ‘allo then. This means that a share of Typical was seling for $28.80 or so, and anyone who bought ‘Typical then would be satisfied now Just remember, Inthe real word, investors can never be certain that any stock wilkeop fs same price-eamings ratio ‘tom year o year, The historcal PIE mutipieisa guide, nota guarantee. The Accumulated Retained Earnings Statement {the income statements tho payot for ohare halders tying to discever now success their ‘company ttulyis or them, the accumulated retained earings statements the pay forte ‘compary its. shows how much money the com- pany nas plawed back ino itsell—fornew grown. ‘Actually accumulated retained earnings sa smple ‘Concept. Just as the stockholder sees more value “hen the ioe ofthe stock ses, the company has ‘more value fo self when is accumulated retained eamings ree. ‘Naural, the key element in tis secton of any financial statement i the size ofthe retained eam Ings.as of te day the company closes is books for the year To each that igure, the company has to begin atthe start of he year Pere $219) 2 “Thon addin the yeare net prot Roos crac ‘And subtract the didends pao stockholders: Ee er tal Bocako’ pecans ‘The esullofthis adding and subtractingis the ‘etal at ne end of the year 38 Balance December31 ra)What does the accumulated retained earnings statement show ‘The most obvious thing the retained earnings section of Typieal Manufacturing’ statement can ‘ellusis that common stockholders were paid $18,000,000 in dividends this year Since we know tom the balance sheet that Typical has 15,000,000 shares outstanding, fe frst hing we can learn here Is what may be—aftral—the most important point tosome potent investors: Pani Ae cred Lata Now when we ook at the dvidends-paid cot uns for both years, we can see that Typical not ‘only paid $1.20 a share this year but also the pre- ious year ‘Once we know the amount of dividends per share, ve can easly discover the dividend payout ratio, This is senpy the percentage of net earnings per share that is paid to stockhoders. Mier 3 Sy Typicalis ow by the vay The average call US. ‘corpotations fs about 4%, What doas this mean? ‘Typecal plows much of sincere back nt sel Comcitd Isome Sater Cates andgag eves ‘Settons a see sna Semon ameter ‘moo "S00 ‘Sg ere es Soaraet tre $70 Siar nee am aso ioe aes ore ray Temi gaamo 5 00 eoueneartieamine _* sae eae ‘Sonoran img Topp esas Peers error CO course the dividends on the $5.83 prefewed stock wil nt change from year to year That word ‘cumulative inthe balance stlamant description {als us that it Typicals management someday ‘ih’ pay a dividend on is prefered stock (and ‘hat could only happen ifthe company did rat ‘make enough prof to pay i}. then the $5.69 pay- ‘ment for hal year would accumulate I would have {obe paidto preferred stockholders bofore ay div donds cauld ever be declared again onthe car ren stock ‘Thals why preferred stock s called preferred. It gets fst crack at any dividend money We've already taked about converibe bonds and Comverse prefered stock Right now wee ‘otinteested in that aspect, because Typical Man- facturing doesnt have any converible secures ‘outstanding. Chances are ts 60,000 shares of pre- fered stock, wth the par value of $100 each, were issued 10 family members of MIsaian Typical, \who founded the company back in 1923. When he took Typical pubic, he cnt keep any of tha com ‘man stock. Inthose days, the quaranteed $5 63 sividend was mor important to Isaiah. He was not interested in taking any more chances on Typ “The important hing we see from the accumu lated retained earinge statemont inthe betom line—what’ there at he end ofthe potiod Pc) This els us that Typical during the year has ‘added $28,400,000 0 is retained earings. Even iTypicalhas some ean yearsin he future, thas Plenty of retained earrings from which to keep on ‘declaring those $5.83 dividends on the preferred ‘stock and $1.20 dvicends on the cernmon. There is one danger in having a let of retained feamings.ftcouldaract another company—Shark Fast Foods & Electonics, forinstance—to buy up Typicals common stock, to gain enough contol ‘ove out the curtent management. Then Shark might merge Typical int itset Where would Shark {get the money to buy Typical stoi? By issuing new shares of is ov stock. perhaps. And where would ‘Shark get the money to pay the dividends on all hat ew stock ofits own’? From Typical retained ean ings. 0 Typicals management has the obigaton to its Stockholders to make sure thal is retained earn- ings are puto work to increase the otal earings or share o he stockholders. Or else the stock holders might cooperate wth Shark and when it makes aa.The Statement of Changes in Financial Position nthe income and earnings statements, weve seen ow much total money passed through ‘Typical Manufacturing hands last year, now ‘mach was made in profits, how much ofthat prof ‘was apportioned out to shareholders, and how much was retained. Now we'e going folearn more ‘about how Typical works. We get ths information ftom the secton in the nancial statement called (Changesin Financial Pasion ‘Changes in Financial Position \wnile we know that net profits came to $47,750,000 this year ifyou look back a the income statement you Gan see that foal sales came to $765 000,000, {ad toal operating costs carma o $685, 500,000, Look atthe breakdown of those costs and yeu see the fem covering depreciaton. shows up again in the statement of changes in financial positon Eo Lay Ped Pree ee Eee cue Peer 40 Total mK) ac why is something that was frst sted as a cost now sted as a source of funds? Becaus, i you ‘remember, the balance sheet defintion of depecie tion isthe decline in usetul value of a fked asset ‘Gul to wear and ter tom use and passage al te. ‘eu place this depreciation figure in your books as ‘a.cost of doing business during the year. But who {G0 you pay tis money 16? You've ala paid for ‘whatever tis hats bang depreciated. So this is. ‘money that you deduct, and you pay ito yours {Wot ely, ofcourse is simply a baokkeeong entry. Bult does te up his money tobe included fonthe asset side ofthe books. It isnt new money, butts “found” money) You can puttin the bank ‘and ad toi, agains the day when you needa replace that panto ruck. Or you can use it ‘elsewhere in your business. So depreciation is “another soutCe of funds for your company during the year eos Poac Ey ‘Companies also obtain funds through the sale of ‘common stock and Typical Manufacturing sold '500,000 shares f add'tonal stock during the year. Same ofthe shares were sold rough an empoyee ‘lock purchase plan in which most empioyees par- ticipate because Typical is such a dynamic com- pany, some through a deferred profit-sharing plan in which Typical purchases shares forts femployees, and some through the exercise of ‘execute slock options. Typical also had a small public stock offering during the year oralse cash foc the business. Deterted taxes ke depreciation, re only @ bookkeeping entry. As we explained eater, com- panes ike Typcal Manufacturing include a charge fordelered taxes agains! curent eamings, even ‘though fe taxes are not actualy paid in that year. ‘Tey do tis to normale ther tax bill ant indicate what taxes would be without fst write os anc ‘ther tax incentives. The diference between the ‘axes actually paid and those aloned for onthe income statements shown here as an increase in fnon-cunent taxes. No cash has been spent, so ris, ‘money is availabe for Typical to use although it ‘Goes not appear so.on the come statement‘Cash Flow “The sale of common stock certainly represents a change in Typicals financial poston during the ‘year, ul, or our purposes, itis not considered part ‘cash few. Cash ow rears to cash that is actly ‘generated by the business and, nthe case oh ‘ypical Manufacturing, includes ne prof, depre- lation, and the increase in non-curren taxes, ‘Now thal you know where your companys cash iow came fom during the year, you can see how it \was used. Some ofthese uses have aac bean listed elsewhere, but more informative tnancial statements show them again here. ets eel aa Een neers eo ee ee cH oc "Now comes the payat on this section, By sub tracing total funds used from teal cash lon. we can see whether he company has increased is ‘working capial duting the year, or decreased it From our analysis of Typical Manuiacturings bal- ance sheet, you ead know that working capital isimportan. And we know how fo fd out how ‘much working captal Typical Manulacturng has ‘This partcular section, onthe other hand, shows us ‘quickly whether Typicals working captalis crowing ‘or shrinking. And tells us what Typical spent ts ‘cashflow to co during the year: Typical used some money to buy equipment—a new heavy duty ‘widget machine. In adit, some of ts cash ‘went to pay prelered and common stock hidends, Analyzing the statement of changes in financial position This parts faity easy in the case of Typical Man- lscloring, because ls salernert nudes @ DUN analysis. This breakdown indicates how he werking capita changes show up in the yearend balance sheet hat began tis book. By comparing this year vith last we can get the same figures: cae Se = % mano 15008 = so aad SST eo ao nese EEE uso - 1008 os 180,000 — 185,000 = —_ (5,000) t pt ee ae caer corse omen mee TEBE” coo - 5 set nad aie $1,000 - 61,000 = (10,000) ra Siro — in eae a ee '$(11,000) We can se from the changes in financial pos ‘ton section that depreciation gave Typical some of the funds that wore translated info working capital. ‘We can also see that this working capital shows up ‘nur balance sheet books in the form of extra ‘cash, more value in the marketable secuttios ‘onned by Typical Manutacturng, more accounts receivable fom ts customers, and alower amount df oustanding shorter notes it must repay. Latgoly because o Typicals greater sales vol Lume, we presume, Typical ones more accounts payable to is ov suppliers. The compary also has ‘more prepaid expenses and more income tax due, both of which reduce cash flow. Honever, Delight: ening and improved operating efficiencies have enabled Typical to reduce accrued expenses even fas fs sales vole was increasing. Infact, accrued ‘expenses have decreased mor than 16% while sales have risen about 8%, and tnat sa very Positive development n addition, Typical vento fies of unsola goods have dropped $5,000 000 du ing the year. Tal means the company is turing ‘veri esting inventory fast, and making its cap: lal work harder forthe stockholders during the yoar 8Return on Equity Soeing how hart money works, of course, is one of the most popular measures that investors use to ‘Come up wth individual jukgments on haw much thay think a certain stock ought to be worth. The ‘market isll—the sum ofall buyers and solos makes the eal decision. But investors often ty to ‘make their avn, in order decide wheter ey ‘want to invest at tho markets price or wait Most investors look for Typical return on equiy, which ‘hows how hard stockhoiders equty in Types ‘working. In oder to find Typical curent return on ‘equity, we look atthe balance sheet and take the ‘common stockholders equiy fr last year—not the ‘curentyear—and then we see how much Typical ‘made this year oni. We use only he amount of net Profit after tne dividends have been paig on te pre- {erred siock. For Tyocal Manufacturing, that means ‘$47,750,000 net pri minus $360,000. Here is what we get: oats pee et _“BaraMTat eerste sly specs ate ES a7, 158% (600 retumon equity For every dolar of stockholders eausty Typical made more than 15¢.Isthat good’? Wel, 5.8.00 the dolais beter than Typical could have done by {going out of business, taking its stockholders) fequiy and pusting thai $299,600 000 inthe bank Typical obviously is batter afin ts own tne of ‘work "When we consider puting our money o workin Typcals stock, we should compare Typicals 18.8¢ not ony to whatever Typicals business com patitors make, bulto Types investment compet {ors for our money For instance, the average rate for all US. industry, according tothe US. Federal Trade Commission, was 15.2¢ for 188i, the latest avaiable 'gure, Just emember that 15.8¢is what Typicalitslt makes onthe dolar By no means st what you Wil make in dvidends on Typicals stock. What that rolum on equily really tls you is whether Typical Manufacturing is eatively attractive as an enter prise. You can only hope thal his tractveness righ be translated into demand fr Typical sock, and rllected ints orice, Many analysts also ike to soe a companys annual retum on the total capial avaiable tothe company. To get this igure, we use all the equity, pls al avalable borrowed tunds, Ths becomes the {otal captal avaiable. And forthe tla return on this figure, we use net income before income taxes and intewest charges. A bigger capital base, and a larger income igure. As stoskholders, however, ‘what we'e most interested in snow hard our own share af the company is working. An thats why we are more interested in return on equityQualifying and Certifying ‘Watch Those Footnotes. ‘The annual eports of many companies contain his latent: "The accompanying footnotes are an integral part of the financial statements" The reason isthat he nancial reports thomsoles are kept ‘concise and condensed. Therefore, any explana {ory matter that cannot readly be abbreviated is sot ‘out greater detaln footnotes: Some examples of appropriate footnotes are: (Changes inthe company’s method of depreciating fred assets, ‘Changes in the value of stock outstanding due to Stock Gividends and spits. Deals of stock options granted io officers and employees, diaimehcietinetietea Employment contracts, prot sharing, pension and ‘etreent plans, Contingent bites representing claims or lawsuits pending Inflaion arcnunting adjustments. Certain com. ‘panies must shaw ihe impact of changing prices on their financial positon by adjusting tems that appear on the balance sheet and he income stato- ‘ent fey Curent costs and the Consumer Pie Index. FASB Statement Number 23 spals cut the requirments fr ptesentnginflatonadusted fnan- al data Inventory valuation method. This footnote incates vhether inventories shown onthe balance sheet oF Used in determining the cost of goods soi on the Income statement are valued on alastin, rst out (IFO) basis ora fist in, fist out FIFO) bass, Last in fist out means tha the cost on the income stato- ‘ment flees the actual cost of Inventories pur ‘chased most recently and fis in, frst out means the income slatoment reflects the cost of he oldast inventories. This isan extremely important consi: ‘ation because a LIFO valuation reflects curent costs and does not overstate profs during inflabor- ary Umes while a FIFO valuation does. Long-term leases, Retail companies, which usvally lease a considerable amount of seling space, must show their lease abies on a per year bass or the next several yeas and thir iota ease lables over _alonger period of ime. ‘Separate breakdowns of sales and gross profs ‘must be shown fr each tna of business that ‘accouns for more than 20% of @ company’ sales. Mutinaional corporations must also snow sales {and gross income on a geographic basis by nee Most people do ot ke to read focinoles because they may be complicated and they aro almost atways hard o read. Thats too bad, ‘because footnotes sometimes can be dynamite. ‘And evenif they don't reveal thatthe corporation has been forcedinto bankruptcy, fotnotes canst tell you many fascinating sideights onthe financial sory Arc those foctnatas must be done in ype that iss lange as the numbers inte financial state ment. $0 Typical wore fo telyou na footnote that ithad gone broke, this couldnt be tid in ype so small you'd need a magnifying glass to read it independent Audits ‘The cetficate ftom the independent accountants, whichis printed in the pot says fs, thatthe auciing steps taken inthe process of vorlication of the account meet the accounting words approved standards of practice, and second, tna the fntan- al statements inthe report have been prepared in conform with generally accepted accounting Principles 'AS a result, when the annual report contains financial statements that have the stamp of approval tom independent public accountants, you have an assurance thatthe igures can be relied Upon as having boen fay presente. However ifthe independent accountants opinion contains words such as “except for or "subject fo the reader should instigate the reason behind such qualfications. ten the answer can be found, 'y reading the fotnotes that pera to the mater They ae Usual elered tain the accountants opinionThe Long View ‘We cannot emphasize to strongly that company reoards, inorder tobe very useful, must be com- pared. We can compare them to cher company Tooards, fo industry averages or even to broader ‘economic factors, we want But most of all we ‘can compare one companys annwal actives tothe same fms resus rom other years This used to be done by keeping ae of old annual reports. Now many corporations include a {ten-year summary in the inancial highights each {yar Tis provides the investing pubic wih infor ration about a decade of pectormance. Thats why Typical Manufacturing, being a good company, has Ineluded a ten-year summary in ts annual report Rg nota part o the statements vouched for by he ‘dts, butts ther for you to ee. ‘ten-year surnmary can show you 1 The tend and consistency of salos ' The tend of earnings, pariculary in relation to ‘sales and the economy ‘Th vondolnetearingsas a prcntage ot ss The trend of etun on capital Net earings per share of common ‘Dividends, and dividend poy. Che: companies may include changes innet wort, book value per share, capital expenditures {orplant and machineny long-term debi, capa stock changes by way of stock dividends and spits, umber of employees, numberof stock holders, umber of outlets, and where appropriate information on foreign subsiianes and the extent 0 ‘which mary foreign operations have been embod- Tedintne financial report ‘Aloft is rally important because of one cen- tral point: you are not only trying to find out how ‘ypeealis doing now. You want to predict how Typical wi do—and how its stock wil perform. Selecting Stocks From the terns we've studied inthis bookie, Typical Manufacturing appears to be a heathy concern. Which should make Board Chairman Patience Typical, ld Isaiah Typical daughter, and ner four risces, who own mast afte snares, happy. Butt ‘makes us rather sad, since Typical is ictional, and. ‘we cant offer you shares ots stock. When you ‘decide to invest money in eal stocks, please remember this: Selecting common stocks fr investment requires caret study of factors cher than those we can Team trom financial statements, The economics of ~ the country and the particular industry must be ‘considered. The management othe company ‘must be studied and its plans forthe fature ‘assessed. Information about these ather things is Tarai inthe financial report. These ther facts must bbe gleaned from the press or the financial services ‘or supplied by some research organization, The ‘Secures Research Division of Mel Lynch, aeroe, Fenner & Smith stands ready to help you get the avaable facts you need to be an intaligent Instat Ask any Account Executive o put Merit Lynch to work fr you.3