A firm’s annual report is the most important report that corporations issue to shareholders and it contains two types of information. A. The first is a verbal statement of the company’s recent operating results during the past year and discusses new developments that will affect future operations. B_ The second is a sct of quantitative financial statements that report what actually happened to the firm’s financial position, carnings, cash flow, and stockholders’ equity over the past few years. 1. The balance sheet shows what assets the company assets as of a given date 2. The income statement shows the firm’s sales, costs, and profit over a period of time. owns and who has claims on those 3. The statement of cash flows shows how much cash the firm began the year with, how much cash it ended up with, and what it did to increase or decrease its cash. 4. The statement of stockholders’ equity shows the amount of equity the stockholders had at the start of the year, the items that increase or decreased equity’, and the equity’ at the end of the year CC. The information contained in an annual report can be used to help forecast future carnings and dividends. ‘The balance sheet is a statement of the firm’s financial p It shows the firm’s assets and the claims against those assets. 4, arc typically shown in the order of ion at a specific point in time. A. Assets, found on the lefi-hand side of the balance sh their liquidity 1, The balance sheet may be thought of as a snapshot of the firm’s financial position at a point in time (for example, the end of the year). The balance sheet changes every day as inventory is increased or decreased, as fixed assets are added or retired, as bank loans are increased or decreased, and so on. 2. Assets are divided into two major categories: current assets and long-term assets Current assets include eash and equivalents, accounts receivable, and inventory Only cash and equivalents represent actual spendable money a. Current assets are often called working capital because these assets “turn over.” ‘They are used and then replaced throughout the year. b. Net working capital is the difference between current assets and current liabilities. ¢. Net operating working capital distinguishes between “free” liabilities and interest- bearing notes payable. It is calculated as current assets less the difference between current liabilities and notes payable. 4, Long-term assets are those whose useful lives exeeed one year, and they include physical assets such as plant and equipment and intellectual property such as patents and copyrights. B. Claims, found on the right-hand side, are generally listed in the order in which they must be paid 1. Claims against the assets consist of liabilities and stockholders’ equity Assets ~ Liabilities ~ Preferred stock = Common stockholders’ equity (Net worth) 2, Liabilities are further divided into current liabilities and long-term debt a. Current liabilities are obligations that are due to be paid off within a year, and include accounts payable, accruals (otal of accrued wages and accrued taxes), and notes payable to banks that are due within one year. b, Long-term debt includes bonds that mature in more than one year. 3. Common stockholders’ equity, ot net worth, is capital supplied by common stockholders and represents ownership. The common equity section of the balance sheet is divided into two accounts: common stock and retained earnings a. The common stock account arises from the issuance of stock to raise capitalmL. Iv. b. Reiained earnings arc built up over time as the firm “saves” a part of its carnings rather than paying all earnings out as dividends 4. Preferred stock is ahybrid, or a cross between common stock and debt. C. Companies use generally accepted accounting principles (GAAP) to determine the values reported on their balance sheets 1. Inmost cases, these accounting numbers (referred to as book values) are different from the corresponding marker values. The income statement summarizes the firm’s revenues and expenses during a reporting period (generally a quarter or a year). A. Earnings per share (EPS) is called “the bottom line,” denoting that of all the items on the income statement, EPS is the most important. A typical stockholder focuses on reported EPS 1. To compare companies’ operating performances, it is essential to focus on their earings before deducting taxes and interest payments, a, This is called BIT and is often referred to as operating income. b. Operating income is derived from the firm’s regular core business, 2. Depreciation is an annual noncash charge against income that reflects the estimated dollar cost of the capital equipment and other tangible assets that were used up in the production process: a, Amortization is similar to depreciation except that it applies to intangible assets, such as patents, copyrights, trademarks, and good will b. Because depreciation and amortization are so similar, they are often lumped together on the income statement EBITDA represents earnings before interest, taxes, depreciation, and amortization. a. Managers, security analysts, and bank loan officers who are concerned with the amount of cash a company is generating often calculate EBITDA. B, Management generally prepares monthly, quarterly, and annual income statements. 1. The quarterly and annual statements are released to investors, while the monthly statements are used intemally for planning and control purposes. C. The income statement is tied to the balance sheet through the retained earnings account on the balance sheet. 1. Netincome, as reported on the income statement, less dividends paid is the retained earnings for the year. 2. Those retained carnings are added to the cumulative retained earnings from prior years to obtain the year-end balance for retained earnings, 3. The retained earnings for the year are also reported in the statement of stockholders equity Management's goal is to maximize the price of the firm’s stock; and the value of any asset, including a share of stock, is based on the cash flows the asset is expected to produce. ‘Therefore, managers strive (0 maximize the cash flows available to investors. The ‘Statement of Cash Flows reports the impact of a firm’s operating, investing, and financing activities on cash flows the firm is generating over an accounting period. A. The company’s cash position as reported on the balance sheet is affected by many factors, including income, changes in working capital, fixed assets, security transactions, and dividend payments. B. The statement can be separated into four parts: 1. Operaung activities, which includes net income, depreciation, and changes in working capital other than cash and short-term debt.2. Investing activities, which includes purchases or sales of fixed assets, 3. Financing activities, which includes raising cash by issuing short-term debt, long-term debi, or stock, or using cash to pay dividends or to buy back outstanding stock or retiring bonds 4, Summary, snows the net decrease (increase) in cash {rom the three activities above, shows the cash at the beginning of the year, and then calculates the cash at the end of the year. C. Financial managers generally use this statement, along with the cash budget, when forecasting their companies” cash positions. ‘The Statement of Stockholders’ Equity reports changes in the equity accounts between balance sheet dates and why these changes occurred. A. The balance sheet account “retained earnings” represents a claim against assets, not assets per se. 1. Retained earings as reported on the balance sheet do not represent cash and are not “available” for the payment of dividends or anything else. Retained earnings represent funds that have already been reinvested in the firm’s operating assets. Financial statements provide a great deal of useful information. At the same time, investors need to be cautious when they review financial statements. A. Companies are required to follow generally accepted accounting principles (GAAP) when reporting financial statements: however, managers still have a lot of discretion in deciding how and when to report certain transactions 1, Two firms in exactly the same situation may report financial statements that convey different impressions about their financial strength. 2. As long as the financial statements follow GAAP. such actions are legal, but these differences make it difficult for investors to compare companies and gauge their truc performances. B. After the Enron and WorldCom scandals. Congress passed the Sarbanes-Oxley Act (SOX) 1. Itrequired companies to improve their internal auditing standards. 2. Itrequired the CEO and CFO to certify that the financial statements were properly prepared Italso created a new watehdog organization to help make sure that the outside accounting firms were doing their jobs,