How to Read & Understand Financial Statements When You Don't Know What You Are Looking At: For Business Owners and Investors

By Brian Kline

Financial statements are fundamental to any business, large or small. They are actually "report cards" on the performance of the business. When reading them, you will encounter odd terminology, strange calculations, and of course, big numbers. But what insight can they give you as a manager, owner, or investor? How can you use financial statements to manage the business or be a wiser investor without having to become a CPA? And what in the world do some of those terms mean and how do you use them? With the guidance in this book, if you can read a nutrition label or a baseball box score, you can learn to read basic financial statements.

There are four main financial statements. They are balance sheets, income statements, cash flow statements, and statements of shareholders equity. It is important to note that a financial statement does NOT tell the complete story. Combined, however, they provide very powerful information for business owners, managers, and investors. Information is the best tool when it comes to managing and investing wisely.

This new easy to follow book will make you an expert on financial statement interpretation including: profit and loss statements (income statements), balance sheets, financial analyses, profit analyses, break-even analyses, and ratios. The book includes an extensive glossary useful lingo and hundreds of hints, tricks, and secrets about how to read these statements and use them to your advantage.

• Language: English
• Publisher: Atlantic Publishing Group, Inc.
• Release date: Jan 12, 2007
• ISBN: 9781601381811

Book preview

Burrell

By Brian Kline

How to Read and UndeRstand

Financial

statements

When You Don’t Know What You Are Looking At

By Brian Kline

How to Read and UndeRstand Financial statements When You Don’t KnoW WhAt You Are LooKing At

Copyright © 2007 by Atlantic Publishing Group, Inc.

1405 SW 6th Ave. • Ocala, Florida 34471 • 800-814-1132 • 352-622-1875–Fax Web site: www.atlantic-pub.com • E-mail: [e-mail] SAN Number: 268-1250

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without the prior written permission of the Publisher. Requests to the Publisher for permission should be sent to Atlantic Publishing Group, Inc., 1405 SW 6th Ave., Ocala, Florida 34471.

ISBN-13: 978-1-60138-012-8

ISBN-10: 1-60138-012-7

Library of Congress Cataloging-in-Publication Data Kline, Brian.

How to read and understand financial statements when you don’t know what you are looking at / Brian Kline.

p. cm.

Includes bibliographical references and index.

ISBN-13: 978-1-60138-012-8 (alk. paper)

ISBN-10: 1-60138-012-7 (alk. paper)

1. Financial statements. 2. Managerial accounting. 3. Business enterprises--Valuation. 4.

Corporations--Valuation. I. Title. II. Title: How to read and understand financial statements when you don’t know what you are looking at.

HF5681.B2K555 2008

658.15’11--dc22

2007025043

LIMIT OF LIABILITY/DISCLAIMER OF WARRANTY: The publisher and the author make no representations or warranties with respect to the accuracy or completeness of the contents of this work and specifically disclaim all warranties, including without limitation warranties of fitness for a particular purpose. No warranty may be created or extended by sales or promotional materials. The advice and strategies contained herein may not be suitable for every situation. This work is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services. If professional assistance is required, the services of a competent professional should be sought. Neither the publisher nor the author shall be liable for damages arising herefrom. The fact that an organization or Web site is referred to in this work as a citation and/or a potential source of further information does not mean that the author or the publisher endorses the information the organization or Web site may provide or recommendations it may make. Further, readers should be aware that Internet Web sites listed in this work may have changed or disappeared between when this work was written and when it is read.

COVER & INTERIOR LAYOUT DESIGN: Vickie Taylor • [e-mail] Printed on Recycled Paper

Printed in the United States

We recently lost our beloved pet Bear, who was not only our best and dearest friend but also the Vice President of Sunshine here at Atlantic Publishing. He did not receive a salary but worked tirelessly 24 hours a day to please his parents. Bear was a rescue dog who turned around and showered me, my wife Sherri, his grandparents Jean, Bob, and Nancy, and every person and animal he met (maybe not rabbits) with friendship and love. He made a lot of people smile every day.

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The Humane Society of the United States (HSUS) makes a difference in the lives of animals here at home and worldwide. The HSUS is dedicated to creating a world where our relationship with animals is guided by compassion.

We seek a truly humane society in which animals are respected for their intrinsic value and where the human-animal bond is strong.

Want to help animals? We have plenty of suggestions. Adopt a pet from a local shelter or join the Humane Society and be a part of our work to help companion animals and wildlife. You will be funding our educational, legislative, investigative, and outreach projects in the United States and across the globe.

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202-452-1100

www.hsus.org

Table of Contents

Preface ................................................. 7

Chapter 1: Introduction .......................... 9

Chapter 2: Important Basics ...................31

Chapter 3: The Balance Sheet ..................55

Chapter 4: The Income Statement ............73

Chapter 5: The Statement of Cash Flows and

Statement of Shareholders’ Equity............87

Chapter 6: Financial Ratio Analysis ........ 109

Chapter 7: The Rest of the Financial Story .. 139

Chapter 8: The SEC and Independent

Audits ............................................... 159

H O W T O R E A D A N D U N D E R S TA N D F I N A N C I A L S TAT E M E N T S

Chapter.9:.Contemporary.Corporate..

Scandals............................................. 185

Chapter.10:.Investment.Strategies.......... 201

Chapter.11:.Bringing.Investors.and..

Businesses.Together............................. 227

Chapter.12:.Analysis.of.Starbucks’.2006..

Annual.Report..................................... 253

Glossary............................................. 269

Author.Biography................................. 285

Index........................................ 287

6

Preface

Financials are at the heart of every business, whether it is a transaction with a customer at a cash register or a multibillion-dollar corporate merger. Both follow the same set of accounting rules and are registered in financial statements, which are nothing more than a summary of all the financial dealings that occurred within the business over a specific period of time. The U.S. Securities and Exchange Commission has oversight responsibility for the financial statements of publicly owned corporations. One clearly stated goal is that these statements be transparent and understandable by non-financial readers. The goal of this book is the same, making financial statements easy to read.

Understanding how transactions get onto financial statements and being able to understand what different sections mean is only the beginning. The four different statements have evolved over many decades and are closely interrelated. The numbers on one statement are not independent of those on another, but each separate statement tells its own story. Being able to do some relatively simple ratio analysis reveals much more about the operations of a company than simply knowing how much was taken in as revenue last year and what the profit margin is. The efficiency of the company can be discovered, and trends can predict future financial results. Without a crystal ball, financial statements are the next best way to see future performance.

When the future does not look as bright as it might, financial

H O W T O R E A D A N D U N D E R S TA N D F I N A N C I A L S TAT E M E N T S

statements provide evidence of where business owners can make needed improvements. This book also provides answers to what those improvements might be, based on what the numbers explain. For the investor, the ability can confirm what on the surface appears to be a solid investment. Likewise, it can avoid a financial blunder into an ailing company.

For public companies, the statements go beyond just numbers. An important part of the reports is the accompanying Management Discussion and Analysis. Here, readers learn about the business risks senior management is aware of and how they believe the business will be affected. Often the future business strategy is divulged from this information. Certainly, a potential investor would want to know this, and a business owner can learn what the big guys in the industry are planning.

For investors, over the long term, corporate ownership through stocks can provide a substantially better return than savings accounts, treasury bonds, or CDs. The risk of investing in a business is choosing the wrong one. Chapter 9 describes how corporate scandals in the early 2000s were pulled off and how the U.S. Congress made stringent improvements to financial reporting to thwart criminal managers from repeating them.

Similarly, owning a business can provide a much more substantial income than working for others. Accomplishing this requires growing a prospering business. Often this requires either loans or outside investors, both of which will demand the review of financial statements before providing funding. Although an accountant can prepare the statements, the owner will need to explain them to the people with the money.

A short trip through this book prepares the investor and the business owner to better succeed at their chosen endeavor.

8

Introduction

CHAPTER 1

Financial statements are the only direct source for gauging a business’s financial performance — they tel the story about profitability, financial health, and the ability to pay obligations, including returning earnings to stockholders. People who rely on financial statements include managers, analysts, attorneys, investors, lenders, customers, and suppliers.

Financial statements and concepts prove simple once you know what you are looking at and understand the lingo. The four different financial statements — (1) Balance Sheet, (2) Income Statement, (3) Statement of Cash Flow, and (4) Statement of Shareholders’ Equity — require nothing more than adding, subtracting, multiplication, and division.

Each statement provides the reader with specific information about the company, but none of the financial statements tells the whole story all by itself. In fact, most of the useful information is obtained by comparing the numbers from one statement with those on another. A comparison by creating ratios from the numbers involved with the statements finds the real information needed by investors and managers alike.

For investors, the numbers tell the financial health of the company and can be a powerful tool for comparing financials among several companies. While past performance cannot predict future profits, it does show how one company has performed against competitors in the same industry, and current trends indicate a company’s future direction.

The universal nature of financial statements simplifies the comparison of companies in different industries.

H O W T O R E A D A N D U N D E R S TA N D F I N A N C I A L S TAT E M E N T S

Managers always need to know their

ALphABETICAL LISTINg

business’s current financial health, but

OF 40 COMpANIES

the numbers reveal much more. A solid

FROM STANDARD AND

pOOR’S 100

financial analysis divulges if the company

Abbott Laboratories

is positioned to improve profitability and

AES-CP Inc.

can forewarn of future financial troubles

Alcoa Inc.

to be avoided by taking early action. All

Allegheny Tech New

this and more comes from discovering the

Allstate CP

meanings behind the numbers.

American Electric Power

Co.

Look.at.the.Numbers

American Express

American Intl. Group Inc.

Managers responsible for the business’s

Amgen

financial health should have a constant

Anheuser Busch

eye on the numbers. Today’s accounting

Avon Products Inc.

software can provide instantaneous, up-to-

Baker Hughes Intl

the-minute information at the push of a Baxter Intl Inc.

button.

Bank of America CP

Black Decker CP

Many managers review sales reports and

Boeing Co.

see the results of business conducted daily.

Bristol Myers Squibb

Two activities make a regular review of the

Burlington N Sante Fe

financial numbers very important. First,

Campbell Soup Co.

when a policy change has been made with

Capital One Fiancial

the intention of improving the company’s

Caterpillar Inc.

financial performance, management

CBS Corp. CL B

needs to know if the change is having the

Chevron Corp.

desired effect. Second, when a company is

Cigna CP

experiencing financial troubles, keeping a

CISCO Sys. Inc.

close eye on changes to its finances often

CitiGroup Inc.

averts disaster. Astute managers know the

Clear Channel COM

critical numbers and how to change them.

Colgate Palmolive

10

C H A P T E R 1 : I N T R O D U C T I O N

Investors rarely need to keep daily tabs on

ALphABETICAL LISTINg

OF 40 COMpANIES

the business’s financial situation. In fact, FROM STANDARD AND

investors only see the financial statements pOOR’S 100

once every three months. Certain companies

Comcast CP A

are legal y required to publish a ful set of Computer Sciences CP

financial statements on a quarterly basis.

Conoco Phillips

Once a year the most detailed information

Dell Inc.

comes out in the Annual Report, fol owed by

DOW Chemical

the Annual Shareholders’ meeting where the

Du Pont E I DE NEM

owners (shareholders) question management

E M C CP

about the company’s financial performance.

Eastman Kodak Co.

El Paso Corporation

There are three times when investors

Entergy CP

need to dig deep into the financial

Exelon Corporation

performance of a company. First is when Walt Disney — Disney Co.

an investor is making the initial decision to invest. Prudent, wise investors conduct

a thorough analysis and comparison with other companies. Second is when the quarterly and annual reports come out. Investors want to be reassured that the company is performing as anticipated. Third is when an extraordinary event occurs. Hopefully, this will be a major contract or better-than-expected financial performance, but it also can be fraud or major customer loss. New financial statements are not issued until the next scheduled date, but information about breaking news can be found in financial media and news releases issued on the company’s Web site. Although new financial statements do not come out, certain companies are legally required by the Security Exchange Commission (SEC) to disclose information about extraordinary events.

Where.to.Find.the.Financial.Statements

Current and past financial statements for publicly traded companies are 11

H O W T O R E A D A N D U N D E R S TA N D F I N A N C I A L S TAT E M E N T S

available to investors anytime. Publicly traded companies have shares bought and sold to the public on stock exchanges like the New York Stock Exchange or the National Association of Security Dealers and Automated Quotations (NASDAQ). The SEC provides the online Electronic Data Gathering, Analysis, and Retrieval system (EDGAR) containing financial statements of al publicly traded companies as far back as 1996, the year statements were required to be submitted electronical y.

Filings made by these publicly traded companies are available at http://

www.sec.gov/edgar/searchedgar/companysearch.html. Not the most user-friendly database, EDGAR retrieves too much information. The advanced search page (http://searchwww.sec.gov/EDGARFSClient/

jsp/EDGAR_MainAccess.jsp) is often more useful because the search can be limited to specific forms such as the 10-K and 10-Q. Another simpler search solution is finding key information by visiting the company’s Web site. The company has discretion about what it provides on its own Web site. There may not be as many years of information, and often companies do not post information about changes in corporate officers’ ownership of shares. However, there should be enough years of financial statements to perform thorough research. Just look for the annual reports and quarterly results on the investor relations page.

Quarterly.Report.Overview

The quarterly results are a full set of financial statements that companies must issue once every three months. These are known as 10-Q reports because quarterly reports are made on SEC Form 10-Q. The exact issue date varies depending on the company’s fiscal year. Many companies maintain a fiscal year that corresponds with the calendar year, making it relatively simple to anticipate when financials will be released. However, some companies elect to operate on a fiscal year that does not correspond to the calendar year. For example, retailers who want to capture sales from after Christmas might elect a fiscal year that ends January 31.

12

C H A P T E R 1 : I N T R O D U C T I O N

Once established, it is difficult for a company to change its fiscal year.

In addition to the four financial statements, the quarterly reports contain notes explaining the numbers in the financial statements. The notes contain important information about long-term debt, purchase and sale of subsidiary businesses, retirement and pension information, changes in accounting practices, and other critical information. The quarterly report also includes the Managements Analysis and Discussion, in which management provides more details about the numbers, such as explanations for increases or decreases. Management is also obligated to provide information it believes will affect the future of the company.

It is important to note that an independent third party does not audit quarterly reports. However, SEC regulations require that management accurately reflect the true condition of the company.

Annual.Report.Overview

The annual report is the primary report issued by publicly traded companies to communicate corporate information to shareholders. It is important to know the difference between annul reports and SEC Form 10-K. The annual report must be sent to shareholders before the annual shareholders’ meeting that elects members to the board of directors and conducts other company business. Annual reports contain the financial statements filed with the SEC on Form 10-K.

The annual report usually contains a letter for the chief executive officer (CEO) and information about new products, marketing efforts, subsidiaries, and the company’s future. Images are used frequently to communicate management’s message to current and prospective investors. Skepticism is needed when reviewing this information because it is intended to portray the company in the best light possible.

Management has more latitude about information presented in the 13

H O W T O R E A D A N D U N D E R S TA N D F I N A N C I A L S TAT E M E N T S

annual report than it does for the 10-Q and 10-K filings. It selects the subjects included as well as the numbers emphasized with charts and graphs. Ultimately, the annual report is an informative document and a marketing tool for reassuring current and attracting new investors.

The time between the end of the fiscal period and publication of financial statements depends on company size. Companies with more than $700

million in assets must file annual reports (10-K) within 60 days and quarterly reports within 40 days. Companies with $75 million have 75

days to file the 10-K and 40 days for the 10-Q. Those with less than $75

million have 90 days and 45 days, respectively.

pERIODIC REpORT FILINg DEADLINES

Category of Filer

Form 10-K Deadline

Form 10-Q Deadline

Large Accelerated Filer 75 days for fiscal years (over $700 million)

ending before Dec. 15

and 60 days for fiscal

40 days

years ending on or after

Dec. 15

Accelerated

Filer

(over $75 million but less

75 days

40 days

than $700 million)

Non-Accelerated Filer

90 days

45 days

(less than $75 million)

Public.Versus.Private.Companies

We must differentiate between the financial reporting requirements of publicly traded companies and those of privately held companies.

Every corporation is registered with at least one state government office.

However, few privately held companies come under the authority of the SEC. Private companies do not have their shares traded on a major stock exchange. These shares are traded in private transactions or through over-the-counter transactions known as Pink Sheets (see Glossary). An exception requires certain private companies — those with more than 14

C H A P T E R 1 : I N T R O D U C T I O N

500 shareholders and $10 mil ion in assets — to comply with SEC

regulations. SEC authority extends to companies that deregister from a stock exchange (go private) and stil have more than 300 shareholders.

State financial disclosure requirements vary but are far less robust than SEC requirements. Few if any states require financial statements of private companies. There is no requirement for an independent audit of private companies that choose to create financial statements. Private companies prefer keeping their financial information out of the public view.

States will not change these policies anytime soon. If they began requiring public disclosure by private companies, it would encourage relocation to states with more lenient requirements. Relocation can be as simple as filing a few papers without physically moving. This does not mean that private companies do not have financial statements or audits by a third party. The board of directors may deem it prudent to have an audit to ensure the accounting system is performing correctly or that audits are in shareholders’ best interest. A bank loaning money to a private company often requires audited financial statements. These and many other reasons result in audits of private companies. However, deciding to produce statements along with who has access is up to each company, and it is likely to be less frequent than for public companies.

Balance.Sheet.Overview

The balance sheet is one of the four major financial statements. Publicly traded companies are required to file all four statements on a quarterly basis using Generally Accepted Accounting Principles (GAAP). The quarterly statements are not audited, but the annual statements are.

The balance sheet has two sections that must equal each other (hence the name). The first section, the Asset section, represents all the resources available to the company to conduct business, including cash 15

H O W T O R E A D A N D U N D E R S TA N D F I N A N C I A L S TAT E M E N T S

and cash equivalents, inventory, land, buildings, and equipment. The opposing section is Liabilities and Shareholders’ Equity. In total, this section represents how every asset was bought or acquired. Liabilities are outstanding loans and other financing obligations that must be repaid. These can be short-term obligations to repay cash loans or long-term commitments to pay off mortgages on buildings and equipment.

Shareholders’ Equity represents the portion of the assets owned outright by the company. This includes the profits made from sales along with the portion of buildings, equipment, and all other resources free from loans or any other obligations. It is everything the business owns.

ThE BALANCE ShEET EquATION

Assets = Liabilities + Shareholders’ Equity

-Or-

Shareholders’ Equity = Assets – Liabilities

The balance sheet equation illustrates the importance of balance between the two sections. At the bottom of each section is a total dollar value.

The total value in the Asset section will always exactly match the total value of the Liabilities and Shareholders’ Equity section.

The balance sheet is a snapshot in time. Near the top will be the exact date the company was in that particular financial position. Every transaction is represented on the balance sheet, although it does not show the details. Change over time is one of the most important ways to analyze the balance sheet (covered in detail in future chapters).

Balance sheet is the most common name for this important financial statement, but it has other names, including Statement of Financial Condition and Statement of Financial Position.

Income.Statement.Overview

The next financial statement likely encountered is the income statement.

16

C H A P T E R 1 : I N T R O D U C T I O N

Here is where investors and managers learn if the company made a profit over a specific period.

INCOME STATEMENT EquATION

Total Revenues – Total Expenses = Profit

The first number found on an income statement is the revenue from sales before expenses are subtracted out. Expenses are subtracted in a specific sequence to reveal useful information. First, the cost of goods sold (COGS) is subtracted from revenue to determine gross profit. Next, administrative and depreciation expenses are taken out to determine

operating profit. Finally, interest paid on loans and taxes is subtracted to reveal the actual profit remaining after all the expenses. It is hoped there is money remaining after all the expenses are paid; otherwise, you have a negative number representing a financial loss for the period.

Earnings per share is the only ratio you will find directly on the financial statements. This appears at or near the bottom of the income statement.

Profit is divided by the number of outstanding stock shares. This tells how much of the profit (or loss) is attributed to each share. If a company made $1 per share and an investor owned 100 shares, the portion of the profit attributed to her ownership is $100. The company does not distribute the $100 to the investor, but the investor is considered $100

better off for owning the 100 shares. When the return on investment is good, the value of the shares increases.

Importantly, where the balance sheet is a snapshot in time of the company’s financial position, the income statement describes what happened financially during that time. Income statements include a comment near the top such as income statement for quarter ended June 30, 20XX. The revenues and expenses contained in the statement explain the change in financial position shown on the