
Financial Statements
Financial statements indicate the status of a company’s operations
and performance. After analyzing these statements, analysts render
their investment recommendations for the company’s stock. Any perceived
long-term changes in a company’s earnings have an effect on
the company’s dividends and its stock price. If earnings are projected
to be greater than the expectations on Wall Street, more investors will
want to buy the company’s stock, pushing prices up. Similarly, if the
company’s earnings fall short of expectations, investors might sell
those stocks if they perceive this trend to be a long-term one, putting
downward pressure on the stock price. Asteady increase in the company’s
earnings also raises the expectation of increases in dividends,
which often contribute to rising stock prices. The opposite is true with
decreased earnings.
Forecasting whether companies will meet their expected sales
and earnings projections is not an easy task, and you should consider
a number of other factors in addition to financial analysis.
Many investors do not have the time or the inclination to
study a company’s financial strengths and weaknesses. If you are
one of these people, you can choose from many sources of published
information, such as Standard & Poor’s or Value Line’s tear
sheets, in addition to brokerage reports.
For many investors, however, the starting point for investing
in a company is the company’s financial statements, found in its
annual report and 10-K report, both filed with the SEC. Annual
financial statements are audited by independent certified public
accountants (CPAs) and are distributed to shareholders and other
interested parties. The annual report contains four financial statements:
income statement, balance sheet, statement of changes in
retained earnings, and statement of changes in cash.
Income Statement
An income statement provides a summary of a company’s earnings
during a specified period (a year for annual statements and three
and six months for quarterly and semiannual income statements,
respectively). The income statement begins with revenues (sales),
from which various expenses are deducted: the cost of goods sold
and selling, general, and administrative expenses. Interest expenses
reflect the costs of a company’s borrowing. After all expenses and
taxes are deducted, the “bottom line” is what remains, which is the
net income. The income statement shows profits, if revenues exceed
costs, and losses, if expenses exceed revenues, during a specified
period. You can compare these profits or losses with the profits or
losses in previous periods. Table 10–1 summarizes the features of
an income statement.
Analysts are always looking to see whether companies will meet
their revenue expectations for each quarter, which puts pressure on
companies to increase their revenues. This situation, unfortunately,
opened the door for many unscrupulous executives to overstate their
revenues to show growth when their revenues were declining. For
example, some telecommunications companies used fiber-swap
transactions to increase revenues through the sale of fiber-optic
capacity and then capitalized the fiber rather than expensed it. This
practice increased revenues and inflated earnings because the asset
was written off over time rather than expensing it. You can be
on the lookout for this type of practice by reading the revenue
recognition policies in the footnotes to the financial statements and
management’s discussion and analysis section, which can provide
additional information about the company’s use of accounting
principles.
Table 10-1
Features of an Income Statement
Summarizes revenues and expenses over a specified period
Measures revenues received from customers over a certain period
Measures the amounts spent on materials, labor, and overhead
Measures the amount of gross profit (sales minus cost of goods sold)
Measures the amount spent on selling, general, and administrative expenses
Measures operating profit (earnings before interest and taxes)
Measures the cost of borrowed funds
Summarizes the amount paid in taxes
Measures the profitability (net income) over a specified period
The gross margin is of interest to investors and analysts because
it shows a company’s efficiency in managing its costs to produce its
products. For example, Cisco System’s gross margin (sales minus
cost of goods sold divided by sales) was 64 percent in 2000, and it
decreased to 49.7 percent in 2001 and then increased to 63.5 percent
in 2002. The notes to the financial statement explain the reason for
the increase in gross margin from 2001 to 2002. The company wrote
off excess inventory in the third quarter of 2001. A drop in gross
margin was a signal to many stock investors to sell the stock.
Deducting total operating expenses from the gross margin
shows you the operating income (loss), also referred to as earnings
before interest and taxes (EBIT). After the interest payments are
deducted from (or interest income is added to) EBIT, the result is
taxable income, or earnings before taxes (EBT). Net income or loss is
EBT minus taxes, also referred to as the bottom line. Following the
net income figures in an income statement are the earnings per
share (EPS) figures (earnings minus preferred dividends divided
by the number of shares outstanding).
Balance Sheet
A balance sheet is a statement that shows a company’s financial
position at a specified point in time. The balance sheet lists a company’s
assets (all resources that belong to a company), liabilities
(the company’s obligations), and shareholders’ equity (the amount of
the stockholders’ capital).
Assets (resources) minus liabilities (obligations) equal shareholders’
equity. From this equation, anyone reading a balance sheet
can see how much the stockholders and creditors have contributed
to the financing of the total assets.
On the assets side of the balance sheet are current assets and
long-term assets. Current assets include cash, marketable securities,
accounts receivable, inventories, and all other resources that are
convertible into cash within one year. The cash generated from
these assets generally provides for the day-to-day expenses of
operations.
Long-term assets consist of resources with holding periods of
greater than a year. These include long-term investments, property,
plant and equipment, intangible assets (goodwill, patents, and
leasehold improvements, for example), and any other assets that
can be converted into cash in longer than one year. Property, plant,
and equipment are recorded on the balance sheet at cost, and these
tangible assets are depreciated (a systematic charge is recorded
against income for wear and tear) over their useful lives. Intangible
assets are amortized over their useful lives.
Analysts check to see whether any assets are significantly
undervalued. The historical cost concept used to record assets does
not recognize any increases in the market value of these assets until
they are sold. Thus property on the balance sheet that might have
been bought many years ago at low prices may be significantly
understated (in terms of its market value).
The liabilities side of the balance sheet is also divided into two
parts: current and long term. Current liabilities, or a company’s
obligations that fall due within one year or less, consist of account
and trade payables, accrued (unrecorded) expenses, and other
short-term debts. Long-term liabilities are a company’s debts that
have maturities beyond one year.
You should compare total current assets with total current
liabilities. The cash generated from the turnover of current assets to
cash generally is used to pay current obligations that fall due. If
current assets are equal to or less than current liabilities, a company
might have difficulty meeting its current obligations. This situation
raises warning flags. In the same vein, if current assets are significantly
lower than current liabilities, cash must come from selling
off long-term assets or raising more debt to pay off the current
liabilities. In this case, you should study the notes to the financial
statements to determine whether the company has open lines of
credit or other short- or long-term sources of credit.
The shareholders’ equity section represents the claims of the
shareholders against the company’s assets. A company’s total
assets minus its total liabilities equal the shareholders’ equity.
The three main parts of the equity section are the capital stock
accounts, the paid-in capital accounts, and the retained earnings
or deficit.
* The capital stock accounts include both common stock and
preferred stock issues. Multiplying the stated or par value
of the stock by the number of shares issued determines the
value of the stock accounts.
* The paid-in-capital accounts represent the amounts that
shareholders paid in excess of the stated (par) value in the
capital accounts when the company originally sold the
shares.
* Retained earnings are the accumulated earnings that have
been retained by the company, in other words, earnings that
have not been paid out in dividends. Companies accumulate
earnings for a number of reasons—namely, to acquire
fixed assets, pay down liabilities, or accumulate reserves for
contingencies. Retained earnings do not represent cash.
Even though a company might have accumulated a large
amount in retained earnings, it is still restricted by the
amount held in cash in terms of spending for projects.
Table 10–2 summarizes the features of a balance sheet.
Table 10-2
Elements of a Balance Sheet
Shows a company’s financial position at a particular point in time
Lists the types and amounts of assets that the company owns
Lists the current assets of a company (cash, accounts receivable, and inventory)
Shows the cost of a company’s fixed assets (land, buildings, and equipment)
Shows the accumulated depreciation of these assets
Lists the current debts (liabilities) that the company owes to suppliers and others
Lists the long-term debts of the company
Shows the amount invested by the company’s shareholders
Shows the earnings retained by the company
With a balance sheet, you can compare a company’s current
assets with its current liabilities. You also can determine the
amount of assets that are financed by debt as compared with the
assets financed from equity.
Statement of Shareholders’ Equity
The link between the income statement and the balance sheet is the
company’s net income (or loss) that is added to (or subtracted
from) retained earnings shown in the statement of changes to
shareholders’ equity. Dividends on common and preferred stocks
are paid out of net income, and the balance of the earnings is then
added to the retained earnings in the equity section of the balance
sheet. The statement of shareholders’ equity is the third statement
included in the financial statements of an annual report. From this
statement you can see how the earnings retained are used by the
company. For example, in 2002, Cisco Systems used its additional
income largely to repurchase its own shares.
Statement of Changes in Cash
A statement of changes in cash analyzes the changes in a company’s
cash over a specified period by showing the sources of and uses of
cash. The first of three sections in the statement, cash from operations,
shows how much cash was provided or used by the company’s
operations. The changes in the cash from investing section show
the uses and sources of cash from the purchases and sales of fixed
assets and investments. The changes in cash from financing section
summarize the uses and sources of cash from the changes in longterm
liabilities and equity sections of the balance sheet. Table 10–3
summarizes the features in a statement of changes in cash.
Table 10-3
Features of the Statement of Changes in Cash
Summarizes the major categories of sources and uses of cash to show what has
happened to the cash account during a period of time
Measures the noncash charges within the specified period
Shows the cash inflows and outflows from operations
Shows the cash amounts spent and received by buying and selling long-term assets
Shows the cash received from borrowing and cash used to repay debt
Shows the cash received from issuing common and preferred stocks and the cash
amounts used to buy back stock
Shows the amount of dividends paid
Cash flow is the amount of net cash generated by a business
over a certain period. To compute the cash flow, noncash expenses
are added to (or noncash revenues are deducted from) net income.
Noncash items are expenses (depreciation, amortization, and deferred
charges) and income that are not paid out or realized in
cash. This calculation explains why companies can have negative
earnings and still have positive cash flows.
Another, more refined measure of cash flow is free cash flow,
or cash flow minus capital spending (investments in net working
capital and long-term assets). Companies that do not generate
strong free cash flows have less flexibility, and this is recognized
most often in their stock prices. Table 10–4 discusses the value of
using cash flow to assess a company’s financial position.
Table 10-4
Cash Is Not as Easy to Manipulate as Earnings
Many companies manipulated their earnings during the economic downturn of
2000–2003. Health South overstated its earnings by $1.4 billion during the period
1999–2002 according to a guilty plea from its former chief executive officer.
WorldCom also overstated its profits by capitalizing expenses. These expenses
were amortized over a period of time rather than deducted as expenses in the
period in which they were incurred. The Dutch company Ahold also overstated its
profits, even though you might think that the supermarket business is more simple
and straightforward and would not lend itself to the manipulation of figures quite
like more complex forms of business such as the telecommunications industry.
The analysis of cash is a better tool for determining a company’s strengths and
weaknesses because cash is harder to manipulate than earnings. The cash flow
adequacy ratio (CFAR) gives a more accurate assessment of the profile of a
company (Hoens and Foley, 1994).
CFAR (which consists of cash flow after taxes, interest, and capital expenditures) is
net free cash flow, which is compared with the average annual principal debt
maturities over the next five-year period. Thomas W. Hoens and Keith B. Foley
(1994) used this CFAR analysis in the following example, which illustrated Enron’s
inability to generate positive cash flows in the years prior to its bankruptcy:
Enron Corporation CFAR Analysis 1996 to 2000
|
2000 |
1999 |
1998 |
1997 |
1996 |
Cumulative |
Revenues |
100,789 |
40,112 |
31,260 |
20,273 |
13,289 |
205,723 |
Costs |
98.836 |
39,310 |
29,882 |
20,258 |
12,599 |
200,885 |
EBIT |
1,953 |
802 |
1,378 |
15 |
690 |
4,838 |
Depr/Amo |
855 |
870 |
827 |
600 |
474 |
3,626 |
EBITDA |
2,808 |
1,672 |
2,205 |
615 |
1,164 |
8,464 |
Cash Interest |
834 |
678 |
585 |
420 |
290 |
2,807 |
Cash Taxes |
62 |
51 |
73 |
68 |
89 |
343 |
Capital Expenses |
2,381 |
2,363 |
1,905 |
1,392 |
864 |
8,905 |
NET FREE |
(469) |
(1,420) |
(358) |
(1,265) |
(79) |
(3,591) |
CASH FLOW |
|
|
|
|
|
|
Equity Invest (1) |
933 |
722 |
1,659 |
700 |
619 |
|
|
(1,402) |
(2,142) |
(2,017) |
(1,965) |
(698) |
(8,224) |
Depreciation and amortization, both noncash charges, were added back to earnings
before interest and taxes to equal earnings before interest, taxes, depreciation, and
amortization (EBITDA), which were positive for Enron for each year in the five-year
period shown in the example. However, when interest, taxes, and capital expenses
were deducted from EBITDA, Enron had negative free cash flows. This meant that
Enron did not have the cash to cover its scheduled debt maturities during the fiveyear
period, the payment of dividends, or the investments in its equity affiliates.*
Enron had a large number of transactions with affiliate companies that siphoned
off large amounts of cash. From this analysis, you can see why members of Enron
upper management went to such great lengths to hide its debt from its balance
sheet. Enron’s debt and dividend payments are listed below (Hoens, 2003):

Because net free cash flows were consistently negative in each of the five years,
a cash flow adequacy ratio for Enron would be meaningless (because the ratio
would be negative). A company with a negative trend of CFARs certainly raises
red flags for potential investors. Companies with CFARs between 0 and 1 indicate
that they are not generating sufficient cash to fund their expenditures and would
need access to outside sources of cash. A company with a CFAR higher than
1 generates sufficient cash to fund its major cash expenditures. You must look at
the trend as opposed to one year’s figures in isolation because companies with
strong cash flows in some years might have negative CFARs in other years
(Hoens, 2003).
Financial statements provide the data for an analysis of a
company’s financial position and an assessment of its strengths
and weaknesses. The relative financial position of the company in
relation to its past data and in relation to other companies in the
same industry provides a more meaningful picture than merely
looking at one set of financial statements in isolation. The company’s
strengths and weaknesses can become more apparent
through ratio analysis.
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