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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