merrill lynch

H O W T O R E A D A

FINANCIALREPORT

HOW TO READ A FINANCIAL REPORT

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GOALS OF THIS BOOKLET

An annual report is unfamiliar terrain to many people. For those who are notaccountants, analysts or financial planners,this booklet can help them to better under-stand such reports and possibly becomemore informed investors.

This booklet was written and designed to help educate and guide its readers so they might:

■ Better understand the data included infinancial reports and how to analyze it.

■ Learn more about companies that offeremployment or provide investmentopportunities.

A good starting point for achieving thesegoals is to become familiar with the maincomponents of a company’s annual report.

Please Note: Highlighted throughout thisbooklet are key selected terms and defini-tions as a reference for readers. See alsothe Glossary of Selected Terms in the back of this booklet.

COMPONENTS OF AN ANNUAL REPORT

Most annual reports have three sections: (1)The Letter to Shareholders, (2) the BusinessReview and (3) the Financial Review. Eachsection serves a unique function:

■ The Letter to Shareholders gives a broad overview of the company’s business and financial performance.

■ The Business Review summarizes a company’s recent developments,trends and objectives.

■ The Financial Review presents a company’s business performance in dollar terms and consists of the

“Management’s Discussion andAnalysis” and “Audited FinancialStatements.” It may also contain supplemental financial information.

In Management’s Discussion and Analysis(MD&A), a company’s managementexplains significant changes from year to yearin the financial statements. Although present-ed mainly in narrative format, the MD&Amay also include charts and graphs highlight-ing the year-to-year changes. The company’soperating results, financial position, changesin shareholders’ equity and cash flows arenumerically captured and presented in theaudited financial statements.

The financial statements generally consist ofthe balance sheet, income statement, state-ment of changes in shareholders’ equity,statement of cash flows and footnotes. Theannual financial statements usually areaccompanied by an independent auditor’sreport (which is why they are called “audited”financial statements). An audit is a systematicexamination of a company’s financial statements; it is typically undertaken by aCertified Public Accountant (CPA). The audi-tor’s report attests to whether the financialreports are presented fairly in keeping withgenerally accepted accounting principles,known as GAAP for short.

Following is a brief description or overviewof the basic financial statements, includingthe footnotes:

The Balance SheetThe balance sheet, also called statement offinancial position, portrays the financialposition of the company by showing whatthe company owns and what it owes at thereport date. The balance sheet may bethought of as a snapshot, since it reportsthe company’s financial position at a spe-cific point in time. Usually balance sheetsrepresent the current period and a previous

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period so that financial statement readerscan easily identify significant changes.

The Income StatementOn the other hand, the income statementcan be thought of more like a motion pic-ture, since it reports on how a companyperformed during the period(s) presentedand shows whether that company’s opera-tions have resulted in a profit or loss.

The Statement of Changes in Shareholders’ EquityThe statement of changes in shareholders’equity reconciles the activity in the equitysection of the balance sheet from period toperiod. Generally, changes in shareholders’equity result from company profits orlosses, dividends and/or stock issuances.(Dividends are payments to shareholdersto compensate them for their investment.)

The Statement of Cash FlowsThe statement of cash flows reports on the company’s cash movements during the period(s) separating them by operating,investing and financing activities.

The FootnotesThe footnotes provide more detailed infor-mation about the financial statements.

This booklet will focus on the basic financial statements, described above, and the related footnotes. It will alsoinclude some examples of methods thatinvestors can use to analyze the basicfinancial statements in greater detail.Additionally, to illustrate how these con-cepts apply to a hypothetical, but realistic business, this booklet will present andanalyze the financial statements of amodel company.

A MODEL COMPANY CALLED“TYPICAL”

To provide a framework for illustration, a fictional company will be used. It will be a public company (generally, onewhose shares are formally registered withthe Securities and Exchange Commission[SEC] and actively traded). A public com-pany will be used because it is required to provide the most extensive amount of information in its annual reports. Therequirements and standards for financialreporting are set by both governmentaland nongovernmental bodies. (The SEC is the major governmental body withresponsibility in this arena. The main nongovernmental bodies that set rules and standards are the FinancialAccounting Standards Board [FASB]*, the American Institute of Certified PublicAccountants [AICPA] and the exchangesthe securities trade on.

This fictional company will represent a typical corporation with the most com-monly used accounting and reportingpractices. Thus, the model company willbe called Typical Manufacturing Company,Inc. (or “Typical,” for short).

* The FASB is the primary, authoritative private-sector body that sets financial accounting standards.From time to time, these standards change andnew ones are issued. At this writing, the FASB is considering substantial changes to the currentaccounting rules in the areas of consolidations,segment reporting, derivatives and hedging, andliabilities and equity. Information regarding current,revised or new rules can be obtained by writing orcalling the Financial Accounting Standards Board,401 Merritt 7, P.O. Box 5116, Norwalk, CT06858-5116, telephone (203) 847-0700.

HOW TO READ A FINANCIAL REPORT

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The following pages show a sample of the core or basic financial statements—a balance sheet, an income statement, a statement of changes in shareholders’equity and a statement of cash flows forTypical Manufacturing Company.

However, before beginning to examinethese financial statements in depth, thefollowing points should be kept in mind:

■ Typical’s financial statements are illus-trative and generally representative for a manufacturing company. However,financial statements in certain special-ized industries, such as banks, broker-dealers, insurance companies and pub-lic utilities, would look somewhat dif-ferent. That’s because specializedaccounting and reporting principles and practices apply in these and otherspecialized industries.

■ Rather than presenting a complete setof footnotes specific to Typical, thisbooklet presents a listing of appropriategeneric footnote data for which a readerof financial statements should look.

■ This booklet is designed as a broad,general overview of financial reporting,not an authoritative, technical referencedocument. Accordingly, specific techni-cal accounting and financial reportingquestions regarding a person’s personalor professional activities should bereferred to their CPA, accountant orqualified attorney.

■ To simplify matters, the statementsshown in this booklet do not illustrateevery SEC financial reporting rule andregulation.

For example, the sample statements pre-sent Typical’s balance sheet at two year-ends; income statements for two years;and a statement of changes in sharehold-ers’ equity and statement of cash flows fora one-year period. To strictly comply withSEC requirements, the report would haveincluded income statements, statements of changes in shareholders’ equity andstatements of cash flows for three years.Also, the statements shown here do notinclude certain additional informationrequired by the SEC. For instance, it doesnot include: (1) selected quarterly finan-cial information (including recent marketprices of the company’s common stock),and (2) a listing of company directors andexecutive officers.

Further, the “MD&A” will not be presentednor will examples of the “Letter toShareholders” and the “Business Review”be provided because these are not “core”elements of an annual report. Rather, they are generally intended to be explana-tory, illustrative or supplemental in nature.To elaborate on these supplemental com-ponents could detract from this booklet’sprimary focus and goal: Providing readerswith a better understanding of the core or basic financial statements in an annual report.

A FEW WORDS BEFORE BEGINNING

CONSOLIDATED BALANCE SHEETS

(Dollars in Thousands, Except Per-Share Amounts)

December 31

19X9 19X8Assets

Current Assets:

Cash and cash equivalents $19,500 $15,000Marketable securities 46,300 32,000Accounts receivable—net of allowance

for doubtful accounts of $2,375 in 19X9 and $3,000 in 19X8 156,000 145,000

Inventories, at the lower of cost or market 180,000 185,000Prepaid expenses and other current assets 4,000 3,000

Total Current Assets 405,800 380,000

Property, Plant and Equipment:

Land 30,000 30,000 Buildings 125,000 118,500Machinery 200,000 171,100Leasehold improvements 15,000 15,000Furniture, fixtures, etc. 15,000 12,000

Total property, plant and equipment 385,000 346,600

Less: accumulated depreciation 125,000 97,000

Net Property, Plant and Equipment 260,000 249,600

Other Assets:

Intangibles (goodwill, patents)—net of accumulated amortizationof $300 in 19X9 and $250 in 19X8 1,950 2,000

Investment securities, at cost 300 —

Total Other Assets 2,250 2,000

Total Assets $668,050 $631,600

See Accompanying Notes to Consolidated Financial Statements.** See pages 40-41 for examples of the types of data that might appear in the notes to a company’s financial statements.4

CONSOLIDATED FINANCIAL STATEMENTSTypical

ManufacturingCompany,

Inc.

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December 31

19X9) 19X8)Liabilities and Shareholders’ Equity

Liabilities:Current Liabilities:

Accounts payable $60,000) $57,000)Notes payable 51,000) 61,000)Accrued expenses 30,000) 36,000)Income taxes payable 17,000) 15,000)Other liabilities 12,000) 12,000)Current portion of long-term debt 6,000) —)

Total Current Liabilities 176,000) 181,000)

Long-term Liabilities:)Deferred income taxes 16,000) 9,000)9.12% debentures payable 2010 130,000) 130,000)Other long-term debt —) 6,000)

Total Liabilities 322,000) 326,000)

Shareholders’ Equity:Preferred stock, $5.83 cumulative,

$100 par value; authorized, issuedand outstanding: 60,000 shares 6,000) 6,000)

Common stock, $5.00 par value,authorized: 20,000,000 shares;issued and outstanding: 19X9 - 15,000,000 shares, 19X8 - 14,500,000 shares 75,000) 72,500)

Additional paid-in capital 20,000) 13,500)Retained earnings 249,000) 219,600)Foreign currency translation

adjustments (net of taxes) 1,000) (1,000)Unrealized gain on available-for-sale securities

(net of taxes) 50) —)Less: Treasury stock at cost

(19X9 and 19X8 - 1,000 shares) (5,000) (5,000)

Total Shareholders’ Equity 346,050) 305,600)

Total Liabilities and Shareholders’ Equity $668,050) $631,600)



Inc.

CONSOLIDATED INCOME STATEMENTS

CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY

(Dollars in Thousands) Year Ended December 31, 19X9

ForeignAdditional currency Unrealized

Preferred Common paid-in Retained translation security Treasurystock stock capital earnings adjustments gain stock Total

Balance Jan. 1, 19X9 $6,000 $72,500 $13,500 $219,600) ($1,000) — ($5,000) $305,600)Net income 47,750) 47,750)Dividends paid on:

Preferred stock (350) (350)Common stock (18,000) (18,000)

Common stock issued 2,500 6,500 9,000)Foreign currency

translation gain 2,000) 2,000)Net unrealized gain on

available-for-sale securities $50 $50)

Balance Dec. 31, 19X9 $6,000 $75,000 $20,000 $249,000) $1,000) $50 ($5,000) $346,050)

See Accompanying Notes to Consolidated Financial Statements

(Dollars in Thousands, Except Per-Share Amounts) Years Ended December 31,19X9 19X8

Net sales $765,050) $725,000)Cost of sales 535,000) 517,000)Gross margin 230,050) 208,000)Operating expenses:Depreciation and amortization 28,050) 25,000)Selling, general and administrative expenses 96,804) 109,500)

Operating income 105,196) 73,500)Other income (expense):Dividend and interest income 5,250) 10,000)Interest expense (16,250) (16,750)Income before income taxes and extraordinary loss 94,196) 66,750)Income taxes 41,446) 26,250)Income before extraordinary loss 52,750) 40,500)Extraordinary item: loss on earthquake destruction (net of income tax benefit of $750) (5,000) —)

Net income $47,750) $40,500)

Earnings per common share:Before extraordinary loss $3.55) $2.77)Extraordinary loss (.34) —)

Net income per common share $3.21) $2.77)

See Accompanying Notes to Consolidated Financial Statements

CONSOLIDATED FINANCIAL STATEMENTS

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TypicalManufacturing

Company,Inc.

CONSOLIDATED STATEMENT OF CASH FLOWS

(Dollars in Thousands) Year Ended December 31, 19X9

Cash flows from operating activities:Net income $47,750)

Adjustments to reconcile net income tonet cash from operating activities:Depreciation and amortization 28,050)Increase in accounts receivable (11,000)Decrease in inventory 5,000)Increase in prepaid expenses and other current assets (1,000)Increase in deferred taxes 7,000)Increase in accounts payable 3,000)Decrease in accrued expenses (6,000)Increase in income taxes payable 2,000)Total adjustments 27,050)

Net cash provided by operating activities 74,800)

Cash flows from investing activities:Securities purchases:

Trading (14,100)Held-to-maturity (350)Available-for-sale (150)

Principal payment received on held-to-maturity securities 50Purchase of fixed assets (38,400)

Net cash used in investing activities (52,950)

Cash flows from financing activities:Payment of notes payable (10,000)Proceeds from issuance of common stock 9,000)Payment of dividends (18,350)

Net cash used in financing activities (19,350)

Effect of exchange rate changes on cash 2,000

Increase in cash 4,500Cash and cash equivalents at beginning of year 15,000

Cash and cash equivalents at the end of year $19,500

Income tax payments totaled $3,000 in 19X9.Interest payments totaled $16,250 in 19X9.

See Accompanying Notes to Consolidated Financial Statements 7



Inc.

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The balance sheet represents the financialpicture for Typical Manufacturing as itstood at the end of one particular day, Dec. 31, 19X9, as though the companywere momentarily at a standstill. Typical’sbalance sheet for the previous year end isalso presented. This makes it possible tocompare the composition of the balancesheets on those dates.

The balance sheet is divided into two halves:

1. Assets, always presented first (either on the top or left side of the page);

2. Liabilities and Shareholders’ Equity(always presented below or to the right of Assets).

In the standard accounting model, the formula of Assets = Liabilities + Share-holders’ Equity applies. As such, bothhalves are always in balance. They are also in balance because, from an econom-ic viewpoint, each dollar of assets must be“funded” by a dollar of liabilities or equity.(Note: this is why this statement is called abalance sheet.)

Reported assets, liabilities, and sharehold-ers’ equity are subdivided into line items or groups of similar “accounts” having a dollar amount or “balance.”

■ The Assets section includes all thegoods and property owned by the company, and uncollected amountsdue (“receivables”) to the companyfrom others.

■ The Liabilities section includes alldebts and amounts owed (“payables”) to outside parties and lenders.

■ The Shareholders’ Equity section repre-sents the shareholders’ ownership inter-est in the company—what the compa-ny’s assets would be worth after allclaims upon those assets were paid.

Now, to make it easier to understand thecomposition of the balance sheet, each of its sections and the related line itemswithin them will be examined one-by-onestarting on page 9. To facilitate this walk-through, the balance sheet has been sum-marized, this time numbering each of itsline items or accounts. In the discussionthat follows, each line item and how itworks will be explained. After examiningthe balance sheet, the income statementwill be analyzed using the same method-ology. Then, the other financial statementswill be broken down element-by-elementfor similar analysis.

A NOTE ABOUT NUMBERS AND CALCULATIONS Before beginning, however, it’s important to clarify how the numbers, calculations andnumerical examples are presented in this booklet. All dollar amounts relating to the financialstatements are presented in thousands of dollars with the following exceptions: (1) Per-share or share amounts are actual amounts; (2) actual amounts are used for accuracyof calculation in certain per-share computations; and (3) actual amounts are used in certainexamples to illustrate a point about items not related to, nor shown in, the model financialstatements. The parenthetical statement “(Actual Amounts Used )” will further identifyamounts or computations where figures do not represent thousands of dollars.

THE BALANCE SHEET


(Dollars in Thousands, Except Per-Share Amounts) December 31

19X9 19X8Assets

Current Assets:1 Cash and cash equivalents $19,500 $15,000

2 Marketable securities 46,300 32,000

3 Accounts receivable—net of 156,000 145,000allowance for doubtful accounts

4 Inventories 180,000 185,000

5 Prepaid expenses and other current assets 4,000 3,0006 Total Current Assets 405,800 380,0007 Total Property, plant and equipment 385,000 346,600

8 Less: accumulated depreciation 125,000 97,000

9 Net Property, Plant and Equipment 260,000 249,600

Other Assets:10 Intangibles (goodwill, patents)— 1,950 2,000

net of accumulated amortization

11 Investment securities, at cost 300 —

Total Other Assets 2,250 2,000

12 Total Assets $668,050 $631,600

CURRENT ASSETSIn general, current assets include cash and thoseassets that, in the normal course of business, will be turned into cash within a year from the balance-sheet date. Current assets are listed on the balancesheet in order of their “liquidity” or amount of time ittakes to convert them into cash.

Cash and Cash EquivalentsThis, just as expected, is money on deposit in thebank, cash on hand (petty cash) and highly liquidsecurities such as Treasury bills.

1 Cash and cash equivalents $19,500

Marketable SecuritiesExcess or idle cash that is not needed immediatelymay be invested in marketable securities. These areshort-term securities that are readily salable and usually have quoted prices. These may include:

■ Trading securities—debt and equity securities,bought and sold frequently, primarily to generateshort-term profits and which are carried at fair mar-ket value. Any changes in such values are includedin earnings. (Fair market value is the price at whicha buyer and seller are willing to exchange an assetin other than a forced liquidation.)

THE BALANCE SHEET

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ASSETS

THE BALANCE SHEET

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■ Held-to-maturity securities—debt secu-rities that the company has the abilityand intent to hold to maturity. “Maturity”is the date when debt instruments, suchas Treasury bills, are due and payable.These securities are reported at amor-tized cost (original cost adjusted forchanges in any purchase discount orpremium less any principal paymentsreceived). (Debt amortization is thepractice of adjusting the original cost of a debt instrument as principal pay-ments are received and writing off anypurchase discount or premium toincome over the life of the instrument.)

■ Available-for-sale securities—debt orequity securities not classified as eithertrading or held-to-maturity. They arerecorded at fair value with unrealizedchanges in their value, net of taxes,reported in stockholders’ equity. (Net of taxes means that the value oramount has been adjusted for theeffects of applicable taxes.)

In Typical’s case, it owns short-term, high-grade commercial paper, classified as “trading securities” and preferred stock,classified as “available-for-sale.” Typical,however, has no short-term “held-to-matu-rity” securities (although it does have an investment in publicly traded mortgage bonds, a long-term “held-to-maturity” debt security, which will be discussed a bit later).

2 Marketable securities:

Trading securities $46,100

Available-for-sale 200

$46,300

Accounts ReceivableHere are found the amounts due from customers that haven’t been collected as yet.When goods are shipped to customers beforepayment or collection, an account receivableis recorded. Customers are usually given 30,60 or 90 days in which to pay. The totalamount due from customers is $158,375.

However, experience shows that somecustomers fail to pay their bills (for example,because of financial difficulties), giving riseto accounts of doubtful collectibility. Thissimply means it is unlikely that the entirebalance recorded as due and receivable willbe collected. Therefore, in order to show theaccounts receivable balance at a figure rep-resenting expected receipts, an allowancefor doubtful accounts is deducted from thetotal amount recorded. This year end, theallowance for doubtful accounts was $2,375.

3 Accounts receivable— $158,375)

Less: allowance for

doubtful accounts (2,375)

$156,000)

InventoryInventory for a manufacturing companyconsists of: (1) Raw materials—items tobe used in making a product (for exam-ple, the silk fabric used in making a silkblouse); (2) work-in-process—partiallycompleted goods in the process of manu-facture (for example, pieces of fabric suchas a sleeve and cuff sewn together duringthe process of making a silk blouse) and(3) finished goods—completed items readyfor shipment to customers. Generally, theamount of each of the above types of inven-tory would be disclosed either on the face

THE BALANCE SHEET

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of the balance sheet or in the footnotes. ForTypical, inventory represents the cost ofitems on hand that were purchasedand/or manufactured for sale to customers.In valuing inventories, the lower of costor market rule or method is used. Thisgenerally accepted rule or method valuesinventory at its cost or market price,whichever is lower. (Here market value,or market price is the current cost ofreplacing the inventory by purchase ormanufacture, as the case may be, withcertain exceptions.) This provides aconservative figure. The value for balance-sheet purposes under this methodusually will be cost. However, wheredeterioration, obsolescence, a decline in prices or other factors are expected to result in the selling or disposing ofinventories below cost, the lower marketprice would be used.

Usually, a manufacturer’s inventoriesconsist of quantities of physical productsassembled from various materials.Inventory valuation includes the directcosts of purchasing the various materialsused to produce the company’sproducts and an allocation (that is, anapportionment or dividing up) of theproduction expenses to make thoseproducts. Manufacturers use costaccounting systems to allocate suchexpenses. (“Cost accounting” focuses onspecific products and is a specialized setof accounting procedures that are used todetermine individual product costs.)When the individual costs for inventoryare added up, they comprise the inventoryvaluation.

4 Inventories $180,000

Prepaid ExpensesDuring the year, Typical paid fire insur-ance premiums and advertising charges forperiods after the balance-sheet date. SinceTypical has the contractual right to thatinsurance and advertising service after thebalance-sheet date, it has an asset, whichwill be used after year end. Typical hassimply “prepaid”—paid in advance—forthe right to use this service. Of course, if these payments had not been made, the company would have more cash in the bank. Accordingly, payments made forwhich the company had not yet receivedbenefits, but for which it will receive ben-efits within the year, are listed among cur-rent assets as prepaid expenses.

5 Prepaid expenses

and other current assets $4,000

TOTAL CURRENT ASSETS

To summarize, the “Total Current Assets”item includes primarily cash, marketablesecurities, accounts receivable, inventoriesand prepaid expenses.

6 Total Current Assets $405,800

These assets are “working” assets in thesense that they are “liquid”—meaning theycan and will, in the near term, be convert-ed into cash for other business purposes orconsumed in the business. Inventories,when sold, become accounts receivable;receivables, upon collection, become cash;and the cash can then be used to pay thecompany’s debts and operating expenses.

THE BALANCE SHEET

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Property, Plant and Equipment

Property, plant and equipment (oftenreferred to as fixed assets) consists ofassets not intended for sale that are used to manufacture, display, warehouse andtransport the company’s products andhouse its employees. This categoryincludes land, buildings, machinery,equipment, furniture, automobiles andtrucks. The generally accepted method for reporting fixed assets is cost minus the depreciation accumulated through thedate of the balance sheet. Depreciationwill be defined and explained further in discussing the next topic.

Property, Plant and Equipment:

Land $30,000

Buildings 125,000

Machinery 200,000

Leasehold improvements 15,000

Furniture, fixtures, etc. 15,000

7 Total property, plant

and equipment $385,000

The figure displayed is not intendedto reflect present market value orreplacement cost, since generally thereis no intent to sell or replace theseassets in the near term. The cost toultimately replace plant and equipmentat some future date might, and probablywill, be higher.

DepreciationThis is the practice of charging to, orexpensing against income, the cost ofa fixed asset over its estimated usefullife. (Estimated useful life is the pro-

jected period of time over which anasset is expected to have productive orcontinuing value to its owner.)Depreciation has been defined foraccounting purposes as the decline inuseful value of a fixed asset due to“wear and tear” from use and thepassage of time.

The cost of acquired property, plant andequipment must be allocated over itsexpected useful life, taking intoconsideration the factors discussedabove. For example, suppose a deliverytruck costs $10,000 and is expected tolast five years. Using the “straight-linemethod of depreciation” (equal periodicdepreciation charges over the life of theasset), $2,000 of the truck’s cost ischarged or expensed to each year’sincome statement. The balance sheet atthe end of one year would show:

(Actual Amounts Used)

Truck (cost) $10,000)

Less:

accumulated depreciation (2,000)

Net depreciated cost $ 8,000)

At the end of the second year it wouldshow:


Truck (cost) $10,000)

Less:

accumulated depreciation (4,000)

Net depreciated cost $ 6,000)

THE BALANCE SHEET

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In Typical’s balance sheet, an amountis shown for accumulated depreciation.This amount is the total of accumulateddepreciation for buildings, machinery,leasehold improvements and furnitureand fixtures. Land is not subject todepreciation, and, generally, its reportedbalance remains unchanged from yearto year at the amount for which it wasacquired.

8 Less: accumulated

depreciation $125,000

Thus, net property, plant and equipment isthe amount reported for balance-sheet pur-poses of the investment in property, plantand equipment. As explained previously, it consists of the cost of the various assetsin this classification, less the depreciationaccumulated to the date of the financialstatement (net depreciated cost).

9 Net Property, Plant

and Equipment $260,000

Depletion is a term used primarily by min-ing and oil companies or any of the so-called extractive industries. Since TypicalManufacturing is not in any of these busi-nesses, depletion is not shown in its finan-cial statements. To “deplete” means toexhaust or use up. As oil or other naturalresources are used up or sold, depletion isrecorded (as a charge against income anda reduction from its cost) to recognize theamount of natural resources sold, consumed or used to date.

Deferred ChargesDeferred charges are expenditures foritems that will benefit future periodsbeyond one year from the balance-sheetdate; for example, costs for introduction of a new product to the market or theopening of a new location. Deferredcharges are similar to prepaid expenses, but are not included in current assetsbecause the benefit from such expendi-tures will be reaped over periods after one year from the balance-sheet date. (To “defer” means to put off or postpone to a future time.) The expenditure incurredwill be gradually written off over the futureperiod(s) that benefit from it, rather thanfully charged off in the year payment ismade. Typical’s balance sheet shows nodeferred charges because it has none.Deferred charges would normally beincluded just before Intangibles in theAssets section of the balance sheet.

IntangiblesIntangible assets (or “intangibles”) areassets having no physical existence, yethaving substantial value to the company.Examples are a franchise to a cable TVcompany allowing exclusive service in certain areas, a patent for exclusive manu-facture of a specific article, a trademark ora copyright.

Another intangible asset often found in corporate balance sheets is goodwill,which represents the amount by which the price of an acquired company exceedsthe fair value of the related net assetsacquired. This excess is presumed to bethe value of the company’s name, reputa-tion, customer base, intellectual capital andworkforce (their know-how, experience,managerial skills and so forth.)

THE BALANCE SHEET

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Intangible assets reported on the balancesheet are generally those purchased fromothers. Intangible assets are amortized(gradually reduced or written off, a processreferred to as amortization) by periodiccharges against income over their estimat-ed useful lives, but in no case for longerthan 40 years. The value of Typical’s intan-gible assets, reduced by the total amountof these periodic charges against income(accumulated amortization), results in afigure for Typical’s net intangible assets.

10 Intangibles

(goodwill, patents)— $ 2,250)

Less: accumulated

amortization (300)

Net intangible assets $1,950)

Investment SecuritiesInvestments in debt securities are carried at amortized cost only when they qualify as “held-to-maturity.” To so qualify, theinvestor must have the positive intent andthe ability to hold those securities untilthey mature. Early in 19X9, Typical pur-chased on the New York Stock Exchangemortgage bonds issued by one of its majorsuppliers. These bonds are due in full infive years and bear interest at 8% per year.In 19X9, the issuer made an unscheduledprincipal prepayment of $50. Since Typicalintends to maintain a continuing relation-ship with this supplier and to hold thebonds until they mature—and appears to have the financial strength to do so—this investment is classified as “held-to-maturity.”

11 Investment securities, at cost

8% mortgage bonds due

19Y4, original cost $350)

Less: principal prepayment

in 19X9 (50)

Investment securities

at amortized cost $300)

However, this investment must also bereviewed to ensure that it is probable thatall contractually specified amounts arefully collectible. If not fully collectible, thisinvestment would be considered perma-nently impaired. If such permanentimpairment were found to exist, it wouldbe necessary to write this investment downto its fair value. In this case, however, theissuer is in a strong financial condition.This is evidenced in two ways. First, theissuer made an unscheduled prepaymentof principal. Second, the property valueshave increased significantly where thiswell-maintained plant that secures thesebonds is located. As such, there is no reason to suspect that all contractualamounts will not be collected. Thus, there is no impairment, and no write down is necessary.

TOTAL ASSETS

All of these assets (line items 1 to 11),added together, make up the figure for the line item “Total Assets“ in Typical’s balance sheet.

12 Total Assets $668,050

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THE BALANCE SHEET

LIABILITIES AND SHAREHOLDERS’ EQUITY

CURRENT LIABILITIES

A current liability, in general, is an obligation that is due and payable within12 months. The “current liabilities” item in the balance sheet is a companion to“current assets” because current assets arethe source for payment of current debts.The relationship between the two isrevealing. This relationship will beexplored more closely a bit later. For now, however, the discussion will focus on the definition of the components ofcurrent liabilities.

Accounts PayableAccounts payable is the amount the com-pany owes to its regular business creditorsfrom whom it has bought goods or ser-vices on open account.

13 Accounts payable $60,000

Notes PayableIf money is owed to a bank, individual,corporation or other lender under apromissory note, and it is due within oneyear of the balance sheet date, it appearsunder notes payable. It is evidence thatthe borrower named in the note is respon-sible for carrying out its terms, such asrepaying the loan principal plus any inter-est charges. Notes may also be due afterone year from the balance-sheet datewhen they would be included in long-term debt.

14 Notes payable $51,000

Accrued ExpensesAs discussed, accounts payable areamounts owed by the company to its regular business creditors for routine purchases. The company also owes, onany given day, salaries and wages to itsemployees, interest on funds borrowedfrom banks and bondholders, fees to attorneys and similar items. The totalamount of such items owed, but unpaid atthe date of the balance sheet, are groupedas a total under accrued expenses.

15 Accrued expenses $30,000

Income Taxes PayableIncome taxes payable are the amountsdue to taxing authorities (such as theInternal Revenue Service and various state,foreign and local taxing agencies) withinone year from the balance-sheet date. Forfinancial-reporting purposes, they aretreated the same as an accrued expense.However, companies that owe a materialamount of taxes, as Typical does here,often report income taxes payable as aseparate line item under the CurrentLiabilities caption in the balance sheet.

16 Income taxes payable $17,000

LIABILITIES AND SHAREHOLDERS’ EQUITY

THE BALANCE SHEET

16


December 31

19X9 19X8Liabilities and Shareholders’ Equity

Liabilities:Current Liabilities:13 Accounts payable $60,000 $57,000 14 Notes payable 51,000 61,000 15 Accrued expenses 30,000 36,000 16 Income taxes payable 17,000 15,000 17 Other liabilities 12,000 12,000 18 Current portion of long-term debt 6,000 —

19 Total Current Liabilities 176,000 181,000

Long-term Liabilities:

20 Deferred income taxes 16,000 9,000 21 9.12% debentures payable 2010 130,000 130,000 22 Other long-term debt — 6,000

23 Total Liabilities 322,000 326,000

Shareholders’ Equity:24 Preferred stock, $5.83 cumulative,

$100 par value; authorized, issuedand outstanding: 60,000 shares 6,000 6,000

25 Common stock, $ 5.00 par value,authorized: 20,000,000 shares;issued and outstanding: 19X9 – 15,000,000 shares,19X8 – 14,500,000 shares 75,000 72,500

26 Additional paid-in capital 20,000 13,500 27 Retained earnings 249,000 219,600 28 Foreign currency translation adjustments (net of tax) 1,000 (1,000)29 Unrealized gain on available-for-sale securities

(net of taxes) 50 —30 Less: Treasury stock at cost

(19X9 and 19X8 – 1,000 shares) (5,000) (5,000)

31 Total Shareholders’ Equity 346,050 305,600

32 Total Liabilities and Shareholders’ Equity $668,050 $631,600


THE BALANCE SHEET

17

Other Current LiabilitiesSimply stated, these are any other liabili-ties that are payable within 12 months, butwhich haven’t been captured in any of theother specific categories presented as cur-rent liabilities in the balance sheet.

17 Other liabilities $12,000

Current Portion of Long-Term DebtCurrent portion of long-term debt repre-sents the amount due and payable within12 months of the balance-sheet date underall long-term (longer than one year) bor-rowing arrangements. In Typical’s case, this is the scheduled repayment of a$6,000 five-year note taken out by Typicalfour years ago and due next year. If Typicalhad a long-term borrowing calling formonthly payments (on a mortgage, forexample), the sum of the principal pay-ments due in the 12 months following thebalance-sheet date would appear here.

18 Current portion

of long-term debt $6,000

TOTAL CURRENT LIABILITIES

19 Total Current Liabilities $176,000

Finally, the “Total Current Liabilities” itemsums up all of the items listed under thisclassification.

LONG-TERM LIABILITIESCurrent liabilities include amounts due“within one year” from the balance-sheetdate. Long-term liabilities are amountsdue “after one year” from the date of thefinancial report, such as unfunded retiree

benefit obligations. (Typical’s balancesheet does not show this obligation.)

Deferred Income TaxesOne of the long-term liabilities on the samplebalance sheet is deferred income taxes.Deferred income taxes are tax liabilities acompany may postpone paying until somefuture time, often to encourage activities forthe public’s good. The opposite of deferredincome tax liabilities are deferred income taxassets. They are future income tax credits rec-ognized in advance of actually receivingthem. Typical has not recorded any futureincome tax credit assets.

The government provides businesses with taxincentives to make certain kinds of investmentsthat will benefit the economy as a whole. Forinstance, for tax-reporting purposes, a compa-ny can take accelerated depreciation deduc-tions on its tax returns for investments in plantand equipment while using less rapid, moreconventional depreciation for financial-reporting purposes. These rapid write-offs fortax purposes in the early years of investmentreduce the amount of tax the company wouldotherwise owe currently (within 12 months)and defer payment into the future (beyond 12months). However, at some point, the taxesmust be paid. To recognize this future liability,companies include a charge for deferredtaxes in their provision for tax expense in the income statement and show what the taxprovision would be without the acceleratedwrite-offs. The liability for that charge is reported as a long-term liability since it relatesto property, plant and equipment (a noncur-rent or long-term asset). [The classification ofdeferred tax amounts follows the classificationof the item that gives rise to it.]

20 Deferred income taxes $16,000

THE BALANCE SHEET

18

DebenturesThe other long-term liability with a bal-ance on Typical’s 19X9 balance sheet isthe 9.12% debentures due in 2010. Themoney was received by the company as aloan from the bondholders, who in turnwere given certificates called bonds, asevidence of the loan. The bonds are reallyformal promissory notes issued by thecompany, which it agreed to repay atmaturity in 2010 and on which it agreedto pay interest at the rate of 9.12% peryear. Bond interest is usually payablesemiannually. Typical’s bond issue iscalled a debenture because the bonds are backed only by the general credit ofthe corporation rather than by specificcompany assets.

Companies can also issue secured debt (for example, mortgage bonds), whichoffers bondholders an added safeguardbecause they are secured by a mortgageon all or some of the company’s property.If the company is unable to pay the bonds when they are due, holders of mortgagebonds have a claim or lien before othercreditors (such as debenture holders) onthe mortgaged assets. In other words,these assets may be sold and the proceedsused to satisfy the debt owed the mortgagebondholders.

21 9.12% debentures

payable 2010 $130,000

Other Long-Term DebtOther long-term debt includes all debtdue after one year from the balance-sheetdate other than what is specifically report-ed elsewhere in the balance sheet. InTypical’s case, this debt is a $6,000, single-payment loan made four years ago,which is scheduled for payment in fullnext year. This loan was reported as long-term debt at the end of 19X8 and, since it is payable in full next year, and it nolonger qualifies as a long-term liability, isreported as current portion of long-termdebt at the end of 19X9.

22 Other long-term debt —

TOTAL LIABILITIES

Current and long-term liabilities aresummed together to produce the figurereported on the balance sheet as “Total Liabilities.”

23 Total Liabilities $322,000

SHAREHOLDERS’ EQUITY

This item is the total equity interest that all shareholders have in this corporation. In other words, it is the corporation’s networth or its assets after subtracting all of its liabilities. This is separated for legal and accounting reasons into the categoriesdiscussed on the following pages.

Capital StockCapital stock represents shares in the own-ership of the company. These shares arerepresented by the stock certificates issuedby the corporation to its shareholders. A corporation may issue several differentclasses of shares, each class having slightlydifferent attributes.

Preferred StockPreferred stock is an equity ownershipinterest that has preference over commonshares with regard to dividends and thedistribution of assets in case of liquidation. Details about the preferences applicable to this type of stock can be obtained fromprovisions in a corporation’s charter.

In Typical’s case, the preferred stock is a $5.83 cumulative $100 par value. (Par value is the nominal or face value of a security assigned to it by its issuer.)The $5.83 is the yearly per-share dividendto which each preferred shareholder isentitled before any dividends are paid tothe common shareholders. “Cumulative”means that if in any year the preferred dividend is not paid, it accumulates (con-tinues to grow) in favor of preferred share-holders. The total unpaid dividends mustbe declared and paid to these sharehold-ers when available and before any divi-dends are distributed on the commonstock. Generally, preferred shareholdershave no voice in company affairs unlessthe company fails to pay them dividends at the promised rate.

24 Preferred stock, $5.83 cumulative,

$100 par value; authorized

issued and outstanding:

60,000 shares $6,000

Common StockAlthough preferred shareholders are enti-tled to dividends before common share-holders, their entitlement is generally lim-ited (in Typical’s case to $5.83 per share,annually). Common stock has no suchlimit on dividends payable each year. Ingood times, when earnings are high, divi-dends may also be high. And when earn-ings drop, so may dividends. Typical’scommon stock has a par value of $5.00per share. In 19X9, Typical sold 500,000shares of stock for a total of $9,000. Ofthe $9,000, $2,500 is reported as commonstock (500,000 shares at a par value of$5.00). The balance, $6,500, is reported as additional paid-in capital, as discussedunder the next heading. When added tothe prior year-end’s common stock bal-ance of $72,500, the $2,500 brings thecommon stock balance to $75,000.

25 Common stock, $5.00 par value,

authorized: 20,000,000 shares;

issued and outstanding:

15,000,000 shares $75,000

Additional Paid-In CapitalAdditional paid-in capital is the amountpaid by shareholders in excess of the paror stated value of each share. In 19X9,paid-in capital increased by the $6,500discussed in the previous paragraph.When this amount is added to last year’sending balance of $13,500, additionalpaid-in capital at Dec. 31, 19X9, comes to $20,000.

26 Additional paid-in capital $20,000

THE BALANCE SHEET

19

THE BALANCE SHEET

20

Retained EarningsWhen a company first starts in business, it has no retained earnings. Retained earn-ings are the accumulated profits the com-pany earns and reinvests or “retains” inthe company. (In less successful compa-nies where losses have exceeded profitsover the years, those accumulated netlosses will be reported as an “accumulateddeficit.”) In other words, retained earningsincrease by the amount of profits earned,less dividends declared to shareholders. If, at the end of its first year, profits are$80,000, dividends of $100 are paid on the preferred stock, and no dividends

are declared on the common, the balancesheet will show retained earnings of$79,900. In the second year, if profits are$140,000 and Typical pays $200 in divi-dends on the preferred and $400 on thecommon, retained earnings will be$219,300.

The Dec. 31, 19X9, balance sheet forTypical shows the company has accumu-lated $249,000 in retained earnings. Thetable below presents retained earningsfrom start-up through the end of 19X9.)

Balance at start-up $0)

Profit in year 1 80,000)

Preferred dividends in year 1 (100)

Retained earnings : End of year 1 79,900)

Profit in year 2 140,000)

Dividends in year 2: Preferred (200)Common (400)

Retained earnings: End of year 2 219,300)

Aggregate profits: Year 3 through 19X8 800,000)

Aggregate dividends: Year 3 through 19X8 (799,700)

Retained earnings: 12/31/X8 and 1/1/X9 219,600)

Net income: 19X9 47,750)

Dividends: 19X9Preferred (350)Common (18,000)

Retained earnings: 12/31/X9 $249,000)

27 Retained earnings $249,000

Calculation: Accumulated Retained Earnings

THE BALANCE SHEET

21

Foreign Currency TranslationAdjustments (Net of Taxes)When a company has an ownership inter-est in a foreign entity, it may be required to include that entity’s results in the com-pany’s consolidated financial statements. If that requirement applies, the financialstatements of the foreign entity (prepared in foreign currency) must be translatedinto U.S. dollars. The gain or loss resultingfrom this translation, after the related taxexpense or benefit, is reflected as a sepa-rate component of shareholders’ equityand is called foreign currency translationadjustments. This adjustment should bedistinguished from conversion gains orlosses relating to completed transactionsthat are denominated in foreign curren-cies. Conversion gains or losses areincluded in a company’s net income.

28 Foreign currency translation

adjustments (net of taxes) $1,000

Unrealized Gain on Available-for-Sale Securities (Net of Taxes)Unrealized gain/loss is the change in thevalue (gain or loss) of securities classifiedas “available-for-sale” that are still beingheld. In Typical’s case, this represents thedifference (a gain here) between the cost(or previously reported fair market value)of investment securities classified as“available-for-sale” held at the balance-sheet date and their fair market value atthat time. Since Typical still holds thesesecurities and has not yet sold them, suchdifferences have not been realized. Assuch, this unrealized amount is not includ-ed in the determination of current income.However, since these securities must bereported at their fair market value, thechanges in that fair market value sincepurchase (or the previously report date)are reported, after the related income tax

expense or benefit, as a separate compo-nent of shareholders’ equity. On Dec. 31,19X9, the total fair market value of thesesecurities exceeded their cost by $65.However, that gain would have increasedtax expense by $15, producing a net unrealized gain of $50. If these securitiesare sold, the difference between their original cost and the proceeds from such sale will be a realized gain or lossincluded in the determination of netincome in that period.

29 Unrealized gain on available-

for-sale securities (net of taxes) $50

Treasury StockWhen a company buys its own stock back, that stock is recorded at cost andreported as treasury stock. (It is calledtreasury stock because after being reac-quired by the company, it is returned tothe company’s treasury. The company can then resell or cancel that stock.)Treasury stock is reported as a deductionfrom shareholders’ equity. Any gains orlosses on the sale of such shares arereported as adjustments to shareholders’equity, but are not included in income.Treasury stock is not an asset.

30 Less: treasury stock at cost ($5,000)

Total Shareholders’ Equity“Total Shareholders’ Equity” is the sum of stock (less treasury stock), additionalpaid-in capital, retained earnings, foreigncurrency translation adjustments and unrealized gains on investment securitiesavailable for sale.

31 Total Shareholders’

Equity $346,050

22

To analyze balance-sheet figures, investorslook to certain financial statement ratiosfor guidance. (A financial statement ratiois the mathematical relationship betweentwo or more amounts reported in thefinancial statements.) One of their con-cerns is whether the business will be ableto pay its debts when they come due.Analysts are also interested in the compa-ny’s inventory turnover and the amount ofassets backing corporate securities (bondsand preferred and common stock), alongwith the relative mix of these securities.The following section will discuss someratios and calculations used for balance-sheet analysis.

WORKING CAPITALOne very important balance-sheet conceptis working capital. This is the differencebetween total current assets and total current liabilities. Remember, current liabilities are debts due within oneyear of the balance-sheet date. Thesource from which those debts arepaid is current assets. Thus, working capital represents the amount of current assets that is left if all current debts are paid.

For Typical this is:

6 Current assets $405,800)

19 Less: current liabilities (176,000)

Working capital $229,800)

Generally, companies that maintain acomfortable amount of working capital are more attractive to conservativeinvestors. A company’s ability to meetobligations, expand volume and takeadvantage of opportunities is often deter-mined by its working capital. Year-to-yearincreases in working capital are a positivesign of a company’s growth and health.

Current RatioWhat is a comfortable amount of workingcapital? Analysts use several methods tojudge whether a company has adequateworking capital. To interpret the currentposition of a company being considered asa possible investment, the current ratio maybe more useful than the dollar total of work-ing capital. The first rough test is to comparethe current assets figure to the total currentliabilities. Although there is considerablevariation among different types of compa-nies, and the relationship is significant onlywhen comparisons are made between com-panies in the same industry, a current ratioof 2-to-1 is generally considered adequate.This means that for each $1 of current liabil-ities, there are $2 in current assets.

To find the current ratio, divide currentassets by current liabilities. In Typical’sbalance sheet:

Thus, for each $1 of current liabilities, thereis $2.31 in current assets to back it up. Thereare so many different kinds of companies,however, that this test requires a great dealof modification if it is to be really helpful inanalyzing companies in different industries.Generally, companies that have a smallinventory and accounts receivable that arequickly collectible can operate safely with alower current ratio than companies having agreater proportion of their current assets ininventory and that sell their products onextended credit terms.

HOW QUICK IS QUICK?In addition to working capital and the cur-rent ratio, another way to test the adequacyof working capital is to look at quick assets.What are quick assets? They’re the assetsavailable to cover a sudden emergency—

JUST WHAT DOES THE BALANCE SHEET SHOW?

16 Current assets $405,800 = 2.31 or 2.3 to 1

19 Current liabilities $176,000 1

23

assets that could be taken to the bank rightaway, if necessary. They are those currentassets that are quickly convertible into cash.This excludes merchandise inventories,because such inventories have yet to besold and are not quickly convertible intocash. Accordingly, quick assets are currentassets minus inventories, prepaid expensesand any other illiquid current assets.

6 Current assets $405,800)

4 Less: inventories (180,000)

5 Less: prepaid expenses (4,000)

Quick assets $221,800)

The quick assets ratio is found by dividingquick assets by current liabilities.

This means that, for each $1 of current liabili-ties, there is $1.26 in quick assets available.

Net quick assets are found by taking thequick assets and subtracting the total currentliabilities. A well-positioned companyshould show a reasonable excess of quickassets over current liabilities. This provides arigorous and important test of a company’sability to meet its obligations.

Quick assets $221,800)

19 Less: current liabilities (176,000)

Net quick assets $45,800)

DEBT TO EQUITYA certain level of debt is acceptable, buttoo much is a sign for investors to be cau-tious. The debt-to-equity ratio is an indi-cator of whether the company is usingdebt excessively. For Typical, the debt-to-equity ratio is computed as follows:

A debt-to-equity ratio of .93 means thecompany is using 93 cents of liabilities for every dollar of shareholders’ equity in the business. Normally, industrial com-panies try to remain below a maximum of a 1-to-1 ratio, to keep debt at a levelthat is less than the investment level of theowners of the business. Utilities, servicecompanies and financial companies often

operate with much higher ratios.

INVENTORY TURNOVERHow much inventory should acompany have on hand? Thatdepends on a combination ofmany factors including the type ofbusiness and the time of the year.An automobile dealer, for example,with a large stock of autos at theheight of the season is in a stronginventory position; yet that sameinventory at the end of the seasonrepresents a weakness in thedealer’s financial condition.


23 Total Liabilities $322,000 = .93

31 Total Shareholders’ Equity $346,050

Quick assets $221,800 = 1.26 or 1.26 to 1

19 Current liabilities $176,000 1


24

One way to measure the adequacy and balance ofinventory is to compare itwith the cost of sales forthe year to determine theinventory turnover. Thistells us how many times ayear goods purchased by acompany are sold to itscustomers. Typical’s cost ofsales for the year is$535,000, which is divid-ed by average inventory for the year of$182,500 (inventory at 12/31/X8 of$185,000 + inventory at 12/31/X9 of$180,000, divided by 2) to determineturnover. Thus, turnover is 2.9 times($535,000 ÷ $182,500), meaning thatgoods are bought, manufactured and soldout almost three times per year. (If thisinformation is not readily available insome published statements, some analystslook instead for sales related to inventory.)“Inventory as a percentage of currentassets” is another comparison that may bemade. In Typical’s case, the inventory of$180,000 represents 44% of the total cur-rent assets, which amounts to $405,800.

BOOK VALUE OF SECURITIESNet book value or net asset valueis the amount of corporate assets backing a bond or a common orpreferred share. Intangible assets aresometimes included whencomputing book value.However, the following cal-culations will focus on themore conservative net tan-gible book value. Here’show to calculate values forTypical’s securities. (Referto Calculations 1 to 4.)

Net Asset Value per BondTo state this figure conservatively, intangi-ble assets are subtracted as if they have no value on liquidation. Current liabilitiesof $176,000 are considered paid. Thisleaves $490,100 in assets to pay the bondholders. So, $3,770 in net asset value protects each $1,000 bond. (See Calculation 1 above.)

Net Asset Value per Shareof Preferred StockTo calculate net asset value of a preferredshare, start with total tangible assets, con-servatively stated at $666,100 (eliminating$1,950 of intangible assets). Current liabil-ities of $176,000 and long-term liabilitiesof $146,000 are considered paid. Thisleaves $344,100 of assets protecting thepreferred. So, $5,735 in net asset valuebacks each share of preferred. (See Calculation 2 below.)

Calculation 1:)12 Total assets $668,050)10 Less: intangibles (1,950)

Total tangible assets 666,100)19 Less: current liabilities (176,000)

Net tangible assets available tomeet bondholders’ claims $490,100)


$490,100,000 = $3,770 net asset value per130,000 (bonds outstanding) $1,000 bond outstanding


Total tangible assets 666,100)19 Less: current liabilities (176,000)20, 21, 22 Long-term liabilities (146,000)Net tangible assets underlying

the preferred stock $344,100)

(Actual Amounts Used)$344,100,000 = $5,735 net asset value per

60,000 (preferred shares outstanding) preferred share


25

Book Value per Share of Common StockThe book value per share of commonstock can be thought of as the amount ofmoney each share would receive if thecompany were liquidated, based on bal-ance-sheet values. Of course, the bond-holders and preferred shareholders wouldhave to be satisfied first. The answer,$22.54 book value per share of commonstock, is arrived at as follows. (SeeCalculation 3 below.)

An alternative method of arriving at thecommon shareholders’ equity, conserva-tively stated at $338,100, is shown inCalculation 4 below.

Book-value figures, particularly of com-mon stocks, can be misleading. Profitablecompanies may show a very low net bookvalue and very substantial earnings, whilemature companies may show a high bookvalue for their common stock but havesuch low or irregular earnings that thestock’s market price is lower than its bookvalue. Insurance companies, banks andinvestment companies are often excep-tions. Because their assets are largely liq-

uid (cash, accounts receivableand marketable securities),their common stock’s bookvalue is sometimes a fair indication of market value.

CAPITALIZATION RATIOThe proportion of each kind ofsecurity issued by a companyis the capitalization ratio. Ahigh proportion of bondssometimes reduces the attrac-tiveness of both the preferredand common stock, and toomuch preferred can detractfrom the common’s value.

That’s because bond interest must be paidbefore preferred dividends, and preferreddividends before common dividends.

Typical’s bond ratio is derivedby dividing the face value ofthe bonds, $130,000, by thetotal value of bonds, preferredand common stock, additionalpaid-in capital, retained earn-ings, foreign currency transla-tion adjustments, unrealizedgains on available-for-salesecurities and treasury stock,less intangibles, which is$474,100. (See the Calculationon page 26.) This shows thatbonds amount to about 27% ofTypical’s total capitalization.

Calculation 3:)25 Common stock $75,000)26 Additional paid-in capital 20,000)27 Retained earnings 249,000)28 Foreign-currency translation adjustments 1,000)29 Unrealized gains on available-for-sale securities 50)30 Treasury stock (5,000)

Total Common Shareholders’ Equity 340,050)10 Less: intangible assets (1,950)

Total Tangible Common Shareholders’ Equity $338,100)


$338,100,000 = $22.54 book value per common share15,000,000 (common shares outstanding)


Total tangible assets 666,100)19 Less: current liabilities (176,000)20, 21, & 22

Long-term liabilities (146,000)24 Preferred stock (6,000)

Net tangible assets available for common stock $338,100)


$338,100,000 = $22.54 book value per common share15,000,000 (common shares outstanding)

The most important report for many analysts, investors or potential investors is the income statement. It shows howmuch the corporation earned or lost dur-ing the year. It appears with numberedline items on page 27 of this booklet.

While the balance sheet shows the funda-mental soundness of a company by reflect-ing its financial position at a given date,the income statement may be of greaterinterest to investors: The reasons aretwofold:

■ The income statement shows the recordof a company’s operating results for thewhole year.

■ It also serves as a valuable guide inanticipating how the company may doin the future.

However, the income statement for a sin-gle year does not tell the whole story. Thehistorical record for a series of years ismore important than the figures for anysingle year. Typical includes two years inits income statement and gives a 10-yearfinancial summary as well, which appearson pages 42 and 43.

An income statement matches the rev-enues earned from selling goods and ser-vices or other activities against all thecosts and outlays incurred to operate thecompany. The difference is the net income(or loss) for the year. The costs incurredusually consist of: Cost of sales; selling,general and administrative expenses, suchas wages and salaries, rent, supplies anddepreciation; interest on money borrowed;and taxes.


26

21 Debentures $130,000)24 Preferred stock 6,000)25 Common stock 75,000)26 Additional paid-in capital 20,000)27 Retained earnings 249,000)28 Foreign currency

translation adjustments 1,000)29 Unrealized gains on

available-for-sale securities 50)30 Treasury stock (5,000) 10 Less: intangibles (1,950)

Total Capitalization $474,100)

The preferred stock ratio is found thesame way—by dividing preferred stock of $6,000 by the entire capitalization of$474,100. The result is about 1%.

The common stock ratio will be the difference between 100% and the total ofthe bond and preferred stock ratio—orabout 72%. The same result is reached byadding common stock, additional paid-incapital, retained earnings, foreign currencytranslation adjustments, unrealized gainson available-for-sale securities and trea-sury stock, less intangibles, and dividingthe result by total capitalization.

Amount Ratio

21 Debentures $130,000 27%

24 Preferred stock 6,000 1%

10 & 25–30

Common Shareholders Equity

less intangibles 338,100 72%

Total $474,100 100%

THE INCOME STATEMENT


27

Net SalesThe most important source of revenue isusually the first item on the income state-ment. It represents the primary source ofrevenue earned by the company from itscustomers for goods sold or services ren-dered. In Typical Manufacturing’s incomestatement, it is shown as “net sales.” The“net sales“ item includes the amountreported after taking into considerationreturned goods and allowances for pricereductions or discounts. By comparing netsales between 19X9 and 19X8, we see thatsales increased in XXXX.

33 Net sales $765,050

Cost of SalesIn a manufacturing establishment, cost ofsales represents all the costs the companyincurs to purchase and convert raw materi-als into the finished products that it sells.These costs are commonly known as prod-uct costs. “Product costs” are those costs thatcan be identified with the purchase or man-ufacture of goods made available for sale.

There are three basic components of productcost: (1) Direct materials, (2) direct labor


Years Ended December 31,

19X9 19X8

33 Net sales $765,050) $725,000)34 Cost of sales 535,000) 517,000)35 Gross margin 230,050) 208,000)

Operating expenses:36 Depreciation and amortization 28,050) 25,000)37 Selling, general and administrative expenses 96,804) 109,500)38 Operating income 105,196) 73,500)

Other income (expense):39 Dividend and interest income 5,250) 10,000)40 Interest expense (16,250) (16,750)41 Income before income taxes and extraordinary loss 94,196) 66,750)42 Income taxes 41,446) 26,250)43 Income before extraordinary loss 52,750) 40,500)44 Extraordinary item: Loss on earthquake

destruction (net of income tax benefit of $750) (5,000) —45 Net income $47,750) $40,500)46 Earnings per share of common stock before

extraordinary loss $3.55) $2.77)47 Earnings per share—extraordinary loss (.34) — )48 Net income per common share $3.21) $2.77)

CONSOLIDATED INCOME STATEMENTS


28

and (3) manufacturing overhead. Directmaterials and direct labor costs can bedirectly traced to the finished product. Forexample, for a furniture manufacturer,lumber would be a direct material costand carpenter wages would be a directlabor cost. Manufacturing overhead costs,while associated with the manufacturingprocess, cannot be traceable to the fin-ished product. Examples of manufacturingoverhead costs are costs associated withoperating the factory plant (rent, electrici-ty, supplies, depreciation, maintenanceand repairs and the salaries of productionsupervisors).

34 Cost of sales $535,000

Gross MarginGross margin is the excess of sales overcost of sales. It represents the actual directprofit from sales after considering productcosts. Comparing period-to-period grossmargin trends in absolute dollars is a use-ful analytical tool. So, too, is comparingthe gross margin percentage (computed by dividing gross margin by net sales) fromyear to year.

35 Gross margin $230,050

Gross margin percentage 30%

($230,050 ÷ $765,050)

Tangible Depreciation and Non-tangible AmortizationEach year’s decline in value would be captured here. Amortization, as reportedin this line item, represents the decline inuseful value of an intangible, such as a 17-year patent.

36 Depreciation and

amortization $28,050

Selling, General and Administrative ExpensesThese expenses are generally grouped sep-arately from cost of sales so that the readerof an income statement may see the extentof selling and administrative costs. Theseinclude expenses such as: sales agents’salaries and commissions; advertising andpromotion; travel and entertainment; exec-utives’ salaries, office payroll; and officeexpenses.

37 Selling, general and

administrative expenses $96,804

Operating IncomeSubtracting all operating expenses from thegross margin determines operating income.

38 Operating income $105,196

Dividend and Interest Income

An additional source of revenue comes fromdividends and interest received by the com-pany from its investment in stocks and bonds.

39 Dividends and

interest income $5,250

Interest ExpenseThe interest earned by bondholders for the use of their money is sometimesreferred to as a “fixed charge.“ That’sbecause the interest must be paid yearafter year whether the company is makingmoney or losing money. Interest differsfrom dividends on stocks, which arepayable only if the board of directorsdeclares them. Interest paid is another cost of doing business, and is deductiblefrom earnings in order to arrive at a basefor the payment of income taxes.


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Typical’s interest expense comes from threesources: (1) Notes payable, (2) debenturesand (3) other long-term debt (whichbecame current portion of long-term debtat this year-end). The notes payable, withan average outstanding balance for theyear of $56,000 at 7% interest, incur aninterest charge of $3,920; the debentures,bearing interest at 9.12% on the $130,000balance, incur interest expense of$11,856; and the $6,000 of other long-term debt at 7.9% incurs interest of $474.

40 Interest expense $16,250

Income TaxesEach corporation has an “effective taxrate,” which depends on the level andnature of its income. Large corporationslike Typical Manufacturing are subject tothe top statutory corporate income taxrate. However, tax credits, tax-free incomeand nondeductible expenses tend tochange the overall tax rate. Typical’sincome before taxes and extraordinary lossis $94,196; its tax comes to $41,446.

41 Income taxes $41,446

Income Before Extraordinary Loss“Income before extraordinary loss” for theyear is the amount by which all revenuesexceed all expenses. Extraordinary gainsor losses (as defined by GAAP ) areexcluded from this determination.

42 Income before income taxes and extraordinary loss $94,196

43 Income beforeextraordinary loss $52,750

Extraordinary ItemsUnder usual conditions, the above income of

$52,750 would be the end of the story.However, there are years in which compa-nies experience unusual and infrequentevents called extraordinary items. For exam-ple, an extraordinary item would be cropdestruction by a hail storm in an area wherehail storms are rare. In this case, one ofTypical’s manufacturing sites was destroyedby an earthquake. Since this event is notexpected to recur, it is isolated on a separateline, net of its tax effect. Its earnings per shareimpact is also separated from the earningsper share attributable to “normal” operations.

44 Extraordinary item: losson earthquake destruction(net of tax benefit of $750) ($5,000)

Net Income—the “Bottom Line”Once all income and costs, includingextraordinary items, are considered, netincome (or loss) is determined.

45 Net income $47,750

Other ItemsThree other items that do not apply toTypical could appear on an income state-ment. First, suppose Typical were heavilyinvolved in research and development(R&D) activities. In that event, Typicalwould be required to include the amountof R&D costs in the income statement ordisclose it in the footnotes.

Second, suppose Typical owned between20% and 50% of another company. In thatcase, Typical would have “significant influ-ence” over that company, but not “control”it. As such, it would have to account for thatinvestment using the equity method andreport its equity interest in that company inits financial statements. For example, supposeTypical’s share of that company’s earnings forthe year were $1,200 and it received $700 individends from the company during that year.


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In that event, Typical would have to include$1,200 on its income statement under thecategory “equity in the earnings of uncon-solidated subsidiaries.” Typical would alsobe required to increase its investment inthat company to the extent of the earningsit picked up in its (i.e., Typical’s) incomestatement. However, this would be reducedby any dividends received, in this case$700, since the dividend represents a returnof its investment. In this case, Typical‘s bal-ance sheet would show a net increase in itsinvestment in this company of $500.

Third, suppose Typical owned a “consoli-dated” subsidiary (more than 50%ownership), in which it had less than a100% ownership interest. For example, sayit owned 85% of that company. Any materi-al change in the related minority interest(15%), would have to be reported in theincome statement or footnotes. A corre-sponding change in the cumulative minorityinterest would also have to be reported in thebalance sheet, between long-term liabilitiesand stockholders’ equity.

ANALYZING THE INCOMESTATEMENT

When used to make a few detailed com-parisons, the income statement will reveala lot more information about a company’s

operating results. For example, a prospectiveinvestor can determine the company’s oper-ating margin and how it has changed overthe years. This determination can be made

by comparing operating income to net sales.To illustrate, in 19X9, Typical reported netsales of $765,050 and operating incomeof $105,196.

This means that for each dollar of 19X9sales, 13.8¢ remained as a profit fromoperations. This figure is interesting, but ismore significant when compared with theoperating margin last year.

Typical’s operating profit margin wentfrom 10.1% to 13.8%, so business didn’tjust grow, it became more profitable.Changes in operating margin can reflectchanges in volume, efficiency, productline or types of customers served.

Typical can also be compared with othercompanies in its field. If Typical’s operatingmargin is very low compared to others, it isan unhealthy sign. If it is high, there is abasis for optimism.

Analysts also frequently use “operating costratio” for the same purpose. Operating costratio is the complement of the operatingmargin. Typical’s operating margin is13.8%. The operating cost ratio is 86.2%.

Amount Ratio33 Net sales $765,050 100.0%34, 36, & 37

Operating costs $659,854 86.2%38 Operating

income $105,196 13.8%

Net profit ratio is still another guide to indi-cate how satisfactory the year’s activitieshave been. In Typical’s case, the year’s netincome was $47,750. The net sales for theyear amounted to $765,050. Therefore,Typical’s income was $47,750 on $765,050of sales or:

19X9 Operating margin:

38 $105,196 Operating income = 13.8%

33 $765,050 Net sales

19X8 Operating margin:

38 $73,500 Operating income = 10.1%

33 $725,000 Net sales

19X9 Net profit ratio:

45 $47,750 Net income = 6.2%

33 $765,050 Net Sales


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This means that this year, for every $1 ofgoods sold, 6.2¢ in profit was ultimatelyearned by the company. By comparing thenet profit ratio from year to year for thesame company and with other companies,profit progress can be evaluated.

Last year, Typical’s net income was$40,500 on $725,000 in sales:

The operating margin, operating cost ratio and net profit ratio—like the ratios examinedfor the balance sheet—provide general infor-mation about the company and help assess itsfuture prospects. All these comparisons have along-term significance because they provideuseful information about the company’s fun-damental economic condition. Another ques-tion to ponder: Are Typical’s securities a goodinvestment? Consideration of some additionalfactors can help provide an answer.

INTEREST COVERAGETypical’s debentures represent a very substan-tial debt, but they are due many years in thefuture. The yearly interest, however, is a fixedcharge. How readily the company can paythe interest on this debt (i.e., the debt’s inter-est coverage) would be of great interest to aninvestor. (Interest coverage is number oftimes the annual interest on a debt obligationis covered by income for the year withoutconsidering interest on the debt and taxes.)More specifically, an investor would like toknow if the borrowed funds have been put togood use, so that the earnings are adequateand thus available to meet interest costs.

The available income representing thesource for payment of the debenture interestis $106,052 (operating profit plus dividendand interest income less the interest

expense on the other debt). The annualdebenture interest amounts to $11,856.This means the debenture’s annual interestexpense is covered 8.9 times.

For a corporate bond (debenture) to beconsidered a safe investment, most ana-lysts say that the company should earn itsbond interest requirement three to fourtimes over. By these standards, Typical’sdebentures have a fair margin of safety.

WHAT ABOUT LEVERAGE?Financial leverage relates a company’slong-term debt and preferred stock to thecompany’s common equity. Sometimes astock is said to be highly leveraged. Whatthis simply means is that the companyissuing the stock has a large proportion ofbonds and preferred stock outstanding rel-ative to the amount of common stock.

“High leverage” can work for or against acompany depending on the earningsavailable to the common shareholders.Generally speaking, however, analystsconsider highly leveraged companies to berisk-prone. A simple illustration will showwhy. Take, for example, a company with$10,000,000 of 4% bonds outstanding. Ifthe company earns $440,000 before bondinterest, there will only be $40,000 left forthe common shareholders after payment of$400,000 bond interest ($10,000,000 at 4%equals $400,000). However, an increase ofonly 10% in earnings (to $484,000) willleave $84,000 for common stock divi-dends, or an increase of more than 100%.If there is only a small amount of commonstock issued, the increase in earnings pershare will appear very impressive.

19X8 Net profit ratio:

45 $40,500 Net income = 5.6%

33 $725,000 Net Sales

Number of timesdebenture interest earned:$106,052 Available income = 8.9$11,856 Debenture interest


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But in this instance, it is also apparent that adecline of 10% in earnings (to $396,000)would wipe out everything available for thecommon shareholders. Moreover, it wouldalso result in the company’s being unable tocover the full interest on its bonds withoutdipping into its cash reserves and retainedearnings. This is the great danger of so-called highly leveraged companies. It alsoillustrates a fundamental weakness of compa-nies that have a disproportionate amount ofdebt. Conservative investors usually steer clearof highly leveraged companies, although theydo appeal to people seeking a higher returnwho are willing to assume the risk.

Typical Manufacturing, on the other hand,is not a highly leveraged company. In19X8, Typical incurred $11,856 indebenture interest and its income beforeextraordinary loss and this expense cameto $52,356 ($40,500 + $11,856 = $52,356).This left $40,500 for the common and pre-ferred stockholders and retained earningsafter recording this interest.

Now look what happened this year. Net prof-it before extraordinary loss and debentureinterest rose by $12,250 ([$52,750 + $11,856= $64,606] - $52,356 = $12,250) or about23%. Since the bond interest stayed thesame, income before extraordinary loss andafter recording this interest also rose $12,250.But that is about 30% of $40,500. While thisis certainly not a dramatic example of lever-age, a 23% increase in pretax earningsgenerates a 30% increase in amounts avail-able for dividends or retained earnings. While this only illustrates the leverage effectof the interest on the debentures, similarcalculations could be made to show theimpact of the interest expense related to theother borrowings and total interest expense.

PREFERRED DIVIDEND COVERAGETo calculate the preferred dividend coverage (the number of times preferred

dividends were earned), net profit must beused as the base. That’s because federalincome taxes and all interest charges mustbe paid before anything is available forshareholders. Because the 60,000 sharesof $100 par value preferred stock pay aper share dividend of $5.83, the total divi-dend requirement for the preferred stock is$350. Dividing the net income of$47,750, by this figure yields approxi-mately 136.4, which means that the divi-dend requirement of the preferred stockhas been earned more than 136 timesover. This ratio is so high primarilybecause Typical has only a relatively smallamount of preferred stock outstanding.

EARNINGS PER COMMON SHAREA buyer of common stock is often moreconcerned with the stock’s earnings pershare than with its dividend. This is because earnings usually influence stockmarket prices. Although the income state-ment separates earnings per share beforeand after the effect of extraordinary items,the remainder of this presentation will onlyconsider net income per common share(net income after extraordinary item). InTypical’s case, the income statement doesnot show income available for commonstock, so it must be calculated as follows:Typical’s capital structure is a very simpleone, comprised of common and preferredstock. As such, the earnings per sharecomputation above will suffice under thisscenario. However, if the capital structureis more complex and contains securities thatare convertible into common stock, options,warrants or contingently issuable shares,the calculation requires modification.(Options and warrants each give the holderthe right to buy securities at a specified price.Contingently issuable shares are shares ofstock whose issuance depends on the occur-rence of certain events.) In fact, two separatecalculations are required. This is called dualpresentation. The calculations are basic anddiluted earnings per common share.


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As of December 15, 1997, as per FinancialAccounting Standard 128, publicly tradedcompanies are required to report bothforms of earnings per share: basic earningsper share and diluted earnings per share.This new standard replaced APB 15,making simple, primary and fully dilutedearnings per share obsolete. FAS 128 alsomakes the calculation of earnings per shareidentical under U.S. and internationalaccounting standards.

Basic Earnings per Common ShareThis is determined by dividing theearnings available to common shareholdersfor the year or the appropriate period bythe average number of shares of commonstock outstanding during the year.

The average calculation is simply thearithmetic mean of the shares outstanding,on a pro rata basis, for the reporting peri-od. Unexercised stock options, convertiblesecurities and contingently issuable sharesare NOT included in the basic earningsper share calculation.

Suppose, for example, that ComplexCapital Corp. has $300,000 in net incomeavailable to common shareholders and100,000 average common shares outstand-ing for the year. Basic earnings per sharewould be $3.00 ($300,000/100,000).

DILUTED EARNINGS PERCOMMON SHAREDiluted earnings per share is determinedby dividing the adjusted earnings available

to common shareholders for the year (orthe period) by the average number of common and potential common sharesoutstanding, if such potential commonshares are dilutive. Dilution occurs whenearnings per share decreases or loss pershare increases.

The “adjustments” to earnings include:• Dividends on convertible preferred stock• After-tax interest expense on convertible

debt• Effect of the change in earnings from

other expenses (such as profit-sharingexpense rising due to the increasedincome from the reduction of interestexpense from the assumed conversion ofconvertible debt)

The “potential” common shares consist ofother securities and contractual arrange-ments that may result in the issuance ofcommon stock in the future, such as:• Options or warrants• Convertible securities• Contingent stock arrangements

Convertible securities can be exchangedor converted into common shares.Examples are convertible preferred stock,convertible bonds and the like. Such secu-rities are deemed to be only one step shortof common stock. Their value stems inlarge part from the value of the commonto which they relate.

Convertible pre-ferred stock andconvertiblebonds offertheir holderssome choices. A holder canelect either (1) areturn at thespecified divi-dend or interest

45 Net Income $47,750)Less: dividend requirement on preferred stock (350)Net income available for common stock $47,400)

(Actual Amounts Used)Net income per common share:$47,400,000 Net income available for the common stock = $3.2114,750,000 Average number of outstanding common shares*

*Shares outstanding at January 1 (14,500,000), plus shares outstanding at December 31(15,000,000), = 29,500,000, divided by 2 = 14,750,000 average shares outstanding for the year.


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rate, or (2) conversion into common stockand participation in market appreciationand dividends resulting from increasedearnings on the common stock. However,the securities don’t have to be actuallyconverted to common stock for them tobe called “potential common shares”because they enable holders—in certaincircumstances—to cause an increase inthe number of common shares by exercis-ing, exchanging or converting.

Each issue of potential common sharesmust be considered separately insequence from the most dilutive (lower-ing earnings per share the most) to theleast dilutive by examining the marginalearnings per share impact. This is knownas antidilution sequencing. When calcu-lating diluted earnings per share, firstcompare the impact of the most dilutivesecurity to basic earnings per share. If apotential common share is antidilutive(therefore raising earnings per share), thatsecurity should NOT be included in thediluted earnings per share calculation.Because antidilutive securities are notincluded in the diluted calculation, dilut-ed earnings per share must always be lessthan, or equal to, basic earnings pershare. Diluted earnings per share are usu-ally less than basic earnings per sharedue to the dilutive effects of potentialcommon shares.

Options and warrants are the mostcommon forms of potential commonshares. As stated earlier, options andwarrants each give the holder the right tobuy securities at a specified price, knownas the “exercise price” or “strike price.”Let’s examine an example of the dilutionfrom the assumed conversion of options.The Treasury Stock Method is a method ofcalculating the effect on earnings per

share from stock options. All of theproceeds from the conversion of the in-the-money (current share price is greaterthan the exercise price) options are usedto repurchase common shares at the average market price for the period.

For example, suppose the same ComplexCapital Corp. used above also has 10,000stock options outstanding with an averagestrike price of $20 per share. The averageshare price for the year was $50. The$200,000 in option proceeds (10,000options x $20 average exercise price) isassumed to repurchase common sharesat $50 per share, therefore reducing com-mon shares by 4,000 ($200,000/$50).The net dilutive effects of the optionswould be an increase in 6,000 commonshares (10,000 options less 4,000repurchased), assuming the hypotheticalconversion of the in-the-money options at the average share price for the periodunder the Treasury Stock Method.Therefore, the earnings per share wouldbe diluted to $2.83 from the net effectof options ($300,000 in netincome/106,000 common shares,including the net 6,000 options).

Let us now further examine the dilutedearnings per share calculation. Supposethe following financial information for thesame Complex Capital Corp. as above:• $300,000 net income available to

common shareholders• 100,000 average common shares

outstanding• 10,000 stock options with an average

strike price of $20• Average share price for the year of $50• Convertible bonds with a par value of

$1,000,000, 6% interest rate, and a con-version ratio of 20 common shares forevery $1,000 bond


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The basic earnings per share are simply$300,000 in net income divided by 100,000average common shares, or $3.00. The effectof options lowered earnings per share to$2.83. Let us now examine the effects of thepotential common shares from the convert-ible bonds.

If the 1,000 bonds were converted into com-mon shares, there would be another 20,000common shares (1,000 bonds x 20). But con-verting the bonds would save the $60,000 ininterest payments ($1,000,000 x 6%), less thetax deduction of $24,000 on the interestexpense. Therefore, the conversion of thebonds would increase net income availableto common shareholders by $36,000($60,000 in interest expense less the $24,000tax deduction).

Adjustments to net income assuming con-version of the bonds:

Net Income availableto common $300,000

Plus: interest expense 60,000

Less: tax deduction oninterest expense (24,000)

Adjusted net income $336,000

Additional common shares assumingconversion of the stock options andthe bonds:

Common shares outstanding 100,000

Plus: options 10,000

Less: assumed shares repurchasedunder Treasury Stock Method (4,000)

Plus: commons shares fromthe conversion of the bonds 20,000

Adjusted common shares 126,000

Diluted earnings per share calculation:

Adjusted net income $336,000

Adjusted common shares 126,000

= Diluted earnings per share $2.67

Complex Capital Corp. would report boththe basic and diluted numbers: Basic earn-ings per share of $3.00 and diluted earn-ings per share of $2.67. In most analyses,the diluted number is the most significantfigure. This reflects the dilution from allpotential common shares. In fact, researchearnings per share estimates are generallygiven as the expected diluted earnings pershare of the company.

PRICE-EARNINGS RATIO

Both the price and the return on commonstock vary with a multitude of factors.One such factor is the relationship thatexists between the earnings per share andthe market price. It is called the price-earnings ratio (abbreviated P/E ratio).

This is how the P/E ratio is calculated. If astock is selling at $25 per share and earning$2 per share annually, its price-earningsratio is 12.5-to-1, usually shortened to12.5. Put another way, the stock is said tobe selling at 12.5 times earnings. If thestock should rise to $40, the P/E ratiowould be 20, or 20 times earnings. Or, ifthe stock drops to $12, the P/E ratio wouldbe 6, or six times earnings.

For Typical, which has no “potential com-mon shares,” net income per common sharewas calculated at $3.21. If the stock wereselling at $33, the P/E ratio would be 10.3.This figure would be used to compare thisstock over a period of years to itself and/orto other similar stocks.

This means that Typical Manufacturing com-

THE STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY

This statement analyzes the changes from year-to-year in each component of shareholders’ equity. It shows that during the year, Typical issued additionalcommon stock at a price above par. It also shows that Typical experienced a foreign currency translation gain and anunrealized gain on investments classifiedas “available-for-sale.” The other components of equity, with theexception of retained earnings (see the paragraph below) remained the same.

Retained earnings reflects thecumulative earnings that the com-pany has invested for future growth. The statement of changes in shareholders’equity shows that retained earningsincreased by net income less dividends on preferred and common stock. Since netincome has already been analyzed,dividends will now be examined.

DIVIDENDSDividends on common stock vary with the company. They do notenter into the determination of net income;

nor are they deductible for tax purposes.Common shareholders were paid $18,000in dividends this year. Since the balancesheet shows that Typical has 15,000,000shares outstanding, the first thing to belearned here may be an important point to some potential investors—the dividendper share.

Once the dividend per share is known, itis easy to go on to the next step: comput-ing the dividend payout percentage. Thisis simply the percentage of earnings pershare paid to shareholders.


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mon stock is selling at approximately 10.3times earnings. Last year, Typical earned$2.77 per share. Assume that its stock sold atthe same P/E ratio then. This means that ashare of Typical was selling for about$28.50, and anyone who bought Typicalthen would be satisfied now. Just remember,

in the real world investors can never be cer-tain that any stock will keep its same P/Eratio from year to year. The historical P/Emultiple is a guide, not a guarantee.

In general, a high P/E multiple, when com-pared with other companies in the sameindustry, means that investors have confi-dence in the company’s ability to producehigher future profits.

Dividend per share:

(Actual amount used)

$18,000,000 Common stock dividends = $1.20

$15,000,000 Common shares outstanding

Dividend payout percentage:

$1.20 Dividend per common share = 37%

48 $3.21 Net income per common share

P/E ratio:$33 Market price = 10.3: 1

49 $3.21 Earnings per share or 10.3times earnings


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Another statistic of great interest to manyinvestors and analysts is the dividendyield, a percentage providing an estimateof the return per share on a given class ofstock. Here, for example, the commondividend yield would be of great interest.This indicates the percentage return thatthe annual common dividend providesbased on the market price of the commonstock. This is derived by dividing the annual common dividend, in this case$1.20, by the market price of the commonstock, earlier determined to be $33 pershare. This provides a “common dividendyield” of 3.6%, which is quite respectablein today’s market.

Of course, the dividends on the $5.83 pre-ferred stock will not change from year-to-year. The word “cumulative” in the bal-ance-sheet description indicates that ifTypical’s management didn’t pay a divi-dend on its preferred stock, then the $5.83payment for that year would accumulate.It would have to be paid to preferredshareholders before any dividends couldever be declared again on the commonstock. That’s why preferred stock is called“preferred”; it gets any dividend moneyfirst. Convertible bonds and convertiblepreferred stock were discussed earlier.However, Typical Manufacturing doesn’thave any convertible securities outstand-ing, so these are of no further interest rightnow. Chances are its 60,000 shares of pre-ferred stock—with a par value of $100each—were issued to family members.

During the year, Typical Manufacturinghas added $29,400 to its retained earnings

after paying dividends totaling $18,350.Even if Typical has some lean years in the future, it has plenty of retained earnings from which to keep on declaringthose $5.83 dividends on the preferredstock and $1.20 dividends on the common stock.

There is one danger in having a lot ofretained earnings. It could attract anothercompany, Great Giant Computers &Electronics for instance, to buy up enoughof Typical’s common to vote out the current management. Then Great Giantmight merge Typical into itself. Wherewould Great Giant get the money to buyTypical stock? By issuing new shares of itsown stock, perhaps. And where wouldGreat Giant get the money to pay the dividends on all that new stock of its own?The funds would come from Typical’sretained earnings. So Typical’s manage-ment has an obligation to its sharehold-ers—to make sure that its retained earnings are put to work to increase their total wealth. Otherwise, the share-holders might cooperate with Great Giantif it conducted a raid on Typical.

27 Retained earnings $249,000

RETURN ON EQUITYSeeing how hard money works, of course,is one of the most popular measures thatinvestors use to come up with individualjudgments on how much they think a cer-tain stock ought to be worth. The marketitself—the sum of all buyers and sellers—makes the real decision. But the investorsoften try to make their own decision onwhether they want to invest at the market’sprice or wait. Most investors look forTypical’s return on equity (also known as“ROE”), which shows how hard share-holders’ equity in Typical is working.

Dividend yield:

$1.20 Dividend per common share = 3.6%

$33 Market price of the common stock

How can an investor compute Typical’sROE? To arrive at this figure, an investorwould look at the balance sheet and com-pute the average common shareholders’equity for the year in order to calculatehow much Typical made on it. In makingthis calculation, the investor uses only theamount of net profit after the dividendshave been paid on the preferred stock. For Typical Manufacturing, that means$47,750 net profit minus $350. (See theCalculation below.)

For every dollar of shareholders’ equity,Typical made about 15¢. Is that good?Well, a 15% return to shareholders isabout twice the return Typical would havereceived had it invested instead in qualitycorporate bonds. It is also several timeswhat it would have received from a sav-ings account. The point is that in consider-ing whether to put money to work in

Typical’s stock, an investor really needs to do two things. First, he or she needs to compare Typical’s 14.8% to returnsfrom Typical’s business competitors.Second, he or she needs to compareTypical’s return to the potential return thatcould be achieved from other types ofinvestment, such as certificates of deposit,corporate bonds, real estate or other com-mon stocks.

Just remember, that 14.8% is what Typical itself makes. By no means is itwhat an investor will make in dividendson Typical’s stock. What ROE reallyreveals is whether Typical Manufacturingis relatively attractive as an enterprise. An investor can only hope that this attrac-tiveness will translate into demand forTypical’s stock and will be reflected in its market price.


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Calculation:

$47,750 Net income less $350 preferred stock dividend =

$325,825 Average 19X9 stockholders’ equity* less $6,000 preferred stock value

$47,400 = 14.8% Return on equity

$319,825

* Stockholders’ equity at January 1 ($305,600), plus stockholders’ equity at December 31 ($346,050) = $615,650, divided by 2 = $325,825 average 19X9 stockholders’ equity.

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THE STATEMENT OF CASH FLOWS

One more statement needs to be analyzedin order to get the full picture of Typical’sfinancial status. The statement of cashflows presents the changes in cash result-ing from business activities. Cash-flow analy-sis is necessary to make proper investingdecisions and to maintain operations.

Cash flows, although related to netincome, are not equivalent to it. This isbecause of the accrual method ofaccounting. Generally, under accrualaccounting, a transaction is recognized onthe income statement when the earningsprocess is completed, that is, when thegoods and/or services have been deliveredor performed or an expense has beenincurred. This does not necessarily coin-cide with the time that cash is exchanged.For example, cash received from merchan-dise sales often lags behind the time when goods are delivered to customers.Generally, however, when the goods areshipped (service performed), the sale isrecorded on the income statement and a related receivable is recorded on thebalance sheet.

Cash flows are also separated by businessactivity. The business activity classifica-tions presented on the statement includefinancing activities, investing activities and

operating activities. Financing and invest-ing activities will be discussed first.

Financing activities include those activitiesrelating to the receipt and repayment offunds provided by creditors and investors.These activities include the issuance ofdebt or equity securities, the repayment of debt, and distribution of dividends.Investing activities include those activitiesrelating to asset acquisition or disposal.

Operating activities basically include allactivities not classified as either financingor investing activities. They involve thecompany’s primary business activities, forexample, the production and delivery ofgoods and services. They reflect the casheffects of transactions, which are includedin the determination of net income.

Since many items enter into the determi-nation of net income, the indirect methodis used to determine the cash provided byor used for operating activities. Thismethod requires adjusting net income toreconcile it to cash flows from operatingactivities. Common examples of cashflows from operating activities are: Cashcollected from customers; interest receivedand paid; dividends received; salary;insurance; and tax payments.

Watch Those NotesThe annual reports of many companiescontain this or a similar statement: “Seethe Accompanying Notes to the Consoli-dated Financial Statements” or “TheAccompanying Notes are an Integral Partof the Financial Statements.” The reason isthat the financial statements themselvessimply report the balances in the variousaccounts. Because there is no room on the face of the statements for a completeand adequate discussion relating to thosebalances, additional required disclosuresare provided in the notes.

Some examples of appropriate footnotedata are:

■ Description of the company’s policies—disclosure of the company’spolicies for depreciation, amortization,consolidation, foreign currency translation, earnings per share, etc.

■ Inventory valuation method—indicateswhich method is used to determine thecost of goods sold on the income state-ment and on the balance sheet such aslast-in, first-out (LIFO), first-in, first-out (FIFO) or average cost. LIFO meansthat the costs on the income statementreflect the cost of inventories purchasedor produced most recently. FIFO meansthe income statement reflects the costof the oldest inventories. This is anextremely important considerationbecause the LIFO method reflects themost current costs in the income state-ment and does not overstate profits dur-ing inflationary times, while the FIFOvaluation does. If not shown on the bal-ance sheet, the composition of theinventories by raw materials, work-in-process, finished goods and suppliesshould be presented.

■ Asset impairment—disclosure of detailsabout impaired assets or assets to bedisposed of.

■ Investments—information about debtand equity securities classified as “trad-ing,” “available-for-sale” or “held-to-maturity.”

■ Income tax provision—the breakdownby current and deferred taxes and itscomposition into federal, state, localand foreign tax, accompanied by a reconciliation from the statutory incometax rate to the effective tax rate for thecompany.

■ Changes in accounting policy—description of changes in accountingpolicy due to new accounting rules.

■ Nonrecurring items—details regardingnonrecurring items such as pension-plan terminations or acquisitions/dispo-sitions of significant business units.

■ Employment and retirement programs—details regarding employ-ment contracts, profit-sharing, pensionand retirement plans and postretirementand postemployment benefits otherthan pensions.

■ Stock options—details about stock opt-ions granted to officers and employees.

■ Long-term leases—disclosure of leaseobligations on assets and facilities on aper-year basis for the next several yearsand total lease obligations over theremaining lease period.

■ Long-term debt—details regarding the issuance and maturities of long-term debt.

■ Contingent liabilities—disclosures relat-ing to potential or pending claims orlawsuits that might affect the company.

ADDITIONAL DISCLOSURES AND AUDIT REPORTS

40

ADDITIONAL DISCLOSURES AND AUDIT REPORTS

41

■ Future contractual commitments—terms of contracts in force that willaffect future periods.

■ Regulations/restrictions—description of regulatory requirements and dividendor other restrictions.

■ Off-balance sheet credit and marketrisks—details of off-balance-sheet creditand market risk associated with certainfinancial instruments. This includesinterest rate swaps, forward and futurescontracts and options contracts (oftenreferred to as derivatives). “Off-balance-sheet risk” is defined as potential forloss over and above the amount record-ed on the balance sheet.

■ Fair value of financial instruments carried at cost—disclosure of fair market values of instruments carried at cost including long-term debt andoff-balance-sheet instruments, such as swaps and options.

■ Segment sales, operating profits andidentifiable assets—information oneach industry segment that accounts formore than 10% of a company’s sales,operating profits and/or assets. Multi-national corporations must also showsales and identifiable assets for eachsignificant geographic area where salesor assets exceed 10% of the relatedconsolidated amounts.

Most people do not like to read footnotesbecause they are complicated and arerarely written in “plain English.” This isunfortunate because the notes are veryinformative. Moreover, they can revealmany critical and fascinating sidelights tothe financial story.

INDEPENDENT AUDITSThe report from the independent auditorsis often referred to as the auditor’s opin-ion, and is printed in the annual report. Itshould say three things, namely that:

1. The audit steps taken to verify thefinancial statements meet the auditingprofession’s approved standards ofpractice.

2. The financial statements prepared bymanagement are management’s respon-sibility and follow generally acceptedaccounting principles.

3. There is no material misstatement.

As a result, when the annual report con-tains financial statements accompaniedby an unqualified (often referred to as“clean”) opinion from independent auditors, there is added assurance that the figures can be relied upon as beingfairly presented.

However, if the independent auditor’sreport contains the qualifying words“except for,” the reader should be on thealert, cautious and questioning. The readershould investigate the reason(s) behindsuch qualification(s), which should besummarily explained in that report andreferenced to the footnotes. In addition,while the auditor(s) may not qualify theopinion, a separate paragraph, usually afourth, may be inserted to emphasize animportant item. Investors should carefullyconsider any matter so emphasized.

It cannot be emphasized too strongly thatcompany reports must be compared ifthey are to be useful. They can be com-pared to other dates and time periods,reports of other companies and to industryaverages. If desired, they can even becompared to broader economic factors.But most of all, one company’s annualactivities can be effectively compared tothe same firm’s results from other years.

At one time this was done by keeping afile of old annual reports. Now, many cor-porations include a 5- or 10-year summaryof their financial highlights in each year’sannual report. This provides the investingpublic with information about a decade ofperformance. That is why TypicalManufacturing has included a 10-yearsummary in its annual report. Although the summary is not a part of the state-

ments verified for by the auditors, it isthere for investors to read. A 10-year sum-mary can show the reader:

■ The trend and consistency of revenues.

■ The trend of earnings, particularly inrelation to sales.

■ The trend of net earnings as a percent-age of sales.

■ The trend of return on equity.

■ Net earnings per common share.

■ Dividends and dividend trends.

Other companies may include changes innet worth; book value per share; capitalexpenditures for plant and machinery;long-term debt; capital stock changes dueto stock dividends and splits; number of

THE LONG VIEW

42

Ten-Year Financial Summary19X9 19X8 19X7 19X6

Net sales $765,050 $725,000 $690,000 $660,000Income before

income taxes andextraordinary loss 94,196 66,750 59,750 54,750

Extraordinary loss (5,000) – – –Net income 47,750 40,500 37,700 33,650Earnings per share

before extraordinary loss 3.55 2.77 2.57 2.28Net income per share 3.21 2.77 2.57 2.28Dividend per

common share 1.20 1.20 1.20 1.00Working capital 229,800 199,000 218,000 223,000Net plant and

equipment 260,000 249,600 205,000 188,000Long-term debt 130,000 136,000 136,000 6,000Preferred stock 6,000 6,000 6,000 6,000Common

shareholders’ equity 340,050 299,600 275,800 254,700Book value per

common share 22.54 20.52 18.39 16.98

Note: Dollars in thousands, except per-share amounts.

THE LONG VIEW

43

employees; number of shareholders; andnumber of outlets. Where appropriate, thesummary may also include information onforeign subsidiaries and the extent towhich foreign operations have beenembodied in the company’s financialreport.

All of this is really important because ofone central point: Investors and potentialinvestors not only are trying to find outhow Typical is doing now, but they alsowant to try to predict how Typical and itsstock will perform in the future.

Given the items explored in this booklet,Typical Manufacturing appears to be ahealthy concern. Since Typical is fictional,financial consultants can’t recommend thepurchase of shares of its stock. Wheninvesting money in real stocks, however,please remember this: Selecting securitiesfor investment requires the careful study of factors other than those included in the basicfinancial statements and related footnotes. Theeconomics of the country and the particular

industry must be considered. The managementof the company must be studied and its plansfor the future assessed. Information about these “other things” is rarely contained in the financial report. These other facts must begleaned from the press or the financial servicesprovided by some research organization.Merrill Lynch’s ongoing research monitors this type of data and the available facts neededto help individuals and businesses becomeinformed investors.

SELECTING STOCKS

19X5 19X4 19X3 19X2 19X1 19X0$600,000 $520,000 $500,000 $450,000 $350,000 $300,000

50,400 42,000 45,800 40,500 34,350 29,500– – – – – –

29,850 27,300 30,360 25,975 21,000 18,100

2.00 1.83 2.20 1.93 1.69 1.432.00 1.83 2.20 1.93 1.69 1.43

1.00 1.00 1.00 .80 .80 .80211,000 178,000 136,000 111,000 86,000 96,000

184,300 187,500 161,600 125,600 92,500 87,6006,000 – – – – –6,000 6,000 6,000 6,000 6,000 6,000

238,100 220,500 203,250 166,000 133,800 128,000

15.87 14.70 13.55 11.07 8.92 8.53

44

GLOSSARY OF SELECTED TERMS

Page numbers in parentheses are page references in this booklet where the terms are first introduced or where additional information about the terms can be found.

Accounts Payable (Page 15).Amounts owed to creditors forgoods and services bought oncredit; generally, they must be paid within 90 days.

Accounts Receivable (Page 10).Amounts due a business from cus-tomers for goods and services soldon credit; generally they must bepaid within 90 days.

Accrual Method of Accounting(Page 39). Method of accounting that recog-nizes revenue when earned andexpenses when incurred in order toappropriately match income withexpenses in an accounting period.

Accrued Expenses (Page 15). The obligation to pay businessexpenses that were incurred, but notpaid, during an accounting period.

Accumulated Amortization(Page 14).A deduction from intangible assetsto show the total amount of peri-odic charges to income over theestimated useful lives of thoseassets. Also called Reserve forAmortization.

Accumulated Depreciation(Page 13).A deduction from fixed assets toshow the total amount of periodiccharges to income over the estimat-ed useful lives of those assets. Alsocalled Reserve for Depreciation.

Additional Paid-in Capital(Page 19).The total excess of the sharehold-ers’ investment in the companyover the par or stated value of itscommon and preferred stock. Alsocalled Paid-in Capital.

American Institute of Certified Public Accountants(AICPA) (Page 2). The major professional publicaccounting group that sets stan-dards of practice for CertifiedPublic Accountants.

Allowance for DoubtfulAccounts (Page 10). Amounts deducted from the totalaccounts receivable balance torecognize that some customers will

not pay what they owe. Alsocalled Provision for DoubtfulAccounts, Reserve for DoubtfulAccounts or Bad Debt Reserve.

Amortization (Page 14). Periodic charges to income to rec-ognize the distribution of the costof the company’s intangible assetsover the estimated useful lives ofthose assets.

Antidilution (to Earnings perCommon Share) (Page 35). An increase in earnings (ordecrease in loss) per commonshare that assumes that convertiblesecurities were converted, stockoptions and warrants were exer-cised or other shares were issuedupon satisfaction of certain condi-tions. When antidilution occurs,the per-share amount that it pro-duces is not used as the reportedper-share amount.

Antidilution Sequencing (Pages 34).Examination of potential commonshares by order of most dilutive toleast dilutive. If the security lowersearnings per share relative to thebase earnings per share, calculatethe earnings per share assumingthe conversion of the security.Securities that are antidilutive arenot included in the diluted earn-ings per share calculation.

Asset (Pages 8, 9-14). Something owned by and havingcontinuing value to its owner or abusiness.

Audit (of Financial Statements) (Page 1). A systematic examination of acompany’s financial statements todetermine if the amounts and dis-closures in the reports are fairlystated and follow generally accept-ed accounting principles.

Available-for-Sale Securities (Page 10).Securities not classified as held-to-maturity or trading. They arecarried at fair market value, withany changes in the value (less applicable taxes) reported inshareholders’ equity in the bal-ance sheet. When sold, any gainor loss will be realized and report-ed in the income statement.

Balance Sheet (Pages 1, 8-26). A report showing the financialposition or condition of a businessat a given date. Also calledStatement of Financial Position orStatement of Financial Condition.

Basic Earnings per Common Share(Page 33).Income available to commonshareholders for the period dividedby the weighted-average numberof common shares outstanding forthe period.

Bonds (Page 18). Formal, secured or unsecured debtobligations specifying interest andrepayment terms.

Book Value per Share (Page 25).The adjusted shareholders’ equityfor each class of stock divided bythe number of shares of each suchclass.

Capitalization Ratio (Page 25). The relationship that each security(debt or equity) bears to total debtand equity, less intangible assets,expressed as a ratio.

Cash and Cash Equivalents(Page 9).Generally, bank accounts and cur-rency on hand, and short-term,highly liquid securities with amaturity under 90 days, such asU.S. Treasury bills.

Cash Flows, Statement of(Pages 2, 39). A report showing cash receiptsand disbursements compiled andtotaled by operating, investingand/or financing activities.

Certified Public Accountant (CPA)(Page 1). Professional title granted to peoplewho pass a comprehensive test on accounting, auditing and business law. CPAs usually performaudits of a company’s financialstatements.

Changes in Shareholders’ Equity, Statement of (Pages 2, 36). A report providing the details,by category, of all activity in allcomponents of shareholdersequity, for the period coveredby the report.

45

Common Dividend Yield(Page 37).Dividends paid on each share ofcommon stock expressed as a per-centage of the market price of thoseshares. See also Dividend Yield.

Common Stock (Pages 19, 33). The par or stated value of the common stock (the basic owner-ship interest in a corporation)issued by a company as reportedin its balance sheet.

Common Stock Ratio (Page 26). The percentage that commonstockholders’ equity reduced byintangible assets bears to total tan-gible capitalization (the sum ofshareholders’ equity and long-termdebt reduced by intangibles).

Compensatory Stock Options(Page 33).See Stock Options.

Contingently lssuable Shares(Page 32). Shares of stock the issuance ofwhich depends on the occurrenceof certain events.

Convertible Securities (Page 33). A debt or equity security that mayunder certain circumstances beexchanged for or converted intoanother security, generally com-mon stock.

Cost of Sales (Page 28). The total cost to purchase and/ormanufacture all of the company’sproducts that were sold during aperiod.

CPA (Page 1).See Certified Public Accountant.

Current Assets (Page 9).Cash or other assets that will beconverted to cash or consumedwithin the normal operating cycle,generally one year.

Current Liability (Page 15). A liability that must be paid within the normal operating cycle, generally one year.

Current Portion of Long-Term Debt (Page 17). The portion of long-term debt thatis due within one year of the balance-sheet date.

Current Ratio (Page 22). The relationship of current assetsto current liabilities, expressed asa ratio.

Debentures (Page 18). Formal, unsecured debt obligations(bonds or notes) that are backed

only by the general credit of the issuer rather than certain of its assets.

Debt Amortization (Page 10). The practice of adjusting the origi-nal cost of a debt instrument asprincipal payments are receivedand any purchase discount or premium is written off to incomeover the life of the instrument.

Debt-to-Equity Ratio (Page 23). The ratio of total debt (liabilities) tototal shareholders’ equity.

Deferred Charges (Page 13). Expenditures for items that willbenefit future periods beyond oneyear from the balance-sheet date.

Deferred Income Taxes (Page 17). The obligation to pay income taxes in future years generally arising from transactions involving noncurrent assets and/or liabilities.

Depletion (Page 13). The process of recognizing, by acharge against income, the reduc-tion in the cost of a naturalresource (minerals, oil, gas) due toits withdrawal and use or sale.

Depreciation (Page 12). Periodic charges to income to recognize the cost of “wear andtear” of a company’s fixed assetsover the estimated useful lives ofthose assets.

Diluted Earnings per CommonShare (page 33)The amount of current earnings orloss per share reflecting the maxi-mum dilution (that is, the negativeimpact) assuming the issuance of allpotentially dilutive common shares.

Dilution (Page 33). The reduction in common earningsper share (or increase in loss) ifconvertible securities are converted,stock options and warrants are exer-cised or other shares are issued.

Dividend Payout Percentage(Page 36).Dividends per share divided byearnings per share, expressed as a percentage.

Dividend Yield (Page 37). The dividend paid on each shareof each class of stock as a percent-age of the market price of thoseshares. See also CommonDividend Yield.

Dividends (Pages 2, 36). Payments, generally declared bythe Board of Directors, fromretained earnings to shareholders

to compensate them for theirinvestment.

Earnings per Common Share(Page 33). Net income reduced by preferreddividends and divided by the aver-age outstanding number of com-mon shares during the accountingperiod.

Estimated Useful Life (Page 12). The period of time over which theowner of an asset (physical orintangible) estimates that that assetwill continue to be of productiveuse or have continuing value.

Extraordinary Items (Page 29).Nonoperating items that are bothunusual and occur infrequently.

Fair Market Value (Page 9). The amount at which an itemcould be exchanged between willing unrelated parties, otherthan in a forced liquidation. It isusually the quoted market pricewhen a market exists for the item.

Financial Accounting Standards Board (FASB) (Page 2).The independent, private-sectororganization designated to estab-lish standards for financialaccounting and reporting. It is thebody that issues GAAP, generallyaccepted accounting principles.

FIFO (Page 40). Acronym for First-In, First-Out.See First-In, First-Out.

Financial Leverage (Page 32). See Leverage (Financial).

Financial Statement Ratio (Page 22). A mathematical relationshipbetween two or more amountsreported in financial statements.Financial statement ratios can pro-vide relative measures of, andinsights into, the health, conditionand performance of a company.

First-In, First-Out (Page 40). An inventory-costing method thatstates inventory at its most currentcost while charging the cost ofsales in the order the inventorywas accumulated.

Fixed Assets (Page 12). Another term for the property,plant and equipment used in theoperation of a business.

Footnotes (Pages 2, 40). Additional details and disclosuresabout the figures and informationcontained in a company’s financialstatements.

46

Foreign Currency TranslationAdjustments (Page 21). The cumulative adjustment, report-ed in the Equity section of the bal-ance sheet, resulting from thetranslation of a foreign subsidiary’slocal currency financial statementsinto the currency of the parentcompany.

Generally Accepted AccountingPrinciples (GAAP) (Page 1). The rules and standards followedin recording transactions and inpreparing financial statements.

Goodwill (Page 13). An intangible asset that representsthe excess of the amount paid foran acquired company over the fairmarket value of the net assets ofthat company. Basically, it is thevalue of the name and reputationof the acquired company.

Gross Margin (Page 28). The excess of sales over cost ofsales or the profit from sales beforeconsidering operating, general andother expenses. Also called GrossProfit or Product Profit.

Gross Margin Percentage(Page 28).Gross margin expressed as a per-centage of sales. Also called GrossProfit Percentage or Product ProfitPercentage.

Held-to-Maturity Securities(Page 10).Debt securities that the holder/owner has the ability and intent tohold to maturity. They are carriedat amortized cost (original cost lessprincipal payments and premiumor discount amortization).

Highly Leveraged (Page 32). A company with a large proportionof bonds and preferred stock out-standing relative to the amount ofcommon stock.

Impairment (Permanent) of Loans(Investments) (Page 14). The probability that the lender(investor) will not collect allamounts in accordance with theloan agreement.

Income Statement(Pages 2, 26-36). Report summarizing the revenuesand expenses and reporting the netincome (or loss) of a business foran entire accounting period. Alsocalled the Statement of Earnings,Statement of Profit and Loss, P&Lor Operating Statement.

Income Taxes (Page 29). The amount of income tax expensereported for the period. It is oftenreferred to as the Tax Provision orProvision for Income Taxes.

Income Taxes Payable (Page 15). The obligation to pay federal, for-eign, state and local income taxesthat are due within one year fromthe balance-sheet date.

Intangible Assets (Page 13).Nonphysical assets with continuingvalue, such as goodwill, copy-rights, trademarks and franchises.

Interest (Page 29). Payments by borrowers of funds tocompensate lenders for the use oftheir funds.

Interest Coverage (Page 31). The number of times the annualinterest on debt obligations is cov-ered by income for the year beforeconsidering interest on the debtobligations and income taxes.

Inventory (Pages 10-11). The cost of goods on handthat were purchased and/ormanufactured or that are beingmanufactured for sale tocustomers.

Inventory Turnover (Pages 23-24). The number of times the averageinventory is sold during the year.

Investment Securities (Page 14).Securities (debt or equity) held forstrategic purposes and/or long-termappreciation or income.

Last-In, First-Out (LIFO). (Page 40). An inventory-costing method thatstates inventory at its earliestcost while charging cost of salesat its latest cost (in the reverseorder that the inventory wasaccumulated).

Leverage (Financial) (Page 32).Relates a company’s long-termdebt to its capital structure. Also, it is the practice of obtainingcapital using borrowed funds or preferred stock, rather thancommon stock.

Liability (Pages 8, 16-18). An obligation to pay for assets orgoods or services acquired or torepay borrowed funds.

LIFO (Page 40).Acronym for Last-In, First-Out. See Last-In, First-Out.

Long-Term Debt (Page 18). Borrowed funds due after one yearfrom the balance sheet date. SeeCurrent Portion of Long-Term Debtand Other Long-Term Debt.

Long-Term Liabilities (Page 17).Obligations that are due after oneyear from the balance-sheet date,

Lower of Cost or Market Rule.(Page 11).The rule is that inventory shouldbe valued at its cost or marketvalue, whichever is lower. Theintent is to provide a conservativefigure in valuing a company’sinventory. See also Market Value.

Management Discussion andAnalysis (MD&A) (Page 1). An SEC-required report in whichmanagement provides selectedfinancial data to highlight signifi-cant trends in the company’s finan-cial position or operating results.

Market Price (Page 11). The price at which a good can besold in the open market. See alsoFair Market Value.

Market Value (Pages 9, 11). See Fair Market Value.

Marketable Securities(Pages 9-10).Readily liquid securities (debt orequity) that can be converted intocash on very short notice.

Mortgage Bonds (Page 18). Formal, secured debt obligationsthat are backed by certain specificassets of the issuer.

Net Asset Value (Page 24).See Book Value.

Net Book Value (Page 24). See Book Value.

Net Income/Loss (Page 29). The final result of all revenue andexpense items for the period. Alsocalled Net Profit or Loss. Oftenreferred to as the “Bottom Line.”

Net of Taxes (Page 10). Term meaning the value or amounthas been adjusted for the effects ofapplicable taxes.

Net Profit Ratio (Page 31). Net income expressed as a }percentage of sales.

Net Quick Assets (Page 23). The excess of quick assets overcurrent liabilities.

47

Notes Payable (Page 15). Short- or long-term obligation, evidenced by a formal borrowingagreement (such as a promissorynote), to repay borrowed funds.

Operating Income or Loss(Page 28). The profit or loss generated by acompany’s normal, recurring oper-ating activities before consideringnonoperating items, income taxes,gains or losses from disposals of a segment of the business andextraordinary items.

Operating Margin (Page 30).Operating income expressed as apercentage of sales.

Other Long-Term Debt (Page 18). All debt due after one year fromthe balance-sheet date that is notreported elsewhere in the balancesheet.

Paid-in Capital. See Additional Paid-in Capital.

Par Value (Page 19). The nominal or face value of asecurity assigned by the issuer forbalance-sheet reporting. It has norelation to market value.

Permanent Impairment (Page 14). See Impairment (Permanent) ofLoan (Investments).

Preferred Dividend Coverage(Page 32). The number of times the preferreddividend is covered (earned) by netincome.

Preferred Stock (Page 19). An equity security that entitles itsholders to certain preferences overcommon shareholders, such as div-idends, liquidation value and con-vertibility into other securities, etc.

Preferred Stock Ratio (Page 26). The percentage that preferredstockholders’ equity bears to totaltangible capitalization (the sum ofshareholders’ equity and long-termdebt reduced by intangibles).

Prepaid Expenses (Page 11).Payments in advance for goods orservices, which will be consumedand deducted from income duringthe future, normal operating cycle,generally one year.

Price-Earnings Ratio (Page 35).The comparison of the marketprice of a share of stock to theearnings per share of that stock,expressed as a ratio. Also calledthe P/E ratio.

Property, Plant and Equipment(Page 12). Assets not intended for sale thatare used to manufacture, display,warehouse and transport thecompany’s products and houseits employees. See also FixedAssets.

Quick Assets (Page 22). Assets that can be converted tocash quickly.

Quick Assets Ratio (Page 23). The relationship between quickassets and current liabilities,expressed as a ratio.

Retained Earnings (Page 20). The total profit or loss of thecompany less the total of alldividends paid, since thecompany’s startup.

Return on Equity (ROE) (Page 37). Net income for the periodexpressed as percentage of averageshareholders’ equity for the period.

Securities and ExchangeCommission (SEC) (Page 2). The main securities regulatoryauthority in the U.S.

Shareholders’ Equity(Pages 8, 18-21). The total of shareholders’ invest-ments in the company and totalprofits or losses since the start-upof the company, less all dividendsand/or capital distributions, unreal-ized gain on available-for-salessecurities and any foreign currencytranslation adjustments since thecompany’s start-up.

Stated Value (Page 19). The nominal or face value of asecurity assigned by the issuer inlieu of par value for balance-sheetreporting. It has no relation to market value.

Statement of Cash Flows. See Cash Flows, Statement of.

Statement of Changes inShareholders’ Equity. See Changes in Shareholders’Equity, Statement of.

Stock Option, Compensatory(on Unissued Stock) (Page 33). An agreement, usually between an issuer and its executives/employees, that grants the right to purchase securities, such ascommon stock, at a specifiedprice. Options are common stockequivalents and may dilute earn-ings per common share.

Stock Option (Publicly Traded).*A security bought and sold in thepublic securities markets that pro-vides the holder the right, but notnecessarily the obligation, to buyor sell a specified security in thequantity, at the amount, and during the time period specified in the option.

Trading Securities (Page 9).Securities (debt or equity) boughtand sold frequently, principally togenerate short-term profits. Theyare carried at fair market value,with any changes in the valuereported in income.

Treasury Stock (Page 21). The total cost of any of the compa-ny’s stock that has been repur-chased or otherwise reacquiredfrom shareholders and held in thecompany’s treasury.

Treasury Stock Method (page 34).A method to calculate the effect onearnings per share of stock optionsand warrants. All option proceedsfrom the assumed conversion of in-the-money options are assumed tobe used to repurchase shares (thatis, reacquired and held in the com-pany’s treasury) at the average stockprice for the period.

Unrealized Gain/Loss (Page 21). The difference between the cost (orpreviously reported fair marketvalue) of an asset held at the bal-ance sheet date and its fair marketvalue at that date.

Warrant (Page 33). A security, generally evidenced bya certificate, giving the holder theright to purchase securities, suchas common stock, at a specifiedprice. Warrants are common stockequivalents and may dilute earn-ings per common share.

Working Capital (Page 22). The excess of current assets overcurrent liabilities.

*Note: This definition is not foundwithin this booklet. We haveincluded the definition in the glossary only to help better definethe differences between the twotypes of stock options.

NOTES

48

NOTES

49

INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . INSIDE FRONT COVER

HOW TO READ A FINANCIAL REPORT . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

A FEW WORDS BEFORE BEGINNING . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

CONSOLIDATED FINANCIAL STATEMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . 4

THE BALANCE SHEET . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

JUST WHAT DOES THE BALANCE SHEET SHOW? . . . . . . . . . . . . . . . . . . . . 22

THE INCOME STATEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

ANALYZING THE INCOME STATEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

THE STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY . . . . . . . . . . . . . 36

THE STATEMENT OF CASH FLOWS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

ADDITIONAL DISCLOSURES AND AUDIT REPORTS . . . . . . . . . . . . . . . . . . . 40

THE LONG VIEW . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

SELECTING STOCKS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

GLOSSARY OF SELECTED TERMS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

INTRODUCTION

Known “from Wall Street to Main Street”—and worldwide—Merrill Lynch is a globalleader in the financial services industry. As a public service, Merrill Lynch wants to sharesome of its expertise in, and knowledge of, financial reporting through this booklet.

We hope this booklet will serve as a valuable resource to help readers learn how to readand analyze a company’s annual report. Through it, readers can learn that an annualreport is not just a jumble of numbers and mind-numbing data. Read with understandingand analytical insight, the numbers and data in an annual report can tell an interesting,meaningful and fascinating story.

TABLE OF CONTENTS

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Economy & Finance