Reading Financial Reports for Dummies (16 page)

statement,
this document reviews a company’s operations over a specific amount of time. This period can last for one month, one quarter, six months, one year, or any other period indicated at the top of the statement. I discuss the income statement in Chapter 7 and how to analyze the statement in Part III.

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Statement of cash flows:
This document discusses the actual flow of cash into and out of the company. The statement has three sections focusing on changes to cash status from operations, from investing, and from financing. Like the income statement, the statement of cash flows reflects results over a specific period of time. I discuss this statement in greater detail in Chapter 8, and I talk about cash-flow analysis in Chapter 13.

Summarizing the Financial Data

Knowing that most people won’t spend the time reading all the way through the annual report, many companies summarize their numbers in various ways. The two most common ways to summarize are to highlight the financial data presented in the financial statements and to summarize some key information in the notes to the financial statements. But beware: Most summaries highlight the good news and skip over the bad.

Finding the highlights

The highlights to the financial data summarize the financial results for the year being reported. Typically, this summary is called the
financial highlights,
but companies can be creative because this section isn’t a required part of the report. And because the highlights aren’t required, they’re not always presented according to GAAP rules, so don’t count on their accuracy. You usually find the financial highlights at the front of the annual report, after the letter from the CEO and chairman of the board. Some companies include them inside the annual report’s back cover.

You frequently find financial highlights at the front of the annual report, designed in a graphically pleasing way. Most companies show either a 10-year or 11-year summary that doesn’t include much detail but allows you to see the firm’s growth trends. Although this type of summary can be a good historical overview, don’t count on it. Instead, do your own research of the company’s financial history to be sure that you’re aware of both the good and bad news.

Remember that even outstanding companies have some bad years that they want to gloss over.

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Reading the notes

The notes to the financial statements is the section where you find any warts on a company’s financial record. The notes are a required part of the annual report, and they give you the details behind the numbers presented in the financial statements. Companies like to hide their problems in the notes; in fact, most companies even print this part of the annual report in smaller type.

Most of the details in the notes discuss the impact that the following business aspects may have on the company’s future financial health:

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Accounting methods used

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Changes to accounting methods

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Key financial commitments that can impact current and future operations

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Lease obligations

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Pension and retirement benefits

If any red flags pop up in a company’s annual report, this part is where you can find the financial details and explanations. The auditors’ report probably highlights any potential problems and red flags that you should search for in the notes. You may also find problems mentioned in the MD&A section, but the full explanations for these problems are probably covered in greater detail in the notes section.

Don’t get turned off by the visually unpleasing presentation. The notes to the financial statements is one of the most critical parts of the annual report. I cover the importance of the notes in more detail in Chapter 9.

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Chapter 6

Balancing Assets against

Liabilities and Equity

In This Chapter

▶ Defining assets, liabilities, and equity

▶ Exploring the basics of balance sheets

▶ Reviewing assets

▶ Understanding liabilities

▶ Examining equity

Picture a tightrope walker carefully making her way across a tightrope.

As if that isn’t challenging enough, imagine that she’s carrying plates of equal weight on both sides of a wobbling rod. What would happen if one of those plates were heavier than the other? You don’t have to understand squat about physics to know that it isn’t gonna be a pretty sight.

Just as the tightrope walker must be in balance, so must a company’s financial position. If the assets aren’t equal to the claims against those assets, then that company’s financial position isn’t in balance, and everything topples over. In this chapter, I introduce you to the balance sheet, which gives the financial report reader a snapshot of a company’s financial position.

Understanding the Balance Equation

A company keeps track of its financial balance on a
balance sheet,
which
is a summary of the company’s financial standing at a particular point in time. To understand balance sheets, you first have to understand the following terms, which typically appear on a balance sheet:

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Assets:
Anything the company owns, from cash to inventory to the paper it prints the reports on

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Liabilities:
Debts the company owes

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Equity:
Claims made by the company’s owners, such as shares of stock The assets a company owns are equal to the claims against that company, either by debtors (liability) or owners (equity). The claims side must equal the assets side for the balance sheet to stay in balance. The parts always balance according to this formula:

Assets = Liabilities + Equity

As a company and its assets grow, its liabilities and equities grow in similar proportion. For example, whenever a company buys a major asset, such as a building, it has to either use another asset to pay for the building or use a combination of assets and liabilities (such as bonds or a mortgage) or equity (owner’s money or outstanding shares of stock).

Introducing the Balance Sheet

Trying to read a balance sheet without having a grasp of its parts is a little like trying to translate a language you’ve never spoken — you may recognize the letters, but the words don’t mean much. Unlike a foreign language, however, a balance sheet is pretty easy to get a fix on as soon as you figure out a few basics.

Digging into dates

The first things you should notice when looking at the financial statements are the dates indicated at the top of the statements. You need to know what date or what period of time the financial statements cover. This information is particularly critical when you start comparing results among companies.

You don’t want to compare the 2008 results of one firm with the 2007 results of another. Economic conditions certainly vary, and the comparison doesn’t give you an accurate view of how well the companies competed in similar economic conditions.

On a balance sheet, the date at the top is written after “As of,” meaning that the balance sheet reports a company’s financial status on that particular day.

A balance sheet differs from other kinds of financial statements, such as the income statement or statement of cash flows, which show information for a period of time such as a year, a quarter, or a month. I discuss income statements in Chapter 7 and statements of cash flows in Chapter 8.

Chapter 6: Balancing Assets against Liabilities and Equity
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When a year is more than a year

Things can get confusing if a company picks a

“Lone Star Steakhouse & Saloon, Inc. . . .

certain point in time rather than an actual date

announced preliminary unaudited operat-

for its fiscal year. For example, a company can

ing results for the 17-week fourth quarter

decide to end its fiscal year on the last Friday

and 53-week fiscal year ended December

of a particular month, which means its fiscal

31, 2002. The company operates on a 52- or

year will sometimes be 52 weeks and some-

53-week fiscal year ending the last Tuesday

times be 53 weeks. If a firm chooses a point in

in December, and fiscal 2002 included 53

time rather than a year-end or month-end date,

weeks, and the fourth quarter, 17 weeks, as

you usually find an explanation in the notes to

compared to 52 and 16 weeks, respectively,

the financial statements about how it handles

for fiscal 2001.”

its 52- and 53-week years, which can get very

Looking at this convoluted paragraph, you can

convoluted.

see the complications of a fiscal year ending on

For example, Lone Star Steakhouse & Saloon

a set period in time rather than on the last day

explained its 52- and 53-week years when it

of a month. Comparing a 16-week quarter with a

released its unaudited fiscal-year 2002 earnings

17-week quarter can be misleading, as an extra

and fourth-quarter results like this:

week of sales is certainly going to look better.

If a company’s balance sheet states “As of December 31, 2008,” the company is most likely operating on the calendar year. Not all firms end their business year at the end of the calendar year, however. Many companies operate on a fiscal year instead, which means they pick a 12-month period that more accurately reflects their business cycles. For example, most retail companies end their fiscal year on January 31. The best time of year for major retail sales is during the holiday season and post-holiday season, so stores close the books after those periods end.

To show you how economic conditions can make it very difficult to compare the balance sheets of two companies during two different fiscal years, I’ll use as an example the terrorist attacks on September 11, 2001. If one company’s fiscal year runs from September 1 to August 31 and another’s runs from January 1 to December 31, the results could be very different. The company that reports from September 1, 2000, to August 31, 2001, wouldn’t be impacted by that devastating event on its 2000/2001 financial reports.

Its holiday-season sales from October 2000 to December 2000 would likely be much different from those of the company that reports from January 1, 2001, to December 31, 2001, because those results would include sales after September 11, when the economy slowed considerably. However, the first company’s balance sheet for September 1, 2001, to August 31, 2002, would show the full impact of the attacks on its financial position.

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Nailing down the numbers

As you start reading the financial reports of large corporations, you see that they don’t use large numbers to show billion-dollar results (1,000,000,000) or carry off an amount to the last possible cent, such as 1,123,456,789.99.

Imagine how difficult it would be to read such detailed financial statements!

At the top of a balance sheet or any other financial report, you see a statement indicating that the numbers are in millions, thousands, or however the company decides to round the numbers. For example, if a billion-dollar company indicates that numbers are in millions, you see 1 billion represented as 1,000

and 35 million as 35. The 1,123,456,789.99 figure would be shown as 1,123.

Rounding off numbers makes a report easier on the eye, but be sure you know how companies are rounding their numbers before you start comparing financial statements among them. This is particularly crucial when you compare a large company with a smaller one. The large company may round to millions, whereas the smaller company rounds to thousands.

Figuring out format

Balance sheets come in three different styles: the account
format, the report format, and the financial position format. I show you a sample of each format in the following figures, using very simple numbers to give you an idea of what you can expect to see. Of course, real balance sheets have much larger and more complex numbers.

Account format

The
account format
is a horizontal presentation of the numbers, as Figure 6-1

shows.

Current assets

$300

Current liabilities

$200

Long-term assets

$150

Long-term liabilities

$100

Other assets

$ 50

Total liabilities

$300

Figure 6-1:

The account

Shareholders’ equity

$200

format.

Total assets

$500

Total liabilities/equity

$500

A balanced sheet shows total assets equal to total liabilities/equity.

Chapter 6: Balancing Assets against Liabilities and Equity
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Report format

The
report
format
is a vertical presentation of the numbers. You can check it out in Figure 6-2.

Current assets

$300

Long-term assets

$150

Other assets

$ 50

Total assets

$500

Current liabilities

$200

Long-term liabilities

$100

Figure 6-2:

Total liabilities

$300

The report

Shareholders’ equity

$200

format.

Total liabilities/equity

$500

Financial position format

The
financial position format,
which is rarely used in the U.S., is commonly used internationally, especially in Europe. The key difference between this format and the other two is that it has two lines that don’t appear on the account and report formats:

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Working capital:
This line is the current assets the company has available to pay bills. You find the working capital by subtracting the current assets from the current liabilities.