Reading Financial Reports for Dummies (5 page)

Slow Inventory Turnover ............................................................................ 334

Slow-Paying Customers ............................................................................... 334

Glossary .................................................................. 335

Index ....................................................................... 343

Introduction

When I open an annual financial report today, one of the first things I ask myself is, “Can I believe the numbers that I’m seeing?” I never used to think that way. I used to think that any corporate financial report audited by a certified public accountant truly was prepared with the public’s interests in mind.

The financial scandals of the late 1990s and early 2000s destroyed my confidence in those numbers, as they did for millions of other U.S. investors who lost billions in the stock-market crash that followed those scandals. Sure, a stock bubble (a period of rising stock prices that stems from a buying frenzy) had burst, but financial reports that hid companies’ financial problems fueled the bubble and helped companies put on a bright, smiling face for the public.

After these financial reporting scandals came to light, more than 500 public companies had to restate their earnings. Yet, in almost a repeat of the scandals, the mortgage mess of 2007 showed how financial institutions were still using the same tricks of keeping key financial information off the books to hide financial troubles.

I still wonder what government regulators and public accountants were thinking and doing during these fiascos. How did the system break down so dramatically and so quickly? Although a few voices raised red flags, their pleas were drowned out by the euphoria of the building stock-market bubble of the early 1990s and the housing-market bubble of the mid-2000s.

These financial scandals occurred partly because Wall Street measures success based on a company’s quarterly results. Many on Wall Street are more concerned about whether a company meets its quarterly expectations than they are about a company’s long-term prospects for future growth.

Companies that fail to meet their quarterly expectations find their stock quickly beaten down on the market. To avoid the fall, companies massage their numbers. This shortsighted race to meet the numbers each quarter is a big reason why these scandals happen in the first place.

Since the scandals broke, legislators have enacted new laws and regulations to attempt to correct the problems. In this book, I discuss these new regulations and show you how to read financial reports with an ounce of skepticism and a set of tools that can help you determine whether the numbers make sense. I help you see how companies can play games with their numbers and show you how to analyze the numbers in a financial report so you can determine a company’s true financial health.

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Reading Financial Reports For Dummies, 2nd Edition

About This Book

This book provides detailed information on how to read a financial report’s key statements — the balance sheet, the income statement, and the statement of cash flows — as well as how to discover and scour a report’s other important parts.

When you finish reading this book, you’ll understand what makes up the parts of financial statements and how to read between their lines, using the fine print to increase your understanding of a company’s financial position.

You’ll also be familiar with the company outsiders who are responsible for certifying the accuracy of financial reports, and you’ll know how the rules have changed since the corporate scandals broke. Although I can’t promise that you’ll be able to detect every type of fraud, I can promise that your antennae will be up and you’ll be more aware of how to spot possible problems. And most important, you’ll get a good understanding of how to use these reports to make informed decisions about whether a company is a sound investment. If you work inside a company, you’ll have a better understanding of how to use the reports to manage your company or your department for success.

Conventions Used in This Book

I use the words “corporation” and “company” almost interchangeably. Just so we’re on the same page, all corporations are companies, but not all companies are corporations. The key difference between them is whether a company has gone through
incorporation,
which is the rather complicated legal process by which a company gets a state charter to operate as a business. To find out more about company structure and incorporation, see Chapter 2.

To help you practice the tools I show you in this book, I use the annual reports of the two largest toy companies, Mattel and Hasbro, and dissect their reports throughout various chapters. You can download a full copy of the reports by visiting the investor-relations section of the companies’ Web sites: www.hasbro.com and www.mattel.com.

What You’re Not to Read

Many of the topics I discuss in this book are, by nature, technical — dealing with finances can hardly be otherwise. But in some cases, I provide details that offer more than the basic stuff you need to know to understand the big
Introduction

3

picture. Because these explanations may not be up your alley, I mark them with a Technical Stuff icon (see the upcoming section “Icons Used in This Book”) and invite you to skip them without even the slightest regret. Even if you skip them, you still get all the information you need. On the other hand, if you savor every financial detail or fancy yourself the bravest of all financial report readers, then dig in!

I’ve also added some sidebars to give you more detail about a topic or some financial history. You can skip those, too, and still be able to understand how to read financial reports.

Foolish Assumptions

To write this book, I made some basic assumptions about who you are. I assume that you

✓

Want to know more about the information in financial reports and how you can use it.

✓

Want to know the basics of financial reporting.

✓

Need to gather some analytical tools to more effectively use financial reports for your own investing or career goals.

✓

Need a better understanding of the financial reports you receive from the company you work for to analyze the results of your department or division.

✓

Want to get a better handle on what goes into financial reports, how they’re developed, and how to use the information to measure the financial success of your own company.

Both investors and company insiders who aren’t familiar with the ins and outs of financial reports can benefit from the information and tools I include in this book.

How This Book Is Organized

I organize this book into six parts. After introducing the basics, I carefully dissect what goes into financial reports, giving you the tools you need to analyze those reports. I introduce you to the company outsiders who are involved in the financial reporting process and show you how to find red flags that may indicate deceptive or fraudulent reporting.

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Reading Financial Reports For Dummies, 2nd Edition

Part I: Getting Down to Financial

Reporting Basics

Part I discusses the basics of accounting and financial reporting. If you need an introduction to these basics or just a simple refresher course, you may want to begin here. In this part, you find information about the types of business structures, the differences between public and private corporations, and the accounting basics necessary to understand financial reports.

Part II: Checking Out the Big

Show: Annual Reports

This part introduces you to the key elements of an annual financial report.

The first chapter reviews the main sections of an annual report; the chapters that follow focus on each of these sections individually, explaining what you find in a financial report and how to use that information. Another chapter explains in more detail what you can expect to find in the notes to the financial statements and what all that drivel means. In the last chapter of this part, I discuss consolidated statements and the information that goes into them.

Part III: Analyzing the Numbers

In this part, I give you the tools you need to analyze the numbers in financial statements. I show you how to test profitability, liquidity, and cash flow (see Chapters 11, 12, and 13 for details on these topics). These tools help you determine whether a company is a good investment.

Part IV: Understanding How Companies

Optimize Operations

This part focuses on using financial statements to measure how efficiently management is using its resources. I review the basics of budgeting and how to use financial reports in the budgeting process. You also find tools for testing how efficiently companies manage their assets and keep cash flowing.

Introduction

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Part V: The Many Ways Companies

Answer to Others

In this part, I focus on the outsiders involved in the financial reporting process. I review the accounting rules and the role of auditors, and I also discuss the key reports the government requires of all public companies. Then I introduce you to the push toward global financial reporting standards. Next, I look at the role analysts play in the world of financial reporting. I also talk about shareholders and what they should expect from the companies they invest in. And in the last chapter, I discuss how some companies massage the numbers when they compile their financial reports.

Part VI: The Part of Tens

In the
Part of Tens,
I give you a quick reference list pointing out the top ten signs that a company is in financial trouble. I also outline some of the juicier financial reporting scandals of the past several years.

Finally, because much of the language of financial reporting may be new to you, I include a glossary at the end of the book.

Icons Used in This Book

Throughout the book, I use icons to flag parts of the text that you’ll want to notice. Here’s a list of the icons and what they mean.

This icon points out ideas for improving your financial report reading skills and directs you to some useful financial resources.

This icon highlights information you definitely want to remember.

This icon points out a critical piece of information that can help you find the dangers and perils in financial reports. I also use this icon to emphasize information you definitely don’t want to skip or skim when reading a financial report.

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Reading Financial Reports For Dummies, 2nd Edition

This icon highlights information that may explain the numbers in more detail than you care to know. Don’t worry; you can skip these points without missing the big picture!

Throughout the book, I give examples from financial reports of real companies, particularly Mattel and Hasbro. I highlight these examples with the icon you see here.

Where to Go from Here

You can start reading anywhere in this book, but if you’re totally new to financial reports, you should definitely start with Part I so you can get a good handle on the basics before delving into the financial information. If you already know the basics, turn to Part II to begin dissecting the parts of a financial report. And to get started on the road to analyzing the numbers, turn to Part III. If your priority is tools for optimizing company operation, you may want to begin with Part IV. Those of you who want to know more about company outsiders involved in the financial reporting process may want to start at Part V.

Part I

Getting Down to

Financial

Reporting Basics

In this part . . .

If you’re a complete novice to the world of financial

reports, this part gives you the background you need

to understand this complex world, which has a language

and rules all its own. In this part, I discuss the key types of financial reports, both internal and external, as well as what you should expect to find in those reports. I also

explore different types of business structures and talk

about the differences between a public and private com-

pany. Finally, I review the accounting basics you need to understand in order to read financial reports.

Chapter 1

Opening the Cornucopia of Reports

In This Chapter

▶ Reviewing the importance of financial reports

▶ Exploring the different types of financial reporting

▶ Discovering the key financial statements

F
inancial reports
give a snapshot of a company’s value at the end of a particular period, as well as a view of the company’s operations and whether it made a profit. The business world couldn’t function without financial reports. Yes, fewer scandals would be exposed because companies wouldn’t be tempted to paint false but pretty financial pictures, but you’d still need a way to gauge a firm’s financial health.

At this point in time, nothing’s available that can possibly replace financial reports. Nothing can be substituted that’d give investors, financial institutions, and government agencies the information they need to make decisions about a company. And without financial reports, the folks who work for a company wouldn’t know how to make it more efficient and profitable because they wouldn’t have a summary of its financial activities during previous business periods. These financial summaries help companies look at their successes and failures and help them make plans for future improvements.