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Generally accepted accounting principles (GAAP) and financial
reporting standards have been extensively developed over the
last half century. These guidelines rest on one key premise”
the separation of management of a business from the outside
investors in the business. In the formulation of GAAP it is
assumed that financial statements are for those who have
supplied the ownership capital to a business but who are not
directly involved in managing the business. Financial state-
ments are prepared for the “absentee owners” of a business,
in other words. GAAP and financial reporting standards do not
ignore the need for information by the lenders to a business.

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FINANCIAL REPORTING


But the shareowners of the business are the main con-
stituency for whom financial statements are prepared.
Federal law governs the communication of financial infor-
mation by businesses whose capital stock shares are traded
on public markets. The federal securities laws are enforced
mainly by the Securities and Exchange Commission (SEC),
which was established in 1934. Also, the New York Stock
Exchange, Nasdaq, and other securities markets enforce
many rules and regulations regarding the release and commu-
nication of financial information by companies whose securi-
ties are traded on their markets. For instance, a business
cannot selectively leak information to some stockholders or
lenders and not to others, nor can a business tip off some of
them before informing others later. The laws and require-
ments of financial reporting are designed to ensure that all
stockholders and lenders have equal access to a company™s
financial information and financial statements.
A business™s financial statements may not be the first news
about its profit performance. Public corporations put out press
releases concerning their earnings for the period just ended
before the company releases its actual financial statements.
Privately owned businesses do not usually send out letters
about profit performance in advance of releasing their finan-
cial statements”although they could do this.


Financial Statements Example
Chapter 3 introduced the external income statement for a
business, followed by the internal management profit report
for the business. Now the complete set of financial statements
for the business is presented, which consists of the following:
• Income statement for the year just ended (Figure 4.1)
• Statement of financial condition at the close of the year just
ended and at the close of the preceding year (Figure 4.2)
• Statement of cash flows for the year just ended (Figure 4.3)
• Statement of changes in stockholders™ equity for the year
just ended (Figure 4.4)

The income statement ranks first in terms of readability and
intuitive understandability. Most people understand that profit
equals revenue less expenses, although the technical jargon in

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I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T S




Sales revenue $39,661,250
Cost-of-goods-sold expense $24,960,750
Gross margin $14,700,500
Selling and administrative expenses $11,466,135
Earnings before interest and income tax $ 3,234,365
Interest expense $ 795,000
Earnings before income tax $ 2,439,365
Income tax expense $ 853,778
Net income $ 1,585,587

Earnings per share* $ 3.75

*Privately owned business corporations do not have to report earnings per
share; publicly owned corporations are required to disclose this key ratio in
their income statements.
FIGURE 4.1 Income statement for the year just ended.




income statements is a barrier to many readers. The balance
sheet (or statement of financial condition) ranks second.
Assets and liabilities are familiar to most people”although
the values reported in this financial statement are not imme-
diately obvious to many readers. The statement of cash flows
is presented in a very technical format that makes the state-
ment very difficult to read, even for sophisticated investors.

The footnotes that accompany the company™s financial state-
ments are not presented here for the business. Footnotes
often run several pages. Footnotes, although difficult and
time-consuming to read through, contain very important
information. Stock analysts and investment managers scour
the footnotes in financial reports, digging for important infor-
mation about the business. The footnotes are not needed for
explaining financial statement ratios. (For a discussion of foot-
notes, see Chapter 16 in my book How to Read a Financial
Report, 5th ed., John Wiley & Sons, 1999.)
Publicly owned businesses present their financial state-
ments in a format that compares the most recent three years
(as required by SEC rules). The three-year comparative format
makes it easier to follow trends, of course. Many privately

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FINANCIAL REPORTING




Assets
At Close of At Close of
Year Just Preceding
Ended Year
Cash $ 2,345,675 $ 2,098,538
Accounts receivable $ 3,813,582 $ 3,467,332
Inventories $ 5,760,173 $ 4,661,423
Prepaid expenses $ 822,899 $ 770,024
Total current assets $12,742,329 $10,997,317
Property, plant, and equipment $20,857,500 $18,804,030
Accumulated depreciation ($ 6,785,250) ($ 6,884,100)
Cost less accumulated depreciation $14,072,250 $11,919,930
Total assets $26,814,579 $22,917,247

Liabilities and Owners™ Equity
Y
Accounts payable $ 2,537,232 $ 2,180,682
Accrued expenses payable $ 1,280,214 $ 1,136,369
FL
Income tax payable $ 58,650 $ 117,300
Short-term debt $ 2,250,000 $ 1,765,000
Total current liabilities $ 6,126,096 $ 5,199,351
AM


Long-term debt $ 7,500,000 $ 5,850,000
Total liabilities $13,626,096 $11,049,351
Capital stock (422,823 and 420,208 shares) $ 4,587,500 $ 4,402,500
TE




Retained earnings $ 8,600,983 $ 7,465,396
Total owners™ equity $13,188,483 $11,867,896
Total liabilities and owners™ equity $26,814,579 $22,917,247
FIGURE 4.2 Statement of financial condition at close of the year just ended
and at close of the preceding year.




owned businesses present their financial statements for two
or three years, although practice is not uniform in this
respect.

The company™s income statement (Figure 4.1) and statement
of cash flows (Figure 4.3) are presented for the most recent
year only. The statement of financial condition (Figure 4.2) is
presented at the close of its two most recent two years. Finan-
cial statement ratios are calculated for each year. The ratios
are calculated the same way for all years for which financial

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I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T S




Cash Flows from Operating Activities
Net income $1,585,587
Changes in operating assets and liabilities:
Accounts receivable ($ 346,250)
Inventories ($1,098,750)
Prepaid expenses ($ 52,875)
Depreciation expense $ 768,450
Accounts payable $ 356,550
Accrued expenses payable $ 143,845
Income tax payable ($ 58,650)
Cash flow from operating activities $1,297,907

Cash Flows from Investing Activities
Investment in property, plant, and equipment ($3,186,250)
Proceeds from disposals of property, plant, and equipment $ 265,480
Cash used in investing activities ($2,920,770)

Cash Flows from Financing Activities
Net increase in short-term debt $ 485,000
Increase in long-term debt $1,650,000
Issuance of capital stock shares $ 185,000
Cash dividends to stockholders ($ 450,000)
Cash from financing activities $1,870,000
Cash increase during year $ 247,137
Cash balance at beginning of year $2,098,538
Cash balance at end of year $2,345,675
FIGURE 4.3 Statement of cash flows for the year just ended.




statements are presented. As a general rule, only a few ratios
are presented in most financial reports. Thus investors and
lenders have to calculate ratios or look in financial informa-
tion sources that report the financial statement ratios for busi-
nesses.
The business in this example is a corporation that is owned
by a relatively small number of persons who invested the capi-
tal to start the business some years ago. The business has over
$39 million annual sales (see Figure 4.1). Many publicly owned
corporations are much larger than this, and most privately
owned businesses are smaller. Size is not the point, however.

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FINANCIAL REPORTING




Capital Retained
Stock Earnings
Beginning balances (420,208 shares) $4,402,500 $7,465,396
Net income for year $1,585,587
Shares issued during year (2,615 shares) $ 185,000
Dividends paid during year ($ 450,000)
Ending balances (422,823 shares) $4,587,500 $8,600,983
FIGURE 4.4 Statement of changes in stockholders™ equity for the year just
ended.




The techniques of financial analysis and the ratios discussed in
the chapter are appropriate for any size of business.


LIMITS OF DISCUSSION
The chapter does not pretend to cover the broad field of secu-
rities analysis (i.e., the analysis of stocks and debt securities
issued by public corporations that are traded in public market-
places). This broad field includes the analysis of the competi-
tive advantages and disadvantages of a business, domestic
and international economic developments affecting a business,
business combination possibilities, political developments,
court decisions, technological advances, demographics,
investor psychology, and much more. The key ratios explained
in this chapter are the basic building blocks used in securities
analysis.
The chapter does not discuss trend analysis, which involves
comparing a company™s latest financial statements with its
previous years™ statements to identify important year-to-year
changes. For example, investors and lenders are very inter-
ested in the sales growth or decline of a business and the
resulting impact on profit performance, cash flows, and finan-
cial condition. The chapter has a more modest objective”to
explain the basic ratios used in financial statement analysis.
Only a handful of ratios are discussed in the chapter, but they
are extremely important and widely used.
The business example does not include any extraordinary
gains or losses for the year. Extraordinary means onetime,

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I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T S


nonrecurring events. For example, a business may sell off or
abandon a major segment of its operations and record a large
loss or gain. A business may record a substantial loss caused

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