How To Read A Financial Report

HOW TO READ A FINANCIAL REPORT
The
Purpose of this presentation is to help you better understand the data included in financial reports and how to analyze it. Learn more about companies that offer employment or provided investment opportunities.
COMPONENTS OF AN ANNUAL REPORT

The
Letter to Shareholders: This gives a broad overview of the companys business and financial performance. The Business Review: This summarizes a companys recent developments, trends and objectives. The Finan ial Review: This presents a companys business performance in .
COMPONENTS OF AN ANNUAL REPORT
The Finan ial Review

!
"anagements #iscussion and $nalysis: This section e%plains all significant changes from year to year in the financial statements. &t also includes charts and graphs highlighting the year to year changes. $udited 'inancial (tatements: )onsists of the balance sheet, income statement, statement of changes e*uity, and cash flow.
THE BALANCE SHEET
The balance sheet portrays the financial position of the company by showing what the company owns and what it owes at the report date. &t is a snapshot, since it reports the companys financial position at a specific point in time.
The Income Statement
The &ncome (tatement can be thought of more li+e a motion picture, since it reports on how a company performed during the period,s- presented and shows whether that companys operations have resulted in a profit or loss.
The Statement of Changes in Sharehol ers! E"#it$
The statement of changes in shareholders e*uity reconciles the activity in the e*uity section of the balance sheet from period to period. )hanges in shareholders e*uity result for company profits or losses, dividends and.or stoc+ issuances.
Statement of Cash Flo%s
The statement of cash flows reports on the companys cash movements during the period,s- separating them by operating, investing and financing activities.
The Footnotes
The footnotes provide more detailed information about the financial statements.
$ "odel )ompany )alled /Typical0
To provide a framewor+ for illustration, a fictional public company will be used. $ public company will be used because it is re*uired to provide the most e%tensive amount of information in its annual reports. The re*uirements and standards for financial reporting are set by both governmental and nongovernmental bodies.
This fictional company will represent a typical corporation with the most commonly used accounting and reporting practices. Thus, the model company will be called Typical "anufacturing )ompany, &nc. ,/Typical0, for short.-

1efore e%amining the financial statement in depth, the following points should be +ept in mind:
'inancial statement in certain specialized industries would loo+ some what different from those of Typicals.
2ather than presenting a complete set of footnotes specific to Typical, we will see a listing of appropriate generic footnote data for which a reader of financial statements should loo+. To simplify matters, the statements shown do not illustrate every (3) financial reporting rule and regulation.
The goal of this presentation is to provide readers with a better understanding of the core or basic financial statements in an annual report. The following slides are the consolidated financial statements for Typical "anufacturing )ompany, &nc.
Consoli ate Balance Sheets& Assets

Assets Current Assets: Cash and cash equivalents Marketable securities Accounts receivable net o! allo"ance !or doubt!ul accounts o! $2,3#5 in 19$9 and %3,000 in 19$& 'nventories, at the lo"er o! cost or (arket )re*aid e+*enses and other current assets Total Current Assets December, 31 19X9 19X8 $19,500 46,300 $15,000 32,000
156,000 1&0,000 4,000 405,800
145,000 1&5,000 3,000 380,000
Consoli ate Balance Sheets& Pro'ert$& Plant an E"#i'ment

Property, Plant and !u"pment: ,and -uildin. Machiner/ ,easehold i(*rove(ents 0urniture, !i+tures, etc1 2otal *ro*ert/, *lant and equi*(ent ,ess3 accu(ulated de*reciation #et Property, Plant and !u"pment 30,000 125,000 200,000 15,000 15,000 3&5,000 125,000 $%0,000 30,000 11&,500 1#1,100 15,000 12,000 346,600 9#,000 $49,%00
Consoli ate Balance Sheets& Other Assets

&t'er Assets: 'ntan.ibles 4.ood"ill, *atents5 net o! accu(ulated a(orti6ation o! $300 in 19$9 and $250 in 19$& 'nvest(ent securities, at cost Total &t'er Assets Total Assets
1,950 2,000 300 $,$50 $,000 (%%8,050 (%31,%00
Consoli ate Balance Sheets& Lia(ilities December, 31

)"ab"l"t"es and *'are'olders+ !u"ty )"ab"l"t"es3 Current )"ab"l"t"es: Accounts *a/able 7otes *a/able Accured e+*enses 'nco(e ta+es )a/able 8ther liabilities Current *ortion o! lon. ter( debt Total Current )"ab"l"t"es )on-.term )"ab"l"t"es: 9e!erred inco(e ta+es 9112: debentures *a/able 2010 8ther lon. ter( debt Total )"ab"l"t"es 19X9 19X8 $60,000 51,000 30,000 1#,000 12,000 6,000 1,%,000 16,000 130,000 3$$,000 $5#,000 61,000 36,000 15,000 12,000 181,000 9,000 130,000 6,000 3$%,000
Consoli ate Balance Sheets& Sharehol ers! E"#it$

*'are'older+ !u"ty: )re!erred stock, $51&3 cu(ulative, $100 *ar value; authori6ed, issued and outstandin.3 60,000 shares Co((on stock, $5100 *ar value, authori6ed3 20,000 shares; issued and outstandin.3 19$9 15,000,000 shares, 19$& 14,500,1000 shares Additional *aid in ca*ital <etained earnin.s 0orei.n currenc/ translation ad=ust(ents 4net o! ta+es5 >nreali6ed .ain on available !or sale securities 4net o! ta+es5 ,ess3 2reasur/ stock at cost 419$9 and 19$& 1,000 shares5 Total *'are'olders+ !u"ty Total )"ab"l"t"es and *'are'olders+ !u"ty 6,000 6,000
#5,000 20,000 249,000 1,000 50
#2,500 13,500 219,600 41,0005
45,0005 45,0005 34%,050 305,%00 (%%8,050 (%31,%00
Consoli ate Income Statement

7et ?ales Cost o! sales @ross (ar.in 8*eratin. e+*enses3 9e*reciation and a(orti6ation ?ellin., .eneral and ad(inistrative e+*enses 8*eratin. inco(e 8ther inco(e 4e+*enses53 9ividend and interest inco(e 'nterest e+*ense 'nco(e be!ore inco(e ta+es and e+traordinar/ loss 'nco(e ta+es 'nco(e be!ore e+traordinar/ loss A+traordinar/ ite(3 loss on earthquake destruction 4net o! inco(e ta+ bene!it o! $#505 #et "ncome /ears nded December 31, 19X9 19X8 $#65,050 $#25,000 535,000 51#,000 230,050 20&,000 2&,050 96,&04 105,196 5,250 416,2505 94,196 41,446 52,#50 45,0005 (4,,,50 (40,500 25,000 109,500 #3,500 10,000 416,#505 66,#50 26,250 40,500
Consoli ate Income Statement& contin#e

arn"n-s per common s'are: -e!ore e+traordinar/ loss A+traordinar/ loss #et "ncome per common s'are
$3155 41345 (30$1
$21## ($0,,
Consoli ate Statement of Changes in Sharehol er!s E"#it$

/ear nded December 31, 19X9 1ore"-n Add+l currency 2nreal"3ed pa"d."n 5eta"ned trans secur"ty cap"tal earn"n-s ad7 -a"n 13,500 $219,600 4#,#50 43505 41&,0005 2,500 6,500 2,000 4$1,0005 Pre4 *toc6 8alance 9an0 1, 19X9 7et inco(e 9ividends *aid on3 )re!erred stock Co((on stock Co((on stock issued 0orei.n currenc/ translation .ain 7et unreali6ed .ain on available !or sale securities Com *toc6 Treas stoc6
Total
$6,000 $#2,500
4$5,0005 $305,600 4#,#50 43505 41&,0005 9,000 2,000
$50 $20,000 $249,000 $1,000 $50
$50 4$5,0005 $346,050
8alance Dec0 31, 19X9 $6,000 $#5,000
Consoli ate Statement of Cash Flo%s

/ear Cash !lo"s !or( o*eratin. activities3 7et inco(e Ad=ust(ents to reconcile net inco(e to net cash !ro( o*eratin. activities3 9e*receation and a(orti6ation 'ncrease in accounts receivable 9ecrease in inventor/ 'ncrease in *re*aid e+*enses and other current assets 'ncrease in de!erred ta+es 'ncrease in accounts *a/able 9ecrease in accrued e+*enses 'ncrease in inco(e ta+es *a/able 2otal ad=ust(ents 7et cash *rovided b/ o*eratin. activities nded December 31, 19X9 $4#,#50
2&,050 411,0005 5,000 41,0005 #,000 3,000 46,0005 2,000 2#,050 ,4,800
Consoli ate Statement of Cash Flo%s& contin#e

Cash !lo"s !ro( investin. activities3 ?ecurities *urchases3 2radin. Beld to (aturit/ Available !or sale )rinci*al *a/(ent received on held to (aturit/ securities )urchase o! !i+ed assets 7et cash used in investin activities Cash !lo"s !ro( !inancin. activities3 )a/(ent o! notes *a/able )roceeds !ro( issuance o! co( stock )a/(ent o! dividends 7et cash used in !inancin. activities A!!ect o! e+chan.e rate chan.es on cash 'ncrease in cash Cash and cash equivalents at be.innin. o! /ear Cas' and cas' e!u"<alents at end o4 year 414,1005 43505 41505 50 43&,4005 :5$,950; 410,0005 9,000 41&,3505 :19,350; 2,000 4,500 15,000 (19,500
The Balance Sheet

The
balance sheet represents the financial picture for Typical "anufacturing as it stood at the end of one particular day, #ec. 45, 5676, as though the company were momentarily at a standstill. Typicals balance sheet for the previous year end is also presented. This ma+es it possible to compare the composition of the balance sheets on those dates.
The Balance Sheet& contin#e

The balance sheet is divided into two halves:

Assets, always presented first Lia(ilities an Sharehol ers! E"#it$ &n the standard accounting model, the formula of Assets=Liabilities + Shareholders Equity applies. 1oth halves are always in balance.
They are also in balance because, form an economic viewpoint, each dollar of assets must be /funded0 by a dollar of liabilities or e*uity. 8ence, the name balance sheet. 2eported assets, liabilities, and shareholders e*uity are subdivided into line items or groups of similar /accounts0 having a dollar amount or /balance.0
The Assets section includes all the goods and property owned by the company, and uncollected amounts due ,receivables- to the company from others. The Liabilities section includes all debts and amounts owed ,payables- to outside parties.
The (hareholders Equity section represents the shareholders ownership interest in the company99what the companys assets would be worth after all claims upon those assets were paid. To ma+e it easier to understand the composition of the balance sheet, each of its sections and the related line items within them will be e%amined one9by9one.
The Balance Sheet& Assets& C#rrent an E"#i)alents
Current Assets include cash and those assets that, in the normal course of business, will be turned into cash within a year from the balance sheet date. Cash and Cash Equivalents is money on deposit in the ban+, cash on hand and highly li*uid securities such as Treasury bills. 5 )ash and cash e*uivalents 56,:;;
The Balance Sheet& Assets& Mar*eta(le Sec#rities
Marketable Securities - 3%cess or idle cash that is not needed immediately may be invested in mar+etable securities. These are short9term securities that are readily salable and usually have *uoted prices.
The Balance Sheet& Assets& Mar*eta(le Sec#rities& cont+

These may include: Trading securities 9 debt and e*uity securities, bought and sold fre*uently, primarily to generate short9term profits and which are carried at fair mar+et value. $ny changes in such values are included in earnings.
eld-to-!aturity securities9 debt securities that the company has the ability and intent to hold to maturity. These securities are reported at amortized cost. "ebt A!orti#ation is the practice of adjusting the original cost of a debt instrument as principal payments are received and writing off any purchase discount or premium to income over its life.
Available-$or-sale securities 9 debt or e*uity securities not classified as either trading or held9to9maturity. They are recorded at fair value with unrealized changes in their value, net of ta%es, reported in stoc+holders e*uity.
&n Typicals case, it owns short9term, high9 grade commercial paper, classified as trading securities and preferred stoc+, classified as available9for9sale. Typical however, has no short9term held9to9maturity securities.
=>,5;; <;; =>,4;;
< "ar+etable securities: Trading securities $vailable9for9sale
The Balance Sheet& Assets& Acco#nts Recei)a(le
Accounts %eceivable are the amounts due form customers that havent been collected yet. ?hen goods are shipped to customers before payment or collection, an account receivable is recorded. )ustomers are usually given 4;, >;, or 6; days in which to pay. The total amount due from customers is 5:@,4A:.
The Balance Sheet& Assets& Acco#nts Recei)a(le& cont+
?hen customers fail to pay their bills it gives rise to accounts of doubtful collectibility. &n order to show the accounts receivable balance at a figure representing e%pected receipts, an allo%ance for o#(tf#l acco#nts is deducted from the total amount recorded.
The Balance Sheet& Assets& Acco#nts Recei)a(le& cont+
This year end, the allowance for doubtful accounts was <,4A:.
5:@,4A: ,<,4A:5:>,;;;
4 $ccounts receivable Less: allowance for doubtful accounts
The Balance Sheet& Assets& In)entor$

&nventory for a manufacturing company consists of: %a& !aterials items to be used in ma+ing a product. 'ork-in-(rocess partially completed goods in the process of manufacture. )inished goods completed items ready for shipment to customers.
The Balance Sheet& Assets& In)entor$& contin#e
Benerally, the amount of each of the above types of inventory would be disclosed either on the face of the balance sheet or in the footnotes. 'or Typical, in)entor$ the cost of items on hand that were purchased and.or manufactured for sale to customers.
The Balance Sheet& Assets & In)entor$& contin#e
&n valuing inventories, the lo%er of cost or mar*et r#le or method is used. This rule values inventory at its cost or mar+et price, whichever is lower. Market value is the current cost of replacing the inventory by purchase or manufacture.
The mar+et rule provides a conservative figure. The value for balance sheet purposes under this method usually will be cost. ?here deterioration, obsolescence, a decline in prices or other factors are e%pected to result in the selling or disposing of inventories below cost, the lower mar+et
$ manufacturers inventories consist of *uantities of physical products assembled form various materials. &nventory valuation includes the direct costs of purchasing the various materials used to produce the companys products and an allocation of the production e%penses to ma+e those products.
"anufacturers use cost accounting systems to allocate such e%penses. ?hen the individual costs for inventory are added up, they comprise the inventory valuation.
= &nventories 5@;,;;;
The Balance Sheet& Assets& Pre'ai E,'enses
#uring the year, Typical paid fire insurance premiums and advertising charges for periods after the balance sheet date. (ince Typical has the contractual right to that insurance and advertising service after the balance sheet date, it has an asset, which will be used after year end.
The Balance Sheet& Assets& Pre'ai E,'enses& contin#e
Typical has simply /prepaid0 ,paid in advance- for the right to use this service. &f these payments had not been made, the company would have more cash in the ban+.
The Balance Sheet& Assets & Pre'ai E,'enses& contin#e
Payments made for which the company had not yet received benefits, but for which it will receive benefits within the year, are current assets as 're'ai e,'enses.
=,;;;
: Prepaid e%penses and other current assets
The Balance Sheet& Assets& Total C#rrent Assets

To (ummarize the total )urrent assets item includes: )ash "ar+etable (ecurities $ccounts receivable &nventories Prepaid 3%penses
> Total )urrent $ssets =;:,@;;
The Balance Sheet& Assets& Total C#rrent Assets& cont+
These assets are &orking assets in the sense that they are liquid meaning they can and will, in the near term, be converted into cash for other business purposes or consumed in the business. &nventories, when sold, become accounts receivableC receivables, upon collection, become cashC and the cash can then be used to pay the companys debts and operating e%penses.
The Balance Sheet& Assets& Pro'ert$& Plant an E"#i'ment
*ro(erty+ (lant and equi(!ent consists of assets not intended for sale that are used to manufacture, display, warehouse and transport the companys products and house it employees.

This category includes: Land 1uilding "achinery 3*uipment 'urniture $utomobiles
The generally accepted method for reporting fi%ed assets is cost minus the depreciation accumulated through the date of the balance sheet.
4;,;;; 5<:,;;; <;;,;;; 5:,;;; 5:,;;; 4@:,;;;
Property, Plant and 3*uipment: Land 1uildings "achinery Leasehold improvements 'urniture, fi%tures, etc. A Total property, plant and e*uipment
The figure displayed is not intended to reflect present mar+et value or replacement cost, since there is no intent to sell or replace these assets in the near term. The cost to ultimately replace plant and e*uipment at some future date might, and probably will, be higher.
The Balance Sheet& Assets& -e'reciation& cont+
This is the practice of charging to, or e%pensing against, income the cost of a fi%ed asset over its estimated useful life. "e(reciation has been defined for accounting purposes as the decline in useful value of a fi%ed asset due to /wear and tear0 from use and the passage of time.
The cost of ac*uired property, plant and e*uipment must be allocated over its e%pected useful life, ta+ing into consideration the factors discussed.
'or e%ample, suppose a delivery truc+ costs 5;,;;; and is e%pected to last five years. Dsing the straight9line method of depreciation ,e*ual periodic depreciation charges over the life of the asset-, <,;;; of the truc+s cost is charged or e%pensed to each years income statement.
The balance sheet at the end of one year would show: Truc+ ,costLess: $ccumulated depreciation Eet depreciated cost 5;,;;; ,<,;;;@,;;;
$t the end of the second year it would show: 5;,;;; ,=,;;;>,;;;
Truc+ ,costLess: $ccumulated depreciation Eet depreciated cost
&n Typicals balance sheet, an amount is shown for acc#m#late e'reciation. This amount is the total of accumulated depreciation for buildings, machinery, leasehold improvements and furniture and fi%tures. Land is not subject to depreciation and its reported balance remains unchanged from year to year at the amount for which it was

@ Less: accumulated depreciation
5<:,;;;
Thus, net property, plant and e*uipment is the amount reported for balance9sheet purposes of the investment in property, plant and e*uipment
$s e%plained previously, it consists of the cost of the various assets in this classification, less the depreciation accumulated to the date of the financial statement ,net depreciated cost-
6 Eet Property, Plant and 3*uipment
<>;,;;;
"e(letion is a term used primarily by mining and oil companies or any of the e%tractive industries. (ince Typical "anufacturing is not in any of these businesses, depletion is not shown in its financial statements.
To /deplete0 means to e%haust or use up. $s oil or other natural resources are used up or sold, depletion is recorded ,as a charge against income and a reduction from it costto recognize the amount of natural resources sold, consumed or used to date.
The Balance Sheet& Assets& -eferre Charges
"e$erred Charges are e%penditures for items that will benefit future periods beyond one year from the balance9sheet date. 'or e%ample, costs for introduction of a new product to the mar+et or the opening of a new location.
The Balance Sheet& Assets& -eferre Charges& cont+
#eferred charges are similar to prepaid e%penses, but are not included in current assets because the benefit from such e%penditures will be reaped over periods after one year from the balance9sheet date. To /defer0 means to put off or postpone to a future time.
The Balance Sheet& Assets& -eferre Charges& cont+
The e%penditure incurred will be gradually written off over the future period,s- that benefit from it, rather than fully charged off in the year payment is made. Typicals balance sheet shows no deferred charges because it has none. #eferred charges would normally be included just before &ntangibles in the assets
The Balance Sheet& Assets& Intangi(les

,ntangible assets ,or /intangibles0- are assets having no physical e%istence, yet having substantial value to the company. 3%amples are: 'ranchise to a cable TF company allowing e%clusive service in certain areas. $ patent for e%clusive manufacture of a specific article. $ trademar+ or a copyright.
The Balance Sheet& Assets& Intangi(les& cont+
$nother intangible asset often found in corporate balance sheets if goo %ill, which represents the amount by which the price of an ac*uired company e%ceeds the fair value of the related net assets ac*uired. This e%cess is presumed to be the value of the companys name and reputation and its customer base, intellectual capital, and wor+force.
&ntangible assets reported on the balance sheet are generally those purchased from others. &ntangible assets are amortized,gradually reduced or written off, a process referred to as amorti.ation- by periodic charges against income over their estimated useful lives, but in no case for longer than =; years.
The value of Typicals intangible assets, reduced by the total amount of these periodic charges against income ,acc#m#late amorti.ation-, results in a figure for Typicals net intangible assets. <,<:; ,4;;5,6:;
5; &ntangibles ,goodwill, patents Less: accumulated amortization Eet intangible assets
The Balance Sheet& Assets& In)estment Sec#rities
&nvestments in debt securities are carried at amortized cost only when they *ualify as /held9to9maturity.0 To *ualify, the investor must have the positive intent and the ability to hold those securities until they mature.
The Balance Sheet& Assets& In)estment Sec#rities& cont+
3arly in 5676, Typical purchased on the Eew Gor+ (toc+ 3%change mortgage bonds issued by one of its major suppliers. These bonds are due in full in five years and bear interest at @H per year. &n 5676, the issuer made an unscheduled principal prepayment of :;.
(ince Typical intends to maintain a continuing relationship with this supplier and to hold the bonds until they mature and appears to have the financial strength to do so this investment is classified as /held9to9 maturity.0

55 &nvestment securities, at cost @H mortgage bonds due 56G=, original cost Less: principal prepayment in 5676 4:; ,:;-
&nvestment securities at amortized cost 4;; 8owever, this investment must also be reviewed to ensure that it is probable that all contractually specified amounts are fully collectible.
&f not fully collectible, this investment would be considered (er!anently i!(aired. &f permanent impairment were found to e%ist, it would be necessary to write this investment down to its fair value. &n this case, however,the issuer is in a strong financial condition

This is evidenced in two ways: The issuer made an unscheduled prepayment of principal.
The property values have increased significantly where this well9maintained plant that secures these bonds is located. $s such, there is no reason to suspect that all contractual amounts will not be collected.
The Balance Sheet& Assets& Total Assets
$ll of these assets ,line items 5 to 55-, added together, ma+e up the figure for the line item ,5<- /Total $ssets0 in Typicals balance sheet. 5< Total $ssets >>@,;:;
The Balance Sheet& Lia(ilities an

Sharehol ers! E"#it$& C#rrent Lia(ilities
$ Current Liability is an obligation that is due and payable within 5< months. The /current liabilities0 item in the balance sheet is a companion to /current assets0 because current assets are the source for payment of current debts.
Lia(ilities an Sharehol ers! E"#it$& C#rrent Lia(ilities& Acco#nts Pa$a(le
The Balance Sheet&
Accounts *ayable is the amount the company owes to its regular business creditors from whom it has bought goods or services on open account. 54 $ccounts payable >;,;;;
Lia(ilities an Sharehol ers! E"#it$& C#rrent Lia(ilities& Notes Pa$a(le
The Balance Sheet&
&f money is owed to a ban+, individual, corporation or other lender under a promissory note, it appears on the balance sheet under notes (ayable. &t is evidence that the borrower named in the note is responsible for carrying out its terms,such as repaying the loan principal plus any interest charges.
Lia(ilities an Sharehol ers! E"#it$& C#rrent Lia(ilities& Notes Pa$a(le
The Balance Sheet&
?hile these particular notes are due within one year of the balance9sheet date, notes payable may also be due after one year from the balance9sheet date when they would be included in long9term debt. 5= Eotes Payable :5,;;;
Lia(ilities an Sharehol ers! E"#it$& C#rrent Lia(ilities& Accr#e E,'enses
The Balance Sheet&
$s discussed, accounts payable are amounts owed by the company to its regular business creditors for routine purchases. The company also owes, on any given day, salaries and wages to its employees, interest on funds borrowed from ban+s and bondholders, fees to attorneys and similar items.
Lia(ilities an Sharehol ers! E"#it$& C#rrent Lia(ilities& Accr#e E,'enses
The Balance Sheet&
The total amount of such items owed, but unpaid at the date of the balance sheet, are grouped as a total under accrued e-(enses. 5: $ccrued e%penses 4;,;;;

Sharehol ers! E"#it$& C#rrent Lia(ilities& Income Ta,es Pa$a(le
&ncome ta%es payable are the amounts due to ta%ing authorities,&nternal 2evenue (ervice- within one year form the balance9 sheet date. 'or financial9reporting purposes, they are treated the same as an accrued e%pense.

Sharehol ers! E"#it$& C#rrent Lia(ilities& Income Ta,es Pa$a(le
8owever, companies that owe a material amount of ta%es, as Typical does here, often report income ta%es payable as a separate line item under the )urrent Liabilities caption in the balance sheet. 5> &ncome Ta%es Payable 5A,;;;

Sharehol ers! E"#it$& C#rrent Lia(ilities& Other Lia(ilities
These are any other liabilities that are payable within 5< months, but which havent been captured in any of the other specific categories presented as current liabilities in the balance sheet. 5A Ither Liabilities 5<,;;;
The Balance Sheet&

Lia(ilities& C#rrent Lia(ilities
Current *ortion o$ Long-Ter! "ebt 2epresents the amount due and payable within 5< months of the balance9sheet date under all long9term,longer than 5 yearborrowing arrangements. &n Typicals case, this is the scheduled repayment of a >,;;; five9year note ta+en out by Typical four years ago and due ne%t year.
The Balance Sheet&

Lia(ilities& C#rrent Lia(ilities
Current *ortion o$ Long-Ter! "ebt+ cont. &f Typical had a long9term borrowing calling for monthly payments,on a mortgage-, the sum of the principal payments due in the 5< months following the balance9sheet date would appear here. >,;;;
5@ )urrent portion of long9term debt
Lia(ilities& Total C#rrent Lia(ilities

56 Total )urrent Liabilities
The Balance Sheet&
5A>,;;;
'inally, the /Total )urrent Liabilities0 item sums up all of the items listed under this classification.
The Balance Sheet&

Lia(ilities& Long/Term Lia(ilities
)urrent liabilities include amounts due /within one year0 from the balance9sheet date. Long-ter! liabilities are amounts due /after on year0 from the date of the financial report.
The Balance Sheet&

"e$erred ,nco!e Ta-es
Ine of the long9term liabilities on the sample balance sheet is deferred income ta%es. "e$erred inco!e ta-es are ta% liabilities a company may postpone paying until some future time, often to encourage activities for the publics good.
The Balance Sheet&

"e$erred ,nco!e Ta-es+ continued
The government provides businesses with ta% incentives to ma+e certain +inds of investments that will benefit the economy as a whole.
The Balance Sheet&

'or instance, for ta%9reporting purposes, a company can ta+e accelerated depreciation deductions on its ta% returns for investments in plant and e*uipment while using less rapid, more conventional depreciation for financial9reporting purposes.
The Balance Sheet&

"e$erred ,nco!e Ta-es+ continued These rapid write9offs for ta% purposes in the early years of investment reduce the amount of ta% the company would otherwise owe currently ,within 5< months-and defer payment into the future.,beyond 5< months8owever, at some point, the ta%es must be paid.
The Balance Sheet&

To recognize this future liability, companies include a charge for deferred ta%es in their provision for ta% e%pense in the income statement and show what the ta% provision would be without the accelerated write9offs.
The Balance Sheet&

"e$erred ,nco!e Ta-es+ continued The liability for that charge is reported as a long9term liability since it relates to property, plant and e*uipment ,a noncurrent or long9 term asset-. JThe classification of deferred ta% amounts follows the classification of the item that gives rise to it. <; #eferred income ta%es 5>,;;;
The Balance Sheet&

"ebentures The other long9term liability with a balance on Typicals 5676 balance sheet is the 6.5<H debentures due in <;5;. The money was received by the company as a loan from the bondholders, who in turn were given certificates called bonds, as evidence of the loan.
The Balance Sheet&

"ebentures+ continued The bonds are really formal promissory notes issued by the company, which it agreed to repay at maturity in <;5; and on which it agreed to pay interest at the rate of 6.5<H per year. 1ond interest is usually payable semiannually.
The Balance Sheet&

"ebentures+ continued Typicals bond issue is called a debenture because the bonds are bac+ed only by the general credit of the corporation rather than by specific company assets. )ompanies can also issue secured debt ,mortgage bonds-, which offers bondholders an added safeguard because they are secured by a mortgage on all or some of the companys property.
The Balance Sheet&

"ebentures+ continued
&f the company is unable to pay the bonds when they are due, holders of mortgage bonds have a claim or lien before other creditors ,such as debenture holders- on the mortgaged assets.
The Balance Sheet&

"ebentures+ continued
&n other words, these assets may be sold and the proceeds used to satisfy the debt owed the mortgage bondholders. 54;,;;;
<5 6.5<H debentures payable <;5;
The Balance Sheet&

/ther Long-Ter! "ebt /ther Long-Ter! "ebt includes all debt due after one year from the balance9sheet date other than what is specifically reported elsewhere in the balance sheet. &n Typicals case, this debt is a >,;;;, single9payment loan made four years ago, which is scheduled for payment in full ne%t year.
The Balance Sheet&

/ther Long-Ter! "ebt This loan was reported as long9term debt at the end of 567@ and, since it is payable in full ne%t year, and it no longer *ualifies as a long9term liability, is reported as current portion of long9term debt at the end of 5676. << Ither Long9Term debt 9999
The Balance Sheet&

Total Liabilities
)urrent and long9term liabilities are summed together to produce the figure reported on the balance sheet as /Total Liabilities.0 <4 Total Liabilities 4<<,;;;
The Balance Sheet&

Sharehol ers! E"#it$
This item is the total e*uity interest that all shareholders have in this corporation. &t is the corporations net worth or its assets after subtracting all of its liabilities. this is separated for legal and accounting reasons into the categories discussed ne%t.
Sharehol ers! E"#it$& Ca'ital Stoc*
The Balance Sheet&
)apital stoc+ represents shares in the ownership of the company. These shares are represented by the stoc+ certificates issued by the corporation to its shareholders. $ corporation may issue several different classes of shares, each class having slightly different attributes.
Sharehol ers! E"#it$& Preferre Stoc*
The Balance Sheet&
*re$erred Stock is an e*uity ownership interest that has preference over common shares with regard to dividends and the distribution of assets in case of li*uidation. #etails about the preferences applicable to this type of stoc+ can be obtained from provisions in a corporations charter.
The Balance Sheet& Sharehol ers!

E"#it$& Preferre Stoc*& cont+
&n typicals case, the preferred stoc+ is a :.@4 cumulative 5;; par value. *ar value is the nominal or face value of a security assigned to it by its issuer. The :.@4 is the yearly per9share dividend to which each preferred shareholder is entitled before any dividends are paid to the common shareholders.

Cu!ulative means that if in any year the preferred dividend is not paid, it accumulates in favor of preferred shareholders. The total unpaid dividends must be declared and paid to these shareholders when available and before any dividends are distributed on the common stoc+.

Benerally, preferred shareholders have no voice in company affairs unless the company fails to pay them dividends at the promised rate.
<= Preferred (toc+, :.@4 cumulative, 5;; par valueC authorized issued and outstanding: >;,;;; shares
>,;;;

E"#it$& Common Stoc*
$lthough preferred shareholders are entitled to dividends before common shareholders, their entitlement is generally limited ,in Typicals case to :.@4 per share, annually-. )ommon stoc+ has no such limit on dividends payable each year. &n good times, when earnings are high, dividends may also be high.

E"#it$& Common Stoc*& cont+

?hen earnings drop, so may dividends. Typicals common stoc+ has a par value of :.;; per share. &n 5676, Typical sold :;;,;;; shares of stoc+ for a total of 6,;;;. If the 6,;;;, <,:;; is reported as common stoc+,:;;,;;; shares at a par

E"#it$& Common Stoc*& cont+
The balance, >,:;;, is reported as additional paid9in capital. ?hen added to the prior year9ends common stoc+ balance of A<,:;;, the <,:;; brings the common stoc+ balance to A:,;;;.
<: )ommon stoc+, :.;; par value, authorized: <;,;;;,;;; sharesC issued and outstanding: 5:,;;;,;;; shares
A:,;;;

E"#it$& A itional Pai /In Ca'ital
Additional (aid-in ca(ital is the amount paid by shareholders in e%cess of the par or stated value of each share. &n 5676, paid9in capital increased by >,:;;, when this amount is added to last years ending balance of 54,:;;, additional paid9in capital at #ec. 45, 5676, comes to <;,;;;. <> $dditional paid9in capital <;,;;;
The Balance Sheet&

Sharehol ers! E"#it$& Retaine Earnings
?hen a company first starts in business, it has no retained earnings. %etained earning are the accumulated profits the company earns and reinvests or /retains0 in the company. &n less successful companies where losses have e%ceeded profits over the years, those accumulated net losses will be reported as
Sharehol ers! E"#it$& Retaine Earnings& cont+
The Balance Sheet&
2etained earnings increase by the amount of profits earned, less dividends declared to shareholders.
&f, at the end of Typicals first year:

Profits are @;,;;;. #ividends of 5;; are paid on the preferred stoc+, and no dividends are declared on the common.
The Balance Sheet&
The balance sheet will show retained earnings of A6,6;;.
&n Typicals second year: Profits are 5=;,;;;. Preferred #ividends are <;;. )ommon #ividends are =;;. The balance sheet will show retained earning of <56,4;;.
The Balance Sheet&
The #ec. 45, 5676, balance sheet for Typical shows the company has accumulated <=6,;;; in retained earnings. <A retained 3arnings <=6,;;;
The following table shows retained earnings from start9up through the end of 5676.
Cal ulation! A u"ulated Retained Earnin#s

8alance at start.up )ro!it in /ear 1 )re!erred dividends in /ear 1 5eta"ned arn"n-s: )ro!it in /ear 2 9ividends in /ear 23 5eta"ned arn"n-s: A..re.ate )ro!its3 A..re.ate dividends3 5eta"ned arn"n-s: 7et 'nco(e3 9ividends3 5eta"ned arn"n-s nd o4 year 1 )re!erred Co((on nd o4 year $ Cear 3 throu.h 19$& Cear 3 throu.h 19$& 1$=31=X8 and 1=1=X9 19$9 19$9 )re!erred Co((on 1$=31=X9 (0 &0,000 41005 ,9,900 140,000 42005 44005 $19,300 &00,000 4#99,#005 $19,%00 4#,#50 43505 41&,0005 ($49,000
Sharehol ers! E"#it$& Foreign C#rrenc$ Translation A 0#stment

Eet of Ta%es
The Balance Sheet&
?hen a company has an ownership interest in a foreign entity, it may be re*uired to to include that entitys results in the companys consolidated financial statements. &f that re*uirement applies, the financial statements of the foreign entity,prepared in foreign currency-must be translated into D.(. dollars.
The Balance Sheet&
The gain or loss resulting from this translation, after the related ta% e%pense or benefit, is reflected as a separate component of shareholders e*uity and is called $oreign currency translation ad0ust!ents. The adjustment should be distinguished from conversion gains or losses relating to completed transactions that are denominated in foreign currencies.
The Balance Sheet&
)onversion gains or losses are included in a companys net income.
<@ 'oreign currency translation adjustments,net of ta%es-
5,;;;
The Balance Sheet&

Sharehol ers! E"#it$&
1nreali#ed 3ain on Available-$or-sale Securities
1nreali#ed gain2loss is the change in the value ,gain or loss- of securities classified as /available9for9sale0 that are still being held.
The Balance Sheet&

&n Typicals case, this represents the difference ,a gain here- between the cost ,or previously reported fair mar+et value- of investment securities classified as /available9for9sale0 held at the balance9 sheet date and their fair mar+et value at that time
The Balance Sheet&

(ince Typical still holds these securities and has not yet sold them, such differences have not been realized. $s such, this unrealized amount is not included in the determination of current income.
The Balance Sheet&

8owever, since these securities must be reported at their fair mar+et value, the changes in the fair mar+et value since purchase ,or the previously report date- are reported, after the related income ta% e%pense or benefit, as a separate component of shareholders e*uity.
The Balance Sheet&

In #ec. 45, 5676, the total fair mar+et value of these securities e%ceeded their cost by >:. That gain would have increased ta% e%pense by 5:, producing a net unrealized gain of :;.
The Balance Sheet&

&f these securities are sold, the difference between their original cost and the proceeds from such sale will be realized gain or loss included in the determination of net income in the period. :;
<6 Dnrealized gain on available 9for9sale securities,net of ta%es-
Sharehol ers! E"#it$& Treas#r$ Stoc*
The Balance Sheet&
?hen a company buys its own stoc+ bac+, that stoc+ is recorded at cost and reported as treasury stock. &t is called treasury stoc+ because after being reac*uired by the company, it is returned to the companys treasury. The company can then resell or cancel that stoc+.
Sharehol ers! E"#it$& Treas#r$ Stoc*
The Balance Sheet&
Treasury stoc+ is reported as a deduction from shareholders e*uity. $ny gains or losses on the sale of such shares are reported as adjustments to shareholders e*uity, but are not included in income. Treasury stoc+ is not an asset. , :,;;;-
4; Less: Treasury (toc+ at )ost
Sharehol ers! E"#it$& Total sharehol ers! e"#it$
The Balance Sheet&
Total Shareholders Equity is the sum of stoc+ ,less treasury stoc+-, additional paid9 in9capital, retained earnings, foreign currency translation adjustments and unrealized gains on investment securities available for sale. 4=>,;:;
45 Total (hareholders 3*uity
1hat -oes The Balance Sheet Sho%2
To analyze balance9sheet figures, investors loo+ to certain financial statement ratios for guidance. $ $inancial state!ent ratio is the mathematical relationship between two or more amounts reported in the financial statements.
1hat -oes The Balance Sheet Sho%2
Ine of their concerns is whether the business will be able to pay its debts when they come due. $nalysts are also interested in the companys inventory turnover and the amount of assets bac+ing corporate securities ,bonds and preferred and common stoc+-, along with the relative mi% of these securities.
1hat -oes The Balance Sheet Sho%2 1or*ing Ca'ital
'orking ca(ital is the difference between total current assets and total current liabilities. 2emember, current liabilities are debts due within one year of the balance9sheet date. The sources from which those debts are paid is current assets.
1hat -oes The Balance Sheet Sho%2 1or*ing Ca'ital& cont+
Thus, wor+ing capital represents the amount of current assets that is left if all current debts are paid. > )urrent $ssets 56 Less: )urrent Liabilities ?or+ing )apital =;:,@;; ,5A>,;;;<<6,@;;
Benerally, companies that maintain a comfortable amount of wor+ing capital are more attractive to conservative investors. $ companys ability to meet obligations, e%pand volume and ta+e advantage of opportunities is often determined by its wor+ing capital
Gear9to9year increases in wor+ing capital are a positive sign of a companys growth and health.
1hat -oes The Balance Sheet Sho%2 C#rrent Ratio
?hat is a comfortable amount of wor+ing capitalK $nalysts use several methods to judge whether a company has ade*uate wor+ing capital. To interpret the current position of a company being considered as a possible investment, the current ratio may be more useful than the dollar total of wor+ing capital.
1hat -oes The Balance Sheet Sho%2 C#rrent Ratio& cont+
The first rough test is to compare the current assets figure with the total current liabilities. $ current ratio of <9to95 is generally considered ade*uate. This means that for each 5 of current liabilities, there are < in current assets.
To find the current ratio, divide current assets by current liabilities.
5> )urrent $ssets =;:,@;; <.45 = = 56 )urrent Liabilities 5A>,;;; 5 or <.4 to 5
Thus, for each 5 of current liabilities, there is <.45 in current assets to bac+ it up.
There are so many different +inds of companies that this test re*uires a great deal of modification if it is to be really helpful in analyzing companies in different industries.
Benerally, companies that have a small inventory and accounts receivable that are *uic+ly collectible can operate safely with a lower current ratio then companies having a greater proportion of their current assets in inventory and that sell their products on e%tended credit terms.
1hat -oes The Balance Sheet Sho%2 3#ic* Assets
&n addition to wor+ing capital and current ratio, another way to test the ade*uacy of wor+ing capital is to loo+ at *uic+ assets. 4uick Assets are the assets available to cover a sudden emergency99assets that could be ta+en to the ban+ right away.
1hat -oes The Balance Sheet Sho%2 3#ic* Assets& cont+
They are those current assets that are *uic+ly convertible into cash. This e%cludes merchandise inventories, because such inventories have yet to be sold and are not *uic+ly convertible into cash.
1hat -oes The Balance Sheet Sho%2 3#ic* Assets& cont+
$ccordingly, *uic+ assets are current assets minus inventories, prepaid e%penses and any other illi*uid current assets. > )urrent $ssets = Less: &nventories : Less: Prepaid 3%penses Luic+ $ssets =;:,@;; ,5@;,;;;,=,;;;<<5,@;;
1hat -oes The Balance Sheet Sho%2 Net 3#ic* Assets
5et quick Assets are found by ta+ing the *uic+ assets and subtracting the total current liabilities. $ well9positioned company should show a reasonable e%cess of *uic+ assets over current liabilities.
1hat -oes The Balance Sheet Sho%2 Net 3#ic* Assets& cont+
This provides a rigorous and important test of a companys ability to meet its obligations. <<5,@;; ,5A>,;;;=:,@;;
Luic+ $ssets 56 Less: )urrent Liabilities Eet Luic+ $ssets
1hat -oes The Balance Sheet Sho%2 3#ic* Assets Ratio
The Luic+ $ssets 2atio is found by dividing *uic+ assets by current liabilities.
Luic+ $ssets <<5,@;; 5<> . = = 56 )urrent Liabilities 5A>,;;; 5 or 5.<> to 5
This means that, for each 5 of current liabilities, there is 5.<> in Luic+ $ssets available.
1hat -oes The Balance Sheet Sho%2 -e(t to E"#it$

$ certain level of debt is acceptable, but too much is a sign for investors to be cautious. The "ebt-To-Equity %atio is an indicator of whether the company is using debt e%cessively.
<4 Total Liabilities 4<<,;;; = =.64 45 Total (hareholdersM 3*uity 4=>,;:;
1hat -oes The Balance Sheet Sho%2 -e(t to E"#it$& cont+

$
debt9to9e*uity ratio of .64 means the company is using 64 cents of liabilities for every dollar of shareholders e*uity in the business. &ndustrial companies try to remain below a ma%imum of a 59to95 ratio, to +eep debt at a level that is less than the investment level of the owners of the business.
1hat -oes The Balance Sheet Sho%2 -e(t to E"#it$& cont+
Dtilities, service companies and financial companies often operate with much higher ratios.
1hat -oes The Balance Sheet Sho%2 In)entor$ T#rno)er
8ow much inventory should a company have on handK That depends on a combination of many factors including the type of business and the time of the year. $n automobile dealer with a large stoc+ of autos at the height of the season is in a strong inventory positionC yet that same inventory at the end of the season represents a wea+ness in the dealers financial condition.
1hat -oes The Balance Sheet Sho%2 In)entor$ T#rno)er& cont+
Ine way to measure ade*uacy and balance of inventory is to compare it with cost of sales for the year to determine inventory turnover.

Typicals cost of sales for the year is :4:,;;;. ?hich is divided by average inventory for the year of 5@<,:;; to determine turnover. ,inventory at 5<.45.7@ of 5@:,;;; N inventory at 5<.45.76 of 5@;,;;;, divided by < Turnover is <.6 times , :4:,;;; . 5@<,:;;-, meaning that goods are bought, manufactured and sold out almost three times per year on average.
&nventory as a percentage of current assets is another comparison that may be made. &n Typicals case the inventory of 5@;,;;; represents ==H of the total current assets, which amounts to =;:,@;;.
1ut there is considerable variation between different types of companies, and thus the relationship is significant only when comparisons are made between companies in the same industry.
1hat -oes The Balance Sheet Sho%2 Boo* 4al#e of Sec#rities
5et book value or net asset value is the amount of corporate assets bac+ing a bond or a common or preferred share. &ntangible assets are sometimes included when computing boo+ value. 8owever, the following calculations will focus on the more conservative net tangible boo+ value.
1hat -oes The Balance Sheet Sho%2 Boo* 4al#e of Sec#rities& cont+
5et Asset 6alue (er 7ond To state this figure conservatively, intangible assets are subtracted as if they have no value on li*uidation. )urrent liabilities of 5A>,;;; are considered paid. This leaves =6;,5;; in assets to pay the bondholders. (o, 4,AA; in net asset value protects each 5,;;; bond.
5et Asset 6alue (er 7ond

12 total Assets 10 ,ess3 'ntan.ibles 2otal 2an.ible Assets 19 ,ess3 Current ,iabilities 7et 2an.ible Assets Available to (eet bondholdersD clai(s $66&,050 41,9505 666,100 41#6,0005 $490,100
$490,100,000 E$3,##0 7et Asset Falue )er 130,000 1,000 -ond 8utstandin.
5et Asset 6alue (er Share o$ *re$erred Stock To calculate net asset value of a preferred share, start with total tangible assets, conservatively stated at >>>,5;;.
)urrent liabilities of 5A>,;;; and long9 term liabilities of 5=>,;;; are considered paid. This leaves 4==,5;; of assets protecting
5et Asset 6alue (er Share o$ *re$erred Stock

12 total Assets 10 ,ess3 'ntan.ibles 2otal 2an.ible Assets 19 ,ess3 Current ,iabilities 20,21,22 ,on. 2er( ,iabilities 7et 2an.ible Assets >nderl/in. the )re!erred ?tock $66&,050 41,9505 666,100 41#6,0005 4146,0005 $344,100
344,100,000 E$5,#35 7et Asset Falue )er 60,000 )re!erred ?hare
7ook 6alue (er Share o$ Co!!on Stock The book value (er share o$ co!!on stock can be thought of as the amount of money each share would receive if the company were li*uidated, based on balance9sheet values. The bondholders and preferred shareholders would have to be satisfied first. The answer, <<.:= boo+ value per share of common stoc+, is arrived at as follows.
7ook 6alue (er Share o$ Co!!on Stock

25 26 2# 2& 29 30 Co((on ?tock Additional *aid in ca*itla <etained Aarnin.s 0orei.n Currenc/ 2ranslation Ad=ust(ents >nreali6ed .ains on available !or sale securities 2reasur/ ?tock 2otal Co((on ?hareholdersD Aquit/ 10 ,ess3 'ntan.ible Assets 2otal 2an.ible Co((on ?hareholdersD Aquit/ $#5,000 20,000 249,000 1,000 50 45,0005 340,050 41,9505 $33&,100
$33&,100,000 E$22154 book value *er co((on share1 15,000,000
$n alternative method of arriving at the common shareholders e*uity, conservatively stated at 44@,5;;, is shown on the following slide.

Second Method
12 2otal Assets 10 ,ess3 'ntan.ibles 2otal 2an.ible Assets 19 ,ess3 Current ,iabilities 20,21,22 ,on. 2er( ,iabilities 24 )re!erred ?tock 7et 2an.ible Assets Available !or Co((on ?tock $66&,050 41,9505 66,100 41#6,0005 4146,0005 46,0005 $33&,100
$33&,100,000 E$22154 book value *er co((on share 15,000,000
7ook 6alue (er Share o$ Co!!on Stock 1oo+9value figures,particularly of common stoc+s, can be misleading. Profitable companies may show a very low net boo+ value and very substantial earnings, while mature companies may show a high boo+ value for their common stoc+ but have such low or irregular earnings that the stoc+s mar+et price is lower than its boo+ value.
1ecause their assets are largely li*uid their common stoc+s boo+ value is sometimes a fair indication of mar+et value.
Ca(itali#ation %atio The proportion of each +ind of security issued by a company is the Ca(itali#ation %atio. $ high proportion of bonds sometimes reduces the attractiveness of both the preferred and common stoc+, and too much preferred can detract from the commons value.
Ca(itali#ation %atio Thats because bond interest must be paid before preferred dividends, and preferred dividends before common dividends.
Ca(itali#ation Typicals bond %atioratio is derived by dividing the face value of the bonds, 54;,;;;, by the total value of bonds, preferred and common stoc+, additional paid9in capital, retained earnings, foreign currency translation adjustments, unrealized gains on available9for9sale securities and treasury stoc+ less intangibles, which is =A=,5;;.
Ca(itali#ation %atio
This shows that bonds amount to about <AH of Typicals total capitalization.
21 24 25 26 2# 2& 9ebentures $130,000 )re!erred ?tock 6,000 Co((on ?tock #5,000 Additional )aid in Ca*ital 20,000 <etained Aarnin.s 249,000 0orei.n Currenc/ 2ranslation Ad=ust(ents 1,000 29 >nreali6ed @ains on Available !or ?ale ?ecurities 50 30 2reasur/ ?tock 45,0005 10 ,ess3 'ntan.ibles 41,9505 2otal Ca*tiali6ation $4#4,100
*re$erred Stock %atio
The Preferred (toc+ 2atio is found the same way99by dividing preferred stoc+ of >,;;; by the entire capitalization of =A=,5;;. The result is about 5H.
Co!!on Stock %atio
The )ommon (toc+ 2atio will be the difference between 5;;H and the total of the bond and preferred stoc+ ratio99or about A<H.
Co!!on Stock %atio
The same result is reached by adding common stoc+, additional paid9in capital, retained earnings, foreign currency translation adjustments, unrealized gains on available9for9sale securities and treasury stoc+, less intangibles, and dividing the result by total capitalization.
"ebenture+ *re$erred+ and Co!!on %atios

21 9ebentures 24 )re!erred ?tock 10 G 25 30 Co((on ?hareholders Aquit/ ,ess 'ntan.ibles 33&,100 2otal $4#4,100 Amount $ 130,000 6,000 5at"o 2#: 1:
#2: 100:
The Income Statement
The most important report for many analysts, investors or potential investors is the income statement. &t shows how much the corporation earned or lost during the year.
The Income Statement& cont+

?hile the balance sheet shows the fundamental soundness of a company by reflecting its financial position at a given date, the income statement may be of greater interest to investors for the following reasons:
The income statement shows the record of a companys operating results for the whole year.
&t also serves as a valuable guide in anticipating how the company may do in the future. 8owever, the income statement for a single year does not tell the whole story. The historical record for a series of years is more important than the figures for any single year.
Typical includes two years in its income statement shown in the beginning of this presentation and gives a 5;9year financial summary that will be shown and discussed later in this presentation.
$n income statement matches the revenues earned from selling goods and services or other activities against all the costs and outlays incurred to operate the company. The difference is the net income ,or lossfor the year.

The costs incurred usually consist of: )ost of (ales (elling Beneral and $dministrative e%penses such as wages and salaries, rent, supplies and depreciation &nterest on money borrowed Ta%es.
The Income Statement& Net Sales
The most important source of revenue is usually the first item on the income statement. &t represents the primary source of revenue earned by the company from its customers for goods sold or services rendered. &n Typical "anufacturings income statement, it is shown as /5et Sales0.
The Income Statement& Net Sales& cont+
The net sales item includes the amount reported after ta+ing into consideration returned goods and allowances for price reductions or discounts. 1y comparing 5676 and 567@, it can be determined if Typical had a better year in 5676, or a worse one. 44 Eet (ales A>:,;:;
The Income Statement& Cost of Sales
&n a manufacturing establishment, Cost o$ Sales represents all the costs the company incurs to purchase and convert raw materials into the finished products that it sells. These costs are commonly +nown as *roduct Costs+ they are those costs that can be identified with the purchase or manufacture of goods made available for sale.
The Income Statement& Cost of Sales& cont+

There are three basic components of product cost: #irect "aterials

#irect Labor "anufacturing Iverhead
#irect materials and direct labor costs can be directly traced to the finished product. 'or e%ample, for a furniture manufacturer, lumber would be a direct material cost and carpenter wages would be a direct labor cost.
"anufacturing overhead costs, while associated with the manufacturing process, cannot be traceable to the finished product. 3%amples of manufacturing overhead costs are costs associated with operating the factory plant.
(uch as rent, electricity, suppliers, depreciation, maintenance and repairs and the salaries of production supervisors. 4= )ost of (ales :4:,;;;
The Income Statement& 5ross Margin
Bross "argin is the e%cess of sales over cost of sales. &t represents the actual direct profit from sales after considering product costs. )omparing period9to9period gross margin trends in absolute dollars is a useful analytical tool.
The Income Statement& 5ross Margin& cont+
$lso, comparing the gross !argin (ercentage from year to year. 3ross Margin *ercentage is computed by dividing gross margin by net sales. 4: Bross "argin <4;,;:; Bross "argin Percentage 4;H , <4;,;:; . A>:,;:;-
The Income Statement& -e'reciation an Amorti.ation
3ach years decline in value of non9 manufacturing facilities would be captured in #epreciation and $mortization. A!orti#ation, as reported in this line item, represents the decline in useful value of an intangible, such as a 5A9year patent. <@,;:;
4> #epreciation and $mortization
The Income Statement& Selling& 5eneral& an A ministrati)e E,'enses
These e%penses are generally grouped separately from cost of sales so that the reader of an income statement may see the e%tent of selling and administrative costs.
The Income Statement& Selling& 5eneral& an A ministrati)e E,'enses& cont+

These include e%penses such as: (ales agents salaries and commissions $dvertising and promotion Travel and entertainment. 3%ecutives salaries Iffice payroll and e%penses. 4A (elling, Beneral, and $dministrative 3%penses 6>,@;=
The Income Statement& O'erating Income
(ubtracting all operating e%penses from the net sales figure determines /(erating ,nco!e.
4@ Iperating &ncome
5;:,56>
The Income Statement& -i)i en an Interest Income
$n additional source of revenue comes from dividends and interest received by the company from it investment in stoc+s and bonds. :,<:;
46 #ividends and &nterest &ncome
The Income Statement& Interest E,'ense
The interest earned by bondholders for the use of their money is sometimes referred to as a $i-ed charge. Thats because the interest must be paid year after year whether the company is ma+ing money or losing money. &nterest differs from dividends on stoc+s, which are payable only if the board of
The Income Statement& Interest E,'ense& cont+

&nterest paid is another cost of doing business, and is deductible from earnings in order to arrive at a base for the payment of income ta%es. Typicals interest e%pense comes from 4 sources: Eotes Payable #ebentures Ither Long9Term #ebt ,which became current portion of long9term debt at this year end.
The notes payable, with an average outstanding balance for the year of :>,;;; at AH interest, incur an interest charge of 4,6<;. The debentures, bearing interest at 6.5<H of the 54;,;;; balance, incur interest e%pense of 55,@:>.
The >,;;; of other long9term debt at A.6H, incurs interest of =A=. =; &nterest 3%pense 5>,<:;
The Income Statement& Income Ta,es
3ach corporation has an e$$ective ta- rate which depends on the level and nature of its income. Large corporations li+e Typical "anufacturing are subject to the top statutory corporate income ta% rate. 8owever, ta% credits, ta%9free income and nondeductible e%penses tend to change the
The Income Statement& Income Ta,es& cont+
Typicals income before ta%es and e%traordinary loss is 6=,56>. &ts ta% comes to =5,==>. 6=,56> =5,==>
=5 &ncome before &ncome Ta% and 3%traordinary Loss =< &ncome Ta%es
The Income Statement& Income Before E,traor inar$ Loss
,nco!e be$ore e-traordinary loss for the year is the amount by which all revenues e%ceed all e%penses. 3%traordinary gains or losses , as defined by B$$P- are e%cluded from this determination. :<,A:;
=4 &ncome before 3%traordinary Loss
The Income Statement& E,traor inar$ Items
Dnder usual conditions, the :<,A:; income would be the end of the story. 8owever, there are years in which companies e%perience unusual and infre*uent events called E-traordinary ,te!s. 'or e%ample, an e%traordinary item would be crop destruction by a hail storm in an area
The Income Statement& E,traor inar$ Items& cont+
&n this case, on e of Typicals manufacturing sites was destroyed by an earth*ua+e. This event is isolated on a separate line, net of its ta% effect.
The Income Statement& E,traor inar$ Item& cont+
&ts earnings per share impact is also separated from the earnings per share attributable to /normal operations.0
== 3%traordinary &tem: Loss on earth *ua+e destruction ,net of ta% benefit A:;-
, :,;;;-
The Income Statement& Net Income
The 7otto! Line Ince all income and costs, including e%traordinary items, are considered, 5et ,nco!e 8or Loss9 is determined. =: Eet &ncome =A,A:;
The Income Statement& Other Items
Three other items that do not apply to Typical could appear on an income statement.
The Income Statement& Other Items& cont+
'irst, suppose Typical were heavily involved in research and development ,2O#- activities. &n that event, Typical would be re*uired to include the amount of 2O# costs in the income statement or disclose it in the footnotes.
(econd, suppose Typical owned between <;H and :;H of another company. &n that case, Typical would have significant influence over that company, but not control it. $s such, it would have to account for that investment using the e*uity method and report its e*uity interest in that company in it
'or e%ample, suppose Typicals share of that companys earnings for the year were 5,<;; and it received A;; in dividends from the company during that year. &n that event, Typical would have to include 5,<;; on its income statement under the category equity in the earnings o$ unconsolidated subsidiaries.
Typical would also be re*uired to increase it investment in that company to the e%tent of the earnings it pic+ed up it is income statement. 8owever, this would be reduced by any dividends received, in this case A;;, since the dividend represents a return of its investment.
&n this case, Typicals balance sheet would show a net increase in its investment in this company of :;;.
Third, suppose Typical owned a consolidated subsidiary ,more than :;H ownership-, in which it had less than a 5;;H ownership interest. 'or e%ample, if Typical owned @:H of that company. $ny material change in the related minority interest ,5:H-, would have to be reported in the income statement or footnotes.
$ corresponding change in the cumulative minority interest would also have to be reported in the balance sheet, between long9 term liabilities and stoc+holders e*uity.
The Income Statement& Anal$.ing the Income Statement
?hen used to ma+e a few detailed comparisons, the income statement will reveal a lot more information about a companys operating results. 'or e%ample, a prospective investor can determine the companys operating margin and how it has changed over the years.
The Income Statement& Anal$.ing the Income Statement& cont+
This determination can be made by comparing operating income to net sales. To illustrate, in 567;, Typical reported net sales of A>:,;:; and operating income of 5;:,56>. 5676 Iperating "argin 4@ 5;:,56> operating income P 54.@H 44 A>:,;:; Eet (ales
This means that for each dollar of 5676 sales, 56.@ cents remained as a profit from operations. This figure is interesting, but is more significant when compared with the operating margin last year. 567@ Iperating "argin 4@ A4,:;; operating income P 5;.5H 44 A<:,;;; net sales
Typicals operating profit margin went from 5;.5H to 54.@H, so business didnt just grow, it beca!e !ore (ro$itable. )hanges in operating margin can reflect changes in volume, efficiency, product line or types of customers served.
Typical can also be compared with other companies in its field. &f Typicals operating margin is very low compared to others, it is an unhealthy sign. &f it is high, there is a basis for optimism. $nalysts also fre*uently use /(erating Cost %atio for the same purpose.
Iperating )ost 2atio is the complement of the operating margin. Typicals operating margin is 54.@H. The operating cost ratio is Amount @>.<H.
33 7et ?ales 34,36,G 3# 8*eratin. Costs 3& 8*eratin. 'nco(e $#65,050 $659,&54 $105,196 5at"o 100: &612: 131&:
5et *ro$it %atio is still another guide to indicate how satisfactory the years activities have been. &n Typicals case, the yearMs net income was =A,A:;. The net sales of the year amounted to A>:,;:;
Therefore, Typicals income was =A,A:; on A>:,;:; of sales or: =: 44 5676 Eet Profit 2atio: =A,A:; Eet &ncome P >.<H A>:,;:; Eet (ales
This means that this year, for every 5 of goods sold, >.< cents in profit was ultimately earned by the company.
1y comparing the net profit ratio from year to year for the same company and with other companies, profit progress can be evaluated. Last year, Typicals net income was =;,:;; on A<:,;;; in sales: 567@ Eet Profit 2atio: =: =;,:;; Eet &ncome P :.>H 44 A<:,;;; Eet (ales
The operating margin, operating cost ratio and net profit ratio provide general information about the company and help assess its future prospects. $ll these comparisons have a long9term significance because they provide useful information about the companys fundamental economic condition.
$nother *uestion to ponder: $re Typicals securities a good investmentK )onsideration of some additional factors can help provide an answer.
The Income Statement& Interest Co)erage
,nterest Coverage is the number of times the annual interest on a debt obligation is covered by income for the year without considering interest on the debt and ta%es. Typicals debentures represent a very substantial debt, but they are due many years in the future. The yearly interest, however, is a fi%ed charge.
The Income Statement& Interest Co)erage& cont+
8ow readily the company can pay the interest on this debt ,i.e. the debts interest coverage- would be of great interest to an investor. "ore specifically, an investor would li+e to +now if the borrowed funds have been put to good use, so that the earnings are ade*uate and thus available to meet interest costs.
The available income representing the source for payment of the debenture interest is 5;>,;:< ,operating profit plus dividend and interest income less the interest e%pense on the other debt-. The annual debenture interest amounts to 55,@:>.
This means the debentures annual interest e%pense is covered @.6 times. Eumber of Times #ebenture &nterest 3arned: 5;>,;:< $vailable &ncome P @.6 55,@:> #ebenture &nterest
'or a corporate bond ,debenture- to be considered a safe investment, most analysts say that the company should earn its bond interest re*uirement 4 to = times over. 1y these standards, Typicals debentures have a fir margin of safety.
The Income Statement& 1hat a(o#t Le)erage2
)inancial Leverage relates a companys long9term debt and preferred stoc+ to the companys common e*uity. (ometimes a stoc+ is said to be highly leveraged, this means that the company issuing the stoc+ has a large proportion of bonds and preferred stoc+ outstanding relative to the amount of common stoc+.
The Income Statement& 1hat a(o#t Le)erage2& cont+
8igh leverage can wor+ for or against a company depending on the earnings available to the common shareholders. $nalysts consider highly leveraged companies to be ris+ prone.
'or e%ample, a company with 5;,;;;,;;; of =H bonds outstanding. &f the company earns ==;,;;; before bond interest, there will only be =;,;;; left for the common shareholders after payment of =;;,;;; bond interest. 8owever, an increase of only 5;H in earning to =@=,;;; will leave @=,;;; for common
&f there is only a small amount of common stoc+ issued, the increase in earnings per share will appear very impressive. 1ut in this instance, it is also apparent that a decline of 5;H in earnings to 46>,;;; would wipe out everything available for the common shareholders.
"oreover, it would also result in the companys being unable to cover the full interest on its bonds without dipping into its cash reserves and retained earnings. This is the great danger of so9called highly leveraged companies. &t also illustrates a fundamental wea+ness of companies that have a disproportionate
)onservative investors usually steer clear of highly leveraged companies, although they do appeal to people see+ing a higher return who are willing to assume the ris+. Typical "anufacturing, on the other hand, is not a highly leveraged company.
&n 567@, Typical incurred 55,@:> in debenture interest and its income before e%traordinary loss and this e%pense came to :<,4:> , =;,:;; N 55,@:>-. This left =;,:;; for the common and preferred stoc+holders and retained earnings after recording this interest.

Eow loo+ what happened this year:
Eet profit before e%traordinary loss and debenture interest rose by 5<,<:; or about <4H. (ince the bond interest stayed the same, income before e%traordinary loss and after recording this interest also rose 5<,<:;. 1ut that is about 4;H of =;,:;;.
?hile this is certainly not a dramatic e%ample of leverage, a <4H increase in preta% earnings generates a 4;H increase in amount available for dividends or retained earnings.
?hile this only illustrates the leverage effect of the interest on the debentures, similar calculations could be made to shoe the impact of the interest e%pense related to the other borrowings and total interest e%pense.
The Income Statement& Preferre -i)i en Co)erage
To calculate the (re$erred dividend coverage ,the number of time preferred dividends were earned-, net profit must be used as the base. Thats because federal income ta%es and all interest charges must be paid before anything is available for shareholders.
The Income Statement& Preferre -i)i en Co)erage& cont+
1ecause the >;,;;; shares of 5;; par value preferred stoc+ pay a per share dividend of :.@4, the total dividend re*uirement for the preferred stoc+ is 4:;. #ividing the net income of =A,A:;, by this figure yields appro%imately 54>.=, which means that the dividend re*uirement of the preferred stoc+ has been earned more than 54> times over.
The Income Statement& Preferre -i)i en Co)erage& cont+
This ratio is so high primarily because Typical has only a relatively small amount of preferred stoc+ outstanding.
The Income Statement& Earnings Per Common Share
$ buyer of common stoc+ is often more concerned with the stoc+s earnings per share than with its dividend. This is because earnings usually influence stoc+ mar+et prices.
The Income Statement& Earnings Per Common Share& cont+
$lthough the income statement separates earnings per share before and after the effect of e%traordinary items, the remainder of this presentation will only consider net income per common share ,net income after e%traordinary item-. &n Typicals case, the income statement does not show income available for common stoc+, so it must be calculated as shown

=: Eet &ncome Less: #ividend 2e*uirement of Preferred (toc+ Eet &ncome $vailable for )ommon (toc+
Eet &ncome Per )ommon (hare: =A,=;;,;;; Eet &ncome $vailable for the )ommon (toc+ = 4.<5 5=,A:;,;;; $verage Eumber of Iutstanding )ommon (hares
=A,A:; ,4:;=A,=;;
Typicals capital structure is a very simple one, comprised of common and preferred stoc+. Therefore, the earnings per share computation will suffice under this scenario. 8owever, if the capital structure is more comple% and contains securities that are convertible into co!!on stock+ o(tion+ &arrants or contingently issuable share , the calculation re*uires modification.
Iptions and warrants each give the holder the right to buy securities at a specified price. )ontingently issuable shares are shares of stoc+ whose issuance depends on the occurrence of certain events.

&f a capital structures has convertible securities, two separate calculations are re*uired:
Primary 3arnings Per )ommon (hare. 'ully #iluted 3arnings Per )ommon (hare.
The Income Statement& Primar$ Earnings Per Common Share
This is determined by dividing the earnings for the year by the average number of shares of common stoc+ outstanding during the year (lus co!!on stock equivalents i$ dilutive.
The Income Statement& Primar$ Earnings Per Common Share& cont+
Co!!on Stock Equivalents are securities that enable their holders to become common shareholders by e%ercising a right to ac*uire common stoc+ under that security,options or warrants- or e%changing or converting a security ,convertible securities- into common shares.
3%amples are convertible preferred stoc+, convertible bonds and the li+e. (uch securities are deemed to be only one step short of common stoc+. Their value stems in large part from the value of the common to which they relate.

)onvertible preferred stoc+ and convertible bonds offer their holders some choices. $ holder can elect either: $ return at the specified dividend or interest rate. )onversion into common stoc+ and participation in mar+et appreciation and dividends resulting from increased earnings on the common stoc+.
8owever, the securities dont have to be actually converted to common stoc+ for them to be called a /common stoc+ e*uivalent0 because they enable holders in certain circumstances to cause an increase in the number of common shares by e%ercising, e%changing or converting.

8ow do accountants determine a /common stoc+ e*uivalent0K (toc+ options and warrants to ac*uire common stoc+ are always considered /common stoc+ e*uivalents.0 $ convertible security is considered a /common stoc+ e*uivalent0 if its effective yield at the date of its issuance is less than two9thirds of the current average $a corporate bond yield.
The following e%ample is of how these new term might operate in a company entirely different form Typical "anufacturing. $ssume there are 5;;,;;; shares of common stoc+ outstanding plus another 5;;,;;; shares of preferred stoc+, convertible into common on a share9for9share basis. $ssume they *ualify as common stoc+ e*uivalents.

$dd the two and get <;;,;;; shares altogether. 'urther, assume earnings are :;;,;;; for the year. ?ith these facts, the computation99 assuming the conversion of the preferred is: Earning Per Common Share Ass#ming Con)ersion of 'referre 6 :;;,;;; 3arnings for the year P <.:; <;;,;;; $djusted (hares
8owever, as mentioned earlier, the /common stoc+ e*uivalent0 shares are only included in the computation if the effect of conversion on earnings per common share is dilutive. "ilution occurs when earnings per share decreases or loss per share increases on the companys common stoc+.

'or e%ample, assume the preferred stoc+ paid 4 a share in dividends. ?ithout conversion, the earnings per common share would be <, as opposed to <.:;.
:;;,;;; 4;;,;;; <;;,;;; 5;;,;;; P <.;;
3arning Per )ommon (hare: Eet income for the year Less: Preferred #ividends Eet &ncome $vailable for )ommon (hareholders )ommon (hares

&n
this case, the common stoc+ e*uivalent shares would be e%cluded from the computation. Thats because conversion results in the <.:; per share amount computed previously, a higher ,antidilutive- earnings per share. Therefore, primary earnings per share of < will be reflected on the income statement.
The Income Statement& F#ll$ -il#te Earnings Per Common Share
The primary earnings per share item ta+es into consideration common stoc+ and /common stoc+ e*uivalents.0 The purpose of $ully diluted earning (er co!!on share is to reflect ma%imum potential dilution in earnings that would result if all contingent issuances of common stoc+ had ta+en place at the beginning of the year.
The Income Statement& F#ll$ -il#te Earnings Per Common Share& cont+
This computation is the result of dividing the earnings for the year by common stoc+ and common stoc+ e*uivalents and all other securities that are convertible ,ever though they do not *ualify as /common stoc+ e*uivalents0-.
'irst, remember that for this earnings per share discussion there are 5;;,;;; share of convertible preferred outstanding and 5;;,;;; shares of common. $ssume there are also convertible bonds with a par value of 5;,;;;,;;; outstanding.
These bonds pay >H interest and have a conversion ratio of <; shares of common for every one9thousand dollar bond. $ssume the current average $a corporate bond yield is @H. These bonds are not /common stoc+ e*uivalents,0 because >H is not less than two9thirds of @H.
8owever, for fully diluted earnings per share they must be included. &f the 5;,;;; bonds were converted, there would be another <;;,;;; shares of stoc+, so adding everything up produces =;;,;;; shares.
1ut by converting the bonds, the >H interest payment, less the related 4;;,;;; ta% deduction, would be saved, adding another 4;;,;;; to net income available to common shareholders.
(o the calculation is:

>;;,;;; ,4;;,;;;:;;,;;;
Eet income for the year &nterest on the bonds Less: The income ta% savings applicable to bond interest deduction $djusted 3arning
4;;,;;; @;;,;;;
F#ll$ -il#te Earnings Per Share6 @;;,;;; $djusted 3arnings P =;;,;;; $djusted (hares
<
The only remaining step is to test for antidilution. The effect of antidilution would be the opposite of dilutionC it would increase earnings per share or reduce loss per share.
3arning per share without bond conversion would be <.:; , :;;,;;; . <;;,;;; shares-. (ince earnings per share if < is less than <.:;, the < is used.
The Income Statement& Price Earnings Ratio
1oth the price and the return on common stoc+ vary with a multitude of factors. Ine factor is the relationship that e%ists between the earnings per share and the mar+et price. &t is call the (rice earnings ratio ,abbreviated P.3 ratio-.
The Income Statement& Price Earnings Ratio& cont+

P.3 ratio is calculated as follows:
&f a stoc+ is selling at <: per share and earning < per share annually, its price earnings ratios 5<.: to 5, usually shortened to 5<.:. Put another way, the stoc+ is said to be selling at 5<.: time earnings.
&f the stoc+ should rise to =;, the P.3 ratio would be <;, or <; times earnings. &f the stoc+ drops to 5<, the P.3 ratio would be >, or > times earnings. 'or Typical, which has no /common stoc+ e*uivalents,0 net income per common share was calculated at 4.<5.
&f the stoc+ were selling at 44, the P.3 ratio would be 5;.4. This figure would be used to compare this stoc+ over a period of years to itself and .or to other similar stoc+s.

P7E ratio6 44 mar+et Price P5;.4 6 5 =6 4.<5 3arnings Per (hare
This means that Typicals common stoc+ is selling at appro%imately 5;.4 times earnings.

Last year, Typical earning <.AA per share. (ay that its stoc+ sold at the same P.3 ratio then. This means that a share of Typical was selling for <@.:; or so, and anyone who bought Typical then would be satisfied now.
&n the real world investors can never be certain that any stoc+ will +eep its same P.3 ratio form year to year. The historical P.3 multiple is a guide, not a guarantee.
&n general, a high P.3 multiple, when compared with other companies in the same industry, means that investors have confidence in the companys ability to produce higher future profits.
The Statement of Changes in Sharehol ers! E"#it$
This statement analyzes the changes from year9to9year in each component of shareholders e*uity. &t shows that during the year, Typical issued additional common stoc+ at a price above par.
The Statement of Changes in Sharehol ers! E"#it$& cont+
&t also shows that Typical e%perienced a foreign currency translation gain and an unrealized gain on investments classified as /available9for9sale.0 The other components of e*uity, with the e%ception of retained earnings remained the same.
The Statement of Changes in Sharehol ers! E"#it$& cont+
2etained earnings reflects the cumulative earnings that the company has invested for future growth. The statement of changes in shareholders e*uity show that retained earnings increased by net income less dividends on preferred and common stoc+.
The Statement of Changes in Sharehol ers! E"#it$& -i)i en s
#ividends on common stoc+ vary with the profitability of the company. They do not enter into the determination or net income nor are they deductible for ta% purposes. )ommon shareholders were paid 5@,;;; in dividends this year.
The Statement of Changes in Sharehol ers! E"#it$& -i)i en s& cont+
(ince the balance sheet shows that Typical has 5:,;;;,;;; shares outstanding, the first thing to be learned here may be an important point to some potential investors, that is the dividend per share.
-i)i en Per Share6 5@,;;;,;;; )ommon (toc+ #ividend P 5.<; 5:,;;;,;;; )ommon (hares Iutstanding
Ince the dividend per share is +nown, it is easy to go on to the ne%t step: computing the dividend payout percentage. The "ividend *ayout *ercentage is the percentage of earnings per share paid to shareholders.

-i)i en Pa$o#t Percentage6 5.<; #ividend Per )ommon (hare P 4AH =@ 4.<5 Eet &ncome Per )ommon (hare
$nother statistic of great interest to many investors and analysts is the dividend yield, a percentage providing an estimate of the return per share on a given class of stoc+. 'or e%ample, the )ommon #ividend Gield would be of great interest.
Co!!on "ividend :ield indicates the percentage return that the annual common dividend provides based on the mar+et price of the common stoc+. This is derived by dividing the annual common dividend, in this case 5.<;, by the mar+et price of the common stoc+, earlier determined to be 44 per share.
This provides a /common dividend yield0 of 4.>H, which is *uite respectable in todays mar+et.
-i)i en 8iel 6 5.<; #ividend Per )ommon (hare P 4.>H 44 "ar+et Price of the )ommon (toc+
If course, the dividends on the :.@4 preferred stoc+ will not change form year9 to9year. The word cu!ulative in the balance9sheet description indicates that if Typicals management didnt pay a dividend on its preferred stoc+, then the :.@4 payment for that year would accumulate.
&t would have to be paid to preferred shareholders before any dividends could ever be declared again on the common stoc+. Thats why preferred stoc+ is called (re$erredC it gets any dividend money first )hances are its >;,;;; shares of preferred stoc+ with a par value of 5;; each were issued to family members.
#uring the year, Typical has added <6,=;; to its retained earnings after paying dividends totaling 5@,4:;. 3ven if Typical has some lean years in the future, it has plenty of retained earnings from which to +eep on declaring those :.@4 dividends on the preferred stoc+ and 5.<; dividends on the common stoc+.
There is one danger in having a lot of retained earnings. &t could attract another company, Breat Biant )omputers O 3lectronics for instance, to buy up enough of Typicals common to vote out the current management. Then Breat Biant might merge Typical into

?here would Breat Biant get the money to buy Typical (toc+K 1y issuing new shares of its own stoc+, perhaps. $nd where would Breat Biant get the money to pay the dividends on all that new stoc+ of its ownK The funds would come from Typicals retained earnings.
(o Typicals management has an obligation to its shareholders to ma+e sure that its retained earnings are put to wor+ to increase their total wealth. Itherwise, the shareholders might cooperate with Breat Biant if it conducted a raid on Typical. <A 2etained 3arnings <=6,;;;
The Statement of Changes in Sharehol ers! E"#it$& Ret#rn on E"#it$
(eeing how hard money wor+s is one of the most popular measures that investors use to come up with individual judgments on how much they thin+ a certain stoc+ ought to be worth. The !arket itself99the sum of all buyers and sellers99 ma+es the real decision.
The Statement of Changes in Sharehol ers! E"#it$& Ret#rn on E"#it$& cont+
1ut the investors often try to ma+e their own decision on whether they want to invest at the mar+ets price or wait. "ost investors loo+ for Typicals %eturn /n Equity 8%/E9+ which shows how hard shareholders e*uity in Typical is wor+ing.
8ow can an investor compute Typicals 2I3K To arrive at this figure, an investor would loo+ at the balance sheet and compute the average common shareholders e*uity for the year in order to calculate how much Typical made on it.
&n ma+ing this calculation, the investor uses only the amount of net profit after the dividends have been paid on the preferred stoc+. 'or Typical "anufacturing, that means =A,A:; net profit minus 4:;.

2eturn In 3*uity: =A,A:; Eet &ncome Less 4:; Preferred (toc+ #ivident = 4<:,@<: $vg 5676 (toc+holdersM 3*uity Less >,;;; Preferred (toc+ Falue =A,=;; = 5=.@H 2eturn on 3*uity 456,@<:
'or every dollar of shareholders e*uity, Typical made about 5: cents. &s that goodK $ 5:H return to shareholders is about twice the return Typical would have received had it invested instead in *uality corporate bonds.

&t is also several times what it would have received from a savings account. The point is that in considering whether to put money to wor+ in Typicals stoc+, an investor really needs to do two things. 'irst, he or she needs to compare Typicals 5=.@H to returns from Typicals business competitors.
(econd, he or she needs to compare Typicals return to the potential return that could be achieved from other types of investment, such as certificates of deposit, corporate bonds, real estate or other common stoc+. Qust remember, that 5=.@H is what Typical itself ma+es.
The Statement of Changes in Sharehol ers! E"#it$& Ret#rn On E"#it$& cont+
1y no means is it what an investor will ma+e in dividends on Typicals stoc+. ?hat 2I3 really reveals is whether Typical "anufacturing is relatively attractive as an enterprise. $n investor can only hope that this attractiveness will translate into demand for Typicals stoc+ and will be reflected in its
The Statement of Cash Flo%s
Ine more statement needs to be analyzed in order to get the full picture of Typicals financial status. The state!ent o$ cash $lo&s presents the changes in cash resulting from business activities. )ash flow analysis is necessary to ma+e proper investing decisions and to maintain
The Statement of Cash Flo%s& cont+
)ash flows, are related to net income, but are not e*uivalent to it. This is because of the accrual method of accounting. Dnder Accrual Accounting, a transaction is recognized on the income statement when the earnings process is completed, that is, when the goods and.or services have been delivered or performed or an e%pense has been incurred.
This does not necessarily coincide with the time that cash is e%changed. 'or e%ample, cash received from merchandise sales often lags behind the time when goods are delivered to customers. Benerally, when the goods are shipped ,service performed-, the sale is recorded on the income statement and a related
)ash flows are also separated by business activity. The business activity classifications presented on the statement include financing activities, investing activities and operating activities. 'inancing and investing activities will be discussed first.
'inancing activities include those activities relating to the receipt and repayment of funds provided by creditors and investors. These activities include the issuance of debt or e*uity securities, the repayment of debt, and distribution of dividends. &nvesting activities include those activities relating to asset ac*uisition or disposal.
Iperating activities basically include all activities not classified as either financing or investing activities. They involve the companys primary business activities, for e%ample the production and delivery of goods and services. They reflect the cash effects of transactions, which are included in the determination of net
(ince many items enter into the determination of net income, the indirect method is used to determine the cash provided by or used for operating activities. This method re*uires adjusting net income to reconcile it to cash flows from operating activities.

)ommon e%amples of cash flows from operating activities are: )ash )ollected from customers &nterest received and paid #ividends received (alary &nsurance Ta% payments
itional -isclos#res an A# it Re'orts
'atch Those 5otes The annual reports of many companies contain this or a similar statement: /(ee the $ccompanying Eotes to the )onsolidated 'inancial (tatements.0 or /The $ccompanying Eotes are an &ntegral Part of the 'inancial (tatements.0
A itional -isclos#res an A# it Re'orts& Footnotes& cont+
The reason is that the financial statements themselves simply report the balances in the various accounts. 1ecause there is no room on the face of the statements for a complete and ade*uate discussion relating to those balances, additional re*uired disclosures are provided in the notes.
(ome e%amples of appropriate footnote data are: "isclosure o$ the co!(anys (olicies $or; #epreciation $mortization )onsolidation 'oreign )urrency Translation 3arnings Per (hare

,nventory 6aluation Method;
&ndicates whether inventories shown on the balance sheet and used to determine the cost of goods sold on the income statement used a method such as Last-,n+ )irst-/ut 8L,)/9+ )irst-,n+ )irst-/ut 8),)/9+ or Average Cost.

,nventory 6aluation Method; L,)/ < ),)/
L&'I means that the costs on the income statement reflect the cost of inventories purchased or produced most recently. '&'I means the income statement reflects the cost of the oldest inventories.

,nventory 6aluation Method; L,)/ < ),)/ This is an e%tremely important consideration because the L&'I method reflects the most current costs in the income statement and does not overstate profits during inflationary times.
?hile the '&'I valuation does

,nventory 6aluation Method; L,)/ < ),)/
&f not shown on the balance sheet, the composition of the inventories by raw materials, wor+9in9process, finished goods, and supplies should be presented.

Asset ,!(air!ent
#isclosure of details about impaired assets or assets to be disposed of. ,nvest!ents &nformation about debt and e*uity securities classified as /trading0, /available9for9sale0 or /held9to9maturity.0

,nco!e Ta- *rovision
The brea+down by current and deferred ta%es and its composition into federal, state, local and foreign ta%, accompanied by a reconciliation from the statutory income ta% rate to the effective ta% rate for the company
Changes in Accounting *olicy #escription of changes in accounting policy due to new accounting rules. 5onrecurring ,te!s #etails regarding nonrecurring items such as pension plan terminations or ac*uisitions.dispositions of significant business units.
E!(loy!ent and %etire!ent *rogra!s #etails regarding employment contracts, profit9sharing, pension and retirement plans and post retirement and post employment benefits other than pensions. Stock /(tions #etails about stoc+ options granted to officers and employees.
Long Ter! Leases #isclosure of lease obligations on assets and facilities on a per year basis for the ne%t several years and total lease obligations over the remaining lease period. Long Ter! "ebt #etails regarding the issuance and maturities of long term debt.
Contingent Liabilities #isclosures relating to potential or pending claims or lawsuits that might affect the company. )uture Contractual Co!!it!ents Terms of contracts in force that will affect future periods.
/$$-7alance Sheet Credit and Market %isks #etails of off9balance9sheet credit and mar+et ris+ associated with certain financial instruments. This includes: &nterest rate swaps, forward and futures contracts and options contracts. /$$-balance-sheet risk is defined as potential for loss over and above the amount recorded on the balance sheet.
%egulations or %estrictions #escription of regulatory re*uirements and dividend or other restrictions. )air 6alue o$ )inancial ,nstru!ents Carried at Cost #isclosure of fair mar+et values of instruments carried at cost including long term debt and off9balance9sheet instruments, such as swaps and options.
Seg!ent Sales+ /(erating *ro$its and ,denti$iable Assets &nformation on each industry segment that account for more than 5;H of a companys sales, operating profits and.or assets. "ultinational corporations must also show sales and identifiable assets for each significant geographic area where sales or assets e%ceed 5;H of the related consolidated amounts.
"ost people do not li+e to read footnotes because they are complicated and are rarely written in /plain 3nglish.0 This is unfortunate because the notes are very informative. "oreover, they can reveal many critical and fascinating sidelights to the financial story.
,nde(endent Audits The report from the independent auditors is often referred to as the auditors opinion, and is printed in the annual report.
&t should say these two things:
The audit steps ta+en to verify the financial statements meet the auditing professions approved standard of practice.
The financial statements prepared by management are managements responsibility and follow generally accepted accounting principles.
$s a result, when the annual report contains financial statements accompanied by an un*ualified ,often referred to as /clean0option from independent auditors, there is added assurance that the figures can be relied upon as being fairly presented.
8owever, if the independent auditors report contains the *ualifying words =e-ce(t $or>+ the reader should be on the alert, cautions and *uestioning. The reader should investigate the reason,sbehind such *ualification,s-, which should be summarily e%plained in that report and referenced to the footnotes.
&n addition, while the auditor,s- may not *ualify the opinion, a separate paragraph may be inserted to emphasize an important item. &nvestors should carefully consider any matter so emphasized.

How To Read A Financial Report

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How To Read A Financial Report

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HOW TO READ A FINANCIAL REPORT

COMPONENTS OF AN ANNUAL REPORT

COMPONENTS OF AN ANNUAL REPORT

The Finan ial Review

THE BALANCE SHEET

The Income Statement

The Statement of Changes in Sharehol ers! E"#it$

Statement of Cash Flo%s

$ "odel )ompany )alled /Typical0

$ "odel )ompany )alled /Typical0

$ "odel )ompany )alled /Typical0

$ "odel )ompany )alled /Typical0

$ "odel )ompany )alled /Typical0

Consoli ate Balance Sheets& Assets

156,000 1&0,000 4,000 405,800

145,000 1&5,000 3,000 380,000

Consoli ate Balance Sheets& Pro'ert$& Plant an E"#i'ment

Consoli ate Balance Sheets& Other Assets

1,950 2,000 300 $,$50 $,000 (%%8,050 (%31,%00

Consoli ate Balance Sheets& Lia(ilities December, 31

Consoli ate Balance Sheets& Sharehol ers! E"#it$

#5,000 20,000 249,000 1,000 50

#2,500 13,500 219,600 41,0005

45,0005 45,0005 34%,050 305,%00 (%%8,050 (%31,%00

Consoli ate Income Statement

Consoli ate Income Statement& contin#e

$3155 41345 (30$1

Consoli ate Statement of Changes in Sharehol er!s E"#it$

4$5,0005 $305,600 4#,#50 43505 41&,0005 9,000 2,000

$50 $20,000 $249,000 $1,000 $50

$50 4$5,0005 $346,050

8alance Dec0 31, 19X9 $6,000 $#5,000

Consoli ate Statement of Cash Flo%s

Consoli ate Statement of Cash Flo%s& contin#e

The Balance Sheet

The Balance Sheet& contin#e

The Balance Sheet& contin#e

The Balance Sheet& contin#e

The Balance Sheet& contin#e

The Balance Sheet& Assets& C#rrent an E"#i)alents

The Balance Sheet& Assets& Mar*eta(le Sec#rities

The Balance Sheet& Assets& Mar*eta(le Sec#rities& cont+

The Balance Sheet& Assets& Mar*eta(le Sec#rities& cont+

The Balance Sheet& Assets& Mar*eta(le Sec#rities& cont+

The Balance Sheet& Assets& Mar*eta(le Sec#rities& cont+

< "ar+etable securities: Trading securities $vailable9for9sale

The Balance Sheet& Assets& Acco#nts Recei)a(le

The Balance Sheet& Assets& Acco#nts Recei)a(le& cont+

The Balance Sheet& Assets& Acco#nts Recei)a(le& cont+

4 $ccounts receivable Less: allowance for doubtful accounts

The Balance Sheet& Assets& In)entor$

The Balance Sheet& Assets& In)entor$& contin#e

The Balance Sheet& Assets & In)entor$& contin#e

The Balance Sheet& Assets & In)entor$& contin#e

The Balance Sheet& Assets & In)entor$& contin#e

The Balance Sheet& Assets & In)entor$& contin#e

The Balance Sheet& Assets& Pre'ai E,'enses

The Balance Sheet& Assets& Pre'ai E,'enses& contin#e

The Balance Sheet& Assets & Pre'ai E,'enses& contin#e

: Prepaid e%penses and other current assets

The Balance Sheet& Assets& Total C#rrent Assets

The Balance Sheet& Assets& Total C#rrent Assets& cont+

The Balance Sheet& Assets& Pro'ert$& Plant an E"#i'ment