Understanding Financial Statements
Why We Have Financial Statements
Generally an accounting department, a bookkeeper or the owner of a business systematically records, sorts and summarizes the thousands of documents (register tapes, invoices and vouchers) representing the transactions of business. These transactions include: sale of merchandise; payroll distribution; material purchases for inventory - to mention just a few. These facts are then compiled, classified and summarized into financial reports for a business so that a financial statement can then be prepared.
Financial statements are customarily prepared on a quarterly, biannual or annual basis. The date of a financial statement is of considerable importance. Most are usually drawn up on a yearly (fiscal) basis. Statements provided that are outside of the fiscal closing are known as interim statements.
Bookkeeping and accounting principles treat any business as a separate entity apart form the owners or principals, purchase goods, sell products and pay salaries. This distinction of the business apart from the owners in important in understanding how financial statements are presented.
D&B maintains information on 12 million U.S. businesses in its information files. Over 99 percent of these concerns are privately held proprietorships, partnerships or corporations. A privately held business is usually run by a small number of principals who answer only to themselves. Publicly owned companies, on the other hand, are corporations run by management answering to an elected board of directors, numerous stockholders and regulators, and whose shares of stock (ownership) can be purchased by the public at large.
There are two parts to the financial statement - the balance sheet and the income (profit and loss) statement.
A balance sheet is a detailed snapshot of the condition or financial health of a company on a specific date. December 31st is the most popular choice among business, however many seasonal businesses issue their statements after their main selling season, because their condition is most favorable at that time. Balance sheets show the dollar amount of assets (what the business owns) and liabilities (what a business owes) in relation to net worth or owner's equity (what the owner, principals or stockholders own). Balance sheets are presented with assets on the left side of a page and liabilities and equity on the right. Totals of both left and right sides must balance, since total assets must equal total liabilities plus net worth.
The income or profit and loss statement is a detailed computation of the money a business makes or loses over a specific time period. Sales or service income is offset against expenses-operating and production costs. You will most often see year-end statements reflecting income and expenses for a particular calendar year.
A shortcoming of reviewing a single financial statement of a business is the inability to establish important trends. However, when you compare two or more successive financial statements of the same concern, a trend becomes apparent. Individual items of the balance sheet and profit and loss statement compared with identical items on previous statements can be significantly reveling in decision making. This observation process is called comparative analysis, which we'll use throughout this guide. Keep in mind, comparative analysis of a company's financial statement to its previous results and to industry averages is essential in assessing its financial health.
As mentioned earlier, the balance sheet is the financial statement that reports the assets, liabilities and net worth of a company at a specific point in time. Assets represent the total resources of a company, which may shrink or increase depending on the results of operations. Assets are listed in liquidity order - ease of converting into cash. Typical assets include: cash, accounts receivable, inventory, fixed assets and a number of miscellaneous assets we have classified as other. Liabilities include what a company owes: accounts and notes payable, bank loans, deferred credits and miscellaneous other. All businesses divide assets and liabilities into two groups: current (convertible to cash within a year) and noncurrent. Net worth is the owner's investment (in the case of a proprietorship or partnership) or capital stock (original investment) plus earned surplus (earnings retained in the business) in the case of a corporation.
Current Assets, also called trading assets, include cash, trade receivable and inventory. These are items that can be converted to cash within one year or in the normal operating cycle of a business. Also included in this category are any assets held that can be readily turned into cash with little effort, such as government and marketable securities.
Cash refers to cash on hand on in banks, checking account balances, and other instruments such as checks or money orders. A rule of thumb is that cash position is generally strongest after the peak selling season. When cash balances are continually small, it may be that a concern is experiencing slow receivable collection or some other financial weakness.
Marketable securities are found on many balance sheets. Marketable securities can include: government bonds and notes, commercial paper, and/or stock and bond investments in public corporations. Marketable securities are usually listed at cost or market price, whichever is lower. Accountants will frequently list securities at cost with a footnote indicating market price on the balance sheet date. (When marketable securities appear on a statement, it frequently indicates investment of excess cash.)
Sales between most businesses are made on a credit basis. Accounts receivable indicate sales made and billed to customers on credit terms. A retailer, such as a department store, may show its customer charge accounts billed and unpaid in this category. In many businesses, accounts receivable are frequently the largest item on the balance sheet. You should pay special attention to this category and to credit terms offered by the company's health depends upon timely collection of receivables.
Every business that has accounts receivable, has some portion that it is unable to collect because customers fail to pay for one reason or another - mismanagement, disaster or intent. Usually a business will set aside an estimated allowance for these uncollectable or doubtful accounts. This allowance called "bad debt" is deducted from the total receivables shown on the balance sheet. Frequently a footnote identifying the amount deducted will be found in the statements.
Notes receivable represent a variety of obligations with terms coming due within a year. Notes receivable may be used by a company to secure payments from past-due accounts, or for merchandise sold on installment terms. In any case, notes receivable should be reviewed closely.
You will find that inventory includes different items depending on whether a business is a manufacturer, wholesaler or retailer. Retailers and wholesalers will show goods that are sold "as is" with o further processing or supplies required in shipping. On the other hand, many manufacturers will show three different classes of inventory: raw materials, work-in-process or progress and finished goods. Raw materials are considered the most valuable part of inventory as they could be resold in the event of liquidation. Work-in-process has the least value because it requires additional labor and a sales effort to get rid of it if liquidation should occur. Finished goods are ready for resale. Finished goods value vary greatly according to circumstances. If they are popular products in good condition that can be easily sold, then the value shown might be justified. If the goods are questionable in salability, the value may be carried too high. The manufacturer's cost of labor employed in the production of finished goods and goods in process, as well as factory expenses is included in the value. Inventory is normally shown on the balance sheet at cost or market value, whichever is lower.
As a company's sales volume increases, larger inventories are required; however, problems can arise in financing their purchases unless turnover (number of time a year goods are bought and sold) is kept in balance with sales. A sales decline could be accompanied by a decrease in inventory in order to maintain a healthy condition. If a business has a sizable inventory, it may have partially completed or finished goods that are obsolete, or it could reflect a change in merchandising conditions.
This category includes prepaid insurance, taxes rent and interest. Some conservative analysts consider prepaid items as noncurrent because they cannot be converted to cash to pay obligations quickly, and therefore have no value to creditors. Normally, this category is not large in relation to other balance sheet items, but if it is sizable there may be problems.
Noncurrent assets are items a business cannot easily turn into cash and are not consumed within business-cycle activity. We have defined current assets as those that can be converted into cash within one year. In the case of noncurrent assets, they are defined as assets that have a life exceeding a year.
Fixed assets are materials, goods, services and land used in the production of a company's goods. Examples include: real estate, buildings, plant equipment, tools and machinery, furniture, fixtures, office or store equipment and transportation equipment. All of these would be used in producing products for a company's customers. Land, equipment or buildings not used in the production of customer goods would be listed as other noncurrent assets or investments. Fixed assets are carried on the company's accounting books at the price they cost at the time of purchase.
All fixed assets, except land, are regularly depreciated since they eventually wear out. Depreciation is an accounting practice that reduces the fixed asset's carrying value on an annual basis. The reductions are considered a cost of doing business and are called a depreciation charge. Eventually the fixed asset will be reduced to its salvage or scrap value. Normally the accounting procedure is to list the fixed asset cost less accumulated depreciation, which would be shown on the statement or in a footnote. Bear in mind, not all companies can be comparable on this item as some rent their equipment and premises. If a business rents, its fixed asset total will be smaller compared with other balance sheet items.
Under the other assets category, several items can been lumped together. The following items may be itemized separately on other balance sheets, and if significant, should be closely examined: investments, intangible, and miscellaneous assets.
Investments of a business represent assets of a permanent nature that will yield benefits a year or more after the date of the financial statement. These may include: investments in related companies such as affiliates (partly owned) and subsidiaries (owned and controlled); stocks and bonds maturing later than one year; securities placed in special funds; and fixed assets not used in production. The value of these items should be shown at cost.
Miscellaneous assets include advances to and receivables from subsidiaries, and receivables from officers and employees.
Intangible assets are those that may have great value to an operating company but have limited value to creditors. Analysts tend to discount these items or value them very conservatively. Intangible assets may be: a company's goodwill, copyrights and trademarks, development costs, patents, mailing lists and catalogs, treasury stock, formulas and processes, organization costs, and research and development costs.
Current liabilities are obligations that a business must pay within a year. Generally they are obligations that are due by a specific date, usually within 30 to 90 days of fulfillment. To maintain a good reputation and successful operations, most businesses find they must have sufficient funds available to pay these obligations on time.
Accounts payable represents merchandise or material requirements purchased on credit terms and not paid for by the balance sheet date. When reviewing balance sheets of small companies, you will frequently find that liabilities principally fall into the accounts payable line. Suppliers dealing in good faith expect their invoices to be paid according to the terms of sales specified. These can range from net 30 to 90 days (after invoice date) plus discount incentives of 1 percent or more if payments are made by a specified earlier time. Reasons for discount incentives were outlined in the accounts receivable section earlier in this guide.
Companies able to obtain bank loans frequently show small accounts payable relative to all of their current liabilities. The loans are often used to cover material and merchandising obligations. Sizable payables shown, when there are loans outstanding, may indicate special credit terms being extended by suppliers or poor timing of purchases.
If a business has borrowed from a bank without collateral, the bank loan would be considered unsecured (no collateral pledged) which is a favorable sign. It shows the business has an alternative credit source available other than suppliers, and the business meets the strict requirements of a bank. On the other hand, if collateral has been pledged, then the loan would be listed as secured (the bank has a claim on part or all of the borrower's assets). Loan nonpayment can result in the bank satisfying its claim by taking possession of the secured asset and selling it. Some companies have a line of credit (a limit up to which it can borrow) as a bank customer, which is also a sign that it is regarded as a good risk. This line is used by companies frequently during peak selling seasons. However, if a company has a line, you would be wise to find out the amount to determine the bank's evaluation of the company. Bank loans listed under current liabilities are to be retired within a year. Bank borrowing needs generally will increase along with the company's growth.
A company's borrowings from firms and individuals other than banks may be included in this category. This may be for convenience or because bank financing was not available. Also, a company may have a credit agreement with suppliers for merchandise or materials. If a company shows outstanding notes and it is not in an industry that traditionally deals in them, you may want to learn more, as this may indicate a weak credit standing.
Several items are lumped together in this category. Since a business acquires debt by either buying on credit, borrowing money or incurring expenses, this line serves as a catch all for the expenses incurred and unpaid at the time the statement was prepared. These items must be paid within a year. For example, wages and salaries due employees for time between the last pay day and the balance sheet date are included in this category. Various federal, municipal, and state taxes (sales, property, social security, and unemployment) appear under the heading accrued taxes. Federal and state taxes on income or profits may also be found here. If a balance sheet does not show a liability for taxes and a profit is claimed, the company may be understating its current debt.
Several items are lumped together in this category. Since a business acquires debt by either buying on credit, borrowing money or incurring expenses, this line service as a catch all for the expenses incurred and unpaid at the time the statement was prepared. These items must be paid within a year. For example, wages and salaries due employees for time between the last pay day and the balance sheet date are included in this category. Various federal, municipal, and state taxes (sales, property, social security, and unemployment) appear under the heading accrued taxes. Federal and state taxes on income or profits may also be found here. If a balance sheet does not show a liability for taxes and a profit is claimed, the company may be understating its current debt.
Long-term liabilities are items that mature in excess of one year from the balance sheet date. Maturity dates (when payment is due) may run up to 20 or more years. An example of this would be real estate mortgages. Normally, items in this area are retired in annual installments.
The items most often appearing in this category are mortgage loans, usually secured by the real estate itself, bonds, or other long term notes payable. Bonds are a means of borrowing long-term funds for large and well established companies. When a company is big enough and financially sound, it will sometimes be able to borrow money on a long-term unsecured basis. When this occurs, the unsecured deferred notes are called debentures. When reviewing unsecured long-term note payable, you should determine the holders of the notes. (This information may be found in the footnotes to the statement prepared by an accountant.) Frequently the owner or principals of the business will hold the notes. In a corporation, the principals can also become creditors and collect interest. To do this, they could simply loan the corporation money. They would be able to obtain repayment along with other unsecured creditors in the event of liquidation. However, at times, other creditors will require that in event of bankruptcy, officer or stockholder loans will be paid back last when assets are distributed. Money invested by stockholders is rarely recovered if insolvency occurs. It should be noted that some analysts categorize officer loans as current liabilities, primarily when repayment schedules do not exist.
Net worth represents the owners' share of the assets of the business. It is the difference between total assets and total debts. Remember our balance sheet formula - Total assets minus Total liabilities equals Net worth or Owner's equity. Basically, this is the investment the owners have at stake in the business. If liquidation occurs, assets are sold off to pay creditors and the owners received whatever remains. This is why equity sometimes is referred to as "risk capital."
In proprietorships (owned by an individual) and partnerships (owned by two or more individuals) the net worth figure on the balance sheet represents:
- Original investment of owners.
- Plus... additional investments they have made.
- Plus... accumulated or retained profits.
- Less... whatever losses have been sustained.
- Less... any withdrawals by partners.
On corporate balance sheets, net worth may be broken down into the following categories:
- Capital stock represents all issued or unissued shares of common or preferred stock. Preferred stock is a class of stock with a claim on earnings before payment may be made to common stockholders. Usually preferred shareholders are entitled to priority over common stockholders if a company liquidates. Common stockholders assume greater risk but normally have greater reward in dividends and capital appreciation.
- Paid-in or capital surplus represents money or other assets contributed to the business, but for which no stock or owner's rights have been issued. (i.e. funds that exceed the stock's par value.)
- Earned surplus is the amount of earnings retained in the corporation and not distributed in dividends.
When a corporation shows a net worth that has as its components capital stock and retained earnings, capital stock represents shares of equity issued to owners. Retained earnings are the amount of corporate profits permitted to remain in the business by design of the officers. Analysts view a sizable amount of retained earnings as significant. It shows a business is profitable and successful if it recognizes the need for net worth growth as the company progresses.
While the balance sheet gives a very detailed description of a business, it does not indicate whether a company is making a profit or losing money. That information comes from reviewing the income statement, which in Gorman's case shows that a small profit was earned. The net worth reduction can happen in one of four ways: a loss was sustained, dividends were paid in excess of profits, capital stock was redeemed or assets were written down. Net worth goes up when earnings are retained, capital is added, assets are written up, or liabilities are written down.
The income statement (also called the profit & loss statement) shows how much money a business makes or loses over a specific time period - a month, 3 months, 6 months or a year. In come statements are often prepared 4 times a year but never cover a period longer than a year. When income statements are prepared, management or its accountants extract sales and other income totals along with totals of various expenses from internal accounting records. Once expenses are computed, they are subtracted from income and either a profit or loss is shown. The results on the income statement affect the balance sheet from period to period, so it is important to review both statements to determine the full impact each has on the other.
The net sales figure is derived by adding up the total invoices billed to customers during the period covered, less any discounts taken by customers. Then, any sales returns accepted from customers during the period are deducted. Deductions can be imported in some industries. For example, in retailing they can run over 10 percent. After deductions are made, the remaining figure in net sales which is important for comparative analysis and percentage calculation.
Gross profit is found by subtracting the cost of goods sold from net sales. Cost of goods sold is comprised of those expenses it took to manufacture, purchase merchandise and service customers. The cost of goods sold takes in material costs, labor and factory expenses involved in producing merchandise sold.
Gross profit measures the profitability of a concern's production set-up. A successful company's gross profit will cover its costs of doing business with enough left over to produce a net profit.
Before coming up with the net profit after tax ( sometimes called net income after tax), you should be aware that all expenses directly applicable to the company's operations, including income taxes, have been deducted from gross profit. Net profit after tax truly measures the operating success of the company. When total expenses exceeds net sales, a minus figure results and a loss has occurred. If there is a surplus (profit greater than 0, it can be added to retained earnings or distributed to owners and stockholders as withdrawals or dividends. When expenses exceed net sales (when a loss occurs), it is charged against net worth and a reduction in the equity accounts occurs.
This item can be very important, depending on the type of business you are reviewing - corporation, partnership or proprietorship. In the case of a partnership or proprietorship, this figure would represent withdrawals by the owners of the business. When withdrawals or dividends exceed profits they diminish net worth. This situation may have an adverse effect on business activities.
Working capital represents the funds available to finance current business operations. Many companies show this computation prominently in their statement, but in some instances you may want to compute it on your own. This figure is important, as it is used to determine how much excess cash a business has to fund current expenses. Working capital is the difference between current assets and current liabilities. Since a company's sources to pay its current debt come partly from current assets, a business with a comfortable margin should be able to pay its bills and operate successfully. How much working captial is enough depends on the proportion of current assets to current liablilites rather than on the dollar amount of working capital. We'll take up this ratio shortly; however keep in mind that it is good to have two dollars or more of current assets to one dollar of current liabilities than to have less, for most businesses.
Previously, we indicated that financial statements are prepared so management can make informed, intelligent decisions affecting the success or failure of its operations. In the business world, outsiders - creditors, bankers, lenders, investors and shareholders - have varying objectives in mind when they look at a company's statements. The type of analysis and the amount of time spent depends upon the objectives of the analyst. An investor interested in a publicly owned company might spend less effort than a banker considering a loan application. A supplier considering an order from a small business might spend less time and effort than the banker. The degree of information available on a business varies according to the requirements of the business under review. For example, a banker considering a sizable loan application would normally require not only a detailed statement of condition and income for several years, but inventory breakdowns and aging schedules of receivables, accounts payable, sales plans and profitability projections. When a banker, credit manager or investor receives the financial information desired, an analysis is started and the leading tool most analysts use is ratio analysis.
Ratios are a means of highlighting relationships between financial statement items. There are literally dozens of ratios which can be complied on any business. Generally, ratios are used in two ways: for internal analysis of items in a balance sheet; and/or for comparative analysis of a company's ratios at different time periods and in comparison to other firms in the same industry.
Below find fourteen key business ratios. The ratios are divided into three groups:
- Solvency Ratios - used to measure the financial soundness of a business and how well the company can satisfy its obligations.
- Efficiency Ratios - used to measure the quality of the firm's receivables and how efficiently it utilizes its other assets.
- Profitability Ratios - used to measure how well a company performs.
The quick ratio, sometimes called the "acid test" or "liquid" ratio measures the extent to which a business can cover its current liabilities with those current assets readily convertible to cash. Only cash and accounts receivable would be included, as inventory and other current assets would require time and effort to convert into cash. A minimum ratio of 1.0 to 1.0 ($1 of cash receivables to $1 current liabilities) is desirable.
The current ratio expresses the working capital relationship of current assets to cover current liabilities. A rule of thumb is that at least 2 to 1 is considered a sign of sound financial strength. However, much depends on the standards of the specific industry you are reviewing.
Current liabilities to net worth ratios indicates the amount due creditor within a year as percentage of the owners or stockholders investment. The smaller the net worth and the larger the liabilities, the less security for creditors. Normally a business starts to have trouble when this relationship exceeds 80 percent.
Current liabilities to inventory ratio shows you, as a percentage, the reliance on available inventory for payment of debt (how much a company relies on funds from disposal of unsold inventories to meet its current debt).
Total liabilities to net worth shows how all of the company's debt relates to the equity of the owners or stockholders. The higher this ratio, the less protection there is for the creditors of the business.
Fixed assets to net worth ratio shows the percentage of assets centered in fixed assets compared to total equity. Generally the higher this percentage is over 75 percent, the more vulnerable a concern becomes to unexpected hazards and business climate changes. Capital is frozen in the form of machinery and the margin for operating funds becomes too narrow for day to day operations.
Collection period ratio is helpful in analyzing the collectabiliy of accounts receivable, or how fast a business can increase its cash supply. Although businesses establish credit terms, they are not always observed by their customers for one reason or another. In analyzing a business, you must know the credit terms it offers before determing the quality of its receivables. While each industry has its own average collection period (number of days it takes to collect payments from customers), there are observers who feel that more than 10 to 15 days over terms should be of concern.
Sales inventory ratio provides a yardstick for comparing stock-to-sales ratios of a business with others in the same industry. When this ratio is high, it may indicate a situation where sales are being lost because a concern is understocked and/ or customers are buying else where. If the ratio is too low, this may show that inventories are obsolete or stagnant.
Assets to sales ratio measures the percentage of investment in assets that is required to generate the current annual sales level. If the percentage is abnormally high, it indicates that a business is not being aggressive enough in its sales efforts, or that its assets are not being fully utilized. A low ratio may indicate a business is selling more than can be safely covered by its assets.
Sales to net worth capital ratio measures the number of times working capital turns over annually in relation to net sales. A high turn over can indicate over trading (an excessive sales volume in relation to the investment in the business). This ratio should be reviewed in conjunction with the assets to sales ratio. A high turnover rate might also indicate that the business relies extensively upon credit granted by suppliers or the bank as a substitute for an adequate margin of operating funds.
Accounts payable to sales ratio measure how the company pay its suppliers in relation to the sales volume being transacted. A low percentage would indicate a healthy ratio.
Return on sales (profit margin) ratio measures the profits after taxes on the year's sales. The higher this ratio, the better the prepared the business is to handle downtrends brought on by adverse conditions.
Return on assets ratio is the key indicator of the profitability of a company. It matches net profits after taxes with the assets used to earn such profits. A high percentage rate will tell you the company is well run and has a healthy return on assets.
Return on net worth ratio measures the ability of a company's management to realize an adequate return on the capital invested by the owners in the company.