This page is designed for the sole purpose of teaching someone how to read financial statements. While intended for those with little or now knowledge of finacial statements, it can be a handy reminder even for the seasoned professional. This page is very long so an outline is provided to help you get the information you desire. (SEE OUTLINE)
 
HOW TO READ A FINANCIAL STATEMENT
 
    If you are a certified public accountant it is most unlikely that you can learn anything from reading this book.  You don't need to be told the basics of understanding what's presented in corporate annual reports.  If you aren't a certified public accountant, and you find that annual reports are "over your head," this booklet can help you to grasp the facts contained in such reports and possibly become a better informed investor.  That is our principal aim in publishing this booklet, but we also hope that it will be useful to other readers who want to understand how business works and to learn more about the companies that provide them with goods and services or that offer them employment.

    Most annual reports can be broken down into three sections: the Executive Letter, the business Review, and the Financial Review. The Executive Letter gives a broad overview of the company's business and financial performance.  The Business Review summarizes recent developments, trends, and objectives of the company.  The Financial Review is where business performance is quantified in dollars.  This is the section we intend to clarify.

    The Financial Review has two major parts: Discussion and Analysis, and Audited Financial Statements.  A third part might include information supplemental to the Financial Statements. In the Discussion and Analysis, management explains changes in operating results from year to year.  This explanation is presented mainly in a narrative format, with charts and graphs highlighting the comparisons.  The Operating results are numerically captured and presented in the Financial Statements.

    The principal components of the Financial Statements are the balance sheet; income statement; statement of changes in shareholders' equity; statement of cash flows; and footnotes.  The balance sheet portrays the financial strength of the company by showing what the company owns and what it owes on a certain date.  The balance sheet can be thought of as a snapshot photograph since it reports on financial position as of the end of the year.  The income statement, on the other hand, is like a motion picture since it reports on how the company performed during the year and shows whether operations have resulted in a profit or loss.  The statement of changes in shareholders' equity reconciles the activity in the equity section of the balance sheet from year to year.  Common changes in equity result from company profits or losses, dividends, or stock issuances.  The statement of cash flows reports on the movement of cash by the company for the year.  The footnotes provide more detailed information on the balance sheet and income statement.

    This booklet will focus on illustrating the basic financial statements and footnotes presented in annual reports in accordance with current practice.  It will also include examples of financial methods used by investors to better analyze financial statements.  In order to provide a framework for illustration, we will invent a company.  It will be a public company (one whose shares are freely traded on the open market).  The reason for choosing a public company is that it is required to provide the most extensive amount of information in its annual reports in accordance with guidelines issued by the Securities and Exchange Commission (SEC).  Our company will represent a typical corporation with the most commonly used accounting and reporting practices.  We'll call our company Typical Manufacturing Company, Inc.
 
A Few Words Before We Begin

    Below are four samples of a  Balance Sheet, Income Statement, Statement of Changes in Shareholders' Equity, and a Statement of Cash Flows.  These are the statements we will discuss in the first section.  To simplify matters, we did not illustrate the Discussion and Analysis nor did we present examples of the Executive Letter or Business Review.  In our sample statements, we've presented two years of financial results on the balance sheet and income statement and one year of activity on the statement of changes in shareholders' equity and statement of cash flows.  This was also done for ease of illustration.  Were we to comply with SEC requirements, we would have had to report the last three years of activity in the Income Statement, Statement of Changes in Shareholders' Equity, and Statement of Cash Flows.  Further SEC requirements that we did not illustrate include: presentation of selected quarterly financial data for the past two years, business segment information for the last three years, a listing of company directors and executive officers, and the market price of the company's common stock for each quarterly period within the two most recent fiscal years.

Typical
Manufacturing
Company Inc.


Consolidated Balance Sheet

December 31,19X9 and 19X8 (dollars in thousands)

Assets 
19X9

19X8

Current Assets
          Cash
$20,000
$15,000
          Marketable securities at cost which 
          approximates market value
 
40,000
 
32,000
          Accounts Receivable 
               Less allowance for doubtful accounts: 
               19X9: $2,375, 19X8: $3,000
 
 
156,000
 
 
145,000
          Inventories
180,000
185,000
Prepaid Expenses and other current assets
    4,000
    3,000

Total current assets 


400,000


380,000

Property, plant and equipment
 
          Land
$30,000
$30,000
          Buildings
125,000
118,500
          Machinery
200,000
171,100
          Leasehold improvements
15,000
15,000
          Furniture, fixtures, etc.
15,000
12,000

Total property, plant, and equipment 


$385,000


$346,600

Less accumulated depreciation 
$125,000
$97,000
Net property, plant and equipment 

$260,000

$249,600
Intagibles(goodwill, Patents) - less amortization
$2,000
$2,000
Total assets
$662,000
631,600

Liabilities 

 



Current liabilities
          Accounts payable
$60,000
$57,000
          Notes payable
51,000
61,000
          Accrued expenses
30,000
36,000
          Income taxes payable
17,000
15,000
          Other liabilities
12,000
12,000

Total current liabilities 

$170,000

$181,000
Long-term liabilities
          Deferred income taxes
$16,000
$9,000
          12.5% Debentures payable 2010
130,000
130,000
          Other long-term debt
0
6,000

Total libilities

$316,000

$326,000

Shareholders Equity 




Preferred staock $5.83 cumulative, 
     $100 par value authorized, issued and outstanding 
     60,000 shares
 
 
$6,000
 
 
$6,000
Common stock $5.00 par value, 
     authorized 20,000,000 shares, 
     19x9 issued 15,000,000 shares, 
     19x8 14,500,000 shares
 
 
 
75,000
 
 
 
72,500
Additional paid-in capital
20,000
13,500
Retained earnings
249,000
219,600
Foreign currency translation adjustments 
1,000
(1,000)
Less: Treasury stock at cost 
(19x9-1,000; 19x8-1,000 shares) 
 
5,000
 
5,000

Total shareholders' equity 

$346,000

$305,600
Total liabilities and shareholders' equity 
$662,000
$631,600
 
Typical
Manufacturing
Company Inc.

Consolidated Income Statement

December 31,19X9 and 19X8 (dollars in thousands)
 
19X9
19X8
Net sales
$765,000
$725,000
Cost of sales 
535,000
517,000
Gross margin
$230,000
$208,000
Operating expenses 
          Depreciation and amortization
 
28,000
 
25,000
          Selling, general and administrative expenses 
96,804
109,500
Operating income
$105,196
$73,500
Other income (expense) 
Dividends and interest income
 
5,250
 
9,500
Interest expense 
(16,250)
(16,250)
Income before income taxes and extraordinary loss 
$94,196
$66,750
Income taxes 
41,446
26,250
Income before extraordinary loss
$52,750
$40,500
Extraordinary item: Loss on early extinguishment 
          of debt (net of income tax benefit of $750) 
 
(5,000)
 
--- 
Net income 
$47,750
$40,500
Common shares outstanding
$14,999,000
$14,499,000
Earnings per common share before 
          extraordinary loss
 
$3.19
 
$2.77
Earnings per share--extraordinary loss
(.33)
---

Net income (per common share) 

$3.16

 
 
Typical
Manufacturing
Company Inc.

Consolidated Statement of Changes
In Shareholders' Equity

December 31,19X9 and 19X8 (dollars in thousands)
 
 
 
    
    
Preferred Stock  
    
    
Common Stock  
    
Additional
Paid-In Capital  
     
    
Retained 
Earnings  
Foreign
Currency Translation Adjustment  
 
 
Treasury Stock  
 
 
 
Total  
Balance, Jan. 1, 19X9
$6,000
$72,500
$13,500
$219,600
($1,000)
($5,000)
$305,600
Net income 
  

  

  

47,750
  

  

47,750
Dividends paid  on:
preferred stock
(350)
(350)
common stock 
 

 

 

(18,000)
 

 

(18,000)
Common stock issued
$2,500
$6,500
$9,000
Translation gain 
 

 

 

 

$2,000 
 

$2,000 
Balance, Dec.31, 19X9  
$6,000 
$75,000 
$20,000 
$249,000 
$1,000 
($5,000) 
$346,000 
 
Typical
Manufacturing
Company Inc.

Consolidated Statement of Cash Flows
December 31,19X9 and 19X8 (dollars in thousands

Cash flows from operating activities:
          Net income 
$47,750 
          Adjustment to reconcile net income to 
          net cash from operating activities:
          Depreciation and amortization
$28,000
          Increase in marketable securities
(8,000)
          Increase in accounts receivable 
(11,000)
          Decrease in inventory
5,000
          Increase in prepaid expenses and other current 
          assets
 
(1,000)
          Increase in deferred taxes 
7,000
          Increase in accounts payable
3,000
          Decrease in accrued expenses
(6,000)
          Increase in income taxes payable 
2,000 
Total Adjustments 
$19,000 
Net Cash Provided by Operating Activities 
$66,750 
Cash Flows from Investing Activities: 
          Purchase of fixed Assets
($38,400)
Net Cash Used in Investing Activities 
($38,400) 
Cash Flows from Financing Activities:
          Decrease in notes payable
($10,000)
          Decrease in other long-term debt
(6,000)
          Proceeds from issuance of common stock
          Payment of dividends
(18,350)
Net Cash Used in Financing Activities 
($25,350) 
Effect of Exchange Rate Changes on Cash
$2,000
Increase in Cash
$5,000
Cash at beginning of year 
15,000 
Cash at end of year 
$20,000 
Income tax payments totaled $3,000 in 19X9.
Interest payments totaled $16,250 in, 19X9.
See accompanying notes to consolidated financial statements.



The Balance Sheet 

    The balance sheet represents the financial picture as it stood on one particular day, December 31, 19X9, as though the wheels of the company were momentarily at a standstill.  Typical Manufacturing's balance sheet not only includes the most recent year, but also the previous year.  This lets you compare how the company fared in its most recent years.
 
    The balance sheet is divided into two sides: on the left are shown assets; on the right are shown liabilities and shareholders' equity.  Both sides are always in balance.  Each asset, liability, and component of shareholders' equity reported in the balance sheet represents an "account" having a dollar amount or "balance." In the assets column, we list all the goods and property owned, as well as claims against others yet to be collected.  Under liabilities we list all debts due.  Under shareholders' equity we list the amount shareholders would split up it Typical were liquidated at its balance sheet value.

    Assume that the corporation goes out of business on the date of the balance sheet.  If that occurs, the illustration which follows shows you what typical Manufacturing
shareholders might expect to receive as their portion of the business.
 
Total assets (Less: intangibles)
$660,000
Amount required to pay liabilities
   316,000
Amount remaining for the shareholders
$344,000
 
    Now, we are going to give you a guided tour of the balance sheet's accounts.  We'll. define each item, one by one, and explain how they work.


Assets  

Current Assets
 
    In general, current assets include cash and those assets which in the normal course of business will be turned into cash in the reasonably near future, i.e., generally within a year from the date of the balance sheet.

Cash
 
    This is just what you would expect-bills and coins in the till (petty cash fund) and money on deposit in the bank.
 
1 Cash $20,000
 
Marketable securities
 
    This asset represents investment of excess or idle cash that is not needed immediately.  In Typical's case it is invested in preferred stock.  Because these funds may be needed on short notice, it is essential that the securities be readily marketable and subject to a minimum of price fluctuation.  The general practice is to show marketable securities at cost or market, whichever is lower.
 
2 Marketable securities at cost which approximates mkt.value $40,000
 
Accounts receivable
 
    Here we find the amount due from customers but not yet collected.  When goods due are shipped prior to collection, a receivable is recorded.  Customers are usually given 30,60, or 90 days in which to pay.  The amount due from customers is $158,375.  However, experience shows that some customers fail to pay their bills, because of financial difficulties or some catastrophic event (a tornado, a hurricane, or a flood) befalling their business.  Therefore, in order to show the accounts receivable item at a figure representing expected receipts, the total is after a provision for doubtful accounts.  This year that debt reserve was $2,375.
 
3 
 
Accounts receivable-less allowance for doubtful accounts of $2,375   
$156,000
 
Inventories
 
    The inventory of a manufacturer is composed of three groups. raw materials to be used in the product, partially finished goods in process of manufacture, and finished goods ready for shipment to customers.  The generally accepted method of valuation of the inventory is cost or market, whichever is lower. This gives a conservative figure.  Where this method is used, the value for balance sheet purposes will be cost, or perhaps less than cost if, as a result of deterioration, obsolescence, decline in prices, or other factors, less than cost can be realized on the inventory. Inventory valuation includes an allocation of production and other expenses, as well as the cost of materials
 
4 Inventories $180,000
 
 


Consolidated Balance Sheet

December 31,19X9 and 19X8 (dollars in thousands)

Assets 
19X9

19X8

Current Assets
         Cash
$20,000
$15,000
 2         Marketable securities at cost which 
            approximates market value
 
40,000
 
32,000
 3         Accounts Receivable 
               Less allowance for doubtful accounts: 
               19X9: $2,375, 19X8: $3,000
 
 
156,000
 
 
145,000
 4         Inventories
180,000
185,000
 5  Prepaid Expenses and other current assets
    4,000
    3,000

 6   Total current assets 


400,000


380,000

Property, plant and equipment
 
          Land
$30,000
$30,000
          Buildings
125,000
118,500
          Machinery
200,000
171,100
          Leasehold improvements
15,000
15,000
          Furniture, fixtures, etc.
15,000
12,000

 7   Total property, plant, and equipment 


$385,000


$346,600

 8   Less accumulated depreciation 
$125,000 
$97,00 
 9   Net property, plant and equipment 

$260,000

$249,600 
10  Intagibles(goodwill, Patents) - less amortization
$2,000
$2,000
11  Total assets 
$662,000
$631,600
 
Prepaid expenses
 
    Prepaid expenses may arise for a situation such as this: During the year, Typical prepaid fire insurance Property, plant and equipment premiums and advertising charges for the next year. Those insurance premiums and advertising services are as yet unused at the balance sheet date, so there exists an unexpended item, which will be used up over the next 12 months. If the advance payments had not been made, the company would have more cash in the bank. So payments made in advance from which the company has not yet received benefits, but for which it will receive benefits next year, are listed among current assets as prepaid expenses.
 
5 Prepaid expenses and other current assets $4,000
 
    Deferred charges for such items as the "introduction" of a new product to the market, or for moving a plant to a new location, represent a type of asset similar to pre-paid expenses.  However, deferred charges are not included in current assets because the benefit from such expenditure will be reaped over several years to come. So the expenditure incurred will be gradually written off over the next several years, rather than fully charged off in the year payment is made. Our balance sheet shows no deferred charges because Typical has none. If it had, they would normally be included 'us' before intangibles on the asset side of the ledger.
 
    To summarize, the total current assets item includes primarily: cash,marketable securities, accounts receivable, inventories, and prepaid expenses.
 
6 Total current assets $400,000
 
    You will observe that these assets are mostly working assets in the sense that they are in a constant cycle of being converted into cash. Inventories, when sold become accounts receivable; receivables, upon collection, become cash; cash is used to pay debts and running expenses. We will discover later in the booklet how to make current assets tell a story.
 
Property, Plant, and Equipment

    Property, plant and equipment represents those assets not intended for sale that are used over and over again in order to manufacture, display, warehouse, and transport the product. This category includes land, buildings, machinery, equipment, furniture, automobiles, and trucks. The generally accepted and approved method for valuation is cost minus the depreciation accumulated by the date of the balance sheet.  Depreciation is discussed in the next section.
 
Property, plant, and equipment
          Land
$ 30,000
          Buildings
125,000
          Machinery
200,000
          Leasehold Improvements
15,000
          Furniture, fixtures, etc
     15,000
7 Total property, plant & equipment
$385,000
 
    The figure displayed is not intended to reflect market value at present or replacement cost in the future.  While it is recognized that the cost to replace plant and equipment at some future date might be higher, that possible cost is obviously variable.  For this reason, up to now, most companies have followed a general rule: acquisition cost less accumulated depreciation based on that cost.
 
Depreciation
 
    Depreciation is the practice of allocating the cost of a fixed asset over its useful life.  This has been defined for accounting purposes as the decline in useful value of a fixed asset due to wear and tear from use and passage of time.
 
    The cost incurred to acquire the property, plant and equipment must be spread over the expected useful life, taking into consideration the factors discussed above. For example: Suppose a delivery truck costs $10,000 and is expected to last five years. Using a straight-line" method of depreciation, $2,000 of the truck's cost is allocated to each year's income statement.  The balance sheet at the end of one year would show:
 
Truck (cost)
$10,000
          Less accumulated depreciation
    2,000
          Net depreciated value
$  8,000
 
    At the end of the second year it would show:
 
Truck (cost)
$10,000
          Less accumulated depreciation
    4,000
          Net depreciated value
$ 6,000
 
    In our sample balance sheet, a figure is shown for accumulated depreciation.  This amount is the total of accumulated depreciation for buildings, machinery, leasehold improvements, and furniture and fixtures. Land is not subject to depreciation, and its listed value remains unchanged from year to year.
 
Less accumulated depreciation $125,000
 
    Thus, net property, plant and equipment is the valuation for balance sheet purposes of the investment in property, plant and equipment.  As explained before, it consists of the cost of the various assets in this classification, less the depreciation accumulated to the date of the financial statement.
 
9 Net property, plant, and equipment  $260,000
 
    Depletion is a term used primarily by mining and oil companies or any of the so-called extractive industries.  Since Typical Manufacturing is not in the mining business, we do not show depletion on the balance sheet.  To deplete means to exhaust or use up.  As the oil or other natural resource is used up or sold, a depletion reserve is set up to compensate for the natural wealth the company no longer owns.

Intangibles
 
    These may be defined as assets having no physical existence, yet having substantial value to the company.  Examples?  A franchise to a cable TV company allowing exclusive service in certain areas, or a patent for exclusive manufacture of a specific article.  It should be noted, however, that only intangibles purchased from other companies are shown on the balance sheet.
 
    Another intangible asset sometimes found in corporate balance sheets is goodwill,
which represents the amount by which the price of acquired companies exceeds the related values of net assets acquired.  Company practices vary considerably in assigning value to this asset.  Accounting rules now require one firm that buys another to write off the goodwill over a period not exceeding 40 years.
 
10 
 
Intangibles (goodwill, patents)less amortization    
$2,000
 
    All of these items added together produce the figure listed on the balance sheet as
total assets.
 
11 Total assets $662,000
 
 
Liabilities 


Consolidated Balance Sheet

December 31,19X9 and 19X8 (dollars in thousands)


Liabilities 

 



Current liabilities
12         Accounts payable
$60,000
$57,000
13          Notes payable
51,000
61,000
14          Accrued expenses
30,000
36,000
15          Income taxes payable
17,000
15,000
16          Other liabilities
12,000
12,000

17   Total current liabilities 

$170,000

$181,000
Long-term liabilities
18          Deferred income taxes
$16,000
$9,000
19          12.5% Debentures payable 2010
130,000
130,000
20          Other long-term debt
0
6,000

21   Total libilities

$316,000

$326,000

Shareholders Equity 




22 Preferred staock $5.83 cumulative, 
     $100 par value authorized, issued and outstanding 
     60,000 shares
 
 
$6,000
 
 
$6,000
23 Common stock $5.00 par value, 
     authorized 20,000,000 shares, 
     19x9 issued 15,000,000 shares, 
     19x8 14,500,000 shares
 
 
 
75,000
 
 
 
72,500
24 Additional paid-in capital
20,000
13,500
25 Retained earnings
249,000
219,600
26 Foreign currency translation adjustments 
1,000
(1,000)
27 Less: Treasury stock at cost 
    (19x9-1,000; 19x8-1,000 shares) 
 
5,000
 
5,000

28 Total shareholders' equity 

$346,000

$305,600
29 Total liabilities and shareholders' Equity 
$662,000
$631,600
 
Current Liabilities

     This item generally includes all debts that fall due within 12 months.  The current assets item is a companion to current liabilities because current assets are the source from which payments are made on current debts.  The relationship between the two is one of the most revealing things to be learned from the balance sheet, and we will go into that later.  For now, we need to define the subgroups within current liabilities.

Accounts payable
 
    The accounts payable item represents amounts the company owes to its regular business creditors from whom it has bought goods or services on open account.
 
12   Accounts payable  $ 60,000
 
Notes payable
 
    If money is owed to a bank, individual, corporation, or other lender, it appears on the balance sheet under notes payable as evidence that a promissory note has been given by the borrower.
 
13 Notes payable  $ 51,000
 
Accrued expenses
 
    Now we have defined accounts payable as the amounts owed by the company to its regular business creditors. The company also owes, on any given day, salaries and wages to its employees, interest on funds borrowed from banks and from bondholders, fees to attorneys, insurance premiums, pensions, and similar items.  To the extent that the amounts owed and not recorded on the books are unpaid at the date of the balance sheet, these expenses are grouped as a total under accrued expenses.
 
14 Accrued expenses $ 30,000
 
Income tax payable
 
    The debt due to the various taxing authorities such as the Internal Revenue Service is the same as any other liability under accrued expenses. But because of the amount and the importance of the tax factor, it is generally stated separately as Income taxes payable.
 
15 Income taxes payable $17,000
 
Other Liabilities

    Simply stated, other liabilities includes all liabilities captured in the specific categories presented.
 
16 Other liabilities $12,000
 
Total current liabilities

    Finally, the total current liabilities item sums up all of the items listed under this classification.
 
17 Total current liabilities $170,000 
 



Long-term Liabilities

    In the matter of current liabilities, you will recall that we included debts due within one year from the balance sheet date. Here, under the heading of long-term liabilities are listed debts due after one year from the date of the financial report.

Deferred income taxes
 
    One of the long-term liabilities on our sample balance sheet is deferred income taxes. The government provides businesses with tax incentives to make certain kinds of investments that will benefit the economy as a whole. Current and long-term debt are summed together to produce the figure listed on the balance sheet as liabilities. For instance, a company can take accelerated depreciation deductions for investments in plant and equipment.  These rapid write-offs in the early years of investment reduce what the company would otherwise owe in current taxes, but at some point in the future the taxes must be paid.  Companies include a charge for deferred taxes in their tax calculations on the income statement and show what taxes would be without the accelerated write-offs.  That charge then accumulates as a long-term liability on the balance sheet.
 
18 Deferred income taxes  $16,000
 
Debentures
 
    The other long-term liability on our balance sheet is 12.5% debentures due in 2010. The money was received by the company as a loan from the bond-holders, who in turn were given a certificate called a bond, as evidence of the loan.  The bond is really a formal promissory note issued by the company, which in this case agreed to repay the debt at maturity in 2010 and also agreed to pay interest at the rate of 12.5% per year.  Bond interest is usually payable semi-annually. Typical's bond issue is called a debenture because the bonds are backed by the general credit of the corporation rather than by the company's assets.  Debentures are the most common type of bond issued by large, well-established corporations today.
 
    Companies can also issue first mortgage bonds, which offer bondholder an added safeguard because they are secured by a mortgage on all or some of the company's property. First mortgage bonds are considered one of the highest grade investments because they give investors an undisputed claim on company earnings and the greatest safety. If the company is unable to pay off the bonds in cash when they are due, holders of first mortgage bonds have a claim or 1ien before other creditors (such as debenture holders) on the mortgaged assets, which may be sold and the proceeds used to satisfy the debt.
 
19 12.5% Debentures payable 2010  $130,000
 
Other long-term debt
 
    Other long-term debt includes all debt other than what is specifically reported on in the balance sheet. In the case of Typical, this debt was extinguished in 1989.
 
20 Other long-term debt  0
 
Total liabilities
 
    Current and long-term debt are summer together to produce the figure listed on the balance sheet as total liabilities.
 
21 Total liabilities  $316,000
 


Shareholders' Equity


 
    This item is the total equity interest that all shareholders have in this corporation.  In other words, it is the corporation's net worth after subtracting all liabilities.  This is separated for legal and accounting reasons into the categories discussed below.

Capital Stock

    In the broadest sense this represents shares in the proprietary interest in the company.  These shares are represented by the stock certificates issued by the corporation to its shareholders.  A corporation may issue several different classes of shares, each class having slightly different attributes.

Preferred Stock
 
    These shares have some preference over other shares with respect to dividends and in distribution of assets in case of liquidation.  Specific provisions can be obtained from a corporation's charter.  In Typical, the preferred stock is a $5.83 cumulative $100 par value, which means that each share is entitled to $5.83 in dividends a year, before any dividends are paid to the common shareholders.  Cumulative means that if in any year the dividend is not paid, it accumulates in favor of the preferred shareholders and must be paid to them when available and declared before any dividends are distributed on the common stock.  Sometimes preferred shareholders have no voice in company affairs unless the company falls to pay them dividends at the promised rate.
 
22 
 
 
Preferred stock $5.83 cumulative, $100 par value, authorized issued and outstanding 60,000 shares    
  
6,000
 
Common Stock
 
    Each year before common shareholders receive any dividends, preferred holders are entitled to $5.83 per share, but no more.  Common stock has no such limit on dividends payable each year.  In good times, when earnings are high, dividends may also be high.  And when earnings drop, so may dividends.
 
23 
 
 
Common stock $5.00 par value authorized 20,000,000 shares, issued 15,000,000 shares $75,000
 
Additional Paid-in Capital

    This is the amount paid in by shareholders over the par or legal value of each share.  Typical's common stock has a par value of $5.00 per share.  In 1989, Typical sold 500,000 shares of stock for a total of $9,000.  The $9,000 was allocated on the balance sheet between capital stock and additional paid-in capital. 500,000 shares at a par value of $5.00 for a total of $2,500 was allocated to common stock.  The remaining $6,500 was allocated to additional paid-in capital.
 
23 
 
 
Common stock $5.00 par value authorized 20,000,000 shares issued 15,000,000 shares   
  
$75,000
24 Additional paid-in capital $20,000
Total of capital stock (common) and additional paid-in capital   
$95,000
 
Retained Earnings
 
    When a company first starts in business, it has no retained earnings.  Retained earnings accumulate as the company earns profits and reinvests or "retains" profits in the company.  In other words, retained earnings increase by the amount of profits earned, less dividends declared to shareholders. At the end of its first year, if profits are $80,000 and dividends of $30,000 are paid on the preferred stock but no dividends are declared on the common, the balance sheet will show retained earnings of $50,000.  In the second year, if profits are $140,000 and Typical pays $30,000 in dividends on the preferred and $40,000 on the common, the accumulated retained earnings will be $120,000:
 
Balance at the end of the first year 
$ 50,000
Net profit for second year 
   140,000
$190,000
Less: all dividends 
    70,000
Retained earnings at the end of the second year
$120,000
 
    The balance sheet for Typical shows the company has accumulated $249,000 in retained earnings.
 
25 Retained earnings $249,000
 
Foreign Currency Translation Adjustments
 
    When a company has an ownership interest in a foreign entity and the entity's results are to be captured in the company's consolidated financial statements, the financial statements of the foreign entity must be translated to U.S. dollars. Generally, the translation gain or loss should be reflected as a separate component of shareholders' equity called foreign currency translation adjustment. This adjustment should be distinguished from adjustments relating to transactions which are denominated in foreign currencies.  The gain or loss in these cases should be included in a company's net income.
 
26 Foreign currency translation adjustments $1,000 
 
Treasury stock
 
    When a company reacquires its own stock, it is reported as treasury stock and is deducted from shareholder's equity. Of the cost and par methods of accounting, the former method is more commonly applied to treasury stock.  Under the cost method the cost of reacquired stock is deducted from share holders' equity.  Any dividends on shares held in thetreasury should never be included as income.
 
27 Treasury Stock $5,000
 

    The sum total of stock (net of treasury stock), additional paid-in capital, retained earnings and foreign currency translation adjustments, represents the total shareholder's equity.
 
28 Total shareholders'  equity  $346,000
 



Just what does the balance sheet show?

    In order to analyze balance sheet figures, investors look to certain financial statement ratios for guidance.  One of their concerns is whether the business will be able to pay its debts when they come due.  They are also interested in the company's inventory turnover and the amount of assets backing corporate securities (bonds, preferred and common stock), along with the relative mix of these securities.  In the following section, we discuss various ratios used for balance sheet analysis

Net Working Capital
 
    One very important thing to be learned from the balance sheet is net working capital or net current assets, sometimes called working capital. This is the difference between total current assets and total current liabilities.  You will recall that current liabilities are debts generally due within one year from the date of the balance sheet.  The source from which to pay those debts is current assets.  Thus, working capital represents the amount that is left free and clear after all current debts are paid off.  For Typical this is:
 
6 Current assets
$400,000
17 Less: current liabilities
   170,000
Working capital
$230,000
 
    If you consider yourself a conservative investor, you should invest only in companies that maintain a comfortable amount of working capital.  A company's ability meet obligations, expand volume, and take advantage of opportunities is often determined by its working capital.  Moreover, since you want your company to grow, this year's working capital should be larger than last year's.

Current Ratio
 
    What is a comfortable amount of working capital?  Analysts use several methods to judge whether a company has a sound working capital position.  To help you interpret the current position of a company in which you are considering investing, the current ratio is more helpful than the dollar total of working capital.  The first rough test for an industrial company is to compare the current assets figure with the total current liabilities.  A current ratio of 2 to1is generally considered adequate.  This means that for each $1 of current liabilities, there should be $2 in current assets.
To find the current ratio, divide current assets by current liabilities.  In Typical's balance sheet:
 
6
   Current assets  $400,000 
Current liabilities $170,000
 = 2.35 or  2.35 to 1
 
    Thus, for each $1 of current liabilities, there is $2.35 in current assets to back it up.
 
    There are so many different kinds of companies, however, that this test requires a great deal of modification if it is to be really helpful in analyzing companies in different industries. Generally, companies that have a small inventory and easily collectible accounts receivable can operate safely with a lower current ratio than those companies having a greater proportion of their current assets in inventory and selling their products on credit.

How Quick is Quick?
 
    In addition to net working capital and current ratio, there are other ways of testing the adequacy of the current position. What are quick assets? They're the assets you have to cover a sudden emergency, assets you could take right away to the bank, if you had to.  They are those current assets that are quickly convertible into cash.  This leaves out merchandise inventories, because such inventories have yet to be sold and are not convertible into cash.  Accordingly, quick assets are current assets minus inventories and prepaid expenses.
 
6 Current assets
$400,000
4 Less: inventories 
180,000
5 Less: prepaid expenses
       4,000
Quick assets
$216,000
 
    Net quick assets are found by taking the quick assets and subtracting the total current liabilities. A well-fixed industrial company should show a reasonable excess of quick assets over current liabilities. This provides a rigorous and important test of a company's ability to meet its obligations.
 
Quick assets
$216,000
17 Less: current liabilities
  170,000
Net Quick Assets
$46,000
 
    The quick assets ratio is found by dividing quick assets by current liabilities.
 
17
$216,000 Quick assets
Current liabilities
= 1.3 or 1.3 to 1
 
    As you see, for each $1 of current liabilities, there is the same industry. $1.30 in quick assets available.

Debt to Equity

    A certain level of debt is acceptable, but too much presents a hazardous signal to investors.  The debt-to-equity ratio is an indicator of whether the company is excessively using debt for financing purposes.  For Typical, the computed as follows:
 
21 
28
        $316,000 Total liabilities 
$346,000Total Shareholders Equity 
= .91
 
    A debt-to-equity ratio of .91 means the company is using 91 cents of liabilities for every dollar of shareholders' equity in the business.  Normally, industrial companies maintain a maximum of a 1 to 1 ratio, to keep debt at a level which is less than the investment level of the owners of the business.  Utilities and financial companies can operate safely with much higher ratios.

Inventory Turnover
 
    How big an inventory should a company have? That depends on a combination of many factors. An inventory is large or small depending upon the type of business and the time of the year. An automobile dealer, for example, with a large stock of autos at the height of the season is in a strong inventory position, yet that same inventory at the end of the season is a weakness in the dealer's financial condition.
 
    One way to measure adequacy and balance of inventory is to compare it with sales for the year to get inventory turnover. Typical's sales for the year are $765,000, and inventory on the balance sheet date is $180,000. Thus turnover is 4.25 times (765+180), meaning that goods are bought and sold out more than four times per year on average. (Strict accounting requires computation of inventory turnover by comparing annual cost of goods sold with average inventory. This information is not readily available in some published statements, so many analysts look instead for sales related to inventory.)

    Inventory as a percentage of current assets is another comparison that may be made. In Typical, the inventory of $180,000 represents 45% of the total current assets, which amount to $400,000. But 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.

Book Value of Securities
 
    The balance sheet will reveal net book value (the value on the company's books) or net asset value of the company's securities.  This value represents the amount of corporate assets backing a bond or a common or preferred share.  Here's how we calculate values for Typical's securities.

Net Asset Value Per Bond

    To state this figure conservatively, intangible assets are subtracted as if they have no value on liquidation. Current liabilities of $170,000 are considered paid. This leaves $490,000 in assets to pay the bondholders. So, $3,769 in net asset value protects each $1,000 bond.
 
11 
Total assets
$662,000
10 
Less: intangibles
     2,000
Total tangible assets
$660,000
17 
Less: current liabilities
170,000
  Net tangible assets available to meet bondholders' claims
$490,000
 
$490,000 =$3,769     
     130 
bonds oustanding
Net asset value per $1,000 bond 
 
 
 
Net Asset Value Per Share of Preferred Stock

    To calculate net asset value of a preferred share, we take total assets, conservatively stated at $660,000 (eliminating $2,000 of intangible assets). Current liabilities of $170,000 and long-term liabilities are con-sidered paid. This leaves $344,000 of assets protecting the preferred. So, $5,733 in net asset value backs each share of preferred.
 
11 
Total assets
$662,000
10 
Less: intangibles
     2,000
  Total tangible assets
$660,000
17 
Less: current liabilities
$170,000
18,19, & 20 
Long-term liabilities
146,000
  Net assets backing the preferred stock
$344,000
 
$344,000,000 = $5,733 
       60,000 
Shares of preferred stock oustanding
Net asset value per share of prefered 
 

Net Book Value per Share of Common Stock

    The net book value per share of common stock can be looked upon as meaning the amount of money each share would receive if the company were liquidated, based on balance-sheet values. Of course, the preferential shareholders would have to be satisfied first. The answer, $22.54 net book value per share of common stock, is arrived at as follows:
 
11 
Total assets
$662,000
10 
Less: intangibles
     2,000
Total tangible assets
$660,000
17 
Less: current liabilities
$170,000
18,19, & 20 
Long-term liabilities
146,000
22 
Preferred stock
     6,000
$322,000
Net assets available for the common stock
$338,000
 
$338,000,000 = $22.54  
  14,999,000  
shares of common  
stock outstanding
Net asset value  per share of common stock 
 
 
 
    An alternative method of arriving at the common shareholders' equity-- conservatively stated at $338,000 - is:
 
23 
Common stock
$ 75,000
24 
Additional paid-in capital
20,000
25 
Retained earnings
249,000
26 
 
Foreign currency translation adjustments
1,000
 
27 
Treasury stock
   (5,000)
$340,000
10 
Less: intangible assets
    (2,000)
Total common shareholders' equity
$338,000
$338,000,000 = $22.54 
  14,999,000 
shares of preferred  
stock oustanding
Net book value per share of common stock 
 
 
 
    Do not be misled by book value figures, particularly of common stocks. Profitable companies often show a very low net book value and very sub- stantial earnings. Railroads, on the other hand, may show a high book value for their common stock but have such low or irregular earnings that the stock's market price is much less than its book value. Insurance companies, banks, and investment companies are exceptions. Because their assets are largely liquid (cash, accounts receivable, and marketable securities), the book value of their common stock is sometimes a fair indication of market value.

Capitalization Ratio

    The proportion of each kind of security issued by a company is the capitalization ratio. A high propor-tion of bonds sometimes reduces the attractiveness of both the preferred and common stock, and too much preferred can detract from the common's value. That's because bond interest must be paid before preferred dividends, and preferred dividends before common dividends.

    To get Typical's bond ratio divide the face value of the bonds, $130,000, by the total value of bonds, preferred and common stock, additional paid-in capital, retained earnings, foreign currency translation ad-justments and treasury stock, less intangibles, which is $474,000. This shows that bonds amount to about 27% of Typical's total capitalization.
 
                        19 
Debentures
$130,000 
22 
Preferred stock
6,000 
23 
Common stock
75,000 
24 
Additional paid-in capital
20,000 
25 
Retained earnings
249,000 
26 
Foreign currency translation adjustments
1,000 
27 
Treasury stock
(5,000) 
10 
Less: intangibles
    (2,000) 
  Total capitalization
 $474,000 
 
    The preferred stock ratio is found the same way-divide preferred stock of $6,000 by the entire capitali-zation of $474,000. The result Is about 1 %. The common stock ratio will be the difference be-tween 1 00% and the total of the bond and preferred stock ratio-or about 72%. The same result is reached by combining common stock, additional paid-in capital, retained earnings, foreign currency translation adjustments, and treasury stock.
 
Amount 
     Ratio
19 
Debentures
    $130,000 
27%
22 
Preferred stock
6,000
1%
10 
Common stock
& 23-27 
 

 

(including additional paid-in capital, related earnings, and foreign currency translation adjustments less: treasury stock and intangibles)
 
 
  338,000
 
 
  72%
Total
$474,000
100%
 


The  Income Statement
(dollars in thousands except per-share amounts)

    Now, we come to the payoff for many potential investors. the income statement. It shows how much the corporation earned or lost during the year. It appears earlier in this page (Go there now). While 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 because it shows the record of its operating activities for the whole year. It serves as a valuable guide in anticipating how the company may do in the future. The figure given for a single year is not nearly the whole story. The historical record for a series of years is more important than the figure of any single year. Typical includes two years in its statement and gives a ten-year financial summary as well, which appears further down this page (Go there now).
 
    An income statement matches the amounts received from selling goods and services and other items of income against all the costs and outlays incurred in order to operate the company. The result is a net income or a net loss for the year. The costs incurred usually consist of cost of sales; overhead expenses such as wages and salaries, rent, supplies, depreciation; interest on money borrowed; and taxes.

Net Sales

    The most important source of revenue always makes up the first item on the income statement. In Typical Manufacturing, it is net sales. It represents the primary source of money received by the company from its customers for goods sold or services rendered. The net sales item covers the amount received after taking into consideration returned goods and allowances for reduction of prices. By comparing 19X9 and 19X8, we can see if Typical had a better year in 19X9, or a worse one.
 
30 Net Sales $765,000 $725,000
 
Cost of Sales

    In a manufacturing establishment, this represents all the costs incurred in the factory in order to convert raw materials into finished products. These costs are commonly known as product costs. Product costs are those costs which can be identified with the purchase or manufacture of goods made available for sale. There are three basic components of product cost: direct materials; direct labor; and manufacturing overhead. Direct materials and direct labor costs can be directly traced to the finished product. For example, for a furniture manufacturer, lumber would be a direct material cost and carpenter wages would be a direct labor cost. Manufacturing overhead costs, while associated with the manufacturing process, cannot be traceable to the finished p roduct. Examples of manufacturing overhead costs are costs associated with operating the factory plant (plant depreciation, rent, electricity, supplies, maintenance and repairs, and production foremen salaries).
 
31 Cost of sales $535,000
 
Gross Margin

    Gross Margin is the excess of sales over cost of sales, It represents the residual profit from sales after consid-ering product costs.
 
32 Gross margin $230,000
 
Depreciation and Amortization

    Each year's decline in value of non-manufacturing facilities would be captured here. Amortization is the decline in useful value of an intangible, such as a 17-year patent.
 
33 Depreciation and amortization  $28,000 
 
Selling, General, and Administrative Expenses

    These expenses are generally grouped separately from cost of sales so that the reader of an income statement may see the extent of selling and adminis-trative.co.sts. They include salesmen's salaries and commissions, advertising and promotion, travel and entertainment, executives' salaries, office payroll and office expenses.
 
34  Selling, general and administrative expenses $96,804
 
    Subtracting all operating expenses from the net sales figure gives us the operating income.
 
35  Operating income $105,196
 
    An additional source of revenue comes from dividends and interest received by the company from its investment in stocks and bonds. This is listed separately under an item called other income (expense).
 
36 Dividends and interest income $5,250 
 



Interest Expense

    The interest paid to bondholders for the use of their money is sometimes referred to as a fixed charge because the interest must be paid year after year whether the company is making money or losing money. Interest differs from dividends on stocks, which are payable only if the board of directors declares them.

    Interest paid is another cost of doing business and is deductible from earnings in order to arrive at a base for the payment of income taxes.

    Typical Manufacturing's debentures, carried on the balance sheet as a long-term liability, bear 12.5% in-terest per year on $130,000. Thus, the interest expense in the income statement Is equal to $16,250 per year. It shows up under other income (expense).
 
37 Interest expense $16,250
 



Income Taxes

    Each corporation has a bas' tax rate, which depends 'II 31c on the level and nature of its income. Large corporations like Typical Manufacturing are subject to the top corpo-rate income tax rate, but tax credits tend to lower the overall tax rate. Typical's income before taxes is $94,196; the tax comes to $41,446.
 
38 Income before provision for income taxes
$94,196
39  Provision for income taxes
41,446
 
Income Before Extraordinary Loss

    After we have taken into consideration all ordinary income (the plus factors) and deducted all ordinary costs (the minus factors), we arrive at income before extraordinary loss for the year.
 
40 Income before extraordinary loss $52,750
 


Extraordinary Loss

    Under ordinary conditions, the above income of $52,750 would be the end of the story. However, there are years in which companies experience unusual and infrequent events called extraordinary items. Examples of extraordinary items include debt extinguishments, tax loss carry forwards, pension plan terminations, and litigation settlements. In this case, Typical extinguished a portion of its debt early. This event's isolated on a separate line, net of its tax effect. Its earnings-per-share impact is also segregated from the earnings per share attribut-able to"normal" operations.
 
41  
 
Loss on early extinguishment of debt (net of tax benefit of $750) ($5,000)
 
Net Income

Once all income and costs, including extraordinary items, are considered, we arrive at net income.
 
42 Net income $47,750
 
Condensed, the income statement looks like this:
 
Plus factors:
30 Net sales
$765,000
36 Dividends and Interest
     5,250
Total
$770,250
Minus factors:
31 Cost of sales
$535,000
33-34 Operating  expenses
124,804
37  Interest expense
16,250
39 Provision for income taxes
   41,446
Total
$717,500
40 
 
Net income before extraordinary loss
 $ 52,750
 
41  Extraordinary loss
   (5,000)
42 Net income
$ 47,750
 
Other Items

    Two other items that do not apply to Typical could appear on an income statement. First, U.S. companies that do business overseas may have transaction gains or losses related to fluctuations in foreign currency exchange rates.

    Second, if a corporation owns more than 20% but less than 51 % of the stock of a subsidiary company, the corporation must show its share of the subsidiary's earnings-minus any dividends received from the subsidiary on its income statement. For example, if the corporation's share of the subsidiary's earnings is $1,200 and the corporation received $700 in dividends from the company, the corporation must include $500 on its income statement under the category equity in the eamings of unconsolidated subsidiaries. The corporation must also increase its investment in the company to the extent of the earnings it picks up on its income statement.
 


Analyzing the Income Statement


    The income statement will tell us a lot more if we make a few detailed comparisons. Before you invest in a company, you want to know its operating margin of profit and how it has changed over the years. Typical had sales of $765,000,000 in 19X9 and showed $105,196,000 as the operating income.
 
35 
30
$105,196 operating income
$765,000 sales
= 13.8%
 
    This means that for each dollar of sales $0.1380 remained as a gross profit from operations. This figure is interesting but is more significant if we compare it with the profit margin last year.
 
35 
30
$ 73,500 operating income 
$725,000 sales
= 10.1%
 
    Typical's profit margin went from 10.1 % to 13.8%, so business didn't just grow, it became more profitable. Changes in profit margin can reflect changes in efficiency, product line, or types of customers served.

    We can also compare Typical with other companies in its field. If our company's profit margin is very low compared to others, it, is an unhealthy sign. If it is high, there are grounds for optimism.

    Analysts also frequently use operating cost ratio for the same purpose. Operating cost ratio is the complement of the margin of profit. Typical's profit margin is 13.8%. The operating cost ratio is 86.2%. -
 
Amount
Ratio
30
Net Sales
$765,000
100.0%
31,33,34
Operating Cost
  659,804
  86.2%
35
Operating Income
$105,196
13.8%
 
    Net profit ratio is still another guide to indicate how satisfactory the year's activities have been. In Typical Manufacturing, the year's net income was $47,750. The net sales for the year amounted to $765,000. Therefore, Typical's income was $47,750 on $765,000 of sales or:
 
42 
30
$47,750 net income
$765,000 sales
= 6.2%
 
This means that this year for every $1 of goods sold, 6.20 in profit ultimately went to the company. By comparing the net profit ratio from year to year for the same company and with other companies, we can best judge profit progress.

    Last year, Typical's net income was $40,500 on $725,000 in sales:
 
42 
30
$40,500 net income
$725,000 sales
= 5.6%
 
We can compare the U.S. Department of Commerce's latest available average profit margins for all U.S. manufacturers to the profit margins calculated from Typical's 10-year summary further down the pag. (Go there now).

    The margin of profit ratio, operating cost ratio, and net profit ratio, like all those we examined in connection with the balance sheet, give us general information about the company and help us 'udge its prospects for the future. All these comparisons have significance for
 
Profit Margins (After Tax)
19X3
19X4
19X5
19X6
19X7
Average of U.S. Manufacturers
4.1
4.6
3.8
3.8
4.9
Typical
6.1
5.3
5.0
5.1
5.5
the long term, because they tell us about the fundamental economic condition of the company. One question remains: are the securities a good investment for you now? For an answer, we must look at some additional factors.


Interest Coverage

    The bonds of Typical Manufacturing represent a very substantial debt, but they are due many years in the future. The yearly interest, however, is a fixed charge, and we want to know how readily the company can pay the interest. More specifically, we would like to know whether the borrowed funds have been put to good use so that the earnings are ample and thus available to meet interest costs.

    The available income representing the source for payment of the bond interest is $110,446 (operating profit plus dividends and interest). The annual bond interest amounts to $16,250. This means the annual interest expense is covered 6.8 times.
 
  37 
$110,446 available income
$16,250 interest on bonds
= 6.8% 
 
    Before an industrial bond can be considered a safe investment, most analysts say that the company should earn its bond interest requirement three to four times over. By these standards, Typical Manufacturing has a fair margin of safety.


What About Leverage?

    A stock is said to have high leverage if the company that issued it has a large proportion of bonds and preferred stock outstanding in relation to the amount of common stock. A simple illustration will show why. Let's take, for example, a company with $10,000,000 of 4% bonds outstanding. If the company is earning $440,000 before bond interest, there will only be $40,000 left for the common stock after payment of $400,000 bond interest ($10,000,000 at 4% equals $400,000). However, an increase of only 10% in earnings (to $484,000) will leave $84,000 for common stock dividends, or an increase of more than 100%. If there is only a small amount of common stock issued, the increase in earnings per share will appear very impressive.

    You have probably realized that a decline of 10% in earnings would not only wipe out everything available for the common stock, but also result in the company's being unable to cover its full interest on its bonds without dipping into accumulated earnings. This is the great danger of so-called high-leverage stocks and also illustrates the fundamental weakness of companies that have a disproportionate amount of debt or preferred stock. Conservative investors usually steer clear of them, although these stocks do appeal to people who are willing to assume the risk.

    Typical Manufacturing, on the other hand, is not a highly leveraged company. Last year, Typical paid $16,250 in bond interest and its net profit --before this payment -- came to $56,750. This left $40,500 for the common stock and retained earnings. Now look what happened this year, Net profit before subtracting bond interest rose by $7,250, or about 13%. Since the bond interest stayed the same, net income after paying this interest also rose $7,250, But that is about 18% of $40,500. While this is certainly not a spectacular example of leverage, 18% is better than 13%.


Preferred Dividend Coverage

    To calculate the preferred dividend coverage (the number of times preferred dividends were earned), we must use net profit as our base, because federal, income taxes and all interest charges must be paid before anything is available for shareholders. Because we have 60,000 shares of $100 par value preferred stock that pays a dividend of $5.83 1/3, the total dividend requirement for the preferred stock is $350,000. Dividing the net income of $47,750,000 by this figure we arrive at approximately 136.4, which means that the dividend requirement of the preferred stock has been earned more than 136 times over. This ratio is so high partly because Typical has only a small amount of preferred stock outstanding.


Earnings Per Common Share

    The buyer of common stock is often more concerned with the earnings per share of a stock than with the dividend. This is because earnings per share usually influence stock market prices. Although our income statement separates earnings per share before and after the effect of the extraordinary item, the remainder of our presentation will only consider earnings per share after the extraordinary item. In Typical's case the income statement shows earnings available for common stock.
 
  46  Earnings per share $3.16
 
But if it didn't, we could calculate it ourselves:
 
42
Net profit for the year
$47,750
Less: dividend requirements on preferred stock
     350
  Earnings available for the common stock
$47,400
$47,400,000
14,999,000
earnings available after preferred dividends 
number of outstanding common shares
= $3.16 earnings per  
   share of common
 
    Typical's capital structure is a very simple one, comprised of common and preferred stock. It's earnings-per-share computation will suffice under this scenario. However, if the capital structure is more complex and contains securities which are convertible into common stock, options, warrants or contingently issuable shares, the calculation requires modification. In fact, separate calculations must be performed. This is called dual presentation. The calculations are primary and fully diluted earnings per common share.


Primary Earnings Per Common Share

    This is determined by dividing the earnings for the year not only by the number of shares of common stock outstanding but by the common stock plus common stock equivalents if dilutive.

    Common stock equivalents are securities, such as convertible preferred stock, convertible bonds, stock options, warrants and the like, that enable the holder to become a common shareholder by exchanging or converting the security. These are deemed to be only one step short of common stock -- their value stems in large part from the value of the common to which they relate.

    Convertible preferred stock and convertible bonds offer the holder either a specified dividend rate or interest return, or the option of participating in increased earnings on the common stock, through conversion. They don't have to be actually converted to common stock for these securities to be called a common stock equivalent. This is because they are in substance equivalent to common shares, enabling the holder at his discretion to cause an increase in the number of common shares by exchanging or converting. How do accountants determine a common stock equivalent? A convertible security is considered a common stock equivalent if its effective yield at the date of its issuance is less than two-thirds of the then-current average Aa corporate bond yield.

    Now, let's put our new terms to work in an example, remembering that it has nothing to do with our own company, Typical Manufacturing. We start with the facts we have available. We'll say we have 100,000 shares of common stock outstanding plus another 100,000 shares of preferred stock, convertible into common on a share-for-share basis. (Assume they qualify as common stock equivalents.) We add the two and get 200,000 shares altogether. Now let's say our earnings figure is $500,000 for the year. With these facts, our primary computation is easy:
 
  
     $500,000 earnings for the year 
200,000 adjusted shares outstanding
= $2.50  primary   
earnings per share
 
    However, as mentioned earlier, the common stock equivalent shares are only included in the computation  if the effect of conversion on earnings per share is dilutive. Dilution occurs when earnings per share  decrease or loss per share increases. For example, assume the preferred stock paid $3 a share in dividends. Without conversion, the earnings per share would be $2, as opposed to $2.50 per share, because net income available for common after payment of dividends would be $200,000 ($500,000 less $300,000) divided by the 100,000 common shares outstanding. In this case, the common stock equivalent shares would be excluded from the computation because conversion results in a higher earnings per share (anti-dilutive). Therefore, earnings per share of $2 will be reflected on the income statement.


Fully Diluted Earnings Per Common Share

    The primary earnings per share item, as we have just seen in the preceding section, takes into consideration common stock and common stock equivalents. The purpose of fully diluted earnings per share is to reflect maximum potential dilution in earnings that would result if all contingent issuances of common stock had taken place at the beginning of the year.

    This computation is the result of dividing the earnings for the year by: common stock and common stock equivalents and all other securities that are convertible (even though they do not qualify as common stock equivalents).

    How would it work? First, remember that we have 100,000 shares of convertible preferred outstanding, as well as our 100,000 in common. Now, let's say we also have convertible bonds with a par value of $10,000,000 outstanding. These bonds pay 6% interest and have a conversion ratio of 20 shares of common for every $1,000 bond. Assume the current average Aa corporate bond yield is 8%. These bonds are not common stock equivalents, because 6% is not less than two-thirds of 8%. However, for fully diluted earnings per share we have to count them in. If the 10,000 bonds were converted, we'd have another 200,000 shares of stock, so adding everything up gives us 400,000 shares. But by converting the bonds, we could skip the 6% interest payment, which gains us another $600,000 gross earnings. So our calculation looks like this:
 
Earnings for the year
$500,000
Interest on the bonds
$600,000
Less: the income tax  
applicable to deduction
 300,000
 
  300,000
Adjusted earnings 
$800,000
         $800,000 adjusted earnings  
400,000 adjusted shares outstanding
= $2 fully diluted  
    earnings per share
 
    The only remaining step is to test for dilution. Earnings per share without bond conversion would be $2.50 ($500,000 divided by 200,000 shares). Since earnings per share of $2 is less than $2.50 we would assume debt conversion in our calculation of fully diluted earnings per share.


Price-Earnings Ratio

    Both the price and the return on common stock vary with a multitude of factors, One such factor is the relationship that exists between the earnings per share and the market price. It is called the price-eamings ratio, and this is how it is calculated: If a stock is selling at 25 and earning $2 per share, its price-earnings ratio is 12 1/2 to 1, usually shortened to 12 1/2 and the stock is said to be selling at 12 1/2 times earnings. If the stock should rise to 40, the price-earnings ratio would be 20. Or, if the stock drops to 12, the price-earnings ratio would be 6.

    In Typical Manufacturing, which has no convertible common stock equivalents, the earnings per share were calculated at $3.16. If the stock were selling at 33, the price-earnings ratio would be 10.4. This is the basic figure that you should use in viewing the record of this stock over a period of years and in comparing the common stock of this company with other similar stocks.
 
  26 
      $33 market price 
$3.16 earnings per share
= 10.4 : 1 or  
   10.4 times
 
    This means that Typical Manufacturing common stock is selling at approximately 10.4 times earnings.

    Last year, Typical earned $2.77 per share. Let's say that its stock sold at the same price-earnings ratio then. This means that a share of Typical was selling for $28.80 or so, and anyone who bought Typical then would be satisfied now. Just remember, in the real world, investors can never be certain that any stock will keep its same price-earnings ratio from year to year. The historical P/E multiple is a guide, not a guarantee.

    In general, a high P/E multiple, when compared with other companies in the same industry, means that investors have confidence in the company's ability to produce higher profits in the future.


Statement of Changes in Shareholders' Equity
(dollars in thousands except per-share amounts)

    This statement analyzes the changes from year to year in each shareholder's equity account. From this statement, we can see that during the year additional common stock was issued at a price above par. We can also see that Typical experienced a translation gain. The rest of the components of equity, with the exception of retained earnings which we discuss below, remained the same.

    Just as the income statement reflects the payoff for shareholders, retained earnings reflects the payoff for the company itself . It shows how much money the company has plowed back into itself for new growth. The Statement of Changes shows that retained earn-ings increase by net income less dividends on pre-ferred and common stock. Since we have already analyzed net income, we will now analyze dividends.


Dividends

    Dividends on common stock vary with the profitability of the company. Common shareholders were paid $18,000 in dividends this year. Since we know from the balance sheet that Typical has 14,999,000 shares outstanding, the first thing we can learn here is what may be the most important point to some potential investors - dividends per share.
 
 
$18,000,000 common stock dividends
14,999,000 shares
= $1.20 per  
   share
 
    Once we know the amount of dividends per share, we can easi ly discover the dividend payout ratio. This is Simply the percentage of net earnings per share that is paid to shareholders.
 
46
$1.20 dividend per common share
$3.16 earnings per common share
= 38%
 
    Of course, the dividends on the $5.83 preferred stock will not change from year to year, The word cumulative in the balance statement description tells us that if Typical's management someday didn't pay a dividend on its preferred stock, then the $5.83 payment for that year would accumulate. It would have to be paid to preferred shareholders before any dividends could ever be declared again on the common stock.
 
    That's why preferred stock is called preferred. It gets at any dividend money first. We've already talked about convertible bonds and convertible preferred stock. Right now, we're not interested in that aspect  because Typical Manufacturing doesn't have any convertible securities outstanding. Chances are its 60,000 shares of preferred stock, with a par value of $100 each, were issued to family members of Mr. Isaiah Typical, who founded the company back in 1923. When he took Typical public, he didn't keep any of the common stock. In those days, the guaranteed $5.83 dividend was more important to Isaiah, He was not interested in taking any more chances on Typical.
 
    During the year, Typical has added $29,400 to its retained earnings. Even if Typical has some lean years in the future, it has plenty of retained earnings from which to keep on declaring those $5.83 dividends on the preferred stock and $1.20 dividends on the com-mon stock.
 
    There is one danger in having a lot of retained earnings. It could attract another company -- Shark Fast Foods & Electronics, for instance -- to buy up Typical's common stock to gain enough control to vote out the current management. Then Shark might merge Typical into itself. Where would Shark get the money to buy Typical stock? By issuing new shares of its own stock, perhaps. And where would Shark get the money to pay the dividends on all that new stock of its own? From Typical's retained earnings. So Typical's management has the obligation to its shareholders to make sure that its retained earnings are put to work to increase the total earnings per share of the shareholders. Or else, the shareholders might cooperate with Shark if and when it makes a raid.
 
25
Retained earnings
$249,000
 
Return on Equity

    Seeing how hard money works, of course, is one of the most popular measures that investors use to come up with individual judgments on how much they think a certain stock ought to be worth. The market itself-- the sum of all buyers and sellers-- makes the real decision. But the investors often try to make their own, in order to decide whether they want to invest at the market's price or wait. Most investors look for Typical's return on equity, which shows how hard shareholders' equity in Typical is working. In order to find Typical's current return on equity, we look at the balance sheet and take the common shareholders'equity for last year--not the current year--and then we see how much Typical made this year on it. We use only the amount of net profit after the dividends have been paid on the preferred stock. For Typical Manufacturing, that means $47,750 net profit minus $350. Here is what we get:
 

                 $47,750 net income - $350 preferred stock dividend                $305,600 last year's stockholders' equity- $6,000 preferred stock value
 
 $47,000   = 15.8% 
$299,600
Return on equity 
 
 
    For every dollar of shareholders' equity, Typical made more than $0.15. Is that good? Well, $0.158 on the dollar is better than Typical could have done by going out of business, taking its shareholders' equity and putting that $299,600 in the bank. So Typical obviously is better off in its own line of work. When we consider putting our money to work in Typical's stock, we should compare Typical's $0.158 not only to whatever Typical's business competitors make, but to Typical's investment competitors for our money.For instance, the latest available average rate for all U.S. industry, according to the U.S. Federal Trade Commission, was $0.16.

    Just remember that $0.158 is what Typical itself makes on the dollar.By no means is it what you will make in dividends on Typical's stock. What that return on equity really tells you is whether Typical Manufacturing is relatively attractive as an enterprise, You can only hope that this attractiveness might be translated into demand for Typical stock, and be reflected in its price.

    Many analysts also like to see a company's annual return on the total capital available to the company. To get this figure, we use all the equity, plus all available borrowed funds. This becomes the total capital available. And for the total return on this figure we use net income before income taxes and interest charges. This gives us a bigger capital base and a larger income figure. As shareholders, however, what we're most interested in is how hard our own share of the company is working, and that's why we are more interested in return on equity.


Statement of Cash Flows

    One more statement needs to be analyzed in order to get the full picture of Typical's financial status. The Statement of Cash Flows examines the changes in cash resulting from business activities. Cash-flow analysis is necessary in order to make proper investing decisions, as well as to maintain operations. Cash flows, although related to net income, are not equivalent, This is because of the accrual concept of accounting. Generally, under accrual accounting, a transaction is recognized on the income statement when the earnings process has been completed or an expense has been incurred. This does not necessarily coincide with the time that cash is exchanged. For example, cash received from merchandise sales often lags behind the time when goods are delivered to customers. However, the sale is recorded on the income statement when the goods are shipped.
 
    Cash flows are separated by business activity. The business activity classifications presented on the statement include investing activities, financing activities, and operating activities. First, we will discuss financing and investing activities. Operating activities basically include all activities not classified as either financing or investing activities.
 
    Financing activities include those activities relating to the generation and repayment of funds prvided by creditors and investors. These activities include the issuance of debt or equity securities and the repayment of debt and distribution of dividends. Investing activities include those activities relating to asset acquisition or disposal.
 
    Operating activities involve activities relating to the production delivery of goods and services. They reflect the cash effects of transactions which are included in the determination of net income. Since 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 requires adjusting net income to reconcile it to cash flows from operating activities. Common examples of cash flows from operating activities are interest received and paid, dividends received, salary, insurance, and tax payments.


Qualifying and Certifying

Watch Those Footnotes

    The annual reports of many companies contain this statement: "The accompanying footnotes are an integral part of the finacial statements." The reason is that the finacial reports themselves are kept concise and condensed. Therefore, any explanatory matter that cannot readily be abbreviated is set out in greater detail in footnotes,
 
    Some examples of approriate footnotes are:
 



    Description of the company's policy for depreciation, amortization, consolidation, foreign currency translation, and earnings per share.
 


    Inventory valuation method. This footnote indicates whether inventories shown on the blance sheet or used in determining the cost of goods sold on the income statement are valued on a last in, first out (LIFO) basis or a first in, first out (FIFO) basis. Last in, last out means that the cost on the income statement reflect the actual cost of inventories purchased most recently. First in, first out means the income statement reflects the cost of the oldest inventories. This is an extremely important consideration because a LIFO valuation reflects current costs and does not overstate profits during inflationary times while a FIFO vlauation does.
 

    Changes in accounting policy as a result of new accounting rules.
 


    Non-reccuring items such as pension-plan terminations or sales of significant business units.
 


    Employment contracts, profit sharing, pension, and retirement plans.
 


    Details of stock options granted to officers and employees.
 


    Long-term leases. Companies which usually lease a considerable amount of selling space must show their lease liabilities on a per-year basis for the next several years and their total lease liabilities over a longer period of time.
 


    Details relating to issuance and maturities of long-temr debt.
 


    Contigent liabilities representing claims or lawsuits pending.
 


    Commitments relating to contracts in force that will affect future periods.
 


    Inflation accounting adjustments. Certain companies must show the impact if changing prices in their finacial position by adjusting items that appear on the balance sheet and the income statement for current costs and the Consumer Price Index. FASB Statement Number 89 spells out the requirements for presenting inflation adjusted fiancial data.
 


    Separate breakdowns of sales and gross profits must be shown for each line of business that accounts for more than 20% of a companies sales. Multinational corporations must also show slaes and gross income on a geographic basis by country.
 

    Most people do not like to read footnotes because that may be complicated and almost always hard to read. This is unfortunate, because footnotes are very informative. Even if they don't reveal that the corporation has been forced into bankruptcy, footnotes can still reveal many fascinating sidelights of the finacial story.

Independent Audits

    The certificate from the independant auditors, which is printed inthe report, says, first, that the auditing steps taken in the process of verification of the account meet the accounting world's approved standards of practice; and second, that the finacial statements in the report have been prepared in conformity with generally accepted accounting principles (GAAP).
 
    As a result, when the annual report contains finacial statements that have the stamp of approval from independant auditors, you have an assurance that the figures can be relied upon as having been fairly presented.
 
    However, if the independent auditors accounts' opinion contains words such as "except for," or "subject to," the reader should investigate the reason behind such qualifications. Often the answer can be found by reading the footnotes that pertain to the matter. They are usually referred to in the auditors opinion.


The Long View

    We cannot emphasize too strongly that company records, in order to be very useful, must be compared. We can compare them to other company records, to industry averages or even to broader economic factors, if we want.But most of all, we can compare one company's annual activities to the same firm's results from other years.
 
    This used to be done by keeping a file of old annual reports. Now, many corporations include a ten-year summary in their financial highlights each year. This provides the investing public with information about a decade of performance. That is why Typical Manufacturing included a ten-year summary in its annual report. It's not a part of the statements vouched for by the auditors, but it is there for you to see. A ten-year summary can show you:

    Other companies may include changes in net worth, book value per share, capital expenditures for plant and machinery, long term debt, capital stock changes by way of stock dividends and splits, number of em-ployees, number of shareholders, number of outlets, and where appropriate, information on foreign subsidiaries and the extent to which foreign operations have been embodied in the financial report.
 
    All of this is really important because of one central point: You are not only trying to find out how Typical is doing now. You want to predict how Typical will do, and how its stock will perform.

Selecting Stocks

    From the items we've studied in this booklet, Typical Manufacturing appears to be a healthy concern. Which should make Board Chairman Patience Typical, old Isaiah Typical's daughter, and her four nieces, who own most of the shares, happy. But it makes us rather sad, since Typical is fictional, and we can't offer you shares of its stock. When you decide to invest money In real stocks, please remember this:
 
    Selecting common stocks for investment requires careful study of factors other than those we can learn from financial statements. The economics of the country and the particular industry must be considered. The management of the company must be studied and its plans for the future assessed. Information about these other things is rarely in the financial report. These other facts must be gleaned from the press or the financial services or supplied by some research organizatlon. Merrill Lynch's Global Securities Research and Economics Group stands ready to help you get the available facts you need to be an intelligent Investor. Ask any Financial Consultant to put Merrill Lynch to work for you.