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GOALS OF THIS BOOKLET “Management’s Discussion and

Analysis” and “Audited Financial
An annual report is unfamiliar terrain
Statements.” It may also contain
to many people. For those who are not
supplemental financial information.
accountants, analysts or financial planners,
this booklet can help them to better under- In Management’s Discussion and Analysis
stand such reports and possibly become (MD&A), a company’s management
more informed investors. explains significant changes from year to year
in the financial statements. Although present-
This booklet was written and designed
ed mainly in narrative format, the MD&A
to help educate and guide its readers
may also include charts and graphs highlight-
so they might:
ing the year-to-year changes. The company’s
■ Better understand the data included in operating results, financial position, changes
financial reports and how to analyze it. in shareholders’ equity and cash flows are
numerically captured and presented in the
■ Learn more about companies that offer audited financial statements.
employment or provide investment
opportunities. The financial statements generally consist of
the balance sheet, income statement, state-
A good starting point for achieving these ment of changes in shareholders’ equity,
goals is to become familiar with the main statement of cash flows and footnotes. The
components of a company’s annual report. annual financial statements usually are
Please Note: Highlighted throughout this accompanied by an independent auditor’s
booklet are key selected terms and defini- report (which is why they are called “audited”
tions as a reference for readers. See also financial statements). An audit is a systematic
the Glossary of Selected Terms in the examination of a company’s financial
back of this booklet. statements; it is typically undertaken by a
Certified Public Accountant (CPA). The audi-
tor’s report attests to whether the financial
COMPONENTS OF reports are presented fairly in keeping with
AN ANNUAL REPORT generally accepted accounting principles,
Most annual reports have three sections: (1) known as GAAP for short.
The Letter to Shareholders, (2) the Business
Following is a brief description or overview
Review and (3) the Financial Review. Each
of the basic financial statements, including
section serves a unique function:
the footnotes:
■ The Letter to Shareholders gives a
broad overview of the company’s The Balance Sheet
business and financial performance. The balance sheet, also called statement of
financial position, portrays the financial
■ The Business Review summarizes position of the company by showing what
a company’s recent developments, the company owns and what it owes at the
trends and objectives. report date. The balance sheet may be
thought of as a snapshot, since it reports
■ The Financial Review presents a
the company’s financial position at a spe-
company’s business performance in
cific point in time. Usually balance sheets 1
dollar terms and consists of the
represent the current period and a previous

period so that financial statement readers A MODEL COMPANY CALLED

can easily identify significant changes. “TYPICAL”
The Income Statement To provide a framework for illustration,
a fictional company will be used. It will
On the other hand, the income statement
be a public company (generally, one
can be thought of more like a motion pic-
whose shares are formally registered with
ture, since it reports on how a company
the Securities and Exchange Commission
performed during the period(s) presented
[SEC] and actively traded). A public com-
and shows whether that company’s opera-
pany will be used because it is required
tions have resulted in a profit or loss.
to provide the most extensive amount
The Statement of Changes of information in its annual reports. The
in Shareholders’ Equity requirements and standards for financial
The statement of changes in shareholders’ reporting are set by both governmental
equity reconciles the activity in the equity and nongovernmental bodies. (The SEC
section of the balance sheet from period to is the major governmental body with
period. Generally, changes in shareholders’ responsibility in this arena. The main
equity result from company profits or nongovernmental bodies that set rules
losses, dividends and/or stock issuances. and standards are the Financial
(Dividends are payments to shareholders Accounting Standards Board [FASB]*,
to compensate them for their investment.) the American Institute of Certified Public
Accountants [AICPA] and the exchanges
The Statement of Cash Flows the securities trade on.
The statement of cash flows reports on This fictional company will represent
the company’s cash movements during a typical corporation with the most com-
the period(s) separating them by operating, monly used accounting and reporting
investing and financing activities. practices. Thus, the model company will
be called Typical Manufacturing Company,
The Footnotes
Inc. (or “Typical,” for short).
The footnotes provide more detailed infor-
mation about the financial statements.
* The FASB is the primary, authoritative private-
This booklet will focus on the basic sector body that sets financial accounting standards.
From time to time, these standards change and
financial statements, described above,
new ones are issued. At this writing, the FASB
and the related footnotes. It will also is considering substantial changes to the current
include some examples of methods that accounting rules in the areas of consolidations,
investors can use to analyze the basic segment reporting, derivatives and hedging, and
financial statements in greater detail. liabilities and equity. Information regarding current,
Additionally, to illustrate how these con- revised or new rules can be obtained by writing or
calling the Financial Accounting Standards Board,
cepts apply to a hypothetical, but realistic
401 Merritt 7, P.O. Box 5116, Norwalk, CT
business, this booklet will present and 06858-5116, telephone (203) 847-0700.
analyze the financial statements of a
model company.


The following pages show a sample of For example, the sample statements pre-
the core or basic financial statements— sent Typical’s balance sheet at two year-
a balance sheet, an income statement, ends; income statements for two years;
a statement of changes in shareholders’ and a statement of changes in sharehold-
equity and a statement of cash flows for ers’ equity and statement of cash flows for
Typical Manufacturing Company. a one-year period. To strictly comply with
SEC requirements, the report would have
However, before beginning to examine included income statements, statements
these financial statements in depth, the of changes in shareholders’ equity and
following points should be kept in mind: statements of cash flows for three years.
■ Typical’s financial statements are illus- Also, the statements shown here do not
trative and generally representative for include certain additional information
a manufacturing company. However, required by the SEC. For instance, it does
financial statements in certain special- not include: (1) selected quarterly finan-
ized industries, such as banks, broker- cial information (including recent market
dealers, insurance companies and pub- prices of the company’s common stock),
lic utilities, would look somewhat dif- and (2) a listing of company directors and
ferent. That’s because specialized executive officers.
accounting and reporting principles Further, the “MD&A” will not be presented
and practices apply in these and other nor will examples of the “Letter to
specialized industries. Shareholders” and the “Business Review”
■ Rather than presenting a complete set be provided because these are not “core”
of footnotes specific to Typical, this elements of an annual report. Rather,
booklet presents a listing of appropriate they are generally intended to be explana-
generic footnote data for which a reader tory, illustrative or supplemental in nature.
of financial statements should look. To elaborate on these supplemental com-
ponents could detract from this booklet’s
■ This booklet is designed as a broad, primary focus and goal: Providing readers
general overview of financial reporting, with a better understanding of the
not an authoritative, technical reference core or basic financial statements in an
document. Accordingly, specific techni- annual report.
cal accounting and financial reporting
questions regarding a person’s personal
or professional activities should be
referred to their CPA, accountant or
qualified attorney.

■ To simplify matters, the statements

shown in this booklet do not illustrate
every SEC financial reporting rule and



(Dollars in Thousands, Except Per-Share Amounts)

December 31

19X9 19X8
Current Assets:
Cash and cash equivalents $19,500 $15,000
Marketable securities 46,300 32,000
Accounts receivable—net of allowance
for doubtful accounts of $2,375 in
19X9 and $3,000 in 19X8 156,000 145,000
Inventories, at the lower of cost or market 180,000 185,000
Prepaid expenses and other current assets 4,000 3,000
Total Current Assets 405,800 380,000

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

Other Assets:
Intangibles (goodwill, patents)—
net of accumulated amortization
of $300 in 19X9 and $250 in 19X8 1,950 2,000
Investment securities, at cost 300 —

Total Other Assets 2,250 2,000

Total Assets $668,050 $631,600

See Accompanying Notes to Consolidated Financial Statements.*

4 * See pages 40-41 for examples of the types of data that might appear in the notes to a company’s financial statements.


December 31
19X9) 19X8)
Liabilities and Shareholders’ Equity
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)
Current portion of long-term debt 6,000) —)
Total Current Liabilities 176,000) 181,000)
Long-term Liabilities:)
Deferred income taxes 16,000) 9,000)
9.12% debentures payable 2010 130,000) 130,000)
Other long-term debt —) 6,000)
Total Liabilities 322,000) 326,000)
Shareholders’ Equity:
Preferred stock, $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;
issued and outstanding:
19X9 - 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 (net of taxes) 1,000) (1,000)
Unrealized gain on available-for-sale securities
(net of taxes) 50) —)
Less: Treasury stock at cost
(19X9 and 19X8 - 1,000 shares) (5,000) (5,000)

Total Shareholders’ Equity 346,050) 305,600)

Total Liabilities and Shareholders’ Equity $668,050) $631,600)



(Dollars in Thousands, Except Per-Share Amounts) Years Ended December 31,
19X9 19X8
Net sales $765,050) $725,000)
Cost of sales 535,000) 517,000)
Gross margin 230,050) 208,000)
Operating expenses:
Depreciation and amortization 28,050) 25,000)
Selling, general and administrative expenses 96,804) 109,500)
Operating income 105,196) 73,500)
Other income (expense):
Dividend and interest income 5,250) 10,000)
Interest expense (16,250) (16,750)
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 earthquake destruction
(net of income tax benefit of $750) (5,000) —)
Net income $47,750) $40,500)
Earnings per common share:
Before extraordinary loss $3.55) $2.77)
Extraordinary loss (.34) —)
Net income per common share $3.21) $2.77)
See Accompanying Notes to Consolidated Financial Statements


(Dollars in Thousands) Year Ended December 31, 19X9
Additional currency Unrealized
Preferred Common paid-in Retained translation security Treasury
stock stock capital earnings adjustments gain 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)
Foreign currency
translation gain 2,000) 2,000)
Net unrealized gain on
securities $50 $50)
Balance Dec. 31, 19X9 $6,000 $75,000 $20,000 $249,000) $1,000) $50 ($5,000) $346,050)
6 See Accompanying Notes to Consolidated Financial Statements


(Dollars in Thousands) Year Ended December 31, 19X9

Cash flows from operating activities:

Net income $47,750)
Adjustments to reconcile net income to
net cash from operating activities:
Depreciation and amortization 28,050)
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 27,050)

Net cash provided by operating activities 74,800)

Cash flows from investing activities:

Securities purchases:
Trading (14,100)
Held-to-maturity (350)
Available-for-sale (150)
Principal payment received on held-to-maturity securities 50
Purchase of fixed assets (38,400)

Net cash used in investing activities (52,950)

Cash flows from financing activities:

Payment of notes payable (10,000)
Proceeds from issuance of common stock 9,000)
Payment of dividends (18,350)
Net cash used in financing activities (19,350)
Effect of exchange rate changes on cash 2,000
Increase in cash 4,500
Cash and cash equivalents at beginning of year 15,000
Cash and cash equivalents at the end of year $19,500
Income tax payments totaled $3,000 in 19X9.
Interest payments totaled $16,250 in 19X9.

See Accompanying Notes to Consolidated Financial Statements 7


The balance sheet represents the financial ■ The Assets section includes all the
picture for Typical Manufacturing as it goods and property owned by the
stood at the end of one particular day, company, and uncollected amounts
Dec. 31, 19X9, as though the company due (“receivables”) to the company
were momentarily at a standstill. Typical’s from others.
balance sheet for the previous year end is
also presented. This makes it possible to ■ The Liabilities section includes all
compare the composition of the balance debts and amounts owed (“payables”)
sheets on those dates. to outside parties and lenders.

The balance sheet is divided into ■ The Shareholders’ Equity section repre-
two halves: sents the shareholders’ ownership inter-
est in the company—what the compa-
1. Assets, always presented first (either ny’s assets would be worth after all
on the top or left side of the page); claims upon those assets were paid.

2. Liabilities and Shareholders’ Equity Now, to make it easier to understand the

(always presented below or to the composition of the balance sheet, each
right of Assets). of its sections and the related line items
within them will be examined one-by-one
In the standard accounting model, the starting on page 9. To facilitate this walk-
formula of Assets = Liabilities + Share- through, the balance sheet has been sum-
holders’ Equity applies. As such, both marized, this time numbering each of its
halves are always in balance. They are line items or accounts. In the discussion
also in balance because, from an econom- that follows, each line item and how it
ic viewpoint, each dollar of assets must be works will be explained. After examining
“funded” by a dollar of liabilities or equity. the balance sheet, the income statement
(Note: this is why this statement is called a will be analyzed using the same method-
balance sheet.) ology. Then, the other financial statements
Reported assets, liabilities, and sharehold- will be broken down element-by-element
ers’ equity are subdivided into line items for similar analysis.
or groups of similar “accounts” having
a dollar amount or “balance.”


Before beginning, however, it’s important to clarify how the numbers, calculations and
numerical examples are presented in this booklet. All dollar amounts relating to the financial
statements are presented in thousands of dollars with the following exceptions:
(1) Per-share or share amounts are actual amounts; (2) actual amounts are used for accuracy
of calculation in certain per-share computations; and (3) actual amounts are used in certain
examples to illustrate a point about items not related to, nor shown in, the model financial
statements. The parenthetical statement “(Actual Amounts Used )” will further identify
amounts or computations where figures do not represent thousands of dollars.

CURRENT ASSETS Marketable Securities
In general, current assets include cash and those Excess or idle cash that is not needed immediately
assets that, in the normal course of business, will may be invested in marketable securities. These are
be turned into cash within a year from the balance- short-term securities that are readily salable and
sheet date. Current assets are listed on the balance usually have quoted prices. These may include:
sheet in order of their “liquidity” or amount of time it
takes to convert them into cash. ■ Trading securities — debt and equity securities,
bought and sold frequently, primarily to generate
Cash and Cash Equivalents short-term profits and which are carried at fair mar-
This, just as expected, is money on deposit in the ket value. Any changes in such values are included
bank, cash on hand (petty cash) and highly liquid in earnings. (Fair market value is the price at which
securities such as Treasury bills. a buyer and seller are willing to exchange an asset
in other than a forced liquidation.)
1 Cash and cash equivalents $19,500


(Dollars in Thousands, Except Per-Share Amounts)
December 31
19X9 19X8
Current Assets:
1 Cash and cash equivalents $19,500 $15,000
2 Marketable securities 46,300 32,000
3 Accounts receivable—net of 156,000 145,000
allowance for doubtful accounts
4 Inventories 180,000 185,000
5 Prepaid expenses and other current assets 4,000 3,000
6 Total Current Assets 405,800 380,000
7 Total Property, plant and equipment 385,000 346,600
8 Less: accumulated depreciation 125,000 97,000
9 Net Property, Plant and Equipment 260,000 249,600
Other Assets:
10 Intangibles (goodwill, patents)— 1,950 2,000
net of accumulated amortization
11 Investment securities, at cost 300 —
Total Other Assets 2,250 2,000

12 Total Assets $668,050 $631,600


■ Held-to-maturity securities — debt secu- Accounts Receivable

rities that the company has the ability Here are found the amounts due from
and intent to hold to maturity. “Maturity” customers that haven’t been collected as yet.
is the date when debt instruments, such When goods are shipped to customers before
as Treasury bills, are due and payable. payment or collection, an account receivable
These securities are reported at amor- is recorded. Customers are usually given 30,
tized cost (original cost adjusted for 60 or 90 days in which to pay. The total
changes in any purchase discount or amount due from customers is $158,375.
premium less any principal payments
However, experience shows that some
received). (Debt amortization is the
customers fail to pay their bills (for example,
practice of adjusting the original cost
because of financial difficulties), giving rise
of a debt instrument as principal pay-
to accounts of doubtful collectibility. This
ments are received and writing off any
simply means it is unlikely that the entire
purchase discount or premium to
balance recorded as due and receivable will
income over the life of the instrument.)
be collected. Therefore, in order to show the
■ Available-for-sale securities — debt or accounts receivable balance at a figure rep-
equity securities not classified as either resenting expected receipts, an allowance
trading or held-to-maturity. They are for doubtful accounts is deducted from the
recorded at fair value with unrealized total amount recorded. This year end, the
changes in their value, net of taxes, allowance for doubtful accounts was $2,375.
reported in stockholders’ equity.
(Net of taxes means that the value or 3 Accounts receivable— $158,375)
amount has been adjusted for the Less: allowance for
effects of applicable taxes.) doubtful accounts (2,375)
In Typical’s case, it owns short-term,
high-grade commercial paper, classified
as “trading securities” and preferred stock, Inventory
classified as “available-for-sale.” Typical, Inventory for a manufacturing company
however, has no short-term “held-to-matu- consists of: (1) Raw materials—items to
rity” securities (although it does have be used in making a product (for exam-
an investment in publicly traded ple, the silk fabric used in making a silk
mortgage bonds, a long-term “held-to- blouse); (2) work-in-process—partially
maturity” debt security, which will be completed goods in the process of manu-
discussed a bit later). facture (for example, pieces of fabric such
as a sleeve and cuff sewn together during
2 Marketable securities: the process of making a silk blouse) and
(3) finished goods—completed items ready
Trading securities $46,100
for shipment to customers. Generally, the
Available-for-sale 200 amount of each of the above types of inven-
$46,300 tory would be disclosed either on the face


of the balance sheet or in the footnotes. For 4 Inventories $180,000

Typical, inventory represents the cost of
items on hand that were purchased Prepaid Expenses
and/or manufactured for sale to customers. During the year, Typical paid fire insur-
In valuing inventories, the lower of cost ance premiums and advertising charges for
periods after the balance-sheet date. Since
or market rule or method is used. This
Typical has the contractual right to that
generally accepted rule or method values
insurance and advertising service after the
inventory at its cost or market price,
balance-sheet date, it has an asset, which
whichever is lower. (Here market value,
will be used after year end. Typical has
or market price is the current cost of simply “prepaid”—paid in advance—for
replacing the inventory by purchase or the right to use this service. Of course,
manufacture, as the case may be, with if these payments had not been made,
certain exceptions.) This provides a the company would have more cash in
conservative figure. The value for balance- the bank. Accordingly, payments made for
sheet purposes under this method which the company had not yet received
usually will be cost. However, where benefits, but for which it will receive ben-
deterioration, obsolescence, a decline efits within the year, are listed among cur-
in prices or other factors are expected rent assets as prepaid expenses.
to result in the selling or disposing of
inventories below cost, the lower market 5 Prepaid expenses
price would be used. and other current assets $4,000

Usually, a manufacturer’s inventories

consist of quantities of physical products TOTAL CURRENT ASSETS
assembled from various materials.
To summarize, the “Total Current Assets”
Inventory valuation includes the direct
item includes primarily cash, marketable
costs of purchasing the various materials
securities, accounts receivable, inventories
used to produce the company’s and prepaid expenses.
products and an allocation (that is, an
apportionment or dividing up) of the 6 Total Current Assets $405,800
production expenses to make those
products. Manufacturers use cost
These assets are “working” assets in the
accounting systems to allocate such
sense that they are “liquid”—meaning they
expenses. (“Cost accounting” focuses on can and will, in the near term, be convert-
specific products and is a specialized set ed into cash for other business purposes or
of accounting procedures that are used to consumed in the business. Inventories,
determine individual product costs.) when sold, become accounts receivable;
When the individual costs for inventory receivables, upon collection, become cash;
are added up, they comprise the inventory and the cash can then be used to pay the
valuation. company’s debts and operating expenses.


Property, Plant and Equipment jected period of time over which an

asset is expected to have productive or
Property, plant and equipment (often
continuing value to its owner.)
referred to as fixed assets) consists of
Depreciation has been defined for
assets not intended for sale that are used
to manufacture, display, warehouse and accounting purposes as the decline in
transport the company’s products and useful value of a fixed asset due to
house its employees. This category “wear and tear” from use and the
includes land, buildings, machinery, passage of time.
equipment, furniture, automobiles and
trucks. The generally accepted method The cost of acquired property, plant and
for reporting fixed assets is cost minus equipment must be allocated over its
the depreciation accumulated through the expected useful life, taking into
date of the balance sheet. Depreciation consideration the factors discussed
will be defined and explained further above. For example, suppose a delivery
in discussing the next topic. truck costs $10,000 and is expected to
last five years. Using the “straight-line
Property, Plant and Equipment: method of depreciation” (equal periodic
Land $30,000 depreciation charges over the life of the
Buildings 125,000 asset), $2,000 of the truck’s cost is
Machinery 200,000 charged or expensed to each year’s
Leasehold improvements 15,000 income statement. The balance sheet at
Furniture, fixtures, etc. 15,000 the end of one year would show:
7 Total property, plant
(Actual Amounts Used)
and equipment $385,000
Truck (cost) $10,000)

The figure displayed is not intended Less:

to reflect present market value or accumulated depreciation (2,000)
replacement cost, since generally there Net depreciated cost $ 8,000)
is no intent to sell or replace these
assets in the near term. The cost to
ultimately replace plant and equipment At the end of the second year it would
at some future date might, and probably show:
will, be higher.
(Actual Amounts Used)
Depreciation Truck (cost) $10,000)
This is the practice of charging to, or Less:
expensing against income, the cost of
a fixed asset over its estimated useful accumulated depreciation (4,000)
life. (Estimated useful life is the pro- Net depreciated cost $ 6,000)


In Typical’s balance sheet, an amount Deferred Charges

is shown for accumulated depreciation. Deferred charges are expenditures for
This amount is the total of accumulated items that will benefit future periods
depreciation for buildings, machinery, beyond one year from the balance-sheet
leasehold improvements and furniture date; for example, costs for introduction
and fixtures. Land is not subject to of a new product to the market or the
opening of a new location. Deferred
depreciation, and, generally, its reported
charges are similar to prepaid expenses,
balance remains unchanged from year
but are not included in current assets
to year at the amount for which it was because the benefit from such expendi-
acquired. tures will be reaped over periods after
one year from the balance-sheet date.
8 Less: accumulated (To “defer” means to put off or postpone
to a future time.) The expenditure incurred
depreciation $125,000
will be gradually written off over the future
period(s) that benefit from it, rather than
Thus, net property, plant and equipment is fully charged off in the year payment is
the amount reported for balance-sheet pur- made. Typical’s balance sheet shows no
poses of the investment in property, plant deferred charges because it has none.
and equipment. As explained previously, Deferred charges would normally be
it consists of the cost of the various assets included just before Intangibles in the
Assets section of the balance sheet.
in this classification, less the depreciation
accumulated to the date of the financial Intangibles
statement (net depreciated cost). Intangible assets (or “intangibles”) are
assets having no physical existence, yet
9 Net Property, Plant having substantial value to the company.
and Equipment $260,000 Examples are a franchise to a cable TV
company allowing exclusive service in
certain areas, a patent for exclusive manu-
Depletion is a term used primarily by min-
facture of a specific article, a trademark or
ing and oil companies or any of the so-
a copyright.
called extractive industries. Since Typical
Manufacturing is not in any of these busi- Another intangible asset often found
nesses, depletion is not shown in its finan- in corporate balance sheets is goodwill,
cial statements. To “deplete” means to which represents the amount by which
the price of an acquired company exceeds
exhaust or use up. As oil or other natural
the fair value of the related net assets
resources are used up or sold, depletion is
acquired. This excess is presumed to be
recorded (as a charge against income and the value of the company’s name, reputa-
a reduction from its cost) to recognize the tion, customer base, intellectual capital and
amount of natural resources sold, workforce (their know-how, experience,
consumed or used to date. managerial skills and so forth.)


Intangible assets reported on the balance 11 Investment securities, at cost

sheet are generally those purchased from 8% mortgage bonds due
others. Intangible assets are amortized
19Y4, original cost $350)
(gradually reduced or written off, a process
referred to as amortization) by periodic Less: principal prepayment
charges against income over their estimat- in 19X9 (50)
ed useful lives, but in no case for longer Investment securities
than 40 years. The value of Typical’s intan- at amortized cost $300)
gible assets, reduced by the total amount
of these periodic charges against income
However, this investment must also be
(accumulated amortization), results in a
reviewed to ensure that it is probable that
figure for Typical’s net intangible assets.
all contractually specified amounts are
fully collectible. If not fully collectible, this
10 Intangibles
investment would be considered perma-
(goodwill, patents)— $ 2,250)
nently impaired. If such permanent
Less: accumulated
impairment were found to exist, it would
amortization (300)
be necessary to write this investment down
Net intangible assets $1,950) to its fair value. In this case, however, the
issuer is in a strong financial condition.
Investment Securities This is evidenced in two ways. First, the
Investments in debt securities are carried issuer made an unscheduled prepayment
at amortized cost only when they qualify of principal. Second, the property values
as “held-to-maturity.” To so qualify, the have increased significantly where this
investor must have the positive intent and well-maintained plant that secures these
the ability to hold those securities until bonds is located. As such, there is no
they mature. Early in 19X9, Typical pur- reason to suspect that all contractual
chased on the New York Stock Exchange amounts will not be collected. Thus,
mortgage bonds issued by one of its major there is no impairment, and no write
suppliers. These bonds are due in full in down is necessary.
five years and bear interest at 8% per year.
In 19X9, the issuer made an unscheduled
principal prepayment of $50. Since Typical
intends to maintain a continuing relation- All of these assets (line items 1 to 11),
ship with this supplier and to hold the added together, make up the figure for
bonds until they mature—and appears the line item “Total Assets“ in Typical’s
to have the financial strength to do so— balance sheet.
this investment is classified as “held-
to-maturity.” 12 Total Assets $668,050



A current liability, in general, is an As discussed, accounts payable are
obligation that is due and payable within amounts owed by the company to its
12 months. The “current liabilities” item regular business creditors for routine
in the balance sheet is a companion to purchases. The company also owes, on
“current assets” because current assets are any given day, salaries and wages to its
the source for payment of current debts. employees, interest on funds borrowed
The relationship between the two is from banks and bondholders, fees to
revealing. This relationship will be attorneys and similar items. The total
explored more closely a bit later. For amount of such items owed, but unpaid at
now, however, the discussion will focus the date of the balance sheet, are grouped
on the definition of the components of as a total under accrued expenses.
current liabilities.
15 Accrued expenses $30,000
Accounts Payable
Accounts payable is the amount the com-
Income Taxes Payable
pany owes to its regular business creditors
Income taxes payable are the amounts
from whom it has bought goods or ser-
due to taxing authorities (such as the
vices on open account.
Internal Revenue Service and various state,
foreign and local taxing agencies) within
13 Accounts payable $60,000
one year from the balance-sheet date. For
financial-reporting purposes, they are
Notes Payable treated the same as an accrued expense.
If money is owed to a bank, individual, However, companies that owe a material
corporation or other lender under a amount of taxes, as Typical does here,
promissory note, and it is due within one often report income taxes payable as a
year of the balance sheet date, it appears separate line item under the Current
under notes payable. It is evidence that Liabilities caption in the balance sheet.
the borrower named in the note is respon-
sible for carrying out its terms, such as 16 Income taxes payable $17,000
repaying the loan principal plus any inter-
est charges. Notes may also be due after
one year from the balance-sheet date
when they would be included in long-
term debt.

14 Notes payable $51,000



(Dollars in Thousands, Except Per-Share Amounts)

December 31
19X9 19X8
Liabilities and Shareholders’ Equity
Current Liabilities:
13 Accounts payable $60,000 $57,000
14 Notes payable 51,000 61,000
15 Accrued expenses 30,000 36,000
16 Income taxes payable 17,000 15,000
17 Other liabilities 12,000 12,000
18 Current portion of long-term debt 6,000 —
19 Total Current Liabilities 176,000 181,000
Long-term Liabilities:
20 Deferred income taxes 16,000 9,000
21 9.12% debentures payable 2010 130,000 130,000
22 Other long-term debt — 6,000
23 Total Liabilities 322,000 326,000
Shareholders’ Equity:
24 Preferred stock, $5.83 cumulative,
$100 par value; authorized, issued
and outstanding: 60,000 shares 6,000 6,000
25 Common stock, $ 5.00 par value,
authorized: 20,000,000 shares;
issued and outstanding:
19X9 – 15,000,000 shares,
19X8 – 14,500,000 shares 75,000 72,500
26 Additional paid-in capital 20,000 13,500
27 Retained earnings 249,000 219,600
28 Foreign currency translation adjustments (net of tax) 1,000 (1,000)
29 Unrealized gain on available-for-sale securities
(net of taxes) 50 —
30 Less: Treasury stock at cost
(19X9 and 19X8 – 1,000 shares) (5,000) (5,000)

31 Total Shareholders’ Equity 346,050 305,600

32 Total Liabilities and Shareholders’ Equity $668,050 $631,600


Other Current Liabilities benefit obligations. (Typical’s balance

Simply stated, these are any other liabili- sheet does not show this obligation.)
ties that are payable within 12 months, but
which haven’t been captured in any of the
Deferred Income Taxes
other specific categories presented as cur- One of the long-term liabilities on the sample
rent liabilities in the balance sheet. balance sheet is deferred income taxes.
Deferred income taxes are tax liabilities a
company may postpone paying until some
17 Other liabilities $12,000
future time, often to encourage activities for
the public’s good. The opposite of deferred
Current Portion of Long-Term Debt income tax liabilities are deferred income tax
Current portion of long-term debt repre- assets. They are future income tax credits rec-
sents the amount due and payable within ognized in advance of actually receiving
12 months of the balance-sheet date under them. Typical has not recorded any future
all long-term (longer than one year) bor- income tax credit assets.
rowing arrangements. In Typical’s case,
this is the scheduled repayment of a The government provides businesses with tax
$6,000 five-year note taken out by Typical incentives to make certain kinds of investments
four years ago and due next year. If Typical that will benefit the economy as a whole. For
had a long-term borrowing calling for instance, for tax-reporting purposes, a compa-
monthly payments (on a mortgage, for ny can take accelerated depreciation deduc-
example), the sum of the principal pay- tions on its tax returns for investments in plant
ments due in the 12 months following the and equipment while using less rapid, more
balance-sheet date would appear here. conventional depreciation for financial-
reporting purposes. These rapid write-offs for
tax purposes in the early years of investment
18 Current portion
reduce the amount of tax the company would
of long-term debt $6,000 otherwise owe currently (within 12 months)
and defer payment into the future (beyond 12
months). However, at some point, the taxes
TOTAL CURRENT LIABILITIES must be paid. To recognize this future liability,
companies include a charge for deferred
19 Total Current Liabilities $176,000
taxes in their provision for tax expense in
the income statement and show what the tax
Finally, the “Total Current Liabilities” item provision would be without the accelerated
sums up all of the items listed under this write-offs. The liability for that charge is
classification. reported as a long-term liability since it relates
to property, plant and equipment (a noncur-
LONG-TERM LIABILITIES rent or long-term asset). [The classification of
deferred tax amounts follows the classification
Current liabilities include amounts due
of the item that gives rise to it.]
“within one year” from the balance-sheet
date. Long-term liabilities are amounts
due “after one year” from the date of the 20 Deferred income taxes $16,000
financial report, such as unfunded retiree

Debentures Other Long-Term Debt

The other long-term liability with a bal- Other long-term debt includes all debt
ance on Typical’s 19X9 balance sheet is due after one year from the balance-sheet
the 9.12% debentures due in 2010. The date other than what is specifically report-
money was received by the company as a ed elsewhere in the balance sheet. In
loan from the bondholders, who in turn Typical’s case, this debt is a $6,000,
were given certificates called bonds, as single-payment loan made four years ago,
evidence of the loan. The bonds are really which is scheduled for payment in full
formal promissory notes issued by the next year. This loan was reported as long-
company, which it agreed to repay at term debt at the end of 19X8 and, since
maturity in 2010 and on which it agreed it is payable in full next year, and it no
to pay interest at the rate of 9.12% per longer qualifies as a long-term liability, is
year. Bond interest is usually payable reported as current portion of long-term
semiannually. Typical’s bond issue is debt at the end of 19X9.
called a debenture because the bonds
are backed only by the general credit of 22 Other long-term debt —
the corporation rather than by specific
company assets.
Companies can also issue secured debt
(for example, mortgage bonds), which Current and long-term liabilities are
offers bondholders an added safeguard summed together to produce the figure
because they are secured by a mortgage reported on the balance sheet as “Total
on all or some of the company’s property. Liabilities.”
If the company is unable to pay the bonds
when they are due, holders of mortgage 23 Total Liabilities $322,000
bonds have a claim or lien before other
creditors (such as debenture holders) on
the mortgaged assets. In other words, SHAREHOLDERS’ EQUITY
these assets may be sold and the proceeds This item is the total equity interest that
used to satisfy the debt owed the mortgage all shareholders have in this corporation.
bondholders. In other words, it is the corporation’s net
worth or its assets after subtracting all
21 9.12% debentures of its liabilities. This is separated for legal
payable 2010 $130,000 and accounting reasons into the categories
discussed on the following pages.


Capital Stock Common Stock

Capital stock represents shares in the own- Although preferred shareholders are enti-
ership of the company. These shares are tled to dividends before common share-
represented by the stock certificates issued holders, their entitlement is generally lim-
by the corporation to its shareholders. ited (in Typical’s case to $5.83 per share,
A corporation may issue several different annually). Common stock has no such
classes of shares, each class having slightly limit on dividends payable each year. In
different attributes. good times, when earnings are high, divi-
dends may also be high. And when earn-
Preferred Stock ings drop, so may dividends. Typical’s
Preferred stock is an equity ownership common stock has a par value of $5.00
interest that has preference over common per share. In 19X9, Typical sold 500,000
shares with regard to dividends and the shares of stock for a total of $9,000. Of
distribution of assets in case of liquidation. the $9,000, $2,500 is reported as common
Details about the preferences applicable stock (500,000 shares at a par value of
to this type of stock can be obtained from $5.00). The balance, $6,500, is reported
provisions in a corporation’s charter. as additional paid-in capital, as discussed
under the next heading. When added to
In Typical’s case, the preferred stock is
the prior year-end’s common stock bal-
a $5.83 cumulative $100 par value.
ance of $72,500, the $2,500 brings the
(Par value is the nominal or face value
common stock balance to $75,000.
of a security assigned to it by its issuer.)
The $5.83 is the yearly per-share dividend
25 Common stock, $5.00 par value,
to which each preferred shareholder is
entitled before any dividends are paid to authorized: 20,000,000 shares;
the common shareholders. “Cumulative” issued and outstanding:
means that if in any year the preferred 15,000,000 shares $75,000
dividend is not paid, it accumulates (con-
tinues to grow) in favor of preferred share-
holders. The total unpaid dividends must Additional Paid-In Capital
be declared and paid to these sharehold- Additional paid-in capital is the amount
ers when available and before any divi- paid by shareholders in excess of the par
dends are distributed on the common or stated value of each share. In 19X9,
stock. Generally, preferred shareholders paid-in capital increased by the $6,500
have no voice in company affairs unless discussed in the previous paragraph.
the company fails to pay them dividends When this amount is added to last year’s
at the promised rate. ending balance of $13,500, additional
paid-in capital at Dec. 31, 19X9, comes
24 Preferred stock, $5.83 cumulative, to $20,000.
$100 par value; authorized
26 Additional paid-in capital $20,000
issued and outstanding:
60,000 shares $6,000


Retained Earnings are declared on the common, the balance

When a company first starts in business, sheet will show retained earnings of
it has no retained earnings. Retained earn- $79,900. In the second year, if profits are
ings are the accumulated profits the com- $140,000 and Typical pays $200 in divi-
pany earns and reinvests or “retains” in dends on the preferred and $400 on the
the company. (In less successful compa- common, retained earnings will be
nies where losses have exceeded profits $219,300.
over the years, those accumulated net
The Dec. 31, 19X9, balance sheet for
losses will be reported as an “accumulated
Typical shows the company has accumu-
deficit.”) In other words, retained earnings
lated $249,000 in retained earnings. The
increase by the amount of profits earned,
table below presents retained earnings
less dividends declared to shareholders.
from start-up through the end of 19X9.)
If, at the end of its first year, profits are
$80,000, dividends of $100 are paid
on the preferred stock, and no dividends 27 Retained earnings $249,000

Calculation: Accumulated Retained Earnings

Balance at start-up $0)
Profit in year 1 80,000)
Preferred dividends in year 1 (100)

Retained earnings : End of year 1 79,900)

Profit in year 2 140,000)
Dividends in year 2: Preferred (200)
Common (400)

Retained earnings: End of year 2 219,300)

Aggregate profits: Year 3 through 19X8 800,000)
Aggregate dividends: Year 3 through 19X8 (799,700)

Retained earnings: 12/31/X8 and 1/1/X9 219,600)

Net income: 19X9 47,750)
Dividends: 19X9
Preferred (350)
Common (18,000)

Retained earnings: 12/31/X9 $249,000)


Foreign Currency Translation expense or benefit, as a separate compo-

Adjustments (Net of Taxes) nent of shareholders’ equity. On Dec. 31,
When a company has an ownership inter- 19X9, the total fair market value of these
est in a foreign entity, it may be required securities exceeded their cost by $65.
to include that entity’s results in the com- However, that gain would have increased
pany’s consolidated financial statements. tax expense by $15, producing a net
If that requirement applies, the financial unrealized gain of $50. If these securities
statements of the foreign entity (prepared are sold, the difference between their
in foreign currency) must be translated original cost and the proceeds from
into U.S. dollars. The gain or loss resulting such sale will be a realized gain or loss
from this translation, after the related tax included in the determination of net
expense or benefit, is reflected as a sepa- income in that period.
rate component of shareholders’ equity
and is called foreign currency translation 29 Unrealized gain on available-
adjustments. This adjustment should be for-sale securities (net of taxes) $50
distinguished from conversion gains or
losses relating to completed transactions
that are denominated in foreign curren-
Treasury Stock
cies. Conversion gains or losses are When a company buys its own stock
included in a company’s net income. back, that stock is recorded at cost and
reported as treasury stock. (It is called
28 Foreign currency translation treasury stock because after being reac-
quired by the company, it is returned to
adjustments (net of taxes) $1,000
the company’s treasury. The company
Unrealized Gain on Available- can then resell or cancel that stock.)
for-Sale Securities (Net of Taxes) Treasury stock is reported as a deduction
from shareholders’ equity. Any gains or
Unrealized gain/loss is the change in the
losses on the sale of such shares are
value (gain or loss) of securities classified
reported as adjustments to shareholders’
as “available-for-sale” that are still being
equity, but are not included in income.
held. In Typical’s case, this represents the
Treasury stock is not an asset.
difference (a gain here) between the cost
(or previously reported fair market value)
of investment securities classified as 30 Less: treasury stock at cost ($5,000)
“available-for-sale” held at the balance-
sheet date and their fair market value at Total Shareholders’ Equity
that time. Since Typical still holds these “Total Shareholders’ Equity” is the sum
securities and has not yet sold them, such of stock (less treasury stock), additional
differences have not been realized. As paid-in capital, retained earnings, foreign
such, this unrealized amount is not includ- currency translation adjustments and
ed in the determination of current income. unrealized gains on investment securities
However, since these securities must be available for sale.
reported at their fair market value, the
changes in that fair market value since
31 Total Shareholders’
purchase (or the previously report date)
are reported, after the related income tax Equity $346,050 21

To analyze balance-sheet figures, investors Current Ratio

look to certain financial statement ratios What is a comfortable amount of working
for guidance. (A financial statement ratio capital? Analysts use several methods to
is the mathematical relationship between judge whether a company has adequate
two or more amounts reported in the working capital. To interpret the current
financial statements.) One of their con- position of a company being considered as
cerns is whether the business will be able a possible investment, the current ratio may
to pay its debts when they come due. be more useful than the dollar total of work-
Analysts are also interested in the compa- ing capital. The first rough test is to compare
ny’s inventory turnover and the amount of the current assets figure to the total current
assets backing corporate securities (bonds liabilities. Although there is considerable
and preferred and common stock), along variation among different types of compa-
with the relative mix of these securities. nies, and the relationship is significant only
The following section will discuss some when comparisons are made between com-
ratios and calculations used for balance- panies in the same industry, a current ratio
sheet analysis. of 2-to-1 is generally considered adequate.
This means that for each $1 of current liabil-
WORKING CAPITAL ities, there are $2 in current assets.
One very important balance-sheet concept
is working capital. This is the difference To find the current ratio, divide current
between total current assets and total assets by current liabilities. In Typical’s
current liabilities. Remember, current balance sheet:
liabilities are debts due within one
16 Current assets $405,800 = 2.31 or 2.3 to 1
year of the balance-sheet date. The
source from which those debts are 19 Current liabilities $176,000 1
paid is current assets. Thus, working
Thus, for each $1 of current liabilities, there
capital represents the amount of
is $2.31 in current assets to back it up. There
current assets that is left if all current
are so many different kinds of companies,
debts are paid.
however, that this test requires a great deal
For Typical this is: of modification if it is to be really helpful in
analyzing companies in different industries.
6 Current assets $405,800) Generally, companies that have a small
inventory and accounts receivable that are
19 Less: current liabilities (176,000)
quickly collectible can operate safely with a
Working capital $229,800) lower current ratio than companies having a
greater proportion of their current assets in
Generally, companies that maintain a inventory and that sell their products on
comfortable amount of working capital extended credit terms.
are more attractive to conservative
investors. A company’s ability to meet HOW QUICK IS QUICK?
obligations, expand volume and take In addition to working capital and the cur-
advantage of opportunities is often deter- rent ratio, another way to test the adequacy
mined by its working capital. Year-to-year of working capital is to look at quick assets.
increases in working capital are a positive What are quick assets? They’re the assets
sign of a company’s growth and health. available to cover a sudden emergency—

assets that could be taken to the bank right DEBT TO EQUITY

away, if necessary. They are those current A certain level of debt is acceptable, but
assets that are quickly convertible into cash. too much is a sign for investors to be cau-
This excludes merchandise inventories, tious. The debt-to-equity ratio is an indi-
because such inventories have yet to be cator of whether the company is using
sold and are not quickly convertible into debt excessively. For Typical, the debt-to-
cash. Accordingly, quick assets are current equity ratio is computed as follows:
assets minus inventories, prepaid expenses
and any other illiquid current assets. 23 Total Liabilities $322,000 = .93
31 Total Shareholders’ Equity $346,050
6 Current assets $405,800)
4 Less: inventories (180,000)
A debt-to-equity ratio of .93 means the
5 Less: prepaid expenses (4,000) company is using 93 cents of liabilities
Quick assets $221,800) for every dollar of shareholders’ equity
in the business. Normally, industrial com-
The quick assets ratio is found by dividing panies try to remain below a maximum
quick assets by current liabilities. of a 1-to-1 ratio, to keep debt at a level
that is less than the investment level of the
This means that, for each $1 of current liabili- owners of the business. Utilities, service
ties, there is $1.26 in quick assets available. companies and financial companies often
operate with much higher ratios.
Quick assets $221,800 = 1.26 or 1.26 to 1
19 Current liabilities $176,000 1 How much inventory should a
company have on hand? That
Net quick assets are found by taking the
depends on a combination of
quick assets and subtracting the total current
many factors including the type of
liabilities. A well-positioned company
business and the time of the year.
should show a reasonable excess of quick
An automobile dealer, for example,
assets over current liabilities. This provides a
with a large stock of autos at the
rigorous and important test of a company’s
height of the season is in a strong
ability to meet its obligations.
inventory position; yet that same
inventory at the end of the season
Quick assets $221,800) represents a weakness in the
19 Less: current liabilities (176,000) dealer’s financial condition.
Net quick assets $45,800)


One way to measure the Calculation 1:)

adequacy and balance of 12 Total assets $668,050)
inventory is to compare it 10 Less: intangibles (1,950)
with the cost of sales for Total tangible assets 666,100)
the year to determine the 19 Less: current liabilities (176,000)
inventory turnover. This Net tangible assets available to
tells us how many times a meet bondholders’ claims $490,100)
year goods purchased by a
(Actual Amounts Used)
company are sold to its
customers. Typical’s cost of $490,100,000 = $3,770 net asset value per
sales for the year is 130,000 (bonds outstanding) $1,000 bond outstanding
$535,000, which is divid-
ed by average inventory for the year of Net Asset Value per Bond
$182,500 (inventory at 12/31/X8 of To state this figure conservatively, intangi-
$185,000 + inventory at 12/31/X9 of ble assets are subtracted as if they have
$180,000, divided by 2) to determine no value on liquidation. Current liabilities
turnover. Thus, turnover is 2.9 times of $176,000 are considered paid. This
($535,000 ÷ $182,500), meaning that leaves $490,100 in assets to pay the
goods are bought, manufactured and sold bondholders. So, $3,770 in net asset
out almost three times per year. (If this value protects each $1,000 bond.
information is not readily available in (See Calculation 1 above.)
some published statements, some analysts
look instead for sales related to inventory.) Net Asset Value per Share
“Inventory as a percentage of current of Preferred Stock
assets” is another comparison that may be To calculate net asset value of a preferred
made. In Typical’s case, the inventory of share, start with total tangible assets, con-
$180,000 represents 44% of the total cur- servatively stated at $666,100 (eliminating
rent assets, which amounts to $405,800. $1,950 of intangible assets). Current liabil-
ities of $176,000 and long-term liabilities
BOOK VALUE OF SECURITIES of $146,000 are considered paid. This
Net book value or net asset value leaves $344,100 of assets protecting the
is the amount of corporate preferred. So, $5,735 in net asset value
assets backing a bond or a common or backs each share of preferred.
preferred share. Intangible assets are (See Calculation 2 below.)
sometimes included when
Calculation 2:)
computing book value.
However, the following cal- 12 Total assets $668,050)
culations will focus on the 10 Less: intangibles (1,950)
more conservative net tan- Total tangible assets 666,100)
gible book value. Here’s 19 Less: current liabilities (176,000)
how to calculate values for 20, 21, 22 Long-term liabilities (146,000)
Typical’s securities. (Refer Net tangible assets underlying
to Calculations 1 to 4.) the preferred stock $344,100)
(Actual Amounts Used)
24 $344,100,000 = $5,735 net asset value per
60,000 (preferred shares outstanding) preferred share

Book Value per Share of Common Stock Book-value figures, particularly of com-
The book value per share of common mon stocks, can be misleading. Profitable
stock can be thought of as the amount of companies may show a very low net book
money each share would receive if the value and very substantial earnings, while
company were liquidated, based on bal- mature companies may show a high book
ance-sheet values. Of course, the bond- value for their common stock but have
holders and preferred shareholders would such low or irregular earnings that the
have to be satisfied first. The answer, stock’s market price is lower than its book
$22.54 book value per share of common value. Insurance companies, banks and
stock, is arrived at as follows. (See investment companies are often excep-
Calculation 3 below.) tions. Because their assets are largely liq-
uid (cash, accounts receivable
Calculation 3:) and marketable securities),
25 Common stock $75,000) their common stock’s book
26 Additional paid-in capital 20,000) value is sometimes a fair
27 Retained earnings 249,000) indication of market value.
28 Foreign-currency translation adjustments 1,000)
29 Unrealized gains on available-for-sale securities 50)
30 Treasury stock (5,000)The proportion of each kind of
security issued by a company
Total Common Shareholders’ Equity 340,050)
is the capitalization ratio. A
10 Less: intangible assets (1,950)
high proportion of bonds
Total Tangible Common Shareholders’ Equity $338,100)
sometimes reduces the attrac-
(Actual Amounts Used) tiveness of both the preferred
$338,100,000 = $22.54 book value per common share and common stock, and too
15,000,000 (common shares outstanding) much preferred can detract
from the common’s value.
An alternative method of arriving at the That’s because bond interest must be paid
common shareholders’ equity, conserva- before preferred dividends, and preferred
tively stated at $338,100, is shown in dividends before common dividends.
Calculation 4 below. Typical’s bond ratio is derived
by dividing the face value of
Calculation 4:) the bonds, $130,000, by the
12 Total assets $668,050) total value of bonds, preferred
10 Less: intangibles (1,950) and common stock, additional
Total tangible assets 666,100) paid-in capital, retained earn-
19 Less: current liabilities (176,000) ings, foreign currency transla-
20, 21, & 22 tion adjustments, unrealized
Long-term liabilities (146,000) gains on available-for-sale
24 Preferred stock (6,000) securities and treasury stock,
Net tangible assets available less intangibles, which is
for common stock $338,100) $474,100. (See the Calculation
on page 26.) This shows that
(Actual Amounts Used) bonds amount to about 27% of
$338,100,000 = $22.54 book value per common share Typical’s total capitalization.
15,000,000 (common shares outstanding) 25

21 Debentures $130,000) The common stock ratio will be the

24 Preferred stock 6,000) difference between 100% and the total of
25 Common stock 75,000) the bond and preferred stock ratio—or
26 Additional paid-in capital 20,000) about 72%. The same result is reached by
27 Retained earnings 249,000) adding common stock, additional paid-in
28 Foreign currency capital, retained earnings, foreign currency
translation adjustments, unrealized gains
translation adjustments 1,000)
on available-for-sale securities and trea-
29 Unrealized gains on
sury stock, less intangibles, and dividing
available-for-sale securities 50)
the result by total capitalization.
30 Treasury stock (5,000)
10 Less: intangibles (1,950) Amount Ratio
Total Capitalization $474,100) 21 Debentures $130,000 27%
24 Preferred stock 6,000 1%
The preferred stock ratio is found the 10 & 25–30
same way—by dividing preferred stock Common Shareholders Equity
of $6,000 by the entire capitalization of
less intangibles 338,100 72%
$474,100. The result is about 1%.
Total $474,100 100%


The most important report for many However, the income statement for a sin-
analysts, investors or potential investors gle year does not tell the whole story. The
is the income statement. It shows how historical record for a series of years is
much the corporation earned or lost dur- more important than the figures for any
ing the year. It appears with numbered single year. Typical includes two years in
line items on page 27 of this booklet. its income statement and gives a 10-year
financial summary as well, which appears
While the balance sheet shows the funda- on pages 42 and 43.
mental soundness of a company by reflect-
ing its financial position at a given date, An income statement matches the rev-
the income statement may be of greater enues earned from selling goods and ser-
interest to investors: The reasons are vices or other activities against all the
twofold: costs and outlays incurred to operate the
company. The difference is the net income
■ The income statement shows the record (or loss) for the year. The costs incurred
of a company’s operating results for the usually consist of: Cost of sales; selling,
whole year. general and administrative expenses, such
■ It also serves as a valuable guide in as wages and salaries, rent, supplies and
anticipating how the company may do depreciation; interest on money borrowed;
in the future. and taxes.


(Dollars in Thousands, Except Per-Share Amounts)

Years Ended December 31,

19X9 19X8
33 Net sales $765,050) $725,000)
34 Cost of sales 535,000) 517,000)
35 Gross margin 230,050) 208,000)
Operating expenses:
36 Depreciation and amortization 28,050) 25,000)
37 Selling, general and administrative expenses 96,804) 109,500)
38 Operating income 105,196) 73,500)
Other income (expense):
39 Dividend and interest income 5,250) 10,000)
40 Interest expense (16,250) (16,750)
41 Income before income taxes and extraordinary loss 94,196) 66,750)
42 Income taxes 41,446) 26,250)
43 Income before extraordinary loss 52,750) 40,500)
44 Extraordinary item: Loss on earthquake
destruction (net of income tax benefit of $750) (5,000) —
45 Net income $47,750) $40,500)
46 Earnings per share of common stock before
extraordinary loss $3.55) $2.77)
47 Earnings per share—extraordinary loss (.34) —)
48 Net income per common share $3.21) $2.77)

Net Sales 33 Net sales $765,050

The most important source of revenue is
usually the first item on the income state- Cost of Sales
ment. It represents the primary source of In a manufacturing establishment, cost of
revenue earned by the company from its sales represents all the costs the company
customers for goods sold or services ren- incurs to purchase and convert raw materi-
dered. In Typical Manufacturing’s income als into the finished products that it sells.
statement, it is shown as “net sales.” The These costs are commonly known as prod-
“net sales“ item includes the amount uct costs. “Product costs” are those costs that
reported after taking into consideration can be identified with the purchase or man-
returned goods and allowances for price ufacture of goods made available for sale.
reductions or discounts. By comparing net
sales between 19X9 and 19X8, we see that There are three basic components of product
sales increased in XXXX. cost: (1) Direct materials, (2) direct labor 27

and (3) manufacturing overhead. Direct Selling, General and

materials and direct labor costs can be Administrative Expenses
directly traced to the finished product. For These expenses are generally grouped sep-
example, for a furniture manufacturer, arately from cost of sales so that the reader
lumber would be a direct material cost of an income statement may see the extent
and carpenter wages would be a direct of selling and administrative costs. These
labor cost. Manufacturing overhead costs, include expenses such as: sales agents’
while associated with the manufacturing salaries and commissions; advertising and
process, cannot be traceable to the fin- promotion; travel and entertainment; exec-
ished product. Examples of manufacturing utives’ salaries, office payroll; and office
overhead costs are costs associated with expenses.
operating the factory plant (rent, electrici-
ty, supplies, depreciation, maintenance 37 Selling, general and
and repairs and the salaries of production
administrative expenses $96,804

34 Cost of sales $535,000 Operating Income

Gross Margin Subtracting all operating expenses from the
gross margin determines operating income.
Gross margin is the excess of sales over
cost of sales. It represents the actual direct
profit from sales after considering product 38 Operating income $105,196
costs. Comparing period-to-period gross
margin trends in absolute dollars is a use- Dividend and Interest Income
ful analytical tool. So, too, is comparing An additional source of revenue comes from
the gross margin percentage (computed dividends and interest received by the com-
by dividing gross margin by net sales) from pany from its investment in stocks and bonds.
year to year.
39 Dividends and
35 Gross margin $230,050
interest income $5,250
Gross margin percentage 30%
($230,050 ÷ $765,050)
Interest Expense
The interest earned by bondholders for
Tangible Depreciation and the use of their money is sometimes
Non-tangible Amortization referred to as a “fixed charge.“ That’s
Each year’s decline in value would be because the interest must be paid year
captured here. Amortization, as reported after year whether the company is making
in this line item, represents the decline in money or losing money. Interest differs
useful value of an intangible, such as a from dividends on stocks, which are
17-year patent. payable only if the board of directors
declares them. Interest paid is another
36 Depreciation and cost of doing business, and is deductible
amortization $28,050 from earnings in order to arrive at a base
28 for the payment of income taxes.

Typical’s interest expense comes from three $52,750 would be the end of the story.
sources: (1) Notes payable, (2) debentures However, there are years in which compa-
and (3) other long-term debt (which nies experience unusual and infrequent
became current portion of long-term debt events called extraordinary items. For exam-
at this year-end). The notes payable, with ple, an extraordinary item would be crop
an average outstanding balance for the destruction by a hail storm in an area where
year of $56,000 at 7% interest, incur an hail storms are rare. In this case, one of
interest charge of $3,920; the debentures, Typical’s manufacturing sites was destroyed
bearing interest at 9.12% on the $130,000 by an earthquake. Since this event is not
balance, incur interest expense of expected to recur, it is isolated on a separate
$11,856; and the $6,000 of other long- line, net of its tax effect. Its earnings per share
term debt at 7.9% incurs interest of $474. impact is also separated from the earnings
per share attributable to “normal” operations.
40 Interest expense $16,250
44 Extraordinary item: loss
Income Taxes on earthquake destruction
Each corporation has an “effective tax (net of tax benefit of $750) ($5,000)
rate,” which depends on the level and
nature of its income. Large corporations Net Income—the “Bottom Line”
like Typical Manufacturing are subject to Once all income and costs, including
the top statutory corporate income tax extraordinary items, are considered, net
rate. However, tax credits, tax-free income income (or loss) is determined.
and nondeductible expenses tend to
45 Net income $47,750
change the overall tax rate. Typical’s
income before taxes and extraordinary loss
Other Items
is $94,196; its tax comes to $41,446.
Three other items that do not apply to
41 Income taxes $41,446 Typical could appear on an income state-
ment. First, suppose Typical were heavily
Income Before Extraordinary Loss involved in research and development
“Income before extraordinary loss” for the (R&D) activities. In that event, Typical
year is the amount by which all revenues would be required to include the amount
exceed all expenses. Extraordinary gains of R&D costs in the income statement or
or losses (as defined by GAAP ) are disclose it in the footnotes.
excluded from this determination.
Second, suppose Typical owned between
20% and 50% of another company. In that
42 Income before
case, Typical would have “significant influ-
income taxes and
ence” over that company, but not “control”
extraordinary loss $94,196
it. As such, it would have to account for that
investment using the equity method and
43 Income before report its equity interest in that company in
extraordinary loss $52,750 its financial statements. For example, suppose
Typical’s share of that company’s earnings for
the year were $1,200 and it received $700 in
Extraordinary Items 29
dividends from the company during that year.
Under usual conditions, the above income of

In that event, Typical would have to include by comparing operating income to net sales.
$1,200 on its income statement under the To illustrate, in 19X9, Typical reported net
category “equity in the earnings of uncon- sales of $765,050 and operating income
solidated subsidiaries.” Typical would also of $105,196.
be required to increase its investment in
This means that for each dollar of 19X9
that company to the extent of the earnings
sales, 13.8¢ remained as a profit from
it picked up in its (i.e., Typical’s) income
operations. This figure is interesting, but is
statement. However, this would be reduced
more significant when compared with the
by any dividends received, in this case
operating margin last year.
$700, since the dividend represents a return
of its investment. In this case, Typical‘s bal- Typical’s operating profit margin went
ance sheet would show a net increase in its from 10.1% to 13.8%, so business didn’t
investment in this company of $500. just grow, it became more profitable.
Changes in operating margin can reflect
Third, suppose Typical owned a “consoli-
changes in volume, efficiency, product
dated” subsidiary (more than 50%
line or types of customers served.
ownership), in which it had less than a
100% ownership interest. For example, say Typical can also be compared with other
it owned 85% of that company. Any materi- companies in its field. If Typical’s operating
al change in the related minority interest margin is very low compared to others, it is
(15%), would have to be reported in the an unhealthy sign. If it is high, there is a
income statement or footnotes. A corre- basis for optimism.
sponding change in the cumulative minority
interest would also have to be reported in the Analysts also frequently use “operating cost
balance sheet, between long-term liabilities ratio” for the same purpose. Operating cost
and stockholders’ equity. ratio is the complement of the operating
margin. Typical’s operating margin is
13.8%. The operating cost ratio is 86.2%.
STATEMENT Amount Ratio
33 Net sales $765,050 100.0%
When used to make a few detailed com-
34, 36, & 37
parisons, the income statement will reveal
Operating costs $659,854 86.2%
a lot more information about a company’s
38 Operating
19X9 Operating margin: income $105,196 13.8%
38 $105,196 Operating income = 13.8% Net profit ratio is still another guide to indi-
33 $765,050 Net sales cate how satisfactory the year’s activities
have been. In Typical’s case, the year’s net
operating results. For example, a prospective income was $47,750. The net sales for the
investor can determine the company’s oper- year amounted to $765,050. Therefore,
ating margin and how it has changed over Typical’s income was $47,750 on $765,050
the years. This determination can be made of sales or:

19X8 Operating margin: 19X9 Net profit ratio:

38 $73,500 Operating income = 10.1% 45 $47,750 Net income = 6.2%
33 $725,000 Net sales 33 $765,050 Net Sales

This means that this year, for every $1 of expense on the other debt). The annual
goods sold, 6.2¢ in profit was ultimately debenture interest amounts to $11,856.
earned by the company. By comparing the This means the debenture’s annual interest
net profit ratio from year to year for the expense is covered 8.9 times.
same company and with other companies,
profit progress can be evaluated. Number of times
debenture interest earned:
Last year, Typical’s net income was
$106,052 Available income = 8.9
$40,500 on $725,000 in sales:
$11,856 Debenture interest
19X8 Net profit ratio:
For a corporate bond (debenture) to be
45 $40,500 Net income = 5.6%
considered a safe investment, most ana-
33 $725,000 Net Sales lysts say that the company should earn its
bond interest requirement three to four
The operating margin, operating cost ratio
times over. By these standards, Typical’s
and net profit ratio—like the ratios examined
debentures have a fair margin of safety.
for the balance sheet—provide general infor-
mation about the company and help assess its WHAT ABOUT LEVERAGE?
future prospects. All these comparisons have a
Financial leverage relates a company’s
long-term significance because they provide
long-term debt and preferred stock to the
useful information about the company’s fun-
company’s common equity. Sometimes a
damental economic condition. Another ques-
stock is said to be highly leveraged. What
tion to ponder: Are Typical’s securities a good
this simply means is that the company
investment? Consideration of some additional
issuing the stock has a large proportion of
factors can help provide an answer.
bonds and preferred stock outstanding rel-
INTEREST COVERAGE ative to the amount of common stock.
Typical’s debentures represent a very substan- “High leverage” can work for or against a
tial debt, but they are due many years in the company depending on the earnings
future. The yearly interest, however, is a fixed available to the common shareholders.
charge. How readily the company can pay Generally speaking, however, analysts
the interest on this debt (i.e., the debt’s inter- consider highly leveraged companies to be
est coverage) would be of great interest to an risk-prone. A simple illustration will show
investor. (Interest coverage is number of why. Take, for example, a company with
times the annual interest on a debt obligation $10,000,000 of 4% bonds outstanding. If
is covered by income for the year without the company earns $440,000 before bond
considering interest on the debt and taxes.) interest, there will only be $40,000 left for
More specifically, an investor would like to the common shareholders after payment of
know if the borrowed funds have been put to $400,000 bond interest ($10,000,000 at 4%
good use, so that the earnings are adequate equals $400,000). However, an increase of
and thus available to meet interest costs. only 10% in earnings (to $484,000) will
leave $84,000 for common stock divi-
The available income representing the
dends, or an increase of more than 100%.
source for payment of the debenture interest
If there is only a small amount of common
is $106,052 (operating profit plus dividend
stock issued, the increase in earnings per 31
and interest income less the interest
share will appear very impressive.

But in this instance, it is also apparent that a dividends were earned), net profit must be
decline of 10% in earnings (to $396,000) used as the base. That’s because federal
would wipe out everything available for the income taxes and all interest charges must
common shareholders. Moreover, it would be paid before anything is available for
also result in the company’s being unable to shareholders. Because the 60,000 shares
cover the full interest on its bonds without of $100 par value preferred stock pay a
per share dividend of $5.83, the total divi-
dipping into its cash reserves and retained
dend requirement for the preferred stock is
earnings. This is the great danger of so-
$350. Dividing the net income of
called highly leveraged companies. It also
$47,750, by this figure yields approxi-
illustrates a fundamental weakness of compa- mately 136.4, which means that the divi-
nies that have a disproportionate amount of dend requirement of the preferred stock
debt. Conservative investors usually steer clear has been earned more than 136 times
of highly leveraged companies, although they over. This ratio is so high primarily
do appeal to people seeking a higher return because Typical has only a relatively small
who are willing to assume the risk. amount of preferred stock outstanding.

Typical Manufacturing, on the other hand, EARNINGS PER COMMON SHARE

is not a highly leveraged company. In A buyer of common stock is often more
19X8, Typical incurred $11,856 in concerned with the stock’s earnings per
debenture interest and its income before share than with its dividend. This is
extraordinary loss and this expense came because earnings usually influence stock
to $52,356 ($40,500 + $11,856 = $52,356). market prices. Although the income state-
This left $40,500 for the common and pre- ment separates earnings per share before
ferred stockholders and retained earnings and after the effect of extraordinary items,
after recording this interest. the remainder of this presentation will only
Now look what happened this year. Net prof- consider net income per common share
it before extraordinary loss and debenture (net income after extraordinary item). In
interest rose by $12,250 ([$52,750 + $11,856 Typical’s case, the income statement does
= $64,606] - $52,356 = $12,250) or about not show income available for common
23%. Since the bond interest stayed the stock, so it must be calculated as follows:
same, income before extraordinary loss and Typical’s capital structure is a very simple
after recording this interest also rose $12,250. one, comprised of common and preferred
But that is about 30% of $40,500. While this stock. As such, the earnings per share
is certainly not a dramatic example of lever- computation above will suffice under this
scenario. However, if the capital structure
age, a 23% increase in pretax earnings
is more complex and contains securities that
generates a 30% increase in amounts avail-
are convertible into common stock, options,
able for dividends or retained earnings. warrants or contingently issuable shares,
While this only illustrates the leverage effect the calculation requires modification.
of the interest on the debentures, similar (Options and warrants each give the holder
calculations could be made to show the the right to buy securities at a specified price.
impact of the interest expense related to the Contingently issuable shares are shares of
other borrowings and total interest expense. stock whose issuance depends on the occur-
rence of certain events.) In fact, two separate
PREFERRED DIVIDEND COVERAGE calculations are required. This is called dual
To calculate the preferred dividend presentation. The calculations are basic and
coverage (the number of times preferred diluted earnings per common share.

As of December 15, 1997, as per Financial to common shareholders for the year (or
Accounting Standard 128, publicly traded the period) by the average number of
companies are required to report both common and potential common shares
forms of earnings per share: basic earnings outstanding, if such potential common
per share and diluted earnings per share. shares are dilutive. Dilution occurs when
This new standard replaced APB 15, earnings per share decreases or loss per
making simple, primary and fully diluted
share increases.
earnings per share obsolete. FAS 128 also
makes the calculation of earnings per share The “adjustments” to earnings include:
identical under U.S. and international
• Dividends on convertible preferred stock
accounting standards.
• After-tax interest expense on convertible
Basic Earnings per Common Share debt
This is determined by dividing the • Effect of the change in earnings from
earnings available to common shareholders other expenses (such as profit-sharing
for the year or the appropriate period by expense rising due to the increased
the average number of shares of common
income from the reduction of interest
stock outstanding during the year.
expense from the assumed conversion of
The average calculation is simply the convertible debt)
arithmetic mean of the shares outstanding,
on a pro rata basis, for the reporting peri- The “potential” common shares consist of
od. Unexercised stock options, convertible other securities and contractual arrange-
securities and contingently issuable shares ments that may result in the issuance of
are NOT included in the basic earnings common stock in the future, such as:
per share calculation. • Options or warrants
Suppose, for example, that Complex • Convertible securities
Capital Corp. has $300,000 in net income • Contingent stock arrangements
available to common shareholders and
100,000 average common shares outstand- Convertible securities can be exchanged
ing for the year. Basic earnings per share or converted into common shares.
would be $3.00 ($300,000/100,000). Examples are convertible preferred stock,
convertible bonds and the like. Such secu-
rities are deemed to be only one step short
of common stock. Their value stems in
Diluted earnings per share is determined large part from the value of the common
by dividing the adjusted earnings available to which they relate.

45 Net Income $47,750) Convertible pre-

ferred stock and
Less: dividend requirement on preferred stock (350)
Net income available for common stock $47,400)
bonds offer
(Actual Amounts Used) their holders
Net income per common share: some choices.
$47,400,000 Net income available for the common stock = $3.21 A holder can
14,750,000 Average number of outstanding common shares* elect either (1) a
return at the
*Shares outstanding at January 1 (14,500,000), plus shares outstanding at December 31 specified divi-
(15,000,000), = 29,500,000, divided by 2 = 14,750,000 average shares outstanding for the year.
dend or interest

rate, or (2) conversion into common stock share from stock options. All of the
and participation in market appreciation proceeds from the conversion of the in-
and dividends resulting from increased the-money (current share price is greater
earnings on the common stock. However, than the exercise price) options are used
the securities don’t have to be actually to repurchase common shares at the
converted to common stock for them to average market price for the period.
be called “potential common shares”
For example, suppose the same Complex
because they enable holders—in certain
Capital Corp. used above also has 10,000
circumstances—to cause an increase in
stock options outstanding with an average
the number of common shares by exercis-
strike price of $20 per share. The average
ing, exchanging or converting.
share price for the year was $50. The
Each issue of potential common shares $200,000 in option proceeds (10,000
must be considered separately in options x $20 average exercise price) is
sequence from the most dilutive (lower- assumed to repurchase common shares
ing earnings per share the most) to the at $50 per share, therefore reducing com-
least dilutive by examining the marginal mon shares by 4,000 ($200,000/$50).
earnings per share impact. This is known The net dilutive effects of the options
as antidilution sequencing. When calcu- would be an increase in 6,000 common
lating diluted earnings per share, first shares (10,000 options less 4,000
compare the impact of the most dilutive repurchased), assuming the hypothetical
security to basic earnings per share. If a conversion of the in-the-money options
potential common share is antidilutive at the average share price for the period
(therefore raising earnings per share), that under the Treasury Stock Method.
security should NOT be included in the Therefore, the earnings per share would
diluted earnings per share calculation. be diluted to $2.83 from the net effect
Because antidilutive securities are not of options ($300,000 in net
included in the diluted calculation, dilut- income/106,000 common shares,
ed earnings per share must always be less including the net 6,000 options).
than, or equal to, basic earnings per Let us now further examine the diluted
share. Diluted earnings per share are usu- earnings per share calculation. Suppose
ally less than basic earnings per share the following financial information for the
due to the dilutive effects of potential same Complex Capital Corp. as above:
common shares. • $300,000 net income available to
Options and warrants are the most common shareholders
common forms of potential common • 100,000 average common shares
shares. As stated earlier, options and outstanding
warrants each give the holder the right to • 10,000 stock options with an average
buy securities at a specified price, known strike price of $20
as the “exercise price” or “strike price.” • Average share price for the year of $50
Let’s examine an example of the dilution • Convertible bonds with a par value of
from the assumed conversion of options. $1,000,000, 6% interest rate, and a con-
The Treasury Stock Method is a method of version ratio of 20 common shares for
34 calculating the effect on earnings per every $1,000 bond

The basic earnings per share are simply Diluted earnings per share calculation:
$300,000 in net income divided by 100,000 Adjusted net income $336,000
average common shares, or $3.00. The effect
Adjusted common shares 126,000
of options lowered earnings per share to
$2.83. Let us now examine the effects of the = Diluted earnings per share $2.67
potential common shares from the convert-
ible bonds. Complex Capital Corp. would report both
the basic and diluted numbers: Basic earn-
If the 1,000 bonds were converted into com-
ings per share of $3.00 and diluted earn-
mon shares, there would be another 20,000 ings per share of $2.67. In most analyses,
common shares (1,000 bonds x 20). But con- the diluted number is the most significant
verting the bonds would save the $60,000 in figure. This reflects the dilution from all
interest payments ($1,000,000 x 6%), less the potential common shares. In fact, research
tax deduction of $24,000 on the interest earnings per share estimates are generally
expense. Therefore, the conversion of the given as the expected diluted earnings per
bonds would increase net income available share of the company.
to common shareholders by $36,000
($60,000 in interest expense less the $24,000 PRICE-EARNINGS RATIO
tax deduction).
Both the price and the return on common
stock vary with a multitude of factors.
Adjustments to net income assuming con-
One such factor is the relationship that
version of the bonds:
exists between the earnings per share and
Net Income available the market price. It is called the price-
to common $300,000 earnings ratio (abbreviated P/E ratio).
Plus: interest expense 60,000 This is how the P/E ratio is calculated. If a
stock is selling at $25 per share and earning
Less: tax deduction on
$2 per share annually, its price-earnings
interest expense (24,000)
ratio is 12.5-to-1, usually shortened to
Adjusted net income $336,000 12.5. Put another way, the stock is said to
be selling at 12.5 times earnings. If the
Additional common shares assuming stock should rise to $40, the P/E ratio
conversion of the stock options and would be 20, or 20 times earnings. Or, if
the bonds: the stock drops to $12, the P/E ratio would
be 6, or six times earnings.
Common shares outstanding 100,000
For Typical, which has no “potential com-
Plus: options 10,000
mon shares,” net income per common share
Less: assumed shares repurchased was calculated at $3.21. If the stock were
under Treasury Stock Method (4,000) selling at $33, the P/E ratio would be 10.3.
This figure would be used to compare this
Plus: commons shares from stock over a period of years to itself and/or
the conversion of the bonds 20,000 to other similar stocks.

Adjusted common shares 126,000 This means that Typical Manufacturing com- 35

P/E ratio: in the real world investors can never be cer-

$33 Market price = 10.3: 1 tain that any stock will keep its same P/E
49 $3.21 Earnings per share or 10.3 ratio from year to year. The historical P/E
times earnings multiple is a guide, not a guarantee.
mon stock is selling at approximately 10.3 In general, a high P/E multiple, when com-
times earnings. Last year, Typical earned pared with other companies in the same
$2.77 per share. Assume that its stock sold at industry, means that investors have confi-
the same P/E ratio then. This means that a dence in the company’s ability to produce
share of Typical was selling for about higher future profits.
$28.50, and anyone who bought Typical
then would be satisfied now. Just remember,


This statement analyzes the changes nor are they deductible for tax purposes.
from year-to-year in each component Common shareholders were paid $18,000
of shareholders’ equity. It shows that in dividends this year. Since the balance
during the year, Typical issued additional sheet shows that Typical has 15,000,000
common stock at a price above par. It shares outstanding, the first thing to be
also shows that Typical experienced a learned here may be an important point
foreign currency translation gain and an to some potential investors—the dividend
unrealized gain on investments classified per share.
as “available-for-sale.” The other
components of equity, with the Dividend per share:
exception of retained earnings
(Actual amount used)
(see the paragraph below) remained
the same. $18,000,000 Common stock dividends = $1.20
$15,000,000 Common shares outstanding
Retained earnings reflects the
cumulative earnings that the com- Once the dividend per share is known, it
pany has invested for future growth. is easy to go on to the next step: comput-
The statement of changes in shareholders’ ing the dividend payout percentage. This
equity shows that retained earnings is simply the percentage of earnings per
increased by net income less dividends share paid to shareholders.
on preferred and common stock. Since net
income has already been analyzed,
dividends will now be examined. Dividend payout percentage:
$1.20 Dividend per common share = 37%
DIVIDENDS 48 $3.21 Net income per common share
Dividends on common stock
vary with the company. They do not
36 enter into the determination of net income;

Another statistic of great interest to many after paying dividends totaling $18,350.
investors and analysts is the dividend Even if Typical has some lean years in
yield, a percentage providing an estimate the future, it has plenty of retained
of the return per share on a given class of earnings from which to keep on declaring
stock. Here, for example, the common those $5.83 dividends on the preferred
dividend yield would be of great interest. stock and $1.20 dividends on the
This indicates the percentage return that common stock.
the annual common dividend provides
based on the market price of the common There is one danger in having a lot of
stock. This is derived by dividing the retained earnings. It could attract another
annual common dividend, in this case company, Great Giant Computers &
$1.20, by the market price of the common Electronics for instance, to buy up enough
stock, earlier determined to be $33 per of Typical’s common to vote out the
share. This provides a “common dividend current management. Then Great Giant
yield” of 3.6%, which is quite respectable might merge Typical into itself. Where
in today’s market. would Great Giant get the money to buy
Typical stock? By issuing new shares of its
own stock, perhaps. And where would
Dividend yield:
Great Giant get the money to pay the
$1.20 Dividend per common share = 3.6% dividends on all that new stock of its own?
$33 Market price of the common stock The funds would come from Typical’s
retained earnings. So Typical’s manage-
Of course, the dividends on the $5.83 pre- ment has an obligation to its sharehold-
ferred stock will not change from year-to- ers—to make sure that its retained
year. The word “cumulative” in the bal- earnings are put to work to increase
ance-sheet description indicates that if their total wealth. Otherwise, the share-
Typical’s management didn’t pay a divi- holders might cooperate with Great Giant
dend on its preferred stock, then the $5.83 if it conducted a raid on Typical.
payment for that year would accumulate.
It would have to be paid to preferred 27 Retained earnings $249,000
shareholders before any dividends could
ever be declared again on the common RETURN ON EQUITY
stock. That’s why preferred stock is called
Seeing how hard money works, of course,
“preferred”; it gets any dividend money
is one of the most popular measures that
first. Convertible bonds and convertible
investors use to come up with individual
preferred stock were discussed earlier.
judgments on how much they think a cer-
However, Typical Manufacturing doesn’t
tain stock ought to be worth. The market
have any convertible securities outstand-
itself—the sum of all buyers and sellers—
ing, so these are of no further interest right
makes the real decision. But the investors
now. Chances are its 60,000 shares of pre-
often try to make their own decision on
ferred stock—with a par value of $100
whether they want to invest at the market’s
each—were issued to family members.
price or wait. Most investors look for
Typical’s return on equity (also known as
During the year, Typical Manufacturing “ROE”), which shows how hard share-
has added $29,400 to its retained earnings 37
holders’ equity in Typical is working.

How can an investor compute Typical’s Typical’s stock, an investor really needs
ROE? To arrive at this figure, an investor to do two things. First, he or she needs
would look at the balance sheet and com- to compare Typical’s 14.8% to returns
pute the average common shareholders’ from Typical’s business competitors.
equity for the year in order to calculate Second, he or she needs to compare
how much Typical made on it. In making Typical’s return to the potential return that
this calculation, the investor uses only the could be achieved from other types of
amount of net profit after the dividends investment, such as certificates of deposit,
have been paid on the preferred stock. corporate bonds, real estate or other com-
For Typical Manufacturing, that means mon stocks.
$47,750 net profit minus $350. (See the
Calculation below.) Just remember, that 14.8% is what
Typical itself makes. By no means is it
For every dollar of shareholders’ equity, what an investor will make in dividends
Typical made about 15¢. Is that good? on Typical’s stock. What ROE really
Well, a 15% return to shareholders is reveals is whether Typical Manufacturing
about twice the return Typical would have is relatively attractive as an enterprise.
received had it invested instead in quality An investor can only hope that this attrac-
corporate bonds. It is also several times tiveness will translate into demand for
what it would have received from a sav- Typical’s stock and will be reflected in its
ings account. The point is that in consider- market price.
ing whether to put money to work in

$47,750 Net income less $350 preferred stock dividend
$325,825 Average 19X9 stockholders’ equity* less $6,000 preferred stock value
$47,400 = 14.8% Return on equity

* Stockholders’ equity at January 1 ($305,600), plus stockholders’ equity at December 31 ($346,050)

= $615,650, divided by 2 = $325,825 average 19X9 stockholders’ equity.


One more statement needs to be analyzed operating activities. Financing and invest-
in order to get the full picture of Typical’s ing activities will be discussed first.
financial status. The statement of cash
flows presents the changes in cash result- Financing activities include those activities
ing from business activities. Cash-flow analy- relating to the receipt and repayment of
sis is necessary to make proper investing funds provided by creditors and investors.
decisions and to maintain operations. These activities include the issuance of
debt or equity securities, the repayment
Cash flows, although related to net of debt, and distribution of dividends.
income, are not equivalent to it. This is Investing activities include those activities
because of the accrual method of relating to asset acquisition or disposal.
accounting. Generally, under accrual
accounting, a transaction is recognized on Operating activities basically include all
the income statement when the earnings activities not classified as either financing
process is completed, that is, when the or investing activities. They involve the
goods and/or services have been delivered company’s primary business activities, for
or performed or an expense has been example, the production and delivery of
incurred. This does not necessarily coin- goods and services. They reflect the cash
cide with the time that cash is exchanged. effects of transactions, which are included
For example, cash received from merchan- in the determination of net income.
dise sales often lags behind the time Since many items enter into the determi-
when goods are delivered to customers. nation of net income, the indirect method
Generally, however, when the goods are is used to determine the cash provided by
shipped (service performed), the sale is or used for operating activities. This
recorded on the income statement and method requires adjusting net income to
a related receivable is recorded on the reconcile it to cash flows from operating
balance sheet. activities. Common examples of cash
Cash flows are also separated by business flows from operating activities are: Cash
activity. The business activity classifica- collected from customers; interest received
tions presented on the statement include and paid; dividends received; salary;
financing activities, investing activities and insurance; and tax payments.


Watch Those Notes ■ Asset impairment—disclosure of details

The annual reports of many companies about impaired assets or assets to be
contain this or a similar statement: “See disposed of.
the Accompanying Notes to the Consoli- ■ Investments—information about debt
dated Financial Statements” or “The and equity securities classified as “trad-
Accompanying Notes are an Integral Part ing,” “available-for-sale” or “held-to-
of the Financial Statements.” The reason is maturity.”
that the financial statements themselves
■ Income tax provision—the breakdown
simply report the balances in the various
by current and deferred taxes and its
accounts. Because there is no room on
composition into federal, state, local
the face of the statements for a complete
and foreign tax, accompanied by a
and adequate discussion relating to those
reconciliation from the statutory income
balances, additional required disclosures
tax rate to the effective tax rate for the
are provided in the notes.
Some examples of appropriate footnote ■ Changes in accounting policy—
data are: description of changes in accounting
policy due to new accounting rules.
■ Description of the company’s
policies—disclosure of the company’s ■ Nonrecurring items—details regarding
policies for depreciation, amortization, nonrecurring items such as pension-
consolidation, foreign currency plan terminations or acquisitions/dispo-
translation, earnings per share, etc. sitions of significant business units.
■ Inventory valuation method—indicates ■ Employment and retirement
which method is used to determine the programs—details regarding employ-
cost of goods sold on the income state- ment contracts, profit-sharing, pension
ment and on the balance sheet such as and retirement plans and postretirement
last-in, first-out (LIFO), first-in, first- and postemployment benefits other
out (FIFO) or average cost. LIFO means than pensions.
that the costs on the income statement ■ Stock options—details about stock opt-
reflect the cost of inventories purchased ions granted to officers and employees.
or produced most recently. FIFO means
the income statement reflects the cost ■ Long-term leases—disclosure of lease
of the oldest inventories. This is an obligations on assets and facilities on a
extremely important consideration per-year basis for the next several years
because the LIFO method reflects the and total lease obligations over the
most current costs in the income state- remaining lease period.
ment and does not overstate profits dur- ■ Long-term debt—details regarding
ing inflationary times, while the FIFO the issuance and maturities of long-
valuation does. If not shown on the bal- term debt.
ance sheet, the composition of the ■ Contingent liabilities—disclosures relat-
inventories by raw materials, work-in- ing to potential or pending claims or
process, finished goods and supplies lawsuits that might affect the company.
should be presented.

■ Future contractual commitments— INDEPENDENT AUDITS

terms of contracts in force that will The report from the independent auditors
affect future periods. is often referred to as the auditor’s opin-
■ Regulations/restrictions—description ion, and is printed in the annual report. It
of regulatory requirements and dividend should say three things, namely that:
or other restrictions.
1. The audit steps taken to verify the
■ Off-balance sheet credit and market financial statements meet the auditing
risks—details of off-balance-sheet credit profession’s approved standards of
and market risk associated with certain practice.
financial instruments. This includes
interest rate swaps, forward and futures 2. The financial statements prepared by
contracts and options contracts (often management are management’s respon-
referred to as derivatives). “Off-balance- sibility and follow generally accepted
sheet risk” is defined as potential for accounting principles.
loss over and above the amount record-
3. There is no material misstatement.
ed on the balance sheet.
■ Fair value of financial instruments As a result, when the annual report con-
carried at cost—disclosure of fair tains financial statements accompanied
market values of instruments carried by an unqualified (often referred to as
at cost including long-term debt and “clean”) opinion from independent
off-balance-sheet instruments, such auditors, there is added assurance that
as swaps and options. the figures can be relied upon as being
fairly presented.
■ Segment sales, operating profits and
identifiable assets—information on However, if the independent auditor’s
each industry segment that accounts for report contains the qualifying words
more than 10% of a company’s sales, “except for,” the reader should be on the
operating profits and/or assets. Multi- alert, cautious and questioning. The reader
national corporations must also show should investigate the reason(s) behind
sales and identifiable assets for each such qualification(s), which should be
significant geographic area where sales summarily explained in that report and
or assets exceed 10% of the related referenced to the footnotes. In addition,
consolidated amounts. while the auditor(s) may not qualify the
Most people do not like to read footnotes opinion, a separate paragraph, usually a
because they are complicated and are fourth, may be inserted to emphasize an
rarely written in “plain English.” This is important item. Investors should carefully
unfortunate because the notes are very consider any matter so emphasized.
informative. Moreover, they can reveal
many critical and fascinating sidelights to
the financial story.


It cannot be emphasized too strongly that ments verified for by the auditors, it is
company reports must be compared if there for investors to read. A 10-year sum-
they are to be useful. They can be com- mary can show the reader:
pared to other dates and time periods,
reports of other companies and to industry ■ The trend and consistency of revenues.
averages. If desired, they can even be ■ The trend of earnings, particularly in
compared to broader economic factors. relation to sales.
But most of all, one company’s annual
activities can be effectively compared to ■ The trend of net earnings as a percent-
the same firm’s results from other years. age of sales.

At one time this was done by keeping a ■ The trend of return on equity.
file of old annual reports. Now, many cor-
■ Net earnings per common share.
porations include a 5- or 10-year summary
of their financial highlights in each year’s ■ Dividends and dividend trends.
annual report. This provides the investing
public with information about a decade of Other companies may include changes in
performance. That is why Typical net worth; book value per share; capital
Manufacturing has included a 10-year expenditures for plant and machinery;
summary in its annual report. Although long-term debt; capital stock changes due
the summary is not a part of the state- to stock dividends and splits; number of

Ten-Year Financial Summary

19X9 19X8 19X7 19X6
Net sales $765,050 $725,000 $690,000 $660,000
Income before
income taxes and
extraordinary loss 94,196 66,750 59,750 54,750
Extraordinary loss (5,000) – – –
Net income 47,750 40,500 37,700 33,650
Earnings per share
before extraordinary loss 3.55 2.77 2.57 2.28
Net income per share 3.21 2.77 2.57 2.28
Dividend per
common share 1.20 1.20 1.20 1.00
Working capital 229,800 199,000 218,000 223,000
Net plant and
equipment 260,000 249,600 205,000 188,000
Long-term debt 130,000 136,000 136,000 6,000
Preferred stock 6,000 6,000 6,000 6,000
shareholders’ equity 340,050 299,600 275,800 254,700
Book value per
common share 22.54 20.52 18.39 16.98
Note: Dollars in thousands, except per-share amounts.

employees; number of shareholders; and All of this is really important because of

number of outlets. Where appropriate, the one central point: Investors and potential
summary may also include information on investors not only are trying to find out
foreign subsidiaries and the extent to how Typical is doing now, but they also
which foreign operations have been want to try to predict how Typical and its
embodied in the company’s financial stock will perform in the future.


Given the items explored in this booklet, industry must be considered. The management
Typical Manufacturing appears to be a of the company must be studied and its plans
healthy concern. Since Typical is fictional, for the future assessed. Information about
financial consultants can’t recommend the these “other things” is rarely contained in
purchase of shares of its stock. When the financial report. These other facts must be
investing money in real stocks, however, gleaned from the press or the financial services
please remember this: Selecting securities provided by some research organization.
for investment requires the careful study of Merrill Lynch’s ongoing research monitors
factors other than those included in the basic this type of data and the available facts needed
financial statements and related footnotes. The to help individuals and businesses become
economics of the country and the particular informed investors.

19X5 19X4 19X3 19X2 19X1 19X0

$600,000 $520,000 $500,000 $450,000 $350,000 $300,000

50,400 42,000 45,800 40,500 34,350 29,500

– – – – – –
29,850 27,300 30,360 25,975 21,000 18,100

2.00 1.83 2.20 1.93 1.69 1.43

2.00 1.83 2.20 1.93 1.69 1.43

1.00 1.00 1.00 .80 .80 .80

211,000 178,000 136,000 111,000 86,000 96,000

184,300 187,500 161,600 125,600 92,500 87,600

6,000 – – – – –
6,000 6,000 6,000 6,000 6,000 6,000

238,100 220,500 203,250 166,000 133,800 128,000

15.87 14.70 13.55 11.07 8.92 8.53


Page numbers in parentheses are page references in this booklet where the terms are first
introduced or where additional information about the terms can be found.

Accounts Payable (Page 15). not pay what they owe. Also Balance Sheet (Pages 1, 8-26).
Amounts owed to creditors for called Provision for Doubtful A report showing the financial
goods and services bought on Accounts, Reserve for Doubtful position or condition of a business
credit; generally, they must be Accounts or Bad Debt Reserve. at a given date. Also called
paid within 90 days. Statement of Financial Position or
Amortization (Page 14). Statement of Financial Condition.
Accounts Receivable (Page 10). Periodic charges to income to rec-
Amounts due a business from cus- ognize the distribution of the cost Basic Earnings per Common Share
tomers for goods and services sold of the company’s intangible assets (Page 33).
on credit; generally they must be over the estimated useful lives of Income available to common
paid within 90 days. those assets. shareholders for the period divided
by the weighted-average number
Accrual Method of Accounting Antidilution (to Earnings per of common shares outstanding for
(Page 39). Common Share) (Page 35). the period.
Method of accounting that recog- An increase in earnings (or
nizes revenue when earned and decrease in loss) per common Bonds (Page 18).
expenses when incurred in order to share that assumes that convertible Formal, secured or unsecured debt
appropriately match income with securities were converted, stock obligations specifying interest and
expenses in an accounting period. options and warrants were exer- repayment terms.
cised or other shares were issued
Accrued Expenses (Page 15). upon satisfaction of certain condi- Book Value per Share (Page 25).
The obligation to pay business tions. When antidilution occurs, The adjusted shareholders’ equity
expenses that were incurred, but not the per-share amount that it pro- for each class of stock divided by
paid, during an accounting period. duces is not used as the reported the number of shares of each such
per-share amount. class.
Accumulated Amortization
(Page 14). Antidilution Sequencing (Pages 34). Capitalization Ratio (Page 25).
A deduction from intangible assets Examination of potential common The relationship that each security
to show the total amount of peri- shares by order of most dilutive to (debt or equity) bears to total debt
odic charges to income over the least dilutive. If the security lowers and equity, less intangible assets,
estimated useful lives of those earnings per share relative to the expressed as a ratio.
assets. Also called Reserve for base earnings per share, calculate
Amortization. the earnings per share assuming Cash and Cash Equivalents
the conversion of the security. (Page 9).
Accumulated Depreciation Securities that are antidilutive are Generally, bank accounts and cur-
(Page 13). not included in the diluted earn- rency on hand, and short-term,
A deduction from fixed assets to ings per share calculation. highly liquid securities with a
show the total amount of periodic maturity under 90 days, such as
charges to income over the estimat- Asset (Pages 8, 9-14). U.S. Treasury bills.
ed useful lives of those assets. Also Something owned by and having
called Reserve for Depreciation. continuing value to its owner or a Cash Flows, Statement of
business. (Pages 2, 39).
Additional Paid-in Capital A report showing cash receipts
(Page 19). Audit (of Financial and disbursements compiled and
The total excess of the sharehold- Statements) (Page 1). totaled by operating, investing
ers’ investment in the company A systematic examination of a and/or financing activities.
over the par or stated value of its company’s financial statements to
common and preferred stock. Also determine if the amounts and dis- Certified Public Accountant (CPA)
called Paid-in Capital. closures in the reports are fairly (Page 1).
stated and follow generally accept- Professional title granted to people
American Institute of ed accounting principles. who pass a comprehensive test
Certified Public Accountants on accounting, auditing and
(AICPA) (Page 2). Available-for-Sale business law. CPAs usually perform
The major professional public Securities (Page 10). audits of a company’s financial
accounting group that sets stan- Securities not classified as held- statements.
dards of practice for Certified to-maturity or trading. They are
Public Accountants. carried at fair market value, with Changes in Shareholders’
any changes in the value (less Equity, Statement of (Pages 2, 36).
Allowance for Doubtful applicable taxes) reported in A report providing the details,
Accounts (Page 10). shareholders’ equity in the bal- by category, of all activity in all
44 Amounts deducted from the total ance sheet. When sold, any gain components of shareholders
accounts receivable balance to or loss will be realized and report- equity, for the period covered
recognize that some customers will ed in the income statement. by the report.
Common Dividend Yield only by the general credit of to compensate them for their
(Page 37). the issuer rather than certain of investment.
Dividends paid on each share of its assets.
common stock expressed as a per- Earnings per Common Share
centage of the market price of those Debt Amortization (Page 10). (Page 33).
shares. See also Dividend Yield. The practice of adjusting the origi- Net income reduced by preferred
nal cost of a debt instrument as dividends and divided by the aver-
Common Stock (Pages 19, 33). principal payments are received age outstanding number of com-
The par or stated value of the and any purchase discount or mon shares during the accounting
common stock (the basic owner- premium is written off to income period.
ship interest in a corporation) over the life of the instrument.
issued by a company as reported Estimated Useful Life (Page 12).
in its balance sheet. Debt-to-Equity Ratio (Page 23). The period of time over which the
The ratio of total debt (liabilities) to owner of an asset (physical or
Common Stock Ratio (Page 26). total shareholders’ equity. intangible) estimates that that asset
The percentage that common will continue to be of productive
stockholders’ equity reduced by Deferred Charges (Page 13). use or have continuing value.
intangible assets bears to total tan- Expenditures for items that will
gible capitalization (the sum of benefit future periods beyond one Extraordinary Items (Page 29).
shareholders’ equity and long-term year from the balance-sheet date. Nonoperating items that are both
debt reduced by intangibles). unusual and occur infrequently.
Deferred Income Taxes (Page 17).
Compensatory Stock Options The obligation to pay income Fair Market Value (Page 9).
(Page 33). taxes in future years generally The amount at which an item
See Stock Options. arising from transactions involving could be exchanged between
noncurrent assets and/or liabilities. willing unrelated parties, other
Contingently lssuable Shares than in a forced liquidation. It is
(Page 32). Depletion (Page 13). usually the quoted market price
Shares of stock the issuance of The process of recognizing, by a when a market exists for the item.
which depends on the occurrence charge against income, the reduc-
of certain events. tion in the cost of a natural Financial Accounting
resource (minerals, oil, gas) due to Standards Board (FASB) (Page 2).
Convertible Securities (Page 33). its withdrawal and use or sale. The independent, private-sector
A debt or equity security that may organization designated to estab-
under certain circumstances be Depreciation (Page 12). lish standards for financial
exchanged for or converted into Periodic charges to income to accounting and reporting. It is the
another security, generally com- recognize the cost of “wear and body that issues GAAP, generally
mon stock. tear” of a company’s fixed assets accepted accounting principles.
over the estimated useful lives of
Cost of Sales (Page 28). those assets. FIFO (Page 40).
The total cost to purchase and/or Acronym for First-In, First-Out.
manufacture all of the company’s Diluted Earnings per Common See First-In, First-Out.
products that were sold during a Share (page 33)
period. The amount of current earnings or Financial Leverage (Page 32).
loss per share reflecting the maxi- See Leverage (Financial).
CPA (Page 1). mum dilution (that is, the negative
See Certified Public Accountant. impact) assuming the issuance of all Financial Statement Ratio
potentially dilutive common shares. (Page 22).
Current Assets (Page 9). A mathematical relationship
Cash or other assets that will be Dilution (Page 33). between two or more amounts
converted to cash or consumed The reduction in common earnings reported in financial statements.
within the normal operating cycle, per share (or increase in loss) if Financial statement ratios can pro-
generally one year. convertible securities are converted, vide relative measures of, and
stock options and warrants are exer- insights into, the health, condition
Current Liability (Page 15). cised or other shares are issued. and performance of a company.
A liability that must be paid
within the normal operating Dividend Payout Percentage First-In, First-Out (Page 40).
cycle, generally one year. (Page 36). An inventory-costing method that
Dividends per share divided by states inventory at its most current
Current Portion of earnings per share, expressed as cost while charging the cost of
Long-Term Debt (Page 17). a percentage. sales in the order the inventory
The portion of long-term debt that was accumulated.
is due within one year of the Dividend Yield (Page 37).
balance-sheet date. The dividend paid on each share Fixed Assets (Page 12).
of each class of stock as a percent- Another term for the property,
Current Ratio (Page 22). age of the market price of those plant and equipment used in the
The relationship of current assets shares. See also Common operation of a business.
to current liabilities, expressed as Dividend Yield.
a ratio. Footnotes (Pages 2, 40).
Dividends (Pages 2, 36). Additional details and disclosures
Debentures (Page 18). Payments, generally declared by about the figures and information 45
Formal, unsecured debt obligations the Board of Directors, from contained in a company’s financial
(bonds or notes) that are backed retained earnings to shareholders statements.
Foreign Currency Translation Income Taxes (Page 29). Long-Term Debt (Page 18).
Adjustments (Page 21). The amount of income tax expense Borrowed funds due after one year
The cumulative adjustment, report- reported for the period. It is often from the balance sheet date. See
ed in the Equity section of the bal- referred to as the Tax Provision or Current Portion of Long-Term Debt
ance sheet, resulting from the Provision for Income Taxes. and Other Long-Term Debt.
translation of a foreign subsidiary’s
local currency financial statements Income Taxes Payable (Page 15). Long-Term Liabilities (Page 17).
into the currency of the parent The obligation to pay federal, for- Obligations that are due after one
company. eign, state and local income taxes year from the balance-sheet date,
that are due within one year from
Generally Accepted Accounting the balance-sheet date. Lower of Cost or Market Rule.
Principles (GAAP) (Page 1). (Page 11).
The rules and standards followed Intangible Assets (Page 13). The rule is that inventory should
in recording transactions and in Nonphysical assets with continuing be valued at its cost or market
preparing financial statements. value, such as goodwill, copy- value, whichever is lower. The
rights, trademarks and franchises. intent is to provide a conservative
Goodwill (Page 13). figure in valuing a company’s
An intangible asset that represents Interest (Page 29). inventory. See also Market Value.
the excess of the amount paid for Payments by borrowers of funds to
an acquired company over the fair compensate lenders for the use of Management Discussion and
market value of the net assets of their funds. Analysis (MD&A) (Page 1).
that company. Basically, it is the An SEC-required report in which
value of the name and reputation Interest Coverage (Page 31). management provides selected
of the acquired company. The number of times the annual financial data to highlight signifi-
interest on debt obligations is cov- cant trends in the company’s finan-
Gross Margin (Page 28). ered by income for the year before cial position or operating results.
The excess of sales over cost of considering interest on the debt
sales or the profit from sales before obligations and income taxes. Market Price (Page 11).
considering operating, general and The price at which a good can be
other expenses. Also called Gross Inventory (Pages 10-11). sold in the open market. See also
Profit or Product Profit. The cost of goods on hand Fair Market Value.
that were purchased and/or
Gross Margin Percentage manufactured or that are being Market Value (Pages 9, 11).
(Page 28). manufactured for sale to See Fair Market Value.
Gross margin expressed as a per- customers.
centage of sales. Also called Gross Marketable Securities
Profit Percentage or Product Profit Inventory Turnover (Pages 23-24). (Pages 9-10).
Percentage. The number of times the average Readily liquid securities (debt or
inventory is sold during the year. equity) that can be converted into
Held-to-Maturity Securities cash on very short notice.
(Page 10). Investment Securities (Page 14).
Debt securities that the holder/ Securities (debt or equity) held for Mortgage Bonds (Page 18).
owner has the ability and intent to strategic purposes and/or long-term Formal, secured debt obligations
hold to maturity. They are carried appreciation or income. that are backed by certain specific
at amortized cost (original cost less assets of the issuer.
Last-In, First-Out (LIFO).
principal payments and premium
(Page 40). Net Asset Value (Page 24).
or discount amortization).
An inventory-costing method that See Book Value.
Highly Leveraged (Page 32). states inventory at its earliest
cost while charging cost of sales Net Book Value (Page 24).
A company with a large proportion
at its latest cost (in the reverse See Book Value.
of bonds and preferred stock out-
standing relative to the amount of order that the inventory was
accumulated). Net Income/Loss (Page 29).
common stock. The final result of all revenue and
Leverage (Financial) (Page 32). expense items for the period. Also
Impairment (Permanent) of Loans
Relates a company’s long-term called Net Profit or Loss. Often
(Investments) (Page 14).
debt to its capital structure. referred to as the “Bottom Line.”
The probability that the lender
(investor) will not collect all Also, it is the practice of obtaining
Net of Taxes (Page 10).
amounts in accordance with the capital using borrowed funds
Term meaning the value or amount
loan agreement. or preferred stock, rather than
has been adjusted for the effects of
common stock.
applicable taxes.
Income Statement
(Pages 2, 26-36). Liability (Pages 8, 16-18).
Net Profit Ratio (Page 31).
Report summarizing the revenues An obligation to pay for assets or
Net income expressed as a }
and expenses and reporting the net goods or services acquired or to
percentage of sales.
income (or loss) of a business for repay borrowed funds.
an entire accounting period. Also Net Quick Assets (Page 23).
called the Statement of Earnings, LIFO (Page 40).
The excess of quick assets over
Statement of Profit and Loss, P&L Acronym for Last-In, First-Out.
current liabilities.
46 or Operating Statement. See Last-In, First-Out.
Notes Payable (Page 15). Property, Plant and Equipment Stock Option (Publicly Traded).*
Short- or long-term obligation, (Page 12). A security bought and sold in the
evidenced by a formal borrowing Assets not intended for sale that public securities markets that pro-
agreement (such as a promissory are used to manufacture, display, vides the holder the right, but not
note), to repay borrowed funds. warehouse and transport the necessarily the obligation, to buy
company’s products and house or sell a specified security in the
Operating Income or Loss its employees. See also Fixed quantity, at the amount, and
(Page 28). Assets. during the time period specified
The profit or loss generated by a in the option.
company’s normal, recurring oper- Quick Assets (Page 22).
ating activities before considering Assets that can be converted to Trading Securities (Page 9).
nonoperating items, income taxes, cash quickly. Securities (debt or equity) bought
gains or losses from disposals of and sold frequently, principally to
a segment of the business and Quick Assets Ratio (Page 23). generate short-term profits. They
extraordinary items. The relationship between quick are carried at fair market value,
assets and current liabilities, with any changes in the value
Operating Margin (Page 30). expressed as a ratio. reported in income.
Operating income expressed as a
percentage of sales. Retained Earnings (Page 20). Treasury Stock (Page 21).
The total profit or loss of the The total cost of any of the compa-
Other Long-Term Debt (Page 18). company less the total of all ny’s stock that has been repur-
All debt due after one year from dividends paid, since the chased or otherwise reacquired
the balance-sheet date that is not company’s startup. from shareholders and held in the
reported elsewhere in the balance company’s treasury.
sheet. Return on Equity (ROE) (Page 37).
Net income for the period Treasury Stock Method (page 34).
Paid-in Capital. expressed as percentage of average A method to calculate the effect on
See Additional Paid-in Capital. shareholders’ equity for the period. earnings per share of stock options
and warrants. All option proceeds
Par Value (Page 19). Securities and Exchange from the assumed conversion of in-
The nominal or face value of a Commission (SEC) (Page 2). the-money options are assumed to
security assigned by the issuer for The main securities regulatory be used to repurchase shares (that
balance-sheet reporting. It has no authority in the U.S. is, reacquired and held in the com-
relation to market value. pany’s treasury) at the average stock
Shareholders’ Equity
price for the period.
Permanent Impairment (Page 14). (Pages 8, 18-21).
See Impairment (Permanent) of The total of shareholders’ invest- Unrealized Gain/Loss (Page 21).
Loan (Investments). ments in the company and total The difference between the cost (or
profits or losses since the start-up previously reported fair market
Preferred Dividend Coverage of the company, less all dividends value) of an asset held at the bal-
(Page 32). and/or capital distributions, unreal- ance sheet date and its fair market
The number of times the preferred ized gain on available-for-sales value at that date.
dividend is covered (earned) by net securities and any foreign currency
income. translation adjustments since the Warrant (Page 33).
company’s start-up. A security, generally evidenced by
Preferred Stock (Page 19).
a certificate, giving the holder the
An equity security that entitles its Stated Value (Page 19). right to purchase securities, such
holders to certain preferences over The nominal or face value of a as common stock, at a specified
common shareholders, such as div- security assigned by the issuer in price. Warrants are common stock
idends, liquidation value and con- lieu of par value for balance-sheet equivalents and may dilute earn-
vertibility into other securities, etc. reporting. It has no relation to ings per common share.
market value.
Preferred Stock Ratio (Page 26).
Working Capital (Page 22).
The percentage that preferred Statement of Cash Flows. The excess of current assets over
stockholders’ equity bears to total See Cash Flows, Statement of. current liabilities.
tangible capitalization (the sum of
shareholders’ equity and long-term Statement of Changes in *Note: This definition is not found
debt reduced by intangibles). Shareholders’ Equity.
within this booklet. We have
See Changes in Shareholders’
Prepaid Expenses (Page 11). included the definition in the
Equity, Statement of.
Payments in advance for goods or glossary only to help better define
services, which will be consumed Stock Option, Compensatory the differences between the two
and deducted from income during (on Unissued Stock) (Page 33). types of stock options.
the future, normal operating cycle, An agreement, usually between
generally one year. an issuer and its executives/
employees, that grants the right
Price-Earnings Ratio (Page 35). to purchase securities, such as
The comparison of the market common stock, at a specified
price of a share of stock to the price. Options are common stock
earnings per share of that stock, equivalents and may dilute earn- 47
expressed as a ratio. Also called ings per common share.
the P/E ratio.



INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . INSIDE FRONT COVER

HOW TO READ A FINANCIAL REPORT . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

A FEW WORDS BEFORE BEGINNING . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

CONSOLIDATED FINANCIAL STATEMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . 4

THE BALANCE SHEET . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

JUST WHAT DOES THE BALANCE SHEET SHOW? . . . . . . . . . . . . . . . . . . . . 22

THE INCOME STATEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

ANALYZING THE INCOME STATEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . 30


THE STATEMENT OF CASH FLOWS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

ADDITIONAL DISCLOSURES AND AUDIT REPORTS . . . . . . . . . . . . . . . . . . . 40

THE LONG VIEW . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

SELECTING STOCKS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

GLOSSARY OF SELECTED TERMS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

Known “from Wall Street to Main Street”—and worldwide—Merrill Lynch is a global
leader in the financial services industry. As a public service, Merrill Lynch wants to share
some of its expertise in, and knowledge of, financial reporting through this booklet.

We hope this booklet will serve as a valuable resource to help readers learn how to read
and analyze a company’s annual report. Through it, readers can learn that an annual
report is not just a jumble of numbers and mind-numbing data. Read with understanding
and analytical insight, the numbers and data in an annual report can tell an interesting,
meaningful and fascinating story.
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