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&Reading
UnderstandingFinancial Statements
A Layman’s Guide to Financial Reporting
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Introduction
Financial statements are an important managementtool. When correctly prepared and properly inter-preted, they contribute to an understanding of thecurrent financial condition, problems and possibil-ities of a company.
This explanation has been prepared to help finan-cial and non-financial managers and own-ers make better use of the information inthe financial statements.
Specifically, this brochure describes four financialstatements:
The Balance Sheet, which is sometimesreferred to as the Statement of FinancialCondition or Statement of FinancialPosition.
The Income Statement, which issometimes referred to as theStatement of Operations or theProfit and Loss Statement.
The Statement of Cash Flows.
The Statement of Comprehensive Income, whichis a new statement that certain companies present.
These statements are prepared and presented usingtechnical terms and rules that are becomingincreasingly complex. Interpretation of these state-ments may be a formidable challenge to manymanagers and owners.
We firmly believe that — no matter how technically correct they are — financial
statements are not useful unless they are actually used in making business
decisions. When the statements “gather dust” because managers and owners do not understand what they are saying, we feel an
obligation to help. We hope this guideto Reading and Understanding Financial
Statements will help you to use financial statements in making decisions, monitoring your business and planning for future growth.
© 1989-2002 Altschuler, Melvoin and Glasser LLP
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Reporting ofBusiness Activity Balance Sheet
Financial condition
at a point in time
Balance SheetFinancial condition
at a point in time
Income StatementSummary of activity
for a period of time
Statement of
Cash FlowsSummary of activity
for a period of time
Beginning of YearJanuary 1, 2002
End of YearDecember 31, 2002
The Balance Sheet is a “snapshot”: it represents, at amoment in time, the financial position of the businessentity. It needs to be compared to other “snapshots” toprovide meaningful information on changes in financialposition. For that reason, the balance sheet from one ormore preceding years is usually presented.
The other primary financial statements — the IncomeStatement, Statement of Cash Flows and Statement of
Comprehensive Income — present a summary of activ-ities over a period of time, usually a fiscal year. TheIncome Statement presents revenues less associatedexpenses and the resulting net income. The Statementof Cash Flows provides information about the sourcesand uses of cash, and the Statement of ComprehensiveIncome shows changes in certain items contained inthe equity section of the balance sheet.
Statement of
Comprehensive Income
Summary of activity
for a period of time
How Do Financial Statements Relate to the Passage of Time?
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The Balance Sheet (or Statement of Financial Position/Condition) is so named because it represents the following equation:
At any point in time this basic equation holds,although the amounts assigned to the individual elements will fluctuate.
Assets increase or decrease as resources are obtained,disposed of, become more or less valuable, or are usedup (expensed) in the course of operations.
Liabilities increase or decrease as obligations to credi-tors are incurred or repaid. In some cases, the amountsof liabilities may need to be estimated (referred to as“accruals”) and are subject to adjustment (upward ordownward) in later periods. In limited circumstances,recorded liabilities are contingent upon the occurrence offuture events, and may not come to pass at all.
Equity increases or decreases as a result of income orloss from operations of the business. It also increaseswhen the owners contribute capital to the business, anddecreases when the capital is withdrawn or dividendsare paid.
The Income Statement (or Statement of Operations) isa summary of revenues and expenses, the latter usuallybroken down (or summarized) by major categories.
Income from operations is an important measure of theentity’s performance, since it represents the pre-taxincome earned (or loss incurred) from the core operationsof the business, before considering certain financialcosts, other non-operating items and extraordinarygains or losses.
Other income and expense includes financial costs (inter-est expense) and other items that are not directly relatedto the primary purposes of the business, such as losses onabandoned or sold assets.
Revenue (or sales)– Cost of Sales
= Gross profit – Selling expenses – Administrative expenses
= Income from operations+/– Other income and expense
– Income taxes
= Income before extraordinary items
+/– Extraordinary items
= Net income
OVERVIEW: The Balance Sheet
OVERVIEW: The Income Statement
Assets Liabilities(Resources of = (Amounts owed tothe business) outside creditors)
+
Equity(Or net worth)
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The Statement of Cash Flows reports the sources and uses of cash for the period, as analyzed into threemajor classifications:
Operations include the cash effects of essentially allitems identified in the Income Statement, such assales, costs of sales, operating expenses and extraordinary items.
Investing activities include the purchase of propertyand equipment or the proceeds from their disposition,and also certain transactions involving investments insecurities or other non-operating assets.
Financing activities include the borrowing and repayment of debt, as well as the contribution andredemption of equity capital and the payment of dividends to owners.
Cash provided by or applied to operations
+/– Cash provided by or applied to investing
activities
+/– Cash provided by or applied to financing
activities
= Net increase or decrease in cash
Extraordinary items are defined as those which areunusual and occur infrequently, and include such losses as those from natural disasters, expropriation of foreign properties and gains or losses arising fromextinguishment of debt prior to its scheduled maturity.While not extraordinary per se, certain other items,including the results of discontinued operations andthe cumulative effects of changes in accounting princi-
ples, are also presented separately at the bottom of theIncome Statement, where the reader can distinguishthese from ongoing results of operations.
Net income or loss is the all-inclusive “bottom line”that reflects all economic activity, by the enterprise forthe period being reported on (year, quarter, month,etc.), except for transactions with owners.
OVERVIEW: The Statement of Cash Flows
The Statement of Comprehensive Income applies tocompanies whose balance sheet equity includes certain items such as foreign currency adjustments,pension liability adjustments and gains and losses oncertain types of investments. Companies that do not
have these items on their balance sheets will not need to present this statement. Companies that do have these items on their balance sheets may presentthis statement separately or combine it with theStatement of Income.
OVERVIEW: The Statement of Comprehensive Income
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In addition to the basic financial statements, mostfinancial statements which have been prepared fordelivery to third parties (i.e., those outside the report-ing entity) will have a section of Notes to FinancialStatements.
The Notes to Financial Statements set forth the majoraccounting principles used in developing the amountsreported in the statements (where a choice was madefrom among alternative generally accepted accountingprinciples or “GAAP”), and also provide additionaldetails about major accounts and transactions. Examplesof the latter include details aboutlong-term leases, long- andshort-term debt (includinginterest rates and maturities),transactions with relatedparties, contingentliabilities andcommitments.
Financial reportsmay also containsupplementaryschedules, which pro-vide more detailed informa-tion about major expense captions(such as administrative expenses) or otheritems appearing in the basic financial statements.Except in rare instances, the presentation of supplementary schedules is not required undergenerally accepted accounting principles, but repre-sents a choice made by the preparer of the financialstatements.
If independent accountants have been associated withthe financial statements, their report will be includedwith the statements. The report will identify what pro-fessional service was provided — an audit, a review or
a compilation — and indicate what conclusions, if any,were reached regarding the financial statements. In thecase of an audit, the independent accountant will pro-vide positive assurances that the financial statements“present fairly” the financial position, results of opera-tions and cash flows of the company in accordancewith generally accepted accounting principles, if it canbe concluded that such is the case. If the statementscontain a departure from generally accepted accountingprinciples, or if the audit was subject to a scope limita-tion, or if there is doubt about the entity’s ability tocontinue as a going concern — these must also bedescribed in the auditor’s report. In a review engage-ment, at best the accountant will express negativeassurance — i.e., that based on limited proceduresnothing came to the accountant’s attention that would
indicate that the financial statements were not fairlypresented. An accountant conducting a compi-
lation merely assists the company inassembling the financial state-
ments, and offers neitherpositive nor negative
assurances aboutwhether they are present-
ed fairly. The level ofassurance offered by the
independent accountant onsupplementary schedules may
be lower than that offered on thebasic financial statements. Thus,
the basic statements may have beenreviewed, and the accountant may
have also reviewed the supplementary information, oralternatively the accountant may only have compiledthe supplementary data. If the basic financial state-ments have been audited, the supplementary informa-tion may have also been subjected to audit procedures,or, if not, the accountant’s report will note that the sup-plementary data have not been audited.
Other Elements of Financial Reports
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ABC CorporationBalance Sheets
December 31, 2002 and 2001
Assets2002 2001
Current AssetsCash and cash equivalents. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 377,000 $ 314,000Investments in trading securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137,000 115,000Accounts receivable, less allowance for doubtful accountsof $12,500 and $8,400 in 2002 and 2001, respectively . . . . . . . 1,178,000 1,175,000
Inventories. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 458,000 424,000Prepaid expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142,000 153,000
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,292,000 2,181,000
Property and EquipmentLand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000 1,000,000Building and improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,602,000 1,292,000Machinery and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,447,000 9,957,000
Total property and equipment. . . . . . . . . . . . . . . . . . . . . . . . . 13,049,000 12,249,000
Less accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,906,000) (3,660,000)
Net property and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . 9,143,000 8,589,000
Other Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201,000 234,000
Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,636,000 $11,004,000
Liabilities and Stockholders’ EquityCurrent Liabilities
Notes payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 110,000 $ 110,000Current maturities of long-term debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261,000 282,000Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 809,000 796,000Income taxes payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 200,000Accrued expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 544,000 436,000
Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,924,000 1,824,000
Other LiabilitiesLong-term debt, less current maturities . . . . . . . . . . . . . . . . . . . . . . . . . . 2,302,000 2,466,000Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,171,000 1,854,000
Total other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,473,000 4,320,000
Total liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,397,000 6,144,000
Stockholders’ Equity9.5% cumulative preferred stock, par value, $10 per share,36,000 shares authorized, issued and outstanding . . . . . . . . . . . . . 360,000 360,000
Common stock, par value, $1 per share, 1,000,000 shares authorized, 150,000 and 146,000 shares issued in 2001 and2001, respectively, including shares held in treasury. . . . . . . . . . 150,000 146,000
Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,639,000 1,575,000Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,120,000 2,809,000Less cost of common stock held in treasury — 4,400 shares . . (30,000) (30,000)
Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,239,000 4,860,000
Total liabilities and stockholders’ equity . . . . . . . . . . . . . . $11,636,000 $11,004,000
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Current Assets are those assets of a company whichare reasonably expected to be realized in cash, sold or consumed during the normal operating cycle of thebusiness or one year, if less. These assets generallyinclude cash and cash equivalents such as moneymarket accounts, certain investments in debt andmarketable equity securities, accounts receivable,inventories and certain prepaid expenses such asinsurance.
Property and Equipment are assets of adurable nature and a relatively long lifethat are used in the regular operations ofthe business.
Accumulated Depreciation is the aggre-gate of charges to expense or to write-offthe cost of property and equipment overits estimated useful life. It is the result ofa bookkeeping entry and does not repre-sent any current cash outlay.
Other Assets may consist of intangibles,such as goodwill, patents or trademarks;assets, such as the cash surrender valueof life insurance; and prepaid expenses,including unexpired multi-year insurancepremiums.
In certain industries, such as construction and realestate, assets are often presented without being classi-fied in the categories shown in this example.
Current Liabilities are those obligations that are rea-sonably expected to be paid using current assets. Theseliabilities generally include notes payable, currentmaturities of long-term debt, accounts payable,income taxes payable and accrued expenses such assalaries and interest.
Long-term Debt is debt less current maturities and
includes those obligations that are not expected to be paid within one year. Bonds and mortgages arecommon long-term liabilities.
Deferred Income Taxes result from differencesbetween taxable income and accounting income.Common items giving rise to deferred income taxesinclude depreciation methods that are allowed by taxlaw but do not match the estimated useful life of the
asset, deferred compensation that is notdeductible until paid but gives rise tocurrently reported expense, and certainprepaid income such as rent received bythe business, which is deferred to laterperiods for accounting purposes, butwhich is taxed currently.
Common Stock and Preferred Stock,if any, represent the ownership interestsin a corporation. The preferred stockwill have preferential rights as to divi-dends or in the event of liquidation ofthe business. Common stock representsthe residual ownership interest.
Additional Paid-in Capital is the differ-ence between the amount of money
obtained by a corporation on the issuance of its ownstock and the par value of the stock.
Retained Earnings are the portions of all the company’s past earnings that were not distributed tothe owners.
Treasury Stock is stock that was once issued by thecompany but later was reacquired. Treasury stockreceives no dividends and has no vote while held bythe company.
Total Liabilities and Stockholders’ Equity is alwaysequal to total assets.
“DeferredIncome Taxesresult from differences
between taxableincome andaccountingincome.”
The Balance Sheet in Greater Detail
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ABC CorporationIncome Statements
For the Years Ended December 31, 2002 and 2001
2002 2001
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7,934,000 $5,891,000
Cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,816,000 5,155,000
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,118,000 736,000
Selling, general and administrative expenses. . . . . . . . . . . . . . . . . . . . . . . . 100,000 100,000
Income from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,018,000 636,000
Other income and expenseInterest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (242,000) (215,000)
Dividend income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000 1,000
Interest income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 44,000
Other items, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 —
Other (expense), net. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (178,000) (170,000)
Income before provision for income taxesand extraordinary item . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 840,000 466,000
Provision for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325,000 194,000
Income before extraordinary item . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515,000 272,000
Extraordinary item, less applicable income tax benefitof $32,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (50,000) —
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 465,000 272,000
Retained earnings — beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,809,000 2,670,000
Dividends paid. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (154,000) (133,000)
Retained earnings — end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,120,000 $2,809,000
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Sales result when a company provides customers thoseproducts or services that it is in business to sell.
Cost of Goods Sold represents the cost of producinggoods for sale. For example, cost of goods sold in amanufacturing company is comprised of direct labor,direct materials and overhead.
Gross Profit is a measure of the profitcontribution from the sales of productsand/or services, before considering administrative overhead.
Selling, General and AdministrativeExpenses are costs associated with the saleand delivery of products and the general costs associated with the operation and management of a business, other than thosecharged to cost of goods sold.
Income from Operations is another measure of profitability, equal to gross profit less selling, general and administra-tive costs.
Other Income and Expense arise from transactions notrelated directly to the primary operations of the business.Items frequently reported in this non-operating categoryare dividend income, interest income and other items suchas gains or losses from sale of property and equipment.
Interest Expense refers to interest paid periodically during the term of a loan by a borrower to the lender for the use of
money. Interest expense must be separatelystated, usually as a subcategory of other
income and expense.
Provision for Income Taxes is an estimate ofthe amount of tax that will eventually be paid,or has been paid, on the reported earnings.
Extraordinary Items are income or lossesof an unusual and infrequent nature.
Net Income is the “bottom line” measure of the earnings performance of the companyfor the period reported on, after consideringall elements of income and expense.
The Income Statement in Greater Detail
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ABC CorporationStatements of Cash Flows
For the Years Ended December 31, 2002 and 2001
2002 2001
Cash Provided by (Applied to) Operating ActivitiesNet income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 465,000 $ 272,000Adjustments to reconcile net income to net cash providedby operating activitiesDepreciation and amortization. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 479,000 300,000Deferred income taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317,000 69,000Gain on sale of property and equipment . . . . . . . . . . . . . . . . . . . . . (28,000) (59,000)Changes in operating assets and liabilitiesAccounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,000) (64,000)Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (34,000) 129,000Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000 32,000Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,000 22,000Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108,000 (110,000)
Net cash provided by operating activities . . . . . . . . . . . . 1,328,000 591,000
Cash Provided by (Applied to) Investing ActivitiesPurchase of property and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,010,000) (1,430,000)Proceeds from disposal of property and equipment. . . . . . . . . . . . 38,000 7,000Purchase of investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (22,000) —
Net cash (applied to) investing activities . . . . . . . . . . . . . (994,000) (1,423,000)
Cash Provided by (Applied to) Financing ActivitiesAdditional long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137,000 863,000Retirement of long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (322,000) (560,000)Issuance of common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68,000 466,000Purchase of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — (18,000)Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (154,000) (133,000)
Net cash provided by (applied to) financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (271,000) 618,000
Increase (decrease) in cash and cash equivalents . . . . . . . . . . . . . . . . . . 63,000 (214,000)
Cash and cash equivalents, beginning of year . . . . . . . . . . . . . . . . 314,000 528,000
Cash and cash equivalents, end of year . . . . . . . . . . . . . . . . . . . . . . . . $ 377,000 $ 314,000
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Operating Activities include all transactions and otherevents that are the result of delivering or producinggoods for sale and providing services.
Cash inflows from operating activities include cashreceipts from the sale of goods or services and frominterest and dividend income. Cash outflows for oper-ating activities include cash payments for the purchaseof inventory, wages and benefits to employees, to government taxing bodies, as interest tolending institutions and to various othersuppliers.
Investing Activities include lendingmoney and collecting on those loans,acquiring and selling investment securi-ties, and acquiring and selling produc-tive assets such as land and equipment.
Cash inflows from investing activitiesinclude principal repayments from bor-rowers, proceeds from sales of loansand receipts from sales of assets such asinvestment securities or property andequipment. Cash outflows for investingactivities include loans made, loans pur-chased and payments to acquire assets such as invest-ment securities or property and equipment.
Financing Activities include obtaining resources fromowners, providing owners with a return on (of) their
investment, obtaining resources from creditors andrepaying amounts borrowed. Interest on borrowings,however, is an operating activity.
Cash inflows from financing activities include pro-ceeds from the issuance of the company’s stock andfrom long- and short-term borrowings. Cash outflowsfor financing activities include payment of dividends,cash paid to reacquire the company’s stock and repay-
ment of amounts borrowed.
The form of the cash flow statementillustrated on page 10 is the so-called“indirect method” favored by mostcompanies. However, an alternative for-mat, the “direct method,” is also accept-able. Under that approach, the CashProvided by (Applied to) OperatingActivities section will list each majorsource or use of cash which correspondsto major captions in the income statement.For example, corresponding to sales willbe the cash flow statement caption “CashCollected From Customers”; correspond-ing to cost of sales will be “Cash Paidto Suppliers”; etc. If the direct method
is used, the cash flow statement (or a supplementaryschedule thereto) will present the reconciliationbetween net income and cash from operations — whichwill closely resemble the cash from operations sectionof the statement illustrated on page 10.
“Cash outflowsfor investing
activities includeloans made,
loans purchased . . .”
The Statement of Cash Flows in Greater Detail
The Statement of Comprehensive IncomeCertain companies present the Statement of Compre-hensive Income. This statement is only presented whenthe equity section of the company’s balance sheet contains adjustments relating to pensions, foreign currencies or certain types of investments. The changesin these items from period to period, instead of beingreflected on the income statement as part of net income,are reflected directly on the balance sheet. TheStatement of Comprehensive Income simply reconcilesthe change in these items for the periods presented.
There are a variety of ways that this information canbe presented. It can be simply added to the bottom ofthe income statement (which would be retitled theStatement of Income and Comprehensive Income),shown as a separate statement or shown in a statementreconciling all changes in the equity section of the balance sheet which would be titled the Statement ofChanges in Stockholders’ Equity.
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Although the basic financial statements — discussed in the preceding sections — do present the company’sfinancial position, results of operations and cash flows,there are other important disclosures, both mandatoryand voluntary, that cannot be incorporated on the faceof the statements. For this reason, most complete setsof financial statements will include asection of notes after the basic state-ments. (These are sometimes still called“footnotes,” a term that is a holdoverfrom a simpler era when these disclo-sures were actually presented at thebottom of the financial statements.)
Certain notes are always found inGAAP financial statements. Forexample, the “summary of signifi-cant accounting policies,” usuallythe first note, identifies whichamong equally acceptable GAAPthe company has elected to use(e.g., straight line versus acceler-ated depreciation, LIFO versus FIFOinventory costing, etc.). Other notes will only be presented when conditions warrant (e.g., details of debt maturities, capital lease obligations, related party transactions, major customers, etc.). Finally, some disclosures will appear because management feels they give useful insight into the company’s economicprospects (e.g., details of long-term contracts with cus-tomers, summary of key ratios, financial highlights).
Notes are considered to be an integral part of the basicfinancial statements. Thus, standards for accuracy andclarity apply equally to the notes, and the independentaccountant must apply the same level of service (audit,review or compilation) to the notes as to the basicfinancial statements themselves. If well-written andorganized, notes should help the user to better under-stand the financial statements and the reporting entity’s
financial and operating prospects.However, because of the substantialamount of detail they often contain,the notes do require a careful studyand a commitment of effort by thereader.
Many financial statements also containa section of supplementary information.Usually this information is in the natureof additional detail (e.g., the elementscomprising “selling expenses”), althoughsometimes it is a recasting of the basicfinancial statements on an alternative basisof accounting (such as FIFO inventorycosting when the basic statements were on
the LIFO basis). Supplementary information may havereceived the same level of attention from the indepen-dent accountant as the basic statements and notes, or itmight have a lesser degree of assurance associated with it. In either case, the accountants’ report letter(s)will indicate the responsibility they assume, if any.
Footnotes to Financial Statements and Supplementary Schedules
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Ratios To Measure Return on Investments
Measures the annual percentage yield on the investment made by the owners.
Measures the annual percentage yield on the gross investment in the business, including that financed by theowners as well as that financed by creditors. The relationship between the returns on assets and on equity isindicative of the effect of the business’s financial leverage — if the leverage is positive, the return on equity will be greater than the return on assets.
1. Return on equity
Net income (Income Statement)Average stockholders’ equity (Balance Sheet)
465,000(5,239,000 + 4,860,000) ÷ 2
Ratio Example*
= 9.2%
2. Return on assets
Net income (Income Statement)Average total assets (Balance Sheet)
465,000(11,636,000 + 11,004,000) ÷ 2
Ratio Example*
= 4.1%
The information contained in the basic financial state-ments and notes can and should be used to provideinsight into the financial strength and earnings capacityof the business. This extends beyond such single state-ment captions as “net income,” and necessitates thatrelationships between accounts be examined. While analmost unlimited number of such ratios and compar-isons are possible, a relatively small group of these aretraditionally the object of most readers’ attention.
The nature of the analysis depends on the perspectiveof the reader. For example, the short-term note holderwould be primarily concerned with the company’sability to pay its current obligations. The holder of
long-term debt might look to both historical and projected earnings and cash flows. The stockholders,current and future, would share a viewpoint similar tothat of the long-term debtholder, with perhaps moreconcern for earnings (vis-a-vis cash flows) and growthtrends than the creditors might exhibit.
The management of a company is concerned with allof the above factors and, in addition, needs financialinformation that is useful for decision-making purposes.
A selection of the financial ratios that are most oftencomputed to analyze a business is shown on the following pages.
Using the Financial Statements To Analyze the Performance of the Business
*Figures in examples are from the sample financial statements presented earlier.
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Ratios To Measure Safety and Liquidity
1. Net working capital
Current assets (Balance Sheet)Current liabilities (Balance Sheet)
$2,292,000–1,924,000$ 368,000
–
Example*
2. Current ratio
Current assets (Balance Sheet)Current liabilities (Balance Sheet)
$2,292,000$1,924,000
Ratio Example*
= 1.19:1
3. Debt to equity ratio
Total liabilities (Balance Sheet)Stockholders’ equity (Balance Sheet)
$6,397,000$5,239,000
Ratio Example*
= 1.22 times
4. Times interest earned
Income before interest and taxes (Income Statement)Interest expense (Income Statement)
$840,000 + 242,000$242,000
Ratio
= 4.5 times
Example*
5. Debt service ratio
Income before interest and taxes (Income Statement)Interest expense plus amounts of scheduled debt repay-ments (Income Statement and Statement of Cash Flows)
$840,000 + 242,000$242,000 + 322,000
Ratio
= 1.9 times
Example*
*Figures in examples are from the sample financial statements presented earlier.
Indicates the ability to meet short-term obligations, reporting the excess of current assets over current liabilities.
Also indicates the ability to pay current liabilities as they mature, providing the ratio of current assets to currentliabilities. A ratio of 1:1 or greater corresponds to positive net working capital.
Indicates the balance between total equity ownership (common and preferred stockholders) and amounts due tocreditors. The greater the number, the “more leveraged” is the company.
Measures the ability of a company to cover the payment of interest to creditors.
This ratio is an indicator of the company’s ability to pay both the interest and the current principal installments onits outstanding debt and suggests the degree of safety for creditors concerning currently due debt service obligations.
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1. Collection period
Average accounts receivable (Balance Sheet)Average daily sales (Income Statement)
(1,178,000 + 1,175,000) ÷ 27,934,000 ÷ 365
Ratio Example*
Ratios To Measure Operating Efficiency
1,176,50021,737
= = 54.1 days
Measures the number of days’ sales that are uncollected in average accounts receivable, providing an idea of howsuccessful the firm is in collecting its customer debt.
2. Receivable turnover ratio
Total sales (Income Statement)Average accounts receivable (Balance Sheet)
7,934,000(1,178,000 + 1,175,000) ÷ 2
Ratio Example*
= 6.7 times
An alternative, but equivalent, measure of the efficiency of the company’s receivable collection efforts. If thecompany also makes sales for cash, “total credit sales” should be substituted for “total sales.”
3. Number of days’ sales in inventory
Average inventory (Balance Sheet)Average daily cost of sales (Income Statement)
(458,000 + 424,000) ÷ 26,816,000 ÷ 365
Ratio Example*
= 23.6 days441,00018,674
=
4. Inventory turnover ratio
Cost of goods sold (Income Statement)Average inventory (Balance Sheet)
6,816,000(458,000 + 424,000) ÷ 2
Ratio Example*= 15.5 times
An indicator of the amount of inventory maintained relative to the company’s sales (as measured by cost ofgoods sold).
An alternative measure of how quickly inventory is sold.
*Figures in examples are from the sample financial statements presented earlier.
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SUMMARY
Financial analysis involves many different
approaches; the ratio analysis presented on the
preceding pages is only one of several means of
gaining an understanding about a company from
its financial data. Other approaches, such as the
careful study of the financial statement notes,
examination of the company’s accounting policies,
and an analysis of operations by division or product-
line should also be considered. We can assist in
developing other procedures that will be useful on
a day-to-day operating basis.
We want your financial statements to be used and
useful. If you would like further information,
please call.
RUF 1/02
