WEB-APPENDIX E*

FINANCIAL STATEMENTS

Acorporation's financial statements are summaries of the decisions made by management and are the subject of this appendix. These decisions include operating, financing, and investment decisions. Throughout this book we have primarily focused on the financing decision (i.e., capital structure decision) and investment decision (i.e., capital budgeting decision). The financial statements should furnish information that can be utilized by the suppliers of capital to be able to forecast future cash flows and the riskiness associated with those forecasts.

There are four basic financial statements: the balance sheet, the income statement, the statement of cash flows, and the statement of shareholders’ equity. We describe each in this appendix.¹ The tools for financial analysis that suppliers of capital can use to assess a firm's performance are the subjects of Web-Appendix F.

E.1 ACCOUNTING PRINCIPLES

The accounting data in financial statements are prepared by the firm's management according to a set of standards, referred to as generally accepted accounting principles (GAAP). Generally accepted accounting principles are not one set of standards, but rather a hierarchy of accounting principles that are promulgated from a number of sources.

The financial statements are prepared using several assumptions that affect how suppliers of capital use and interpret the financial data. Following are the key assumptions:

1. Transactions are recorded at historical cost, not at market or replacement value.
2. The appropriate unit of measurement is the dollar.
3. The statements are recorded for predefined periods of time (generally, they cover a chosen fiscal year or quarter).
4. The business will continue as a going concern.
5. Statements are prepared using accrual accounting and the matching principle.
6. Statements are prepared assuming conservatism.

The first four assumptions are straightforward. Let's take a closer look at the last two assumptions.

Assumption 5 is important to understand because most businesses use an accounting method known as accrual accounting. Under accrual accounting, income and revenues are matched in timing such that income is recorded in the period in which it is earned and expenses are reported in the period in which they are incurred in an attempt to generate revenues. The result of the use of accrual accounting is that reported income does not necessarily coincide with cash flows. Because the financial analyst is concerned ultimately with cash flows, he or she often must understand how reported income relates to a company's cash flows.

Assumption 6 means that in instances where more than one interpretation of an event is possible, the financial statements are to be prepared using the most conservative interpretation.

In addition to the above six assumptions, financial statements are prepared with the understanding that full disclosure provides information beyond the financial statements. The requirement that there be full disclosure means that, in addition to the accounting numbers for such accounting items as revenues, expenses, and assets, narrative and additional numerical disclosures are provided in notes accompanying the financial statements.

E.2 THE BALANCE SHEET

The balance sheet is a report of the assets, liabilities, and equity of a firm at a point in time, generally at the end of a fiscal quarter or fiscal year. There are three components of the balance sheet: assets, liabilities, and equity. The relation between assets, liabilities, and equity, referred to as the accounting identity, is:

Assets = Liabilities + Equity

Assets are anything that the firm owns that has a value. These assets may be tangible (e.g., inventory, plant, and equipment) or intangible (e.g., a patent). Assets may also be current or long term, depending on how fast the company would be able to convert them into cash. The most liquid assets of the company are the current assets, consisting of cash, marketable securities, accounts receivable, and inventories.

Liabilities, also referred to as debt, includes not only the explicit contracts that a company has, in terms of short-term and long-term debt obligations, but also includes obligations that are not specified in a contract, such as environmental obligations or obligations to retired employees when a corporation has a defined benefit pension plan. Current liabilities are obligations due within one year or one operating cycle (whichever is longer). Included in current liabilities are accounts payable, wages and salaries payable, current portion of long-term indebtedness, and short-term bank loans. Obligations that are due beyond one year are classified as long-term liabilities.

The equity of a corporation represents the ownership interest. The book value of equity, which for a corporation is often referred to as shareholders’ equity or stockholders’ equity, is basically the amount that investors paid the company for their ownership interest, plus any earnings (or minus any losses), and minus any distributions to owners. For a corporation, equity is the amount that investors paid the corporation for the stock when it was initially sold, plus or minus any earnings or losses, less any dividends paid. Keep in mind that for any company, the reported amount of equity is an accumulation over time since the company's inception.

E.3 INCOME STATEMENT

The income statement is a summary of operating performance over a period of time (e.g., a fiscal quarter or a fiscal year). The statement begins with the revenue of the company over a period of time and then subtracts the costs and expenses related to that revenue. The bottom line of the income statement consists of the owners’ earnings for the period. To arrive at this “bottom line,” we need to compare revenues and expenses.

The basic idea of the structure of the income statement is to present the operating results first, followed by non-operating results. The cost of goods sold is deducted from revenues, producing a gross profit; that is, a profit without considering all other, general operating costs. These general operating expenses are expenses related to the support of the general operations of the company, which includes salaries, marketing costs, and research and development. Depreciation, which is the amortized cost of physical assets, is also deducted from gross profit.

At this point, the operating income is obtained, summarizing the company's performance with respect to the operations of the business. But there is generally more to a company's performance. From operating income, interest expense is subtracted and any interest income is added. Further, adjustments are made for any other income or cost that is not a part of the company's core business. There are then a number of other items that may appear as adjustments to arrive at net income. One of these is extraordinary items, which are defined as unusual and infrequent gains or losses.

E.3.1 Earnings Per Share

Companies provide information on earnings per share (EPS) in their annual and quarterly financial statement information, as well as in their periodic press releases. Generally, EPS is calculated as net income, divided by the number of shares outstanding. Companies must report both basic and diluted earnings per share.

Basic earnings per share is net income (minus preferred dividends), divided by the average number of shares outstanding. Diluted earnings per share is net income (minus preferred dividends), divided by the number of shares outstanding considering all dilutive securities (e.g., convertible debt, options). Diluted earnings per share, therefore, gives the shareholder information about the potential dilution of earnings. For companies with a large number of dilutive securities (e.g., stock options, convertible preferred stock or convertible bonds), there can be a significant difference between basic and diluted EPS. You can see the effect of dilution by comparing the basic and diluted EPS.

E.4 STATEMENT OF CASH FLOWS

The statement of cash flows is the summary of a firm's cash flows, summarized by operations, investment activities, and financing activities. By studying the cash flows of a company over time, investors can gauge a company's financial health. For example, if a company relies on external financing to support its operations (i.e., if it relies on cash flows from financing and not from operations) for an extended period of time, this is a warning sign of financial trouble up ahead.

Cash flow from operations is cash flow from day-to-day operations. Cash flow from operating activities is basically net income adjusted for (1) noncash expenditures, and (2) changes in working capital accounts. The adjustment for changes in working capital accounts is necessary to adjust the net income figure determined using the accrual accounting method to a cash flow amount. Increases in current assets and decreases in current liabilities are positive adjustments to arrive at the cash flow; decreases in current assets and increases in current liabilities are negative adjustments to arrive at the cash flow.

Cash flow for/from investing is the cash flow related to the acquisition (purchase) of plant, equipment, and other assets, as well as the proceeds from the sale of assets. Cash flow for/from financing activities is the cash flow from activities related to the sources of capital funds (e.g., buyback common stock, pay dividends, issue bonds).

The sources of a company's cash flows can reveal a great deal about the company and its prospects. For example, a financially healthy company tends to consistently generate cash flows from operations (i.e., positive operating cash flows) and invests cash flows (i.e., negative investing cash flows). To remain viable, a company must be able to generate funds from its operations; to grow, a company must continually make capital investments.

The change in cash flow—also called net cash flow—is the bottom line in the statement of cash flows and is equal to the change in the cash account as reported on the balance sheet.

E.5 STATEMENT OF STOCKHOLDERS’ EQUITY

The statement of stockholders’ equity (also referred to as the statement of shareholders’ equity) is a summary of the changes in the equity accounts, including information on stock options exercised, repurchases of shares, and Treasury (or reacquired) shares. The basic structure includes a reconciliation of the balance in each component of equity from the beginning of the fiscal year with the end of the fiscal year, detailing changes attributed to net income, dividends, purchases, or sales of Treasury stock. The components are common stock, additional paid-in capital, retained earnings, and Treasury stock. For each of these components, the statement begins with the balance at the end of the previous fiscal period and then adjustments are shown to produce the balance at the end of the current fiscal period.

In addition, there is a reconciliation of any gains or losses that affect stockholders’ equity but do not flow through the income statement, such as foreign-currency translation adjustments and unrealized gains on investments. These items are of interest because they are part of income to owners, but they are not represented on the company's income statement.

E.6 FOOTNOTES TO FINANCIAL STATEMENTS

Footnotes to the financial statements contain additional information, supplementing or explaining financial statement data. These notes are presented in both the annual report and the 10-K filing (with the SEC), though the latter usually provides a greater depth of information. Through the footnotes, a company provides information that is crucial in analyzing a company's financial health and performance.

The footnotes to the financial statements provide information pertaining to:

1. Any significant accounting policies and practices that the company uses.
2. Current and deferred income taxes, breakdowns by the type of tax (e.g., federal versus state), and the effective tax rate that the company is paying.
3. The details about pension plans, including pension assets and the pension liability incurred by the reporting company.
4. Lease obligations, both (1) reported on the balance sheet for certain types of leases (capital leases) and (2) future commitments for other types of leases (operating leases) that are not reflected on the balance sheet.

REFERENCES

Peterson, Pamela P., and Frank J. Fabozzi. (2006). Analysis of Financial Statements (2nd ed.). Hoboken, NJ: John Wiley & Sons.