Documenti di Didattica
Documenti di Professioni
Documenti di Cultura
FINANCIAL
REPORT
TABLE OF CONTENTS
SELECTING STOCKS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
INTRODUCTION
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.
HOW TO READ A FINANCIAL REPORT
2
A FEW WORDS BEFORE BEGINNING
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 present-
and practices apply in these and other ed 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 read- tory, illustrative or supplemental in nature.
er 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 read-
general overview of financial reporting, ers 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.
3
Typical
Manufacturing
Company,
Inc.
CONSOLIDATED FINANCIAL STATEMENTS
December 31,
19X9 19X8
Assets
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
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 —
December 31,
19X9) 19X8)
Liabilities and Shareholders’ Equity
Liabilities:
Current Liabilities:
Accounts payable $60,000) $57,000)
Notes payable 51,000) 61,000)
Accrued expenses 30,000) 36,000)
Income taxes payable 17,000) 15,000)
Other liabilities 12,000) 12,000)
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)
5
Typical
Manufacturing
Company,
Inc.
CONSOLIDATED FINANCIAL STATEMENTS
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.
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.
ASSETS
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. usually have quoted prices. These may include:
Cash and Cash Equivalents ■ Trading securities — debt and equity securities,
bought and sold frequently, primarily to generate
This, just as expected, is money on deposit in the
short-term profits and which are carried at fair mar-
bank, cash on hand (petty cash) and highly liquid
ket value. Any changes in such values are included
securities such as Treasury bills.
in earnings. (Fair market value is the price at
1 Cash and cash equivalents $19,500 which a buyer and seller are willing to exchange
an asset in other than a forced liquidation.)
9
THE BALANCE SHEET
10
THE BALANCE SHEET
11
THE BALANCE SHEET
12
THE BALANCE SHEET
14
THE BALANCE SHEET
15
THE BALANCE SHEET
December 31,
19X9 19X8
Liabilities and Shareholders’ Equity
Liabilities:
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)
16
THE BALANCE SHEET
LONG-TERM LIABILITIES
Current liabilities include amounts due
“within one year” from the balance-sheet
date. Long-term liabilities are amounts
due “after one year” from the date of the
financial report.
17
THE BALANCE SHEET
18
THE BALANCE SHEET
19
THE BALANCE SHEET
20
THE BALANCE SHEET
INVENTORY TURNOVER
Quick assets $221,800)
How much inventory should a company
19 Less: current liabilities (176,000) have on hand? That depends on a combi-
Net quick assets $45,800) nation of many factors including the type
of business and the time of the year. An
The quick assets ratio is found by dividing automobile dealer, for example, with a
quick assets by current liabilities. large stock of autos at the height of the
season is in a strong inventory position;
This means that, for each $1 of current yet that same inventory at the end of
liabilities, there is $1.26 in quick assets the season represents a weakness in the
available. dealer’s financial condition.
23
JUST WHAT DOES THE BALANCE SHEET SHOW?
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)
CAPITALIZATION RATIO
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
JUST WHAT DOES THE BALANCE SHEET SHOW?
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
reflecting its financial position at a given An income statement matches the rev-
date, the income statement may be of enues earned from selling goods and ser-
greater interest to investors: The reasons vices or other activities against all the
are 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;
26
in the future. and taxes.
THE INCOME STATEMENT
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)
27
THE INCOME STATEMENT
the operating margin. Typical’s operating because they provide useful information
margin is 13.8%. The operating cost ratio about the company’s fundamental eco-
is 86.2%. nomic condition. Another question to
ponder: Are Typical’s securities a good
Amount Ratio investment? Consideration of some addi-
33 Net sales $765,050 100.0% tional factors can help provide an answer.
34, 36, & 37
Operating costs $659,854 86.2% INTEREST COVERAGE
38 Operating Typical’s debentures represent a very sub-
income $105,196 13.8% stantial debt, but they are due many years
in the future. The yearly interest, however,
is a fixed charge. How readily the compa-
Net profit ratio is still another guide to
ny can pay the interest on this debt (i.e.,
indicate how satisfactory the year’s activi-
the debt’s interest coverage) would be of
ties have been. In Typical’s case, the year’s
great interest to an investor. (Interest cov-
net income was $47,750. The net sales for
erage is number of times the annual inter-
the year amounted to $765,050.
est on a debt obligation is covered by
Therefore, Typical’s income was $47,750
income for the year without considering
on $765,050 of sales or:
interest on the debt and taxes.) More
specifically, an investor would like to know
19X9 Net profit ratio: if the borrowed funds have been put to
45 $47,750 Net income = 6.2% good use, so that the earnings are adequate
33 $765,050 Net Sales and thus available to meet interest costs.
The operating margin, operating cost ratio For a corporate bond (debenture) to be
and net profit ratio—like the ratios exam- considered a safe investment, most ana-
ined for the balance sheet—provide gener- lysts say that the company should earn its
al information about the company and bond interest requirement three to four
help assess its future prospects. All these times over. By these standards, Typical’s
comparisons have a long-term significance debentures have a fair margin of safety.
31
THE INCOME STATEMENT
approximately 136.4, which means that shares, the calculation requires modifica-
the dividend requirement of the preferred tion. (Options and warrants each give
stock has been earned more than 136 the holder the right to buy securities at a
times over. This ratio is so high primarily specified price. Contingently issuable
because Typical has only a relatively small shares are shares of stock whose issuance
amount of preferred stock outstanding. depends on the occurrence of certain
events.) In fact, two separate calculations
EARNINGS PER COMMON SHARE are required. This is called dual presenta-
A buyer of common stock is often more tion. The calculations are primary and
concerned with the stock’s earnings per fully diluted earnings per common share.
share than with its dividend. This is
because earnings usually influence stock Primary Earnings per Common Share
market prices. Although the income state- This is determined by dividing the earn-
ment separates earnings per share before ings for the year by the average number of
and after the effect of extraordinary items, shares of common stock outstanding dur-
the remainder of this presentation will ing the year plus common stock equiva-
only consider net income per common lents if dilutive.
share (net income after extraordinary
item). In Typical’s case, the income state- Common stock equivalents are securities
ment does not show income available that enable their holders to become com-
for common stock, so it must be calculat- mon shareholders by exercising a right to
ed as follows: acquire common stock under that security
(options or
warrants) or
45 Net Income $47,750) exchanging or
Less: dividend requirement on preferred stock (350) converting a
Net income available for common stock $47,400) security (con-
(Actual Amounts Used) vertible secu-
Net income per common share: rities) into
common
$47,400,000 Net income available for the common stock = $3.21
shares.
14,750,000 Average number of outstanding common shares*
Examples are
*Shares outstanding at January 1 (14,500,000), plus shares outstanding at December 31 convertible
(15,000,000), = 29,500,000, divided by 2 = 14,750,000 average shares outstanding for preferred
the year.
stock, convert-
ible bonds and
Typical’s capital structure is a very simple
the like. Such securities are deemed to be
one, comprised of common and preferred
only one step short of common stock.
stock. As such, the earnings per share
Their value stems in large part from the
computation above will suffice under this
value of the common to which they relate.
scenario. However, if the capital structure
is more complex and contains securities Convertible preferred stock and convert-
that are convertible into common stock, ible bonds offer their holders some
options, warrants or contingently issuable choices. A holder can elect either
33
THE INCOME STATEMENT
(1) a return at the specified dividend or However, as mentioned earlier, the “com-
interest rate, or (2) conversion into com- mon stock equivalent” shares are only
mon stock and participation in market included in the computation if the effect of
appreciation and dividends resulting from conversion on earnings per common share
increased earnings on the common stock. is dilutive. Dilution occurs when earnings
However, the securities don’t have to be per share decreases or loss per share
actually converted to common stock for increases on the company’s common
them to be called a “common stock equiv- stock. For example, assume the preferred
alent” because they enable holders—in stock paid $3 a share in dividends. With-
certain circumstances—to cause an in- out conversion, the earnings per common
crease in the number of common shares share would be $2, as opposed to $2.50.
by exercising, exchanging or converting.
Following is an example of how these new In this case, the common stock equivalent
terms might operate in a company entirely shares would be excluded from the com-
different from Typical Manufacturing. Say putation. That’s because conversion results
there are 100,000 shares of common stock in the $2.50 per share amount computed
outstanding plus another 100,000 shares above, a higher (antidilutive) earnings per
of preferred stock, convertible into com- share. Therefore, primary earnings per
mon on a share-for-share basis. (Assume share of $2 (the lower amount) will be
they qualify as common stock equiva- reflected on the income statement.
lents.) Add the two and get 200,000 shares
altogether. Further, say earnings is Fully Diluted Earnings per
$500,000 for the year. With these facts, Common Share
the computation—assuming the conver-
sion of the preferred—is easy: The primary earnings per share item, as
just illustrated, takes into consideration
common stock and “common stock equiv-
Earnings per common share assuming alents.” The purpose of fully diluted earn-
conversion of preferred: ings per common share is to reflect maxi-
$500,000 Earnings for the year = $2.50 mum potential dilution in earnings that
$200,000 Adjusted shares would result if all contingent issuances of
common stock had taken place at the
beginning of the year.
34
THE INCOME STATEMENT
This computation is the result of dividing The only remaining step is to test for
the earnings for the year by common stock antidilution. (The effect of antidilution
and common stock equivalents and all would be the opposite of dilution; it
other securities that are convertible (even would increase earnings per share or
though they do not qualify as “common reduce loss per share.) Earnings per share
stock equivalents”). without bond conversion would be $2.50
($500,000 divided by 200,000 shares).
How would it work? First, remember Since earnings per share of $2 is less than
that for this earnings per share discussion $2.50, the $2 is used.
there are 100,000 shares of convertible
preferred outstanding, as well as 100,000 PRICE-EARNINGS RATIO
shares of common. Now, assume there Both the price and the return on common
are also convertible bonds with a par stock vary with a multitude of factors. One
value of $10,000,000 outstanding. These such factor is the relationship that exists
bonds pay 6% interest and have a conver- between the earnings per share and the
sion ratio of 20 shares of common for market price. It is called the price-earn-
every one-thousand dollar bond. Assume ings ratio (abbreviated P/E ratio).
the current average Aa corporate bond
yield is 8%. These bonds are not “com- This is how the P/E ratio is calculated. If a
mon stock equivalents,” because 6% is stock is selling at $25 per share and earn-
not less than two-thirds of 8%. However, ing $2 per share annually, its price-earn-
for fully diluted earnings per share they ings ratio is 12.5-to-1, usually shortened to
must be included. If the 10,000 bonds 12.5. Put another way, the stock is said to
were converted, there would be another be selling at 12.5 times earnings. If the
200,000 shares of stock, so adding every- stock should rise to $40, the P/E ratio
thing up produces 400,000 shares. But by would be 20, or 20 times earnings. Or, if
converting the bonds, the 6% interest pay- the stock drops to $12, the P/E ratio would
ment, less the related $300,000 tax deduc- be 6, or six times earnings.
tion, would be saved, adding another
For Typical, which has no “common
$300,000 to net income available to
stock equivalents,” net income per
common shareholders. So the calculation
common share was calculated at $3.21.
would look like this:
If the stock were selling
at $33, the P/E ratio would
Net income for the year $500,000
be 10.3. This figure would
Interest on the bonds $600,000) be used to compare this
Less: the income tax savings stock over a period
applicable to bond of years to itself and/or
interest deduction (300,000) 300,000 to other similar stocks.
Adjusted earnings $800,000
This statement analyzes the changes the determination or net income nor are
from year-to-year in each component they deductible for tax purposes. Common
of shareholders’ equity. It shows that shareholders were paid $18,000 in
during the year, Typical issued additional dividends this year. Since the balance
common stock at a price above par. It sheet shows that Typical has 15,000,000
also shows that Typical experienced a shares outstanding, the first thing to be
foreign currency translation gain and an learned here may be an important point
unrealized gain on investments classified to some potential investors—the dividend
as “available-for-sale.” The other per share.
components of equity, with the
exception of retained earnings Dividend per share:
(see the paragraph below) remained (Actual amount used)
the same.
$18,000,000 Common stock dividends = $1.20
Retained earnings reflects the $15,000,000 Common shares outstanding
cumulative earnings that the com-
pany has invested for future growth. Once the dividend per share is known, it
The statement of changes in shareholders’ is easy to go on to the next step: comput-
equity shows that retained earnings ing the dividend payout percentage. This
increased by net income less dividends is simply the percentage of earnings per
on preferred and common stock. Since net share paid to shareholders.
income has already been analyzed,
dividends will now be examined.
Dividend payout percentage:
DIVIDENDS $1.20 Dividend per common share = 37%
Dividends on common stock 48 $3.21 Net income per common share
vary with the profitability of the
36 company. They do not enter into
THE STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY
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.
THE STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY
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
Calculation:
$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
$319,825
38
THE STATEMENT OF CASH FLOWS
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 relating to the receipt and repayment of
analysis is necessary to make proper invest- funds provided by creditors and investors.
ing 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.
39
ADDITIONAL DISCLOSURES AND AUDIT REPORTS
41
THE LONG VIEW
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 to be ■ The trend of earnings, particularly in
compared to broader economic factors. relation to sales and the economy.
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
SELECTING STOCKS
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.
43
GLOSSARY OF SELECTED TERMS
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). Allowance for Doubtful Bonds (Page 18).
Amounts owed to creditors for Accounts (Page 10). Formal, secured or unsecured debt
goods and services bought on Amounts deducted from the total obligations specifying interest and
credit; generally, they must be accounts receivable balance to repayment terms.
paid within 90 days. recognize that some customers will
not pay what they owe. Also Book Value per Share (Page 25).
Accounts Receivable (Page 10). called Provision for Doubtful The adjusted shareholders’ equity
Amounts due a business from cus- Accounts, Reserve for Doubtful for each class of stock divided by
tomers for goods and services sold Accounts or Bad Debt Reserve. the number of shares of each such
on credit; generally they must be class.
paid within 90 days. Amortization (Page 14).
Periodic charges to income to rec- Capitalization Ratio (Page 25).
Accrual Method of Accounting ognize the distribution of the cost The relationship that each security
(Page 39). of the company’s intangible assets (debt or equity) bears to total debt
Method of accounting that recog- over the estimated useful lives of and equity, less intangible assets,
nizes revenue when earned and those assets. expressed as a ratio.
expenses when incurred in order
to appropriately match income Antidilution (to Earnings per Cash and Cash Equivalents
with expenses in an accounting Common Share) (Page 35). (Page 9).
period. An increase in earnings (or Generally, bank accounts and cur-
decrease in loss) per common rency on hand, and short-term,
Accrued Expenses (Page 15). share that assumes that convertible highly liquid securities with a
The obligation to pay business securities were converted, stock maturity under 90 days, such as
expenses that were incurred, but options and warrants were exer- U.S. Treasury bills.
not paid, during an accounting cised or other shares were issued
period. upon satisfaction of certain condi- Cash Flows, Statement of
tions. When antidilution occurs (Pages 2, 39).
Accumulated Amortization the per-share amount that it pro- A report showing cash receipts and
(Page 14). duces is not used as the reported disbursements compiled and
A deduction from intangible assets per-share amount. totaled by operating, investing
to show the total amount of peri- and/or financing activities.
odic charges to income over the Asset (Pages 8, 9-14).
estimated useful lives of those Something owned by and having Certified Public Accountant (CPA)
assets. Also called Reserve for continuing value to its owner or a (Page 1).
Amortization. business. Professional title granted to people
who pass a comprehensive test
Accumulated Depreciation Audit (of Financial on accounting, auditing and
(Page 13). Statements) (Page 1). business law. CPAs usually perform
A deduction from fixed assets to A systematic examination of a audits of a company’s financial
show the total amount of periodic company’s financial statements to statements.
charges to income over the esti- determine if the amounts and dis-
mated useful lives of those assets. closures in the reports are fairly Changes in Shareholders’
Also called Reserve for stated and follow generally accept- Equity, Statement of (Pages 2, 36).
Depreciation. ed accounting principles. A report providing the details, by
category, of all activity in all com-
Additional Paid-in Capital Available-for-Sale ponents of shareholders equity, for
(Page 19). Securities (Page 10). the period covered by the report.
The total excess of the sharehold- Securities not classified as held-
ers’ investment in the company to-maturity or trading. They are Common Dividend Yield
over the par or stated value of its carried at fair market value, with (Page 37).
common and preferred stock. Also any changes in the value (less Dividends paid on each share of
called Paid-in Capital. applicable taxes) reported in common stock expressed as a per-
shareholders’ equity in the balance centage of the market price of
American Institute of sheet. When sold, any gain or those shares. See also Dividend
Certified Public Accountants loss will be realized and reported Yield.
(AICPA) (Page 2). in the income statement.
The major professional public Common Stock (Pages 19, 33).
accounting group that sets stan- Balance Sheet (Pages 1, 8-26). The par or stated value of the
dards of practice for Certified A report showing the financial common stock (the basic owner-
Public Accountants. position or condition of a business ship interest in a corporation)
44 at a given date. Also called issued by a company as reported
Statement of Financial Position or in its balance sheet.
Statement of Financial Condition.
Common Stock Equivalents Debentures (Page 18). Earnings per Common Share
(Page 33). Formal, unsecured debt obligations (Page 33).
Securities, other than common (bonds or notes) that are backed Net income reduced by preferred
stock, such as certain convertible only by the general credit of dividends and divided by the aver-
securities (stocks or bonds), stock the issuer rather than certain of age outstanding number of com-
options or warrants, which are its assets. mon shares during the accounting
considered to be common stock, period.
and are recognized in the primary Debt Amortization (Page 10).
earnings-per-common share The practice of adjusting the orig- Estimated Useful Life (Page 12).
computation. inal cost of a debt instrument as The period of time over which the
principal payments are received owner of an asset (physical or
Common Stock Ratio (Page 26). and any purchase discount or intangible) estimates that that asset
The percentage that common premium is written off to income will continue to be of productive
stockholders’ equity reduced by over the life of the instrument. use or have continuing value.
intangible assets bears to total tan-
gible capitalization (the sum of Debt-to-Equity Ratio (Page 23). Extraordinary Items (Page 29).
shareholders’ equity and long-term The ratio of total debt (liabilities) Nonoperating items that are both
debt reduced by intangibles). to total shareholders’ equity. unusual and occur infrequently.
Compensatory Stock Options Deferred Charges (Page 13). Fair Market Value (Page 9).
(Page 33). Expenditures for items that will The amount at which an item
See Stock Options. benefit future periods beyond one could be exchanged between
year from the balance-sheet date. willing unrelated parties, other
Contingently lssuable Shares than in a forced liquidation. It is
(Page 33). Deferred Income Taxes (Page 17). usually the quoted market price
Shares of stock the issuance of The obligation to pay income when a market exists for the item.
which depends on the occurance taxes in future years generally
of certain events. arising from transactions involving Financial Accounting
noncurrent assets and/or liabilities. Standards Board (FASB) (Page 2).
Convertible Securities (Page 33). The independent, private-sector
A debt or equity security that may Depletion (Page 13). organization designated to estab-
under certain circumstances be The process of recognizing, by a lish standards for financial
exchanged for or converted into charge against income, the reduc- accounting and reporting. It is the
another security, generally com- tion in the cost of a natural body that issues GAAP, generally
mon stock. resource (minerals, oil, gas) due to accepted accounting principles.
its withdrawal and use or sale.
Cost of Sales (Page 28). FIFO (Page 40).
The total cost to purchase and/or Depreciation (Page 12). Acronym for First-In, First-Out.
manufacture all of the company’s Periodic charges to income to See First-In, First-Out.
products that were sold during a recognize the cost of “wear and
period. tear” of a company’s fixed assets Financial Leverage (Page 32).
over the estimated useful lives of See Leverage (Financial).
CPA (Page 1). those assets.
See Certified Public Accountant. Financial Statement Ratio
Dilution (Page 34). (Page 22).
Current Assets (Page 9). The reduction in common earnings A mathematical relationship
Cash or other assets that will be per share (or increase in loss) if between two or more amounts
converted to cash or consumed convertible securities are convert- reported in financial statements.
within the normal operating cycle, ed, stock options and warrants are Financial statement ratios can pro-
generally one year. exercised or other shares are vide relative measures of, and
issued. insights into, the health, condition
Current Liability (Page 15). and performance of a company.
A liability that must be paid Dividend Payout Percentage
within the normal operating (Page 36). First-In, First-Out. (Page 40).
cycle, generally one year. Dividends per share divided by An inventory-costing method that
earnings per share, expressed as states inventory at its most current
Current Portion of a percentage. cost while charging the cost of
Long-Term Debt (Page 17). sales in the order the inventory
The portion of long-term debt that Dividend Yield (Page 37). was accumulated.
is due within one year of the The dividend paid on each share
balance-sheet date. of each class of stock as a percent- Fixed Assets (Page 12).
age of the market price of those Another term for the property,
Current Ratio (Page 22). shares. See also Common plant and equipment, used in the
The relationship of current assets Dividend Yield. operation of a business.
to current liabilities, expressed as
a ratio. Dividends (Pages 2, 36). Footnotes (Pages 2, 40).
Payments, generally declared by Additional details and disclosures
the Board of Directors, from about the figures and information
retained earnings to shareholders contained in a company’s financial
to compensate them for their statements.
45
investment.
Foreign Currency Translation Income Statement Liability (Pages 8, 16-18).
Adjustments (Page 21). (Pages 2, 26-36). An obligation to pay for assets or
The cumulative adjustment, report- Report summarizing the revenues goods or services acquired or to
ed in the Equity section of the bal- and expenses and reporting the net repay borrowed funds.
ance sheet, resulting from the income (or loss) of a business for
translation of a foreign subsidiary’s an entire accounting period. Also LIFO (Page 40).
local currency financial statements called the Statement of Earnings, Acronym for Last-In, First-Out.
into the currency of the parent Statement of Profit and Loss, P&L See Last-In, First-Out.
company. or Operating Statement.
Long-Term Debt (Page 18).
Fully Diluted Earnings per Income Taxes (Page 29). Borrowed funds due after one from
Common Share (Page 34). The amount of income tax expense the balance sheet date. See
The amount of current earnings or reported for the period. It is often Current Portion of Long-Term Debt
loss per share reflecting the referred to as the Tax Provision or and Other Long-Term Debt.
maximum dilution (that is, Provision for Income Taxes.
negative impact) assuming the Long-Term Liabilities (Page 17).
issuance of all potentially dilutive Income Taxes Payable (Page 15). Obligations that are due after one
shares. The obligation to pay federal, for- year from the balance-sheet date,
eign, state and local income taxes
Generally Accepted Accounting that are due within one year from Lower of Cost or Market Rule.
Principles (GAAP) (Page 1). the balance-sheet date. (Page 11).
The rules and standards followed The rule is that inventory should
in recording transactions and in Intangible assets (Page 13). be valued at its cost or market
preparing financial statements. Nonphysical assets with continu- value, whichever is lower. The
ing value, such as goodwill, copy- intent is to provide a conservative
Goodwill (Page 13). rights, trademarks and franchises. figure in valuing a company’s
An intangible asset that represents inventory. See also Market Value.
the excess of the amount paid for Interest (Page 29).
an acquired company over the fair Payments by borrowers of funds to Management Discussion and
market value of the net assets of compensate lenders for the use of Analysis (MD&A) (Page 1).
that company. Basically, it is the their funds. An SEC-required report in which
value of the name and reputation management provides selected
of the acquired company. Interest Coverage (Page 31). financial data to highlight signifi-
The number of times the annual cant trends in the company’s finan-
Gross Margin (Page 28). interest on debt obligations is cov- cial position or operating results.
The excess of sales over cost of ered by income for the year before
sales or the profit from sales before considering interest on the debt Market Price (Page 11).
considering operating, general and obligations and income taxes. The price at which a good can be
other expenses. Also called Gross sold in the open market. See also
Profit or Product Profit. Inventory (Pages 10-11). Fair Market Value.
The cost of goods on hand that
Gross Margin Percentage were purchased and/or manufac- Market Value (Pages 9, 11).
(Page 28). tured or that are being manufac- See Fair Market Value.
Gross margin expressed as a per- tured for sale to customers.
Marketable Securities
centage of sales. Also called Gross
Inventory Turnover (Pages 23-24). (Pages 9-10).
Profit Percentage or Product Profit
The number of times the average Readily liquid securities (debt or
Percentage.
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).
Securities (debt or equity) held for Mortgage Bonds (Page 18).
Debt securities that the holder/
strategic purposes and/or long-term Formal, secured debt obligations
owner has the ability and intent to
appreciation or income. that are backed by certain specific
hold to maturity. They are carried
assets of the issuer.
at amortized cost (original cost less
Last-In, First-Out (LIFO).
principal payments and premium Net Asset Value (Page 24).
(Page 40).
or discount amortization). See Book Value.
An inventory-costing method that
Highly Leveraged (Page 32). states inventory at its earliest cost
while charging cost of sales at its Net Book Value (Page 24).
A company with a large proportion See Book Value.
of bonds and preferred stock out- latest cost (in the reverse order that
standing relative to the amount of 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 Also, it is the practice of obtaining
(investor) will not collect all capital using borrowed funds Net of Taxes (Page 10).
amounts in accordance with the or preferred stock, rather than Term meaning the value or amount
loan agreement. common stock. has been adjusted for the effects of
46 applicable taxes.
Net Profit Ratio (Page 31). Prepaid Expenses (Page 11). Statement of Cash Flows.
Net income expressed as a } Payments in advance for goods or See Cash Flows, Statement of.
percentage of sales. services, which will be consumed
and deducted from income during Statement of Changes in
Net Quick Assets (Page 23). the future, normal operating cycle, Shareholders’ Equity.
The excess of quick assets over generally one year. See Changes in Shareholders’
current liabilities. Equity, Statement of.
Price-Earnings Ratio (Page 35).
Notes Payable (Page 15). The comparison of the market Stock Option, Compensatory
Short- or long-term obligation, price of a share of stock to the (on Unissued Stock) (Page 33).
evidenced by a formal borrowing earnings per share of that stock, An agreement, usually between
agreement (such as a promissory expressed as a ratio. Also called an issuer and its executives/
note), to repay borrowed funds. the P/E ratio. employees, that grants the right
to purchase securities, such as
Operating Income or Loss Primary Earnings per common stock, at a specified
(Page 28). Common Share (Page 33). price. Options are common stock
The profit or loss generated by a The amount of earnings attribut- equivalents and may dilute earn-
company’s normal, recurring oper- able to each share of common ings per common share.
ating activities before considering stock, including common stock
nonoperating items, income taxes, equivalents. Stock Option, (Publicly Traded).*
gains or losses from disposals of A security bought and sold in the
a segment of the business and Property, Plant and Equipment public securities markets that pro-
extraordinary items. (Page 12). vides the holder the right, but not
Assets not intended for sale that necessarily the obligation, to buy
Operating Margin (Page 30). are used to manufacture, display, or sell a specified security in the
Operating income expressed as a warehouse and transport the com- quantity, at the amount, and
percentage of sales. pany’s products and house its during the time period specified
employees. See also Fixed Assets. in the option.
Other Long-Term Debt (Page 18).
All debt due after one year from Quick Assets (Page 22). Trading Securities (Page 9).
the balance-sheet date that is not Assets that can be converted to Securities (debt or equity) bought
reported elsewhere in the balance cash quickly. and sold frequently, principally to
sheet. generate short-term profits. They
Quick Assets Ratio (Page 23). are carried at fair market value,
Paid-in Capital. The relationship between quick with any changes in the value
See Additional Paid-in Capital. assets and current liabilities, reported in income.
expressed as a ratio.
Par Value (Page 19). Treasury Stock (Page 21).
The nominal or face value of a Retained Earnings (Page 20). The total cost of any of the compa-
security assigned by the issuer for The total profit or loss of the com- ny’s stock that has been repur-
balance-sheet reporting. It has no pany less the total of all dividends chased or otherwise reacquired
relation to market value. paid, since the company’s startup. from shareholders and held in the
company’s treasury.
Permanent Impairment (Page 14). Return on Equity (ROE) (Page 37).
See Impairment (Permanent) of Net income for the period Unrealized Gain/Loss (Page 21).
Loan (Investments). expressed as percentage of average The difference between the cost
shareholders’ equity for the period. (or previously reported fair market
Preferred Dividend Coverage
value) of an asset held at the bal-
(Page 32). Securities and Exchange ance sheet date and its fair market
The number of times the preferred Commission (SEC) (Page 2). value at that date.
dividend is covered (earned) by The main securities regulatory
net income. authority in the U.S. Warrant (Page 33).
A security, generally evidenced by
Preferred Stock (Page 19). Shareholders’ Equity a certificate, giving the holder the
An equity security that entitles its (Pages 8, 18-21). right to purchase securities, such
holders to certain preferences over The total of shareholders’ invest- as common stock, at a specified
common shareholders, such as div- ments in the company and total price. Warrants are common stock
idends, liquidation value and con- profits or losses since the start-up equivalents and may dilute earn-
vertibility into other securities, etc. of the company, less all dividends ings per common share.
and/or capital distributions, unreal-
Preferred Stock Ratio (Page 26). ized gain on available-for-sales Working Capital (Page 22).
The percentage that preferred securities and any foreign currency The excess of current assets over
stockholders’ equity bears to total translation adjustments since the current liabilities.
tangible capitalization (the sum of company’s start-up.
shareholders’ equity and long-term *Note: This definition is not found
debt reduced by intangibles). Stated Value (Page 19). within this booklet. We have
The nominal or face value of a included the definition in the
security assigned by the issuer in glossary only to help better define
lieu of par value for balance-sheet the differences between the two
reporting. It has no relation to types of stock options. 47
market value.
NOTES
48
NOTES
49
To learn more about Merrill Lynch and its services, be sure
to visit us on the Internet at http://www.ml.com., or if you
would like additional copies of this booklet write to: