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proo fReading &Understanding

Financial Statements

A Guide to Financial Reporting

Reading & Understanding

Financial Statements

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Introduction

Financial statements are an important manage- ment tool. When correctly prepared and properly interpreted, they contribute to an understanding of the current financial condition, problems, and possibilities of a company.

This explanation has been prepared to help financial and nonfinancial managers and owners make better use of the information in financial statements.

Specifically, this brochure describes five financial statements:

The Balance Sheet, which is sometimes referred to as the Statement of Financial Condition or Statement of Financial Position.

The Income Statement, which is sometimes referred to as the Statement of Income, Statement of Operations or the Profit and Loss Statement.

The Statement of Cash Flows.

The Statement of Comprehensive Income.

The Statement of Stockholders’ Equity, also called the Statement of Changes in Stockholders’ Equity. If the only change in the equity accounts is in retained earnings, this statement may be called a Statement of Retained Earnings or simply included on the face of the Income Statement.

These statements are prepared and presented using technical terms and rules that are becoming increasingly complex. Interpretation of these statements may be a formidable challenge to many managers 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 guide to Reading

and Understanding Financial Statements will help you to use financial statements in making decisions, monitoring your business, and plan- ning for future growth.

Income Statement Summary of activity

for a period of time

Balance Sheet Financial condition

at a point in time

Balance Sheet Financial condition

at a point in time

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Reporting of Business Activity

Beginning of Year January 1, 2009

End of Year December 31, 2009

The Balance Sheet is a “photograph”: It represents, at a moment in time, the financial position of the business entity. It needs to be compared to other “photographs” to provide meaningful information on changes in finan- cial position. For that reason, the balance sheet as of the end of one or more preceding years is usually presented with the balance sheet as of the end of the current year.

The other primary financial statements — the Income Statement, Statement of Cash Flows, Statement of

Comprehensive Income, and Statement of Stockholders’ Equity — present a summary of activities over a period of time, usually a fiscal quarter or year. The Income Statement presents revenues less associated expenses and the resulting net income. The Statement of Cash Flows provides information about the sources and uses of cash, and the Statement of Comprehensive Income and the Statement of Stockholders’ Equity show changes in items contained in the equity section of the balance sheet.

How Do Financial Statements Relate to the Passage of Time?

Statement of

Cash Flows Summary of activity

for a period of time

Statement of

Stockholders’ Equity Summary of activity

for a period of time

Statement of

Comprehensive Income

Summary of activity

for a period of time

Balance Sheet Financial condition

at a point in time

Income Statement Summary of activity

for a period 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 used up (expensed) in the course of operations.

Liabilities increase or decrease as obligations to suppliers, lenders, and other creditors are incurred or repaid. In some cases, the amounts of liabilities need to be estimated (referred to as “accruals”) and are subject to adjustment (upward or downward) in later periods. In limited circumstances, recorded liabilities are contingent upon the occurrence of future events, and may not be paid in part or full.

Equity increases or decreases as a result of income or loss from operations of the business. It also increases when the owners contribute capital to the business, and decreases when the capital is withdrawn or dividends are paid.

The Income Statement (or Statement of Operations) is a summary of revenues and expenses, the latter usually broken down (or summarized) by major categories.

Income from operations is an important measure of the entity’s performance, since it represents the pretax income earned (or loss incurred) from the core operations of the business, before considering certain financial costs, other nonoperating items, and extraordinary gains or losses.

Other income and expense include financial costs (interest expense) and other items that are not directly related to the primary purposes of the business.

Revenue (or sales) – Cost of sales

= Gross profit (or gross margin) – 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 to the business) outside creditors)

Equity (Capital provided by owners)

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The Statement of Cash Flows reports the sources and uses of cash for the period, as separated into three major classifications:

Operations include the cash effects of essentially all items identified in the Income Statement, such as sales, costs of sales, operating expenses, and extraordinary items.

Investing activities include the purchase of property and equipment or the proceeds from their disposition, and also certain transactions involving investments in securities or other nonoperating assets.

Financing activities include debt borrowings and repayments, as well as the contribution and withdrawal of equity capital, and the payment of dividends to owners.

Cash provided by or used for operations

+/– Cash provided by or used for investing activities

+/– Cash provided by or used for financing activities

= Net increase or decrease in cash

Extraordinary items are defined as those which are unusual and occur infrequently, and include such losses as those from natural disasters and expropria- tion of foreign properties. While not extraordinary per se, certain other items, including the results of discontinued operations and the cumulative effects of changes in accounting principles, are also presented separately at the bottom of the Income Statement,

where the reader can distinguish them from ongoing results of operations.

Net income or loss is the all-inclusive “bottom line” that reflects all economic activity by the enterprise for the 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 to companies whose balance sheet equity includes certain items such as foreign currency adjustments, pension liability adjustments, and gains and losses on certain 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 present this statement separately or combine it with the Statement of Income.

OVERVIEW: The Statement of Comprehensive Income

The Statement of Stockholders’ Equity details changes in the interests of the company’s owners, including stock issuances, stock repurchases, stock conversions, dividends paid, other comprehensive income or loss, and net income or loss. A company is required to

disclose all changes in equity accounts and in the number of shares outstanding. This can be accom- plished through disclosure in the footnotes, or as is often the case, in a separate Statement of Stockholders’ Equity.

OVERVIEW: The Statement of Stockholders’ Equity

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In addition to the basic financial statements, most financial statements which have been prepared for delivery to third parties (i.e., those outside the report- ing entity) will have a section of Notes to Financial Statements.

The Notes to Financial Statements set forth the major accounting principles used in developing the amounts reported in the statements (where a choice was made from among alternative generally accepted accounting principles or “GAAP”), and also provide additional details about major balances and transactions. Examples of the latter include details about long-term leases, long- and short-term debt (including interest rates and maturities), transactions with related parties, contingent liabilities, and commitments.

Financial reports may also include supplementary schedules, which provide more detailed infor- mation about major expense captions (such as administrative expenses) or other items appearing in the basic financial statements. Except in rare instances, the presentation of supplementary schedules is not required under generally accepted accounting principles, but repre- sents a choice made by the preparer of the financial statements to provide the reader with additional information.

If independent accountants have been associated with the financial statements, their report will be included with 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 the case of an audit, the independent accountant will provide positive assurances that the financial state- ments materially “present fairly” the financial position, results of operations, and cash flows of the company in accordance with generally accepted accounting princi- ples, if it can be concluded that this is the case. If the statements contain a departure from generally accepted accounting principles, or if the audit was subject to a scope limitation, or if there is doubt about the entity’s ability to continue as a going concern — these matters must also be described in the auditor’s report. In a review engagement, at best the accountant will express negative assurance — i.e., that based on performing limited procedures, nothing came to the accountant’s

attention that would indicate that the financial statements were not fairly presented. An

accountant performing a compilation merely assists the company in

assembling the financial statements, and offers

neither positive nor negative assurances

about whether they are presented fairly. The level

of assurance offered by the independent accountant on

supplementary schedules may be lower than that offered on the

basic financial statements. Thus, the basic statements may have been

reviewed, and the accountant may have also reviewed the supplementary information, or alternatively the accountant may only have compiled the supplementary data. If the basic financial statements have been audited, the supplementary information may have also been subjected to audit procedures, or, if not, the accoun- tant’s report will note that the supplementary data have not been audited.

Other Elements of Financial Reports

ABC Corporation Balance Sheets

December 31, 2009 and 2008

Assets 2009 2008

Current Assets Cash and cash equivalents. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 377,000 $ 314,000 Investments in trading securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137,000 115,000 Accounts receivable, less allowance for doubtful accounts of $12,500 and $8,400 in 2009 and 2008, respectively . . . . . . . 1,178,000 1,175,000

Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 458,000 424,000 Prepaid expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142,000 153,000

Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,292,000 2,181,000

Property and Equipment Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000 1,000,000 Building and improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,602,000 1,292,000 Machinery 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’ Equity Current Liabilities

Notes payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 110,000 $ 110,000 Current maturities of long-term debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261,000 282,000 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 809,000 796,000 Income taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 200,000 Accrued expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 544,000 436,000

Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,924,000 1,824,000

Other Liabilities Long-term debt, net of current maturities . . . . . . . . . . . . . . . . . . . . . . . 2,302,000 2,466,000 Deferred 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’ Equity 9.5% 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 and outstanding in 2009 and 2008, respectively, including shares held in treasury . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 146,000

Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,639,000 1,575,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,120,000 2,809,000 Less 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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ABC Corporation Balance Sheets

December 31, 2009 and 2008

Assets 2009 2008

Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,292,000 2,181,000

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’ Equity Current Liabilities

Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,924,000 1,824,000

Total other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,473,000 4,320,000

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,397,000 6,144,000

Stockholders’ Equity 9.5% cumulative preferred stock, par value, $10 per share, 36,000 shares authorized, issued, and outstanding . . . . . . . . . . . . 360,000 360,000

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 which are reasonably expected to be realized in cash, sold, or consumed during the normal operating cycle of the business or one year, if less. These assets generally include cash and cash equivalents such as money market accounts, certain investments in debt and marketable equity securities, accounts receivable, inventories, and certain prepaid expenses such as insurance.

Property and Equipment are assets of a durable nature and a relatively long life that are used in the regular operations of the business.

Accumulated Depreciation is the aggre- gate of charges to expense or to write off the cost of property and equipment over its estimated useful life. It is the result of a bookkeeping entry and does not represent any current cash outlay.

Other Assets may consist of intangibles, such as goodwill, patents or trademarks; assets, such as the cash surrender value of life insurance; and prepaid expenses, including unexpired multi-year insurance premiums.

In certain industries, such as real estate, assets are presented without being classified in the categories shown in this example.

Current Liabilities are those obligations that are reasonably expected to be paid using current assets. These liabilities generally include notes payable, current maturities of long-term debt, accounts payable, income taxes payable, and accrued expenses such as salaries 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 are common long-term liabilities.

Deferred Income Taxes result from differences between taxable income and accounting income. Common items giving rise to deferred income taxes include depreciation methods that are allowed by tax law but do not match the estimated useful life of the

asset, deferred compensation that is not deductible until paid but gives rise to currently reported expense, and certain prepaid income such as rent received by the business in advance of the date it is due, which is deferred to later periods for accounting purposes, but which is taxed currently.

Common Stock and Preferred Stock, if any, represent the ownership interests in a corporation. The preferred stock will have preferential rights as to divi- dends or in the event of liquidation of the business. Common stock represents the residual ownership interest.

Additional Paid-in Capital is the difference between the amount of money obtained by a corporation on the issuance of its own stock and the par value of the stock.

Retained Earnings are the portions of all the company’s past earnings that were not distributed to the owners.

Treasury Stock is stock that was once issued by the company but later was reacquired. Treasury stock receives no dividends and has no vote while held by the company.

Total Liabilities and Stockholders’ Equity is always equal to total assets.

“ Deferred Income Taxes result from differences

between taxable income and accounting income.”

The Balance Sheet in Greater Detail

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ABC Corporation Statements of Income and Retained Earnings Years Ended December 31, 2009 and 2008

2009 2008

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 expense Interest 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 income taxes and extraordinary item . . . . . . 840,000 466,000

Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325,000 194,000

Income before extraordinary item . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515,000 272,000

Extraordinary item, less applicable income tax benefit of $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 those products or services that it is in business to sell.

Cost of Goods Sold represents the cost of producing goods for sale. For example, cost of goods sold in a manufacturing company is comprised of direct labor, direct materials, and overhead.

Gross Profit is a measure of the profit contribution from the sales of products and/or services, before considering administrative overhead.

Selling, General and Administrative Expenses are costs associated with the sale and delivery of products and the general costs associated with the operation and management of a business, other than those charged to cost of goods sold.

Income from Operations is another measure of profitability, equal to gross profit less selling, general and administrative costs.

Other Income and Expense arise from transactions not related directly to the primary operations of the business. Items frequently reported in this nonoperating category are dividend income, interest income, and certain gains or losses.

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 separately stated, usually as a subcategory of other

income and expense.

Income Taxes is an estimate of the amount of income tax that will eventually be paid, or has been paid, on the reported earnings.

Extraordinary Items are income or losses of an unusual and infrequent nature.

Net Income is the “bottom line” measure of the earnings performance of the company for the period reported on, after considering all elements of income and expense.

The Income Statement in Greater Detail

ABC Corporation Statements of Cash Flows

Years Ended December 31, 2009 and 2008

2009 2008

Cash Provided by (Used for) Operating Activities Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 465,000 $ 272,000 Adjustments to reconcile net income to net cash provided by operating activities Depreciation and amortization. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 479,000 300,000 Deferred income taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317,000 69,000 Gain on sale of property and equipment . . . . . . . . . . . . . . . . . . . . . (28,000) (59,000) Changes in operating assets and liabilities Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,000) (64,000) Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (34,000) 129,000 Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000 32,000 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,000 22,000 Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108,000 (110,000)

Net cash provided by operating activities . . . . . . . . . . . . 1,328,000 591,000

Cash Provided by (Used for) Investing Activities Purchase of property and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,010,000) (1,430,000) Proceeds from disposal of property and equipment . . . . . . . . . . . . 38,000 7,000 Purchase of investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (22,000) —

Net cash used for investing activities . . . . . . . . . . . . . . . . . (994,000) (1,423,000)

Cash Provided by (Used for) Financing Activities Additional long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137,000 863,000 Retirement of long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (322,000) (560,000) Issuance of common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68,000 466,000 Purchase of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — (18,000) Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (154,000) (133,000)

Net cash provided by (used for) 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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ABC Corporation Statements of Cash Flows

Years Ended December 31, 2009 and 2008

2009 2008

Net cash provided by operating activities . . . . . . . . . . . . 1,328,000 591,000

Net cash used for investing activities . . . . . . . . . . . . . . . . . (994,000) (1,423,000)

Net cash provided by (used for) 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 other events that are the result of delivering or producing goods for sale and providing services.

Cash inflows from operating activities include cash receipts from the sale of goods or services and from interest and dividend income. Cash outflows for oper- ating activities include cash payments for the purchase of inventory, wages and benefits to employees, to government taxing bodies, as interest to lending institutions, and to various other suppliers.

Investing Activities include lending money 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 activities include principal repayments from bor- rowers, proceeds from sales of loans and receipts from sales of assets such as investment securities or property and equipment. Cash outflows for investing activities include loans made, loans purchased, and payments to acquire assets such as investment securities or property and equipment.

Financing Activities include obtaining resources from owners, providing owners with a return on (of) their

investment, obtaining resources from lenders, and repaying 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 and from long- and short-term borrowings. Cash outflows for 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 statement illustrated on page 10 is the so-called “indirect method” favored by most companies. However, an alternative format, the “direct method” is also acceptable. Under that approach, the Cash Provided by (Used for) Operating Activities section will list each major source or use of cash which corresponds to major captions in the income statement. For example, corresponding to sales will be the cash flow statement caption “Cash Collected from Customers”; correspond- ing to cost of sales will be “Cash Paid to Suppliers”; etc. If the direct method

is used, the cash flow statement (or a supplementary schedule) will present the reconciliation between net income and cash from operations — which will closely resemble the cash from operations section of the state- ment illustrated on page 10.

“Cash outflows for investing

activities include loans made,

loans purchased . . . .”

The Statement of Cash Flows in Greater Detail

The Statement of Comprehensive Income Certain companies present the Statement of Compre- hensive Income. This statement is only presented when the equity section of the company’s balance sheet contains adjustments relating to pensions, foreign currencies, or certain types of investments. The changes in these items from period to period, instead of being reflected on the income statement as part of net income, are reflected directly on the balance sheet. The Statement of Comprehensive Income simply reconciles the change in these items for the periods presented.

There are a variety of ways that this information can be presented. It can be simply added to the bottom of the income statement (which would be retitled the Statement of Income and Comprehensive Income), shown as a separate statement, or shown in a statement reconciling all changes in the equity section of the balance sheet which would be titled the Statement of Stockholders’ Equity.

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Although the basic financial statements — discussed in the preceding sections — do present the company’s financial position, results of operations, and cash flows, there are other important disclosures, both mandatory and voluntary, that cannot be incorporated on the face of the statements. For this reason, most complete sets of financial statements will include a section of notes after the basic statements. (These are sometimes still called “footnotes,” a term that is a holdover from a simpler era when these disclosures were actually presented at the bottom of the financial statements.)

Certain notes are always found in GAAP financial statements. For example, the “summary of significant accounting policies,” usually the first note, identifies which among equally acceptable GAAP the company has elected to use (e.g., straight line versus accelerated depreciation; LIFO versus FIFO inventory 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 believes they give useful insight into the company’s economic prospects (e.g., details of long- term contracts with customers, summary of key ratios, financial highlights).

Notes are considered to be an integral part of the basic financial statements. Thus, standards for accuracy and clarity apply equally to the notes, and the independent accountant must apply the same level of service (audit, review, or compilation) to the notes as to the basic financial statements themselves. If well-written and organized, 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 substantial amount of detail they often contain, the notes do require a careful study by the reader.

Many financial statements also contain a section of supplementary information. Usually this information is in the nature of additional detail (e.g., the elements comprising “selling expenses”), although sometimes it is a recasting of the basic financial statements on an alternative basis of accounting (such as FIFO inven- tory costing when the basic statements were prepared using the LIFO basis). Supplementary information may have received the same level of attention from the independent accountant as the basic statements and notes, or it might 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.

Notes to Financial Statements and Supplementar y Schedules

The Statement of Stockholders’ Equity

When both a balance sheet and income statement are presented, disclosure of all changes in equity accounts and in the number of shares outstanding during at least the most recent annual fiscal period presented is required. There are a number of ways this information can be presented. Disclosure of these changes may be made in a separate statement, called the Statement of Stockholders’ Equity, or may be made in the basic financial statements or notes thereto. Companies fre- quently choose to provide a Statement of Stockholders’ Equity with their other financial statements.

The purpose of the Statement of Stockholders’ Equity is to report the events that caused individual stockholders’

equity accounts to change during the accounting period. Accordingly, the Statement of Stockholders’ Equity is dated like the income statement. It covers a period of time. The Statement of Stockholders’ Equity summa- rizes the changes in the various components of the stockholders’ equity section of the balance sheet. In many cases the specific events that caused the change in one or more stockholders’ equity accounts are of interest to the financial statement user. The Statement of Stockholders’ Equity includes stock issuances, stock repurchases, stock conversions, dividends paid, and other comprehensive income or loss components which may be important and useful information to many readers of the financial statements.

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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 financed collectively by the owners and creditors. The relationship between the returns on assets and on equity is indicative 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. Businesses that perform in this manner make effective use of debt financing to increase returns to their stockholders.

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

Ratio Example*

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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The information contained in the basic financial state- ments and notes can and should be used to provide insight into the financial strength and earnings capacity of the business. This extends beyond such single state- ment captions as “net income,” and necessitates that relationships between amounts be examined. While an almost unlimited number of such ratios and compar- isons are possible, a relatively small group of these are traditionally the object of most readers’ attention.

The nature of the analysis depends on the perspective of the reader. For example, the short-term note holder would be primarily concerned with the company’s ability 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 to that of the long-term debtholder, with perhaps more concern for earnings (vis-a-vis cash flows) and growth trends than the creditors might exhibit.

The management of a company is concerned with all of the above factors and, in addition, needs financial information that is useful for decision-making purposes.

A selection of the financial ratios that are most often computed to analyze a business is shown on the following pages.

Net income (Income Statement) Average total assets (Balance Sheet)

= 4.1% 465,000

(11,636,000 + 11,004,000) ÷ 2

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Ratios To Measure Safety and Liquidity

1. Net working capital

–

Example*

Current assets (Balance Sheet) Current liabilities (Balance Sheet)

$2,292,000 $1,924,000

Ratio Example*

= 1.19:1

3. Liabilities to equity ratio**

Total liabilities (Balance Sheet) Stockholders’ equity (Balance Sheet)

$6,397,000 $5,239,000

Ratio Example*

= 1.22:1

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*

= 1.9 times

*Figures in examples are from the sample financial statements presented earlier. **Many analysts refer to this ratio as the “debt to equity ratio” even though, technically, the term “debt” normally refers to loans made to the company and excludes other liabilities.

Another measure of the ability to pay current liabilities as they mature. A ratio of 1:1 or greater corresponds to positive net working capital.

Indicates the mix of funding provided by owners (common and preferred stockholders) and creditors. The greater the number, the “more leveraged” is the company.

Measures the company’s ability to pay both the interest and the current principal installments on its outstanding debt and suggests the degree of safety for creditors concerning currently due debt service obligations.

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A measure of the shorter-term, more liquid assets available to meet short-term obligations and serve as a cushion against unforeseen needs for resources.

$2,292,000 –1,924,000 $ 368,000

2. Current ratio

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 Example*

Measures the ability of a company to cover the payment of interest to creditors.

Current assets (Balance Sheet) Current liabilities (Balance Sheet)

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1. Average collection period

Average accounts receivable (Balance Sheet) Average daily sales (Income Statement)

(1,178,000 + 1,175,000) ÷ 2 7,934,000 ÷ 365

Ratio Example*

Ratios To Measure Operating Efficiency

1,176,500 21,737

= = 54.1 days

Measures the average number of days’ sales that are uncollected in accounts receivable, providing an idea of how successful the firm is in collecting amounts due from its customers.

2. Receivables turnover

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 the company 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) ÷ 2 6,816,000 ÷ 365

Ratio Example*

= 23.6 days 441,000 18,674

4. Inventory turnover

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 average number of days’ shipments that would be filled. This measure can be used to assess the efficiency of the company’s distribution system.

An alternative measure of how quickly inventory is sold and how efficiently it is managed.

*Figures in examples are from the sample financial statements presented earlier.

◆ RUF 1/1016

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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.