Understanding Financial Statements EIGHTH EDITION

1. Understanding Financial Statements EIGHTH EDITION Lyn M. Fraser Aileen Ormiston

2. Income Statement and Statement of Stockholders’ Equity Learning about earnings, the bottom line, Is very important most of the time. A phony number Just may encumber Those folks trying to make more than a dime. --A. Ormiston (C) 2007 Prentice Hall, Inc.

3. The Income Statement Also called the Statement of Earnings Presents: Revenues Expenses Net Income Earnings Per Share (C) 2007 Prentice Hall, Inc.

4. The Income Statement (cont.) Comes in two basic formats Multiple-step Single-step (C) 2007 Prentice Hall, Inc.

5. The Income Statement (cont.) Multiple-step Provides several intermediate profit measures prior to the amount of net earnings for the period: • Gross profit • Operating profit • Earnings before income taxes Should be used for purposes of analysis (C) 2007 Prentice Hall, Inc.

6. The Income Statement (cont.) Single-step Groups all items of revenue together, then deducts all categories of expense to arrive at a figure for net income (C) 2007 Prentice Hall, Inc.

7. The Income Statement (cont.) Regardless of format, certain special items, if they occur during an accounting period, must be disclosed separately on an income statement These include. . . (C) 2007 Prentice Hall, Inc.

8. The Income Statement (cont.) • Discontinued operations • Extraordinary transactions • Cumulative effect of changes in accounting principles (C) 2007 Prentice Hall, Inc.

9. Common-Size Income Statement Useful analytical tool Expresses each income statement item as a percentage of net sales Shows the relative magnitude of various expenses relative to sales, the profit percentages, and the relative importance of “other” revenues and expenses (C) 2007 Prentice Hall, Inc.

10. Common-Size income statement (cont.) Comparison of two major retail companies* Comparison using $ ($ are in millions): Retailer ARetailer B Net Sales $ 287,989 $ 46,839 Cost of Sales 219,793 31,445 Operating Expenses 51,105 11,793 Net Income 10,267 3,198 *Data from SEC website, www.sec.gov (C) 2007 Prentice Hall, Inc.

11. Common-Size income statement(cont.) Comparison of two major retail companies* Comparison using common size income statement %: Retailer ARetailer B Net Sales 100.00 100.00 Cost of Sales 76.32 67.13 Operating Expenses 17.75 25.18 Net Income 3.57 6.83 *Data from SEC website, www.sec.gov (C) 2007 Prentice Hall, Inc.

12. Net Sales Sales are generally reported net of sales returns and sales allowances A sales return is a cancellation of a sale A sales allowance is a deduction from the original sales invoice price (C) 2007 Prentice Hall, Inc.

13. Net Sales—Related Issue Are sales growing in “real” (inflation-adjusted) as well as “nominal” (as reported) terms? (C) 2007 Prentice Hall, Inc.

14. Net Sales—Related Issue(cont.) An adjustment of the reported sales figure with the Consumer Price Index (or some other measure of general inflation) will enable the analyst to make a comparison of the changes in real and nominal terms (C) 2007 Prentice Hall, Inc.

15. Cost of Goods Sold (COGS) • Also called “Cost of Sales” • Cost to seller of products or services sold to customers • Important for profit determination • Largest expense item for many firms • Impacted by cost flow assumption used to value inventory • Cost of goods sold percentage is: Cost of goods sold Net sales (C) 2007 Prentice Hall, Inc.

16. Gross Profit • First step of profit measurement • Difference between net sales and COGS • Key analytical tool in assessing a firm’s operating performance • Gross Profit Margin is: Gross profit Net sales (C) 2007 Prentice Hall, Inc.

17. Understand the Math! If COGS percentage increases or decreases, this does not necessarily mean that costs have increased or decreased (C) 2007 Prentice Hall, Inc.

18. Understand the Math!(cont.) The change in the percentage may be caused by decreases or increases in the selling price For example. . . (C) 2007 Prentice Hall, Inc.

19. Understand the Math! (cont.) Always pay attention to the numbers—know the difference between raw dollars and percentages! (C) 2007 Prentice Hall, Inc.

20. Operating Expense Have considerable impact on the firm’s current and future profitability Important to track carefully--trends, absolute amounts, relationship to sales, relationship to industry competitors (C) 2007 Prentice Hall, Inc.

21. Operating Expense(cont.) Selling and administrative Advertising Operating lease payments Depreciation and amortization Repairs and maintenance Examples: (C) 2007 Prentice Hall, Inc.

22. Depreciation and Amortization Depreciation Used to allocate the cost of tangible fixed assets, other than land, that will benefit a business for more than a year, such as: Buildings Machinery Equipment Furniture and Fixtures Motor Vehicles (C) 2007 Prentice Hall, Inc.

23. Depreciation and Amortization (cont.). Amortization is the allocation process applied to: Capital leases Leasehold improvements Cost expiration of intangible assets Patents Copyrights Trademarks Licenses Franchises Goodwill (C) 2007 Prentice Hall, Inc.

24. Depreciation and Amortization(cont.) The amount of expense recognized in any accounting period will depend on • the level of investment in the relevant asset • estimates with regard to the asset’s service life and residual value • and for depreciation, the method used (C) 2007 Prentice Hall, Inc.

25. Operating Profit • Second step of profit measurement • Also called EBIT—Earnings Before Interest and Taxes • Measures overall performance of company’s operations: sales revenue less expenses associated with generating sales (C) 2007 Prentice Hall, Inc.

26. Operating Profit (cont.) • Provides a basis for assessing the success of a company apart from its financing and investing activities and separate from tax considerations • Operating Profit Margin is: Operating profit Net sales (C) 2007 Prentice Hall, Inc.

27. Other Income (Expense) Revenues/expenses other than from operations Dividend and interest income Interest expense Investment gains/losses Equity earnings/losses Sales of fixed assets gains/losses Includes (C) 2007 Prentice Hall, Inc.

28. Equity Earnings Two methods may be used to account for investments in voting stock of other companies of less than 50% Equity Cost (C) 2007 Prentice Hall, Inc.

29. Equity Method Allows the investor proportionate recognition of the investee’s net income, irrespective of the payment or nonpayment of cash dividends (C) 2007 Prentice Hall, Inc.

30. Cost Method Investor recognizes investment income only to the extent of any cash dividends received (C) 2007 Prentice Hall, Inc.

31. Cost vs. Equity Analysts should be aware of whether a company uses the cost or the equity method Equity method distorts earnings in the sense that income is recognized even though no cash may ever be received (C) 2007 Prentice Hall, Inc.

32. Earnings Before Income Taxes/Effective Tax Rate • Earnings before income taxes is the profit recognized before deduction of income tax expense • Remember, income taxes paid may differ from income tax expense (deferred taxes) • Effective tax rate is: Income taxes Earnings before income taxes (C) 2007 Prentice Hall, Inc.

33. Special Items Are often one-time items that will not recur in the future (C) 2007 Prentice Hall, Inc.

34. Special Items (cont.) If companies are affected by the following three items, they must be disclosed separately on the income statement, net of income tax effects or retrospectively applied to prior periods’ financial statements: Discontinued operations Extraordinary items Accounting changes (C) 2007 Prentice Hall, Inc.

35. Discontinued Operations Occur when a firms sells or discontinues a clearly distinguishable portion of its business (C) 2007 Prentice Hall, Inc.

36. Extraordinary Items Gains and losses that meet two criteria: • Unusual in nature • Not expected to recur in the foreseeable future, considering the firm’s operating environment (C) 2007 Prentice Hall, Inc.

37. Accounting Changes • Prior to 2006, the cumulative effect of a change in accounting principle was disclosed when a firm changed an accounting policy • Retrospective application to prior periods’ financial statements is required for changes in accounting principles for fiscal years beginning after 12/15/2005 per SFAS #154, “Accounting Changes and Error Corrections” (C) 2007 Prentice Hall, Inc.

38. Net Earnings • Also called the “bottom line” • Represents the firm’s profit after consideration of ALL revenue and expense • Net profit margin is: Net earnings Net sales (C) 2007 Prentice Hall, Inc.

39. Earnings Per Common Share The net earnings available to common stockholders for the period divided by the average number of common stock shares outstanding (C) 2007 Prentice Hall, Inc.

40. Earnings Per Common Share (cont.) If firm has “complex” capital structure, it will report basic and diluted EPS Extensively used by analysts in evaluating a firm (C) 2007 Prentice Hall, Inc.

41. Earnings Per Common Share (cont.)Examples of basic and diluted EPS data reported by a variety of companies* Basic EPSDiluted EPS Airline $ .70 $ .67 Grain Mill 3.34 3.08 Recreation 1.56 1.50 Retailer 2.45 2.43 Semicond. Mfg. 1.03 1.01 *Data from SEC website, www.sec.gov (C) 2007 Prentice Hall, Inc.

42. Comprehensive Income The change in equity of a company during a period from transactions, other events, and circumstances relating to nonowner sources (C) 2007 Prentice Hall, Inc.

43. Comprehensive Income (cont.) Companies are required to report total comprehensive income in one of three ways: • On the face of the income statement • In the statement of stockholders’ equity • In a separate statement of comprehensive income (C) 2007 Prentice Hall, Inc.

44. Comprehensive Income(cont.) Currently, there are four items that may comprise a company’s other comprehensive income: • Foreign currency translation effects • Unrealized gains and losses • Additional pension liabilities • Cash flow hedges (C) 2007 Prentice Hall, Inc.

45. The Statement of Stockholders’ Equity Details transactions that affected the balance sheet equity accounts during an accounting period (C) 2007 Prentice Hall, Inc.

46. The Statement of Stockholders’ Equity (cont.) Basically, it simply explains how each account got from the balance at the beginning of the period to the balance at the end of the period and describes “events” that caused the balances to change (C) 2007 Prentice Hall, Inc.

47. Earnings Quality, Cash Flow, Segmental Accounting Other topics directly related to the income statement: • Earnings quality – assessment of the quality of reported earnings is an essential element of income statement analysis • Cash flow – cash flow from operations is a key ingredient in analyzing operating performance • Segmental accounting – reviewing the contribution by each segment of a diversified company facilitates the analysis of operating performance (C) 2007 Prentice Hall, Inc.

48. The Journey Through the Maze Continues Ch. 4: Statement of Cash Flows Ch. 5: A Guide to Earnings and Financial Reporting Quality Ch. 6: The Analysis of Financial Statements (C) 2007 Prentice Hall, Inc.