language without panaceaic jargon or buzzwords, and many look for willing- ness to discuss bad stuff in these letters — a sign of management honesty and integrity.
Business summary
This objectively worded section covers the business — its products; markets;
competition; and factors such as seasonality, patents, and international expo- sure that may affect the business. That’s usually followed by a summary of the management team, which is in turn followed by a fairly detailed discus- sion of potential risks to the business. The business summary section is one of the best ways for an investor to gain business understanding.
Management’s discussion and analysis
From there, we move into the financials themselves, which usually begin with a management discussion and analysis of the financials. The discussion covers specific financial statement components, including sales, costs, expenses, assets, liabilities, liquidity, and may cover market expansion risks.
The statements
The financial statement section usually consumes the last half to two-thirds of an annual report. Several versions of consolidatedfinancial data are presented.
What does “consolidated” mean? Are they leaving something out? No.
Consolidated means that (1) many legal subsidiaries include foreign sub- sidiaries; and (2) many, many accounts are combined into a simplified report- ing structure for presentation. Consolidation makes the resulting statements shorter and easier to understand.
Financials invariably include a balance sheet, income statement, and state- ment of cash flows. Most reports include a statement of shareholder’s equity, a statement of working capital, or some other summary of changes in the financials. The main statements, covered in more detail in Chapters 7 and 8:
The balance sheetcaptures a company’s financial position at a point in time. It shows all assets, liabilities, and owner’s equity, usually in clearly defined subsections. In fact, the balance sheet is often called a statement of financial positionor statement of financial condition.
The income statementcaptures a company’s performance over an inter- val of time. Of interest here are the sales or revenues, cost of those sales, other expenses, and, of course, the difference between sales and costs — earnings. This statement is sometimes called the statement of operationsor operating activity.
The statement of cash flowsalso captures company activity and perfor- mance over a time interval, but this time it’s done in cash terms. As explained in Chapter 8, cash and accounting flows can be different. The difference is usually timing. Cash flows are just as the name implies — cash or checks coming in, cash or checks being paid out. Cash flows are a lifeblood flow into and out of the business. Cash flows tell you a lot about company liquidity — which refers to the presence or absence of enough cash to operate, and the quality of earnings — and whether the earnings are real or a result of accounting gimmicks.
No assessment of company performance, quality, or success can be achieved without these statements and, in particular, without looking at all three state- ments together. Consider some examples of financial statements. Figures 6-1 through 6-3 are presented from the Simpson Manufacturing Company (a man- ufacturer of construction fastening products) 2006 Annual Report. Simpson is chosen as an example for the relative simplicity of the business and it’s “fit”
as a value stock. The Simpson statement example is referred to repeatedly in Chapters 7 through 10 and beyond.
Common size statements
Some annual reports provide, in addition to normal financial statements, a set of common sizestatements. Common size statements are standard finan- cial reports with all information presented as percentages. Thus, cash or accounts receivable are presented as a percentage of total assets, and the cost of goods sold or marketing expenses are presented as a percent of rev- enue. Common size statements are useful for comparing companies.
Simpson Manufacturing Co., Inc. and Subsidiaries Consolidated Statements of Operations
(In thousands, except per share data)
Years Ended December 31 2005
2006 863,180 517,885 345,295
19,254 72,199 91,975 457 183,885 161,410
(97) 3,927 (208) 165,032 62,370 166 102,496
2.12 2.10
48,300 48,891 Net Sales
Cost of sales Gross profit Operating expenses
Research and development and other engineering
Selling
General and administrative Loss (gain) on sale of assets
Income from operations Income (loss) in equity method
investment, before tax Interest income Interest expense
Income before income taxes Provision for income taxes Minority interest
Net income
Net income per common share Basic
Diluted
Weighted average number of shares outstanding Basic
Diluted
846,256 515,420 330,836
14,573 64,317 100,261 (2,044) 177,107 153,729
284 1,745 (194) 155,564 57,170 – 98,394
2.05 2.02
48,081 48,606
$
$
$
$
$
$
$
$
2004 689,053 404,388 293,665
13,029 58,869 90,959 (409) 162,448 131,217
– 749 (364) 131,602 50,094 – 81,508
1.70 1.67
48,052 48,919
$
$
$
$ Figure 6-1:
Simpson Manufactur- ing consolidated statements of operations.
Simpson Manufacturing Co., Inc. and Subsidiaries Consolidated Balance Sheets
(In thousands, except per share data)
December 31 2005 2006
148,299 95,991 217,608 11,216 6,224 479,338 197,180 44,337 33 14,446 735,344
327 22,909 36,874 8,616 7,817 3,712 80,255 338 1,866 82,459
–
–
484 114,535 526,362 11,494 652,875 735,334 Current assets
Cash and cash equivalents Trade accounts receivable, net Inventories
Deferred income taxes Other current assets Total current assets Property, plant and equipment, net Goodwill
Equity method investment Other noncurrent assets
Total assets
LIABILITIES, MINORITY INTEREST AND STOCKHOLDERS’ EQUITY Current liabilities
Current portion of long-term debt Trade account payable Accrued liabilities
Accrued profit sharing trust contributions Accrued cash profit sharing and commissions Accrued workers’ compensation
Total current liabilities
Long-term debt, net of current portion Other long-term liabilities
Total liabilities
Commitments and contingencies (Note 9) Minority interest in consolidated variable
interest entities Stockholders’ equity
Preferred stock par value $0.01; authorized shares, 5,000; issued and outstanding shares, none
Common stock par value $0.01; authorized shares, 160,000; issued and outstanding shared, 48,412 and 48,322 at
December 31, 2006 and 2005, respectively:
Additional paid-in capital Retained earnings
Accumulated other comprehensive income Total stockholders’ equity
Total liabilities and stockholders’ equity ASSETS
131,203 101,621 181,492 10,088 10,051 434,455 166,480 42,681 244 15,855 659,715
2,186 29,485 39,076 7,721 10,229 3,262 91,959 2,928 1,362 96,249
5,337
–
483 94,398 456,474 6,774 558,129 659,715
$
$
$
$
Figure 6-2:
Simpson Manufactur- ing consolidated balance sheet.
Simpson Manufacturing Co., Inc. and Subsidiaries Consolidated Statements of Cash Flows
(In thousands)
Years Ended December 31 2005 2006
102,496
457 24,536 – (2,141) 7,765 97 – (3,056) 81 232 166
7,109 (34,139) (654) (35) 8,053) 577 868 (2,417) 711 450 4,017 99,067
(51,537) (9,135) 114, 86 – – – – (60,472) Cash flows from operating activities
Net income
Adjustments to reconcile net income to net cash provided by operating activities:
Loss (gain) on sale of capital assets Deprecation and amortization
Loss on sale of available-for-sale investments Deferred income taxes
Noncash compensation related to stock plans Loss (income) in equity method investment Tax benefit of options exercised Excess tax benefit of options exercised Provision for obsolete inventory Provision for (recovery of) doubtful accounts Minority interest
Changes in operating assets and liabilities, net of effects of acquisitions:
Trade accounts receivable Inventories
Other current assets Other noncurrent assets Trade accounts payable Accrued liabilities
Accrued profit sharing trust contribution Accrued cash profit sharing and commissions Other long-term liabilities
Accrued workers’ compensation Income taxes payable
Net cash provided by operating activities Cash flows from investing activities
Capital expenditures Acquisition of minority interest Distributions from equity investment Proceeds from sale of capital assets Asset acquisitions, net of cash acquired Purchases of available-for-sale investments Maturities of available-for-sale investments Sale of available-for-sale investments Net cash used in investing activities
98,394
(2,044) 22,370 2 (4,589) 6,385 (284) 3,843 – 1,113 (134) –
(13,260) 8,409 (4,714) (192) (3,025) 11,403 701 2,025 1,249 502 2,448 130,602
(42,602) – – 4,068 – – 12,100 4,700 (21,734)
$ $
2004 81,508
(409) 18,449 – (355) 5,531 – 2,886 – 2,782 455 –
(20,296) (83,093) (506) 9 6,939 9,447 694 742 918 337 (3,484) 22,820
(45,966) – – 630 (32,525) (41,451) 8,600 60,495 (50,217)
$
Supplemental Disclosure of Cash Flow Information 727 (1.599) (17,166) 8,947 3,056 (15,444) (21,479) (20) 17,096 131,203 148,099
91 59,374 507 – 229 3,870 (5,337) Cash flows from financing activities
Line of credit borrowings
Repayment of debt and line of credit borrowings Repurchase of common stock
Issuance of Company’s common stock Excess tax benefit of options exercised Dividends paid
Net cash used in financing activities Effect of exchange rate changes on cash
Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period
Cash paid during the year for Interest
Income taxes
Noncash activity during the year for Noncash capital expenditures Common stock issued for acquisition Common stock issued for compensation Dividends declared but not paid Consolidation of assets and liabilities of variable interest entities (Note 15)
699 (2,006) – 4,095 – (9,606) (6,818) (1,764) 100,286 30,917 131,203
195 55,511 954 – 714 3,867 5,337
$
$
$
$
$
$
$
$
$ 2,047 (5,595) (31,274) 4,211 – (7,194) (37,805) 983 (64,219) 95,136 30,917
374 50,666 463 5,000 – 2,399 –
Figure 6-3:
Simpson Manufactur- ing consolidated statements of cash flows.
Notes
Ironically, the notes part of an annual report may take more room and con- tain more detail than the financial statements themselves. Notes can give a lot of important detail or “color” to support the statements.
Notes not only show more detail, but also show the accounting practice a company uses in preparing a statement. A company’s description of deprecia- tion methods, option accounting, pension funding, and the like can make big difference in interpreting the statements. Notes also disclose one-time situa- tions such as acquisitions, discontinued businesses, and asset write-downs in greater detail, or changes in accounting methods.
Auditor’s review
The auditor’s review is normally a one-page boilerplate somewhere toward the back of the annual report. This element looks pretty much the same in every annual report (because the AICPA specifies the format) and also reads much the same.
The purpose of the auditor’s review is to provide concrete evidence of review and acceptance of a company’s accounting and financial practices. Financial procedures are audited (sampled) for correct handling of material and money flow. Financial reporting practices are reviewed to make sure that information is being reasonably captured. What is important is identifying exceptions. The standard auditor’s review is three paragraphs. If the words “qualified” or
“adverse” creep into the third paragraph, or if there’s a fourth paragraph, watch out.