Understanding Financial Statements

In This Chapter

Understanding the functions of accounting and financial reporting Looking at recent trends in financial reporting

Examining mainline financial statements and what they’re for Using financial statements for value investing.

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nowledge is power. Nowhere is that more true than in the investing world. Value investors need to know about the companies they invest in, just as traders need to know what’s happening in the market minute-by- minute. In either investing space, absence of knowledge reduces investment decisions to mere guesswork.

Fortunately for the value investor, the SEC requires publicly traded companies to publish complete financial information about themselves. An enor- mous amount is available and easy to find. But for most of us, unfortunately, it’s too muchinformation, and too confusing. How many of you have read an annual report from cover to cover and gained a solid understanding of the business from doing so? Not many, right?

Most people who open an annual report look at the pictures and read a few highlights — if they open it at all. Some may read management’s optimistic commentary about the strength of the company’s markets, products, and financials. A few may look at the colorful graphs and charts. The more curi- ous look enviously at executive salary and option grant disclosures.

But what about the financials themselves? The goes-into’s and goes-outta’s indicating the true health and success of the business? The challenge is to acquire the right information about a company and then to convert it into

actionable investing knowledge. This knowledge reveals the true character and dynamics of a business, the intrinsic value, the business performance characteristics that conclusively indicate whether you’d want to own a company — which in turn may suggest that it’s a good place to invest.

To the untrained eye, most of the information public companies disclose is too complex and detailed to make much sense of for the common reader. The unknowing reader is unaware of what’s important and may even be misled.

Although it was worse prior to the 2001 Enron and WorldCom scandals, it is still possible to present legally correct information in ways that the true meaning isn’t necessarily obvious to the investor.

The goal of this chapter and the next few chapters is to provide a guide for separating the wheat from the chaff. You won’t emerge from this section of the book prepared for the next CPA examination or a career in a corporate finance department. You won’t be able to prepare financial statements. The main idea is to know what you need to know to invest rationally and wisely.

We start with a basic overview of financial statements and moves forward into the balance sheet, income, and cash flow statements. Building on that base, it advances into basic financial analysis, using ratios to gain a better understanding of what the financial data tell us. Along the way, you’ll see some of the tricks of the trade and creative accounting practices that can and do deceive the inattentive investor from time to time.

Accounting Isn’t Just for Accountants

Why is accounting so important, anyway? Why does an individual investor care how a company counts its beans? The purpose of accounting is just to pay bills, collect money owed, pay taxes, and keep track of what’s in the bank, right? And to keep a small army of CPAs, analysts, and clerks employed?

Wrong. Accounting, and the financial reporting that emerges from accounting, serves a critical function: to reflect the economic reality of a company and its business.

Accounting and accountants are supposed to project a fair, unbiased view of company performance. Accountants build financial reports according to accepted practices in the field, which dictate such principles as substance over form, conservatism, and materiality. But despite (and maybe because of) the fact that no fewer than three governing bodies decree accounting and reporting practice, a degree of latitude and flexibility exists in how reporting is actually done.

This flexibility exists mostly in the valuation of assets and determination of revenue and cost. Those issues are covered in Chapters 7 through 9. And companies took advantage of this flexibility, especially in the late 1990s as

they became increasingly under the gun to perform, especially in the short term. Back in those days, the art of creative accounting bloomed to help companies achieve desired levels — on paper — of performance. Accounting is supposed to be used to measure and report business results, not to achieve them!

Value investors need to be smart about what and how much to question in a financial report. The investor who spends his time questioning the origin of every number in a financial report will never come up for air and probably will never make a successful value investment as a result. Without seeing all background data, you can’t possibly understand the origin of all those stated numbers anyway. The smart investor knows what to look for in a statement and what levers a company’s management can throw to convey a certain image. It’s okay to be a skeptic, but it’s probably not productive to dispute every figure in the report. As with so much else in life, focus on what’s important.

The State of Financial Statements

If every company were able to report information as it pleased, financial reports would be apple-to-orange nightmares, rendering all information use- less to everyone. The purpose of financial reporting is to present accounting information in a comprehensible, consistent format. But one person’s “comprehensible” may be another’s “complex,” and “consistent” doesn’t mean

“exactly the same.” Why did financial reporting evolve this way? In part, because financial statements serve a lot of different readers.

A family of readers

Financial information isn’t just for those who commit equity capital to a company. Those who commit debt capital (as in loans from banks, for example) have an equal, if not greater, vested interest in a company’s financial health.

Here’s a short list of interested parties and what they want to know:

Shareholderswant to know about a company’s short- and long-term financial health and performance to decide whether to keep or expand their investment.

Potential shareholderswant to know a company’s financial health and performance before they make an initial investment.

Creditors and lenderskeeping track of a company’s financial health to know whether to keep or expand credit.

Supplierswant to better understand a company’s business to determine product fit and know whether to extend credit.

Customers,especially business-to-business customers, want information about a company’s products and dependability as a supplier.

Potential employees want to understand a company’s products and culture to determine whether the company is stable.

Government statisticians and market analystslook at financial reports to understand industries and financial performance within an industry.

The point: As an individual investor, realize that you aren’t the only customer.

It’s hard to speculate how company-published financial information would change if investors werethe only customer, but it’s unlikely that reporting will change to perfectly meet the investor’s needs. You have to make do with what you have.

A slave of many masters

Imagine if the tax code were specified not only by the IRS, but also by three or four different agencies, public and private, all with a hand in the matter.

That scenario is pretty close to what the financial reporting professional faces.

No fewer than three agencies are involved in creating the rules and constructs for reporting financial performance:

The Financial Accounting Standards Board (FASB) The U.S. Securities and Exchange Commission (SEC)

The American Institute of Certified Public Accountants (AICPA) Each entity researches and publishes opinions and acts as a watchdog. The SEC can require compliance to its own dictates and to those of the others, especially the FASB. The FASB issues numbered guidelines for financial reporting that companies can choose to adopt or be required to adopt by the SEC.

The SEC acts as overseer and enforcer of regulations and cooperates with the FASB and other agencies to initiate new regulations and standards. The AICPA sets standards governing the accountancy profession and the conduct of indi- viduals within that profession.

While the FASB, SEC, and AICPA shape most financial reporting law and practice, recognize that Congress itself plays a big role, especially with sweeping legislation like the 2002 Sarbanes-Oxley Act. And there is a push toward greater international consistency in financial reporting being led by the International Accounting Standards Board (IASB). Someday, it all may be simpler, but right now it’s a pretty complicated landscape.

Value investors should watch out of the corner of their eyes for financial reporting standards changes and discussions leading toward change. The financial media usually report the big ones. For a deeper look — or to see what’s coming before it arrives — the SEC Web site, www.sec.gov, is a good source.

Financial Statement Anatomy

The rest of this chapter covers the financial statements themselves and the forms in which they typically arrive. Many of you will get your statements from published annual reports or quarterly summaries, but more and more this information is found in Web portals like Yahoo! Finance.

Regardless of your source, what you’ll find is usually the same. The annual report is a more complete package, containing company market information, management perspective, and certain other legal reporting requirements. So the discussion will start there, recognizing that regardless of where you get your financial statements, there’s more work to do to understand them.

The 10-K annual report

The Form 10-K annual report and its quarterly sibling, the 10-Q, form the backbone of detailed company analysis for investors and other financial statement readers.

One of the SEC’s many goals is to ensure that financial information about public companies is correct, consistent, regularly reported, and readily available. So the SEC created reporting forms for an assortment of financial information: financial results, financial changes, and ownership changes.

The 10-K is similar to a company’s printed and distributed annual report.

However, it goes into more detail, and most dispense with the glossy pictures and marketing material. It looks like a government document because it is one. The reports are available from the company investor relations site or the EDGAR site (http://sec.gov/edgar/searchedgar/company search.htmlfor the company search page) and through certain other sources like The Wall Street Journalannual reports service. A 10-K goes into the following details about a company’s business and financials:

Detailed business description:This includes business segments, product lines, geography, operating units, plants, property, technologies, patents, customer base and key customers, employees and employee mix, and so forth.

Company markets:And market size, market position, market growth, market share, competition, threats, and strengths.

Detailed financials:The line items are often similar to printed annual reports, but there is more history, often five to ten years’ worth, deeper analysis, and more complete notes explaining certain lines in greater detail. More detailed explanations of acquisitions, pensions, and other special accounting transactions are also usually available.

Risk factors:10-K reports list a company’s risks and how those risks may affect company performance.

Management’s analysis of results, financial condition, and go-forward prospects: Again, the information is often more detailed and contains less “spin” than that found in printed reports.

Description of legal proceedings:Usually not important, unless the company is involved in major patent, asbestos litigation, or something similar.

Dissecting the annual report

Making generalizations about the construction of an annual report isn’t easy, but most, if not all, reports contain the following elements. From one company to the next, these elements won’t look the same, be the same size, be in the same order, or contain the same information. But the main pieces are all present in some form.

Highlights

The highlights section is usually a one-page graphic summary of significant financial results: sales, earnings, and a few productivity measures key to a company’s industry. Four or five years of history are often included. Highlights are useful for a first glance, but there’s usually more to the story.

Letter to shareholders

The letter to shareholders presents a chipper one- or two-page summary, usually from the CEO, describing the past year and the year ahead. Although some managers are frank in describing and confronting a company’s difficul- ties, others are not. You may see a discussion of milestones and achievements (“We opened our 2,000th store,” “We maintain an in-stock level unequaled in the retail world,” or “We achieved #1 position according to XYZ Industry News”) without a lot of discussion of whether they were worthwhile. The letter may include something about new customers, new technologies, and employment practices. The value investor can assess accomplishments and the overall tone and candidness of these statements, Investors look for clear

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 discussion 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 subsidiaries; and (2) many, many accounts are combined into a simplified reporting structure for presentation. Consolidation makes the resulting statements shorter and easier to understand.

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