How to read the financial statements

The SEC requires that public corporations submit financial statements four times a year (quarterly). Quarterly reports (10Q) must be filed within 45 days of the end of each quarter, and a 10K (annual) report is required within 90 days of the end of the company’s fiscal year. The SEC reports are filed in electronic format and are immediately available on the SEC’s EDGAR database (www.sec.gov). Anyone can access the SEC database directly, but it’s easier to use a third-party site such as FreeEdgar.

Data services such as Media General Financial Services (MGFS) and Multex compile the EDGAR data into more user-friendly formats for display on major financial sites. These reports typically display the five most recent quarters or years on one page to facilitate comparisons. There is usually several days’ delay after a report is filed with the SEC before it appears on the compiled reports. However MGFS and Multex update their financial statements using data from each compa ny’s quarterly report press release. So that preliminary data is often available weeks before the firm files its SEC report. The SEC requires three financial statements in each quarterly and annual report.

Income statement: shows a company’s sales and expenses for a quarter or for a year.

Balance sheet: a snapshot showing the company’s financial condition as of the last business day of the reporting period.

Cash flow statement: shows the change in the company’s cash position from the beginning to the end of the reporting period.

Income Statement

The income statement, sometimes called the profit and loss statement, shows the firm’s sales and expenses, for the quarter or fiscal year, and for the year-ago period. Here are terms which typically appear on the income statement.

Revenues: the company’s total sales for the period. Sometimes another other revenue figure is included showing sales unrelated to its main business.

Cost of sales : the direct material and labor costs of making or acquiring the products sold. Cost of sales often includes deprecation and amortization, but it doesn’t include marketing, R&D, or other indirect costs.

Gross profit : Revenues minus cost of sales.

Research and development : Costs of developing new products and services.

Sales and marketing : Often combined with general and administrative costs.

General and administrative : All other expenses that are not listed separately.

Depreciation and amortization : A noncash accounting entry.

Depreciation represents the loss in value of hard assets such as buildings and machinery over the reporting period. When a company makes an acquisition, the excess paid over the acquired firm’s book value is termed goodwill. Until recently, the acquiring company was required To amortize the goodwill over a specified period. That requirement was changed in 2002, and firms are no longer required to amortize goodwill. Note: some companies include D&A in the cost of sales.

Interest expense : Interest on loans acquired to finance the firm’s main business.

Total operating expenses : the total of all expenses listed above including cost of sales.

Operating income : revenues less operating expenses, also known as EBIT.

Interest income/expense : interest income or expenses not associated with the company’s main business.

Income before tax : Operating income less interest expense.

Income tax : Taxes due for period.

Net income : Income before tax less income tax. This is the bottom line net profit.

Average number of shares : The average number of shares outstanding during the period.

Earnings per share: Net Income divided by average number of shares.

Balance Sheet

The balance sheet lists a firm’s assets and liabilities as of the last day of the reporting period. On traditional balance sheets, assets are listed in a column on the left and liabilities on the right. Accounting rules require that the sum of those two columns match. Since assets usually exceed liabilities, another entry, called shareholders equity, is added to the right column to make the column totals match. The shareholders equity is negative when liabilities exceed assets. Nowadays, balance sheets list everything in a single column, but the same principles apply. Assets and liabilities are divided into two sections: current and long-term.

Current assets typically include cash, accounts receivables, inventories and prepaid expenses. Long-term assets include buildings, equipment, long-term investments, and goodwill. Current liabilities are short-term debts such as accounts payable, short-term loans, the current portion (due this year) of long-term debts, lease obligations, and the like. Long-term debt includes lease obligations as well as bond obligations and other long-term loans.

Current Assets

Cash and equivalents : cash and highly liquid fixed income investments with maturities of three months or less.

Short-term investments : stocks and other liquid securities.

Accounts receivable : money owed to the company by customers for products received.

Inventory: raw materials, work in process, and finished products.

Long-Term Assets

Property, plant, and equipment : all hard assets such as buildings, airplanes, machinery, and so forth.

Goodwill : a product of an acquisition. Goodwill is the difference between the purchase price and the book value of the acquired company.

Intangibles : patents, trademarks, and so forth.

Long-Term investments : investment in other companies, and so forth.

Current Liabilities

Accounts payable : amounts owed to suppliers, consultants, contractors, and so forth.

Accrued expenses : similar to accounts payable.

Short-term debt : any borrowings that must be repaid within one year.

Current portion LT debt : the portion of long-term debt principal and interest due within one-year.

Capital leases : lease payments due within one year.

Long Term Debt

Long-term debt : bonds and other long-term credit.

Capital lease obligations : if a company signs a 10-year lease, the entire 10-year’s payments are considered a long-term debt. This entry covers the lease payments due beyond 12 months.

Deferred income tax : taxes due, but not yet paid.

Deferred anything : any income statement expense that hasn’t been paid can go here.

Other liabilities : other long-term obligations.

Total liabilities : total of all short- and long-term liabilities.

Shareholders Equity

A variety of accounting entries go in this section to make the total liabilities plus shareholders equity equal the total assets.

Statement of Cash Flows

Shows the cash generated or consumed by the company’s business operations, and investing and financing activities. The cash flow statement consists of three sections:

Operating

Investing

Financing activities

Unlike the quarterly income statement that shows each quarter’s results separately, the quarterly cash flow statement shows fiscal yearto- date totals for each line item.

Operating Activities

The operating cash flows can be shown in one of two formats. The direct method lists the cash received and disbursed by line item. The more widely used indirect method starts with the net income and adds back the noncash deductions that reduced reported earnings, and subtracts real cash expenses that, according to accounting rules, weren’t deducted from earnings.

Net Income : reported after-tax income.

Depreciation and amortization : reverses noncash D&A added to operating costs on the income statement. If the D&A charge wasn’t listed as a separate line item on the income statement, it was added to cost of sales, thereby reducing the reported gross profit by the D&A amount.

Deferred taxes : Taxes deducted from income that have not yet been paid.

Tax benefits from employee stock options : when an employee exercises an option to buy stock, the difference between market price at the time of exercise, and the price the employee pays, is taxable income for the employee. However, the employer is allowed to deduct the same amount from its income taxes for the period. The tax credit shows up as positive cash flow since it was deducted from income, but not paid. Most Websites do not list stock option benefits as a separate line item on their cash flow statements. It is shown separately, however, on the company’s SEC reports.

Deferred revenue: revenues received that have not as yet appeared on the income statement, usually because they are for services not yet provided.

Accounts receivables and inventories: these working capital items are shown as negative numbers (subtracted) if their value increased during the period, and vice versa. If a company sells its receivables to a third party, a process call “factoring,” the amount received from the third party increases cash from operations.

Accounts payable: added to operating cash flow if the monies owed increased, and subtracted if the accounts payable decreased during the period.

Cash from operations: reported net income adjusted for operating cash flow line items.

Investing Activities

Investing cash flow includes capital expenditures and other investments.

Capital Expenditures: net investments in buildings and equipment. Operating cash flow less capital expenditures is typically defined as free cash flow. Software development costs are frequently capitalized instead of appearing as a charge on the income statement. In those instances, the capitalized software expenditures are listed in investing activities. Companies capitalizing software development will report higher operating cash flow than if they hadn’t capitalized those costs.

Acquisitions: cash flows resulting from the acquisition or sale of a subsidiary, partnership, and so forth.

Purchase license: Cisco Systems and probably others list a separate purchase license line item. Consider these and similar entries the same as capital expenditures when computing free cash flow.

Purchase and sales of investments: investments not directly related to the company’s main business.

Change in long-term receivables: changes in working capital (inventories, receivables, and accounts payables) are typically included in the operating cash flow total. However, Nortel Networks, and possibly others, lists changes in long-term receivables in the investing section.

Financing Activities

Money raised from the sale of the company’s own stock as well as the net of new debt versus paid down debts and dividends paid out.

Net Change in Cash

The net effect of operating, investing, and financing activities to the company’s total cash position is listed on this line.

Finding the Data

The financial statements included with the SEC reports provide more detail than the statements provided by most Websites. But the financial sites usually present the data in a format better suited to analysis. For instance, most display several quarters, or years, side by side, making it easier to spot trends.

Multex Investor and MSN Money both provide easily readable financial statements. Multex reports the numbers exactly as reported to the SEC, while MSN Money subtracts D&A from cost of sales before computing gross margin.

MSN Money lists EBITDA as a separate line item, a big help when you’re analyzing financial strength. Unfortunately, MSN Money’s income statements combine R&D and SG&A expenses into one SG&A line item, making the statements unsuitable for many analyses. On the other hand, MSN Money’s key ratios and financial statements 10-year summaries are essential tools for calculating target prices

Hoover’s simplifies margin analysis by calculating gross margins, operating margins, and profit margins for you. Hoover’s calculates its gross margins excluding D&A, making them usable for comparing gross margins between companies. Hoover’s combines the income statement and balance sheet on the same page, making it easier to calculate receivables and inventory percentages of sales. Like MSN Money, Hoover’s doesn’t separate SG&A and R&D expenses on its income statements, even on their premium in-depth financials. Hoover’s free service doesn’t provide cash flow statements.

Morningstar is the only site I’ve found that displays TTM operating cash flow, making its Financials report a huge timesaver for our busted cash burner analysis.

Pro Forma Accounting vs. GAAP

During the 1990s, many firms, especially techs, emphasized pro forma results in their earnings reports over the numbers resulting from generally accepted accounting practices (GAAP). Originally pro forma meant as if and was mainly employed to present the results of recently merged companies as if they had always been a single company. Lately company managements gloomed onto pro forma as a way of inflating their reported earnings by designating a variety of loss items as nonoperating or nonrecurring, and simply not counting them when computing earnings. Unfortunately, the analyst community decided that was a good idea and based their published earnings forecasts on pro forma instead of GAAP results.

However the SEC requires companies to report their results in GAAP format. So at least one of the detailed financial statements included in quarterly report press releases, and all financial statements filed with the SEC and compiled on financial Websites do follow GAAP standards. Since the analysts’ earnings forecasts don’t match GAAP earnings, you can’t compare forecast EPS to historical values found on the company’s financial statements.

The entire pro forma issue is in the spotlight at this writing, and it’s possible that its use will have diminished by the time you read this.