Reading Financial Reports For Dummies. Lita Epstein
in Chapter 14.
Tracking cash is vital to the day-to-day operations of any company. The frequency of a company's cash reporting depends on the volatility of its cash status — the more volatile the cash, the more likely the company needs frequent reporting to be sure that it has cash on hand to pay its bills. Some large firms actually provide cash reporting to their managers daily. I talk more about cash reporting in Chapters 15 and 16; Chapter 15 focuses on incoming cash, and Chapter 16 deals with outgoing cash.
Dissecting the Annual Report to Shareholders
The annual report gives more details about a company's business and financial activities than any other report. This document is primarily for shareholders, although any member of the general public can request a copy. Glossy pictures and graphics fill the front of the report, highlighting what the company wants you to know. After that, you find the full details about the company's business and financial operations; most companies include the full 10-K that they file with the SEC.
Breaking down the parts
The annual report is broken into the following parts (I summarize the key points of each of these parts in Chapter 5):
Highlights: These are a narrative summary of the previous year's activities and general information about the company, its history, its products, and its business lines.
Letter from the president or chief executive officer (CEO): This letter is directed to the shareholders and discusses the company's key successes or explains any major failures.
Auditors’ report: This report tells you whether the numbers are accurate or whether you need to have any concerns about the future operation of the business.
Management's discussion and analysis: In this part, you find management's discussion of the financial results and other factors that impact the company's operations.
Financial statements: The key financial statements are the balance sheet, income statement, and statement of cash flows. In the financial statements, you find the actual financial results for the year. For details about this part of the report, check out the following section, “Getting to the meat of the matter.”
Notes to the financial statements: In the notes, you find details about how the numbers were derived. I talk more about the role of the notes in Chapter 9.
Other information: In this part, you find information about the company's key executives and managers, officers, board members, and locations, along with new facilities that have opened in the past year.
Getting to the meat of the matter
No doubt, the most critical part of the annual report for anyone who wants to know how well a company did financially is the financial statements section, which includes the balance sheet, the income statement, and the statement of cash flows.
The balance sheet
The balance sheet gives a snapshot of the company's financial condition. On a balance sheet, you find assets, liabilities, and equity. The balance sheet got its name because the total assets must equal the total liabilities plus the total equities so that the value of the company is in balance. Here's the equation:
Assets = Liabilities + Equities
Assets appear on the left side of a balance sheet, and liabilities and equities are on the right side. Assets are broken down into current assets (holdings that the company will use in the next 12 months, such as cash and savings) and long-term assets (holdings that the company will use longer than a 12-month period, such as buildings, land, and equipment).
Liabilities are broken down into current liabilities (payments on bills or debts that are due in the next 12 months) and long-term liabilities (payments on debt that are due after the next 12 months).
The equities portion of the balance sheet can be called owner's equity (when an individual or partners closely hold a company) or shareholders’ equity (when shares of stock have been sold to raise cash). I talk more about what information goes into a balance sheet in Chapter 6.
The income statement
The income statement, also known as the profit and loss statement (P&L), gets the most attention from investors. This statement shows a summary of the financial activities of one quarter or an entire year. Many companies prepare P&Ls on a monthly basis for internal use. Investors always focus on the exciting parts of the statement: revenue, net income, and earnings per share of stock.
The income statement also tells you how much the company is spending to produce or purchase the products or services it sells, how much the company costs to operate, how much it pays in interest, and how much it pays in income tax. To find out more about the information you can find on an income statement, go to Chapter 7.
The statement of cash flows
The statement of cash flows is relatively new to the financial reporting game. The SEC didn't require companies to file it with the other financial reports until 1988. Basically, the statement of cash flows is similar to the income statement, in that it reports a company's performance over time. But instead of focusing on profit or loss, it focuses on how cash flows through the business. This statement has three sections: cash from operations, cash from investing, and cash from financing. I talk more about the statement of cash flows in Chapter 8.
Keeping the number crunchers in line
Every public company's internal accounting team and external audit team must answer to government entities. The primary government entity responsible for overseeing corporate reporting is the SEC. Its staff reviews reports filed with the SEC. If SEC employees have any questions or want additional information, they notify the company after reviewing the reports.
With GAAP in place, you may wonder why so many accounting scandals have hit the front pages of newspapers around the country for the past few years. Filing statements according to GAAP has become a game for many companies. Unfortunately, investors and regulators find that companies don't always engage in transactions for the economic benefit of the shareholders, but sometimes do so to make their reports look better and to meet the quarterly expectations of Wall Street. Many times, companies look financially stronger than they actually are. For example,