Understanding Financial Statements

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Long-Term Liabilities

Long-term liabilities are items that mature in excess of one year from the balance sheet date. Maturity dates (when payment is due) may run up to 20 or more years. An example of this would be real estate mortgages. Normally, items in this area are retired in annual installments.

Long-Term Liabilities - Other Long-Term

The items most often appearing in this category are mortgage loans, usually secured by the real estate itself, bonds, or other long term notes payable. Bonds are a means of borrowing long-term funds for large and well established companies. When a company is big enough and financially sound, it will sometimes be able to borrow money on a long-term unsecured basis. When this occurs, the unsecured deferred notes are called debentures. When reviewing unsecured long-term note payable, you should determine the holders of the notes. (This information may be found in the footnotes to the statement prepared by an accountant.) Frequently the owner or principals of the business will hold the notes. In a corporation, the principals can also become creditors and collect interest. To do this, they could simply loan the corporation money. They would be able to obtain repayment along with other unsecured creditors in the event of liquidation. However, at times, other creditors will require that in event of bankruptcy, officer or stockholder loans will be paid back last when assets are distributed. Money invested by stockholders is rarely recovered if insolvency occurs. It should be noted that some analysts categorize officer loans as current liabilities, primarily when repayment schedules do not exist.

Long-Term Liabilities - Deferred Credits

A deferred credit may indicate that a business has received prepayment from customers on work yet to be completed. Since the completed work is still owed to the customer, the prepayment continues to be carried as a liability until the product is completed and delivered, or the prepayment is returned to the customer. Some businesses will require an advance or payment for custom, made-to-order work or as a show of good faith.

Net Worth

Net worth represents the owners' share of the assets of the business. It is the difference between total assets and total debts. Remember our balance sheet formula - Total assets minus Total liabilities equals Net worth or Owner's equity. Basically, this is the investment the owners have at stake in the business. If liquidation occurs, assets are sold off to pay creditors and the owners received whatever remains. This is why equity sometimes is referred to as "risk capital." In proprietorships (owned by an individual) and partnerships (owned by two or more individuals) the net worth figure on the balance sheet represents:

1. Original Investment of owners.
2. Plus ... additional investments they have made.
3. Plus ... accumulated or retained profits.
4. Less ... whatever losses have been sustained.
5. Less ... and withdrawals by partners.

On corporate balance sheets, net worth may be broken down into the following categories:

• Capital stock represents all issued or unissued shares of common or preferred stock. Preferred stock is a class of stock with a claim on earnings before payment may be made to common stockholders. Usually preferred shareholders are entitled to priority over common stockholders if a company liquidates. Common stockholders assume greater risk but normally have greater reward in dividends and capital appreciation.
• Paid-in or capital surplus represents money or other assets contributed to the business, but for which no stock or owner's rights have been issued. (i.e. funds that exceed the stock's par value.)
• Earned surplus is the amount of earnings retained in the corporation and not distributed in dividends.

When a corporation shows a net worth that has as its components capital stock and retained earnings, capital stock represents shares of equity issued to owners. Retained earnings are the amount of corporate profits permitted to remain in the business by design of the officers. Analysts view a sizable amount of retained earnings as significant. It shows a business is profitable and successful if it recognizes the need for net worth growth as the company progresses. While the balance sheet gives a very detailed description of a business, it does not indicate whether a company is making a profit or losing money. That information comes from reviewing the income statement, which in Gorman's case shows that a small profit was earned. The net worth reduction can happen in one of four ways: a loss was sustained, dividends were paid in excess of profits, capital stock was redeemed or assets were written down. Net worth goes up when earnings are retained, capital is added, assets are written up, or liabilities are written down.

The Income Statement

The income statement (also called the profit & loss statement) shows how much money a business makes or loses over a specific time period - a month, 3 months, 6 months or a year. In come statements are often prepared 4 times a year but never cover a period longer than a year. When income statements are prepared, management or its accountants extract sales and other income totals along with totals of various expenses from internal accounting records. Once expenses are computed, they are subtracted from income and either a profit or loss is shown. The results on the income statement affect the balance sheet from period to period, so it is important to review both statements to determine the full impact each has on the other.

The Incomes Statement - Net Sales

The net sales figure is derived by adding up the total invoices billed to customers during the period covered, less any discounts taken by customers. Then, any sales returns accepted from customers during the period are deducted. Deductions can be imported in some industries. For example, in retailing they can run over 10 percent. After deductions are made, the remaining figure in net sales which is important for comparative analysis and percentage calculation.

The Income Statement - Gross Profit

Gross profit is found by subtracting the cost of goods sold from net sales. Cost of goods sold is comprised of those expenses it took to manufacture, purchase merchandise and service customers. The cost of goods sold takes in material costs, labor and factory expenses involved in producing merchandise sold.

Gross profit measures the profitability of a concern's production set-up. A successful company's gross profit will cover its costs of doing business with enough left over to produce a net profit.

The Income Statement - Net Profit After Tax

Before coming up with the net profit after tax ( sometimes called net income after tax), you should be aware that all expenses directly applicable to the company's operations, including income taxes, have been deducted from gross profit. Net profit after tax truly measures the operating success of the company. When total expenses exceeds net sales, a minus figure results and a loss has occurred. If there is a surplus (profit greater than 0, it can be added to retained earnings or distributed to owners and stockholders as withdrawals or dividends. When expenses exceed net sales (when a loss occurs), it is charged against net worth and a reduction in the equity accounts occurs.

The Income Statement - Dividends/Withdrawals

This item can be very important, depending on the type of business you are reviewing - corporation, partnership or proprietorship. In the case of a partnership or proprietorship, this figure would represent withdrawals by the owners of the business. When withdrawals or dividends exceed profits they diminish net worth. This situation may have an adverse effect on business activities.

Working Capital

Working capital represents the funds available to finance current business operations. Many companies show this computation prominently in their statement, but in some instances you may want to compute it on your own. This figure is important, as it is used to determine how much excess cash a business has to fund current expenses. Working capital is the difference between current assets and current liabilities. Since a company's sources to pay its current debt come partly from current assets, a business with a comfortable margin should be able to pay its bills and operate successfully. How much working capital is enough depends on the proportion of current assets to current liabilities rather than on the dollar amount of working capital. We'll take up this ratio shortly; however keep in mind that it is good to have two dollars or more of current assets to one dollar of current liabilities than to have less, for most businesses.

Analyzing The Financial Statement

Previously, we indicated that financial statements are prepared so management can make informed, intelligent decisions affecting the success or failure of its operations. In the business world, outsiders - creditors, bankers, lenders, investors and shareholders - have varying objectives in mind when they look at a company's statements. The type of analysis and the amount of time spent depends upon the objectives of the analyst. An investor interested in a publicly owned company might spend less effort than a banker considering a loan application. A supplier considering an order from a small business might spend less time and effort than the banker. The degree of information available on a business varies according to the requirements of the business under review. For example, a banker considering a sizable loan application would normally require not only a detailed statement of condition and income for several years, but inventory breakdowns and aging schedules of receivables, accounts payable, sales plans and profitability projections. When a banker, credit manager or investor receives the financial information desired, an analysis is started and the leading tool most analysts use is ratio analysis. Ratios are a means of highlighting relationships between financial statement items. There are literally dozens of ratios which can be complied on any business. Generally, ratios are used in two ways: for internal analysis of items in a balance sheet; and/or for comparative analysis of a company's ratios at different time periods and in comparison to other firms in the same industry.

Below find fourteen key business ratios. The ratios are divided into three groups:

1. Solvency Ratios - used to measure the financial soundness of a business and how well the company can satisfy its obligations.
2. Efficiency Ratios - used to measure the quality of a firm's receivables and how efficiently it utilizes its other assets.
3. Profitability Ratios - used to measure how well a company performs.

Solvency Ratios - Quick Ratios

The quick ratio, sometimes called the "acid test" or "liquid" ratio measures the extent to which a business can cover its current liabilities with those current assets readily convertible to cash. Only cash and accounts receivable would be included, as inventory and other current assets would require time and effort to convert into cash. A minimum ratio of 1.0 to 1.0 ($1 of cash receivables to $1 current liabilities) is desirable.

Solvency Ratios - Current Ratios

The current ratio expresses the working capital relationship of current assets to cover current liabilities. A rule of thumb is that at least 2 to 1 is considered a sign of sound financial strength. However, much depends on the standards of the specific industry you are reviewing.

Solvency Ratios - Current Liabilities To Net Worth

Current liabilities to net worth ratios indicates the amount due creditor within a year as percentage of the owners or stockholders investment. The smaller the net worth and the larger the liabilities, the less security for creditors. Normally a business starts to have trouble when this relationship exceeds 80 percent.

Solvency Ratios - Current Liabilities To Inventory

Current liabilities to inventory ratio shows you, as a percentage, the reliance on available inventory for payment of debt (how much a company relies on funds from disposal of unsold inventories to meet its current debt).

Solvency Ratios - Total Liabilities To Net Worth

Total liabilities to net worth shows how all of the company's debt relates to the equity of the owners or stockholders. The higher this ratio, the less protection there is for the creditors of the business.

Solvency Ratios- Fixed Assets To Net Worth

Fixed assets to net worth ratio shows the percentage of assets centered in fixed assets compared to total equity. Generally the higher this percentage is over 75 percent, the more vulnerable a concern becomes to unexpected hazards and business climate changes. Capital is frozen in the form of machinery and the margin for operating funds becomes too narrow for day to day operations.

Efficiency Ratios - Collection Period

Collection period ratio is helpful in analyzing the collect-ability of accounts receivable, or how fast a business can increase its cash supply. Although businesses establish credit terms, they are not always observed by their customers for one reason or another. In analyzing a business, you must know the credit terms it offers before determining the quality of its receivables. While each industry has its own average collection period (number of days it takes to collect payments from customers), there are observers who feel that more than 10 to 15 days over terms should be of concern.

Efficiency Ratios - Sales to Inventory

Sales inventory ratio provides a yardstick for comparing stock-to-sales ratios of a business with others in the same industry. When this ratio is high, it may indicate a situation where sales are being lost because a concern is under stocked and/ or customers are buying else where. If the ratio is too low, this may show that inventories are obsolete or stagnant.

Efficiency Ratios - Assets To Sales

Assets to sales ratio measures the percentage of investment in assets that is required to generate the current annual sales level. If the percentage is abnormally high, it indicates that a business is not being aggressive enough in its sales efforts, or that its assets are not being fully utilized. A low ratio may indicate a business is selling more than can be safely covered by its assets.

Efficiency Ratios - Sales To Net Working Capital

Sales to net worth capital ratio measures the number of times working capital turns over annually in relation to net sales. A high turn over can indicate over trading (an excessive sales volume in relation to the investment in the business). This ratio should be reviewed in conjunction with the assets to sales ratio. A high turnover rate might also indicate that the business relies extensively upon credit granted by suppliers or the bank as a substitute for an adequate margin of operating funds.

Efficiency Ratios - Accounts Payable To Sales

Accounts payable to sales ratio measure how the company pay its suppliers in relation to the sales volume being transacted. A low percentage would indicate a healthy ratio.

Profitability Ratios - Return On Sales (Profit Margin)

Return on sales (profit margin) ratio measures the profits after taxes on the year's sales. The higher this ratio, the better the prepared the business is to handle downtrends brought on by adverse conditions.

Profit Ratios - Return On Assets

Return on assets ratio is the key indicator of the profitability of a company. It matches net profits after taxes with the assets used to earn such profits. A high percentage rate will tell you the company is well run and has a healthy return on assets.

Profitability Ratios - Return On Net Worth (Return Of Equity)

Return on net worth ratio measures the ability of a company's management to realize an adequate return on the capital invested by the owners in the company.

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