Reading Financial Reports For Dummies
Overview
Your personal roadmap to becoming fluent in financial reports
At first glance, the data in financial reports might seem confusing or overwhelming. But, with the right guide at your side, you can learn to translate even the thickest and most complex financial reports into plain English.
In Reading Financial Reports For Dummies, you'll move step-by-step through each phase of interpreting and understanding the data in a financial report, learning the key accounting and business fundamentals as you go. The book includes clear explanations of basic and advanced topics in finance, from the difference between private and public companies to cash flow analysis.
In this book, you'll also find:
- Full coverage of how to analyze annual reports, including their balance sheets, income statements, statements of cash flow, and consolidated statements
- Real-world case studies and financial statement examples from companies like Mattel and Hasbro
- Strategies for analyzing financial reports to reveal opportunities for operations optimization
Reading Financial Reports For Dummies is a can't-miss resource for early-career investors, traders, brokers, and business leaders looking to improve their financial literacy with a reliable, accurate, and easy-to-follow financial handbook.
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About The Author
LITA EPSTEIN (ORLANDO, FL) is a financial writer who focuses on career growth and business topics. She earned her MBA from Emory University and her BA from Rutgers University. Lita has written more than 40 books, including the previous editions of Reading Financial Reports For Dummies.
Sample Chapters
reading financial reports for dummies
CHEAT SHEET
If you're looking at a business with an interest in investing in it, you need to read its financial reports. Of course, when it comes to the annual report, you don't need to read everything, just the key parts.Combining the annual report with some of the financial reports a corporation files with the Securities and Exchange Commission (SEC) can help you figure profitability and liquidity ratios and get a better sense of cash flow.
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Calculation & Analysis
If you don't recognize a company's danger signs by reading the financial reports, your investment decisions may not be the best ones. The following are key signs of trouble that you may find within these pages.
Lower liquidity
Liquidity is the ability of a company to quickly convert assets to cash so that it can pay its bills and meet other debt obligations, such as a mortgage payment or a payment due to bond investors.
Calculation & Analysis
Plenty of apps on the market can help you get key company stock and financial information. Here are some of the best apps for reading financial reports (these are all free).
American Economy: This one is a must for all financial report readers. Developed by the Census Bureau, the Bureau of Economic Analysis, and the Bureau of Labor Statistics, it helps you quickly find all the key economic indicators and their trends.
Calculation & Analysis
Officially, two types of accounting methods dictate how a company records its transactions in its financial books: cash-basis accounting and accrual accounting. The key difference between the two types is how the company records cash coming into and going out of the business.
Within that simple difference lies a lot of room for error — or manipulation.
Calculation & Analysis
Form 10-K is the official annual report form the SEC requires, and it's the report you're most likely to see as part of the glossy annual report that companies send out to investors. The 10-K includes four parts.
Business operations
In Part I of the 10-K, you find the following details about business operations:
Item 1 — Business: This section describes the company's operations with discussions about product lines, major classes of customers, industries in which the company operates, and details about domestic and foreign operations.
Calculation & Analysis
Every quarter, corporations must report financial results to the SEC (which has primary responsibility for the U.S. government's oversight of public corporations) on Form 10-Q. The 10-Q isn't a blank form that needs to be filled in. Instead, the SEC provides general instructions for the information that must be included and the format in which it must be presented.
Calculation & Analysis
Any company that allows its customers to buy on credit has an accounts receivable line on its balance sheet. On a financial report, accounts receivable is a collection of individual customer accounts listing money that customers owe the company for products or services they've already received.
A company must carefully monitor not only whether a customer pays, but also how quickly she pays.
Calculation & Analysis
On a balance sheet, you may see numerous line items that start with accumulated depreciation. On the financial report, these line items appear under the type of asset whose value is being depreciated or shown as a total at the bottom of long-term assets. Accumulated depreciation is the total amount depreciated against tangible assets over the life span of the assets shown on the balance sheet.
Calculation & Analysis
For companies, cash is basically the same as what you keep in your checking and savings accounts. Keeping track of the money on financial reports is a lot more complex for companies, however, because they usually keep it in many different locations. Every multimillion-dollar corporation has numerous locations, and every location needs cash.
Calculation & Analysis
Any products a company holds ready for sale are considered inventory. The inventory on the balance sheet is valued at the cost to the company, not at the price the company hopes to sell the product for. Companies can pick from among five different methods to track inventory, and the method they choose can significantly impact the bottom line.
Calculation & Analysis
Assets that a company plans to hold for more than one year belong in the long-term assets section of the balance sheet. For financial reporting, this section shows you the assets that a company has to build its products and sell its goods.
Land and buildings
Companies list any buildings they own on the balance sheet's land and buildings line.
Calculation & Analysis
Marketable securities are a type of liquid asset on the balance sheet of a financial report, meaning they can easily be converted to cash. They include holdings such as stocks, bonds, and other securities that are bought and sold daily.
Securities that a company buys primarily as a place to hold on to assets until the company decides how to use the money for its operations or growth are considered trading securities.
Calculation & Analysis
Like the Sales line item, the Cost of goods sold line item has many different pieces that make up its calculation on the income sheet. You don't see the details for this line item unless you're a company manager. Few firms report the details of their cost of goods sold to the general public.
Items that make up the cost of goods sold vary depending on whether a company manufactures the goods in-house or purchases them.
Calculation & Analysis
The Gross profit line item in the income statement's revenue section is simply a financial reporting calculation of net revenue or net sales minus the cost of goods sold. Basically, this number shows the difference between what a company pays for its inventory and the price at which it sells this inventory.
This summary number tells you how much profit the company makes selling its products before deducting the expenses of its operation.
Calculation & Analysis
For readers of financial statements, bottom-line numbers don't tell the entire story of how a company is doing. When you hear earnings or profits reports on the news, most of the time, the reporters are discussing the net profit, net income, or net loss. Relying solely on the bottom-line number is like reading the last few pages of a novel and thinking that you understand the entire story.
Calculation & Analysis
Not all products sell for their list price. This will be accounted for on the income statement in the financial report. Companies frequently use discounts, returns, or allowances to reduce the prices of products or services.
Whenever a firm sells a product at a discount, it needs to keep track of those discounts, as well as its returns and allowances.
Calculation & Analysis
Companies can't always raise all the cash they need from their day-to-day operations. Financing activities listed on financial reports are another means of generating cash. Any cash raised through activities that don't include day-to-day operations appears in the financing section of the statement of cash flows.
Calculation & Analysis
The investment activities section of the statement of cash flows on the financial reports, which looks at the purchase or sale of major new assets, is usually a drainer of cash. Consider what this section typically lists:
Purchases of new buildings, land, and major equipment
Mergers or acquisitions
Major improvements to existing buildings
Major upgrades to existing factories and equipment
Purchases of new marketable securities, such as bonds or stock
The sale of buildings, land, major equipment, and marketable securities also appears in the investment activities section.
Calculation & Analysis
The operating activities section is the part of the statement of cash flows on financial reports where you find a summary of how much cash flowed into and out of the company during the day-to-day operations of the business.
Operating activities is the most important section of the statement of cash flows. If a company isn't generating enough cash from its operations, it isn't going to be in business long.
Calculation & Analysis
For financial reading purposes, how do you know what a reasonable P/E ratio is for a company? Historically, the average P/E ratio for stock falls between 15 and 25. This ratio depends on economic conditions and the industry the company's in. Some industries, such as technology, regularly maintain higher P/E ratios in the range of 30 to 40.
Calculation & Analysis
Basically, a statement of cash flows gives the financial report reader a map of the cash receipts, cash payments, and changes in cash that a company holds, minus the expenses that arise from operating the company. The statement also looks at money that flows into or out of the firm through investing and financing activities.
Calculation & Analysis
Sometimes you see line items on the statement of cash flows that appear unique to a specific company. For financial reporting, businesses use these line items in special circumstances, such as the discontinuation of operations. Companies that have international operations use a line item that relates to exchanging cash among different countries, which is called foreign exchange.
Calculation & Analysis
For the purpose of financial reporting, you probably think of the word debit as a reduction in your cash. Most nonaccountants see debits only when they're taken out of their banking account. Credits likely have a more positive connotation in your mind. You see them most frequently when you've returned an item and your account is credited.
Calculation & Analysis
Today investors and financial report readers get information not only by reading press releases or newspapers, but also by attending company calls for analysts, which used to be open only to financial analysts and institutional investors. Companies usually sponsor these calls when they release their annual or quarterly earnings reports.
Calculation & Analysis
With so many tricks up so many corporate sleeves, as a financial report reader, you may feel that you're at the mercy of the tricksters. You can get to the bottom of many of the common creative accounting tactics by carefully reading and analyzing the financial reports, but you have to play detective and crunch some numbers.
Calculation & Analysis
If a company is playing games with its expenses, the most likely place financial report readers find evidence is in its capitalization or its amortization policies. You can find details about these policies in the notes to the financial statements.
Companies that want their bottom lines to look better may shift the way that they report depreciation and amortization, which are the tools they use to account for an asset's use and to show the decreasing value of that asset.
Calculation & Analysis
Overstated assets make a company look financially healthier to annual report readers than it truly is. The company may report that it has more cash due than it really does, or that it holds more inventory than is actually on its shelves. The company may also report that the value of its inventory is greater than it really is.
Calculation & Analysis
Undervaluing liabilities can certainly make a company look healthier to financial report readers, but this deception is likely to lead the company down the path to bankruptcy. Games played by misstating liabilities frequently involve large numbers and hide significant money problems.
Accounts payable
Most times, an increase in accounts payable is directly related to the fact that the company is delaying payments for inventory.
Calculation & Analysis
The statement of cash flows is derived primarily from information found on a company's income statement and balance sheet in financial reports. You usually don't find massaged numbers on this statement because it's based primarily on the numbers that have already been shown on these other documents. But you may find that the presentation of the numbers hides cash flow problems.
Calculation & Analysis
There is a gamut of revenue recognition games, from slight misrepresentations to gross exaggerations. Unfortunately, many of these problems are difficult for financial report readers who are company outsiders to find.
Goods ordered but not shipped
In some cases, a company considers goods that have been ordered but not yet shipped to be part of its revenue earned.
Calculation & Analysis
Financial report readers should be aware of creating accounting tricks. Enron, once the world's largest energy trader, now lives in infamy as the host of one of the world's largest accounting scandals.
After the company declared bankruptcy in 2001, Congress enacted legislation to correct the flaws in the U.S. financial reporting system and protect investors and consumers from misleading accounting practices.
Calculation & Analysis
Financial reports developed for internal use can vary significantly from what the public sees. Internal reports don't have to follow the strict rules of GAAP (generally accepted accounting principals): They can be designed in any way that helps management make decisions.
The data for internal reports are usually the same data that companies need to collect to prepare their external reports, but the internal documents usually include more detail.
Calculation & Analysis
Although a CPA's primary role as an auditor is to make sure that a company's financial statements are presented fairly and accurately, he must also ensure that the generally accepted accounting principles (GAAP) are followed.
GAAP guidelines help a company determine the amount of financial information it must disclose and help it measure its assets, liabilities, revenues, expenses, and equity.
Calculation & Analysis
Companies love hiding their dirty laundry in the small print of the notes to the financial statements. As you read through the notes, keep an eye out for possible red flags.
Whenever you see notes titled “Restructuring,” “Discontinued operations,” and “Accounting changes,” look for red flags that may mean continuing expenses for a number of years.
Calculation & Analysis
Asset accounts come first in the Chart of Accounts, with the most current accounts (ones that the company will use in less than 12 months) listed before the long-term accounts (ones that the company will use in more than 12 months).
Tangible assets
Assets that you can hold in your hand are tangible assets, and they include current assets and long-term assets.
Calculation & Analysis
The eliminations to adjust for reporting subsidiary results don't show up in the parent company's financial reports unless some portion of the stock acquisition takes place in the year that's being reported. When the acquisition or some financial impact of that acquisition does take place in the year that's being reported, you need to look to the notes to the financial statements to get details about any financial impacts.
Calculation & Analysis
Equity accounts reflect the portion of the assets on financial reports that isn't subject to liabilities and is therefore owned by a company's shareholders. If the company isn't incorporated, the ownership of the partners or sole proprietors is represented in this part of the balance sheet in an account called Owner's equity or Shareholders’ equity.
Calculation & Analysis
Any costs on the financial statements not directly related to generating revenue are considered expenses. Expenses fall into four categories: operating, interest, depreciation or amortization, and taxes. A large company can have hundreds of expense accounts, so here is a broad overview of the types of expense accounts that fall into each of these categories:
Operating expenses: The largest share of expense accounts falls under the umbrella of operating expenses, which include advertising, dues and subscriptions, equipment rental, store rental, insurance, legal and accounting fees, meals, entertainment, salaries, office expenses, postage, repairs and maintenance, supplies, travel, telephone, utilities, vehicle expenses, and just about anything else that goes into the cost of operating a business and isn't directly related to selling a company's products.
Calculation & Analysis
Sometimes one company decides to buy another or merge with another. If a company acquires another company or merges during the year the annual report covers, a note to the financial statements is dedicated to the financial implications of that transaction. In this note, you see information about
The market value of the company purchased
The amount paid for the company
Any exchange of stock involved in the transaction
The transaction's impact on the bottom line
When a company acquires another company, it frequently pays more for that acquisition than for the total value of the purchased company's assets.
Calculation & Analysis
You may not think of pension and other retirement benefits on financial reports as types of debt, but they are. In fact, for most companies that offer pension benefits, the amount of money they owe their employees is higher than the amount they owe to bondholders and banks.
Some companies offer both pensions (which are an obligation to pay retirees a certain amount for the rest of their lives after they leave the company) and other retirement benefits (which include contributions to retirement savings plans such as 401(k)s or profit-sharing plans).
Calculation & Analysis
The final piece of the balancing equation for financial reporting is equity. All companies are owned by somebody, and the claims that owners have against the assets the company owns are called equity. In a small company, the equity owners are individuals or partners. In a corporation, the equity owners are shareholders.
Calculation & Analysis
Expenses include the items on a financial report that a company must pay for to operate the business that aren't directly related to the sale and production of specific products. Expenses differ from the cost of goods sold, which can be directly traced to the actual sale of a product. If management doesn't carefully watch the expenses, the gross profit can quickly turn into a net loss.
Calculation & Analysis
Companies must spend money to conduct their day-to-day operations, which must be accounted for on financial reports. Whenever a company makes a commitment to spend money on credit, be it short-term credit using a credit card or long-term credit using a mortgage, that commitment becomes a debt or liability.
Current liabilities
Current liabilities are any obligations that a company must pay during the next 12 months.
Calculation & Analysis
A company doesn't actually make different kinds of profits, but it has different ways to track a profit on financial reports and compare its results with similar companies. The three key profit types are gross profit, operating profit, and net profit.
Gross profit
The gross profit reflects the revenue earned minus any direct costs of generating that revenue, such as costs related to the purchase or production of goods before any expenses, including operating, taxes, interest, depreciation, and amortization.
Calculation & Analysis
The dividend payout ratio looks at the amount of a firm's earnings on financial reports that it pays out to investors. Using this ratio, you can determine the actual cash return you'll get by buying and holding a share of stock.
Some companies pay a portion of their earnings directly to their shareholders using dividends.
Calculation & Analysis
Management has been required to include a section in the annual financial report called “Corporate Responsibility for Financial Reports” or “Management's Responsibility for Financial Reports” since the financial reporting scandals of the late 1990s and early 2000s. When the Sarbanes-Oxley Act of 2002 passed Congress, this guarantee became more critical.
Calculation & Analysis
It is important for you to understand how to read your company’s liability accounts in the Chart of Accounts. Money a company owes to creditors, vendors, suppliers, contractors, employees, government entities, and anyone else who provides products or services to the company is called a liability.
Current liabilities
Current liabilities include money owed in the next 12 months.
Calculation & Analysis
At the top of every income statement on financial reports is the revenue the company brings in. This revenue is offset by any costs directly related to it. The top section of the income statement includes sales, cost of goods sold, and gross margin. Below this section, and before the profit and loss section, are the expenses.
Calculation & Analysis
Knowing that most people won't spend the time to read all the way through the annual financial report, many companies summarize their numbers in various ways. The two most common ways to summarize are to highlight the financial data presented in the financial statements and to summarize some key information in the notes to the financial statements.
Calculation & Analysis
The first note in almost every company's financial report gives you the ammunition you need to understand the accounting policies used to develop the financial statements. This note explains the accounting rules the company used to develop its numbers. The note is usually called the “Summary of significant accounting policies.
Calculation & Analysis
Any publicly traded company must provide financial reports that outside auditors have examined. You usually find the auditors’ report (a letter from the auditors to the company's board of directors and shareholders) either before the financial information or immediately following it.
Before you read the financial statements or the notes to the financial statements, be sure that you've read the auditors’ report.
Calculation & Analysis
Trying to read a balance sheet without having a grasp of its parts on a financial report is a little like trying to translate a language you've never spoken — you may recognize the letters, but the words don't mean much. Unlike a foreign language, however, a balance sheet is pretty easy to get a fix on as soon as you figure out a few basics.
Calculation & Analysis
The main course of any annual report is the financial statements. In this part, you find out what the company owns, what the company owes, how much revenue it took in, what expenses it paid out, and how much profit it made or how much it lost.
When looking at a company's financial results, make sure that you're comparing periods of similar length or a similar collection of months.
Calculation & Analysis
The income statement is the part of the financial report where you find out whether a company made a profit or took a loss. You also find information about the company's revenues, its sales levels, the costs it incurred to make those sales, and the expenses it paid to operate the business. These are the key parts of the statement:
Sales or revenues: How much money the business took in from its sales to customers.
Calculation & Analysis
The management's discussion and analysis (MD&A) section is one of the most important sections of an annual report. The MD&A may not be the most fun section to look at, but in it you find the key discussions about what went smoothly over the year and what went wrong.
Read the MD&A section carefully. It has a lot information that gives you details about how the company's doing.
Calculation & Analysis
Depreciation and amortization are accounting methods you use to track the use of an asset on your financial reports and record its value as it ages. Tangible assets (assets you can touch or hold in your hand) are depreciated (reduced in value by a certain percentage each year). Intangible assets (like intellectual property) are amortized (reduced in value by a certain percentage each year).
Calculation & Analysis
To give you an idea of how inventory can impact the bottom line on financial reports, here is an inventory scenario to take you through the calculations for cost-of-goods value by using the three key methods: average costing, FIFO, and LIFO.
In all three cases, the same beginning inventory is used, purchases, and ending inventory for a one-month accounting period in March.
Calculation & Analysis
Sales are great, but if customers don't pay on time, the sales aren't worth much to a business and their financial reports. In fact, someone who doesn't pay for the products he takes is no better for business than a thief. When you're assessing a company's future prospects, one of the best ways to judge how well it's managing its cash flow is to calculate the accounts receivable turnover ratio.
Calculation & Analysis
Debt and the interest paid on that debt are not a company's only cash requirements on financial reports. Businesses also need cash for capital expansion to grow the company (including new plants, tools, and equipment) and pay dividends to investors.
As a shareholder, you make money only when the company's stock goes up in price.
Calculation & Analysis
In addition to net income, the other number you hear in financial reporting almost as often about a company's earnings results is earnings per share. Earnings per share is the amount of net income the company makes per share of stock available on the market.
For example, if you own 100 shares of stock in ABC Company and it earns $1 per share, $100 of those earnings are yours unless the company decides to reinvest the earnings for future growth.
Calculation & Analysis
The first step in determining a company's solvency is to use financial reports to find out it’s free cash flow or how much money the company earns from its operations that it can actually put into a savings account for future use — in other words, a company's discretionary cash. This money is also called the free cash flow.
Calculation & Analysis
Gross margin looks at the profit margin based solely on sales and the cost of producing those sales. For financial reporting, it gives you a picture of how much revenue is left after subtracting all the direct costs of producing and selling the product. These costs can include discounts offered, returns, allowances, production costs, and purchases.
Calculation & Analysis
In the world of financial reporting, the net profit margin looks at a company's bottom line. This calculation shows you how much money the company has left after it has deducted all expenses — whether from operations related to the production and selling of the company's products or from nonoperating expenses or revenue not related to the company's sales of products or services.
Calculation & Analysis
The operating margin takes the financial report reader one step further in the process of finding what's left over for future use and looks at how well a company controls costs, factoring in any expenses not directly related to the production and sales of a particular product. These costs include advertising, selling, distribution, administration, research and development, royalties, and other expenses.
Calculation & Analysis
You can judge how well a company uses its assets by using financial reports to calculate the return on assets (ROA). If the ROA is a high percentage, the company is likely managing its assets well. As an investor, that consideration is important because your shares of stock represent a claim on those assets.
You want to be sure that the company is using your claim wisely.
Calculation & Analysis
Return on equity (ROE) measures how well a company does earning money for its investors. As a financial report reader, you'll probably find it easier to determine an ROE for a company than an ROA. Although the ROE is an excellent measure of how profitable the company is in comparison with other companies, you want to examine the ROA also because that ratio looks at returns for investors and creditors.
Calculation & Analysis
You can test how efficiently a company runs its operations using financial reports to calculate its return on sales (ROS). This ratio measures how much profit the company is producing per dollar of sales. By analyzing the numbers in the income statement using ROS, you can get a picture of the company's profit per dollar of sales and gauge how much extra cash the company is bringing in per sale.
Calculation & Analysis
A company's reputation for paying its bills is just as important to financial report readers as its ability to collect from its own customers. If a company develops the reputation of being a slow payer, it can have a hard time buying on credit.
The situation can get even more serious if a company is late paying on its loans.
Calculation & Analysis
Lenders are always sure to look at debt on financial reports using the debt-to-capital ratio, which measures a company's leverage by looking at what portion of its capital comes from debt financing.
How to calculate the debt-to-capital ratio
You use a three-step process to calculate the debt-to-capital ratio:
Find the total debt.
Calculation & Analysis
The interest coverage ratio looks at income on financial reports to determine whether the company is generating enough profits to pay its interest obligations. If the company doesn't make its interest payments on time to creditors, its ability to get additional credit will be hurt; eventually, if nonpayment goes on for a long time, the company may end up in bankruptcy.
Calculation & Analysis
The number of days in accounts payable ratio lets financial report readers see the average length of time a company takes to pay its bills. If a company is taking longer to pay its bills each year, or if it pays its bills over a longer time period than other companies in its industry, it may be having a cash-flow problem.
Calculation & Analysis
The financial reporting profit number you hear discussed most often in the news is the price/earnings ratio, or the P/E ratio. Basically, the P/E ratio looks at the price of the stock versus its earnings.
For example, a P/E ratio of 10 means that, for every $1 in company earnings per share, people are willing to pay $10 per share to buy the stock.
Calculation & Analysis
Stricter than the current ratio is a test in financial reporting called the quick ratio or acid test ratio, which measures a company's ability to pay its bills without taking inventory into consideration. The calculation includes only cash on hand or cash already due from accounts receivable.
Unlike the current ratio, the quick ratio doesn't include money anticipated from the sale of inventory and the collection of money from those sales.
Calculation & Analysis
You can measure a company's cash position to meet long-term debt needs by using financial reports to determine the cash debt coverage ratio. Long-term liabilities are debts that a company must pay beyond that 12-month period. If you see signs that a firm may have difficulties meeting long-term debt, that, is a major cause for concern.
Calculation & Analysis
One common way companies encourage their customers to pay early is to offer them a discount. In the world of financial reporting, when a discount is offered, a customer may see a term such as “2/10 net 30” or “3/10 net 60” at the top of its bill. “2/10 net 30” means that the customer can take a 2 percent discount if it pays the bill within 10 days.
Calculation & Analysis
How to Use Financial Reports to Determine Current Cash Debt Coverage Ratio Here's the two-step formula for calculating the current cash debt coverage ratio:
Find the average current liabilities.
Current liabilities for current year + Current liabilities for previous year ÷2 = Average current liabilities
Find the current cash debt coverage ratio.
Calculation & Analysis
You want to test how efficiently a company uses its fixed assets to generate sales, a ratio in financial reporting known as the fixed assets turnover. Fixed assets are assets that a company holds for business use for more than one year and that aren't likely to be converted to cash anytime soon.
Fixed assets include items such as buildings, land, manufacturing plants, equipment, and furnishings.
Calculation & Analysis
The big question you have for any company when examining financial reports is how quickly it sells its inventory and turns a profit. As long as a company turns over its inventory quickly, you probably won't find outdated products sitting on the shelves. But if the company's inventory moves slowly, you're more likely to find a problem in the valuation of its inventory.
Calculation & Analysis
As an investor, using financial reports to tracking the owner of stock by insiders can give you a good idea of how they feel about owning the company's stock. If most of the insiders buy the stock, it's usually a good sign — the insiders believe in the long-term performance of the company. But if you find that insiders primarily sell their holdings, trouble may be brewing.
Calculation & Analysis
One of the most commonly used debt-measurement tools in financial reporting is the current ratio, which measures the assets a company plans to use over the next 12 months with the debts it must pay during that same period. This ratio lets you know whether the company will be able to pay any bills due over the next 12 months with assets it has on hand.
Calculation & Analysis
You can look at how well a company manages its assets overall by using financial reports to calculate its total asset turnover. Instead of just looking at inventories or fixed assets, the total asset turnover measures how efficiently a company uses all its assets.
How to calculate total asset turnover
Here's the formula for calculating total asset turnover:
Net sales ÷ Total assets = Total asset turnover
You can use information from Mattel's and Hasbro's income statements and balance sheets to show you how to calculate total asset turnover.
Calculation & Analysis
U.S. financial reporting standards are different than the reporting standards of every other country in the industrialized world. The U.S. is the last of the major financial players to adopt the international reporting standards set by the international accounting community. All but the U.S. have made the commitment to adopt the international standards, even though some industrial countries are just beginning the adoption process.
Calculation & Analysis
Sometimes significant changes in a company's financial position occur between the times the company files its financial reports. When that happens, the company must file a special report called an 8-K, which reports any material changes (changes that may have a significant financial impact on the company's earnings) that happen between the times of the quarterly or annual reports.
Calculation & Analysis
The key financial statements required by both the IFRS and GAAP are similar, but the ways in which the numbers are calculated sometimes differ. Also, IFRS standards require only two years of data for the income statements, changes in equity, and cash flow statements, whereas GAAP requires three years of data for SEC registrants.
Calculation & Analysis
Financial report readers should make themselves aware of possible changes on the global horizon. So how did the process get started to reshape the global financial road map, and who are the key players?
In 2002, the U.S. Financial Accounting Standards Board (which issues GAAP rules) and the London-based International Accounting Standards Board (which issues the IFRS) entered into the Norwalk Agreement, which lays out a plan to undertake efforts to converge the U.
Annual reports can be daunting, and you may be relieved to know that you don’t actually need to scour every page of one. The following parts best serve to give you the big picture:
Auditor’s report: Tells you whether the numbers are accurate and whether you should have any concerns about the future operation of the business
Financial statements: The balance sheet, the income statement, and the statement of cash flows; where you find the actual financial results for the year
Notes to the financial statements: Details about potential problems with the numbers or how the numbers were derived
Management’s discussion and analysis: The higher-ups’ breakdown of the financial results and other factors that impact the company’s operations
The rest is fluff.
Calculation & Analysis
Reports to the government are more extensive than the glossy reports sent to shareholders. Although many different types of forms must be filed with the Securities and Exchange Commission, you can get most of the juicy information from just a few:
10-K: Annual report that provides a comprehensive overview of
Calculation & Analysis
When you're thinking of buying a stock, you want to quickly be able to determine how that stock is performing compared to others on the stock market. But you can't read financial reports in a vacuum. To assess how well a company is doing, you must compare it to other similar companies, as well as to its overall industry.
Calculation & Analysis
If you're looking at a business with an interest in investing in it, you need to read its financial reports. Of course, when it comes to the annual report, you don't need to read everything, just the key parts.Combining the annual report with some of the financial reports a corporation files with the Securities and Exchange Commission (SEC) can help you figure profitability and liquidity ratios and get a better sense of cash flow.
Calculation & Analysis
You're interested in a company, so you're reading its financial reports. Part of the test of a viable operation is having enough cash to keep the company going. Use the following formulas to make sure a company has plenty of cash to keep operating.
Free cash flow shows you how much money a company earns from its operations that can actually be put in a savings account for future use.
Calculation & Analysis
If a company doesn’t have cash on hand to cover its day-to-day operations, it’s probably on shaky ground. Use the following formulas to find out whether a company has plenty of liquid (easily converted to cash) assets.
Current ratio gives you a good idea of whether a company will be able to pay any bills due over the next 12 months with assets it has on hand.
Calculation & Analysis
You read financial reports to get a sense of a company's financial position and how viable it is in the marketplace. You can test a company's money-making prowess using the following important formulas.
Price/earnings ratio compares the price of a stock to its earnings. A ratio of 10 means that for every $1 in company earnings per share, people are willing to pay $10 per share to buy the stock.
Calculation & Analysis
Reading up on financial reports needs to become a daily routine for anyone who invests in the stock market. When companies release their financial reports, that can mean a major jump up or down in a stock's price. Finding a few good sources on the Internet to help with a quick review of the key news of the day can go a long way toward keeping you aware of what's going on with your portfolio.
Calculation & Analysis
A company groups the accounts it uses to develop the financial statements in the Chart of Accounts, which is a listing of all open accounts that the accounting department can use to record transactions, according to the role of the accounts in the statements. All businesses have a Chart of Accounts, even if it's so small that they don't realize they do and have never formally gone about designing it.
Calculation & Analysis
A company that offers shares of stock on the open market is a public company, and will have different financial reporting requirements than a private company. Public company owners don't make decisions based solely on their preferences — they must always consider the opinions of the business's outside investors.
Calculation & Analysis
So the owners of a company have finally decided to sell the company's stock publicly. What does that mean for your financial reports? You will want to know the role of an investment banker in helping a company sell its stock, as well as the process of making a public offering.
How to team up with an investment banker
The first step after a company decides to go public is to choose who will handle the sales and which market to sell the stock on.
Calculation & Analysis
You can find out a lot about a company's financial management by reading the report notes related to financial commitments. How a company manages its debt is critical to its short- and long-term profitability.
Mattel has one note that summarizes everything under one umbrella called “Seasonal financing and long-term debt.
Calculation & Analysis
Corporations must report special events to their shareholders as soon as the event can materially impact the company's results (affect the profits or losses of the company). The most common special events include the following:
Acquisitions: Before a company can finalize plans to acquire another company, it must report those plans to its shareholders.
Calculation & Analysis
Watching the board of directors can be a helpful tool for financial report readers. The shareholder landscape changed dramatically after the corporate scandals of the 2000s exposed severe corporate governance problems, beginning with the collapse of Enron.
Today shareholder groups — many led by institutional investors such as pension plans and mutual funds that own large blocks of shares in various companies — closely watch the following four major issues in the companies in which they own shares of stock.
Calculation & Analysis
Analysts can be useful tools for financial report readers, if you know what information is good information. Analysts, many of whom have completed a grueling testing process that takes at least three years to get the designation Chartered Financial Analyst, serve different roles for different people:
For large investment groups (such as mutual or pension funds): They determine whether a company's stock price accurately reflects the firm's worth and whether the stock fills a particular niche that the group wants to fill in its overall portfolio-management objectives.
Calculation & Analysis
Bond analysts are most concerned with a company's liquidity and the company's ability on financial reports to make its interest payments, repay its debt principal, and pay its bills. They used to have a reputation of doing things with a more cautious eye, but their close relationship to the investment banking side of the house was exposed during the mortgage crisis beginning in 2007.
Calculation & Analysis
Financial report readers should become familiar with bond rating agencies. Bond ratings have a great impact on a company's operations and the cost of funding its operations. The quality rating of a company's bonds determines how much interest the firm has to offer to pay in order to sell the bonds on the public bond market.
Calculation & Analysis
Companies not only send out financial reports to analysts, but also talk with analysts regularly about the reports. Sometimes you can get access to what's said by listening in to analyst calls or reading press releases. You can also get information from road shows, but you usually don't have access to them unless you're a major investor.
Calculation & Analysis
As a financial report reader, you may wonder whether you can depend on any analysts out there. Well, the answer is yes and no. Certainly, some independent analyst groups — ones that aren't paid by a brokerage house or other financial institution but that provide reports for a fee paid by people who want them — report on companies as well.
Calculation & Analysis
Financial report readers should know about reinvestment options. One way a company can build better relations with its investors is to offer them stock directly so they can avoid broker costs on every share they buy. Some companies offer their investors dividend reinvestment plans and direct stock purchase plans.
Calculation & Analysis
As an individual investor and financial report reader, you most likely see reports from sell-side analysts. These analysts work for brokerage houses or other financial institutions that sell stocks to individual investors. You get reports written by these analysts when you ask your broker for research on a particular stock.
Calculation & Analysis
Financial report readers should be aware of stock ratings, but use the information with caution. Stock ratings for general public consumption are primarily done by sell-side analysts, who seem to err on the side of optimism.
You rarely find a stock with a sell rating (a recommendation to sell the stock). In fact, when analysts testified in Congress after the analyst scandals in the early 2000s, one analyst was heard saying that everybody on Wall Street knows that a hold rating (which is intended to mean you should hold the stock but probably not buy more) really means to sell.
Calculation & Analysis
Company owners seeking the greatest level of protection may choose to incorporate their businesses. The courts have clearly determined that corporations are separate legal entities, and their owners are protected from claims filed against the corporation's activities. An owner (shareholder) in a corporation can't get sued or face collections because of actions the corporation takes.
Calculation & Analysis
A partnership or sole proprietorship can limit its liability by using an entity for financial reporting called a limited liability company, or LLC. First established in the U.S. about 30 years ago, LLCs didn't become popular until the mid-1990s, when most states approved them.
This business form actually falls somewhere between a corporation and a partnership or sole proprietorship in terms of protection by the law.
Calculation & Analysis
The IRS automatically considers any business started by more than one person a partnership, and must report their finances as such. Each person in the partnership is equally liable for the activities of the business, but because more than one person is involved, a partnership is a slightly more complicated company type than a sole proprietorship.
Calculation & Analysis
Private companies don't sell stock to the general public, so they don't have to report their finances to the government (except for filing their tax returns, of course) or answer to the public. No matter how big or small these companies are, they can operate behind closed doors.
A private company gives owners the freedom to make choices for the firm without having to worry about outside investors’ opinions.
Calculation & Analysis
Public companies must file an unending stream of financial reports with the SEC. They must file financial reports quarterly as well as annually. They also must file reports after specific events, such as bankruptcy or the sale of a company division.
Quarterly reports
Each quarter, public companies must file audited financial statements on Form 10Q, in addition to information about the company's market risk, controls and procedures, legal proceedings, and defaults on payments.
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