Understanding Financial Statements
©Prof. P.V. Viswanath, 1999, 2000

Introduction

The following introduction is uses Erich A. Helfert, Techniques of Financial Analysis, A Modern Approach, Irwin, 9th edition.

The process of value creation has three components:

Corresponding to these three components, we can visualize the three processes in the running of a firm:

  

Investment is based on plans for committing existing or new funds to three main areas:

If an investment is not working out, then it is necessary to disinvest.  Yardsticks, such as Net Present Value are used in making investment decisions.  

Once the investments are made, it is necessary to operate the resulting projects efficiently.  Decisions such as the appropriate level of operating leverage, on the production side; and the choice of price/marketing strategy on the sales side are involved in the operating process.

The profits from the operations of the firm feed into the third process, the financing process.  Here dividend payout decisions have to be made, as well as the appropriate sourcing of funds from a variety of sources, both equity-based and debt-based.

In order to take the proper decisions, it is necessary for the manager to have access to the right information.  Information related to the investment and the funding process can be found in the balance sheet, while information related to the operating process can be found primarily in the Income Statement.  The Statement of Retained Earnings provides more details regarding the disposition of the equity account.  The Statement of Cash Flows provides more detail regarding the sources and uses of cash, which can help in a proper analysis of the operations of the firm.  

We will now discuss these four financial statements in a little more detail.

The Balance Sheet

The balance sheet is a snapshot of the firm; it is a means of organizing and summarizing what a firm owns (its assets) and what it owes (its liabilities). Here is an example of a balance sheet.

Example

Assets     Liabilities    
  1993 1994   1993 1994
Current Assets     Current Liabilities    
Receivables 1200 1250 Payables 1229 1149
Inventories 1400 1683      
Cash 1987 2087      
Total Current Assets 4587 5020 Total Current Liabilities 1229 1149
      Working Capital =Current Assets- Current Liabilities 3358 3871
Fixed Assets     Long-term debt 3475 4300
Tangible Fixed Assets 5106 5315      
Intangible Fixed Assets 3000 3000      
Total assets 12693 13335 Total liabilities 4704 5449
      Shareholders' equity =    
      Owner's Equity    
      Common Stock and Paid-in Surplus 2000 1476
      Retained Earnings 5989 6410
      Total liabilities and shareholders' equity 12693 13335

Damodaran presents a convenient way of categorizing the items in a balance sheet:
 
Assets 
           Liabilities
Long Lived Real Assets Fixed Assets Current Liabilities Short-term Liabilities of the firm
Short-lived Assets Current Assets Debt Debt Obligations of the firm
Investments in securities and assets of other firms Financial Investments Other Liabilities Other long-term Obligations
Assets which are not physical, like patents & trademarks Intangible Assets Equity Equity Investment in Firm

Important Concepts Pertaining to the Balance Sheet:

Net Working Capital: The difference between current assets and current liabilities. This represents the amount of capital that the firm is using for the short-run needs of the business.

Shareholders’ Equity: The difference between what the business owns and what it owes, i.e. the shareholder’s wealth in the firm.

Liquidity: This refers to the speed and ease with which an asset can be converted to cash. Assets are normally listed on the balance sheet in order of liquidity.

Market Value versus Book Value: The Book Value of an asset is based on accounting concepts, which are often linked up with historical cost. This need not be the same as market value. In addition, assets such as managerial talent and liabilities such as potential product liability suits are often not represented on the balance sheet. Finance is usually interested in market value, rather than in book value.

The rule that assets are valued at book rather than market, in financial statements is generally true.  However, financial investments are not always subject to this rule, since, often, dependable market values can be obtained from liquid markets.  The rules that apply in this case are, in summary form, as follows:
Majority  Minority
Active Investment Active Investment Passive Investment
> 50% ownership of asset 20% to 50% ownership of asset Between 0% and 20% ownership of asset
    Investments held to maturity Investments available for sale Trading Investments
The accounting treatment:
The balance sheets of the two firms are consolidated, with the assets and the liabilities of the two firms being merged and shown together.  The ownership stake of the minority shareholders is shown in the balance sheet as a liability.		 The accounting treatment:
The investment is carried at historical acquisition cost; a proportional amount of the income of the firm is added to the book value of the investment, while dividends paid are deducted from the book value.  The proportional income is reported in the income statement, but the receipt of dividends is not recognized in the income statement.  However, the concomitant increase in cash is recorded.		 The accounting treatment:
Shown at historical value, with interest/dividends shown in the income statement		 The accounting treatment:
Valued at market, but unrealized gains and losses are shown as part of equity in the balance sheet and not in the income statement.		 The accounting treatment:
Valued at market and unrealized gains/losses are shown in the income statement.
My interpretation:
Essentially treated as a subsidiary, except that minority holdings in the owned firm are shown on the liabilities side; the same is done in the Income Statement as well.		 My interpretation:
Equity approach:
Recorded at book value just like any other asset; except that income and dividends are treated as adjustments to the book value (dividends in this case are comparable to depreciation in the usual fixed asset case, except that there will be cash implications in our situation).
The regular income of the firm would show up on the liabilities side, as an addition to retained earnings, while in our case, it is treated as a reduction on the assets side.		 My interpretation:
Recorded at book value, just like any other asset; however, this approach differs from the equity approach in terms of how income is treated.		 My interpretation:
Since these assets are traded in a liquid market, there is a reliable price available for them, and there is an intention to use this market (since the assets are considered available for sale); in this case, this price trumps acquisition cost as an accounting measure of  value.  Unrealized gains-and-losses are shown on the liabilities side, and not on the assets side as in the equity approach. 		 My interpretation:
For the same reasons as in the case of investments available for sale, these are valued at market.  Their treatment can be compared to the treatment of inventory, but even unsold "inventory" is considered "sold," because they are so liquid and saleable. 

Intangible assets, such as patents, if they are generated internally through research and development don't even show up as assets in the balance sheet since they are simply expensed.  If they are acquired from other parties, then they are shown at historical value.  Goodwill is an example of such an intangible asset.  It is created when a firm acquires another firm where the purchase price is greater than the book value of tangible assets or intangible assets such as patents and trade names; the excess price is called goodwill.  Hence it is simply a reflection of the difference between the book value of assets and the market value of the acquired firm that owned the assets.

Income Statement

An Income Statement provides information about a firm's operating activities over a specified time period.  The main categories are shown in the table below:
 
Gross Revenues from sale of products and services    Revenues
Expenses associated with generating revenues -  Operating Expenses
Operating Income for the period = Operating Income
Expenses associated with borrowing and other financing - Financial Expenses
Taxes due on taxable income - Taxes
Earnings to Common and Preferred Equity for current period = Net Income before Extraordinary Items
Profits and Losses not associated with operations -(+) Extraordinary Losses (Profits)
Profits or losses associated with changes in accounting rules - Income Changes caused by changes in 
accounting methods
Dividends paid to preferred stockholders - Preferred Dividends
  = Net Income to Common Stockholders

Example: Rasputin Corporation

Income Statement (in Millions of Dollars) 1993 1994
Sales 1745 1990
Cost of Goods Sold 690 770
Depreciation 184 184
EBIT 871 1036
Interest 122 148
Taxable Income 749 888
Taxes (34%) 255 302
Net Income 494 586
Dividends 150 165
Addition to Retained Earnings 344 421

Shares Outstanding = 125 million

Earnings per share for 1993= Net Income/# shares = 494/125 = $3.95

Dividend per share for 1993= Total Dividends/# shares = 150/125 = $1.20

An Income Statement is a record of the revenues and expenses of a firm over a particular period of time using GAAP, rather than the actual cash flows.

What sorts of information would a financial analyst look for in a firm's Financial Statements?

Let us consider a balance sheet.  We know that GAAP rules are used to make up the balance sheet; and these are tilted towards recording the past.  However, the financial analyst is interested in what the balance sheet can tell him about the future.  When a financial analyst looks at a balance sheet for purposes of valuation or for purposes of analyzing the firm's capital structure, he might like to see a balance sheet that looks somewhat like this:
 
Assets 
     Liabilities
Existing Investments
Generate Cashflows today
Includes long lived (fixed) and short-lived (working capital) assets		 Assets-in-place Debt Fixed Claim on cashflows
Little or no role in management
Fixed Maturity
Tax Deductible
Expected value that will be created by future investments Growth Assets Equity Residual Claim on cashflows
Significant role in management
Perpetual Lives

The Assets side of the picture

Given the discussion of valuation principles above, we see that it is not easy to generate values for assets-in-place and growth assets from the traditional balance sheet information.  For example, intangible assets are given short shrift in the traditional accounting methodology.  One way to do this would be to take the research and development expenses from the Income Statement and to capitalize them.

In order to do this, we would first need to get an estimate of the amount of time that it takes for research and development to be converted into commercial products.  This is called the amortizable life of the product.  This would be long for a pharmaceutical company, but shorter for a software company.  Suppose, for example, that the amortizable life is six years.  We then collect the annual R&D expenses for the company.  Assuming that the amortization is uniform over time, R&D expenses from six years ago and more, would have been fully amortized.  R&D expenses from five years ago would only have one-sixth of their value unamortized; R&D from four years ago, would be two-sixths unamortized, and so on.  These unamortized values are then added together to obtain an estimate of the value of R&D as an asset, following accounting principles similar to that used with Property, Plant and equipment.

This approach would, first of all, give us a better idea of the market value of the firm; secondly, by looking at the ratio of such "growth" assets to the total value of all assets, we can get a better estimate of the growth rate.  In addition, the greater the proportion of such "growth" assets, the lower the proportion, we would expect, of debt in the capital structure of the firm, as will be explained in the notes on Capital Structure.

Capitalization of R&D:

For example, SmithKline Beecham (SBH) report on their website Research and Development expenses for the last five years:
 
Year R & D expense (in £) Unamortized proportion Unamortized Value
1999 1018 1 1018
1998 910 0.8 728
1997 843 0.6 505.8
1996 764 0.4 305.6
1995 653 0.2 130.6

Suppose we assume that the amortizable life is five years.  Then, if we are computing the value of R&D asset in 1999, none of the £1018 incurred this year will have been amortized; all of it will be added into the value of R&D asset.  For 1998, 20% of that (or one-fifth) will be amortized, and the remaining 80% (0.8 times £910) will be included in the value of R&D asset.  Proceeding thus, we have a value of £2688 for the R&D asset as of 1999.

Of course, if we capitalize R&D expenses to create a new asset, we will have to adjust Operating Income as well.  We will add back R&D expenses, but then subtract the amortization of the R&D asset.  Hence:

Adjusted Operating Income = Operating Income + R&D expenses - Amortization of the R&D asset

Adjusted Net Income = Net Income + R&D expenses - Amortization of the R&D asset

The Liabilities side

Similarly, on the liabilities side, a financial analyst would want to know the firm's debt-equity ratio, or equivalently, the debt ratio.  Let's look at the simplest measure of the debt ratio.
 
The Debt Ratio:

How would you compute the debt ratio?  Well, we know the debt ratio is defined as Total Debt/Total Assets: just find total debt and divide by total  assets!  However, we are faced with several questions: do we take long-term debt or only short-term debt?  And what do we do with other liabilities, such as Provisions for Risks and Charges and Deferred Taxes?  The custom is to only use Long-term debt in the computation of the debt ratio number.  The reason is that short-term debt or other liabilities acquired in the normal running of the business are considered operational.  The debt ratio is used more as a financing ratio -- as a measure of risk from a long-term perspective.  If we use the example of GE (see below for the reported financial statements), the debt ratio would be 46603/304012 or 15.33% for 1997.   However, we often use the identity Debt + Equity = Total assets to generate the Debt/Equity ratio.  If we simply defined Equity as 34,438 (Total Common Equity), we would get a Debt/Equity ratio of 1.353.  However, if we used the identity, we would get a debt-equity ratio of 0.1811 or 18.11%, which gives quite a different picture.  If we are excluding current liabilities because they pertain to the operational side of the business, clearly it would be the 1.353 that would give us a better idea of the extent of the firm's leverage.

Yet another approach would be to rewrite the balance sheet by excluding all current assets and current liabilities and simply including net current liabilities (net of current assets) as an element on the liabilities side.  (On the other hand, one might argue that it's more appropriate to include working capital on the assets side).  Items such as Provisions for Risks, etc. could be folded into equity if they could be considered operational charges, effectively being financed by retained earnings.  In this case, we would have net current liabilities of 29,367 (Current Liabilities - Current Assets), with total assets the being $212,711.  Obviously, this would give us different numbers altogether.

A debt ratio, by itself, does not tell us much, however, until we compare it to the debt ratios of other firms.  Hence, the main point, is to make sure that the ratios are constructed similarly for all firms.  This again is the reason why many analysts look at the debt/equity ratio rather than the debt ratio.

For another example of debt-equity ratio computation, using AT&T, click here.  This example highlights the different numbers that are computed by different sources.

In addition to the issues mentioned above, there are some liabilities that are not clearly laid out in the firm's balance sheet.  For example, lease obligations and employee benefits are also liabilities, but these have to be estimated separately.  

Operating Leases:

Here is an example using projected operating lease payments.  Operating leases do not, under current GAAP rules, have to be reported as liabilities.  Nevertheless, they are similar to liabilities, such as bonds, in that they constitute fixed cash outflows in the future.

 Suppose a firm had equity with a book value of $800 million, and a market value of $1 billion.  It has no debt at all.  However, it does have operating leases.  The estimated operating lease payments is $90 million for the next two years, 85 m. three years hence, 80m. each for the fourth and fifth year, and 75m. for the following five years.  The firm's cost of debt is around 7%.  How would a financial analyst capitalize these lease payments?

Since the projected operating lease payments have, more or less, the same risk characteristics as the firm's debt, it is reasonable to use the cost of debt to discount the lease payments.  Doing this, we have the table below:
Year Operating Lease expense Present Value at7%
1 90 84.11215
2 90 78.60949
3 85 69.38532
4 80 61.03162
5 80 57.03889
6-10 75 219.2358
Sum of present values 569.4313

This gives us a debt value for the operating leases of $569.4313 million.  The firm's debt-to-equity ratio now jumps from 0.0 to 0.57!

Of course, if the operating lease payments are capitalized, we need to adjust the assets side of the balance sheet as well.  In fact, an asset of equal size will be created.  In addition, operating income will be affected as well, since depreciation on this asset will have to be recognized; furthermore, the operating lease expenses that had originally been recognized will have to be added back to Operating Income, since these lease payments are no more expensed.  On the other hand, there will be an imputed interest expense on the operating lease liability that will affect financing cash flows, but not operating income.

Damodaran suggests assuming, for convenience, that the interest expense on the debt created by converting operating leases be equal to the operating lease expense less the depreciation of the asset created by the operating leases.  Using this assumption, we get:

Adjusted Operating Income = Operating Income - Depreciation on operating lease asset + operating lease expenses
                                           = Operating Income + Imputed Interest expense on operating leases.

Net Income will not be affected because the imputed interest expense will have to be subtracted from Operating Income, just as any other interest expense would be.  

Here is another example in Excel.

Statement of Retained Earnings:

This statement provides information on how much of the firm’s earnings were retained in the business, and how much were paid out in dividends, as well as the cumulative amount retained during the life of the business.

Statement of Retained Earnings, Rasputin Corporation for the Year Ending December 31, 1994.
 
Balance of retained earnings, December 31, 1993 $5989
Add Net Income, 1994 $586
Less: Dividends to Common Stockholders  $165
Balance of Retained Earnings, December 31, 1994 $6410

Accounting flows versus cash flows

GAAP uses the realization principle, which recognizes revenue when the earnings process is virtually complete, and the value of an exchange of goods or services can be reliably determined. In practice, revenue is usually recognized at the time of a sale, whether or not cash is generated, as e.g. in the case of a credit sale.

Noncash Items

Income statements contain other noncash items, such as depreciation. Depreciation is the recognition of the decrease in value of a productive asset over time, although based on a predetermined rule, rather than the actual value decrease. Clearly, there is no cash flow associated with depreciation; the actual cash flow would have occurred whenever the asset was paid for.

Time and Costs

It is common to treat costs as being variable or fixed depending on one’s time horizon. For a given time horizon, all costs that are fixed within that time horizon are called fixed, and those that vary are called variable. For example, if the time horizon is relatively short, wages, payments to suppliers, etc. are variable, while machinery and plant are fixed. Given a sufficiently long horizon, all costs are variable. This concept is important to the financial manager in that it determines which costs are irrelevant for decision making because they are fixed, and hence unalterably sunk.

Average Versus Marginal Tax Rates:

The difference between these two concepts is similar to the concept of fixed versus variable costs. Just as variable costs are relevant for decision making, even though fixed costs, too, must be borne; similarly, the marginal tax rate is the relevant quantity for decision making, although all taxes must be paid.

The marginal tax rate is the tax paid on the marginal dollar of income. In other words, if income increases by one dollar, the total tax paid would increase by as many cents as the marginal tax rate.

Statement of Cash Flows

Since it is cash flow that ultimately repays loans, replaces equipment, expands facilities and pays dividends, it is necessary to look beyond the income statement at the Statement of Cash Flows (SCF).  Analyzing a company's cash inflows and outflows and their operating, financing or investing sources helps us assess a company's liquidity (nearness to cash of assets and liabilities), solvency (the ability to pay liabilities when they mature) and financial flexibility (the ability to react and adjust to opportunities and adversities).  Net Cash Flows can differ from Net Income because of non-cash-flow items, such as depreciation.  The SCF reports cash receipts and payments by operating, financing, and investing activities.
  • Operating activities are earnings-related activities.  Generally these relate to Income Statement activities, and items included in working capital.  Included are:
    • Sales and expenses necessary to obtain sales
    • Related operating activities, such as extending credit to customers
    • investing in inventories
    • obtaining credit from suppliers
    • payment of taxes
    • insurance payments
    • Other activities that don't easily fit into the other two categories, such as settlements in lawsuits.
  • Investing activities relate to  the acquisition and disposal of noncash assets: assets which are expected to generate income for the company over a period of time.  These include lending funds and collecting on these loans.
  • Financing activities relate to the contribution, withdrawing and servicing of funds to support business activities.
Cash Flow computations are useful in Asset Valuation, in Capital Structure Analysis, and in Dividend Policy Analysis.  A key concept for these purposes is Free Cash Flow to Equity, as well as Free Cash Flows to the firm.  These are often conveniently defined using accounting quantities as
Free Cash Flows to Equity (FCFE) =  Net Income - (Capital Expenditures - Depreciation) - (Change in Noncash Working Capital) + (New Debt Issued - Debt Repayments) - Preferred Dividends
Cash Flows to the Firm (FCFF) =  EBIT (1-tax rate) - (Capital Expenditure - Depreciation) - (Change in Noncash Working Capital)
Cash Flows to the Firm (FCFF) =  FCFE + Interest Expense (1- tax rate) - (New Debt Issues - Principal Repayments) + Preferred Dividends.

A more conceptually reasonable definition of Free Cash Flow to Equity is:

Cash Flows from Operating Activities - (Capital expenditures required to maintain productive capacity) - (dividends on preferred stock) - (New Debt Issued - Debt Repayments).

In practice, this works out, more or less, to the definition of FCFE given above, as can be seen by inspecting the definition of Cash flows provided by Operating Activities given below.

Computation of Cash Flows:

Before looking at a more realistic set of financial statements, it is worthwhile looking at the general methodology used in computing cash flows.  There are two ways of doing this: one, to start with the accounting numbers and then modifying them in order to arrive at the cash flow; two, to compute the cash flow numbers directly.  We first look at the indirect method:
 
Net Cash flows provided by Operating Activities =  Net Income
  + Depreciation
  - Increase in Receivables
  - Increase in Inventories
  + Increase in Accounts Payable

Two kinds of adjustments are shown above.  One, noncash deductions from Net Income like depreciation are added back.  Two, the effect of changes in working capital accounts that are due to non-cash transactions are undone.  For example, if goods are sold on credit, two things occur: one, sales increase and thereby net income; two, accounts receivable increase by the same.  However, no cash has come into the firm.  Hence, we adjust for this by subtracting the increase in accounts receivable from Net Income.  The other adjustments are similar.

Financing flows occur because of increases or decreases in the firm's common or preferred stock or in its long-term debt.  Furthermore, he main entry under Investing Activities is Capital Expenditures.  Hence, in simple cases, we could write:
Net Cash flows provided by Financing Activities = Net Proceeds from Long-term Borrowing
  + Net Proceeds from Sale of Common Stock
  - Cash Dividends paid to Stockholders 
   
Net Cash flows used by Investing Activities =  Capital Expenditures

Finally,
Cash at end of year = Cash at beginning of year + Net Cash flows provided by Operating Activities + Net Cash flows provided by Financing Activities- Net Cash flows used by Investing Activities

Using this model, we can compute for 1994:

Net Cash Flows provided by Operating Activities =
 
Net Income 586
+ Depreciation +184
- Increase in Receivables -(1250-1200)
- Increase in Inventories -(1683-1400)
+ Increase in Accounts Payable +(1149-1229)
  =357

Net Cash flows provided by Financing Activities =
 
Net Proceeds from Long-term Borrowing 4300-3475
+ Net Proceeds from Sale of Common Stock +(1476-2000)
- Cash Dividends paid to Stockholders  -165
  =136

Net Cash Flows Used by Investing Activities = Capital Expenditures = Ending Fixed Assets - Beginning Fixed Assets + Depreciation = 8315-8106+184 = 393.

We can now reconcile Beginning Cash with Ending Cash:
 
Ending Cash = Beginning Cash   $1987
  + Net Cash flows provided by Operating Activities + 357  
  + Net Cash flows provided by Financing Activities + 136  
  - Net Cash flows used by Investing Activities - 393 +$100
      =$2087

An alternate approach to the computation of Net Cash Flows provided by Operating Activities:

The formula provided above for Net Cash Flows provided by Operating Activities, however, do not take into account other sources of cash flows. For example, there may be an entry for changes in prepaid expenses, which would have to be deducted from Net Income. Prepaid expenses refer to expenses pertaining to income generation in future periods, which nevertheless have been paid in advance. Since they do not relate to income this period, they don't show up in the current Income statement; however, since they represent operating cash outflows, they must be taken into account in the Statement of Cash Flows.

In principle, it would be necessary to first adjust each item in the Income Statement to take into account any non-cash entries, and then to take into account cashflows that have occurred in the current period, but have not been recorded in the Income Statement because they do not pertain to this period's income.

However, many of the non-cash entries in the Income Statement would probably show up as changes in Current Assets or Current Liabilities. Furthermore, any cashflows occuring in the current period, but not pertaining to this period's income would also show up as changes in Current Assets or Current Liabilities, provided that these assets/liabilities have a maturity of one year or less. Hence, an alternate approach to computing the Net Cash Flow provided by Operating Activities would be to begin with Net Income, subtract from that the changes in non-cash Working Capital, and then make adjustments for items that are Current Assets or Current Liabilities, but do not pertain to Operations (i.e. add back changes in such items if they are assets, and subtract changes in such items if they are liabilities). The following formula gives some examples of such adjustments. However, it must be noted that these examples are not exhaustive.
 
Net Cash Flow provided by Operating Activities = Net Income
  - Change in Noncash Working Capital
  - Change in Dividends Payable
  + Depreciation

Computation of Capital Expenditures

It must be noted that Depreciation in the Income Statement could vary from the change in Accumulated Depreciation recorded in the Balance Sheet under Property, Plant and Equipment. This is because there could be other sources of Depreciation, such as in Cost of Goods sold. Only the depreciation recorded under Property, Plant and Equipment is relevant for the computation of capital expenditures. Furthermore, the computation as shown above assumes that any sales of Property, Plant and Equipment is done at book value. If there is a loss or gain, that can complicate the computation of capital expenditures.

Example using GE's Financial Statements

Let's now take an actual firm's financial statements and note the problems involved in computing various financial ratios, as well as in reconstructing the Cash Flow Statement, using the information provided.  Here's information on GE's Financial Statements for 1996 and 1997.
 
(In millions of $) Assets     Liabilities  
1997 1996 Difference   1997 1996 Difference
Cash and marketable securities 76,482 64,080 12,402 Current Liabilities
120,668
100,507
20,161
Noncash Current Assets 14,819 13,177 1,642 Long Term Debt 
46,603
49,246
-2,643
Other Investments  10,320 9,148 1,172 Prov Risks/Charges
5,484
5,177
307
Invst in Assoc Companies 5,983 6,442 -459 Deferred Taxes 
8,651
8,273
378
Long Term Receivables 121,454 115,132 6,322 Other Liabilities
84,486
75,067
9,419
Prop Plant Eq-Gross 55,657 50,784 4,873 Total Liabilities 
265,892
238,270
27,622
Less Accum. Depreciation 23,341 21,989 1,352 Minority Interest
3,682
3,007
675
Net PP&E 32,316 28,795 3,521 Common Shareholder's Equity
6,368
 3,763 2,605
      Less Treasury Stock 15,268 11,308 3,960
Other Assets 42,638 35,628 7,010 plus Retained Earnings 43,338 38,670 4,668
      Total Common Equity 34,438 31,125 3,313
Total Assets  304,012 272,402 31,610 Total Liabs and Equity 304,012 272,402 31,610

Here is the Income Statement for 1996 and 1997 (in millions):
 
1996 1997
Net Sales or Revenue 90,777 79,082
Cost of Goods Sold  34,724 28,637
Gross Income  51,971 46,660
Depreciation and Amortization 4,082 3,785
Selling, Gen and Admn expenses 9,367 8,160
Total Operating Expenses 48,173 40,582
Operating Income  42,604 38,500
Non Operating Interest Income 1 18
Extra Charges - Pretax 3,401 0
Other Income/Expenses - Net -20,939 -19,539
Interest Expense  8,384 7,904
Pretax Income  9,881 11,075
Income Taxes  2,976 3,526
Minority Interest  240 269
After tax Other Income/Expenditures 1,538 0
Net Income 8,203 7,280

Construction of the Statement of Cash Flows:
 
      Outflows
1997 1996 Increase from  1996 to 1997 Operating Activity Investing Activity Financing Activity
Assets (in millions)            
Cash and Equivs  76,482 64,080 12,402      
Net Receivables  8,924 8,704 220 220    
Raw Materials 3,070 3,028 42      
Finished Goods 2,895 2,404 491      
Progress Payments & Other -70 -959 889      
Inventories  5,895 4,473 1,422 1422    
Tot Current Assets 91,301 77,257 14,044      
Other Investments 10,320 9,148 1,172   1,172  
Invst in Assoc Cos 5,983 6,442 -459   -459  
Long Term Receivables 121,454 115,132 6,322 6,322    
PP&E - Gross 55,657 50,784 4,873   7,6031  
Accum Depr. 23,341 21,989 1,352 -4,0821    
Net PP&E  32,316 28,795 3,521      
Deferred Charges 9,095 7,832 1,263   1,263  
Other Tangible Assets 14,422 11,789 2,633   2,633  
Intang Other Assets 19,121 16,007 3,114   3,114  
Other Assets 42,638 35,628 7,010      
Total Assets  304,012 272,402 31,610      
           
Liabilities            
Accounts Payable  10,407 10,205 202 -202    
ST Debt and Curr Portion of LT debt 98,075 80,200 17,875 -17,875    
Accrued Payroll 1,321 1,315 6 -6    
Dividends Payable 979 855 124     -124
Income Taxes Payable 2,866 2,487 379 -379    
Other Current Liabs 7,020 5,445 1,575 -1,575    
Tot Curr Liabs 120,668 100,507 20,161      
Long Term Debt  46,603 49,246 -2,643     2,643
Provisions for Risks/Charges 5,484 5,177 307 -307    
Deferred Taxes  8,651 8,273 378 -378    
Other Liabs 84,486 75,067 9,419     -9,419
Tot Liabs  265,892 238,270 27,622      
Unrealized Sec Gains/Losses 2,138 671 1,467     -1,467 

 
Minority Interest  3,682 3,007 675     -675
Common Stock/Ordinary Capital 594 594 0      
Capital Surplus  2,838 2,442 396     -396
Retained Earnings  43,338 38,670 4,668 -8,2032   3,5352
Unrealized ForEx Gains/Losses 798 56 742     -742
Treasury Stock  15,268 11,308 3,960     3,960
Common Shareholders Equity 34,438 31,125 3,313      
Tot Liabs and Equity 304,012 272,402 31,610      
  Computed Cash and Cash Equivalent Outflows -25,043 15,326 -2,685
  Computed Cash (only) Outflows -14,311 15,326 -2,685
  Reported Cash (only) Outflows -14,240 18,275 -5,705

Footnotes:

  1. Increase in Gross PP&E is only $4,873.  However, Increase in Accumulated Depreciation is only $1,352, whereas Depreciation Expense is $4,082.  The reason for the lower value of Accumulated Depreciation is presumed to be Asset Sales of $2,730 (4,082-1,352).  Hence Capital Expenditures are presumed to be $7,603 (Increase in Gross PP&E + Asset Sales).
  2. Increase in Retained Earnings of $4,668 can be computed as Net Income ($8,203) less Dividends Declared ($3,535).
  3. Note that in order to consistently record all entries in the last three columns as outflows, the cashflow entries for liabilities will be the negative of the fourth column (Increase from 1997 to 1996).  Thus, Increase in Net Receivables is recorded in the Operating Cashflow column as 220, because an increase in receivables implies that goods of the corresponding have been sold to customers, without a corresponding payment inflow; the entry in the fourth column is also 220, since that is the amount by which Net Receivables for 1997 is higher compared to Receivables for 1996.  On the other hand, Increase in Accounts Payables is recorded in the Operating Cashflow column as -202, even though the 1997 figure is greater than the 1996 figure by 202.  This is because an increase in Accounts Payables means that goods have been purchased to the tune of 202, without a corresponding payment; i.e. there has been an inflow of 202, rather than an outflow.  In order to consistently record flows as outflows, we must record the number as -202.  (However, note Depreciation and Dividends.)
Using the information generated above, we can write out the Statement of Cash Flows:
 
Cash Flows from Operating Activities    
Net Income 8,203  
Add (deduct) adjustments to cash basis:    
Increase in accounts receivables -220  
Increase in Inventory -1,422  
Increase in Long-term receivables -6,322  
Depreciation 4,082  
Increase in Accounts Payable 202  
Increase in ST debts and currentportion of LT debt 17,875  
Increase in Accrued Payroll 6  
Increase in Income Taxes Payable 379  
Increase in Other Current Liabs 1,575  
Increase in Provisions for Risks/Charges 307  
Increase in Deferred Taxes 378  
Net Cash Flows from Operating Activities   14,311
Cash Flows from Investing Activities    
Increase in Other Investments -1,172  
Decrease in Investments in Associated Cos 459  
Capital Expenditures -7,603  
Increase in Deferred Charges -1,263  
Increase in Other Tangible Assets -2,633  
Increase in Other Intangible Assets -3,114  
Net Cash Flows from Investing Activities   -15,326
Cash Flows from Financing Activities    
Dividends Declared -3,535  
Increase in Dividends Payable (adjustment to dividends declared) 124  
Decrease in Long-Term Debt (Debt Repayments) -2,643  
Decr in Treasury Stock (Stock repurchase) -3,960  
Increase in Minority Interest 675  
Incr in Unrealized Securities Gains/Losses 1,467  
Incr. Unrecognized ForEx Gains/Losses  742  
Increase in Other Liabs 9,419  
Net Cash Flows from Financing Activities   2,685
Net Increase in Cash and Equivalents   12,402
     
Beginning Cash and Equivalents   64,080
Add Increase from SCF   12,402
Ending Cash and Equivalents   76,482

Explanatory Notes:

  1. Minority Interest represents the proportionate stake of minority shareholders in a company's majority-owned subsidiary that is consolidated.  Since the parent includes all net assets of a consolidated subsidiary in its financial statements, it reports the minority's interest as a credit.
  2. Actual Dividends paid equal $3,535 - $124 = $3,411.
  3. Deferred Charges are costs incurred but deferred because they are expected to benefit future periods or are prepaids benefitting future periods.  Examples are prepaid pension costs and certain intangibles.
Treatment of Cash and Cash Equivalents:

Our computed numbers do not match precisely with the Reported Statement of Cash Flows; part of the problem is that our balance sheet combines figures for Cash and Cash Equivalents.  The reported numbers are:
 
  1996 1997 Change
Cash (from reported SCF) 4,191 5,861 1,670
Cash and Equivalents (from Balance Sheet) 64,080 76482 12,402
Equivalents 59,889 70621 10,732

If we include this increase in Cash Equivalents as an operating cash flow, we need to modify our figure for Cash and Cash Equivalent Outflows by $10,732 in order to get the corresponding figure for cash outflows alone.  Our Operating Cash Outflows becomes -25,043 + 10,732 = -14,311.

There is still a discrepancy between the reported numbers and the numbers that we have computed.  If some of the posited asset sales were made at a price higher than the book value, there would be a gain from the sale of assets that would be included in Net Income.  This amount would need to be subtracted from Net Income, giving us a lower value for Operating Cash Flows.  It would then be added to Cash Flows from Investing, since it is more properly an investing flow, than an operating flow.

Furthermore, there were several acquisitions made by GE during 1997.  If GE used the purchase method to account for the acquisition, then the flows that we have in our computations assigned to Operating Flows should be reassigned to Cash Flows from Investing.  This would also cause some discrepancies between our computations and the reported SCF numbers.

Here is the complete Statement of Cash Flows reported by GE:
 
CASH FLOW PROVIDED BY OPERATING ACTIVITY (in millions of dollars)
Net Income (Loss) 8,203
Depreciation/Amortization 4,082
Net Incr (Decr) Assets/Liabs 1,733
Other Adjustments, Net 222
Net Cash Prov (Used) by Oper 14,240
 
CASH FLOW PROVIDED BY INVESTING ACTIVITY(in millions of dollars)
(Incr) Decr in Prop, Plant -6,137
(Acq) Disp of Subs, Business -5,245
(Incr) Decr in Securities Inv -1,898
Other Cash Inflow (Outflow) -4,995
Net Cash Prov (Used) by Inv -18,275
 
CASH FLOW PROVIDED BY FINANCING ACTIVITY(in millions of dollars)
Issue (Purchase) of Equity -2,815
Issue (Repayment) of Debt 21,249
Incr (Decr) In Borrowing -10,103
Dividends, Other Distribution -3,411
Other Cash Inflow (Outflow) 785
Net Cash Prov (Used) by Finan 5,705
Net Change in Cash or Equiv 1,670
Cash or Equiv at Year Start 4,191
Cash or Equiv at Year End 5,861

The Impact of Capital Structure on Total Returns to Suppliers of Capital

Example: The Menendez Corporation expects to have sales of $12m. in 1998. Costs other than depreciation are expected to be 75% of sales, and depreciation is expected to be $1.5m. All sales revenue will be collected in cash, and costs other than depreciation must be paid for during the year. Menendez’s federal-plus-state tax rate is 40%.

Income Statement (in millions of dollars):
 
Sales $12
Costs of Goods Sold 9
Depreciation 1.5
Net Profit 1.5
Taxes .6
After Tax Income 0.9

Total returns to investors = $0.9m.
Total cash flow = 0.9 (After-tax income) + 1.5 (Depreciation) = 2.4m.

Suppose Menendez were financed with debt as well as equity, and interest payments in 1998 totalled $0.5 m. Then the Income Statement would read as follows:

Income Statement (in millions of dollars):
 
Sales $12
Costs of Goods Sold 9
Depreciation 1.5
Interest paid 0.5
Net Profit 1.0
Taxes .4
After Tax Income 0.6

Total Returns to Investors = 0.6 to stockholders + 0.5 to bondholders = 1.1m.

Note that the second capital structure decreased taxes paid by 0.2m and thus increased total returns to investors (stockholders as well as bondholders) by 0.2m. from 0.9m to 1.1m.

Selected Information On Restating Financial Results
(provided by Ali Gursoy)

Q. When does a company need to restate its financial results?

Ans. Restatements in financial statements are made for many reasons. Generally, firms restate financial statements when;

  1. A change in accounting principle. (A change from straight-line to declining- balance depreciation)
  2. A change in accounting estimate. (A change in the estimated useful life or estimated residual value of depreciable asset.)
  3. A change in reporting entity. (Substitution of consolidated statements for individual company financial statements)
  4. Error correction.
Q. How far back can it restate?

Ans. There are three approaches in restatement of financial statements.

  1. Current approach: This method recognizes in current period earnings the cumulative difference between the total expense or revenue under the old and new accounting principles for all affected prior periods up to the beginning of the current period. (Companies post this amount, if any, to the account titled Cumulative Effect of Change in Accounting Principle)
  2. Retroactive Approach: This method restates all prior financial statements presented on a comparative basis to conform to the new principle.
  3. Prospective Approach: This method applies revised accounting estimates to current and future periods affected by change. Prior financial statements remain unchanged, and no cumulative effect effect on prior years' income is computed.
Q. How would restating affect the company stock price?

Ans. Unfortunately, restatements in financial statements affect stock prices. The goal of financial reporting is to provide useful and comparable data to third parties. (Investors, government,...) Third parties justify the usefulness of any relevant financial data by making time series analysis and cross-sectional analysis. Any changes in past financial data will affect the current perception of investor, because:

  • The sustainability, measurement, or manageability of the reported (un-restated) earnings number keep it from reflecting economic value-added of a firm.
  • Financial statements of previous years are restated in the current year.
  • Financial statement items are classified in different ways across companies.
If restatements are material, then inevitably there would be big changes in time series analysis, which means new information about riskiness of the company.  Consider the following excerpt from USA Today of 3/20/2000:

MicroStrategy tanks on restatement news

VIENNA, Va. (Bloomberg) -  MicroStrategy Inc., an inventory-management software maker, said it is revising revenue and operating results for the past two years because of a change in the way it accounts for software sales. The shares tumbled 62%.

In the case of MicroStrategy, restatements in the past years' earnings affected the current price of the company.  Whatever the current year (2000) earning of MicroStrategy before restatement of financial statements, since the trend of earning has changed significantly after restatement and the market has perceived it as a bad sign for MicroStrategy's future.

Q. What causes a company to restate its earning?

A. These changes sometimes are required by regulating authorities or companies make them voluntarily.

The reasons are:
-To improve matching of expenses and revenues
-To enhance asset valuation
-To provide new information
-To respond to changed economic/market condition
-To comply with new reporting standards

In addition to restatement of financial statements, an investment student should always keep in mind that using financial statements as given by companies may cause misleading judgments about future performance of companies.  Disclosures in some accounts of financial statements are prime candidates for judging the company's future.

1-Discontinued Operations
2-Extraordinary gains and loses
3-Changes in accounting principle
4-Impairment losses
5-Restructuring charges
6-Changes in estimates
7-Gains and losses from peripheral operations.

Before making any analysis (ratio, trend,...) these accounts should be carefully investigated.

Sources:

  • Intermediate Accounting, Dyckman/Dukes/Davis, 4th. Edition, Irwin/McGraw-Hill, pp.1262,1263,1264,1265,1275,1277,1286
  • Financial Reporting and Statement Analysis, Stickney/Brown, 4th. Edition, Dryden, pp.202,203,204,205,210,211,229
  • Financial Statement Analysis, Bernstein/Wild, 6th. Edition, Irwin/McGraw-Hill, pp.69,70,178,179
  • Investment Analysis and Portfolio Management, Reilly, 3rd. Edition, Dryden, pp.442,443,444
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