Reading Financial Reports For Dummies

Lita Epstein, MBA, helps people develop business and personal financial and investing skills. She designs and teaches online courses on bookkeeping, accounting, starting a business, and finance and investing for women. She is the author of more than 40 books, including Bookkeeping For Dummies, Stock Charts For Dummies, and Trading For Dummies.

Introduction 1

About This Book 2

Conventions Used in This Book 2

What You’re Not to Read 2

Foolish Assumptions 3

Icons Used in This Book 3

Beyond the Book 4

Where to Go from Here 4

Part 1: Getting Started with Reading Financial Reports 5

Chapter 1: Opening the Cornucopia of Reports 7

Figuring Out Financial Reporting 8

Preparing the reports 8

Seeing why financial reporting counts (and who’s counting) 9

Checking Out Types of Reporting 10

Keeping everyone informed 11

Following the rules: Government requirements 12

Going global 13

Staying within the walls of the company: Internal reporting 13

Dissecting the Annual Report to Shareholders 15

Breaking down the parts 15

Getting to the meat of the matter 16

Keeping the number crunchers in line 17

Chapter 2: Recognizing Business Types and Their Tax Rules 19

Flying Solo: Sole Proprietorships 20

Keeping taxes personal 20

Reviewing requirements for reporting 21

Joining Forces: Partnerships 21

Partnering up on taxes 22

Meeting reporting requirements 22

Seeking Protection with Limited Liability Companies 22

Taking stock of taxes 23

Reviewing reporting requirements 23

Shielding Your Assets: S and C Corporations 23

Paying taxes the corporate way 24

Getting familiar with reporting requirements 26

Chapter 3: Public or Private: How Company Structure Affects the Books 27

Investigating Private Companies 28

Checking out the benefits 29

Defining disadvantages 30

Figuring out reporting 31

Understanding Public Companies 32

Examining the perks 33

Looking at the negative side 34

Filing and more filing: Government and shareholder reports 35

Entering a Whole New World: How a Company Goes from Private to Public 38

Teaming up with an investment banker 38

Making a public offering 39

Chapter 4: Digging into Accounting Basics 41

Making Sense of Accounting Methods 41

Cash-basis accounting 42

Accrual accounting 42

Why method matters 42

Understanding Debits and Credits 44

Double-entry accounting 45

Profit and loss statements 45

The effect of debits and credits on sales 46

Depreciation and amortization 47

Checking Out the Chart of Accounts 48

Asset accounts 49

Liability accounts 52

Equity accounts 52

Revenue accounts 53

Expense accounts 54

Differentiating Profit Types 55

Gross profit 55

Operating profit 56

Net profit 56

Part 2: Checking Out the Big Show: Annual Reports 57

Chapter 5: Exploring the Anatomy of an Annual Report 59

Everything but the Numbers 60

Debunking the letter to shareholders 60

Making sense of the corporate message 61

Meeting the people in charge 62

Finding basic shareholder information 62

Getting the skinny from management 62

Management as a whole? 65

Getting guarantees from management 66

Bringing the auditors’ answers to light 67

Presenting the Financial Picture 70

Summarizing the Financial Data 70

Finding the highlights 71

Reading the notes 71

Chapter 6: Balancing Assets against Liabilities and Equity 73

Understanding the Balance Equation 73

Introducing the Balance Sheet 74

Digging into dates 74

Nailing down the numbers 76

Figuring out format 76

Ogling Assets 78

Current assets 78

Long-term assets 81

Accumulated depreciation 84

Looking at Liabilities 85

Current liabilities 85

Long-term liabilities 86

Navigating the Equity Maze 87

Stock 87

Retained earnings 88

Capital 88

Drawing 88

Chapter 7: Using the Income Statement 89

Introducing the Income Statement 90

Digging into dates 91

Figuring out format 91

Delving into the Tricky Business of Revenues 94

Defining revenue 94

Adjusting sales 95

Considering cost of goods sold 97

Gauging gross profit 98

Acknowledging Expenses 99

Sorting Out the Profit and Loss Types 101

EBITDA 101

Nonoperating income or expense 102

Net profit or loss 103

Calculating Earnings per Share 103

Chapter 8: The Statement of Cash Flows 105

Digging into the Statement of Cash Flows 106

The parts 106

The formats 107

Checking Out Operating Activities 109

Depreciation 110

Inventory 110

Accounts receivable 110

Accounts payable 111

The cash flow from activities section, summed up 111

Investigating Investing Activities 112

Understanding Financing Activities 113

Issuing stock 113

Buying back stock 114

Paying dividends 114

Incurring new debt 115

Paying off debt 115

Recognizing the Special Line Items 116

Discontinued operations 116

Foreign currency exchange 116

Adding It All Up 117

Chapter 9: Scouring the Notes to the Financial Statements 119

Deciphering the Small Print 120

Accounting Policies Note: Laying out the Rules of the Road 121

Depreciation 122

Revenue 122

Expenses 123

Figuring out Financial Borrowings and Other Commitments 124

Long-term obligations 124

Short-term debt 125

Lease obligations 126

Mergers and Acquisitions: Finding Noteworthy Information 127

Pondering Pension and Retirement Benefits 128

Breaking Down Business Breakdowns 130

Reviewing Significant Events 132

Finding the Red Flags 133

Finding out about valuing assets and liabilities 134

Considering changes in accounting policies 134

Decoding obligations to retirees and future retirees 135

Chapter 10: Considering Consolidated Financial Statements 137

Getting a Grip on Consolidation 137

Looking at Methods of Buying up Companies 142

Reading Consolidated Financial Statements 144

Looking to the Notes 146

Mergers and acquisitions 147

Goodwill 147

Liquidations or discontinued operations 148

Part 3: Analyzing the Numbers 149

Chapter 11: Testing the Profits and Market Value 151

The Price/Earnings Ratio 152

Figuring out earnings per share 152

Calculating the P/E ratio 153

Practicing the P/E ratio calculation 154

Using the P/E ratio to judge company market value (stock price) 155

Understanding variation among ratios 157

The Dividend Payout Ratio 158

Determining dividend payout 158

Digging into companies’ profits with dividends 159

Return on Sales 161

Figuring out ROS 161

Reaching the truth about profits with ROS 162

Return on Assets 162

Doing some dividing to get ROA 163

Ranking companies with the help of ROA 163

Return on Equity 163

Calculating ROE 164

Reacting to companies with ROEs assistance 164

The Big Three: Margins 165

Dissecting gross margin 165

Investigating operating margin 166

Catching the leftover money: Net profit margin 167

Chapter 12: Looking at Liquidity 169

Finding the Current Ratio 170

Calculating the current ratio 170

What do the numbers mean? 171

Determining the Quick Ratio 171

Calculating the quick ratio 171

What do the numbers mean? 172

Investigating the Interest Coverage Ratio 173

Calculating the interest coverage ratio 173

What do the numbers mean? 174

Comparing Debt to Shareholders’ Equity 174

Calculating debt to shareholders’ equity 175

What do the numbers mean? 176

Determining Debt-to-Capital Ratio 176

Calculating the debt-to-capital ratio 176

What do the numbers mean? 178

Chapter 13: Making Sure the Company Has Cash to Carry On 179

Measuring Income Success 180

Calculating free cash flow 180

Figuring out cash return on sales ratio 182

Checking Out Debt 183

Determining current cash debt coverage ratio 184

Computing cash debt coverage ratio 186

Calculating Cash Flow Coverage 188

Finding out the cash flow coverage ratio 188

Mattel 189

Hasbro 190

What do the numbers mean? 190

Part 4: Understanding How Companies Optimize Operations 191

Chapter 14: How Reports Help with Basic Budgeting 193

Peering into the Budgeting Process 194

Understanding who does what 194

Setting goals 195

Building Budgets 197

Providing Monthly Budget Reports 199

Using Internal Reports 201

Chapter 15: Turning Up Clues in Turnover and Assets 203

Exploring Inventory Valuation Methods 203

Applying Three Inventory Valuation Methods 206

Average costing 207

FIFO 208

LIFO 208

How to compare inventory methods and financial statements 209

Determining Inventory Turnover 209

Calculating inventory turnover 210

What do the numbers mean? 211

Investigating Fixed Assets Turnover 212

Calculating fixed assets turnover 212

What do the numbers mean? 213

Tracking Total Asset Turnover 213

Calculating total asset turnover 213

What do the numbers mean? 214

Chapter 16: Examining Cash Inflow and Outflow 215

Assessing Accounts Receivable Turnover 215

Calculating accounts receivable turnover 216

What do the numbers mean? 217

Taking a Close Look at Customer Accounts 218

Finding the Accounts Payable Ratio 219

Calculating the ratio 220

What do the numbers mean? 221

Determining the Number of Days in Accounts Payable 221

Calculating the ratio 221

What do the numbers mean? 222

Deciding Whether Discount Offers Make Good Financial Sense 222

Calculating the annual interest rate 223

What do the numbers mean? 224

Chapter 17: How Companies Keep the Cash Flowing 225

Slowing Bill Payments 225

Speeding Up Collecting Accounts Receivables 226

Borrowing on Receivables 228

Reducing Inventory 229

Getting Cash More Quickly 230

Part 5: The Many Ways Companies Answer to Others 233

Chapter 18: Finding Out How Companies Find Errors: The Auditing Process 235

Inspecting Audits and Auditors 236

Looking for mistakes 236

Meeting Mr or Ms Auditor 236

Examining Records: The Role of the Auditor 237

Preliminary review 238

Fieldwork 238

Audit report 240

Filling the GAAP 240

Accounting standards: Four important qualities 240

Changing principles: More work for the FASB 241

Chapter 19: Digging into Government Regulations 245

Checking Out the 10-Q 246

Financial information 246

Other critical matters 247

Introducing the 10-K 248

Business operations 248

Financial data 248

Information about directors and executives 249

The extras 250

Investigating Internal Controls 250

Uncovering the Ways Companies Keep in Compliance 251

Digging into Board Operations 254

Understanding the nominating process 254

Contacting board members 255

Finding Out about Insider Ownership 255

Chapter 20: Creating a Global Financial Reporting Standard 257

Why Develop a Worldwide Financial Standard? 258

Key Moves to Reshape Global Financial Reporting 258

Who Benefits from a Global Standard and How? 259

Investors 260

Capital Markets 260

Companies 260

Key Differences between GAAP and the IFRS 261

Accounting framework 261

Financial statements 262

Revenue recognition 263

Assets 264

Inventory 264

Related-party transactions disclosures 265

Discontinued operations 265

Impairment charges 266

Chapter 21: Checking Out the Analyst–Corporation Connection 267

Typecasting the Analysts 268

Buy-side analysts 268

Sell-side analysts 269

Independent analysts 272

Bond analysts 272

Regarding Bond-Rating Agencies 273

Delving into Stock Rating 275

Taking a Look at How Companies Talk to Analysts 276

Analyst calls 276

Press releases 277

Mobile apps 278

Road shows 278

Chapter 22: How Companies Communicate with Shareholders 279

Making the Most of Meetings 280

Checking Out How the Board Runs the Company 281

Watching the directors 281

Speaking out at meetings 283

Moving away from duking it out 284

Sorting through Reports 284

Catching Up on Corporate Actions 285

Culling Information from Analyst Calls 287

Listening between the lines 288

Knowing when to expect analyst calls 291

Staying Up-to-Date Using Company Websites 291

Regarding Reinvestment Plans 292

Dividend reinvestment plans 292

Direct stock purchase plans 292

Chapter 23: Keeping Score When Companies Play Games with Numbers 293

Getting to the Bottom of Creative Accounting 294

Defining the scope of the problem 294

Seeing through cooked books 295

Unearthing the Games Played with Earnings 297

Reading between the revenue lines 297

Detecting creative revenue accounting 301

Exploring Exploitations of Expenses 304

Advertising expenses 305

Research and development costs 305

Patents and licenses 305

Asset impairment 306

Restructuring charges 307

Finding Funny Business in Assets and Liabilities 308

Recognizing overstated assets 308

Looking for undervalued liabilities 310

Playing Detective with Cash Flow 313

Discontinued operations 313

Income taxes paid 314

Part 6: The Part of Tens 315

Chapter 24: Ten (+1) Financial Scandals That Rocked the World 317

Enron 318

Madoff 319

Citigroup 319

Adelphia 320

WorldCom/MCI 320

Sunbeam 321

Tyco 322

Waste Management 322

Bristol-Meyers Squibb 323

Halliburton 324

Arthur Andersen 325

Chapter 25: Ten Signs That a Company’s in Trouble 327

Lower Liquidity 327

Low Cash Flow 328

Disappearing Profit Margins 328

Revenue Game Playing 329

Too Much Debt 330

Unrealistic Values for Assets and Liabilities 330

A Change in Accounting Methods 330

Questionable Mergers and Acquisitions 331

Slow Inventory Turnover 331

Slow-Paying Customers 332

Appendix: Glossary 333

Index 341