Reading Financial Reports 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 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 11 Keeping everyone informed 11 Following the rules: Government requirements 12 Going global 13 Staying within the walls of the company: Internal reporting 14 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 25 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 Quarterly reports 35 Yearly report 35 The rules of the Sarbanes-Oxley Act 36 Dodd-Frank’s impact on financial industry regulation 39 Entering a Whole New World: How a Company Goes from Private to Public 41 Teaming up with an investment banker 41 Making a public offering 42 Chapter 4: Digging into Accounting Basics 45 Making Sense of Accounting Methods 45 Cash-basis accounting 46 Accrual accounting 46 Why method matters 46 Understanding Debits and Credits 48 Double-entry accounting 49 Profit and loss statements 50 The effect of debits and credits on sales 50 Depreciation and amortization 51 Checking Out the Chart of Accounts 52 Asset accounts 54 Liability accounts 56 Equity accounts 57 Revenue accounts 58 Expense accounts 59 Differentiating Profit Types 60 Gross profit 60 Operating profit 60 Net profit 61 Part 2: The Big Show: Annual Reports 63 Chapter 5: Exploring the Anatomy of an Annual Report 65 Everything but the Numbers 66 Debunking the letter to shareholders 66 Making sense of the corporate message 67 Meeting the people in charge 68 Finding basic shareholder information 68 Getting the skinny from management 68 Getting guarantees from management 72 Bringing the auditors’ answers to light 73 Presenting the Financial Picture 76 Summarizing the Financial Data 77 Finding the highlights 77 Reading the notes 78 Chapter 6: Balancing Assets against Liabilities and Equity 79 Understanding the Balance Equation 80 Introducing the Balance Sheet 80 Digging into dates 80 Nailing down the numbers 81 Figuring out format 82 Ogling Assets 84 Current assets 84 Long-term assets 88 Accumulated depreciation 90 Looking at Liabilities 91 Current liabilities 91 Long-term liabilities 92 Navigating the Equity Maze 93 Stock 93 Retained earnings 94 Capital 94 Drawing 94 Chapter 7: Using the Income Statement 95 Introducing the Income Statement 96 Digging into dates 97 Figuring out format 97 Delving into the Tricky Business of Revenues 100 Defining revenue 100 Adjusting sales 101 Considering cost of goods sold 103 Gauging gross profit 104 Acknowledging Expenses 105 Sorting Out the Profit and Loss Types 107 EBITDA 107 Nonoperating income or expense 108 Net profit or loss 109 Calculating Earnings per Share 109 Chapter 8: The Statement of Cash Flows 111 Digging into the Statement of Cash Flows 112 The parts 112 The formats 113 Checking Out Operating Activities 115 Depreciation 116 Inventory 116 Accounts receivable 116 Accounts payable 117 The cash flow from activities section, summed up 117 Investigating Investing Activities 118 Understanding Financing Activities 119 Issuing stock 119 Buying back stock 119 Paying dividends 120 Incurring new debt 120 Paying off debt 121 Recognizing the Special Line Items 121 Discontinued operations 121 Foreign currency exchange 122 Adding It All Up 122 Chapter 9: Scouring the Notes to the Financial Statements 123 Deciphering the Small Print 124 Accounting Policies Note: Laying out the Rules of the Road 125 Depreciation 126 Revenue 126 Expenses 127 Figuring out Financial Borrowings and Other Commitments 128 Long-term obligations 128 Short-term debt 129 Lease obligations 130 Mergers and Acquisitions: Finding Noteworthy Information 131 Pondering Pension and Retirement Benefits 132 Breaking Down Business Breakdowns 134 Reviewing Significant Events 135 Finding the Red Flags 137 Finding out about valuing assets and liabilities 138 Considering changes in accounting policies 138 Decoding obligations to retirees and future retirees 139 Chapter 10: Considering Consolidated Financial Statements 141 Getting a Grip on Consolidation 141 Looking at Methods of Buying Up Companies 147 Reading Consolidated Financial Statements 148 Looking to the Notes 150 Mergers and acquisitions 152 Goodwill 152 Liquidations or discontinued operations 152 Part 3: Analyzing the Numbers 155 Chapter 11: Testing the Profits and Market Value 157 The Price/Earnings Ratio 158 Figuring out earnings per share 158 Calculating the P/E ratio 159 Practicing the P/E ratio calculation 160 Using the P/E ratio to judge company market value (stock price) 162 Understanding variation among ratios 163 The Dividend Payout Ratio 164 Determining dividend payout 165 Digging into companies’ profits with dividends 165 Return on Sales 167 Figuring out ROS 167 Reaching the truth about profits with ROS 168 Return on Assets 168 Doing some dividing to get ROA 169 Ranking companies with the help of ROA 169 Return on Equity 169 Calculating ROE 170 Testing companies using ROE 170 The Big Three: Margins 171 Dissecting gross margin 171 Investigating operating margin 172 Catching the leftover money: Net profit margin 173 Chapter 12: Looking at Liquidity 175 Finding the Current Ratio 177 Calculating the current ratio 177 What do the numbers mean? 178 Determining the Quick Ratio 178 Calculating the quick ratio 178 What do the numbers mean? 179 Investigating the Interest Coverage Ratio 180 Calculating the interest coverage ratio 180 What do the numbers mean? 181 Comparing Debt to Shareholders’ Equity 182 Calculating debt to shareholders’ equity 182 What do the numbers mean? 183 Determining Debt-to-Capital Ratio 184 Calculating the debt-to-capital ratio 184 What do the numbers mean? 186 Chapter 13: Making Sure the Company Has Cash to Carry On 187 Measuring Income Success 188 Calculating free cash flow 188 Figuring out cash return on sales ratio 190 Checking Out Debt 191 Determining current cash debt coverage ratio 192 Computing cash debt coverage ratio 194 Calculating Cash Flow Coverage 196 Finding out the cash flow coverage ratio 196 Mattel 197 Hasbro 198 What do the numbers mean? 198 Part 4: How Companies Optimize Operations 199 Chapter 14: Turning Up Clues in Turnover and Assets 201 Exploring Inventory Valuation Methods 201 Applying Three Inventory Valuation Methods 204 Average costing 205 FIFO 206 LIFO 206 How to compare inventory methods and financial statements 207 Determining Inventory Turnover 208 Calculating inventory turnover 208 What do the numbers mean? 210 Investigating Fixed Assets Turnover 210 Calculating fixed assets turnover 210 What do the numbers mean? 211 Tracking Total Asset Turnover 211 Calculating total asset turnover 212 What do the numbers mean? 212 Chapter 15: Examining Cash Inflow and Outflow 213 Assessing Accounts Receivable Turnover 213 Calculating accounts receivable turnover 214 What do the numbers mean? 216 Taking a Close Look at Customer Accounts 217 Finding the Accounts Payable Ratio 218 Calculating the ratio 218 What do the numbers mean? 219 Determining the Number of Days in Accounts Payable 219 Calculating the ratio 220 What do the numbers mean? 220 Deciding Whether Discount Offers Make Good Financial Sense 221 Calculating the annual interest rate 221 What do the numbers mean? 222 Chapter 16: How Companies Keep the Cash Flowing 223 Slowing Bill Payments 223 Speeding Up Collecting Accounts Receivables 224 Borrowing on Receivables 226 Reducing Inventory 227 Getting Cash More Quickly 228 Part 5: The Many Ways Companies Answer to Others 231 Chapter 17: How Companies Find Errors: The Auditing Process 233 Inspecting Audits and Auditors 234 Looking for mistakes 234 Meeting Mr or Ms Auditor 234 Examining Records: The Role of the Auditor 235 Preliminary review 236 Fieldwork 236 Audit report 238 Filling the GAAP 238 Accounting standards: Four important qualities 239 Changing principles: More work for the FASB 240 Getting more involved internationally 241 Chapter 18: Government Regulations and Reporting Requirements 243 Checking Out the 10-Q 244 Financial information 244 Other critical matters 245 Introducing the 10-K 246 Business operations 246 Financial data 246 Information about directors and executives 247 The extras 248 Investigating Internal Controls 248 Uncovering the Ways Companies Keep in Compliance 250 Digging into Board Operations 252 Understanding the nominating process 253 Contacting board members 254 Finding Out about Insider Ownership 254 Chapter 19: Creating a Global Financial Reporting Standard 255 Why Develop a Worldwide Financial Standard? 256 Key Moves to Reshape Global Financial Reporting 256 Who Benefits from a Global Standard and How? 258 Investors 258 Capital Markets 258 Companies 258 Key Differences between GAAP and IFRS 259 Accounting framework 259 Financial statements 260 Revenue recognition 262 Assets 262 Inventory 262 Related-party transactions disclosures 263 Discontinued operations 263 Impairment charges 264 Chapter 20: Understanding the Analyst–Corporation Connection 265 Typecasting the Analysts 266 Buy-side analysts 266 Sell-side analysts 267 Independent analysts 270 Bond analysts 270 Regarding Bond-Rating Agencies 271 Delving into Stock Rating 273 Taking a Look at How Companies Talk to Analysts 274 Analyst calls 274 Press releases 275 Mobile apps 276 Road shows 276 Chapter 21: How Companies Communicate with Shareholders 277 Making the Most of Meetings 278 Checking Out How the Board Runs the Company 279 Watching the directors 279 Speaking out at meetings 281 Moving away from duking it out 282 Sorting through Reports 282 Catching Up on Corporate Actions 283 Culling Information from Analyst Calls 285 Listening between the lines 286 Knowing when to expect analyst calls 289 Staying Up-to-Date Using Company Websites 289 Regarding Reinvestment Plans 290 Dividend reinvestment plans 290 Direct stock purchase plans 290 Chapter 22: Keeping Score When Companies Play Games with Numbers 291 Getting to the Bottom of Creative Accounting 292 Defining the scope of the problem 292 Seeing through cooked books 293 Unearthing the Games Played with Earnings 295 Reading between the revenue lines 296 Detecting creative revenue accounting 300 Exploring Exploitations of Expenses 302 Advertising expenses 303 Research and development costs 303 Patents and licenses 304 Asset impairment 304 Restructuring charges 305 Finding Funny Business in Assets and Liabilities 306 Recognizing overstated assets 306 Looking for undervalued liabilities 309 Playing Detective with Cash Flow 311 Discontinued operations 311 Income taxes paid 312 Part 6: The Part of Tens 315 Chapter 23: Ten Financial Scandals That Rocked the World 317 Enron 318 Madoff 319 Citigroup 319 Adelphia 320 WorldCom/MCI 320 Tyco 321 Waste Management 322 Bristol-Myers Squibb 323 Halliburton 324 Arthur Andersen 325 Chapter 24: 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 332 Slow-Paying Customers 332 Glossary 333 Index 341