Guide to financial statements

THIS GUIDE IS NEITHER AN OFFER TO SELL, NOR A SOLICITATION OF AN OFFER TO BUY, ANY SECURITIES OF INTERNATIONAL BUSINESS MACHINES CORPORATION OR ANY OTHER COMPANY.

The guide to financials provides basic information on how to read financial statements in a company's annual report. It discusses key numbers in each of the statements common to all annual reports and offers suggestions from experienced investors on making sense of these numbers.

Like any new and complex subject, the language of financial statements may at first seem mysterious, even intimidating. This guide can help you begin to gain basic financial vocabulary and to understand the subject. Topics cover only the fundamentals of accounting and financial reporting and the guide and its glossary explains the terms and ideas you will need to understand these topics.

THIS GUIDE IS NEITHER AN OFFER TO SELL, NOR A SOLICITATION OF AN OFFER TO BUY, ANY SECURITIES OF INTERNATIONAL BUSINESS MACHINES CORPORATION OR ANY OTHER COMPANY.

The guide to financials provides basic information on how to read financial statements in a company's annual report. It discusses key numbers in each of the statements common to all annual reports and offers suggestions from experienced investors on making sense of these numbers.

Like any new and complex subject, the language of financial statements may at first seen mysterious, even intimidating. This guide can help you begin to gain basic financial vocabulary and to understand the subject. Topics cover only the fundamentals of accounting and financial reporting and the guide and its glossary explains the terms and ideas you will need to understand these topics

Statement basics : Overview

What's in them?

Annual reports include at least three financial statements:

Statement of earnings: Summarizes results of the company's business operations (revenue and expenses)

Statement of financial position: Lists the company's assets and the claims against them (liabilities and stockholders' equity)

Statement of cash flows: Measures the flow of cash into and out of the company

The statements contain the financial information for a publicly held company. If a company is composed of many subsidiaries, divisions, and other companies, it presents the financial information of all its holdings as one "consolidated" company. IBM, for example, publishes a "consolidated statement of cash flows" and other "consolidated" financial statements, representing all the parts of its large organization.

To learn more about other components of an annual report, visit guide to Annual Reports.  

Who prepares the financial statements?

The people who prepare the statements may differ from company to company. Usually, the accounting staff prepares them, but others, such as investor relations staff , review the statements and related notes.

Regardless of who the preparers are, federal securities laws require publicly-owned companies to follow a set of rules and financial reporting guidelines. Associations - such as the Financial Accounting Standards Board (FASB) , a private organization of accounting professionals, and the Securities and Exchange Commission (SEC) , a U.S. government agency - develop the rules and guidelines. These generally accepted accounting principles (GAAP) help ensure that the financial information reported is reliable and consistent in form with the reports all other companies prepare. GAAP also helps safeguard against investor fraud.

Although all companies follow common standards and requirements, they report on their financial performance in varied ways. Many decisions - from the statements' names to the accounts within them and the ways management calculates the numbers - are left to companies' discretion.

What is the auditors' report?

The auditors' report is a summary of the results of an audit, or examination of the financial statements by an independent firm of certified public accountants. The audit is an attempt to determine whether a company's financial statements report the company's financial status accurately and reliably. During an audit, for example, the auditors investigate a company's internal accounting controls, confirm the existence of many assets, and gather supporting information from external sources. The auditors make sure the financial statements are complete, reasonable, and prepared consistent with GAAP at a set time. If the auditors consider the statements are fair events of the company's financial position in relation to GAAP, they issue an "unqualified" opinion.

The Notes

The notes are required reading to understand the financial statements. Companies use notes to explain how they arrived at the numbers in the financial statements and to describe any significant events or changes in procedures that may affect the numbers. Notes also explain items in the statements and report details of the company's financial performance not shown in the statements.

A note might explain, for example, that a company's accounting methods have changed from the previous year or differ significantly from methods other companies in the same industry use (assuming they follow GAAP ). Analysts might examine why the company changed accounting methods, probing, for example, to learn whether the change distorts the company's financial results.

Another note might disclose an acquisition that may have a material effect on the company's financial condition, both short and long term. For example, with its acquisition of Lotus in 1995, IBM incurred costs and assumed liabilities associated with this significant event.

Finally, a note might provide additional detail on an item in a financial statement. For example, a note on "Investments and sundry assets" on the statement of financial position lists the assets IBM includes in this category (one listing is the intangible asset called goodwill).  

Statement basics: Statement of financial position

Purpose

The statement of financial position reports a company's financial status at a set date noted on the statement. The statement is like a snapshot because it shows what the company is worth at that set date. The statement shows:

  • What the company owns
  • What the company owes
  • What belongs to the owners

Analysts often call the statement of financial position a balance sheet because of the way one part - assets - is in balance with the sum of the other two parts - liabilities and stockholders' equity.
In an annual report, the statement of financial position includes information for at least the last two years to allow comparison of changes between years.

Key numbers

The statement of financial position shows three main categories of information for each year covered. To interpret this information, analysts look at three key numbers related to these categories:

Assets

Companies own things, called assets. These things might be physical assets such as buildings, trucks, inventories of products, equipment, and cash. Or things might be intangible assets such as goodwill, trademarks, and patents.

Assets are either current or noncurrent. Current assets are things a company expects to convert to cash within one year. Examples are accounts receivable or inventories of products to sell. Finally, current assets include cash and securities such as treasury bills and certificates of deposit the company expects to convert to cash within the year.

Non-current assets are things a company does not intend to convert to cash or that would take longer than a year to convert. Non-current assets include fixed assets, often listed as "property, plant, and equipment" because that is what they usually are. Companies use fixed assets to manufacture, display, store, and transport products.

The amounts of fixed assets vary by company and industry. For example, manufacturing companies generally have a large investment in fixed assets because making things requires property, plant, and equipment. Service companies usually have fewer fixed assets.

Liabilities

On the statement of financial position, debts are called liabilities. All companies have liabilities. Examples of liabilities include:

  • Money owed to banks and other lenders
  • Money owed to suppliers of goods and services (accounts payable)
  • Taxes owed to government authorities
  • Rents owed to owners of land and buildings

Liabilities are either current (short term) or long term. Current liabilities are due within one year. Long term liabilities are due after one year.

Although liabilities are a necessary part of doing business, companies must manage their liabilities carefully. If a company cannot make interest payments on time and repay the principal when due, the company can be forced to declare bankruptcy and either reorganize or disband.

Stockholders' equity

Stockholders' equity is the amount owners invested in new stock plus the earnings the company retained since it started (retained earnings is the amount of profit kept after dividends are paid). On the statement of financial position the amount of stockholders' equity always equals the value of all the assets minus all the liabilities. For example, if a company's assets are valued at $10,000 and liabilities total $6,000, the equity is $4,000.

Statement basics: Analyzing the statements

Overview

When financial analysts evaluate a company for possible investment, they look both at the information in the financial statements and at other information that puts these numbers into a larger context.

Analysts can make more reliable investment decisions by taking the basic information in the financial statements and extending it to identify:

  • A company's internal strengths and weaknesses
  • Company and industry trends
  • Performance in the larger business environment

Brokerage firms offer the results of their analysts' research to individual investors as part of their service. Additionally, many professional analysts sell their evaluations and recommendations. Examples of sources of financial analysis are Moody's, Standard and Poor's, and Value Line.

Interpreting the numbers

Analysts usually begin evaluating a company by studying its financial statements. These sources present recent financial history in a concise format, making it easy to see short term changes in key numbers. Financial statements are also fairly standard within an industry, making it easy to compare the performance of a company to that of its competitors.

Analysts interpret the numbers on each financial statement using a variety of ratios and other comparative measures. Analysis covers:

Analysis: Statement of earnings

Analysts use the statement of earnings to examine a company's profitability. For example, analysts look at trends in revenue, operating income, and gross profit rates (or margins). Other measures include calculation of return on assets and return on equity. To view IBM's performance over recent years, see the historical charts.

Analysis: Statement of financial position

Analysts use the statement of financial position to examine a company's liquidity and to gain insight into the state of the company's debt and inventory. One measure analysts use is the current ratio, a comparison of current assets with current liabilities. Analysts also look at the relationship of this statement with the statement of earnings. For example, they may explore the relationships of accounts receivable with sales, and of inventory with the costs of sales. Collection of accounts receivable is a task financial analysts also watch closely. If customers take long to pay for goods and services, accounts receivable may become large, forcing the company to borrow money (and pay interest) to finance these receivables. The longer it takes to collect accounts receivable the less valuable they are.

Analysis: Statement of cash flows

Analysts use the statement of cash flows to determine how effectively a company generates and manages cash. Analysts look most closely at the cash from operating activities in evaluating a company's potential for long-term success because this figure shows how efficiently the company can produce and sell its primary product or service.

Analysts also evaluate cash flows in relation to earnings figures (from the statement of earnings). For example, in some cases, a company can report positive earnings on the statement of earnings and still report a negative net cash flow on the statement of cash flows. This situation may occur when a company is unable to meet the current demand for its products and consequently invests its profits, or even borrows additional money, to expand its manufacturing capability (for example, by purchasing equipment or new facilities). When such a situation occurs, analysts look for the implications. They try to determine if the prospective demand for the company's product is great enough to justify the expenditures and new debt.

Statement basics: Statement of earnings

Purpose

The statement of earnings indicates how much revenue a company brings into the business by providing goods or services, or both, to its customers for a set time (usually one year). It also shows the costs and expenses associated with earning that revenue during that time.

In an annual report, the statement of earnings shows sales revenue and expenses for at least the last three years. The net earnings (or loss), often literally the "bottom line" on the statement, shows how much the company earned (or lost).

Key numbers

The statement of earnings shows two main categories of information for each year covered:

1. Revenue from products and services sold
2. Expenses, or costs, of doing business

To interpret this information, analysts look at several key numbers:

 

Revenue

Companies earn revenue in one or more of the following ways:

  • By selling products or services, or both
  • By leasing and renting equipment or property to others
  • By receiving interest from loans to other companies or individuals

Some companies have only one source of revenue; others have several. For example, IBM reports revenue from its products, such as computer hardware and software. It also reports revenue from its services, which include maintenance, rentals, and financing.

Gross profit

A rule of business is, "it takes money to make money". Typically, producing goods for sale is the greatest cost of generating revenue. For example, a computer manufacturing company must buy wiring and other raw materials to make computers; pay wages to workers and managers; and spend money on overhead - power, facilities, and maintenance.

A company deducts these costs (cost of sales, cost of goods sold) from revenue, showing gross profit (or loss).

Operating income

In addition to the expenses directly related to producing goods and services, companies incur operating expenses. These include advertising, salaries, rent, research and development, office supplies, and any other administrative amounts spent. A company deducts these operating expenses from gross profit, resulting in operating income (or loss).

Operating income represents a company's revenue minus all expenses required to obtain that revenue. From this key number, companies deduct costs relating to debt financing and tax expenses. The remainder is called net earnings .

Net earnings

Net earnings are the "bottom line" (often literally the last line on the statement). After a company deducts all costs and expenses from revenue , the statement of earnings shows the net earnings (or loss). When revenue exceeds costs and expenses, the bottom line shows a profit. When costs and expenses exceed revenue, the bottom line shows a loss.

Growth in net earnings usually signals that a company is doing well.

Earnings per share

Earnings per share (EPS) shows how much money stockholders would receive for each share of stock if the company distributed all net earnings to its stockholders. For example, if the net earnings are $1 million and 500,000 shares are outstanding, the earnings per share are $2 ($1 million ÷ 500,000 shares = $2).

Although all net earnings really belong to the stockholders, a company almost never distributes the full amount to them directly. A company needs money to grow, so it takes part of the net earnings and reinvests that money in itself. The total amount of a company's net earnings since its inception, minus any payments made to stockholders, is called retained earnings.

Although the term may suggest a large pool of cash, that image is misleading. Retained earnings is actually part of stockholders' equity and represents the portion of a company's assets that is financed from profitable operations rather than from selling stock to investors or borrowing from external sources. If the company reinvests those earnings profitably, the stockholders benefit from that reinvestment over the long term.

A second way stockholders benefit from retained earnings is through dividends. A company's board of directors, with the advice of management, decides on the amount of dividends per share to pay. Companies usually pay dividends quarterly; however, many companies do not pay dividends at all, and a few pay dividends irregularly.

Using the information

Now that you have reviewed a brief introduction to the statement of earnings, you can learn about ways to interpret this information.

To see how analysts use this statement and related information, read analyzing the statements.

To get tips from three experienced investors on using this statement, visit the investors' tips section to review tips from a business school dean, a business executive, and a high school economics teacher.

Statement basics: Statement of cash flows

Purpose

The statement of cash flows reports the flow of cash into and out of a company in a given year.

Cash is a company's lifeblood. Cash includes currency, checks on hand, and deposits in banks. Cash equivalents are short term, temporary investments - such as treasury bills, certificates of deposit, or commercial paper - that can be quickly and easily converted to cash.

A company uses cash to pay bills, repay loans, and make investments, allowing it to provide goods and services to customers. If all goes well, a company uses cash to generate even more cash as a result of higher profits.

Key numbers

The statement of cash flows reports the company's sources and uses of cash and the beginning and ending values for cash and cash equivalents each year. It also includes (near the bottom of the statement) the combined total change in cash and cash equivalents from all sources and uses of cash.

Key numbers in this statement show results of transactions in three categories that are sources and uses of cash:

 

Net cash provided (or used) by operating activities

A company generates cash just from operating its business. Therefore, the first key number is net cash provided from operating activities. This total includes some items from the statement of earnings; for example:

  • Net earnings, showing the company's profit (or loss)
  • Depreciation expense
 

This key number also includes changes in some items from the statement of financial position:

  • Inventory changes (increases in inventories use cash and reductions provide cash)
  • Changes in accounts receivable, the sales the company has not yet been paid for (again, increases use cash and decreases provide cash)
  • Changes in accounts payable, the cash a company owes its vendors and suppliers (in this area, increases provide cash and decreases use cash)
 

The statement of cash flows adds the net cash from each type of operating activity and reports the company's total net cash provided (or used) by all operating activities.

Net cash provided (or used) by investing activities

The second key number might include investments in property (land), plant (factories and assembly plants), and equipment (machines, trucks, computer systems, telephone systems). Investing in such assets is a use of cash, selling them is a source of cash.

Examples of investing activities are overhauling trucks to extend their years of use or renovating factories and assembly plants to be more productive.

The statement of cash flows adds the net cash from each type of investing activity and reports the company's total net cash provided (or used) by all investing activities.

Net cash provided (or used) by financing activities

The third key number includes the sources and uses of cash for financing activities. Sources of cash include what a company raises by selling stocks and bonds and by borrowing from banks.

Uses of cash include buying back stock from stockholders , paying dividends to share profits with stockholders and repaying borrowed cash.

The statement of cash flows adds the net cash from each type of financing activity and reports the company's total net cash provided (or used) by all financing activities.

Statement basics: Looking at other information

 

Most analysts agree that the financial statements, financial ratios, and other comparative measures offer the best starting points for evaluating a company. However, they look at these items to provide only a portion of the information required to adequately evaluate a company for investment.

Analysts begin to put the key numbers into a larger context by looking at two other critical parts of the annual report itself:

The notes to the financial statements offer further explanation of the numbers on the statements. For example, for the statement of earnings, notes might describe changes in a company's investment in research and development (R & D). For the statement of financial position, notes might describe significant liabilities and contingencies.

The management discussion section provides management's perspective on the company's financial operation and performance. Reading this section in consecutive annual reports also allows analysts to gather more subjective information about a company, such as its ability to articulate and consistently pursue long term goals.

For company financial information not contained in the annual report, such as that in copies of form 10-K or form 10-Q filed with the Securities and Exchange Commission, analysts and investors frequently contact the company's investor relations department for copies of those forms.

Finally, analysts extend the scope of their financial information comparisons beyond the two to three year figures in a single set of financial statements. Instead, they look at the same ratios and performance measures over five to ten year periods. To see changes in IBM's financial record over time, visit the historical charts.

Analysts also compare these figures with several other numbers from other sources of business and economic information. For example, they:

THIS GUIDE IS NEITHER AN OFFER TO SELL, NOR A SOLICITATION OF AN OFFER TO BUY, ANY SECURITIES OF INTERNATIONAL BUSINESS MACHINES CORPORATION OR ANY OTHER COMPANY.

The guide to financials provides basic information on how to read financial statements in a company's annual report. It discusses key numbers in each of the statements common to all annual reports and offers suggestions from experienced investors on making sense of these numbers.

Like any new and complex subject, the language of financial statements may at first seen mysterious, even intimidating. This guide can help you begin to gain basic financial vocabulary and to understand the subject. Topics cover only the fundamentals of accounting and financial reporting and the guide and its glossary explains the terms and ideas you will need to understand these topics

Investors' Tips : Overview

In this section of the guide, these educators and experienced investors explain how they look at financial statements. In a few paragraphs, each suggests ways to read financial statements and critical areas to study.

Note: In this guide, financial statement names are statement of earnings, statement of financial position, and statement of cash flows. For synonyms, visit the glossary.

Business school dean

Dr. Al Hartgraves is senior associate dean and professor of accounting at Goizueta Business School, Emory University. He teaches corporate financial reporting to MBA students; to corporate executives in executive MBA programs; and corporate management development programs. He has co-authored two books on management accounting and published numerous articles in professional and academic journals.

Business executive

Nathaniel Alexander is chief executive officer and a member of the board of directors of IVEX Corporation, a privately held corporation that designs, develops, and manufactures visual systems for flight simulation. He has started new businesses; acquired and divested companies; managed turnaround and pre-bankruptcy situations, restoring profitability; and worked with stockholders, banks, and financial institutions. He has been an investor in stocks for more than thirty years.

High school economics teacher

Carol Penland, a former "state high school economics teacher of the year" and the founding president of her state's association of economic educators, has been teaching for more than twenty years. She currently teaches at Campbell High School in Smyrna, Georgia. She coached three winning state championship teams in the National Council of Economics Education Stock Market Game and two winning state championship teams in the Chicago Board of Trade Commodity Challenge Game.

Investors' tips: Business executive

General suggestions

Before I talk about the statements, let me explain what I do in general as an investor. When I buy shares of an established company - public at least ten years - I look at trends for five numbers. These include net sales, net earnings, net cash provided by operating activities, price-earnings ratio (P/E ratio), and backlog, preferably over the last four years. The first three items are easily found in the financial statements; the P/E ratio and backlog figures may require additional research.

When it comes to young companies, particularly technology, I speak to friends who understand the technology or market. I also read reports from brokers who make a market, or specialize, in trading that stock. Novice investors can contact a reputable broker whose research department will happily mail out research on stocks the firm follows or helped bring public.

Comments on statement of earnings

The first number I look at is net sales and ask: Was there an increase over the last four years at a pace substantially above the inflation rate? If the answer is yes, that is a good sign. The U.S. government periodically reports inflation rates, and you can find this information in the papers and on radio and TV. (Check also the Internet links to the U.S. Department of Commerce and to the Bureau of Labor Statistics in Resources). Remember, this rate varies from year to year. If you are an international investor, remember it varies from country to country.

A second number I look at is net earnings and ask: Did net earnings increase over the same period, at least at the same percentage rate as net sales? If the answer is yes, that is another good sign. If net earnings are lower in one year than in previous years, I try to determine why. Sometimes there are valid reasons for a slump in earnings. For example, intense competition may force cuts in prices. Or the cost of utilities may rise because of unusually severe weather. Other times, a drop in net earnings is a sign for caution.

Comments on statement of cash flows

On this statement, I focus on the number for net cash provided by operating activities. Learning whether the business generates cash is important because eventually, a business must generate cash from its core activities. This cash covers payroll, rent, utilities, and so on.

During some periods in its life, particularly growth spurts, a business may not generate sufficient cash to buy extra material for inventory and to hire more people. In these periods, the business can borrow from banks. But if the business does not ultimately generate cash, it goes bankrupt.

The line usually labeled "cash and cash equivalents" is also important, but it includes financing and investing activities. In the end, the cash generated by operating activities is crucial because the company invests for the future using cash provided by operations.

Comments on P/E ratio and backlog

A fourth number I look at is the price-earnings ratio (P/E ratio) for a company's stock. As I mentioned before, not all financial statements contain this figure, so finding it may require additional research. This information is quoted daily in the stock tables. Sometimes, an annual report includes the P/E ratio at the end of the fiscal year. Investors should compare a company's price-earnings ratio to the ratios of its major competitors.

The price-earnings ratio can change daily as the price of the stock moves up or down, so be sure to compare ratios from different companies at the same times.

[For content of an annual report, see "Guide to Annual Reports". For addresses of Web sites that provide information on industry ratios, see Resources.]

The last number I look at is a year-end figure and is usually called backlog (again, finding this number may require additional research). This number is the dollar value of unshipped orders available for delivery in the next year, ultimately resulting in net sales. For manufacturing companies, the backlog at the end of the year is a good indicator of what might happen in the next year.

Having a backlog means orders come in faster than a company can ship them. Customers expect and understand some delay. Too long a delay means customers get frustrated and place their orders elsewhere.

Frequently, a company will give its perspective on backlog in the management discussion section in the annual report. Also, checking the notes to the statement of financial position, for example, might reveal details on inventories to fill back orders.

Investors' tips: High school economics teacher

General suggestions

When my students are considering an investment in a company, I encourage them to start research in three places: the statement of earnings, statement of financial position, and statement of cash flows.

The statement of earnings will give them an overall picture of the company's revenue, its costs, and the resulting profit.

The statement of financial position will give them a cumulative performance of the company over time, showing assets versus liabilities and net worth.

The statement of cash flows will tell how much money came in and how much went out. It may give insight into how the company is being managed, ultimately answering the question: Is management making wise use of resources?

However, these numbers by themselves should not be used to make decisions about investing in a company. I do not put a great deal of significance on numbers alone because they can be manipulated, and oversight and enforcement may not be 100% effective at all times. You must look inside the company for answers.

Comments on statement of earnings

If a company shows a profit on the statement of earnings, I tell my students to find out why - even if it means calling and asking a company official or reviewing the company's Web site. Asking the right questions can identify the reasons for a profit. Has the company introduced a new product that boosted sales? Has the company's management changed tactics, such as increasing efficiency or entering new markets? Has the competition changed, causing the company to gain new customers? If a profit resulted because the answers to these questions are yes, it can indicate a healthy, growing company.

On the other hand, a profit on paper can sometimes result from practices that are not good for the company's long term health. For example, although cost-cutting is often desirable, it can have serious consequences. If cost-cutting brings about a greater efficiency without sacrificing quality, the company may be a sensible investment. However, if a company cuts costs by reducing product quality, it will probably lose sales in the future. If you are investing your hard-earned money, you want to feel confident a "financial wizard" has not been manipulating numbers that will mislead you.

I also tell my students that a loss on the statement of earnings does not always indicate a weak company. A company showing a loss might be investing heavily in research and development to perfect future products, which could result in greater future profits. A company could be experiencing temporary losses due to bad decisions. A stockholder must ask: Are these decisions irreversible or just temporary setbacks?

If a loss has caused a company's stock price to fall, stockholders must ask: Is this stock "on sale" (a bargain investment that will increase in value) or "down the drain" (a losing investment that will continue to decline)? The answers to these questions will not be found in the standard financial statements. These statements are simply starting points for further research.

Comments on statement of cash flows

A company is in business to make money. If the company shows a negative cash flow on the statement of cash flows, it is spending more than it makes. As a potential investor, you must ask: How long can the company survive following its current practices? Is this a "temporary" negative cash flow that's part of a bigger overall plan for a more profitable future? Or is the situation one which the company can not turn around?

Comments on statement of stockholders' equity

This statement can help give a clearer picture of what is going on inside a company. The statement should contain information on how the profits are being dispersed. If a large percentage of the profit is being declared in dividends, it could indicate the company is not planning for expansion and innovations. Such practice could result in a decrease in the value of the stock in the future. Accepting a financial page at face value could be a big mistake.

Make sure you always do your homework to understand that information in the bigger picture.

Investors' tips: Business school dean

General suggestions

With any financial statement, you should first look at the changes from year to year - both in the raw numbers and in the percentage changes in the numbers. These comparisons may indicate "trends" and are very helpful in assessing a company.

It is hard to generalize about a good rate of change - it depends on the line item you are looking at and the rates of change in prior years. If a company's sales rose 15 percent in each of the past three years, and rose only 10 percent this year, it would not be good. However, if the past years' rates of increase had been only five percent, and this year's rate is 10 percent, it would be quite good.

Most large companies include data for three years, but I recommend looking at longer periods of time if possible.

The financial statements represent a good starting point in judging a company's financial strength, but they are only a starting point. To complete the picture, you must acquire more information about the company's products, people, technology, and other resources that may give it a competitive advantage in the marketplace. One of the best sources of supplemental information is the non-financial section of the annual report. This section, usually in front, often tells a lot about top management's views on the company's future and ability to compete.

Comments on statement of earnings

On this statement, one of the figures I look at is the total operating income and its ratio to total revenue (net sales):

total operating income

total revenue

Ideally, I would like to see operating income growing, both as an absolute number and as a percentage of total revenue. That would usually mean a company is growing its operating income and becoming more efficient over time in managing its costs and operating expenses. There is no "ideal percentage" because the target percentage varies from industry to industry.

Comments on statement of financial position

On this statement, two things I look for are the figure for total stockholders' equity and the ratio of total liabilities to total stockholders' equity:

total liabilities

total stockholders' equity

Generally, a lower ratio of liabilities to equity means a lower risk for a company's creditors and lower costs when the company borrows money. Yet, how much debt a company carries compared with stockholders' equity varies widely according to the norms for the industry and the company's financial strategy. Just because a company has a high debt ratio is not a signal of weakness, if the ratio is in the ballpark for the industry.

With the statement of financial position, it is important to remember that most companies try to shine the spotlight on assets, not on liabilities. For instance, this statement typically provides a number for total assets and total stockholders' equity but not for total liabilities (to obtain total liabilities, subtract total stockholders' equity from total assets). An anonymous writer once said, "The needs of man are few - to get food, find shelter, and keep debt off the balance sheet [statement of financial position]". Keep this in mind and train yourself to seek out liabilities reported indirectly as well as directly.

Be sure to check the notes too, for liabilities you might find there. Look into note titles such as "Debt", "Other Liabilities and Environment", "Interest on Debt", "Commitments and Contingencies", "Leases", "Pensions" and "Post-Retirement Obligations".

Financial information is useful, but not every asset and liability can be measured in accounting terms. Statements of financial position often omit assets that are hard to measure or do not result from specific past events. For example, Coca-Cola does not report the company trademark - estimated to be worth more than $50 billion - on this statement. Also, Boeing's statement of financial position does not include the value of its vast workforce of engineers and aeronautics experts. These intangible assets can make the market value of a successful company's stock much greater than the statement reports.

Comments on statement of cash flows

On this statement, I look at the figure for cash provided, or used, by operating activities (operations). Without a doubt, this number is the most critical on this statement. These activities represent the basic business of the company. If a company consistently fails to make money at its basic business, it will have a hard time surviving. In a healthy mature company, operating activities normally result in positive cash flows.

The other ways a company receives or spends cash - investing and financing - are more difficult to interpret. For example, negative investing cash flows may indicate only that the company is growing and buying assets that enable it to manufacture more products. Financing cash flows are affected by a company's borrowing and the amount paid in dividends during the year. To interpret these numbers, you need more information on the company's strategies.
 

THIS GUIDE IS NEITHER AN OFFER TO SELL, NOR A SOLICITATION OF AN OFFER TO BUY, ANY SECURITIES OF INTERNATIONAL BUSINESS MACHINES CORPORATION OR ANY OTHER COMPANY.

The guide to financials provides basic information on how to read financial statements in a company's annual report. It discusses key numbers in each of the statements common to all annual reports and offers suggestions from experienced investors on making sense of these numbers.

Like any new and complex subject, the language of financial statements may at first seen mysterious, even intimidating. This guide can help you begin to gain basic financial vocabulary and to understand the subject. Topics cover only the fundamentals of accounting and financial reporting and the guide and its glossary explains the terms and ideas you will need to understand these topics

Resources: Overview

This section of the guide includes a small sampling of Internet links and other resources to help you extend your investment-related education. Use them as starting points for locating other materials.

Note: The following list is provided for the convenience of users and does not imply sponsorship or approval of any items. When you access a Web site on the list, you will open a new Web browser window. To easily reopen the guide anytime, add the guide home page as a bookmark on your personal menu of favorite topics.

Resources: Internet

Note: The following list is provided for the convenience of users and does not imply sponsorship or approval of any items. When you access a Web site on the list, you will open a new Web browser window. To easily reopen the guide anytime, add the guide home page as a bookmark on your personal menu of favorite topics.

Government agencies


The number of resources, of all types, on the Internet grows daily. You may find new Internet investment resources listed in your daily paper, in popular and special interest publications, at your online service provider's Web site, and at other Web sites (many of the following Web sites contain links to related Web sites). You can also use Internet search tools to locate other Web sites containing investment information.

The Securities and Exchange Commission is a regulatory agency that administers federal securities laws. These laws protect stockholders and ensure access to disclosure of all material information concerning publicly traded securities. The SEC also regulates brokerage firms, investment advisers, and investment companies.

The Department of Commerce promotes American businesses and trade, fosters economic growth, and helps create jobs. Two of its responsibilities that are frequently useful to investors are gathering and distributing statistical data, and measuring economic growth.

Investment and financial news


Financial news Web site focusing on business, world, technology, and sports. Links include markets, analysis, products and lifestyles. This Web site has member services and addresses the demand for investment performance through the combination of information and analyses. It delivers this information to corporations, issuers, financial intermediaries, and institutional investors.

A news, financial information, quotation, research, commentary, educational and investment planning service from Standard and Poor's Investment Advisory Services, Inc. ("SPIAS"). This Web site helps the individual investor track current investments, research potential ones, and provide information and insights from financial experts. Enables users to personalize the Web site and arrange news and insights that are particular to that user.

Breaking news releases from leading organizations and companies worldwide.

Provides top news, a market view, market winners, market losers, features and earnings reports to help the individual investor manage financial information.

From the editors of CNN and Money magazine. This Web site offers real-time quotes, archives of articles, letters, business headlines and a market watch section.

Online version of this business and investment magazine.

Your source for global business knowledge. The News/Periodicals - International Web page links to more than 70 online versions of international business publications, including Business Beijing (China), Central European Online, the London Financial Times, Nikkei Business Publications (Japan), Le Quotidien (Canada), and the Singapore Business Times.

Provider of financial data to the individual investor via the Internet. Links include stock quotes, support, a broker zone and more. The Web site also provides "Markets at a Glance" on the home page to allow users to see cross-market performance.

Online version.

Online version. To gain access to the Web site, you must take out a subscription.

Investment directories


Links to information on other business schools, business publications, careers on the Internet, reference Web sites, financial and economic data, companies on the Internet, and miscellaneous business topics.

Links to information on the markets, investing, companies, banking and finance, government, business news and directories, and miscellaneous topics. To gain access to the Web site, you must take out a free subscription.

Links to business libraries and to other Web sites that provide financial data, market news, and current quotes.

Links to data and information archives, news, economic and business publications, and other business and economic resources.

Investment education


An online bookstore that presents itself as the "Earth's biggest bookstore". The Web site's search feature allows you to search by title, author, and subject. A search for titles containing the words "financial statements" yields more than 1000 matches.

An independent, not-for-profit corporation to assist individuals in managing their investments. AAII offers investment information through publications, seminars, home study texts, educational videos, and local chapters.

Promotes itself as the market leader in investment club technologies.

Aims to educate, amuse and enrich the individual investor. Provides strategies, ideas and information, as well as the basic knowledge to put these things in context and allow individuals to begin making investment decisions.

A non-profit organization of investment clubs and individual investors. NAIC offers products, services, and professional support to help inexperienced and experienced investors become more informed. NAIC also publishes the monthly magazine, Better Investing.

Research

Research


Web site for a library of annual reports from national and international corporations, foundations, banks, mutual funds, and public institutions. Although full use of the services requires a paid membership, the Web site does offer some free information.

The Bureau of Labor Statistics collects and analyzes labor economics and statistics information for the U.S. Department of Labor and distributes the information to the public, Congress, other federal agencies, state and local governments, business, and labor. This Web site includes a link to "Economy at a Glance", a compilation of several economic indicators.

Index of Company overview. It offers IPO filings, quotes, latest news and search capability for corporate information, in addition to access to historical financials for over 8,000 companies. Personal subscriptions are available for individuals while special licensing is required for business purposes.

Online information for individual investors from Research:, a magazine for investment professionals. Many resources are free; others require a subscription.

Resources: Print and other

Books

The following list provides a few examples of the many books on finance, investing, annual reports, and financial statements. You can search for additional titles using Internet resources such as Amazon.com. This online bookstore's catalog includes all of the books listed below except "How to Read a Financial Report" from Merrill Lynch.

Budgeting & finance

Engel, Peter H. (First Books for Business Series). New York: McGraw-Hill. 1995. An illustrated introduction to business finance - cash flows, audits, balance sheets, and other key topics - that includes worksheets, checklists, case studies, and frequently asked questions.

How to profit from reading annual reports

Loth, Richard, B. Chicago: Dearborn Financial Publishing, Inc., 1993. Explains what to look for in the letter to stockholders, why the notes to financials are important, which words (and when they are used) are warning signs, and where to look for the overall financial health of a company.

How to read a financial report

Merrill Lynch, Pierce, Fenner & Smith, Inc. Fifth edition. Philadelphia: Merrill Lynch. 1984. A booklet for readers who find annual reports formidable reading. Using a fictitious company, the publisher walks through a balance sheet and income statement, explaining each, line item by line item.

How to read a financial report

Tracy, John A. Fourth edition. New York: John Wiley & Sons. 1993. Elements of financial statements and their inter-relationships explained, for users with no knowledge of accounting.

Keys to reading an annual report

Friedlob, George Thomas, Ph.D., CPA, and Welton, Ralph E., Ph.D. Second edition. New York: Barron's Educational Series. 1995. 54 keys explain laws, vocabulary, accounting procedures, financial analysis, reporting systems, and elements related to understanding and using financials and annual reports.

Understanding financial statements

Fraser, Lyn M. Fourth edition. Englewood Cliffs, NJ: Prentice Hall, 1995. Features cases based on actual published financial statements, self-tests with solutions included, and study questions and problems.

Magazines, newspapers, and other periodicals


Besides the publications listed below, many popular news magazines and daily papers carry regular stories on business, finance, and investment news. Check your local news stand and public library for other sources.
Note: Many of these publications also have online versions.

Magazines

  • Barron's
  • Business Week
  • The Economist
  • Forbes
  • Fortune
  • Kiplinger's personal finance magazine
  • Money
  • Worth

Newspapers

  • The Financial Times
  • Investor's Business Daily
  • The New York Times
  • The Nikkei Weekly
  • USA Today (Money Section)
  • The Wall Street Journal

Journals

This Web site provides an extensive list of current business publications. You can search the list for specific titles, for publishing locations, and for journals with Web sites.

Miscellaneous publications


To identify sources of financial information useful in analyzing financial statements, refer to:

  • Industry analysts reports in the press and on radio and television
  • Earnings releases in the press and on radio and television
  • Subscription newsletters (for example, Value Line Investment Survey)
  • Sources of industry ratios and of statistical summaries of financial statement information by industry (for example, Robert Morris Associates and Standard & Poor's Corporation)

Radio and television


Check your local radio and television listings for availability and schedules of subject-related programs.

A business news radio program produced by KUSC at the University of Southern California, distributed by Public Radio International, and carried by many public radio stations.

Nightly business report

A business news television program carried by many Public Broadcasting System stations.

Wall Street Week with Louis Rukeyser

A weekly Public Broadcasting System television program featuring Louis Rukeyser discussing the economy and financial issues with various guest experts. You can search for information about this PBS program and others at http://www.pbs.org/programs.

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