Reading Financial Reports for Dummies (6 page)

This chapter introduces you to the many facets of financial reports and how internal and external players use them to evaluate a company’s financial health.

Figuring Out Financial Reporting

Financial reporting gives readers a summary of what happens in a company based purely on the numbers. The numbers that tell the tale include the following:

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Part I: Getting Down to Financial Reporting Basics

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Assets:
The cash, marketable securities, buildings, land, tools, equipment, vehicles, copyrights, patents, and any other items needed to run a business that a company holds.

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Liabilities:
Money a company owes to outsiders, such as loans, bonds, and unpaid bills.

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Equity:
Money invested in the company.

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Sales:
Products or services that customers purchase.

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Costs and expenses:
Money spent to operate a business, such as expenditures for production, compensation for employees, operation of buildings and factories, or supplies to run the offices.

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Profit or loss:
The amount of money a company earns or loses.

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Cash flow:
The amount of money that flows into and out of a business during the time period being reported.

Without financial reporting, you’d have no idea where a company stands financially. Sure, you’d know how much money the business has in its bank accounts, but you wouldn’t know how much is still due to come in from customers, how much inventory is being held in the warehouse and on the shelf, how much the firm owes, or even how much the firm owns. As an investor, if you don’t know these details, you can’t possibly make an objective decision about whether the company is making money and whether it’s worth investing in the company’s future.

Preparing the reports

A company’s accounting department is the key source of its financial reports.

This department is responsible for monitoring the numbers and putting together the reports. The numbers are the products of a process called
double-entry accounting,
which requires a company to record resources and the assets it uses to get those resources. For example, if you buy a chair, you must spend another asset, such as cash. An entry in the double-entry accounting system shows both sides of that transaction — the cash account is reduced by the chair’s price, and the furniture account value is increased by the chair’s price.

This crucial method of accounting gives companies the ability to record and track business activity in a standardized way. Accounting methods are constantly updated to reflect the business environment as financial transactions become more complex. To find out more about double-entry accounting, turn to Chapter 4.

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Why financial reporting counts

(and who’s counting)

Many people count on the information companies present in financial reports. Here are some key groups of readers and why they need accurate information:

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Executives and managers:
They need information to know how well the company is doing financially and to find out about problem areas so they can make changes to improve the company’s performance.

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Employees:
They need to know how well they’re meeting or exceeding their goals and where they need to improve. For example, if a salesperson has to make $50,000 in sales during the month, he needs a financial report at the end of the month to gauge how well he did in meeting that goal. If he believes that he met his goal but the financial report doesn’t show that he did, he’d have to provide details to defend his production levels. Most salespeople are paid according to their sales production.

Without financial reports, they’d have no idea what their compensation is based on.

Employees also make career and retirement-investment decisions based on the company’s financial reports. If the reports are misleading or false, employees could lose most, if not all, of their 401(k) retirement savings, and their long-term financial futures could be at risk.

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Creditors:
They need to understand a company’s financial results to determine whether they should risk lending more money to the company and to find out whether the firm is meeting the minimum requirements of any loan programs that are already in place. To find out how creditors gauge whether a business meets their requirements, see Chapters 9 and 12.

If a firm’s financial reports are false or misleading, creditors may loan money at an interest rate that doesn’t truly reflect the risks they’re taking. And by trusting the misleading information, they may miss out on a better opportunity.

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Investors:
They need information to judge whether a company is a good investment. If investors think that a company is on a growth path because of the financial information it reports but those reports turn out to be false, investors can pay, big time. They may buy stock at inflated prices and risk the loss of capital as the truth comes out, or miss out on better investing opportunities.

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Government agencies:
These agencies need to be sure that companies comply with regulations set at the state and federal levels. They also need to be certain that companies accurately inform the public about their financial position.

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Analysts:
They need information to develop analytical reviews for clients who are considering the company for investments or additional loan funds.

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Financial reporters:
They need to provide accurate coverage of a company’s operations to the general public, which helps make investors aware of the critical financial issues facing the company and any changes the company makes in its operations.

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Competitors:
Every company’s bigwigs read their competitors’ financial reports. If these reports are based on false numbers, the financial playing field gets distorted. A well-run company could make a bad decision to keep up with the false numbers of a competitor and end up reducing its own profitability.

Companies don’t produce financial reports only for public consumption.

Many financial reports are prepared for internal use only. These internal reports help managers

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Find out which of the business’s operations are producing a profit and which are operating at a loss.

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Determine which departments or divisions should receive additional resources to encourage growth.

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Identify unsuccessful departments or divisions and make needed changes to turn the troubled section around or kill the project.

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Determine staffing and inventory levels needed to respond to customer demand.

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Review customer accounts to identify slow-paying or nonpaying customers in order to devise collection methods and to develop guidelines for when a customer should be cut off from future orders.

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Prepare production schedules and review production levels.

These are just a few of the many uses companies have for their internal financial reports. The list is endless and is limited only by the imagination of the executives and managers who want to find ways to use the numbers to make business decisions. I talk more about using internal reports to optimize results in Chapters 14, 15, and 16.

Checking Out Types of Reporting

Not every company needs to prepare financial statements, but any company seeking to raise cash through stock sales or by borrowing funds certainly does.

How public these statements must be depends on the business’s structure.

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Most businesses are
private companies,
which share these statements only with a small group of stakeholders: managers, investors, suppliers, vendors, and the financial institutions that they do business with. As long as a company doesn’t sell shares of stock to the general public, it doesn’t have to make its financial statements public. I talk more about the reporting rules for private companies in Chapter 2.

Public
companies,
which sell stock on the open market, must file a series of reports with the Securities and Exchange Commission (SEC) each year if they have at least 500 investors or at least $10 million in assets. Smaller companies that have incorporated and sold stock must report to the state in which they incorporated, but they aren’t required to file with the SEC. You can find more details about the SEC’s reporting requirements for public companies in Chapters 3 and 19.

Even if a firm doesn’t need to make its financial reports public, if it wants to raise cash outside a very small circle of friends, it has to prepare financial statements and have a certified public accountant (CPA)
audit
them,
or certify that the financial statements meet the requirements of the generally accepted accounting principles (or GAAP, which you can find out more about in the section “How the number crunchers are kept in line,” later in this chapter). Few banks consider loaning large sums of money to businesses without audited financial statements. Investors who aren’t involved in the daily management of a business also usually require audited financial statements.

Keeping everyone informed

One big change in a company’s operations after it decides to publicly sell stock is that it must report publicly on both a quarterly and annual basis to its stockholders. Companies send these reports directly to their stockholders, to analysts, and to the major financial institutions that help fund their operations through loans or bonds. The reports often include glossy pictures and pleasingly designed graphics at the beginning, keeping the less eye-pleasing financial reports that meet the SEC’s requirements in the back.

Quarterly reports

Companies must release
quarterly reports
within 45 days after the quarter ends. Companies with holdings over $75 million must file more quickly.

In addition to the three key financial statements — the
balance sheet,
the
income statement,
and the
statement of cash flows
(check out the upcoming section “The meat of the matter” for details on these documents) — the company must state whether a CPA has audited (see Chapter 18) or reviewed (a much less intensive look at the data) the numbers. A report reviewed rather than audited by a CPA holds less weight.

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Annual reports

Most small companies must file their
annual reports
within 90 days of the end of their fiscal year. Companies with over $75 million in assets must file their reports within 60 days. The annual report includes the information presented in the quarterly reports and much more, including a full business description, details about the management team and its compensation, and details about any filings done during the year.

Most major companies put a lot of money into producing glossy reports filled with information and pictures designed to make a good impression on the public. The marketing or public relations department, rather than the financial or accounting department, writes much of the summary information. Too often, annual reports are puff pieces that carefully hide any negative information in the
notes to the financial statements,
which is the section that offers additional details about the numbers provided in those statements (see Chapter 9). Read between the lines — especially the tiny print at the back of the report — to get some critical information about the accounting methods used, any pending lawsuits, or other information that may negatively impact results in the future.

Following the rules: Government

requirements

Reports for the government are more extensive than the glossy reports sent to shareholders (see the preceding section). Companies must file many types of forms with the SEC, but I focus on only three of them in this book:

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The 10-K:
This form is the annual report that provides a comprehensive overview of a company’s business and financial activities.

Firms must file this report within 90 days after the end of the fiscal year (companies with more than $75 million in assets must file within 60 days). In addition to the information included in the glossy annual reports sent to shareholders (see the preceding section), investors can find more detailed information about company history, organizational structure, equity holdings, subsidiaries, employee stock-purchase and savings plans, incorporation, legal proceedings, controls and procedures, executive compensation, accounting fees and services, and changes or disagreements with accountants about financial disclosures.

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The 10-Q:
This form is the quarterly report that describes key financial information about the prior three months. Most companies must file this report within 45 days of the end of the quarter (firms with more than $75 million in assets must file within 40 days). In addition to the information sent directly to shareholders, this form includes details about the company’s market risk, controls and procedures, legal proceedings, and defaults on payments.

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The 8-K:
This form is a periodic report that accounts for any major events that may impact a company’s financial position. Examples of major events include the acquisition of another company, the sale of a company or division, bankruptcy, the resignation of directors, or a change in the fiscal year. When a major event occurs, the company must file a report with the SEC within four days of the event.

You can access reports filed with the SEC online at Edgar, which is run by the SEC. To use Edgar, go to www.sec.gov/edgar.shtml.

Going global

More and more companies operate across country borders. For years, each country had its own set of rules for preparing financial reports to meet government regulations. Global companies had to keep separate sets of books and report results under different sets of rules in each country in which they operated.