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Anatomy 201 - Why Are They Telling Us This?

Financial Planning

February 2006

Anatomy 201 - Why Are They Telling Us This?

Last month, we began talking about the Annual Report; that magical and mystical report you get from every public company in which you own stock. It’s the book you, as an investor, look for every year, expecting to find out what your company plans on doing and how well they did what they said they would do last year. Well, you might be anxiously awaiting your company’s annual report just a little, but chances are you don’t think about it very much, if at all.

Why don’t most small investors look at their investment’s annual report with a more critical eye? Why do they flip through the pages and put the report on the "to be read if I have any time and I’m bored to death" pile? It’s probably because they don’t understand what they are reading and it’s hard to get excited over something you don’t understand.

If you are in the "What did they say and why are they saying it" group, have no fear. Over the next two months we will attempt to unravel the Annual Report in a way that you will be better able to monitor you company’s performance.

Three's a Charm

Most annual reports have essentially three components -
  • The financial statements and the auditors’ report on them;

  • Management's discussion and analysis of the company's performance and
  • Other information.
The financial statements and auditors' report give you a historical perspective of the company. They are a scorecard, if you will, telling you how well the company did in any given year. The basic financial statements include the balance sheet, income statement, statement of cash flows and statement of stockholder’s equity.

Management's discussion and analysis of the company’s operating results gives you a bit of a view into why the company performed as it did and what management thinks will happen in the future. We will discuss this in detail, along with the Chairman’s or President’s letter and other information next month.

Other information is what management decides is appropriate to show in the annual report, some of which is required. For our purposes, this area will include the Chairman’s or President’s letter, a description of the company, including product lines, subsidiaries and other structural issues.

Financial Statements and Auditors' Report

Independent auditors are supposed to be the investors’ watchdog. Their job is to take a look at the recorded transactions in the company’s books and report on whether they think the financial statements are fairly presented in all material respects with Generally Accepted Accounting Principles (GAAP). Don’t let these words confuse you. Going in reverse order, GAAP is the set of rules that tell management how to record transactions. The phrase "fairly in all material respects" means that the auditors think management reported correctly anything that would affect how you view your company’s performance.

The balance sheet tells you what your company owns, how much it owes to others and how much equity the shareholders have in the company. The first item you see will be a listing of assets broken down by current assets and other longer term assets like property and equipment, land, investments that the company won’t sell or use in the next year and so on. Current assets are assets expected to be used up or received in the next year like inventories, cash, accounts receivable, prepaid expenses, etc.

The balance sheet is called what it is because the total of all the assets must equal the total of everything the company owes third parties plus the stockholder’s equity in the company.

Any debt of the company is called a liability. Current liabilities are liabilities that are expected to be paid off within a year like accounts payable, accrued unpaid expenses, short-term loans and the portion of long-term loans expected to be paid during the next year. By comparing current assets to current liabilities, you can get a glimpse of the company’s health. If current liabilities are less than current assets, then it’s likely the company should be able to pay its debts when they come due. If the liabilities are greater than assets, it is an indication that the company is having or may have financial difficulties. Just like there are long-term assets, there are long-term liabilities. The portion of loans that aren’t payable the following year and other obligations not due in the coming year are called long-term liabilities.

Stockholder’s equity is the company’s cumulative scorecard. Stockholder’s equity consists of any stock sold by the company to raise cash for operations or investment and how much of the company’s profits have been kept for operations over the years. If the stock of the company has a stated or par value and investors pay more than that value, you have what’s called additional paid-in capital.

It is the stockholder’s equity that gives you the best clue about the company’s financial health. The higher the stockholder’s equity, the better the health of the company. A very low equity indicates the company may be heading for financial trouble unless things change and a negative equity mean’s the company is technically bankrupt.

One thing to remember about the balance sheet numbers is they are historical. That means they have been recorded at what they cost and not what their current value is. This can be misleading to some extent. For example, say you have a company that shows a building with a balance sheet value of $1,000, but you have a buyer who is willing to pay $20,000 for the building. That $20,000 value can’t be recorded until the sale transaction actually takes place because of U.S. accounting rules. What number would you use if you were trying to figure out how healthy the company is?

The income statement is the company’s report card. It tells you the dollar value of the products the company sold, what the items cost and what it cost to run the administrative, sales and perhaps research and development side of the company. It also tells you how much income your company had that was unrelated to the sale of products. Items like interest income or dividends or gains on sales of assets are examples of other income. Finally, if the company is profitable, there should be an income tax expense reflected on the income statement. Generally, the tax expense is shown as a single line item on the face of the financial statements with a note explaining what makes up the total.

Most of the descriptions on the income statement are self-explanatory, but there are one or two points to remember. First, cost of goods sold is exactly what it says. It is the cost of what the company sold. It is the total of all of the materials it took to make the product and the cost of the labor and facilities also. Depending on the type of business, the process of costing the items sold can be simple or extremely complex.

If your company has significant research and development costs, that doesn’t mean that’s all money down the drain. Accounting rules say research and development costs must be expensed, and sometimes they are useless for future purposes, but sometimes those costs yield information that bring the company closer to creating a new product.

The statement of cash flows tells you where the company’s cash came from and where it went. It is made up of three sections - operating, investing and financing. Cash from or used in operating activities is cash generated by product sales activities along with the other income and expenses it took to run the company. Cash from or used in investing activities is cash with which the company purchased investment property and equipment, stock of other companies as well as other investments. Cash from or used in financing activities is generally cash generated by new loans and sales of stock less dividends paid and loans repaid.

The statement of stockholders' equity shows the increases and decreases in the shareholders' equity.

The notes to the financial statements are extremely important because they tell you what’s behind the numbers you see on the financial statements. A summary of accounting policies tells you how the company accounts for certain items and detailed notes give you the breakdown of various items in the financial statements. Just as they can be extremely important, they can also be very lengthy. Most of the time, the notes to the financial statements will be longer than the financial statements themselves.


The annual report is the scorecard of your company. It tells you how well management did its job in making your money grow. For this reason, it’s very important that you review the annual report of the companies you own to help you make the most of your investment. Unfortunately, accounting rules are so complex, when you start reading the financial statements, you may get a bad headache. If you should need any help deciphering the upcoming crop of annual reports, or if we can help you in other ways, don’t hesitate to give us a call.

Have a great February.

These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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