Advanced Financial Statements Analysis

AdvancedFinancialStatementsAnalysisByDavidHarper://)Introduction2)Who'sinCharge?3)TheFinancialStatementsAreaSystem4)CashFlow5)Earnings6)Revenue7)WorkingCapital8)Long-LivedAssets9)Long-TermLiabilities10)PensionPlans11)ConclusionandResourcesIntroductionWhetheryouwatchanalystsonCNBCorreadarticlesintheWallStreetJournal,you'llhearexpertsinsistingontheimportanceofdoingyourhomeworkbeforeinvestinginacompany.Inotherwords,investorsshoulddigdeepintothecompany'sfinancialstatementsandanalyzeeverythingfromtheauditor'sreporttothefootnotes.Butwhatdoesthisadvicereallymean,andhowdoesaninvestorfollowit?Theaimofthistutorialistoanswerthesequestionsbyprovidingasuccinctyetadvancedoverviewoffinancialstatementsanalysis.Ifyoualreadyhaveagraspofthedefinitionofthebalancesheetandthestructureofanincomestatement,great.Thistutorialwillgiveyouadeeperunderstandingofhowtoanalyzethesereportsandhowtoidentifytheredflagsandgoldnuggetsofacompany.Inotherwords,itwillteachyoutheimportantfactorsthatmakeorbreakaninvestmentdecision.Ifyouarenewtofinancialstatements,havenoworries.Youcangetthebackgroundknowledgeyouneedintheseintroductorytutorialsonstocks,fundamentalanalysis,andratioanalysis.(Page1of66)Copyright©2004,Investopedia.com-Allrightsreserved.Investopedia.com–theresourceforinvestingandpersonalfinanceeducation.Who'sinCharge?IntheUnitedStates,acompanythatoffersitscommonstocktothepublictypicallyneedstofileperiodicfinancialreportswiththeSecuritiesandExchangeCommission(SEC).Wewillfocusonthethreeimportantreportsoutlinedinthistable:TheSECgovernsthecontentofthesefilingsandmonitorstheaccountingprofession.Inturn,theSECempowerstheFinancialAccountingStandardsBoard(FASB)--anindependent,nongovernmentalorganization--withtheauthoritytoupdateU.S.accountingrules.Whenconsideringimportantrulechanges,FASBisimpressivelycarefultosolicitinputfromawiderangeofconstituentsandaccountingprofessionals.ButonceFASBissuesafinalstandard,thisstandardbecomesamandatorypartofthetotalsetofaccountingstandardsknownasGenerallyAcceptedAccountingPrinciples(GAAP).GenerallyAcceptedAccountingPrinciples(GAAP)GAAPstartswithaconceptualframeworkthatanchorsfinancialreportstoasetofprinciplessuchasmateriality(thedegreetowhichthetransactionisbigenoughtomatter)andverifiability(thedegreetowhichdifferentpeopleagreeonhowtomeasurethetransaction).Thebasicgoalistoprovideusers--equityinvestors,creditors,regulatorsandthepublic--withrelevant,reliableandusefulinformationformakinggooddecisions.Astheframeworkisgeneral,itrequiresinterpretationandoftenre-interpretationinlightofnewbusinesstransactions.Consequently,sittingontopofthesimpleframeworkisagrowingpileofliterallyhundredsofaccountingstandards.Butcomplexityintherulesisunavoidableforatleasttworeasons.First,thereisanaturaltensionbetweenthetwoprinciplesofrelevanceandreliability.Atransactionisrelevantifareasonableinvestorwouldcareaboutit;areportedtransactionisreliableifthereportednumberisunbiasedandaccurate.Wewantboth,butweoftencannotgetboth.Forexample,realestateiscarriedonthebalancesheetathistoricalcostbecausethishistoricalcostisreliable.Thatis,wecanknowwithobjectivecertaintyhowmuchwaspaidtoacquireproperty.However,Thistutorialcanbefoundat:(Page2of66)Copyright©2004,Investopedia.com-Allrightsreserved.Investopedia.com–theresourceforinvestingandpersonalfinanceeducation.eventhoughhistoricalcostisreliable,reportingthecurrentmarketvalueofthepropertywouldbemorerelevant--butalsolessreliable.Consideralsoderivativeinstruments,anareawhererelevancetrumpsreliability.Derivativescanbecomplicatedanddifficulttovalue,butsomederivatives(speculativenothedgederivatives)increaserisk.Rulesthereforerequirecompaniestocarryderivativesonthebalancesheetatfairvalue,whichrequiresanestimate,eveniftheestimateisnotperfectlyreliable.Again,theimprecisefairvalueestimateismorerelevantthanhistoricalcost.Youcanseehowsomeofthecomplexityinaccountingisduetoagradualshiftawayfromreliablehistoricalcoststorelevantmarketvalues.Thesecondreasonforthecomplexityinaccountingrulesistheunavoidablerestrictiononthereportingperiod:financialstatementstrytocaptureoperatingperformanceoverthefixedperiodofayear.Accrualaccountingisthepracticeofmatchingexpensesincurredduringtheyearwithrevenueearned,irrespectiveofcashflows.Forexample,sayacompanyinvestsahugesumofcashtopurchaseafactory,whichisthenusedoverthefollowing20years.Depreciationisjustawayofallocatingthepurchasepriceovereachyearofthefactory'susefullifesothatprofitscanbeestimatedeachyear.Cashflowsarespentandreceivedinalumpypatternand,overthelongrun,totalcashflowsdotendtoequaltotalaccruals.Butinasingleyear,theyarenotequivalent.Evenaneasyreportingquestionsuchashowmuchdidthecompanysellduringtheyear?requiresmakingestimatesthatdistinguishcashreceivedfromrevenueearned:forexample,didthecompanyusereb