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288 Part IV: Preparing and Using Financial Reports The business example in Figure 13-2 has two “quick” assets: $14.85 million cash and $42.5 million accounts receivable, for a total of $57.35 million. (If it had any short-term marketable securities, this asset would be included in its total quick assets.) Total quick assets are divided by current liabilities to determine the company’s acid-test ratio, as follows: $57,350,000 quick assets ÷ $58,855,000 current liabilities = .97 acid-test ratio Its .97 to 1.00 acid-test ratio means that the business would be just about able to pay off its short-term liabilities from its cash on hand plus collection of its accounts receivable. The general rule is that the acid-test ratio should be at least 1.0, which means that liquid (quick) assets should equal current liabilities. Of course, falling below 1.0 doesn’t mean that the business is on the verge of bankruptcy, but if the ratio falls as low as 0.5, that may be cause for alarm. This ratio is also known as the pounce ratio to emphasize that you’re calculating for a worst-case scenario, where a pack of wolves (known as creditors) could pounce on the business and demand quick payment of the business’s liabilities. But don’t panic. Short-term creditors do not have the right to demand immediate payment, except under unusual circumstances. This ratio is a very conservative way to look at a business’s capability to pay its short-term liabilities — too conservative in most cases. Return on assets (ROA) ratio and financial leverage gain As I discuss in Chapter 5, one factor affecting the bottom-line profit of a business is whether it uses debt to its advantage. For the year, a business may realize a financial leverage gain, meaning it earns more profit on the money it has borrowed than the interest paid for the use of that borrowed money. A good part of a business’s net income for the year could be due to financial leverage. The first step in determining financial leverage gain is to calculate a business’s return on assets (ROA) ratio, which is the ratio of EBIT (earnings before interest and income tax) to the total capital invested in operating assets. Here’s how to calculate ROA: EBIT ÷ Net operating assets = ROA Note: This equation uses net operating assets, which equals total assets less the non-interest-bearing operating liabilities of the business. Actually, many stock analysts and investors use the total assets figure because deducting all the non-interest-bearing operating liabilities from total assets to determine Chapter 13: How Lenders and Investors Read a Financial Report net operating assets is, quite frankly, a nuisance. But I strongly recommend using net operating assets because that’s the total amount of capital raised from debt and equity. Compare ROA with the interest rate: If a business’s ROA is, say, 14 percent and the interest rate on its debt is, say, 6 percent, the business’s net gain on its debt capital is 8 percent more than what it’s paying in interest. There’s a favorable spread of 8 points (one point = 1 percent), which can be multiplied times the total debt of the business to determine how much of its earnings before income tax is traceable to financial leverage gain. In Figure 13-2, notice that the business has $100 million total interest-bearing debt: $40 million short-term plus $60 million long-term. Its total owners’ equity is $217.72 million. So its net operating assets total is $317.72 million (which excludes the three short-term non-interest-bearing operating liabilities). The company’s ROA, therefore, is: $55,570,000 EBIT ÷ $317,720,000 net operating assets = 17.5% ROA The business earned $17.5 million (rounded) on its total debt — 17.5 percent ROA times $100 million total debt. The business paid only $6.25 million interest on its debt. So the business had $11.25 million financial leverage gain before income tax ($17.5 million less $6.25 million). ROA is a useful ratio for interpreting profit performance, aside from determining financial gain (or loss). ROA is a capital utilization test — how much profit before interest and income tax was earned on the total capital employed by the business. The basic idea is that it takes money (assets) to make money (profit); the final test is how much profit was made on the assets. If, for example, a business earns $1 million EBIT on $25 million assets, its ROA is only 4 percent. Such a low ROA signals that the business is making poor use of its assets and will have to improve its ROA or face serious problems in the future. Frolicking Through the Footnotes Reading the footnotes in annual financial reports is no walk in the park. The investment pros read them because in providing consultation to their clients they are required to comply with due diligence standards — or because of their legal duties and responsibilities of managing other peoples’ money. When I was an accounting professor, I had to stay on top of financial reporting; every year I read a sample of annual financial reports to keep up with current practices. But beyond the group of people who get paid to read financial reports, does anyone read footnotes? 289 290 Part IV: Preparing and Using Financial Reports For a company you’ve invested in (or are considering investing in), I suggest that you do a quick read-through of the footnotes and identify the ones that seem to have the most significance. Generally, the most important footnotes are those dealing with the following matters:  Stock options awarded by the business to its executives: The additional stock shares issued under stock options dilute (thin out) the earnings per share of the business, which in turn puts downside pressure on the market value of its stock shares, assuming everything else remains the same.  Pending lawsuits, litigation, and investigations by government agencies: These intrusions into the normal affairs of the business can have enormous consequences.  Employee retirement and other post-retirement benefit plans: Your main concerns here should be whether these future obligations of the business are seriously underfunded. I have to warn you that this particular footnote is one of the most complex pieces of communication you’ll ever encounter. Good luck.  Debt problems: It’s not unusual for companies to get into problems with their debt. Debt contracts with lenders can be very complex and are financial straitjackets in some ways. A business may fall behind in making interest and principal payments on one or more of its debts, which triggers provisions in the debt contracts that give its lenders various options to protect their rights. Some debt problems are normal, but in certain cases lenders can threaten drastic action against a business, which should be discussed in its footnotes.  Segment information for the business: Public businesses have to report information for the major segments of the organization — sales and operating profit by territories or product lines. This gives a better glimpse of the different parts making up the whole business. (Segment information may be reported elsewhere in an annual financial report than in the footnotes, or you may have to go to the SEC filings of the business to find this information.) These are a few of the important pieces of information you should look for in footnotes. But you have to stay alert for other critical matters that a business may disclose in its footnotes, so I suggest scanning each and every footnote for potentially important information. Finding a footnote that discusses a major lawsuit against the business, for example, may make the stock too risky for your stock portfolio. Chapter 13: How Lenders and Investors Read a Financial Report Checking for Ominous Skies in the Auditor’s Report The value of analyzing a financial report depends on the accuracy of the report’s numbers. Understandably, top management wants to present the best possible picture of the business in its financial report. The managers have a vested interest in the profit performance and financial condition of the business; their yearly bonuses usually depend on recorded profit, for instance. As I mention several times in this book, the top managers and their accountants prepare the financial statements of the business and write the footnotes. This situation is somewhat like the batter in a baseball game calling the strikes and balls. Where’s the umpire? Independent CPA auditors are like umpires in the financial reporting game. The CPA comes in, does an audit of the business’s accounting system and methods, and gives a report that is attached to the company’s financial statements. Publicly owned businesses are required to have their annual financial reports audited by independent CPA firms, and many privately owned businesses have audits done, too, because they know that an audit report adds credibility to the financial report. What if a private business’s financial report doesn’t include an audit report? Well, you have to trust that the business prepared accurate financial statements following authoritative accounting and financial reporting standards and that the footnotes to the financial statements cover all important points and issues. Unfortunately, the audit report gets short shrift in financial statement analysis, maybe because it’s so full of technical terminology and accountant doublespeak. But even though audit reports are a tough read, anyone who reads and analyzes financial reports should definitely read the audit report. Chapter 15 provides more information on audits and the auditor’s report. The auditor judges whether the business’s accounting methods are in accordance with appropriate accounting and financial reporting standards — generally accepted accounting principles (GAAP) for businesses in the United States. In most cases, the auditor’s report confirms that everything is hunkydory, and you can rely on the financial report. However, sometimes an auditor waves a yellow flag — and in extreme cases, a red flag. Here are the two important warnings to watch out for in an audit report:  The business’s capability to continue normal operations is in doubt because of what are known as financial exigencies, which may mean a low cash balance, unpaid overdue liabilities, or major lawsuits that the business doesn’t have the cash to cover. 291 292 Part IV: Preparing and Using Financial Reports  One or more of the methods used in the report are not in complete agreement with appropriate accounting standards, leading the auditor to conclude that the numbers reported are misleading or that disclosure is inadequate. (Look for language in the auditor’s report to this effect.) Although auditor warnings don’t necessarily mean that a business is going down the tubes, they should turn on that light bulb in your head and make you more cautious and skeptical about the financial report. The auditor is questioning the very information on which the business’s value is based, and you can’t take that kind of thing lightly. Also, just because a business has a clean audit report doesn’t mean that the financial report is completely accurate and aboveboard. As I discuss in Chapter 15, auditors don’t always catch everything, and they sometimes fail to discover major accounting fraud. Also, the implementation of accounting methods is fairly flexible, leaving room for interpretation and creativity that’s just short of cooking the books (deliberately defrauding and misleading readers of the financial report). Some massaging of the numbers is tolerated, which may mean that what you see on the financial report isn’t exactly an untarnished picture of the business. I explain window dressing and profit smoothing — two common examples of massaging the numbers — in Chapter 12. Chapter 14 How Business Managers Use a Financial Report In This Chapter
Recognizing the limits of external financial statements
Locating detailed financial condition information
Identifying more in-depth profit information
Looking for additional cash flow information I f you’re a business manager, I strongly suggest that you read Chapter 13 before continuing with this one. Chapter 13 discusses how a business’s lenders and investors read its financial reports. These stakeholders are entitled to regular financial reports so they can determine whether the business is making good use of their money. The chapter explains key ratios that the external stakeholders can use for interpreting the financial condition and profit performance of a business. Business managers should understand the financial statement ratios in Chapter 13. Every ratio does double duty; it’s useful to business lenders and investors and equally useful to business managers. For example, the profit ratio and return on assets ratio are extraordinarily important to both the external stakeholders and the managers of a business — the first measures the profit yield from sales revenue, and the second measures profit on the assets employed by the business. But as important as they are, the external financial statements do not provide all the accounting information that managers need to plan and control the financial affairs of a business. Managers need additional information. Managers who look no further than the external financial statements are being very shortsighted — they don’t have all the information they need to do their jobs. The accounts reported in external financial statements are like the table of contents of a book; each account is like a chapter title. Managers need to do more than skim chapter titles. As the radio personality Paul Harvey would say, managers need to look at the rest of the story. 294 Part IV: Preparing and Using Financial Reports This chapter looks behind the accounts reported in the external financial statements. I explain the types of additional accounting information that managers need in order to control financial condition and performance, and to plan the financial future of a business. Building on the Foundation of the External Financial Statements Managers are problems solvers. Every business has some problems, perhaps even some serious ones. However, external financial statements are not designed to expose those problems. Except in extreme cases — in which the business is obviously in dire financial straits — you’d never learn about its problems just from reading its external financial statements. To borrow lyrics from an old Bing Crosby song, external financial statements are designed to “accentuate the positive, eliminate the negative . . . [and] don’t mess with Mister In-Between.” Seeking out problems and opportunities Business managers need more accounting information than what’s disclosed in external financial statements for two basic purposes:  To alert them to problems that exist or may be emerging that threaten the profit performance, cash flow, and financial condition of the business  To suggest opportunities for improving the financial performance and health of the business A popular expression these days is “mining the data.” The accounting system of a business is a rich mother lode of management information, but you have to dig that information out of the accounting database. Working with the controller (chief accountant), a manager should decide what information she needs beyond what is reported in the external financial statements. Avoiding information overload Business manages are very busy people. Nothing is more frustrating than getting reams of information that you have no use for. For that reason, the controller should guard carefully against information overload. While some types of accounting information should stream to business managers on a regular basis, other types should be provided only on as as-needed basis. Chapter 14: How Business Managers Use a Financial Report Ideally, the controller reads the mind of every manager and provides exactly the accounting information that each manager needs. In practice, that can’t always happen, of course. A manager may not be certain about which information she needs and which she doesn’t. The flow of information has to be worked out over time. Furthermore, how to communicate the information is open to debate and individual preferences. Some of the additional management information can be put in the main body of an accounting report, but most is communicated in supplemental schedules, graphs, and commentary. The information may be delivered to the manager’s computer, or the manager may be given the option to call up selected information from the accounting database of the business. My point is simply this: Managers and controllers must communicate — early and often — to make sure managers get what they need without being swamped with unnecessary data. No one wants to waste precious time compiling reports that are never read. So before a controller begins the process of compiling accounting information for managers’ eyes only, be sure there’s ample communication about what each manager needs. Gathering Financial Condition Information The balance sheet — one of three primary financial statements included in a financial report — summarizes the financial condition of the business. Figure 14-1 lists the basic accounts in a balance sheet, without dollar amounts for the accounts and without subtotals and totals. Just 12 accounts are given in Figure 14-1: five assets (counting fixed assets and accumulated depreciation as only one account), five liabilities, and two owners’ equity accounts. A business may report more than just these 12 accounts. For instance, a business may invest in marketable securities, or have receivables from loans made to officers of the business. A business may have intangible assets. A business corporation may issue more than one class of capital stock and would report a separate account for each class. And so on. The idea of Figure 14-1 is to focus on the core assets and liabilities of a typical business. 295 296 Part IV: Preparing and Using Financial Reports Assets Cash Accounts receivable Inventory Prepaid expenses Figure 14-1: Fixed assets Hardcore Accumulated depreciation accounts reported in a balance sheet. Liabilities Accounts payable Accrued expenses payable Income tax payable Short-term notes payable Long-term notes payable Owners’ Equity Invested capital Retained earnings Cash The external balance sheet reports just one cash account. But many businesses keep several bank checking and deposit accounts, and some (such as gambling casinos and food supermarkets) keep a fair amount of currency on hand. A business may have foreign bank deposits in euros, English pounds, or other currencies. Most businesses set up separate checking accounts for payroll; only payroll checks are written against these accounts. Managers should monitor the balances in every cash account in order to control and optimize the deployment of their cash resources. So, information about each bank account should be reported to the manager. Managers should ask these questions regarding cash:  Is the ending balance of cash the actual amount at the balance sheet date, or did the business engage in window dressing in order to inflate its ending cash balance? Window dressing refers to holding the books open after the ending balance sheet date in order to record additional cash inflow as if the cash was received on the last day of the period. Window dressing is not uncommon. (For more details, see Chapter 12.) If window dressing has gone on, the manager should know the true, actual ending cash balance of the business.  Were there any cash out days during the year? In other words, did the company’s cash balance actually fall to zero (or near zero) during the year? How often did this happen? Is there a seasonal fluctuation in cash flow that causes “low tide” for cash, or are the cash out days due to running the business with too little cash?  Are there any limitations on the uses of cash imposed by loan covenants by the company’s lenders? Do any of the loans require compensatory balances that require that the business keep a minimum balance relative Chapter 14: How Business Managers Use a Financial Report to the loan balance? In this situation the cash balance is not fully available for general operating purposes.  Are there any out-of-the-ordinary demands on cash? For example, a business may have entered into buyout agreements with a key shareholder or with a vendor to escape the terms of an unfavorable contract. Any looming demands on cash should be reported to managers. Accounts receivable A business that makes sales on credit has the accounts receivable asset — unless it has collected all its customers’ receivables by the end of the year, which is not very likely. To be more correct, the business has hundreds or thousands of individual accounts receivable from its credit customers. In its external balance sheet, a business reports just one summary amount for all its accounts receivable. However, this total amount is not nearly enough information for the business manager. Here are questions a manager should ask about accounts receivable:  Of the total amount of accounts receivable, how much is current (within the normal credit terms offered to customers), slightly past due, and seriously past due? A past due receivable causes a delay in cash flow and increases the risk of it becoming a bad debt (a receivable that ends up being partially or wholly uncollectible).  Has an adequate amount been recorded for bad debts? Is the company’s method for determining its bad debts expense consistent year to year? Was the estimate of bad debts this period tweaked in order to boost or dampen profit for the period? Has the IRS raised any questions about the company’s method for writing off bad debts? (Chapter 7 discusses bad debts expense.)  Who owes the most money to the business? (The manager should receive a schedule of customers that shows this information.) Which customers are the slowest payers? Do the sales prices to these customers take into account that they typically do not pay on time? It’s also useful to know which customers pay quickly to take advantage of prompt payment discounts. In short, the payment profiles of credit customers are important information for managers.  Are there “stray” receivables buried in the accounts receivable total? A business may loan money to its managers and employees or to other businesses. There may be good business reasons for such loans. In any case, these receivables should not be included with accounts receivable, which should be reserved for receivables from credit sales to customers. Other receivables should be listed in a separate schedule. 297