How to Read A Financial Report by John A. Tracy – Accounting sounds about as fun as watching infomercials, but I must say that I didn’t struggle getting through this book. In fact I spent most of the book thinking that I could have learned more from this book than my college accounting courses. Instead of focusing on computing missing data from a balance sheet the book focused on the most valuable thing regarding being able to read statements; being able to see how they are interconnected. Much like a foreign language, I am sure that I will forget many of the lessons of this book if I do not use them on a daily basis. However I think that I will be much more adept at intuitively following data from the income statement all the way through to the statement of cash flows, and in doing so will be able to draw conclusions about the financial condition of a business. The book wasn’t very long which helped make it an easy read. But it was the fact that it had a great number of simple example statements that always focused on how the statements work together that made it a very useful book. Another book down on my Personal MBA journey that I would definitely recommend to anyone seeking a life in the business world. One thing I learned in sports is to always focus on the fundamentals no matter how far along you go, and there is nothing more fundamental in business than understanding the basic language of business known as financial accounting.
Lurking somewhere amidst all the figures in a financial report is vitally important information about where a company has been and where it is headed. But without a guide to isolate and interpret those numbers, the dizzying array of columns and rows doesn't add up to a hill of beans. That's why thousands of professionals and savvy individuals have referred to this bestselling resource that shows anyone how to make sense of all those numbers. If you're someone who works with financial reports or needs to understand them-but have neither the time nor the need for an in-depth knowledge of accounting-this book will help you cut through the maze of accounting information to find out what those numbers really mean. It steers you quickly and painlessly through the basic accounting concepts and line-by-line explanations of the basic financial statement. Complete with a visual guide that leads you through the intricacies of financial reporting, How to Read a Financial Report shows you how the three essential parts of every financial report-the balance sheet, the income statement, and the cash flow statement-fit together and what it all means to you and your company. Updated throughout, this new edition addresses the many changes in the financial world in the past few years, including new pronouncements of the Financial Accounting Standards Board, new income tax laws, and emerging financial reporting problems. Also, all exhibits have been made easier to
Here are my notes from the book. As I stated before they would be a lot more beneficial if they had the actual example statements and illustrations included but I guess you will just have to go read the book!
Starting with Cash Flows:
- Cash inflows and outflows are the heartbeat of every business
- 2 groups of cash flows: 1. Cash flows of making profit (inflows from sales and outflows from expenses) 2. Cash flows of the business (raising capital, investing capital, distributing profits)
- 2 most important things a cash flow summary won’t tell you: 1. The profit earned for the period 2. The financial condition of the business
- Accrual based accounting recognizes receivables from sales on credit and liabilities for unpaid expenses to determine profit measure for that period
Introducing the Balance Sheet and Income Statement:
- The financial condition of a company is communicated in an accounting report called the balance sheet and profit performance is presented in the income statement
- Income statement summarizes revenue and expenses for a period of time
- The balance sheets liabilities have first claim on assets that’s why they are listed above owners equity
- Balance sheet is prepared on the last day of the income statement period
Profit Isn’t Everything:
- Prevent cash shortages that cause default on liabilities
- Threefold: 1. Earning profit 2. Controlling assets and liabilities 3. Preventing cash outs
- The balance sheet, income statement, and statement of cash flows are all interconnected and in order to effectively manage the business you must understand how they work together
Sales Revenue and Accounts Receivable:
- Extending credit to customers creates a cash inflow lag. The accounts receivable balance is the amount of this lag
- You have fast slow and average payoff times with credit. The average sales credit period determines the size of accounts receivable
- Exhibit page 26
- Accounts turnover ratio page 30 is most meaningful when used to determine how long it takes to turn receivables into cash
- If you turnover into cash faster it is less you have to borrow at 8% or the owners could have invested less. Capital has a COST!
Cost of Goods Sold and Inventory:
- Gross margin is the starting point for earning adequate bottom line profit
- Sell products for enough gross margin so all other business expenses can be covered and still have a remainder for profit
- Inventory holding period determines the size of inventory relative to annual costs of goods sold
Inventory and Accounts Payable:
Operating Expenses and Accounts Payable:
- Some operating expenses have to be recorded before they are paid
- Examples on page 44
Operating Expenses and Prepaid Expenses:
- Example of prepaid expense is insurance premium
- Used to show prepaid expense but delay recording it in expenses
Long Term Operating Assets: Depreciation and Amortization Expense:
- Financial accounting doesn’t just keep track of expenses it is concerned with correct timing of expenses
- Matching expenses with sales revenue
- Matching expenses with the correct period
- Depreciation in financial accounting means cost allocation
- Leased assets are not reported
- Accounting for fixed assets does not attempt to record changes in current replacement costs. It is a cost recovery based method not mark to market
- There are many reasons to pay more for a company than the sum of its identifiable assets. The excess is called goodwill.
- Writing off intangible assets is called Amortization
Accruing Unpaid Operating Expenses and Interest Expense:
- Notes payable pay interest where accounts payable do not
Income Tax and Income Tax Payable:
- Tax not paid from prior year goes on balance sheet as a payable liability
Net Income and Retained Earnings: Earnings Per Share:
- Retained earnings is the cumulative result of all the years it has been in business minus dividends
- Many people think it is an asset or even cash. This is not true cash is also reported in the balance sheet
- Only public companies must report EPS
Cash Flow From Profit and Loss:
- Why doesn’t profit equal cash flow?
- Business managers have double duty: earn a profit and convert profit into cash as soon as possible
- 8 changes in operating assets and liabilities that determine cash flow from profit for year: 1. Accounts receivable 2. Inventory 3. Prepaid expenses 4. Depreciation 5. Amortization 6. Accounts payable 7. Accrued expense 8. Income tax payable
- Cash flow adjustments to net income: Increase in operating assets cause decrease in cash flow from profit and decreases in operating assets cause increases in cash flow from profit. Increases in operating liabilities help cash flow from profit. Decreases in operating liabilities decrease cash flow from profit
- Profit generates cash flow, cash flow doesn’t generate profit
Cash flows from Investing and Financing Activities:
- Capital expenditures area a bet on the future
Growth, Decline, and Cash Flow:
- 3 major pieces to cash flow: Depreciation and amortization, operating assets, operating liabilities
- Growth doesn’t instantly boost cash flow
Footnotes, The Fine Print in Financial Reports:
- Footnotes are an essential supplement to financial statements
- Managers have to decide how much to disclose in footnotes above minimum standards
CPA’s Audits and Audit Failures:
- Financial Statements can be misleading for two major reasons: 1. Honest mistakes 2. Deliberate dishonesty
- Audits done by independent CPAs are supposed to prevent this
- Audits add credibility but it is an opinion so be careful!
- You want a clean unqualified audit
- qualified is good except for…..
- Adverse opinion is that the statement is misleading
- CPA may also withdraw
Choosing Accounting Methods and Quality of Earnings:
- 6 basic steps in the accounting process of a business:
1. Identify and analyze all transactions and operations during the period
2. Determine the correct accounting according to GAAP
3. Record the transactions, operations, and development
4. At the end of the period assemble the accounts for sales, revenue, expenses, assets, liabilities, and owners equity making sure they’re up to date and accurate
5. Prepare financial statements for period with footnotes
6. Distribute to those entitled a copy
- Once a business chooses an accounting method it cannot flip-flop
- Managers can massage the numbers by timing things like expenditures
- Cooking the books means sales revenue is recorded when no sales were made
- Quality of earnings refers to the quality of accounting methods to record profit
- Look to cash flows because it is the hardest to manipulate
Making and Changing Accounting Standards:
- Financial statement users are interested in 3 main things: 1. Profit or loss performance 2. Financial condition particularly the solvency 3. Capitalization structure or ownership structure
- Recording stock options can cause many problems. It is a big debate whether or not to record them
Cost of Goods Sold Conundrum:
- 3 methods: 1. Average cost method 2. LIFO method 3. FIFO method
- The 3 methods affect inventory and most importantly gross margins
- Accelerated deductions have higher depreciation and therefore lower taxes in the early years
- Accelerated depreciation coupled with shorter depreciation schedules than actual useful life encourages capital investment
- Accelerated or straight line method
- Chart comparisons on page 165
- Only straight line is used for Amortization
Ratios for Creditors and Investors:
- Current ratio is used to test short term liability paying ability of a business
- Current ratio = total current assets/total current liabilities
- Should be 2 to 1 or higher
- The acid test ratio or quick ratio only includes cash and liquid assets
- Quick ratio = cash +accounts receivable/total current liabilities
- Should be 1 to 1 or higher
- Debt to equity ratio measures how prudently they are using their debt
- Debt to equity = liabilities/stockholder equity
- Most below a 1 to 1 ratio
- Times interest earned ratio is the ability to pay interest from earnings
- Times interest earned ratio = operating earnings/interest expense
- Should be higher than a 1 to 1
- Return on sales ratio = net income/sales revenue
- Profit divided by capital invested is ROI
- Net income by owners equity is ROE
- Operating earnings by assets is ROA
- Net income for common stockholders/Total number of outstanding shares = EPS
- Earnings yield and market cap
- Earnings yield is reciprocal of P/E ratio is a E/P = EPS/Price
- Market value X outstanding shares = market capitalization
A Look Inside Management Accounting:
- Internal accounting or managerial accounting is wide open without many rules
- Helps to determine variables and ways to reach goals
A Few Parting Comments:
- Are financial statements reliable and trustworthy? Yes most are.
- Are some misleading and fraudulent? Yes unfortunately.
- Is it worth your time to read statements and compute ratios? Doubtful. Market prices reflect all publicly available information.
- Why read them then? To know what you are getting into.
- Is there any quick litmus test? Yes. Percent increase/decrease in sales revenue and test that vs. bottom line profit.
- Do conservative accounting methods cause conservative market values? No not necessarily
- Do financial statements report the truth the whole truth and nothing but the truth? With regards to profit yes. Disclosure…..no.
- Does a financial report explain the basic profit making strategy? Not really.
- Do financial statements report the value of the business? No it doesn’t report what it should be on the auction block.
- Should financial statements be taken at face value when buying a business? No a lot more goes into it.