Financial Statement Analysis, Course No.

Course No. 2. UNDERSTADING FINANCIAL STATEMENTS

2.1. The Business System
As we know, theres a dynamic interrelationship among decisions made by managers.
Decisions cause resource movements in various forms that ultimately change the cash flow pattern
of the business as a whole. The process might involve some intermediate steps before cash
movements occur, but increases or decreases in cash will invariably follow any decision made. We
observed that in a successful business, the balancing of cash uses and sources over time generates
positive cash flow patterns that lead to the desired buildup of economic value and long-term
viability. In fact, creation of shareholder value and cash flow patternsachieved and expectedare
inseparable concepts.
As we take up the analytical concepts and tools, well relate them, as appropriate, to the
simple principle that cash in versus cash out is the key to any economic analysis. Later well
discuss the formal ways of tracking and analyzing overall resource flow patterns and their cash
impact.
Lets now develop a practical, simplified view of how a typical business operates. With the
help of an intuitive systems diagram well demonstrate the basic cash flow patterns, the key
relationships, and the key decisions involved in an integrated fashion. Then well show how the
major financial/economic analysis measures and key business strategies relate to this business
system. Every one of the measures and concepts will, of course, be discussed in greater depth later
on, but this overview provides a structure for keeping the individual elements in proper perspective.
Figure 2.1 presents the basic flow chart of the business system, which contains all major
elements necessary to understand the broad cash flow patterns of any business. The arrangement of
boxes, lines, and arrows is designed to show that were dealing with a system in which all parts are
interrelated to each other and which therefore has to be managed as a whole. The solid lines with
arrows represent cash flows, while the dashed lines symbolize trade-off relationships. The system is
organized into three segments that match the three major decision areas weve defined: investment,
operations, and financing.
The top segment represents the three components of business investment: the
investment base already in place, the addition of new investments, and any
disinvestment (divestment) of resources no longer deemed effective or strategically
necessary. In addition, it shows the depreciation effect caused by accounting write-offs
of portions of depreciable assets against the investment base and against profits. This
box, which effectively enhances the funding potential shown in the bottom segment,
represents available cash that was masked when the accounting-based operating profit
after taxes was calculated, as well discuss in Chapter 3.
The center segment represents the operational interplay of three basic elements: price,
volume, and costs of products and/or services. It also recognizes that usually costs are
partly fixed and partly variable relative to volume changes. The ultimate result of the
complex set of continuously made trade-offs in the operations area is the periodic
operating profit or loss, after applicable income taxes. Operating profit is shown as
part of the bottom segment in the diagram, because profit represents one of the key
elements of financing the business.
The bottom segment represents, in two parts, the basic financing choices open to a
business:
1. The normal disposition of the operating profit after taxes (or loss after taxes) that
has been achieved for a period:
This is a three-way split among dividends paid to owners, interest paid to
lenders (adjusted for taxes because of its tax deductibility), and earnings retained for
-1-

Financial Statement Analysis, Course No. 2

reinvestment in the business. As the arrows indicate, the cash used for paying
dividends and interest leaves the system.
Figure 2.1. The business system: an overview
Investment
New
investment
Disinvestment

Depreciation
effect
Investment
base

Operations

Price

Volume

Costs (fixed
&variable)

Financing
Dividends

Operating profit
after taxes

Interest
(tax-adjusted)

Retained
earnings

Shareholders
equity

Long-term
debt

Funding
potential

-2-

Financial Statement Analysis, Course No. 2

2. The available choices for using long-term capital sources:

This reflects shareholders equity (ownership), augmented by retained
earnings, and long-term debt held by outsiders. Trade-offs and decisions that affect
the levels of shareholders equity, retained profits, or long-term capital sources
impact the companys funding potential, which, as the arrow moving from the left to
the top indicates, affects the amount of new investment that can be added to the
investment base. As was already mentioned, the depreciation effect shown in the top
segment enhances the funding potential, because it reflects cash that was masked in
the accounting profit calculation. Alternatively, of course, some of the enhanced
funding potential can be used to reduce long-term debt, or to repurchase outstanding
ownership shares in the market. These actions will, of course, change the capital
structure proportions and cause cash to leave the system.

2.2. The Nature of Financial Statements

To apply the insights gained from the conceptual overview of the business system, we must
now look for available information that will:

Allow the manager or analyst to track the financial condition and operating results of
the business.

Assist in understanding the cash flow patterns in more specific terms.
In the process of financial/economic analysis, a variety of formal or informal data are
normally reviewed and tested for their relevance to the specific purpose of the analysis. The most
common form in which basic financial information is available publicly, unless a company is
privately held, is the set of financial statements issued under guidelines of national and/or
international financial reporting regulations, usually contains balance sheets as of given dates,
income statements for given periods, and cash flow statements for the same periods. A special
statement highlighting changes in owners equity on the balance sheet is commonly provided as
well.
Since financial statements are the source for a good portion of analytical efforts, we must first
understand their nature, coverage, and limitations before we can use the data and observations
derived from these statements for our analytical judgments. Financial statements reflect the
cumulative effects of all of managements past decisions. However, they involve considerable
ambiguity. Financial statements are governed by rules that attempt to consistently and fairly account
for every business transaction using the following conservative principles:

Transactions are recorded at values prevailing at the time.

Adjustments to recorded values are made only if values decline.

Revenues and costs are recognized when committed to, not when cash actually
changes hands.

Periodic matching of revenues and costs is achieved via accruals, deferrals, and
accounting allocations.

Allowances for negative contingencies are required in the form of estimates that
reduce both profits and recorded value, usually affecting shareholders equity or
special set-asides.
These rules leave reported financial accounting results open to considerable interpretation,
especially if the analyst seeks to understand a companys economic performance and to establish
the basis for shareholder value results. Its common practice among professional analysts to adjust
the data reflected on financial statements for known accounting transactions which do not affect
cash flows, and to make assumptions about the economic values underlying recorded asset values.

-3-

Financial Statement Analysis, Course No. 2

2.2.1. The Balance Sheet
The balance sheet, prepared as of a specific date, records the categories and amounts of assets
employed by the business (i.e., the resources committed) and the offsetting liabilities incurred to
lenders and owners (i.e., the funds obtained). Also called the statement of financial condition or
statement of financial position, it must always balance. By definition, the recorded value of the total
assets invested in the business at any point in time must be matched precisely by the recorded
liabilities and owners equity supporting these assets. Liabilities are specific obligations that
represent claims against the assets of the business, ranking ahead of the owners in repayment
priority. In contrast, the recorded shareholders equity in effect represents a residual claim of the
owners on the remaining assets after all liabilities have been subtracted.
The major categories of assets, or resources committed, are:

Current assets (items that turn over in the normal course of business within a relatively
short period of time, such as cash, marketable securities, accounts receivable, and
inventories).

Fixed assets (such as land, mineral resources, buildings, equipment, machinery, and
vehicles), all of which are used over a longer time frame.

Other assets, such as deposits, patents, and various intangibles, including goodwill that
arose from an acquisition.
Major sources of the funds obtained are:

Current liabilities, which are obligations to vendors, tax authorities, employees, and
lenders due within one year or less.

Long-term liabilities, which are a variety of debt instruments repayable beyond one
year, such as bonds, loans, and mortgages.

Owners (shareholders) equity, which represents the recorded net amount of funds
contributed by various classes of owners of the business as well as the accumulated
earnings retained in the business after payment of dividends.
Balance sheets are static in that, like snapshots, they reflect conditions on the date of their
preparation. Theyre also cumulative because they represent the effects of all decisions and
transactions that have taken place since the inception of the business and have been accounted for
up to the date of preparation.
As we indicated earlier, financial accounting rules require that all transactions be recorded at
costs and values as incurred at the time, and retroactive adjustments to recorded values are made
only under very limited circumstances. As a consequence, balance sheets (being cumulative)
display assets and liabilities acquired or incurred at different times. Because the current economic
value of assets can change, particularly in the case of longer-lived items (such as buildings and
machinery) or basic resources (such as land and minerals), the costs stated on the balance sheet are
not likely to reflect true economic values. Moreover, changes in the value of the currency in which
the transactions are recorded can, over time, distort the balance sheet.
Ultimately, the recorded book value of owners equity is affected by all of these value
differentials. There generally is quite a divergence between this residual accounting value and the
current economic value of the business as reflected in share prices or in valuations for acquisition.
In fact, the shares of successful companies are usually traded at price levels far above their recorded
book value.
Finally, a number of relatively recent accounting rules require the estimation and recording of
contingent liabilities arising from a variety of future obligations, such as pension and health-care
costs, further introducing a series of value judgments. These are frequently shown as other
liabilities, listed just ahead of shareholders equity, and, in effect, amount to a reclassification from
being part of the owners residual claims, to a special form of long-term liability.
The accounting professions FASB is expending a great deal of effort to resolve these and
other issues affecting the meaning of the balance sheet, but only with partial success. Accounting
standards continue to evolve, and a manager or analyst must be aware of the underlying issues and
-4-

Financial Statement Analysis, Course No. 2

processes when reviewing and analyzing this statement. Well discuss the most important of these
more specifically as we examine analytical techniques in later chapters.
In our decisional context of investment, operations, and financing, the balance sheet is a
cumulative listing of the impact of past investment and financing decisions, and of the net
operational results from using these resources. Its a historical record of all transactions that
affected the current business over time. The net effect of operations in the form of periodic profit or
loss is reflected in the changing shareholders equity account. Figure 2.2 is a simple conceptual
picture of the balance sheet as it relates to the three areas of management decisions.
Only the major categories normally found on the balance sheet are listed in Figure 2.2, which
is an oversimplification. In actual practice, the analyst encounters a large variety of detailed asset,
liability, and net worth accounts because balance sheets reflect the unique nature of a given
company and the business sector to which it belongs. But the actual accounts always can be
grouped into the basic categories listed.
Figure 2.2. Balance sheet in decisional context

To provide an example of the balance sheet of a major corporation, Table 2.1 shows the
consolidated balance sheets for December 31, 2007, and December 31, 2006, of TRW Inc., as
published in its 2007 annual report, but presented here without accompanying notes. TRW Inc. is a
global manufacturing and service company headquartered in Cleveland, Ohio. Its strategically
focused on providing products and services with a high technology or engineering content to the
automotive, space and defense, and information systems markets. TRW holds leading positions in
most of its market segments. Founded in 1901, the company employs about 72,500 people in 24
countries, and was ranked 146th in sales in the Fortune 500 listing for 1997.

-5-

Financial Statement Analysis, Course No. 2

TABLE 2.1. TRW INC. AND SUBSIDIARIES
Consolidated Balance Sheets
December 31, 2007 and 2006 ($ millions)
Source: Adapted from 2007 TRW Inc. annual report.
Assets
Current assets:
Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Property, plant, and equipment at cost . . . . . . . . . . . . . . . .
Less: Allowances for depreciation and amortization . . . .
Total property, plant, and equipmentnet . . . . . . . . . .
Intangible assets:
Intangibles arising from acquisitions . . . . . . . . . . . . . . . .
Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . .
Less: Accumulated amortization . . . . . . . . . . . . . . . . . . . . .
Total intangible assetsnet . . . . . . . . . . . . . . . . . . . . .
Investments in affiliated companies . . . . . . . . . . . . . . . . . .
Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Liabilities and Shareholders Investment
Current liabilities:
Short-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accrued compensation . . . . . . . . . . . . . . . . . . . . . . . . . .
Trade accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . .
Other accruals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Dividends payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Current portion of long-term debt . . . . . . . . . . . . . . . . . . .
Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . .
Long-term liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Minority interests in subsidiaries . . . . . . . . . . . . . . . . . . . . .
Shareholders investment:
Serial preference stock II . . . . . . . . . . . . . . . . . . . . . . . . .
Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cumulative translation adjustments . . . . . . . . . . . . . . . . .
Treasury sharescost in excess of par value . . . . . . . . .
Total shareholders investment . . . . . . . . . . . . . . . . . . .
Total liabilities and shareholders investment . . . . . . . . . . .

2007

2006

$ 70
1,617
573
79
96
2,435
6,074
3,453
2,621

$ 386
1,378
524
69
424
2,781
5,880
3,400
2,480

673
232
905
94
811
139
404
$ 6,410

258
31
289
78
211
51
376
$ 5,899

$ 411
338
859
846
38
99
128
2,719
788
1,117
57
105

$ 52
386
781
775
39
52
72
2,157
767
458
272
56

1
78
462
1,776
(130)
(563)
1,624
$ 6,410

1
80
437
1,978
47
(354)
2,189
$ 5,899

2.2.2. The Income Statement

The income statement reflects the effect of managements operating decisions on business
performance and the resulting accounting profit or loss for the owners of the business over a
specified period of time. The profit or loss calculated in the statement increases or decreases
owners equity on the balance sheet. Thus, the income statement is a necessary adjunct to the
balance sheet in explaining this major component of change in owners equity, and it provides a
variety of performance assessment information. The income statement, also referred to as the
operating statement, earnings statement, or profit and loss statement, displays the revenues
recognized for a specific period, and the costs and expenses charged against these revenues,
-6-

Financial Statement Analysis, Course No. 2

including write-offs (e.g., depreciation and amortization of various assets) and taxes. Revenues and
costs involve elements such as:

Sales for cash or credit.

Purchases of goods for resale or manufacture, or cost of services provided.

General and administrative expenses.

Sales and marketing expenses.

Research and development costs.
The income statement represents the best effort of the firms accountants to match the
relevant items of revenue with the relevant items of cost and expense for the period, a process
which involves accrual accounting and extensive use of allocation of prior and future revenues and
costs.
Among the judgmental areas involving costs are:

Recognizing the incidence of revenues received in advance or delayed in time.

Depreciation of assets being used over more periods than the current reporting period.

Cost of goods purchased or manufactured in previous periods.

Proper allocation of general expenses to a specific period.
Well take up the more critical of these elements and choices as we apply the analysis
techniques in later chapters.
When viewed in our decisional context, the income statement in the center column of Figure
2.3 expands the details of the transactions and allocations that make up one of the key performance
elements, profit or loss.
Figure 2.3. Income statement in decisional context

Again, we are providing an actual example of an income statement in Table 2.2, the
consolidated statement of earnings for TRW Inc. for the years ending December 31, 2007, and
December 31, 2006.

-7-

Financial Statement Analysis, Course No. 2

TABLE 2.1. TRW INC. AND SUBSIDIARIES
Statements of Earnings
for the Years Ended December 31, 2007 and 2006 ($ millions)
Source: Adapted from 1997 TRW Inc. annual report.

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Administrative and selling expenses . . . . . . . . . . . . . . . . .
Research and development expenses . . . . . . . . . . . . . . . .
Purchased in-process research and development . . . . . . .
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other expenses (income) net . . . . . . . . . . . . . . . . . . . . . . .
Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Earnings (loss) from continuing operations before taxes
Excluding purchased R&D; special charges (06) . . . . . .
Reported earnings (loss) before income taxes . . . . . . . .
Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Earnings (loss) from continuing operations
Excluding purchased R&D; special charges (06) . . . . . .
Reported earnings (loss) after income taxes . . . . . . . . . .
Discontinued operations, gain on disposition, after taxes .
Net earnings (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Preference dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Earnings (loss) applicable to common stock . . . . . . . . . . .
Per share of common stock:
Average number of shares outstanding (millions)
Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Diluted net earnings (loss) per share
From continuing operations
Excluding purchased R&D; special charges . . . . . . . . .
Reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
From discontinued operations . . . . . . . . . . . . . . . . . . . . .
Diluted net earnings (loss) per share . . . . . . . . . . . . . . . . .
Basic net earnings (loss) per share
From continuing operations
Excluding purchased R&D; special charges . . . . . . . . .
Reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
From discontinued operations . . . . . . . . . . . . . . . . . . . . .
Basic net earnings (loss) per share . . . . . . . . . . . . . . . . . .
Book value per share (year-end) . . . . . . . . . . . . . . . . . . . .
Tangible book value per share (year-end) . . . . . . . . . . . . .
Other data ($ millions):
Depreciation of property, plant, and equipment . . . . . . . . .
Amortization of intangibles, other assets . . . . . . . . . . . . . .
Capital expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

-8-

2007
$10,831
8,826
2,005
461
684
548
75
(3)
1,765

2006
$ 9,857
8,376
1,481
412
613
84
70
1,179

788
240
289

687
302
120

499
(49)
$ (49)
$ (49)

434
182
298
$ 480
1
$ 479

123.7
123.7

132.8
128.7

$ 4.03
(0.40)
$ (0.40)

$ 3.27
1.37
2.25
$ 3.62

$ 4.03
(0.40)
$ (0.40)
13.19
6.58

$ 3.29
1.41
2.31
$ 3.72
17.29
15.62

$ 480
10
549
154

$ 442
10
500
148