Chapter Nine

Basic reporting and accounting

            Under current laws and regulations governing the stock market industry, any public company must report periodically a complete set of financial statements including:

1. An income statement

2. A balance sheet

3. A cash flow statement

4. A statement of changes in equity, and

5. Notes comprising a summary of significant accounting policies and other explanatory notes.

            In the United States, such information can be found in the first three financial statements filed quarterly in the form of 10Q, or annually in the form of 10K, and also in the annual report to shareholders.

            Among the five statements above, the three first statements which are the income statement, the balance sheet statement and the cash flow statement are the most important and will be explained in details in this chapter.

            Understanding financial statements is crucial for any investor who would like to know how the company is doing, businesswise.

Income statement

            The income statement presents information regarding financial results of a company’s business activities over a period, either quarterly (10Q) or annually (10K). The basic equation of the income statement is:

Revenue – Expenses =  Income

            The formula looks very simple. Unfortunately accruing accounting is not that easy. Revenue means the amount of money that the company takes in during the reporting period. For manufacturers and retailers, this is the amount of sales that the companies were able to report. The question is what can be reported as revenue? There are some amounts that the company takes in but doesn't deliver the goods yet called un-earned revenue. On the other hand, there are also certain orders that the company already delivered the products but didn't cash in the money yet.

            Expenses are rather complicated too. Some expenses are related to the business (operating expenses) thus directly reflect the true nature and status of the business. But some are not directly related and may be discretionary (for example R&D expenses). Also, even though a company may report a significant loss but if the expenses are reported as extraordinary (or one-time) charge such as severance expenses associated with workforce reduction or asset write-down, those charges may be excluded when evaluating a company's continued earnings potential.

            However, an ordinary investor doesn't need to comprehend fully all aspects of an income statement but should at least be familiar with the most basic concepts of an income statement.

            Let’s take a look at a breakdown of the income statement of Dell Inc.

during full year 2008:

1. First step

            The first step is to deduct any expenses directly related to goods sold in order to have the gross income. These expenses comprise direct labor costs and depreciation of equipments.

            Gross income helps to calculated the gross profit margin which is one of the most important factors when researching about a company or an industry. As a norm, gross profit margin for technology companies or startup companies are pretty high while mature or established companies (such as airliners, banks...) are lower because of competition.

            In this case, gross profit margin can be computed as follows:

            Gross Profit Margin = (Sales - COGS - Depreciation)/Sales

            61.1 - 49.9 - 0.769 / 61.1 = 17%

2. Second step

            The second step is to deduct expenses indirectly linked to goods sold, such as but not limited to advertising, staff’s salaries, office rental, transportation, etc… in order to get the operating income.

            Operating Income starts to define the "true" earnings potential of a company. Usually after this step if the company has a decent operating income, it can claim to be profitable. To squeeze out some more operating income, the company can try to cut down some extravagant administrative expenses without affecting the business.

3. Third step

            The third step is to deduct or to add any extraordinary (one-time) charges, and any other income or expenses not related to normal business activities in order to have the Earnings Before Interest & Taxes (EBIT) figure.

            EBIT can be lower or higher than Operating Income. In case it is lower because of excessive one-time charge, an investor should investigate is the charge truly "extraordinary" and not likely to repeat? On the other hand, if it is higher due to other profitable investments in other companies, investor should question the nature of the added other income. Will it be likely to repeat in the future? After all, a company is supposed to mind on its own business and not to venture into other companies.

4. Fourth step

            The fourth step is to deduct interest expenses on actual long-term debts, as well interest capitalized that is not expensed but treated as an asset and amortized over time.

            This step is pretty straight-forward. The Pretax Income is calculated after deducting long-term debts interest expenses and any other expenses related to interest.

5. Fifth step

            The fifth step is to deduct Income Taxes. Some businesses have carried-over losses thus lower taxes which lead to higher income. They should be taken account when researching those companies.

6. Six and last step

            The last step is to take account of any extra items & gain or loss of sale of assets. Preferred dividends requirement is also deducted at this step. The bottom line is NET INCOME.

            The whole income statement should look like as follows:

            A detailed income statement would include calculations of Earnings Per Share (EPS), i.g., to divide net income to shares outstanding. In this case, Dell Inc. has Basic Weighted Average Shares of 1,980 millions at the end of Q2/2009. EPS then can be computed as $2.48 B / 1.980 B shares = $1.25 per share. A fully diluted EPS takes account of convertibles preferred shares, warrants, stock options which can be converted into common shares.

Balance Sheet Statement

            A balance sheet statement discloses what a company owns (Assets) and what it owes (Liabilities) at a specific point of time; thus can be considered as a statement of the company’s financial position. The general idea is a statement of:

            ASSETS = LIABILITIES + EQUITY or ASSETS – LIABILITIES = EQUITY

            Equity can be viewed as a residual or balancing amount after subtracting liabilities from assets and which is the remaining company’s value left for shareholders.

            Let’s take a look at the balance sheet statement of Dell Inc. at the end of 2008

            The first part of the balance sheet is to record Current Assets, which are cash and cash equivalent resources that the company can expect to have readily in hands in a short term (within a year time period) to conduct business.

            Long term assets such as long term receivables, other investments, tangible and intangible assets are added into Assets to come to the TOTAL ASSETS number.

            Current liabilities are expenses that the company must pay in a short term (within a year) no matter what. The company’s solvency or ability to do so, depends deeply on its current assets, which are resources that it can collect in a short term to meet its obligations.

            A measure to assess solvency is to compute the current ratio by dividing current assets to current liabilities. A positive number higher than one indicates a relatively good short term financial standing of the company. In this case, Dell Inc. has a current ratio of 20.15 / 14.86 = 1.36.

            However, because inventories can be hard to be converted into liquidity in a short term, a more stringent measure to gauge a company’s ability to meet its short term obligations is to eliminate inventories’ value from current assets before dividing to current liabilities. The measure is called quick ratio or acid-test ratio:

Quick ratio = (Current Assets – Inventories) / Current Liabilities

            In this case, Dell Inc. has a quick ratio of (20.15 – 0.867) / 14.86 = 1.30

            At this step, other long term liabilities are inserted to come up with TOTAL LIABILITIES.

            Shareholders’ Equity is calculated by subtracting Total Liabilities from Total Assets. At the end of 2008, Dell Inc. has a Shareholders’ Equity of:

25.93 B – 21.66 B = 4.27 B

            Dividing shareholders’ equity by the number of shares outstanding can give the book value per share of a stock. In this case, Dell Inc. stock has a book value of $2.20 per share.

            The complete balance sheet of Dell Inc. at the end of 2008 should look like:

Cash Flow Statement

            The cash flow statement provides information about cash inflows and outflows of a company, as well the opening and ending cash balance during an accounting period. Cash flow statement is prepared according a cash-based format, in contrast with the accrued-based of the income statement. What it means is that cash flow is recorded whenever the company receives or pays cash out of its coffers. On the other hand, income statement may record “un-earned” revenues, which are registered but not yet collected as cash.

            Cash flow is of crucial importance for a business because it reflects the ability of a company to turn around its working capital and to meet its short term obligations. Using an extreme example, a company may be able to sell completely its products, but on credit. Thus, its income statement may reflect a profitable business but in reality, the company doesn’t receive any cash yet and may run out very soon of working capital. If no financing resources available to meet short term liabilities, the company may face financial crisis and go bankrupt in no time.

            Cash flows are categorized under three categories: (1) Operating activities, (2) Investing activities, and (3) Financing activities.

1. Operating activities include the company day-to-day activities that create cash inflows, such as selling products and services. They comprise also of cash outflows resulting from cash payments for inventory, salaries, taxes and all activities related to its business operations.

2. Investing activities are related to purchasing or selling investments, including property, plant, equipment, intangible assets, long term assets, and both long term and short term investments in bonds and loans issued by other companies.

3. Financing activities include obtaining or repaying capital, such as equity and long term debts. Shareholders and creditors are the two main sources of financing, therefore cash receipts from selling common stocks (equity), from borrowing through bonds and loans (debt) belong to this category.

            Following is the cash flow statement of Dell Inc. for 2008:

Note: This cash flow statement has been simplified to better demonstrate the concepts

            The starting line is the net income reported on the income statement. In theory,  net income should reflect a surplus of cash into the company's coffers. However some expenses are reported but the company doesn't have to actually pay for them (for example depreciation, depletion & amortization). Also, the net income is never a "lump sum" that the company receives at the end of the reporting period but a turn around of working capital. Therefore, the company has to spend in order to generate that net income. This is reported as Funds for Operating Activities." Therefore, the Net Cash Flow of Operating Activities can be calculated as follows:

            2.48 + 0.769 + 536 - 1.93 = 1.86B

            This is a good number. Now let's see how the company managed this inflow of cash.

            On the Investing section,  we see that the company has spent some money to acquire other businesses and the most relevant investing expense is the purchase of investments (2.87B). This will add to the value of the stock. However, the company sold a significant amount of investments on other companies (2.33B). This may be because the company decided that those investments are not worthy anymore.

            Disposal of fixed assets means simply the sale of some unused or obsolete assets that the company no longer needs. The Net Cash Flow of Investing Activities can be computed as follows:

            2.33 + 0.044 - 2.87 - 0.176 = 0.672B

            Financing activities are related to long term debts and equity, therefore there are two main categories that we should consider: (1) creditors (banks, bondholders, preferred stockholders...) and (2) common shareholders. In this case, the most relevant expense is the retirement of stocks, meaning the company spent a considerable amount of cash to retire its own stocks (1.52 B). This is a way to maximize shareholders wealth. Some companies may choose to distribute dividends. In this case Dell chose to retire outstanding shares by buying them in the market, thus supporting the stock price.

            We note also that the company has borrowed more short and long term debts, although not significant (0.1 + 0.237B).

            In summary, we see that the company has used its net cash flow from operating activities (1.86B)  to fund its investing activities (-0.672B) and financing activities (-1.18B):

            1.86 - 0.672 - 1.18 = 0.008B

            We can conclude that the company has managed to use efficiently its cash flow during the reporting period.