Financial Literacy

Richard A. Lambert

• Publisher: Wharton Digital Press
• Year: 2016
• ISBN:
  9781613630174

Chapter 1: Your Company’s Financial Health and Performance: What Financial Statements Can Tell You

In this chapter:

• The 3 fundamental financial statements
  
• How the 3 financial statements relate
  

When Krispy Kreme went public in 2000, it was hard to resist its sugary doughnuts or its stock. America is well known for having a sweet tooth, and investors figured consumers would keep buying those sugary sweets the way they kept digesting Big Macs. By the summer of 2003, the stock had skyrocketed to $50, more than double its initial offering price. By the end of 2003, Krispy Kreme had opened 357 outlets, including some stores overseas. Revenues rose from $300 million in 2000 to $649 million in 2003. But by the summer of 2004, a slew of low-carbohydrate diets were in vogue that made doughnuts a no-no. America’s tastes had changed, and those doughnuts and its stock began to turn stale.

Krispy Kreme’s aggressive expansion was funded in part by sharply increasing their debt load; long-term debt rose from a modest $3.5 million at the end of 2000 to $56 million in 2002 to $137 million in 2003. Accordingly, interest costs rose sharply. As revenues started to drop, profits declined even more sharply. By 2005, the stock had slid to $6, and the company started closing stores. Revenues in 2010 were only $362 million, compared to $649 million in its heyday in 2003. However, their stock price bounced back slightly in 2011.

Understanding Krispy Kreme’s opportunities and risks as it grew demanded reading and understanding its income statement, cash flow statement, and balance sheet. In this chapter, we’ll discuss the importance of each of those financial statements and cover the following topics:

• How the balance sheet represents a snapshot of the company’s resources (assets) at a fixed period of time and also provides information about the firm’s capital structure and its riskiness
  
• Income statements, which measure a company’s revenues, expenses, and profitability
  
• Cash flow statements, which provide information about liquidity and the sources and uses of cash, the lifeblood of the company
  
• How income statements and cash flow statements differ
  

The 3 Fundamental Financial Statements

The financial statements—the balance sheet, income statement, and cash flow statement—are an important means by which timely information is provided to managers as well as to investors, creditors, and other users of financial statements. Each statement furnishes a different type of information. Each is useful in its own right; however, understanding how the three are linked is vital to assessing a company’s strengths and weaknesses. Together they provide a fuller picture of a company’s current financial status and offer a glimpse into its future. In this chapter, we will describe what each statement does and how they are interrelated. An example of a set of financial statements is contained in chapter 2.

What distinguishes the three statements? The balance sheet lists the resources (assets) the firm has acquired and still retains, as well as the nature of the claims on these assets (liabilities and owners' equity). The balance sheet is analogous to a snapshot; it represents the financial position of the firm at a specific point in time (for example, at the end of the quarter or year). Income statements report the profitability of the firm during the period. Cash flow statements provide information about the inflows and outflows of cash during the period. These latter two statements therefore help provide information about how and why the firm's financial status has changed since the end of the prior period. Profitability (value generated) and liquidity (cash generated) are not the same thing, however, which is why we have two different statements.

Balance Sheet

The phrase “balance sheet” comes from a relation that financial statements must always preserve:

Assets = Liabilities + Owners’ Equity

This equation simply states that the assets or resources of the firm have to be claimed by someone. If it is not someone else (the liability holders or creditors), then it is the owners. A simple example from personal finance illustrates: if you have a house that’s worth $500,000 and have a mortgage with a balance of $300,000, your owners’ equity in the house is the difference, $200,000. Although the concept might look simple, we will see that this relationship has important implications for understanding how to interpret financial statements and also for understanding how balance sheets and income statements are related. The fact that balance sheets always balance to the penny is one of the factors that contributes to the illusion of exactness in accounting. A balance sheet that balances does not mean there are no errors, and it does not mean that everything is valued correctly. If we misvalued our house at, say, $700,000, we would similarly mismeasure the value of our equity at $400,000. Everything still balances, but the economic picture presented is distorted relative to reality.

Assets

A company’s balance sheet starts with its assets. Assets are the keys to sustaining the company. Assets represent the resources a company has available to use to generate profits or provide other future economic benefits, such as the ability to pay back debt. Assets include the following types of resources:

• Financial assets: cash, notes and accounts receivable, marketable securities, derivative instruments
  
• Physical assets: inventories, plant and equipment, real estate
  
• Intangible assets: patents and copyrights, other contractual rights, goodwill
  

Assets are grouped on the balance sheet into two categories, current and noncurrent. Current assets are those expected to generate their benefits within one year; examples include cash, accounts receivable, inventories, and many types of marketable securities. Noncurrent assets are expected to take longer than a year and include property plant and equipment, long-term investments, and most intangibles.

Valuing Assets

All of the assets, liabilities, and owners' equity accounts are expressed in dollars. How do we place a value on them? Accountants have traditionally used historical cost for most assets. The historical cost is the amount that was paid for the asset when it was acquired. The virtue of historical cost accounting is that the numbers are objective and reliably measured. Unfortunately, historical costs can become out-of-date and lose their relevance over time.

To address this problem, an alternative basis for valuing assets termed “fair value” was developed. If you have heard the phrase "mark to market," this is what fair value tries to do—to estimate what the current market value of the asset is. Unfortunately, this is often not easy to do with any precision, which leads to questions about the reliability of these values. The virtue of fair-value accounting is that values are more up-to-date, so they are, in principle, more relevant to decision making. The "relevance versus reliability" debate regarding which valuation method is better has gone on for many decades, and it will continue far into the future. When an asset is newly acquired, its historical cost and market value are usually the same thing. It is only after the asset is acquired that the two values diverge.

For financial assets, obtaining reliable values is often easier to do because there are actively traded markets for many of them (e.g., the stock market and bond market).² Financial assets (and an increasing number of financial liabilities) are therefore shown on the balance sheet at their fair value. But for many physical assets (especially property plant and equipment) and intangible assets, assets are so unique and markets so inactive that market values are deemed too unreliable to use. Accountants use historical costs (sometimes adjusted downward to reflect depreciation) for them.

When accountants provide inaccurate values, this can cause users of the financial statements to make poor decisions regarding what to do with the assets. Although both overvaluation errors and undervaluation errors have consequences, a long-held view in accounting (and by the courts) is that overvaluation is the more serious problem. That is, if we tell you an asset is worth $100 and it turns out to be worth only $80, that is a more serious error than if we tell you it's worth $80 and it turns out to generate $100 of benefits. Because "bad surprises" have more serious consequences than "good surprises," accounting statements are influenced by a policy of conservatism. In particular, many nonfinancial assets are valued on the financial statements at neither their historical cost nor their current market value, but instead at the lower of the two. The "lower of cost or market" method recognizes declines in asset values (called impairments) but not increases in asset values.

To be recognized by accountants, the value of the asset must be measurable with a reasonable degree of precision. Because of this requirement, many assets that are important from an economic perspective but are considered difficult to value are often excluded. Brand names are a prime example. For example, Coca-Cola is considered to be one of the most valuable brands in the world, and certainly one of the most valuable assets that Coca-Cola possesses, yet it does not appear on their balance sheet.³ To make things even more confusing to new readers of financial statements, that same brand name would be recognized if it were obtained via a corporate acquisition. In this case, there is an objective, defined transaction that can be referred to as a means of establishing the value of a brand name. Brands and other types of intangible assets that have been developed internally lack such an objective valuation and therefore do not appear on the balance sheet.⁴

For all of these reasons, one has to be careful when looking at asset values on a balance sheet. When we sum up the asset values to calculate total assets, for example, we could be adding our cash in the bank to the price we paid for a building 20 years ago to the current market value of marketable securities we hold. It is not clear what, if anything, this sum means economically. It is certainly not the current value of the firm's assets. If you were to try to use this asset value in the calculation of a performance measure like return on assets (ROA), you would need to understand that your measure is distorted by the accounting valuation problems. Understanding what is included and excluded from financial statements and how things are valued are critical skills to effectively analyze them.

Liabilities

Liabilities are obligations of the firm to transfer assets or provide services to other entities in the future as a result of past transactions or events. These are claims by creditors against the assets of the firm. Liabilities include the following types of obligations:

• Obligations to transfer assets: notes and accounts payable, taxes payable, bonds payable
  
• Obligations to provide services: rents and royalties received in advance, warranty liabilities, frequent-flier miles
  

Like assets, liabilities are classified as current if they are due within a year and noncurrent if they are due more than a year from now. Short-term liabilities are simply valued at the amount to be repaid or the estimated cost of providing the service. However, if the time period until the obligation becomes due is long (more than a year), the present value of the cash payments to be made is used. We will discuss present-v...

Table of contents

• Cover
• Title Page
• Copyright
• Contents
• Introduction
• Chapter 1: Your Company’s Financial Health: What Financial Statements Can Tell You
• Chapter 2: Impacting the Scorecard: How and When Actions and Events Affect the Numbers
• Chapter 3: Using the Income Statement: Revenues, Expenses, and Profits
• Chapter 4: Utilizing and Financing Your Assets: ROA, ROE, and Leverage
• Chapter 5: Using Cost Information: Know How Your Costs Behave
• Chapter 6: Evaluating Investment Opportunities: Discounted Cash Flow Analysis
• Conclusion
• Acknowledgments
• Appendix: More on the Cash Flow Statement: The Indirect Method
• Endnotes
• Index
• About the Author