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by Ben Best
(This essay presents a traditional view of financial statements. See also my essay Financial Statements in the "New Economy").
Financial statements are summaries of monetary data about an enterprise.
The most common financial statements include the balance sheet, the income
statement, the statement of changes of financial position and the statement
of retained earnings. These statements are used by management, labor,
investors, creditors and government regulatory agencies, primarily. Financial
statements may be drawn up for private individuals, non-profit organizations,
retailers, wholesalers, manufacturers and service industries. The nature of
the enterprise involved dramatically affects the kind of data available in
the financial statements. The purposes of the user dramatically affects the
data he or she will seek.
The balance sheet provides the user with data about available
resources as well as the claims to those resources. The income
statement provides the user with data about the profitability of the
enterprise detailing sources of revenue and the expenses which reduce profit.
The statement of changes of financial position shows the sources and
uses of a firm's financial resources, demonstrating trends in the alteration
of its capital structure. The statement of retained earnings reconciles
the owners' equity section of successive balance sheets, showing what has
happened to generated revenue.
Comparison of financial statements forms the basis for much financial
analysis. Four main types of comparison are made: (1) comparison of
statements for the enterprise between successive years (2) comparison of a
firm's statements with those of a specific competitor (3) comparison of a
firm against an industry standard and (4) comparison with a target, such
as a company's budget. Comparisons between different organizations may be
difficult or even meaningless because of differences in (1) size of the
organization (2) type of organization and (3) accounting methods
used by the organization. Often, both the size and type of organization will
dictate the kind of accounting methods used.
Non-profit organizations such as government and charities typically
present statements which exhibit their resources and the way those resources
are distributed or held. Stewardship and responsibility are the focus for
these statements. Financial statements for private individuals focus on
resources and obligations -- helping the person to assess his or her financial
condition and to plan financial affairs (or obtain a bank loan) [Rosenfield,
1981]. Retailers are typically highly mortgaged, rely on credit to wholesalers
(following a desire for a large and varied stock), often offer extensive
credit to customers (or no credit, on a strictly cash basis) and reside in
high-rent locations. Wholesalers tend to be characterized by large
inventories, large sales volume (with small profit margin) and chronic credit
problems with retailers. Manufacturers tend to have a substantial investment
in fixed assets (machinery, equipment and buildings) and often face major
problems due to a large work-force [Costales,1979]. Service industries
-- such as railroads, airlines and public utilities -- have less of a problem
with flow of inventory. Their focus tends to be on balancing operating revenue
against operating expenses dominated by fixed assets (depreciation, repairs,
replacement, maintenance, etc.). Companies with high proportions of current
assets tend to be financed through short-term borrowing and shareowner
investment. Industrial corporations tend to be financed primarily through
shareowners, whereas public utilities and railroads are more often financed
by long-term borrowing (bonds) [Holmes, et al,1970].
Careful financial statement analysis usually means the extraction of
meaningful ratios from the statements. These ratios have been classified as
measuring (1) liquidity (current ratio, acid-test ratio, etc.)
(2) activity
(receivables turnover, inventory turnover, etc.) (3) profitability
(profit margin on sales, rate of return on assets, earnings per share, etc.)
and (4) leverage (debt to total assets, times interest earned,
etc.) [Kiesco and Weygandt,1982]. Ratios are often used to assess
performance or as diagnostic tools to point up potential problem areas. Given
the extremely varied entities for which financial statements are made -- and
even the extreme variation between industries of an entity type -- the most
productive use of these ratios is probably made either against industry
standards or against ratios for previous years of the entity in question.
Current ratio (the ratio of current assets to current liabilities) was
perhaps the earliest ratio to gain widespread use as a measure of solvency.
On the theory that $2 in current assets could safely cover $1 of current
liabilities (with enough remaining to operate) a 2-to-1 value
became an inflexible standard. But inventories can vary greatly in their
liquidities. Oil, for example, can be rapidly liquidated, but inventories of
service parts
could take years to sell -- hardly "current assets". Also, small businesses
can often liquidate their inventories more rapidly than large ones, indicating
that current ratio may not be comparable for different size firms. Moreover,
the relative investment in inventory rose from 77% of working capital
to 83% of working capital between 1950 and 1962 for American corporations
[Miller,1966]. Just-In-Time (JIT) inventory control using computers has
dramatically decreased the amount of inventory held. Thus, indicators from
the past might not be useful for the future. A 1-to-1 "acid-test"
ratio which excluded inventory from current assets was a
suggested replacement for current ratio, but the liquidity of the receivables
portion of current assets is still open to question without information on
collectability. In a strike or a recession, the business might have to pay
its current liabilities by liquidating its current assets. Yet it is
questionable if this could be done without a loss in operating capacity --
especially serious in a recession. In the case of an airline, cash flows are
more a function of its current assets than of its non-current assets.
A five-year average (1960-1964) of current ratio stands at 4.56 for
hardware stores, 1.95 for grocery stores, 4.11 for cotton cloth mills and
1.70 for building construction contractors. Note the variation between types
of retailer and manufacturer. These industry standards are not unhealthy.
Another interesting ratio is fixed assets (depreciated book value) per
tangible net worth. Five year percentages for this ratio are 5.7% for
manufacturers of womens' coats, 80.1% for manufacturers of bakery goods,
59.9% for grocery stores and 10.2% for furniture stores. In
general, this ratio is best kept low for new businesses, which should rent
land and buildings until the future of the business is ensured. Experience
has shown that small businesses should attempt not to exceed 66% and large
businesses should avoid exceeding 75% [Foulke,1968].
Ratios are useful to indicate various symptoms. Usually those symptoms
require more detailed analysis. For example, ratio analysis may reveal an
increase in sales volume relative to inventory and receivables. But
inventories could have increased less rapidly than sales due to reduced cost
of goods, inability to replace inventory items, change in inventory policy or a
change in inventory valuation. Receivables could have increased less rapidly
than sales because of a more efficient collection policy, a larger proportion
of cash sales or a change in policy with regard to the extension of credit.
Sales volume could have increased due to plant expansion, an aggressive sales
campaign, price increase, price decrease or extension of sales territories.
Ratio changes lead managers to ask pointed questions.
Government officials are generally concerned that reporting and valuation regulations have been complied with -- and that taxable income is fairly represented. Labor leaders pay particular attention to sources of increased wages and the strength and adequacy of pension plans (which tend to be chronically underfunded). Owners, shareholders and potential investors tend to be most interested in profitability. Many investors look for a high payout ratio (cash dividend/net income). Speculators pay more attention to stock value insofar as growth companies tend to have a low payout ratio because they reinvest their earnings. Bondholders are inclined to look for indicators of long-run solvency. Short-term creditors, such as bankers, pay special attention to cash flow and short-term liquidity indicators, such as current ratio. Both classes of creditors prefer lending to firms with low (usually no higher than 40-50%) leverage ratios, such as debt to total assets.
As indicated earlier, management can use financial statements for
diagnostic purposes -- with different managers paying attention to different
ratios. A buyer may look closely at inventory turnover. Too much inventory
may mean excessive storage space and spoilage, whereas too little inventory
could mean loss of sales and customers due to stock shortages. A credit
manager may be more interested in the accounts receivable turnover to assess
the correctness of her credit policies. A high sales-to-fixed-assets ratio
reflects efficient use of money invested in plant and in other productive or
capital assets. Higher levels of management, as with investors, tend to look
at overall profitability ratios as the standards by which their
performance is judged [Tamari,1978].
Much of the incomparability of financial statements between businesses
can be traced to different accounting methods. The most striking differences
occur in (1) inventory valuation (FIFO, weighted average, etc.)
(2) depreciation (straight-line, sum-of-the-years'-digits, etc.)
(3) capitalization versus expense of certain costs, eg. leases and
developmentof natural resources (4) investments in common stock
carried at cost, equity, and sometimes market (5) definition of
discontinued operations and extraordinary items [Kieso and Weygandt,1982].
Superior Oil Company owned 1.4% of Texaco, Inc. which was carried at a cost of $64 million, despite its market value of $118 million. A major brewery using LIFO inventory valuation revealed that the average cost method would increase inventory value by $33 million [Kiesco and Weygandt,1982]. High interest rates and a drop in oil prices caused Texaco, Inc. to reduce its LIFO-valued inventories by 16%, netting $454 million. A loss year was thereby turned into a profit year. General Motors doubled its net earnings in 1981 by changing its "assumed rate of return" on its pension plan from 6% to 7% [Bernstein,1982]. With its many old and historical-cost undervalued plants and buildings, Ford Motor Company showed historical cost earnings of $9.75 per share in 1979, despite a current cost income of $1.78 [Greene,1980].
Patents may represent unrecorded assets insofar as their true earning
value far exceeds their costs. Goodwill is another asset with a true value
which is hard to assess.
If these methodological variations are not enough to make the would-be
investor wary, he or she should be aware that those who prepare financial
statements often have an intention to misinform rather than to inform.
Reduction in discretionary costs (research, adverstising, maintenance,
training, etc.) can
increase net income while having a detrimental effect on future earnings
potential. A new management may similarly write-down the value of assets to
reduce depreciation and amortization expenses for future years. A businessman
may avoid replenishing inventory during the period prior to closing the books
so as to increase his current ratio. Temporary payment of a current debt just
prior to the financial statement date will achieve the same result. Retained
earnings can be appropriated for future inventory price decline and later
reported as net profit. Often an analysis of a series of annual statements,
rather than those of a single year, will highlight such methods. More extreme
practices are generally avoided by firms that must answer to regulatory
agencies to be quoted on the stock exchange.
There are generally two kinds of footnotes. The first type identifies and
explains the major accounting policies of the business. The second type
provides additional disclosure, such as details of long-term debts, stock
option plans, details of pension plans, previous errors, lack of internal
control and law suits in progress. Although the footnotes are required,
there are no standards for clarity or conciseness. Footnotes often
seem intentionally legalistic and are awkwardly written [Tracy,1980].
A survey of bank lending officers revealed that half of them would refuse to loan to a company that did not submit financial statements, even though these might not be explicitly requested. Bank lending officers exhibited no preference for inventory or depreciation methods, but believed that consistency in the use of accounting methods is important [Stephens,1980].
Another study attempted to compare General Price Level (GPL) and traditional ratios in the prediction of bankruptcy. GPL data was found to be neither more nor less accurate than historical data. To justify the expense of preparing GPL statements, GPL data would have to be more useful. The investigators noted that GPL data may or may not be of value for other uses of accounting data [Norton and Smith,1979].
An extensive study was made of ratio tests in the prediction of bankruptcy.
All nonliquid asset ratios performed better than any of the liquid asset
ratios -- including the highly-touted current ratio and acid-test ratio -- for
anywhere from one to five years in advance of bankruptcy. The researcher
explains that a firm with good profit prospects in a poor liquid asset position
rarely has trouble obtaining necessary funds. Another surprising discovery
was that the failed firms tended to have less rather than more inventory --
contrary to what the literature might suggest [Beaver,1968].
Extensive studies were conducted of three categories of investors: individual investors, institutional investors and financial analysts. Both individual and institutional investors regarded long-term capital gains as more important than dividend income which was more important than short-term capital gains. Both individual and institutional investors with portfolios under $10,000 rated short-term capital gains higher than investors with large portfolios [Most and Chang,1979].
All groups in the USA regarded financial statements as the most important
source of information for investment decisions. In the United Kingdom, only
institutional investors made that judgement. Financial analysts regarded
communications with management as the most important source, whereas
individual investors preferred newspapers and magazines. Financial
statements were found to be equally important for "buy decisions" as for
"hold/sell decisions" [Chang and Most,1981].
Questionnaires were sent to controllers of the 500 largest American
industrial firms with a 53.8% response. The accountants were asked to
evaluate the adequacy of current reporting procedures. The disclosure rated
as more deficient, accounting for human resources, was ranked fifth in
importance. Effects of price-level changes were deemed the second largest
deficiency, but ranked sixth in importance. The rate of return on investment
was rated third in deficiency, but first in importance [Francia and
Strawser,1972].
Although financial statements provide information useful to
decision-makers, there is much relevant information that they omit. Factors
of market demand, technological developments, union activity, price of raw
materials, human capital, tariffs, government regulation, subsidies,
competitor actions, wars, acts of nature, etc. can have a dramatic effect
on a company's prospects.
A critical assumption in the use of financial statements (aside from
stewardship), is often made that the past will predict the future. For
trends that have continued for many years this will usually be true, at least
for the near future. Ratio analysis for a single company or within an
industry using similar accounting methods will be the most fruitful way of
using the data provided by financial statements.
(See also my essay Financial Statements in the "New Economy").