The Balance Sheet

SECTION 2 What Comprises the Business? The Balance Sheet

The balance sheet represents the financial position of the business as of a certain day, usually the last day of the fiscal period. This end of period most often coincides with the end of the calendar year or the end of a calendar quarter. Most balance sheets you see will show the numbers for the current period as well as those for the immediate past period for comparison. This lets you see how the various components of the business have changed from one period to the next. The balance sheet can be divided in many ways, but the most logical and easiest to understand is the separation of what we have (assets) from where it came from (including both liabilities and equity, also known as shareholders’ investment or shareholders’ equity.)6 In its most typical format, the balance sheet shows assets on one side (the left side) and liabilities and equity on the other side (the right side). Let’s see why. ASSETS The total assets of the business represent the resources the business owns, including all the goods and property owned, as well as claims against others yet to be collected. In the U.S., these assets are listed in order of their liquidity (nearness to cash) at their historical cost to the business, adjusted for certain items we will discuss later. When you list the assets of the business, you also need to show where these assets came from. As we said earlier, the funding for assets arise from three sources: invested capital, creditors, and profitable operations. These sources represent specific stakes that various

6 Some accountants use the term equities to mean the right side of the balance sheet—both liabilities and shareholders equity.

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parties have in the business. These are categorized as either liabilities (the business owes money to the claimant) or as stockholders’ equity (shareholders’ investment in the business plus undis- tributed profits of the past). Logically, the claims against the assets will always be exactly equal to the total amount of the assets. By definition, there must always be a claim against the assets by either a creditor or an owner. Let us take a look at the development of a business and the recording of its transactions by an accountant. We will learn the concepts and the language by studying a balance sheet for ABC Laboratories (ABC) a hypothetical company based on a real publicly owned medical products/services business operated for profit. Refer to the financial statements in the back of this handbook as you go through the accounts. ABC has organized itself into various divisions, each of which could maintain their own balance sheets and income statements. When ABC reports its financial results to the public it con- solidates all its units into a single set of statements. There are some exceptions to this and we will cover some of them later. Current Assets The most liquid (cash-like) assets ABC owns are its current assets (assets that will become cash within one year). These include cash, marketable securities (expected to be sold in the near future), trade receivables (amounts owed to ABC by its customers), inventories of various products, taxes that have been prepaid, and other prepaid expenses such as rent or insurance.

Cash —is just what it sounds like. ABC shows $608 million for year end 2012 and $315 million for 2011. This account balance includes bills and coins as well as amounts in checking accounts that are unrestricted in their ability to be withdrawn. Cash is drawn to the business when investors buy shares from the business, when cash is collected from customers, and when the business borrows money or when it sells one of its assets. Cash is withdrawn from the business to pay debts of the business. These might include amounts payable for items purchased on credit, for salaries due, or for utilities. The business must also pay interest and principle on the money it borrows to run the business or to buy land, plant, or equipment. When the business is profitable, it may pay cash dividends to its stockholders rather than retain the cash in the business.

10 Getting Behind the Numbers — Fletcher/NACD Section 2: The Balance Sheet

Short-Term Securities —represent temporary investments in stocks that are very marketable and that usually have very little price fluctuation. ABC shows $115 million for 2012, up from $96 million at year end of 2011. Again, these investments are to enable the business to earn a return on its cash rather than have it sit idle.

Trade Receivables —are established when the business sells products or services on credit to its customers. It is customary for businesses to allow its customers up to 30 days to pay the amounts due. The business must pay its own bills regardless of the agreement it has with its customers. Cash flow becomes a problem when the business pays its creditors in a timely manner but its customers pay slowly or not at all. The amount booked to trade accounts receivable is usually equal to the sales price of the deal reached with the customer. At the end of each accounting period, the accountants will assess the likelihood that all the amounts will be collected as planned. To the extent they feel some amounts will not be paid, they will estimate and book an adjustment to the account for what they refer to as allowance for bad debts—also known as doubtful accounts. The 2012 Trade Receivables account for ABC is shown at the net amount of $2.06 billion after the accounts were reduced by the allowance for doubtful accounts that same year ($239 million). The net amount for the previous year was $1.96 billion. As sales volume increases, you might expect trade receivables as well as costs to increase proportionately.  Red flag: Notice and flag inconsistencies between changes in revenues, receivables, and costs.7

Inventories —is the account used to collect costs of the various products ABC has purchased or manufactured for resale. It is normal for a business to show its inventories at their cost to the business, whether they bought or manufactured the goods. If the market value of the inventories has fall- en below their cost, the business will usually write the amounts down to reflect this loss even before the items are sold to customers. This involves showing a loss by reducing the asset value on the balance sheet.

7 Throughout this book, we will give tips to audit committee members. However, all directors, including members of other committees such as a finance committee, may find these tips useful.

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Note that three categories of inventories are listed for ABC: for 2012 the finished products total $772 million in cost, work in progress totals $339 million, and raw materials total $384 million in costs. The cost of the raw materials is easy to track, but measuring the cost of work-in- process or finished manufactured products is much harder. The accountant must keep track of the labor, material, and overhead costs attributable to each product line. This often leads to con- troversy when the business has multiple or complex product lines. Obviously, ABC must use its cash to pay for items it purchases for resale as well as purchases of raw materials for further manufacture. It must also pay for labor used to manage inventory or to manufacture goods. All of the expenses of running the business to store or to make products must also be paid. It is to ABC’s good to minimize the inventory it carries if it is to minimize cost invested. Goods do not usually earn a profit while they sit on the shelf. Yet ABC must carry inventory in order to satis- fy customer demands for just-in-time deliveries. Thus, the age old battle: should ABC carry inventory that costs them money sitting on the shelf and that may become obsolete, or should it carry small amounts of inventory and risk not having the items when customers demand quick delivery?  Red flag: Unexplained inventory growth or decline may suggest that the company is unable to accurately forecast customer demand.

Total inventories — include, a sum total of the value of all inventories (finished products, work in process, and raw materials). For 2012, the inventories totaled $1.5 billion, an increase of $83 million from the previous year. Again, as with trade receivables, an increase in sales might be associated with a proportionate increase in inventories.

Prepaid expenses, taxes, and other receivables —arise when the business pays its bills before it uses the services for which it is paying. Examples are rents paid in advance, advertising expenses, and insurance premiums paid in advance. Amounts owed to the business for other than trade transactions are usually reported as a separate item from trade receivables. ABC’s 2012 statements show $1.2 billion for this com- bined account total.

Total Current Assets Current assets when totaled are $6.4 billion as of December 31, 2012. The company expected these to become cash within the 2013 business year as part of the normal business cycle of cash to inventory to receivables to cash.

12 Getting Behind the Numbers — Fletcher/NACD Section 2: The Balance Sheet

Investment Securities This account includes amounts invested in securities of other businesses. Only those maturing after one year or planned to be sold after one year are included here. Items planned for maturity in less than one year are included in current assets. Note that these long-term investments are accounted for at the lesser of their acquisition cost or their current market value. As a conservative principle, if they have appreciated above cost, any increase is not shown in these accounts. ABC held $955 million in investment securities on December 31, 2012. There are three basic ways to keep track of these investments. These methods include recording the investment at cost (if we own less than 20 percent of their stock), at equity (if we own 20 to 50 percent of their stock), or as a consolidated entity (if we own more than 50 percent of the stock). For a discussion of these three methods, contact your external auditor or your chief financial officer (CFO), who can provide a detailed explanation of the implications for your financial statements. Property, Plant, and Equipment This category of assets, which may also be referred to as fixed assets, includes assets that are not intended for resale by the business. In most cases, these assets are used to generate the products or services that the business offers.

Land —includes just what the term suggests. It is recorded at historical cost and is not restated to reflect any appreciation in value (even though appreciation is expected with land in the U.S.). Nor is the land’s value depreciated over time: land is not considered a depreciable asset. ABC shows $203 million in land owned. It is possible that the land owned by ABC could be appraised today for as much as $2 billion or more.

Buildings —are shown at their historical cost. This amount is eventually adjusted for “wear and tear,” as shown in an accumulated depreciation and amortization account. ABC shows $1.9 billion in this account for year end 2012.

Equipment —is shown at $7.3 billion for 2012. This represents the cost to buy and install the machinery and equipment for ABC operations. This could include manufacturing equipment or

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handling/distribution equipment. Again, the historical cost is shown and is adjusted through an allowance for depreciation as the historical cost is matched with annual revenues to calculate annual profits.

Construction in progress —is an account to show new facilities that are being prepared for addition to the production process but are not yet ready to generate sales for ABC. The total of $373 million is the cost incurred to date and is not usually depreciated until installation is complete.

Total property, plant, and equipment —includes all the previously stated accounts at historical cost ($9.8 billion for 2012). The next line on the balance sheet shows the accumulated depreciation for all fixed assets since their acquisition. This amount for 2012 is $5.0 billion and is deducted from the total cost of $9.8 billion to arrive at the net property and equipment amount of $4.8 billion for 2012. The accumulated depreciation account is increased each year as more of the cost of the depreciable assets is removed from the balance sheet and shown on the income statement as an expense. The historical cost will be spread over the useful life of the asset. For public reporting purposes a straight line approach is usually made, spreading an equal amount each year. For tax purposes, an accelerated method is used to depreciate the assets, spreading a larger amount to the earlier years of the asset’s life. The company wishes to show lower income on the tax return to minimize the tax payments in the early years of the asset’s life. The acquisition cost of plant and equipment is spread over the expected useful life of the asset in determining how well the business performed from year to year. Various techniques are avail- able to the accountant to measure the appropriate amount to add to the depreciation account each period. Each year’s amount of depreciation is accumulated in the single account on the balance sheet. The report shows how much was paid for the existing plant and equipment and how much of that cost has been recognized as an expense over the life of the assets. Deferred Charges and Other Assets This category includes such things as goodwill, intangibles, long-term receivables, and investments in affiliates. For ABC this category of assets totals $752 million for 2012. For some firms, an account is established for goodwill when another business entity is bought. If the transaction represents a purchase of assets and the price paid exceeds the fair market value of the assets less the liabilities, the price paid in excess is considered goodwill.

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Total Assets The various categories of assets on the balance sheet are added together to constitute the total assets of the business. For ABC, this amounts to $14.5 billion, up from $13.3 billion at year end 2011. As you will see when you examine the income statement, ABC grew the business primar- ily from profitable operations, rather than from additional investment or from borrowing. LIABILITIES AND EQUITY The business entity has been defined in terms of the assets that have been put together to run the business. This listing of assets is in fact the business defined in terms of historical cost, or what the business paid for the assets. The next question we ask is, who has a stake in these assets? Said another way, how did the business finance these assets? Did it borrow money to buy plant and equipment? Did vendors provide materials on credit or on account? Did investors buy stock from the firm so that the funds could be used to operate the business? Did the business make a profit that it decided to retain to operate the business (retained earnings)? These questions are answered in the section of the balance sheet that lists liabilities and shareholder’s investment. Once again, we will refer to ABC. Liabilities Liabilities are the accounts to which the business is contractually liable to pay specific amounts. These accounts are separated into current and long-term accounts. The current accounts are those due to be paid within the next year. Long-term accounts are due in the next year or beyond. Current Liabilities ABC’s 2012 balance of current liabilities totals $4.5 billion and comprises short-term borrowing, trade accounts payable, and so forth, ending with the current portion of long-term debt. Note that ABC has an account for other accrued liabilities. The accrued liabilities are amounts that ABC knows it owes but for which bills have not yet been received or at least they have not been entered in the accounting records. Examples include interest that ABC knows it owes on debt but for which the bank doesn’t send a bill.

Income taxes payable —are recorded in full amounts for the year even if the company has already paid some of the taxes in installments. (Income taxes are usually paid in quarterly installments.) ABC has

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calculated its total estimated income tax liability owed to various government bodies as $314 million, and has booked this amount as payable now. The final tax bills will result in some adjustments.

Total Current Liabilities As mentioned, ABC owes a total of $4.5 billion considered to be current. This amount should be paid within one year, much of this due within the next 60 days. This is normal for a business the size of ABC. But, like other businesses, ABC has to be careful not to run out of cash. Note: Recall that ABC has $6.4 billion in current assets and consider now it has $4.5 billion in current liabilities. This difference of $1.9 billion is called ABC’s net working capital. It is the difference between current assets and current liabilities. Many people view net working capital as a measure of the firm’s safety in liquidity.  Red flag: Remember that ABC’s inventories may not be sold and converted to cash as quick- ly as the liabilities may come due. Timing may become a real issue for ABC unless it has a good relationship with the banks. Insight: Many firms hold their operating managers responsible for performance against the investment they control. One measure of this investment is the net assets, or net working capital plus all other assets including property, plant, and equipment. For ABC, net assets include the $1.9 billion in net working capital and $4.8 billion in net property and equipment, a total of about $6.7 billion. Long-Term Debt Long-term debt is any debt that has portions coming due after one year. ABC has borrowed money on a long-term basis totaling $1.3 billion. For a firm with $14.5 billion in assets, this is a relatively small amount of long-term debt. Other Liabilities and Deferrals The category of other liabilities and deferrals includes deferred income taxes. The Internal Revenue Service allows certain expenses on the tax return that may not be allowed in the gener- ally accepted accounting practice. It is possible then that the tax liability that ABC shows in its income statement does not exactly match its tax return. This is a complex subject and one that is under change most of the time.

16 Getting Behind the Numbers — Fletcher/NACD Section 2: The Balance Sheet

Total Other Liabilities and Deferrals ABC’s other liabilities and deferrals totaled $1.2 billion at year end 2012. There are various types of deferrals. One type is deferred taxes, as mentioned earlier. The U.S. tax laws allow a business to expense certain costs earlier on the tax return than is shown on the published financial statements; this tax difference is reflected in a “deferred taxes” account. Another type of deferral is deferred revenue. This is gross income that must be deferred because the goods have not been shipped by the cut-off date (end of period). Remember, we are trying to match earned revenue with incurred expenses. Shareholders’ Equity ABC has about 1.6 billion shares of common stock outstanding. Over the years, as the company sold shares to the public, it received a total of about $1.9 billion in return for these shares. Over the same time period it has also made a lot of profits (net income), which has been reported on its income statement (statement of profits or loss). Each quarter, when ABC reports its earnings for the quarter, it also declares a percentage of these earnings to be distributed to the shareholders as dividends with the balance of the profits being retained. It is not unusual for a business to distribute 40 percent of its earnings as dividends and to retain the balance for use in growing the business. As you can see on ABC’s balance sheet, a total of $6.2 billion in past profits (earnings) have been retained and employed in the business. Other firms might call this retained earnings.

Common stock in treasury —is stock that is not outstanding. From time to time a firm may buy its own shares in the market place. It may use these shares as additional compensation for employees, or it may simply wish to reduce the number of shares outstanding. It may or may not retire these shares. ABC now has almost 18 million shares in its treasury, for which it paid about $258 million on aver- age over time. If you were to check the current value of ABC stock, it would be about $22 per share. It can now award as a bonus a share of stock that cost it about $14.60, but for which the current value is about $22. A final account in this section, called unearned compensation, identifies a number of shares that have been awarded to executives but that have not yet been earned. They may not be traded by the executives until they have removed the restrictions which were placed when they were awarded. For ABC, this totals about $23 million.

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Total Shareholders’ Investment Total shareholders’ investment (also called stockholders’ equity) is the sum of preferred shares (if any), common shares, and retained earnings, which may or may not be adjusted for other factors. ABC’s shareholders have a total equity of $7.4 billion of the total $14.5 billion in the firm. You must remember that the $14.5 billion reflects historical cost of most assets, not current market value. We do not know the current market value of the assets until they are sold, so we stick with historical costs as a conservative indicator of value. Certainly, the inventories are expected to sell for much more than their cost and the land that has been purchased over the years is probably worth a great deal more than ABC paid for it. If we want to know the current value of ABC’s assets, we could hire an appraiser to establish this value as of the current date. Total Liabilities and Shareholders’ Investment When we total all the liabilities and the owners’ equity accounts for ABC we find the total is $14.5 billion. Note that this amount must always equal the total assets of the business, since it is merely a statement of where the assets come from, or how the assets have been financed. uestion: If ABC’s balance sheet grows by $1 billion next year, where will the growth have Qcome from, and where may it show up on the balance sheet? nswer: ABC can grow by making a profit on its sales, by borrowing more money from the Abank, and/or by selling more shares to the public. It can also sell some of its fixed assets. If ABC grows this year, any or all of the asset accounts could grow. If it grows, obviously, some of the stakeholder accounts (liabilities and/or equity) must grow. If it borrows money to grow, debt accounts will grow. If it makes a profit, retained earnings will grow. If it sells more shares, the common stock account will grow. BALANCE SHEET VARIATIONS Balance sheets from different industries and countries will vary in form and terminology. Here are discussions of a bank and a British company, following financial statements in the back of this handbook (starting on page 54). Bank Balance Sheets Banks operate under a federal or state charter and as such are required to prepare uniform financial statements for the Comptroller of the Currency. The balance sheet of a bank is

18 Getting Behind the Numbers — Fletcher/NACD Section 2: The Balance Sheet

sometimes referred to as a statement of condition. This statement will be somewhat different from ABC or any traditional manufacturing, retail, or service business. The accounts may seem opposite. As an example, checking accounts or demand deposits are liabilities to a bank, as it owes the customers money in these cases. Similarly, loans to customers are assets, or receivables. Further, the balance sheet accounts do not have to be subdivided into current or noncur- rent accounts.

Assets Representative assets of a bank may include cash on hand or due from other banks, investment securities, loans, bank premises, and equipment. You should closely review the disclosure of assets of a bank. At a minimum, you must examine the footnotes that accompany the financial statements. This will be a starting point to lead you to a more informed discussion with the CFO or the CEO of the bank. Notice in the KLM Financial (KLM) balance sheet for 2012, the major asset is the loan and leases account which is at $4.46 billion with an associated allowance for credit losses of $60 million. KLM has total assets of $6.9 billion. Recently, the use of derivatives has become an issue for financial institutions as well as the businesses that they have guided in this arena. Be sure you understand exactly how much risk the institution is taking in any of these complex arrangements. This is an area in which you should consider getting outside expert advice.

Liabilities Notice in the liabilities section of KLM, customer deposits total $4.96 billion. Customers gave their money to the bank for safekeeping and to earn an interest. These deposits were loaned to other customers at a rate differential that was designed to render a profit for KLM. So the funds on deposit are a liability for the bank, and the funds loaned out are an asset—in that the funds are owed to the bank with interest. If KLM invests the unloaned balance in profitable ventures, it may earn a good return for its business. The security of the investments made by a bank are a good monitor of the skill of the managers. Remember that some bank managers are driven to outperform the competition. In their quest for greater returns on their investments or loans they make, these managers could take on excessive risk.

Getting Behind the Numbers — Fletcher/NACD 19 Section 2: The Balance Sheet

Shareholders’ Equity Shareholders’ equity in a bank’s balance sheet is similar to that for any other public company. KLM shows $550 million, including $301 million in earnings that have been retained in the business.

An astute director of a bank will:

• Review the disclosure of the market value versus the book value of investments. This review may indicate that investments have a market value substantially above or below the book amount. • When reviewing assets, ask about the any derivative instruments especially mortgage- backed obligations or credit default swaps, to ensure that their underlying risk is under- stood. • Ask if the firm is liable for any debts that are not included on their balance sheet (“off balance sheet loans.”) • Pay particular attention to foreign loans and the political stability of the area as well as the general business climate. • Review the footnote that describes any “related party” loans. Observe the materiality of related party loans and the trend of these loans. • Evaluate the loan loss reserves. Look for changes and for particular loans which have been identified as problem loans. • Review the footnotes for disclosure on nonperforming loans, loans on which the bank is receiving no or inadequate income. Pay attention to renegotiated loans, especially in the area of real estate development. • Closely review the liabilities for significant changes in trends. Look also at any footnotes which describe commitments and contingent liabilities. • In reviewing the statement of stockholder’s equity, look for any significant changes from year to year. Non-U.S. Balance Sheets We have included in this handbook the 2012 and 2011 financial statements of a hypothetical public corporation based in the United Kingdom. Because this U.K. firm, which we will call

20 Getting Behind the Numbers — Fletcher/NACD Section 2: The Balance Sheet

GHI, is based in the U.K., its financial statements are slightly different from those of a U.S.- based company. Rather than list the assets and liabilities of the firm, U.K.-based firms reverse the order of the assets and also deduct the current liabilities in arriving at a net asset position, which is then equal to the owners’ equity. Note that all amounts are shown in British Pounds (£), worth about $1.60 in U.S. dollars (at the time of printing). GHI’s balance sheet begins with fixed assets, which totaled £5.575 billion. In these fixed assets are included the fair value of the brands that GHI owns. Upon purchase, the brands are booked at fair value and are listed in the accounts as intangible assets. If these brands are deemed to have lost value, the loss is not shown in the income statement as an expense; rather, it is shown as a reduction in the equity section as a goodwill reserve. Note this section is titled capital and reserves in the GHI statements, while it would be called shareholders’ investment (or shareholders’ equity) in a U.S. statement. Note also that, contrary to U.S. practice, some assets may be written up to reflect appreciation. This appreciation is then identified as a revaluation reserve in the owners’ equity section of the balance sheet. After fixed assets, GHI then lists current assets (£4.2 billion), from which they deduct current liabilities (£3.235 billion) to arrive at net current assets of £969 million. When these net current assets are added to fixed assets, the total assets less current liabilities are calculated to be £6.544 billion. From this net asset position GHI subtracts long-term debt and other creditor accounts of £2.373 billion and provisions for liabilities (reserves) to arrive at an amount of £3.587 billion, which is total assets less total liabilities. This number is then by definition equal to owners’ equity which is disclosed in some detail. Notice in GHI’s balance sheet, a number of references to footnotes are shown. As in the U.S., the footnotes provide a great deal of detail about the contents of the accounts listed.

Money Measurement Accountants measure everything in terms of a single domestic currency, so that all the business assets can be consolidated into a single set of statements. For example, if a business owns an operation in a foreign country, the financial statements must be translated from the local currency to U.S. dollars. This translation of currencies cause “paper” financial gains or losses for the home company—results that appear better or worse than operating reality warrants.

Getting Behind the Numbers — Fletcher/NACD 21 SECTION 3 How Did the Business Perform? The Income Statement

Let us now look at the income statement (page 56), which shows how well ABC did in making and selling products for the year 2012. Basically, the income statement includes two categories of accounts—income and expense. Our objective here is to match inflows and outflows of the business to gauge how well we performed. Our objective is to earn more in sales revenue in a period than we incur in expenses. We are careful to match revenue with expense in order to gain a fair measurement of the performance for the specific period (month, quarter, or year as an example). The rules are simple: sales revenue is recorded when goods are shipped to the customer or service is provided, and expense is recorded when expenses are incurred (not necessarily when they are paid). Sales ABC earned (invoiced customers) $13.2 billion in sales revenue for goods and services delivered during 2012. This is about a 6 percent increase in sales from $12.5 billion in 2011. This amount is net of any returns and allowances related to sales. Remember, this does not include contracts or orders for future delivery—it only includes goods or services that were actually delivered or provided to the customer during this period. Total Operating Costs and Expenses Total operating costs and expenses include the cost of the goods ABC sold, whether it purchased them for resale or whether it bought raw materials that it converted through manufacture to finished goods. This cost totaled $6 billion or 45 percent of each sales dollar. The cost of goods sold section of the income statement includes some interesting accounting concepts. When a business begins to manufacture a product it spends money on labor, materials, and various overhead items. Assume a business spends $100,000 on

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these items but does not sell the goods until the next year. If the business were to report the costs in the year it built the goods and the sales revenue the next year, it would not be matching revenue and expense. So the business keeps track of these product costs and reports them as an asset in the inventory accounts. Items that are completed but not sold are in the finished goods account and partially complete items are reported in the work-in-process account which includes labor, material, and overhead costs. When the items are sold the following year, their cost will be reported as an expense so they are properly matched with the related revenue. Many firms will match their sales and cost of sales to arrive at a gross margin. From this figure they subtract sales, general, and administrative expenses to arrive at operating income. From this they subtract interest expense to get income before taxes. Also included in operating expense is the cost to administer the business and to sell and distribute its products—$2.9 billion, or 21 percent of each sales dollar. ABC spent an additional $1.2 billion to conduct research and development during the year. Total operating expenses of $10 billion represents about 76 percent of each sales dollar. This is an acceptable ratio for a manufacturing company. Operating Earnings Operating earnings of $3.1 billion represents the difference between net sales and total operating costs and expenses. This is a key figure in any company, because it points to operations profitability (or lack thereof). Some firms may report this as earnings before interest and tax (EBIT). Some go further and report earnings before interest, tax, depreciation, and amortization (EBITDA). To some extent, statement format is a matter of choice. Adjustments to operating earnings From the operating earnings, ABC must also deduct its interest expense and tax expense before it determines how much it really made “bottom line.” ABC reported $82 million in net interest expense (remember, it has some $1.3 billion in long-term debt which calls for interest payments). ABC earned $390 million income from its investment in ZAP holdings (a joint venture). This is in brackets to show it is a reduction in non-operating expenses. ABC also had $26 million in foreign exchange loss. Subtracting the interest and other non-operating expenses from operating income yields ABC an income before taxes of $3.4 billion. Net Earnings Using standard tax rates, ABC calculated its tax expense as $951 million, leaving it $2.4 billion in net earnings, since there were no significant accounting changes or extraordinary gains or

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losses to be reflected in this year’s income statement. This amount is added to the retained earnings account (earnings employed in the business) on the balance sheet. It reflects how much the company grew through profitable operations. On a per share basis this represents an earnings of about $1.59 per share (~$2.4 billion income divided by ~1.5 billion shares outstanding). From this income, ABC declared dividends of $1 billion to shareholders. This represents almost 42 percent of net income paid to stockholders as dividends. Reminder: In trying to measure success for each year, accountants have established an objective to match revenue with expense as closely as possible each period. Revenue is defined as sales of products or services, and the revenue may be recognized when the goods have been shipped or when the service has been provided. This recognition is made without regard to the timing of cash receipt for the sale. A delivery made in December 2012 will be considered a 2012 sale even though the customer will not receive a invoice until January of the following year and may not pay until March. Because the invoice has not been prepared as of December 31, the accountant must “accrue” the sale. Against this accumulation of revenue (inflow or sales), the accountant matches the expenses that have been incurred during the period. As explained earlier (page 8) for an expense to be recognized, it must be incurred. An expense is incurred when an asset’s cost is used up or expires. The consumption of supplies, the purchase and use of rent and utilities, the use of labor, and so forth become expenses for the period in which they were incurred, not the period when they are paid. As an example, if the business uses a building for which it will have to pay rent next year, the rent charge will be accrued at year end so that a better matching of revenue and expense occurs. On the other hand, if rent has been paid in advance, the expense will be deferred because the value has not yet expired. Question: What does the income statement really tell me? nswer: The income statement tells me how well the business performed during the period Aunder review. It compares the revenues earned with the expenses incurred to arrive at a profit measurement. It usually separates the cost of goods sold from the sales and administrative expenses to help the reader understand how the business is doing. An important analysis would include comparison of this year’s results with last year’s.

24 Getting Behind the Numbers — Fletcher/NACD Section 3: The Income Statement

uestion: Does the $2.4 billion profit ABC earned on its sales of $13.2 billion suggest good Qperformance? nswer: The answer depends on the industry you are in, the amount of capital required to Adrive the business, and the investment required of the owners (shareholders). The 18.6 percent return on sales (net income as a percentage of sales) is good for a pharmaceutical firm, but it would be great for an automotive manufacturing firm. Insight: ABC’s 33 percent return on shareholders’ investment (net income as a percentage of shareholders’ investment) may seem very good, but when compared to the previous year’s performance of 40 percent is actually a decline—even though sales went up. The $700 million increase in sales did not produce a significant increase in profits. Question: What should ABC be doing to improve its performance? nswer: It will continue to improve its customer service and quality control systems; invest Awisely in research and development or in the acquisition of new products so that it speeds up the development and introduction of new and better products; control its investment in inventory and other operating assets; get the most out of its selling, distribution, and administrative expense; and develop better ways to capitalize on changes occurring in the healthcare field, especially the concentration of buying power reflected in the managed care and medical consor- tium arenas. In short, it will get even better at doing what it has done for years.

Getting Behind the Numbers — Fletcher/NACD 25 SECTION 4 What Can We Spend? The Statement of Cash Flows

In the balance sheet and income statement, we have seen how much total money passed through ABC’s books in 2012. We saw how each account has changed in balance, how much profit was made when expenses were matched with sales revenue, and how much of that profit was apportioned to the shareholders as dividends. If we look more closely we can see that trade receivables increased, inventories increased, and prepaid expenses increased. We can also see that each of the current liability accounts increased except for short-term borrowings, which decreased. In addition to gleaning insights from balance sheets, we can learn from the statement of cash flows—another of the financial statements that is required of a publicly held corporation. Look at the bottom of the statement of cash flows to see how much the cash account changed over the year at ABC. You can also verify these numbers by examining the cash account on the balance sheet for the past two years. ABC’s cash accounts increased from $315 million to $608 million. What ABC has to do is to explain how this $293 million change occurred. Some of the accounts are difficult to understand, so we will focus on the major accounts. Remember also that these statements are a consolidation of accounts and as such often combine accounts that make it difficult to verify the exact account changes. Basically, the statement of cash flow should explain how much of the change in the cash accounts are from operations (profit or loss), how much from investing in fixed assets, and how much from financing activities (borrowing or paying dividends). Cash Flow from Operations The starting point for determining cash flow is the income statement. We start by assuming that the net income (earnings) is net cash flow from operations. If in fact all

26 Getting Behind the Numbers — Fletcher/NACD Section 4: The Statement of Cash Flows

revenue (net sales) were received in cash and all expenses were paid in cash, net income would represent cash flow. For ABC in 2012 this totals $2.4 billion. Any income statement expenses that we know did not require a cash disbursement at the time will be used to adjust this amount. As an example, we know that $828 million in depreciation and amortization expense was included in operating expenses, but that in fact this was an allocation of an earlier cash flow. Thus, it did not really affect cash flow this year. It was a non-cash expense on the income statement. This depreciation expense is included in the costs of products but is identified separately in the statement of cash flows. Also, if accounts receivable increased from one year to the next, we can see that all sales were not collected. We would need to adjust net cash flow for this. If inventories were increased this would have an adverse effect on cash flow. If ABC had reduced these inventories it would have increased its cash flow. This is one of the reasons many firms are trying to reduce their inventory levels. The cash that is tied up in inventories could be used to earn a positive return rather than sitting on the shelf. ABC operations produced $2.9 billion in positive cash flow for 2012. Cash Flow from Investing When ABC invested to buy new fixed assets, it used cash or borrowed the money. This investing activity has a negative impact on cash flow. The one part of the fixed asset account that changed and did not affect cash flow was the depreciation. When the expense for depreciation is deducted from revenue on the income statement, this does not reduce cash flow. Thus, when you start with operating income as the beginning cash flow you have to add back depreciation. In total, ABC used $1.2 billion cash in buying and selling properties or securities. Cash Flow from Financing The third category of cash flow is that derived from financing activities: borrowing/repaying debt, selling shares to the public, paying dividends, and purchasing treasury stocks on the open market. ABC used a total of $1.4 billion of its cash flow in financing activities. You may notice that currency fluctuations around the world resulted in a $20 million negative impact on cash flow as well. A number of transactions that affect cash flow occur within the business. So it is not possible to prepare the cash flow statement from the abbreviated balance sheet and income statement. We have included the cash flow statement from ABC’s annual report in the back of this handbook. Examine this statement for its design rather than the specific details. (Note: You will not be able to reconcile all the cash flow adjustments that are shown in ABC’s cash flow statement.

Getting Behind the Numbers — Fletcher/NACD 27 Section 4: The Statement of Cash Flows

Do not be concerned! A number of accounting transactions have been consolidated and a number of currencies are used in the consolidation. You should be looking for the line that shows how much cash flow was generated by the operations as compared with investing and financing activities.)

• Most of the $2.9 billion of operations cash flow was used to buy new fixed assets, pay off debt, pay dividends, or buy treasury stock on the open market. • The second category of cash flow is the investing portion. This section isolates the effects of purchases and sales of fixed assets and investment securities. As you can see in ABC’s cash flow statement, the investing activity consumed $1.2 billion of ABC’s 2012 cash flow. • The third and final category of cash flow is that associated with financing. This includes selling stock, paying dividends, and borrowing or paying of debt. For 2012, ABC used $1.4 billion in the financing activity. Note that most of this was cash dividends paid to shareholders. Reconciliation After considering a small exchange-rate effect, the net increase in cash accounts was $293 million. Operations provided $2.9 billion, investing used $1.5 billion, and financing used $1.4 billion. You should appreciate that this cash flow is managed by ABC. The management has a rep- utation of being very disciplined in budgeting and cash flow management. Surely, that has an effect on ABC’s consistently positive performance. Conclusion It is very important that you understand the flows of cash through the organization from year to year. Looking at this process through the three categories will help you build a better under- standing of the long-term strength of the business. Note that ABC can increase its cash flow by selling off assets, borrowing money, or reducing the expenses for research and development. These actions may not be in the best long-run interest of the business. The management team that knows how to build shareholder value by strengthening the consistent improvement in future cash flows will be valued most by the market.

28 Getting Behind the Numbers — Fletcher/NACD