D5586 ?
For more than 30 years, a document done by Merrill Lynch has been the
gold standard in explaining income statement and balance sheet terms
found in annual reports. Since graduate school I?ve had several
copies of ?How to Read a Financial Report,? first published in 1973,
because it?s both complete and succinct.
The online file (5.1M) is available here as an Acrobat (PDF) file:
Merrill Lynch
http://philanthropy.ml.com/ipo/resources/
Note too that it?s been supplemented by another guide called ?How to
Understand a Financial Report? with a bit more about the analysis.
However, let?s jump to the definitions used in ?How to Read a Financial Report?:
PROFIT: Sales ? COGS ? Depreciation & Amortization ? SG&A ? Dividends
? Interest Expense ? Taxes
Where: COGS = cost of goods sold
SG&A = selling, general & administrative expenses
There are actually several definitions of profitability that you?ll see:
GROSS PROFIT: Sales ? COGS.
This allows a definition of the gross margins for major business units
though it skips many business expenses
OPERATING PROFIT: Sales ? COGS ? Depreciation & Amortization ? SG&A.
This allows a measure of the firm profitability without interest & taxes.
EBIT: This is basically the same thing as operating profit, but
sometimes one-time income or one-time charges add or subtract to the
Operating Profit. This measure is popular with Wall Street analysts
who are trying to make meaningful comparisons between firms.
EBITDA: This is EBIT (usually Operating Profit) with Depreciation and
Amortization added back. Why do that? Because Depreciation &
Amortization charges don?t use cash. Inasmuch as cash is what keeps
the firm alive, it?s an attempt to measure ?free cash flow.?
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TURNOVER: In the U.K. ?turnover? is used synonymously with ?sales,?
but in the U.S. it usually refers to inventory turnover. (It?s also
used in other areas, such as personnel changes during the year.)
Inventory turnover is Sales/Inventory. So that sales of $100 million
with inventory of $12 million on the date of the balance sheet has a
turnover of 8.33. More properly it should be done against average
inventory, but we usually settle for the annual report supplemented by
the quarterly reports. Note that for manufacturing companies the
inventory includes both finished goods and work-in-process (WIP).
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WORKING CAPITAL: to define Working Capital (WC) we first need to
define Current Assets (CA) and Current Liabilities (CL) because:
Working Capital (WC) = CA ? CL
Current Assets (CA) = Cash + Marketable securities + Accounts
receivable + Inventory + Prepaid expenses
Current liabilities (CL) = Accounts payable + Notes payable + Accrued
expenses + Current portion of Federal income taxes
There are detailed definitions of each of these in the Merrill Lynch
document. For example, Accounts Receivable must be reduced by bad
debt reserves. Needless to say, at audit time there?s substantial
discussion with the firm?s outside auditors over proper valuations of
each account.
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EQUITY: The shareholder?s equity is made up of several elements:
1. Par value of common and preferred stock, if any. It?s the legal
?par value? assigned when shares are issued. Many states no longer
require a ?par value.?
2. Capital surplus: amount paid ABOVE ?par value? when investors
bought their shares
3. Retained earnings: net profits retained by the firm. These would
be net profits after dividends because dividends are profits that have
been returned to shareholders.
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RETAINED PROFIT: Usually referred to as ?retained earnings? or
?accumulated retained earnings,? this number is derived from
cumulative past Net Profits (after dividends).
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RETURN ON CAPITAL EMPLOYED: the Merrill Lynch document doesn?t do a
great job here, choosing to rely on ?Return on Equity,? which is Net
Profit/Shareholder?s Equity. (Note that preferred stock payments AND
preferred stock values are usually excluded from this measure.)
But a longstanding firm can have substantial cash, which isn?t really
?deployed.? For example, Microsoft has been so profitable that it had
cash and short-term investments of $60.6 billion ? money that isn?t
really ?employed? in the business.
Return on Capital Employed is EBIT/(CA ? CL) or Earnings Before
Interest & Taxes divided by (Current Assets ? Current Liabilities)
As the article below notes, it?s a much better indication of returns
on the operating portion of the business:
Investorwords.com
?Return on Capital Employed?
http://www.investorwords.com/5770/Return_on_Capital_Employed.html
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DEBTORS AND CREDITORS:
Debtors are those who owe the firm money. It can include anyone, from
a customer to an officer who?s been granted a loan of company money.
Typically it includes customers in arrears and those to whom money has
been lent.
Investorwords
?Debtor?
http://www.investorwords.com/1323/debtor.html
Creditors are those who lend the company money ? though suppliers
don?t count (as customers don?t count as debtors) unless the company
is behind in payments. Most typically they?ll be banks (for
short-term or line-of-credit loans) and bond holders.
Investopedia.com
?Creditor?
http://www.investopedia.com/terms/c/creditor.asp
---
Realizing that some of this may be confusing to someone without a
finance background, don?t hesitate to ask for a clarification before
rating this Google Answer.
Best regards,
Omnivorous-GA |
Clarification of Answer by
omnivorous-ga
on
09 Jan 2005 10:00 PST
D5586 ?
I do financial reports for international firms, and the only
significant difference between the U.S. and U.K. terms on this page is
in ?turnover.? As previously mentioned, in the U.S. the term is used
as an operating measure (inventory turnover, personnel changes, etc.)
In the U.K. it?s used in the place of ?sales? or ?revenues? in the
U.S.
There are some issues with respect to what gets EXCLUDED from
turnover, though the international accounting communities are trying
hard to reconcile this, as noted by this work-in-process description
of the U.K. Accounting Standards Board:
U.K. ASB
?ASB exposure draft on revenue recognition,? (May 2003)
http://www.frc.org.uk/asb/publications/it5_p30.html
The definition of ?turnover? is:
Sales ? Trade Discounts ? VAT ? Returned Products
This number excludes VAT but INCLUDES any special levies considered to
be part of cost of product regulation.
Note that until about 3 years ago, U.S. accounting standards permitted
?trade discounts? to be included as sales/marketing costs instead of
reductions of revenue. And the U.S. has no VAT but does have excise
taxes levied at the factory level for a limited number of products
(for example, an excise tax is levied on vehicle tires and the tax
goes to highway trust funds as a form of ?use tax.?). The excise
taxes in the U.S. would be handled in the same manner as ?special
levies? in the U.K.
Here?s an excellent discussion of the precise application of turnover
rules for the Pesticide industry:
Department for Environment, Food and Rural Affairs
?Declaration of UK Turnover, Net of VAT,? (September, 2003)
www.defra.gov.uk/corporate/ regulat/forms/pesticid/dtl1nc_notes.pdf
Google search strategy:
?definition of turnover? U.K. accounting
Turnover U.K. ?auditing standards?
Site: search of http://www.asb.org.uk/
Best regards,
Omnivorous-GA
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