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#Written by David Tam, 1997. #
#davidkftam@netscape.net Copyright 1999#
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1.
Yes, she must read the notes to the financial statements. Yes, these notes
are really important. She must read these very carefully and have a full
understanding of them. The notes disclose very important information that may
have affected the values on the financial statements (e.g. how depreciation is
accounted for and what the depreciation rates are, how research and development
is expensed or capitalized). Other important information may be disclosed such
as major acquisitions, investments or divestitures, debt and share structure,
and contingency commitments. These notes may contain more useful information
than the financial statements themselves. They provide the reader with an
understanding of how the figures on the financial statements were derived. As
a side note, one possibility stemming from this freedom is that a company can
arrive at two different financial statements depending on how depreciation is
accounted.
Other possible information found in the notes to the financial statements
include:
- whether the financial statements include accounts of its subsidiaries
- what the subsidiaries are
- whether or not inventory is accounted for using FIFO
- depreciation rates
- how goodwill is accounted for
- any deferred taxes
- how foreign currency is translated
- acquisitions of other companies
- long-term debts and repayment methods
- share structure and stock options
- any unusual items such as company write-offs
- litigations
From the wealth of additional information presented in the notes to the
financial statements, the importance of reading these should be obvious.
2.
Financial ratios are very important when comparing companies that are in
the same industry because they provide a common base for the comparisons.
These ratios are derived from numbers on the balance sheet and income
statement. Fractions and percentages are used rather than absolute values so
different sized companies (in the same industry) can be compared using this
scheme. Commonly used ratios such as liquidity, leverage/capital structure,
turnover, and profitability ratios allow readers to measure a company's ability
to:
(1) meet short term obligations
(2) utilize capital to meet obligations to funding sources
(3) effectively utilize assets
(4) produce profits
When comparing companies, the reader is performing financial analysis.
Interpretation of the numbers on the balance sheet and income statement can be
done quickly and easily with financial ratios. These ratios are often compared
to generally accepted ratios for the particular industry, giving the reader a
benchmark for comparison purposes. These ratios also allow the reader to
observe trends in a particular company over a period of time. These ratios
provide a very quick and easy way to evaluate a company's financial health in a
general way. However, it is important to note that these ratios do not
disclose any information about the cash flow of a company.
Another caution is that ratios of companies in different industries can not
be easily compared. The reader SHOULD NOT attempt to compare the ratios of two
companies from two totally different industries (as mentioned in the
assignment). Instead, the reader should cautiously compare each ratio to the
generally accepted ratios from those particular industries.
3.
Debt/Equity preference refers to how a company raises any additional funds
for its operations. Companies with debt preference prefer to arrange long-term
bank loans. Companies with equity preference prefer to issue additional shares
to raise the needed capital. The advantages of the former preference are that
the existing shareholders gain more leverage and retain their control of the
company, as well as receive a larger percentage of the profits (or losses) per
share. With a bank loan, only fixed monthly interest payments must be met.
Any profits made from the loan are not shared with the banks. This leverage
situation is advantageous when a company produces a lot of profit from the
additional funds. However, if losses are incurred, the leverage works to a
disadvantage for the company. If the company can not meet interest payments on
the loan, stiff penalties may be issued or bankruptcy may be forced upon the
company. With a preference towards equity, a company can receive additional
funding without paying monthly interest on the amount. This reduces the debt
load on the company. However, any further profits must be shared with the new
shareholders. As well, existing shareholders have less control of the company.
In short, leverage is decreased.
To answer the question of whether a company has a preference to debt or
equity, it depends on the company's current financial position, financial
forecasts, cash flow situation, shareholder preferences, current markets,
interest rates, and many other factors. By looking at the debt to equity
ratio, the reader can determine whether a company has a preference for debt or
equity. A high ratio would indicate a preference for debt, while a low ratio
would indicate a preference for equity.
4.
No, the balance sheet figure does not equal the actual market value of the
company. One obvious reason is that land appreciation is not accounted for.
Only the purchased value of the land is recorded in the financial records.
This follows the matching principle under GAAP, which states that revenue and
expenses are recorded at the time that the economic event occurred. For
instance, if a company had purchased a piece of land 20 years ago for
$1-million and the land currently has a market value of $2-million, this
appreciation is not recorded in the financial records. Only the historical
value of the asset ($1-million) appears on the balance sheet, not the current
value ($2-million).
The GAAP principle of conservatism also plays a role. By overstating costs
and understating income, any potential for misrepresentation of the value of
the company can be avoided. Goodwill also fails to appear in the financial
statements for this reason, although it can account for a significant portion
of the market value of the company. Another example is a company's holding of
marketable securities. This asset would be record at the purchase price, while
the actual market value is listed in the notes to the financial statements.
Another situation that distorts the values stated on the balance sheet is
the depreciation of assets, such as inventory or equipment, because does not
appear on the balance sheet. Cash flow information is not present either
though this affects the actual market value of a company.
To evaluate the real worth of a company, the reader must have an indication
of whether the company can meet its obligations such as payment of bills,
fulfillment of contracts, and payment of profits. Because the balance sheet
does not contain all of this information, the reader can not determine the real
worth of a company by looking solely at the balance sheet. As a consequence,
she must review the other financial statements as well and perform a bit of
financial analysis.
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