No. of Recommendations: 10
Dear y'all,

This is my first attempt at a FAQ for this board.  Please comment or
email me about it.

In particular, is it too long?  Too short?  Should I write a glossary at
the end, or make it a separate message?  Any thoughts to improve would be
appreciated.

Lleweilun Smith

Q.  What information is available on publically traded companies?  Where
can I find it?

A.  There are of course many news items available on most publically
traded companies.  One good resource for finding them is
excite.transium.com.

In this FAQ we concentrate on the financial information all US companies 
must provide.  All companies put out an annual report, a 10K (like an
annual report with less photos and more legalese), quarterly reports
(10Qs), as well as current reports (8Ks), proxy statements (DEF 14As) and
a few others.  We focus mainly on the annual reports, 10Ks, and 10Qs, all
of which have similar formats.

These reports are available in several places.  First, many companies'
web sites will allow you to download their annual report, often in Adobe
PDF format.  Also the companies usually have an email or phone number,
where you can request information be mailed to you (usually they have a 
standard "investor's packet" with the latest annual report and 10K, as
well as 10Qs and some news clippings).  10Ks, 10Qs and other forms are
available on a  bunch of websites.  My favourite is www.freeedgar.com,
others include www.edgar-online.com and the "SEC" link at quote.fool.com.

Q.  What information is available in these reports?

A.  The annual report is broken up into a few sections.  There is usually
a letter from the CEO, who talks about how great the company is doing.
In this letter, "outstanding" means "good", "good" means "average", and 
"challenging" means "bad".

Afterwards there is a spiel about all the wonderful stuff this company
produces, with wonderful photos of products and people made happy by them.

Further back, on somewhat cheaper paper, is the "management's discussion"
as well as financial results.  It is these which we focus on here.

10Ks look much like annual reports except there aren't glossy pictures
and there is more "legalese".  10Qs have the financial section, 
except they are not for a full year and are unaudited.  Quarterlies are
important to be sure, but many companies experience significant seasonal
fluctuations.

Q.  What are the main sections in the financial sections?

A.  They are the income statement, the balance sheet and the cash flow
statement.  Also there is a statement of stockholder's equity, and there
are several footnotes.  Many companies have a "selected financial
data" section and perhaps a 5 year or a 10 year review.  Without 
belittling them (especially the footnotes, where much important
 information may
lie), we focus on the three statements.

Q.  What is the format of the income statement?

A.  The income statement may also have the names "Consolidated Statement
of Income", "Consolidated Statement of Operations" or something similar.
In general there is three years of information on the annuals.

The format varies between different types of companies, what follows 
is a generic form for a retailer or a generic industrial.

Sales                                        For many types of companies
                                             the cost of goods sold is the
Cost of goods sold (COGS)                    highest single expense.  Gross
                                             earnings / sales = gross profit
Gross earnings                               margin.  The Rule Makers us$
                                             gross profit margin as a
                                             screening criterion.

Selling, general and administrative (SG&A)   Here is lumped other sorts
                                             of costs that go into running
Advertising, research and development        a business.  SG&A is crucial for
                                             the business to run, others like
Goodwill amortization                        advertising and R&D are
                                             "optional" but important (one
Depreciation                                 could cut R&D but eventually
                                             there won't be any new products!)
Amortization
                                             Goodwill amortization is often
Operating earnings                           lumped together with
                                             depreciation.  These non-cash
                                             charges may or may not represent
                                             "real" cash outlays.

                                             Operating earnings/Sales =
                                             "operating margin".

Other earnings                               Down here other sources of
                                             earnings may be included.  For
Extraordinary items                          example, interest income or
                                             gains from sale of divisions
Income tax provision                         may be added here.  Also here
                                             is where taxes are accounted
Net earnings                                 for.


Earnings per share  - basic                  Diluted EPS is calculated from
                    - diluted                assuming all outstanding
                                             "in the money" options and
                                             warrants are exercised.


Note that earnings per share and EPS growth is portrayed by the media as
the "be all" for companies.  There are many reasons why this isn't so,
among them accounting distortions and "accrual" vs "cash" accounting.

Accounting distortions must be left for v. 2 of this FAQ :).  For one
attempt to eliminate them see The Quest for Value by Bennett
Stewart (this stuff is often discussed on the Boring portfolio boards).


Q.  What is "accrual" vs. "cash" accounting?

A.  In the easiest kind of company, say a lemonade stand, all
transactions are in cash.  However, most companies use and grant credit.
Furniture dealers often offer several months before payment need be
received from consumers.  Similarly many companies purchase from
suppliers using credit.

This presents a dilemma to bookkeepers.  When should a sale be
recognized?  Is it when the item is shipped or when the cash is received,
or somewhere in between?

The income statement is based on the "accrual" principle, i.e. a sale (or
cost of sale) should be recorded when the item is shipped.  The cash flow
statement is based on when the cash actually comes in.  In the case of
the furniture company, "income" (i.e. the sale) is recorded before the
cash is received.  For a purchase using credit, the "cost" is recorded
before cash is spent.

Obviously "cash now" is better than "cash later".  One simple tool to
look at how cash is managed is the Rule Maker's "Flow Ratio".

Q.  What is the format of the "cash flow" statement?

A.  The cash flow statement, or the Consolidated Statement of Cash Flows,
is the "cash accounting" version of the Income Statement.  It has three
main sections:
              
Operating Activities                         The "look" of the cash flow
                                             statement is a bit different
Income from continuing operations            than the income statement and
                                             is broken up into three parts.
Depreciation and amortization                The first, cash from operations,
                                             starts from the income statement
Write-offs and impairments                   and adds back non-cash charges.
                                             Also it adds back changes in net
Changes in working capital:                  working capital (inventory,
                                             accounts payable/receivable)
Inventory                                    as well as changes in deferred
                                             taxes and other non-cash items.
Deferred taxes

Accounts Payable/Receivable

Net cash provided by operating activities

Investing Activities                         "Investments" include not only
                                             purchases or sales of marketable
Purchases of plant, property and equipment   securities but also of plant,
                                             property and equipment (PP&E).
Sales of plant, property and equipment       For example the purchase of a
                                             new location for a store would
Purchases of marketable securities           go here.  Some companies require
                                             much investment and maintenance
Sales of marketable securities               of fixed assets, others do not.
                                             Peering at this section, or
Other investing activities                   cash from operations - cash from
                                             investing (the "Rule Maker"
                                             definition of "free cash flow")
Net cash used in investing activities        may help distinguish cash
                                             generation ability that the
                                             income statement does not.  Note
                                             also that a few select companies
                                             actually generate cash from
                                             investments.

Financing Activities                         This section talks about
                                             raising and repaying debt.  Also
Repayments of debt                           included here are payments of
                                             dividends and share repurchases
Issuance of debt                             or issuances.  Note "interest"
                                             is taken out of income.
Share repurchases

Shares issued

Dividends paid

Net cash provided by financing activities    Possibly there would be an
                                             item for currency exchange.

Net increase/decrease in cash and
cash equivalents

Cash and cash equivalents at beginning of
year

Cash and cash equivalents at end of year

Supplemental cash flow information           Often there is an extra item
                                             which accounts for taxes and
Cash paid for                                interest.

income taxes

interest


Note that in itself, negative free cash flow isn't a bad thing.  Fast 
growing companies often consume cash to build infrastructure, new stores
etc.  Cash flow tends to be less smooth than income.  Special note should
be taken if cash flow and income amounts regularly are very different.

Q.  What is the format of a balance sheet?

A.  The Balance Sheet, also known as "Statement of Condition",
"Consolidated Statement of Financial Position" etc., consists of two
parts, "assets" and "liabilities and shareholder's equity".  Always the
total is the same on both sides; assets = liabilities + shareholder's 
equity.  Usually only two years worth of information are included
(unlike the other statements).  Bennett Stewart's Quest for Value
suggests thinking in terms of "operating" (asset side) and "financing"
(liability side), since "assets" include things like property and
inventories (stuff used to run a company) and liabilities include debt
and equity (stuff used to pay for a company).

Assets                                       This is the "operations"
                                             side; stuff that runs a company
                                             is here.

Current Assets:                              "Current" assets are in theory
                                             things which are easy to
Cash and cash equivalents                    liquidate.  This includes
                                             cash and short-term securities,
Marketable securities                        marketable securities, accounts
                                             receivable and inventories.
Accounts receivable                          For companies with much
                                             inventory "last in first out"
Inventories                                  (LIFO) vs. "first in first out" 
                                             (FIFO) valuation may be
Total current assets                         important.  True liquidation
                                             value may be rather different
                                             than that stated here.

Property plant and equipment                 PP&E may include land, equipment
                                             and machinery.  The value on the
Less accumulated depreciation                books may overstate or understate
                                             true liquidation value.

Other assets                                 This may include anything from
                                             royalties to brand name to
Intangible assets                            "goodwill", the amount in excess
                                             of market value paid for a
Less accumulated goodwill                    bought company.  Estimating this
                                             true value is difficult,
Total Assets                                 especially for companies which
                                             rely on R&D or brand name.

Liabilities and Shareholder's Equity         This is the "financing" side;
                                             stuff that pays for a company's
                                             operations are here.

Current liabilities                          This includes accounts payable,
                                             short-term and current part of
Accounts payable                             long-term debt, dividends,
                                             income taxes and some other
Short-term debt                              accrued liabilities (e.g.
                                             payroll).  At the very least      
Dividends payable                            a company should be able to
                                             easily "pay for" current
Current portion of income taxes              liabilities.

Other accrued liabilities                    Stewart talks about non-interest
                                             bearing current liabilities
Total current liabilities                    (e.g. accounts payable), which
                                             is money that has no cost which
                                             can fund a business (what Warren
                                             Buffett calls "float").  The
                                             Rule Makers have the "flow ratio"
                                             which compares current
                                             liabilities to current assets.

Noncurrent liabilities                       The rest of debt is included
                                             here, as well as other
Deferred income taxes                        liabilities such as deferred
                                             income taxes and certain
Long-term debt                               benefits.  
Other noncurrent liabilities

Total liabilities

Shareholder's Equity                         This number (also known as
                                             the "book value") is in theory
Preferred stock                              the liquidation value to
                                             shareholders after all liabilities
Common stock, at par value                   are paid off.  In practice it
                                             may be thought more of a measure
Additional paid in capital                   of what is "put into" a company
                                             than what may be "taken out".
Retained earnings
                                             Par value so far as I can tell
Treasury stock at cost                       is a completely irrelevant
                                             number.  Together with "paid in
Total shareholder's equity                   capital" it is a measure of how
                                             much equity was raised from its
Total liabilities and shareholder's equity   IPO or secondary offerings.

                                             Retained earnings is money kept
                                             to fuel the business.  Treasury
                                             stock is repurchased shares.

Note that all three statements convey important information.  They are
also interrelated.  For example, when a sale is booked it could have
three entries: sale amount (income statement), cash received (cash flow
statement) and accounts receivable (amount owing for sale not paid in cash).

Many "efficiency" ratios are based on some sort of asset measure.  Return
on assets, return on equity and return on invested capital all measure
cash production per dollar invested.  Days in inventory, days sales
outstanding and days payable outstanding measure how fast inventory,
receivables and payables respectively are turned over.  Cost of capital
is a measure of how much financing costs, real and implicit, come from a
company.

The ultimate measure is how much cash can be drawn out of a company over
its lifetime.  This depends on industry and characteristics, efficiency,
"moats" around a company, hidden assets (e.g. appreciated real estate)
and many more things.  Spending some time on financial statements is an
important first step to understand a business.

Q.  Where may I read more about this stuff?

A.  Here's a short bibliography.

How to Read a Financial Report: Wringing Vital Signs Out of the
Numbers, 5th Edition --- John A. Tracy 

    Easy-to-understand, step-by-step treatment of financial
statements.

Keys to Reading an Annual Report (Barron's Business Keys) ---
Welton, Friedlob

    Another easy-to-understand financial statement book.

The Interpretation of Financial Statements : The Classic 1937
Edition --- Ben Graham, Spencer Meredith, Michael Price

    Many useful insights.  Not so useful for GAAP, since accounting has
    changed since 1937.

The Analysis and Use of Financial Statements --- White, Sondhi,
Fried

    Very comprehensive description of financial statements.                                              
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Q. What is "accrual" vs. "cash" accounting?

A. In the easiest kind of company, say a lemonade stand, all transactions are in cash. However, most companies use and grant credit. Furniture dealers often offer several months before payment need be received from consumers. Similarly many companies purchase from
suppliers using credit.

This presents a dilemma to bookkeepers. When should a sale be recognized? Is it when the item is shipped or when the cash is received, or somewhere in between?

The income statement is based on the "accrual" principle, i.e. a sale (or cost of sale) should be recorded when the item is shipped.
[The cash flow
statement is based on when the cash actually comes in. In the case of the furniture company, "income" (i.e. the sale) is recorded before the cash is received. For a purchase using credit, the "cost" is recorded before cash is spent.] Should be in its own section, not with accounting method.

Way, way too wordy and very inaccurate. There is no real dilemma since it is generally quite clearly governed by IRC, SEC, FASB and GAAP. In any case, a bookkeeper would not be the one determining accounting method. If there is a choice to be made, an accountant would make it, not the bookkeeper.

Cash basis accounting recognizes income on the date when received regardless of the date services were rendered or items were shipped and recognizes expenses on the date when paid regardless of the date the goods were received or the services were rendered for the company.

Accrual basis accounting recognizes income on the date services were rendered or the item(s) were shipped regardless of when payment is actually received and recognizes expenses as of the date goods are received or services are rendered regardless of the date they are actually paid for by the company.

Income statements may be based on either method of accounting but must be based on the method used by the company for tax purposes.

All public companies are required by SEC (and IRS) to use the accrual method of accounting.

Small companies with inventory may use the hybrid method of accounting which accounts for the cost of goods sold on the accrual method of accounting with all other things being accounted for using the cash method or any acceptable hybrid method of accounting that will accurately reflect inventory and cost of goods sold.
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Dear RooCat,

Point taken. Yes, there is no real dilemma.

How would you suggest I state this? Perhaps I should just cut out the other comments and say "cash" accounting vs. "accrual" accounting.

My point is that som people just think of EPS, and don't know what or why a cash flow statement. Can you suggest a succint way to say that?

Thanks

Lleweilun Smith
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Thanks for taking on this project. It will be a big, big help to be able to refer people to the FAQ when answering questions.

For some of the longer topics, it might make things cleaner if you post individual messages and then make the FAQ link to those posts. See the Foolish Workshop FAQ for an example of this method.

http://boards.fool.com/Message.asp?id=1030063001715000

A glossary is a great idea as well.

Thanks again! I would be happy to help with any sections of this FAQ.

Mike
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Perhaps I should just cut out the other comments and say "cash" accounting vs. "accrual" accounting.

Yes, this would be my choice. Then, say also see "Cash Flow Statement". Discuss the whys of Cash Flow Statements by itself. Then relate that to EPS under which you could expand on what Cash Flow vs. net profit means to the shareholder.

Good start. I'll try to read the rest of what you've done more thoroughly and comment if I see any other areas you need to clarify.
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You have taken on an excellent project that is being provided in the true spirit of giving to your fellow Fools. I happen to think that this document should be required reading for all traversing the Fool Boards. I never could understand why this Board was not as active as some of the stock boards.

I think what might be of use is some sort of "pep-talk" if you will as part of an introduction that lets folks know just how important it is to gain an understanding and work with the financial statements if they are going to understand how the company makes money, what the future outlook for the company is, and just what is it that would make this company a good investment.

Also perhaps a brief explanation of how the three statements are tied together.

I'll be happy to read through the FAQ in more detail and see if I can add anything else.

Thanks again for doing this worthwhile project.

Ev Luecke - St. Louis, Mo.
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Hi. It's nice to see a FAQ developing here! I agree with the Fool who wrote that this should be a requirement, to learn how to read these things and figure out what's up with a company before investing. I can't do that yet, so I haven't started a portfolio yet either.

I will look for that book on reading financial reports. I work at Barnes & Noble so I ought to be able to get my hands on it!

Thanks for the effort on the FAQ. I will be checking in on its progress and hope to use it as it evolves.

Tracie
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