######################################## #Written by David Tam, 1997. # #davidkftam@netscape.net Copyright 1999# ######################################## 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.