How to Read a Financial Report: Wringing Vital Signs Out of the Numbers

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HOW TO READ A FINANCIAL REPORT

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HOW TO READ A

WRINGING VITAL SIGNS OUT OF

Seventh Edition

JOHN WILEY & SONS, INC.

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FINANCIAL REPORT

THE NUMBERS

JOHN A. TRACY

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Copyright © 2009 by John A. Tracy. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical,

photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without

either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance

Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 464-8600, or on the web at www.copyright.com. Requests to the

Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201)

748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make

no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifi cally disclaim any implied

warranties of merchantability or fi tness for a particular purpose. No warranty may be created or extended by sales representatives or written

sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where

appropriate. Neither the publisher nor author shall be liable for any loss of profi t or any other commercial damages, including but not limited to

special, incidental, consequential, or other damages.

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Library of Congress Cataloging-in-Publication Data

Tracy, John A.

How to read a fi nancial report : wringing vital signs out of the numbers / John A. Tracy. — 7th ed.

p. cm.

Includes bibliographical references and index.

ISBN 978-0-470-40530-7 (pbk.)

1. Financial statements. I. Title.

HF5681.B2T733 2009

657'.3—dc22

2008047055

Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1

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PREFACE TO THE SEVENTH EDITION

When I started this book, we had no grandchildren; we now have 12. At the time

the fi rst edition was released in 1980, the Dow Jones Industrial Average hovered

around 850 (really!). This most - watched stock market index reached 11,700 in

early 2000, and then it abruptly plunged, causing a big dent in my retirement

savings. The Dow recovered over the following years, but then dropped again.

As I write this sentence the Dow is on the north side of 8,000. As J. P. Morgan

once said: “ The market will fl uctuate. ”Millions of individuals keep their money

in the stock market, and stock investments are a large part of most retirement

plans. Knowing how to read a fi nancial report is as important as ever.

In the Preface to the sixth edition I spoke about the alarming surge of fi nancial

reporting frauds that culminated in the infamous Enron scandal, which brought

down the venerable CPA fi rm Arthur Andersen. The fallout from these fi nancial

frauds was widespread and caused billions of dollars of losses to investors. The

good news is that we have come a long way from those dismal days.

The federal legislation passed in response to the Enron debacle has been

largely effective. Corporate executives and CPA auditors of public companies

now operate under new rules. The general view is that the new rules govern￾ing fi nancial reporting and auditing will make the stock market a fairer place

to invest money. But we shouldn ’ t let our guard down. The fi rst defense is, as

always, to have a clear - minded understanding of fi nancial statements and the lim￾its of fi nancial reporting.

This edition catches up with the major changes in fi nancial reporting and

auditing since the previous edition. At the top of this list is the movement toward

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international fi nancial reporting and accounting standards. At the same time, the

basic architecture of the book remains unchanged. The framework of the book

has proved very successful for more than 25 years. I ’ d be a fool to mess with this

success formula. My mother did not raise a fool. Cash fl ows are underscored

throughout the book. This cash fl ow emphasis is the hallmark of the book.

All the exhibits in this edition have been refreshed to make them clearer

and crisper. I prepared these exhibits as Excel worksheets. To request a copy of

the workbook fi le of all the exhibits, please contact me at my e - mail address:

[email protected] . I ’ m retired now, so I have more time to read and answer my

e - mails. I express my sincere thanks to all of you who have sent compliments

about my book. The royalties from sales of the book are nice, but the bouquets

from readers are icing on the cake.

Not many books of this ilk make it to the seventh edition. It takes a good

working partnership between the author and the publisher. I thank most sincerely

the many persons at John Wiley &Sons who have worked with me on the book

for going on three decades now. The suggestions on my fi rst draft of the book by

Joe Ross, then national training director of Merrill Lynch, were extraordinarily

helpful. The continuing support of Debra Englander, Executive Editor at Wiley,

is much appreciated. And I ’ d be remiss without mentioning Mary Daniello and

Kelly O ’ Connor, who have been such a pleasure to work with. Thanks go, too, to

the staff at Cape Cod Compositors.

I dedicate this book to Gordon B. Laing, my original editor and sponsor of

the book. His superb editing was a blessing that few authors enjoy. His guidance,

encouragement, and enthusiasm made all the difference. He was a true gentle￾man who taught me a great deal about writing. His criticisms of my manuscript

drafts were sharp but always kindly and supportive. Gordon took much pride in

the success of the book — as well he should have! To my great sorrow Gordon

died in early 2003. If somehow he can hear this message, I ’ d like to say again:

Gordon, I couldn ’ t have done it without you.

John A. Tracy

Boulder, Colorado

March 2009

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CONTENTS

Part One—Components and Connections in

Financial Statements

1 Starting with Cash Flows 3

2 The Three Financial Statements 9

3 Profi t Isn’t Everything 19

4 Sales Revenue and Accounts Receivable 27

5 Cost of Goods Sold Expense and Inventory 33

6 Inventory and Accounts Payable 39

7 Operating Expenses and Accounts Payable 45

8 Operating Expenses and Prepaid Expenses 51

9 A Unique Expense: Depreciation 57

10 Accruing the Liability for Unpaid Expenses 67

11 Income Tax Expense and Its Liability 73

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viii Contents

12 Net Income and Retained Earnings;

Earnings per Share (EPS) 79

13 Cash Flow from Operating (Profi t-Making)

Activities 85

14 Cash Flows from Investing and Financing

Activities 93

15 Footnotes to Financial Statements 101

Part Two—Financial Statement Analysis

16 Impact of Growth and Decline on Cash Flow 111

17 Financial Statement Ratios 123

18 Profi t Analysis for Business Managers 139

Part Three—Reliability of Financial Reports

19 Accounting and Financial Reporting Standards 151

20 Accounting Methods and Massaging

the Numbers 161

21 Audits of Financial Reports in the

Post-Enron Era 173

22 Parting Comments 187

Index 197

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HOW TO READ A FINANCIAL REPORT

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Part One

COMPONENTS AND

CONNECTIONS IN

FINANCIAL STATEMENTS

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1

STARTING WITH

CASH FLOWS

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