Structure
1. Balance Sheet
2. Income Statement
3. Overstating Profit
Every business asks themselves two questions, How much is the firm worth? How much did the firm make last year? Each of the financial statements that are released by firms attempt to answer these questions. So it seems appropriate to examine what the statements are saying.
The balance sheet is the firms answer to the question of how much the firm is worth. It answers this question by using a fundamental equation. The equation is
Net worth = Total Assets - Total Liabilities
Total Assets are the items that a firm owns that has current or future value. This includes such items as cash, accounts receivable, machinery, buildings and goodwill.
Total Liabilities is the sum of what the firm owes. This are non owner claims on the firms assets. This occurs because most firms borrow to finance their acquisition of assets. The amount that a firm still owes to its creditors is listed here. Other common liabilities are the wages that have to be paid to the employees of the firm and what the firm has to pay its workers when they retire and begin drawing their pensions.
Net Worth is the answer to how much is the firm worth? A firm is worth the value of what it owns less the amount that it owes others.
To an investor, a more appropriate question is, how much is the firm worth to me? This is found by taking Net Worth and dividing by the total number of shares outstanding. This figure gives the firms value per share. Then each investor multiplies the value per share by the number of shares that they own. This gives them the value of the firm to the individual investor.
The second question that a firm asks is, how much did we make last year? The income statement answers that question. The income statement follows this basic equation:
Net Income = Total Revenues - Total Costs
Total revenues is equivalent to total sales. Most firms have more than one product, so total revenues is the sum of the revenues for each product. The revenue for each product is determined by the formula price x quantity of the good sold. Unlike national income accounting most firms do not count production that is not sold. An exception may occur when the item being produced has been ordered and take many years to produce, such as a ship. Future revenues may be allocated over the time of production.
Total Costs is the value of all materials and labor used to produce the goods sold. Note that materials produced but not sold are added into inventories as an asset. The costs from producing these unsold goods determines the value of inventory and are not included in total costs. Total costs are only the costs that are associated with the goods that have been sold. In addition machinery and building have a tendency to wear down, the cost of this wear down is called depreciation and is a part of total costs.
In addition, net income is taxed so this must also be removed. Once again a basic equation tells us how to calculate this.
Net income after taxes = Net income - Net income*Tax rate
So the relevant answer to the question of how much the firm made last year is net income after taxes. This is the addition to the firms net worth that occurred last year.
There are some common ways in which firms can overstate their profits. We look at these methods. Note this is only a guide not the formal method of analysis for these problems. this is presented only to inform you of what you need to be aware of when looking at an income statement.
Understate Depreciation. By overstating how long a machine will last the firm can understate the amount of depreciation that should removed from revenues. For example, in the late eighties and early nineties many firms indicated that the computers that they bought would last ten years. The reality is that computers are outdated and usually replaced in three years. This means that the firms that used ten years for the life of their computers only reported depreciation on computers at 1/3 of its true value.
In addition, many firms calculate depreciation based upon historical cost. This is also misleading. In a period of inflation (or rising prices) the true cost of depreciation is higher. This is because the cost to replace the worn out machinery is higher. For example, assume that a firm depreciates a piece of machinery at a constant rate of 10% per year , the cost of the machinery 6 years ago was $1,000 and the current replacement cost is $1,500. The firm using historical values would then report depreciation of $100. However the cost to replace that portion of the machine that wore out would not be $100, it would be $150 (10% of current replacement cost). So by using historical prices the firm does not reflect the true cost of the worn out machinery. (Note, this is a constant debate between economists and accountants, for the accounting side of the argument please see a basic accounting text.)
Overstate the value of increased inventories. If a firm can not sell all that it produces it adds the unsold portion to inventories. However, if the firm failed to sell it in the current period then they may never be able to sell it. If this is the case, then the firm should put the costs of production of this unsellable production into total costs. However many time firms pretend that they can sell this production at some point in the future and add the value to inventories. Eventually firms do write the value of unsold inventories, however when they do write off the inventory they write it off at the cost of production, they do not include the additional costs of storage. This means that even if the firm does eventually write off the cost of producing unsold goods they write it off at a value that is too low.
Ignore new liabilities. When certain liabilities are incurred some part of it should be reported on the income statement, firms have traditionally ignored these costs. Examples of these types of liabilities are lawsuits and increases in retirees health benefits.
Overstate sales. Some new sales are generated by the firm landing money to the buyer. The full amount of this sale is created to revenue, but some of these loans will not be collected. The amount of the loan that will not be collected should not be credited to sales. This is a tricky part of analysis. The allowance for bad debts is designed to allow for uncollected credit sales. However this allowance is often times too small, to determine if a firm has too small of an allowance for bad debts you should look at the amount of write-offs due to uncollectible receivable that have occurred over the past ten years. If the total amount of write-off is large relative to the amount of receivable then the allowance for bad dents is too small.
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