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The Quality of Financial Information

Published December 19, 2013 by Mayrbear's Lair

financial-reporting

The holidays are creeping up on us and I just realized, I neglected to post Wednesday’s blog. This post is significant to my research work in financial analysis because it helps us understand that in order to keep apprised of how well a company is doing, the quality of financial reporting is the key component that determines whether the statements paint an accurate portrait of the firm or not. For example, because of scandals that occurred from companies like ENRON, AEI, and WorldCom, a revolution occurred with respect to financial reporting. According to Bahnson and Miller (2002) old practices and habitual thought processes with respect to accounting principles were put aside and replaced with new strategies and systems. As a result, accountants and finance executives are expected to embark on a different path that embraces a new shift in the bookkeeping paradigm called quality financial reporting (QFR). For financial managers to consider investing in a company they are looking for accurate information about two significant components: (1) opportunities to receive future cash flows, and (2) information about those opportunities (Bahnson & Miller, 2002). QFR provides complete information to investors and creditors to give them confidence in a company’s performance abilities. Much of the information provided on financial statements can be intimidating to many managers and entrepreneurs. This is a typical response from those who lack the financial intelligence required that can help them make more effective decisions in running their firms. Berman and Knight (2008) explain that the figures on financial statements help strategists determine a variety of estimates and assumptions. Learning how to assess that information helps planners to identify the bias of the data provided, in one direction or another (Berman & Knight, 2008). In this context, where financial results are considered, bias merely suggests that the numbers may be skewed in a certain direction. In other words, bookkeepers and finance professionals are trained to use certain assumptions and estimates rather than others who view the reports for other purposes. QFR is essential because it provides sufficient information to identify not only the source of those gains, but whether there are any other events or circumstances that could have an effect out the outcome, like pending litigation.

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Much of the information provided on financial statements can be intimidating to many managers and entrepreneurs. This is a typical response from those who lack the financial intelligence required that can help them make more effective decisions in running their firms. QFR is effective at painting an accurate view of the company’s financial condition. For example, revenue should not be recognized until there is evidence that a sale has transpired. In other words, the recipient has received delivery of the product or completion of the services rendered and revenue is collected. Many companies, however, violate this policy and report revenue prematurely without all criteria being met. Analysts can look for clues of false revenue reporting in the financial reports. For instance, the notes can reveal the company’s position with respect to collecting revenue policies to ascertain whether any changes occurred and determine the reason for the changes as well as the impact they can have.  Another clue is an analysis of the financial statements to determine the pattern of movement from sales, inventory, and accounts payable. For example, spikes in revenue during the final quarter may be a sign of revenue reported prematurely unless there is a specified reason for the spike to generate sales (like an end of the year close-out sale to liquidate inventory). Companies do not commonly experience spikes from sales in the fourth-quarter so this immediately raises flags. Other methods companies use to raise revenue levels include keeping the account records open longer at the end of the allotted accounting period. Some corporations on the other hand, use deceptive tactics like reporting gross sales rather than net to show higher revenue. For example, a company that is acting as an agent for another organization may collect their revenue in the form of a commission. According to regulations set forth by the GAAP (generally accepted accounting practices), agents are not considered the owner of merchandise being moved. Fraser and Ormiston (2010) explain that the GAAP requires the reporting of Gross Revenue for Principal Owners and Net Revenue for those who act as a representative in the in the sale of a product or service.  In other words, because agents are not considered the owners or originators of the product who assume the risk of the merchandise, the company acting as the agency can use the net method for recording revenue. Therefore knowing that a company collects revenue as an agency analysts can scrutinize the data closely to determine whether they reported gross or net revenue.

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QFR is also important because it can help strategists understand the various inventory valuation methods. For instance, there are times when companies produce lower or higher earnings due to the fluctuation of inflation. Analysts again must look to the financial notes to determine the details of the company’s accounting policies to disclose whether the changes in revenue occurred due to LIFO (last in first out) or FIFO (first in first out) inventory cost flow accounting assumptions. If the value of the products sold, for example, falls under its original cost, the product is written down to reflect the market value and is determined by the cost to replace or produce an equivalent. This means that write downs can also play a part in the company’s profit margins which affects the comparability and quality of financial reporting. Accounting practices that do not provide details and incorporate misleading information is considered an unacceptable practice and any CEO that signs off on documentation that provides a misrepresentation of the truth is putting their career at risk and may face dire consequences as a result. That should be incentive enough to engage in QFR. To surmise, QFR provides investors the ratios that reveal whether companies are able to buy inventory and pay their bills. Furthermore, they provide profitability ratios that help creditors understand how much capital the company is generating while efficiency ratios reveal how well the company is managing their assets. The more complete these reports are the more likely they are to reduce shareholder uncertainty. In the eyes of investors and creditors, certainty reduces risk and reduced risk, provides shareholders with the satisfaction of a lower rate of return. In the long run, a lower rate of return means a lower cost for capital, which ultimately produces a higher stock price for the company. In conclusion, providing quality financial information is an essential component to management that contributes to a company’s long term success.  Tomorrow’s blog will post on schedule and will take a look at how different conflicts of interest can effect quality reporting.

References:

Bahnson, P., & Miller, P. (2002). Quality financial reporting. New York, NY: McGraw-Hill.

Berman, K., & Knight, J. (2008). Financial intelligence for entrepreneurs. Boston, MA: Harvard Business School Press.

Fraser, L., & Ormiston, A. (2010). Understanding financial statements. Pearson Education.

Eastman Kodak Cash Flow Statement

Published December 16, 2013 by Mayrbear's Lair

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Early last week, I revealed the significance and meaning of cash flow statements. As we discovered, a corporation’s cash flow statements reveal a company’s ability to generate and allocate working capital. In fact Tracy and Tracy (2012) describe the movement of a company’s cash flow as the bloodline of a business due to its continual need to keep in circulation to avoid fatality (Tracy & Tracy, 2012). The focus of this post is a continuation of the analysis work of the Kodak Corporation’s financial condition provided from the data contained within their 2007 Annual Report. The analysis will reveal how well they managed their working capital. The study will also examine the following components that are contained within the cash flow statement: (a) the changes in balances that occurred with respect to Kodak’s assets and liability accounts such as inventory, accounts receivable, supplies, insurance, accounts payable and other unearned revenues; (b) adjustments that occurred as a result of their investing activities which include the purchase and sale of long term investments, equipment, and property; (c) changes that transpired from Kodak’s financing activities that also had an effect on the balances of long term liability and stockholders’ equity accounts due to such items as deferred income taxes and stock activity; and (d) the supplemental information provided from the notes that report the exchange of important items that did not involve cash such as income taxes and interest paid all of which may have had an effect on the flow of their working capital. The findings of this research will conclude that Kodak’s cash management strategies were effective in keeping enough operating capital available needed to operate during that time.

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The Significance of Cash Flow Statements

Companies risk running out of money and can go bankrupt without effective cash management strategies in place; plain and simple. Cash flow statements act as a tool to help analysts assess a company’s ability to generate and disperse their working capital. Friedlob and Plewa (1995) assert that in order for a company to run efficiently, they must budget their cash flow operations. Managing cash flow is a complex issue that requires today’s cash managers to have general knowledge in accounting practices and the ability to develop effective networking skills because of their extensive involvement in the company’s banking relationships, investment decisions, and forecasting decisions. For example, managing cash inflow from sales require that cash managers know how to extend credit and collect revenue so that it can be used effectively for functions like: (a) accelerating cash receipts to move cash faster using methods like fast bill pay, offering cash discounts and electronic transfers; (b) the planning and delaying of disbursements to gain the maximum use of cash; (c) forecasting cash inflows and outflows to avoid such events like overdrafts, deficiencies, and late payments; (d) investing idle cash to convert excess cash into short-term investments and back into cash again when they are needed; (e) reporting cash balances to make it convenient for managers to monitor and determine a company’s cash position; and (f) monitoring the cash flow system to assess whether the system is operating as designed and that goals are being achieved (Friedlob & Plewa, 1995). To ensure the cash is being used efficiently, managers require skills to help them maximize the earning potential of their organization and cash flow statements serve as tools that help them monitor and manage working capital.

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Kodak Annual Report Cash Flow Statement Analysis

An analysis of Kodak Company’s cash flow statement will reveal their ability to generate and disperse working capital they acquired from their operating, investing, and financing activities during a specified accounting period. Fraser and Ormiston (2010) explain that cash flow statements reveal the absolute dollar amounts of a company’s various accounts and are prepared by calculating all of the changes that are reflected in the balance sheet accounts, including cash; then itemizing those adjustments into cash flow categories to reflect the changes in their operating, financing, and investing activities (Fraser & Ormiston, 2010). For example, a quick overview of Kodak’s Cash Flow Statement (see Exhibit A) shows that in 2005, Kodak generated $1,208 (in the millions) from operating activities that decreased about 21% in 2006 to $956 and then took a dramatic 67% drop in 2007 when they only showed that $314 was generated in cash from their operating activities. In addition, the cash statement reveals that the income generated during each of those years was reflected as a loss. In fact a closer look reveals that changes in cash occurred with positive balance results not from income that was generated, but were due to the adjustments that were made with respect to depreciation and amortization, restructuring and impairment charges, as well as increases in receivables and inventories that were reported. Regardless of the losses from income reported each year, the statement revealed that Kodak’s operating activities during that accounting period showed they generated enough cash to cover their outflow leaving them a positive ending balance each year.

Kodak’s cash flow statement also disclosed that in 2005, the net cash they collected from investing activities was reported as a loss of $1,304, (in the millions) but in 2006, they only showed a loss of $225. This means the cash they received from investing activities jumped up about 83%. In 2007 they reported a considerable profit gain of $2408. A closer look at the statement to identify the source of that gain points to their other investing activities provided from the financial notes of the report, that explained the gain was due to proceeds Kodak received from the sale of the Health Group and HPA businesses. In the meantime, the statement also shows that in 2005 the cash generated from Kodak’s financing activities revealed a profit of $533 while in 2006 those figures plummeted about 170% when they reported a loss of $947. The numbers dived even further in 2007, however, when they showed a 235% loss of $1,280.  The report revealed those losses were due to the payment of long term borrowing debt and shareholder dividends.

A general overview of the figures reported on Kodak’s cash flow statement revealed that the totals for operating, investing, and financing activities all showed positive balances at the end of each of those years. For example, in 2005 they showed a balance of $1665 that dropped down about 12% in 2006 to $1469. In 2007 however, the cash balance at the end of that year was reported at $2,947 which reflected an impressive increase of about 101% in only one year. This result occurred due to the profits Kodak generated from their investing activities and not because of their operating or financing activities with both reported considerable cash losses.

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Conclusion

Without the use of cash flow statements, businesses risk running out of money and going bankrupt. The Kodak Company’s cash flow statement disclosed that the increases and decreases which occurred had an effect on how the company utilized their working capital that were produced from their operating activities and highly liquid short-term marketable securities, that were also considered cash equivalents. In analyzing the figures on the statement strategists could assess Kodak’s financial condition to make more effective decisions about: (a) their ability to generate future cash flow, (b) their capability to meet their cash obligations, (c) what their future external financial needs might be, (d) their success and productivity in managing their investment activities, and (e) Kodak’s effectiveness in implementing financing and investment strategies. The findings of this research disclosed that Kodak was effective during that time with their investing strategies that but that they were struggling to show considerable profit gains from their operating and financing activities. The assessment of the cash flow statement that was conducted, deduced that the Kodak Company was effective at generating and allocating working capital during that accounting period because of their investing activities, however, more productive results were required from their operating and financing activities in order to help them maneuver the organization into a better position to achieve more profitable results.

Appendix A

Assignment 4 Exhibit A

(Kodak, 2008)

References

(2008). Kodak. Washington: Securities and Exchange Commission.

Averkamp, H. (2013). Cash flow statement. Retrieved November 21, 2013, from Accounting Coach: http://www.accountingcoach.com/cash-flow-statement/explanation/1

Fraser, L., & Ormiston, A. (2010). Understanding financial statements. Pearson Education.

Friedlob, G., & Plewa, F. (1995). Understanding cash flow. New York, NY: John Wiley & Sons, Inc.

Tracy, J., & Tracy, T. (2012). Cash flow for dummies. Hoboken, NJ: John Wiley & Sons, Inc.

The Statement of Cash Flows

Published December 9, 2013 by Mayrbear's Lair

Water tap dripping dollar bills, Water waste concept

In order to operate a company successfully, leaders must implement cash flow management systems. This helps them work with banks and financial institutions more effectively to collect, borrow, and invest their revenue to conduct business efficiently and profitably. Tracy and Tracy (2012) assert that for owners, one of the most important elements in running a business is maintaining an adequate cash balance to make sure the company does not run out of money. To control cash inflow and outflow, managers devise systems to monitor and control these components. Cash flow statements provide information that lists how a company generated their cash and how they dispersed it. In this context, cash flow refers to the generating of incoming cash and the allocation of outgoing cash (Tracy & Tracy, 2012). Another way to look at the company’s cash flow is to consider it the bloodline of the company’s business affairs. In other words, a company’s cash needs to be in continuous circulation to avoid casualties. The first rule of thumb is to make sure it does not run out, the same way a person does not run out of blood, in spite of devising short term cash flow life-support solutions. In short, without some kind of effective cash management strategy in place, the outcomes can become extremely detrimental for a firm.

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Income statements reveal changes that transpire in the financial condition of an organization during a certain time frame but they do not explain all the changes that occur.  For example, Friedlob and Plewa (1995) purport that working capital accounts like inventory or accounts receivable have an impact on the company’s liquidity, however, this information does not appear on an income statement. Furthermore, a company’s financial condition can change considerably if their mortgage gets paid off or stock is issued in exchange for land. These are all examples of activities that do not affect the income statement (Friedlob & Plewa, 1995). To help identify these issues, cash flow statements provide information to analysts that disclose how changes in working capital affects cash from operations that produced income including: (a) delivering or producing goods for sale, (b) providing services, and (c) other transactions or events. In short, cash flow statements provide valuable information that discloses how a company managed cash inflows so that analysts can determine how they sought or granted credit, how they collected their revenue and whether it was allocated effectively.

example-cash-flow-statement

Cash flow statements reveal how well a company managed the earning potential of their cash. In order to continue operating, companies must have enough cash to run their business. This includes having enough revenue to purchase inventory to satisfy consumer needs, pay their debts and operating expenses, as well as meet the requirements of their investment activities.  Fraser and Ormiston (2010) explain that investing activities are also included on cash flow statements and provide valuable information on: (a) the purchase and sale of securities that are not cash equivalents and productive assets with long term benefits; and (b) lending money and loan collection revenue. Financing actions listed, on the other hand, include the borrowing of funds from creditors and paying off debt principals while obtaining resources from owners that provide them with returns on their investment (Fraser & Ormiston, 2010). This information is significant to creditors, investors, and cash managers who are concerned with liquidity. Effective cash management systems help companies avoid cash flow issues to ensure they are generating a healthy stream of cash required to operate efficiently and earn a profit. An income statement alone does not report how much of sales revenue collected were in the form of cash during a specific accounting period. In addition, the bottom line profit numbers on income statements do not indicate the increase of cash for making a profit. In reality, a company’s cash flow can be about the same, or alternatively can be considerably higher or lower than the profit figures  that are reported on income statements. It is for this reason that analysts look to cash flow statements to get a better picture of how a company utilized their working capital.

References:

Fraser, L., & Ormiston, A. (2010). Understanding financial statements. Pearson Education.

Friedlob, G., & Plewa, F. (1995). Understanding cash flow. New York, NY: John Wiley & Sons, Inc.

Tracy, J., & Tracy, T. (2012). Cash flow for dummies. Hoboken, NJ: John Wiley & Sons, Inc.

Income Statements

Published December 4, 2013 by Mayrbear's Lair

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Corporations exist for the benefit of their shareholders. Comprehending financial statements is an essential skill that can help investors and creditors make more effective decisions with respect to investment management and commercial lending. Alvarez and Fridson (2011) explain that because corporate financial statements are difficult to understand strategists must have a comprehensive knowledge of how to read the data that is contained within these financial statements. The objective of these reports is not to educate the public about a firm’s financial situation. Their goal rather, is to maximize the wealth of their shareholders. In other words, financial statements serve to help leaders develop more effective methods to maximize shareholder wealth while reducing the cost (or interest rate) at which they can borrow and in turn, sell shares of stock at higher rates to generate more wealth for the shareholders (Alvarez & Fridson, 2011). In short, the main objective of financial reports is to help corporations acquire inexpensive capital.

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Financial report Income statements provide a picture that helps analysts determine a company’s profitability. Ittelson (2009) postulates that in order to understand the information that is contained within these statements the reader must first have a better understanding of the item terms they contain. For instance, the terms sales and revenue are identified as the income statement’s top line and are used to measure the capital a company receives from their consumers. The terms profitsearnings, and income on the other hand, are used to measure the company’s bottom line and reflects the amount of capital that is left over as revenue after expenses are deducted. Simply put, revenue is the top line of the income statement while income is considered the bottom line (Ittelson, 2009). Understanding the these terms more clearly can help make it easier for individuals to extract information that is pertinent to them.

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Sales, in the meantime, are considered a major source of revenue for a firm and income statements are utilized to provide analysts a means to measure and assess a company’s operating performance because they help paint a better picture of a firm’s earnings. Fraser and Ormiston (2010) explain for instance, that earnings on income statements provide data for several years. This allows strategists to observe and compare changes and trends that occur over a given period of time (Fraser & Ormiston, 2010). For example, there are two significant causes that can effect changes in sales numbers: (a) price increases and (b) liquidity of sales units. When a company’s sales increase for instance, analysts must determine whether the change occurred due to price increases, volume activity changes, or a combination of both. In other words, strategists use this information to determine whether sales figures are increasing due to price hikes, the movement or liquidity of large volumes of units, or whether it resulted from of a combination of both factors. Generally, as a rule, higher earnings result from moving large units of stock. Another reason could be that higher prices were implemented to keep up with the expanding rates of inflation. Sales figures can also become affected by a cost flow assumption that some accountants used to value inventory. For example, some companies use the last-in, first-out (LIFO) method to report sales and inventory. This strategy allows the last purchases a company makes during the year appear as an expense on their income statements and is reflected on the statement to show higher-quality production earnings. Because of these kinds of strategies, income statements must be assessed accurately to help analysts determine the true picture of the revenue, expenses, and earnings of an organization with an awareness of the imperfections of the accounting system implemented by the manipulation of bookkeepers intended on distorting a firm’s economic reality to impress potential investors.

References:

Alvarez, F., & Fridson, M. (2011). Financial statement analysis: A practioner’s guide. Hoboken, NJ: John Wiley & Sons, Inc.

Fraser, L., & Ormiston, A. (2010). Understanding financial statements. Pearson Education.

Ittelson, T. (2009). Financial statements: A step-by-step guide. Amazon Digital Services, Inc.

Eastman Kodak Balance Sheet Analysis

Published December 2, 2013 by Mayrbear's Lair

Accounting.

A corporation’s balance sheet provides significant data about a company’s assets and liabilities and divulges the true nature of their financial condition. Makoujy (2010) contends that balance sheets are the financial statements which provide an overview of a company’s assets, liabilities, and stockholders’ equity. These documents disclose how much capital is brought into an organization and how it is allocated to satisfy the firm’s liabilities and owner’s equity commitments (Makoujy, 2010). This information is important for helping investors deduce a company’s risk levels by analyzing the profit and loss measurements they provide. It also gives creditors an indication of a firm’s financial condition from the short-term liquidity ratios they disclose. The focus of this research continues with the analysis work centered on the Kodak Company’s financial condition provided from their 2007 Annual Report. This study will take a closer look at the report’s balance sheets to reveal how strategists determine the firm’s net financial position by the information provided in the statements that summarize Kodak’s assets, liabilities, and owner’s equity. The research will disclose how the data from the balance sheets help investors and creditors in their financial decision making by examining the figures that revealed the truth about Kodak’s operating condition and overall net worth during that given point in time. The findings of this research, from evaluating the information provided in the Kodak Company’s balance sheet statements, will determine that the company’s overall financial condition and their stability as a business during that time was below par.

The Balance Sheet’s Function

The true nature of a company’s balance sheet that is provided their annual reports, serves to summarize the company’s assets, liabilities, and shareholder equity during a specified period of time. To understand these concepts more clearly, it is important to comprehend that all the possessions of a company (assets) are either owned free and clear (equity) or were purchased by acquiring debt (liability). To measure a company’s performance levels, Skonieczny (2012) asserts that their balance sheets must follow one important equation in that the total amount of assets must equal the total amounts of both the company’s liabilities and equity or net worth. In other words, the accounting figures of a balance sheet must mathematically balance out by adhering to the following equation:

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For example, when the Kodak Company makes a down payment for property, equipment, or any other expenditure meant to help with the operation of the firm, that payment would be classified as an example of equity. In the meantime, the mortgage payments on their facilities are considered a form of debt (Skonieczny, 2012). Balance sheets can be intimidating and difficult to comprehend for those who are not proficient in mathematics or are untrained and lack bookkeeping skills. To help those that are unfamiliar traverse safely through these accounting waters, one efficient instrument that is used for scrutinizing a balance sheet is the common-size balance sheet. Common-size balance sheets provide the same information only rather than disclosing the actual figures, the values are provided as percentages with a common denominator. This strategy enables investors and creditors to compare account sizes as percentage rates over a period of time. This kind of balance sheet is also ideal for helping investors identify and observe trends.

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Kodak Company’s Annual Report Findings

Even though they may be difficult to comprehend, balances sheets provide vital information that creditors use to measure a company’s short-term liquidity. Fraser and Ormiston (2010) postulate that the information provided on the balance sheet with respect to a company’s inventory is an important element in the examination of a company’s liquidity. This component is significant, for instance, because creditors can determine the ability of an organization to meet currency needs as they arise (Fraser & Ormiston, 2010). In addition these figures can offer insight as to how well a company is performing during a certain period in time. For instance, Kodak’s balance sheet (Exhibit A) indicates that in 2006 their current assets (including cash equivalents, short term investments, accounts receivable and inventories) totaled about $5.5 million, while in 2007 that figure rose to $6. However, the total assets reported in 2006 were much higher ($14.3 million) than they were in 2007 where it dropped down about a million dollars ($13.6 million). This indicates that the long-term assets values increased during that time period which may have resulted from the accumulated depreciation values.

Shareholders are interested in a company’s balance sheet because it provides valuable information that can help them determine a company’s risk levels. For example, Kodak’s balance sheet (Exhibit A) indicates that in 2007, their assets totaled about $14 million while their liabilities reflected a total amount of about $11 million. To help investors ascertain the ratio measurements they may look to a common-size balance sheet to give them a simpler overview of their financial condition. Using this strategy analysts would conclude that during that given period, the Kodak Company committed a substantive percentage (around 78%) of their total assets on meeting their debt obligations leaving only 22% that was allocated towards shareholder equity. Those figures are a slight improvement however, from 2006, whose figures during that year disclosed that the company committed 90% of their total assets to meet their debt requirements. To investors and creditors these figures represent a high level of risk and a clear indication that although they were making progress, the Kodak Company was still not in a healthy financial condition during this period in time.

Conclusion

Balance sheets measure a firm’s profitability and provide shareholders important information on current and future risk levels. It is for this reason that stockholders and owners require a system to help them measure a company’s performance levels in a periodic manner. The balance sheets help provide investors and creditors with information that allows them to determine whether a company is operating in a profitable manner which also helps them predict whether stock prices will rise or fall. A closer examination of the Kodak Company’s balance sheets indicates the risks they took were considerable. However, it also revealed that their strategies and cutbacks were slowly proving effective which allowed them to keep the company operational. In conclusion, the findings of this study’s assessment with respect to the Kodak Company’s balance sheet provided from their 2007 Annual Report, deduced that although the Kodak Company was making a valiant effort to maintain operations, they were still struggling in their efforts to achieve profitable goals during that given time.

Exhibit A

Kodak Balance Sheet Exhibit A Assignment 2

(Kodak, 2008)

References

(2008). Kodak. Washington: Securities and Exchange Commission.

Fraser, L., & Ormiston, A. (2010). Understanding financial statements. Pearson Education.

Makoujy, R. (2010). How to read a balance sheet: The bottom line. New York, NY: McGraw-Hill.

Skonieczny, M. (2012). The basics of understanding financial statements. Schaumburg, IL: Investment Publishing.

Understanding the Balance Sheet

Published November 25, 2013 by Mayrbear's Lair

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Making investments in a company’s stock is a significant event in an individual’s life because an uninformed decision can become quite costly. To make the most informed decisions, individuals should conduct extensive research to help them make choices they feel secure about. To achieve this, many people can look to a company’s annual report for more insight into their financial condition. Roth (2008) explains that a company’s financial statements contained within their annual report are a significant asset to help individuals who are looking to make a sound investment in a company’s stock. They help people make better assessments by learning about a company’s strategies, financial health, and even information about their behavioral and moral values (Roth, 2008).  For this blog post, we will address our fictitious friend Liz who is confused about the true state of the Target Corporation’s financial condition (See Exhibit A below). This is a brand she is considering investing in because of her emotional attachment to it. However, the figures her buddy Tom disclosed upon reviewing their balance sheet suggested that investing in Target was not a sound idea because of the substantial percentage amount (74%) they invested of their total assets as risky obligations. Tom’s percentage rate caused Liz confusion because her calculations arrived at a different figure which was lower and amounted to 65%.

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To help Liz with her confusion, we must explain how Tom arrived at his position. First, let’s analyze how Liz calculated her figures. For example, at the end of their fiscal year in February, 2008, the Target Corporation had liabilities (including current and long-term) that rounded off to about $29 million, while their asset totals came to about $45 million. To help Liz better understand these debt structure figures, she looked to a common-size balance sheet formula to translate these numbers into percentages. By taking the $29 million liabilities figure and dividing it by the $45 million asset figures, Liz came up with 65% as amount of debt Target has accrued. Tom, however, arrived at a figure that was nearly 10% higher which confused Liz because her math equations incontrovertibly added up.

Calculating-Percentages

What Liz did not take into consideration in her calculations, however, were the company’s commitments and contingencies contained within the notes of the report.  Fraser and Ormiston (2010) suggest that even though the balance sheet may not reflect a dollar amount in this category, this disclosure is intended to draw attention to the information that is located in the notes of the financial statements. These notes are significant because they list the commitments of a company’s contractual obligations that may still have an adverse effect on their financial outlook. Because companies engage in complicated financial reporting procedures that include such things as product financing, sales of receivables with recourse, limited partnerships and joint-ventures, that are not required to be included on the balance sheets, they are however, provided in the notes (Fraser & Ormiston, 2010). These are complicated components that are difficult to comprehend but play an important role in painting a full picture of the company’s operations. In other words, there are other factors that are not reported on a company’s balance sheet with unpredictable outcomes that can have an effect on Target’s future liabilities. In other words, Liz also needed to include in her calculations the figures provided in the commitments and contingency notes as well. These notes revealed for instance, that Target also had further contractual obligations and operating leases that extended beyond the year 2008 which included lease payments of $1,721 million with options that could extend the terms of the lease. Their contractual obligation payments also consisted of interest rates and a $98 million commitment in legally binding lease payments for the planned openings of future facilities that were scheduled to occur in 2008 or later. Tom arrived at his additional 10% figure because he factored in the information of these provisions to his equations and Liz did not.

Exhibit A

Target Example

References:

Fraser, L., & Ormiston, A. (2010). Understanding financial statements. Pearson Education.

Roth, R. (2008). The writers guide to annual reports. Atlanta, GA: Booksurge.com.

The Balance Sheet

Published November 22, 2013 by Mayrbear's Lair

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What is a Balance Sheet?

Balance sheets are financial statements contained within a company’s annual report. The information provided on a balance sheet reveals what a company owns, how much it owes and what remains in the form of equity for its shareholders. Skonieczny (2012) explains that a company’s balance sheet discloses their financial position on a particular day like the end of the year or the first quarter and are based on the following important equation:

assets = liabilities + equity

The reason it is called a balance sheet is due to the fact that the accounting equation has to balance out at all times (Skonieczny, 2012). This means that the assets must always be an equal amount that reflects the companies liabilities and equity. In other words, all possessions (assets) are either owned free and clear (equity) and were purchased by acquiring debt (liabilities). For example, a down payment on a company building is an example of equity, while the monthly payments are an example of debt. The information provided on a balance sheet is comprised of the company’s: (a) assets, including current assets, long and short term investments, property, plant and equipment, plus any other tangible and intangible assets; (b) liabilities such as accounts payable, salaries, interest and taxes paid, bank notes, loans, mortgage obligations and other debts; and (c) stockholder’s equity including capital stock and retained earnings.

BALANCE-SHEET

What is a common sized balance sheet?

Makoujy (2010) asserts that an expense occurs when value is lost and that balance sheets help strategists understand not only what a company possesses during a certain period of time, but how much it has grown or lost during that time (Makoujy, 2010). In the meantime, common-size balance sheets are helpful instruments that allow companies to assess their financial situation. Fraser and Ormiston (2010) explain that a common-size balance sheet specifically serves as a tool designed for vertical ratio analysis as a means of measuring and comparing various components that have a common denominator (Fraser & Ormiston, 2010). In other words, it is a kind of balance sheet that shows each dollar amount as a percentage of a common number. This allows analysts to compare account sizes over time as the balance sheet grows and the figures change. They are also effective for identifying and observing trends.

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How to create a common sized balance sheet?

To create a common-sized balance sheet, analysts must convert each asset, liability, and shareholders’ account to a percentage amount so that the balance sheet reflects that the total assets are equal to the total liabilities and shareholders’ equity figures. To create a common-sized balance sheet the amount of total assets must be determined first, like $100,000 for instance. Next the amount of each asset is divided by the amount of total assets. Then each result amount is multiplied by 100 to establish the common-size percentage for each asset. If the company’s cash account, for example, is $30,000, you would divide $30,000 by $100,000 to obtain a figure of 0.3. You would then multiply that 0.3 figure by 100 to arrive at 30% as the common-size percentage for the cash account. In other words, the company’s cash account makes up 30% of the total assets. The same formula is applied to determine the percentage amounts of the company’s liabilities and shareholders’ equity which amount should total the $100,000 figure to balance out the total assets.

Monday’s post will focus on understanding how investors use the information on a balance sheet to determine whether a company would make a good investment. Until then … have a great weekend everyone!

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References:

Fraser, L., & Ormiston, A. (2010). Understanding financial statements. Pearson Education.

Makoujy, R. (2010). How to read a balance sheet: The bottom line. New York, NY: McGraw-Hill.

Skonieczny, M. (2012). The basics of understanding financial statements. Schaumburg, IL: Investment Publishing.