THIS GUIDE IS NEITHER AN OFFER TO SELL, NOR A SOLICITATION OF AN OFFER TO BUY, ANY SECURITIES OF INTERNATIONAL BUSINESS MACHINES CORPORATION OR ANY OTHER COMPANY.

The guide to financials provides basic information on how to read financial statements in a company’s annual report. It discusses key numbers in each of the statements common to all annual reports and offers suggestions from experienced investors on making sense of these numbers.

Like any new and complex subject, the language of financial statements may at first seem mysterious, even intimidating. This guide can help you begin to gain basic financial vocabulary and to understand the subject. Topics cover only the fundamentals of accounting and financial reporting and the guide and its glossary explains the terms and ideas you will need to understand these topics.

THIS GUIDE IS NEITHER AN OFFER TO SELL, NOR A SOLICITATION OF AN OFFER TO BUY, ANY SECURITIES OF INTERNATIONAL BUSINESS MACHINES CORPORATION OR ANY OTHER COMPANY.

The guide to financials provides basic information on how to read financial statements in a company’s annual report. It discusses key numbers in each of the statements common to all annual reports and offers suggestions from experienced investors on making sense of these numbers.

Like any new and complex subject, the language of financial statements may at first seen mysterious, even intimidating. This guide can help you begin to gain basic financial vocabulary and to understand the subject. Topics cover only the fundamentals of accounting and financial reporting and the guide and its glossary explains the terms and ideas you will need to understand these topics

Statement basics. Overview

What’s in them?

Annual reports include at least three financial statements:

Statement of earnings: Summarizes results of the company’s business operations (revenue and expenses)

Statement of financial position: Lists the company’s assets and the claims against them (liabilities and stockholders’ equity)

Statement of cash flows: Measures the flow of cash into and out of the company

The statements contain the financial information for a publicly held company. If a company is composed of many subsidiaries, divisions, and other companies, it presents the financial information of all its holdings as one consolidated company. IBM, for example, publishes a consolidated statement of cash flows and other consolidated financial statements, representing all the parts of its large organization.

To learn more about other components of an annual report, visit guide to Annual Reports. В

Who prepares the financial statements?

The people who prepare the statements may differ from company to company. Usually, the accounting staff prepares them, but others, such as investor relations staff. review the statements and related notes.

Regardless of who the preparers are, federal securities laws require publicly-owned companies to follow a set of rules and financial reporting guidelines. Associations — such as the Financial Accounting Standards Board (FASB). a private organization of accounting professionals, and the Securities and Exchange Commission (SEC). a U.S. government agency — develop the rules and guidelines. These generally accepted accounting principles (GAAP) help ensure that the financial information reported is reliable and consistent in form with the reports all other companies prepare. GAAP also helps safeguard against investor fraud.

Although all companies follow common standards and requirements, they report on their financial performance in varied ways. Many decisions — from the statements’ names to the accounts within them and the ways management calculates the numbers — are left to companies’ discretion.

What is the auditors’ report?

The auditors’ report is a summary of the results of an audit, or examination of the financial statements by an independent firm of certified public accountants. The audit is an attempt to determine whether a company’s financial statements report the company’s financial status accurately and reliably. During an audit, for example, the auditors investigate a company’s internal accounting controls, confirm the existence of many assets, and gather supporting information from external sources. The auditors make sure the financial statements are complete, reasonable, and prepared consistent with GAAP at a set time. If the auditors consider the statements are fair events of the company’s financial position in relation to GAAP, they issue an unqualified opinion.

The notes are required reading to understand the financial statements. Companies use notes to explain how they arrived at the numbers in the financial statements and to describe any significant events or changes in procedures that may affect the numbers. Notes also explain items in the statements and report details of the company’s financial performance not shown in the statements.

A note might explain, for example, that a company’s accounting methods have changed from the previous year or differ significantly from methods other companies in the same industry use (assuming they follow GAAP ). Analysts might examine why the company changed accounting methods, probing, for example, to learn whether the change distorts the company’s financial results.

Another note might disclose an acquisition that may have a material effect on the company’s financial condition, both short and long term. For example, with its acquisition of Lotus in 1995, IBM incurred costs and assumed liabilities associated with this significant event.

Finally, a note might provide additional detail on an item in a financial statement. For example, a note on Investments and sundry assets on the statement of financial position lists the assets IBM includes in this category (one listing is the intangible asset called goodwill). В

Statement basics: Statement of financial position

The statement of financial position reports a company’s financial status at a set date noted on the statement. The statement is like a snapshot because it shows what the company is worth at that set date. The statement shows:

• What the company owns
• What the company owes
• What belongs to the owners

Analysts often call the statement of financial position a balance sheet because of the way one part — assets — is in balance with the sum of the other two parts — liabilities and stockholders’ equity.

In an annual report, the statement of financial position includes information for at least the last two years to allow comparison of changes between years.

The statement of financial position shows three main categories of information for each year covered. To interpret this information, analysts look at three key numbers related to these categories:

Companies own things, called assets. These things might be physical assets such as buildings, trucks, inventories of products, equipment, and cash. Or things might be intangible assets such as goodwill, trademarks, and patents.

Assets are either current or noncurrent. Current assets are things a company expects to convert to cash within one year. Examples are accounts receivable or inventories of products to sell. Finally, current assets include cash and securities such as treasury bills and certificates of deposit the company expects to convert to cash within the year.

Non-current assets are things a company does not intend to convert to cash or that would take longer than a year to convert. Non-current assets include fixed assets, often listed as property, plant, and equipment because that is what they usually are. Companies use fixed assets to manufacture, display, store, and transport products.

The amounts of fixed assets vary by company and industry. For example, manufacturing companies generally have a large investment in fixed assets because making things requires property, plant, and equipment. Service companies usually have fewer fixed assets.

On the statement of financial position, debts are called liabilities. All companies have liabilities. Examples of liabilities include:

• Money owed to banks and other lenders
• Money owed to suppliers of goods and services (accounts payable)
• Taxes owed to government authorities
• Rents owed to owners of land and buildings

Liabilities are either current (short term) or long term. Current liabilities are due within one year. Long term liabilities are due after one year.

Although liabilities are a necessary part of doing business, companies must manage their liabilities carefully. If a company cannot make interest payments on time and repay the principal when due, the company can be forced to declare bankruptcy and either reorganize or disband.

Stockholders’ equity

Stockholders’ equity is the amount owners invested in new stock plus the earnings the company retained since it started (retained earnings is the amount of profit kept after dividends are paid). On the statement of financial position the amount of stockholders’ equity always equals the value of all the assets minus all the liabilities. For example, if a company’s assets are valued at $10,000 and liabilities total $6,000, the equity is $4,000.

Statement basics: Analyzing the statements

When financial analysts evaluate a company for possible investment, they look both at the information in the financial statements and at other information that puts these numbers into a larger context.

Analysts can make more reliable investment decisions by taking the basic information in the financial statements and extending it to identify:

• A company’s internal strengths and weaknesses
• Company and industry trends
• Performance in the larger business environment

Brokerage firms offer the results of their analysts’ research to individual investors as part of their service. Additionally, many professional analysts sell their evaluations and recommendations. Examples of sources of financial analysis are Moody’s, Standard and Poor’s, and Value Line.

Interpreting the numbers

Analysts usually begin evaluating a company by studying its financial statements. These sources present recent financial history in a concise format, making it easy to see short term changes in key numbers. Financial statements are also fairly standard within an industry, making it easy to compare the performance of a company to that of its competitors.

Analysts interpret the numbers on each financial statement using a variety of ratios and other comparative measures. Analysis covers:

Analysis: Statement of earnings

Analysts use the statement of earnings to examine a company’s profitability. For example, analysts look at trends in revenue, operating income, and gross profit rates (or margins). Other measures include calculation of return on assets and return on equity. To view IBM’s performance over recent years, see the historical charts.

Analysis: Statement of financial position

Analysts use the statement of financial position to examine a company’s liquidity and to gain insight into the state of the company’s debt and inventory. One measure analysts use is the current ratio, a comparison of current assets with current liabilities. Analysts also look at the relationship of this statement with the statement of earnings. For example, they may explore the relationships of accounts receivable with sales, and of inventory with the costs of sales. Collection of accounts receivable is a task financial analysts also watch closely. If customers take long to pay for goods and services, accounts receivable may become large, forcing the company to borrow money (and pay interest) to finance these receivables. The longer it takes to collect accounts receivable the less valuable they are.

Analysis: Statement of cash flows

Analysts use the statement of cash flows to determine how effectively a company generates and manages cash. Analysts look most closely at the cash from operating activities in evaluating a company’s potential for long-term success because this figure shows how efficiently the company can produce and sell its primary product or service.

Analysts also evaluate cash flows in relation to earnings figures (from the statement of earnings). For example, in some cases, a company can report positive earnings on the statement of earnings and still report a negative net cash flow on the statement of cash flows. This situation may occur when a company is unable to meet the current demand for its products and consequently invests its profits, or even borrows additional money, to expand its manufacturing capability (for example, by purchasing equipment or new facilities). When such a situation occurs, analysts look for the implications. They try to determine if the prospective demand for the company’s product is great enough to justify the expenditures and new debt.

Statement basics: Statement of earnings

The statement of earnings indicates how much revenue a company brings into the business by providing goods or services, or both, to its customers for a set time (usually one year). It also shows the costs and expenses associated with earning that revenue during that time.

In an annual report, the statement of earnings shows sales revenue and expenses for at least the last three years. The net earnings (or loss), often literally the bottom line on the statement, shows how much the company earned (or lost).