DECEMBER 2002

The Balance Sheet

Understanding Income Statements, Balance Sheets and Cash Flow Statements

Learn how to use an annual report's financial statements in this workshop. Diane Graese describes how to use the balance sheet, income statement, cash flow statement, and MD&A (Management Discussion and Analysis.)

The workshop uses the 1998 Diebold, Inc. online annual report as an example. You may review the complete report online if you would like to prepare for the discussion that follows.

Introduction

Welcome to the Better Investing School Financial Statements Workshop. The workshop consists of four individual sessions.

Session #1 presented a brief history of financial statements and Generally Accepted Accounting Principles (GAAP). This second session will present the Balance Sheet. Session #3 will cover the Income Statement. Session #4 will cover the Statements of Cash Flows.

Workshop Resources

The workshop uses the 1998 Diebold, Inc. online annual report as an example. We thank Diebold for permission to duplicate selected financial statements for workshop illustrations. The four annual report sections for this workshop are:

• MD&A - Management's Discussion and Analysis of Financial Condition and Results of Operations
• Balance Sheet (Consolidated Balance Sheet)
• Income Statement (Consolidated Income Statement)
• Cash Flows (Consolidated Statement of Cash Flows)

I will cite information in the illustrations as the workshop progresses. Selected lines on the financial statements have been highlighted in yellow to identify references used in the workshop sessions. Similarly, text in the MD&A illustration in a bold blue font identifies material referred to in the workshop.

Please note that the workshop illustrations taken from the Diebold annual report present dollars in thousands except per share amounts. However the text of the workshop sessions will present dollars in their full unit value i.e. $42,540,000 rather than $42,540 as in the financial statement illustration.

The Balance Sheet - An Introduction

The balance sheet is a required financial statement. It presents a picture of the value of assets, liabilities, and shareholders' equity calculated using specified accounting rules on a specific date. It is also referred to as a Statement of Financial Position.

Assets are property. They are used to generate revenue. Examples are cash, inventory and equipment. Assets also include amounts owed to the company (receivables) and paid expenses related to future revenues (prepaid expenses).

Liabilities are obligations. They include unpaid expenses incurred to produce revenue or debts incurred to acquire assets. Examples are accounts payable, income taxes payable, and bonds payable. Also included are estimates of amounts to be paid in the future (e.g. pensions) or the value of services paid but not yet provided (e.g. deferred income).

Shareholders' equity balances the difference between assets and liabilities. It is the book value of shareholders' interests in the net assets of the business. The individual components of equity are not meaningful for most investors unless preferred shares have been issued.

Accounting Methods

The balance sheet is prepared using generally accepted accounting principles (GAAP). When GAAP allows alternative accounting methods, the specific accounting used by the company will be listed in the Notes to the Financial Statements.

In general all values presented in the balance sheet are calculated using historical cost -- the price paid or the amount owed. Accountants like historical cost because it can be verified by looking at a check or invoice. Very little judgment is involved.

Hidden Assets and Liabilities

Historical cost fails to present the true WORTH of some assets. The prices paid years ago for land, film libraries, or art collections are not a measure of their worth today. Benjamin Graham, the father of Security Analysis, became famous for analyzing balance sheets and uncovering undervalued assets.

The value of many assets is not measurable in a verifiable or reliable manner. The dedication and quality of employees are significant assets which contribute to the production of revenue. How do you quantify this value? What is the worth of a global brand name or franchise?

You won't see these assets on a balance sheet. They are hidden, but their value is often reflected in the price of the stock. It may be a reason for premium price/earnings ratios.

Liabilities may also be hidden. Will a tobacco company have future obligations related to its product sales? Probably yes, in today's society. But until liability is assessed and amounts are measurable, no amounts can be recorded.

Hidden liabilities may depress price/earnings ratios and make some stocks look like bargains.

What's Important?

I believe the most important pictures presented on the balance sheet are the company's financial liquidity and leverage. Look at them on the Diebold, Inc. balance sheet and read management's discussion in the analysis of the company's financial condition (MD&A).

Liquidity

Liquidity measures how easily assets can be turned into cash to pay bills, pay dividends to shareholders, and make future investments in the growth of the business. Good liquidity allows management to focus on running the business rather than on obtaining funds to pay the bills.

Diebold's balance sheet shows a high degree of liquidity. Diebold has sufficient current assets to pay current liabilities and meet other short-term needs. Diebold's current assets ($543,548,000) exceed current liabilities ($235,533,000) by a ratio of 2.3 to 1.

Indeed, many assets are cash or close to cash equivalents. Diebold has short-term cash and investments totaling $79,973,000 ($42,450,000 + $37,433,000). Diebold also has long-term securities and other investments of $168,008,000. In MD&A, management states these securities are marketable and could be sold if funds were needed for other projects.

Leverage and Debt

Leverage is the ratio of financing provided by lenders versus shareholders, or debt versus equity. There are no right or wrong levels of leverage. High leverage may provide extra return but often means additional risk. We generally trust quality management to use debt carefully.

Balance sheets with high leverage leave little room for additional borrowing and can place strains on a company during poor economic times. Lenders can dictate certain restraints on spending through bond covenants. Should the situation warrant, they can pull a company into bankruptcy.

Balance sheets with low leverage are said to be financially strong. Management can borrow additional funds when necessary to acquire companies, build new plants, or embark on major new initiatives.

Diebold has a financially strong balance sheet. The company has almost no debt, only Bonds payable ($20,800,000) issued in 1997 to construct three new manufacturing facilities. In MD&A, management indicates that they have an unrestricted line of credit totaling $150,000,000 for any future borrowing needs.

The Big Picture

So what do I see looking at Diebold's balance sheet? I see a picture of tremendous financial resources. This is my kind of company -- LOTS of cash and debt capacity to grow the business.

Session #3 will look at the Income Statement.

Session #2 - Questions and Answers

Judith Russ Leon: Would you please explain what is meant by the statement, "When GAAP allows alternative accounting methods, . . ." Exactly how does this happen? Are there different rules for varying situations? Something else?

Diane: GAAP has multiple rules when a single accounting method doesn't fit all circumstances. GAAP wants recorded transactions to reflect economic events but not all companies produce net income in the same fashion. A simple example is the choice for recognizing revenue. In most cases, revenue is recorded when an asset is sold. This makes sense when the selling cycle is quite short. At Wal-Mart, a sale is made in minutes. When you are dealing with selling 747 airplanes or constructing a dam, the cycle can take a year or more. When the building/selling cycle takes a long time, it may be a better presentation of company operations to show revenues being earned over the cycle rather than on the last day of completion. Thus, you may find revenues being recorded using an installment method or percentage of contract completion method. Company management is responsible for using accounting methods which best present the economics of their business.

David Todtman: Under the heading "The Balance Sheet," you wrote: "The individual components of equity are not meaningful for most investors unless preferred shares have been issued." I know the difference (at least I think I do) between preferred and common shares, but I am not sure what you mean by the statement. I.e., why would the individual components be "meaningful" to owners of preferred shares?

Allen Theobald: Preferred stock has an equity interest in preference over common stock with regard to dividends and the distribution of assets in case of liquidation.

Diane: The individual components are not relevant to preferred shareholders. It is the common shareholders who must be aware that not all equity belongs to them when preferred shares exist. As Allen indicates, preferred shareholders have priority claims. When preparing SSGs and forecasting earnings per share, you must take preferred shareholder's claims on earnings into account.

Zeydy Ortiz: I have a question about on of the lines in the balance sheet. 'Deferred income taxes' are classified under 'Assets.' If this is money to be paid, why are they an asset and not a liability?

Allen Theobald: Deferred means that the benefit will occur at some point beyond one year from the balance-sheet date. Maybe they are expecting a refund? (Grin)

Diane: First part: Let's define deferred. Allen is correct that benefit will occur in the future and beyond the current year. We can also figure this out because the line is classified in the long-term section and is not included in Current Assets. Second part: Why are deferred taxes an asset? Deferred taxes can either be a liability or an asset depending on the sources of the difference between taxable income (computed according to IRS rules) and net income (computed according to GAAP). Allen is correct that since deferred taxes are an asset, the company is in a way expecting a refund. More likely, they are expecting to be able to take a tax deduction for certain expenses included in the current year income statement when these expenses are actually paid in the future. Diebold does have a current liability called Estimated income taxes ($13,582) which is closer to the amount they will pay to the government when they file their current year's tax return.

Nancy deGraff: "Liabilities are obligations... Also included are estimates of amounts to be paid in the future (e.g. pensions) or the value of services paid but not yet provided (e.g. deferred income)." I love this format for learning! Can you explain more about pensions? (I just read in the Wall Street Journal, June 15 front page "Joy of over funding.") I thought they were "funded" and therefore would have an off-setting number in the LT Asset side. But can they be like debt or a loan that is funded from current revenues too? How can you tell? I remember looking at automobile companies years ago and reading that the prices were depressed as their pensions were so under funded it would affect earnings for many years.

Diane: Pension accounting has a fascinating history. Originally, who knew what a pension was? You literally worked until the day you died. Eventually, pensions became a way for management to offer a benefit other than increasing your current salary. Accounting for compensation was on a pay-as- you-go method. Management became aware that you could offer benefits to employees without increasing expenses. The obligations weren't going to be paid for many years. Since you couldn't know how much you would eventually pay, accountants did not require any liabilities to be recorded. As benefit plans became popular, accountants realized management was making ever-larger promises with no apparent financial consequence. Pension (and later, all other benefits) accounting became a hot topic. Now companies are required to estimate future obligations much in the same way an insurance company is forced to estimate how much they will pay out in future claims. Estimates are based on the contractual agreement and estimates of mortality and interest rates. It should make sense to you that some expense should be realized over the time the employee works for the company and vests in the benefit plan. Now companies must recognize some pension expense every year. Funding of future and current obligations is a separate matter. Pension plans may be over or under funded. As you note, the auto manufacturers were terribly underfunded when pension accounting first became an issue. At some companies (not necessarily the autos), the estimates of obligations exceeded the net worth of the company. On the other hand, once the information became known, certain companies with overfunded plans became takeover targets. The corporate raiders of the 60s, 70s, and 80s earned their name because they often sought to buy a company and raid the pension plan for excess cash. Today, all information on the assumptions used to calculate pension obligations, the calculated future liability, and the current funding status are included in a footnote. The footnote also identifies the assets and liabilities related to pensions which are included in the balance sheet.

Nancy deGraff: I have never been sure how to classify pensions... included as part of Total Debt calculation when it is listed separately like Diebold does? Or is it usually included in the "LT Debt/bonds" number in annual reports?

Diane: The only thing included in the annual report line LT Debt/bonds is Long-term Debt and Bonds. Obligations are presented on their own line when they are deemed significant. Dissimilar items with small balances may be lumped together and shown on a line labeled OTHER. I do not include any long-term obligations other than Debt in my calculations of Debt/Equity. This is not to say others won't.

Roxie Kellam: Do pension obligations affect EPS or dilution of earnings? Do we account for that in the SSG when it asks for 'Potential Dilution'? Or is there something else that affects the potential dilution that we should be looking for?

Diane: First question: Pensions. Companies must now include estimates of unfunded benefit obligations on their balance sheet. Changes in this obligation are recorded through the income statement and affect EPS. For the most part pension expense is now just another normal operating expense. There is no need for special attention to this expense. Second question: Dilution. Dilution occurs when additional common shares are issued from the conversion of some other obligation the company has issued. Common potentially dilutive obligations include convertible debt, convertible preferred stock, warrants, or stock options. I am by no means an SSG expert. But if basic and diluted EPS are about the same, I don't worry about the dilution. The diluted EPS takes all of this into account, in my opinion. If the differences are large, I then used diluted EPS in my SSG. This is a very conservative stance but one that I choose to use to make other analysis easier.

Continue to Session #3 - Income Statement

Return to Session #1- Introduction to Financial Statements

Diane Graese was formerly an officer of the Computer Group Advisory Board and a director for the BetterInvesting Las Vegas Chapter. She is an active member of i-club-list and the BetterIinvesting Community at Compuserve. Diane is well known for her seminars on cash flow and interpreting financial statements. Contact Diane at dmg1031@aol.com.