HF UC-NRLF B M SD7 =lfll CO 00 lO o :a ANALYSIS OF FINANCIAL STATEMENTS ONE OF A SERIES OP LECTURES IN A SYSTEMATIC COUBSI RICHARD P. WILSON HARRY J. CARPENTER Credit Department, National Bank of Commerce, New York HU-345 La Salle Extension University - CKicagfo ANALYSIS OF FINANCIAL STATEMENTS RICHARD P. WILSON HARRY J. CARPENTER Credit Department, National Bank of Commerce, New Yorlc La Salle Extension University - Chicag^o 1919 (9-119) Copyright, 1918 LaSalle Extension University CONTENTS I. Analysis of a Wholesale Grocery Statement 2 The Audited Statement 2 Classification of Accounts 3 Analysis of the Assets 6 Cash 6 Notes Receivable 7 Acceptances 8 Accounts Receivable 9 Merchandise 10 Real Estate and Buildings 12 Machinery and Fixtures 13 Patents, Goodwill, Leases, Patterns, etc 13 Investments 14 Deferred Assets 15 Consignment Accounts 15 Analysis of the Liabilities 15 Notes Payable 16 Accounts Payable 17 Accrued Liabilities 18 Reserves 18 Bonded Debt 18 Capital Stock 20 Surplus and Undivided Profits 20 Net Worth 20 Profit and Loss Statement 21 Contingent Liability 22 Insurance 23 Life Insurance on Members 23 ... 7 111 iv Contents II. Analysis of a Packing Statement 26 Notes and Accounts Receivable 26 Merchandise 27 Real Estate, Buildings, Machinery, and Fixtures ... 27 Notes and Accounts Payable 27 Bonded Debt 30 Gain for the Year 30 Conclusion 30 III. Analysis of a Jobbing Statement 30 Notes and Accounts Receivable 30 Net Worth 31 Special Capital 31 Discounted Receivables 31 IV, Analysis of a Cotton Mill Statement 32 Current Assets 32 Fixed Assets 33 Management 36 V. Summary 36 ANALYSIS OF FINANCIAL STATEMENTS Too much stress cannot be laid upon the importance of a proper analysis of the financial statement. The statement is a photograph of the business and, if not correctly viewed, the whole complexion of the risk is altered and the possibilities of use defeated. The financial statement assumes an important place in modem management. Executives, officers, and direct- ors of corporations should be able to make an actual analysis of the financial statement of their business if they are to plan constructively and wisely. Investors are able to buy securities on a more scientific basis when they are able to view the exact conditions and contingencies of a business as shown in its statements. Credit men make daily use of statements. While it is time in granting credit, whether in the form of loans or merchandise, that the personal equation and the knowledge of the debt-paying record of the subject are important features, the story told by the financial state- ment is the fundamental basis upon which credit is granted. Accountants, of course, are interested in the accounting science and the technique involved in the preparation of statements, as well as in the use they serve. The exact purpose of the analysis differs somewhat with these classes. The credit dispenser is interested pri^iarily in deteniiining the debt-paying ability of 1 2 WILSON AND CARPENTER the applicant for credit a short period ahead. The executive and the investor are likemse interested in these factors, but they are more vitally interested in a growing earning power and a consistent dividend-pay- ing ability over a considerable period of time. The principles of analysis are quite similar, whatever the purpose. Since by far the most important use of financial statements is in the granting of credit, this treatise will explain the analysis of financial statements chiefly from that point of view. The principles and methods of analysis will be developed in connection with an analysis of representative statements from tj^pi- cal classes of industries. I. Analysis of a Wholes.u.e Grocery Statement The first type of statement will be that of a whole- sale grocery house. Figure 1 is the form in which the statement is received from the company. THE AUDITED STATEMENT One of the first points to determine is whether the statement is audited. The value of an audited state- ment is- readily appreciated in that it is the opinion of a disinterested party of the condition of a business, as against a compilation by the concern itself, which concern would be inclined, without any dishonest inten- tion, to be liberal in its attitude as regards realization on certain assets. The next step is to consider how the accountants rank in their profession, the value of the audit being lost should it develop that the accountants are other than unbiased parties or lack the necessaiy qualifications of their profession. FINANCIAL STATEMENTS 3 CLASSIFICATION OF ACCOUNTS The initial step in analyzing statements is more or less a process of elimination. The information from the statement is transferred to a ** Comparison of State- ments" form, Fii^Tire 2, and so grouped as to bring out more prominently certain leading features of the finan- cial condition of the concern. The assets are separated" into two classifications: (1) those of a current or debt-paying character and (2) those of a permanent character. The latter assets, of course, could be divided into several other classifications, but their slow liquidating character would not be altered; thus the foregoing distinction into two classes will answer our purpose. ^ The distinction between the current liabilities and those of a deferred nature is not so marked as in the case of the assets ; deferred or long-time obligations are those of a bonded indebtedness, mortgage or debenture nature only. The percentage of total current liabilities to total quick assets is indicated. In this illustration it is 47, indicating that the current liabilities are 47 per cent of the quick assets. Credit men ordinarily look for a 2 for 1 condition, or, in other words, $2 of quick assets to discharge $1 of debt. Where the statement varies from this condition, consideration should be given to the reason therefor. [ The 2 to 1 ratio of ' ' quicks ' ' is not an absolute standard, isimply a working rale. Another method of indicating the percentage, in line with the foregoing, is through the division of the quick assets by current liabilities, which, in the instance under discussion, results in a percentage of 2.14, or $2.14 for every $1 of current debt. Let us now take the statement, item for item. WILSON AND CARPENTER LAKESIDE GROCERY COMPANY DETROIT, MICH. Statemext as of December 31, 1916 Assets Cash $88,225.16 Notes Receivable 104,424.22 Accounts Receivable . . 506,325.36 Merchandise 812,150.09 Real Estate, Bldgs., etc. 328,147.51 Investment in A. B. C. Can Co 180,000.00 Loans to Officers, Em- ployees, etc 13,652.62 Deferred Assets 7,804.31 Machinery & Fixtures. 92,018.04 Patents & Goodwill . . . 400,000.00 Liabilities Notes Payable $600,000.00 Accounts Payable .... 69,558.32 Accrued Interest 1,562.21 Bonded Debt ($10,000. Exp. Annually) 100,000.00 Reserve for Bonus, etc. 25,162.44 Capital — Preferred ( 6% Cu- mulative) 700,000.00 Common 400,000.00 Surplus 636,464.34 $2,532,747.31 $2,532,747.31 Sales (1916)— $4,688,293.78 Profits— $147,983.35 Dividends — 6% Preferred — 8% Common Depreciation — $25,762.54 We have examined the books and accounts of the Lakeside Grocery Company, of Detroit, Mich., as of December 31, 1916, for the purpose of verifying the assets and liabilities and certifj'ing that the foregoing state- ment is correctly prepared therefrom. We have satisfied ourselves that the inventories of merchandise, mate- rials, and supplies, as reported to us by the management of the company, have been prepared on a proper basis and that the values placed on the various items are cost or lower than cost to conform to the fluctuations in the market price. All ascertained liabilities have been provided for. We hereby certify that in our opinion the foregoing statement sets forth the true financial position of the company as at December 31. 1916. Smith Joxes & Co.mpaxy January 22, 1917 (Chartered Accountants) Detroit, Mich. Fig. 1. — Statement as Received from the Wliolesale Grocery Company FINANCIAL STATEMENTS COMPARISON OF STATEMENTS fi^KKS ICR-GaOCER? D9llEait..Micli. »K ifi? ~ Tom CcniRinT LiAaiimti 7n(i ?n? <>i BofKled Debt (When due>1923 90 000 00 MortRage Loans (Wliffo due) Total Liabilities 7?fi 2fl?; 17 1 AutI) Prf 1 6 7. ihr Cxir Tnn nnn nn ^P'- I Auth. Com. 400 onn nn SufDluj & Urtdivlded Profits mii 4£i 2A TOTAL 1 532 747 31 rriTAi. QinrK a<;<;pt«; f.l f^ll 124 RS •■ CURRENT LIABILITIES *> •mA 7a? <17 ■ ' EXCESS-OUICK 804 841 S6 SalM 4 fiflfl P.l.-l 7fi ConUncent Liabilities Innranrr Diyidcnds '^ ^^ ii^ iiii Dcpreciatioa /fS 7f? ^4 T4« Pro6ti M7 Rflrt i^fi Fig. 2. — Comparison of Statements — Lakeside Grocery Company Note. — In these printed forms the terms "Bills Receivable" and "Bills Payable" are used instead of the more acceptable accounting terminology of "Notes Receivable" and "Notes Payable." 6 WILSON AND CARPENTER ANALYSIS OF THE ASSETS After the information from tlie statement has been transferred to the ** Comparison of Statements" form, and it has been ascertained that the ratio of current assets to current liabilities is such as to warrant the extension of the credit applied for, then the credit man begins to analyze and compare the different items of the report. First he considers the assets. He analyzes those items of a liquid character rather minutely because they are of primary importance in considering banking and commercial credit. Fixed assets interest him as much on account of the carrying charges which they may involve as on account of their ultimate, realizable value. Bonds, for example, involve a current liability for interest charges. CASH In this particular statement the item indicates a good cash position, which is generally a mark of a healthy condition. In some cases, a nominal cash item is shown, due to the company's practice of using a large portion of its available cash to retire outstanding obligations just prior to statement date. Cases have been found where a concern has applied its cash to the reduction of its Notes Payable without an actual retirement of that indebtedness; e. g., a book- keeping transaction by which a reduction of an equiva- lent amount is made in both the Cash and the Notes Payable items. It is scarcely necessary to mention that this practice is not condoned, as the statement so sub- mitted does not show the actual condition of the business. Most commercial banks, when making loans to custom- FINANCIAL STATEMENTS 7 ers, endeavor to have cash balances maintained with them of about 20 per cent of the amount of the loans. A nominal cash item, compared to Notes Payable, indi- cates, therefore, that the banks of deposit are not being treated liberally in the way of balances. (We are, of course, assuming that the company's borrowings are all secured through banks and not through commercial paper brokers; in the latter case the cash item could not be reconciled to the payables.) It is also desirable to know whether there are included in the cash item Time Certificates of Deposit, for, while these certificates represent actual cash on deposit, they may be used as collateral against loans, which fact would not be shown on the face of the statement. This would naturally mean the tying up of these funds until the maturity of the loans ; therefore although a case of this character is unusual, it should be borne in mind. NOTES RECEIVABLE I The most vital point to be considered in the analysis of this item is whether the figure shown represents notes from customers only, obtained in the regular course of business. If included in this amount are notes due from subsidiary or affiliated interests, officers, or employees, the amount of such notes should be with- ._^rawn and placed in the slow assets. In the foregoing statement, the Notes Receivable item is in good proportion to the volume, but if, for instance, these receivables should total, say, $300,000, it would be an indication that many of the company's customers were not of a particularly high grade; for example, retail dealers, short of ready cash, who have been obliged to give notes in payment for merchandise. A large Notes Receivable item might also reflect unfa- 8 WILSON AND CARPENTER vorable business conditions prevailing in the company's locality. Even in cases where a fairly good knowledge is had of the class of customers catered to, and despite the fact that the statement is audited by reputable accountants and all doubtful accounts are eliminated, a certain allow- ance must be made for depreciation in this item, maybe not in actual figures, although this is done quite often — to be borne in mind when forming a judgment of the value of the concern's receivables. At times we find the item "Notes Receivable Secured by Eeal Estate," or some other collateral. This always leaves the impression that the prompt collecti- bility of the item is questioned ; consequently should this amount be large, a word of explanation from the cus- tomer would be in order. In the grocery business, goods are sold on 30 days, 60 days, and sometimes four months, but the last-men- tioned tenns are the exception, the majority of the accounts being settled in at least 60 days. In view of this comparatively quick ''turnover," one seldom finds a large Notes Receivable item in the statement of a wide-awake, aggressively managed, wholesale grocery concern. Of course, a small Notes Receivable item might be indicative of a practice by the company of discount- ing its customers' notes, which would constitute a con- tingent liability, a point which is covered in detail further along in the discussion. ACCEPTANCES In instances where companies sell their merchandise on an acceptance basis, the acceptances would, of course, be available for discount with their bankers, or for dis- posal in the open market. This would obviate the neces- -V FINANCIAL STATEMENTS 9 sity of borrowing on their own note to the extent of their operations tinder such an arrangement. The dis- count or sale of such acceptances unless ''without recourse" would constitute a contingent liability. ACCOUNTS RECEIVABLE As mentioned above, groceries are usually sold by the wholesaler on 30 or 60-day terms; thus with Accounts Beceivable of $506,325.36 and Notes Receivable of $104,- 424.22, a total of $610,749.58, on a volume of $4,688,- 293.78, it is quite plain that in this instance the accounts are being carefully watched, the collections averaging approximately 45 days. This conclusion is reached by dividing the total sales by the total of the Accounts and Notes Receivable. The result in this instance is about eight times, corresponding to one and a half months each, or 45 days. A point worthy of note in this connection is whether the accounts have been pledged in any way. Of course, with reputable accountants, this fact would be forcibly brought out, but otherwise there would be no indication of the assignment of accounts. A word of explanation regarding assigned accounts might not be amiss at this time. In the banking world there are private bankers whose business is that of assisting concerns in a rather weak financial position, by making advances to these con- cerns, secured by the regular open accounts on the books. The rate for this accommodation is always higher than the average discount rate. As the accounts are settled, the proceeds are applied to the money advanced, but in hypothecating its accounts the company remains contingently liable for their ultimate payment. This method of financing is not in favor with credit 10 WILSON AND CARPENTER grantors, the feeling being that if a concern is in a sufficiently good position to cash its accounts, it should be able to effect a connection with a bank from which it can obtain its requirements and thus effect a con- siderable saving of interest. In connection with the Accounts Receivable it is also well to learn whether all doubtful accounts have been charged off and whether, as in the case of the Notes Receivable, these accounts are due from customers for merchandise sold in the usual course of business. Indebtedness due from subsidiaries or affiliations (which concerns might be operating as branches, in the case of distributors, or as producers in allied lines, in the case of manufacturers) should not be included in the quick assets, because while the receivables so due may be liquidated from time to time, they are more or less of a permanent character (depending of course on the line of business) and frequently represent the actual working capital or investment in the subsidiary. There- fore, in the event of liquidation, these funds are not usually found to be of full realizable value. Where branch houses are not separately incorporated, no current or open accounts with the main office should appear as an asset. The cash, receivables, and merchan- dise and whatever indebtedness the branch may be per- mitted to incur, are merely a subdivision of the resources and the liabilities of the company as a whole and should assume their respective places in the balance sheet. MERCHANDISE This is usually the most important item in the current assets and, as a nile, constitutes the major portion thereof. It is important to know whether the inventory has been careful Ij^ taken. Inventories are frequently FINANCIAL STATEMENTS 11 taken and certified to by the management, but the super- intendence of the inventory checking by accountants is desirable. If the market price at inventory date is above cost, the goods should be carried at cost figure, but if there has been a decline in price, the merchandise should be carried at the current market value ; in the latter case, it is also well to provide for further shrinkage due to increased selling expenses, etc. It is important that the merchandise of a more or less unsalable character be separately considered and that a movable valuation be set upon it. In view of the staple character of the grocery business, a liberal charge-off on the merchandise is not so neces- saiy as would be the case with a concern handling spe- cialties, such as in the electrical goods, hardware, and other lines, in which the depreciation may be heavy, due to change in style, etc. ^ One of the principal points to be borne in mind is how (rapidly the merchandise is being turned over. By com- parison with the volume of business it will be noted that the merchandise of the concern under discussion, taking the amount as fairly representative of the average amount of stock carried through the year, has been turned over something like six times, which indicates an efficient management. The credit examiner should be familiar with the customary turnover in the line of business represented by the concern whose statement is under consideration. ^^ The success of any business hinges largely on two points: (1) the ability to turn the merchandise rapidly at a profit and (2) the prompt collection of accounts. In the event that an abnormal amount of merchandise in proportion to the business is shown, it is well to learn the reason, and if possible the credit grantor should 12 WILSON AND CARPENTER make inquiry regarding the prevailing conditions in the particular line of business in which engaged. In some cases an unusually large inventory is necessaiy, due to the company's distance from its sources of supply. Sea- sonal conditions may at times affect the inventories. In other words, the credit grantor must determine for himself whether the conditions existing warrant the carrying of an unusual supply of merchandise. EEAL ESTATE AND BUILDINGS The first point to be covered is ownership. Is the property owned by the company in fee simple, or does the title rest with a realty holding company, individuals, or others? Of what construction are the buildings? Is a sprink- ler system installed? Is everything properly insured? Last and most important, has a proper depreciation charge been made each year? It is very important, despite careful upkeep and replacements, to make rea- sonable depreciation charges. The repairs and replace- ments made during the year should be charged direct to Operating Expense; new additions and betterments, however, constitute a charge to Plant Investment. If a steady increase in Plant Investment is reflected from year to year, it would be well to know the com- pany's policy in this direction. Commercial banks do not condone the policy of the borrowing of money by concerns to invest in fixed assets; it is their feeling that new additions, etc., should be financed either out of the earnings of the company or through increased capital investment. In prosperous times there is a strong temptation to spread out and make substantial additions to plants. It is here that the banker should step in and sound a FINANCIAL STATEMENTS 13 note of warning, for, while it may be true that condi- tions at the moment warrant the plant enlargements contemplated, serious thought must be given to whether the business is likely to continue increasing or whether the increased demand is due only to temporaiy con- ditions. Sometimes statements show only a ''Real Estate Equity"; that is, the value of the property, less mort- gage. This is a poor way of showing real estate invest- ment, as it is essential for the credit grantor to know the amount and maturity of the mortgage and the fixed interest charges. Where an increase in the Real Estate item is shown, it should be learned whether this increase is due to additions or improvements or to a revaluation. MACHINERY AND FIXTURES What has been said in the foregoing as regards depre- ciation of buildings, holds good with equal force in this instance. Machinery is subject to constant wear and tear, and in these days of modem invention, machinery is often made obsolete over night. The age of the equip- ment should be learned and also whether it is kept up- to-date. In some lines of business, as in the case of cotton mills, printing concerns, etc., it is not unusual to find that the machinery has been purchased on an instalment basis, a chattel mortgage being given the machinery manu- facturers pending payment. » PATENTS, GOODWILL, LEASES, PATTERNS, ETC. Goodwill is of intangible value and usually covers the so-called "water" in the capitalization. It sometimes represents the value at which the company holds the name it has established in the business world. While in 14 WILSON AND CARPENTER many cases the concern is justified in carr^dng such an item, for the purpose of the credit grantor it has no particuhir value and should be eliminated from con- sideration when judging a risk. In the case of patterns, leases, formulas, etc., these, to a going concern, are often of inestimable worth, but in the event of liquidation their value is always more or less problematical. INVESTMENTS The investment item in the statement should be care- fully gone into, and where a large amount appears, a schedule of the investments is valuable. If composed of government or municipal issues, or listed stock exchange securities, taken at proper valuations, the item can be considered as a current asset because of its liquid char- acter. Investigation should extend to determining whether any are pledged as collateral to loans or otherwise. If the item represents the subject's investment in affiliated concerns, it should be classified with the slow assets and consideration should be given to the com- pany's commitments in that direction; i.e., whether it finances these concerns by advances of cash or mer- chandise, by indorsement or guarantees, etc., and the extent of such operations. In the case under discussion, the item represents an investment in only one concern, that of a canning com- pany. The company proved to be a successful one, netting the "parent" company a substantial return on its investment, and at the same time enabling it to con- trol a source of supply. Where a manufacturing or distributing company controls several affiliations, through stock o'WTiership, FINANCIAL STATEMENTS 15 and is interested in their financial arrangements, a con- solidated balance sheet is most essential to establish properly the status of the risk. UEFEREED ASSETS Under this classification are included such items as Advances to Salesmen, for traveling expenses, etc., Pre- paid Interest, Taxes, Insurance Premiums, etc., covering the succeeding period's operations, and which should not ty i be included in.ihe current assets. They are only nomi- ' ^ ' nal assets and usually have no realizable value. CONSIGNMENT ACCOUNTS It is important to ascertain whether there are any consignment accounts included in the Accounts Receiva- ble or in the inventory item, for it can be readily appre- ciated that merchandise out on consignment is not prop- erly an accounL receivable until the merchandise is sold and deliveredH^ Further, the merchandise so consigned not being under the direct control of the company at all times, is subject to incidental hazards, and, therefore, should be carried under a separate classification so that the amount can be taken into consideration. Incidentally it might be well to mention that a com- mon rule to follow when in doubt as to the liquid char- acter of an asset, is to take the item under discussion and ask yourself, ^' Could this be turned into cash readily in the event of liquidation?" ANALYSIS OF THE LIABILITIES After the asset side of the statement has been sub- jected to a sufiicient analysis, the same process is applied to the liabilities. 16 WILSON AND CARPENTER NOTES PAYABLE The first thing to look for in this instance is whether the Notes Payable are secured in any manner, that is, through indorsement, collateral, etc. There is no fixed rule as to the proportion of debt the average concern should show as compared with its capi- tal investment, and while one naturally likes to see the Notes Payable not greatly in excess of the capital, there are so many circumstances affecting this that it cannot be reduced to any fixed ratio. In the foregoing state- ment the indebtedness of the company is in good propor- tion. We shall assume that the Notes Payable in this instance, represent the company's notes discounted at its various banks, but in the event that the amount should read $411,692.97, it would be a warning to the analyst that the concern might be giving notes for its merchandise, and this is usually an indication of lack of working capital and the best evidence to a bank that the funds advanced are not being properly used. Sometimes, however, this odd amount is explained by the fact that the company has accepted deposits of money from directors or friends, and evidenced by notes, the odd amount representing the interest which has accumulated on the funds so deposited. In connection with deposits of money by stockholders or interested parties, it is well to determine how the amount was arrived at, i.e., whether through dividends not withdrawn or through money loaned for the needs of the business. When of large amounts, it is quite apparent how much better it would be to have this money fixed in the business through the issue of capital stock, for even though it is in friendly hands, in the event of trouble this money is usually the first to be drawn out. FINANCIAL STATEMENTS 17 If proper evidence is submitted that tlie indebtedness to stockholders or directors has been definitely subor- dinated to the general creditors and is fixed in the busi- ness for a specific period and the indorsement or guar- anty of such stockholders or directors offered or obtained, then one would be safe in considering the item a slow liability. A further explanation of the odd amount of the Notes Payable item might be the fact that some companies deduct the unearned interest charge on their Notes Payable. Still another reason for the odd amount in the Notes Payable item might be that the company has included its commitments through the acceptance by its bank for its account of drafts drawn under ''commercial let- ters of credit," which the company has had issued for shippers. A veiy essential point in connection with the Notes Payable is to determine the peak of the company's bor- rowings and at what period this figure is reached. The amount of Notes Payable may also bear some relation to commodity prices, high prices requiring more capital, and vice versa. ACCOUNTS PAYABLE This item represents money owed for the purchase of supplies and, comparatively speaking, should never be large. The average company borrows money from its bank to take advantage of the cash discounts offered for the payment of bills within a specified period. A large Accounts Payable item is, therefore, a warning to the analyst that the company is not availing itself of these discounts. Accounts Payable are at times secured, and due con- sideration should be given to this feature. 18 WILSON AND CARPENTER ACCRUED LIABILITIES This constitutes a current debt of the company and consists of accrued interest charges, taxes, pay rolls, dividends, etc. RESERVES This item is worthy of close attention. Resei^v^es set aside for a specific purpose, such as Depreciation of Real Estate, Plant, Machinery, etc., may be deducted directly from the asset which they affect, but this is a matter of opinion, as some analysts prefer to show these reserA^es under the head of ''Deferred Liabilities" in order that the increase which should appear in such reserves from year to year may be apparent. Reserves for Replacements, Repairs, or Improve- ments, etc., of course, should be classified in the slow liabilities. Reserves for Discounts, Allowances, Doubtful Accounts, etc., should, however, in all cases, be deducted from the receivable items in the assets. Reserves for Taxes, Interest, Bonuses, Pay Rolls, Dividends, etc., are not properly reserves at all, but are accrued liabilities and as such should be included in the current debt. BONDED DEBT This feature of the statement should be given very careful thought. The first point to detennine is when the issue was first brought out, then its original amount, how secured, etc. In most cases, bond issues are secured by mortgages on real estate, plant, etc. The actual security back of the issue should be learned, as there are many bond issues secured by mortgages covering both real and personal property, that is, real estate, FINANCIAL STATEMENTS 19 plant, merchandise, accounts, cash, etc., in effect a chattel mortgage on the entire assets of the company. With a security of this character the bondholders have first lien on all the assets of the company in the event of failure. The next step is to learn the date of the maturity of the issue, the rate of interest, and whether there is a specified annual retirement provision. In the case under discussion we shall suppose that the original bond issue amounted to $150,000 and that the bonds were brought out in 1911 with an annual retirement provision of $10,- 000. At statement date, therefore, there was $100,000 of the bonds still outstanding, and as there is $10,000 maturing during the coming year, this amount should be placed in the current liabilities. There is no set rule for detennining to what extent of the value of the security a bond issue may be made, the amount usually being determined by the under- writers of the issue. It must be remembered, however, that in the event of liquidation, the fixed assets of any concern undergo rapid shrinkage in value. It is quite natural to lose interest in a proposition once your own claim has been settled. In the event of a sale of the property, the bondholders naturally are interested only to the extent of their holdings. Careful attention must also be given to the final date of maturity, and should such date occur during the current year, it should be learned what plans the com- pany has in mind for the refunding of the issue, whether by replacing the bonds through a like issue, by issuing short-time notes or debentures, or by issuing additional capital stock. Sometimes there is a conversion clause, permitting the conversion of the bonds into stock at definite periods. All such questions should be analyzed with a view to the debt-paying ability. 20 WILSON AND CARPENTER CAPITAL STOCK What is the authorized issue? What is the par value? Is there any unissued stock in the treasury? Is the treasury stock ever used as collateral? Treasury stock or treasury bonds appearing in the assets should be deducted from the capital liability. If there is preferred stock, what is the rate of interest on this stock? If the dividends are cumulative, are there any in arrears? If, in comparing the statement, the capital stock shows an increase, the analyst should determine whether this represents now money paid in or is the result of a stock dividend declared out of surplus and undivided profits. Where there are preferred stock retirement pro- visions what are the requirements? SURPLUS AND UNDIVIDED PROFITS This should represent the accumulation of earnings left in the business from year to year after all disburse- ments have been made. This item, taken with the capi- tal liability, indicates the investment in the business, and it is well to know how it is represented in the assets, that is, how much by quick assets, and how much by fixed or other assets. NET WORTH This represents, in the case of a copartnership, the partners' interest or investment. When the term is used in connection ^dth a corporation, it means the paid-in capital plus the accretion thereon (surplus and undivided profits). FINANCIAL STATEMENTS 21 PROFIT AND LOSS STATEMENT The Profit and Loss Statement submitted by the company is shown in Figure 3. LAKESIDE GROCERY COMPANY DETROIT, MICH. Profit and Loss Statement December 31, 1916 Sales $4,688,293.78 Inventory, Dec. 31, 1915 $683,741.69 Purchased during 1916 4,391,789.57 $5,075,531.26 Less— Inventory, Dec. 31, 1916 812,150.09 4,263,381.17 Gro&s Profit on Sales $424,912.61 Selling Expenses $82,476.26 Administration Expenses 114,372.94 Miscellaneous 24,835.26 221,684.46 $203,228.15 Deduct: Depreciation on Plant $24,563.49 Bad Debts written off 1,199.05 25,762.54 Operating Profits $177,465.61 Deduct from Operating Profits: Interest on Borrowed Money $23,482.26 Interest on Bonded Debt 6,000.00 29,482.26 Net Profits $147,983.35 Dividend Payments— $74,000 Fig. 3. — Profit and Loss Statement It is desirable and very valuable to have a statement of the Profit and Loss Account supplementing the bal- ance sheet for, while the balance sheet reflects the finan- cial condition of the company at a single period of time, 22 WILSON AND CARPENTER the Profit and Loss Account shows how it arrived at that condition from that of a previous period. The Profit and Loss Statement also reflects the earning power of the business and, after all, this is a most important fact to know and one from which can be deter- mined w^hether the company will be able to carry out its contracts. The Profit and Loss Statement can be compared with those of previous periods and the trend of operating expenses in relation to sales noted, the various features of which can be elaborated upon in line with the business under consideration. For instance, the interest paid on borrow^ed money may be used as a check on the Notes Payable item, which might tend to disclose a concealed debt in this direction. The percentage of gross and net profits to sales may be determined, which, of course, would fluctuate largely in the many different lines of business pursuits. CONTINGENT LIABILITY The most common form of contingent liability that is encountered is that brought about through the prac- tice of indorsing and discounting notes receivable, which feature has already been discussed under ** Notes Receivable." Other forms of contingent liability may be found in connection with the financing of subsidiary companies through the indorsement of current borrowings, the guaranty of merchandise obligations, the guaranty of their funded debt, etc. A contingent liability sometimes arises in connection with leases and contracts and in other directions peculiar to some lines of business, the existence of which may be recognized when met. Law- suits outstanding and unsettled claims for damages or FINANCIAL STATEMENTS 23 personal injury not covered by insurance also fall in the contingent class. Then there is a contingent liability brought about through the discounting or the sale of acceptances; also through the discounting of foreign bills of exchange. INSURANCE This is a very important feature to the credit grantor •and one which is very often overlooked. The features to be covered are whether the merchandise is adequately protected and whether a reasonable amount of insurance is carried on the plant. LIFE INSURANCE ON MEMBERS It is becoming more and more prevalent among pro- gressive business houses to insure the lives of the prin- cipal executives. To insure the life of the producing member, or members, of a prosperous business would seem to be sound judgment, as the producing genius of a growing concern is really one of its most valuable assets. Frequently the death of a member of a firm causes embarrassment, and life insurance might go a long way toward paying out the interest of the deceased and relieving the firm of a possible capital stringency. Further, a life policy acquires a cash surrender value, which, in the event of difficulty or liquidation, would be available to the creditors. In the statement of a going concern, where ''Cash Surrender Value" appears as an asset, the item should be included among the investments and not as a quick asset. Life insurance could also be utilized in the nature of a sinking fund taken out against the ultimate payment of mortgage indebtedness. 24 WILSON AND CARPENTER ALL-AMERICAN PACKING COMPANY CHICAC40, ILL. January 1, 191 A suet s Cash $902,368.72 Notes & Accounts Receivable 2,422,476.83 Merchandise 4,560,322.71 Real Estate, Buildings, etc 2,934,376.82 Investments 630,750.00 $11,450,295.08 Liabilities Notes Payable $4,320,624.72 Bonded Debt 1,000,000.00 Capital — Common 4.500,000.00 Surplus 1,629,070.36 $11,450,295.08 Dividends — 7% Fig. 4. — Statement of a Packing Concern FINANCIAL STATEMENTS 25 COMPARISON or STATBMBNttf . 1 Rend.Mraqt Reed.Dlreot ASSETS ,„„ , ,„ ft Jnn. 1 1017 1 Cash 947 547 ^65 sn? J£fl 72 1 Bills Receirsble, Customers R| Accounts RecciTable, CuttomerB ?. 04.1 Of^P iV P 4'P 17^1 n.1 Merchandise, finished ,1 77n IPn ?■! 4 STin rip? 71 Merchandise, unfiniEhcd Raw Material 1 TOfAt iiX^lCK A^sfeYS 6 7fil 403 03 .^ Rftn 1An 26 * Kcal h*Ut« ' ■ B!n £24: ■rl EXCESS-QUICK 3 904 JOS S3 3 5."^, 543 54 - =_ — Salo ' I Contingent LiaMUtit* InEuranct Omdeods 71 7«il Deprectatton Net Prodj ' Ootelde Mcana Fig. 5. — Comparison of Statements — AU-American Packing Company 26 WILSON AND CARPENTER II. Analysis of a Packing Statement We shall now take up tlie statement of a concern engaged in the meat-packing business. The methods used in financing such a business introduce some new points in statement analysis. Figure 4 shows the form in which the figures are received from the company. For the sake of clearness we shall show the company ^s statement as compared with that of the previous year on the comparison sheet, Figure 5. The point that stands out forcibly is the indebtedness of the company. However, with concerns engaged in this line of business a liberal indebtedness is not unusual, which fact is attributable to the rapid turnover of the business. This necessitates a very active employment of working capital, and because of this, it will be found that packing concerns are rather steady borrowers of their banks. This heavy debt, however, is offset by the liquid character of the inventory. The products are staple and in such constant demand that one would have compara- tively little difficulty in disposing of merchandise of this character in the event of liquidation. NOTES and accounts RECEIVABLE In the foregoing statement the Notes and Accounts Receivable are combined, and if possible this item should be divided, as it is quite important to learn the amount of the Notes Receivable. Packing products are sold on short terms, and one seldom looks for a large amount of Notes Receivable; therefore, should the item appear substantial, a word in explanation from the customer would be in order. FINANCIAL STATEMENTS 27 MEECHANDISE From the comparison of the statements it will be noted that the merchandise item has increased substan- tially over that of the previous year. When favorable conditions are obtaining in whatever line of business may be under consideration, a reasonable increase in the merchandise item is not necessarily viewed with alarm, but this feature should always be given due thought and investigation, as the increase may be the result of higher prices rather than of a heavier inventory, which higher values, under less favorable conditions, might be subject to fluctuations and be the direct cause of serious loss in a succeeding period. With the packing company under discussion, however, the increase reflected would not seem inconsistent with the normal progress of the business; further, the quick salability of the product should be borne in mind. eeaIj estate, buildings, machinery, and fixtures As compared with the previous year, this item also shows a material gain. What is the reason for this? Does it represent a revaluation of the real estate, or new additions and extensions, etc.? Are further building operations contemplated during the coming year? How are they to be financed, and what depreciation has been made on the property? notes and accounts payable This item also should be divided. While there is a marked increase in the account over that of the pre- vious year, this can be attributed to the carrying of a heavier inventory. 28 WILSON AND CARPENTER HENDKICKS BKOTHERS SEATTLE, WASH. December 31, 1916 Assets Cash $ 16,728.29 Merchandise 391,607.51 Accounts Receivable 437,400.03 Notes Receivable 12,163.17 Machinery & Fixtures 37,420.01 Investments 135,000.00 $1,030,319.01 Liabilities Notes Payable $ 350,000.00 Accounts Payable 76,742.95 Taxes, Insurance, etc 23,141.01 Deposits of Partners & Friends 46,693.27 Net Worth 433,741.78 Special Capital 100,000.00 $1,030,319.01 Sales $1,667,000.00 Profits 92,543.00 Withdrawals 40,000.00 Notes Receivable discounted and not included in the above 35,545.00 FlO. 6. — Hendricks Brothers' Statement FINANCIAL STATEMENTS 29 COMPARISON OP STATEMBNTS JDI BEES' BOOTS A SHOES ASSETS ;^P ^1 ^ibi!itr« il'i V^ Profit. 92 S4S 00 W'.r.hrtraiials 40 009 00 ft 1 Fig. 7. — Comparison of Statements — Hendricks Brothers 30 WILSON AND CARPENTER BONDED DEBT In this instance no annual retirement has been stijDU- lated, and as the final maturity of the issue is still some time hence, there is little to worry about on that score ; but it must not be forgotten, however, that there is an annual interest charge of $60,000 to be paid. GAIN FOR THE YEAR "We have not been given the volume or profits in this case, but the successful year enjoyed by the company is best evidenced by the fact that after paying the regular 7 per cent dividends, the Surplus item shows an increase of some $128,000. CONCLUSION A view of the statement as a whole shows it to be a very satisfactory one, and despite tlie increased indebt- edness, the figures indicate that the business is in good liquid condition and showing progress. III. Analysis of a Jobbing Statement The next statement to be analyzed is that of a jobbing concern in the shoe line. The statement received from the firm is represented in Figure 6. This is not a particularly attractive statement. For a concern engaged in this line, the indebtedness is too heavy, indicating a lack of working capital, which is also further verified by the practice of discounting receiva- bles. notes AND ACCOUNTS RECEIVABLE A comparison of these items with the volume indicates that collections are not being watched as closely as is FINANCIAL STATEMENTS 31 necessary. In this line of business accounts usually average close to 60 days, but with this firm it will be noted that accounts are averaging about 90 days. NET WORTH In comparing statements the fluctuations of the net worth, as in the case of the surplus item in corporations, should be carefully watched, and an explanation should be forthcoming for any imusual decline in this item. It will be noted that the withdrawals for the year amounted to $40,000, and in view of the lack of working capital evidenced, it can be readily appreciated that it would have been better to have allowed this money to remain in the business. SPECIAL CAPITAL In the case of a firm, the means of the general part- ners, both in and out of the business, are at the risk of the business with certain exemptions under the laws of some states, such as homestead laws, etc. This is not so in the case of a contributory or special partner, whose liability extends only to the amount of his invest- ment. Special capital is usually left in the business for a definite period and, therefore, it is necessary to secure the maturity date, as the necessity of paying out such an interest could very well cripple the credit standing. DISCOUNTED RECEIVABLES At the foot of the statement it will be noted that the company has discounted with its banks, receivables to the extent of $35,000. This is one of the unfavorable 32 WILSON AND CARPENTER features of the statement and, as mentioned above, is indicative of the lack of working capital. In some instances the practice of discounting receivables is fol- lowed in order to facilitate the collection of the notes. If, therefore, some question might arise in the mind of the credit grantor as to whether the receivables had been discounted to secure immediate use of the funds, or the practice had been followed only for collection pur- poses, this point could be covered by inquiry. IV. Analysis of a Cotton Mill Statement We now have for consideration the financial statement of a cotton mill. Figure 8 is the form in which the statement is received from the mill. When examining the financial status of a cotton mill, the features to be borne in mind are the size of the plant, its physical character, the nature of the product, and the ability and morale of the management. CURRENT assets The output of cotton mills which manufacture staple lines, such as gray goods, sheetings, shirtings, drills, ginghams, etc., is of a most liquid character. The raw cotton on hand or contracted for, could always be sold in the open market. There is also an open market for the finished product, and the merchandise in process could with great rapidity be turned into the finished product and readily sold. The quick liquidating character of the inventory is therefore readily apparent. The practice of disposing of the output through sell- ing agents of established financial standing and with broad distributing facilities is another element of strength inasmuch as it eliminates credit risks in con- FINANCIAL STATEMENTS 33 nection with sales and the expense of finding a market for the merchandise. The commisson house makes fre- quent settlements with mills, and from this it can be seen that credits with selling agents or commission houses are almost as available as cash in bank. FIXED ASSETS The fixed assets of a cotton mill have more definite liquidating value than is the case with most other lines of manufacturing. The equipment and processes in this industry are quite standardized. AMiile skill is required to conduct the business, skilled manual labor is not an important factor. Most of the work is done by automatic machinery, and no special difficulties are presented in establishing or maintaining the operating end of the organization. It is not an especially complicated busi- ness. Furthermore, a large part of the machinery in a cot- ton mill can be moved. Second-hand machinery is fre- quently purchased and moved from one mill to another. It has a tangible value, independent of the plant in w^hich it is installed. These things tend to make a readier market for the sale of cotton mills and their so-called "fixed assets." Hence the plant and equip- ment has some more or less defined liquidating value and the figures set up in the statement are liable to less shrinkage on a forced sale than is the case in most other kinds of manufacturing plants. Therefore, the fixed assets play a more important part than usual m consid- ering the commercial credit of the mill. And it is a corollary that the ratio of quick assets to indebtedness is generally smaller than in other commercial risks. It follows then that the fixed assets must be more care- fully considered than in a risk where the ratio of 34 WILSON AND CARPENTER ALLISON COTTON MILLS CHARLOTTE, N. C. December 31, 1916 Assets Cash $ 49,731.85 Merchandise Finished 17,868.02 Merchandise Unfinished 30,876.00 Cotton 29,963.93 Real Estate, Buildings, etc 641,790.46 Prepaid Interest, Insurance, etc 28,133.06 Due from Selling Agency 187,768.14 $986,131.46 Liabilities Notes Payable $200,000.00 Accounts Payable 21,397.16 Accrued Wages, Taxes, etc 9,206.58 Reserve for Depreciation 170,101.60 Capital Stock 350,000.00 Surplus 235,426.12 $986,131.46 Fig. 8. — Statement of the Allison Cotton Mills FINANCIAL STATEMENTS 35 COMPARISON OP ST AUlSQlL5aTTOH.MILL5!»_ CH/JILOTTE. If. C. \T EEMBNTS „n-.»..J*;lWIPllVI1TB«>«f StlEGf n"l!*, Be e/1. Direct ^S5"* iDe... 31. 1916 1 - Cash « 7.-n7 - - TOTAL QUICK ASSETS 14 - CURRENT LIABILITIEJ <> :.io .O,'? 4 EXCESS-QUICK £&. ifili sL Salca " Cootiii«ui1 UabUities lutumnM Diridends Depredation Net Froaes \ Outside Means 1 Fig. 9. — Comparison of Statements — Allison Cotton Mills 36 WILSON AND CARPENTER quick assets is higher and where consequently the fixed assets are more prone to be disregarded or eliminated in passing the commercial credit. MANAGEMENT It is important to learn the history of the manage- ment, its record for successful operation over a period of years, its freedom from speculative tendencies, its policy with respect to plant extension, and its moral standing. The purchase of raw material affords many opportunities for speculation necessitating a close check on this feature of the risk. As a general rule, a mill man should cover his orders with cotton or contracts with cotton merchants, thereby eliminating the hazards incident to the fluctuations in the price of cotton. With the mill under discussion the small margin of working capital will be noted; but if one considers the fundamental features mentioned in the foregoing and is satisfied as to the moral character and ability of the management and the earning power evidenced by the business over several years, the risk would appear sat- isfactory, as one could be assured that the money loaned could be quickly turned into merchandise, sold and con- verted into cash, and the indebtedness liciuidated. V. Summary The foregoing analj^sis of statements from various industrial lines emphasizes some of the vital points involved in the analysis of fmancial statements. It is obvious that an efficient knowledge of the principles of accounting is required to appreciate the accounting significance of each item, but in the final interpretation FINANCIAL STATEMENTS 37 of a statement, a still broader knowledge is required, involving these five general points : 1. Line of business. 2. Terms of purcliase and sale. 3. Local conditions, geographical or otherwise. 4. Necessary capital for needs of business. 5. Ability and character of the management. The underlying principle of the proper analysis of the financial statement is this: Determine those items Avhich in the usual course of business would indicate the debt-paying or liquidating ability of the concern under consideration. SELF-TEST QUESTIONS These questions are for the reader to use in testing his knowledge of the treatise. The answers are not to be sent in to the university. 1. What groups of business men are particularly interested in the analj'sis of financial statements? 2. TIov/ may the analysis of a credit man differ from that of an investor? 3. What are the principal special characteristics of the wholesale grocery business that have a bearing on credit analysis ? 4. How is the ratio of "quicks" determined in credit analysis ? 5. What is the function of the "Comparison of State- ments"? 6. Explain at least three factors to look out for in the examination of the cash item. 7. Why should the Notes Receivable item be relatively small in a wholesale grocery statement? 38 WILSON AND CARPENTER 8. What effect does the use of acceptances have upon the figures of the statement? 9. Explain by illustration how to figure the period which collections average. 10. Indicate at least four important tests to apply to Accounts Receivable. 11. What points should be checked in the merchandise item? 12. How may investments affect the debt-paying ability of a concern? 13. How should consignment accounts be regarded? 14. Explain how to check Notes Payable. 15. How should reserves be treated? 16. How would you check up bonded debt? 17. How is net worth determined? 18. What information does a Profit and Loss Statement supply ? 19. What comparisons with previous statements might be made? 20. In what different ways may a contingent liability arise ? 21. What special points are to be considered in the analysis of a packing-house statement? 22. What special considerations may be given to the cur- rent assets of a cotton mill? To the fixed assets? 23. Is a large working capital essential in a cotton mill? Why? 24. What are the principal points to consider in the analysis of financial statements as brought out in this treatise ? THIS BOOK IS DUE ON THE LAST DATE STAMPED BELOW AN INITIAL FINE OF 25 CENTS WILL BE ASSESSED FOR FAILURE TO RETURN THIS BOOK ON THE DATE DUE. THE PENALTY WILL INCREASE TO 50 CENTS ON THE FOURTH DAY AND TO $1.00 ON THE SEVENTH DAY OVERDUE. OCT 4 ^S32 SEP 18 1933 I 1934 ^^^ 22 Jd3tf ^81 DEC JUL 21 l943 18fEB'59TJ RECD LD FEB 4 1959 T3MajrebC^ RECt)T-b 5 ^93«"AY2 0'65-8AM LD 'Jl-SOm-S.S'J ! GAYLAMOUNT PAMPHLET BINDEt ManafaclurtJ by I eAYLORD BROS. U*. \ Syracuse, N. Y. Stockton, Calif. 401592 UNIVERSITY OF CALIFORNIA LIBRARY ■/