C H A P T E R
BALANCE SH EET AN D STATEMENT OF CASH FLOWS
After studying this chapter, you should be able to:
•1 •2 •3 •4 •5 •6 •7 •8 •9
Explain the uses and limitations of a balance sheet. Identify the major classifications of the balance sheet. Prepare a classified balance sheet using the report and account formats. Determine which balance sheet information requires supplemental disclosure. Describe the major disclosure techniques for the balance sheet. Indicate the purpose of the statement of cash flows. Identify the content of the statement of cash flows. Prepare a basic statement of cash flows. Understand the usefulness of the statement of cash flows.
“There Ought to Be a Law”
As one manager noted, “There ought to be a law that before you can buy a stock, you must be able to read a balance sheet.” We agree, and the same can be said for a statement of cash flows. Krispy Kreme Doughnuts provides an example of how stunning earnings growth can hide real problems. Not long ago the doughnut maker was a glamour stock with a 60 percent earnings per share growth rate and a price-earnings ratio around 70. Seven months later its stock price had dropped 72 percent. What happened? Stockholders alleged that Krispy Kreme may have been inflating its revenues and not taking enough bad debt expense (which inflated both assets and income). In addition, Krispy Kreme’s operating cash flow was negative. Most financially sound companies throw off positive cash flow. Following are additional examples of how one rating agency rated the earnings quality of some companies, using some key balance sheet and statement of cash flow measurements.
Company Avon Products Capital One Financial Ecolab Timberland
Earnings-Quality Indicators Strong cash flow Conservatively capitalized Good management of working capital Minimal off-balance-sheet commitments Earnings-Quality Indicators High debt and underfunded pension plan High goodwill and debt Negative free cash flow Selling assets to meet liquidity needs
Company Ford Motor Kroger Ryder System Teco Energy
Just as a deteriorating balance sheet and statement of cash flows warn of earnings declines (and falling stock prices), improving balance sheet and cash flow information is a leading indicator of improved earnings. Source: Adapted from Gretchen Morgenson, “How Did They Value Stocks? Count the Absurd Ways,” New York Times on the Web (March 18, 2001), and from K. Badanhausen, J. Gage, C. Hall, and M. Ozanian, “Beyond Balance Sheet: Earnings Quality,” Forbes.com (January 28, 2005).
PR EVI EW
C H APTE R
Readers of the financial statements sometimes ignore important information in the balance sheet and statement of cash flows. As our opening story shows, analyzing these financial statements helps investors avoid surprises in earnings. In this chapter we examine the many different types of assets, liabilities, and stockholders’ equity items that affect the balance sheet and the statement of cash flows. The content and organization of the chapter are as follows.
BALANCE SHEET AND S TAT E M E N T O F C A S H F L O W S
• Usefulness • Limitations • Classification • Additional information reported • Techniques of disclosure
S TAT E M E N T O F CASH FLOWS
• Purpose • Content and format • Preparation overview • Usefulness
178 · Chapter 5 Balance Sheet and Statement of Cash Flows
SECTION 1 • BAL ANC E SH EET
Objective•1 Explain the uses and limitations of a balance sheet.
The balance sheet, sometimes referred to as the statement of financial position, reports the assets, liabilities, and stockholders’ equity of a business enterprise at a specific date. This...