A Financial Statement Glossary

As you prepare to crunch the numbers for yourself, you've got to speak the language. Here's a quick glossary. For more info on dissecting the balance sheet and income statement, see Contributing Editor Andy Greta's series on the basics of fundamental analysis.

Terms

Accounts receivables (A/R) If a sale is made on credit, a corresponding receivables account will be created on the day of that sale. So this balance is the total amount of money owed to the company for goods rendered or services performed. You can find the receivables account on the asset side of the balance sheet. Allowance for doubtful accounts A company must have a "cushion" set aside for all its uncollectible receivable accounts. So this allowance for doubtful accounts is the company's estimate of uncollectibles. This is where that long-overdue customer's bill should be -- his balance should not still be sitting in accounts receivable. The allowance is a negative number against the receivables account on the balance sheet, so it decreases the total number of assets and is an expense to the company. That means, in the end, that net income is decreased. Analytical This is auditor-speak for finding the percentage difference from the current year's revenue balance to the prior year's balance. Ignore the awkward phrase. It's a great exercise because it can help you spot large swings from one year to the next. Big percentage changes relative to past performance should be red flags. Capitalization When a cost is capitalized, it is taken off the income statement and put on the balance sheet as a long-term asset, then written off over a period of years (as opposed to expensing the cost and taking the hit in one lump sum). If a $10,000 cost was capitalized over a five-year period, $2,000 would be considered an expense each of the five years. If the $10,000 was expensed, it would all be taken in the current year. Expenses Listed on the income statement, expenses can be anything from depreciation to salaries to research and development, and every company has them. You'll find any current-year restructuring charges here as well. Expenses are subtracted from total revenues, determining both a company's net income and profit margins. Extraordinary items. These are additional gains or losses on the income statement that are unusual in nature and occur very infrequently. Some examples: a gain/loss on the disposal of a segment of a business; a loss associated with a hailstorm that destroys a crop in an area that rarely has hailstorms. Because these items are unusual, they are reported after operating income. The logic is that you can then see how much income the company generated before the supposed major event. Each extraordinary item should be explained by its own footnote. Take close look to make sure they're reasonable and unlikely to happen again. Goodwill Think of goodwill as the "extra" a company is willing to pay to own a certain business. It represents the premium paid for an acquired company in excess of its property, plant, equipment and other tangible assets. Goodwill is created when purchase accounting is used in an acquisition, and reflects the acquirer's belief that the company being acquired has more earnings potential than the Street is valuing. Intangibles Things that are very valuable to the company -- and are considered assets -- but cannot be physically touched. Things like patents, copyrights, goodwill and trademarks are all intangibles. They are usually amortized -- or used up a little each year -- over a longer period of time. For instance, goodwill is amortized over a 40-year period. Inventories The goods that are held for sale in the ordinary course of business. Also included in inventory are raw materials, factory supplies and any work in process. Letter to the shareholders Generally written by the CEO, this really gives you a sense of the company's personality. It tells you what the company is doing and where it's going. Are they moving in a direction that you're comfortable with? You can pick up a lot by reading between the lines, and comparing one company with another. Management's Discussion and Analysis This summary details the company's results for the period and analyzes its current outlook. Anything that happened out of the ordinary would also be detailed here. There may have been industry issues or a company catastrophe. Either way, think of it as your bible. Pooling accounting In its simplest form, this is when two companies combine on a "merger of equals" basis, thus pooling their assets. They basically slap their financials together, line by line, combining the numbers. Company A's cash, inventory and debts are combined with Company B's to create new, pooled numbers. And so on right down the financials. Historical costs, not fair market value, are used, so pooling may lead to higher earnings in later years. That's why the Financial Accounting Standards Board has proposed that it no longer be permitted Purchase accounting If a company is acquired using the purchase method, the financials are not combined, like they are in pooling accounting. With purchase accounting, one company is actually purchased. But here, goodwill is created. Let's say a Company A purchases Company B for $1.5 million. The fair market value, a.k.a. the street value, of Company B at the date of purchase is only $1 million. But A believes that B has earnings potential and is willing to pay more. So $1 million will be recorded as a new investment asset for the company and the extra $500,000 will be considered goodwill. Revenue The company's sales. They represent the total money the company collected for any goods provided and/or services performed and are found on the income statement. Revenue recognition policy When does the company recognize a sale? After the good is shipped? Or right after production, but before the good is shipped? This is important to know because aggressive recognition can improperly boost sales. This policy should be outlined in the Summary of Accounting Policies Footnote, in the back of your annual report.

Some Ratios

Receivable turnover This ratio can help you get a feel for just how quickly a company collects the money it's owed from its customers. Just divide total annual sales by average of the most recent two years' accounts receivable. Thirty days is a pretty good benchmark (most companies require payment in 30 days), but check with the company's competitors. Days sales outstanding This calculation will help you determine how many days' worth of sales are still uncollected. Divide the total balance in accounts receivable by the average sales per day (which is annual sales divided by 365). Inventory turnover This ratio helps you get a feel for how quickly items are produced and sold. Take the cost of goods sold (on the income statement) and divide it by the average of the most recent two years' ending inventory balances. Leverage Basically, if the company had to liquidate today, could it pay all its bills? Leverage is the amount of liabilities compared to the company's net worth. Divide total long-term liabilities by the total net worth (i.e., stockholders' equity). A number of one or lower is comforting, although the reasons for higher numbers can be justified, depending on the industry. Compare against the company's industry peers.