FINANCIAL STATEMENTS AND REPORTS

The annual report is the most important report that corporations issue to stockholders,
and it contains two types of information.2 First, there is a verbal section,
often presented as a letter from the chairperson, which describes the firm’s operatingresults during the past year and discusses new developments that will affect future
operations. Second, the report provides these four basic financial statements:
1. The balance sheet, which shows what assets the company owns and who has
claims on those assets as of a given date—for example, December 31, 2008.
2. The income statement, which shows the firm’s sales and costs (and thus profits)
during some past period—for example, 2008.
3. The statement of cash flows, which shows how much cash the firm began the
year with, how much cash it ended up with, and what it did to increase or
decrease its cash.
4. The statement of stockholders’ equity, which shows the amount of equity the
stockholders had at the start of the year, the items that increased or decreased
equity, and the equity at the end of the year.
These statements are related to one another; and taken together, they provide an
accounting picture of the firm’s operations and financial position.
The quantitative and verbal materials are equally important. The firm’s
financial statements report what has actually happened to its assets, earnings, and
dividends over the past few years, whereas management’s verbal statements
attempt to explain why things turned out the way they did and what might
happen in the future.
For discussion purposes, we use data for Allied Food Products, a processor
and distributor of a wide variety of food products, to illustrate the basic financial
statements. Allied was formed in 1981, when several regional firms merged; and it
has grown steadily while earning a reputation as one of the best firms in its
industry. Allied’s earnings dropped from $121.8 million in 2007 to $117.5 million
in 2008. Management reported that the drop resulted from losses associated with a
drought as well as increased costs due to a three-month strike. However, management
then went on to describe a more optimistic picture for the future, stating
that full operations had been resumed, that several unprofitable businesses had
been eliminated, and that 2009 profits were expected to rise sharply. Of course, an
increase in profit-ability may not occur; and analysts should compare management’s
past statements with subsequent results. In any event, the information
contained in the annual report can be used to help forecast future earnings and dividends.
Therefore, investors are very interested in this report.
We should note that Allied’s financial statements are relatively simple and
straightforward; we also omitted some details often shown in the statements.
Allied finances with only debt and common stock—it has no preferred stock,
convertibles, or complex derivative securities. Also, the firm has made no acquisitions
that resulted in goodwill that must be carried on the balance sheet. Finally, all
of its assets are used in its basic business operations; hence, no nonoperating assets
must be pulled out when we evaluate its operating performance. We deliberately
chose such a company because this is an introductory text; as such, we want to
explain the basics of financial analysis, not wander into arcane accounting matters
that are best left to accounting and security analysis courses. We do point out some
of the pitfalls that can be encountered when trying to interpret accounting statements,
but we leave it to advanced courses to cover the intricacies of accounting.