56 Part 2 Fundamental Concepts in Financial Management
results during the past year and discusses new developments that will affect future
operations. Second, the report provides these four basic! nancial statements:- 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. - The income statement, which shows the! rm’s sales and costs (and thus pro! ts)
during some past period —for example, 2008. - The statement of cash! ows, which shows how much cash the! rm began the
year with, how much cash it ended up with, and what it did to increase or
decrease its cash. - 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! rm’s operations and! nancial position.
The quantitative and verbal materials are equally important. The! rm’s! nancial
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! nancial
statements. Allied was formed in 1981, when several regional! rms merged; and it
has grown steadily while earning a reputation as one of the best! rms in its indus-
try. 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 opera-
tions had been resumed, that several unpro! table businesses had been eliminated,
and that 2009 pro! ts were expected to rise sharply. Of course, an increase in pro! t-
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! nancial statements are relatively simple and
straightforward; we also omitted some details often shown in the statements.
Allied! nances with only debt and common stock—it has no preferred stock, con-
vertibles, or complex derivative securities. Also, the! rm 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! nancial 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 state-
ments, but we leave it to advanced courses to cover the intricacies of accounting.
SELF^ TEST What is the annual report, and what two types of information does it
provide?
What four! nancial statements are typically included in the annual report?
Why is the annual report of great interest to investors?