Investor Analysis of Financial Statements

In the last lesson, we learned about managerial accounting and stockholders' equity. This lesson describes how investors analyze financial statements in order to calculate figures such as shares of oustanding stock and dividend values.

Example: Analysis of an Equity Section of a Balance Sheet

Stockholders' Equity and Paid in Capital

The post closing year-end balance sheet of Technical Services, Inc. includes the following stockholders equity section (with certain details omitted):

 Stockholders? equity: 6% cumulative preferred stock, \$100 par value, callable at \$102, 100,000 shares authorized \$2,400,000 Common stock, \$2 par value, 2,000,000 shares authorized 2,200,000 Additional paid-in capital: Common stock 1,485,000 Donated capital 410,000 Retained earnings, end of year 3,470,000 Total stockholders? equity \$9,965,000

Instructions

From this information, compute answers to the following questions:

a. How many shares of preferred stock have been issued?

 Recorded Par value of all preferred stock outstanding \$2,400,000 Divided by: Par value per share of preferred stock \$100 Number of shares of preferred stock outstanding [2,400,000 / 100] 24,000 shares

[Note: Preferred stock usually has a par value of \$100 per share. In this case there is no additional paid-in capital associated with preferred stock.]

b. What is the total amount of the annual dividends paid to preferred stockholders?

 Dividend requirement per share of preferred stock (\$100 x 6%) \$6 per share Times: Number of shares of preferred stock outstanding (from part a) 24,000 Annual preferred stock dividend requirement [24,000 * \$6] \$144,000

c. How many shares of common stock are outstanding?

 Recorded Par value of all common stock outstanding \$2,200,000 Divided by: Par value per share of common stock \$2 Number of shares of common stock outstanding [2,200,000 / \$2] 1,100,000 shares

[Note: this company has no Treasury stock. Treasury shares would be subtracted from total shares, but only when they are present.]

d. What was the average issuance price per share of common stock?

 Recorded Par value of all common stock outstanding \$2,200,000 Plus: Additional paid-in capital: Common stock 1,485,000 Total issue price of all common stock \$3,685,000 Divided by Number of shares of common stock outstanding (from part c) 1,100,000 Average issue price per share of common stock [\$3,685,000 / 1,100,000] \$3.35 per share

[Note: this company has recorded additional paid-in capital on common stock. At least some of the stockholders paid a price greater than par value for their shares. Since stock prices tend to fluctuate, this would be a typical situation for most corporations.]

e. What is the amount of legal capital?

 Par value of preferred stock issued \$2,400,000 Plus: Par value of common stock issued 2,200,000 Total legal capital \$4,600,000

[Note: Legal capital is the total of par value of all shares issued. Legal capital laws and requirements vary from state to state. Check with the Secretary of State to find out the legal capital requirements in your state.]

f. What is the total amount of paid-in capital?

 Total Stockholders Equity \$9,965,000 Less: Retained earnings 3,470,000 Total paid-in capital \$6,495,000

[Note: Paid-in capital represents all amounts paid by stockholders to the corporation in exchange for stock. Donated Capital is also called Contributed Capital. GAAP requires us to include Donated Capital in the computation of paid-in capital. See the note below on Donated Capital.]

g. What is the book value per share of common stock? (Assume there are no dividends in arrears.)

 Total stockholders' equity \$9,965,000 Less: Call value of Preferred stock [\$102 * 24,000 shares] 2,448,000 Total Book Value belonging to common stockholders \$7,517,000 Divided by number of common shares outstanding (from part c) 1,100,000 Book value per share of common stock, rounded to nearest cent \$6.83

[Note: Book Value is an artificial amount. It merely represents the amount of value due to the common stockholders, divided by the number of common shares outstanding. Call price of preferred stock represents the amount that would be paid to buy out preferred stockholders.]

h. Dividends on common stock

Assume that retained earnings at the beginning of the year amounted to \$745,000 and the net income for the year was \$3,600,000. What was the dividend declared during the year on each share of common stock?

 Retained earnings, beginning of year \$745,000 Add: Net income for the year 3,600,000 Subtotal 4,345,000 Less: Retained earnings end of year 3,470,000 Total dividends paid during the year 875,000 Less: Dividends on preferred stock (part b) 144,000 Total dividends due common stockholders \$731,000 Divided by: Number of common shares outstanding (part c) 1,100,000 Dividends per share of common stock outstanding, rounded \$ .6645

[Note: This part simply follows the general format of a Retained Earnings statement. Accountants generally carry Dividend and EPS calculations out to 4 decimal places, for greater accuracy. Most publicly traded companies have millions, perhaps even tens-of-millions of shares of common stock. It's easy to see how those 2 extra decimal places can make a big difference in accuracy when you are dealing with many shares of stock.]

Donated Capital

Donated Capital is a gift of assets to a company, usually by state or local governments, typically to induce a business to relocate to their jurisdiction. Donated Capital belongs to the Common Stockholders, unless otherwise stated in stockholders' agreements.

When calculating part g, you will use the CALL price of preferred stock. If there is no call price, then you will use the par value. But when preferred stock has a call price, that is the amount used, because it is the amount that would be paid to preferred stockholders if the corporation were to call and retire the preferred stock.

Non-Cash Stock Transactions

Stock must be paid for before it can be issued. It is a violation of law to issue or record stock prior to receiving payment from investors. It's easy to value a stock sale for cash, since the cash paid fixes the actual value of the transaction.

Sometimes stock is issued for something other than cash. Land, buildings, equipment, vehicles or other assets can be exchanged for stock. Shares of one company's stock can also be exchanged for shares of another company. Investments of various types (stocks, bonds, etc.) may also be exchanged for shares of stock. In some cases, the value of the property given up can easily be determined, making it easy to place a value on the stock transaction.

When a non-cash transaction occurs, we have to take a market value approach, and we try to identify the part of the transaction that has the most widely accepted market value. There is a specific hierarchy accountants must use to determine the overall value of such transactions. We apply the hierarchy in the following order.

1. If the stock being issued is publicly traded, the entire transaction is the market value of the stock given up. We will assign that value to any assets received.

Example: On March 27, 2006 Microsoft Corp. exchanges 100,000 shares of company stock for a piece of undeveloped real estate. What is the value of this transaction?

On March 27, 2006 Microsoft stock sells for \$27.25 per share. They give up 100,000 shares, in effect saying "we think the property we are purchasing is worth \$2,725,000.

[\$27.25 * 100,000 shares = \$2,725,000]

We assign the market price of Microsoft stock to this transaction, because the stock is heavily traded on global stock markets, and the price is fixed by a very large market of investors. If Microsoft feels that the real estate is worth 100,000 shares, who are we to argue? Accountants just have to record the transaction.We don't have to care if company management is making a good deal or not. But we do assume that the transaction is "fair" and "at arms length" and that neither party is under any particular pressure or duress to enter into this fair market value agreement.

On the other side of the coin -- the seller (now stockholder) must also feel that \$2,725,000 is a "fair" price for his/her real estate, or he/she would not have accepted Microsoft's offer. Since the 100,000 shares can immediately be sold on open market for \$2,725,000, the seller can convert the shares to cash the same day as the transaction.

Microsoft common stock is \$0.00000625 par value per share, so they will record \$0.63 in par value, with the remaining recorded as additional paid-in capital, as follows:

[\$0.00000625 x 100,000 = \$ 0.625, rounded to \$ 0.63]

General Journal

 Date Account Debit Credit Real Estate 2,725,000.00 Common Stock .63 Additional Paid-in Capital 2,724,999.37 To record the issue of 100,000 shares common stock in exchange for unimproved real estate.

This is a rather unusual example because Microsoft's par value is so low. But this is how it's done, regardless of the dollar amounts involved.

2. If the stock being issued is NOT publicly traded, the entire transaction is the market value of the asset received. We will assign that value to any shares of stock issued.

XYZ Corporation is a small private company. It's stock is not sold on a public stock exchange, and there is no ready market for the company's stock at this time. XYZ Corporation agrees to exchange 10,000 shares of company stock for a piece of unimproved real estate. Two independent, certified and licensed appraisers are hired to provide appraisals of the real estate value. The appraisers agree that the real estate has a fair market value in the range of \$100,000 to \$110,000 at the time of the transaction.

Following the accounting rule of conservatism, we apply the lower of the range of values, or \$100,000, to this transaction. We follow the conservatism rule to minimize the effect of making an estimate. If the company stock has a par value of \$1 we would record the transaction as follows:

General Journal

 Date Account Debit Credit Real Estate 100,000 Common Stock 10,000 Additional Paid-in Capital 90,000 To record the issue of 10,000 shares \$1 par common stock in exchange for unimproved real estate.

3. In some rare instances neither of the two approaches above will work, and we have to take a slightly different approach. We still need to approximate true market value of the transaction, since that is always considered the fair approach.

Assume ABC Corporation is not publicly traded. They agree to exchange 5,000 shares of company stock for a piece of unimproved real estate. The real estate is in an area that is facing economic downturn in the real estate market, and has been available for sale for many years, with no interested buyers or offers. Appraisers are reluctant to place a market value on the property.

After updating and analyzing the company's books, the accountants determine that ABC Corporation's stock has a Book Value of \$2.10 per share. We seldom use book value for any calculation, but this is one rare instance where it is used. We place a value on the transaction of \$10,500 [5000 shares * \$2.10]. IF the par value is \$1 per share, we record the transaction as follows:

General Journal

 Date Account Debit Credit Real Estate 10,500 Common Stock 5,000 Additional Paid-in Capital 5,500 To record the issue of 5,000 shares \$1 par common stock in exchange for unimproved real estate.

In this case, the corporation is willing to give a share in the company equal to \$10,500 in exchange for the real estate. This represents a future interest in profits and ownership to the person selling the property. The new stockholder believes the value of the land is worth \$10,500 since he/she accepts the offer under these terms. Both parties will apply the same value to the transaction.

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