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Interpretation of financial statements benjamin graham pdf

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The Interpretation of Financial Statements [Benjamin Graham, Spencer B. Meredith, Michael F. Price] on pflegeelternnetz.info *FREE* shipping on qualifying offers . The Interpretation of. Financial Statements. BY. BENJAMIN GRAHAM. AND. CHARLES McGOLRICK. A revision of the book by Benjamin Graham and. Spencer. Biographical Sketch of Benjamin Graham, Financial Analyst. 1. II. to investment securities analysis, investment management, financial analysis, securities.


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The interpretation of financial statements: the classic edition / Benjamin Graham and Spencer B. Meredith ;. Introduction by Michael F. Price. Benjamin Graham - Interpretation of Financial Statements - Download as PDF File .pdf), Text File .txt) or read online. Lesson from the Legends of Wall Street, How Warren Buffet, Benjamin Graham, Phil Fisher, T. Rowe Prince, and John Templeton can help you grow rich.

Contingency reserves and other similar reserves tend to make corporate statements confusing. Recognized claims against an enterprise.. Amazon Giveaway allows you to run promotional giveaways in order to create buzz, reward your audience, and attract new followers and customers. Stocks are not negotiable instruments. The volume you hold in your hands is Graham's timeless guide to interpreting and understanding financial statements.

As he writes in the preface, "if you have precise information as to a company's present financial position and its past earnings record, you are better equipped to gauge its future possibilities. And this is the essential function and value of security analysis. Readers will learn to analyze a company's balance sheets and income statements and arrive at a true understanding of its financial position and earnings record.

Graham provides simple tests any reader can apply to determine the financial health and well-being of any company. Graham's original language has been restored, and readers can be assured that every idea and technique presented here appears exactly as Graham intended. Highly practical and accessible, it is an essential guide for all business people--and makes the perfect companion volume to Graham's investment masterpiece The Intelligent Investor.

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Back Security Analysis: Principles and Techniques Benjamin Graham 4. Fisher 4. Price, president, Franklin Mutual Advisors, Inc.

The volume is Benjamin Graham's timeless guide to interpreting and understanding financial statements. It has long been out of print, but now joins Graham's other masterpieces, The Intelligent Investor and Security Analysis, as the three keys to understanding Graham and value investing. Would you like to tell us about a lower price? If you are a seller for this product, would you like to suggest updates through seller support? Read more Read less. Frequently bought together. Total price: Add all three to Cart Add all three to List.

Buy the selected items together This item: Security Analysis: The Intelligent Investor: Customers who bought this item also bought. Page 1 of 1 Start over Page 1 of 1. Sixth Edition, Foreword by Warren Buffett. Benjamin Graham. Warren Buffett and the Interpretation of Financial Statements: Mary Buffett. Principles and Techniques. Philip A. Warren Buffett Accounting Book: Reading Financial Statements for Value Investing. Stig Brodersen. Review "This reissue of the classic edition Read more.

Product details Hardcover: English ISBN Tell the Publisher! I'd like to read this book on Kindle Don't have a Kindle? Is this feature helpful? Thank you for your feedback. Share your thoughts with other customers. Write a customer review. Read reviews that mention financial statements balance sheet security analysis interpretation of financial intelligent investor benjamin graham cash flow warren buffett income statement benjamin graham intrinsic value sheet and income value investing warren buffet short concise read on financial analysis and the intelligent financial terms analysis is a great financial reports.

Top Reviews Most recent Top Reviews. There was a problem filtering reviews right now. Please try again later. Hardcover Verified Purchase. Benjamin Graham was a pioneer in the field of value investing. The Interpretation of Financial Statements was originally published in This page book focuses on the balance sheet and income statement.

Graham also wrote Security Analysis, first published in , and The Intelligent Investor, first published in There are a number of intangible assets on the balance sheet. In the introduction, Michael Price describes an experience early in his career. This writing down of good-will does not mean that it is actually worth less than before, but only that the management has decided to be more conservative in its accounting policy.

This point illustrates one of the many contradictions in corporate accounting. But this means that the good-will is in fact considerably more valuable than it was at the beginning. Such intangibles may have a very large value indeed, but it is the income account and not the balance sheet that offers the clue to this value.

In other words, it is the earning power of these intangibles, rather than the balance sheet valuation, that really counts. If the receivables seem unusually large in proportion to sales, or to other items, there is some indication that an unduly liberal credit policy has been pursued, and that more or less serious losses are likely to be sustained from bad accounts. In such a case the bank loans should be studied over a period of years to see whether they have been growing faster than sales and profits.

If they have, it is a definite sign of weakness. In the great majority of instances the attractiveness or the success of an investment will be found to depend on the earning power behind it. Here are some examples: It should be based both upon the past record, and upon a reasonable assurance that the future will not be vastly different from the past.

Hence companies with highly variable records or especially uncertain futures may not logically be thought of as having a well-defined earning power. Expenditures are outlays of cash or the equivalent; frequently they involve no concurrent charge against operations or earnings e. Capital Expenditures. Expenses are costs, i. Accruals, Depreciation. Intangible Asset purporting to reflect the capitalization of excess future profits expected to accrue as a result of some special intangible advantage held, such as good name, reputation, strategic location, or special connections.

In practice, the amount at which good-will is carried on the balance sheet is rarely an accurate measure of its true value. Generally a rather indefinite concept; but sometimes the balance sheet and earnings record supply dependable evidence that the intrinsic value is substantially higher or lower than the market price.

A guarantee by more than one party under which each party is potentially liable for the full amount involved if his associates do not meet their share of the obligation. An issue whose claim for interest or dividends, or for principal value, comes after some other issue, called a senior issue. Second mortgages are junior to first mortgages on the same property; common stock is junior to preferred stock, etc.

Accounts receivable Notes receivable Interest receivable Due from agents 3. Sometimes they are called liquid or quick or floating assets.

For example. In the operation of the business these assets change gradually into cash. For the most part these are the debts contracted by the company in the ordinary course of operating the business. In addition. Those most generally encountered may be described as follows: Accounts Payable are the various amounts of money owed by the corporation to those with whom it does business. Accrued Expenses include wages and commissions owed to employees and other small debts not substantial enough to warrant an individual label.

Income Taxes Accrued are the unpaid portion of income and excess profits taxes due on various dates in the ensuing year. Money borrowed from banks or others for a short term will be listed as Bank Loans or Notes Payable. Other such items include Dividends Payable. Customer Advances. But tobacco companies. Shortage of working capital. Working capital is a consideration of major importance in determining the financial strength of an industrial enterprise.

The proper amount of working capital will vary with the volume of sales and the type of business. Its more serious consequence is insolvency and the bankruptcy court. The current position involves two important factors: The working capital is found by subtracting the current liabilities from the current assets. The investment in plant account or fixed assets is of little aid in meeting these demands.

The chief point of comparison is the amount of working capital per dollar of sales. In the working capital is found the measure of the company's ability to carry on its normal business comfortably and without financial stringency.

Food companies in The working capital available for each share of common stock is an interesting figure in common stock analysis.

A good industrial bond or preferred stock is expected. Products of petroleum and coal 0. The ratio "sales per dollar of working capital" is used in comparative analysis. United States Steel Corporation in its Summary of Financial Operations in gave the following detailed changes in working capital: The careful investor. These may be called the quick assets. The working capital of a corporation is increased by a the amount of the net income.

The financial position is more readily determined by the current ratio and quick ratio described in Chapter VII. A prosperous utility may at times permit its current liabilities to exceed its current assets.

It is desirable to have an excess of quick assets over all current liabilities. It has been customary to provide for expansion by means of new financing rather than out of surplus cash.

In the field of railroads and public utilities. Working capital is decreased by the amount expended for new plant and equipment or other noncurrent assets and by dividends paid on preferred and common stocks. The growth or decline of the working capital position over a period of years is also worthy of the investor's attention.

The working capital is also studied in relation to fixed assets and to capitalization. The nature of these service enterprises is such as to require relatively little investment in receivables or inventory supplies. Working capital December In general. What constitutes a satisfactory current ratio varies to some extent with the line of business.

When a company is in a sound position. In industrial companies a current ratio of 2 to 1 has been considered a sort of standard minimum. S0 Paper and allied products 2. Railroads and public utilities have not generally been required to show a large current ratio.

This is usually called the current ratio. Many companies reduce their tax liabilities on the balance sheet by subtracting there from U. This is the so-called "acid test. Without this deduction. In every such case. The current ratio should be generally analyzed further by separating out the inventory. It is customary to require that the cash items and the receivables together exceed all the current liabilities.

The ratio of current assets excluding inventory to current liabilities may be called the "quick ratio. Where there are U. If the inventory is of a readily salable kind. In the usual case. In theory. Where the cash holdings are exceptionally large in relation to the market price of the securities.

In such a case the stock may be worth more than the earning record indicates. For practical purposes the various kinds of cash assets may be considered interchangeable. Other concerns show a serious loss of cash or—what amounts to the same thing— a substantial increase in bank loans. They may yield substantial profits or losses due to market changes.

But many companies tend to hold more cash than the business seems to need. The current return on these investments is usually small. Companies frequently build up their cash account even during periods of operating losses by liquidating a large part of their other assets. During recessionary stages in the economy it is particularly important to watch the cash account from year to year.

In such periods the way in which the losses reflect themselves in the balance sheet may be more important than the losses themselves.

A shortage of cash is ordinarily taken care of by bank borrowings. Much of this surplus cash is held in the form of marketable securities. Eventually the stockholders are likely to get the benefit of these cash assets. Any sudden increase in receivables as a percentage of sales may indicate that an unduly liberal credit policy is being extended in an effort to sustain the volume.

This group includes department stores. In these instances neither the receivable nor the debt appears directly on the balance sheet of the manufacturer.

In most cases the finance company exacts a repurchase agreement from the manufacturer. In analyzing the balance sheet such discounted receivables should be given full consideration as the equivalent of both assets and liabilities.

As in the case of inventories. Farm implements. Receivables thus work out to 8. Much of this installment business is carried on through finance companies which advance funds against the notes or guarantee of the seller. The accounts receivable require the most careful scrutiny in the case of companies selling goods on a long-term payment basis.

The range of variation among industries and a norm for individual lines is supplied in the accompanying table. This accepted turnover is thus always larger than the true figure. The chief criterion of inventory soundness is the turnover.

The comparison of inventory turnover among companies within an industry will in many cases reveal an important competitive advantage which marks the leading companies in the group. For manufacturing companies the figure is generally broken down into categories of raw materials.

But this fact in itself is not conclusive unless all the companies being compared are using the same basis for valuing their inventory. The two important ways of calculating inventory values are known as "first-in.

The coal on hand at the inventory date would represent some old or original purchase. As long as prices advance. The old coal is used up first and the stock that remains would naturally be valued on the basis of the most recent purchases.

The LIFO method was introduced about in order to avoid marking up inventories to reflect the war-induced rise in the price level. FIFO method. The difference between them turns on how the cost of the items on hand is calculated. If the coal bought is piled on top and the coal used is taken from the bottom. But if we assume the coal used is taken off the top we would have the typical last-in.

An additional object of importance is to avoid paying income tax on such questionable "profits. It is widely felt that such gains in inventory values are illusory. This basic difference is generally illustrated by a company's coal pile. This has introduced a complication into statement analysis. These advantages are reversed when the price level turns downward. For a detailed discussion we can recommend Survey of Accounting by Leonard W.

The modest scope of this book prevents us from devoting adequate space to clarify so involved a subject. But more or less permanent bank loans. If the notes payable are substantially exceeded by the cash holdings. Seasonal borrowings. If they have. Unless the inventory is of unusually liquid character. This generally represents bank loans.

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But if the borrowings are larger than the cash and receivables combined. You have already seen the importance of the current ratio total current assets to total current liabilities.

The most important individual item among the current liabilities is that of notes payable. In such a case the bank loans should be studied over a period of years to see whether they have been growing faster than sales and profits.

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Where the balance sheet shows notes payable. The fact that a company has borrowed from the banks is not in itself a sign of weakness. During the past forty years investors have come to pay less and less attention to the asset values shown by a company and to place increasing weight upon its earnings record and earnings prospects. Years ago it was not uncommon to find arbitrarily high values placed on the fixed assets—values which bore little relation to their actual cost or subsequent fair value.

The usual basis is actual cost less depreciation. The proportion of the total assets taken up by the property account varies widely with different types of businesses. The property investment of a railroad is very large. We suggest that if the insured value of the plant and property were given as a footnote to the balance sheet. Because of the frequent wide differences between book value and true value.

This change in attitude was due in part to the frequent unreliability of the property-account figure. Present-day balance sheets are generally quite dependable as measures of the actual cash investment in property. These are often referred to as the "fixed assets. In many cases. Important amounts of new plant were written off in full by the accelerated amortization permitted under the tax laws during World War II.

It deserves reasonable consideration in appraising the company's securities. We think the pendulum has swung too far in the direction of ignoring balance sheet values. In nearly all companies the property account is carried at a conservative figure. Subsequently the "water" was taken out of the property account of United States Steel by various kinds of special charges against earnings and surplus. The property account should neither be accepted at face amount nor overlooked entirely.

This gave the common stock a fictitious book value. In utility and railroad accounting it often appears as an offsetting entry on the right or liability side. Allowances for depreciation. The original cost of the property. Depletion applies to the gradual removal of mineral and timber resources by turning them into products for sale.

It is charged by mining enterprises.

Interpretation of financial statements - By Benjamin Graham

The allowance made for this loss in value is known variously as depreciation. This explains why the accumulated depreciation on the balance sheet may not increase in a given period by the full amount charged as amortization against earnings. Depreciation applies to the ordinary wearing out of buildings and equipment. When property is retired or sold. The more important aspects of the annual allowances for depreciation and depletion will be discussed in our section on the income account.

Amortization is a general term applied to all deductions of the depreciation type. Obsolescence refers to an extra-rapid loss of value due to technological and similar changes. The figure after accrued depreciation. In industrial companies the accumulated depreciation is subtracted directly from the fixed-asset account on the left side of the balance sheet.

Such investments are usually listed among the current assets. A consolidated balance sheet eliminates the securities held in wholly owned and often in majority owned subsidiary companies. It is difficult to estimate the true value of these investments. Some investments stand midway between ordinary marketable securities and the typical nonmarketable permanent commitment in a related company. But the interest in partly owned subsidiary and affiliated enterprises may appear even in consolidated balance sheets under the heading of "non-current investments and advances.

Such holdings will appear among the miscellaneous assets rather than the current assets. They consist of stocks or bonds of affiliated or subsidiary companies. Where it appears from the balance sheet that these items are likely to be of importance.

This intermediate type is illustrated by du Pont's enormous holdings of General Motors. Some of these investments are of the same sort as are made by the ordinary buyer of securities. In some cases good will has actually been acquired at a definite cost in the original purchase of the business from its former owners. The "leasehold" item is supposed to represent the cost or money value of long-term leases held at advantageous rentals. In most cases the writing off of good will takes place after the company's position has improved.

This excess is generally classified as good will and set up in the balance sheet as an asset to be written off against income over a period of years. When one company acquires another. The most common intangibles are good will. The value at which the patents are carried on the balance sheet seldom offers any useful clue to their true worth. This writing down of good will does not mean that it is actually worth less than before.

But in a period of declining real estate values. The modern tendency is not to ascribe any value to good will on the balance sheet. Somewhat distinct from the concept of good will proper is the concept of going- concern value. But this means that the good will is.

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Patents constitute a somewhat more definite form of asset than good will. Trade-marks and brands constitute a rather definite type of good will. The most usual practice nowadays is either not to mention this asset at all. This point illustrates one of the many contradictions in corporate accounting. The treatment of good will on the balance sheet varies among different companies.

An investor should recognize a very strong distinction between good will as it appears—or more generally.. But it is extremely difficult to decide what is the true or fair value of a patent at any given time. In other words. Such intangibles may have a very large value indeed. Whatever the item may be. Prepaid rentals on property are handled in the same way.

Treasury Department has ruled that under tax regulations such amounts may be written off against future income over a period of not less than ten years. Fire insurance premiums. The American Institute of Accountants has suggested that prepaid-expense items chargeable to earnings within a year be included in the current assets—as the equivalent of accounts receivable— and they are now beginning to be treated in this fashion.

They represent amounts paid to others for services to be rendered in the future. Because the amount of money they involve is small they are frequently excluded in computing asset values.

The U. An item of increasing importance among deferred charges is the amount paid out as "past-service cost of pensions. This method maintains reported income in line with income tax provisions—an important check point for analysts.

Deferred charges. Prepaid expense items differ somewhat from deferred charges in that the former are tangible assets and they may even properly be considered current assets. The expense of moving a plant might logically be amortized over a period of five years.

Bond discount is usually written off over the life of the bond issue. In each succeeding year. During the first year. Sound and informing financial statements should. If the former is true. The most important valuation reserves are those for depreciation and depletion. Another offsetting reserve is that for losses on receivables. In dealing with such a reserve it is essential to know whether it reflects a decline that has already taken place or merely one that may be expected.

A third important offset reserve is that for decline in inventories. It follows that the loss. Valuation reserves. Surplus or "voluntary" reserves. The same point may be made with respect to reserves against marketable securities and other investments. Liability reserves. Contingency reserves and other similar reserves tend to make corporate statements confusing. To avoid being deceived by these devices the analyst must examine both the income statement and the reinvested earnings over several years and make due allowance for any amount charged to surplus reinvested earnings or reserves which really represent business losses during the period.

But if in the next year a decline in inventory takes place. But if the reserve is set up to take care of a possible future decline in value it must be viewed rather as a reserve for contingencies.

These are for the most part semicurrent liabilities. If in one year a company sets up a reserve for future decline in inventory value. Reserves of the first class are set up for taxes. The published balance sheets of Chrysler Corporation are models in this respect.

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The thinking on the subject may be summarized as follows: If this is so. They are clearly part of the surplus account. Reserves of this sort represent neither a debt nor a definite deduction from any asset. Now and then the balance sheet contains items such as "reserve for plant improvement. The purpose in setting them up is usually to indicate that these funds are not available for distribution to the stockholders.

Among the steps taken is a strong drive in the direction of eliminating reserves of various kinds from the balance sheet. Yet in these cases some attention must be given to the book-value situation. An appreciable loss is likely to be realized on the sale of the inventory.

In most cases the adverse conditions which would lead to a decision to liquidate the business would also make it impossible to obtain anywhere near cost for the plant and machinery. The book value really measures. It is assumed that if the company were to liquidate. In recent years there have been exceptions to this rule. The book value is of some importance in analysis because there may be some relationship between the amount invested in a business and its future average earnings or its realizable value.

It is true that in many individual cases we find companies with small asset values earning large profits. For there is always a possibility that large earnings on the invested capital may attract competition and thus prove temporary. As a matter of fact. Then the amounts applicable to the various securities in their due order would be their book value.

Adjustment may be made. As an alternative. As an illustration. The simplest rule to follow is to value stocks with preference claims at the highest of their par value. This will give the total common-stock equity. In the case of a high-coupon noncallable preferred.

Where there are preferred dividend arrears. In most cases the book values may be computed readily from the conventional published balance sheet. The use of this method would reduce the book value per share of U. The proper calculation of this liability often presents a problem. Good will and intangibles would be deducted as in the case of the bonds.

Steel has produced asset protection for the bond issue in an unusually high amount. In Bethlehem Steel Corporation. To find the tangible-asset protection or "book value" for the preferred stock. If there are intangibles on the asset side they should be deducted from the total. In the more typical case the coverage would be lower. To find the tangible asset protection for the bonds.

This total for U. Steel balance sheet may be used also to illustrate asset value computations for senior securities. The balance is then divided by the number of bonds outstanding.

In finding the net book value all the intangibles should be deducted. Such deferred charges as organization expense and unamortized bond discount.

In the chapter on reserves. Reserves for insurance may also properly be considered in the same class. These reserves equivalent to surplus sometimes called "voluntary reserves" which are really part of the surplus.

Graham Benjamin. The Interpretations of Financial Statements

These include reserves for contingencies unless they relate to a definite and reasonably probable payment or loss of value. These would all be added together and regarded as surplus. In some cases of liquidation it happens that the fixed assets realize only about enough to make up the shrinkage in the current assets.

This is true because the current assets usually suffer a much smaller loss in liquidation than do the fixed assets. Hence the "net current asset value" of an industrial security is likely to constitute a rough measure of its liquidating value. In the case of industrial enterprises. When a stock is selling at much less than its net current asset value.

It is found by taking the net current assets or "working capital" alone and deducting therefrom the full claims of all senior securities. It is obviously impractical to talk of the liquidating value of a railroad or the ordinary public utility. It is particularly interesting when the current assets make up a relatively large part of the total assets. Since the future is largely unpredictable.

The term "earning power" should be used to mean the earnings that may reasonably be expected over a period of time in the future. This is particularly true if the purpose is to determine whether a bond or a preferred stock constitutes a safe investment. In the next few chapters the elements of an earnings statement will be discussed. If there have been reasonably normal business conditions for a period of years. In the great majority of instances the attractiveness or the success of an investment will be found to depend on the earning power behind it.

The division of total operating revenue by source shows that sales of electricity provide the bulk of revenue. Elsewhere in the. Federal income Interest during construction charged to property and plant 1. This amount has been set aside as Earnings Retained for Use in the Business. In calculating the fixed-charge coverage test explained in detail in a subsequent chapter. As a result. This statement means that the company charged to earnings more income tax than it will actually have to pay for This breakdown for was as follows: The provision for future federal income taxes is explained in a footnote to the financial statements.

It will be used to offset the increase in taxes which will be incurred after the 5-year amortization period. Maintenance and depreciation are discussed in a later chapter.

Restricted for Future Federal Income Taxes. During the year the Company amortized defense facilities for income tax purposes.

Some of the more important items are frequently referred to under more popular names. These reports are too elaborate to be presented here in full detail. Sinking fund 1. The following condensation will show the more important elements in the income account.

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For example: Official title Popular title Total operating revenue Gross earnings or gross revenue Railway operating income Net after taxes Net railway operating income Net after rents Net income Balance for dividends Joint facility rents represent amounts paid dr. Fixed charges include not only interest on bonds but also rentals for lines leased and operated as part of the system.

Equipment rents refer to payments made and payments received to and from other railroads and private owners for the use of rolling stock —freight and passenger cars and locomotives. On preferred stock 1. It should be observed. But the income tax figure is either shown or easily determinable. Where there is a preferred stock issue not preceded by bonds. The coverage of interest or fixed charges is calculated.

In dealing with the bonds of holding companies it is usually necessary to consider the subsidiaries' preferred dividends as fixed charges. The method of calculating earnings coverage is complicated by the question whether earnings before or after taxes should be used. This may give very misleading results. In many corporate reports to stockholders. To find the preferred dividend coverage. In the case of a senior bond issue it may be useful. The latter method has more to recommend it.

It is never correct to calculate the coverage on a junior issue alone. Under tax laws interest payments on debt are deducted before arriving at the amount of profits subject to income tax. This is a supplementary figure. Increases or decreases in the rate of federal taxation would not therefore influence the ability of the company to meet the fixed charges on its bonds.

Charges of the same nature as bond interest such as "other interest. They are computed after deducting preferred dividends at the full annual rate to which the issue is entitled including the participating feature. The doubling of preferred dividend is an arithmetic offset to compensate for the tax disadvantage of preferred stocks. The addition of such a tax component gives the same basic coverage for a preferred stock as the coverage before taxes of a corresponding bond.

To the fixed charges add an amount equal to twice the preferred dividend requirements. The total of fixed charges plus the preferred dividends doubled is then divided into the amount available for fixed charges. It is common practice in these cases to calculate the preferred dividends separately. Railroad Co. Common stock earnings are always shown as so much a share. Consideration should be given the fact that preferred dividends in contrast to bond interest are paid after taxes and that changes in the corporate income tax rate may affect the ability of some companies to pay dividends.

Central Westinghouse Illuminating Co. Back dividends on a preferred stock are not deducted from current earnings in figuring the amount available for the common. In the interest of simplifying the coverage test for preferred stocks preceded by bonds. In the case of a high-grade preferred stock, the comparable test is the coverage of the sum of twice the preferred stock dividends and the fixed charges. Minimum required coverages should be set high enough to provide reasonable assurance of safety and should reflect variations in the inherent stability of the several major types of enterprises—public utilities, railroads, and industrials.

The following tests are recommended for investment grade bonds: Average earnings, before income taxes, for a period covering the most recent seven years should equal, at least, the following multiple of fixed charges. Type of enterprise 7-year average Public utility 4 times Railroad 5 times Industrial 7 times. Alternatively, the earnings before income taxes of the poorest year, in the seven-year period, should equal at least the following multiple of fixed charges.

Type of enterprise Poorest year coverage Public utility 3 times Railroad 4 times Industrial 5 times. For investment-grade preferred stocks the same minimum figures as above are required to be shown by the ratio of earnings before income taxes to the sum of the fixed charges plus twice preferred stock dividends. The coverage figures suggested in our table are more stringent than those generally accepted.

We recommend them nevertheless because experience suggests that investors in fixed- rate securities have suffered losses in the past which can be traced to acceptance of inadequate earnings protection. In an investment study of the income account, attention is given the following additional factors among others: This is a measure of the operating efficiency of the company and also of its ability to absorb reductions in volume or in selling price; 2 the ratio of fixed charges or fixed charges and preferred dividends to gross revenues; 3 the maintenance and depreciation charges; 4 the nature and amount of charges to surplus not included in the income account.

In studying these figures, comparisons should be made between various companies in the same field and for the same company in successive years. But the subject of maintenance and depreciation must be given a fair amount of attention even in an elementary text such as this. By making excessive or insufficient allowances for these items the net earnings may readily be understated or overstated.

It is important to remember that depreciation charges differ from other operating expenses in that they are not actually laid out in cash, but are book entries deducted from the profits on one hand and from the property account on the other. The tax law permits several different basic methods of calculating amortization, and different percentage rates may be admissible within the same method.

In addition, companies frequently take greater or less depreciation in their published reports than is used in their tax returns. The maintenance ordinarily represents a direct cash outlay similar to any other expense.

In the case of industrial companies it is taken for granted that current maintenance is kept up to date, and the figure is not separately examined. But in railroading, where maintenance outlays absorb about a third of operating revenues, there is room for considerable variance in policy between one road and another and from year to year in the same road.

Thus the "maintenance ratio" receives considerable emphasis in railroad analysis. This figure includes depreciation. In the case of public utilities, the maintenance charge or ratio is usually studied in conjunction with the separately stated provision for depreciation. The most common depreciation method is the "straight-line" basis, which writes off the cost of the property less expected salvage in equal amounts each year over the estimated life of the asset.

Typical straight- line depreciation rates for important kinds of property include: More liberal depreciation charges in the early years are permitted by the "declining balance" method.

Somewhat similar results would be obtained by a third permissive method known as the "sum of the digits. This is known as "accelerated amortization. However, by an inexcusable ruling of the Interstate Commerce Commission on this matter, the carriers are required to overstate their true earnings. They may deduct from income only their "normal" depreciation on their facilities, and at the same time they must include in profits the taxes saved by applying the higher, accelerated rates.

A few companies e. Years ago it was frequent practice to understate the required depreciation, especially through the use by public utilities of the so-called retirement reserve method, but this too has now become rare. We should mention that many corporation executives insist that depreciation charges should be large enough to replace the property worn out, and thus reflect increases in the price level inflation.

However, both the accounting profession as a whole and the tax laws insist that depreciation allowances should return only the original dollar cost of each asset. The relationship between gross value of the property account and annual depreciation in for various manufacturing industries is shown in the appended table. The company may ordinarily choose the most liberal of three possible methods, as applied to each separate depletable property, as follows: In ordinary cost depletion, the company deducts that percentage of the cost of the property which the minerals extracted bear to the total estimated content.

In percentage depletion, the company may deduct either a specified percentage of the gross income from the property e. In discovery depletion, the original cost of the property is marked up to a higher value established by the discoveries of mineral content after the purchase was made, and such larger value is amortized in lieu of cost.

Moreover, most of them do not make this charge-off in their published statements. As a consequence, the reported earnings of such companies are overstated, in the same way as those of railroads, because of the way they are required to account for accelerated amortization.

In a thorough analysis, these methods of accounting for various kinds of amortization and development expense must be carefully examined. Obviously it is desirable that a company show a favorable trend in gross and net earnings.

In selecting common stocks it is proper to assign more weight to the indicated trend than in the purchase of senior issues. Senior securities of a company revealing a definitely unfavorable trend should not be bought for ordinary investment.

The most important trends for our purpose are those of interest and preferred dividends coverage. In the case of investment issues it is well to require in every case that the average earnings show a satisfactory coverage for interest and preferred dividends. The market takes the trend or future prospects into account by varying this ratio for different types of companies. When neither boom nor deep depression is affecting the market. The prospective earnings are. If the market price of some issue appears out of line with the facts and figures available.

Yet stock A may be selling at twice the price of stock B. The trend is gauged in turn from the past record and current data. The price of common stocks will depend. In the typical case the earnings will determine the dividends. Some of these estimates may be entirely incorrect and some may be exceedingly accurate. In the ordinary case the price of a common stock is the resultant of the many estimates of what the earnings are going to be in the next six months.

There is. There are also important influences of a general or technical nature affecting stock prices—such as credit. Thus two common stocks may show the same current earnings per share. This is manifest in the. Common stocks of enterprises with only slight possibilities of increasing profits ordinarily sell at a rather low price-earnings ratio less than 12 times their current earnings.

The accepted idea that a common stock should sell at a certain ratio to its current earnings must be considered more the result of practical necessity than of logic.

Looking backward. Common stock selection is a difficult art. It requires a skillful mental balance between the facts of the past and the possibilities of the future. At bottom the ability to buy securities—particularly common stocks—successfully is the ability to look ahead accurately. Knowledge of securities is becoming more and more widespread among the general public. The outlook for the industry. By an examination of the statements it is possible to form an opinion as to the present position and potentialities of the company.

The asset value. They can be judged only by a general knowledge gained by constant contact with financial and business news. The investor who buys securities only when the market price looks cheap on the basis of the company's statements. And this is the chief objective of intelligent investing. He should have a better than average chance of obtaining satisfactory results. While this development gives an increasingly wide field for security salesmen and customers' men. The ordinary operations of a business involve various income and expense accounts such as sales.

The total of all debit balances must be equal to the total of all credit balances. At the beginning of the period Company X showed the following balance sheet: Hence the books are always kept in balance. An entry which increases an asset account is called a debit. Since income entries are equivalent to additions to surplus. An entry which increases a liability account is called a credit.

Business books are kept by what is called the "double-entry system. It is not to be expected that corporate bookkeeping can be adequately treated within the confines of this presentation.

Since capital and the various forms of surplus are liability accounts. The appended simplified case history may be found useful as indicating how the operations of a company are entered on the books.

Expense entries. Sales 3. Expense Cr. Cost of sales 1. Cash Inventory Accts. The ledger the book in which the accounts are kept. Cash 2. The original entries. Cash At the end of the period the above entries are transferred to the ledger.

The ledger would now appear as follows: Sales Dr. These entries eliminate the operating accounts. We use the above entry for the sake of simplicity Dr.

Assets Liabilities Cash 2. Various items in the balance sheet and income account are numbered. Operating income is item No. This will facilitate the explanation of the method of computing ratios. Earnings on Invested Capital Net income plus fixed charges divided by the sum of the bonds.

The ratio for Bethlehem Steel in was about in line with steel companies in general. From this amount plus other income must be paid bond interest. Fixed Charge Coverage Total income divided by fixed charges. Earnings per Share of Common Stock Balance for common stock divided by the number of shares of common stock outstanding.

The ratio of 4. Since the stock passes the average test. For the 7-year period the coverage was 9. Increased sales resulting from heavier use of the plant could justify increased depreciation even though there was no additional investment in the gross amount of the plant account. Depreciation as a Percentage of Net Sales This ratio is used. Preferred Dividend Coverage Total income divided by the sum of fixed charges and twice preferred dividends.

In the main test the average coverage was 21 times. This test is sometimes called the "service" or "usage" test. The average industrial company should not have more than one-third of its capitalization in bonds. The pay-out of earnings during was low for Bethlehem Steel in relation to the steel industry.

Inventory Turnover Net sales divided by inventory. The company is capitalized as follows: This calculation is known as the stock-value. Preferred Stock. Capitalization Ratios Bond Ratio Amount of bonds outstanding divided by the sum of the bonds. Common Stock. If future average earnings of Bethlehem Steel do not fall below the figure. A day liquidation of receivables is in line with the policy prevailing among manufacturing companies in A similar calculation is frequently used which takes the market value of the preferred and common stocks for a period of years.

In this calculation the turnover is 5. Quick Assets Ratio Current assets less inventory. Price-Earnings Ratio Market price of the stock divided by earnings per share. At Bethlehem Steel sold at A more suitable figure for investment analysis is the ratio of price to average earnings for a 7. This is a key ratio in determining the attractiveness of a common stock. Book Value of Common Stock The sum of common stock and surplus divided by the number of shares of common stock outstanding.

The formula for bonds is: Bethlehem Steel was selling at 5. Preferred and common stocks are valued at both the average price of the 5 previous years and at the current price. The formula for preferred stock is: This will meet the standard minimum requirement. Current Ratio Current assets divided by current liabilities. Early in Articles of Association.

Provision in a bond indenture whereby the principal may be declared due in advance of maturity. Asset Value. The same as definition b of Book Value. Thus bond interest may be accrued on the corporation's books each month. See Capital Assets. Accumulative Dividends. Expenses charged against current operations but not requiring cash payment therefor until some future date. Deferred Assets.

Intangible Assets. Current Assets. Simultaneous completion of purchase and sale of securities or commodities at a profit-yielding price spread. A document similar to a charter or certificate of incorporation setting forth the terms under which an enterprise is authorized by the state to do business. Adjustment Bonds. Example of 2: Accruals may also refer to credit items. Acceleration Clause. Extra-rapid depreciation usually in a 5-year period allowed on facilities constructed for war or defense purposes.

Same as Cumulative. The valuable resources. The process of gradually extinguishing a liability. A provision in a mortgage indenture which places property subsequently acquired by the issuing company under the lien of the mortgage.

See Income Bonds. Example of 1: Registration of securities under such laws is now called "blue-skying. Bonds conforming to the standard pattern. See also Certified Report. So named. They usually hold a first mortgage on property of a corporation which is also pledged under a junior general mortgage.

This discount usually is amortized over the life of the bonds. Blue Chip Issues.