When a professional securities analyst wants the cold dope about a corporation, he studies its financial reports. He may take field trips to its factories. He may interview management extensively. But to find out exactly where the company stands, he dissects its balance sheet and income statement, plus what­ever supporting schedules and explanatory data he can lay his hands on. Probably 90 per cent of his conclusions and recommendations about a stock derive from his work with these statistics and the relationships he develops from them.

Years ago it was virtually impossible to pry much financial fact out of a company; today it is readily available. Corpora­tions have learned that full and frank reports on their condition are among the finest public-relations documents they can issue, and great effort is expended to make them clear, concise, and understandable.

Even so, it takes work to thread your way through one. There is no way around it, the reports are complicated. They involve highly technical accounting procedures. They attempt to reduce the entire range of a company's activities to a few pages, and therefore require a great deal of interpretation. Worst of all, despite yeoman work to standardize accounting practices and terms, there is still wide variance among the reports corporations find it appropriate to issue.

This is not to say that balance sheets or income statements are deliberately misleading. A few may be, but the majority are honest. The days of blatant padding—or "watering"-^of assets (thereby falsely inflating the stockholders' equity on the liability side of the sheet) are pretty much past. The confusion lies in the many items of a financial report which are subject to varying evaluations. There are many ways to measure the worth of an inventory of goods, of a depreciat­ing plant, of an obsolescing piece of equipment, of a foreign investment. All of them may be legitimate, but some will be more optimistic than others, and thereby put the company in a better light. Again, not necessarily in a better light than it deserves, but in a better light than an equally sound com­pany which states its condition in more sober terms. For the investor seeking to compare the two companies, there will be pitfalls unless he is knowledgeable and alert.

The statements we will be concerned with in this chapter are the balance sheet, which sets forth the assets and liabilities of a company on a given day—usually the last day of its fiscal year—and the income statement, which is a summary of the company's operations for a specific period—the entire year in an annual report, cumulative three-month periods in quarterly reports.

As a model for study, we'll use the 1958 annual report of the Standard Oil Company of California. It is a large com­pany; the dollar totals it reports are enormous. But, as you will see, a careful grouping of perhaps a dozen items on each side of the balance sheet, and another dozen in the income statement, are sufficient to summarize a year's enter-prize around the globe by a corporation worth nearly $2.5 billion.

First, the balance sheet.

The name of this report is self-explanatory. It balances assets—what the company owns or has owing to it—against liabilities—what the company owes to suppliers, banks, stockholders, Government tax bureaus, and other creditors.

The balance sheet proves that the corporation is solvent. Had it been necessary to liquidate the firm on the day the balance was struck, the statement shows that there would have been a dollar of assets to cover every dollar of liabilities. On any given day throughout the year, the items of the bal­ance sheet will vary. Cash, inventories, and accounts payable fluctuate. Depreciation of plant and equipment mounts. De­pending on how profitable the year is, surplus will be seen to wax or wane from day to day. But whatever day is picked for examination of the company's condition, assets may be expected to equal liabilities.

Notice, first of all, that this is a "Consolidated Balance Sheet." This simply means that the statement represents an aggregate of the assets and liabilities of California Standard and its 38 wholly owned subsidiaries. A subsidiary may be a corporate entity in its own right and issue its own balance sheet. But inasmuch as its assets actually are at someone else's disposal and its liabilities ultimately someone else's re­sponsibility, they should be integrated into the balance sheet of the parent company.

Note also that California Standard lists comparative fig­ures for 1957. This is purely a convenience to the reader, to help give dimension to the company's financial facts.

Now look at the Assets side of the balance sheet. Current Assets are traditionally listed first. They are the most liquid, the most readily convertible items that a company owns. Cash, of course, is dollars on hand or in the bank. U. S. Gov­ernment securities may be bonds or other Treasury obliga­tions into which the company has sunk some excess cash to earn interest while being held in a safe and highly marketable form. Accounts and notes receivable means money owed to the company by its customers; for California Standard, this could be five gallons of gas charged to a Chevron credit card or 100,000 gallons of jet fuel for the Air Force. These are short-term receivables. Most of the money due will be paid in the course of the next twelve months. Most, but not all. A certain percentage of receivables always goes sour. Some people just don't pay their bills. Accordingly, it is common practice to deduct a "reserve," which is an experi­enced guess as to the amount that will prove to be un­collectible.

Inventories may be stockpiles of raw materials, products in the process of manufacture, or finished merchandise ready to go on the dealers' shelves. California Standard's largest inventory is in crude oil and major petroleum products. The other two are not specified, but might include the company's petrochemical products,' miscellaneous materials and ingre­dients, and a supply of the barrels, cans, and containers in which bulk items will be packaged for retail sale.

How much is an inventory worth? In an inflationary period such as this one, when costs and prices are spiraling upward steadily, this is a tricky question to answer. California Standard, as you can see, carries its crude-oil-and-products inven­tory at cost, on a "last-in, first-out" basis.

To understand what the LIFO method of accounting means, visualize one of those large, aluminum-colored storage tanks into which, over a period of six months, California Standard has been pouring oil from the refinery, and from which it has been drawing oil, a barrel at a time, to sell to this customer or that. The $2.5 billion California Standard corporation would be appalled to hear that it does business this way, but our crude example will illustrate a subtle point.

Now, six months ago, a barrel drawn off and sold to a customer for $5 could be replaced with a fresh barrel from the refinery for $4. Today, the inflationary pressures being what they are, the barrel is priced at $5.25 and it costs $4.75 to replace it.

Question: When next you open the spigot at the storage tank, what comes out—$4 oil or $4.75 oil? As you can see, $4 oil sold for $5 makes a profit of $1. $4.75 oil, selling at $5.25, makes only $.50. But $4 oil at $5.25 would mean a $1.25 profit.

Consolidated Balance Sheet at December, 31
Standard Oil Company of California

ASSETS

Current Assets:                                                            1958                           1957

   Cash ……………………………………            $   86,594,940                   $   96,692,415

U.S. Government securities, at cost
which approximates market ……………..               105,708,931                       638,432

Accounts and notes receivable
(less reserve of $2,548,000 in 1958 and
$2,480,000 in 1957) …………………………        250,231,190                      228,506,987

   Inventories:

Crude oil and products, at cost
(on last-in, first-out basis), which is below
market ……………………                                 166,152,883                           161,923,073

  Other merchandise,
at cost ………………….                                   22,274,032                               22,726,342

   Materials and supplies,
at or below cost …………                                22,274,032                                  22,726,342

   Materials and supplies,
at or below cost ……………                          54,911,986                                     71,135,987
                                                                       685,873,962                                   581,623,236

Long Term Receivables

   (less reserve of $270,000 in 1958
and 1957) ……………………………..           20,188,650                                   16,017,121

Investments in Companies Not Wholly Owned (At or Below Cost):

   Operating in foreign
countries ……………………………              67,679,153                                     65,201,899

   Operating in the United
States ……………………………                    17,558,828                                  16,521,322

Properties, Plant and Equipment:

Classification	Gross Book Value Depreciation	Depletion and Amortization Reserves	Net Book Value
Producing ……	$1,834,284,323	$   832,792,970	$1,001,491,353
Pipe Line …….	107,033,849	52,132,680	54,901,169
Manufacturing..	621,297,702	308,714,359	312,583,343
Marine ……….	109,457,145	46,087,719	63,369,426
Marketing ……	246,357,351	94,097,840	152,259,511
Motor Transport	26,452,328	14,813,616	11,638,712
Other …………	47,287,624	14,201,838	33,085,786
Total ………….	$2,992,170,322	$1,362,841,022	$1,629,329,300

 

 

 

 

1,629,329,300 , $1,537,533,829

Prepaid and Deferred Charges ……………..	30,439,508	29,398,691
Total Assets …………………….	$2,451,069,401	$2,246,296,098
LIABILITIES
Current Liabilities:	1958	1957
Accounts payable ………………………	$ 164,193,469	$ 168,855,642
Current installments of long term debt and notes payable ……	1,705,120	31,743,540
Federal and other taxes based on income (estimated) ………	53,517,428	45,647,750
Other taxes payable ………………………	40,021,194	38,152,411
	259,437,211	284,399,343
Long Term Debt
Standard Oil Company of California:
4⅜ % sinking fund debentures due July 1, 1983 ……	150,000,000	–
Loans from banks – paid in 1958 …………………	–	50,000,000
Purchase obligation due annually to 1961 ………	985,652	1,782,808
Subsidiary Company:
Salt Lake Pipe Line Company 2.7% to 4.75% notes due in varying amounts to 1979 …	28,500,000	30,500,000
	179,455,652	82,282,808
Reserves – General Insurance and Benefits ……………..	21,936,262	20,713,718
Total Liabilities …………………………………...	460,859,125	387,395,869
STOCKHOLDERS’ EQUITY
Capital Stock - $6.25 per value …………	395,152,412	395,152,412
Shares authorized ……………. 80,000,000
Shares issued …………………. 63,224,386
Capital Surplus …………………………………	401,668,819	401,668,819
Earned Surplus ………………………………	1,193,389,045	1,062,078,998
Total Stockholders’ Equity ………………………….	1,990,210,276	1,858,900,229
Total Liabilities and Equity ………………	$2,451,069,401	$2,246,296,098

The problem for Standard Oil of California is to repre­sent these shifting values fairly and sensibly. In essence, it does not want to claim profits of $ 1.25 a barrel if it is making only $.50. On the other hand, it does not want to pretend that replacement of inventory costs $4, when really it costs $4.75. The last-in, first-out method of accounting, therefore, simply says that the newest items in an inventory are assumed to be the first ones sold. As the last items manufactured and the first to be replaced they are more likely to reflect current costs than the older items that preceded them, and profit margins, shifting with costs, will tend to be smaller but over the long run probably more realistic.

Cash, Government securities, receivables, and inventories taken together make up a company's Current Assets. In ad­dition to these, it may have a miscellany of other assets. Cal­ifornia Standard shows an item of $20 million in Long Term Receivables, which again are not specified, but probably rep­resent money the corporation does not expect to collect in the immediate future.

It also lists, under a separate heading, its total invest­ments in partially owned companies here and abroad. It would be misleading and improper to consolidate the assets of a corporation only partly owned, unless, of course, partial ownership meant effective control. California Standard scrupulously follows its balance sheet with an explanatory note outlining its "Principles of Consolidation," so that the analyst can determine what comes under this umbrella and what does not.

A company may have Other Investments, a portfolio of stocks or bonds, other than Governments, which it usually carries at cost or market, whichever is less. It may be ac­cumulating a fund for plant improvement or land acquisition that it wishes to call attention to. This would be purely in­formational; such a fund would most likely be cash or securi­ties, and could easily be represented by those totals.

The major category following Current Assets on most balance sheets is Property, Plant, and Equipment. These are the fixed physical assets which often represent most of the company's wealth, but which inevitably would be most dif­ficult to liquidate. For California Standard, these enormous facilities would mean oil wells, pipelines, refineries, storage tanks, tank trucks, and a fleet of tankers. It would mean geologists' equipment, vice presidents' desks, safety helmets, etc., etc., etc. All told, it has a net book value of $1.6 billion, or two-thirds of the entire worth of the corporation.

This, too, is an area of some uncertainty for analysts. The usual method of evaluating fixed assets is to combine original cost and improvements, and deduct depreciation, thereby arriving—hopefully—at a current, net book value. Generally speaking, however, the original cost of a building or a ma­chine—plus improvements—may have no real relationship to replacement cost today. Estimates of accumulated deprecia­tion may be quite in error. And, in some instances, the real value of a piece of equipment may be far above or below its actual dollar price.

Be that as it may, most companies struggle to achieve some fair representation of what their land and bricks and tools are worth. For California Standard, there are problems not only of depreciation—a certain degree of value lost through wear and tear—but of depletion and amortization. Depletion is the gradual exhaustion of a natural resource, like oil or copper or bauxite, and a depletion reserve is what the ex­tractive company is allowed as compensation for the irretriev­able loss of its raw material. Amortization, likewise, is a rationing over a period of time of irretrievable expenses— for instance, the cost to an oil company of a dry hole.

Sometimes depreciation items are entered on the liability side of the balance sheet, although, of course, it makes no difference whether they are subtracted from assets or added to liabilities.

Following Fixed Assets are entries for Prepayments and Deferred Charges. California Standard lumps them as one item. Other companies may separate them, although in char­acter they are much the same. The former are prepaid ex­penses: insurance, rent, interest, royalties to an inventor, anything for which the company has paid in anticipation of benefits to be derived. A year's rent, prepaid, would have to be reduced by one-twelfth on each month's balance sheet, and by year's end would have vanished from the prepayments entry.

Deferred charges are expenses a company pro-rates over a period of months or years. For example, instead of charg­ing all the expenses of developing a new product to the year in which they occurred, a company might spread them over a span of five years. In this way, profits from the new item may help to offset the expenses that went into creating it. A certain equilibrium is thereby maintained, a certain modera­tion. In a way, it is the benefits of the expenditure or the in­vestment that are deferred, and the expenses therefore are also deferred until the one compensates for the other.

The final entry under Assets is intangibles: patents, trade­marks, good will. There may, of course, be a real value in any or all of these items: Kodak is a much better name for photographic equipment than E-Z-Snap. Yet it is difficult to fix a proper price on people's confidence in your product, or on the familiarity of your brand name. Most companies, therefore, carry intangibles at $1 or, like California Standard, do not mention them at all.

So much for assets. It is not, as you can see, very difficult to find out what they are. The problem lies in assigning a realistic value to them. For unless they are pegged with rea­sonable accuracy, the ratios that will later be developed from them will be quite pointless and unreliable. The material is too complicated to permit you to discover where the ac­countants may possibly have slipped up. But it should not be beyond your powers to make sure that similar elements are involved in comparative studies of two companies. Beware of adding apples and pears.

Liabilities are somewhat more simply determined and understood. This side of the balance sheet, in essence, liqui­dates the company and shows to whom each dollar of assets will go. Heading the list of obligations are Current Liabil­ities. These, the opposite of current assets, ate the company's short-term debts that will fall due and be paid during the next 12 months. Accounts payable are the accounts receivable of suppliers and merchants who have provided California Stand­ard with goods and services of one sort or another on credit. Current installments on long-term debt are the big-money equivalent of your monthly payment to the savings bank that holds your mortgage or the finance company through whom you bought your car. Taxes must also be paid during the year. Property, sales, and other taxes are fairly predictable; taxes based on income must be estimated, until the scope of the year's operations can be determined.

Long-term debt may be bonds, loans from banks or in­surance companies, funds due to subsidiaries, or any other scheduled, recurring obligation of a fixed nature. California Standard has no high-grade bonds, in the classic sense: it is Strong and stable enough simply to offer unsecured deben­tures, $10 million of which will be paid off each year for the next 15 years, plus interest at 4⅜ per cent. The company is free and clear of banks, having paid off a $50 million loan in 1958. It has a small purchase obligation that must be met by 1961, and a schedule of notes to pay for its acquisition of the Salt Lake Pipe Line Company, a wholly owned subsidiary. All in all, a very modest amount of debt.

Reserves—General Insurance and Benefits are probably money taken from surplus and earmarked for contingencies. General insurance and benefits are probably commitments for employee retirement, medical care, and similar security items. Since the expenditures are predictable, it gives a more real­istic picture of surplus to isolate the reserve and tag it plainly.

Current liabilities, long-term debt, and contingency re­serves comprise a company's general obligations. Also in­cluded as a liability, however, is the Stockholders' Equity. The logic behind this is simply that after all prior claims are met, what's left will be distributed to the stockholders—the com­pany's owners—in proportion to their holdings. Bonds are a liability because they represent debt. The company is obli­gated to pay back to the bondholder the face amount of his bond, which is the capital he has loaned, plus interest. If the company ever went under, the bondholders would be right up there with the accounts-payable people and the Govern­ment tax agents, looking for their due share of assets.

In the case of the healthy and muscular California Stand­ard, however, there would be $1.99 billion left over for distribution to stockowners after liabilities had been paid. Some $395 million of this is Capital Stock—that is, 63,224,-386 shares of stock with a par value of $6.25. Another $401 million is Capital Surplus, which means that those 63 million shares actually netted the company $6.35 per share more than their par value, an average of $12.60 per share. This has nothing to do, of course, with the stock's prevailing market price in the 40's. This is what you or I would have to pay to become a California Standard shareholder. Capital stock and capital surplus are the funds the company orig­inally received in return for issuing common shares. Tech­nically, this could be viewed as a cash asset, except for the fact that the dollars paid for stock, and the profits earned with those dollars and put by as Earned Surplus, represent the stockholders' share of the enterprise. It is an owner's claim, not a debtor's. If liabilities ate up all that beautiful surplus and the stock equity as well, the shareowners would be just plumb out of luck. But to the extent that assets ex­ceed liabilities, the stockholder has an equity, part of it rep­resented by his stock, part of it by accumulated profits.

What the Balance Sheet Discloses

You have deciphered a balance sheet. You have satisfied yourself that you understand the purpose of the various en­tries and, to some extent, the accounting philosophy that governs them. The company's finances are in balance. Assets and liabilities are in harmony. Now the task is to shuffle and tumble the figures to establish new relationships reveal­ing more facts.
Practically all the exercises that analysts perform with financial reports are efforts to determine the dynamics of a corporation, a sense of its capacity for vital and resourceful action, beyond what is indicated by the moment of time frozen in the balance sheet.

One important factor is the company's net working capital, which is arrived at by subtracting current liabilities from current assets. Working capital is a gauge of the financial leeway the company  enjoys, a  measure  of  the  resources it can deploy to meet obligations, seize opportunities, and overcome crises.

How much net working capital is enough? The rule of thumb says that for minimum safety it should equal current liabilities. Standard Oil of California far exceeds the margin. Subtracting its current liabilities of some $259 million from current assets of nearly $686 million leaves net working capital of more than $426 million.

These huge dollar totals are impressive, butfor many analysts a more significant measure of working capital is the ratio between current assets and current liabilities—the so-called current ratio. In the case of California Standard, di­viding current assets of $686 million by current liabilities of $259 million gives a current ratio of 2.64, a quite comfort­able figure.

Of course, the working-capital requirements of one company or industry may vary from those of another. Small inven­tories and receivables that are quickly and easily collected create fairly liquid conditions, and reduce the need for capital to compensate for funds tied up in merchandise and sales on credit. Railroads are likely to have low current ratios, say, under 2. Chemicals and steels may run between 3 and 3.5, and tobacco companies may well be over 4.

Still another indicator of fluidity is the amount of net quick assets available to a company. Net quick assets are cur­rent assets minus inventories and minus current liabilities. In other words, after deducting inventory, the value of which may take some time to realize, and paying off current obli­gations, how well fixed is the company for really negotiable assets? Again, Standard of California shows up well. Its $686 million in current assets, minus inventories of some $243 million, is reduced to about $442 million. This sum is in cash, Government securities, and receivables—virtually money in the pocket. After paying current liabilities of $259 million, the net quick assets are still $183 million.

An alternate way to calculate the same element is to apply the "Acid Test." This is the ratio of current assets (minus inventory) to current liabilities. One to one is considered ade­quate. Standard of California is 1.7 to 1, or quite a bit in ex­cess of the requirement.

The balance sheet also gives the analyst sufficient informa­tion with which to figure the book value of whatever classi­fications of securities his company has issued.  Book value is the amount of tangible assets behind a security. Standard Oil of California has no bonds or preferred stock outstanding, so the book (or equity) value is figured entirely in terms of the common stock. You know from study of the liabilities that capital stock and capital surplus total $796 million, and that there is also an earned surplus of $1.99 billion. Add to these the nearly $22 million reserve item. The total ascribable to stockholders is slightly over $2 billion. Divide by 63 mil­lion common shares. Result: a net book value of $30.40 per share.

The market price of the stock is in the mid-40's, which means that every $45 you invest for a share of California Standard purchases more than $30 in tangible assets, not to mention a rather considerable earning power. Occasionally, stocks will be found selling below book value. These are sit­uations that will bear looking into. Sometimes they are the re­sult of a great deal of cash surplus in the vaults and general stagnation elsewhere. Sometimes they are quite sound issues, no more than temporarily depressed, and offering a quiet opportunity to buy perhaps $50 worth of assets for $35.

To depart for a moment from the tediously successful ac­counting of Standard Oil of California, here are the book-value calculations as they apply to a modest public utility with a handsome array of bonds and preferreds ahead of the common. This is Central Illinois Public Service, a $245 mil­lion corporation.

The liability half of its 1958 balance sheet shows more than $90 million in various bond issues; $25 million in preferred stock issues; $34.6 million in common stock; and an earned surplus of $23.8 million. Altogether, this totals a bit over $183 million. Reserves that can be construed as cash items should also be added in, ordinarily. Central Illinois' principal reserve, however, is $44.5 million for depreciation, which is merely an estimate of wear and tear on the facilities, not money in the bank.

Bondholders, therefore, are protected by a total of $183 million, or about $2,024 for each $1,000 bond. In other words, assets are more than twice the amount needed to meet the corporation's indebtedness to the bondholders.

To judge the preferred issues, first eliminate the face value of the bonds—$90 million. Then add up preferred values, common-stock values, earned surplus, and reserves, and de­duct good will.  For Central Illinois that is  $92.7 million, omitting reserves, as above, and the good will item which does not appear. Thus, each $100 par-value preferred is covered by a book value of $927.

For the common stockholders of Central Illinois, the book-value figure will have less meaning because of the rather con­siderable mass of senior securities ahead of the common. Nevertheless, it will have comparative uses, and can be found, as before, by taking the value of the common plus earned surplus, and dividing by the number of shares (3,463,600) outstanding. Net book value per share: $19.55. The stock is selling at around 45.

While looking at Central Illinois' capitalization, it will be useful to note the proportions of bonds, preferred, and com­mon stock, for this will have a bearing on a factor known as leverage. Now, $90 million in bonds on a total capitalization of $183 million is about 50 per cent. Preferreds—$25 mil­lion—are about 14 per cent. And common, therefore, is only about 36 per cent. Were anything but a utility (or a railroad) under consideration, these proportions would be thought grievously out of line. The usual industrial corporation has no more than 25 per cent of its capitalization in bonds. Com­mon stock "should" at least equal bonds and preferreds. Otherwise, the corporation gives the appearance of being top-heavy with debt and, therefore, saddled with fixed charges that will leave precious little out of earnings for the common stockholder.

A public utility, however, is permitted a somewhat different structure because of its tremendous investment in fixed assets, and the relative ease with which its receivables can be col­lected. On this basis, a capitalization of which more than half is in senior securities is frequently encountered.

Now, leverage. It is a curious and pleasant arithmetical fact that when fixed senior securities overweigh the common, a very small increase in earnings will result in quite con­siderably improved prospects for the common. Take, for in­stance, a public utility with $50 million in 4 per cent bonds. Out of each year's earnings, $2 million is taken right off the top for bond interest. If the utility earns no more than $2.5 million, there's a scant half-million for the common share­holders.

But suppose earnings increase 10 per cent. The total is now $2.75 million. Bondholders do no better; they will get the $2 million that represents 4 per cent. Common stockholders, however, now have $750,000, or an increase of 50 per cent! The smaller the common issue, the more impressive leverage can be.

As with most stock-market gymnastics, leverage accentu­ates losses in the same breathtaking manner that it enhances profits. Just look: a 10 per cent drop in earnings lowers the original net to $2.25 million, of which, inexorably, $2 million must go to the bondholders. The $250,000 left for common shareowners, however, means that their portion has shrunk by 50 per cent!

Interpreting the Income Statement

The balance sheet indicates the soundness of a corpora­tion's financial structure. It arrays the company's resources, and shows what use is being made of them. It also ticks off the claim that others may have against the company.

But it does not tell you where the money is coming from, or at what rate money is being made. This is the job of the income statement. This is a summary of the company's op­erations for the calendar or fiscal year. It is easier to grasp than a balance sheet. There may be some of the same con­fusion about the definition of items, and what properly should be grouped under the various headings, but essentially the income statement is like a budget. What comes in is matched against what goes out, and what is left over is net income, or profit.

Then, either as an extension of the income statement or as a separate statement of earned surplus, the disposition of that net is reported.

Consider now the income and earned surplus statements of Standard Oil of California.

Consolidated Statement of Income

Gross Income	1958	1957
Sales and other operating revenues	$1,559,159,867	$1,650,823,119
Dividends from affiliated and other companies	124,992,107	85,745,948
Other income	4,374,710	3,435,846
	1,688,526,684	1,740,004,913
Expenses:
Operating  expenses	622,599,940	611,056,338
Purchased crude oil, petroleum pro­ ducts and other merchandise	559,742,184	591,858,236
Depreciation, depletion and amortization	145,890,940	148,996,072
Taxes—income, property and other	98,437,390	97,803,724
Interest and debt expense	4,097,411	2,060,152
	1,430,767,865	1,451,774,522
Net Income	$257,758,819	$288,230,391

Consolidated Statement of Earned Surplus

	1958	1957
Balance at Beginning of Year	$1,062,078,998	$893,970,554
Net Income for Year	257,758,819	288,230,391
Cash   Dividends	(126,448,772)	(120,121,947)
Balance at End of Year	$1,193,389,045	$1,062,078,998

Note, again, that these are also consolidated statements. The first item is Gross Income, the largest part of which, naturally, is revenue from the sale of California Standard products. (Most manufacturers say Net Sales. Railroads and utilities use Gross Revenues.) Some dividends from affiliated companies are reported. A small amount of Other Income is received from unspecified sources; much of it is probably in­terest on the company's portfolio of Government securities. Total:  $1,688,526,684.

Subtracted from this in the course of the year are Expenses. These may be broken down in several ways, but inevitably what is being shown is the cost of the raw mate­rials that went into the products sold, the cost of manufac­turing, the cost of selling, and the cost of operating the corporation. Very often, a general heading, such as Cost of Sales, Expenses, and Other Operating Charges, is used. Some­times the elements are specified, and a differentiation made between manufacturing costs and administrative expenses.

Standard Oil of California uses the catchall Operating Ex­penses, plus an entry for crude oil and other merchandise and materials purchases.

Following these are deductions for Depreciation, Deple­tion and Amortization, for Taxes, and for the year's share of Interest and Debt Expense. Total:  $1,430,767,865.

Income exceeds expenses by $257,758,819, which is net income. Net income is profit. Net income is the melon. Net income is the source of the common stockholders' dividends. The Statement of Earned Surplus shows how well they did.

At the beginning of the reporting year, the company had an earned surplus of $1,062 million. Net income was added to it, and $126,448,772 in dividends ($2 per share) was sub­tracted from it, leaving a new earned surplus balance of $1,193,389,045. This, you'll remember, shows up under Stockholders' Equity on the liability side of the balance sheet.

These relatively few items make up the income statement. Interpretations of them and conclusions to be drawn from them may be as numerous and as complex as the analyst's training permits. For every investor, however, there are sev­eral key ratios to be established.

The first is margin of profit. In California Standard's case, this is arrived at by deducting all expenses (except Interest and debt expense) from Sales and other operating revenues, which is the equivalent of net sales. This gives a so-called "net profit from operations" of $133 million. Dividing this figure by net sales ($1,559 million) gives a profit margin of 8 per cent. By itself this figure is meaningless. It should be compared with California Standard's profit margins in pre­vious years, and with the current profit margins of competi­tive companies.

The operating ratio is the other side of the coin. This is ar­rived at by dividing net sales into operating costs to see how great a percentage of expense dollars must be employed to create a dollar of sales. Again, this is useful only in compari­son with past performances, or in comparison with the ratios of other companies within the industry.

Common stockholders of companies which have senior securities must also consider the extent to which the com­pany has earned the interest on its bonded debt. Standard of California has no bonds, but reference again to Central Illinois Public Service will illustrate the arithmetic. Net rev­enues of $54.6 million minus operating expenses and taxes of $41.6 million leaves a net profit from operations of about $13 million. "Other income" of about $245,000 should be added in, and the total divided by the total bond interest. For Central Illinois in 1958, this was a little over $3 million. The result—4.4—shows that Central Illinois has earned nearly four-and-one-half times its required bond interest. For a utility with the customary large superstructure of debt, this is quite respectable.

Earnings per common share is a fundamental figure that most companies calculate for you in their reports. But should you want to find it for yourself, divide net earnings by num­ber of shares outstanding. For California Standard this would be $258 million divided by 63 million-plus shares, or $4.08 per share.

With earnings per share known, the price/earnings ratio can be established. California Standard, selling at 48, would have a most conservative ratio of 13 to 1—that is, the price is only 12 times earnings.

Remember, these are only the most basic relationships to be calculated from balance sheets and income statements. For a start, they are quite enough. The main thing is to get used to the notion that financial reports, complex as it is possible for them to be, are basically a source of illumination for the struggling investor trying to decide whether he's got hold of a good thing or not.

Ask around. Get a bundle of annual reports and see what kind of comparisons you can make. See first whether they are all speaking the same language, and then how their per­formances stack up against each other. Much of it will be routine arithmetic. But sooner or later you will encounter a surprising relationship or an unexpected result, and then you will see the fascination—and value—of financial reports in stock selection.