CFA 2018 Level 1 Financial Reporting and Analysis

(1)

TM

JuiceNotes

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FinTree

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CFA Level 1 JuiceNotes 2017

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Contact Information

(2)

Provide a variety of users with useful information about a company’s performance (Income statement) and ﬁnancial position (Balance sheet)

Use the data from ﬁnancial statements to support economic decisions

Financial reporting

-Financial statement analysis

-Aka statement of ﬁnancial position

Reports the ﬁrm’s ﬁnancial position at

a point in time

Assets - Resources controlled by ﬁrm

Liabilities - Amounts owed to lenders and other

creditors

Equity - Residual interest in net

assets

Fundamental accounting

equation -Assets = Liabilities

+ Equity

Reports all changes in equity except for

shareholder transactions (eg.

issuing stock, paying dividends

etc.) statement of shareholders’

equity

Aka statement of operations / proﬁt and loss statement

Reports the ﬁrm’s ﬁnancial performance over a

period of time

Revenues - Inﬂows from ﬁrm’s ordinary course of business

Expenses - Outﬂows from ﬁrm’s ordinary course of business

Other income - Gains that may or

may not arise in ordinary course of

business

Income statement + Other comprehensive

income = Comprehensive

income

Reports the amounts and sources of changes

in equity owners’ investment in the ﬁrm over a period

of time.

Reports the company’s cash

receipts and payments

Operating cash ﬂows - Inﬂows and

outﬂows of transactions that are ﬁrm’s ordinary course of business

Investing cash ﬂows - Inﬂows and

outﬂows resulting from the acquisition

or sale of ﬁrm’s assets

Financing cash ﬂows - Inﬂows and

outﬂows resulting from issuance or retirement of ﬁrm’s

debt and equity securities and dividends paid

Roles of ﬁnancial reporting and ﬁnancial statement analysis

Financial Statement Analysis: An Introduction

LOS a

LOS c

LOS b

Statement of changes in equity Income

statement statementCash ﬂow

Balance sheet Comprehensive _income

Financial statement notes

Management’s commentary

Aka management’s report, operating and ﬁnancial review

and management’s discussion and analysis (MD&A)

Contains an overview of the company and important information (eg. business

trends, liquidity etc.) Aka footnotes

Important information about accounting methods, estimates

and assumptions is disclosed

(3)

Audit

Information sources that analysts use in ﬁnancial statement analysis

Financial statement analysis framework

LOS d

LOS e

LOS f

ª It is an independent review of an entity’s ﬁnancial statements ª Conducted by public accountants

ª To provide an opinion on fairness and reliability of ﬁnancial statements ª Auditor examines the company’s accounting and internal control systems,

conﬁrms assets and liabilities, and tries to determine the ﬁnancial statements are free of any material errors

ª Unqualiﬁed opinion (Clean opinion) - Issued when ﬁnancial statements are free from material omissions and errors

ª Qualiﬁed opinion - Issued when ﬁnancial statements deviate from accounting principles

ª Adverse opinion - Issued when ﬁnancial statements are not presented fairly or are materially nonconforming with accounting standards

ª Disclaimer of opinion - Issued when auditor is unable to express an opinion ª Company’s management is responsible for maintaining an effective internal

control system to ensure the accuracy of its ﬁnancial statements, not the auditor

Œ State the objective of the analysis Gather data

Ž Process the data

Analyze and interpret the data

Report the conclusions or recommendations ‘ Update the analysis

Ê Quarterly and semiannual reports Ê Proxy statements

Ê Press releases Ê Corporate reports Ê Earnings guidance

Ê Information on industry and peer companies from external sources such as trade journals, statistical reporting services, and

government agencies

Ê Form 8-K - Filed when there is acquisition or disposals of major asset or changes in its

management or corporate governance

Ê Form 10-K - Filing of annual ﬁnancial statements

Ê Form 10-Q - Filing of quarterly ﬁnancial statements

(4)

Classiﬁcation of business activities

Financial statement elements, accounts and classiﬁcation of accounts

Accounting equation

Financial Reporting Mechanics

LOS a

LOS b

LOS c

Firm’s ordinary course of business (producing and selling goods and services)

Assets, liabilities, equity, revenues and expenses Speciﬁc records within each element

Chart of accounts is a detailed list of the accounts that make up the ﬁve ﬁnancial statement elements

Contra accounts are used for entries that offset some part of the value of another account (Eg. Machinery and accumulated depreciation)

Buying or selling long-term assets (PPE or land) Issuing/redeeming debt, issuing/repurchasing common stock or paying cash dividend

Assets = Equity + Liabilities Assets = Contributed capital (No. of shares × FV) + Retained earnings (beginning)

+ Revenue − Expenses − Dividend + Liabilities

Operating activities

Elements

Accounts

-Basic form

Expanded form

Investing activities

Financing activities

-Liabilities

Equity

Revenues

Expenses

Assets

Ÿ Investment in afﬁliates Ÿ Investment

income

Ÿ COGS Ÿ SGA

expenses Ÿ Depreciation

and

amortization Ÿ Interest and tax expense

(5)

Accounting system

Accrual accounting

Relationship between Balance sheet and other ﬁnancial statements

Flow of information in accounting system

Use of results of accounting process in security analysis

LOS d

LOS e

LOS f

LOS g

Double entry accounting - Transactions are recorded in at least two accounts To hold “Assets = Equity + Liabilities” true, double entry accounting is required

Asset

Equity or Liability

Equity or another Liability Or

Or

As per accrual accounting, revenues and expenses must be recorded when earned and incurred whether or not the cash has actually been received or paid

Unearned revenue

Cash is received before making sale

é

Cash

é

Liability (Un. Rev.)

After making sale,

é

Revenue

Liability (Un. Rev.)ê

Sale is made ﬁrst, cash is received later

é

Revenue

é

Asset (A/c Rec.)

After ﬁrm receives cash,

When exp is incurred

Asset (Pre. Exp.) ê é

Expenses

Firm owes cash for expenses

é

Expenses

(Accr. Exp.) é

Liability

After ﬁrm pays cash,

(Accr. Exp.)

Liability ê

Accrued revenue Prepaid expenses Accrued expenses

è Balance sheet shows company’s ﬁnancial position at a point in time

è Changes in balance sheet accounts during an accounting period are reﬂected in the income statement, cash ﬂow statement and statement of owners’ equity

General journal General ledger Initial trial _balance _{trial balance}Adjusted

Balance sheet

Income statement

ª Since ﬁnancial reporting requires choices of method, judgment, and estimates, an analyst must understand the accounting process used to produce the ﬁnancial statements in order to understand the results for the period

(6)

3, 4, 5 securities to

the public

Annual ﬁling

ﬁrm’s annual report is not a substitute

for 10-K

Quarterly ﬁling

Do not have to be audited

Proxy

statement events such Material as asset acquisition and disposal,

changes in management

or corporate governance

etc.

When company

issues securities to

qualiﬁed buyers

Beneﬁcial ownership of securities by a

company’s ofﬁcers and directors SEC forms

Provide current and potential investors and creditors with useful

information about ﬁrm’s ﬁnancial performance and position

ª Professional organizations of accountants and auditors that establish ﬁnancial reporting standards ª Two primary standardsetting bodies

-Ÿ Financial Accounting Standards Board (FASB) - US GAAP

Ÿ International Accounting Standards Board (IASB) - IFRS

Government agencies that enforce compliance with ﬁnancial reporting standards. Eg. SEC - US, FSA - UK

3 objectives;

ª Protect investors

ª Ensure the fairness, efﬁciency, and transparency of markets

ª Reduce systemic risk

They are designed to ensure that ﬁnancial statements of different ﬁrms are comparable to one another.

They are needed to provide consistency by narrowing the range

of acceptable responses

Objective of

ﬁnancial statements

Importance of ﬁnancial

reporting standards

Barriers to developing one universally accepted set of ﬁnancial reporting standards include differences of opinion among standard-setting bodies and regulatory authorities from different countries. There are also political pressures from business groups and others who

will be affected by changes in reporting standards

LOS c

LOS b

Global convergence of accounting standards

Standard setting bodies

Regulatory authorities

International Organization

of Securities Commissions

(IOSCO)

Financial Reporting Standards

LOS a

(7)

LOS d

LOS e

International Accounting Standards Board’s (IASB) conceptual framework

General requirements for ﬁnancial statements under IFRS

Objective to provide ﬁnancial information that is useful in making decisions for resource providers and users of ﬁnancial statements

Two fundamental characteristics of ﬁnancial statements:

Œ Relevance - Information in financial statements can influence users’ economic decisions Information should have predictive value, confirmatory value or both Materiality is an aspect of relevance

Faithful representation - Information is complete, neutral and free from error

Four characteristics that enhance relevance and faithful representation

Œ Comparability - Presentation should be consistent among ﬁrms and across time periods

Veriﬁability - Different observers using same method must arrive at same result

Ž Timeliness - Information must be available to economic decision maker in time

Understandability - Users with a basic knowledge of business and accounting and who

make a reasonable effort to study the ﬁnancial statements should be able to understand information presented in the statements.

Two underlying assumptions of ﬁnancial statements

Œ Accrual - Financial statements should reﬂect transactions at the time they actually occur, not necessarily when cash is paid

Going concern - Company will continue to exist for the foreseeable future

Constraints

Œ Cost-beneﬁt tradeoff - Beneﬁts the user gains from the information should be greater than the cost of presenting it

Information such as reputation, brand loyalty, capacity for innovation, etc. cannot be captured directly in ﬁnancial statements

ª Required ﬁnancial statements - Balance sheet, comprehensive income statement, cash ﬂow statement, statement of changes in owners’ equity, and footnotes

ª Features for preparing ﬁnancial statements - Fair presentation, going concern, accrual accounting, consistency, materiality, aggregation, no offsetting, reporting

frequency, comparative information

ª Structure and content of ﬁnancial statements:

Ÿ Classiﬁed balance sheet - Showing current and noncurrent assets and liabilities

Ÿ Minimum information - On the face of each ﬁnancial statement and in

the notes

Ÿ Comparative information - Information for prior periods should be included

(8)

IFRS

US GAAP

ª Standards issued by the IASB ª Financial performance - Income

and expenses

ª Asset - Resource from which a future economic beneﬁt is expected to ﬂow

ª Upward valuation is allowed under IASB

ª Standards issued by the FASB ª Financial performance -

Revenues, expenses, gains, losses and comprehensive income

ª Asset - Future economic beneﬁt ª FASB does not allow the

upward valuation of most assets

LOS f

LOS g

LOS h

LOS i

Financial reporting standards under IFRS and US GAAP

Coherent ﬁnancial reporting framework

Implications of ﬁnancial analysis of different ﬁnancial reporting systems

Disclosures of signiﬁcant accounting policies

Disclosure of likely impact

Reconciliation is no longer required for IFRS ﬁrms, who have their shares listed in the United States

è It is one that ﬁts together logically

è It should exhibit transparency, comprehensiveness and consistency

è It has barriers such as valuation, standard setting and measurement

è An analyst must be aware of evolving ﬁnancial reporting standards, new products and innovations that generate new types of transactions

è He must also monitor company disclosures for signiﬁcant accounting standards and estimates

Under IFRS and US GAAP, companies must disclose their accounting policies and estimates in the footnotes and MD&A

Public companies are also required to disclose the likely impact of recently issued accounting standards on their ﬁnancial statements

FinTree

No impact No material _impact

or

Impact yet to be evaluated

or

Uncertain

(9)

Cash paid/received Expense/income

Asset/Liability

Eg. Combining depreciation expense of manufacturing and administration as one

expense

Eg. COGS, it consists of costs associated with

manufacturing (function of business)

$60,000 $100,000 $120,000 $80,000

$100,000 $100,000 $100,000

$70,000 $50,000 $60,000 $60,000 $60,000

- $10,000 $10,000 - $20,000 $20,000

Eg.

Scenario

A Scenario B Scenario C Scenario A Scenario B Scenario C Parent company reports pro rata share of the subsidiary’s income not owned by it as

minority interest

It is subtracted in arriving at net income because the parent company reports all of

subsidiary’s revenue and expense

Revenues and expenses must be recorded when earned and incurred whether or not the cash has actually been received or paid

Based on

nature Based on function

1

3

2

Prepaid

salary Outstanding salary Accrued income receivableAccount Salary expense - $60,000 Consulting income - $100,000

LOS b & c

Accrual accounting

-Understanding Income Statements

LOS a

Presentation format of income statement

Minority interest

Expense classiﬁcation

Revenue/Sales/Turnover

EBIT (Operating proﬁt)

EBT

EAT/PAT/Net Proﬁt/Bottomline

Taxes

Interest

EBITDA (Cash operating proﬁt)

Depreciation & amortization

SGA expenses

(10)

Revenue recognition

Long term contracts

Installment sales

Proﬁt

Loss

Outcome can be

reliably measured Outcome can not be reliably measured

Recognize loss immediately in both

IFRS and US GAAP % completion

method in both IFRS and US GAAP

IFRS US GAAP

Revenue = Cost Completed contract method

Collectibility is uncertain Collectibility is

certain be reliably estimatedCollectibility can not

Normal revenue

recognition at t (PV of future Recognize sales 0 Cost recovery method installments) Installment sales

Barter transactions - Revenue is recognized only if fair value can be estimated

Installment sales - Under IFRS, PV of the installment payments is recognized at the time of sale. Difference between installment payments and the discounted PV is recognized as interest over time

Revenue reporting

Gross

Sales and COGS are reported separately

Should be used by the ﬁrm who is primary obligor under the contract

Eg. Airline company

Only the difference in sales and cost is

reported

Should be used by the ﬁrm who is an

agent

Eg. Ticket agent

(11)

LOS d

Key aspects of the converged accounting standards

Five-step process for

recognizing revenue - Œ Identify the contract with a customerIdentify the performance obligations in the contract

Ž Determine the transaction price

Allocate the transaction price to the performance obligations in the contract Recognize revenue when the entity satisﬁes a performance obligation

LOS e

Expense recognition

Under accrual accounting, expense recognition is based on matching principle where expenses to generate revenue are recognized in the same period as revenue

Inventory

1

First In

First Out First OutLast In Weighted average

COGS - First purchases

Ending inventory - Recent purchases

Appropriate for inventory that has

a limited shelf life

Eg. Food products company

COGS - Recent purchases

Ending inventory - First purchases

Appropriate for inventory that does

not deteriorate with age

Eg. Coal distributor will sell coal off the

top of the pile

COGS - Between FIFO and LIFO

Ending inventory - Between FIFO and

LIFO

Makes no assumption about

physical ﬂow of inventory

ª If a ﬁrm can identify exactly which items were sold and which items remain in inventory,

it can use the speciﬁc identiﬁcation method

ª LIFO is allowed under US GAAP, but not under IFRS

ª Under inﬂationary environment;

Ÿ LIFO COGS > FIFO COGS

Ÿ LIFO inventory < FIFO inventory

Depreciation

2

Straight-line Accelerated

Cost − Residual value Useful life

Equal amount of depreciation each year

Double declining balance

Depreciation ends once the estimated residual value has been reached

Op. Book value Useful life x 2

ª In early years of asset’s life; Ÿ SML deprc. < DDB deprc.

Ÿ Net income (SML) > Net income (DDB)

ª In later years;

Ÿ SML deprc. > DDB deprc.

Ÿ Net income (SML) < Net income (DDB)

(12)

Amortization Bad debts and Warranty

3

4

ª It is allocation of cost of intangible

asset over its useful life

ª Most ﬁrms use the straight-line method

ª Intangible assets with indeﬁnite lives are not amortized, they are tested for impairment at least annually (Eg. goodwill)

These expenses must be recognized in the year they are estimated rather than in a later period

LOS f

LOS g

LOS h & i

Discontinued operations, unusual or infrequent

items and changes in accounting policies

Operating and non-operating income

Earnings per share (EPS)

Discontinued operations

Unusual or infrequent items

Changes in accounting policies

-Income or loss from discontinued operations is reported separately in the income statement, net of tax, after income from continuing operations These events are either unusual in nature or infrequent in occurrence (Eg. impairments, write-offs etc.)

Included in income from continuing operations Reported before tax

Change in accounting principle - Eg. changing from LIFO to FIFO. Requires retrospective application (Except changing to LIFO)

Change in accounting estimate - Change in estimated useful life of asset. Applied prospectively

Operating income - Generated from the ﬁrm’s normal business operations

For a financial firm, income from investing and financing activities is classified as operating income since its business operations include investing in and financing securities

ª It is reported only for shares of common stock

ª Simple capital structure - Does not contain potentially dilutive securities

ª Complex capital structure - Contains potentially dilutive securities such as convertible debt, warrants etc. ª A ﬁrm with complex capital structure must report both basic and diluted EPS

(13)

Basic and diluted EPS

Eg. PAT = 500,000

st

No. of equity shares as on 1 Jan = 40,000

st

20,000 shares issued on 1 Apr

st

Stock dividend declared on 1 May (20%)

st

Share repurchase on 1 July (15,000)

st

Stock split on 1 Sep (3:2)

Preferred dividend = 80,000 No. of convertible preferred stock = 20,000

Weighted average number of common shares outstanding

-Jan 1

Apr 1

July 1

40,000 x 1.2 x 1.5 x 12/12

20,000 x 1.2 x 1.5 x 9/12

(15,000) x 1.5 x 6/12

27,000

(11,250) 72,000

87,750

Basic EPS =

Diluted EPS =

=

PAT − Preferred dividend Wt. avg. no. of common shares

PAT + Interest (1 − Tax rate)

Wt. avg. no. of common shares + Shares from conversion 500,000 − 80,000

87,750

500,000 87,750 + 20,000

4.786

4.64

Dilutive security -

Antidilutive security -

A security that would decrease the EPS if exercised i.e. converted to common stock

A security that would increase the EPS if exercised i.e. converted to common stock

LOS j

Common-size income statement

Vertical common-size income statement expresses each item as a percentage of revenue. i.e Revenue = 100% and rest other items as its percentage

Allows time-series and cross-sectional analysis

Tax expense is more meaningful when expressed as a percentage of pretax income (Effective tax rate)

(14)

Margin ratios

Comprehensive income

LOS k

LOS l & m

Gross proﬁt

margin Net proﬁt margin

Gross proﬁt = Sales − COGS Net proﬁt = GP − Expenses

Can be increased by raising prices

or reducing production costs Can be increased by raising prices or reducing expenses GP margin = Gross proﬁt_Sales NP margin = Net proﬁt_Sales

Comprehensive income = Net income + Other comprehensive income It is a more inclusive measure that includes all changes in equity

except for owner contributions and distributions

Other comprehensive income - Ÿ Foreign currency translation gains and losses Ÿ Pension obligation adjustments

Ÿ Unrealized gains and losses from cash ﬂow hedging derivatives

Ÿ Unrealized gains and losses from available-for-sale securities

(15)

Understanding Balance Sheet

LOS a

LOS b

LOS c

LOS d

Elements of balance sheet

Uses and limitations of the balance sheet in ﬁnancial analysis

Alternative formats of balance sheet presentation

Ê It can be used to assess a ﬁrm’s liquidity, solvency,

and ability to make distributions to shareholders

Ê Balance sheet assets, liabilities, and equity should not be interpreted as market value or intrinsic value

Ê Some assets and liabilities are difﬁcult to quantify and are not reported on the balance sheet

Ê Liquidity - Ability to meet short-term obligations

Ê Solvency - Ability to meet long-term obligations

Current

assets

liabilities

Current

Noncurrent

assets

Noncurrent

liabilities

Liabilities that do not meet the deﬁnition of current liabilities.

They provide information about

ﬁrm’s long-term ﬁnancing activities

Assets that do not meet the deﬁnition

of current assets. They provide information about

ﬁrm’s investing activities

Liabilities that ﬁrm expects to satisfy in less than one year or

one operating cycle, whichever is greater Assets expected to

be used up or converted to cash in less than one year or one operating cycle, whichever is greater

Assets

Classiﬁed

balance sheet Liquidity-based format

Liabilities Equity

Resources controlled as a result of past transactions that are

expected to provide future economic beneﬁts

Reporting assets and liabilities as current/non-current

Useful in evaluating liquidity

Required under both IFRS and US GAAP

Reporting assets and liabilities in order of liquidity

Used in the banking industry

Allowed only under IFRS if the presentation is more relevant

and reliable

Obligations as a result of past events that are expected to require an

outﬂow of economic resources

The owners’ residual interest in the assets after deducting the

liabilities

(16)

Different types of assets and liabilities

LOS e

Current assets

Current liabilities

Cash and cash

equivalents Marketable securities receivableAccounts Inventories Other

Cash equivalents are short-term,

highly liquid ﬁnancial assets that are readily convertible to

cash

Eg. Commercial paper, T-bills

These are traded in a public market and whose value can be readily

determined

Eg. Equity securities, bonds

etc.

These represent amounts owed to

the ﬁrm by customers

Reported at net realizable value by estimating bad

debt expense

Goods held for sale to customers

or used in manufacture of

goods to be sold

Reported at the lower of cost or net realizable value (IFRS) or the lower of cost

or market (US GAAP)

These are amounts that may

not be material if shown separately

Items are combined into a

single amount

Eg. Prepaid expenses and

deferred tax assets

1

2

ª Manufacturing ﬁrms separately report inventories of raw materials, work-in-process and ﬁnished goods

ª All costs necessary to bring the inventory to its present location and condition are included in the cost of inventory

ª Standard costing - Involves assigning predetermined amounts of materials, labor and overhead to goods produced

ª Retail method - Inventory is measured at retail prices and gross proﬁt is subtracted

to determine the cost

ª Net realizable value (NRV) = Selling price − Selling costs

ª Market = Range - (NRV − NP margin) to NRV

ª Inventory can be written down and written back up under IFRS

ª Under US GAAP inventory can be written down but can not be written back up

Accounts payable

Current portion of long-term debt

Accrued liabilities

Unearned revenue Notes payable

Amounts the ﬁrm owes to suppliers

It is the principal portion of debt due within one year or operating cycle, whichever is greater Firm owes cash for expenses. Eg. taxes payable, wages payable etc.

Cash is received before making sale. Eg. subscription received for magazines Obligations in the form of promissory notes owed to creditors and lenders

(17)

Non-current assets

3

Property, plant and equipment (PPE)

Investment property

-ª Tangible assets used in the production of goods and services

ª Includes land and buildings, machinery and equipment, furniture, and natural resources ª IFRS - Cost model or revaluation model

ª US GAAP - Only cost model

ª Land is not depreciated because it has an indeﬁnite life

ª Historical cost = Purchase price + Cost necessary to get the asset ready for use

ª Under cost model, PP&E must be tested for impairment

ª Impairment - Recoverable amount < Carrying value

ª Recoverable amount - NRV or Value in use whichever is greater (IFRS)

ª Value in use - PV of asset’s future CFs

ª If impaired, the asset is written down to its recoverable amount and loss is recognized in income statement

ª Loss recovery is allowed under IFRS, but not under US GAAP

ª Under revaluation model - Fair value

IFRS - Assets that generate rental income or capital appreciation Can be reported at amortized cost or fair value

US GAAP - No speciﬁc deﬁnition

Goodwill - Purchase price of business − Fair value of net identiﬁable assets acquired

Internally generated goodwill is expensed as incurred

It is not amortized but must be tested for impairment at least annually

Economic goodwill - Expected future performance of the ﬁrm Accounting goodwill - Result of past acquisitions

FinTree

Intangible assets Measurement base for internally

created intangible assets

Identiﬁable

IFRS Unidentiﬁable

US GAAP

Cannot be acquired separately and may have an unlimited life

Eg. Goodwill

Not amortized, but are tested for impairment

at least annually Can be acquired

separately

Eg. Patent

Amortized and tested for impairment

Research cost - Expensed

Development cost - Capitalized

Development cost - Expensed

Exception - Software costs. These are treated the same way as under IFRS

(18)

Securities

Held-to-maturity Trading securities Available-for-sale

Reported at fair value

These are not expected to be held to maturity or traded in the near term

Unrealized gains and losses are reported in other comprehensive income Reported at fair value

Acquired with the intent to proﬁt over the near term

Unrealized gains and losses are recognized in

the income statement Reported at amortized cost

Acquired with the intent to be held to maturity

Unrealized gains and losses are ignored

Non-current liabilities

4

Long-term ﬁnancial liabilities

Deferred tax liabilities

These include bank loans, notes payable, bonds payable and derivatives

If they are not issued at face value, they are reported at amortized cost

These are amounts of income tax payable in future as a result of temporary differences

LOS f

LOS g

Components of shareholders’ equity

Common-size balance sheet

Owners’ equity

Owners’ equity - Residual interest in the assets after deducting liabilities

Vertical common-size balance sheet expresses each item as a percentage of total assets. i.e Assets = 100% and rest other items as its percentage

Allows time-series and cross-sectional analysis

Realized gains/losses are always taken to Income Statement

Contributed

capital Preferred stock Minority interest Retained earnings (Treasury stock) Accumulated OCI

Includes all changes in equity from sources other than net income

& transactions with shareholders Stock that is

reacquired by the ﬁrm but not

yet retired Cumulative

undistributed earnings of the

ﬁrm since inception Pro rata share

of the subsidiary’s

income not owned by parent company Has certain

rights and privileges not

possessed by common shareholders Amount

(19)

LOS h

Liquidity

ratios Solvency ratios

Measure ﬁrm’s ability to satisfy its short-term obligations Current ratio, Quick ratio, Cash

ratio

Measure ﬁrm’s ability to satisfy its long-term obligations Debt-to-equity ratio, Debt ratio,

Financial leverage ratio

(20)

Direct method Indirect method

ª They are not reported in the cash flow statement since they do not result in inflows or outflows of cash

ª However they must be disclosed in the footnotes

Cash collected from customers Net income

Cash paid to suppliers Adjustments :

Cash paid for operating expenses Depreciation

Taxes paid Income tax payable

Interest income Working capital changes CFO

Understanding Cash flow Statements

LOS a

LOS b

LOS c

LOS d

Categories of Cash Flow

Reporting of non-cash investing and ﬁnancing activities

Cash ﬂow statement IFRS Vs. US GAAP

Direct and indirect method of presenting CFO

CFO CFI CFF

Cash Flow from Operating activities

Inﬂows and outﬂows generated from normal

business operations

Eg. Cash paid to creditors, cash collected from

debtors etc.

Cash Flow from Investing activities

Inﬂows and outﬂows resulting from acquisition

or disposal of long-term assets

Eg. Acquisition of PPE, Sale proceeds from debt

investment

Cash Flow from Financing activities

Inflows and outflows resulting from transactions affecting firm’s capital structure

Eg. Proceeds from issuing shares, payment of

dividend

Cash ﬂow item

IFRS

US GAAP

Dividends paid CFO/CFF CFF

Dividends received CFO/CFI CFO

Interest paid CFO/CFF CFO

Interest received CFO/CFI CFO

Taxes CFO/CFI/CFF CFO

(21)

Relation of CF statement to income statement and balance sheet

Computation of CFs using income statement and balance sheet data

Converting cash ﬂows from the indirect method to direct method

Common-size cash ﬂow statements

LOS e

LOS f

LOS g

LOS h

CFO CFI CFF

-Relate to current assets and current liabilities Relate to non-current assets

Relate to non-current liabilities and equity

Credit sales

Interest

expense expenseTax

Credit purchases Eg.

Opening AR = 10,000

Opening interest payable = 50,000 Opening tax payable = 25,000 Opening AP = 30,000

Cash received = 50,000

Cash paid = 10,000

Cash Paid = 65,000

Cash Paid = 15,000

Ending AR = 15,000

Ending interest

payable = 55,000 payable = 15,000Ending tax Ending AP = 25,000 65,000

55,000

15,000 5,000

60,000

65,000 30,000

90,000

CFO using indirect method - Net income

Cash Flow from Operating activities

+ Non cash charges (NCC) +/− Transactions related to

CFI and CFF

+/− Working capital changes

A common-size cash flow statement shows each item as a percentage of revenue or shows each cash inflow as a percentage of total inflows and each outflow as a percentage of total outflows

Indirect cash ﬂow statement can be converted to a direct cash ﬂow statement by adjusting each income statement account for changes in associated balance sheet

accounts and by eliminating noncash and non-operating items

(22)

FCFF, FCFE and Cash ﬂow ratios

LOS i

FCFF

FCFE

ª FCFE = CFO ± Fixed capital investment ± Net borrowing

ª FCFE = FCFF − [Int. × (1 − t)] ± Net

borrowing

ª It is the cash available only for equity owners

ª FCFF = NI + NCC + [Int. x (1 − t)] ± Fixed & working capital

investment

ª FCFF = CFO + [Int. x (1 – t)] ±

Fixed capital investment

ª It is the cash available to all investors, both equity owners and debt holders

Ratios

Performance ratios

Coverage ratios è CF to revenue - CFO/Net revenue

è Cash return on assets - CFO/Avg assets

è Cash return on equity - CFO/Avg. equity

è Cash to income - CFO/Operating income

è CFPS - CFO − Preferred dividend/Wt. avg. no. of shares

è Debt coverage - CFO/Total debt

è Interest coverage - CFO + Int. paid + Taxes paid/Int. paid

è Reinvestment ratio - CFO/Cash paid for long term assets

è Debt payment - CFO/Long term debt payment

è Dividend payment - CFO/Dividend paid

è Investing and ﬁnancing - CFO/CFF and CFI outﬂows

1

2

(23)

Ratio

Analysis

Common-Size

Analysis

Regression

Analysis

Graphical

Analysis

Ÿ Ratios must be viewed relative to one another

Ÿ Require

adjustments when different

companies use different accounting treatments

Ÿ Difﬁcult to ﬁnd

comparable industry ratios when a company operates in

multiple industries

Ÿ Requires a range of acceptable values

Ÿ Stacked column graph

Ÿ Line graph

Ÿ Used to identify

relationships between variables

Ÿ Results are used for forecasting

Ÿ Vertical common-size - Stated as a % of sales (income

statement) or as a % of total assets for balance sheets

Ÿ Horizontal commonsize

-Each item is presented as a percentage of its value in base year

Accounts receivable turnover ratio (ARTR)

Accounts payable turnover ratio (APTR)

Asset turnover ratio Inventory turnover ratio (ITR)

Avg. collection period (days of sales outstanding)

No. of days in inventory (days of inventory on hand)

No. of days in payables (days of inventory on hand)

Working capital turnover ratio Credit sales

Avg. AR

Purchases Avg. AP

Sales

Avg. assets Avg. Working capitalSales COGS

Financial Analysis Techniques

LOS a

LOS b

Tools and techniques used in ﬁnancial analysis

Ratios

Activity ratios

Higher the better Higher the better

Lower the better

Lower the better Lower the better

Higher the better

(24)

Liquidity ratios

Net proﬁt margin

Operating proﬁt margin

Return on total capital

Return on common equity Return on assets

Debt-to-assets ratio

Interest coverage ratio Cash ratio

Cash conversion cycle

-Quick ratio (Acid-test ratio)

Debt-to-capital ratio

Gross proﬁt margin

Pretax margin

Return on equity (ROE) Operating return on assets Financial leverage ratio

Fixed charge coverage ratio Defensive interval ratio Current assets Avg. total capital

NP − Preferred dividend Avg. common equity NP Debt + Equity

Gross proﬁt

EBIT + Lease Interest + Lease

Cash + Marketable securities + AR Current liabilities

Cash + Marketable securities + AR Avg. daily expenses

Cash + Marketable securities Current liabilities

No. of days in inventory + No. of days in AR − No. of days in AP

(25)

Evaluation of company using ratio analysis

DuPont analysis

Ratios used in equity analysis and credit analysis

Segment reporting

Use of ratio analysis in modeling and forecasting earnings

Return on equity (ROE)

LOS c

LOS d

LOS e

LOS f

LOS g

Analyst should use an appropriate combination of different ratios to evaluate a company over time

Net proﬁt

margin turnoverAsset leverage ratioFinancial

Net proﬁt Sales

Net proﬁt

EBT EBITEBT SalesEBIT

Tax burden

ratio burden ratioInterest EBIT margin Sales

Avg. assets Avg. assetsEquity

Equity analysis

Credit analysis

-P/E ratio, P/CF ratio, P/Sales ratio, P/BV ratio and Basic and Diluted EPS

Interest coverage ratio, Return on capital, Debt-to-Asset ratio and CF-to-Debt ratio

ª Business segment is a portion of a larger company that accounts for more than 10% of the company’s revenues or assets, and is distinguishable from the

company’s other lines of business in terms of the risk and return

ª Both US GAAP and IFRS require companies to report segment data

Ratio analysis can be used to construct pro forma ﬁnancial statements that provide estimates of ﬁnancial statement items for one or more future periods

Three methods of examining the variability of ﬁnancial outcomes around point estimates;

ª Sensitivity analysis - Based on “what if” questions

ª Scenario analysis - Based on speciﬁc scenarios

ª Simulation - Computer based technique to generate distribution of values

(26)

Inventory and COGS are updated

continuously Inventory and COGS are determined at the end of the accounting period

LOS b

LOS c

Inventory valuation methods

Perpetual inventory system

Periodic inventory system

Inventories

LOS a

Costs included in

inventory

Costs recognized as

expense

ª Purchase cost

ª Conversion cost

ª Other costs necessary to bring the inventory to its present location and condition

ª Abnormal loss

ª Storage cost (Except where it is considered as a part of manufacturing process)

ª Administration costs ª Selling costs

First In

First Out First OutLast In Weighted average

COGS - First purchases

Ending inventory - Recent purchases

Appropriate for inventory that has

a limited shelf life

Eg. Food products company

COGS - Recent purchases

Ending inventory - First purchases

Appropriate for inventory that does

not deteriorate with age

Eg. Coal distributor will sell coal off the

top of the pile

COGS - Between FIFO and LIFO

Ending inventory - Between FIFO and

LIFO

Makes no assumption about

physical ﬂow of inventory

ª If a firm can identify exactly which items were sold and which items remain in inventory, it can use the specific identification method

ª LIFO is allowed under US GAAP, but not under IFRS

ª Under inﬂationary environment; Ÿ LIFO COGS > FIFO COGS

Ÿ LIFO inventory < FIFO inventory

(27)

Eg.

First In First Out Last In

First Out Weighted average COGS

Perpetual Periodic Perpetual Periodic Perpetual Periodic

Date Quantity Cost per unit

January 30 10 10

March 30 10 20

April 30 10 30

May 30 10 40

Sales on April 10 = 10 Q @ 50 = 500

10 × 40

= 400 (10 × 10)+ (10 × 20) 10 × 10= 100 10 × 10= 100 = 300

Cost per unit = 300/20 = 15

COGS = 15 × 10 =150

Weighted average = 25

COGS = 10 × 25 =250

10 × 20 = 200

LOS d

Impact of inflation and deflation on financial statements

Impact on ratios

Environment LIFO Weighted

average FIFO Inﬂationary COGS Ç COGS (Between) COGS È

Closing inventory È Closing inventory _(Between) Closing inventory Ç

Deﬂationary COGS È COGS (Between) COGS Ç

Closing inventoryÇ Closing inventory _(Between) Closing inventory È

Particulars LIFO

Inﬂationary Deﬂationary

FIFO

Inﬂationary Deﬂationary

GP ratio È Ç Ç È

Working capital È Ç Ç È

Current ratio È Ç Ç È

Inventory turnover Ç È È Ç

Debt-equity ratio Ç È È Ç

(28)

LIFO reserve

LIFO liquidation

LOS e & f

A ﬁrm that reports under LIFO must also report a LIFO reserve LIFO reserve = FIFO inventory − LIFO inventory

Year Particulars LIFO FIFO LIFO reserve

1 Purchases 5,000 5,000

− COGS 1,500 1,000 500

Cl. inventory 3,500 4,000 500

2 Op. inventory 3,500 4,000

− COGS 2,500 1,500 1,000

Cl. inventory 1,000 2,500 1,500

3 Op. inventory 1,000 2,500

− COGS 1,000 300 700

Cl. inventory 0 2,200 2,200

Year Particulars LIFO FIFO LIFO reserve

1 Purchases (10 @ 10)

and (10 @ 20) 300 300

− COGS (Sold 10Q) 200 100 100

Cl. inventory 100 200 100

2 Op. inventory 100 200

Purchases (10 @ 30) 300 300

− COGS (Sold 10Q) 300 200 100

Cl. inventory 100 300 200

3 Op. inventory 100 300

− COGS (Sold 10Q) 100 300 (200)

Cl. inventory 0 0 0

Ç LIFO reserve = LIFO COGS − FIFO COGS

Closing LIFO reserve = Opening LIFO reserve + Ç in LIFO reserve

LIFO liquidation occurs when a LIFO ﬁrm’s inventory quantities decline

It results in higher proﬁt margins and higher income taxes

(29)

Conversion of LIFO ﬁnancials to FIFO

Income statement Balance sheet

COGS decreases by

Ç in LIFO reserve Inventory increases byLIFO reserve

Taxes increase by

Ç in LIFO reserve x Tax rate Closing LIFO reserve x Tax rateCash decreases by PAT increases by

Ç in LIFO reserve x (1 - t) Closing LIFO reserve x (1 - t)Reserves increase by

LOS g

LOS h

Inventory measurement

Implications of inventory writedown

Impact on ROE and ROA

Cost vs. Net realizable value Cost vs. Lower of market or_{replacement cost}

Cost = 100

NRV = SP − SC = 80

Since NRV < Cost, inventory will be valued at 80

Cost = 100 Replacement cost = 95

Since replacement cost (95) is beyond NRV (80), inventory

must be valued at 80

Inventory write-up is not allowed

Inventory write-up is allowed only to the extent of previous

writedown

Eg. Cost - 100

Selling price - 90 Selling cost - 10 Replacement cost - 95 NP margin - 20

ª In ceratin industries inventory can be shown above historical cost in both IFRS and US GAAP - agricultural and forest products, mineral ores and precious metals

Inventory

È

COGS Ç GP & NP

_È

Taxes

_È

Cash Ç

% decrease in net income > % decrease in assets or equity

As a result, both ROA and ROE are decreased

NRV − NP margin

80 − 20 = 60

NRV

(30)

Inventory disclosures

Evaluation using inventory turnover

Analysis of companies that use different

inventory methods

Issues that analysts should consider when examining a

company’s inventory disclosures

LOS i

LOS k

LOS l

LOS j

Ê Cost ﬂow method (FIFO,LIFO etc.) Ê Carrying value of inventory

Ê Carrying value of inventories reported at fair value less selling costs Ê COGS

Ê Amount of inventory writedown Ê Reversals of inventory writedown

Ê Carrying value of inventories pledged as collateral

è Finished goods inventory is increasing but raw materials and work-in-progress are decreasing, indicates decreasing demand and potential future inventory writedowns

è Raw materials and work-in-progress are decreasing, indicates increasing demand and higher earnings

è Finished goods inventory is increasing but there is no proportionate increase in sales, indicates decreasing demand or inventory obsolescence.

An analyst must adjust the financial statements to reflect same inventory costing methods for both firms

ª Low ITR - Slow-moving or obsolete inventory

ª High ITR with low sales growth - Inadequate inventory levels and lost sales

ª High ITR with high sales growth - Reﬂects greater efﬁciency

(31)

If capitalized (as compared with ‘if expensed’);

ª Assets are higher

ª Proﬁt in ﬁrst year is higher

ª Proﬁts in later years are lower

ª There is less volatility

LOS b

Intangible assets

Long-Lived Assets

LOS a

_{Capitalized costs}

_{Expensed costs}

Expenditure that is expected to provide a future economic beneﬁt

is capitalized

Recorded as an asset in B/S

Interest that accrues during the construction period is capitalized

If the future economic beneﬁt is unlikely or highly uncertain,

expenditure is expensed

Recorded as an expense in I/S

Interest paid after construction period is expensed

Goodwill - Purchase price of business − Fair value of net identiﬁable assets acquired

Internally generated goodwill is expensed as incurred

It is not amortized but must be tested for impairment at least annually

Economic goodwill - Expected future performance of the ﬁrm Accounting goodwill - Result of past acquisitions

Intangible assets Measurement base for internally created intangible assets

Identiﬁable

IFRS Unidentiﬁable

US GAAP

Cannot be acquired separately and may have an unlimited life

Eg. Goodwill

Not amortized, but are tested for impairment

at least annually Can be acquired

separately

Eg. Patent

Amortized and tested for impairment

Development cost - Capitalized

Development cost - Expensed

Exception - Software costs. These are treated the same way as under IFRS Measurement base for purchased assets - Same as PPE

(32)

Impact of capitalization on various ratios

Depreciation methods

LOS c

LOS d

Particulars Increase/decrease

Total assets

Ç

Total liabilities No change

st

Equity (1 year)

_Ç

Equity (Subsequent yrs.)

_Ç

st

Net income (1 year)

_Ç

Net income (Subsequent yrs.)

È

CFO

_Ç

CFI

_È

CFF No change

Total CF No change

Interest coverage (EBIT/Int.)

Ç

Interest coverage (Subsequent yrs.)

È

Debt-equity ratio (D/E)

_È

Cost − Residual value Useful life

Equal amount of depreciation each year

Deprc. per unit =

Cost − Residual value Total no. of units

Total depreciation = Deprc. per unit x units

produced Depreciation ends once

the estimated residual value has been reached

Op. book value Useful life × 2

Straight line

method Double declining balance method Units of production method

Component depreciation - Depreciating components of asset separately (Eg. in case of building - ﬂooring, roof, walls etc. are depreciated separately)

IFRS - Component depreciation is required

US GAAP - Component depreciation is allowed (not required) but is seldom used

Economic depreciation - Actual decline in the value of the asset

(33)

Impact of depreciation related assumptions

Amortization methods

Revaluation model

LOS e

LOS f & g

LOS h

As compared to SLM, using DDB method results in;

Higher depreciation

Lower net income

Lower ROA and ROE There is no impact on CF

Estimating lower salvage value (residual value) or less useful life results in higher depreciation

Ê Amortization is same as depreciation of tangible assets

Ê Intangible assets with ﬁnite lives are amortized over their useful lives Ê These methods are same as depreciation i.e. SLM, DDB and UOP Ê Choice of amortization method affects expenses, assets, equity and

ﬁnancial ratios just the same way the choice of depreciation does

ª Cost model - Long-lived assets are also reported at depreciated cost ª Revaluation model - Long-lived asset are reported at fair value

ª Revaluation model is permitted only under IFRS

ª Revaluation can be used if active market exists for the asset

ª Reporting - Balance sheet - Fair value, OCI - Gain, Income statement - Loss

Eg.

20

(Reported in OCI) (Loss is reversed)

20

(Reported in I/S) (Loss is reversed)

30

(Reported in I/S)

50

(Reported in OCI)

100

120

80

70

150

Gain = 20 (Reported in OCI as revaluation surplus)

Loss = 20 (Reported in I/S)

Loss = 50

Gain = 70

Asset’s FV

-Impairement of PPE and intangible assets

LOS i

ª Depreciation - Systematic reduction in the value of asset

ª Impairment - One time reduction because of signiﬁcant decline in the market value of asset

(34)

Derecognition of PPE

LOS j

Impairment

Long-lived assets held for sale

Recoverable amount is higher of ;

Œ NRV or,

Value in use (PV of future CFs) Impairment =

CV − Recoverable amount

Œ If CV > Total of undisounted CFs then,

Impairment =

CV − FV or PV of future CFs Carrying value (CV) vs.

Recoverable amount Determine if impairment is required

ª Under US GAAP impairment can not be reversed

ª Under IFRS impairment can be reversed but only to the extent of previous carrying value

ª For long-lived assets held for sale, loss can be reversed under both IFRS and US GAAP PPE

Held for use Reclassiﬁed as Held for salePPE

è Tested for impairment

è No longer depreciated

PPE is abandoned PPE is exchanged

PPE is sold

Asset is removed from the B/S

Gain/loss is reported in I/S

Asset is removed from the B/S

Loss is reported in I/S

New asset is recorded at FV

Gain/loss is computed by comparing CV and

FV of asset given up or acquired