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Financial Statement Analysis Study Session 7 & 8.

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Presentation on theme: "Financial Statement Analysis Study Session 7 & 8."— Presentation transcript:

1 Financial Statement Analysis Study Session 7 & 8

2 Financial Statement Analysis Financial Statement Analysis Basic Concepts Study Session 7

3 Financial Statement Analysis CONTENTS OF STOCKHOLDERS REPORT Management’s Discussion and Analysis (MDA) Balance Sheet Income Statement Statement of Stockholders’ Equity Statement of Cash Flows Statement of Comprehensive Income Auditor’s Report Explanatory Notes Supplementary Information LOS 29 d discuss the additional sources of information accompanying the financial statements, including the financial footnotes, supplementary schedules, Management Discussion and Analysis (MD&A) and Proxy statements

4 Financial Statement Analysis CONTENTS OF MANAGEMENT DISCUSSION AND ANALYSIS Results of operations + discussion of trends Capital resources and liquidity + trends in cashflows General business overview based on known trends Effects of known trends, events and uncertainties Discontinued operations, extraordinary items, unusual items Disclosures in interim financial statements Segmental cash flow requirements and contributions LOS 29 d discuss the additional sources of information accompanying the financial statements, including the financial footnotes, supplementary schedules, Management Discussion and Analysis (MD&A) and Proxy statements

5 Financial Statement Analysis Corporate Filings/Proxy Statements Form 10-K Annual Report Proxy Detailed financial results reported to the SEC on annual basis. Audited and filed 90 days after the close of a fiscal year. Publicly held companies report their financial results annually to shareholders in an annual report. Effectively the report is a condensed version of the 10- K. A proxy statement is sent to all shareholders in connection with company meetings. The proxy explains proposals that will be voted on by the shareholders. The proxy also contains information about management remuneration, stock options, special deals and related party transactions. The proxy will also detail any changes of auditor. LOS 29 d discuss the additional sources of information accompanying the financial statements, including the financial footnotes, supplementary schedules, Management Discussion and Analysis (MD&A) and Proxy statements

6 Financial Statement Analysis Corporate Filings/Proxy Statements Form 10-Q Form 8-K Form 144 Registration Public companies must file quarterly reports 45 days after the end of the period using form 10-Q. The form contains a balance sheet, statement of operations, cashflow and MDA but is not audited. 8-K is used to inform the SEC of special events: changes in control, acquisitions, dispositions, auditor changes, director resignation and bankruptcy. (Normally due within 15 days – 5 for auditor) Insiders must register every time they buy or sell stock. LOS 29 d discuss the additional sources of information accompanying the financial statements, including the financial footnotes, supplementary schedules, Management Discussion and Analysis (MD&A) and Proxy statements When a publicly held company plans to issue securities, it must file a registration statement, including a prospectus and exhibits

7 Financial Statement Analysis FINANCIAL ACCOUNTING STANDARD SETTING Financial Accounting Standards Board (FASB) American Institute of Certified Public Accountants (AICPA) Securities and Exchange Commission (SEC) (Recognize) Pre-1973 APB Statements of Financial Accounting Concepts (SFAC) Statements of Financial Accounting Standards (SFAS) LOS 29 a discuss the general principles of the financial reporting system and explain the objectives of financial reporting according to the Financial Accounting Standards Board (FASB) conceptual framework;

8 Financial Statement Analysis INTERNATIONAL FINANCIAL ACCOUNTING STANDARD SETTING Different accounting standards make international comparisons difficult IOSCO IASB International Organization of Securities Commissions – 65 countries securities regulators investigate and set standards on multinational disclosure and financial statements. Implementation is left to the individual members. International Accounting Standards Board – attempting to provide a unified international framework of accounting standards. Has issued over 40 proclamations. Lacks a formal mechanism to ensure compliance with standards. Many governments now voluntarily adopting IAS. International Accounting standards were adopted by the EU in 2005. US and IAS are slowly converging. LOS 29c discuss the role of IOSCO and IASB in setting and enforcing global accounting standards

9 Financial Statement Analysis General Principals of Financial Reporting System Timing Economic events and accounting entries may take place in different periods, e.g., changes in market value of PP&E RecognitionMany economic events do not receive recognition, e.g., contingencies, off balance sheet finance MeasurementCertain items may be reported in different ways, e.g., FIFO vs. LIFO LOS 29a : Discuss the general principals of the financial reporting system

10 Financial Statement Analysis Objectives of Financial Reporting Equity Investors Short Term Creditors Long Term Creditors Interested in identifying firms with long term earning power, growth opportunities and ability to pay dividends Interested in liquidity of the business Long term asset position and earning power LOS 29a : Discuss the general principals of the financial reporting system Classes of user Investors – debt and equity Government – taxes/regulators Others – public, special interest groups, workforce etc

11 Financial Statement Analysis Foundations of Accrual Accounting Recognition Principle Matching Principle Historic Cost Principle Revenue is recognized when goods are delivered or services performed, not necessarily when the cash is received Revenues and associated costs are recognized in the same accounting period Assets and liabilities are recorded at the transaction’s original value. The advantage is that historic cost is objective and verifiable. LOS 29a : Discuss the general principals of the financial reporting system

12 Financial Statement Analysis Statement of Financial Accounting Concepts (SFAC) 2 Relevance Timeliness Reliability Consistency Comparability Materiality Information that could potentially affect a decision Information looses value rapidly in the financial world. Helpful for forecasting. Verifiable and representational faithfulness Same accounting principles consistently applied over time Information should allow comparison between companies. Often difficult due to estimates and methods. Which data is important enough for inclusion in the financial statements. LOS 29 b identify the accounting qualities (e.g., relevance, reliability, predictive value, timeliness) set forth in Statement of Financial Accounting Concepts (SFAC) 2, and discuss how these qualities provide useful information to an analyst

13 Financial Statement Analysis The Audit Report Audit = independent review of the company’s financial statements Financial statements are true and fair Audit Report Responsibility of management to prepare accounts Independence of Auditor’s Properly prepared in accordance with relevant GAAP Free from material misstatement Accounting principles and estimates chosen are reasonable Unqualified opinion vs. qualified opinion Uncertainties LOS 29 e Discuss the role of the Auditor and the meaning of the audit opinion

14 Financial Statement Analysis MONEY INMONEY OUT Loan capital (ST & LT) Share capital Reserves Long-lived assets Current assets Investments LIABILITIES + STOCKHOLDER EQUITY ASSETS = Assets – In order of liquidity Liabilities – In order of due date LOS 29 d describe and distinguish between the principal financial statements: Balance Sheet, Income Statement, Statement of Comprehensive Income, Statement of Cash Flows and Statement of Stockholders’ Equity Assets Liabilities Equity probable current and future economic benefit obtained as a result of past transactions probable sacrifices of economic benefit/transfers of wealth as a result of past transactions residual interest in Net Assets of an entity (Total Assets – Total Liabilities)

15 Financial Statement Analysis LOFTUS INC. BALANCE SHEET AS AT 31 DECEMBER 20X0 ASSETS Current assets Cash Short term investments Accounts receivable Less: Bad debt provision Inventory Prepayments Total current assets Investments Property plant & equipment Land and Buildings Plant & Machinery Less: Accumulated depreciation Intangible assets: Goodwill TOTAL ASSETS $’000 100 40 380 540 10 400 (20) 1,070 200 500 1800 (400) 1400 1,900 2,000 5,170 LOS 29 d describe and distinguish between the principal financial statements: Balance Sheet LOS 30 a describe the factors that distinguish long-term assets from and identify common types of long-term assets and their carrying values on the balance sheet;

16 Financial Statement Analysis Long Term Assets Long term asset = asset held for continuing use within the business, not resale Cost Accumulated Dep n /Amort Net Book Value (NBV) X (X) X Carrying Value Balance Sheet Proceeds NBV Profit/(loss) X (X) X/(X) Profit on disposal – Income Statement Cost includes all expenditure to acquire the asset and ready it for usage (installation, broker, legal fees, etc.) $ $ For part exchange replace proceeds with trade in allowance LOS 30 a identify the common types of long-term assets and their carrying values on the balance sheet LOS 30 b determine the cost and record the purchase, of property, plant, and equipment LOS 30 d describe how to account for the sale, exchange, or disposal of depreciable assets

17 Financial Statement Analysis LOFTUS INC BALANCE SHEET AS AT 31 DECEMBER 20X0 LIABILITIES Current liabilities Accounts payable Tax payable Current portion of long term debt Total current liabilities Long term liabilities Common stock $1 par value 500,000 shares issued and outstanding Other paid in capital Total contributed capital Retained earnings Total stockholders equity $’000 390 250 120 760 500 200 700 1,370 2,070 5,170 Bonds payable STOCKHOLDERS EQUITY Contributed capital TOTAL LIABILITIES AND STOCKHOLDERS EQUITY 2,340 LOS 29 d describe and distinguish between the principal financial statements: Balance Sheet LOS 31 f describe the components/format of the balance sheet

18 Financial Statement Analysis Stockholders Equity Preferred Stock Common Stock Additional Paid in Capital Other items Disclosure – dividends (fixed, floating, participating), call provisions, conversion privileges. If redeemable by holder reclassify after liabilities Each class reported separately, recorded at par value, treasury stock contra for repurchases LOS 31 f describe the format and the components of the balance sheet and the format, classification, and use of each component of the statement of stockholders’ equity. If common stock is issued above par value any excess is recorded in additional paid in capital - Minimum Liability Adjustment (Pensions) - Forex gains and losses under the all current method - Market Valuation Adjustment (Available for sale securities) - Unearned shares issued to employee stock ownership plans

19 Financial Statement Analysis STATEMENT OF STOCKHOLDERS’ EQUITY – LOFTUS INC. Year Ending December 31 20X0 Stockholders’ Equity at beginning1,520 Additions: Sale of Common Stock at Par 200 Additional Paid-In Capital: 200 Net Income 200X 500 Dividends Paid:(350) Stockholders’ Equity at end2,070 $’000 LOS 29 d describe and distinguish between the principal financial statements: Statement of Stockholders’ Equity LOS 31 f describe the format and the components of the balance sheet and the format, classification, and use of each component of the statement of stockholders’ equity.

20 Financial Statement Analysis INCOME STATEMENT FOR THE YEAR ENDING 31 DECEMBER 20X0 Revenues Cost of goods sold Gross profit Operating expenses Depreciation Earnings before interest and taxes Interest expense Earnings before taxes Taxes Net income $’000 6,350 2,400 3,950 2,500 200 1,250 500 750 250 500 LOS 29 d describe and distinguish between the principal financial statements: Balance Sheet, Income Statement, Statement of Comprehensive Income, Statement of Cash Flows and Statement of Stockholders’ Equity LOS 31 a describe the format on the Income Statement and the components of net income LOFTUS INC

21 Financial Statement Analysis FINANCIAL STATEMENT FOOTNOTES Information on accounting methods, assumptions and estimates Additional information on items appearing in major statements Disclosures relating to contingent losses Accrue a loss:- probable that loss has been incurred - amount can be reasonably estimated Footnote disclosure:- loss is reasonably possible - e.g., litigation, expropriation (these are potential losses/payments potentially to be incurred by the firm, subject to the outcome of some future event/action e.g. litigation) LOS 29 d discuss the additional sources of information accompanying the financial statements, including the financial footnotes, supplementary schedules, Management Discussion and Analysis (MD&A) and Proxy statements Depreciation methods Inventory valuation methods Leasing arrangements Deferred tax calculations Items not otherwise reported in the financial statements that are relevant and/or material

22 Financial Statement Analysis INCOME STATEMENT FORMAT SUGGESTED IN READING Revenues from the sales of goods and services: Other income and revenues Operating expenses Financing costs Unusual or infrequent items Pre-tax earnings from continuing operations Income tax expense Net income from continuing operations Income from discontinued operations Extraordinary items Cumulative effect of accounting changes Net income + – +/– – – LOS 29 d describe and distinguish between the principal financial statements: Balance Sheet, Income Statement, Statement of Comprehensive Income, Statement of Cash Flows and Statement of Stockholders’ Equity LOS 31 a describe the format on the Income Statement and the components of net income

23 Financial Statement Analysis CRITERIA FOR REVENUE RECOGNITION In order to recognize revenues (in the Income Statement) two conditions must be met: 1.Completion of the earnings process This amounts to the firm having provided all or virtually all of the services for which it is to be paid, knowing the total expected cost of providing those services and the associated revenues 2.Assurance of payment LOS 31 b Identify the requirements for revenue recognition to occur. The seller must be able to reasonably estimate the probability of payment

24 Financial Statement Analysis Sales basis Percentage-of-completion Completed contract METHODS OF REVENUE RECOGNITION Sales and corresponding costs recognized at the point of sale and/or when a service has been provided For long term contracts where a reliable estimate of revenues, costs and completion time exists. Revenues and costs recognized according to the proportion of work completed. For long term contracts where there is no contract or estimates of revenues and costs are unreliable. Revenues and costs are not recognized in the Income Statement until the entire project is completed. LOS 31 b explain the importance of the matching principle for revenue and expense recognition, identify the requirements for revenue recognition to occur, identify and describe the appropriate revenue recognition, given the status of completion of the earning process and the assurance of payment, and discuss different revenue recognition methods and their implications for financial analysis;

25 Financial Statement Analysis Instalment sales Cost recovery METHODS OF REVENUE RECOGNITION For contracts where costs and revenues are known but the exact timing of the receipt of sales cash is unclear. Revenues and costs are recognized in the Income Statement in proportion to the cash collection. For contracts where revenues are known but the exact size of costs is not clear. Profits are not recognized in the Income Statement until all costs have been ‘recovered,’ i.e., through the recognition of sales just equal to costs incurred. LOS 31 b explain the importance of the matching principle for revenue and expense recognition, identify the requirements for revenue recognition to occur, identify and describe the appropriate revenue recognition, given the status of completion of the earning process and the assurance of payment, and discuss different revenue recognition methods and their implications for financial analysis;

26 Financial Statement Analysis PERCENTAGE OF COMPLETION METHOD – EXAMPLE Bircham Properties Ltd. has a contract to build a hotel for $2,000,000 to be received in equal installments over 4 years. A reliable estimate of total cost of this contract is $1,600,000. During the first year, Bircham Properties incurred $400,000 in cost. During the second year, $500,000 of costs were incurred. The estimate of the projects total cost did not change in the second year. Calculate the revenue to be recognized in each of the first two years. LOS 31 c identify the appropriate income statement and balance sheet entries using the percentage-of-completion method and the completed contract method and describe and calculate the effects on cash flows and selected financial ratios that result from using the percentage-of-completion method versus the completed contract method;

27 Financial Statement Analysis POC vs. CC METHODS – EXAMPLE (BALANCE SHEET) Cook Properties has a contract to build an office building for $2 million. An estimate of the contract’s total costs is $1.5 million. Billings and cost patterns are as follows: 20x1 800 600 500 20x2 700 900 700 20x3 500 300 Total 2,000 1,500 Amounts billed Cash received Costs incurred You are required to prepare the balance sheets using the percentage of completion and completed contract methods. LOS 31 c identify the appropriate income statement and balance sheet entries using the percentage-of-completion method and the completed contract method and describe and calculate the effects on cash flows and selected financial ratios that result from using the percentage-of-completion method versus the completed contract method;

28 Financial Statement Analysis BALANCE SHEET – PERCENTAGE-OF-COMPLETION METHOD Total Assets 20x2 Cash (Cash Rec’d – Cost Incurred) Accounts receivable (Amounts Billed – Cash Rec’d) Net CIP* Total Assets 20x320x1 LOS 31 c identify the appropriate income statement and balance sheet entries using the percentage-of-completion method and the completed contract method and describe and calculate the effects on cash flows and selected financial ratios that result from using the percentage-of-completion method versus the completed contract method; * See working slide

29 Financial Statement Analysis BALANCE SHEET – PERCENTAGE-OF-COMPLETION METHOD Total Liabilities and Equity 20x120x220x3 Net Advanced Billings* Retained Earnings Total Liabilities & Equity LOS 31 c identify the appropriate income statement and balance sheet entries using the percentage-of-completion method and the completed contract method and describe and calculate the effects on cash flows and selected financial ratios that result from using the percentage-of-completion method versus the completed contract method; * See working slide

30 Financial Statement Analysis MEMO CIP 20x220x320x1 Cost Profit Allocation Amounts Billed Cost to Date Total Cost X Contract Price – Total Cost Net CIP/(Net Advanced Billings)

31 Financial Statement Analysis BALANCE SHEET – COMPLETED CONTRACT METHOD 20x2 Cash Accounts receivable Net CIP Total Assets 20x320x1 Total Assets LOS 31 c identify the appropriate income statement and balance sheet entries using the percentage-of-completion method and the completed contract method and describe and calculate the effects on cash flows and selected financial ratios that result from using the percentage-of-completion method versus the completed contract method;

32 Financial Statement Analysis BALANCE SHEET – COMPLETED CONTRACT METHOD Total Liabilities and Equity 20x120x220x3 Net Advanced Billings Retained Earnings Total Liabilities & Equity LOS 31 c identify the appropriate income statement and balance sheet entries using the percentage-of-completion method and the completed contract method and describe and calculate the effects on cash flows and selected financial ratios that result from using the percentage-of-completion method versus the completed contract method;

33 Financial Statement Analysis MEMO CIP 20x220x320x1 Cost Amounts Billed Net CIP/(Net Advanced Billings)

34 Financial Statement Analysis Net income Volatility of income Total assets Liabilities R/E Cash flow Importance of CFO POC CC Income Statement Balance Sheet Statement of Cash Flows PERCENTAGE-OF-COMPLETION vs. COMPLETED CONTRACT During Project Life LOS 31 c identify the appropriate income statement and balance sheet entries using the percentage-of-completion method and the completed contract method and describe and calculate the effects on cash flows and selected financial ratios that result from using the percentage-of-completion method versus the completed contract method;

35 Financial Statement Analysis INSTALLMENT SALES METHOD – EXAMPLE During 20X0, Sturridge Inc. sold $20,000 of inventory, with a cost of $10,000. During 20X0 and 20X1, Sturridge collected $8,000 and $12,000 respectively, of its receivables. Under the Instalment Method, what are the sales and gross profit to be reported in each of the two years? LOS 31 b explain the importance of the matching principle for revenue and expense recognition, identify the requirements for revenue recognition to occur, identify and describe the appropriate revenue recognition, given the status of completion of the earning process and the assurance of payment, and discuss different revenue recognition methods and their implications for financial analysis;

36 Financial Statement Analysis COST RECOVERY METHOD – EXAMPLE During 20X0, Sturridge Inc. sold $20,000 of services but the cost of providing this service was unclear at the outset of the contract. During 20X0 and 20X1, Sturridge Inc. collected $8,000 and $12,000, respectively of its receivables. The project was completed during 20X1 at which time the company had incurred total costs of $10,000. Under the Cost Recovery Method, what are the sales and gross profit to be reported in each of the two years? LOS 31 b explain the importance of the matching principle for revenue and expense recognition, identify the requirements for revenue recognition to occur, identify and describe the appropriate revenue recognition, given the status of completion of the earning process and the assurance of payment, and discuss different revenue recognition methods and their implications for financial analysis;

37 Financial Statement Analysis CHOOSING THE APPROPRIATE REVENUE RECOGNITION METHOD Completion of Earning Process Complete Complete with contingencies Incomplete and costs can be estimated Incomplete and costs can’t be estimated Revenue Recognition Method Sales basis Installment sales Cost recovery Percentage of completion Completed contract Assurance of Payment Assured Not assured Assured Not assured Assured Not assured Assured Not assured LOS 31 b explain the importance of the matching principle for revenue and expense recognition, identify the requirements for revenue recognition to occur, identify and describe the appropriate revenue recognition, given the status of completion of the earning process and the assurance of payment, and discuss different revenue recognition methods and their implications for financial analysis;

38 Financial Statement Analysis INCOME STATEMENT FORMAT SUGGESTED IN READING Revenues from the sales of goods and services: Other income and revenues Operating expenses Financing costs Unusual or infrequent items Pre-tax earnings from continuing operations Income tax expense Net income from continuing operations Income from discontinued operations Extraordinary items Cumulative effect of accounting changes Net income + – +/– – – LOS 31 d describe the types and analysis of unusual or infrequent items, extraordinary items, discontinued operations, accounting changes, and prior period adjustments; Gross of tax Net of tax

39 Financial Statement Analysis INCOME STATEMENT: NON-RECURRING ITEMS Unusual or infrequent items Extraordinary items Gains of losses from disposal of a portion of a business segment Gains or losses from sale of assets or investments Impairments, write-offs and restructuring costs Gains or losses from the early retirement of debt (note can be extraordinary if infrequent) Provisions against environmental remediation Unusual AND infrequent AND material: Losses due to a foreign governments expropriation of assets Uninsured losses from natural disasters LOS 31 d describe the types and analysis of unusual or infrequent items, extraordinary items, discontinued operations, accounting changes, and prior period adjustments;

40 Financial Statement Analysis INCOME STATEMENT: NON-RECURRING ITEMS Discontinued operations Changes in accounting principle Operating income (e.g., revenue and expenses up to the date of disposal) and any gains or losses from their sale are reported separately since these activities will not contribute to future income and cash flows. The cumulative impact on prior period earnings is reported net of tax after extraordinary items and discontinued operations where, for example, the company changes the depreciation method. Not that this is not required for changes in accounting estimates. LOS 31 d describe the types and analysis of unusual or infrequent items, extraordinary items, discontinued operations, accounting changes, and prior period adjustments;

41 Financial Statement Analysis Role of Nonrecurring Items in Estimating Earnings Power Classification of good/bad news Income smoothing The analyst focus is often on net income from ‘continuing’ operations as this serves as a basis for forecasts. Companies therefore tend towards putting profitable one off transactions above this line in the income statement and loss producing one off items below this line Companies attempt to reduce earnings in years of good performance and inflate earnings in years of bad performance through aggressive or conservative accounting policy selection. LOS 31 e discuss managerial discretion in areas such as classification of good news/bad news, income smoothing, big bath behaviour, and accounting changes, and explain how this discretion can affect the financial statements;

42 Financial Statement Analysis Big bath techniques Accounting changes When firms are experiencing a bad year they may attempt to recognize all of their ‘bad news’ at once. Going forward therefore, the subsequent improvement in performance will be magnified and this will show management in a better light. Firms can use accounting changes to smooth earnings, as noted above, and these can often have a material impact on earnings without effecting cash flow. LOS 31 e discuss managerial discretion in areas such as classification of good news/bad news, income smoothing, big bath behaviour, and accounting changes, and explain how this discretion can affect the financial statements; Role of Nonrecurring Items in Estimating Earnings Power

43 Financial Statement Analysis The Cashflow Statement Regular operations generate enough cash to sustain the business Enough cash is generated to pay off maturing debt Highlights the need for additional finance Ability to meet unexpected obligations The flexibility to take advantage of new business opportunities Benefits for the analyst How the firm obtains and spends cash Borrowing and debt repayment activities Issue and repurchase of equity Distributions to owners (dividends) Other factors affecting liquidity and solvency FASB requirements LOS 32 a identify the types of important information for investment decision making presented in the statement of cash flows;

44 Financial Statement Analysis STATEMENT OF CASH FLOWS – SFAS 95 Cash flow from operations (CFO) Cash flow from investing (CFI) Cash flow from financing (CFF) + + Change in cash balance= Beginning cash+ Ending cash= LOS 32 a identify the types of important information for investment decision making presented in the statement of cash flows; LOS 32 b compare and contrast the categories (i.e., cash provided or used by operating activities, investing activities, and financing activities) in a statement of cashflows, and describe how noncash investing and financing transactions are reported Cash received from customers Cash dividends received Cash interest received Other cash income Payments to suppliers Cash expenses (wages etc) Cash interest paid Cash taxes paid CFO $ X (X) X/(X)

45 Financial Statement Analysis CASH FROM INVESTING Purchase and sale proceeds of: Property, plant & equipment Subsidiaries, Joint Ventures and Affiliates Investments CASH FROM FINANCING Issue and redemption of: Common stock Debt Dividend payments (divs rec’d = CFO) LOS 32 b compare and contrast the categories (i.e., cash provided or used by operating activities, investing activities, and financing activities) in a statement of cashflows, and describe how noncash investing and financing transactions are reported LOS 33 a classify a particular transaction or item as cash flow from 1) operations, 2) investing, or 3) financing;

46 Financial Statement Analysis Non-Cash Investing and Financing Activities Retirement of debt via conversion into equity Conversion of preferred stock into common stock Assets acquired under capital leases Obtaining assets by issuing notes payable Exchange of one non cash asset for another Purchase of non cash assets by issuing equity or other securities All the above items will affect the Balance Sheet but not the Cashflow Statements as no cash is raised or paid LOS 32 b compare and contrast the categories (i.e., cash provided or used by operating activities, investing activities, and financing activities) in a statement of cashflows, and describe how noncash investing and financing transactions are reported

47 Financial Statement Analysis CASH FROM OPERATIONS DIRECT METHOD Cash inflows less cash outflows Cash from operations LOS 33 b compute and interpret a statement of cash flows, using the direct method and the indirect method; LOS 32 c calculate and interpret, using the indirect method, the net cash provided or used by operating activities; Net income depreciation & amortisation gains on disposal of l/t assets losses on disposal of l/t assets other non-cash expenses non-cash revenues changes in non-cash working capital + – + – +/– Cash from operations INDIRECT METHOD

48 Financial Statement Analysis Direct Method CFO Steps 1.Start at the top of the Income Statement – e.g., Sales 2.Move to the balance sheet and identify any asset and liability that relate to that Income Statement item – e.g., Accounts Receivable 3.Look at the change in the Balance Sheet item during the period (ending balance – opening balance) 4.Apply the rule: 5.Adjust the Income Statement amount by the change in the Balance Sheet Increases in an asset – deduct Increase in a liability – add Decrease in an asset – add Decrease in a liability – deduct LOS 33 b compute and interpret a statement of cash flows, using the direct method and the indirect method; LOS 32 c calculate and interpret, using the indirect method, the net cash provided or used by operating activities;

49 Financial Statement Analysis Direct Method cont. 6.Tick off the items dealt with in both the Income Statement and Balance sheet 7.Move to the next item on the Income Statement and repeat 8.Ignore depreciation/amortization and gains/losses on the disposal of assets as these are all non cash items 9.Keep moving down the Income Statement until all items included in Net Income have been addressed applying steps 1-8 10.Total up the amounts and you have CFO LOS 33 b compute and interpret a statement of cash flows, using the direct method and the indirect method; LOS 32 c calculate and interpret, using the indirect method, the net cash provided or used by operating activities;

50 Financial Statement Analysis EXAMPLE – HOLLOWAY INDUSTRIES Holloway Industries has the following Income Statement for 20X3 and Balance Sheets for 20X2 and 20X3. You are to construct the Statement of Cash Flows using the templates provided. Income Statement for Year to 31 December 20X3 Sales revenue Expenses: Cost of goods sold Salaries Goodwill amortization Depreciation Interest Gain from sale of PPE Pre-tax income Provision for taxes Net income 80,000 10,000 2,000 12,000 1,000 200,000 105,000 95,000 20,000 115,000 40,000 75,000 LOS 33 b compute and interpret a statement of cash flows, using the direct method and the indirect method; LOS 32 c calculate and interpret, using the indirect method, the net cash provided or used by operating activities;

51 Financial Statement Analysis EXAMPLE – HOLLOWAY INDUSTRIES cont. Balance Sheets Current assets Cash Accounts receivable Inventory Noncurrent assets Land Plant & equipment Less: Acc depreciation Goodwill Total Assets 20X2 $ 18,000 14,000 80,000 120,000 (18,000) 20,000 252,000 20X3 $ 66,000 20,000 10,000 80,000 150,000 (20,000) 18,000 324,000 PPE includes an asset that cost $20,000 and had accumulated depreciation of $20,000 at the point of disposal LOS 33 b compute and interpret a statement of cash flows, using the direct method and the indirect method; LOS 32 c calculate and interpret, using the indirect method, the net cash provided or used by operating activities; Note the order of years (older/most recent) may be reversed in questions – always check!

52 Financial Statement Analysis Balance Sheets Current liabilities Accounts payable Salaries payable Interest payable Taxes payable Dividends payable Noncurrent liabilities Bonds Deferred taxes Stockholders’ equity Common stock Retained earnings Total Liabilities & Equity 20X2 $ 10,000 16,000 6,000 8,000 2,000 20,000 30,000 100,000 60,000 252,000 20X3 $ 18,000 9,000 7,000 10,000 12,000 30,000 40,000 80,000 118,000 324,000 LOS 33 b compute and interpret a statement of cash flows, using the direct method and the indirect method; LOS 32 c calculate and interpret, using the indirect method, the net cash provided or used by operating activities; EXAMPLE – HOLLOWAY INDUSTRIES cont.

53 Financial Statement Analysis HOLLOWAY INDUSTRIES – CASH FLOW FROM OPERATIONS Direct Method $$ Cash Inflows Sales Less: increase in A/R Cash collected from customers Direct cash outflows Cost of goods sold Add: decrease in inventory Purchases Add: increase in A/P Cash paid to suppliers Operating expense (wages) Less: decrease in salaries payable Cash paid to employees LOS 33 b compute and interpret a statement of cash flows, using the direct method and the indirect method; LOS 32 c calculate and interpret, using the indirect method, the net cash provided or used by operating activities;

54 Financial Statement Analysis Direct Method cont. Cash outflows Interest Expense Add: increase in interest payable Cash interest paid Taxation Expenses Add: Increase in deferred tax Tax payable Add: increase in taxes payable Cash paid to IRS $$ CFO LOS 33 b compute and interpret a statement of cash flows, using the direct method and the indirect method; LOS 32 c calculate and interpret, using the indirect method, the net cash provided or used by operating activities;

55 Financial Statement Analysis Indirect Method CFO Steps 1.Start at the bottom of the Income Statement – e.g., Net Income. This means we have already included all the items on the Income Statement 2.Return to the top of the Income Statement and adjust each item line by line. Note that we have already included Sales in our Net Income figure 3.Look at the change in the Balance Sheet item during the period (ending balance – opening balance). These are identical to the Direct Method! 4.Apply the rule: Increases in an asset – deduct Increase in a liability – add Decrease in an asset – add Decrease in a liability – deduct LOS 33 b compute and interpret a statement of cash flows, using the direct method and the indirect method; LOS 32 c calculate and interpret, using the indirect method, the net cash provided or used by operating activities;

56 Financial Statement Analysis Indirect Method cont. 5. Tick off the items dealt with in both the Income Statement and Balance sheet 6.Move to the next item on the Income Statement and repeat 7.Eliminate depreciation and amortization by adding them back (they’ve been deducted in arriving at Net Income but have no cash implication) 8.Eliminate gains on disposal by deducting them and losses on disposal by adding them back. 9.Keep moving down the Income Statement until all items included in Net Income have been addressed applying steps 1-8 10.Total up the amounts and you have CFO LOS 33 b compute and interpret a statement of cash flows, using the direct method and the indirect method; LOS 32 c calculate and interpret, using the indirect method, the net cash provided or used by operating activities;

57 Financial Statement Analysis HOLLOWAY INDUSTRIES – CASH FLOW FROM OPERATIONS Net income depreciation goodwill amortisation gain from sale of land increase in deferred taxes Current asset adjustments increase in accounts receivable decrease in inventory Current liability adjustments increase in accounts payable decrease in salaries payable increase in interest payable increase in taxes payable $ Cash flow from operations Indirect Method LOS 33 b compute and interpret a statement of cash flows, using the direct method and the indirect method; LOS 32 c calculate and interpret, using the indirect method, the net cash provided or used by operating activities;

58 Financial Statement Analysis Computing CFI Additions to PPE 2 Methods Opening Cost Cost of Disposals Additions β Closing Cost Opening NBV NBV of Disposals Depreciation Charge Additions β Closing NBV $ X (X) X $ X (X) X The method to choose depends on whether cost and accumulated depreciation have been disclosed separately or together as NBV LOS 32 d prepare and interpret, using the indirect method, the statement of cash flows for investing activities and financing activities.

59 Financial Statement Analysis Computing CFI Holloway Industries Additions to PPE 2 Methods Opening Cost Cost of Disposals Additions β Closing Cost Opening NBV NBV of Disposals Depreciation Charge Additions β Closing NBV $ $ The method to choose depends on whether cost and accumulated depreciation have been disclosed separately or together as NBV LOS 32 d prepare and interpret, using the indirect method, the statement of cash flows for investing activities and financing activities.

60 Financial Statement Analysis Computing Proceed on Disposal Proceeds β NBV Profit/(loss) X (X) X/(X) $ Disclosed in question From Income Statement LOS 32 d prepare and interpret, using the indirect method, the statement of cash flows for investing activities and financing activities. Profit/(loss) on disposal of long lived assets Proceeds β NBV Profit/(loss) $ Holloway Industries

61 Financial Statement Analysis Computing CFF Change in Debt Change in Common Stock Cash Dividends Paid Simply closing balance less opening balance – don’t forget to check current liabilities for any debt maturing within 12 months! Simply the change in both common stock and additional paid in capital during the period – this could be made more complicated by including scrip issues Calculate Dividends Net Income Dividends β Δ in Retained Earnings $ X (X) X Dividends Proposed Dividends Payable Cash Paid $ (X) X/(X) (X) LOS 32 d prepare and interpret, using the indirect method, the statement of cash flows for investing activities and financing activities.

62 Financial Statement Analysis Holloway CFF Change in Debt Change in Common Stock Cash Dividends Paid Calculate Dividends Net Income Dividends β Δ in Retained Earnings $ Dividends Proposed Dividends Payable Cash Paid $ LOS 32 d prepare and interpret, using the indirect method, the statement of cash flows for investing activities and financing activities. $

63 Financial Statement Analysis HOLLOWAY INDUSTRIES – STATEMENT OF CASH FLOWS $ Cash flow from operations Cash flow from investing activities Sale of PP&E Purchase of PP&E Cash flow from investing Cash flow from financing activities Increase in bonds Decrease in common stock Payment of dividends Cash flow from financing Net increase in cash Cash at beginning Cash at end $ LOS 33 b compute and interpret a statement of cash flows, using the direct method and the indirect method

64 Financial Statement Analysis FREE CASH FLOW Measures the cash available to the firm for discretionary uses after making all required cash outlays. Formally, it should be the operating cash flow minus those cash flows necessary to maintain the firm’s productive capacity and provide for growth. However, it is not practical for an analyst to determine which capital expenditures are necessary to maintain capacity and which are allotted for growth. Consequently, free cash flow is measured by: Free Cash Flow = Operating cash flow - Net capital expenditures Expenditure on capital items – after tax sales proceeds from disposals LOS 33 e describe and compute free cash flow;

65 Financial Statement Analysis STATEMENT OF CASH FLOW U.S. GAAP vs. IAS GAAP LOS 33 f Distinguish between the U.S. GAAP and IAS GAAP classifications of dividends paid or received and interest paid or received for statement of cash flow purposes Interest received Interest paid Dividends received Dividends paid CFO CFF CFO or CFI CFO or CFF CFO or CFI CFO or CFF U.S. GAAP (SFAS 95) IAS GAAP (IAS 7)

66 Financial Statement Analysis Future FASB Changes and the Analytical Challenges of GAAP European Commission – Publicly traded companies mandatory adoption of IAS by 2005 (unless producing accounts under U.S. GAAP in which they must adopt IAS by 2007) ISAB and FASB attempting to eliminate 3 major differences: Expensing of employee stock options Business combinations under the purchase method In-process R&D Restructuring costs Measurement date for acquisitions using stock Reconciling standards in revenue recognition LOS 34 a identify the projects on the FASB agenda that were/are related to international convergence

67 Financial Statement Analysis Future FASB Changes and the Analytical Challenges of GAAP Other convergence projects Revisions to Income Statement format/content Accounting for financial instruments with both equity and liability characteristics (e.g., convertibles) Fair-value measurement LOS 34 a identify the projects on the FASB agenda that were/are related to international convergence

68 Financial Statement Analysis FASB Revenue Recognition 2 conceptual approaches that may conflict Approach 1 Recognition criteria 1.Completion of earnings process 2.Assurance of receipt Approach 2 Revenue recognition occurs when there is any increase in net assets resulting from transactions with non shareholders i.e., any increase in Net Assets (worth) that is not the result of issuing new equity LOS 34 b describe two different guidance rules for revenue recognition discussed by FASB and IASB

69 Financial Statement Analysis Financial Statement Analysis Financial Ratios and Earnings Per Share Study Session 8

70 Financial Statement Analysis Why are Ratios so Important in Financial Analysis? The analyst reviews the company’s financial statements to gain an insight into a company’s financial decision making and performance. Ratios allow the analyst to raise questions about the performance of the firm. This performance may be compared year on year within the firm or with competitors within the industry and the economy as a whole. Although there are many dozens of ratio’s that could be computed there are several key ratio’s that give the analyst an insight into the firm’s: Performance:determine how well management operate the business Liquidity:determine the firms ability to pay its short term liabilities Risk:measure the uncertainty of the firms income flows LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential;

71 Financial Statement Analysis INTERNAL LIQUIDITY RATIOS Current ratio Quick ratio Cash ratio Receivables turnover current assets current liabilities current assets – inventory current liabilities cash + marketable securities current liabilities net sales avg. receivables LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential;

72 Financial Statement Analysis INTERNAL LIQUIDITY RATIOS Receivables collection period Inventory turnover Inventory processing period 365 receivables turnover cost of goods sold avg. inventory 365 inventory turnover LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential; avg. receivables net sales × 365 OR avg. inventory cost of goods sold × 365 OR

73 Financial Statement Analysis Payables turnover Payables payment period cost of goods sold avg. accounts payable 365 payables turnover LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential; avg. inventory cost of goods sold OR × 365 INTERNAL LIQUIDITY RATIOS

74 Financial Statement Analysis Cash Conversion Cycle Raw Materials Arrive Production Commences Production Complete Goods Sold Cash Collected Pay Supplier Payables payment period Inventory processing period Receivables collection period Cash Conversion Cycle Inventory Period Receivables Period Payables Period Cash Conversion Cycle Days X (X) X LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential;

75 Financial Statement Analysis Current ratio Quick ratio Cash ratio Holloway Industries 20x2 20x3 LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential;

76 Financial Statement Analysis Receivables turnover Average receivables collection period 20x3 LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential; Inventory turnover Average inventory processing period 20x3 Holloway Industries

77 Financial Statement Analysis Payables turnover Payables payment period 20x3 Collection period + Inventory period – Payment period LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential; Cash Conversion Cycle Holloway Industries

78 Financial Statement Analysis Total asset turnover Fixed asset turnover Equity turnover OPERATING EFFICIENCY net sales avg. total net assets net sales avg. net fixed assets net sales avg. equity LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential; Holloway Industries

79 Financial Statement Analysis 20x3 Total asset turnover Fixed asset turnover Equity turnover LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential; Holloway Industries

80 Financial Statement Analysis Gross profit margin Operating profit margin Net profit margin OPERATING PROFITABILITY sales – COGS (GP) net sales EBIT net sales EAT net sales × 100 LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential; Holloway Industries

81 Financial Statement Analysis Gross profit margin Operating profit margin Net profit margin OPERATING PROFITABILITY LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential; 20x3 Holloway Industries

82 Financial Statement Analysis Return on total capital Return on equity OPERATING PROFITABILITY EAT + interest avg. total capital Equity Liabilities EAT avg. equity × 100 LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential; = Total Assets Holloway Industries

83 Financial Statement Analysis Return on total capital Return on equity OPERATING PROFITABILITY LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential; 20x3 Holloway Industries

84 Financial Statement Analysis Income statement Balance sheet COMMON SIZE STATEMENTS income statement account sales balance sheet account total assets e.g., marketing expense sales e.g., inventory total assets LOS 35 a interpret common-size balance sheets and common-size income statements, and discuss the circumstances under which the use of common-size financial statements is appropriate;

85 Financial Statement Analysis DUPONT RATIO ANALYSIS ROE= EAT EQUITY ROE= EAT SALES EQUITY × ROE= EAT SALES ASSETS × EQUITY × After tax profit margin Asset turnover Financial leverage multiplier Traditional version of DuPont equation LOS 35 c calculate and interpret the various components of the company’s return on equity using the original and extended DuPont systems and a company’s financial ratios relative to its industry, to the aggregate economy, and to the company’s own performance over time;

86 Financial Statement Analysis DUPONT RATIO ANALYSIS 20x3 ROE= Traditional version of DuPont equation LOS 35 c calculate and interpret the various components of the company’s return on equity using the original and extended DuPont systems and a company’s financial ratios relative to its industry, to the aggregate economy, and to the company’s own performance over time; Holloway Industries

87 Financial Statement Analysis EXTENDED DUPONT EQUATION SALES ASSETS ROE=EBT SALES × ASSETS EQUITY ×(1 – t)× ROE=EAT SALES ASSETS × EQUITY × SALES ASSETS ROE=EBIT SALES × ASSETS EQUITY ×(1 – t)×– I ASSETS Operating profit margin Asset turnover Financial leverage multiplier Interest expense rate Tax retention rate LOS 35 c calculate and interpret the various components of the company’s return on equity using the original and extended DuPont systems and a company’s financial ratios relative to its industry, to the aggregate economy, and to the company’s own performance over time; t = effective tax rate

88 Financial Statement Analysis EXTENDED DUPONT EQUATION 20x3 ROE= LOS 35 c calculate and interpret the various components of the company’s return on equity using the original and extended DuPont systems and a company’s financial ratios relative to its industry, to the aggregate economy, and to the company’s own performance over time; ROE=75,000 200,000 324,000 × 198,000 × = 38% Holloway Industries

89 Financial Statement Analysis RISK PROFILE Business risk Financial risk CV’s- operating income - sales Operating leverage Leverage Coverage Measures the uncertainty of the firms operating income as a result of variability of sales and production costs Additional volatility of the firms equity returns caused by the firm’s use of debt LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential;

90 Financial Statement Analysis BUSINESS RISK Coefficient of Variation of Operating Income Coefficient of Variation of Sales Operating Leverage  EBIT  EBIT %  in EBIT %  in Sales  Sales  Sales LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential;

91 Financial Statement Analysis Debt to equity ratio Debt to long term capital ratio long-term debt stockholder equity long-term debt long-term debt + stockholder equity FINANCIAL RISK RATIOS LEVERAGE Long-term liabilities Deferred tax PV of operating leases Common Stock Preferred Stock Additional Paid in Capital Other Reserves Retained Earnings LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential;

92 Financial Statement Analysis Total Debt Ratio Total Interest-Bearing Debt to Total Funded Capital current liabilities + long-term debt stockholder equity total interest-bearing debt total capital – non-interest-bearing liabilities FINANCIAL RISK RATIOS LEVERAGE LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential;

93 Financial Statement Analysis FINANCIAL RISK RATIOS COVERAGE Interest Coverage EBIT interest expense Cash Flow Interest Coverage cash flow + interest expense + ELIE interest expense + ELIE Fixed Financial Cost EBIT + ELIE gross interest expense + ELIE ELIE = Estimated Lease Interest Expense LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential;

94 Financial Statement Analysis HOLLOWAY INDUSTRIES – FINANCIAL RISK RATIOS Interest Coverage Long Term Debt to equity Debt to long term capital 20x3 LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential;

95 Financial Statement Analysis GROWTH ANALYSIS Sustainable growth=(earnings retention rate)(ROE) Earnings retention rate=[1 – (dividends/net income)] ROE=[EAT/sales] [sales/assets] [assets/equity] Example: A firm has a dividend payout ratio of 35%, a net profit margin of 10%, an asset turnover of 1.4 and an equity multiplier leverage measure of 1.2. Estimate the firm’s sustainable growth rate. LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential;

96 Financial Statement Analysis CONSIDERATIONS WHEN USING FINANCIAL RATIOS Financial ratios should always be relative Are alternative firms’ accounting treatments comparable? Is the firm involved in several industries or just one? Are the implied results consistent or just a “one-off” Is the ratio within a reasonable range for the industry?

97 Financial Statement Analysis EARNINGS PER SHARE (EPS) Simple capital structure - Basic EPS Complex capital structure - Diluted EPS One that contains no potentially dilutive securities Contains potentially dilutive securities (that would decrease EPS if exercised or converted to common stock LOS 36 a differentiate between simple and complex capital structures for purposes of calculating earnings per share (EPS), describe the components of EPS, and calculate a company’s EPS in a simple capital structure; Convertible Bonds Convertible Preferred Stock Warrants and Employee Stock Options

98 Financial Statement Analysis earnings attributable to common stockholders weighted average number of shares of common outstanding Earnings = net income – preference dividends EPS – BASIC CALCULATION Weighted Average Number of Shares A time weighted average, necessary when the number of shares in issue has changed during the year. For example: share repurchases - which are excluded from date of repurchase share issues for cash or to acquire subsidiary share issues for free (via stock splits or stock dividends) LOS 36 a differentiate between simple and complex capital structures for purposes of calculating earnings per share (EPS), describe the components of EPS, and calculate a company’s EPS in a simple capital structure;

99 Financial Statement Analysis 1 January4 million common stock in issue ranking for dividend 30 September1 million further shares issued ranking for dividend (assuming year ending 31 December) Million Number of shares used in EPS calculation CHANGES IN EQUITY ISSUE FOR CASH AT MARKET PRICE LOS 36 a differentiate between simple and complex capital structures for purposes of calculating earnings per share (EPS), describe the components of EPS, and calculate a company’s EPS in a simple capital structure;

100 Financial Statement Analysis The following have no effect on earnings: CHANGES IN EQUITY NO EFFECT ON EARNINGS stock dividends stock splits These changes in equity are back dated, to assume that they occurred on the first day of the year with all prior year figures being retrospectively adjusted. 10% stock dividend – the holder of 100 shares would receive 10 new shares 5:4 Stock split – The holder of 100 shares would be holding 125 shares post split 5:4 New holdingOld holding LOS 36 c describe stock dividends and stock splits and determine the effect of each on a company’s weighted average number of shares outstanding;

101 Financial Statement Analysis EPS – WORKED EXAMPLE Profit Inc had 10 million shares outstanding at the beginning of the year and net income of $20m. The following transactions occurred during the year: 1 July2 million new shares issued for cash 1 September10% stock dividend 1 November500,000 common shares repurchased (assuming year ending 31 December) Calculate the EPS for the year LOS 36 c describe stock dividends and stock splits and determine the effect of each on a company’s weighted average number of shares outstanding;

102 Financial Statement Analysis Dilutive vs. Anti-Dilutive Securities Convertible Bonds Convertible Preferred Stock Warrants and Employee Stock Options coupon saved (1–T) Shares Created < Basic EPS preferred dividend saved shares created < Basic EPS Average Share Price > Strike Price Securities are Dilutive if: LOS 36 d distinguish between dilutive and antidilutive securities and calculate a company’s basic and diluted EPS in a complex capital structure and describe and determine the effects of convertible securities, options, and warrants on a company’s EPS;

103 Financial Statement Analysis DILUTED EPS – CONVERTIBLE SECURITIES EXAMPLE Earnings for equity in year to 31/Dec/X12,500,000 Common stock of $10 each10,000,000 Basic EPS$2.50 Tax rate30% There have been in issue throughout the year $2,000,000 of 5% convertible loan stock. The terms of conversion are, for every $1,000 nominal value of loan stock: On31 March 20X2110 common shares 31 March 20X3120 common shares 31 March 20X4103 common shares Calculate fully diluted EPS for 20X1. $ LOS 36 d distinguish between dilutive and antidilutive securities and calculate a company’s basic and diluted EPS in a complex capital structure and describe and determine the effects of convertible securities, options, and warrants on a company’s EPS;

104 Financial Statement Analysis Earnings Add:Interest saved Less:Relief for tax @ 30% No. of equity shares if loan stock was converted: In issue On conversion $$ DILUTED EPS – CONVERTIBLE SECURITIES SOLUTION LOS 36 d distinguish between dilutive and antidilutive securities and calculate a company’s basic and diluted EPS in a complex capital structure and describe and determine the effects of convertible securities, options, and warrants on a company’s EPS;

105 Financial Statement Analysis DILUTED EPS – CONVERTIBLE PREFERRED STOCK EXAMPLE Earnings for equity in year to 31/Dec/X14,000,000 Common stock of $10 each20,000,000 Basic EPS $2.00 Tax rate n/a There have been in issue throughout the year $5,000,000 of 7% convertible preferred stock. The terms of conversion are, for every $1,000 nominal value of preferred stock: On30 April 20X2120 common stock shares 30 April 20X3110 common stock shares 30 April 20X4105 common stock shares Calculate fully diluted EPS for 20X1. $ LOS 36 d distinguish between dilutive and antidilutive securities and calculate a company’s basic and diluted EPS in a complex capital structure and describe and determine the effects of convertible securities, options, and warrants on a company’s EPS;

106 Financial Statement Analysis $ DILUTED EPS – CONVERTIBLE PREFERRED STOCK SOLUTION Earnings Add:Preferred dividend saved No. of common stock shares if preferred shares were converted: In issue On conversion LOS 36 d distinguish between dilutive and antidilutive securities and calculate a company’s basic and diluted EPS in a complex capital structure and describe and determine the effects of convertible securities, options, and warrants on a company’s EPS;

107 Financial Statement Analysis DILUTIVE STOCK OPTIONS TREASURY STOCK METHOD Dilutive only when the exercise price is less than the average market price Assume proceeds from sale of stock issued to buy back shares in the market at the average market price STEPS Calculate number of common shares created if options are exercised Calculate cash received from sale of stock Calculate number of shares that can be purchased at the average market price with sale proceeds Calculate the net increase in common shares outstanding LOS 36 d distinguish between dilutive and antidilutive securities and calculate a company’s basic and diluted EPS in a complex capital structure and describe and determine the effects of convertible securities, options, and warrants on a company’s EPS;

108 Financial Statement Analysis EPS – OPTIONS FOR COMMON STOCK EXAMPLE Earnings for equity in year to 31/Dec/X1$1,200,000 Weighted average no. of common stock shares 500,000 Average price of common stock during year $20 Exercise price $15 Number of options outstanding in the year 100,000 Basic EPS Calculate diluted EPS for 20X1. LOS 36 d distinguish between dilutive and antidilutive securities and calculate a company’s basic and diluted EPS in a complex capital structure and describe and determine the effects of convertible securities, options, and warrants on a company’s EPS;

109 Financial Statement Analysis EPS Reporting A company with a complex capital structure must report: Basic EPS Dilutive EPS In addition the impact of the following effects must be shown: Discontinued Activities Extraordinary Items Cumulative Effect of Accounting Policy Changes LOS 36 e compare and contrast the requirements for EPS reporting in simple versus complex capital structures.

110 Financial Statement Analysis Seek and Ye Shall Find and Searching for Shenanigans Study Session 8

111 Financial Statement Analysis FINANCIAL SHENANIGANS Two basic strategies underlying all accounting “tricks”:  To inflate current period earnings by inflating current-period revenue and gains or by deflating current-period expenses  To deflate current-period earnings (and, consequently, inflate future periods’ results) by deflating current period revenue or by inflating current-period expenses 1.Recording revenue too soon or of questionable quality 2.Recording bogus revenue 3.Boosting income with one-time gains 4.Shifting current expenses to a later or earlier period 5.Failing to record or improperly reducing liabilities 6.Shifting current revenue to a later period 7.Shifting future expenses to the current period as a special charge Shenanigan LOS 38 a explain the two basic strategies underlying all accounting “shenanigans,” and describe seven categories of techniques that may be used by management to distort a company's reported financial performance and financial condition;

112 Financial Statement Analysis EVALUATING ACCOUNTING POLICIES Accounting Policies Revenue recognition Depreciation choice Inventory method Amortization of goodwill* Estimate of warranty Estimate of bad debts Treatment of advertising Loss contingencies Conservative After sale, when risk has passed to buyer Accelerated over shorter period LIFO (assuming prices are rising) Over a shorter period High estimate Expense Accrue loss Aggressive At sale, although risk remains Straight line over longer period FIFO (assuming prices are rising) Over 40 years Low estimate Capitalize Footnote only LOS 38 b identify conservative and aggressive accounting policies; * NB Goodwill is no longer amortized under U.S. GAAP

113 Financial Statement Analysis WHY DO SHENANIGANS EXIST? Based on the author’s research, there are three general reasons for shenanigans: It Pays to Do It Management bonuses encourage the posting of high sales and profits Misguided incentive plans It’s Easy to Do Look for: Compensation structures that heavily emphasize the bottom line Profit can vary widely while complying with GAAP Management has considerable flexibility in interpreting financial standards Look for: Overly liberal accounting rules Poor internal controls It’s Unlikely That You’ll Get Caught Often, companies are not caught for improper accounting Penalties are often too little, too late Look for: Over reliance on unaudited quarterly financial reports LOS 38 c describe why “shenanigans” exist and explain where they are most likely to occur

114 Financial Statement Analysis WHERE DO SHENANIGANS OCCUR? Early Warning Signs A weak control environment Management facing extreme competitive pressure Management known or suspected of having questionable character Likely Companies Fast growth companies whose real growth is beginning to slow Basket-case companies that are struggling to survive Newly listed public companies Private companies LOS 38 c describe why “shenanigans” exist and explain where they are most likely to occur

115 Financial Statement Analysis IDENTIFYING SHENANIGANS Where to Look Auditor’s report Proxy statement Footnotes President’s letter MD&A Form 8-K Registration statement What to Look For Absence of opinion or qualified report Reputation of auditor Litigation Executive compensation Related-party transactions Accounting policies/changes in those policies Related-party transactions Contingencies or commitments Forthrightness Specific concise disclosure Consistency with footnote disclosure Disagreements over accounting policies Past performance Quality of management and directors LOS 38 d list the documents that an analyst should use to identify “shenanigans” and explain what information to look for in such documents.

116 Financial Statement Analysis SOLUTIONS

117 Financial Statement Analysis PERCENTAGE OF COMPLETION METHOD EXAMPLE (INCOME STATEMENT) Bircham Properties Ltd. has a contract to build a hotel for $2,000,000 to be received in equal installments over 4 years. A reliable estimate of total cost of this contract is $1,600,000. During the first year, Bircham Properties incurred $400,000 in cost. During the second year, $500,000 of costs were incurred. The estimate of the projects total cost did not change in the second year. Calculate the revenue to be recognized in each of the first two years. Year 1:$2,000,000 × (400,000/1,600,000) = $500,000 Year 2:$2,000,000 × (900,000/1,600,000) = $625,000 –$500,000

118 Financial Statement Analysis BALANCE SHEET – PERCENTAGE-OF-COMPLETION METHOD Total Assets 20x2 Cash (Cash Rec’d – Cost Incurred) Accounts receivable (Amounts Billed – Cash Rec’d) Net CIP* Total Assets 20x320x1 LOS 31 c identify the appropriate income statement and balance sheet entries using the percentage-of-completion method and the completed contract method and describe and calculate the effects on cash flows and selected financial ratios that result from using the percentage-of-completion method versus the completed contract method; 100 200 0 300 0 100 400 500 0 500 * See working slide

119 Financial Statement Analysis BALANCE SHEET – PERCENTAGE-OF-COMPLETION METHOD Total Liabilities and Equity 20x120x220x3 Net Advanced Billings Retained Earnings Total Liabilities & Equity LOS 31 c identify the appropriate income statement and balance sheet entries using the percentage-of-completion method and the completed contract method and describe and calculate the effects on cash flows and selected financial ratios that result from using the percentage-of-completion method versus the completed contract method; 133 167 300 0 400 0 500

120 Financial Statement Analysis MEMO CIP 20x220x320x1 Cost Profit Allocation Amounts Billed Cost to Date Total Cost × Contract Price – Total Cost 500 167 667 (800) (133) Net CIP/(Net Advanced Billings) 1,200 400 1,600 (1,500) 100 1,500 500 2,000 (2,000) 0

121 Financial Statement Analysis BALANCE SHEET – COMPLETED CONTRACT METHOD 20x2 Cash Accounts receivable Net CIP Total Assets 20x320x1 Total Assets LOS 31 c identify the appropriate income statement and balance sheet entries using the percentage-of-completion method and the completed contract method and describe and calculate the effects on cash flows and selected financial ratios that result from using the percentage-of-completion method versus the completed contract method; 100 200 0 300 0 300 500 0 500

122 Financial Statement Analysis BALANCE SHEET – COMPLETED CONTRACT METHOD Total Liabilities and Equity 20x120x220x3 Net Advanced Billings Retained Earnings Total Liabilities & Equity LOS 31 c identify the appropriate income statement and balance sheet entries using the percentage-of-completion method and the completed contract method and describe and calculate the effects on cash flows and selected financial ratios that result from using the percentage-of-completion method versus the completed contract method; 300 0 300 0 300 0 500

123 Financial Statement Analysis MEMO CIP 20x220x320x1 Cost Amounts Billed Net CIP/(Net Advanced Billings) 500 (800) (300) 1,200 (1,500) (300) 0 (0)

124 Financial Statement Analysis Net income Volatility of income Cash flow Importance of CFO POC CC Income Statement Balance Sheet Statement of Cash Flows PERCENTAGE-OF-COMPLETION vs. COMPLETED CONTRACT HIGHER LOWER HIGHER SAME LOWER SAME HIGHER Total assets Liabilities R/E During Project Life HIGHER LOWER HIGHER LOWER HIGHER LOWER

125 Financial Statement Analysis INSTALLMENT SALES METHOD – EXAMPLE Sales Cost of sales Gross profit 20X0 8,000 (4,000) 4,000 20X1 12,000 (6,000) 6,000 During 20X0, Sturridge Inc. sold $20,000 of inventory, with a cost of $10,000. During 20X0 and 20X1, Sturridge Inc. collected $8,000 and $12,000 respectively, of its receivables. Under the Instalment Method, what are the sales and gross profit to be reported in each of the two years?

126 Financial Statement Analysis COST RECOVERY METHOD – EXAMPLE Sales Cost of sales Gross profit 20X0 8,000 (8,000) - 20X1 12,000 (2,000) 10,000 During 20X0, Sturridge Inc. sold $20,000 of services but the cost of providing this service was unclear at the outset of the contract. During 20X0 and 20X1, Sturridge Inc. collected $8,000 and $12,000, respectively of its receivables. The project was completed during 20X1 at which time the company had incurred total costs of $10,000. Under the Cost Recovery Method, what are the sales and gross profit to be reported in each of the two years?

127 Financial Statement Analysis HOLLOWAY INDUSTRIES – CASH FLOW FROM OPERATIONS Direct Method $$ Cash Inflows Sales Less: increase in A/R Cash collected from customers Direct cash outflows Cost of goods sold Add: decrease in inventory Purchases Add: increase in A/P Cash paid to suppliers Operating expense (wages) Less: decrease in salaries payable Cash paid to employees 200,000 (2,000) 198,000 (80,000) 4,000 (76,000) 8,000 (68,000) (10,000) (7,000) (17,000)

128 Financial Statement Analysis Direct Method cont. Cash outflows Interest Expense Add: increase in interest payable Cash interest paid Taxation Expenses Add: Increase in deferred tax Tax payable Add: increase in taxes payable Cash paid to IRS $$ CFO (1,000) 1,000 0 (40,000) 10,000 (30,000) 2,000 (28,000) (85,000)

129 Financial Statement Analysis GOULBURN INDUSTRIES – CASH FLOW FROM OPERATIONS Net income 75,000 Add: depreciation + 12,000 Add: goodwill amortisation + 2,000 Less: gain from sale of land – 20,000 Add: increase in deferred taxes + 10,000 Current asset adjustments Less: increase in accounts receivable – 2,000 Add: decrease in inventory + 4,000 Current liability adjustments Add: increase in accounts payable + 8,000 Less: decrease in accounts payable – 7,000 Add: increase in interest payable + 1,000 Add: increase in taxes payable + 2,000 $ Cash flow from operations 85,000 Indirect Method

130 Financial Statement Analysis Computing CFI Holloway Industries Additions to PPE 2 Methods Opening Cost Cost of Disposals Additions β Closing Cost Opening NBV NBV of Disposals Depreciation Charge Additions β Closing NBV $ 120,000 (20,000) 50,000 150,000 $ 102,000 (10,000) (12,000) 50,000 130,000

131 Financial Statement Analysis Computing Proceed on Disposal Proceeds β NBV Profit/(loss) X (X) X/(X) $ Disclosed in question From Income Statement Profit/(loss) on disposal of long lived assets Proceeds β NBV Profit/(loss) 30,000 (10,000) (20,000) $ Holloway Industries

132 Financial Statement Analysis Holloway CFF Change in Debt Change in Common Stock Cash Dividends Paid Calculate Dividends Net Income Dividends β Δ in Retained Earnings $ 75,000 (17,000) 58,000 Dividends Proposed Dividends Payable Cash Paid $ (17,000) 10,000 (7,000) $ 10,000 (20,000) (7,000) $30,000 – $20,000 = $10,000 $80,000 – $100,000 = $(20,000)

133 Financial Statement Analysis HOLLOWAY INDUSTRIES – STATEMENT OF CASH FLOWS $ Cash flow from operations 85,000 Cash flow from investing activities Sale of PP&E 30,000 Purchase of P&E–50,000 Cash flow from investing–20,000 Cash flow from financing activities Issue of debt 10,000 Purchase of stock–20,000 Payment of dividends– 7,000 Cash flow from financing–17,000 Net increase in cash 48,000 Cash at beginning 18,000 Cash at end 66,000 $

134 Financial Statement Analysis Current ratio Quick ratio Cash ratio Holloway Industries 20x2 20x3 LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential; 50,000 42,000 36,000 42,000 18,000 42,000 =1.19 =0.86 =0.43 96,000 56,000 86,000 56,000 66,000 56,000 =1.71 =1.54 =1.18

135 Financial Statement Analysis Receivables turnover Average receivables collection period 20x3 LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential; 200,000 19,000 = 10.52 19,000 200,000 × 365 Inventory turnover Average inventory processing period 80,000 12,000 = 6.67 12,000 80,000 × 365 = 34.68 Days = 54.75 Days 20x3 Holloway Industries

136 Financial Statement Analysis Payables turnover Payables payment period 20x3 Collection period + Inventory period – Payment period Holloway Industries LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential; 80,000 14,000 80,000 × 365 = 63.88 days = 5.71 = 34.68 Days = 54.75 Days = (63.88) Days Cash Conversion Cycle 25.55 Days

137 Financial Statement Analysis 20x3 Total asset turnover Fixed asset turnover Equity turnover LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential; 200,000 288,000 200,000 215,000 200,000 179,000 = 0.69 = 0.93 = 1.12 Holloway Industries

138 Financial Statement Analysis Gross profit margin Operating profit margin Net profit margin OPERATING PROFITABILITY 200,000 – 80,000 200,000 116,000 200,000 75,000 200,000 × 100 LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential; 20x3 = 60% = 58% = 37.5% Holloway Industries

139 Financial Statement Analysis Return on total capital Return on equity OPERATING PROFITABILITY 75,000 + 1,000 288,000 Equity All liabilities 75,000 179,000 = Total assets × 100 LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential; = 26.38% = 41.90% 20x3 Holloway Industries

140 Financial Statement Analysis DUPONT RATIO ANALYSIS 20x3 ROE=75,000 198,000 ROE=75,000 200,000 198,000 × ROE=75,000 200,000 324,000 × 198,000 × 0.3750.621.64 Traditional version of DuPont equation LOS 35 c calculate and interpret the various components of the company’s return on equity using the original and extended DuPont systems and a company’s financial ratios relative to its industry, to the aggregate economy, and to the company’s own performance over time; = 38% Holloway Industries

141 Financial Statement Analysis EXTENDED DUPONT EQUATION 20x3 200,000 324,000 ROE= 115,000 200,000 × 324,000 198,000 ×(1 – 0.35)× 200,000 324,000 ROE= 116,000 200,000 × 324,000 198,000 ×(1 – 0.35)×– 1,000 324,000 0.580.6171.6360.003 LOS 35 c calculate and interpret the various components of the company’s return on equity using the original and extended DuPont systems and a company’s financial ratios relative to its industry, to the aggregate economy, and to the company’s own performance over time; ROE=75,000 200,000 324,000 × 198,000 × = 38% 0.65 = 38% Holloway Industries

142 Financial Statement Analysis HOLLOWAY INDUSTRIES – FINANCIAL RISK RATIOS Interest Coverage Long Term Debt to equity Debt to long term capital 20x3 40,000 + 30,000 198,000 = 0.35 116,000 1,000 = 116 40,000 + 30,000 40,000 + 30,000 + 198,000 = 41.2% LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential;

143 Financial Statement Analysis GROWTH ANALYSIS Sustainable growth=(earnings retention rate)(ROE) Earnings retention rate=[1 – (dividends/net income)] ROE=[EAT/sales] [sales/assets] [assets/equity] Example: A firm has a dividend payout ratio of 35%, a net profit margin of 10%, an asset turnover of 1.4 and an equity multiplier leverage measure of 1.2. Estimate the firm’s sustainable growth rate. Growth rate=RR × ROE (1 – 0.35)0.1 × 1.4 × 1.2 =0.1092 =10.92%

144 Financial Statement Analysis 1 January4 million common stock in issue ranking for dividend 30 September1 million further shares issued ranking for dividend Million Number of shares used in EPS calculation CHANGES IN EQUITY ISSUE FOR CASH AT MARKET PRICE 4 million sharesx9/123 5 million sharesx3/121.25 4.25

145 Financial Statement Analysis EPS – WORKED EXAMPLE Profit Inc had 10 million shares outstanding at the beginning of the year and net income of $20m. The following transactions occurred during the year: 1 July2 million new shares issued for cash 1 September10% stock dividend 1 November500,000 common shares repurchased Calculate the EPS for the year 10m + 1m 2m + 0.2m (0.5m) Adjusted for stock dividend 1/1 1/7 1/11 Not affected by stock dividend 12/12 6/12 2/12 ====== Number of Shares 11m 1.1m (0.083m) 12.017m Basic EPS = $20m 12.017m = $1.6643

146 Financial Statement Analysis Earnings Add:Interest saved Less:Relief for tax @ 20% No. of equity shares if loan stock was converted: In issue On conversion $2,000,000 × 120/$1,000 $$ DILUTED EPS – CONVERTIBLE SECURITIES SOLUTION 2,500,000 100,000 (30,000) 70,000 2,570,000 1,000,000 240,000 1,240,000 Diluted EPS $2,570,000 = $2.07 1,240,000

147 Financial Statement Analysis $$ DILUTED EPS – CONVERTIBLE PREFERRED STOCK SOLUTION 2,000,000 550,000 2,550,000 Diluted EPS $4,350,000 = $1.71 2,550,000 350,000 4,350,000 Earnings Add: Preferred dividend saved 4,000,000 No. of common stock shares if preferred shares were converted: In issue On conversion $5,000,000 × 110/$1,000

148 Financial Statement Analysis EPS - OPTIONS FOR COMMON STOCK SOLUTION Step 1 - Assume all options are exercised Proceeds if all options exercised 100,000 × $15$1,500,000 Step 2 - Calculate number of shares that can be bought at average price $1,500,000 $20 = 75,000 shares Step 3 - Calculate dilutive effect of reduced option price Number of shares issued100,000 Effective number at average price 75,000 Dilution number of shares 25,000 Diluted EPS $1,200,000 = $2.29 525,000 LOS 2.g:Describe and determine the effects of convertible securities, options and warrants on a company’s EPS

149 Financial Statement Analysis AREAS NOT COVERED IN CLASS LOS referenceDescriptionSchweser pages P2 e) d) Identify the accounting qualities (relevance, reliability, predictive value, timeliness) set forth in Statement of Financial Accounting Concepts and discuss how these qualities provide useful information to the analyst LOS 2h) Compare and contrast the requirements for EPS reporting in simple versus complex capital structures 154

150 Financial Statement Analysis AREAS NOT COVERED IN CLASS LOS referenceDescriptionSchweser pages LOS 2h) Compare and contrast the requirements for EPS reporting in simple versus complex capital structures 154


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