2010 level 1 ss8_workbook
TRANSCRIPT
Financial Reporting and Analysis - Book 3
Study Session 8:
Financial Reporting and Analysis:
The Income Statement, Balance
Sheet, and Cash Flow Statement
32. Understanding the Income Statement
33. Understanding the Balance Sheet
34. Understanding the Cash Flow Statement
35. Financial Analysis Techniques
Financial Reporting and Analysis - Book 3
Understanding the
Income Statement
Financial Reporting and Analysis
60
Income Statement Format
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Financial Reporting and Analysis
61
IASB Requirements for Revenue
Recognition (General Principles)
1. Risk and reward of ownership transferred
2. No continuing control or management over
the good sold
3. Reliable revenue measurement
4. Probable flow of economic benefits
5. Cost can be reliably measured
LOS 32.a, CFAI Vol. 3 P. 139
Financial Reporting and Analysis
62
SEC Requirements for
Revenue Recognition“Revenue should be recognized when it is realizable and earned” FASB
1. Evidence of an arrangement between buyer and seller
2. Completion of the earnings process, firm has delivered product or service
3. Price is determined
4. Assurance of payment, able to estimate probability of payment
LOS 32.b, CFAI Vol. 3 P. 143
Financial Reporting and Analysis
63
IASB Requirements for Revenue
Recognition for Services
1. When the outcome can be measured reliably, revenue will be recognised by reference to the stage of completion
2. Outcome can be measured reliably if:
Amount of revenue can be measured
Probable flow of economic benefits
Stage of completion can be measured
Cost incurred and remaining cost to complete can be measured
Relia
ble
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Financial Reporting and Analysis
64
Revenue Recognition MethodsSales-basis method – Used when good or service
is provided at time of sale, cash or credit with high
payment probability (majority of transactions)
Exceptions
1) Percentage-of-completion method – Used for L-T
projects under contract, with reliable estimates of
revenues, costs, and completion time
2) Completed-contract method – Used for L-T
projects when there is no contract, or estimates of
revenue or costs are unreliable; revenue and
expenses are not recognized until project is
completed
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Financial Reporting and Analysis
65
Revenue Recognition Methods
3) Installment sales method – Used when you
cannot estimate likelihood of collection, but
cost of goods/services is known; revenue
and profit are based on percentage of cash
collected
4) Cost recovery method (most extreme) –
Used when cost of goods/services is
unknown and when you cannot estimate the
likelihood of collection; only recognize profit
after all costs are recovered
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Financial Reporting and Analysis
66
Ledesma 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, Ledesma incurred $400,000 in cost.
During the second year, $500,000 of costs were
incurred. The estimate of the project’s total cost did
not change in the second year.
Calculate the revenue and profit to be recognized in
each of the first two years.
S3: 21
Percentage-of-Completion Method
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Financial Reporting and Analysis
67
Percentage-of-Completion Method
Cumulative Revenue
Revenue Recognized in Prior Years (X)
This Period’s Revenue X
Costs Incurred in Period (X)
Profit Recognized in Period X
Total Costs to Date
Total Project Cost× Sales Price = X
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Financial Reporting and Analysis
68
Percentage-of-Completion Method—
Solution
Year 1: $2,000,000 × (400,000 / 1,600,000)
Revenue = $500,000
Profit = $500,000 – $400,000 = $100,000
Year 2: $2,000,000 × (900,000 / 1,600,000)
– $500,000
Revenue = $625,000
Profit = $625,000 – $500,000 = $125,000
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Financial Reporting and Analysis
69
Completed-Contract Method
Revenue and expenses are not recognized until
project is completed; used for short-term
contracts.
Example: Building a hotel for $40 million, cost to
build is $32 million; cost incurred in Year 1 is $6.4
million
revenue = 0; expense = 0; income = 0
On completion/final year:
revenue = $40m; expenses = $32m; income = $8m
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Financial Reporting and Analysis
70
Percentage-of-Completion (POC) vs.
Completed Contract (CC) Method
Net income is higher for POC because CC does not recognize revenue until completion ↑ Net Income → ↑Equity (until final year)
Income volatility is greater with CC method because POC recognizes some revenue and income each year instead of all at one time
Cash flow is the same for both (CF is unaffected by the revenue recognition method used)
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Financial Reporting and Analysis
71
Installment Sales Method—Example
During 20X0, Cook, Inc. sold $20,000 of
inventory, with a cost of $10,000.
During 20X0 and 20X1, Cook collected
$8,000 and $12,000, respectively, of its
receivables. Under the installment
method, what are the sales and gross
profit to be reported in each of the two
years?
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Financial Reporting and Analysis
72
Sales
Cost of sales
Gross profit
20X0
8,000
(4,000)
4,000
20X1
12,000
(6,000)
6,000
Installment Sales Method—Solution
LOS 32.b, CFAI Vol. 3 P. 143
$8,000
$20,000× $10,000
$12,000
$20,000× $10,000
Financial Reporting and Analysis
73
Cost Recovery Method—Example
During 20X0, Cook, 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, Cook 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?
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Financial Reporting and Analysis
74
Sales
Cost of sales
Gross profit
20X0
8,000
(8,000)
0
20X1
12,000
(2,000)
10,000
Cost Recovery Method—Solution
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Financial Reporting and Analysis
75
Barter
Exchange of goods or services between
two parties (no exchange of cash)
A agrees to exchange inventory in
exchange for a service provided by B
IASB: Revenue = fair value of similar non-
barter transactions with unrelated parties
FASB: Revenue = fair value only if the
company has received cash payments for
such services historically
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Financial Reporting and Analysis
76
Gross vs. Net Reporting
Internet-based merchandising companies
Sell product but never hold in inventory
Arrangement for supplier to ship directly to
end customer
Revenue
Cost of Good Sold
Gross Profit
$
100
80
20 Net Sale
$
20
Sales Commission
Gro
ss
Rep
ort
ing
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Financial Reporting and Analysis
77
Gross vs. Net Reporting
U.S. GAAP: Report gross if:
Company is primary obligator
Bears inventory risk
Bears credit risk
Can choose supplier
Latitude to set price
If criteria are not met, then company is acting as an agent—report net
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Financial Reporting and Analysis
78
Implications for Analysis
Review revenue recognition policies in
footnotes
Earlier revenue recognition—aggressive
Later revenue recognition—conservative
Consider estimates used in methods
Assess how different policies would affect
financial ratios
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Financial Reporting and Analysis
79
Revenue Recognition – Problem
Project cost estimate = $10 mil, contract totals $12
mil, $2 mil of costs occur in years 1 and 2; invoiced
amounts $4 mil year 1 and $3 mil year 2; $1 mil in
cash collected each year. Year 2 income under
percentage of completion is:
A. $1 million
B. $400,000
C. $1 million loss
(2/10)(12 mil – 10 mil) = $400,000
- 2
Financial Reporting and Analysis
80
Expense Recognition Accrual Basis—Matching Principle
Match costs against associated revenues
Examples
Inventory
Depreciation/amortization
Warranty expense
Doubtful debt expense
Period Expenses
Expenditures that less directly match the timing of revenues; e.g., admin costs
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Financial Reporting and Analysis
81
Analysis Implications
Inventory valuation
Warranty expense
Depreciation
Amortization
Doubtful debt provisions
Revenue recognition
Review year-on-year consistency
Review footnotes and MD&A
All require
significant
estimates and
assumptions
affecting net
income
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Financial Reporting and Analysis
82
Inventories—Matching Principle
LOS 32.d, CFAI Vol. 3 P. 155
Beginning inventory + Purchases – COGS =
Ending inventory
Cost of goods sold should be matched with
items sold and recorded as revenue over
the period
Inventories matching goods flow
Specific identification First-in-first-out
Average cost
Financial Reporting and Analysis
83
Depreciation Methods
Match depreciation to asset’s decrease in value over time:
Truck cost $20,000 will run 100,000 miles, depreciate at $0.20 per mile used
Oil tanker will last 25 years and then be sold for scrap, use straight-line depreciation
DVDs purchased for rental decrease rapidly in value the first year, use accelerated depreciation
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Financial Reporting and Analysis
84
Amortization
Amortization of intangible assets (e.g., patents)
Spreading cost over life
If the earnings pattern cannot be established, use straight line (IAS 38)
IFRS and U.S. GAAP firms both typically amortize straight-line with no residual value
Goodwill not amortized, checked annually for impairment
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Financial Reporting and Analysis
85
Unusual or Infrequent Items “Or” is the key word that describes these items
Reported pre-tax before net income from continuing operations (above the line)
Items include:
Gain (loss) from disposal of a business segment or assets
Gain (loss) from sale of investment in subsidiary
Provisions for environmental remediation
Impairments, write-offs, write-downs, restructuring
Integration expense for recently acquired business
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Financial Reporting and Analysis
86
Non-Operating Items
Financial service
companies
Non-financial service
companies
Interest
Dividends
Gains/losses on disposal
Operating
activities
Non-operating
income
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Financial Reporting and Analysis
87
Discontinued Operations
Operations that management has decided
to dispose of but (1) has not done so yet or
(2) did so in current year after it generated
profit or loss
Reported net of taxes after net income from
continuing operations (below the line)
Assets, operations, and financing activities
must be physically and operationally distinct
from firm
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Financial Reporting and Analysis
88
Extraordinary Items
Items that are both unusual and infrequent
Reported net of taxes after net income from
continuing operations (below the line)
Items include:
Losses from expropriation of assets
Uninsured losses from natural disaster
Prohibited under IAS 1
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Financial Reporting and Analysis
89
Accounting Changes
Two types of accounting changes:
1) Change in accounting principle
(e.g. LIFO to FIFO)
Retrospective application: IFRS and
US GAAP require prior years’ data
shown in the financial statements to be
adjusted
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Financial Reporting and Analysis
90
Accounting Changes
2) Change in accounting estimate
(e.g., change in the estimated useful life of
a depreciable asset)
Does not require restatement of prior
period earnings
Disclosed in footnotes
Typically, changes do not affect cash flow
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Financial Reporting and Analysis
91
Accounting Changes
Prior Period Adjustments
Correcting errors or changing from an
incorrect accounting method to one that
is acceptable under GAAP
Typically requires restatement of prior
period financial statements
Must disclose the nature of the error and
its effect on net income
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Financial Reporting and Analysis
92
Simple vs. Complex Capital Structures
A simple capital structure contains no
potentially dilutive securities
Firm reports only basic EPS
A complex capital structure contains
potentially dilutive securities
Firm must report both basic and diluted EPS
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Financial Reporting and Analysis
93
Dilutive vs. Antidilutive Securities
Potentially dilutive securities
Stock options
Warrants
Convertible debt
Convertible preferred stock
Dilutive securities decrease EPS if exercised or converted to common stock
Antidilutive securities increase EPS if exercised or converted to common stock
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Financial Reporting and Analysis
94
Calculating Basic EPS
Net income minus preferred dividends
equals earnings available to common
stockholders
Note that common stock dividends are not
subtracted from net income
NI – Preferred div
Weight ave # common stock
Basic
EPS =
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Financial Reporting and Analysis
95
Stock Dividends and Stock Splits A 10% stock dividend increases shares
outstanding by 10%
A 2 for 1 stock split increases shares outstanding
by 100%
In calculating the weighted average shares
outstanding, stock dividends and splits are
applied retroactively to the beginning of the year,
or the stock’s issue date for new stock
Although weighted average shares is actually
based on days, the exam is likely to use months
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Financial Reporting and Analysis
96
Calculating the Weighted Average
Number of Shares Outstanding
1/1/X3 Shares outstanding 10,000
4/1/X3 Shares issued 4,000
7/1/X3 10% stock dividend
9/1/X3 Shares repurchased 3,000
Shares adjusted for the 10% dividend:
1/1/X3 Initial shares (× 1.1) 11,000
4/1/X3 Shared issued (× 1.1) 4,400
9/1/X3 Shares repurchased (no adj.) 3,000
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Financial Reporting and Analysis
97
Calculating the Weighted Average
Number of Shares Outstanding
Initial shares (11,000) (12 months) 132,000
Shares issued (4,400) (9 months) 39,600
Shares repurchased (3,000) (4 months) (12,000)
Total weighted shares 159,600
Weighted average shares outstanding
159,600/12
13,300
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Financial Reporting and Analysis
98
convertible convertible
net income – preferredpreferred debt 1– t
dividendsdividend int erest
weighted shares from shares fro
average conversion of
shares conv. pfd. shares
m shares
conversion of issuable from
conv. debt options/warrants
Include only if
security is
dilutive
Include only if
security is
dilutive
Diluted Earnings Per Share
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Financial Reporting and Analysis
99
Checking for Dilution
Only those securities that would reduce EPSbelow basic EPS if converted are used in the calculation of diluted EPS
Conv. pfd: is dividends/new shares < basic?
Conv. debt: is interest (1 – t)/new shares < basic?
Options and warrants: is avg. price > ex. price?
If answer is yes, the security is dilutive
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Financial Reporting and Analysis
100
Diluted EPS – Example
Earnings available to common, year to 12/31/X1 $4,000,000
Common stock of $10 each $20,000,000
Basic EPS $2.00
$5,000,000 of 7% convertible preferred stock is outstanding all
year. The terms of conversion are that every $10 nominal value
of preferred stock can be converted to 1.1 common shares.
Calculate fully diluted EPS for 20X1.
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Financial Reporting and Analysis
101
Convertible Preferred Stock – Example
No. of common stock shares if preferred shares were converted:
Outstanding all year
On conversion $5,000,000/10 × 1.1
$
2,000,000
550,000
2,550,000
350,000
4,350,000
Earnings available to common
Add: Preferred dividend saved
4,000,000
LOS 32.g,h, CFAI Vol. 3 P. 169
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Financial Reporting and Analysis
102
Convertible Preferred Stock – Example
Check for dilution:
Preferred Dividend
Shares Created
< Basic EPS?
$350,000
550,000< $2.00
Diluted EPS:
Diluted EPS $4,350,000 = $1.71
2,550,000
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Financial Reporting and Analysis
103
Convertible Bonds – Example
Earnings available to common, year to 12/31/X1 $2,500,000
Common stock of $10 each $10,000,000
Basic EPS $2.50
Tax rate 30%
$2,000,000 par value of 5% convertible bonds have been
outstanding all year. Each $1,000 par value convertible bond
can be converted to 120 common shares.
Calculate fully diluted EPS for 20X1.
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Financial Reporting and Analysis
104
Diluted EPS – Convertible Bond – Example
1,000,000
240,000
2,570,000
Earnings available to common
Add: Interest saved
Less: Tax @ 30%
100,000
(30,000)
$ $
2,500,000
70,000
1,240,000
No. of common shares if bonds were converted:
Outstanding
On conversion $2,000,000/$1,000 × 120
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- 2
Financial Reporting and Analysis
105
Diluted EPS – Convertible Bond – Solution
Check for dilution:
Diluted EPS:
Check for dilution:
Interest savings (1– t)
Shares Created
< Basic EPS?
$70,000
240,000< $2.50
Diluted EPS:
$2,570,000 = $2.07
1,240,000
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- 2
Financial Reporting and Analysis
106
Dilutive Stock Options –
Treasury Stock MethodDilutive only when the exercise price is less than the
average market price
STEPS
1. Calculate number of common shares created if
options are exercised
2. Calculate cash received from sale of stock
3. Calculate number of shares that can be purchased at
the average market price with sale proceeds
4. Calculate the net increase in common shares
outstanding
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Financial Reporting and Analysis
107
Dilutive Employee Stock Options—
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 $2.40
Calculate diluted EPS for 20X1.
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Financial Reporting and Analysis
108
Dilutive Stock Options – Example
Assume all options are exercised
Proceeds if all options exercised: 100,000 × $15 = $1,500,000
Calculate number of shares that can be
bought at average price
$1,500,000
$20= 75,000 shares
Calculate Net Increase In Common Stock
Total shares needed 100,000
Shares “purchased” with proceeds 75,000
Number of new shares needed 25,000
Calculate Cash Proceeds
Shares issued = 100,000Step 1 –
Step 2 –
Step 3 –
Step 4 –
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- 4
Financial Reporting and Analysis
109
Dilutive Stock Options – Solution
Diluted EPS:$1,200,000
525,000
LOS 32.g,h, CFAI Vol. 3 P. 169
- 1
= $2.29
Financial Reporting and Analysis
110
Comprehensive Income
Comprehensive income =
Net income + Other comprehensive income
Net income from income statement
∆ Foreign currency translation adjustment
∆ Minimum pension liability adjustment
∆ Unrealized gains or losses on derivatives
contracts accounted for as hedges
∆ Unrealized gains and losses on available
for sale securities
Comprehensive income
X
X/(X)
X/(X)
X/(X)
X/(X)
X
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the
r C
om
pre
he
nsiv
e
Inco
me
Financial Reporting and Analysis
111
Weighted Average Shares – Problem
Jan 1 10,000 shares
Mar 1 3,000 shares issued
July 1 20% stock dividend
Nov 1 3,000 shares repurchased
The weighted average number of shares
outstanding over the year equals:
A. 12,000
B. 11,300
C. 14,500
10,000(1.2)
+3,000(10/12)(1.2)
-3,000(2/12) = 14,500 sh.
- 2
Financial Reporting and Analysis
112
Financial Reporting and Analysis
113
Financial Reporting and Analysis - Book 3
Understanding the
Balance Sheet
Financial Reporting and Analysis
115
Balance Sheet
Current assets
Cash
Others
Long-lived assets
Investments
PP&E
Intangibles
Total assets
$m
50
100
150
20
200
50
420
Current liabilities
Long-term liabilities
Owners’ equity
Contributed capital
Retained earnings
Liabilities and equity
$m
70
180
250
100
70
170
420
Components and Format of Balance Sheet
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Financial Reporting and Analysis
116
Assets
Asset Recognition
Probable future flow of future
economic benefit to the entity
Measurable with reliability
Cash and equivalents
Inventories
Trade and other
receivables
Prepaid expenses
Financial assets
Deferred tax assets
Property, plant, and
equipment
Investment property
Intangible assets
Equity a/c investments
Natural resources
Assets held for saleAsse
ts D
isclo
se
d o
n
the
B/S
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Financial Reporting and Analysis
117
LiabilitiesLiability Recognition
Probable sacrifice of future economic benefit to the entity as a result of past transactions/events
Amounts received but not reported as revenue in the income statement
Amounts reported as expenses but which have not been paid
Bank borrowings
Notes payable
Provisions
Unearned revenues
Financial liabilities
Accrued liabilities
Deferred tax liabilities
Lia
bili
ties
Dis
clo
se
d o
n
the
B/S
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Financial Reporting and Analysis
118
Equity
Assets – Liabilities = Equity
Net Assets
Capital Characteristics
Permanent
No mandatory charges against
earnings
Legal subordination to creditors
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Financial Reporting and Analysis
119
Balance Sheet Format
Report Format
Assets, liabilities and equity in a single column
Account Format
Assets on the left
Liabilities and equity on the right
Classified Balance Sheet
Grouping of accounts into sub-categories
Current vs. non-current
Financial vs. non-financial
Liquidity based presentation
LOS 33.b, CFAI Vol. 3 P. 201
Financial Reporting and Analysis
120
Assets/Liabilities and the
Accrual Process
Revenue reported before cash is received:
Accounts receivable (trade debtor)
Accrued revenue
Cash received before revenue is reported:
Deferred revenue
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Financial Reporting and Analysis
121
Assets/Liabilities and the
Accrual Process
Expense recorded before cash is paid:
Accrued expense
Accounts payable (trade creditor)
Cash paid before expense is reported:
Prepaid expense
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Financial Reporting and Analysis
122
Current Assets
Current assets include cash and other assets that
will likely be converted into cash or used up within
one year or one operating cycle, whichever is greater
The operating cycle is the time it takes to produce
or purchase inventory, sell the product, and collect
the cash
Current assets presented in the order of liquidity
Current assets reveal information about the
operating activities/capacity of the firm
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Financial Reporting and Analysis
123
Noncurrent Assets
Assets held for continuing use within the business,
not resale
Assets not consumed or disposed in the current
period
Represent the infrastructure from which the entity
operates
Provides information on the firm’s investing
activities
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Financial Reporting and Analysis
124
Current Liabilities
Satisfies any of the following 4 criteria:
1. Expected to be settled in the entity’s
normal operating cycle
2. Held primarily for the purpose of being
traded
3. Is due to be settled < 12 months from
the balance sheet date
4. The entity does not have a right to
defer settlement for > 12 months
All other liabilities—noncurrent
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Financial Reporting and Analysis
125
IFRS vs US GAAP B/S
IFRS
Non-current assets
Current assets
Non-current liabilities
Current liabilities
US GAAP
Current assets
Non-current assets
Current liabilities
Non-current liabilities
Minority interest =
Equity component
Minority interest =
Mezzanine
Liabilities
Equitybetween
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Financial Reporting and Analysis
126
Measurement of Assets/Liabilities
Fair Value
Amount at which:
An asset could be
exchanged
A liability could be settled
Arm’s-length transactions
Market price =
fair market value
Historic Cost
Cost or fair value at
acquisition
Includes all costs of
acquisition and
preparation
B/S contains assets/liabilities at both:
Other basis
Current cost (replacement)
Present value
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Financial Reporting and Analysis
127
Measurement Disclosure IFRS
Accounting policies (including cost formulae)
Total carrying amount of inventory and amount
per category
Amount of inventory carried at fair value – costs
to sell
Amount of writedowns and reversals
Circumstances leading to the reversal of
writedowns
Inventory pledged as security
Amount of inventory recognized as an expense
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Financial Reporting and Analysis
128
Current Assets
Cash or cash equivalents
Marketable securities
Trade receivables (net of bad debt provision):
accounts receivable/customer related notes
receivable
Inventory:
Raw materials
Finished goods
Work in progress
Others, e.g., prepaid expenses
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Financial Reporting and Analysis
129
Inventory
Lower of cost and net realizable value
All costs of bringing the
inventory to its current
location and condition
Excludes:
Abnormal amounts
Storage costs
Admin overheads
Selling costs
NRV
Estimated selling
price
Estimated cost of
completion
Selling costs
X
(X)
(X)
X
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Financial Reporting and Analysis
130
Inventory Valuation
Valuation methods
US GAAP: FIFO, LIFO, AVCO
IFRS: FIFO, AVCO
Techniques
Standard Cost—normal levels of
materials, labor and production
overheads
Retail method—Sales price less
standard gross margin
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Financial Reporting and Analysis
131
Current Liabilities
Trade and other payables (accounts
payable)
Notes payable
Current portion of non-current borrowings
Current tax payable
Accrued liabilities
Unearned revenue
LOS 33.e, CFAI Vol. 3 P. 207
Financial Reporting and Analysis
132
As we will discuss in our topic review of Income Taxes, deferred taxes are the result of temporary
differences between financial reporting income and tax reporting income. Deferred tax assets
are created when the amount of taxes payable exceeds the amount of income tax expense
recognized in the income statement. This can occur when expenses or losses are recognized in the
income statement before they are tax deductible, or when revenues or gains are taxable before they
are recognized in the income statement. Eventually, the deferred tax asset will reverse when the
expense is deducted for tax purposes or the revenue is recognized in the income statement. Deferred
tax assets can also be created from unused tax losses.
Deferred tax liabilities. Deferred tax liabilities are amounts of income taxes payable in future periods
as a result of taxable temporary differences. Deferred tax liabilities are created when the amount
of income tax expense recognized in the income statement is greater than taxes payable. This
can occur when expenses or losses are tax deductible before they are recognized in the income
statement. A good example is when a firm uses an accelerated depreciation method for tax purposes
and the straight-line method for financial reporting. Deferred tax liabilities are also created when
revenues or gains are recognized in the income statement before they are taxable. For example, a
firm often recognizes the earnings of a subsidiary before any distributions (dividends) are made.
Eventually, deferred tax liabilities will reverse when the taxes are paid.
Deferred taxes
Financial Reporting and Analysis
133
Accounting for Long-Term Assets
Long-term assets convey benefits over time
Tangible assets: e.g., land, buildings, and
equipment
Intangible assets: e.g., copyrights, patents,
trademarks, franchises, and goodwill
Natural resources: oil fields, mines, timberland
Plant, property, and equipment recorded at purchase cost
including shipping and installation, or construction cost
including labor, materials, overhead, and interest
LOS 33.e, CFAI Vol. 3 P. 207
Financial Reporting and Analysis
134
Depreciation and Depletion
Tangible assets have decreased value over time:
depreciation is the allocation of the cost of tangible assets
over time; land is not depreciated
Natural resources are used up over time: depletion is the
allocation of the cost (per unit) of natural resources as they
are used
Balance sheet (book) values are:
Historical cost – accumulated depreciation or depletion
unless asset values are impaired
LOS 33.e, CFAI Vol. 3 P. 207
Financial Reporting and Analysis
135
Intangible Assets
Identifiable intangible
Can be acquired singularly, linked to rights and privileges having finite benefit periods
Amortized over estimated useful life
Unidentifiable Intangible
Cannot be acquired singularly and has indefinite benefit period (e.g. goodwill)
Not amortized
Annual impairment review
LOS 33.e, CFAI Vol. 3 P. 207
Financial Reporting and Analysis
136
Intangibles
May only be recognized if they can be measured reliably
Generally excludes internally generated intangibles – subjectivity
Typical intangibles
Purchased patents and copyrights
Purchased brands and trademarks
Purchased franchise and licence costs
Direct response advertising
Goodwill
Computer software development costs
LOS 33.e, CFAI Vol. 3 P. 207
Financial Reporting and Analysis
137
Expensed Items
Internally generated brands, mastheads,
publishing titles, customer lists, etc.
Start-up costs
Training costs
Admin and general overhead
Advertising and promotion
Relocation and reorganization costs
Redundancy and termination costs
R&D (Development may be capitalized IAS)
LOS 33.e, CFAI Vol. 3 P. 207
Financial Reporting and Analysis
138
Goodwill
Goodwill is the difference between acquisition price
and the fair market value of the acquired firm’s net
assets
The additional amount paid represents the amount
paid for assets not recorded on the balance sheet
Acquisition price
FMV net assets acquired
Goodwill
$
X
(X)
X
Fair value
involves
management
discretion –
goodwill is not
amortized
LOS 33.e, CFAI Vol. 3 P. 207
Financial Reporting and Analysis
139
Goodwill Analysis
LOS 33.e, CFAI Vol. 3 P. 207
Financial Reporting and Analysis
140
Goodwill Analysis
LOS 33.e, CFAI Vol. 3 P. 207
Financial Reporting and Analysis
Financial Assets/Liabilities
Stocks
Bonds
Receivables
Notes receivable
Notes payable
Loans
Derivatives
LOS 33.e, CFAI Vol. 3 P. 207
1
Financial Reporting and Analysis
Fair Value Assets and Liabilities
Financial assets:
Trading securities
Available-for-sale securities
Derivatives (stand-alone or embedded in a nonderivative instrument)
Assets with fair value exposures hedged by derivatives
Financial liabilities:
Derivatives
Nonderivative investments with fair value exposures hedged by derivatives
LOS 33.e, CFAI Vol. 3 P. 207
2
Financial Reporting and Analysis
Cost or Amortized Cost
Financial assets
Unlisted instruments
Held-to-maturity investments
Loans
Receivables
Financial liabilities
All other liabilities (e.g. bonds, notes
payable, etc.)
LOS 33.e, CFAI Vol. 3 P. 207
3
Financial Reporting and Analysis
Marketable Securities
Classification of securities based on company’s intent
with regard to eventual sale:
Held-to-
maturity
securities:
• Debt securities which the company intends to hold to maturity
• Securities are carried at cost
• I/S income and realized gains/(losses) on disposal
Available-
for-sale
securities:
• May be sold to satisfy company needs
• Debt or equity
• Current or non-current
• Carried on balance sheet at market value
• Income statement same as HTM method
LOS 33.f, CFAI Vol. 3 P. 223
4
Financial Reporting and Analysis
Trading
securities:
• Acquired for the purpose of selling in the near term
• Carried on the balance sheet as current assets at market value
• Income statement includes dividends, realized & unrealized gains/losses
Marketable Securities
LOS 33.f, CFAI Vol. 3 P. 223
5
Financial Reporting and Analysis
Financial Reporting and Analysis
Marketable Securities—Example
Ellerslie, Inc. purchased 1,000 shares on 1 January
20x4 for $30 per share. The market price of the shares
on 31 December 20x4 was $50.
Dividends of $1 were paid during the year.
What are the balance sheet and income statement
entries for 20x4 if these shares are classified by the
firm as held-to-maturity, available-for-sale, or trading
securities?
LOS 33.f, CFAI Vol. 3 P. 223
6
Financial Reporting and Analysis
Treatment of Dividends Received
The dividends received, $1,000 will
be reported as income on the
income statement for 20x4,
regardless of how the securities are
classified by the firm
LOS 33.f, CFAI Vol. 3 P. 223
Marketable Securities Example
7
Financial Reporting and Analysis
Treatment of Unrealized Gains
The 1,000 × (50 – 30) = $20,000 in unrealized
gains are treated as follows:
Trading Securities
$20,000 in gains reported on 20x4 income
statement, which increases net income and
retained earnings
The 20x4 balance sheet will reflect the increase
in share value: assets increase, equity increases
from increase in retained earnings
LOS 33.f, CFAI Vol. 3 P. 223
Marketable Securities Example
8
Financial Reporting and Analysis
The 1,000 × (50 – 30) = $20,000 in unrealized
gains are treated as follows:
Available-for-sale Securities
$20,000 unrealized gains reported as other
comprehensive income for 20x4, not reported on
income statement
The 20x4 balance sheet will reflect the increase in
share value: assets increase and equity increases
from increase in other comprehensive income
LOS 33.f, CFAI Vol. 3 P. 223
Marketable Securities Example
Treatment of Unrealized Gains
9
Financial Reporting and Analysis
As stock has no maturity date, it cannot be
classified as held-to-maturity
Held-to-maturity Securities (Debt securities)
Unrealized gains are not reported on the income
statement or as other comprehensive income
The balance sheet will show the debt at
amortized cost; unrealized gains do not affect
assets or equity
LOS 33.f, CFAI Vol. 3 P. 223
Marketable Securities Example
Treatment of Unrealized Gains
10
Financial Reporting and Analysis
Classification of Securities: Summary
Point #1: Dividends and realized gains always appear on the income statement
Point #2: Unrealized G/L only affect the income statement for trading securities
Point #3: Unrealized G/L on both trading and available-for-sale securities are reflected on the balance sheet
Point #4: Unrealized G/L on available-for-sale securities show up as other comprehensive income, not on income statement
LOS 33.f, CFAI Vol. 3 P. 223
11
Financial Reporting and Analysis
Components of Equity
Capital contributed by owners
Minority interest (IAS)
Retained earnings
Treasury stock (reduces equity)
Accumulated other comprehensive income
LOS 33.g, CFAI Vol. 3 P. 228
12
Financial Reporting and Analysis
LOS 33.g, CFAI Vol. 3 P. 228
12
The statement of changes in stockholders' equity summarizes all transactions that increase or
decrease the equity accounts for the period. The statement includes transactions with shareholders
and reconciles the beginning and ending balance of each equity account, including capital stock,
additional paid-in-capital, retained earnings, and accumulated other comprehensive income. In
addition, the components of accumulated other comprehensive income are disclosed (i.e., unrealized
gains and losses from available-for-sale securities, cash flow hedging derivatives, foreign currency
translation, and adjustments for minimum pension liability).
Financial Reporting and Analysis
Common Size Balance Sheet
Balance sheet account
Total assets
e.g. Inventory
Total assets
Uses:
Comparisons over time (trend analysis)
Cross-sectional comparisons
LOS 33.h, CFAI Vol. 3 P. 231
13
A vertical common-size balance sheet expresses each item of the balance sheet as a percentage of total
assets. The common-size format standardizes the balance sheet by eliminating the effects of size. This
allows for comparison over time (time-series analysis) and across firms (cross-sectional analysis). For
example, following are the balance sheets of industry competitors East Company and West Company.
Financial Reporting and Analysis
Financial Reporting and Analysis
Liquidity Ratios
Current ratio
Quick ratio
Cash ratio
Current assets
Current liabilities
Current assets – inventory
Current liabilities
Cash + marketable securities
Current liabilities
LOS 33.h, CFAI Vol. 3 P. 231
14
Financial Reporting and Analysis
Solvency Ratios
Long-term debt to
equity
Total long-term debt
Total equity
Debt to equityTotal debt
Total equity
Total debtTotal debt
Total assets
Financial leverageTotal assets
Total equity
LOS 33.h, CFAI Vol. 3 P. 231
15
Financial Reporting and Analysis
Usefulness of Ratio Analysis
Provide insights into firm’s macroeconomic
relationships. Helps forecasting:
Earnings
Free cash flows
Provide insights into financial flexibility
Ability to fund investment opportunities
Meet financial obligations
Cope with unexpected events
Provide tools to evaluate management ability
LOS 33.h, CFAI Vol. 3 P. 231
16
Financial Reporting and Analysis
Limitations of Ratio Analysis
Not useful in isolation
Alternative accounting methods reduce
comparability
Conglomerates (cross sectional benchmarks)
Mutually consistent ratios
Analyst judgement
LOS 33.h, CFAI Vol. 3 P. 231
17
Financial Reporting and Analysis - Book 3
Understanding the
Cash Flow Statement
Financial Reporting and Analysis
Importance of Cash Flow Statement
Net income from accrual accounting does not tell us
about the sources and uses of cash to meet liabilities
and operating needs
The statement of cash flows has three components
under both IFRS and US GAAP:
Cash provided or used by operating activities
Cash provided or used by investing activities
Cash provided or used in financing activities
LOS 34.a, CFAI Vol. 3 P. 251
19
Financial Reporting and Analysis
Operating Cash Flows (CFO)
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
(X)
(X)
(X)
(X)
X/(X)
LOS 34.a, CFAI Vol. 3 P. 251
20
Financial Reporting and Analysis
Investing Cash Flows (CFI)
Purchases of property, plant, and equipment
Proceeds from sales of assets
Investments in joint ventures and affiliates
Payments for businesses acquired
Purchases and sales of intangibles
Purchases or sales of marketable securities
Excludes:
Trading securities (part of CFO)
Cash equivalents (part of B/S cash)
LOS 34.a, CFAI Vol. 3 P. 251
21
Financial Reporting and Analysis
Financing Cash Flows
Issue and redemption of:
Common stock
Preferred stock
Treasury stock repurchases
Debt
Dividend payments (dividends rec’d CFO—
US GAAP)
Excludes:
Indirect financing via AP (CFO)
LOS 34.a, CFAI Vol. 3 P. 251
22
Financial Reporting and Analysis
Financial Reporting and Analysis
Non-Cash Investing and Financing
ActivitiesSeveral types of transactions do not involve the payment or receipt of cash and are not reflectedin financing and investing cash flows, but are disclosed in the footnotes or other schedules
Non-cash financing and investing activities:
Converting debt or preferred into common equity
Assets acquired under capital leases
Purchase of assets via issuance of debt/equity
Exchanging one non-cash asset for another
Stock dividends
LOS 34.b, CFAI Vol. 3 P. 254
23
Financial Reporting and Analysis
US GAAP vs IFRS
Interest received
Interest paid
Dividends received
Dividends paid
Taxes paid
Bank overdraft
CFO
CFO
CFO
CFF
CFO
CFF
CFO or CFI
CFO or CFF
CFO or CFI
CFO or CFF
CFO or CFI & CFF
*
US GAAP
(SFAS 95)
IAS GAAP
(IAS 7)
* Considered part of cash and cash equivalents
LOS 34.c, CFAI Vol. 3 P. 254
24
Financial Reporting and Analysis
Statement of Cash Flow:
Direct vs. Indirect Method
Direct vs. indirect method refers only to the
calculation of CFO, the value of CFO is the same
for both methods; CFI and CFF are unaffected
Direct method: Identify actual cash inflows and
outflows; e.g., collections from customers, amount
paid to suppliers
Indirect method: Begin with net income and make
necessary adjustments to get operating cash flow
LOS 34.d, CFAI Vol. 3 P. 255
25
Financial Reporting and Analysis
Cash collected from customers
Cash paid to suppliers
Cash paid to employees
Cash interest paid
Cash taxes paid
Cash flow from operations
198,000
(68,000)
(17,000)
CFO – Direct Method
(28,000)
0
85,000
LOS 34.d, CFAI Vol. 3 P. 255
26
Financial Reporting and Analysis
Financial Reporting and Analysis
Ecclestone Industries—Example
Ecclestone Industries has the following income
statement for 20X9 and balance sheets for 20X8 and
20X9. You are to construct the statement of cash flows
using the indirect method.
Additional information:
Ecclestone disposed of PP&E during the period which
had a cost of $20,000 and accumulated depreciation of
$10,000
Ecclestone has a tax rate of 40%
LOS 34.e, CFAI Vol. 3 P. 263
27
Financial Reporting and Analysis
Financial Reporting and Analysis
Income Statement for Year to 31 December 20X9
Sales revenue
Expenses:
Cost of goods sold
Salaries
Amortization
Depreciation
Interest
Gain from sale of PPE
Pre-tax income
Provision for taxes
Net income
$
200,000
105,000
95,000
20,000
115,000
40,000
75,000
$
80,000
10,000
2,000
12,000
1,000
LOS 34.e, CFAI Vol. 3 P. 263
28
Financial Reporting and Analysis
Ecclestone Balance Sheet Data
Balance Sheets
Current assets
Cash
Accounts receivable
Inventory
Non-current assets
Land
Plant & equipment
Intangibles
Total Assets
20X8
$
18,000
18,000
14,000
80,000
102,000
20,000
252,000
20X9
$
66,000
20,000
10,000
80,000
130,000
18,000
324,000
LOS 34.e, CFAI Vol. 3 P. 263
29
Financial Reporting and 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
20X8
$
10,000
16,000
6,000
8,000
2,000
20,000
30,000
100,000
60,000
252,000
20X9
$
18,000
9,000
7,000
10,000
12,000
30,000
40,000
80,000
118,000
324,000
LOS 34.e, CFAI Vol. 3 P. 263
30
Financial Reporting and Analysis
Cash Inflows and Outflows
General rules regarding increases and decreases in balance sheet items over time:
Increase Decrease
Assets outflow inflow
Liabilities & Equity inflow outflow
e.g.: An increase in AR or inventory uses cash
An increase in payables generates cash
Adjust net income for these changes (indirect)
LOS 34.e, CFAI Vol. 3 P. 263
31
Financial Reporting and Analysis
Indirect Method CFOSteps
1. Start with net income
2. Adjust net income for changes in relevant
balance sheet items:
Increases in an asset: deduct
Increase in a liability: add
Decrease in an asset: add
Decrease in a liability: deduct
LOS 34.e, CFAI Vol. 3 P. 263
32
Financial Reporting and Analysis
Indirect method continued
3. Eliminate depreciation and amortization
by adding them back (they’ve been
deducted in arriving at net income but are
non-cash expenses)
4. Eliminate gains on disposal by deducting
them and losses on disposal by adding
them back (these are CFI, not CFO)
LOS 34.e, CFAI Vol. 3 P. 263
33
Financial Reporting and Analysis
Net income 75,000
Add: Depreciation 12,000
Add: Amortization 2,000
Less: Gain from sale of PPE (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 salaries payable (7,000)
Add: Increase in interest payable 1,000
Add: Increase in taxes payable 2,000
$
Cash flow from operations 85,000
Ind
irec
t M
eth
od
So
luti
on
LOS 34.e, CFAI Vol. 3 P. 263
34
Financial Reporting and Analysis
Calculating CFI
CFI =
investment in assets – cash received on asset sales
Gain (loss) on sale = sales price – net book value
Net book value =
historical cost – accumulated depreciation
LOS 34.e, CFAI Vol. 3 P. 263
35
Financial Reporting and Analysis
Ecclestone CFICFI = cash additions – cash received on disposal
Plant and Equip.
Closing NBV
Opening NBV
NBV of disposals
Depreciation
Additions
210,000
(182,000)
10,000
12,000
50,000
Intangibles
Closing NBV
Opening NBV
NBV of disposals
Amortization
Additions
18,000
(20,000)
0
2,000
0
LOS 34.e, CFAI Vol. 3 P. 263
36
Financial Reporting and Analysis
CFI = cash additions – cash received on disposal
Gain(loss) on sale
NBV of disposals
Proceeds
20,000
10,000
30,000
$
CFI = –additions + proceeds
CFI = –$50,000 + $30,000 = –$20,000
Ecclestone CFI
LOS 34.e, CFAI Vol. 3 P. 263
37
Financial Reporting and Analysis
If NBV of Disposals is Not Disclosed
Closing NBV
Opening NBV
Depreciation
= Additions – NBV
210,000
182,000
(12,000)
40,000
Gain on disposal =
20,000
= Proceeds – NBV
CFI = –$40,000 + $20,000 = –$20,000
LOS 34.e, CFAI Vol. 3 P. 263
From balance sheet From income statement
(Proceeds – NBV) – (Additions – NBV) =
Proceeds – Additions = CFI
38
Financial Reporting and Analysis
Computing CFF
Change in debt
Change in common stock
Cash dividends paid
Net income
Dividends declared
Δ in retained earnings
$
X
(X)
X
Dividends declared
ΔDividends payable
Cash paid
$
(X)
X
(X)
LOS 34.e, CFAI Vol. 3 P. 263
39
Financial Reporting and Analysis
Change in debt
Change in common stock
Cash dividends paid
Net income
Div declared
Δ in R/E
$
75,000
(17,000)
58,000
Dividends decl.
Δ Div. payable
Cash div. paid
$
(17,000)
10,000
(7,000)
Ecclestone CFF$
10,000
(20,000)
(7,000)
(17,000)
LOS 34.e, CFAI Vol. 3 P. 263
40
Financial Reporting and Analysis
$
85,000
(20,000)
(17,000)
48,000
18,000
66,000
Putting the Cash Flow Statement
Together
Cash flow from operations
Cash flow from investments
Cash flow from financing
Net increase in cash
Cash balance 12/31/X8
Cash balance 12/31/X9
LOS 34.e, CFAI Vol. 3 P. 263
41
Financial Reporting and Analysis
Converting an Indirect Statement to a
Direct Statement of Cash Flows
Most firms use the indirect method, but the analyst
may want information on the cash flows by function;
some examples of this technique are:
Net sales – Δ accounts receivable + Δ advances
from customers = cash collections
Cost of goods sold – Δ inventory + Δ accounts
payable = cash paid for inputs
Interest expense + Δ interest payable = cash
interest
LOS 34.f, CFAI Vol. 3 P. 278
42
Financial Reporting and Analysis
Direct Method from Indirect CFO1. Take each income statement item in turn
– e.g., sales
2. Move to the balance sheet and identify asset and liability accounts that relate to that income statement item—e.g., accounts receivable
3. Calculate the change in the balance sheet item during the period (ending balance – opening balance)
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 34.f, CFAI Vol. 3 P. 278
43
Financial Reporting and Analysis
Direct from Indirect CFO
5. Adjust the income statement amount by the
change in the balance sheet
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 non-cash
or non-CFO items
LOS 34.f, CFAI Vol. 3 P. 278
44
Financial Reporting and Analysis
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
Direct from Indirect CFO
LOS 34.f, CFAI Vol. 3 P. 278
45
Financial Reporting and Analysis
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)
(80,000)
4,000
(76,000)
8,000
198,000
(68,000)
(10,000)
(7,000)
(17,000)
Direct from Indirect CFO
LOS 34.f, CFAI Vol. 3 P. 278
46
Financial Reporting and Analysis
(28,000)
(40,000)
10,000
2,000
(1,000)
1,000
Direct from Indirect, cont.
Cash outflows
Interest Expense
Add: Increase in interest payable
Cash interest paid
Tax Expense
Add: Increase in deferred tax liab.
Tax payable
Add: Increase in taxes payable
Cash taxes paid
$ $
CFO
0
85,000
(30,000)
LOS 34.f, CFAI Vol. 3 P. 278
47
Financial Reporting and Analysis
Cash Flow Statement Analysis
Do regular operations generate enough
cash to sustain the business?
Is 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
LOS 34.g, CFAI Vol. 3 P. 279
48
Financial Reporting and Analysis
Analysis
1. Analyze the major sources and uses of cash flow (CFO, CFI, CFF)
Where are the major sources and uses?
Is CFO positive and sufficient to cover capex?
2. Analyze CFO
What are the major determinants of CFO?
Is CFO higher or lower than NI?
How consistent is CFO?
LOS 34.g, CFAI Vol. 3 P. 279
49
Financial Reporting and Analysis
Analysis3. Analyze CFI
What is cash being spent on?
Is the company investing in PP&E?
What acquisitions have been made?
4. Analyze CFF
How is the company financing CFI and CFO?
Is the company raising or repaying capital?
What dividends are being returned to owners?
LOS 34.g, CFAI Vol. 3 P. 279
50
Financial Reporting and Analysis
Financial Reporting and Analysis
Common Size Statements
2 Approaches
Show each item as a
% of net revenue
Show each inflow as a
% of total inflows
Show each outflow as
a % of total outflows
Useful for:
Trend analysis (time series)
Forecasting future cash flows
LOS 34.g, CFAI Vol. 3 P. 279
51
Financial Reporting and Analysis
Common Size Statements Ecclestone
Receipts from customers $198,000 83.2%
Sale of Equipment $30,000 12.6%
Debt Issuance $10,000 4.2%
Total $238,000 100%
Inflows
LOS 34.g, CFAI Vol. 3 P. 279
52
Financial Reporting and Analysis
Common Size Statements Ecclestone
Outflows
Payments to suppliers $68,000 35.8%
Payments to employees $17,000 8.9%
Payments for interest $0 0%
Payments for income tax $28,000 14.7%
Purchase of equipment $50,000 26.3%
Retirement of common stock $20,000 10.5%
Dividend payments $7,000 3.7%
Total $190,000 100%
LOS 34.g, CFAI Vol. 3 P. 279
53
Financial Reporting and Analysis
Free Cash Flow (FCF)
FCF is cash available for discretionary uses
Frequently used to value firms
FCFF = NI + NCC - WCInv + Int (1-T) – FCInv
FCFF = CFO + Int (1-T) – FCInv
FCFE = CFO – FCInv + Net debt increase
LOS 34.h, CFAI Vol. 3 P. 287
54
Financial Reporting and Analysis
Free Cash Flow (FCF) Ecclestone
FCFF = CFO + Int (1 – T) – FCInv
$65,600 = $85,000 + $1,000 (1 – 0.4) – $20,000
FCFE = CFO – FCInv + Net debt increase
$75,000 = $85,000 – $20,000 + $10,000
FCFE = FCFF – Int (1 – T) + Net debt increase
$75,000 = $65,600 – $1,000 (1 – 0.4) + $10,000
LOS 34.h, CFAI Vol. 3 P. 287
55
Financial Reporting and Analysis
Financial Reporting and Analysis
Cash Flow Performance Ratios
Cash flow to revenue
Cash return on assets
Cash return on equity
Cash to income
CFO
Net revenue
CFO
Ave total assets
CFO
Ave equity
CFO
Operating income
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Financial Reporting and Analysis
Cash Flow Performance Ratios
Cash flow per shareCFO – pref div
No common stock
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57
Financial Reporting and Analysis
Cash Flow Coverage Ratios
Debt coverage
Interest coverage
Reinvestment
CFO
Total debt
CFO + interest + tax
Interest paid
CFO
Cash paid for long-
term assets
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Financial Reporting and Analysis
Cash Flow Coverage Ratios
Debt payment
Dividend payment
Investing and financing
CFO
Cash paid for long-term
debt repayment
CFO
Dividends paid
CFO
Cash outflows for CFI
& CFF
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Financial Reporting and Analysis - Book 3
Financial Analysis
Techniques
Financial Reporting and Analysis
Interpreting Ratios
1. Cross-sectional analysis:
Comparison to industry norm or average
2. Time-series analysis (trend analysis):
Comparison to a company’s past ratios
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Financial Reporting and Analysis
Vertical Common-Size Statements
Income Statement
Balance Sheet
Income statement account
Sales
Balance sheet account
Total assets
e.g., Marketing expense
Sales
e.g., Inventory
Total assets
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Financial Reporting and Analysis
Horizontal Common-Size Statements
Assets Year 1 Year 2 Year 3
Cash 1.0 1.2 1.1
AR 1.0 1.3 1.0
Inventory 1.0 0.8 1.2
PP&E 1.0 1.5 2.0
Total 1.0 1.25 1.5
Each line shown as a relative to some base year
Facilitates trend analysis
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Financial Reporting and Analysis
Graphs
Facilitate comparisons over time:
Performance
Financial structure
Communicate analyst conclusions
Types
Pie graph – composition of total value
Stacked column graph – composition of total
value over time
Line graph – change over time
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Financial Reporting and Analysis
Stacked Column Graph
0
500
1000
1500
2000
2500
3000
3500
4000
4500
20X4 20X5 20X6 20X7 20X8
Tradepayables Cash
Lease obligations Long-term notes
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Financial Reporting and Analysis
Line Graph
0
500
1000
1500
2000
2500
20X4 20X5 20X6 20X7 20X8
Tradepayables Cash
Leaseobligations Long-term notes
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Financial Reporting and Analysis
Limitations of Financial Ratios
Not useful in isolation – only valid when compared
to other firms or the company’s historical performance
Different accounting treatments – particularly when
analyzing non-U.S. firms
Finding comparable industry ratios for companies
that operate in multiple industries (homogeneity of
operating activities)
All ratios must be viewed relative to one another
Determining the target or comparison value requires
some range of acceptable values
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Financial Reporting and Analysis
Common-Size Income Statement
Expresses each income statement item as
a percentage of sales
Used to analyze changes in cost structure
and profitability
Used for both cross-sectional and time-
series analysis
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Financial Reporting and Analysis
Common-Size Income Statement
Example: Consider a common-size
income statement that reveals the following
(selected items only):
10%8%9%Net Income
18%22%18%SG&A
60%62%58%COGS
Industry Avg.20X820X7Income statement item
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Financial Reporting and Analysis
Common-Size Income Statement
Increased COGS% suggests a lower selling
price or higher cost of material and labor
Increased SG&A% also suggests a lower
selling price or higher costs in this area
Lower net profit margin (net income as a %
of sales) reflects a lower selling price or
higher expenses
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Financial Reporting and Analysis
Measures of Operating Performance
All can be seen on common size income statement
Operating profitability ratios:
Gross profitGross profit margin =
Net sales
Net incomeNet profit margin =
Net sales
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Financial Reporting and Analysis
Categories of Ratios
Activity
Liquidity
Solvency
Profitability
Valuation
Efficiency of day-to-day
tasks/operations
Ability to meet short-term liabilities
Ability to meet long-term obligations
Ability to generate profitable
sales from asset base
Quantity of asset or flow associated
with an ownership claim
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Financial Reporting and Analysis
Ratio Analysis Context
1. Company goals and strategy
2. Industry norms
Ratios may be industry specific
Multiple lines of business distort
aggregate ratios
Differences in accounting methods
3. Economic conditions
Cyclical businesses and the stage
of the business cycle
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Financial Reporting and Analysis
Ratio Analysis
Some general rules:
For ratios that use only income statement
items, use the values from the current income
statement
For ratios using only balance sheet items,
use the values from the current balance sheet
For ratios using both income statement and
balance sheet items, use the value from the
current income statement and the average
value for the balance sheet item
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Financial Reporting and Analysis
Activity Ratios
RevenueReceivables
turnover Average receivables
365Days of sales
outstanding (DSO) Receivables turnover
Cost of goods soldInventory turnover
Average inventory
365Days of inventory
on hand (DOH) Inventory turnover
=
=
=
=
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Financial Reporting and Analysis
Activity Ratios
PurchasesPayables turnover
Average trade payables=
Payables turnover
Number of days
of payables
365=
RevenueWorking capital
turnover Average working capital=
Working capital =Current
assets
Current
liabilities–
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Financial Reporting and Analysis
Activity Ratios
RevenueFixed asset
turnover Average net fixed assets=
RevenueTotal asset
turnover Average total assets=
Net of accumulated
depreciation
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Financial Reporting and Analysis
Liquidity Ratios
Current liabilities
Current assetsCurrent ratio
Current liabilities
Cash + short term
marketable securities +
receivables
Quick ratio
Current liabilities
=
=
=
Cash ratio
Cash + short term
marketable securities
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Financial Reporting and Analysis
Definitions: Liquidity Ratios
Defensive
interval ratio Daily cash expenditure
Cash + short term
marketable investments
+ receivables=
DOH
DSO
No. of days of payables
Cash conversion cycle
Days
X
X
(X)
X
Cash
conversion
cycle=
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Financial Reporting and Analysis
Cash Conversion Cycle
Raw materials arrive
Production commences
Production complete
Goods sold
Cash collected
from customer
Pay supplier
Number of
days of
payablesDOH
DSO
Cash
conversion
cycle
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Financial Reporting and Analysis
Solvency
Earnings variability
Business risk Financial leverage
Sales volatility Operating leverage
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Financial Reporting and Analysis
Solvency Ratios
Total debtDebt-to-assets
ratio Total assets=
Total debtDebt-to-capital
ratio Total debt + total
shareholders’ equity
=
Total debt = interest bearing
short-term and long-term debtTotal debt ratio
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Financial Reporting and Analysis
Solvency Ratios
Total debtDebt-to-equity
ratio Total shareholders’
equity
=
Average total assetsFinancial
leverage ratio Average total equity=
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Financial Reporting and Analysis
Solvency Ratios
EBITInterest
coverage Interest payments=
EBIT + Iease paymentsFixed charge
coverage Interest payments +
lease payments
=
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Financial Reporting and Analysis
Gross profitGross profit margin =
Revenue
Operating incomeOperating profit margin =
Revenue
Profitability Ratios
Operating income
Gross profit – operating costs
Approximation = EBIT
EBIT contains non-operating items (dividends rec’d
and gains and losses on investment securities)
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Financial Reporting and Analysis
Earnings before tax
but after interestPretax margin
Revenue=
Net incomeNet profit margin
Revenue=
Profitability Ratios
Most of the return-on-sales profitability ratios are on
the face of the common-size income statement
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Financial Reporting and Analysis
Operating incomeOperating ROA
Average total assets=
Net incomeReturn on assets
ROA Average total assets=
Profitability Ratios
Alternatively:
Return on assets
ROA
Net income + interest
expense (1 – T)
Average total assets=
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Financial Reporting and Analysis
Net income – pref. div.Return on
common equity Average common equity=
EBITReturn on total
capital Short + long-term debt +
equity
=
Profitability Ratios
Return on equity
ROE
Net income
Average total equity=
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Financial Reporting and Analysis
Integrated Financial Ratio Approach
Important to analyze all ratios collectively
Use information from one ratio category to
answer questions raised by another ratio
Classic example = DuPont analysis
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Financial Reporting and Analysis
Integrated Financial Ratios –
Example
20X8 20X7 20X6
Current ratio 2.0 1.5 1.2
Quick ratio 0.5 0.8 1
20X8 20X7 20X6
DOH 60 50 30
DSO 20 30 40
What can you conclude about this firm’s performance?
(Note that years are presented right-to-left)
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Financial Reporting and Analysis
1. Current ratio and Quick ratio?
2. Inventory management?
3. Accounts receivable management?
4. Cash collection and use?
Integrated Financial Ratios – Example
1.Current ratio up – Quick ratio down – Why?
2. DOH has increased – indicates rising
inventory rather than low cash
3. DOS decreasing – collecting cash from
customers sooner
4. Current and quick ratios indicate the
collected cash is being spent on inventory
accumulation
5. Appears collections have been accelerated
to make up for poor inventory management
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Financial Reporting and Analysis
ROE =
Equity
Net income
Net income
Total assets
Total assets
Equity×
ROA Financial leverage
ratio
DuPont System Analysis
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Financial Reporting and Analysis
DuPont System: Original Equation
ROE =
Equity
Net income
Revenue
Equity
Net income
Revenue×
Net income
Revenue
Revenue
Total assets
Total assets
Equity× ×
Net profit margin Asset turnover Leverage
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Financial Reporting and Analysis
DuPont System: Extended Equation
Net income
Revenue
Revenue
Total assets
Total assets
Equity× ×
EBIT
Revenue
EBT
EBIT
Net income
EBT× ×
EBIT margin Interest burden Tax burden
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Financial Reporting and Analysis
DuPont System: Extended Equation
EBIT
margin
Interest
burden
Tax
burden
Asset
turnoverLeverage× × × ×
Operating profit
margin1 – Effective tax rate
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Financial Reporting and Analysis
Per-Share Ratios for Valuation
Price per shareP
Earnings per share=
E
Price per shareP
Cash flow per share=
CF
Price per shareP
Sales per share=
S
Price per ShareP
Book value per share=
BV
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Financial Reporting and Analysis
Per-Share Quantities
NI – Pref divBasic EPS
Weighted ave #
ordinary shares
=
Income adjusted for dilutive
securities
Weighted ave # shares
adjusted for dilution
=Diluted EPS
Cash flow
per share
CFO
Weighted ave #
shares
=
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Financial Reporting and Analysis
Per-Share Quantities
EBITDA per
share
EBITDA
Ave # ordinary shares=
Dividends
per share
Common dividend=
Weighted ave #
common shares
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Financial Reporting and Analysis
Dividend Related Quantities
Dividend
payout ratio
Common dividend
Net income – pref div=
Retention
rate (b)
Net income attributable to
common shares – common
dividend=
Net Income attributable to common shares
Net income attributable to
common shares
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Financial Reporting and Analysis
Dividend Related Quantities
Sustainable
growth rateb × ROE=
Retention rate
1 – Dividend payout ratio
Return on equity
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Financial Reporting and Analysis
Sustainable Growth Rate – Problem
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 = b × ROE
(1 – 0.35) 0.1 × 1.4 × 1.2
= 0.1092
= 10.92%
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Financial Reporting and Analysis
Business Risk Ratios
Operating incomeCoefficient of
variation of
operating income Operating income=
Net incomeCoefficient of
variation of net
income Net income=
RevenueCoefficient of
variation of
revenue Revenue=
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Financial Reporting and Analysis
Using Ratios for Equity Analysis
Research has found ratios (and changes in
ratios) can be useful in forecasting earnings
and stock returns (valuation)
Some items useful in forecasting:
% change in: current ratio • quick ratio • inventory •
inventory turnover • inventory/total assets • sales •
depreciation • capex/assets • asset turnover •
depreciation/plant assets • total assets
ROE • Δ ROE • debt/equity • ROA • gross margin •
working capital/assets • dividends/cash flow • Δ dividend •
% debt repaid • operating ROA • pretax margin
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Financial Reporting and Analysis
Standard and Poor’s Credit Ratios
EBITReturn on total capital =
Total capital
EBIT Interest coverage =
Gross interest
EBITDAEBITDA coverage =
Gross interest
Total debt Debt to EBITDA =
EBITDA
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Financial Reporting and Analysis
Standard and Poor’s Credit Ratios
Note: Adjustments are made for off-balance-sheet debt
Net Income adj. for non - cash itemsFFO to total debt =
Total debt
CFO – capexFree operating cash flow to total debt =
Total debt
Total debtTotal debt to debt + equity =
Total debt + equity
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Financial Reporting and Analysis
Segment Reporting
Reportable business or geographic segment:
50% of its revenue from sales external to the firm, and
at least 10% of a firm’s revenue, earnings, or assets
For each segment, firm reports limited financial
statement information
For primary segments, must report: revenue (internal
and external), operating profit, assets, liabilities (IFRS
only), capex, depreciation and amortization
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Financial Reporting and Analysis
Definitions: Segment Ratios
Segment marginSegment profit
Segment revenue =
Segment asset
turnover
Segment revenue
Segment assets=
Segment ROASegment profit
Segment assets =
Segment debt ratio
(IFRS only)
Segment liabilities
Segment assets=
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Financial Reporting and Analysis
Model Building
Common-size statements and ratios can
be used to model/forecast results
Expected relationships among financial
statement data
Earnings model
Revenue driven models
Sensitivity analysis
Scenario analysis
Simulation
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Financial Reporting and Analysis
Financial Analysis – Problem
Analysis has generated the following data:
Tax rate 35%
Equity multiplier 2.7
Net profit margin 4.6%
Equity turnover 5.2
ROE is closest to:
A. 13%
B. 17%
C. 24%
Net income / Sales × Sales / Equity =
Net income / Equity = 4.6% × 5.2 = 23.92%
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