chapter 2 financial statements and measuring value

Chapter 2 Financial Statements and Measuring

Value

Some Basic Accounting Principles 2-3

• Historical Cost Principle - Assets recorded at their cost

• Reliability Principle – FS should be reasonably reliable but cost efficient; materiality

• Economic Entity Principle Consolidation– A owns B. A sells widget for $500 and cost is $100.

Unconsolidated shows $400 profit for A which is eliminated on consolidation.

• Matching Income & Expenses in Accounting Period (Accrual) – This means income is unrelated to having cash.

Some Basic Accounting Principles 2-3

• Transparency of Methods – Disclosure and notes• Consistency of Methods – Allows comparison• Going Concern Assumption • Conservatism Principle e.g. lower of cost or

market for assets held for sale

Accounting Methods Disclosure – Footnote 1 2-4

Revenue Recognition • Scientific_Atlanta's revenue recognition policies are in compliance with

Staff Accounting Bulletin No. 101 "Revenue Recognition in Financial Statements" issued by the Securities and Exchange Commission. Revenue is recognized at the time product is shipped or title passes pursuant to the terms of the agreement with the customer which include a standard right of return, the amount due from the customer is fixed and collectibility of the related receivable is reasonably assured. Revenue is recognized only when we have no significant future performance obligation.

• Our right of return policy, which is standard for virtually all sales, allows a customer the right to return product for refund only if the product does not conform to product specifications; the non-conforming product is identified by the customer; and the customer rejects the non-conforming product and notifies us within ten days of receipt.

• Revenues from progress-billed contracts are primarily recorded using the percentage-of-completion method based on contract costs incurred to date. Losses, if any, are recorded when determinable. Costs incurred and accrued profits not billed on these contracts are included in receivables. Unbilled receivables, which consist of retainage, were $443 at June 29, 2001 and $1,269 at June 30, 2000. It is anticipated that substantially all such amounts will be collected within one year.

Quick Check Question 2.1 2- 5

• Your client informs you that he has just bought a $100,000 dog. You ask him how and what he paid for it. He responds that he exchanged his two $50,000 cats for it. How should he book the transaction, if it is part of a business (perhaps dog-breeding)? What accounting principles are applicable?


• What if he paid $100,000 cash then you would book dog at cost - $100,000


• What if he paid $100,000 cash then you would book dog at cost (historical cost convention)- $100,000

• BUT if dog held for sale you would book at lower of cost or market value (Conservatism Principle)


• But he did not pay cash; he swapped two $50,000 cats. Where does this $50,000 value come from? Current value or is it what he paid for the cats?

• If he paid $20,000 for each cat then their carrying value is $40,000 and unless another rule allows recognition of built in gain he only can record lower of historical cost of $40,000 or market value of dog

Format of Balance Sheets 2- 9

• Balance Sheet• John Lawyer

• December 31, 2003

• Assets Liabilities• Current Assets xx Current Liabilities

xx• Long-Term Assets xx Long-Term Liabilities xx• Owners’ Equity • Total Assets xxx Total liabilities & Equity

xxx

–

Scientific-Atlanta –Current Assets 2-10

• In Thousands

Assets 2001 2000

Current assets

Cash and cash equivalents $ 563,322 $ 462,496 Short_term investments 191,001 61,481

Receivables, less allowance for doubtful accounts of $5,982,000 in 2001 and

$4,134,000 in 2000 502,289 333,242 Inventories 201,762 209,916 Deferred income taxes 57,195 49,681

Other current assets 33,165 33,818

Total current assets 1,548,734 1,150,634

Scientific-Atlanta Long-Term Assets 2-11

• In Thousands 2001

2000 Property, plant and equipment, at cost

Land and improvements 22,218 20,248 Buildings and improvements 67,946 40,915 Machinery and equipment 246,385 214,295

336,549 275,458 Less - accumulated depreciation and

amortization 108,934 96,209 227,615 179,249

Goodwill and other intangible assets, net 81,491 7,475 Non-current marketable securities 17,159 381,983 Deferred income taxes 26,732 __ Other assets 101,097 60,119 Total Assets $2,002,828 $1,779,460

Scientific-Atlanta Liabilities 2-12

• In Thousands 2001

2000

Liabilities and Stockholders' Equity

Current liabilities

Current maturities of long-term debt $ 91 $ 386 Accounts payable 223,990 212,111 Accrued liabilities 164,991 149,402 Income taxes currently payable 5,051 18,264 Total current liabilities 394,123 380,163

Long term debt, less current maturities __ 102 Deferred income taxes __ 114,428 Other liabilities 99,766 69,807

[Total Liabilities 493,889 564,500]

Owens-Illinois Note on Contingent Liabilities – slide 1 2-10

The following table shows the approximate number of plaintiffs and claimants involved in asbestos claims pending at the beginning of, disposed of and filed during, and pending at the end of, each of the years listed (eliminating duplicate filings): 2001 2000 1999

• Pending at beginning of year... 20,000 17,000 15,000 • Disposed.............................…..24,000 17,000 10,000 • Filed......................................... 31,000 20,000 12,000 • Pending at end of year............ 27,000 20,000 17,000 * * *

• The Company believes that its ultimate asbestos-

related contingent liability (i.e., its indemnity or other claim disposition costs plus related legal fees) cannot be estimated with certainty. In 1993, the Company established a liability of $975 million to cover indemnity payments and legal fees associated with the resolution of outstanding and expected future asbestos lawsuits and claims. In 1998, an additional liability of $250 million was established. During the third quarter of 2000, the Company established an additional liability of $550 million ….

Owens- Illinois Note on Contingent Liabilities – slide 2 2-14

• The Company's ability to reasonably estimate its liability has been significantly affected by the volatility of asbestos-related litigation in the United States, the expanding list of non-traditional defendants that have been sued in this litigation and found liable for substantial damage awards, the continued use of litigation screenings to generate new lawsuits, the large number of claims asserted or filed by parties who claim prior exposure to asbestos materials but have no present physical impairment as a result of such exposure, and the growing number of co-defendants that have filed for bankruptcy.

• Since the beginning of 2000, A. P. Green Industries, Inc., Armstrong World Industries, Babcock & Wilcox, Federal-Mogul Corporation, Fibreboard Corporation, G-I Holdings (GAF), Harbison-Walker Refractories Group, Kaiser Aluminum Corporation, North American Refractories Co., Owens Corning, Pittsburgh-Corning, Plibrico Company, Porter Hayden Company, USG Corporation, W. R. Grace & Co. and several other smaller companies have sought protection under Chapter 11 of the Bankruptcy Code.

•

General Motors Note on Defined Benefit Plans – Slide 1 2-15• GM has a number of defined benefit pension plans covering

substantially all employees. Plans covering U.S. and Canadian represented employees generally provide benefits of negotiated, stated amounts for each year of service as well as significant supplemental benefits for employees who retire with 30 years of service before normal retirement age. The benefits provided by the plans covering . . . employees . . . are generally based on years of service and salary history. * * *

Pension plan assets are primarily invested in U.S. Government obligations, equity and fixed income securities, commingled pension trust funds, insurance contracts, GM $1-2/3 common stock (valued at December 31, 2001 at $50 million), and GM Class H common stock (valued at December 31, 2001 at $2.3 billion).

GM's funding policy with respect to its qualified pension plans is to contribute annually not less than the minimum required by applicable law and regulations. GM made no pension contributions to the U.S. hourly and salary plans in 2001 and made contributions of $5.0 billion in 2000 (consisting entirely of GM Class H common stock contributed during the second quarter of 2000), and $794 million in 1999. In addition, GM made pension contributions to all other U.S. plans of $99 million, $69 million, and $67 million in 2001, 2000, and 1999, respectively.

G. M. Note on Defined Benefit Plans – Slide 2 2-13

• “The projected benefit obligation, accumulated benefit obligation, and fair value of plan assets for pension plans with accumulated benefit obligations in excess of plan assets were $59.3 billion, $58.8 billion, and $48.2 billion, respectively, as of December 31, 2001, and $4.0 billion, $3.4 billion, and $0, respectively, as of December 31, 2000.”

G. M. Note– Questions 2-13

1. What is a “defined benefit” pension plan?

2. How large is the deficit in GM’s funding for its pension obligations at the close of 2002?



2. How large is the deficit in GM’s funding for its pension obligations at the close of 2002? $23 B

Analysis of GM’s Pension Benefit Deficit 2-19

• (in billions)• 2002

2001• Projected Benefit Obligation $92

$59• Accumulated Benefit Obligations 89 59• Fair value of plan assets 66

48 • Funding Deficit based on accumulated

benefit obligations $23$11




3. How does this compare to its 2002 net income of $1.736 billion?




3. How does this compare to its 2002 net income of $1.736 billion?

• It would take over 13 years of profits at this level to cover the deficit. ($23/1.736 billion)


4. GM’s Balance Sheet reveals a deduction from shareholders’ equity of $22.762 billion, leaving a net equity of $6.814 billion. Note that in calculating this deficit, GM has shown over $17.954 billion in intangible assets, including goodwill of $6.992 billion, . Goodwill is the cost of acquired businesses in excess of the fair value of their identifiable net assets. What does this tell you about the tangible net worth of GM?

Excerpts from GM’s 12/31/02 Balance Sheet 2-23

• December 31,• GENERAL MOTORS CORPORATION AND SUBSIDIARIES 2002 2001

ASSETS * * * Total cash & marketable securities 38,274 30,624 Finance Receivables (less allowances) 134,647 109,211 Deferred Income Taxes 41,649 28,239 Equipment on operating leases 34,811 36,087 Equity in net assets of nonconsolidated associates 5,044 4,950 Property - net (Note 9) 37,973 36,440 Intangible assets - net (Notes 1 and 10) 17,954 16,967

* * * Total assets $370,782 $322,412• LIABILITIES AND STOCKHOLDERS' EQUITY * * * • Postretirement benefits other than pensions (Note 14) 38,187 38,393

Pensions (Note 14) 22,762 10,389

* * * Total liabilities 363,134 301,959

– * * * Stockholders' equity (Note 17) * * *

– Minimum pension liability adjustment (23,215) (9,581 )– Accumulated other comprehensive loss (25,832) (12,295 )– Total stockholders' equity 6,814 19,707

» Total liabilities and stockholders' equity $370,782 $322,412


5. What are Post-retirement benefits other than pensions? Note that GM’s balance sheet shows a deduction from shareholders’ equity of $38.197 billion. Note that footnote 14 the total benefit obligation is $57.229 billion.


“Additionally, GM maintains hourly and salary benefit plans that provide postretirement medical, dental, vision and life insurance to most U.S. retirees and eligible dependents.”


6. In calculating the funding of its pension plans, GM assumes a certain rate of return on a portfolio consisting of “U.S. Government obligations, equity and fixed income securities, commingled pension trust funds, insurance contracts, GM $1-2/3 common stock..., and GM Class H common stock ....” In its 2001 annual report GM stated that returns on this portfolio are “below GM's long-term asset return assumption, in any 10-year period over the last 15 years, GM has achieved pension asset returns of 10% per annum or greater.”

G. M. Note Questions 2-13

6. Keep in mind that some of the highest returns in history were earned in the period 1985-2000, when the Dow rose from less than 1,500 to over 11,000. Further, long-term returns to broad stock market averages have been between 10 - 11% over the past seventy years or more. Returns on corporate bonds have averaged 5.7% and long-term Treasury Bonds have averaged 5.2%. Would it make sense to use an assumed return of 10% on a portfolio of government and corporate bonds, stocks and GM stock? If so, why did GM reduce its assumed rate of return to 9% in its 2002 report?

G. M. Note Questions 2-13

Anyone remember what happened to the stock market after 2000????? Do you think GM could see this by the end of 2001?


7. In an announcement in December, 2003, GM stated that it intended “to reduce the GM pension funds’ exposure to stocks in both U.S. and international markets, and increase investments in global bonds and other alternatives to stocks.” “GM Says It Closed Gap in Pension Fund; 9% Return is Needed,” Wall Street Journal, Dec. 15, 2003, C1. What do you think the shift from stocks to bonds is likely to do to expected returns on the portfolio?

Table 3-6. Returns to Asset Classes, 1926-1997 2-30• Table 3-6 • Returns to Asset Classes

Std. Deviation Risk Premium• Nominal Real of over• Asset Class Return Return Annual Returns T- Bills

• Short-term Treasury Bills3.8% 0.7% 3.2% 0%• Intermediate-Term T- Bonds 5.3% 2.2% 5.7% 1.5%

• Long-Term Treasury Bonds 5.2% 2.1% 9.2% 1.4%

• Corporate Bonds 5.7% 2.6% 8.7% 1.9%

• Large-Company Stocks 11% 7.9% 20.3% 7.2%

• Small-Company Stocks 12.7% 9.6% 33.9% 8.9%•

Table 3-6. Analysis 2-31

• Dropping from stocks to bonds reduces returns from 11% to 5.7%.

• A 50-50 portfolio would yield 8.85% if stock yields were expected to remain at 11%.

• If you assume a 10% return on stocks, the yield on a 50-50 portfolio would be 7.85%.

• Their Assumption is “Troubling”


8. Much of GM’s non-pension benefit obligations are for health care for retirees. GM makes certain assumptions about rates of increase in health-care benefit costs through 2009. If GM’s estimates are on the low side by one percent, what would this do to GM’s currently estimated $38.187 obligation?


• This is the “Accumulated Post-Retirement Benefit Obligation” or “APBO.”

• GM’s assumptions about health care cost increases on page 58:

– 7.2% for 2003, decreasing on a linear basis to 5% to 5% in 2009.

• Note that Medicare projects per capita health care costs will increase at annual rates of 7 - 7.5% through 2011. (National Health Care Expenditures Projections: 2004-2014), at http://www.cms.hhs.gov/statistics/nhe/projections-2004/proj2004.pdf

Table 3-6. Analysis 2-349. From Dec. 31, 2002 until Dec. 15, 2003, the Dow

Jones Industrial Average rose from 8,341 to approximately 10,040, or approximately 20%. The GM press release quoted above stated that “Thanks to a $13.5 billion debt offering, improving stock-market conditions, and an expected $4.1 billion the company plans to contribute to the fund after selling its Hughes Electronics Co. subsidiary within the next few weeks, GM expects its pension obligations to be nearly fully funded by the end of this year. The forecast is based on an expected 18% annual return on assets at the end of the calendar year, at a discount rate of 6.25%.” What does this say about the dependence of GM’s pension funds on equity investments?


As we will see later, discount rates are related to the riskiness of activities. Risk correlates with standard deviations, which are shown in Table 3-6 for various asset classes.

Table 3-6. Returns to Asset Classes, 1926-1997 2-36• Table 3-6 • Returns to Asset Classes

Std. Deviation Risk Premium• Nominal Real of over• Asset Class Return Return Annual Returns T- Bills

• Short-term Treasury Bills3.8% 0.7% 3.2% 0%• Intermediate-Term T- Bonds 5.3% 2.2% 5.7% 1.5%

• Long-Term Treasury Bonds 5.2% 2.1% 9.2% 1.4%

• Corporate Bonds 5.7% 2.6% 8.7% 1.9%

• Large-Company Stocks 11% 7.9% 20.3% 7.2%

• Small-Company Stocks 12.7% 9.6% 33.9% 8.9%•


• Assumptions of 18% annual returns are totally unreasonable for any asset class.

Scientific-Atlanta Shareholders’ Equity 2- 38

• In Thousands 2001 2000

• Stockholders' equity • Preferred stock, authorized 50,000,000 shares;

no shares issued • Common stock, $0.50 par value, authorized

350,000,000 shares, issued 164,899,158 shares in 2001 and 159,971,077 shares in 2000 82,450 79,986 Additional paid-in capital 545,602 339,649

• Retained earnings 935,038 607,822

Accumulated other comprehensive income (loss), net of taxes of $3,723,000 in 2001 and

$135,538,000 in 2000 (6,075) 221,141 • 1,557,015 1,248,598

Less - Treasury stock, at cost (859,339 shares in

2001 and 651,805 shares in 2000) 48,076 33,638

[Stockholders’ Equity] 1,508,939 1,214,960

Total Liabilities and Stockholders' Equity $2,002,828 $1,779,460

Scientific-Atlanta Income Statement 2-42• (In Thousands, Except Per Share Data)

2001 2000 1999 Sales $2,512,016 $1,715,410 $1,243,473 Costs and expenses Cost of sales 1,718,160 1,212,655 888,162

[Gross margin on sales 793,856 502,755 355,311]sales and administrative 222,027 177,588 162,017 Research and development 154,346 122,403 117,261

Stock compensation 10,778 __ –___ [Operating Profit 406,705 202,764 76,033]

Interest expense 411 564 635 Interest income (36,879) (19,636) (8,526) Other (income) expense, net (67,229) (747) (62,281) Total costs and expenses 2,001,614 1,492,827 1,097,268 Earnings before income taxes 510,402 222,583 146,205 Provision for income taxes 176,728 66,775 43,862

• Net earnings $ 333,674 $ 155,808 $ 102,343 Earnings per common share Basic $ 2.06 $ 0.99 $ 0.67 Diluted $ 1.99 $ 0.94 $ 0.65 Weighted avge. no. common shs. out Basic 161,601 157,807 153,630 Diluted 167,688 164,895 157,130

Scientific-Atlanta Income Statement 2-43• (In Thousands, Except Per Share Data)

2001 2000 1999 Sales $2,512,016 $1,715,410 $1,243,473 Costs and expenses Cost of sales 1,718,160 1,212,655 888,162

[Gross margin on sales 793,856 502,755 355,311]sales and administrative 222,027 177,588 162,017 Research and development 154,346 122,403 117,261

Stock compensation 10,778 __ –___ [Operating Profit 406,705 202,764 76,033]

Interest expense 411 564 635 Interest income (36,879) (19,636) (8,526) Other (income) expense, net (67,229) (747) (62,281) Total costs and expenses 2,001,614 1,492,827 1,097,268 Earnings before income taxes 510,402 222,583 146,205 Provision for income taxes 176,728 66,775 43,862

• Net earnings $ 333,674 $ 155,808 $ 102,343 Earnings per common share Basic $ 2.06 $ 0.99 $ 0.67 Diluted $ 1.99 $ 0.94 $ 0.65 Weighted avge. no. common shs. out Basic 161,601 157,807 153,630 Diluted 167,688 164,895 157,130

Securities Litigation and Income Statements 2-44

In re Software Toolworks, Inc.

• 50 F.3d 615 (9th Cir. 1994)

Securities Litigation and Income Statements 2-45

• July, 1990 registered secondary offering at $18.50.• Stock ultimately fell to $2.375 by Oct. 11, 1990.• Complaint alleges that Toolworks falsely fabricated

1990 income by reporting as revenue sales to original equipment manufacturer (“OEMs”) (Hyosung) with whom Toolworks had no binding agreement.

• Complaint also alleges that Toolworks fabricated large consignment sales in order to meet first quarter 1991 financial projections.

• And alleges that Toolworks lied to SEC in response to questions before the registration statement became effective.

Securities Act of 1933, §11 2-46

• (a) In case any part of the registration statement, when such part became effective, contained an untrue statement of a material fact . . ., any person acquiring such security . . . may, either at law or in equity, in any court of competent jurisdiction, sue – (1) every person who signed the registration statement; * * *

• (5) every underwriter with respect to such security. * * *• (b) Notwithstanding the provisions of subsection (a) no person, other than

the issuer, shall be liable as provided therein who shall sustain the burden of proof -- * * *

• (3) that (A) as regards any part of the registration statement not purporting to be made on the authority of an expert, . . . he had, after reasonable investigation, reasonable ground to believe and did believe, at the time such part of the registration statement became effective, that the statements therein were true . . . (C) as regards any part of the registration statement purporting to be made on the authority of an expert . . . , he had no reasonable ground to believe and did not believe, at the time such part of the registration statement became effective, that the statements therein were untrue or that there was an omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading . . . .

In Re Software Toolworks 2-47

1. Underwriters reasonably relied on the financial statements and did not ignore red flags

2. Underwriters were not entitled to summary judgment on questions arising from press criticism of Toolworks’ accounting, an SEC investigation, and a surprise booking of sales at the last minute before going effective?

In Re Software Toolworks Questions 2-48

1. What legal doctrine would prevent the Hyosung contract from being a binding agreement in March, 1990?


2. If underwriters’ counsel rather than the underwriters had conducted the due diligence, would the court have attached more weight to the argument that they were charged with knowledge of the non-binding nature of the Hyosung contract?


3. Would the officers & directors of Toolworks (who are also liable under §11(a) of the Securities Act) be able to rely on the same defense as the underwriters with respect to the Hyosung contract? Suppose that Toolworks’ lawyer is also a director?


4. What’s a consignment sale contract? Why might it be misleading to include it in the June quarter sales?


5. Why does the court require the underwriters to investigate whether the consignment sale contracts in the June quarter were legitimate obligations, when it didn’t require this for the Hyosung contract?


6. What would your obligations be as a lawyer representing the company in this offering with respect to the Hyosung contract, the revenue from which was reported as part of the audited financial statements?


7. Set out below is part of footnote 1 to Scientific-Atlanta’s financial statements for the year ended June 29, 2001. How would you treat the Hyosung situation if this were the stated policy of Software Toolworks?


“Scientific-Atlanta's revenue recognition policies are in compliance with Staff Accounting Bulletin No. 101 "Revenue Recognition in Financial Statements" issued by the Securities and Exchange Commission. Revenue is recognized at the time product is shipped or title passes pursuant to the terms of the agreement with the customer which include a standard right of return, the amount due from the customer is fixed and collectibility of the related receivable is reasonably assured. Revenue is recognized only when we have no significant future performance obligation.”

Scientific-Atlanta’s Cash from Operations 2-58

(In Thousands) 2001 2000 1999 Operating Activities:

Net earnings $333,674 $155,808 $102,343 Adjustments to reconcile net earnings to net cash provided by operating activities: (Gains) on marketable securities, net (77,953) (5,780) (59,465) Depreciation and amortization 66,342 50,707 46,075 Compensation related to stock benefit plans 26,296 20,779 9,720 Provision for doubtful accounts 1,866 (3,165) (1,615) Losses on sale of property, plant and equipment 2,740 2,396 4,436 (Gain) on sale of businesses, net __ (6,527) __ (Earnings) losses of partnerships, net (257) 754 (6,023) Changes in operating assets and liabilities, net of effects of acquisitions Receivables (170,503) (55,409) (34,209)

Inventories 8,303 (28,308) (29,809) Deferred income taxes (27,530) (22,570) (15,593) Accounts payable and accrued liabilities 17,009 74,435 25,185 Other assets (23,868) (29,204) (7,867) Other liabilities 104,941 71,571 12,658 Exchange rate fluctuations, net (2,181) (3,266) 316 Net cash provided by operating activities 258,879 222,221 46,152

Scientific-Atlanta’s Cash from Investing 2-59

• Investing Activities: 2001 2000 1999

Purchases of property, plant and equipment (104,810) (82,772) (51,352)

Purchases of short-term investments (129,520) (60,628) __

Tender for shares of PowerTV (64,607) __ __

Proceeds from the sale of businesses __ 68,606 __

Proceeds from the sale of investments 84,158 8,719 152,974

Other investments (24,179) (37,713) 4,952

Other 207 106 469

Net cash provided (used) by investing activities (238,751) (103,682)

107,043

Scientific-Atlanta’s Cash from Financing 2- 60

Financing Activities: • Principal payments on long-term debt (397) (298) (923) • Dividends paid (6,458) (5,541) (4,618) • Issuance of stock 87,553 53,087 42,636 • Treasury shares acquired __ (3,745)

(65,228) • Net cash provided (used) by financing

activities 80,698 43,503 (28,133)

• Increase in cash and cash equivalents 100,826 162,042 125,062 • Cash and cash equivalents at beginning

of year 462,496 300,454 175,392

• Cash and cash equivalents at end of year $563,322 $462,496 $300,454

Operating Income v.s Net Income 2-62

• __________________________________________________ Company A Company B

• (000s omittted)_________

• Revenues 20,000 20,000• Operating Profit 4,000 3,000• Interest Expense (2,500) 0• Profit Before Taxes 1,500 3,000• Taxes (@ 35%) (525) (1,050)• After Tax Profit 925 1,950• __________________________________________________


• Calculate the EBIT and EBITDA for Scientific-Atlanta. Which provides a better representation of the cash left for investors?

EBIT for Scientific-Atlanta, 2001 2- 64

• Scientific-Atlanta’s Net Earnings for 2001: $333,674• Add back interest expense: 411• Add back provision for income taxes: 176,728

EBIT:$510,813

EBITDA for Scientific-Atlanta, 2001 2- 65

Scientific-Atlanta’s Net Earnings for 2001: $333,674

Add back interest expense: 411

Add back provision for income taxes: 176,728• Add back depreciation & amortization expense

• (from Cash Flow Statement): 66,342

EBITDA: $577,155

Different Versions of 2001 Results 2-66

• Balance Sheet:• Stockholders’ Equity 2001: $1,508,939

Stockholders’ Equity 2000: - 1,214,960• $293,979• Income Statement:• Net Income: $333,674• Statement of Cash Flows:• Cash provided by operating activities: $258,879• (understates results because of $$170,503 increase in receivables)

• EBIT:• Net Earnings for 2001: $333,674• Add back interest expense: 411• Add back provision for income taxes: 176,728• EBIT: $510,813• EBITDA (Slide 25): $577,155• Less: Equipment Purchases (from Cash Flow Statement) -104,810• Free Cash Flows $472,345

Cost of Goods Sold – Inventory Accounting 2- 67

• Period Purchases Price Sales Price Income• 1 1 unit $1.00• 2 1 unit $1.00• 3 1 unit $1.00• 4 1 unit $2.00• 5 1 unit $2.00• 6 1 unit $2.00 3 units $2.00 = $6.00• First In, First Out (FIFO) accounting:• Income: $6.00• Cost: 3.00 • Net profit $3.00• Last In, First Out (LIFO) accounting:• Income: $6.00• Cost: 6.00 • Net profit: $0.00

Effect of Compounding Depreciation Reserves 3-68

$10 for 9 years 23.58• $10 for 8 years 21.44• $10 for 7 years 19.49• $10 for 6 years 17.72• $10 for 5 years 16.11• $10 for 4 years 14.64• $10 for 3 years 13.31

$10 for 2 years 12.10 $10 for 1 year 11.00 $10 at the end 10.00

– Total: $159.39

Sum of the Digits Method Depreciation 2-69

Year 1 10/55 = 18.1% $18.10 depreciation expense• Year 2 9/55 = 16.3% $16.30 depreciation expense• Year 3 8/55 = 14.5% $14.50 depreciation expense• Year 4 7/55 = 12.7% $12.70 depreciation expense• Year 5 6/55 = 10.9% $10.90 depreciation expense• Year 6 5/55 = 9.1% $9.10 depreciation expense• Year 7 4/55 = 7.2% $7.20 depreciation expense• Year 8 3/55 = 5.5% $5.50 depreciation expense• Year 9 2/55 = 3.6% $3.60 depreciation expense• Year 10 1/55 = 1.8% $1.80 depreciation expense• Total depreciation: $99.70

Double Declining Balance Depreciation 2- 70

• End of Depreciation Remaining

• Year Calculation Expense Balance• 1 $100 (.10 x 2) $20 $80• 2 $80 (.10 x 2) 16 64• 3 $64 (.10 x 2) 12.80 51.20• 4 $51.20 (.10 x 2) 10.24 40.96• 5 $40.96 (.10 x 2) 8.19 32.77• 6 $32.77 (.10 x 2) 6.55 26.22• 7 $26.22 (.10 x 2) 5.24 20.98• 8 $20.98 (.10 x 2) 4.20 16.78• 9 $16.78 (.10 x 2) 3.36 13.42• 10 $13.42 (.10 x 2 2.68 10.74

Statement of Changes in Stockholders’ Equity 2-71

•

• Net Income this year• Less dividends paid• Plus funds raised by new share sales• Less funds expended on stock repurchases

– (like dividends, but not pro rata)

Sources of Industry Classifications 2-72

• “Standard Industrial Classification” (“SIC”) system, for categorizing all companies.

• In 1997 the Census Bureau replaced the SIC with the “North American Industry Classification System” (“NAICS”).

• The US NAICS Manual is published annually, with definitions for each industry classification.

• Risk Management Associates still uses the Standard Industrial Classification (“SIC”) Codes, with a reference to the NAICS codes.

• Location of the NAICS Manual is at www.census.gov/epcd/www/naics.html.

•

http://www.census.gov/epcd/www/naics.html

NAICS Manual – Sample 2- 73

• 334 Computer and Electronic Product Manufacturing• 3341 Computer and Peripheral Equipment Manufacturing• 33411 Computer and Peripheral Equipment Manufacturing• 334111 Electronic Computer Manufacturing• 334112 Computer Storage Device Manufacturing• 334113 Computer Terminal Manufacturing• 334119 Other Computer Peripheral Equipment

Manufacturing• 3342 Communications Equipment Manufacturing• 33421 Telephone Apparatus Manufacturing

33422 Radio and Television Broadcasting and Wireless Communications Equipment Manufacturing

• 33429 Other Communications Equipment Manufacturing

NAICS Class 33422 2- 74

• Business Description:• “Scientific_Atlanta, Inc. provides its customers with broadband

transmission networks, digital interactive subscriber systems, content distribution networks and worldwide customer service and support. Established as a Georgia corporation in 1951, we have evolved from a manufacturer of electronic test equipment for antennas and electronics to a producer of a wide variety of products for the cable television industry, including digital video, voice and data communications products. * * * We now operate only in the broadband segment.”

• NAICS Manual: “334220 Radio and Television Broadcasting and Wireless Communication Equipment Manufacturing

• “This industry comprises establishments primarily engaged in manufacturing radio and television broadcast and wireless communications equipment. Examples of products made by these establishments are: transmitting and receiving antennas, cable television equipment, GPS equipment, pagers, cellular phones, mobile communications equipment, and radio and television studio and broadcast equipment.”

Profitability Ratios 2- 75

• Earnings Per Share (the most widely reported ratio)

• Gross Profit % (sales minus cost of goods sold [“Gross Margin on Sales”])

• Profit Margin (Net Income/Sales) (how much of sales winds up as net income?)

• Return on Sales (“ROS”) (EBIT/Sales)

• Return on Assets (ROA) (EBIT/average total assets)

• Sales to Assets (Asset Turnover) Ratio (sales/average total assets)

• Return on Equity (ROE) (net income/average shareholders’ equity)

• Economic Value Added (EVA) (Post-Tax Net Operating Profit/cost of capital)

Financial Leverage Ratios 2-76

• Debt/Assets Ratio

• Debt/Equity Ratio

• Fixed Assets/Tangible Net Worth Ratio (the owners’ investment in plant & equipment)

• Debt/Worth Ratio (Total Liabilities/Tangible Net Worth)

Liquidity Ratios 2- 77

• Current Ratio - Current Assets/Current Liabilities (Difference is Working Capital)

• Quick (“Acid-Test”) Ratio (Cash +short term securities + Receivables/Current Liabilities)

• Cash Ratio (Cash +short term securities/Current Liabilities)

• Times-Interest Earned (Interest Cover) Ratio - EBIT/Interest

Activity Ratios 2-78

• Asset Turnover Ratio (Net Sales/Average Total Assets)

• Receivables Turnover Ratio (Sales/Average Receivables)

• Inventory Turnover Ratio (Cost of Goods Sold/Average Inventory)

Market Value Ratios 2- 79

• Price-Earnings Ratios (Market Price Per Share/Earnings Per Share)

• (Wall St. J. Quote of 9/6/02):

• YTD 52-WEEK YLD VOL NET %CHG HI LO STOCK (SYM) DIV % PE 100s CLOSE CHG

• -42.7 31.19 11.09 SciAtlanta SFA .04 .3 21 12247 13.71 -0.22•

• Dividend Yield (Dividend Per Share/Market Price)

• Dividend Payout Ratio (Dividend Per Share/Earnings Per Share)

• Market to Book Ratio (Stock Price/Book Value Per Share)

• Tobin’s q (Market Value of Assets/Estimated Replacement Cost)

Earnings Per Share 2-80 (Net Earnings/Number of Shares)

Notice this is shown on Scientific-Atlanta’s Income Statement - the only ratio given.

• “Earnings per common share:• Basic $2.06• Diluted $1.99"

• Basic: Net Earnings: $333,674 = $2.0648 Average weighted shares: 161,601

(beginning & end of year)

• Diluted: Net Earnings: $333,674 = $2.0137 Average weighted shares: 167,688

Gross Profit Margin 2- 81

(Gross Profit/Sales)

From Income Statement:

Sales $2,512,016

Cost of Sales - 1,718,160 • Gross Margin on Sales $ 793,856

• Gross profit %: $793,856 = 0.316• $2,512,016

Comparison of S-A’s Gross Profit Margin of 31% 2-82

• MANUFACTURING-RADIO & TELEVISION BROADCASTING COMMUNICATIONS EQUIPMENT SIC# 3663 (NAICS 33422)

• Current Data Sorted By Assets Comparative Historical Data

• * * *

• 15 (4/1-9/30/00) 57 (10/1/00-3/31/01) 4/1/96 - 4/1/97- 3/31/97 3/31/98

• 0-500M 500M-2MM 2-10MM 10-50MM 50-100MM 100-250MM ALL ALL INCOME DATA

– 100.0 100.0 100.0 Net Sales100.0 100.0

49.5 35.4 39.0 Gross Profit 38.0 37.2

Slightly below the median •

Profit Margin 2-83

(Net Income/Sales)

Net Income (per income statement) $333,674 = 0.13283 Sales $2,512,016

Return on Sales (“ROS”) 2-84 (EBIT/Sales)

• Net Earnings for 2001: $333,674• Add back interest expense: 411

• Add back provision for income taxes: 176,728

• EBIT: $510,813

• Thus: EBIT $510,813 = 0.2039• Sales $2,512,016

Return on Assets (“ROA”) 2-85

(EBIT/ Average Total Assets)

• Average total assets = Beginning & ending assets, taken from previous year’s balance sheet.

• Assets:• 2001: $2,002,828• 2000: 1,779,460• Total: $3,782,288 / 2 = $1,891,144

• Thus: (EBIT) $510,813 = 0.27• Assets $1,891,144

Asset Turnover Ratio 2-86 (Sales/Average Total Assets)

Sales $2,512,016 =1.329

Average Total Assets $1,891,144• Compare with industry norms:

MANUFACTURING RADIO & TELEVISION BROADCASTING & COMMUNICATIONS EQUIPMENT SIC# 3663 (NAICS 33422)

• Comparative Historical Data Current Data Sorted By Sales• * * *• 4/1/98- 4/1/99- 4/1/00- 15 (4/1- 9/30/00) 57 (10/1/00 –3/31/01)• 3/31/99 3/31/00 3/31/01• ALL ALL ALL 0-1M 1-3M 3-5M 5-10MM 10-25MM 25MM & OVER• 90 74 72 NUMBER OF STATEMENTS 3 5 5 20 17 22_________

• % % % % % % % % %• RATIOS• * * *

• 2.5 2.5 2.6 2.7 3.0 1.9• 2.0 1.9 (error) SALES/TOTAL ASSETS 1.9 1.8 1.3 • 1.3 1.1 1.1 1.0 1.3 1.1________

• Just barely above the median

Return on Equity (ROE) 2-87

(net income/average shareholders’ equity)

• Average shareholders’ equity is average of ending equity for this year and last year.

• 2000: $1,214,690• 2001: $1,508,939• Total: $2,723,629 / 2 = $1,361,814

• Net Income: $333,674 = 0.245• $1,361,814

Debt/Assets Ratio 2-88

• Total Liabilities $493,889 = 0.246 Total Assets: $2,002,828

Debt/Equity Ratio 2-89

S-A Debt (total liabilities): $493,889 = 0.327

Total Stockholders’ Equity: $1,508,939

Fixed Assets/Tangible Net Worth Ratio 2-90

(Owners’ investment in plant & equipment) • Fixed Assets = Equipment, Plant (less depreciation) & land = $277,615 • Tangible Net Worth (Net worth less intangibles) ($1,508,939 - $81,491) =

$1,427,448• Thus: $277,615 = 0.194• $1,427,448• Compare with industry norms:• MANUFACTURING RADIO & TELEVISION BROADCASTING & COMMUNICATIONS EQUIPMENT SIC# 3663 (NAICS

33422) • Comparative Historical Data Current Data Sorted By Sales• * * *• 4/1/98- 4/1/99- 4/1/00- 15 (4/1- 9/30/00) 57 (10/1/00 –3/31/01)• 3/31/99 3/31/00 3/31/01• ALL ALL ALL 0-1M 1-3M 3-5M 5-10MM 10-25MM 25MM & OVER• 90 74 72 NUMBER OF STATEMENTS 3 5 5 20 17 22_________ • % % % % % % % % %• RATIOS• * * *• .2 .2 .2 .2 .2 .2 • .4 .5 .4 FIXED/WORTH .7 .3 .3• .7 .3 1.0 2.9 7 5_______

Low Ratio makes it a good credit risk as fixed assets are the hardest to realize on in liquidation

•

Debt/Worth Ratio 2-91

(Total Liabilities/Tangible Net Worth)Total Debt (Liabilities) $ 493,889 Tangible Net Worth $1,427,448 Thus $ 493,889_

$1,427,448 = 0.345

Compare with industry norms:

• MANUFACTURING RADIO & TELEVISION BROADCASTING & COMMUNICATIONS EQUIPMENT SIC# 3663 (NAICS 33422)

• Comparative Historical Data Current Data Sorted By Sales• * * *• 4/1/98- 4/1/99- 4/1/00- 15 (4/1- 9/30/00) 57 (10/1/00 –3/31/01)• 3/31/99 3/31/00 3/31/01• ALL ALL ALL 0-1M 1-3M 3-5M 5-10MM 10-25MM 25MM & OVER• 90 74 72 NUMBER OF STATEMENTS 3 5 5 20 17 22_________ • % % % % % % % % %• RATIOS• * * *• .5 .5 .4 1.0 .4 .3 • 1.3 1.5 1.0 DEBT/WORTH 2.1 1.0 .7• 3.1 3.0 2.2 4.9 2.1 1.2_______

Low Debt Worth means it is a safe investment for creditors

Current Ratio 2-92

(Current Assets/Current Liabilities) Current Assets: $1,548,734 = 0.393

• Current Liabilities $394,123

• Compare with industry norms:

• MANUFACTURING RADIO & TELEVISION BROADCASTING & COMMUNICATIONS EQUIPMENT SIC# 3663 (NAICS 33422)

• Comparative Historical Data Current Data Sorted By Sales• * * *• 4/1/98- 4/1/99- 4/1/00- 15 (4/1- 9/30/00) 57 (10/1/00 –3/31/01)• 3/31/99 3/31/00 3/31/01• ALL ALL ALL 0-1M 1-3M 3-5M 5-10MM 10-25MM 25MM & OVER• 90 74 72 NUMBER OF STATEMENTS 3 5 5 20 17

22_________ • % % % % % % % % %• RATIOS• * * *• 3.4 3.6 3.4 2.3 2.5 3.8 • 1.9 1.7 2.2 CURRENT 1.6 2.4 2.9• 1.3 1.2 1,3 .9 1.5 1.7_______

Top quartile – posative working capital

Quick Ratio 2-93 (Cash + Short-Term Securities + Receivables/Current

liabilities)Cash: $563,322Short-term securities: 191,001Receivables 502,289 Total: $1,256,612 Thus: $1,256,612

$394,123 = 3.188Compare:MANUFACTURING RADIO & TELEVISION BROADCASTING & COMMUNICATIONS EQUIPMENT SIC# 3663 (NAICS

33422)

• Comparative Historical Data Current Data Sorted By Sales• * * *• 4/1/98- 4/1/99- 4/1/00- 15 (4/1- 9/30/00) 57 (10/1/00 –3/31/01)• 3/31/99 3/31/00 3/31/01• ALL ALL ALL 0-1M 1-3M 3-5M 5-10MM 10-25MM 25MM & OVER• 90 74 72 NUMBER OF STATEMENTS 3 5 5 20 17 22_________ • % % % % % % % % %• RATIOS• * * *• 2.2 1.7 2.2 1.0 2.2 2.8 • 1.1 1.0 1.0 QUICK .7 1.3 1.2• .6 .5 .6 .5 .8 .8_ _____

Really high and good news for creditors

Cash Ratio 2-94

Cash +short term securities/Current Liabilities)

Cash & equivalents $563,322

Short-term investments $191,001

$754,323• Thus: $754,323

$394,123 = 1.914

Times-Interest Earned (Interest Cover) Ratio 2- 95 (EBIT/Interest)

Net Earnings for 2001: $333,674 Add back interest expense: 411 Add back provision for income taxes: 176,728 EBIT: $510,813Thus: $510,813 = 1242

411 Compare:



22_________ • % % % % % % % % %• RATIOS• * * *• 14.1 14.1 15.7 12.9 35.0 10.3 • 5.6 3.8 4.2 EBIT/INTEREST 4.9 4.6 2.9• 1.6 ,7 1.4 2.0 - 1.6 1.1 _ _____

Way above normal ratios

Receivables Turnover Ratio 2-96

(Sales/Average Receivables)Average Receivables:2000 Ending Receivables: $333,2422001 Ending Receivables: 502,289

$835,531 ÷ 2 = $417,765Sales: $2,512,016 = 6.01Average Receivables: 417,765Comparison:



22_________ • % % % % % % % % %• RATIOS• * * *• 9.5 10.0 8.3 9.1 7.6 7.5• 7.9 7.4 7.1 SALES/RECEIVABLES 7.1 7.0 7.2• 5.6 6.0 5.4 __ 5.0 5.4 6.0 ___

At top of bottom quartile – accoutns may be paid slowly; perhaps anticipates the coming risk with a big account

Inventory Turnover Ratio 2-97

(Cost of Goods Sold/Average Inventory)• 2000 Ending Inventory: $209,916• 2001 Ending Inventory: 201,762• $411,678 ÷ 2 = $205,839 = Avge Inv.

• Cost of Sales: $1,718,160 = 8.347 Average Inventory: $205,839

• Industry Comparison:MANUFACTURING RADIO & TELEVISION BROADCASTING & COMMUNICATIONS EQUIPMENT SIC# 3663 (NAICS

33422)

• Comparative Historical Data Current Data Sorted By Sales• * * *• 4/1/98- 4/1/99- 4/1/00- 15 (4/1- 9/30/00) 57 (10/1/00 –3/31/01)• 3/31/99 3/31/00 3/31/01• ALL ALL ALL 0-1M 1-3M 3-5M 5-10MM 10-25MM 25MM & OVER• 90 74 72 NUMBER OF STATEMENTS 3 5 5 20 17 22_________ • % % % % % % % % %• RATIOS• * * *• 7.6 7.8 8.8 13.0 8.7 7.5 • 4.2 4.1 4.5 COST OF SALES/INVENTORY 4.8 4.0 4.4• 2.4 2.7 2.6 2.2 2.5 3.3 ___

• Near the top; efficiently managing inventory in relation to sales.

Price-Earnings Ratios 2-98

(Market Price Per Share/Earnings Per Share)

Market Price is the Current Market Price, which was $40.60 on June 29,2001.

• Basic:$40.60 = 19.7• $2.06• Diluted: $40.60 = 20.4• $1.99• (Wall St. J. Quote of 9/6/02):

• YTD 52-WEEK YLD VOL NET %CHG HI LO STOCK (SYM) DIV % PE 100s CLOSE CHG

• -42.7 31.19 11.09 SciAtlanta SFA .04 .3 21 12247 13.71 -0.22

Dividend Payout Ratio 2-99 (Dividend Per Share/Earnings Per Share)

– Dividends: $6,458 = 0.019– Earnings: $333,674

Market to Book Ratio 100 (Stock Price/Book Value Per Share)

• Book Value Per Share:• Stockholders’ Equity: $1,508,939• Outstanding Shares: 164,899 = $9.15 book

value

• Market Price: $40.60 = 4.43• Book Value: $9.15

Travelex 101

Travelex 102

chapter 2 financial statements and measuring value

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