Analysis of Financial Statement Lec#0 01
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Analysis of Financial Statement Lecture # 01 By: Faisal Dhedhi
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Analysis Of Financial Statement
Transcript of Analysis of Financial Statement Lec#0 01
Analysis of Financial Statement
Lecture # 01
By: Faisal Dhedhi
Teaching & Testing Methodology
• Grading Basis
Quizzes: 15% (3 Quizzes of Equal Points)
Assignments: 5% (4 Assignments of Equal Points)
Project: 15%
Mid-term Exam: 25%
Final Exam: 40%
• Quiz & Exams Testing Style
Various Forms of Objective Questions
Every Topic is IMPORTANT
The Accounting Cycle
Journal Entry
Ledger Posting
Trial BalanceAdjusted Trial Balance
Periodical Adjustments
Financial Statements
Accounting Cycle
Introduction• Financial statements are a snapshot of a company's well being at a
specific point in time. • The length of time (the accounting period) that these financial
statements represent varies; • The timing and the methodology used to record revenues and
expenses may also impact the analysis and comparability of financial statements across companies.
• Accounting statements are prepared in most cases on the basis of these three basic premises:1. The company will continue to operate (going-concern assumptions).2. Revenues are reported as they are earned within the specified accounting period (revenues-recognition principle).3. Expenses should match generated revenues within the specified accounting period (matching principle).
Financial statement analysis framework
Consist of six steps:
1) Sate the objective and context: Determine what questions the analysis seeks to answer, the form in which this information needs to be presented, and what resources and how much time are available to perform the analysis.
2) Gather Data: Acquire the company’s financial statements and other relevant data on its industry and the economy. Ask questions of the company’s management, suppliers and customers and visit company sites.
3) Process the data: Make any appropriate adjustments to the financial statements, calculate ratios. Prepare exhibits such as graphs and common-size balance sheet.
4) Analyze and interpret the data: Use the data to answer the questions stated in the first step. Decide what conclusions or recommendations the information supports.
5) Report the conclusion or recommendations: Prepare a report and communicate it to its intended audience. Be sure the report and its dissemination comply with the code and standards that relate to investments analysis and recommendations.
6) Update the analysis: Repeat these steps periodically and change the conclusions or recommendations when necessary.
Business Environment, Accounting and Financial Statements
Business EnvironmentLabor Markets
Capital Markets
Product Markets:• Suppliers• Customers• Competitors
Business Regulations
Business StrategyScope of Business:• Degree of Diversification• Type of Diversification
Competitive Positioning:• Cost Leadership• Differentiation
Key Success Factors & Risks
Accounting EnvironmentCapital Market Structure
Contracting & Governance
Accounting Conventions & Regulations
Tax & Financial Accounting Linkage
Independent Auditing
Legal System for Accounting Disputes
Accounting StrategyChoice of:• Accounting Policies• Accounting Estimates• Reporting Formats• Supplementary
Disclosures
Business ActivitiesOperating
Investment
Financing
Accounting SystemMeasure & Report
Economic Consequences of
Business Activities
Financial Statements
Basic Accounting Methods• Cash-basis accounting – This method consists of recognizing
revenue (income) and expenses when payments are made (checks issued) or cash is received (deposited in the bank).
• Accrual accounting – This method consists of recognizing revenue in the accounting period in which it is earned (revenue is recognized when the company provides a product or service to a customer, regardless of when the company gets paid). Expenses are recorded when they are incurred instead of when they are paid.
• Benefits of Cash Accounting: It is easy to use and implement because the company records income only when it gets paid and records expenses only when it pays them.
• Benefits of Cash Accounting: If accepted by the IRS (limited cases only), the company is taxed when it has money in the bank.
• Benefits of Cash Accounting: On average, fewer transactions will be recorded (bookkeeping).
• Biggest drawback of cash accounting: Cash accounting can distort a company's actual income and expenses, especially if it extends credit to its customers, purchases raw materials on credit from its suppliers or keeps inventory.
Benefits of Accrual Accounting
• Generally, it provides a clearer picture of the financial performance (income statement) and financial health (balance sheet).
• It allows management to keep track of accounts receivables and payables more efficiently.
• It is more representative of the economic reality of the business. A service provider may not require upfront payment for an annual service; this revenue will be recorded as it is performed, not when it is paid. Similarly, expenses that are paid in advance - such as property taxes, which are paid semiannually - will be recognized on a monthly basis.
• It enhances comparability of performance (income statement) and financial stability (balance sheet) from one period to the next.
• There is a smoother earning stream.
• There is enhanced predictability of future cash flow.
Cash Basis AccountingTaken as is, the financial statements in Figure 6.1 below indicate that XYZ Corporation is not doing well, with a net loss of $43,200, and may not be a good investment opportunity. Figure 6.1: XYZ Corporation's Financial Statements using Cash Basis Accounting
Accrual Basis Accounting:
Armed with some additional information, let's see what the income statement would look like if the accrual-basis accounting method was used. Additional Information:
A1. June 12, 2005 – The company received a rush order for $80,000 of wood panels. The order was delivered to the customer five days later. The customer was given 30 days to pay. (With the cash-basis method, sales are not recorded in the income statement and not recorded in accounts receivables: no cash, no record).A2. June 13, 2003 – The company received $60,000 worth of wood panels to replenish their inventory, and $40,000 was related to the rush order. The company paid the invoice in full to take advantage of a 2% early-payment discount. (With the cash-basis method, this is recorded in full on the income statement, and there is no record of inventory on hand).A3. June 1, 2005 – The company launched an advertising campaign that will run until the end of August. The total cost of the advertising campaign was $15,000 and was paid on June 1, 2005.
XYZ Corporation's Restated Financial Statements using Accrual Basis Accounting
Income statement basics• Multi-Step Income Statement
A multi-step income statement is a condensed statement of income as opposed to a single-step format, which is the more detailed format. Both single and multi-step formats conform to GAAP standards. Both yield the same net income figure
• Sales – These are defined as total sales (revenues) during the accounting period. Remember these sales are net of returns, allowances and discounts
• Cost of goods sold (COGS) – These are all the direct costs related to the product or rendered service sold and recorded during the accounting period. (Reminder: matching principle.)
• Operating expenses – These include all other expenses that are not included in COGS but are related to the operation of the business during the specified accounting period. This account is most commonly referred to as "SG&A" (sales general and administrative) and includes expenses such as selling, marketing, administrative salaries, sales salaries, maintenance, administrative office expenses (rent, computers, accounting fees, legal fees), research and development (R&D), depreciation and amortization, etc.
• Other revenues & expenses – These are all non-operating expenses such as interest earned on cash or interest paid on loans.
• Income taxes – This account is a provision for income taxes for reporting purposes.
Income statement Components:
• Operating income from continuing operations – This comprises all revenues net of returns, allowances and discounts, less the cost and expenses related to the generation of these revenues. The costs deducted from revenues are typically the COGS and SG&A expenses.
• Recurring income before interest and taxes from continuing operations – This component includes, in addition to operating income from continuing operations, all other income, such as investment income from unconsolidated subsidiaries and/or other investments and gains (or losses) from the sale of assets. To be included in this category, these items must be recurring in nature. This component is generally considered to be the best predictor of future earning. That said, it does assume that noncash expenses such as depreciation and amortization are a good indicator of future capital expenditures. Since this component does not take into account the capital structure of the company (use of debt), it is also used to value similar companies.
• Recurring (pre-tax) income from continuing operations – This component takes the company's financial structure into consideration as it deducts interest expenses.
Income statement Components:
• Pre-tax earning from continuing operations – This component considers all unusual or infrequent items. Included in this category are items that are either unusual or infrequent in nature but cannot be both. Examples are an employee-separation cost, plant shutdown, impairments, write-offs, write-downs, integration expenses, etc.
• Net income from continuing operations – This component takes into account the impact of taxes from continuing operations.
Non-Recurring ItemsDiscontinued operations, extraordinary items and accounting changes are all reported as separate items in the income statement. They are all reported net of taxes and below the tax line, and are not included in income from continuing operations. In some cases, earlier income statements and balance sheets have to be adjusted to reflect changes.
• Income (or expense) from discontinued operations – This component is related to income (or expense) generated due to the shutdown of one or more divisions or operations (plants). These events need to be isolated so they do not inflate or deflate the company's future earning potential. This type of nonrecurring occurrence also has a nonrecurring tax implication and, as a result of the tax implication, should not be included in the income tax expense used to calculate net income from continuing operations. That is why this income (or expense) is always reported net of taxes. The same is true for extraordinary items and cumulative effect of accounting changes (see below).
• Extraordinary items - This component relates to items that are both unusual and infrequent in nature. That means it is a one-time gain or loss that is not expected to occur in the future. An example is environmental remediation.
• Cumulative effect of accounting changes - This item is generally related to changes in accounting policies or estimations. In most cases, these are non cash-related expenses but could have an effect on taxes.
Prior Period Adjustments
These adjustments are related to accounting errors. These errors are typically reported in the net income but in some cases are made directly to retained earnings. (These can be found in changes in retained earnings.) These errors are disclosed as footnotes explaining the nature of the error and its effect on net income.
Balance Sheet basics
Balance Sheet CategoriesThe balance sheet provides information on what the company owns (its assets), what it owes (its liabilities) and the value of the business to its stockholders (the shareholders' equity) as of a specific date.
Total Assets = Total Liabilities + Shareholders' Equity• Assets are economic resources that are expected to produce economic
benefits for their owner. • Liabilities are obligations the company has to outside parties. Liabilities
represent others' rights to the company's money or services. Examples include bank loans, debts to suppliers and debts to employees.
• Shareholders' equity is the value of a business to its owners after all of its obligations have been met. This net worth belongs to the owners. Shareholders' equity generally reflects the amount of capital the owners have invested, plus any profits generated that were subsequently reinvested in the company.
• Total assets on the balance sheet are composed of:1. Current Assets – These are assets that may be converted into cash, sold or consumed within a year or less. These usually include:
• Cash – This is what the company has in cash in the bank. Cash is reported at its market value at the reporting date in the respective currency in which the financials are prepared. (Different cash denominations are converted at the market conversion rate.
• Marketable securities (short-term investments) – These can be both equity and/or debt securities for which a ready market exist. Furthermore, management expects to sell these investments within one year's time. These short-term investments are reported at their market value.
• Accounts receivable – This represents the money that is owed to the company for the goods and services it has provided to customers on credit. Every business has customers that will not pay for the products or services the company has provided. Management must estimate which customers are unlikely to pay and create an account called allowance for doubtful accounts. Variations in this account will impact the reported sales on the income statement. Accounts receivable reported on the balance sheet are net of their realizable value (reduced by allowance for doubtful accounts).
• Notes receivable – This account is similar in nature to accounts receivable but it is supported by more formal agreements such as a "promissory notes" (usually a short term-loan that carries interest). Furthermore, the maturity of notes receivable is generally longer than accounts receivable but less than a year. Notes receivable is reported at its net realizable value (what will be collected).
• Inventory – This represents raw materials and items that are available for sale or are in the process of being made ready for sale. These items can be valued individually by several different means - at cost or current market value - and collectively by FIFO (first in, first out), LIFO (last in, first out) or average-cost method. Inventory is valued at the lower of the cost or market price to preclude overstating earnings and assets.
• Prepaid expenses – These are payments that have been made for services that the company expects to receive in the near future. Typical prepaid expenses include rent, insurance premiums and taxes. These expenses are valued at their original cost (historical cost). 2. Long-term assets – These are assets that may not be converted into cash, sold or consumed within a year or less. The heading "Long-Term Assets" is usually not displayed on a company's consolidated balance sheet. However, all items that are not included in current assets are long-term Assets. These are:
• Investments – These are investments that management does not expect to sell within the year. These investments can include bonds, common stock, long-term notes, investments in tangible fixed assets not currently used in operations (such as land held for speculation) and investments set aside in special funds, such as sinking funds, pension funds and plan-expansion funds. These long-term investments are reported at their historical cost or market value on the balance sheet.
• Fixed assets – These are durable physical properties used in operations that have a useful life longer than one year. This includes:
– Machinery and equipment – This category represents the total machinery, equipment and furniture used in the company's operations. These assets are reported at their historical cost less accumulated depreciation.
– Buildings (plants) – These are buildings that the company uses for its operations. These assets are depreciated and are reported at historical cost less accumulated depreciation.
– Land – The land owned by the company on which the company's buildings or plants are sitting on. Land is valued at historical cost and is not depreciable under U.S. GAAP
• Other assets – This is a special classification for unusual items that cannot be included in one of the other asset categories. Examples include deferred charges (long-term prepaid expenses), non-current receivables and advances to subsidiaries.
Intangible assets – These are assets that lack physical substance but provide economic rights and advantages: patents, franchises, copyrights, goodwill, trademarks and organization costs. These assets have a high degree of uncertainty in regard to whether future benefits will be realized. They are reported at historical cost net of accumulated depreciation.
Liabilities:
Liabilities have the same classifications as assets: current and long-term.3. Current liabilities – These are debts that are due to be paid within one year or the operating cycle, whichever is longer; further, such obligations will typically involve the use of current assets, the creation of another current liability or the providing of some service.Usually included in this section are:Bank indebtedness – This amount is owed to the bank in the short term, such as a bank line of credit.Accounts payable – This amount is owed to suppliers for products and services that are delivered but not paid for.Wages payable (salaries), rent, tax and utilities – This amount is payable to employees, landlords, government and others
• Accrued liabilities (accrued expenses) - These liabilities arise because an expense occurs in a period prior to the related cash payment. This accounting term is usually used as an all-encompassing term that includes customer prepayments, dividends payables and wages payables, among others.
• Notes payable (short-term loans) – This is an amount that the company owes to a creditor, and it usually carries an interest expense.
• Unearned revenues (customer prepayments) – These are payments received by customers for products and services the company has not delivered or started to incur any cost for its delivery.
• Dividends payable – This occurs as a company declares a dividend but has not of yet paid it out to its owners.Current portion of long-term debt - The currently maturing portion of the long-term debt is classified as a current liability. Theoretically, any related premium or discount should also be reclassified as a current liability.
• Current portion of capital-lease obligation – This is the portion of a long-term capital lease that is due within the next year.
4. Long-term Liabilities – These are obligations that are reasonably expected to be liquidated at some date beyond one year or one operating cycle. Long-term obligations are reported as the present value of all future cash payments. Usually included are:
• Notes payables – This is an amount the company owes to a creditor, which usually caries an interest expense.
• Long-term debt (bonds payable) – This is long-term debt net of current portion.
• Deferred income tax liability – GAAP allows management to use different accounting principles and/or methods for reporting purposes than it uses for corporate tax fillings (IRS). Deferred tax liabilities are taxes due in the future (future cash outflow for taxes payable) on income that has already been recognized for the books. In effect, although the company has already recognized the income on its books, the IRS lets it pay the taxes later (due to the timing difference). If a company's tax expense is greater than its tax payable, then the company has created a future tax liability (the inverse would be accounted for as a deferred tax asset).
• Pension fund liability – This is a company's obligation to pay its past and current employees' post-retirement benefits; they are expected to materialize when the employees take their retirement (defined-benefit plan).
• Long-term capital-lease obligation – This is a written agreement under which a property owner allows a tenant to use and rent the property for a specified period of. Long-term capital-lease obligations are net of current portion.
Share holder’s Equity basics:
• Components of Shareholder’s EquityAlso known as “equity” and “net worth”, the shareholders’ equity refers to the shareholders’ ownership interest in a company.Usually included are:
• Preferred stock – This is the investment by preferred stockholders, which have priority over common shareholders and receive a dividend that has priority over any distribution made to common shareholders. This is usually recorded at par value.
• Additional paid-up capital (contributed capital) – This is capital received from investors for stock; it is equal to capital stock plus paid-in capital. It is also called “contributed capital”.Common stock – This is the investment by stockholders, and it is valued at par or stated value.
• Retained earnings – This is the total net income (or loss) less the amount distributed to the shareholders in the form of a dividend since the company’s initiation.
• Other items – This is an all-inclusive account that may include valuation allowance and cumulative translation allowance (CTA), among others. Valuation allowance pertains to noncurrent investments resulting from selective recognition of market value changes.
Stockholders’ Equity StatementInstead of presenting a detailed stockholders’ equity section in the balance sheet and a retained earnings statement, many companies prepare a stockholders’ equity statement.
This statement shows the changes in each type of stockholders’ equity account and the total stockholders’ equity during the accounting period. This statement usually includes:
• Preferred stock • Common stock • Issue of par value stock • Additional paid-in capital • Treasury stock repurchase • Retained earning
• Contributed CapitalContributed capital is the total legal capital of the corporation (par value of preferred and common stock) plus the paid-in capital.
• Par value – This is a value of preferred and common stock that is arbitral (artificial); it is set by management on a per share basis. This artificial value has no relation or impact on the market value of the shares.
• Legal capital of the corporation – This is par value per share multiplied by the total number of shares issued.
• Additional paid-in capital (paid-in capital) – This is the difference between the actual value the company sold the shares for and their par value.
Example: Company XYZ issued 15,000 preferred shares to investors for $300,000.Company XYZ issued 30,000 common shares to investors for $600,000.Par value of preferred shares is $20 per share.Par value of common shares is $15 per share.
Legal capital:Preferred shares: $300,000(15,000 x $20)Common shares: $450,000(30,000 x $15)Legal capital $750,000Paid-in capital:Preferred shares: $ 0 ($300,000-$300,000)Common shares: $150,000($600,000-$450,000)Paid-in capital $150,000Legal capital + Paid-in capital = Contributed Capital
There are two basic dividend forms:
• Cash dividends – These are cash payments made to stockholders of record. Retained earnings are reduced when dividends are declared.
• Stock dividends – These are dividends paid in the form of additional stock of the issuing company to shareholders of record in proportion to their current holdings. A stock dividend does not increase the wealth of the recipient nor does it reduce the net assets of the firm. It is a permanent capitalization of retained earnings to contributed capital.
Dividend Terminology
• Date of Declaration: This is the date the board approved and declared a dividend.
• Date of record: This is the date set by the issuer that determines who is eligible to receive a declared dividend or capital-gains distribution.
• Ex-dividend date: This is the first day of trading when the selling shareholder is entitled to the recently announced dividend payment. Shares purchased as of the ex-dividend date will not receive the previously declared dividend.
• Date of payment: This is the date on which the company will pay the declared dividend to its stockholders of record as of the date of record.
Stock SplitStock splits are events that increase the number of shares outstanding and reduce the par or stated value per share of the company’s stock. For example, a two-for-one stock split means that the company stockholders will receive two shares for every share they currently own. This will double the number of shares outstanding and reduce by half the par value per share. Existing shareholders will see their shareholdings double in quantity, but there will be no change in the proportional ownership represented by the shares (i.e. a shareholder owning 2,000 shares out of 100,000 would then own 4,000 shares out of 200,000).
Most importantly, the total par value of shares outstanding is not affected by a stock split (i.e. the number of shares times par value per share does not change). Therefore, no journal entry is needed to account for a stock split. A memorandum notation in the accounting records indicates the decreased par value and increased number of shares. Stocks that are trading on the exchange will normally be re-priced in accordance to the stock split. For example, if XYZ stock was trading at $90 and the company did a 3-for-1 stock split, the stock would open at $30 a share.Stock splits are usually done to increase the liquidity of the stock (more shares outstanding) and to make it more affordable for investors to buy regular lots (regular lot = 100 shares).
• The statement of cash flow reports the impact of a firm's operating, investing and financial activities on cash flows over an accounting period. The cash flow statement is designed to convert the accrual basis of accounting used in the income statement and balance sheet back to a cash basis.
The cash flow statement will reveal the following to analysts:
• How the company obtains and spends cash
• Why there may be differences between net income and cash flows
• If the company generates enough cash from operation to sustain the business
• If the company generates enough cash to pay off existing debts as they mature
• If the company has enough cash to take advantage of new investment opportunities
Segregation of Cash FlowsThe statement of cash flows is segregated into three sections:
• Operating activities
• Investing activities
• Financing activities
1. Cash Flow from Operating Activities (CFO)CFO is cash flow that arises from normal operations such as revenues and cash operating expenses net of taxes.
2. Cash Flow from Investing Activities (CFI)CFI is cash flow that arises from investment activities such as the acquisition or disposition of current and fixed assets.
3. Cash flow from financing activities (CFF)CFF is cash flow that arises from raising (or decreasing) cash through the issuance (or retraction) of additional shares, short-term or long-term debt for the company's operations.
The statement of cash flow can be presented by means of two ways:The indirect method
The direct method
The Indirect MethodThe indirect method is preferred by most firms because it shows a reconciliation from reported net income to cash provided by operations.
• Calculating Cash flow from OperationsHere are the steps for calculating the cash flow from operations using the indirect method:
Start with net income. • Add back non-cash expenses.
– (Such as depreciation and amortization)
• Adjust for gains and losses on sales on assets. – Add back losses
– Subtract out gains
• Account for changes in all non-cash current assets. • Account for changes in all current assets and liabilities except notes
payable and dividends payable.
In general, candidates should utilize the following rules:• Increase in assets = use of cash (-) • Decrease in assets = source of cash (+) • Increase in liability or capital = source of cash (+) • Decrease in liability or capital = use of cash (-)
Cash Flow from Investment ActivitiesCash Flow from investing activities includes purchasing and selling long-term assets and marketable securities (other than cash equivalents), as well as making and collecting on loans.
Cash Flow from Financing ActivitiesCash Flow from financing activities includes issuing and buying back capital stock, as well as borrowing and repaying loans on a short- or long-term basis (issuing bonds and notes). Dividends paid are also included in this category, but the repayment of accounts payable or accrued liabilities is not.
Free Cash Flow (FCF)Free cash flow (FCF) is the amount of cash that a company has left over after it has paid all of its expenses, including net capital expenditures. Net capital expenditures are what a company needs to spend annually to acquire or upgrade physical assets such as buildings and machinery to keep operating.Free cash flow = cash flow from operating activities – net capital expenditures (total capital expenditure - after-tax proceeds from sale of assets) The FCF measure gives investors an idea of a company's ability to pay down debt, increase savings and increase shareholder value, and FCF is used for valuation purposes.
• Financial Statement FootnotesThese footnotes are additional information provided to the reader in an effort to further explain what is displayed on the consolidated financial statements. Generally accepted accounting principles (GAAP) and the SEC require these footnotes. The information contained in these footnotes help the reader understand the amounts, timing and uncertainty of the estimates reported in the consolidated financial statements. Included in the footnotes are the following:
• Balance sheet and income statement breakdown of items such as:
– The revenues-recognition method used
– Depreciation methods and rates
• Balance sheet and income statement breakdown of items such as:
– Marketable securities
– Significant customers (percentage of customers that represent a significant portion of revenues)
– Sales per regions
– Inventory
– Fixed assets and Liabilities (including depreciation, inventory, accounts receivable, income taxes, credit facility and long-term debt, pension liabilities or assets, contingent losses (lawsuits), hedging policy, stock option plans
Audit: An audit is a process for testing the accuracy and completeness of information presented in an organization's financial statements. This testing process enables an independent Certified Public Accountant (CPA) to issue what is referred to as "an opinion" on how fairly a company's financial statements represent its financial position and whether it has complied with generally accepted accounting principles.
• The audit report is addressed to the board of directors as the trustees of the organization. The report usually includes the following:
• a cover letter, signed by the auditor, stating the opinion.
• the financial statements, including the balance sheet, income statement and statement of cash flows
• notes to the financial statements
• In addition to the materials included in the audit report, the auditor often prepares what is called a "management letter" or "management report" to the board of directors. This report cites areas in the organization's internal accounting control system that the auditor evaluates as weak.What Does the Auditor Do?The auditor will request information from individuals and institutions to confirm:
• bank balances
• contribution amounts
• conditions and restrictions
• contractual obligations
Auditor ResponsibilityAuditors are not expected to guarantee that 100% of the transactions are recorded correctly. They are required only to express an opinion as to whether the financial statements, taken as a whole, give a fair representation of the organization's financial picture. In addition, audits are not intended to discover embezzlements or other illegal acts. Therefore, a "clean" or unqualified opinion should not be interpreted as assurance that such problems do not exist.The Qualified OpinionAn unqualified opinion indicates that the auditor believes the statements are free from material omissions and errors. A qualified opinion is issued when the accountant believes the financial statements are, in a limited way, not in accordance with generally accepted accounting principles. A qualified option may be issued if the auditor has concerns about the going-concern assumption of the company, the valuation of certain items on the balance sheet or some unreported pending contingent liabilities.Proxy Statement: are issued to share holders when there are matters that require a shareholder vote. These statements which are also filed with the SEC and available about the election of different sources.
Objectives of Financial ReportingObjectives of financial reporting identified in SFAC 1 are to do the following:
• They are to provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. (Note the FASB's emphasis on investors and creditors as primary users. However, this does not exclude other interested parties.)
• They are to provide information to help present and potential investors and creditors and other users in assessing the amounts, timing and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sale, redemption or maturity of securities or loans. (Emphasize the difference between the cash basis and the accrual basis of accounting.)
• They are to provide information about the economic resources of an enterprise, the claims on those resources and the effects of transactions, events and circumstances that change its resources and claims to those resources.
Accounting Qualities:
1) Primary qualities of useful accounting information:- Relevance - Accounting information is relevant if it is capable of making a difference in a decision. Relevant information has:(a) Predictive value(b) Feedback value(c) Timeliness- Reliability - Accounting information is reliable to the extent that users can depend on it to represent the economic conditions or events that it purports to represent. Reliable information has:(a) Verifiability(b) Representational faithfulness(c) Neutrality
2) Secondary qualities of useful accounting information:Comparability - Accounting information that has been measured and reported in a similar manner for different enterprises is considered comparable.Consistency - Accounting information is consistent when an entity applies the same accounting treatment to similar accountable events from period to period.
Accounting Qualities and Useful Information for AnalystsHere is how these qualities provide analysts with useful information:Relevance– Relevant information is crucial in making the correct investment decision. Reliability – If the information is not reliable, then no investor can rely on it to make an investment decision.Comparability – Comparability is a pervasive problem in financial analysis even though there have been great strides made over the years to bridge the gap.Consistency – Accounting changes hinder the comparison of operation results between periods as the accounting used to measure those results differ.
Financial Ratio:
A) ANALYZING FINANCIAL STATEMENTS I. Common-Size Financial StatementsCommon-size balance sheets and income statements are used to compare the performance of different companies or a company's progress over time.
Common-Size Balance Sheet is a balance sheet where every dollar amount has been restated to be a percentage of total assets.
Common-Size Income Statement is an income statement where every dollar amount has been restated to be a percentage of sales.
Example: FedEx Common Size Balance Sheet and Income StatementAt first glance, all numbers stated within FedEx's income statement in figure 7.1, and balance sheet in figure 7.2, can seem daunting. It requires close examination to determine whether operating expenses are increasing or decreasing, or which particular expense comprises the highest percentage total operating expenses.
B) Classification of Financial RatiosRatios were developed to standardize a company’s results. They allow analysts to quickly look through a company’s financial statements and identify trends and anomalies. Ratios can be classified in terms of the information they provide to the reader. There are four classifications of financial ratios:Internal liquidity – The ratios used in this classification were developed to analyze and determine a company’s financial ability to meet short-term liabilities.
Operating performance - The ratios used in this classification were developed to analyze and determine how well management operates a company. The ratios found in this classification can be divided into ‘operating profitability’ and ‘operating efficiency’. Operating profitability relates the company’s overall profitability, and operating efficiency reveals if the company’s assets were utilized efficiently.
Risk profile - The ratios found in this classification can be divided into ‘business risk’ and ‘financial risk’. Business risk relates the company’s income variance, i.e. the risk of not generating consistent cash flows over time. Financial risk is the risk that relates to the company’s financial structure, i.e. use of debt.
Growth potential - The ratios used in this classification are useful to stockholders and creditors as it allows the stockholders to determine what the company is worth, and allows creditors to estimate the company’s ability to pay its existing debt and evaluate their additional debt applications, if any.
Internal Liquidity Ratios
1. Current Ratio: This ratio is a measure of the ability of a firm to meet its short-term obligations. In general, a ratio of 2 to 3 is usually considered good. Too small a ratio indicates that there is some potential difficulty in covering obligations. A high ratio may indicate that the firm has too many assets tied up in current assets and is not making efficient use to them.
Current ratio = current assets / current liabilities2. Quick RatioThe quick (or acid-test) ratio is a more stringent measure of liquidity. Only liquid assets are taken into account. Inventory and other assets are excluded, as they may be difficult to dispose of
Quick ratio = (cash+ marketable securities + accounts receivables) current liabilities3. Cash RatioThe cash ratio reveals how must cash and marketable securities the company has on hand to pay off its current obligations.
Cash ratio = (cash + marketable securities)/current liabilities4. Cash Flow from Operations RatioPoor receivables or inventory-turnover limits can dilute the information provided by the current and quick ratios. This ratio provides a better indicator of a company's ability to pay its short-term liabilities with the cash it produces from current operations.
Cash flow from operations ratio = cash flow from operations current liability5. Receivable Turnover RatioThis ratio provides an indicator of the effectiveness of a company's credit policy. The high receivable turnover will indicate that the company collects its dues from its customers quickly. If this ratio is too high compared to the industry, this may indicate that the company does not offer its clients a long enough credit facility, and as a result may be losing sales. A decreasing receivable-turnover ratio may indicate that the company is having difficulties collecting cash from customers, and may be a sign that sales are perhaps overstated.
Receivable turnover = net annual sales / average receivablesWhere:Average receivables = (previously reported account receivable + current account receivables)/26. Average Number of Days Receivables Outstanding (Average Collection Period)This ratio provides the same information as receivable turnover except that it indicates it as number of days.
Average number of days receivables outstanding = 365 days_ receivables turnover
7. Inventory Turnover RatioThis ratio provides an indication of how efficiently the company's inventory is utilized by management. A high inventory ratio is an indicator that the company sells its inventory rapidly and that the inventory does not languish, which may mean there is less risk that the inventory reported has decreased in value. Too high a ratio could indicate a level of inventory that is too low, perhaps resulting in frequent shortages of stock and the potential of losing customers. It could also indicate inadequate production levels for meeting customer demand
Inventory turnover = cost of goods sold / average inventoryWhere: Average inventory = (previously reported inventory + current inventory)/28. Average Number of Days in StockThis ratio provides the same information as inventory turnover except that it indicates it as number of days.Average number of days in stock = 365 / inventory turnover9. Payable Turnover RatioThis ratio will indicate how much credit the company uses from its suppliers. Note that this ratio is very useful in credit checks of firms applying for credit. Payable turnover that is too small may negatively affect a company's credit rating.Payable turnover = Annual purchases / average payables
Where:Annual purchases = cost of goods sold + ending inventory – beginning inventoryAverage payables = (previously reported accounts payable + current accounts payable) / 210. Average Number of Days Payables Outstanding (Average Age of Payables)This ratio provides the same information as payable turnover except that it indicates it by number of days.Average number of days payables outstanding = 365_____ payable turnover
II. Other Internal-Liquidity Ratios11.Cash Conversion CycleThis ratio will indicate how much time it takes for the company to convert collection or their investment into cash. A high conversion cycle indicates that the company has a large amount of money invested in sales in process. Cash conversion cycle = average collection period + average number of days in stock - average age of payablesCash conversion cycle = average collection period + average number of days in stock - average age of payables12.Defensive Interval This measure is essentially a worst-case scenario that estimates how many days the company has to maintain its current operations without any additional sales.
Defensive interval = 365 * (cash + marketable securities + accounts receivable) projected expendituresWhere:Projected expenditures = projected outflow needed to operate the company
7.3 - Operating Profitability Ratios
Operating Profitability can be divided into measurements of return on sales and return on investment
Return on Sales
1. Gross Profit MarginThis shows the average amount of profit considering only sales and the cost of the items sold. This tells how much profit the product or service is making without overhead considerations. As such, it indicates the efficiency of operations as well as how products are priced. Wide variations occur from industry to industry. Gross profit margin = gross profit / net sales
Gross profit = net sales – cost of goods sold
2. Operating Profit MarginThis ratio indicates the profitability of current operations. This ratio does not take into account the company's capital and tax structure.
Operating profit margin = operating income/net sales
3. Per-Tax Margin (EBT margin)This ratio indicates the profitability of Company's operations. This ratio does not take into account the company's tax structure. Pre-tax margin = Earning before tax/sales
4. Net Margin (Profit Margin)This ratio indicates the profitability of a company's operations. Net margin = net income/sales
5. Contribution Margin This ratio indicates how much each sale contributes to fixed expenditures.
Contribution margin = contribution / salesWhere: Contributions = sales - variable cost
Return on Investment Ratios
1. Return on Assets (ROA)
This ratio measures the operating efficacy of a company without regards to financial structure Return on assets = (net income + after-tax cost of interest) average total assetsORReturn on assets = earnings before interest and taxes average total assets
2. Return on Common Equity (ROCE)This ratio measures the return accruing to common stockholders and excludes preferred stockholders. Return on common equity = (net income – preferred dividends) average common equity
3. Return on Total Equity (ROE)This is a more general form of ROCE and includes preferred stockholders.Return on total equity = net income/average total equity
Operating Efficiency Ratios
1. Total Asset TurnoverThis ratio measures a company's ability to generate sales given its investment in total assets. A ratio of 3 will mean that for every dollar invested in total assets, the company will generate 3 dollars in revenues. Capital-intensive businesses will have a lower total asset turnover than non-capital-intensive businesses.Total asset turnover = net sales / average total assets
2. Fixed-Asset TurnoverThis ratio is similar to total asset turnover; the difference is that only fixed assets are taken into account.Fixed-asset turnover = net sales / average net fixed assets
3. Equity TurnoverThis ratio measures a company's ability to generate sales given its investment in total equity (common shareholders and preferred stockholders). A ratio of 3 will mean that for every dollar invested in total equity, the company will generate 3 dollars in revenues. Equity turnover = net sales / average total equity
FINANCIAL RISK RATIOS Financial Risk – This is risk related to the company's financial structure.
Analysis of a Company's Use of Debt
1.Debt to Total Capital This measures the proportion of debt used given the total capital structure of the company. A large debt-to-capital ratio indicates that equity holders are making extensive use of debt, making the overall business riskier.
Debt to capital = total debt / total capitalWhere:Total debt = current + long-term debtTotal capital = total debt + stockholders' equity
2. Debt to EquityThis ratio is similar to debt to capital. Debt to equity = total debt / total equityAnalysis of the Interest Coverage Ratio
3. Times Interest Earned (Interest Coverage ratio)This ratio indicates the degree of protection available to creditors by measuring the extent to which earnings available for interest covers required interest payments.Times interest earned = earnings before interest and tax interest expense
• Growth Potential Ratios
1. Sustainable Growth Rate
G = RR * ROEWhere:RR = retention rate = % of total net income reinvested in the companyor, RR = 1 – (dividend declared / net income)ROE = return on equity = net income / total equityNote that dividend payout is the residual portion of RR. If RR is 80% then 80% of the net income is reinvested in the company and the remaining 20% is distributed in the form of cash dividends.Therefore, Dividend Payout = Dividend Declared/Net Income
Let's consider an example:
DuPont SystemA system of analysis has been developed that focuses the attention on all three critical elements of the financial condition of a company: the operating management, management of assets and the capital structure. This analysis technique is called the "DuPont Formula". The DuPont Formula shows the interrelationship between key financial ratios. It can be presented in several ways. The first is:
Return on equity (ROE) = net income / total equity
If we multiply ROE by sales, we get:
Return on equity = (net income / sales) * (sales / total equity)Said differently:
ROE = net profit margin * return on equityThe second is: Return on equity (ROE) = net income / total equity
If in a second instance we multiply ROE by assets, we get:ROE = (net income / sales) * (sales / assets) * (assets / equity)Said differently:ROE = net profit margin * asset turnover * equity multiplier
Uses of the DuPont EquationBy using the DuPont equation, an analyst can easily determine what processes the company does well and what processes can be improved. Furthermore, ROE represents the profitability of funds invested by the owners of the firm. All firms should attempt to make ROE as high as possible over the long term. However, analysts should be aware that ROE can be high for the wrong reasons. For example, when ROE is high because the equity multiplier is high, this means that high returns are really coming from overuse of debt, which can spell trouble. If two companies have the same ROE, but the first is well managed (high net-profit margin) and managed assets efficiently (high asset turnover) but has a low equity multiplier compared to the other company, then an investor is better off investing in the first company, because the capital structure can be changed easily (increase use of debt), but changing management is difficult. More Useful DuPont Formula ManipulationsROE = (net income / sales) * (sales / assets) * (assets / equity)
Limitations of Financial RatiosThere are some important limitations of financial ratios that analysts should be conscious of:
• Many large firms operate different divisions in different industries. For these companies it is difficult to find a meaningful set of industry-average ratios.
• Inflation may have badly distorted a company's balance sheet. In this case, profits will also be affected. Thus a ratio analysis of one company over time or a comparative analysis of companies of different ages must be interpreted with judgment.
• Seasonal factors can also distort ratio analysis. Understanding seasonal factors that affect a business can reduce the chance of misinterpretation. For example, a retailer's inventory may be high in the summer in preparation for the back-to-school season. As a result, the company's accounts payable will be high and its ROA low.
• Different accounting practices can distort comparisons even within the same company (leasing versus buying equipment, LIFO versus FIFO, etc.).
• It is difficult to generalize about whether a ratio is good or not. A high cash ratio in a historically classified growth company may be interpreted as a good sign, but could also be seen as a sign that the company is no longer a growth company and should command lower valuations.
• A company may have some good and some bad ratios, making it difficult to tell
if it's a good or weak company.
Basic Earnings Per Share
EPS is simply the net income that is attributable to common shareholders divided by the number of shares outstanding. If a company has a complex capital structure, it means that a portion of their dilutive securities may be converted to equity at some point in time. Since EPS basic does not take into account these dilutive securities, EPS basic will always be greater than EPS fully diluted. Basic Earnings Per Share (EPS)EPS basic does not consider potential dilutive securities. A company with a simple capital structure will calculate only a basic EPS, which is defined as:
Basic EPS = (net income – preferred dividends)_____ weighted average number of shares outstanding
- Dividends declared to common stockholders are not subtracted from ESP as they belong to
common stockholders.
- Preferred stock dividends are the current year's dividend only. (a) If none are declared, then calculate an amount equal to what the current dividend would have been. (b) Don't include dividends in arrears. (c) If a net loss occurs, add the preferred dividend.
- EPS is calculated for each component of income: income from continuing operations, income
before extraordinary items or changes in accounting principle, and net income.Calculating the Weighted Average Number of Shares OutstandingThe weighted average number of shares outstanding (WASO) is:
The # of shares outstanding during each month, weighted by the # of months those shares were outstanding.
Dilutive SecuritiesDilutive Securities are securities that are not common stock in form, but allow the owner to obtain common stock upon exercise of an option or a conversion privilege. The most common examples of dilutive securities are: stock options, warrants, convertible debt and convertible preferred stock. These securities would decrease EPS if exercised or if they were converted common stock. In other words, a dilutive security is any securities that could increase the weighted number of shares outstanding.
If a security after conversion causes the EPS figure to increase rather than decrease, such a security is an anti-dilutive security, and it should be excluded from the computation of the dilutive EPS.
For example, assume that the company XYZ has a convertible bond issue: 100 bonds, $1,000 par value, yielding 10%, issued at par for the total of $100,000. Each bond can be converted into 50 shares of the common stock. The tax rate is 30%. XYZ’s weighted average number of shares, used to compute basic EPS, is 10,000. XYZ reported an NI of $12,000, and paid preferred dividends of $2,000.
What is the basic EPS? What is the diluted EPS?
