Financial Statement Analysis

The process of extracting information from financial statements to better understand a

company’s current and future performance and financial condition.

Valuation―the process of drawing on the results of financial statement analysis to estimate

a company’s worth (enterprise value)

Modules 1 and 2 – Understanding business environment and accounting information

Modules 3 and 4 – Profit and risk analysis
Modules 5 to 10 – Adjusting and analyzing financial information and accounting information
Modules 11 onwards – forecasting financial information and using information for valuation

Module 1:

• Investors and equity analysts – Use FS information to judge profitability and financial
strength
• Lenders and credit analysts – assess companies ability to repay debt
• Company managers – inform decisions on where to invest scarce resources

3 types of business activities:

- Operating activities
- Investing activities
- Financing activities
x
In the US, publicly traded firms must file accounting information with the SEC – two main
SEC filings

- Form 10-K – audited annual report

- Form 10-Q – unaudited quarterly report

Benefits of disclosure – capital markets provide debt and equity financing – the better a
company’s prospects, the lower the cost of financing

Costs of disclosure
- Preparation and dissemination costs
- Loss of competitive advantage
- Litigation
- Political costs – public pressure

FASB – financial accounting standards board – issues accounting standards called Generally
Accepted Accounting Principles (GAAP)

Module 2:

Balance sheet basics:

 - Three sections of the balance sheet
o Assets
o Liabilities
o Stockholders’ equity
- Reports all three of these sections at a certain point of time
- Balance sheet accounts are permanent accounts because their balance carries from
period to period

Assets:

- Assets are expected to produce future economic benefits

- An asset must meet the following two conditions to be reported on the balance
sheet.
o It must be owned or controlled by the company.
o It must arise from a past transaction or event.

• Current assets: Assets are current if the company expects to convert the asset to cash
within a year.

- Eg: Cash and cash equivalents, accounts receivable

• Long term assets: PPE, Long term investments, Intangible and other assets

• Most assets are recorded at historical cost - the original acquisition cost and NOT at
current market value

• If a company cannot value an asset with relative certainty, it does not recognize an
asset on the balance sheet – excluded items can include IP assets

• Many valuable asstes such as trademarks are not reported on the balance sheet –
value cannot be estimated, developed in house

Liabilities:

- Liabilities are future economic sacrifices.

- Represents an amount that is to be repaid.
- Can be interest bearing or non-interest bearing
Stockholders’ equity:

- represents capital that has been invested by the stockholders.

- Directly via the purchase of stock
- Indirectly in the form of retained earnings that reflect earnings that are reinvested in
the business and not paid out as dividends.

Current liabilities
 - A/P
- Accr. Liabilities
- Deferred/Unearned revenues - cash received from a customer in advance for goods
or services to be delivered late
- Short term debt
- Current maturities/Current portion of long-term debt—principal portion of long-term
debt that is due to be paid within one year

Net working capital = Current assets – current liabilities

The net working capital required to conduct business depends on the company’s operating
cycle (Aka Cash Conversion Cycle) - time between paying cash for goods and receiving cash
from customers – time for which this cash can be invested.

Non-current liabilities – obligations due after a year

- includes bonds, notes, debentures, mortgages, and other long-term loans

Stockholders’ equity – contributed capital

- Common stock—par value received from the original sale of common stock to
investors
- Additional paid-in capital—amounts received from the original sale of stock to
investors in excess of the par value of stock
- Preferred stock—value received from the original sale of preferred stock to investors
- Treasury stock—amount the company paid to reacquire its common stock from
shareholders. Treasury shares are “held” by the company for potential resale on the
open market. AKA: Capital in excess of par
- Retained earnings - cumulative net income that has not been distributed to
stockholders via dividends or share repurchases

Book value vs. Market value:

• A company’s book value – the company’s stockholders’ equity as per GAAP

• Market value = Number of shares outstanding x market value per share
• GAAP reports assets and liabilities at historical costs, whereas the market attempts to
estimate fair values

Income Statement:

- Reports revenues, expenses and net income during a period

- The income statement is created based on accrual based accounting and not cash
based accounting
- Two principles that guide recognition
o Revenue recognition principle
o Expense recognition principle
- Some income statements also report additional components for discontinued
operations
 o Discontinued operations segregated from “Income from continuing
operations” because they will not recur

Revenue recognition principle: Recognize revenue when the company has done what it is
obligated to do under the sales contract, revenue may or may not coincide with cash
received

Expense recognition principle: recognize expenses when incurred

Gross profit margin = Gross profit/Sales

Operating expense margin = operating expense/sales

Common size income statement = all income statement line items divided by total revenues
- All items represented in % terms

Adjusting for non controlling interest – when income statements show net income separated
into two parts
- Attributable to stockholders – when a controlling interest is owned – determined by
split of common stock owned – if company owns 60% of common stock, 60% of
subsidiary’s income is attributable to owners’ shareholders
- Attributable to noncontrolling interest – when less than 50% of a subsidiary owned

Statement of Stockholders’ equity:

Statement of stockholders’ equity reconciles the beginning and ending balances of

stockholders’ equity account
- Common stock and additional paid-in capital increase by the proceeds from the sale
of stock
- Retained earnings increase by net income and decrease by dividends to shareholders
and by stock repurchased and retired
- Accumulated other comprehensive income increases and decreases by changes in
asset and liability fair values that are not reported in the income statement

Beginning RE + net income – dividends = ending RE

Statement of Cash Flows:

- Income statement prepared based on accrual based accounting

- The statement of cash flows provides information about the company’s ability to
generate cash from its transactions
- The statement of cash flows tells us about sources of cash and what its done with the
cash

Format:

Inflows and outflows:

 1. Cash flows from operating activities
2. Investing activities
3. Financing activities

The 4 step accounting cycle:

1. Record transactions in the accounting records

2. Prepare accounting adjustments to recognize a number of events that have occurred
but that have not yet been recorded
3. Construct the financial statement
4. Close the books in anticipation of the start of a new accounting cycle

T accounts:

- T-accounts capture increases and decreases to individual balance sheet and income
statement accounts
- Assets’ normal balance is on the LEFT. Asset T-accounts record increases on the left
and decreases on the right
- Liabilities’ and Equity accounts have a normal balance on the RIGHT. Their T-accounts
record increases on the right and decreases on the left

Accounting Adjustments:

Purpose of the adjustments – recap

• Revenue recognition principle – recorded when earned
• Expense recognition principle – recorded when incurred to generate revenue

• Companies wait until the end of the period to adjust their financial documents – very
costly and time consuming to adjust on a daily basis

Types of adjustments:

• Deferred revenues – when a customer pays for a good/service before they are
delivered – initially recorded in an unearned revenue account – recording revenue is
deferred until the company meets its obligation
o Prepaid expenses for the good/service (A)
o Unearned revenue (L) – until delivered
• Accrued revenues – companies provide good/service before a customer pays –
revenues that have been earned but not recorded
 • Deferred expenses – the expenses from the use of a particular asset – adjustment
made at the end of every period to show how much of an asset was used in the
period
Eg:

*Land does not depreciate in an accounting sense – equipment and buildings will but land
will not

• To keep track of depreciation subtractions are not made from the asset account but a
‘contra-account’ is used. It is linked to another account in the financial statement but
with an opposite balance
o The contra account used to track depreciation of buildings and equipment is
accumulated depreciation
o Treasury stock is the contra account for stockholders equity

*Cash is never recorded in an adjusting entry because it was either recorded in the past or
will be recorded in the future

• Net book value = ending balance of property and equipment accounts – accumulated
depreciation

• Accrued expenses – Expenses incurred in the current period but which will only be
paid later
• If the financial performance of a company appears strong, the company’s stock rises
– shareholders receive dividends and managers generally receive bonuses and stock
options
o If actual performance lags behind expectations managers and owners may
manipulate accruals and deferrals to make up the difference – misleading the
investors
o Sarbanes Oxley has outlawed such manipulation
Cost to cost method of accounting:

- Recognize revenue over the life of a long term contract in amounts that track to the
percentage of completion of the contract

The Closing Process: aka Closing the books

- ‘zeroing out’ of the temporary accounts by transferring their ending balances to

retained earnings
- Revenues, expenses and dividends are temporary accounts because their balance at
the start of every period is 0
- Retained earnings are not continuously updated, only closed at the end of each
reporting period

Eg to close revenue account:

To close expense accounts :

Module 3 – Profitability Analysis and Interpretation

Return on equity: Relates net income to the average total stockholders equity – measures
return from the perspective of the company’s stockholders

Accounts to use to compute ROE:

For companies with preferred stock:

For companies with noncontrolling interest:

Example:
 125$%
ROE = (3##$5&9()*),(*#3*(&9()*)
= 81%
*

Return on equity drivers:

• Two methods to measure ROE drivers:
o Dupont analysis that disaggregates ROE into components of profitability,
productivity and leverage
o ROE analysis with an operating focus that separates operating and
nonoperating activities

DuPont Disaggregation of ROE: breaks ROE into multiple sections

ROE reflects both:

• Company performance – as measured by ROA

• How assets are finances – measured by financial leverage

Return on Assets:

ROA = Net income / Average total assets

- Measures return from the perspective of the entire company – enterprise level
- To have a high ROA company must be profitable and manage assets ‘
Financial leverage (FL) = Average total assets / average stockholders equity
- Measures the degree to which the company finances its assets with debt versus
equity
- Higher FL increases the probability of default and bankruptcy

Noncontrolling interest ratio:

For most S&P firms NCIR = 1

Disaggregation of ROA into profitability and productivity:

ROA can be increased by increasing PM or AT or both

Analysis of profitability:

• Gross profit margin = gross profit / sales

o Influenced by sale price, COGS, consumer preferences, competition
• Operating expense margin = SG&A Expense / Sales
o Measures general operating costs for each sales dollar
• Asset Turnover = Sales/ Average total assets

Cash conversion cycle = DIO + DSO – DPO

Analysis of PPE:

• PPE Turnover = how many dollars of sales the company receives for each dollar
invested in PPE
• è PPE Turnover = net sales / total PPE net of accumulated depreciation

Analysis of financial leverage:

• Total liabilities to equity = total liabilities/ shareholder’s equity - indicates how much
a company relies on debt financing which can be considered riskier
• Times interest earned = EBIT / Interest and taxes = how easily the company can pay
its debts with its current income

Adjusted ROA =

- Stock buybacks have increased dramatically in the past several years – this reduces
stockholder’s equity and thereby due to the low balance in the ROE, ROE gets
inflated

Operating focus to ROE analysis:

- Balance sheet and income statement include both operating and non-operating
items – analysis can be improved if we separately identify the operating and
nonoperating components of the business and their separate returns
- ROE = operating return + nonoperating return

Operating returns are measured by return on net operating assets (RNOA)

RNOA = net operating profit after tax (NOPAT) / Average net operating assets (NOA)

• Net operating assets = operating assets – operating liabilities

 • Net nonoperating obligations (NNO) = nonoperating liabilities – nonoperating assets
(CASH and cash equivalents are nonoperating)

Net Operating Profit After Tax (NOPAT)

NOPAT = Net operating profit before tax (NOPBT) – tax on operating profit

• NOPBT = sales – operating expenses

• Tax on operating profit = tax expense + (Pretax net nonoperating expense x statutory
tax rate)è tax shield

• Tax shield – taxes a company saves by having tax deductible nonoperating expenses –
do not relate to operating profits and are added back to tax expense to compute tax
on operating profit

Return on Net Operating Assets (RNOA)

RNOA disaggregation into margin and turnover

NOPM – Net operating profit margin – how much operating profit the company earns from
each sales dollar

NOAT – net operating asset turnover – measures the productivity of the company’s net
operating assets
Module 4 – Credit Risk Analysis and Interpretation

Demand and Supply of Credit:

- Credit markets governed by laws of supply and demand

- Main parties that offer credit:
o Trade creditors - suppliers or vendors that a business owes money to for
goods or services that have been delivered or work that has been completed
o Private lenders
o Banks
o Public debt investors
- Credit demanded for operating, investing, financing activities

Demand
Operating activities:
- Companies have cyclical operating cash needs
o For materials and labor
o For advance seasonal purchases

Investing activities – cash needed for investing activities such as new PP&E, intangible assets,
M&A

Financing activities:
- Companies need credit for bank loans or when a bond matures, or to repurchase
stock

Supply of credit-

Trade credit:
- Credit is routine and non interest bearing
- Credit terms specify-
o Details of early payment discounts
o Max credit limit
o Payment terms

Bank loans: Structured differently based on the client needs

• Revolving credit line (revolver) – cash available for seasonal shortfalls, credit
maximum committed to and balance repaid later
• Lines of credit – guarantee that funds will be provided when needed
• Term loans – typically used to fund PP&E purchases and the term matches useful life
of PPE
• Mortgages – used for real estate transactions – lender takes property as security

Other forms of financing :

Lease financing - a financial arrangement that allows a business or individual to use an asset
without purchasing it outright
- Used to finance Capex

Publicly traded debt – cost efficient way to raise large amounts of funding
- Regulated by SEC
- Commercial paper- matures within 270 days
- Bonds and debentures – longer term – trade on major exchanges

The Credit Risk Analysis Process:

Used to quantify the expected credit losses to inform lending decisions

Expected credit loss = chance of default x Loss given default

Credit risk analysis performed by many parties:
- Trade creditors, financial institutions, public debt markets, credit rating agencies

Chance of default: depends on company’s ability to repay obligations – depends on future

performance and cash flows

Steps to assess chance of default:

Step 1 – evaluate nature and purpose of loan

- Nature and purpose of loan affects riskiness

Step 2 – assess macroeconomic environment and industry conditions

- Industry competition increases cost of business
- Bargaining power of buyers – can demand lower prices
- Bargaining power of suppliers – can demand higher prices
- Threat of substitution
- Barriers to entry and economies of scale

Step 3 – analyze financial ratios

- 3 classes of credit risk ratios:
o Capital structure
o Coverage
o Liquidity

Step 4 – perform prospective analysis

- Creditors forecast borrower’s cash flows to estimate ability to repay its obligations
- Compute key ratios using company’s historical and forecasted statements

Loss given default – amount that could be lost if the company defaulted on its obligations

To minimize loss lenders structure credit terms:

• Credit limit – maximum a creditor will allow a customer to owe at any point in time
o Based on customer’s history
o Credit limit can increase/decrease with credit rating
• Collateral – property the borrower pledges to guarantee payment
o Limits the amount of loss but amounts in excess of fair value of the collateral
will be lost
• Repayment terms – length of time the creditor has to repay the debt
o Early payment discounts offered by trade creditors
 • Covenants – loan terms and conditions designed to limit the loss given default
o Three common types of covenants:
§ Require borrower to take actions like submit financial statements to
lender
§ Preventing actions like mergers or major investments
§ Require borrower to maintain specific financial conditions

Computing and Interpreting Credit Risk Measures –

General approach – fundamental questions

- Will company be able to pay back the amount borrowed
- What is the downside risk if the company fails to make payments

Creditors focus on – capital structure (solvency), coverage, and liquidity

- Forecast company’s free operating cash flow and compare with expected maturities
of company’s debt

Capital structure (solvency) analysis:

- Capital structure – the specific mix of debt and equity used to finance and company’s
assets and operations
- Use dupont analysis : total assets / stockholders equity
- And two other common ratios:

Coverage analysis – considers the likelihood that the company will be able to make its
required principal and interest payments

Two categories –

1. Coverage ratios based on income

a. Times interest earned
b. EBITDA coverage ratio
2. Coverage ratios based on operating cash flow
a. Cash from operations to total debt
b. Free operating cash flow to total debt

Times interest earned : operating income available to pay the interest expense
EBITDA coverage ratio – used more widely that times interest earned since D&A do not
require a cash outflow – measures company’s ability to pay interest out of current profits

Cash from operations to total debt – measures the ability to generate additional cash to
cover debt payments as they come due

Cash from operations to total debt = cash from operations / short term debt + long term
debt

Free operating cash flow to total debt – considers excess operating cash flow after cash
spent on capital expenditures

Liquidity Analysis - refers to cash availability

Credit rating – an opinion of an entity’s creditworthiness, captured in alpha-numeric scales

- Affect the cost of debt

- Affect investment decisions

• Each credit rating agency has its own approach to credit rating
• Each model has at least three types of inputs – macroeconomic stats, industry data,
company specific information
 • Below BB is considered non-investment grade

Bankruptcy prediction indicators:

- Altman’s Z model used to predict bankruptcy risk:

Interpretation of Z scores:

Module 10 – Analyzing Leases, Pensions and Taxes

Leases –

• A contract between the owner of the asset and the party desiring to use that asset
• Leases provide the following terms usually –
o Grants lessee unrestricted right to use the asset
o Lessee agrees to maintain the asset and make periodic payments
• Leases are a financing vehicle like a bank loan but with advantages
o Often require less equity investment by the lessee
o Terms can be structures to meet both parties’ needs
o Can be utilized for vehicles, equipment, and real estate
• Leases reported on balance sheet as both assets and liabilities

Lease accounting –

First step is to determine whether a lease is operating or financing

Finance leases meet one or more of the following criteria:

- Transfer of ownership by the end of the lease term – title transfer
- Purchase option to purchase the underlying asset
- Lease term is for a major part of the remaining economic life of the underlying asset
- Specialized asset – expected to have no alternative use at the end of the lease term
- PV of payments is substantially all of the fair market value of the lease
(approximately over 90%)

Three events that happen in leases:

- The effect of leases being discounted to present value is reversed
 - Lease liability eventually Ldecreases to 0
- Right of use asset eventually decreases to 0

Leases and balance sheet:

- A lease liability is recognized at the present value of the remaining lease payments

A right of use asset is recognized at an amount calculated as follows:

- Amount of lease obligation
- + lease payments made at or before commencement date
- - lease incentives received
- + initial direct costs of right of use asset
- = right of use asset

- Finance leases are typically included in PPE, finance lease liabilities included in debt

- Operating lease assets and liabilities reported in a separate line item

Amortization - Amortization and depreciation are two methods of calculating the value of
business assets over time. Amortization is the practice of spreading an intangible asset's cost
over that asset's useful life. Depreciation involves expensing a fixed asset as it's used to
reflect its anticipated deterioration.

Leases and income statement:

- Total expense over the lifetime of the lease is the total remaining lease payments
plus total amortization of any upfront costs
- The income statement reflects total lease cost differently for operating and finance
leases:
o Operating leases - lease expense recognized each period
o Finance lease – includes interest on the lease liability plus straight-line
amortization of the right of use asset

Leases and statement of cash flows:

 - Operating lease – cash flow from operating activities includes the entire lease
payment
- Finance lease – include payment of accrued interest and reduction of the principle
balance of the lease liability
o Interest portion included in net cash flows from operating
o Payment of principal considered financing

For both operating and financing – balance sheet treatment is identical

For income statement and statement of cash flows presentation depends on lease
classification

Analysing and interpreting pension disclosures:

Post-retirement benefit plans:

- Companies generally offer two types of post retirement plans to employees:

- 1. Defined contribution plan – requires the company to make periodic contributions

to an employee’s account
o Most plans require an employee matching contribution
o After retirement employee makes periodic withdrawals from the account
o 401(K) plan is an example – contributions are exempt from federal taxes until
withdrawn by the employee after retirement
- 2. Defined benefit plan – requires company to make periodic payments to a third
party which then makes payments to an employee after retirement
o Vary based on years of service and employee’s salary
o Companies may or may not set aside sufficient funds for this, leading to
benefit plans being either underfunded or overfunded
o All payments retained by third party until paid to employees

Accounting for defined contribution plans:

- Similar to accrual of wages payable

 o When company liable to make its contribution it accrues the liability and the
related expense
o When payment made liability reduced and cash reduced

Accounting for defined benefit plans:

- The company promises to pay retirees based on a formula of the employee’s final
salary level and years of employment which is unknown
- Estimating is difficult and companies usually only set aside the minimum contribution
required by law – makes it uncertain whether funds will be available to make
payments - companies hire actuarial advisors to project these payments

Projected benefit obligations – the present value of the estimated benefit payments to
retirees
- Involves a number of estimates that include
o No. of employees who will reach age of retirement with the company
o Salary levels at retirement – requires an estimate of wage inflation
o Years of service at retirement
o Years over which annual payments will be made – requires estimation of life
span
- These estimates used to estimate the amount that will be paid to employees after
retirement until they die
- This amount is discounted ( at a rate called the settlement rate ) to yield the present
value of the future pension benefits to be paid

On the balance sheet companies report the ‘funded status’ for pension and other post
employment obligations:

Funded Status = Projected Benefit Obligation – Pension Plan Assets

• Pension plan assets – investment portfolio with debt and equity securities
o Portfolio provided a return that will fund future payments to retirees
o Each period portfolio increases with interest, dividends, gains, and additional
contributions
o Portfolio decreases with payments and investment losses
• If the plan assets > PBO è pension plan overfunded and a net asset reported on the
balance sheet
• If PBO > Plan assets è plan is underfunded and balance sheet reports a liability for
the unfunded amount

Funded status is not the only measure to assess a company’s ability to pay pension
obligations – Sufficiency of plan assets
 - Companies usually provide a schedule of expected benefit payments for the next 5
year period – the analysis question is just whether the company’s plan assets will
generate returns sufficient to cover the required pension payments
- If plans are underfunded companies may need to use operating cash flow or borrow
to cover its pension benefit obligations

Defined benefit plans on the income statement:

• Service cost – as employees give more years of service, their salary and their benefits
at retirement increase – this is called service cost
• Interest cost- PBO is computed as present value of expected benefit payments – each
year liability increases by the interest on the PBO liability – computed using the
discount rate
• Investment returns – If investment portfolio generates positive return, plan assets
increase and funded status reduces - creates income
• Actuarial adjustments - computing PBO requires estimates – these estimates can
change and affect funded status

Pension expense smoothing – a mechanism that allows companies to include two items in
comprehensive income and accumulated other comprehensive income (AOCI) instead of net
income – reduces large fluctuations in the funded status and dampens earnings volatility
1. Large investments gains and losses on pension assets
2. Changes in PBO that arise from changes in actuarial assumptions

- Instead of recognizing actual returns on pension assets each year in the income
statement, companies use an expected rate of return over the long term from the
pension plan assets and amortize any excess gains or losses
o Leads to net pension expense in income statement:
Pension plan assets updated each year as follows:

Projected Benefit Obligation updated as follows:

All rates and assumptions used by the company disclosed in the footnotes

Important analysis points:

1. How will pension plans compete with investing and financing needs for the available
cash flows
a. If returns insufficient, company must make up shortfall with other cash flows
– may need to postpone other investments
2. Are pension costs and funded status treated as operating or nonoperating
a. Service cost component in same line item as other compensation costs
b. Other components of pension expense outside of operating income
c. Funded status liability is treated as an operating item

Other Post-Employment Benefits (OPEB)

- Companies may provide healthcare or insurance benefits to retired employees

- Reported as a liability called Accumulated Post-Employment Benefit Obligation
(APBO)
 • Companies have leeway in cash they contribute to pension plans
• Volatility in the amount of cash contributed to pension plans can skew liquidity and
coverage ratios
• Thus analysts may level out such cash flow effects by using an average level of
pension plan cash contributions each year – calculate multi year weighted average
and use to calculate average cash contribution

Income Tax Reporting

When preparing income tax returns, companies prepare statements based on the internal
revenue code (IRC)

- Recognize revenues and expenses differently

- In general, companies seek to report lowest possible income to tax authorities to
reduce tax liability

Timing differences in deferred tax assets and liabilities:

- For tax returns, companies use an accelerated method of depreciation – taxable

income lower in the asset’s early years – tax payments reduced and after-tax cash
flow is increased – excess cash can be reinvested

- Same total depreciation recognized under straight line and accelerated, only the
timing differs

Deferred tax assets arise when the tax payment is greater than the tax expense for financial
reporting purposes – timing difference between GAAP and IRC

Net operating loss carryforwards – IRC permits companies to deduct taxable losses incurred
in current years from taxable income earned in the future
Module 5 – Revenue Recognition and Operating Income

Sales on credit – customer agreed to pay the company in the future

- Company recognizes revenue when the good/service is transferred to the customer –
accounts receivable recorded to be collected later

Revenue recognition rule – 5 steps

1. Identify the contract with the customer – parties and terms of sale
2. Identify performance obligations in the contract – contractual promise to transfer a
good or service
3. Determine transaction price
4. Allocate transaction price to the performance obligation
5. Recognize revenue as/when each performance obligation is satisfied – when
customer obtains control of the good/service

Complications of Revenue Recognition:

• Right of return – estimation of amount that will be returned – deduct to reach net
sales
• Gift cards – recognize when used
• Nonrefundable up front fees – recognize when future good/service is provided
• Bill and hold arrangements – recognize when control of goods transfers to customer
• Consignment sales – if seller acts as an agent, recognize commission
• Licenses – revenue recognition depends on contract
o Right to use – recognize rev when customer can first use licensed IP
o Promise of access – recognize over period of time
• Franchises – goods component recognized when goods transferred to buyer
• Variable consideration – recognize the expected amount to be received when goods
or services are provided
• Multiple element contracts
o Recognize rev separately for each distinct component

Cost to Cost method of accounting:

Recognize revenue over the life of a long term contract in an amount that tracks the
percentage of completion
- If 15% of costs incurred, 15% of revenues will be recognized

Sales Allowances:

Companies offer customers sales allowances such as rights of return, sales discounts for
volume purchases and retailer promotions
- Reduce amount of cash company receives
- Under GAAP companies must report Net sales à companies must deduct allowances
from gross sales
Sales allowances example -

Analysis of sales allowance – three metrics

• Additions charged to gross sales – measures income statement amount – reveals
effects of pricing pressure on net sales – percentage of net sales allowences to gross
sales increases as pricing pressure increases
• Allowance as percentage of gross sales – measures balance sheet amount
• Adequacy of allowance amount – compares estimates to amount actually realized

Because sales allowances require estimates, managers can (and do) pad or shave their
estimates to help the company meet net sales or earnings targets

To adjust our numbers for analysis – we estimate average rate of additions charged by gross
sales

Analyze deferred revenue:

Unearned/deferred revenue – cash received before revenue recorded – liability reduced

when goods or services are delivered

Growth in deferred revenue could predict future increases in revenue and profit and vice
versa
- Slowdown in deferred revenue is a likely predictor of slower revenue growth

Foreign currency exchange rates and how they affect revenue:

Foreign subsidiaries transact in their home currency – before financial statements are
consolidated they must be translated into the US dollar

- As dollar strengthens each unit of foreign currency buys less in dollar terms – means
that income statement and balance sheet items all shrink
- Stockholders equity also changes – cumulative translation adjustment account is
included in AOCI as a component of stockholder’s equity
 Analyze accounts receivable and uncollectible amounts:

• Selling goods on account carries risk of non payment

• GAAP requires companies to estimate the amount of receivables that are likely
uncollectable – bad debt expense on income statement
• Firms frequently employ aging analysis to estimate – groups accounts receivable by
number of days past due

Assuming company has A/R of 100,000 and allowance for uncollectible accounts of 2900

If now a customer who owes 500 files for bankruptcy – 500 written off from from A/R and
allowance adjusted down

Analysis of accounts receivable

1. Accounts receivable turnover = sales / average accounts receivable

2. Days sales outstanding = 365 / accounts receivable turnover

If A/R has grown quicker than sales – lower A/R turnover, longer DSO
- Collected A/R more quickly increases operating cash flow
To adjust – average allowance to A/R used:

Analyze Operating expenses and discontinued operations:

Deductions from income:

- Cost of sales
- SG&A expense
- R&D – analysed by comparing over time and to peers
- Amortization of intangible assets – noncash expense similar to depreciation
- Restructuring charges
- Income taxes
- Discontinued operations
- Income attributable to noncontrolling interest

EBITDA – non GAAP number reported by many companies

- Proponents – metric captures core operating profit and cash flow

- Detractors – adding back D&A removed focus on CAPEX and clouds image of
company’s financial health

Discontinued operations – line item has two components

• Net income (or loss) from segment’s business activities prior to divestiture
• Gain/loss on sale of business

To be classified as a discontinued operation – disposal of business must:

- Represent strategic shift
- Have major effect on company’s financial results

Pro forma income reporting:

• Non gaap numbers that management believes provide a better measure of financial
performance
Module 6 – Asset Recognition and Operating Assets:

Evaluate inventory costing methods:

Flow of costs – when inventory purchased or produced it is capitalized on the balance sheet
- When inventory is sold cost transferred from balance sheet to income statement as
COGS

Capitalization of inventory cost – means that cost is recorded on the balance sheet and is not
immediately expensed in the income statement
- For purchased inventory = purchase price
- For manufactured inventory : capitalize all manufacturing costs – raw materials,
labour, overhead

Gross profit = sales – COGS

- Higher costs for manufacturing – lower gross profit

Companies have a choice when it comes to determining COGS and remaining inventory on
BS:

FIFO - first in first out

LIFO – last in first out
Average Cost – computes average cost of inventory

Retail inventory costing – units available x retail selling price

Financial statement effects of inventory costing:

FIFO yields lowest COGS and highest gross profit

In periods of rising costs LIFO inventory can be markedly lower than FIFO
GAAP requires that companies that use LIFO also report FIFO numbers in footnotes

LIFO reserve = FIFO inventory value – LIFO inventory value

- LIFO generally used to minimize tax expenses (LIFO yields higher COGS)

Inventory disclosures in financial statements:

Lower of cost or market (LCM): If the market value of inventory is lower than its cost – the
inventory must be written down to its market value – noncash expense reflected in COGS
LIFO Reserve adjustments:

FIFO Inventory = LIFO inventory + LIFO reserve

To convert LIFO to FIFO Inventory on balance sheet:

1. Increase inventory by LIFO reserve

2. Increase tax liabilities by tax rate x LIFO reserve
3. Increase retained earnings by difference è LIFO reserve – Tax addition

To convert LIFO to FIFO COGS:

FIFO COGS = LIFO COGS – Change in LIFO reserve

• FIFO COGS will be lower, meaning higher pretax profit, higher income tax and higher
net income

To adjust the income statement:

1. Decrease COGS by change in LIFO reserve
2. Increase tax expense by Increase in LIFO Reserve x tax rate
3. Increase net income by difference è change in lifo reserve – tax change)

LIFO liquidations – assuming an inflationary environment, sales of older inventory can often
boost gross profit as older, lower cost inventory is matched against current selling prices

Analyze inventories and related accounts payable:

Gross profit analysis:

Gross profit margin = gross profit / sales

- measures number of times during period company

sells inventory

- measures number of days required to

sell average inventory available for sale

- Analysis of DIO is important as it indicates inventory quality and asset utilization

- measures number of payment cycles per

period
 - average length of time company
takes to pay suppliers

Cash Conversion Cycle:

Analyze capitalization and depreciation of tangible assets:

- When PP&E acquired – recorded at cost on balance sheet (capitalized) – includes all
costs to put asset into service
- Once capitalized PP&E cost recognized as expense over its life – depreciation
recognizes using up of asset
- Companies may lease PP&E but if lease term exceeds a year equipment capitalized
like other intangibles

To determine depreciation expense – company makes 3 estimates:

1. Useful life
2. Salvage value
3. Depreciation method

Straight line method of depreciation –

Expense = (cost-salvage value)/useful life

Recorded as follows:

Accumulated depreciation contra asset account reduces PPE

Accelerated depreciation – record more depreciation in early years of asset’s useful life

Units of production method – records depreciation according to asset use

R&D facilities and equipment:

- Not immediately expense
- If general use in nature – capitalized on balance sheet and depreciated
 - If have no alternative use expensed immediately
- Usually not capitalized – uncertain results and benefits

Evaluate asset sales, impairments, and restructuring activities

Gain or loss on asset sale =

Net Book Value = acquisition cost less accumulated depreciation

Asset impairment – when market value of PP&E decreases – if decrease is permanent

company must write off impaired cost and recognize losses

Restructuring costs – designed to turn a company around and can involve eliminating
business segments, selling major assets, downsizing workforce
• Costs can include:
o Employee severance or relocation costs – estimated cost
o Asset write downs
o Other restructuring costs

Analyze tangible assets and related activities

PPE Turnover rate =

- Higher is better because it implies lower capital investment for a given level of sales
- Higher turnover increases profitability –
- Turnover lower for capital intensive firms and higher for companies in service or IT

PPE Useful life – assuming straight line and 0 salvage value

PPE percent used up – percent already transferred to income statement

- can help forecast future cash flows –

higher percent used can indicate future capex to replace aging assets

Analyze capitalization and subsequent accounting for intangible assets:

When a company is acquired purchase price allocated to all assets and liabilities
- Intangible assets are also purchased which may not be on the balance sheet – can
explain part of disparity between market value and book value of stockholders equity

Accounting for goodwill - not amortized as it is expected to have an indefinite life

 - Must be evaluated each year for impairment

Module 7- Liability Recognition and Non-Owner Financing

Current liabilities – liabilities that mature within the year

Accrued liabilities – adjustments made to balance sheet after transactions recorded and
prior to issuance of financial statements
- Recognizes liabilities not a result of external transactions

Two broad categories of accruals:

1. Routine contractual liabilities – wages, interest, income taxes, other expenses
incurred but not yet paid
2. Contingent liabilities – depend on occurrence of a future uncertain event
a. Eg – litigation brought against company, warranty liabilities

Contingent liabilities recorded when two conditions met:

- Probable that one or more future events will confirm that a liability existed at the
financial statement date
- Amount required to settle the liability can be reasonably determined at the financial
statement date

Warranty liability – commitments that manufacturers make to repair or replace defective

products within a specific period of time
- If obligation probable and amount estimable companies must record expected cost
of warranties as liability and record related warranty expense in income statement

• Companies may intentionally underestimate warranty liability to report higher

current income or overestimate to underreport – illegal and warranty liability
footnotes must be scrutinized
• Possible due to the large number of estimates involved in warranty expense

Historical average warranty expense used to forecast

Short term debt:

- A current liability
 - Borrower incurs interest
- Under GAAP interest liability and interest expense must be accrued each time
financial statements are issued

Principal payments on long term debt made during next year are called : current maturities
of long term debt

Long Term Debt Pricing:

Issuing bonds in capital markets is a cost efficient way to raise funds
- Bond principal repaid at maturity
- Interest payments made in the interim (usually semi-annually)

Issuance of bonds –
- Companies usually work with an underwriter to set terms of the bond issue
- The underwriter sells individual bonds to its clients and receives a fee for
underwriting the bond issue
- Prospectus needs to be filed with SEC stating key terms – coupon, payments, term

Interest rates and bond prices –

- Issued bonds can trade in secondary market
- Bond prices fluctuate with D and S

• Coupon rate – stated in bond contract – used to compute dollar amount of interest
payments paid to bondholders
• Market rate – rate of return investors expect to earn on their investment in the bond
o Market rate used to price the bond

Bond price = Present value of the annuity payments plus the present value of the lump sum
payment

Pricing of bonds at par:

- When the coupon rate equals the market rate
Pricing of bonds at discount
- When the market rate exceeds the coupon rate – bond carries a coupon rate lower
than what investors demand

Pricing of bonds at premium

- Whenever the coupon rate is greater than the market rate

Effective cost of debt – bonds are priced to yield the return (market rate) demanded by
investors
- The effective rate of a bond ALWAYS equals the yield demanded by investors,
regardless of bond coupon rate
- Companies cannot influence effective cost of debt by raising or lowering coupon
- Effective cost of debt used to determine interest expense reported on the issuers
income statement
Effective cost of debt used to determine interest expense – because of discounts and
premiums interest expense is often different from cash interest paid

Analyze long term debt:

• Companies report debt net of discounts (or including premium)

• Debt note in financial statements includes:
o Maturities, interest rates, premiums/discounts…

Income statement reporting for debt:

FS effects of bond repurchase – when companies repurchase bonds prior to maturity –

companies report a loss on “early debt redemptions”

Net bonds payable = book value or the carrying value of the bond

Time Value of Money:

Module 8 – Equity recognition and owner financing

Analysing stockholder’s equity:

• Companies raise funds by selling shares of stock
• Stockholder’s equity section of balance sheet reports book value of stockholders’
investment
• Two types of stockholder’s equity accounts
o Contributed capital
o Earned capital

Contributed capital accounts:

• Preferred stock – authorized shares indicates how many preferred stocks can be sold
• Common stock – par value, authorized shares, issued shares – how many of
authorized have already been sold

Earned capital accounts:

• AOCI – cumulative changes to SE other than from transactions with owners and
transactions reflected in net income
• RE – net income less dividends

Statement of stockholder’s equity – reconciles beginning and ending balances of SE accounts

Preferred stock – multi use security with number of desirable features

- Dividend and liquidation preferences
- Yield – preferred stock can be structured to provide investors with a dividend yield
just like a bond
- Conversion privileges – conversion into predetermined number of common stock

Treasury shares – number of shares repurchased by the company

Shares outstanding = issued shares – treasury shares
Market capitalization – number of outstanding common shares * market price per share

Noncontrolling interest – portion of a subsidiary’s stock not owned by the company

- Account increases – with additional investment from noncontrolling shareholders
and by their share of the subsidiary’s net income
- Account decreases – by any dividends paid to noncontrolling shareholders, and with
share of net losses of subsidiary

Analyze stock issuances and repurchases:

Stock issuance –
- Increase cash by issue proceeds
- Increase equity through contributed capital
o Common stock increases by number of shares * par valu e
 o APIC increases by remainder

Stock repurchases:
- Company may repurchase for multiple reasons:
o Believes market undervalues stock
o To offset dilutive effects of share-based compensation plans
- Stock repurchase reduces size of company
- Treasury stock (contra equity account) has a negative balance which reduces
stockholder’s equity
- Financial statement effects:
o Reduce cash
o Treasury stock also reduces – negative balance

Reselling treasury stock:

- Cash increases by market value of sold stock
- Treasury stock increases by (cost of treasury stock x number resold)
- APIC increases by remainder

Stock repurchased and retired:

- Cash decreases by total cost of repurchase

- Common stock decreases by par value of common stock
- APIC reduces by remainder (original issue price – par value)
- Retained earnings reduces by any remainder

Stock based compensation – including restricted stock and options

Companies use a range of stock-based compensation plans to:

- Create incentives for employees to act like shareholders
- Encourage employee retention and longevity
o Stocks have vesting period – employees earn right to own or purchase shares
over time

Types of stock-based compensation plans:

- Restricted stock – shares issued to employee but employee not fee to sell shares
during a restriction period
- Restricted stock units – shares only issued to employee after restriction period after
which employee has complete rights
- Employee stock options – employee given right to purchase stocks at fixed strike
price for a specified period of time – has a vesting period before employee can
purchase shares
- Stock appreciation rights – employees paid in stock or cash for stock appreciation
 - Employee share purchase plans – employees permitted to purchase shares directly
from company at a discounted price

Analysis of stock based compensation:

1. Expense recognition –When shares or options awarded, companies must
a. Estimate fair value of award
b. Recognize fair value as compensation expense in period
2. Potential dilution – dilution relates to number of common shares outstanding that
have a claim on company’s earnings
a. Companies often repurchase stock in advance to use for stock based
compensation

Compensation expense is included on income statement but rarely as a separate line item

Financial note disclosures for stock based compensation:

1. Plan activity – company discloses

a. Number of shares granted to employees
b. Number of shares issued
c. Any shares forfeited – employees leave/fail to exercise
2. Fair value and expense
a. What is fair value and how it was determined

Analyze cash dividends and stock splits:

Dividends – can be paid in cash, other assets, or stock

- Stock dividends – company reduces RE and increases contributed capital accounts
Stock splits – where additional shares of stock are distributed to existing shareholders –
usually to reduce stock price to improve marketability of shares
- Not a monetary transaction – no financial statement effects

Dividend payout and yield – metrics uses to assess dividends:

- measures proportion of company’s

earnings paid out as dividends

- measures relation between dividends and

current market value of company’s stock

Cash dividends reduce cash and retained earnings by the same amount – do not affect net
income – affect RE and therefore bypass the income statement
Accumulated Other Comprehensive Income and its components:

Common Items in AOCI:

• Foreign currency translation adjustments – foreign financial statements translated to

US dollar and strengthening/weakening of $US accounted for here
• Employee benefit plans – unrealized gains/losses on pension investments and
liabilities
• Gains and losses on marketable securities – on debt and equity securities
• Gains and losses on derivatives and hedges

Other comprehensive income

- Market values on AOCI items change throughout the year and these changes are
aggregated and labelled OCI

Earnings per share:

Companies report two EPS statistics – basic and diluted

Diluted EPS denominator presumes most extreme case – at beginning of year all option
holders exercise and all convertible debt holders convert

- EPS of different companies cannot be compared – number of shares outstanding not

proportional to income

Module 11 – Financial Statement Forecasting

Forecasting process:

• Integral to many business decisions

• Purpose of forecasting future financial statements:
o Value stocks and inform investment decisions
 o Evaluate creditworthiness of prospective borrower

• Forecasting process begins with retrospective analysis – financial statements

analysed to make sure they accurately reflect company’s core, economic condition
o First – identify and eliminate transitory items

Order of forecasting – income statements, balance sheets, statement of cash flows

- Revenues account most crucial – other income statement and balance sheet
accounts are derived from the revenue

Forecasting consistency and precision – forecasts must be internally consistent and precise.
- Internally consistent – financial statements linked in the same way historical financial
statements are
- Precise – to the nth decimal place

Forecast revenues and income statement:

• Begins with estimate of sales growth rate : forecast = sales * 1+0.0x

• COGS – Use historical ratio of COGS/Sales
• SG&A – Use historical ratio of SG&A / Sales and check MD&A
• Interest expense = average debt balance x estimated interest rate
• Income tax expense – Apply estimated tax rate to pretax income

• Impact of acquisitions:
o Revenues and expenses of acquired company is consolidated but only from
the date of acquisition – can greatly impact IS
o Until all three past income statements include acquired company, the
acquirer must disclose what revenue and net income would have been before
acquisition

• Impact of divestitures: when companies divest of discontinued operations, they are

required to:
o Exclude sales and expenses of discontinued operations
o Separately report net income from discontinued operations
o Report any gain/loss on disposal
o Forecast 0 balances for discontinued operations

Forecast the balance sheet:

Working capital items – inventory, A/R, prepaid expenses etc.

- All forecasted as a % of sales – based on historical
- Nonoperating items are usually assumed to have no change or are predicted using
company guidance

Forecasting CAPEX – guidance provided

Forecasting depreciation expense – estimate historic rate and apply that rate to the
beginning of year PP&E

Forecasting PP&E

Forecasting intangible assets – intangible assets other than goodwill are typically forecasted
to decrease during the year by the expected amortization expense
- Goodwill is not amortized like other intangible assets – forecast no change

Forecasted retained earnings = Current RE + Forecasted NI – Forecasted Dividends

Absent company guidance, estimate dividends using the dividend payout ratio:

Forecasting treasury stock – companies generally disclose in notes or MD&A

Forecasting cash – compute amount of cash needed to balance the balance sheet

Cash = (Total liabilities and equity) – all other asset balances

- Evaluate whether this forecasted amount deviates from historical trend

Prepare forecasts using segment data:

Sales forecast uses an estimate of sales growth for the company as a whole –

alternative approach is to prepare separate sales forecasts for the business

segments and then sum the forecasted segment sales to arrive at the overall

sales estimate
 Forecasting the Statement of Cash Flows:

To prepare SCF we use forecasted IS and BS

• Begins with net income and adds/deducts any noncash expenses or

revenues

• Common method – compute changes in each line item on forecasted

BS and classify as operating, investing, or financing

Multi-Year Forecasting

Same method as one year forecasting

Analysts use multiyear forecasts to – value equity, assess ability to repay debt,

assign credit ratings

Managers – use for CAPEX plans, M&A, cash flow budgets

Module 9 – Intercorporate Investments

Examine and interpret marketable securities reporting
Intercorporate equity investments – where one company purchases voting
stock of another – for multiple reasons:
• Short term investment of excess cash
• Strategic alliances
• Targeted projects – redcue risks with investing alone
• Market penetration or expansion
Levels of ownership interest affects the level of influence or control investor
has over the investee:
• little or no investments (passive investment)
o Small investment – less that 20% of outstanding voting stock
• Significant influence
o 20 to 50% of voting shares
• Control
o Over 50%
o Ability to affect investee’s decisions and hiring

Passive investments

- Companies make passive investments in:

• Marketable securities and non marketable securities (shares of private
 companies)

Acquisition and sale accounting:

- When purchased – shares recorded at fair value – purchase price
- When sold – recognized gain or loss on sale

Changes in the fair value of equity securities during the current period flows to
current period net income

Fair value adjustments:

3 methods to determine fair value: (in order of preferred usage)

Level 1 – quoted market prices if security publicly traded

Level 2 – quoted market prices in active markets for similar securities and
model based valuation techniques
Level 3 – unobservable inputs supported by little/no market activities (market
multiples, DCF)

Investments in debt securities – classified as:

• Held to maturity securities
• Available for sale securities – may be sold prior to maturity
• Trading securities – held for short period and actively traded

HTM debt securities:

- Changes in fair value do not affect BS or IS because with HTM securities
market value will eventually equal face value
- Investment recorded at acquisition cost and amortizes any discount or
 premium over remaining life

Available for sale securities:

- Reported at fair value
- Changes in fair value do not flow to the IS
- Unrealized gains and losses transferred to equity section of BS under AOCI
- When company sells AFS securities any related gains/losses transferred from
AOCI to current period income

Equity investments with significant influence:

Significant influence investments usually made for strategic reasons such as:
• Prelude to acquisition – access to board of directors to learn about
company
• Strategic alliance – permits investor to gain trade secrets, technical
knowhow
• Pursuit of R&D – research activities conducted jointly

Evidence of influence –
• Seat on board of directors
• Investor controls technical knowhow or patents
• Investor able to exert influence due to legal contracts

Companies must use the equity method when significant influence exists:

1. Investments recorded at purchase cost

2. Dividends received reduce investment balance – not reported as
income
3. Investor reports income = percentage share of investee’s net income
4. Investment account increased by percentage share of investees income
or decreased by loss
5. Changes in fair value do not affect investment’s carrying value

Equity method accounting analysis:

- Only investor’s proportion of investee’s equity reported on BS (not assets and

liabilities)
- Only investor’s proportion of investee’s earnings reported on IS (not
underlying sales and expenses)
Equity Investments with Control:

Once control over investee company is achieved GAAP requires consolidation

for financial statements issued to the public

Control –
- Investor has ability to influence investee’s decision making, financial results,
absorb losses/gains, receive residual returns

If the above indicators of economic power are in play, the investment is a

Variable Interest Entity (VIE) – all VIE’s must be consolidated

If VIE test not met, Voting Interest Test is used:

- If investor owns more than 50% of voting stock of investee, economic control
is in evidence and investment must be consolidated

Consolidation accounting includes:

- 100% of investee’s assets and liabilities on BS
- 100% of investee’s sales and expenses on IS

Investments – Subsidiary not wholly-owned

- remaining percentage of equity and net income are owned by noncontrolling
shareholders
• subtracted from consolidated equity and net income to yield
statements that reflect the parent company’s ownership

Investments above book value:

- If a premium paid to book value of stockholder’s equity on the acquisition
date
• Premium related to additional value from corporate synergies
• Premium recognized on balance sheet as goodwill – intangible asset
with indefinite useful life
• Tested for impairment and adjusted as needed – goodwill not
amortized

Consolidation of foreign subsidiaries:

- Financial statements translated into US dollar
- As us $ value of assets and liabilities change so does the stockholder’s equity
account:
• Change in SE – translation adjustment
• Cumulative translation adjustment included in AOCI in SE
Cumulative translation adjustment account remains on BS as long as foreign
subsidiary is owned
-if subsidiary sold translation adjustment account is transferred from AOCI into
current income:

Year over year change in AOCI is called other comprehensive income

Comprehensive income = net income + other comprehensive income

Limitations of consolidation reporting:

i. Consolidated income does not imply the parent company has received
any of the subsidiaries’ net income as cash
a. Parent can only receive cash from subsidiaries via dividend
payments
b. It is possible for a subsidiary to experience cash flow problems
even if the parent has strong cash flows
ii. Consolidated balance sheets and income statements are a mix of
various subsidiaries, often from different industries
a. Comparisons across companies are complicated
iii. Consolidated disclosures are highly aggregated which can affect
effective analysis
a. Consolidated numbers can mask poorly performing subsidiaries

*An analysis challenge arises from a company being acquired part way through
a fiscal year:
- IS only includes months after acquisition
- BS includes all assets and liabilities

Derivative disclosures:

Hedging risk – companies often face many market related risks in addition to
the risks they face in the ordinary course of business
These risks are derived from changes in:
- IR, commodity prices, foreign exchange rates, marketable security price

Can cause earnings and cash flow volatility

- Companies mitigate these risks by purchasing financial securities whose value
is negatively correlated to risk – hedging

Derivatives- companies hedge with derivatives – financial instruments whose

value derives from the value of some underlying asset – insulates against
potential losses but also gives up prospect of gains

Eg – southwest airlines hedges against its jet fuel purchases

Hedge accounting –
- Hedge transactions fall into two groups:
• Hedging the fair value of a recognized asset or liability – called fair
value hedge
o Such as hedging marketable securities
• Hedging future cash flows from forecasted transactions
o Such as commodity/supplies purchases

Fair value hedges

- Both derivative and the recognized asset/liability are reported at fair value on
BS
- Changes in fair value recognized in current earnings
- If hedge is effective changes in fair value of A/L will be offset by opposite
changes in the value of the hedge

Cash flow hedges

- Only derivative reported at fair value on the BS
- Because cash flow hedges are related to forecasted transactions changes in
fair value of derivative are deferred until the transaction occurs
- Unrealized gains/losses includes in comprehensive income and recognized in
AOCI
- When transaction occurs deferred gain or loss shifted from AOCI to current
earnings

Analysis of derivatives
- Companies provide information on the amounts and types of derivatives used
by the company and the purposes for which they are used
- In footnotes – amounts of derivatives, fair values…

For fair value hedges – changes included in current earnings and offsetting
effects generally leave net income/profit unaffected

For cash flow hedges – hedges purchased in advance and gain/loss on

derivative may not match the loss or gain on transaction
- Deferred gain or loss moved from AOCI to CE is the amount of the ffect on
current profit of derivatives

Equity Carve Outs:

- Companies divest subsidiaries in whole or in part
• Can help capture value from high-performing subsidiaires
• May reduce debt, increase liquidity, help raise cash
• Regulators may insist a company divest a part of its business to
approve an acquisition
Types of Equity Carve Outs:

• Sell-offs – parent sells shares of subsidiary to an unrelated party

• IPO – sells unissued shares to public as in IPO
o Ownership diluted but control retained
• Spin-offs – company declares dividend and distributes all shares of the
subsidiary – subsidiary shares can be publicly traded
• Split-offs- parent company repurchases its own shares using shares of
subsidiary – chief difference between spin-off and split-off is the
voluntary nature of a split off – each shareholder decides whether or
not to exchange their shares
Appendix B – Computing and Analyzing Cash Flows

Statement of cash flows – summarizes flow of cash into and out of a company

Allows stakeholders to assess

- Ability to generate positive net cash flows
- Ability to meet debt obligations
- Need for financing
- Ability to pay dividends

SCF prepared from IS and comparative balance sheets

SCF provides information on 4 dimensions:

1. Activity type
a. Operating, investing, financing
2. Liquidity - emphasizes role cash plays in day to day operations
3. Additional detail
a. Depreciation
b. Impairments
c. Stock based comp
d. Cash portion of interest and income tax
e. Gains or losses on asset sales
4. Earnings quality – when profit and operating cash flow differ, reasons
for the difference must be studied

Beginning cash balance + change in cash = ending cash balance

The three types of cash flows roughly correspond to parts of the BS

Operating – current assets and liabilities

Investing – long term assets
Financing – long term liabilities and stockholder’s equity

Non cash adjustments

- Net income includes items that do not involve cash
- Eg – depreciation is a non cash expenditure
- Non cash expenditures added back
- Depreciation, amortization, stock based compensation, deferred income
taxes, losses/gains on investments and derivatives

Computation of operating cash flow:

Investing activities:
- PP&E and intangibles, purchase and sale of stocks/bonds
- Lending and collection of money

Financing activities
- Owner or creditor financing

Net Cash Flows from operating activities:

Two formats to report operating cash flows – direct and indirect method –
most companies use indirect

Indirect method
1. Begin with net income
2. Adjust for noncash revenues/expenses and gains/losses
a. Noncash expenses added back
b. Gains and losses on sale of assets part of investing – remove
from operating
3. Adjust for changes in operating line items
4. Sum up
Net cash flows from investing activities:

- Investing – changes in asset accounts

- To determine net cash flows – analyze changes in all noncash asset accounts
not used to compute operating cash flow
- PP&E , equipment, land, investments

Net cash flows from financing activities:

- Can cause changes in liability and SE accounts

- Accounts affected are noncurrent such as bonds payable, common stock,
current liabilities such as short term notes payable
- We analyze changes in liability and SE accounts not used in operating

When indirect method used – supplemental disclosures required:

- Cash paid for interest and income taxes
- A schedule/description of all noncash investing/financing transactions

Interpret SCF:

3 Overarching principles guide our interpretation and analysis of the SCF:

1. Large and increasing net cash flows from operating activities are
preferred
a. Cash net income is net income plus add backs for non cash
expenses
b. To determine whether particular changes are good/bad –
consult MD&A
2. Negative cash flows from investing not necessarily bad
a. Purchases of CAPEX reduce CF but support growth
b. CAPEX should be greater than depreciation
c. M&A can be justified if lead to immediate income and cash flow
d. Liquidity less critical but excess liquidity allows mgmt. to make
investments without scrutiny if they had issued debt/stock to
fund investments
3. Negative cash flows from financing not necessarily bad
a. Using excess cash flow to reduce financial leverage can be a
sound strategy
b. Distributing excess cash through dividends, share repurchases is
a way to avoid excess liquidity
c. Red flag – when company using financing cash flows to fund net
losses and negative operating cash flows over the long run
Quality of Earnings:

Operating cash flows – split into:

1. Net income
2. Add backs – generally stable
3. Accruals – changes in line item amounts – not stable

Predictability research – how/whether net income, operating CF and accruals

predict future earnings or cash flows
Value-relevance research – how they predict stock price

Predictability research finds that net income compared to operating cash flows
does a better job at predicting future net income

Cash flow patterns:

The product life-cycle framework proposes 4 stages for products or services

1. Introduction
2. Growth
3. Maturity
4. Decline

Revenues grow over first 2 stages, level at maturity and decline

Net losses in introduction, max at maturity and decreases after

Research shows that cash flow patterns can indicate life cycle stage for the
company
Ratio Analysis based on operating cash flows:

Operating cash flows to current liabilities – measures companies ability to

liquidate current liabilities

Operating cash flows to CAPEX – assess a firm’s ability to replace and expand
its PP&E from internally generated cash flow

Abridged definition: Free cash flow = operating cash flow – CAPEX

Free cash flow = NOPAT – NOA

Direct method statement of cash flows:

Presents net cash flow from operating activities by showing major categories of operating cash
receipts and payments

• Convert accrual revenues and expenses to corresponding cash amounts

Only operating section different under direct

Supplemental disclosures for the direct method:

1. Reconciliation of net income to net cash flow from operating – essentially the indirect
method
2. A schedule or description of all noncash investing/financing transactions
3. The firm’s policy for determining which liquid short term investments are treated as cash
equivalents.