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Financial Statement Analysis

K.R. Subramanyam

Copyright 2014 McGraw-Hill Education. All rights reser ed. !o reproduction or distri"ution without the prior written consent o# McGraw-Hill Education.

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Analyzing Investing Activities

CHAPTER

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Asset Introduction
Classi$ication Current (Short-term) Assets
Resources or claims to resources that are expected to e sold! collected! or used "ithin one year or the operating cycle! "hichever is longer#

Noncurrent (Longterm) Assets

Resources or claims to resources that are expected to yield ene$its that extend eyond one year or the operating cycle! "hichever is longer#

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Asset Introduction
Classi$ication Current (Short-term) Assets
Cash & Equivalents Accounts Receivables Inventory Prepaid Expenses

Noncurrent (Longterm) Assets

Fixed Assets Intangible Deferred charges

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Current Asset Introduction

Cash! Cash &'uivalents and Li'uidity Cash Currency! coins and amounts on deposit in an% accounts! chec%ing accounts! and some savings accounts#

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Current Asset Introduction

Cash! Cash &'uivalents and Li'uidity Cash &'uivalents Short-term! highly li'uid investments that are( Readily converti le to a %no"n cash amount# Close to maturity date and not sensitive to interest rate changes#

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Current Asset Introduction

Analysis o$ Cash and Cash &'uivalents Companies ris% a reduction in li'uidity should the
mar%et value o$ short-term investments decline# Cash and cash e'uivalents are sometimes re'uired to e maintained as compensating balances to support existing orro"ing arrangements or as collateral $or inde tedness#

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Current Asset Introduction

Receiva les Receivables are amounts due $rom others that arise $rom the sale o$ goods or services! or the loaning o$ money Accounts receivable re$er to oral promises o$ inde tedness due $rom customers Notes receivable re$er to $ormal "ritten promises o$ inde tedness due $rom others

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Current Asset Introduction

+aluation o$ Receiva les Receiva les are reported at their net reali able value ) total amount o$ receiva les less an allo"ance $or uncollecti le accounts *anagement estimates the allo"ance $or uncollecti les ased on experience! customer $ortunes! economy and industry expectations! and collection policies

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Current Asset Introduction

Analyzing Receiva les
Assessment o$ earnings 'uality is o$ten a$$ected y an analysis o$ receiva les and their collecti ility Analysis must e alert to changes in the allo"ance)computed relative to sales! receiva les! or industry and mar%et conditions# ,"o special analysis 'uestions( (1) Collection Risk Revie" allo"ance $or uncollecti les in light o$ industry conditions Apply special tools $or analyzing collecti ility( - .etermining competitors/ receiva les as a percent o$ sales)vis-0-vis the company under analysis - &xamining customer concentration)ris% increases "hen receiva les are concentrated in one or a $e" customers - Investigating the age pattern o$ receiva les)overdue and $or ho" long - .etermining portion o$ receiva les that is a rene"al o$ prior receiva les - Analyzing ade'uacy o$ allo"ances $or discounts! returns! and other credits (2) Authenticity of Receivables Revie" credit policy $or changes Revie" return policies $or changes Revie" any contingencies on receiva les

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Current Asset Introduction

Securitization o$ Receiva les
!ecuriti ation "or factoring# is "hen a company sells all or a portion o$ its receiva les to a third party Receiva les can e sold "ith or "ithout recourse to a uyer (recourse re$ers to guarantee o$ collecti ility) Sale o$ receiva les $ith recourse does not e$$ectively trans$er ris% o$ o"nership

1or securitizations "ith any type o$ recourse! the seller must record oth an asset and a compensating lia ility $or the amount $actored 1or securitizations "ithout any recourse! the seller removes the receiva les $rom the alance sheet

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Current Asset Introduction

2repaid &xpenses
2repaid expenses are advance payments $or services or goods not yet received that extend eyond the current accounting period) examples are advance payments $or rent! insurance! utilities! and property taxes

Analysis o$ 2repaids
,"o analysis issues( (3) 1or reasons o$ expediency! noncurrent prepaids sometimes are included among prepaid expenses classi$ied as current--"hen their magnitude is large! they "arrant scrutiny

(4) Any su stantial changes in prepaid expenses "arrant scrutiny

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Inventories
.e$initions
Inventories are goods held $or sale! or goods ac'uired (or in process o$ eing readied) $or sale! as part o$ a company/s normal operations Expensing treats inventory costs li%e period costs)costs are reported in the period "hen incurred (&xample 5 6$$ice supplies) Capitali ing treats inventory costs li%e product costs)costs are capitalized as an asset and su se'uently charged against $uture period(s) revenues ene$iting $rom their sale (&xample 5 .irect la or)

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Inventories
Inventory Costing *ethod 7se o$ Inventory *ethods in 2ractice

LIFO 30%

FIFO 46%

Weighted Average 20%

Other 4%

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Inventories
1irst-In! 1irst-6ut (1I16)

6ldest Costs

Costs o$ 8oods Sold

Recent Costs

&nding Inventory

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Inventories
Last-In! 1irst-6ut (LI16)

Recent Costs

Costs o$ 8oods Sold

6ldest Costs

&nding Inventory

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Inventories
Average Cost 9hen a unit is sold! the average cost o$ each unit in inventory is assigned to cost o$ goods sold#

Cost o$ 7nits 8oods : availa le on Availa le $or the date o$ Sale sale

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Inventories
Illustration o$ Costing *ethods
Inventory on ;anuary 3! <ear 4 => ? @A>> @ 4>!>>> Inventories purchased during the year B> ? @B>> CB!>>> Cost o$ 8oods availa le $or sale 3>> units @ AB!>>> Note( C> units are sold in <ear 4 $or @D>> each $or total Revenue o$ @4=!>>>

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Inventories
Illustration o$ Costing *ethods
Eeginning Net Inventory F 2urchases G Inventory FIFO $20,000 LIFO $20,000 Average $20,000 + $36,000 + $36,000 + $36,000 Cost o$ 8oods Sold F $15,000 $18,000 $16,800 + + + &nding

$41,000 $38,000 $39,200

Assume sales o$ @CA!>>> $or the period)then gross pro$it under each method is( Sales 5 Cost o$ 8oods Sold G 8ross 2ro$it 1I16 @4=!>>> -- 3A!>>> G @H!>>> LI16 @4=!>>> -- 3D!>>> G @B!>>>

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&conomic 2ro$it vs# Jolding 8ain

In periods of rising prices, FIFO !r"d#$e% higher gr"%% !r"&it% tha' LIFO (e$a#%e )"*er $"%t i've't"rie% are +at$hed agai'%t %a)e% reve'#e% at $#rre't +ar,et !ri$e%- .hi% i% %"+eti+e% re&erred t" a% FIFOs phantom profits. .he FIFO gr"%% !r"&it i% a$t#a))/ a %#+ "& t*" $"+!"'e't%0 a' economic pro$it a'd a holding gain( 1$"'"+i$ !r"&it 30 #'it% 2 3$800 - $6004 $6,000 5")di'g gai' 30 #'it% 2 3$600 - $5004 $3,000

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Inventories
LI16 Li'uidations
(3) Companies maintain LI16 inventories in separate cost pools# (4) 9hen inventory 'uantities are reduced! each cost layer is matched against current selling prices# (C) In periods o$ rising prices! dipping into lo"er cost layers can in$late pro$its#

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Inventories
Analyzing Inventories)Restatement o$ LI16 to 1I16
,hree step process( (3) Reported LI16 Inventory F LI16 reserve (4) .e$erred tax paya le F KLI16 reserve x ,ax rateL (C) Retained earnings F KLI16 reserve x (3-,ax rate)L !I"# reser ve is the amount y "hich current cost exceeds reported cost o$ LI16 inventories

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Long-Lived Asset Introduction

.e$initions
Long-lived assets)resources that are used to generate revenues (or reduce costs) in the long run %angible fixed assets such as property! plant! and e'uipment Intangible assets such as patents! trademar%s! copyrights! and good"ill Deferred charges such as research and development (RM.) expenditures! and natural resources

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Long-Lived Asset Introduction

Capitalization
Capitali ation )process o$ de$erring a cost that is incurred in the current period and "hose ene$its are expected to extend to one or more $uture periods 1or a cost to e capitalized! it must meet each o$ the $ollo"ing criteria( - It must arise $rom a past transaction or event - It must yield identi$ia le and reasona ly pro a le $uture ene$its - It must allo" o"ner (restrictive) control over $uture ene$its

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Long-Lived Asset Introduction

Allocation
Allocation )process o$ periodically expensing a de$erred cost (asset) to one or more $uture expected ene$it periodsN determined y ene$it period! salvage value! and allocation method ,erminology

$ %epreciation $or tangi le $ixed assets $ A&orti ation $or intangi le assets $ %epletion $or natural resources

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Long-Lived Asset Introduction

Impairment
I&pair&ent )process o$ "riting do"n asset value "hen its expected (undiscounted) cash $lo"s are less than its carrying ( oo%) value ,"o distortions arise $rom impairment( - Conservative iases distort long-lived asset valuation ecause assets are "ritten do"n ut not "ritten up - Large transitory e$$ects $rom recognizing asset impairments distort net income#

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2lant Assets

,angi le Actively 7sed in 6perations &xpected to Eene$it 1uture 2eriods 2roperty! 2lant and &'uipment

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2lant Assets
2lant Assets Costing Rule
2urchase price Ac'uisition cost All expenditures needed to prepare the asset $or its intended use

Ac'uisition cost excludes $inancing charges and cash discounts#

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2lant Assets
+aluation Analysis
+aluation emphasizes o Oectivity o$ historical cost! the conservatism principle! and accounting $or the money invested !i&itations of historical costs' - Ealance sheets do not purport to re$lect mar%et values - Not especially relevant in assessing replacement values - Not compara le across companies - Not particularly use$ul in measuring opportunity costs - Collection o$ expenditures re$lecting di$$erent purchasing po"er

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2lant Assets
.epreciation .epreciation is the process o$ allocating the cost o$ a plant asset to expense in the accounting periods ene$iting $rom its use#
Ealance Sheet Ac'uisition Cost (7nused) Income Statement &xpense (7sed)

Cost Allocation

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2lant Assets
1actors in Computing .epreciation ,he calculation o$ depreciation re'uires three amounts $or each asset( Cost# Salvage +alue# 7se$ul Li$e# .epreciation *ethod

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2lant Assets
Comparing .epreciation *ethods Straight-Line *ethod .epreciation G &xpense per <ear Cost - Salvage +alue 7se$ul li$e in periods
SL

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2lant Assets
.ou le-.eclining-Ealance *ethod
Step 3( Straight-line depreciation rate Step 4( .ou le-decliningalance rate Step C( .epreciation expense G 3>> Q 7se$ul li$e Straight-line depreciation rate Eeginning period oo% value

G 4 P

.ou le-decliningalance rate Ignores salvage value

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2lant Assets
Analyzing .epreciation and .epletion
- Assess reasona leness o$ deprecia le ase! use$ul li$e! and allocation method - Revie" any revisions o$ use$ul lives - &valuate ade'uacy o$ depreciation)ratio o$ depreciation to total assets or to other size-related $actors - Analyze plant asset age)measures include Average total life span Average age Average re&aining life Average total life span G 8ross plant and e'uipment assets R Current year depreciation expense# G Accumulated depreciation R Current year depreciation expense# G Net plant and e'uipment assets R Current year depreciation expense# G Average age F Average re&aining life

(these measures also re$lect on pro$it margins and $inancing re'uirements)

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Intangi le Assets
Noncurrent assets "ithout physical su stance# 6$ten provide exclusive rights or privileges#

Intangi le Assets
7se$ul li$e is o$ten di$$icult to determine# 7sually ac'uired $or operational use#

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Intangi le Assets
Accounting $or Intangi le Assets Record at cost! including purchase price! legal $ees! and $iling $ees2atents Copyrights Leaseholds Leasehold Improvements 8ood"ill ,rademar%s and ,rade Names

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Intangi le Assets
Analyzing Intangi les and 8ood"ill
Search $or unrecorded intangi les and
good"ill) o$ten misvalued and most li%ely exist o$$- alance-sheet &xamine $or super earnings as evidence o$ good"ill Revie" amortization periods)any li%ely ias is in the direction o$ less amortization and can call $or adOustments Recognize good"ill has a limited use$ul li$e--"hatever the advantages o$ location! mar%et dominance! competitive stance! sales s%ill! or product acceptance! they are a$$ected y changes in usiness