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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

Financial Statements

Accounting
Cycle
Adjusted Trial Balance

Periodical Adjustments

Ledger Posting

Trial Balance

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 companys financial statements and other relevant
data on its industry and the economy. Ask questions of the companys
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 commonsize 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 Environment

Business Strategy

Labor Markets
Capital Markets
Product Markets:
Suppliers
Customers
Competitors
Business Regulations

Scope of Business:
Degree of Diversification
Type of Diversification
Competitive Positioning:
Cost Leadership
Differentiation
Key Success Factors & Risks

Business Activities
Operating
Investment
Financing

Accounting Environment

Accounting Strategy

Capital Market Structure


Contracting & Governance
Accounting Conventions &
Regulations
Tax & Financial Accounting
Linkage
Independent Auditing
Legal System for Accounting
Disputes

Choice of:
Accounting Policies
Accounting Estimates
Reporting Formats
Supplementary
Disclosures

Accounting System
Measure & 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 Accounting


Taken 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, writedowns, integration expenses, etc.
Net income from continuing operations This component takes into
account the impact of taxes from continuing operations.

Non-Recurring Items
Discontinued 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 Categories
The 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 averagecost 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 longterm 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 holders Equity basics:


Components of Shareholders Equity
Also 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 companys
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 Statement


Instead 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 Capital
Contributed 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
$750,000
Paid-in capital:
Preferred shares: $
0 ($300,000-$300,000)
Common shares: $150,000($600,000-$450,000)
Paid-in capital $150,000
Legal 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 Split
Stock splits are events that increase the number of shares outstanding and
reduce the par or stated value per share of the companys 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 Flows
The 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 Method
The 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 Operations


Here 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 Activities


Cash 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 Activities
Cash 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 Footnotes


These 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 Responsibility
Auditors 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 Opinion


An 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 Reporting

Objectives 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 Analysts


Here 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 Statements
Common-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 Statement


At 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 Ratios


Ratios were developed to standardize a companys results. They allow analysts
to quickly look through a companys 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 companys 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 companys overall
profitability, and operating efficiency reveals if the companys 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 companys income variance, i.e.
the risk of not generating consistent cash flows over time. Financial risk is the
risk that relates to the companys 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 companys 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 liabilities
2. Quick Ratio
The 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 liabilities
3. Cash Ratio
The 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 liabilities
4. Cash Flow from Operations Ratio
Poor 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 liability
5. Receivable Turnover Ratio
This 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 receivables
Where:
Average receivables = (previously reported account receivable + current
account receivables)/2
6. 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 Ratio


This 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 inventory
Where:
Average inventory = (previously reported inventory + current inventory)/2
8. Average Number of Days in Stock
This 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 turnover
9. Payable Turnover Ratio
This 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
inventory
Average payables = (previously reported accounts payable + current accounts
payable) / 2
10. 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 Ratios
11.Cash Conversion Cycle
This 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 payables
Cash conversion cycle = average collection period + average number of days in
stock - average age of payables
12.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 expenditures

Where:
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 Margin
This 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 Margin


This 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 / sales
Where: 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 assets
OR
Return 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 Turnover
This 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 Turnover
This 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 Turnover
This 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 capital
Where:
Total debt = current + long-term debt
Total capital = total debt + stockholders' equity
2. Debt to Equity
This ratio is similar to debt to capital.
Debt to equity = total debt / total equity
Analysis 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 * ROE
Where:
RR = retention rate = % of total net income reinvested in the company
or, RR = 1 (dividend declared / net income)
ROE = return on equity = net income / total equity
Note 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 System
A 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 equity
The 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 Equation


By 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 Manipulations
ROE = (net income / sales) * (sales / assets) * (assets / equity)

Limitations of Financial Ratios


There 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 Outstanding
The 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 Securities
Dilutive 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%.
XYZs 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?