01 Financial Reporting and Analysis Flashcards
1
Q
Financial Analysis Framework
Steps (6)
A
- Context of the analysis
- Collected Data
- Process Data
- Analyze/Interpret
- Communicate Conclusions
- Follow Up
2
Q
Financial Analysis Framework
Context of the analysis (3)
A
- Statement of the purpose or objective of the analysis
- List of specific questions to be answered
- Timetable and budget resources for completion
3
Q
Financial Analysis Framework
Collected Data (6)
A
- Financial statements
- Other financial Data
- Questionnaires
- Industry and economic data
- Discussion with management and customers
- Company site visits
4
Q
Financial Analysis Framework
Process data (4)
A
- Adjust financial statements
- Common-size statements
- Ratios and graphs
- Forecasts
5
Q
Financial Analysis Framework
Analyze/Interpret (3)
A
- Historic development
- Comparison with competitors
- Derive buy, hold or sell decision
The answer is seldom a numerical answer alone
6
Q
Financial Analysis Framework
Communicate Conclusion
A
Develop and issue an internal or external report, e.g. equity analysis report
Includes:
- Summary and investment conclusion
- Business summary
- Risks
- Valuation
- Historical pro forma tables
7
Q
Financial Analysis Framework
Follow Up
A
Periodically repeat steps 1-5 to determine whether changes to holdings or recommendation are necessary
8
Q
Role of Financial Reporting
A
Provide information about the company’s performance, financial position, and changes in financial position over the reported period
9
Q
What do primary financial statements include?
A
- Income statement
- Balance sheet
- Cash flow statement
10
Q
What do secondary financial statements include?
A
- Statement of shareholder’s equity
- Financial notes and supplementary schedules
- Management’s discussion and analysis
- Auditor’s reports
11
Q
What do primary and secondary financial statements (along with other information) allow analysts to do?
A
- Evaluate past, current, and prospective performance
- Determine the creditworthiness of a company
- Assigning debt rating or compliance with debt covenants
- Forecasting future net income and cash flow
12
Q
Purpose of Financial Reporting Standards
A
Limit the range of acceptable answers of how business transactions have to be reported
13
Q
Standard- Setting Body in the US
A
The Financial Accounting Standards Board (FASB) is the primary body setting the U.S. GAAP
14
Q
Standard- Setting Body in the EU
A
Listed companies have to adopt International Financial Reporting Standards (IFRS) for financial statements since 2005 issued by the International Accounting Standards Board (IASB)
15
Q
IFRS Framework
A
The International Financial Reporting Standards (IFRS) framework, developed by the International Accounting Standards Board (IASB), is a set of accounting standards that provides guidelines for the preparation and presentation of financial statements globally.
16
Q
IFRS Framework - Objective
A
Provide Fair presentation of
- Financial position
- Financial performance
- Cash flows
17
Q
IFRS Framework - Qualitative Characteristics (4)
A
- Understandability
- Relevance
- Reliability
- Comparability
18
Q
IFRS Framework - Qualitative Characteristics
Understandability
A
Information should be understandable to users with basic knowledge of business, economic activities, accounting and who have the willingness to study the information with reasonable diligence.
19
Q
IFRS Framework - Qualitative Characteristics
Relevance
A
Defined as the influence of an information at hand which must be material, i.e. that omission or misstatement of the information could make a difference to users’ decision
20
Q
IFRS Framework - Qualitative Characteristics
Reliability
A
Defined as Information free from material error or bias and includes the following factors:
- Faithful representation
- Substance over form
- Neutrality
- Prudence
- Completeness
21
Q
IFRS Framework - Qualitative Characteristics
Comparability
A
Defined in the way that information should be presented in a consistent manner over time and between entities
22
Q
IFRS Framework - Reporting Elements
A
Performance
- Income
- Expenses
- Capital Maintenance Adjustments
Financial Position
- Assets
- Liabilities
- Equity
23
Q
IFRS Framework - Constraints (3)
A
- Trade-off between timely information and the time it takes to prepare reliable and audited information -> Timeliness
- The benefit from providing the information should exceed the cost of providing it
- Qualitative characteristics are not directly captured in financial statements, e.g. environmental respectfulness, creativity, or customer loyalty
24
Q
IFRS Framework - Underlying Assumptions
A
- Accrual basis will reflect business transactions when they actually occur not necessarily when cash movement occurs
- Going concern refers to the assumption that the company will business for the foreseeable future
25
Classification of Business Activities - **Groups**
**Business Activities may be classified into three groups** for accounting purposes:
- **Operating** Activities
- **Investing** Activities
- **Financing** Activities
For an analyst it is crucial to understand in which of these areas a company is performing well and where not
26
Classification of Business Activities - **Operating Activities**
- Part of the day-to-day business functioning of an entity
- e.g. sale of meals for a restaurant or making loans by a bank
--> Ideally most of a company’s profits should come from its operating activities
27
Classification of Business Activities - **Investing Activities**
- Associated with the **acquisition and disposal of long-term assets**
- E.g. sale or purchase of a surplus equipment such as an oven for a restaurant
28
Classification of Business Activities - **Financing Activities**
- Those activities related to **obtaining or repaying capital**
- Two **Primary sources**: shareholders or creditors
- E.g. taking a bank loan or issuing bonds
29
Primary Financial Statements
- Balance Sheet
- Income Statement
- Statement of Cash Flows
30
Primary Financial Statements - Balance Sheet
Provides information about a **company’s financial position at a point of time**
- It shows the entity’s assets, liabilities and owner’s equity at a particular date (*Assets - Liabilities = Owners' equity*)
- Two years are usually presented so that comparison can be made
- Less significant accounts can be grouped into a single item
31
Primary Financial Statements - Income Statement
Provides information about a **company’s profitability over a period of time**
- It shows revenue, expense and net income during the period (*Revenue - Expenses = Net Income*)
- Less significant accounts can be groupe
32
Primary Financial Statements - Statement of Cash Flows
Provides information about a **company’s cash flows over a period of time**
- Inflows (receipts) and outflows (payments) are shown (*Delta Cash = CFI + CFF + CFO*)
- The cash flow are categorized according to the business activity
33
Additional Required Financial Statements
- Statement of shareholders equity
- Notes
- Management discussion and analysis (MD&A)
Supplementary schedules are not subject to audits
34
Additional Required Financial Statements - Statement of shareholder's equity
Provides information about the **composition and changes in owner’s equity** during a period of time (*Owners' equity = Contributed capital + Retained Earnings*)
- Contributed capital (preferred and common stock)
- Retained earnings
35
Additional Required Financial Statements - Notes
Explain accounting methods, assumptions and estimates
- Additional information on fixed assets, inventory, income taxes, pensions, debt, significant customers, sales to related party and export sales
- Contingent losses
- Subject to audit
36
Additional Required Financial Statements - Management discussion and analysis (MD&A)
- Required by SEC (Securities and Exchange Commission)
- **Results from operations, including trends in sales and expenses**
- Capital resources, including trend in cash flows
- Discontinued operations
- Effects of currently known trends, events, and uncertainties
37
Balance Sheet
- Starting point for analyzing a company’s financial position
- Provides information about the company’s resources (assets) and its sources of capital (equity and liabilities/debt) at a particular point in time
- It can also be referred to as the statement of financial position or statement of financial condition
38
Equity
A residual or balancing amount, taking assets and liabilities into account
39
Balance Sheet - Format
- **Report format** lists assets, liabilities and equity in a single column
- **Account format** follows the pattern of grouping different accounts into sub-categories to increase the readability of the balance sheet
40
Balance Sheet - Classification of Assets
Assets are classified as current or short-term when they are expected to be liquidated within one year
- Current/noncurrent distinction is an attempt at incorporating liquidity expectations into the balance sheet
- Current assets are allocated immediately when a cash transaction takes place
- Non-current assets are allocated over the useful life of such assets
41
Net Working Capital
Excess of current assets over current liabilities
42
Classified Balance Sheet
Lists assets in order of liquidity (most to least), liabilities are listed in order of when they become due, equity is presented with contributed (or paid-in) capital first and retained earnings last
43
Most current balance sheet items are
- Assets
- Liabilities and Equity
44
Assets - Examples
**Short-term/current assets**
- Cash and cash equivalents
- Accounts receivable, net
- Income tax receivable
- Inventories
- Deferred tax assets
- Prepaid expenses and other assets
**Long-term assets/non-current assets**
- Furniture, fixtures and equipment, net
- Intangible assets, net
- Investments
- Deferred tax assets
- Other assets
45
Liabilities and Equity - Examples
**Current liabilities**
- Accounts payable
- Accrued liabilities
- Current portion of long-term debt
- Income taxes payable
- Deferred tax liabilities
- Deferred revenue
**Long-term debt
Stockholder’s equity**
- Additional paid-in capital
- Retained earnings
- Treasury stock, at cost
- Accumulated other comprehensive income
46
Assets - Definition
Defined as **economic resources controlled by the company** and can be interpreted as a **storage of wealth** as they have not been recorded as expense on the income statement.
47
Current Assets - Definition
Consumed within the longer of one year or the firm’s operating cycle
48
Cash - Definition
Currency or demand deposits
49
Short-term investments - Definition
**Debt or equity investments** for which a **ready market exists** and management intends to **sell them within one year or operating cycle**
50
Accounts Receivable - Definition
**Amounts owed to the firm by customers**, valued at net realizable value
51
Notes Receivable - Definition
Amount owed which will not be collected within the typical collection period, interest is charged on notes receivable
52
Inventory - Definition
**Products that will be sold in the normal course of business**, valued at the lower of cost or market price
53
Prepaid Expenses - Definition
Services paid for but not yet used (e.g. insurance, rent)
54
Property, Plant and Equipment - Definition
**Long-term assets** which are **used in the value-adding process** and are not intended to be sold within one year
- Direct and indirect costs must be capitalized and depreciated over lifetime
55
Intangible Assets - Definition
**Economic resources lacking tangible existence** (e.g. patents, goodwill), valued at historical cost reduced by the amount amortized
56
Liabilities - Definition
Defined as the **amounts received which have not been reported on the income statement** as revenues or income and **have to be repaid**
57
Current Liabilities - Definition
Will be paid within the longer of one year or the firm’s operating cycle
58
Accounts Payable - Defiinition
Amount owed to supplier not yet paid for
59
Wages, rent and other payables - Definition
Amount owed for services used but not yet paid for
60
Notes payable - Definition
Amounts owed to creditors, usually with explicit interest expense
61
Dividends Payable - Definition
Owed to owners, i.e. **declared but not yet paid dividends**
62
Current portion of long-term debt - Definition
The portion that will be paid within one year
63
Long-term liabilities - Definition
Owed to creditors, valued at the present value of future cash flows
64
Equity - Definition
Represents the portion belonging to the shareholder of a business
65
Contributed (paid-in) capital - Definition
Stockholder’s investment in the firm’s equity
66
Common stock - Definition
Portion of stockholder’s investment valued at par or stated value
67
Other paid-in-capital - Definition
Excess of stockholder’s investment over the stock’s par value
68
Retained Earnings - Definition
**Net income less the amount distributed to the owners from the beginning of the business**, it does not represent ready cash
69
Different value definitions in financial reporting (4)
- Fair value
- Historical cost
- Current cost
- Present value
70
Different value definitions in financial reporting - **Fair Value**
Fair value is the **amount at which an asset could be exchanged or liability settled in an arm’s length transaction**. When an asset trades regularly its fair value is determined by its market price (sometimes referred to as fair market value)
71
Different value definitions in financial reporting - **Historical Cost**
Historical cost of an asset or liability is its cost at acquisition, including any cost of acquisition and preparation
72
Different value definitions in financial reporting - **Current cost**
Current cost is the amount at which the asset could be replaced
73
Different value definitions in financial reporting - **Present Value**
Present value is the **discounted value of future cash flows** which can be assigned to this asset
74
Current Assets
Short-term or current assets are those assets hold for less than one year or hold for trading
They are managed to meet the companies seasonal cashflow needs
Examples:
- Cash and cash equivalents
- Marketable securities (held at fair value or at cost)
- Accounts receivable (trade receivables) are amounts owed to the busiess for products already delivered
- Inventory are physical products that will eventually be sold either in their current form (finished goods) or as input to the manufacturing process (raw materials and work-in-progress)
- Other current assets are not easily classifiable into the above categories, e.g. prepaid expenses
75
Accounts receivable and bad debt
- Sales can be recorded directly, i.e. credit sales and debit cash, when cash is received immediately or as a current asset, i.e. credit sales and debit accounts receivable, if cash is to be received at later time
- Uncollectible accounts cannot or will not be paid by the customer
-> Direct write-off
-> Allowance method for doubtful accounts is preferred and consistent with matching principle
- Accounts receivable can be subject to factoring, i.e. with or without recourse
76
Accounts receivable and bad debt - **Promissory Note** (+features)
A promissory note is an **obligation to pay a specific amount at a specific point in the future**. A/R balance is “traded” for longer-term notes receivable. Usually notes have the following features
- Maturity date
- Maturity value
- Interest rate
77
Inventory - Options to value goods
Goods are valued **according to the chosen cost flow assumption**. The actual physical flow may take on a completely different pattern
- First-in, first-out (FIFO)
- Weighted average-cost method (WAC)
- Specific identification method
- Last-in, first-out (LIFO) is allowed under U.S. GAAP, but not allowed under IFRS
- Inventory accounting should best match the cost of goods sold (CoGS) for the accounting period
78
Inventory - LIFO vs. FIFO
**Financial statement adjustments have to be conducted to compare companies using different inventory accounting**
LIFO to FIFO:
- US GAAP requires all companies using LIFO to report a **LIFO reserve** (ResLIFO) which is the difference between ending inventory using FIFO and LIFO
-> Add LIFO reserve
-> Increase retained earning and deferred tax liability
-> Adjust income statement
FIFO to LIFO:
- No Precise calculation
-> Estimating industry inflation ratio
-> Average cost to LIFO
In general, LIFO should be used to examine profitability or cost rations, whereas FIFO is used for assets and equity ratios
79
Current Liabilities
**Liabilities are probable future payments and current liabilities are expected to be due within one year**
- Trade and other payables (accounts payable)
- Notes payable
- Current portion of noncurrent borrowings
- Current tax payable
- Accrued liabilities (accrued expenses)
- Unearned revenue (deferred revenue)
80
Depreciation
Depreciation is the process of **allocating the cost of an asset over time** and is subject to management’s strategy
81
Long-term assets
Long-term assets **have a useful life of greater than one year** and are **used for production of the company’s goods or services**
- They are reported as their **carrying value or book value**, i.e. historical cost less accumulated depreciation
- They may be written down to market value if they loose their revenue-generating ability
82
Depreciation (Definition and Methods)
Depreciation is the process of **allocating the cost of an asset over time** and is subject to management’s strategy
**Methods**
- **Straight-line** method
- **Units-of-production** method
- **Double-declining-balance**
- **Sum-of-the-years digit** method
83
Intangible Assets
Intangible Assets are the **amounts paid** by a company **to acquire certain rights** that are **not represented by the possession of physical assets**
- Identifiable intangibles can be acquired singly, e.g. patents
- Unidentifiable intangibles cannot be acquired singly, e.g. accounting goodwill
84
Intangible assets that might not be recorded on the balance sheet and that are expensed
- Internally generated brands, customer lists, etc.
- Start-up, training, reorganization costs
- Advertising and promotion
- Almost all R&D costs
85
Financial Instruments
- **Financial assets** include investments in stocks, bonds, and similar instruments
- **Financial liabilities** include bonds, notes payable, and similar instruments
86
Financial Instruments - Assets: Market to Market
If the asset is **held for trading or classified as available for sale** it is mark-to-market, i.e. the **value is adjusted to reflect current market condition**
- In case of **trading securities** the unrealized gain is included on the income statement
- In case of **available-for-sale securities** the unrealized gain is not included on the income statement, but deferred as other comprehensive income
87
Financial Instruments - Assets: Held-to-Maturity
If the asset is classified held-to-maturity it is **measured at cost**, hence **unrealized gains are not reflected on the income statement or on the balance sheet**
88
Equity - Definition
The residual interest in the assets of an entity after deducting its liabilities
89
Components of Equity - Minority Interest (or non controlling interest)
Minority interest (or noncontrolling interest) in subsidiaries that have been consolidated but are not wholly owned
90
Components of Equity - Retained Earnings (or retained deficits)
Retained earnings (or retained deficits) **amounts which passed through the companies income statement but have not been paid to the owners**
91
Components of Equity - Treasury Stock (or own shares repurchased)
Treasury Stock (or own shares repurchased) may occur if management considers the shares undervalued or wants to limit dilution from employee stock compensation plans.
Capital contributed by owners is evidenced through the issuance of common stock and preferred stock. The number of shares outstanding equals the number of shares issued minus those shares repurchased (treasury stock)
92
Components of Equity - Treasury Shares
Treasury shares are **nonvoting** and **do not receive dividends** if declared by the company
93
Components of Equity - Accumulated Comprehensive Income
Accumulated comprehensive income (or other reserves) is **derived from foreign currency translation adjustments, minimum pension liability adjustment, unrealized gains on available-for-sale investments and derivatives** (U.S. GAAP)
94
Common Size Balance Sheet
- Comparing companies on an absolute basis is difficult and the balance sheet must be adjusted for size
- **Common-size statements normalize absolute values**
-> All items of the balance sheet are expressed as a **percentage of total assets**
-> The items of a common-size income statement are expressed as percentage of sales
- This format is used to **compare companies of different size** within the same industry and with the firm’s own history (horizontal)
- It allows for a quick assessment of certain financial ratios such as gross profit margin or net income margin
95
Long-Term Liabilities
Long-term debt represents a **legal obligation to repay the amount borrowed plus interest**
96
Interest Coverage Ratio
Interest coverage ratio (a.k.a. times interest earned) represents the **ability of the company to satisfy the debt commitments**
97
Common Features of Bonds (5)
- **Principal value** (a.k.a. par value, principal, maturity value, redemption value, or face value)
- **Interest rate** (a.k.a. coupon rate, nominal rate)
- **Security** (secured/unsecured bond)
- **Ownership** (bearer/registered bond)
- **Term to maturity** (term/serial bond)
98
Mortgage
**Long-term liability that is typically backed by real estate or land**. Typically, equal payments are made at regular intervals including interest and repayment
99
Leases
Executory contracts, may be equivalent to an asset purchase using long-term debt
- Capital Lease
- Operating Lease
100
Capital Lease
Treated as purchased property
- Transfer ownership by end of lease / contains a bargain purchase option
- Lease term is > 75% of estimated economic life
- PV of minimum lease payments > 90% of market value
101
Operating Lease
no obligation / receivable appears on the lessee’s balance sheet
102
Pension Plan
An Agreement under which an employer agrees to pay monetary benefits to employees once their period of activity ends
- Defined Contribution Plan
- Defined Benefit Plan
103
Pension Plan - Defined Contribution Plan
A **fixed or variable contribution to the employee’s retirement account** (pension fund) is made, the employer bears the risk of investment performance, no provisions are constituted
104
Pension Plan - Defined Benefit Plan
The employer promises a monetary benefit upon retirement
105
Income Statement
The income statement presents information on the **financial results of a company’s business activities** over a period of time
- Also called statement of operations, statement of earnings or profit and loss (P&L)
- Generally the most relevant financial statement for company valuation
-> For fixed-analysts: The ability to make the promised payments is derived from the income statement
106
Income Statement - Components
- The top line typically reports revenue as the amounts charged for delivery of goods and services from ordinary business activity
- The bottom line reports the companies net income -> Viewed as the single most relevant line in financial statements
- Financial income and expenses are nonoperating items and reported separately
- Minority interests represent the portion of income that belongs to minority shareholders of consolidated subsidiaries
107
Multi-Step Income Statement
Shows gross profit subtotal
- Single-Step Income Statement does not provide this lie item
108
Income Statement - What can Expenses be grouped by?
- Nature (e.g. depreciation)
- Function (e.g. cost of goods sold including salespeople’s salary, material cost, depreciation, and other direct sales-related expenses)
109
Income Statement: Revenue Recognition
Defines **whether and to which extend** a **business transaction** and the **resulting revenue is attributed to a given accounting period**
110
The recognition of revnue needs following conditions to be satisfied (IASB)
- Significant **risks and rewards** of the ownership are transferred to the buyer
- Neither **continuing managerial involvement** nor **effective control** are retained
- The amount of **revenue can be measured** easily
- It is probable that the **economic benefits will flow to the seller**
- The **cost incurred** can be **measured reliable**
111
Common-size income statement
As for the balance sheet it is the first step towards comparison across time (time-series analysis) or different sizes (cross-sectional analysis)
- The common-size adjustment of the income statement is performed by stating each line item as percentage of revenue
112
Most Common Income Statement Ratios
- (Net) profit margin (or return on sales)
- Gross profit margin
113
Cash Flow Statement
Provides information about a company’s **cash receipts and cash payments** during a period
114
Formats for reporting cash flows
Indirect and direct format
115
Formats for reporting cash flows: Direct Method
- Shows the **specific cash inflows and outflows**
- Income statements are adjusted to remove the effect of accruals
Primary argument in favor of the direct method: It **provides information on the specific sources of (operating) cash receipts** -> Indirect method only shows the net result of the receipts and payments
Under U.S. GAAP, if the direct method is used the company has to provide the indirect method in the footnotes
116
Formats for reporting cash flows: Indirect Method
- **Derives the cash flow from reported net income** as a result of a series of adjustments:
-> Adjustments are made for noncash items, for nonoperating items and for net changes in operating accruals
- The indirect method is used for forecasting future cashflows
117
Cash Flow Analysis - Interpretation
- CFO tell **how much cash is generated by sales activity**
- Cash flows can indicate **problems with liquidity and solvency**, i.e. negative CFO indicates that the company relies on external funding
- Cash flow trends are particularly useful when **compared to income trends over time** -> Discrepancies suggest that earnings trend is not reliable
118
Major sources of cash for a company
Vary with its stage of growth
- **Mature Companies:** Primary source of cash should be operating activities
- **Consistently negative cash flow from operation** will restrict access to other sources of cash in the long run
- **Negative or null investing cash flow** is a sign for missing growth opportunities
- **Operating cash flow should suffice to cover capex**. The best estimate for capex often is the CFI
119
Free Cash Flow (FCF)
Measures the cash available for discretionary purposes
120
Indicator for Earnings Quality
**Comparing CFO with net income**
e.g. **high net income** and **poor operating cash flow** -> Sign for **poor earnings quality**
121
Aim of Cash Flow Analysis
Analyze whether the **operating cash flow and net income** are **consistent in the future**
122
Common-Size Cash Flow Statement - Approaches
Two approaches usually applied
- Each line item is expressed as **percentage of net revenue**
- Each line item of **cash outflow (inflow) is expressed as percentage of total cash outflow (inflow)**
-> Common-size format makes it easier to analyze trends and is useful for forecasting cash flows
123
Cash Flow: Performance Ratios (5)
Used to assess performance (profitability) and coverage (solvency)
- **Cash flow to revenue:** Measures the cash generated per dollar revenue
- **Cash return on assets:** Measures the cash generated from all resources
- **Cash return on equity:** Measures the cash generated from owners source
- **Cash to income:** Measures the cash-generating ability of operations
- **Cash flow per share:** Measure the operating cash flow on a per share basis
124
Cash Flow: Coverage Ratios (6)
- **Debt coverage:** Measures financial risk and financial leverage
- **Interest coverage:** Measures the ability to meet interest obligations
- **Reinvestment:** Measures the ability to acquire assets with operating cash flow
- **Debt payment:** Measures the ability to repay debt with operating cash flows
- **Dividend payment:** Measures the ability to pay dividends with operating cash flow
- **Investing and financing:** Measures the ability to acquire assets, pay debts, and make distribution to owners
125
Earnings per Share (EPS)
Basic EPS is the **amount of income available to common shareholders**, hence after the distribution of preferred dividends, **divided by the weighted average number of common shares outstanding over a period**
The number of common stock outstanding increases as a result of a stock dividend, stock bonus, or a stock split
- Particular importance to an equity investor
- IFRS: Presentation of (basic) EPS is required on the face of the income statement
126
Dilution
An **increase in common stock outstanding** -> Reduces the EPS of current stockholders
127
Objective of financial reporting
Provide users with information necessary to evaluate a firms financial position
128
Objective of tax reporting
Determine **taxable income** and hence **taxes payable**
129
Differences in financial and tax reporting
The **differences in the two reporting systems create tax liabilities** and **prepaid taxes** or **deferred tax assets**
- Primary reason for differences: Different depreciation methods
130
Balance Sheet Debt
The liability amount reported does not equal the total cash outflow required to satisfy the debt
131
Project Finance
Debt that is repaid solely from the operations of a particular activity
132
What does the issue of a bond "at par" mean?
The amount borrowed may differ from the face value
Only if the market rate of interest equals the coupon rate the amounts are the same and the bond is issued “at par”
133
Bond covenants/Debt covenants
Creditors use debt covenants in lending agreements to **protect their interests by restricting activities of the debtor**
If any covenant is violated the creditor can demand the repayment of the debt after the stated grace period
134
Leasing
Leasing **allows the use of certain assets for specific periods and stipulated rental payments including some or all of the benefits and risks of ownership**
- Legally the lessor owns the entity and rents the asset to the lessee who can be treated as the economic owner
135
Why do firms engage in leasing?
- Avoid reporting high debt levels and leverage ratios
- Reduce the probability of technical default under restrictive covenants
136
Classification of Leasing
- Capital Leasing
- Operating Leasing
137
Classification of Leasing: Capital Leasing
Leases are classified as capital (vs. operating) if **one of the following criteria** hold:
- The **title is transferred to the lessee** at the end of the lease period
- A **bargain purchase option** exists
- The **lease period is at least 75% of the assets life**
- The **present value of the lease payments is at least 90% of the fair value of the asset** (using the minimum of the lessee’s incremental borrowing rate or the rate implicit in the lease)
138
Classification of Leasing: Operating Leasing
- No entry in B/S is made
- The rent expense is charged to income and cash flow from operations
- Footnote disclosure of the lease payments for the next five years is required
139
Take-or-pay and throughput arrangements
- Commitment to buy a minimum quantity of an input, usually raw material
- Neither the asset nor any borrowings used to secure the commitment are recognized. However, they can be found in footnotes
140
Financial Ratios
Financial analysis applies analytical tools to financial data to **assess a company’s performance and trends**
141
Financial Ratios - Limitations of ratio analysis (3)
- Homogenity of a company’s operating activities
- Use of alternative accounting methods
- Judgement and interpretation by the analyst
142
Benefits of Financial Ratios
Ratios are important in **predicting stock returns** and are an effective instrument in **selecting investments** and **predicting financial distress**
143
For the evaluation of what **facets** of a company's performance are Financial Ratios used? (5)
* Internal liquidity
* External liquidity
* Operating performance
* Risk profile (business and financial)
* Growth potential
144
Objects to ratio analysis (5)
- Stock valuation
- Systematic risk measurement
- Financial Ratios
- Bond Ratings
- Forecasting bankruptcy
145
Activity Ratios (6)
Activity ratios, asset utilization ratios, or operating efficiency ratios **reflect the efficient management of working capital and long-term assets**
- **Inventory** Turnover
- **Receivable** Turnover
- **Payables** Turnover
- Net working capital / **Working capital** turnover
- **Fixed Asset** Turnover
- **Total Asset** Turnover
146
Activity Ratios - Inventory Turnover or Days of inventory at hand (DOH)
Indicates the **inventory management effectiveness**
- *Inventory Turnover = CoGS/Avg. Inventory*
- *DOH = 365/Inventory Turnover*
146
Activity Ratios - Receivable Turnover or days of sales outstanding (DSO)
Reflects how fast the company collects cash from customers
146
Activity Ratios - Payables Turnover and number of days of payables
Measures the number of days the company takes to pay its suppliers
146
Activity Ratios - Net working capital
Net working capital = Current assets - Current liabilities
147
Activity Ratios - Working Capital Turnover
Indicates **how efficiently the company generates revenue with its working capital**
- Near zero or negative working capital render ratios incapable of interpretation
*Net Sales/Avg. Working Capital*
147
Activity Ratios - Fixed Asset Turnover
Measures how efficiently the company **generates revenues from its investment in fixed assets**
*Net Sales/Avg. net fixed assets*
147
Activity Ratios - Total asset turnover
Measures the company’s overall ability to generate revenues with a given level of assets
147
Liquidity Ratios (5)
- Current Ratio
- Quick Ratio
- Cash Ratio
- Defensive inverval ratio
- Cash conversion cycle
147
Liquidity Ratios - Current ratio
**Indicates liquidity** -> Implies inventories and accounts receivable to be liquid
*Current Assets/Current Liabilities*
147
Liquidity Ratios - Quick ratio
Quick ratio is a **more stringent/conservative measure of liquidity** than the current ratio
*(Cash+Marketable Securities+Receivables)/Current Liabilities*
147
Liquidity Ratios - Cash ratio
Reliable measure of liquidity even in crisis situation
- Only highly marketable assets are included
- The most stringent liquidity measure
147
Liquidity Ratios - Defensive interval ratio
Measures **how long the company can continue to pay its expenses from its existing liquidity**
*(Cash+Marketable Securities + Receivables)/Daily cash expenditure)*
147
Liquidity Ratios - Cash conversion cycle (net operating cycle)
Indicates the **time that elapses from the point when a company invests in working capital until cash is collected**
*DOH + DSO - Number of days payables*
148
Solvency
Solvency refers to the ability to fulfill long-term debt obligation
149
Solvency Ratios (Debt Ratios) (4)
- **Debt-to-asset** ratio
- **Debt-to-capital** ratio
- **Debt-to-equity** ratio
- **Financial leverage** ratio
150
Solvency Ratios (Debt Ratios) - Debt-to-asset ratio
Measures the **percentage of total assets financed with debt**
- Higher debt means higher financial risk and thus weaker solvency
*Total Debt/Total Assets*
151
Solvency Ratios (Debt Ratios) - Debt-to-capital ratio
Measures the percentage of a company’s capital represented by debt
152
Solvency Ratios (Debt Ratios) - Debt-to-equity ratio
Measures the **amount of debt relative to equity capital**
- Alternative definitions use market values
*Total Debt/Shareholder's Equity*
153
Solvency Ratios (Debt Ratios) - Financial leverage ratio (or simply leverage ratio)
measures the **amount of total assets supported for each unit of equity**
*Avg. Total Assets/Avg. Total Equity*
154
Solvency Ratios (Coverage Ratios)
- **Interest** Coverage
- **Fixed Charge** Coverage
-> Both ratios are often used by creditors to assess the risk connected to an investment
-> Maintenance of these two ratios are very common covenants
155
Solvency Ratios (Coverage Ratios) - Interest Coverage
Measures the **number of times a company’s EBIT could cover its interest payments**
- It indicates the company’s ability to service its debt from operating earnings
*EBIT/Interest Payments*
156
Solvency Ratios (Coverage Ratios) - Fixed Charge Coverage
Measures the **ability to cover fixed charges** thus including leasing payments into the calculation
(wie Intest coverage nur mit zusätzlichem Lease)
*(EBIT+Lease Payments)/(Interest+Lease Payments)*
157
Profitability Ratios (Return on Sales) (4)
- **Operating Profit** Margin
- **Net profit** Margin or net income margin
- **Gross Profit** Margin
- **Pretax** Margin
158
Profitability Ratios (Return on Sales) - Gross Profit Margin
Indicates the **percentage of revenue available to cover operating and other expenditures**
- Higher gross profit margin indicates a competitive advantage
*Gross Profit/Revenue*
159
Profitability Ratios (Return on Sales) - Operating Profit Margin
**Includes operating costs into the calculation** (compared to Gross Profit Margin)
- The margin should develop in line with gross margin else operating costs should be analyzed
*Operating Income/Revenue*
160
Profitability Ratios (Return on Sales) - Pretax Margin
Also called earnings before tax
Reflects the **effects on profitability of leverage and other non-operating items**
*EBT/Revenue*
161
Profitability Ratios (Return on Sales) - Net profit margin or net income
Calculated as revenue minus all expenses
- Generally this ratio is to be adjusted for nonrecurring items
162
Profitability Ratios (Return on Investment) (4)
- Return on Assets
- Operating ROA
- Return on Capital
- Return on Equity
163
Profitability Ratios (Return on Investment) - Return on assets
Measures the **return earned by a company on its assets**
- Some analysts prefer to add back the tax adjusted interest expenses because assets are financed by equity or debt
*NI/Avg. Total Assets*
164
Profitability Ratios (Return on Investment) - Operating ROA
Corresponds to ROA but on a pre-interest and pretax basis
*Operating Income or EBIT/Avg. Total Assets*
165
Profitability Ratios (Return on Investment) - Return on Total Capital
Measures the **profit earned on all capital employed**
*EBIT/Avg. Total Capital*
166
Profitability Ratios (Return on Investment) - Return on equity
Measures the **return earned by a company on its equity capital**, including minority interest, preferred equity, and common equity
*NI/Avg. Total Equity*
167
DuPont System
- Approach to **decompose and analyze return on equity**
- It breaks down RoE into a function of different ratios, so an analyst can distinguish between different RoE drivers
- **If RoE is low**, the company has at least a **poor profit margin, a poor asset turnover, or is not leveraged**
168
Extended DuPont System
**Breaks the net profit margin down further**
- Net income is substituted by earnings before tax times tax retention rate
- EBT is simply EBIT less interest expenses
->This version of the DuPont equation emphasizes that higher leverage does not always yield higher RoE. As leverage rises so does the interest expansions
