Deck 2 - Financial Statement Analysis & Corporate Issuers Flashcards
What is the statement of comprehensive income?
It is the results of a firm’s business activities
What is the framework for financial analysis
- State the objective of the analysis
- Gather data
- Process the data
- Analyze and interpret the data
- Report the conclusions or recommendations
- Update the analysis
What are the fundamental characteristics of financial statements and what are the primary assumptions
The fundamental characteristics are relevance and faithful representation, and the enhancing characteristics include comparability, verifiability, timeliness, and understandability. The primary assumptions are the accrual basis and the going concern assumption.
What is the difference between multistep and single step income statement
Multistep income provides a subtotal for gross profit while a single step does not
How do firms recognize revenue
- Identify the contract
- Identify performance obligations
- Determine the transaction price
- Allocate the transaction price to the performance obligations
- Recognize revenue when or as the entity satisfies a performance
How do intangible assets change their value?
If they have limited lives they should be amortized using a method that reflects the flow over time of their economic benefits. If the have indefinite lives like good will they are not amortized.
Where do you report value of discontinued operations?
Below income from continuing operations, net of tax
Changes in what require retrospective restatement of all prior year statements?
Changes in accounting standards, changes in accounting methods applied, and corrections of account errors require retrospective restatement
What is applied prospectively to statements?
A change in an accounting estimate is provided respectively.
What is basic EPS
Net Income - Preferred dividends/Weighted average number of common shares outstanding
What is diluted EPS
((net income - preferred dividends) + convertible preferred dividends + convertible debt (1-t))/(Weighted average shares + shares from conversion of conv. pfd. shares + shares from conversion of conv. debt + shares issuable from stock options
What are the gross and net profit margin used to determine profitability?
Gross profit margin - gross profit/revenue
Net Profit Margin - net income/revenue
What is in comprehensive income?
- Gains and losses from foreign currency translation
- Pension obligation adjustments
- Unrealized gains and losses from cash flow hedging derivatives
- Unrealized gains and losses on available-for-sale securities
What is a classified balance sheet and liquidity-based presentations?
Classified balance sheet separately reports current and noncurrent assets and liabilities
Liquidity is from most to least liquidity
How are accounts receivable reported?
It is reported at net realizable value by estimating bad debt expense
How are inventories reported?
Inventories are reported at the lower of cost or net realizable value (IFRS) or the lower of cost or market (U.S. GAAP).
How is PP&E reported
Using the cost model or the revaluation model under IFRS Under U.S. GAAP only cost. Recoveries allowed under IFRS but not US GAAP
How are different debts treated?
Those held to maturity - amortized cost
Sell before maturity - fair value through other comprehensive income
Sell them in the near term - fair value through profit and loss
What does owner’s equity include?
Contributed capital, preferred stock, treasury stock, retained earnings, noncontrolling interest, accumulated other comprehensive income
What is the difference between liquidity and solvency?
Liquidity is ability to meet short term obligations and solvency is ability to meet long term obligations
What is CFO?
Cash flow from operations - inflows and outflows of cash resulting from transactions that affect net income
What is CFI?
Cash flow from investing activities - flows of cash resulting from the acquisition or disposal of long-term assets
What is CFF?
Cash flow from financing activities are flows resulting from transactions affecting a firm’s capital structure, such as issuing or repaying debt and issuing or repurchasing stock
What is disclosed in the footnotes or a supplemental schedule
noncash investing and financing activities, such as taking on debt to the seller of a purchased asset
How are dividends paid and received, interest paid and received, taxes paid reported under U.S. GAAP?
Dividends paid - Financing cash flows
Dividends received - operating cash flow
Interest paid - operating cash flow
Interest received - operating cash flow
Taxes paid - operating cash flow
How are dividends paid and received, interest paid and received, taxes paid reported under IFRS?
Dividends paid - Financing or operating cash flows
Dividends received - operating or investing cash flow
Interest paid - Financing or operating cash flows
Interest received - operating or investing cash flow
Taxes paid - operating cash flow unless they arise from an investing or financing transaction
What are the main differences between operating, investing, and financing activities?
Opr - current assets and current liabilities
Investing - Noncurrent assets
Financing - noncurrent liabilities and equity
How to calculate CFO directly vs. indirectly?
Directly add Cash collections from customers, paid for inputs, operating expenses, interest paid, taxes paid
Indirectly - Net income and adjusts for gains or losses related to investing or financing cash flows, noncash charges to income, and changes in balances sheet
How to convert direct to indirect cash flow statement?
Eliminating noncash and non-operating items
What is Free Cash Flow to the Firm
FCFF = net income + noncash charges + [cash interest paid x (1-tax rate)] - fixed capital investment - working capital investment or CFO + [cash interest paid x (1-tax rate)] - fixed capital investment
What is Free cash flow to equity?
Cash available for distribution FCFE = CFO - Fixed capital investment + net borrowing
What are activity and valuation ratios?
Activity - how well the firm uses its assets
Valuation - Relative values of stocks
What is basic Dupont?
ROE = (Net Income/Sales) (Sales/Assets) (Assets/Equity) or net profit margin * asset turnover * leverage ratio
What is Extended Dupont?
ROE = (Net Income/EBT) (EBT/EBIT) (EBIT/Revenue)(Revenue/Total Assets) (Total Assets/ Total Equity)
What is a segment of the business?
Risk and return characteristics are distinguishable and account for more than 10% of the firm’s sales or assets.
When prices are increasing how does it impact Gross Profit?
LIFO lower gross profit
FIFO higher gross profit
How do you convert a firm’s financial statements from LIFO to FIFO
- Add LIFO reserve to LIFO inventory
- Subtract the change in LIFO reserve for the period from COGS
- Decrease cash by LIFO reserve x tax rate
- Increase equity by LIFO Reserve x (1-tax rate)
Which inventory system allows write ups
IFRS but not GAAP, under GAAP, inventories are valued at the lower of cost or net realizable value for companies using cost methods other than LIFO or the retail method
What are required inventory disclosures?
Cost flow method, carrying value of inventories, COGS, Amount write-downs and their reversals, value of inventories pledged as collateral
What is the formula for double-declining balance and units of production
2/depreciable life in years x book value at beginning of year vs.
Original cost - Salvage value/life in output units x output units used in the period
What is an impairment of assets according to IFRS and US GAAP
For US GAAP, the carrying value is greater than discounted cash, and IFRS is when the carrying value is greater than the recoverable amount. Impact income statement but not cash flows
How to recognize sold, abandoned, and exchanged assets?
For sold assets reported as gain or loss on income statement
Abandoned carrying value is removed from balance sheet and loss recorded
Exchanged - gain or loss is computed by comparing the carrying value of the old asset with fair value of the old asset
How to calculate total useful life and remaining useful life
Historical cost/annual depreciation expense and Ending net PP&E/Annual depreciation expense
What is the investment property by IFRS?
Property is defined as property owned for the purpose of earning rent, or capital appreciation.
What is accounting profit?
It is pre-tax income from the income statement.
What is the difference taxes payable and income tax expense?
Tax liability is what tax needs to be paid, and Income tax expense is taxes payable and changes in deferred tax assets and liabilities
What is the formula for income tax expense?
Taxes payable + ∆DTL - ∆DTA
What happens when DTA is not realized
DTA reduced by a valuation allowance. This increases the valuation allowance, which will increase income tax expenses and reduce earnings.
Interest expense
The book value of the bond liability at the beginning of the period, multiplied by the bond’s yield difference between interest expense and coupon payment, is subtracted or added from bond liability.
What is the difference between a finance and operating lease?
Finance transfers the benefits and risks of ownership to the lessee. Operating lease is one that does not
What is the difference between a finance and operating lease on the balance sheet?
Under both, for a finance lease, the lessor removes the leased asset from its balance sheet and adds a lease receivable asset. The lessor reports the interest portion of the lease payment as income. For an operating lease, the lessor keeps the leased asset on its balance sheet and reports the lease payments as income.
How should defined benefit and contribution plans be treated?
Net pension liability if the fair value is less than the estimated pension obligation or vice versa. Change in net pension is reflected in comprehensive income.
Pension expense for a defined contribution pension plan is equal to the contribution
What is debt to capital ratio?
Total debt / (total debt + total equity)
What is debt to assets or equity ratio?
Total Debt/Total Assets and Total Debt/Total Equity
What is the financial leverage ratio?
Average total assets / average total equity
What is the interest coverage ratio?
EBIT / Interest Payments
What is Fixed charge coverage?
(EBIT + lease payments) / (interest payments + lease payments)
What accounting choices and estimates that can be used to manage earnings
- Revenue recognition choices such as shipping terms,
- estimates of reserves for uncollectible accounts
- Valuation allowances
- Depreciation methods
- Inventory cost flow methods
- Capitalization of expenses
- Related-party transaction
Warning signs of manipulation
Revenue growth out of line, decrease in turnover rations, net income not supported, capitalization decisions, fourth0quarter earnings, emphasis on non-GAAP measures
What is the principal-agent relationship?
Owners employing agents to act in their interests. Conflict can arise because the agent’s incentives may not align with those of the owner or more generally, because the interest of one group within a corporation are not the same as those of other groups
What is a business model
Should identify firm’s potential customers, describe its products or services and how it will sell them, describe its key assets and suppliers, and explain the pricing strategy
What is the value proposition and value chain?
Proposition - how a firm’s customers will value the goods sold
Value chain - How a firm will execute its value proposition
What are some common mistakes in the capital allocation process?
Failing to incorporate economic responses, basing long-term investment decisions on short-term EPS or ROE, incorrect discount rate, improper handling of sunk and opportunity cost
How can return on invested capital be used to determine value?
It can be compared to a company’s weighted average cost of capital to indicate whether the company has increased or decreased firm value over time
What is the difference between conservative approach and aggressive approach to working capital management?
Conservative - high levels of current assets financed with long-term debt and equity. Conservative approach provides more liquidity and involves less financial risk but has higher financing costs and will reduce returns.
How is a company’s liquidity evaluated?
- Effectiveness of its cash flow management
- Drags on cash inflows (uncollected receivables, obsolete inventory)
- Pulls on its cash outflows (early payments to vendors, reductions in credit limits)
What is the quick ratio
Cash + marketable securities + receivables / current liabilities
What is the receivables turnover?
Credit Sales / Average receivables
What is the inventory turnover?
Costs of goods sold / average inventory
What is payables turnover?
Purchases / Average trade payables
What is the cash conversion cycle
CCC = days of inventory + days of receivables - days of payables
What are the two ways to estimate cost of common equity
CAPM: Kce = Rf + ℬ[E(Rmkt) - Rf]
Bond yield plus risk premium: add a risk premium of 3% to 5% to the market yield of firm’s long-term debt
How to do BETA estimation?
- Estimate the beta for a comparable company or companies
- Unlever the beta ℬassets = ℬequity {1/[1+ (1-t)D/E]}
- Relever the beta ℬassets = ℬequity {1/[1+ (1-t)D/E]}
- Use the CAPM to estimate the target company’s required rate of return
How do you account for floatation costs for cash outflow?
Increase a project’s initial cash outflow by the flotation cost attributable to the project when calculation the project’s NPV
What are MM propositions?
No taxes - company structure is irrelevant because WACC and firm structure are unchanged
With taxes - WACC is minimized and value maximised with 100% debt financing
Static trade-off theory adds the expected costs of financial distress to the model
What is the pecking order theory?
Based on information asymmetry between firm management and investors signals their beliefs. Retained earnings are most preferred, followed by debt financing and issuing new equity
What is the degree of operating leverage?
(Q(P-V))/[Q(P-V)-F] and is %∆EBIT/%∆sales
What is the degree of financial leverage?
EBIT/EBIT-I and is interpreted as %∆EPS/%∆EBIT
What is the breakeven quantity of sales?
0 = Fixed operating costs + Fixed financing costs/price - variable cost per unit
What is the operating breakeven quantity of sales?
Fixed Operating Costs / Price - Variable Cost Per Unit
When are futures preferred over forwards?
When interest rates are positively correlated with the price of the underlying.
What is the value of a call option at expiration?
MAX (0, S − X)
What is a convenience yield?
The convenience yield is a non-cash benefit that comes from holding a physical commodity. It decreases the forward price
When can you have a profit for futures and forwards?
the forward contract price is less than the future value of the spot price.
What are examples of relative value hedge strategy?
examples ar convertible arbitrage fixed income, asset-backed fixed income, general fixed income, volatility, and multi-strategy.
How should stock dividends and stock splits be treated when calculating EPS
They should be applied to the beginning of the year balance
Motivations for low quality reporting?
A large range of acceptable accounting treatments is conducive to manager bias affecting the quality of financial reporting.
What is working capital?
current assets minus current liabilities
