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Bernard My CRC Exam > Dimension 3 - Financial Assessments of the Client > Flashcards

Dimension 3 - Financial Assessments of the Client Flashcards

1
Q

FACTORS THAT AFFECT FINANCIAL STATEMENT RELIABILITY

A
  • Degree of Compliance with GAAP
  • Qualification and Independence of the Auditor
  • Integrity of the Issuer (Management)
  • Relationship of the Financial Statement Date to the Company’s Operating Cycle
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2
Q

Three types of CPA prepared documents that are particularly relevant to your analytical work

A
  • Engagement Letter - outlines the terms of the contract between the CPA and your customer
  • Financial Statements
  • Management Letter
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3
Q

Four types of opinions for Audited Statements

A

1) Unqualified
- Most reliable data to analyze.
- According to GAAP

2) Qualified:
- Reliability depends on the nature of the qualification.
- Contains an exception or some departure from GAAP or when the scope of the audit has been limited.
- Example, statement of cash flows is not presented, or accounts receivable or inventory have not been verified.

3) Disclaimer
- Auditor does not wish to express an opinion because there is not enough information to do so.
- Casts serious doubt on reliability
- Important to investigate the reasons for the disclaimer.

4) Adverse:
- Red flag, significant bearing on creditworthiness.
- Departures from GAAP are too material to allow even a qualified opinion.

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4
Q

When to require audited statements?

A
  • The riskier you judge the loan to be, the more likely you will require an audit.
  • The longer the loan will be outstanding, the more likely you will require an audit.
  • When you have identified margins of protection within the financial information
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5
Q

Types of Unaudited statements

A

1) Review - Less in scope than an audit and provides only limited assurance that the statement is prepared in accordance with GAAP. Some are expanded to include specially requested tests of inventory or receivables.
2) Compilation - Contains few or no disclosures of accounting methods. No assurance of compliance with GAAP.
3) Company Prepared - Least assurance of objectivity. Most potential for undisclosed inconsistencies or departures from GAAP.
4) Cash Basis - Can give the user a false impression of profitability and economic viability.

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6
Q

CONSOLIDATED AND CONSOLIDATING FINANCIAL STATEMENTS

A
  • If you are lending to a subsidiary and the parent will not be a party to the loan, you need to analyze the separate statements of the subsidiary, not just the statement of the parent or the statement of the parent combined with the subsidiary.
  • If you are lending to the parent without the guaranty of the subsidiaries, you will need the separate statements of that parent.
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7
Q

Consolidated Statements

A
  • Presents the condition and performance of two or more companies combined.
  • Intercompany transactions and account balances are eliminated and do not appear in the financial statements.
  • The first footnote to the financial statement will identify whether multiple entities are included in the report
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8
Q

Consolidating Statements

A
  • This form of statement displays the financial statements of two or more related companies, shows the intercompany accounts and transactions, then eliminates them and presents the condition and performance of the combined entities.
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9
Q

Separate or Parent Only Statements

A

Reflects the condition and performance of only one company not combined with any other company.

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10
Q

Lenders generally prefer GAAP financial statements because?

A
  • Transactions will be measured by historical cost.
  • Revenues are recognized when earned.
  • Expenses are matched with the revenues they produce.
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11
Q

Preparers of GAAP financial statements rely on three broad standards:

A

Conservatism - Assets and revenues will not be overstated. Liabilities and expenses will not be understated.

Consistency and comparability - Measured and recorded in the same way from one period to the next for similar kinds of companies. Changes and permissible variations will be explained in sufficient detail

Materiality - Classify and disclose the results of transactions in a way that acknowledges their significance

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12
Q

PROPRIETORSHIP

A

PROPRIETORSHIP
- No capital stock. Balance sheet of borrower includes business and personal assets and liabilities.

  • One individual, a sole proprietor, goes into business. Individual and business are not separatelegal entities. Business may have trade name or be referred to as individual doing business as (dba) [trade name].

Owner has unlimited liability for actions and obligations of business. Management is solely the owner/operator. When owner dies, business as legal entity dies also.

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13
Q

GENERAL PARTNERSHIP

A
  • Partners’ initial investments, if any, and partnership earnings not yet withdrawn.
  • Two or more individuals go into business together.Partnership is separate legal entity but in most cases is automatically disbanded on the death of one partner. Partnership agreements, required in many states, specify who can obligate partnership and how profits or losses will be shared.
  • Each partner is fully liable for obligations of partnership, but in some states that liability is second in priority to personal obligations of individual partner.
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14
Q

LIMITED LIABILITY PARTNERSHIP

A
  • Dictated by the state in which they are established.
  • Same as General Partnership. Requires registration with the state to obtain LLP status.
  • Same as General Partnership except partners not liable for wrongful conduct if they are not involved. Partners are liable for debts of partnership that existed prior to registration but not new debt incurred since registration. Single taxation applies. Partners are taxed individually on their share of the profits.
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15
Q

LIMITED LIABILITY COMPANY

A
  • Dictated by the state in which they are established.
  • Two or more individuals—“members”—enter into an operating agreement and file a certificate of organization with the state. Taxed for federal purposes as a partnership.
  • Members have no personal liability even though they manage company. Personal guarantees needed to make members liable for debts of LLC. Members are taxed individually on their share of the profits.
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16
Q

LIMITED PARTNERSHIP

A
  • Same as general partnership.
  • General partner manages the business and limited partners contribute capital but are not usually active in the business. Limited partners are liable for partnership obligations only to the extent of their investment.
  • To have a claim against limited partners for loans to partnership, bankers must take specialsteps in structuring and documenting the loan, such as obtaining guarantee agreements from limited partners.
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17
Q

JOINT VENTURE

A
  • Same as general partnership.
  • Special form of partnership in which investors go into businessto do a specific project (venture).When project iscompleted, joint venture is dissolved, and profits or losses are shared.
  • Lending to joint ventures requires both special documentation and analysis that addresses temporary nature of the business. Joint venturers are taxed individually on their share of the profits.
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18
Q

CORPORATION

A
  • Accounts for capital stock additional paid-in capital, retained earnings, and treasury stock (if any).
  • Legal entities, chartered under the laws of each state, have unlimited life and are unaffected by changes in ownership. Owners’ potential for loss is limited to the amount of their investment and they are not personally liable for obligations of corporation.
  • When bankers want the support of owners for loans to corporations, special documentation such as personal guarantees is necessary. Corporations are double taxed on corporate income and dividends.
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19
Q

Capital Stock

A

The balances of these accounts (in the case of multiple and/or different kinds of stock issues—common or preferred) represent the par value (in many cases $1/share) of the company’s stock issues.

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20
Q

Capital In Excess Of Par

A

This account balance is the amount of money received by the company, in excess of the par value described above, when the stock is sold to investors.

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21
Q

Treasury Stock

A

This account balance represents the dollar cost of repurchasing shares of stock.

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22
Q

A Note on Dividends:

A
  • You should determine which dividends are legally contractual, contractual by precedence, or truly discretionary.
  • It is important to review the equity security documentation in order to determine the dividend payout terms of an issue.
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23
Q

Three Major Types of Corporations

A

1) C Corp - incur tax liability according to standard provisions of the tax code for corporations. Stockholders are shielded from personal liability for business debts; only their investment is at risk.
2) S-Corp - those electing to be taxed as if they were partnerships, passing tax responsibility for profits or losses to the stockholders. A company may have only a limited number of stockholders and must adopt December 31 as its year-end. Stockholders are shielded from personal liability for business debts; only their investment is at risk.
3) Personal Service Corporations (ie. incorparated law, consulting) - derive the majority of their revenues from the active involvement of their owners are subject to special tax provisions that tend to increase taxes relative to regular C corporations. Members or partners are shielded from personal liability for business debts; only their investment is at risk.

24
Q

Four Liquidity Ratios

A

1) CURRENT RATIO = Curr Assets / Curr Liab
2) QUICK RATIO (Acid Test) = Quick Assets / Current Liab OR (current assets – inventories) / Curr Liab

Those assets that can be readily converted into cash at approximately their stated value.; no reliance on inventory to satisfy current liabilities.

3) INVENTORY RELIANCE PERCENT
4) NET WORKING CAPITAL = Curr Assets - Curr Liab

25
Q

Four Leverage Ratios

A

1) Debt to Worth = Total Liab / NW

measures the direct proportion between debt and owner’s equity

2) TNW = NW - Intangible Assets

Eliminates potentially least liquid assets (intangibles) from net worth to refine margin of protection.

3) DEBT TO TANGIBLE NET WORTH = Total Liab / TNW

Eliminate any margin of protection dependent on liquidation of intangible assets

4) NET FIXED ASSETS TO NET WORTH = NFA / NW

Measures the extent to which net worth is composed of fixed assets.

26
Q

Formula for Ending Inventory

A 
Beg Inv
\+ Purchases
= Goods Available for Sale
- COGS
= End Inv
27
Q

What are Operating Expenses?

A

Those expenses that are necessary to run the company that are not included in COGS.

Two Types:
1) Selling Expenses: expenses necessary to develop, package, market and sell the product or service

2) Administrative Expenses: expenses relating to the overhead costs of the company

28
Q

Operating Leverage

A

A business that has a higher proportion of fixed costs and a lower proportion of variable costs is said to have used more operating leverage. Those businesses with lower fixed costs and higher variable costs are said to employ less operating leverage.

29
Q

INCOME TAXES

A

The effective tax rates vary for any given company from year to year and for similar companies in the same year. To improve comparability, you might use profit before tax (pretax income) for trend analysis and industry comparisons.

30
Q

Types of Income Statement Ratios

A
  • Profit Margins
  • Coverage Margins
  • Financial Productivity
31
Q

Net Profit Margin

A

Net Income / Net Sales

Limitations: Net profit margin is affected by tax rate strategies and extraordinary income or expense items, so results for any one year can be misleading.

32
Q

Pretax Profit Margin

A

Profit before Tax / Net Sales

33
Q

Operating Profit Margin

A

Operating Income / Net Sales

34
Q

Gross Profit Margin

A

Gross Profit / Net Sales

35
Q

Types of COVERAGE MARGINS

A

Interest Coverage
Fixed Charge Coverage
Dividend Payout Ratio
Cash Flow Coverage Ratio

36
Q

Interest Coverage

A

EBIT / Interest Expense

Indicates the number of times operating earnings cover interest expense.

37
Q

Fixed Charge Coverage

A

EBIT + Lease and Rental Expense /

Interest Expense + Lease and Rental Expense + CPLTD

38
Q

Dividend Payout Ratio

A

Dividends / Profit after Tax

Indicates the proportion of profit that is paid to shareholders.

A dividend payout ratio that exceeds 1.0x suggests that a company is paying out more to its owners than it is earning—not an acceptable occurrence to your financial institution as a lender.

39
Q

Cash Flow Coverage Ratio

A

Net Income + Depreciation + Amortization + Depletion / CPLTD

Indicates the number of times this adjusted net income (traditional cash flow) covers the current portion of long-term debt (CPLTD).

Aka Cash Flow Coverage Ratio

40
Q

Types of FINANCIAL PRODUCTIVITY

A

Return on Assets (ROA)
Return On Equity (ROE)

These ratios measure a company’s productivity, i.e. the ability to generate profits from its assets.

41
Q

Return on Assets (ROA)

A
  • Return on Assets = Profit after Tax/Total Assets
  • Pretax Return on Assets = Profit before Tax/Total Assets
  • Return on Average Assets = Profit after Tax/Average Assets
42
Q

Return On Equity (ROE)

A

Profit after Tax / Net Worth

It expresses the total earnings of the company as a return on the owner’s investment.

43
Q

Total Earnings

A

Total earnings include salaries, business income (from proprietorships and partnerships), gambling earnings, investment income, and gains on sale. Taxable income begins with total earnings and subtracts nontaxable income, deductions, and exemptions.

44
Q

Partnerships

A

Partnerships never pay taxes. The tax returns for these entities report taxable income and identify the partners. Then, the partners are taxed on their pro-rata shares of the income.

45
Q

S Corporations

A
  • Similar to that for partnerships.
  • For business purposes, S corporations do not differ from other corporations.
  • To qualify as an S corporation, the corporation must be a domestic business incorporated in the United States. Also, the corporation may have no more than 75 shareholders.
46
Q

Passive Income

A
  • Losses on passive activities can offset income from other passive activities. Passive activity losses, however, cannot offset income from the non-passive and portfolio income categories.
  • Exception: losses from rental real estate rentals by low and middle-income taxpayers, rental losses by real estate professionals offset other income.
47
Q

Net Capital Gains

A

Individuals are allowed to deduct up to $3,000 of capital losses each year from other income.

48
Q

Section 179 Deduction for Certain Qualifying Equipment

A

Section 179 provides that each taxpayer may elect to deduct up to $100,000 of equipment purchases per year. This provision applies to smaller businesses.

49
Q

LIFO Reserve

A 
- The amount by which LIFO-based
balance sheet inventories are less
than they would be by using FIFO.
- The amount by which COGS expense
using LIFO exceeds the amount of
COGS it would have reported using
FIFO.
- The amount by which cumulative
pretax profits using LIFO are less than
pretax profits using FIFO.
50
Q

Capital Lease

A
  • contractual arrangement which transfers

substantially all benefits and risks of ownership to lessee so that lease is, in effect, a purchase of the property.

51
Q

Lessee must record lease as an asset (i.e. capital lease) if any one of the following exists:

A
  • Lease transfers ownership of the property to lessee.
  • Lease contains a bargain purchase option.
  • Lease term is equal to 75% or more of the economic life of the leased property.
  • Present value of lease payments equals or exceeds 90% of the fair market value of the leased property
52
Q

Operating Lease

A

contractual arrangement giving the lessee

temporary use of the property with continued ownership of the property by the lessor.

53
Q

Impact of operating leases:

A
  • Understate liabilities by keeping lease financing off the balance sheet.
  • Understate assets (inflates return on total assets).
  • Delay recognition of expenses in comparison to capital leases (overstate income in early term of lease, but understate income late in the lease term).
  • Understate current liabilities by keeping current portion of principal payment off the balance sheet.
  • Include interest with lease rental (operating expense).
  • Understate both operating income and interest expense and,
    therefore, inflate interest coverage ratios.
54
Q

Percentage-of-Completion Method

A
  • Recognizes income as work on a contract (or group of related contracts) progresses. Recognition of revenue and profits is related to costs incurred in providing services under the contract.
  • At any point in time, if cumulative billings to date exceed amount of work-in-process (WIP) plus the portion of gross profit attributable to that WIP, contractor recognizes a current liability,
    “Billings in Excess of Costs and Estimated Earnings”.
  • Conversely, if accumulated WIP and gross profit earned exceed billings to date, contractor recognizes a current asset, Costs and Estimated Earnings in Excess of Billings”.
55
Q

Completed Contract Method:

A
  • Recognizes income only when the contract is complete or substantially complete.
  • In general, when estimates of costs to complete and extent of progress toward completion are reasonably dependable, the percentage-ofcompletion method is preferable.
  • Completed contract method is usually acceptable when the contractor has numerous relatively short-term contracts.

Bernard My CRC Exam (42 decks)

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