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CFA: Level 1 > Financial Reporting and Analysis: Income Statements, Balance Sheets, and Cash Flow Statements > Flashcards

Financial Reporting and Analysis: Income Statements, Balance Sheets, and Cash Flow Statements Flashcards

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1
Q

Understanding Income Statements: Income Statement Attributes

A
  • Alternative names:

Statement of operations

Statement of earnings

Profit and Loss statement

Revenue - Expenses = Net Income

  • IFRS: May combine with comprehensive income items
  • Two types:
    • Single step
    • Multi-step
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2
Q

Understanding Income Statements: Revenues, Expenses, and Gains & Losses

A
  • Revenues: Amounts reported from the sale of goods and services in the normal course of business. Revenue less adjustments for estimated returns and allowances is known as net revenue.
  • Expenses: Amounts incurred to generate revenue and include cost of goods sold, operating expenses, interest, and taxes. Expenses grouped together by their nature.
  • _Gains and losses: _Typically arise on the disposal of long-lived assets.
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3
Q

Understanding Income Statements: Multi-step Income Statement

A
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4
Q

Understanding Income Statements: IASB Requirements for Revenue Recognition (General Principles)

A
  1. Risk and reward of ownership transferred
  2. No continuing control or management over the good sold
  3. Reliable revenue measurement
  4. Probable flow of economic benefits
  5. Cost can be measured reliably
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5
Q

Understanding Income Statements: IASB Requirements for Revenue Recognition for Services

A
  1. When the outcome can be measured reliably, revenue will be recognized by the reference to the stage of completion
  2. Outcome can be measured reliably if:
  • Amount of revenue can be measured
  • Probable flow of economic benefits
  • Stage of completion can be measured
  • Cost incurred and remaiing cost to complete can be measured
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6
Q

Understanding Income Statements: SEC Requirement for Revenue Recognition

A

“Revenue should be recognized when it is realizable and earned” FASB

SEC Additional guidance:

  1. Evidence of an arrangement between buyer and seller
  2. Completion of the earnings process, firm has delivered product or service
  3. Price is determined
  4. Assurance of payment, able to estimate probability of payment
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7
Q

Understanding Income Statements: Revenue Recognition Methods

A
  • Sales-basis method – used when good or service is provided at time of sale, cash, or credit with high payment probability (majority of transactions)
  • Exceptions (construction contracts)
  1. **Percentage-of-completion method- **used for L-T projects under contract, with **reliable estimates **of revenue, costs, and completion time
  2. Completed-contract method (U.S. GAAP) – used for L-T project with no contract, or unreliable estimates of revenue or costs; revenue and expenses are not recognized until project is completed (IFRS: Report revenue but no profit)
  3. Installment sales method (U.S. GAPP) - used when firm cannot estimate likelihood of collection, but cost of goods/servicesis known; revenue and profit are based on percentage of cash collected
    • Installment sale: A firm finances a sale and payments are expected to be received over an extended period. If collectability is certain, revenue is recognized at the time of sale using normal revenue recognition criteria.
  4. **Cost recovery method (most extreme) **- used when cost of good/servies is unknown and firm cannot estimate the likelihood of colle tion; only recognize profit after all costs are recovered
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8
Q

Understanding Income Statements: Percentage of Completion Method - Problem

A
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9
Q

Understanding Income Statements: Completed-Contract Method

A

Revenue and expenses are not recognized until project is completed

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10
Q

Understanding Income Statements: IFRS: Long-term Contracts With Uncertain Outcome

A

Revenue and expenses are recognized over the project’s life; however, no profit is reccorded until project is completed.

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11
Q

Understanding Income Statements: POC vs CC Method

A
  • Net income is higher for POC because CC does not recognize revenue until completion

Rise in Net income Rise in Equity (until final year)

  • **Income volatility **is greater with the CC method because POC recognizes some revenue and income each year instead of all at one time
  • Cash flow is the **same **for both (CF is unaffected by the revenue recognition method used)
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12
Q

Understanding Income Statements: Installment Sales Method - Problem

A
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13
Q

Understanding Income Statements: Cost Recovery Method

A
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14
Q

Understanding Income Statements: Installment sale: IFRS

A
  • Present value of the installment payments is recognized at the time of sale
  • Difference between installment payments and the discounted present value is recognized as interest over time
  • If the outcome of the project cannot be estimated reliably, revenue recognition under IFRS is similar to cost recovery method
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15
Q

Understanding Income Statements: Barter

A
  • Exchange of goods or services between two parties (no exchange of cash)
  • A agrees to exchange inventory for a service provided by B
  • **IFRS: **Revenue = fair value of similar non-barter transactions with unrelated parties
  • **U.S. GAAP: **Revenue = fair value only if the company has received cash payments for such servies historically (otherwise record sale at carrying value of asset)
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16
Q

Understanding Income Statements: Gross vs. Net Reporting

A
  • Internet-based merchandising companies
  • Sell product but never hold in inventory
  • Arrangement for supplier to ship directly to end customer
  • U.S. GAAP: Report gross if company
    • is primary obligator
    • Bears inventory risk
    • Bears credit risk
    • Can choose supplier
    • Has latitude to set price

If criteria are not met, then company is action as an agent: report net

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17
Q

Understanding Income Statements: Revenue Rec Implications for Analysis

A

Review revenue recognition policies in footnotes:

  • Earlier revenue recognition - aggressive
  • Later revenue recognition - conservative
  • Consider estimates used in methods
  • Assess how different policies would affect financial ratios
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18
Q

Understanding Income Statements: Revenue Recognition - Problem

A
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19
Q

Understanding Income Statements: Expense Recognition

A

Accrualbasis - matching principle

  • Match costs against associated revenues
  • Examples
    • Inventory
    • Depreciation/Amortization
    • Warranty expense
    • Doubtful debt expense

Period expenses

  • Expenditures that less directly match the timing of revenues (e.g. admin costs)
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20
Q

Understanding Income Statements: Analysis Implications

A

Requires significan estimates and assumption affecting net income:

  1. Inventory valuation
  2. Warranty expense
  3. Depreciation
  4. Amortization
  5. Doubtful debt provisions
  6. Revenue recognition
  • Review year-on-year consistency
  • Review footnotes and MD&A
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21
Q

Understanding Income Statements: Inventories: Matching Principle

A

Beginning inventory + Purchases - Ending inventory = COGS

Cost of goods sold should be matched with items sold and recorded as revenue over the period

Inventory cost flow should match goods flow

  • Specific identification
  • Average cost
  • First-in-first-out
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22
Q

Understanding Income Statements: Depreciation Methods

A
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23
Q

Understanding Income Statements: Amortization

A
  • Amortization of intangible assets (e.g. patents)
  • Spreading cost over life
  • If the earnings patterns cannot be established, use straight line (IAS 38)
  • IFRS and U.S. GAAP firms both typically amortize straight-line with no residual value
  • Goodwill not amortized - checked annually for impairment
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24
Q

Understanding Income Statements: Unusual or Infrequent Items

A
  • “Or” is the key word that describes these items
  • Reported pretax before net income from continuing operations (above the line)
  • Items include:
    • Gain (loss) from disposal of a business segment or asset
    • Gain (loss) from sale of investment in subsidiary
    • Provisions for environmental remediation
    • **Impairments, **write-offs, write-downs, restructuring
    • Integrateion expense for recently acquired business
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25
Q

Understanding Income Statements: Discontinued Operations

A
  • Operations that management has decided to dispose of but (1) has not done so yet or (2) did so in current year after it generated profit or loss
  • Reported net of taxes after net income from continuing operation (below the line)
  • Assets, operations, and financing activities must be physically and operationally distinct from firm
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26
Q

Understanding Income Statements: Extraordinary Items (U.S. GAAP)

A
  • Items that are both unusual and infrequent
  • Reported _net of taxes after net income from continuing operations _(below the line)

Items include:

  • Losses from expropriation of assets
  • Gains or losses form early retirment of debt (when judged to be both unusual and infrequent)
  • Uninsured losses from natural disaster
  • Prohibited under IFRS
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27
Q

Understanding Income Statements: Accounting Changea

A

Two types of accounting changes:

  1. **Change in accounting principle **(e.g., LIFO to FIFO)
    • Retrospective application: IFRS and U.S. GAAP require prior years’ data shown in the financial statments to be adjusted
  2. **Change in accounting estimate **(e.g., change in the estimated useful life of a depreciable asset)
    • Does not require restatment of prior period earnings
    • Disclosed in footnots
    • Typically, changes do not affect cash flow
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28
Q

Understanding Income Statements: Prior period adjustments

A

Prior period adjustments

  • Correcting errors or changing from an **incorrect accounting method **to one that is acceptable under GAAP
  • Typically requires restatement of prior period financial statements
  • Must disclose the nature of the error and its effect on net income
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29
Q

Understanding Income Statements: Non-Operating Items

A
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30
Q

Understanding Income Statements: Simple vs. Complex Capital Structure

A
  • A _simple capital structure _ contains no *potentially * dilutive securities
    • Firm reports only basic EPS
  • A _complex capital structure _ contrains *potentially *dilutive securities
    • Firm must report both basic and diluted EPD
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31
Q

Understanding Income Statements: Dilutive vs. Antidilutive Securities

A

Potentially dilutive securities:

  1. Stock options
  2. Warrants
  3. Convertible debt
  4. Convertible preferred stock

**Dilutive securities **_decrease EPS _if exercised or converted to common stock

Antidilutive securities _increase EPS _if exercised or converted to common stock

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32
Q

Understanding Income Statements: Calculating Basic EPS

A
  • Net income minus preferred dividends equals earnings available to common stockholders
  • Note that common stock dividends are not subtracted from net income
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33
Q

Understanding Income Statements: Stock Dividends and Stock Splits

A
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34
Q

Understanding Income Statements: Calculating the Weighted-Average Number of Shares Outstanding

A
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35
Q

Understanding Income Statements: Diluted Earnings Per share

A
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36
Q

Understanding Income Statements: Checking for Dilution

A
  • Only those securities that would reduce EPS below basic EPS if converted are used in calculation of diluted EPD

Conv. pfd: is dividents/new shares < basic?

Conv. debt: is interest (1 - t) / new shares < basic?

Options and warrants: is avg. price > ex. price?

If answer is yes, the security is dilutive.

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37
Q

Understanding Income Statements: Diluted EPS - Example

A
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38
Q

Understanding Income Statements: Convertible Bonds - Example

A
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39
Q

Understanding Income Statements: Dilutive Stock Options - Treasury Stock Method

A

Dilutive only when the exercise price is less than the adverage market price

STEPS

  1. Calculate number of common shares created if options are exercised
  2. Calculated cash received from exercise
  3. Calculate number of shares that can be purchased at the average market price with sale proceeds
  4. Calculate net increase in common shares outstanding
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40
Q

Understanding Income Statements: Dilutive Employee Stock Options - Example

A
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41
Q

Understanding Income Statements: Vertical Common-Size Income Statements

A
  • Converts inome statement to relative percentages
  • Useful for comparing entities of differing sizes
  • Compare % to strategy in MD&A
  • Time series or cross-section use
  • Gross and net profit margin are common-size ratios
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42
Q

Understanding Income Statements: Comprehensive Income

A
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43
Q

Understanding Income Statements: Weighted-Average Shares - Problem

A
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44
Q

Understanding Balance Sheets: Components and Format of Balance Sheet

A
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45
Q

Understanding Balance Sheets: Assets

A
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46
Q

Understanding Balance Sheets: Liabilities

A
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47
Q

Understanding Balance Sheets: Equity

A

Capital Characteristics

  • Permanent
  • No mandatory charges against earnings
  • Legal subordination to creditors
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48
Q

Understanding Balance Sheets: Balance Sheet Analysis

A

Uses of balance sheet analysis

  • Assessing liquidity, solvency, and ability to make distributions to shareholders

Limitations

  • Mixed measurement conventions:
    • Historic cost
    • Amortized cost
    • Fair value
  • Fair values may change after balance sheet date
  • Off-balance-sheet assets and liabilities
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49
Q

Understanding Balance Sheets: Balance Sheet Format

A

Report format

  • Assets, liabilities, and equity in a single column

Account format

  • Assets on the left
  • Liabilities and equity on the right

Classified balance sheet

  • Grouping of accounts into sub-categories:
    • Current vs. non-current
    • Financial vs. non-financial
  • Liquidity-based presentation (financial institutions)
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50
Q

Understanding Balance Sheets: Current Assets Description

A
  • **Current assets **include cash and other assets that will likely be _converted into cash or used up _within one year or one operating cycle, whichever is greater
  • The operating cycle is the time it takes to produce or purchase inventory, sell the product, and collect the cash
  • Current assets presented in the order of liquidity
  • Current assets reveal information about the operating activities/capacity of the firm
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51
Q

Understanding Balance Sheets: Current Assets Types

A
  • Cash and cash equivalents: amortized cost or fair value
  • **Marketable securitiesL **amortized cost or fair value
  • Accounts receivable/trade receivables: net realizable value
  • Inventories:
    • Raw materials, work in process, finished goods
    • Manufacturing (standardized costs)
    • Cost flow methodology (FIFO, Avco, LIFO)
  • **Prepaid expenses: **historical cost
  • **Deferred tax assets: **net of valuation allowance
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52
Q

Understanding Balance Sheets: Inventory - IFRS

A
53
Q

Understanding Balance Sheets: Noncurrent Assets

A
  • Assets held for continuing use within the business, not resale
  • Assets not consumed or disposed of in the current period
  • Represent the infrastructure from which the entity operated
  • Provides information on the firm’s investing activities
54
Q

Understanding Balance Sheets: Accounting for Long-Term Assets

A

Long-term assets convey benefits over time

  • **Tangible assets **(e.g., land, buildings, equipment, natural resources)
  • Intangible assets (e.g. copyrights, patents, trademarks, franchises, and goodwill
  • Investment property (IFRS only) generates investment income or capital appreciation

Plant, property, and equipment recorded at purchose cost including shipping and installation, or construction cost including labor, materials, overhead, and interest.

55
Q

Understanding Balance Sheets: Depreciation and Depletion

A
  • **Tangible assets **have decreased value over time: depreciation is the allocation of the cost of tangible assets over time; land is not depreciated.
  • **Natural resources **are used up over time: depletion is the allocaton of the cost (per unit) of natural resources as they are used
  • Balance sheet (book) values are:

Historical cost less accumulated depreciation of depletion, unless asset values are impaired (U.S. GAAP & IFRS)

Fair value less any accumulated depreciation (IFRS)

56
Q

Understanding Balance Sheets: Intangible Assets: Un/identifiable

A

Identifiable intangible

  • Can be acquired singularly, linked to rights and privileges having finite benefit periods
  • Amortized over estimated useful life

Unidentified intangible

  • Cannot be acquired singularly and has indefinite benefit period (e.g., goodwill)
  • Not amortized
  • Annual impairment review
57
Q

Understanding Balance Sheets: Typical Intangibles

A
  • May only be recognized if they can be measured reliably
  • Generally excludes internally generated intangibles - subjectivity
  • Typical intangibles:
    • Purcahsed patents and copyrights
    • Purhased brands and trademarks
    • Purchased franchise and license costs
    • Direct reponse advertising
    • Goodwill
    • Computer software development costs
58
Q

Understanding Balance Sheets: Expensed Items

A
  1. Internally generated brands, mastheads, publishing titles, cutomer lists, etc.
  2. Start-up costs
  3. Training costs
  4. Administrativeand general overhead
  5. Advertising and promotion
  6. Relocation and reorgranization costs
  7. Reundancy and termination costs
  8. Research and development (Development may be capitalized under IFRS)
59
Q

Understanding Balance Sheets: Goodwill

A

Goodwill is the difference between acquisition price and the fair market value of the acquired firm’s net assets

The additional amount paid represents the amount paid for assets not recorded on the balance sheet.

60
Q

Understanding Balance Sheets: Goodwill Analysis

A
  • Impairment indicated that goodwill often results from overpayment to acquire entity
  • Remove the impact of goodwill of ratios
    • Remove goodwill from assets
    • Remove any impairment from income statement
    • Evaluate business acquisitions considering:
      • Purchase price
      • Net assets
      • Earnings prospects
61
Q

Understanding Balance Sheets: Financial Assets/Liabilities

A
  1. Stocks
  2. Bonds
  3. Receivables
  4. Notes receivables
  5. Notes payable
  6. Loans
  7. Derivatives
62
Q

Understanding Balance Sheets: Fair Value Assets and Liabilities

A

Financial assets

  • Trading securities
  • Available-for-sale securities
  • Derivatives (standalone or embedded in a non-derivative instrument)
  • Assets with fair value exposures hedged by derivatives

Financial liabilities

  • Derivatives
  • Non-derivative investment with fair value exposures hedged by derivatives
63
Q

Understanding Balance Sheets: Cost or Amortized Cost

A

Financial assets

  • Unlisted instruments
  • Held-to-maturity investments
  • Loans
  • Receivables

Financial liabilities

  • All other liabilities (e.g. bonds, notes, payable, etc.)
64
Q

Understanding Balance Sheets: Marketable Securities

A

Classification of securities based on company’s intent with regard to eventual sale:

  • Held-to-maturity securities
    • Debt securities which the company intends to hold to maturity
    • Securities are carried at cost
    • I/S/ income and realized gains/(losses) on disposal
  • Available-for-sale securities
    • May be sold to satisfy company needs
    • Debt or equity
    • Current or non-current
    • Carried on balance sheet at market value
    • Income statement same as HTM
  • Trading securities
    • Acquiried for the purpose of selling in the near term
    • Carried on the balance sheet as current assets at market value
    • Income statement includes dividends, realized and unrealized gains/losses.
65
Q

Understanding Balance Sheets: Classification of Securities - Summary

A
  • Dividends, interest, and realized gains always appear on the income statement
  • Unrealized G/L only affect the income statement for trading securities
  • Unrealized G/L are reflected on the balance sheet for both trading and available-for-sale securities
  • Unrealized G/L on available-for-sale securities show up as other comprehensive incme, not on income statement
66
Q

Understanding Balance Sheets: Current Liabilities - Criteria

A

Satisfies any of the following 4 criteria:

  1. Expected to be settled in the entity’s normal operating cycle
  2. Held primarily for the purpose of being traded
  3. Is due to be settled < 12 months from the balance sheet date
  4. The entity does not have a right to defer settlement for > 12 months

All other liabilities - noncurrent

67
Q

Understanding Balance Sheets: Current Liabilities - Types

A
  • Account payable/ trade payables
  • Notes payable
  • Current portion of long-term debt
  • Accrued liabilities
  • Taxes payable
  • Unearned revenue
68
Q

Understanding Balance Sheets: Components of Equity

A
  • Capital contributed by owners
    • Issued and authorized
  • Preferred stock (irredeemable)
  • Treasury stock (reduces equity)
  • Retained earnings
  • Noncontrolling (minority) interest
  • Accumulated other comprehensive income
69
Q

Understanding Balance Sheets: Statement of Changes in Stockholders’ Equity

A
70
Q

Understanding Balance Sheets: Common Size Balance Sheet

A

Uses:

Comparisons over time (trend analysis)

Cross-sectional comparisons)

71
Q

Understanding Balance Sheets: Liquidity Ratios

A
72
Q

Understanding Balance Sheets: Solvency Ratios

A
73
Q

Understanding Cash Flow Statements: Importance of Cash Flow Statement

A

Net income from accrual accounting does not tell us about the **sources and uses of cash **to meet liabilities and operating needs

The statement of cash flows has three components under bother IFRS and U.S. GAAP

  • Cash provided or used by operating activities
  • Cash provided or used by **investing **activities
  • Cash provided or used by financing activities
74
Q

Understanding Cash Flow Statements: CFO

A
75
Q

Understanding Cash Flow Statements: CFI

A

Investing Cash Flows (CFI)

  • Purchases of property, plant, and equipment
  • Proceeds from sales of assets
  • Investments in joint ventures and affiliated
  • Payments for businesses acquired
  • Purchases and sales of intangibles
  • Purchases or sales of marketable securities

Excludes:

  • Trading securities (part of CFO)
  • Cash equivalents (part of balance sheet cash)
76
Q

Understanding Cash Flow Statements: Financing Cash Flows

A
  • Issue and redemption of:
    • Common stock
    • Preferred stock
    • Treasury stock repurchases
    • Debt
    • Dividend payments (dividends rec’d CFO - U.S. GAAP)
  • Excludes:
    • Indirect financing via accounts payable (CFO)
77
Q

Understanding Cash Flow Statements: Non-Cash Investing and Financing Activities

A

Several types of transactions do not invole the payment or receipt of cash and are not reflected in financing and investing cash flows, but are disclosed in the footnotes or other schedules

Non-cash financing and investing activities:

  • Coverting debt or preferred into comon equity
  • Assets acquired under capital leases
  • Purchase of assets via issuance of debt/equity
  • Exchanging one non-cash asset for another
  • Stock dividends
78
Q

Understanding Cash Flow Statements: U.S. GAAP vs. IFRS

A
79
Q

Understanding Cash Flow Statements: Direct vs. Indirect Method

A

Direct vs. indirect method refers only to the calculation of CFO; the value of CFO is the same for both methods; CFI and CFF are unaffected.

Direct method: Identify actual cash inflows and outflows (e.g. collections from customers, amounts paid to suppliers)

Indirect method: Begin with net income and make necessary adjustments to get operating cash flow

80
Q

Understanding Cash Flow Statements: Linkages Between Statements

A
81
Q

Understanding Cash Flow Statements: Cash Inflows and Outflows

A

General rules regarding increases and decreases in balance sheet items over time:

82
Q

Understanding Cash Flow Statements: Indirect Method CFO

A

Steps

  1. Start with net income
  2. Adjust net income for changes in relevant balance sheet items:
    • Increases in an asset: deduct
    • Increase in a liability: add
    • Decrease in an asset: add
    • Decrease in an liability: deduct
  3. Eliminate depreciation and amortization by adding them back (they’ve been deducted in arriving at net income but are non-cash expenses)
  4. Eliminate gains on disposal by deducting them and losses on disposal by adding them back (these are CFI, not CFO)
83
Q

Understanding Cash Flow Statements: Calculating CFI

A

CFI = investment in assts - cash received on asset sales

Net book value = Gross PPE - accumulated depreciation

Gain (loss) on sale = sales price - net book value

84
Q

Understanding Cash Flow Statements: CFI - Problem

A
85
Q

Understanding Cash Flow Statements: Computing CFF

A
86
Q

Understanding Cash Flow Statements: Converting an Indirect Statement to a Direct Statement of Cash Flows

A

Most firms use the indiret method, bu the analyst may want information on the cash flows by function; some examples of this technique are:

87
Q

Understanding Cash Flow Statements: Direct Method From Indirect CFO

A
  1. Take each income statement item in turn (e.g. sales)
  2. Move to the balance sheet and identify asset and liability accounts that relate to that income statement item - e.g., accounts receivable
  3. Calculate the cange in the balance sheet item during the period (ending balance - opening balance)
  4. Apply the rule
    • Increase in an asset: deduct
    • Increase in a liability: add
    • Decrease in an asset: add
    • Decrease in a liability: deduct
  5. Adjust the income statement amount by the change in the balance sheet
  6. Tick off the items dealt with in both the income statement and balance sheet
  7. Move to the next item on the income statement and repeat
  8. Ignore depreciation/amortization and gains/losses on the disposal of assets as these are non-cash or non-CFO items
  9. Keep moving down the income statement until all items included in net income have been addresses applying steps 1-8
  10. Total up the amounts and you have CFO
88
Q

Understanding Cash Flow Statements: Direct From Indirect CFO - Statement

A
89
Q

Understanding Cash Flow Statements: Benefits of Cash Flow Statement Analysis

A

Benefits for the analyst

  • Do regualr operations generate enough cash to sustain the business?
  • Is enough cash generated to pay off maturing debt?
  • Highlight the need for additional finance
  • Ability to meet unexpected obligations
  • The flexibility to take advantage of new business opportunities
90
Q

Understanding Cash Flow Statements: Analysis

A
  1. Analyse the major sources and uses of cash flow (CFO, CFI, CFF)
    • Where are the major sources and uses?
    • Is CFO positive and sufficient to cover capex/
  2. Analyze CFO
    • What are the maor determinants of CFO
    • Is CFO higher or lower than NI?
    • How consistent is CFO
  3. Analyze CFI
    • What is cash being spent on?
    • Is the company investing in PP&E?
    • What acquisitions have been made?
  4. Analyze CFF
    • How is the company financing CFI and CFO?
    • Is the company raising or repaying capital?
    • What dividends are being returned to owners?
91
Q

Understanding Cash Flow Statements: Common Size Statements

A
92
Q

Understanding Cash Flow Statements: FCF

A
  • FCF is cash available for discretionary uses
  • Frequently used to value firms
93
Q

Understanding Cash Flow Statements: Cash Flow Performance Ratios

A
94
Q

Understanding Cash Flow Statements: Cash Flow Coverage Ratios

A
95
Q

Financial Analysis Techniques: Interpreting Ratios

A
  1. Cross-sectional analysis
    • Comparison to industry norm or average
  2. Time-series analysis (trend analysis)
    • Comparison to a company’s past ratios

Ratios help the analyst identify questions that need answering

96
Q

Financial Analysis Techniques: Vertical Common-Size Statements

A
97
Q

Financial Analysis Techniques: Horizontal Common-Size Statements

A
98
Q

Financial Analysis Techniques: Graphs

A
  • Facilitates comparisons over time
  • Performance
  • Financial structure
  • Communicate analyst conclusions
  • Types
    • Pie graph - composition of total value
    • Stacked column graph - composition of total value over time
    • Line graph - change over time
99
Q

Financial Analysis Techniques: Stacked Column Graph

A
100
Q

Financial Analysis Techniques: Line Graph

A
101
Q

Financial Analysis Techniques: Limitations of Financial Ratios

A
  • **Not useful in isolation - **only valid when compared to other firms or the company’s historical performance
  • **Different accounting treatments - **particularly when analyzing non-U.S. firms
  • **Findin comparable industry ratios **for companies that operate in multiple industries (homgeneity of operating activities)
  • All ratios must be viewed relative to one another
  • Determining the target or comparison value required some range of acceptable values.
102
Q

Financial Analysis Techniques: Common-Size Income Statement

A
  1. Expresses each income statement item as a percentage of sales
  2. Used to analyze changes in cost structure and profitability
  3. Used for both cross-sectional and time-series analysis
103
Q

Financial Analysis Techniques: Common-Size Income Statement - Example

A
104
Q

Financial Analysis Techniques: Categories of Ratios

A
  1. Activity → Efficiency of day-to-day tasks/operations
  2. **Liquidity → **Ability to meet short-term liabilities
  3. **Solvency → **Ability to meet long-term obligations
  4. **Profitability → **Ability to generate profitabel sales from asset base
  5. Valuation → Quantity of asset or flow associatied with an owership claim
105
Q

Financial Analysis Techniques: Ratio Analysis Context

A
  1. Company goals and strategies
  2. Industry norms
    • Ratios may be industry specific
    • **Multiple lines **of business distort aggregate ratios
    • Difference in accounting methods
  3. Economic conditions
    • Cyclical businesses and the stage of the business cycle
106
Q

Financial Analysis Techniques: Ratio Analysis

A

Some general rules:

  • For ratios that use only income statement items, use the values from the current income statement
  • For ratios usng only balance sheet items, use the values from the current balance sheet
  • For ratios using both income statement and balance sheet items, use the value from the current income statement and the average value for the balance sheet item
107
Q

Financial Analysis Techniques: Activity Ratios

A
108
Q

Financial Analysis Techniques: Liquidity Ratios

A
109
Q

Financial Analysis Techniques: Cash Conversion Cycle

A
110
Q

Financial Analysis Techniques: Solvency

A
111
Q

Financial Analysis Techniques: Solvency Ratios

A
112
Q

Financial Analysis Techniques: Profitability Ratios

A
113
Q

Financial Analysis Techniques: Integrate Financial Ratio Approach

A
  • Important to analyze all ratios collectively
  • Use information from one ratio category to answer questions raised by another ratio
  • Classic example = DuPont analysis
114
Q

Financial Analysis Techniques: Integrated Financial Ratios - Example

A
115
Q

Financial Analysis Techniques: DuPont System Analysis

A
116
Q

Financial Analysis Techniques: DuPont System Original Equation

A
117
Q

Financial Analysis Techniques: DuPont System: Extended Equation

A
118
Q

Financial Analysis Techniques: Per-Share Ratios for Valuation

A
119
Q

Financial Analysis Techniques: Per-Share Quantities

A
120
Q

Financial Analysis Techniques: Dividend Related Quantities

A
121
Q

Financial Analysis Techniques: Sustainable Growth Rate - Problem

A
122
Q

Financial Analysis Techniques: Business Risk Ratios

A
123
Q

Financial Analysis Techniques: Using Ratios for Equity Analysis

A

Research has found ratios ( and changes in ratios) can be useful in forecasting earnings and stock returns (valuation)

Some items useful in forecasting

% change in: current ratio, quick ratio, inventory, inventory turnover, inventory/total assets, sales, depreciation, capex/assets, asset turnover, depreciation/plant assets, total asets

ROE, ^ ROE, debt/equity, ROA, gross margin, working capital/assets, dividends/cash flow, ^ divident, % debt repaid, operating ROA, pretax margin

124
Q

Financial Analysis Techniques: Credit Ratings and Ratios

A

Assessing a company’s ability to service and repay its debt

Interest coverage ratos

Return on capital

Debt-to-assets ratio

Other ratios focus on various measures of cash flow to total debt

Note: Adjustment are made for off-balance-sheet debt

125
Q

Financial Analysis Techniques: Segment Reporting

A

Reportable business or geographic segment:

50% of its revenue from sales external to the firm, and at least 10% of a firm’s revenue, earnings, or assets

  • For each segment, firm reports limited financial statement information
  • For primary segments, must report: revenue (internal and external), operating profit, assets, liabilities (IFRS only), capex, depreciation and amortization
126
Q

Financial Analysis Techniques: Segment Ratios

A
127
Q

Financial Analysis Techniques: Model Building

A
  • Common-size statements and ratios can be used to model/forecast results
    • Expected relationships aong financial statement data
    • Earnings model
    • Revenue driven models
  • Sensitivity analysis
  • Scenario analysis
  • Simulation
128
Q

Financial Analysis Techniques: Financial Analysis - Problem

A

CFA: Level 1 (18 decks)

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