Financial Statement Analysis Flashcards
6business segment or operating segment
accounts for more than 10% of the company’s revenues, assets, or income
Management commentary, or management discussion and analysis (MD&A)
assessment of the financial performance from the perspective of its management;
Effects of inflation and changing prices, if material
Trends, significant events,
Impact of off-balance-sheet and contractual obligations
Accounting policies that require significant judgment
Forward-looking expenditures and divestitures
audit
opinion on the fairness and reliability of the financial reports. financial statements are prepared by management and are its responsibility, the auditor has performed an independent review., reasonable assurance that the financial statements contain no MATERIAL errors.,
auditor is satisfied that the statements were prepared in accordance with accepted accounting principles and that the accounting principles chosen and estimates made are reasonable. The auditor’s report must also contain additional explanation when accounting methods have not been used consistently between periods.
unqualified opinion (also known as an unmodified opinion or clean opinion)
free from material omissions and errors; Any opinion other than unqualified is sometimes referred to as a modified opinion.
qualified opinion
explain these exceptions in the audit report statements make any exceptions to the accounting principles
adverse opinion
statements are not presented fairly or are materially nonconforming with accounting standards,
disclaimer of opinion
auditor is unable to express an opinion
Under U.S. GAAP, the auditor must state an opinion on a publicly traded company’s internal controls, the processes by which the company ensures that it presents accurate financial statements
responsibility of the firm’s management
Proxy statements are issued to shareholders when there are matters that require a shareholder vote.
filed with the SEC and available from EDGAR
GAAP vs IFRS
Based on Rules vs Principles;
FIFI, LIFO, weighted average vs no LIFO;
developement cost expensed vs may be capitalized;
interest is CFO vs CFO or CFF;
reversal of inventory write down no vs allowed;
revenue recognition
goods are exchanged for cash and returns are not allowed, rev recognized at time of exchange, not cash pmt received, create accounts receivable;
If payment for the goods is received before the transfer of the good, unearned rev e.g. subscription;
long-term contracts, revenue is recognized based on a firm’s progress toward completing a performance obligation e.g. input: % of completion cost incurred or output: % of total output delivered.
expense recognition
accrual method: matching principle=expense COGS recognized as revenue is recognized. for expenses not tied to rev (admin cost)=period costs expensed in the period incurred;
warranty expense at time of sale (esetimate);
depreciation and amort capitalized and release as cost to match with benefit;
cost of long-lived assets must also be matched with revenues; expenditure create benefit over long time is capitalized; but if the future benefit is highly uncertain, expensed as incurred (depreciation, amortization, depletion).
interest accrued from building asset for own use is capitalized as asset cost, not in income stmt as interest expense but depreciation expense (asset is held for use) or COGS (held for sale), CFI!!!! not as CFO (GAAP) or CFO/CFF (IFRS);
research costs are expensed; developement cost GAAP expensed, IFRS expensed or capitalized (intangible asset, technical feasibility, intention to complete/use/sell, can generate cash flow). IFRS treate cost of creating software to sale like R&D;
sell g&s on cretdit or warranty, matching principal=estimate bad-debt expense/warranty expense as recog rev;
delay recog expense increase NI=more aggressive;
Nonrecurring Items
discontinued operation=decided not yet disposed or disposed, g&l repoerted seperated in after tax at continuing operations income stmt; do not affect net income from continuing operations and exclude when forecast future earnings;
Unusual or infrequent items=sales of assets g&l as BAU, impairments, write-offs, write-down, restructuring cost are income from continuing operations
accounting changes
retrospective=restate prior period, enhance comparibility over time; changes in accounting POLICY=inventory method or capitalizing rather than expensing, changes in the classification noncur or cur of financial assets and liabilities, specific purchases are retrospective;
prospective=prior statements are not restated, and the new policies are applied only to future; Changes in ESTIMATES (new info, mgmt judgement, do not affect cash flow)=depreciation methods useful life, provision for doubltful accounts;
modified retrospective=not change past but adjust begining amount cumulatively;
Retrospective restatement for corrections of errors is required;
EPS
Potentially dilutive securities=stock optoins, warrants, convert debt, convert pref stock; decrease EPS if execercised/convert to CS;
antidilutive=increase EPS if converted;
simple vs complex capital structure=assume no potential dilutive securities vs yes;
Weighted average shares outstanding=weight share by portion of year outstanding (split and div applied to beg of year);
basic EPS=no potential dilutive=(NI-pref div)/weighted avg CS shares outstadning, no PS shares in numerator; calc each seperately:
convertible stock dilutive?=convertible pref stock div/#shares from conversion of PS;
convertible debt dilutive?=converitble debt int(1-tax)/#shares from conversion of conv debt; <1 dilutive;
diluted EPS=(NI-PSdiv+debt div(1-t)+pref div)/(weighted avg CS+con PS shares+debt shares+issuable from stock options);
Options and warrants are dilutive whenever the exercise price is less than the average stock price; new shares=(avg mk price-excercise price)/avg mkt price*# shares conv options/warrants
vertical common-size income statement
each category as a percentage of revenue; time-series and cross-sectional analysis for firms sizes;
Gross profit margin
gross profit/revenue
net profit margin
NI/Rev
Other comprehensive income
defined benefit pension plans remeasuerment, FX adjustment, cash flow hedges, AFS unrealized g&l
capitalizing vs expense
spread cost in IS over time, creat BS asset;
take cost expense now
Intangible assets
nonmonetary assets that lack physical substance;
cost is amortized if finite life, recorded at fair value;
unidentifiable intangible asset that cant be purchased separately and have indefinite life; goodwill not amortized but impairment;
or finite life identifiable intangible that can be renewed at minimal cost (trademarks) are not amortized but impaired.
appear on group account but not individual company account;
if gain, take out of BS and put in stockholder’s equity; if loss (acquire price>fair value) buyer, loss on IS impaired
intangible assets that are created internally, including R&D costs, are expensed as incurred in under U.S. GAAP, except software internally developed for sale (technical feasibility) for use (probable completion and use as intended); capitalize development cost under IFRS if technically feasible;
expensed:
Start-up and training costs
Administrative overhead
Advertising and promotion costs
Relocation and reorganization costs
Termination costs
goodwill
business bought for more than fair value of asset net of liability;
not amortized but impairment, decrease in fair value at least annually;
cuz not amortized, manipulate by allocate more acquisition price to goodwill and less to identifiable asset, so less dep and amort;
goodwill from business combination is capitalijed on balance sheet impairment gradually, internallly generated goodwill are expensed as incurred;
exclude goodwill from BS (overpaid when acquired) and impairment charges from NI IS when analyze ratios;
goodwill impairment, not tax allowable so no effect on cash flow
IFRS, annual impairment check, allow reversal of write downs if value recover:
impaired when carrying value [=cost-accumulated depreciation] > recoverable amount [MAX(fair value-selling cost, value in use [=PV of future cash flows])],
if impaired, write down on balance sheet to the recoverable amount, an impairment loss [CV-recoverable amount] is recognized in IS;
GAAP, an asset is test for impairment only when events signal firm might not be able to recover, loss reversal prohibited for held for use:
- recoverability test: impaired if CV>future undiscounted cash flow;
- if impaired, write down to fair value on BS and recognize loss in IS equal to excess of CV-FV or discounted cash flow if FV is unkown
Accounting Treatments for Financial assets
GAAP: HTM (debt, loans, notes receivable and unlist securities with unsure fair value amortized
through historical cost @BS),
AFS (fair value @BS, unrealized g&l @OCI, dividend and realized g&l @IS),
trading securities (fair value @BS, dividends and any unrealized or realized gains or losses @IS->NI->RE->shareholders equity)
IFRS: Securities measured at amortized cost, Securities measured at fair value through other comprehensive income (FVOCI), Securities measured at fair value through profit and loss (FVPL)
effective interest @IS for all
Accounting Treatments for Financial liabilities
loans, notes payable, bonds payable that are not issued at face value are amortized @BS;
premium/discount is amortized through interest expense over time (IS gradual decrease);
BS liability move towards face value at maturity;
@IS effecitve interest rate*historical value;
@CFS, interest as decrease CFO, principal payment as decrease CFF, issuance proceed as increase CFF;
BS carrying value=amortized total cost;
interest expense=coupon-amortization
vertical common-size balance sheet
percentage of total assets
Liquidity ratios
ability to satisfy short-term obligations when due;
current ratio=CA/CL;
quick ratio=(cash+marketable securities+AR)/CL=cash-inventory;
cash ratio=(cash+marketable securities)/CL [most conservative]=cash-inventory-AR
Solvency ratios
ability to satisfy long-term obligations (its solvency);
long-term debt-to-equity ratio= long-term financing sources relative to E;
debt-to-equity ratio;
total debt ratio=total debt/total asset =which assets are financed by creditors;
financial leverage ratio=total asset/total equity in depont
CFO
use of the direct method is encouraged by both GAAP IFRS;
direct method provides more information than the indirect method. difference CFO and NI;
CFO:
direct method: NI+NCC (dep)-WC [-increase of CA, -decrease of CL];
GAAP IFRS prefer direct but most firms present the cash flow statement using the indirect method, convert to direct method: aggregate all rev, exp, gains, losses, minus NCC and disaggregate the remaining items, convert from accruals to CF by adjust change in WC; add change of WC and dep, g&l all to NI without categorizing except of COGS, Rev, provision for tax, interest and operating expense cuz they are all included
CFI=proceeds of asset sales-expenditure+g&l on sale;
cash from asset sold = book value of the asset + gain (or − loss) on sale;
CFF=transactions affecting a firm’s capital structure, such as borrowing, repaying debt, and issuing or redeeming equity securitie, exclude indirect financing from acct payable CFO;
net cash flows from creditors = new borrowings – principal repaid;
net cash flows from shareholders = new equity issued – share repurchases – cash dividends; e
Cash flows GAAP vs IFRS
interest received: CFO, CFO/CFI;
dividend received: CFO, CFO/CFI;
interest paid on debt: CFO, CFO/CFF;
dividends paid to shareholders: CFF, CFO/CFF;
exception on internal built equip interest capitalized as CFI?
tax paid: CFO, CFO unless expense tied to I or F;
bank overdrafts: CFF, part of BS cash;
format: both direct or indirect;
reconcile NI to CFO: required, NA
if CFO=NI, means high quality earnings; earnings exceed CFO might be premature recognition of rev or delay recog of expense
increase capital expenditure is sign of growth, reduce capex or sell capital asset to generate cash is not a good sign. could lead to higher cash outflow in future to replace PPE
cash flow statement common-size format
each inflow item as % of total cash inflow, vice versa; use for trend anlaysis time seris;
show each CF item as % of rev; forecast future cash flow;
Free cash flow
cash available for discretionary use after capex;
FCFF=cash available to all investors (E&D)=CFO+cash interest paid*(1-T)-fixed capital investment;
FCFE=cash available to common shareholders=CFO+net borrowing-fixed capital investment;
diff between is net borrowing and cash int paid
cash flow-to-revenue ratio
CFO/rev;
amount of operating cash flow generated for each dollar of revenu
cash return-on-assets ratio
CFO/average total asset;
return of operating cash flow attributed to all providers of capital
debt coverage ratio
CFO/total deb;
measures financial risk and leverage
interest coverage rato
(CFO+interest paid+taxes paid)/interest paid;
ability to meet interest obligations
HTM AFS are CFI, trading CFO;
cash equivalent is part of balance sheet cash, very liquid
carring value=book value recorded on BS = cost-accumulated depreciation;
same as carrying value aka net PPE=gross PPE-accumulated depreciation
net PPE=carrying value=book value on BS;
- find gross PPE disposed=beg net PPE+purchase+gross PPE disposed=end net PPE;
- find acc dep on gross ppe: beg acc dep+dep expense-acc dep on disposal=end acc dep;
- proceeds on PPE disposed: proceeds-CV on disposal [gross ppe disposed-acc dep]=g&l on disposal;
- CFI=proceeds on ppe disposal-purchase
noncash charges
g&l on assets disposal, changes in DTA/DTL, unrealized g&l on trading securities (noncash charges but realized is CFO), inventory write-down and off, provision (doubtful debt, warranties, tax provision, if using direct method, already in NI for indirect method), defined benefit pension expenses, impairments, dep, amort, operating expense, interest expense
COGS starts as negative in CFO calc
tax provision expense (negative)+increase in DTL=tax payable;
tax payable-decrease in tax payable liability=cash tax paid
beg RE +NI-dividend paid=end RE
negative dividend paid+increase in dividend payable liability=negative cash dividend paid;
CFF=cash dividend paid+equity issued [-repurchased]+debt issuance
change in total cash flow=
beg BS cash+CFO+CFI+CFF=end BS cash
processing data
include adjust financial stmt, calc ratio, prepare exhibits like common sized financial stmt
inventory
IFRS: min(cost, net realizable value=sale prices-selling cost-completion cost);
if NRV<BV of inventory, inventory write down to NRV, recognize loss in IS as separate or increase COGS; allow inventory write up to extent of previous write-down; no LIFO
GAAP: FIFO&avg cost method: same as IFRS;
LIFO: min(cost, market replacement cost between [NRV-normal profit margin, NRV]));
allow write down but not write up;
for commodities (agriculture produce), inventory can be above historical cost using either quoted market price or latest transactions;
average cost inventory method, COGS, inventory balance, gross profit will be between LIFO and FIFO no matter price rise or fall;
assuming price increase, LIFO COGS increase, gross profit net profit decrease;
inventory balance decrease, WC, CA decrease, current ratio decrease, quick ratio not affected;
activity ratio: inventory turnover ratio=COGS/avg inventory increase->lower days of inventory on hand DOH=365/inventory turnover;
solvency ratio: lower asset so lower shareholders equity (A-L), debt ratio and debt to equity is higher;
CFO lower cuz lower tax lower taxable income;
LIFO liquidation
when LIFO inventory declines as price rise, COGS based on older inventory so artificially low, increase gross and net profit but not sustainable;
disclose in footnote of decrease in LIFO reserve, also disclose method used, CV of inventory, write downs and reversals, CV of inventory as collaterals
decognije long-lived asset
removed from the balance sheet when they are sold, exchanged, or abandoned.
when sold:
g&l from sale=sale proceeds-CV; CV=cost-acc dep-impairment charges;
report g&l on IS as other g&l or as unusual/infrequent item if material;
when abandoned:
no proceeds, record CV removed from B/S and recog loss in IS;
exchanged:
removed CV of old asset from BS and record FV of old asset on BS;
average age=accumulated depreciation/annual depreciation expense;
total useful life=historical cost [gross cost]/annual depreciation expense;
remaining useful life=end net PPE/annual depreciation expense
lease
lessee purchases the right to use an asset from another firm (lessor) for a specific period; lease must 1. refer to an asset, 2. give lessee all economic benefit during term, 3. lessee has the right to determine how to use the asset during term;
Less initial cash outflow, less costly financing (less int rate than loan to purchase asset), less obsolescence risk so no risk of asset value decline cuj returned to lessor;
finance lease=both benefits and risks of ownership are substantially transferred to the lessee;
operating lease=either the benefits or the risks are not substantially transferred
lessee reporting
IFRS for both financing and operating lease: record PV of lease payments as right-of-use (ROU) asset and lease liability on BS; ROU asset is amortized straight-line over time. amortization amount and interest portion of lease payments are separately reported as expense on IS; lease liability is reduced by principal portion of lease payment; both A&L start at PV of lease payments and end at 0, value during life are different; amortization of ROU asset will exceed principal portion of lease payment in early years meaning decrease faster?;
finance lease: int portion is CFO or CFF (paid), principal is CFF (paid);
operating lease: same
GAAP finance lease same as IFRS;
operating lease: report both interest portion of lease payment and amortization of ROU asset (which is equal to interest portion of the lease payment, not a straight line like IFRS) on IS as one expense; due to amortization of lease liability and amortization of ROU are equal each period, A&L have equal value over whole lease life.
finance lease: interest portion is CFO, principal is CFF (div paid);
operating lease: CFO, CFO
lessor reporting
GAAP same as IFRS
finance lease: initiation, lessor remove lease asset from BS and add lease receivable asset=PV of lease payments expected. if value is different from asset’s book value, lessor recognize g&l. over time, lessor amortize lease receivables and report int portion as income (rev if rev-generating lease).
operating lease: keep leased asset on BS and record depreciation expense; report lease payment as income on IS and depreciation and other costs as expense;
int and principal both CFO for both type
defined contribution pension plan
firm contributes a sum each period; firm makes no promise to the employee regarding the future value of plan;
employee bear investment risk on investments;
reporting:
IS: pension expense = employer’s contribution. BS: no liability reported
defined benefit pension plan
firm promises to make periodic payments to employees after retirement based on the employee’s years of service and compensation at retirement; employer bears investment risk;
reporting:
if fair value of asset>estimated pension obligation, plan is overfunded, record net pension asset on BS;
if <, underfunded, funded status is net pension laiblity on BS;
Share-based compensation
issuing employees company stock or options to buy company stock; not require cash flow but dilute shareholder ownership and reduce EPS;
IFRS GAAP measure fair value BS at grant date, expense to IS over vesting period or service period (received stock or exercise stock option)
debt to capital; total debt
debt/(debt+equity); debt/asset
interest bearing short long term debt excludes leases, accrual liability no int
amortization=int expense-coupon; positive, discount bond; negative, premium bond
<12 month short term lease are expensed
Financial reporting quality
how well reportings follow GAAP;
high-quality should be: decision useful (relevance [useful in decision-making] and faithful representation [completeness, neutrality, absence of errors])
quality of earnings (not the quality of earnings reports)
high if earnings represent an adequate return on equity and are sustainable; firm can have high financial reporting quality but low earnings quality but if a firm has low-quality financial reporting, we might not be able to determine the quality of its earnings.
Neutral Accounting vs. Biased Accounting (Conservative or Aggressive)
neutral (unbiased) to be most valuable to users;
biased are used to smooth earnings;
conservative=decrease reported earnings and financial position for currently period; increase future earnings; e.g. adjust acrued liability upward if higher than expected earnings to defer recognize earnings; Accrued liabilities, representing obligations incurred but not yet paid, affect earnings by increasing expenses in the period they are incurred, thus reducing net income, regardless of when the actual cash payment occurs
aggressive=increase current earnings or improve financial position of current period; decreased future earnings; earnings are less than expected;
unqualified or “clean” audit opinion does not guarantee that no fraud has occurred, but reasonable assurance the stmt is fairly reported to GAAP
Conservative
Larger valuation allowances on DTAs
Greater reserve for bad debt
why low-Quality Financial Reporting
motivation [avoid violating debt covenants, meet benchmark, EPS growth, promotion, incentive compenstaion], opportunity [weak internal controls, inadequate BOD oversight, large range of accting treatments, inconsequential penalties], and rationalization of the behavior [less-than-ethical actions]:
channel stuffing
Overloading a distribution channel with more goods than would normally be sold to recog revenue
bill-and-hold transaction
customer buys the goods and receives an invoice but requests that the firm keep the goods at their location for a period of time; bad: increase earnings in the current period by recognizing revenue for goods that are actually still in inventory. revenue for future periods will be decreased as real customer orders for these bill-and-hold items are filled but not recognized in revenue, offsetting the previous overstatement of revenue
eserve for uncollectible debt is an offset to accounts receivable
decrease of credit losses=accounts receivable will be uncollectible is lower than their current estimate, a decrease in the reserve for uncollectible debt will increase net receivables and increase net income.
valuation allowance reduces the carrying value of a DTA based on managers’ estimates of the probability it will not be realized. Similar to the effects of an allowance for bad debt, increasing a valuation allowance will decrease the net deferred tax asset on the balance sheet and reduce net income for the period, while a decrease in the valuation allowance will increase the net deferred tax asset and increase net income for the period.
DTL
recognize an expense sooner (decerease net income) for tax purposes, it saves on taxes now but have to pay tax late;
temporary difference;
DTA
recognize expense later (increase NI now, increase tax), pay less tax later;
temporary difference;
DTL or a DTA
equals the amount of the timing (temporary) difference times the company’s statutory tax rate;
tax laws are not the same as the financial reporting standards, so financial reporting needs a special set of rules to account for the differences.
income tax expense = taxes payable + ΔDTL – ΔDTA
increase in a DTL increases income tax expense;decrease in a DTA increases income tax expense. If the statutory tax rate changes, existing DTLs and DTAs must be adjusted. An increase in the statutory rate will increase both DTLs and DTAs. A decrease in the statutory rate will decrease both DTLs and DTAs.
tax loss carryforward
a current or past loss that can be used to reduce taxable income in the future. This can result in a DTA
DTA to have value, a company must have at least that much future tax to pay, which means it must expect enough future income to owe that much tax
otherwise must decrease DTA directly in IFRS or create valuation allowance in GAAP, increase income tax expense for the period
permanent differences do not result in DTLs or DTAs. change the company’s effective tax rate
footnote disclosure in the financial statements must reconcile the statutory tax rate to the effective tax rate
cash tax rate, which is cash taxes paid as a percentage of pretax income.
asset, CV (accounting base)>tax base=>pay less tax now, DTL
DTL=(CV-TB)*tax rate
tax payable=taxable income*statutory tax rate
tax loss carryforward
investor can use capital losses realized in the current tax year to offset gains or profits in a future tax year
permanent differences between taxable income and pretax income
tax exempt income, increase accouting income but not taxable income;
some expense (donation) decrease accounting income but not taxable income;
tax credits;
anythine that causes difference between pretax income and taxable income
GAAP if make loss in futre, GAAP use valuation allowance to offset DTA, but IFRS reduce DTA to 0 and recog expense (DTA*probability so no need VA)
working capital turnover
revenue/
average working capital
operating profit margin
operating income/
revenue
=
EBIT/
revenue
return on invested capital
EBIT/
average total capital
Total capital includes debt capital, so interest is added back to net income.
return on total equity
net income/
average total equity;
return on common equity
=
net income - preferred dividends/
average common equity
interest coverage
EBIT/
interest payments;
fixed-charge coverage
=
EBIT + lease payments/
interest payments + lease payments
solvency
anchoring (insufficiently changing forecasts when new information arrives)
representativeness bias (overreliance on known classifications);
confirmation bias (seeking out data that affirms an existing opinion and disregarding information that calls it into question).
Porter’s five forces:
threat of new entrants,
threat of substitute products,
intensity of industry rivalry,
bargaining power of buyers,
bargaining power of suppliers.
A difficult part of an analyst’s job is recognizing inflection points, those instances when the future will not be like the past. Examples of inflection points include changes in the economic environment or business cycle stage, government regulations, or technology.
100% interest burden means no interest: EBT/EBIT;
100% tax burdent means no tax: NI/EBT
coefficient of variation of operating income
volatility of EBIT/EBIT
operating leverage
% change in EBIT/% change in sales; high if high fixed cost=>if volume drop, sales, drop, EBIT stays; once those fixed costs are covered, each additional dollar of revenue contributes disproportionately to profits
