Financial statements 2 Flashcards
Comment on this statement, ‘Just because you see in the balance sheet a given reported total assets, this does not necessarily mean that the company’s assets were worth this much!’
The market or fair value of a company’s assets can be less than, or greater than, their balance sheet value. This divergence occurs for two reasons. One reason is that for many assets, such as land and buildings, these are recorded at their acquisition (or historical) cost, which is basically what the company paid for the assets when they were acquired. However, over time, the market value of these assets will vary from the acquisition costs. A good example of assets whose value varies over time is real estate.
In some countries, companies are allowed periodically to restate real estate to their market value. This treatment is allowed, but not necessarily required, under International Financial Reporting Standards (IFRS).
Another reason for this divergence between the book (or balance sheet) value of assets and what they are really worth is that some assets – in particular, those of an intangible nature, such as intellectual capital – might not even appear on a balance sheet and, therefore, will not be reflected in total assets. Many intangibles appear on balance sheets only when they are acquired from other firms. This rule allows a reasonably objective valuation of the asset, but in knowledge-intensive companies, effectively significant assets are left out.
It is worth knowing that this treatment is permitted – no matter how inconsistent it may appear – ie reporting assets only when they are acquired from other firms, and not reporting them if they have been developed internally.
What are ‘noncurrent assets’?
Noncurrent are long term assets, such as investment, property, plant and equipment, and intangible assets, including ‘goodwill’.
Investments are long-term assets that the management wants to hold, such as shares of stock in one of its suppliers to ensure the continued availability of materials.
Property, plant and equipment are tangible, long-term assets used in a firm’s operations over a period of years and typically not acquired for resale. This type of noncurrent asset can include land, buildings, equipment, machinery, vehicles and computers.
All tangible assets, apart from land, are depreciated because their contribution to the firm’s operations erodes over time.
What’s the reason that a company does not use the same accounting for its income statement as it uses for its tax return?
The main purpose of IFRS and US GAAP is to assist companies to produce a set of accounts that capture the underlying economic reality of their businesses. So, it can help investors and other parties to make better decisions, one of them being the efficient allocation of capital.
On the other hand, tax law exists to allow governments to assess and collect tax revenues from businesses consistent with the public-policy priorities of the country’s lawmakers. When tax laws are written and amended, the efficient allocation of capital may not be the main objective of politicians. The main concerns and objectives may be, for example, to promote investment in capital goods or personnel hiring in an economically depressed region, or to discourage excessive management pay.
In order to deal with this issue, accountants came up with the idea of separating tax reporting from the financial reports used to raise funds in the capital markets. In short, this means that firms calculate their earnings in two ways:
One of them is based on tax law (tax earnings) and the other one is based on GAAP or IFRS (book earnings).
What is the difference in accounting between expenditure and expense?
In everyday life, we typically do not differentiate between expenditure vs expense; however, in accounting, there are differences. When an expenditure is made, a company can either capitalise it or expense it. You capitalise an expenditure by recording it as an asset. This treatment implies that the expenditure is expected to benefit a future period.
A good example is real estate: when a company buys a building, the cost appears as an asset on the balance sheet, and only gradually finds its way into the income statement through the process of depreciation. When an expenditure is expensed, the amount is charged in the current period to expense and effectively reduces earnings.
A general guiding principle is that if an expenditure is expected to benefit more than the current period, then it should be capitalised and appear on the balance sheet. All other expenditures should be expensed, meaning charged immediately to earnings on the income statement. However, this guiding principle can sometimes be violated.
Explain the difference between accounting for tax and accounting for book earnings.
Temporary differences are items of income or expense that are recognized in one period for book but in a different period for tax. These cause timing differences between the two incomes but, in the long run, there is no difference between book and tax.
What information financial statements can and cannot reveal.
Financial Performance:
Revenue and Profitability: Income statements show how much money a company earns and its net profit or loss.
Cost Structure: They detail expenses, helping to understand where money is spent.
Financial Position:
Assets and Liabilities: The balance sheet provides a snapshot of what a company owns (assets) and owes (liabilities).
Equity: It shows the net worth of the company, which can indicate financial stability
Future earnings
insight into managment decicisions.Strategic Direction: The motivations behind management decisions or future strategies are not disclosed
Describe the Porter model and explain how the five forces constrain profitable operation.
An approach to industry analysis is known as the ‘5-forces’ or Porter model. The Porter looks at five basic competitive forces that affect industry returns. Based on Porter, if any of these forces is strong enough, it can reduce or even eliminate industry profits.
These ‘5 forces’ are:
rivalry among existing firms
threat of new entrants
threat of substitute products
bargaining power of buyers
bargaining power of suppliers.
How can we calculate the free cash flow?
Free Cash Flow (FCF) is a measure of a company’s financial performance that represents the cash available after accounting for capital expenditures. It’s an important metric for assessing the health and viability of a business. Here’s how to calculate it:
Formula for Free Cash Flow:
FreeCashFlow
=
OperatingCashFlow
−
CapitalExpenditures
FreeCashFlow=OperatingCashFlow−CapitalExpenditures
EBIT x (1-Tax)
+ Depreciation
+ Amortisation
- Investment
Free cash flow
Depreciation as well as amortisation too, if applicable, is added back because it’s not a cash expense.
Finally, investment in working capital and in Property, Plant and Equipment (PP&E) is subtracted.
What are the practical considerations when you value an asset or a company as the sum of future free cash flow discounted at the opportunity cost of capital?
One practical problem with this model is the theoretically indefinite life of the business. Annual cash flows cannot be estimated in perpetuity. This problem can be overcome by dividing the future cash flows into two separate elements, one that reflects the present value of cash flows during an explicit forecast period and the other that reflects the present value of cash flows after the forecast period. The latter value is typically known as terminal, or continuing, value. The length of the explicit forecast period utilised varies, typically a period of three to seven years is common.
Another complicating factor is that the above model measures only the value of operations. It must be extended to include the value of any non-operating sources of value, such as cash and marketable securities. In effect, the value of the firm does not just include the present value of future cash flows, but also the value of any cash or near-cash resources that the company may already have. In fact, any resource that has a cash value, but which is not considered in the cash flow forecasts, can be viewed as a non-operating asset. The value of such resources must also be considered in estimating the value of the firm.
Therefore, a more complete picture of DCF valuation is:
Non-operating assets
+ PV of cash flows during the forecast period
+ terminal value
Asset and company value
How can you estimate the terminal value?
In order to carry out any company valuation as complete as possible, we should estimate a terminal value for the end of the forecast horizon. This estimate requires a forecast of future free cash flows or economic profits.
There are various approaches that can be employed to estimate the terminal value. An approach that appears sensible is not to assume that value-creating investments are likely to continue indefinitely. Rather assume that any further investments made by the company will be value neutral. Investments could generate enough net operating profit after tax (NOPAT) to cover the opportunity cost of capital (OCC), but no value creating returns should be assumed. This means that while the return on invested capital (ROIC) might remain well above the company’s OCC for a long time, the return on any newly invested capital (RONIC) is expected to equal the OCC.
This is a sensible approach otherwise the valuation would assume that a company can create additional sources of competitive advantage in perpetuity.
What are the best steps for carrying out the relative valuation?
he steps for carrying out relative valuations typically involve:
Decide on a list of comparable companies. Usually, these comparables are publicly traded in order to obtain easily observed market prices. The comparables may be industry peers, but it is worth also including companies beyond the industry for companies of similar size and with similar risk profiles.
Convert market values into trading multiples, such as price–earnings (PE), price-to-book (P/B), enterprise value-to-EBITDA ratios, etc. The idea is to identify some attribute of a company that gives rise to value, and to define the market price with respect to this attribute.
While some attributes apply to any business – examples include earnings, EBITDA, and sales – other attributes are industry-specific.
Adjust multiples for differences between the comparables and the subject company. For example, if the comparables have an average PE ratio of 12, but the subject company has an above-average growth rate, the PE ratio used for valuation purposes will probably be higher than 12.
How can you combine the discounted cash flow (DCF) or economic profit (EP) approach with the relative valuation?
Build your own DCF or EP model based on the assumptions you feel best suit your purposes. Then calculate multiples to use them as communication tools with other investors.
