Volume 2/3 - Financial Statement Analysis Flashcards
Introduction to Financial Statement Analysis
describe the steps in the financial statement analysis framework
describe the roles of financial statement analysis
describe the importance of regulatory filings, financial statement notes and supplementary information, management’s commentary, and audit reports
describe implications for financial analysis of alternative financial reporting systems and the importance of monitoring developments in financial reporting standards
describe information sources that analysts use in financial statement analysis besides annual and interim financial reports
Financial Statement Analysis Framework :
1- Articulate the Purpose and Context of Analysis
Produce a statement of objectives for the analysis, including a list of questions to be answered. The context of the analysis must be defined – audience, end product, timeframe, and resource constraints.
2- Collect Data
Understand the company’s business, financial performance, and financial position.
3- Process Data
Appropriate analytical tools must be used. This could include calculating ratios, growth rates, regression analysis, and simulation. Make needed adjustments for comparisons, and prepare common-size financial data.
4- Analyze/Interpret the Processed Data
Interpret the results generated during the data processing stage, supporting recommendations and conclusions.
5- Develop and Communicate Conclusions and Recommendations
Produce a report that addresses all of the questions that were formulated during the initial stage of the process. All relevant factors that support the conclusions and recommendations should be communicated to the audience.
6- Follow-Up
A periodic review is needed to make sure the recommendation is still valid. (revisit others steps if new information becomes available )
Financial reporting provides information about a company’s financial performance (i.e., its ability to generate profits and cash flows) as well as its financial position (i.e., its assets and liabilities).
Use of F/s and other reports:
Evaluating assets to add to a portfolio
Security valuation
Assessing a company’s creditworthiness and determining appropriate lending terms
Issuing debt ratings
Informing private equity investment decisions
Evaluating proposed or prospective mergers
International Organization of Securities Commissions (IOSCO) :
The principles of securities regulation are based on the core objectives of 1) protecting investors, 2) ensuring markets are fair, efficient, and transparent, and 3) reducing systematic risk.
The principles of financial reporting are 1) full, accurate, and timely disclosure of financial results, and 2) high, internationally acceptable quality.
US Securities and Exchange Commission (SEC) is a member of IOSCO
Sarbanes-Oxley Act of 2002: This act created the Public Company Accounting Oversight Board, which addresses auditor independence and strengthens corporate responsibility for financial reports. Internal controls over financial reporting must also be reported.
Disclosures to file with SEC :
1- Securities Offerings Registration Statement: This relates to new securities offerings and is required by the 1933 Act.
2- Forms 10-K, 20-F, and 40-F: These forms must be filed annually, containing information about a company’s business, financial disclosures, and legal proceedings.
3- Annual Report: Most companies provide an annual report to shareholders, but it is not required by the SEC. It is usually a user-friendly report.
4- Proxy Statement / Form DEF-14A: Shareholders must be sent a proxy statement prior to a shareholder meeting. A proxy form allows a shareholder to transfer their right to vote.
(can have additional information : management compensation or potential conflicts of interest in their annual reports or proxy statements )
5- Forms 10-Q and 6-K: These interim (quarterly or semi-annual) reports are unaudited.
6- Form 8-K: This must be filed for major events such as acquisitions and matters related to accounting and financial statements.
7- Form 144: This form is a notice for the sale of restricted security relying on Rule 144.
8- Forms 3, 4, and 5: These forms report the beneficial ownership of securities.
9- Form 11-K: This is the annual report for employee stock purchases and similar plans.
Each member of the European Union (EU) regulates its own capital markets. There is a balance between member state autonomy and the need for co-operation.
If all separately reported segments cumulatively account for less than 75 percent of total revenues, the company must continue to identify additional reportable segments until this threshold is reached.
Management Commentary or Management’s Discussion and Analysis :
Important but often unaudited
The International Accounting Standards Board (IASB) recommends the following five elements be included:
- Nature of business
- Management’s objectives and strategies
- Company’s significant resources, risks, and relationships
- Results of operations
- Critical performance measures
The Securities and Exchange Commission (SEC) requires :
- Any favorable and unfavorable trends
- Information about effects of inflation, changing prices, or other material events
- Off-balance-sheet obligations and contractual commitments
- Critical accounting policies
Under the international standards for auditing (ISAs), the auditor’s objectives are:
1- Obtain reasonable assurance the financial statements are free from material misstatement and determine if statements are prepared according to the applicable financial reporting framework
2- Report the findings
The auditor cannot provide absolute assurance. Only reasonable assurance (high probability)
The opinion can be one of several forms.
1- Unqualified audit opinions state the financial statements give a true and fair view. This is referred to as a clean opinion.
2- Qualified audit opinions point out limitations or exceptions to the accounting standards.
3- Adverse audit opinions are issued when the statements materially depart from accounting standards.
4- A disclaimer of opinion occurs when the auditor is unable to issue an opinion.
Sarbanes-Oxley Act requires auditors to provide an additional opinion on the internal control systems that companies used to ensure that a sound process is used to prepare financial reports.
Companies may use new types of transactions as “window dressing” to obscure their true performance and financial position until financial standards are updated.
Company managers tend to be more rigorous about calculations of figures that appear in the main elements of their financial statements compared to the level of scrutiny that they give to items that appear in the accompanying notes.
Analysts should also use outside sources of information on peer companies, the industry, and the overall economy.
CFAI’s proposed model : Specific recommendations include the provision of more detailed information about the fair value of assets and liabilities and the use of the direct method of presenting the statement of cash flows.
Public third-party sources :
Industry whitepapers available freely online
Economic or industry indicators prepared by governments or private organizations
General news reports
Industry-specific publications
Social media as a gauge of consumer sentiment
Proprietary third-party sources
Reports from sell-side equity analysts and credit analysts
Data platforms (e.g., Bloomberg, FactSet)
Report from industry-focused consultancies
Proprietary primary research
Includes any surveys, studies, product tests, or comparisons that are commissioned and/or undertaken directly by the analyst.
New companies are least likely to result in changes to financial reporting standards
Analyzing Income Statements
describe general principles of revenue recognition, specific revenue recognition applications, and implications of revenue recognition choices for financial analysis
describe general principles of expense recognition, specific expense recognition applications, implications of expense recognition choices for financial analysis and contrast costs that are capitalized versus those that are expensed in the period in which they are incurred
describe the financial reporting treatment and analysis of non-recurring items (including discontinued operations, unusual or infrequent items) and changes in accounting policies
describe how earnings per share is calculated and calculate and interpret a company’s basic and diluted earnings per share for companies with simple and complex capital structures including those with antidilutive securities
evaluate a company’s financial performance using common-size income statements and financial ratios based on the income statement
One of the basic principles of accounting is that revenue must only be recognized when it is earned, which is often not the same time (or accounting period) that cash is received.
If goods or services are sold on credit, revenue is recognized on the income statement, and an account receivable is created on the balance sheet. Cash that is received as payment before the good or service is delivered goes on the balance sheet as an unearned revenue liability that is reversed when the associated revenue is earned and recognized (Ex: subscription fee in advance).
The new standards are based on the core principle that companies should recognize revenue according to what they expect to collect in exchange for delivering goods and services. This principle calls for a multi-step revenue recognition process:
1- Identify the contract with a customer.
2- Identify the rights and obligations specified in the contract.
3- Determine the transaction price.
4- Allocate the transaction price to each performance obligation.
5- Recognize the revenue when/as performance obligations are met.
Standars for both IFRS and US GAAP
A contract only exists if it is probable that payment will be collected. –> US GAAP defines probable as “likely to occur,” while IFRS interprets this term to mean “more likely than not.”
IFRS 15 ; revenue is recognized when control of an asset has been transferred to the customer :
- The customer has physical possession of the asset
- The customer accepts that the asset meets the terms of the contract
- Legal title of the asset belongs to the customer
- The seller has met all contractual obligations and is entitled to payment
- The “significant risks and rewards” of owning the asset belong to the customer
Principal Versus Agent :
A retailer that acts only to facilitate sales without owning the goods (e.g., online marketplace) is acting as an agent and must only recognize their commission as revenue. No COGS are recognized, although the agent may incur SG&A expenses.
A traditional retailer recognizes the full amount of any revenue derived from a sale, as well as the associated cost of goods sold (COGS) and selling, general, and administrative (SG&A) expense. Therefore, acts as a principal and transfers the risks and benefits of owning the goods.
Franchising/Licensing :
A franchisor may only recognize royalty fees, which are typically a percentage of a franchisee’s sales, as its own revenue, not the full value of sales. Upfront franchise fees received must be initially recorded as unearned revenue, with revenue being recognized on a straight-line basis over the term of the agreement.
Software as a Service or License :
Software developers must recognize revenue over the term of a license contract if they retain any significant obligations that affect the value of the software, such as servicing and upgrades. Revenue may only be recognized at the time of the sale if the seller has no further obligations.
If it is possible to distinguish between the portion of a sale that is purely for the right to use the software and the portion related to after-sales service, the former part may be recognized immediately while the latter must be amortized over the term of the license. Payments for subscription-style access to software must be recognized as the service is used.
Long-Term Contracts :
Revenue from long-term contracts is recognized as goods are produced or services are rendered. IFRS 15 allows for progress to be measured in terms of either outputs (e.g., percentage of units delivered) or inputs (e.g., share of total estimated costs incurred).
Performance bonus (e.g., a bonus for early delivery) must not be recognized until the seller has satisfied all of the necessary conditions.
Bill and Hold Arrangements :
Under a “bill and hold” arrangement, revenue is recognized from a sale even though the seller retains physical possession of the asset. Revenue is recognized if all of the following conditions are met:
There is a substantive reason for the arrangement (e.g., the customer has requested it due to a lack of storage space)
The asset is specifically identified as belonging to the customer
The asset must be physically ready to be transferred to the customer
The seller must not be able to either use the asset or transfer it to another customer
Expenses are deducted from revenue to determine net profit or loss. Expenses can be incurred in the form of direct outflows for purchasing goods or services or as a result of depleting asset values. The definition of expenses includes losses attributable to non-routine (e.g., selling long-lived assets for less than their book value).
The three commonly used expensing methods are:
The matching principle
Expensing as incurred
Depreciation or amortization of capitalized assets
The matching principle, companies recognize certain expenses when the associated revenues are recognized. COGS expense is recorded at the same time that the associate revenue is recognized.
Period costs are expensed as they are incurred because they are less directly linked to sales. Their impact on the income statement is observed in the period when the company makes the expenditure. Common examples of period costs include administrative expenses, managerial salaries, and research and development costs.
Recognizing expenses involves capitalizing an asset on the balance sheet and recognizing its cost incrementally in the form of depreciation (or amortization) over multiple periods.
The decision to capitalize costs and recognize them over time rather than expensing the entire amount immediately has several implications for a company’s financial statements. Specifically, during the first year of an asset’s life:
- Profits (and taxes) are higher because only part of the cost is recognized.
- Shareholders’ equity is greater at the end of the year due to higher net income.
- Assets are higher because the capitalized cost is being carried on the balance sheet.
- Operating cash flows are higher because the cash outflow to acquire the asset is treated as an investing activity.
The interest costs are treated differently if the asset is capitalized. If the asset is capitalized, the interest costs will be depreciated along with the long-lived asset and not be part of interest expense.
These capitalized interest costs are treated as investing cash outflows. Analysts will need to make adjustments to account for capitalized interest costs when calculating and comparing interest coverage ratios.
Most costs to internally develop intangible assets are expensed. However, there are some exceptions, like capitalizing software development after feasibility is established.
Adjustments will be needed when comparing companies that expense the costs with those that capitalize them.
When a company reports a change to its expense recognition policies, analysts should evaluate whether there is a valid rationale based on changes in operating conditions or if management may be attempting to manipulate reported earnings.
Unusual or infrequent items include restructuring costs, gains or losses on asset sales, and costs incurred due to natural disasters.
Discontinued operations represent components of the operation that will have no effect on the future. When a company has decided to divest a segment or subsidiary, its impact on the income statement is reported separately from continuing operations and its assets and liabilities are recognized as held for sale on the balance sheet.
Unlike unsual items, discontinued operations are removed from a company’s reported net income (they must be both physically and operationally separable from the rest of the company).
Companies also make changes in accounting estimates, such as revised estimates of asset lives for the purpose of calculating depreciation. These changes are made on a prospective basis, with no impact on earlier periods.
Occasionally, companies will make adjustments to correct errors from previous periods. When this happens, financial statements for all periods that were affected by the error must be restated.
Large companies that have acquired subsidiaries must issue consolidated financial statements. When these subsidiaries are international, figures for current and historical periods can be materially affected by fluctuating exchange rates.
Accounting standards do not require disclosure of the impact of exchange rate changes on individual items (but companies often comply)
In June of 20X6, a US company announced that it would immediately begin the process of splitting off its profitable European division. In November of 20X6, the company issued an update on this process, which it expected to be formally completed in the fourth quarter of 20X7. Net income attributable to the European division should most likely be:
A
excluded from the company’s 20X6 income statement.
B
recorded as a separate line item in the company’s 20X6 income statement.
C
included in net income from the company’s continuing operations in its 20X6 income statement with details of the pending split-off disclosed in the notes.
B) Under both IFRS and US GAAP, revenues from a business unit that will not impact a company’s balance sheet in the future should be reported as income from discontinued operations in a separate line in the income statement.
Under IFRS, a loss from the destruction of property in a fire would most likely be classified as:
A
continuing operations.
B
discontinued operations.
C
other comprehensive income.
A is correct. A fire may be infrequent, but it would still be part of continuing operations and reported in the profit and loss statement. Discontinued operations relate to a decision to dispose of an operating division.
A company chooses to change an accounting policy. This change requires that, if practical, the company restate its financial statements for:
A
all prior periods.
B
current and future periods.
C
prior periods shown in a report.
C is correct. If a company changes an accounting policy, the financial statements for all fiscal years shown in a company’s financial report are presented, if practical, as if the newly adopted accounting policy had been used throughout the entire period; this retrospective application of the change makes the financial results of any prior years included in the report comparable. Notes to the financial statements describe the change and explain the justification for the change.
Some convertible securities could be anti-dilutive (i.e., including them would increase the EPS). For example, this could occur if the dividend rate on the preferred stock was high. Under IFRS and US GAAP, anti-dilutive securities are not included.
Analyzing Balance Sheets
explain the financial reporting and disclosures related to intangible assets
explain the financial reporting and disclosures related to goodwill
explain the financial reporting and disclosures related to financial instruments
explain the financial reporting and disclosures related to non-current liabilities
calculate and interpret common-size balance sheets and related financial ratios
Current assets are expected to be sold or used up within one year or one operating cycle, whichever is longer :
Cash and cash equivalents
Marketable securities
Accounts receivable
Inventories
Prepaid expenses
Non-current assets include items that are expected to be used or remain on the balance sheet over multiple years or operating cycles :
Property, plant, and equipment (PPE)
Intangible assets
Goodwill
Financial assets
Deferred tax assets
Current liabilities are expected to be settled within one year or one operating cycle. Liabilities held primarily for trading purposes are also considered current :
Accounts payable
Notes payable
Current portion of long-term debt
Accrued expenses
Unearned revenue
Non-current liabilities include:
Long-term debt
Long-term leases
Deferred tax liabilities
Intangible assets are identifiable non-monetary assets without physical substance (e.g., patents, licenses, trademarks). These assets are capitalized on the balance sheet and their costs are recognized incrementally over time. The equivalent of depreciation for intangible assets is known as amortization. Intangible assets may be subject to impairment.
Under the cost model, the asset is carried at amortized cost, which is the historical cost less accumulated depreciation/amortization and impairment losses. Depreciation is used to allocate the cost over an asset’s useful life.
Under the revaluation model, impairment occurs if the asset’s recoverable amount (greater of fair value less cost to sell and value in use) is less than its carrying amount. IFRS permits the reversals of impairment losses while US GAAP does not.
IFRS requires research costs to be expensed but allows the capitalization of costs incurred during the development phase once certain criteria have been met, such as demonstrating technical feasibility and commercial viability.
Under IFRS, intangible assets are considered identifiable and recorded on the balance sheet if:
They are likely to generate future benefits.
Their cost can be measured reliably.
The excess of the purchase price over this fair value is placed on the acquirer’s balance sheet as a goodwill asset. In theory, this amount includes the value of the target company’s non-identifiable intangible assets (e.g., reputation) as well as potential synergies between the two companies. It may also include investments in R&D that have created value that has not been capitalized as an asset on the target company’s balance sheet.
Opponents argue acquisitions are often based on unrealistic assumptions, which will require goodwill to be written down in the future. Analysts typically apply close scrutiny to the reported value of intangible assets and, when appropriate, make downward adjustments that reduce the book value of equity. For example, the impact of goodwill is often excluded when computing financial ratios.
Unlike intangible assets with finite lives, goodwill is not amortized.
Instead, under both IFRS and US GAAP, goodwill is treated as if it has an indefinite life and tested annually for impairment. When recognized, impairment losses are non-cash expenses that reduce a company’s net income by the amount of the reduction in the asset’s book value.
Financial assets that are carried at cost or amortized cost include:
- Debt securities that the company has no intention of selling (designated as held-to-maturity securities under US GAAP).
- Loans to other companies or notes receivable.
- Equity instruments, but only in the very rare circumstance where fair value cannot be reliably measured and historical cost is used as a proxy for estimated fair value.
- Fair value through profit or loss (FVPL) records all changes in fair value directly on the income statement with a corresponding impact on retained earnings.
- Fair value through other comprehensive income (FVOCI) bypasses the income statement by recording changes as OCI and in an account called Accumulated OCI in the equity section of the balance sheet.
The types of financial assets that qualify for fair value through other comprehensive income (FVOCI) treatment are:
- Debt instruments that have been designated as available-for-sale (US GAAP only).
- Debt instruments that are a passive source of interest and principal, but that may be sold in the future (IFRS only).
- Equity securities, if the company has made the irrevocable decision to treat them as FVOCI (IFRS only).
Fair value through profit or loss (FVPL) assets include:
- Debt instruments that the company intends to sell and has designated as trading securities (US GAAP only).
- All equity securities, unless the company has significant influence over the issuer (US GAAP only).
- Any securities that do not meet the criteria to be carried at face value and have not been designated as FVOCI (IFRS only).
Deferred tax liabilities arise due to temporary timing differences between the amount of taxable income that a company reports for tax purposes and the amount that it reports on its financial statements. Specifically, a long-term liability is created when the actual cash tax obligation paid to the government is less than the income tax expense reported on its income statement. Effectively, this represents a tax obligation that has already been incurred but that will not be settled in cash within the coming year.
This type of timing difference is often observed when a company is permitted to record certain expenses for tax purposes before they may be recognized on the income statement. For example, tax authorities may allow a fixed asset to be depreciated at a faster rate than the method that is used for financial reporting purposes.
Defining total asset turnover as revenue divided by average total assets, all else equal, impairment write-downs of long-lived assets owned by a company will most likely result in an increase for that company in:
A
the debt-to-equity ratio but not the total asset turnover.
B
the total asset turnover but not the debt-to-equity ratio.
C
both the debt-to-equity ratio and the total asset turnover.
C is correct. Impairment write-downs reduce equity in the denominator of the debt-to-equity ratio but do not affect debt, so the debt-to-equity ratio is expected to increase. Impairment write-downs reduce total assets but do not affect revenue. Thus, total asset turnover is expected to increase.
The initial measurement of goodwill is most likely affected by:
A
an acquisition’s purchase price.
B
the acquired company’s book value.
C
the fair value of the acquirer’s assets and liabilities.
A is correct. Initially, goodwill is measured as the difference between the purchase price paid for an acquisition and the fair value of the acquired, not acquiring, company’s net assets (identifiable assets less liabilities).
Analyzing Statements of Cash Flows I
The candidate should be able to:
describe how the cash flow statement is linked to the income statement and the balance sheet
describe the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data
demonstrate the conversion of cash flows from the indirect to direct method
contrast cash flow statements prepared under International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (US GAAP)
Analyzing Statements of Cash Flows II
The candidate should be able to:
analyze and interpret both reported and common-size cash flow statements
calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios
Balance sheet : Point in time, of the company’s financial position at the beginning and the end of a reporting period.
Three other primary financial statements are flow statements that show a company’s financial performance
1- Income statement
2- Cash Flow statement
3- Shareholder’s equity statement : summarizes the impact of all activities that have caused the book value of a company’s equity to change over the reporting period.
The cash flow from operating activities (CFO) may be presented using either the direct method or the indirect method. The direct method includes line items for the cash receipts and disbursements associated with each specific operating activity.
Because the values that appear on a company’s balance sheet and income statement are based on accrual accounting, adjustments are required to determine cash flows. For example, the amount of cash collected from customers is equal to revenue with an adjustment for the change in accounts receivable.
The Indirect Method for Cash Flows from Operating Activities :
- Start with net income
- Add back depreciation and amortization expenses
- Add back any amortization of discounts on long-term bonds
- Subtract any amortization of bond premiums
- Add back any losses (or subtract any gains) attributable to asset sales, write-downs, or debt retirement
- Subtract any increases in current operating assets (e.g., accounts receivable, inventory, prepaid expenses, but ignore changes in cash)
- Add back any increases in current operating liabilities (e.g., accounts payable, accrued expenses)
- Add back any increase in deferred tax liabilities
- If the equity method is used to account for investments in other companies, add back any losses and subtract any income
Net income must be adjusted for non-cash items, non-operating activities, and net changes in accruals.
Which of the following statements is most accurate? A company’s cash flow statement links to its balance sheet by showing the change in the value of:
A
equity.
B
an asset.
C
net income.
The cash flow statement shows a change in cash (an asset). The income statement would show the change in revenue, and the statement of changes in owners’ equity shows the change in equity.
The next steps in the preparation of the statement of cash flows are to calculate the cash flows from investing activities (CFI) and cash flows from financing activities (CFF). These last two sections of the statement of cash flows are prepared and presented the same way under both the direct and indirect methods.
For many companies, acquisitions of long-lived assets are major sources of CFI outflows. Assets are recorded at cost and depreciated over their useful lives.
When a company sells an asset for more than its carrying value (net of accumulated depreciation), a gain is recorded (and vice versa).
Retirement of debt principal and share repurchases are CFF outflows. Dividend payments must be recorded as financing cash outflows under US GAAP, while IFRS-compliant companies may record these outflows as either financing or operating activities.
Note that there may be a temporary difference between the amount of the dividend that a company has declared and the amount that it has actually paid. If, as of the reporting date, the company has not paid the full amount of its declared dividend, the impact of any unpaid amount will be observed on the balance sheet as an increase in the dividends payable liability account.
Under US GAAP, companies must provide a reconciliation of net income and CFO, regardless of whether they have used the direct or indirect method.
A is correct. The increase of $42 million in common stock and additional paid-in capital indicates that the company issued stock during the year. The increase in retained earnings of $15 million indicates that the company paid $10 million in cash dividends during the year, determined as beginning retained earnings of $100 million plus net income of $25 million minus ending retained earnings of $115 million, which equals $10 million in cash dividends.
Under both IFRS and U.S. GAAP, an income tax payment attributable to operating income is an operating expense. The two sets of accounting standards have differences regarding the classification of income taxes paid on transactions that are specifically linked to investing or financing activities.
Evaluating Sources and Uses of Cash :
1- Major sources and uses of cash between operating, investing, and financing activities
Mature companies will primarily get cash flows from operating activities. These cash flows can be used for investing activities if there are good opportunities to grow the business. If not, they should be returned to capital providers as a financing activity.
2- Primary determinants of operating cash flow
Companies get cash from customers and pay cash to employees and suppliers. Operating cash flow should exceed net income for mature companies.
3- Primary determinants of investing cash flow
Analyzing this section sheds light on a company’s investing activities. Also, this analysis aids in understanding why assets are sold.
4- Primary determinants of financing cash flow
Companies can either raise capital or repay the capital.
Each line item can be expressed as a percentage of total inflows/outflows or as a percentage of net revenue.
The second method makes it easier to build forecasts based on net revenue.
An appropriate method to prepare a common-size cash flow statement is to show each line item on the cash flow statement as a percentage of net revenue. An alternative way to prepare a statement of cash flows is to show each item of cash inflow as a percentage of total inflows and each item of cash outflows as a percentage of total outflows.
Free cash flow is the excess of operating cash flow over capital expenditures.
Free cash flow to the firm (FCFF) is available to providers of both debt and equity capital. It can be computed from net income or operating cash flow.
Free cash flow to the firm can most accurately be described as:
A
Cash flow from operations
B
Cash flow available to all suppliers of capital
C
Cash flow available for distribution to owners
Free cash flow to the firm is the company’s excess cash flow, after all operating (and tax) obligations have been met and investments in fixed and working capital have been made. This is the cash that is available to all providers of capital and can be used to pay back bondholders, pay dividends to shareholders, or other financing activities.
LIFO only for US GAAP as IFRS dosen’t allow it
Analysis of Inventories
describe the measurement of inventory at the lower of cost and net realisable value and its implications for financial statements and ratios
calculate and explain how inflation and deflation of inventory costs affect the financial statements and ratios of companies that use different inventory valuation methods
describe the presentation and disclosures relating to inventories and explain issues that analysts should consider when examining a company’s inventory disclosures and other sources of information
If a company track inventory items individually for accounting purposes, this is known as the specific identification method. This is feasible for low-volume retailers of highly differentiated products, such as fine art dealers.
The two best known inventory valuation methods are first-in-first-out (FIFO) and last-in-first-out (LIFO). As the name implies, FIFO assumes that the items sold during the reporting are those that the company has held as inventory the longest. Similarly, LIFO is based on the assumption that the most recently acquired inventory items are sold first.
Under IFRS, companies are required to hold inventory at the lower of cost and net realizable value (NRV), which is defined as the ordinary selling price less costs of sale and costs to get ready for sale.
Inventory before issold can have its value deviate from their acquisition cost (Ex: raw materials –> spoil or items may become obsolete).
When either the LIFO method or the retail inventory method are used, market value is defined as the current replacement cost subject to an upper limit equal to the net realizable value and a lower limit equal to the net realizable value less a normal profit margin.
Both IFRS and US GAAP allow some firms, such as producers of agricultural and forest products, producers of minerals and mineral products, and commodity broker-traders, to hold inventory at net realizable value, even if this is greater than its historical cost.
If no active market exists, market-determined prices (e.g., recent transaction prices) can be used as the basis for inventory valuation. When this mark-to-market inventory valuation method is used, changes in the market value inventory are reflected in the company’s profit or loss for the period.
Corex, a producer of rare minerals used in various industrial processes, prepares its financial reports in accordance with IFRS. The company is most likely:
A
required to carry its inventory at the lower of cost or net realizable value.
B
permitted to carry its inventory at net realizable value even if this exceeds cost and there is not an active market for the minerals.
C
permitted to carry its inventory at net realizable value even if this exceeds cost, but only if the minerals trade in an active market.
B) IFRS allow mineral producers to report their inventories at their net realizable value even when this is greater than cost. (Most companies that adhere to IFRS must report inventories at the lower of cost or net realizable value, but producers of certain commodities are exempt from this requirement.)
If the products trade in an active market, a quoted market price may be used to determine fair value. Even if an active market does not exist, fair value can be established based on market determined prices, such as the price at which the most recent transaction was executed.
If the value of inventory declines below its carrying amount, both IFRS and US GAAP permit a write-down that is is recorded by reducing the inventory balance and recognizing an equivalent expense.
Can be included in COGS or separate item
Write-downs hurt profitability, liquidity, and solvency ratios for the period. However, write-downs improve activity ratios such as asset turnover and inventory turnover.
If written-down inventory subsequently increases in value, IFRS-compliant firms are permitted to recognize a reversal up the the amount of the original write-down. A reversal impacts the balance sheet by increasing the inventory balance and the income statement, where it is recorded as a reduction in COGS for the period. However, unlike IFRS, US GAAP does not allow reversals of write-downs.
According to IFRS, inventory write-downs must be recorded:
A
on the income statement for the period when the inventory is sold.
B
on the income statement for the period when the assessment is made.
C
directly on the balance sheet for the period when the assessment is made after bypassing the income statement.
Under IFRS, inventory must be carried at the lower of cost or net realizable value. If an assessment determines that the net realizable value is below the current carrying cost, an immediate write-down is required. This is treated as an expense on the income statement.
Note that IFRS does allow for the reversal of prior-year write-downs if a later assessment finds that inventories have increased in value.
Fernando’s Pasta purchased inventory and later wrote it down. The current net realisable value is higher than the value when written down. Fernando’s inventory balance will most likely be:
A
higher if it complies with IFRS.
B
higher if it complies with US GAAP.
C
the same under US GAAP and IFRS.
A is correct. IFRS require the reversal of inventory write-downs if net realisable values increase; US GAAP do not permit the reversal of write-downs.
In an environment with rising input costs and constant or increasing inventory quantities, the COGS expense reported under FIFO will be lower than the replacement cost of the inventory units that have been sold. Conversely, the inventory will be carried on the balance sheet at close to replacement value.
In a rising price environment, the LIFO method will produce a COGS expense that is approximately equal to replacement cost. However, the carrying value of the remaining inventory will be below its replacement cost.
The effect of the valuation method may be minor if prices are relatively constant, or they may be more significant if prices are rising (i.e., positive inflation) or falling (i.e., deflation).
Assuming rising prices and constant or increasing inventory levels, using LIFO (vs. FIFO) will result in higher COGS, lower gross profit, lower income tax expense, and a lower ending inventory balance. The opposite will be observed during deflationary periods with falling prices.
Several disclosures are required by IFRS and US GAAP, including:
- Inventory valuation methodology
- Carrying value of inventory by classification (e.g., raw materials, work in progress, and finished goods)
- The amount of inventories recognized as COGS during the period
- The value of any inventories being carried at fair value less selling cost (NRV)
- The value of any inventories pledged as security for liabilities
- The value of any write-downs
- The value of any reversals of previous write-downs (IFRS only)
- The circumstances leading to the recognition of a reversal (IFRS only)
Inventory turnover : A high inventory turnover ratio is more likely to be due to efficient management if sales are growing faster than the industry average and the company has not recognized significant write-downs. By contrast, the same high ratio with relatively slow sales growth is more likely to be reflective of failing to hold sufficient quantities of inventory.
Company A adheres to US GAAP and Company B adheres to IFRS. Which of the following is most likely to be disclosed on the financial statements of both companies?
A
Any material income resulting from the liquidation of LIFO inventory
B
The amount of inventories recognized as an expense during the period
C
The circumstances that led to the reversal of a write down of inventories
B is correct. Both US GAAP and IFRS require disclosure of the amount of inventories recognized as an expense during the period. Only US GAAP allows the LIFO method and requires disclosure of any material amount of income resulting from the liquidation of LIFO inventory. US GAAP does not permit the reversal of prior-year inventory write downs.
US GAAP : Impairment is permanent, except for held-for-sale assets
Analysis of Long-Term Assets
compare the financial reporting of the following types of intangible assets: purchased, internally developed, and acquired in a business combination
explain and evaluate how impairment and derecognition of property, plant, and equipment and intangible assets affect the financial statements and ratios
analyze and interpret financial statement disclosures regarding property, plant, and equipment and intangible assets
The cost of long-lived assets is recognized incrementally over multiple periods in the form of depreciation (for tangible assets) or amortization (for intangible assets).
US GAAP-compliant companies are required to use the cost model to determine the carrying value of long-lived assets on the balance sheet. Under this model, assets are carried at historical cost less accumulated depreciation.
Companies that adhere to IFRS may use either the cost model or the revaluation model, which allows assets to be carried at their fair value less accumulated depreciation.
Both models require impairments (write-downs) of long-lived assets when deemed necessary, but, unlike the cost model, the revaluation model allows for the possibility of upward revisions.
Under IFRS, three definitional criteria must be met to record an identifiable intangible asset:
1- Identifiable
2- Under the control of the company
3- Expected to generate future economic benefits
In order to be recognized in the accounting, it must meet the following criteria :
1- It is probable that the expected future economic benefits generated by the asset will flow to the company
2- The asset’s cost can be readily measured
The three possible ways to acquire intangible assets are: 1) in a transaction other than a business combination (e.g., a sale), 2) developed by the firm internally, and 3) in a business combination.
Intangible Assets Purchased in Situations Other Than Business Combinations :
An intangible asset that is purchased directly (i.e., not acquired as part of a merger) is recorded on the acquirer’s balance sheet at its fair value when acquired, which is assumed to be the purchase price. When multiple intangible assets are acquired in a single transaction, the purchase price is allocated among them according to their fair value.
Analysts should be aware that companies exercise significant judgment when valuing intangible assets.
If a company develops a tangible long-lived asset, such as a machine to be used in its operations, the direct construction costs can generally be capitalized and included as part of the asset’s depreciable cost (interest cost on borrowing too).
Intangible assets developped internally :
The research and development costs incurred to create intangible assets in-house are typically expensed rather than capitalized.
IFRS requires research-stage costs to be expensed but allows the capitalization of development costs incurred after technical feasibility has been demonstrated and the company intends to use or sell the asset.
Companies that follow US GAAP must expense both research and development costs with the exception of software development costs, which may be capitalized after the product’s technological feasibility has been established or it is probable that the project will be completed and the software will be used within the company as intended.
Expensing the R&D costs incurred to develop intangible assets internally will impact a company’s financial statements in several ways:
- Profits (and taxes) are lower in the current period because expenses are higher.
- In later periods, profits (and taxes) are higher because there is no amortization to record after the cost has been expensed.
- The book values of assets and equity are initially lower than they would be if costs were capitalized.
- Operating cash flows are lower because R&D spending is an operation cash outflow, while acquiring intangible assets externally is treated as an investing activity.
The amount by which the purchase price exceeds the fair value of the target company’s assets (net of its liabilities) is recorded as a goodwill asset. After goodwill appears on the acquirer’s balance sheet, it is not amortized because it is considered to have an indefinite useful life. However, it must be tested at least annually for impairment.
Under US GAAP, when assets are acquired in a business combination, goodwill most likely arises from:
A
contractual or legal rights.
B
assets that can be separated from the acquired company.
C
assets that are neither tangible nor identifiable intangible assets.
C is correct. Under both International Financial Reporting Standards (IFRS) and US GAAP, if an item is acquired in a business combination and cannot be recognized as a tangible asset or identifiable intangible asset, it is recognized as goodwill. Under US GAAP, assets arising from contractual or legal rights and assets that can be separated from the acquired company are recognized separately from goodwill.
Expensing rather than capitalising an investment in long-term assets will result in higher expenses and lower net income and net profit margin in the current year. Future years’ incomes will not include depreciation expense related to these expenditures. Consequently, year-to-year growth in profitability will be higher. If the expenses had been capitalised, the carrying amount of the assets would have been higher and the 2022 total asset turnover would have been lower.
Impairment charges represents unanticipated decreases in the value of long-lived assets. When an asset is deemed to be impaired, its carrying value is reduced on the balance sheet and there is an equivalent reduction in equity. (loss on the i/s BUT NO cash flow)
Indicators of impairment include obsolescence, a decline in demand, or technological advancements. However, companies are only required to conduct actual impairment testing if any such indicators are discovered during the annual assessment process.
Under IFRS, an asset is deemed to be impaired if its carrying amount exceeds its recoverable amount. The impairment loss is calculated as the difference between these amounts.
US GAAP considers an asset’s carrying amount to be unrecoverable if it exceeds the total value of undiscounted expected future cash flows.
Intangible assets with finite lives are treated in the same manner as tangible long-lived assets. An assessment for signs of impairment is performed at the end of each reporting period and testing is done if evidence of impairment is discovered.
Intangible assets with indefinite lives, such as goodwill, must be tested at least annually for impairment.
Impairment of Long-Lived Assets Held for Sale :
Intention of sale –> reclassify the asset as held for sale and no longer used.
At the time of reclassification, the asset is tested for impairment and it is no longer depreciated or amortized. If the asset is deemed to be impaired, its carrying value is written down to fair value less selling cost, and a loss is recognized on the income statement.
Reversals of Impairments of Long-Lived Assets :
Under US GAAP, reversals of impairment losses are permitted for assets that have been reclassified as held for sale, but it is not permitted for assets that are currently in use.
Reversals of impairment losses are permitted under IFRS, regardless of whether the asset is in use or held for sale (limited to the amount of the previously recognized impairment). Cannot go above pre-impariment value
Long-lived assets are derecognized (i.e., removed from the company’s financial statements) when one of the following conditions is met:
1- The asset is disposed of (e.g., sold, abandoned, exchanged).
2- The asset is expected to provide no future benefits from use or disposal.
Sale of Long-Lived Assets :
Difference between the sale proceeds and the asset’s carrying amount (net of accumulated depreciation) at the time of sale.
Long-Lived Assets Disposed of Other than by a Sale :
The asset must continue to be depreciated and assessed for impairment as always until it is no longer controlled by the company.
If the asset is abandoned, it is treated as a sale with no cash proceeds and a loss is recorded for the asset’s carrying amount at that time.
If an asset is exchanged for another asset, the fair value of the acquired asset replaces the carrying value of the asset given up. The difference is reported as a gain or loss on the income statement. If the fair value of the acquired asset cannot be determined, it is deemed to be the carrying amount of the exchanged asset, and no gain or loss is recorded (NO change).
Impairment decreases both the net income and asset values.
Under IFRS, companies must disclose the following information for each asset class of PP&E:
- Measurement basis
- Depreciation method
- Useful life (or depreciation rate)
- Gross carrying amount
- Accumulated depreciation at the beginning and end of period (in total or by major asset class)
- Reconciliation of carrying amount at the beginning and end of period
- Title restrictions for existing PP&E
- Contracts to acquire new PP&E
- General description of depreciation methods used for each major asset class
- Depreciation expense for the period
- Carrying amounts of major asset classes
IFRS requires firms to disclose whether the useful lives of each class of intangible assets are finite or infinite. For each class of intangibles with finite lives, the following disclosures are required:
- Useful lives (or the amortization rate used)
- Amortization methods used
- Gross carrying amount
- Accumulated amortization at the beginning and end of period
- Where amortization has been recorded on the income statement
- Reconciliation of carrying amount at the beginning and end of period
The IFRS-required disclosures for intangible assets with indefinite lives are:
- Carrying amount
- Why the asset is considered to have an indefinite life
- Title restrictions and pledges as security
- Contracts to acquire new intangible assets
Under US GAAP, companies must disclose the following with respect to intangible assets:
- Gross carrying amounts (in total and by major category of intangibles)
- Accumulated amortization (in total and by major category of intangibles)
- Aggregate amortization expense for the period
- Estimated amortization expense for the next five fiscal years
Disclosure Requirements for Impairment Losses :
Under IFRS, companies are required to disclose the amounts of impairment losses and/or reversals of impairment losses, the main classes of assets affected by impairment losses (and/or reversals of impairment losses) as well as the events and circumstances that caused the losses.
US GAAP must disclose a description of impaired assets, a description of what led to the impairment, fair value methodology, the amount of impairment loss and where it is recorded in the financial statements. Impairment reversals are not permitted unless assets have been designated as held for sale.
If the cost model is used, an analyst can gather information about depreciation to estimate the total useful life, which is the sum of the time since purchase (age) and remaining life (estimates).
Assets within the same class may have different useful lives and salvage values, and companies may use multiple different depreciation methods.
The estimated average total useful life of a company’s assets is calculated by adding the estimates of the average remaining useful life and the average age of the assets. The average age of the assets is estimated by dividing accumulated depreciation by depreciation expense. The average remaining useful life of the asset base is estimated by dividing net property, plant, and equipment by annual depreciation expense.
Topics in Long-Term Liabilities and Equity
explain the financial reporting of leases from the perspectives of lessors and lessees
explain the financial reporting of defined contribution, defined benefit, and stock-based compensation plans
describe the financial statement presentation of and disclosures relating to long-term liabilities and share-based compensation
In a lease agreement, the lessor owns an asset and the lessee receives the right to use it in exchange for periodic payments.
A lease contract must:
- Identify a specific underlying asset
- Give the lessee control over how the asset is used during the term of the lease
- Allow the lessee the right to obtain substantially all of the economic benefits derived from the asset over the contract term
Advantages of Leasing :
- Little to no up front cash payment is required
- Lower financing costs, as the effective interest rate for a lease is typically lower than that of a loan
- Lower risk of obsolescence
Lease Classification as Financing or Operating (transaction resembles a purchase or a rental agreement ?)
A finance lease is effectively the purchase of an asset by the lessee with the financing provided by the seller (the lessor). A lease is a finance lease if any of the following conditions are met:
- Ownership of the leased asset is transferred to the lessee
- The lessee has the option to purchase the asset and will most likely do so
- The lease term covers most of the asset’s expected useful life
- The present value of lease payments at inception is close to the fair value of the asset
- The leased asset is so specialized that it has no alternative use to the lessor
All leases that fail to meet any of these conditions are classified as operating leases. An operating lease is more akin to a rental.
Lessee Disclosure
Under IFRS :
- Total carrying values of leased assets, organized by asset class
- Carrying value of leased assets added during the reporting period
- Total cash outflow from lease payments
- Interest expense attributable to leases
- Depreciation expense attributable to leased assets
Analysts should consider the following for lessees:
- The nature of leasing activities
- Future cash outflow obligations due to existing lease commitments
- Any restrictions or covenants imposed by lease contracts
- Sale and leaseback transactions
Lessor Disclosure under IFRS.
For finance leases:
- Profit or loss attributable to lease transactions
- Interest income from lease transactions
- Any variable lease-related income that has not been captured in the measurement of leases
Additionally, lessors should provide:
- Explanations for any significant changes in the carrying amount of net investments in leased assets
- Maturity analysis of lease payments receivable
- Undiscounted total expected lease payments to be received in each of the next 5 years, and a cumulative total for all periods beyond this horizon.
Lessor Disclosure under IFRS.
For operating leases lessors must disclose:
- Lease income
- Separate disclosure income related to variable lease payments
Additional useful disclosures include:
- Carrying values of leased assets disaggregated by asset class
- Maturity analysis of lease payments by asset class
- Undiscounted total expected lease payments to be received in each of the next 5 years, and a cumulative total for all periods beyond this horizon.
Under IFRS and US GAAP, lessees are required to record a right-of-use (ROU) asset and a corresponding liability for the present value of future lease payments when the lease is signed.
Avoid lease accounting rules for short-term leases of less than 12 months. An additional exemption for a “low-value asset” exists only under IFRS, not US GAAP.
Lessee Accounting — IFRS (and US GAAP Finance Leases) :
IFRS requires lessees to use the same accounting model for both operating and finance leases. When signed, the lessee must record a right-of-use asset and a corresponding lease payable liability. Initial carrying of asset and liability is the present value of future lease payments discounted at an interest rate that is either stated in the lease or an estimate of the lessee’s secured borrowing rate.
Lease payments include both interest and principal. The principal component of a lease payment is considered as a financing activity on the statement of cash flows, while the interest component may be classified under either operating or financing activities.
The income statement will reflect the impact of expenses for both interest and amortization
Lessee Accounting — US GAAP Operating Leases :
With an operating lease under US GAAP, the initial value of the ROU asset and lease liability is calculated the same way as finance lease.
Ammortization of ROU : the principal component of the lease payment (i.e., total lease payment minus interest expense). As a result, the carrying values of the lease liability and the ROU asset will always match at the end of each period.
On i/s, single “lease expense” that includes both interest and principal equal to the lease payment. This is also the amount of the cash outflow, which must be classified as an operating activity under US GAAP.
Lessor Accounting :
Both IFRS and US GAAP allow lessors to classify a lease as either an operating lease or a finance lease. Under US GAAP, lessors may recognize finance leases as either “sales-type” or “direct financing”.
For finance leases, the lessor removes the leased asset from its balance sheet and creates a lease receivable asset with a value equal to the present value of future lease payments. Any difference is recorded by the lessor as a gain or loss.
Lease receivable asset is reduced by each lease payment using the effective interest rate method. Each lease payment consists of interest income and principal proceeds (difference between the lease payment and the interest income).
Operating leases : The leased asset remains on the lessor’s balance sheet and is depreciated over its useful life( NO lease receivable asset). On the i/s, lease revenue is recognized on a straight-line basis over the term of the agreement and the asset’s depreciation expense is recorded for each period.
Employee Compensation :
- Base salary
- Performance-based cash bonuses
- Non-monetary benefits (e.g., coverage of health and life insurance premiums)
- Deferred compensation (e.g., pension plans)
- Share-based compensation
The first three components typically vest immediately, meaning that employees are eligible to receive them as soon as they are granted.
Defined-contribution (DC) or Defined-benefit (DB) structure. With DC pension plans, the sponsoring company has no obligation beyond making contributions to employee accounts. Payments are recorded as a pension expense on the income statement and classified as operating cash outflows.
Defined-Benefit Pension Plans :
The present value of a sponsor’s liability is calculated by applying an appropriate discount rate, such as the yield on an investment-grade corporate bond, to estimates of future payments based on several assumptions about variable factors such as employment tenure, retirement age, final salary, and life expectancy (accounting treatement is difficult).
Sponsors typically create a separate entity, called a pension trust fund, which is responsible for investing contributions from the sponsor and administering post-retirement benefits for retired employees.
Accounting for Defined-Benefit Plans under IFRS (net pension asset or liability is split into three components) :
1- Employees’ service cost: The present value of the increase in pension benefits earned by employees based on their service over the reporting period. The impact of any changes to the plan is included in this component and labeled as a past service cost.
2- Net interest expense/income: The change in the present value of the plan’s surplus or liability attributable to the passage of time. A net pension liability will increase as the weighted average time to payments decreases. This amount is calculated as the product of the funded status (deficit or surplus) and the discount rate (expense on the sponsor’s i/s current period).
Remeasurement: This component captures the actual return on plan assets adjusted for net interest expense/income as well as actuarial gains or losses due to changes in assumptions about variable factors (Bypass the i/s) –> recognized in other comprehensive income (OCI) but it is not subsequently amortized into profit or loss over time.
Accounting for Defined-Benefit Plan under US GAAP ( change in the net pension asset or liability is broken into five components.) :
1- Current service cost
2- Interest expense
3- Expected return on plan assets, which is a reduction in the amount of expense recognized.
4- Past service costs
5- Actuarial gains/losses
Components 1 - 3 are recorded on the sponsor’s i/s current period. 4 is recognized as OCI and amortized into pension expense over time and 5 may be recognized immediately on the i/s but sponsors typically choose to recognize this component in OCI and then amortized it.
A manufacturing firm with DB plan:
Pension expenses attributable to production workers will be recorded in the inventory account and pass through the i/s as part of COGS. Pension costs attributable to employees who are not directly involved in the production process will be included with salaries or other administrative expenses.
The pension expense is found in the footnotes
Presentation and Disclosure of Postemployment Plans :
IFRS;
- the characteristics of their DB plans and the associated risks
- the amounts in their financial statements arising from their DB plans
- how their DB plans may affect the amount, timing, or uncertainty of future cash flows
Issuers disclosures :
- The nature of post-employment benefits
- The applicable regulatory framework
- The governance plan and risk exposures
- A reconciliation of the opening and closing balances of the funded position
- A reconciliation of the opening and closing balances of plan assets
- A reconciliation of the opening and closing balances of the present value of the pension obligation
- The composition of plan assets by category
- An analysis of the sensitivity of the plan’s funded status to changes in key assumptions
- An analysis of the plan’s expected impact on the sponsor’s future cash flows
Disclosures are typically included as part of the notes. Disclosure requirement for DC plans are minimal compared to those for DB plans.
Share-Based Compensation :
Can bring employees to take increased risk or become risk averse. Normally given to executives, and can be found on the proxy statements.
Stock Grants :
If the grant is unconditional (e.g., no vesting requirements), the fair value of shares can be recorded as part of salary expense for the current period. If the grant is subject to a vesting requirement, the associated compensation expense can be allocated over the time until this has been satisfied.
A restricted stock grant requires recipients to return shares if they do not meet certain conditions, such as remaining with the company for a specified period or achieving performance targets ( calculated as the market value of shares on the grant date and allocated over the required service period).
Stock Options
Important dates :
- Grant date – the date the options are granted to employees
- Vesting date – the date employee is first -eligible to exercise the options
- Service period – the period between the grant date and vesting date
- Exercise date – the date the employee exercises the options
(MAY include an expiration date)
Both IFRS and US GAAP require companies to use an appropriate option-pricing model (e.g., Black-Scholes, binomial). Regardless of which model is chosen, certain key inputs are necessary, such as estimates of time to exercise and the volatility of the underlying stock.
Accounting for Stock Options
The compensation expense associated with stock options is determined by their fair value on the grant date, unless this value is contingent on events that have yet to occur at that time. In such cases, this expense is based on fair value of the options at the time all relevant facts related to contingencies are known.
The fair value of the options at the time of exercise has no impact on the issuer’s compensation expense.
Unless the options vest immediately, the recognition of the compensation expense is spread out over the vesting period.
Any amount attributable to unvested options will be reported in the notes as an unrecognized compensation cost. Incremental recognition of the compensation expense reduces retained earning. However, because there is a corresponding increase in the paid-in capital account, the overall book value of equity is unaffected.
Other Types of Share-Based Compensation :
Stock appreciation rights (SARs) can compensate employees based on changes in the share price without transferring ownership (cash-settled). SARs are recorded at fair value and the associated compensation expense is allocated over an employee’s service period.
2 advantages :
1- Employees have limited downside risk and unlimited upside potential, the incentive for being too risk-averse is minimized compared to stock grants.
2- Existing shareholders will not experience dilution.
Disadvantage : Trigger a current-period cash outflow.
Phantom shares are another form of share-based compensation that does not require actual share ownership (based on the performance of a hypothetical stock).
Useful for employees of companies that are not publicly traded or public companies with highly illiquid shares.
Presentation and Disclosure of Share-Based Compensation :
IFRS, companies are required to describe the terms of their share-based compensation plans, such as vesting requirements and whether options are settled in cash or equity.
Stock option programs must disclose the number (or weighted average number) of:
- options outstanding at the beginning of the period
- options outstanding at the end of the period
- exercisable options at the end of the period
- options that were granted, forfeited, exercised, or that expired during the period
For other types of share-based compensation ; disclose the number and fair value of equity instruments that have been granted and provide information about how this fair value was measured.
Objective of share-based compensation plans : Attracting new employees, retaining and motivating existing employees and aligning employee interests with those of shareholders.
Analysis of Income Taxes
contrast accounting profit, taxable income, taxes payable, and income tax expense and temporary versus permanent differences between accounting profit and taxable income
explain how deferred tax liabilities and assets are created and the factors that determine how a company’s deferred tax liabilities and assets should be treated for the purposes of financial analysis
calculate, interpret, and contrast an issuer’s effective tax rate, statutory tax rate, and cash tax rate
analyze disclosures relating to deferred tax items and the effective tax rate reconciliation and explain how information included in these disclosures affects a company’s financial statements and financial ratios
Tax laws and accounting standards often differ with respect to how certain revenues or expenses are recognized, leading to differences between the profits (and tax obligations) that are calculated for tax reporting and financial reporting purposes.
Accounting profit is determined by applying accounting standards. It is the basis for the income tax expense (or recoverable) that appears on a company’s income statement.
Taxable income is based on the tax laws that are applicable in the jurisdictions in which a company operates. Any tax obligations are recorded as an income tax payable liability (or an income tax recoverable asset) on the balance sheet.
Factors that result in differences between accounting profit and taxable income :
- Revenues or expenses that are recognized in one period for accounting purposes and another period for tax purposes
- Differences in the deductibility of gains or losses for accounting and tax purposes
- Differences in how accounting rules and tax laws recognized adjustments to financial data reported in previous years
- The use of losses in previous years to reduce tax obligations for the current year (tax loss carryforwards)
Taxable temporary differences occur when “underpayment” of taxes in the current period creates an obligation to “overpay” taxes in future periods. That future obligation is recorded on the balance sheet as a deferred tax liability.
Asset : Carrying ammount > Tax base
Liability : Carrying ammount < Tax base
The creation of a deferred tax liability is associated with the following circumstances:
- Accounting profit is greater than taxable income
- The carrying amount of an asset is greater than its tax base
- The carrying amount of a liability is less than its tax base
Deductible temporary differences result in a reduction of taxable income in future periods and the recording of a deferred tax asset. These arise under the following conditions:
- Taxable income is greater than accounting profit
- The tax base of an asset is greater than its carrying amount
- The tax base of a liability is less than its carrying amount
Asset : Carrying ammount < Tax base
Liability : Carrying ammount > Tax base
Temporary difference often occurs when companies are permitted to depreciate long-lived assets on an accelerated schedule for tax purposes.
Permanent Differences :
Can not be reversed in the future. Because differences of this nature do not result in the creation of a deferred tax item on the balance sheet, they produce a discrepancy between the statutory tax rate and a company’s effective tax rate.
May arise from:
- Revenues or expenses that are recorded for financial reporting but are not allowed to be recognized for tax purposes (e.g., fines)
- Tax credits for certain expenditures that directly reduce taxes
The taxes a company must pay in the immediate future are taxes payable.
Deferred Tax Assets and Liabilities :
Deferred tax assets represent taxes that have been paid but not yet included as part of income tax expense on the income statement. Conversely, deferred tax liabilities arise when taxes have already been recognized for financial reporting purposes but not yet paid in cash.
The difference between a company’s income tax expense and the amount of cash taxes payable for the period will be captured by the net changes in deferred tax assets liabilities.
Under IFRS, deferred tax assets and liabilities must be recalculated each year by comparing tax bases and carrying values and evaluating whether any adjustments are needed.
Deferred tax assets and liabilities must be adjusted for changes in applicable tax rates. Both deferred tax assets and liabilities will increase as a result of higher tax rates (and vice versa).
Deferred tax asset will only be able to eliminate this temporary difference if it is able to generate sufficient accounting profits. If there is significant doubt about a company’s ability to realize the economic benefits represented by a deferred tax asset, IFRS requires that it be reversed.
Under US GAAP, a valuation allowance is created as a contra-asset account that reduces the deferred tax asset’s net carrying value down to the amount that is deemed more likely than not to be realized.
Three tax rates are important for analysts to consider when modeling forecasts of a company’s future tax obligations.
- The statutory tax rate is the corporate income tax rate in a company’s domestic market.
- The effective tax rate is the reported income tax expense as a share of pre-tax income (EBT).
- The cash tax rate is the actual amount of cash taxes paid as a share of pre-tax income (EBT).
Cash and effective are used for forecast a company’s income and cash flows
Difference between can cause :
- Tax credits
- Withholding taxes on dividends
- Adjustments to previous year’s financial reports
- Expenses not being deductible for tax purposes
For forecasting purposes, analysts should use a normalized tax rate that has been adjusted to reflect past one-time events and volatile sources of income, such as distributions from investments in companies that have been accounted for using the equity method.
Normalized operating income that exclude the impact of special times and investments in associates is typically a useful basis for estimating future tax expenses.
Presentation and Disclosure :
For the purpose of calculating a company’s balance sheet ratios, analysts should make the following adjustments:
- If deferred tax liabilities are not expected to reverse, they should be treated as equity rather than as liabilities.
- If there is uncertainly about both the timing and amount of tax payments attributable to the reversal of temporary differences, deferred tax liabilities should be treated as neither liabilities nor equity (i.e., excluded from both).
A company purchased equipment worth $1,000,000 at the beginning of the year. The associated depreciation expense for the year was $200,000 for financial reporting purposes and $300,000 for income tax purposes. All else equal, if the company reported an operating profit of $500,000 and the tax rate is 40%, the change in the company’s deferred tax liability attributable to this asset is closest to:
A
$40,000.
B
$60,000.
C
$160,000.
After initially being purchases for $1,000,000, the asset would be carried at $800,000 (net of the $200,000 depreciation expense) on the company’s balance sheet, but its tax base will be only $700,000 (net of the $300,000 depreciation expense).
The change in the company’s deferred tax liability is calculated as follows:
($800 000 - $700 000) * 40% = $40 000
Which of the following is added to income tax payable to determine the company’s income tax expense as reported on the income statement?
A
Deferred tax assets
B
Deferred tax liabilities
C
Changes in deferred tax assets and liabilities
C is correct. The changes in deferred tax assets and liabilities are added to income tax payable to determine the company’s income tax expense (or credit) as it is reported on the income statement.
Financial Reporting Quality
compare financial reporting quality with the quality of reported results (including quality of earnings, cash flow, and balance sheet items)
describe a spectrum for assessing financial reporting quality
explain the difference between conservative and aggressive accounting
describe motivations that might cause management to issue financial reports that are not high quality and conditions that are conducive to issuing low-quality, or even fraudulent, financial reports
describe mechanisms that discipline financial reporting quality and the potential limitations of those mechanisms
describe presentation choices, including non-GAAP measures, that could be used to influence an analyst’s opinion
describe accounting methods (choices and estimates) that could be used to manage earnings, cash flow, and balance sheet items
describe accounting warning signs and methods for detecting manipulation of information in financial reports
High-quality reporting provides useful information for analysts to make informed decisions. Earnings quality can only be ascertained if there is high financial reporting quality.
A company with low financial reporting quality does not necessarily have low-quality earnings. However, investors may reduce their valuations when they lack decision-useful information.
Financial reporting quality is high if a company’s financial reports provide investors with decision-useful information that accurately represents its underlying economics.
Earnings quality is high if a company’s operations are likely to generate the returns that investors require on a sustainable basis.
The spectrum of financial reporting quality (from best to worst) is summarized below:
1- GAAP, Decision-Useful, Sustainable, and Adequate Returns
These quality financial reports conform to generally accepted accounting principles (GAAP) or other applicable accounting standards.
2- GAAP, Decision-Useful, but Sustainable?
In this category, financial reporting is high-quality, but earnings are not considered sustainable. The return could be expected to decrease or be insufficient to sustain the company.
3- Biased Accounting Choices
Aggressive choices increase current profits, which can intuitively be understood as misleading. By contrast, conservative accounting choices may seem desirable because managers are not overstating the company’s performance. However, conservative accounting choices may be used to create “hidden reserves” that can be drawn upon during a downturn to smooth out earnings over the business cycle.
4- Within GAAP, but “Earnings Management”
There’s deliberate intent to affect reported earnings and their interpretation. In addition to purely accounting choices, managers may seek to manipulate earnings through “real” decisions, such as delaying spending on maintenance until the next reporting period.
5- Departures from GAAP
Their financial reports are often based on fictitious transactions.
1- (comparability, verifiability, timeliness, and understandability.)
2- Not sustainable source of profit for the company (one time events, recorder as income)
3- Ultimately, both aggressive and conservative biases reduce the quality of financial reporting by creating an impression of a company’s performance that fails to accurately reflect its economic reality.
- Companies that use non-GAAP financial measures in SEC filings must give equal prominence to an equivalent GAAP measure as well as a reconciliation between the two measures.
4- Difficult to prove intent, therefore often considered as “biased choices”
5- Enron and WorldCom
Conservative and Aggressive Accounting :
- Aggressive accounting choices may include recognizing revenue early or deferring the recognition of expenses (better short-term performance).
- Conservative accounting choices reduce a company’s profits in the current reporting period in order to increase future profits ( potential for positive earnings surprises).
Financial reporting choices should be neither aggressive nor conservative BUT unbiased.
Conservatism in Accounting Standards :
Conceptual frameworks behind IFRS and US GAAP = neutrality (financial reports without any biases).
However, many of the standards from IFRS and US GAAP reflect conservative bias. Ex:
US GAAP requires long-lived assets to be written down if they are deemed to be impaired, but it prohibits upward adjustments if the asset’s fair value subsequently increases.
Conservative statements are less likely to be sued if future results are disappointing.
Bias in the Application of Accounting Standards :
Some companies have intentionally generated large current period losses to create a “cookie jar” of reserves that can be used to increase profits in later periods, a practice known as “big bath accounting.”
Context for Assessing Financial Reporting Quality :
Motivations ; Management may be motivated to issue low-quality reports to mask poor performance or avoid breaching debt covenants.
At personal level, managers could think that being associated with a poorly performing company will limit their career prospects.
Conditions Conducive to Issuing Low-Quality Financial Reports :
The fraud triangle consists of three conditions that usually accompany the issuance of low-quality financial reports:
1- Opportunity created by internal or external factors (e.g., poor internal controls, insufficient regulatory oversight).
2- Motivation rooted in performance expectations or personal circumstances.
3- Rationalization of decisions that the individual knows, on some level, to be wrong.
Mechanisms that are used to increase the quality of financial reporting include regulation, auditors, and private contracts.
Market Regulatory Authorities (International Organization of Securities Commissions (IOSCO), securities regulators (e.g., SEC) and other market participants (e.g., NYSE)) :
The following features of regulation directly impact financial reporting quality:
- Registration requirements: Required documentation includes relevant information about the issuer’s prospects and risk exposures.
- Disclosure requirements: Periodic reports. Standards are often set by self-regulatory bodies (e.g., IASB, FASB) and enforced by regulators.
- Auditing requirements: Financial statements have to conform to relevant standards. Some regulators also require opinions on internal controls.
- Management commentaries: These may include a “fair review” of an issuer’s business and a description of its risk exposures.
- Responsibility statements: Individuals who attest to the correctness of corporate statements may be held personally responsible for inaccuracies.
- Enforcement mechanisms: Regulators can enforce compliance through fines, suspensions, or even criminal prosecutions.
Auditors :
Independent audit opinions give investors some assurance that a company’s financial statements are fairly presented.
A company’s financials can be failry presented and in accordance with relevant accounting standards even if internal controls have issues.
There are several limitations of audit opinions:
- Companies may make deliberate efforts to deceive their auditors.
- Audits are based on samples, not an exhaustive review of all relevant information.
- Unlike the public’s expectation, an audit is not intended to detect fraud, only to provide some assurance of fair presentation.
- Auditors are paid directly by the company being audited, which can create an incentive for leniency.
Private Contracting :
Lenders have strong incentives to ensure that borrowers are providing high-quality information in their financial reports.
EBITDA tends to be a more stable measure than net income, as it eliminates the impact of different accounting choices that companies make with respect to depreciation and amortization, as well as differences in capital structure.
Rules have subsequently been implemented requiring companies to explain the use of non-GAAP and non-IFRS financial measures and display the most directly comparable GAAP/IFRS-compliant measure with equal prominence.
Depreciation :
- Accelerated methods allocate more depreciation to earlier periods and less to later periods compared to the straight-line method. For example, the annual depreciation rate for the double-declining balance method is two times the straight-line rate.
- Under the units-of-production method, the depreciation rate for a given year is calculated as the asset’s production that year as a percentage of its total expected production over the course of its entire useful life.
Goodwill :
Managers may be motivated to understate the fair value of acquired fixed assets in order to improve earnings expectations by reducing future depreciation costs. A company’s testing policies for impairment should be disclosed in its notes and compared to those of its peers.
Analysts should be particularly suspicious if a company’s CFO is consistently less than its reported net income.
Which technique most likely increases the cash flow provided by operations?
A
Stretching the accounts payable credit period
B
Applying all non-cash discount amortization against interest capitalized
C
Shifting classification of interest paid from financing to operating cash flow
A is correct. Managers can temporarily show a higher cash flow from operations by stretching the accounts payable credit period. In other words, the managers delay payments until the next accounting period. Applying all non-cash discount amortization against interest capitalized causes reported interest expenses and operating cash outflow to be higher, resulting in a lower cash flow provided by operations. Shifting the classification of interest paid from financing to operating cash flows lowers the cash flow provided by operations.
Bias in revenue recognition would least likely be suspected if:
A
the firm engages in barter transactions.
B
reported revenue is higher than the previous quarter.
C
revenue is recognized before goods are shipped to customers.
B is correct. Bias in revenue recognition can lead to manipulation of information presented in financial reports. Addressing the question as to whether revenue is higher or lower than the previous period is not sufficient to determine if there is bias in revenue recognition. Additional analytical procedures must be performed to identify warning signals of accounting malfeasance. Barter transactions are difficult to value properly and may result in bias in revenue recognition. Policies that make it easier to prematurely recognize revenue, such as before goods are shipped to customers, may be a warning sign of accounting malfeasance.
Which of the following would most likely signal that a company may be using aggressive accrual accounting policies to shift current expenses to later periods? Over the last five-year period, the ratio of cash flow to net income has:
A
increased each year.
B
decreased each year.
C
fluctuated from year to year.
B is correct. If the ratio of cash flow to net income for a company is consistently below 1 or has declined repeatedly over time, this may be a signal of manipulation of information in financial reports through aggressive accrual accounting policies. When net income is consistently higher than cash provided by operations, one possible explanation is that the company may be using aggressive accrual accounting policies to shift current expenses to later periods.
Which of the following is most likely a warning sign of overstated earnings in the current period?
A
A LIFO liquidation in an inflationary environment
B
Excluding one-time payments received from revenues
C
An unjustified increase in bad debt allowance relative to receivable
A) In a LIFO liquidation, the firm sells more inventory than it replaces. Assuming positive inflation, older, lower cost inventory units are presumed to be sold thereby reducing cost of goods sold and increasing profits. However, analysts should investigate to verify whether these profits are supported by accompanying cash flows.
Financial Analysis Techniques
describe tools and techniques used in financial analysis, including their uses and limitations
calculate and interpret activity, liquidity, solvency, and profitability ratios
describe relationships among ratios and evaluate a company using ratio analysis
demonstrate the application of DuPont analysis of return on equity and calculate and interpret effects of changes in its components
describe the uses of industry-specific ratios used in financial analysis
describe how ratio analysis and other techniques can be used to model and forecast earnings
Equity analysis focuses on growth while credit analysis focuses on risk.
Objectives of the Financial Analysis Process :
The analyst should know the purpose, level of detail, data available, important factors, and analytical limitations.
The following steps could be used for financial statement analysis:
- Articulate the purpose and context of the analysis.
- Collect input data.
- Process data.
- Analyze/interpret the processed data.
- Develop and communicate conclusions and recommendations.
- Follow up.
Analysis should address why things happened, not just what happened.
The analyst should also look for trends and the management’s likely response to those trends. Important risks should be highlighted. A written report is often the best way to communicate findings.
Ratio names and the formulas used to compute them may vary between databases, firms, and analysts. Even a relatively straightforward ratio, such as return on assets, will be different depending on whether the value used in the denominator is beginning assets, ending assets, or an average of the two.
limitations to consider when using ratios:
1- Industry-specific ratios may not be applicable to companies with heterogeneous operations in multiple industries.
2- Different ratios can give inconsistent indications about a company. Ratio analysis requires considerable judgment about, for example, macroeconomic and industry factors.
3- Comparing companies can be complicated by the use of different accounting standards or different choices that are allowed within the same set of accounting standards.
Common-Size Analysis of the Balance Sheet :
A vertical analysis is done with only one reporting period, dividing all items by the total assets. A horizontal analysis involves multiple time periods or companies. It focuses on the percentage increase or decrease in each item.
Common-Size Analysis of the Income Statement :
A vertical analysis will divide by revenue, or, less commonly, by total assets (especially in the case of financial institutions).
Cross-Sectional Analysis :
Cross-sectional analysis, sometimes called relative analysis, compares a specific metric of one company to another. This is more easily done with a common-sized statement.
Model Building and Forecasting :
1- Sensitivity analysis measures the impact of changes in specific assumptions by producing a range of outcomes. This method is also known as “what if” analysis.
2- Scenario analysis models the impact of economic events, such as the loss of a key supplier. If the possible events are mutually exclusive and collectively exhaustive, it is possible to assign probabilities and estimate expected values.
3- Simulation uses computer models to run sensitivity or scenario analysis and generates a forecast based on the probability assigned to each outcome.
Common Ratio Categories :
- Activity ratios (operational efficiency)
- Liquidity ratios (ability to meet short-term obligations)
- Solvency ratios (ability to meet long-term obligations)
- Profitability ratios (efficiency in using assets to generate profits)
Activity ratios, also called asset utilization ratios, are indicators of ongoing operational efficiency.
A key type of activity ratio is known as a turnover ratio, which combines an income statement item in the numerator with a balance sheet item in the denominator to show how effectively a company is making use of the resources at its disposal.
Total asset turnover: company’s ability to generate revenue from its assets, with a higher ratio indicating greater efficiency.
- Can vary considerably by industry, making comparisons to a company’s peers more relevant than comparisons to companies in different sectors.
Fixed asset turnover : measures how efficiently a company is using its fixed assets.
- A high ratio indicates more efficient operations but contextual analysis is necessary.
- A low ratio could indicate that the company operates in a capital-intensive industry or that it is a growing company that has yet to reach full capacity.
- A company may have a relatively high ratio because it relies on older assets with low net carrying values and high levels of accumulated depreciation.
-Even with steady revenues, this ratio can be highly volatile if investments in fixed assets are lumpy.
Working capital turnover: measures how effectively a company generates revenue from its working capital.
Working capital is current assets minus current liabilities.
- It is meaningless for those companies that have net negative working capital (i.e., current assets < current liabilities).
Inventory turnover: shows the level of company resources that are tied up in inventory, which imposes carrying costs.
- A high ratio could indicate effective inventory management, particularly if the company’s sales are also growing at a healthy rate.
- high inventory turnover ratio could also mean inadequate inventory levels and the company is at risk of stock-outs (no inventory).
Receivables turnover: helpful to compare the company’s historical estimates of uncollected accounts and subsequent recorded credit losses.
- A high ratio could indicate efficient credit management and collections practices.
- An alternative interpretation of high receivables turnover ratio is that the credit standards are too stringent, causing the company to miss out on potential sales.
Payables turnover
- A relatively high payables turnover ratio indicates that a company is not making efficient use of its credit facilities.
- An alternative interpretation is that the company is taking advantage of discounts for early payments.
- A very low ratio suggest that the company is having difficulty making payments on time.
Days of inventory on hand (DOH) : shows the average number of days of inventory that a company is carrying.
- Lower level indicates more effective inventory management practices. Should be analyzed in the context of measures such as sales growth.
Days of sales outstanding (DSO) : average amount of time that passes between credit sales and cash collection.
Days of payables outstanding (DPO) : how many days it takes the company to pay suppliers.
- A high ratio may indicate difficulty making payments.
- Alternatively, if the company has sufficient cash flows, a high ratio could reflect generous credit terms offered by suppliers.
Liquidity ratios indicate a company’s ability to meet its short-term obligations. An analysis of a company’s liquidity position should also consider any contingent liabilities, which are disclosed in the notes to its financial statements.
Liquidity ratios in the context of their historical levels and relative to those of a company’s peers.
Current ratio : broad measure of a company’s liquidity, with a higher ratio indicating a stronger position.
- A company with a lower current ratio is more reliant on operating cash flows and outside financing to meet its short-term obligations.
- Based on the assumption that all current assets can be converted into cash quickly at their carrying values.
Quick ratio
- Prepaid expenses, deferred tax assets, and, notably, inventories are excluded from the numerator.
- The quick ratio is often preferable to the current ratio for measuring of a company’s ability to meet its short-term obligations, particularly if its inventory is relatively illiquid (as indicated by a low inventory turnover ratio).
Cash ratio
- Appropriate for assessing a company’s ability to navigate a crisis situation.
Defensive interval ratio : The length of time that a company could rely only on quick assets to finance its operations if all cash inflows were to stop.
- A company with a low ratio is more dependent on alternative sources of liquidity (e.g., lines of credit) to meet its cash needs.
Cash conversion cycle : Measures the length of time between when a company pays cash for inputs to when it receives cash for sales made to customers on credit.
- While it is technically not a ratio, a shorter cash conversion cycle (aka. net operating cycle) indicates a shorter period during which a company has cash tied up in inventory and uncollected receivables.
Solvency relates to a company’s ability to meet its long-term obligations.
- Operating leverage comes from the use of fixed costs in the business operations. It will cause operating income to increase faster than revenues.
- Financial leverage arises from fixed financing costs. It will magnify the earnings flowing to equity holders.
Both types of leverage increase the riskiness of a company’s profits, so a higher level of one type can limit its ability to accept more of the other.
Debt ratios rely on inputs from the balance sheet and measure the extent to which a company relies on debt as part of its capital structure. For the purpose of calculating these ratios, “debt” is defined as interest-bearing short-term and long-term debt obligations.
Debt-to-equity
- As with all ratios in this category, a higher ratio indicates greater financial risk.
Debt-to-capital
- If a company’s capital structure includes equal amounts of debt and equity, its debt-to-capital ratio will be 0.5.
Debt-to-assets : Percentage of total assets financed with debt.
- If a company’s assets are financed entirely with debt and equity, this measure will match the debt-to-capital ratio.
Financial leverage : amount of total assets supported by each unit of equity.
Debt-to-EBITDA : measures the number of years of EBITDA that would be required for a company to repay all of its outstanding debt.
The second category of solvency ratios is called coverage ratios. These metrics which use inputs from the income statement to measure a company’s ability to generate the income needed to service its fixed financial obligations.
Interest coverage ( times interest earned):represents how many times EBIT can cover the interest payments.
- Along with the debt-to-EBITDA ratio, it is commonly used as a metric for debt covenants.
Fixed charge coverage : number of times operating income can cover interest and lease payments.
- A higher ratio is generally interpreted as indicating that a company’s preferred dividend is more secure.
Gross profit margin : Percentage of revenue that is available to non-COGS operating expenses and other expenses (e.g., interest), as well as to generate a profit for shareholders.
- It reflects a company’s bargaining power relative to both its customers and suppliers.
Operating profit margin
Operating profit is gross profit less non-COGS operating expenses.
- An operating profit margin that is increasing faster than gross profit margin indicates that a company is controlling its selling, general, and administrative (SG&A) expenses (and vice versa).
- Affected by operating leverage (i.e., fixed costs), but not by financial leverage.
Pretax margin
EBT is operating profit minus interest.
- Increasing pretax margin is positive, but analysts should examine the extent to which this growth relies on non-operating income that is not central to a company’s operations and/or unlikely to be recurring.
Net profit margin
- Because this bottom-line figure is affected by one-time items, analysts often make adjustments for to eliminate the impact of non-recurring components.
Return on assets (ROA) : measures a company’s bottom-line profit as a rate of return on its assets.
- A more accurate version of this ratio uses net operating profit less adjusted taxes (NOPAT), also known as after-tax operating profit, in the numerator.
Return on invested capital (ROIC)
- Also known as return on capital employed (ROCE), this profitability measure uses NOPAT in the numerator
- Because invested capital (i.e., interest-bearing debt and equity) is used in the denominator, this is an unlevered measure that is unaffected by financing decisions.
Return on common equity
- A more narrowly defined version of ROE subtracts preferred dividends from net income in the numerator and includes only the book value of common equity in the denominator.
Dupont Analysis : decomposes a company’s return on equity (ROE), allowing analysts to isolate how different components contribute to profitability.
First, the ROE is decomposed into just two components – return on assets and leverage.
The return on assets (ROA) term can be decomposed into two components – net profit margin and total asset turnover.
Introduction to Financial Statement Modeling
demonstrate the development of a sales-based pro forma company model
explain how behavioral factors affect analyst forecasts and recommend remedial actions for analyst biases
explain how the competitive position of a company based on a Porter’s five forces analysis affects prices and costs
explain how to forecast industry and company sales and costs when they are subject to price inflation or deflation
explain considerations in the choice of an explicit forecast horizon and an analyst’s choices in developing projections beyond the short-term forecast horizon
Revenue Forecast :
1- Top-down approaches begin with an analysis of the overall economy. Revenue can be modeled with growth relative to GDP growth. Alternatively, the analyst can forecast revenues at the industry level and then extrapolate based on a company’s market share.
2- Bottom-up revenue forecasts use the individual company as a starting point and arrive at an aggregate amount based on estimates for each business segment, product line, or geographical source.
3- Hybrid: For example, a top-down approach can be applied to individual business segments.
COGS :
The cost of goods sold (COGS) is usually the largest cost for manufacturing and merchandising companies.
It is common to forecast COGS as a percentage of sales. When gross profit is expressed as a percentage of sales, it is typically referred to as gross margin.
SG&A Expenses and Other Operating Expenses :
Selling, general, and administrative expenses (SG&A) are also key operating costs. They include salaries and benefits for sales staff as well as overhead costs, such as those incurred to maintain a head office.
Companies may separate selling expenses from general and administrative expenses.
Non-Operating Items :
For many companies, the most significant non-operating expenses are financing expenses and taxes. The term “financing expense” refers to both interest income and interest costs. A company’s interest expense is driven by the amount of debt on its balance sheet and its borrowing rate. Interest income is an important item for financial companies, such as banks and insurers.
It is typically not significant for other types of companies, which often only report their interest expense net of interest income on their income statement rather than including interest income as a separate line item.
Corporate Income Tax Forecast :
However, when modeling a company’s financial statements, an analyst should consider both the statutory tax rate that applies to corporate income in a company’s home country and the effective tax rate, which is calculated as a company’s reported income tax expense divided by its pre-tax income.
Shares Outstanding :
Estimates of a company’s intrinsic value and earnings on a per share basis require assumptions about potential changes in the number of shares outstanding due to new share issues or repurchases, as well as the potential exercising of warrants, stock options, or convertible stocks and bonds.
Balance Sheet and Cash Flow Modeling :
It is important to consider the level of investments that are necessary to meet the company’s needs for working capital and fixed assets.
Capital Investments and Depreciation Forecasts :
Net PP&E is driven by capital expenditures and depreciation. Capital expenditures include both maintenance capital expenditures and growth capital expenditures. As a general rule, forecasts of maintenance capital expenditures should exceed depreciation in order to account for inflation.
Working Capital Forecasts :
Working capital accounts — notably accounts receivable, accounts payable, and inventory — are often closely linked to income statement projections. For many companies, these accounts are maintained as a relatively predictable percentage of sales or COGS.
- Efficiency ratios example: the accounts receivable could be modeled as a fraction, such as 60/365, of the credit sales.
A bottom-up approach could assume historical efficiency ratios will apply to the future. A top-down approach could forecast a decline in economy-wide sales, resulting in slower inventory turnover and higher inventory balances.
Best practices for mitigating overconfidence bias include regularly reviewing forecasts to assess how accurate they turned out to be rather than allowing analysts to assume that their forecasts were correct. The lessons that are learned by going over forecasting errors can be incorporated into the modeling process.
In order to incorporate competition into the financial forecasts, Michael Porter’s five forces framework:
1- Threat of substitutes
2- Intensity of rivalry
3- Bargaining power of suppliers
4- Bargaining power of customers
5- Threat of new entrants
1 : If there are many substitutes and switching costs are low, companies will have little pricing power. By contrast, companies that have developed strong brand loyalty have more pricing power.
2: Other factors that limit pricing power include limited industry growth potential, high exit barriers, high fixed costs, and undifferentiated products.
3: A company with more ability to choose among potential suppliers will enjoy greater bargaining power and face less cost pressure.
4: Companies operating in an industry where purchasing decisions are made by a relatively small number of large buyers will have very little pricing power. By contrast, factors that increase a company’s pricing power include a fragmented customer base, differentiated products, and high switching costs.
5: Higher barriers protect pricing power by limiting the risk that new competitors will emerge. Significant barriers to entry include high capital spending requirements, long-term contracts with suppliers, strong established brands, and logistical challenges.
Sales Projections with Inflation and Deflation
Inflation : Strong pricing power = more ability to pass rising input costs along to their customers, resulting in higher and more stable profits.
Deflation : In the event of lower input costs (i.e., deflation), producers that respond by lowering their prices quickly are likely to experience an increase in market share at the cost of lower profit margins. Companies that wait to reduce their prices will maintain their profit margins while losing market share.
Cost Projections with Inflation and Deflation
Inflation : Companies can protect themselves against unexpected inflation by using long-term contracts to lock in prices for key inputs.
Monitoring the underlying factors that affect input prices can help forecast costs (Ex: weather for agriculture).
The impact of input cost increases may be mitigated in industries where companies have the ability to rely on alternative inputs.
A company’s ability to pass on higher input costs is least likely to be affected by which of the following competitive factors from Porter’s five forces framework?
A
Rivalry
B
Threat of substitutes
C
Bargaining power of suppliers
C) Although the bargaining power of suppliers directly affects the cost of a company’s inputs, it does not influence whether any increase in these costs can be passed on to consumers. For example, two companies operating in the same industry may have the same supplier and pay the same price for inputs, but one may be able to pass on a higher share of rising costs due to greater brand loyalty.
The threat of substitutes and industry rivalry are two factors in Porter’s framework that can significantly impact the prices that a company is able to charge its customers.
The determination of an appropriate forecast horizon may be based on several factors, such as the timing of the economic cycle, industry cyclicality, company-specific factors, or an investor’s personal timeline.
This timeframe should be consistent with how the portfolio is managed. For example, 20% annual portfolio turnover implies a typical holding period of five years.
Modeling should be done over a period that is long enough to reach a mid-cycle level of industry activity. Longer-term projections are better in the sense that the impact of temporary or unusual events is reduced, allowing analysts to produce a better estimate of a company’s normalized earnings and cash flows.
Normalized earnings represent a company’s expected level of profitability assuming no unusual or temporary factors such as mergers, restructurings, or changes in strategy.
Using DCF:
- If the terminal year is expected to occur at the peak of a business cycle, the expected cash flows can lead to a significant overvaluation.
-The terminal rate of growth may be different from the assumed growth rate at the beginning of the forecast period. Historical growth rates may no longer be appropriate due to changes in company-specific, industry-level, and macroeconomic factors.
- Forecasts can be complicated by inflection points, which represent an abrupt departure from the recent past. For example, an analyst may expect a relatively young company to experience rapid growth as it reaches the mature stage of its life cycle.
- Affected by disruptive developments, such as a financial crisis, major changes in regulatory policies, or significant technological advancements.
If the future growth or profitability of a company is likely to be lower than the historical average (in this case, because of a potential technological development), then the target multiple should reflect a discount to the historical multiple to reflect this difference in growth and/or profitability. If a multiple is used to derive the terminal value of a company, the choice of the multiple should be consistent with the long-run expectations for growth and required return.
Which of the following is most likely to be among the recommendations for an analyst using the discounted cash flow approach to estimate a company’s terminal value?
A
The forecast horizon should be based on the timing of the next inflection point
B
The terminal growth rate assumption should be based on the company’s historical growth rate
C
The terminal year free cash flow projection should be adjusted based on the timing of the business cycle
C) When using the DCF method to estimate a company’s terminal value, analysts should adjust their estimates of terminal year free cash flows to account for the timing of the business cycle. Using an estimate for a terminal year that coincides with the peak or trough of a cycle can lead to excessively high or low valuations.
