2006 Level 1 SS 7 and 8

Financial Statement Analysis

Study Session 7 & 8
Financial Statement Analysis Basic Concepts

Study Session 7
CONTENTS OF STOCKHOLDERS REPORT

Managements Discussion and Analysis (MDA) Balance Sheet Income Statement Statement of Stockholders Equity Statement of Cash Flows Statement of Comprehensive Income Auditors Report Explanatory Notes Supplementary Information
LOS 29 d discuss the additional sources of information accompanying the financial statements, including the financial footnotes, supplementary schedules, Management Discussion and Analysis (MD&A) and Proxy statements
CONTENTS OF MANAGEMENT DISCUSSION AND ANALYSIS

Results of operations + discussion of trends
Capital resources and liquidity + trends in cashflows

General business overview based on known trends Effects of known trends, events and uncertainties Discontinued operations, extraordinary items, unusual items Disclosures in interim financial statements Segmental cash flow requirements and contributions
Corporate Filings/Proxy Statements

Form 10-K Annual Report Detailed financial results reported to the SEC on annual basis. Audited and filed 90 days after the close of a fiscal year. Publicly held companies report their financial results annually to shareholders in an annual report. Effectively the report is a condensed version of the 10K. A proxy statement is sent to all shareholders in connection with company meetings. The proxy explains proposals that will be voted on by the shareholders. The proxy also contains information about management remuneration, stock options, special deals and related party transactions. The proxy will also detail any changes of auditor.
Proxy
Corporate Filings/Proxy Statements

Form 10-Q Public companies must file quarterly reports 45 days after the end of the period using form 10-Q. The form contains a balance sheet, statement of operations, cashflow and MDA but is not audited. 8-K is used to inform the SEC of special events: changes in control, acquisitions, dispositions, auditor changes, director resignation and bankruptcy. (Normally due within 15 days 5 for auditor) Insiders must register every time they buy or sell stock. When a publicly held company plans to issue securities, it must file a registration statement, including a prospectus and exhibits
Form 8-K
Form 144 Registration
FINANCIAL ACCOUNTING STANDARD SETTING

American Institute of Certified Public Accountants (AICPA)
(Recognize) Pre-1973 APB
Securities and Exchange Commission (SEC)
Financial Accounting Standards Board (FASB)
Statements of Financial Accounting Concepts (SFAC)
Statements of Financial Accounting Standards (SFAS)
LOS 29 a discuss the general principles of the financial reporting system and explain the objectives of financial reporting according to the Financial Accounting Standards Board (FASB) conceptual framework;
INTERNATIONAL FINANCIAL ACCOUNTING STANDARD SETTING

Different accounting standards make international comparisons difficult IOSCO International Organization of Securities Commissions 65 countries securities regulators investigate and set standards on multinational disclosure and financial statements. Implementation is left to the individual members. International Accounting Standards Board attempting to provide a unified international framework of accounting standards. Has issued over 40 proclamations. Lacks a formal mechanism to ensure compliance with standards. Many governments now voluntarily adopting IAS. International Accounting standards were adopted by the EU in 2005. US and IAS are slowly converging.
IASB
LOS 29c discuss the role of IOSCO and IASB in setting and enforcing global accounting standards
General Principals of Financial Reporting System

Timing Economic events and accounting entries may take place in different periods, e.g., changes in market value of PP&E Many economic events do not receive recognition, e.g., contingencies, off balance sheet finance Certain items may be reported in different ways, e.g., FIFO vs. LIFO
Recognition
Measurement
LOS 29a : Discuss the general principals of the financial reporting system
Objectives of Financial Reporting

Equity Investors
Interested in identifying firms with long term earning power, growth opportunities and ability to pay dividends Interested in liquidity of the business
Long term asset position and earning power Investors debt and equity
Short Term Creditors
Long Term Creditors
Classes of user
Government taxes/regulators Others public, special interest groups, workforce etc
Foundations of Accrual Accounting

Recognition Principle
Revenue is recognized when goods are delivered or services performed, not necessarily when the cash is received Revenues and associated costs are recognized in the same accounting period Assets and liabilities are recorded at the transactions original value. The advantage is that historic cost is objective and verifiable.
Matching Principle
Historic Cost Principle
Statement of Financial Accounting Concepts (SFAC) 2

Relevance Timeliness Reliability Consistency Comparability Materiality Information that could potentially affect a decision Information looses value rapidly in the financial world. Helpful for forecasting. Verifiable and representational faithfulness Same accounting principles consistently applied over time Information should allow comparison between companies. Often difficult due to estimates and methods. Which data is important enough for inclusion in the financial statements.
LOS 29 b identify the accounting qualities (e.g., relevance, reliability, predictive value, timeliness) set forth in Statement of Financial Accounting Concepts (SFAC) 2, and discuss how these qualities provide useful information to an analyst
The Audit Report

Audit = independent review of the companys financial statements
Financial statements are true and fair
Audit Report
Responsibility of management to prepare accounts Independence of Auditors Properly prepared in accordance with relevant GAAP Free from material misstatement
Accounting principles and estimates chosen are reasonable

Unqualified opinion vs. qualified opinion Uncertainties
LOS 29 e Discuss the role of the Auditor and the meaning of the audit opinion
MONEY IN
Loan capital (ST & LT)
Share capital Reserves Assets Liabilities Equity
MONEY OUT
Long-lived assets Current assets Investments
probable current and future economic benefit obtained as a result of past transactions probable sacrifices of economic benefit/transfers of wealth as a result of past transactions residual interest in Net Assets of an entity (Total Assets Total Liabilities) = ASSETS
LIABILITIES + STOCKHOLDER EQUITY
Assets In order of liquidity

Liabilities In order of due date
LOS 29 d describe and distinguish between the principal financial statements: Balance Sheet, Income Statement, Statement of Comprehensive Income, Statement of Cash Flows and Statement of Stockholders Equity
LOFTUS INC. BALANCE SHEET AS AT 31 DECEMBER 20X0

ASSETS Current assets Cash Short term investments Accounts receivable Less: Bad debt provision Inventory Prepayments Total current assets Investments Property plant & equipment Land and Buildings Plant & Machinery Less: Accumulated depreciation Intangible assets: Goodwill TOTAL ASSETS
LOS 29 d describe and distinguish between the principal financial statements: Balance Sheet LOS 30 a describe the factors that distinguish long-term assets from and identify common types of long-term assets and their carrying values on the balance sheet;
$000
$000 100 40
$000
400 (20)
380 540 10 1,070 200
500 1800 (400) 1400
1,900
2,000 5,170
Long Term Assets

Long term asset = asset held for continuing use within the business, not resale Carrying Value Balance Sheet $ Profit on disposal Income Statement $ Proceeds NBV Profit/(loss) X (X) X/(X)
Cost
Accumulated Depn /Amort Net Book Value (NBV)
X
(X) X
Cost includes all expenditure to acquire the asset and ready it for usage (installation, broker, legal fees, etc.)
For part exchange replace proceeds with trade in allowance
LOS 30 a identify the common types of long-term assets and their carrying values on the balance sheet LOS 30 b determine the cost and record the purchase, of property, plant, and equipment LOS 30 d describe how to account for the sale, exchange, or disposal of depreciable assets
LOFTUS INC BALANCE SHEET AS AT 31 DECEMBER 20X0

LIABILITIES Current liabilities $000 $000 $000
Accounts payable Tax payable Current portion of long term debt

Total current liabilities Long term liabilities Bonds payable STOCKHOLDERS EQUITY Contributed capital Common stock $1 par value 500,000 shares issued and outstanding Other paid in capital Total contributed capital Retained earnings Total stockholders equity TOTAL LIABILITIES AND STOCKHOLDERS EQUITY
LOS 29 d describe and distinguish between the principal financial statements: Balance Sheet LOS 31 f describe the components/format of the balance sheet
390 250 120

760
2,340
500 200 700 1,370 2,070 5,170
Stockholders Equity
Preferred Stock Disclosure dividends (fixed, floating, participating), call provisions, conversion privileges. If redeemable by holder reclassify after liabilities
Each class reported separately, recorded at par value, treasury stock contra for repurchases If common stock is issued above par value any excess is recorded in additional paid in capital
Common Stock
Additional Paid in Capital Other items
- Minimum Liability Adjustment (Pensions) - Forex gains and losses under the all current method - Market Valuation Adjustment (Available for sale securities) - Unearned shares issued to employee stock ownership plans
LOS 31 f describe the format and the components of the balance sheet and the format, classification, and use of each component of the statement of stockholders equity.
STATEMENT OF STOCKHOLDERS EQUITY LOFTUS INC.

Year Ending December 31 20X0 $000
Stockholders Equity at beginning

Additions: Sale of Common Stock at Par Additional Paid-In Capital: Net Income 200X Dividends Paid: Stockholders Equity at end
1,520
200 200 500 (350) 2,070
LOS 29 d describe and distinguish between the principal financial statements: Statement of Stockholders Equity LOS 31 f describe the format and the components of the balance sheet and the format, classification, and use of each component of the statement of stockholders equity.
INCOME STATEMENT FOR THE YEAR ENDING 31 DECEMBER 20X0

LOFTUS INC $000 Revenues Cost of goods sold Gross profit Operating expenses Depreciation Earnings before interest and taxes Interest expense Earnings before taxes Taxes Net income 6,350 2,400 3,950 2,500 200 1,250 500 750 250 500
LOS 29 d describe and distinguish between the principal financial statements: Balance Sheet, Income Statement, Statement of Comprehensive Income, Statement of Cash Flows and Statement of Stockholders Equity LOS 31 a describe the format on the Income Statement and the components of net income
FINANCIAL STATEMENT FOOTNOTES

Information on accounting methods, assumptions and estimates Additional information on items appearing in major statements
Depreciation methods Inventory valuation methods Leasing arrangements Deferred tax calculations Items not otherwise reported in the financial statements that are relevant and/or material
(these are potential losses/payments potentially to be incurred by the firm, subject to the outcome of some future event/action e.g. litigation)
Disclosures relating to contingent losses Accrue a loss: - probable that loss has been incurred - amount can be reasonably estimated Footnote disclosure: - loss is reasonably possible - e.g., litigation, expropriation
INCOME STATEMENT FORMAT SUGGESTED IN READING
+ +/
+/ +/ +/
Revenues from the sales of goods and services: Other income and revenues Operating expenses Financing costs Unusual or infrequent items
Pre-tax earnings from continuing operations Income tax expense Net income from continuing operations Income from discontinued operations Extraordinary items Cumulative effect of accounting changes Net income
LOS 29 d describe and distinguish between the principal financial statements: Balance Sheet, Income Statement, Statement of Comprehensive Income, Statement of Cash Flows and Statement of Stockholders Equity LOS 31 a describe the format on the Income Statement and the components of net income
CRITERIA FOR REVENUE RECOGNITION

In order to recognize revenues (in the Income Statement) two conditions must be met: 1. Completion of the earnings process This amounts to the firm having provided all or virtually all of the services for which it is to be paid, knowing the total expected cost of providing those services and the associated revenues
2. Assurance of payment The seller must be able to reasonably estimate the probability of payment
LOS 31 b Identify the requirements for revenue recognition to occur.
METHODS OF REVENUE RECOGNITION

Sales basis Sales and corresponding costs recognized at the point of sale and/or when a service has been provided For long term contracts where a reliable estimate of revenues, costs and completion time exists. Revenues and costs recognized according to the proportion of work completed. For long term contracts where there is no contract or estimates of revenues and costs are unreliable. Revenues and costs are not recognized in the Income Statement until the entire project is completed.
Percentage-of-completion
Completed contract
LOS 31 b explain the importance of the matching principle for revenue and expense recognition, identify the requirements for revenue recognition to occur, identify and describe the appropriate revenue recognition, given the status of completion of the earning process and the assurance of payment, and discuss different revenue recognition methods and their implications for financial analysis;
METHODS OF REVENUE RECOGNITION

For contracts where costs and revenues are known but the exact timing of the receipt of sales cash is unclear. Revenues and costs are recognized in the Income Statement in proportion to the cash collection. For contracts where revenues are known but the exact size of costs is not clear. Profits are not recognized in the Income Statement until all costs have been recovered, i.e., through the recognition of sales just equal to costs incurred.
Instalment sales
Cost recovery
PERCENTAGE OF COMPLETION METHOD EXAMPLE

Bircham Properties Ltd. has a contract to build a hotel for $2,000,000 to be received in equal installments over 4 years. A reliable estimate of total cost of this contract is $1,600,000. During the first year, Bircham Properties incurred $400,000 in cost. During the second year, $500,000 of costs were incurred. The estimate of the projects total cost did not change in the second year. Calculate the revenue to be recognized in each of the first two years.
LOS 31 c identify the appropriate income statement and balance sheet entries using the percentage-of-completion method and the completed contract method and describe and calculate the effects on cash flows and selected financial ratios that result from using the percentage-of-completion method versus the completed contract method;
POC vs. CC METHODS EXAMPLE (BALANCE SHEET)

Cook Properties has a contract to build an office building for $2 million. An estimate of the contracts total costs is $1.5 million. Billings and cost patterns are as follows: 20x1 20x2 20x3 Total Amounts billed
Cash received Costs incurred
800
600 500
700
900 700
500
500 300
2,000
2,000 1,500
You are required to prepare the balance sheets using the percentage of completion and completed contract methods.
BALANCE SHEET PERCENTAGE-OF-COMPLETION METHOD

Total Assets 20x1 20x2 20x3
Cash
(Cash Recd Cost Incurred)
Accounts receivable
(Amounts Billed Cash Recd)
Net CIP* Total Assets
* See working slide


Total Liabilities and Equity 20x1 Net Advanced Billings* Retained Earnings Total Liabilities & Equity 20x2 20x3
* See working slide

MEMO CIP
20x1 Cost Profit Allocation
Cost to Date
Total Cost Contract Price Total X Cost
20x2
20x3
Amounts Billed Net CIP/(Net Advanced Billings)
BALANCE SHEET COMPLETED CONTRACT METHOD

Total Assets 20x1 Cash Accounts receivable Net CIP Total Assets 20x2 20x3

Total Liabilities and Equity 20x1 Net Advanced Billings 20x2 20x3
Retained Earnings
Total Liabilities & Equity
MEMO CIP
20x1 Cost 20x2 20x3
PERCENTAGE-OF-COMPLETION vs. COMPLETED CONTRACT

During Project Life
Net income Income Statement Volatility of income Total assets Balance Sheet Statement of Cash Flows Liabilities POC CC
R/E
Cash flow Importance of CFO
INSTALLMENT SALES METHOD EXAMPLE

During 20X0, Sturridge Inc. sold $20,000 of inventory, with a cost of $10,000. During 20X0 and 20X1, Sturridge collected $8,000 and $12,000 respectively, of its receivables. Under the Instalment Method, what are the sales and gross profit to be reported in each of the two years?
COST RECOVERY METHOD EXAMPLE

During 20X0, Sturridge Inc. sold $20,000 of services but the cost of providing this service was unclear at the outset of the contract. During 20X0 and 20X1, Sturridge Inc. collected $8,000 and $12,000, respectively of its receivables. The project was completed during 20X1 at which time the company had incurred total costs of $10,000. Under the Cost Recovery Method, what are the sales and gross profit to be reported in each of the two years?
CHOOSING THE APPROPRIATE REVENUE RECOGNITION METHOD

Completion of Earning Process
Complete Complete Complete with contingencies Complete with contingencies Incomplete and costs can be estimated Incomplete and costs can be estimated
Assurance of Payment
Assured Not assured Assured Not assured Assured Not assured
Revenue Recognition Method

Sales basis Installment sales Cost recovery Cost recovery Percentage of completion Completed contract
Incomplete and costs cant be estimated

Incomplete and costs cant be estimated
Assured
Not assured
Completed contract
Completed contract
INCOME STATEMENT FORMAT SUGGESTED IN READING

+ +/
+/ +/ +/
Revenues from the sales of goods and services: Other income and revenues Operating expenses Financing costs Gross of tax Unusual or infrequent items
Pre-tax earnings from continuing operations Income tax expense Net income from continuing operations Income from discontinued operations Extraordinary items Cumulative effect of accounting changes Net income
LOS 31 d describe the types and analysis of unusual or infrequent items, extraordinary items, discontinued operations, accounting changes, and prior period adjustments;
Net of tax
INCOME STATEMENT: NON-RECURRING ITEMS

Gains of losses from disposal of a portion of a business segment Unusual or infrequent items Gains or losses from sale of assets or investments Impairments, write-offs and restructuring costs Gains or losses from the early retirement of debt (note can be extraordinary if infrequent) Provisions against environmental remediation
Extraordinary items
Unusual AND infrequent AND material: Losses due to a foreign governments expropriation of assets Uninsured losses from natural disasters
INCOME STATEMENT: NON-RECURRING ITEMS

Discontinued operations Operating income (e.g., revenue and expenses up to the date of disposal) and any gains or losses from their sale are reported separately since these activities will not contribute to future income and cash flows.
Changes in accounting principle
The cumulative impact on prior period earnings is reported net of tax after extraordinary items and discontinued operations where, for example, the company changes the depreciation method. Not that this is not required for changes in accounting estimates.
Role of Nonrecurring Items in Estimating Earnings Power

The analyst focus is often on net income from continuing operations as this serves as a basis for forecasts.
Companies therefore tend towards putting profitable one off transactions above this line in the income statement and loss producing one off items below this line Companies attempt to reduce earnings in years of good performance and inflate earnings in years of bad performance through aggressive or conservative accounting policy selection.
Classification of good/bad news
Income smoothing
LOS 31 e discuss managerial discretion in areas such as classification of good news/bad news, income smoothing, big bath behaviour, and accounting changes, and explain how this discretion can affect the financial statements;
Role of Nonrecurring Items in Estimating Earnings Power

When firms are experiencing a bad year they may attempt to recognize all of their bad news at once. Going forward therefore, the subsequent improvement in performance will be magnified and this will show management in a better light.
Big bath techniques
Accounting changes
Firms can use accounting changes to smooth earnings, as noted above, and these can often have a material impact on earnings without effecting cash flow.
LOS 31 e discuss managerial discretion in areas such as classification of good news/bad news, income smoothing, big bath behaviour, and accounting changes, and explain how this discretion can affect the financial statements;
The Cashflow Statement

Regular operations generate enough cash to sustain the business Enough cash is generated to pay off maturing debt Highlights the need for additional finance Ability to meet unexpected obligations The flexibility to take advantage of new business opportunities How the firm obtains and spends cash FASB requirements Borrowing and debt repayment activities Issue and repurchase of equity Distributions to owners (dividends) Other factors affecting liquidity and solvency
LOS 32 a identify the types of important information for investment decision making presented in the statement of cash flows;
Benefits for the analyst
STATEMENT OF CASH FLOWS SFAS 95

Cash flow from operations Cash flow from investing Cash flow from financing Change in cash balance Beginning cash Ending cash (CFO) (CFI) (CFF)
Cash received from customers Cash dividends received Cash interest received Other cash income
$ X
+ + = + =
X
X X (X)
Payments to suppliers
Cash expenses (wages etc) (X) Cash interest paid Cash taxes paid CFO (X)
(X)
X/(X)
LOS 32 a identify the types of important information for investment decision making presented in the statement of cash flows; LOS 32 b compare and contrast the categories (i.e., cash provided or used by operating activities, investing activities, and financing activities) in a statement of cashflows, and describe how noncash investing and financing transactions are reported
CASH FROM INVESTING

Purchase and sale proceeds of: Property, plant & equipment
Subsidiaries, Joint Ventures and Affiliates

Investments CASH FROM FINANCING
Issue and redemption of:

Common stock Debt
Dividend payments (divs recd = CFO)
LOS 32 b compare and contrast the categories (i.e., cash provided or used by operating activities, investing activities, and financing activities) in a statement of cashflows, and describe how noncash investing and financing transactions are reported LOS 33 a classify a particular transaction or item as cash flow from 1) operations, 2) investing, or 3) financing;
Non-Cash Investing and Financing Activities

Retirement of debt via conversion into equity Conversion of preferred stock into common stock Assets acquired under capital leases Obtaining assets by issuing notes payable Exchange of one non cash asset for another Purchase of non cash assets by issuing equity or other securities
All the above items will affect the Balance Sheet but not the Cashflow Statements as no cash is raised or paid
LOS 32 b compare and contrast the categories (i.e., cash provided or used by operating activities, investing activities, and financing activities) in a statement of cashflows, and describe how noncash investing and financing transactions are reported
CASH FROM OPERATIONS
DIRECT METHOD
INDIRECT METHOD
Cash inflows
less
cash outflows
Net income + depreciation & amortisation gains on disposal of l/t assets + losses on disposal of l/t assets + other non-cash expenses non-cash revenues +/ changes in non-cash working capital Cash from operations
Cash from operations
LOS 33 b compute and interpret a statement of cash flows, using the direct method and the indirect method; LOS 32 c calculate and interpret, using the indirect method, the net cash provided or used by operating activities;
Direct Method CFO

Steps 1. Start at the top of the Income Statement e.g., Sales 2. Move to the balance sheet and identify any asset and liability that relate to that Income Statement item e.g., Accounts Receivable 3. Look at the change in the Balance Sheet item during the period (ending balance opening balance) 4. Apply the rule: Increases in an asset deduct Increase in a liability add Decrease in an asset add Decrease in a liability deduct
5. Adjust the Income Statement amount by the change in the Balance Sheet
Direct Method cont.

6. Tick off the items dealt with in both the Income Statement and Balance sheet 7. Move to the next item on the Income Statement and repeat 8. Ignore depreciation/amortization and gains/losses on the disposal of assets as these are all non cash items 9. Keep moving down the Income Statement until all items included in Net Income have been addressed applying steps 1-8 10.Total up the amounts and you have CFO
EXAMPLE HOLLOWAY INDUSTRIES

Holloway Industries has the following Income Statement for 20X3 and Balance Sheets for 20X2 and 20X3. You are to construct the Statement of Cash Flows using the templates provided.
Income Statement for Year to 31 December 20X3

Sales revenue Expenses: Cost of goods sold Salaries Goodwill amortization Depreciation Interest Gain from sale of PPE Pre-tax income Provision for taxes Net income
200,000
80,000 10,000 2,000 12,000 1,000
105,000 95,000 20,000 115,000 40,000 75,000
EXAMPLE HOLLOWAY INDUSTRIES cont.

Balance Sheets Current assets Cash Accounts receivable Inventory Noncurrent assets Land Plant & equipment Less: Acc depreciation Goodwill Total Assets 20X2 $ 18,000 18,000 14,000 80,000 120,000 (18,000) 20,000 252,000 20X3 $ 66,000 20,000 10,000 80,000 150,000 (20,000) 18,000 324,000
Note the order of years (older/most recent) may be reversed in questions always check!
PPE includes an asset that cost $20,000 and had accumulated depreciation of $20,000 at the point of disposal
EXAMPLE HOLLOWAY INDUSTRIES cont.

Balance Sheets Current liabilities Accounts payable Salaries payable Interest payable Taxes payable Dividends payable Noncurrent liabilities Bonds Deferred taxes Stockholders equity Common stock Retained earnings Total Liabilities & Equity 20X2 $ 10,000 16,000 6,000 8,000 2,000 20,000 30,000 100,000 60,000 252,000 20X3 $ 18,000 9,000 7,000 10,000 12,000 30,000 40,000 80,000 118,000 324,000
HOLLOWAY INDUSTRIES CASH FLOW FROM OPERATIONS

$ $
Direct Method
Cash Inflows Sales Less: increase in A/R Cash collected from customers Direct cash outflows Cost of goods sold Add: decrease in inventory Purchases Add: increase in A/P Cash paid to suppliers
Operating expense (wages) Less: decrease in salaries payable Cash paid to employees
Direct Method cont.

$ Cash outflows Interest Expense Add: increase in interest payable Cash interest paid $
Taxation Expenses Add: Increase in deferred tax Tax payable Add: increase in taxes payable Cash paid to IRS CFO
Indirect Method CFO

Steps 1. Start at the bottom of the Income Statement e.g., Net Income. This means we have already included all the items on the Income Statement 2. Return to the top of the Income Statement and adjust each item line by line. Note that we have already included Sales in our Net Income figure 3. Look at the change in the Balance Sheet item during the period (ending balance opening balance). These are identical to the Direct Method! Increases in an asset deduct 4. Apply the rule: Increase in a liability add Decrease in an asset add Decrease in a liability deduct
Indirect Method cont.

5. Tick off the items dealt with in both the Income Statement and Balance sheet 6. Move to the next item on the Income Statement and repeat 7. Eliminate depreciation and amortization by adding them back (theyve been deducted in arriving at Net Income but have no cash implication) 8. Eliminate gains on disposal by deducting them and losses on disposal by adding them back. 9. Keep moving down the Income Statement until all items included in Net Income have been addressed applying steps 1-8 10. Total up the amounts and you have CFO

$
Indirect Method
Net income depreciation goodwill amortisation gain from sale of land increase in deferred taxes Current asset adjustments increase in accounts receivable decrease in inventory Current liability adjustments increase in accounts payable decrease in salaries payable increase in interest payable increase in taxes payable
Cash flow from operations
Computing CFI
Additions to PPE 2 Methods $ Opening Cost $ Opening NBV
X
(X) X
X
(X) (X)
Cost of Disposals
Additions Closing Cost
NBV of Disposals
Depreciation Charge Additions
X
X
Closing NBV
The method to choose depends on whether cost and accumulated depreciation have been disclosed separately or together as NBV
LOS 32 d prepare and interpret, using the indirect method, the statement of cash flows for investing activities and financing activities.
Computing CFI Holloway Industries

Additions to PPE 2 Methods $ Opening Cost Opening NBV $
Cost of Disposals
NBV of Disposals
Closing NBV
The method to choose depends on whether cost and accumulated depreciation have been disclosed separately or together as NBV
Computing Proceed on Disposal

Profit/(loss) on disposal of long lived assets $ Proceeds NBV Profit/(loss) X (X) X/(X) Disclosed in question From Income Statement Proceeds NBV Profit/(loss) Holloway Industries $
Computing CFF
Change in Debt Change in Common Stock Cash Dividends Paid Simply closing balance less opening balance dont forget to check current liabilities for any debt maturing within 12 months!
Calculate Dividends
Net Income Dividends in Retained Earnings
$ X (X)
$
Dividends Proposed (X) Dividends Payable X/(X) Cash Paid (X)
Simply the change in both common stock and additional paid in capital during the period this could be made more complicated by including scrip issues
Holloway CFF
$ Change in Debt Change in Common Stock Cash Dividends Paid
Calculate Dividends
Net Income
Dividends in Retained Earnings
Dividends Proposed
Dividends Payable Cash Paid
HOLLOWAY INDUSTRIES STATEMENT OF CASH FLOWS

$
Cash flow from operations Cash flow from investing activities Sale of PP&E Purchase of PP&E Cash flow from investing Cash flow from financing activities Increase in bonds Decrease in common stock Payment of dividends Cash flow from financing Net increase in cash Cash at beginning Cash at end
LOS 33 b compute and interpret a statement of cash flows, using the direct method and the indirect method
FREE CASH FLOW

Measures the cash available to the firm for discretionary uses after making all required cash outlays. Formally, it should be the operating cash flow minus those cash flows necessary to maintain the firms productive capacity and provide for growth. However, it is not practical for an analyst to determine which capital expenditures are necessary to maintain capacity and which are allotted for growth.
Consequently, free cash flow is measured by:
Free Cash Flow = Operating cash flow - Net capital expenditures

Expenditure on capital items after tax sales proceeds from disposals
LOS 33 e describe and compute free cash flow;
STATEMENT OF CASH FLOW

U.S. GAAP vs. IAS GAAP
U.S. GAAP (SFAS 95) Interest received Interest paid Dividends received Dividends paid CFO CFO CFO CFF IAS GAAP (IAS 7) CFO or CFI CFO or CFF CFO or CFI CFO or CFF
LOS 33 f Distinguish between the U.S. GAAP and IAS GAAP classifications of dividends paid or received and interest paid or received for statement of cash flow purposes
Future FASB Changes and the Analytical Challenges of GAAP

European Commission Publicly traded companies mandatory adoption of IAS by 2005 (unless producing accounts under U.S. GAAP in which they must adopt IAS by 2007) ISAB and FASB attempting to eliminate 3 major differences: Expensing of employee stock options
Business combinations under the purchase method

In-process R&D Restructuring costs
Measurement date for acquisitions using stock

Reconciling standards in revenue recognition
LOS 34 a identify the projects on the FASB agenda that were/are related to international convergence
Future FASB Changes and the Analytical Challenges of GAAP

Other convergence projects Revisions to Income Statement format/content Accounting for financial instruments with both equity and liability characteristics (e.g., convertibles)
Fair-value measurement
LOS 34 a identify the projects on the FASB agenda that were/are related to international convergence
FASB Revenue Recognition

2 conceptual approaches that may conflict
Approach 1 Recognition criteria 1. Completion of earnings process
Approach 2
Revenue recognition occurs when there is any increase in net assets resulting from transactions with non shareholders i.e., any increase in Net Assets (worth) that is not the result of issuing new equity
2. Assurance of receipt
LOS 34 b describe two different guidance rules for revenue recognition discussed by FASB and IASB
Financial Statement Analysis Financial Ratios and Earnings Per Share

Study Session 8
Why are Ratios so Important in Financial Analysis?

The analyst reviews the companys financial statements to gain an insight into a companys financial decision making and performance. Ratios allow the analyst to raise questions about the performance of the firm. This performance may be compared year on year within the firm or with competitors within the industry and the economy as a whole. Although there are many dozens of ratios that could be computed there are several key ratios that give the analyst an insight into the firms: Performance: Liquidity: Risk: determine how well management operate the business determine the firms ability to pay its short term liabilities measure the uncertainty of the firms income flows
LOS 35 b calculate, interpret, and discuss the uses of measures of a companys internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential;
INTERNAL LIQUIDITY RATIOS

Current ratio current assets current liabilities current assets inventory current liabilities
Quick ratio
Cash ratio
cash + marketable securities current liabilities
Receivables turnover
net sales avg. receivables

Receivables collection period
365 receivables turnover
OR
avg. receivables net sales
365
Inventory turnover
cost of goods sold avg. inventory

365 inventory turnover avg. inventory cost of goods sold 365
Inventory processing period
OR
Payables turnover
cost of goods sold avg. accounts payable
Payables payment period
365 payables turnover
OR
avg. inventory 365 cost of goods sold
Cash Conversion Cycle

Raw Materials Arrive Production Commences Inventory processing period Payables payment period Pay Supplier Days Cash Conversion Cycle
Production Complete
Receivables collection period Cash Collected
Goods Sold
Inventory Period Receivables Period Payables Period
X X
(X)
Cash Conversion Cycle X

Holloway Industries
20x2 Current ratio 20x3
Quick ratio
Cash ratio
Holloway Industries
20x3 20x3 Inventory turnover
Average receivables collection period
Average inventory processing period
Holloway Industries
20x3
Payables turnover
Collection period + Inventory period Payment period

Holloway Industries
OPERATING EFFICIENCY
Total asset turnover
net sales avg. total net assets net sales avg. net fixed assets
Fixed asset turnover
Equity turnover
net sales avg. equity
Holloway Industries
20x3
Equity turnover
Holloway Industries
OPERATING PROFITABILITY
Gross profit margin
sales COGS (GP) net sales
100
Operating profit margin
EBIT 100 net sales EAT 100 net sales
Net profit margin
Holloway Industries
20x3
Gross profit margin
Net profit margin
Holloway Industries
Return on total capital
EAT + interest avg. total capital
100
Equity Liabilities Return on equity
= Total Assets
EAT 100 avg. equity
Holloway Industries
OPERATING PROFITABILITY 20x3
Return on total capital
Return on equity
COMMON SIZE STATEMENTS
Income statement
income statement account sales
e.g., marketing expense sales
balance sheet account Balance sheet total assets
e.g.,
inventory total assets
LOS 35 a interpret common-size balance sheets and common-size income statements, and discuss the circumstances under which the use of common-size financial statements is appropriate;
DUPONT RATIO ANALYSIS

ROE = EAT
EQUITY ROE = EAT SALES SALES EQUITY
ROE
EAT SALES
SALES ASSETS Asset turnover
ASSETS EQUITY
Traditional version of DuPont equation
After tax profit margin
Financial leverage multiplier
LOS 35 c calculate and interpret the various components of the companys return on equity using the original and extended DuPont systems and a companys financial ratios relative to its industry, to the aggregate economy, and to the companys own performance over time;
Holloway Industries
DUPONT RATIO ANALYSIS 20x3 ROE =
ROE
ROE

EXTENDED DUPONT EQUATION

ROE = EAT
SALES
SALES
ASSETS
ASSETS EQUITY
ROE
EBT
SALES
(1 t)
SALES
ASSETS
ASSETS
EQUITY
t = effective tax rate
ROE
EBIT SALES
SALES
ASSETS Asset turnover
I
ASSETS Interest expense rate
ASSETS
EQUITY Financial leverage multiplier
(1 t)
Tax retention rate
Holloway Industries
EXTENDED DUPONT EQUATION 20x3 ROE = 75,000 200,000 200,000 324,000 198,000 = 38%
324,000
ROE
ROE
RISK PROFILE
Business risk Measures the uncertainty of the firms operating income as a result of variability of sales and production costs CVs operating income sales
Operating leverage
Additional volatility of the firms equity returns caused by the firms Financial risk use of debt Leverage Coverage
BUSINESS RISK
Coefficient of Variation of Operating Income
EBIT EBIT Sales Sales
Coefficient of Variation of Sales
Operating Leverage
% in EBIT % in Sales
FINANCIAL RISK RATIOS LEVERAGE

Long-term liabilities Deferred tax
Debt to equity ratio
long-term debt stockholder equity
PV of operating leases Common Stock Preferred Stock Additional Paid in Capital Other Reserves
Debt to long term capital ratio
long-term debt long-term debt + stockholder equity
Retained Earnings
FINANCIAL RISK RATIOS LEVERAGE

Total Debt Ratio current liabilities + long-term debt stockholder equity
Total Interest-Bearing Debt to Total Funded Capital
total interest-bearing debt total capital non-interest-bearing liabilities
FINANCIAL RISK RATIOS COVERAGE

Interest Coverage EBIT interest expense ELIE = Estimated Lease Interest Expense
EBIT + ELIE
Fixed Financial Cost gross interest expense + ELIE
Cash Flow Interest Coverage
cash flow + interest expense + ELIE interest expense + ELIE
HOLLOWAY INDUSTRIES FINANCIAL RISK RATIOS

20x3
Interest Coverage
Long Term Debt to equity
Debt to long term capital
GROWTH ANALYSIS
Sustainable growth Earnings retention rate ROE
Example:
= =
(earnings retention rate)(ROE) [1 (dividends/net income)]
[EAT/sales] [sales/assets] [assets/equity]
A firm has a dividend payout ratio of 35%, a net profit margin of 10%, an asset turnover of 1.4 and an equity multiplier leverage measure of 1.2. Estimate the firms sustainable growth rate.
CONSIDERATIONS WHEN USING FINANCIAL RATIOS
Financial ratios should always be relative

Are alternative firms accounting treatments comparable? Is the firm involved in several industries or just one? Are the implied results consistent or just a one-off Is the ratio within a reasonable range for the industry?
EARNINGS PER SHARE (EPS)

Simple capital structure - Basic EPS
One that contains no potentially dilutive securities Contains potentially dilutive securities (that would decrease EPS if exercised or converted to common stock
Convertible Bonds
Complex capital structure - Diluted EPS
Convertible Preferred Stock

Warrants and Employee Stock Options
LOS 36 a differentiate between simple and complex capital structures for purposes of calculating earnings per share (EPS), describe the components of EPS, and calculate a companys EPS in a simple capital structure;
EPS BASIC CALCULATION

Earnings = net income preference dividends
earnings attributable to common stockholders weighted average number of shares of common outstanding
Weighted Average Number of Shares A time weighted average, necessary when the number of shares in issue has changed during the year. For example: share repurchases - which are excluded from date of repurchase share issues for cash or to acquire subsidiary share issues for free (via stock splits or stock dividends)
CHANGES IN EQUITY ISSUE FOR CASH AT MARKET PRICE

1 January 4 million common stock in issue ranking for dividend 30 September 1 million further shares issued ranking for dividend (assuming year ending 31 December) Million
Number of shares used in EPS calculation

CHANGES IN EQUITY NO EFFECT ON EARNINGS

The following have no effect on earnings: stock dividends 10% stock dividend the holder of 100 shares would receive 10 new shares 5:4 Stock split The holder of 100 shares would be holding 125 shares post split 5:4
stock splits
New holding
Old holding
These changes in equity are back dated, to assume that they occurred on the first day of the year with all prior year figures being retrospectively adjusted.
LOS 36 c describe stock dividends and stock splits and determine the effect of each on a companys weighted average number of shares outstanding;
EPS WORKED EXAMPLE

Profit Inc had 10 million shares outstanding at the beginning of the year and net income of $20m. The following transactions occurred during the year:
1 July 1 September 1 November
2 million new shares issued for cash 10% stock dividend 500,000 common shares repurchased
(assuming year ending 31 December)

Calculate the EPS for the year
LOS 36 c describe stock dividends and stock splits and determine the effect of each on a companys weighted average number of shares outstanding;
Dilutive vs. Anti-Dilutive Securities

Securities are Dilutive if: Convertible Bonds coupon saved (1T)
<
Basic EPS
Shares Created
Convertible Preferred Stock
preferred dividend saved shares created
<
Basic EPS
Warrants and Employee Stock Options
Average Share Price > Strike Price
LOS 36 d distinguish between dilutive and antidilutive securities and calculate a companys basic and diluted EPS in a complex capital structure and describe and determine the effects of convertible securities, options, and warrants on a companys EPS;
DILUTED EPS CONVERTIBLE SECURITIES EXAMPLE

$
Earnings for equity in year to 31/Dec/X1 2,500,000 Common stock of $10 each 10,000,000 Basic EPS $2.50 Tax rate 30% There have been in issue throughout the year $2,000,000 of 5% convertible loan stock. The terms of conversion are, for every $1,000 nominal value of loan stock:
On 31 March 20X2 31 March 20X3 31 March 20X4 110 common shares 120 common shares 103 common shares
Calculate fully diluted EPS for 20X1.
DILUTED EPS CONVERTIBLE SECURITIES SOLUTION

$
Earnings Add: Interest saved Less: Relief for tax @ 30%
No. of equity shares if loan stock was converted: In issue On conversion
DILUTED EPS CONVERTIBLE PREFERRED STOCK EXAMPLE

$ Earnings for equity in year to 31/Dec/X1 4,000,000 Common stock of $10 each 20,000,000 Basic EPS $2.00 Tax rate n/a There have been in issue throughout the year $5,000,000 of 7% convertible preferred stock. The terms of conversion are, for every $1,000 nominal value of preferred stock: On 30 April 20X2 30 April 20X3 30 April 20X4 120 common stock shares 110 common stock shares 105 common stock shares
Calculate fully diluted EPS for 20X1.
DILUTED EPS CONVERTIBLE PREFERRED STOCK SOLUTION

$
Earnings Add: Preferred dividend saved
No. of common stock shares if preferred shares were converted: In issue On conversion
DILUTIVE STOCK OPTIONS TREASURY STOCK METHOD

Dilutive only when the exercise price is less than the average market price Assume proceeds from sale of stock issued to buy back shares in the market at the average market price STEPS Calculate number of common shares created if options are exercised
Calculate cash received from sale of stock Calculate number of shares that can be purchased at the average market price with sale proceeds Calculate the net increase in common shares outstanding
EPS OPTIONS FOR COMMON STOCK EXAMPLE

Earnings for equity in year to 31/Dec/X1 Weighted average no. of common stock shares Average price of common stock during year Exercise price Number of options outstanding in the year Basic EPS Calculate diluted EPS for 20X1. $1,200,000 500,000 $20 $15 100,000
EPS Reporting
A company with a complex capital structure must report: Basic EPS Dilutive EPS In addition the impact of the following effects must be shown:
Discontinued Activities Extraordinary Items Cumulative Effect of Accounting Policy Changes
LOS 36 e compare and contrast the requirements for EPS reporting in simple versus complex capital structures.
Seek and Ye Shall Find and Searching for Shenanigans

Study Session 8
FINANCIAL SHENANIGANS
Two basic strategies underlying all accounting tricks: To inflate current period earnings by inflating current-period revenue and gains or by deflating current-period expenses To deflate current-period earnings (and, consequently, inflate future periods results) by deflating current period revenue or by inflating current-period expenses Shenanigan 1. 2. 3. 4. 5. 6. Recording revenue too soon or of questionable quality Recording bogus revenue Boosting income with one-time gains Shifting current expenses to a later or earlier period Failing to record or improperly reducing liabilities Shifting current revenue to a later period
7.
Shifting future expenses to the current period as a special charge
LOS 38 a explain the two basic strategies underlying all accounting shenanigans, and describe seven categories of techniques that may be used by management to distort a company's reported financial performance and financial condition;
EVALUATING ACCOUNTING POLICIES

Accounting Policies Revenue recognition Depreciation choice Conservative After sale, when risk has passed to buyer Accelerated over shorter period LIFO (assuming prices are rising) Over a shorter period High estimate High estimate Aggressive At sale, although risk remains Straight line over longer period FIFO (assuming prices are rising) Over 40 years Low estimate Low estimate
Inventory method
Amortization of goodwill* Estimate of warranty Estimate of bad debts Treatment of advertising Loss contingencies
Expense
Accrue loss
Capitalize
Footnote only
* NB Goodwill is no longer amortized under U.S. GAAP

LOS 38 b identify conservative and aggressive accounting policies;
WHY DO SHENANIGANS EXIST?

Based on the authors research, there are three general reasons for shenanigans:
It Pays to Do It
Management bonuses encourage the posting of high sales and profits Misguided incentive plans Look for: Compensation structures that heavily emphasize the bottom line
Its Easy to Do
Profit can vary widely while complying with GAAP Management has considerable flexibility in interpreting financial standards Look for: Overly liberal accounting rules Poor internal controls
Its Unlikely That Youll Get Caught

Often, companies are not caught for improper accounting Penalties are often too little, too late Look for: Over reliance on unaudited quarterly financial reports
LOS 38 c describe why shenanigans exist and explain where they are most likely to occur
WHERE DO SHENANIGANS OCCUR?

Early Warning Signs Likely Companies
A weak control environment Management facing extreme competitive pressure Management known or suspected of having questionable character
Fast growth companies whose real growth is beginning to slow Basket-case companies that are struggling to survive Newly listed public companies
Private companies
LOS 38 c describe why shenanigans exist and explain where they are most likely to occur
IDENTIFYING SHENANIGANS
Where to Look Auditors report What to Look For Absence of opinion or qualified report Reputation of auditor Litigation Executive compensation Related-party transactions Accounting policies/changes in those policies Related-party transactions Contingencies or commitments Forthrightness Specific concise disclosure Consistency with footnote disclosure Disagreements over accounting policies Past performance Quality of management and directors
Proxy statement
Footnotes
Presidents letter MD&A
Form 8-K Registration statement
LOS 38 d list the documents that an analyst should use to identify shenanigans and explain what information to look for in such documents.
SOLUTIONS
PERCENTAGE OF COMPLETION METHOD EXAMPLE (INCOME STATEMENT)

Bircham Properties Ltd. has a contract to build a hotel for $2,000,000 to be received in equal installments over 4 years. A reliable estimate of total cost of this contract is $1,600,000. During the first year, Bircham Properties incurred $400,000 in cost. During the second year, $500,000 of costs were incurred. The estimate of the projects total cost did not change in the second year.
Calculate the revenue to be recognized in each of the first two years.
Year 1: Year 2:
$2,000,000 (400,000/1,600,000) = $500,000 $2,000,000 (900,000/1,600,000) = $625,000 $500,000

Total Assets
20x1 20x2
300
20x3
500
Cash
(Cash Recd Cost Incurred)
100
Accounts receivable
(Amounts Billed Cash Recd)
200
Net CIP* Total Assets
0
300
100 400
500
* See working slide


Total Liabilities and Equity
20x1 Net Advanced Billings Retained Earnings Total Liabilities & Equity 133 167 300 20x2 0 400 400 20x3 0 500 500
MEMO CIP
20x1 Cost Profit Allocation
Cost to Date
Total Cost Contract Price Total Cost
20x2 1,200 400
20x3 1,500 500
500
167
667
1,600
2,000
(800)
(1,500)
(2,000)
(133)
100

Total Assets
20x1 20x2 20x3
Cash Accounts receivable Net CIP Total Assets
100
300 0 0 300
500 0 0 500
200
0 300

Total Liabilities and Equity
20x1 Net Advanced Billings 300 20x2 300 20x3 0
Retained Earnings
500
Total Liabilities & Equity
300
300
500
MEMO CIP
20x1 Cost 500 20x2 20x3 0
1,200
(800)
(1,500)
(0)
(300)
(300)
(0)
PERCENTAGE-OF-COMPLETION vs. COMPLETED CONTRACT

During Project Life
POC Net income Income Statement Volatility of income HIGHER LOWER
CC
LOWER HIGHER
Total assets Balance Sheet Liabilities R/E
HIGHER LOWER HIGHER
LOWER HIGHER LOWER
Cash flow
Statement of Cash Flows Importance of CFO
SAME
LOWER
SAME
HIGHER
INSTALLMENT SALES METHOD EXAMPLE

During 20X0, Sturridge Inc. sold $20,000 of inventory, with a cost of $10,000. During 20X0 and 20X1, Sturridge Inc. collected $8,000 and $12,000 respectively, of its receivables. Under the Instalment Method, what are the sales and gross profit to be reported in each of the two years?
Sales Cost of sales Gross profit
20X0 8,000 (4,000) 4,000
20X1 12,000 (6,000) 6,000
COST RECOVERY METHOD EXAMPLE

During 20X0, Sturridge Inc. sold $20,000 of services but the cost of providing this service was unclear at the outset of the contract. During 20X0 and 20X1, Sturridge Inc. collected $8,000 and $12,000, respectively of its receivables. The project was completed during 20X1 at which time the company had incurred total costs of $10,000. Under the Cost Recovery Method, what are the sales and gross profit to be reported in each of the two years?
Sales Cost of sales Gross profit
20X0 8,000 (8,000) -
20X1 12,000 (2,000) 10,000

$ $
Direct Method
Cash Inflows 200,000 Sales (2,000) Less: increase in A/R Cash collected from customers Direct cash outflows Cost of goods sold Add: decrease in inventory Purchases Add: increase in A/P Cash paid to suppliers Operating expense (wages) Less: decrease in salaries payable Cash paid to employees
(80,000) 4,000 (76,000) 8,000
198,000
(68,000) (10,000) (7,000) (17,000)
Direct Method cont.

$ Cash outflows Interest Expense Add: increase in interest payable Cash interest paid
(1,000) 1,000
Taxation Expenses Add: Increase in deferred tax Tax payable Add: increase in taxes payable Cash paid to IRS
(40,000) 10,000 (30,000) 2,000 (28,000)
CFO
(85,000)
GOULBURN INDUSTRIES CASH FLOW FROM OPERATIONS

Indirect Method
Net income Add: depreciation Add: goodwill amortisation Less: gain from sale of land Add: increase in deferred taxes Current asset adjustments Less: increase in accounts receivable Add: decrease in inventory Current liability adjustments Add: increase in accounts payable Less: decrease in accounts payable Add: increase in interest payable Add: increase in taxes payable Cash flow from operations + + + +
$
75,000 12,000 2,000 20,000 10,000
2,000 4,000
+ + +
8,000 7,000 1,000 2,000 85,000
Computing CFI Holloway Industries

Additions to PPE 2 Methods $ Opening Cost $ Opening NBV
120,000
(20,000) 50,000
102,000
(10,000) (12,000)
Cost of Disposals
NBV of Disposals
150,000
50,000
130,000
Closing NBV
Computing Proceed on Disposal

Profit/(loss) on disposal of long lived assets $ Proceeds NBV Profit/(loss) X (X) X/(X) Disclosed in question Proceeds NBV Holloway Industries $ 30,000 (10,000) (20,000)
From Income StatementProfit/(loss)
Holloway CFF
$ Change in Debt Change in Common Stock Cash Dividends Paid 10,000 $30,000 $20,000 = $10,000 $80,000 $100,000 = $(20,000)
(20,000)
(7,000)
Calculate Dividends
$ 75,000 (17,000) 58,000
Net Income
Dividends in Retained Earnings
Dividends Proposed
Dividends Payable Cash Paid
(17,000) 10,000 (7,000)
HOLLOWAY INDUSTRIES STATEMENT OF CASH FLOWS

$
Cash flow from operations Cash flow from investing activities Sale of PP&E Purchase of P&E Cash flow from investing
$ 85,000
30,000 50,000 20,000
Cash flow from financing activities Issue of debt Purchase of stock Payment of dividends Cash flow from financing
Net increase in cash Cash at beginning Cash at end
10,000 20,000 7,000 17,000 48,000 18,000 66,000
Holloway Industries
20x2 Current ratio 50,000 42,000 =1.19
20x3
96,000 56,000 =1.71
36,000 Quick ratio 42,000
=0.86
86,000 56,000
=1.54
18,000 Cash ratio 42,000 =0.43
66,000
56,000 =1.18
Holloway Industries
20x3 200,000
19,000 20x3 80,000 12,000
= 10.52
Inventory turnover
= 6.67
Average receivables collection period
19,000 200,000 365
Average inventory processing period
12,000 80,000 365
= 34.68 Days
= 54.75 Days
Holloway Industries
20x3
Payables turnover 80,000 14,000
= 5.71

Collection period + Inventory period Payment period = 34.68 Days = 54.75 Days = (63.88) Days 25.55 Days
14,000 80,000
365
= 63.88 days
Holloway Industries
20x3 200,000 288,000 200,000 215,000 200,000 179,000
= 0.69
= 0.93
Equity turnover
= 1.12
Holloway Industries
OPERATING PROFITABILITY 20x3 Gross profit margin 200,000 80,000 200,000 100 = 60%
116,000 200,000
100
= 58%
Net profit margin
75,000 100 200,000
= 37.5%
Holloway Industries
20x3 Return on total capital 75,000 + 1,000 288,000 Equity All liabilities Return on equity
100
= 26.38%
= Total assets
75,000 100 179,000
= 41.90%
Holloway Industries
DUPONT RATIO ANALYSIS 20x3 ROE = 75,000 198,000 ROE = 75,000 200,000 200,000 198,000 = 38%
= 38%
ROE
75,000 200,000
200,000 324,000 0.62
324,000 198,000 1.64
= 38%
0.375
Holloway Industries
EXTENDED DUPONT EQUATION 20x3 ROE = 75,000 200,000 200,000 324,000 324,000 198,000
= 38%
ROE
115,000 200,000
(1 0.35)
200,000 324,000
324,000 198,000
= 38%
ROE
116,000 200,000 0.58
200,000 324,000 0.617
1,000 324,000 0.003
324,000 198,000 1.636
(1 0.35)
0.65 = 38%
HOLLOWAY INDUSTRIES FINANCIAL RISK RATIOS

20x3 116,000 1,000 = 116
Interest Coverage
Long Term Debt to equity
40,000 + 30,000 = 0.35 198,000
Debt to long term capital
40,000 + 30,000 40,000 + 30,000 + 198,000
= 41.2%
GROWTH ANALYSIS
Sustainable growth Earnings retention rate = = (earnings retention rate)(ROE) [1 (dividends/net income)]
ROE
Example:
[EAT/sales] [sales/assets] [assets/equity]
A firm has a dividend payout ratio of 35%, a net profit margin of 10%, an asset turnover of 1.4 and an equity multiplier leverage measure of 1.2. Estimate the firms sustainable growth rate. Growth rate = RR ROE (1 0.35) 0.1092 0.1 1.4 1.2
10.92%
CHANGES IN EQUITY ISSUE FOR CASH AT MARKET PRICE

1 January 4 million common stock in issue ranking for dividend 30 September 1 million further shares issued ranking for dividend Million 4 million shares x 5 million shares x 9/12 3/12 3 1.25
Number of shares used in EPS calculation
4.25
EPS WORKED EXAMPLE

Profit Inc had 10 million shares outstanding at the beginning of the year and net income of $20m. The following transactions occurred during the year: 1 July 1 September 1 November 2 million new shares issued for cash 10% stock dividend 500,000 common shares repurchased
Calculate the EPS for the year Number of Shares 1/1 1/7 1/11 10m + 1m 2m + 0.2m Adjusted for stock dividend Adjusted for stock dividend Not affected by stock dividend $20m 12.017m = $1.6643 12/12 6/12 2/12
=
= =
11m 1.1m (0.083m) 12.017m
(0.5m)
Basic EPS =
DILUTED EPS CONVERTIBLE SECURITIES SOLUTION

$
Earnings Add: Interest saved Less: Relief for tax @ 20% 100,000 (30,000)
$
2,500,000
70,000
2,570,000 No. of equity shares if loan stock was converted: In issue On conversion $2,000,000 120/$1,000 Diluted EPS $2,570,000 1,240,000 = $2.07
1,000,000 240,000 1,240,000
DILUTED EPS CONVERTIBLE PREFERRED STOCK SOLUTION

$ $
Earnings Add: Preferred dividend saved
4,000,000 350,000 4,350,000
No. of common stock shares if preferred shares were converted: In issue On conversion $5,000,000 110/$1,000
2,000,000 550,000 2,550,000
Diluted EPS $4,350,000 2,550,000
= $1.71
EPS - OPTIONS FOR COMMON STOCK SOLUTION

Step 1 - Assume all options are exercised Proceeds if all options exercised 100,000 $15 $1,500,000
Step 2 - Calculate number of shares that can be bought at average price $1,500,000 $20
=
75,000 shares
Step 3 - Calculate dilutive effect of reduced option price

Number of shares issued Effective number at average price Dilution number of shares Diluted EPS $1,200,000 525,000
LOS 2.g: Describe and determine the effects of convertible securities, options and warrants on a companys EPS
100,000 75,000 25,000
= $2.29
AREAS NOT COVERED IN CLASS

LOS reference P2 e)
LOS 2h)
Description
d) Identify the accounting qualities (relevance, reliability, predictive value, timeliness) set forth in Statement of Financial Accounting Concepts and discuss how these qualities provide useful information to the analyst
Schweser pages
Compare and contrast the requirements for EPS reporting in simple versus complex capital structures
154
AREAS NOT COVERED IN CLASS

LOS reference
LOS 2h)
Description
Compare and contrast the requirements for EPS reporting in simple versus complex capital structures
Schweser pages
154

2006 Level 1 SS 7 and 8

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Financial Statement Analysis

Financial Statement Analysis

Financial Statement Analysis

Financial Statement Analysis Basic Concepts

Financial Statement Analysis

CONTENTS OF STOCKHOLDERS REPORT

Financial Statement Analysis

CONTENTS OF MANAGEMENT DISCUSSION AND ANALYSIS

Capital resources and liquidity + trends in cashflows

Financial Statement Analysis

Corporate Filings/Proxy Statements

Financial Statement Analysis

Corporate Filings/Proxy Statements

Form 144 Registration

Financial Statement Analysis

FINANCIAL ACCOUNTING STANDARD SETTING

Securities and Exchange Commission (SEC)

Financial Accounting Standards Board (FASB)

Statements of Financial Accounting Concepts (SFAC)

Statements of Financial Accounting Standards (SFAS)

Financial Statement Analysis

INTERNATIONAL FINANCIAL ACCOUNTING STANDARD SETTING

Financial Statement Analysis

General Principals of Financial Reporting System

Financial Statement Analysis

Objectives of Financial Reporting

Short Term Creditors

Long Term Creditors

Government taxes/regulators Others public, special interest groups, workforce etc

Financial Statement Analysis

Foundations of Accrual Accounting

Historic Cost Principle

Financial Statement Analysis

Statement of Financial Accounting Concepts (SFAC) 2

Financial Statement Analysis

The Audit Report

Accounting principles and estimates chosen are reasonable

Financial Statement Analysis

LIABILITIES + STOCKHOLDER EQUITY

Assets In order of liquidity

Financial Statement Analysis

LOFTUS INC. BALANCE SHEET AS AT 31 DECEMBER 20X0

380 540 10 1,070 200

500 1800 (400) 1400

Financial Statement Analysis

Long Term Assets

For part exchange replace proceeds with trade in allowance

Financial Statement Analysis

LOFTUS INC BALANCE SHEET AS AT 31 DECEMBER 20X0

Accounts payable Tax payable Current portion of long term debt

390 250 120

500 200 700 1,370 2,070 5,170

Financial Statement Analysis

Additional Paid in Capital Other items

Financial Statement Analysis

STATEMENT OF STOCKHOLDERS EQUITY LOFTUS INC.

Stockholders Equity at beginning

200 200 500 (350) 2,070

Financial Statement Analysis

INCOME STATEMENT FOR THE YEAR ENDING 31 DECEMBER 20X0

Financial Statement Analysis

FINANCIAL STATEMENT FOOTNOTES

Financial Statement Analysis