T1 FAR 2011 - Notes

CPTC 31125
Financial Accounting and Reporting

T1 2011/2012
Andrei FILIP (filip@essec.fr)

Course Catalog – Financial Accounting
CPTC31080/31081 CPTC21020
Pre-MSC Accounting (AST) Comptabilité financière
CPTC31124/31125
CPTC31260/31261 CPTC31264/31265 CPTC31254

IFRS-Investor Relations Group financial statements Audit et management
CPTC31247 CPTC31354/31355
Financial statement analysis Bus. Anal. & Value Creation
CPTC31155 CPTC31484/31485
Fiscalité des affaires Research seminar in Acctg.
Andrei Filip @ 2011 2

Swatch Group 2010
CHF Mio. 2010 2009 2008 2007 2006 2005

Sales 6 440 5 421 5 966 5 941 5 050 4 497
Operating profit 1 436 903 1 202 1 236 973 735
Net income 1 080 763 838 1 015 830 621
Equity 7 101 5 981 5 451 5 329 4 967 4 603
Market value 22 537 13 735 7 640 18 331 14 807 10 978

1. Understanding the Financial Statements (FS)

2. Oversight of the cash flow statement
3. The notes to the FS
4. Inter-corporate investments
5. Analytical tools for gaining financial statements insights

1 Understanding the Financial Statements (FS)
 A complete set of financial statements is composed of

 A statement of financial position (balance sheet)
 A statement of (comprehensive) income (income statement)
 A statement of changes in equity
 A statement of cash flows
 Notes
 The annual report comprehends the financial statements and
additional information (message from the chairman, organization of
the firm, development of the group, governance, MD&A, interim
reports, etc)

 Can we be sure that the data is true and fair?

 Forget about being 100% correct !
 Numerous estimations are used
 …and cross the fingers
 Only the financial statements are audited
 The Board of Directors is responsible for the preparation of the
financial statements
 The auditor expresses an opinion on the financial statements:
Auditor’s report
 Who are the auditors?
Ernst & Young,

PriceWaterhouse,
KPMG, Deloitte, etc.
Andersen…

1.1 The Balance Sheet
 Explains the financial position of the firm at a certain date

 Asset: a resource from which future economic benefits (f.e.b.)
are expected to flow to the entity (otherwise stated, future inflows
of cash)
 Liability: obligation for the settlement of which an outflow of f.e.b.
is expected to result (otherwise stated, future outflows of cash)
 Equity: the accounting value of the company
Equity = Assets – Liabilities

1.2 The Income Statement
 Explains the changes in the value of the firm during the period as a
result of operations
 Revenue: increase of e.b. during the period (other than
contributions from the owners)
 Expense: decrease of e.b. during the period (other than
distributions to the owners)
Earnings/Income = Revenues – Expenses

1.2.1 The Comprehensive Income
 Presented separately or together with the IS

 Comprehensive income =
Net income + Other changes in equity (Dirty Surplus)
Net income Dirty Surplus
BS BS
Gain Gain Gain Gain
IS IS
Gain

1.2.1 The Comprehensive Income
 Dirty Surplus = Other Comprehensive Income

 changes in revaluation surplus
 actuarial gains and losses on defined benefit plans
 gains and losses arising from translating the financial statements
of a foreign operation
 gains and losses on re-measuring available-for-sale securities
 the effective portion of gains and losses in a cash flow hedge
 The comprehensive income is sometimes called total recognized
income and represents the changes in the value of the firm during
the period as a result of operations

1.3 The statement of changes in equity
 Explains all the changes in equity (the value of the firm) during the
period
 The statement of changes in equity reconciles the beginning
balance with the ending balance by showing:
 The comprehensive income
 Contributions from the shareholders
 Distributions to the shareholders

1.3 The statement of changes in equity
Operations in N
Net income N
Equity Equity N-1

end N-1 Retained
Net income N
Equity
Dividends CI end N
Other CI
Net contributions
Shareholders
in N
CI = Comprehensive Income

1.4 The statement of cash flows
 Explains the changes in the cash and cash equivalents during the
period
 Inflows of cash
 Outflows of cash
Cash Flow = Inflows – Outflows
 Cash equivalents: short term (< 3 months) highly liquid and low risk
instruments

1.5 The notes to the financial statements
 Comprise a summary of significant accounting policies and other

explanatory information
 Disclose the information required by IFRS that is not presented
elsewhere in the financial statements
 Provide any other information relevant to an understanding of the



2 Oversight of the cash flow statement
 Cash flow presented in 3 categories

 Cash flow from operating activities
 Cash flow from investing activities
 Cash flow from financing activities
 Problems in classifying certain cash flows

 Income tax: operating
 Interests and dividends received: operating or investing
 Interests and dividends paid: operating or financing

2.1 The operating cash flow
 Presented using
 The direct method
 Or the indirect method
 Direct method (rarely used)
+ Operating cash receipts (cash received from sales, etc)
– Operating cash payments (purchases, wages, taxes… paid)
= Operating cash flow

 Indirect method: the operating cash flow is obtained by adjusting the

net income
 For this purpose
 Adjustment 1: eliminate non-operating items (financial expenses
and revenues)
 Adjustment 2: eliminate non-cash expenses (depreciation and
provisions) and revenues (reversal of provisions)
 Adjustment 3: take into account changes in working capital

Adjustment 3
Example of sales Receivables from
Payments received
clients at the beg. of
the period from clients during
the period
(Receipts)
Sales of the period
(Revenue) Receivables from
clients at the end of the
period
Cash inflows = Revenue + Receivables beg. – Receivables end

= Revenue – (Receivables end – Receivables beg.)
= Revenue – Changes in receivables
Same reasoning for all operating assets (inventories, receivables, etc)
and operating liabilities (suppliers)
Adjustment 3
Operating Operating
assets liabilities
Inventories Suppliers
Receivables from Other short term

clients liabilities
Other short term

receivables Working Capital
(WC)
WC = Operating assets – Operating liabilities

Net income
– Non operating revenues
+ Non operating expenses Adjustment 1
= Operating income
+ Non cash expenses
– Non cash revenues Adjustment 2
– Changes in working capital Adjustment 3
= Operating cash flow

2.2 The cash flow statement
Operating cash flow (I)

Receipts from investing activities
– Payments from investing activities
= Cash flow from investing activities (II)
Receipts from financing activities
– Payments from financing activities
= Cash flow from financing activities (III)
Net cash flow (IV = I + II + III)
Cash and cash equivalents at the beginning of the period (CN-1)
Cash and cash equivalents at the end of the period (CN = CN-1 + IV)
2.3 Understanding the statement of cash flows
A. Change in cash and cash equivalent

B. The operating cash flow
 Internally generated cash
 Changes in working capital
C. The investing cash flow
 The free cash flow
D. The financing cash flow
E. Conclusion

2.3 Understanding the statement of cash flows
 Internally generated cash = Net income +/- Adjustment 1 and 2

 The ability of the firm to generate “potential” cash
 Independent to earnings management
 Changes in working capital

 Link to the operating activity of the firm
 Increase/decrease of operating assets and liabilities
 The free cash flow = Operating + Investing Cash flow

 The cash flow available for distribution among all the security
holders of the firm



3 The notes to the FS
 An entity whose financial statements comply with IFRS shall make

an explicit and unreserved statement
 An entity shall not describe financial statements as complying with
IFRS unless they comply with all the requirements of IFRS
 The notes shall
 Comprise a summary of significant accounting policies
 Disclose the information required by IFRS that is not presented
elsewhere in the financial statements
 Provide any other information relevant to an understanding of the


3.1 Accounting policies
3.2 Segment reporting
3.3 Leases
3.4 Provisions
3.5 Income taxes
3.6 Retirement benefits

3.1 Accounting policies - Inventories
 The cost of goods sold is calculated using an accounting convention

 FIFO
 Weighted average cost
 LIFO (not allowed under IFRS)

3.1 Accounting policies - Inventories
 If prices are increasing

 FIFO  min CGS  max Income before tax  max
Income tax  min cash-flow  detrimental to the interest of the
company
 LIFO  max CGS  min Income before tax  min
Income tax  max cash-flow  consistent with the interest of
the company (provided that LIFO is accepted for tax purpose)
 Never forget: The interest of the company is to maximize its cash-
flow, not its income !

3.1 Accounting policies - Depreciation
 Tangible fixed assets are depreciated by using various methods

 Straight-line method
 Double declining balance method
 Unites of production method
 Etc.

3.1 Accounting policies - Impairment
 Principle: If recoverable amount < carrying amount, the company

must recognize an impairment loss
 Recoverable amount =
Maximum (value in use, fair value – costs to sell)
 Value in use: amount expected to be obtained from the use of
the asset => present value of future (pre-tax) cash flows
 Fair value – costs to sell: amount that could be obtained from the
sale of the asset

3.1 Accounting policies - Impairment
Identifying the assets that may be impaired

 Impairment only if there is an indication of an impairment loss
 The enterprise must annually test for impairment:
 Intangible assets whose useful life is indefinite (goodwill)
 Intangible assets not yet available for use (development costs)
 Assets for which the value in use cannot be easily estimated:
regrouped in a cash-generating unit (CGU)


3.3 Leases
3.4 Provisions
3.5 Income taxes

 Operating segments with external revenues should be identified by

the management of the entity
 An operating segment becomes a reportable segment if at least its
 external and internal sales
 operating profit / loss
 assets
… are 10% or more of the corresponding combined figures of all the
operating segments
 At least 75% of the entity’s external revenue must be attributable to
reportable segments
 For the reportable segments: segment information

 Information about other operating segments that are not reportable
is combined and disclosed in an “all other segments”
 If an operating segment is identified as a reportable segment in the
current period, data for the prior period is restated for comparative
purposes

 Disclosures for each reportable segment

 Revenues
 Operating profit or loss
 Assets
 Liabilities
 Depreciation and amortization, etc
 Entities are also required to disclose additional information about:
products and services, geographical areas, major customers


3.3 Leases
3.4 Provisions
3.5 Income taxes

3.3 Leases
 A lease is an agreement whereby the lessor conveys to the lessee

in return for a series of payments the right to use an asset for an
agreed period of time
 2 types of leases
 Finance lease – transfers substantially all the risks and rewards
incidental to ownership of an asset
 Operating leases – other than a finance lease

3.3 Leases
 A lease must be classified as a finance lease if at least one of the

following criteria is met
 There is a transfer of ownership by the end of the lease
 The lessee has the option to purchase the asset at a price that is
expected to be sufficiently lower than the fair value
 The lease covers the major part of the economic life of the asset
 The PV of the minimum lease payments amounts to at least
substantially all of the fair value of the asset
 The leased assets are of such a specialized nature that only the
lessee can use them without major modifications

3.3 Leases
 Finance lease – treat as if assets were purchased with debt

 Balance sheet: Asset and Liability
 Income statement: Depreciation and Interest expense
 Notes: Long term liabilities; PPE
 Operating lease
 Balance sheet: Nothing
 Income statement: Rent expense
 Notes: Contingent liabilities

3.3 Leases
Finance Lease Operating Lease

BS BS
Lease
Leased assets
obligation
IS IS
Interest
Rent
Depreciation

3.3 Leases
 Additional disclosures (for both types of leases)

 A description of the lease contract
 For each class of asset, the net carrying amount
 The future minimum lease payments (1, 2-5, after 5 years)
 A reconciliation between the total of future minimum lease
payments and their present value


3.3 Leases
3.4 Provisions
3.5 Income taxes

3.4 Provisions
 Provision: Liability of uncertain timing or amount

 Conditions for provision recognition
 There is a present obligation (legal or constructive)
 Arisen from a past event
 That will lead to a probable future outflow of cash
 Contingent liability: Obligation mentioned in the notes if the
conditions for recognition of a provision are not met
 Contingent liabilities ARE NOT recognized; they are only mentioned
in the notes

3.4 Provisions
Special cases
 Future operating losses – forbidden
 Restructuring – only if:
 Detailed formal plan for the restructuring
 The entity has started to implement that plan or announced its
main features to those affected by it

3.4 Provisions
Example: Warranties
 A manufacturer gives warranties at the time of sale to purchasers of
its product. Under the terms of the contract for sale the
manufacturer undertakes to make good, by repair or replacement,
manufacturing defects that become apparent within three years from
the date of sale. On past experience, it is probable (i.e. more likely
than not) that there will be some claims under the warranties.

3.4 Provisions
Example: Contaminated land

 An entity in the oil industry causes contamination but cleans up only
when required to do so under the laws of the particular country in
which it operates. One country in which it operates has had no
legislation requiring cleaning up, and the entity has been
contaminating land in that country for several years. At 31
December 20X0 it is virtually certain that a draft law requiring a
clean-up of land already contaminated will be enacted shortly after
the year-end.

3.4 Provisions
Example: Refunds policy

 A retail store has a policy of refunding purchases by dissatisfied
customers, even though it is under no legal obligation to do so. Its
policy of making refunds is generally known.

3.4 Provisions
Example: Closure of a division

 On 12 December 20X0 the board of an entity decided to close down
a division. Before the end of the reporting period (31 December
20X0) the decision was not communicated to any of those affected
and no other steps were taken to implement the decision.

3.4 Provisions
Example: A court case

 After a wedding in 20X0, ten people died, possibly as a result of
food poisoning from products sold by the entity. Legal proceedings
are started seeking damages from the entity but it disputes liability.
Up to the date of authorization of the financial statements for the
year to 31 December 20X0 for issue, the entity’s lawyers advise that
it is probable that the entity will not be found liable. However, when
the entity prepares the financial statements for the year to 31
December 20X1, its lawyers advise that, owing to developments in
the case, it is probable that the entity will be found liable.


3.3 Leases
3.4 Provisions
3.5 Income taxes

3.5 Income taxes
 Principle: the accounting tax expense must be proportional to the

pre-tax accounting income
Income tax expense = Pre-tax accounting income x Tax rate
 Problem: The income tax actually owed depends on the taxable
income
 Consequence:
 If income tax owed < income tax expense:
difference = deferred tax liability (accrued expense)
 If income tax owed > income tax expense:
difference = deferred tax asset (prepaid expense)
3.5 Income taxes
 Deferred Tax Asset or Liability?
Tax Reporting Year 1 Financial Reporting Year 1

Revenue 150 Revenue 150
Depreciation 100 Depreciation 50
Taxable income 50 Pre-tax income 100
Taxes payable 20 Tax expense 40

3.5 Income taxes
 2 sources of deferred taxes

 Temporary differences
 Tax losses that may be carried forward
 Temporary difference = difference between the book value of an
asset or liability and its tax base
 Temporary differences are taxable if they result in future tax
increases (i.e. deferred tax liability)
 Temporary differences are deductible if they result in future tax
savings (i.e. deferred tax asset)
 Tax loss carried forward = future tax savings (deferred tax asset)
3.5 Income taxes
 Deferred Tax Asset or Liability?
Year 1 Year 2 Year 3 Year 4

Book value 150 100 50 0
Tax base 100 0 0 0
Difference 50 100 50 0
Deferred tax 20 40 20 0

3.5 Income taxes
Financial Reporting Tax Reporting
Accounting Balance Sheet Tax Balance Sheet
PPE TR = 40 % PPE
Carrying amount: 150 000 € Carrying amount: 100 000 €
Temporary difference
Up to now, we had tax savings because: Taxable because the tax
50 000 €
TAX DEPR. > ACC. DEPR. treatment was more
(TAX INCOME < ACC. INCOME), but in favorable than the
the future TAXABLE accounting treatment
TAX DEPR. < ACC. DEPR.
OR DEDUCTABLE?
(TAX INCOME >ACC. INCOME)
DEFERRED TAX LIABILITY in the BS

Tax rate x taxable temporary difference
40 % x 50 000 € = 20 000 €

3.5 Income taxes
Financial Reporting Tax Reporting
Accounting Balance Sheet Tax Balance Sheet
PPE TR = 40 % PPE
Carrying amount: 100 000 € Carrying amount: 150 000 €
Temporary difference
Up to now, we paid more tax because: Deductible because the
50 000 €
TAX DEPR. < ACC. DEPR. tax treatment was less
(TAX INCOME > ACC. INCOME), but in favorable than the
the future TAXABLE accounting treatment
TAX DEPR. > ACC. DEPR.
OR DEDUCTABLE?
(TAX INCOME <ACC. INCOME)
DEFERRED TAX ASSET in the BS

Tax rate x taxable temporary difference
40 % x 50 000 € = 20 000 €

3.5 Income taxes
 Deferred tax liability: always recognized

 Deferred tax asset: recognize only if it is more likely than not that
there will exist taxable profit against which the deductible temporary
difference can be used (if not: report in the notes)
 Compensation only within each tax-paying component and tax
jurisdiction of the firm
 Deferred tax assets and liabilities are classified as non-current
 If the temporary difference relates to an item taken directly to equity,
the same holds true for the deferred tax

3.5 Income taxes
Current assets Current liabilities

Current income tax assets Current income tax liabilities
Receivables from the state Payables to the state
Non-current assets Non-current liabilities

Deferred tax assets Deferred tax liabilities
Temporary deductable differences Temporary taxable differences

Tax loss carried forward

3.5 Income taxes
Income tax expense (income statement)

Income tax actually owed
Current income tax expense (tax basis)
Temporary deductable differences

Tax savings Tax loss carried forward *
Deferred income tax expense Temporary taxable differences
* Tax losses carried forward for which it is more likely than not that there will NOT exist taxable profit against
which the deductible temporary difference can be used are only reported in the Notes


3.3 Leases
3.4 Provisions
3.5 Income taxes

 Retirement benefit plans are arrangements whereby a firm provides

benefits for employees on or after termination of service
Risk for the employee
 These plans may be classified in
 Defined-contribution plans (DC) – the company promises
employees that it will contribute a certain amount to the plan for
each period (expense of the period)
 Defined-benefit plans (DB) – the company promises that the
employee will receive a certain pension amount after retirement
Risk for the employer

 Principle for DB Plans: the cost of the retirement is recognized when

the employee acquires these rights (i.e. during the employee’s
length of service) and not when they receive the retirement benefits
 Therefore: recognition of retirement benefits in the Balance Sheet
 Actuaries calculate the Projected Benefit Obligation (PBO) of the
employer (I)
PBO = f (discount rate, rate of compensation increase, etc)
(-) (+)
 Plan assets are valued at fair value (II)

 If (I) > (II): difference recognized as a liability (provision)

 If (II) > (I): difference recognized as an asset
Yearly variations of (I) – (II)

 Recognized in the comprehensive income
(Income or Other Comprehensive Income)
 Not income!!!
 Contributions to the fund
 Withdrawals from the fund



4 Inter-corporate investments
 4 categories of inter-corporate investments

 Minority passive investments – without significant influence or
control (generally < 20% of ownership)
 Minority active investments – with significant influence but no
control (generally > 20% but < 50%)
 Controlling interest – with control (generally > 50%)
 Joint ventures – shared control


4.1 Minority passive investments
4.2 Minority active investments
4.3 Controlling interest
4.4 Joint ventures
 Shares and bonds issued by other firms bought in order to generate

a financial profit
 NO significant influence and NO control: generally < 20%
 Passive Investments must be classified into 3 categories
4.1.1 Held to Maturity
4.1.2 Held for Trading
4.1.3 Available for Sale

4.1.1 Held to Maturity
ST or LT Short & long term assets
NATURE Debt securities for which the firm must have both the
intention and the ability to hold to maturity
VALUATION
BS Amortized cost
IS Interest
+/- Realized gains and losses

4.1.2 Held for Trading
ST or LT Short term assets
NATURE Debt and equity securities acquired for speculative

purpose (in order to make short term profits)
VALUATION
BS Fair value
IS Interest / Dividends
+/- Unrealized gains and losses

4.1.3 Available for Sale
ST or LT Short & long term assets
NATURE Debt and equity securities that can not be classified in

another category
VALUATION
BS Fair value
IS Interest / Dividends
Comprehensive +/- Unrealized gains and losses
Income

4.4 Joint ventures
 The investor can exercise a significant influence but no control on

the management, operations, and investing and financing decisions
of the investee (generally more than 20% of ownership but less than
50%)
 Equity method
 Significant influence could mean
 Representation on the board
 Participation in the policy-making process
 Material transactions between investor and investee
 Etc

BS P BS P
Liabilities Liabilities P
Other assets Other assets P
Equity Equity
Investm. in S Investm. - – part P
BS S Equity method
Liabilities
Assets
Equity

 Principle
 A simple revaluation of the investment based on the accounting
value of the investee
 The investment in the balance sheet is
 Increased by the investor’s share of the income earned by the
investee during the year
 Decreased by the dividends received by the investor
 The investment income is a function of the earnings of the investee
and is independent of dividends received (!)


4.4 Joint ventures
 If the investor is exercising a control on the management,

operations, and investing and financing decisions of the investee
(generally more than 50%)
 Consolidation

BS P Consolidated BS P
100%
Equity
Liabilities S
Investm. in S
BS S Minority Interest
100% Assets S
Consolidated
Liabilities Equity
Assets – part P
Equity

 Principle
 From an economic point of view, the parent company and the
subsidiary form only one company
 All the assets, liabilities, revenues, expenses, and cash flows of the
subsidiary are included in the corresponding accounts of the parent
 When ownership is less than 100%, a “minority interest” results

 What if purchase price is higher than the book value of the

investee?
 The purchase price may be explained by
 The book value of the net assets
 The identifiable differences between the FMV and the BV of
these net assets
 Goodwill (difference)
 How do we account for these differences?
 Identifiable differences – depreciated
 Goodwill - impaired
Steps in consolidating financial statements

 Adjustments in individual financial statements
 Aggregation of financial statements
 Fair value adjustments
 Identify goodwill and minority interest
 Remove investment in subsidiaries
 Remove intra-group balances and transactions
Group financial statements

Example: Balance Sheet consolidation at the acquisition date

 Company A is buying 100% of the shares issued by company B
 The purchase price is higher than the book value of the net
assets of company B at the acquisition date
 At the acquisition date, there are identifiable differences of 8’000
€ on the fixed assets of company B
 Company A is buying 80% of the shares issued by company B
 The purchase price is equal to the book value of the net assets
of company B at the acquisition date
 At the acquisition date, there are no identifiable differences
between the FMV and the BV of the net assets of company B
BEFORE the transaction

A B
Cash 140 000 € 10 000 €
Clients 50 000 20 000
PPE 200 000 100 000
390 000 130 000
Suppliers 50 000 10 000

Share capital 200 000 100 000
Retained earnings 140 000 20 000
390 000 130 000

AFTER the transaction
Purchase price > Book value of net assets ; Identifiable differences on PPE 8’000 €
% of shares bought : 100%
A B Adjustments Consolidated
Cash 10 000 10 000
Clients 50 000 20 000
Investments in B 130 000
PPE 200 000 100 000
Goodwill
390 000 130 000 0 0
Suppliers 50 000 10 000

Minority interest
390 000 130 000 0 0

AFTER the transaction
Purchase price = Book value of net assets ; No identifiable differences
% of shares bought : 80%
A B Adjustments Consolidated
Cash 44 000 10 000
Clients 50 000 20 000
Investments in B 96 000
PPE 200 000 100 000
Goodwill
390 000 130 000 0 0
Suppliers 50 000 10 000

Minority interest
390 000 130 000 0 0


4.4 Joint ventures
4.4 Joint ventures
 A joint venture is an entity that is owned and operated by a small

group of investors (not necessary 50%) called ventures
 Equity method
 Proportionate consolidation (option allowed under IFRS)

4.4 Joint ventures
BS P Consolidated BS P
Equity 40 % liabilities S
Investm. in S
Consolidated
BS S 40 % assets S Equity
– part P
Liabilities
Assets
Equity

4.4 Joint ventures
 Principle
 The parent company includes its share of each asset and liability
account of the affiliate in the corresponding account of the parent
 Similarities with consolidation: the investment in the affiliate is
eliminated against the parent’s share of the affiliate’s equity
 Differences with consolidation: includes only a share of each asset
and liability; no minority interest

4.5 Comparison Equity/Proportionate/Full
Item Equity Method Proportionate Full

Consolidation Consolidation
Equity & Same Same Same
Net income
Assets & Liab. Lowest In-between Highest
& Sales
ROE Same Same Same
ROA Highest In-between Lowest
Profit margin Highest In-between Lowest
Leverage Lowest In-between Highest

4 Inter-corporate investments (summary)
Category Definition Valuation
Held-to-Maturity …intention and the ability… Cost
Held-for-Trading Speculative purpose Fair value
Available-for-Sale Other <20% Fair value

but no significant influence (comprehensive income)
Associates Significant influence >20% Equity method
but no control <50%
Subsidiary Control >50% Consolidation
Joint-ventures Joint control 50% Proportionate consolidation /

Equity method



5 Analytical tools for gaining FS insights
 Ratio analysis is one of the most popular tools used by financial

analysts because it eliminates the scale effect
 To be meaningful, a ratio must refer to an economical underlying
relation
 Ratios become useful if compared to
 Prior ratios
 Predetermined standards
 Industry average
 Ratios of competitors


5.1 Performance ratios
5.2 Equilibrium ratios

5.1.1 Return on assets (ROA)
Sales
Current liabilities (-) Cost of sales
Current assets
= Gross profit
(-) Other operating expenses
Non-current liabilities = EBIT
(-) Interest
= EBT
Non-current assets (-) Income tax
Equity
= Net income
EBIT 1 436 Industry

ROA = = = 16.67 % (11.72 % for 2009)
Assets 8 614 8.17 %

5.1.1 Return on assets (ROA)
 Measures the ability of the firm to generate profit from its assets,
independent of the level of debt (EBIT)
 Pie theory
State
Debt holders
Company
Shareholders

5.1.2 Return on equity (ROE)
Sales
Current assets
= Gross profit
(-) Interest
= EBT
Equity
= Net income
Net income 1 080

ROE = = = 15.21 % (12.76 % for 2009)
Equity 7 101

5.1.2 Return on equity (ROE)
 Measures the rate of return on the ownership interest

 Shows how well a firm uses investments to generate earnings
growth
 If a company has issued preferred shares, it becomes relevant to
compute a return on common equity
 Best used to compare firms in the same industry

5.1.3 Net margin (NM)
Sales
Current assets
= Gross profit
(-) Interest
= EBT
Equity
= Net income
Net income 1 080

NM = = = 17.68 % (14,84 % for 2009)
Sales 6 108

5.1.3 Net margin (NM)
 How many cents in average are earned on each € of sales

 A common measure of profitability
 Influenced by businesses’ operating and financing arrangements
 Indicates the margin of safety
 Ratio mostly used for time series and internal comparison

5.1.4 Operating margin (OM)
Sales
Current assets
= Gross profit
(-) Interest
= EBT
Equity
= Net income
EBIT 1 436 Industry

OM = = = 23.51 % (17.56 % for 2009)
Sales 6 108 6.03 %

5.1.4 Operating margin (OM)
 Operating income may be used instead of EBIT (sometimes not the

same)
 Used in order to compare firms from the same industry
 The financing policy has no effect on this ratio

5.1.5 Asset turnover (AT)
Sales
Current assets
= Gross profit
(-) Interest
= EBT
Equity
= Net income
Sales 6 108 Industry

AT = = = 0.71 (0.67 for 2009)
Assets 8 614 0.81

 Measures the general efficiency of the firm

 annual sales generated by each € of assets
 What is the commercial strategy of the firm?
Return on assets = Asset turnover x Operating margin
EBIT Sales EBIT
= x
Assets Assets Sales
 2010 SWATCH
16.67% = 0.71 x 23.51 %

Trend
 The higher the asset turnover (> 1)
 The lower the operating margin (< 1%)
 The firm counts on the asset turnover (volume of sales)
 The lower the asset turnover (< 1)

 The higher the operating margin (> 1%)
 The firm counts on the profit margin (selling at high prices)

5.1 Synthesis of performance ratios
2010 2009 2008 2007 Industry
Return on assets 16.67 % 11.72 % 16.61 % 16.60 % 8.17 %
Return on equity 15.21 % 12.76 % 15.37 % 19.05 % n/a
Net margin 17.68 % 14.84 % 14.76 % 17.98 % n/a
Operating margin 23.51 % 17.56 % 21.17 % 21.89 % 6.03 %
Asset turnover 0.71 0.67 0.78 0.76 1.35


5.1 Performance ratios
5.2 Equilibrium ratios

5.2.1 Capital structure (CS)
Sales
Current assets
= Gross profit
(-) Interest
= EBT
Equity
= Net income
Liabilities 1 513
CS = = = 17.56 % (22.38 % for 2009)
Assets 8 614

5.2.1 Capital structure (CS)
 Is a primary measure of risk and it refers to the way a firm is

financing its assets through a combination of equity and debt
 Used by analysts as a screening device: as long as is within certain
limits, the focus is on other ratios
 Does not make a distinction between short term and long term

5.2.2 Long term debt to equity (LTDE)
Current liabilities Sales

(-) Cost of sales
Current assets Current port. of LTD
= Gross profit
(-) Interest
= EBT
Equity
= Net income
Long term debt 493 + 31 Industry

LTDE = = = 0.07 (0.15 for 2009)
Equity 7 101 0.76

5.2.2 Long term debt to equity (LTDE)
 Long term debt represents the part of debt that may be considered
permanent; therefore:
Long term debt = Non-current liabilities
+ Current portion of the Non-current liabilities
 Some analysts take into account only borrowings and bonds issued

5.2.3 Current ratio (CR)
Sales
Current assets
= Gross profit
(-) Interest
= EBT
Equity
= Net income
Current assets 6 235 Industry

CR = = = 6.11 (4.36 for 2009)
Current liabilities 1 020 4.03

5.2.3 Current ratio (CR)
 Measures if the firm has enough resources to pay its debts over the
next 12 months
 A low current ratio signals that the firm may have problems in
meeting its short term obligations
 A high current ratio may signal that the firm is not using efficiently its
current assets
 Generally, should be around 2

5.2.4 Quick ratio (QR)
Current assets Sales

Cash Current liabilities (-) Cost of sales
ST Investments = Gross profit
Receivables from cl. (-) Other operating expenses
(-) Interest
= EBT
Equity
= Net income
Cash + ST Investm. + Clients 1 827 + 542 + 716

QR = = = 3.02 (1.94 for 2009)
Current liabilities 1 020
Industry
2.31

5.2.5 Acid test (AT)
Current assets Sales

Cash Current liabilities (-) Cost of sales
ST Investments = Gross profit
Receivables from cl. (-) Other operating expenses
(-) Interest
= EBT
Equity
= Net income
Cash 1 827
QR = = = 1.79 (0.88 for 2009)
Current liabilities 1 020

5.2.4-5 Quick ratio (QR) / Acid test (AT)
 Quick ratio: measures the firm’s ability to maintain operations as

usual with current cash and near cash reserves (without additional
sales)
 In a conservative view, should be around 1
 Acid test: gives an idea of what will happen if al current liabilities are
to be settled right away
 Might give a distorted picture of the firm

5.2 Synthesis of equilibrium ratios
2010 2009 2008 2007 Industry
Capital structure 17.56 % 22.38 % 24.66 % 28.44 % n/a
Long term debt to equity 0.07 0.15 0.17 0.18 0.76
Current ratio 6.11 4.36 5.53 4.61 4.03
Quick ratio 3.02 1.94 2.17 2.37 2.31
Acid test 1.79 0.88 0.75 1.08 n/a

T1 FAR 2011 - Notes

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CPTC 31125

Financial Accounting and Reporting

Andrei FILIP (filip@essec.fr)

CPTC31260/31261 CPTC31264/31265 CPTC31254

Andrei Filip @ 2011 2

CHF Mio. 2010 2009 2008 2007 2006 2005

Andrei Filip @ 2011 3

1. Understanding the Financial Statements (FS)

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 A complete set of financial statements is composed of

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 Can we be sure that the data is true and fair?

Ernst & Young,

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 Explains the financial position of the firm at a certain date

Equity = Assets – Liabilities

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Earnings/Income = Revenues – Expenses

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 Presented separately or together with the IS

Gain Gain Gain Gain

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 Dirty Surplus = Other Comprehensive Income

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Equity Equity N-1

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 Comprise a summary of significant accounting policies and other

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1. Understanding the Financial Statements (FS)

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 Cash flow presented in 3 categories

 Problems in classifying certain cash flows

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 Indirect method: the operating cash flow is obtained by adjusting the

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Cash inflows = Revenue + Receivables beg. – Receivables end

Receivables from Other short term

Other short term

WC = Operating assets – Operating liabilities

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Operating cash flow (I)

A. Change in cash and cash equivalent

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 Internally generated cash = Net income +/- Adjustment 1 and 2

 Changes in working capital

 The free cash flow = Operating + Investing Cash flow

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1. Understanding the Financial Statements (FS)

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 An entity whose financial statements comply with IFRS shall make

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1. Understanding the Financial Statements (FS)

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 The cost of goods sold is calculated using an accounting convention

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 If prices are increasing

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 Tangible fixed assets are depreciated by using various methods

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