Assignment

Course Name: Financial Statement Analysis and Valuation

Course Code: F-401.

Submitted to
Md. Sajib Hossain, CFA
Assistant Professor
Department of Finance
University of Dhaka.

Submitted by
Sadia Sultana
ID-23-103
Section-B
Department of Finance
University of Dhaka

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 Long-Lived Assets
Long-lived assets, also referred to as non-current assets or long-term assets, are assets that are
expected to provide economic benefits over a future period of time, typically greater than one
year. Long-lived assets generally include tangible assets, intangible assets, and financial
assets. The cost of long-lived asset includes all the cost that was incurred before making the
assets ready for production. The cost of long-lived asset should be recognized more than the
purchase price.

An expenditure that is expected to provide a future economic benefit over multiple accounting
periods is capitalized. For this reason, repair cost that increases the life of the assets is capitalized
& maintenance cost is taken as expense.

Traditionally, we show interest as expense in investment activities. But if the interest is given for
a loan that is taken for construction purposes, then interest expense is capitalized. According to
IFRS, interest expense can be showed in financial or operating activities where US GAAP permits
to show only in operating activities.

The capitalized costs of long-lived assets are allocated to expense in subsequent periods over
their useful lives. Among two types of assets, depreciation is for tangible assets & amortization
is for intangible assets. There are several techniques to calculate depreciation. But both IFRS &
US GAAP instructs us to use the same techniques over & over.

Assets with finite lives are reviewed for impairment when there is some indication that the
carrying amount of an asset may not be recoverable. On the other hand, intangible assets with
an indefinite useful life are not amortized but are reviewed for impairment annually.
Research & development costs are incurred for a company to grow internally. US GAAP permits
to show all the research & development cost as expense except software development.
According to IFRS all research cost should be recorded in income statement and development.
For the valuation and reporting of long-lived assets, IFRS allow the use of either the cost model
or the revaluation model. But the revaluation model is not permitted under US GAAP.

Lease
Lease is a legal contract between two party where one party allows another party to use the asset
in exchange for fee. Generally, small & medium firms use lease instead of buying assets. Owner
of the asset is known as lessor & the party who uses the asset is called lessee. There are two

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types of lease. In case of IFRS, if all the risk & rewards are transferred to the lessee then it will be
capital lease otherwise it will be considered as operating lease. In US GAAP, four conditions
needed to be fulfilled to be called as capital lease.

Long-term Liabilities
Firms sell share & bond to collect funds from people. Bond is one of the main sources of long-
term liability. A long-term liability represents probable economic sacrifice of economic benefits
in periods greater than one year in the future, common types of long-term liabilities are bonds
payable, notes payable, lease, pension liabilities and deferred tax liabilities etc. Bond can be sold
as per value, at a premium, or a discount and bond has coupon rate, coupon payment and face
value. The market interest rate on the day of issue is known as the effective rate of the interest
rate. The selling price of bond depend on this effective rate. The discount or premium of bond
will be fully amortized when the bond matures. When a bond is issued at par, both interest
expense and payment are the same. When it is issued at either premium or discount, there is a
deviation between interest expenses and payments, this deviation is called amortization. At
discount issue, amortization amount is to be added with liability and ta premium issue this
amount is to be subtracted to liability. If a company redeems bonds before maturity, it reports
gain or loss on debt extinguishment computed as the net carrying amount of the bonds less the
required amount. The carrying amount of bonds is typically the amortized historical cost.
Bonds can be derecognized into two ways either-calling or purchasing the bond in open market.
When a bond is redeemed before maturity, the bonds payable account is recorded by carrying
amount of bonds and any gain or loses will be recorded in the income statement.
Debt covenants impose restrictions on borrowers, such as limitations on future borrowing or
requirements to maintain a minimum debt to equity ratio. Companies are required to disclose
the fair value of financial liabilities, including debt.

Financial reporting quality

The objective of financial reporting is to provide useful information to the shareholder. Financial
reporting quality varies across the companies. High quality reporting provides decision useful
information, which is relevant and faithfully represents the economic reality of the company’s
activities. Earnings quality and financial reporting quality are interrelated concept but they are
not same. Every company is obliged by the law to provide high-quality information to the users.
A high-quality financial statement has two criteria. The first one is relevance which means the
information must be useful and material. The second criterion is a faithful representation. This

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means the information must be unbiased, free from error, and complete. The high quality of
earning must also be needed to be insured to make sure the quality of the financial statement is
high.

Quality Spectrum of Financial Reports:

1.Financial report is compliant with GAAP, information is decision useful, earnings are sustainable
and adequate.
2. Financial reports are compliant with GAAP, information is decision useful but earnings quality
is questionable.
3. Financial reports are compliant with GAAP, but not decision useful because accounting choices
are biased.
4. Financial reports are compliant with GAAP, but earnings can be managed for representing
smooth pictures of earnings over the period.
5. Financial reports are not compliant with GAAP, but earnings represent company’s real financial
picture.
6. Financial reports are not compliant with GAAP, but accounting numbers can be fraudulent.

Aggressive Accounting vs Conservative Accounting:

A company can follow a conservative policy or aggressive policy to record its assets, liability,
revenue, and expense. There is some difference between aggressive and conservative
accounting. Aggressive accounting occurs when a company repots higher amount of earnings,
assets, and lower amount of liability and expenses. As a result, current year financial performance
and financial position will be higher but subsequent year these will be lower. Conservative
accounting may result from either accounting standards that specifically require a conservative
treatment or judgment by managers.

Managers may be motivated to show high or less quality financial reports to mask poor
performance or to increase price or to increase personal compensation. This is known as creative
accounting. The company needs to recognized revenue when it is earned. But sometimes the
manager may show revenue before earning it. The manager may use estimations to manipulate
the earnings. Estimating high bad debt provision, warranty provision and estimations for
depreciation are some of the examples.

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 Applications of Financial statements Analysis
The financial statement is used by the users for various purposes. The financial statement helps
investors to find the business strategy of the company through the financial statement. It is just
a presentation of company’s operation over the year and condition at the end of the day. To
make it more meaningful an analyst needs to analyze the financial statement. For analyzing a
financial statement an analyst can use graphic analysis, regression analysis, common size analysis
and ratio analysis. Analysts examine companies past financial performance for number of reasons
such as cross-sectional analysis (comparison between two companies), trend analysis
(comparison between two different periods financial performance) and forecasting future
financial growth Projecting future financial performance and credit analysis etc. An analyst can
forecast the income and cash flow of the company from the financial statement.
Financial statements can be used by the credit rating company to rate the company. That
determines the credit risk of the company and also helps to find the sustainability of the
company. Credit quality can be measured through several ways such as scale and diversification,
operational efficiency, margin stability and leverage.

Free Cash Flow Valuation

Free cash flow to the firm is the cash flow available to the company’s suppliers of capital after all
operating expenses have been paid and necessary investments in working capital and fixed
capital equipment have been made. Before investing in a company, the investors do some
analysis and research on the company to find whether they should invest or not. Analysts like to
use free cash flow valuation when the following conditions is present: the company does not pay
dividend; dividend payment is not related to earnings and the growth rate od dividend is unstable
etc. In this method, a growth rate is estimated and some estimate the future cash flow and find
the present value of that cash flow. Single-stage or multi-stage FCF can be used to find the value
of the company. FCF can be FCFF or FCFE. If FCFF is used that the market value of debt is
subtracted from the value of the firm and cash and marketable securities are added to the value
to find the value of equity of the firm.
There are several ways to calculate FCFF.

FCFF from Net Income

FCFF= Net Income + Non-cash charges+ interest expense (1-atx) – Investment in fixed Capital –
investment in Working Capital.

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FCFF from Cash Flow
FCFF= Cash Flow from operations+ Interest Expenses (1-tax) – investment in fixed capital.

Computing FCFF from Sales

FCFF= Sales –COGS-operating expenses- Interest Expenses- Tax+ Non-cash expenses-Investment
in working capital –Investment in fixed capital.

FCFF from EBIT

FCFF= EBIT (1-Tax) +non-cash charge- Investment in working capital – Investment in fixed capital.

FCFF from EBITDA

FCFF= EBITDA (1-Tax) + Depreciation (TAX) - investment in fixed capital – Investment in working
capital. Computing FCFE from FCFF FCFE= FCFF – Interest expenses (1-tax) + Net Borrowing.