Financial

Statement
Analysis

K R Subramanyam
John J Wild

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 4-2

Analyzing Investing Activities

4
CHAPTER
 4-3

Current Asset Introduction

Classification
Current
Current (Short-term)
(Short-term) Noncurrent
Noncurrent (Long-
(Long-
Assets
Assets term)
term) Assets
Assets

Resources
Resourcesor orclaims
claimsto to Resources
Resourcesor orclaims
claimsto to
resources
resourcesthat
that are
are resources
resourcesthat
that are
are
expected
expectedto tobe
besold,
sold, expected
expectedtotoyield
yield
collected,
collected, or
orused
used within
within benefits
benefitsthat
thatextend
extend
one
oneyear
yearor
orthe
theoperating
operating beyond
beyondone
oneyear
yearor or the
the
cycle,
cycle, whichever
whichever isis operating
operating cycle,
cycle,
longer.
longer. whichever
whichever is
is longer.
longer.
 4-4

Current Asset Introduction

Cash, Cash Equivalents and Liquidity
Cash
Cash
Currency,
Currency, coins
coins and
and amounts
amounts on
on deposit
deposit
in
in bank
bank accounts,
accounts, checking
checking accounts,
accounts, and
and
some
some savings
savings accounts.
accounts.
 4-5

Current Asset Introduction

Cash, Cash Equivalents and Liquidity
Cash
Cash Equivalents
Equivalents
Short-term,
Short-term, highly
highly liquid
liquid investments
investments that
that are:
are:
 Readily
 Readily convertible
convertible to to aa known
known cash
cash
amount.
amount.
 Close
 Close to
to maturity
maturity date
date and
and not
not
sensitive
sensitive to
to interest
interest rate
rate changes.
changes.
 4-6

Current Asset Introduction

Analysis of Cash and Cash Equivalents

•• Companies
Companiesrisk
riskaareduction
reductionin
in liquidity
liquidityshould
shouldthe
the
market
market value
valueof of short-term
short-terminvestments
investmentsdecline.
decline.
••Cash
Cashand
andcash
cashequivalents
equivalentsare
aresometimes
sometimesrequired
required
to
tobe
bemaintained
maintainedas ascompensating
compensatingbalances
balancestoto
support
supportexisting
existing borrowing
borrowing arrangements
arrangementsoror as
as
collateral
collateralfor
for indebtedness.
indebtedness.
 4-7

Current Asset Introduction

Receivables
Receivables
Receivables are are amounts
amounts due due from
from others
others
that
that arise
arise from
from the
the sale
sale of
of goods
goods or or services,
services,
or
or the
the loaning
loaning ofof money
money
Accounts
Accounts receivable
receivable refer refer to
to oral
oral
promises
promises of of indebtedness
indebtedness due due from
from customers
customers
Notes
Notes receivable
receivable refer refer to
to formal
formal written
written
promises
promises of of indebtedness
indebtedness due due from
from others
others
 4-8

Current Asset Introduction

Valuation of Receivables
Receivables
Receivables are
are reported
reported at
at their
their net
net realizable
realizable
value
value —
— total
total amount
amount ofof receivables
receivables less
less an
an
allowance
allowance for
for uncollectible
uncollectible accounts
accounts

Management
Management estimates
estimates the
the allowance
allowance for
for
uncollectibles
uncollectibles based
based on
on experience,
experience, customer
customer
fortunes,
fortunes, economy
economy andand industry
industry expectations,
expectations,
and
and collection
collection policies
policies
 4-9

Current Asset Introduction

Analyzing Receivables
Assessment
Assessmentof ofearnings
earningsquality
qualityisisoften
oftenaffected
affectedby byanananalysis
analysisofofreceivables
receivablesandandtheir
their
collectibility
collectibility
Analysis
Analysismust
mustbe bealert
alerttotochanges
changesin inthe
theallowance—computed
allowance—computedrelativerelativetotosales,
sales,
receivables, or industry and market conditions.
receivables, or industry and market conditions.
Two
Twospecial
specialanalysis
analysisquestions:
questions:
(1)
(1) Collection Risk
Collection Risk
Review
Reviewallowance
allowancefor foruncollectibles
uncollectiblesin inlight
lightofofindustry
industryconditions
conditions
Apply
Applyspecial
specialtools
toolsfor foranalyzing
analyzingcollectibility:
collectibility:
••Determining
Determiningcompetitors’
competitors’receivables
receivablesas asaapercent
percentof
ofsales—vis-à-vis
sales—vis-à-visthe the
company under analysis
company under analysis
••Examining
Examiningcustomer
customerconcentration—risk
concentration—riskincreases
increaseswhen
whenreceivables
receivablesareare
concentrated in one or a few customers
concentrated in one or a few customers
••Investigating
Investigatingthe theageagepattern
patternof ofreceivables—overdue
receivables—overdueand andforforhow
howlong
long
••Determining
Determiningportion
portionof ofreceivables
receivablesthatthatisisaarenewal
renewalof
ofprior
priorreceivables
receivables
••Analyzing
Analyzingadequacy
adequacyof ofallowances
allowancesfor fordiscounts,
discounts,returns,
returns,and
andother
othercredits
credits
(2) Authenticity of
(2) Authenticity of ReceivablesReceivables
Review
Reviewcredit
creditpolicy
policyforforchanges
changes
Review
Review return policies forchanges
return policies for changes
Review
Review any contingencies onreceivables
any contingencies on receivables
 4-10

Current Asset Introduction

Securitization of Receivables
Securitization
Securitization(or
(orfactoring)
factoring)is
iswhen
whenaacompany
companysellssellsall
allor
oraa
portion
portionof
ofits
itsreceivables
receivablestotoaathird
thirdparty
party
Receivables
Receivablescancanbebesold
soldwith
withor
orwithout
withoutrecourse
recourseto toaabuyer
buyer
(recourse
(recourserefers
refersto
toguarantee
guaranteeofofcollectibility)
collectibility)
Sale
Saleof
ofreceivables
receivableswith
withrecourse
recoursedoes
doesnot
noteffectively
effectivelytransfer
transferrisk
risk
of
ofownership
ownership

•For securitizations with any type of recourse, the seller

must record both an asset and a compensating liability
for the amount factored
•For securitizations without any recourse, the seller
removes the receivables from the balance sheet
 4-11

Current Asset Introduction

Prepaid Expenses
Prepaid
Prepaidexpenses
expensesare
areadvance
advancepayments
paymentsfor forservices
servicesor
orgoods
goodsnotnot
yet
yetreceived
receivedthat
thatextend
extendbeyond
beyondthe
thecurrent
currentaccounting
accountingperiod—
period—
examples
examplesareareadvance
advancepayments
paymentsfor
forrent,
rent,insurance,
insurance,utilities,
utilities,and
and
property taxes
property taxes

Analysis of Prepaids
Two
Twoanalysis
analysisissues:
issues:
(1)
(1) For
Forreasons
reasonsof
ofexpediency,
expediency,noncurrent
noncurrentprepaids
prepaidssometimes
sometimes
are
areincluded
includedamong
amongprepaid
prepaidexpenses
expensesclassified
classifiedas
ascurrent--
current--
when
whentheir
theirmagnitude
magnitudeis
islarge,
large,they
theywarrant
warrantscrutiny
scrutiny
(2)
(2)Any
Anysubstantial
substantialchanges
changesin
inprepaid
prepaidexpenses
expenseswarrant
warrant
scrutiny
scrutiny
 4-12

Inventories
Definitions
Inventories are goods held for sale, or goods
acquired (or in process of being readied) for
sale, as part of a company’s normal
operations
Expensing treats inventory costs like period
costs—costs are reported in the period when
incurred
Capitalizing treats inventory costs like
product costs—costs are capitalized as an
asset and subsequently charged against
future period(s) revenues
benefiting
from their sale
 4-13

Inventories
Inventory Costing Method

Use of Inventory Methods in Practice

 4-14

Inventories
First-In, First-Out (FIFO)

Oldest
Oldest Costs
Costs of
of Goods
Goods
Costs
Costs Sold
Sold

Recent
Recent Ending
Ending
Costs
Costs Inventory
Inventory
 4-15

Inventories

Last-In, First-Out (LIFO)

Recent
Recent Costs
Costs of
of
Costs
Costs Goods
Goods Sold
Sold

Oldest
Oldest Ending
Ending
Costs
Costs Inventory
Inventory
 4-16

Inventories
Average Cost
When
When aa unit
unit is
is sold,
sold, the
the
average
average cost
cost ofof each
each
unit
unit in
in inventory
inventory isis
assigned
assigned to to cost
cost of
of
goods
goods sold.
sold.

Cost of Units
Goods ÷ available on
Available for the date of
Sale sale
 4-17

Inventories
Illustration of Costing Methods

Inventory
InventoryononJanuary
January1,1,Year
Year22 40
40@@$500
$500 $$20,000
20,000
Inventories
Inventoriespurchased
purchased
during
duringthe
theyear
year 60
60@@$600
$600 36,000
36,000
Cost
CostofofGoods
Goodsavailable
available
for
forsale
sale 100
100units
units $$56,000
56,000

Note:
Note:30
30units
unitsare
aresold
soldin
inYear
Year22for
for$800
$800each
eachfor
fortotal
total
Revenue
Revenueofof$24,000
$24,000
 4-18

Inventories
Illustration of Costing Methods

Beginning
Beginning Net
Net Cost
Costof
of Ending
Ending
Inventory
Inventory ++ Purchases
Purchases == Goods
GoodsSold
Sold ++ Inventory
Inventory
FIFO
FIFO $20,000
$20,000 ++ $36,000
$36,000 == $15,000
$15,000 ++ $41,000
$41,000
LIFO
LIFO $20,000
$20,000 ++ $36,000
$36,000 == $18,000
$18,000 ++ $38,000
$38,000
Average
Average $20,000
$20,000 ++ $36,000
$36,000 == $16,800
$16,800 ++ $39,200
$39,200

Assume
Assumesales
salesof
of$35,000
$35,000for
forthe
theperiod—then
period—thengross
grossprofit
profitunder
undereach
each
method
methodis:
is:
Sales
Sales –– Cost
Costof
ofGoods
GoodsSold
Sold == Gross
GrossProfit
Profit
FIFO
FIFO $24,000
$24,000 ---- 15,000
15,000 == $9,000
$9,000
LIFO
LIFO $24,000
$24,000 ---- 18,000
18,000 == $6,000
$6,000
Average
Average $24,000
$24,000 ---- 16,800
16,800 == $7,200
$7,200
 4-19

Economic Profit vs. Holding Gain

• In periods of rising prices, FIFO produces higher gross

profits than LIFO because lower cost inventories are
matched against sales revenues at current market
prices. This is sometimes referred to as FIFO’s phantom
profits.

• The FIFO gross profit is actually a sum of two

components: an economic profit and a holding gain:
– Economic profit = 30 units x ($800 - $600) = $6,000
– Holding gain = 30 units x ($600 - $500) = $3,000
 4-20

Inventories
LIFO Liquidations

(1)
(1)Companies
Companiesmaintain
maintain LIFO
LIFOinventories
inventoriesin
in separate
separate
cost
costpools.
pools.

(2)
(2)When
Wheninventory
inventoryquantities
quantitiesare
arereduced,
reduced,each
eachcost
cost
layer
layer is
ismatched
matchedagainst
against current
current selling
selling prices.
prices.

(3)
(3)In
Inperiods
periodsof
of rising
rising prices,
prices,dipping
dipping into
intolower
lowercost
cost
layers
layerscan
caninflate
inflateprofits.
profits.
 4-21

Inventories
Analyzing Inventories—Restatement of LIFO to 
FIFO
  
Three step process:
Three step process:

(1) Reported LIFO Inventory + LIFO reserve
(1) Reported LIFO Inventory + LIFO reserve
(2) Deferred tax payable + [LIFO reserve x Tax rate]
(2) Deferred tax payable + [LIFO reserve x Tax rate]
(3) Retained earnings + [LIFO reserve x (1-Tax rate)]
(3) Retained earnings + [LIFO reserve x (1-Tax rate)]
  
LIFO
LIFO reserve is the amount by which current cost 
reserve is the amount by which current cost 
exceeds reported cost of LIFO 
exceeds reported cost of LIFO 
inventories 
inventories 
 4-22

Long-Lived Asset Introduction 
Definitions 
Long-lived assets—resources that are used to generate revenues (or 
Long-lived assets—resources that are used to generate revenues (or 
reduce costs) in the long run
reduce costs) in the long run
Tangible fixed assets such as 
property, plant, and equipment

Intangible assets such as 
patents, trademarks, 
copyrights, and goodwill

Deferred charges such as 
research and development 
(R&D) expenditures, and natural
resources
 4-23

Long-Lived Asset Introduction 
Capitalization  
Capitalization—process of deferring a cost that is incurred in the 
Capitalization—process of deferring a cost that is incurred in the 
current period and whose benefits are expected to extend to one or more 
current period and whose benefits are expected to extend to one or more 
future periods
future periods
  
For a cost to be capitalized, it must meet each of the following criteria:
For a cost to be capitalized, it must meet each of the following criteria:

• It must arise from a 
• It must arise from a 
past transaction or event
past transaction or event

• It must yield identifiable and 
• It must yield identifiable and 
reasonably probable future benefits
reasonably probable future benefits

• It must allow owner (restrictive) 
• It must allow owner (restrictive) 
control over future benefits 
control over future benefits 
 4-24

Long-Lived Asset Introduction 

Allocation   
Allocation—process of periodically expensing a deferred 
Allocation—process of periodically expensing a deferred 
cost (asset) to one or more future expected benefit periods; 
cost (asset) to one or more future expected benefit periods; 
determined by benefit period, salvage value, and allocation 
determined by benefit period, salvage value, and allocation 
method
method

Terminology
Terminology
•• Depreciation
Depreciation for tangible fixed 
 for tangible fixed 
   
     assets
 assets
•• Amortization
Amortization for intangible assets
 for intangible assets
•• Depletion
Depletion for natural resources
 for natural resources
 4-25

Long-Lived Asset Introduction 
Impairment    
Impairment—process of writing down asset value when its 
Impairment—process of writing down asset value when its 
expected (undiscounted) cash flows are less than its carrying 
expected (undiscounted) cash flows are less than its carrying 
(book) value
(book) value
  
Two distortions arise from impairment:
Two distortions arise from impairment:
         •  Conservative biases distort 
         •  Conservative biases distort 
long-lived asset valuation 
long-lived asset valuation 
because assets are written 
because assets are written 
down but not written up
down but not written up
     
      • Large transitory effects from
• Large transitory effects from
             recognizing asset impairments
             recognizing asset impairments
             distort net income.
             distort net income.
 4-26

Plant Assets & Natural Resources  

Plant Assets   
   
Tangible

Actively Used in Operations

Expected to Benefit Future Periods

Property, Plant and Equipment
 4-27

Plant Assets & Natural Resources  

Plant Assets Costing Rule 
      
Purchase All 
price expenditures 
needed to 
Acquisition prepare the 
cost asset for its 
intended use

Acquisition cost excludes 
financing charges and
cash discounts. 
 4-28

Plant Assets & Natural Resources  

Valuation Analysis         

 Valuation emphasizes objectivity of historical cost, the 
 conservatism principle, and accounting for the money 
 invested
 
Limitations of historical costs:
 • Balance sheets do not purport to reflect market values
 • Not especially relevant in assessing replacement values
 • Not comparable across companies
 • Not particularly useful in measuring opportunity costs
 • Collection of expenditures reflecting different 
   purchasing power  
 4-29

Plant Assets & Natural Resources  

Depreciation
Depreciation is the process of allocating the 
cost of a plant asset to expense in the 
accounting periods benefiting from its use.

Balance Sheet Income Statement
 Cost
Acquisition Expense
Cost Allocation

(Unused) (Used)
 4-30

Plant Assets & Natural Resources  

Factors in Computing Depreciation

The calculation of depreciation requires 
three amounts for each asset:
 Cost.
 Salvage Value.
 Useful Life.
 Depreciation Method
 4-31

Plant Assets & Natural Resources

Comparing Depreciation Methods

Straight-Line Method

Depreciation Cost - Salvage Value

=
Expense per Year Useful life in periods

SL
 4-32

Plant Assets & Natural Resources

Double-Declining-Balance Method
Step 1:
Straight-line 100 %
depreciation rate = Useful life
Step 2:
Double-declining- Straight-line
balance rate = 2 × depreciation rate

Step 3:
Depreciation Double-declining- Beginning period
expense = balance rate × book value

Ignores salvage value

 4-33

Plant Assets & Natural Resources

Activity (Units-of-Production) Method

Step 1:
Depreciation Cost - Salvage Value
=
Per Unit Total Units of Production

Step 2:
Depreciation Depreciation Units Produced
= ×
Expense Per Unit in Period
 4-34

Plant Assets & Natural Resources

Natural Resources
Natural resources (wasting assets)—rights to extract or consume natural resources

Total cost, Extracted from

including the natural
exploration and environment
development, and reported
is charged to at cost less
depletion expense accumulated
over periods depletion.
benefited.

Examples: oil, coal, gold

 4-35

Plant Assets & Natural Resources

Depletion of Natural Resources

Depletion is calculated using the

units-of-production method.

Unit depletion rate is calculated as follows:

Cost – Salvage Value

Total Units of Capacity
 4-36

Plant Assets & Natural Resources

Depletion of Natural Resources

Total depletion cost for a period is:

Unit Depletion Number of Units
Rate × Extracted in Period

Cost of
Total goods sold
depletion
cost Unsold
Inventory
 4-37

Plant Assets & Natural Resources

Analyzing Depreciation and Depletion

• Assess reasonableness of depreciable base, useful life, and allocation
method
• Review any revisions of useful lives
• Evaluate adequacy of depreciation—ratio of depreciation to total
assets or to other size-related factors
• Analyze plant asset age—measures include

Average total life span = Gross plant and equipment assets /

Current year depreciation expense.
Average age = Accumulated depreciation / Current
year depreciation expense.
Average remaining life = Net plant and equipment assets /
Current year depreciation expense.

Average total life span = Average age + Average remaining life

(these measures also reflect on profit margins and financing requirements)
 4-38

Intangible Assets

Noncurrent
Noncurrentassets
assets Often
Oftenprovide
provide
without
withoutphysical
physical exclusive
exclusiverights
rights
substance.
substance. or
orprivileges.
privileges.

Intangible
Assets
Usually
Usuallyacquired
acquired
Useful
Usefullife
lifeis
is for
foroperational
operational
often
oftendifficult
difficult use.
use.
to
todetermine.
determine.
 4-39

Intangible Assets
Accounting for Intangible Assets

Record at cost,  Patents

including  Copyrights
purchase price,  Leaseholds
legal fees, and
 Leasehold
filing fees.
Improvements
 Goodwill
 Trademarks and
Trade Names
 4-40

Intangible Assets
Analyzing Intangibles and Goodwill
 Search for unrecorded intangibles and
goodwill—often misvalued and
most likely exist off-balance-sheet
 Examine for superearnings as
evidence of goodwill
 Review amortization periods—any likely bias is in the
direction of less amortization and can call for
adjustments
 Recognize goodwill has a limited useful life--
whatever the advantages of location, market
dominance, competitive stance, sales skill, or
product acceptance, they are affected by