2024 L1 Fsa

Last Revised: 06/29/2023
2024 Level 1 - Financial Statement Analysis
Learning Modules Page

Introduction to Financial Statement Analysis 2
Analyzing Income Statements 10
Analyzing Balance Sheets 25
Analyzing Statements of Cash Flows I 31
Analyzing Statements of Cash Flows II 42
Analysis of Inventories 48
Analysis of Long-Term Assets 51
Topics in Long-Term Liabilities and Equity 59
Analysis of Income Taxes 71
Financial Reporting Quality 78
Financial Analysis Techniques 87
Introduction to Financial Statement Modeling 102
This document should be used in conjunction with the corresponding learning modules in the 2024 Level 1 CFA® Program
curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2023, CFA Institute. Reproduced and
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1
Introduction to Financial Statement Analysis
a. describe the steps in the financial statement analysis framework
b. describe the roles of financial statement analysis
c. describe the importance of regulatory filings, financial statement notes and

supplementary information, management’s commentary, and audit reports
d. describe implications for financial analysis of alternative financial reporting

systems and the importance of monitoring developments in financial
reporting standards
e. describe information sources that analysts use in financial statement analysis

besides annual and interim financial reports
2
Financial Statement Analysis
1. Determine the purpose and context of the analysis
2. Collect data - Financial Statements

- Discussions with management
- Company site visits
3. Process data - Ratios

- Growth Rates
- Common Size Statements
- Statistical tools
4. Analyze/interpret data - Conclusions/Recommendations
5. Develop/Communicate Conclusions - Analyst Report - Note: Fact v. opinion
6. Follow up
Roles of Financial Statement Analysis

Evaluate performance and position for purpose of making economic decisions
Potential Investment Other

Past
Current Credit
Equity Invt. for Loan decision Merger/

Portfolio Acqn.
Debt Rating
Valuation for a
Recommendation
VC/PE investment
3
1. Regulatory Filings
- IOSCO: Objectives and Principles of Securities Regulation

Protecting investors
Objectives Ensuring that markets are fair, efficient and transparent
Reducing systemic risk
10 categories including Regulators, Auditing, Issuers

2 Principles for Issuers relate directly to Financial Reporting
Principles - Full, Accurate, Timely disclosure of Risk, Results, Other
- Accounting Standards used high and internationally

accepted quality
4
- US Securities and Exchange Commission (SEC)

Securities Act 1933 - information & registration
Significant
Securities Exchange Act 1934 - empowered SEC
Statutes
Sarbanes-Oxley Act 2002 - auditors, internal controls
Securities offerings registration statement 8-K

Forms 10-K, 20-F, 40-F (Annual) Forms 3, 4, 5, 144
Filings Annual report Form 11-K
Proxy Statement/Form DEF-14A
10-Q and 6-K
- European Union
member states regulate their own capital markets

some regulation at EU level
- notably consolidated accounts of EU-listed companies
use IFRS
securities regulation:
- European Securities Committee (ESC)
- European Securities and Market Authority (ESMA)
5
2. Financial Statement Notes and Supplementary Schedules
- additional information on every line of B/S, I/S plus:

major accounting policies
subsequent events
contractual obligations
off-balance sheet items ... etc.
- Business and Geographic Segment Reporting Revenue & (expenses)
disclose key line items by operating segment results reviewed
if ≥ 10% Revenue, Assets, Profit discrete data
all reported segments must add to 75% external revenue
6
3. Management Commentary (MD&A)
- included in 10-K , 10-Q
- unaudited !! (except for Germany)
- IASB provides a framework for ‘decision-useful management commentary’
1. the nature of the business

2. management objectives and strategies Prices Inflation
3. significant resources, risks, relationships significant events/

uncertainties
4. results of operations favorable/unfavorable trends
5. critical performance measures accounting policies

off B/S obligations
- SEC specifies content
4. Audit Reports
- Financial Statements audited by independent Auditor in accordance
with specified auditing standards
independent auditor provides written opinion, the ‘audit report’
- International Auditing Standards (ISA) - Sarbanes-Oxley Act (US)
Reasonable assurance express opinion on internal
Free from material misstatement controls
Prepared in accordance with acceptable standards

- unmodified = unqualified = clean
- modified Qualified
Adverse
Disclaimer
7
4. Audit Reports
IFRS versus the World
- global adoption of IFRS has advanced goal of convergence
- IFRS v. US GAAP differences still exist:

e.g.
Reconciliation between standards
not required
Analysts should monitor developments
new products/transactions may not

have specific guidance
8
Other Sources of Information
- Issuer Sources: earnings calls, presentations, press releases, ...
- Public Third Party: industry whitepapers, analyst reports, social media, ...
- Proprietary Third Party: Bloomberg etc., Analyst reports, industry specific, ...
- Proprietary Primary Research: surveys, conservations, product comparisons, ...
9
Analyzing Income Statements
a. describe general principles of revenue recognition, specific revenue

recognition applications, and implications of revenue recognition choices for
financial analysis
b. describe general principles of expense recognition, specific expense

recognition applications, implications of expense recognition choices for
financial analysis and contrast costs that are capitalized versus those that are
expensed in the period in which they are incurred
c. describe the financial reporting treatment and analysis of non-recurring items

(including discontinued operations, unusual or infrequent items) and changes
in accounting policies
d. describe how earnings per share is calculated and calculate and interpret a
company’s basic and diluted earnings per share for companies with simple
and complex capital structures including those with antidilutive securities
e. evaluate a company’s financial performance using common-size income

statements and financial ratios based on the income statement
10
Analyzing Income Statements
Revenue
- Recognized when earned Risks and Rewards transferred
‘more likely
IFRS than not’
- Converged Standard
1. Identify contract with customer ➞ collectability ‘probable’ US ‘likely to
GAAP occur’
2. Identify separate/distinct performance obligations
3. Determine the transaction price ➞ allocate to distinct obligations
4. Allocate the price to performance obligations
5. Recognize revenue when entity satisfies a performance obligation

‘highly probable not reversed’
Revenue
5. Recognize revenue when entity satisfies a performance obligation
- transfer control of good/service to customer
- entity has present right to payment
- customer has legal title
- customer has physical possession
- customer has significant risks & rewards o’ship
- customer has accepted the good or service
11
Revenue
Revenue
12
Revenue
Expenses
- Recognize in period that:
- economic benefits associated with the expenditure are consumed
OR - Previously recognized economic benefit is lost

Three models Capitalization and
Matching Expensing as Incurred Subsequent Depreciation
or Amortization
Expenses and Revenues Period Costs
Tangible Intangible
e.g. COGS Sales e.g. Admin., Payroll Assets Assets
13
14
Expenses
- Interest: companies must capitalize interest costs associated with
acquiring or constructing an asset that takes a long period
of time to get ready for its intended use
Asset Own Use Asset to Sell

Balance Sheet: Long-Lived Asset Balance Sheet: Inventory
Income Statement: Depreciation Income Statement: Cost of Sales
Cash Flow Statement: Investing Cash Flow Statement: Investing

(CFI) (CFI)
15
Expenses
- companies must capitalize software development costs after a product’s
feasibility is established
Judgment!
16
Expenses
- Recognition: Conservative or Aggressive
early recognition is conservative
- Estimates: Comparisons year v. year / between companies

should consider estimates:
uncollectable debts as a % sales
warranty expenses as a % sales
useful lives of assets
17
Non-Recurring Items
- income statements tell us about the past. What about the future?
- Forecast accuracy improved by removing items less likely to repeat
Unusual or Infrequent Items
- IFRS: income/expenses ‘material or relevant’ to understanding performance
disclosed separately
- US GAAP: ‘material items that are unusual or infrequent or both are shown as
part of continuing operations but disclosed separately.
e.g. Restructuring charges
Sale of a business
18
Non-Recurring Items
- Discontinued Operations: disposed of or established plan to dispose of

a component operation
IFRS and US GAAP require separate disclosure
- component must be separable both physically & operationally
- results presented on a net basis at the bottom of the income statement
- assets and liabilities shown on balance sheet as held for sale
- Changes in accounting policy v. Changes in accounting estimates

new standards may require prospective always prospective
or retrospective adoption
no restatement
management may change policies to
‘better reflect company performance’
- Changes in scope and exchange rates no required disclosures!
Earnings Per Share
- EPS based on net profit (or loss) and net profit or loss from continuing
operations must be disclosed on the face of the income statement
- ‘per share’ refers to: ordinary shares (IFRS) interchangeable

common stock/shares (US GAAP) terms
- Complex Capital Structure

any structure with financial instruments that are potentially
convertible into common stock e.g. Convertible Bonds
Convertible Preferred Shares
These instruments have the
Employee Stock Options
potential to dilute EPS
Warrants
19
Earnings Per Share uses weighted average number

of shares outstanding
- Simple Capital Structure: report basic EPS
- Complex Capital Structure: report basic and diluted EPS

Assumes all dilutive
instruments are converted/
exercised
Basic EPS e.g. Net Income USD 1,950,000

𝐍𝐞𝐭 𝐈𝐧𝐜𝐨𝐦𝐞 − 𝐏𝐫𝐞𝐟𝐞𝐫𝐫𝐞𝐝 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝𝐬 shares outstanding 1,500,000
𝐖𝐞𝐢𝐠𝐡𝐭𝐞𝐝 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 # 𝐬𝐡𝐚𝐫𝐞𝐬 𝐨𝐮𝐭𝐬𝐭𝐚𝐧𝐝𝐢𝐧𝐠 No preferred stock
Earnings Per Share
Basic EPS calculations
Stock split
20
Earnings Per Share
Diluted EPS: Adjust Basic EPS for dilutive instruments
Basic EPS Adjustments
Net income - preferred divs. + savings from conversion
weighted avg. # shares outstanding + shares issued on conversion/exercise
Convertible preferred stock: + convertible preferred dividend

+ shares issued on conversion
Convertible debt securities: + interest (1 - tax rate)

+ shares issued on conversion
Convertible Preferred
21
Convertible Debt
Treasury Stock Method (TSM)
Net income - preferred divs.
weighted avg. # shares outstanding + net shares issued using TSM
- for outstanding stock options & warrants calculate diluted EPS using
the treasury stock method (US GAAP):
1. Assume all dilutive options/warrants have been exercised
2. Assume company uses exercise proceeds to repurchase as many
shares as possible at the average market price for the period
3. Add net number of shares to the denominator of basic EPS
- IFRS uses similar method, unnamed but same result
22
Treasury Stock Method (TSM)
Net income - preferred divs.
weighted avg. # shares outstanding + net shares issued using TSM
Antidilutive Securities
If adjusting for an instrument increases EPS above basic EPS then it

is antidilutive Antidilutive Securities are ignored in the calculation
of diluted EPS
23
Ratios and Common Size Analysis
- Common size income statement - each line stated as a % of sales

- removes the effect of size
- useful for cross sectional/time series analysis
𝐧𝐞𝐭 𝐢𝐧𝐜𝐨𝐦𝐞 𝐠𝐫𝐨𝐬𝐬 𝐩𝐫𝐨𝐟𝐢𝐭

- Profitability Ratios net margin gross margin
𝐬𝐚𝐥𝐞𝐬 𝐬𝐚𝐥𝐞𝐬
24
Analyzing Balance Sheets
a. explain the financial reporting and disclosures related to intangible assets
b. explain the financial reporting and disclosures related to goodwill
c. explain the financial reporting and disclosures related to financial instruments
d. explain the financial reporting and disclosures related to non-current liabilities
e. calculate and interpret common-size balance sheets and related financial ratios
25
Analyzing Balance Sheets

ill?
Goodw
Intangible Assets
- Intangible Assets are - Identifiable can be acquired on a stand alone basis
- Non Monetary
- Without physical substance
- Recognition - IFRS - Cost or Revaluation Model

- US GAAP - Cost only
- useful life may be assessed as finite or indefinite
- Finite : Amortized over useful economic life, review annually

Impairment as for PPE
- Indefinite : No amortization
Annual Review of Assumption and test for impairment
Intangible Assets Probable Future Economic

Benefit
- Identifiable intangible asset recognized on balance sheet if:
Cost measured reliably
e.g. Patents, trademarks, licenses
- Internally created intangibles: IFRS - Research Costs (seeking knowledge) expensed

e.g. brands, customer lists, - Development Costs (design/testing) capitalized if
training costs, advertising criteria RE: feasibility, profitability, completion met
US GAAP - expense research and development
- Purchased Intangibles: capitalized if arise from contractual/legal right or can be sold

separately
Analyst Adjustments - Intangibles are viewed with ‘caution’ and some
may exclude them to get “tangible book value”
- B/S : Reduce Assets - I/S : add back amortization to
Reduce Equity pretax income
26
Goodwill
- Goodwill arises on acquisition of one company by another (internally generated
goodwill not recognized)
- Calculation : excess purchase price above fair value of identifiable assets and
liabilities
- Represents: value not recognized on balance sheet e.g. Reputation, Staff skills
intangible assets that have not been recorded e.g. Research

strategic value e.g. Future operating cost savings
- Goodwill capitalized and tested annually for impairment
- Analyst Adjustments - B/S : exclude goodwill

I/S : exclude impairment charges
Financial Instruments
Definition : ‘contract that gives rise to a financial asset of one entity

and a financial liability or equity instrument of another’
(focus on this reading is financial assets)
Realized gains/losses ➞ I/S

Measurement of Financial Assets: Fair Value (Profit and Loss)
Unrealized gains/losses ➞ I/S
Fair Value (other comprehensive income) Realized gains/losses ➞ I/S

Unrealized gains/losses ➞ OCI
Realized gains/losses ➞ I/S

Amortized Cost
Unrealized gains/losses not recognized
27
IFRS : Amortized Cost Method - Cash flows are on specified dates and consist
of principal and interest only (debt)
(US GAAP ‘held to maturity’) - Business model is to hold the asset to maturity
IFRS Fair Value through OCI - Debt

- Business model is to collect cash flows and
(US GAAP ‘available-for-sale’)
sell the asset
- Equity only if irrevocable election at purchase
IFRS only
IFRS Fair Value through P&L - If not in either of the other categories
US GAAP ‘trading’ (debt) - Or if made irrevocable election at purchase

and all equity
Example : Purchase 5% semi-annual coupon bond for EUR 100,000,000
in six months fair value is EUR 102,000,000.
28
Non-Current Liabilities
Long Term Financial Liabilities : Amortized Cost except
- Held for trading
- Derivatives
- Non-derivatives that are hedged by derivatives
Deferred Tax Liabilities : Result from temporary timing differences
e.g. Accelerated depreciation for tax purposes

v. Straight line in accounts
Vertical Common Size Analysis : every line stated as a % of total assets
29
Liquidity Ratios Solvency Ratios

(Ability to meet short-term obligations) (Ability to meet long-term obligations)
Long-Term 𝐓𝐨𝐭𝐚𝐥 𝐋𝐨𝐧𝐠 𝐓𝐞𝐫𝐦 𝐃𝐞𝐛𝐭

𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐀𝐬𝐬𝐞𝐭𝐬 =
Current = Debt-to-Equity 𝐓𝐨𝐭𝐚𝐥 𝐄𝐪𝐮𝐢𝐭𝐲
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬
Debt-to-Equity = 𝐓𝐨𝐭𝐚𝐥 𝐃𝐞𝐛𝐭
𝐓𝐨𝐭𝐚𝐥 𝐄𝐪𝐮𝐢𝐭𝐲
𝐂𝐚𝐬𝐡 + 𝐌𝐚𝐫𝐤𝐞𝐭𝐚𝐛𝐥𝐞 𝐒𝐞𝐜. + 𝐑𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞𝐬
Quick =
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬 𝐓𝐨𝐭𝐚𝐥 𝐃𝐞𝐛𝐭
(Acid Test) Total Debt =
𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬
𝐂𝐚𝐬𝐡 + 𝐌𝐚𝐫𝐤𝐞𝐭𝐚𝐛𝐥𝐞 𝐒𝐞𝐜𝐮𝐫𝐢𝐭𝐢𝐞𝐬

Cash = Financial Leverage = 𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬
𝐓𝐨𝐭𝐚𝐥 𝐄𝐪𝐮𝐢𝐭𝐲
30
Analyzing Statements of Cash Flows I
a. describe how the cash flow statement is linked to the income statement and the
balance sheet
b. describe the steps in the preparation of direct and indirect cash flow statements,
including how cash flows can be computed using income statement and balance
sheet data
c. demonstrate the conversion of cash flows from the indirect to direct method
d. contrast cash flow statements prepared under International Financial Reporting

Standards (IFRS) and US generally accepted accounting principles (US GAAP)
31
Analyzing Statements of Cash Flows I
Linkages Between Statements

Example: Purchases, Sales on Credit Balance Sheet Income Statement Statement Cash Flows
Inventory +100 Revenue - CFO -
1 Jan. Purchase EUR 100 Accounts +100 Cost of Sales -
Inventory on credit Payable
Accounts -100 Revenue -

31 Jan. Pay for Inventory Payable Cost of Sales -
Cash -100 CFO -100
1 Feb. Sell Inventory for Inventory -100 Revenue +150

CFO -
EUR 150 on credit Accounts Cost of Sales +100
Receivable +150
15 Feb. Customer pays Accounts -150 Revenue -

Receivable CFO +150
EUR 150 Cost of Sales -
Cash +150
32

Example: Depreciation Balance Sheet Income Statement Statement Cash Flows
1 Jan. Own equipment, PPE 100 Depreciation CFI -

Expense
-
Cost USD 100
Depreciation for year USD 10
1 July Buy equipment for cash

PPE +200 Depreciation
- CFI -200
Cost USD 200 Expense
Cash -200
Depreciation for year USD 50
Accumulated Depreciation
+35 CFI -
31 Dec. Charge depreciation Depreciation Expense +35
expense for year

Example: Borrowing Balance Sheet Income Statement Statement Cash Flows
Cash +500 Interest CFF +500

31 March Borrow USD 500 -
Expense
Loan +500
Cash -525 Interest CFO/CFF -25

30 Sept. Repay USD 500 +25
Expense
Loan -500 CFF -500
and USD 25 interest
33

Example: Deferred Revenue Balance Sheet Income Statement Statement Cash Flows
Company agrees to manufacture Cash - Revenue - CFO -

a custom piece of equipment Deferred
Revenue -
for a customer for USD 1000
1 Oct. Customer makes a down Cash +300 CFO +300

Revenue -
payment of USD 300 Deferred +300
Revenue
30 Nov. Equipment delivered Cash +700 CFO +700

Revenue +1,000
and balance paid Deferred
-300
Revenue
The Direct Method

Direct presentation lists out cash flows by type to calculate CFO
Most common presentation is indirect, but direct can be constructed using

the income statement and opening and closing balance sheets:
Cash Received from Customers : B/S : Accounts Receivable I/S : Revenue

2018 2017
e.g. B/S: Accounts Receivable 1,012 957 increase 55
I/S: Revenue 23,598
Revenue 23,598
[deduct] Increase in AR (55)
23,543
34
The Direct Method
Cash paid to suppliers B/S : Accounts Payable I/S : Cost of Goods Sold
Inventory
2018 2017
e.g. B/S: Inventory 3,984 3,277 increase 707
Accounts Payable 3,588 3,325 increase 263
I/S: Cost of Goods Sold 11,456
Cost of Goods Sold (11,456)

[deduct] Increase in Inventory (707)
Purchases from Suppliers (12,163)
add
back Increase in Accounts Payable 263
Cash Paid to Suppliers (11,900)
The Direct Method
Cash paid to employees B/S: Salary and Wages Payable I/S: Salary and Wages Expense
2018 2017
e.g. B/S: Salary and Wages Payable 85 75 increase 10
I/S: Salary and Wages Expense 4,123
Salary and Wages Expense (4,123)
add Increase in Salary and Wages Payable 10

back
Cash Paid to Employees (4,113)
35
The Direct Method
Cash paid for other operating expenses B/S: Prepaid Expenses I/S: Other Operating
Accrued Liabilities Expenses
2018 2017
e.g. B/S : Prepaid Expenses 155 178 decrease 23
Accrued Liabilities 1,126 1,104 increase 22
I/S : Other Operating 3,577

Expenses
Other Operating Expenses (3,577)

add
back Decrease in Prepaid Expenses 23
add Increase in Accrued Liabilities 22
back
Cash Paid for Other Operating Expenses (3,532)
The Direct Method
Cash paid for Interest B/S: Interest Payable I/S: Interest Expense
2018 2017
e.g. B/S : Interest Payable 62 74 decrease 12

I/S : Interest Expense 246
Interest Expense (246)

Decrease in Interest Payable (12)
Cash Paid for Interest (258)
36
The Direct Method
Cash paid for Income Taxes B/S: Income Tax Payable I/S: Income Tax Expense
2018 2017
e.g. B/S : Income Tax Payable 55 50 increase 5
I/S : Income Tax Expense 1,139
Income Tax Expense (1,139)

add
back Increase in Income Tax Payable 5
(1,134)
The Indirect Method
Instead of disclosing cashflows by type, CFO is calculated by adjusting net income

for : (1) non cash items (2) changes in operating working capital items
Additions
Depreciation & Amortization expense
Depletion expense of natural resources Subtractions
Amortization of bond discount Amortization of bond premium
Loss on sale/write-down of assets Gain on sale of assets
Loss on retirement of debt Gain on retirement of debt
Loss on investments under equity method Income on investments under equity method
Increase in deferred income tax liability Decrease in deferred income tax liability
Decrease in current operating assets Increase in current operating assets
(AR, Inventory, Prep.) Decrease in current operating liabilities
Increase in current operating liabilities
(AP, Accruals)
37
Indirect Example (CFO)
Net Income 2,210

Depreciation Expense 1,052
Gain on Sale Equipment (205)
Increase in Accounts Receivable (55)
Increase in Inventory (707)
Increase in Accounts Payable 263
B/S 2018 2017 Change Increase in Salary and Wage Payable 10
Decrease in Prepaid Expenses 23
Increase in Other Accrued Liabilities 22
Decrease in Interest Payable (12)
Increase in Income Tax Payable 5
Net Cash Provided by Operating Activities 2,606
Direct Example (CFO)
Cash Received from Customers [23,598-55] 23 543

Cash Paid to Suppliers [(11,456)-707+263] (11,900)
Cash Paid to Employees [(4,123)+10] (4,113)
Cash Paid for Other Operating Expenses
[(3,577)+23+22] (3,532)
Cash Paid for Interest [(246)-12] (258)
Cash Paid for Income Taxes [(1,139)+5] (1,134)
B/S 2018 2017 Change Net Cash Provided by Operating Activities 2,606
38
Converting Indirect ➞ Direct (CFO)

Three Step Process:
(1) Disaggregate net income into revenues and expenses
(2) Remove non-operating and non-cash items
(3) Convert accruals based revenue/expenses into cash flow by adjusting for changes
in working capital amounts
(1) Revenue [23,598 + 205] 23 803

Expenses [(11,456)+(4,123)+(1,052)+(3,577)+(246)+(1,139)]
(21,593)
2,210
(2) Total Revenue less non-cash items [23,803-205] 23,598
Total Expenses less non-cash items [(21,593)+1,052] (20,541)
(3) Exactly as per direct method!
Cash Flows From Investing Activities

Most common components are cash flows from purchase/sale of PPE:
Purchase: cash spent on additions is an outflow from investing activities
Sale : cash received from disposals is an inflow from investing activities
Net PPE on balance sheet also changes due to depreciation which is not a cash flow
if historic cost and depreciation are given separately:
Beginning Historic Cost PPE x Beginning Accumulated Depreciation x
Additions x Accumulated Depreciation of Disposals (x)
Historic Cost of Disposals (x) Depreciation Expense x
Ending Historic Cost PPE x Ending Accumulated Depreciation x
If only given net PPE : Beginning Net PPE x
Additions x
NBV of Disposals (x)
Depreciation Expense (x)
Ending Net PPE x
39

2018 2017 Beginning Historic Cost PPE 12,745
Additions 1,300
Historic Cost of Disposals (1,057)
Ending Historic Cost PPE 12 988
Beginning Accumulated Depreciation 2,891

Accumulated Depreciation of Disposals (500)
Ending Accumulated Depreciation 3,443
Beginning Net PPE 9,854

Additions 1,300
NBV of Disposals (557)
Depreciation Expense (1,052)
Ending Net PPE 9,545

Beginning Historic Cost PPE 12,745
Additions 1,300 Cash Paid for Purchase of Equipment (1,300)
Historic Cost of Disposals (1,057) Cash Received from Sale of Equipment 762
Ending Historic Cost PPE 12 988 Net Cash Used for Investing Activities 538
Beginning Accumulated Depreciation 2,891

Accumulated Depreciation of Disposals (500)
Ending Accumulated Depreciation 3,443 Proceeds 762
NBV of Disposal 557
Beginning Net PPE 9,854 Gain on Sale 205
Additions 1,300
NBV of Disposals (557)
Depreciation Expense (1,052)
Ending Net PPE 9,545
40
Cash Flows From Financing Activities

Cash Flows from sources of finance (debt and equity) and dividends paid
(although there is a choice under IFRS for dividends paid)
Movements in debt and equity are straightforward to calculate from the balance sheet
Dividends paid can be calculated using net income and retained earnings:
Beginning Retained Earnings 2,876
Net Income 2,210
Dividends (1,120)
Ending Retained Earnings 3,966
Cash Paid to Retire Long-Term Debt (500)

Cash Paid to Retire Common Stock (600)
Cash Paid for Dividends (1,120)
Net Cash Used for Investing Activities (2,220)
US GAAP v. IFRS
US GAAP : Interest Received CFO IFRS : Interest Received CFO or CFI
Interest Paid CFO Interest Paid CFO or CFF
Dividends Received CFO Dividends Received CFO or CFI
Dividends Paid CFF Dividends Paid CFO or CFF
Bank Overdrafts Part of Cash Bank Overdrafts CFF

Taxes Paid CFO Taxes Paid CFO or CFI or
CFF
Format of Statement : US GAAP : Direct or Indirect (Direct encouraged)

Reconciliation of Net Income to CFO must be provided
IFRS : Direct or Indirect (Direct encourage)
41
Analyzing Statements of Cash Flows II
a. analyze and interpret both reported and common-size cash flow statements
b. calculate and interpret free cash flow to the firm, free cash flow to equity, and
performance and coverage cash flow ratios
42
Analyzing Statements of Cash Flows II
Analyze Cash Flow Statements

Evaluation of the cash flow statement involves: 1. Assessment of sources and uses of
cash in CFO, CFI, CFF
2. Assessment of the main drivers of cash
flow in CFO, CFI, CFF
1. Major Sources and Uses
Major sources of cash for a company vary with its stage of growth
Mature Companies: Operating activities should be primary source ➞ CFO can be used in
investing or financing activities
if profitable opportunities exist if no profitable opportunities exist
New/Growth Stage Companies: CFO likely to be negative for a period, must eventually
turn positive
Long Run : Desirable for CFO to cover capital expenditure
Main Drivers of Cash Flows

2. Analyze Main Drivers of Cash Flows
CFO : Is the company generating cash from its operation? How?
- movements in Receivables, Inventories, Payables
- compare CFO to Net Income (earnings quality)
- CFO > Net Income due to non-cash charges
- Net Income > CFO may indicate poor earnings quality
CFI : Identify each line as a source or use of cash
- is the company using cash to invest in PPE, make acquisitions, invest in liquid assets
- what sources of cash are being used to cover investments, excess CFO,
CFF or sales of assets (CFI)?
CFF : Is the company raising capital or repaying capital
- if consistently raising capital, when is repayment required
- CFF will also include dividend payments
43
E.G. Group Danone
2016 2017
CFO 2,652 2,958
CFI (848) (11,437)
CFF (1,616) 8,289
Ex Rates (151) 272
Inc/dec Cash 38 81
1. Major sources and uses?

2. Does CFO cover CAPEX?
3. What is the relationship between net income and CFO?
Common Size Statements and Ratios

There are two approaches to common size cash flow statements:
(1) Every inflow is shown as a % of total inflows
(outflow) (outflows)
- Direct Method - Indirect Method
44
Common Size Statements and Ratios

(2) Each line item is expressed as a % of net revenue useful in forecasting
1. Trend in depreciation?
2. Trend in CAPEX?
3. CFO v. Net Income
Free Cash Flow Measures

Operating cash flows should be sufficient to cover capital expenditures:
CFO - Capital Expenditures = Free Cash Flow (FCF)
Analysts calculate two FCF measures for valuation purposes:
(1) Free Cash Flow to the Firm (FCFF) : FCF available to both debt and equity investors
after operating expenses and taxes are paid
(2) Free Cash Flow to Equity (FCFE) : FCF available to equity investors after borrowing
costs have been paid
(1) Free Cash Flow to the Firm (FCFF)
FCFF = Net Income + Non Cash Charges - Working Capital Investment - Fixed Capital Investment
+ Interest(1-𝐭)
FCFF = NI + NCC + Int(1-𝐭) - FCInv - WCInv
(2) Free Cash Flow to Equity (FCFE)

FCFE = Net Income + Non Cash Charges - Working Capital Investment - Fixed Capital Investment
+ Net Borrowings - Net Repayment
FCFE = NI + NCC - FCInv - WCInv + NB
45

FCFF Calculation
Assume a marginal tax rate of 34%
FCFF = NI + NCC + Int(1-𝐭) - FCInv - WCInv

(2) Free Cash Flow to Equity
FCFE = CFO - FCInv + Net Borrowing
(- Net Debt Repayment)
46
Cash Flow Ratios
47
Analysis of Inventories
a. describe the measurement of inventory at the lower of cost and net realisable
value and its implications for financial statements and ratios
b. calculate and explain how inflation and deflation of inventory costs affect the
financial statements and ratios of companies that use different inventory
valuation methods
c. describe the presentation and disclosures relating to inventories and explain

issues that analysts should consider when examining a company’s inventory
disclosures and other sources of information
48
Analysis of Inventories
Measurement of Inventory
IFRS: Value inventory at lower of cost and net realizable value
if NRV < cost write-down charged to income statement
subsequent increases in NRV recognized and reduce
Cost of Sales in the income statement (reversal)
US GAAP: Any method other than LIFO, Retail Inventory method:

same as IFRS except: no reversals permitted
LIFO, Retail Inventory method:
lower of cost or market value
market value is defined as current replacement cost
Exception: Agricultural products, forest products, minerals, commodity broker-traders

(both)
Measurement of Inventory
Impact of write-down on ratios
Write-down: Reduces inventory (current, total assets ↓) less likely using LIFO
Increases expenses (net income, equity ↓)
Solvency Ratios Liquidity Ratios Profitability Ratios Activity Ratios
[negative effect] [negative effect] [negative effect] [positive effect]
Decrease in Equity Decrease in Current Assets Decrease in Net Income Decrease in Assets
Increase in COGS
49
Effect of Inflation and Deflation

How the cost of inventory is allocated between inventory (B/S) and cost of sales (I/S)
depends on the accounting method used
Key Point: FIFO method: oldest units in I/S LIFO method: newest units in I/S
newest units in B/S oldest units in B/S
Inflation: FIFO method: Higher Profit (I/S) LIFO method: Lower Profit (I/S)
(Rising Input Prices) Higher Inventory (B/S) Lower Inventory (B/S)
Higher Taxes Lower Taxes
Presentation and Disclosure

Choice of accounting method for inventory affects - Cost Sales, Gross Profit, Net Income
- Inventory, Current Assets, Total Assets, Equity
IFRS Disclosures
Accounting Policy adopted
Total carrying amount broken down by: merchandise, raw materials, prodn supplies, work
in progress, finished goods
Carrying amount of inventories held at fair value less costs to sell
Amount of inventories recognized as an expense during period (cost of sales)
Amount of write-downs recognized as an expense in the period
Amount of any reversal of any write-down recognized as a reduction in cost of sales in
the period
Circumstances/events that led to reversal
Carrying amount of inventories pledged as security for liabilities
US GAAP Disclosures
As above: Less: Disclosures on reversals
Add: Significant estimates applicable to inventories
Any material income resulting from a LIFO liquidation
50
Analysis of Long-Term Assets
a. compare the financial reporting of the following types of intangible assets:

purchased, internally developed, and acquired in a business combination
b. explain and evaluate how impairment and derecognition of property, plant, and
equipment and intangible assets affect the financial statements and ratios
c. analyze and interpret financial statement disclosures regarding property, plant, and
equipment and intangible assets
51
Analysis of Long-Term Assets
Intangible Assets
Definition : Non-Monetary
Lack Physical Substance
IFRS Definition Criteria: (1) Identifiable Goodwill!
(2) Under the control of the company
(3) Expected to generate future economic benefits
IFRS Recognition Criteria: (1) Probable that the expected future economic benefits will flow to
(2) Cost of the asset can be reliably measured the company
Purchased (other than Bus. Combn) Developed Internally Acquired in a Business Combination
Record on B/S at fair value (cost) Expensed as incurred Purchase price allocated to identifiable
(cost allocated to each asset if part Exceptions: Development assets & liabilities at fair value
of a group)
Capitalizing versus Expensing IFRS: Must meet the definitional
Higher Assets Lower Assets and recognition criteria
Higher CFO Lower CFO US GAAP: (1) arises from contractual
Lower CFI Higher CFI or legal right
or (2) can be separated from co.
Goodwill
In a business combination the excess of the
purchase price over and above the fair value
of identifiable assets and liabilities acquired
is goodwill
Purchase Price x
FV ID NA Acquired (x)
Goodwill X
Goodwill is not separable

has indefinite life
is not amortized
is checked annually for impairment
52
Intangible Assets
Internally Developed: Specific rules for research and development and software
development costs
Research and Development
IFRS Research (gaining knowledge and understanding) expensed
Development (application to design new/improved products) capitalized technically
feasible
intent to use/sell
US GAAP Research and development expensed
Exception: software development costs - capitalize when technologically feasible
probable completion (for
internal use project)
Impairment
Property, Plant, and Equipment
At the end of each period the company ‘assesses whether there are indications of impairment’
(obsolescence, decline demand for product etc.)
If there are indications Impairment Test
IFRS (one step) US GAAP (two step)

Impaired if carrying value > recoverable amount 1. If undiscounted cash flows
from use < carrying value
Higher of Value in use asset is impaired
Fair value less 2. If impaired, calculate the
costs to sell amount of impairment as:
carrying value - fair value
Impact on Accounts : PPE, Total Assets, Equity ↓
Not a cashflow!
Net Income ↓
53
Impairment
PPE Example
1. Under IFRS, what would the company report for the machine? 2. Under US GAAP, what would the company report for the machine?
Impairment
PPE Example (2)
1. Under IFRS, what would the company report for the machine? 2. Under US GAAP, what would the company report for the machine?
54
Impairment
Intangible Assets : Finite Lives
As with PPE, assessed for indications of impairment e.g. Adverse change in legal or
economic factors
Accounting is as for PPE
Intangible Assets : Indefinite Lives

Intangible assets with indefinite lives are not amortized but : Reviewed annually for impairment
Long-Lived Assets Held-For-Sale

Long-lived assets held-for-sale if Management’s intent is to sell
Sale is highly probable
Tested for impairment when classified as held-for-sale
If carrying value > fair value less costs to sell, recognize impairment loss
(Held-for-sale assets are not depreciated or amortized)
Reversal of Impairments
What if after recording an impairment, recoverable amount recovers?

IFRS US GAAP
Reverse : Record a credit in income statement (I/S) Only for held-for-sale
Increase asset carrying value (B/S)
Can only reverse up to previous carrying amount
Held-for-use, or held-for-sale losses can be reversed
Impact on Accounts : Long-lived assets, total assets, equity ↑ Not a cash flow!
Expenses decrease so net income ↑
55
Derecognition
Derecognize an asset when it no longer provides economic benefit
If sale is highly probable move to held for sale
Gain/Loss on Sale
Proceeds From Sale* x CFI (cash flow statement), + cash B/S
Net Book Value (x) Remove from PPE in B/S
Gain/(Loss) x/(x) Income Statement - other gains and losses
- separate if material
*[zero if abandoned]
= FV asset given up
or FV asset acquired if
Asset Exchange ‘more evident’
or CV asset if no reliable FV
Carrying value removed, replaced with fair value asset acquired
[G/L = zero]
Disclosures
IFRS US GAAP
Measurement Basis (Historic Cost, Fair Value)
Depreciation Method (straight line, declining balance etc.)
Gross Carrying Amount start and end of period
Accumulated Depreciation + estimated amortization
Depreciation Expense for Period expense for next 5 yrs.
Reconciliation of Carrying Amount from Beginning to End Period
Major Classes of Assets
Justification of Indefinite Lives for Intangibles
Restrictions on title, pledges as security
Contractual Agreements to Acquire PPE
Revaluation Model : Date of revaluation
Details of fair value calculation not allowed
Carrying amount under cost model
Revaluation surplus
56
Disclosures
IFRS US GAAP
Amount of impairment losses
Circumstances leading to impairment + method of determining fair value
Amount of impairment losses reversed not allowed for held-for-use
Circumstances leading to reversal
Where impairment losses are recognized
Note: If company uses ‘function of expense’ method for income statement depreciation
expense is shown separately
Using Disclosures
The extensive amount of PPE disclosure can be used to calculate:
1. Fixed Asset Turnover : Total Revenue
Higher Ratio = More efficient use of assets
Average Net Fixed Assets
2. Asset Age Ratios : Historic Cost = Estimated Total Useful Life

Annual Depreciation Expense
Accumulated Depreciation = Estimated Age of Assets

Annual Depreciation Expense
Assumptions : Straight Line Depreciation

No Salvage Value
57
Using Disclosures
Orange BCE Verizon
Total Life: 97,092 69,230 246,498 - 806
4,708 3,037 14,741
20.6 22.8 16.7
Age : 70,427 45,197 157,930

4,708 3,037 14,741
15.0 14.9 10.7
Remaining : 5.6 7.9 6.0

Life
58
Topics in Long-Term Liabilities and Equity
a. explain the financial reporting of leases from the perspectives of lessors and lessees
b. explain the financial reporting of defined contribution, defined benefit, and stock-
based compensation plans
c. describe the financial statement presentation of and disclosures relating to long-

term liabilities and share-based compensation
59
Topics in Long-Term Liabilities and Equity
Leases
Lease : A contract that conveys the right to use an asset for a period of
time in exchange for consideration
Lessee : Pays consideration and uses an asset (e.g. a manufacturer leases a warehouse to
use)
Lessor : Receives consideration for granting the use of an asset (e.g. an investment
property company)
Requirements For Lease Accounting
The Contract Must: identify a specific underlying asset
give the customer the right to obtain largely all of the economic
benefits from the asset over the contract term
give the customer, not the supplier, the ability to direct how and for
what objective the underlying asset is used
Leases
Advantages to Leasing (v. Purchasing):
less cash required up front
lower ‘finance’ cost than an unsecured loan - asset acts as security
convenience and lower risks of ownership e.g. obsolescence
lessor widens market for customers
lessor receives income stream over the lease term
Accounting Standards classify leases as operating : Resembles a rental agreement

or finance : Resembles the purchase of an asset
Classified as finance if it meets any of the following criteria:
1. The lease transfers ownership of the underlying asset to the lessee
2. The lessee has an option to purchase the underlying asset and is reasonably certain it
3. The lease term is for a major part of the asset’s life will do so
4. The PV of the sum of lease payments equals or exceeds substantially all the FV of the
asset
5. The underlying asset has no alternative use to the lessor
60
Leases
Is it a lease? specific asset
largely all benefits over term
customer directs use
Finance lease? transfers ownership

option to purchase (reasonably
certain)
term = major part of asset’s life
PV pmts. substantially all of FV
asset no other use to lessor
Leases
Exemption from lease accounting : Term ≤ 12 months (IFRS and US GAAP)
Asset ≤ USD 5,000 (IFRS only)
Lessee Accounting (IFRS)
Operating and Finance Leases treated identically:
Lease Liability B/S at inception Right-of-Use Asset
Present value* of future lease payments Present value* of future lease payments
(amortize using effective interest method) (amortized, usually straight line)
Interest expense I/S during life Amortization expense
Principal Repayment : (CFF) C/F during life

Interest Payment : (CFO)/(CFF)
* [discount rate = implicit rate or estimated secured borrowing rate]
61
Leases (IFRS)
Leases
Lessee Accounting (US GAAP)
Finance Leases treated identically to IFRS
Operating Leases treated differently
US GAAP Operating Leases

Lease Liability B/S at inception Right-of-Use Asset
Present value* of future lease payments Present value* of future lease payments
(amortize using effective interest method) (amortization = lease payment - interest)
I/S during life
Lease Expense
(one line, equal to lease payment)
Lease Payment : (CF0) C/F during life
* [discount rate = implicit rate or estimated secured borrowing rate]
62
Leases (US GAAP)
Leases (US GAAP)
63
Leases
Lessor Accounting
IFRS and US GAAP pleasingly similar
Finance Lease
Derecognize Leased Asset B/S at inception Lease Receivable Asset
Remove from Balance Sheet Present value* of future lease payments
Reduced by pmts. using effective interest
method
I/S at inception
Difference = Gain/Loss
I/S during life
Interest income (Revenue if primary activity)
C/F during life
CFO
[ * discount rate = implicit rate]
Leases
Lessor Accounting
IFRS and US GAAP pleasingly similar
Operating Lease
Retain Leased Asset B/S at inception
Do Not Remove from Balance Sheet
I/S during life
Lease Revenue Recognized Straight Line
Cash Flow during life

CFO
64
Leases
Employee Compensation
Salary Defined Contribution Pension Plan
Bonus Defined Benefit Pension Plan
Health & Life Insurance Premiums Share Based Compensation
Usually vest immediately or shortly after Deferred - employees may earn compensation
the grant date in the current period but receive in future
Reported as an expense in the period periods
in which they vest Amount may be based on future variables
e.g. Final Salary, Stock Price
Defined Contribution Plan

Company pays into plan, no further
obligation
Payment recorded as an expense in
the period
65
Defined Benefit Plan
Company promises a value of future benefits to be paid in retirement:
e.g. Annual payment during retirement until death equal to # Yrs. service × Final Salary
60
Company has an obligation which it will fund with assets
PV of future obligation Held in separate legal entity (Pension Trust Fund)

Discount Rate = yield on high quality corp. bond Company makes payments into fund which
Assumptions used significantly affect obligation are invested until needed
Fund makes pension payments when required
PV of future obligation > Fair value plan assets [deficit]
Company reports a net pension liability (B/S)
PV of future obligation < Fair value plan assets [surplus]

Company reports a net pension asset (B/S)
Accounting For Defined Benefit Plan
The change in the net pension asset/liability over the year is recognized in either
the income statement or other comprehensive income (OCI). The split differs between
IFRS and US GAAP
IFRS
Income Statement Other Comprehensive Income
Service Cost - PV increase in benefit earned Remeasurements - (1) Actuarial Gains/Losses from
by employee in the year changes in assumptions
- Past service costs resulting from (e.g. Avg. service life, salary increases etc.)
changes in plan rules - (2) Difference between the actual
Net Interest return on assets and return
Expense/Income - Change in the PV of the net included in interest (P&L)
pension asset/liability due to the
passage
= (Net Pension Asset/Liability × Disc. Rate)
66
US GAAP
Income Statement Other Comprehensive Income
Service Cost - PV increase in benefit earned Actuarial
by employee in the year Gains/Losses - on obligation (as for IFRS)
- actual return on assets less
Interest Expense - interest accrued on beginning expected return on assets (I/S)
plan obligation using discount [Typically amortized into income statement over
rate time. May be recognized immediately in I/S]
Expected Return
on Assets - return plan assets would have - past service costs resulting from
generated using expected rate changes in plan rules
of return [Amortized into income statement over
future service period of employees]
Share-Based Compensation
Aim is to align employee’s interests with those of shareholders - does it though?
Potentially involves no cash outlay but:
is a form of compensation expense
has the potential to dilute EPS
may be cash settled
may cause management to be risk averse/take excessive risks
Stock Grants
Compensation expense based on fair value of stock on the grant date
Expense recognized over the plan’s vesting schedule
Outright - Allocated over service period (current period unless specified)
Restricted - Allocated over service period related to performance
67
Stock Options
Compensation based on fair value of option on grant date
Valuation Mode Required (Black Scholes, Binomial?)

Standards do not specify a particular model but require that it:
(1) Be consistent with fair value measurement
(2) Be based on established principles of financial economic theory
(3) Reflect all substantive characteristics of the award ➞ if dependent on events after
Key Valuation Inputs the grant date wait until
Exercise Price those facts are known
Stock Price Volatility
Estimated life of award
Estimated # options that will be forfeited
Dividend yield
Risk-Free interest rate
Accounting For Stock Options
Grant Date Vesting Date Exercise Date
Service Period Price at exercise date irrelevant

to compensation expense
Compensation expense recognized Record cash and APIC
over Service Period
Add to additional paid in
capital
No impact on equity!
Cash Settled Share Compensation

Stock Appreciation Rights (SARs) Reward for increase in share value without issuing shares
Limited potential to induce risk aversion
Fair Value allocated as expense over the service period
68

Leases
B/S : Assets : Right of Use Asset
(may be grouped in ‘other’ if not significant)
Liabilities: Lease Liability
Lessee Disclosures
Carrying Amount of ROU Asset at end of period (by class)
Total cash outflow for leases
Interest Expense on lease liabilities
Depreciation charges for ROU assets (by class)
Additions to ROU Assets
Maturity and qualitative analysis of lease liabilities and activities:
- Nature of the lessee’s leasing activities
- Future cash outflows to which lessee is potentially exposed (that are not in liabilities)
- Restrictions or Covenants imposed by leases
- Sale and leaseback transactions

Lessor Disclosure
Finance Leases - Amount of selling Profit or Loss
- Finance income on the net investment in the lease
- Income relating to variable lease payments not included in measurement
of the lease
- Qualitative and Quantitative explanation of significant changes in the
carrying amount of the net investment
- Maturity Analysis of lease payments receivable - undiscounted CF Yrs. 1-5
thereafter
Operating Leases - lease income

- income relating to variable lease payments not based on an index or rate
- disaggregated information about each class of PPE subject to operating
leases
- maturity analysis of lease payments receivable - undiscounted CF Yrs. 1-5
thereafter
Plus : Qualitative and Quantitative information about leasing activities

How lessor manages risks associated with rights it retains in underlying leased assets
69

Postemployment Plans
Defined Contribution Pension Plan - Amount recognized in income statement for period
Defined Benefit Pension Plan
Characteristics and Risks
Identify and explain amounts in financial statements
Describe how plan may affect the amount, timing and uncertainty of the entity’s future
In addition, specific disclosures required include: cash flows
Nature of benefits provided, regulatory framework, governance, risks

Reconciliation opening net position to closing net position
Composition of plan assets by category (asset class)
Indications of the effect of the plan on the entity’s future cash flows
Sensitivity analysis showing how changes in assumptions would impact the financial statements
Discount Rate
Future Salary increases etc.

Share-Based Compensation
Description of each type of share-based payment arrangement - Vesting Requirements
- Maximum Term of Options
- Method of Settlement
Options : Number outstanding at start of period
Granted during period
Forfeited during period
Exercised during period
Expired during period
Outstanding at the end of the period
Exercisable at the end of the period
Other equity instruments granted during the period - number and weighted average fair value
- How fair value was measured
70
Analysis of Income Taxes
a. contrast accounting profit, taxable income, taxes payable, and income tax expense
and temporary versus permanent differences between accounting profit and taxable
income
b. explain how deferred tax liabilities and assets are created and the factors that
determine how a company’s deferred tax liabilities and assets should be treated for
the purposes of financial analysis
c. calculate, interpret, and contrast an issuer’s effective tax rate, statutory tax rate, and
cash tax rate
d. analyze disclosures relating to deferred tax items and the effective tax rate
reconciliation and explain how information included in these disclosures affects a
company’s financial statements and financial ratios
71
Analysis of Income Taxes
Review of Terminology
Accounting Profit = Pretax Income: Reported in income statement, based on accounting standards
Taxable Income : Income subject to income taxes under relevant tax laws
Account Profit and Taxable Income are likely to be different
due to temporary differences and permanent differences
Income Tax Payable : Based on taxable income, appears on the balance sheet
Income Tax Paid : Cash amount paid, reduces income tax payable
Carrying Amount : The amount at which an asset/liability is recorded in the financial statements
Tax Base : The amount at which an asset/liability is valued for tax purposes
Carrying value and tax base are likely to be different
due to temporary differences and permanent differences
Taxable Temporary Difference Deductible Temporary Difference do not reverse

Carrying Value Asset > Tax Base Carrying Value Asset < Tax Base do not give rise to deferred tax
Carrying Value Liab. < Tax Base Carrying Value Liab. > Tax Base
[deferred tax liability] [deferred tax asset] [company tax rate ≠ statutory tax
rate]
Review of Terminology
Tax Expense = provision for income taxes : appears in income statement :
Tax Expense : Income tax payable X

Changes in deferred tax assets/liabilities X/(X)
X
72
Deferred Tax Assets/Liabilities

DTA’s and DTL’s result from temporary differences and are shown on B/S
Assets
Carrying value > tax base ➞ deferred tax liability on B/S DTL
Carrying value < tax base ➞ deferred tax asset on B/S DTA
Liabilities
Carrying value > tax base ➞ deferred tax asset on B/S DTA
Carrying value < tax base ➞ deferred tax liability on B/S DTL
Calculation
Balance Sheet DTA/DTL : (temporary difference × tax rate)
Income Statement DT charge/credit : change in DTA/DTL during year
Valuation Allowance
Deferred tax assets should only be recognized if the company expects to be able to
realize the economic benefit of the deferred tax asset
If this is in doubt for existing DTA : IFRS : write down the DTA
US GAAP: create a valuation allowance to offset DTA
Depreciation relates to PPE that cost 20,000 at start of year one. Assume statutory tax rate is 30%
End of: YR 3 YR 2 YR 1
Carrying Value 14,000 16,000 18,000
Tax Base 11,429 14,286 17,413
Temporary Difference 2,571 1,714 857
Balance Sheet : DT Liability 771 514 257
Income Statement : DT Charge 257 257 257
73
Income Tax Expense: Tax Payable (30%) 7,753 4,327 1,153

Tax Payable 7,753 4,327 1,153
Deferred Tax Charge 257 257 257
8,010 4,584 1,410
Practice Questions
74
Calculating Tax Rates

Statutory Tax Rate
The corporate income tax rate in the country in which the company is domiciled
Effective Tax Rate
An accounting ratio: Reported Income Tax Expense
useful for forecasting NI
Pre-Tax Income
Cash Tax Rate

An accounting ratio: Tax Paid in Cash in Period
useful for forecasting CF
Pre-Tax Income
Statutory ≠ Effective due to:
Tax credits
Expenses not deductible for tax purposes
Adjustments to previous years
Withholding taxes on dividends
Activity outside country of domicile
75
effective tax rate consistently lower than statutory /competitors not unusual
analysts should adjust for one-off items
normalized operating income may be used to calculate a normalized tax rate:
- Remove special items
- Remove associates
Analyzing Disclosures
76
Analyzing Disclosures
77
Financial Reporting Quality
a. compare financial reporting quality with the quality of reported results (including
quality of earnings, cash flow, and balance sheet items)
b. describe a spectrum for assessing financial reporting quality
c. explain the difference between conservative and aggressive accounting
d. describe motivations that might cause management to issue financial reports that
are not high quality and conditions that are conducive to issuing low-quality, or
even fraudulent, financial reports
e. describe mechanisms that discipline financial reporting quality and the potential
limitations of those mechanisms
f. describe presentation choices, including non-GAAP measures, that could be used

to influence an analyst’s opinion
g. describe accounting methods (choices and estimates) that could be used to manage
earnings, cash flow, and balance sheet items
h. describe accounting warning signs and methods for detecting manipulation of

information in financial reports
78
Financial Reporting Quality
FRQ v. Quality of Reported Results

Financial Reporting Quality = Quality of information in Financial Reports
High-Quality Reporting provides decision-useful information:
Relevant (affects decision, material)
Faithful Representation (complete, neutral, free from error)
Enhancing characteristics of decision useful information:
Comparability, verifiability, timeliness, understandability
Quality of reported results (earnings quality) = quality of earnings - income statement

cash-flow - cash flow statement
position - balance sheet
High earnings quality result from activities that are
Sustainable
Provide sufficient return on investment
Key Point : Assessing earnings quality only possible with at least a basic level
of Financial Reporting Quality
Assessment Spectrum
Financial Reporting Quality ranges from high : Relevant, Complete, Neutral, Free from error
to low : Pure Fabrication
Earnings Quality ranges from high : Sustainable, high (adequate ROI)
to low : Unsustainable, low (inadequate ROI)
Best :① GAAP, Decision-Useful, Sustainable, Adequate Returns
② GAAP, Decision-Useful, Sustainable ?
79
Assessment Spectrum
Best : ① GAAP, Decision-Useful, Sustainable
② GAAP, Decision-Useful, Sustainable?
③ GAAP, Biased accounting choices
Aggressive : Improve Financial Performance, Position in period
Increase revenue, earnings, CFO
Decrease expenses, level of debt
Conservative : Improve Financial Performance, Position in future periods
Decrease revenue, earnings, CFO
Increase expenses, level of debt
Examples: earnings smoothing : Conservative choices today
Aggressive choices in future
Transparency of disclosure : Do disclosures obscure unfavorable information
Assessment Spectrum
Best : ① GAAP, Decision-Useful, Sustainable
② GAAP, Decision-Useful, Sustainable?
③ GAAP, Biased accounting choices
④ GAAP, Earnings management
‘intentional choices that create biased financial reports’
I know what you’re thinking, didn’t we just... ?
Distinction (somewhat arbitrary) : intent
Real Actions: delay research expenditure to next period , earnings ↑
Accounting Choices: increase useful economic life assets , depn. ↓ , earnings ↑
⑤ Non Compliant Accounting

Incorrect treatment of transactions
⑥ Fictitious Transactions
Making stuff up
80
Conservative v. Aggressive
Unbiased financial reporting is the ideal (faithful representation: neutral)
Investors: may prefer conservative choices (positive surprises are acceptable)
Management: may prefer aggressive choices (look how well I’m doing, reward me)
Standards ① may require conservative treatment
e.g. Research and development costs expensed
Litigation losses recognized when ‘probable’
The amount of time we spent on the rules for revenue recognition v.
expenses
② Require Judgment in their application
e.g. Big Bath Accounting
Cookie Jar Reserves
Benefits of Conservatism: Protection for lenders taking on risk (asymmetric information)

Reduces chances of litigation
Reduces chances of regulators/politicians catching heat
If taxable income = Accounting income ➞ Reduce Taxes
Motivation For Mischief

What motivates an otherwise all round good human being to dabble with the
lower end of the quality spectrum?
Mask Poor Performance
Meet or Beat Analyst Expectations
Manipulate Compensation
Avoiding debt covenant violations? If highly-leveraged, unprofitable
Conditions Conducive to Mischief
Opportunity e.g. Poor Internal Controls
Fraud
Triangle
e.g. Incentives e.g. Everyone agreed it was
a good idea
Pressure/Motivation Rationalization
81
Discipline !
Are there mechanisms that provide discipline?
Markets : Companies compete for capital ➞ its cost is a function of perceived risk
Regulatory Authorities: Registration Requirements - before IPO

Disclosure Requirements - We have seen these. A lot of them.
Auditing Requirements - We have seen this. We’re about to again
Management Commentaries - ‘MD&A’, ‘Management Report’
Responsibility Statements - Sarbanes-Oxley & internal controls
Regulatory Review of Filings - Periodically review financial reports
Enforcement Mechanisms - Fines, Prosecution, Public Announcements
Auditors : Independent Opinion - Fairly Presented, key audit matters, internal controls
Limitations - expectation gap, sampling, independence?
Private Contracting : loan agreements & covenants ➞ motivation for manipulation?
➞ motivation for monitoring
Presentation Choices
GAAP Earnings : calculated using relevant accounting standards
Non-GAAP Earnings (pro forma earnings) : No rules. Justification? comparability
e.g. Investors use EBITDA to eliminate ‘noise’ of different dep’n./amt’n. policies
Common exclusions in Pro-Forma (non-GAAP) earnings:

Rental payments for leases EBITDAR
Equity based compensation
Acquisition related charges
Impairment charges
Litigation costs
Loss/Gain on extinguishment of debt
Loan covenants may also use non-GAAP earnings measure preferred by the lender
82
SEC definition non-GAAP measures:
Measure of Performance that differs from that presented in the financial statements
Measure of Liquidity that differs from cash flow or CFO calculated using GAAP
If non GAAP measures are reported:
SEC: Most directly comparable GAAP measure must be displayed with equal prominence
A reconciliation to the GAAP measure must be provided
Management must justify its reasoning for believing it is useful
Management must disclose additional purposes, if material, for which it is used
Excluding charges that require cash settlement from liquidity measures prohibited
Measures that eliminate non-recurring items cannot exclude items very likely to re-occur
IFRS: Definition and explanation of non-IFRS measures must be given

A reconciliation to the IFRS measure must be provided
Management must explain why it is relevant
83
Management Methods
Earnings and Balance Sheet
Timing of Revenue Recognition: Point at which Risks & Rewards transferred
Goods leave warehouse 31 Dec. Arrive at customer 2 Jan.
Shipping Point Destination
(Revenue this year) (Revenue next year)
Channel Stuffing: Deep discounts at quarter end, send goods without orders (DSO?, Returns?)
Bill and Hold : Goods sold but held by seller - minimal effort to fabricate
Revenue Arrangement : Manage allocation of revenue to performance obligations
Rebates : Manage the recognition of rebate allowance

Inventory Cost-Flow Assumption : FIFO v. Weighted Av. v. (LIFO)
Uncollectible Receivables : Manage allowance for uncollectible receivables
Management Methods
Earnings and Balance Sheet
Deferred Tax Assets : Manage recognition of valuation allowance
Depreciation Method : Manage UEL, salvage value, depreciation method

Capitalization v. Expensing: Incorrectly capitalize/expense costs
Acquisition/Goodwill : Underestimate fair value acquired assets
Capitalizing Intangibles : Manage timing of recognition e.g. Development Costs
Warranty Reserves : Manage allowance for warranty expenses matched to revenue
Related Party Transactions: Undertake transactions with related parties at favorable rates
84
Management Methods
Cash Flow
Cash flow from operations is ‘closely scrutinized’ by investors
accruals based earnings (I/S) that don’t turn into cash flow may indicate shenanigans
‘more insulated’ from managerial manipulation than earnings but not immune to it
Accounts Payable : Delaying payment of suppliers increases CFO

Capitalizing Interest : Interest incurred in relation to construction of assets CFI
IFRS Choices : Interest Received CFO / CFI
Dividends Received CFO / CFI
Interest Paid CFO / CFF
Dividends Paid CFO / CFF
Warning Signs
“The choices management makes to achieve desired results leave a trail, like tracks in
sand or snow” (Ciesielski, Henry, Selling)
Revenue
Accounting Policies Note: Evidence of revenue recognition policies that make it easier to manipulate
e.g. FOB shipping, bill-and-hold, barter transactions, rebates, multiple
deliverables
Revenue Relationships: Revenue growth v. competitors v. industry v. economy
Accounts Receivable v. Revenue Trend
Asset Turnover
Inventory
Inventory Relationships: Trend
Inventory Turnover Ratio
LIFO usage (US GAAP)
Capitalization Policies
Accounting Policies Note: Capitalization Policy v. Competitors/industry practice
85
Warning Signs
Cash Flow v. Net Income
Ratio of CFO/net income : Trend, consistently below I.O
Other
PPE Disclosures : Dep’n methods and UELs
4th Quarter Results: Consistent positive surprises in Q4
Related Party Disclosures: Evidence of related party transactions
Non-Operating Income : If included in revenue
Non-Recurring Expenses: Repetitive non-recurring expenses make no sense
Ratio Analysis : Are ratios superior to competitors - why?
Risk Factors : Young companies with stellar history maturing
Minimalist disclosures by management
Management fixated with earnings
Company cultures
Restructuring charges
Acquisition focus
86
Financial Analysis Techniques
a. describe tools and techniques used in financial analysis, including their uses and
limitations
b. calculate and interpret activity, liquidity, solvency, and profitability ratios
c. describe relationships among ratios and evaluate a company using ratio analysis
d. demonstrate the application of DuPont analysis of return on equity and calculate

and interpret effects of changes in its components
e. describe the uses of industry-specific ratios used in financial analysis
f. describe how ratio analysis and other techniques can be used to model and forecast
earnings
87
Financial Analysis Techniques
Framework
1. Articulate the purpose and context of the analysis

2. Collect input data
3. Process data
4. Analyze/interpret data
5. Develop and communicate conclusions
6. Follow-up
Ratio Analysis
Ratios help with comparability Remove size as a factor
Remove impact of different currencies
Assist in identification of trends
Ratios highlight relationships Between financial accounts

From one point in time to another
Ratios are not the answer Ratios are indicators

Ratios require interpretation
Ratios are at the mercy of GAAP Accounting policies can distort ratios
Ratios may need adjusting to common GAAP
Ratios have no standard form It’s up to the analyst

The universe is limitless
88
Ratio Analysis
The Value of Ratios
Evaluate past performance
Assess current financial position
Provide helpful insights for predicting future
Evaluate changes over time
Compare to peer group
Limitations of Ratios
Finding comparables for multi-divisional companies
Conflicting Ratios: Liquidity v. Solvency
Require Judgment
Accounting Policies
Sources of Data
Financial Statements
Vendors - be wary of varying definitions
Ratios
Vertical Common Size - B/S % of Total Assets
- I/S % of Revenue
- CFS % of Revenue or % cash inflow/outflow
Horizontal Common Size
Each line item expressed as a percentage of same item from base year
e.g. Inventory : 2019 2020 2021 2022 2023
100 110 115 98 99
Cross Sectional Analysis (Relative Analysis) Trend Analysis

Specific metric for one company v. another Use historical data to identify trends
e.g. use Horizontal Common Size
Graphs
Yes. We can use graphs
Regression Analysis
Identification of relationships among variables
89
Categories
Activity Ratios - Efficiency of operations
Liquidity Ratios - Ability to meet short-term obligations
Solvency Ratios - Ability to meet long-term obligations
Profitability Ratios - Ability to generate profits from its resources
Context is King : Ratios are a social animal, they lose their value in isolation
Compare : prior periods, industry norms, competitors, company goals
Set expectations
View in context of Economic Conditions
Activity
( Asset utilization, operating efficiency )
Measures of operational performance - How effectively is company using - working capital
- longer term assets
Working Capital
Turnover and days for inventory, receivables, payables
Turnover : Income Statement Days : Number Days in Period
Average Balance Sheet Turnover Ratio
Cost of Goods Sold Days of Inventory Number Days in Period

Inventory Turnover
Average Inventory on Hand (DOH) Inventory Turnover
Revenue Days of Sales Number Days in Period

Receivables Turnover
Average Receivables Outstanding (DSO) Receivables Turnover
Cost of Goods Sold Number of Days Number Days in Period

Payables Turnover
Average Payables of Payables Inventory Turnover
90
Activity
Cost of Goods Sold Days of Inventory Number Days in Period
Inventory Turnover
Average Inventory on Hand (DOH) Inventory Turnover
High v. Industry : Efficient inventory management?
check revenue growth
or Inadequate inventory levels?
Revenue Days of Sales Number Days in Period

Receivables Turnover
Average Receivables Outstanding (DSO) Receivables Turnover
High v. Industry : Efficient debt collection?
check revenue growth, receivables aging
or Credit terms too stringent?
Payables Turnover Cost of Goods Sold Number of Days Number Days in Period
Average Payables of Payables Inventory Turnover
High v. Industry : not making use of credit terms?
compare to liquidity
or taking early payment discounts?
Activity
( Asset utilization, operating efficiency )
Measures of operational performance - How effectively is company using - working capital
- longer term assets
Working Capital Revenue Dollars of Revenue per Dollar of WC

Turnover Average Working Capital High - greater efficiency
Industry is important
* *
Fixed Asset Revenue Dollars of Revenue per Dollar of FC/TA
Turnover Average Net Fixed Assets High - greater efficiency
[DP] * Low - inefficient?

*
- capital intensive business?
Total Asset Revenue - new business not at full capacity?
Average Total Assets - new assets?
Turnover
91
Activity Ratios
Activity Ratios
92
Activity Ratios
Liquidity Ratios
Ability to meet short-term obligations - level of liquidity required differs by
industry ➞ banking
Adequate? Depends on analysis of historical funding needs, access to capital
Current Ratio Current Assets [Assumes Inventory, Recbles Liquid]

Current Liabilities
Higher = Higher Liquidity

Quick Ratio Cash + Short-Term Marketable Investments + Receivables Lower = Reliance on CFO,
Current Liabilities outside financing
Cash Ratio Cash + Short-Term Marketable Investments [crisis measure]

Current Liabilities
93
Liquidity Ratios
Defensive Interval Ratio Cash + Short-Term Marketable Investments + Receivables

Daily Cash Expenditure
How long can a company pay daily cash expenditures with existing liquid assets
Higher = More defensive
Cash Conversion Cycle (net operating cycle) DOH + DSO - Number Days Payables
Purchase Pay For Sell Collect

Goods Goods Finished Product Cash
Cash Conversion Cycle
DOH
DSO
Days Payables
Liquidity Ratios
94
Liquidity Ratios
Liquidity Ratios
95
Solvency Ratios
Solvency : Ability to fulfill long-term debt obligations
Solvency Ratios measure: Relative amount of debt in capital structure (debt ratios)
Adequacy of earnings and cash flow to cover
interest expenses and other fixed charges (coverage ratios)
[ operating leverage may limit the company’s
ability to make use of financial leverage ]
For purposes of calculation in this module :
Total-Debt = sum of interest-bearing short-term and long-term debt
[this excludes accrued expenses, accounts payable, leases]
Coverage Ratios
Interest Coverage : EBIT used in debt covenants Higher
Interest Payments
Greater
Solvency
Fixed Charge Coverage EBIT + Lease Payments used to measure
Interest Payments + Lease Payments quality of pref. divs.
Solvency Ratios
Debt-to-Assets Ratio Total Debt % Total Assets Financed with debt
(Total Debt Ratio) Total Assets
Debt-to-Capital Ratio Total Debt % capital represented by debt

Total Debt + Total S.H. Equity
Debt-to-Equity Ratio Total Debt Amount debt relative to equity

Total S.H. Equity
* *
Financial Leverage Ratio Average Total Assets Average used here & DuPont
* Average Total Equity Year-end is common

* [DP]
Debt-to-EBITDA Total Debt or Net Debt [Total Debt - (cash & mktble sec)]
EBITDA EBITDA How many years it would take
to repay debt based on EBITDA
96
Profitability Ratios
Measure return earned during a period
Return on Sales Ratio = Income v. Revenue Return on Investment = Income v. Capital
(common size I/S) (Equity, Assets, Capital employed)
Operating Income
Gross Profit Margin Gross Profit Operating ROA
Average Total Assets
Revenue
* * Net Income
ROA
Average Total Assets
Operating Profit Margin Operating Income * [DP] *
Revenue EBIT(1 - 𝐭)
Return on Invested Capital
Avg. Total ST&LT Debt & Equity
Pretax Margin EBT
Revenue Net Income
ROE
Average Total Equity
* *
Net Profit Margin Net Income Return on Common Equity NI - Preferred Divs.
* [DP] * Revenue Average Common Equity
Relationships
97
DuPont Analysis
Return on Equity (ROE) = NI / Avg. Equity , this we already know
What drives ROE? to find that out we shall decompose it
ROE = Net Income = Net Income Avg. Total Assets
× ROE = ROA × Leverage
Avg. Sh. Equity Avg. Total Assets Avg. Sh. Equity
5 4 3 2
ROE 5.92% 1.66% 1.62% (0.62%)
ROA 3.70% 1.05% 1.05% (0.39%)

× × × ×
Leverage 1.60 1.58 1.54 1.60
98
DuPont Analysis
ROE = Net Income = Net Income Revenue Avg. Total Assets
× ×
Avg. Sh. Equity Revenue Avg. Total Assets Avg. Sh. Equity
ROE = Net Margin × Total Asset Turnover × Leverage
5 4 3 2
ROE 5.92% 1.66% 1.62% (0.62%)
Net Margin 3.33% 1.11% 1.13% (0.47%)

× × × ×
Total Asset Turnover 1.11 0.95 0.93 0.84
× × × ×
Leverage 1.60 1.58 1.54 1.60
99
DuPont Analysis
ROE = Net Income = Net Income Revenue Avg. Total Assets
× ×
Avg. Sh. Equity Revenue Avg. Total Assets Avg. Sh. Equity
ROE = Net Income EBT EBIT × Revenue × Avg. Total Assets

× ×
EBT EBIT Revenue Avg. Total Assets Avg. Sh. Equity
Tax Interest EBIT Total Asset Leverage
× × × ×
Burden Burden Margin Turnover
Revenue 1,000
Operating Expenses (400) Net = 315
=
315
× ×
EBIT 600 Margin 1,000 1,000
Interest (150) 31.5% =

EBT 450
Tax at 30% (135)
Net Income 315
DuPont Analysis
What might the analyst conclude?
100
Industry Specific
Be aware!
Explain what this ratio is measuring and compare the results reported for
each of the years shown in the chart. What other information might an ana-
lyst want to review before making any conclusions on this information?
Models & Forecasting

Based upon forecasts of growth and expected relationships among financial data
analysts can build models to forecast future performance.
Forecasts should involve a range of possibilities using the following techniques:
Sensitivity Analysis ( what if ? ) - range of possibilities as specific assumptions are changed
Scenario Analysis - change resulting from given economic events

- mutually exclusive and exhaustive events can be assigned
probabilities and mean/median etc. outputs can be derived
Simulation - computer-generated sensitivity/scenario analysis based on probability

models for input factors e.g. Monte-Carlo simulation
101
Introduction to Financial Statement Modeling
a. demonstrate the development of a sales-based pro forma company model
b. explain how behavioral factors affect analyst forecasts and recommend remedial
actions for analyst biases
c. explain how the competitive position of a company based on a Porter’s five forces
analysis affects prices and costs
d. explain how to forecast industry and company sales and costs when they are
subject to price inflation or deflation
e. explain considerations in the choice of an explicit forecast horizon and an analyst’s

choices in developing projections beyond the short-term forecast horizon
102
Introduction to Financial Statement Modeling
Sales Based Pro-Forma Model

Steps in Income Statement forecast process:
1. Revenue Forecast (by segment)
Drivers : Volume (organic & acquisition)
Price (product & mix)
Forex
2. Operating Expense Forecast
COGS : Revenue and gross margin forecast
SG&A and other : Forecast % of revenue
3. Non-Operating Expense Forecast
Interest Expense : Fixed or Variable (MRR)
Interest Income : Forecasted Rate on liquid assets
Interest Tax : Effective Rate
4. Shares Outstanding
Equity-based compensation
Share repurchases

(FY 2022E)
Steps in Cash Flow projection process:
1. Forecasted Net Income Net Income 179
From Pro-Forma income statement Depn. & Amtn. 36
2. Capital Expenditure and Depreciation (and Amortization) Decrease Inv.
CAPEX : % of revenue (CFI) Increase Rec. 64

Decrease Pay.
Depn & Am: % of prior year fixed assets (add back ➞ CFO)
Share Based Comp. 2
3. Working Capital Forecasts
Forecast : Days of inventory, receivables, payables CFO 281
Combine with sales and COGS forecasts CAPEX (55)
Movement (➞ CFO) Inv. Other 0
× 365
e.g. Forecasted Days Inventory = 1,500 COGS CFI (55)
Forecasted COGS = 347 Debt Issuance 0
1,500 = Inv. × 365 Inv. = 1,500 × 347 = 1,426 Share Issuance 0
347 365 Divs. Paid (10)
CFF (10)
103

Steps in Forecasting Balance Sheet :
Combination of : Projected income statement, statement of cash flows, balance sheet
e.g. PPE : Historic (2021) 845 Payables: COGS (2022 E) 347

Depn. & Amtn. (36) Days (2022 E) 628
CAPEX 55
Forecast (2022 E) 864 Forecast (2022 E) 597
Valuation Model Inputs :

Valuation models may start with : Free Cash Flow
EPS
EBITDA
EBIT
Behavioral Factors
Experts persistently make forecasting errors resulting from behavioral biases
Overconfidence
‘Unwarranted faith in own ability’
More common when making contrarian predictions
Mitigation : Share, Review, Widen Confidence Intervals, Scenario Analysis
Illusion of Control
‘Overestimation of ability to control what cannot be controlled’
Can lead to overly complex models - leads to diminishing marginal returns
Mitigation : Focus on most important variables
Conservatism Bias (Anchoring and Adjustment)

‘Maintaining prior views or forecasts by inadequately incorporating new information’
Mitigation : Regular Review, more flexible models
104
Behavioral Factors
Experts persistently make forecasting errors resulting from behavioral biases
Representativeness Bias
‘Classifying information based on past experiences and known classifications’
Base-Rate neglect : inside view v. outside view
considers base rate
Mitigation : Consider base-rate, make adjustments
Confirmation Bias
‘Seek and notice information that confirms prior belief’
Mitigation : Seek opinions that differ
Porter’s Five Forces

[Equity : industry and competitive analysis framework]
Helps assess relative profit potential

of a company
Prospects for high/low sales growth
Forecasts of margins
Competitive advantage ?
105
Inflation and Deflation

The impact of inflation differs : From company to company
For Revenues and Expenses
Key question for an analyst : Can the company pass on higher input prices to customers
Key Factors: Industry Structure

e.g. US Beer Market - oligopoly (AB InBev - 50% market share)
- fragmented customer base
- US beer prices generally rise and fall with input costs
European Beer Market - distributed through concentrated customer base
- no dominant brewer
- changes in European beer prices average 100bps <
inflation
Elasticity
(Inflation) Increasing prices if demand is elastic can have a negative impact
(Deflation) Dropping prices may benefit volume in the short-run until competitors react

Cost Projections :
Inflation impact will be delayed where companies use long-term price-fixed forward contracts
Analysts should consider industry specific factors e.g. Agriculture ➞ weather
Vertical integration can offset impact of inflation
Availability of substitutes
Offsetting Expenses :
Forecasted increases in raw material costs may lead to decrease in discretionary spend
e.g. Advertising
Research and Development
106

Analysts can use common size analysis to forecast impact of price rises:
Company S Company C
Net Sales 100% 100%
COGS 50% 36%
Gross Margin 50% 64%
SG&A 31% 47%

Depreciation 3% 4%
EBIT 16% 13%
If each company experiences 10% inflation in all costs except depreciation:

Company S experiences greater decline in gross margin
Company C experiences greater decline in EBIT margin
Horizon and Long-Term

Factors affecting choice of time horizon :
Investment strategy for which the security is being considered
- e.g. Stated Investment Horizon 3 - 5 years
Average Annual Turnover 33% - 20%
Cyclicality of the industry

- forecast period should be long enough to reach expected mid-cycle sales/profitability
level
Company specific factors

- e.g. Recent acquisition/restructuring ➞ need time to realize full impact
Employer’s preferences
107
Horizon and Long-Term

Longer-Term Projections : normalized earnings / free cash flow
- mid cycle
- absence of unusual/temporary factors
e.g. cycle, acquisitions, restructuring
- use historical data to calculate a trend
Terminal Value Estimation : going concern value after the explicit forecast horizon
(DCF Models) - normalize free cash flow
- future growth rate v. historical
- inflection points/economic disruption can be critical
108

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2024 Level 1 - Financial Statement Analysis

Learning Modules Page

Analyzing Income Statements 10

Analyzing Balance Sheets 25

Analyzing Statements of Cash Flows I 31

Analyzing Statements of Cash Flows II 42

Analysis of Long-Term Assets 51

Topics in Long-Term Liabilities and Equity 59

Analysis of Income Taxes 71

Financial Reporting Quality 78

Financial Analysis Techniques 87

Introduction to Financial Statement Modeling 102

© 2533695 Ontario Limited d/b/a MarkMeldrum.com. All rights reserved.

Introduction to Financial Statement Analysis

a. describe the steps in the financial statement analysis framework

b. describe the roles of financial statement analysis

c. describe the importance of regulatory filings, financial statement notes and

d. describe implications for financial analysis of alternative financial reporting

e. describe information sources that analysts use in financial statement analysis

Financial Statement Analysis

1. Determine the purpose and context of the analysis

2. Collect data - Financial Statements

3. Process data - Ratios

4. Analyze/interpret data - Conclusions/Recommendations

5. Develop/Communicate Conclusions - Analyst Report - Note: Fact v. opinion

Roles of Financial Statement Analysis

Potential Investment Other

Equity Invt. for Loan decision Merger/

- IOSCO: Objectives and Principles of Securities Regulation

10 categories including Regulators, Auditing, Issuers

- Accounting Standards used high and internationally

- US Securities and Exchange Commission (SEC)

Securities offerings registration statement 8-K

member states regulate their own capital markets

2. Financial Statement Notes and Supplementary Schedules

- additional information on every line of B/S, I/S plus:

- Business and Geographic Segment Reporting Revenue & (expenses)

disclose key line items by operating segment results reviewed

if ≥ 10% Revenue, Assets, Profit discrete data

all reported segments must add to 75% external revenue

3. Management Commentary (MD&A)

- included in 10-K , 10-Q

- unaudited !! (except for Germany)

- IASB provides a framework for ‘decision-useful management commentary’

1. the nature of the business

3. significant resources, risks, relationships significant events/

5. critical performance measures accounting policies

Prepared in accordance with acceptable standards

IFRS versus the World

- global adoption of IFRS has advanced goal of convergence

- IFRS v. US GAAP differences still exist:

Analysts should monitor developments

new products/transactions may not

Other Sources of Information

- Issuer Sources: earnings calls, presentations, press releases, ...

- Proprietary Primary Research: surveys, conservations, product comparisons, ...

Analyzing Income Statements

a. describe general principles of revenue recognition, specific revenue

b. describe general principles of expense recognition, specific expense

c. describe the financial reporting treatment and analysis of non-recurring items

e. evaluate a company’s financial performance using common-size income

Analyzing Income Statements