Analysis of Financial Statement

Lecture # 01 By: Faisal Dhedhi

Teaching & Testing Methodology ‡ Grading Basis 
Quizzes: 15% (3 Quizzes of Equal Points)  Assignments:  Project:

5% (4 Assignments of Equal Points) 15% 

Mid-term Exam: 25%  Final Exam:

40%

‡ Quiz & Exams Testing Style 
Various Forms of Objective Questions  Every Topic is IMPORTANT

The Accounting Cycle
Journal Entry

Financial Statements

Ledger Posting

Accounting Cycle
Adjusted Trial Balance Trial Balance

Periodical Adjustments

The company will continue to operate (going-concern assumptions). Revenues are reported as they are earned within the specified accounting period (revenues-recognition principle). ‡ The timing and the methodology used to record revenues and expenses may also impact the analysis and comparability of financial statements across companies. ‡ Accounting statements are prepared in most cases on the basis of these three basic premises: 1.Introduction ‡ Financial statements are a snapshot of a company's well being at a specific point in time. . 3. 2. Expenses should match generated revenues within the specified accounting period (matching principle). ‡ The length of time (the accounting period) that these financial statements represent varies.

suppliers and customers and visit company sites. Be sure the report and its dissemination comply with the code and standards that relate to investments analysis and recommendations. . and what resources and how much time are available to perform the analysis. 6) Update the analysis: Repeat these steps periodically and change the conclusions or recommendations when necessary. Ask questions of the company s management.Financial statement analysis framework Consist of six steps: 1) Sate the objective and context: Determine what questions the analysis seeks to answer. 4) Analyze and interpret the data: Use the data to answer the questions stated in the first step. Prepare exhibits such as graphs and common-size balance sheet. the form in which this information needs to be presented. 2) Gather Data: Acquire the company s financial statements and other relevant data on its industry and the economy. 5) Report the conclusion or recommendations: Prepare a report and communicate it to its intended audience. 3) Process the data: Make any appropriate adjustments to the financial statements. Decide what conclusions or recommendations the information supports. calculate ratios.

Accounting and Financial Statements Business Environment Labor Markets Capital Markets Product Markets: Suppliers Customers Competitors Business Regulations Business Strategy Scope of Business: Degree of Diversification Type of Diversification Competitive Positioning: Cost Leadership Differentiation Key Success Factors & Risks Business Activities Operating Investment Financing Accounting Environment Capital Market Structure Contracting & Governance Accounting Conventions & Regulations Tax & Financial Accounting Linkage Independent Auditing Legal System for Accounting Disputes Accounting Strategy Accounting System Measure & Report Economic Consequences of Business Activities Choice of: Accounting Policies Accounting Estimates Reporting Formats Supplementary Disclosures Financial Statements .Business Environment.

Expenses are recorded when they are incurred instead of when they are paid. ‡ Benefits of Cash Accounting: It is easy to use and implement because the company records income only when it gets paid and records expenses only when it pays them. ‡ Benefits of Cash Accounting: If accepted by the IRS (limited cases only). fewer transactions will be recorded (bookkeeping). ‡ Accrual accounting This method consists of recognizing revenue in the accounting period in which it is earned (revenue is recognized when the company provides a product or service to a customer. ‡ Benefits of Cash Accounting: On average. regardless of when the company gets paid). the company is taxed when it has money in the bank. .Basic Accounting Methods ‡ Cash-basis accounting This method consists of recognizing revenue (income) and expenses when payments are made (checks issued) or cash is received (deposited in the bank).

There is a smoother earning stream. especially if it extends credit to its customers. Similarly. A service provider may not require upfront payment for an annual service. not when it is paid. It allows management to keep track of accounts receivables and payables more efficiently. purchases raw materials on credit from its suppliers or keeps inventory. There is enhanced predictability of future cash flow.will be recognized on a monthly basis. It is more representative of the economic reality of the business. which are paid semiannually . ‡ ‡ ‡ . It enhances comparability of performance (income statement) and financial stability (balance sheet) from one period to the next. this revenue will be recorded as it is performed. Benefits of Accrual Accounting ‡ ‡ ‡ Generally. it provides a clearer picture of the financial performance (income statement) and financial health (balance sheet).such as property taxes.‡ Biggest drawback of cash accounting: Cash accounting can distort a company's actual income and expenses. expenses that are paid in advance .

the financial statements in Figure 6.1: XYZ Corporation's Financial Statements using Cash Basis Accounting .1 below indicate that XYZ Corporation is not doing well. Figure 6.Cash Basis Accounting Taken as is. and may not be a good investment opportunity.200. with a net loss of $43.

000 and was paid on June 1. and $40. (With the cash-basis method. 2005 The company received a rush order for $80. A3. June 13. The company paid the invoice in full to take advantage of a 2% early-payment discount. this is recorded in full on the income statement.000 of wood panels. A2.000 worth of wood panels to replenish their inventory. sales are not recorded in the income statement and not recorded in accounts receivables: no cash. 2005 The company launched an advertising campaign that will run until the end of August. June 1. and there is no record of inventory on hand). .000 was related to the rush order.Accrual Basis Accounting: Armed with some additional information. no record). (With the cash-basis method. The customer was given 30 days to pay. The order was delivered to the customer five days later. 2003 The company received $60. 2005. let's see what the income statement would look like if the accrual-basis accounting method was used. The total cost of the advertising campaign was $15. Additional Information: A1. June 12.

XYZ Corporation's Restated Financial Statements using Accrual Basis Accounting .

which is the more detailed format. Both single and multi-step formats conform to GAAP standards.Income statement basics ‡ Multi-Step Income Statement A multi-step income statement is a condensed statement of income as opposed to a single-step format. Both yield the same net income figure .

depreciation and amortization. etc. (Reminder: matching principle. maintenance. Income taxes This account is a provision for income taxes for reporting purposes. accounting fees. marketing. . research and development (R&D). allowances and discounts Cost of goods sold (COGS) These are all the direct costs related to the product or rendered service sold and recorded during the accounting period. administrative salaries. legal fees).) Operating expenses These include all other expenses that are not included in COGS but are related to the operation of the business during the specified accounting period. sales salaries. Other revenues & expenses These are all non-operating expenses such as interest earned on cash or interest paid on loans. This account is most commonly referred to as "SG&A" (sales general and administrative) and includes expenses such as selling.‡ ‡ ‡ ‡ ‡ Sales These are defined as total sales (revenues) during the accounting period. Remember these sales are net of returns. administrative office expenses (rent. computers.

all other income. . it is also used to value similar companies. To be included in this category. these items must be recurring in nature. it does assume that noncash expenses such as depreciation and amortization are a good indicator of future capital expenditures. allowances and discounts. less the cost and expenses related to the generation of these revenues. The costs deducted from revenues are typically the COGS and SG&A expenses. ‡ Recurring (pre-tax) income from continuing operations This component takes the company's financial structure into consideration as it deducts interest expenses. Since this component does not take into account the capital structure of the company (use of debt). ‡ Recurring income before interest and taxes from continuing operations This component includes. This component is generally considered to be the best predictor of future earning.Income statement Components: ‡ Operating income from continuing operations This comprises all revenues net of returns. That said. in addition to operating income from continuing operations. such as investment income from unconsolidated subsidiaries and/or other investments and gains (or losses) from the sale of assets.

Examples are an employee-separation cost. . ‡ Net income from continuing operations This component takes into account the impact of taxes from continuing operations. write-offs. etc. and are not included in income from continuing operations. extraordinary items and accounting changes are all reported as separate items in the income statement. write-downs. earlier income statements and balance sheets have to be adjusted to reflect changes. Non-Recurring Items Discontinued operations. In some cases. They are all reported net of taxes and below the tax line. integration expenses. plant shutdown. Included in this category are items that are either unusual or infrequent in nature but cannot be both. impairments.Income statement Components: ‡ Pre-tax earning from continuing operations This component considers all unusual or infrequent items.

Extraordinary items .This component relates to items that are both unusual and infrequent in nature. The same is true for extraordinary items and cumulative effect of accounting changes (see below). These events need to be isolated so they do not inflate or deflate the company's future earning potential. Cumulative effect of accounting changes . In most cases.This item is generally related to changes in accounting policies or estimations. An example is environmental remediation. as a result of the tax implication. . That means it is a one-time gain or loss that is not expected to occur in the future. That is why this income (or expense) is always reported net of taxes. these are non cash-related expenses but could have an effect on taxes.‡ ‡ ‡ Income (or expense) from discontinued operations This component is related to income (or expense) generated due to the shutdown of one or more divisions or operations (plants). This type of nonrecurring occurrence also has a nonrecurring tax implication and. should not be included in the income tax expense used to calculate net income from continuing operations.

Prior Period Adjustments These adjustments are related to accounting errors. . (These can be found in changes in retained earnings.) These errors are disclosed as footnotes explaining the nature of the error and its effect on net income. These errors are typically reported in the net income but in some cases are made directly to retained earnings.

Shareholders' equity is the value of a business to its owners after all of its obligations have been met. debts to suppliers and debts to employees. Shareholders' equity generally reflects the amount of capital the owners have invested. This net worth belongs to the owners. what it owes (its liabilities) and the value of the business to its stockholders (the shareholders' equity) as of a specific date. Examples include bank loans. Total Assets = Total Liabilities + Shareholders' Equity Assets are economic resources that are expected to produce economic benefits for their owner. Liabilities are obligations the company has to outside parties. plus any profits generated that were subsequently reinvested in the company.Balance Sheet basics Balance Sheet Categories The balance sheet provides information on what the company owns (its assets). Liabilities represent others' rights to the company's money or services. ‡ ‡ ‡ .

Furthermore. management expects to sell these investments within one year's time. Marketable securities (short-term investments) These can be both equity and/or debt securities for which a ready market exist. Every business has customers that will not pay for the products or services the company has provided. These usually include: Cash This is what the company has in cash in the bank. These short-term investments are reported at their market value. Cash is reported at its market value at the reporting date in the respective currency in which the financials are prepared. Management must estimate which customers are unlikely to pay and create an account called allowance for doubtful accounts. Accounts receivable This represents the money that is owed to the company for the goods and services it has provided to customers on credit. sold or consumed within a year or less. Variations in this account will impact the reported sales on the income statement. Current Assets These are assets that may be converted into cash. (Different cash denominations are converted at the market conversion rate.‡ ‡ ‡ ‡ Total assets on the balance sheet are composed of: 1. . Accounts receivable reported on the balance sheet are net of their realizable value (reduced by allowance for doubtful accounts).

These are: . Typical prepaid expenses include rent. The heading "Long-Term Assets" is usually not displayed on a company's consolidated balance sheet. Long-term assets These are assets that may not be converted into cash. sold or consumed within a year or less.at cost or current market value . LIFO (last in. 2. first out). Notes receivable is reported at its net realizable value (what will be collected). These items can be valued individually by several different means . Prepaid expenses These are payments that have been made for services that the company expects to receive in the near future.and collectively by FIFO (first in. the maturity of notes receivable is generally longer than accounts receivable but less than a year.‡ ‡ ‡ Notes receivable This account is similar in nature to accounts receivable but it is supported by more formal agreements such as a "promissory notes" (usually a short term-loan that carries interest). Inventory This represents raw materials and items that are available for sale or are in the process of being made ready for sale. Inventory is valued at the lower of the cost or market price to preclude overstating earnings and assets. insurance premiums and taxes. first out) or average-cost method. These expenses are valued at their original cost (historical cost). Furthermore. all items that are not included in current assets are long-term Assets. However.

Land is valued at historical cost and is not depreciable under U. pension funds and plan-expansion funds. Examples include deferred charges (long-term prepaid expenses). ± Buildings (plants) These are buildings that the company uses for its operations. such as sinking funds. This includes: ± Machinery and equipment This category represents the total machinery. . These investments can include bonds. These long-term investments are reported at their historical cost or market value on the balance sheet. GAAP Other assets This is a special classification for unusual items that cannot be included in one of the other asset categories.S. long-term notes. ± Land The land owned by the company on which the company's buildings or plants are sitting on. equipment and furniture used in the company's operations. Fixed assets These are durable physical properties used in operations that have a useful life longer than one year. common stock. non-current receivables and advances to subsidiaries. These assets are depreciated and are reported at historical cost less accumulated depreciation. investments in tangible fixed assets not currently used in operations (such as land held for speculation) and investments set aside in special funds.‡ ‡ ‡ Investments These are investments that management does not expect to sell within the year. These assets are reported at their historical cost less accumulated depreciation.

Accounts payable This amount is owed to suppliers for products and services that are delivered but not paid for. the creation of another current liability or the providing of some service. Current liabilities These are debts that are due to be paid within one year or the operating cycle. such as a bank line of credit. such obligations will typically involve the use of current assets. franchises. trademarks and organization costs. copyrights. 3. landlords. tax and utilities This amount is payable to employees.Intangible assets These are assets that lack physical substance but provide economic rights and advantages: patents. They are reported at historical cost net of accumulated depreciation. Usually included in this section are: Bank indebtedness This amount is owed to the bank in the short term. goodwill. rent. whichever is longer. These assets have a high degree of uncertainty in regard to whether future benefits will be realized. Wages payable (salaries). government and others y . Liabilities: Liabilities have the same classifications as assets: current and long-term. further.

.The currently maturing portion of the longterm debt is classified as a current liability. Current portion of long-term debt . Dividends payable This occurs as a company declares a dividend but has not of yet paid it out to its owners.These liabilities arise because an expense occurs in a period prior to the related cash payment. Theoretically. Current portion of capital-lease obligation This is the portion of a long-term capital lease that is due within the next year. among others. This accounting term is usually used as an all-encompassing term that includes customer prepayments. dividends payables and wages payables. Notes payable (short-term loans) This is an amount that the company owes to a creditor. Unearned revenues (customer prepayments) These are payments received by customers for products and services the company has not delivered or started to incur any cost for its delivery. any related premium or discount should also be reclassified as a current liability.‡ ‡ ‡ ‡ ‡ Accrued liabilities (accrued expenses) . and it usually carries an interest expense.

Long-term obligations are reported as the present value of all future cash payments. . In effect. ‡ Deferred income tax liability GAAP allows management to use different accounting principles and/or methods for reporting purposes than it uses for corporate tax fillings (IRS). then the company has created a future tax liability (the inverse would be accounted for as a deferred tax asset).4. Long-term Liabilities These are obligations that are reasonably expected to be liquidated at some date beyond one year or one operating cycle. Usually included are: ‡ Notes payables This is an amount the company owes to a creditor. ‡ Long-term debt (bonds payable) This is long-term debt net of current portion. the IRS lets it pay the taxes later (due to the timing difference). Deferred tax liabilities are taxes due in the future (future cash outflow for taxes payable) on income that has already been recognized for the books. If a company's tax expense is greater than its tax payable. which usually caries an interest expense. although the company has already recognized the income on its books.

which have priority over common shareholders and receive a dividend that has priority over any distribution made to common shareholders.Share holder s Equity basics: ‡ Components of Shareholder s Equity Also known as equity and net worth . the shareholders equity refers to the shareholders ownership interest in a company. It is also called contributed capital . This is usually recorded at par value. and it is valued at par or stated value. . Common stock This is the investment by stockholders. ‡ Additional paid-up capital (contributed capital) This is capital received from investors for stock. ‡ Other items This is an all-inclusive account that may include valuation allowance and cumulative translation allowance (CTA). it is equal to capital stock plus paid-in capital. ‡ Retained earnings This is the total net income (or loss) less the amount distributed to the shareholders in the form of a dividend since the company s initiation. among others. Valuation allowance pertains to noncurrent investments resulting from selective recognition of market value changes. Usually included are: ‡ Preferred stock This is the investment by preferred stockholders.

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This statement shows the changes in each type of stockholders equity account and the total stockholders equity during the accounting period.Stockholders Equity Statement Instead of presenting a detailed stockholders equity section in the balance sheet and a retained earnings statement. This statement usually includes: ‡ ‡ ‡ ‡ ‡ ‡ Preferred stock Common stock Issue of par value stock Additional paid-in capital Treasury stock repurchase Retained earning . many companies prepare a stockholders equity statement.

Par value of common shares is $15 per share.000 common shares to investors for $600. ‡ Legal capital of the corporation This is par value per share multiplied by the total number of shares issued. This artificial value has no relation or impact on the market value of the shares. ‡ Par value This is a value of preferred and common stock that is arbitral (artificial). it is set by management on a per share basis.000. Par value of preferred shares is $20 per share. ‡ Additional paid-in capital (paid-in capital) This is the difference between the actual value the company sold the shares for and their par value. . Example: Company XYZ issued 15. Company XYZ issued 30.000.000 preferred shares to investors for $300.‡ Contributed Capital Contributed capital is the total legal capital of the corporation (par value of preferred and common stock) plus the paid-in capital.

000(30.000 Paid-in capital: Preferred shares: $ 0 ($300.Legal capital: Preferred shares: $300.000-$450.000-$300.000 Legal capital + Paid-in capital = Contributed Capital There are two basic dividend forms: ‡ Cash dividends These are cash payments made to stockholders of record.000 x $15) Legal capital $750.000(15.000($600.000 x $20) Common shares: $450. It is a permanent capitalization of retained earnings to contributed capital.000) Paid-in capital $150. A stock dividend does not increase the wealth of the recipient nor does it reduce the net assets of the firm. . Retained earnings are reduced when dividends are declared.000) Common shares: $150. ‡ Stock dividends These are dividends paid in the form of additional stock of the issuing company to shareholders of record in proportion to their current holdings.

000 would then own 4. ‡ Ex-dividend date: This is the first day of trading when the selling shareholder is entitled to the recently announced dividend payment. ‡ Date of payment: This is the date on which the company will pay the declared dividend to its stockholders of record as of the date of record.e. a shareholder owning 2. a two-for-one stock split means that the company stockholders will receive two shares for every share they currently own. Stock Split Stock splits are events that increase the number of shares outstanding and reduce the par or stated value per share of the company s stock.000). This will double the number of shares outstanding and reduce by half the par value per share.000 shares out of 200.000 shares out of 100. but there will be no change in the proportional ownership represented by the shares (i. Date of record: This is the date set by the issuer that determines who is eligible to receive a declared dividend or capital-gains distribution. Existing shareholders will see their shareholdings double in quantity. Shares purchased as of the ex-dividend date will not receive the previously declared dividend.Dividend Terminology Date of Declaration: This is the date the board approved and declared a dividend. For example. ‡ ‡ .

A memorandum notation in the accounting records indicates the decreased par value and increased number of shares. .e. Therefore.Most importantly. Stock splits are usually done to increase the liquidity of the stock (more shares outstanding) and to make it more affordable for investors to buy regular lots (regular lot = 100 shares). For example. the number of shares times par value per share does not change). Stocks that are trading on the exchange will normally be re-priced in accordance to the stock split. if XYZ stock was trading at $90 and the company did a 3-for-1 stock split. the stock would open at $30 a share. the total par value of shares outstanding is not affected by a stock split (i. no journal entry is needed to account for a stock split.

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‡ The statement of cash flow reports the impact of a firm's operating. investing and financial activities on cash flows over an accounting period. The cash flow statement is designed to convert the accrual basis of accounting used in the income statement and balance sheet back to a cash basis. The cash flow statement will reveal the following to analysts: ‡ How the company obtains and spends cash ‡ Why there may be differences between net income and cash flows ‡ If the company generates enough cash from operation to sustain the business ‡ If the company generates enough cash to pay off existing debts as they mature ‡ If the company has enough cash to take advantage of new investment opportunities Segregation of Cash Flows The statement of cash flows is segregated into three sections: ‡ Operating activities ‡ Investing activities ‡ Financing activities .

.1. The statement of cash flow can be presented by means of two ways: The indirect method The direct method The Indirect Method The indirect method is preferred by most firms because it shows a reconciliation from reported net income to cash provided by operations. Cash Flow from Investing Activities (CFI) CFI is cash flow that arises from investment activities such as the acquisition or disposition of current and fixed assets. Cash flow from financing activities (CFF) CFF is cash flow that arises from raising (or decreasing) cash through the issuance (or retraction) of additional shares. short-term or long-term debt for the company's operations. 2. Cash Flow from Operating Activities (CFO) CFO is cash flow that arises from normal operations such as revenues and cash operating expenses net of taxes. 3.

Account for changes in all current assets and liabilities except notes payable and dividends payable. ‡ Add back non-cash expenses. In general. ± (Such as depreciation and amortization) ‡ Adjust for gains and losses on sales on assets. candidates should utilize the following rules: ‡ Increase in assets = use of cash (-) ‡ Decrease in assets = source of cash (+) ‡ Increase in liability or capital = source of cash (+) ‡ Decrease in liability or capital = use of cash (-) ‡ ‡ .‡ Calculating Cash flow from Operations Here are the steps for calculating the cash flow from operations using the indirect method: Start with net income. ± Add back losses ± Subtract out gains Account for changes in all non-cash current assets.

Cash Flow from Investment Activities Cash Flow from investing activities includes purchasing and selling long-term assets and marketable securities (other than cash equivalents). Cash Flow from Financing Activities Cash Flow from financing activities includes issuing and buying back capital stock. but the repayment of accounts payable or accrued liabilities is not. . and FCF is used for valuation purposes.after-tax proceeds from sale of assets) The FCF measure gives investors an idea of a company's ability to pay down debt. Net capital expenditures are what a company needs to spend annually to acquire or upgrade physical assets such as buildings and machinery to keep operating. as well as borrowing and repaying loans on a short.or long-term basis (issuing bonds and notes). including net capital expenditures. Free cash flow = cash flow from operating activities net capital expenditures (total capital expenditure . Free Cash Flow (FCF) Free cash flow (FCF) is the amount of cash that a company has left over after it has paid all of its expenses. increase savings and increase shareholder value. Dividends paid are also included in this category. as well as making and collecting on loans.

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inventory. hedging policy. credit facility and long-term debt. accounts receivable.‡ ‡ ‡ Financial Statement Footnotes These footnotes are additional information provided to the reader in an effort to further explain what is displayed on the consolidated financial statements. The information contained in these footnotes help the reader understand the amounts. stock option plans . Generally accepted accounting principles (GAAP) and the SEC require these footnotes. Included in the footnotes are the following: Balance sheet and income statement breakdown of items such as: ± The revenues-recognition method used ± Depreciation methods and rates Balance sheet and income statement breakdown of items such as: ± Marketable securities ± Significant customers (percentage of customers that represent a significant portion of revenues) ± Sales per regions ± Inventory ± Fixed assets and Liabilities (including depreciation. contingent losses (lawsuits). pension liabilities or assets. timing and uncertainty of the estimates reported in the consolidated financial statements. income taxes.

‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ Audit: An audit is a process for testing the accuracy and completeness of information presented in an organization's financial statements. stating the opinion. This testing process enables an independent Certified Public Accountant (CPA) to issue what is referred to as "an opinion" on how fairly a company's financial statements represent its financial position and whether it has complied with generally accepted accounting principles. signed by the auditor. the auditor often prepares what is called a "management letter" or "management report" to the board of directors. This report cites areas in the organization's internal accounting control system that the auditor evaluates as weak. income statement and statement of cash flows notes to the financial statements In addition to the materials included in the audit report. The audit report is addressed to the board of directors as the trustees of the organization. the financial statements. including the balance sheet. The report usually includes the following: a cover letter. What Does the Auditor Do? The auditor will request information from individuals and institutions to confirm: bank balances contribution amounts conditions and restrictions contractual obligations .

. These statements which are also filed with the SEC and available about the election of different sources. A qualified opinion is issued when the accountant believes the financial statements are. Proxy Statement: are issued to share holders when there are matters that require a shareholder vote. A qualified option may be issued if the auditor has concerns about the going-concern assumption of the company. the valuation of certain items on the balance sheet or some unreported pending contingent liabilities. They are required only to express an opinion as to whether the financial statements. in a limited way.Auditor Responsibility Auditors are not expected to guarantee that 100% of the transactions are recorded correctly. audits are not intended to discover embezzlements or other illegal acts. In addition. a "clean" or unqualified opinion should not be interpreted as assurance that such problems do not exist. The Qualified Opinion An unqualified opinion indicates that the auditor believes the statements are free from material omissions and errors. Therefore. give a fair representation of the organization's financial picture. not in accordance with generally accepted accounting principles. taken as a whole.

redemption or maturity of securities or loans. and similar decisions. (Emphasize the difference between the cash basis and the accrual basis of accounting. credit. ‡ ‡ . (Note the FASB's emphasis on investors and creditors as primary users.) They are to provide information to help present and potential investors and creditors and other users in assessing the amounts. events and circumstances that change its resources and claims to those resources.) They are to provide information about the economic resources of an enterprise. However. timing and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sale. the claims on those resources and the effects of transactions.Objectives of Financial Reporting ‡ Objectives of financial reporting identified in SFAC 1 are to do the following: They are to provide information that is useful to present and potential investors and creditors and other users in making rational investment. this does not exclude other interested parties.

Accounting information is reliable to the extent that users can depend on it to represent the economic conditions or events that it purports to represent.Accounting information is relevant if it is capable of making a difference in a decision.Reliability .Accounting information is consistent when an entity applies the same accounting treatment to similar accountable events from period to period. Reliable information has: (a) Verifiability (b) Representational faithfulness (c) Neutrality 2) Secondary qualities of useful accounting information: Comparability .Accounting information that has been measured and reported in a similar manner for different enterprises is considered comparable. Consistency . Relevant information has: (a) Predictive value (b) Feedback value (c) Timeliness .Relevance . .Accounting Qualities: 1) Primary qualities of useful accounting information: .

Accounting Qualities and Useful Information for Analysts Here is how these qualities provide analysts with useful information: Relevance Relevant information is crucial in making the correct investment decision. then no investor can rely on it to make an investment decision. Comparability Comparability is a pervasive problem in financial analysis even though there have been great strides made over the years to bridge the gap. . Consistency Accounting changes hinder the comparison of operation results between periods as the accounting used to measure those results differ. Reliability If the information is not reliable.

2. Common-Size Balance Sheet is a balance sheet where every dollar amount has been restated to be a percentage of total assets.1. all numbers stated within FedEx's income statement in figure 7. Common-Size Income Statement is an income statement where every dollar amount has been restated to be a percentage of sales. and balance sheet in figure 7. Common-Size Financial Statements Common-size balance sheets and income statements are used to compare the performance of different companies or a company's progress over time. . It requires close examination to determine whether operating expenses are increasing or decreasing. or which particular expense comprises the highest percentage total operating expenses.Financial Ratio: A) ANALYZING FINANCIAL STATEMENTS I. Example: FedEx Common Size Balance Sheet and Income Statement At first glance. can seem daunting.

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use of debt.The ratios used in this classification were developed to analyze and determine how well management operates a company. i. They allow analysts to quickly look through a company s financial statements and identify trends and anomalies.e. i. Financial risk is the risk that relates to the company s financial structure. and operating efficiency reveals if the company s assets were utilized efficiently. and allows creditors to estimate the company s ability to pay its existing debt and evaluate their additional debt applications. Business risk relates the company s income variance. Ratios can be classified in terms of the information they provide to the reader. . Growth potential .B) Classification of Financial Ratios Ratios were developed to standardize a company s results. Operating performance . if any. Risk profile .The ratios found in this classification can be divided into business risk and financial risk .e. The ratios found in this classification can be divided into operating profitability and operating efficiency . Operating profitability relates the company s overall profitability. the risk of not generating consistent cash flows over time. There are four classifications of financial ratios: Internal liquidity The ratios used in this classification were developed to analyze and determine a company s financial ability to meet short-term liabilities.The ratios used in this classification are useful to stockholders and creditors as it allows the stockholders to determine what the company is worth.

a ratio of 2 to 3 is usually considered good. Quick Ratio The quick (or acid-test) ratio is a more stringent measure of liquidity. . Cash Flow from Operations Ratio Poor receivables or inventory-turnover limits can dilute the information provided by the current and quick ratios. Inventory and other assets are excluded. Current ratio = current assets / current liabilities 2. Too small a ratio indicates that there is some potential difficulty in covering obligations. as they may be difficult to dispose of Quick ratio = (cash+ marketable securities + accounts receivables) current liabilities 3.Internal Liquidity Ratios 1. Only liquid assets are taken into account. A high ratio may indicate that the firm has too many assets tied up in current assets and is not making efficient use to them. In general. Current Ratio: This ratio is a measure of the ability of a firm to meet its shortterm obligations. Cash ratio = (cash + marketable securities)/current liabilities 4. This ratio provides a better indicator of a company's ability to pay its short-term liabilities with the cash it produces from current operations. Cash Ratio The cash ratio reveals how must cash and marketable securities the company has on hand to pay off its current obligations.

Average Number of Days Receivables Outstanding (Average Collection Period) This ratio provides the same information as receivable turnover except that it indicates it as number of days. this may indicate that the company does not offer its clients a long enough credit facility. Average number of days receivables outstanding = 365 days_ receivables turnover . Receivable Turnover Ratio This ratio provides an indicator of the effectiveness of a company's credit policy. and may be a sign that sales are perhaps overstated. and as a result may be losing sales. If this ratio is too high compared to the industry. Receivable turnover = net annual sales / average receivables Where: Average receivables = (previously reported account receivable + current account receivables)/2 6. A decreasing receivable-turnover ratio may indicate that the company is having difficulties collecting cash from customers. The high receivable turnover will indicate that the company collects its dues from its customers quickly.Cash flow from operations ratio = cash flow from operations current liability Efficiency / Turnover Ratios 5.

Average Number of Days in Stock This ratio provides the same information as inventory turnover except that it indicates it as number of days. Payable turnover = Annual purchases / average payables . A high inventory ratio is an indicator that the company sells its inventory rapidly and that the inventory does not languish. Note that this ratio is very useful in credit checks of firms applying for credit. It could also indicate inadequate production levels for meeting customer demand Inventory turnover = cost of goods sold / average inventory Where: Average inventory = (previously reported inventory + current inventory)/2 8. Inventory Turnover Ratio This ratio provides an indication of how efficiently the company's inventory is utilized by management. Average number of days in stock = 365 / inventory turnover 9.7. which may mean there is less risk that the inventory reported has decreased in value. Too high a ratio could indicate a level of inventory that is too low. Payable turnover that is too small may negatively affect a company's credit rating. perhaps resulting in frequent shortages of stock and the potential of losing customers. Payable Turnover Ratio This ratio will indicate how much credit the company uses from its suppliers.

Where: Annual purchases = cost of goods sold + ending inventory beginning inventory Average payables = (previously reported accounts payable + current accounts payable) /2 10. Average Number of Days Payables Outstanding (Average Age of Payables) This ratio provides the same information as payable turnover except that it indicates it by number of days. Average number of days payables outstanding = 365_____ payable turnover II. Other Internal-Liquidity Ratios 11.Cash Conversion Cycle This ratio will indicate how much time it takes for the company to convert collection or their investment into cash. A high conversion cycle indicates that the company has a large amount of money invested in sales in process. Cash conversion cycle = average collection period + average number of days in stock average age of payables Cash conversion cycle = average collection period + average number of days in stock average age of payables 12.Defensive Interval This measure is essentially a worst-case scenario that estimates how many days the company has to maintain its current operations without any additional sales.

Defensive interval = 365 * (cash + marketable securities + accounts receivable) projected expenditures

Where: Projected expenditures = projected outflow needed to operate the company 7.3 - Operating Profitability Ratios Operating Profitability can be divided into measurements of return on sales and return on investment Return on Sales 1. Gross Profit Margin This shows the average amount of profit considering only sales and the cost of the items sold. This tells how much profit the product or service is making without overhead considerations. As such, it indicates the efficiency of operations as well as how products are priced. Wide variations occur from industry to industry. Gross profit margin = gross profit / net sales Gross profit = net sales cost of goods sold

2. Operating Profit Margin This ratio indicates the profitability of current operations. This ratio does not take into account the company's capital and tax structure. Operating profit margin = operating income/net sales 3. Per-Tax Margin (EBT margin) This ratio indicates the profitability of Company's operations. This ratio does not take into account the company's tax structure. Pre-tax margin = Earning before tax/sales 4. Net Margin (Profit Margin) This ratio indicates the profitability of a company's operations. Net margin = net income/sales 5. Contribution Margin This ratio indicates how much each sale contributes to fixed expenditures. Contribution margin = contribution / sales Where: Contributions = sales - variable cost

Return on total equity = net income/average total equity . Return on common equity = (net income preferred dividends) average common equity 3. Return on Common Equity (ROCE) This ratio measures the return accruing to common stockholders and excludes preferred stockholders. Return on Assets (ROA) This ratio measures the operating efficacy of a company without regards to financial structure Return on assets = (net income + after-tax cost of interest) average total assets OR Return on assets = earnings before interest and taxes average total assets 2.Return on Investment Ratios 1. Return on Total Equity (ROE) This is a more general form of ROCE and includes preferred stockholders.

Equity Turnover This ratio measures a company's ability to generate sales given its investment in total equity (common shareholders and preferred stockholders). Capital-intensive businesses will have a lower total asset turnover than non-capital-intensive businesses. A ratio of 3 will mean that for every dollar invested in total equity. Fixed-Asset Turnover This ratio is similar to total asset turnover. the company will generate 3 dollars in revenues. the difference is that only fixed assets are taken into account. the company will generate 3 dollars in revenues. Total Asset Turnover This ratio measures a company's ability to generate sales given its investment in total assets. A ratio of 3 will mean that for every dollar invested in total assets.Operating Efficiency Ratios 1. Fixed-asset turnover = net sales / average net fixed assets 3. Total asset turnover = net sales / average total assets 2. Equity turnover = net sales / average total equity .

Debt to equity = total debt / total equity Analysis of the Interest Coverage Ratio 3.Debt to Total Capital This measures the proportion of debt used given the total capital structure of the company. Debt to capital = total debt / total capital Where: Total debt = current + long-term debt Total capital = total debt + stockholders' equity 2. Times Interest Earned (Interest Coverage ratio) This ratio indicates the degree of protection available to creditors by measuring the extent to which earnings available for interest covers required interest payments. Analysis of a Company's Use of Debt 1. Debt to Equity This ratio is similar to debt to capital.FINANCIAL RISK RATIOS Financial Risk This is risk related to the company's financial structure. A large debt-to-capital ratio indicates that equity holders are making extensive use of debt. making the overall business riskier. Times interest earned = earnings before interest and tax interest expense .

Dividend Payout = Dividend Declared/Net Income Let's consider an example: . RR = 1 (dividend declared / net income) ROE = return on equity = net income / total equity Note that dividend payout is the residual portion of RR.‡ Growth Potential Ratios 1. Therefore. Sustainable Growth Rate G = RR * ROE Where: RR = retention rate = % of total net income reinvested in the company or. If RR is 80% then 80% of the net income is reinvested in the company and the remaining 20% is distributed in the form of cash dividends.

This analysis technique is called the "DuPont Formula".DuPont System A system of analysis has been developed that focuses the attention on all three critical elements of the financial condition of a company: the operating management. we get: Return on equity = (net income / sales) * (sales / total equity) Said differently: ROE = net profit margin * return on equity The second is: Return on equity (ROE) = net income / total equity If in a second instance we multiply ROE by assets. The first is: Return on equity (ROE) = net income / total equity If we multiply ROE by sales. The DuPont Formula shows the interrelationship between key financial ratios. It can be presented in several ways. management of assets and the capital structure. we get: ROE = (net income / sales) * (sales / assets) * (assets / equity) Said differently: ROE = net profit margin * asset turnover * equity multiplier .

More Useful DuPont Formula Manipulations ROE = (net income / sales) * (sales / assets) * (assets / equity) .Uses of the DuPont Equation By using the DuPont equation. For example. If two companies have the same ROE. an analyst can easily determine what processes the company does well and what processes can be improved. but changing management is difficult. then an investor is better off investing in the first company. this means that high returns are really coming from overuse of debt. Furthermore. which can spell trouble. However. because the capital structure can be changed easily (increase use of debt). but the first is well managed (high net-profit margin) and managed assets efficiently (high asset turnover) but has a low equity multiplier compared to the other company. ROE represents the profitability of funds invested by the owners of the firm. All firms should attempt to make ROE as high as possible over the long term. analysts should be aware that ROE can be high for the wrong reasons. when ROE is high because the equity multiplier is high.

‡ It is difficult to generalize about whether a ratio is good or not. . A high cash ratio in a historically classified growth company may be interpreted as a good sign.Limitations of Financial Ratios There are some important limitations of financial ratios that analysts should be conscious of: ‡ Many large firms operate different divisions in different industries. As a result. but could also be seen as a sign that the company is no longer a growth company and should command lower valuations.). LIFO versus FIFO. making it difficult to tell if it's a good or weak company. ‡ Different accounting practices can distort comparisons even within the same company (leasing versus buying equipment. ‡ Seasonal factors can also distort ratio analysis. ‡ A company may have some good and some bad ratios. Understanding seasonal factors that affect a business can reduce the chance of misinterpretation. Thus a ratio analysis of one company over time or a comparative analysis of companies of different ages must be interpreted with judgment. For example. the company's accounts payable will be high and its ROA low. For these companies it is difficult to find a meaningful set of industry-average ratios. a retailer's inventory may be high in the summer in preparation for the back-to-school season. In this case. profits will also be affected. etc. ‡ Inflation may have badly distorted a company's balance sheet.

and net income. A company with a simple capital structure will calculate only a basic EPS.Dividends declared to common stockholders are not subtracted from ESP as they belong to common stockholders. (b) Don't include dividends in arrears. then calculate an amount equal to what the current dividend would have been. Basic Earnings Per Share (EPS) EPS basic does not consider potential dilutive securities.Basic Earnings Per Share EPS is simply the net income that is attributable to common shareholders divided by the number of shares outstanding. which is defined as: Basic EPS = (net income preferred dividends)_____ weighted average number of shares outstanding . add the preferred dividend. . (a) If none are declared. Calculating the Weighted Average Number of Shares Outstanding The weighted average number of shares outstanding (WASO) is: The # of shares outstanding during each month. . weighted by the # of months those shares were outstanding. it means that a portion of their dilutive securities may be converted to equity at some point in time.EPS is calculated for each component of income: income from continuing operations.Preferred stock dividends are the current year's dividend only. If a company has a complex capital structure. income before extraordinary items or changes in accounting principle. (c) If a net loss occurs. . EPS basic will always be greater than EPS fully diluted. Since EPS basic does not take into account these dilutive securities.

The tax rate is 30%. $1. and paid preferred dividends of $2. assume that the company XYZ has a convertible bond issue: 100 bonds.000. such a security is an anti-dilutive security. XYZ s weighted average number of shares. In other words. yielding 10%.000. used to compute basic EPS. issued at par for the total of $100. warrants. Each bond can be converted into 50 shares of the common stock. If a security after conversion causes the EPS figure to increase rather than decrease. These securities would decrease EPS if exercised or if they were converted common stock. convertible debt and convertible preferred stock. What is the basic EPS? What is the diluted EPS? .000. is 10. but allow the owner to obtain common stock upon exercise of an option or a conversion privilege.Dilutive Securities Dilutive Securities are securities that are not common stock in form. XYZ reported an NI of $12.000. The most common examples of dilutive securities are: stock options. For example.000 par value. and it should be excluded from the computation of the dilutive EPS. a dilutive security is any securities that could increase the weighted number of shares outstanding.

Prepare Cash-flow statement for 2007 using indirect method: .

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