FSA 5

Analyzing Investment activities

 M5-1
• Current assets expected to be converted to Cash or cash
equivalents within the Operating Cycle or 1 year whichever is longer
• CA-CL=W/c . In an attempt to reduce their w/C, cos. Try to finance a
good portion of their C/A thru’ C/L

• Liquidity refers to the ability of a company to meet its short term

obligations in time; it again is a factor of the cash the company has
with it or, its ability to raise cash/ cash equivalents at short notice

• Sometimes certain restrictive loan/financing covenants demand

that a certain portion of the cash with the company be kept inform
of cash only. It also is to be recognized that cash equivalents
representing investments shares can lead to a loss of liquidity
should the share prices plummet
 M5-2
• Receivables
• Receivables accounted at their NET REALIZABLE VALUE book value
minus uncollectible
• Analyzing receivables
• Analysis tools for investigating collectibility
• 1) Comparing competitor’s receivables as a percentage of sales
• 2)Examining CUSTOMER CONCENTRATION– risk is high if not spread
among a lot of customers
• 3)Investigating AVERAGE COLLECTION PERIODS WITH INDUSTRY
FIGURES
• 4) determining the proportion of receivables that are RENEWALS of
prior a/cs or Notes receivable
• Adequate Provision must be made for Doubtful debts
 M5-3
• Authenticity of receivables—a provision allowing
SIGNIFICANT RETURN OF MERCHANDIZE can impair
the quality of receivables . Also Receivables carrying
contingencies can get badly impaired
• Securitization-off b/s financing thru’ an SPE is
possible only as long as there is no consolidation of
a/cs. Variable Interest Entities can get consolidated
• Factoring—With recourse or Without recourse
• Prepaid expenses
 M5-4
• Inventory accounting– goods held for sale
• CGS=O/s+ P- CL/s
• GAAP allows 3 options in determining WHICH
INVENTORY COSTS TO MATCH against sales
• FIFO, LIFO & Av.cost
• Inventory Costing effects on profitability
• O/s+ P-CL/s= CGS
Gross profits=Sales-CGS
See the example on Pg 203/04 of text
 M5-5
• The example depicted brings to focus the following—
• 1) In a RISING price regime, FIFO generates PHANTOM PROFITS because of—
• A) Economic gains—Qnty. Sold* ( SR- PR)
• Sr—sales rate, PR—latest purchase rate
• Eco. Gains represents PROFITS on Sale
• B) Holding Gains; gains for having BOUGHT the Inventory earlier and at a cheaper
rate-EARLY BIRD ADVANTAGE
• =Qnty sold *(PR—HR)
• HR-The holding rate-> the rate at which inventory is valued
• High Inventory turnover reduces/eliminates Holding gains—as is happening in the
US where the JUST IN TIME concept is hugely popular. However rising Inflation can
increase H/G and play spoilsport ( in case of FIFO)
•
 M5-6
• INVENTORY COSTING EFFECTS on the B/s
• In a rising Price regime, LIFO will cost Closing
Inventory at rates MUCH LOWER than
REPLACEMENT COSTS vitiating the a/cs and the
B/s in the process( Current assets must reflect
something close to current values). To the extent
of lower valuation, the INVESTED CAPITAL is
obviously UNDERVALUED!
 M5-6
• Inventory costing effects on CASH FLOWS
• FIFO creates a HIGHER TAX LIABILITY
• High Tax liability in a rising price regime can lead to a cash squeeze as
NEW PURCHASES come at higher costs!
• LIFO on the other hand, reduces tax outgo and adoption of this is,
from the point of view of Tax Planning, LEGITIMATE. However the IRS
requires ‘LIFO CONFORMITY RULE to be adopted by companies
adopting LIFO—i.e LIFO must be used for COSTING and FINANCIAL
ACCOUNTING if tax deductions are to be availed of!
• Also such companies must disclose LIFO RESERVE- the difference
between the amounts at which Inventory would be carried at FIFO
and LIFO prices
 M5-7
• LIFO RESERVE represents savings in Pre tax incomes and multiplied
by the Tax rate indicates the TAX SAVINGS MADE!
• LIFO LIQUIDATION
• Cos. Using LIFO in periods of QUICK INVENTORY CONSUMPTION
accompanied by a RISING RATE REGIME dip into OLD INVENTORY
PRICES for VALUING THEIR CGS . This results in HIGHER GROSS
PROFITS as was seen in FIFO
• While LIFO RESERVE is supposed to reflect tax savings and is really an
unrecorded asset , there seems to be a NEGATIVE correlation
between the Quantum of the reserve and stock prices HIGHER THE
RESERVE, LOWER the PRICES. This could be because of INVESTOR
PERCEPTION of a DECLINE in the REAL VALUE of the company
consequent to INFLATION!
 M5-8
• RESTATEMENT of LIFO to FIFO
• LIFO as seen earlier,--- understates Inventory value in a
rising rate regime. THIS—
• A) UNDERSTATES the company’s DEBT PAYING
CAPACITY( as Current assets are LOWER) B) It OVERSTATES
INVENTORY TURNOVER (Sales/ av. Inventory)
• To covert LIFO figures to FIFO—
• 1) Inventories=Reported LIFO Inventory + LIFO Reserve
• 2) Increased deferred tax payable=LIFO RESERVE X Tax rate
3) Retained earnings=Reported Retained earnings+ ( LIFO
reserve X ( 1-Tax rate)
 M5-9
• Generally Cos. Choosing LIFO exhibited the following
characteristics- a survey
• -Greater Expected tax savings
• --Large inventory Quantities (the LIFO RESERVE helps
reduce taxes under these circumstances)
• --lower variability in Inventory balances
• ---less likelihood of inventory obsolescence
• --Less leveraged
• --Higher Current ratios ( trying to reduce it thru’ LIFO)
 M5-10
• Hassles of OVERHEAD ABSORPTION
• Overheads are absorbed INTO INVENTORIES as produced Quantities
absorb O/Hs. THUS THEY ( O/H costs) REMAIN in the B/S UNTIL the
INVENTORIED GOODS are SOLD; On SALES THEY GET REFLECTED IN
CGS. IF an increase in INVENTORY is seen as a result of higher
Production say, HIGHER PROFITS RESULT AS A CONSEQUENCE of
HIGHER CLOSING INVENTORY. However LATER if INVENTORY
QUANTITIES DECREASE for whatever reason, THE INCOME
STATEMENT IS BURDENED WITH OVERHEADS OF NOT ONLY THE
CURRENT PERIOD BUT OF PREVIOUS BACKLOG OF OVERHEADS
CARRIED BY INVENTORIES, REDUCING PROFITS in the process
• Analysts need to be aware of this hassle of Overhead absorption
 ADDENDUM
• Fixed costs are absorbed by inventories on the
basis of Normal production in PRICE CONTROLLED
INDUSTRIES- fertilizers say-
• WHAT is the situation when PLANT CAPACITIES
are under rated? Explain
 M5-11
• LOWER OF COST or MARKET
• The P&L a/c takes a charge when MARKET VALUE goes
BELOW COST
• MARKET VALUE MUST NOT BE—
• A) UPPER LIMITNRV
• B) LOWER LIMITNRV less Profit Margin
• Understand ; the LOWER LIMIT ensures that if INVENTORY
is WRITTEN DOWN FROM COST to MARKET, it is written
down to a FIGURE THAT ENSURES NORMAL PROFIT
MARGINS IN THE NEXT PERIOD!!
 M5-12
• COST is Cost as per LIFO, FIFO/Average
• When Prices are rising, the lower of cost/ Market
UNDERVALUES stock irrespective of the method of Cost
arrived at. This depresses the Current ratio
• ------------------------------------------
• LONG TERM ASSETS
• Tangible and Intangible assets
• Long term assets are RESOURCES that are used to generate
OPERATING REVENUES or reduce operating costs for more
period than one.
 M5-13
• Accounting for long term assets
• Involves 3 distinct activities—Capitalization/ Allocation and
Impairment.
• Capitalization is a process of deferring a cost that is incurred in the
current period, but whose benefits are expected to extend to one or
more future periods.
• Allocation is the process of periodically expensing a deferred cost to
one or more future periods. This process is called DEPRECIATION for
TANGIBLE ASSETS, AMORTIZATION for Intangible assets and
DEPLETION for NATURAL RESOURCES
• IMPAIRMENT is the process of WRITING DOWN the BOOK VALUE of
the asset when the EXPECTED CASH FLOWS are NO LONGER
sufficient to recover the COST REMAINING in the B/s
 M5-14
• Capitalization
• Is putting the asset on the B/s rather than
expensing it soon thru’ the income statement
• Hard Tangible assets- capitalized at Acquistion
costs plus all costs necessary to bring it to that
location and condition
• Soft assets-R&D-- developed IN HOUSE expensed
to Income Statements, as it is difficult to estimate
its useful life and the future benefits flowing from
out of it
 M5-15
• SOFTWARE DEVELOPMENT COSTS
• As already discussed, the software developed in house is capitalized
and AMORTIZED over its estimated useful life
• Software developed for sale/lease is Capitalized and amortized “only after
it has reached “Technical feasibilty’ stage. If it does not reach that stage
treated as R&D and expensed
• Allocation ( depreciation)
• 3 factors determine it—1) Useful life 2) Salvage value 3) Allocation
method—all 3 require estimates
• Impairment- when the EXPECTED UNDISCOUNTED cash flowsARE LESS
THAN THE asset”s carrying amount, THE ASSET IS DEEMED TO BE
IMPAIRED AND WRITTEN DOWN TO ITS Market Value-the DISCOUNTED
AMOUNT of Future Cash flows.This reduces Profits by a like amount
 M5-16
• CAPITALIZING vs EXPENSING- effects
• Capitalization has 2 effects on INCOME—a) postpones recognition of expense on
the income statement leading to HIGHER income in the Year of capitalization and
LOWER Income thereafter( depreciation effect)
• b) It yields a smoother Income series-especially if amortization is by a St. line
method
• Capitalization and ROI
• Affects both the NUMERATOR(INCOME) and the DENOMINATOR (investment
base) in ROI; this is smoothing again . Expensing leads to volatile ROI as only
Income is affected; the asset base being smaller, the greater is the Volatility. Ratios
are less useful
• Effects on CASH FLOWS
• When Assets are EXPENSED immediately, they create OPERATING CASH OUT
FLOWS; when CAPITALIZED, they are depicted as INVESTING CASH FLOWS. Wrong
expensing can overstate OPERATING CASH FLOWS and UNDERSTATE INVESTING
CASH FLOWS in the year of acquisition
 M5-17
• Valuing PPE(Property, plant and Equipment)
• Valued at Historical costs less depreciation
• Valuing Natural resources ( wasting assets)
• These are RIGHTS to extract minerals, natural gas, petroleum etc. Capitalization
costs are substantial and are EXPENSED as and when the resources are extracted.
(In fact, Companies allocate these Capital costs OVER ESTIMATED reserves
generally)
• The RATE of depreciation depends on 2 factors– 1) USEFUL LIFE 2) METHOD USED
• Useful life– rate of Obsolescence HIGH for HIGH END Technology. Also use of the
asset can be on SINGLE SHIFT as also triple shift.( Rate for triple shift usually
doubles)
• Methods
• Straight line—uniformity; assumes that the Equipment carries the SAME PHYSICAL
STATUS AT THE BEGINNING AND AS AT THE END OF ITS LIFE! It also depicts
INCREASING RETURNS over TIME. This is in reality NOT reflective of an Ageing
Asset
 M5-18
Accelerated Method
Allocate the cost of the asset over its useful life in a DECREASING
MANNER i.e. the initial years depreciation is higher compared to
the later periods. So an accelerated write off is welcome for tax
purposes 1) The FASTER the WRITE OFF, the faster the tax shield
availability and the faster the cash flows 2) decreasing
depreciation charge in later years help as, maintenance costs are
generally higher then. Also then Operating Efficiency is LOWER and
revenue uncertainties can creep in by then
THE 2 Accelerated Methods—1) WDV 2) Sum of digits
SDM Add up the years of life. A 5 yr asset 1+2+3+4+5=15
In the Ist year---5/15 in the second yr---4/15 last yr—1/15
Double declining method—St. line rateX2= double declining rate
 M5-19
Analyzing Plant Assets and Natural Resources
Assets here are carried at HISTORICAL COSTS less depreciation. Historical costs—
--don’t compare with latest REPLACEMENT COSTS
--they are NOT comparable across Companies Reports
---Not useful in measuring opportunity costs
--in changing price levels, they represent a COLLECTION OF EXPENDITURES
reflecting different PURCHASING POWER!
---------------------
IMPAIRMENTS
accounting rules require that assets are tested for impairments time and again. The
test—RECOVERABILITY TEST—
Future cash flow+ disposal value-if LESS than CURRENT CARRYING AMOUNTS, the
asset is impaired
The impairment loss=Asset book value LESS Fair value
Fair value is the Market value or PV of expected future net cash flows
 M5-20
• Analyzing Depreciation and Depletion
• Many cos. Suddenly in the course of the asset life go about revising its
ESTIMATED USEFUL LIFE An analyst should read in between the lines to
small a rat!
• A hassle for the analyst is that depreciation methods in Books and for
taxes COULD VARY. A st.line for Books and an accelerated method for
taxes, presents tax savings—a cost free fund! Also the use of
Accelerated method in both a/cs and for tax purposes provides
HIGHER DEPRECIATION in the EARLIER Years which can be extended
for several years by project expansions!
• The ADEQUACY of DEPRECIATION --St. line only
• AV TOTAL LIFE SPAN= Av. Age+ Av. Remaining life
• AV. Life span=Gross Asset costs/ current yr Depr.
• Av.age=Accum. Dep/Current yr. dep AV. REMAINING life= Net block/
current yr. depr
 M5-21
• Av. Age of Plant and equipment is useful in evaluating several factors
including PROFIT MARGINS and FUTURE FINANCING METHODS. For ex.
Capital intensive cos. WITH AGED FACILITIES often have PROFIT
MARGINS NOT SUPPORTING FUNDS REQUIRED TO PROVIDE
MARGINS / DEPOSIT/ COLATERALS FOR future REPLACEMENTS!!
The CAPITAL STRUCTURES also might not offer hopes for raising
replacement funds
INTANGIBLE RIGHTS
GOODWILL PATENTS, COPY RIGHTS ETC
---these are INSEPARABLE from the company/its segments
----have INDEFINITE Benefit periods
---experience LARGE valuation changes BASED ON COMPETITIVE
CIRCUMSTANCES
 M5-22
• Only PURCHASED INTANGIBLES are recorded in the BALANCE SHEET—
at historical prices. Expenses incurred on developing –possibly—
intangibles are WRITTEN OFF to the Income
• Identifiable intangibles are recorded at COST and amortized over their
benefit period
• UNIDENTIFIABLE INTANGIBLES
• Ex. Goodwill on the acquisition of a firm. G/W here, is the Difference
between the PRICE of Acquisition AND the Net assets taken over at
agreed valuation/ book value. Good will must result in EXCESS
EARNINGS ie Earnings above NORMAL EARNINGS—otherwise an
accelerated write off is called for!
• Patents/ copyrights etc are exclusive rights for a Specific period. They
are to be written off over this period Impairments to
intangibles( identifiable) must be recorded just the way they are
recorded for FIXED ASSETS
 M5-23
• Goodwill is not amortized; its impairment however is recognized
• Expenses on GOODWILL development( brand say) might create
this asset; to the extent that it is not recognized it reflects
undercapitalization