Professional Documents
Culture Documents
STATEMENTS
By White, Sondhi and Fried
CONTENTS
1. Measuring business income................................................................................................. 2
2. Financial reporting and analysis.......................................................................................... 3
3. Short-term liquid assets ....................................................................................................... 4
4. Inventories ........................................................................................................................... 5
5. Current liabilities ................................................................................................................. 5
6. Long term assets .................................................................................................................. 7
10. The statement of cash flows .............................................................................................. 7
13. Analysis of cash flows....................................................................................................... 8
14. Analysis of financial statements (Ratios).......................................................................... 9
19. Depreciation, impairment ................................................................................................ 10
20. Analysis of income taxes................................................................................................. 12
21. Analysis of financing liabilities....................................................................................... 14
22. Leases and off-balance-sheet financing .......................................................................... 16
Vocabulary ............................................................................................................................ 18
1. Measuring business income
Income:
Gross profit, operating profit, net income from continuing operations, net income.
Accounting periods:
On yearly basis is obligatory, and shorter periods are used on interim basis.
The most important assumptions – going concern assumption. Second very important assumption is
- matching principle.
Accounts adjustments:
Prepaid accounts = prepaid expenses (only part of it should expensed, e.g. rent, insurance)
Depreciation
Unearned revenues
Accounting conventions
- Comparability and consistency
- Materiality
- Conservatism
- Full discloser
- The cost benefit
Fixed assets:
Tangible assets
Intangible assets (Goodwill is not amortized in US, but IAS allows to amortize)
Current Liabillities:
- Accounts payable
- Wages, rents and other payable
- Notes payble
- Dividend payable
- Current portion of long term debt
Long-term liabilities (valued at present value of future cash flows)
Shareholders’ Equity
Income statement
What is allowance?
What is maintenance expenses?
Credit policy
Credit policies are established to enhance sales. Credit policy effectiveness might be estimated by:
Receivable turnover
Average days’ sales uncollected
Financing receivables:
- Receivables might be used as collateral for barrowing.
- Accounts receivables might be sold (factoring) with or without recourse. With recourse sold
receivables are called contingent liability.
- Securitized receivables.
Cash
Cash equivalents are securities that have term of less than 90 days.
Marketable securities
Are held only until cash is needed.
Short term investments are initially recorded at cost (cash price plus any acquisition costs).
Reporting requirements:
1. Short-term investments that are held at maturity are reported at original cost.
2. Trading short-term investments are carried on the balance at its fair market value. Gain or
loss are reported on the income statement.
3. AFS (available for sale) investment is reported on the balance sheet at its fair market value.
But appreciation or depreciation is listed directly on equity account, but not on the income
statement.
There are two approaches to accounting for uncollectible receivables. The direct write-off
method ( and the allowance method (Debit expense, credit receivable allowance, as you learn
for sure that debtor goes bankrupt, we debit allowance and credit receivables).
Promissory notes – usually A/R are traded in exchange for promissory notes. The payee makes
notes receivable instead of A/R and payer makes notes payable. If not all the notes are paid at the
maturity then than the note is dishonored. The A/R is again restored in this case.
Questions:
What is AFS?
What is the difference between the write-off and write down?
What is aging of accounts?
4. Inventories
The cost of inventory includes invoice price less discounts, transportation costs, and taxes.
Inventory computations:
Specific identification method
The average cost method
First-in, first-out method FIFO
Last-in first-out method LIFO
EI = BI + P - COGS
COGS = BI + P – EI
5. Current liabilities
Warranty payables – payables where the payees are not yet known .
At the end of the reporting period some of the expenses must be recognized (pensions, employee
benefits, etc.).
Estimated liabilities
Questions:
What is estimated liability? – The precise amount of the liability is not yet known, but the liability
can be reasonably estimated (vocation pay, income taxes, product warranty, property tax)
What is contingent liability? A liability only if future event occurs.
- Probable – the loss must be disclosed on the income statement.
- Reasonably likely, but not reasonably estimable – should be disclosed on the footnotes.
- Future payment is remote – then no discloser is required.
6. Long term assets
Role of an Auditor
The public accountants carry audits on company’s financial statements. The auditor provides an
opinion on the fairness and reliability of the financial reports. The auditors examines the companies
accounting and internal control system, conforms assets and liabilities, no material errors.
Auditor’ s report contain three parts:
- Whereas the financial statements are prepared by management and are its responsibility, the
auditor has performed an independent review.
- Generally accepted audit standards were fallowed, providing reasonable assurance that the
financial statements contain no material errors.
- The auditor is satisfied that the statement were prepared in accordance with GAAP.
Qualified opinion – concerns about ongoing concern principle, asset valuation and litigation.
Unqualified opinion – the auditor is unaware of any uncertainties.
International differences
Under IAS GAAP
1. Interest and dividends received may be classified as CFO or CFI
2. Dividends and interest paid may be classified as CFO or CFF
Direct method:
CFO
Cash collections (net sales, changes in receivable, cash advances from customers)
Cash inputs (COGS, changes in inventory, accounts payable and other liabilities)
Cash operating expenses (operating expenses and operating liabilities (salaries))
Cash taxes (tax expense, changes in tax payable, changes in deferred taxes)
Cash interest (interest expense, changes in interest payable, amortization of bonds discounts
and premia)
Indirect method:
Net income.
Less gains or losses from financing and investing cash flows.
Add non cash components such as depreciation and amortization.
Add or subtract changes to the operating accounts.
CFI
Gross changes in assets (excluding depreciation and goodwill).
Cash from assets disposal = decrease in asset and gain from the sale.
CFF
Net cash flow from creditors = new barrowings – principal paid
Net cash flow from owners = new equity issued – share repurchases – cash dividends
Discrepancies in balance sheet and cash flow statement is due to mergers and acquisitions and
exchange rate changes:
- Inventory acquired through acquisition will be reported in CFI, not in CFO.
- Exchange rate changes loss and gains should be reported separately.
RATIOS
Internal liquidity
1. current ratio
2. quick ratio
3. cash ratio
4. receivable turnover
5. average receivable collection period
6. inventory turnover
7. average inventory processing period
8. payables turnover
9. payable payment period
10. cash conversion cycle
Efficiency (assets and equity turnover ratios) Desired to be close to industry norms.
1. Total assets turnover.
2. Fixed assets turnover.
3. Equity turnover.
Financial risk
1. Debt to equity ratio - deferred taxes should be included into debt if we know for sure that it
will be paid (early income recognition), but if it is only due to different depreciation
methods, it should be excluded.
2. Long term debt to total (log term) capital
3. Total debt ratio
4. Total interest bearing debt to total funded capital (without non-interest bearing debt).
5. Interest coverage ratio (gross interest expense is used in the denominator).
6. Fixed financial cost ratio (EBIT + ELIE)/(gross interest expense + ELIE)
7. Cash flow coverage of fixed financial cost (CFO + gross interest expense +ELIE)/(gross
interest expense + ELIE).
8. Cash flow to long-term debt. (CFO/BV of long-term debt plus PV of operating leases).
9. Cash flow to total interest bearing debt.
Growth analysis
g = RR * ROE
External liquidity
- Bid-ask spread.
- Total market value.
- Number of shareholders,.
- Trading turnover.
DuPont analyses
ROE calculation
RELATIVE RATIOS
- Ratios should be compared to the industry averages. If there big variations in industry
ratios, the median should be used.
- It would be better to use only a subset o firms with similar. (Cross-sectional analyses).
Average life
Average age (Accumulated depreciation\depreciation expense)
Relative age (Accumulated depreciation\ending gross investment)
Average depreciable life (ending gross investment\depreciation expense)
Assets impairment
Carrying amounts of acquisition costs less depreciation should be reduced when there is no longer
an expectation that those amounts can be recovered from future operations:
- A change in business environment.
- A decline in the usage rate or market value.
- Decline in profitability of the asset.
- Significantly higher than expected costs.
Deferred tax liability – is reported as the income tax expense showed for financial reporting is
grater than taxes payable on tax return (e.g. for accelerated depreciation method for IRS). But as the
financial reporting shows greater taxes, which will be paid to IRS later, the liability of deferred
taxes must be reported.
Deferred tax assets – occurs when the payable tax is greater than the tax expense, which means
that less taxes will be paid later or this is equivalent to making a record of deferred tax assets.
Discloser requirements
Deferred tax liabilities, assets, valuation allowance and loss carry forwards, credits, components
of tax expense, reconciliation of tax expense with that based upon the tax rate.
Indefinite reversals
Undistributed earnings of unconsolidated subsidiaries or joint ventures. Because retained
earnings in the subsidiary, which are not distributed in the forms of dividends to the mother
company, at the mother’s statements are considered as pretax income, but not taxable income. The
liability of deferred tax might not never be reversed due to overall control of the subsidiary. Then
this difference might be considered as permanent.
Bond terminology
Par value = stated value = face value
Coupon payments
Market rate of interests
Long-term debt
- Is equal to the present value of the future payments (interest and principal).
- Subordinated and senior claim.
Accounting for debt issuance, interest, and amortization or premiums and discounts
Bonds are initially listed on the balance at its market value on the books. And bond payables are
carried as the present value of all future payments. The book value can be calculated as the present
value of all future payments. The market interest rate for book values is the market rate at the time
the bond was issued.
Premium and discount is amortized during the life of the bond.
Interest expenses is always equal to the book value of the bonds at the beginning of the period
multiplied by the market of interest at the issuance. At the beginning the coupon is recognized as
the interest expense. But the amortization of the premium reduces the interest expense until it equals
market interest expense.
Cash flow. Coupon payments affect CFO. But for analytical purposes the interest expense
should treated as CFF.
Premium bonds CFO is understated and CFF is overstated.
Discount bonds: CFO is overstated and CFF is understated.
Long-term debt is carried at the present value of the remaining cash payments discounted at the
market rate existing when the debt was issued.
Zero-coupon debt
For zero-coupon bonds CFO is overstated as there are no coupons.
Non-interest payable notes are carried at the balance sheet at its present value (the same as zero
coupon bonds)
Unlike convertible bonds where option is non-detachable, for warrants – the option is
detachable.
The discount is amortized, hence the interest expense will be higher.
Balance sheet value: Warrants<convertibles=regular bonds
Interest expense: Convertible<warrants<regular bonds. Thought the cash interested paid will be
the same for convertibles and warrants.
Operating cash flows: warrants=convertibles>regular bonds.
Preferred stock.
- Dividends are cumulative.
- Almost always callable by the issuer.
- Some shares may be also redeemable (for analysis should be treated as debt).
If the preferred stock is redeemable then it should be treated as debt for analytical purposes.
ANALYSIS OF LESSORS:
Sales-type lease. Lease must be capital lease and the lessor is the dealer . Revenue is recognized
at the inception less costs of the assets is equal to the gross profit. The implicit interest rate is such
that the PV of MLPs is equal to the selling price of the leasing asset.
Direct-financing lease. Lease must be capital lease and the lessor is not the dealer (Finance
institution). No profit is recognized. All revenue is interest type. The implicit interest rate is such
that the PV of MLPs is equal to the cost of the asset.
2. Periodic transactions:
a. Interest income is calculated y multiplying the years beginning value of net
investment by discount rate on the lease.
Income statement:
The income for capital and operating leases will be the same over all economic life.
Arreage – iskolinimas