THE USE AND ANALYSIS OF FINANCIAL STATEMENTS

By White, Sondhi and Fried

CONTENTS

1. Measuring business income.................................................................................................22. Financial reporting and analysis..........................................................................................33. Short-term liquid assets........................................................................................................44. Inventories............................................................................................................................55. Current liabilities..................................................................................................................56. Long term assets...................................................................................................................710. The statement of cash flows...............................................................................................713. Analysis of cash flows.......................................................................................................714. Analysis of financial statements (Ratios)...........................................................................819. Depreciation, impairment.................................................................................................1020. Analysis of income taxes.................................................................................................1121. Analysis of financing liabilities.......................................................................................1322. Leases and off-balance-sheet financing...........................................................................15Vocabulary.............................................................................................................................17

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)DepreciationUnearned revenues

Revenue recognition principle – accrual principle. Accrual basis and cash basis accounting. Accrual basis is more important as it better reflects economic events. Adjusting entries.

Prepaid expenseDepreciationUnearned revenueAccrued expensesUnrecorded revenue

2. Financial reporting and analysis

Accounting information should be:UnderstandabilityUsefulness:

- Relevant - Reliable

Accounting conventions- Comparability and consistency- Materiality- Conservatism- Full discloser- The cost benefit

The Balance sheetCurrent assets (Operating cycle).

- Cash- Short term investments (market value).- Accounts receivables (net realisable value).- Notes receivable (NRV, interest charged, not collected within typical collection period). - Inventory (LCM, cost flow assumption).- Prepaid expenses (Original-historical cost, e.g.: insurance and rent) .

Fixed assets:Tangible assetsIntangible 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 the difference between gross and net sales?Net sales or revenues is gross less returns, allowances, and discounts.

What is allowance?What is maintenance expenses?

SG&A – Selling, general and administrative expenses. What is general expenses?

3. Short-term liquid assets

Credit policyCredit policies are established to enhance sales. Credit policy effectiveness might be estimated by:

Receivable turnoverAverage 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.

CashCash equivalents are securities that have term of less than 90 days.

Marketable securitiesAre 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.

Accounts receivable and bad debt.

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).

For estimating uncollectible receivables can be these methods used:1. Percentage of net sales method. 2. Aging of accounts (valuing specifically every period)

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 methodThe average cost methodFirst-in, first-out method FIFOLast-in first-out method LIFO

EI = BI + P - COGSCOGS = BI + P – EI

Under increasing prices this happens:- LIFO (higher COGS and cash flows, lower income, taxes, working capital)- FIFO (opposite).

The effect of inventory measurement errors.

The use of the lower of cost or market value (LCM) assumption. If the market value is higher than the cost, then nothing is done. If the market value is lower

than the cost then the difference is written down to lower replacement market value. It is important to understand that that LCM means that firstly cost flow assumption (FIFO or

LIFO) is used and then the value of the inventory is compared to the market value. It is also important that to note that LCM can be done on an individual product basis or all

group.

5. Current liabilities

Current liabilities (due within one year or operating cycle).Long-term 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

10. The statement of cash flows

CFO – net cash flow focuses rather on liquidity than on profitability. CFFCFI

CFO – shows changes in working capital (receivables, payables, inventories). CFF – shows changes in long-term payables. CFI – show changes in long-term assets.

Interest and dividends (US GAAP)Interest, dividends received, interest paid – CFO.Dividends paid – CFF.

Non cash operations.- Retiring by issuing equity- Capital lease- Exchanging non cash items.

11. Framework for financial statement analysis

Comprehensive income (changes to equity from external transactions).Footnotes (audited) Supplementary schemes (not audited). MD&A (Management Discussion and analyses):

1. Trends in sales and expenses. 2. Capital resources and liquidity, trends in cash flows. 3. Business overview on known trends. 4. Events and uncertainties 5. Discontinued operations, extraordinary items and other unusual or

infrequent events. 6. Disclosure of interim financial statements.

Role of an AuditorThe 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.

13. Analysis of cash flows

Non cash operations (usually involving a combination of financing and investing decisions)1. Acquiring assets for debt (mortgage, lease)2. Exchanging debt into stock.

International differencesUnder IAS GAAP 1. Interest and dividends received may be classified as CFO or CFI2. Dividends and interest paid may be classified as CFO or CFF

Direct method:CFOCash 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.

CFIGross changes in assets (excluding depreciation and goodwill). Cash from assets disposal = decrease in asset and gain from the sale.

CFFNet cash flow from creditors = new barrowings – principal paidNet cash flow from owners = new equity issued – share repurchases – cash dividends

Cash dividends = dividends expense – changes in dividends payable.

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.

INTERPRETATION OF CASH FLOW:- CFO is most important, revealing how much cash is generated from business. - CFO may indicate problems related to liquidity and solvency.

- Cash flows can be extrapolated to forecast. Discrepancies between income trend and cash flow trend shows that income trend is not reliable.

- Relationship between cash collections and inputs gives insight similar to the ratio analysis.

THE CONCEPT OF FREE CASH FLOWS (FCF)Free cash flow = operating cash flow – net capital expendituresNet capital expenditures = total capital expenditures – after tax proceeds from sale of assets

Notes to the questions:1. Amortization of bond is included in the calculation of CFO (in cash flow related to the

interest). So bond premium amortization is subtracted from the net income, and bond discount amortization is added to net income. (Flash back 120

14. Analysis of financial statements (Ratios)

COMMON-SIZE STATEMENTS

RATIOS

Internal liquidity 1. current ratio2. quick ratio3. cash ratio4. receivable turnover5. average receivable collection period6. inventory turnover7. average inventory processing period8. payables turnover9. payable payment period10. cash conversion cycle

Evaluating operating performance (operating efficiency and operating performance)

Efficiency (assets and equity turnover ratios) Desired to be close to industry norms. 1. Total assets turnover. 2. Fixed assets turnover. 3. Equity turnover.

Operating profitability ratios 1. Gross profit margin2. Operating profit margin3. Net profit margin4. Return on total capital (ROTC)5. Return on total equity (ROTE)6. Return on common equity (mostly analyzed using DuPont decomposition).

Risk analysis (Business risk and financial risk)

Business risk ( 5 to 10 years data should be used)1. Business risk.2. Sales volatility.3. Operating leverage.

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 ratio4. 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 analysisg = RR * ROE

External liquidity- Bid-ask spread.- Total market value.- Number of shareholders,.- Trading turnover.

DuPont analysesROE calculation

ROE = (net income/equity

Traditional approach (net profit margin, assets turnover, equity multiplier)Extended approach (operating profit margin, assets turnover, interest expense rate, equity

multiplier, tax retention rate).

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).

19. Depreciation, impairment

Average life

Average age (Accumulated depreciation\depreciation expense)Relative age (Accumulated depreciation\ending gross investment)Average depreciable life (ending gross investment\depreciation expense)

Assets impairmentCarrying 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.

US GAAP does not allow to restore impairment.The IAS allows to restore value of the asset.

20. Analysis of income taxes

IAS 12 – Income taxes.

Taxable income (on tax return) vs. pretax income.Taxes payable (on tax return) vs. income tax expense.

The liability method for deferred taxesThe deferral method is currently seldom used. Calculates deferred tax expense under current tax

expense.

Creation of deferred tax and liabilitiesThese tax deferrals occur due to different expenses treatments on the income statement and tax

return.

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.

Deferral versus liability methodThese methods are used for the calculation of deferred tax expense. Deferral method uses

current tax rate, with no adjustments for tax rate changes. Liability method (mostly used). According to the latter method deferred assets and liabilities are measured at the tax rate which is in power at the reversal date.

Discloser requirementsDeferred 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.

Changing tax ratesUnder the liability method, all deferred tax assets and liabilities are revalued using new tax rate

expected to be in place when the liability reverses. Tax rate increases: increase in tax rate increases current tax expense and the increase in

deferred tax assets decreases current tax expense

Analysis of deferred tax liabilitiesThe question is when the deferred taxes will reverse. An analyst must decide on a case-by-case

basis. If the deferred tax does not reverse in the near future then it should considered not as assets or liabilities, but as equity. Some creditors, notably banks, ignore deferred tax.

Analysis of deferred assetsDeferred tax assets might be reduced by two ways:1. Valuation allowance. 2. Decreasing equity and decreasing assets of deferred taxes.

The difference between the stated value of deferred taxes (undiscounted value) and present value of deferred taxes should be treated as equity.

Factors influencing the level and trend of deferred taxes1. The law and accounting changes.2. Growth of the firms. Under these factors everything is carried normally, with changes to equity.

Permanent and temporary differencesPermanent differences – are differences that will not reverse in the future, such as: tax-exempt

interest revenue, proceeds from life insurance, tax-exempt interest expenses, premiums paid on life insurance, goodwill amortization. These differences are never deferred, but are considered decreases and increases in the effective tax rate. I.e. no deferred tax liabilities or assets are created due to permanent differences and tax expense is equal to tax payable.

Temporary differences – are differences that will reverse in the future. Classification of temporary differences:

- Current liabilities- Long-term liabilities- Current assets- Long-term assets- Stockholder equity

Indefinite reversalsUndistributed 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.

What is associated expenses? What is a valuation allowance? It is a contra account against deferred tax assets. What is MACRS? Modified accelerated cost recovery system. What is expenditures?What is timing, permanent and temporarily difference?

21. Analysis of financing liabilities

Conceptual overview: Bond liability on the balance sheet is posted at its present not par value. The premium or discount is amortized over the bond’s life, so that interest expense

decreases over time for a premium bond and increases for a discount bond. Coupon payments affect CFO, and the amortized portion is recognized as CFF. Convertible bonds should be treated as equity for analytical purposes when the stock price is

significantly higher than the conversion price. For analytical purposes the market value of the bond should be used to calculate leverage

ratios and to value the firm. Gains and losses on debt retirement are treated as extraordinary gains and losses.

Bond terminologyPar value = stated value = face valueCoupon paymentsMarket rate of interests

Types of balance sheet debtCurrent liabilities – are reported at their full maturity value. - Operating and trade liabilities (Operating). - Advances from customers (Operating).- Short-term debt (Financing).- Current portion of long term debt (Financing).The shift from operating to financing may indicate the beginning of liquidity crisis.

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 discountsBonds 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 debtFor 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)

Convertibles, Warrants and preferred stockThe convertibility feature of a bond is ignored when the bond is issued, which means that bond

is normally reported as normal bond (debt). At the time of the conversion bond is transferred to equity. This conversion will dramatically influence leverage ratios.

In-the-money, out-of-the money, at-the-money. - Analyst should calculate the financial leverage in two ways. - Value the conversion feature using option pricing methods, separating debt and equity.

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 bondsInterest 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.

Changes in interest ratesWhen the debt is already issued (bonds), then the changes in the interest rates will have no

effects on the balance sheet. Because debt is held at its historical costs. For purposes of analyses book values should be adjusted for market values: as the interest rate increase, the outstanding debt should be reduced and equity increased.

Early retirement of debtThe gain or loss resulting from retirement of debt prior to maturity is treated as extraordinary

item (reported after income from continuing operations net of taxes). The firm may wish to retire its debt for several reasons:

- Higher operating cash flows. - Sale of assets. - Decline in the interest rates.

What is redeemable preferred stock?

22. Leases and off-balance-sheet financing

Conceptual overview: Operating versus capital lease. Criteria for classifying capital lease. Differences on financial statements and ratios due to capital and operating lease. Lease accounting calculations. Off-balance-sheet financing: take or pay contracts, throughput arrangements, sales of

receivables.

Criteria for capital lease:1. Transfer of title. 2. Bargain purchase option exists. 3. Lease period is at least 75 % of assets life. 4. The PV of payments of lease is at least 90 %.

ANALYSIS OF LESSORS:

Criteria for capital lease:1. Any of four criteria for lessee hold. 2. One of the following criteria hold:

a. Collectibility. b. Certainty

Incentive for capital lease:- Early recognition of revenue.- Higher profitability and turnover ratios.

Sales-type and direct-financing leases:

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.

Accounting for leases:1. At sale two transactions are made:

a. Sale (Credit) is recorded as the present values of MLPs with the costs of goods sold being equal to the net difference of the cost of the assets being leased less the PV of future estimated salvage value. There is negative cash flows from operations and positive cash flow from operations.

b. Asset account (net investment in lease) is increased (debit), which is the PV of all future lease payments plus the PV of salvage value.

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.

Notes to the questions:1. The purchase option is not considered to be a bargain option if lease payments are greater

than the fair market value of the asset2. Operating lease is like contract, and capital lease is like purchase. 3. .

Vocabulary

Defunct – not existingPerplex – puzzle, glumintiEnacted – ivykdytasConcise – glaustas, trumpas

Arreage – iskolinimas