Financial Statement Analysis Study Session 7 & 8.

Financial Statement Analysis


Study Session 7 & 8


Financial Statement AnalysisBasic Concepts

Study Session 7


CONTENTS OF STOCKHOLDERS REPORT

• Management’s Discussion and Analysis (MDA)

• Balance Sheet

• Income Statement

• Statement of Stockholders’ Equity

• Statement of Cash Flows

• Statement of Comprehensive Income

• Auditor’s Report

• Explanatory Notes

• Supplementary Information

LOS 29 d discuss the additional sources of information accompanying the financial statements, including the financial footnotes, supplementary schedules, Management Discussion and Analysis (MD&A) and Proxy statements


CONTENTS OF MANAGEMENTDISCUSSION AND ANALYSIS

• Results of operations + discussion of trends

• Capital resources and liquidity + trends in cashflows

• General business overview based on known trends

• Effects of known trends, events and uncertainties

• Discontinued operations, extraordinary items,unusual items

• Disclosures in interim financial statements

• Segmental cash flow requirements and contributions



Corporate Filings/Proxy Statements

Form 10-K

Annual

Report

Proxy

Detailed financial results reported to the SEC on annual basis. Audited and filed 90 days after the close of a fiscal year.

Publicly held companies report their financial results annually to shareholders in an annual report. Effectively the report is a condensed version of the 10-K.

A proxy statement is sent to all shareholders in connection with company meetings. The proxy explains proposals that will be voted on by the shareholders. The proxy also contains information about management remuneration, stock options, special deals and related party transactions. The proxy will also detail any changes of auditor.



Corporate Filings/Proxy Statements

Form 10-Q

Form 8-K

Form 144

Registration

Public companies must file quarterly reports 45 days after the end of the period using form 10-Q. The form contains a balance sheet, statement of operations, cashflow and MDA but is not audited.8-K is used to inform the SEC of special events: changes in control, acquisitions, dispositions, auditor changes, director resignation and bankruptcy. (Normally due within 15 days – 5 for auditor)

Insiders must register every time they buy or sell stock.


When a publicly held company plans to issue securities, it must file a registration statement, including a prospectus and exhibits


FINANCIAL ACCOUNTING STANDARD SETTING

Financial Accounting Standards Board (FASB)

American Institute of CertifiedPublic Accountants (AICPA)

Securities and ExchangeCommission (SEC)

(Recognize)Pre-1973

APB

Statements of FinancialAccounting Concepts

(SFAC)

Statements of FinancialAccounting Standards

(SFAS)

LOS 29 a discuss the general principles of the financial reporting system and explain the objectives of financial reporting according to the Financial Accounting Standards Board (FASB) conceptual framework;


INTERNATIONAL FINANCIAL ACCOUNTING STANDARD SETTING

Different accounting standards make international comparisons difficult

IOSCO

IASB

International Organization of Securities Commissions – 65 countries securities regulators investigate and set standards on multinational disclosure and financial statements. Implementation is left to the individual members.

International Accounting Standards Board – attempting to provide a unified international framework of accounting standards. Has issued over 40 proclamations. Lacks a formal mechanism to ensure compliance with standards. Many governments now voluntarily adopting IAS. International Accounting standards were adopted by the EU in 2005. US and IAS are slowly converging.

LOS 29c discuss the role of IOSCO and IASB in setting and enforcing global accounting standards


General Principals ofFinancial Reporting System

• Timing Economic events and accounting entries may take place in different periods, e.g., changes in market value of PP&E

• Recognition Many economic events do not receive recognition, e.g., contingencies, off balance

sheet finance

• Measurement Certain items may be reported in different ways, e.g., FIFO vs. LIFO

LOS 29a : Discuss the general principals of the financial reporting system


Objectives of Financial Reporting

Equity Investors

Short Term Creditors

Long Term Creditors

Interested in identifying firms with long term earning power, growth opportunities and ability to pay dividends

Interested in liquidity of the business

Long term asset position and earning power


Classes of user

Investors – debt and equity

Government – taxes/regulators

Others – public, special interest groups, workforce etc


Foundations of Accrual Accounting

• Recognition Principle

• Matching Principle

• Historic Cost Principle

Revenue is recognized when goods are delivered or services performed, not necessarily when the cash is received

Revenues and associated costs are recognized in the same accounting period

Assets and liabilities are recorded at the transaction’s original value. The advantage is that historic cost is objective and verifiable.



Statement of Financial Accounting Concepts (SFAC) 2

• Relevance

• Timeliness

• Reliability

• Consistency

• Comparability

• Materiality

Information that could potentially affect a decision

Information looses value rapidly in the financial world. Helpful for forecasting.

Verifiable and representational faithfulness

Same accounting principles consistently applied over time

Information should allow comparison between companies. Often difficult due to estimates and methods.

Which data is important enough for inclusion in the financial statements.

LOS 29 b identify the accounting qualities (e.g., relevance, reliability, predictive value, timeliness) set forth in Statement of Financial Accounting Concepts (SFAC) 2, and discuss how these qualities provide useful information to an analyst


The Audit Report

• Audit = independent review of the company’s financial statements

• Financial statements are true and fair

• Audit ReportResponsibility of management to prepare accounts

Independence of Auditor’s

Properly prepared in accordance with relevant GAAP

Free from material misstatement

Accounting principles and estimates chosen are reasonable

Unqualified opinion vs. qualified opinion

UncertaintiesLOS 29 e Discuss the role of the Auditor and the meaning of the audit opinion


MONEY IN MONEY OUTLoan capital (ST & LT)

Share capital

Reserves

Long-lived assets

Current assets

Investments

LIABILITIES + STOCKHOLDER EQUITY ASSETS=

Assets – In order of liquidity

Liabilities – In order of due dateLOS 29 d describe and distinguish between the principal financial statements: Balance Sheet, Income Statement, Statement of Comprehensive Income, Statement of Cash Flows and Statement of Stockholders’ Equity

Assets

Liabilities

Equity

probable current and future economic benefit obtained as a result of past transactionsprobable sacrifices of economic benefit/transfers of wealth as a result of past transactionsresidual interest in Net Assets of an entity (Total Assets –Total Liabilities)


LOFTUS INC. BALANCE SHEET AS AT 31 DECEMBER 20X0ASSETSCurrent assets

CashShort term investmentsAccounts receivableLess: Bad debt provisionInventoryPrepayments

Total current assetsInvestmentsProperty plant & equipment

Land and BuildingsPlant & MachineryLess: Accumulated depreciation

Intangible assets: Goodwill TOTAL ASSETS

$’000 $’000 $’000

10040

380540

10

400(20)

1,070200

5001800(400)

14001,900

2,000

5,170LOS 29 d describe and distinguish between the principal financial statements: Balance SheetLOS 30 a describe the factors that distinguish long-term assets from and identify common types of long-term assets and their carrying values on the balance sheet;


Long Term Assets

Long term asset = asset held for continuing use within the business, not resale

Cost

Accumulated Depn /Amort

Net Book Value (NBV)

X

(X)

X

Carrying Value Balance Sheet

Proceeds

NBV

Profit/(loss)

X

(X)

X/(X)

Profit on disposal – Income Statement

Cost includes all expenditure to acquire the asset and ready it for usage (installation, broker, legal fees, etc.)

$ $

For part exchange replace proceeds with trade in allowance

LOS 30 a identify the common types of long-term assets and their carrying values on the balance sheetLOS 30 b determine the cost and record the purchase, of property, plant, and equipmentLOS 30 d describe how to account for the sale, exchange, or disposal of depreciable assets


LOFTUS INC BALANCE SHEET AS AT 31 DECEMBER 20X0LIABILITIESCurrent liabilities

Accounts payableTax payableCurrent portion of long term debt

Total current liabilitiesLong term liabilities

Common stock $1 par value500,000 shares issued and outstandingOther paid in capital

Total contributed capitalRetained earningsTotal stockholders equity

$’000 $’000 $’000

390250120

760

500200

7001,370

2,070

5,170

Bonds payable

STOCKHOLDERS EQUITYContributed capital

TOTAL LIABILITIES AND STOCKHOLDERS EQUITY

2,340

LOS 29 d describe and distinguish between the principal financial statements: Balance SheetLOS 31 f describe the components/format of the balance sheet


Stockholders Equity

Preferred Stock

Common Stock

Additional Paid in

Capital

Other items

Disclosure – dividends (fixed, floating, participating), call provisions, conversion privileges. If redeemable by holder reclassify after liabilities

Each class reported separately, recorded at par value, treasury stock contra for repurchases

LOS 31 f describe the format and the components of the balance sheet and the format, classification, and use of each component of the statement of stockholders’ equity.

If common stock is issued above par value any excess is recorded in additional paid in capital

- Minimum Liability Adjustment (Pensions)- Forex gains and losses under the all current method- Market Valuation Adjustment (Available for sale securities)- Unearned shares issued to employee stock ownership plans


STATEMENT OF STOCKHOLDERS’ EQUITY – LOFTUS INC.

Year Ending December 31 20X0

Stockholders’ Equity at beginning 1,520

Additions: Sale of Common Stock at Par 200 Additional Paid-In Capital: 200 Net Income 200X 500

Dividends Paid: (350)

Stockholders’ Equity at end 2,070

$’000

LOS 29 d describe and distinguish between the principal financial statements: Statement of Stockholders’ EquityLOS 31 f describe the format and the components of the balance sheet and the format, classification, and use of each component of the statement of stockholders’ equity.


INCOME STATEMENT FOR THE YEAR ENDING 31 DECEMBER 20X0

RevenuesCost of goods soldGross profitOperating expensesDepreciationEarnings before interest and taxesInterest expenseEarnings before taxesTaxesNet income

$’000

6,3502,4003,9502,500

2001,250

500750250500

LOS 29 d describe and distinguish between the principal financial statements: Balance Sheet, Income Statement, Statement of Comprehensive Income, Statement of Cash Flows and Statement of Stockholders’ EquityLOS 31 a describe the format on the Income Statement and the components of net income

LOFTUS INC


FINANCIAL STATEMENT FOOTNOTES

• Information on accounting methods, assumptions and estimates

• Additional information on items appearing in major statements

• Disclosures relating to contingent losses Accrue a loss: - probable that loss has been incurred

- amount can be reasonably estimated

Footnote disclosure: - loss is reasonably possible- e.g., litigation, expropriation

(these are potential losses/payments potentially to be incurred by the firm, subject to the outcome of some future event/action e.g. litigation)


Depreciation methodsInventory valuation methodsLeasing arrangementsDeferred tax calculationsItems not otherwise reported in the financial statements that are relevant and/or material


INCOME STATEMENT FORMAT SUGGESTED IN READING

Revenues from the sales of goods and services:Other income and revenuesOperating expensesFinancing costsUnusual or infrequent items

Pre-tax earnings from continuing operationsIncome tax expense

Net income from continuing operationsIncome from discontinued operationsExtraordinary itemsCumulative effect of accounting changes

Net income

+

–

+/–––

+/–+/–+/–

LOS 29 d describe and distinguish between the principal financial statements: Balance Sheet, Income Statement, Statement of Comprehensive Income, Statement of Cash Flows and Statement of Stockholders’ EquityLOS 31 a describe the format on the Income Statement and the components of net income


CRITERIA FOR REVENUE RECOGNITION

In order to recognize revenues (in the Income Statement) two conditions must be met:

1. Completion of the earnings process

This amounts to the firm having provided all or virtually all of the services for which it is to be paid, knowing the total expected cost of providing those services and the associated revenues

2. Assurance of payment

LOS 31 b Identify the requirements for revenue recognition to occur.

The seller must be able to reasonably estimate the probability of payment


• Sales basis

• Percentage-of-completion

• Completed contract

METHODS OF REVENUE RECOGNITION

Sales and corresponding costs recognized at the point of sale and/or when a service has been provided

For long term contracts where a reliable estimate of revenues, costs and completion time exists. Revenues and costs recognized according to the proportion of work completed.

For long term contracts where there is no contract or estimates of revenues and costs are unreliable. Revenues and costs are not recognized in the Income Statement until the entire project is completed.

LOS 31 b explain the importance of the matching principle for revenue and expense recognition, identify the requirements for revenue recognition to occur, identify and describe the appropriate revenue recognition, given the status of completion of the earning process and the assurance of payment, and discuss different revenue recognition methods and their implications for financial analysis;


• Instalment sales

• Cost recovery

METHODS OF REVENUE RECOGNITION

For contracts where costs and revenues are known but the exact timing of the receipt of sales cash is unclear. Revenues and costs are recognized in the Income Statement in proportion to the cash collection.

For contracts where revenues are known but the exact size of costs is not clear. Profits are not recognized in the Income Statement until all costs have been ‘recovered,’ i.e., through the recognition of sales just equal to costs incurred.



PERCENTAGE OF COMPLETION METHOD – EXAMPLE

Bircham Properties Ltd. has a contract to build a hotel for $2,000,000 to be received in equal installments over 4 years. A reliable estimate of total cost of this contract is $1,600,000. During the first year, Bircham Properties incurred $400,000 in cost. During the second year, $500,000 of costs were incurred. The estimate of the projects total cost did not change in the second year.

Calculate the revenue to be recognized in each of the first two years.

LOS 31 c identify the appropriate income statement and balance sheet entries using the percentage-of-completion method and the completed contract method and describe and calculate the effects on cash flows and selected financial ratios that result from using the percentage-of-completion method versus the completed contract method;


POC vs. CC METHODS – EXAMPLE (BALANCE SHEET)

Cook Properties has a contract to build an office building for $2 million. An estimate of the contract’s total costs is $1.5 million. Billings and cost patterns are as follows:

20x1

800

600

500

20x2

700

900

700

20x3

500

500

300

Total

2,000

2,000

1,500

Amounts billed

Cash received

Costs incurred

You are required to prepare the balance sheets using the percentage of completion and completed contract methods.



BALANCE SHEET – PERCENTAGE-OF-COMPLETION METHOD

Total Assets

20x2

Cash

(Cash Rec’d – Cost Incurred)

Accounts receivable

(Amounts Billed – Cash Rec’d)

Net CIP*

Total Assets

20x320x1


* See working slide



Total Liabilities and Equity

20x1 20x2 20x3

Net Advanced Billings*

Retained Earnings

Total Liabilities & Equity


* See working slide


MEMO CIP

20x2 20x320x1

Cost

Profit Allocation

Amounts Billed

Cost to Date

Total Cost XContract Price – Total Cost

Net CIP/(Net Advanced Billings)


BALANCE SHEET – COMPLETED CONTRACT METHOD

20x2

Cash

Accounts receivable

Net CIP

Total Assets

20x320x1

Total Assets





20x1 20x2 20x3

Net Advanced Billings

Retained Earnings




MEMO CIP

20x2 20x320x1

Cost

Amounts Billed



Net income

Volatility ofincome

Total assets

Liabilities

R/E

Cash flow

Importance of CFO

POC CC

IncomeStatement

BalanceSheet

Statement ofCash Flows

PERCENTAGE-OF-COMPLETION vs. COMPLETED CONTRACT

During Project Life



INSTALLMENT SALES METHOD – EXAMPLE

During 20X0, Sturridge Inc. sold $20,000 of inventory, with a cost of $10,000.

During 20X0 and 20X1, Sturridge collected $8,000 and $12,000 respectively, of its receivables. Under the Instalment Method, what are the sales and gross profit to be reported in each of the two years?



COST RECOVERY METHOD – EXAMPLE

During 20X0, Sturridge Inc. sold $20,000 of services but the cost of providing this service was unclear at the outset of the contract. During 20X0 and 20X1, Sturridge Inc. collected $8,000 and $12,000, respectively of its receivables. The project was completed during 20X1 at which time the company had incurred total costs of $10,000.

Under the Cost Recovery Method, what are the sales and gross profit to be reported in each of the two years?



CHOOSING THE APPROPRIATEREVENUE RECOGNITION METHOD

Completion of Earning Process

Complete

Complete

Complete with contingencies

Complete with contingencies

Incomplete and costs can be estimated

Incomplete and costs can be estimated

Incomplete and costs can’t be estimated

Incomplete and costs can’t be estimated

Revenue Recognition Method

Sales basis

Installment sales

Cost recovery

Cost recovery

Percentage of completion

Completed contract

Completed contract

Completed contract

Assurance of Payment

Assured

Not assured

Assured

Not assured

Assured

Not assured

Assured

Not assured



INCOME STATEMENT FORMAT SUGGESTED IN READING

Revenues from the sales of goods and services:Other income and revenuesOperating expensesFinancing costsUnusual or infrequent items

Pre-tax earnings from continuing operationsIncome tax expense

Net income from continuing operationsIncome from discontinued operationsExtraordinary itemsCumulative effect of accounting changes

Net income

+

–

+/–––

+/–+/–+/–

LOS 31 d describe the types and analysis of unusual or infrequent items, extraordinary items, discontinued operations, accounting changes, and prior period adjustments;

Gross of tax

Net of tax


INCOME STATEMENT: NON-RECURRING ITEMS

• Unusual or infrequent items

• Extraordinary items

Gains of losses from disposal of a portion of a business segment

Gains or losses from sale of assets or investments

Impairments, write-offs and restructuring costs

Gains or losses from the early retirement of debt (note can be extraordinary if infrequent)

Provisions against environmental remediation

Unusual AND infrequent AND material:

Losses due to a foreign governments expropriation of assets

Uninsured losses from natural disasters



INCOME STATEMENT: NON-RECURRING ITEMS

• Discontinued operations

• Changes in accounting principle

Operating income (e.g., revenue and expenses up to the date of disposal) and any gains or losses from their sale are reported separately since these activities will not contribute to future income and cash flows.

The cumulative impact on prior period earnings is reported net of tax after extraordinary items and discontinued operations where, for example, the company changes the depreciation method. Not that this is not required for changes in accounting estimates.



Role of Nonrecurring Items inEstimating Earnings Power

• Classification of good/bad news

• Income smoothing

The analyst focus is often on net income from ‘continuing’ operations as this serves as a basis for forecasts.

Companies therefore tend towards putting profitable one off transactions above this line in the income statement and loss producing one off items below this line

Companies attempt to reduce earnings in years of good performance and inflate earnings in years of bad performance through aggressive or conservative accounting policy selection.

LOS 31 e discuss managerial discretion in areas such as classification of good news/bad news, income smoothing, big bath behaviour, and accounting changes, and explain how this discretion can affect the financial statements;


• Big bath techniques

• Accounting changes

When firms are experiencing a bad year they may attempt to recognize all of their ‘bad news’ at once. Going forward therefore, the subsequent improvement in performance will be magnified and this will show management in a better light.

Firms can use accounting changes to smooth earnings, as noted above, and these can often have a material impact on earnings without effecting cash flow.

LOS 31 e discuss managerial discretion in areas such as classification of good news/bad news, income smoothing, big bath behaviour, and accounting changes, and explain how this discretion can affect the financial statements;

Role of Nonrecurring Items inEstimating Earnings Power


The Cashflow Statement

Regular operations generate enough cash to sustain the business

Enough cash is generated to pay off maturing debt

Highlights the need for additional finance

Ability to meet unexpected obligations

The flexibility to take advantage of new business opportunities

Benefits for the analyst

How the firm obtains and spends cash

Borrowing and debt repayment activities

Issue and repurchase of equity

Distributions to owners (dividends)

Other factors affecting liquidity and solvency

FASB requirements

LOS 32 a identify the types of important information for investment decision making presented in the statement of cash flows;


STATEMENT OF CASH FLOWS – SFAS 95

Cash flow from operations (CFO)Cash flow from investing (CFI)Cash flow from financing (CFF)

++

Change in cash balance=

Beginning cash+

Ending cash=

LOS 32 a identify the types of important information for investment decision making presented in the statement of cash flows;LOS 32 b compare and contrast the categories (i.e., cash provided or used by operating activities, investing activities, and financing activities) in a statement of cashflows, and describe how noncash investing and financing transactions are reported

Cash received from customers

Cash dividends received

Cash interest received

Other cash income

Payments to suppliers

Cash expenses (wages etc)

Cash interest paid

Cash taxes paid

CFO

$

X

X

X

X

(X)

(X)

(X)

(X)

X/(X)


CASH FROM INVESTING

Purchase and sale proceeds of:

•Property, plant & equipment

•Subsidiaries, Joint Ventures and Affiliates

•Investments

CASH FROM FINANCING

Issue and redemption of:

• Common stock

• Debt

• Dividend payments (divs rec’d = CFO)

LOS 32 b compare and contrast the categories (i.e., cash provided or used by operating activities, investing activities, and financing activities) in a statement of cashflows, and describe how noncash investing and financing transactions are reportedLOS 33 a classify a particular transaction or item as cash flow from 1) operations, 2) investing, or 3) financing;


Non-Cash Investing and Financing Activities

• Retirement of debt via conversion into equity

• Conversion of preferred stock into common stock

• Assets acquired under capital leases

• Obtaining assets by issuing notes payable

• Exchange of one non cash asset for another

• Purchase of non cash assets by issuing equity or other securities

All the above items will affect the Balance Sheet but not the Cashflow Statements as no cash is raised or paid

LOS 32 b compare and contrast the categories (i.e., cash provided or used by operating activities, investing activities, and financing activities) in a statement of cashflows, and describe how noncash investing and financing transactions are reported


CASH FROM OPERATIONS

DIRECT METHOD

Cash inflows

less

cash outflows

Cash from operations

LOS 33 b compute and interpret a statement of cash flows, using the direct method and the indirect method;LOS 32 c calculate and interpret, using the indirect method, the net cash provided or used by operating activities;

Net incomedepreciation & amortisationgains on disposal of l/t assetslosses on disposal of l/t assetsother non-cash expensesnon-cash revenueschanges in non-cash working capital

+–++–

+/–

Cash from operations

INDIRECT METHOD


Direct Method CFO

Steps

1. Start at the top of the Income Statement – e.g., Sales

2. Move to the balance sheet and identify any asset and liability that relate to that Income Statement item – e.g., Accounts Receivable

3. Look at the change in the Balance Sheet item during the period (ending balance – opening balance)

4. Apply the rule:

5. Adjust the Income Statement amount by the change in the Balance Sheet

Increases in an asset – deduct Increase in a liability – addDecrease in an asset – addDecrease in a liability – deduct



Direct Method cont.

6. Tick off the items dealt with in both the Income Statement and Balance sheet

7. Move to the next item on the Income Statement and repeat

8. Ignore depreciation/amortization and gains/losses on the disposal of assets as these are all non cash items

9. Keep moving down the Income Statement until all items included in Net Income have been addressed applying steps 1-8

10.Total up the amounts and you have CFO



EXAMPLE – HOLLOWAY INDUSTRIES

Holloway Industries has the following Income Statement for 20X3 and Balance Sheets for 20X2 and 20X3. You are to construct the Statement of Cash Flows using the templates provided.

Income Statement for Year to 31 December 20X3

Sales revenueExpenses:

Cost of goods soldSalariesGoodwill amortizationDepreciationInterest

Gain from sale of PPEPre-tax incomeProvision for taxesNet income

80,00010,0002,000

12,0001,000

200,000

105,00095,00020,000

115,00040,00075,000



EXAMPLE – HOLLOWAY INDUSTRIES cont.

Balance Sheets

Current assetsCashAccounts receivableInventory

Noncurrent assetsLandPlant & equipmentLess: Acc depreciationGoodwill

Total Assets

20X2$

18,00018,00014,000

80,000

120,000(18,000)20,000

252,000

20X3$

66,00020,00010,000

80,000

150,000(20,000)18,000

324,000

PPE includes an asset that cost $20,000 and had accumulated depreciation of $20,000 at the point of disposal


Note the order of years (older/most recent) may be reversed in questions – always check!


Balance Sheets

Current liabilitiesAccounts payableSalaries payableInterest payableTaxes payableDividends payable

Noncurrent liabilitiesBondsDeferred taxes

Stockholders’ equityCommon stockRetained earnings


20X2$

10,00016,0006,0008,0002,000

20,00030,000

100,00060,000

252,000

20X3$

18,0009,0007,000

10,00012,000

30,00040,000

80,000

118,000

324,000


EXAMPLE – HOLLOWAY INDUSTRIES cont.


HOLLOWAY INDUSTRIES – CASH FLOW FROM OPERATIONS

DirectMethod

$ $Cash Inflows Sales

Less: increase in A/R Cash collected from customers

Direct cash outflows Cost of goods sold Add: decrease in inventoryPurchases Add: increase in A/P

Cash paid to suppliers

Operating expense (wages) Less: decrease in salaries payable

Cash paid to employees



Direct Method cont.

Cash outflows Interest Expense Add: increase in interest payable

Cash interest paid

Taxation Expenses Add: Increase in deferred tax Tax payable Add: increase in taxes payable

Cash paid to IRS

$ $

CFO



Indirect Method CFOSteps

1. Start at the bottom of the Income Statement – e.g., Net Income. This means we have already included all the items on the Income Statement

2. Return to the top of the Income Statement and adjust each item line by line. Note that we have already included Sales in our Net Income figure

3. Look at the change in the Balance Sheet item during the period (ending balance – opening balance). These are identical to the Direct Method!

4. Apply the rule:

Increases in an asset – deduct Increase in a liability – addDecrease in an asset – addDecrease in a liability – deduct



Indirect Method cont.

5. Tick off the items dealt with in both the Income Statement and Balance sheet

6. Move to the next item on the Income Statement and repeat

7. Eliminate depreciation and amortization by adding them back (they’ve been deducted in arriving at Net Income but have no cash implication)

8. Eliminate gains on disposal by deducting them and losses on disposal by adding them back.

9. Keep moving down the Income Statement until all items included in Net Income have been addressed applying steps 1-8

10.Total up the amounts and you have CFO




Net incomedepreciationgoodwill amortisation gain from sale of land increase in deferred taxes

Current asset adjustmentsincrease in accounts receivable decrease in inventory

Current liability adjustmentsincrease in accounts payable decrease in salaries payable increase in interest payable increase in taxes payable

$

Cash flow from operations

Indirect Method



Computing CFI

Additions to PPE 2 Methods

Opening Cost

Cost of Disposals

Additions β

Closing Cost

Opening NBV

NBV of Disposals

Depreciation Charge

Additions β

Closing NBV

$

X

(X)

X

X

$

X

(X)

(X)

X

X

The method to choose depends on whether cost and accumulated depreciation have been disclosed separately or together as NBV

LOS 32 d prepare and interpret, using the indirect method, the statement of cash flows for investing activities and financing activities.


Computing CFI Holloway Industries


Opening Cost

Cost of Disposals

Additions β

Closing Cost

Opening NBV

NBV of Disposals

Depreciation Charge

Additions β

Closing NBV

$ $

The method to choose depends on whether cost and accumulated depreciation have been disclosed separately or together as NBV



Computing Proceed on Disposal

Proceeds β

NBV

Profit/(loss)

X

(X)

X/(X)

$

Disclosed in question

From Income Statement


Profit/(loss) on disposal of long lived assets

Proceeds β

NBV

Profit/(loss)

$

Holloway Industries


Computing CFF

• Change in Debt

• Change in Common Stock

• Cash Dividends Paid

Simply closing balance less opening balance – don’t forget to check current liabilities for any debt maturing within 12 months!

Simply the change in both common stock and additional paid in capital during the period – this could be made more complicated by including scrip issues

Calculate Dividends

Net Income

Dividends β

Δ in Retained Earnings

$

X

(X)

X

Dividends Proposed

Dividends Payable

Cash Paid

$

(X)

X/(X)

(X)



Holloway CFF

• Change in Debt



Calculate Dividends

Net Income

Dividends β


$

Dividends Proposed

Dividends Payable

Cash Paid

$


$


HOLLOWAY INDUSTRIES – STATEMENT OF CASH FLOWS

$Cash flow from operations Cash flow from investing activities

Sale of PP&E Purchase of PP&E

Cash flow from investing Cash flow from financing activities

Increase in bonds Decrease in common stock

Payment of dividends Cash flow from financing

Net increase in cash Cash at beginning Cash at end

$

LOS 33 b compute and interpret a statement of cash flows, using the direct method and the indirect method


FREE CASH FLOW

Measures the cash available to the firm for discretionary uses after making all required cash outlays. Formally, it should be the operating cash flow minus those cash flows necessary to maintain the firm’s productive capacity and provide for growth. However, it is not practical for an analyst to determine which capital expenditures are necessary to maintain capacity and which are allotted for growth.

Consequently, free cash flow is measured by:

Free Cash Flow = Operating cash flow - Net capital expenditures

Expenditure on capital items – after tax sales proceeds from disposals

LOS 33 e describe and compute free cash flow;


STATEMENT OF CASH FLOWU.S. GAAP vs. IAS GAAP

LOS 33 f Distinguish between the U.S. GAAP and IAS GAAP classifications of dividends paid or received and interest paid or received for statement of cash flow purposes

Interest received

Interest paid

Dividends received

Dividends paid

CFO

CFO

CFO

CFF

CFO or CFI

CFO or CFF

CFO or CFI

CFO or CFF

U.S. GAAP(SFAS 95)

IAS GAAP(IAS 7)


Future FASB Changes and theAnalytical Challenges of GAAP

European Commission – Publicly traded companies mandatory adoption of IAS by 2005 (unless producing accounts under U.S. GAAP in which they must adopt IAS by 2007)

ISAB and FASB attempting to eliminate 3 major differences:• Expensing of employee stock options

• Business combinations under the purchase method

• In-process R&D

• Restructuring costs

• Measurement date for acquisitions using stock

• Reconciling standards in revenue recognition

LOS 34 a identify the projects on the FASB agenda that were/are related to international convergence


Future FASB Changes and theAnalytical Challenges of GAAP

Other convergence projects

• Revisions to Income Statement format/content

• Accounting for financial instruments with both equity and liability characteristics (e.g., convertibles)

• Fair-value measurement

LOS 34 a identify the projects on the FASB agenda that were/are related to international convergence


FASB Revenue Recognition

2 conceptual approaches that may

conflict

Approach 1

Recognition criteria

1. Completion of earnings process

2. Assurance of receipt

Approach 2

Revenue recognition occurs when there is any increase in net assets resulting from transactions with non shareholders

i.e., any increase in Net Assets (worth) that is not the result of issuing new equity

LOS 34 b describe two different guidance rules for revenue recognition discussed by FASB and IASB


Financial Statement AnalysisFinancial Ratios and Earnings

Per Share

Study Session 8


Why are Ratios so Important in Financial Analysis?

The analyst reviews the company’s financial statements to gain an insight into a company’s financial decision making and performance.

Ratios allow the analyst to raise questions about the performance of the firm. This performance may be compared year on year within the firm or with competitors within the industry and the economy as a whole.

Although there are many dozens of ratio’s that could be computed there are several key ratio’s that give the analyst an insight into the firm’s:

• Performance: determine how well management operate the business• Liquidity: determine the firms ability to pay its short term liabilities• Risk: measure the uncertainty of the firms income flows

LOS 35 b calculate, interpret, and discuss the uses of measures of a company’s internal liquidity, operating performance (i.e., operating efficiency (activity) and operating profitability), risk profile, and growth potential;


INTERNAL LIQUIDITY RATIOS

Current ratio

Quick ratio

Cash ratio

Receivables turnover

current assetscurrent liabilities

current assets – inventorycurrent liabilities

cash + marketable securitiescurrent liabilities

net salesavg. receivables




Receivables collection period

Inventory turnover

Inventory processing period

365receivables turnover

cost of goods soldavg. inventory

365inventory turnover


avg. receivablesnet sales

× 365OR

avg. inventory cost of goods sold × 365OR


Payables turnover

Payables payment period

cost of goods soldavg. accounts payable

365payables turnover


avg. inventory cost of goods soldOR × 365



Cash Conversion Cycle

Raw Materials Arrive

Production Commences

Production Complete

Goods Sold

Cash Collected

Pay Supplier

Payables payment periodInventory

processing period

Receivables collection period

Cash Conversion

CycleInventory Period

Receivables Period

Payables Period


Days

X

X

(X)

X



Current ratio

Quick ratio

Cash ratio

Holloway Industries

20x2 20x3




Average receivables collection period

20x3


Inventory turnover

Average inventory processing period

20x3

Holloway Industries


Payables turnover


20x3

Collection period

+ Inventory period

– Payment period



Holloway Industries


Total asset turnover

Fixed asset turnover

Equity turnover

OPERATING EFFICIENCY

net salesavg. total net assets

net salesavg. net fixed assets

net salesavg. equity


Holloway Industries


20x3



Equity turnover


Holloway Industries


Gross profit margin

Operating profit margin

Net profit margin

OPERATING PROFITABILITY

sales – COGS (GP)net sales

EBITnet sales

EATnet sales

× 100

× 100

× 100


Holloway Industries


Gross profit margin


Net profit margin



20x3

Holloway Industries


Return on total capital

Return on equity


EAT + interest

avg. total capital

EquityLiabilities

EAT

avg. equity

× 100

× 100


= Total Assets

Holloway Industries



Return on equity



20x3

Holloway Industries


Income statement

Balance sheet

COMMON SIZE STATEMENTS

income statement account

sales

balance sheet account

total assets

e.g., marketing expense

sales

e.g., inventory

total assets

LOS 35 a interpret common-size balance sheets and common-size income statements, and discuss the circumstances under which the use of common-size financial statements is appropriate;


DUPONT RATIO ANALYSIS

ROE = EAT

EQUITY

ROE = EAT

SALES

SALES

EQUITY×

ROE = EAT

SALES

SALES

ASSETS×

ASSETS

EQUITY×

After taxprofit margin

Assetturnover

Financial leveragemultiplier

Traditional version of DuPont equation

LOS 35 c calculate and interpret the various components of the company’s return on equity using the original and extended DuPont systems and a company’s financial ratios relative to its industry, to the aggregate economy, and to the company’s own performance over time;


DUPONT RATIO ANALYSIS 20x3

ROE =

ROE =

ROE =

Traditional version of DuPont equation


Holloway Industries


EXTENDED DUPONT EQUATION

SALES

ASSETS

ROE = EBT

SALES×

ASSETS

EQUITY×(1 – t) ×

ROE = EAT

SALES

SALES

ASSETS×

ASSETS

EQUITY×

SALES

ASSETS

ROE = EBIT

SALES×

ASSETS

EQUITY× (1 – t)×–

I

ASSETS

Operatingprofit

margin

Assetturnover

Financial leveragemultiplier

Interest expense

rate

Tax retention

rate


t = effective tax rate


EXTENDED DUPONT EQUATION 20x3

ROE =

ROE =


ROE = 75,000

200,000

200,000

324,000×

324,000

198,000× = 38%

Holloway Industries


RISK PROFILE

• Business risk

• Financial risk

CV’s - operating income- sales

Operating leverage

Leverage

Coverage

Measures the uncertainty of the firms operating income as a result of variability of sales and production costs

Additional volatility of the firms equity returns caused by the firm’s use of debt



BUSINESS RISK

Coefficient of Variation of Operating Income

Coefficient of Variation of Sales

Operating Leverage

EBIT EBIT

% in EBIT

% in Sales

Sales Sales



Debt to equity ratio

Debt to long term capital ratio

long-term debt

stockholder equity

long-term debt

long-term debt + stockholder equity

FINANCIAL RISK RATIOSLEVERAGE

Long-term liabilities

Deferred tax

PV of operating leases

Common Stock

Preferred Stock

Additional Paid in Capital

Other Reserves

Retained Earnings



Total Debt Ratio

Total Interest-Bearing Debt to Total Funded

Capital

current liabilities + long-term debt

stockholder equity

total interest-bearing debt

total capital – non-interest-bearing liabilities

FINANCIAL RISK RATIOSLEVERAGE



FINANCIAL RISK RATIOSCOVERAGE

Interest Coverage EBIT

interest expense

Cash Flow Interest Coverage

cash flow + interest expense + ELIE

interest expense + ELIE

Fixed Financial CostEBIT + ELIE

gross interest expense + ELIE

ELIE = Estimated Lease Interest Expense



HOLLOWAY INDUSTRIES – FINANCIAL RISK RATIOS

Interest Coverage

Long Term Debt to equity

Debt to long term capital

20x3



GROWTH ANALYSIS

Sustainable growth = (earnings retention rate)(ROE)

Earnings retention rate = [1 – (dividends/net income)]

ROE = [EAT/sales] [sales/assets] [assets/equity]

Example:

A firm has a dividend payout ratio of 35%, a net profit margin of 10%, an asset turnover of 1.4 and an equity multiplier leverage measure of 1.2. Estimate the firm’s sustainable growth rate.



CONSIDERATIONS WHEN USINGFINANCIAL RATIOS

• Financial ratios should always be relative

• Are alternative firms’ accounting treatments comparable?

• Is the firm involved in several industries or just one?

• Are the implied results consistent or just a “one-off”

• Is the ratio within a reasonable range for the industry?


EARNINGS PER SHARE (EPS)

• Simple capital structure- Basic EPS

• Complex capital structure- Diluted EPS

One that contains no potentially dilutive securities

Contains potentially dilutive securities (that would decrease EPS if exercised or converted to common stock

LOS 36 a differentiate between simple and complex capital structures for purposes of calculating earnings per share (EPS), describe the components of EPS, and calculate a company’s EPS in a simple capital structure;

Convertible Bonds

Convertible Preferred Stock

Warrants and Employee Stock Options


earnings attributable to common stockholdersweighted average number of shares of common outstanding

Earnings = net income – preference dividends

EPS – BASIC CALCULATION

Weighted Average Number of Shares

A time weighted average, necessary when the number of shares in issue has changed during the year. For example:

• share repurchases - which are excluded from date of repurchase• share issues for cash or to acquire subsidiary• share issues for free (via stock splits or stock dividends)



1 January 4 million common stock in issue ranking for dividend30 September 1 million further shares issued ranking for dividend(assuming year ending 31 December)

Million

Number of shares used in EPS calculation

CHANGES IN EQUITYISSUE FOR CASH AT MARKET PRICE



The following have no effect on earnings:

CHANGES IN EQUITYNO EFFECT ON EARNINGS

• stock dividends

• stock splits

These changes in equity are back dated, to assume that they occurred on the first day of the year with all prior year figures being retrospectively adjusted.

10% stock dividend – the holder of 100 shares would receive 10 new shares

5:4 Stock split – The holder of 100 shares would be holding 125 shares post split

5:4

New holding Old holding

LOS 36 c describe stock dividends and stock splits and determine the effect of each on a company’s weighted average number of shares outstanding;


EPS – WORKED EXAMPLE

Profit Inc had 10 million shares outstanding at the beginning of the year and net income of $20m. The following transactions occurred during the year:

1 July 2 million new shares issued for cash1 September 10% stock dividend1 November 500,000 common shares repurchased(assuming year ending 31 December)

Calculate the EPS for the year

LOS 36 c describe stock dividends and stock splits and determine the effect of each on a company’s weighted average number of shares outstanding;


Dilutive vs. Anti-Dilutive Securities

Convertible Bonds

Convertible Preferred Stock

Warrants and Employee Stock Options

coupon saved (1–T)

Shares Created< Basic EPS

preferred dividend saved

shares created< Basic EPS

Average Share Price > Strike Price

Securities are Dilutive if:

LOS 36 d distinguish between dilutive and antidilutive securities and calculate a company’s basic and diluted EPS in a complex capital structure and describe and determine the effects of convertible securities, options, and warrants on a company’s EPS;


DILUTED EPS – CONVERTIBLE SECURITIESEXAMPLE

Earnings for equity in year to 31/Dec/X1 2,500,000Common stock of $10 each 10,000,000Basic EPS $2.50Tax rate 30%

There have been in issue throughout the year $2,000,000 of 5% convertible loan stock. The terms of conversion are, for every $1,000 nominal value of loan stock:

On 31 March 20X2 110 common shares31 March 20X3 120 common shares31 March 20X4 103 common shares

Calculate fully diluted EPS for 20X1.

$



Earnings

Add: Interest savedLess: Relief for tax @ 30%

No. of equity shares if loan stock was converted:

In issueOn conversion

$ $

DILUTED EPS – CONVERTIBLE SECURITIESSOLUTION



DILUTED EPS – CONVERTIBLE PREFERRED STOCKEXAMPLE

Earnings for equity in year to 31/Dec/X1 4,000,000Common stock of $10 each 20,000,000Basic EPS $2.00Tax rate n/a

There have been in issue throughout the year $5,000,000 of 7% convertible preferred stock. The terms of conversion are, for every $1,000 nominal value of preferred stock:

On 30 April 20X2 120 common stock shares30 April 20X3 110 common stock shares30 April 20X4 105 common stock shares

Calculate fully diluted EPS for 20X1.

$



$

DILUTED EPS – CONVERTIBLE PREFERRED STOCKSOLUTION

Earnings

Add: Preferred dividend saved

No. of common stock shares if preferred shares were converted:

In issueOn conversion



DILUTIVE STOCK OPTIONSTREASURY STOCK METHOD

• Dilutive only when the exercise price is less than the average market price

• Assume proceeds from sale of stock issued to buy back shares in the market at the average market price

STEPS

• Calculate number of common shares created if options are exercised

• Calculate cash received from sale of stock

• Calculate number of shares that can be purchased at the average market price with sale proceeds

• Calculate the net increase in common shares outstanding



EPS – OPTIONS FOR COMMON STOCKEXAMPLE

Earnings for equity in year to 31/Dec/X1 $1,200,000Weighted average no. of common stock shares 500,000Average price of common stock during year $20Exercise price $15

Number of options outstanding in the year 100,000

Basic EPS

Calculate diluted EPS for 20X1.



EPS Reporting

A company with a complex capital structure must report:

Basic EPS

Dilutive EPS

In addition the impact of the following effects must be shown:

Discontinued Activities

Extraordinary Items

Cumulative Effect of Accounting Policy Changes

LOS 36 e compare and contrast the requirements for EPS reporting in simple versus complex capital structures.


Seek and Ye Shall Findand

Searching for Shenanigans

Study Session 8


FINANCIAL SHENANIGANSTwo basic strategies underlying all accounting “tricks”:

To inflate current period earnings by inflating current-period revenue and gains or by deflating current-period expenses

To deflate current-period earnings (and, consequently, inflate future periods’ results) by deflating current period revenue or by inflating current-period expenses

1. Recording revenue too soon or of questionable quality

2. Recording bogus revenue

3. Boosting income with one-time gains

4. Shifting current expenses to a later or earlier period

5. Failing to record or improperly reducing liabilities

6. Shifting current revenue to a later period

7. Shifting future expenses to the current period as a special charge

Shenanigan

LOS 38 a explain the two basic strategies underlying all accounting “shenanigans,” and describe seven categories of techniques that may be used by management to distort a company's reported financial performance and financial condition;


EVALUATING ACCOUNTING POLICIES

Accounting Policies

Revenue recognition

Depreciation choice

Inventory method

Amortization of goodwill*

Estimate of warranty

Estimate of bad debts

Treatment of advertising

Loss contingencies

Conservative

After sale, when risk has passed to buyer

Accelerated over shorter period

LIFO (assuming prices are rising)

Over a shorter period

High estimate

High estimate

Expense

Accrue loss

Aggressive

At sale, although risk remains

Straight line over longer period

FIFO (assuming prices are rising)

Over 40 years

Low estimate

Low estimate

Capitalize

Footnote only

LOS 38 b identify conservative and aggressive accounting policies;

* NB Goodwill is no longer amortized under U.S. GAAP


WHY DO SHENANIGANS EXIST?

Based on the author’s research, there are three general reasons for shenanigans:

It Pays to Do It

• Management bonuses encourage the posting of high sales and profits

• Misguided incentive plans

It’s Easy to Do

Look for:

Compensation structures that heavily emphasize the bottom line

• Profit can vary widely while complying with GAAP

• Management has considerable flexibility in interpreting financial standards

Look for:

Overly liberal accounting rulesPoor internal controls

It’s Unlikely ThatYou’ll Get Caught

• Often, companies are not caught for improper accounting

• Penalties are often too little, too late

Look for:

Over reliance on unaudited quarterly financial reports

LOS 38 c describe why “shenanigans” exist and explain where they are most likely to occur


WHERE DO SHENANIGANS OCCUR?

Early Warning Signs

• A weak control environment

• Management facing extreme competitive pressure

• Management known or suspected of having questionable character

Likely Companies

• Fast growth companies whose real growth is beginning to slow

• Basket-case companies that are struggling to survive

• Newly listed public companies

• Private companies

LOS 38 c describe why “shenanigans” exist and explain where they are most likely to occur


IDENTIFYING SHENANIGANSWhere to Look

Auditor’s report

Proxy statement

Footnotes

President’s letter

MD&A

Form 8-K

Registration statement

What to Look For

Absence of opinion or qualified report

Reputation of auditor

Litigation

Executive compensation

Related-party transactions

Accounting policies/changes in those policies

Related-party transactions

Contingencies or commitments

Forthrightness

Specific concise disclosure

Consistency with footnote disclosure

Disagreements over accounting policies

Past performance

Quality of management and directors

LOS 38 d list the documents that an analyst should use to identify “shenanigans” and explain what information to look for in such documents.


SOLUTIONS


PERCENTAGE OF COMPLETION METHODEXAMPLE (INCOME STATEMENT)

Bircham Properties Ltd. has a contract to build a hotel for $2,000,000 to be received in equal installments over 4 years. A reliable estimate of total cost of this contract is $1,600,000. During the first year, Bircham Properties incurred $400,000 in cost. During the second year, $500,000 of costs were incurred. The estimate of the projects total cost did not change in the second year.

Calculate the revenue to be recognized in each of the first two years.

Year 1: $2,000,000 × (400,000/1,600,000) = $500,000

Year 2: $2,000,000 × (900,000/1,600,000) = $625,000–$500,000



Total Assets

20x2

Cash

(Cash Rec’d – Cost Incurred)

Accounts receivable

(Amounts Billed – Cash Rec’d)

Net CIP*

Total Assets

20x320x1


100

200

0

300

300

0

100

400

500

0

0

500

* See working slide




20x1 20x2 20x3


Retained Earnings



133

167

300

0

400

400

0

500

500


MEMO CIP

20x2 20x320x1

Cost

Profit Allocation

Amounts Billed

Cost to Date

Total Cost ×Contract Price – Total Cost

500

167

667

(800)

(133)Net CIP/(Net Advanced Billings)

1,200

400

1,600

(1,500)

100

1,500

500

2,000

(2,000)

0



20x2

Cash

Accounts receivable

Net CIP

Total Assets

20x320x1

Total Assets


100

200

0

300

300

0

0

300

500

0

0

500




20x1 20x2 20x3


Retained Earnings



300

0

300

300

0

300

0

500

500


MEMO CIP

20x2 20x320x1

Cost

Amounts Billed


500

(800)

(300)

1,200

(1,500)

(300)

0

(0)

(0)


Net income

Volatility ofincome

Cash flow

Importance of CFO

POC CC

IncomeStatement

BalanceSheet

Statement ofCash Flows

PERCENTAGE-OF-COMPLETION vs. COMPLETED CONTRACT

HIGHER

LOWER

LOWER

HIGHER

SAME

LOWER

SAME

HIGHER

Total assets

Liabilities

R/E

During Project Life

HIGHER

LOWER

HIGHER

LOWER

HIGHER

LOWER


INSTALLMENT SALES METHOD – EXAMPLE

SalesCost of salesGross profit

20X08,000

(4,000)4,000

20X112,000(6,000)6,000

During 20X0, Sturridge Inc. sold $20,000 of inventory, with a cost of $10,000.

During 20X0 and 20X1, Sturridge Inc. collected $8,000 and $12,000 respectively, of its receivables. Under the Instalment Method, what are the sales and gross profit to be reported in each of the two years?


COST RECOVERY METHOD – EXAMPLE

SalesCost of salesGross profit

20X08,000

(8,000)-

20X112,000(2,000)10,000

During 20X0, Sturridge Inc. sold $20,000 of services but the cost of providing this service was unclear at the outset of the contract. During 20X0 and 20X1, Sturridge Inc. collected $8,000 and $12,000, respectively of its receivables. The project was completed during 20X1 at which time the company had incurred total costs of $10,000.

Under the Cost Recovery Method, what are the sales and gross profit to be reported in each of the two years?



DirectMethod

$ $Cash Inflows Sales

Less: increase in A/R Cash collected from customers

Direct cash outflows Cost of goods sold Add: decrease in inventoryPurchases Add: increase in A/P

Cash paid to suppliers

Operating expense (wages) Less: decrease in salaries payable

Cash paid to employees

200,000

(2,000)

198,000

(80,000)

4,000

(76,000)

8,000

(68,000)

(10,000)

(7,000)

(17,000)


Direct Method cont.

Cash outflows Interest Expense Add: increase in interest payable

Cash interest paid

Taxation Expenses Add: Increase in deferred tax Tax payable Add: increase in taxes payable

Cash paid to IRS

$ $

CFO

(1,000)

1,000

0

(40,000)

10,000

(30,000)

2,000(28,000)

(85,000)


GOULBURN INDUSTRIES – CASH FLOW FROM OPERATIONS

Net income 75,000 Add: depreciation + 12,000Add: goodwill amortisation + 2,000Less: gain from sale of land – 20,000Add: increase in deferred taxes + 10,000

Current asset adjustmentsLess: increase in accounts receivable – 2,000Add: decrease in inventory + 4,000

Current liability adjustmentsAdd: increase in accounts payable + 8,000Less: decrease in accounts payable – 7,000Add: increase in interest payable + 1,000Add: increase in taxes payable + 2,000

$

Cash flow from operations 85,000

Indirect Method


Computing CFI Holloway Industries


Opening Cost

Cost of Disposals

Additions β

Closing Cost

Opening NBV

NBV of Disposals

Depreciation Charge

Additions β

Closing NBV

$

120,000

(20,000)

50,000

150,000

$

102,000

(10,000)

(12,000)

50,000

130,000


Computing Proceed on Disposal

Proceeds β

NBV

Profit/(loss)

X

(X)

X/(X)

$

Disclosed in question

From Income Statement

Profit/(loss) on disposal of long lived assets

Proceeds β

NBV

Profit/(loss)

30,000

(10,000)

(20,000)

$

Holloway Industries


Holloway CFF

• Change in Debt



Calculate Dividends

Net Income

Dividends β


$

75,000

(17,000)

58,000

Dividends Proposed

Dividends Payable

Cash Paid

$

(17,000)

10,000

(7,000)

$

10,000

(20,000)

(7,000)

$30,000 – $20,000 = $10,000

$80,000 – $100,000 = $(20,000)


HOLLOWAY INDUSTRIES – STATEMENT OF CASH FLOWS$

Cash flow from operations 85,000 Cash flow from investing activities

Sale of PP&E 30,000Purchase of P&E –50,000

Cash flow from investing –20,000 Cash flow from financing activities

Issue of debt 10,000Purchase of stock –20,000

Payment of dividends – 7,000Cash flow from financing –17,000

Net increase in cash 48,000

Cash at beginning 18,000

Cash at end 66,000

$


Current ratio

Quick ratio

Cash ratio

Holloway Industries20x2 20x3


50,000

42,000

36,000

42,000

18,000

42,000

=1.19

=0.86

=0.43

96,000

56,000

86,000

56,000

66,000

56,000

=1.71

=1.54

=1.18



Average receivables collection period

20x3


200,000

19,000= 10.52

19,000

200,000× 365

Inventory turnover

Average inventory processing period

80,000

12,000= 6.67

12,000

80,000× 365

= 34.68 Days = 54.75 Days

20x3

Holloway Industries


Payables turnover


20x3

Collection period

+ Inventory period

– Payment period

Holloway Industries


80,000

14,000

14,000

80,000× 365

= 63.88 days

= 5.71

= 34.68 Days

= 54.75 Days

= (63.88) Days


25.55 Days


20x3



Equity turnover


200,000

288,000

200,000

215,000

200,000

179,000

= 0.69

= 0.93

= 1.12

Holloway Industries


Gross profit margin


Net profit margin


200,000 – 80,000200,000

116,000200,000

75,000200,000

× 100

× 100

× 100


20x3

= 60%

= 58%

= 37.5%

Holloway Industries



Return on equity


75,000 + 1,000

288,000

EquityAll liabilities

75,000

179,000

= Total assets

× 100

× 100


= 26.38%

= 41.90%

20x3

Holloway Industries


DUPONT RATIO ANALYSIS 20x3

ROE = 75,000

198,000

ROE = 75,000

200,000

200,000

198,000×

ROE = 75,000

200,000

200,000

324,000×

324,000

198,000×

0.375 0.62 1.64Traditional version of DuPont equation


= 38%

= 38%

= 38%

Holloway Industries


EXTENDED DUPONT EQUATION 20x3

200,000

324,000

ROE = 115,000

200,000×

324,000

198,000×(1 – 0.35) ×

200,000

324,000

ROE = 116,000

200,000×

324,000

198,000× (1 – 0.35)×–

1,000

324,000

0.58 0.617 1.6360.003


ROE = 75,000

200,000

200,000

324,000×

324,000

198,000× = 38%

= 38%

0.65= 38%

Holloway Industries


HOLLOWAY INDUSTRIES – FINANCIAL RISK RATIOS

Interest Coverage

Long Term Debt to equity

Debt to long term capital

20x3

40,000 + 30,000198,000

= 0.35

116,0001,000 = 116

40,000 + 30,00040,000 + 30,000 + 198,000 = 41.2%



GROWTH ANALYSIS

Sustainable growth = (earnings retention rate)(ROE)

Earnings retention rate = [1 – (dividends/net income)]

ROE = [EAT/sales] [sales/assets] [assets/equity]

Example:

A firm has a dividend payout ratio of 35%, a net profit margin of 10%, an asset turnover of 1.4 and an equity multiplier leverage measure of 1.2. Estimate the firm’s sustainable growth rate.

Growth rate = RR × ROE

(1 – 0.35) 0.1 × 1.4 × 1.2= 0.1092

= 10.92%


1 January 4 million common stock in issue ranking for dividend30 September 1 million further shares issued ranking for dividend

Million

Number of shares used in EPS calculation

CHANGES IN EQUITYISSUE FOR CASH AT MARKET PRICE

4 million shares x 9/12 3

5 million shares x 3/12 1.25

4.25


EPS – WORKED EXAMPLE

Profit Inc had 10 million shares outstanding at the beginning of the year and net income of $20m. The following transactions occurred during the year:

1 July 2 million new shares issued for cash1 September 10% stock dividend1 November 500,000 common shares repurchased

Calculate the EPS for the year

10m + 1m

2m + 0.2m

(0.5m)

Adjusted for stock dividend

Adjusted for stock dividend

1/1

1/7

1/11 Not affected by stock dividend

12/12

6/12

2/12

=

=

=

Number of Shares

11m

1.1m

(0.083m)

12.017m

Basic EPS =$20m

12.017m= $1.6643


Earnings

Add: Interest savedLess: Relief for tax @ 20%

No. of equity shares if loan stock was converted:

In issueOn conversion $2,000,000 × 120/$1,000

$ $

DILUTED EPS – CONVERTIBLE SECURITIESSOLUTION

2,500,000100,000(30,000)

70,000

2,570,000

1,000,000240,000

1,240,000Diluted EPS $2,570,000 = $2.07

1,240,000


$ $

DILUTED EPS – CONVERTIBLE PREFERRED STOCKSOLUTION

2,000,000550,000

2,550,000

Diluted EPS $4,350,000 = $1.71

2,550,000

350,0004,350,000

Earnings

Add: Preferred dividend saved4,000,000

No. of common stock shares if preferred shares were converted:

In issueOn conversion $5,000,000 × 110/$1,000


EPS - OPTIONS FOR COMMON STOCKSOLUTION

Step 1 - Assume all options are exercised

Proceeds if all options exercised 100,000 × $15 $1,500,000

Step 2 - Calculate number of shares that can be bought at average price

$1,500,000$20

= 75,000 shares

Step 3 - Calculate dilutive effect of reduced option price

Number of shares issued 100,000Effective number at average price 75,000Dilution number of shares 25,000

Diluted EPS $1,200,000 = $2.29

525,000

LOS 2.g: Describe and determine the effects of convertible securities, options and warrants on a company’s EPS


AREAS NOT COVERED IN CLASS

LOS reference Description Schweser pages

P2 e) d) Identify the accounting qualities (relevance, reliability, predictive value, timeliness) set forth in Statement of Financial Accounting Concepts and discuss how these qualities provide useful information to the analyst

LOS 2h) Compare and contrast the requirements for EPS reporting in simple versus complex capital structures

154


AREAS NOT COVERED IN CLASS

LOS reference Description Schweser pages

LOS 2h) Compare and contrast the requirements for EPS reporting in simple versus complex capital structures

154

Financial Statement Analysis Study Session 7 & 8.

Documents

financial footnotes

financial results

statement of operations

registration statement

annual report proxy

supplementary schedules

management remuneration

q form