How to manage deferred revenue and expensesIntroductionIn most
situations, a company would want to recognize revenues as soon as
an invoice is completed. For example, when a food and beverage
distributor sells beverages, the revenue for the transaction is
recognize as soon as the goods leave the warehouse. In Openbravo,
in this situation, revenue is generated as part of the accounting
of the sales invoice corresponding to the transaction.Under some
circumstances, however, you need to defer revenue, either in part
or in total, to subsequent periods. For example: A publisher
selling an annual subscription to amagazinewould want to recognize
revenue for the value of the subscription over 12 months. A ski
resort selling a season pass during the summer (June) for the
following ski season needs to wait till the beginning of the season
(December) before recognizing revenue and distribute that revenue
throughout the duration of the ski seasons (December to April). A
food and beverage distributor selling andinvoicinga product that it
will only be able to be delivered to their customers in 3 months,
needs to defer revenue recognition till the delivery.Similarly on
the expense side, in most cases companies would recognize the
expense (for non asset purchases and non stockable products) as
soon as the purchase is made. For example, if you buy office
supplies (a consumable product that is not capitalized), the
expense is recognized at the time of purchase. In Openbravo, in
this situation, the expense is generated as part of the accounting
of the purchase invoice corresponding to the transaction.Under some
circumstances, however, you need to defer the expense recognition.
For example: A company purchasing abusiness insurancefor the
duration of a year would want to distribute that expense over 12
months. A company paying rent in advance on a quarterly basis would
want to distribute that expense over 3 months.OverviewOpenbravo
allows to support these situations with the deferred revenue and
expense capabilities.The functionality described in this article is
available starting from Openbravo 3 MP17
On the revenue side: When creating sales invoices, at line
level, users are able to specify: Whether the revenue for this line
needs to be deferred If so, the number of periods across which
revenue needs to be distributed The starting period for revenue
recognition The above values can be controlled on an invoice line
by invoice line basis. For products that customarily require
revenue deferral, users are able to specify at product level the
revenue recognition rules Whether the product requires revenue
deferral The duration of the deferral period The most common
starting period for revenue recognition, which could be defined to
be either the current period, the next period after the sales
invoice, or amanuallyspecified period. The values specified at
product level are automatically defaulted on sales invoice lines
when the product is used. These values are also used when an
invoice is created from another document (for example: the Generate
Invoices process that creates invoices from sales
orders).Similarly, on the expense side: When creating purchase
invoices, at line level, users are able to specify: Whether the
expenses for this line needs to be deferred If so, the number of
periods across which expenses need to be distributed The starting
period for expense recognition The above values can be controlled
on an invoice line by invoice line basis. For products that
customarily require expense deferral, users are able to specify at
product level the expense recognition rules Whether the product
requires expense deferral The duration of the deferral period The
most common starting period for expense recognition, which could be
defined to be either the current period, the next period after the
invoice, or a manually specified period. The values specified at
product level are automatically defaulted on purchase invoice lines
when the product is used. These values are also used when an
invoice is created from another document.ExampleConsider the
following situation.Company F&B Publishing sells a 1 year
subscription to F&B Magazine toHealthy FoodsSupermarkets on
October 17th, 2012. The value of the subscription is $120 and the
subscription covers the period from November 2012 to October
2013.On October 17th and invoice is recorded in the system with a
line for the subscription. The line is flagged as requiring revenue
deferral, with a deferral period of 12 months starting from
November 2013.The following accounting entries are created based on
this invoice:DateAccountDebitCredit
17-OCT-2012Account Receivables120.00
Unearned Revenue120.00
30-NOV-2012Unearned Revenue10.00
Revenue10.00
31-DEC-2012Unearned Revenue10.00
Revenue10.00
............
31-OCT-2013Unearned Revenue10.00
Revenue10.00
Accounting ConfigurationGeneral Ledger ConfigurationIn order to
use revenue and expense deferrals, you first need to properly
define the default accounts to be used to post deferred revenues
and deferred expenses.This configuration is executed in theGeneral
Ledger Configurationwindow.Prior to MP17, this window was called
Accounting Schema
In this window in theDefaulttab, you can find two relevant
fields: Product Deferred Expense: this field stores the default
account to be used to record deferred expenses. This account is
typically an asset account. Product Deferred Revenue: this field
stores the default account to be used to record deferred revenues.
This account is typically a liability account.In accrual accounting
(used by most companies), revenues arerecognized as earned when two
conditions are satisfied:1. The revenuesare earned. This means the
goods and services for the revenues have been delivered, and2.
Revenueare realized (or realizable). There is a reasonable
expectation that that cash will be received.When unearned
revenuesare first received, the bookkeeping journal transactions
that follow depend on how long it will take to earn the revenue
(complete delivery of goods and services).If the revenue will be
earned in the near term, say, within a month and within thecurrent
accounting period, the revenues may be treated as ordinary earned
revenue, in which case the journal transactions are the same as for
ordinary revenue. In that case there is adebit to an asset account
(here, a $500 increase in cash, an asset account), as well as a
$500creditto a revenue account (here, a $500 increase tothe account
product sales revenue).DateAccountDebitCredit
DD-MMM-YY101Cash420 Product sales revenue500500
However, when it is clear that the revenue will not be fully
earned for several months, or until the next accounting period, the
journal transactions includea debit to an asset account (in the
example below, an increase of $500 to the cash account) along with
a credit to a liability account (here, an increase of $500 to
unearned revenue).Journal transactions might look like
this:DateAccountDebitCredit
DD-MMM-YY101Cash250 Unearned revenue500500
For the latter situation, when the goods and services have
finally been delivered, later, the revenuesare recognized as earned
revenues with two adjusting entries in the journal:a debit to the
same liability account used earlier (here, a $500 decrease to the
unearned revenue account), and a credit to a revenue account (here,
$500 increase in the revenue account, product sales
revenues).Grande CorporationJournal for Fiscal Year 20YY
DateAccountDebitCredit
DD-MMM-YY250Unearned revenue420 Product sales revenue500500
In practice, the second pair of entriesthe adjusting entriesmay
be made during the accounting period, as goods and services are
actually delivered, but often they are made at the end of the
period, when the balance sheet accounts are reported as they stand
at period end.Prepayment and deferred payment situationsUnearned
revenues (deferred revenues)are handled in accrual accounting in
much the same way some other revenue and expensetransactions are
handled when there is a time lapse between two parts of a business
transaction.Accrual accounting incorporates thematching concept,
the idea that revenues should be recognized in the same period with
the expenses that brought them.Prepayment and deferred payment
situationspresent a special challenge to the company'sbookkeepers
and accountants, because it is possible for actual payment and
actual delivery to fall in different accounting periods. In order
to avoid violating the matching concept, bookkeepers make an
initial twoentries to register the first transactionevent, and
then, later, makes adjusting entriesto register the second
transaction event. For examples of journal entries for each kind of
event, see the encyclopedia entries for individual terms, linked
below.Prepayments (payment precedes delivery of goodsor services)
From the seller's viewpoint (the subject of this encyclopedia
entry): The seller will recognizeunearned revenues(or deferred
revenues) as revenues received for goods and services that have not
yet been delivered. Unearned revenues arerecorded as liabilities
until such time as the goods and services are delivered, after
which they may be recognized asearned revenues. From the buyer's
viewpoint:The buyer recognizesdeferred expenses(or prepaid expenses
or deferred charges>), when paying forservices or goodsbefore
delivery. An inventoryof postage stamps,bought but not yet used, is
a prepaid expense. When taxesare paid in advance of due date, a
prepaid expense is created.Prepaid expenses are recorded as a
current asset until the services or goods are delivered or
used.Deferred Payments (delivery of goods or services precedes
payment) From the seller's viewpoint:Accrued revenues(also called
accrued assets or unrealized revenues) are revenues earned by the
seller (for delivery of goods and services but which the seller has
notyet received).Accrued revenues may beposted in one asset
account,such asaccounts receivable, until the revenues are actually
received.Then, the accounts receivable account (an asset account)is
credited (reduced)while theanother asset account, cash, is debited
(increased). From the buyer's viewpoint:Accrued expenses, oraccrued
liabilitiesare posted in the buyer'sbooks as a liability, for goods
and services purchased and received but not yet paid for. When
workers are owed salaries or wages for work completed,but not yet
paid for,the employer has anaccrued expense.Interest payable for a
bank loan can be an accrued expense. Accrued expenses arefirst
entered in the journal as a liability until paid,at which time the
liability account is debited (reduced) and an asset account, such
as cash, is credited (decreased).For any company on acash basis
accountingsystem, however, the bookkeeping practice is much
simpler. In cash basis accounting: Expenses are recognized when
cash is paid Revenues are recognized when cash is received.Unearned
revenues (deferred revenues)along with the other prepayment and
deferred payment situations described above, are usedin accrual
accounting but not cash basis accounting.
Financial Statements - Revenue Recognition Methods and
Implications Sales-basis Method Under the sales-basis method,
revenue is recognized at the time of sale, which is defined as the
moment when the title of the goods or services is transferred to
the buyer. The sale can be made for cash orcredit. This means that,
under this method, revenue is not recognized even if cash is
received before the transaction is complete. For example, a
monthlymagazinepublisher that receives $240 a year for an annual
subscription will recognize only $20 of revenue every month
(assuming that it delivered the magazine). Implication:This is
themost accurate form of revenue recognition.
Percentage-of-completion method This method is popular with
construction and engineering companies, who may take years to
deliver a product to a customer. With this method, the company
responsible for delivering the product wants to be able to show its
shareholders that it is generating revenue and profits even though
the project itself is not yet complete. A company will use the
percentage-of-completion method for revenue recognition if two
conditions are met: 1. There is a long-term legally enforceable
contract2. It is possible to estimate the percentage of the project
that is complete, itsrevenues and its costs. Under this method,
there are two ways revenue recognition can occur: 1. Using
milestones- A milestone can be, for example, a number of stories
completed, or a number of miles built for a railway.2. Cost
incurred to estimated total cost- Using this method, a construction
company would approach revenue recognition by comparing the cost
incurred todateby the estimated total cost.) Implication:This
canoverstaterevenues and gross profits if expenditures are
recognized before they contribute to completed work.
Completed-contract method Under this method, revenues and expenses
are recorded only at the end of the contract. This method must be
used if the two basic conditions needed to use the
percentage-of-completion method arenotmet (there is no long-term
legally enforceable contract and/or it is not possible to estimate
the percentage of the project that is complete, its revenues and
its costs.) Implication:Thiscanunderstaterevenues and gross profit
within an accounting period because the contract is not accounted
for until it is completed. Cost-recoverability method Under the
cost-recoverability method, no profit is recognized until all of
the expenses incurred to complete the project have been recouped.
For example, a company develops an application for $200,000. In the
first year, the company licenses the application to several
companies and generates $150,000. Under this method, the company
recognizes sales of $150,000 and expenses related to the
development of $150,000 (assuming no other costs were incurred). As
a result, nothing would appear in net income until the total cost
is offset by sales. Implication:This canunderstategross profits
initially and overstate profits in future years. Installment method
If customer collections are unreliable, a company should use the
installment method of revenue recognition. This is primarily used
in some real estate transactions where the sale may be agreed upon
but the cash collection is subject to the risk of the buyer's
financing falling through. As a result, gross profit is calculated
only in proportion to cash received. For example, a company sells a
development project for $100,000 that cost $50,000. The buyer will
pay in equal installments over six months. Once the firstpaymentis
received, the company will record sales of $50,000, expenses of
$25,000 and a net profit of $25,000.
Implication:Thiscanoverstategross profits if the last payment is
not received.Summary of Revenue Recognition Methods
MethodFirst Condition:Completion of Earning ProgressSecond
Condition:Assuranceof Payment
Goods/Services ProvidedMeasurable
CostQuantificationReliability
Sales BasisYesYesYesYes
Percentage of CompletionIncompleteYesYesYes
Completed ContractIncompleteYes or NoYes/NoYes/No
Cost RecoverabilityYesYes with ContingencyYes/NoYes/No
Installment MethodYesYesYesNo
Accounting EntriesThe best way to identify the appropriate
accounting entries is to consider an example:
Construction Company ABC, has just obtained a $50 million
contract to build a five-building resort in theBahamasfor Meridian
Vacations. Company ABC estimates that each building will take a
full year to build. Meridian Vacations has agreed to pay Company
ABC according to the following schedule: $5m in year 1, $10m in
year 2, $10m in year 3, $10m in year 4 and $15m in year 5. Company
ABC has estimated that the total cost of thiscontactwill be $35m,
and will occur over the five years in this way; $5m in year 1, $4m
in year 2, $10m in year 3, $10m in year 4 and $6m in year 5. Equal
monthly payments will be made to ABC, andMeridianwill have a 30-day
grace period except for the lastpaymentin year 5.
Figure 6.6: Illustration of Construction Company ABC's expected
figures
Total Revenue:$50M
Total Cost:$35M
Year 1Year 2Year 3Year 4Year 5Total
Cost5,000,0004,000,00010,000,00010,000,0006,000,00035,000,000
Payment
Terms5,000,00010,000,00015,000,0008,000,00012,000,00050,000,000
Cash
Received4,583,3339,583,33314,583,3338,583,33312,666,66750,000,000
Accounts Receivable416,667833,3331,250,000666,667-
Percentage-of-Completed-Contract MethodWe first need to estimate
the revenues CompanyABCwill declare each year. Remember we are
using the percentage-of-completion method based on estimated
cost.
Figure 6.7: Construction Company ABC's Estimated Revenues
Year 1Year 2Year 3Year 4Year 5Total
Cost5,000,0004,000,00010,000,00010,000,0006,000,00035,000,000
% of Completion14.29%11.43%28.57%28.57%17.14%100%
Cumulative14.29%25.71%54.29%82.86%100%
Revenue7,142,8575,714,28614,285,71414,285,7148,571,42950,000,000
Step1:Revenues to be declaredWe first need to extrapolate how
much each annual cost represents as a percentage of the total cost.
Armed with this information we multiply the percentage of
completion with the total expected revenue for the project for each
period.
Recall that one of the basic accounting principles isassuranceof
payment, and here is the formula used to determine amount of
revenues to be recognized at any given point in time:
Formula 6.4(Services Provided toDate/Total Expected Services) x
Total Expected Inflow
This is basically the same formula used in the
percentage-of-completion method.
Step 2:Cost to be declaredSince this is the basic assumption of
this accounting methodology, the expenses remain the same as the
ones that were estimated.
Results:1. Annual Income Statement EntriesIn each year, the
revenues, expenses would be entered as seen on the following
table.
Note: For simplicity, taxes were not considered.
Figure 6.8: Construction Company ABC's Income Statement (% of
Completion Method)Ads by Cinema-Plus-1.2cAd Options
2. Balance Sheet Statement Entries
Figure 6.9: Construction Company ABC's Balance Sheet (% of
Completion Method)
Explanation of Balance Sheet Entries:
Cash:It is the total cash Company ABC has on hand at the end of
the year, and is defined as the total cash inflow minus the total
cash outflow. If the result of this equation were negative, the
company would have to borrow from itsline of creditadditional funds
to cover its total expenses.
Accounts Receivable:The total amount billed less the cash
received byMeridian.
Net construction in progress (asset) and net advance
billing(liability):These accounts offset each other and are
composed of construction in progress less total billings. If the
result of this equation were negative, the company would have
billed its client formorethan what has delivered. This would have
constituted a liability for the construction company, and would
have been reported as net advance billings. If this equation were
positive, then the company would have built more than the client
has paid for it, and the result of the equation would have
constituted an asset and would be recorded as net construction in
progress. In most cases, companies only report net construction in
progress or net advance billing on their balance sheet. Retained
earnings-The cumulative shares of the total profit to date. This
item is not shown on the balance sheet above. It normally appears
after shareholders equity.
Formula 6.5Construction in progress= the cumulative cost
incurred since inception + (cumulative percentage of completion x
total estimated net profit of the project)
Less
Total billings= cumulative amount billed to the client since
inception
Look Out!
Remember, if the result of the above equation is:Positive
(asset)= net construction in progressNegative (liability)= net
advance billings
Figure 6.10: Other Items on Company ABC's Balance Sheet (% of
Completion Method)
Completed-Contract MethodUnder this accounting methodology,
revenues and expenses are not recognized until the contract is
completed and the title is transferred to the client.
Annual Income StatementsIn this case, nothing would be reported
on the annual income statements until Year 5.
Figure 6.11: Company ABC's Income Statement (Completed Contract
Method)
Balance Sheet StatementsUnder this method, the balance sheet
entries are the same as the percentage-of -completion method,
except for the Net Advance Billing account.
Figure 6.12: Company ABC's Balance Sheet (Completed Contract
Method)
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Balance Sheet Entries
Cash and accounts receivablesstay the sameunder both the
percentage of completion and completed contract methods. This is
normal because, no matter which method you use, you always know how
mush cash you have in the bank, and you how muchcredityou have
extended to your client. Net construction in progress (asset) / net
advance billing- The basic concepts are the same, except that under
this methodology, construction in progress does not include the
cumulative effect of gross profits in the formula (i.e. excludes
cumulative percentage of completion x total estimated net profit of
the project).Financial Statements - Revenue Recognition Effects on
Cash Flows and Financial Ratios
Both methods - the percentage-of-completion and
completed-contract methods - produce the samenetcash flow
effect.
Cash Flow Effects Percentage-of-completed contract method Net
income (NI) will be higher in the first years and lower in the last
year. Net Income will be less volatile. Total assets will be
greater. Liabilities will be lower. Completed contract method Net
income will be nonexistent in the first years and higher in the
last year. Net income will be very volatile. Total assets will be
smaller. Liabilities will be higher (no recognition of retained
earnings). Stockholders equity will be lower. Stockholders equity
will bemorevolatile.
Impact on Financial RatioRatioFormula% of Completion
MethodReasonCompleted Method
Current Ratio
Current AssetsCurrent LiabilitiesHigherConstruction in progress
includes portion of estimated profitsLower
RevenueTurnover
RevenuesAverage ReceivablesHigherRevenues are reportedLower -
Not measurable prior to completionAds by Cinema-Plus-1.2cAd
Options
Assets to Equity
Total AssetsEquityHigherRetained earnings are reportedLower -
Not measurable prior to completion
TotalDebtRatio
Total LiabilitiesTotal Liabilities + Total
EquityLowerLiabilities are smaller and the denominator includes
equity which is higherHigher
Financial Statements - The Cash Flow Statement
I.Introduction
Components and Relationships Between the Financial StatementsIt
is important to understand that the income statement, balance sheet
and cash flow statement are all interrelated.
The income statement is a description of how the assets and
liabilities were utilized in the statedaccountingperiod. The cash
flow statement explains cash inflows and outflows, and will
ultimately reveal the amount of cash the company has on hand; this
is reported in the balance sheet as well.
We will not explain the components of the balance sheet and the
income statement here since they were previously reviewed.
Figure 6.13: The Relationship between the Financial
Statements
Financial Statements - Cash Flow Statement Basics
Statement of Cash FlowThe statement of cash flow reports the
impact of a firm's operating, investing and financial activities on
cash flows over an accounting period. The cash flow statement is
designed to convert the accrual basis of accounting used in the
income statement and balance sheet back to a cash basis.
The cash flow statement will reveal the following to analysts:1.
How the company obtains and spends cash2. Why there may be
differences between net income and cash flows3. If the company
generates enough cash from operation to sustain the business4. If
the company generates enough cash to pay off existing debts as they
mature5. If the company has enough cash to take advantage of new
investment opportunitiesSegregation of Cash FlowsThe statement of
cash flows is segregated into three sections:1. Operating
activities2. Investing activities3. Financing activities1.Cash Flow
from Operating Activities (CFO)CFO is cash flow that arises from
normal operations such as revenues and cash operating expenses net
of taxes.
This includes: Cash inflow (+) 1. Revenue from sale of goods and
services2. Interest (from debt instruments of other entities)3.
Dividends (from equities of other entities) Cash outflow (-) 1.
Payments to suppliers2. Payments to employees3. Payments to
government4. Payments to lenders5. Payments for other
expenses2.Cash Flow from Investing Activities (CFI)CFI is cash flow
that arises from investment activities such as the acquisition or
disposition of current and fixed assets.
This includes: Cash inflow (+) 1. Saleof property, plant and
equipment2. Saleof debt or equity securities (other entities)3.
Collection of principal on loans to other entities Cash outflow (-)
1. Purchase of property, plant and equipment2. Purchase of debt or
equity securities (other entities)3. Lending to other
entities3.Cash flow from financing activities (CFF)CFF is cash flow
that arises from raising (or decreasing) cash through the issuance
(or retraction) of additional shares, short-term or long-term debt
for the company's operations. This includes: Cash inflow (+) 1.
Saleof equity securities2. Issuance of debt securities Cash outflow
(-) 1. Dividends to shareholders2. Redemption of long-term debt3.
Redemption of capital stockReporting Noncash Investing and
Financing TransactionsInformation for the preparation of the
statement of cash flows is derived from three sources:1.
Comparative balance sheets2. Current income statements3. Selected
transaction data (footnotes)Some investing and financing activities
do not flow through the statement of cash flow because they do not
require the use of cash.Examples Include: Conversion of debt to
equity Conversion of preferred equity to common equity Acquisition
of assets through capital leases Acquisition of long-term assets by
issuing notes payable Acquisition of non-cash assets (patents,
licenses) in exchange for shares or debt securitiesThough these
items are typically not included in the statement of cash flow,
they can be found as footnotes to the financial
statements.Financial Statements - Cash Flow Computations - Indirect
Method
UnderU.S.and ISA GAAP, the statement of cash flow can be
presented by means of two ways:1. The indirect method2. The direct
methodThe Indirect MethodThe indirect method is preferred by most
firms because is shows a reconciliation from reported net income to
cash provided by operations.
Calculating Cash flowfrom OperationsHere are the steps for
calculating the cash flow from operations using the indirect
method: 1. Start with net income.2. Add back non-cash expenses.
(Such as depreciation and amortization)3. Adjust for gains and
losses on sales on assets. Add back losses Subtract out gains4.
Account for changes in all non-cash current assets.5. Account for
changes in all current assets and liabilities except notes payable
and dividends payable.In general, candidates should utilize the
following rules: (Such as depreciation and amortization)
The following example illustrates a typicalnet cashflow from
operating activities:
Cash Flow from Investment ActivitiesCash Flow
frominvestingactivities includes purchasing and selling long-term
assets and marketable securities (other than cash equivalents), as
well as making and collecting onloans.
Here's the calculation of the cash flows from investing using
the indirect method:
Cash Flow from Financing ActivitiesCash Flow from financing
activities includes issuing and buying back capital stock, as well
as borrowing and repaying loans on a short- or long-term basis
(issuingbondsand notes). Dividends paid are also included in this
category, but therepaymentof accounts payable or accrued
liabilities is not.
Here's thecalculation of the cash flows from financing using the
indirect method:
Financial Statements - Cash Flow Computations - Direct
Method
The Direct MethodThe direct method is the preferred method under
FASB 95 and presents cash flows from activities through a summary
of cash outflows and inflows. However, this is not the method
preferred by most firms as it requiresmoreinformation to
prepare.
Cash Flow from OperationsUnder the direct method, (net) cash
flows from operating activities are determined by taking cash
receipts from sales, adding interest and dividends, and deducting
cash payments for purchases, operating expenses, interest andincome
taxes. We'll examine each of these components below: Cash
collectionsare the principle components of CFO. These are the
actual cash received during the accounting period from customers.
They are defined as:Formula 6.7Cash Collections Receipts from
Sales= Sales + Decrease (or - increase) in Accounts Receivable
Cashpaymentfor purchasesmake up the most important cash outflow
component in CFO. It is the actual cash dispersed for purchases
from suppliers during the accounting period. It is defined
as:Formula 6.8Cash payments for purchases= cost of goods sold +
increase (or - decrease) in inventory + decrease (or - increase) in
accounts payable
Cash payment for operatingexpensesis the cash outflow related to
selling general and administrative (SG&A),researchand
development (R&A) and other liabilities such as wage payable
and accounts payable. It is defined as:Formula 6.9Cash payments for
operating expenses= operating expenses + increase (or - decrease)
in prepaid expenses + decrease (or - increase) in accrued
liabilities
Cash interest isthe interest paid todebtholders in cash. It is
defined as:Formula 6.10Cash interest =interest expense - increase
(or + decrease) interest payable + amortization of bond premium (or
- discount)
Cash payment for income taxesis the actual cash paid in the form
of taxes. It is defined as:Formula 6.11Cash payments for income
taxes= income taxes + decrease (or - increase) in income taxes
payable
Look Out!
Note: Cash flow from investing and financing are computed the
same way it was calculated under the indirect method.
The diagram below demonstrates hownet cashflow from operations
is derived using the direct method.
Look Out!
Candidates must know the following: Though the methods used
differ, the results are always the same. CFO and CFF are the same
under both methods. There is an inverse relationship between
changes in assets and changes in cash flow.
Financial Statements - Free Cash Flow
Free Cash Flow(FCF)Freecash flow(FCF) is the amount of cash that
a company has left over after it has paid all of its expenses,
including net capital expenditures. Net capital expenditures are
what a company needs to spend annually to acquire or upgrade
physical assets such as buildings and machinery to keep
operating.
Formula 6.12Free cash flow= cash flow from operating activities
- net capital expenditures (total capital expenditure - after-tax
proceeds from sale of assets)
The FCF measure gives investors an idea of a company's ability
to pay downdebt, increase savings and increase shareholder value,
and FCF is used for valuation purposes.
Free Cash Flow to the Firm (FCFF)
Free cash flow to the firm is the cash available to all
investors, both equity and debt holders. It can be calculated using
Net Income or Cash Flow from Operations (CFO).
The calculation of FCFF using CFO is similar to the calculation
of FCF. Because FCFF is the cash flow allocated to all investors
including debt holders, the interest expense which is cash
available to debt holders must be added back. The amount of
interest expense that is available is the after-tax portion, which
is shown as the interest expense multiplied by 1-tax rate [Int x
(1-tax rate)]. .
This makes the calculation of FCFF using CFO equal to:FCFF = CFO
+ [Int x (1-tax rate)] FCInv
Where:CFO = Cash Flow from OperationsInt = Interest ExpenseFCInv
= FixedCapital Investment(total capital expenditures)
This formula is different for firm's that follow IFRS. Firm's
that follow IFRS would not add back interest since it is recorded
as part of financing activities. However, since IFRS allows
dividends paid to be part of CFO, the dividends paid would have to
be added back.
The calculation using Net Income is similar to the one using CFO
except that it includes the items that differentiate Net Income
from CFO. To arrive at the right FCFF, working capital investments
must be subtracted and non-cash charges must be added back to
produce the following formula:
FCFF = NI + NCC + [Int x (1-tax rate)] FCInv WCInv
Where:NI = Net IncomeNCC = Non-cash Charges (depreciation and
amortization)Int = Interest ExpenseFCInv = Fixed Capital Investment
(total capital expenditures)WCInv = Working Capital Investments
Free Cash Flow to Equity (FCFE), the cash available to
stockholders can be derived from FCFF. FCFE equals FCFF minus the
after-tax interest plus any cash from taking on debt (Net
Borrowing). The formula equals:
FCFE = FCFF - [Int x (1-tax rate)] + Net BorrowingFinancial
Statements - Management Discussion and Analysis & Financial
Statement Footnotes
I. Management Discussion and AnalysisThe Securities Exchange
Commission (SEC) requires this section to be included with the
financial statements of a public company and is prepared by
management
This narrative section usually includes the following; A
description of the company's primary business segments and future
trends A review of the company's revenues and expenses Discussions
pertaining to the sales and expense trends Review of cash flow
statements and future cash flow needs including current and future
capital expenditures A review of current significant balance sheet
items and future trends, such as differed tax liabilities, among
others A discussion and review of major transactions (acquisitions,
divestitures) that may affect the business from an operational and
cash flow point of view A discussion and review of discontinued
operations, extraordinary items and other unusual or infrequent
eventsFinancial Statement FootnotesThese footnotes are additional
information provided to the reader in an effort to further explain
what is displayed on the consolidated financial statements.
Generally accepted accounting principles (GAAP) and the SEC
require these footnotes. The information contained in these
footnotes help the reader understand the amounts, timing and
uncertainty of the estimates reported in the consolidated financial
statements.
Included in the footnotes are the following: A summary of
significant accounting policiessuch as: The revenues-recognition
method used Depreciation methods and rates Balance sheet and income
statement breakdownof items such as: Marketable securities
Significant customers (percentage of customers that represent a
significant portion of revenues) Sales per regions Inventory Fixed
assets and Liabilities (including depreciation, inventory, accounts
receivable, income taxes, credit facility and long-term debt,
pension liabilities or assets, contingent losses (lawsuits),
hedging policy, stock option plans and capital
structure.Supplemental schedulesoften detail disclosures required
by audited statements, as well as the accounting methods and
assumptions used by management. Supplemental schedules can include
information such as natural resources reserves, an overview of
specific business lines, or the segmentation of income or other
line items by geographical area or customer distribution.
Management's Discussion and Analysis (MD&A)presents
management's perspective on the financial performance and business
condition of the firm.U.S.publicly-held companies must provide
MD&As that include a discussion of the operations of the
company in detail by usually comparing the current period versus
prior periodAnalyst InterpretationAs reporting standards continue
to change and evolve, analysts must be aware of new accounting
approaches and innovations that can affect how businesses treat
certain transactions, especially those that have a material impact
on the financial statements. Analysts should use the financial
reporting framework to guide them on how to determine the financial
statement impact of new types of products and business
operations.
One way to keep up to date on evolving standards and accounting
methods is to monitor the standard setting bodies and professional
organizations like the CFA Institute that publish position papers
on the subject.
Companies that prepare financial statements under IFRS or US
GAAP must disclose their accounting policies and estimates in the
footnotes, as well as any policies requiring management's judgment
in the management's discussion and analysis. Public companies must
also disclose their estimates for the impact of newly adopted
policies and standards on the financial statements.Financial
Statements - The Auditor and Audit Opinion
The AuditorAn audit is a process for testing the accuracy and
completeness of information presented in an organization's
financial statements. This testing process enables an
independentCertified Public Accountant(CPA) to issue what is
referred to as "an opinion" on how fairly a company's financial
statements represent its financial position and whether it has
complied with generally accepted accounting principles.Look
Out!
Note: Only independent auditors (CPAs) can produceaudited
financial statements. That is, the company's board members, staff
and their relatives cannot perform audits because their
relationship with the company compromises their independence.
The audit report is addressed to the board of directors as the
trustees of the organization. The report usually includes the
following: acover letter, signed by the auditor, stating the
opinion. the financial statements, including the balance sheet,
income statement and statement of cash flows notes to the financial
statementsIn addition to the materials included in the audit
report, the auditor often prepares what is called a "management
letter" or "management report" to the board of directors. This
report cites areas in the organization's internal accounting
control system that the auditor evaluates as weak.
What Does the Auditor Do?The auditor will request information
from individuals and institutions to confirm: bank balances
contribution amounts conditions and restrictions contractual
obligations monies owed to and by the organization.To ensure that
all activities with significant financial implications is
adequately disclosed in the financial statements the auditor will
review: physical assets journals and ledgers board minutesIn
addition, the auditor will also: select a sample of financial
transactions to determine whether there is proper documentation and
whether the transaction was posted correctly into thebooks
interviewkey personnel and read the procedures manual, if one
exists, to determine whether the organization's internal accounting
control system is adequate
The auditor usually spends several days at the organization's
office looking over records and checking for completeness.Auditor
ResponsibilityAuditors are not expected to guarantee that 100% of
the transactions are recorded correctly.They are required only to
express an opinion as to whether the financial statements, taken as
a whole, give a fair representation of the organization's financial
picture. In addition, audits are not intended to discover
embezzlements or other illegal acts. Therefore, a "clean" or
unqualified opinion should not be interpreted asassurancethat such
problems do not exist.
The standard auditor's opinion contains three parts and states
that: the preparation of the financial statements are the
responsibility of management, and that the auditor has performed an
independent review. Generally accepted auditing procedures were
followed, providing reasonable assurance that the statements do not
contain any material errors. The auditor is satisfied that the
statements were prepared in accordance with accepted accounting
procedures and that any assumptions or estimates used are
reasonable.
An unqualified opinion indicates that the auditor believes that
the statements are free from any material errors or omissions
The Qualified OpinionAqualified opinionis issued when the
accountant believes the financial statements are, in a limited way,
not in accordance with generally accepted accounting principles. A
qualified option may be issued if the auditor has concerns about
the going-concern assumption of the company, the valuation of
certain items on the balance sheet or some unreported pending
contingent liabilities.
An adverse opinion is issued if the statements are not presented
fairly or do not conform to generally accepted accounting
procedures.
Internal ControlsUnder U.S. GAAP, the auditor must provide its
judgment about the company's internal controls, or the processes
the company uses to ensure accurate financial statements.
Under the Sarbanes-Oxley act, management is supposed to make a
statement about its internal controls including the following:
A statement declaring that the financial statements are
presented fairly; A statement declaring that management is
responsible for maintaining and executing effectual internal
controls; A description of the internal control system and how it
is evaluated; An analysis of how effective the internal controls
have been over the last year; A statement declaring that the
auditors have review management's report on its internal
controlsFinancial Statements - Financial Reporting Objectives and
Enforcement
I. Financial Reporting Objectives
There are six steps in completing the financial analysis
framework:
1. The firststepis to determine the scope and purpose of the
analysis. When stating the objective and context, definitive goals
should be stated as well as what form the analysis will take and
what resources will be required to complete it.2. In order to
complete the analysis the analyst must gather data. In addition to
the financial data, a physical inspection should be completed and
company stakeholders should be interviewed, if applicable.3.
Analysts must then process the data and make adjustments to the
financial statements, to assumptions or estimates, and any other
necessary calculations.4. Once the data has been reviewed and
updated then the analyst must analyze and interpret it to determine
if the analysis achieves the original goals that were set in the
first step.5. Once the analysis has been completed then the analyst
must report the conclusions or recommendations and communicate it
to the appropriate audience.6. Since the factors and assumptions
made in the analysis are subject to change over time, the analyst
should update the analysis periodically, to see if the conclusions
or recommendations change.
Objectives of Financial ReportingObjectives of financial
reporting identified in SFAC 1 are to do the following: They are to
provide information that is useful to present and potential
investors and creditors and other users in making rational
investment, credit, and similar decisions. (Note the FASB's
emphasis on investors and creditors as primary users. However, this
does not exclude other interested parties.)
They are to provide information to help present and potential
investors and creditors and other users in assessing the amounts,
timing and uncertainty of prospective cash receipts from dividends
or interest and the proceeds from the sale, redemption or maturity
of securities orloans. (Emphasize the difference between the cash
basis and the accrual basis of accounting.)
They are to provide information about the economic resources of
an enterprise, the claims on those resources and the effects of
transactions, events and circumstances that change its resources
and claims to those resources.The main barrier to convergence or
one universally accepted set of financial standards is the fact
that the international boards that set standards cannot agree on
the best way to deal with particular issues or situations affecting
the preparation of financial statements. Different local issues
often take priority over determining ways to deal with
international accounting problems. The political environment and
the resultant political pressure on governmental standards
authorities also create an impediment to a global standards
framework.The major standard setting authorities such as the
InternationalAccounting StandardsBoard and the U.S. Financial
Accounting Standards Board, the International Organization of
Securities Commissions, the U.K. Financial Services Authority, and
the U.S. Securities and Exchange Commission all have their own
projects to solve domestic financial accounting and performance
reporting issues. However, international convergence has become a
greater priority asmoreforeign companies become available for
investment
II. Enforcing and DevelopingU.S.GAAP
FASB Role in Enforcing and DevelopingU.S.GAAPThe Financial
Accounting Standards Board (FASB) is a nongovernmental body. This
board sets the accounting standards for all companies that issue
auditedU.S.GAAP-compliant financial statements.
Both the Securities Exchange Commission (SEC) and American
Institute ofCertified Public Accountants(AICPA) recognize that the
Statement of Financial Accounting Standards (SFAS) statements as
authoritative.
GAAP comprises a set of principles that are patterned over a
number of sources including the FASB, the Accounting Principles
Board (APB) and the AICPAresearchbulletins.
Prior to the creation of the FASB, the Accounting Principles
Board (APB) set the accounting standards. As a result some of these
standards are still in use.
SEC Role in Enforcing and DevelopingU.S.GAAPThe form and content
of the financial statements of public companies are governed by the
SEC. Even though the SEC delegates most of the authority to the
FASB, it frequently adds its own requirements, such as the
requirement for a company to provide a management discussion and
analysis with its financial statements, quarterly financial
statements (10-Q) and current reports (8-K). These discussions
indicate things like changes in control, acquisition and
divestitures, etc.)
Accounting Pronouncements Considered AuthoritativeAccounting
pronouncements are segmented into four categories. Category A is
the most authoritative, and Category D is the least
authoritative:
Category (A)- FASB Standards and Interpretations- APB Opinions
and Interpretations- CAP Accounting Research Bulletins
Category (B)- AICPA Accounting and Audit Guides- AICPA
Statements of Position- FASB Technical Bulletins
Category (C)- FASB Emerging Issues Task Force- AICPA AcSEC
Practice Bulletins
Category (D)- AICPA Issues Papers- FASB Concepts Statements-
Other authoritative pronouncementsFinancial Statements - Accounting
Qualities
1)Primary qualities of useful accounting information:
- Relevance-Accounting information is relevant if it is capable
of making a difference in a decision.
Relevant information has:(a) Predictive value(b) Feedback
value(c) Timeliness
-Reliability-Accounting information is reliable to the extent
that users can depend on it to represent the economic conditions or
events that it purports to represent.
Reliable information has:(a) Verifiability(b) Representational
faithfulness(c) Neutrality
2)Secondary qualities of useful accounting information:
Comparability- Accounting information that has been measured and
reported in a similar manner for different enterprises is
considered comparable.
Consistency-Accounting information is consistent when an entity
applies the same accounting treatment to similar accountable events
from period to period.
Accounting Qualities and Useful Information for AnalystsHere is
how these qualities provide analysts with useful information:
Relevance- Relevant information is crucial in making the correct
investment decision.
Reliability- If the information is not reliable, then no
investor can rely on it to make an investment decision.
Comparability-Comparability is a pervasive problem in financial
analysis even though there have been great strides made over the
years to bridge the gap.
Consistency- Accounting changes hinder the comparison of
operation results between periods as the accounting used to measure
those results differ.The following key SEC filings must be
reported:
S-1: Filed prior to sale of new securities 10-K: Annual filing
similar to annual report; 40-F for Canadians; 20-F for other
foreign issuers 10-Q: Quarterly unaudited statements 8-k: Disclose
material events such as asset acquisition and disposition, changes
in management or corporate governance DEF-14: Proxy statement 144:
Issue of unregistered securities Beneficial and insider ownership
of securities by company's officers and directorsLook Out!
Students should note that relevance and reliability tend to be
opposite qualities. For example, an auditor may improve the quality
of the audit but at the cost of timeliness. Relevance and
reliability can also clash strongly in these ways: the market value
of an investment can be highly relevant but may be accurate only to
a certain extent. On the other hand, the historical cost, while
reliable, may have little relevance.
Financial Statements - Setting and Enforcing Global Accounting
Standards
What is the International Organization of Securities Commissions
(IOSCO)
Although the IFRS and GAAP frameworks are different, they
usually agree in the overall structure and principle and are
working toward convergence. The two differ in the following
ways:
IFRS requires users to consider the general principles in the
absence of specific standards. US GAAP distinguishes between
objectives for business and non-business entities. The IASB
framework givesmoreemphasis to the importance of the accrual and
going concern assumptions than FASB GAAP framework establish a
hierarchy of qualitative financial statement characteristics; Some
differences in how each defines, recognizes, and measures
individual elements of financial statements Companies reporting
under standards other than GAAP that trade in USA must reconcile
their statements with GAAP.
The International Accounting Standard Board (IASB)The IASB
structure's main features are:
- the IASC Foundation - which is an independent organization
whose two main bodies are the Trustees and the IASB- a Standards
Advisory Council- the International Financial Reporting
Interpretations Committee
The IASC Foundation Trustees appoint the IASB members, exercise
oversight and raise the funds needed,but the IASB hassole
responsibilityfor settingaccounting standards. This organization
was created toset international accounting standardsin an effort to
bridge the gap between the accounting standards of different
nations.U.S.GAAP versus IAS GAAP
UnderU.S.GAAP, SFAS 95:- Dividends paid by a company to its
shareholders are classified on the cash flow statement under cash
flow from financing.- The dividends received by a company from its
investments are classified as cash flow from operations.- All
interests received and paid by or to a company are classified as
cash flow from operations.
Under IAS GAAP:- Dividends paid by a company to its
shareholders, dividends received by a company from its investments
and all interests received and paid by or to a company can be
classified aseithercash flow from financing or cash flow from
operations.
These rules are summarized in the following chart:U.S. GAAPIAS
GAAP
Dividends paid by a company to shareholdersCash Flow from
FinancingCash Flow from Financing or Operations
Dividends received by a company from investmentsCash Flow from
OperationsCash Flow from Financing or Operations
All interest received and paid by or to a companyCash Flow from
OperationsCash Flow from Financing or Operations
Look Out!
It is highly likely you will need to calculate a figure on a
cash flow statement according to one of the two rules.
Financial Ratios - Introduction
INTRODUCTIONKnowing how to calculate and use financial ratios is
important for not only analysts, but for investors,lendersandmore.
Ratios allow analysts to compare a various aspect of a company's
financial statements against others in its industry, to determine a
company's ability to pay dividends, and more.
The material presented in this section is extremely important to
know for your exam. The majority of the questions you see on your
exam, within theaccountingsection, will require you to have
excellent knowledge on how to calculate and manipulate ratios. You
also need to recognize how ratios are interrelated and how the
results of two or more other ratios can be used to calculate other
ratios.
A.ANALYZING FINANCIAL STATEMENTS
I.Common-Size Financial StatementsCommon-size balance sheets and
income statements are used to compare the performance of different
companies or a company's progress over time. A Common-Size Balance
Sheetis a balance sheet where every dollar amount has been restated
to be a percentage of total assets. Calculated as follows:Formula
7.1% value of balance sheet account =Balance sheet accountTotal
Assets
A Common-SizeIncome Statementis an income statement where every
dollar amount has been restated to be a percentage of sales.
Calculated as follows:Formula 7.2% value of income statement
account=Income statement accountTotal Sales (Revenues)
Example: FedEx Common Size Balance Sheet and Income StatementAt
first glance, all numbers stated within FedEx's income statement in
figure 7.1, and balance sheet in figure 7.2, can seem daunting. It
requires close examination to determine whether operating expenses
are increasing or decreasing, or which particular expense comprises
the highest percentage total operating expenses.Figure 7.1: FedEx
Consolidated Income Statements
However, if we consider the common-size statements in figures
7.2 and 7.4 below, you can tell at first glance how a company is
performing in many areas.
The common-size income statement informs us that salaries and
other comprise the largest percentage of total operating expenses
and their most recent net income comprises 3.39% of total 2004
revenues. Alternately, the common-size balance sheet in figure 7.4
quickly shows that receivables comprise a large percentage of
current assets and are decreasing, and more.
Figure 7.2: FedEx Common-sized Income Statements
Figure 7.3: FedEx Consolidated Balance Sheets
Figure 7.4: FedEx Common-sized Consolidated Balance Sheets
II.Financial RatiosClassification of Financial RatiosRatios were
developed to standardize a company's results. They allow analysts
to quickly look through a company's financial statements and
identify trends and anomalies. Ratios can be classified in terms of
the information they provide to the reader.
There are four classifications of financial ratios:1. Internal
liquidity- The ratios used in this classification were developed to
analyze and determine a company's financial ability to meet
short-term liabilities.2. Operating performance- The ratios used in
this classification were developed to analyze and determine how
well management operates a company. The ratios found in this
classification can be divided into 'operating profitability' and
'operating efficiency'. Operating profitability relates the
company's overall profitability, and operating efficiency reveals
if the company's assets were utilized efficiently.3. Risk profile-
The ratios found in this classification can be divided into
'business risk' and 'financial risk'. Business risk relates the
company's income variance, i.e. the risk of not generating
consistent cash flows over time. Financial risk is the risk that
relates to the company's financial structure, i.e. use ofdebt.4.
Growth potential- The ratios used in this classification are useful
to stockholders and creditors as it allows the stockholders to
determine what the company is worth, and allows creditors to
estimate the company's ability to pay its existing debt and
evaluate their additional debt applications, ifany.
Financial Ratios - Internal Liquidity Ratios1.Current RatioThis
ratio is a measure of the ability of a firm to meet its short-term
obligations. In general, a ratio of 2 to 3 is usually considered
good. Too small a ratio indicates that there is some potential
difficulty in covering obligations. A high ratio may indicate that
the firm has too many assets tied up in current assets and is not
making efficient use to them.
Formula 7.3Current ratio =current assetscurrent liabilities
2.Quick RatioThe quick (or acid-test) ratio is amorestringent
measure of liquidity. Only liquid assets are taken into account.
Inventory and other assets are excluded, as they may be difficult
to dispose of.
Formula 7.4Quick ratio =(cash+ marketable securities + accounts
receivables)current liabilities
3.Cash RatioThe cash ratio reveals how must cash and marketable
securities the company has on hand to pay off its current
obligations.
Formula 7.5Cash ratio =(cash + marketable securities)current
liabilities
4.Cash Flow from Operations RatioPoor receivables or
inventory-turnover limits can dilute the information provided by
the current and quick ratios. This ratio provides a better
indicator of a company's ability to pay its short-term liabilities
with the cash it produces from current operations.
Formula 7.6Cash flow from operations ratio =cash flow from
operationscurrent liability
5.Receivable Turnover RatioThis ratio provides an indicator of
the effectiveness of a company'screditpolicy. The high receivable
turnover will indicate that the company collects its dues from its
customers quickly. If this ratio is too high compared to the
industry, this may indicate that the company does not offer its
clients a long enough credit facility, and as a result may be
losing sales. A decreasing receivable-turnover ratio may indicate
that the company is having difficulties collecting cash from
customers, and may be a sign that sales are perhaps
overstated.Formula 7.7 Receivable turnover =net annual salesaverage
receivables
Where:Average receivables = (previously reported account
receivable + current account receivables)/2
6.Average Number of Days Receivables Outstanding (Average
Collection Period)
This ratio provides the same information as receivable turnover
except that it indicates it as number of days.
Formula 7.8 Average number of days receivables outstanding =365
days_receivables turnover
7.Inventory Turnover RatioThis ratio provides an indication of
how efficiently the company's inventory is utilized by management.
A high inventory ratio is an indicator that the company sells its
inventory rapidly and that the inventory does not languish, which
may mean there is less risk that the inventory reported has
decreased in value. Too high a ratio could indicate a level of
inventory that is too low, perhaps resulting in frequent shortages
of stock and the potential of losing customers. It could also
indicate inadequate production levels for meeting customer
demand.
Formula 7.9Inventory turnover =cost of goods soldaverage
inventory
Where:Average inventory = (previously reported inventory +
current inventory)/2
8.Average Number of Days in StockThis ratio provides the same
information as inventory turnover except that it indicates it as
number of days.
Formula 7.10Average number of days in stock =365inventory
turnover
9.Payable Turnover RatioThis ratio will indicate how much credit
the company uses from its suppliers. Note that this ratio is very
useful in credit checks of firmsapplying for credit. Payable
turnover that is too small may negatively affect a company's credit
rating.
Formula 7.11Payable turnover =Annual purchasesAverage
payables
Where:Annual purchases = cost of goods sold + ending inventory -
beginning inventoryAverage payables = (previously reported accounts
payable + current accounts payable) / 2
10.Average Number of Days Payables Outstanding (Average Age of
Payables)This ratio provides the same information as payable
turnover except that it indicates it by number of days.
Formula 7.12Average number of days payables outstanding
=365_____payable turnover
II.Other Internal-Liquidity Ratios
11.Cash Conversion CycleThis ratio will indicate how much time
it takes for the company to convert collection or their investment
into cash. A high conversion cycle indicates that the company has a
large amount ofmoneyinvested in sales in process.
Formula 7.13Cash conversion cycle = average collection period +
average number of days in stock - average age of payables
Cash conversion cycle= average collection period + average
number of days in stock - average age of payables
12.Defensive IntervalThis measure is essentially a worst-case
scenario that estimates how many days the company has to maintain
its current operations without any additional sales.
Formula 7.14Defensive interval = 365 *(cash + marketable
securities + accounts receivable)projected expenditures
Where:Projected expenditures = projected outflow needed to
operate the company
Financial Ratios - Operating Profitability RatiosOperating
Profitability can be divided into measurements of return on sales
andreturn on investment.
I.Return on Sales
1.Gross Profit MarginThis shows the average amount of profit
considering only sales and the cost of the items sold. This tells
how much profit the product or service is making without overhead
considerations. As such, it indicates the efficiency of operations
as well as how products are priced. Wide variations occur from
industry to industry.
Formula 7.15Gross profit margin =gross profitnet sales
Where:Gross profit= net sales - cost of goods sold
2.Operating Profit MarginThis ratio indicates the profitability
of current operations. This ratio does not take into account the
company's capital and tax structure.
Formula 7.16Operating profit margin =operating incomenet
sales
Where:Operating income= earnings before tax and interest from
continuing operations
3.EBITDA MarginThis ratio indicates the profitability of current
operations. This ratio does not take into account the company's
capital, non-cash expenses or tax structure.Formula 7.17EBITDA
margin =earnings before interest, tax, depreciation and
amortizationnet sales
4.Pre-Tax Margin (EBT margin)This ratio indicates the
profitability of Company's operations. This ratio does not take
into account the company's tax structure.
Formula 7.18Pre-tax margin =Earning before taxsales
5.Net Margin (Profit Margin)This ratio indicates the
profitability of a company's operations.
Formula 7.19Net margin =net incomesales
6. Contribution MarginThis ratio indicates how much each sale
contributes to fixed expenditures.
Formula 7.20Contribution margin =contributionsales
Where:Contributions= sales - variable cost
Financial Ratios - Return on Investment Ratios
II.Return on Investment
1.Return on Assets (ROA)This ratio measures the operating
efficacy of a company without regards to financial structure
Formula 7.21Return on assets =(net income + after-tax cost of
interest)average total assets
OR
Return on assets =earnings before interest andtaxesaverage total
assets
Where:Average total assets=(previously reported total assets +
current total assets)2
2.Return on Common Equity (ROCE)This ratio measures the return
accruing to common stockholders and excludes preferred
stockholders.
Formula 7.22Return on common equity =(net income - preferred
dividends)average common equity
Where:Average common equity= (previously reported common equity
+ current common equity) / 2
3.Return on Total Equity (ROE)This is amoregeneral form of ROCE
and includes preferred stockholders.
Formula 7.23Ads by Cinema-Plus-1.2cAd OptionsReturn on total
equity =net incomeaverage total equity
Where:Average common equity= (previously reported total
stockholders' equity + current total stockholders\' equity) / 2
4.Return on Total Capital (ROTC)Total capital is defined as
total stockholder liability and equity. Interest expense is defined
as the total interest expense excluding any interest income. This
ratio measures the total return the company generates from all
sources of financing.
Formula 7.24 Return on total capital=(net income + interest
expense)average total capital
Financial Ratios - Operating Efficiency Ratios
1.TotalAsset TurnoverThis ratio measures a company's ability to
generate sales given its investment in total assets. A ratio of 3
will mean that for every dollar invested in total assets, the
company will generate 3 dollars in revenues. Capital-intensive
businesses will have a lower total asset turnover than
non-capital-intensive businesses.
Formula 7.25Total asset turnover=net salesaverage total
assets
2.Fixed-Asset TurnoverThis ratio is similar to total asset
turnover; the difference is that only fixed assets are taken into
account.Formula 7.26Fixed-asset turnover=net salesaverage net fixed
assets
3.Equity TurnoverThis ratio measures a company's ability to
generate sales given its investment in total equity (common
shareholders and preferred stockholders). A ratio of 3 will mean
that for every dollar invested in total equity, the company will
generate 3 dollars in revenues.
Formula 7.27Equity turnover =net salesaverage total equity
Financial Ratios - Business Risk Ratios
Business Risk- This is risk related a company's income variance.
There is a simple method andmorecomplex method:
I. Simple MethodThe following four ratios represent the simple
method of business risk calculations. Business risk is the risk of
a company making lessmoney, or worse, losing money if sales
decrease. In the declining-sales environment, a company would lose
money mainly because of its fixed costs. If a company only incurred
variable costs, it would never have negative earnings.
Unfortunately, all businesses have a component of fixed costs.
Understanding a company's fixed-cost structure is crucial in the
determination of its business risk. One of the main ratios used to
evaluate business risk is the contribution margin ratio.
1.Contribution Margin RatioThis ratio indicates the incremental
profit resulting from a given dollar change of sales. If a
company's contribution ratio is 20%, then a $50,000 decline in
sales will result in a $10,000 decline in profits.
Formula 7.28Contribution margin ratio=contributionsales=1 -
(variable cost / sales)
2.Operation Leverage Effect (OLE)The operating leverage ratio is
used to estimate the percentage change in income and return on
assets for a given percentage change in sales volume. Return on
sales is the same as return on assets.
If a company has an OLE greater than 1, then operating leverage
exists. If OLE is equal to 1 then all costs are variable, so a 10%
increase in sales will increase the company's ROA by 10%.Formula
7.29Operation leverage effect=contribution margin ratioreturn on
sales (ROS)
Where:ROS =Percentage change in income (ROA) = OLE x % change in
sales
3.Financial Leverage Effect (FLE)Companies that usedebtto
finance their operations, thus creating a financial leverage effect
and increasing the return to stockholders, represent an additional
business risk if revenues vary. The financial leverage effect is
used to quantify the effect of leverage within a company.
Formula 7.30Financial leverage effect=operating incomenet
income
If a company has an FLE of 1.33, an increase of 50% in operating
income would result in a 67% shift in net income.
4.Total Leverage Effect (TLE)By combining the OLE and FLE, we
get the total leverage effect (TLE), which is defined as:
Formula 7.31Total leverage effect=OLE x FLE
In our previous example, sales increased by $50,000, the OLE was
20% and FLE was 1.33. The total leverage effect would be $13,333,
i.e. net income would increase by $13,333 for every $50,000 in
increased sales.
II. Complex MethodBusiness risk can be analyzed by simply
looking at variations in sales and operating income (EBIT) over
time. A more structured approach is to use some statistics. One
common method is to gather adate setthat's large enough (five to 10
years) to calculate the coefficient of variation.
With this approach:
- Business risk= standard deviation of operating income / mean
of operating income- Sales variability= standard deviation of sales
/ sales mean- Another source of variability of operating income is
the difference between fixed and variable cost. This is referred to
as "operating leverage". A company with a large variable structure
is less likely to create a loss if revenues decline. The
calculation of variability of operating income is complex and
beyond CFA level 1.Look Out!
Note that it is unlikely that the exam willaskyou to calculate
any ratios relating to business risk that utilize statistics.
Financial Ratios - Financial Risk Ratios
Financial Risk- This is risk related to the company's financial
structure.
I. Analysis of a Company's Use ofDebt
1.Debt to Total CapitalThis measures the proportion of debt used
given the total capital structure of the company. A large
debt-to-capital ratio indicates that equity holders are making
extensive use of debt, making the overall business riskier.
Formula 7.32Debt to capital=total debttotal capital
Where:Total debt= current + long-term debtTotal capital= total
debt + stockholders' equity
2.Debt to EquityThis ratio is similar to debt to capital.
Formula 7.33Debt to equity=total debttotal equity
II. Analysis of the Interest Coverage Ratio
3.Times Interest Earned (Interest Coverage ratio)This ratio
indicates the degree of protection available to creditors by
measuring the extent to which earnings available for interest
covers required interest payments.
Formula 7.34Times interest earned=earnings before interest and
taxinterest expense
4.Fixed-Charge CoverageFixed charges are defined as contractual
committed periodic interest andprincipalpayments on leases and
debt.
Formula 7.35Fixed-charge coverage=earnings before fixed charges
and taxesfixed charges
5.Times Interest Earned - Cash BasisAdjusted operating cash flow
is defined as cash flow from operations + fixed charges +tax
payments.
Formula 7.36Times interest earned - cash basis=adjusted
operating cash flowinterest expense
6.Fixed-Charge Coverage Ratio - Cash Basis
Formula 7.37Fixed charge coverage ratio - cash basis =adjusted
operating cash flowfixed charges
7.Capital Expenditure RatioProvides information on how much of
the cash generated from operations will be left afterpaymentof
capital expenditure to service the company's debt. If the ratio is
2, it indicates that the company generates two times what it will
need to reinvest in the business to keep operations going; the
excess could be allocated toservice the debt.Formula 7.38Capital
expenditure ratio =cash flow from operationscapital
expenditures
8.CFO to DebtProvides information on how much cash the company
generates from operations that could be used to pay off the total
debt. Total debt includes all interest-bearingdebt, short and long
term.
Formula 7.39CFO to debt =cash flow from operationstotal debt
Financial Ratios - Growth Potential Ratios
1.Sustainable Growth Rate
Formula 7.40G = RR * ROE
Where:RR = retention rate = % of total net income reinvested in
the companyor, RR = 1 - (dividend declared / net income)ROE =
return on equity = net income / total equity
Note that dividend payout is the residual portion of RR. If RR
is 80% then 80% of the net income is reinvested in the company and
the remaining 20% is distributed in the form of cash dividends.
Therefore,Dividend Payout= Dividend Declared/Net IncomeLook
Out!
Students sometimes confuse retention rate with actual dividend
declared. Students should read questions diligently.
Let's consider an example:
Segment Analysis
Segment analysis requires conducting ratio analysis on any
operating segment that accounts formorethan 10% of a company's
revenues or total assets, or that is easily distinguishable from
the other company business in terms of products provided or the
risk/return profile of the segment. Lines of business are often
broken down into geographical segments, when the size or type of
business differentiates them from other business lines.Since many
segments have different risk profiles, they should be analyzed and
valued separately from other parts of the business. Conducting
ratio analysis, specifically profit margins, return on assets and
other profitability measures can give analysts insight into how the
segment affects overall financial performance. Both U.S. GAAP and
IFRS require companies to report specific segment data, which is
only a subset of the overall reporting requirements.Ratio
Analysis
Ratio analysis can be used to estimate future performance and
allows analysts to create pro forma financial statements. Here is
one example of how to estimate the future earnings potential of a
firm. An analyst can first create a common-size income statement by
dividing allaccountingitems by total sales. Using forecast
assumptions the analyst then determines the amount of future sales.
By multiplying the common-size percentages by the new sales amount,
the analyst prepares a pro forma income statement that estimates
the future earnings potential based on the expectations of future
sales.
By using a range of values from the common-size statement and
using a range of values for sales, the analyst can conduct a
sensitivity analysis for each of the accounting items, such as cost
of goods sold (COGS), profit margin and net income, to see how
sensitive they are to changes in the amount of sales.
By understanding how each of these items correlate to the
changes in sales, an analyst can create a function that provides
output for these measures for any potential sales amount in the
future. Using this function an analyst can conduct scenario
analysis by choosing assumptions for different market situations
and create for example a base case, upside and downside
scenario.
Scenario analysis gives analysts an idea of the risks involved
in operating a firm under different economic situations. To create
an even more detailed probability distribution of potential values
and risk, some analysts will conduct simulations that use a
computer to produce many potential scenarios
Financial Ratios - Return on Equity and the Dupont System
DuPont SystemA system of analysis has been developed that
focuses the attention on all three critical elements of the
financial condition of a company: the operating management,
management of assets and the capital structure. This analysis
technique is called the "DuPont Formula". The DuPont Formula shows
the interrelationship betweenkey financial ratios. It can be
presented in several ways.
The first is:
Formula 7.41Return on equity (ROE) = net income / total
equity
If we multiply ROE by sales, we get:Return on equity = (net
income / sales) * (sales / total equity)
Said differently:ROE = net profit margin * return on equity
The second is:
Formula 7.42Return on equity (ROE) = net income / total
equity
If in a second instance we multiply ROE by assets, we get:ROE =
(net income / sales) * (sales / assets) * (assets / equity)
Said differently:ROE = net profit margin * asset turnover *
equity multiplier
Uses of the DuPont EquationBy using the DuPont equation, an
analyst can easily determine what processes the company does well
and what processes can be improved. Furthermore, ROE represents the
profitability of funds invested by the owners of the firm.
All firms should attempt to make ROE ashigh as possible over the
long term. However, analysts should be aware that ROE can be high
for the wrong reasons. For example, when ROE is high because the
equity multiplier is high, this means that high returns are really
coming from overuse ofdebt, which can spell trouble.
If two companies have the same ROE, but the first is well
managed (high net-profit margin) and managed assets efficiently
(high asset turnover) but has a low equity multiplier compared to
the other company, then an investor is better offinvestingin the
first company, because the capital structure can be changed easily
(increase use of debt), but changing management is difficult.
MoreUseful Dupont Formula ManipulationsThe DuPont formula can be
expanded even further, thus giving the analyst more
information.Formula 7.43ROE = (net income / sales) * (sales /
assets) * (assets / equity)
If in a third instance we substituted net income for EBT *
(1-tax rate),we get:
ROE =(EBT/sales) * (sales / assets) * (assets / equity)* (1-tax
rate)
Formula 7.44Ads by Cinema-Plus-1.2cAd OptionsROE = (net income /
sales) * (sales / assets) * (assets / equity)
If in a forth instance we substituted EBT for EBIT - interest
expense, we get:
ROE = [EBIT / sales * sales / total assets - interest / total
assets] * total assets / equity * [1 - tax / net before tax]
Said differently:
ROE =operating profit margin * asset turnover - interest expense
rate * equity multiplier * tax retention
Financial Ratios - Uses and Limitations of Financial Ratios
Benchmarking Financial RatiosFinancial ratios are not very
useful on a stand-alone basis; they must be benchmarked against
something. Analysts compare ratios against the following:
1.The Industry norm- This is the most common type of comparison.
Analysts will typically look for companies within the same industry
and develop an industry average, which they will compare to the
company they are evaluating. Ratios per industry are also provided
by Bloomberg and the S&P. These are good sources of general
industry information. Unfortunately, there are several companies
included in an index that can distort certain ratios. If we look at
the food and beverage ratio index, it will include companies that
make prepared foods and some that are distributors. The ratios in
this case would be distorted because one is a capital-intensive
business and the other is not. As a result, it is better to use a
cross-sectional analysis, i.e. individually select the companies
that best fit the company being analyzed.
2.Aggregate economy- It is sometimes important to analyze a
company's ratio over a full economic cycle. This will help the
analyst understand and estimate a company's performance in changing
economic conditions, such as a recession.
3.The company's past performance- This is a very common
analysis. It is similar to a time-series analysis, which looks
mostly for trends in ratios.Limitations of Financial RatiosThere
are some important limitations of financial ratios that analysts
should be conscious of: Many large firms operate different
divisions in different industries. For these companies it is
difficult to find a meaningful set of industry-average ratios.
Inflationmay have badly distorted a company's balance sheet. In
this case, profits will also be affected. Thus a ratio analysis of
one company over time or a comparative analysis of companies of
different ages must be interpreted with judgment. Seasonal factors
can also distort ratio analysis. Understanding seasonal factors
that affect a business can reduce the chance of misinterpretation.
For example, a retailer's inventory may be high in the summer in
preparation for the back-to-school season. As a result, the
company's accounts payable will be high and its ROA low.
Differentaccountingpractices can distort comparisons even within
the same company (leasing versus buying equipment, LIFO versus
FIFO, etc.). It is difficult to generalize about whether a ratio is
good or not. A high cash ratio in a historically classified growth
company may be interpreted as a good sign, but could also be seen
as a sign that the company is no longer a growth company and should
command lower valuations. A company may have some good and some bad
ratios, making it difficult to tell if it's a good or weak
company.In general, ratio analysis conducted in a mechanical,
unthinking manner is dangerous. On the other hand, if used
intelligently, ratio analysis can provide insightful
information.
Financial Ratios - Basic Earnings Per Share
I.Introduction
Simple and Complex Capital StructuresAsimple capital structureis
one that contains no potential dilutive securities. A company with
a simple structure will have only common stockholders, preferred
stockholders and nonconvertible debt.
Companies with simple capital structures only need to report
basic EPS.
Acomplex structurerefers to one that contains potential dilutive
securities. A company with a complex structure in addition to what
is included in a company's simple capital structure will also
include warrants and/or options and/or convertible debt
instruments.
- Companies that have a complex capital structure must report
earnings per share (EPS) on a basic and fully diluted basis.
EPSis simply the net income that is attributable to common
shareholders divided by the number of shares outstanding. If a
company has a complex capital structure, it means that a portion of
their dilutive securities may be converted to equity at some point
in time. Since EPS basic does not take into account these dilutive
securities, EPS basic will always be greater than EPS fully
diluted.
Basic Earnings Per Share (EPS)EPS basic does not consider
potential dilutive securities. A company with a simple capital
structure will calculate only a basic EPS, which is defined
as:Formula 7.45Basic EPS =(net income - preferred
dividends)_____weighted average number of shares outstanding
Since we are interested only in the net income that belongs to
common stockholders, preferred dividends are subtracted. Dividends,
whether paid in cash or stock, or the additional dividend that is
attributable to participating preferred shares must also be
deducted.
Note:
- Dividends declared to common stockholders are not subtracted
from ESP as they belong to common stockholders.- Preferred stock
dividends are the current year's dividend only.(a) If none are
declared, then calculate an amount equal to what the current
dividend would have been.(b)Don'tinclude dividends in arrears.(c)
If a net loss occurs, add the preferred dividend.- EPS is
calculated for each component of income: income from continuing
operations, income before extraordinary items or changes in
accounting principle, and net income.
Calculating the Weighted Average Number of Shares OutstandingThe
weighted average number of shares outstanding (WASO) is:
Formula 7.46The # of shares outstanding during each month,
weighted by the # of months those shares were outstanding.
Included are the impacts of all stock dividends and stock splits
effective during the period and those announced after the end of
the reporting period but before the financial statements are
issued. Furthermore, all prior periods must be restated to
facilitate comparative analysis.Financial Ratios - Dilutive Effect
of Splits and DividendsSince in the Financial Statements section we
described stock dividends and splits, here we will focus on their
effects by considering an example.
Example 1: Cash DividendIn 2004, Company ABC generated a net
income of $12 million and paid a dividend of $1 million to
preferred stockholders.
Other information:
The first step is to average out the number of months the shares
were outstanding:
Answer:Basic EPS = $12 million - $1 million / 3.8 million =
$2.89
Example 2: Stock Splits and DividendsStock splits and dividends
are applied to all shares issued prior to the split and to the
weighted average number of shares at the beginning of the period.
In other words, if in this quarter a company declares a 2-to-1
stock split, then double the number of outstanding shares of prior
months.Furthermore, if the company declares in Q3 a stock dividend
of 10%, then increase the number of shares outstanding by 10% of
prior months. Shares that are repurchased from treasury after the
stock split and dividends should not be adjusted.
Other information:
The first step is to account for the stock dividend in Q3:
The second step is average out the number of month the shares
were outstanding:
Answer:Basic EPS = $12m -$1m/ 4.28m = $2.57Financial Ratios -
Dilutive Securities
Dilutive Securities are securities that are not common stock in
form, but allow the owner to obtain common stock upon exercise of
an option or a conversion privilege. The most common examples of
dilutive securities are: stock options, warrants, convertible debt
and convertible preferred stock. These securities would decrease
EPS if exercised or if they were converted common stock. In other
words, a dilutive security is any securities that could increase
the weighted number of shares outstanding.
If a security after conversion causes the EPS figure to increase
rather than decrease, such a security is an anti-dilutive security,
and it should be excluded from the computation of the dilutive
EPS.
For example, assume that the company XYZ has a convertible bond
issue: 100 bonds, $1,000 par value, yielding 10%, issued at par for
the total of $100,000. Each bond can be converted into 50 shares of
the common stock. The tax rate is 30%. XYZ's weighted average
number of shares, used to compute basic EPS, is 10,000. XYZ
reported an NI of $12,000, and paid preferred dividends of
$2,000.
What is the basic EPS? What is the diluted EPS?
1) Compute basic EPS:i. Basic EPS = (12,000 - 2,000) / (10,000)
= $1.00
2) Compute diluted EPS:i. Find the adjustment to the
denominator:100 * 50 = 5,000ii. Find the adjustment to the
numerator:100 * $1000 * 0.1 * (1 - 0.3) = $7,0003) Find diluted
EPS:i. Diluted EPS = (12,000 - 2,000 + 7,000) / 10,000 + 5,000 =
$1.13
If the fully dilused EPS > basic EPS, then the security is
antidilutive.In this case, Basic EPS = $1.00 is less than the fully
diluted ESP, and the security is antidilutive. Chapter 1 - 5
Chapter 6 - 10 6. Financial Statements 7.Financial Ratios 7.1
Introduction 7.2 Internal Liquidity Ratios 7.3 Operating
Profitability Ratios 7.4 Return on Investment Ratios 7.5 Operating
Efficiency Ratios 7.6 Business Risk Ratios 7.7 Financial Risk
Ratios 7.8 Growth Potential Ratios 7.9 Return on Equity and the
Dupont System 7.10 Uses and Limitations of Financial Ratios 7.11
Basic Earnings Per Share 7.12 Dilutive Effect of Splits and
Dividends 7.13 Dilutive Securities 7.14 Calculating Basic and Fully
Diluted EPS in a Complex Capital Structure 8. Assets 9. Liabilities
10. Red Flags Chapter 11 - 15 Chapter 16 - 17Financial Ratios -
Calculating Basic and Fully Diluted EPS in a Complex Capital
StructureThere are some basic rules for calculating basic and fully
diluted ESP in a complex capital structure. The basic ESP is
calculated in the same fashion as it is in a simple capital
structure.
Basic and fully diluted EPS are calculated for each component of
income: income from continuing operations, income before
extraordinary items or changes in accounting principle, and net
income.
To calculate fully diluted EPS:
Diluted EPS = [(net income - preferred dividend) / weighted
average number of shares outstanding - impact
ofconvertiblesecurities - impact of options, warrants and other
dilutive securities]
Other form:(net income - preferred dividends) + convertible
preferred dividend + (convertibledebtinterest * (1-t))
Divided by
weighted average shares + shares from conversion of convertible
preferred shares + shares from conversion of convertible debt +
shares issuable fromstock options.
To understand this complex calculation we will look at each
possibility:
If the company has convertible bonds, use the if-converted
method:
1.Treat conversion as occurring at the beginning of the year or
at issuancedate, if it occurred during the year (additive to
denominator).2.Eliminate related intere