Unit 5: Financial Reporting and Analysis

Financial Reporting and Analysis

Financial Reporting and Analysis:

I. Financial Statements Analysis: An Introduction
II. Understanding Income Statements
III. III. Understanding Income Statements
IV. IV. Understanding Cash Flow Statements
V. V. Financial Analysis Techniques
VI. VI. Inventories
I. Financial Statements Analysis: An Introduction

Role of Financial Reporting

"The objective of general purpose financial

reporting is to provide financial information about
the reporting entity that is useful to existing and
potential investors, lenders, and other creditors in
making decisions about providing resources to the
entity. Those decisions involve buying, selling or
holding equity and debt instruments, and providing
or settling loans and other forms of credit."

IASB Conceptual Framework

I. Financial Statements Analysis: An Introduction

Role of Financial Statement Analysis

• Using the information in a company's financial
statements, along with other relevant
information, to make economic decisions:
• (e.g., evaluate securities, acquisitions,
creditworthiness)
• To evaluate a company's past performance and
current financial position in order to form
opinions about a firm's ability to earn profits
and generate cash flow in the future
 I. Financial Statements Analysis: An Introduction

Key Financial Statements

1. Income statement (statement of operations or the profit
and loss statement)
Summari zes events over a peri od:
• Revenues are inflows from delivering or producing
goods, rendering services, or other activities that
constitute the entity's ongoing major or central
operations
• Expenses are outflows from delivering or producing
goods or services that constitute the entity's ongoing
major or central operations
• Other income includes gains and losses which may or
may not arise in ordinary course of business
 I. Financial Statements Analysis: An Introduction

Key Financial Statements

2. Statement of comprehensive income reports all
changes in equity except for shareholder
transactions
3. Balance she e t -at a point in time
• Assets = liabilities + owners' equity
• Assets are the resources controlled by the firm
• Liabilities are amounts owed to lenders and other
creditors
• Owners' equity is the residual interest in the net
assets of an entity that remains after deducting its
liabilities
 I. Financial Statements Analysis: An Introduction

Key Financial Statements

4. Cash flow statement reconciles beginning and
ending cash balance, splitting changes into three
categories:
• Operating cash flows (CFO)
• Investing cash flows (CFI)
• Financing cash flows (CFF)

5. Statement of changes in owners' equity

amounts and sources of changes in
shareholders' equity over the period
 I. Financial Statements Analysis: An Introduction

Footnotes and Supplementary Schedules

• Basis of presentation
• Accounti ng methods and assumptions
• Further information on amounts in primary statements
• Business acquisitions/disposals
• Contingencies
• Legal proceedings
• Stock options and benefit plans
• Significant customers
• Segment data
• Quarterly data
• Related-party transactions
I. Financial Statements Analysis: An Introduction

Management Discussion and

Analysis
• Nature of the business
• Results from operations, business overview
• Trends in sales and expenses
• Capital resources and liquidity
• Cash flow trends
• Discussion of critical accounting choices
• Effects of inflation, price changes, and
uncertainties on future results
I. Financial Statements Analysis: An Introduction

The Audit Report

• Audit: Independent review of company's financial
statements
• Reasonable assurance that financial statements are
free of material errors
• Audit opinion:
Unqualified: "Clean" opinion
Qualified: Exceptions to accounting principles
Adverse: Statements not presented fairly
Disclaimer of opinion: Unable to form an opinion
• Must provide opinion on company's internal controls
under U.S. GAAP
 I. Financial Statements Analysis: An Introduction

Audit Report
1. Responsibility of management to prepare
accounts
• Independence of auditors

2. Properly prepared in accordance with relevant

GAAP
• Reasonable assurance that the statements are
free from material misstatement

3. Accounti ng principles and estimates chosen are

reasonable
 I. Financial Statements Analysis: An Introduction

Supplementary Sources of Information

• Quarterly, semi-annual reports: Updates of major
financial statements and footnotes; SEC filings
• Proxy statements: Issued when shareholder vote
is required; contain information on board elections,
management compensation, stock options
• Corporate reports, press releases written by
management
• Economic, industry data from trade journals,
reporting services, government agencies
I. Financial Statements Analysis: An Introduction

Financial Statement Analysis

Framework
1. Purpose and context of analysis
2. Collect data
3. Process data
4. Analyze/interpret data
5. Conclusions and recommendations
6. Update analysis periodically
II. Understanding Income Statements

Income Statement
• Alternative names:
Statement of operations
Statement of earnings
Profit and loss statement
Revenue - Expenses = Net Income
• IFRS: May combine with
comprehensive income items
• Two types:
• Single step
• Multi-step
II. Understanding Income Statements
II. Understanding Income Statements

Multi-Step Income Statement

Income before tax

- Provision for income taxes

Income from continuing operations "The line"
+/- Income from discontinued operations All net
+/- Extraordinary items of tax
Net income "The bottom line"
II. Understanding Income Statements

IASB Requirements for Revenue

Recognition (General Principles)
1. Risk and reward of ownership transferred
2. No continuing control or management over the
good sold
3. Reliable revenue measurement
4. Probable flow of economic benefits
5. Cost can be measured reliably
II. Understanding Income Statements

IASB Requirements for Revenue

Recognition for Services
1. When the outcome can be measured
reliably, revenue will be recognized by
reference to the stage of completion
2. Outcome can be measured reliably if:
• Amount of revenue can be measured
• Probable flow of economic benefits
• Stage of completion can be measured
• Cost incurred and remaining cost to
complete can be measured
 II. Understanding Income Statements

SEC Requirements for

Revenue Recognition
"Revenue should be recognized when it is realizable and
earned" FASB
SEC additional guidance:
1. Evidence of an arrangement between buyer and seller
2. Completion of the earnings process, firm has
delivered product or service
3. Price is determined
4. Assurance of payment, able to estimate probability of
payment
 II. Understanding Income Statements

Revenue Recognition Methods

• Sales-basis method- used when good or service is
provided at time of sale, cash, or credit with high payment
probability (majority of transactions)
Except ions (construction contracts)
1. Percentage-of-compl etion method- used for L-T
projects under contract, with reliable estimates of
revenues, costs, and completion time
2. Completed-contract method (U.S. GAAP)- used for L-
T projects with no contract. or unreliable estimates of
revenue or costs; revenue and expenses are not
recognized until project is completed
(IFRS: Report revenue but no profit)
 II. Understanding Income Statements

Revenue Recognition Methods

Installment sale: A firm finances a sale and payments are
expected to be received over an extended period. If
collectability is certain, revenue is recognized at the time of
sale using the normal revenue recognition criteria.
3. Installment sales method (U.S. GAAP)- used when
firm cannot estimate likelihood of collection, but cost of
goods/services is known; revenue and profit are based
on percentage of cash collected
4. Cost recovery method (most extreme)- used when
cost of goods/services si unknown
and firm cannot estimate the likelihood of collection; only
recognize profit after all costs are recovered
II. Understanding Income Statements

Percentage-of-Completion Method
Ledesma 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, Ledesma incurred $400,000 in cost. During
the second year, $500,000 of costs were incurred.
The estimate of the project's total cost did not
change in the second year.

Calculate the revenue and profit to be recognized in

each of the first two years.
II. Understanding Income Statements

Percentage-of-Completion Method
Cumulative Revenue
II. Understanding Income Statements

Percentage-of-Co mpletion
Method Solution
Year 1: $2,000,000 x(400,000 I 1,600,000)
Revenue = $500,000
Profit = $500,000 - $400,000 = $100,000

Year 2: $2,000,000 x (900,000 I 1,600,000)

- $500,000
Revenue = $625,000
Profit = $625,000 - $500,000 = $125,000
II. Understanding Income Statements

Completed-Contract Method
Revenue and expenses are not recognized until
project is completed
Example: Building a hotel for $40 million, cost to
build is $32 million; cost incurred in Year 1 is $6.4
million
revenue = 0; expense = 0; income = 0

On completion/final year :
revenue = $40m ; expenses = $32m; income = $8m

14
II. Understanding Income Statements

Implications for Analysis

Review revenue recognition policies in
footnotes:
• Earlier revenue recognition-aggressive
• Later revenue recognition- conservative
• Consider estimates used in methods
• Assess how different policies would affect
financial ratios
II. Understanding Income Statements

Revenue Recognition - Problem

Project cost estimate = $10 million; contract totals
$12 million; $2 million of costs occur in Years
1 and 2; invoiced amounts $4 million in Year
1 and
$3 million in Year 2; $1 million in cash
collected each year. Year 2 income under
percentage of completion is:
A. $1 million.
B. $400,000.
C. $1 million loss.
II. Understanding Income Statements

Expense Recognition
• Accrual basis- matching principl e
• Match costs against associated revenues
• Examples
• Inventory
• Depreciation/amortization
• Warranty expense
• Doubtful debt expense
• Peri od expenses
• Expenditures that less directly match the timing of
revenues (e.g. admin costs)
II. Understanding Income Statements

Analysis Implications
• Inventory valuation
• Warranty expense All require
• Depreciation significant
estimates and
• Amort ization
assumptions
• Doubtful debt affecting net
provisions income

• Revenue recognition

• Review year-on-year consistency

• Review footnotes and MD&A
28
II. Understanding Income Statements

VI. Inventories: Matching Principle

Beginning inventory + Purchases - Ending inventory =
COGS
Cost of goods sold should be matched with items sold
and recorded as revenue over the period

Inventory cost flow should match goods flow

Specific identification First-in-first-out
Average cost
 II. Understanding Income Statements

Depreciation Methods
Match depreciation to asset's decrease in value
over time:
• Truck cost $20,000, will run 100,000 miles depreciate
at $0.20 per mile used
• Oil tanker will last 25 years and then be sold for
s c r a p -use straight-line depreciation
• DVDs purchased for rental decrease rapidly in value
the first year use accelerated depreciation
II. Understanding Income Statements

Amortization
• Amortization of intangible assets (e.g., patents)
• Spreading cost over life
• If the earnings pattern cannot be established,
use straight line (IAS 38)
• IFRS and U.S. GAAP firms both typically
amortize straight-line with no residual value
• Goodwill not amortized- checked annually for
impairment
II. Understanding Income Statements

Unusual or Infrequent Items

• "Or" is the key word that describes these items
• Reported pretax before net income from continuing
operations (above the line)
• Items include:
• Gain (loss) from disposal of a business segment
or assets
• Gain (loss) from sale of investment in subsidiary
• Provisions for environmental remediation
• Impairments, write-offs, write-downs , restructuring
• Integration expense for recently acquired business
II. Understanding Income Statements

Discontinued Operations
• Operations that management has decided to
dispose of but (1) has not done so yet or (2)
did so in current year after it generated profit or
loss
• Reported net of taxes after net income from
continuing operations (below the line)
• Assets , operations, and financing activities
must be physically and operationally distinct
from the firm
II. Understanding Income Statements

Extraordinary Items (U.S. GAAP)

• Items that are both unusual and infrequent
• Reported net of ta xes after net income from
continuing operations (below the line)
Items include:
• Losses from expropriation of assets
• Gains or losses from early retirement of debt
(when judged to be both unusual and infrequent)
• Uninsured losses from natural disaster
• Prohibited under IFRS
II. Understanding Income Statements

Vertical Common-Size Income

Statements
Income statement account e.g., Marketing expense
Sales Sales

• Converts income statement to relative percentages

• Useful for comparing entities of differing sizes
• Compare % to strategy in MD&A
• Time series or cross-section use
• Gross and net profit margin are common-size ratios
III. Understanding Income Statements
III. Understanding Income Statements

Liabilities
Liability recognition:
• Probable sacrifice of future economic benefit to the
entity as a result of past transactions/events
• Amounts received but not reported as revenue in the
income statement (deferred/unearned revenue)
• Amounts reported as expenses but which have not
been paid

Bank borrowings Accounts payable

Notes payable Financial liabilities
Provisions Accrued liabilities
Unearned revenues Deferred tax liabilities
III. Understanding Income Statements
III. Understanding Income Statements

Balance Sheet Analysis

Uses of balance sheet analysis
• Assessing liquidity, solvency, and ability
to make distributions to shareholders
Limitations
• Mixed measurement conventions:
• Historic cost
• Amortized cost
• Fair value
• Fair values may change after balance
sheet date
• Off-balance-sheet assets and liabilities
 III. Understanding Income Statements

Current Assets
• Current assets include cash and other assets that will
likely be cor)v erted i nto cash or used up within one year
or one operating cycle, whichever is greater
• The operating cycle is the time it takes to produce or
purchase inventory, sell the product, and collect the
cash
• Current assets presented in the order of liquidity
• Current assets reveal information about the
operating activities/capacity of the firm
 III. Understanding Income Statements

Current Assets
• Cash and cash equivalents: amortized cost or fair value
• Marketable securities: amortized cost or fair value
• Accounts receivable/trade receivables: net realizable
value
• VI. Inventories:
• Raw materials, wo rk in process, finished goods
• Manufacturing (standa rdized costs)
• Cost flow methodology (FIFO, Avco, LIFO)
• Prepaid expenses: historic cost
• Deferred tax assets: net of valuation allowance
III. Understanding Income Statements

Noncurrent Assets
• Assets held for continuing use within the
business, not resale
• Assets not consumed or disposed of in the
current period
• Represent the infrastructure from which the
entity operates
• Provides information on the firm's
investing activities
III. Understanding Income Statements

Accounting for Long-Term Assets

Long-term assets convey benefits over time
• Tangible assets (e.g., land, buildings,
equipment, natural resources)
• Intangib le assets (e.g., copyrights, patents,
trademarks , franchises, and goodwill)
• Investm ent property (IFRS only ) - generates
investment income or capital appreciation
Plant, property, and equipment recorded at
purchase cost including shipping and installation,
or construction cost including labor, materials,
overhead, and interest
 III. Understanding Income Statements

Depreciation and Depletion

• Tangible assets have decreased value over time:
depreciation is the allocation of the cost of tangible
assets over time; land is not depreciated
• Natural resources are used up over time: depletion is
the allocation of the cost (per unit) of natural resources
as they are used
• Balance sheet (book) values are:
Historical cost less accumulated depreciation or
depletion, unless asset values are impaired (U.S.
GAAP & IFRS)
Fair value less any accumulated depreciation (IFRS)
III. Understanding Income Statements

Intangible Assets
• Identifiable intangible
• Can be acquired singularly, linked to rights
and privileges having finite benefit periods
• Amortized over estimated useful life
• Unidentifiable intangible
• Cannot be acquired singularly and has
indefinite benefit period (e.g., goodwill)
• Not amortized
• Annual impairment review
III. Understanding Income Statements

Intangible Assets
• May only be recognized if they can be
measured reliably
• Generally excludes internally generated
intangibles- subjectivity

Ty pical intangibles:
• Purchased patents and copyrights
• Purchased brands and trademarks
• Purchased franchise and licence costs
• Direct response advertising
• Goodwill
• Computer software development costs
.
III. Understanding Income Statements

Expensed Items
• Internally generated brands, mastheads,
publishing titles, customer lists, etc.
• Start-up costs
• Training costs
• Administrative and general overhead
• Advertising and promotion
• Relocation and reorganization costs
• Redundancy and termination costs
• Research and development (Development
may be capitalized under IFRS)
III. Understanding Income Statements
,

Goodwill
Goodwill is the difference between acquisition price and
the fair market value of the acquired firm's net assets
The additional amount paid represents the amount paid
for assets not recorded on the balance sheet
III. Understanding Income Statements

Goodwill Analysis
• Impairment indicates that goodwill often results
from overpayment to acquire entity
• Remove the impact of goodwill from ratios
• Remove goodwill from assets
• Remove any impairment from income statement
• Evaluate business acquisitions considering:
• Purchase price
• Net assets
• Earnings prospects
III. Understanding Income Statements

Current Liabilities
Satisfies any of the following 4 criteria:
1. Expected to be settled in the entity's normal
operating cycle
2. Held primarily for the purpose of being traded
3. Is due to be settled < 12 months from the
balance sheet date
4. The entity does not have a right to defer
settlement for > 12 months
All other liabilities – non concurrent
III. Understanding Income Statements

Current Liabilities
• Accounts payable/trade payables
• Notes payable
• Current portion of long-term debt
• Accrued liabilities
• Taxes payable
• Unearned revenue
III. Understanding Income Statements

Components of Equity
• Capital contributed by owners
• Issued and authorized
• Preferred stock (irredeemable)
• Treasury stock (reduces equity)
• Retained earnings
• Noncontrolling (minority) interest
• Accumulated other comprehensive income
III. Understanding Income Statements
III. Understanding Income Statements

Common Size Balance Sheet

Balance sheet account e.g., Inventory
Total assets Total assets

Uses:
Comparisons over time (trend analysis)
Cross-sectional comparisons
III. Understanding Income Statements

Liquidity Ratios
Current assets
Current ratio =
Current liabilities

Quick ratio
= Current assets - inventory
Current liabilities

Cash ratio = Cash + marketable securities

Current liabilities
III. Understanding Income Statements

Solvency Ratios
Long term Total long–term debt
debt to equity =
Total Equity

Total debt
Debt to equity =
Total equity

Total debt
Total debt =
Total assets

Total assets
Financial leverage =
Total equity
IV. Understanding Cash Flow Statements

Importance of Cash Flow Statement

Net income from accrual accounting does not tell
us about the sources and uses of cash to meet
liabilities and operating needs
The statement of cash flows has three components
under both IFRS and U.S. GAAP:
• Cash provided or used by operating activities
• Cash provided or used by investing activities
• Cash provided or used in financing activities
IV. Understanding Cash Flow Statements

Operating Cash Flows (CFO)

Cash received from customers x

Cash dividends received x
Cash interest received x
Other cash income x
Payments to suppliers (X)
Cash expenses (wages, etc.) (X)
Cash interest paid (X)
Cash taxes paid (X)
CFO X -(X)
IV. Understanding Cash Flow Statements

Investing Cash Flows (CFI)

• Purchases of property, plant, and equipment
• Proceeds from sales of assets
• Investments in joint ventures and affiliates
• Payments for businesses acquired
• Purchases and sales of intangibles
• Purchases or sales of marketable securities
Excludes:
• Trading securities (part of CFO)
• Cash equivalents (part of balance sheet cash)
IV. Understanding Cash Flow Statements

Financing Cash Flows

• Issue and redemption of:
• Common stock
• Preferred stock
• Treasury stock repurchases
• Debt
• Dividend payments (dividends rec'd CFO
U.S. GAAP)

• Excludes:
• Indirect financing via accounts payable (CFO)
IV. Understanding Cash Flow Statements

Non-Cash Investing and Financing

Activities
• Several types of transactions do not involve the
payment or receipt of cash and are not
reflected in financing and investing cash flows,
but are disclosed in the footnotes or other
schedules
Non-cash financing and investing activities:
• Converting debt or preferred into common equity
• Assets acquired under capital leases
• Purchase of assets via issuance of debUequity
• Exchanging one non-cash asset for another
• Stock dividends
IV. Understanding Cash Flow Statements
IV. Understanding Cash Flow Statements

Statement of Cash Flow: Direct

vs. Indirect Method
Direct vs. indirect method refers only to the
calculation of CFO; the value of CFO is the same for
both methods; CFI and CFF are unaffected
• Di rect method: Identify actual cash inflows and
outflows (e.g., collections from customers,
amounts paid to suppliers)
• Ind i rect method: Begin with net income and make
necessary adjustments to get operating cash flow
IV. Understanding Cash Flow Statements

Cash Inflows and Outflows

General rules regarding increases and
decreases in balance sheet items over time:

Inc rease Decrease

Assets outflow inflow
Liabilities & Equity inflow outflow

e.g.: An increase in AR or inventory uses cash

An increase in payables generates cash
Adjust net income for these changes
(indirect)
.
IV. Understanding Cash Flow Statements

Indirect Method CFO

Steps
1. Start with net income
2. Adjust net income for changes in relevant
balance sheet items:

Increases in an asset: deduct

Increase in a liability: add
Decrease in an asset: add
Decrease in a liability: deduct
IV. Understanding Cash Flow Statements

Indirect Method (continued)

3.Eliminate depreciation and amortization by
adding them back (they've been deducted in
arriving at net income but are non-cash
expenses)

4.Eliminate gains on disposal by deducting them

and losses on disposal by adding them back
(these are CFI, not CFO)
IV. Understanding Cash Flow Statements

Indirect Method example

Net income 75,000
Add: Depreciation 14,000
Less: Gain from sale of PPE (20,000) $
Add: Increase in deferred taxes 10,000
Current asset adjustments
Less: Increase in accounts receivable (2,000)
Add: Decrease in inventory 4,000
Current liability adjustments
Add: Increase in accounts payable 8,000
Less: Decrease in salaries payable (7,000)
Add : Increase in interest payable 1,000
Add: Increase in taxes payable 2,000
Cash flow fro m operations 85,000
IV. Understanding Cash Flow Statements

Calculating CFI
CFI =
investment in assets - cash received on asset sales

Net book value =

Gross PPE - accumulated depreciation

Gain (loss) on sale = sales price - net book value

IV. Understanding Cash Flow Statements

CFI - Problem
Last year Acme Corp. bought an asset for $72,000, depreciation
expense was $15,000, accumulated depreciation increased by
$5,000, and gross PPE increased by $32,000. If a gain on an asset
sold during the year was
$13,000, the sales proceeds on the asset sale were:

A. $30,000 .
B. $43,000 .
C. $48,000.
IV. Understanding Cash Flow Statements

Computing CFF
• Change in debt
• Change in common stock
• Cash dividends paid

$ $
IV. Understanding Cash Flow Statements

Cash Flow Statement Analysis

Do regular operations generate

enough cash to sustain the business?
Is enough cash is generated to pay off
maturing debt?
Benefits
for the Highlights the need for additional finance
analyst
Ability to meet unexpected obligations

The flexibility to take advantage of new

business opportunities
IV. Understanding Cash Flow Statements

Analysis
1. Analyze the major sources and uses of cash
flow (CFO, CFI, CFF)
• Where are the major sources and uses?
• Is CFO positive and sufficient to cover
capex?
2. Analyze CFO
• What are the major determinants of CFO?
• Is CFO higher or lower than NI?
• How consistent is CFO?
IV. Understanding Cash Flow Statements

Analysis
3. Analyze CFI
• What is cash being spent on?
• Is the company investing in PP&E?
• What acquisitions have been made?
4. Analyze CFF
• How is the company financing CFI and
CFO?
• Is the company raising or repaying
capital?
• What dividends are being returned to
owners?
IV. Understanding Cash Flow Statements

Common Size Statements

Two Ap proaches

Show each item as a Show each inflow as a

% of net revenue % of total inflows
Show each outflow as
a % of totaI outflows

Useful for:
Trend analysis (time series)
Forecasting future cash flows (% of net revenue)
IV. Understanding Cash Flow Statements

Free Cash Flow (FCF)

• FCF is cash available for discretionary uses
• Frequently used to value firms
• FCFF = NI + NCC - WClnv + Int (1-T) - FClnv
• FCFF = CFO + Int (1-T) - FClnv
• FCFE = CFO - FClnv + Net debt increase
IV. Understanding Cash Flow Statements

Cash Flow Performance Ratios

CFO
Cash flow to revenue
Net Revenue
CFO
Cash return on assets
Ave total assets

CFO
Cash return on equity
Ave equity

CFO
Cash to income
Operating income

CFO – pref div

Cash flow per share
N° Common Stocks
IV. Understanding Cash Flow Statements
IV. Understanding Cash Flow Statements

Cash Flow Coverage Ratios

CFO
CFO
Debt payment
Cash paid for long-term
debt repayment

CFO
Dividend payment
Dividends paid

CFO
Investing and financing
Cash outflows for CFI
& CFF
V. Financial Analysis Techniques

Interpreting Ratios
1. Cross -sectional analysis:
Comparison to industry norm or average

2. Time-series analysis (trend analysis):

Comparison to a company's past ratios

Ratios help the analyst identify the questions
that need answering
V. Financial Analysis Techniques
V. Financial Analysis Techniques

L imitations of Financial Ratios

• Not useful in isolation - only valid when
compared to other firms or the company's
historical performance
• Different accounting treatments - particularly
when analyzi ng non-U.S. firms
• Finding comparable industry ratios for
companies that operate in multiple industries
(homogeneity of operating activities)
• All ratios must be viewed relative to one another
• Determining the target or comparison value requires
some range of acceptable values
V. Financial Analysis Techniques

Common-Size Income Statement

• Expresses each income statement item as a
percentage of sales

• Used to analyze changes in cost structure

and profitability

• Used for both cross-sectional and time

series analysis
V. Financial Analysis Techniques

Common-Size Income Statement

Example: Consider a common-si ze
income statement that reveals the following
(selected items only):
V. Financial Analysis Techniques

Common-Size Income Statement

• Increased COGS % suggests a lower
selling price or higher cost of material
and labor
• Increased SG&A % also suggests a
lower selling price or higher costs in
this area
• Lower net profit margin (net income as
a % of sales) reflects a lower selling
price or higher expenses
V. Financial Analysis Techniques

Categories of Ratios
• Activity -+ Efficiency of day-to-day
tasks/operations

• Liquidity -+ Ability to meet short-term liabilities

• Solvency -+ Ability to meet long-term obligations

• Profitability -+ Ability to generate profitable

sales from asset base

• Valuation Quantity of asset or flow associated

-+
.
with an ownership claim
V. Financial Analysis Techniques

Ratio Analysis Context

1. Company goals and strategy
2. Industry norms
• Ratios may be industry specific
• Multiple lines of business distort
aggregate ratios
• Differences in accounting methods
3. Economic conditions
• Cyclical businesses and the stage of
the business cycle
V. Financial Analysis Techniques

Ratio Analysis
Some ge neral rules:
• For ratios that use only income statement
items, use the values from the
current income statement
• For ratios using only balance sheet items,
use the values from the current balance sheet
• For ratios using both income
statement and balance sheet items ,
use the value from the current
income statement and the average
value for the balance sheet item
V. Financial Analysis Techniques

Activity Ratios
Cost of goods sold
Inventory tu rnover =
Average inventory

Days of inventory 365

=
on hand (DOH) Inventory turnover

Receivab les Revenue

=
tu rnover Average receivables

Days of sales 365

=
outstand ing (DSO) Receivables turnover
V. Financial Analysis Techniques
V. Financial Analysis Techniques

Activity Ratios

Fixed asset Revenue

=
turnover Ave rage net fixed assets

Net of accumulated
depreciation

Total asset Revenue

=
turnover Average total assets
V. Financial Analysis Techniques
V. Financial Analysis Techniques
 V. Financial Analysis Techniques

Solvency
Earnings variability

Business risk Financial leverage

Sales volatility Operating Leverage

V. Financial Analysis Techniques
V. Financial Analysis Techniques

Solvency Ratios

Debt-to -equity Total debt

=
ratio Total shareholders'
equity

Financ ial = Average total assets

leverage ratio Average total equity
V. Financial Analysis Techniques

Solvency Ratios
V. Financial Analysis Techniques

Profitability Ratios

Gross Profit
Gross profit margin =
Revenue
Operating income
Operating profit margin =
Revenue
V. Financial Analysis Techniques
V. Financial Analysis Techniques

Profitability Ratios
Net income
Return on assets =
ROA Average total assets

A lternatively: Net income + interest

expense (1 - T)
Return on assets =
ROA Average total assets

Operating income
Operating ROA =
Average total assets
V. Financial Analysis Techniques
VI. Inventories
VI. Inventories
VI. Inventories

Inventory Costs
• Product costs are capitalized as inventory
• Purchase cost less discounts and rebates
• Conversion costs including labor and overhead
• Other costs necessary to bring the inventory
to its present location
• Period costs are expensed when incurred
• Abnormal waste
• Storage costs (unless a required production cost)
• Selling and administrative costs
VI. Inventories
VI. Inventories

Inventory Cost Flow Methods

M:ethod Descrip tion Endi n g COGS

Inventory
FIIFO El most recent Highest Lowest
purchases
LIIIFO El oldest purchases Lowest Highest
VI. Inventories
VI. Inventories

Example - Inventory Cost Flow

FIFO Avg . Cost LIFO
Revenue $17 $17 $17
COGS 10a 12c 14e
Gross Profit $7 $5 $3
End Inventory $26 b $24d $22 f

a First unit purchased

b Most recent purchases = $12 + $14

c Average cost per unit = ($10 + $12 + $14) I 3

d Average cost of units remaining = 2 units x $12

e Last unit purchased

f Earliest purchases = $10 + $12
VI. Inventories
VI. Inventories
VI. Inventories

LIFO vs. FIFO Inflationary Environment

LIFO FIFO
COGS Higher Lower
Income EBT Lower Higher
Statement Taxes Lower Higher
NI Lower Higher
Balance Inv Lower Higher
Sheet W/C Lower Higher
R/E Lower Higher
Statement of
Cash Flows
CFO Higher Lower
VI. Inventories
VI. Inventories

Liquidity Ratios and Inventory Method

• As compared to LIFO, FIFO is a better representation
of economic cost on the balance sheet (inventory
based on recent prices)

• Assuming inflation, FIFO produces:

• Higher inventory balances

Higher
• Higher current ratio Current Assets

• Higher working capital

VI. Inventories
VI. Inventories

Leverage Ratios and Inventory Method

• Assumi ng inflation, FIFO results in higher assets
(inventory reported at recent prices) and higher equity
(higher net income from lower COGS) as compared to
LIFO

• Assuming inflation, FIFO produces lower leverage:

Lower debt-to-assets ratio Higher

Denominators
Lower debt-to-equity ratio
VI. Inventories
VI. Inventories

Inventory Management
Condition Possible Interpretation
Low turnover (high DOH) Slow-moving or obsolete
inventory

High turnover (low DOH) May be losing sales from

with low sales growth insufficient inventory
relative to industry levels

High turnover (low DOH) Efficient inventory

with sales growth at or management
above industry average
VI. Inventories

Inventory Methods - Problem

For analytical purposes an analyst
would prefer to use:
A. LIFO COGS and FIFO inventory.
B. FIFO COGS and FIFO inventory.
C. FIFO COGS and LIFO inventory.