The Use and Analysis of Financial Statements

THE USE AND ANALYSIS OF FINANCIAL STATEMENTS

By White, Sondhi and Fried

CONTENTS

1. Measuring business income

2. Financial reporting and analysis

3. Short-term liquid assets

4. Inventories

5. Current liabilities

6. Long term assets

10. The statement of cash flows

13. Analysis of cash flows

14. Analysis of financial statements (Ratios)

19. Depreciation, impairment

20. Analysis of income taxes

21. Analysis of financing liabilities

22. Leases and off-balance-sheet financing

Vocabulary

1. Measuring business income

Income:

Gross profit, operating profit, net income from continuing operations, net income.

Accounting periods:

On yearly basis is obligatory, and shorter periods are used on interim basis.

The most important assumptions – going concern assumption. Second very important assumption is - matching principle.

Accounts adjustments:

Prepaid accounts = prepaid expenses (only part of it should expensed, e.g. rent, insurance)

Depreciation

Unearned revenues

Revenue recognition principle – accrual principle.

Accrual basis and cash basis accounting.

Accrual basis is more important as it better reflects economic events.

Adjusting entries.

Prepaid expense

Depreciation

Unearned revenue

Accrued expenses

Unrecorded revenue

2. Financial reporting and analysis

Accounting information should be:

Understandability

Usefulness:

- Relevant

- Reliable

Accounting conventions

- Comparability and consistency

- Materiality

- Conservatism

- Full discloser

- The cost benefit

The Balance sheet

Current assets (Operating cycle).

- Cash

- Short term investments (market value).

- Accounts receivables (net realisable value).

- Notes receivable (NRV, interest charged, not collected within typical collection period).

- Inventory (LCM, cost flow assumption).

- Prepaid expenses (Original-historical cost, e.g.: insurance and rent) .

Fixed assets:

Tangible assets

Intangible assets (Goodwill is not amortized in US, but IAS allows to amortize)

Current Liabillities:

- Accounts payable

- Wages, rents and other payable

- Notes payble

- Dividend payable

- Current portion of long term debt

Long-term liabilities (valued at present value of future cash flows)

Shareholders’ Equity

Income statement

What is the difference between gross and net sales?

Net sales or revenues is gross less returns, allowances, and discounts.

What is allowance?

What is maintenance expenses?

SG&A – Selling, general and administrative expenses.

What is general expenses?

3. Short-term liquid assets

Credit policy

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

Receivable turnover

Average days’ sales uncollected

Financing receivables:

-Receivables might be used as collateral for barrowing.

-Accounts receivables might be sold (factoring) with or without recourse. With recourse sold receivables are called contingent liability.

-Securitized receivables.

Cash

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

Marketable securities

Are held only until cash is needed.

Short term investments are initially recorded at cost (cash price plus any acquisition costs).

Reporting requirements:

1. Short-term investments that are held at maturity are reported at original cost.
2. Trading short-term investments are carried on the balance at its fair market value. Gain or loss are reported on the income statement.
3. AFS (available for sale) investment is reported on the balance sheet at its fair market value. But appreciation or depreciation is listed directly on equity account, but not on the income statement.

Accounts receivable and bad debt.

There are two approaches to accounting for uncollectible receivables. The direct write-off method (and the allowance method (Debit expense, credit receivable allowance, as you learn for sure that debtor goes bankrupt, we debit allowance and credit receivables).

For estimating uncollectible receivables can be these methods used:

1. Percentage of net sales method.

2. Aging of accounts (valuing specifically every period)

Promissory notes – usually A/R are traded in exchange for promissory notes. The payee makes notesreceivable instead of A/R and payer makes notes payable. If not all the notes are paid at the maturity then than the note is dishonored. The A/R is again restored in this case.

Questions:

What is AFS?

What is the difference between the write-off and write down?

What is aging of accounts?

4. Inventories

The cost of inventory includes invoice price less discounts, transportation costs, and taxes.

Inventory computations:

Specific identification method

The average cost method

First-in, first-out method FIFO

Last-in first-out method LIFO

EI = BI + P - COGS

COGS = BI + P – EI

Under increasing prices this happens:

- LIFO (higher COGS and cash flows, lower income, taxes, working capital)

- FIFO (opposite).

The effect of inventory measurement errors.

The use of the lower of cost or market value (LCM) assumption.

If the market value is higher than the cost, then nothing is done. If the market value is lower than the cost then the difference is written down to lower replacement market value.

It is important to understand that that LCM means that firstly cost flow assumption (FIFO or LIFO) is used and then the value of the inventory is compared to the market value.

It is also important that to note that LCM can be done on an individual product basis or all group.

5. Current liabilities

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

Long-term liabilities

Warranty payables – payables where the payees are not yet known .

At the end of the reporting period some of the expenses must be recognized (pensions, employee benefits, etc.).

Estimated liabilities

Questions:

What is estimated liability? – The precise amount of the liability is not yet known, but theliability can be reasonably estimated (vocation pay, income taxes, product warranty, property tax)

What is contingent liability? A liability only if future event occurs.

- Probable – the loss must be disclosed on the income statement.

- Reasonably likely, but not reasonably estimable – should be disclosed on the footnotes.

- Future payment is remote – then no discloser is required.

6. Long term assets

10. The statement of cash flows

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

CFF

CFI

CFO – shows changes in working capital (receivables, payables, inventories).

CFF – shows changes in long-term payables.

CFI – show changes in long-term assets.

Interest and dividends (US GAAP)

Interest, dividends received, interest paid – CFO.

Dividends paid – CFF.

Non cash operations.

-Retiring by issuing equity

-Capital lease

-Exchanging non cash items.

11. Framework for financial statement analysis

Comprehensive income (changes to equity from external transactions).

Footnotes (audited)

Supplementary schemes (not audited).

MD&A (Management Discussion and analyses):

1. Trends in sales and expenses.
2. Capital resources and liquidity, trends in cash flows.
3. Business overview on known trends.
4. Events and uncertainties
5. Discontinued operations, extraordinary items and other unusual or infrequent events.
6. Disclosure of interim financial statements.

Role of an Auditor

The public accountants carry audits on company’s financial statements. The auditor provides an opinion on the fairness and reliability of the financial reports. The auditors examines the companies accounting and internal control system, conforms assets and liabilities, no material errors.

Auditor’ s report contain three parts:

-Whereas the financial statements are prepared by management and are its responsibility, the auditor has performed an independent review.

-Generally accepted audit standards were fallowed, providing reasonable assurance that the financial statements contain no material errors.

-The auditor is satisfied that the statement were prepared in accordance with GAAP.

Qualified opinion – concerns about ongoing concern principle, asset valuation and litigation.

Unqualified opinion – the auditor is unaware of any uncertainties.

13. Analysis of cash flows

Non cash operations (usually involving a combination of financing and investing decisions)

1. Acquiring assets for debt (mortgage, lease)
2. Exchanging debt into stock.

International differences

Under IAS GAAP

1. Interest and dividends received may be classified as CFO or CFI
2. Dividends and interest paid may be classified as CFO or CFF

Direct method:

CFO

Cash collections (net sales, changes in receivable, cash advances from customers)

Cash inputs (COGS, changes in inventory, accounts payable and other liabilities)

Cash operating expenses (operating expenses and operating liabilities (salaries))

Cash taxes (tax expense, changes in tax payable, changes in deferred taxes)

Cash interest (interest expense, changes in interest payable, amortization of bonds discounts and premia)

Indirect method:

Net income.

Less gains or losses from financing and investing cash flows.

Addnon cash components such as depreciation and amortization.

Add or subtract changes to the operating accounts.

CFI

Gross changes in assets (excluding depreciation and goodwill).

Cash from assets disposal = decrease in asset and gain from the sale.

CFF

Net cash flow from creditors = new barrowings – principal paid

Net cash flow from owners = new equity issued – share repurchases – cash dividends

Cash dividends = dividends expense – changes in dividends payable.

Discrepancies in balance sheet and cash flow statement is due to mergers and acquisitions and exchange rate changes:

-Inventory acquired through acquisition will be reported in CFI, not in CFO.

-Exchange rate changes loss and gains should be reported separately.

INTERPRETATION OF CASH FLOW:

-CFO is most important, revealing how much cash is generated from business.

-CFO may indicate problems related to liquidity and solvency.

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

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

THE CONCEPT OF FREE CASH FLOWS (FCF)

Free cash flow = operating cash flow – net capital expenditures

Net capital expenditures = total capital expenditures – after tax proceeds from sale of assets

Notes to the questions:

1. Amortization of bond is included in the calculation of CFO (in cash flow related to the interest). So bond premium amortization is subtracted from the net income, and bond discount amortization is added to net income. (Flash back 120

14. Analysis of financial statements (Ratios)

COMMON-SIZE STATEMENTS

RATIOS

Internal liquidity

1. current ratio
2. quick ratio
3. cash ratio
4. receivable turnover
5. average receivable collection period
6. inventory turnover
7. average inventory processing period
8. payables turnover
9. payable payment period
10. cash conversion cycle

Evaluating operating performance (operating efficiency and operating performance)

Efficiency (assets and equity turnover ratios) Desired to be close to industry norms.

1. Total assets turnover.
2. Fixed assets turnover.
3. Equity turnover.

Operating profitability ratios

1. Gross profit margin
2. Operating profit margin
3. Net profit margin
4. Return on total capital (ROTC)
5. Return on total equity (ROTE)
6. Return on common equity (mostly analyzed using DuPont decomposition).

Risk analysis (Business riskand financial risk)

Business risk( 5 to 10 years data should be used)

1. Business risk.
2. Sales volatility.
3. Operating leverage.

Financial risk

1. Debt to equity ratio - deferred taxes should be included into debt if we know for sure that it will be paid (early income recognition), but if it is only due to different depreciation methods, it should be excluded.
2. Long term debt to total (log term) capital
3. Total debt ratio
4. Total interest bearing debt to total funded capital (without non-interest bearing debt).
5. Interest coverage ratio (gross interest expense is used in the denominator).
6. Fixed financial cost ratio (EBIT + ELIE)/(gross interest expense + ELIE)
7. Cash flow coverage of fixed financial cost (CFO + gross interest expense +ELIE)/(gross interest expense + ELIE).
8. Cash flow to long-term debt. (CFO/BV of long-term debt plus PV of operating leases).
9. Cash flow to total interest bearing debt.

Growth analysis

g = RR * ROE

External liquidity

-Bid-ask spread.

-Total market value.

-Number of shareholders,.

-Trading turnover.

DuPont analyses

ROE calculation

ROE = (net income/equity

Traditional approach (net profit margin, assets turnover, equity multiplier)

Extended approach(operating profit margin, assets turnover, interest expense rate, equity multiplier, tax retention rate).

RELATIVE RATIOS

-Ratios should be compared to the industry averages. If there big variations in industry ratios, the median should be used.

-It would be better to use only a subset o firms with similar. (Cross-sectional analyses).

19. Depreciation, impairment

Average life

Average age (Accumulated depreciation\depreciation expense)

Relative age (Accumulated depreciation\ending gross investment)

Average depreciable life (ending gross investment\depreciation expense)

Assets impairment

Carrying amounts of acquisition costs less depreciation should be reduced when there is no longer an expectation that those amounts can be recovered from future operations:

-A change in business environment.

-A decline in the usage rate or market value.

-Decline in profitability of the asset.

-Significantly higher than expected costs.

US GAAP does not allow to restore impairment.

The IAS allows to restore value of the asset.

20. Analysis of income taxes

IAS 12 – Income taxes.

Taxable income (on tax return) vs. pretax income.

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

The liability method for deferred taxes

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

Creation of deferred tax and liabilities

These tax deferrals occur due to different expenses treatments on the income statement and tax return.

Deferred tax liability – is reported as the income tax expense showed for financial reporting is grater than taxes payable on tax return (e.g. for accelerated depreciation method for IRS). But as the financial reporting shows greater taxes, which will be paid to IRS later, the liability of deferred taxes must be reported.

Deferred tax assets – occurs when the payable tax is greater than the tax expense, which means that less taxes will be paid later or this is equivalent to making a record of deferred tax assets.

Deferral versus liability method

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

Discloser requirements

Deferred tax liabilities, assets, valuation allowance and loss carry forwards, credits, components of tax expense, reconciliation of tax expense with that based upon the tax rate.

Changing tax rates

Under the liability method, all deferred tax assets and liabilities are revalued using new tax rate expected to be in place when the liability reverses.

Tax rate increases: increase in tax rate increases current tax expense and the increase in deferred tax assets decreases current tax expense

Analysis of deferred tax liabilities

The question is when the deferred taxes will reverse. An analyst must decide on a case-by-case basis. If the deferred tax does not reverse in the near future then it should considered not as assets or liabilities, but as equity. Some creditors, notably banks, ignore deferred tax.

Analysis of deferred assets

Deferred tax assets might be reduced by two ways:

1. Valuation allowance.
2. Decreasing equity and decreasing assets of deferred taxes.

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

Factors influencing the level and trend of deferred taxes

1. The law and accounting changes.
2. Growth of the firms.

Under these factors everything is carried normally, with changes to equity.

Permanent and temporary differences

Permanent differences – are differences that will not reverse in the future, such as: tax-exempt interest revenue, proceeds from life insurance, tax-exempt interest expenses, premiums paid on life insurance, goodwill amortization. These differences are never deferred, but are considered decreases and increases in the effective tax rate. I.e. no deferred tax liabilities or assets are created due to permanent differences and tax expense is equal to tax payable.

Temporary differences–are differences that will reverse in the future.

Classification of temporary differences:

-Current liabilities

-Long-term liabilities

-Current assets

-Long-term assets

-Stockholder equity

Indefinite reversals

Undistributed earnings of unconsolidated subsidiaries or joint ventures. Because retained earnings in the subsidiary, which are not distributed in the forms of dividends to the mother company, at the mother’s statements are considered as pretax income, but not taxable income. The liability of deferred tax might not never be reversed due to overall control of the subsidiary. Then this difference might be considered as permanent.

What is associated expenses?

What is a valuation allowance? It is a contra account against deferred tax assets.

What is MACRS? Modified accelerated cost recovery system.

What is expenditures?

What is timing, permanent and temporarily difference?

21. Analysis of financing liabilities

Conceptual overview:

• Bond liability on the balance sheet is posted at its present not par value.
• The premium or discount is amortized over the bond’s life, so that interest expense decreases over time for a premium bond and increases for a discount bond.
• Coupon payments affect CFO, and the amortized portion is recognized as CFF.
• Convertible bonds should be treated as equity for analytical purposes when the stock price is significantly higher than the conversion price.
• For analytical purposes the market value of the bond should be used to calculate leverage ratios and to value the firm.
• Gains and losses on debt retirement are treated as extraordinary gains and losses.

Bond terminology

Par value = stated value = face value