Financial Analysis

Process to evaluate financial position and performance using financial statements

Profitability analysis Evaluate return on investments Risk analysis Evaluate riskiness & creditworthiness Analysis of cash flows Evaluate source & deployment of funds

Common tools
Cash flow analysis

Ratio analysis

Financial Statements Reflect Business Activities

Planning
Investing
Current:

Financing
Current:

Operating
Sales Cost of Goods Sold Selling Expense Administrative Expense Interest Expense Income Tax Expense

Cash Accounts Receivable Inventories Marketable Securities Land, Buildings, & Equipment Patents Investments

Notes Payable Accounts Payable Salaries Payable Income Tax Payable Bonds Payable Common Stock Retained Earnings

Noncurrent:

Noncurrent:

Net Income

Income statement
Assets

Liabilities & Equity

Cash Flow

Balance Sheet

Balance Sheet

Statement of Cash Flows

Statement of Shareholders Equity

Financial Statements
Balance Sheet

Income Statement Statement of Shareholders Equity

Statement of Cash Flows

Balance Sheet
Total Investing = Total Financing = Creditor Financing + Owner Financing

Income Statement
Revenues Cost of goods sold = Gross Profit Gross profit Operating expenses = Operating Profit

Off-Balance-Sheet Financing
Basics of Off-Balance-Sheet Financing
Off-Balance-Sheet Financing is the non-recording of financing obligations Motivation To keep debt off the balance sheetpart of ever-changing landscape, where as one accounting requirement is brought in to better reflect obligations from a specific off-balance-sheet financing transaction, new and innovative means are devised to take its place Transactions sometimes used as off-balance-sheet financing: Operating leases that are indistinguishable from capital leases Through-put agreements, where a company agrees to run goods through a processing facility Take-or-pay arrangements, where a company guarantees to pay for goods whether needed or not Certain joint ventures and limited partnerships Product financing arrangements, where a company sells and agrees to repurchase inventory or guarantee a selling price Sell receivables with recourse and record them as sales rather than liabilities Sell receivables as backing for debt sold to the public Outstanding loan commitments

GAAP

either

Off-Balance-Sheet Financing
Analysis of Off-Balance-Sheet Financing
Sources of useful information: Notes and MD&A and SEC Filings Companies disclose the following info about financial instruments with off-balance-sheet risk of loss: Face, contract, or principal amount Terms of the instrument and info on its credit and market risk, cash requirements, and accounting Loss incurred if a party to the contract fails to perform Collateral or other security, if any, for the amount at risk Info about concentrations of credit risk from a counterparty or groups of counterparties Useful analyses: Scrutinize management communications and press releases Analyze notes about financing arrangements Recognize a bias to not disclose financing obligations Review SEC filings for details of financing arrangements

Off-Balance-Sheet Financing
Benefits of SPEs:

1. SPEs may provide a lower-cost financing alternative than borrowing from the credit markets directly. 2. Under present GAAP, so long as the SPE is properly structured, the SPE is accounted for as a separate entity, unconsolidated with the sponsoring company.

Statement of Cash Flows

Net Cash Flows from Operating Activities Net Cash Flows from Investing Activities Net Cash Flows from Financing Activities

Shareholders Equity
Basics of Equity Financing
Equity refers to owner (shareholder) financing; its usual characteristics include: Reflects claims of owners (shareholders) on net assets Equity holders usually subordinate to creditors Variation across equity holders on seniority Exposed to maximum risk and return Equity Analysis involves analyzing equity characteristics, including: Classifying and distinguishing different equity sources Examining rights for equity classes and priorities in liquidation Evaluating legal restrictions for equity distribution Reviewing restrictions on retained earnings distribution Assessing terms and provisions of potential equity issuances Equity Classes two basic components: Capital Stock Retained Earnings

Shareholders Equity
Reporting Capital Stock
Sources of increases in capital stock outstanding: Issuances of stock Conversion of debentures and preferred stock Issuances pursuant to stock dividends and splits Issuances of stock in acquisitions and mergers Issuances pursuant to stock options and warrants exercised Sources of decreases in capital stock outstanding: Purchases and retirements of stock Stock buybacks Reverse stock splits

Shareholders Equity
Components of Capital Stock
Contributed (or Paid-In) Capital total financing received from shareholders for capital shares; usually divided into two parts: Common (or Preferred) Stock financing equal to par or value;if stock is no-par, then equal to total financing Contributed (or Paid-In) Capital in Excess of Par or Stated financing in excess of any par or stated value Treasury Stock (or buybacks) - shares of a companys stock reacquired after having been previously issued and fully paid for. Reduces both assets and shareholders equity contra-equity account (negative equity). typically recorded at cost stated

Value

Shareholders Equity
Classification of Capital Stock
Preferred Stock stock with features not possessed common stock; typical preferred stock features include: Dividend distribution preferences Liquidation priorities Convertibility (redemption) into common stock Call provisions Non-voting rights Common Stock stock with ownership interest and ultimate risks and rewards (residual interests) of company performance bearing by

Financial Accounting
Important Accounting Principles
o

Historical Cost - fair & objective values from arms-length bargaining Accrual Accounting - recognize revenues when earned, expenses when incurred Materiality - threshold when information impacts decision making

Conservatism - reporting or disclosing the least optimistic information about uncertain events and transactions

Financial Accounting
Limitations of Accounting Information
o o o

Timeliness - periodic disclosure, not real-time basis Frequency - quarterly and annually Forward Looking - limited prospective information

Auditing And Financial Statement Analysis

Analyzing Financing Activities

3
CHAPTER

Liabilities
Classification
Current (short-term) Liabilities Noncurrent (Long-Term) Liabilities

Obligations whose settlement requires use of current assets or the incurrence of another current liability within one year or the operating cycle, whichever is longer.

Obligations not payable within one year or the operating cycle, whichever is longer.

Liabilities
Alternative Classification
Operating Liabilities
Obligations that arise from operating activities--examples are accounts payable, unearned revenue, advance payments, taxes payable, postretirement liabilities, and other accruals of operating expenses

Financing Liabilities

Obligations that arise from financing activities--examples are short- and longterm debt, bonds, notes, leases, and the current portion of long-term debt

Liabilities
Important Features in Analyzing Liabilities
Terms of indebtedness (such as maturity, interest rate, payment pattern, and amount). Restrictions on deploying resources and pursuing business activities. Ability and flexibility in pursuing further financing. Obligations for working capital, debt to equity, and other financial figures. Dilutive conversion features that liabilities are subject to. Prohibitions on disbursements such as dividends.

Postretirement Benefits
Two kinds of Postretirement Benefits
Pension benefits -- Employer-promises monetary benefits to employees after retirement, e.g., monthly stipend until death Other Postretirement Employee Benefits (OPEB) -- Employer-provided non-pension (usually nonmonetary) benefits after retirement, e.g., health care and life insurance

Postretirement Benefits
Pension Basics
Pension Plan agreement by the employer to provide pension benefits involving 3entities: employer-who contributes to the plan; employee-who derives benefits; and pension fund Pension Fund account administered by a trustee, independent of employer, entrusted with responsibility of receiving contributions, investing them in a proper manner, & disbursing pension benefits to employees Vesting specifies employees right to pension benefits regardless of whether employee remains with the company or not; usually conferred after employee has served some minimum period with the employer

Pension Plan Categories

Defined benefit a plan specifying amount of pension benefits that employer promises to provide retirees; employer bears risk of pension fund performance Defined contribution a plan specifying amount of pension contributions that make to the pension plan; employee bears risk of pension fund performance employers

Focus of Pension Analysis

Defined benefit plans constitutes the major share of pension plans and are the focus of analysis given their implications to future company performance and financial position

Analyzing Investing Activities

4
CHAPTER

Current Asset Introduction

Classification
Current (Short-term) Assets
Resources or claims to resources that are expected to be sold, collected, or used within one year or the operating cycle, whichever is longer.

Noncurrent (Long-term) Assets

Resources or claims to resources that are expected to yield benefits that extend beyond one year or the operating cycle, whichever is longer.

Current Asset Introduction

Cash, Cash Equivalents and Liquidity Cash Currency, coins and amounts on deposit in bank accounts, checking accounts, and some savings accounts.

Current Asset Introduction

Cash, Cash Equivalents and Liquidity Cash Equivalents Short-term, highly liquid investments that are: Readily convertible to a known cash amount. Close to maturity date and not sensitive to interest rate changes.

Current Asset Introduction

Prepaid Expenses
Prepaid expenses are advance payments for services or goods not yet received that extend beyond the current accounting periodexamples are advance payments for rent, insurance, utilities, and property taxes

Analysis of Prepaids
Two analysis issues: (1) For reasons of expediency, noncurrent prepaids sometimes are included among prepaid expenses classified as current--when their magnitude is large, they warrant scrutiny (2) Any substantial changes in prepaid expenses warrant scrutiny

Inventories
Definitions
Inventories are goods held for sale, or goods acquired (or in process of being readied) for sale, as part of a companys normal operations Expensing treats inventory costs like period costs costs are reported in the period when incurred Capitalizing treats inventory costs like product costscosts are capitalized as an asset and subsequently charged against future period(s) revenues benefiting from their sale

Inventories
First-In, First-Out (FIFO)

Oldest Costs

Costs of Goods Sold

Recent Costs

Ending Inventory

Inventories
Last-In, First-Out (LIFO)

Recent Costs

Costs of Goods Sold

Oldest Costs

Ending Inventory

Inventories
Average Cost When a unit is sold, the average cost of each unit in inventory is assigned to cost of goods sold.

Cost of Goods Units available Available for on the date of Sale sale

Long-Lived Asset Introduction

Definitions
Long-lived assetsresources that are used to generate revenues (or reduce costs) in the long run
Tangible fixed assets such as property, plant, and equipment Intangible assets such as patents, trademarks, copyrights, and goodwill

Deferred charges such as research and development (R&D) expenditures, and natural resources

Long-Lived Asset Introduction

Capitalization
Capitalizationprocess of deferring a cost that is incurred in the current period and whose benefits are expected to extend to one or more future periods For a cost to be capitalized, it must meet each of the following criteria:

It must arise from a past transaction or event

It must yield identifiable and reasonably probable future benefits It must allow owner (restrictive) control over future benefits

Long-Lived Asset Introduction

Allocation
Allocationprocess of periodically expensing a deferred cost (asset) to one or more future expected benefit periods; determined by benefit period, salvage value, and allocation method Terminology

Depreciation for tangible fixed

assets

Amortization for intangible assets

Depletion for natural resources

Intangible Assets
Noncurrent assets without physical substance. Often provide exclusive rights or privileges.

Intangible Assets
Useful life is often difficult to determine. Usually acquired for operational use.

Intangible Assets
Accounting for Intangible Assets Record at cost, including purchase price, legal fees, and filing fees. Patents Copyrights Leaseholds Leasehold Improvements Goodwill Trademarks and Trade Names

Intangible Assets
Analyzing Intangibles and Goodwill
Search for unrecorded intangibles and goodwilloften misvalued and most likely exist off-balance-sheet Examine for superearnings as evidence of goodwill Review amortization periodsany likely bias is in the direction of less amortization and can call for adjustments Recognize goodwill has a limited useful life--whatever the advantages of location, market dominance, competitive stance, sales skill, or product acceptance, they are affected by changes in business

Analyzing Investing Activities: Intercorporate Investments

05
CHAPTER

Investment Securities
Composition Investment (marketable) securities: Debt Securities Government or corporate debt obligations Equity Securities
Corporate stock that is readily marketable

Investment Securities
Accounting for Debt Securities

Investment Securities
Accounting for Transfers between Security Classes

Investment Securities
Classification and Accounting for Equity Securities

Investment Securities
Analyzing Investment Securities Two main objectives:
To separate operating performance from investing (and financing) performance
Remove all gains (losses) relating to investing activities Separate operating and nonoperating assets when determining RNOA

To analyze accounting distortions from securities

Opportunities for gains trading Liabilities recognized at cost Inconsistent definition of equity securities Classification based on intent

Equity Method Accounting

Required for intercorporate investments in which the investor company can exert significant influence over, but does not control, the investee.
Reports the parents investment in the subsidiary, and the parents share of the subsidiarys results, as line items in the parents financial statements (one-line consolidation)

Note: Generally used for investments representing 20 to

50 percent of the voting stock of a companys equity securities--main difference between consolidation and equity method accounting rests in the level of detail reported in financial statements

Equity Method Accounting

Equity Method Accounting

Investment account:
Initially recorded at acquisition cost Increased by % share of investee earnings Decreased by dividends received

Income:
Investor reports % share of investee company earnings as equity earnings in its income statement Dividends are reported as a reduction of the investment account, not as income

Equity Method Accounting

Important points:
Investment account reported at an amount equal to the proportionate share of the stockholders equity of the investee company. Substantial assets and liabilities may not be recorded on balance sheet unless the investee is consolidated. Investment earnings should be distinguished from core operating earnings (unless strategic). Investments are reported at adjusted cost, not at market value. Should discontinue equity method when investment is reduced to zero and should not provide for additional losses unless the investor has guaranteed the obligations of the investee or is otherwise committed to providing further financial support to the investee.
Resumes once all cumulative deficits have been recovered via investee earnings.

Excess of initial investment over the proportionate share of the book value is allocated to identifiable tangible and intangible assets that are depreciated/amortized over their respective useful lives. Investment income is reduced by this additional expense. The excess not allocated in this manner is treated as goodwill and is no longer amortized.

Business Combinations
The merger, acquisition, reorganization, or restructuring of two or more businesses to form another business entity Motivations

enhance company image and growth potential acquiring valuable materials and facilities acquiring technology and marketing channels securing financial resources strengthening management enhancing operating efficiency encouraging diversification rapidity in market entry achieving economies of scale acquiring tax advantages management prestige and perquisites management compensation

Business Combinations
Consolidated Financial Statements
Consolidated financial statements report the results of operations and financial condition of a parent corporation and its subsidiaries in one set of statements

Basic Technique of Consolidation

Consolidation involves two steps: aggregation and elimination Aggregation of assets, liabilities, revenues, and expenses of subsidiaries with the parent Elimination of intercompany transactions (and accounts) between subsidiaries and the parent Note: Minority interest represents the portion of a subsidiarys equity securities owned by other than the parent company

Business Combinations
Impairment of Goodwill
Goodwill recorded in the consolidation process is subject to annual review for impairment. The fair market value of Micron is compared with the book value of its associated investment account on Synergys books. If the current market value is less than the investment balance, goodwill is deemed to be impaired and an impairment loss must be recorded in the consolidated income statement. Impairment loss reported as a separate line item in the operating section of Synergys consolidated income statement. A portion of the goodwill contained in Synergys investment account is written off, and the balance of goodwill in the consolidated balance sheet is reduced accordingly.

Business Combinations
Issues in Business Combinations
Contingent Consideration - a company usually records the amount of
any contingent consideration payable in accordance with a purchase agreement when the contingency is resolved and the consideration is issued or issuable. Allocating Total Cost - once a company determines the total cost of an acquired entity, it is necessary to allocate this cost to individual assets received; the excess of total cost over the amounts assigned to identifiable tangible and intangible assets acquired, less liabilities assumed, is recorded as goodwill. In-Process Research & Development (IPR&D) - some companies are writing off a large portion of an acquisitions costs as purchased research and development. Pending accounting standard will require capitalization of IRR&D and annual testing for impairment. Debt in Consolidated Financial Stetements - Liabilities in consolidated financial statements do not operate as a lien upon a common pool of assets.

Business Combinations
Issues in Business Combinations
Gain on subsidiary stock sales - The equity investment account is
increased via subsidiary stock sales. Companies can record the gain either to income or to APIC

Consequences of Accounting for Goodwill - goodwill is not permanent

and the present value of super earnings declines as they extend further into the future future impairment losses are likely

Push-Down Accounting - a controversial issue is how the acquired

company (from a purchase) reports assets and liabilities in its separate financial statements (if that company survives as a separate entity)

Business Combinations
Additional Limitations of Consolidated Financial Statements Financial statements of the individual companies composing the larger entity are not always prepared on a comparable basis. Consolidated financial statements do not reveal restrictions on use of cash for individual companies. Nor do they reveal intercompany cash flows or restrictions placed on those flows. Companies in poor financial condition sometimes combine with financially strong companies, thus obscuring analysis. Extent of intercompany transactions is unknown unless the procedures underlying the consolidation process are reported. Accounting for the consolidation of finance and insurance subsidiaries can pose several problems for analysis. Aggregation of dissimilar subsidiaries can distort ratios and other relations.

Business Combinations
Additional Limitations of Consolidated Financial Statements Financial statements of the individual companies composing the larger entity are not always prepared on a comparable basis. Consolidated financial statements do not reveal restrictions on use of cash for individual companies. Nor do they reveal intercompany cash flows or restrictions placed on those flows. Companies in poor financial condition sometimes combine with financially strong companies, thus obscuring analysis. Extent of intercompany transactions is unknown unless the procedures underlying the consolidation process are reported. Accounting for the consolidation of finance and insurance subsidiaries can pose several problems for analysis. Aggregation of dissimilar subsidiaries can distort ratios and other relations.

Business Combinations
Consequences of Accounting for Goodwill
Superior competitive position is subject to change.
Goodwill is not permanent.

Residual goodwill - measurement problems. Timing of goodwill write-off seldom reflects prompt recognition of this loss in value. In many cases goodwill is nothing more than mechanical application of accounting rules giving little consideration to value received in return. Goodwill on corporate balance sheets typically fails to reflect a companys entire intangible earning power

Derivative Securities

Derivative Securities
Analysis of Derivatives

Identify Objectives for Using Derivatives

Risk Exposure and Effectiveness of Hedging Strategies Transaction Specific versus Companywide Risk Exposure Inclusion in Operating or Nonoperating Income

The Fair Value Option

Analysis Implications

Reliability of fair value measurements Opportunistic adoption of SFAS 159

SFAS 159 allows considerable discretion to companies in choosing the specific assets or liabilities for which they exercise the fair value option. An analyst needs to verify whether the fair value election has been opportunistic with an aim to window dressing the financial statements.