MGIMO Finance Club

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MGIMO Finance Club

• Introduction to Financial Accounting

October 18, 2003
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Table of Contents

• In-Depth Analysis of Complex Issues (cont'd)
• 1.1 Working Capital
• 1.2 Depreciation
• 1.3 Accounting for non-recurring items
• Financial Ratios Analysis
• 2.1 Liquidity ratios
• 2.2 Leverage ratios
• 2.3 Profitability ratios
• 2.4 Asset utilization ratios

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Section 1
In-Depth Analyses of Complex Issues (cont'd)
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Working Capital

• Working capital is the amount of resources
  available to meet a company's day-to-day needs,
  such as paying expenses or debts incurred to
  purchase current assets
• The difference between current assets and current
  liabilities determines the amount of working
  capital the net current assets on the balance
  sheet. In accounting terms, it is the part of
  current assets that is not financed by current
  liabilities
• Working Capital Current Assets Current
  Liabilities
• Analysts use working capital to measure a
  company's ability to pay its current bills. In
  other words, WC is a test of liquidity
• Working capital can be positive and negative
• If current assets are greater than current
  liabilities, WC is positive. Which means, it can
  probably pay its current bills within a year.
  Why? Because it can its short-term assets into
  cash within a year
• Conversely, if current assets are less than
  current liabilities, working capital is negative

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Working Capital (cont'd)

• Some financial analysts use operating working
  capital instead of working capital. Operating
  working capital excludes current assets and
  current liabilities not driven by day-to-day
  operating activities
• Analysts use use operating working capital
  because it's a better measure of the funding
  needed for the company's daily activities
  (operating activities)
• In addition, a company can't manipulate its
  operating activities as easily as its investing
  or financing activities. A company can always
  wait to buy that new factory it can't wait to
  replace the inventory it sold
• As a general rule
• Operating working capital (current assets
  cash) (current liabilities debt)

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DepreciationRecap

• Most assets fall in value over time, they get
  used up. This is normally true for office
  buildings (if they are not renovated on a regular
  basis), machinery etc. Apart from land, most
  long-term tangible assets lose their value over
  time unless more money is spent on them
• True, a certain location may become very
  fashionable. But accounting recognizes only the
  historical cost of an assets, not its market
  value
• As we already know, accounting records the
  gradual loss of an assets usefulness in an
  account called accumulated depreciation (contra
  account)
• Net PPE Original cost of PPE Accumulated
  Depreciation
• All three account appear on the balance sheet,
  but Net PPE is the only account which is added
  to total assets
• When you fully depreciate your asset, only the
  salvage value will be left on the balance sheet

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Depreciation (contd)Accounting for depreciation

• When you add depreciation to the balance sheet
• Your accumulated depreciation rises
• Your total assets fall
• And your balance sheet no longer balances
• To bring the balance sheet back into balance, you
  record depreciation on the income statement as an
  expense so that
• Your net income falls
• And your retained earnings fall
• And you balance sheet balances!

I/S
-
Assets
LE
-
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Depreciation (contd)Depreciation and the I/S
and the CF/S

• So where is depreciation expense recorded on the
  income statement? It depends on the type of fixed
  asset you are depreciating
• Production assets Add depreciation to COGS
• Non-production assets Add depreciation to SGA
• Please note that depreciation is not a cash
  expense, so you always, always have to add it
  back to your operating cash flow!

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Depreciation (contd)Straight-line vs.
accelerated

• When a company buys a new fixed asset, it
  estimates how many years of useful life the asset
  will have and its expected salvage value at the
  end of its life
• Total depreciation Original cost of assets
  Estimated salvage value
• Each year the company will expense part of the
  assets total depreciation. It has a choice of
  two ways to calculate its yearly depreciation
  expense
• Straight-line depreciation
• Accelerated depreciation

• Please note that irrespective of the depreciation
  type total depreciation expense over the life of
  the asset will be the same. It's only the timing
  that is different

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Depreciation (contd)Most common used methods

• Straight-line method
• S-L (cost salvage value) / useful life
• Double declining method (DDB)
• DDB (2/useful life) (cost accumulated
  depreciation)
• DDB method uses 200 of the straight-line rate
• DDB does not explicitly uses the salvage value in
  calculations, but depreciation expense will be
  halted when the cost less salvage value has been
  depreciated
• Sum of the years' digits method (SYD)
• SYD (original cost salvage value)(n n
  1) / SYD
• Units-of-production and service hours methods
  apply depreciation at the rate at which an asset
  is being used. When the asset is put into
  service, either the production capacity or the
  service life of the asset is estimated. Then the
  cost of the asset is divided by the capacity (or
  service life) to achieve a rate per unit (or a
  rate per hour)
• Once the asset's book value reaches its estimated
  salvage value ? no depreciation is charged

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Accounting for Non-Recurring Items

• The definition of unusual or infrequent items is
  obvious from the title these events are either
  unusual or infrequent in occurrence
• Examples include gains or losses from the sale
  of a portion of a business segment, gains or
  losses from a sale of assets or investments in
  subsidiaries, restructuring costs etc.
• Unusual or infrequent items are reported pre-tax
  before net income from continuing operations
  (I.e., above the line)
• Events that are both unusual and infrequent in
  occurrence are defined as extraordinary
• Examples include losses from expropriation of
  assets, gains or losses from early retirements of
  debt
• Extraordinary items are reported net of tax after
  the income from continuing operations (i.e.,
  below the line)
• Sometimes the management decides to dispose of
  certain business operation but either has not yet
  done so or did in the current year after it had
  generated income or losses. To be accounted for
  as a discontinued operation, the business must be
  physically and operationally distinct from the
  rest of the firm
• Measurement date the date when the company
  develops a formal plan for disposing

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Accounting for Non-Recurring Items (cont'd)

• Phaseout period time between the measurement
  date and the actual disposal date
• The income or loss from discontinued operations
  is reported separately, and past income
  statements must be restated, separating the
  income or loss from discontinued operations. On
  the measurement date, the company will accrue any
  estimated loss during the phaseout period and
  estimated loss on the sale of the disposal. Any
  expected gain on the disposal cannot be reported
  until after the sale is completed (same rule
  applies to the sale of a portion of a business
  segment)
• Income and losses from discontinued operations
  are reported net of tax after net income from
  continuing operations operations (i.e., below the
  line)
• Any impact on prior period earnings resulting
  from a change in accounting methods is reported
  on an after-tax basis (i.e., below the line). In
  general, prior years' financial statements do not
  need to be restated unless it is a change
• From LIFO accounting to another method, in
  depreciation method for existing assets, any
  change just prior to an IPO etc.
• Please note that change is depreciation method
  for new assets or change in depreciable
  lives/salvage values are considered changes in
  accounting estimates and not a change in
  accounting principle ? past income does not need
  to be restated

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Section 2
Financial Ratios Analysis
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Financial Ratios Analysis General Overview

• Ratio analysis is an important part of any
  financial study of firm
• Generally, ratios are evaluated for a firm over
  time, or are compared with industry averages
• When comparing ratios of one firm but for
  different periods, you must recognize conditions
  that have changed between the periods being
  compared (different product lines or geographic
  markets served, changes in economic conditions,
  changes in prices).
• Similarly, when comparing ratios of a particular
  firm with those of similar firms, you need to see
  the differences (in their methods of accounting,
  in their operations, types of financing, and so
  on)
• Ratios based on financial statement data are
  necessarily subject to the same criticisms as
  financial statements namely, that historical
  acquisition cost may misstate current replacement
  cost or net realizable value, and that firms have
  wide latitude in selecting from among various
  generally accepted accounting principles.

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The Key Financial Ratios

• Liquidity ratios Used to evaluate a firms
  short-term liquidity, measuring its ability to
  pay wages, short-term creditors, taxes, and
  interest on bonds without delay
• Leverage ratios Used to evaluate a firms
  creditworthiness from a long-term lenders
  perspective
• Profitability ratios Used by prospective or
  existing shareholders to evaluate a firms past
  earnings, its potential for future income growth,
  and how much profit is paid out to shareholders
  in the form of dividends
• Asset utilization ratios Used to evaluate the
  productivity of a firms assets

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With other words - the key financial ratios
indicate, in terms of

• Liquidity does the business have enough money to
  pay its bills?
• Leverage does the company have a lot of debt or
  is it financed mainly by shares?
• Profitability has the business made a good
  profit compared to its turnover?
• Asset Utilization how has the business used its
  fixed and current assets?

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Liquidity and Turnover ratios

• Current Ratio Current Assets / Current
  Liabilities
• The higher the current ratio, the more likely it
  is that the company will be able to pay for its
  short-term bills. A current ratio of less than
  one means that the company has negative working
  capital and is facing a liquidity crisis. As
  mentioned in the previous section Working Capital
  equals current assets minus the current
  liabilities.
• Acid Test (Quick) ratio (Current Assets-Stocks)
  / Current Liabilities
• The quick ratio is a more stringent measure of
  liquidity because it does not include inventories
  and other assets that might not be very liquid.
  Again, the higher the quick ratio the more likely
  the company will be able to pay its short-term
  bills.
• Cash Ratio (Cash Marketable Securities) /
  Current Liabilities
• The cash ratio is the most conservative
  liquidity measure.
• Receivables Turnover Average Accounts
  Receivable / (Net annual sales / 365)
• A measure of accounts receivable turnover is the
  receivables turnover. In most cases when a ratio
  compares a balance sheet account (such as
  receivables) with an income or cash flow item
  (such as sales), the balance sheet item will be
  the average of the account instead of simply the
  end-of-year balance. Averages are calculated by
  adding the beginning of year value and the
  end-of-year account value and dividing the sum by
  two.

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Liquidity and Turnover ratios (contd)

• Inventory Turnover in days Average Inventory /
  (Cost of Goods Sold / 365)
• A measure of a firms efficiency with respect to
  its processing and inventory management is the
  inventory turnover. As is the case with accounts
  receivable, it is considered desirable to have an
  inventory processing period (and inventory
  turnover) close to the industry norm. A
  processing period that is too high might mean
  that too much capital is tied up in inventory and
  could mean that the inventory is obsolete. A
  processing period that is too low might indicate
  that the firm has inadequate stock on hand, which
  could adversely impact sales.

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Leverage Ratios

• Leverage is concerned with the relationship
  between the long terms liabilities that a
  business has and its capital employed. The idea
  is that this relationship ought to be in balance,
  with the shareholders' funds being significantly
  larger than the long term liabilities.
• The ratios
• Total Debt to Total Capital (Current
  Liabilities Long-term liabilities) / (Equity
  Capital Total Liabilities)
• Total long-term debt equals all long-term debt
  plus preferred stock and equity.
• Long-term Debt to Total Capital Total long-term
  debt / Total long-term capital
• Some analysts exclude preferred stock and only
  use owners equity. Increases and decreases in
  this ratio suggest a greater or lesser reliance
  on debt as a source of financing.
• Interest Coverage Earnings before interests and
  taxes / Interest expense
• The lower this ratio, the more likely it is that
  the firm will have difficulty in meeting its debt
  payments.

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Profitability Ratios

• Gross Profit Margin Gross Profit / Net Sales
• Industry (US) norms
• Net Profit Margin Net Income / Net Sales
• The net profit margin ratio tells us the amount
  of net profit per //Ruble, etc. of turnover a
  business has earned. That is, after taking
  account of the cost of sales, the administration
  costs, the selling and distributions costs and
  all other costs, the net profit is the profit
  that is left, out of which they will pay
  interest, tax, dividends and so on.

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Profitability Ratios (contd)

• Return on Total Capital (Net Income Interest
  Expense) / Average total capital
• The return on total capital is the ratio of net
  income before interest expense to total capital.
  Total capital is the same as total assets. The
  interest expense that should be added back is
  gross interest expense, not net interest expense
  (which is gross interest expense less interest
  income)
• Return on Total Equity (Net Income Preferred
  Dividends) / Average Common Equity
• This ratio differs from the return on total
  equity in that it only measures the returns paid
  to, and the capital invested by, common
  stockholders, instead of common and preferred
  stockholders. That is why preferred dividends are
  deducted from net income in the numerator.

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Asset Utilization Ratios

• Sales to Fixed Assets Sales / Average Fixed
  Assets
• Sales to Total Assets Sales / Average Total
  Assets
• Sales to Inventories Sales / Average
  Inventories