Financial Statement Analysis: A Valuation Approach

1
Understanding Financial Statements EIGHTH
EDITION
Lyn M. Fraser Aileen Ormiston
2
The Balance Sheet
Old accountants never die they just lose their
balance --Anonymous

3
The Balance Sheet

• Also called the statement of condition or
  statement of financial position
• Shows the financial condition or financial
  position of a company on a particular date

Financial Condition
4
Financial Condition (cont.)
Assets
Liabilities Stockholders equity

• Assets What the firm owns
• Liabilities What the firm owes to outsiders
• Stockholders equity What the firm owes to
  Internal owners

5
General Parameters

• Consolidation when financial statements are
  combined due to parent owning more than 50 of
  voting stock in subsidiary
• Balance Sheet Date
• prepared at a point in time/on a particular date
  at end of accounting period
• end of accounting period date can be calendar
  year or fiscal year or interim period such as
  year, quarter, etc.

6
General Parameters (cont.)

• Comparative Data
• SEC requires that Balance Sheet includes two
  years of data (current and prior year balances)
• Provides reference point for determining changes
  in financial position over time

7
General Parameters (cont.)

• Common-Size balance sheet
• useful tool for analyzing the balance sheet
• expresses each item on the balance sheet as a
  percentage of total assets
• form of vertical ratio analysis that allows
  comparison of firms regardless of size
• useful for evaluating trends within a firm and to
  make industry comparisons

8
Common-Size balance sheet (cont.) Comparison of
two major retail companies

• Comparison using ( are in millions)
• Retailer A
  Retailer B
• Cash 5,488 2,245
• A/R 1,715 5,069
• Inventories 29,447 5,384
• Current Assets 38,491 13,922
• PPE, net 65,408 16,860
• Total Assets 120,223 32,293
• Data from SEC website, www.sec.gov

9
Common-Size balance sheet (cont.) Comparison of
two major retail companies

• Comparison using common size balance sheet
• Retailer A
  Retailer B
• Cash 4.56 6.95
• A/R 1.43 15.70
• Inventories 24.49 16.67
• Current Assets 32.02
  43.11
• PPE, net 54.41 52.21
• Data from SEC website, www.sec.gov

10
Assets

• Generally presented in order of liquidity
• Common Balance Sheet Accounts/Groupings
• Current Assets
• Cash and Marketable Securities
• Accounts Receivable
• Inventories
• Prepaid Expenses
• Long-Term Assets
• Property, Plant, and Equipment
• Other Assets

11
A Few Definitions

• Current Assets-Cash or other assets expected to
  be converted into cash within one year or one
  operating cycle, whichever is longer
• Operating Cycle-Time required to purchase or
  manufacture inventory, sell the product, and
  collect the cash

12
A Few Definitions (cont.)

• Working Capital (Net working capital)designates
  the amount by which current assets exceed current
  liabilities

13
Cash and Marketable Securities

• Two accounts are often combined as
• Cash and Cash Equivalents
• Cash in any formcash awaiting deposit or in a
  bank account
• Generally includes currency, coin, balances in
  checking and other demand or near demand
  accounts

Cash
14
Cash and Marketable Securities (cont.)
Marketable Securities

• Also called short-term investments
• Are cash substitutes
• Represent cash not needed immediately in the
  business
• Temporarily invested to earn a return
• Have short-term maturities
• May include T-bills, certificates, notes, bonds,
  CDs and commercial paper

15
Statement of Financial Accounting Standards No.
115

• Effective for fiscal years beginning after
  December 15, 1993
• Requires the separation of investment securities
  into three categories
• 1. Held to maturity
• 2. Trading securities
• 3. Securities available for sale

16
Statement of Financial Accounting Standards No.
115 (cont.)
Held to Maturity

• Applies to debt securities that the firm has the
  positive intent and ability to hold to maturity
• Reported at amortized cost

17
Statement of Financial Accounting Standards No.
115 (cont.)
Trading Securities

• Debt and equity securities that are held for
  resale in the short term
• Reported at fair value with unrealized gains and
  losses included in earnings

18
Statement of Financial Accounting Standards No.
115 (cont.)
Securities Available for Sale

• Debt and equity securities that are not
  classified as one of the other two categories
• Reported at fair value with unrealized gains or
  losses included in comprehensive income

19
Statement of Financial Accounting Standards No.
115 (cont.)

• Does not apply to investments in consolidated
  subsidiaries nor to investments in equity
  securities accounted for under the equity method

20
Accounts Receivable

• Arise from sales transactions to customers on
  credit
• Reported on the balance sheet at
• NET REALIZABLE VALUE

Net Realizable Value
Accounts Receivable
- Allowance for Doubtful Accounts
21
A Word on the Allowance

• Management must estimate the dollar amount of
  accounts receivable they expect to be
  uncollectible
• Affects balance sheet valuation AND bad debt
  expense on income statement
• Can be important in assessing earnings
  quality--changes should be analyzed

22
Inventories

• Items held for sale or used in the manufacture of
  products that will be sold

23
Inventories (cont.)

• Retail Company
• One type of inventory Finished goods
• Manufacturing Company
• Three types of inventories
• Raw materials
• Work-in-process
• Finished goods

24
Inventories (cont.)

• Accounting method chosen to value inventory and
  the associated measurement of cost of goods sold
  have a considerable impact on a companys
  financial position and operating results

25
Inventory Accounting Methods

• Inventory valuation is based on an assumption
  regarding the flow of goods
• Has nothing to do with the actual order in which
  products are sold
• Cost flow assumption made in order to match the
  cost of products sold to the revenue generated

26
Inventory Accounting Methods (cont.)

• Three cost flow assumptions
• FIFO (First In, First Out)
• LIFO (Last In, First Out)
• Average cost

27
Inventory Accounting Methods (cont.)
Accounting Method FIFO LIFO Average Cost
Cost of Goods Sold (Income Statement) first
purchases last purchases (close to current
cost) average of all purchases
Inventory Valuation (Balance Sheet) last
purchases (close to current cost) first
purchases average of all purchases
28
Inventory Accounting Methods (cont.)
LIFO During Inflation

• Produces the highest COGS expense and the lowest
  ending inventory valuation
• Matches current costs to current sales

29
Inventory Accounting Methods (cont.)
FIFO During Inflation

• Produces the lowest COGS expense and the highest
  ending inventory valuation
• Values ending inventory at current cost

30
Inventory Accounting Methods (cont.)

• Inventory valuation may significantly affect BOTH
  the balance sheet and the income statement
• Disclosure of inventory cost flow assumption
  found in notes
• Inventory reported on balance sheet at LOWER OF
  COST OR MARKET

31
Prepaid Expenses

• Represent expenses paid in advance--
  included in current assets if they expire within
  one year or one operating cycle
• Usually not a material item
• Present few or no reporting or valuation issues

32
Property, Plant, and Equipment (PPE)

• Encompasses a companys fixed assets
• Also called tangible, long-lived, and capital
  assets
• Fixed assets other than land are depreciated
  over the period of time they benefit the firm
• process of depreciation is method of allocating
  the cost of long-lived assets

33
Property, Plant, and Equipment (PPE) (cont.)

• On any balance sheet date, PPE is shown at BOOK
  VALUE
• Book value original cost
• - accumulated depreciation to date

34
Property, Plant, and Equipment (PPE) (cont.)
Depreciation methods

• Straight line spreads the expense evenly by
  periods
• Accelerated yields higher depreciation
  expense in the early years of an assets useful
  life, and lower depreciation expense in the later
  years
• Units of production bases depreciation
  expense for a given period on actual use

?
?
?
35
Property, Plant, and Equipment (PPE) (cont.)

• Proportion of fixed assets (PPE) in a companys
  asset structure determined by nature of the
  business
• Comparisons between firms can be difficult due to
  different depreciation methods and estimates

36
Other Assets

• Can include multitude of other noncurrent items
  such as
• Property held for sale
• Start-up costs in connection with a new business
• Cash surrender value of life insurance policies
• Long-term advance payments
• Long-term investments
• Intangible assets

37
Other AssetsIntangible
Goodwill

• Most important for analytical purposes
• because of potential materiality
• Arises when one company acquires another company
  for a price in excess of the fair market value of
  the net identifiable assets acquired

38
Goodwill (cont.)

• Beginning in 2002, companies required to evaluate
  goodwill and determine whether it has lost value
• Amount of impairment is expensed in the year the
  determination is made

39
Goodwill (cont.)

• Some corporations take enormous
• write-offs when companies they have acquired
  lose value
• Earnings increase for some firms relative to
  prior years because amortization expense is no
  longer recorded

40
Goodwill (cont.)

• Companies have some discretion in deciding when
  and how much
• write-off to take as a result of goodwill
  impairment

41
Goodwill (cont.)
Example of the impact the 2002 change for
goodwill expense had on a major entertainment
company over a 5 year period

• ( in millions)
• Year GW Impairment GW Amortization
• 2005 24 ----
• 2004 10 ----
• 2003 318 ----
• 2002 44,039 ----
• 2001 ---- 6,366
• Data from SEC website,
  www.sec.gov

42
Liabilities

• Represent claims against assets by creditors
• Current Liabilities must be satisfied in one year
  or one operating cycle and include
• Accounts Payable
• Notes Payable
• Current Portion of Long-Term Debt
• Accrued Liabilities
• Unearned Revenue
• Deferred Taxes

43
Liabilities (cont.)
Accounts Payable

• Short-term obligations that arise from credit
  extended by suppliers for the purchase of goods
  and services
• Account is eliminated when the bill is satisfied
• Significant changes from period to period often
  result from changes in sales volume, economic
  conditions or credit policies available to firm
  from its suppliers

44
Liabilities (cont.)
Notes Payable

• Short-term obligations in the form of promissory
  notes and/or lines of credit to suppliers or
  financial institutions

45
Liabilities (cont.)
Current Maturities of Long-Term Debt

• When a firm has bonds, mortgages, or other forms
  of long-term debt outstanding, the portion of the
  principal that will be repaid during the upcoming
  year is classified as a current liability

46
Liabilities (cont.)

• Result from recognition of expenses before they
  are actually paid
• Under accrual accounting, expenses are recognized
  when INCURRED and thus ACCRUED, not when paid in
  cash
• In this case, cash flow succeeds expense
  recognition

Accrued Liabilities
47
Liabilities (cont.)
Unearned Revenue or Deferred Credits

• Result from prepayments received in advance for
  services or products
• Under accrual accounting, revenue is recognized
  when EARNED, not when cash is received
• In this case, cash flow precedes revenue
  recognition

48
Liabilities (cont.)
Deferred Federal Income Taxes

• Result of temporary differences in the
  recognition of revenue and expense for taxable
  income relative to reported financial income

49
Deferred Federal Income Taxes (cont.)

• Objective is to take advantage of all available
  tax deferrals in order to reduce actual tax
  payments, while showing the highest possible
  amount of reported net income

50
Deferred Federal Income Taxes (cont.)
Temporary Differences/Timing Differences

• When the total amount of expense and revenue
  recognized will eventually be the same for tax
  and financial reporting purposes

51
Deferred Federal IncomeTaxes (cont.)
Permanent Differences

• Do not affect deferred taxes because a tax will
  never be paid on the income or the expense will
  never be deducted on the tax return

52
Noncurrent Liabilities
Obligations with maturities beyond one year

• Long-Term Debt
• Capital Lease Obligations
• Postretirement Benefits Other Than Pensions
• Commitments and Contingencies
• Hybrid Securities

53
Noncurrent Liabilities (cont.)
Long-Term Debt

• Bonds
• Long-Term Notes Payable
• Mortgages
• Obligations under leases
• Pension Liabilities
• Long-Term Warranties

54
Noncurrent Liabilities (cont.)
Capital Lease Obligations

• Are, in substance, a purchase rather than a
  lease
• Affect both balance sheet and income statement

55
Noncurrent Liabilities (cont.)
Postretirement benefits Other Than Pensions

• Can appear under the liability section of the
  balance sheet
• Can have a significant impact on corporate
  balance sheets
• Can also impact profitability by substantially
  increasing the recognition of annual
  postretirement benefit expense

56
Noncurrent Liabilities (cont.)
Commitments and Contingencies

• Intended to draw attention to the fact that
  required disclosures can be found in the notes to
  the financial statements

57
Noncurrent Liabilities (cont.)
Commitments

• Refer to contractual agreements that will have a
  significant financial impact on the company in
  the future
• For example An operating lease is a common type
  of commitment and is a form of
• off-balance-sheet financing

58
Noncurrent Liabilities (cont.)
Contingencies

• Refer to potential liabilities of the firm such
  as possible damage awards assessed in lawsuits

59
Noncurrent Liabilities (cont.)
Hybrid Securities

• Have the characteristics of both debt and equity
• Some companies have
  mandatorily redeemable preferred stock
  outstanding

For example
60
Stockholders Equity

• Ownership equity is the residual interest in
  assets that remains after deducting liabilities

61
Stockholders Equity (cont.)
Common Stock

• Shareholders
• Do not ordinarily receive a fixed return
• Have voting privileges in proportion to ownership
  interest
• Dividends are declared at the discretion of a
  companys board of directors

62
Stockholders Equity (cont.)
Additional Paid-In Capital

• Reflects the amount by which the original sales
  price of the stock shares exceeded par value

63
Stockholders Equity (cont.)
Retained Earnings

• Is the sum of every dollar a company has earned
  since its inception, less any payments made to
  shareholders in the form of cash or stock
  dividends
• Beginning retained earnings
• Net income (loss) Dividends
• Ending retained earnings

64
Stockholders Equity (cont.)
Other Equity Accounts

• Other accounts that can appear in the equity
  section include
• Preferred stock
• Accumulated other comprehensive income
• Treasury stock

65
Other Balance Sheet Items

• Corporate balance sheets are not limited to the
  accounts described in this chapter
• The reader of annual reports will encounter
  additional accounts and will also find many of
  the same accounts listed under a variety of
  different titles

66
The Journey Through the Maze Continues

• Ch. 3 Income Statement and Statement of
  Stockholders Equity
• Ch. 4 Statement of Cash Flows
• Ch. 5 A Guide to Earnings and Financial
  Reporting Quality
• Ch. 6 The Analysis of Financial Statements