FINANCIAL STATEMENT ANALYSIS

1. 1 FINANCIAL STATEMENT ANALYSIS Lecture 2

2. 2 What is a Balance Sheet? Also called the statement of condition or statement of financial position Shows the financial condition or financial positions of a company on a particular date

3. 3 Financial Condition Continued Assets = What the firm owns Liabilities = What the firm owes to outsiders Stockholder’s equity = Internal owners (also what is left of the assets after all liabilities are covered).

4. 4 Basic Construction i.e., Current Assets Cash Accounts Receivable Inventory Other current assets Property Plant & Equipment Intangibles (Goodwill, patents, etc.)

5. 5 Some General Parameters Financial statements are often CONSOLIDATED (when ownership of operations is greater than 50%) Balance sheet is DATED (end of accounting period): calendar year or fiscal year or interim period (quarter)

6. 6 More General Parameters SEC requirements stipulate some COMPARATIVE DATA is presented (e.g. balances for end of previous year shown on balance sheet)

7. 7 Common-Size Balance Sheet Categories displayed as a % of Total Assets. Good for comparative purposes: Year to year Between companies With industry averages Often displayed in column adjacent to $ figures: i.e., Cash $3,000 30% or 30.0 Property, Plant & Equipment $7,000 70% or 70.0 Total Assets $10,000 100% or 100.0

8. 8 Common-Size balance sheet (cont.) Comparison of two major retail companies* Comparison using $ and % ($ are in millions): Retailer A (%) Retailer B (%) Cash $ 5,488 4.6 $ 2,245 7.0 A/R 1,715 1.4 5,069 15.7 Inventories 29,447 24.5 5,384 16.7 Other current 1,841 1.5 1,224 3.8 Current Assets 38,491 32.0 13,922 43.1 PPE, net 65,408 54.4 16,860 52.2 Other 16,324 13.6 1,511 4.7 Total Assets 120,223 32,293 *Data from SEC website, www.sec.gov

9. 9 Assets (the “left” side) Generally presented in order of liquidity Common Balance Sheet Accounts—Assets Current Assets Cash and Marketable Securities Account Receivables Inventories Prepaid Expenses Long-Term Assets Property, Plant, and Equipment (PP&E) Other Assets and Intangibles

10. 10 Some Definitions Current Assets--Cash or assets expected to be converted to cash within one year or operating cycle, whichever is longer Operating Cycle--Time required to purchase or manufacture inventory, sell the product, and collect the cash (usually less than one year)

11. 11 Working Capital VERY VERY IMPORTANT Working Capital (Net working capital)—designates the amount by which current assets exceed current liabilities Represents the amount of liquid assets a company has available to support day to day operations and build its business. Companies that have a lot of working capital have an advantage since they can expand and improve their operations using existing liquid funds. May be the single most important measure of liquidity.

12. 12 Working Capital Intellicheck (IDN: AMEX) working capital is: $8.5 m (current assets) - $1.9 m (current liabilities) = $6.6m

13. 13 Cash and Marketable Securities Cash in any form—cash awaiting deposit or in a bank account Generally includes currency, coin, balances in checking and other demand or “near demand” accounts

14. 14 Cash and Marketable Securities continued Are cash substitutes Not needed immediately in the business Temporarily invested to earn a return May include T-bills, certificates of deposit, notes, bonds, and commercial paper Many firms group them together as one category

15. 15 Statement of Financial Accounting Standards No. 115 Requires the separation of investment securities into three categories. . .

16. 16 Statement of Financial Accounting Standards No. 115 Con’t. 1. Held to maturity 2. Trading securities 3. Securities available for sale

17. 17 Statement of Financial Accounting Standards No. 115 Con’t. Applies to those debt securities that the firm has the positive intent and ability to hold maturity Are reported at amortized cost Bonds often sell at a premium or discount when the current interest rate is different from the bonds stated rated. The dollar value of this difference must be accounted for by amortizing the amount over the remaining life of the bond. i.e., Own a $100 face value bond maturing in 5 years with a coupon (interest payment) of 5% Current new 5 year bonds pay 4%. So your bond sells at a premium – i.e., $105. Must amortize difference of $5 (105 – 100) over five years, or $1 per year (straight line). Amortization - The process of systematically allocating costs of an asset over its useful life. Essentially depreciation of a non-tangible asset.

18. 18 Statement of Financial Accounting Standards No. 115 Con’t. Are debt and equity securities that are held for resale in the short term Are reported at fair value with unrealized gains and losses included in earnings.

19. 19 Statement of Financial Accounting Standards No. 115 Con’t. Are debt and equity securities that are not classified as one of the other two categories (i.e. securities that may be held for more than a year but probably will not be held to maturity) Are reported at fair value with unrealized gains or losses included in comprehensive income Comprehensive income includes all income (operational and non-operational). It is either reported as part of the Statement of Stockholder’s Equity, or separately (Chapter 3).

20. 20 Statement of Financial Accounting Standards No. 115 Con’t. Does not apply to investments in consolidated subsidiaries nor to investments in equity securities accounted for under the equity method Equity method – when ownership is between 20% and 50% and “influence” is assumed.

21. 21 Accounts Receivable Arise from credit-sale transactions Reported on the balance sheet at NET REALIZABLE VALUE

22. 22 A Word on the “Allowance…” Management must estimate the dollar amount of accounts receivable estimated to be uncollectable - Potential for Manipulation Affects balance sheet valuation AND bad debt expense on income statement Can be important in assessing earnings quality--changes should be analyzed Generally, Allowances between 1% and 5% are not a concern.

23. 23 Inventories Are items held for sale or used in the manufacture of products that will be sold

24. 24 Inventories Continued Retail Company One type of inventory: Finished goods Manufacturing Company Three types of inventories: Raw materials Work-in-process Finished goods

25. 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

26. 26 Inventory Accounting Methods Continued Three cost flow assumptions: FIFO (First In, First Out) LIFO (Last In, First Out) Average cost

27. 27 Inventory Accounting Methods Continued

28. 28 During Inflation Produces the highest COGS expense and the lowest ending inventory valuation Matches current costs to current sales

29. 29 During Inflation Produces the lowest COGS expense and the highest inventory valuation Values ending inventory at current cost

30. 30 FIFO vs. LIFO Example Purchase and Sale of Widgets (retail company)

31. 31 FIFO vs. LIFO Example Purchase and Sale of Widgets (retail company)

32. 32 FIFO vs. LIFO Example Purchase and Sale of Widgets (retail company)

33. 33 FIFO vs. LIFO Example Purchase and Sale of Widgets

34. 34 Inventory Accounting Methods Continued 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 (i.e. every once in a while inventory values are reassessed for “impairment”.)

35. 35 Prepaid Expenses Represent expenses paid in advance (i.e., insurance, rent, taxes, utilities, etc.) -- included in current assets if they expire within one year or operating cycle Usually not a material item

36. 36 Property, Plant, and Equipment (PP&E) Encompasses a company’s 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

37. 37 Property, Plant, and Equipment (PP&E) Continued On any balance sheet date, PP&E is shown at book value Book value = difference between original cost and any accumulated depreciation to date

38. 38 Property, Plant, and Equipment (PP&E) Continued Straight line spreads the expense evenly by periods Accelerated Yields higher depreciation expense in the early years of an asset’s useful life, and lower depreciation expense in the later years Units of production bases depreciation expense for a given period on actual use

39. 39 Property, Plant, and Equipment (PP&E) Continued Comparison among firms can be made difficult with different methods and different estimates Proportion of fixed assets (PP&E) in a company’s asset structure determined by nature of the business (i.e, manufacturing has high PP&E, Consulting firm has low PP&E)

40. 40 Depreciation Methodologies Straight Line – Most often used method (even depreciation over lifetime). Example $10,000 asset depreciated over 5 years - $2,000 per year Accelerated – Double Declining Balance (DDB) - Double the straight-line depreciation amount is taken the first year, and then that same percentage is applied to the undepreciated amount in subsequent years.

41. 41 Depreciation Continued DDB of $10K asset over 5 years Year 1 – ($10,000/5) X 2 = $4,000 $10,000 - $4,000 = $6000 (remaining balance) Year 2 – ($6,000/5) X 2 = $2,400 $6,000 - $2,400 = $3,600 (remaining balance) Etc.

42. 42 Depreciation Continued Sum of The Years’ Digits – Add the value of the year’s digits to get the denominator. (i.e.,1+2+3+4+5=15) $10,000 Asset – Five year deprecation: Year 1 - 5/15 X $10,000 = $3,333.33 Year 2 – 4/15 X $10,000 = $2,666.66 Etc.

43. 43 Sample Depreciation Table

44. 44 Other Assets Can include multitude of other noncurrent items, for example: Property held for sale Start-up costs in connections with a new business Cash surrender value of life insurance policies Long-term advance payments Long-term investments Intangible assets

45. 45 Other Assets—Intangible Most important for analytical purposes Arises when one company acquires another operation (company, division, subsidiary, etc.) for a price in excess of the fair market value of the net identifiable assets acquired (identifiable assets less liabilities assumed) Can also have negative goodwill (when the price paid for an acquisition is less than the fair value of its net assets). Negative goodwill appears in the stockholders' equity section of the balance sheet.

46. 46 Goodwill Continued FASB 142, effective in 2002, has made companies evaluate goodwill and determine whether it has lost value. FASB 142 requires that a company must revalue the assets acquired at least annually. If there is an overall decline in the value of the acquired assets, then earlier booked goodwill is deemed “impaired” and must be written down and a current charge taken against income equal to the write down. FASB 142 allows the write down of goodwill in the first year of its application to be reflected as an extraordinary item, below the line. Thereafter, any impairment charge must be treated as an operating expense.

47. 47 Goodwill Continued What that means is that some corporations will take (and have taken) enormous write-offs when companies they have acquired have lost value For instance, from Arrow Electronics recent year end financial press release – “Effective January 1, 2002 the company adopted Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets." As a result of this new rule, the company recorded an impairment charge of $603.7 million ($6.05 per share) for 2002, which has been recorded as a cumulative effect of a change in accounting principle “

48. 48 Goodwill Continued Earnings may increase for some firms relative to prior years because amortization expense will no longer be recorded

49. 49 Goodwill Continued Companies will also have some discretion in deciding when and how much write-off to take as a result of goodwill impairment

50. 50 Goodwill Continued On the plus side. . . . Firms will not have to deduct amortization expense each year, which will increase earnings for many companies

51. 51 Liabilities Represent claims against assets Current Liabilities include: Accounts Payable Notes Payable Current Portion of Long-Term Debt Accrued Liabilities Unearned Revenue Deferred Taxes

52. 52 Liabilities Continued Short-term obligations in the form of promissory notes to suppliers or financial institutions Reflect the amount extended under a line of credit

53. 53 Liabilities Continued 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

54. 54 Liabilities Continued 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

55. 55 Liabilities Continued Result from accrual basis of accounting Represent expenses that have been INCURRED and thus ACCRUED, but have NOT BEEN PAID in cash In this case, cash flow follows expense recognition

56. 56 Liabilities Continued Example: You contract to have two floors of an office renovated and paid for on a % of completion basis. When the first floor is completed you record an Accrued Liability, even if an invoice has not been prepared.

57. 57 Liabilities Continued Results from a prepayment received in advance for services or products (amount is transferred to revenue account when service/product is delivered) Under accrual accounting, revenue is recognized when EARNED, not when received in cash -- in this case, cash flow precedes revenue recognition

58. 58 Liabilities Continued Example: You are the contractor for the previously mentioned office renovation. The client pays for the first floor renovation before it is completed or invoiced. This is recorded as Unearned Revenue.

59. 59 Liabilities Continued Are the result of temporary differences in the recognition of revenue and expense for taxable income relative to reported income Example (different depreciation methods): Tax Reporting Dif. Pre-Tax earnings $ 100m $ 150m $ 50mTax (35%) $ 35m (paid) $ 53m $ 18m (Def. Liab.) Net Income $ 65m $ 97m $ 32m

60. 60 Deferred Federal Income Taxes Continued The 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

61. 61 Deferred Federal Income Taxes Continued Are when the total amount of expense and revenue recognized will eventually be the same for tax and reporting purposes For example – Straight Line and Double Declining balance ultimately total to the same amount but are different in individual years

62. 62 Deferred Federal Income Taxes Continued 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

63. 63 Deferred Federal Income Taxes Continued Items that cause Deferred Income tax liabilities include: Depreciation methods Retirement benefits Warranties Advertising and sales promotion accruals Inventory valuation methods Special Charges

64. 64  Long-Term Debt (cont.) Bonds Long-Term Notes Payable Mortgages Obligations under leases Pension Liabilities Long-Term Warranties

65. 65 Other Long-Term obligations Capital Lease Obligations Postretirement Benefits Other Than Pensions (i.e, long-term health care coverage for retired employees) Commitments and Contingencies Hybrid Securities (i.e., Convertible Bonds, Preferred Bonds, etc.)

66. 66 Long-Term Debt Continued Are, in substance, a “purchase” rather than a “lease” when any of the four following occur: Ownership transfer to lessee Bargain purchase option Term of 75% or more of economic life Lease payments with present value of 90% or more of fair value Affect both balance sheet and income statement (i.e., amortization of expense)

67. 67 Long-Term Debt Continued Can appear under the liability section of the balance sheet Can have a significant impact on many corporate balance sheets

68. 68 Long-Term Debt Continued Intended to draw attention to the fact that required disclosures can be found in the notes to the financial statements Generally no entry on the balance sheet

69. 69 Long-Term Debt Continued Refer to contractual agreements that will have a significant financial impact on the company in the future This is an area where off-balance sheet financing may be found (i.e., operating leases)

70. 70 Long-Term Debt Continued Refer to potential liabilities of the firm such as possible damage awards assessed in lawsuits

71. 71 Long-Term Debt Continued Have the characteristics of both debt and equity Some companies have mandatorily redeemable preferred stock outstanding

72. 72 Stockholders’ Equity Ownership equity is the residual interest in assets that remains after deducting liabilities. Often referred to as the “Book Value” of the company

73. 73 Stockholders’ Equity Continued Shareholders: Do not ordinarily receive a fixed return but can receive dividends. Have voting privileges in proportion to ownership interest Dividends are declared at the discretion of a company’s board of directors

74. 74 Stockholders’ Equity Continued Reflects the amount by which the original sales price of the stock shares exceeded par value Par value (stock) – From Motley Fool Glossary An arbitrary dollar value that a company assigns to its shares. Par value has no economic significance. The legal significance of par value is, roughly, that if shares are issued below par value, the holders of those shares might be assessed the difference between par value and the issue price. Most stock certificates state that the shares are fully paid and nonassessable to indicate that holders are not on the hook for additional contributions because the shares were issued at a price greater than par value. Companies usually assign a very low par value to common stock. Par value is the “Legal Capital” of the firm. It protects creditors. This minimum level must be maintained and can not be used for dividends. For instance, a firm on the verge of going bankrupt could, in theory, pay an enormous dividend to shareholders. It could not, however, use the Par Value as part of this dividend.

75. 75 Stockholders’ Equity Continued 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

76. 76 Stockholders’ Equity Continued Other accounts that can appear in the equity section are: Preferred stock Accumulated other comprehensive income Treasury stock

77. 77 Stockholders’ Equity Continued 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

78. 78 Asset and Liability Valuationand Income Measurement POSSIBLE BASES: Historical Cost – Acquisition Cost – Adjusted Acquisition Cost (i.e. depreciation) – PV of CF using historical interest rates Current Values – Replacement Cost – Net Realizable Value – PV of CF using current interest rates

79. 79 Present Value of Cash Flow Choice – $1,000 today or $1,000 one year from now Rational Man: Take $1,000 today, invest @ risk adjusted rate (i.e., 5%) – get $1,050 one year later. Hence $1,000 today is worth $1,050 one year from now. Or, $1,000 has a future value of $1,050. Alternatively, $1,050 (cash flow) has a Present Value (PV) of $1,000 using a 5% discount rate/factor.

80. 80 GAAP REQUIRES: Acquisition cost: Prepaid items, land, intangibles with indefinite lives, goodwill (unimpaired) Adjusted acquisition cost: buildings, equipment, intangibles w/limited lives PV of CF historical interest rates: HTM (held to maturity) investments, L/T receivables & payables Asset and Liability Valuationcontinued

81. 81 GAAP REQUIRES (continued): Fair Values: marketable security investments, financial instruments and derivatives, assets/liabilities of business to be discontinued Combination of values: LCM inventories, Impaired assets Asset and Liability Valuationcontinued

82. 82 Income Recognition Possible treatments: Treatment 1 - On both BS and IS when realized (i.e., Other income = net effect of …. Treatment 2 - On BS when value change takes place but not on IS until realized Treatment 3 - On BS and IS when the value change takes place regardless of when realized (in a market transaction – sale or purchase of asset)

83. 83 Income Recognition

84. 84 Accounting for Income Taxes Permanent differences: examples include tax-exempt revenue items, and nondeductible fines/penalties Temporary (or timing) differences: these give rise to deferred tax assets or liabilities. Examples include depreciation and warranty expenses.

85. 85 Accounting for Income Taxes

86. 86 Income Taxes Reported on the income statement in different places Income from continuing operations—income tax expense calculated based on this subtotal Discontinued operations, extraordinary items and changes in accounting principle are reported net of tax

87. 87 An Analytical Framework Assets = Liabilities + Owners’ Equity Cash + Non$assets = Liabilities + Contributed Capital + Accum Other Comprehensive Income + Retained Earnings C + N$A = L + CC + AOCI + RE