Financial Ratios - Financial Risk Ratios

Financial Ratios - Financial Risk Ratios

Financial Risk - This is risk related to the company's financial structure.

I. Analysis of a Company's Use of Debt

1. Debt to Total Capital 
This measures the proportion of debt used given the total capital structure of the company. A large debt-to-capital ratio indicates that equity holders are making extensive use of debt, making the overall business riskier.

Formula 7.32

Debt to capital = total debt                             total capital Where: Total debt = current + long-term debt Total capital = total debt + stockholders' equity

2. Debt to Equity
This ratio is similar to debt to capital.

Formula 7.33

Debt to equity = total debt                          total equity

II. Analysis of the Interest Coverage Ratio

3. Times Interest Earned (Interest Coverage ratio)
This ratio indicates the degree of protection available to creditors by measuring the extent to which earnings available for interest covers required interest payments.

Formula 7.34

Times interest earned = earnings before interest and tax                                                 interest expense

4. Fixed-Charge Coverage
fixed charges are defined as contractual committed periodic interest and principal payments on leases and debt.

Formula 7.35

Fixed-charge coverage = earnings before fixed charges and taxes                                                            fixed charges

5. Times Interest Earned - Cash Basis
adjusted operating cash flow is defined as cash flow from operations + fixed charges + tax payments.

Formula 7.36

Times interest earned - cash basis = adjusted operating cash flow                                                                  interest expense

6. Fixed-Charge Coverage Ratio - Cash Basis

Formula 7.37

Fixed charge coverage ratio - cash basis = adjusted operating cash flow                                                                                fixed charges

7. Capital Expenditure Ratio
Provides information on how much of the cash generated from operations will be left after payment of capital expenditure to service the company's debt. If the ratio is 2, it indicates that the company generates two times what it will need to reinvest in the business to keep operations going; the excess could be allocated to service the debt.

Formula 7.38

Capital expenditure ratio = cash flow from operations                                                   capital expenditures

8. CFO to Debt 
Provides information on how much cash the company generates from operations that could be used to pay off the total debt. Total debt includes all interest-bearing debt, short and long term.

Formula 7.39

CFO to debt = cash flow from operations                                   total debt

Financial Ratios - Internal Liquidity Ratios

1. Current Ratio
This ratio is a measure of the ability of a firm to meet its short-term obligations. In general, a ratio of 2 to 3 is usually considered good. Too small a ratio indicates that there is some potential difficulty in covering obligations. A high ratio may indicate that the firm has too many assets tied up in current assets and is not making efficient use to them.

Formula 7.3

Current ratio = current assets                     current liabilities

2. Quick Ratio
The quick (or acid-test) ratio is a more stringent measure of liquidity. Only liquid assets are taken into account. Inventory and other assets are excluded, as they may be difficult to dispose of.

Formula 7.4

Quick ratio = (cash+ marketable securities + accounts receivables)                                             current liabilities

3. Cash Ratio
the cash ratio reveals how must cash and marketable securities the company has on hand to pay off its current obligations.

Formula 7.5

Cash ratio = (cash + marketable securities)                            current liabilities

4. Cash Flow from Operations Ratio
Poor receivables or inventory-turnover limits can dilute the information provided by the current and quick ratios. This ratio provides a better indicator of a company's ability to pay its short-term liabilities with the cash it produces from current operations.

Formula 7.6

Cash flow from operations ratio = cash flow from operations                                                        current liability

5. Receivable Turnover Ratio
This ratio provides an indicator of the effectiveness of a company's credit policy. The high receivable turnover will indicate that the company collects its dues from its customers quickly. If this ratio is too high compared to the industry, this may indicate that the company does not offer its clients a long enough credit facility, and as a result may be losing sales. A decreasing receivable-turnover ratio may indicate that the company is having difficulties collecting cash from customers, and may be a sign that sales are perhaps overstated.

Formula 7.7

Receivable turnover = net annual sales                               average receivables Where: Average receivables = (previously reported account receivable + current account receivables)/2

6. Average Number of Days Receivables Outstanding (Average Collection Period)

This ratio provides the same information as receivable turnover except that it indicates it as number of days.

Formula 7.8

Average number of days receivables outstanding = 365 days_                                                                        receivables turnover

7. Inventory Turnover Ratio
This ratio provides an indication of how efficiently the company's inventory is utilized by management. A high inventory ratio is an indicator that the company sells its inventory rapidly and that the inventory does not languish, which may mean there is less risk that the inventory reported has decreased in value. Too high a ratio could indicate a level of inventory that is too low, perhaps resulting in frequent shortages of stock and the potential of losing customers. It could also indicate inadequate production levels for meeting customer demand.

Formula 7.9

Inventory turnover = cost of goods sold                              average inventory Where: Average inventory = (previously reported inventory + current inventory)/2

8. Average Number of Days in Stock
This ratio provides the same information as inventory turnover except that it indicates it as number of days.

Formula 7.10

Average number of days in stock = 365                                               inventory turnover

9. Payable Turnover Ratio
This ratio will indicate how much credit the company uses from its suppliers. Note that this ratio is very useful in credit checks of firms applying for credit. Payable turnover that is too small may negatively affect a company's credit rating.

Formula 7.11

Payable turnover = Annual purchases                            Average payables Where: Annual purchases = cost of goods sold + ending inventory - beginning inventory Average payables = (previously reported accounts payable + current accounts payable) / 2

10. Average Number of Days Payables Outstanding (Average Age of Payables)
This ratio provides the same information as payable turnover except that it indicates it by number of days.

Formula 7.12

Average number of days payables outstanding = 365_____                                                                    payable turnover

II. Other Internal-Liquidity Ratios

11. Cash Conversion Cycle
this ratio will indicate how much time it takes for the company to convert collection or their investment into cash. A high conversion cycle indicates that the company has a large amount of money invested in sales in process.

Formula 7.13

Cash conversion cycle = average collection period + average number of days in stock - average age of payables

Cash conversion cycle = average collection period + average number of days in stock - average age of payables

12. Defensive Interval
This measure is essentially a worst-case scenario that estimates how many days the company has to maintain its current operations without any additional sales.

Formula 7.14

Defensive interval = 365 * (cash + marketable securities + accounts receivable)                                                               projected expenditures Where: Projected expenditures = projected outflow needed to operate the company

Financial Ratios - Operating Profitability Ratios

Operating Profitability can be divided into measurements of return on sales and return on investment.

I. Return on Sales

1. Gross Profit Margin
this shows the average amount of profit considering only sales and the cost of the items sold. This tells how much profit the product or service is making without overhead considerations. As such, it indicates the efficiency of operations as well as how products are priced. Wide variations occur from industry to industry.

Formula 7.15

Gross profit margin = gross profit                                 net sales Where: Gross profit = net sales - cost of goods sold

2. Operating Profit Margin
This ratio indicates the profitability of current operations. This ratio does not take into account the company's capital and tax structure.

Formula 7.16

Operating profit margin = operating income                                       net sales Where: Operating income = earnings before tax and interest from continuing operations

3. EBITDA Margin
This ratio indicates the profitability of current operations. This ratio does not take into account the company's capital, non-cash expenses or tax structure.

Formula 7.17

EBITDA margin = earnings before interest, tax, depreciation and amortization                                                   net sales

4. Pre-Tax Margin (EBT margin)
This ratio indicates the profitability of Company's operations. This ratio does not take into account the company's tax structure.

Formula 7.18

Pre-tax margin = Earning before tax                                sales

5. Net Margin (Profit Margin)
This ratio indicates the profitability of a company's operations.

Formula 7.19

Net margin = net income                      sales

6. Contribution Margin
This ratio indicates how much each sale contributes to fixed expenditures.

Formula 7.20

Contribution margin = contribution                                    sales Where: Contributions = sales - variable cost

Financial Ratios - Business Risk Ratios

Business Risk - This is risk related a company's income variance. There is a simple method and more complex method:

I. Simple Method
The following four ratios represent the simple method of business risk calculations. Business risk is the risk of a company making less money, or worse, losing money if sales decrease. In the declining-sales environment, a company would lose money mainly because of its fixed costs. If a company only incurred variable costs, it would never have negative earnings. Unfortunately, all businesses have a component of fixed costs. Understanding a company's fixed-cost structure is crucial in the determination of its business risk. One of the main ratios used to evaluate business risk is the contribution margin ratio.

1. Contribution Margin Ratio
this ratio indicates the incremental profit resulting from a given dollar change of sales. If a company's contribution ratio is 20%, then a $50,000 decline in sales will result in a $10,000 decline in profits.

Formula 7.28

Contribution margin ratio = contribution                                           sales                                          = 1 - (variable cost / sales)

2. Operation Leverage Effect (OLE) 
the operating leverage ratio is used to estimate the percentage change in income and return on assets for a given percentage change in sales volume. Return on sales is the same as return on assets.

If a company has an OLE greater than 1, then operating leverage exists. If OLE is equal to 1 then all costs are variable, so a 10% increase in sales will increase the company's ROA by 10%. 

Formula 7.29

Operation leverage effect = contribution margin ratio                                           return on sales (ROS) Where: ROS = Percentage change in income (ROA) = OLE x % change in sales

3. Financial Leverage Effect (FLE)
Companies that use debt to finance their operations, thus creating a financial leverage effect and increasing the return to stockholders, represent an additional business risk if revenues vary. The financial leverage effect is used to quantify the effect of leverage within a company.

Formula 7.30

Financial leverage effect = operating income                                             net income

If a company has an FLE of 1.33, an increase of 50% in operating income would result in a 67% shift in net income.

4. Total Leverage Effect (TLE)
By combining the OLE and FLE, we get the total leverage effect (TLE), which is defined as:

Formula 7.31

Total leverage effect = OLE x FLE

In our previous example, sales increased by $50,000, the OLE was 20% and FLE was 1.33. The total leverage effect would be $13,333, i.e. net income would increase by $13,333 for every $50,000 in increased sales.

II. Complex Method
Business risk can be analyzed by simply looking at variations in sales and operating income (EBIT) over time. A more structured approach is to use some statistics. One common method is to gather a date set that's large enough (five to 10 years) to calculate the coefficient of variation.

With this approach:

- Business risk = standard deviation of operating income / mean of operating income
- Sales variability = standard deviation of sales / sales mean
- Another source of variability of operating income is the difference between fixed and variable cost. This is referred to as "operating leverage". A company with a large variable structure is less likely to create a loss if revenues decline. The calculation of variability of operating income is complex and beyond CFA level 1.

Liabilities - Current Liability Basics

Liabilities - These are obligations a company owes to outside parties. Liabilities represent others' rights to money or services of the company. Examples include bank loans, debts to suppliers and debts to employees.

Current liabilities - These are debts that are due to be paid within one year or the operating cycle, whichever is longer; further, such obligations will typically involve the use of current assets, the creation of another current liability or the provision of some service.

Long-term liabilities - These are obligations that are reasonably expected to be liquidated at some date beyond one year or one operating cycle. Long-term obligations are reported as the present value of all future cash payments.

Uncertainties Regarding Liability Value
In some cases the timing and/or the total liability may be difficult to estimate:

1. Some companies offer clients a warranty period. The company does not know at the time of the sale who the payee will be. Furthermore, the company does not know when this payment will occur.
2. At year-end some companies will estimate some expenses, and recognize some liabilities such as pension benefits.

Recording and Reporting Estimated and Contingent Liabilities
Liabilities whose timing and amount are known can easily be accounted for. But others - such as warranties, taxes, vacation-pay liability and contingent liabilities, among others - require some estimation.

Warranties
when a company sells a product, it sometimes offers its customers a warranty of a certain number of years. To be consistent with the matching principle, companies, at the time of the sale, must estimate an amount that must be allocated to the costs associated with the warranties. Most companies will use a historical or industry average to estimate its warranty cost. The estimated warranty cost or liability will be allocated to the estimated warranty liability. For example, say Company ABC sells 100 appliances at $100 and estimates that each appliance will carry a $10 warranty liability.
Journal entry:

Taxes
Due to timing differences, companies will report deferred income tax liabilities. These are taxes that have not yet been paid but are expected to be paid in the future. For example, say Company ABC estimates its tax bill will total $500. At year-end it has an actual tax bill of $600.

Vacation-pay Liability
This liability arises when employees do not take their vacation during an accounting period. Even though they have not taken their vacation, they are still entitled to them, and the result is a future liability.

For example, say an executive has three weeks of earned but unfulfilled vacation days, which have a total value to $10,000.

Contingent Liabilities
Contingent liabilities are liabilities that will materialize if some future event occurs and are contingent on a specific outcome. The most frequent contingent liability is a pending lawsuit against the company, which will materialize only if the firm is found guilty. Pending lawsuits can be significantly large for some companies, especially those involved in large class action lawsuits with hundreds or even thousands of potential plaintiffs. Examples of these industries include pharmaceuticals, oil companies or any company that produces large amounts of products that can harm consumers.

The disclosure and/or inclusion of contingent liabilities in a company's financial statements will depend on the company's ability to estimate the amount of the liability and the likelihood that it will occur.

Rules for classifying liabilities:

• If the liability is probable and can be reasonably estimated, it must be included in the company's financial statements. The loss will be included in the financial statements, and the liability must be included on the balance sheet.
• If the liability is probable but cannot be reasonably estimated, then only a footnote disclosure is required.
• If the liability is not probable and cannot be reasonably estimated, then no disclosure is required.

Financial Statements - Financial Statement Analysis

A. Financial Statement Analysis
The income statement is a statement of earnings that shows managers and investors whether the company made money over the period of time being reported. This statement details the revenues of the firm as well as the expenses incurred to achieve them, and transforms this into net income. The conclusion of the statement is to show the firm's gains or losses for the period.
The balance sheet reports the company's financial position at a specific point in time. The balance sheet is made up of three parts: assets, liabilities and owners' equity. Assets detail the firm's economic resources that have been built up through the firm's operations or acquisitions. Liabilities are the current or estimated obligations of the firm. The difference between assets and liabilities is known as net assets or net worth of the firm. The net assets of the firm are also known as owners' equity, which is amount of assets that would remain once all creditors are paid. According to the accounting equation, owners' equity equals assets minus liabilities

Assets – Liabilities = Owners' Equity

The statement of cash flows reconciles the firm's net income to its reports on the company's cash inflows and outflows. It shows how changes in balance sheet accounts and income affect cash and cash equivalents. These cash receipts and payments are categorized as by operating cash flows, investing cash flows and financing cash flows
The statement of changes in owners' equity reports the sources and amounts of changes in owners' equity over the period of time being reported
Let's consider a practical example to fully understand the impact of Cash versus Accrual Accounting on XYZ Corporation's Income Statement and Balance Sheet.

Cash Basis Accounting
Taken as is, the financial statements in Figure 6.1 below indicate that XYZ Corporation is not doing well, with a net loss of $43,200, and may not be a good investment opportunity. 

Figure 6.1: XYZ Corporation's Financial Statements using Cash Basis Accounting

Note: For simplicity the tax effect not considered.

Accrual Basis Accounting
Armed with some additional information, let's see what the income statement would look like if the accrual-basis accounting method was used. 

Additional Information:

A1. June 12, 2005 - The company received a rush order for $80,000 of wood panels. The order was delivered to the customer five days later. The customer was given 30 days to pay. (With the cash-basis method, sales are not recorded in the income statement and not recorded in accounts receivables: no cash, no record).

A2. June 13, 2003 - The company received $60,000 worth of wood panels to replenish their inventory, and $40,000 was related to the rush order. The company paid the invoice in full to take advantage of a 2% early-payment discount. (With the cash-basis method, this is recorded in full on the income statement, and there is no record of inventory on hand).
A3. June 1, 2005 - The Company launched an advertising campaign that will run until the end of August. The total cost of the advertising campaign was $15,000 and was paid on June 1, 2005. 

Figure 6.2: XYZ Corporation's Restated Financial Statements using Accrual Basis Accounting

Note: tax effect not considered

Adjustments:
To obtain the figures in the restated financial statements in figure 6.2 above, the following adjusting entries were made:

A1. Product sales and Accounts receivable - Even though the client has not paid this invoice, the company still made a sale and delivered the products. As a result, sales for the accounting period should increase by $80,000. Account s receivables (reported sales made but awaiting payment) should also increase by $80,000. 

Adjusting entries:

A2. June 13, 2003 - Since the entire $60,000 order was paid during the accounting period, the full amount was included in production costs under the cash-basis method. Only $40,000 of the order was related to product sales during that accounting period, and the rest was stored as inventory for future product sales. 

Adjusting entries:

A3. June 1, 2005 - Marketing expenses included in the income statement totaled $15,000 for a three-month advertising campaign because it was paid in full at initiation (cash-basis accounting). The reality is that this campaign will last for three months and will generate a benefit for the company every month. As a result, under accrual-basis accounting, the company should record in this accounting period only one-third of the cost. The remainder should be allocated to the next period and recoded as prepaid expenses on the assets side of the balance sheet. 

Adjusting entries:

Results:

Under cash-basis accounting, this company was not profitable and its balance sheet would have been weak at best. Under accrual accounting, the financials tell us a very different story.

Accrual accounting requires that revenue is recorded when the firm earns it, and that expenses are taken when the firm incurs them regardless of when the cash is actually received or paid. If cash is received first then an unearned revenue or prepaid expense account is set up and decreased as the revenue and expense is recorded over time. If cash is received after goods are delivered then the revenue and expense is recorded and a receivables or payables account is set up and decreased as the cash is paid. Most accruals fall into one of four categories:

1. Accrued Revenues: A firm will usually earn revenue before it is actually paid for its goods or services. Typically the asset account for accounts receivable is increased until the customer actually pays for goods that have been invoiced. The company records the revenue when the goods are delivered and invoiced. The accounts receivable account is decreased when the customer pays the invoice in cash.

2. Unearned Revenue: Some firms collect income before goods are provided. Subscriptions are examples of goods that are prepaid, but the revenue is not recognized until the goods are delivered. In this situation the firm increases the asset account cash and a liability account for unearned income. Unearned income is decreased as revenue is earned over time.

3. Accrued Expenses: Most firms buy inventories and supplies on account and pay for them after they have been invoiced. When the goods are delivered and equal amount is recorded in the expense account and in accounts payable. When the invoice is paid, cash and the accounts payable account are decreased.

4. Prepaid Expenses: Some companies pay some expenses in advance. A prepaid expanse account is increased and the actual expense is not recorded until the actual goods or services are delivered.

Look Out! Debit:An accounting term that refers to an entry that increases an expense or asset account, or decreases an income, liability or net-worth account. Credit: An accounting term that refers to an entry that decreases an expense or asset account, or increases an income, liability or net-worth account.

Look Out! Going forward, all statements will use accrual-basis accounting. Please note that on the exam, candidates should assume that all financial statements use accrual-basis accounting, unless it is specified that the cash-basis accounting method is used in the question.

Financial Statements - Income Statement Basics

I. Basics
within this basics section, we will define each component of a multi-step income statement, and prepare a multi-step income statement.

Multi-Step Income Statement
a multi-step income statement is a condensed statement of income as opposed to a single-step format, which is the more detailed format. Both single and multi-step formats conform to GAAP standards. Both yield the same net income figure.

The main difference is how they are formatted, not how figures are calculated.

Figure 6.3: Multi-Step Income Statement

• Sales - These are defined as total sales (revenues) during the accounting period. Remember these sales are net of returns, allowances and discounts
• Cost of goods sold (COGS) - These are all the direct costs related to the product or rendered service sold and recorded during the accounting period. (Reminder: matching principle.)
• Operating expenses - These include all other expenses that are not included in COGS but are related to the operation of the business during the specified accounting period. This account is most commonly referred to as "SG&A" (sales general and administrative) and includes expenses such as selling, marketing, administrative salaries, sales salaries, maintenance, administrative office expenses (rent, computers, accounting fees, legal fees), research and development (R&D), depreciation and amortization, etc.
• Other revenues & expenses - These are all non-operating expenses such as interest earned on cash or interest paid on loans.
• Income taxes - This account is a provision for income taxes for reporting purposes.

Financial Statements - Accounting Process

Accounting Process
Accounting systems take the cash and accruals from various transactions and generate financial reports and statements. Information flows through an accounting system in four steps:

1. the first step is to create journal entries and adjusting entries. The general journal is list of each transaction, the amount, and the accounts affected in chronological order. At the end of accounting periods adjustments are made to record accruals not yet made.

2. The general ledger show the journal entries sorted by the accounts affected rather than in chronological order. This can be useful for reviewing the activity in a specific account.

3. At the end of the accounting period an initial trial balance is prepared lists the ending balance of each account on a given date. If needed, adjusting entries are recorded in an adjusted trial balance.

4. The financial statements are prepared as a final product of the system, based on the totals from an adjusted trial balance.

Security Analysis
in conducting security analysis, an analyst cannot solely rely on the financial statements. Financial reporting is affected by the choice of accounting methods, and the estimates that management uses to determine the value of assets. In order to get a good understanding of the earnings potential of a business, an analyst must understand the accounting process used to produce the financial statements to better understand the business and the results for the period.
Since much of the detail information on management's accruals, adjustments and estimates is contained in the footnotes to the statements and Management's Discussion and Analysis, it is imperative that the analyst review these sections of the financial statements. Using this information an analyst should determine: 

• The various accruals, adjustments and assumptions that went into the financial statements.
• The detailed information that underlies the company's accounting system.
• How well the financial statements reflect the company's true performance.
• How the data needs to be adjusted for the analyst's own analysis

Because adjustments and assumptions are at the discretion of management, analysts should always be on the lookout for possible financial statement manipulation and any situation that might incent management to falsify or misrepresent the actual operations of the firm

Financial Statements - Balance Sheet Components - Assets

Total Assets
Total assets on the balance sheet are composed of:

1. Current Assets - These are assets that may be converted into cash, sold or consumed within a year or less. These usually include:

• Cash - This is what the company has in cash in the bank. Cash is reported at its market value at the reporting date in the respective currency in which the financials are prepared. (Different cash denominations are converted at the market conversion rate.
• Marketable securities (short-term investments) - These can be both equity and/or debt securities for which a ready market exist. Furthermore, management expects to sell these investments within one year's time. These short-term investments are reported at their market value.
• Accounts receivable - This represents the money that is owed to the company for the goods and services it has provided to customers on credit. Every business has customers that will not pay for the products or services the company has provided. Management must estimate which customers are unlikely to pay and create an account calledallowance for doubtful accounts.Variations in this account will impact the reported sales on the income statement. Accounts receivable reported on the balance sheet are net of their realizable value (reduced byallowance for doubtful accounts).
• Notes receivable - This account is similar in nature to accounts receivable but it is supported by more formal agreements such as a "promissory notes" (usually a short term-loan that carries interest). Furthermore, the maturity of notes receivable is generally longer than accounts receivable but less than a year. Notes receivable is reported at its net realizable value (what will be collected).
• Inventory - This represents raw materials and items that are available for sale or are in the process of being made ready for sale. These items can be valued individually by several different means - at cost or current market value - and collectively by FIFO (first in, first out), LIFO (last in, first out) or average-cost method. Inventory is valued at the lower of the cost or market price to preclude overstating earnings and assets.
• Prepaid expenses - These are payments that have been made for services that the company expects to receive in the near future. Typical prepaid expenses include rent, insurance premiums and taxes. These expenses are valued at their original cost (historical cost).

2. Long-term assets - These are assets that may not be converted into cash, sold or consumed within a year or less. The heading "Long-Term Assets" is usually not displayed on a company's consolidated balance sheet. However, all items that are not included in current assets are long-term Assets. These are:

• Investments - These are investments that management does not expect to sell within the year. These investments can include bonds, common stock, long-term notes, investments in tangible fixed assets not currently used in operations (such as land held for speculation) and investments set aside in special funds, such as sinking funds, pension funds and plan-expansion funds. These long-term investments are reported at their historical cost or market value on the balance sheet.
• Fixed assets - These are durable physical properties used in operations that have a useful life longer than one year. This includes:
• Machinery and equipment - This category represents the total machinery, equipment and furniture used in the company's operations. These assets are reported at their historical cost less accumulated depreciation.
• Buildings (plants) - These are buildings that the company uses for its operations. These assets are depreciated and are reported at historical cost less accumulated depreciation.
• Land - The land owned by the company on which the company's buildings or plants are sitting on. Land is valued at historical cost and is not depreciable under U.S. GAAP
• Other assets - This is a special classification for unusual items that cannot be included in one of the other asset categories. Examples include deferred charges (long-term prepaid expenses), non-current receivables and advances to subsidiaries.
• Intangible assets - These are assets that lack physical substance but provide economic rights and advantages: patents, franchises, copyrights, goodwill, trademarks and organization costs. These assets have a high degree of uncertainty in regard to whether future benefits will be realized. They are reported at historical cost net of accumulated depreciation.

The value of an identifiable intangible asset is based on the rights or privileges conveyed to its owner over a finite period, and its value is amortized over its useful life. Identifiable intangible assets include patents, trademarks and copyrights. Intangible assets that are purchased are reported on the balance sheet at historical cost less accumulated amortization.

An unidentifiable intangible asset cannot be purchased separately and may have an infinite life. Intangible assets with infinite lives are not amortized, and are tested for impairment annually, at least. Goodwill is an example of an unidentifiable intangible asset. Goodwill is recorded when one company acquires another at an amount that exceeds the fair market value of its net identifiable assets. It represents the premium paid for the target company's reputation, brand names, customers, suppliers, human capital, etc. When computing financial ratios, goodwill and the offsetting impairment charges are usually removed from the balance sheet.

Certain intangible assets that are created internally such as research and development costs are expensed as incurred under U.S. GAAP. Under IFRS, a firm must identify if the R&D cost is in the research and development stage. Costs are expensed in the research stage and capitalized during the development stage.

Look Out! These assets are listed in order of their liquidity and tangibility. Intangible assets are listed last since they have high uncertainty and liquidity.

Financial Statements - Balance Sheet Basics

I. Basics
Within this section we'll define each asset and liability category on the balance sheet, and prepare a classified balance sheet

Balance Sheet Categories
The balance sheet provides information on what the company owns (its assets), what it owes (its liabilities) and the value of the business to its stockholders (the shareholders' equity) as of a specific date.

Total Assets = Total Liabilities + Shareholders' Equity

• Assets are economic resources that are expected to produce economic benefits for their owner.
• Liabilities are obligations the company has to outside parties. Liabilities represent others' rights to the company's money or services. Examples include bank loans, debts to suppliers and debts to employees.
• Shareholders' equity is the value of a business to its owners after all of its obligations have been met. This net worth belongs to the owners. Shareholders' equity generally reflects the amount of capital the owners have invested, plus any profits generated that were subsequently reinvested in the company.

Look Out! Components of Total Assets on the balance sheet are listed in order of liquidity and maturity.

Balance Sheet Presentation Formats
Although there are no required reporting balance sheet designs there are two customary formats that are used, the account format and the report format. The two formats follow the accounting equation by subtotaling assets and showing that they equal the combination of liabilities and shareholder's equity. However, the report format presents the categories in one vertical column, while the report format places assets in one column on the left hand side and places liabilities and shareholder's equity on the right. Both formats can be collapsed further into a classified balance sheet that subtotals and shows only similar categories such as current assets, noncurrent assets, current liabilities, noncurrent liabilities, etc.

Balance Sheet Components - Assets

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Financial Statements - Balance Sheet Components - Marketable & Nonmarketable Instruments

Marketable & Nonmarketable Instruments
Financial instruments are found on both sides of the balance sheet. Some are contracts that represent the asset of one company and the liability of another. Financial assets include investment securities like stocks and bonds, derivatives, loans and receivables. Financial liabilities include derivatives, notes payable and bonds payable. Some financial instruments are reported on the balance sheet at fair value (marking to market), while others are reported at present value or at cost. The FASB recently issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities," which allows any firm the ability to report almost any financial asset or liability at fair value. Marketable investment securities are classified as one of the following:

• Held to Maturity Securities: Debt securities that are acquired with the intention of holding them until maturity. They are reported at cost and adjusted for the payment of interest. Unrealized gains or losses are not reported.
• Trading Securities: Debt and equity securities that are acquired with the intention to trade them in the near term for a profit. Trading securities are reported on the balance sheet at fair value. Unrealized gains and losses before the securities are sold are reported in the income statement.
• Available for Sale Securities: are debt and equity securities that are not expected to be held until maturity or sold in the near term. Although like trading securities, available for sale securities are reported on the balance sheet at fair value, unrealized gains and losses are reported as other income as part of stockholder's equity.

With all three types of financial securities, income in the form of interest and dividends, as well as realized gains and losses when they are sold, are reported in the income statement.

The following are measured at fair value:

Assets	Liabilities
Financial assets held for trading	Financial assets held for trading
Financial assets available for sale	Derivatives
Derivatives	Non-derivative instruments hedged by derivatives
Non-derivative instruments hedged by derivatives

The following are measured at cost or amortized cost:

Assets	Liabilities
Unlisted instruments	All other liabilities (accounts payable, notes payable)
Held-to-maturity investments
Loans and receivables

Shareholders' (Stockholders') Equity Basics

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Financial Statements - Cash Flow Statement Basics

Statement of Cash Flow
The statement of cash flow reports the impact of a firm's operating, investing and financial activities on cash flows over an accounting period. The cash flow statement is designed to convert the accrual basis of accounting used in the income statement and balance sheet back to a cash basis.

The cash flow statement will reveal the following to analysts:

1. How the company obtains and spends cash
2. Why there may be differences between net income and cash flows
3. If the company generates enough cash from operation to sustain the business
4. If the company generates enough cash to pay off existing debts as they mature
5. If the company has enough cash to take advantage of new investment opportunities

Segregation of Cash Flows
The statement of cash flows is segregated into three sections:

1. Operating activities
2. Investing activities
3. Financing activities

1. Cash Flow from Operating Activities (CFO)
CFO is cash flow that arises from normal operations such as revenues and cash operating expenses net of taxes.

This includes: 

• Cash inflow (+)
1. Revenue from sale of goods and services
2. Interest (from debt instruments of other entities)
3. Dividends (from equities of other entities)
• Cash outflow (-)
1. Payments to suppliers
2. Payments to employees
3. Payments to government
4. Payments to lenders
5. Payments for other expenses

2. Cash Flow from Investing Activities (CFI)
CFI is cash flow that arises from investment activities such as the acquisition or disposition of current and fixed assets.

This includes: 

• Cash inflow (+)
1. Sale of property, plant and equipment
2. Sale of debt or equity securities (other entities)
3. Collection of principal on loans to other entities
• Cash outflow (-)
1. Purchase of property, plant and equipment
2. Purchase of debt or equity securities (other entities)
3. Lending to other entities

3. Cash flow from financing activities (CFF)
CFF is cash flow that arises from raising (or decreasing) cash through the issuance (or retraction) of additional shares, short-term or long-term debt for the company's operations. This includes:

• Cash inflow (+)
1. Sale of equity securities
2. Issuance of debt securities
• Cash outflow (-)
1. Dividends to shareholders
2. Redemption of long-term debt
3. Redemption of capital stock

Reporting Noncash Investing and Financing Transactions
Information for the preparation of the statement of cash flows is derived from three sources:

1. Comparative balance sheets
2. Current income statements
3. Selected transaction data (footnotes)

Some investing and financing activities do not flow through the statement of cash flow because they do not require the use of cash.

Examples Include:

• Conversion of debt to equity
• Conversion of preferred equity to common equity
• Acquisition of assets through capital leases
• Acquisition of long-term assets by issuing notes payable
• Acquisition of non-cash assets (patents, licenses) in exchange for shares or debt securities

Though these items are typically not included in the statement of cash flow, they can be found as footnotes to the financial statements

Financial Statements - The Cash Flow Statement

I. Introduction

Components and Relationships Between the Financial Statements
It is important to understand that the income statement, balance sheet and cash flow statement are all interrelated.

The income statement is a description of how the assets and liabilities were utilized in the stated accounting period. The cash flow statement explains cash inflows and outflows, and will ultimately reveal the amount of cash the company has on hand; this is reported in the balance sheet as well.

We will not explain the components of the balance sheet and the income statement here since they were previously reviewed.

Figure 6.13: The Relationship between the Financial Statements

Cash Flow Statement Basics

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Financial Statements - Cash Flow Computations - Indirect Method

Under U.S. and ISA GAAP, the statement of cash flow can be presented by means of two ways:

1. The indirect method
2. The direct method

The Indirect Method
The indirect method is preferred by most firms because is shows a reconciliation from reported net income to cash provided by operations.

Calculating Cash flow from Operations
Here are the steps for calculating the cash flow from operations using the indirect method:

1. Start with net income.
2. Add back non-cash expenses.
• (Such as depreciation and amortization)
3. Adjust for gains and losses on sales on assets.
• Add back losses
• Subtract out gains
4. Account for changes in all non-cash current assets.
5. Account for changes in all current assets and liabilities except notes payable and dividends payable.

In general, candidates should utilize the following rules:

• (Such as depreciation and amortization)

The following example illustrates a typical net cash flow from operating activities:

Cash Flow from Investment Activities
Cash Flow from investing activities includes purchasing and selling long-term assets and marketable securities (other than cash equivalents), as well as making and collecting on loans.

Here's the calculation of the cash flows from investing using the indirect method:

Cash Flow from Financing Activities
Cash Flow from financing activities includes issuing and buying back capital stock, as well as borrowing and repaying loans on a short- or long-term basis (issuing bonds and notes). Dividends paid are also included in this category, but the repayment of accounts payable or accrued liabilities is not.

Here's the calculation of the cash flows from financing using the indirect method:

Cash Flow Computations - Direct Method

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Financial Statements - Setting and Enforcing Global Accounting Standards

What is the International Organization of Securities Commissions (IOSCO)

Although the IFRS and GAAP frameworks are different, they usually agree in the overall structure and principle and are working toward convergence. The two differ in the following ways:

• IFRS requires users to consider the general principles in the absence of specific standards.
• US GAAP distinguishes between objectives for business and non-business entities.
• The IASB framework gives more emphasis to the importance of the accrual and going concern assumptions than FASB
• GAAP framework establish a hierarchy of qualitative financial statement characteristics;
• Some differences in how each defines, recognizes, and measures individual elements of financial statements
• Companies reporting under standards other than GAAP that trade in USA must reconcile their statements with GAAP.

The International Accounting Standard Board (IASB)
The IASB structure's main features are:

- the IASC Foundation - which is an independent organization whose two main bodies are the Trustees and the IASB
- a Standards Advisory Council
- the International Financial Reporting Interpretations Committee

The IASC Foundation Trustees appoint the IASB members, exercise oversight and raise the funds needed, but the IASB has sole responsibility for setting accounting standards. This organization was created to set international accounting standards in an effort to bridge the gap between the accounting standards of different nations. 

U.S. GAAP versus IAS GAAP

Under U.S. GAAP, SFAS 95:
- Dividends paid by a company to its shareholders are classified on the cash flow statement under cash flow from financing. 
- The dividends received by a company from its investments are classified as cash flow from operations. 
- All interests received and paid by or to a company are classified as cash flow from operations.

Under IAS GAAP:
- Dividends paid by a company to its shareholders, dividends received by a company from its investments and all interests received and paid by or to a company can be classified as either cash flow from financing or cash flow from operations. 

These rules are summarized in the following chart:

	U.S. GAAP	IAS GAAP
Dividends paid by a company to shareholders	Cash Flow from Financing	Cash Flow from Financing or Operations
Dividends received by a company from investments	Cash Flow from Operations	Cash Flow from Financing or Operations
All interest received and paid by or to a company	Cash Flow from Operations	Cash Flow from Financing or Operations

Look Out! It is highly likely you will need to calculate a figure on a cash flow statement according to one of the two rules.

Financial Statements - Financial Reporting Objectives and Enforcement

I. Financial Reporting Objectives

There are six steps in completing the financial analysis framework:

1. The first step is to determine the scope and purpose of the analysis. When stating the objective and context, definitive goals should be stated as well as what form the analysis will take and what resources will be required to complete it.
2. In order to complete the analysis the analyst must gather data. In addition to the financial data, a physical inspection should be completed and company stakeholders should be interviewed, if applicable.
3. Analysts must then process the data and make adjustments to the financial statements, to assumptions or estimates, and any other necessary calculations.
4. Once the data has been reviewed and updated then the analyst must analyze and interpret it to determine if the analysis achieves the original goals that were set in the first step.
5. Once the analysis has been completed then the analyst must report the conclusions or recommendations and communicate it to the appropriate audience.
6. Since the factors and assumptions made in the analysis are subject to change over time, the analyst should update the analysis periodically, to see if the conclusions or recommendations change.

Objectives of Financial Reporting
Objectives of financial reporting identified in SFAC 1 are to do the following:

• They are to provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. (Note the FASB's emphasis on investors and creditors as primary users. However, this does not exclude other interested parties.)
• They are to provide information to help present and potential investors and creditors and other users in assessing the amounts, timing and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sale, redemption or maturity of securities or loans. (Emphasize the difference between the cash basis and the accrual basis of accounting.)
• They are to provide information about the economic resources of an enterprise, the claims on those resources and the effects of transactions, events and circumstances that change its resources and claims to those resources.

The main barrier to convergence or one universally accepted set of financial standards is the fact that the international boards that set standards cannot agree on the best way to deal with particular issues or situations affecting the preparation of financial statements. Different local issues often take priority over determining ways to deal with international accounting problems. The political environment and the resultant political pressure on governmental standards authorities also create an impediment to a global standards framework.

The major standard setting authorities such as the International Accounting Standards Board and the U.S. Financial Accounting Standards Board, the International Organization of Securities Commissions, the U.K. Financial Services Authority, and the U.S. Securities and Exchange Commission all have their own projects to solve domestic financial accounting and performance reporting issues. However, international convergence has become a greater priority as more foreign companies become available for investment

II. Enforcing and Developing U.S. GAAP

FASB Role in Enforcing and Developing U.S. GAAP
The Financial Accounting Standards Board (FASB) is a nongovernmental body. This board sets the accounting standards for all companies that issue audited U.S. GAAP-compliant financial statements.

Both the Securities Exchange Commission (SEC) and American Institute of Certified Public Accountants (AICPA) recognize that the Statement of Financial Accounting Standards (SFAS) statements as authoritative.

GAAP comprises a set of principles that are patterned over a number of sources including the FASB, the Accounting Principles Board (APB) and the AICPA research bulletins.

Prior to the creation of the FASB, the Accounting Principles Board (APB) set the accounting standards. As a result some of these standards are still in use.

SEC Role in Enforcing and Developing U.S. GAAP
The form and content of the financial statements of public companies are governed by the SEC. Even though the SEC delegates most of the authority to the FASB, it frequently adds its own requirements, such as the requirement for a company to provide a management discussion and analysis with its financial statements, quarterly financial statements (10-Q) and current reports (8-K). These discussions indicate things like changes in control, acquisition and divestitures, etc.)

Accounting Pronouncements Considered Authoritative
Accounting pronouncements are segmented into four categories. Category A is the most authoritative, and Category D is the least authoritative:

Category (A)
- FASB Standards and Interpretations
- APB Opinions and Interpretations
- CAP Accounting Research Bulletins

Category (B)
- AICPA Accounting and Audit Guides
- AICPA Statements of Position
- FASB Technical Bulletins

Category (C)
- FASB Emerging Issues Task Force
- AICPA AcSEC Practice Bulletins

Category (D)
- AICPA Issues Papers
- FASB Concepts Statements
- Other authoritative pronouncements

Financial Statements - The Auditor and Audit Opinion

The Auditor
An audit is a process for testing the accuracy and completeness of information presented in an organization's financial statements. This testing process enables an independent Certified Public Accountant (CPA) to issue what is referred to as "an opinion" on how fairly a company's financial statements represent its financial position and whether it has complied with generally accepted accounting principles.

Look Out! Note: Only independent auditors (CPAs) can produce audited financial statements. That is, the company's board members, staff and their relatives cannot perform audits because their relationship with the company compromises their independence.

The audit report is addressed to the board of directors as the trustees of the organization. The report usually includes the following:

• a cover letter, signed by the auditor, stating the opinion.
• the financial statements, including the balance sheet, income statement and statement of cash flows
• notes to the financial statements

In addition to the materials included in the audit report, the auditor often prepares what is called a "management letter" or "management report" to the board of directors. This report cites areas in the organization's internal accounting control system that the auditor evaluates as weak.

What Does the Auditor Do?
The auditor will request information from individuals and institutions to confirm:

• bank balances
• contribution amounts
• conditions and restrictions
• contractual obligations
• monies owed to and by the organization.

To ensure that all activities with significant financial implications is adequately disclosed in the financial statements the auditor will review:

• physical assets
• journals and ledgers
• board minutes

In addition, the auditor will also:

• select a sample of financial transactions to determine whether there is proper documentation and whether the transaction was posted correctly into the books
• interview key personnel and read the procedures manual, if one exists, to determine whether the organization's internal accounting control system is adequate

The auditor usually spends several days at the organization's office looking over records and checking for completeness.

Auditor Responsibility
Auditors are not expected to guarantee that 100% of the transactions are recorded correctly. They are required only to express an opinion as to whether the financial statements, taken as a whole, give a fair representation of the organization's financial picture. In addition, audits are not intended to discover embezzlements or other illegal acts. Therefore, a "clean" or unqualified opinion should not be interpreted as assurance that such problems do not exist.

The standard auditor's opinion contains three parts and states that:
• the preparation of the financial statements are the responsibility of management, and that the auditor has performed an independent review.
• Generally accepted auditing procedures were followed, providing reasonable assurance that the statements do not contain any material errors.
• The auditor is satisfied that the statements were prepared in accordance with accepted accounting procedures and that any assumptions or estimates used are reasonable.

An unqualified opinion indicates that the auditor believes that the statements are free from any material errors or omissions

The Qualified Opinion
A qualified opinion is issued when the accountant believes the financial statements are, in a limited way, not in accordance with generally accepted accounting principles. A qualified option may be issued if the auditor has concerns about the going-concern assumption of the company, the valuation of certain items on the balance sheet or some unreported pending contingent liabilities.

An adverse opinion is issued if the statements are not presented fairly or do not conform to generally accepted accounting procedures.

Internal Controls
Under U.S. GAAP, the auditor must provide its judgment about the company's internal controls, or the processes the company uses to ensure accurate financial statements.

Under the Sarbanes-Oxley act, management is supposed to make a statement about its internal controls including the following:

• A statement declaring that the financial statements are presented fairly;
• A statement declaring that management is responsible for maintaining and executing effectual internal controls;
• A description of the internal control system and how it is evaluated;
• An analysis of how effective the internal controls have been over the last year;
• A statement declaring that the auditors have review management's report on its internal controls

Financial Statements - Management Discussion and Analysis & Financial Statement Footnotes

I. Management Discussion and Analysis
The Securities Exchange Commission (SEC) requires this section to be included with the financial statements of a public company and is prepared by management

This narrative section usually includes the following;

• A description of the company's primary business segments and future trends
• A review of the company's revenues and expenses
• Discussions pertaining to the sales and expense trends
• Review of cash flow statements and future cash flow needs including current and future capital expenditures
• A review of current significant balance sheet items and future trends, such as differed tax liabilities, among others
• A discussion and review of major transactions (acquisitions, divestitures) that may affect the business from an operational and cash flow point of view
• A discussion and review of discontinued operations, extraordinary items and other unusual or infrequent events

Financial Statement Footnotes
These footnotes are additional information provided to the reader in an effort to further explain what is displayed on the consolidated financial statements.

Generally accepted accounting principles (GAAP) and the SEC require these footnotes. The information contained in these footnotes help the reader understand the amounts, timing and uncertainty of the estimates reported in the consolidated financial statements.

Included in the footnotes are the following:

• A summary of significant accounting policies such as:
• The revenues-recognition method used
• Depreciation methods and rates
• Balance sheet and income statement breakdown of items such as:
• Marketable securities
• Significant customers (percentage of customers that represent a significant portion of revenues)
• Sales per regions
• Inventory
• Fixed assets and Liabilities (including depreciation, inventory, accounts receivable, income taxes, credit facility and long-term debt, pension liabilities or assets, contingent losses (lawsuits), hedging policy, stock option plans and capital structure.

Supplemental schedules often detail disclosures required by audited statements, as well as the accounting methods and assumptions used by management. Supplemental schedules can include information such as natural resources reserves, an overview of specific business lines, or the segmentation of income or other line items by geographical area or customer distribution.

Management's Discussion and Analysis (MD&A) presents management's perspective on the financial performance and business condition of the firm. U.S. publicly-held companies must provide MD&As that include a discussion of the operations of the company in detail by usually comparing the current period versus prior period

Analyst Interpretation
As reporting standards continue to change and evolve, analysts must be aware of new accounting approaches and innovations that can affect how businesses treat certain transactions, especially those that have a material impact on the financial statements. Analysts should use the financial reporting framework to guide them on how to determine the financial statement impact of new types of products and business operations.

One way to keep up to date on evolving standards and accounting methods is to monitor the standard setting bodies and professional organizations like the CFA Institute that publish position papers on the subject.

Companies that prepare financial statements under IFRS or US GAAP must disclose their accounting policies and estimates in the footnotes, as well as any policies requiring management's judgment in the management's discussion and analysis. Public companies must also disclose their estimates for the impact of newly adopted policies and standards on the financial statements.

Financial Statements - Accounting Qualities

1) Primary qualities of useful accounting information:

- Relevance - Accounting information is relevant if it is capable of making a difference in a decision.

Relevant information has:
(a) Predictive value
(b) Feedback value
(c) Timeliness

- Reliability - Accounting information is reliable to the extent that users can depend on it to represent the economic conditions or events that it purports to represent.

Reliable information has:
(a) Verifiability
(b) Representational faithfulness
(c) Neutrality

2) Secondary qualities of useful accounting information:

Comparability - Accounting information that has been measured and reported in a similar manner for different enterprises is considered comparable.

Consistency - Accounting information is consistent when an entity applies the same accounting treatment to similar accountable events from period to period.

Accounting Qualities and Useful Information for Analysts
Here is how these qualities provide analysts with useful information:

Relevance- Relevant information is crucial in making the correct investment decision.

Reliability - If the information is not reliable, then no investor can rely on it to make an investment decision.

Comparability - Comparability is a pervasive problem in financial analysis even though there have been great strides made over the years to bridge the gap.

Consistency - Accounting changes hinder the comparison of operation results between periods as the accounting used to measure those results differ.

The following key SEC filings must be reported:

• S-1: Filed prior to sale of new securities
• 10-K: Annual filing similar to annual report; 40-F for Canadians; 20-F for other foreign issuers
• 10-Q: Quarterly unaudited statements
• 8-k: Disclose material events such as asset acquisition and disposition, changes in management or corporate governance
• DEF-14: Proxy statement
• 144: Issue of unregistered securities
• Beneficial and insider ownership of securities by company's officers and directors