FINANCIAL ANALYSIS



Financial Analysis

95-711

Fall 2002

LECTURE NOTES

SESSION ONE

PROF. L. A. PASTOR

FINANCIAL STATEMENTS

INTERPRETATION

Managers’ decisions affect financial statements

Financial Statements are designed to report performance consistently

External users need financial statements to evaluate management decisions

Generally Accepted Accounting Principles (GAAP)

Guidelines and rules, that govern the preparation financial statements

Accrual (vs. Cash) Basis of Accounting

“Promulgated” by FASB

Required by the SEC

Financial Statements

Balance Sheet

Income Statement

Statement of Cash Flows

Statement of Changes in Owner Equity

Book vs. Market

Accrual vs. Cash

GAAP Preferred

Not for Taxes

Matches Revenues with Expenses

Accrual Basis

Simultaneous

Cash flows and revenue and expense recognition (Same for Cash Basis)

Accruals

Revenues and expense recognition preceding cash in flow and out flow

Deferrals

Cash flows precedes revenue and expense recognition

Examples

John began working at XYZ Co. in December and got paid $5,000 on the first of January for the preceding month. What is the salary expense for John in the month of December using:

the accrual basis of accounting?

the cash basis of accounting?

Example

In December ABC Co. purchased and received $20,000 worth of XYZ’s services on 30 day terms. What is the revenue related to this sale for XYZ in December using

the accrual basis of accounting?

the cash basis of accounting?

Example

If John was the only cost related to the services received by ABC in December what was the profits related to this job for XYZ in December and January using

the accrual basis of accounting?

the cash basis of accounting?

Example

XYZ received a deposit of $10,000 in December from ABC for a new project which is to start in the new year? What is the Revenue for December using

the accrual basis of accounting?

the cash basis of accounting?

Accounting Conventions

Conservatism

Although accuracy is paramount, it is preferable to err on the side of conservatism

Measurement

Consistent Currency Unit

Consistent Time Periods

Going Concern

Reliability

Objective

Cost

Cost

Historical cost

Amount originally paid for the asset

Net realizable value (NRV)

Amount expected to be realized

Replacement cost

Current cost to replace (e.g., certain marketable securities).

Present value

Amount of estimated future cash flows (e.g., monetary assets and liabilities)

Fair Market value (or FMV)

What the market will bear

Types of Business Organizations

Sole Proprietorships

Partnerships

Corporations

Hybrids

Limited Partnerships

LLP

LLC

PC

Organizing a Business

Goals of The Corporation

Shareholders desire wealth maximization

Do managers maximize shareholder wealth?

Managers have many constituencies “stakeholders”

“Agency Problems” represent the conflict of interest between management and owners

Managing Corporations

Shareholder

Elects Board of Directors

Shareholder Votes vs. Proxy

Board of Directors

Hires Management

Oversight of Management

Management makes decision

Authorizes Dividends to Shareholders

Usually Approved by the Board

Balance Sheet

Balance Sheet Format

Value of Assets

Record the asset at either the FMV of what is received or the FMV of what is given up, whichever is more clearly determinable.

Cash, value of services, other assets

If unclear, emphasize the asset received

Acquisition of Assets

Paying cash

Issuing debt

Notes payable, leases

Issuing equity

Common stock, preferred stock

By self-construction

Current Assets (Short Term)

Cash and equivalents

Short-term investments

Receivables (net of allowance for doubtful accounts)

Inventories

Prepaid expenses

Notes receivable

Deferred income taxes

Non Current Assets ( Long Term Assets)

Property, plant and equipment

Natural resources

Intangible assets

Fixed Assets

Property, plant and equipment (PP&E)

Land

Buildings

Furniture, vehicles and equipment

Leasehold improvements

Less: allowance for accumulated depreciation

Property Plant & Equipment

Tangible

Used in the operations of the business

Relatively long-lived

Not intended for resale

“Costs” Capitalized

Transportation

Installation

Additions

Maintenance is not Capitalized

Natural Resources

Acquisition costs (capitalized)

Exploration costs – two methods

Successful efforts (capitalize costs related only to successful completion)

Full costing (capitalize costs related to all exploration)

Intangible Assets

Patents

Copyrights

Trademarks and Trade names

Organization costs

Goodwill

Capitalized R&D

Cost Allocation through “Amortization”

Research & Development

Expensed as incurred until feasibility is established

Capitalized as an Asset after feasibility point

Cost Allocation

Method is Management’s Decision

Depreciation & Amortization

Long Term Assets

Matches Use of Asset to related Revenue

Depletion

Natural Resources

Cost of Resources Extracted

Related Depreciation Expense

Reduce the Value of the asset on the Balance Sheet

Accumulated Depreciation is a “contra asset” account

Increase in Accumulated Depreciation results in a corresponding increase in Depreciation Expense on the Income Statement

Liabilities

Current liabilities

Accounts payable

Accrued expenses payable

Short term Notes

Current portion of long-term debt

Long-term liabilities

Long Term Notes and Bonds Payable

Capital Leases

Mortgages

Liabilities (Obligations) Arise From:

Using or taking possession of resources in the course of operations before paying for them

Receive payment in advance of delivery of service or products

Raise Cash from Financial Institutions or Other Debt holders

Promises that obligate the company in the future like warranties

Requirement of Liabilities

An obligation has been incurred

Amount of obligation can be measured with reasonable certainty

Determine when the debt will be due and payable with reasonable certainty

Time value of money

Is this a Liability

ABC Company has placed an order for 200 units to be delivered in 30 days

Is this a liability?

Why or why not?

Is this a Liability

All of ABC Company’s products come with a one year warranty. Costs are incurred when repairs are made under the warranty.

Is this a Liability?

Why or why not?

Is this a Liability

ABC Company has been notified that it is being sued for discrimination.

Is this a liability?

What do you need to know?

Would a shareholder want to know about this?

Is this a Liability

Hilton Hotels has a frequent visitor program which award points and allows redemption for free stays.

Is this a liability?

What do you need to know?

Would a shareholder want to know about this?

Short Term or Current Liabilities

Expected to be paid within 1 year (or business cycle)

May also incur Interest Expense

Include:

Accounts Payable

Short Term Portion of Long Term Debt

Accrued Expenses

Payroll not yet paid out

Utilities

Long Term or Non Current Liabilities

Do not expect to pay off within the next year

Include

Long Term Loans

Bonds

Mortgages

Long Term Debt

Obligation to Repay

Unlike Stocks

Interest Rate

Even if not stated

Gives Rise to Interest Expense

Security

Claims against specific asset (secured)

General claims against all assets (unsecured)

Maturity

Have a definite maturity date

May be callable earlier at the borrower’s discretion

Interest

Principal x Interest Rate x Time

Interest Rate always stated on an annual basis

Ex. On a 10% loan the monthly interest equals

Principal x 10% x 1/12

Leases

Operating leases

Like renting an apartment

Risks and benefits of ownership is not transferred to Lessee (renter)

Payments are recorded as an Expense only

Leased Asset is not recorded on the Balance Sheet

Leases

Capital Lease

Economic Benefits and Risks are transferred to Lessee

Lease is for 75% of assets useful life or

Present value of the lease payments equals 90% of the value of the Asset or

Lease has a bargain purchase option

Asset must be recorded on the books

Lease is recorded as a Liability

Interest has to be calculated for each payment on the lease

Is this a Liability

ABC Company takes a 4 year lease on a vehicle that has a useful life of 5 years

Is this a Liability

ABC Company takes a 2 year lease on a vehicle that has a useful life of 5 years. At the end of the second year, ABC can purchase the car for less than its Fair Market Value.

Is this a Liability

ABC Company takes a 3 year lease on a vehicle that has a useful life of 5 years. The sticker price on the car is $20,000. The present value of all the lease is $19,000.

How will this affect the financial statements?

Answer

Increase in Assets

Increase in Liabilities

Must Depreciate Asset

Must “break out” Interest Expense when lease payment is made

Capital Lease

ABC makes an annual payment on the lease of $7,911 on this 3 year Capital Lease.

What is the effect on the Financial Statements?

Calculate Interest Expense and Principal Payment

Interest Expense

$19,000 x 12% = $2,280

Principal Pay Down

$7,911 - $2,280 = $5,631

Principal Balance

$19,000 - $5,631 = $13,369

Amortization Table

To get Payment amount, use the Excel Function: =PMT(.12, 3, 19000)

Calculate Depreciation

Use Straight line Depreciation

Historical Cost = $19,000

Lease (proxy for useful life) = 3

Annual Depreciation Expense

$19,000/3 = $6,333

Corresponding Accumulated Depreciation

Stockholders’ Equity

Contributed capital

Common stock

Preferred stock

Additional contributed capital

Retained earnings

Equity

Residual Rights

Assets = Liabilities + Equity

Difference between Assets and Liabilities

Sources of Equity

Sales of Stock

Stock = Par Value x Shares sold

Additional Paid in Capital

Retention of Profits (earnings)

Types of Stock

Common

Voting rights

Last to get anything in a liquidation

Preferred

No voting rights

Has preference over Common Shareholders if dividends are declared

Has preference over Common Shareholder in a liquidation

May include a Preferred Stock Dividend which is based on the Par Value of the Preferred Stock

Common Stock

Authorized

In the Charter

Issued

Sold to Investors

Outstanding

Still in Investors hands

Treasury

Bought back by the Company for future Reissue

Retired

Bought back by the Company and “disposed” of

Issue Stock for Cash

ABC Company is authorized to issue 1,000,000 shares of $2 par value common stock. The company issues, 100,000 shares at $10 per share.

If it costs ABC $50,000 to issue the shares how are the financial statements affected

Answer

Assets

Cash $950,000

Total Effect on Assets $950,000

Stockholders’ Equity

Common stock, $2 par $200,000

Additional paid-in capital 750,000

Total Effect on Equity $950,000

Issue Stock for Service

ABC Company issues 5,000 shares of $2 par common stock, in exchange for services quoted at $20,000.

How are the financial statements affected?

Answer

(not including the earlier transaction)

Income Statement

Professional Services $20,000

Balance Sheet

Stockholders’ Equity

Common stock $2 par $10,000

Additional paid-in capital 10,000

$20,000

Dividends

Management is under no obligation to declare dividends on Common Stock

Management can declare dividends but not pay them out right away (in arrears)

Not included in calculating profit

Deducted from profit to calculate Retained Earnings

Declaring Dividends

At the end of the fiscal year, ABC Company had a profit of $2 million. Management with consent of the Board of Directors declares a $.50 dividend per share. Remember, ABC has 105,000 shares outstanding.

How are the financial statements affected?

Answer

Income Statement

Profit $2,000,000

Statement of Shareholder Equity

Dividends $52,500

Balance Sheet (Equity)

Retained Earnings $1,947,500

Dilution

When more shares are issued, the % of the company that existing stockholder own is reduced.

In public companies shareholders may not care

In closely held companies shareholders may care a whole lot!

Stock rights for common stock

Gives shareholder preemptive right to buy new share

Allows shareholders to maintain a proportional ownership in the corporation when additional shares are issued

Rights are usually for a few weeks

Like a warrant which can be for years

Stock Dividends

A company may declare a stock dividend to reward shareholders without paying out cash

Shareholders do not pay anything for these shares

Total Value of Equity Section does not change

Stock Split

Doubles the number of shares each stockholder owns

Reduces Par Value by half

Does not affect Additional Paid in Capital or Retained Earnings

Total Equity stays the same

Does not increase the number of shares not yet issued by the company

Asset?

Since Advertising should result in future sales and therefore future benefits, is advertising an Asset?

Been on lately?

Seventeen dot-coms, as Internet companies are known, were among about three dozen advertisers who paid a record average of $2.2 million for a 30-second commercial on the ABC telecast which saw the St. Louis Rams beat the Tennessee Titans, 23-16.

: "Don't Go" (30 Seconds)

The company's sock puppet dog sings a woeful tale of a pet's life when his or her owner leaves home to buy pet food.

is gone

Still think it’s a good idea to capitalize advertising and marketing cost?

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Total Liabilities

Total Equity

Total Assets

Current Liabilities

Non Current Liabilities

Total Liabilities & Equity

Non Current Assets

Current Assets

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