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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