Financial Reporting and Analysis
My understanding
EPGP 2009-10 - Term I – End Term Project Submission
24-Oct-2009
Instructor: Prof. A. Kanagaraj
Submitted by:
Rajendra Inani – Roll # 27

Table of Contents
1 MECHANICS OF FINANCIAL ACCOUNTING ..................................................................................................4
2 PRINCIPAL FINANCIAL STATEMENTS – BALANCE SHEET, INCOME STATEMENTS AND CASH FLOW
STATEMENT..................................................................................................................................................5
3 REVENUE RECOGNITION AND MATCHING OF EXPENSES – REALIZED AND EARNED......................................6
4 INVENTORY VALUATION AND ESTIMATION OF COGS – LIFO / FIFO.............................................................8
5 ACCOUNTING FOR LONG LIVED FIXED ASSETS ............................................................................................8
6 ACCOUNTING FOR DEPRECIATION .............................................................................................................9
7 FINANCIAL PERFORMANCE REPORTING...................................................................................................10
PURPOSE OF FINANCIAL STATEMENT ANALYSIS..........................................................................................10
ANALYSIS OF FINANCIAL RATIOS................................................................................................................10
IMPORTANCE OF RELATIVE FINANCIAL RATIOS...........................................................................................10
COMPARING TO THE AGGREGATE ECONOMY.............................................................................................10
COMPARING TO THE INDUSTRY NORMS.....................................................................................................10
COMPARING TO THE FIRM’S MAJOR COMPETITORS...................................................................................10
COMPARING TO THE FIRM’S OWN PAST PERFORMANCE............................................................................10
EBITDA.......................................................................................................................................................11
CATEGORIES OF FINANCIAL RATIOS............................................................................................................11
COMMON SIZE STATEMENTS......................................................................................................................11
EVALUATING INTERNAL LIQUIDITY.............................................................................................................11
EVALUATING OPERATING PERFORMANCE..................................................................................................12
OPERATING EFFICIENCY RATIOS.................................................................................................................12
OPERATING PROFITABILITY RATIOS............................................................................................................12
COMMON SIZE INCOME STATEMENT..........................................................................................................13
OPERATING PROFITABILITY RATIOS............................................................................................................13
RISK ANALYSIS...........................................................................................................................................13
BUSINESS RISK...........................................................................................................................................14
FINANCIAL RISK..........................................................................................................................................14
EXTERNAL LIQUIDITY RISK..........................................................................................................................15
ANALYSIS OF GROWTH POTENTIAL.............................................................................................................15
DETERMINANTS OF GROWTH.....................................................................................................................15
THE QUALITY OF FINANCIAL STATEMENTS..................................................................................................15
THE VALUE OF FINANCIAL STATEMENT ANALYSIS.......................................................................................16
USES OF FINANCIAL RATIOS........................................................................................................................16
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FINANCIAL RATIOS AND STOCK VALUATION MODELS.................................................................................16
FINANCIAL RATIOS AND SYSTEMATIC RISK..................................................................................................16
FINANCIAL RATIOS AND BOND RATINGS.....................................................................................................16
FINANCIAL RATIOS AND INSOLVENCY (BANKRUPTCY).................................................................................16
LIMITATIONS OF FINANCIAL RATIOS...........................................................................................................16
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1 Mechanics of Financial Accounting
Learning’s in the class
• Two criteria necessary for economic events to be reflected in the financial statements.
• The accounting equation and how it relates to the balance sheet, income statement,
statement of retained earnings, and statement of cash flows.
• Journal entries (and T-accounts) and how they express the effect of economic events on
the basic accounting equation and the financial statements.
• Why managers need to understand how economic events affect the financial statements.
• Why the financial statements are adjusted periodically to reflect certain economic events.
Economic Events
• Relevant events have economic significance to a company and include any occurrence
that affects its financial condition.
• The dollar values assigned to these events must be determined in an objective manner.
Recognizing Gains and Losses
• Often investments and noncurrent assets are sold for more or less than the amounts at
which they are carried on the balance sheet.
• In such cases a gain or loss must be recognized.
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2 Principal Financial Statements – Balance Sheet, Income Statements
and Cash Flow Statement
Purpose and Content of the Three Principal Financial Statements
• Balance sheet,
• Income statement,
• Statement of cash flows,
• Notes to the financial statements, including various supporting schedules,
• Opinion of the independent certified public accountant.
Review Balance Sheet
• Snap shot in time
• Asset, liabilities, owners’ equity
• Retained earnings
• Assets = Liabilities + Owners’ Equity
• Historical valuation
• Analysis of the balance sheet
Balance Sheet
• Snapshot of investing and financing activities at a moment in time.
• Basic Accounting Equation:
Assets = Liabilities + Shareholders’ Equity
which is the same idea as Investing = Financing
Resources = Sources of Resources
Liabilities = Claims on Resources
Relationship between Balance Sheet and Income Statement
• The income statement links the balance sheet at the beginning of the period with the
balance sheet at the end of the period.
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• Retained Earnings is increased by net income and decreased by dividends.
Income Statement
• Indicates earning or profit
• Reports amounts for a period of time – typically one year
• Explain the concepts of Revenue and Expenses
• Results of the operating activities of a firm for a specific time period.
• Basic Income Equation: Net Income = Revenues - Expenses
• Revenues are the inflows of assets from selling goods and services.
• Expenses are the outflows of assets used in generating revenues.
Statement of Cash Flows
• Classification
o Operations: cash from customers less cash paid in carrying out the firm’s
operating activities
o Investing: cash paid to acquire noncurrent assets less amounts from any sale of
noncurrent assets
o Financing: cash from issues of long-term debt or new capital less dividends
Primary Participants in the Reporting Process
• Business firms and their managers
• Accounting standards setting and regulatory bodies
• Independent auditors
• Security analysts and other users of financial statements
3 Revenue Recognition and Matching of Expenses – Realized and
earned
Accrual basis accounting – In most cases, GAAP requires the use of accrual basis accounting
rather than cash basis accounting. Accrual basis accounting, which adheres to the revenue
recognition, matching, and cost principles, captures the financial aspects of each economic event in
the accounting period in which it occurs, regardless of when the cash changes hands. Under cash
basis accounting, revenues are recognized only when the company receives cash or its equivalent,
and expenses are recognized only when the company pays with cash or its equivalent.
Revenue recognition principle – Revenue is earned and recognized upon product delivery or
service completion, without regards to t eh timing of cash flow. Suppose a store orders five hundered
CDs from a wholesaler in March, receives them in April, and pays for them in May. The wholesaler
recognizes the sales revenue in Aprils when delivery occurs, not in March when the deal is struck or
in May when the cash is received.
Matching principle – The costs of doing business are recorded in the same period as the revenue
they help to generate. Examples of such costs include the cost of goods sold, salaries and
commissions earned, insurance premiums, supplies used, and estimates for potential warranty work
on the merchandise sold. Consider the whole seller who delivered five hundred CDs to a store in
April. These CDs change from as asset (Inventory) to an expenses (cost of goods sold) when the
revenue is recognized so that the profit from the sale can be determined.
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Cost principle – Assets are recorded at cost, which equals the value exchanged at the time of their
acquisition. In the most countries, even if assets such as land or buildings appreciate in value over
time, they are not revalued for financial reporting purposes.
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4 Inventory Valuation and Estimation of COGs – LIFO / FIFO
LIFO and FIFO are used as descriptions for inventory. LIFO stands for "last in first out," which means
that the product put into the warehouse last or more recently is what will leave the warehouse for
shipment first. FIFO stands for "first in first out." This means that product that entered the warehouse
first will be shipped before more recently built products.
How a company decides to handle their inventory can affect their bottom line, or profit. When
inventory increases within a month, an income statement will reflect a higher net profit due to a
positive increase in the value of the inventory. Also, if cost of goods sold is shown at a low value, this
will increase the net income as well. More profit typically means that more taxes will be due. FIFO
inventory causes these occurrences.
FIFO will keep the cost of goods sold low due to the fact that products built in the past are normally
produced with materials that cost less, and therefore their value in the inventory is lower. Using older
products first shows a lower cost of goods sold on the income statement. It also normally raises the
value of inventory left in the warehouse, because products that are built to replace the older items in
the inventory are more expensive to manufacture. LIFO has the opposite effect, lowering the value of
inventory and raising the cost of goods sold.
Why would a company use LIFO instead of FIFO?
If a company that sells products (retailer, manufacturer, etc.) finds the cost of its items increasing, the
use of LIFO will result in less taxable income and less income tax payments than FIFO. Over a long
period of time, or when costs increase dramatically, the lower income tax payments will be significant.
Another reason for a company to use the LIFO cost flow assumption is to improve the matching of
costs with sales. Under LIFO, the recent costs will be matched on the income statement with the
recent sales revenues. (Recall that LIFO means the “last costs in” will be the “first costs out” of
inventory and onto the income statement as the cost of goods sold.)
5 Accounting for Long Lived Fixed Assets
A fixed asset is an asset of a business intended for continuing use, rather than a short-term,
temporary asset such as stocks. Fixed assets must be classified in a company's balance sheet
as intangible, tangible, or investments. Examples of intangible assets include goodwill, patents,
and trademarks. Examples of tangible fixed assets include land and buildings, plant and machinery,
fixtures and fittings, motor vehicles and IT equipment.
The benefits that a business obtains from a fixed asset extend over several years. For example, a
company may use the same piece of production machinery for many years, whereas a company-
owned motor car used by a salesman probably has a shorter useful life. By accepting that the life of a
fixed asset is limited, the accounts of a business need to recognize the benefits of the fixed asset as it
is "consumed" over several years.
This consumption of a fixed asset is referred to as depreciation.
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6 Accounting for Depreciation
Depreciation is defined as the reduction in the value of a product arising from the passage of time due to use
or abuse, wear and tear. Depreciation is not a method of valuation but of cost allocation. This cost allocation
can be based on a number of factors, but it is always related to the estimated period of time the product can
generate revenues for the company (economic life). Depreciation expense is the amount of cost allocation
within an accounting period. Only items that lose useful value over time can be depreciated. That said, land
can't be depreciated because it can always be used for a purpose.
Straight-line Depreciation
The simplest and most commonly used method, straight-line depreciation is calculated by taking the purchase
or acquisition price of an asset, subtracting by the salvage value (value at which it can be sold once the
company no longer needs it) and dividing by the total productive years for which the asset can be reasonably
expected to benefit the company, or its useful life.
Accelerated Depreciation
Accelerated depreciation allows companies to write off their assets faster in earlier years than the straight-line
depreciation method and to write off a smaller amount in the later years. The major benefit of using this
method is the tax shield it provides. Companies with a large tax burden might like to use the accelerated-
depreciation method, even if it reduces the income shown on the financial statement.
This depreciation method is popular for writing off equipment that might be replaced before the end of its
useful life since the equipment might be obsolete (e.g. computers).
Companies that have used accelerated depreciation will declare fewer earnings in the beginning years and will
seem more profitable in the later years. Companies that will be raising financing (via an IPO or venture capital)
are more likely to use accelerated depreciation in the first years of operation and raise financing in the later
years to create the illusion of increased profitability (higher valuation).
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7 Financial Performance Reporting
Purpose of Financial Statement Analysis
• Evaluate management performance in
o Profitability
o Efficiency
o Risk
• Although financial statement information is historical, it is used to project future performance
Analysis of Financial Ratios
• Ratios can often be more informative that raw numbers
• Puts numbers in perspective with other numbers
• Helps control for different sizes of firms
• Ratios provide meaningful relationships between individual values in the financial statements
Importance of Relative Financial Ratios
• In order to make sense of a ratio, we must compare it with some appropriate benchmark or
benchmarks
• Examine a firm’s performance relative to:
o The aggregate economy
o Its industry or industries
o Its major competitors within the industry
o Its own past performance (time-series analysis)
Comparing to the Aggregate Economy
• Most firms are influenced by economic expansions and contractions in the business cycle
• Analysis helps you estimate the future performance of the firm during subsequent business
cycles
Comparing to the Industry Norms
• Most popular comparison
• Industries affect the firms within them differently, but the relationship is always significant
• The industry effect is strongest for industries with homogenous products
• Can also examine the industry’s performance relative to aggregate economic activity
Comparing to the Firm’s Major Competitors
• Industry averages may not be representative
• A firm may operate in several distinct industries
• Several approaches:
o Select a subset of competitors for the comparison group
o Construct a composite industry average from the different industries in which the firm
operates
Comparing to the Firm’s Own Past Performance
• Determine whether it is progressing or declining
• Helpful for estimating future performance
• Consider trends as well as averages over time
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EBITDA
• Earnings before Interest, Taxes, Depreciation, and Amortization
• A more generous measure of operating earnings, since all of these items are added back
• Perhaps a somewhat questionable measure of actual operating performance
Categories of Financial Ratios
• Common size statements
• Internal liquidity (solvency)
• Operating performance
o Operating efficiency
o Operating profitability
• Risk analysis
o Business risk
o Financial risk
o External liquidity risk
• Growth analysis
Common Size Statements
• Normalize balance sheets and income statement items to allow easier comparison of different
size firms
• A common size balance sheet expresses accounts as a percentage of total assets
• A common size income statement expresses all items as a percentage of sales
Evaluating Internal Liquidity
• Internal liquidity (solvency) ratios indicate the ability to meet future short-term financial
obligations
• Current Ratio examines current assets and current liabilities
Current Assets
Current Ratio =
Current Liabilities
• Quick Ratio adjusts current assets by removing less liquid assets
Cash + Marketable Securities + Receivables
Quick Ratio =
Current Liabilities
• Cash ratio relates cash (ultimate liquid asset) to current liabilities
Cash + Marketable Securities
Cash Ratio =
Current Liabilities
• Receivables turnover examines the management of accounts receivable
Net Annual Sales
Receivables Turnover =
Average Receivables
• Receivables turnover can be converted into an average collection period
365
Average Receivables Collection Period =
Annual Turnover
• Inventory turnover relates inventory to sales or cost of goods sold (CGS)
Cost of Goods Sold
Inventory Turnover =
Average Inventory
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• Given the turnover values, you can compute the average inventory processing time
365
Average Invetory Processing Period =
Annual Turnover
• Cash conversion cycle combines information from the receivables turnover, inventory
turnover, and accounts payable turnover
CCC = Receivables Collection Period + Inventory Processing Period - Payables
Payment Period
Evaluating Operating Performance
• Ratios that measure how well management is operating a business
o Operating efficiency ratios
 Examine how management uses its assets to generate sales; considers the
relationship between various asset categories and sales
o Operating profitability ratios
 Examine how management is doing at controlling costs so that a large
proportion of the sales dollar is converted into profit
Operating Efficiency Ratios
• Total asset turnover ratio indicates the effectiveness of a firm’s use of its total asset base to
produce sales
Net Sales
Total Asset Turnover =
Average Total Net Assets
• Net fixed asset turnover reflects utilization of fixed assets
• This number can look temporarily bad if the firm has recently added greatly to its capacity in
anticipation of future sales
Net Sales
Fixed Asset Turnover =
Average Net Fixed Assets
Operating Profitability Ratios
• Operating profitability ratios measure
o The rate of profit on sales (profit margin)
o The percentage return on capital
• Gross profit margin measures the rate of return after cost of goods sold
o What proportion of the sales dollar is left after cost of goods sold?
o Is the firm buying inputs (inventory and direct labor) at good prices?
Gross Profit
Gross Profit Margin =
Net Sales
• Operating profit margin measures the rate of profit on sales after operating expenses
o Operating profit is sometimes called Earnings before interest and taxes (EBIT)
o Operating income can be thought of as the “bottom line” from operations
Operating Profit
Operating Profit Margin =
Net Sales
• Net profit margin relates net income to sales
o Shows the combined effect of operating profitability and the firm’s financing decisions
(since net income is after interest and tax payments)
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Net Income
Net Profit M argin =
Net Sales
Common Size Income Statement
• Since Net Sales is in the denominator of all of the three previous ratios, the common size
income statement gives all of these ratios at once
o It also allows us to focus on any categories of expenses that are out of line with the
appropriate benchmark
Operating Profitability Ratios
• Return on total capital relates the firm’s earnings to all capital invested in the business
Net Income + Interest Expense
Return on Total Capital =
Average Total Capital
• Consideration of Lease Obligations
o Leases for assets are economically similar to debt obligations, but have different
accounting treatment
o May want to capitalize operating leases in order to get a more accurate measure of
assets and financing
 Should also consider the implied interest and depreciation for leases when
including the impact of leases on the Return on total capital
• Return on owner’s equity (ROE) indicates the rate of return earned on the capital provided by
the stockholders after paying for all other capital used
Net Income
Return on Total Equity =
Average Total Equity
• Return on owner’s equity (ROE) can be computed for the based only on the common
shareholder’s equity
o Deducts preferred dividends, which are a priority claim on net income
Net Income - Preferred Dividend
Return on Owner' s Equity =
Average Common Equity
• The DuPont System divides ROE into several ratios that collectively equal ROE while
individually providing insight
Net Income Net Income Net Sales
ROE = = ×
Common Equity Net Sales Common Equity
Sales Sales Total Assets
= ×
Equity Total Assets Equity
Net Income
=
Common Equity
Net Income Sales Total Assets
= × ×
Sales Total Assets Common Equity
• An extended DuPont System provides additional insights into the effect of financial leverage
on the firm and pinpoints the effect of income taxes on ROE
Risk Analysis
• Risk analysis examines the uncertainty of income for the firm and for an investor
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• Total firm risks can be decomposed into two basic sources:
o Business risk: The uncertainty in a firm’s operating income, highly influenced by
industry factors
o Financial risk: The added uncertainty in a firm’s net income resulting from a firm’s
financing decisions (primarily through employing leverage).
• External liquidity analysis considers another aspect of risk from an investor’s perspective
Business Risk
• Variability of the firm’s operating income over time
• Can be measured by calculating the standard deviation of operating income over time or the
coefficient of variation
• In addition to measuring business risk, we want to explain its determining factors.
• Two primary determinants of business risk
o Sales variability
 The main determinant of earnings variability
o Cost Variability and Operating leverage
 Production has fixed and variable costs
 Greater fixed production costs cause greater profit volatility with changes in
sales
 Fixed costs represent operating leverage
 Greater operating leverage is good when sales are high and increasing, but
bad when sales fall
Financial Risk
• Interest payments are deducted before we get to net income
o These are fixed obligations
• Similar to fixed production costs, these lead to larger earnings during good times, and
lower earnings during a business decline
o Fixed financing costs are called financial leverage
• The use of debt financing increases financial risk and possibility of default while
increasing profitability when sales are high
• Two sets of financial ratios help measure financial risk
o Balance sheet ratios
o Earnings or cash flow available to pay fixed financial charges
• Acceptable levels of financial risk depend on business risk
o A firm with considerable business risk should likely avoid lots of debt financing
• Proportion of debt (balance sheet) ratios
• Long-term debt can be related to:
o Equity (L-t D/Equity)
 How much debt does the firm employ in relation to its use of equity?
o Total Capital [L-t D/(L-t D +Equity)]
 How much debt does the firm employ in relation to all long-term sources
of funds?
• Total debt can be related to:
o Total Capital [Total Debt/(Ttl. Liab.–Non-int. Liab.)]
 Assessment of overall debt load, including short-term
• Earnings or Cash Flow Ratios
o Relate operating income (EBIT) to fixed payments required from debt obligations
o Higher ratio means lower risk
• Interest Coverage or Times Interest Earned Ratio
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o Measures the number of times Interest payments are “covered” by EBIT
o Interest Coverage = EBIT/Interest Expense
• May also want to calculated coverage ratios that reflect other fixed charges
o Lease obligations (Fixed charge coverage)
• Cash flow ratios
o Fixed financing costs such as interest payments must be paid in cash, so these
ratios use cash flow rather than EBIT to assess the ability to meet these
obligations
o Relate the flow of cash available from operations to:
 Interest expense
 Total fixed charges
 The face value of outstanding debt
External Liquidity Risk
• Market Liquidity is the ability to buy or sell an asset quickly with little price change from a
prior transaction assuming no new information
• External market liquidity is a source of risk to investors
• The most important factor of external market liquidity is the dollar value of shares traded
o This can be estimated from the total market value of outstanding securities
o It will be affected by the number of security owners
 Numerous buyers and sellers provide liquidity
Analysis of Growth Potential
• Want to determine sustainable growth potential
o Important to both creditors and owners
 Creditors interested in ability to pay future obligations
 For owners, the value of a firm depends on its future growth in earnings,
cash flow, and dividends
Determinants of Growth
• Sustainable Growth Model
o Suggests that the sustainable growth rate is a function of two variables:
 What is the rate of return on equity (which gives the maximum possible
growth)?
 How much of that growth is put to work through earnings retention (rather
than being paid out in dividends)?
• g = ROE x Retention rate
o The retention rate is one minus the firm’s dividend payout ratio
o Anything that impacts ROE would also be a determinant of future growth
• ROE (recall the DuPont equation) is a function of
o Net profit margin
o Total asset turnover
o Financial leverage (total assets/equity)
The Quality of Financial Statements
• “Quality financial statements” reflect reality rather than use accounting tricks or one-time
adjustments to make things look better than they are
• High-quality balance sheets typically have
o Conservative use of debt
o Assets with market value greater than book
o No liabilities off the balance sheet
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• High-quality income statements
o Reflect repeatable earnings
 Gains from nonrecurring items should be ignored when examining
earnings
o High-quality earnings result from the use of conservative accounting principles
that do not overstate revenues or understate costs
The Value of Financial Statement Analysis
• Financial statements, by their nature, are backward-looking
• An efficient market will have already incorporated these past results into security prices,
so why analyze the statements?
o Analysis provides knowledge of a firm’s operating and financial structure
o This aids in estimating future returns
Uses of Financial Ratios
• Stock valuation
• Identification of corporate variables affecting a stock’s systematic risk (beta)
• Assigning credit quality ratings on bonds
• Predicting insolvency (bankruptcy) of firms
Financial Ratios and Stock Valuation Models
• Stock valuation often considers discounted cash flow analysis
o Estimate cash flows
o Estimate an appropriate discount rate
 A number of financial ratios can be useful in arriving at estimates for each
of these inputs
• Price ratio analysis for a stock
o Sometimes we estimate the value of a stock through various price ratios such as
P/E
 Would need to estimate variables such as expected growth rate of
earnings and dividends
Financial Ratios and Systematic Risk
• A firm’s systematic risk (as measured by beta) is related to a number of financial
statement variables
Financial Ratios and Bond Ratings
• Changes in bond ratings are linked to changes in various financial statement variables
o Predicting such changes in ratings before they occur can increase the return on a
bond or stock portfolio
Financial Ratios and Insolvency (Bankruptcy)
• Certainly, analysts and investors are concerned with the possibility of bankruptcy
o A number of variables have a rather strong relationship to the bankruptcy
experience of firms in the past
o Can use financial statement analysis to identify firms where insolvency is a likely
outcomes
Limitations of Financial Ratios
• Always consider relative financial ratios
o Accounting treatments may vary among firms, especially among non-U.S. firms
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o Firms may have have divisions operating in different industries making it difficult
to derive industry ratios
o Are the results consistent?
o Ratios outside an industry range may be cause for concern
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