Financial Reporting and Analysis

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Financial Reporting and Analysis by Mind Map: Financial Reporting and Analysis

1. I-19.Introduction to Financial Statement Analysis

1.1. Learning Outcomes

1.1.1. a.describe the roles of financial reporting and financial statement analysis

1.1.2. b.describe the roles of the statement of financial position, statement of comprehensive income, statement of changes in equity, and statement of cash flows in evaluating a company’s performance and financial position

1.1.3. c.describe the importance of financial statement notes and supplementary information— including disclosures of accounting policies, methods, and estimates— and management’s commentary

1.1.4. d.describe the objective of audits of financial statements, the types of audit reports, and the importance of effective internal controls

1.1.5. e.identify and describe information sources that analysts use in financial statement analysis besides annual financial statements and supplementary information

1.1.6. f.describe the steps in the financial statement analysis framework

1.2. Roles of Financial Reporting and Financial Statement Analysis

1.2.1. Role of financial statement reporting

1.2.2. Role of financial statement analysis

1.3. Primary Financial Statements and Other Information Sources

1.3.1. Financial Statements and Supplementary Information

1.3.1.1. Balance Sheet

1.3.1.2. Statement of Comprehensive Income

1.3.1.2.1. Income Statement

1.3.1.2.2. Other Comprehensive Income

1.3.1.3. Statement of Changes in Equity

1.3.1.4. Cash Flow Statement

1.3.1.5. Financial Notes and Supplementary Schedules

1.3.1.6. Management Commentary or Management’s Discussion and Analysis

1.3.1.7. Auditor’s Reports

1.3.1.7.1. Unqualified

1.3.1.7.2. Qualified

1.3.1.7.3. Adverse

1.3.1.7.4. Disclaimer

1.3.2. Other Sources of Information

1.3.2.1. Interim reports

1.3.2.2. Proxy statements

1.3.2.3. Press releases

1.3.2.4. External sources

1.4. Financial Statement Analysis Framework

1.4.1. 1.Articulate the Purpose and Context of Analysis

1.4.2. 2.Collect Data

1.4.3. 3.Process Data

1.4.4. 4.Analyze/ Interpret the Processed Data

1.4.5. 5.Develop and Communicate Conclusions/ Recommendations

1.4.6. 6.Follow-Up

2. I-20.Financial Reporting Standards

2.1. The Objective of Financial Reporting

2.2. Standard-Setting Bodies and Regulatory Authorities

2.2.1. Accounting Standards Boards

2.2.1.1. International Accounting Standards Board's (IASB's)

2.2.1.2. Financial Accounting Standards Board (FASB)

2.2.2. Regulatory Authorities

2.2.2.1. International Organization of Securities Commissions (IOSCO)

2.2.2.2. The Securities and Exchange Commission (US SEC)

2.2.2.2.1. Securities Act of 1933

2.2.2.2.2. Securities Exchange Act of 1934

2.2.2.2.3. Sarbanes– Oxley Act of 2002

2.2.2.2.4. Securities Offerings Registration Statement

2.2.2.2.5. Forms 10-K, 20-F, and 40-F

2.2.2.2.6. Annual Report

2.2.2.2.7. Proxy Statement/ Form DEF-14A

2.2.2.2.8. Forms 10-Q and 6-K

2.2.2.2.9. Form 8-K

2.2.2.2.10. Forms 3, 4, 5 and 144

2.2.2.2.11. Form 11-K

2.2.2.3. Capital Markets Regulation in Europe

2.3. The International Financial Reporting Standards Framework

2.3.1. Qualitative Characteristics of Financial Reports

2.3.1.1. Fundamental qualitative characteristics

2.3.1.1.1. Relevance

2.3.1.1.2. Faithful representation

2.3.1.2. Conceptual Framework

2.3.1.2.1. Comparability

2.3.1.2.2. Verifiability

2.3.1.2.3. Timeliness

2.3.1.2.4. Understandability

2.3.2. Constraints on Financial Reports

2.3.3. The Elements of Financial Statements

2.3.3.1. Underlying Assumptions in Financial Statements

2.3.3.1.1. Accrual basis

2.3.3.1.2. Going concern

2.3.3.2. Recognition of Financial Statement Elements

2.3.3.3. Measurement of Financial Statement Elements

2.3.3.3.1. Historical cost

2.3.3.3.2. Amortised cost

2.3.3.3.3. Current cost

2.3.3.3.4. Realizable (settlement) value

2.3.3.3.5. Present value (PV)

2.3.3.3.6. Fair value

2.3.3.4. Reporting Elements

2.3.3.4.1. Measurement of financial position

2.3.3.4.2. Measurement of financial performance

2.3.4. General Requirements for Financial Statements

2.3.4.1. Required Financial Statements

2.3.4.2. General Features of Financial Statements

2.3.4.2.1. Fair presentation

2.3.4.2.2. Going concern

2.3.4.2.3. Accrual basis

2.3.4.2.4. Materiality and aggregation

2.3.4.2.5. No offsetting

2.3.4.2.6. Frequency of reporting

2.3.4.2.7. Comparative information

2.3.4.2.8. Consistency

2.3.5. Structure and Content Requirements

2.3.5.1. Classified Statement of Financial Position (Balance Sheet)

2.3.5.2. Minimum Information on the Face of the Financial

2.3.5.3. Minimum Information in the Notes

2.3.5.3.1. Disclosure of accounting policies

2.3.5.3.2. Estimation uncertainty

2.3.5.3.3. Other disclosures

2.3.5.4. Comparative Information

2.4. Comparison of IFRS with Alternative Reporting Systems

2.5. Monitoring Developments in Financial Reporting Standards

2.5.1. New Products or Types of Transactions

2.5.2. Evolving Standards and the Role of CFA Institute

3. I-21.Understanding Income Statements

3.1. Learning Outcomes

3.1.1. a.Describe the components of the income statement and alternative presentation formats of that statement

3.1.2. b.Describe general principles of revenue recognition and accounting standards for revenue recognition

3.1.3. c.calculate revenue given information that might influence the choice of revenue recognition method

3.1.4. d.describe general principles of expense recognition, specific expense recognition applications, and implications of expense recognition choices for financial analysis

3.1.5. e.describe the financial reporting treatment and analysis of non-recurring items (including discontinued operations, unusual or infrequent items) and changes in accounting policies

3.1.6. f.distinguish between the operating and non-operating components of the income statement

3.1.7. g.describe how earnings per share is calculated and calculate and interpret a company’s earnings per share (both basic and diluted earnings per share) for both simple and complex capital structures

3.1.8. h.distinguish between dilutive and antidilutive securities and describe the implications of each for the earnings per share calculation

3.1.9. i.convert income statements to common-size income statements

3.1.10. j.evaluate a company’s financial performance using common-size income statements and financial ratios based on the income statement

3.1.11. k.describe, calculate, and interpret comprehensive income

3.1.12. l.describe other comprehensive income and identify major types of items included in it

3.2. Components and Format of the Income Statement

3.2.1. Revenue

3.2.2. Expenses

3.2.2.1. Grouping by Nature

3.2.2.2. Grouping by Function

3.2.3. Gross profit

3.2.4. Operating profit

3.2.5. Net income

3.2.6. Noncontrolling Interests

3.3. Revenue Recognition

3.3.1. Revenue General Principles

3.3.1.1. 1.Identify the contract(s) with a customer

3.3.1.2. 2.Identify the separate or distinct performance obligations in the contract

3.3.1.3. 3.Determine the transaction price

3.3.1.4. 4.Allocate the transaction price to the performance obligations in the contract

3.3.1.5. 5.Recognize revenue when (or as) the entity satisfies a performance obligation

3.3.2. Accounting Standards for Revenue Recognition

3.3.2.1. Revenue from Contracts with Customers

3.3.2.1.1. Identifying the Performance Obligation

3.3.2.1.2. Percentage-of-completion

3.3.2.1.3. Variable consideration

3.3.2.1.4. Cumulative catch-up adjustment

3.3.2.1.5. Suppliers deliver

3.4. Expense Recognition

3.4.1. Expense General Principles

3.4.2. Issues in Expense Recognition

3.4.2.1. Doubtful Accounts

3.4.2.2. Warranties

3.4.2.3. Depreciation and Amortisation

3.4.2.3.1. Straight-line method

3.4.2.3.2. Double declining balance depreciation

3.4.3. Implications for Financial Analysis

3.5. Non-Recurring Items and Non-Operating Items

3.5.1. Discontinued Operations

3.5.2. Unusual or Infrequent Items

3.5.3. Changes in Accounting Policies

3.5.4. Non-Operating Items

3.6. Earnings per Share

3.6.1. Simple versus Complex Capital Structure

3.6.2. Basic EPS

3.6.3. Diluted EPS

3.6.3.1. Diluted EPS When a Company Has Convertible Preferred Stock Outstanding

3.6.3.2. Diluted EPS When a Company Has Convertible Debt Outstanding

3.6.3.3. Diluted EPS When a Company Has Stock Options, Warrants, or Their Equivalents Outstanding

3.6.3.4. Other Issues with Diluted EPS

3.6.4. Changes in EPS

3.7. Analysis of the Income Statement

3.7.1. Common-Size Analysis of the Income Statement

3.7.2. Income Statement Ratios

3.7.2.1. Net Profit Margin = Net Income / Revenue

3.7.2.2. Gross Profit Margin = Gross profit / Revenue

3.8. Comprehensive Income

4. II-9.Intercorporate Investments

4.1. Learning Outcomes

4.2. Introduction

4.3. Basic Corporate Investment Categories

4.4. Investments In Financial Assets: IFRS 9

4.4.1. Classification and Measurement

4.4.2. Reclassification of Investments

4.5. Investments In Associates And Joint Ventures: Equity Method of Accounting, Basis Principles

4.5.1. Equity Method of Accounting: Basic Principles

4.6. Investment Costs That Exceed the Book Value of the Investee, Amortization of Excess Purchase Price, Fair Value Option and Impairment

4.6.1. Amortization of Excess Purchase Price

4.6.2. Fair Value Option

4.6.3. Impairment

4.7. Transactions with Associates and Disclosure

4.7.1. Disclosure

4.7.2. Issues for Analysts

4.8. Business Combinations: Acquisition Method and Impact of the Acquisition Method on Financial Statements Post-Acquisition

4.8.1. Acquisition Method

4.8.1.1. Recognition and Measurement of Identifiable Assets and Liabilities

4.8.1.2. Recognition and Measurement of Contingent Liabilities

4.8.1.3. Recognition and Measurement of Indemnification Assets

4.8.1.4. Recognition and Measurement of Financial Assets and Liabilities

4.8.1.5. Recognition and Measurement of Goodwill

4.8.1.6. Recognition and Measurement when Acquisition Price Is Less than Fair Value

4.8.2. Impact of the Acquisition Method on Financial Statements, Post-Acquisition

4.9. The Consolidation Process

4.9.1. Business Combination with Less than 100% Acquisition

4.9.2. Non-controlling (Minority) Interests: Balance Sheet

4.9.3. Non-controlling (Minority) Interests: Income Statement

4.9.4. Goodwill Impairment

4.10. Financial Statement Presentation Subsequent to the Business Combination

4.11. Variable Interest and Special Purpose Entities

4.11.1. Securitization of Assets

4.12. Additional Issues in Business Combinations That impair Comparability

4.12.1. Contingent Assets and Liabilities

4.12.2. Contingent Consideration

4.12.3. In-Process R& D

4.12.4. Restructuring Costs

5. II-10.Employee Compensation: Post-Employment and Share-Based

5.1. Learning Outcomes

5.2. Introduction

5.3. Pensions and Other Post-Employment Benefits

5.3.1. Types of Post-Employment Benefit Plans

5.4. Measuring a Defined Benefit Pension Plan's Obligations

5.5. Financial Statement Reporting of Pension Plans and Other Post-Employment Benefits: Defined Contribution Pension Plans

5.5.1. Defined Contribution Pension Plans

5.6. Financial Statement Reporting of Pension Plans: Balance Sheet Reporting for Defined Benefit Pension Plans

5.6.1. Balance Sheet Presentation

5.7. Financial Statement Reporting of Pension Plans: Periodic Pension Costs for Defined Benefit Pension Plans Reporting the Periodic Pension Cost.

5.8. More on the Effect of Assumptions and Actuarial Gains and Losses on Pension and Other Post-Employment Benefit Costs

5.9. Calculation of Defined Benefit Pension Obligation and Current Service Costs

5.10. Disclosures of Pension and Other Post-Employment Benefits: Assumptions

5.10.1. Assumptions

5.11. Disclosures of Pension and Other Post-Employment Benefits: Net Pension Liability (or Asset) and Periodic Pension Costs

5.11.1. Total Periodic Pension Costs

5.11.2. Periodic Pension Costs Recognised in P& L vs. OCI

5.11.3. Classification of Periodic Pension Costs Recognised in P& L

5.12. Disclosures of Pension and Other Post-Employment Benefits: Cash Flow Information

5.13. Share-Based Compensation

5.14. Stock Grants

5.15. Stock Options

5.16. Other Types of Share -Based Compensation

6. II-11.Multinational Operations

6.1. Learning Outcomes

6.2. Introduction and Foreign Currency Transactions: Foreign Currency Transaction Exposure to Foreign Exchange Risk and Analytical Issues

6.2.1. Foreign Currency Transactions

6.2.1.1. Foreign Currency Transaction Exposure to Foreign Exchange Risk

6.2.1.1.1. Accounting for Foreign Currency Transactions with Settlement before Balance Sheet Date

6.2.1.1.2. Accounting for Foreign Currency Transactions with Intervening Balance Sheet Dates

6.2.1.2. Analytical Issues

6.3. Disclosures Related to Foreign Currency Transaction Gains and Losses

6.4. Translation of Foreign Currency Financial Statements and Translation Conceptual Issues

6.4.1. Translation Conceptual Issues

6.4.1.1. All Assets and Liabilities Are Translated at the Current Exchange Rate

6.4.1.2. Only Monetary Assets and Monetary Liabilities Are Translated at the Current Exchange Rate

6.4.1.3. Balance Sheet Exposure

6.5. Translation Methods

6.5.1. Foreign Currency Is the Functional Currency

6.5.2. Parent’s Presentation Currency Is the Functional Currency

6.5.3. Translation of Retained Earnings

6.5.4. Highly Inflationary Economies

6.6. Illustration of Translation Methods (Excluding Hyperinflationary Economies)

6.7. Translation Analytical Issues

6.8. Translation When a Foreign Subsidiary Operates in an Hyperinflationary Economy

6.9. Companies Use Both Translation Methods at the Same Time and Disclosures Related to Translation Methods

6.9.1. Disclosures Related to Translation Methods

6.10. Multinational Operations and a Company's Effective Tax Rate

6.11. Additional Disclosures on the Effects of Foreign Currency

6.11.1. Disclosures Related to Sales Growth

6.11.2. Disclosures Related to Major Sources of Foreign Exchange Risk

7. II-12.Analysis of Financial Institutions

7.1. Learning Outcomes

7.2. Introduction to Financial Institutions

7.2.1. What Makes Financial Institutions Different?

7.2.2. Global Organizations

7.2.3. Individual Jurisdictions’ Regulatory Authorities

7.3. Analyzing a Bank: the CAMELS Approach

7.3.1. The CAMELS Approach

7.3.1.1. Capital Adequacy

7.3.1.2. Asset Quality

7.3.1.3. Management Capabilities

7.3.1.4. Earnings

7.3.1.5. Liquidity Position

7.3.1.6. Sensitivity to Market Risk

7.4. Analyzing a Bank: non-CAMELS Factors

7.4.1. Banking-Specific Analytical Considerations Not Addressed by CAMELS

7.4.2. Analytical Considerations Not Addressed by CAMELS That Are Also Relevant for Any Company

7.5. Analyzing a Bank: Example of CAMELS Approach

7.5.1. Capital Adequacy

7.5.2. Asset Quality

7.5.3. Management Capabilities

7.5.4. Earnings

7.5.5. Liquidity Position

7.5.6. Sensitivity to Market Risk

7.5.7. Overall CAMELS Assessment

7.6. Analyzing Property and Casualty Insurance Companies

7.6.1. Property and Casualty Insurance Companies

7.6.1.1. Operations: Products and Distribution

7.6.1.2. Earnings Characteristics

7.6.1.3. Investment Returns

7.6.1.4. Liquidity

7.6.1.5. Capitalization

7.7. Analyzing Life and Health Insurance Companies

7.7.1. Life and Health Insurance Companies

8. II-13.Evaluating Quality of Financial Reports

8.1. Learning Outcomes

8.2. Introduction

8.3. Quality of Financial Reports: Conceptual Framework

8.3.1. Conceptual Framework for Assessing the Quality of Financial Reports

8.4. Potential Problems that Affect the Quality of Financial Reports and Reported Amounts and Timing of Recognition

8.4.1. Reported Amounts and Timing of Recognition

8.5. Classification

8.6. Quality Issues and Mergers and Acquisitions & Financial Reporting that Diverges from Economic Reality Despite Compliance with Accounting Rules

8.6.1. Financial Reporting that Diverges from Economic Reality Despite Compliance with Accounting Rules

8.7. Evaluating the Quality of Financial Reports: General Steps

8.7.1. General Steps to Evaluate the Quality of Financial Reports

8.8. Quantitative Tools to Assess the Likelihood of Misreporting

8.8.1. Beneish Model

8.8.2. Other Quantitative Models

8.8.3. Limitations of Quantitative Models

8.9. Earnings Quality Indicators and Recurring Earnings

8.9.1. Indicators of Earnings Quality

8.9.1.1. Recurring Earnings

8.10. Earnings Persistence and Related Measures of Accruals

8.11. Mean Reversion in Earnings, Beating Benchmarks and External Indicators of Poor-Quality Earnings

8.11.1. Beating Benchmarks

8.11.2. External Indicators of Poor-Quality Earnings

8.12. Evaluating the Earnings Quality of a Company - Revenue Recognition Case: Sunbeam Corporation

8.12.1. Revenue Recognition Case: Sunbeam Corporation Premature/ Fraudulent Revenue Recognition

8.13. Revenue Recognition Case: MicroStrategy, Inc.

8.13.1. Multiple-Element Contracts

8.14. Cost Capitalization Case: WorldCom Corp.

8.14.1. Property/ Capital Expenditures Analysis

8.15. Bankruptcy Prediction Models: Altman Model, Developments in Bankruptcy Prediction Models

8.15.1. Altman Model

8.15.2. Developments in Bankruptcy Prediction Models

8.16. Cash Flow Quality

8.16.1. Indicators of Cash Flow Quality

8.16.2. Evaluating Cash Flow Quality

8.17. Balance Sheet Quality

8.18. Sources of Information about Risk and Limited Usefulness of Auditor's Report

8.18.1. Limited Usefulness of Auditor’s Opinion as a Source of Information about Risk

8.19. Risk-Related Disclosures in the Notes

8.20. Management Commentary (MD& A), Other Required Disclosures, Financial Press

8.20.1. Other Required Disclosures

8.20.2. Financial Press as a Source of Information about Risk

9. II-14.Integration of Financial Statement Analysis Techniques

9.1. Learning Outcomes

9.2. Introduction

9.3. Case Study 1: Long -Term Equity Investment: Early Phases of the Analysis

9.3.1. Phase 1: Define a Purpose for the Analysis

9.3.2. Phase 2: Collect Input Data

9.3.3. Phases 3 & 4: DuPont Analysis: Isolating "Pure Nestle"

9.3.3.1. Phase 3: Process Data and Phase 4: Analyze/ Interpret the Processed Data

9.3.4. Phases 3 & 4: DuPont Decomposition

9.3.5. Phases 3 & 4: Adjusting for Unusual Charges

9.3.6. Phases 3 & 4: Asset Base Composition Asset Base Composition

9.3.7. Phases 3 & 4: Capital Structure Analysis Capital Structure Analysis

9.3.8. Phases 3 & 4: Segment Analysis: Earnings & Capital Segment Analysis and Capital Allocation

9.3.9. Phases 3 & 4: Segment Analysis: Cash Flow & Capital

9.3.10. Phases 3 & 4: Segment Analysis by Product Group

9.3.11. Phases 3 & 4: Accruals and Earnings Quality

9.3.12. Phases 3 & 4: Cash Flow Relationships

9.3.13. Phases 3 & 4: Decomposition and Analysis of the Company's Valuation

9.3.14. Phases 5 & 6: Develop and Communicate Conclusions and Recommendations and Follow-up

9.3.14.1. Phase 5: Develop and Communicate Conclusions and Recommendations (e.g., with an Analysis Report) Support for an Investment in Nestlé Shares Causes for Concern

9.3.14.2. Phase 6: Follow-up

10. I-22.Understanding Balance Sheets

10.1. Components and Format of the Balance Sheet

10.1.1. Balance Sheet Components

10.1.2. Current and Non-Current Classification

10.1.3. Liquidity-Based Presentation

10.2. Current Assets

10.2.1. Cash and Cash Equivalents

10.2.2. Marketable Securities

10.2.3. Trade Receivables

10.2.4. Inventories

10.2.5. Other Current Assets

10.3. Current Liabilities

10.3.1. Trade payables

10.3.2. Accrued expenses

10.3.3. Deferred income

10.4. Non-Current Assets

10.4.1. Property, Plant, and Equipment

10.4.2. Investment Property

10.4.3. Intangible Assets

10.4.3.1. Identifiable Intangibles

10.4.4. Goodwill

10.4.4.1. Accounting Goodwill

10.4.4.2. Economic Goodwill

10.4.4.3. Goodwill Impairment

10.4.5. Financial Assets

10.4.5.1. Derivatives

10.4.5.2. Amortised cost

10.4.5.3. Held-to-maturity

10.4.5.4. Available-for-sale

10.4.6. Deferred Tax Assets

10.5. Non-Current Liabilities

10.5.1. Long-term Financial Liabilities

10.5.2. Deferred Tax Liabilities

10.6. Equity

10.6.1. Components of Equity

10.6.1.1. Common stock

10.6.1.2. Preferred shares

10.6.1.3. Treasury stock

10.6.1.4. Retained earnings

10.6.1.5. Accumulated other comprehensive income

10.6.1.6. Noncontrolling interest

10.6.2. Statement of Changes in Equity

10.7. Analysis of the Balance Sheet

10.7.1. Common-Size Analysis of the Balance Sheet

10.7.2. Balance Sheet Ratios

10.7.2.1. Liquidity Ratios

10.7.2.1.1. Current = Current assets / Current liabilities

10.7.2.1.2. Quick (acid test) = (Cash + Marketable securities + Receivables) / Current liabilities

10.7.2.1.3. Cash = (Cash + Marketable securities) / Current liabilities

10.7.2.2. Solvency Ratios

10.7.2.2.1. Long-term debt-to-equity = Total long-term debt / Total equity

10.7.2.2.2. Debt-to-equity = Total debt / Total equity

10.7.2.2.3. Total debt = Total debt / Total assets

10.7.2.2.4. Financial leverage = Total assets / Total equity

11. I-23.Understanding Cash Flow Statements

11.1. Components and Format of the Cash Flow Statement

11.1.1. Classification of Cash Flows and Non-Cash Activities

11.1.2. A Summary of Differences between IFRS and US GAAP

11.1.3. Direct and Indirect Methods for Reporting Cash Flow from Operating Activities

11.1.3.1. An Indirect-Format Cash Flow Statement Prepared under IFRS

11.1.3.2. A Direct-Format Cash Flow Statement Prepared under IFRS

11.1.3.3. Illustrations of Cash Flow Statements Prepared under US GAAP

11.2. The Cash Flow Statement: Linkages and Preparation

11.2.1. Linkages of the Cash Flow Statement with the Income Statement and Balance Sheet

11.2.2. Steps in Preparing the Cash Flow Statement

11.2.2.1. Operating Activities: Direct Method

11.2.2.1.1. Cash Received from Customers

11.2.2.1.2. Cash Paid to Suppliers

11.2.2.1.3. Cash Paid to Employees

11.2.2.1.4. Cash Paid for Other Operating Expenses

11.2.2.1.5. Cash Paid for Interest

11.2.2.1.6. Cash Paid for Income Taxes

11.2.2.2. Investing Activities

11.2.2.3. Financing Activities

11.2.2.3.1. Long-Term Debt and Common Stock

11.2.2.3.2. Dividends

11.2.2.4. Overall Statement of Cash Flows: Direct Method

11.2.2.5. Overall Statement of Cash Flows: Indirect Method

11.2.3. Conversion of Cash Flows from the Indirect to the Direct Method

11.3. Free Cash Flow to the Firm and Free Cash Flow to Equity

11.4. Cash Flow Statement Analysis

11.4.1. Evaluation of the Sources and Uses of Cash

11.4.2. Common-Size Analysis of the Statement of Cash Flows

11.4.3. Cash Flow Ratios

12. I-24.Financial Analysis Techniques

12.1. The Financial Analysis Process

12.1.1. The Objectives of the Financial Analysis Process

12.1.2. Distinguishing between Computations and Analysis

12.2. Analytical Tools and Techniques

12.2.1. Ratios

12.2.2. Common-Size Analysis

12.2.3. The Use of Graphs as an Analytical Tool

12.2.4. Regression Analysis

12.3. Common Ratios Used in Financial Analysis

12.3.1. Interpretation and Context

12.3.2. Activity Ratios

12.3.2.1. Inventory turnover = Cost of sales or cost of goods sold / Average inventory

12.3.2.2. Days of inventory on hand (DOH) = Number of days in period / Inventory turnover

12.3.2.3. Receivables turnover = Revenue / Average receivables

12.3.2.4. Days of sales outstanding (DSO) = Number of days in period / Receivables turnover

12.3.2.5. Payables turnover = Purchases / Average trade payables

12.3.2.6. Number of days of payables = Number of days in period / Payables turnover

12.3.2.7. Working capital turnover = Revenue / Average working capital

12.3.2.8. Fixed asset turnover = Revenue / Average net fixed assets

12.3.2.9. Total asset turnover = Revenue / Average total assets

12.3.3. Liquidity Ratios

12.3.3.1. Current ratio = Current assets / Current liabilities

12.3.3.2. Quick ratio = (Cash + Short-term marketable investments + Receivables) / Current liabilities

12.3.3.3. Cash ratio = (Cash + Short-term marketable investments) / Current liabilities

12.3.3.4. Defensive interval ratio = (Cash + Short-term marketable investments + Receivables) / Daily cash expenditures

12.3.3.5. Cash conversion cycle (net operating cycle) = DOH + DSO – Number of days of payables

12.3.4. Solvency Ratios

12.3.4.1. Debt Ratios

12.3.4.1.1. Debt-to-assets ratio = Total debt / Total assets

12.3.4.1.2. Debt-to-capital ratio = Total debt / (Total debt + Total shareholders’ equity)

12.3.4.1.3. Debt-to-equity ratio = Total debt / Total shareholders’ equity

12.3.4.1.4. Financial leverage ratio = Average total assets / Average total equity

12.3.4.1.5. Debt-to-EBITDA = Total debt / EBITDA

12.3.4.2. Coverage Ratios

12.3.4.2.1. Interest coverage = EBIT / Interest payments

12.3.4.2.2. Fixed charge coverage = (EBIT + Lease payments) / (Interest payments + Lease payments)

12.3.5. Profitability Ratios

12.3.5.1. Return on Sales

12.3.5.1.1. Gross profit margin = Gross profit / Revenue

12.3.5.1.2. Operating profit margin = Operating income / Revenue

12.3.5.1.3. Pretax margin = EBT / Revenue

12.3.5.1.4. Net profit margin = Net income / Revenue

12.3.5.2. Return on Investment

12.3.5.2.1. Operating ROA = Operating income / Average total assets

12.3.5.2.2. ROA = Net income / Average total assets

12.3.5.2.3. Return on total capital = EBIT / Average short- and long-term debt and equity

12.3.5.2.4. ROE = Net income / Average total equity

12.3.5.2.5. Return on common equity = (Net income – Preferred dividends) / Average common equity

12.3.6. DuPont Analysis: The Decomposition of ROE

12.3.6.1. ROE = Net income/ Average shareholders’ equity

12.3.6.2. ROE = ROA × Leverage

12.3.6.2.1. ROA = Net Income / Average Total Assets

12.3.6.2.2. Leverage = Average total assets / Average shareholders' equity

12.3.6.3. ROE = Net profit margin × Total asset turnover × Leverage

12.3.6.3.1. Net profit margin = Net income / Revenue

12.3.6.3.2. Total asset turnover = Revenue / Average total assets

12.3.6.3.3. Leverage = Average total assets / Average shareholders' equity

12.3.6.4. ROE = Tax burden × Interest burden × EBIT margin × Total asset turnover × Leverage

12.3.6.4.1. Tax burden = Net income / EBT

12.3.6.4.2. Interest burden = EBT / EBIT

12.3.6.4.3. EBIT margin = EBIT / Revenue

12.3.6.4.4. Total asset turnover = Revenue / Average total assets

12.3.6.4.5. Leverage = Average total assets / Average shareholders' equity

12.4. Equity Analysis

12.4.1. Valuation Ratios

12.4.1.1. Valuation Ratios

12.4.1.1.1. P/ E = Price per share / Earnings per share

12.4.1.1.2. P/ CF = Price per share / Cash flow per share

12.4.1.1.3. P/ S = Price per share / Sales per share

12.4.1.1.4. P/ BV = Price per share / Book value per share

12.4.1.2. Per-Share Quantities

12.4.1.2.1. Basic EPS = Net income minus preferred dividends / Weighted average number of ordinary shares outstanding

12.4.1.2.2. Diluted EPS = Adjusted income available for ordinary shares, reflecting conversion of dilutive securities / Weighted average number of ordinary and potential ordinary shares outstanding

12.4.1.2.3. Cash flow per share = Cash flow from operations / Weighted average number of shares outstanding

12.4.1.2.4. EBITDA per share = EBITDA / Weighted average number of shares outstanding

12.4.1.2.5. Dividends per share = Common dividends declared / Weighted average number of ordinary shares outstanding

12.4.1.3. Dividend-Related Quantities

12.4.1.3.1. Dividend payout ratio = Common share dividends / Net income attributable to common shares

12.4.1.3.2. Retention rate (b) = (Net income attributable to common shares – Common share dividends) / Net income attributable to common shares

12.4.1.3.3. Sustainable growth rate = Retention rate (b) × ROE

12.4.2. Industry-Specific Ratios

12.4.2.1. Business Risk

12.4.2.1.1. Coefficient of variation of operating income = Standard deviation of operating income / Average operating income

12.4.2.1.2. Coefficient of variation of net income = Standard deviation of net income / Average net income

12.4.2.1.3. Coefficient of variation of revenues = Standard deviation of revenue / Average revenue

12.4.2.2. Financial Sector Ratios

12.4.2.2.1. Capital adequacy— banks = Various components of capital / Various measures such as risk-weighted assets, market risk exposure, or level of operational risk assumed

12.4.2.2.2. Monetary reserve requirement (Cash reserve ratio) = Reserves held at central bank / Specified deposit liabilities

12.4.2.2.3. Liquid asset requirement = Approved “readily marketable” securities / Specified deposit liabilities

12.4.2.2.4. Net interest margin = Net interest income / Total interest-earning assets

12.4.2.3. Retail Ratios

12.4.2.3.1. Same (or comparable) store sales = Average revenue growth year over year for stores open in both periods

12.4.2.3.2. Sales per square meter (or square foot) = Revenue / Total retail space in square meters (or square feet)

12.4.2.4. Service Companies

12.4.2.4.1. Revenue per employee = Revenue / Total number of employees

12.4.2.4.2. Net income per employee = Net income / Total number of employees

12.4.2.5. Hotel

12.4.2.5.1. Average daily rate = Room revenue / Number of rooms sold

12.4.2.5.2. Occupancy rate = Number of rooms sold / Number of rooms available

12.4.3. Historical Research on Ratios in Equity Analysis

12.5. Credit Analysis

12.5.1. The Credit Rating Process

12.5.2. Credit Ratio

12.5.2.1. EBITDA interest coverage = EBITDA / Interest expense, including non-cash interest on conventional debt instruments

12.5.2.1.1. EBITDA = earnings before interest, taxes, depreciation, and amortization

12.5.2.2. FFO (Funds from operations) to debt = FFO / Total debt

12.5.2.2.1. FFO = funds from operations, defined as EBITDA minus net interest expense minus current tax expense (plus or minus all applicable adjustments).

12.5.2.3. Free operating cash flow to debt = CFO (adjusted) minus capital expenditures / Total debt

12.5.2.3.1. CFO = cash flow from operations

12.5.2.4. EBIT margin = EBIT / Total revenues

12.5.2.4.1. EBIT = earnings before interest and taxes

12.5.2.5. EBITDA margin = EBITDA / Total revenues

12.5.2.6. Debt to EBITDA = Total debt / EBITDA

12.5.2.7. Return on capital = EBIT / Average beginning-of-year and end-of-year capital

12.5.2.7.1. Capital = debt plus noncurrent deferred taxes plus equity (plus or minus all applicable adjustments)

12.6. Business and Geographic Segments

12.7. Model Building and Forecasting

13. I-30.Applications of Financial Statement Analysis

13.1. Application: Evaluating Past Financial Performance

13.2. Application: Projecting Future Financial Performance

13.2.1. Projecting Performance: An Input to Market-Based Valuation

13.2.2. Projecting Multiple-Period Performance

13.3. Application: Assessing Credit Risk

13.4. Application: Screening for Potential Equity Investments

13.5. Analyst Adjustments to Reported Financials

13.5.1. A Framework for Analyst Adjustments

13.5.2. Analyst Adjustments Related to Investments

13.5.3. Analyst Adjustments Related to Inventory

13.5.4. Analyst Adjustments Related to Property, Plant and Equipment

13.5.5. Analyst Adjustments Related to Goodwill

14. I-25.Inventories

14.1. Cost of Inventories

14.1.1. Costs of purchase

14.1.2. Costs of conversion

14.1.3. Exclude the costs from inventory

14.2. Inventory Adjustments

14.3. Inventory Method Changes

14.4. Inventory Valuation Methods

14.4.1. Specific Identification

14.4.2. First-In, First-Out (FIFO)

14.4.3. Weighted Average Cost

14.4.4. Last-In, First-Out (LIFO)

14.4.4.1. LIFO Reserve

14.4.4.2. LIFO Liquidations

14.4.5. Calculation of Cost of Sales, Gross Profit, and Ending Inventory

14.4.6. Periodic versus Perpetual Inventory Systems

14.4.7. Comparison of Inventory Valuation Methods

14.5. Evaluation of Inventory Management

14.5.1. Presentation and Disclosure

14.5.2. Inventory Ratios

14.5.3. Financial Analysis Illustrations

15. I-26.Long-Lived Assets

15.1. Acquisition of Long-Lived Assets

15.1.1. Property, Plant, and Equipment

15.1.2. Intangible Assets

15.1.2.1. Intangible Assets Purchased in Situations Other Than Business Combinations

15.1.2.2. Intangible Assets Developed Internally

15.1.2.3. Intangible Assets Acquired in a Business Combination

15.1.3. Capitalising versus Expensing: Impact on Financial Statements and Ratios

15.1.4. Capitalisation of Interest Costs

15.1.5. Capitalisation of Internal Development Costs

15.2. Depreciation and Amortisation of Long-Lived Assets

15.2.1. Depreciation Methods and Calculation of Depreciation Expense

15.2.2. Amortisation Methods and Calculation of Amortisation Expense

15.3. The Revaluation Model

15.4. Impairment of Assets

15.4.1. Impairment of Property, Plant, and Equipment

15.4.2. Impairment of Intangible Assets with a Finite Life

15.4.3. Impairment of Intangibles with Indefinite Lives

15.4.4. Impairment of Long-Lived Assets Held for Sale

15.4.5. Reversals of Impairments of Long-Lived Assets

15.5. Derecognition

15.5.1. Sale of Long-Lived Assets

15.5.2. Long-Lived Assets Disposed of Other Than by a Sale

15.6. Presentation and Disclosures

15.7. Investment Property

16. I-27.Income Taxes

16.1. Differences between Accounting Profit and Taxable Income

16.1.1. Current Tax Assets and Liabilities

16.1.2. Deferred Tax Assets and Liabilities

16.2. Determining the Tax Base of Assets and Liabilities

16.2.1. Determining the Tax Base of an Asset

16.2.2. Determining the Tax Base of a Liability

16.2.3. Changes in Income Tax Rates

16.3. Temporary and Permanent Differences Between Taxable and Accounting Profit

16.3.1. Taxable Temporary Differences

16.3.2. Deductible Temporary Differences

16.3.3. Examples of Taxable and Deductible Temporary Differences

16.3.4. Temporary Differences at Initial Recognition of Assets and Liabilities

16.3.5. Business Combinations and Deferred Taxes

16.3.6. Investments in Subsidiaries, Branches, Associates and Interests in Joint Ventures

16.4. Unused Tax Losses and Tax Credits

16.5. Recognition and Measurement of Current and Deferred Tax

16.5.1. Recognition of a Valuation Allowance

16.5.2. Recognition of Current and Deferred Tax Charged Directly to Equity

16.6. Presentation and Disclosure

16.7. Comparison of IFRS and US GAAP

17. I-28.Non-Current (Long-Term) Liabilities

17.1. Bonds Payable

17.1.1. Accounting for Bond Issuance

17.1.2. Accounting for Bond Amortisation, Interest Expense, and Interest Payments

17.1.3. Current Market Rates and Fair Value Reporting Option

17.1.4. Derecognition of Debt

17.1.5. Debt Covenants

17.1.6. Presentation and Disclosure of Long-Term Debt

17.2. Leases

17.2.1. Lessee accounting

17.2.2. Lessor accounting

17.3. Introduction to Pensions and Other Post-Employment Benefits

17.4. Evaluating Solvency: Leverage and Coverage Ratios

18. I-29.Financial Reporting Quality

18.1. Conceptual Overview

18.1.1. GAAP, Decision-Useful, Sustainable, and Adequate Returns

18.1.2. GAAP, Decision-Useful, but Sustainable?

18.1.3. Biased Accounting Choices

18.1.3.1. Within GAAP, but “Earnings Management”

18.1.4. Departures from GAAP

18.1.5. Differentiate between Conservative and Aggressive Accounting

18.1.5.1. Conservatism in Accounting Standards

18.1.5.2. Bias in the Application of Accounting Standards

18.2. Context for Assessing Financial Reporting Quality

18.2.1. Motivations

18.2.2. Conditions Conducive to Issuing Low-Quality Financial Reports

18.2.3. Mechanisms That Discipline Financial Reporting Quality

18.2.3.1. Market Regulatory Authorities

18.2.3.2. Auditors

18.2.3.3. Private Contracting

18.3. Detection of Financial Reporting Quality Issues

18.3.1. Presentation Choices

18.3.2. Accounting Choices and Estimates

18.3.2.1. How Accounting Choices and Estimates Affect Earnings and Balance Sheets

18.3.2.2. How Choices Affect the Cash Flow Statement

18.3.2.3. Choices That Affect Financial Reporting

18.3.3. Warning Signs