Dear Blog Readers
I'm interested in making this more of a two-way conversation. Therefore, I'm thinking of trying a free discussion board application and customizing it for our class and for MBA students in general.
If you're willing to be one of the guinea pigs who will help me test out this technology, please contact me in class or at my gmail address: eliezerappleton.
EA
Thursday, October 23, 2008
Thursday, October 16, 2008
Lecture 6 - Analyzing Financial Statements
Analyzing Financial Statements
Horizontal Analysis
Show Income statement columns for comparable periods. Calculate % increase in an additional column. If you do it for many years, it’s called trend analysis.
Vertical Analysis
Calculate each balance sheet and income statement line as a percentage of Sales. You can trend that out also, combining vertical and horizontal analysis.
Ratio Analysis
Know these ratios! They will be on the final exam! No cheat sheet allowed.
Go to finance.yahoo.com and got to investing – stock investing – stock screener.
Current Ratio = current assets / current liabilities
You would typically want this to be > 1.0
Some companies can have < 1 and still be well run – Walmart and Dell.
Quick Ratio = Very current assets / current liabilities
This is a greater test of whether a company is liquid or not. This ratio will not be on the final exam, but it’s mentioned because Benjamin Graham uses it.
This is calculated by not including prepaid expenses or inventory.
Receivables Turnover = Net Credit Sales / Avg Accts Receivables
Days in Receivables = 365 / Receivables Turnover
Inventory Turnover = COGS / Avg Inventory
Days in Inventory = 365 / Inventory Turnover
Payables Turnover = (COGS +/- in/decrease in inventory) / Avg Accts Payable
Numerator is essentially the purchases
Profitability Ratios
Profit Margin = Net Income / Net Sales
Walmart has small profit margin, but makes it up in large sales volume.
Manufacturing companies like Boeing have much higher profit margins
Asset Turnover = Net Sales / Avg Total Assets
Return on Assets = Net Income / Avg Total Assets
Return on Equity = Net Income / Avg Equity
Equity is almost always lower than assets, so ROE is higher than ROA.
Many ppl would make adjustments to the Net Income numerator in the last two ratios.
Solvency Ratios
Debt to Equity = Total Debt / Avg Total Equity
Utility companies and Lehmann Brothers have high D2E ratio. Many industries have a standard for this ratio that is “expected”.
Interest Coverage = Income before Interest and Taxes / Interest Expense
This measures how capable the firm is of paying off its debt.
Banks certainly look at this ratio when lending.
Cash Flow Adequacy Ratios
Skip the first three: Cash Flow Yield, Cash Flow to Sales, Cash Flow to Assets
Free Cash Flow = Cash Flow from Operations – Dividends – Net Capital Expenditures
Cash Flow from Operations is somewhat difficult to compute. But it is on the statement of cash flows.
Subtract out dividends to keep shareholders happy.
Subtract out maintenance of plant and property so operations can continue in the future.
The rest is not subject to prior commitments. It’s up to managerial discretion on how to spend it.
Not really a ratio. It’s a cash flow computation.
Cash flow can come from 3 sources: Operations, investing, financing.
Next two are not in the book:
EBIT = Earnings before interest and taxes
Net Income + Interest Paid + Taxes
The numerator from Interest Coverage.
Interest = how to finance – high debt or low debt
Taxes = how company is organized – partnership, S corp, etc
This is raw earnings.
EBITDA = Earnings before interest, taxes, depreciation and amortization
Amortization is like depreciation for intangibles. Depreciation and amortization are an expense on the income statement that doesn’t represent a current cash flow. These are non-cash charges that are added back to net income to calculate EBITDA.
These last two, EBIT and EBITDA, are also not ratios.
Market Strength Ratios
Price/Earnings Ratio = Stock Price / Earnings per Share
High ratio indicates that the market values it highly. Others, like Benjamin Graham, target low PE ratio in the hopes that the market will value the company in the future.
Dividend Yield = Dividend / Stock Price
Compare this yield to the interest yield in the bank or other debt instruments.
Horizontal Analysis
Show Income statement columns for comparable periods. Calculate % increase in an additional column. If you do it for many years, it’s called trend analysis.
Vertical Analysis
Calculate each balance sheet and income statement line as a percentage of Sales. You can trend that out also, combining vertical and horizontal analysis.
Ratio Analysis
Know these ratios! They will be on the final exam! No cheat sheet allowed.
Go to finance.yahoo.com and got to investing – stock investing – stock screener.
Current Ratio = current assets / current liabilities
You would typically want this to be > 1.0
Some companies can have < 1 and still be well run – Walmart and Dell.
Quick Ratio = Very current assets / current liabilities
This is a greater test of whether a company is liquid or not. This ratio will not be on the final exam, but it’s mentioned because Benjamin Graham uses it.
This is calculated by not including prepaid expenses or inventory.
Receivables Turnover = Net Credit Sales / Avg Accts Receivables
Days in Receivables = 365 / Receivables Turnover
Inventory Turnover = COGS / Avg Inventory
Days in Inventory = 365 / Inventory Turnover
Payables Turnover = (COGS +/- in/decrease in inventory) / Avg Accts Payable
Numerator is essentially the purchases
Profitability Ratios
Profit Margin = Net Income / Net Sales
Walmart has small profit margin, but makes it up in large sales volume.
Manufacturing companies like Boeing have much higher profit margins
Asset Turnover = Net Sales / Avg Total Assets
Return on Assets = Net Income / Avg Total Assets
Return on Equity = Net Income / Avg Equity
Equity is almost always lower than assets, so ROE is higher than ROA.
Many ppl would make adjustments to the Net Income numerator in the last two ratios.
Solvency Ratios
Debt to Equity = Total Debt / Avg Total Equity
Utility companies and Lehmann Brothers have high D2E ratio. Many industries have a standard for this ratio that is “expected”.
Interest Coverage = Income before Interest and Taxes / Interest Expense
This measures how capable the firm is of paying off its debt.
Banks certainly look at this ratio when lending.
Cash Flow Adequacy Ratios
Skip the first three: Cash Flow Yield, Cash Flow to Sales, Cash Flow to Assets
Free Cash Flow = Cash Flow from Operations – Dividends – Net Capital Expenditures
Cash Flow from Operations is somewhat difficult to compute. But it is on the statement of cash flows.
Subtract out dividends to keep shareholders happy.
Subtract out maintenance of plant and property so operations can continue in the future.
The rest is not subject to prior commitments. It’s up to managerial discretion on how to spend it.
Not really a ratio. It’s a cash flow computation.
Cash flow can come from 3 sources: Operations, investing, financing.
Next two are not in the book:
EBIT = Earnings before interest and taxes
Net Income + Interest Paid + Taxes
The numerator from Interest Coverage.
Interest = how to finance – high debt or low debt
Taxes = how company is organized – partnership, S corp, etc
This is raw earnings.
EBITDA = Earnings before interest, taxes, depreciation and amortization
Amortization is like depreciation for intangibles. Depreciation and amortization are an expense on the income statement that doesn’t represent a current cash flow. These are non-cash charges that are added back to net income to calculate EBITDA.
These last two, EBIT and EBITDA, are also not ratios.
Market Strength Ratios
Price/Earnings Ratio = Stock Price / Earnings per Share
High ratio indicates that the market values it highly. Others, like Benjamin Graham, target low PE ratio in the hopes that the market will value the company in the future.
Dividend Yield = Dividend / Stock Price
Compare this yield to the interest yield in the bank or other debt instruments.
Lecture 6 - Accounting Conventions
Review of the Accounting Cycle
In the last step of the cycle, prepare the financial statements.
Prepare Income Statement first, Statement of Retained Earnings and finally the Balance Sheet.
We’ll cover the Statement of Cash Flows at the end of the course.
Accounting Conventions
Comparability
Financial statements should be comparable from one period to the next and between different companies. Must go out of your way to disclose ways in which they are not comparable – in footnotes and in Auditors’ Opinion.
Financial statements should facilitate comparisons among firms and period to periods comparisons of the same firm.
Consistency
Use the same methods to become comparable. Financial statements should be prepared on a consistent basis to facilitate comparisons. Inconsistencies in the method of preparation should be highlighted.
Materiality
Is it worth our time, effort and money to get the data right down to the last cent? Historically, if it has less than 5% effect on net income, it was considered immaterial. However, lately, this has become insufficient. Enron was an example where several immaterial dollar amounts added up to something that would effect investors and creditors.
In deciding the level of detail to examine and disclose, accountants should take into account whether the detail is likely to affect decision makers.
Conservatism
When in doubt, accountants tend to choose Underestimate income and underestimate net carry value of assets.
Germany is ultra-conservative in this regard due to smaller capital markets and funding being provided primarily by banks.
Full Disclosure
Accountants should attempt to fully disclose all information needed to understand the financial statements.
Cost-Benefit
Balance Sheet Categories
Current Assets
There’s a sub-total called “current assets”. Then all other assets are listed, but not subtotaled and then a grand total of all assets is listed.
Current assets: Cash and assets that are expected to be converted into cash, sold or consumed during the next year or operating cycle, whichever is longer. Typically, a year is longer.
What is the Operating Cycle?
Cash -> Inventory -> Receivables -> back to Cash
Typical current assets:
Cash, account and notes receivables (including installment payments – even if no payments are to be received for more than a year), some investments, inventory, prepayments (usually consumed within the next year)
Investments
Property held as an investment, as opposed to used in the trade or business. Parking lot next door is not an investment.
Property, Plant and Expenses
These are long-lived assets, except for land.
On books at cost and depreciated over their typical life.
Use the Accumulated Depreciation account.
Land is put on the books at cost and not depreciated.
Intangibles
These are long-lived assets without a traditional physical existence, such as patents, franchises, trademarks, etc.
Liabilities
Current liabilities – those that will be satisfied within the next year or operating cycle, whichever is longer.
Long-Term Liabilities
Ex: a long term note which is paid off over more than a year. The portion that will be paid within the current year goes into Current Liabilities.
Owners’ Equity
Contributed capital: Common Stock, Excess over Par, Preferred Stock
Earned capital: Retained Earnings.
Income Statement Categories
Can be either single-step or multi-step statement.
Usually says margin, not “profit”. Groceries stores still use the term profit.
Multi-step:
Sales-COGS = Gross Profit
Gross Profit – Operating Expenses = Net Operating Income
Net Operating Income – Non-Operating Items = Net Income before taxes
Single Step:
List and total all revenues and then list and total all expenses. Net Income before taxes = Revenue – Expenses
In the last step of the cycle, prepare the financial statements.
Prepare Income Statement first, Statement of Retained Earnings and finally the Balance Sheet.
We’ll cover the Statement of Cash Flows at the end of the course.
Accounting Conventions
Comparability
Financial statements should be comparable from one period to the next and between different companies. Must go out of your way to disclose ways in which they are not comparable – in footnotes and in Auditors’ Opinion.
Financial statements should facilitate comparisons among firms and period to periods comparisons of the same firm.
Consistency
Use the same methods to become comparable. Financial statements should be prepared on a consistent basis to facilitate comparisons. Inconsistencies in the method of preparation should be highlighted.
Materiality
Is it worth our time, effort and money to get the data right down to the last cent? Historically, if it has less than 5% effect on net income, it was considered immaterial. However, lately, this has become insufficient. Enron was an example where several immaterial dollar amounts added up to something that would effect investors and creditors.
In deciding the level of detail to examine and disclose, accountants should take into account whether the detail is likely to affect decision makers.
Conservatism
When in doubt, accountants tend to choose Underestimate income and underestimate net carry value of assets.
Germany is ultra-conservative in this regard due to smaller capital markets and funding being provided primarily by banks.
Full Disclosure
Accountants should attempt to fully disclose all information needed to understand the financial statements.
Cost-Benefit
Balance Sheet Categories
Current Assets
There’s a sub-total called “current assets”. Then all other assets are listed, but not subtotaled and then a grand total of all assets is listed.
Current assets: Cash and assets that are expected to be converted into cash, sold or consumed during the next year or operating cycle, whichever is longer. Typically, a year is longer.
What is the Operating Cycle?
Cash -> Inventory -> Receivables -> back to Cash
Typical current assets:
Cash, account and notes receivables (including installment payments – even if no payments are to be received for more than a year), some investments, inventory, prepayments (usually consumed within the next year)
Investments
Property held as an investment, as opposed to used in the trade or business. Parking lot next door is not an investment.
Property, Plant and Expenses
These are long-lived assets, except for land.
On books at cost and depreciated over their typical life.
Use the Accumulated Depreciation account.
Land is put on the books at cost and not depreciated.
Intangibles
These are long-lived assets without a traditional physical existence, such as patents, franchises, trademarks, etc.
Liabilities
Current liabilities – those that will be satisfied within the next year or operating cycle, whichever is longer.
Long-Term Liabilities
Ex: a long term note which is paid off over more than a year. The portion that will be paid within the current year goes into Current Liabilities.
Owners’ Equity
Contributed capital: Common Stock, Excess over Par, Preferred Stock
Earned capital: Retained Earnings.
Income Statement Categories
Can be either single-step or multi-step statement.
Usually says margin, not “profit”. Groceries stores still use the term profit.
Multi-step:
Sales-COGS = Gross Profit
Gross Profit – Operating Expenses = Net Operating Income
Net Operating Income – Non-Operating Items = Net Income before taxes
Single Step:
List and total all revenues and then list and total all expenses. Net Income before taxes = Revenue – Expenses
The Midterm
Midterm Results
Here is the grading "schedule" for the midterm:
75-80 A
71-74 A-
66-70 B+
58-65 B
53-57 B-
45-52 C+
41-44 C
34-40 C-
Below 34 D
The letter grades are not tracked, only your numeric grade. After the final, Prof Sullivan will take both the midterm and final exam grades and average them and create a new "schedule" for those average grades.
My thoughts on the midterm
I thought it was thorough and difficult. All of the answers were more or less straightforward. Nothing really tricky. You either knew it, or you didn't. You just needed to be very precise - which makes sense in an accounting course.
Here is the grading "schedule" for the midterm:
75-80 A
71-74 A-
66-70 B+
58-65 B
53-57 B-
45-52 C+
41-44 C
34-40 C-
Below 34 D
The letter grades are not tracked, only your numeric grade. After the final, Prof Sullivan will take both the midterm and final exam grades and average them and create a new "schedule" for those average grades.
My thoughts on the midterm
I thought it was thorough and difficult. All of the answers were more or less straightforward. Nothing really tricky. You either knew it, or you didn't. You just needed to be very precise - which makes sense in an accounting course.
Thursday, October 2, 2008
Lecture 4 - Investments (cont.)
Accounting for Investments (continued)
The valuation of market price of investment assets is difficult in these times when the market value of many securities has fallen dramatically and there is no liquid market. Some companies claim that the rules in FASB 157 (Fair Value Measurements) are not appropriate for this situation. Financial Accounting Foundation and FASB claims that there is too much pressure from Congress and other governmental agencies. See this article from the FASB web site: http://www.fasb.org/news/2008-FairValue.pdf
Long Term Investments
Available for Sale Securities (less than 20% interest) may be short-term or long-term. In either case, the rules are the same.
If you own more than 20% interest in the investee, you use the Equity Method. Record it at cost and every year, increase or decrease the carrying value by your share of the investees income.
If there's income, debit Investments and credit Income from Investment. If the investee has a loss, debit Loss from Investment and credit Investment.
If the investee pays a dividend, debit Cash and credit Investment.
If you own more than 50% interest in the investee, you treat the two companies as one consolidated whole and issue consolidated financial statement. (Some people say the 50% rule is too low and it shouldn't require consolidation until 60% or higher.) The same thing holds true if the investee is a non-US company. It needs to be consolidated. This is known as "worldwide consolidation". However, you can't consolidate foreign entities for tax accounting.
Debt Securities
There are three categories: trading, available for sale (both of which are treated exactly like equity securities), and held-to-maturity. For held-to-maturity securities, the market value is less relevant since they are going to be held to maturity.
Investment Quiz
The valuation of market price of investment assets is difficult in these times when the market value of many securities has fallen dramatically and there is no liquid market. Some companies claim that the rules in FASB 157 (Fair Value Measurements) are not appropriate for this situation. Financial Accounting Foundation and FASB claims that there is too much pressure from Congress and other governmental agencies. See this article from the FASB web site: http://www.fasb.org/news/2008-FairValue.pdf
Long Term Investments
Available for Sale Securities (less than 20% interest) may be short-term or long-term. In either case, the rules are the same.
If you own more than 20% interest in the investee, you use the Equity Method. Record it at cost and every year, increase or decrease the carrying value by your share of the investees income.
If there's income, debit Investments and credit Income from Investment. If the investee has a loss, debit Loss from Investment and credit Investment.
If the investee pays a dividend, debit Cash and credit Investment.
If you own more than 50% interest in the investee, you treat the two companies as one consolidated whole and issue consolidated financial statement. (Some people say the 50% rule is too low and it shouldn't require consolidation until 60% or higher.) The same thing holds true if the investee is a non-US company. It needs to be consolidated. This is known as "worldwide consolidation". However, you can't consolidate foreign entities for tax accounting.
Debt Securities
There are three categories: trading, available for sale (both of which are treated exactly like equity securities), and held-to-maturity. For held-to-maturity securities, the market value is less relevant since they are going to be held to maturity.
Investment Quiz
Lecture 4 - Investments
Accounting for Investements
We approach investments from the point of view of how a company accounts for their investments in other companies.
The accounting rules depend on whether the investments are debt or equity and whether we classify them as current and non-current. They're broken down this way on the balance sheet. If there are plans to sell the investment within the next year, it's classified as current. Otherwise, it's non-current.
Current investments are assumed to be less than 20% ownership in the investee. Such investments are divided into 2 categories: Trading securities and Available for Sale securities.
Trading Securities are those investments that the company holds to make a short-term profit. Available for Sale were purchases for more long-term investment, but they have now been "marked for market", i.e. to be sold within the next year.
Investments are recorded at market rate. Since there are plans to sell them soon, the market price is the most relevant value. Investments can be written down and then written back up if the price goes back up.
At purchase, debit Investment, credit Cash.
At the end of year, if the value of the investment goes up, debit Allowance to Adjust Securities to Market (a revenue account) and credit Unrealized Gain on Securities.
If the investment value decreases, debit Unrealized Loss on Securities and credit Allowance to Adjust Securities to Market (an expense account).
This is a very controversial topic, perhaps the most controversial, in Financial Accounting today.
We approach investments from the point of view of how a company accounts for their investments in other companies.
The accounting rules depend on whether the investments are debt or equity and whether we classify them as current and non-current. They're broken down this way on the balance sheet. If there are plans to sell the investment within the next year, it's classified as current. Otherwise, it's non-current.
Current investments are assumed to be less than 20% ownership in the investee. Such investments are divided into 2 categories: Trading securities and Available for Sale securities.
Trading Securities are those investments that the company holds to make a short-term profit. Available for Sale were purchases for more long-term investment, but they have now been "marked for market", i.e. to be sold within the next year.
Investments are recorded at market rate. Since there are plans to sell them soon, the market price is the most relevant value. Investments can be written down and then written back up if the price goes back up.
At purchase, debit Investment, credit Cash.
At the end of year, if the value of the investment goes up, debit Allowance to Adjust Securities to Market (a revenue account) and credit Unrealized Gain on Securities.
If the investment value decreases, debit Unrealized Loss on Securities and credit Allowance to Adjust Securities to Market (an expense account).
This is a very controversial topic, perhaps the most controversial, in Financial Accounting today.
Lecture 4 - Accounting for Inventory (cont.)
Midterm Exam is next week
Income Statement - Retained Earnings - Balance Sheet
Calculators will be provided
ACE questions will be useful review
Midterm questions come from the book test bank
Misstatements of Inventory
Fundamental formula for accounting of inventory is:
The consequences to income of misstatements of inventory fall into the following four scenarios:
Overstatement of ending inventory decreases COGS which increases net income. Then, next beginning inventory next year will also be overstated as well. This will increase next year's COGS and decrease next year's net income. Overstating ending inventory takes next year's income and brings it into this year.
Overstatement of beginning inventory increases COGS which decreases net income. This overstatement will not effect next year's income.
Understatement of ending income increases COGS which decreases net income. Next year's beginning income is therefore too low and net income will be too high.
Understatement of beginning inventory decreases COGS which increases net income. Net year's net income is not effected.
Terminology: "Cost of goods available for sale" = Beginning Inventory + Purchases
Lower of Cost or Market
Some companies can use the Lower of Cost or Market technique. (If you use LIFO, you can't use it.) The concept is not to overvalue inventory. Use the lower of cost or market. If cost is lower, use that as usual. If market is lower, mark down the cost to market cost.
When we say "market cost", we refer to the current replacement cost.
In summary, the Lower of Cost or Market rule requires that when the replacement cost of inventory falls below historical cost, the inventory is written down to the lower value.
It can be applied item by item or as an aggregate on major categories of items. Item by item will always be equal to or lower than the aggregate method. For tax accounting, you must use the item by item method.
Retail Method
When taking physical inventory, it's often easier to record the retail price and derive the cost from that. We also sometimes want to estimate the ending inventory without making a physical count. To accomplish these goals, we use the Retail Method.
Calculate the ratio of the cost vs. retail of all goods available for sale (=beginning inventory + purchases) and apply that ratio to the ending inventory which you value at retail price to get the cost of ending inventory. However, doing this is very difficult in practice.
Modify the inventory equation to read:
Ending Inventory = Beginning Inventory + Purchases - COGS
Goods Available for sale - Sales = Estimate of Ending Inventory at retail
Then apply the ratio to get the Estimate of Ending Inventory at cost
Gross Profit Method
The Gross Profit Method usually deals with estimating loss due to damaged inventory. Often used for insurance purposes. This method uses the modified inventory equation that we saw above: Ending Inventory = Beginning Inventory + Purchases - COGS. It uses this equation to determine the inventory that was on hand when it was damaged (e.g. by fire, tornado, etc).
Usually, you have records of beginning inventory and purchases from accounting records. You can derive COGS from Sales x Historic Gross Margin, where Gross Margin = Historic (Sales-COGS/Sales).
David H. Brooks
See the case of David Brooks who overstated inventory to hide his theft from the company.
Inventory Quiz
Income Statement - Retained Earnings - Balance Sheet
Calculators will be provided
ACE questions will be useful review
Midterm questions come from the book test bank
Misstatements of Inventory
Fundamental formula for accounting of inventory is:
COGS = Beginning Inventory + Purchases - Ending Inventory
The consequences to income of misstatements of inventory fall into the following four scenarios:
Overstatement of ending inventory decreases COGS which increases net income. Then, next beginning inventory next year will also be overstated as well. This will increase next year's COGS and decrease next year's net income. Overstating ending inventory takes next year's income and brings it into this year.
Overstatement of beginning inventory increases COGS which decreases net income. This overstatement will not effect next year's income.
Understatement of ending income increases COGS which decreases net income. Next year's beginning income is therefore too low and net income will be too high.
Understatement of beginning inventory decreases COGS which increases net income. Net year's net income is not effected.
Terminology: "Cost of goods available for sale" = Beginning Inventory + Purchases
Lower of Cost or Market
Some companies can use the Lower of Cost or Market technique. (If you use LIFO, you can't use it.) The concept is not to overvalue inventory. Use the lower of cost or market. If cost is lower, use that as usual. If market is lower, mark down the cost to market cost.
When we say "market cost", we refer to the current replacement cost.
In summary, the Lower of Cost or Market rule requires that when the replacement cost of inventory falls below historical cost, the inventory is written down to the lower value.
It can be applied item by item or as an aggregate on major categories of items. Item by item will always be equal to or lower than the aggregate method. For tax accounting, you must use the item by item method.
Retail Method
When taking physical inventory, it's often easier to record the retail price and derive the cost from that. We also sometimes want to estimate the ending inventory without making a physical count. To accomplish these goals, we use the Retail Method.
Calculate the ratio of the cost vs. retail of all goods available for sale (=beginning inventory + purchases) and apply that ratio to the ending inventory which you value at retail price to get the cost of ending inventory. However, doing this is very difficult in practice.
Modify the inventory equation to read:
Ending Inventory = Beginning Inventory + Purchases - COGS
Goods Available for sale - Sales = Estimate of Ending Inventory at retail
Then apply the ratio to get the Estimate of Ending Inventory at cost
Gross Profit Method
The Gross Profit Method usually deals with estimating loss due to damaged inventory. Often used for insurance purposes. This method uses the modified inventory equation that we saw above: Ending Inventory = Beginning Inventory + Purchases - COGS. It uses this equation to determine the inventory that was on hand when it was damaged (e.g. by fire, tornado, etc).
Usually, you have records of beginning inventory and purchases from accounting records. You can derive COGS from Sales x Historic Gross Margin, where Gross Margin = Historic (Sales-COGS/Sales).
David H. Brooks
See the case of David Brooks who overstated inventory to hide his theft from the company.
Inventory Quiz
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