Financial Statement Analysis: Exam 1 Study Guide

Cash

the most liquid assets on a corporation’s balance sheet that are not subject to any restrictions or delay in access

Cash Includes:

• physical currency

• demand deposits

• cash in transit

Cash Equivalents

original maturities of 3 months or less, easily convertible into cash, and subject to insufficient default risk and must not be legally restricted

Cash Equivalents Include:

• t-bills

• commercial paper

• money market funds

• short-term government bonds

• cds

Restricted Cash

funds legally or contractually (for debt servicing or escrow) are not included in CCE

High CCE

indicates a strong liquidity bugger and excess cash for acquisitions or negative shocks

Low CCE

operational efficiency in capital deployment (corporations shouldn’t hold too much in cash

Low CCE Firms

rely on short-term borrowings/credit lines as a substitute for holding cash. Risky for firms without strong credit ratings

Marketable Securities

liquid financial instruments that are easily convertible into cash at a reasonable value

Marketable Securities Assets

are classified as a current asset if expected to be liquidated within one year, versus 3 months for CCE. Non-current asset if held longer than a year

Marketable Securities Include:

• t-bills

• commercial paper

• short-term corporate bonds

• muni securities

• equities

HTM: Held Until Maturity

most marketable securities are classified as this. No gains or losses are realized. If securities are expected to be sold in the future, they are trading securities and marked-market

Accounts Receivables

amount owed to a company by its customers from the sale of goods or services on credit. Reflection of future demand for products

Accounts Receivable Current Assets

recognized when performance obligations are satisfied, the revenue can be measured reliably, collection is probable

Accounting Recognition

accounts receivables are initially measured at a transaction price

Issues With Account Receivables

accounts receivables may be adjusted due to returns, rebates, and failure of customer to pay

Allowance as a Percentage of Gross AR

easier for tracking trends over time as sales change

Allowance For Doubtful Accounts

accounts receivable are reported net of an allowance for doubtful accounts (ADA), reflecting management’s estimate of the amount unlikely to be collected

Key Ratios Involving Account Receivables

• accounts receivable turnover ratio

• days sales outstanding (DSO)

• percentage of AR past due

• allowance as a percentage of gross AR

Accounts Receivable Turnover Ratio

this measures how efficiently the firm collects its receivable. a higher turnover indicates faster collection, while a lower turnover may suggest lenient credit policies or collection problems

Days Sales Outstanding (DSO)

this metric reflects the average number of days it takes to collect receivables. it should be benchmarked against industry norms and credit terms. a rising DSO may be a red flag for deteriorating collections

Percentage of AR Past Due

this breakdown (often found in financial footnotes) helps assess the aging of receivables and potential impairment

Accounts Receivables Industry

ARs are typically low in industries with low-priced goods that are paid via credit cards (generally consumer-oriented industries such as consumer goods). generally high in manufacturing and business to business services

Factoring and Securitization

selling receivables to third parties for immediate cash, often used by firms seeking liquidity or capital optimization

Dynamic Discounting

offering early payment discounts to accelerate cash inflows. (this converts ARs into cash, especially for companies)

Extended Payment Terms

can be used to drive sales growth, thought at the cost of liquidity and higher credit risk. (this boosts ARs)

Early Shipping to Customers

ship excess product to customers early to inflate sells (this boosts ARs)

Inventory

can be assets held for sale, in the process of production, or raw materials

Inventory Valuation Methods

inventory is valued at the lower cost or net realizable value. value includes purchase price of raw materials, direct labor, and overhead

First-In, First-Out (FIFO)

assumes earliest goods purchased are sold first

Last-In, Last-Out (LIFO)

assumes latest inventory is sold out

Weighted Average Cost

cost per unit is the average of all inventory costs

Specific Identification

used when items are unique or high-value (real estate, luxury goods)

Risks Associated With Inventory

• obsolescence and spoilage

• inventory shrinkage

• overproduction and holding costs

• revenue manipulation risk

Smooth Production

build inventory in low-demand periods to maintain production levels

Lock in Costs

stockpile raw materials during favorable pricing environments

Leverage Volume Discounts

bulk purchases may lower per-unit costs

Respond to Demand Surges

safety stock minimizes stockouts

Prepaid Expenses

payments made by a corporation for goods or services that will be received in the future (within 12 months). not recognized as expenses due to matching principle

Obsolescence and Spoilage

technology and perishable goods face rapid obsolescence. firms must write down inventory to net realizable value when recoverable amounts fall below cost

Inventory Shrinkage

caused by theft, fraud, or administrative errors. companies may estimate and include it in COGS or bad debt provisions

Overproduction and Holding Costs

excess inventory ties up capital and incurs storage, insurance, and depreciation costs. this impacts working capital and return on assets (ROA)

Revenue Manipulation Risk

inflated inventory can falsely improve gross profit margins and hide COGS. auditors and analysts scrutinize unusual changes in inventory relative to sales

Prepaid Expenses Classification

recognized as expenses only when the associated benefit is realized

Prepaid Expenses Examples:

• prepaid rent

• insurance

• licenses

• subscriptions

• advertisement

Common Types of Prepaid Expenses:

• prepaid rent and leases

• prepaid insurance

• software licenses and maintenance contracts

• prepaid advertising

Property, Plant, and Equipment (PP&E)

tangible, long-lived assets, especially important for capital-intensive industries

PP&E on Corporate Balance Sheets

recognized when asset will yield future economic benefits (isn’t used up) and the cost of the asset can be reliably measured

Classification of PP&E

• land

• buildings

• machinery and equipment

• furniture and fixtures

• vehicles

• leasehold improvements

Land

non-depreciable; includes purchase cost and closing fees

Buildings

offices, warehouses, and manufacturing facilities

Machinery and Equipment

production machinery, tools, and factory equipment

Furniture and Fixtures

office furniture, shelving, and interior installations

Vehicles

trucks, delivery vans, and company cars

Leasehold Improvement

modifications to rented properties

Initial Cost Includes:

• purchase price

• direct costs such as delivery

• site preparation

• site restoration

Capital Expenditures (CapEx)

routine maintenance and repairs are expensed

All PP&E Except Land

is depreciated, including buildings

Common Depreciation Methods:

• straight-line method

• declining balance method

• units of production method

Straight-Line Method

equal expense across each period

Declining Balance Method

higher expense across each period

Units of Production Method

based on usage or output

Asset Impairment

PP&E must be tested for impairment when there are indicators that its carrying amount may not be recoverable

Undiscounted Cash Flows

the asset is impaired if this thing is less than the carrying amount

Recoverable Amount

impairment is recognized when this thing (higher of fair value less costs to sell and value in use) is below the carrying amount

When Impaired:

• the asset’s carrying amount is written down

• an impairment loss is recorded in the income statement

PP&E Industries

this is especially important for manufacturing, utilities, and real estate linked industries, less important for industries with significant amounts of intellectual capital (such as tech)

Intangible Assets

non-physical assets that provide future economic benefits to a company

Intangible Assets on Corporate Balance Sheets

these assets have become more important over time

Intangible Assets Include:

• patents

• trademarks and trade names

• copyrights

• licenses and permits

• franchise agreement

• customer lists and relationships

• technology and software

• non-compete agreements

Patents

legal rights to inventions or processes

Trademarks and Trade Names

brand identifiers and logos

Copyrights

exclusive rights to creative works

Licenses and Permits

rights to operate under a franchisor’s brand

Franchise Agreements

rights to operate under a franchisor’s brand

Recognition and Initial Measurement

• it is identifiable

• the company controls the asset (can obtain future economic benefits)

• the asset’s cost can be measured reliably

Internally Generated Intangible Assets Criteria:

• research costs are expensed as incurred

• development costs may be capitalized under IFRS if specific conditions are met; under U.S. GAAP, they are typically expensed

Intangible Assets Measured at Cost:

• purchase price

• duties/taxes

• direct costs necessary to prepare the asset for use

Research Costs

are expenses as incurred

Amortization

intangible assets with a finite useful life are amortized over their expected life

Amortization Method

must reflect the pattern of benefit consumption, typically on a straight-line basis unless a better method is evident

Most Common Examples of Amortization

software licenses and patents

Intangible Assets Industry Examples:

• technology firm

• pharmaceuticals

• consumer goods

• media and publishing

• telecom and utilities

Technology Firm

significant software, R&D, and intellectual property

Pharmaceuticals

patents dominate; amortization affects profit margins

Consumer Goods

brands and trademarks are key intangible drivers

Media and Publishing

copyrights and content libraries hold core valur

Telecom and Utilities

spectrum licenses and permits can be substantial

Goodwill on Corporate Balance Sheets

is an intangible asset that arises when a company acquires another business for a price exceeding the fair value of its identifiable (assets minus liabilities)

Non-Balance Sheet Intangibles Such as…

culture, data, and relationships rarely appear on balance sheets, yet are essential for firm value

Goodwill

an intangible asset that arises when a company acquires another business for a price exceeding the fair value of its identifiable net assets

Goodwill Is Not Amortized,

it is tested annually for impairment, and cannot be separated for the acquired entity

Common Sources of Goodwill

• strong brand name or market reputation

• superior customer relationships and loyalty

• skilled workforce and managerial talent

• economies of scale and synergies from the merger

• competitive advantages or proprietary technologies

Impairment Occurs When…

the carrying amount of goodwill exceeds its recoverable amount. cannot reverse goodwill

Impairment is Recorded…

as an expense on the income statement, which reduces net income

Goodwill to % of Total Assets

indicates how important acquisitions are in a company’s growth strategy

Goodwill May Reflect…

overpayment for acquisitions and poor corporate governance

Sectors With High Levels of Goodwill Include:

• tech

• pharma

• consumer brands

• (companies with high levels of intangible assets

Deferred Tax Assets (DTA)

amount that a corporation can use to reduce future taxable income

DTAs arise when

a company pays more tax to the government in the current period than is recognized as an expense. prepaying taxes