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primary users of financial statements
shareholders and creditors
cost constraint
entities only disclose information who’s benefit exceeds the cost - the disclosure of information can have costly consequences (like disclosing salaries may lead to employees demanding a raise)
advantages of disclosing
(1) helps users make better decisions
(2) reduces the cost of capital
(3) improves information quality
(4) improve reputation
disadvantages of disclosing
(1) cost to process, collect, and communicate the data
(2) competitive disadvantage
(3) political exposure
(4) legal exposure
(5) set expectations (precedent of certain disclosures
unqualified opinion
the financial statements present fairly
qualified opinion
the financial statements present fairly except for…
adverse opinion
the financial statements do not present fairly (very rare because usually auditors quit before they get to this point)
scope limitation
auditor cannot form an opinion
do audits catch all mistakes
no
just because an audit presents an unqualified opinion, doesn’t mean that the auditor didn’t miss something and the financial statements may not be free from error - they just present fairly in all material aspects
When is an error material
when it could cause a user of the financial statements to change their mind (usually 5-10% of net income for public companies)
accounting standards board
creates GAAP and modifies existing rules as needed
securities regulators
regulate public company financial reporting
IFRS conceptual framework 6 guidelines
(1) relevance
(2) faithful representation
(3) verifiability
(4) comparability
(5) timeliness
(6) understandability
3 components of faithful representation
(1) completedness
(2) neutrality
(3) freedom from error
financial statements
Balance sheet, statement of changes in equity, cash flow statement, and income statement
Always backwards-looking, meaning they cannot contain any predictive information/projections - contain information about things that have already happened
governed by GAAP
Management Discussion and Analysis (MD&A)
Public companies are required to publish an MD&A and laws dictate what must be included, but it is not audited like the F/S
should contain:
balanced discussion of good and bad news
information that helps investors understand what financial statements show and do not dhow
discussion of material information that is not reflected in the financial statement
discussion of both present and expected future trends/risk that impacted or may impact F/S
Annual Report
Contains:
MD&A
audited financial statements and notes
may contain:
BOD letters to shareholders
Marketing materials (nice photos)
appendices of historical information
investor targeted materials
public companies may generate various types of information targeted to investors such as investor presentations and fact books
The purpose of these documents is to provide investors with relevant information but must keep in mind that this information is compiled by management and not audited and thus subject to bias
other name for the income statement
Profit and Loss (P+L) statement
Grouping by function
If you can add the word “department” instead of “expense” and have it make sense, then it is likely grouped by function
Example
marketing expense → marketing department makes sense so by function
grouping by nature
if you cannot add the word “department” instead of “expense” and have it make sense, then it is likely grouped by nature
Example
salaries expense → salaries department does not make sense so by nature
key point of differences between companies income statements
(1) grouping by nature or by function
(2) more vs. less detailed
recurring item
happens every year at the same predictable amount
transitory item
non-recurring, not expected every single year (also referred to as infrequent)
what may be management’s bias in regards to transitory vs. recurring items
to highlight transitory costs b/c those are easier to downplay to investors
common size analysis
used to compare the F/S of companies that a different scale
expresses financial data in relation to a single item or base
where is common size analysis typically performed
on the income statement → total revenues as base
on the balance sheet → with total assets as a base
can be preformed over time → using year x as the base year
total comprehensive income
net income + other comprehensive income (OCI)
quality of earnings
assesses the usefulness of reported earnings but no numerical score/quantitative measure
if current earnings are a good predictor of future earnings and cash flows → high quality of earnings
if not → low quality of earnings
relationship between net income and cash flows
in the short run:
net income =/= cash flow
in the long-run
net income = cash flow
the more earnings diverge from CF, the lower their quality
major sources of difference between cash and income
CAPEX, deferred revenue, stock-based compensation
Why do investors like FCF
reminder → FCF = CFO - CFI
Because that is the money a company has to pay back debt debt and payout dividends to shareholders
Estimates and earnings
preparation of F/S requires estimates and judgement from management. Changes in estimates affect reported income and therefore quality of earnings
management can use estimates to “massage results” like with cookie jar reserves
cookie jar reserves
a technique where accounting estimates (typically pertaining to liabilities (ex. lawsuit liability)) are used to create reserves of income that can be drawn upon in future years by reversing these liabilities
steps to creating a cookie jar reserve
(1) overestimate liability in Year 1 and record a higher expense (on the basis of being “conservative”)
(2) reverse excess liability to boost future income when needed
note: hard to do this with one big liability without it being spotted but with lots of little liabilities it is almost impossible to detect.
earnings management
When operational decisions are made for the purpose of manipulating the F/S → difficult to detect because accounting is correct
Earnings management exploits GAAP’s flexibility and is done to accomplish an objective
all companies engage in some form of earnings management
Objectives of earning’s management
(1) maximize income - management/users may benefit from higher reporting results for financing, compensation, and other items
(2) minimize income - for private companies, lower income means lower taxes and public companies may want to seem less successful to not tempt competitors or to avoid scrutiny
(3) “taking a bath” - very large reported losses, usually generated from writing off assets, “cleaning up” the balance sheet making future years look better (for example, lower depreciation)
(4) smooth income - company may prefer to show slow and steady growth rather than volatility because this indicates lower risk and thus better financing terms and higher stock price.
The purpose of trends
trends hint at what may happen in the future
trend analysis lets you focus what matters → i.e. is anything changing? why?
trend analysis considerations
(1) having sufficient data points
(2) cause and effect → what is behind the trend?
(3) small numbers → trend analysis is more meaningful when the numbers are material
(4) comparing trends → can only compare comparable trends like trend in revenue, trend in profits, etc.
limitations of ratio analysis
(1) tells you what happened but not why
(2) can return nonsense numbers, especially when dealing with negatives
(3) multiple definitions of the same ratio can exist
(4) one company that houses many different activities may make it hard to untangle the various activities from one another
what is asset turnover dependent on
whether the industry is capital intensive as well as accounting policies like depreciation
thus, usually not particularly useful in isolation as it does not contain a profitability component
liquidity
how quickly can you turn an asset into cash
example: short term investments (STIs) are easily convertible into cash
companies with low solvency ratios are more likely to ___
go bankrupt
issues with ROA
ROA is a lagging indicator - means that decisions made today may not show up in ROA for years
lag may cause management to avoid long term projects if their performance is measured based on ROA
2 strategies to increase ROA
differentiation: high margins, low asset turover
cost leadership: low margins, high turnover
cost structure
the mix of fixed and variable costs within an organization
fixed cost
cost is constant as volume changes
variable cost
cost that changes as volumes changes
operating leverage
measures how changes in revenues affect profit
cost structure’s impact on operating leverage
degree of operating leverage depends on organizations cost structue
companies with more fixed costs have higher operating leverage
when operating leverage is high, a small % change in revenues results in % change in profits
when is a high degree of operating leverage good
when revenues are growing (but it is terrible when shrinking because when you’re an organization with high fixed costs it can very hard to switch to variable costs
how can companies finance their operations (purchase assets to operate a business)
they can either use debt (leverage) or equity
how can leverage be used to increase ROE
borrow money and invest it into the business (assets) and get those assets to generate a return (profit) and if profit generated > interest cost incurred, then owners earn a higher ROE
borrowing is beneficial for ROE when the after tax cost of debt is less than adjusted ROA
when there is no financial leverage, what is the relationship between ROE and ROA
when no financial leverage, ROE = ROA
after tax cost of debt
interest rate(1-T)
advantages and disadvantages of increasing leverage
advantage:
reduce capital cost (cost of debt usually less than equity)
increase % returns to equity holders
disadvantage:
reduce financial flexibility
increase risk of default
higher interest rate
advantages and disadvantages of decreasing leverage
advantages:
increase financial flexibility
decrease risk of default
lower interest rate
Disadvantages:
increased cost of capital (cost of equity higher than cost of debt)
reduced returns to equity holders
earnings per share
measures the amount of earnings available to common shareholders
used for valuation purposes like the P-E multiple
reported on statement of profit or loss (only ratio!)
basic EPS
EPS based on outstanding common shares
diluted EPS
Worst case scenario for EPS by considering the potential impact of dilutive items
can you compare earnings per share between companies
never
the amount of shares outstanding that a company has is arbitrary
the only comparison that can be made is for EPS growth over time
relationship between diluted and basic EPS
diluted EPS will always be equal or less than EPS
diluted EPS is the conservative measure of Basic EPS → arguably, it is the best representation of a shareholder’s true economic claim
common potentially dilutive items
stock based compensation
convertible debt
antidilutive
items who’s inclusion would increase EPS (we only included dilutive items)
in-the-money options will always be ___
dilutive
out-of-the-money options will always be ___
antidilutive (but they remain potential outstanding shares)
for diluted EPS calculation, we should assume all outstanding stock options are exercised when?
what is done with the proceeds at exercise?
at the beginning of the period
repurchase shares at market price
What should be considered when looking at EPS
EPS is based on net income so we need to consider the quality of earnings
Since it is also based on the number of shares outstanding, when EPS changes, we must look at whether its due to a change in income or in the share units
share capital
funds contributed by owners for shares
retained earnings
profits not distributed to shareholders, they are retained
contributed surplus
stock based compensation and other items
common share possible rights
(1) voting
(2) dividends
(3) liquidation → right to proportionate share of assets remaining upon liquidation
(4) pre-emptive → right to maintain proportionate ownership in the corporation
(5) other → information, right to hold meeting, transfer of ownership
dual class share structure
one class of shares with significant voting power and another class/classes with limited voting power
done to concentrate voting power amongst certain individuals and allows the access to capital markets without giving up control
issues with dual-class share structures
(1) vote share not proportional to the capital at risk
(2) little power for minority shareholders
(3) potential for poor corporate governance
preferred shares
separate legal class of shares from common shareholders that have a preferential claim on earnings meaning they get paid before common shareholders (but after creditors)
no voting rights
dividend can be fixed or variable, cumulative or non-cumulative
why issue preferred shares
(1) good alternative to debt
(2) positive effect on debt-to-equity ratios
(3) positive effects on covenants that restrict debt issuance
(4) payment flexibility
(5) customizable
downsides of preferred shares
(1) equity is riskier than debt so investors demand higher returns
(2) dividends payments are not tax deductible
GAAP may (but does not always) require preferred shares be…
classified as debt on the balance sheet
this means dividend payments are expensed
This happens when the shares are
retractable → shareholders can force the company to repurchase the shares
mandatorily redeemable → company must repurchase the shares
Capital allocation
when a company generates cash from operations it can…
reinvest it
pay down debt
put it back in the bank account
distribute to shareholders
mix of the above is the capital allocation policy
purpose of reinvestment
to drive future growth in income and cash flow
growth in future income and CF drives growth in equity value
purpose of shareholder distributions
shareholders may be better of investing the company’s cash themselves if they have access to higher return projects
considerations for shareholder distributions
(1) stage in company’s life cycle
in young companies, little to no cash is generated from operations and if it is available CapEx opportunities are significant so shareholders do not expect distributions
in mature companies a lot of cash is generate and reinvestment opportunities are more limited and so shareholders expect distributions
(2) current leverage levels
(3) impact on ability to capitalize on future investment opportunities (called “dry powder”)
(4) the signal distributions send to investors
(5) investor expectations (e.g. what do competitors do? what do investors want?)
why is dividend policy a critical capital allocation decision
because it has long term implications → it is hard to reverse and change payout policy once a precedence has been established
dividends - what do investors want
balance between distributions and reinvestment
sustainable, predictable current dividend AND future dividend growth
dividends - what do managers want
keep investor happy, tell a good story
maintain flexibility → hard to do with high dividends because those reduce funds for strategic projects
why repurchase shares
more flexibility than dividends - they are discretionary which means they don’t really set a precedent
more tax efficient for investors
shows belief that company shares are undervalued
offset dilution from employee share compensation plans
control the company’s debt level
Cash includes
cash (cash on hand, deposits)
cash equivalents (short-term investments (<90 days))
Negative cash (overdraft, short term bank indebtedness/line of credit)
what happens when a company has too little cash
not able to pay bills, need to borrow, reputation risk
what happens when a company has too much cash
not efficient, results in negative carry when there is debt
statement of cash flow
measures cash generated from operating, investing, and financing activities
Why is the statement of cash flows so useful?
(1) least effected by accounting policy choices/estimates
(2) hardest to “game” or “manipulate”
(3) paints the current picture of how a company is doing
(4) most useful for valuation purposes
cash from operations
cash the company has earned from the principal revenue-producing activities of the entity
add back non cash expenses
remove non cash incomes
adjust for changes to working capital
cash from investing
cash from the sale of assets or purchase of CapEx → pertains to non current assets and payments
cash from financing
cash from borrowing or from the issuance ofshares
working capital
current assets and liabilities
the difference between current assets and current liabilities, excluding cash and short term debt
changes to working capital
increase in current assets → decrease in cash
decrease in current assets → increase in cash
increase in current liabilities → increase in cash
decrease in current liabilities → decrease in cash
dividends and cash flow statement
dividend payments are not included in net income so we must remove this cash from net income for cash from financing
relationship between distributions, debt, and FCF
when distributions > FCF → debt increases
when distributions < FCF → debt decreases
t/f FCF is capital structure agnostic
true
revenue
income arising in the course of an entity’s ordinary activities
