FSA ACCT 302

Grade Composition: * Assignments: Account for $9\%$ of the total grade. Most have been submitted, and the remaining few will not significantly impact final standing. * Major Components: The Disclosure Project, the Financial Statement Analysis (FSA) Project, and the Final Exam constitute the majority of the grade. * Outstanding Grade: Approximately $27\%$ of the grade is currently pending.
Course Schedule and Deadlines: * Tuesday: The last formal class period of the semester. * Wednesday: Designated as a group workday; no formal class is held. * Thursday: No class; dedicated day for students to complete projects. * Friday: The class semester technically ends at $05:00\text{ PM}$ . The project is due at exactly $05:00\text{ PM}$ on this Friday.

Basic ROE Formula and Calculation: * $\text{Net Income} = \$6,705$ * \text{Average Stockholders' Equity} = \frac{\16,024 + \text{Other Value}}{2} = \ $16,204$ * $\text{ROE} = \frac{\$6,705}{\$16,204} = 41.38\%$ * Note: The ROE is typically much higher than the cost of equity capital.
The Additive (DuPont) Model: * Formula: $\text{ROE} = \text{Net Profit Margin} \times \text{Asset Turnover} \times \text{Financial Leverage}$ * Net Profit Margin: $\text{Net Income} / \text{Total Revenue}$ . Total revenue includes sales ( $59,427$ ) plus other income ( $1,291$ ), totaling $\$60,718$ . * $\text{Net Profit Margin} = 0.1104$ * Asset Turnover: $\text{Total Revenue} / \text{Average Assets}$ . * $\text{Average Assets} = \$82,368$ * $\text{Asset Turnover} = 0.7371$ * Manufacturing companies like Caterpillar often have lower asset turnovers because they are heavily invested in Property, Plant, and Equipment (PP\&E). * Financial Leverage: $\text{Average Assets} / \text{Average Stockholders' Equity}$ . * $\text{Financial Leverage} = 5.083$ * Final Calculation: $0.1104 \times 0.7371 \times 5.083 = 41.38\%$

Interest-Bearing Liabilities (IBL): Debts that require interest payments. Keywords include "Borrowings," "Debt," and "Leases." * Examples: Short-term borrowings, long-term debt, and liability for post-employment benefits.
Non-Interest-Bearing Liabilities (NIBL): Obligations that do not accrue interest. * Examples: Accounts Payable (AP), accrued expenses (utilities), accrued wages/benefits, customer advances (deferred revenue), and dividends payable. * Rule of Thumb: If the notes to the financial statements do not explicitly break down "Other Current Liabilities" into interest items, they must be assumed as NIBL.
Asset Equation for NIBL Calculation: * To simplify calculations, use: $\text{Assets} = \text{IBL} + \text{NIBL} + \text{Stockholders' Equity}$ * Example: $\$82,368 = \$42,289 + X + \$16,204$ * $\text{NIBL} (X) = \$23,875$

Operating Cycle Metrics: * $\text{Receivable Days} = 108.23$ * $\text{Inventory Days} = 133.77$ * $\text{Operating Cycle} = \text{Receivable Days} + \text{Inventory Days} = 242\text{ days}$
Cash-to-Cash Cycle: * $\text{AP Days} = 74.34$ * $\text{Cash-to-Cash Cycle} = \text{Operating Cycle} - \text{AP Days} = 167.66\text{ days}$ * This represents the time from paying for raw materials to collecting cash from sales, which is nearly half a year for Caterpillar.
Profitability Ratios: * $\text{Gross Profit Margin} = 30.42\%$ * $\text{SG\&A to Revenue} = 9.31\%$ * $\text{R\&D to Revenue} = 2.99\%$
Liquidity and Coverage Ratios: * $\text{Interest Coverage Ratio} = \frac{\text{Interest Expense} + \text{Income Taxes}}{\text{Interest Expense}} = 9.704$ * $\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} = 1.39$ * A value of $1.39$ is considered somewhat weak; a higher ratio is generally preferred for liquidity security.

This model (a version of the DuPont model) seeks to isolate the impact of debt and leverage on ROE.
Return on Assets (ROA): Calculate what ROE would be in the absence of debt. * $\text{Operating Margin} = 12.58\%$ * $\text{Asset Turnover (Adjusted)} = 1.016$ * $\text{ROA} = 12.78\%$
Spread: The difference between ROA and the after-tax cost of borrowing. * $\text{Spread} = \text{ROA} - \left( \frac{\text{Interest Expense} \times (1 - \text{Tax Rate})}{\text{Average Interest-Bearing Liabilities}} \right)$ * Caterpillar's after-tax cost of borrowing is very low ( $\approx 1.22\%$ ), leading to a high spread of $10.96\%$ .
Financial Leverage: $\text{Average Interest-Bearing Liabilities} / \text{Average Stockholders' Equity}$ . * $\text{Leverage} = 2.61$
Effective Leverage: $\text{Spread} \times \text{Leverage} = 28.61\%$
Final ROE Reconciliation: $\text{ROE} = \text{ROA} + \text{Effective Leverage} = 12.78\% + 28.61\% = 41.38\%$

Purpose: To normalize financial statements for future forecasting by removing "noise" from accounting choices or one-time events.
Discontinued Operations: Never use net income after discontinued operations. Use Income from Continuing Operations as it is more reflective of the future.
Transitory Items: One-time charges that do not represent ongoing business reality. * Examples: Restructuring charges, purchasing in-process R\&D, impairment losses, and certain merger expenses.
Example: Goodwill Impairment Adjustment: * Caterpillar recorded a goodwill impairment of $\$925\text{ million}$ . * This charge is added back to net income because it is non-recurring. * Effective Tax Rate (ETR) Adjustment: * Reported ETR is $23.6\%$ . However, if certain impairments are non-tax deductible, the ETR may be artificially inflated. * If a non-deductible portion exists (e.g., $1.8\%$ ), the adjusted ETR for forecasting should be $21.8\% (23.6\% - 1.8\% = 21.8\%)$ .
Impact of Adjustments: Removing the goodwill impairment for Caterpillar changed the ROE from $41.38\%$ to an "ongoing operations" ROE of $46.06\%$ .

Metaphor on Accounting vs. Science: The professor explained that engineers (common in the MBA program) often struggle with accounting because engineering is a "hard science" where formulas are absolute. Accounting is a "social science" where different companies report identical transactions in varied ways.
Excel Spreadsheets: For the project, students will use pre-formatted Excel spreadsheets to enter data from financial statements, which will automatically calculate averages and adjusted ROE.
Final Exam Preparation: * Formula sheets are provided; memorization of formulas is not required. * The exam will focus on reading and extracting numbers from approximately $6$ to $10$ pages of financial statements and notes. * Practice with the Caterpillar case and the provided cash flow statements is highly recommended.