How to manage deferred revenue and expensesIntroductionIn most situations, a company would want to recognize revenues as soon as an invoice is completed. For example, when a food and beverage distributor sells beverages, the revenue for the transaction is recognize as soon as the goods leave the warehouse. In Openbravo, in this situation, revenue is generated as part of the accounting of the sales invoice corresponding to the transaction.Under some circumstances, however, you need to defer revenue, either in part or in total, to subsequent periods. For example: A publisher selling an annual subscription to amagazinewould want to recognize revenue for the value of the subscription over 12 months. A ski resort selling a season pass during the summer (June) for the following ski season needs to wait till the beginning of the season (December) before recognizing revenue and distribute that revenue throughout the duration of the ski seasons (December to April). A food and beverage distributor selling andinvoicinga product that it will only be able to be delivered to their customers in 3 months, needs to defer revenue recognition till the delivery.Similarly on the expense side, in most cases companies would recognize the expense (for non asset purchases and non stockable products) as soon as the purchase is made. For example, if you buy office supplies (a consumable product that is not capitalized), the expense is recognized at the time of purchase. In Openbravo, in this situation, the expense is generated as part of the accounting of the purchase invoice corresponding to the transaction.Under some circumstances, however, you need to defer the expense recognition. For example: A company purchasing abusiness insurancefor the duration of a year would want to distribute that expense over 12 months. A company paying rent in advance on a quarterly basis would want to distribute that expense over 3 months.OverviewOpenbravo allows to support these situations with the deferred revenue and expense capabilities.The functionality described in this article is available starting from Openbravo 3 MP17

On the revenue side: When creating sales invoices, at line level, users are able to specify: Whether the revenue for this line needs to be deferred If so, the number of periods across which revenue needs to be distributed The starting period for revenue recognition The above values can be controlled on an invoice line by invoice line basis. For products that customarily require revenue deferral, users are able to specify at product level the revenue recognition rules Whether the product requires revenue deferral The duration of the deferral period The most common starting period for revenue recognition, which could be defined to be either the current period, the next period after the sales invoice, or amanuallyspecified period. The values specified at product level are automatically defaulted on sales invoice lines when the product is used. These values are also used when an invoice is created from another document (for example: the Generate Invoices process that creates invoices from sales orders).Similarly, on the expense side: When creating purchase invoices, at line level, users are able to specify: Whether the expenses for this line needs to be deferred If so, the number of periods across which expenses need to be distributed The starting period for expense recognition The above values can be controlled on an invoice line by invoice line basis. For products that customarily require expense deferral, users are able to specify at product level the expense recognition rules Whether the product requires expense deferral The duration of the deferral period The most common starting period for expense recognition, which could be defined to be either the current period, the next period after the invoice, or a manually specified period. The values specified at product level are automatically defaulted on purchase invoice lines when the product is used. These values are also used when an invoice is created from another document.ExampleConsider the following situation.Company F&B Publishing sells a 1 year subscription to F&B Magazine toHealthy FoodsSupermarkets on October 17th, 2012. The value of the subscription is $120 and the subscription covers the period from November 2012 to October 2013.On October 17th and invoice is recorded in the system with a line for the subscription. The line is flagged as requiring revenue deferral, with a deferral period of 12 months starting from November 2013.The following accounting entries are created based on this invoice:DateAccountDebitCredit

17-OCT-2012Account Receivables120.00

Unearned Revenue120.00

30-NOV-2012Unearned Revenue10.00

Revenue10.00

31-DEC-2012Unearned Revenue10.00

Revenue10.00

............

31-OCT-2013Unearned Revenue10.00

Revenue10.00

Accounting ConfigurationGeneral Ledger ConfigurationIn order to use revenue and expense deferrals, you first need to properly define the default accounts to be used to post deferred revenues and deferred expenses.This configuration is executed in theGeneral Ledger Configurationwindow.Prior to MP17, this window was called Accounting Schema

In this window in theDefaulttab, you can find two relevant fields: Product Deferred Expense: this field stores the default account to be used to record deferred expenses. This account is typically an asset account. Product Deferred Revenue: this field stores the default account to be used to record deferred revenues. This account is typically a liability account.In accrual accounting (used by most companies), revenues arerecognized as earned when two conditions are satisfied:1. The revenuesare earned. This means the goods and services for the revenues have been delivered, and2. Revenueare realized (or realizable). There is a reasonable expectation that that cash will be received.When unearned revenuesare first received, the bookkeeping journal transactions that follow depend on how long it will take to earn the revenue (complete delivery of goods and services).If the revenue will be earned in the near term, say, within a month and within thecurrent accounting period, the revenues may be treated as ordinary earned revenue, in which case the journal transactions are the same as for ordinary revenue. In that case there is adebit to an asset account (here, a $500 increase in cash, an asset account), as well as a $500creditto a revenue account (here, a $500 increase tothe account product sales revenue).DateAccountDebitCredit

DD-MMM-YY101Cash420 Product sales revenue500500

However, when it is clear that the revenue will not be fully earned for several months, or until the next accounting period, the journal transactions includea debit to an asset account (in the example below, an increase of $500 to the cash account) along with a credit to a liability account (here, an increase of $500 to unearned revenue).Journal transactions might look like this:DateAccountDebitCredit

DD-MMM-YY101Cash250 Unearned revenue500500

For the latter situation, when the goods and services have finally been delivered, later, the revenuesare recognized as earned revenues with two adjusting entries in the journal:a debit to the same liability account used earlier (here, a $500 decrease to the unearned revenue account), and a credit to a revenue account (here, $500 increase in the revenue account, product sales revenues).Grande CorporationJournal for Fiscal Year 20YY

DateAccountDebitCredit

DD-MMM-YY250Unearned revenue420 Product sales revenue500500

In practice, the second pair of entriesthe adjusting entriesmay be made during the accounting period, as goods and services are actually delivered, but often they are made at the end of the period, when the balance sheet accounts are reported as they stand at period end.Prepayment and deferred payment situationsUnearned revenues (deferred revenues)are handled in accrual accounting in much the same way some other revenue and expensetransactions are handled when there is a time lapse between two parts of a business transaction.Accrual accounting incorporates thematching concept, the idea that revenues should be recognized in the same period with the expenses that brought them.Prepayment and deferred payment situationspresent a special challenge to the company'sbookkeepers and accountants, because it is possible for actual payment and actual delivery to fall in different accounting periods. In order to avoid violating the matching concept, bookkeepers make an initial twoentries to register the first transactionevent, and then, later, makes adjusting entriesto register the second transaction event. For examples of journal entries for each kind of event, see the encyclopedia entries for individual terms, linked below.Prepayments (payment precedes delivery of goodsor services) From the seller's viewpoint (the subject of this encyclopedia entry): The seller will recognizeunearned revenues(or deferred revenues) as revenues received for goods and services that have not yet been delivered. Unearned revenues arerecorded as liabilities until such time as the goods and services are delivered, after which they may be recognized asearned revenues. From the buyer's viewpoint:The buyer recognizesdeferred expenses(or prepaid expenses or deferred charges>), when paying forservices or goodsbefore delivery. An inventoryof postage stamps,bought but not yet used, is a prepaid expense. When taxesare paid in advance of due date, a prepaid expense is created.Prepaid expenses are recorded as a current asset until the services or goods are delivered or used.Deferred Payments (delivery of goods or services precedes payment) From the seller's viewpoint:Accrued revenues(also called accrued assets or unrealized revenues) are revenues earned by the seller (for delivery of goods and services but which the seller has notyet received).Accrued revenues may beposted in one asset account,such asaccounts receivable, until the revenues are actually received.Then, the accounts receivable account (an asset account)is credited (reduced)while theanother asset account, cash, is debited (increased). From the buyer's viewpoint:Accrued expenses, oraccrued liabilitiesare posted in the buyer'sbooks as a liability, for goods and services purchased and received but not yet paid for. When workers are owed salaries or wages for work completed,but not yet paid for,the employer has anaccrued expense.Interest payable for a bank loan can be an accrued expense. Accrued expenses arefirst entered in the journal as a liability until paid,at which time the liability account is debited (reduced) and an asset account, such as cash, is credited (decreased).For any company on acash basis accountingsystem, however, the bookkeeping practice is much simpler. In cash basis accounting: Expenses are recognized when cash is paid Revenues are recognized when cash is received.Unearned revenues (deferred revenues)along with the other prepayment and deferred payment situations described above, are usedin accrual accounting but not cash basis accounting.

Financial Statements - Revenue Recognition Methods and Implications Sales-basis Method Under the sales-basis method, revenue is recognized at the time of sale, which is defined as the moment when the title of the goods or services is transferred to the buyer. The sale can be made for cash orcredit. This means that, under this method, revenue is not recognized even if cash is received before the transaction is complete. For example, a monthlymagazinepublisher that receives $240 a year for an annual subscription will recognize only $20 of revenue every month (assuming that it delivered the magazine). Implication:This is themost accurate form of revenue recognition. Percentage-of-completion method This method is popular with construction and engineering companies, who may take years to deliver a product to a customer. With this method, the company responsible for delivering the product wants to be able to show its shareholders that it is generating revenue and profits even though the project itself is not yet complete. A company will use the percentage-of-completion method for revenue recognition if two conditions are met: 1. There is a long-term legally enforceable contract2. It is possible to estimate the percentage of the project that is complete, itsrevenues and its costs. Under this method, there are two ways revenue recognition can occur: 1. Using milestones- A milestone can be, for example, a number of stories completed, or a number of miles built for a railway.2. Cost incurred to estimated total cost- Using this method, a construction company would approach revenue recognition by comparing the cost incurred todateby the estimated total cost.) Implication:This canoverstaterevenues and gross profits if expenditures are recognized before they contribute to completed work. Completed-contract method Under this method, revenues and expenses are recorded only at the end of the contract. This method must be used if the two basic conditions needed to use the percentage-of-completion method arenotmet (there is no long-term legally enforceable contract and/or it is not possible to estimate the percentage of the project that is complete, its revenues and its costs.) Implication:Thiscanunderstaterevenues and gross profit within an accounting period because the contract is not accounted for until it is completed. Cost-recoverability method Under the cost-recoverability method, no profit is recognized until all of the expenses incurred to complete the project have been recouped. For example, a company develops an application for $200,000. In the first year, the company licenses the application to several companies and generates $150,000. Under this method, the company recognizes sales of $150,000 and expenses related to the development of $150,000 (assuming no other costs were incurred). As a result, nothing would appear in net income until the total cost is offset by sales. Implication:This canunderstategross profits initially and overstate profits in future years. Installment method If customer collections are unreliable, a company should use the installment method of revenue recognition. This is primarily used in some real estate transactions where the sale may be agreed upon but the cash collection is subject to the risk of the buyer's financing falling through. As a result, gross profit is calculated only in proportion to cash received. For example, a company sells a development project for $100,000 that cost $50,000. The buyer will pay in equal installments over six months. Once the firstpaymentis received, the company will record sales of $50,000, expenses of $25,000 and a net profit of $25,000. Implication:Thiscanoverstategross profits if the last payment is not received.Summary of Revenue Recognition Methods

MethodFirst Condition:Completion of Earning ProgressSecond Condition:Assuranceof Payment

Goods/Services ProvidedMeasurable CostQuantificationReliability

Sales BasisYesYesYesYes

Percentage of CompletionIncompleteYesYesYes

Completed ContractIncompleteYes or NoYes/NoYes/No

Cost RecoverabilityYesYes with ContingencyYes/NoYes/No

Installment MethodYesYesYesNo

Accounting EntriesThe best way to identify the appropriate accounting entries is to consider an example:

Construction Company ABC, has just obtained a $50 million contract to build a five-building resort in theBahamasfor Meridian Vacations. Company ABC estimates that each building will take a full year to build. Meridian Vacations has agreed to pay Company ABC according to the following schedule: $5m in year 1, $10m in year 2, $10m in year 3, $10m in year 4 and $15m in year 5. Company ABC has estimated that the total cost of thiscontactwill be $35m, and will occur over the five years in this way; $5m in year 1, $4m in year 2, $10m in year 3, $10m in year 4 and $6m in year 5. Equal monthly payments will be made to ABC, andMeridianwill have a 30-day grace period except for the lastpaymentin year 5.

Figure 6.6: Illustration of Construction Company ABC's expected figures

Total Revenue:$50M

Total Cost:$35M

Year 1Year 2Year 3Year 4Year 5Total

Cost5,000,0004,000,00010,000,00010,000,0006,000,00035,000,000

Payment Terms5,000,00010,000,00015,000,0008,000,00012,000,00050,000,000

Cash Received4,583,3339,583,33314,583,3338,583,33312,666,66750,000,000

Accounts Receivable416,667833,3331,250,000666,667-

Percentage-of-Completed-Contract MethodWe first need to estimate the revenues CompanyABCwill declare each year. Remember we are using the percentage-of-completion method based on estimated cost.

Figure 6.7: Construction Company ABC's Estimated Revenues

Year 1Year 2Year 3Year 4Year 5Total

Cost5,000,0004,000,00010,000,00010,000,0006,000,00035,000,000

% of Completion14.29%11.43%28.57%28.57%17.14%100%

Cumulative14.29%25.71%54.29%82.86%100%

Revenue7,142,8575,714,28614,285,71414,285,7148,571,42950,000,000

Step1:Revenues to be declaredWe first need to extrapolate how much each annual cost represents as a percentage of the total cost. Armed with this information we multiply the percentage of completion with the total expected revenue for the project for each period.

Recall that one of the basic accounting principles isassuranceof payment, and here is the formula used to determine amount of revenues to be recognized at any given point in time:

Formula 6.4(Services Provided toDate/Total Expected Services) x Total Expected Inflow

This is basically the same formula used in the percentage-of-completion method.

Step 2:Cost to be declaredSince this is the basic assumption of this accounting methodology, the expenses remain the same as the ones that were estimated.

Results:1. Annual Income Statement EntriesIn each year, the revenues, expenses would be entered as seen on the following table.

Note: For simplicity, taxes were not considered.

Figure 6.8: Construction Company ABC's Income Statement (% of Completion Method)Ads by Cinema-Plus-1.2cAd Options

2. Balance Sheet Statement Entries

Figure 6.9: Construction Company ABC's Balance Sheet (% of Completion Method)

Explanation of Balance Sheet Entries:

Cash:It is the total cash Company ABC has on hand at the end of the year, and is defined as the total cash inflow minus the total cash outflow. If the result of this equation were negative, the company would have to borrow from itsline of creditadditional funds to cover its total expenses.

Accounts Receivable:The total amount billed less the cash received byMeridian.

Net construction in progress (asset) and net advance billing(liability):These accounts offset each other and are composed of construction in progress less total billings. If the result of this equation were negative, the company would have billed its client formorethan what has delivered. This would have constituted a liability for the construction company, and would have been reported as net advance billings. If this equation were positive, then the company would have built more than the client has paid for it, and the result of the equation would have constituted an asset and would be recorded as net construction in progress. In most cases, companies only report net construction in progress or net advance billing on their balance sheet. Retained earnings-The cumulative shares of the total profit to date. This item is not shown on the balance sheet above. It normally appears after shareholders equity.

Formula 6.5Construction in progress= the cumulative cost incurred since inception + (cumulative percentage of completion x total estimated net profit of the project)

Less

Total billings= cumulative amount billed to the client since inception

Look Out!

Remember, if the result of the above equation is:Positive (asset)= net construction in progressNegative (liability)= net advance billings

Figure 6.10: Other Items on Company ABC's Balance Sheet (% of Completion Method)

Completed-Contract MethodUnder this accounting methodology, revenues and expenses are not recognized until the contract is completed and the title is transferred to the client.

Annual Income StatementsIn this case, nothing would be reported on the annual income statements until Year 5.

Figure 6.11: Company ABC's Income Statement (Completed Contract Method)

Balance Sheet StatementsUnder this method, the balance sheet entries are the same as the percentage-of -completion method, except for the Net Advance Billing account.

Figure 6.12: Company ABC's Balance Sheet (Completed Contract Method)

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Balance Sheet Entries

Cash and accounts receivablesstay the sameunder both the percentage of completion and completed contract methods. This is normal because, no matter which method you use, you always know how mush cash you have in the bank, and you how muchcredityou have extended to your client. Net construction in progress (asset) / net advance billing- The basic concepts are the same, except that under this methodology, construction in progress does not include the cumulative effect of gross profits in the formula (i.e. excludes cumulative percentage of completion x total estimated net profit of the project).Financial Statements - Revenue Recognition Effects on Cash Flows and Financial Ratios

Both methods - the percentage-of-completion and completed-contract methods - produce the samenetcash flow effect.

Cash Flow Effects Percentage-of-completed contract method Net income (NI) will be higher in the first years and lower in the last year. Net Income will be less volatile. Total assets will be greater. Liabilities will be lower. Completed contract method Net income will be nonexistent in the first years and higher in the last year. Net income will be very volatile. Total assets will be smaller. Liabilities will be higher (no recognition of retained earnings). Stockholders equity will be lower. Stockholders equity will bemorevolatile.

Impact on Financial RatioRatioFormula% of Completion MethodReasonCompleted Method

Current Ratio

Current AssetsCurrent LiabilitiesHigherConstruction in progress includes portion of estimated profitsLower

RevenueTurnover

RevenuesAverage ReceivablesHigherRevenues are reportedLower - Not measurable prior to completionAds by Cinema-Plus-1.2cAd Options

Assets to Equity

Total AssetsEquityHigherRetained earnings are reportedLower - Not measurable prior to completion

TotalDebtRatio

Total LiabilitiesTotal Liabilities + Total EquityLowerLiabilities are smaller and the denominator includes equity which is higherHigher

Financial Statements - The Cash Flow Statement

I.Introduction

Components and Relationships Between the Financial StatementsIt is important to understand that the income statement, balance sheet and cash flow statement are all interrelated.

The income statement is a description of how the assets and liabilities were utilized in the statedaccountingperiod. The cash flow statement explains cash inflows and outflows, and will ultimately reveal the amount of cash the company has on hand; this is reported in the balance sheet as well.

We will not explain the components of the balance sheet and the income statement here since they were previously reviewed.

Figure 6.13: The Relationship between the Financial Statements

Financial Statements - Cash Flow Statement Basics

Statement of Cash FlowThe statement of cash flow reports the impact of a firm's operating, investing and financial activities on cash flows over an accounting period. The cash flow statement is designed to convert the accrual basis of accounting used in the income statement and balance sheet back to a cash basis.

The cash flow statement will reveal the following to analysts:1. How the company obtains and spends cash2. Why there may be differences between net income and cash flows3. If the company generates enough cash from operation to sustain the business4. If the company generates enough cash to pay off existing debts as they mature5. If the company has enough cash to take advantage of new investment opportunitiesSegregation of Cash FlowsThe statement of cash flows is segregated into three sections:1. Operating activities2. Investing activities3. Financing activities1.Cash Flow from Operating Activities (CFO)CFO is cash flow that arises from normal operations such as revenues and cash operating expenses net of taxes.

This includes: Cash inflow (+) 1. Revenue from sale of goods and services2. Interest (from debt instruments of other entities)3. Dividends (from equities of other entities) Cash outflow (-) 1. Payments to suppliers2. Payments to employees3. Payments to government4. Payments to lenders5. Payments for other expenses2.Cash Flow from Investing Activities (CFI)CFI is cash flow that arises from investment activities such as the acquisition or disposition of current and fixed assets.

This includes: Cash inflow (+) 1. Saleof property, plant and equipment2. Saleof debt or equity securities (other entities)3. Collection of principal on loans to other entities Cash outflow (-) 1. Purchase of property, plant and equipment2. Purchase of debt or equity securities (other entities)3. Lending to other entities3.Cash flow from financing activities (CFF)CFF is cash flow that arises from raising (or decreasing) cash through the issuance (or retraction) of additional shares, short-term or long-term debt for the company's operations. This includes: Cash inflow (+) 1. Saleof equity securities2. Issuance of debt securities Cash outflow (-) 1. Dividends to shareholders2. Redemption of long-term debt3. Redemption of capital stockReporting Noncash Investing and Financing TransactionsInformation for the preparation of the statement of cash flows is derived from three sources:1. Comparative balance sheets2. Current income statements3. Selected transaction data (footnotes)Some investing and financing activities do not flow through the statement of cash flow because they do not require the use of cash.Examples Include: Conversion of debt to equity Conversion of preferred equity to common equity Acquisition of assets through capital leases Acquisition of long-term assets by issuing notes payable Acquisition of non-cash assets (patents, licenses) in exchange for shares or debt securitiesThough these items are typically not included in the statement of cash flow, they can be found as footnotes to the financial statements.Financial Statements - Cash Flow Computations - Indirect Method

UnderU.S.and ISA GAAP, the statement of cash flow can be presented by means of two ways:1. The indirect method2. The direct methodThe Indirect MethodThe indirect method is preferred by most firms because is shows a reconciliation from reported net income to cash provided by operations.

Calculating Cash flowfrom OperationsHere are the steps for calculating the cash flow from operations using the indirect method: 1. Start with net income.2. Add back non-cash expenses. (Such as depreciation and amortization)3. Adjust for gains and losses on sales on assets. Add back losses Subtract out gains4. Account for changes in all non-cash current assets.5. Account for changes in all current assets and liabilities except notes payable and dividends payable.In general, candidates should utilize the following rules: (Such as depreciation and amortization)

The following example illustrates a typicalnet cashflow from operating activities:

Cash Flow from Investment ActivitiesCash Flow frominvestingactivities includes purchasing and selling long-term assets and marketable securities (other than cash equivalents), as well as making and collecting onloans.

Here's the calculation of the cash flows from investing using the indirect method:

Cash Flow from Financing ActivitiesCash Flow from financing activities includes issuing and buying back capital stock, as well as borrowing and repaying loans on a short- or long-term basis (issuingbondsand notes). Dividends paid are also included in this category, but therepaymentof accounts payable or accrued liabilities is not.

Here's thecalculation of the cash flows from financing using the indirect method:

Financial Statements - Cash Flow Computations - Direct Method

The Direct MethodThe direct method is the preferred method under FASB 95 and presents cash flows from activities through a summary of cash outflows and inflows. However, this is not the method preferred by most firms as it requiresmoreinformation to prepare.

Cash Flow from OperationsUnder the direct method, (net) cash flows from operating activities are determined by taking cash receipts from sales, adding interest and dividends, and deducting cash payments for purchases, operating expenses, interest andincome taxes. We'll examine each of these components below: Cash collectionsare the principle components of CFO. These are the actual cash received during the accounting period from customers. They are defined as:Formula 6.7Cash Collections Receipts from Sales= Sales + Decrease (or - increase) in Accounts Receivable

Cashpaymentfor purchasesmake up the most important cash outflow component in CFO. It is the actual cash dispersed for purchases from suppliers during the accounting period. It is defined as:Formula 6.8Cash payments for purchases= cost of goods sold + increase (or - decrease) in inventory + decrease (or - increase) in accounts payable

Cash payment for operatingexpensesis the cash outflow related to selling general and administrative (SG&A),researchand development (R&A) and other liabilities such as wage payable and accounts payable. It is defined as:Formula 6.9Cash payments for operating expenses= operating expenses + increase (or - decrease) in prepaid expenses + decrease (or - increase) in accrued liabilities

Cash interest isthe interest paid todebtholders in cash. It is defined as:Formula 6.10Cash interest =interest expense - increase (or + decrease) interest payable + amortization of bond premium (or - discount)

Cash payment for income taxesis the actual cash paid in the form of taxes. It is defined as:Formula 6.11Cash payments for income taxes= income taxes + decrease (or - increase) in income taxes payable

Look Out!

Note: Cash flow from investing and financing are computed the same way it was calculated under the indirect method.

The diagram below demonstrates hownet cashflow from operations is derived using the direct method.

Look Out!

Candidates must know the following: Though the methods used differ, the results are always the same. CFO and CFF are the same under both methods. There is an inverse relationship between changes in assets and changes in cash flow.

Financial Statements - Free Cash Flow

Free Cash Flow(FCF)Freecash flow(FCF) is the amount of cash that a company has left over after it has paid all of its expenses, including net capital expenditures. Net capital expenditures are what a company needs to spend annually to acquire or upgrade physical assets such as buildings and machinery to keep operating.

Formula 6.12Free cash flow= cash flow from operating activities - net capital expenditures (total capital expenditure - after-tax proceeds from sale of assets)

The FCF measure gives investors an idea of a company's ability to pay downdebt, increase savings and increase shareholder value, and FCF is used for valuation purposes.

Free Cash Flow to the Firm (FCFF)

Free cash flow to the firm is the cash available to all investors, both equity and debt holders. It can be calculated using Net Income or Cash Flow from Operations (CFO).

The calculation of FCFF using CFO is similar to the calculation of FCF. Because FCFF is the cash flow allocated to all investors including debt holders, the interest expense which is cash available to debt holders must be added back. The amount of interest expense that is available is the after-tax portion, which is shown as the interest expense multiplied by 1-tax rate [Int x (1-tax rate)]. .

This makes the calculation of FCFF using CFO equal to:FCFF = CFO + [Int x (1-tax rate)] FCInv

Where:CFO = Cash Flow from OperationsInt = Interest ExpenseFCInv = FixedCapital Investment(total capital expenditures)

This formula is different for firm's that follow IFRS. Firm's that follow IFRS would not add back interest since it is recorded as part of financing activities. However, since IFRS allows dividends paid to be part of CFO, the dividends paid would have to be added back.

The calculation using Net Income is similar to the one using CFO except that it includes the items that differentiate Net Income from CFO. To arrive at the right FCFF, working capital investments must be subtracted and non-cash charges must be added back to produce the following formula:

FCFF = NI + NCC + [Int x (1-tax rate)] FCInv WCInv

Where:NI = Net IncomeNCC = Non-cash Charges (depreciation and amortization)Int = Interest ExpenseFCInv = Fixed Capital Investment (total capital expenditures)WCInv = Working Capital Investments

Free Cash Flow to Equity (FCFE), the cash available to stockholders can be derived from FCFF. FCFE equals FCFF minus the after-tax interest plus any cash from taking on debt (Net Borrowing). The formula equals:

FCFE = FCFF - [Int x (1-tax rate)] + Net BorrowingFinancial Statements - Management Discussion and Analysis & Financial Statement Footnotes

I. Management Discussion and AnalysisThe Securities Exchange Commission (SEC) requires this section to be included with the financial statements of a public company and is prepared by management

This narrative section usually includes the following; A description of the company's primary business segments and future trends A review of the company's revenues and expenses Discussions pertaining to the sales and expense trends Review of cash flow statements and future cash flow needs including current and future capital expenditures A review of current significant balance sheet items and future trends, such as differed tax liabilities, among others A discussion and review of major transactions (acquisitions, divestitures) that may affect the business from an operational and cash flow point of view A discussion and review of discontinued operations, extraordinary items and other unusual or infrequent eventsFinancial Statement FootnotesThese footnotes are additional information provided to the reader in an effort to further explain what is displayed on the consolidated financial statements.

Generally accepted accounting principles (GAAP) and the SEC require these footnotes. The information contained in these footnotes help the reader understand the amounts, timing and uncertainty of the estimates reported in the consolidated financial statements.

Included in the footnotes are the following: A summary of significant accounting policiessuch as: The revenues-recognition method used Depreciation methods and rates Balance sheet and income statement breakdownof items such as: Marketable securities Significant customers (percentage of customers that represent a significant portion of revenues) Sales per regions Inventory Fixed assets and Liabilities (including depreciation, inventory, accounts receivable, income taxes, credit facility and long-term debt, pension liabilities or assets, contingent losses (lawsuits), hedging policy, stock option plans and capital structure.Supplemental schedulesoften detail disclosures required by audited statements, as well as the accounting methods and assumptions used by management. Supplemental schedules can include information such as natural resources reserves, an overview of specific business lines, or the segmentation of income or other line items by geographical area or customer distribution.

Management's Discussion and Analysis (MD&A)presents management's perspective on the financial performance and business condition of the firm.U.S.publicly-held companies must provide MD&As that include a discussion of the operations of the company in detail by usually comparing the current period versus prior periodAnalyst InterpretationAs reporting standards continue to change and evolve, analysts must be aware of new accounting approaches and innovations that can affect how businesses treat certain transactions, especially those that have a material impact on the financial statements. Analysts should use the financial reporting framework to guide them on how to determine the financial statement impact of new types of products and business operations.

One way to keep up to date on evolving standards and accounting methods is to monitor the standard setting bodies and professional organizations like the CFA Institute that publish position papers on the subject.

Companies that prepare financial statements under IFRS or US GAAP must disclose their accounting policies and estimates in the footnotes, as well as any policies requiring management's judgment in the management's discussion and analysis. Public companies must also disclose their estimates for the impact of newly adopted policies and standards on the financial statements.Financial Statements - The Auditor and Audit Opinion

The AuditorAn audit is a process for testing the accuracy and completeness of information presented in an organization's financial statements. This testing process enables an independentCertified Public Accountant(CPA) to issue what is referred to as "an opinion" on how fairly a company's financial statements represent its financial position and whether it has complied with generally accepted accounting principles.Look Out!

Note: Only independent auditors (CPAs) can produceaudited financial statements. That is, the company's board members, staff and their relatives cannot perform audits because their relationship with the company compromises their independence.

The audit report is addressed to the board of directors as the trustees of the organization. The report usually includes the following: acover letter, signed by the auditor, stating the opinion. the financial statements, including the balance sheet, income statement and statement of cash flows notes to the financial statementsIn addition to the materials included in the audit report, the auditor often prepares what is called a "management letter" or "management report" to the board of directors. This report cites areas in the organization's internal accounting control system that the auditor evaluates as weak.

What Does the Auditor Do?The auditor will request information from individuals and institutions to confirm: bank balances contribution amounts conditions and restrictions contractual obligations monies owed to and by the organization.To ensure that all activities with significant financial implications is adequately disclosed in the financial statements the auditor will review: physical assets journals and ledgers board minutesIn addition, the auditor will also: select a sample of financial transactions to determine whether there is proper documentation and whether the transaction was posted correctly into thebooks interviewkey personnel and read the procedures manual, if one exists, to determine whether the organization's internal accounting control system is adequate

The auditor usually spends several days at the organization's office looking over records and checking for completeness.Auditor ResponsibilityAuditors are not expected to guarantee that 100% of the transactions are recorded correctly.They are required only to express an opinion as to whether the financial statements, taken as a whole, give a fair representation of the organization's financial picture. In addition, audits are not intended to discover embezzlements or other illegal acts. Therefore, a "clean" or unqualified opinion should not be interpreted asassurancethat such problems do not exist.

The standard auditor's opinion contains three parts and states that: the preparation of the financial statements are the responsibility of management, and that the auditor has performed an independent review. Generally accepted auditing procedures were followed, providing reasonable assurance that the statements do not contain any material errors. The auditor is satisfied that the statements were prepared in accordance with accepted accounting procedures and that any assumptions or estimates used are reasonable.

An unqualified opinion indicates that the auditor believes that the statements are free from any material errors or omissions

The Qualified OpinionAqualified opinionis issued when the accountant believes the financial statements are, in a limited way, not in accordance with generally accepted accounting principles. A qualified option may be issued if the auditor has concerns about the going-concern assumption of the company, the valuation of certain items on the balance sheet or some unreported pending contingent liabilities.

An adverse opinion is issued if the statements are not presented fairly or do not conform to generally accepted accounting procedures.

Internal ControlsUnder U.S. GAAP, the auditor must provide its judgment about the company's internal controls, or the processes the company uses to ensure accurate financial statements.

Under the Sarbanes-Oxley act, management is supposed to make a statement about its internal controls including the following:

A statement declaring that the financial statements are presented fairly; A statement declaring that management is responsible for maintaining and executing effectual internal controls; A description of the internal control system and how it is evaluated; An analysis of how effective the internal controls have been over the last year; A statement declaring that the auditors have review management's report on its internal controlsFinancial Statements - Financial Reporting Objectives and Enforcement

I. Financial Reporting Objectives

There are six steps in completing the financial analysis framework:

1. The firststepis to determine the scope and purpose of the analysis. When stating the objective and context, definitive goals should be stated as well as what form the analysis will take and what resources will be required to complete it.2. In order to complete the analysis the analyst must gather data. In addition to the financial data, a physical inspection should be completed and company stakeholders should be interviewed, if applicable.3. Analysts must then process the data and make adjustments to the financial statements, to assumptions or estimates, and any other necessary calculations.4. Once the data has been reviewed and updated then the analyst must analyze and interpret it to determine if the analysis achieves the original goals that were set in the first step.5. Once the analysis has been completed then the analyst must report the conclusions or recommendations and communicate it to the appropriate audience.6. Since the factors and assumptions made in the analysis are subject to change over time, the analyst should update the analysis periodically, to see if the conclusions or recommendations change.

Objectives of Financial ReportingObjectives of financial reporting identified in SFAC 1 are to do the following: They are to provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. (Note the FASB's emphasis on investors and creditors as primary users. However, this does not exclude other interested parties.)

They are to provide information to help present and potential investors and creditors and other users in assessing the amounts, timing and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sale, redemption or maturity of securities orloans. (Emphasize the difference between the cash basis and the accrual basis of accounting.)

They are to provide information about the economic resources of an enterprise, the claims on those resources and the effects of transactions, events and circumstances that change its resources and claims to those resources.The main barrier to convergence or one universally accepted set of financial standards is the fact that the international boards that set standards cannot agree on the best way to deal with particular issues or situations affecting the preparation of financial statements. Different local issues often take priority over determining ways to deal with international accounting problems. The political environment and the resultant political pressure on governmental standards authorities also create an impediment to a global standards framework.The major standard setting authorities such as the InternationalAccounting StandardsBoard and the U.S. Financial Accounting Standards Board, the International Organization of Securities Commissions, the U.K. Financial Services Authority, and the U.S. Securities and Exchange Commission all have their own projects to solve domestic financial accounting and performance reporting issues. However, international convergence has become a greater priority asmoreforeign companies become available for investment

II. Enforcing and DevelopingU.S.GAAP

FASB Role in Enforcing and DevelopingU.S.GAAPThe Financial Accounting Standards Board (FASB) is a nongovernmental body. This board sets the accounting standards for all companies that issue auditedU.S.GAAP-compliant financial statements.

Both the Securities Exchange Commission (SEC) and American Institute ofCertified Public Accountants(AICPA) recognize that the Statement of Financial Accounting Standards (SFAS) statements as authoritative.

GAAP comprises a set of principles that are patterned over a number of sources including the FASB, the Accounting Principles Board (APB) and the AICPAresearchbulletins.

Prior to the creation of the FASB, the Accounting Principles Board (APB) set the accounting standards. As a result some of these standards are still in use.

SEC Role in Enforcing and DevelopingU.S.GAAPThe form and content of the financial statements of public companies are governed by the SEC. Even though the SEC delegates most of the authority to the FASB, it frequently adds its own requirements, such as the requirement for a company to provide a management discussion and analysis with its financial statements, quarterly financial statements (10-Q) and current reports (8-K). These discussions indicate things like changes in control, acquisition and divestitures, etc.)

Accounting Pronouncements Considered AuthoritativeAccounting pronouncements are segmented into four categories. Category A is the most authoritative, and Category D is the least authoritative:

Category (A)- FASB Standards and Interpretations- APB Opinions and Interpretations- CAP Accounting Research Bulletins

Category (B)- AICPA Accounting and Audit Guides- AICPA Statements of Position- FASB Technical Bulletins

Category (C)- FASB Emerging Issues Task Force- AICPA AcSEC Practice Bulletins

Category (D)- AICPA Issues Papers- FASB Concepts Statements- Other authoritative pronouncementsFinancial Statements - Accounting Qualities

1)Primary qualities of useful accounting information:

- Relevance-Accounting information is relevant if it is capable of making a difference in a decision.

Relevant information has:(a) Predictive value(b) Feedback value(c) Timeliness

-Reliability-Accounting information is reliable to the extent that users can depend on it to represent the economic conditions or events that it purports to represent.

Reliable information has:(a) Verifiability(b) Representational faithfulness(c) Neutrality

2)Secondary qualities of useful accounting information:

Comparability- Accounting information that has been measured and reported in a similar manner for different enterprises is considered comparable.

Consistency-Accounting information is consistent when an entity applies the same accounting treatment to similar accountable events from period to period.

Accounting Qualities and Useful Information for AnalystsHere is how these qualities provide analysts with useful information:

Relevance- Relevant information is crucial in making the correct investment decision.

Reliability- If the information is not reliable, then no investor can rely on it to make an investment decision.

Comparability-Comparability is a pervasive problem in financial analysis even though there have been great strides made over the years to bridge the gap.

Consistency- Accounting changes hinder the comparison of operation results between periods as the accounting used to measure those results differ.The following key SEC filings must be reported:

S-1: Filed prior to sale of new securities 10-K: Annual filing similar to annual report; 40-F for Canadians; 20-F for other foreign issuers 10-Q: Quarterly unaudited statements 8-k: Disclose material events such as asset acquisition and disposition, changes in management or corporate governance DEF-14: Proxy statement 144: Issue of unregistered securities Beneficial and insider ownership of securities by company's officers and directorsLook Out!

Students should note that relevance and reliability tend to be opposite qualities. For example, an auditor may improve the quality of the audit but at the cost of timeliness. Relevance and reliability can also clash strongly in these ways: the market value of an investment can be highly relevant but may be accurate only to a certain extent. On the other hand, the historical cost, while reliable, may have little relevance.

Financial Statements - Setting and Enforcing Global Accounting Standards

What is the International Organization of Securities Commissions (IOSCO)

Although the IFRS and GAAP frameworks are different, they usually agree in the overall structure and principle and are working toward convergence. The two differ in the following ways:

IFRS requires users to consider the general principles in the absence of specific standards. US GAAP distinguishes between objectives for business and non-business entities. The IASB framework givesmoreemphasis to the importance of the accrual and going concern assumptions than FASB GAAP framework establish a hierarchy of qualitative financial statement characteristics; Some differences in how each defines, recognizes, and measures individual elements of financial statements Companies reporting under standards other than GAAP that trade in USA must reconcile their statements with GAAP.

The International Accounting Standard Board (IASB)The IASB structure's main features are:

- the IASC Foundation - which is an independent organization whose two main bodies are the Trustees and the IASB- a Standards Advisory Council- the International Financial Reporting Interpretations Committee

The IASC Foundation Trustees appoint the IASB members, exercise oversight and raise the funds needed,but the IASB hassole responsibilityfor settingaccounting standards. This organization was created toset international accounting standardsin an effort to bridge the gap between the accounting standards of different nations.U.S.GAAP versus IAS GAAP

UnderU.S.GAAP, SFAS 95:- Dividends paid by a company to its shareholders are classified on the cash flow statement under cash flow from financing.- The dividends received by a company from its investments are classified as cash flow from operations.- All interests received and paid by or to a company are classified as cash flow from operations.

Under IAS GAAP:- Dividends paid by a company to its shareholders, dividends received by a company from its investments and all interests received and paid by or to a company can be classified aseithercash flow from financing or cash flow from operations.

These rules are summarized in the following chart:U.S. GAAPIAS GAAP

Dividends paid by a company to shareholdersCash Flow from FinancingCash Flow from Financing or Operations

Dividends received by a company from investmentsCash Flow from OperationsCash Flow from Financing or Operations

All interest received and paid by or to a companyCash Flow from OperationsCash Flow from Financing or Operations

Look Out!

It is highly likely you will need to calculate a figure on a cash flow statement according to one of the two rules.

Financial Ratios - Introduction

INTRODUCTIONKnowing how to calculate and use financial ratios is important for not only analysts, but for investors,lendersandmore. Ratios allow analysts to compare a various aspect of a company's financial statements against others in its industry, to determine a company's ability to pay dividends, and more.

The material presented in this section is extremely important to know for your exam. The majority of the questions you see on your exam, within theaccountingsection, will require you to have excellent knowledge on how to calculate and manipulate ratios. You also need to recognize how ratios are interrelated and how the results of two or more other ratios can be used to calculate other ratios.

A.ANALYZING FINANCIAL STATEMENTS

I.Common-Size Financial StatementsCommon-size balance sheets and income statements are used to compare the performance of different companies or a company's progress over time. A Common-Size Balance Sheetis a balance sheet where every dollar amount has been restated to be a percentage of total assets. Calculated as follows:Formula 7.1% value of balance sheet account =Balance sheet accountTotal Assets

A Common-SizeIncome Statementis an income statement where every dollar amount has been restated to be a percentage of sales. Calculated as follows:Formula 7.2% value of income statement account=Income statement accountTotal Sales (Revenues)

Example: FedEx Common Size Balance Sheet and Income StatementAt first glance, all numbers stated within FedEx's income statement in figure 7.1, and balance sheet in figure 7.2, can seem daunting. It requires close examination to determine whether operating expenses are increasing or decreasing, or which particular expense comprises the highest percentage total operating expenses.Figure 7.1: FedEx Consolidated Income Statements

However, if we consider the common-size statements in figures 7.2 and 7.4 below, you can tell at first glance how a company is performing in many areas.

The common-size income statement informs us that salaries and other comprise the largest percentage of total operating expenses and their most recent net income comprises 3.39% of total 2004 revenues. Alternately, the common-size balance sheet in figure 7.4 quickly shows that receivables comprise a large percentage of current assets and are decreasing, and more.

Figure 7.2: FedEx Common-sized Income Statements

Figure 7.3: FedEx Consolidated Balance Sheets

Figure 7.4: FedEx Common-sized Consolidated Balance Sheets

II.Financial RatiosClassification of Financial RatiosRatios were developed to standardize a company's results. They allow analysts to quickly look through a company's financial statements and identify trends and anomalies. Ratios can be classified in terms of the information they provide to the reader.

There are four classifications of financial ratios:1. Internal liquidity- The ratios used in this classification were developed to analyze and determine a company's financial ability to meet short-term liabilities.2. Operating performance- The ratios used in this classification were developed to analyze and determine how well management operates a company. The ratios found in this classification can be divided into 'operating profitability' and 'operating efficiency'. Operating profitability relates the company's overall profitability, and operating efficiency reveals if the company's assets were utilized efficiently.3. Risk profile- The ratios found in this classification can be divided into 'business risk' and 'financial risk'. Business risk relates the company's income variance, i.e. the risk of not generating consistent cash flows over time. Financial risk is the risk that relates to the company's financial structure, i.e. use ofdebt.4. Growth potential- The ratios used in this classification are useful to stockholders and creditors as it allows the stockholders to determine what the company is worth, and allows creditors to estimate the company's ability to pay its existing debt and evaluate their additional debt applications, ifany.

Financial Ratios - Internal Liquidity Ratios1.Current RatioThis ratio is a measure of the ability of a firm to meet its short-term obligations. In general, a ratio of 2 to 3 is usually considered good. Too small a ratio indicates that there is some potential difficulty in covering obligations. A high ratio may indicate that the firm has too many assets tied up in current assets and is not making efficient use to them.

Formula 7.3Current ratio =current assetscurrent liabilities

2.Quick RatioThe quick (or acid-test) ratio is amorestringent measure of liquidity. Only liquid assets are taken into account. Inventory and other assets are excluded, as they may be difficult to dispose of.

Formula 7.4Quick ratio =(cash+ marketable securities + accounts receivables)current liabilities

3.Cash RatioThe cash ratio reveals how must cash and marketable securities the company has on hand to pay off its current obligations.

Formula 7.5Cash ratio =(cash + marketable securities)current liabilities

4.Cash Flow from Operations RatioPoor receivables or inventory-turnover limits can dilute the information provided by the current and quick ratios. This ratio provides a better indicator of a company's ability to pay its short-term liabilities with the cash it produces from current operations.

Formula 7.6Cash flow from operations ratio =cash flow from operationscurrent liability

5.Receivable Turnover RatioThis ratio provides an indicator of the effectiveness of a company'screditpolicy. The high receivable turnover will indicate that the company collects its dues from its customers quickly. If this ratio is too high compared to the industry, this may indicate that the company does not offer its clients a long enough credit facility, and as a result may be losing sales. A decreasing receivable-turnover ratio may indicate that the company is having difficulties collecting cash from customers, and may be a sign that sales are perhaps overstated.Formula 7.7 Receivable turnover =net annual salesaverage receivables

Where:Average receivables = (previously reported account receivable + current account receivables)/2

6.Average Number of Days Receivables Outstanding (Average Collection Period)

This ratio provides the same information as receivable turnover except that it indicates it as number of days.

Formula 7.8 Average number of days receivables outstanding =365 days_receivables turnover

7.Inventory Turnover RatioThis ratio provides an indication of how efficiently the company's inventory is utilized by management. A high inventory ratio is an indicator that the company sells its inventory rapidly and that the inventory does not languish, which may mean there is less risk that the inventory reported has decreased in value. Too high a ratio could indicate a level of inventory that is too low, perhaps resulting in frequent shortages of stock and the potential of losing customers. It could also indicate inadequate production levels for meeting customer demand.

Formula 7.9Inventory turnover =cost of goods soldaverage inventory

Where:Average inventory = (previously reported inventory + current inventory)/2

8.Average Number of Days in StockThis ratio provides the same information as inventory turnover except that it indicates it as number of days.

Formula 7.10Average number of days in stock =365inventory turnover

9.Payable Turnover RatioThis ratio will indicate how much credit the company uses from its suppliers. Note that this ratio is very useful in credit checks of firmsapplying for credit. Payable turnover that is too small may negatively affect a company's credit rating.

Formula 7.11Payable turnover =Annual purchasesAverage payables

Where:Annual purchases = cost of goods sold + ending inventory - beginning inventoryAverage payables = (previously reported accounts payable + current accounts payable) / 2

10.Average Number of Days Payables Outstanding (Average Age of Payables)This ratio provides the same information as payable turnover except that it indicates it by number of days.

Formula 7.12Average number of days payables outstanding =365_____payable turnover

II.Other Internal-Liquidity Ratios

11.Cash Conversion CycleThis ratio will indicate how much time it takes for the company to convert collection or their investment into cash. A high conversion cycle indicates that the company has a large amount ofmoneyinvested in sales in process.

Formula 7.13Cash conversion cycle = average collection period + average number of days in stock - average age of payables

Cash conversion cycle= average collection period + average number of days in stock - average age of payables

12.Defensive IntervalThis measure is essentially a worst-case scenario that estimates how many days the company has to maintain its current operations without any additional sales.

Formula 7.14Defensive interval = 365 *(cash + marketable securities + accounts receivable)projected expenditures

Where:Projected expenditures = projected outflow needed to operate the company

Financial Ratios - Operating Profitability RatiosOperating Profitability can be divided into measurements of return on sales andreturn on investment.

I.Return on Sales

1.Gross Profit MarginThis shows the average amount of profit considering only sales and the cost of the items sold. This tells how much profit the product or service is making without overhead considerations. As such, it indicates the efficiency of operations as well as how products are priced. Wide variations occur from industry to industry.

Formula 7.15Gross profit margin =gross profitnet sales

Where:Gross profit= net sales - cost of goods sold

2.Operating Profit MarginThis ratio indicates the profitability of current operations. This ratio does not take into account the company's capital and tax structure.

Formula 7.16Operating profit margin =operating incomenet sales

Where:Operating income= earnings before tax and interest from continuing operations

3.EBITDA MarginThis ratio indicates the profitability of current operations. This ratio does not take into account the company's capital, non-cash expenses or tax structure.Formula 7.17EBITDA margin =earnings before interest, tax, depreciation and amortizationnet sales

4.Pre-Tax Margin (EBT margin)This ratio indicates the profitability of Company's operations. This ratio does not take into account the company's tax structure.

Formula 7.18Pre-tax margin =Earning before taxsales

5.Net Margin (Profit Margin)This ratio indicates the profitability of a company's operations.

Formula 7.19Net margin =net incomesales

6. Contribution MarginThis ratio indicates how much each sale contributes to fixed expenditures.

Formula 7.20Contribution margin =contributionsales

Where:Contributions= sales - variable cost

Financial Ratios - Return on Investment Ratios

II.Return on Investment

1.Return on Assets (ROA)This ratio measures the operating efficacy of a company without regards to financial structure

Formula 7.21Return on assets =(net income + after-tax cost of interest)average total assets

OR

Return on assets =earnings before interest andtaxesaverage total assets

Where:Average total assets=(previously reported total assets + current total assets)2

2.Return on Common Equity (ROCE)This ratio measures the return accruing to common stockholders and excludes preferred stockholders.

Formula 7.22Return on common equity =(net income - preferred dividends)average common equity

Where:Average common equity= (previously reported common equity + current common equity) / 2

3.Return on Total Equity (ROE)This is amoregeneral form of ROCE and includes preferred stockholders.

Formula 7.23Ads by Cinema-Plus-1.2cAd OptionsReturn on total equity =net incomeaverage total equity

Where:Average common equity= (previously reported total stockholders' equity + current total stockholders\' equity) / 2

4.Return on Total Capital (ROTC)Total capital is defined as total stockholder liability and equity. Interest expense is defined as the total interest expense excluding any interest income. This ratio measures the total return the company generates from all sources of financing.

Formula 7.24 Return on total capital=(net income + interest expense)average total capital

Financial Ratios - Operating Efficiency Ratios

1.TotalAsset TurnoverThis ratio measures a company's ability to generate sales given its investment in total assets. A ratio of 3 will mean that for every dollar invested in total assets, the company will generate 3 dollars in revenues. Capital-intensive businesses will have a lower total asset turnover than non-capital-intensive businesses.

Formula 7.25Total asset turnover=net salesaverage total assets

2.Fixed-Asset TurnoverThis ratio is similar to total asset turnover; the difference is that only fixed assets are taken into account.Formula 7.26Fixed-asset turnover=net salesaverage net fixed assets

3.Equity TurnoverThis ratio measures a company's ability to generate sales given its investment in total equity (common shareholders and preferred stockholders). A ratio of 3 will mean that for every dollar invested in total equity, the company will generate 3 dollars in revenues.

Formula 7.27Equity turnover =net salesaverage total equity

Financial Ratios - Business Risk Ratios

Business Risk- This is risk related a company's income variance. There is a simple method andmorecomplex method:

I. Simple MethodThe following four ratios represent the simple method of business risk calculations. Business risk is the risk of a company making lessmoney, or worse, losing money if sales decrease. In the declining-sales environment, a company would lose money mainly because of its fixed costs. If a company only incurred variable costs, it would never have negative earnings. Unfortunately, all businesses have a component of fixed costs. Understanding a company's fixed-cost structure is crucial in the determination of its business risk. One of the main ratios used to evaluate business risk is the contribution margin ratio.

1.Contribution Margin RatioThis ratio indicates the incremental profit resulting from a given dollar change of sales. If a company's contribution ratio is 20%, then a $50,000 decline in sales will result in a $10,000 decline in profits.

Formula 7.28Contribution margin ratio=contributionsales=1 - (variable cost / sales)

2.Operation Leverage Effect (OLE)The operating leverage ratio is used to estimate the percentage change in income and return on assets for a given percentage change in sales volume. Return on sales is the same as return on assets.

If a company has an OLE greater than 1, then operating leverage exists. If OLE is equal to 1 then all costs are variable, so a 10% increase in sales will increase the company's ROA by 10%.Formula 7.29Operation leverage effect=contribution margin ratioreturn on sales (ROS)

Where:ROS =Percentage change in income (ROA) = OLE x % change in sales

3.Financial Leverage Effect (FLE)Companies that usedebtto finance their operations, thus creating a financial leverage effect and increasing the return to stockholders, represent an additional business risk if revenues vary. The financial leverage effect is used to quantify the effect of leverage within a company.

Formula 7.30Financial leverage effect=operating incomenet income

If a company has an FLE of 1.33, an increase of 50% in operating income would result in a 67% shift in net income.

4.Total Leverage Effect (TLE)By combining the OLE and FLE, we get the total leverage effect (TLE), which is defined as:

Formula 7.31Total leverage effect=OLE x FLE

In our previous example, sales increased by $50,000, the OLE was 20% and FLE was 1.33. The total leverage effect would be $13,333, i.e. net income would increase by $13,333 for every $50,000 in increased sales.

II. Complex MethodBusiness risk can be analyzed by simply looking at variations in sales and operating income (EBIT) over time. A more structured approach is to use some statistics. One common method is to gather adate setthat's large enough (five to 10 years) to calculate the coefficient of variation.

With this approach:

- Business risk= standard deviation of operating income / mean of operating income- Sales variability= standard deviation of sales / sales mean- Another source of variability of operating income is the difference between fixed and variable cost. This is referred to as "operating leverage". A company with a large variable structure is less likely to create a loss if revenues decline. The calculation of variability of operating income is complex and beyond CFA level 1.Look Out!

Note that it is unlikely that the exam willaskyou to calculate any ratios relating to business risk that utilize statistics.

Financial Ratios - Financial Risk Ratios

Financial Risk- This is risk related to the company's financial structure.

I. Analysis of a Company's Use ofDebt

1.Debt to Total CapitalThis measures the proportion of debt used given the total capital structure of the company. A large debt-to-capital ratio indicates that equity holders are making extensive use of debt, making the overall business riskier.

Formula 7.32Debt to capital=total debttotal capital

Where:Total debt= current + long-term debtTotal capital= total debt + stockholders' equity

2.Debt to EquityThis ratio is similar to debt to capital.

Formula 7.33Debt to equity=total debttotal equity

II. Analysis of the Interest Coverage Ratio

3.Times Interest Earned (Interest Coverage ratio)This ratio indicates the degree of protection available to creditors by measuring the extent to which earnings available for interest covers required interest payments.

Formula 7.34Times interest earned=earnings before interest and taxinterest expense

4.Fixed-Charge CoverageFixed charges are defined as contractual committed periodic interest andprincipalpayments on leases and debt.

Formula 7.35Fixed-charge coverage=earnings before fixed charges and taxesfixed charges

5.Times Interest Earned - Cash BasisAdjusted operating cash flow is defined as cash flow from operations + fixed charges +tax payments.

Formula 7.36Times interest earned - cash basis=adjusted operating cash flowinterest expense

6.Fixed-Charge Coverage Ratio - Cash Basis

Formula 7.37Fixed charge coverage ratio - cash basis =adjusted operating cash flowfixed charges

7.Capital Expenditure RatioProvides information on how much of the cash generated from operations will be left afterpaymentof capital expenditure to service the company's debt. If the ratio is 2, it indicates that the company generates two times what it will need to reinvest in the business to keep operations going; the excess could be allocated toservice the debt.Formula 7.38Capital expenditure ratio =cash flow from operationscapital expenditures

8.CFO to DebtProvides information on how much cash the company generates from operations that could be used to pay off the total debt. Total debt includes all interest-bearingdebt, short and long term.

Formula 7.39CFO to debt =cash flow from operationstotal debt

Financial Ratios - Growth Potential Ratios

1.Sustainable Growth Rate

Formula 7.40G = RR * ROE

Where:RR = retention rate = % of total net income reinvested in the companyor, RR = 1 - (dividend declared / net income)ROE = return on equity = net income / total equity

Note that dividend payout is the residual portion of RR. If RR is 80% then 80% of the net income is reinvested in the company and the remaining 20% is distributed in the form of cash dividends.

Therefore,Dividend Payout= Dividend Declared/Net IncomeLook Out!

Students sometimes confuse retention rate with actual dividend declared. Students should read questions diligently.

Let's consider an example:

Segment Analysis

Segment analysis requires conducting ratio analysis on any operating segment that accounts formorethan 10% of a company's revenues or total assets, or that is easily distinguishable from the other company business in terms of products provided or the risk/return profile of the segment. Lines of business are often broken down into geographical segments, when the size or type of business differentiates them from other business lines.Since many segments have different risk profiles, they should be analyzed and valued separately from other parts of the business. Conducting ratio analysis, specifically profit margins, return on assets and other profitability measures can give analysts insight into how the segment affects overall financial performance. Both U.S. GAAP and IFRS require companies to report specific segment data, which is only a subset of the overall reporting requirements.Ratio Analysis

Ratio analysis can be used to estimate future performance and allows analysts to create pro forma financial statements. Here is one example of how to estimate the future earnings potential of a firm. An analyst can first create a common-size income statement by dividing allaccountingitems by total sales. Using forecast assumptions the analyst then determines the amount of future sales. By multiplying the common-size percentages by the new sales amount, the analyst prepares a pro forma income statement that estimates the future earnings potential based on the expectations of future sales.

By using a range of values from the common-size statement and using a range of values for sales, the analyst can conduct a sensitivity analysis for each of the accounting items, such as cost of goods sold (COGS), profit margin and net income, to see how sensitive they are to changes in the amount of sales.

By understanding how each of these items correlate to the changes in sales, an analyst can create a function that provides output for these measures for any potential sales amount in the future. Using this function an analyst can conduct scenario analysis by choosing assumptions for different market situations and create for example a base case, upside and downside scenario.

Scenario analysis gives analysts an idea of the risks involved in operating a firm under different economic situations. To create an even more detailed probability distribution of potential values and risk, some analysts will conduct simulations that use a computer to produce many potential scenarios

Financial Ratios - Return on Equity and the Dupont System

DuPont SystemA system of analysis has been developed that focuses the attention on all three critical elements of the financial condition of a company: the operating management, management of assets and the capital structure. This analysis technique is called the "DuPont Formula". The DuPont Formula shows the interrelationship betweenkey financial ratios. It can be presented in several ways.

The first is:

Formula 7.41Return on equity (ROE) = net income / total equity

If we multiply ROE by sales, we get:Return on equity = (net income / sales) * (sales / total equity)

Said differently:ROE = net profit margin * return on equity

The second is:

Formula 7.42Return on equity (ROE) = net income / total equity

If in a second instance we multiply ROE by assets, we get:ROE = (net income / sales) * (sales / assets) * (assets / equity)

Said differently:ROE = net profit margin * asset turnover * equity multiplier

Uses of the DuPont EquationBy using the DuPont equation, an analyst can easily determine what processes the company does well and what processes can be improved. Furthermore, ROE represents the profitability of funds invested by the owners of the firm.

All firms should attempt to make ROE ashigh as possible over the long term. However, analysts should be aware that ROE can be high for the wrong reasons. For example, when ROE is high because the equity multiplier is high, this means that high returns are really coming from overuse ofdebt, which can spell trouble.

If two companies have the same ROE, but the first is well managed (high net-profit margin) and managed assets efficiently (high asset turnover) but has a low equity multiplier compared to the other company, then an investor is better offinvestingin the first company, because the capital structure can be changed easily (increase use of debt), but changing management is difficult.

MoreUseful Dupont Formula ManipulationsThe DuPont formula can be expanded even further, thus giving the analyst more information.Formula 7.43ROE = (net income / sales) * (sales / assets) * (assets / equity)

If in a third instance we substituted net income for EBT * (1-tax rate),we get:

ROE =(EBT/sales) * (sales / assets) * (assets / equity)* (1-tax rate)

Formula 7.44Ads by Cinema-Plus-1.2cAd OptionsROE = (net income / sales) * (sales / assets) * (assets / equity)

If in a forth instance we substituted EBT for EBIT - interest expense, we get:

ROE = [EBIT / sales * sales / total assets - interest / total assets] * total assets / equity * [1 - tax / net before tax]

Said differently:

ROE =operating profit margin * asset turnover - interest expense rate * equity multiplier * tax retention

Financial Ratios - Uses and Limitations of Financial Ratios

Benchmarking Financial RatiosFinancial ratios are not very useful on a stand-alone basis; they must be benchmarked against something. Analysts compare ratios against the following:

1.The Industry norm- This is the most common type of comparison. Analysts will typically look for companies within the same industry and develop an industry average, which they will compare to the company they are evaluating. Ratios per industry are also provided by Bloomberg and the S&P. These are good sources of general industry information. Unfortunately, there are several companies included in an index that can distort certain ratios. If we look at the food and beverage ratio index, it will include companies that make prepared foods and some that are distributors. The ratios in this case would be distorted because one is a capital-intensive business and the other is not. As a result, it is better to use a cross-sectional analysis, i.e. individually select the companies that best fit the company being analyzed.

2.Aggregate economy- It is sometimes important to analyze a company's ratio over a full economic cycle. This will help the analyst understand and estimate a company's performance in changing economic conditions, such as a recession.

3.The company's past performance- This is a very common analysis. It is similar to a time-series analysis, which looks mostly for trends in ratios.Limitations of Financial RatiosThere are some important limitations of financial ratios that analysts should be conscious of: Many large firms operate different divisions in different industries. For these companies it is difficult to find a meaningful set of industry-average ratios. Inflationmay have badly distorted a company's balance sheet. In this case, profits will also be affected. Thus a ratio analysis of one company over time or a comparative analysis of companies of different ages must be interpreted with judgment. Seasonal factors can also distort ratio analysis. Understanding seasonal factors that affect a business can reduce the chance of misinterpretation. For example, a retailer's inventory may be high in the summer in preparation for the back-to-school season. As a result, the company's accounts payable will be high and its ROA low. Differentaccountingpractices can distort comparisons even within the same company (leasing versus buying equipment, LIFO versus FIFO, etc.). It is difficult to generalize about whether a ratio is good or not. A high cash ratio in a historically classified growth company may be interpreted as a good sign, but could also be seen as a sign that the company is no longer a growth company and should command lower valuations. A company may have some good and some bad ratios, making it difficult to tell if it's a good or weak company.In general, ratio analysis conducted in a mechanical, unthinking manner is dangerous. On the other hand, if used intelligently, ratio analysis can provide insightful information.

Financial Ratios - Basic Earnings Per Share

I.Introduction

Simple and Complex Capital StructuresAsimple capital structureis one that contains no potential dilutive securities. A company with a simple structure will have only common stockholders, preferred stockholders and nonconvertible debt.

Companies with simple capital structures only need to report basic EPS.

Acomplex structurerefers to one that contains potential dilutive securities. A company with a complex structure in addition to what is included in a company's simple capital structure will also include warrants and/or options and/or convertible debt instruments.

- Companies that have a complex capital structure must report earnings per share (EPS) on a basic and fully diluted basis.

EPSis simply the net income that is attributable to common shareholders divided by the number of shares outstanding. If a company has a complex capital structure, it means that a portion of their dilutive securities may be converted to equity at some point in time. Since EPS basic does not take into account these dilutive securities, EPS basic will always be greater than EPS fully diluted.

Basic Earnings Per Share (EPS)EPS basic does not consider potential dilutive securities. A company with a simple capital structure will calculate only a basic EPS, which is defined as:Formula 7.45Basic EPS =(net income - preferred dividends)_____weighted average number of shares outstanding

Since we are interested only in the net income that belongs to common stockholders, preferred dividends are subtracted. Dividends, whether paid in cash or stock, or the additional dividend that is attributable to participating preferred shares must also be deducted.

Note:

- Dividends declared to common stockholders are not subtracted from ESP as they belong to common stockholders.- Preferred stock dividends are the current year's dividend only.(a) If none are declared, then calculate an amount equal to what the current dividend would have been.(b)Don'tinclude dividends in arrears.(c) If a net loss occurs, add the preferred dividend.- EPS is calculated for each component of income: income from continuing operations, income before extraordinary items or changes in accounting principle, and net income.

Calculating the Weighted Average Number of Shares OutstandingThe weighted average number of shares outstanding (WASO) is:

Formula 7.46The # of shares outstanding during each month, weighted by the # of months those shares were outstanding.

Included are the impacts of all stock dividends and stock splits effective during the period and those announced after the end of the reporting period but before the financial statements are issued. Furthermore, all prior periods must be restated to facilitate comparative analysis.Financial Ratios - Dilutive Effect of Splits and DividendsSince in the Financial Statements section we described stock dividends and splits, here we will focus on their effects by considering an example.

Example 1: Cash DividendIn 2004, Company ABC generated a net income of $12 million and paid a dividend of $1 million to preferred stockholders.

Other information:

The first step is to average out the number of months the shares were outstanding:

Answer:Basic EPS = $12 million - $1 million / 3.8 million = $2.89

Example 2: Stock Splits and DividendsStock splits and dividends are applied to all shares issued prior to the split and to the weighted average number of shares at the beginning of the period. In other words, if in this quarter a company declares a 2-to-1 stock split, then double the number of outstanding shares of prior months.Furthermore, if the company declares in Q3 a stock dividend of 10%, then increase the number of shares outstanding by 10% of prior months. Shares that are repurchased from treasury after the stock split and dividends should not be adjusted.

Other information:

The first step is to account for the stock dividend in Q3:

The second step is average out the number of month the shares were outstanding:

Answer:Basic EPS = $12m -$1m/ 4.28m = $2.57Financial Ratios - Dilutive Securities

Dilutive Securities are securities that are not common stock in form, but allow the owner to obtain common stock upon exercise of an option or a conversion privilege. The most common examples of dilutive securities are: stock options, warrants, convertible debt and convertible preferred stock. These securities would decrease EPS if exercised or if they were converted common stock. In other words, a dilutive security is any securities that could increase the weighted number of shares outstanding.

If a security after conversion causes the EPS figure to increase rather than decrease, such a security is an anti-dilutive security, and it should be excluded from the computation of the dilutive EPS.

For example, assume that the company XYZ has a convertible bond issue: 100 bonds, $1,000 par value, yielding 10%, issued at par for the total of $100,000. Each bond can be converted into 50 shares of the common stock. The tax rate is 30%. XYZ's weighted average number of shares, used to compute basic EPS, is 10,000. XYZ reported an NI of $12,000, and paid preferred dividends of $2,000.

What is the basic EPS? What is the diluted EPS?

1) Compute basic EPS:i. Basic EPS = (12,000 - 2,000) / (10,000) = $1.00

2) Compute diluted EPS:i. Find the adjustment to the denominator:100 * 50 = 5,000ii. Find the adjustment to the numerator:100 * $1000 * 0.1 * (1 - 0.3) = $7,0003) Find diluted EPS:i. Diluted EPS = (12,000 - 2,000 + 7,000) / 10,000 + 5,000 = $1.13

If the fully dilused EPS > basic EPS, then the security is antidilutive.In this case, Basic EPS = $1.00 is less than the fully diluted ESP, and the security is antidilutive. Chapter 1 - 5 Chapter 6 - 10 6. Financial Statements 7.Financial Ratios 7.1 Introduction 7.2 Internal Liquidity Ratios 7.3 Operating Profitability Ratios 7.4 Return on Investment Ratios 7.5 Operating Efficiency Ratios 7.6 Business Risk Ratios 7.7 Financial Risk Ratios 7.8 Growth Potential Ratios 7.9 Return on Equity and the Dupont System 7.10 Uses and Limitations of Financial Ratios 7.11 Basic Earnings Per Share 7.12 Dilutive Effect of Splits and Dividends 7.13 Dilutive Securities 7.14 Calculating Basic and Fully Diluted EPS in a Complex Capital Structure 8. Assets 9. Liabilities 10. Red Flags Chapter 11 - 15 Chapter 16 - 17Financial Ratios - Calculating Basic and Fully Diluted EPS in a Complex Capital StructureThere are some basic rules for calculating basic and fully diluted ESP in a complex capital structure. The basic ESP is calculated in the same fashion as it is in a simple capital structure.

Basic and fully diluted EPS are calculated for each component of income: income from continuing operations, income before extraordinary items or changes in accounting principle, and net income.

To calculate fully diluted EPS:

Diluted EPS = [(net income - preferred dividend) / weighted average number of shares outstanding - impact ofconvertiblesecurities - impact of options, warrants and other dilutive securities]

Other form:(net income - preferred dividends) + convertible preferred dividend + (convertibledebtinterest * (1-t))

Divided by

weighted average shares + shares from conversion of convertible preferred shares + shares from conversion of convertible debt + shares issuable fromstock options.

To understand this complex calculation we will look at each possibility:

If the company has convertible bonds, use the if-converted method:

1.Treat conversion as occurring at the beginning of the year or at issuancedate, if it occurred during the year (additive to denominator).2.Eliminate related intere