Financial Statement Analysis 11th Edition Subramanyam Solutions Manual by Ace Test Banks

Financial Statement Analysis 11th Edition Subramanyam Solutions Manual

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Comprehensive Case - Applying Financial Statement Analysis

Comprehensive Case Applying Financial Statement Analysis REVIEW A comprehensive case analysis of the financial statements and notes of Campbell Soup Company is our focus. The book has prepared us to tackle all facets of financial statement analysis. This comprehensive case analysis provides us the opportunity to illustrate and apply these analysis tools and techniques. This case also gives us the opportunity to show how we draw conclusions and inferences from detailed analysis. We review the basic steps of analysis, the building blocks, and the attributes of an expert analysis report. Throughout the case we emphasize applications and inferences associated with financial statement analysis.

Comprehensive Case - Applying Financial Statement Analysis

OUTLINE •

Steps in Analyzing Financial Statements

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Building Blocks of Financial Statement Analysis

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Reporting on Financial Statement Analysis

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Specialization in Financial Statement Analysis

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Comprehensive Case: Campbell Soup Company Preliminary Financial Analysis Short-Term Liquidity Capital Structure and Solvency Return on Invested Capital Analysis of Asset Utilization Analysis of Operating Performance and Profitability Forecasting and valuation Summary Evaluation and Inferences

Comprehensive Case - Applying Financial Statement Analysis

ANALYSIS OBJECTIVES •

Describe the steps in analyzing financial statements.

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Review the building blocks of financial statement analysis.

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Explain important attributes of reporting on financial statement analysis.

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Describe implications to financial statement analysis from evaluating companies in specialized industries or with unique characteristics.

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Analyze in a comprehensive manner the financial statements and notes of Campbell Soup Company.

Comprehensive Case - Applying Financial Statement Analysis

QUESTIONS 1. The six major "building blocks" of financial analysis that we have studied are: i. Short-term liquidity—the ability to meet short-term obligations. ii. Cash analysis and forecasting—future availability and disposition of cash. iii. Capital structure and solvency—ability to generate future revenues and meet longterm obligations. iv. Return on invested capital—ability to provide financial rewards sufficient to attract and retain financing. v. Asset utilization (turnover)—asset intensity in generating revenues to reach a sufficient profitability level. vi. Operating performance and profitability—success at maximizing revenues and minimizing expenses from operating activities over the long run. The initial step in applying the building blocks to financial statement analysis involves: i. Determining the specific objectives of the analysis task. ii. Arriving at a judgment about which of the six major areas of analysis must be evaluated with what degree of emphasis and in what order of priority. 2. Financial statement analysis is oriented toward the achievement of specific objectives. So that an analysis can best serve these objectives, the first step is to define them carefully. The thinking and clarification leading up to the definition of objectives is an important part of the analytical process as it insures a clear understanding of objectives, of what is pertinent and relevant, and thus leads to avoidance of unnecessary work. This is indispensable to an effective as well as an efficient analysis. Effectiveness, given the specific objectives, is enhanced because of a focus on the most important elements of the financial statements in light of the decision task. It is also efficient in that it leads to an analysis with maximum economy of time and effort. 3. An analyst of financial statement data must always bear in mind that financial statements are at best an abstraction of an underlying reality. Further mathematical manipulation of financial data can result in second, third, and even further levels of abstractions. As the book mentioned, no set of photos of the Rocky Mountains can fully convey the grandeur of the terrain. One has to see them to fully appreciate them. This is because photos, like financial statements, are at best, abstractions. That is why analysts must, at some point, leave the financial statements and “visit the companies” to get a full understanding of the phenomena underlying by the analysis. This is particularly true because of the static nature of the abstractions found in the financial statements. In contrast, business reality is dynamic and constantly changing. 4. The financial analyst must recognize that there are industries with distinct accounting treatments that arise either from their specialized nature or from the special conditions in which they operate (such as governmental regulations). The analysis of the financial statements of such a company requires a thorough understanding of the accounting peculiarities to which they are subject. Accordingly, the analyst must be prepared for this task by studying and understanding the specialized areas of accounting which affect the analysis. Examples of specialized industries include oil and gas, life insurance, and public utilities. As in any field of endeavor, specialized areas of inquiry require that specialized knowledge be brought to bear upon them. Financial statement analysis is, of course, no exception. CC-4 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Comprehensive Case - Applying Financial Statement Analysis

5. A good analysis highlights for the reader the interpretations and conclusions of the analysis from the facts and data upon which they are based. This helps to distinguish fact from opinions and estimates. It also enables the reader to follow the rationale of the analyst's conclusions and allows him/her to modify them as judgment dictates. To this end, the analysis should contain distinct sections devoted to: i. A brief "Summary and Conclusion" (executive summary) section as well as a table of contents to help the reader decide how much of the report he/she wants to read and which parts of it to emphasize. ii. General background material on the enterprise analyzed, the industry of which it is a part, and the economic environment in which it operates. iii. Financial and other evidential data used in the analysis as well as ratios, trends, and other analytical measures that have been developed from them. iv. Assumptions as to the general economic environment and other conditions on which estimates and projections are based. v. A listing of positive and negative factors, quantitative and qualitative, by area of analysis. vi. Projections, estimates, interpretations, and conclusions based on the aforementioned data.

Comprehensive Case - Applying Financial Statement Analysis

EXERCISES Exercise CC-1 (30 minutes) The factors that would determine the relative PE ratios are: a. Growth in earnings per share Year 5 to 6 ........................................... Year 2 to 6 ...........................................

Axel 21% 150%

Bike 20% 54%

Assuming net income is comparable as far as accounting practices go, Axel would be likely to have a higher PE ratio because of greater historic growth in earnings per share. b. Leverage in capital structure

Axel 33% of its total capital is debt

Bike No debt

Axel's earnings are likely to be greater, relative to Bike, because of this leverage (assuming successful trading on the equity). Accordingly, its growth in per share earnings is likely to be faster, producing greater market appreciation. This is likely to produce a higher PE for Axel. However, Axel does have greater financial risk, which would tend to reduce its PE differential.

c. Return on common equity Year 6 ..................................................

Axel $2,125 $20,000 = 10.6%

Bike $2,250 $30,000 = 7.5%

Axel's greater ROCE is mainly due to the leverage in its capital structure. This will tend to produce a higher PE for the stock (assuming successful trading on the equity). This will result in larger growth in retained earnings as long as dividend policies are about the same, and should yield faster growth of the stockholders' investment. It should also reduce the need to finance expansion with further stock issuances and the potential dilution of earnings per share.

Comprehensive Case - Applying Financial Statement Analysis

Exercise CC-1—continued d. Net income as % of sales

Axel $2,125 $30,000 = 7.1%

Bike $2,250 $30,000 = 7.5%

The difference is due to Axel's use of debt in its capital structure. If we calculate net income before tax and interest (assuming a 50% tax rate), Axel is seen to be more profitable as shown here:

NI before tax and interest ..................... Interest expense.................................... NI before tax .......................................... NI before tax & interest as % of sales .

Axel $4,750,000 500,000 4,250,000 15.8%

Bike $4,500,000 -4,500,000 15.0%

Axel's interest payment can be considered by the analyst as a cost of servicing the capital structure. Therefore, a better measure of operating profitability is the ratio of net income before tax and interest to sales. This shows Axel to be marginally more profitable in Year 6, which will tend to produce a faster growth in earnings per share and PE. e. Ratios 1. Current ratio ...............................................

Axel 2.85

Bike 2.97

6.00

8.00

No significant difference. 2. Receivables turnover ................................

Implies Bike has a more efficient and strict collection policy. 3. Ratio of sales to net plant and equip. ......

2.30

1.88

Suggests Axel is more efficient in utilizing its plant. f. Patent position Axel seems to have a stronger patent position, but to accurately determine this one would need to know the policy in accounting for patents. These include answers for questions such as: Will amortization of Axel's patents’ cost be a drain on future earnings? Do the patents’ book values represent market values?

Comprehensive Case - Applying Financial Statement Analysis

Exercise CC-1—concluded g. Return on long-term fixed assets Axel: Bike:

$2,125,000 / $13,000,000 = 16.35% $2,250,000 / $15,900,000 = 14.15%

The results from the return on long-term assets increase Axel's return to an even more favorable comparison with Bike—implying higher PE for Axel.

Other considerations that one would want to examine for PE include a. Reputation of the company. b. Quality of management. c. Product range and its potential. d. Accounting policies—inventory, depreciation, amortization of intangibles, etc. e. Dividend payout and policies (these policies could markedly affect the relative PE for these companies if there were significant differences). f. Capital expenditure programs—Will Axel need new plant soon? g. Expansion program—internal and via acquisition.

Overall Analysis: On most factors, Axel appears to be more efficient and profitable than Bike. The greater prospects for increases in Axel's earnings per share and market value are likely to produce a higher PE ratio for Axel.

Exercise CC-2 (25 minutes)

Company a. b. c. d. e. f. g. h. i.

(6) (2) (8) (1) (9) (3) (5) (7) (4)

Comprehensive Case - Applying Financial Statement Analysis

Exercise CC-2—concluded Identification Strategy Industry Pharmaceuticals Health care

Expected Characteristics Company # High R & D 2 No inventory 8 High plant and equipment No advertising expense High cost of goods sold Utilities High plant and equipment 1 Large debt (financed with bonds) Low inventories Investment advising No inventory 9 Low plant and equipment High "other" assets (investments) High interest expense Low cost of goods sold Grocery stores Low NI as % of sales 5 Low receivables Low plant and equipment (operating leases) Computing equipment High R&D 7 Higher inventory than pharmaceutical company Public opinion surveys No inventory 4 No R&D To distinguish between the tobacco manufacturer (6) and the brewery (3), recognize that the tobacco manufacturer would keep higher inventories, while a brewery would maintain a higher investment in plant and equipment. This implies that company (6) is the tobacco manufacturer, and company (3) is the brewery company. Alternative Solution—Explanations for identification: i. Three firms have zero inventory—(4), (8) and (9). These likely correspond to firms that have operating expenses instead of cost of goods sold—specifically, investment advising, health care, and public survey companies. Since company (8) has a very high property, plant and equipment account, it is most likely the health care company. Company (9) has large "Other assets," which probably represents investments, and high current liabilities—it is most likely the investment advising company. By process of elimination, company (4) is the public opinion survey company. ii. Company (1) has a large plant and equipment account, as well as high long-term debt and interest expense. It is the utility company. iii. Companies (2) and (7) have high R&D expense. This would correspond to the pharmaceutical company and the computing equipment company. Since drugs typically have a shorter shelf-life than computer equipment, the pharmaceutical company will have lower inventory relative to sales. Company (2) is, therefore, the pharmaceutical company, while company (7) manufactures computer equipment. iv. Company (5) must be the grocery store company since it shows very low receivables (few sales on account), and very low net income relative to sales (typical for the industry). v. Of the two firms left (tobacco manufacturer and brewery), tobacco products require aging. The tobacco manufacturer would keep higher inventories, while a brewery would represent a higher investment in plant and equipment. Company (6) is the tobacco manufacturer, and company (3) is the brewery company.

Comprehensive Case - Applying Financial Statement Analysis

PROBLEMS Problem CC-1 (55 minutes) a. 1. Brewing industry compared with the S&P 400 The brewing industry and the S&P 400 are similar in terms of short-term liquidity as indicated by the current ratio and quick ratio—the ratios are similar in both absolute value and trend (both ratios are about the same as in Year 2). However, there are substantial differences in long-term financial risk. While the industry has experienced a decline in the proportion of debt, the aggregate market data indicates a higher level of debt. This divergence in trend is also evident in the flow ratios. While the brewing industry increased interest coverage and relative cash flow ratios, the aggregate market experienced a decline in coverage and relative cash flow. In turning to total asset turnover ratios, the results are similar although the industry is better. Both experienced an increase in net profit margin, but the industry looked better in the most recent year. Moreover, the industry increased its return on total assets over time, while the return for the market declined. In the most recent year, the industry's return was almost twice as large as the S&P (7.90 percent vs. 3.97 percent). To summarize, the brewing industry showed progress in reducing its financial risk and increasing its profits and return on assets. It had a better trend and final position than the market. 2. Anheuser-Busch compared with the brewing industry Regarding short-term liquidity, BUD is about the same in Year 6 as in Year 2— moreover, its ratios are consistently below the industry. While there is no deterioration, the firm is less liquid than is normal for the industry. It is important to determine why BUD is able to maintain such a tight short-term posture compared to the rest of the industry. BUD's long-term debt posture has improved slightly over time as evidenced by the debt to asset ratios. The industry also has improved, so on a relative basis they are about the same as in Year 2. BUD's interest coverage ratio has declined in absolute terms and relative to the industry. In Years 2, 3, and 4, BUD had coverage of about 12-13 versus 7-8 for the industry; in Year 6 it is about 10 times for BUD versus 11 for the industry. BUD’s cash flow ratios have improved along with the industry. Total asset turnover has increased for both BUD and the industry. The profit margin performance for the industry is somewhat better—it went from 5.36 percent to 6.16 percent, while BUD is stable (6.30% versus 6.17%). Notably, this stability in the profit margin is impressive considering the sales growth and industry market share gained by BUD during this time period. Finally, the return on total assets for BUD has increased over time and has been consistently above the returns for the industry. In summary, BUD is less liquid than the industry, but is stable on a relative basis. Its financial risk is mixed—its debt ratios declined, its interest coverage declined on an absolute and relative basis although it is still a very healthy 10 times, and its cash flow ratios improved. BUD's profit margin is constant but declined on a relative basis, and its return on total assets improved but was constant on a relative basis.

Comprehensive Case - Applying Financial Statement Analysis

Problem CC-1—concluded 3. Anheuser-Busch compared with the S&P 400 BUD has maintained its short-term liquidity position, but its liquidity ratios are consistently below the market. Its long-term financial leverage declined over time while its market leverage increased—by Year 6, BUD was better on this factor. This position is also reflected in interest coverage, which declined somewhat but is still more than twice the market number. Also, the cash flow ratios for BUD are the same or lower than the market in Year 2, but are substantially better absolutely and relative to the market in Year 6. BUD's total asset turnover increased while the market declined slightly over this period. The net profit margin performance is similar—the market and BUD experienced small declines over the period. BUD did have a larger return on assets in Year 2 and increased its spread by Year 6 when it was twice as large (8.89 percent vs. 3.97 percent). In summary, with the exception of the short-term liquidity ratios, BUD is superior in an absolute sense and generally experienced a better trend. As a result, the firm has much lower financial risk and a much higher return on assets.

b. There should be no problem with extending credit to BUD given its declining debt ratios, its strong interest coverage ratios, and its strong cash flow ratio that is already better than the market and trending upward compared to a decline for the market. With the lone exception of the interest coverage ratio, which declined in Year 6, all the financial risk measures have improved on an absolute basis and relative to the market. Even in the case of the coverage ratio, it is still quite large and about 2.5 times the coverage for the aggregate market. Therefore, one would not expect a change in the credit rating of BUD based on these financial ratios.

Comprehensive Case - Applying Financial Statement Analysis

Problem CC-2 (65 minutes) a. [Note: Forecast data taken from Exhibit I of Case 10-5.] ABEX Chemicals Forecasted Operating Income For Year Ended Year 10 Petrochemicals

Pipeline

Total

Segment revenues (volume x price) 4,950 x $0.470......................................... $2,326.50 6,290 x $0.187.........................................

$1,176.23

Segment operating costs (volume x cost) 4,950 x $0.37...........................................

1,831.50

$1,176.23 x (1-27%) ................................ Segment operating income ........................ $ 495.00

858.65 $ 317.58

Total operating income ($495 + $317.58) ..

$ 812.58

b. Additional information necessary to prepare a forecast of net income includes: 1. Schedule of debt outstanding including interest cost estimates. 2. Estimate for administration cost (such as the trend). 3. Estimate for rental expenses. 4. Estimate for investment income. 5. Tax rates. 6. Schedule of preferred shares outstanding including dividend rates. 7. Average number of shares outstanding. This information can be obtained from the following primary sources: (1) quarterly reports, (2) annual reports, (3) company information packages, (4) prospectuses, (5) management interviews, (6) 10-K filings, and (7) 10-Q filings.

Comprehensive Case - Applying Financial Statement Analysis

Problem CC-2—concluded c. 1. Incremental EPS = Incremental operating income x (1-tax rate) Shares outstanding Volume x Price increase per pound x (1-tax rate) Shares outstanding = [4,950 lbs. x ($0.47)(8%) x (1- 0.44)] / 305 = $0.34 per share increase

2. Incremental EPS = Volume increase x (Price - Cost) x (1-tax rate) Shares outstanding = [(4,950 lbs.)(8%) x ($0.47-$0.37) x (1- 0.44) / 305 = $0.07 per share increase

In this case, an 8% increase in price has a much greater impact than an 8% increase in volume. This is because higher volume creates an increase in variable costs. If costs rise as much as prices, then the impact on EPS is reduced. Note that higher prices often coincide with higher volume if both occur due to an increase in demand that is greater than an increase in capacity. This is why it is particularly important for analysts to pay attention to industry conditions of supply, demand, capacity, inventories, prices, and costs.

Comprehensive Case - Applying Financial Statement Analysis

Problem CC-3 (75 minutes) a. The principal limitation of the four ratios computed is that they say little about the company's ability to generate cash. It is a lack of cash that ultimately forces a company into bankruptcy. First, let’s look at the quick ratio. Notice that FGC is able to maintain its quick ratio over the period. This occurs while its working capital declines from $448.7 million in Year 4 to negative $8.3 million in Year 5 to $5.4 million by the middle of Year 6. Similarly, neither the receivables turnover nor the inventory turnover help in revealing this decline in liquidity. Adding to the decline in liquidity is the company’s increasing reliance on external financing. This is evidenced by the marked increase in long-term debt. Again, the four ratios computed ignore this implication to liquidity—that is, interest costs must be paid. Finally, its operating margin trend over the 2 1/2 years is equally deceptive in not revealing the decline in liquidity. This is primarily because this margin is computed before interest and taxes. Consequently, it fails to reflect the dramatic increase in interest expenses over this period. The operating profit margin after interest expense would reflect this decline in liquidity. In summary, these four ratios do not reflect the decline in FGC’s liquidity. b. Several better measures of liquidity and operating performance exist (or at least can supplement the four ratios computed). There are two such measures reported in FGC’s "Selected Cash Flow Data" schedule: (i) Cash flow from operations and (ii) Net liquid balance. The operating cash flow data clearly show a decline in FGC's liquidity over the recent 2 1/2 years. Moreover, the components of this measure also evidence a decline in liquidity. Specifically, notice that earnings from continuing operations falls from $173.2 million for Year 4 to only $10.4 million for the first 6 months of Year 6. Furthermore, noncash working capital—which declines in Years 4 and 5 (thereby acting as a source of cash)—increases in the first half of Year 6, reflecting a further $84.1 million drain on cash (admittedly, seasonal factors could explain some of this decline). The net liquid balance reflects that part of working capital that is most liquid—it excludes items of working capital that are less liquid. In the case of FGC, the net liquid balance was already negative in Year 4, even before the recapitalization of FGC. This suggests that FGC was overdependent on short-term external sources of financing. This measure remained negative throughout this period. Indeed, the net liquid balance appears to be a good leading indicator of default risk—at least in the case of FGC. Other potentially useful measures are times interest earned, return on assets, and return on common equity. Times interest earned reflects the ability of operating income to cover the expense of long-term debt. The computation of this ratio reveals a dramatic decline from a comfortable 5.4 in Year 4 to only 1.1 in the first half of Year 6. A value less than 1.0 is a red flag for solvency risk. Return on assets and return on

Comprehensive Case - Applying Financial Statement Analysis

Problem CC-3—concluded equity also reflect FGC's long term financial prospects. Without sufficient returns, the company's debt holders cannot expect security for their claims on income or assets. Return on assets slipped from 10.9% in Year 4 to 6.4% in the first half of Year 6. Both metrics reveal the decline in FGC’s liquidity. c. Based on the information provided, you should seek to sell the bonds. Indeed, you should probably accept bid prices as low as the lower 50s. The bonds are subordinated debentures, meaning they do not have first claim on assets in case of bankruptcy. Also, the default risk for these bonds appears to be unacceptably high. Industry conditions appear to have deteriorated due to a combination of lower demand and increased supply. Reduced capacity utilization has put downward pressure on prices. The fact that FGC's major competitor is also highly leveraged may reduce the risk of unbridled price competition. On the other hand, it could lead to aggressive pricing policies in the event both companies become desperate to spur sales to service their large debt loads. The industry is cyclical, so being highly leveraged places an even greater risk on FGC. It also calls into question the past decisions of management. Given the poor ability of FGC to generate cash and its weak net liquid balance—along with its heavy reliance on external, short-term financing—you are well advised to recommend the sale of its bonds.

Comprehensive Case - Applying Financial Statement Analysis

CASES Case CC-1 (90 minutes) The answers to the case depend on the company selected for analysis. The comprehensive case analysis of Campbell Soup Company should serve as excellent guidance for a student in completing the requirements of this case.

Case CC-2 (120 minutes) a. $7,000 = Net income - Cash dividends = $10,000 - $3,000 (Note: The 10% stock dividend has no effect on total stockholders' equity.) b. Two accounts are increased by the following amounts: Property, plant & equipment ................................

$1,000

Long-term debt......................................................

$1,000

These accounts are increased to record these leases at the present value of their future rental payments. These leases are reflected in the statement of cash flows as a separate disclosure as a significant noncash activity. c.

Repaid in Year 6

Long-Term Debt (includes current portion) 16,200 Beginning balance 7,500 Issuance per SCF 2,500 4,800 From TRO acquisition 1,000 Capital lease (noncash) 27,000 Ending balance

ZETA's statement of cash flows (SCF) reports "Reduction in long-term debt" at $1,500. The only way an external analyst could arrive at this amount is to assume that the capital lease is included in the $7,500 issuance of long-term debt. Unresolved is the question of why the capitalized lease, a noncash transaction, is seemingly included in this amount.

Comprehensive Case - Applying Financial Statement Analysis

Case CC-2—continued d. 1. and 2. ZETA's change in accounting for inventories had the following effects: (1) (2) BALANCE SHEET Effect of change Analytical change to new method in to restate Year 5 Year 6 to new method Inventories .......................................

$2,800 *

$2,000

Income taxes payable .....................

1,400 **

1,000

Retained earnings ...........................

1,400

1,000

* Cumulative pre-tax effect of $2,000 plus pre-tax effect on Year 6 income from continuing operations (per note 5, statutory tax rate is 50%). ** 50% of $2,800 restatement of cumulative income.

RETAINED EARNINGS Beginning balance ..........................

$ 700 *

Net income ......................................

1,400

300 *

Ending balance ...............................

$1,400

$1,000

* Pro forma income data shows that Year 5 income from continuing operations is increased by $300 based on retroactive application of the accounting change. Thus, the remaining $700 ($1,000 - $300) after-tax effect must pertain to prior years.

INCOME STATEMENT Cost of sales ...........................................

$ (800)

$ (600)

Income tax expense ...............................

400

300

Income from continuing operations ....

400

$ 300

Cumulative effect (net of $1,000 tax) ...

1,000

Net income ..............................................

$1,400

3. The accounts increased, along with their respective amounts, to record the $1,000 “cumulative effect” are: Inventories ................................................................. $2,000 Income taxes payable ............................................... 1,000 Retained earnings (“cumulative effect”) ................. 1,000 Notice there is no effect on cash. The cumulative effect of $1,000 (net) should be included with expenses. It will then be offset by the change in inventories and in tax payable which will all net to zero.

Comprehensive Case - Applying Financial Statement Analysis

Case CC-2—continued e. 1. TRO must be a separate entity because minority interest is outstanding. If 100% of TRO had been acquired, we would be unable to determine whether it was maintained as a separate legal entity or dissolved into ZETA. 2. ZETA Corporation balance sheet: The following accounts are affected by these amounts: Investment in subsidiary........................................... $8,000 (increase) Cash ............................................................................ 8,000 (decrease) Consolidated balance sheet (per SCF): Receivables & Inventories ........................................ $4,200 (increase) Property, plant & equipment..................................... 6,000 (increase) Goodwill ..................................................................... 2,000 (increase) Current liabilities ....................................................... 3,200 (increase) Long-term debt .......................................................... 4,800 (increase) Minority interest......................................................... 400 (increase) Cash (net of 4,200 acquired) ..................................... 3,800 (decrease) 3. Pro forma revenues (per note 3) .............................. $205,000 Reported revenues (without TRO) ........................... 186,000 TRO's revenues ......................................................... $ 19,000 f. 1. Investment in Associated Companies Beginning balance 11,000 Equity in income (per IS) 2,000 Dividends received [a] Additional investment (per SCF) 1,600 600 Ending balance 14,000 [a] Dividends received: Equity in NI........................................... Less undistributed portion................. Distributed equity ................................

$2,000 1,400 (per SCF) $ 600

2. Sources of Cash Flows Included in net income ...................................... Items not affecting cash.................................... Effect on cash from operations ........................ Uses of Cash Flows: Investment in associated companies ..............

$ 2,000 Cr. (increase) (1,400) Dr. (decrease) 600 Cr. (increase) $ 1,600 Dr. (decrease)

Comprehensive Case - Applying Financial Statement Analysis

Case CC-2—continued g. 1. Minority interest 800 400 200 1,400

Beginning balance TRO acquisition (note 3) Share of net income (per IS) Ending balance

2. There is NO relation between these accounts. Minority Interest relates to consolidated companies, while the Investment in Associated Companies relates to unconsolidated companies. h. Beginning inventory ............................. + Purchases........................................... - Ending inventory ................................ = Cost of goods sold ............................

LIFO $ 38,000 P (56,000) P-18,000

Difference $ 4,500 -(6,000) (1,500)

FIFO $ 42,500 P (62,000) P-19,500

Therefore: $1,500 difference less 50% taxes = $750 increase in Net Income Alternate solution: From Note 2: Inventories, the change in the LIFO reserve x (1- tax rate) = ($6,000 - $4,500) x (1-.50) = $750.

1. Loss on disposal * .......................................................... $1,400 (increase) Property, plant & equipment ........................................... 1,000 (decrease) Inventories ........................................................................ 100 (decrease) Accounts payable & accruals ......................................... 300 (increase) Taxes payable .................................................................. 700 (decrease) Loss on disposal * ........................................................... 700 (decrease) * These amounts could be netted—they are separated here to emphasize that they arise from two separate transactions.

2. There is no effect on cash flows. The effect of the loss on disposal is reported as follows in the statement of cash flows: Included in net income ................................................... $(700) Dr. (decrease) Items not affecting cash ................................................. 700 Cr. (increase) Effect on CFO .................................................................. $ 0 3. The $1,100 operating loss consists of the following gross amounts (revenues per note 4; expenses are a plug): Revenues ......................................................................... $18,000 Expenses .......................................................................... 19,100 Net loss ............................................................................. $(1,100) The $1,100 would be part of the statement of cash flows as shown here: Included in revenues ....................................................... $18,000 Included in expenses....................................................... 19,100

Comprehensive Case - Applying Financial Statement Analysis

Case CC-2—concluded i. Discontinued operations cannot be segregated because the changes in operating current assets and current liability accounts represent both continuing and discontinued operations.

j. Under current GAAP, there is no amortization of goodwill. Therefore, the statement of cash flows is unaffected. In the event of an impairment, the impairment loss will be reflected in net income and added back in the Statement of Cash Flows as a noncash expense for no net effect on operating cash flows. k. (Note: All amounts per the statement of cash flows.) Beginning balance Additions for cash TRO acquisition Ending balance

Property, Plant, and Equipment (net) 33,000 6,500 6,000 Depreciation expense 6,000 1,000 Write-down of disc. operations 500 Disposal of equipment 38,000

Comprehensive Case - Applying Financial Statement Analysis

Case CC-3 (60 minutes) a. 1. Short-term liquidity Four of the ratios are indicators of short-term liquidity. KO has a greater current ratio and acid-test ratio. CCE has a significantly higher inventory turnover ratio. Turnover of accounts receivable is virtually the same for both companies. On balance, KO is slightly more liquid, and is in a stronger position since CCE has virtually no cash. 2. Capital structure and solvency Looking at the ratio of long-term debt to equity, CCE has significantly greater financial leverage. CCE's large investment in fixed assets and purchased goodwill is mainly debt financed. This ratio, which ignores short-term debt, exaggerates the difference between the two companies. Total debt to total capital ratios are much closer. CCE's greater dependence on interest-bearing debt and lower profitability result in significantly lower interest coverage as measured by the times interest earned ratio. 3. Asset Utilization Both ratios in this category show KO to be superior. Asset turnover and property, plant and equipment turnover are higher for KO. CCE's capital intensive business is responsible for this disparity. 4. Profitability KO is clearly the more profitable enterprise by all four measures. The higher gross profit margin is carried down to net income. KO's return on assets and return on common equity also are superior to those of CCE. KO's better competitive position is reflected in its profitability ratios. b.

Potential Analytical Adjustments 1. Remove non-recurring items from income statement of CCE. (From income statement take $104 million gain on sale of operations, less $27 million provision for restructuring, and add from footnote #2 the $8.5 million gain on repurchase of debt to equal a net $85.5 million pre-tax nonrecurring gain.) Reduce pretax earnings by $85.5 million for CCE. Impact: CCE profitability reduced further in comparison to that of KO (ROA, profit margins, ROCE). No other ratios affected. 2. Add back LIFO reserve to inventory for both companies. Effect is $30 million for KO (cost of goods sold drops and reported profits rise) and $2 million for CCE. Equity increases by same amounts. (Footnote 1 for both companies.) Impact: KO current ratio improves slightly. KO inventory turnover decreases. KO debt ratios decline due to higher equity. Effects on CCE immaterial as LIFO reserve relatively small. 3. Recognize market value of KO investments in excess of carrying value—$291 million (footnote 2). Impact: Higher equity reduces debt ratios and return on equity. Higher assets reduce turnover and return on assets.

Comprehensive Case - Applying Financial Statement Analysis

Case CC-3—concluded 4. Recognize off-balance sheet obligations for KO. KO has guarantees of $133 million (footnote 3). Impact: Higher debt ratios for KO. Guarantees also added to assets affecting asset-based ratios: decreasing ROA and turnover. 5. Recognize off-balance sheet obligations for CCE. CCE has operating leases (footnote 3) for which analyst must estimate present value of "liability." One potential simple calculation follows: Year Future value PV factor * Present value 9 11,749 0.909 10,680 10 8,436 0.826 6,969 11 6,881 0.751 5,168 12 4,972 0.683 3,396 13 3,485 0.621 2,164 14 3,727 ** 0.564 2,102 15 3,727 ** 0.513 1,912 16 3,727 ** 0.467 1,741 34,132 * **

Assumed interest rate of 10%. Dividing payments beyond Year 13 ($11,181) by Year 13 payment ($3,485) results in 3.21 years. As an approximation, the payments beyond Year 13 are spread equally over Years 14-16.

Impact: Higher debt ratios for CCE. Current portion of lease obligation reduces CCE current ratio. Leases would also be added to asset side of balance sheet, affecting all asset-based ratios. Lease would increase fixed assets, reducing turnover ratio and ROA. 6. Add pension plan surplus to equity for both companies. Excess of plan assets over projected benefit obligation is $83 million for KO and $46 million for CCE. (Footnote 4 for both companies). Impact: About the same for both companies as relative impacts the similar. Debt ratios decline due to higher equity. ROCE decreases due to higher equity base. 7. Remove purchased goodwill from balance sheets of both companies, reducing assets and shareholders equity by $56 million for KO and $2,935 million for CCE (wiping out shareholders equity). Impact: Not material for KO. CCE debt ratios sharply higher because of lower equity. CCE asset turnover improved because of lower assets. CCE ROE and ROCE more than doubled because of lower base.

Chapter 01 - Overview of Financial Statement Analysis

Chapter 1 Overview of Financial Statement Analysis REVIEW Financial statement analysis is one important step in business analysis. Business analysis is the process of evaluating a company’s economic prospects and risks. This includes analyzing a company’s business environment, its strategies, and its financial position and performance. Business analysis is useful in a wide range of business decisions such as investing in equity or debt securities, extending credit through short or long term loans, valuing a business in an initial public offering (IPO), and evaluating restructurings including mergers, acquisitions, and divestitures. Financial statement analysis is the application of analytical tools and techniques to general-purpose financial statements and related data to derive estimates and inferences useful in business analysis. Financial statement analysis reduces one’s reliance on hunches, guesses, and intuition for business decisions. This chapter describes business analysis and the role of financial statement analysis. The chapter also introduces financial statements and explains how they reflect underlying business activities. Several tools and techniques of financial statement analysis are also introduced. Application of these tools and techniques is illustrated in a preliminary business analysis of Dell.

Chapter 01 - Overview of Financial Statement Analysis

OUTLINE •

Introduction to Business analysis Types of Business Analysis Credit Analysis Equity Analysis Other Uses of Business Analysis Managers Mergers, Acquisitions, and Divestitures Financial Management External Auditors Components of Business Analysis Business Environment and Strategy Analysis Financial Analysis Accounting Analysis Prospective Analysis Valuation Financial Statement Analysis and Business Analysis

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Financial Statements-Basis of Analysis Financial Statements Reflect Business Activities Planning Activities Financing Activities Investing Activities Operating Activities The Annual Report Balance Sheet Income Statement Statement of Shareholders’ Equity Statement of Cash Flows Links Between Financial Statements Additional Information Management Discussion and Analysis (MD&A) Management Report Auditor Report Explanatory Notes Supplementary Information 1-2

Chapter 01 - Overview of Financial Statement Analysis

Social Responsibility Reports Proxy Statements ▪

Financial Statement Analysis Preview Analysis Tools Areas of Preliminary Analysis Comparative Financial Statement Analysis Year-to-Year Change Analysis Index-Number Trend Analysis Common-Size Financial Statement Analysis Ratio Analysis Factors Affecting Ratios Ratio Interpretation Illustration of Ratio Analysis Cash Flow Analysis

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Specialized Analysis Tools Valuation Models Debt Valuation Equity Valuation Analysis in an Efficient Market Market Efficiency Market Efficiency Implications for Analysis

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Book Organization

Chapter 01 - Overview of Financial Statement Analysis

ANALYSIS OBJECTIVES •

Explain business analysis and its relation to financial statement analysis

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Identify and discuss different types of business analysis

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Describe the component analyses that constitute business analysis

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Explain business activities and their relation to financial statements

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Describe the purpose of each financial statement and linkages between them

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Identify relevant analysis information beyond financial statements

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Analyze and interpret financial statements as a preview to more detailed analyses

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Apply several basic financial statement analysis techniques

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Define and formulate some fundamental valuation models

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Explain the purpose of financial statement analysis in an efficient market

Chapter 01 - Overview of Financial Statement Analysis

QUESTIONS 1. Business analysis is the evaluation of a company’s prospects and risks for business decisions. Applicable business decisions include, among others, equity and debt valuation, credit risk assessment, earnings prediction, audit testing, compensation negotiations, and countless other decisions. The objective of business analysis is to aid with decision making by helping to structure the decision task, including an evaluation of a company’s business environment, its strategies, and its financial position and performance. As a result, the decision-maker will make a more informed decision. 2. Business analysis is the evaluation of a company’s prospects and risks for business decisions. Financial statements are the most comprehensive source of information about a company. As a result, financial statement analysis is an integral part of business analysis. 3. Some major types of business analysis include credit analysis, equity analysis, management and control, analysis of mergers and acquisitions, and others. Credit analysis is the evaluation of the ability of a company to honor its financial obligations (i.e., pay all of its debts). Current and potential creditors and debt investors perform credit analysis. Equity analysis supports equity investment decisions. Equity investment decisions involve buying, holding, or selling the stock of a company. Current and potential investors perform equity analysis. Managers perform business analysis to optimize their managerial activities. From business analysis, managers are better prepared to recognize challenges and opportunities and respond appropriately. Business analysis is also a part of a company’s restructuring decisions. Before a merger, acquisition, or divestiture is completed, managers and directors perform business analysis to decide whether the contemplated action will increase the combined value of the firm. Business analysis supports financial decisions by financial managers. Business analysis helps assess the impact of financing decisions for both future profitability and risk. External auditors perform business analysis to support their assurance function. Directors of a company use business analysis to support their activities as overseer of the operations of the company. Regulators use business analysis to support the performance of regulatory activities. Labor union representatives use business analysis to support collective bargaining activities. Lawyers use business analysis to provide evidence regarding litigation matters. 4. Credit analysis supports the lending decision. As such, credit analysis involves determining whether a company will be able to meet financial obligations over a given time horizon. Equity analysis supports the decision to buy, hold, or sell a stock. As such, equity analysis involves the identification of the optimal portfolio of stocks for wealth maximization.

Chapter 01 - Overview of Financial Statement Analysis

5. Fundamental analysis is the process of determining the value of a company by analyzing and interpreting key factors for economy, industry, and company attributes. A major part of fundamental analysis is evaluation of a company’s financial position and performance. The objective of fundamental analysis is to determine the intrinsic value of an entity. Determination of fundamental value can be used to support stock decisions and to price acquisitions. 6. Total business analysis involves several component processes. Each process is critical to the ultimate summary beliefs about the business. The first component is analysis of the business environment and the company’s strategy in the context of the business environment. From this analysis, qualitative conclusions can be drawn about the future prospects of the firm. These prospects are crucial in investment decisions. The second component of business analysis is financial analysis. Financial analysis is the use of financial statements to analyze a company’s financial position and performance, and to assess future performance. Financial analysis supports equity decisions by providing quantified evidence regarding the financial position and performance of the company. Accounting analysis is another component of business analysis. Accounting analysis is the process of evaluating the extent that a company’s accounting reflects economic reality. If the accounting information distorts the economic picture of the firm, decisions made using this information can be flawed. Thus, accounting analysis should be performed before financial analysis. Prospective analysis is the forecasting of future payoffs. This analysis draws on accounting analysis, financial analysis, and business environment and strategy analysis. The output of prospective analysis is a set of expected future payoffs used to estimate intrinsic value such as earnings and cash flows. Another component of business analysis is valuation, which is the process of converting forecasts of future payoffs into an estimate of a company’s intrinsic value. 7. Accounting analysis is crucial to effective financial analysis. The limitations of financial analysis in the absence of accounting analysis include: • Lack of uniformity in accounting principles applied by different companies can impede the reliability of financial analysis. The seeming comparability of accounting data is sometimes illusory. • Lack of information in the aggregate financial data to inform the analyst on how the accounting of the company was applied. The analyst needs to analyze the explanatory notes for this information. • Increased frequency of “anomalies” in financial statements such as the failure to change previous years' data for stock splits, missing data, etc. • Retroactive changes cannot be made accurately because companies only change final figures. • Certain comparative analyses (leases and pensions) cannot be done since all companies do not provide full information in the absence of analytical accounting adjustments. (CFA adapted)

8. The financial statements of a company are one of the richest sources of information about a company. Financial statement analysis is a collection of analytical processes that are an important part of overall business analysis. These processes are applied to the financial statement information to produce useful information for decision making. The objective of financial statement analysis is to use the information provided in the statements to produce quantified information to support the ultimate equity, credit, or other decision of interest to the analyst. 1-6 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 01 - Overview of Financial Statement Analysis

9. Internal users: Owners, managers, employees, directors, internal auditors; External users: Current and potential equity investors, current and potential debt investors, current and potential creditors, current and potential suppliers, current and potential customers, labor unions members and representatives, regulators, and government agencies. 10. A business pursues four major activities in a desire to provide a saleable product and/or service and to yield a satisfactory return on investment. These activities are: Planning activities. A company implements specific goals and objectives. A company's goals and objectives are captured in its business plans (or strategies)—that describe the company's purpose, strategy, and tactics. The business plan assists managers in focusing their efforts and identifying expected opportunities and obstacles. Financing Activities. A company requires financing to carry out its business plan. Financing activities are the means companies use to pay for these ventures. A company must take care in acquiring and managing its financial resources because of both their magnitude and their potential to determine success or failure. There are two main sources of business financing: equity investors (referred to as owner financing) and creditors (referred to as non-owner financing). Investing Activities. Investing activities are the means a company uses to acquire and maintain investments for purchasing, developing, and selling products and services. Financing provides the funds necessary for acquisition of investments needed to carry out business plans. Investments include land, buildings, equipment, legal rights (patents, licenses, and copyrights), inventories, human capital (managers and employees), accounting systems, and all components necessary for the company to operate. Operating Activities. Operating activities represent the carrying out of the business plan, given necessary financing and investing. These activities involve several basic functions such as research, purchasing, production, marketing, and labor. Operating activities are a company's primary source of income. Income measures a company's success in buying from input markets and selling in output markets. How well a company does in devising business plans and strategies, and with decisions on elements comprising the mix of operating activities, determines its success or failure. 11. Business activities—planning, financing, investing, and operating—can be synthesized into a cohesive picture of how businesses function in a market economy. Step one is the company's formulation of plans and strategies. Next, a company obtains necessary financing from equity investors and creditors. Financing is used to acquire investments in resources to produce goods or services. The company uses these investments to undertake operating activities. At the end of a period of time—typically quarterly or annually—financial statements are prepared and reported. These statements list the amounts associated with financing and investing activities, and summarize operating activities for the most recent period(s). This is the role of financial statements—the object of analysis. The financial statements listing of financing and investing activities is at a point in time, whereas the reporting of operating activities cover a period of time. 1-7 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 01 - Overview of Financial Statement Analysis

12. The four primary financial statements are the balance sheet, the income statement, the statement of shareholders’ (owner’s) equity, and the statement of cash flows. Balance Sheet. The accounting equation is the basis of the balance sheet: Assets = Liabilities + Equity. The left-hand side of this equation relates to the economic resources controlled by the firm, called assets. These resources are valuable in the sense that they represent potential sources of future revenues. The company uses these resources to carry out its operating activities. In order to engage in its operating activities, the company must obtain funds to fund its investing activities. The right-hand side of the accounting equation details the sources of these funds. Liabilities represent funds obtained from creditors. These amounts represent obligations or, alternatively, the claims of creditors on assets. Equity, also referred to as shareholders' equity, encompasses two different financing sources: (1) funds invested or contributed by owners, called "contributed capital", and (2) accumulated earnings since inception and in excess of distributions to owners (dividends), called "retained earnings". From the owners' viewpoint, these amounts represent their claim on assets. It often is helpful for students to rewrite the accounting equation in terms of the underlying business activities: Investing Activities = Financing Activities. Recognizing the two basic sources of financing, this can be rewritten as: Investments = Creditor Financing + Owner Financing. Income Statement. The income statement is designed to measure a company's financial performance between balance sheet dates—hence, it refers to a period of time. An income statement lists revenues, expenses, gains, and losses of a company over a period. The "bottom line" of an income statement, net income, measures the increase (or decrease) in the net assets of a company (i.e., assets less liabilities), before consideration of any distributions to owners. Most contemporary accounting systems, the U.S. included, determine net income using the accrual basis of accounting. Under this method, revenues are recognized when earned, independent of the receipt of cash. Expenses, in turn, are recognized when incurred (or matched with its related revenue), independent of the payment of cash. Statement of Cash Flows. Under the accrual basis of accounting, net income equals net cash flow only over the life of the firm. For periodic reporting purposes, accrual performance numbers nearly always differ from cash flow numbers. This creates a demand for periodic reporting on both income and cash flows. The statement of cash flows details the cash inflows and outflows related to a company's operating, investing, and financing activities over a period of time. Statement of Shareholders' Equity. The statement of shareholders' equity reports changes in the component accounts comprising equity. The statement is useful in identifying the reasons for changes in owners' claims on the assets of the company. In addition, accepted practice excludes certain gains and losses from net income which, instead, are directly reported in the statement of shareholders' equity.

Chapter 01 - Overview of Financial Statement Analysis

13. Financial statements are one of the most reliable of all publicly available data for financial analysis. Also, financial statements are objective in portraying economic transactions and events, they are concrete, and they quantify important business activities. Moreover, since financial statements express transactions and events in a common monetary unit, they enable users to readily work with the data, to relate them to other data, and to deal with them in different arithmetic ways. These attributes contribute to the usefulness of financial statements, both historical and projected, in business decision-making. On the other hand, one must recognize that accounting is a social science subject to human decision making. Moreover, it is a continually evolving discipline subject to revisions and improvements, based on experience and emerging business transactions. These limitations sometimes frustrate certain users of financial statements such that they look for substitute data. However, there is no equivalent substitute. Double-entry accounting is the only reliable system for the systematic recording, classification, and summarization of most business transactions and events. Improvement lies in the refinement of this time-tested system rather than in substitution. Accordingly, any serious analyst of a company’s financial position and results of operations, learns the accounting framework and its terminology, conventions, as well as its imperfections in financial analysis. 14. Financial statements are not the sole output of the financial reporting system. Additional financial information is communicated by companies through the following sources: Management's Discussion and Analysis (MD&A). Companies with publicly traded debt and equity securities are required by the SEC to provide a report of their financial condition and results of operations in a MD&A section of its financial reports. Management Report. The management report sets out the responsibilities of management in preparing the company's financial statements. Audit Report. The external auditor is an independent certified public accountant hired by management to assess whether the company's financial statements are prepared in conformity with generally accepted accounting principles. Auditors provide an important check on financial statements prior to their release to the public. Explanatory Notes. Notes are an integral part of financial statements and are intended to communicate additional information regarding items included in, and excluded from, the statements. Supplementary Information. Certain supplemental schedules are required by accounting regulatory agencies. These schedules can appear in notes to financial statements or, in the case of companies with publicly held securities, in exhibits to regulatory filings such as the Form 10-K that is filed with the Securities and Exchange Commission. Social Responsibility Reports. Companies increasingly recognize their need for social responsibility. While reports of socially responsible activities are increasing, there is no standard format or accepted standard. Proxy Statements. A proxy statement is a document containing information necessary to assist shareholders in voting on matters for which the proxy is solicited.

Chapter 01 - Overview of Financial Statement Analysis

15. Financial analysis includes analysis of the profitability of a company, the risk of the company, and the sources and uses of funds for the company. Profitability analysis is the evaluation of a company’s return on investment. It focuses on a company’s sources and levels of profits, and involves identifying and measuring the impact of various drivers of profitability. Profitability analysis includes evaluation of two sources of profitability: margins and turnover. Risk analysis is the evaluation of a company’s riskiness and its ability to meet its commitments. Risk analysis involves assessing the solvency and liquidity of a company along with its earnings variability. An analysis of sources and uses of funds is the evaluation of how a company is obtaining and deploying funds. This analysis provides insights into a company’s future financing implications. 16. Financial analysis tools include the following: a. Comparative financial statements i. Year-to-year change analysis ii. Index-number trend analysis b. Common-size financial statements c. Ratio analysis d. Cash flow analysis 17. a. Comparative analysis focuses on exceptions and variations and helps the analyst to formulate judgments about data that may be interpreted in various ways. In short, the usefulness of comparative analysis is the notion that a number is more meaningfully interpreted when it is evaluated relative to a comparable quantity. b. Comparison can be made against (1) past experience, (2) external data—industry or economy-wide, or (3) accepted guidelines such as standards, budgets, or forecasts. c. A comparison, to be meaningful and fair, must be made between data, which are prepared on a similar basis. If data are not directly comparable, the analyst should make appropriate adjustments before undertaking any comparative analysis. One also must remember that the past is not always an unqualified guide to the future. 18. Past trend often is a good predictor of the future if all relevant variables remain constant or nearly constant. In practice, however, this is seldom the case. Consequently, the analyst should use the results of trend analysis and adjust them in the light of other available information, including the expected state of the economy and industry. Trend analysis will, in most cases, reveal the direction of change in operating performance along with the velocity and the magnitude of change. 19. Both indicators complement one another. Indeed, one indicator in the absence of the other is of limited value. To illustrate, an increase to $4,000 of receivables from base year receivables of $100 indicates a 3,900 % [($4,000-$100)/$100] increase. However, the huge percent change in this case is misleading given the relatively small base year amount. This simple case demonstrates that both indicators need to be considered simultaneously. That is, reference to the absolute dollar amounts must be made to retain the proper perspective when a significant change in percent is revealed.

Chapter 01 - Overview of Financial Statement Analysis

20. Several answers are possible. Since division by zero is not mathematically defined, it is impossible to get changes in percent when there is no figure for the base year. Also, if there is a negative figure in the base year and a positive figure in another year, or vice versa, a mere mathematical computation of percent change is nonsensical. 21. In index-number trend analysis, all figures are expressed with reference to a base year figure. Since the base year serves as the frame of reference, it is desirable to choose a year that is "typical" for the business. If the earliest year in the series analyzed is not typical, then a subsequent (more typical) year should be chosen as the base year. 22. By utilizing index numbers, the analyst can measure change over time. Such analysis enables the analyst to assess management's policies and, when examined in the light of the economic and industry environment of the periods covered, the ability of the company to effectively confront challenges and opportunities. Moreover, trend analysis of index-numbers enables the analyst to uncover important relations among various components of financial statements. This helps in the evaluation of the relative change in these components. For example, changes in sales and accounts receivable are logically correlated and can be expected to display a natural relation when examining trends. 23. a. Common-size financial statements enable comparisons of changes in the elements that make up financial statements. The figures in each line item of financial statements are divided by a reasonable aggregate total and then expressed as percents. The total of these elements will add to 100%. For example, the balance sheet items are usually expressed as a percentage of total assets and the income statement items are usually expressed as a percentage of total revenues. This makes it easier for the analyst to identify internal structural changes in companies that are reflected in financial statements. b. The analysis of common-size financial statements focuses on major aspects of the internal structure of company operations such as: • Capital structure and sources of financing • Distribution of assets or make up of investing activities • Composition of important segments of financial position such as current assets • Relative magnitude of various expenses in relation to sales Moreover, useful information can be obtained by a comparison of common-size statements of a company across years. The advantage of this temporal analysis is even more evident in comparisons between two companies of different sizes. Since analyses can be made on a uniform basis, this tool greatly facilitates such comparisons. 24. A ratio expresses a mathematical relation between two quantities. To be meaningful (useful in analysis), a ratio of financial numbers must capture an important economic relation. Certain items in financial statements have no logical relation to each other and, therefore, would not be amenable to ratio analysis. Also, some type of benchmark or norm must exist for interpretation of the ratio. One can draw minimal inference from being told that the return on assets for a certain firm is .02. However, if the analyst is told that the company’s return on assets is .02 and the industry average is .08, the ratio becomes more useful for interpretation purposes.

Chapter 01 - Overview of Financial Statement Analysis

25. Since not all relations have meaning and not all ratios are useful for all analytical purposes, the analyst must be careful in selecting ratios that are useful for the particular task at hand. Unfortunately, ratios are too often misunderstood and their significance overrated. Ratios can provide an analyst with clues and symptoms of underlying conditions. Ratios also can highlight areas that require further investigation and inquiry. Still, ratios, like all other analysis tools, cannot predict the future. Moreover, the usefulness of insights obtained from ratios depends on their skillful interpretation by the analyst. Of these several limitations on ratio analysis, two are especially problematic: Changing Price Levels. Different items on financial statement are valued at different times, with the result that ratios can change over time even though underlying factors do not. For example, a plant constructed in 1980 and running at full capacity ever since might be blindly compared to, say, year 2002 dollar sales in computing a sales to gross plant ratio. Moreover, once we begin multiplying ratios, it becomes more difficult (if not impossible) to view everything in comparable real dollar terms. Diverse Underlying Businesses. For most diversified companies, even one reporting limited diversification of sales and earnings, the ratios calculated from financial statements reflect composites or approximations of operations and financial condition. This means they can obscure what may be significant differences by product or service line. For example, a utilization ratio may conceal markedly different levels of facility utilization for different products. Yet, the overall utilization ratio might show a balanced picture with no serious problems. (CFA adapted)

26. a. Current ratio; Acid-test (quick) ratio; Cash ratio; Total debt ratio; Total debt to equity ratio; Long-term debt to equity; Financial leverage ratio; Book value per share b. Times interest earned; Gross margin ratio; Operating profit margin ratio; Pretax profit margin ratio; Net profit margin ratio; Effective tax rate c. Inventory turnover; Days' sales in receivables; Return on total assets; Return on equity; Cash turnover; Accounts receivable turnover; Sales to inventory; Working capital turnover; Fixed asset turnover; Total assets turnover; Equity growth rate 27. Besides the general tools of analysis, many special-purpose tools of financial analysis exist. Most of these tools are designed for specific financial statements or specific segments of statements. Other special-purpose tools apply to a particular industry. Special-purpose tools include (1) cash flow analyses, (2) statements of variation in gross profit, (3) earning power analysis, and (4) industry-specific techniques like occupancy to capacity analyses for hotels, hospitals, and airlines. 28. A dollar is worth more to an entity today than it is worth a year from now. The reason is that the dollar can be employed today and begin earning additional money (such as with an interest-bearing bank account). In the context of valuation, the time value of money is important because the timing of pay offs becomes important. An investor is willing to pay more for cash flows that will occur sooner rather than later.

Chapter 01 - Overview of Financial Statement Analysis

29. In the market, a bond’s value is determined by what investors are willing to pay (supply and demand dynamics). The effective interest implicit in the deal is determined by finding the rate at which the present value of the future cash outflows associated with the bond are equal to the proceeds received at issuance. Thus, the effective interest rate might be viewed as a function of the bond price set by market forces. 30. The present value of cash flows often means something different to different people. For example, some believe that the value of the firm is the present value of operating cash flows or investing cash flows or financing cash flows. Others believe value is derived as the present value of net cash flows. Others define the value of the firm as the present value of free cash flows. Thus, there are many definitions of cash flows. Also, the widely accepted valuation formula written as a function of future dividends cannot be written in terms of cash flows proper. 31. The residual income model computes value from accounting variables only. This model performs quite well relative to cash flow models (several recent research articles and working papers support this conclusion). Thus, this model seems to refute the argument that the value of an entity can only be determined by discounting the underlying cash flows. 32. The efficient market hypothesis (EMH) deals with the reaction of market prices to financial and other data. First, note that EMH has its origins in the random walk hypothesis—which states that at any given point in time the size and direction of the next price change is random relative to what is known about an investment at that given time. Second, there are three derivatives of this hypothesis. The first is known as the weak form of the EMH—it states that current prices reflect fully the information conveyed by historical time series of prices. The second is the semi-strong form—it states that prices fully reflect all publicly available information. The third is the strong form—it asserts that prices reflect all information, including inside information. The EMH, in all its forms, has undergone extensive empirical testing. Much of this evidence supports the weak form EMH, but there is considerable debate about the validity of the semi-strong EMH due to various conflicting evidence. 33. The EMH is dependent on the assumption that competent and well-informed analysts, using tools of analysis, continually evaluate and act on the ever-changing stream of new information entering the marketplace. Still, hardcore theorists seemingly rely on the notion that since all information is immediately reflected in prices, there is no obvious role for financial statement analysis. This scenario presents a paradox. On one hand, analysts’ efforts are assumed to keep security markets efficient. On the other hand, analysts are sufficiently wise to recognize that their efforts yield no individual rewards. However, should analysts recognize that their efforts are unrewarded, then the market would cease to be efficient. Several points may help explain this paradox. First, EMH is built on aggregate rather than individual investor behavior. The focus on aggregate behavior not only highlights average performance but masks the results achieved by individual ability, efforts, and ingenuity as well as by superior timing in acting on information as it becomes available. Second, few doubt that important information travels fast. After all, enough is at stake to make it travel fast. Nor is it surprising that securities markets are rapid processors of information. Consequently, using deductive reasoning similar to the hardcore theorist, we could conclude that the speed and efficiency of the market is evidence that market participants are motivated by substantial, real rewards. Third, the reasoning behind 1-13 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 01 - Overview of Financial Statement Analysis

EMH's alleged implication for the lack of usefulness of analysis fails to recognize the essential difference between information and its proper interpretation. That is, even if all the information available on a security at a given point in time is impounded in price, that price may not reflect intrinsic value. It may be under- or over-priced depending on the degree to which an incorrect interpretation or evaluation of the available information is made by those whose actions determine the price at a given time. The work of financial statement analysis is complex and demanding. The spectrum of users of financial statements varies from the institutional analyst who concentrates on only a few companies in one industry to a person who merely looks at the pictures in an annual report. All act on financial information, but surely not with the same insights and competence. Competent evaluation of "new information" entering the marketplace requires special skills. Few have the ability and are prepared to expend the efforts and resources needed to conduct such analysis. It is only natural that they would reap the rewards by being able to act both competently and confidently on information. The vast resources that must be brought to bear on the competent analysis of securities has caused some segments of the market to be more efficient than others. For example, the market for shares of larger companies is more efficient because more analysts follow such securities in comparison to those who follow small, lesser-known companies. One must also recognize that those who judge usefulness in an efficient market construe the function and purpose of analysis too narrowly. While the search for overvalued and undervalued securities is an important part of many analyses, the importance of risk assessment and loss avoidance, in the total framework of business decision making, cannot be overemphasized. For instance, analysis can evaluate the reasonableness of a risk premium associated with a security. Moreover, the prevention of serious investment errors is at least as important as the discovery of undervalued securities. Yet, a review of CAPM and beta theory tends to explain why strict adherents to these macro-oriented models of security markets neglect this important function of analysis. Namely, it is a basic premise of these theories that analysis of unsystematic risk is not worthwhile because the market does not reward that kind of risk taking. Instead, such risks should be diversified away and the portfolio manager should look only to systematic or market risk for rewards. In sum, most financial statement analysis assumes that investment results are achievable through careful study and analysis of individual companies. This approach emphasizes the value of fundamental analysis not only as a means of keeping markets efficient but also as the means by which those investors who, having obtained information, are willing and able to apply knowledge, effort, and ingenuity in analysis to reap rewards. For those analysts, the fruits of fundamental analysis—long before being converted to a "public good"—will yield rewards. These rewards are not discernable, however, in the performance of analysts aggregated to comprise major market segments, such as mutual funds. Instead they remain as individual as the efforts needed to realize them.

Chapter 01 - Overview of Financial Statement Analysis

EXERCISES Exercise 1-1 (20 minutes) a. Comparative financial statement analysis for a single year reflects a brief period of a company's history. It is essentially an interim analysis of a company’s business activities for that year. Moreover, the accounting system’s allocation of costs and revenues to such short periods of time is, to a considerable extent, based upon convention, judgment, and estimates. The shorter the time period, the more difficult is the matching and recognition process and the more it is subject to error. In addition, single-year comparative analysis may not accurately reflect a company's long-run performance. This is because of the possibility of unusually favorable or unfavorable economic or other conditions experienced in any particular year. Consequently, any comparative financial statement analysis for a single year cannot provide information on trends and changing relations that might occur over time. For this reason, the information generated by comparative analysis of a set of single-year statements is of limited interpretive value. Moreover, the financial statements themselves have limitations for analytical and interpretive purposes by virtue of the inherent limitations of the accounting function applied to a single year. Also, many factors that significantly affect the progress and success of a firm are not of a financial character and are not, therefore, expressed explicitly in financial statements. These include factors such as general economic conditions, labor relations, and customer attitudes. The preparation of comparative statements for a single year would not alleviate these limitations.

b. Changes or inconsistencies in accounting methods, policies, or classifications for the years covered by comparative financial statement analysis can yield misleading inferences regarding trends or changing relations. For example, a change in a firm's depreciation or inventory methods, even though the alternative procedures are acceptable or preferable, can inhibit the comparability of corresponding items in two or more of the periods covered. Further, the existence of errors (and their correction in subsequent periods), nonrecurring gains or losses, mergers and acquisitions, and changes in business activities can yield misleading inferences from comparative analysis performed over several years.

Chapter 01 - Overview of Financial Statement Analysis

Exercise 1-1—continued To avoid the potential for misleading inferences from these factors, we must carefully examine footnotes, explanations, and qualifications that are disclosed as part of financial reporting. Our comparative analysis must be adjusted for such possibilities. Also, changing price levels for the periods of analysis can distort comparative financial statements. For example, even items on a comparative balance sheet or income statement that pertain to a single year are not all expressed in dollars having the same purchasing power. Namely, in an era of rising prices, a given year's depreciation represents older dollars having greater purchasing power compared with most other income statement items. Further, inventory methods other than LIFO can add to the inflationary distortion of the income statement. Similarly, balance sheet items for a given year are expressed in dollars of varying purchasing power. Beyond these vertical distortions that exist within individual years covered by comparative financial statements, are horizontal distortions in the trends and relations of corresponding items across years. For example, an upward trend in sales may actually reflect a constant level of, or even decline in, actual sales volume because of increases in prices. Because of the potential for misleading inferences from comparative analysis during periods of changing price levels, its usefulness as an analytical and interpretative tool is severely restricted. This is because price level changes can limit the comparability of the data in financial statements across time. Of course, analysis of price-level adjusted financial statements can restore the comparability of these statements across time and, thereby, enhance their usefulness as tools of analysis and interpretation.

Exercise 1-2 (25 minutes)

Sales ......................................... Cost of goods sold .................. Gross profit .............................. Operating expenses ................ Net income ...............................

2006 100.0% 66.0 34.0% 21.0 13.0%

2005 100.0% 52.4 47.6% 19.4 28.2%

Analysis and Interpretation: This situation appears to be unfavorable. Both cost of goods sold and operating expenses are taking a larger percent of each sales dollar in year 2006 compared to the prior year. Also, even though sales volume increased, net income both decreased in absolute terms and declined to only 13.0% of sales as compared to 28.2% in the year before.

Chapter 01 - Overview of Financial Statement Analysis

Exercise 1-3 (25 minutes) a. Current ratio: 2006:

$30,800 + $88,500 + $111,500 + $9,700 $128,900

= 1.9 to 1

2005:

$35,625 + $62,500 + $82,500 + $9,375 $75,250

= 2.5 to 1

2004:

$36,800 + $49,200 + $53,000 + $4,000 $49,250

= 2.9 to 1

b. Acid-test ratio: 2006:

$30,800 + $88,500 $128,900

= 0.9 to 1

2005:

$35,625 + $62,500 $75,250

= 1.3 to 1

2004:

$36,800 + $49,200 $49,250

= 1.7 to 1

Analysis and Interpretation: Mixon's short-term liquidity position has weakened over this two-year period. Both the current and acid-test ratios show declining trends. Although we do not have information about the nature of the company's business, the acid-test ratio shift from ‘1.7 to 1’ down to ‘0.9 to 1’ and the current ratio shift from ‘2.9 to 1’ down to ‘1.9 to 1’ indicate a potential liquidity problem. Still, we must recognize that industry standards may show that the 2004 ratios were too high (instead of 2006 ratios as too low).

Chapter 01 - Overview of Financial Statement Analysis

Exercise 1-4 (20 minutes) Mixon Company Common-Size Comparative Balance Sheet December 31, 2004-2006 2006 2005* Cash ...................................................................... 5.9% 8.0% Accounts receivable, net .................................... 17.1 14.0 Merchandise inventory........................................ 21.5 18.5 Prepaid expenses ................................................ 1.9 2.1 Plant assets, net ................................................. 53.6 57.3 Total assets ......................................................... 100.0% 100.0% Accounts payable ................................................ Long-term notes payable secured by mortgages on plant assets ............................. Common stock, $10 par value ............................ Retained earnings ............................................... Total liabilities and equity ................................... *

2004* 9.9% 13.2 14.2 1.1 61.6 100.0%

24.9%

16.9%

13.2%

18.8 31.4 24.9 100.0%

23.0 36.5 23.5 100.0%

22.1 43.6 21.0 100.0%

Column does not equal 100.0 due to rounding.

Chapter 01 - Overview of Financial Statement Analysis

Exercise 1-5 (25 minutes) a. Days' sales in receivables: 2006:

$88,500 x 360 = 47 days $672,500

2005:

$62,500 x 360 = 42 days $530,000

b. Accounts receivable turnover: 2006:

$672,500 ($88,500 + $62,500)/2

= 8.9 times

2005:

$530,000 ($62,500 + $49,200)/2

= 9.5 times

c. Inventory turnover: 2006:

$410,225 ($111,500 + $82,500)/2

= 4.2 times

2005:

$344,500 ($82,500 + $53,000)/2

= 5.1 times

d. Days’ sales in inventory: 2006:

$111,500 x 360 = 98 days $410,225

2005:

$82,500 x 360 = 86 days $344,500

Analysis and Interpretation: The number of days' sales uncollected has increased and the accounts receivable turnover has declined. Also, the merchandise turnover has decreased and days’ sales in inventory has increased. While none of these changes in ratios that occurred from 2005 to 2006 appear dramatic, it seems that Mixon is becoming less efficient in managing its inventory and in collecting its receivables.

Chapter 01 - Overview of Financial Statement Analysis

Exercise 1-6 (25 minutes) a. Total debt ratio (solution also includes the equity ratio): 2006 Total liabilities (and debt ratio): $128,900 + $97,500 .................. $226,400 43.7% $75,250 + $102,500 .................. Total equity (and equity ratio): $162,500 + $129,100 ................ 291,600 56.3 $162,500 + $104,750 ................ _______ Total liabilities and equity ........... $518,000 100.0%

2005

$177,750

39.9%

267,250 $445,000

60.1 100.0%

b. Times interest earned: 2006: ($34,100 + $8,525 + $11,100)/$11,100 = 4.8 times 2005: ($31,375 + $7,845 + $12,300)/$12,300 = 4.2 times

Analysis and Interpretation: Mixon added debt to its capital structure during 2006, with the result that the debt ratio increased from 39.9% to 43.7%. However, the book value of pledged assets is well above secured liabilities (2.8 to 1 in 2006 and 2.5 to 1 in 2005), and the increased profitability of the company allowed it to increase the times interest earned from 4.2 to 4.8 times. Apparently, the company is able to handle the increased debt. However, we should note that the debt increase is entirely in current liabilities, which places a greater stress on short-term liquidity.

Chapter 01 - Overview of Financial Statement Analysis

Exercise 1-7 (30 minutes) a. Net profit margin: 2006: $34,100/$672,500 = 5.1% 2005: $31,375/$530,000 = 5.9%

b. Total asset turnover: 2006:

$672,500 = 1.4 times ($518,000 + $445,000)/2

2005:

$530,000 = 1.3 times ($445,000 + $372,500)/2

c. Return on total assets: 2006:

$34,100 ($518,000 + $445,000)/2

= 7.1%

2005:

$31,375 ($445,000 + $372,500)/2

= 7.7%

Analysis and Interpretation: Mixon's operating efficiency appears to be declining because the return on total assets decreased from 7.7% to 7.1%. While the total asset turnover favorably increased slightly from 2005 to 2006, the profit margin unfavorably decreased from 5.9% to 5.1%. The decline in profit margin indicates that Mixon's ability to generate net income from sales has declined.

Chapter 01 - Overview of Financial Statement Analysis

Exercise 1-8 (20 minutes) a. Return on common stockholders' equity: 2006:

$34,100 ($291,600 + $267,250)/2

= 12.2%

2005:

$31,375 ($267,250 + $240,750)/2

= 12.4%

b. Price earnings ratio, December 31: 2006: $15/$2.10 = 7.1 2005: $14/$1.93 = 7.3 c. Dividend yield: 2006: $.60/$15 = 4.0% 2005: $.30/$14 = 2.1%

Exercise 1-9 (25 minutes) Answer: Net income decreased. Supporting calculations: When the sums of each year's common-size cost of goods sold and expenses are subtracted from the common-size sales percents, net income percents are as follows: 2004: 100.0 - 58.1 - 14.1 = 27.8% of sales 2005: 100.0 - 60.9 - 13.8 = 25.3% of sales 2006: 100.0 - 62.4 - 14.3 = 23.3% of sales Also notice that if 2003 sales are assumed to be $100, then sales for 2004 are $103.20 and the sales for 2005 are $104.40. If the income percents for the years are applied to these amounts, the net incomes are: 2004: $100.00 x 27.8% = $27.80 2005: $103.20 x 25.3% = $26.12 2006: $104.40 x 23.3% = $24.33 This case shows that the company’s net income decreased over the three-year period.

Chapter 01 - Overview of Financial Statement Analysis

Exercise 1-10 (30 minutes) Comparative Report Mesa has a greater amount of working capital. But that by itself does not indicate whether Mesa is more capable of meeting its current obligations. Further support is provided by the current ratios and acid-test ratios that show Mesa is in a more liquid position than Huff. However, this evidence does not mean that Huff's liquidity is inadequate. Such a conclusion would require more information such as norms for the industry or its other competitors. Notably, Huff's acid-test ratios approximate the traditional rule of thumb (1 to 1). This evidence also shows that Mesa's working capital, current ratio, and acid-test ratio all increased dramatically over the three-year period. This trend toward greater liquidity may be positive. But the evidence also may suggest that Mesa holds an excess amount of highly liquid assets that typically earn a low return. The accounts receivable turnover and merchandise turnover indicate that Huff Company is more efficient in collecting its accounts receivable and in generating sales from available merchandise inventory. However, these statistics also may suggest that Huff is too conservative in granting credit and investing in inventory. This could have a negative impact on sales and net income. Mesa's ratios may be acceptable, but no definitive determination can be made without having information on industry (or other competitors) standards. Exercise 1-11 (20 minutes) Sales ................................... Cost of goods sold ............ Accounts receivable ..........

Year 5 188 190 191

Year 4 180 181 183

Year 3 168 171 174

Year 2 156 158 162

Year 1 100 100 100

The trend in sales is positive. While this is better than no growth, one cannot definitively say whether the sales trend is favorable without additional information about the economic conditions in which this trend occurred such as inflation rates and competitors’ performances. Given the trend in sales, the comparative trends in cost of goods sold and accounts receivable both appear to be somewhat unfavorable. In particular, both are increasing at slightly faster rates (indexes for cost of goods sold is 190 and accounts receivable is 191) than sales (index is 188). Exercise 1-12 (15 minutes)

Short-term investments ...... Accounts receivable ............ Notes payable ......................

Dollar Change $52,800 (5,880) 57,000

Base Amount $165,000 48,000 0

Percent Change 32% -12% (not calculable)

Chapter 01 - Overview of Financial Statement Analysis

Exercise 1-13 (10 minutes) a. Bond price = Present value (PV) of cash flows (both interest payments and principal repayment) Present value of interest payments: Payment = $100 x 10% = $10 per year at end of each year (ordinary annuity) PVint = $10 x PV factor for an ordinary annuity (n=5, i=14%) = $10 x 3.43308 = $34.33 Present value of principal repayment: PVprin = $100 x PV factor for a lump sum (n=5, i=14%) = $100 x 0.51937 = $51.94 Price

= PV of interest payments + PV of principal repayment = $34.33 + $51.94 = $86.27

b. Interest payments ($1,000 x 8% = $80 annually): PVint = $80 x Present value factor for an ordinary annuity (n=5; i=6%) = $80 x 4.21236 = $336.99 Principal repayment ($1,000 in 5 years hence): PVprin = $1,000 x Present value factor for a lump sum (n=5; i=6%) = $1,000 x 0.74726 = $747.26 Price

= $336.99 + $747.26 = $1,084.25

c. Interest payments ($1,000 x 8% x (1/2)= $40): PVint = $40 x Present value factor for an ordinary annuity (n=10; i=3%) = $40 x 8.53020 = $341.21 Principal repayment ($1,000 in 5 years hence): PVprin = $1,000 x Present value factor for a lump sum (n=10; i=3%) = $1,000 x .74409 = $744.09 Price

= $341.21 + $744.09 = $1085.30 1-24

Chapter 01 - Overview of Financial Statement Analysis

Exercise 1-14 (10 minutes) a. Interest payments ($10,000 x 8% x (1/2) = $400 semiannually): PVint = $400 x Present value factor for an ordinary annuity (n=20; i=3%) = $400 x 14.87747 = $5,950.99 Principal repayment ($10,000 in 10 years hence): PVprin = $10,000 x Present value factor for a lump sum (n=20; i=3%) = $10,000 x 0.55368 = $5,536.80 Price

= $5,950.99 + $5,536.80 = $11,488

b. Interest payments ($10,000 x 8% x (1/2) = $400): PVint = $400 x Present value factor for an ordinary annuity (n=20; i=5%) = $400 x 12.46221 = $4,984.88 Principal repayment ($10,000 in 10 years hence): PVprin = $10,000 x Present value factor for a lump sum (n=20; i=5%) = $10,000 x 0.37689 = $3,768.90 Price

= $4,984.88 + $3,768.90 = $8,754

c. Risk is the possibility that Colin Company will not make all of the interest and principal payments that are called for in the debt agreement. The higher that an investor perceives the risk of non-payment to be, the more the investor should discount the cash flows. Thus, a higher risk of repayment is reflected in a higher discount rate. By using the higher discount rate, the amount that the investor is willing to pay for the bonds is lower.

Chapter 01 - Overview of Financial Statement Analysis

Exercise 1-15 (15 minutes) End of: Net income Book value Capital charge (Beg. book value x 20% cost of capital) Residual income Discount factor Value at time t

Year 0 50

Year 1 8 58a

Year 2 11 69

10b (2)c 1/1.2 50 +

Year 3 20 89

11.6 13.8 (.6) 6.2 1/(1.2)2 1/(1.2)3

Year 4 40 129

Year 5 30 159

17.8 22.2 1/(1.2)4

25.8 4.2 1/(1.2)5

(1.67) + (.417) + 3.588 + 10.706 + 1.688 = $64

a: $50 beginning book value + $8 net income - $0 dividends b: $50 beginning book value x 20% cost of capital c: $8 net income (projected) - $10 capital charge

Comments: One of the key variables for the residual income model is book value. Book value is readily available and subjected to auditing procedures. The other key variables are future net income and cost of capital. Net income is generally considered easier to predict than future dividends or cash flows. These points are advantages of the residual income valuation model. The cost of capital must be estimated in all of the valuation models. The primary limitation of the residual income model is that it requires predictions of earnings for the life of the firm. Simplifying assumptions are usually necessary.

Chapter 01 - Overview of Financial Statement Analysis

PROBLEMS Problem 1-1 (30 minutes) Comparative Report Arbor's profit margins are higher than Kampa's. However, Kampa has significantly higher total asset turnover ratios. As a result, Kampa generates a substantially higher return on total assets. The trends of both companies include evidence of growth in sales, total asset turnover, and return on total assets. However, Arbor's rates of improvement are better than Kampa's. These differences may result from the fact that Arbor is only 3 years old while Kampa is an older, more established company. Arbor's operations are considerably smaller than Kampa's, but that will not persist many more years if both companies continue to grow at their current rates. To some extent, Kampa's higher total asset turnover ratios may result from the fact that its assets may have been purchased years earlier. If the turnover calculations had been based on current values, the differences might be less striking. The relative ages of the assets also may explain some of the difference in profit margins. Assuming Arbor's assets are newer, they may require smaller maintenance expenses. Finally, Kampa successfully employed financial leverage in 2006. Its return on total assets is 8.9% compared to the 7% interest rate it paid to obtain financing from creditors. In contrast, Arbor's return is only 5.8% as compared to the 7% interest rate paid to creditors.

Chapter 01 - Overview of Financial Statement Analysis

Problem 1-2 (100 minutes) Part 1 COHORN COMPANY Income Statement Trends For Years Ended December 31, 2000-2006 2006 2005 2004 2003 2002 Sales ..................................... 192.5 168.6 153.4 140.6 131.2 Cost of goods sold ..............235.8 191.8 165.0 144.4 134.2 Gross profit ..........................131.0 135.7 136.8 135.1 126.9 Operating expenses ............265.6 207.8 190.6 140.6 121.9 Net income ........................... 50.5 92.5 104.7 131.8 129.9

2001 122.0 125.5 117.0 120.3 115.0

2000 100.0 100.0 100.0 100.0 100.0

COHORN COMPANY Balance Sheet Trends December 31, 2000-2006 2006 2005 2004 2003 Cash ...................................... 68.7 88.9 92.9 94.9 Accounts recble., net ..........233.0 244.7 221.4 169.9 Merchandise inventory........337.5 245.4 214.4 181.0 Other current assets............242.1 221.1 126.3 231.6 Long-term investments ....... — — — 100.0 Plant and equip., net............257.0 256.2 224.5 126.5 Total assets ..........................247.3 222.9 196.0 144.4

2002 99.0 149.5 162.3 200.0 100.0 130.7 138.6

2001 97.0 141.7 137.9 200.0 100.0 116.4 124.0

2000 100.0 100.0 100.0 100.0 100.0 100.0 100.0

Current liabilities .................411.8 Long-term liabilities.............306.2 Common stock .....................156.3 Other contrib. capital...........156.3 Retained earnings................262.7 Total liabilities & equity .......247.3

164.0 123.1 131.3 112.5 162.1 138.6

155.1 133.3 100.0 100.0 145.0 124.0

100.0 100.0 100.0 100.0 100.0 100.0

346.3 266.7 156.3 156.3 230.8 222.9

227.2 259.5 156.3 156.3 191.7 196.0

189.0 120.5 131.3 112.5 176.3 144.4

Part 2 The statements and the trend percent data indicate that the company significantly expanded its plant and equipment in 2004. Prior to that time, the company enjoyed increasing gross profit and net income. Sales grew steadily for the entire period of 2000 to 2006. However, beginning in 2004, cost of goods sold and operating expenses increased dramatically relative to sales, resulting in a significant reduction in net income. In 2006 net income was only 50.5% of the 2000 base year amount. At the same time that net income was declining, assets were increasing. This indicates that Cohorn was becoming less efficient in using its assets to generate income. Also, the short-term liquidity of the company continued to decline. Accounts receivable did not change significantly for the period of 2004 to 2006, but cash steadily declined and merchandise inventory sharply increased, as did current liabilities.

Chapter 01 - Overview of Financial Statement Analysis

Problem 1-3 (25 minutes) Yr. 6

Yr. 5

Yr. 4

Cumulative Amount

Net Sales ............................... Cost of Goods Sold .............. Gross Profit ........................... Operating Expenses ............. Income Before Taxes ............

$6,880 3,210 $3,670 930 $2,740

$3,490 2,810 $ 680 465 $ 215

$2,860 1,810 $1,050 945 $ 105

$13,230 7,830 $ 5,400 2,340 $ 3,060

Annual Average Amount $4,410 2,610 $1,800 780 $1,020

Net Income ............................

$1,485

$ 145

$ 1,688

$ 563

Interpretation of Comparative Analysis Overall, this analysis suggests a rather volatile financial picture for Eastman Corp. For example, net sales have steadily increased for this three-year period—almost doubling in Year 6—while gross profit dips in Year 5 but increases considerably in Year 6. Also, operating expenses are especially low in Year 5—this occurs at the same time when income taxes expense is low.

Problem 1-4 (25 minutes)

Net Sales ....................... Cost of Goods Sold ...... Gross Profit ................... Operating Expenses ...... Income Before Taxes .... Net Income ....................

Index No. 129 139 126 120 114 129

Year 7 Change in % 29% 39 26 20 14 29

Index No. 100 100 100 100 100 100

Year 6 Change in % 11.1% 17.6 25.0 53.8 42.9 33.3

Year 5 Index No. 90 85 80 65 70 75

Interpretation of Trend Analysis The growth in cost of goods sold exceeds the growth in net sales in both Years 6 and 7. A continuation of these trends in both sales and cost of goods sold will limit future growth in net income. The growth in operating expenses is erratic—that is, it is 53.8% in Year 6 and 20% in Year 7.

Chapter 01 - Overview of Financial Statement Analysis

Problem 1-5 (45 minutes) MESCO COMPANY Balance Sheet December 31, Year 5 Assets Current Assets Cash ................................................................... $ 10,250 Accounts receivable ......................................... 46,000 Inventories......................................................... 86,250 Total current assets .......................................... Noncurrent assets ............................................... Total assets ..........................................................

$142,500 280,000 $422,500

Liabilities and Stockholders' Equity Current liabilities ................................................. $ 22,500 Noncurrent liabilities ........................................... 62,000 Total liabilities......................................................

$ 84,500

Stockholders' Equity Common stock..................................................... $150,000 Additional paid-in capital .................................... 60,000 Retained earnings ............................................... 128,000 Total stockholders' equity .................................. Total liabilities and equity ...................................

$338,000 $422,500

Supporting computations: Note 1: Compute net income for Year 5 Sales .............................................................................. Cost of goods sold ....................................................... Gross profit .................................................................. Operating expenses ..................................................... Income before taxes ..................................................... Taxes expense .............................................................. Net income .....................................................................

$920,000 690,000 $230,000 180,000 $ 50,000 20,000 $ 30,000

Note 2: Compute Stockholders' Equity Common stock ($15 par x 10,000 sh.) ........................ Additional paid-in capital ($21-$15) x 10,000 sh. .......

$150,000 60,000

Retained earnings, Dec. 31, Year 4 ............................. Net income ..................................................................... Retained earnings, Dec. 31, Year 5 ............................. Total................................................................................

(75% of sales) (25% of sales)

(tax at 40% rate)

$210,000

98,000 30,000 128,000 $338,000

Chapter 01 - Overview of Financial Statement Analysis

Problem 1-5—continued Note 3:

Total equity Total debt

Note 4:

$338,000  4 $ 84,500

Cost of goods sold / Inventory = 8 $690,000 / Inventory = 8 Inventory = $86,250 Receivables / (Credit sales360) = 18 days Receivables / ($920,000360) = 18 days Receivables = $46,000

Note 5:

Note 6:

Total assets

= Total equity + Total liabilities = $338,000 + $84,500 = $422,500

Current assets

= Total assets - Noncurrent assets = $422,500 - $280,000 = $142,500

Cash

= $142,500 - $46,000 - $86,250 = $10,250

Acid-test ratio = (Cash + Accounts receivable) / Current liabilities = 2.5 Current liabilities = ($10,250 + $46,000)/2.5 = $22,500 Noncurrent liabilities = Total liabilities - Current liabilities = $84,500 - $22,500 = $62,000

Chapter 01 - Overview of Financial Statement Analysis

Problem 1-6 (45 minutes) FOXX COMPANY Balance Sheet December 31, Year 2 ASSETS LIABILITIES AND EQUITY Current assets: Current liabilities ...................... Cash .................................... $ 75,000 Noncurrent liabilities ............... Accounts receivable .......... 75,000 Total liabilities .......................... Inventory ............................. 50,000 Noncurrent assets ............... $300,000 Total equity ............................... Total assets.......................... $500,000 Total Liabilities and Equity ......

Supporting computations: Note 1: Compute net income for Year 2 Sales ............................................................................. Cost of goods sold ..................................................... Gross profit .................................................................. Expenses ...................................................................... Net income ...................................................................

$1,000,000 500,000 $ 500,000 450,000 $ 50,000

$100,000 150,000 $250,000 $250,000 $500,000

(50% of sales) (50% of sales) (given)

Note 2: Return on end-of-year equity = 20% Net income / End-of-year equity = 20% 50,000 / Equity = 0.20 Equity = $250,000 Note 3: Total debt to total equity Total debt / $250,000 Total debt = $250,000

=1 =1

Note 4: Accounts receivable turnover = Sales / Average accounts receivable 16 =

$1,000,000 ($50,000 + ?) / 2

Ending accounts receivable = $75,000 Note 5: Days’ sales in inventory = (Inventory x 360) / Cost of goods sold 36 = (Inventory x 360) / $500,000 Ending inventory = $50,000

Chapter 01 - Overview of Financial Statement Analysis

Problem 1-6—continued Note 6:

Total assets

= Total liabilities + Total equity = $250,000 + $250,000 = $500,000

Current assets

= Total assets - Noncurrent assets = $500,000 - $300,000 = $200,000

Current ratio 2 Current liabilities

= Current assets  Current liabilities = $200,000  ? = $100,000

Noncurrent liabilities= Total liabilities - Current liabilities = $250,000 - $100,000 = $150,000 Note 7:

Cash

= Current assets - Accounts receivable - Inventory = $200,000 - $75,000 - $50,000 = $75,000

Chapter 01 - Overview of Financial Statement Analysis

Problem 1-7 (70 minutes) a. VOLTEK COMPANY Balance Sheet December 31, Year 6 Assets Current Assets Cash ................................................................... Account receivable ........................................... Inventories......................................................... Prepaid expenses ............................................. Total current assets .......................................... Plant and equipment, net .................................... Total assets .......................................................... Liabilities and Stockholders' Equity Current liabilities ................................................. Bond payable ....................................................... Stockholders’ equity ........................................... Total liabilities and equity ...................................

$3,900 2,600 1,820 1,430 $ 9,750 6,000 $15,750

$6,500 6,500 2,750 $15,750

Supporting computations: Note 1: Net income/Sales = 10% $1,300 / ? = 10% Sales = $13,000 Note 2: Gross Margin

= Sales x Gross margin ratio = $13,000 x 30% = $3,900

Cost of good sold = Sales - Gross margin = $13,000 - $3,900 = $9,100 Inventory

= Cost of goods sold  Inventory turnover = $9,100  5 = $1,820

Note 3: Accounts recble. = Sales  Accounts receivable turnover = $13,000  5 = $2,600

Chapter 01 - Overview of Financial Statement Analysis

Problem 1-7—continued Note 4: Working capital

= Sales  Sales to end-of-year working capital = $13,000  4 = $3,250

Note: Current assets = Current liabilities + Working capital Current assets = Current liabilities + $3,250 Current liabilities = Current assets - $3,250 Then: Current ratio = Current assets  Current liabilities 1.5 = Current assets  (Current assets - $3,250) Current assets /1.5 = (Current assets - $3,250) Current assets = 1.5 x Current assets - $4,875 0.5 x Current assets= $4,875 Current assets = $9,750 And:

Current liabilities = $9,750 - $3,250 = $6,500

Note 5: Acid-test ratio

= 1.0

Then: Cash + Accounts receivable = Current liabilities Cash = $6,500 - $2,600 = $3,900 Note 6: Prepaid expenses = Current assets - Cash - Accounts recble. - Inventory = $9,750 - $3,900 - $2,600 - $1,820 = $1,430 Note 7: Times interest earned 5 5 (Interest expense) 4 (Interest expense) Interest expense

= (Income before tax + Interest exp.) / Interest exp. = ($1,300 + Interest expense) / Interest expense = $1,300 + Interest expense = $1,300 = $325

Par value of bonds payable = Interest expense / Interest rate on bonds = $325 / 0.05 = $6,500 Note 8: Shareholders' equity

= Total assets - Current liabilities - Bonds payable = $15,750 - $6,500 - $6,500 = $2,750

Note 9: Par value of preferred stock = Dividend on preferred  Dividend rate = $40  0.08 = $500 Note 10:

EPS = (Net income-Preferred dividend) / Common shares outstanding $3.75 = ($1,300 - $40) / Common shares outstanding $3.75 x Common shares outstanding = $1,260 Common shares outstanding = 336 Par value of common stock = 336 x $5 = $1,680

Chapter 01 - Overview of Financial Statement Analysis

Problem 1-7—continued Note 11:

Retained earnings

= Stockholders' equity -Common stock - Preferred stock = $2,750 - $1,680 - $500 = $570

b. Dividends paid on common stock: Retained earnings, Jan. 1, Year 6 ................................ $ 350 Net income for Year 6 ................................................... 1,300 $1,650 Dividends paid on preferred ........................................ 40 Dividends paid on common – plug.............................. ? Retained earnings, Dec. 31, Year 6.............................. $ 570 Dividends paid on common stock = $1,040

Problem 1-8 (45 minutes) Financial ratios for Chico Electronics: a. Acid-test ratio: (Cash + Accounts receivable)  Total current liabilities ($325 + $3,599)  $3,945 = 0.99 Interpretation: The most liquid assets can adequately cover current liabilities b. Return on assets: [Net income + Interest expense (1-tax rate)]  Average total assets [$1,265 + $78 (1 - .40)]  [($4,792 + $8,058)  2] = 20.4% Interpretation: Return on each dollar invested in assets (this return would seem to be good to very good) c. Return on common equity: (Net income - Preferred dividends)  Average common equity [$1,265 - $45]  [($2,868 - $500 + $3,803 - $450)  2] = 42.7% Interpretation: Return on each dollar invested by equity holders (this return would seem to be excellent) d. Earnings per share: (Net income - Preferred dividends)  Average common shares outstanding [$1,265 - $45]  [(550 + 829)  2] = $1.77 Interpretation: Net income earned per each share owned (difficult to assess this EPS value in isolation)

Chapter 01 - Overview of Financial Statement Analysis

Problem 1-8—continued e. Gross profit margin: (Net sales - Cost of goods sold)  Net sales ($12,065 - $8,048)  $12,065 = 33.3% Interpretation: Gross profit for each dollar of net sales (difficult to assess this value in isolation) f. Times interest earned: (Net income before tax + Interest expense)  Interest expense ($2,259 + $78)  $78 = 30 times Interpretation: Magnitude (multiple) that net income before tax exceeds interest expense – a measure of safety, and a value of 30 is probably good to very good g. Days to sell inventory: Average inventory  (Cost of goods sold  360) [($2,423 + $1,415)  2]  [$8,048  360] = 85.8 days Interpretation: Time it would take to dispose of inventory (difficult to assess the value in isolation) h. Long-term debt to equity: (Long-term debt + Other liabilities)  Shareholders' equity ($179 + $131)  $3,803 = 8.2% Interpretation: Percent contributed by long-term debt holders relative to equity holders – this is not a highly leveraged company in terms of long-term debt i. Total debt to total equity: Total liabilities  Total shareholders' equity $4,255  $3,803 = 1.12 Interpretation: Total nonowner financing relative to owner financing j. Sales to end-of-year working capital: Net sales  Working capital $12,065  ($6,360 - $3,945) = 5 Interpretation: Sales as a multiple of working capital – measure of efficiency and safety

Chapter 01 - Overview of Financial Statement Analysis

Problem 1-9 (55 minutes) Year 5

Year 4

At December 31: Current ratio ....................................................... Acid-test ratio ................................................... Book value per share .........................................

2.30 1.05 $12.50

1.95 0.80 $10.18

Year ended December 31: Gross profit margin ratio ................................... Days to sell inventory ........................................ Times interest earned ........................................ Price-to-earnings ratio ....................................... Gross expenditures for plant & equipment .....

35% 82 18.0 17.5 $1,105,000

30% 86 12.5 15.4 $975,000

Supporting computations: a. Current ratio: Current assets .........................................................  Current liabilities.................................................... Current ratio .........................................................

$13,570,000 $ 5,900,000 2.3

$12,324,000 $ 6,320,000 1.95

b. Acid-test ratio: Cash, marketable sec., accts. rec. (net) .................  Current liabilities.................................................... Acid-test ratio .........................................................

$6,195,000 $5,900,000 1.05

$5,056,000 $6,320,000 0.80

c. Book value per common share: Stockholders' equity ................................................. - Preferred stock at liquidating value ..................... Common stockholders' equity ................................  Equivalent shares outstanding at year end ........ Book value per common share ...............................

$11,875,000 5,000,000 $ 6,875,000 550,000 $ 12.50

$10,090,000 5,000,000 $ 5,090,000 500,000 $ 10.18

d. Gross profit margin ratio: Gross margin (Sales - Cost of sales)......................  Net sales ................................................................ Gross profit margin ratio .........................................

$16,940,000 48,400,000 35%

$12,510,000 41,700,000 30%

$ 7,050,000 7,250,000 $14,300,000 7,150,000 87,389 82

$ 6,850,000 7,050,000 $13,900,000 6,950,000 81,083 86

e. Days to sell inventory: Inventories: Beginning of year ...................................................... End of year................................................................. (A) Average inventories (Total  2) ......................... (B) Cost of sales ( 360) ........................................... Days to sell inventory (A  B) ..................................

Chapter 01 - Overview of Financial Statement Analysis

Problem 1-9—continued f.

Times interest earned: Income before taxes ................................................. + Interest expense ....................................................  Interest expense..................................................... Times interest earned ...............................................

g. Common stock price-to-earnings ratio: Market value, at end of year ....................................  Earnings per share ................................................ Common stock price-to-earnings ratio .................. h. Gross expenditures for plant and equipment: Plant and equipment at cost: End of year................................................................. Beginning of year ...................................................... Add disposals at cost ............................................... Gross expenditures for P&E ....................................

$ 4,675,000 275,000 4,950,000 275,000 18

$ 3,450,000 300,000 3,750,000 300,000 12.5

$ 73.5 4.2 17.5

$ 47.75 3.10 15.4

$ 22,750,000 22,020,000 730,000

$22,020,000 21,470,000 550,000

375,000 $ 1,105,000

425,000 975,000

Analysis and interpretation: Lakeland's financial statements reveal significant improvements across the board. In terms of liquidity, both the current and acid-test ratios increase, while the days to sell inventory decreases by 4 days. The nearly 50% increase in times interest earned indicates a more solid financial position. Profitability improved as evidenced by the 5% increase in gross profit margin. In addition, it appears that Lakeland is poised for additional earnings growth based on its increasing capital expenditures. The improved performance has not gone unnoticed by the stock market as the price-to-earnings ratio rose from 14.0 to 17.5. Additional analysis is needed before determining an appropriate price for the proposed acquisition.

Chapter 01 - Overview of Financial Statement Analysis

Problem 1–10 (20 minutes) Company A is the merchandiser – evidenced by: • Low gross profit margin ratio • Low net profit margin ratio • High inventory turnover • High accounts receivable turnover • Higher advertising to sales ratio Company B is the pharmaceutical – evidenced by: • High gross profit margin ratio • High research and development costs to sales • Slightly higher advertising costs to sales Company C is the utility – evidenced by: • Low advertising expenses to sales • High long-term debt to equity ratio • Nonapplicable inventory turnover • Higher interest expense to sales

Problem 1-11 (20 minutes) a. The liquidity of the company appears reasonable. Current assets are 3.45 times current liabilities and even cash-like assets are fully 2.58 times current liabilities. The company is selling its inventory in reasonable time (18 days). However, the collection period for receivables is a bit slow (42 days). The capital structure and solvency of the company also appears reasonable. Long-term debt is only 37 percent of equity and total debt is 67% of total equity. This debt total would seem to be on the high end of the acceptable range. Likewise, the return on assets and equity are quite good (31% and 53%, respectively). This is a positive sign for long-term solvency and for long-term growth. Profit margins appear relatively strong as well. The strong profit margins reflect healthy asset utilization. The company is turning over its inventory 30 times per year and turning over receivables 7 times per year. The market measures reflect these relatively strong operating results. The price to earnings ratio of 27.8 reflects a strong stock market valuation. The lack of dividends for this company is not surprising given the growth rate that the company is achieving.

Chapter 01 - Overview of Financial Statement Analysis

Problem 1-11—continued b. The liquidity of the company is strong. The company has a current ratio that is strong (3.45) and slightly above industry average (3.1). The near cash assets are also strong (acid-test ratio of 2.58 versus 1.85). The size of the acid-test ratio coupled with the receivables collection period (42.19 days versus 36.6 days) raises a question about the quality of the receivables for Best. That relationship warrants some additional investigation. Nevertheless, Best appear to be adequately liquid. Best also appears strong in terms of solvency and capital structure. The company approximates average industry levels of debt and interest coverage. Likewise, the company is slightly above industry averages in terms of return on assets and return on equity. This provides additional comfort about Best’s ability to remain solvent and to grow. The asset utilization ratios reflect reasonably healthy operations. The company is turning over inventory slightly above the industry average and utilizing its fixed assets efficiently relative to industry norms. Again, the accounts receivable turnover warrants investigation. The company is turning over receivables significantly slower than industry averages. The market measures reflect a healthy market capitalization for the company. The slightly lower p/e ratio for Best is interesting given the company’s above average performance. This could reflect the market’s concern about Best’s ability to convert its sales into cash (i.e., accounts receivable collection). c. The following ratios deviate from industry norms and warrant some investigation: Acid-test ratio, collection period, accounts receivable turnover, working capital turnover. These are all related to accounts receivable. Specifically, accounts receivable is higher than normal for the industry. One possible explanation is that the company offers looser collection terms than the industry. Another possibility is that the company extends credit to less creditworthy customers. It could also be random variation but this is unlikely given the magnitude of the difference. Also, the times interest earned ratio is interesting. While it is near industry norms, it is low considering the following. One would expect this to be higher than the industry average because the company has lower than average debt and higher than average earnings. One possible explanation for this relationship is that the company paid down debt late in the year. Thus, the debt ratios look lower at year-end than they were most of the year. Another possibility is that the company has higher priced debt than industry average.

Chapter 01 - Overview of Financial Statement Analysis

Problem 1-12 (30 minutes) a.

Dividend Discount factor Present value

2003

2004

2005

2006

2007

1.00 1/(1.1)1 .9091

1.00 1/(1.1)2 .8264

1.00 1/(1.1)3 .7513

1.00 1/(1.1)4 .6830

1.00 1/(1.1)5 .6209

Terminal Value 7.30 1/(1.1)5 4.5327

2002 9.00

2003 1.45 9.45

2004 1.10 9.55

2005 .60 9.15

2006 .25 8.40

2007 (.10) 7.30

.90 .55 1/1.1 .50

.945 .155 1/(1.1)2 .128

.955 (.355) 1/(1.1)3 (.267)

.915 .840 (.665) (.940) 1/ (1.1)4 1/(1.1)5 (.454) (.584)

Value = $8.32 b. Net income Book value Capital charge (Beg. book value x 10% cost of capital) Residual income Discount factor Present value

Value at time t = Sum of previous line = $8.32 c.

Operating cash flows Capital expenditures Debt incr (decr) Free cash flows Discount factor Present value

2003

2004

2005

2006

2007 |

2.00 -1.00 1.00 1/(1.1)1 .9091

1.50 -0.50 1.00 1/(1.1)2 .8264

1.00 1.00 1.00 1.00 1/(1.1)3 .7513

.75 1.00 1.25 1.00 1/(1.1)4 .6830

.50 | 0.50 1.00 1/(1.1)5 .6209

Terminal Value 7.30

1/(1.1)5 4.5327

Value = $8.32

Chapter 01 - Overview of Financial Statement Analysis

CASES Case 1-1 (35 minutes) a.

Financing = Amount Invested

Return on investment = profit/average amount invested)

NIKE $5,397.4

REEBOK $1,756.1

$399.6 $135.1 = 0.076 = 0.074 [($5,397.4 + $5,361.2)/2] [($1,756.1 + $1,786.2)/2]

Revenues-Expenses =Net income

$9,553.1-Expenses=$399.6 Expenses=$9,153.5

$3,637.4-Expenses=$135.1 Expenses=$3,502.3

Analysis of return on investment: Nike’s 7.4% return is marginally satisfactory given the moderate risk NIKE confronts. Similarly, Reebok’s 7.6% return is marginally acceptable.

Analysis conclusions—Nike’s return is borderline acceptable but its market share is high. Reebok’s return is also borderline acceptable, and it needs greater market share.

Chapter 01 - Overview of Financial Statement Analysis

Case 1-2 (35 minutes) a. Key figures Cash and equivalents .... Accounts receivable ...... Inventories ...................... Retained earnings .......... Costs of sales ................. Income taxes .................. Revenues (NIKE) ............ Net sales (Reebok) ......... Total assets ....................

NIKE 2.0% $ 108.6 31.0 1,674.4 25.9 1,396.6 56.4 3,043.4 63.5 6,065.5 2.6 253.4 100.0 9,553.1 — — 100.0 5,397.4

Reebok 11.9% $ 209.8 32.0 561.7 32.1 563.7 65.2 1,145.3 63.0 2,294.0 0.3 12.5 — — 100.0 3,643.6 100.0 1,756.1

b. NIKE incurred income taxes at 2.6% of revenues while Reebok incurred income taxes at 0.3% of its net sales. c. Reebok’s retained earnings comprises a greater percent of its assets (65.2%) as compared to NIKE (56.4%). d. Since Nike’s costs of sales percent is slightly higher at 63.5% compared to Reebok’s 63.0%, NIKE has a lower gross margin ratio on sales (36.5%).

e. Reebok has a higher percent of total assets in the form of inventory at 32.1%, compared to Nike’s 25.9%.

Chapter 01 - Overview of Financial Statement Analysis

Case 1-3 (60 minutes) Part a Datatech Company

Sigma Company

Current ratio:

$150,440 $60,340 = 2.5 to 1

$233,050 $92,300 = 2.5 to 1

Acid-test ratio:

$63,000 = 1.0 to 1 $60,340

$95,600 = 1.0 to 1 $92,300

Accounts receivable turnover: $660,000 ($36,400 + $8,100 + $28,800)/2

$780,200

= 18.0 times ($56,400 + $6,200 + $53,200)/2 = 13.5 times

Inventory turnover: $532,500 = 4.5 times ($131,500 + $106,400)/2

$485,100 = 7.0 times ($83,440 + $54,600)/2

Days’ sales in inventory: With ending inventory, $83,440 x 360 = 62 days $485,100

$131,500 $532,500

x 360 = 89 days

With average inventory, ( $69,020/$485,100) x 360 = 51 days

($118,950/$532,500) x 360 = 80 days.

Days' sales in receivables: With ending receivables, $36,400 + $8,100 x 360 = 24 days $660,000

With average receivables, ($36.650/$660,000) x 360 = 20 days

$56,400 + $6,200 x 360 = 29 days $780,200

($57,900/$780,200) x 360 = 27 days.

Short-term credit risk analysis: Datatech and Sigma have equal current ratios and equal acid-test ratios. However, Datatech both turns its merchandise and collects its accounts receivable more rapidly than does Sigma. On this basis, Datatech probably is the better short-term credit risk. 1-45 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 01 - Overview of Financial Statement Analysis

Case 1-3—continued Part b Datatech Company

Sigma Company

Net profit margin: $67,770 = 10.3% $660,000

$105,000 = 13.5% $780,200

Total asset turnover: $660,000 = 1.6 times ($434,440 + $388,000)/2

$780,200 = 1.7 times ($536,450 + $372,500)/2

Return on total assets: $67,770+ [$6,900(1-.159)] = 17.9% ($434,440 + $388,000)/2

$105,000+ [$11,000(1-.155)] = 25.1% ($536,450 + $372,500)/2

Return on common stockholders' equity: $67,770 = 24.0% ($294,300 + $269,300)/2

$105,000 = 32.8% ($344,150 + $295,600)/2

Price-earnings ratio: $25 $1.94

= 12.9

$25 $2.56

= 9.8

$1.50 $25

= 6.0%

Dividend yield: $1.50 $25

= 6.0%

Investment analysis: Sigma's profit margin, total asset turnover, return on total assets, and return on common stockholders' equity are all higher than Datatech's. Although the companies pay the same dividend, Sigma's price-earnings ratio is lower. All of these factors suggest that Sigma's stock is likely the better investment.

Chapter 01 - Overview of Financial Statement Analysis

Case 1-4 (35 minutes) a. No. Although the current ratio improved over the three-year period, the acid-test ratio declined and accounts receivable and merchandise inventory turned more slowly. These conditions indicate that an increasing portion of the current assets consisted of accounts receivable and inventories from which current debts could not be paid. b. No. The decreasing turnover of accounts receivable indicates the company is collecting its debt more slowly. c. No. Sales are increasing and accounts receivable are turning more slowly. Either of these trends would produce an increase in accounts receivable, even if the other remained unchanged. d. Probably yes. Since there is nothing to indicate the contrary, cost of goods sold is probably increasing in proportion to sales. Consequently, with sales increasing, cost of goods sold increasing in proportion, and merchandise turning more slowly, the amount of merchandise in the inventory must be increasing. e. Yes. To illustrate, if sales are assumed to equal $100 in 2004, the sales trend shows that they would equal $125 in 2005 and $137 in 2006. Then, dividing each sales figure by its ratio of sales to plant assets would give $33.33 for plant assets in 2004 ($100/3.0), $37.88 in 2005 ($125/3.3) and $39.14 in 2006 ($137/3.5). f. No. The percent of return on owner’s equity declines from 12.25% in 2004 to 9.75% in 2006. g. The ratio of sales to plant assets increased from 3.0 in 2004 to 3.5 in 2006. However, the return on total assets declined from 10.1% in 2004 to 8.8% in 2006. Whether these results are derived from a more efficient use of assets depends on a comparison with other companies and on the expectations of the individual doing the evaluation. h. The dollar amount of selling expenses increased in 2005 and decreased sharply in 2006. Again assuming sales figures of $100 in 2004, $125 in 2005, and $137 in 2006, and multiplying each by its selling expense to net sales ratio gives $15.30 of selling expenses in 2004, $17.13 in 2005, and $13.43 in 2006.

Chapter 01 - Overview of Financial Statement Analysis

Case 1-5 (75 minutes) a. Current ratio = Current assets  Current liabilities $1,518.5 [36]  $1,278.0 [45] = 1.19 b. Acid-test ratio = (Cash + Cash equiv. + Acct. recble.)  Current liabilities ($178.9 [31] + $12.8 [32] + $527.4 [33])  $1,278.0 [45] = 0.56 c. Collection period = Average accounts receivable  (Sales  360) [($527.4 + $624.5)/2 [33]]  ($6,204.1 [13]/360) = 33.4 d. Days to sell inventory = Average inventory  (Cost of goods sold  360) [($706.7 + $819.8)/2 [34]  ($4,095.5/360) [14] = 67.1 e. Total debt to equity = (Current liab + Long-term liab. + Oth Liab)  Stockholders’ equity ($1,278.0[45]+$772.6[46]+$305.0 [47])  $1,793.4[54] = 1.31 f. Long-term debt to equity = Long-term debt  Equity $772.6[46]+$305.0[47] = 0.60 $1,793.4[54] g. Times interest earned = Income before interest and taxes  Interest expense $667.4 [26] + $116.2 [18] = 6.74 $116.2[18] h. Return on assets = Net income + Interest expense (1 - Tax rate)  Average assets $401.5 [28] + $116.2 [18] (1 - .35) = 13.96% ($4,149.0 [55] + $4,115.6 [55])/2 i. Return on common equity = NI - Preferred dividend  Average common equity $401.5 [28] - $0 = 23.0% ($1,793.4 [54] + $1,691.8 [54])/2 j. Gross profit margin ratio = Gross profit / Sales $2,108.6 [13 - 14] = 34.0% $6,204.1 [13] k. Operating profit margin = (Income before interest and taxes)  Sales $667.4 [26] + $116.2 [18] - $26.0 [19] = 12.2% $6,204.1 [13] l. Pretax profit margin ratio = Pretax income / Sales $667.4 [26]__= 10.8% $6,204.1 [13]

Chapter 01 - Overview of Financial Statement Analysis

Case 1-5—continued m. Net profit margin ratio = Net income / Sales $401.5 [28] = 6.47% $6,204.1 [13] n. Cash turnover = Sales / Average cash and cash equivalents $6,204.1 [13] = 47.8 ($178.9 [31] + $80.7 [31])/2 o. Accounts receivable turnover = Sales / Average accounts receivable $6,204.1 [13] = 10.77 ($527.4 + $624.5 [33])/2 p. Inventory turnover = Cost of goods sold / Average inventories $6,204.1 [13] - $4,095.5 [14] = 2.76 ($706.7+$819.8)/2 [34] q. Working capital turnover = Sales / Average working capital $6,204.1 [13] = 20.4 (($1,518.5 [36] - $1,278.0 [45]) + ($1,665.5 [36] - $1,298.1 [45]))/2 r. PPE turnover = Sales / Average PPE $6,204.1 [13] = 3.53 ($1,790.4 + $1,717.7 [37])/2 s. Total assets turnover = Sales / Average total assets $6,204.1 [13] = 1.50 ($4,149.0+$4,115.6)/2 t. Price-to-earnings ratio = Market price / Earnings per share $46.73 [179] = 14.8 $3.16 [29] u. Earnings yield = Earnings per share / Market price per share $3.16 [29] = 6.76% $46.73 [179] v. Dividend yield = Dividends per share / Market price per share $1.12 [89] = 2.4% $46.73 [179] w. Dividend payout rate = Dividends per share / Earnings per share $1.12 [89] = 35.4% $3.16 [29] x. Price-to-book ratio = Market price per share / Book value per share $46.73 [179] = 3.31 $14.12 [185]

Chapter 01 - Overview of Financial Statement Analysis

Case 1-6 (25 minutes) A company pursues four major business activities in a desire to provide a saleable product and/or service, and with the goal to yield a satisfactory return on investment. Planning activities. A company exists to implement specific goals and objectives. A company's goals and objectives are captured in a business plan, describing the company's purpose, its strategy, and its tactics for activities. A business plan assists managers in focusing their efforts and identifying expected opportunities and obstacles. Financing Activities. A company requires financing to carry out its business plan. Financing activities are the means companies use to pay for these ventures. Because of their magnitude, and their potential to determine success or failure of a venture, companies take care in acquiring and managing their financial resources. There are two main sources of business financing: equity investors (sometimes referred to as owners or shareholders) and creditors. Investing Activities. Investing activities are the means a company uses to acquire and maintain investments for obtaining, developing, and selling products or services. Financing provides the funds necessary for acquisition of investments needed to carry out business plans. Investments include land, buildings, equipment, legal rights (patents, licenses, and copyrights), inventories, human capital (managers and employees), accounting systems, and all components necessary for the company to operate. Operating Activities. Operating activities represent the "carrying out" of the business plan, given necessary financing and investing. These activities usually involve at least five basic components--research, purchasing, production, marketing, and labor. Operating activities are a company's primary source of income. Income measures a company's success in buying from input markets and selling in output markets. How well a company does in devising business plans and strategies, and with decisions on materials comprising the mix of operating activities, determines business success or failure.

Chapter 01 - Overview of Financial Statement Analysis

Case 1-7 (25 minutes) a. The CEO appears to have selectively chosen from the 11 available ratios to present only the ones that show trends that are favorable to the company. (However, some analysts may not interpret a decline in selling expenses as a percent of revenue as positive since it might imply a scaling back on advertising campaigns.) The CEO’s motivation might be to make her and/or the company’s performance appear better than it is in the eyes of the analysts. b. The consequences of this action by the CEO might be mixed. It is likely that the analysts will ask other questions that may reveal some negative trends such as the trends in return and profit margins. The CEO’s actions may become transparent to the analysts as they discover the presence of less favorable trends through their questions. If discovered, such a disclosure ploy by the CEO will not reflect favorably on the company. Both the CEO and the company are likely to suffer losses in reputation and credibility. Even if the CEO is able to succeed with this strategy in the short term, once the financial statements are issued all users can compile additional ratio information and see that some of the trends are unfavorable to the company. This is likely to damage the credibility of the CEO.

Chapter 01 - Overview of Financial Statement Analysis

Case 1-8 (75 minutes) Please note that it is essential to use Excel or similar software for solving this case. Excel files for this case are available on the book’s web site. a. Index –number trend analysis COLGATE 2011 177% 176% 206% 212%

2010 165% 169% 188% 192%

2009 163% 165% 194% 200%

2008 163% 165% 179% 171%

2007 146% 151% 159% 152%

2006 130% 132% 138% 118%

2005 121% 121% 127% 118%

2004 112% 113% 118% 116%

2003 105% 105% 115% 124%

2002 99% 98% 109% 112%

2001 100% 100% 100% 100%

212% 206%

197% 191%

200% 194%

180% 185%

168% 169%

143% 154%

131% 135%

121% 121%

127% 117%

112% 109%

100% 100%

Total Assets Total Liabilities Long Tern Debt Shareholders' Equity Treasury Stock at cost

182% 172% 158% 244% 246%

160% 141% 100% 316% 217%

159% 133% 100% 368% 201%

143% 134% 128% 227% 186%

145% 130% 115% 270% 171%

131% 128% 97% 167% 155%

122% 119% 104% 160% 146%

124% 122% 110% 147% 134%

107% 107% 95% 105% 125%

101% 110% 114% 41% 118%

100% 100% 100% 100% 100%

Basic Earnings per share Cash Dividends per share Closing Stock Price Shares Outstanding (billions)

247% 336% 160% 87%

220% 301% 139% 90%

224% 255% 142% 90%

189% 231% 119% 91%

166% 207% 135% 92%

127% 185% 113% 93%

126% 164% 95% 94%

121% 142% 89% 96%

129% 133% 87% 97%

115% 107% 91% 97%

100% 100% 100% 100%

Net Sales Gross Profit Operating Income Net Income Before restructuring: Net Income before restructuring Op Income before restructuring

Chapter 01 - Overview of Financial Statement Analysis

KIMBERLEY CLARK 2011 144% 92% 94% 99%

2010 136% 110% 111% 114%

2009 132% 108% 118% 117%

2008 134% 99% 101% 105%

2007 126% 98% 106% 113%

2006 115% 95% 100% 93%

2005 109% 91% 99% 97%

2004 104% 88% 100% 112%

2003 99% 84% 97% 105%

2002 93% 83% 99% 104%

2001 100% 100% 100% 100%

114% 104%

112% 110%

120% 120%

106% 102%

117% 108%

110% 111%

105% 104%

110% 99%

103% 96%

102% 98%

100% 100%

Total Assets Total Liabilities Long Tern Debt Shareholders' Equity Treasury Stock at cost

129% 163% 224% 98% 77%

132% 154% 211% 105% 172%

128% 146% 198% 96% 149%

121% 150% 201% 69% 156%

123% 138% 181% 93% 139%

114% 115% 94% 108% 51%

109% 113% 107% 98% 232%

113% 109% 95% 117% 184%

112% 107% 113% 120% 139%

104% 107% 117% 100% 122%

100% 100% 100% 100% 100%

Basic Earnings per share Cash Dividends per share Closing Stock Price Shares Outstanding (billions)

132% 249% 123% 76%

147% 232% 105% 78%

149% 214% 107% 80%

134% 205% 88% 79%

136% 187% 116% 81%

108% 173% 114% 87%

110% 158% 100% 89%

118% 139% 110% 93%

110% 119% 99% 96%

107% 106% 79% 98%

100% 100% 100% 100%

Net Sales Gross Profit Operating Income Net Income Before restructuring: Net Income before restructuring Op Income before restructuring

Chapter 01 - Overview of Financial Statement Analysis

b. Ratio Analysis COLGATE Return on equity Return on assets Operating profit margin Gross profit margin Before restructuring: Return on equity Return on assets Operating profit margin Total asset turnover Total liabilities to equity Long-term debt to equity Price to earnings Price to book Dividend Payout

2011 102% 32% 23% 57%

2010 76% 31% 22% 59%

2009 91% 34% 24% 59%

2008 93% 33% 22% 59%

2007 94% 31% 21% 60%

2006 98% 29% 21% 59%

2005 104% 28% 21% 58%

2004 124% 27% 21% 58%

2003 230% 29% 22% 58%

2002 215% 29% 22% 58%

2001 135% 27% 20% 58%

102% 32% 23%

78% 32% 23%

91% 34% 24%

98% 34% 22%

104% 33% 23%

119% 32% 23%

115% 29% 22%

130% 28% 21%

236% 30% 22%

215% 29% 22%

135% 27% 20%

1.40 4.92 2.14 18.55 21.43 46%

1.40 3.12 1.05 18.06 14.87 46%

1.45 2.53 0.91 18.13 13.03 38%

1.53 4.13 1.87 17.99 17.88 41%

1.43 3.37 1.41 23.27 17.36 42%

1.39 5.40 1.93 25.39 23.71 49%

1.33 5.22 2.16 21.59 20.97 44%

1.31 5.79 2.48 20.88 21.63 39%

1.36 7.19 3.03 19.25 30.11 35%

1.32 18.63 9.17 22.50 80.22 31%

1.35 7.01 3.32 28.59 37.58 33%

Note: For 2001 alone, return on equity (return on asset) is computed using only the closing balance of shareholder’s equity (total assets). For all other years these ratios are computed using the average of opening and closing balances.

Chapter 01 - Overview of Financial Statement Analysis

2011 28% 12% 12% 30%

2010 33% 15% 15% 37%

2009 41% 16% 16% 38%

2008 37% 14% 14% 34%

2007 32% 15% 15% 36%

2006 26% 16% 16% 38%

2005 26% 15% 16% 38%

2004 27% 15% 17% 39%

2003 27% 16% 18% 39%

2002 30% 17% 19% 41%

2001 29% 17% 18% 46%

33% 14% 13%

33% 15% 15%

43% 17% 17%

38% 15% 14%

34% 16% 16%

31% 17% 17%

28% 16% 17%

27% 15% 17%

27% 16% 18%

30% 17% 19%

29% 18% 18%

1.06 2.50 0.98 18.30 5.26 69%

1.01 2.22 0.87 14.10 4.34 58%

1.02 2.31 0.89 14.06 4.91 53%

1.06 3.30 1.26 12.93 5.62 56%

1.03 2.25 0.84 16.79 5.59 50%

1.00 1.60 0.37 20.78 5.08 59%

0.95 1.73 0.47 17.91 4.95 53%

0.89 1.40 0.35 18.38 4.79 43%

0.89 1.35 0.40 17.69 4.38 40%

0.89 1.62 0.50 14.56 4.29 36%

0.97 1.51 0.43 19.67 5.52 37%

Chapter 01 - Overview of Financial Statement Analysis

c. Index-trend analysis for ratios COLGATE Return on equity Return on assets Operating profit margin Gross profit margin Before restructuring: Return on equity Return on assets Operating profit margin Total asset turnover Total liabilities to equity Long-term debt to equity Price to earnings Price to book Dividend Payout

2011 76% 121% 116% 99%

2010 56% 117% 114% 102%

2009 67% 129% 120% 102%

2008 69% 124% 110% 102%

2007 69% 115% 109% 103%

2006 72% 109% 106% 102%

2005 77% 104% 105% 100%

2004 92% 102% 105% 100%

2003 170% 110% 109% 100%

2002 159% 108% 110% 99%

2001 100% 100% 100% 100%

76% 121% 116%

58% 119% 116%

67% 129% 120%

73% 128% 114%

77% 123% 115%

88% 122% 118%

85% 110% 112%

96% 105% 108%

174% 112% 111%

159% 108% 110%

100% 100% 100%

104% 70% 64% 65% 57% 136%

103% 45% 32% 63% 40% 137%

108% 36% 27% 63% 35% 114%

113% 59% 56% 63% 48% 123%

106% 48% 42% 81% 46% 125%

103% 77% 58% 89% 63% 146%

98% 75% 65% 76% 56% 131%

97% 83% 75% 73% 58% 117%

101% 103% 91% 67% 80% 104%

98% 266% 276% 79% 213% 92%

100% 100% 100% 100% 100% 100%

Chapter 01 - Overview of Financial Statement Analysis

KIMBERLEY CLARK Return on equity Return on assets Operating profit margin Gross profit margin Before restructuring: Return on equity Return on assets Operating profit margin

2011 98% 72% 65% 64%

2010 114% 86% 82% 81%

2009 142% 95% 90% 82%

2008 130% 83% 76% 74%

2007 113% 89% 84% 78%

2006 90% 90% 87% 82%

2005 90% 89% 90% 83%

2004 94% 89% 96% 85%

2003 96% 90% 98% 85%

2002 104% 97% 106% 89%

2001 100% 100% 100% 100%

113% 79% 72%

112% 84% 81%

146% 96% 91%

131% 84% 76%

116% 91% 86%

107% 100% 96%

98% 93% 95%

93% 88% 95%

94% 89% 97%

102% 96% 105%

100% 100% 100%

Total asset turnover Total liabilities to equity Long-term debt to equity Price to earnings Price to book Dividend Payout

110% 166% 229% 93% 95% 188%

104% 147% 202% 72% 79% 158%

106% 153% 206% 71% 89% 144%

110% 219% 293% 66% 102% 152%

106% 149% 196% 85% 101% 138%

104% 106% 87% 106% 92% 161%

99% 114% 109% 91% 90% 144%

92% 93% 81% 93% 87% 118%

92% 90% 94% 90% 79% 108%

92% 107% 117% 74% 78% 99%

100% 100% 100% 100% 100% 100%

d. See (a), (b) and (c) above. Note that only return on equity, return on assets and operating profit margins are affected by the restructuring charge.

Chapter 01 - Overview of Financial Statement Analysis

e. Computation of cum-dividend stock return (This is advanced analysis only for those students with strong finance background). COLGATE

Cum-Div Return (Gross)

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

1.18

1.00

1.22

0.90

1.22

1.21

1.09

1.04

0.97

0.92

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

1.21

1.03

1.25

0.79

1.05

1.17

0.93

1.14

1.27

0.81

2001

OVERALL 1.0692

KIMBERLEY CLARK

Cum-Div Return (Gross)

2001

OVERALL 1.0533

f. The performance of Colgate and Kimberley Clark offer an interesting contrast. Let us start with stock price performance. The cum-dividend return on Colgate’s stock was 6.92% per annum over the ten-year period. The comparable return for Kimberley Clark was 5.33% per annum. Put differently, every dollar invested in Colgate’s stock at the end of 2001 would be worth $ 1.95 by 2011 (assuming that dividends were reinvested in the company’s stock). In contrast, a dollar invested in Kimberley Clark’s stock in 2001 would be worth $ 1.68 in 2011. Therefore an investor in Colgate would have become 16% richer relative to an investor in Kimberley Clark over this period. While the stock price performance of these firms is fairly comparable over the 2001-2011 period, this masks differences in the underlying financial performance of the two companies. Colgate’s net income (before restructuring charge) grew by 112% during 2001-2011, compared to just 14% for Kimberley Clark. In contrast, Colgate’s shareholder’s equity increased by 144% over this time period compared to a 2% decline for Kimberley Clark. As a result, Colgate’s ROE (before restructuring) fell by 24% during 2001-2011 compared to Kimberley Clark’s ROE, which increased by 13% over the same period. Despite the inferior growth in profitability, Kimberley Clark was able to payout more of its earnings as dividends; Kimberley Clark’s dividend payout has grown from 37% to 69%, while Colgate’s payout increased only slightly from 33% to 46%. This suggests that Colgate is paying less of its earnings as dividends, although it spends much of the balance in buying back shares as treasury stock. Because of these opposing trends, the stock market now rewards Colgate and Kimberly Clark’s financial performance with similar price-to-earnings ratios in 2011. However, due to Colgate’s small level of shareholder’s equity, Colgate retains a

Chapter 01 - Overview of Financial Statement Analysis

much higher price-to-book ratio. Despite the differences in trends over the recent 10-year period, Colgate maintains a phenomenal ROE of 102% in 2011 (before restructuring charge), compared to the good, but modest 33% for Kimberley Clark. What explains this difference in ROE? For starters, Colgate’s ROA (32% before restructuring) is much higher than Kimberley Clark’s (14%). However, this difference is largely magnified by Colgate’s much higher leverage: Colgate’s debt-to-equity (total liability to equity 4.92 and long-term-debt to equity 2.14) are much higher than Kimberley Clark’s (total liability to equity 2.50 and long-term-debt to equity 0.98). However, the trends in both of these leverage measures have narrowed the difference over the 2001-2011 period for the firms. The higher leverage for Colgate is both the result of its disappearing equity base and a slight build-up in liabilities. Obviously, the higher leverage makes Colgate a more risky company. However Colgate’s management appears to have greater faith in the stability and growth of its core business in order to keep leverage so high. Du Pont analysis of profitability shows that Colgate has a much higher operating profit margin (before restructuring charge) than Kimberley Clark (23% to 12%) and a much higher asset turnover (1.40 to 1.06). This suggests that Colgate has greater pricing power than Kimberley Clark and uses its assets more efficiently. Also Colgate’s gross profit margin (57%) is much higher than Kimberley Clark’s (30%). This suggests that Colgate actually has much higher pricing power than Kimberley Clark but it also tends to invest more heavily in SG&A.

Chapter 02 - Financial Reporting and Analysis

Chapter 2 Financial Reporting and Analysis REVIEW Financial statements are the most visible products of a company’s financial reporting process. The financial reporting process is governed by accounting rules and standards, managerial incentives, and enforcement and monitoring mechanisms. It is important for a user of financial information to understand the financial reporting environment along with the accounting information presented in financial statements. In this chapter, the concepts underlying financial reporting are discussed with special emphasis on accounting rules. Next the purpose of financial reporting is discussed – its objectives and how these objectives determine both the quality of the accounting information and the principles that underlie the accounting rules. The relevance of accounting information for business analysis and valuation is also discussed and limitations of accounting information are identified. Last, accrual accounting is discussed including the strengths and limitation of accruals, and the implications of accruals for financial statement analysis.

Chapter 02 - Financial Reporting and Analysis

OUTLINE •

Financial Reporting Environment Statutory Financial Reports Financial Statements Earnings Announcements Other Statutory Reports Factors Affecting Statutory Financial Reports Generally Accepted Accounting Principles GAAP Defined Setting Accounting Standards Role of the Securities and Exchange Commission International Accounting Standards Managers Monitoring and Enforcement Mechanisms Securities and Exchange Commission Auditing Corporate Governance Litigation Alternative Information Sources Economic, Industry, and Company Information Voluntary Disclosure Information Intermediaries

•

Nature and Purpose of Financial Accounting Objectives of Financial Accounting Stewardship Information for Decisions Desirable Qualities of Accounting Information Primary Qualities: Relevance and Reliability Secondary Qualities: Comparability and Consistency Important Principles of Accounting Double-Entry Historical Cost Accrual Accounting Full Disclosure Materiality Conservatism Relevance and Limitations of Accounting Relevance of Financial Accounting Information Limitations of Financial Statement Information Relevance and Limitations of Accrual Accounting Relevance of Accrual Accounting Conceptual Relevance of Accrual Accounting Empirical Relevance of Accrual Accounting Accruals Can Be a Double-Edged Sword Analysis Implications of Accrual Accounting Myths and Truths About Accruals and Cash Flows Accruals and Cash Flows – Myths Accruals and Cash Flows – Truths 2-2

Chapter 02 - Financial Reporting and Analysis

Should We Forsake Accruals for Cash Flows? •

Concept of Income Economic Concept of Income Economic Income Permanent Income Operating Income Accounting Concept of Income Revenue Recognition and Matching Analysis Implications

•

Fair Value Accounting Understanding Fair Value Accounting Considerations in Measuring Fair Value Hierarchy of Inputs Analysis Implications

•

Introduction to Accounting Analysis Need for Accounting Analysis Accounting Distortions Accounting Standards Estimation Errors Reliability versus Relevance Earnings Management Analysis Objectives Comparative Analysis Income Measurement Earnings Management Earnings Management Strategies Increasing Income Big Bath Income Smoothing Motivations for Earnings Management Contracting Incentives Stock Price Effects Other Incentives Mechanics of Earnings Management Income Shifting Classificatory Earnings Management Analysis Implications of Earnings Management Process of Accounting Analysis Evaluating Earnings Quality Steps in Evaluating Earnings Quality Adjusting Financial Statements

Appendix 2A: Earnings Quality • Determinants of Earnings Quality Accounting Principles • Income Statement Analysis of Earnings Quality Analysis of Maintenance and Repairs Analysis of Advertising 2-3 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 02 - Financial Reporting and Analysis

Analysis of Research and Development Analysis of Other Discretionary Costs • Balance Sheet Analysis of Earnings Quality Conservatism in Reported Assets Conservatism in Reported Provisions and Liabilities Risks in Reported Assets • External Factors and Earnings Quality

Chapter 02 - Financial Reporting and Analysis

ANALYSIS OBJECTIVES • Explain the financial reporting and analysis environment • Identify what constitutes generally accepted accounting principles (GAAP) • Describe the objectives of financial accounting, and identify primary and secondary qualities of accounting information • Define principles and conventions that determine accounting rules • Describe the relevance of accounting information to business analysis and valuation • Identify limitations of accounting data and their importance for financial statement analysis • Understand alternative income concepts and distinguish them from cash flows • Understand fair value accounting, its advantages, limitations and analysis implications • Explain the importance of accrual accounting and its advantages and limitations • Describe the need for and techniques of accounting analysis • Analyze and measure earnings quality and its determinants (Appendix 2A)

QUESTIONS The users of financial reporting information include investors, creditors, analysts, and other interested parties. There are several sources of information available to users. These include statutory financial reports and alternative information sources such as economic information and industry information. Statutory financial reports are prepared according to the set of generally accepted accounting principles (GAAP). A regulatory hierarchy that includes the Securities and Exchange Commission, the American Institute of Certified Public Accountants, and the Financial Accounting Standards Board promulgates these principles. GAAP is also influenced in some industries by specialized industry practices. Managers prepare the statutory financial reports. Thus, the reports are subject to manipulation based on incentives of managers to present the company in its best light. However, the ability of managers 2-1. to manipulate the financial reports is limited by several monitoring and enforcement mechanisms including the SEC, internal and external auditors, corporate governance, and the possibility of litigation against the company and/or the managers. 2-5 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 02 - Financial Reporting and Analysis

2-2.

Earnings announcements provide summary information about the company’s performance and financial position during the quarter and/or year just ended. The earnings announcement contains much less detail than the financial statements, which are only released after they are prepared and audited. Although the earnings announcement contains few details, it does contain important summary data such as the results of operations. By making an earnings announcement, the company conveys important information to the market in a timely manner.

2-3.

The Securities and Exchange Commission serves as an advocate for investors. As such, the SEC requires registrant companies to file periodic standard reports. These reports allow the SEC to oversee the financial reporting activities of the company and allow the SEC to make key financial information available to all investors. Some of the reports required by the SEC are summarized in Exhibit 2.1. The Form 10-K is a filing that includes audited annual financial statements and management discussion and analysis. The Form 10-Q is filed on a quarterly basis and contains quarterly financial statements and management discussion and analysis. The Form 20-F is an annual filing by foreign issuers of financial securities. This report reconciles reports that were prepared using non-U.S. GAAP to reports prepared using U.S. GAAP. The Form 8-K is a report of current activities that must be filed within 15 days of the occurrence of any of the following events: change in management control, acquisition or disposition of major assets, bankruptcy or receivership, auditor change, or resignation of a director. Regulation 14-A is commonly called the Proxy Statement. The Proxy Statement contains details of directors, managerial ownership, managerial compensation, and employee stock options. The Prospectus contains audited statements and other information about proposed project or share issues.

2-4.

Contemporary generally accepted accounting principles (GAAP) is the set of rules and guidelines of financial accounting that are currently mandated as the acceptable rules and guidelines for preparing financial reports for the external users of financial information. These rules are comprised of the following: Financial Accounting Standards Board (FASB) Statements of Financial Accounting Standards; Accounting Principle Board Opinions; Accounting Research Bulletins issued by the Committee of Accounting Practices; Pronouncements of the American Institute of Certified Public Accountants such as Statements of Position regarding issues not yet addressed by the FASB; and Industry Audit and Accounting Guidelines for any industry-specific matters. The FASB also issues Emerging Issues Task Force (EITF) Bulletins that contain guidance regarding emerging issues that will be on the agenda of the FASB in the near future. GAAP is also influenced by generally accepted practices in certain industries.

2-5.

The accounting profession currently establishes accounting standards. The Financial Accounting Standards Board is currently the primary rule making body. The SEC and the AICPA oversee the activities of the FASB. The FASB proposes rules by first issuing a discussion memorandum. Interested parties are asked to render an opinion regarding the proposal by the FASB. Next, the FASB issues an Exposure Draft of the proposed rule and invites additional comment. Finally, based on input received via the exposure and comment process, the FASB issues the new rule.

2-6.

Managers have the main responsibility for ensuring fair and accurate financial reporting by a company.

2-7.

Managers have discretion in financial reporting in most cases. This discretion may 2-6

Chapter 02 - Financial Reporting and Analysis

result from either of two sources. First, managers often have a choice between alternative generally accepted rules in accounting for certain transactions. Second, managers often have to make estimates of uncertain future outcomes. Each of these managerial judgments creates managerial discretion. 2-8.

Monitoring and control mechanisms include SEC oversight, internal and external auditor review, corporate governance such as Board of Director subcommittees assembled to oversee the audit and financial reporting (known as audit committees), and the omnipresent threat of litigation.

2-9.

Statutory financial reports are not the only source of information about a company that is available to interested parties outside of the organization. Other sources include forecasts and recommendations of information intermediaries (analysts), general economic information, general information about the company’s industry, and news about the company. Also, management will often provide voluntary disclosure of information that is not required by GAAP or other regulatory mandate.

2-10.

Financial intermediaries (analysts) play an important role in capital markets. They are an active and sophisticated group of users that provide useful information to market participants. Tasks performed by intermediaries include collecting, processing, interpreting, and disseminating information about the financial prospects of companies. The outputs of analysts include forecasts, stock buy or sell recommendations, and/or research reports that investors can use to make investment decisions.

2-11.

Under the historical cost model, asset and liability values are determined on the basis of prices obtained from actual transactions that have occurred in the past. Under the fair value accounting model, asset and liability values are determined on the basis of their fair values (typically market prices) on the measurement date (i.e., approximately the date of the financial statements). Under historical cost method, when asset (or liability) values subsequently change, continuing to record value at the historical cost—i.e., at the value at which the asset was originally purchased—impairs the usefulness of the financial statements, in particular the balance sheet. Because of this the historical cost model has come under a lot of criticism for various quarters, resulting in the move toward fair value accounting.

2-12.

In accounting, conservatism states that when choosing between two solutions, the one that will be least likely to overstate assets and income should be selected. The two main advantages of conservatism are that (1) it naturally offsets the optimistic bias on the part of management to report higher income or higher net assets; and (2) it is important for credit analysis and debt contracting because creditors prefer financial statements that highlight downside risk.

2-13.

The two types of conservatism are unconditional and conditional conservatism. Unconditional conservatism understates assets (or income) regardless of the economic situation. An example is writing-off R&D irrespective of the nature of the research. Conditional conservatism understates assets conditioned on the economic situation. An example is an asset impairment charge that occurs when changed economic circumstances lower an asset’s economic value below its carrying value. Of the two, conditional conservatism is more useful for analysis because it reflects current economic information in a timely, albeit in an asymmetric, manner. 2-7

Chapter 02 - Financial Reporting and Analysis

2-14.

Finance and accounting researchers have established that accounting information is indeed relevant for decision making. For example, researchers have shown that accounting earnings explain much (50% - 70%) of the fluctuation in stock price changes. This is some of the most important empirical research about accounting earnings. Accounting earnings are shown repeatedly to explain stock prices better than other available measures such as cash flows or EBITDA. Simply put, if you can predict whether accounting earnings per share will increase or decrease, you can, on average, predict whether the stock price will increase or decrease. Also, book value does a reasonable job in explaining market value changes.

2-15.

Financial statement information has several limitations. First, financial statements are released well after the end of the quarter and/or fiscal year. Thus, they are not entirely timely. Second, they are only released on a quarterly basis. Investors often have a need for information more often than just on a quarterly basis. Thus, financial statements are limited by the relative infrequency of their release. Third, financial statements have little forward-looking information. Investors must use the largely backward looking financial statements to generate their own beliefs about the future. Fourth, financial statements are prepared using rules that are promulgated with a relevance and reliability trade-off. The need for reliability causes the relevance of the information to be, in certain instances, compromised. Fifth, the usefulness of financial statement information may also be limited by the bias of the managers that prepare the statements. For example, managers in certain instances may have incentives to overstate or understate earnings, assets, liabilities, and/or equity.

2-16.

Timing and matching problems make short-term performance measurement difficult and often less meaningful. Timing problems arise because cash is often not received in the period that the revenues are earned and cash is often not paid in the period that the expenses are incurred. To the extent that the timing of cash receipt does not occur in the period that the goods or services are delivered, a timing problem is created in performance measurement. Likewise, a matching problem can arise because the expenses incurred to generate the revenues may be paid in a different period than the revenue was recorded (earlier period or later period). As a result, performance is not measured appropriately because the economic efforts required to generate the revenues are not appropriately matched against the revenues to measure the net benefit of the activities.

2-17.

Accrual accounting calls for recognizing revenue when the revenue is both earned and realizable. Revenues are earned when the company delivers the products or services. Revenues are realized when cash is received. Revenues are realizable when an asset is acquired for the products or services delivered that is convertible into cash or cash equivalents. The asset received is usually an account receivable that is collectible.

2-18.

Accrual accounting requires that the economic efforts required to generate revenues be matched against the related revenues. As a result, product costs are recognized in the period the related goods are sold. Period costs are matched with revenues of the same period.

2-19.

Short-term accruals arise because of the timing differences between income and cash flows. For example, the accrual of revenues before or after cash is received and the accrual of expenses before or after cash is paid are short-term accruals. Long2-8

Chapter 02 - Financial Reporting and Analysis

term accruals arise from the capitalization of assets that will provide benefits to the company for more than one year. 2-20.

Cash flow measures of performance almost always suffer from the timing and matching problems that accrual accounting was developed to mitigate. For example, cash often is not received in the accounting period when it is earned. Further, expenses are often not paid in the period that the cash of the sale that the expense helped to generate was received. As a result, cash flow measures of performance can be very misleading. Consider for example, a company that increases inventory levels substantially in the fourth quarter of the current year. This company will likely report a negative cash flow from operations. However, they may have had an excellent year and are increasing inventories because they expect continued strong sales.

2-21.

Accrual accounting is a superior measure of performance and financial position relative to cash flows. The factors that give rise to this superiority are the more appropriate timing of revenue recognition and the more precise matching of costs against these revenues. Also, these accruals create a balance sheet that is a more precise indication of the current financial position of the company. As a result, accrual-based income information is more relevant for assessing a company's present and future cash generating ability and accrual-based balance sheets are a better measure of the financial position of the company.

2-22.

Accrual-accounting based income measures repeatedly out-perform cash flow-based measures such as operating cash flow or free cash flow at explaining changes in stock price. That is, increases or decreases in net income have been shown to have a much higher positive relation to increases or decreases in the stock price. Increases or decreases in cash flow measures are much less likely to have corresponding increases or decreases in the stock price.

2-23.

Cash flows are highly reliable because the receipt or payment of cash measures the cash flows. Accounting net income is less reliable than cash flows because calculating net income often requires estimations of future outcomes. Analysts' forecasts are the least reliable because they are simply an estimate by one or a few individuals. However, in terms of relevance the ranking reverses. Analysts' forecasts are highly relevant because the forecasts can impound additional information and are more timely than accounting income or cash flows. Accounting income is more relevant than cash flows because net income contains the additional information contained in accruals. Cash flow is the least relevant of the performance information alternatives because of timing and matching problems between cash flow and revenues and expenses.

2-24.

Income (also referred to as earnings or profit) summarizes, in financial terms, the net effects of a business’s operations during a given time period. Economic income differs from cash flow because it includes not only current cash flows but also changes in the present value of future cash flows. Similarly, accounting income considers not only current cash flow but also future cash flow implications of current transactions.

2-25.

The two basic income concepts are economic income and permanent income. Economic income is typically determined as cash flow during the period plus the 2-9

Chapter 02 - Financial Reporting and Analysis

change in the present value of expected future cash flows, typically represented by the change in the fair value of the business’s net assets. Permanent income (also called sustainable income or recurring income) is the stable average income that a business is expected to earn over its life, given the current state of its business conditions. Economic income measures change in shareholder value and is useful in evaluating the total shareholder value created during a period. Permanent income is proportional to shareholder value and is useful in valuing firms using pricing multiples. 2-26.

Economic income measures the net change in shareholder value during a period. We cannot use economic income to directly value a company. In contrast, permanent income is a measure of the stable income that the firm is expected to generate over the long run. We can get an estimate of firm value by merely multiplying permanent income with an appropriate multiplier. Because of this, economic income measures change in value while permanent income is proportional to value.

2-27.

Accounting income is the excess of revenues and gains over expenses and losses measured using accrual accounting. As such, revenues are recognized when earned and realized and expenses are matched against the recognized revenues to generate income.

2-28.

Economic income is a measure of the change in shareholder value over a period of time. Permanent income is the normal, recurring amount of income that a company is able to earn each period. Accounting income has aspects of both. For example, fair value accounting for investment securities recognizes the change in the value of certain financial assets during the period. This is reflective of economic income. Accrual accounting also measures the operating profit related to ongoing operations which is especially reflective of permanent income.

2-29.

The permanent component of accounting income is the portion of total earnings that is expected to persist indefinitely (recur). Revenues and cost of goods sold components are largely permanent income components. The transitory component of accounting income is the portion of total earnings that is not expected to recur. Onetime gains or losses on the sale of operating assets are transitory income items for most companies.

2-30.

Value irrelevant income components have no economic content and, as the name suggests, have no effect on the value of the company. They are accounting distortions that arise from the imperfections in accounting. An example of a value irrelevant income component is the gain or loss related to a change in accounting principle.

2-31.

Core income refers to a current period’s recognized income from which all transitory components have been removed. Typically one-time items such as extraordinary items, gain and loss on sale of business units, asset impairments and restructuring charges are removed from net income to estimate core income. Determining core income is an important first step in estimating permanent income, because it provides a measure of income created from the ongoing operating activities for the current period.

2-32.

Some of the major adjustments to net income for determining economic income are including various unrealized gains and losses that are included in other 2-10

Chapter 02 - Financial Reporting and Analysis

comprehensive income, such as unrealized gains/losses on marketable securities or net pension assets. 2-33.

Accounting principles can, in certain cases, create differences between financial statement information and economic reality. The principles are promulgated to strike a balance between relevance and reliability. In certain cases, this creates problems. For example, accounting principles require that long-lived assets be recorded on the books at historical cost because this is a reliable number that can be verified by examining documents related to the acquisition of the asset. Economic reality is represented by the current market value of the long-lived asset. Unfortunately, fair market value, while more relevant, is often difficult to determine. Thus, any market value measure might not be entirely reliable. As a result, economic reality is often not reflected in the reported value of long-lived assets like land and buildings. Another example is internally generated goodwill and the value of the work force. Each comprises a significant portion of the overall value of many companies. However, quantifying that value would be difficult. Thus, while relevant, the amount is not reliable enough to formally record and report on the financial statements.

2-34.

2-35.

Under historical cost accounting, income is the accountants estimate of what an enterprise has “earned” during a period. Under fair value accounting, income is merely the residual amount that measures the net change in the fair values of assets and liabilities.

2-36.

Formally, SFAS 157 defines fair value as exchange price, that is, the price that would be received from selling an asset (or paid to transfer a liability) in an orderly transaction between market participants on the measurement date. There are five key elements to this definition: (1) the fair value is determined on the measurement date, i.e., date of the balance sheet; (2) it is based on a hypothetical, and not actual , transaction; (3) the hypothetical transaction must be orderly; (4) fair values are market based and not entity specific measurements; and (5) fair values are based on exit, and not entry, prices.

2-37.

Consider a cab service that operates in an area without competition and charges very high rates, and is extremely profitable. Therefore, the present value of future net cash flows from the use of each automobile over its normal life in this enterprise is $ 85,000. However, the blue book value is only $ 20,000. For fair value purposes we will use $ 20,000, i.e., the market value, and not $ 85,000, i.e., the entity-specific value, when valuing the automobiles.

2-38.

Two types of inputs are recognized: (1) observable inputs, where market prices are obtainable from sources independent of the reporting company—for example, from quoted market prices of traded securities; and (2) unobservable inputs, where fair values are determined through assumptions provided by the reporting company because the asset or liability is not traded. They are divided into three levels: Level 1 2-11

Chapter 02 - Financial Reporting and Analysis

Inputs. These inputs are quoted prices in active markets for the exact asset or liability that is being valued, preferably available on the measurement date. Level 2 Inputs. These inputs are either (1) quoted prices from active markets for similar, but not identical, assets or liabilities or (2) quoted prices for identical assets or liabilities from markets that are not active. Level 3 Inputs. These are unobservable inputs and are used when the asset or liability is not traded or when traded substitutes cannot be identified. Level 3 inputs reflect manager’s own assumptions regarding valuation, including internal data from within the company. Level 3 inputs are the least reliable and therefore least useful for valuation. 2-39.

Financial assets/liabilities are easier to fair value. This is because they are more homogenous and usually have liquid markets with traded quotes. Because of this, financial assets/liabilities can be valued using Level 1 or Level 2 inputs. In contrast, most operating assets are not traded in liquid markets and therefore will need to be valued using Level 3 inputs.

2-40.

Market approach: As the name implies, this approach directly or indirectly uses prices from actual market transactions. Sometimes, market prices may need to be transformed in some manner in determining fair value. This is approach is applicable to most of the Level 1 or Level 2 inputs. Income approach: Under this approach fair values are measured by discounting future cash flow (or earnings) expectations to the current period. Current market expectations need to be used to the extent possible in determining these discounted values. Examples of such an approach is valuing intangible assets based on expected future cash flow potential or using option pricing techniques (such as the Black-Scholes model) for valuing employee stock options. Cost approach: Cost approaches are used for determining the current replacement cost of an asset, i.e., determining the cost of replacing an asset’s remaining service capacity. Under this approach, fair value is determined as the current cost to a market participant (i.e., buyer) to acquire or construct a substitute asset that generates comparable utility after adjusting for technological improvements, natural wear and tear and economic obsolescence. Income and cost approached apply to Level 3 inputs.

2-41.

The major advantages are: Reflects current information; Consistent measurement criteria; Comparability; No conservative bias. The major disadvantages are: Lower objectivity; Susceptibility to manipulation; Use of Level 3 Inputs; Lack of conservatism; Excessive income volatility.

2-42.

Historical cost model generates more reliable accounting information, since all numbers are based on actual transaction, i.e. the exact price paid by the company at acquisition; Fair value model is more relevant, as it reflects market participant (e.g., investor) assumptions about the present value of expected future cash inflows or outflows arising from an asset or a liability.

2-43.

Some of the issues that the analyst needs to consider when evaluating fair value accounting are: (1) balance sheet and not income statement is the most important statement under fair value accounting; (2) income under fair value accounting measures change in net assets, it is not a measure of profitability and cannot be used for directly valuing an enterprise; (3) use of fair value assumptions, especially for Level 3 inputs is suspect and must be evaluated for reliability. 2-12

Chapter 02 - Financial Reporting and Analysis

2-44.

Preparers of financial statements must make certain estimates of uncertain outcomes and make judgments about other uncertainties. For example, the company must estimate the amount of accounts receivables that will ultimately prove uncollectible and must assess the probability and amount of losses that are contingent upon some event or outcome. To the extent that these estimates or judgments are not exactly correct, the financial statements can depart from economic reality.

2-45.

Accounting analysis is the process of evaluating the extent to which a company’s accounting numbers reflect economic reality. The process involves a number of different tasks, such as evaluating a company’s accounting risk and earnings quality, estimating earning power, and making necessary adjustments to financial statements to both better reflect economic reality and assist in financial analysis.

2-46.

Accounting analysis involves several interrelated processes and tasks. First, the analyst must evaluate the quality of the financial information. To do this, the analyst should identify and assess key accounting policies, evaluate the extent of accounting flexibility that the preparers had, determine the reporting strategy used by the preparers, and identify and assess any red flags of potential misstatements. Second, the analyst must adjust the financial information based on the findings in the evaluation of the quality of the financial information. Adjustments, while rarely perfect, enhance the quality of the financial information that will be used in the analyst’s models of financial analysis.

2-47.

Accounting distortions are deviations of reported information in financial statements from the underlying business reality. These distortions arise from accounting policy choices, errors in estimation, the trade-off between relevance and reliability, and the latitude in application.

2-48.

Managers have several potential incentives to manage earnings. First, managers that earn bonus payments as a function of reported earnings may manage earnings to maximize their bonus. Second, if the company is subject to debt contract constraints (debt covenants) such as minimum net income, minimum working capital, minimum net worth, or maximum debt levels then the manager might have incentive to manage earnings to minimize the probability that the company will violate any of the debt covenant constraints. Third, the company might choose to manage earnings because of potential stock price implications. For example, managers may increase earnings to temporarily boost company stock price for events such as a forthcoming merger or security offering, or plans to sell stock or exercise options. Managers also smooth income to lower market perceptions of risk and to decrease the cost of capital. Still another stock price related incentive for earnings management is to beat market expectations. Fourth, the company might manage earnings downward to reduce political costs from scrutiny from government agencies such as anti-trust regulators and the IRS. It is very possible that Microsoft employed such a strategy when U.S. officials were contemplating anti-trust charges.

2-49.

There are several popular earnings management strategies. First, managers often adhere to a strategy of increasing income where latitude exists. The motivation is to portray the success of the company more favorably. Second, managers might take a big bath. This strategy involves taking all discretionary losses in the current period. As a result, net income in the current period is very low but future income is increased. The period chosen to take a bath is usually one with poor performance even before recognition of the additional losses. Third, managers might follow a 2-13

Chapter 02 - Financial Reporting and Analysis

strategy of income smoothing in which slightly higher than usual earnings are reduced in line with the trend of earnings and slightly lower than usual earnings are increased in line with the trend of earnings. 2-50.

Earnings management is the “purposeful intervention by management in the earnings determination process, usually to satisfy selfish objectives” (Schipper, 1989). Incentives to manage earnings are created by contracts tied to accounting numbers, stock price effects of reported accounting numbers, and government scrutiny based on reported accounting numbers.

2-51.

Different persons use accrual accounting information and cash flow information to varying degrees in their valuation models. Accrual accounting information is often used in valuation models based on price to earnings multiples, market to book multiples, and abnormal accounting earnings-based valuation models. Cash flow information is used in such models as discounted dividend and discounted cash flow models.

2-52.

Accounting concepts and standards are subject to individual judgments and incentives in the promulgation process. Accounting regulation is proposed by accounting regulators and then commented upon by the financial reporting community. Respondents have incentives to get the final standard to conform to their economic desires. As a result, the standards themselves are ultimately a product, at least in part, of these incentives. Likewise, when statements are prepared the preparer has certain choices among alternative accounting policies and has to make estimates of uncertainties. All of these choices and estimates can be influenced by incentives faced by the parties making the choices.

2-53.

An investor would not be willing to pay as much for a stock, on average, when the accounting information provided to him/her about the firm is unaudited. The reason is that the investor must price protect him/herself against the integrity of the information. That is, the investor must be conservative since he/she is assuming the risks inherent in the business and the risk that the information that they are using is not fairly presented in conformity with generally accepted accounting principles (and specifically portrays a more favorable performance and financial position than economic reality).

2-54.

The "quality" of earnings of an enterprise is a measure of the degree of care and unbiased judgment with which they are determined, the extent to which all important and necessary costs have been provided for and the variability which industry conditions subject these earnings to. Analysts must assess the quality of earnings in order to render them comparable to those of other enterprises. The quality of earnings depends, among other factors, on: (1) The degree of conservatism with which the estimates of present and future conditions are arrived at. That is, the degree of risk that real estimates or assumptions may prove over-optimistic or downright unwarranted and misleading. (2) Management's discretion in applying GAAP. This requires the analysis of discretionary and future directed costs. (3) The relation between earnings and business risk. The stability and the growth trend of earnings as well as the predictability of factors that may influence their future levels. 2-14

Chapter 02 - Financial Reporting and Analysis

2-55.

Discretionary costs are outlays which management can vary to some extent from period to period in order to conserve resources and/or to influence reported income. Two important categories of discretionary costs are repairs and maintenance and advertising. Discretionary costs are readily subject to manipulation by management who may desire to present a good earnings picture when operational performance is poor in fact. The analyst should realize that an excessive "savings" in the discretionary costs in the current year will inevitably affect future earnings adversely.

2-56.

The carrying amounts of most assets appearing in the balance sheet ultimately enter the cost streams of the income statement. Therefore, whenever assets are overstated, the income, both present and cumulative, is overstated because it has been relieved of charges needed to bring such assets down to realizable value. The converse should also hold true, that is, to the extent to which assets are understated, the income, current and cumulative, is also understated. For similar reasons as above, an overstatement of income can occur because the latter is relieved of charges required to bring the provision or the liabilities up to their proper amounts. Conversely, an overprovision of present and future liabilities or losses results in the understatement of income or in the overstatement of losses.

2-57.

The assets and liabilities of an enterprise hold important clues to an assessment of both the validity and the quality of its earnings. Thus, the analysis of the balance sheet is an important complement to the other approaches of income analysis discussed in the book. The importance we attach to the amounts at which assets are carried on the balance sheet is due to the fact that, with few exceptions such as cash and land, the cost of most assets enters ultimately the cost stream of the income statement. Thus, we can state the following as a general proposition: Whenever assets are overstated the income, both present and cumulative, is overstated because it has been relieved of charges needed to bring such assets down to realizable values. Similarly, an understatement of provisions and liabilities will result in an overstatement of income because the latter is relieved of charges required to bring the provision or the liabilities up to their amounts. For example, an understatement of the provision for income taxes, product warranties, or pension costs means that income, current and cumulative, is overstated. Conversely, an overprovision for present and future liabilities or losses results in the understatement of income or in the overstatement of losses. Provisions for future costs and losses which are excessive in amount represent attempts to shift the burden of costs and expenses from future income statements to that of the present. Bearing in mind the general proposition regarding the effect on income of the amounts at which assets and liabilities are carried in the balance sheet, the critical analysis and evaluation of such amounts represents an important check on the validity of reported income.

Chapter 02 - Financial Reporting and Analysis

2-58.

The concept of earnings quality is so broad that it encompasses many additional factors that can make earnings more reliable or more desirable. These external factors include: • The effect of changing price levels on the measurement of earnings. In times of rising price levels the inclusion of "inventory profits" or the understatement of expenses such as depreciation lowers in effect the reliability of earnings and hence their quality. • The quality of foreign earnings is affected by factors such as difficulties and uncertainties regarding the repatriation of funds, currency fluctuations, the political and social climate as well as local customs and regulation. With regard to the latter, the inability to dismiss personnel in some countries in effect converts labor costs into fixed costs. • Regulation provides another example of external factors that can affect earnings quality. For example, the regulatory environment of a public utility can affect the quality of its earnings if an unsympathetic or even hostile regulatory environment causes serious lags in obtaining rate relief. • The stability and reliability of earnings sources also affect earnings quality. Defense-related revenues can be regarded as nonrecurring in time of war and affected by political uncertainties in peacetime. • Finally, some analysts regard complexity of operations and difficulties in their analysis (e.g., highly diversified companies) as factors that negatively affect the quality of earnings.

2-59.

Analysts must be alert to accounting distortions. Some of the most common and most pervasive manipulative practices in accounting are designed to affect the presentation of earnings trends. These manipulations are based on the assumptions, generally true, that the trend of income is more important than its absolute size, that retroactive revisions of income already reported in prior periods have little, if any, market effect on security prices and that once a company has incurred a loss, the size of the loss is not as significant as the fact that the loss has been incurred. These assumptions and the propensities of some managers to use accounting as a means of improving the appearance of the earnings trend has led to techniques which can be broadly described as "earnings management." The earnings management process so as to distinguish it from outright fraudulent reporting must meet a number of requirements. This process is a rather sophisticated device. It does not rely on outright or patent falsehoods and distortions, but rather uses the wide leeway existing in accounting principles and their interpretation in order to achieve its ends. It is usually a matter of form rather than one of substance. Consequently, it does not involve a real transaction (e.g., postponing an actual sale to another accounting period in order to shift revenue) but only a redistribution of credits or charges among periods. The general objective is to moderate income variability over the years by shifting income from good years to bad years, by shifting future income to the present (in most cases presently reported earnings are more valuable than those reported at some future date) or vice versa.

2-60.

Earnings management may take many forms. Listed here are some forms to which the analyst should be particularly alert: • Changing accounting methods or assumptions with the objective of improving or modifying reported results. For example, to offset the effect on earnings of slumping sales and of other difficulties, Chrysler Corp. revised upwards the assumed rate of return on its pension portfolio, thus increasing income 2-16

Chapter 02 - Financial Reporting and Analysis

• •

2-61.

significantly. Similarly, Union Carbide improved results by switching to a number of more aggressive accounting alternatives. Misstatements, by various methods, of inventories as a means of redistributing income among the years. The offsetting of extraordinary credits by identical or nearly identical extraordinary charges as a means of removing an unusual or sudden injection of income that may interfere with the display of a growing earnings trend.

There are powerful incentives at work, which motivate companies and their employees to engage in income smoothing. Companies in financial difficulties may be motivated to engage in such practices for what they see and justify as their battle for survival. Successful companies will go to great lengths to uphold a hard-earned and well-rewarded image of earnings growths by smoothing those earnings artificially. Moreover, compensation plans or other incentives based on earnings will motivate managers to accelerate the recognition of income by anticipating revenues or deferring expenses. Analysts must appreciate the great variety of incentives and objectives that lead managers and, at times, second-tier management without the knowledge of top management, to engage in practices ranging from smoothing to the outright falsification of income. It has been suggested that smoothing is justified if it can help a company report earnings closer to its true "earning power" level. Such is not the function of financial reporting. As we have repeatedly seen in this work, the analyst will be best served by a full disclosure of periodic results and the components which make these up. It is up to the analyst to average, smooth, or otherwise adjust reported earnings in accordance with specific analytical purposes. The accounting profession has earnestly tried to promulgate rules that discourage practices such as the smoothing of earnings. However, given the powerful propensities of companies and of their owners and employees to engage in such practices, analysts must realize that, where there is a will to smooth or even distort earnings, ways to do so are available and will be found. Consequently, particularly in the case of companies where incentives to smooth are likely to be present, analysts should analyze and scrutinize accounting practices in order to satisfy themselves to the extent possible, regarding the integrity of the income-reporting process.

Chapter 02 - Financial Reporting and Analysis

EXERCISES Exercise 2-1 (10 minutes) a. Perhaps the most important disadvantage of complete uniform accounting is that it would be inflexible and, if nationally or internationally adopted, it would be exceedingly difficult to change and to utilize new ideas. In short, total uniformity might freeze the state of accounting at its current level of development. Second, complete uniformity might stifle new approaches and ideas. This would be particularly true from the technical approach to accounting (as contrasted with the economic and business approaches). Third, entirely uniform accounting might not be appropriate for all industries and all countries. Different countries have different economic objectives. For example, uniformity in accounting is more desirable in France where economic planning is important than in Germany, where the long-term trend in accounting has been toward less uniformity. Furthermore, the same accounting system may not be appropriate for the utility industry as opposed to railroads. Accounting must in some respects be tailored to the nature of the business. Fourth, an additional problem is that total uniformity in accounting would be difficult and expensive to implement. Accountants and regulatory authorities would disagree on the standardized form, and small firms would have difficulty shouldering the cost of adopting the full standardized form.

b. Uniform accounting does not necessarily mean comparability. Uniform accounting can mean (a) uniform classification of accounts (a classification system), (b) a uniform plan (a system of procedures), or (c) total uniformity. The latter would not seem to be desirable in view of the different characteristics of different businesses. For example, different pieces of equipment may have different lives and should be depreciated accordingly. Different mines have different expected reserves and should be depleted accordingly. Different lists of receivables have different quality, and bad debts reserves should accordingly vary. It would seem very unfair and inadvisable to apply the same depreciation rate, the same depletion rate, and the same bad debts reserves for all companies regardless of the nature of their businesses. Thus, comparability might include uniform classification of accounts and a uniform plan but not total uniformity.

Chapter 02 - Financial Reporting and Analysis

Exercise 2-2 (10 minutes) a. Market prices usually will appropriately increase or decrease in advance of an earnings announcement. For example, stock prices usually rise in advance of a strong earnings report and fall in advance of a weak earnings report. This happens as the market receives information that suggests strong or weak earnings. b. There are many types of information that might be received in advance of earnings announcements. For example, the market can receive signals about the strength of macroeconomic conditions, conditions in the industry, and the relative strengths or weaknesses of sales of the company’s products. All of these indicators can contain information about the ultimate strength of the company’s earnings. Of course, there are a limitless number of such signals available that can be used to predict earnings with some accuracy. c. The relatively small reaction after the formal announcement represents the market updating the price to account for the difference between the expected earnings based on prior information and the actual earnings report.

Exercise 2-3 (10 minutes) a. Summary earnings information is released well in advance of release of the annual report. As a result, when the financial statements are released, the market via the earlier earnings announcement already knows the bottom-line earnings number. b. Release of the income statement does contain additional information for the market because the income statement has much more line item revenue and expense detail than does the earnings announcement.

Exercise 2-4 (10 minutes) Quarterly financial reports are subject to seasonal differences. It is not always meaningful to compare for example, the third and fourth quarters for a couple of reasons. (1) Companies might have seasonal sales (consider retailers and the holiday season for example). (2) Companies tend to make most of their large, annual accruals and adjustments in the fourth quarter of the fiscal year. These are the two factors to keep in mind when using quarterly financial information.

Chapter 02 - Financial Reporting and Analysis

Exercise 2-5 (10 minutes) a. Form 10-K (Annual Report) b. Regulation 14-A (Proxy statement) c. Regulation 14-A (Proxy statement) d. Regulation 14-A (Proxy statement) e. Form 10-Q (Quarterly Report) f. Form 8-K (Current Report) g. Prospectus Exercise 2-6 (15 minutes) Several penalties can be imposed upon a manager that contemplates or perpetrates fraudulent revenue recognition. First, the auditors may identify the fraudulent revenue and refuse to issue an unqualified opinion on the financial statements. When this occurs, the managers often relent and correct the misstatement. If the auditor is unable to force a correction, the auditor will either quit or be forced to issue an adverse opinion. Second, the Securities and Exchange Commission may force the manager to restate the financials. This action often results in a stock price drop and questions about the integrity of the manager in the managerial labor market. The SEC may also fine the manager or even prosecute the manager criminally. Third, corporate governance exists to limit the ability of managers to misstate the financial statements. For example, the Board of Directors will form an audit committee that will oversee the audit of the firm. In addition, the Board of Directors will usually hire and oversee internal auditors that should search for such misstatements. Last, but certainly not least, the manager and/or the firm may face litigation as a result of misstatements.

Exercise 2-7 (10 minutes) a. Yes, the manager is likely to voluntarily disclose this early to lessen the probability of a resulting lawsuit. b. Yes, the manager is likely to voluntarily disclose this early to adjust earnings expectations downward. c. The manager is less likely to voluntarily disclose this early because it is good news. Usually managers would prefer to simply exceed expectations with the actual announcement of unexpectedly favorable news. d. Yes, the manager is likely to voluntarily disclose this to adjust earnings expectations downward in line with his/her lower expected earnings. e. Management might voluntarily disclose this under the signaling hypothesis. The signal that the manager would hope to convey via voluntary disclosure is that the market appears to be undervaluing the firm. 2-20 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 02 - Financial Reporting and Analysis

Exercise 2-8 (15 minutes) a. The primary advantage of financial statements over analysts’ forecasts is that financial statements are reliably prepared according to a known set of generally accepted accounting principles. The analysts’ forecasts are the result of the analysts’ individual beliefs and calculations. Thus, they can be arrived at using an infinite number of models. For example, analysts’ forecasts are believed to be biased towards understating earnings. b. Analysts’ forecasts have advantages over financial statement information. First, they are timelier. The analyst can revise the forecast as soon as news is received. Financial statements will only reflect this information the next time they are issued. Also, analysts’ forecasts can consider additional signals that aren’t captured by financial accounting such as the hiring of talented employees or changing economic conditions. Last, analysts’ forecasts are forward looking. Financial statements are only backward looking. c. Analysts’ forecasts and financial statements are interrelated because financial statements are usually a major input into the analysts’ forecasting process. Analysts use the backward looking financial statements to help them predict future results and financial position. Also, since analysts are a significant user group, the input of analysts is important when accounting principles are formulated. Thus, analysts have a role in the generation of financial statements.

Exercise 2-9 (15 minutes) a. Historical cost accounting measures assets and liabilities at the original cost at which they were transacted at. Fair value accounting measures assets and liabilities at their fair value (market value) on the date of the balance sheet. Under historical cost accounting entries are made only when an actual transaction arises, under fair value accounting measurements are updated on periodically even in the absence of explicit transactions. b. Advantages of fair value accounting are: it reflects more current valuation f assets/liabilities, uses a consistent measurement criteria for all assets and liabilities, enhances comparability across firms and time and is useful for equity analysis because it eschews conservatism. The disadvantages of fair value accounting are that it is less reliable and objective and increases susceptibility to manipulation especially when Level 3 inputs are used, it is less useful for credit analysis since it removes conservatism, and income under fair value accounting is excessively volatile and does not reflect underlying operating profitability. c. Financial assets and liabilities more readily lend themselves to fair value accounting. This is because they are homogenous and are generally traded in

Chapter 02 - Financial Reporting and Analysis

d. liquid markets with observable prices. It is more difficult to visualize a situation when operating assets, especially fixed assets and intangible assets are measured at fair value. For such assets it is necessary to use Level 3 inputs to a large extent, and such usage will decrease the reliability and objectivity of accounting information. e. Under fair value accounting, income largely becomes a number that represents the net change in the fair value of assets and liabilities. This number will be very volatile because of movements in the fair value of long-term assets and liabilities. Because of this, income measured under fair value accounting will cease to measure the underlying profitability of an enterprise, which is one of the central quests in financial statement analysis. Exercise 2-10 (20 minutes) a. Accrual accounting income statements are more useful for analyzing business performance than cash flow based statement for a number of reasons. The reasons pertain to the matching and timing problems inherent in cash flow based statements. Accrual based information attempts to recognize revenues when earned and match the related costs against the revenues. This is a reflection of the performance for the month. Cash inflows may or may not occur in the period that the benefits are earned. Likewise, cash outflows may or may not occur in the appropriate period to be matched against the related revenues. As a result, performance measures can be greatly skewed and misleading. Also, accruals have some information value. We can gain some insight by assessing management’s estimate of future losses such as bad debts. Last, cash flow performance can be manipulated easily by management. For example, if the manager wants to show better performance on a cash basis, he/she will simply delay the payment of expenses until the first day of the next accounting period. b. The asset side of a cash flow based balance sheet would simply be cash. This is because we make no accruals. As a result, fixed assets would be expensed when paid for rather than being capitalized and depreciated. Likewise, accounts receivables would not be accrued. We would simply recognize revenue when cash is received. The cost of inventory would also be expensed in the period that the inventory is purchased. The asset side of an accrual balance sheet is, of course, much more informative. It would contain items of value like inventory, accounts receivable, and fixed assets. c. Cash flow information is reliable because it involves no estimates, judgments, or choices by the preparer of the information. Instead, the amounts are based on verifiable cash receipts and cash payments. However, this cash flow based information is not always relevant for decision-making purposes. For example, a measure of performance based on cash flows is highly variant and not a great indicator of future cash flows. However, performance measures

Chapter 02 - Financial Reporting and Analysis

d. using accrual accounting such as net income are more relevant. These measures, with revenues recognized when earned and costs matched to the revenues, are useful data for assessing past performance and predicting future cash generating capacity. Thus, the information is more relevant than cash flow information. Exercise 2-11 (10 minutes) a. Analysts’ forecasts are often more relevant than financial statement information for a couple of reasons. First, the forecasts are more timely in that they are often updated based on new information. Financial statements are only issued quarterly. Also, analysts’ forecasts can impound information not impounded in financial statements such as beliefs about future macroeconomic changes. Last, analysts’ forecasts are forward looking. Financial statement information is backward looking. b. Analysts’ forecasts are generally not as reliable as financial statements for a couple of reasons. First, financial statement information is based on verifiable transactions and economic events. Second, financial statements are prepared based on a known set of generally accepted principles. Analysts’ forecasts are the product of the analyst’s model, which may or may not be known to the user. Also, empirical research has shown that, on average, analysts’ forecasts are often biased down. That is, actual earnings are, on average, higher than analysts’ forecasts creating positive earnings surprises. Exercise 2-12 (15 minutes) First, the principles underlying accounting information may not be entirely reflective of economic reality. For example, long-lived assets are reported at historical cost less accumulated depreciation. Asset value appreciation is not recognized. As a result, the carrying value of long-lived assets is often not reflective of fair value (economic reality). Also, accounting standards do not allow for the recognition of internally generated goodwill. As a result, the company can be worth far more than the reported book value due to internally generated goodwill that is not recorded in the accounts. Second, preparing accounting information requires certain judgments and estimates. The actual outcome may or may not equal the estimate. As a result, economic reality may differ from the reported accounting information. For example, a company estimates the amount of obsolescence present in inventory at the end of an accounting period. The actual obsolescence (economic reality) may be greater or less than the amount estimated.

Chapter 02 - Financial Reporting and Analysis

Third, the relevance / reliability trade-off causes differences between reported accounting information and economic reality. For example, consider a firm that is facing a large lawsuit. The amount of the loss will be estimated and disclosed if the probability of loss is high, the amount of the potential loss is significant, and the amount of the ultimate loss can be estimated. If the amount of a loss cannot be estimated, the liability will not be reported on the balance sheet. As a result, economic reality is not reflected in the accounting information. A fourth reason why accounting information might deviate from economic reality is the latitude that managers have in preparing the information. Managers often use this latitude opportunistically. For example, firms often overstate the amount of certain liabilities such as restructuring charges. These overstated liabilities are then used in the future to increase net income. The overstated liabilities cause differences between economic reality and reported accounting information.

Exercise 2-13 (10 minutes) a. A “cookie-jar” reserve is created in the reserve for bad debts and obsolete inventory by overstating the expected amount of future uncollectible accounts and inventory that is not salable. Overstating the amount of future loss creates hidden reserves in certain liabilities. b. In future periods, these overstated reserves can be used to increase earnings. For example, in a period of soft sales, net income can be increased by making a smaller than necessary accrual for bad debts or obsolete inventory. Some past accrual can even be reversed. Likewise, these certain liabilities can be reversed or simply debited for certain expenses rather than an expense account. Exercise 2-14 (10 minutes) a. Overstated loan loss reserves can be used to manage earnings in the future. As a result, banks often choose to overstate future losses as part of a “big bath” accounting strategy. b. In future years, if net income is somewhat less than expected, it can be increased by recognizing less loan loss expense than usual. This is possible because the reserve will still be adequately large since it was overstated in an earlier year.

Chapter 02 - Financial Reporting and Analysis

PROBLEMS Problem 2-1 (15 minutes) The standard setting process is of great relevance to the financial analyst because it provides insight into the final product of this process, i.e., accounting standards. The financial analyst, in order to analyze financial statements intelligently, must have a sound understanding of the standards that underlie the preparation of these financial statements. Since financial accounting standards are the result of the standard setting process, the nature of this process affects the soundness and the lack of ambiguity of the standards. The standard-setting process is at risk to subversion by special interests and by standard setters trying to accommodate all. For example, if standards are written in such a way so as to satisfy different conflicting interests then they are likely to be "soft," i.e., subject to a wide variety of interpretations. That, in turn, can lead to practice that avoids the letter as well as the spirit of the standard.

Problem 2-2 (15 minutes) a. Neutrality lies at the heart of reliability--it implies accounting devoid of ulterior motives and devoid of interests other than that of objective and fair presentation and reporting. It is even-handed with respect to the impact of the information on user's behavior. b. Examples are when accounting slants presentations so as to make financial statements present a financial position in a way superior to that which exists or to present results of operations more favorable than were in fact achieved. The motives for such presentations that lack in neutrality relate to the parties’ selfinterests. Cases can be readily drawn from news media such as Business Week.

Problem 2-3 (20 minutes) a. Under current generally accepted accounting standards, measurement means determination of the cost or net realizable value of an asset or liability. Determining the original cost of an asset, say, in the purchase of land, involves little more than recording the purchase price in most cases. Measuring the fair value of accounts receivable, however, involves estimating how much will ultimately be collected. Here we deal with probabilities based on experience, and this is a different level of precision in measurement.

Chapter 02 - Financial Reporting and Analysis

Problem 2-3—continued b. Many analysts seem to be offended by the precision implied in the accountant's use of the word "measurement." Equity analysts want the measurement to have a link to or relevance to the ultimate valuation by the market place. This is, however, an altogether different level of measurement and estimation. Analysts may start with accounting measurements but they must build on their assessments of how the market will (1) adjust these accounting measurements to its perceptions of relevant valuation factors and (2) value these, e.g., determine what price-earnings ratios they will accord to the adjusted earnings. c. The two measurement objectives are different. Accountants lay no claim to engaging in valuation. They merely provide the raw material for this process. Accounting measurements aim to estimate the most probable cash flows that will ultimately be realized from an asset or be devoted to the repayment of a liability. Measurement is only selectively concerned with the time value of money. Analysts seek measurements that are relevant to the valuation of the aggregate business enterprise in the context of the market place. Measurement is concerned with the timing of these cash flows and their valuation. In many cases, as a practical matter, it is concerned with the capitalization of the most relevant earnings number. The analyst's measurement starts with that of the accountant and builds on it.

Problem 2-4 (20 minutes) a. Pure rules of measurement are possible only when the process of measuring is scientific, objective, and generally incontrovertible. In accounting, rules of measurement cannot be "sold" to those who have to live with them solely on that basis. These rules must be made acceptable to a majority of those who must abide by them. It is this requirement that gives them the character of rules of conduct to be abided by. To many, abiding by such rules may involve sacrifices. Hence, the need for acceptability as well as fairness. b. The process by which acceptability is secured is basically a political process. It requires that those whose concurrence is sought be involved in the decision process, have a voice in the consideration of alternatives, be persuaded that compromises which have to be reached are fair, and recognize the theoretical soundness of the proposed solution. Purists would argue that accounting is a science and that solutions to questions of accounting standards should be arrived at by the "scientific method" of observation, experimentation, and verification. In the final analysis, accounting is more of a service activity than a service governed by natural law. To the extent that accounting is a science, it is a social science subject to the mores of the society of which it is part. 2-26 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 02 - Financial Reporting and Analysis

Problem 2-5 (20 minutes) a. Society has brought increasing pressure to bear on accountants in its desire to improve the efficiency with which its assets are priced and its capital investment directed. It has also chosen to exploit the notion that corporation activity is an appropriate point at which to extract taxes from the economy and control economic activity. Aspects of pressure on accountants include the increasing role of securities commissions requiring "full disclosure," the emergence of class action suits, the growing taxation bureaucracy, and the increasing literacy of the populace, including the press, corporate clients, and securities analysts. Indeed, society's developing objectives have made the practice of accounting and auditing increasingly demanding, if not hazardous. Recent reports and hearings by congressional committees are part of society's pressures on accountants so that it is better served. b. Accountants' accommodation consists mainly of educating the profession and the public and enlarging the professional membership. Standards boards and research committees are sometimes viewed as devices to protect accountants by providing them an authority with which to counter and modify the thrusts of society. The accounting profession can enhance its position and at the same time improve its service to society by insisting that, while numbers are not possible without definitions, by recognizing the uniqueness of each enterprise, qualifications and descriptions enhance meaning and reduce possibilities for abuse of numbers and generally applied definitions. The organized profession's response to congressional action has been to organize politically as well as to promote and promise self-reform. Among these measures are the establishment of a Public Oversight Board by the AICPA, and the establishment of Peer Review as well as the institution of continuing Professional Education. (CFA Adapted)

Chapter 02 - Financial Reporting and Analysis

Problem 2-6 (20 minutes) a. In accounting, conservatism states that when choosing between two solutions, the one that will be least likely to overstate assets and income should be selected. The two main advantages of conservatism are that (1) it naturally offsets the optimistic bias on the part of management to report higher income or higher net assets; and (2) it is important for credit analysis and debt contracting because creditors prefer financial statements that highlight downside risk. b. The standard setters opinion arises because conservatism violates the “neutrality” requirement of accounting and therefore purportedly reduces reliability. However, one could argue that neutral standards suffer from an optimistic bias because of managers propensity to overstate income and/or net assets. By counteracting this inherent optimistic bias one could argue that conservatism actually increases neutrality in financial reporting. c. An equity analyst may prefer a neutral accounting model, like fair value accounting, because equity analysis seeks to also determine upside potential that is not reported in conservative statements. Credit analysts, however, obviously prefer conservative presentation of financial statements. d. Many analysts and investors (Warren Buffet) believe that conservative accounting is high “quality” accounting. However, conservatism can reduce accounting quality in many instances. For example, many managers write-off assets through aggressive use of one-time charges. This reduces the information content of the financial statements and allows managers to report excessively higher income in future periods. e. The two forms of conservatism are unconditional conservatism and conditional conservatism. Unconditional conservatism refers to understatement of assets without regard to the underlying economics, such as not capitalizing R&D. Conditional conservatism refers to a conservative presentation of economic events by recognizing the future effects of bad news immediately but deferring the recognition of good news. For example, an asset impairment is immediately recognized but an increase in asset values is only gradually recognized through future revenues and cash flows as they arise. Problem 2-7 (25 minutes) a. The business observer's view is certainly skeptical, bordering on cynical. Also, there is a good deal of misunderstanding regarding the function of generalpurpose financial reports in what he says. It also appears that the observer is confusing the function of the corporate controller (management accountant) with that of the independent public accountant whose function it is to probe and to reveal.

Chapter 02 - Financial Reporting and Analysis

While we have come a long way from the time when almost any financial disclosure was viewed as the giving away of competitive information, there remains a great deal that is not disclosed primarily for competitive reasons. Present-day financial disclosure requirements do not require details about the physical composition of inventories or the identification of specific slow-paying customers. Much additional information which analysts may view as essential need similarly not be disclosed. It is this lack of requirements rather than the accountant's subservience to management that represents the main reason why such information is rarely found in published financial reports. That independent public accountants, whose primary function it is to serve the public interest, are sometimes unduly influenced by management's desires is well known and a problem much in the forefront of public discussion today. (See examples in Appendix 2A and elsewhere in the book.) However, the degree of public disclosure necessary is a matter of public policy, which is importantly influenced by the SEC. The day is long past when accountants were the sole setters of disclosure policy. For reasons of competition, cost, and other considerations, it is unlikely that all information desired by financial analysts will ever be provided in general purpose public reports. Consequently, this will remain an area where analysts will have to exercise their information-gathering ingenuity to the fullest extent. Much additional information of a statistical nature is often available on request. b. The omitted information which the business observer is referring to is the type every serious financial analyst would like to get as much as possible of to assess the risks inherent in a business enterprise as well as the rewards which can be expected from it. Such quantified data as product sales breakdowns, inventory composition, and customer-paying records are indeed data needed by any good management in the conduct and planning of business operations. While analysts will not find these data in most financial statements, they attempt to obtain them, if they need them, from management or from other sources. In a report based on a survey of financial reports, the Financial Analysts Federation's corporate information committee listed the following most prevalent problem areas: • Lack of detail in production costs and marketing types of information. • Lack of non-statement detail, such as labor costs or contracts, pension information, regulations, etc. • Limited discussion on economic and industry developments that represent current or recent problems, unusual developments or facts not generally available to average investors or shareholders. • A need for more disclosure of operating statistics already on file with regulatory agencies.

Chapter 02 - Financial Reporting and Analysis

A very important source of narrative as well as quantified information which is available is "Management's Discussion and Analysis of Financial Condition and Results of Operations" which, because of specific SEC requirements, must contain significant and meaningful information.

Problem 2-8 (15 minutes) The logic underlying the “new paradigm” argument is intuitively appealing. Indeed, the future earning potential of many of these companies is based on assets that aren’t recognized on accounting balance sheets under GAAP. For example, these companies invest heavily in research and development, which is expensed. As a result, net income and assets are quite low. Since the market is valuing the stock highly, both the price to earnings and price to book ratios are high. However, new paradigm proponents would argue that this is because the base is too low. The future earning potential is very high. Opponents argue that valuations must ultimately be supported by positive earning ability and they don’t believe that these great earnings will materialize given the competitive nature of the high-tech business environment. Further, they argue that “new paradigm”-type arguments are not new. Similar statements were made with all of the great financial “bubbles” of the past. The valuations of these firms is simply momentum investing that is far beyond the fundamental value of the firm given future earnings potential and probabilities of future earnings. Who is right? At the time of this writing, that is the most debated question on Wall Street and Main Street. There are certain intuitively appealing aspects to arguments on both sides. There is some historical data that supports the view of opponents. Future empirical researchers will spend great energy answering, in retrospect, which argument was more correct. For now, one person’s opinion is no better than another. Problem 2-9 (10 minutes) a. While the above argument appeals to intuition, it is unworkable. We need a method of profit determination on a periodic basis and we cannot liquidate the business every time a profit measurement is needed. b. The most practical solution is the diligent and impartial application of the accrual method of accounting measurement. The assumptions underlying accrual accounting are important to bear in mind as one uses accrual accounting information. For example, accrual accounting assumes that the company can continue as a going concern so that the business will be around to realize the conversion of accrued amounts to cash.

Chapter 02 - Financial Reporting and Analysis

Problem 2-10 (10 minutes) The production company will be providing accounting information in this special setting. The information that is provided should be useful in deciding whether the movie investment is worthwhile and must be somewhat reliable. a. The film makers should provide a description of the story or even make the script available. The name of the key production personnel such as producers and directors should be disclosed along with information about past work. Key employees should also be listed including any signed cast members. Also, investors should receive reliable cost projections related to the movie production. This information would enable potential investors to make assessments about the revenue potential of the movie and the expected cost of production. b. The prospectus should provide information to enhance the credibility of the information. For example, a complete list of the relevant past works of the producers, directors, and cast members should be provided. Any relevant education and training history for the producers and directors would be useful as well. If available, revenue figures from the past works of the producers, directors, and prominent actors and actresses (the individuals who are most directly related to the revenue potential of the movie) should be provided. This is some evidence to support claims that the production team is able to produce work that produces revenues. The movie cost projections should be classified by major cost type to lend credibility to the overall cost projections. Problem 2-11 (15 minutes) a. Discussion of the role the following parties should play in standard setting: 1. The FASB should be the most important component of the guideline promulgation process. The Board has the knowledge to produce rules that are the best solution to information needs of the capital markets. Their conclusions must be grounded in accounting and finance theory and produced independent of political or other pressures. 2. The SEC should oversee the FASB to ensure that the Board is continuing to successfully fulfill its role as an independent rule-making body working in the best interests of the accounting profession. 3. The AICPA should ensure that the FASB is comprised of highly qualified professionals and is continuing to successfully fulfill its role as an independent rule-making body working in the best interests of the accounting profession.

Chapter 02 - Financial Reporting and Analysis

4. Members of Congress are subject to great pressures from important constituencies. Thus, Congress should be kept largely out of the rule-making process. However, this is difficult given the hierarchy that empowers the SEC, the AICPA, and ultimately the FASB to make the rules. 5. Company CEO’s should continue to diligently provide input to the FASB regarding existing rules and regarding proposed new rules. The FASB, in turn, should value the input of the CEO’s greatly and use this input as they finalize the rules. 6. Much like the executives of companies, accounting firm partners should remain active in the rule-making process by providing the FASB valuable input on existing rules and proposed new rules. Again, the FASB should heed the input of the accounting firms. 7. Investors should play an active, if not the most active, role in accounting standard setting. Investors are the ‘end-users’ of financial accounting reports, and, as such, should have the most input into the promulgation of standards. However, investors’ knowledge of the ramifications of accounting standards and the cost to implement new standards may not be of the best quality. b. Company executives diligently pressured Congress to intervene and ensure the FASB does not pass a rule requiring the expensing of the fair value of stock options. The pressure apparently worked. In the end, the FASB passed a compromise rule that suggests but does not require expensing the value of options. Problem 2-12 (25 minutes) a. Yr 9

Yr 8

Yr 7

Yr 6

Yr 5

Yr 4

Net income per share Price per share

1.04a 2.07 1.57 0.91 1.04 1.22 32.375 39.312 28.375 14.625 16.125 24.375

Operating cash flow per share

Price per share

2.47b -0.86 3.76 1.23 0.99 0.62 32.375 39.312 28.375 14.625 16.125 24.375

Net cash flow per share Price per share

0.00c -2.79 2.34 0.35 -0.46 -0.03 32.375 39.312 28.375 14.625 16.125 24.375

Free cash flow per share Price per share

0.91d -2.41 3.19 0.82 0.07 0.14 32.375 39.312 28.375 14.625 16.125 24.375

a: (31.2/30.1) b: (74.3/30.1) c: (0.03/30.1) d: (27.5/30.1)

Chapter 02 - Financial Reporting and Analysis

b. The net income per share figure best explains stock price. As you can see from your graph, the graph of these two values across time is almost parallel. c. Solutions depends on the company and data collected.

Problem 2-13 (10 minutes) The wording in management’s discussion and analysis of Marsh suggests that the company decided to “take a big bath” in conjunction with the recognition of the large charge related to the implementation of FAS 121. Marsh believes that the additional charges taken in the quarter will be perceived less unfavorably by the market than if they had each been recorded in separate quarters. Now the company has recognized all of its losses. These items are no longer looming as losses that need to be recognized. Thus, in the future, net income will be higher. Problem 2-14 (10 minutes) a. Earnings smoothing b. The earnings record of Emerson reflects primarily a core business that is very stable in nature. Also, excellent management has contributed to the ability of the company to report this impressive string of earnings increases. Lastly, earnings management has had to be used to report the unfailing string of earnings increases. Despite the solid management team and the stable core businesses, it would be very difficult for a company to achieve this record without some earnings management. c. In good years, Emerson likely records especially large expense accruals related to estimate future losses. In bad years, the company simply records an amount of expense accrual at the lower end of the acceptable range. By doing this, the company is able to manage earnings to some extent.

Chapter 02 - Financial Reporting and Analysis

d. In Y5, the company barely beat Y4 earnings (less than 1% increase). It is possible that the company needed to draw upon hidden reserve to beat the Y4 total. Again, in Y8, the company only beat the prior year by 1.9%. The company may have needed to use earnings management to bring earnings above the Y7 total. In Y13, the company beat the previous year by about 3%. Again, earnings management may have been needed to lift earnings that year. There are several years when earnings were much higher than the previous year (e.g., 2, 6, 11, 16, 17, 18, 19, 20). In these years, the company likely created hidden reserves by recognizing larger loss estimates.

Problem 2-15 (10 minutes) The “nail soup” analogy is attention grabbing and uses imagery to make an interesting point. However, most do not agree with the fundamental point asserted. It is true that accruals have a discretionary component and other estimation errors built into it. To the extent that managers use this discretion opportunistically, the accruals can create some distortion in financial reporting. However, the positive information provided by accruals is of much greater benefit than the distortion created by accruals. To illustrate this, see the graphs in Problem 2-11. Problem 2-16 (15 minutes) a. Most agree with the statement. Accruals do, in fact, have disadvantageous properties such as providing an opportunity for some manipulation. However, to ignore them because of a slight imperfection is not prudent. b. Accrual accounting information provides a better measure of performance because accruals eliminate the timing and matching problems of revenues and expenses. As a result, accrual-based net income is very useful in assessing the performance of the company and predicting future cash flows. c. Many accruals such as interest expense are largely non-discretionary. As a result, the amount of the accrual is reliable and verifiable. The imperfections of accrual accounting arise from the discretionary nature of certain accruals. These accruals involve predictions about the future that are slightly less reliable because of uncertainty about the future. Thus, accrual-based information may not exactly depict “economic reality.” However, the information is closer to economic reality than if no accruals were recorded.

Chapter 02 - Financial Reporting and Analysis

d. The prudent approach to analysis using accrual accounting information is to review the nature of the accruals for a company. If the company’s management appears to have had many discretionary accruals than this should be considered in the analysis. Discretionary accruals lead to the possibility of lower quality financial reporting. The quality of the information can be enhanced via accounting analysis and recasting certain disclosures to more closely reflect accounting reality.

Problem 2-17 (30 minutes) The quarter ended September 30, 20X9 contains two unusual items. First, the company recorded the effect of a change in the accounting rules related to software development. This change resulted in additional income totaling $68 million (approximately $44 million after tax). Second, the company recorded a gain on sale of receivables totaling $36 million after incremental tax expense. If reported net income is reduced by these amounts, net income is actually less than the third quarter of the previous year. After these adjustments are made, earnings per share is approximately equal to the prior year. Return on equity as reported is 25.3%. This suggests equity totaling approximately $2,561 ($648/.253). If net income is reduced by the $80 million of unusual items, return on equity falls to 22.2%. Again, this would suggest that performance in the current quarter was worse than that of the same quarter in the prior year. Thus, while 22% return on equity is quite good, it is not as good as the reported 25%. Also, the trend would be much less positively sloped.

Chapter 02 - Financial Reporting and Analysis

CASES Case 2-1 (15 minutes) a. The management of Colgate-Palmolive, Inc. is responsible for the preparation and integrity of the consolidated financial statements and related notes that appear in the annual report. This is stated in the Report of Independent Registered Public Accounting Firm. b. Note #2: Summary of Significant Accounting Policies c. The international accounting firm of PriceWaterhouseCoopers, LLP issued an unqualified (clean) opinion on the Colgate financial statements. d. Yes, estimates are used. Estimates).

The company discusses this in note #1 (Use of

Case 2-2 (30 minutes) a. Political influences on accounting are, and remain, strong. The SEC's resistance to the adoption of the preferred successful accounting method was strongly influenced by pressure not only from affected oil companies but also by congressmen from oil-producing states. The bending of rules was narrowly avoided when the commission stood up to the companies and to its staff. Had the SEC acquiesced to this bending of rules in time of stress, accounting integrity would have suffered another blow. b. Tenneco's change in accounting method seems designed to avoid a write-off to income of capitalized production costs that exceed the SEC-defined ceiling which are affected by dropping oil prices. Tenneco had demonstrated how companies could use accounting rules to their advantage. Tenneco's past drilling expenses would be offset against past reported results and would never appear on a current income statement. Those costs will now be matched against revenues earned at a time when oil prices were much higher than at present. While analysts may be able to adjust for the effects of Tenneco's accounting strategy their task in assessing the company's real earning power will be rendered more difficult.

Chapter 02 - Financial Reporting and Analysis

Case 2-3 (60 minutes) (1) The tonnage-of-production method provides an especially good matching of depreciation expense against revenues for Canada Steel's highly cyclical business. A unit-of-production method effectively makes depreciation a variable rather than a fixed cost and, therefore, tends to stabilize earnings. Casting metals is not a high technology business, and actual wear and tear on the equipment is more relevant to replacement need than technological obsolescence. A switch to straight-line would not eliminate the deferred tax liability as this difference is caused by accelerated methods and shorter lives rather than the difference between the tonnage-of-production and straight-line methods. Moreover, Canada Steel should not attempt to extinguish this liability since it is an interest-free loan from the government, which may never have to be repaid as long as new assets are acquired. A switch to straight-line would leverage profits on any production increase (or decrease) because depreciation expense would be a direct function of time rather than units produced. However, the quality of earnings could be reduced by a switch to straight-line inasmuch as this method would accentuate the highly cyclical nature of our business and result in an increased net income volatility. (2) The reasons for adopting the LIFO method--reducing taxes and increasing cash flow--are still valid. Inflation usually declines during recessions, but this does not mean its recurrence is improbable. Maximizing cash flow remains important to the corporation and shareholders. A return to FIFO would relinquish the tax savings of prior years, although it is true that the balance sheet and income statement would be strengthened by the change. The quality of earnings is likely to be affected adversely by the lack of consistency in inventory method (two changes in a period of several years) and a perception that the motive in making the change was to increase book value per share, avoid two consecutive unprofitable years, and escape violation of a loan covenant. The $4 million upward adjustment in working capital is a result of increasing the inventory account by this amount, which has the effect of increasing the current ratio as shown below: LIFO FIFO Current Assets .............................................. $10.5 $14.5 Current Liabilities ......................................... $ 4.5 $ 4.5 Current Ratio ................................................. 2.3 3.2 The $0.5 million increment to net income will offset an operating loss of $0.4 million, which would not be unexpected on a sales decline of 31%. In addition, the $2.0 million addition to shareholders' equity from prior years' profits is likely to be far less significant than current profit trends, as Canada Steel has had to disclose regularly in the footnotes to its financial statements the difference in inventory values resulting from the use of LIFO versus FIFO. 2-37 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 02 - Financial Reporting and Analysis

Case 2-3—continued (3) The inventory change will enable Canada Steel to meet the minimum current ratio requirements. However, the stock repurchase program should not be recommended for the following reasons: a. The proposed repurchase price of $100 per share is well above book value and recent market prices, suggesting dilution for remaining shareholders. b. The potential dividend savings are outweighed by interest costs of $118,800 ($2.0 million x 11% x (1-0.46 marginal tax rate)) to finance the purchase--in other words, leverage is negative. c. The debt-to-equity ratio is increased significantly from 10% ($2.0 million long-term debt/$17.7 million equity + $2.0 million long-term debt) to 35% ($6.1 million long-term debt/$11.4 million equity + $6.1 million long-term debt). An additional $2.0 million of stock repurchased would raise this ratio to 41% ($8.1 million long-term debt/$11.5 million equity + $8.1 million long-term debt). The increased financial risk is particularly inappropriate for an industry with significant sensitivity to the business cycle. Shrinking shareholders' equity under present circumstances is prudent only by sale of fixed assets, not the incurrence of additional debt. In summary, each of the foregoing would have a negative impact on the quality of Canada Steel's earnings.

Chapter 03 - Analyzing Financing Activities

Chapter 3 Analyzing Financing Activities REVIEW Business activities are financed through either liabilities or equity. Liabilities are obligations requiring payment of money, rendering of future services, or dispensing of specific assets. They are claims against a company's present and future assets and resources. Such claims are usually senior to holders of equity securities. Liabilities include current obligations, long-term debt, capital leases, and deferred credits. This chapter also considers securities straddling the line separating liabilities from equity. Equity refers to claims of owners to the net assets of a company. While claims of owners are junior to creditors, they are residual claims to all assets once claims of creditors are satisfied. Equity investors are exposed to the maximum risk associated with a business, but are entitled to all residual rewards associated with it. Our analysis must recognize the claims of both creditors and equity investors, and their relationship, when analyzing financing activities. This chapter describes business financing and how this is reported to external users. We describe two major sources of financing—credit and equity—and the accounting underlying reports of these activities. We also consider off-balance-sheet financing, including Special Purpose Entities (SPEs), the relevance of book values, and liabilities "at the edge" of equity. Techniques of analysis exploiting our accounting knowledge are described.

Chapter 03 - Analyzing Financing Activities

OUTLINE •

Liabilities Current Liabilities Noncurrent Liabilities Analyzing Liabilities

•

Leases Lease Accounting and Reporting – Lessee Analyzing Leases

•

Postretirement benefits Pension Accounting Other Postretirement Benefits (OPEBs) Analyzing Postretirement Benefits

•

Contingencies and Commitments Contingencies Commitments

•

Off-Balance-Sheet Financing Through-put and Take-or-pay agreements Product financing arrangements Special Purpose Entities (SPEs)

•

Shareholders’ Equity Capital Stock Retained Earnings Computation of Book Value Per Share

▪

Liabilities at the “Edge” of Equity Redeemable Preferred Stock Minority Interest

▪

Appendix 3A: Lease Accounting – Lessor

▪

Appendix 3B: Accounting Specifics for Postretirement Benefits

Chapter 03 - Analyzing Financing Activities

ANALYSIS OBJECTIVES •

Identify and assess the principal characteristics of liabilities and equity.

•

Analyze and interpret lease disclosures and explain their implications and the adjustments to financial statements.

•

Analyze postretirement disclosures and assess their consequences for firm valuation and risk.

•

Analyze contingent liability disclosures and describe risks.

•

Identify off-balance-sheet financing and its consequences to risk analysis.

•

Analyze and interpret liabilities at the edge of equity.

•

Explain capital stock and analyze and interpret its distinguishing features.

•

Describe retained earnings and their distribution through dividends.

Chapter 03 - Analyzing Financing Activities

QUESTIONS 1. Business activities are financed with either liabilities or equity, or both. Liabilities are financing obligations that require future payment of money, services, or other assets. They are outsiders’ claims against a company’s present and future assets and resources. Liabilities can be either financing or operating in nature and are usually senior to those of equity holders. Financing liabilities are all forms of debt financing such as long term notes and bonds and short-term borrowings. Capitalized leases are also considered a financial liability. Operating liabilities are obligations that arise from operations such as trade creditors, and postretirement obligations. In contrast, equity refers to claims of owners on the net assets of a company. Claims of owners are junior to creditors, meaning they are residual claims to all assets once claims of creditors are satisfied. Equity holders are exposed to the maximum risk associated with a company but also are entitled to all residual returns of a company. Certain other securities, such as convertible bonds, straddle the line separating liabilities and equity and represent a hybrid form of financing. 2. Operating liabilities arise in the normal course of operations for a particular business. Examples of operating liabilities include accounts payable, taxes payable, unearned revenues, and other accruals of operating expenses, such as wages payable. In contrast, financing liabilities arise from financing activities. Examples of financing liabilities include short and long term borrowings and interest payable. 3. The major forms of financing liabilities are private and public debt and capitalized leases. Private debt consists of loans that are taken from a bank or other financial institution. Public debt consists of loans directly from investors by issuing securities, usually in the form of bonds. Both public and private debt may be short or long term in nature and contain various contractual provisions, such as those specifying seniority and collateral for the loan. Leases are an indirect form of long term borrowing where firms borrow to pay for a specific asset. 4. Bond premiums and discounts arise when the coupon rate on the loan differs from the prevailing market rate for the loan, known as the effective interest rate. In cases where the effective interest rate is below the coupon rate, firms record debt at a premium relative to the face value. Alternatively, when the effective interest rate is above the coupon rate, firms record debt at a discount relative to the face value. When debt is recorded at present value, the discount or premium related to the loan at the time of issue is recorded in the balance sheet. This discount or premium is then amortized over the life of the loan through interest expense on the income statement. This interest expense is recorded based on the effective interest rate at the time of issue. 5. Debt may be accounted for at either present value on the issue date or at current date fair value. When debt is recorded at present value, the discount or premium related to the loan at the time of issue is recorded in the balance sheet. The discount or premium is then amortized over the life of the loan through interest expense on the income statement. This interest expense is recorded based on the effective interest rate at the time of issue. In contrast, when debt is recorded at fair value, the balance sheet recognizes the current fair value of the loan and all changes in the fair value of 3-4 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 03 - Analyzing Financing Activities

debt during a period are included in net income as unrealized gain or loss on debt. Interest expense under fair value is recorded based on the effective interest rate from the prior balance sheet date. 6. Short term borrowing is classified as a current liability and appears on the balance sheet as line items called bank borrowing, commercial paper or short term notes. Unlike long term debt, short term debt is typically reported at face value. The reasoning behind reporting short term debt at face value is that face values rarely diverge from present values given the short term nature of the loan. 7. Companies are required to report details regarding their long term (and short term) debt in notes to the financial statements. In addition to explaining the amount recognized on the balance sheet, the note disclosures provide other useful information. These include information regarding anticipated future maturities of the debt, details of contractual provisions such as collateral and covenants, unused balances in lines of credit, and any other pertinent information relating to a company’s debt. 8. Finance theory suggests that present values are typically more appropriate measures of future cash commitments. While this is true, it must be noted that present values tend to underestimate future cash commitments of a company. For firms with maturing debt, the real cash commitment when this debt matures is its face value. This is because it is the face value that must be returned to the lender upon maturity. Many credit analysts use the face value of debt when determining a company’s debtequity or coverage ratios because it measures the company’s debt-related commitments. Also, it is important for an analyst to consider the face value of future maturing debt when preparing cash flow forecasts. Face values of debt do not diverge significantly from amortized present values as long as the coupon rates and effective interest rates are similar. In the current era of low interest rates, companies issue debt with coupon rates close to prevailing interest rates. However, during high interest rate environments, cash strapped companies could issue debt with substantially lower coupon payments (sometimes, even zero coupon). In such cases, amortized cost and face values can diverge significantly. Fair value also reflects the current value of debt. However, fair values diverge from amortized present values because they reflect current interest rates, unlike amortized present values which reflect interest rates at the time of issue. Under normal conditions, fair value measures the liquidating value of the debt. This amount is useful if the company plans to retire its debt forthwith. But fair values are less useful as a measure of debt that is held to maturity. For debt that is held to maturity, changes in the fair value of debt lead to unrealized gains and losses that are recorded in net income. However, these unrealized gains/losses are not real gains/losses until the company retires its debt. This aspect of fair value accounting for debt can cause transitory unrealized gains or losses to create unnecessary volatility in reported income. It is important for an analyst to identify these items and remove them when estimating sustainable income. 9. Typically, there are three ways in which lenders protect themselves: (1) seniority; (2) collateral; and (3) covenants. Information in the notes to the annual report provides details about these protections. 3-5 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 03 - Analyzing Financing Activities

10. Seniority refers to the order in which different parties will be paid when a company’s business is dissolved. Senior claims will be paid before junior claims. The seniority of certain claims is predetermined by law. Within similar classes of claims, for example within the broad classes of creditors, seniority can be determined explicitly by contractual provisions. Senior debt is less risky than junior debt because it gets paid first during company dissolution. Obviously, this implies that senior claims will need to be considered more favorably by a credit analyst than junior claims. However two other issues must be kept in mind. First, the presence of senior debt makes the junior debt more risky than otherwise. This is because senior claimants will have the right to be paid off first from the assets of the company. In the absence of seniority, the junior claimants would also get to share in the payoffs. Second, certain debts like unpaid taxes and wages get priority over all other claims. Therefore, even senior lenders could suffer if a company has large unpaid taxes or wages. 11. Security or collateral refers to assets that are set aside during dissolution to specifically satisfy a particular claim. A claim that is backed by collateral is called secured. In the event of dissolution of the company, the owners of these particular claims can sell the identified assets to satisfy their claims. The particular types of assets offered as collateral are laid down in the lending contract. Secured debt is less risky because there are explicit assets (the collateral) that transfer to the holders of the secured debt during company dissolution. Therefore, a credit analyst needs to rate secured debt more favorably than unsecured debt. The following points, however, must be considered. First, the safety of secured debt crucially depends on the value of the collateralized assets. If the value of the collateral falls, the debt becomes riskier. For example, debt secured by inventory may not be protected if a firm is likely to go bankrupt because there is no demand for its products. Second, unsecured debt becomes more risky in the presence of secured debt. This is because certain assets (the collateral) are removed from the common pool of assets that are used to pay common claims. Third, sometimes seniority— especially of the legal kind—can override security. For example, in 2009 the U.S. Government forced even secured lenders to incur losses so that the future postretirement benefits of General Motor’s employees could be protected. 12. a. Details of covenants are available in notes to the financial statements and also in the debt agreements or prospectus to the debt issue. b. Covenants can be either affirmative or negative. Affirmative covenants specify actions that management needs to take to keep the debt in good standing. An example of an affirmative covenant is the requirement that the company must file audited financial statements that are in accordance with GAAP within a specified time period. Negative covenants limit management behaviors that might be harmful to lenders. Such covenants typically consist of two parts: (1) constraints, which specify when a company has violated a covenant; and (2) penalties or restrictions that arise when a covenant has been violated. Covenant violations allow lenders to start monitoring and controlling the borrower at the earliest sign of trouble, and hopefully well before things really start to deteriorate. In the worst case scenario, covenants allow the lender to demand immediate 3-6 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 03 - Analyzing Financing Activities

repayment of debt through technical default (see part c below). Negative covenants may also impose restrictions on management behavior when a violation occurs. Such restrictions may include restrictions on dividend payment, restrictions on further borrowing, restrictions on issuing senior debt, restrictions on capital expenditures, and restrictions on mergers and acquisitions. The objective of such restrictions is to limit the dilution of net assets by constraining management’s ability to distribute assets to new or continuing shareholders or to new lenders. By doing this, current lenders ensure that the money they have loaned to the company is protected. c. Typically, violating a covenant is grounds for technical default, which provides lenders legal rights to demand immediate repayment of their debts. While lenders rarely seek immediate repayment in practice, they may specify fresh conditions and constraints on the company as part of the renegotiation that occurs during technical default. 13. Covenant slack (or margin of safety) is a measure of how close a company is to violating its covenants. Covenant slack can be estimated by calculating the particular ratios that are specified in the covenant using current financial statement information and then comparing these values to the value which will potentially trigger a violation. Because a covenant violation can be a destabilizing and potentially dangerous event for a company, analyzing covenants and how likely it is that a company will violate these covenants in the near term is an important task in analysis. The margin of safety aids in determining the likelihood of a future covenant violation. 14. a. Convertible debt is a loan that can be converted into equity shares at maturity. Because convertible debt contains features of both debt and equity, convertible debt is classified as a hybrid security. Usually, convertible debt allows the holder an option to convert the loan to equity at a fixed price. Therefore, conversion will occur only if the share price is higher than the conversion price at maturity. If it is not, the debt holders can ask for repayment of principal. b. Companies sometimes issue bonds with attached warrants on the company’s equity. Warrants entitle the holder to buy the underlying stock of the issuer at a fixed exercise price until the expiration date, similar to a call option. This is different from convertible debt because the bonds and the warrants are separate securities, and the holder can sell the warrants or the debt separately. The accounting treatment for warrants is similar to that for convertible bonds. That is, the bonds are accounted for as debt and the warrants as equity at their respective fair values on the date of issue. c. Companies may choose to issue convertible debt in place of traditional bonds in order to achieve a lower cash interest payment. Because investors receive a bond along with the option to convert the bond into equity, investors are willing to accept a lower effective interest rate on the debt. A second advantage for companies that issue convertible bonds is that if the bonds are converted into equity, the companies' debt vanishes. However, in exchange for these benefit to convertible debt, the value of shareholder's equity is reduced due to the stock dilution expected when bondholders convert their bonds into new shares. d. Current accounting rules under both US GAAP (ASC 470-20) and IFRS (IAS 32) recognize the mixed nature of convertible debt. Specifically, companies issuing convertible debt must separately account for the liability (debt) and equity (conversion option) components on the date of the issue. The amount allocated to 3-7 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 03 - Analyzing Financing Activities

the liability is estimated by determining the fair value of a pure debt security that is similar in every other respect to the convertible security. Once the liability amount is estimated, the amount allocated to equity is simply the residual value of the convertible security. e. Analysts evaluating a company with convertible bonds must take note of the analysis issues that go along with evaluating traditional debt, such as evaluating the ability of the company to make promised interest payments and whether the protections available to convertible debtholders alter the riskiness of the firm’s remaining debt and equity. Because firms may issue convertible debt to achieve a lower interest payment, firms in poor financial health may be tempted to issue convertible debt rather than traditional bonds. Analysts should take note of this signal. In addition to evaluating the debt component of convertible debt, analysts must factor in the potential dilution of existing equity holders that will result from the conversion of the convertible debt securities.

15. a. A lease is classified and accounted for as a capital lease if at the inception of the lease it meets one of four criteria: (1) the lease transfers ownership of the property to the lessee by the end of the lease term; (2) the lease contains an option to purchase the property at a bargain price; (3) the lease term is equal to 75 percent or more of the estimated economic life of the property; or (4) the present value of the rentals and other minimum lease payments, at the beginning of the lease term, equals 90 percent of the fair value of the leased property less any related investment tax credit retained by the lessor. If the lease does not meet any of those criteria, it is to be classified and accounted for as an operating lease. With regard to the last two of the above four criteria, if the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property, neither the 75 percent of economic life criterion nor the 90 percent recovery criterion is to be applied for purposes of classifying the lease and as a consequence, such leases will be classified as operating leases.

Chapter 03 - Analyzing Financing Activities

b. Summary of accounting for leases by lessees: 1. The lessee records a capital lease as an asset and an obligation at an amount equal to the present value of minimum lease payments during the lease term, excluding executory costs (if determinable) such as insurance, maintenance, and taxes to be paid by the lessor together with any profit thereon. However, the amount so determined should not exceed the fair value of the leased property at the inception of the lease. If executory costs are not determinable from provisions of the lease, an estimate of the amount shall be made. 2. Amortization, in a manner consistent with the lessee's normal depreciation policy, is called for over the term of the lease except where the lease transfers title or contains a bargain purchase option; in the latter cases amortization should follow the estimated economic life. 3. In accounting for an operating lease the lessee will charge rentals to expenses as they become payable, except when rentals do not become payable on a straight-line basis. In the latter case they should be expensed on such a basis or on any other systematic or rational basis that reflects the time pattern of benefits serviced from the leased property. 16. a. The major classifications of leases by lessors are: 1. Sales-type leases 2. Direct financing leases 3. Operating leases The criteria for classifying each type are as follows: If a lease meets any one of the four criteria for capitalization (see question 10a above) plus two additional criteria (see below), it is to be classified and accounted for as either a sales-type lease (if manufacturer or dealer profit is involved) or a direct financing lease. The additional criteria are (1) collectibility of the minimum lease payments is reasonable predictable, and (2) no important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease. A lease not meeting these criteria is to be classified and accounted for as an operating lease. b. The accounting procedures for leases by lessors are: Sales-type leases 1. The minimum lease payments plus the unguaranteed residual value accruing to the benefit of the lessor are recorded as the gross investment in the lease. 2. The difference between gross investment and the sum of the present value of its two components is recorded as unearned income. The net investment equals gross investment less unearned income. Unearned income is amortized to income over the lease term so as to produce a constant periodic rate of return on the net investment in the lease. Contingent rentals are credited to income when they become receivable. 3. At the termination of the existing lease term of a lease being renewed, the net investment in the lease is adjusted to the fair value of the leased property to the lessor at that date, and the difference, if any, recognized as gain or loss. The same procedure applies to direct financing leases (see below.) 4. The present value of the minimum lease payments discounted at the interest rate implicit in the lease is recorded as the sales price. The cost, or carrying amount, if different, of the leased property, and any initial direct costs (of negotiating and consummating the lease), less the present value of the unguaranteed residual value is charged against income in the same period. 3-9 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 03 - Analyzing Financing Activities

5. The estimated residual value is periodically reviewed. If it is determined to be excessive, the accounting for the transaction is revised using the changed estimate. The resulting reduction in net investment is recognized as a loss in the period in which the estimate is changed. No upward adjustment of the estimated residual value is made. (A similar provision applies to direct financing leases.) Direct-financing leases 1. The minimum lease payments (net of executory costs) plus the unguaranteed residual value plus the initial direct costs are recorded as the gross investment. 2. The difference between the gross investment and the cost, or carrying amount, if different, of the leased property, is recorded as unearned income. Net investment equals gross investment less unearned income. The unearned income is amortized to income over the lease term. The initial direct costs are amortized in the same portion as the unearned income. Contingent rentals are credited to income when they become receivable. Operating leases The lessor will include property accounted for as an operating lease in the balance sheet and will depreciate it in accordance with his normal depreciation policy. Rent should be taken into income over the lease term as it becomes receivable except that if it departs from a straight-line basis income should be recognized on such basis or on some other systematic or rational basis. Initial costs are deferred and allocated over the lease term. 17. Where land only is involved the lessee should account for it as a capital lease if either of the enumerated criteria (1) or (2) is met. Land is not usually amortized. In a case involving both land and building(s), if the capitalization criteria applicable to land (see above) are met, the lease will retain the capital lease classification and the lessor will account for it as a single unit. The lessee will have to capitalize the land and buildings separately, the allocation between the two being in proportion to their respective fair values at the inception of the lease. If the capitalization criteria applicable to land are not met, and at the inception of the lease the fair value of the land is less than 25 percent of total fair value of the leased property both lessor and lessee shall consider the property as a single unit. The estimated economic life of the building is to be attributed to the whole unit. In this case if either of the enumerated criteria (3) or (4) is met the lessee should capitalize the land and building as a single unit and amortize it. If the conditions above prevail but the fair value of land is 25 percent or more of the total fair value of the leased property, both the lessee and the lessor should consider the land and the building separately for purposes of applying capitalization criteria (3) and (4). If either of the criteria is met by the building element of the lease it should be accounted for as a capital lease by the lessee and amortized. The land element of the lease is to be accounted for as an operating lease. If the building element meets neither capitalization criteria, both land and buildings should be accounted for as a single operating lease. Equipment which is part of a real estate lease should be considered separately and the minimum lease payments applicable to it should be estimated by whatever means are appropriate in the circumstances. Leases of certain facilities such as airport, bus terminal, or port facilities from governmental units or authorities are to be classified as operating leases. 3-10 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 03 - Analyzing Financing Activities

18. In the books of the lessee, the primary consideration regarding leases is the appropriate classification of operating leases. When leases are classified as operating leases, the lease payment is recorded as rent expense. However, lease assets and liabilities are kept off the balance sheet. Because of this, many companies avail themselves of operating lease treatment even when the underlying economics justify capitalizing the leases. If this is done, the asset and liabilities of a company are underreported and its debt-toequity ratios are biased downward. Often such leases are a form of “off balance sheet” financing. Therefore, an analyst must carefully examine the classification of operating leases and capitalize the leases when the underlying economic justify. 19. For the lessor, when a lease is considered an operating lease, the leased asset remains on its books. For the lessee, it will not report an asset or an obligation on its balance sheet. 20. When a lease is considered a capital lease for both the lessor and the lessee, the lessor will report lease payments receivable on its balance sheet. The lessee will report the leased asset and a lease obligation totaling the present value of future lease payments. 21. a. Rent expense b. Interest expense and depreciation expense 22. a. Leasing revenue b. Interest revenue (and possibly gain on sale in the initial year of the lease) 23.

Property, plant, and equipment can be financed by having an outside party acquire the facilities while the company agrees to do enough business with the facility to provide funds sufficient to service the debt. Examples of these kinds of arrangements are through-put agreements, in which the company agrees to run a specified amount of goods through a processing facility or "take or pay" arrangements in which the company guarantees to pay for a specified quantity of goods whether needed or not. A variation of the above arrangements involves the creation of separate entities for ownership and the financing of the facilities (such as joint ventures or limited partnerships) which are not consolidated with the company's financial statements and are, thus, excluded from its liabilities. Companies have attempted to finance inventory without reporting on their balance sheets the inventory or the related liability. These are generally product financing arrangements in which an enterprise sells and agrees to repurchase inventory with the repurchase price equal to the original sales price plus carrying and financing costs or other similar transactions such as a guarantee of resale prices to third parties.

24. a. A loss contingency is any existing condition, situation, or set of circumstances involving uncertainty as to possible loss that will be resolved when one or more future events occur or fail to occur. Examples of loss contingencies are: litigation, threat of expropriation, uncollectibility of receivables, claims arising from product warranties or product defects, self-insured risks, and possible catastrophe losses of property and casualty insurance companies. b. The two conditions that must be met before a provision for a loss contingency can be charged to income are: (1) it must be probable that an asset had been impaired or a 3-11 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 03 - Analyzing Financing Activities

liability incurred at a date of a company’s financial statements. Implicit in that condition is that it must be probable that a future event or events will occur confirming the fact of the loss. (2) the amount of loss must be reasonably estimable. The effect of applying these criteria is that a loss will be accrued only when it is reasonably estimable and relates to the current or a prior period. 25.

Commitments are potential claims against a company’s resources due to future performance under a contract. Examples of commitments include contracts to purchase products or services at specified prices, purchase contracts for fixed assets calling for payments during construction, and signed purchase orders.

26.

Commitments are not recorded liabilities because commitments are not completed transactions. Commitments become liabilities when the transaction is completed. For example, consider a commitment by a manufacturer to purchase 100,000 units of materials per year for 5 years. Each time a purchase is made at the agreed upon price, part of the purchase commitment expires and a purchase is recorded. The remaining part continues as an obligation by the manufacturer to purchase materials.

27.

Off-balance-sheet financing refers to the nonrecording of certain financing obligations. Examples of off-balance-sheet financing include operating leases when they are in-substance capital leases, joint ventures and limited partnerships, and many recourse obligations on sold receivables.

28. Under SFAS 105, companies are required to disclose the following information about financial instruments with off-balance-sheet risk of accounting loss: a. The face, contract, or notional principal amount. b. The nature and terms of the instruments and a discussion of their credit and market risk, cash requirements, and related accounting policies. c. The accounting loss the company would incur if any party to the financial instruments failed completely to perform according to the terms of the contract, and the collateral or other security, if any, for the amount due proved to be of no value to the company. d. The company's policy for requiring collateral or other security on financial instruments it accepts, and a description of collateral on instruments presently held. Information about significant concentrations of credit risk from an individual counter-party or groups of counterparties for all financial instruments is also required. These disclosures help financial analysis by revealing existing economic events that can reduce the relevance and reliability of the balance sheet as reported by management. With the information in these disclosures, the analyst can revise his/her personal models to factor in the impact of off-balance-sheet items or otherwise adjust the analyses for these items. 29.

SFAS 140 replaced SFAS 125 and defines new rules for the sale of accounts receivable to special purpose entities (SPEs). In order to treat the transfer as a sale (rather than a borrowing), the SPE must be a Qualifying SPE. Otherwise, the SPE must be consolidated unless third-party investors make equity investments that are, • Substantive (more than 3% of assets) • Controlling (e.g., more than 50% ownership) • Bear the first dollar risk of loss • Take the legal form of equity 3-12

Chapter 03 - Analyzing Financing Activities

If any of the above conditions is not met, the transfer of the receivable is considered as a loan with the receivables pledged as security for such loan. 30. Analysts should identify off-balance-sheet financing arrangements and either factor these arrangements into their models or otherwise adjust the analyses for the additional risk created by off-balance-sheet financing arrangements. 31. Some equity securities have mandatory redemption provisions that make them more akin to debt than they are to equity—a typical example is preferred stock. Whatever their name, these securities impose upon the issuing companies various obligations to dispense funds at specified dates. Such provisions are inconsistent with the true nature of an equity security. The analyst must be alert to the existence of such “equity securities” and examine for substance over form when making financial statement adjustments.

32. In order to facilitate their understanding and analysis, reserves and provisions can be redivided into a number of major categories. The first category is most correctly described as comprising provisions for obligations that have a high probability of occurrence, but which are in dispute or are uncertain in amount. As is the case with many financial statement descriptions, neither the title nor the location in the financial statement can be relied upon as a rule-of-thumb guide to the nature of an account. The best key to analysis is a thorough understanding of the business and the financial transactions that give rise to the account. The following are representative items in this group: provisions for product guarantees, service guarantees, and warranties that are established in recognition of future costs that are certain to arise although presently impossible to measure. Another type of obligation that must be provided for is the liability for “unredeemed coupons” such as trading stamps. To the company issuing these coupons, there is no doubt about the liability to redeem them for merchandise or cash. The only uncertainty concerns the number of coupons that will be presented for redemption. Consequently, a provision is established for these types of items by a charge to income at the time products covered by guarantees (or related to these coupons) are sold—the amount is established on the basis of experience or on the basis of any other reliable factor. The second category comprises reserves for expenses and losses, which by experience or estimates are very likely to occur in the future and that should properly be provided for by current charges to operations. One group within this category is comprised of reserves for operating costs such as maintenance, repairs, painting, or overhauls. Thus, for example, since overhauls can be expected to be required at regularly recurring intervals, they are provided for ratably by charges to operations to avoid charging the entire cost to the year in which the actual overhaul takes place. A third category comprises provisions for future losses stemming from decisions or actions already taken. Included in this group are reserves for relocations, replacement, modernization, and discontinued operations. A fourth category includes reserves for contingencies. For example, reserves for self-insurance are designed to provide the accumulation against which specific types of losses, not covered by insurance, can be charged. Although the term self-insurance contradicts the very concept of insurance, which is based on the spreading of risks among many business units, it nevertheless is a practice that has a good number of 3-13 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 03 - Analyzing Financing Activities

adherents. Other contingencies provided against by means of reserves are those arising from foreign operations and exchange losses due to official or de facto devaluations. A fifth group of future costs that must be provided for is that of employee compensation. These costs, in turn, give rise to provisions for vacation pay, deferred compensation, incentive compensation, supplemental unemployment benefits, bonus plans, welfare plans, and severance pay. The related category of estimated liabilities includes provisions for claims arising out of pending or existing litigation. Of importance to the analyst is the adequacy of the reserves and provisions that are often established on the basis of prior experience or on the basis of other estimates. Concern with adequacy of amount is a prime factor in the analysis of all reserves and provisions, whatever their purpose. Reserves and provisions appearing above the equity section are almost invariably created by means of charges to income. They are designed to assign charges to the income statement based on when they are incurred rather than when they are paid in cash. 33. Reserves for future losses represent a category of accounts that require particular scrutiny. While conservatism in accounting calls for recognition of losses as they can be determined or clearly foreseen, companies tend, particularly in loss years, to over-provide for losses not yet incurred. Such “losses not yet incurred” often involve disposal of assets, relocations, and plant closings. Overprovision shifts expected future losses to the present period, which likely already shows adverse results. One problem with such reserves is that once established there is no further accounting for the expenses and losses that are charged against them. Only in certain financial statements required to be filed with the SEC (such as Form 10-K) are details of changes in reserves required. Recent requirements have, however, tightened the disclosure rules in this area. The reason why over-provisions of reserves occur is that the income statement effects are often accorded more importance than the residual balance sheet effects. While a provision for future expenses and losses establishes a reserve account that is analytically in the "never-never land" between liabilities and equity accounts, it serves the important purpose of creating a cushion that can absorb future expenses and losses. This shields the all-important income statement from them and their related volatility. The analyst should endeavor to ascertain that provisions for future losses reflect losses that can reasonably be expected to have already occurred rather than be used as a means of artificially benefiting future income by adding excessive provisions to present adverse results. 34.

An ever increasing variety of items and descriptions are included in the "deferred credits" group of accounts. In many cases these items are akin to liabilities; in others, they either represent deferred income yet to be earned or serve as income-smoothing devices. A lack of agreement among accountants as to the exact nature of these items or the proper manner of their presentation compounds the confusion confronting the analyst. Thus, regardless of category or presentation, the key to their analysis lies in an understanding of the circumstances and the financial transactions that brought them about. At one end of the spectrum we find those items that have characteristics of liabilities. Here we can find items such as advances or billings on uncompleted contracts, unearned royalties and deposits, and customer service prepayments. The outstanding 3-14

Chapter 03 - Analyzing Financing Activities

characteristics of these items is their liability aspects even though, as in the case of advances of royalties, they may, after certain conditions are fulfilled, find their way into the company's income stream. Advances on uncompleted contracts represent primarily methods of financing the work in progress while deposits of rent received represent, as do customer service prepayments, security for performance of an agreement. At the other end of the spectrum are deferred credits that exhibit many qualities similar to equity. The key to effective analysis is the ability to identify those items most like liabilities from those most like equity. 35. The accounting for the equity section as well as its presentation, classification, and note disclosure have certain basic objectives. The most important of these are: a. To classify and distinguish among the major sources of owner capital contributed to the entity. b. To set forth the priorities of the various classes of stockholders and the manner in which they rank in partial or final liquidation. c. To set forth the legal restrictions to which the distribution of capital funds are subject to for whatever reason. d. To disclose the contractual, legal, managerial, and financial restrictions that the distribution of current and retained earnings is subject to. The accounting principles that apply to the equity section do not have a marked effect on income determination and, as a consequence, do not hold many pitfalls for the analyst. From the analyst's point of view, the most significant information here relates to the composition of the capital accounts and to the restrictions that they are subject to. The composition of equity capital is important because of provisions affecting the residual rights of common equity. Such provisions include dividend participation rights, and the great variety of options and conditions that are characteristic of the complex securities frequently issued under merger agreements, most of which tend to dilute common equity. Analysis of restrictions imposed on the distribution of retained earnings by loan or other agreements will usually shed light on a company's freedom of action in such areas as dividend distributions and the required levels of working capital. Such restrictions also shed light on the company's bargaining strength and standing in credit markets. Moreover, a careful analysis of restrictive covenants will enable the analyst to assess how far a company is from being in default of these provisions. 36. Preferred stock often carries features that make it preferred in liquidation and preferred as to dividends. Also, it is often entitled to par value in liquidation and can be entitled to a premium. On the other hand, the rights of preferred stock to dividends are generally fixed—although they can be cumulative, which means that preferred shareholders are entitled to arrearages of dividends before common stockholders receive any dividends. These features of preferred stock as well as the fixed nature of the dividend give preferred stock some of the earmarks of debt with the important difference that preferred stockholders are not generally entitled to demand redemption of their shares. However, there are preferred stock issues that have set redemption dates and require sinking funds to be established for that purpose—these issuances are essentially debt. Characteristics of preferred stock that make them more akin to common stock are dividend participation rights, voting rights, and rights of conversion into common stock. 37. Accounting standards state (APB 10): “Companies at times issue preferred (or other senior) stock which has a preference in involuntary liquidation considerably in excess of the par or stated value of the shares. The relationship between this preference in 3-15 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 03 - Analyzing Financing Activities

liquidation and the par or stated value of the shares may be of major significance to the users of the financial statements of those companies and the Board believes it highly desirable that it be prominently disclosed. Accordingly, the Board recommends that, in these cases, the liquidation preference of the stock be disclosed in the equity section of the balance sheet in the aggregate, either parenthetically or in short rather than on a per share basis or by disclosure in notes." Such disclosure is particularly important since the discrepancy between the par and liquidation value of preferred stock can be very significant. 38. This question is answered in a SEC release titled Pro Rata Distribution to Shareholders: Several instances have come to the attention of the Commission in which registrants have made pro rata stock distributions that were misleading. These situations arise particularly when a registrant makes distributions at a time when its retained earnings or its current earnings are substantially less than the fair value of the shares distributed. Under present generally accepted accounting rules, if the ratio of distribution is less than 25 percent of shares of the same class outstanding, the fair value of the shares issued must be transferred from retained earnings to other capital accounts. Failure to make this transfer in connection with a distribution or making a distribution in the absence of retained or current earnings is evidence of a misleading practice. Distributions of over 25 percent (which do not normally call for transfers of fair value) may also lend themselves to such an interpretation if they appear to be part of a program of recurring distribution designed to mislead shareholders. It has long been recognized that no income accrues to the shareholder as a result of such stock distributions or dividends, nor is there any change in either the corporate assets or the shareholders' interest therein. However, it is also recognized that many recipients of such stock distributions, which are called or otherwise characterized as dividends, consider them to be distributions of corporate earnings equivalent to the fair value of the additional shares received. In recognition of these circumstances, the American Institute of Certified Public Accountants has specified in Accounting Research Bulletin No. 43, Chapter 7, paragraph 10, that "... the corporation should in the public interest account for the transaction by transferring from earned surplus to the category of permanent capitalization (represented by the capital stock and capital surplus accounts) an amount equal to the fair value of the additional shares issued. Unless this is done, the amount of earnings which the shareholder may believe to have been distributed will be left, except to the extent otherwise dictated by legal requirements, in earned surplus subject to possible further similar stock issuances or cash distributions. Both the New York and American Stock Exchanges require adherence to this policy by their listed companies. 39. a. Minority interests are the claims of shareholders of a majority owned subsidiary whose total net assets are included in a consolidated balance sheet. b. Consolidated financial statements often show minority interests as liabilities: however, they are fundamentally different in nature from legally enforceable obligations. Minority shareholders do not have any legally enforceable rights for payments of any kind from the parent company. Therefore, the financial analyst can justifiably classify minority interest as equity funds in most cases. 40. B In a defined contribution plan, the employer promises to currently contribute a fixed sum of money to the employee’s retirement fund, so it is the contribution that is defined. In a defined benefit plan, the employer promises to pay a periodic pension 3-16 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 03 - Analyzing Financing Activities

benefit to the employee after retirement (typically until death), so it is the benefit that is defined. The risk (or reward) of the investment performance in the former case is borne by the employee and in the latter by the employer. Accounting for defined contribution plans is simple: whenever a contribution is made it is recorded as an expense. Defined benefit plans’ accounting is complex and involves currently recording a liability based on future expected benefit payments and an asset to the extent the plan is funded. Pension expense in this case depends on the changes in pension obligation and the return on plan assets. 41. B

(a) Pension obligation: This is the present value of expected benefit payments to the employee based on current service. (b) Pension asset: this is the fair market value of the plan assets on the date of the balance sheet. (c) Net economic position of the plan: This is the difference between the fair market value of the pension assets and the pension obligation. When this difference is positive the plan is referred to as overfunded and when negative the plan is termed underfunded. (d) Economic pension cost: Economically, pension cost is equal to the change (increase) in pension obligation minus return on plan assets. This is called the funded status. Typically, pension obligation changes because of additional employee service (service cost) and present value effects (interest cost).

42. B

The common non-recurring components are: (a) Actuarial Gain/Loss: This arises because of changes in actuarial assumptions such as discount rates and compensation growth rates. (b) Prior Service Cost: This arises because of changes in pension formulas, usually because of renegotiation of pension contracts. In addition, the return on plan assets can have a recurring or expected component and an unexpected component that is not expected to persist into the future. SFAS 158 has a complex method by which the non-recurring amounts are first deferred, i.e., excluded from current income, and then the opening net deferrals are amortized over the remaining employee service. For this purpose, the excess of actual plan asset return over expected return is netted against actuarial gains or losses and then deferred/amortized using something called the corridor method. Prior service cost is deferred and amortized separately on its own.

43. B

The net periodic pension cost is a smoothed version of the economic pension cost. For determining net periodic pension cost, all non-recurring or unusual components of economic pension cost (e.g., actuarial gain/loss, prior service cost, excess of actual plan return over expected return) are deferred and amortized using a complex corridor method. The rationale for this smoothing mechanism is that the economic pension cost is very volatile. Including this in income would cause income to be very volatile and also hide the true operating profitability of the firm.

Chapter 03 - Analyzing Financing Activities

44. B

Under the current standard (SFAS 158), the balance sheet recognizes the funded status of the plan. The income statement, however, does not recognize the net economic cost, but a net periodic pension cost in which unusual or non-recurring pension cost components are deferred and amortized. The cumulative net deferrals are included in accumulated other comprehensive income. Under the older standard, SFAS 87, the net periodic pension cost is recognized on the income statement. The balance sheet however, merely recognized the accrued (or prepaid) pension cost, which was simply the cumulative net periodic pension cost. The accrued (or prepaid) pension cost was equal to the funded status minus cumulative net deferrals.

45. B

Under SFAS 158, the difference between the economic pension cost (which articulates with the change in the funded status which is recorded in the balance sheet) and the smoothed net periodic pension cost (which is essentially the net deferral for the period) is included in other comprehensive income for the period, which is transferred to accumulated other comprehensive income on the balance sheet.

46. B

Other post employment benefits (OPEBs) are retirement benefits other than pensions, such as post retirement health care benefits. OPEBs differ from pension on two dimensions: (1) most of them are non-monetary and therefore create difficulties in estimation and (2) because of tax laws, companies rarely fund these benefits.

47. B

The pension note consists of five main parts: (1) an explanation of the reported position in the balance sheet, (2) details of net periodic benefit costs, (3) information regarding actuarial and other assumptions, (4) information regarding asset allocation and funding policies, and (5) expected future contributions and benefit payments.

48. B

Since the funded status of the plan is reported on the balance sheet under SFAS 158, there is no adjustment to the balance sheet that is required. However, some analysts note that netting pension assets and obligations tends to mask the underlying pension risk exposure and thus recommend showing pension assets and liabilities separately without netting them out. Adjustments to the income statement depend on the purpose of the analysis. The net periodic benefit cost that is reported under SFAS 158 is appropriate if the objective of the analysis is identifying the permanent or core component of income. However, to estimate a period’s economic income it is advisable to use the economic pension cost which includes all non-recurring items.

49. B

The major actuarial assumptions underlying pension accounting are: (a) discount rate (b) compensation growth rate and (c) expected rate of return on pension assets. Less important assumptions include life expectancy and employee turnover. In addition OPEBs also make assumptions about healthcare cost trends. Managers can affect both the post-retirement benefit economic position (or economic cost) and the reported cost. For example, choosing a higher discount rate can reduce the pension obligation and thus improve economic position (funded status). Also, increasing the expected rate of return on plan assets can reduce the reported pension cost (net periodic pension cost).

Chapter 03 - Analyzing Financing Activities

50. B Pension risk exposure is the risk that a company is exposed to from its pension plans. This risk arises because of a mismatch of the risk profiles of pension assets and liabilities, primarily because companies invest pension assets whose returns are not correlated with those of long-term bonds which form the basis for the discount rate assumption affecting the measurement of the pension obligation. The pensions “crisis” in the early 2000s in the U.S. was precipitated by an unusual combination of declining equity values (which lowered the value of pension assets) and declining long-term interest rates, which increased the pension obligations. The net effect was a steep reduction in pension funded status which even resulted in some companies filing for bankruptcy. The three factors that an analyst needs to consider when evaluating pension exposure are: (1) the plan’s funded status relative to the company’s assets (2) the pension intensity, i.e., the size of the pension obligation and assets (without netting) relative to total assets and (3) the extent to which the assets and obligation is mismatched, which can be determined by the proportion of pension assets invested in non-debt securities or assets. 51. B

Current cash flows for pensions (or OPEBs) measure the extent of company contributions into the plan during the year. For pensions, this is obviously not a good indicator of future cash contributions since contributions are affected by complex factors which eventually affect the funded status of the plan. For OPEBs, current contributions are a somewhat better indicator of future contributions since contributions in a period typically equal benefits paid (since most OPEB plans are unfunded), and benefits are more predictable over time.

52. C

Accumulated benefit obligation (ABO): This is the present value of estimated future pension benefit payments assuming current compensation. Projected benefit obligations (PBO): This is the present value of estimated future pension benefit payments assuming future compensation on the date of retirement. ABO is closer to the legal obligation.

53. C

The “corridor method” is used for determining the amount of amortization for net gain or loss. Net gain or loss for the period is determined by netting the actuarial gain/loss for the period with the difference between actual and expected return on plan assets. Then the net gain or loss for the period is added to the cumulative net gain or loss at the start of the period. Next a “corridor” for cumulative net gain/loss is determined as the greater of 10% of PBO or 10% of plan assets (whichever is greater). Only the amount of cumulative net gain/loss beyond this corridor (in either direction) is amortized.

54. C

Like the pension obligation, the OPEB obligation is the present value of expected future benefits attributable to employee service to-date. The present value of the expected future benefits is termed EPBO and that portion which is attributable to service to-date is termed the APBO. The APBO is the obligation that is used to estimate the funded status or the economic position of the plan reported on the balance sheet.

Chapter 03 - Analyzing Financing Activities

While the estimation process for OPEB costs is similar to that of estimating pension costs it is more difficult and more subjective. First, data about costs are more difficult to obtain. Pension benefits involve either fixed dollar amounts or a defined dollar amount, based on pay levels. Health benefits, by contrast, are estimates not easily computed by actuarial formula. Many factors enter in to such estimates, including deductibles, ages, marital status, number of dependents, etc. Second, more assumptions than those governing pension calculations are needed. For example, in addition to retirement dates, life expectancy, turnover, and discount rates, there is a need for estimates of the medical costs trend rate, Medicare reimbursements, etc.

Chapter 03 - Analyzing Financing Activities

EXERCISES Exercise 3-1 (20 minutes) a. Long-term debt [46] A B

159.7 0.3

G H

24.3 250.3

805.8

beg

0.1 99.8 100.0 199.6

C D E F

1.9 772.6

I end

A = Retirement of 13.99% Zero Coupon Notes. B = Repayment of 9.125% Note. C = Additional borrowing on 7.5% Note. D = Borrowing on 9% Note E = Borrowing on Medium-Term Notes. F = Borrowing on 8.875% Debentures G = Repayment of Other Notes H = Reclassification of Note I = Increase in capital lease obligation

b. Campbell Soup’s debt footnote indicates maturities of (in $millions) $227.7 in Year 12, $118.9 in Year 13, $17.8 in Year 14, $15.9 in Year 15, and $108.3 in Year 16. The remaining long-term debt matures in excess of 5 years. Given Campbell’s operating cash flow of $805.2 million, solvency does not appear to be a problem. Further, Campbell reports net income of $401.5, well in excess of its interest expense of $116.2 in Year 11, an interest coverage ratio of 6.7 [$667.4 + $116.2]/ $116.2). The company should also be able to meet its interest obligations. Campbell reports total liabilities of $2,355.6 million ($1278+$772.6+$305) against stockholders’ equity of $1,793.4 million, a 1.3 times multiple. The amount of debt does not appear to be excessive. Nor does the company appear to be underutilizing its equity. Given present debt levels that are not excessive and adequate cash flow, the company should be able to finance additional investments with debt if desired by management.

Chapter 03 - Analyzing Financing Activities

Exercise 3-2 (20 minutes) a. The economic effects of a long-term capital lease on the lessee are similar to that of an equipment purchase using installment debt. Such a lease transfers substantially all of the benefits and risks incident to the ownership of property to the lessee, and obligates the lessee in a manner similar to that created when funds are borrowed. To enhance comparability between a firm that purchases an asset on a long-term basis and a firm that leases an asset under substantially equivalent terms, the lease should be capitalized. b. A lessee should account for a capital lease at its inception as an asset and an obligation at an amount equal to the present value at the beginning of the lease term of minimum lease payments during the lease term, excluding any portion of the payments representing executory costs, together with any profit thereon. However, if the present value exceeds the fair value of the leased property at the inception of the lease, the amount recorded for the asset and obligation should be the fair value. c. A lessee should allocate each minimum lease payment between a reduction of the obligation and interest expense so as to produce a constant periodic rate of interest on the remaining balance of the obligation. d. Von should classify the first lease as a capital lease because the lease term is more than 75 percent of the estimated economic life of the machine. Von should classify the second lease as a capital lease because the lease contains a bargain purchase option.

Exercise 3-3 (15 minutes) a. A lessee would account for a capital lease as an asset and an obligation at the inception of the lease. Rental payments during the year would be allocated between a reduction in the obligation and interest expense. The asset would be amortized in a manner consistent with the lessee's normal depreciation policy for owned assets, except that in some circumstances the period of amortization would be the lease term. b. No asset or obligation would be recorded at the inception of the lease. Normally, rental on an operating lease would be charged to expense over the lease term as it becomes payable. If rental payments are not made on a straight-line basis, rental expense nevertheless would be recognized on a straight-line basis unless another systematic or rational basis is more representative of the time pattern in which use benefit is derived from the leased property, in which case that basis would be used.

Chapter 03 - Analyzing Financing Activities

Exercise 3-4 (18 minutes) a. The gross investment in the lease is the same for both a sales-type lease and a direct-financing lease. The gross investment in the lease is the minimum lease payments (net of amounts, if any, included therein for executory costs such as maintenance, taxes, and insurance to be paid by the lessor, together with any profit thereon) plus the unguaranteed residual value accruing to the benefit of the lessor. b. For both a sales-type lease and a direct-financing lease, the unearned interest income would be amortized to income over the lease term by use of the interest method to produce a constant periodic rate of return on the net investment in the lease. However, other methods of income recognition may be used if the results obtained are not materially different from the interest method. c. In a sales-type lease, the excess of the sales price over the carrying amount of the leased equipment is considered manufacturer's or dealer's profit and would be included in income in the period when the lease transaction is recorded. In a direct-financing lease, there is no manufacturer's or dealer's profit. The income on the lease transaction is composed solely of interest.

Exercise 3-5 (25 minutes) A number of major companies have a meager debt ratio. Still, even when a company shows little if any debt on its balance sheet, it can have considerable long-term liabilities. This situation can reflect one or more of several factors such as the following: Lease commitments, while detailed in notes, are not recorded in the balance sheets of many companies. This could be a critical problem for companies that have expanded by leasing rather than buying property. These lease commitments, while reflecting different attributes of pure debt, are just as surely long-term obligations. Many companies have very large unfunded postretirement liabilities. These often are not recorded on the balance sheet, but are disclosed in the notes. At one time, a case could have been made that such obligations were not a problem, for as long as the business operated, payments would be made, and if it went bankrupt, the liability would end. Now, under most laws, the company has a real long-term obligation to employees. Several companies guarantee the debt of another company. The most typical is a nonconsolidated lease subsidiary. Although disclosed in the notes, this debt, which is real and can be large, is not recorded on the parent's balance sheet.

Chapter 03 - Analyzing Financing Activities

Exercise 3-5—continued Off-balance-sheet debt—such as industrial revenue bonds or pollution control financing where a municipality sells tax-free bonds guaranteed for payment—are cases where a supposedly debt-free balance sheet could look much worse if these obligations were recorded. Finally, the practice of deferred taxes—such as taking some expenses for tax, but not book purposes, or through differences in timing for recognition of sales—is one that, while recorded on the balance sheet, is normally not recognized as a long-term obligation. However, if the rate of investment slows dramatically for some reason or if the sales trend is reversed, the sudden coming due of these tax liabilities could be a major problem. (CFA Adapted)

Exercise 3-6 (20 minutes) a. An estimated loss from a loss contingency is accrued with a charge to income if both of the following conditions are met: •

Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.

•

The amount of loss can be reasonably estimated.

b. In this case, disclosure should be made for an estimated loss from a loss contingency that need not be accrued by a charge to income when there is at least a reasonable possibility that a loss may have been incurred. The disclosure should indicate the nature of the contingency and should estimate the possible loss or range of loss or state that such an estimate cannot be made. Disclosure of a loss contingency involving an unasserted claim is required when it is probable that the claim will be asserted and there is a reasonable possibility that the outcome will be unfavorable.

Exercise 3-7 (15 minutes) a. One reason that managers might want to resist recording a liability related to an ongoing lawsuit is that the recorded liability can cause deterioration in the financial position of the company. A second reason is that the opposing attorneys may use the disclosure inappropriately as an admission of liability.

Chapter 03 - Analyzing Financing Activities

Exercise 3-7—continued b. If a manager believes that it is inevitable that a liability will be recorded, the manager may want to time the recognition of the liability opportunistically. For example, if the company has a relatively bad period, the liability can be recorded in conjunction with a “big bath.” If the company has a very good period, the manager might find that the liability can be recorded in that period without causing an unexpectedly bad earnings report.

Exercise 3-8 (40 minutes) [Note: Unless otherwise indicated, much of the information to answer this exercise can be found in item [68] of Campbell’s financial statements.]

a. The causes of the $101.6 million increase are identified in the table below (see Campbell’s Consol. Statement of Owners’ Equity and Changes in Number of Shares): Millions Net Income .......................................................... Cash Dividends ................................................... Treasury Stock Purchase ................................... Treasury Stock Issued Capital Surplus .............................................. Treasury Stock............................................... Translation Adjustment ...................................... Sale of foreign operations ..................................

11 $401.5 (142.2) (89) (175.6)

10 $ 4.4 (28) (126.9) (87) (41.1) (87)

45.4 (91) 12.4 (91) (29.9) (92) (10.0) (93)

11.1 (87) 4.6 (87) 61.4 (87)

Increase in Stockholders' Equity .......................

101.6a

(86.5)b

1,793.4 - 1,691.8 101.6

[54]

1,691.8 [54] 1,778.3 [87] (86.5)

b. The average price for treasury share purchases is computed as: [($175.6 million1 / 3.395 million treasury shares purchased)] = $51.72 1

Treasury stock purchases from Statement of Cash Flows and Statement of Shareholders’ Equity

c. Book Value per Share of Common Stock is computed as: [$1,793.4 [54] / 127.0* ] = $14.12 *135.6 [49] - 8.6 [52] – note: There is no preferred stock outstanding (Note: This value equals the company's computed amount [185] of $14.12.)

Chapter 03 - Analyzing Financing Activities

Exercise 3-8—continued d. The book value per share of common stock is $14.12. However, shares were purchased during the year at an average of about $52 per share (an indicator of market value during the year). In fact, according to note 24 to the financial statements the stock traded in the $70 - $80 range in the fourth quarter of Year 11. There are several reasons why the market value of the stock is much higher than the book value of the stock. First, the market value impounds the investors’ beliefs about the future earning power of the company. Investors apparently have high expectations regarding future profitability. Second, the book value is recorded using accounting conventions such as historical cost and conservatism. Each of these conventions is designed to optimize the reliability of the information but can cause differences between the market and book values of a company’s stock.

Exercise 3-9 (30 minutes) a. The principal transactions and events that reduce the amount of retained earnings include the following: 1. Operating losses (including extraordinary losses and other debit adjustments) . 2. Stock dividends. 3. Dividends distributing corporate assets such as cash or in-kind. 4. Recapitalizations such as quasi-reorganizations. b. The principal reason for making the distinction between contributed capital and retained earnings (earned capital) in the stockholders' equity section is to enable stockholders and creditors to identify dividend distributions as actual distributions of earnings or as returns of capital. This identification also is necessary to comply with most state statutes that provide that there should be no impairment of the corporation's legal or stated capital by the return of such capital to owners in the form of dividends. This concept of legal capital provides some measure of protection to creditors and imposes a liability upon the stockholders in the event of such impairment. Knowledge of the distinction between contributed capital and earned capital provides a guide to the amount of dividends that can be distributed by the corporation. Assets represented by the earned capital, if in liquid form, may properly be distributed as dividends; but invested assets represented by contributed capital should ordinarily remain for continued operation of the corporation. If assets represented by contributed capital are distributed to shareholders, the distribution should be identified as a return of capital and, hence, is in the nature of a liquidating dividend. Knowledge of the amount of capital that has been earned over a period of years after adjustment for dividends also is of value to stockholders in judging dividend policy and obtaining an indication of past profits to the extent not distributed as dividends.

Chapter 03 - Analyzing Financing Activities

Exercise 3-9—continued c. The acquisition and reissuance of its own stock by a firm results only in the contraction or expansion of the amount of capital invested in it by stockholders. In other words, an acquisition of treasury shares by a corporation is viewed as a partial liquidation and the subsequent reissuance of these shares is viewed as an unrelated capital-raising activity. To characterize as gain or loss the changes in equity resulting from a corporation's acquisition and subsequent reissuance of its own shares at different prices is a misuse of accounting terminology. When a corporation acquires its own shares, it is not "buying" anything nor has it incurred a "cost." The price paid represents the amount by which the corporation has reduced its net assets or "partially liquidated." Similarly, when the corporation reissues these shares it has not "sold" anything. It has increased its total capitalization by the amount received. It is the practice of referring to the acquisition and reissuance of treasury shares as a buying and selling activity that gives the superficial impression that, in this process, the firm is acquiring and disposing of assets and that, if different amounts per share are involved, a gain or loss results. Note, when a corporation "buys" treasury shares it is not acquiring assets; nor is it disposing of any assets when these shares are subsequently "sold."

Exercise 3-10 (25 minutes) a. There are four basic rights inherent in ownership of common stock. The first right is that common shareholders may participate in the actual management of the corporation through participation and voting at the corporate stockholders meeting. Second, a common shareholder has the right to share in the profits of the corporation through dividends declared by the board of directors (elected by the common shareholders) of the corporation. Third, a common shareholder has a pro rata right to the residual assets of the corporation if it liquidates. Fourth, common shareholders have the right to maintain their interest (percent of ownership) in the corporation if the corporation issues additional common shares, by being given the opportunity to purchase a proportionate number of shares of the new offering. This fourth right is most commonly referred to as a "preemptive right." b. Preferred stock is a form of capital stock that is afforded special privileges not normally afforded common shareholders in return for giving up one or more rights normally conveyed to common shareholders. The most common right given up by preferred shareholders is the right to participate in management (voting rights). In return, the corporation grants one or more preferences to the preferred shareholders. The most common preferences granted to preferred shareholders are these:

Chapter 03 - Analyzing Financing Activities

Exercise 3-10—continued 1. Dividends are paid to common shareholders only after dividends have been paid to preferred shareholders. 2. Claims of preferred shareholders are senior to common shareholders for residual assets (after creditors have been paid) in the case of corporation liquidation. 3. Although the board of directors is under no obligation to declare dividends in any particular year, preferred shareholders are granted a cumulative provision stating that any dividends not paid in a particular year must be paid in subsequent years before common shareholders are paid any dividend. 4. Preferred shareholders are granted a participation clause that allows them to receive additional dividends beyond their normal dividend if common shareholders receive dividends of greater percentage than preferred shareholders. This participation is on a one-to-one basis (fully participating); common shareholders are allowed to exceed the rate paid to preferred shareholders by a defined amount before preferred shareholders begin to participate: or, the participation clause can carry a maximum rate of participation to which preferred shareholders are entitled. 5. Preferred shareholders have the right to convert their preferred shares to common shares at a set future price no matter what the current market price of the common stock is. 6. Preferred shareholders also can agree to have their stock callable by the corporation at a higher price than when the stock was originally issued. This item is generally coupled with another preference item to make the issue appear attractive to the market. c. 1. Treasury stock is stock previously issued by the corporation but subsequently repurchased by the corporation. It is not retired stock, but stock available for issuance at a subsequent date by the corporation. 2. A stock right is a privilege extended by the corporation to acquire additional shares (or fractional shares) of its capital stock. 3. A stock warrant is physical evidence of stock rights. The warrant specifies the number of rights conveyed, the number of shares to which the rightholder is entitled, the price at which the rightholder can purchase additional shares, and the life of the rights (time period over which the rights can be exercised).

Chapter 03 - Analyzing Financing Activities

Exercise 3-11 (12 minutes) a. These cash distributions are not dividends. Instead, they are returns of capital. Dividends are distributions of past earnings of the company. Since this company has not earned any net income, there are no retained earnings from which dividends could be paid. Thus, these cash distributions are being made from capital previously contributed to the company by the owners. b. There are at least a couple of reasons why a return of capital might be made. First, the company may be going out of business. Second, in a closely held company, influential owners may have mandated the payments. A distribution of capital is usually the result of special circumstances confronted by a company.

Exercise 3-12 (12 minutes) a. Purchasing its own shares is similar to the payment of dividends in that cash assets are reduced in both situations. That is, in each case, the company is distributing cash to shareholders. In the case of dividends, all shareholders are receiving cash in a proportionate manner. In the case of share repurchases, only selected shareholders receive cash distributions from the company. b. Managers might prefer to purchase its own company’s shares because this serves to increase financial performance measures such as earnings per share and return on shareholders equity. c. Investors are taxed on dividends received from companies. The tax rate on dividends is often quite high. Investors also are taxed on gains on the sale of shares. Thus, investors often would prefer that companies buy back shares rather than pay a dividend. In this way, investors that are happy with the performance of the company can maintain or increase their ownership (it can increase as a percent of the total). Investors that would like to reduce their investment in the company can choose to do so by selling shares back to the company pursuant to the offer of the company to repurchase shares. Also, the gain on sale of stock by investors is usually taxed at a lower rate than dividends.

Chapter 03 - Analyzing Financing Activities

Exercise 3-13 (15 minutes) a. Defined contribution plans are not affected by variables such as stock market performance and employee tenure and life span. As a result, pension expense and liability associated with defined contribution plans is more predictable and less variable than are pension expense and liability associated with defined benefit plans. b. If managers can attract adequate talent with defined contribution plans, they would prefer the defined contribution plans because of the predictability of and less volatility associated with pension expense. c. Defined contribution plans place the investment risk on the employee whereas defined benefit plans place the risk on the company. Under a defined contribution plan, the company pays a defined contribution into the employees’ pension plan and then the employee invests the assets according to their tolerance for risk and investment strategy. Thus, employees with a low tolerance for risk might prefer the defined benefit plan because they would not have to bear any of the investment risk. Conversely, employees with a high tolerance for risk might prefer the defined contribution plan because they might feel that they can invest the funds better and reap higher benefits at retirement.

Exercise 3-14 (25 minutes) a. Two major accounting challenges resulting from the use of a defined benefit pension plan are: • Estimates or assumptions must be made concerning the future events that will determine the amount and timing of benefit payments. • Some method of attributing the cost of pension benefits to individuals’ years of service must be selected. These two challenges arise because a company must recognize pension costs before it pays pension benefits. b. Carson determines the service cost component of the net pension cost as the actuarial present value of pension benefits attributable to employee services during a particular period based on the application of the pension benefit formula. c. Carson determines the interest cost component of the net pension cost as the increase in the projected benefit obligation due to the passage of time. Measuring the projected benefit obligation requires accrual of an interest cost at an assumed discount rate. d. Carson determines the actual return on plan assets component of the net pension cost as the change in the fair value of plan assets during the period, adjusted for (1) contributions and (2) benefit payments.

Chapter 03 - Analyzing Financing Activities

PROBLEMS Problem 3-1 (30 minutes) a. 1. $200 million 2. As the maturity date approaches the liability will be shown at increasingly larger amounts to reflect the accrual of interest that will be due at maturity. 3. The annual journal entry is: Interest expense ...................................................... Unamortized discount ................................... [Note: No cash is involved since it is a zero coupon note.]

# #

b. This amount represents repayment of principal along with interest—it is also equal to the present value of the future principal and interest payments, discounted at the interest rate in effect at the time of issuance. Cash outflows will mimic the principal repayment and interest payment schedules per the debt contract(s).

c. The $28 million amount will be paid out. This amount will include $6.5 million of interest implicit in the leases.

d. This is reported in the notes—Note 10 to the financial statements (the Lease footnote). The lease payments will be expensed as they occur over the years.

e. The company paid an average interest rate of 11.53% on the beginning balance of interest-bearing debt [($116.2 /($202.2 + $805.8)]. The debt structure did not change substantially during Year 11. At the beginning of Year 12, the company has interest bearing debt totaling $1,054.8 ($282.2 + $772.6). The relative mix of debt has not changed substantially. Thus, it is reasonable to predict interest expense by multiplying this beginning balance by the 11.53% average rate experienced in the previous year. Therefore, the interest expense projection is $121.6 million. (Note that the short-term debt is a bit larger in percent of the total debt burden so the company may pay an average interest amount of slightly less than the 11.53% paid in the previous year.)

Chapter 03 - Analyzing Financing Activities

Problem 3-2 (40 minutes)

a. 1/1/Year 1 Enter into Lease Contract Leased Property under Capital Leases ............................... Lease Obligation under Capital Leases ..........................

39,930 39,930

12/31/Year 1 Payment of Rental Interest on Leases ................................................................ Lease Obligations under Capital Leases ............................ Cash .................................................................................

3,194.40 (1) 6,805.60

Amortization of Property Rights Amor. of Leased Property under Capital Leases ............... Leased Property under Capital Leases .........................

7,986 (2)

10,000

7,986

(1) $39,930 x .08 = $3,194.40 (2) $39,930  5 = $7,986

ASSETS Leased property under capital leases……………

Balance Sheet December 31, Year 1 LIABILITIES Lease Obligations under $31,944 (1) capital leases……. $33,124.40 (2)

Income Statement For Year Ended December 31, Year 1 Amortization of leased property ................................................. Interest on leases.......................................................................... Total lease-related cost for Year 1 ..............................................

$ 7,986.00 3,194.40 $11,180.40 (3)

(1) $39,930 - $7,986 = $31,944 (2) $39,930 - $6,805.60 = $33,124.40 (3) To be contrasted to rental costs of $10,000 when no capitalization takes place.

Chapter 03 - Analyzing Financing Activities

Problem 3-2—continued c. Payments of Interest and Principal Total Interest Payment of Payment at 8% Principal

Year 1 2 3 4 5

10,000 10,000 10,000 10,000 10,000 $50,000

$3,194.40 2,649.95 2,061.95 1,426.90 736.80 $10,070.00

$6,805.60 7,350.05 7,938.05 8,573.10 9,263.20 $39,930.00

Principal Balance $39,930.00 33,124.40 25,774.35 17,836.30 9,263.20 —

Year 1 2 3 4 5

Expenses to Be Charged to Income Statement Lease Total Expense Amortization Interest Expenses $10,000 $ 7,986.00 $ 3,194.40 $11,180.40 10,000 7,986.00 2,649.95 10,635.95 10,000 7,986.00 2,061.95 10,047.95 10,000 7,986.00 1,426.90 9,412.90 10,000 7,986.00 736.80 8,722.80 $50,000 $39,930.00 $10,070.00 $50,000.00

e. The income and cash flow implications from this capital lease are apparent in the solutions to parts c and d. The student should note that reported expenses exceed the cash flows in earlier years, while the reverse occurs in later years.

Chapter 03 - Analyzing Financing Activities

Problem 3-3 (30 minutes) a. A lease should be classified as a capital lease when it transfers substantially all of the benefits and risks inherent to the ownership of property by meeting any one of the four criteria for classifying a lease as a capital lease. Specifically: • Lease J should be classified as a capital lease because the lease term is equal to 80 percent of the estimated economic life of the equipment, which exceeds the 75 percent or more criterion. • Lease K should be classified as a capital lease because the lease contains a bargain purchase option. • Lease L should be classified as an operating lease because it does not meet any of the four criteria for classifying a lease as a capital lease. b. Borman records the following liability amounts at inception: • For Lease J, Borman records as a liability at the inception of the lease an amount equal to the present value at the beginning of the lease term of minimum lease payments during the lease term, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon. However, if the amount so determined exceeds the fair value of the equipment at the inception of the lease, the amount recorded as a liability should be the fair value. • For Lease K, Borman records as a liability at the inception of the lease an amount determined in the same manner as for Lease J, and the payment called for in the bargain purchase option should be included in the minimum lease payments. • For Lease L, Borman does not record a liability at the inception of the lease. c. Borman records the MLPs as follows: • For Lease J, Borman allocates each minimum lease payment between a reduction of the liability and interest expense so as to produce a constant periodic rate of interest on the remaining balance of the liability. • For Lease K, Borman allocates each minimum lease payment in the same manner as for Lease J. • For Lease L, Borman charges minimum lease (rental) payments to rental expense as they become payable. d. From an analysis viewpoint, both capital and operating leases represent economic liabilities as they involve commitments to make fixed payments. The fact that companies can structure leases as "operating leases" to avoid balance sheet recognition is problematic from the perspective of analysis of assets. If the leased assets are used to generate revenues, they should be considered in ratios such as return on assets and other measures of financial performance and condition.

Chapter 03 - Analyzing Financing Activities

Problem 3-4 (30 minutes) a. The proceeds from the issue are $ 55.36 million. b. Amortized Cost Year 0 1 2 3 Total

Coupon 3.00 3.00 3.00 9.00

Present Value 55.36 56.79 58.33 60.00

Interest Rate = Premium/ (Discount) (4.64) (3.21) (1.67) 0.00

8% Interest

Amortization

Total

4.43 4.54 4.67 13.64

(1.43) (1.54) (1.67) (4.64)

3.00 3.00 3.00 9.00

Interest

Unrealized Gain

Total Expense

4.43 3.00 1.30 8.73

3.21 5.19 (3.49) 4.91

7.64 8.19 (2.19) 13.64

c. Fair Value Accounting Interest Year Coupon Rate 0 8% 1 3.00 5% 2 3.00 2% 3 3.00 Total 9.00

Fair Value 55.36 60.00 65.19 60.00

d. Amortized cost accounting assumes the same effective interest rate of 8% every year. Fair value accounting updates the effective interest rate every year. Because of this, the fair value of the bond is updated every year. The change in fair value is accounted for as unrealized gain or loss, while the interest rate every year is determined using the updated fair value and effective interest rate. However, note that the total amount charged to income ($ 13.64 million) is the same under both methods over the life of the bond: the amortized cost method charges the entire amount as interest expense while the fair value method as interest expense and unrealized gain/loss.

Chapter 03 - Analyzing Financing Activities

Problem 3-5B (45 minutes) a. Ratio calculations for Jerry’s Department Stores (JDS) and Miller Stores (MLS) 1. Price-to-book ratio: Ratio

JDS

MLS

Book value

= $6,000 / 250 shares = $24.00

= $7,500 / 400 shares = $18.75

Price/book value

= $51.50 / $24.00 = 2.15

= $49.50 / $18.75 = 2.64

2. Total debt to equity ratio: Ratio

JDS

MLS

Total debt to equity [Total debt = (S-T debt + L-T debt)] / Equity

= $0 + 2,700 / $6,000

=$1,000 + $2,500 / $7,500

= $2,700 / $6,000 = 45.00%

= $3,500 / $7,500 = 46.67%

3. Fixed-asset utilization (turnover): Ratio

JDS

MLS

Sales / fixed assets

= $21,250 / $5,700 = 3.73

= $18,500 / $5,500 = 3.36

b. Investment Choice and Justification Based on Part A Based on Westfield’s investment criteria for investing in the company with the lowest price-to-book ratio (P/B) and considering solvency and asset utilization ratios, JDS is the better purchase candidate. The analysis justification follows: Ratio

JDS

MLS

Company Favored

Price-to-book ratio (P/B)

2.15

2.64

JDS: lower P/B

ii.

Total debt to equity

45%

47%

JDS: lower debt or ratios are very similar

iii.

Asset turnover

3.73

3.36

JDS: higher turnover

Chapter 03 - Analyzing Financing Activities

Problem 3-5—continued c.

Investment Choice and Justification Based on Note Information Note: Details underlying the Balance Sheet Adjustments ($ millions): JDS: i. Leases – recognition of MDS’s present value lease payments will add $1,000 to JDS’s property, plant, and equipment (PP&E) and is offset by a $1,000 addition to JDS’s long-term debt. ii. Receivables – recognition of JDS’s sale of receivables with recourse will increase assets (accounts receivable) by $800 and short-term debt used to finance accounts receivable by $800. MLS: iii. Pension – recognition of current excess funding for the pension plan will add $1,600 to assets and $1,600 to owners’ equity ($3,400 plan assets - $1,800 projected benefit obligation).

Adjusted Calculations Made ($ millions) JDS: Needed adjustments: Assets (PP&E) +$1,000 (Accounts receivable) +$800 i.

ii.

Liabilities (Long-term debt [LTD]) +$1,000 (Short-term debt [STD]) +$800

Book value per common share: No net adjustment to JDS owners’ equity of $6,000; thus, $6,000 / 250 million shares = $24.00 book value per share Adjusted total debt-to-equity ratio: $2,700 +1,000 + 800 $4,500 Adjusted debt-to-equity ration = $4,500 / $6,000 = 75%

iii.

Historical LTD LTD STD Adjusted total debt

Fixed-asset utilization (turnover) = $5,700 Historical fixed assets +1,000 PP&E (JDS leases) $6,700 JDS adjusted fixed assets Adjusted fixed-asset utilization (sales/adjusted fixed assets): $21,250 / $6,700 = 3.17

MLS: Needed adjustments: Assets (Pension) +$1,600

Owner’s Equity +$1,600

Book value per common share: $7,500 historical equity + $1,600 = $9,100 Adjusted equity; thus, $9,100 / 400 million shares = $22.75 adjusted book value per share

ii.

Adjusted total debt-to-equity ratio: Debt (no adjustments) / Adjusted equity = Adjusted debt / equity $3,500 / $9,100 = 38%

iii.

Fixed-asset utilization (turnover): Sales / Fixed assets (no adjustments) $18,500 / $5,500 = 3.36

Chapter 03 - Analyzing Financing Activities

Problem 3-5B—continued Part c continued:

Summary of Adjustments Ratio Adjusted book value Adjusted debt to equity Fixed-asset utilization

JDS $24.00 75% 3.17

MLS $22.75 38% 3.36

Final Results of Analysis: Based on Westfield’s investment criteria of investing in companies with low adjusted Price-to-Book and considering the adjusted solvency and asset utilization ratios, MLS is the better purchase candidate. The analysis justification follows: Ratio

JDS

MLS

Company favored

Price to adjusted book

2.15a

2.18b

approximately equal

ii.

Adjusted debt to equity

75%

36%

MLS – lower adjusted debt to equity

iii.

Fixed-asset utilization

3.17

3.36

MLS – higher asset utilization

$51.50 / $24.00 = 2.15. $49.50 / $22.75 = 2.18.

Chapter 03 - Analyzing Financing Activities

Problem 3-6 (20 minutes) a. In the case of environmental liabilities, there are several unknowns that are especially difficult to predict. The unknowns relate to the clean up and to the lawsuits that result from the hazardous waste. Specifically: ▪ The company cannot predict the timing of an environmental tragedy such as that which occurred in the Union Carbide factory. ▪ The company doesn’t know if it will be identified as a potentially responsible party in a yet uncovered hazardous waste site. This can include a former site of the company. ▪ If the company is identified as a potentially responsible party, we do not know the portion of the clean up costs that it will be required to pay. ▪ The company doesn’t know what costs would be incurred in the actual clean up of the site. ▪ The company needs to determine which internal costs should be included in the cost of the clean up. For example, if it uses its laborers for site clean up activities, the direct cost of labor can become a part of the overall cost of cleanup. ▪ The company must guess whether lawsuits will be filed against the company related to the hazardous waste site. ▪ The company must estimate the probability of loss or settlement in the lawsuit and the amount of the damages to be paid b. We must factor the possibility of catastrophic environmental loss into the pricing of the company. For some industries, the probability assigned to occurrence might be very small. Thus, we will not assign a large weighting factor. However, in some industries, the base-line probability can be significant. In addition, we will update these probabilities based on additional information. For example, after the Bhopal tragedy, analysts discounted the valuations of key competitors. This indicates that analysts revised their beliefs about the possibility of loss upwards from earlier estimations. In classic valuation models, an analyst can reflect this risk in the discount factor applied to future earnings or future cash flows. c. Some industries especially predisposed to environmental risks include: oil producers, chemical manufacturers, tobacco producers, insulation manufacturers and distributors, medical firms, bio-tech firms.

Chapter 03 - Analyzing Financing Activities

Problem 3-7B (30 minutes) a. The service cost of $22.1 million for Year 11 is the present value of actuarial benefits earned by employees in Year 11. b. Year 11: Discount rate = 8.75% Year 10: Discount rate = 9.00% A higher discount rate will lead to a lower present value of service cost. In this case, with the reduction in discount rate from 9% to 8.75%, the service cost is increased. c. The interest cost is computed by multiplying the projected benefit obligation (PBO) as of the end of the prior year by the discount rate of 8.75%. d. The actual return on assets in Year 11 is $73.4 million [113]. It consists of investment income plus the realized or unrealized appreciation or depreciation of plan assets during the year. The expected return on plan assets is computed by multiplying the expected long-term rate of return (9%) on plan assets by the market value of plan assets at the beginning of the period or $773.9 million [120]. This means the expected return is $69.65 million (computed as $773.9 x 9%). The actual return subjects pension cost to more fluctuation from volatility in the financial market—and, accordingly, increasing volatility in the annual pension cost. As a result, expected return is used in determining pension expense. The difference between actual and expected return will be amortized over an appropriate period. e. Accumulated benefit obligation (ABO) is the employer's obligation to employees' pension based on current and past compensation levels rather than future levels. Therefore, it could amount to the employer's current obligation if the plan were discontinued presently. f. The projected benefit obligation (PBO) is the employer's obligation to employees' pension based on future compensation level. The difference between PBO and ABO is due to the inclusion of a provision of 5.75% increase in future compensation level by PBO. In Year 11, the difference between PBO and ABO is $113.3 million [120]. g. Yes; indeed, there is prepaid pension expense of $172.5 million in Year 11 [120].

Problem 3-8 (20 minutes) Periodic pension cost computation ($ millions) Service Cost ($586 x 1.10) .............................................................................. Interest Cost (PBO x Discount Rate = $2,212 x 0.085) ................................. Return on plan assets ($3,238 x 0.115).......................................................... Amortization of deferred loss ($48 / 30 years) .............................................. Periodic pension cost ....................................................................................

$645 188 (372) 2 $463

Chapter 03 - Analyzing Financing Activities

Problem 3-9 (10 minutes) Because this is a zero coupon bond, it has only one payment of the face value at the end of 10 years. 100 Therefore, at 8% effective rate its present = $ 46.32 value is (1.08)10 The amortized cost of the bond is therefore $ 46.32 million. This is the amount allocated to liability. The amount allocated to equity is $ 97.4 million - $ 46.32 million = $ 51.08 million. The discount on the bond = (100 - 46.32) = $ 53.68 million.

Chapter 03 - Analyzing Financing Activities

CASES Case 3-1B (90 minutes) a. Key ratios for Revlon in 2010 and 2011 are as follows: Revlon 2011

2010

Return on Investment* Return on Assets

4.76%

30.12%

Return on Equity

-7.69%

-47.00%

Total Debt to Equity

-2.670

-2.560

Long Term Debt to Equity

-1.752

-1.734

Times Interest Earned

1.981

1.824

Current Ratio

1.547

1.495

Solvency

Liquidity

*Return ratios for 2010 computed on year-end asset and equity balances, in place of 2-year average values.

Revlon’s financial performance shows a marked drop from 2010 to 2011. Return on assets fell from 30.1% in 2010 to 4.8% in 2011 due to a sharp drop in net income across the years. However, 2010 appears to be an anomalous year for Revlon, as a large portion of 2010’s net income is due to a tax benefit for the year. If we focus instead on income from continuing operations before tax, return on assets increases from 7.3% in 2010 to 8.0% in 2011. As a result, it appears that Revlon is slightly profitable in both 2010 and 2011 when one-time charges/benefits are excluded from consideration. Further, Revlon has a negative return on equity in both 2010 and 2011. This is due to accumulated losses in retained earnings for Revlon, which makes the ROE numbers difficult to interpret for the firm. Revlon’s financial position also shows little change from 2010 to 2011. Revlon continues to fund its accumulated losses in retained earnings with debt, as indicated by the negative total debt to equity and long-term debt to equity ratios that are above 1.0 in 2010 and 2011. In order to sustain this highly levered financial position, Revlon must demonstrate to lenders an ability to pay annual interest and refinance principal amounts. Revlon’s times interest earned ratio increased from 1.82 in 2010 to 1.98 in 2011, indicating that Revlon is earning twice what it pays in interest on an annual basis. In addition, Revlon’s current ratio increased slightly from 1.50 to 1.55. These ratios 3-42 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 03 - Analyzing Financing Activities

indicate that Revlon is currently demonstrating an ability to make payments on its outstanding loans and appears somewhat liquid. Revlon’s riskiness stems from two sources: operating risk and financial risk. Operating risk stems from the nature of Revlon’s operations in the cosmetics and toiletries industry. This industry is generally viewed as highly stable, as consumers tend to require these products regardless of economic conditions. This points to a moderate degree of operating risk for Revlon. In contrast, Revlon’s financial risk is high due to its high degree of leverage. Financial leverage increases the risk that Revlon fails to make a required interest or principal payment, thereby defaulting on its loans. A default allows creditors to force the firm into bankruptcy proceedings. In bankruptcy, equity holders in the firm generally receive no compensation for their holdings and lenders receive only partial return of funds. In addition to default risk, Revlon also faces refinancing risk from its loans. If Revlon fails to generate sufficient internal funds over the next few years to fund more of its assets using retained earnings in place of debt, the firm will be forced to refinance its existing debt when it comes due. This exposes the firm to the risk that its refinanced debt carries a much higher rate than existing debt, or that the firm may not be able to refinance at all. In this case, Revlon would either be forced to approach a buyer for the firm’s assets, issue shares on an equity exchange at potentially high cost to existing equity holders, or file for bankruptcy protection. Refinancing risk will increase as Revlon moves closer to the maturity dates for its existing loans. b. Revlon currently funds its asset base with debt in place of equity. There are several potential benefits of this strategy for Revlon’s management and/or shareholders. First, the reliance on debt to fund its assets limits the number of equity holders in Revlon with voting rights. In the case of an acquisition, this may make negotiating with a buyer much simpler as the number of parties involved will likely be fewer. Second, the low interest rates charged on existing debt for Revlon may be difficult to achieve on a flotation of Revlon shares on the stock market. This cost advantage for debt is due to the low interest rate regime in place during 2010 and 2011. Third, some financial structure experts point to the disciplining effect of debt on firm management. When debt is issued, managers now must work to make required interest payments each period rather than choosing to make optional dividend payments. This can force managers to streamline operations in order to have sufficient funds to make interest payments. In contrast, there are some potential drawbacks to Revlon’s existing debt load. First, debt increases the risk that Revlon fails to make a required interest or principal payment, thereby defaulting on its loans. A default allows creditors to force the firm into bankruptcy proceedings. In bankruptcy, equity holders in the firm generally receive no compensation for their holdings and managers are usually fired with minimal severance pay. Second, Revlon faces refinancing risk from its loans. If Revlon fails to generate sufficient internal funds over the next few years to finance more of its assets using retained 3-43 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 03 - Analyzing Financing Activities

earnings in place of debt, the firm will be forced to refinance its existing debt when it comes due. This exposes the firm to the risk that its refinanced debt carries a much higher rate than existing debt, or that the firm may not be able to refinance at all. In this case, Revlon would either be forced to approach a buyer for the firm’s assets, issue shares on an equity exchange at potentially high cost to existing equity holders, or file for bankruptcy protection. Refinancing risk will increase as Revlon moves closer to the maturity dates for its existing loans. Third, Revlon’s debt load may make managers overly cautious in their selection of projects. If managers are focused on making upcoming interest payments, they may forego profitable but risky projects that pay off in the long term. This can destroy long-term value for equity holders in the firm. c. Revlon’s principal debt types are as follows: 2011 Revolving Credit Facility

2011 Term Loan Facility Eurodollar Rate plus 3.50% per annum or the Alternate Base Rate plus 2.50%

9¾% Senior Secured Notes

Senior Subordinated Term Loan

9.75% coupon rate, 10% effective rate

Not specified

Interest rate

Commitment fee of 0.375% on unused portion

Total term

4.5 years

6 years

3 years

Remaining term

4.5 years (or 3.5 years, if the 9¾% notes are not repaid in 2015)

6 years (or 3.5 years, if the 9¾% notes are not repaid in 2015)

4 years

3 years

Prior to maturity, revolving loans are required to be prepaid with: (i) the net cash proceeds from sales of Revolving Credit First Lien Collateral by Revlon or any of its subsidiaries; and (ii) the net proceeds from the issuance by Revlon or any of its subsidiaries of certain additional debt.

At the end of every quarter, Revlon is required to repay $2 million of the principal amount of the term loans. In addition, the term loans under the 2011 Term Loan Facility are required to be prepaid with: (i) the net cash proceeds in excess of $10 million received each year from sales of Term Loan First Lien Collateral by Revlon; (ii) the net proceeds from the issuance by Revlon or any of its subsidiaries of certain additional debt; and (iii) 50% of Revlon’s “excess cash flow” for each year payable during the first 100 days of the following year.

Upon a Change in Control (as defined by the agreement), each holder of the 9¾% Senior Secured Notes will have the right to require Revlon to repurchase all or a portion of such holder’s 9¾% Senior Secured Notes at a price equal to 101% of the principal amount, plus accrued and unpaid interest, if any, to the date of repurchase.

Upon any change of control, Revlon is required to repay the Senior Subordinated Term Loan in full. If Revlon conducts any equity offering before the full payment of such loan, and if holders of the Senior Subordinated Term Loan elect to participate, the holders may pay for any shares it acquires in such offering either in cash or by tendering debt valued at its face amount, including any accrued but unpaid interest, on a dollar for dollar basis or in any combination of cash and such debt.

Payment details

Protections: Seniority

------------------------- Senior debt -------------------------

2nd priority

Chapter 03 - Analyzing Financing Activities

Security

The liens on inventory, accounts receivable, deposit accounts, investment property, real property, equipment, fixtures and certain intangible property (the “Revolving Credit First Lien Collateral”) secure the 2011 Revolving Credit Facility on a first priority basis, the 2011 Term Loan Facility on a second priority basis and the 9¾% Senior Secured Notes on a third priority basis. The liens on the capital stock of Revlon and its subsidiaries and intellectual property and certain other intangible property (the “Term Loan First Lien Collateral”) secure the 2011 Term Loan Facility on a first priority basis and the 2011 Revolving Credit Facility and the 9¾% Senior Secured Notes on a second priority basis.

Negative covenants

The 2011 Credit Facilities, 9¾% Senior Secured Notes, and the Senior Subordinated Term Loan Agreement all contain covenants that limit the ability of Revlon and its subsidiaries to, among other things: (i) incur additional indebtedness, (ii) pay dividends on or redeem or repurchase stock, (iii) engage in certain asset sales, (iv) make certain types of investments and other restricted payments, (v) engage in certain transactions with affiliates, (vi) restrict dividends or payments from subsidiaries, and (vii) create liens on their assets.

Affirmative covenants

If and when the difference between amounts borrowed and the borrowing base ($ 140 million) is less than $20.0 million for a specified period, Revlon needs to maintain a consolidated fixed charge coverage ratio (the ratio of EBITDA minus Capital Expenditures to Cash Interest Expense for such period) of a minimum of 1.0 to 1.0.

The term loan contains a financial covenant limiting Revlon’s first lien senior secured leverage ratio (the ratio of Revlon’s Senior Secured Debt that has a lien on the collateral which secures the 2011 Term Loan Facility to EBITDA), to no more than 4.0 to 1.0 for each period of four consecutive fiscal quarters.

None

Revlon’s 2011 credit facilities and its 9¾% notes are all senior loans that are required to be paid in full during bankruptcy proceedings before other loans are paid. These loans are also secured by Revlon’s assets, with varying priority for each of these loans. Finally, these three loans specify a series of negative covenants that prohibit Revlon from taking specific actions that are outside the normal course of operations for Revlon. The 2011 credit facilities also specify some affirmative covenants. The 2011 Revolving Loan requires Revlon to maintain a sufficient value in accounts receivable, inventory, and real property and equipment in order to support the loan. If Revlon’s asset values fall close to the amount borrowed under the revolving facility, Revlon must then maintain a consolidated fixed charge coverage ratio of 1.0. The 2011 Term Loan carries an affirmative covenant that specifies threshold values that must be met for the senior secured leverage to EBITDA ratio. The seniority, security, and covenants placed in the lending agreements for these loans make them the safest borrowings for Revlon’s creditors. The next loan that follows in the pecking order in terms of safety for lenders is the Senior Subordinated Term Loan. The term “senior subordinated” indicates 3-45 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 03 - Analyzing Financing Activities

that this loan is paid in bankruptcy after the 2011 credit facilities and the 9¾% notes have been paid, but before any remaining loans or equity of Revlon. This term loan has no assets securing its payment, indicating that it is a general obligation of Revlon that will be paid from funds remaining after the secured assets are sold. Finally, the senior subordinated term loan has negative covenants similar to the loans discussed above, and has no affirmative covenants that specify thresholds for financial ratios. After the above loans have been paid, any remaining funds will go first to the holders of redeemable preferred shares and then finally to common equity holders in Revlon. d. 1. Negative covenants placed in Revlon’s lending agreements avoid involving lenders in managing Revlon’s operations. Because lenders are not experts in managing the day-to-day operations of a cosmetics and toiletries firm like Revlon, covenants are designed to ensure that managers retain responsibility for the day-to-day operations of Revlon’s business. This is essentially a clear division of responsibility between decisions that involve the financial structure of the firm (like changes in control due to mergers and acquisitions) vs. the operations of the firm. Negative covenants are generally aimed at involving lenders in major decisions where the lenders have a vested interest. In contrast, affirmative covenants specify thresholds that must be maintained by Revlon’s managers to avoid covenant violation. These affirmative covenants allow lenders to step in and review the day-to-day operations of Revlon in cases where managers may be failing to act in the best interest of the lenders. These covenants are essentially trip wires that act as an early warning system for lenders when the firm’s operations are deteriorating. 2. The amount that Revlon is able to borrow under its 2011 Revolving Credit Facility is determined by the value of a group of assets that consists of accounts receivable, inventory, and real property and equipment. Revlon may borrow up to the value of these assets less $ 20 million, up to a full amount of $ 140 million. If the value of Revlon’s assets falls to within $ 20 million of the amount borrowed, then Revlon is still eligible to borrow up to $ 140 million if its consolidated fixed charge coverage ratio (the ratio of EBITDA minus Capital Expenditures to Cash Interest Expense) is greater than 1.0. Otherwise, Revlon must pay down the revolving loans until the outstanding borrowing is below the asset value minus $ 20 million. This calculation is specified in the loan agreement to ensure that Revlon maintains enough value in secured assets to pay off the revolving loan. In 2011, the value of Revlon’s current assets and net PP&E comes to $ 617.6 million. If we assume that this is a good measure of the asset base that is securing the revolving loan, then Revlon is eligible to borrow the full $ 140 million amount. 3-46 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 03 - Analyzing Financing Activities

3. If Revlon fails to repay or refinance its 9¾% notes, the terms specified in the 2011 Credit Facilities indicate that these obligations will come due in August, 2015 in place of their later maturity dates. This is essentially an acceleration provision that requires Revlon to repay its other outstanding loans early if the firm appears unable to repay or refinance its 9¾% notes. These types of acceleration provisions protect lenders from further deterioration in a firm’s ability to pay. e. Revlon’s 2011 Revolving Credit Facility specifies a minimum fixed charge coverage ratio of 1.0 in the event that the value of assets securing the loan falls to within $ 20 million of the amount borrowed. Although Revlon has no outstanding amounts borrowed under this loan at the end of 2011, we can examine the margin of safety available under this covenant should Revlon choose to borrow under the loan. Revlon’s 2011 ratio of EBITDA minus Capital Expenditures to Cash Interest Expense is: (202.4 - 13.2)/91.3 = 2.07. This assumes that interest expense on the income statement is paid in cash. Based on this calculation, it appears that Revlon has a fairly wide margin of safety under this covenant. Revlon’s 2011 Term Loan specifies an acceptable range for Revlon’s first lien senior secured leverage ratio (the ratio of Revlon’s Senior Secured Debt that has a lien on the collateral which secures the 2011 Term Loan Facility to EBITDA) of 1.0 to 4.0. Because Revlon has not borrowed any funds under the 2011 Revolving Credit Facility and Revlon’s 9¾% notes have only second and third priority liens on assets, the first lien senior secured leverage ratio is based only on the amount borrowed under the 2011 Term Loan. This ratio is: 787.6/202.4 = 3.89. Based on this calculation, Revlon appears very close to the maximum secured leverage ratio. If Revlon’s EBITDA drops in 2012 and/or Revlon borrows additional funds under the 2011 Revolving Credit Facility, then Revlon stands a good chance of violating this covenant. f. 1. Redeemable preferred stock is classified as debt on Revlon’s balance sheet because the preferred stock carries a number of features that are similar to debt. First, the preferred shares are required to be redeemed by Revlon in October, 2013 for $ 5.21 in cash. This redemption amount is similar to the face value of debt. Second, Revlon is required to pay the holders of preferred shares an annual dividend, similar to an interest payment. While preferred shareholders are not legally able to force Revlon into default for failing to pay this annual dividend, all dividends are required to be paid by the October, 2013 redemption date. Third, Revlon is prevented from paying dividends to common equity holders until redeemable preferred dividends have been paid in full. This is similar to debt covenants preventing dividend payment in the event that interest is not paid. 2. Despite sharing several features with debt, Revlon’s redeemable preferred shares are lower in the pecking order relative to Revlon’s remaining longterm debt. Redeemable preferred shares have no specific assets securing 3-47 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 03 - Analyzing Financing Activities

their value, are subordinate in payment order to all other debt, and have no covenants other than a covenant restricting payment of common dividends until preferred dividends have been paid in full. In addition to the limited protections available, preferred shareholders are unable to force Revlon into default for the non-payment of preferred dividends. As a result of the limited legal and contractual protections available to holders of redeemable preferred shares, the redeemable preferred shares are riskier than Revlon’s remaining debt. In order to compensate preferred shareholders for this additional risk, Revlon must offer a higher rate of return relative to its other debt. This explains why the 12.75% annual cash dividend on each preferred share is higher than the 9.75% rate on Revlon’s senior secured notes. 3. The effective interest rate on Revlon’s redeemable preferred shares may be computed by dividing the interest expense recognized in 2011 related to redeemable preferred shares by the present value of those shares at the end of 2010. The effective interest rate is: 6.4/48.1 = 13.31%. The interest expense recognized for redeemable preferred shares will gradually increase each year as the discount on the redeemable preferred shares at the issue date is amortized. This discount will be completely amortized by the time of redemption in October, 2013. For the first year following the issue of Revlon’s redeemable preferred shares, the interest expense would have been calculated based on the effective interest rate of 13.31%. Given a fair value at issue of $ 47.9 million, the interest expense during the first year was: 13.31% x 47.9 = $ 6.37 million. Of this interest expense, $ 6.20 million represents the cash dividend payment to preferred shareholders and $ 0.17 million goes toward amortizing the $ 0.7 million discount on preferred stock at issue. g. A loss on early extinguishment of debt means that Revlon paid off existing debt in 2010 and 2011 at an amount that was higher than the book value of those loans. Companies frequently decide to refinance existing debt by paying off loans early when interest rates drop. Many loan agreements allow this early payment for a premium over the face value. For instance, Revlon’s 9¾% notes allow Revlon to pay off this loan prior to redemption for some premium over the face value. Companies find this early extinguishment advantageous when the current interest rates are low enough to compensate for this early payment premium.

Case 3-2 (30 minutes) a. Campbell Soup reports the following categories of liabilities • Interest bearing (short-term and long-term) 3-48 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 03 - Analyzing Financing Activities

• •

Non-interest-bearing short-term operating obligations (payables and accruals) Other – primarily deferred taxes (non-interest-bearing)

b. Long-term debt [46] A B

159.7 0.3

G H

24.3 250.3

805.8

beg

0.1 99.8 100.0 199.6

C D E F

1.9 772.6

I end

c. Campbell Soup has issued a number of long-term Notes and Debentures, all of which appear to be fixed rate. Thus, the company does not require derivatives in order to manage interest rate risk. Further, Campbell Soup’s debt footnote indicates maturities of (in $millions) $227.7 in Year 12, $118.9 in Year 13, $17.8 in Year 14, $15.9 in Year 15, and $108.3 in Year 16. The remaining long-term debt matures in excess of 5 years. Given Campbell’s operating cash flow of $805.2 million, solvency does not appear to be a problem.

Chapter 03 - Analyzing Financing Activities

Case 3-3 (30 minutes) a. Book value of common stock is equal to total assets less liabilities and claims of securities senior to the common stock (e.g., preferred stock) at amounts reported on the balance sheet. Book value can also be reduced by unrecorded claims of senior securities. Year 11 Analysis: Book value ($ millions) = ($1,793.4 - 0) = $1,793.4 Number of shares outstanding = 135,622,676-8,618,911=127,003,765 Book value per share = $14.12 b. The par value of Campbell’s common shares is $0.15. Its details follow: (in millions) Year 11 Authorized 140,000,000 Issued 135,622,676 Outstanding 127,003,765 (part a) c.

Year 11 175.6 million $175.6 million / $3.3954 million shares = $51.72

Common shares purchased (mil) Average share repurchase price

Case 3-4 (75 minutes) a. Ratio Analysis Liquidity Current ratio Solvency Total debt to equity Long-term debt to equity Times interest earned Return on Investment Return on total assets Return on equity

AMR 1998 1997

Delta 1998 1997

UAL 1998 1997

0.865

0.895

0.735

0.702

0.513

0.562

2.330 1.488 6.817

2.356 1.459 4.867

2.630 1.492 9.310

3.237 1.879 7.509

4.657 2.929 4.463

5.617 3.371 6.220

7.17%

8.18%

6.21%

20.23%

28.17%

29.23%

Note: We treat preference share capital as debt and include preference dividend with interest.

All three companies appear to be in poor liquidity position. UAL’s liquidity is especially troubling. From a balance sheet perspective, all companies show an excess of creditor financing in their capital structure. Once again, UAL is the most worrisome with total debt (long-term debt) at 4.66 (2.93) times equity. Still, these ratios seem to be improving over this short time period. All three companies are profitable. The ROA is respectable and the ROE is extremely good—ROE is much higher than ROA partly because of extreme leverage. Because of good profitability, all companies seem to be in a good position to pay interest expenses, despite high debt-to-equity ratios. 3-50 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 03 - Analyzing Financing Activities

Overall, the three companies (in particular UAL) reveal higher than usual liquidity and solvency risk. Although the high profitability (at least at present) appears to mitigate these risks to a large extent. b. Sensitivity Analysis The sensitivity analysis examines the impact of both a 5% and a 10% drop in revenues on the profitability and key ratios of these companies during 1998. We assume that 25% of operating expenses are variable (75% are fixed). We also assume a 35% tax rate for the changes to income. Recast income statements appear below: AMR Drop in Revenue

10%

Delta 10%

10%

13,431 12,724 (12,289) (12,134) 1142 590 141 141 (197) (197) 1,086 534 (454) (261) 632 273 36% 72%

16,683 (15,882) 801 133 (361) 573 (192) 381 54%

15,805 (15,681) 124 133 (361) (104) 45 (59) 107%

UAL

Revised Income Statement for Yr 8

Operating Revenue Operating Expenses Operating Income Other Income & Adjustments Interest Expense* Income before Tax Tax Provision (35% tax rate) Continuing Income % drop in Continuing Income

18,245 17,285 (16,656) (16,445) 1,589 840 198 198 (372) (372) 1,415 666 (596) (333) 819 332 37% 75%

Part b continued: The profitability of the airlines is reduced dramatically by moderate revenue shortfalls under our assumptions. A mere 5% drop in revenues can reduce income by a third (half for UAL), while a 10% drop in revenues can all but wipe out the airlines’ profits. This happens because of the high proportion of fixed costs in the cost structure. We also examine the impact of the changes on key 1998 ratios: AMR Drop in Revenue Liquidity Current Ratio Solvency Total Debt to Equity Long Term Debt to Equity Times Interest Earned Return on Investment Return on Total Assets Return on Equity

10%

Delta 10%

UAL 10%

0.865

0.735

0.513

2.330 1.488 4.803

2.330 1.488 2.788

2.630 1.492 6.511

2.630 1.492 3.712

4.657 2.929 2.587

4.657 2.929 0.712

4.91% 12.68%

2.66% 5.14%

5.56% 17.97%

2.94% 7.77%

3.62% 13.56%

1.03% -2.10%

The balance sheet ratios do not change. The ROA and ROE mirror the drop in profitability. The most interesting change occurs in interest coverage, which drops significantly with reduced revenues. While AMR and Delta can still pay their interest in the event of a demand slump, UAL may have difficulty meeting its interest payments in the case of a 10% revenue drop. c. Because of the volatile nature of profitability and consequent risk, airline companies often find it difficult to raise debt at reasonable terms. Raising equity is a possibility, but the equity cost of capital is high in this industry (airline companies have some of the lowest P/E ratios in the market). Consequently, 3-51 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 03 - Analyzing Financing Activities

leasing offers a convenient alternative to financing the high capital investment requirements of this industry. The lessor is probably able to offer better terms than other creditors for several reasons: (1) the lessor may be connected to suppliers of capital equipment and can use leasing as a marketing tool; and (2) in the event of insolvency the lessor is often in a better position to recover the assets because ownership often rests with the lessor. Finally, the bigger airline companies (such as AMR, Delta and UAL) prefer to maintain a young fleet of aircraft, both because of obsolescence and because of the high maintenance cost associated with maintaining older aircraft. In such a scenario, it is easier to lease aircraft rather than purchase outright and sell it later. d. Examine Capital and Operating Leases and Their Classification: All three companies are increasingly structuring their leases to be operating leases. The outstanding MLP on operating leases for AMR, Delta and UAL is approximately $17 billion, $15 billion and $24 billion, respectively, compared to $2.7 billion, $0.4 billion and $3.4 billion for capital leases. The lease classification appears arbitrary. The capital and operating leases do not seem to differ either on the basis of the type of asset leased or the length of the lease. The average remaining life on the operating leases, for all three companies, varies between 16 to 20 years, which is much more than those on capital leases (see part e below). Overall, there does not seem to be any logic underlying the lease classification, except that the companies have structured the leases to avail themselves of the benefits of operating lease accounting.

Chapter 03 - Analyzing Financing Activities

e. Reclassification of Operating Leases as Capital Leases and Restatement of Financial Statements AMR Capital

UAL

Capital

Operating

Capital

Operating

12480 919 14 5 19

71 48 1 5 6

10360 960 11 5 16

1759 242 7 5 12

17266 1305 13 5 18

13,366 887 15 5 20

118 57 2 5 7

9,780 850 12 5 17

1,321 277 5 5 10

19,562 1,357 14 5 19

1998

AMR 1997

1998

Delta 1997

1998

1997

273 154 119 1,918 6.20%

255 135 120 1,764 6.80%

100 63 37 312 11.86%

101 62 39 384 10.16%

317 176 141 2,289 6.16%

288 171 117 1,850 6.32%

Estimate Average Remaining Lease Term (1998) 1 MLP in Later Years 1261 2 MLP in Last Reported Year 191 3 # of later years (1)/(2) 7 4 Add # of reported years 5 5 Average Remaining Lease 12 (3)+(4) Estimate Average Remaining Lease Term (1997) 1 MLP in Later Years 1,206 2 MLP in Last Reported Year 247 3 # of later years (1)/(2) 5 4 Add # of reported years 5 5 Average Remaining Lease 10 (3)+(4)

Estimate Interest Rate on Capital Leases 6 MLP During Next Year 7 Less Principal Component 8 Interest (6) - (7) 9 PV of Capital Leases 10 Interest Rate (8)/(9)

Delta

Operating

UAL

Note: The principal component is shown as a current liability on the balance sheet.

Chapter 03 - Analyzing Financing Activities

AMR 1997

1998

Delta 1997

1998

1997

Estimate Average MLP per year on Operating Leases 11 Total MLP 17,215 12 Average Remaining Lease 19 Term 13 Average MLP (11) / (12) 927

18,115 20

15,120 16

14,020 17

23,798 18

26,515 19

903

957

849

1,305

1,366

Estimate Present Value of Operating Leases 10.8505 14 Present Value Factor 15 Average MLP (13) 927 16 Present Value (14)X(15) 10,053

10.7762

6.9958

7.8515

10.7746

11.0047

903 9,727

957 6,698

849 6,669

1,305 14,065

1,366 15,029

1998

UAL

Note: Present value factor represents the present value of an annuity of $ 1 at a given interest rate and lease term from the annuity tables. We use the interest rate on capital leases (estimated in (10) above) as a surrogate interest rate for operating leases. The lease term for operating leases was estimated in (5) above. AMR 1998

Delta 1998

UAL 1998

E. Estimate Interest and Depreciation on Operating Lease 17 Present Value of Operating Leases 9,727 18 Interest Rate 7% 19 Interest Expense (17) X (18) 662

6,669 10% 677

15,029 6% 950

9,727

6,669

15,029

20 485

17 404

19 774

21 22

Value of Operating Lease Assets Average Remaining Lease Term (Lease Life) Depreciation Expense

F. Estimate Efect of Operating Lease Conversion on Income Statement 23 Increase in Depreciation Expense (485) (404) Decrease in Lease Rental 24 Expense 1,011 860 25 Effect on Operating Income 526 456

1,419 645

26 27

Increase in Interest Expense Effect on Income before Tax

(662) (135)

(677) (221)

(950) (306)

28 29

Decrease in Tax Provision (35%) Effect on Continuing Income

47 (88)

77 (144)

107 (199)

(774)

Note: For computing interest and depreciation for 1998, we use the lease asset/obligation we estimated at the end of 1997.

Chapter 03 - Analyzing Financing Activities

AMR

Delta

UAL

G. Determine Principal and Interest Component of Next Year's MLP 30 Next Year MLP (1999) 1,012 950 31 Estimated Interest Component 624 794 32 Estimated Principal Component 388 156

1,320 866 454

H. Decompose Operating Lease Liability into Current and Non-Current Components 33 Total Operating Lease Liability 10,053 6,698 14,065 34 Estimated Current Portion 388 156 454 35 Estimated Non-Current Portion 9,665 6,543 13,611 Restated Balance Sheet $ Millions Assets Current Assets Freehold Assets (Net) Leased Assets (Net) Intangibles & Other Total Liabilities Current Liabilities: Current Portion of Capital Lease Other Current Liabilities Long Term Liabilities: Lease Liability Long Term Debt Other Long Term Liabilities Preferred Stock Shareholder's Equity Contributed Capital Retained Earnings Treasury Stock Total Restated Income Statement $ Millions

Operating Revenue Operating Expenses Operating Income Other Income & Adjustments Interest Expense* Income before Tax Tax Provision Continuing Income * Includes preference dividends.

AMR 1998

Delta 1998

UAL 1998

4,875 12,239 12,200 3,042 32,356

3,362 9,022 6,997 1,920 21,301

2,908 10,951 16,168 2,597 32,624

542 5,485

219 4,514

630 5,492

11,429 2,436 5,766

6,792 1,533 4,046 175

15,724 2,858 3,848 791

3,257 4,729 (1,288) 32,356

3,299 1,776 (1,052) 21,301

3,518 1,024 (1,261) 32,624

AMR 1998

Delta 1998

UAL 1998

19205 (16396) 2809 198 (996) 2011 (805) 1207

14138 (11919) 2219 141 (991) 1369 (553) 815

17561 (15535) 2026 133 (1227) 932 (318) 614

Chapter 03 - Analyzing Financing Activities

f. We made several assumptions in estimating the effects of the lease classification. Some of the important assumptions are: •

Interest Rate Parity across Capital and Operating Leases. We use the average interest rate on the capital leases as a proxy for the interest rate on operating lease. To the extent capital and operating leases are dissimilar, the interest rate estimate is inaccurate or biased. This problem arises especially if the capital leases and the operating leases, on average, have been contracted during different time periods with different interest rate regimes. In this particular case, the interest rate on Delta’s capital leases is substantially higher than that on either AMR or UAL. While it is not impossible, it is improbable that lease rates could differ so markedly across similar companies in the same industry. The average remaining lease term offers a clue: for Delta’s capital leases it is 6-7 years compared to 10-12 years for AMR and UAL. Under the assumption that the average lease terms are similar across companies, this implies that Delta’s capital leases, on average, were contracted 4-5 years before AMR or UAL, which is consistent with the higher interest rate on Delta’s capital leases. To some extent, this problem is alleviated (at least on a comparative basis) because Delta’s operating leases also appear to have been contracted around three years earlier to AMR’s or UAL’s. It appears that the capital leases for all three companies were entered into at an earlier time than the operating leases. If these leases were entered at a time with a sufficiently different interest rate regime, we need to make appropriate corrections to our interest rate estimates.

•

Depreciation Policy. We set the lease asset and liability equal to each other. In reality, the depreciation of the asset seldom equals the lease principal payments. Some people use a simplifying assumption such as lease assets should be equal to 80% the liability. However, these ad hoc rules are no better than putting them equal to each other.

Chapter 03 - Analyzing Financing Activities

g. Ratio Analysis on Restated Financial Statements AMR

Delta

1998 Liquidity Current Ratio 0.809 Solvency Total Debt to Equity 3.831 Long Term Debt to Equity 2.931 Times Interest Earned 3.020 Return on Investment* Return on Total Assets 5.89% 18.69% Return on Equity *computed on adjusted yearend asset and equity balances

UAL

1998

0.710

0.475

4.295 3.118 2.380

8.943 7.078 1.759

7.17%

4.47%

23.20%

21.87%

Note: We treat preference share capital as debt and include preference dividend with interest.

Capitalizing the operating leases significantly worsens the liquidity and solvency picture of all three companies. The impact on current ratio is not dramatic, but the current ratios are bad to start with. In particular UAL’s current ratio of less than 50% is cause for concern. The solvency picture deteriorates significantly after lease capitalization. We realize that all three companies are extremely reliant on creditor financing, particularly through lease financing that constitutes between 25% to 50% of the total assets. The debt to equity ratios are significantly above acceptable levels. UAL’s debt to equity is particular high. Part of the reason for the high debt equity ratios is that these companies had all but wiped out their retained earnings during the recession in the early 1990s, which makes their equity base very low. While this is an explanation for the high debt to equity ratios, it does not absolve the risk associated with such extreme debt orientation in the capital structure. Despite the excellent profitability of all three companies, the interest coverage ratios are not as impressive as they appeared before the operating leases were capitalized. By classifying a significant part of their leases as operating, all three companies were able to underreport interest expense by over two-thirds. In particular, UAL’s interest coverage looks weak even when its profitability is spectacularly high. The ROA has not deteriorated significantly although total assets have increased by at least a third for all companies. The reason is that operating income was significantly underreported earlier because the interest costs pertaining to operating leases were being treated as operating expenses. ROE has reduced significantly for all three companies, mainly because of drop in continuing income. The ROE is still good although not as spectacular as reported.

Chapter 03 - Analyzing Financing Activities

Sensitivity Analysis after lease capitalization AMR Drop in demand

UAL

10%

17285 (15986) 1298

13431 (11770) 1661

12724 (11621) 1103

16683 (15340) 1343

15805 (15146) 659

198 (996) 501 (276) 225

141 (991) 811 (358) 453

141 (991) 253 (162) 90

133 (1227) 248 (78) 170

133 (1227) (436) 161 (275)

81%

44%

89%

72%

145%

0.809

0.710

0.475

3.831 2.931 2.261

3.831 2.931 1.503

4.295 3.118 1.818

4.295 3.118 1.255

8.943 7.078 1.202

8.943 7.078 0.645

4.33% 10.69%

2.77% 3.36%

5.39% 11.26%

3.61% 2.24%

3.07% 5.18%

1.66% -8.37%

Revised Income Statement for 1998 Operating Revenue 18245 Operating Expenses (16191) Operating Income 2054 Other Income & Adjustments 198 Interest Expense* (996) Income before Tax 1256 Tax Provision (540) Continuing Income 716 % drop in Continuing Income 41% Revised Ratios (1998) Liquidity Current Ratio Solvency Total Debt to Equity Long Term Debt to Equity Times Interest Earned Return on Investment Return on Total Assets Return on Equity

Delta 10%

The sensitivity analysis after the capitalization of operating leases further highlights the high degree of risk in these companies. With a 10% drop in revenue all the three companies have little or no “cushion” to pay their interest costs. UAL in particular is highly unlikely to be able to meet its interest commitments in such a scenario (also realize that for operating leases, both the interest and principal portions need to be paid). The results also highlight that the return on assets and equity will be considerably affected with a downturn in demand. In short, capitalizing operating leases shows that the solvency of the companies is clearly a risk, and this risk could come to the forefront if and when these companies experience even a moderate drop in revenues, which is not unlikely if history is any indicator.

Chapter 03 - Analyzing Financing Activities

h. Accounting Motivations for Leasing and Lease Classification: In (c) above we presented some economic arguments for the popularity of leasing in the airline industry. After the analysis in g and h, we added an important motivation that is purely related to financial reporting. By leasing a large proportion of their assets and successfully classifying most leases as operating, the airlines attempt to camouflage the high risk inherent in their capital structure. The big question is whether managers can fool the market with these accounting gimmicks. Research does indicate that the market seems to consider the additional risk imposed by operating leases and to reflect what is not shown on the financial statements. However, a surprising number of even “sophisticated” investors fall prey to these window-dressing tactics—for example, many analyst reports and financial databases fail to adjust the solvency and other ratios for operating leases. This case highlights the importance for a financial analyst to understand the accounting issues. It also highlights the importance of “getting ones hands dirty” by doing a detailed and careful accounting analysis before embarking on further financial analysis. Case 3-5 (60 minutes) a. The number of claims by categories are: (1) Smoking and health cases alleging

personal injury brought on behalf of individual plaintiffs—510 cases; (2) Smoking and health cases alleging personal injury and purporting to be brought on behalf of a class of individual plaintiffs—60 cases; and (3) Health care cost recovery cases brought by governmental and nongovernmental plaintiffs seeking reimbursement for health care expenditures allegedly caused by cigarette smoking (actions by all 50 states, several commonwealths and territories of the United States—95 cases, as well as cases in several foreign countries—27 cases plus 6 foreign class actions suits). b. The company recorded the following pre-tax charges related to tobacco litigation: $3.081 billion and $1.457 billion during 1998 and 1997, respectively, to accrue for the company's share of all fixed and determinable portions of the company's obligations under the tobacco settlements with various states. In addition, the company accrued $300 million during 1998 and $1.359 billion in total for its unconditional obligations under an agreement in principle to contribute to a tobacco growers' trust fund. These amounts relate to the third category. c. Charges totaling $3.381 billion were recorded as losses in the 1998 income statement related to tobacco litigation. d. The eventual losses will likely dwarf what is currently recorded on the Balance Sheet of Philip Morris. There are vast amounts of loss that are currently deemed to not meet one of the 2 requirements to accrue contingent liability. In most 3-59 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 03 - Analyzing Financing Activities

cases, the company likely contends that the amount of the loss is not yet reasonably estimable. e. While certain contingent losses do not meet the threshold for accrual and recognition in the balance sheet, analysts should adjust their models to reflect much greater exposure to losses from tobacco litigation. The current balance sheet should be adjusted to report much greater amounts of liability and tobacco litigation charges and losses. Case 3-6B (60 minutes) a. Colgate administers both defined contribution and defined benefit plans for its employees. The primary OPEBs provided by Colgate and health care and life insurance benefits. b. 1. The economic positions are follows (in $ millions): Pensions

OPEB

Total

Domestic

International

2010

(575)

(302)

(730)

(1,607)

2011

(599)

(323)

(744)

(1,666)

Negative numbers indicate underfunded status. Colgate’s plans are underfunded and so are net liabilities. 2. The position reported in the balance sheet is the same as the economic position reported in part (1), as the company reports the fair value of the net pension asset/liability in the balance sheet. The balance sheet presentation is as follows ($ million): Pensions

OPEB

Total

Domestic

International

2010

(575)

(302)

(730)

(1,607)

2011

(599)

(323)

(744)

(1,666)

Negative/positive numbers indicate liability/asset. Colgate’s postretirement benefit plans are net liabilities on the balance sheet. 3. The amounts are primarily reported as noncurrent liabilities, but also included in noncurrent assets and current liabilities. 4. The projected benefit obligation (PBO) and accumulated benefit obligation (PBO) are as follows ($ million): Projected Benefit Obligation (PBO)

Accumulated Benefit Obligation (ABO)

Chapter 03 - Analyzing Financing Activities

Domestic

International

Total

Domestic

International

Total

2010

1,952

736

2,688

1,808

654

2,462

2011

2,025

760

2,785

1,892

688

2,580

The accumulated benefit obligation is closer to the legal liability related to pensions. The PBO is used to determine the net funded status on the balance sheet under ASC 715.30. 5. If the plans were terminated, Colgate will be liable to pay the ABO amounts to the employees for domestic plans. While it is unclear if such liability exists in other countries, we assume this is the case. Therefore, assuming that the assets can be sold at their reported fair value, the net economic position of the pensions plans if terminated are the difference between the fair value of plan assets and the ABO ($ million): Pensions

Total

Domestic

International

2010

(431)

(220)

(651)

2011

(466)

(251)

(717)

There is no clear basis for determining the company’s legal liability regarding OPEBs. There is no legal requirement to provide OPEBs to employees. 6. The closing value of plan assets is as follows ($ million): Pensions

OPEB

Total

Domestic

International

2010

1,377

434

1,843

2011

1,426

437

1,895

Colgate invests its plan assets primarily in equity securities, with a lower proportion in debt securities and a much smaller proportion in real estate and other investments. 7. For 2011, Colgate net periodic benefit cost (reported cost) is $ 69 million ($ 40 million, $ 64 million) for its domestic pension (international pension, OPEB) plans. Therefore a total postretirement benefit expense of $ 173 million was charged to income. Its components are the service cost, interest cost, expected return on plan assets and amortization of actuarial gain/loss and prior service cost. In addition, it should be noted that Colgate also charged unusual items (largely termination benefits) termed “other postretirement charges” totaling 4 million for 2011.

Chapter 03 - Analyzing Financing Activities

8. The two non-recurring items are actuarial gain/loss and prior service cost/plan amendments. The movement in these two items is given below ($ million):

Pensions

OPEB

Total

Domestic

Int’l

Opening Balance (unrecognized)

693

142

343

1,178

Actuarial (Gain)/Loss for the year

126

(1)

146

Movement in Actuarial (Gain)/Loss

Actual less Expected Return

110

Amortization

(46)

(9)

(16)

(71)

Adjustments

(5)

(6)

(11)

855

174

323

1,352

Opening Balance (unrecognized)

121

Amortization

(9)

(3)

(2)

(14)

Adjustments

Closing Balance (Accumulated Other Compr Inc)

111

Closing Balance (Accumulated Other Compr Inc)

Movement in Prior Service Cost (Plan Amendments)

Note: Because of foreign exchange translation effects on international plans and the effects of rounding, the numbers do not articulate exactly and so there is a need to introduce adjustments.

9. Colgate’s actual return on plan assets and expected return—that is included in income—is given below ($ million): Pensions Domestic Actual plan return

OPEB

Total

International

Expected return

110

140

Difference

(82)

(25)

(3)

(110)

10. The economic benefit cost (excluding unusual items such as termination benefits, curtailments and settlements) and the reported benefit cost are compared below: 2011

Pensions

OPEB

Total

Domestic

International

Service cost

Interest cost

100

175

Actual return on plan assets

(28)

(2)

(30)

Actuarial (gain)/loss

126

(1)

146

(7)

(6)

(13)

Foreign exchange impact

Chapter 03 - Analyzing Financing Activities

Economic benefit cost/(income)

222

333

Net periodic benefit cost (reported cost)

173

Difference

153

(20)

160

The differences between the reported and economic benefit costs arise primarily because of the treatment of the non-recurring items, actuarial gain/loss (also called net gain/loss) and prior service cost. See answer for (8) above for a detailed reconciliation of the balance sheet and income statement effects for these items. 11. The primary actuarial assumptions used by Colgate are: (a) discount rate (2) long-term rate of return on plan assets (3) long-term rate of compensation growth and (4) ESOP growth rate. In 2011, Colgate changed two assumptions for domestic plans: it reduced the discount rate to 4.90% from 5.30% and it lowered the expected return on plan assets to 7.75% from 8.00%. The reduction in discount rate is expected to increase the pension obligation and create an actuarial loss. The reduction in the expected return on plan assets is expected to increase the net periodic pension cost recognized on the income statement each year. For international plans, Colgate decreased the discount rate, expected return on plan assets, and the compensation growth rate. The decrease in discount rate will increase the pension obligation and the decrease in expected return on plan assets will increase net periodic pension cost (as with the domestic plans). The decrease in compensation growth rate will decrease the pension obligation. 12. Colgate’s cash flows related to benefit plans are the contributions it makes to the plans. In 2011, Colgate contributed $ 272 million to its benefit plans ($ 198 million, $ 45 million and $ 29 million respectively for its domestic pension, international pension and OPEB plans). This contribution is a cash outflow. For 2012, Colgate estimates that it will contribute $ 100 million to the domestic pension plan.

Chapter 03 - Analyzing Financing Activities

Case 3-7B (60 minutes) a.

The schedule below provides details of Colgate’s benefit plans’ economic position (funded status) and the net amount recognized in the balance sheet for 2011 and 2010 ($ million): 2011

Pensions

OPEB

Total

Domestic

Int’l

437 760

1,895

Benefit Obligation

1,426 2,025

776

3,561

Net Economic Position (Funded Status)

(599)

(323)

(744)

(1,666)

Reported Position on Balance Sheet

(599)

(323)

(744)

(1,666)

OPEB

Total

Plan Assets

NO ADJUSTMENTS

2010

Pensions Domestic

Int’l

434 736

1,843

Benefit Obligation

1,377 1,952

762

3,450

Net Economic Position (Funded Status)

(575)

(302)

(730)

(1,607)

Reported Position on Balance Sheet

(575)

(302)

(730)

(1,607)

Plan Assets

NO ADJUSTMENTS

No adjustments are required in 2011 or 2010, as the net economic position is reported on the balance sheet under ASC 715.30. If the purpose of the analysis is to determine the liquidation value of Colgate, then it is appropriate to determine the funded status using the ABO, rather than the PBO. Using the ABO will improve the funded status by $ 981 million ($ 988 million) in 2011 (2010). Since we are proposing no adjustments in 2011 or 2010 to the balance sheet, there will be no change to the debt-equity ratios. Long-term debt to equity ratio will not be affected since postretirement benefits are not included in long-term debt.

Chapter 03 - Analyzing Financing Activities

The schedule below gives details of Colgate’s economic and reported benefit costs for 2011 and 2010 ($ million): 2011

Pensions

OPEB

Total

Domestic

Int’l

Service cost

Interest cost

100

175

Actual return on plan assets

(28)

(2)

(30)

Actuarial (gain)/loss

126

(1)

146

(7)

(6)

(13)

Economic benefit cost/(income)

222

333

Net periodic benefit cost (reported cost)

173

Difference

153

(20)

160

2010

Pensions

OPEB

Total

Foreign exchange impact

Domestic

Int’l

Service cost

Interest cost

167

Actual return on plan assets

(145)

(30)

(4)

(179)

Actuarial (gain)/loss

150

271

(14)

(11)

Economic benefit cost/(income)

141

147

320

Net periodic benefit cost (reported cost)

195

Difference

(6)

125

Foreign exchange impact

On an economic basis, Colgate’s costs pertaining to its postretirement benefit plans are $ 333 million and $ 320 million in 2011 and 2010 respectively. However, it recognized net periodic benefit cost of $ 173 million and $ 195 million during these years. If the analysis objective is to ascertain economic income, then pretax income increasing (decreasing) adjustments of $ 160 million ($ 125 million) should be made in 2011 (2010). No adjustments need to be made when the analysis objective is measuring permanent (or core) income. b. Overall, there is little to suggest that Colgate’s key actuarial assumptions are unusual or unreasonable. It also appears that Colgate is somewhat conservative in its assumptions choices. For example, the US discount rate is 4.9%, which for 2011 is slightly below the yield on high yield bonds and closer to the treasury yield. (One reason for the lower discount rates could be that Colgate is benchmarking itself to shorter term bonds; being an old company, it has a mature work force that is expected to retire sooner than that of average companies). Colgate has marginally lowered its discount rate in 2011, which would have increased the value of the PBO and lowered its funded status. In contrast, Colgate’s assumptions on expected rates of return appear more aggressive given the actual returns in the recent past. Colgate’s 2011 expected return on plan 3-65 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 03 - Analyzing Financing Activities

assets is 7.75% for US plans, while the actual return over the past 10 years is only 6%. Colgate uses somewhat lower discount rates and expected rates of return for its international plans. This could reflect the different economic environments that it operates in internationally. Colgate has also lowered both these rates in 2011, which would have had adverse effects both on the balance sheet and income statement by increasing the pension obligation and decreasing expected return from plan assets, respectively. Overall, there is little to suggest that Colgate is being overly aggressive in its choice of actuarial assumptions or that it is using changes in these assumptions to manage earnings. c. An analyst needs to examine three dimensions with respect to pension risk exposures: • The extent of underfunding: Colgate’s pension plans are underfunded, but not seriously. In 2011, the underfunding for pension plans is around $ 1.6 billion, which translates to about 13% of total assets. • Pension intensity: In 2011, Colgate’s pension obligation (assets) are 28% (15%) of total assets, which is not very high. However, in light of Colgate’s high leverage, the pension risk is much higher. For example, the above percentages are around 100% of equity, which is very high. • Colgate also invests fairly heavily in equity securities: around ½ of its pension assets for both domestic and international plans. This does create some pension risk exposure. Overall, Colgate has moderate risk exposure from its pension plans. d. In 2011, Colgate contributed $ 272 million to its benefit plans ($ 198 million, $ 45 million and $ 29 million respectively for its domestic pension, international pension and OPEB plans). The level of these contributions is somewhat higher than the reported postretirement benefit cost, which is something that an analyst needs to note. However, given Colgate’s copious operating cash flows, these contributions need not be cause for concern. Generally, it is difficult to use current contributions to predict future contributions. However, Colgate appears to follow a policy of slightly underfunding its plans and contributing amounts that are not very different from benefits paid. One can use the estimated benefits payable (which Colgate forecasts all the way up to 2021 in the footnote) to reasonably forecast future contributions.

Chapter 04 - Analyzing Investing Activities

Chapter 4 Analyzing Investing Activities REVIEW Assets are the driving forces of profitability for a company. Assets produce revenues that compensate workers, repay lenders, reward owners, and fund growth. Current assets are resources or claims to resources readily convertible to cash. Major current assets include cash and cash equivalents, marketable securities, receivables, derivative financial instruments, inventories, and prepaid expenses. Our analysis of current assets provides us insights into a company's liquidity. Liquidity is the length of time until assets are converted to cash. It is an indicator of a company's ability to meet financial obligations. The less liquid a company, the lower is its financial flexibility to pursue promising investment opportunities and the greater its risk of failure. Noncurrent assets are resources or claims to resources expected to benefit more than the current period. Major noncurrent assets include property, plant, equipment, intangibles, investments, and deferred charges. Our analysis of noncurrent assets provides us insights into a company's solvency and operational capacity. Solvency refers to the ability of a company to meets its long-term (and current) obligations. Operational capacity is the ability of a company to generate future profits. This chapter shows how we use financial statements to better assess liquidity, solvency, and operational capacity using asset values, and to critically evaluate a company's financial performance and prospects. The accounting practices underlying the measurement and reporting of current and noncurrent assets are described. We discuss the accounting for these assets and its implications for analysis of financial statements. Special attention is given to various analytical adjustments helping us better understand current and future prospects.

Chapter 04 - Analyzing Investing Activities

OUTLINE Section 1: Current Assets • Cash and Cash Equivalents Analyzing Cash and Cash Equivalents • Receivables Valuation of Receivables Analyzing Receivables • Prepaid Expenses • Inventories Inventory Accounting and Valuation Analyzing Inventories

Section 2: Noncurrent Assets • Introduction to Long-Lived Assets Accounting for Long-Lived Assets Capitalizing versus Expensing: Financial Statement and Ratio Effects • Plant Assets and Natural Resources Valuing Plant Assets and Natural Resources Depreciation and Depletion • Intangible Assets Accounting for Intangibles Analyzing Intangibles Goodwill Unrecorded Intangibles and Contingencies

Chapter 04 - Analyzing Investing Activities

ANALYSIS OBJECTIVES •

Define current assets and their relevance for analysis.

•

Explain cash management and its implications for analysis.

•

Analyze receivables, allowances for bad debts, and securitization.

•

Interpret the effects of alternative inventory methods under varying business conditions.

•

Explain the concept of long-lived assets and its implications for analysis.

•

Interpret valuation and cost allocation of plant assets and natural resources.

•

Describe and analyze intangible assets and their disclosures.

•

Analyze financial statements for unrecorded and contingent assets.

Chapter 04 - Analyzing Investing Activities

QUESTIONS 1. a. No. When analyzing cash, the most liquid of current assets, the analyst is interested in the availability of cash in meeting the company's obligations. A restriction under compensating balance arrangements does, at worst, remove these cash balances from immediate availability as means of payment. Indeed, use of such balances can have repercussions for the company that can affect its future access to bank credit. b. The analyst should exclude cash restricted under compensating balance agreements from current assets. SEC Accounting Series Release 148 requires that a company that has borrowed money from a bank segregate on its balance sheet any cash subject to withdrawal or usage restrictions under compensating balance agreements with the lending bank. These requirements may, as is often the case in such situations, move companies and their banker to alter the form of their contractual agreements while retaining their substance. The analyst must be ever alert to such attempts to distort analysis measurements by presentations whose form is not a true reflection of their substance. One measure of a company’s vulnerability in this area is the ratio of restricted cash to total cash. 2. a. The operating cycle concept is important in the classification of assets and liabilities as either current or noncurrent. The operating cycle encompasses the period of time from the commitment of cash for purchases until the collection of receivables resulting from the sale of goods or services. The diagram near the beginning of Chapter 4 illustrates this concept. b. If the normal collection interval of a receivables is longer than a year (such as with longer term installment receivables), then their inclusion as current assets is proper provided the operating cycle is equal to or greater than the obligation due date for the receivables. Similarly, if inventories, by business need or custom, have to be kept on average for more than 12 months, then this normal inventory holding period becomes part of the operating cycle and such inventories are included among current assets. c. The limitations of the current ratio (which is computed from items defined as working capital) as a measure of short-term liquidity are discussed in Chapter 11. Still, if we accept the proposition that it is useful to measure the current resources available to pay current obligations, then it is difficult to see how extension of "current" from the customary 12 months to periods of 36 months or longer can serve a useful purpose. The operating cycle concept may help companies show the kind of positive current position that they otherwise might not be able to show, but this concept is of doubtful value or validity from the point of view of a financial analyst that must assess a company’s short-term liquidity. d. (1) Tobacco Industry. The tobacco leaf must go through an aging, curing, and drying process extending over several years. This tobacco inventory (green leaves), that may not be used in the production of a salable product for many years, is classified as current under the operating cycle concept. This would occur even if long-term loans (classified among noncurrent liabilities) were taken out to finance the carrying of this inventory.

Chapter 04 - Analyzing Investing Activities

(2) Liquor Industry. The liquor industry has an operating cycle extending beyond the customary 12 months. In this case, the holding of liquor inventory for aging purposes over many years provides sufficient justification for inclusion of such inventories among current assets. (3) Retailing Industry. In retailing, the sale of "large ticket" items on the installment plan can extend the operating cycle to, for example, 36 months or longer. As such, these installment receivables are reported among current assets. 3. a. The two most important questions facing the financial analyst with respect to receivables are: (1) Is the receivable genuine, due, and enforceable?, and (2) Has the probability of collection been properly assessed? While the unqualified opinion of an independent auditor lends some assurance with regard to these questions, the financial analyst must recognize the possibility of an error of judgment as well as the lack of complete independence. b. Description of the receivables in the notes to financial statements usually do not contain sufficient clues to allow a reliable judgment as to whether a receivable is genuine, due, and enforceable. Consequently, knowledge of industry practices and supplementary sources of information must be used for additional assurance, e.g.: • In some industries, such as compact discs, toys, or books, a substantial right of merchandise return exists and allowance must be made for this. • Most provisions for uncollectible accounts are based on past experience although they should also make allowances for current and emerging industry conditions. In practice, the accountant is likely to attach more importance to the former than to the latter. The analyst must, in such cases, use one’s own judgment and knowledge of industry conditions to assess the adequacy of the provision for uncollectible accounts. • Information that would be helpful in assessing the general level of collection risks with receivables is not usually found in published financial statements. Such information can, of course, be sought from the company directly. Examples of such information are: (1) What is customer concentration? What percent of total receivables is due from one or a few major customers? Would failure of any one customer have a material impact on the company's financial condition? (2) What is the age pattern of the receivables? (3) What proportion of notes receivable represent renewals of old notes? (4) Have allowances been made for trade discounts, returns, or other credits to which customers are entitled? • The analyst, in assessing current financial position and a company's ability to meet its obligations currently—as expressed by such measures as the current ratio—must recognize the full impact of accounting conventions that relate to classification of receivables as "current." For example, the operating cycle concept allows the inclusion of installment receivables, which may not be fully collectible for years. In balancing these against current obligations, allowance for such differences in timing of cash flows should be made. 4.

a. Factoring or securitization of receivables refers to the practice of selling all or a portion of a company’s receivables to a third party.

Chapter 04 - Analyzing Investing Activities

When receivables are sold with recourse, the third party purchaser of the receivables retains the right to collect from the company that sold the receivable if the receivable proves uncollectible. When receivables are sold without recourse, the purchaser of the receivables assumes the collection risk.

When receivables are sold with recourse, the balance sheet reports the cash received from the sale of the receivable. However, the balance sheet may or may not report the contingent liability to the receivables purchaser for uncollectible receivables purchased with recourse—this depends on who assumes the risk of ownership.

5. a. Few useful generalizations about the effect of differing methods of inventory valuation on financial analysis can be made. Yet, we provide some guidance. • In the case of LIFO, we know that under conditions of fluctuating price levels, it will have a smoothing effect on income. Moreover, the LIFO method yields, in times of price inflation, an unrealistically low inventory amount. This, in turn, lowers the current ratio and tends to increase the inventory turnover ratio. We also know that the LIFO method affords management an opportunity to manipulate profits by allowing inventory to be depleted in poor years, thus drawing on the low cost pool to inflate income. A judgment on all of these consequences can only be made on the basis of an assessment of all surrounding circumstances. For example, a slight change in a current ratio of 4:1 may be of no significance, whereas the same change in a ratio of 1.5:1 may be of far greater importance. • The use of FIFO for the valuation of inventories will generally result in a higher inventory on the balance sheet and a lower cost of goods sold (and higher income) in comparison to LIFO. • The average cost method smoothes out cost fluctuations by using a weighted average cost in valuing inventories and in pricing cost of goods sold. The resulting net income will be close to an average of the net income under LIFO and FIFO. • The "lower-of-cost-or-market" principle of inventory accounting has additional implications for the analyst. In times of rising prices it tends to undervalue inventories regardless of the cost method used. This, in turn, will depress the current ratio below its true level since the other current assets (as well as current liabilities) are not valued on a consistent basis with the methods used in valuing inventories. b. In practice we can find wide variations in the kinds of costs that are included in inventory. Practice varies particularly with respect to the inclusion or exclusion of (1) various classes of overhead costs, (2) freight-in, and (3) general and administrative costs. This variety in practices can have a significant effect on comparability across companies. 6. a. The allocation of overhead costs to all units of production must be done on a rational basis designed to get the best approximation of actual cost. However, this is far from easy. The greatest difficulty stems from the fact that a good part of overhead is fixed costs, i.e., costs that do not vary with production but vary mostly with the lapse of time. Examples are rent payments and the factory manager's salary. Thus, assuming only a single product is produced, fixed costs are $100,000, and 10,000 units are produced, then each unit will absorb $10 of fixed costs. However, if 5,000 units are 4-6 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 04 - Analyzing Investing Activities

produced, each unit will absorb $20 of fixed costs. This shows that level of activity is an important determinant of unit cost—wide fluctuations in output can yield wide fluctuations in unit cost. b. To allocate fixed costs to units, an assumption initially must be made as to how many units the company expects to produce. This determines over how many units the overhead costs is allocated. That calculation requires estimates of sales and related production. To the extent that actual production differs from estimated production, overhead costs will be either overapplied or underapplied. That means that production and inventory are charged with more than total overhead costs or with an insufficient amount of overhead costs. 7. The major objective of the LIFO method of inventory accounting is to charge cost of goods sold with the most recent costs incurred. When the price level is stable, the results under either the FIFO or the LIFO method will be the same. When price levels change, the use of these different methods can yield significantly different financial results. One of the primary aims of LIFO is to obtain a better matching of costs and revenues in times of inflation. Under the LIFO method, the income statement is given priority over the balance sheet. This means that while a matching of more current costs with revenues occurs in times of price inflation (deflation), the inventory carrying amounts in the balance sheet will be unrealistically low (high). Note that use of the LIFO method is encouraged by its acceptance for tax purposes. The tax law stipulates that its use for tax purposes makes mandatory its adoption for financial reporting. 8. In most annual reports, insufficient information is given to allow the analyst to convert inventories accounted for under one method to a figure reflecting a different method of inventory accounting. Most analysts want such information to better compare the financial statements of companies that use different inventory accounting methods. Converting an inventory figure from one method to another is made even more difficult by the use of different methods for various components of inventory. Still, analysts must, in most cases, make an overall assessment of the impact of different inventory methods on the comparability of inventory figures. Such an assessment should be based on a thorough understanding of the inventory methods in use and the effect they are likely to have on inventory values. The differences that arise between informed approximations and exact figures using additional data generally are not materially different. To be most useful, disclosures of inventory methods must give, in addition to methods used, an identification of the inventory components (in amounts) where such methods are used. More important, disclosure of the dollar difference between the method in use and the method most prevalent in the industry would be very useful. 9. a. Cost, defined generally as the price paid or consideration given to acquire an asset, is the primary basis in accounting for inventories. As applied to inventories, cost generally means the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location. These applicable expenditures and charges include all acquisition and production costs— but they exclude selling expenses and general and administrative expenses not clearly related to production.

Chapter 04 - Analyzing Investing Activities

b. Market, as applied to the valuations of inventories, means the current bid price at the balance sheet date for the inventory in the volume for which it is usually purchased in. The term is applicable to inventories of purchased goods and to manufactured goods (involving materials, labor, and overhead). More generally, market means current replacement cost—although, it must not exceed the net realizable value (estimated selling price less predicted costs of completion and disposal) and must not be less than net realizable value reduced by an allowance for a normal profit margin. c. The usual basis for carrying forward inventory to the next period is cost. Departure from cost is required, however, when the utility of the goods included in inventory is less than their cost. This loss in utility should be recognized as a loss of the current period, the period in which it occurred. Furthermore, the subsequent period should be charged for goods at an amount that measures their expected contribution to that period. In other words, the subsequent period should be charged for inventory at prices no higher than those that would have been paid if the inventory had been obtained at the beginning of that period. (Historically, the lower-of-cost-or-market rule arose from the accounting convention of providing for all losses and anticipating no profits—conservatism.) In accordance with the foregoing reasoning the rule of "cost or market, whichever is lower" may be applied to each item in the inventory, to the total of the components of each major category, or to the total of the inventory, whichever most clearly reflects the economic reality. The LCM rule is usually applied to each item, but if individual inventory items enter into the same category or categories of finished product, alternative procedures are suitable. d. Arguments against use of the lower-of-cost-or-market method of valuing inventories include: (1) The method requires the reporting of estimated losses (all or a portion of the excess of actual cost over replacement cost) as income charges even though the losses have not been sustained to date and may never be sustained. Under a consistent criterion of realization, a drop in selling price below cost is no more a sustained loss than a rise above cost is a realized gain. (2) A price shrinkage is brought into the income statement before the loss has been sustained through sale. Furthermore, if the charge for the inventory write-down is not made to a special loss account, the cost figure for goods actually sold is inflated by the amount of the estimated shrinkage in price of the unsold goods. The title "Cost of Goods Sold" therefore becomes a misnomer. (3) The method is inconsistent in application in a given year because it recognizes the propriety of implied price reductions but gives no recognition in the accounts or financial statements to the effect of price advances. (4) The method is inconsistent in application in one year as opposed to another because the inventory of a company may be valued at cost at one year-end and at market at the next year-end. (5) The lower-of-cost-or-market method values inventory in the balance sheet conservatively. Its effect on the income statement, however, may be the opposite. Although the income statement for the year in which the unsustained loss is taken is reported conservatively, the net income for the subsequent period may be distorted if the expected reductions in sales prices do not materialize.

Chapter 04 - Analyzing Investing Activities

(6) In the application of the lower of cost or market rule, a prospective "normal profit" is used in determining inventory values in certain cases. Since normal profit is an estimated figure based upon past experiences (and might not be attained in the future), it is not objective in nature and presents an opportunity for manipulation of the results of operations. 10. LIFO tends to yield lower reported earnings when prices rise as compared to FIFO. The following illustration highlights these effects: Period Units in Inventory Cost per Unit Total Cost Period 1……………… 5 $5 $25 Period 2……………… 5 10 50 Period 3……………… 5 15 75 Under LIFO, if 10 units are sold, then cost of goods sold is $125, computed as (5 x $15) + (5 x $10). Also, the LIFO inventory value is $25, computed as 5 x $5. If units are sold for $20, then gross profit is $75, computed as (10 x $20) - $125. Under FIFO, if 10 units are sold, then cost of goods sold is $75, computed as (5 x $5) + (5 x $10). Gross profit would be $125, computed as $200 - $75. Inventory would be valued at $75, computed as 5 x $15—inflating the balance sheet. This shows that FIFO tends to increase income and taxes in inflationary periods. 11. Increases in raw materials can, in certain instances, be a positive sign that the company is building inventories to meet expected demand. However, increases in both raw materials and work-in-process inventories, can reflect inefficient operations that have slowed production. Increases in finished goods can reflect the building of warehoused inventory to meet large demand or it can represent the stock piling of finished goods that are not in great demand. The crucial part of analysis is to interpret these changes in the context of current and projected industry conditions. 12. The observation is correct in pointing out that an analyst must subject the data regarding an entity's depreciation policies to critical analysis and scrutiny. The company can choose among several acceptable but vastly different depreciation methods. The reasons a particular choice(s) is made by the company and the effect on reported depreciation expense and accumulated depreciation should be assessed. 13. In the absence of more precise data, an analyst is better off adjusting depreciation charges on the basis of his/her estimates and assumptions than not adjusting them at all. Analyses such as those described in the chapter can help to create a more useful estimate of periodic depreciation expense and accumulated depreciation.

Chapter 04 - Analyzing Investing Activities

14. There are a number of measures relating to plant assets that are useful in comparing depreciation policies over time as well as for intercompany comparisons. The average total life span of plant and equipment can be approximated as: Gross Plant and Equipment  Current Year Depreciation Expense. The average age of plant and equipment can be computed as: Accumulated Depreciation  Current Year Depreciation Expense. The average remaining life of plant and equipment is computed as: Net Depreciated Plant and Equipment  Current Year Depreciation Expense. Also, drawing on the above relations, we can compute: Average Total Life Span = Average Age + Average Remaining Life. The above ratios are helpful in assessing a company's depreciation policies and assumptions over time. The ratios can be computed on a historical cost basis as well as on a current cost basis. 15. One of the more common solutions applied by analysts to the analysis of goodwill is to simply ignore it. That is, they ignore the asset shown on the balance sheet. As for the income statement, under current accounting standards, goodwill is no longer amortized, but is subjected to an impairment test annually and written down if required. Often, however, the write-down expense is treated with skepticism and is frequently ignored. By ignoring goodwill, analysts ignore investments of very substantial resources in what may often be a company's most important and valuable asset. Ignoring the impact of goodwill on reported income is no solution to the analysis of this complex item. Even considering the limited information available, an analyst is better off evaluating the accounting numbers for goodwill rather than dismissing them altogether. Goodwill is measured by the excess of cost over the fair market value of tangible net assets acquired in a transaction accounted for as a purchase. It is the excess of the purchase price over the fair value of all the tangible assets acquired, arrived at by carefully ascertaining the value of such assets—at least in theory. The analyst must be alert to the makeup and the method of valuation of Goodwill as well as to the method of its ultimate disposition. One way of disposing of the Goodwill account, frequently preferred by management, is to write it off at a time when it would have the least impact on the market's assessment of the company's performance. (for example, in a period of losses or reduced earnings). 16. Costs are capitalized as assets when these expenditures are expected to bring the entity value beyond the current year. If the value associated with the expenditure will be used up in the current period, the expenditure is expensed. 17. Hard assets are assets such as the factory and machinery—they are tangible and identifiable. Soft assets are assets such as software, research and development efforts, and intellectual capital—they are more intangible in nature.

Chapter 04 - Analyzing Investing Activities

18. a. Generally accepted accounting principles require that natural resources (wasting) assets be stated at historical cost plus costs of discovery, exploration, and development. This means the large cost outlays that occur following the discovery of natural resources are not given accounting recognition as part of natural resource assets. Rather, they generally are expensed as incurred. Consequently, relations such as income to assets are distorted by a failure to capitalize all relevant costs and by the related implications to current and future earnings. b. When a company acquires natural resources from another entity, this cost is more likely to reflect the entire fair value of these resources. In such a situation the relation between the cost of the assets and the revenues, expenses, and income they generate is likely to be more economically sensible. 19. In valuing property, plant and equipment, and in reporting it in conventional financial statements, accountants emphasize the objectivity of historical cost. They also show an emphasis on conservatism with an accounting for the number of dollars originally invested in the assets. The emphasis is not overly focused on the objectives of those that analyze and depend on financial statements for business decisions. They are content to proclaim that "a balance sheet does not purport to reflect and could not usefully reflect the value of the enterprise." From the user’s perspective, historical costs possess several limitations. They are not relevant to questions of current replacement costs or of future needs. They are not directly comparable to similar data in other companies' reports. They do not enable users to measure opportunity costs of disposal, nor of the alternative uses of funds. They do not provide a valid yardstick against which to measure return. Also, in times of changing price levels, they represent an odd conglomeration of a variety of purchasing power disbursements. 20. a. The basic approach in accounting for identifiable intangibles (other than goodwill) is to record at historical cost and subsequently amortize that cost to benefit periods. If assets other than cash are given in exchange for the intangible, the intangible must be recorded at the fair market value of the consideration given. Notice that if a company spends material and labor in the construction of a "tangible" asset, such as a machine, these costs are capitalized and recorded as an asset that is depreciated over its estimated useful life. On the other hand, if a company spends a great amount of resources advertising a product or training a sales force to sell and service it— which is one process for creating goodwill—it usually cannot capitalize such costs. This is even when such costs may be as, or more, beneficial to the company's future operations than are any "tangible" assets. The reason for this inconsistency in accounting for these two classes of assets extends to several basic accounting conventions such as conservatism. These conventions, drawing on the level of certainty in future returns, casts more doubt on the future realizations of benefits from intangibles (such as advertising or training) than realizations from tangible, "hard" assets. b. Goodwill is an important intangible asset. Still, it represents the only case where the valuation of the asset is restricted to its cost of acquisition from a third party. Moreover, any costs of defending a patent, copyright, or trademark (or similar) are properly included as part of the cost of intangible assets. This extends to other intangibles such as leases, leasehold improvements, special processes, licenses, and franchises. In marked contrast, internally developed goodwill cannot be capitalized and carried as an asset. 4-11 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 04 - Analyzing Investing Activities

c. Identifiable intangibles (other than goodwill) can be separately identified and given reasonably descriptive names such as patents, trademarks, and franchises. Identifiable intangibles can be developed internally, acquired singly or as part of a group of assets. They should be recorded at cost and amortized over their useful lives. Write-down or complete write-off at date of acquisition is not permitted. Unidentifiable intangibles can be developed internally or purchased from others. They cannot be acquired singly—they are inherently part of a group of assets or part of an entire entity. The excess of cost of an acquired company (or segment) over the sum total of identifiable net assets is the most common unidentifiable intangible asset—that of “goodwill.” It is the residual amount in an acquisition after the amount of tangible and identifiable intangibles are determined. Goodwill is no longer amortized, but is tested annually for impairment and written down if required. d. Identifiable intangibles are believed to have limited useful lives. Accordingly, they are amortized. Depending on the type of intangible asset, its useful life may be limited by such factors as legal, contractual, regulations, demand and competition, life expectancies of employees, and other economic and social factors. The cost of each intangible should be amortized over its useful life taking into account all factors that determine its life. Goodwill is not amortized, but is tested annually for impairment and written down if required. 21. Goodwill is often a sizable asset. It can be recorded only upon the purchase of an ongoing business enterprise or segment. The accounting conventions governing the recording of goodwill mean that only purchased goodwill is reported among the recorded assets and that more goodwill likely exist off the balance sheet. The description of what is being paid for in such a transaction varies and this adds to the uncertainty surrounding this asset. Some refer to an ability to attract and keep satisfied customers, while others point to qualities inherent in an enterprise that is well organized and efficient in production, service, and sales. Still others point out that if there is value in goodwill it must be reflected in earnings. That is, if there is value to goodwill, then it should give rise to superior earnings within a reasonably short time after acquisition. If those earnings are not evidenced, then it is fair to assume that the investment in goodwill is of no value regardless of whether it is reported on the balance sheet. Regardless of the amount incurred in the acquisition or internal development of an intangible, the carrying amount of any asset is not to be carried at an amount in excess of realizable value (sales price or future utility). Actual implementation is another matter, and the analyst must be prepared to form judgments on the amounts reported for intangible assets. 22. There are a number of categories of deferred charges. In each case, the rationale for deferral is that these outlays hold future utility (benefits) for the company. (1) Business development, expansion, merger, and relocation costs. a. Pre-operating expenses, initial start-up costs, and tooling costs. b. Initial operating losses or preoperating expenses of subsidiaries. c. Moving, plant rearrangement, and reinstallation costs. d. Merger or acquisition expenses. e. Purchased customer accounts. f. Non-compete agreements. 4-12 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 04 - Analyzing Investing Activities

(2) Deferred expenses. a. Advertising and promotional expenses. b. Imputed interest. c. Selling, general and administrative expenses. d. Pension plan costs. e. Property and other taxes. f. Rental and leasing costs. g. Vacation pay. h. Seasonal growing and packing expenses. (3) Intangible costs. a. Intangible drilling and development costs. b. Contracts, films, copyright materials, art rights c. Costs of computer software (4) Debt discount and expenses. (5) Future income tax benefits. (6) Organization costs. (7) Advance royalties. 23. a. One category of assets not recorded on the balance sheet is internally created goodwill. In this case, if the intangible is internally developed, rather than purchased from an outside party, it cannot be capitalized and all costs must be expensed as incurred. This means, to the extent an asset is created (that can be sold or possesses earning power), prior income that is charged with the expense of its development is understated (and future income will be overstated). Numerous intangible assets fit this category. Another category is that of contingent assets. Under the principle of conservatism, the contingent rights/claims to resources are not recognized due to their uncertainty. b. The analyst must realize that reported book values are not substitutes for market values. As illustrated by the accounting-based equity valuation model, unrecorded assets must eventually be realized in the form of residual income (abnormal earnings). If there is no above-normal income, then there is little value in any unrecorded assets.

Chapter 04 - Analyzing Investing Activities

EXERCISES Exercise 4-1 (12 minutes) a. An allowance method based on credit sales attempts to match bad debts with the revenues generated by the sales in the same period. Thus, it focuses on the income statement rather than the balance sheet. On the other hand, an allowance method based on the balance in the trade receivables accounts attempts to value the accounts receivable at the end of a period at their future collectible amounts. Thus, it focuses on the balance sheet rather than the income statement. (Note that both of these allowance methods are acceptable under GAAP.) b. Carme Company will report on its balance sheet at December 31, Year 1, the balance in the allowance for bad debts account as a valuation or contra asset account—that is, as a subtraction from the accounts receivable asset. Bad debt expense can be reported in the income statement as a selling expense, or as a general and administrative expense, or as a subtraction to arrive at net sales. c. When examining the reasonableness of the allowance for bad debts, the analyst is interested in assessing the collectibility of accounts receivable. The analyst is especially interested in changing business conditions and their impact on this allowance balance (that is, is it sufficient). In addition, the analyst must assess any changes in collectibility assumptions as they have a direct impact on net income through the determination of bad debt expense. Finally, there is some evidence that managers use the allowance account (among others) to help manage earnings levels.

Chapter 04 - Analyzing Investing Activities

Exercise 4-2 (15 minutes) a. Inventory costs include all reasonable and necessary costs of preparing inventory for sale. These costs include not only the purchase price of the inventories, but also other necessary costs of readying inventories for sale. b. The lower of cost or market rule produces a more realistic estimate of future cash flows to be realized from the sale of inventories when market is less than cost. This rule is consistent with the principle of conservatism, and recognizes (matches) the anticipated loss in the income statement for the period in which the price decline occurs. c. K2's inventories should be reported on the balance sheet at market. Specifically, according to the lower of cost or market rule, market is defined as replacement cost. However, market cannot exceed net realizable value and cannot be less than net realizable value less a normal profit margin. For K2, replacement cost is between net realizable value and net realizable value less a normal profit margin. Therefore, market is established as replacement cost. Since market is less than original cost, inventory should be reported at market. d. Ending inventories and net income would have been the same under either lower of (average) cost or market or the lower of (FIFO) cost or market. In periods of declining prices, the lower of cost or market rule results in a write-down of inventory to market under both methods, resulting in similar inventory costs. Therefore, net income using either inventory method is very similar.

Chapter 04 - Analyzing Investing Activities

Exercise 4-3 (15 minutes) a. (i) The average cost method is based on the assumption that the average costs of the goods in the beginning inventory and the goods purchased during the period should be used for both the inventory and the cost of goods sold computation. (ii) The FIFO (first-in, first-out) method is based on the assumption that the first goods purchased are the first sold. As a result, inventory is reported at the most recent purchase prices, while cost of goods sold is at older purchase prices. (iii) The LIFO (last-in, first-out) method is based on the assumption that the latest goods purchased are the first sold. As a result, the inventory is at the oldest (less recent) purchase prices, while cost of goods sold is at more recent purchase prices. b. In an inflationary economy, LIFO provides a better matching of current costs with current revenue on the income statement because cost of goods sold is at more recent purchase prices. Also, net cash inflow is generally increased because taxable income is generally decreased, resulting in payment of lower income taxes. c. Where there is evidence that the value of inventory to be disposed of in the ordinary course of business will be less than cost, the difference should be recognized as a loss in the current period. This is done by restating inventory to its market value in the financial statements. The concept of conservatism, yielding inventory reported at the lower of cost or market, is the primary justification of this approach. (AICPA Adapted)

Exercise 4-4 (12 minutes) a. The inventory asset is more meaningful for analysis purposes when calculated using the FIFO cost flow assumption. This is because the costs assigned to units remaining in ending inventory are the more recent costs. b. Cost of goods sold is usually more meaningful for analysis purposes when calculated using the LIFO cost flow assumption. This is because the costs assigned to units sold are the costs from the more recently purchased units. c. When a company uses LIFO, the costs assigned to units in ending inventory are the costs from older (less recent) units. As a result, analysts would prefer to calculate what ending inventory would have been had FIFO been used. This can be accomplished by adding the LIFO reserve value to the LIFO ending inventory value.

Chapter 04 - Analyzing Investing Activities

Exercise 4-5 (25 minutes) a. Computation of Year 10 Cost of Goods Sold (and Gross Profit): LIFO FIFO Beginning inventory………………………………... $ 816.0 (a) $ 904.0 (b) Cost of goods purchased………………………... 4,262.0 (c) 4,262.0 (c) Goods available for sale……………………….. $5,078.0 $5,166.0 Less ending inventory………………………….. (819.8) (34) (904.4)(152) Cost of goods sold………………………………... $4,258.2 (14)

$4,261.6

Revenues…………………………………………… $6,205.8 (13) Cost of goods sold (above) …….………. (4,258.2) Gross profit: As reported …..…………………………………. $1,947.6 Under FIFO ………………………………………

$6,205.8 (13) (4,261.6)

$1,944.2

(a) Given—from Year 9 balance sheet. (b) $816.0 + $88.0 (given—from Year 9 balance sheet). (c) Cost of goods purchased is the same under either method—derived.

b. The primary analysis objective in making the LIFO-to-FIFO restatement of cost of goods purchases and gross profit is to achieve comparability between firms using different inventory methods. c. FIFO Inventory = LIFO Inventory Year 10 (see Campbell note 14): $904.4 = $819.8 Year 11 (see Campbell note 14): $796.3 = $706.7

+ LIFO Reserve +

$84.6

$89.6

d. When a company uses the LIFO cost flow assumption, it can be valuable to convert the reported inventory asset to a FIFO basis for analysis purposes. This is because the inventory value reported under FIFO is more reflective of the current cost of inventory since reported costs reflect the more recent costs of units purchased.

Exercise 4-6 (10 minutes) In a period of rising inventory costs, the most recently purchased units are more expensive. As a result, the cost of goods sold is higher under LIFO and lower under FIFO. Thus, if output prices are stable, then net income is higher under FIFO than under LIFO. Also, the ending inventory asset value, and therefore total assets, is higher under FIFO and lower under LIFO. In contrast, in a period of declining inventory costs and stable output prices, all of the answers here will reverse.

Chapter 04 - Analyzing Investing Activities

Exercise 4-7 (20 minutes) Examples of potentially unrecorded assets on balance sheets include: • Excess of replacement values over costs for plant assets. • LIFO inventory reserve. • Excess of market value over adjusted cost of equity in nonconsolidated subsidiaries and in affiliates. • Intangibles--recognized firm name, product name, or brand name not capitalized. • Successful R&D such as a new drug that has passed all but final FDA clearance. • Proved reserves of extractive-type companies carried at substantially less than market value of the product less extraction costs. • Human (intellectual) capital. • Value of savings on short-term credit lines where maximum interest payable is currently below bank prime rate. The analyst must remember that book values are only the starting point for accounting-based valuation. If unrecorded assets have economic value, they will eventually be recognized through higher future abnormal earnings (residual income). This means the analyst must consider the impact of unrecorded assets when projecting future profitability for valuation purposes. (CFA Adapted)

Exercise 4-8 (25 minutes) a. A cost should be capitalized (that is, treated as an asset) when it is expected that the asset will produce benefits in future periods. The important concept here is that the incurrence of such a cost results in the acquisition of an asset (future service potential). Not only should the incurrence of the cost result in the acquisition of an asset possessing expected future benefits, but also the cost should be measurable with a reasonable degree of objectivity. Examples of costs that are typically capitalized as assets include the costs of merchandise available at the end of an accounting period, the costs of insurance coverage relating to future periods, and the costs of self-constructed plant or equipment. In contrast, if a cost is incurred that results in benefits not expected to persist beyond the current period, then the cost is expensed. This expense treatment reflects the cost of service potential that expired in producing current period revenues. b. In the absence of a direct basis for associating asset cost with revenue, and if the asset provides benefits for two or more accounting periods, its cost should be allocated to these periods (as an expense) in a systematic and rational manner. Examples of systematic and rational allocation of asset cost would include depreciation of fixed assets, amortization of intangibles, and allocation of rent and insurance costs. When it is impractical, or impossible, to find a reasonable cause-and-effect relation between revenue and cost, this relation is often assumed to exist. In this case, the asset cost is allocated to some assumed benefit period in a systematic manner. The allocation method used should be reasonable and should be applied consistently from period to period.

Chapter 04 - Analyzing Investing Activities

Exercise 4-9 (20 minutes) a. 1. Average total life span of plant and equipment: Gross plant and equipment Current year depreciation expense

2006 $5549a

= 16.87 years

$329b aSee note 16. Note that land must not be included. bAmortization should be subtracted, but it is not broken out in the Colgate cash flow

statement.

2. Average age of plant and equipment: Accumulated depreciation Current year depreciation expense

2006 $2999

= 9.12 years

$329a aAmortization should be subtracted, but it is not broken out in the Dell income statement.

3. Average remaining life of plant equipment: Net plant and equipment Current year depreciation expense

2005 $2550

= 7.76 years

$329b aLand should be subtracted, see note 16. bAmortization should be subtracted, but it is not broken out in the Colgate cash flow

statement.

b. Generally, these ratios can be used to assess a company's depreciation policies both over time (temporal) and for comparative purposes with other companies in the same industry. An analyst must take care whenever comparisons are made between companies. There often are economic reasons for different depreciation methods and assumptions, which can be obscured in a simple restatement of results. For example, Colgate uses straight-line depreciation for plant and equipment; another company may use an accelerated method such as double-declining-balance. The selection of different methods may reflect fundamental differences in management philosophy and action toward capital financing and maintenance. Also, with capital intensive companies, profit margins may not reflect the higher costs that may be expended to replace existing plant assets.

Chapter 04 - Analyzing Investing Activities

Exercise 4-10 (20 minutes) a. 1. Average total life span of plant and equipment: Gross plant and equipment Current year depreciation expense 11 $2,538.0a $194.5

10 $2,404.1a

= 13.05 years

$184.1

= 13.06 years

Buildings [159] ($758.7 in Year 11, $746.5 in Year 10) plus machinery and equipment [160] ($1779.3 in Year 11 and $1657.6 in Year 10). b From Form 10-K, item [187].

2. Average age of plant and equipment: Accumulated depreciation Current year depreciation expense 11 $1,131.5

10 $1,017.2

= 5.82 years

$194.5

= 5.53 years

$184.1

cFrom Campbell note 16 [162].

3. Average remaining life of plant equipment: Net plant and equipment Current year depreciation expense 11 $2,538.0 – $1,131.5d

10 $2,404.1 – $1,017.2d = 7.53 yrs 184.1

= 7.23 yrs

$194.5 d

Gross plant and equipment minus accumulated depreciation.

b. Generally, these ratios can be used to assess a company's depreciation policies both over time (temporal) and for comparative purposes with other companies in the same industry. An analyst must take care whenever comparisons are made between companies. There often are economic reasons for different depreciation methods and assumptions, which can be obscured in a simple restatement of results. For example, Campbell uses straight-line depreciation for plant and equipment; another company may use an accelerated method such as double-declining-balance. The selection of different methods may reflect fundamental differences in management philosophy and action toward capital financing and maintenance. Also, with capital intensive companies, profit margins may not reflect the higher costs that may be expended to replace existing plant assets. Specifically, all three of these measures for Campbell reveal no marked changes from Year 10 to Year 11. Still, a more complete analysis of this conjecture would involve comparisons of Campbell’s measures with those from competitors.

Chapter 04 - Analyzing Investing Activities

Exercise 4-11 (10 minutes)

Balance sheet assets are: c, d (in some cases), e, g, h, i, j, m, p, q

Exercise 4-12 (10 minutes) Ending inventory under FIFO would be $796.3 million [151+152]. Gross profit would be higher by the amount of the increase in the LIFO reserve, or $89.6 million - $84.6 million = $5 million.

Chapter 04 - Analyzing Investing Activities

PROBLEMS Problem 4-1 (30 minutes) a. Under the FIFO method of accounting for inventories, cost of goods sold reflects the cost of inventories purchased earlier (less recent costs). During periods of rising costs, operating margins are higher under FIFO because sales at current prices are matched with older, lower cost inventory. During periods of declining costs, operating margins are compressed because older, higher cost inventories are matched with current, lower priced sales. More specifically, in the case of ABEX Corp. we estimate the following impacts: (1) During the period Year 5 through Year 7, according to Exhibit I, cost per pound produced declined from 34 cents to 31 cents to 29 cents. The use of FIFO compresses ABEX's margins because higher cost, older inventory is being expensed. (2) During the period Year 7 through Year 9, according to Exhibit I, unit costs were rising. Namely, unit costs rose from 29 cents in Year 7 to 35 cents and 39 cents in Year 8 and Year 9, respectively. The use of FIFO would increase ABEX's operating margins during this period as older, lower cost inventory is being expensed first. b. According to Exhibit I, prices and costs are expected to decline in Year 10. In contrast, for Year 11, prices (and presumably costs) are expected to increase. Consequently, adopting LIFO at in Year 11, prior to the projected rise in prices would produce tax savings, increased cash flows, and a better matching of costs and revenues on the income statement. This supports a recommendation to adopt LIFO in Year 11.

Problem 4-2 (15 minutes) a. Year 9 retained earnings adjustment for LIFO to FIFO change: LIFO Reserve x (1- Tax rate) = ($50,000) x (1 - .35) = $32,500 increase b. Year 9 net income adjustment for LIFO to FIFO change for both Years 8 and 9: Change in LIFO Reserve x (1- Tax rate) = [ $(46,000) - $(50,000) ] x (1 - .35) = $2,600 increase c. The primary analysis objective when making a LIFO to FIFO restatement is to (1) achieve better comparability between firms using different inventory methods, and (2) obtain better measures, using more recent costs, of the value of inventory on the balance sheet.

Chapter 04 - Analyzing Investing Activities

Problem 4-3 (30 minutes) a. Ending Inventory Adjusted from LIFO to FIFO: At Jan. 29, 1999: = LIFO Inventory + LIFO Reserve = $219,686 + $26,900 = $246,586 At Jan. 30, 1998: = LIFO Inventory + LIFO Reserve = $241,154 + $25,100 = $266,254

b. Net Income as Adjusted from LIFO to FIFO: Year ended Jan. 29, 1999: = LIFO Income + After-Tax Change in LIFO Reserve = $31,185 + [ ($26,900 – $25,100) x (1 - .37) ] = $32,319 c. The primary analysis objective when making a LIFO to FIFO restatement is to (1) achieve better comparability between firms using different inventory methods, and (2) obtain better measures, using more recent costs, of the value of inventory on the balance sheet.

Problem 4-4 (25 minutes) a. Reconstruction of Transactions using T-Account Analysis:

[161A] Beg. [186] Additions [186] Acquired assets [161A] End.

[187] Retirement/sale [187] Translation Adj.

Property, Plant & Equipment (gross) 2,734.9 371.1 156.7 Retirements/sales [186] 4.7 32.1 Rate variance [186] 2,921.9 Accumulated Depreciation 1,017.2 194.5 69.5 10.7 1,131.5

Beg [162] Depreciation [186]

End [162]

b. The reconstruction of transactions through T-account analysis enables the financial statement reader to examine the economic substance behind the accounting disclosures and to better interpret the changes in key accounts.

Chapter 04 - Analyzing Investing Activities

Problem 4-5 (55 minutes) Software Development Costs: a. Current Unamortized Bal. – Prior Unamortized Bal. + Current Amortization Expense 2000: $18 = $31 - $20 + $7 2001: $5 = $27 - $31 + $9 2002: $7 = $22 - $27 + $12 2003: $22 = $31 - $22 + $13 2004: $26 = $42 - $31 + $15 2005: $16 = $43 - $42 + $15 2006: $7 = $36 - $43 + $14 b. Software development costs typically (arguably) lead to more direct products. The success or failure of software development efforts is determined by whether functioning software is ultimately produced that can be sold to customers. When salable software is reasonably expected to be developed, the cost of the software development can be capitalized and amortized to the presumed benefit periods. The product that results from other R&D efforts is often less identifiable. Indeed, many R&D efforts fail. Moreover, many R&D efforts are only indirectly related to future products. This has resulted in GAAP requirements that expense R&D costs in the periods when incurred. That is, R&D costs are not capitalized and allocated against future revenues generated by any products developed from those efforts. c. A review of the data suggests a one-year lag between R&D expenditures and additional income. Specifically, income appears to increase in the year following substantial R&D efforts and to decline in the year following reduced R&D efforts. Also, this analysis should use income before R&D expenses when assessing the impact of R&D on income. ($000s)

R&D Income Pre-R&D

1999 $400

2000 $491

2001 $216

2002 $212

2003 $355

2004 $419

2005 $401

2006 $455

712

858

604

418

410

500

568

634

d. All else equal, if Trimax invests more in software development in a given year, net income will be higher because the company can capitalize many software development costs. In contrast, expenditures for other R&D projects must be expensed in the year when incurred. Of course, this response ignores the economic implications for which we require additional information to judge the relative successes of these expenditures.

Chapter 04 - Analyzing Investing Activities

Problem 4-5—continued e. Ratio Implications of Alternative Accounting Treatments for R&D and Software: [Note: Answers disregard income tax consequences.] (Year 2006) (1)

Net income $186,000a

Return on Assets .040b

Return on Equity .057c

(2)

$287,250d

.050e

.066f

a: Net income +Add back amortized costs –Actual software development expenditures = $179 + $14 – $7. b: Revised income (col. 1)/ (Total assets –Capitalized software development costs) = $186 / ($4,650 – $36). c: Revised income (col. 1)/ (Total equity –Capitalized software development costs) = $186 / ($3,312 – $36). d: Net income + Add back expensed R&D - Amortization = $179 + $455 – ($212/4) – ($355/4) – ($419/4) – ($401/4) = $179 + $455 - $346.75 = $287.25 e: Revised income (col.1)/(Total assets +Unamortized R&D) =$287.25/ ($4,650 +$455 +$300.75 +$209.50 +$88.75) =$287.25 / $5,704 f: Revised income (col.1)/(Total equity +Unamortized R&D) =$287.25 / ($3,312 +$455 +$300.75 +$209.50 +$88.75) =$287.25 / $4,366

f. Cash flow from operations are unaffected by the capitalizing versus expensing issue. However, cash flow from operations is affected by the decision regarding the quantity of software development and other R&D efforts that will be carried out in a given year. Problem 4-6 (45 minutes) STRAIGHT-LINE ($000s)

YEAR 1

YEAR 2

YEAR 3

YEAR 4

YEAR 5

Earnings before taxes & depreciation: ... $1,500.0 (a) Depreciation .......... (200.0) Net Before Taxes .. $1,300.0 (b) Income Taxes ........ (650.0) (c) Net Income ............ $ 650.0

$2,000.0 (200.0) $1,800.0 (900.0) $ 900.0

$2,500.0 (200.0) $2,300.0 (1,150.0) $1,150.0

$3,000.0 (200.0) $2,800.0 (1,400.0) $1,400.0

$3,500.0 (200.0) $3,300.0 (1,650.0) $1,650.0

Depreciation .......... (d) Cash Flow ..............

200.0 $1,100.0

200.0 $1,350.0

200.0 $1,600.0

200.0 $1,850.0

200.0 $ 850.0

Chapter 04 - Analyzing Investing Activities

SUM-OF-THE-YEARS'-DIGITS ($000s) YEAR 1 (a) (b) (c) (d)

Earnings before taxes & depreciation ....... Depreciation ............. Net Before Taxes ..... Income Taxes ........... Net Income ............... Depreciation ............. Cash Flow .................

$1,500.0 (363.6) $1,136.4 (568.2) $ 568.2 363.6 $ 931.8

YEAR 2

YEAR 3

YEAR 4

YEAR 5

$2,000.0 (327.3) $1,672.7 (836.4) $ 836.3 327.3 $1,163.6

$2,500.0 (290.9) $2,209.1 (1,104.6) $1,104.5 290.9 $1,395.4

$3,000.0 (254.5) $2,745.5 (1,372.8) $1,372.7 254.5 $1,627.2

$3,500.0 (218.2) $3,281.8 (1,640.9) $1,640.9 218.2 $1,859.1

Note: Vs. Straight-Line—Cash flow larger; Net Income smaller; Depreciation larger

DOUBLE-DECLINING-BALANCE ($000s) YEAR 1

YEAR 2

YEAR 3

YEAR 4

YEAR 5

Earnings before taxes & depreciation: ... $1,500.0 (a) Depreciation .......... (400.0) Net Before Taxes .. $1,100.0 (b) Income Taxes ........ (550.0) (c) Net Income ............ $ 550.0

$2,000.0 (320.0) $1,680.0 (840.0) $ 840.0

$2,500.0 (256.0) $2,244.0 (1,122.0) $1,122.0

$3,000.0 (204.8) $2,795.2 (1,397.6) $1,397.6

$3,500.0 (163.8) $3,336.2 (1,668.1) $1,668.1

Depreciation .......... (d) Cash Flow ..............

320.0 $1,160.0

256.0 $1,378.0

204.8 $1,602.4

163.8 $1,831.9

400.0 $ 950.0

Note: Cash flow higher than straight line*, lower than S.Y.D. (except Year 1). Net income lower than straight line*, higher than S.Y.D. (except Year 1). Depreciation higher than straight line*, lower than S.Y.D. (except Year 1). *(except year 5) (CFA adapted)

Chapter 04 - Analyzing Investing Activities

Problem 4-7 (30 minutes) STRAIGHT-LINE Year

Beginning book value

Depreciation expense

1 2 3 4 5

$300,000 $240,000 $180,000 $120,000 $ 60,000

$60,000 $60,000 $60,000 $60,000 $60,000

Net income Net income before taxes after taxes

ROA

$40,000 $40,000 $40,000 $40,000 $40,000

10% 12.5% 16.67% 25% 50%

$30,000 $30,000 $30,000 $30,000 $30,000

SUM-OF-THE-YEARS’-DIGITS Year

Beginning book value

Depreciation expense

1 2 3 4 5

$300,000 $200,000 $120,000 $ 60,000 $ 20,000

$100,000 $80,000 $60,000 $40,000 $20,000

Net income Net income before taxes after taxes

ROA

$0 $20,000 $40,000 $60,000 $80,000

0% 7.5% 25% 75% 300%

$0 $15,000 $30,000 $45,000 $60,000

Problem 4-8 (45 minutes) a. The expenditures that should be capitalized when equipment is acquired include the invoice price of the equipment (net of discounts), all incidental outlays relating to its purchase or preparation for use, any insurance during transit, freight, duties, ownership search costs, ownership registration costs, installation fees, and break-in costs. All available discounts, whether taken or not, should be deducted from the capitalizable cost of the equipment. b. (1) When the market value of the equipment is not determinable by reference to a similar cash purchase, the capitalizable cost of equipment purchased with bonds that have an established market price should be the market value of the bonds. (2) When the market value of the equipment is not determinable by reference to a similar cash purchase, and the common stock used in the exchange does not have an established market price, the capitalizable cost of equipment should be the equipment's estimated fair value if that is more clearly evident than the fair value of the common stock. Independent appraisals may be used to determine the fair values of the assets involved. (3) When the market value of equipment acquired is not determinable by reference to a similar cash purchase, the capitalizable cost of equipment purchased by exchanging dissimilar equipment having a determinable market value should be the market value of the dissimilar equipment exchanged.

Chapter 04 - Analyzing Investing Activities

c. The factors that determine whether expenditures toward property, plant, and equipment already in use should be capitalized are as follows: • Expenditures are relatively large in amount • They are nonrecurring in nature • They extend the useful life of the property, plant, and equipment • They increase the usefulness (for example, quantity or quality of goods produced) of the property, plant, and equipment d. The net book value at the date of the sale (cost of the property, plant, and equipment less the accumulated depreciation) should be removed from the accounts. The excess of cash from the sale over the net book value removed is accounted for as a gain on the sale, while the excess of net book value removed over cash from the sale is accounted for as a loss on the sale. e. Considerations in analyzing property, plant, and equipment include: (1) recognition that book values are at historical cost, (2) need for sufficient capacity to meet anticipated demand, (3) need for writedowns of impaired assets, (4) assess effects of changes in price levels, (5) identify use of assets under operating lease arrangements, and (6) review for existence of idle facilities.

Problem 4-9 (40 minutes) a. Assuming a 25-year useful life for Bellagio, annual depreciation would be $64 million. Thus, net income would be: Year 1: $(10.5) million ($50 - $64 depreciation + $3.5 tax benefit) Year 2: $4.5 million ($70 - $64 depreciation – $1.5 tax expense) Year 3: $8.25 million ($75 – $64 depreciation – $2.75 tax expense) Net assets total $1,536 million, $1,472 million, and $1,408 million in 2001, 2002, and 2003, respectively. Accordingly, return on assets is -0.68%, 0.31%, and 0.59% for 2001, 2002, and 2003, respectively. b. Assuming a 15-year useful life for Bellagio, annual depreciation would be $106.67 million. Thus, net income would be: 2001: $(42.5) million ($50 - $106.67 depreciation + $14.17 tax benefit) 2002: $(27.5) million ($70 - $106.67 depreciation + $9.17 tax benefit) 2003: $(23.75) million ($75 – $106.67 depreciation + $7.92 tax benefit) Net assets total $1,493 million, $1,387 million, and $1,280 million in 2001, 2002, and 2003 respectively. Accordingly, return on assets is -2.85%, -1.98%, and -1.86% for 2001, 2002, and 2003, respectively. c. Assuming a 10-year useful life for Bellagio, annual depreciation would be $160 million. Thus, net income would be: 2001: $(82.5) million ($50 - $160 depreciation + $27.5 tax benefit) 4-28 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 04 - Analyzing Investing Activities

2002: $(67.5) million ($70 - $160 depreciation + $22.5 tax benefit) 2003: $(63.75) million ($75 – $160 depreciation + $21.25 tax benefit) Net assets total $1,440 million, $1,280 million, and $1,120 million in 2001, 2002, and 2003, respectively. Accordingly, return on assets is -5.73%, -5.27%, and -5.69% for 2001, 2002, and 2003, respectively. d. Assuming a 1-year useful life for Bellagio, depreciation would be $1,600 million in 2001. Thus, net income would be: 2001: $(1,162.5) million ($50 - $1,600 depreciation + $387.5 tax benefit) 2002: $52.5 million ($70 - $17.5 tax expense) 2003: $56.25 million ($75 – $18.75 tax expense) The net assets are written down to zero. Thus, return on assets is infinite for 2001, 2002, and 2003.

Problem 4-10 (30 minutes) a. A company may wish to construct its own fixed assets rather than acquire them from outsiders to utilize idle facilities and/or personnel. In some cases, fixed assets may be self-constructed to effect an expected cost saving. In other cases, the requirements for the asset demand special knowledge, skills, and talents not readily available outside the company. Also, the company may want to keep the manufacturing process for a particular product as a trade secret. b. Costs that should be capitalized for a self-constructed fixed asset include all direct and indirect material and labor costs identifiable with the construction. All direct overhead costs identifiable with the asset being constructed should also be capitalized. Examples of cost elements which should be capitalized during the construction period include charges for licenses, permits, fees, depreciation of equipment used in the construction, taxes, insurance, interest on borrowings, and other similar charges related to the asset being constructed. c. (1) The increase in overhead caused by the self-construction of fixed assets should be capitalized. These costs would not have been incurred if the assets had not been constructed. This proposition holds regardless of whether or not the plant is operating at full capacity. It is improper to increase the cost of finished goods with costs that were not incurred in their manufacture and that would not have been incurred if fixed assets had not been produced. However, if the total construction costs on self-constructed fixed assets were substantially in excess of their business and economic usefulness, the excess cost is not capitalized but instead is recorded as a loss. (2) It is clear that the capitalized costs of self-constructed assets should include a proportionate share of overhead on the same basis as that applied to goods manufactured for sale when the plant is operating at full capacity at the time the fixed asset is constructed. Under these circumstances costs of finished 4-29 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 04 - Analyzing Investing Activities

goods produced should not be increased for overhead for goods for which production was foregone. The activity replacing the production of goods for sale should be charged with the related overhead. When idle plant capacity is used for the construction of a fixed asset, opinion varies as to the propriety of capitalizing a share of general factory overhead allocated on the same basis as that applied to goods manufactured for sale. The arguments to allocate overhead maintain that constructed fixed assets should be accorded the same treatment as inventory, new products, or joint products. It is maintained that this procedure is necessary, or special favors or exemptions from under-costing of fixed assets will cause a consequent over-costing of inventory assets. Those arguing against allocating overhead to fixed assets where the assets are constructed when idle capacity exists maintain that, since normal production will not be affected or overhead increased, capitalization will result in increased reported income for the period resulting from construction rather than production of goods for sale. It is also sometimes maintained that the full cost of the constructed asset should not include overhead that would be incurred in the absence of such construction. d. The $90,000 cost by which the initial machine exceeded the cost of the subsequent machines should be capitalized. Without question there are substantial future benefits expected from the use of this machine. Because future periods will benefit from the extra outlays required to develop the initial machine, all development costs should be capitalized and subsequently associated with the related revenue produced by the sale of products manufactured. If, however, it can be determined that the excess cost of producing the first machine was the result of inefficiencies or failure which did not contribute to the machine's successful development, these costs should be recognized as an extraordinary loss. Subsequent periods should not be burdened with charges arising from costs that are not expected to yield future benefits. Capitalizing the excess costs as a cost of the initial machine can be justified under the general rules of asset valuation. That is, an asset acquired should be charged with all costs incurred in obtaining the asset and placing it in service. (AICPA Adapted)

Chapter 04 - Analyzing Investing Activities

Problem 4-11 (50 minutes) a. Intangible assets represent rights or claims to future benefits. An intangible asset is usually defined as a noncurrent asset having no physical existence with a high degree of uncertainty regarding future benefits—its value being dependent on the rights that possession confers upon the owner. b. (1) A dollar to be received in the future is worth less than a dollar received today because of an interest or discount factor—often referred to as the time value of money. The discounted value of the expected royalty receipts can be thought of either in terms of the present value of an annuity of 1 or in terms of the sum of several present values of 1. (2) If the royalty receipts are expected to occur at regular intervals and the amounts are to be fairly constant, their discounted value can be calculated by multiplying the value of one such receipt by the present value of an annuity of 1 for the number of periods the receipts are expected. On the other hand, if receipts are expected to be irregular in amount, or if they are to occur at irregular intervals, each expected future receipt would have to be multiplied by the present value of 1 for the number of periods of delay expected. In each case some interest rate (discount factor) per period must be assumed and used. As an example, if receipts of $10,000 are expected each six months over the next 10 years and an 8 percent annual interest rate is selected, the present value of the twenty $10,000 payments is equal to $10,000 times the present value of an annuity of 1 for 20 periods at 4 percent. Twice as many periods as years, and half the annual interest rate of 8 percent, are used because the payments are expected at semiannual intervals. Thus the discounted (present) value of these receipts is $135,903 ($10,000 x 13.5903). Because of the interest rate, this discounted value is considerably less than the total expected collections of $200,000. Continuing the example, if instead it is expected that $10,000 will be received six months hence, $20,000 one year from now, and a terminal payment of $15,000 is expected 18 months hence, the calculation is as below: $10,000 x present value of 1 at 4% for 1 period = $10,000 x .96154 $20,000 x present value of 1 at 4% for 2 periods = $20,000 x .92456 $15,000 x present value of 1 at 4% for 3 periods = $15,000 x .88900 Adding the results of these three calculations yields a total of $41,441 (rounded), considerably less than the $45,000 total collections, again due to the discount factor.

Chapter 04 - Analyzing Investing Activities

Problem 4-11—continued c. The basis of valuation for the patents that is generally accepted in accounting is cost. Evidently the cartons were developed and the patents obtained directly by the client corporation. Therefore, their cost would include government and legal fees, and the costs of any models and drawings. The proper initial valuation would be the sum of these costs plus any other costs incident to obtaining the two patents. This is in accord with the accounting principle that the initial valuation of any asset generally includes virtually all costs necessary to acquire and make it ready for normal use. Such values are objectively determined and rest upon actual completed transactions rather than upon estimates and future expectations. d. (1) Intangible assets represent rights to future benefits. The ideal measure of the value of intangible assets is the discounted present value of their future benefits. For the Vandiver Corporation, this would include the discounted value of expected net receipts from royalties as suggested by the financial vice-president as well as the discounted value of the expected net receipts to be derived from the Vandiver Corporation's production. Other valuation bases that have been suggested are current cash equivalent or fair market value. (2) The amortization policy is implied in the definition of intangible assets as rights to future benefits. As the firm receives the benefits, the cost or other value should be charged to expense or to inventory to provide a proper matching of revenues and expenses. Under the discounted value approach the periodic amortization would be the decline during the year in the present value of expected net receipts. e. The litigation can and probably should be mentioned in notes to the financial statements. Some indication of the expectations of legal counsel in respect to the outcome can properly accompany the statements. It would be inappropriate to record a contingent asset reflecting the expected damages to be recovered. Costs incurred to September 30, Year 1, in connection with the litigation should be carried forward and charged to expense (or to loss if the cases are lost) as royalties (or damages) are collected from the parties against whom the litigation has been instituted; however, the conventional treatment would be to charge these costs as ordinary legal expenses. If the final outcome of the litigation is successful, the costs of prosecuting it should be capitalized. Similarly, if the client were the successful defendant in an infringement suit on these patents, the generally accepted accounting practice would be to add the costs of the legal defense to the Patents account. Developments to the time that the statements are prepared and released can be reflected in notes to the statements as a post-balance sheet (or subsequent event) disclosure. (AICPA Adapted)

Chapter 04 - Analyzing Investing Activities

CASES Case 4-1 (30 minutes) a. The main determinants of the valuation of feature films, television programs, and general release feature productions by Columbia Pictures are (1) the cost of productions and (2) estimates on how to allocate those costs over the earnings-generating capacity of the films. b. The reasonableness of the bases of valuation depends almost entirely on the reasonableness of the estimates of the expiration of value of the inventory costs. Judging from the second paragraph of the note, it appears that some of the company's estimates of the value of films were overly optimistic and that this prior optimism required subsequent and substantial writedowns. If this is an indication of management's ability to estimate the potential earnings of its film releases, then the analyst should treat its inventory values with suspicion and caution. c. An unsecured lender would want to carefully assess the valuation of film inventories in the light of past experience and of future prospects in the industry. This is particularly crucial here because inventories form such an important part of total assets for Columbia Pictures and other companies in this industry. The analyst would want to know Columbia’s experience in valuing its inventory—from available evidence in Columbia's note this is not reassuring. The analyst would want to compare Columbia’s estimation process with that followed by other companies in the industry, and also would want to compare Columbia’s estimates with forecasted conditions and trends in the industry.

Chapter 04 - Analyzing Investing Activities

Case 4-2 (45 minutes) a. (1) FIFO allocates costs to sales in the order goods are purchased: Sales (1,000 units x $1.70) .......................................................... $ 1,700 Cost of goods sold (1,000 units x $1.00, which is all beginning-year inventory)..................................................... (1,000) Net income before taxes .............................................................. $ 700 Provision for federal income taxes (50%)................................... (350) Net Income Transferred to Retained Earnings........................... $ 350 (2) LIFO allocates recent cost to sales: Sales (1,000 units x $1.70) .......................................................... $ 1,700 Cost of goods sold (1,000 units x $1.50, which are the most recent 1,000 units acquired) ...................................... (1,500) Net income before taxes .............................................................. $ 200 Provision for federal income taxes (50%)................................... (100) Net Income Transferred to Retained Earnings........................... $ 100

b. (1) FIFO: Balance Sheet ASSETS Cash ............................................................................................... Inventory (FIFO method) .............................................................. Total Assets .................................................................................

$ 200 1,500 $1,700

LIABILITIES AND EQUITY Federal income taxes payable ..................................................... Total equity .................................................................................. Total Liabilities and Equity ..........................................................

$ 350 1,350 $1,700

(2) LIFO: Balance Sheet ASSETS Cash ............................................................................................... Inventory (LIFO method) .............................................................. Total Assets ..................................................................................

$ 200 1,000 $1,200

$ 100 1,100 $1,200

Chapter 04 - Analyzing Investing Activities

Case 4-2—continued c. During a period of rising costs, the LIFO method is more conservative in profit determination and in the evaluation of the financial position of a company than the FIFO method. LIFO allocates recent costs of inventory to sales, the result being that these costs are higher in light of cost increases. Accordingly, inventory is valued more conservatively, and income reported is lower than those under the FIFO method. Parts (a) and (b) of this case reveal this relation. That is, under LIFO, income reported is $100 after taxes as compared to $350 under FIFO. Likewise, inventory is reported at $1,000 under LIFO as opposed to $1,500 under FIFO. Evidence of rising costs is that existing inventory is valued at $1.00 per unit while goods purchased during the year ran at $1.50 per unit. Tax considerations also are important. As we can see from parts (a) and (b), the LIFO method produces a tax liability of $100, whereas taxes under the FIFO method amount to $350. As long as inventory is maintained at a given level or increases, LIFO produces an interest-free, perpetual loan from the government. Of course, should inventory be liquidated, cost of goods sold will be very low compared to sales, with a resulting higher income tax liability (making up for the prior deferrals).

d. Companies use a dollar pool LIFO method to prevent liquidation of low-cost LIFO inventory units. Under this method, groups of items are viewed as a dollar pool, and if one item is sold, it may be replaced by new items of the same or greater dollar value, and there is no liquidation of the pool. The problem for a company that prepares interim statements is to decide whether liquidated items in one quarter will be replaced before the end of the fiscal year. If the items are replaced, income taxes allocated to profits of the current quarter will be lower than if the items are not replaced. (CFA Adapted)

Chapter 04 - Analyzing Investing Activities

Case 4-3 (45 minutes) a. Net Income Computation: FIFO

LIFO

Average cost

Sales (1,000 x $25) ......................... Cost of sales: Beginning inventory .................... Add: Purchases ............................ Less: Ending inventory ............... Cost of sales ................................... Gross profit .................................... Operating expenses ....................... Net income ......................................

$25,000

0 23,200 (11,700) 11,500 13,500 5,000 $ 8,500

0 23,200 (9,100) 14,100 10,900 5,000 $ 5,900

0 23,200 (10,312) 12,888 12,112 5,000 $ 7,112

Net income per share.....................

$4.25

$2.95

$3.56

NOTES: (1) FIFO inventory computation is based on 500 units at $15 and 300 at $14. (2) LIFO inventory computation is based on 100 units at $10, 300 units at $11, and 400 units at $12. (3) Average cost is obtained by dividing $23,200 by 1,800 units purchased, yielding an average unit price of $12.89.

b. Financial Ratio Computations (1) Current ratio …………………….. (2) Debt-to-equity ratio ……………. (3) Inventory turnover ……………… (4) Return on total assets ………… (5) Gross margin ratio…………………. (6) Net profit as percent of sales…….

FIFO

LIFO

Average Cost

2.47 67.8% 2.00 9.8% 54.0% 34.0%

2.36 71.3% 3.10 7.0% 43.6% 23.6%

2.41 69.6% 2.50 8.3% 48.5% 28.5%

c. LIFO Effects. Under conditions of fluctuating inventory costs, the LIFO inventory method will have a smoothing effect on income. Moreover, the LIFO method results, in times of cost increases, in an unrealistically low reported inventory figure. This, in turn, will lower the current ratio of a company and at the same time tend to increase its inventory turnover ratio. The LIFO method also affords management an opportunity to manipulate profits by allowing inventory to be depleted in poor years, thus drawing on the low cost base pool. FIFO Effects. The use of FIFO in the valuation of inventories will generally result in a higher inventory on the balance sheet and a lower cost of goods sold than under LIFO resulting. This would result in a higher net income. Average Cost Effects. The average cost method smoothes out cost fluctuations by using a weighted average cost in the valuation of inventories and cost of goods sold. The resulting net income will be close to an average of the net income under LIFO and FIFO.

Chapter 04 - Analyzing Investing Activities

Case 4-4 (45 minutes) a. $1,518.5 [36] - $1,278.0 [45] = $240.5. b. Campbell Soup sells to retailers, like grocery stores. Note 13 reports that the company has established an allowance for uncollectible accounts of $16.3 million as of the end of the year. This amount represents 3.4% of gross accounts receivable from trade creditors (see Note 13). c. The company employs LIFO inventory costing. Inventories are written down to the lower of cost or market. d. Inventory turnover = $4095.5 million /($706.7 million +$819.8 million)/2 = 5.37 times. Companies can improve the inventory turnover rate by reducing raw materials on hand (with just-in-time deliveries), work-in-process inventories (by improved manufacturing processes), and finished goods inventories (by producing to order rather than to demand forecasts). e. The LIFO reserve is $89.6 million (Note 14). The cumulative tax savings are $89.6 million x 35% = $31.4 million. f. Had it used FIFO inventory costing, gross profit would have been higher by the increase in the LIFO reserve, or $89.6 million - $84.6 million = $5 million. The pre-tax profit would have been $667.4 million + 5 million = $672.4 million. g. PPE represents $1,790.4 million / $4,149.0 million = 43% of total assets. Campbell Soup uses straight-line depreciation (Note 1). Accumulated depreciation is $1,131.5 million / ($2,921.9 million - $56.3 million - $327.6 million) = 44.6% of total gross long-term depreciable assets. The accumulated depreciation to gross depreciable assets yields information about the percentage that these assets have been “used up.” As this percentage increases, the company will have to expend more cash on repairs and upgrades. h. Intangible assets arise from acquisitions. They represent the portion of the purchase price for acquired companies that has been allocated to intangible assets.

Chapter 04 - Analyzing Investing Activities

Case 4-5 (45 minutes) a. Depreciation is a system whose purpose is to allocate the cost of tangible capital assets, less salvage, over their useful lives in a systematic and rational manner. Under GAAP, depreciation is a process of cost allocation, not of valuation, through which the productive effort (cost) is to be matched with productive accomplishment (revenue). This process is founded on the matching principle. Depreciation, therefore, is mainly concerned with the timing of the expiration of the cost of tangible fixed assets. b. The proposed depreciation method is, of course, systematic. Whether it is rational in terms of cost allocation depends on the facts of the case. It produces an increasing depreciation charge, which is usually not justifiable in terms of the benefits derived from the use of an asset. This is because manufacturers typically prefer to use their new equipment as much as possible and their old equipment only as needed, such as to meet production quotas during periods of peak demand. As a general rule, benefits decline with age. Assuming that the actual operations (including equipment usage) of each year are identical, then maintenance and repair costs are likely to be higher in the later years of usage than in the earlier years. This means the proposed method would match lower depreciation with lower repair charges in the early years, while it would match higher depreciation with higher repair charges in the later years. However, reported net income in the early years would be much higher than reported net income in the later years of the asset’s life. This is an unreasonable and undesirable variation during periods of identical operation. On the other hand, if the expected level of operations (including equipment usage) in the early years of the asset’s life is expected to be low relative to that of later years, then the pattern of depreciation charges of the proposed method approximately parallels expected benefits (and revenues). In this admittedly unusual case, the method may be viewed as reasonable. Although, the units-of-production depreciation method is the more usual method selected to fit this case. c. (1) Depreciation charges neither recover nor create cash. Revenue-producing activities are the sources of cash from operations. If revenues exceed out-of-pocket costs during a period, then cash is available to cover other than out-of-pocket costs. However, if revenues do not exceed out-of-pocket costs, then no cash is made available no matter how much, or little, depreciation is charged. (2) Depreciation can affect cash in at least two ways. First, depreciation charges affect reported income and, hence, can affect managerial decisions such as those regarding pricing, product selection, and dividends. For example, the proposed method would result initially in higher reported income than would the straight-line method. Consequently, shareholders might demand higher dividends in the earlier years than they would otherwise expect. The straight-line method, by yielding a lower reported income during the early years of asset life and by reducing the amount of potential dividends in early 4-38 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 04 - Analyzing Investing Activities

years as compared with the proposed method, could encourage earlier reinvestment in other profit-earning assets to meet increasing demand. Second, depreciation charges affect reported taxable income. This means they affect directly the amount of income taxes payable in the year of deduction. Using the proposed method for tax purposes would reduce the total tax bill over the life of the assets (1) if the tax rates were increased in future years or (2) if the business were doing poorly now but were to do significantly better in the future. The first condition is political and speculative, but the second condition may be applicable to Toro in view of its recent origin and its rapid expansion program. Consequently, more funds might be available for reinvestment in fixed assets in years of larger deductions if the business remains profitable. If Toro is not profitable now, it would not benefit from higher deductions now and should consider an increasing charge method for tax purposes, such as the one proposed. If Toro is profitable now, the president should reconsider his proposal because it will delay the availability of cash that must be paid to cover taxes. Also the proposed method could result in lower estimated production costs in earlier years, which could lead to underpricing of the product. (AICPA Adapted)

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

Chapter 5 Analyzing Investing Activities: Intercorporate Investments

REVIEW Intercompany investments play an increasingly larger role in business activities. Companies pursue intercompany activities for several reasons including diversification, expansion, and competitive opportunities and returns. This chapter considers our analysis and interpretation of these intercompany activities as reflected in financial statements. We consider current reporting requirements from our analysis perspective--both for what they do and do not tell us. We describe how current disclosures are relevant for our analysis, and how we might usefully apply analytical adjustments to these disclosures to improve our analysis. We direct special attention to the unrecorded assets and liabilities in intercompany investments.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

OUTLINE •

Passive investments Accounting for Investment Securities Disclosure of Investment Securities Analyzing Investment Securities

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Investments with Significant Influence Equity Method Accounting Analysis Implications of Equity Investments

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Business Combinations Accounting Mechanics of Business Combinations Analysis Implications of Business Combinations Comparison of Pooling versus Purchase Accounting for Business Combinations

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Derivative Securities Defining a Derivative Classification and Accounting for Derivatives Disclosure of Derivatives Analysis of Derivatives

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Appendix 5A: International Activities

•

Appendix 5B: Investment Return Analysis

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

ANALYSIS OBJECTIVES

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Analyze financial reporting for intercorporate investments.

•

Interpret consolidated financial statements.

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Analyze implications of both the purchase and pooling methods of accounting for business combinations.

•

Interpret goodwill arising from business combinations.

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Describe derivative securities and their implications for analysis.

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Analyze foreign currency translation disclosures.

•

Analyze investment returns.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

QUESTIONS 1. Long-term investments are usually investments in assets such as debt instruments, equity securities, real estate, mineral deposits, or joint ventures acquired with longerterm goals. Such goals often include the acquisition of control or affiliation with other companies, investment in suppliers, securing sources of supply, etc. The valuation and presentation of noncurrent investments depends on the degree of influence that the investor company has over the investee company. With no influence, debt investments other than held-to-maturity bonds and equity investments are accounted for at market value. Once influence is established, equity investments are accounted for under the equity method or consolidated with the statements of the investor company.

a. In the absence of evidence to the contrary, an investment (direct or indirect) in 20% or more of the voting stock of an investee carries the presumption of an ability to exercise significant influence over the investee. Conversely, an investment of less than 20% in the voting stock of the investee leads to the presumption of a lack of such influence unless the ability to influence can be demonstrated. Accounting requirements are: Held-to-maturity securities are reported at amortized cost. Noncurrent available-for-sale securities are reported at fair value. Influential securities are accounted for under the equity method. b. Standards indicate that a position of more than 20% of the voting stock might give the investor the ability to exercise significant influence over the operating and financial policies of the investee. When such an ability to exercise influence is evident, the investment should be accounted for under the equity method. Basically this means at cost, plus the equity in the earnings or losses of the investee since acquisition (with the addition of certain other adjustments). Evidence of an investor's ability to exercise significant influence over operating and financial policies of the investee is reflected in several ways such as management representation and participation. While eligibility to use the equity method is based on the percent of voting stock outstanding, that can include, for example, convertible preferred stock, the percent of earnings that can be picked up under the equity method depends on ownership of common stock only.

2. a. The accounting for investments in common stock representing over 20% of equity requires the equity method. While use of the equity method is superior to reporting cost, one must note that this is not equivalent to fair market value—which, depending 5-4 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

on the circumstances, can be significantly higher or lower than the carrying amount under the equity method.

An analyst also must remember that the presumption that an investment holding of 20% or more of the voting securities of an investee results in significant influence over that investee is arbitrary—an assumption made in the interest of accounting uniformity. If such influence is absent, then there is some question regarding the investor's ability to realize the amount reported.

b. A loss in value of an investment that is other than a temporary decline should be recognized the same as a loss in value for other long-term assets. This statement suggests considerable judgment and interpretation and, in the past, has resulted in companies being very slow to recognize losses in their investments. Since

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

accounting does not consider a decline in market value to be conclusive evidence of such a loss, the analyst must be alert to situations where hope rather than reason supports the carrying amount of an investment. It must be recognized that the equity method reflects only current operating losses rather than the capital losses that occur when the earning power of an investment deteriorates or disappears.

3. Some weaknesses and inconsistencies pertaining to the accounting for marketable securities carried as noncurrent assets include: • The classification of securities as noncurrent investments is based on management intent, a subjective notion. • Changes in the fair value of noncurrent available-for-sale securities bypass net income. • Equity securities of companies in which the enterprise has a 20 percent or larger interest, and in some instances an even smaller interest than 20 percent, need not be adjusted to market. Instead, it is reported using the equity method, which may at times yield values significantly below and at other times above, market. • With regard to such relatively substantial blocks of securities, the values at which they are carried on the balance sheet may be substantially different that their realizable values.

4. Generally, investments in marketable securities are one use of excess cash available to managers. Other uses include financing growth projects, paying down debt, paying dividends, or buying back stock. In certain instances, the purchase of investment securities is viewed as an admission by the company that they have no positive net present value growth projects available to direct its monies.

5. Hedging activities are designed to protect the company against fluctuations in market instruments. Speculative activities seek to profit on fluctuations in market instruments.

6. A futures contract is an agreement between two or more parties to purchase or sell a certain commodity or financial asset at a future date and at a definite price.

7. A swap contract is an arrangement between two or more parties to exchange future cash flows. Swaps are typically used to hedge risks such as interest rate and foreign currency risks. 5-6 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

8. An option contract gives a party the right, but not an obligation, to execute a transaction. An option to purchase a security at a specified price at a future date is an example of an option contract. This option is likely to be exercised if the security price on that future date is higher than the contract price and not otherwise.

9. A hedge transaction is a transaction executed in an attempt to protect the company against a specific market risk.

10. To qualify for hedge accounting, a derivative instrument must hedge either the fair value or the cash flows of an asset, liability, or some other exposure.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

11. A cash flow hedge is designed to hedge exposure to volatility in cash flows attributable to a specific risk. An example of a cash flow hedge is a floating-for-fixed interest rate swap. This swap hedges the cash flows related to an interest-bearing financial instrument. An example of a fair value hedge is a fixed future commitment to sell a fixed quantity of a commodity at a specified price. This transaction hedges the fair value of the commodity against loss before the time that it is sold.

12. In fair value accounting, both the hedging instrument and the hedged asset or liability are recorded at fair value in the balance sheet. All realized and unrealized gains and losses on both the hedging instrument and the hedged asset or liability are immediately recognized in income.

Unrealized gains and losses relating to the effective portion of a cash flow hedge are immediately recorded as part of other comprehensive income up to the effective date of the transaction. After the effective date of the transaction, the gains and losses are transferred to income. The cash flow hedging instrument is recorded at fair value on the balance sheet. However, there is no offsetting asset or liability as in the case of a fair value hedge. Instead, the offset in the balance sheet occurs through accumulated comprehensive income, which is part of equity.

13. Speculative derivatives are recorded at fair value on the balance sheet and any unrealized or realized gains or losses are immediately recorded in net income.

14. From a strict legal viewpoint, the statement is basically correct. Still, we must remember that consolidated financial statements are not prepared as legal documents. Consolidated financial statements disregard legal technicalities in favor of economic substance to reflect the economic reality of a business entity under centralized control. From the analysts' viewpoint, consolidated statements are often more meaningful than separate financial statements in providing a fair presentation of financial condition and the results of operations.

15. The consolidated balance sheet obscures rather than clarifies the margin of safety enjoyed by specific creditors. To gain full comprehension of the financial position of each part of the consolidated group, an analyst needs to examine the individual financial statements of each subsidiary. Specifically, liabilities shown in the consolidated financial statements do not operate as a lien upon a common pool of assets. The creditors, 5-8 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

secured and unsecured, have recourse in the event of default only to assets owned by the individual corporation that incurred the liability. If, on the other hand, a parent company guarantees a specific liability of a subsidiary, then the creditor would have the guarantee as additional security.

16. Consolidated financial statements generally provide the most meaningful presentation of the financial condition and the results of operations of the combined entity. Still, they do have certain limitations, including: •

The financial statements of the individual companies in the group may not be prepared on a comparable basis. Accounting principles applied, valuation bases, and amortization rates used can differ. This can impair homogeneity and the validity of ratios, trends, and key relations.

•

Companies in relatively poor financial condition may be combined with sound companies, obscuring information necessary for effective analysis.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

•

The extent of intercompany transactions is unknown unless consolidating financial statements (worksheets) are presented. The latter reveal the adjustments involved in the consolidation process, but are rarely disclosed.

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Unless disclosed, it is difficult to estimate how much of consolidated retained earnings are actually available for payment of dividends.

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The composition of the minority interest (such as between common and preferred stock) cannot be determined because the minority interest is usually shown as a combined amount in the consolidated balance sheet.

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Consolidated financial statements do not reveal restrictions on use of cash for individual companies nor the intercompany cash flows.

•

Consolidation of nonhomogeneous subsidiaries (such as finance or insurance subsidiaries) can distort ratios and other relations.

17. a. This disclosure is necessary—it is a subsequent event required to be disclosed. Also, the contingency conditions involving additional consideration are adequately disclosed. Still, it would have been more informative had the note disclosed the market value of net assets or stocks issued. b. This must be accounted for by the purchase method. Since the more readily determinable value in this case is the consideration given in the form of the Best Company stock, the investment should be recorded at $1,057,386 (48,063 shares x $22 market price at acquisition). In the consolidated statements, there may or may not be goodwill to be recognized—this depends on a comparison of the market value of its net assets to the$1,057,386 purchase price. c. The contingency is based on the earnings performance of the acquired companies over the next five years—but the total amount payable in stock is limited to 151,500 shares, to a maximum of $2 million. d. During the course of the next five years, if the acquired companies earn cumulatively over $1 million, then the Best Company will record the additional payment when the outcome of the contingency is determined beyond a reasonable doubt. The payments are considered additional consideration in the purchase and will either increase the carrying values of tangible assets or the "excess of cost over net tangible assets" (goodwill) account.

18. a. The total cost of the assets is the present value of the amounts to be paid in the future. If the liabilities are issued at an interest rate that is substantially above or 5-10 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

below the current effective rate for similar securities, the appropriate amount of premium or discount should be recorded.

b. The general rule for determining the total cost of assets acquired for stock is to value the assets acquired at the fair value of the stock given (as traded in the market) or fair value of assets received, whichever is more clearly evident. If there is no ready market for either the stock or the assets acquired, the valuation has to be based on the best means of estimation, including a detailed review of the negotiations leading up to the purchase and the use of independent appraisals.

19. Usually, the purchase method of accounting for a business combination is preferable from an analyst's viewpoint. Since purchase accounting recognizes the acquisition values on which the buyer and seller actually bargained, the balance sheet likely reflects more realistic (economic) values for both assets and liabilities. Moreover, the income statement likely better reflects the actual results of operations due to accounting procedures such as cost allocation of more appropriate asset values.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

20. a. Goodwill represents the excess of the total cost over the fair value assigned to the identifiable tangible and intangible assets acquired less the liabilities assumed.

b. It is possible that the market values of identifiable assets acquired less liabilities assumed exceed the cost (purchase price) of the acquired company. In this case, the values otherwise assignable to noncurrent assets (except for marketable securities) acquired should be reduced by a proportionate part of the excess. Negative goodwill should not be recorded unless the value assigned to such long-term assets is first reduced to zero. If negative goodwill must be recorded, it is recorded as an extraordinary gain (net of tax) below income from continuing operations

c. Marketable Securities are recorded at current net realizable values.

d. Receivables are recorded at the present value of amounts to be received, computed at proper current interest rates, less allowances for uncollectibility and collection costs.

e. Finished Goods are recorded at selling prices less cost of disposal and reasonable profit allowance.

Work-in-Process is recorded at the estimated selling price of the finished goods less the sum of the costs to complete, costs of disposal, and a reasonable profit allowance.

g. Raw Materials are recorded at current replacement costs.

h. Plant and Equipment are recorded at current replacement costs unless the expected future use of these assets indicates a lower value to the acquirer.

Land and Mineral Reserves are recorded at appraised market values. 5-12

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

Payables are recorded at present values of amounts to be paid, determined at appropriate current interest rates.

k. The goodwill of the acquired company is not carried forward to the acquiring company's accounting records.

21. A crude way of adjusting for omitted values in a pooling combination is to estimate the difference between the market value and the recorded book value of the net assets acquired, and then to amortize this difference on some reasonable basis. The result would be approximately comparable to the net income reported using purchase accounting. Admittedly, the information available for making such adjustments is limited.

22. Analysis should be alert to the appropriateness of the valuation of the net assets acquired in the combination. In periods of high stock market price levels, purchase accounting can introduce inflated values when net assets (particularly the intangibles) of acquired companies are valued on the basis of the high market price of the stock issued. Such values, while determined on the basis of temporarily inflated stock prices, remain on a company's balance sheet and may require future write-downs if impaired. This concern also extends to temporarily depressed stock prices and its related implications.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

23. a. An acquisition program aimed at purchasing companies with lower PE ratios can, in effect, "buy" earnings for the acquiring company. To illustrate, say that Company X has earnings of $1 million, or $1 per share on 1 million shares outstanding, and that its PE is 50. Now, let’s assume it purchases Company Y at 10 times it earnings of $5,000,000 ($50 million price) by issuing an additional 1,000,000 shares of X valued at $50 per share. Then: Earnings of Combined Entity are: X earnings .....$1,000,000 Y earnings ..... 5,000,000 $6,000,000

The new number of shares outstanding is 2,000,000, providing an EPS of $3.00 (computed as $6 million divided by 2 million shares). Also, note that earnings per share increases from $1 to $3 per share for Company X by means of this acquisition.

We should recognize the “synergistic effect” in this case. That is, two companies combined can sometimes show results that are better than the total effect of each separately. This can occur through combination of vertical, horizontal, or other basis of company integration. Consider the following example: Company S:

PE = 10 EPS = $1.00

Earnings = $1,000,000 Number of shares = 1,000,000 Company T:

PE = 10 Earnings = $1,000,000

Assume Company S buys Company T at a bargain of 10 times earnings and it assumes $1,000,000 after-tax savings from efficiencies. Then: Combined entity: S earnings .....................................$1,000,000 T earnings ...................................... 1,000,000

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

Savings from merger .................... 1,000,000 New earnings ................................$3,000,000 New number of shares ................. 2,000,000 New EPS ........................................

$1.50

The EPS of the combined entity increases 50 percent (relative to Company S) as a result of this merger.

b. For adjustment purposes, the financial statements should be pooled as if the two companies had been merged prior to the years under consideration—with any intercompany sales eliminated. This would give the best indication of the earnings potential. However, adjusting backwards to reflect merger savings subsequently realized is a bit tenuous. It is probably better to use the actual combined figures, with “mental adjustments” by the analyst. Too many "adjusted for merger savings" statements bear little relation to the historical record. Also, the analyst may want to compare the acquiring company’s actual results with the new merged company's record to get an idea of the success of the acquisition program. One “trick” in the acquisition game is to look for companies with “satisfactory” performance in two prior years (say, Year 1 and Year 2) and a good subsequent year (Year 3). Such companies are prime acquisition candidates since the Year 3 pooled statements

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

would look good in comparison with pooled years 1 and 2. An analysis of the acquiring company’s results alone versus the combined entity would reveal this trick.

24. The amount of goodwill that is carried on the acquirer's statement too often bears little relation to its real value based on the demonstrated superior earning power of the acquired company. Should the goodwill become impaired, the resulting write-down could significantly impact earnings and the market value of the company.

25. All factors supporting the estimates of the benefit periods should be reexamined in the light of current economic conditions. Some circumstances that can affect such estimates are: •

A new invention that renders a patented device obsolete.

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Significant shifts in customer preferences.

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Regulatory sanctions against a segment of the business.

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Reduced market potential because of an increased number of competitors.

26.A

The major provisions of accounting for foreign currency translation (SFAS 52) are:

•

The translation process requires that the functional currency of the entity be identified first. Ordinarily it will be the currency of the country where the entity is located (or the U.S. dollar). All financial statement elements of the foreign entity must then be measured in terms of the functional currency in conformity with GAAP.

•

Under the current rate method (most commonly used), translation from the functional currency into the reporting currency, if they are different, is to be at the current exchange rate, except that revenues and expenses are to be translated at the average exchange rates prevailing during the period. The current method generally considers the effect of exchange rate changes to be on the net investment in a foreign entity rather than on its individual assets and liabilities (which was the focus of SFAS 8).

•

Translation adjustments are not included in net income but are disclosed and accumulated as a separate component of stockholders' equity (Other Comprehensive Income or Loss) until such time that the net investment in the foreign entity is sold or liquidated. To the extent that the sale or liquidation represents realization, the relevant amounts should be removed from the separate equity component and included as a gain or loss in the determination of the net income of the period during which the sale or liquidation occurs. 5-16

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

27. A The accounting standards for foreign currency translation have as its major objectives: (1) to provide information that is generally compatible with the expected economic effects of a change in exchange rate on an enterprise's cash flows and equity, and (2) to reflect in consolidated statements the financial results and relations as measured in the primary currency of the economic environment in which the entity operates, which is referred to as its functional currency. Moreover, in adopting the functional currency approach, the FASB had the following goals of foreign currency translation in mind: (1) to present the consolidated financial statements of an enterprise in conformity with U.S. GAAP, and (2) to reflect in consolidated financial statements the financial results and relations of the individual consolidated entities as measured in their functional currencies. The Board's approach is to report the adjustment resulting from translation of foreign financial statements not as a gain or loss in the net income of the period but as a separate accumulation as part of equity (in comprehensive income).

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

28. A Following are some analysis implications of the accounting for foreign currency translation: (a) The accounting insulates net income from balance sheet translation gains and losses, but not transaction gains and losses and income statement translation effects. (b) Under current GAAP, all balance sheet items, except equity, are translated at the current rate; thus, the translation exposure is measured by the size of equity or the net investment. (c) While net income is not affected by balance sheet translation, the equity capital is. This affects the debt-to-equity ratio (the level of which may be specified by certain debt covenants) and book value per share of the translated balance sheet, but not of the foreign currency balance sheet. Since the entire equity capital is the measure of exposure to balance sheet translation gain or loss, that exposure may be even more substantial, particularly with regard to a subsidiary financed with low debt and high equity. The analyst can estimate the translation adjustment impact by multiplying year-end equity by the estimated change in the period to period rate of exchange. (d) Under current GAAP, translated reported earnings will vary directly with changes in exchange rates, and this makes estimation by the analyst of the "income statement translation effect" less difficult. (e) In addition to the above, income will also include the results of completed foreign exchange transactions. Also, any gain or loss on the translation of a current payable by the subsidiary to parent (which is not of a long-term capital nature) will pass through consolidated net income.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

EXERCISES Exercise 5-1 (20 minutes)

a. Usual objectives underlying the holding of both current and noncurrent portfolios of securities are: Current—for temporary investments of excess cash in highly liquid investments. Noncurrent—for investment income, appreciation value, control purposes of another entity, or to secure sources of supplies or avenues of sales.

b. Securities should be classified as follows: Trading securities are always classified as current. Held-to-maturity securities are classified as noncurrent, except for the reporting period immediately prior to maturity. Available-for-sale securities are classified as current or noncurrent based on management’s intent regarding sale. Influential securities are noncurrent unless their sale is imminent. Marketable securities that are temporary investments of cash specifically designated for special purposes such as plant expansion or sinking fund requirements are classified as noncurrent.

Unrealized losses on trading securities (which are classified as current assets) are the only unrealized losses to flow through the income statement. Unrealized losses on noncurrent investments (and current investments in available-for sale securities) are included as a separate component of shareholders' equity. Some analysts treat much if not all of these unrealized gains and losses as another component of adjusted net income.

Exercise 5-2 (12 minutes)

a. When available-for-sale securities are marked to market, an asset account is adjusted to market (either upward or downward) and an equity account is increased when marked up or decreased when marked down. 5-19 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

b. If the investments being marked to market were trading securities instead of availablefor-sale securities, then an asset account would be adjusted to market. In addition, a gain or loss account that flows through income would also be included to reflect the change in market value (and equity would change accordingly when income is closed to it).

c. Although under available-for-sale accounting unrealized gains are not recorded, realized gains are reflected in reported income. Microsoft, therefore, can sell securities with unrealized gains and increase its reported income.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

Exercise 5-3 (20 minutes)

a. Passive interest investments declared to be available-for-sale or trading securities are reported at fair market value on the balance sheet. Passive interest investments declared to be held-to-maturity are reported at historical cost. Significant influential investments are reported at historical cost increased by a pro rata share of investee net income and decreased by a pro rata share of dividends declared by the investee company. Controlling interests investments are reported using consolidation procedures.

b. Passive interest investments declared to be trading or available-for-sale securities are reported at fair market value. Fluctuations in the value of trading securities are reported in net income in the period of the fluctuation. Fluctuations in the value of available-forsale securities are reported in comprehensive income of each period.

c. Held-to-maturity securities are reported at historical cost because period to period value fluctuations are arguably less relevant since the company intends to hold the security to maturity and receive the maturity value of the investment. On one hand, not reporting the volatility in the value of held-to-maturity securities seems appropriate since the company does not intend to sell the security at its higher or lower current value. On the other hand, management intent can change, and such changes in market value directly impact the value of the company.

Exercise 5-4 (30 minutes)

a. Under purchase accounting, goodwill is reported if the purchase price exceeds fair value of the acquired tangible and intangible net assets.

b. All identifiable tangible and intangible assets acquired, either individually or by type, and liabilities assumed in a business combination, whether or not shown in the financial statements of Moore, should be assigned a portion of the cost of Moore, normally equal to the fair values at date of acquisition. Then, the excess of the cost of Moore over the sum of the amounts assigned to identifiable tangible and intangible assets acquired less the liabilities assumed is recorded as goodwill. 5-21 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

c. Consolidated financial statements should be prepared to present financial position and operating results in a manner more meaningful than in separate statements. Such statements often are more useful for analysis purposes.

d. The first necessary condition for consolidation is control, as typically evidenced by ownership of a majority voting interest. As a general rule, ownership by one company, directly or indirectly, of over fifty percent of the outstanding voting shares of another company is a condition necessary for consolidation.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

Exercise 5-5 (35 minutes)

a. Each of the four corporations will maintain separate accounting records based on its own operations (for example, C1's accounting records are not affected by the fact it has only one stockholder).

b. For SEC filing purposes, consolidated statements would be presented for Co. X and Co. C1 and Co. C2 as if these three separate legal entities were one combined entity. C1 or C2 would probably not be consolidated if controlled only temporarily. C3 would be shown as a one-line consolidation (both balance sheet and income statement) under the equity method.

c. The analyst likely would request the following types of information (only consolidated statements normally are available):

(1) Consolidated Co. X with subsidiaries C1 and C2 (C3 would be a one-line consolidation). (2) Co. X statements only (all three investee companies, C1, C2, and C3 would be one-line consolidations). (3) Separate statements for one or more of the investee companies (C1, C2, and C3). (4) Consolidating statements (which would provide everything in (1)-(3) except separate statements for C3, and would also show the elimination entries). (5) Sometimes partial consolidations (such as Co. X plus C2) or combining statements (such as only C1 and C2) also are useful. For example, if C1 is a foreign subsidiary, the analyst may ask for a partial consolidation excluding C1, with separate statements for C1. Also, loan covenants (or loan collateral) frequently cover only selected companies, and a partial consolidation or combined statements are necessary to assess safety margins.

d. Co. X will show an asset "investment in common stock of subsidiary" valued at either cost or equity. (The equity method would be required only if no consolidated statements were presented.) Note: Co. X owns shares of common stock of Co. C1—that is, Co. X does not own any of C1's assets or liabilities. 5-23 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

e. 100 percent of C2's assets and liabilities are included in the consolidated balance sheet. However, the stockholders' equity of C2 is split into two parts: 80 percent is added to the stockholders' equity of Co. X and 20 percent is shown on a separate line (above Co. X's stockholders' equity) as "minority ownership of C2" (frequently just simply called "minority interest"). The portion of the 80 percent representing the past purchase by Co. X would be eliminated (in consolidation) against the "investment in subsidiary."

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

Exercise 5-5—concluded

Co. X must purchase enough additional common stock from the other stockholders in C3 or purchase enough new shares issued by C3 to increase its ownership to more than 50 percent of C3's common stock. (Alternatively, C1 or C2 could purchase the additional shares.)

g. There would be no intercompany investment or intercompany dividends. But any other intercompany transactions must be eliminated (such as intercompany sales and intercompany receivables and payables).

Exercise 5-6A (20 minutes)

a. The choice of the functional currency would make no difference for the reported sales numbers. This is because sales are translated at rates on the transaction date, or average rates, regardless of the choice of the functional currency.

b. When the U.S. dollar is the functional currency (Bethel Company), some assets and liabilities (mainly inventory and fixed assets) are translated at historic rates. The monetary assets and liabilities are translated at current exchange rates. This means the translation gain or loss is based only on those assets and liabilities that are translated at current rates. When the functional currency is the local currency (Home Brite Company), all assets and liabilities are translated at current exchange rates, and common and preferred stock are translated at historic rates. The translation gain or loss is based on the net investment in each local currency.

c. When the U.S. dollar is the functional currency, all translation gains or losses are included in reported net income. When the functional currency is the local currency, the translation gain or loss appears on the balance sheet as a separate component of shareholders' equity (in comprehensive income or loss), thus bypassing the net income statement. (CFA Adapted) 5-25 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

PROBLEMS Problem 5-1 (20 minutes)

a. Investments Reported on the Balance Sheet: Able Corp. bonds ...................................

$ 330

Bryan Co. bonds ................................................................ 825 Caltran, Inc. bonds ............................................................ 515 Available-for-sale equity securities .............................. 1,600 Trading equity securities .............................................

950

Total ................................................................................. $4,220

Reporting of Unrealized Value Fluctuations: •

Unrealized price fluctuations on available-for-sale securities are reported in comprehensive income (Bryan Co. bonds and available-for-sale equity securities).

•

Unrealized price fluctuations on trading securities are reported in net income (Caltran bonds and trading equity securities).

Problem 5-2 (30 minutes)

1. Since the aggregate market value of the portfolio exceeds cost, there is no write down of the individual security whose market value declined to less than one-half of its cost. Stockholders' equity will be increased (decreased) to the extent that the excess of market over cost has increased (decreased) over the period. There is no effect on the income statement.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

2. This situation is similar to 1 above. The only difference is that the firm in question does not use the classified balance sheet format. In this case, the analyst must be sure to review note disclosures regarding the classification of investments (if not provided on the face of the balance sheet).

3. This is not a reclassification between categories as the securities remain in the availablefor-sale category. However, the analyst should note that management is contemplating a sale in the near future.

4. The increase in fair value of the security should be credited to shareholders' equity. (Since the security is classified as noncurrent, it cannot be a trading security).

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

Problem 5-3 (45 minutes)

a. Effects of Investments on Simpson Corp.: 2004 (Fair Value Method Applies): Sales:

Investment has no effect on Simpson’s sales.

Net income:

Simpson’s net income increases by the 2004 dividend income from Bailey Company (BC) of $10,000 (computed as: [$1,000,000 dividend /1,000,000 shares = $1.00 per share] x 10,000 shares = $10,000)

Cash flows:

Dividends received (1% of $1,000,000)

$ 10,000

Cost of shares (10,000 shares x $10) Net cash flow

(100,000) $(90,000)

2005 (Equity Method Applies) Sales:

Investment has no effect on Simpson’s sales.

Net income:

Simpson’s net income increases by 30% share earnings of Bailey Company (BC) (computed as: [300,000 shares /1,000,000 shares = 30%] x $2,200,000 income = $660,000)

Cash flows:

Dividends received (30% of $1,200,000) Cost of shares (290,000 shares x $11) Net cash flow

360,000 (3,190,000)

$(2,830,000)

b. Carrying (Book) Value of Investment in Bailey Company: 2004 (Fair Value Method Applies) At December 31, 2004, Simpson’s carrying value of the investment in BC is the historical cost of $100,000 (10,000 shares * $10 per share).

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

(i) Equity method is applied retroactively to prior years of ownership (2004): Original cost ($10 x 10,000 shares)

$100,000

Add: Percentage share of 2004 earnings (1% x $2,000,000)

20,000

Less: Dividends received in 2004

(10,000)

Net carrying value at January 1, 2004

($11 per share)

$110,000

(ii) Equity method is carried through year-end 2005: Net carrying value at January 1, 2004 Add: Original cost of additional shares ($11 x 290,000)

$ 110,000 3,190,000

Add: Percentage share of 2005 earnings (30% x $2,200,000)

660,000

Less: Dividends received in 2005

(360,000)

Net carrying value at December 31, 2005 ($12 per share)

$3,600,000

c. Accounting method for 2006. For 2006, with ownership in excess of 50% (in this case, 100%) and Simpson in control of BC, the consolidation method is used to combine BC’s financial statements with those of Simpson. In a consolidation, only the purchase method is available to account for the investment–pooling of interest is not allowed.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

Problem 5-4 (40 minutes)

Computation of Burry’s Investment in Bowman Co.

($ thousands)

Investment

Cost of Acquisition .......................................

$40,000

Net income for Year 6 ...................................

1,600 [1]

Dividends for Year 6 ....................................

(800) [2]

Net loss for Year 7 ........................................

(480) [3]

Dividends for Year 7 .....................................

(640) [4]

Investment at Dec. 31, Year 7 ......................

$39,680

Notes ($000s): [1] 80% of $2,000 net income [2] 80% of $1,000 dividends [3] 80% of $(600) net loss [4] 80% of $800 dividends

b. The strengths associated with use of the equity method in this case include: •

It reduces the balance in the investment account in Year 7 due to the net loss. Note: Just recording dividend income would obscure the loss. 5-30

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

•

It recognizes goodwill on the balance sheet (via inclusion in the investment balance) and, therefore, it reflects the full cost of the investment in Bowman Co.

The possible weaknesses with use of the equity method in this case include: •

Lack of detailed information (one-line consolidation).

•

Dollar earned by Bowman may not be equivalent to dollar earned by Burry.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

Problem 5-5 (40 minutes)

a. For Year 6:

• No effect on sales. • Net income effect equals the dividend income of $10 (1% of $1,000, or $1 per share) since the investment is accounted for under the market method. Also, assuming the shares are classified as available-for-sale (a reasonable assumption given subsequent purchases), the price appreciation of $1 per share will bypass the income statement. • Cash flow effect equals the dividend income of $10. If the outflow due to the stock purchase is included: Net cash flow = dividend income less purchase price = $10 $100 = $(90).

For Year 7 (the equity method applies):

• No effect on sales. • Net income effect equals the percentage share of Francisco earnings for Year 7, or 30% of $2,200 = $660. • Cash flow effect equals the dividend income of $360 (computed as 30% of $1,200). If the outflow due to the stock purchase is included: Net cash flow = dividend income less purchase price = $360 - $3,190 = $(2,830).

b. As of December 31, Year 6:

At December 31, Year 6, the carrying value of the investment in Francisco is $110 (computed as 10 shares x $11 per share). The $11 per share figure is the fair value at Jan. 1, Year 7.

As of December 31, Year 7 (the equity method applies):

Step one—the equity method is applied retroactively to the prior years of ownership (that is, Year 6). Original cost (10 shares x $10) ......................................................................

$ 100

Add: Percentage share of Year 6 earnings (1% x $2,000) ..........................

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

Less: Dividends received in Year 6 ..............................................................

(10)

Net carrying value at Jan. 1, Year 7 ..............................................................

$ 110

Step two—the equity method is applied throughout Year 7. Net carrying value, Jan. 1, Year 7 .................................................................

$ 110

Add: Original cost of additional shares (290 shares x $11) ......................

3,190

Add: Percentage share of Year 7 earnings (30% x $2,200) .......................

660

Less: Dividends received in Year 7 ..............................................................

(360)

Net carrying value at Dec. 31, Year 7 ............................................................

$3,600

c. For Year 8, with ownership in excess of 50% (indeed, 100%), Francisco’s financial statements would be consolidated with those of Potter. The purchase method is the only available choice under current GAAP. Under this method, all assets and liabilities for Francisco are restated to fair market value. To do this, one must know fair market values. Also, information about off-balance sheet items (such as identifiable intangibles) that may need to be recognized must be obtained. Due to these implications to asset and liability values in applying purchase accounting, knowing that the initial purchase price is in excess of the book value of the acquired company’s net assets does not necessarily indicate that goodwill is recorded.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

Problem 5-6 (35 minutes)

a. Pierson, Inc., Pro Forma Combined Balance Sheet

ASSETS Current assets ..........................................................................................

$135

Land ...........................................................................................................

Buildings, net ...........................................................................................

130

Equipment, net .........................................................................................

130

Goodwill ....................................................................................................

35 *

Total assets...............................................................................................

$500

LIABILITIES AND EQUITY Current liabilities .............................................................................

$140

Long-term liabilities ........................................................................

180

Shareholders' equity .......................................................................

180

Total liabilities and equity ..............................................................

$500

*Goodwill computation: Cash payment .......................................................................................................................... $180 Fair value of net assets acquired ($165 - $20) ...................................................................... 145 $ 35

b. The basic difference between pooling and purchase accounting for business combinations is that in the pooling case there is a high likelihood of not recording all 5-34 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

assets acquired and paid for by the acquiring company. This results in an understatement of assets and, consequently, an overstatement of current and future net income. This is because pooling accounting is limited to recording only book values of the acquired company’s net assets, which do not necessarily reflect current fair values of net assets. Given the inflationary tendencies of most economies, pooling tends to understate asset values. The understatement of assets under pooling leads to an understatement of expenses (from lack of cost allocations) and to an overstatement of gains realized on the disposition of these assets.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

Problem 5-7 (35 minutes)

a. They are reported in "other assets" [166] at an amount of $155.8 million under investments in affiliates, which also includes $28.3 million as goodwill.

b. No, disclosure is limited to this note.

c. These acquisitions indicate that of the $180.1 million paid, $132.3 million is for intangibles, principally goodwill [107]. This implies that most of the purchase price was in effect for some form of superior earning power (residual income) assumed to be enjoyed by the acquired companies.

d. Analytical entry to reflect the Year 11 acquisitions: Working capital items .............................................

5.1

Fixed assets net ......................................................

4.7

Intangibles, principally goodwill ...........................

132.3

Other assets.............................................................

1.5

Minority interest ......................................................

36.5

Cash (or other consideration) ..........................

180.1

e. (1) The change in the cumulative translation adjustment accounts [101] for Europe is most likely due to significant translation losses in Year 11.

(2) In the case of Australia, the decrease in the credit balance of the account may be due to sales of businesses by Arnotts Ltd. [169A], which may have involved the removal of a proportionate part of the account as well as gains or losses on translation in Year 11. This is corroborated by item [93] that shows a reduction in the cumulative translation account due to sales of foreign operations.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

CASES Case 5-1 (45 minutes)

a. (1) Pooling Accounting: Investment in Wheal ..........................................

110,000

Capital Stock—Axel ....................................

110,000

(2) Purchase Accounting: Investment in Wheal ..........................................

350,000

Capital Stock—Axel ....................................

110,000

Other Contributed Capital—Axel ...............

240,000

b. (1) Pooling Worksheet Entries: Capital Stock—Wheal .......................................

100,000

Other Contributed Capital—Wheal ..................

10,000

Investment in Wheal ....................................

110,000

(2) Purchase Worksheet Entries: Inventory ...........................................................

25,000

Property, Plant, and Equipment .......................

100,000

Secret Formula (Patent) ....................................

30,000

Goodwill .............................................................

40,000

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

Long-Term Debt .................................................

2,000

Accounts Receivable ...................................

5,000

Accrued Employee Pensions ......................

2,000

Investment in Wheal ....................................

190,000

Capital Stock—Wheal .......................................

100,000

Other Contributed Capital—Wheal ..................

25,000

Retained Earnings—Wheal ..............................

35,000

Investment in Wheal ....................................

160,000

c. Consolidated Retained Earnings at Dec. 31, Year 4 Pooling

Purchase

Retained Earnings, Axel.......................................................

$150,000

Retained Earnings, Wheal....................................................

35,000

—

Consolidated Retained Earnings ........................................

$185,000

$150,000

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

Case 5-2 (50 minutes)

a. When mergers occur, the resulting company is different than either of the two former, separate companies. Consequently, it is often difficult to assess the performance of the combined entity relative to that of the two former companies. While this problem extends to both purchase and pooling methods, it is especially apparent when the pooling method is used. Under pooling accounting, the book values of the two companies are combined. Lost is the fair value of the consideration exchanged and the fair value of the acquired assets and liabilities. As a result, the assets of the combined company are usually understated. Since the assets are understated, combined equity is understated and expenses also are understated. This means that return on assets and return on equity ratios are overstated.

b. Tyco’s high price-to-earnings ratio was primarily driven by its relatively high stock price. Its high stock price meant that poolings could be completed with relatively fewer of its shares being given in consideration. Accordingly, a high price is crucial to Tyco’s ability to execute, and continue to execute, acquisitions at a favorable price.

c. When large charges are recorded in conjunction with acquisitions, subsequent periods are relieved of these charges. This means that future net income is increased because the items currently written off will not have to be written off in future periods. As a result, the reported net income in future periods may be misleadingly high. It is important that analysts assess the nature and amount of write-offs related to acquisitions to see if such charges are actually related to past/current events or more appropriately should be carried to future periods. If such misstatements are identified, net income in the period of the acquisition should be adjusted upward to compensate for the over-charge, and the reported net income of future periods should be commensurately reduced.

d. Cost-cutting can be valuable when the costs that are cut relate to redundant processes or other non-value added processes. However, cost-cutting can have adverse consequences for the future of the company if the costs that are cut relate to activities that bring future value—such potential costs include research and development or management training.

e. When the market perceives a company to have low quality financial reporting, the stock price of the company can fall precipitously for at least two important reasons. First, the market will assign a higher discount rate to the company to price protect itself against 5-39 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

accounting risk or the risk of misleading financial information. Second, the integrity of management is called into question. As a result, the market will not be willing to pay as much for the stock of the company given the commensurate increase in risk.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

Case 5-2—continued

Focusing on earnings before special items can be a useful tool when attempting to measure earnings that is more reflective of the permanent earnings stream and, consequently, more reflective of future earnings. However, several companies record repeated special item charges. These companies are essentially overstating earnings for several periods (not including those with special charges) and then catching up by recording the huge charge. Analysts must be careful to identify such companies so that they are not relying on overstated earnings of the company in predicting future performance. For such companies, it is prudent to assign a portion of the charges to several periods to develop an approximation of the ongoing earnings of the company.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

Case 5-3 (120 minutes)

a. See table below. b. See table below.

Transaction

Newmont’s Strategy

Accounting Treatment by Newmont (pre-SFAS 133)

Forward Sales of

To lock-in the price

No unrealized gain or

125,000 ounces

of future gold

loss recorded in the

from Indonesian

sales. Hedge.

Accounting Treatment under SFAS 133 Classification: Cash Flow Hedge.

books. Realized gains

The fair value of the forward sale (future) recorded as asset

mine @ $454 per

and losses recorded

and liability (as the case may be) in the balance sheet until the

ounce

when sold.

date of actual sale. The compensating effect goes to accumulated comprehensive income. Any change in fair value of forward sale (future) is recognized in other comprehensive income. At the time of sale, accumulated comprehensive income is adjusted with net income so that the amount recognized as revenue is $454/ounce.

Purchased calls

To provide an

No unrealized gain or

Classification: Fair-Value Hedge of above fixed commitment.

on 50,000 ounces

upside potential for

loss recorded in the

The forward sale commitment @ $454/ounce is the hedged

with strike price

40% of the forward

books. Realized gains

item for this instrument. The call is recorded at fair value. The

$454 linked to the

sales in case of

and losses recorded

net income effect is the difference between the value of the call

forward sale.

break out of gold

when sold.

and the value of the equivalent quantity (50,000 ounces) of

price above $454.

forward sales. The effect of 50,000 ounces of the above forward sale is removed from accumulated comprehensive income and other comprehensive income (because it is now recorded in net income). The purchase cost of the call is amortized over its holding period.

Prepaid Sale in

To raise immediate

No unrealized gains

July 1999: 483,333

cash to service

and losses are

Classification: Cash Flow Hedge.

ounces at various

debt. Secondary

recognized. Realized

Note the fair value of the instrument is non-zero only when the

prices with a floor

objective, to hedge

price recorded on

gold price is above $380 or below $300. Fair value is recorded

of $300 and

downside risk

date of sale.

in the balance sheet and offset by accumulated comprehensive

ceiling of $380.

below $300 per

income. Any change in fair value is recognized in other

ounce, but provide

Prepaid amount

comprehensive income. At time of sale, accumulated

upside potential up

computed @ $300 per

comprehensive income is adjusted with net income so that the

to $380. A hedge

ounce and treated as

realized amount (variable between $300 and $380 per ounce) is

with some limited

deferred revenue that

recorded as revenue. The deferred revenue accounting is

upside potential

is adjusted when

unchanged.

within a range.

actual sales occur to reflect the actual sales proceeds.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

Case 5-3—continued (parts a & b)

Transaction

Newmont’s Strategy

Accounting Treatment by Newmont (pre-SFAS 133)

Accounting Treatment under SFAS 133

Prepaid Sales in

To raise immediate

No unrealized gains

Classification: Cash Flow Hedge. Accounting effects similar to

July 1999: 35,900

cash to service

and losses

the first instrument in this table (forward sale on Indonesian

per annum at

debt. Yet, first

recognized on either

mine).

some fixed price

instrument locks-in

security. Realized

(no information

sales price, the

(fixed) price on

given about fixed

second instrument

forward sale adjusted

price).

reverses it. So the

by the value of

objective is clearly

forward purchase

not hedging

recorded when sold,

related.

whereby the revenue recorded is identical to actual realization.

Treated as deferred

Forward purchase

revenue that is

in July 1999 of

adjusted when actual

identical

sales occur.

quantities at

Classification: Fair Value Hedge of the forward sale (which is a

prices ranging

fixed commitment). Recorded at fair value and any unrealized

from $263 to $354.

gains and losses on both the forward sale and purchase recorded in net income. Together both the sale and purchase have no effect on income or balance sheet.

Purchased Put

To provide

No unrealized gains

Classification: Difficult to say. Probably fair-value hedge

Option in August

downside risk

and losses

because it is not linked to forecast sale of gold. Fair value of

1999 for 2.85

protection for 2.85

recognized. Cost of

puts and equivalent quantity of gold reported at fair value in

million ounces.

million ounces but

put options amortized

balance sheet. Unrealized gains and losses on puts and

allow for upside

over term.

equivalent quantity of gold charged to net income.

potential. Written Call

To finance the put

All unrealized gains

Classification: Speculative transaction. Fair value on balance

Options in August

purchase.

and losses recorded

sheet and all unrealized gains and losses charged to net

in net income.

income.

1999 for 2.35 million ounces.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

Case 5-3—continued

c. Forward sales: Economically, this agreement locks in the cash flows associated with sales. There is no potential for gain or loss on this sales price. As a result, risk is removed. The accounting treatment does reflect the economics of this transaction as there is no impact until the date of sale.

Purchased calls: Economically this agreement makes the lock in of $454 on 40% of the forward sales a floor sales price, with no economic impact until the date of sale. Earlier method does reflect the economics. SFAS 133 treatment recognizes the change in value over time even though no cash will change hands until the date of sale.

Prepaid sale: Economically, this agreement locks the cash flows associated with the sales into a specified range. The deferred revenue treatment is consistent with the economics. Hedge accounting treatment, both before SFAS 133 and under SFAS 133, is consistent with the economics as there is no income statement impact until the date of sale.

Prepaid sale (35,900 ounces) and forward purchase (35,900 ounces): Considered simultaneously, the economic impact of these transactions is a wash and the accounting treatment reflects this offsetting effect.

Purchased put option: Economically, this option sets a floor on the sales price of 2.85 million ounces of product. The accounting treatment, both before SFAS 133 and under SFAS 133 should be a good reflection of the economic reality.

Written call option: Economically, this option exposes the company to lower sales prices in the future. The value of this option will change over time. Thus, the accounting treatment is an adequate reflection of the economics.

d. The justification for not allowing the hedging treatment comes from the fact that the written calls are not hedging a specific transaction or event. SFAS 133 requires that the derivative be tied to a specific transaction, not just an overall business risk.

e. Newmont’s criticism is valid if hedging is defined in terms of firm-wide risk, rather than in terms of transaction risk. From the firm-wide perspective, Newmont is correct in 5-44 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

describing the economic impact as only being the opportunity cost of selling at a higher price in the future.

The economic reality is that Newmont was unable to benefit fully from the sudden increase in gold prices because of its various hedging arrangements. The financial statements exaggerate the opportunity costs of the hedging program, primarily because the loss recognized on the written options is not offset by an increase in the value of the gold reserves.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

Case 5-4A (65 minutes)

a. Trial Balance in U.S. Dollars:

SWISSCO Trial Balance December 31, Year 8 Trial

Exchange

Trial

Balance

Rate

Balance

$/€

(in $)

(in €)

Code

Cash................................................... 50,000

.38 19,000

Accounts Receivable ...................................

100,000

.38

38,000

Property, Plant, and Equipment, net .........

800,000

.38

304,000

Depreciation Expense .................................

100,000

.37

37,000

Other Expenses (including taxes) .............

200,000

.37

74,000

Inventory 1/1/Year 8 .....................................

150,000

[1]

56,700

Purchases .....................................................

1,000,000A

.37

Total debits ...................................................

2,400,000

Sales ..............................................................

2,000,000A

.37

Allowance for Doubtful Accounts ..............

10,000

.38

3,800

Accounts Payable ........................................

80,000

.38

30,400

Note Payable ................................................

20,000

.38

7,600

Capital Stock ................................................

100,000

.30

30,000

Retained Earnings 1/1/Year 8 .....................

190,000

[2]

61,000

Translation Adjustment ...............................

________

370,000 898,700

[3]

740,000

25,900

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

Total credits ..................................................

2,400,000

898,700

Notes: C = Current rate; A = Average rate; H = Historical rate [1] Dollar amount needed to state cost of goods sold at average rate: € Inventory, 1/1/Year 8

Rate

150,000

$ 56,700 To Balance

Purchases

1,000,000

Goods available for sale

1,150,000

Inventory, 12/31/Year 8

120,000

.38

45,600

1,030,000

.37

381,100

Cost of goods sold

.37

370,000 426,700

[2] Dollar balance at Dec. 31, Year 7 [3] Amount to balance.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

Case 5-4A—continued

SWISSCO Income Statement (In Dollars) For the Year Ended Dec. 31, Year 8 Sales ..........................................................................

$740,000

Beginning inventory ................................................

$ 56,700 [1]

Purchases .................................................................

370,000

Goods available .......................................................

426,700

Ending inventory (€ 120,000 x $0.38).....................

(45,600) [1]

Cost of goods sold ..................................................

381,100

Gross profit...............................................................

358,900

Depreciation expense ..............................................

37,000

Other expenses (including taxes) ..........................

74,000

Net income ................................................................

111,000 $247,900

[1] See Note 1 to translated trial balance.

SWISSCO Balance Sheet (In Dollars) At December 31, Year 8 ASSETS Cash..................................................................................

$ 19,000

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

Accounts receivable .......................................................

$38,000

Less: Allowances for doubtful accounts .....................

3,800

34,200

Inventory ..........................................................................

45,600 [A]

Property, plant, and equipment, net .............................

304,000

Total assets .....................................................................

$402,800

LIABILITIES AND EQUITY Accounts payable ...........................................................

$30,400

Note payable ....................................................................

7,600

Total liabilities .................................................................

38,000

Capital stock ....................................................................

30,000

Retained earnings: 1/1/Year 8 .......................................

61,000

Add: Income for Year 8 ..................................................

247,900

308,900

Equity Adjustment from translation of foreign currency statements ........................................

25,900 [B]

Stockholders' equity .......................................................

364,800

Total liabilities and equity ..............................................

$402,800

Notes: [A] Ending Inventory € 120,000 x 0.38 [B] First time this account appears in the financial statements.

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

c. Unisco Corp. Entry to Record its Share in SwissCo Year 8 Earnings: Investment in SwissCo Corporation .........................

185,925

Equity in Subsidiary's Income ..............................

185,925

To record 75% equity in SwissCo's earnings of $247,900.

Note: While not specifically required by the problem, the parent would also pick up the translation adjustment as follows:

Investment in SwissCo Corporation .........................

19,425

Equity adjustment from translation of foreign currency statements (75% x $25,900)

.......

19,425

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

Case 5-5A (60 minutes)

a. With the dollar as the functional currency, FI originally translated its statements using the "temporal method." Now that the pont is the functional currency, FI must use the "current method" as follows: FUNI, INC. Balance Sheet December 31, Year 9 Ponts (millions)

Exchange Rate Ponts/$

Dollars (millions)

ASSETS Cash ......................................................

4.0

20.50

Accounts receivable ............................

700

4.0

175.00

Inventory ...............................................

455

4.0

113.75

Fixed assets (net) ................................

360

4.0

90.00

Total assets ..........................................

1,597

399.25

LIABILITIES AND EQUITY Accounts payable ...............................

532

4.0

133.00

Capital stock ........................................

600

3.0

200.00

Retained earnings ...............................

465

132.86

Translation adjustment ......................

(66.61)*

Total liabilities and equity ...................

1,597

399.25

*Translation adjustment = 600 (1/3.0 - 1/4.0) = 600 (1/12) = (50.00) +465 (1/3.5 -1/4.0) = 465 (1/28) = (16.61) (66.61)

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

Case 5-5—continued

FUNI, INC. Income Statement For Year Ended Dec. 31, Year 9 Ponts (millions)

Exchange Rate Ponts/$

Dollars (millions)

Sales .....................................................

3,500

3.5

1,000.00

Cost of sales ........................................

(2,345)

3.5

(670.00)

Depreciation expense ..........................

(60)

3.5

(17.14)

Selling expense ...................................

(630)

3.5

(180.00)

Net income ............................................

465

b. (1) Dollar:

132.86

Inventory and fixed assets translated at historical rates. Translation gain (loss) computed based on net monetary assets.

Pont:

All assets and liabilities translated at current exchange rates. Translation gain (loss) computed based on net investment (all assets and liabilities).

(2) Dollar:

Cost of sales and depreciation expenses translated at historical rates. Translation gain (loss) included in net income (volatility increased).

Pont:

All revenues and expenses translated at average rates for period. Translation gain (loss) in separate component of stockholder equity (in comprehensive income). Net income less volatile.

(3) Dollar: Pont:

Financial statement ratios skewed. Most ratios in dollars are the same as ratios in ponts. 5-52

Chapter 06 - Analyzing Operating Activities

Chapter 6 Analyzing Operating Activities REVIEW Income is the residual of revenues and gains less expenses and losses. Net income is measured using the accrual basis of accounting. Accrual accounting recognizes revenues and gains when earned, and recognizes expenses and losses when incurred. The income statement (also referred to as statement of operations or earnings) reports net income during a period of time. This statement also reports income components--revenues, expenses, gains, and losses. We analyze income and its components to evaluate company performance, assess risk exposures, and predict amounts, timing, and uncertainty of future cash flows. While "bottom line" net income frames our analysis, income components provide pieces of a mosaic revealing the economic portrait of a company. This chapter examines the analysis and interpretation of income components. We consider current reporting requirements and their implications for our analysis of income components. We describe how we might usefully apply analytical adjustments to income components and related disclosures to better our analysis. We direct special attention to revenue recognition and the recording of major expenses and costs. Further use and analysis is made of income components in Part Three of the book.

Chapter 06 - Analyzing Operating Activities

OUTLINE •

Income Measurement Concept of Income Measuring Accounting Income Alternative Classification and Income Measures

•

Non-recurring items Extraordinary Items Discontinued Operations Accounting Changes Special Items

•

Revenue and Gain Recognition Guidelines for Revenue Recognition Uncertainty in Revenue Collection Revenue When Right of Return Exists Franchise Revenues Product Financing Arrangements Revenue under Contracts Analysis Implications of Revenue Recognition

•

Deferred Charges Research and Development Computer Software Expenses Exploration and Development Costs in Extractive Industries Supplementary Employee Benefits Employee Stock Options Interest Costs Income Taxes

• •

Appendix 6A Earnings per Share: Computation and Analysis Appendix 6B Economics of Employee Stock Options

Chapter 06 - Analyzing Operating Activities

ANALYSIS OBJECTIVES •

Explain the concepts of income measurement and their implications for analysis of operating activities.

•

Describe and analyze the impact of non-recurring items - including extraordinary items, discontinued segments, accounting changes, and restructuring charges and write-offs.

•

Analyze revenue and expense recognition and its risks for financial analysis.

•

Analyze deferred charges, including expenditures for research, development, and exploration.

•

Explain supplementary employee benefits and analyze disclosures for employee stock options (ESOs)

•

Describe and interpret interest costs and the accounting for income taxes.

•

Analyze and interpret earnings per share data (Appendix 6A).

•

Understand the economics of employee stock options (appendix 6B).

Chapter 06 - Analyzing Operating Activities

QUESTIONS 1. The income statement portrays the net results of operations of an enterprise. Since results are what enterprises are established to achieve and since their value is, in large measure, determined by the size and quality of these results, it follows that the analyst attaches great importance to the income statement. 2. Income summarizes in financial terms the operating activities of a company. Income is the amount of revenues and gains for the period in excess of expenses and losses, all computed under accrual accounting. Income provides a measure of the change in shareholder wealth for a period and an indication of a company’s future earning power. Accounting income differs from cash flows because certain revenues and gains are recognized in periods before or after cash is received and certain expenses and losses are recognized in periods before or after cash is paid. 3. Economic income is net cash flows plus the change in the present value of future cash flows. Another similar concept, the Hicksian concept of income, considers income for the period to be the amount that can be withdrawn from the company in a period without changing the net wealth of the company. Hicksian income equals cash flow plus the change in the fair value of net assets. 4. Accounting income is the excess of revenues and gains over expenses and losses measured using accrual accounting. As such, revenues (and gains) are recognized when earned and expenses (losses) are matched against the revenues (and gains). 5. Net income is the excess of the revenues and gains of the company over the expenses and losses of the company. Net income often is called the “bottom line,” although that is a misnomer because certain unrealized holding gains and losses are charged directly to equity and bypass net income. Comprehensive income includes all changes in equity that result from non-owner transactions (excluding items such as dividends and stock issuances). Items creating differences between net income and comprehensive income include unrealized gains and losses on available for sale securities, foreign currency translation adjustments, minimum pension liability adjustments, and unrealized holding gains or losses on derivative instruments. Comprehensive income is the ultimate “bottom line” income number. Continuing income is a measure of net income earned by ongoing segments of the company. Continuing income differs from net income because continuing income excludes the income or loss of segments of the company that are to be discontinued or sold (it also excludes extraordinary items and effects from changes in accounting principles). 6. Details regarding comprehensive income are reported by the vast majority of companies in the statement of stockholders’ equity rather than the income statement. 7. Core income is a measure of income that excludes all non-recurring items that are reported as separate items on the income statement.

Chapter 06 - Analyzing Operating Activities

8. Operating income is a measure of firm performance from operating activities. Examples of operating income include product sales, cost of product sales, and selling, general, and administrative costs. Non-operating income includes all components of income not included in operating income. Examples of non-operating income include interest revenue and interest expense. 9. Operating versus non-operating and recurring versus non-recurring are distinct dimensions of classifying income. While there is overlap across selected items, these dimensions reflect different characteristics of business activities. For example, the interest income and interest expense of most companies recur in net income; hence, they are included in recurring income. However, these items are non-operating in nature. Similarly, non-recurring items such as restructuring charge are operating in nature. 10. Accounting standards (APB 30) restricted the use of the "extraordinary" category by requiring that an extraordinary item be both unusual in nature and infrequent in occurrence. These attributes are defined as follows: a. Unusual nature of the underlying event or transaction should possess a high degree of abnormality and be of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity, taking into account the environment in which the entity operates. b. Infrequency of occurrence of the underlying event or transaction should be of a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates. Three examples of extraordinary items are: • Major casualty losses from an event such as an earthquake, flood, or fire. • A gain or loss from expropriation of property. • A gain or loss from condemnation of land by eminent domain. 11. To qualify as discontinued operations, the assets and business activities of the divested segment must be clearly distinguishable from the assets and business activities of the remaining entity. Accounting and reporting for discontinued operations is two-fold. First, the income statement for the current and prior two years are restated after excluding the effects of the discontinued operations from the line items that determine continuing income. Second, gains or losses pertaining to the discontinued operations are reported separately, net of related tax effects. An analyst should separate and ignore discontinued operations in predicting future performance and financial condition. 12. To qualify as a prior period adjustment, an item must meet the following requirements: • Material in amount. • Specifically identifiable with the business activities of specific prior periods. • Not attributable to economic events occurring subsequent to the prior period. • Dependent primarily on determinations by persons other than management. • Not reasonably estimable prior to such determination.

Chapter 06 - Analyzing Operating Activities

13. Distortions in revenues (gains) and expenses (losses) can arise from several accounting sources. These include choices in the timing of transactions (such as revenue recognition and expense matching), selections from the variety of generally accepted principles and methods available, the introduction of conservative or aggressive estimates and assumptions, and choices in how revenues, gains, expenses, and losses are classified and presented in financial statements. Generally, a company wishing to increase current income at the expense of future income will engage in one or more of the following practices: (a) It will choose inventory methods that allow for maximum inventory carrying values and minimum current charges to cost of goods or services sold. (b) It will choose depreciation methods and useful lives of property that will result in minimum current charges as depreciation expense. (c) It will defer all managed costs to the future such as, for example: pre-operating, moving, rearrangement and start-up costs, and marketing costs. Such costs would be carried as deferred charges or included with the costs of other assets such as property, plant, and equipment. (d) It will amortize assets and defer costs over the largest possible period. Such assets include goodwill, leasehold improvements, patents, and copyrights. (e) It will elect the method requiring the lowest possible pension and other employment compensation cost accruals. (f) It will inventory rather than expense administrative costs, taxes, and similar items. (g) It will choose the most accelerated methods of income recognition such as in the areas of leasing, franchising, real estate sales, and contracting. (h) It immediately will recognize as revenue, rather than defer the taking up of benefits, items such as investment tax credits. (i) Companies that wish to “manage” the size of accounting income can regulate the flow of income and expense by means of reserves for future costs and losses. 14. (1) Depreciation a. Straight Line: This is calculated by taking the salvage value (S) from the original cost (C) and dividing by the useful life of the asset in question; that is, (CS)/(Useful life). Sum-of-Years'-Digits: This depreciation formula is: (C-S) x (X/Y); where C and S are the same as above, X is the remaining years (that is, if item is being depreciated over 5 years and this is the first year, then X=5), and Y equals the "sum-of-years'-digits" (that is, for a 5-year asset, Y=5+4+3+2+1=15). b. Straight line is easily understood and provides level depreciation and earnings effects. The sum-of-the-years'-digits gives heavier weight to earlier years and causes higher depreciation and lower earnings in the early years and lower depreciation and higher earnings toward the end of the asset's life. (2) Inventory a. LIFO (last-in, first-out) method: The LIFO method assumes the inventory employed are those most recently acquired. FIFO (first-in, first-out) method: The FIFO method assumes the first inventory items acquired are used first. b. The effect on earnings depends on whether the economy is in an inflationary or deflationary period. In times of inflation (the more usual case), LIFO inventory accounting would result in lower earnings being reported than would be the case had FIFO been employed.

Chapter 06 - Analyzing Operating Activities

(3) Installment sales a. Accrual method: Assumes income is recognized when the sale is made (earned). Installment method: Assumes income is recognized only when cash is received as the various installments come in. b. The installment method is commonly used for tax purposes while the accrual method is employed in financial statements. The accrual method would result in a higher earnings figure being reported than the installment method. 15. Three different types of accounting changes include: (a) Changes in accounting principle (b) Changes in accounting estimate (c) Changes in reporting entity 16. Special items refer to transactions and events that are unusual or infrequent, not both. These items are reported as separate line items on the income statement before continuing income. Examples of special items include restructuring charges, impairments of long-lived assets, and asset write-offs. 17. Special (one-time) charges usually receive less attention by investors because it often is believed that such charges will not recur in the future. As a result, companies often include as much operating expense and loss as possible in special charges hoping that investors will focus on income before special charges that excludes these expenses and losses. If investors do focus on income before these charges, company value may be erroneously perceived to be higher than is supported by the fundamentals. 18. Many special charges should be viewed as operating expenses that need to be reflected in permanent income. Essentially, many special charges are either corrections of understated past expenses or investments for improved future profitability. As such, analysts should adjust their income measurements to include special charges in operating income. 19. The following criteria exemplify the rules that have been established to prevent the premature anticipation of revenue. Realization is deemed to take place only after the following conditions have been met: (a) The earning activities undertaken to create revenue are substantially complete; for example, no significant effort is necessary to complete the transaction. (b) In the case of a sale, the risk of ownership has effectively passed to the buyer. (c) The revenue, as well as the associated expenses, can be measured or estimated with substantial accuracy. (d) The revenue recognized should normally result in an increase in cash, receivables, or marketable securities and, under certain conditions, in an increase in inventories or other assets, or a decrease in a liability. (e) The business transactions giving rise to the income should be at arm's-length with independent parties (that is, not with controlled parties). (f) The transactions should not be subject to revocation, for example, carrying the right of return of merchandise sold. 20. SFAS 48 ("Revenue Recognition When Right of Return Exists") specifies that revenue from sales transactions in which the buyer has a right to return the product should be recognized at the time of sale only if all of the following conditions are met: • At the date of sale, the price is substantially fixed or determinable. 6-7 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 06 - Analyzing Operating Activities

•

The buyer has paid the seller, or is obligated to pay the seller (not contingent on resale of the product). • In the event of theft or physical damage to the product, the buyer's obligation to the seller would not be changed. • The buyer acquiring the product for resale has economic substance apart from that provided by the seller. • The seller does not have significant obligations for future performance to directly bring about resale of the product. • Product returns can be reasonably estimated. If these conditions are not met, revenue recognition is postponed; if they are met, sales revenue and cost of sales should be reduced to reflect estimated returns and expected costs or losses should be accrued. Note: The Statement does not apply to accounting for revenue in (a) service industries if part or all of the service revenue may be returned under cancellation privileges granted to the buyer, (b) transactions involving real estate or leases, or (c) sales transactions in which a customer may return defective goods such as under warranty provisions. 21. Some of the factors that might impair the ability to predict returns (when right of return exists in transactions) are: (1) susceptibility to significant external factors, such as technological obsolescence or swings in market demand, (2) long return privilege periods, and (3) absence of appropriate historical return experience. 22. SFAS 49 ("Accounting for Product Financing Arrangements") is concerned with the issue of whether revenue has been earned. A product financing arrangement is an agreement involving the transfer or sponsored acquisition of inventory that, although it resembles a sale, is in substance a means of financing inventory through a second party. For example, if a company transfers inventory to another company in an apparent sale, and in a related transaction agrees to repurchase the inventory at a later date, the arrangement may be a product financing arrangement rather than a sale and subsequent purchase of inventory. If the party bearing the risks and rewards of ownership transfers inventory to a purchaser, and in a related transaction agrees to repurchase the product at a specified price, or guarantees some specified resale price for sales of the product to outside parties, the arrangement is a product financing arrangement and should be accounted for as such. 23. The percentage-of-completion method is preferred when estimates of costs to complete along with estimates of progress toward completion of the contract can be made with reasonable dependability. A common basis of profit estimation is to record that part of the estimated total profit that corresponds to the ratio that costs incurred to date bears to expected total costs. Other methods of estimation of completion can be based on units completed or on qualified engineering estimates or on units delivered. The completed-contract method of accounting is preferable where the conditions inherent in the contract present risks and uncertainties that result in an inability to make reasonable estimates of costs and completion time. Problems under this method concern the point at which completion of the contract is deemed to have occurred as well as the kind of expenses to be deferred. For example, some companies defer all costs to the completion date, including general and administrative overhead while others consider such costs as period costs to be expensed as they are incurred. Under either of the two contract accounting methods, losses (present or anticipated) must be fully provided for in the period in which the loss first becomes apparent. 6-8 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 06 - Analyzing Operating Activities

24. The recording of revenue is the first step in the process of income determination and is a step for which the recognition of any and all revenue depends. The analyst should be particularly inquisitive about revenue recognition policies and procedures. Some specific aspects include the following: (1) One element that casts doubt on the validity of revenue is uncertainty about the ability of the seller to collect the resulting receivable. Special collection problems exist with respect to installment sales, real estate sales, and franchise sales. Problems of collection exist, however, in the case of all sales and the analyst must be alert to them. (2) The analyst must also be alert to the problems related to the timing of revenue recognition. The present rules generally do not allow for recognition of profit in advance of sale—such as with increases in market value of property such as land or equipment, the accretion of values in growing timber, or the increase in the value of inventories are not recognized in the accounts. As a consequence, income will not be recorded before sale and the timing of sales is a matter that lies within the discretion of management. That, in turn, gives management a certain degree of discretion in the timing of profit recognition. (3) In the area of contract accounting, the analyst should recognize that the use of the completed contract method is justified only in cases where reasonable estimates of costs and the degree of completion are not possible. Yet, some companies consider the choice of method a matter of discretion. (4) Other alternative methods of taking up revenue, as in the case of lessors or finance companies, must be fully understood by the analyst before an evaluation of a company's earnings or a comparison among companies in the same industry is undertaken. 25. SFAS 2 ("Accounting for Research and Development Costs") offers a simple solution to the complex problem of accounting for research and development costs. Namely, it requires that R&D costs be charged to expense when incurred. It defines research and development activities as follows: (a) Research activities are aimed at discovery of new knowledge for the development of a new product or process or in bringing about a significant improvement to an existing product or process. (b) Development activities translate the research findings into a plan or design for a new product or process or a significant improvement to an existing product or process. R&D specifically excludes routine or periodic alterations to ongoing operations and market research and testing activities. The Board recommended the following accounting treatment for R&D costs: (a) The majority of expenditures incurred in research and development activities as defined above constitutes the costs of that activity and should be charged to expense when incurred. (b) Costs of materials, equipment, and facilities that have alternative future uses (in research and development projects or otherwise) should be capitalized as tangible assets. (c) Intangibles purchased from an external party for R&D use that have alternative future uses should also be capitalized. (d) Indirect costs involved in acquiring patents should be capitalized as well.

Chapter 06 - Analyzing Operating Activities

Elements of costs that should be identified with R&D activities are: (a) Costs of materials, equipment, and facilities that are acquired or constructed for a particular research and development project and purchased intangibles, that have no alternative future uses (in research and development projects or otherwise). (b) Costs of materials consumed in research and development activities, the depreciation of equipment or facilities, and the amortization of intangible assets used in research and development activities that have alternative future uses. (c) Salaries and other related costs of personnel engaged in R&D activities. (d) Costs of services performed by others. (e) A reasonable allocation of indirect costs. General and administrative costs that are not clearly related to R&D activities should be excluded. The specific disclosure requirements as stipulated by SFAS 2 are: (1) for each income statement presented, the total R&D costs charged to expense is to be disclosed, and (2) government-regulated companies that defer R&D costs in accordance with the addendum to SFAS 2 must make certain additional disclosures to that effect. 26. For an analyst to form a reliable opinion on the quality and the future potential value of research outlays, the analyst needs to know a great deal more than the totals of periodic research and development outlays. The analyst needs information on (1) the types of research performed, (2) the outlays by category, (3) the technical feasibility, commercial viability, and future potential of each project assessed and reevaluated at the time of each periodic report, and (4) information on a company's success-failure experience in its several areas of research activity to date. Of course, present disclosure requirements will not give the analyst such information and it appears that, except in cases of voluntary disclosure, only the investor or the lender with the necessary clout will be able to obtain such information. In general, one can assume that the outright expensing of all research and development outlays will result in more conservative balance sheets and fewer bad-news surprises stemming from the wholesale write-offs of previously capitalized research and development outlays. However, the analyst must realize that along with a lack of knowledge about future potential s/he may also be unaware of the potential disasters that can befall an enterprise tempted or forced to sink ever greater amounts of funds into research and development projects whose promise was great but whose failure is nevertheless inevitable. 27. One of the most common solutions applied by analysts to the complex problem of the analysis of goodwill is to simply ignore it. That is, they ignore the asset shown on the balance sheet. Unfortunately, by ignoring goodwill, analysts ignore investments of very substantial resources in what may often be a company's most important asset. Ignoring the impact of goodwill impairment losses on reported periodic income is no solution to the analysis of this complex cost. Even considering the limited amount of information available to the analyst, it is far better that the analyst understand the effects of accounting practices in this area on accounting income rather than dismiss them altogether.

Chapter 06 - Analyzing Operating Activities

28. Goodwill is measured by the excess of cost over the fair market value of tangible net assets acquired in a transaction accounted for as a purchase. That is the theory of it. The financial analyst must be alert to the makeup and the method of valuation of the Goodwill account as well as to the method of its ultimate disposition. One way of disposing of the Goodwill account, frequently chosen by management, is to write it off at a time when it would have the least serious impact on the market's judgment of the company's earnings, for example, at a time of loss or reduced earnings. Under normal circumstances, goodwill is not indestructible but is rather an asset with a limited useful life. Still, whatever the advantages of location, market dominance and competitive stance, sales skill, product acceptance, or other benefits are, they cannot be unaffected by the passing of time and by changes in the business environment. Thus, the analyst must assess the carrying amount of goodwill by reference to such evidence of continuing value as the profitability of units for which the goodwill consideration was originally paid. 29. The interest cost to a company is the nominal rate paid including, in the case of bonds, the amortization of any bond discount or premium. A complication arises when companies issue convertible debt or debt with warrants, thus achieving a nominal debt coupon cost that is below the cost of similar debt not carrying these features. After trial pronouncements on the subject and much controversy, APB 14 concluded in the case of convertible debt that the inseparability of the debt and equity features is such that no portion of the proceeds from the issuance should be accounted for as attributable to the conversion feature. In the case of debt issued with stock warrants attached, the proceeds of the debt attributable to the warrants should be accounted for as paid-in capital. The corresponding charge is to a debt discount account that must be amortized over the life of the debt issue thus increasing the effective interest cost. 30. a. SFAS 34 ("Capitalization of Interest Cost") requires capitalization of interest cost as part of the historical cost of "assets that are constructed or otherwise produced for an enterprise's own use (including assets constructed or produced for the enterprise by others for which deposits or progress payments have been made)." Inventory items that are routinely manufactured or produced in large quantities on a repetitive basis do not qualify for interest capitalization. The objectives of interest capitalization, according to the FASB, are (1) to measure more accurately the acquisition cost of an asset, and (2) to amortize that acquisition cost against revenues generated by the asset. b. The amount of interest to be capitalized is based on the entity's actual borrowings and interest payments. The rate to be used for capitalization may be ascertained in this order: (1) the rate of specific borrowings associated with the assets and (2) if borrowings are not specific for the asset, or the asset exceeds specific borrowings therefore, a weighted average of rates applicable to other appropriate borrowings may be used. Alternatively, a company may use a weighted average of rates of all appropriate borrowings regardless of specific borrowings incurred to finance the asset.

Chapter 06 - Analyzing Operating Activities

c. Interest capitalization is not permitted to exceed total interest costs for any period, nor is imputing interest cost to equity funds permitted. A company without debt will have no interest to capitalize. The capitalization period begins when three conditions are present: (1) expenditures for the asset have been made by the entity, (2) work on the asset is in progress, and (3) interest cost is being incurred. Interest capitalization ceases when the asset is ready for its intended use. 31. The intrinsic value of an option is the amount by which the market value of the underlying security exceeds the option exercise price at the time of measurement. The fair value of an option is the amount that market participants would be willing to pay today to purchase the option. 32. The fair value of an option is affected by the exercise price, the current market price, the risk-free rate of interest, the expected life of the option, the expected volatility of the stock price, and the expected dividend yield. 33. SFAS 123 requires that the company amortize the fair value of employee stock options (estimated using various option pricing models) at the grant date over the expected life of the option. The cumulative amortization of all employee stock options granted in the past is collectively called the option compensation expense. Until recently, option compensation expense was not charged to income. However, a recent revision of the standard, SFAS 123R, requires that the option compensation expense be charged to income. Compensation expense may be included in various expense categories such as cost of goods sold, SG&A, R&D etc. based on which area of the company the respective employee works for. 34. The economic cost of issuing options at the prevailing market price are: (1) the interest cost, which is that the employee is able to pay for the stock purchase many years later using the current stock price; and (2) cost of providing an option to exercise, which arises because the employee can share in the potential upside but is protected from sharing in the potential downside risk. 35. Option overhang refers to the intrinsic value of outstanding options (both exercisable and otherwise) as a proportion of the company’s market value. It is a measure of the value of potential dilution that arises from option grants to employees. It measured by aggregating the intrinsic value of all outstanding employee stock options, using the current stock price, and dividing it by the current market capitalization of the company’s equity. 36. The net income computed on the basis of generally accepted accounting principles (also known as "book income") is usually not identical to the "taxable income" computed on the entity's tax return. This is due to two types of difference. Permanent differences (discussed here) and temporary, or timing, differences. Permanent differences result from provisions of the tax law under which: (a) Certain items may be nontaxable—for example, income on tax exempt obligations and proceeds of life insurance on an officer

Chapter 06 - Analyzing Operating Activities

(b) Certain deductions are not allowed—for example, penalties for filing certain returns, government fines, and officer life insurance premiums. (c) Special deductions granted by law—for example, dividend exclusion on dividends from unconsolidated subsidiaries and from dividends received from other domestic corporations. 37. The effective tax rate paid by a corporation on its income will vary from the statutory rate because: • The basis of carrying property for accounting purposes may differ from that for tax purposes from reorganizations, business combinations, or other transactions. • Nonqualified and qualified stock-option plans may result in book-tax differences. • Certain industries, such as savings and loan associations, shipping lines, and insurance companies enjoy special tax privileges. • Up to $100,000 of corporate income is taxed at lower tax rates. • Certain credits may apply, such as R&D credits and foreign tax credits. • State and local income taxes, net of federal tax benefit, are included in total tax expenses. What makes these differences and factors permanent is the fact that they do not have any future repercussions on a company's taxable income. Thus, they must be taken into account when reconciling a company's actual (effective) tax rate to the statutory rate. 38. SFAS 109 ("Accounting for Income Taxes") establishes financial accounting and reporting standards for the effects of income taxes that result from an enterprise's activities during the current and preceding years, and requires an asset and liability approach. SFAS 109 requires that deferred taxes should be determined separately for each tax-paying component (an individual entity or group of entities that is consolidated for tax purposes) in each tax jurisdiction. The determination includes the following procedures: • Identify the types and amounts of existing temporary differences and the nature and amount of each type of operating loss and tax credit carry forward, plus the remaining length of the carry forward period. • Measure the total deferred tax liability for taxable temporary differences, using the applicable tax rate. • Measure the total deferred tax asset for deductible temporary differences and operating loss carry forwards, using the applicable tax rate. • Measure deferred tax assets for each type of tax credit carry forward. • Reduce deferred tax assets by a valuation allowance if based on the weight of available evidence. It is more likely than not (a likelihood of more than 50 percent) that some portion or all of the deferred tax assets will not be realized. The valuation allowance should be sufficient to reduce the deferred tax asset to the amount that is more likely than not to be realized. Deferred tax assets and liabilities should be adjusted for the effect of a change in tax laws or rates. The effect should be included in income from continuing operations for the period that includes the enactment date.

Chapter 06 - Analyzing Operating Activities

39. (a) Revenues or gains are included in taxable income later than they are included in pretax accounting income. (b) Expenses or losses are deducted in determining taxable income later than they are deducted in determining pretax accounting income. (c) Revenues or gains are included in taxable income earlier than they are included in pretax accounting income. (d) Expenses or losses are deducted in determining taxable income earlier than they are deducted in determining pretax accounting income. 40. The components of the net deferred tax liability or net deferred tax asset recognized in a company's balance sheet should be disclosed. These include the: • Total of all deferred tax liabilities. • Total of all deferred tax assets. • Total valuation allowance recognized for deferred tax assets. Additional disclosures include the significant components of income tax expense attributable to continuing operations for each year presented which include, for example: • Current tax expense or benefit. • Deferred tax expense or benefit (exclusive of the effects of other components). • Investment tax credits. • Government grants (to the extent recognized as a reduction of income tax expense). • The benefits of operating loss carry forwards. • Tax expense that results from allocating certain tax benefits either directly to contributed capital or to reduce goodwill or other noncurrent intangible assets of an acquired entity. • Adjustments of a deferred tax liability or asset for enacted changes in tax laws or rates or a change in the tax status of the enterprise. • Adjustments of the beginning-of-year balance of a valuation allowance because of a change in circumstances that causes a change in judgment about the realizability of the related deferred tax asset in future years. Also to be disclosed is a reconciliation between the effective income tax rate and the statutory federal income tax rate. In addition, the amounts and expiration dates of operating loss and tax credit carry forwards for tax purposes must be disclosed. 41. (1) One of the flaws remaining in tax allocation procedures is that no recognition is given to the fact that a future obligation, or loss of benefits, should be discounted rather than shown at its entire amount as today's tax deferred accounts actually are. The FASB has reviewed the issue and decided not to address it because of the conceptual and implementation issues involved. (2) Another flaw is that the Board allowed parent companies to avoid providing taxes on unremitted earnings of subsidiaries and other specialized exceptions to the requirements of deferred tax accounting. 42. A The determination of the earnings level of an enterprise, which is relevant to the purpose of the analyst, is a complex analytical process. The earnings figure can be converted into a per-share amount that is useful in evaluating the price of the common stock, its dividend coverage, and the potential effects of dilution. As with any measure, there are strengths and weaknesses associated with its computation. Thus, the analyst must have a thorough understanding of the principles that govern the computation of earnings per share to effectively analyze it and use it in decision making.

Chapter 06 - Analyzing Operating Activities

43. A Earnings per share data are used in making investment decisions. They are used in evaluating the past operating performance of a company and in forming an opinion as to its future potential. They are commonly presented in prospectuses, proxy material, and reports to stockholders, and is the only financial statement ratio that is audited. They are used in the compilation of business earnings data for the press, statistical services, and other publications. When presented with formal financial statements, they assist the investor in weighing the significance of a corporation's current net income and of changes in its net income from period to period in relation to the shares an analyst holds or may acquire. Current GAAP regarding EPS conforms to international standards. The analyst must be aware that basic EPS does not take into account securities that, although not common stock, are in substance equivalent to common stock. The analyst must take care to focus on diluted EPS, which intends to show the maximum extent of potential dilution of current earnings that conversions of securities could create. 44. A Diluted earnings per share is the amount of current earnings per share reflecting the maximum dilution that would result from conversions, exercises, and other contingent issuances that individually would decreased earnings per share and in the aggregate yield a dilutive effect. All such issuances are assumed to have taken place at the beginning of the period (or at the time the contingency arose, if later). 45. A The amount of any dividends on preferred stock that have been paid (declared) for the year should be deducted from net income before computing earnings per share. 46. A Yes, if warrants or options are present, an increase in the market price of the common stock can increase the number of common equivalent shares by decreasing the number of shares repurchasable under the treasury stock method. 47. A SFAS 128 has a number of flaws and inconsistencies that the analyst must consider in interpreting EPS data: (a) The computation of basic EPS completely ignores the potentially dilutive effects of options and warrants. (b) There is a basic inconsistency in treating certain securities as the equivalent of common stock for purposes of computing EPS while not considering them as part of the stockholders' equity in the balance sheet. Consequently, the analyst will have difficulty in interrelating reported EPS with the debt-leverage position pertaining to the same earnings. (c) Generally, EPS are considered to be a factor influencing stock prices. Whether options and warrants are dilutive or not depends on the price of the common stock. Thus we can get a circular effect in that the reporting of EPS may influence the market price which, in turn, influences EPS. Under these rules earnings may depend on market prices of the stock rather than only on economic factors within the enterprise. In the extreme, this suggests that the projection of future EPS requires not only the projection of earnings levels but also the projection of future market prices. 48. A (a) Earnings per share data are used in making investment decisions. They are used in evaluating the past operating performance of a company and in forming an opinion as to its future potential. They are commonly presented in prospectuses, proxy material, and reports to stockholders. They are used in the compilation of business earnings data for the press, statistical services, and other publications. When 6-15 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 06 - Analyzing Operating Activities

presented with formal financial statements, they assist the investor in weighing the significance of a corporation's current net income and of changes in its net income from period to period in relation to the shares an analyst holds or may acquire. (b) Earnings per common share are not fully relevant to the valuation of preferred stock. For purposes of preferred stock evaluation, the earnings coverage ratio of preferred stock is among the most relevant. It measures the number of times preferred dividends have been earned and, thus, is a measure of the safety of the dividend as well as the safety of the preferred issue.

Chapter 06 - Analyzing Operating Activities

EXERCISES Exercise 6-1 (25 minutes) a. Cash xxx Gain on disposition* Net assets of discontinued operations * (A loss on disposition would be recorded as a debit)

xxx xxx

b. Income (expense) related to discontinued operations include the operating profit (loss) recorded prior to sale and the gain (loss) on sale. These are reported net of applicable tax. c. When estimating future earning power, the results from discontinued operations should not be treated as recurring. This is important for an assessment of the permanent income of a company. d. Separately reporting discontinued operations allows the analyst to view the results of operations without the segment that will not be ongoing. As a result, the analyst can better assess the permanent component of income, for which results of discontinuing operations will be excluded.

Exercise 6-2 (30 minutes) a. By the use of reserves, a company can allocate costs in excess of actual experience in the current period, based on estimates of additional costs in the future, or even based on the simple possibility of further costs in the future. Then, in later periods, actual costs can be written off against the reserve rather than reported as expenses in the company's income statement for those periods. The advantage to the company is that earnings trends can be "smoothed," and a cushion for future earnings can be built up during good economic years for use during leaner periods. To the extent that stability and predictability of earnings are market virtues, the company's common stock might be accorded a higher multiple for these efforts, in effect lowering the cost of capital to the company. The use of reserves both poses problems for the analyst and conflicts with some basic accounting principles. These include: (1) Use of reserves contradicts the matching principle, by which revenues and related costs should be recognized in the same period. (2) Reserving for future events (especially contingencies) is obviously subject to estimate, and accounting should attempt to record quantifiable value as much as possible.

Chapter 06 - Analyzing Operating Activities

Exercise 6-2—continued (3) The reserving technique makes reported earnings less indicative of fundamental trends in the company. The effects of the economic cycle are reduced, making correlation techniques (such as GNP growth vs. EPS growth) invalid. These reported numbers might mislead the “uninformed” investor. In contrast to the artificial smoothing referred to earlier, the company's growth rate may be exaggerated, by over-reserving for losses in a bad year, and subsequent writing off of the reserve. It should be noted that a reserve can be properly taken such as when it recognizes a liability that (1) likely exists in the relatively near future—such as costs of winding up a plant shutdown with the next year or (2) is subject to quantification—such as the outright expropriation of net assets in a foreign country. b. If the analyst is able to discern the impact of reserves, s/he should exclude the reserves' impact from accounting income when assessing past trends. Only operating or normal earnings should be compared over the short-term. However, over a longer period of time, the losses against which reserves have been taken should be included. In estimating future earnings, the analyst must carefully consider the impact of reserves and exclude the impact when forecasting normal earnings. By doing this, the analyst will have a better understanding of the true operations of the company. In the valuation of common stock, the analyst must focus on the sustainable earning power of the company. Thus, earnings may have to be adjusted upward or downward depending on the degree of abuse of reserves. c. Several examples of reserves are cited in the chapter. Also, students often benefit from a review of business magazines in attempting to identify such reserves. (CFA Adapted)

Exercise 6-3 (35 minutes) a. A change from the sum-of-the-years'-digits method of depreciation to the straight-line method for previously recorded assets is a change in accounting principle. Both the sum-of-the-years'-digits method and the straight-line method are generally accepted. A change in accounting principle results from adoption of a generally accepted accounting principle different from the generally accepted accounting principle used previously for reporting purposes.

Chapter 06 - Analyzing Operating Activities

Exercise 6-3—continued b. A change in the expected service life of an asset arising because of more experience with the asset is a change in accounting estimate. A change in accounting estimate occurs because future events and their effects cannot be perceived with certainty. Estimates are an inherent part of the accounting process. Therefore, accounting and reporting for certain financial statement elements requires the exercise of judgment, subject to revision based on experience. c. 1. The cumulative effect of a change in accounting principle is the difference between: (1) the amount of retained earnings at the beginning of the period of change and (2) the amount of retained earnings that would have been reported at that date if the new accounting principle had been used in prior periods. 2. FASB 2005 Statement “Accounting Changes and Error Corrections” requires that effective in 2005, companies should apply the “retrospective approach” to changes in accounting principle. Thus, all presented periods must be restated as if the change were in effect during those periods, and any cumulative effect from periods before those presented is an adjustment to beginning retained earnings of the earliest period presented. d. Consistent use of accounting principles from one accounting period to another enhances the usefulness of financial statements in comparative analysis of accounting data across time. e. If a change in accounting principle occurs, the nature and effect of a change in accounting principle should be disclosed to avoid misleading financial statement users. There is a presumption that an accounting principle, once adopted, should not be changed in accounting for events and transactions of a similar type. f. Mandatory accounting changes are largely non-discretionary. Thus, managerial discretion is not present, or at least is to a lesser degree. One should examine the motivations for voluntary accounting changes and assess any earnings quality impact. g. Mandatory accounting changes are largely non-discretionary. However, there is often a window of time for a company to adopt a mandatory accounting change. If a window exists, management has discretion as to the timing of the adoption. Thus, the timing of adoption and any accounting ramifications should be considered. For example, if a manager is going to adopt an accounting change that includes a large charge, the manager might choose to adopt in a relatively poor quarter to attempt to potentially conceal or downplay the poor operating performance.

Chapter 06 - Analyzing Operating Activities

Exercise 6-3—concluded h. Mandatory accounting changes often include the recognition of retroactive earnings affects. For example, the rules in accounting for other post-employment benefits require that companies establish a liability for the accrued benefits to date. This results in a large charge for many companies. Of course, the market potentially views the charge as largely the fault of accounting rule makers. Thus, managers have incentive to increase the amount of the charge and use the bloated liability to increase future earnings.

Exercise 6-4 (20 minutes) Comprehensive income computation: a. Computation: $1,000,000 + 50,000 - 75,000 - 12,000 $ 963,000

b. Balance sheet accounts affected: Net income (closed to equity) Foreign currency translation gain Unrealized gain or loss on pension assets/liabilities Unrealized holding losses on derivative instruments Comprehensive income (component of equity)

Chapter 06 - Analyzing Operating Activities

Exercise 6-5 (30 minutes) a. The point of sale is the most widely used basis for the timing of revenue recognition because in most cases it provides the degree of objective evidence many consider necessary to measure reliably periodic business income. That is, sales transactions with outsiders represent the point in the revenue generating process when most of the uncertainty about the final outcome of business activity has been alleviated. It is also at the point of sale in most cases that substantially all of the costs of generating revenues are known, and they can at this point be matched with the revenues generated to produce a reliable statement of a firm's effort and accomplishment for the period. Any attempt to measure business income prior to the point of sale would, in the vast majority of cases, introduce considerably more subjectivity into financial reporting than most accountants are willing to accept. b. 1. Though it is recognized that revenue is earned throughout the entire production process, generally it is not feasible to measure revenue on the basis of operating activity. It is not feasible because of the absence of suitable criteria for consistently and objectively arriving at a periodic determination of the amount of revenue to take up. Also, in most situations the sale is the most important single step in the earning process. Prior to the sale the amount of revenue anticipated from the processes of production is merely prospective revenue; its realization remains to be validated by actual sales. The accumulation of costs during production does not alone generate revenue; rather, revenues are earned by the entire process including the actual sales. Thus, as a general rule the sale cannot be regarded as being an unduly conservative basis for the timing of revenue recognition. Except in unusual circumstances, revenue recognition prior to sale would be anticipatory in nature and unverifiable in amount. 2. To criticize the sales basis as not being sufficiently conservative because accounts receivable do not represent disposable funds, it is necessary to assume that collection of receivables is the decisive step in the earning process and that periodic revenue measurement and, therefore, net income should depend on the amount of cash generated during the period. This assumption disregards the fact that the sale usually represents the decisive factor in the earning process and substitutes for it the administrative function of managing and collecting receivables. That is, the investment of funds in receivables should be regarded as a policy designed to increase total revenues, properly recognized at the point of sale; and the cost of managing receivables (e.g., bad debts and collection costs) should be matched with the sales in the proper period. The fact that some revenue adjustments (such as sales returns) and some expenses (such as bad debts and collection costs) can occur in a period subsequent to the sale does not detract from the overall usefulness of the sales basis for the timing of revenue recognition. Both can be estimated with sufficient accuracy so as not to detract from the reliability 6-21 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 06 - Analyzing Operating Activities

Exercise 6-5—concluded of reported net income. Thus, in the vast majority of cases for which the sales basis is used, estimating errors, though unavoidable, will be too immaterial in amount to warrant deferring revenue recognition to a later point in time. c. 1. During production. This basis of recognizing revenue is frequently used by companies whose major source of revenue are long-term construction projects. For these companies the point of sale is far less significant to the earning process than is production activity because the sale is assured under the contract, except of course where performance is not substantially in accordance with the contract terms. To defer revenue recognition until the completion of long-term construction projects could impair significantly the usefulness of the intervening annual financial statements because the volume of completed contracts during a period is likely to bear no relationship to production volume. During each year that a project is in process a portion of the contract price is therefore appropriately recognized as that year's revenue. The amount of the contract price to be recognized should be proportionate to the year's production progress on the project. It should be noted that the use of the production basis in lieu of the sales basis for the timing of revenue recognition is justifiable only when total profit or loss on the contracts can be estimated with reasonable accuracy and its ultimate realization is reasonably assured. 2. When cash is received. The most common application of this basis for the timing of revenue recognition is in connection with installment sales contracts. Its use is justified on the grounds that, due to the length of the collection period, increased risks of default, and higher collection costs, there is too much uncertainty to warrant revenue recognition until cash is received. The mere fact that sales are made on an installment contract basis does not justify using the cash receipts basis of revenue recognition. The justification for this departure from the sales depends essentially upon an absence of a reasonably objective basis for estimating the amount of collection costs and bad debts that will be incurred in later periods. If these expenses can be estimated with reasonable accuracy, the sales basis should be used. (AICPA Adapted)

Chapter 06 - Analyzing Operating Activities

Exercise 6-6 (25 minutes) a. Michael Company should recognize revenue as it performs the work on the contract (the percentage-of-completion method) given that the right to revenue is established and collectibility is reasonably assured. Furthermore, the use of the percentage-of-completion method avoids distortion of income from period to period, and it provides for better matching of revenues with the related expenses. b. Progress billings would be accounted for by increasing Accounts Receivable and increasing Progress Billings on Contract, a contra asset account that is offset against the Construction Costs in Progress account. If the Construction Costs in Progress account exceeds the Progress Billings on Contract account, the two accounts would be shown in the current assets section of the balance sheet. If the Progress Billings on Contract account exceeds the Construction Costs in Progress account, the two accounts would be shown, in most cases, in the current liabilities section of the balance sheet. c. The income recognized in the second year of the four-year contract would be determined as follows: • First, the estimated total income from the contract would be determined by deducting the estimated total costs of the contract (the actual costs to date plus the estimated cost to complete) from the contract price. • Second, the actual costs to date would be divided by the estimated total costs of the contract to arrive at a percentage completed, which would be multiplied by the estimated total income from the contract to arrive at the total income recognized to date. • Third, the total income recognized in the second year of the contract would be determined by deducting the income recognized in the first year of the contract from the total income recognized to date. d. Earnings in the second year of the four-year contract would be higher using the percentage-of-completion method instead of the completed-contract method. This is because income would be recognized in the second year of the contract using the percentage-of-completion method, whereas no income would be recognized in the second year of the contract using the completed-contract method.

Chapter 06 - Analyzing Operating Activities

Exercise 6-7 (15 minutes) a. Crime Control's revenue recognition practices, while not the most conservative, conform to GAAP. The important issue is whether lessees will, in fact, continue for their eight-year terms. Should large cancellations occur, substantial portions of the revenue recognized in earlier years might have to be reversed in subsequent years. This would result in distortions of earning power and earning trends. Thus, a critical issue of this accounting is whether the company provides adequately for contingencies such as cancellations. Should the pace of newly written sales-type leases slow, the company's earnings growth may stop or earnings may even decline. b. While the tax accounting does provide the company with significant funds from tax postponement, it does not affect reported results because under GAAP the company is required to provide for deferred taxes which it is assumed will be payable in the future. c. While it is true that the sale of the receivables without recourse would enable the company to book profits in the year the lease originated, this practice would at the same time substantially increase the company's tax bill.

Exercise 6-8 (20 minutes) a. This revenue recognition issue stirs controversy. Many believe that it is reasonable for both companies to record offsetting advertising revenues and advertising expenses from this contract. This is justified in that the transaction seemingly meets the usual revenue recognition criteria. Opponents of this treatment worry about uncertainty and completeness of the earning process. b. Revenues and revenue growth are considered good indicators of future prospects for Dot.Com (Internet) companies. Accordingly, Internet companies want to maximize the amount of reported revenues; even if those revenues are entirely offset with expenses. c. An analyst should seek to determine the percent of revenues that come from advertising in such barter transactions versus revenues from cash-paying (or credit) customers. Some believe that barter-based revenues should be segregated and viewed in a different light from that of more normal revenues. This might affect revenue multiples in determining stock price or decisions in other applications that rely on financial statements. Analysts should adjust their models according to their beliefs about the relative merits of such revenues.

Chapter 06 - Analyzing Operating Activities

Exercise 6-9 (30 minutes) a. Some costs are recognized as expenses on the basis of a presumed direct association with specific revenue. This has been identified both as "associating cause and effect" and as the "matching concept." Direct cause-and-effect relations can seldom be conclusively demonstrated, but many costs appear to be related to particular revenue, and recognizing them as expenses accompanies recognition of the revenue. Generally, the matching concept requires that the revenue recognized and the expenses incurred to produce the revenue be given concurrent periodic recognition in the accounting records. Only if effort is properly related to accomplishment will the results, called earnings, have useful significance concerning the efficient utilization of business resources. Thus, applying the matching principle recognizes the cause-and-effect relationship that exists between expense and revenue. Examples of expenses that are usually recognized by associating cause and effect are sales commissions, freight-out on merchandise sold, and cost of goods sold or services provided. b. Some costs are assigned as expenses to the current accounting period because (1) their incurrence during the period provides no discernible future benefits; (2) they are measures of assets recorded in previous periods from which no future benefits are expected or can be discerned; (3) they must be incurred each accounting year, and no buildup of expected future benefits occurs; (4) by their nature they relate to current revenues even though they cannot be directly associated with any specific revenues; (5) the amount of cost to be deferred can be measured only in an arbitrary manner or great uncertainty exists regarding the realization of future benefits, or both; and (6) uncertainty exists regarding whether allocating them to current and future periods will serve any useful purpose. Thus, many costs are called "period costs" and are treated as expenses in the period incurred because neither do they have a direct relationship with revenue earned nor can their occurrence be directly shown to give rise to an asset. The application of this principle of expense recognition results in charging many costs to expense in the period in which they are paid or accrued for payment. Examples of costs treated as period expenses would include officers' salaries, advertising, research and development, and auditors' fees. c. A cost should be capitalized, that is, treated as an asset, when it is expected that the asset will produce benefits in future periods. The important concept here is that the incurrence of the cost has resulted in the acquisition of an asset, a future service potential. If a cost is incurred that resulted in the acquisition of an asset from which benefits are not expected beyond the current period, the cost may be expensed as a measure of the service potential that expired in producing the current period's revenues. Not only should the incurrence of the cost result in the acquisition of an asset from which future benefits are expected, but also the cost should be measurable with a reasonable degree of objectivity, and there should be reasonable grounds for associating it with the asset acquired. Examples of costs that should be treated as measures of assets are the costs of merchandise 6-25 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 06 - Analyzing Operating Activities

Exercise 6-9—concluded on hand at the end of an accounting period, the costs of insurance coverage relating to future periods, and the costs of self-constructed plant or equipment. d. In the absence of a direct basis for associating asset cost with revenue, and if the asset provides benefits for two or more accounting periods, its cost should be allocated to these periods (as an expense) in a systematic and rational manner. When it is impractical, or impossible, to find a close cause-and-effect relationship between revenue and cost, this relationship is often assumed to exist. Therefore, the asset cost is allocated to the accounting periods by some method. The allocation method used should appear reasonable to an unbiased observer and should be followed consistently from period to period. Examples of systematic and rational allocation of asset cost would include depreciation of fixed assets, amortization of intangibles, and allocation of rent and insurance. e. A cost should be treated as a loss when an unfavorable event results from an activity other than a normal business activity. The matching of losses to specific revenue should not be attempted because, by definition, they are expired service potentials not related to revenue produced. That is, losses resulting from extraneous and exogenous events that are not recurring or anticipated as necessary in the process of producing revenue. There is no simple way of identifying a loss, because ascertaining whether a cost should be a loss is often a matter of judgment. The accounting distinction between an asset, expense, loss, and prior-period adjustment is not clear-cut. For example, an expense is usually voluntary, planned, and expected as necessary in the generation of revenue. But a loss is a measure of the service potential expired that is considered abnormal, unnecessary, unanticipated, and possibly nonrecurring and is usually not taken into direct consideration in planning the size of the revenue stream. (AICPA Adapted) Exercise 6-10 (15 minutes) a. Research and development costs are expensed in the year that they are incurred. This means R&D costs impact current income dollar for dollar. Also, to the extent that research and development efforts lead to future revenues, this is a violation of the matching principle in relating costs to revenues in determining future income. b. R&D expenditures at Frontier Biotech decreased substantially in fiscal 2006. As a result, fiscal 2006 net income is substantially higher. However, this may not be a good signal for future profitability. To the extent that one has confidence in the ability of the R&D department at Frontier Biotech, future revenues may be compromised by management’s decision to curtail research efforts.

Chapter 06 - Analyzing Operating Activities

Exercise 6-11 (15 minutes) a. First, the fair value of the option grant is determined on the date of the grant using an option pricing model, such as Black-Scholes. Second, this fair value amount is amortized over the period that the employee is expected to hold on to the option, i.e., the expected “term” of the ESO by charging it to income as compensation expense. In the balance sheet, the option expense reduces retained earnings and increases a special account in the share capital. This special account is closed to paid-in share capital when the employee exercises the option. b. The cost arises because of the (1) interest cost and the (2) option cost. One way to understand the cost is to realize that issuing of ESO is like selling a call option. Therefore to perfectly hedge the transaction the company needs to buy a similar call option. Call option have a price and therefore this transaction is not costless to the company. c. This is untrue. The benefits of options arising from more motivated and longlived workforce will translate to higher income through improved revenues or reduced costs. The options cost is amortized to match the benefits that are expected to arise. d. For equity analysis the compensation expense is a legitimate expense that reflects potential reduction in value of shareholdings of current shareholders. For credit analysis option expense is irrelevant because it is only a transfer of wealth between current and potential shareholders.

Exercise 6-12 (40 minutes) a. The plan will be deemed to be compensatory. This is because the stock option plan is only offered to certain employees and the life of the option is not short. b. Incent.Com would offer such a lucrative plan to its employees to attract and retain a talented work force. Human capital is a key asset in technology companies. c. The grant date is January 1, 2004; Vesting date is January 1, 2009; First exercise date is January 1, 2009. d. No, the employee stock options are not “in-the-money” at the grant date. This is because at the grant date the exercise price is greater than or equal to (not less than) the market price of the stock. e. Total compensation cost should be measured at the date of measurement. The date of measurement is the earliest date that the number of shares and the stock option price is known—which is January 1, 2004, in this case. 6-27 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 06 - Analyzing Operating Activities

f. Total compensation cost to be recognized will depend upon the accounting rules applied. Under APB 25, total compensation cost is $0; computed as the intrinsic value of the options times the number of shares, or [($20–$20) x 100,000 shares]. Under SFAS 123, the 81,538 options (rounded up) are expected to vest based on the 4% forfeiture rate. Specifically, 100,000 x 4% = 4,000 options in 2000; 96,000 x 4% = 3,840 options in 2001; 92,160 x 4% = 3,686 options in 2002; 88,474 x 4% = 3,539 options in 2003; and 84,935 x 4% = 3,397 options in 2004. Consequently, $652,304 in total compensation expense should be recognized (81,538 options x $8 fair value per option). g. Compensation cost should be allocated over the service period, years 2004 through 2008. h. The employee stock option plan transfers wealth from stockholders to employees by granting potential ownership rights to employees with less than “full buy-in” to acquire these ownership rights. That is, if existing ownership were diluted via a normal issuance of shares to investors, contributed capital received from the investors would be much greater than that received from the exercise price of stock options.

Exercise 6-13 (15 minutes) a. Managers often hold, or expect to hold, stock options. As a result, they will increase their wealth when the market price of the stock increasing exceeds the exercise price of stock options they hold. By withholding good news and selectively releasing bad news before the date that the option’s exercise price is established, the managers allegedly depress the price of the stock (at least temporarily) until the exercise price is established. b. In the analysis of company performance and stock valuation, silence before a grant date might be interpreted as a sign that no significant bad news is known by the managers (given their incentive to release bad news prior to the date to establish an exercise price when managers hold stock options). Moreover, an analyst might expect that good news would be withheld by managers until after the date that the exercise price of the stock options is established. c. The “backdating’ of employee stock options was a scandal that embarrassed corporate America. This was clearly unethical practice, whereby current shareholders were unfairly affected. The beneficiaries were the employees who were able to get the ESO exercise prices set at the lowest level possible after the fact.

Chapter 06 - Analyzing Operating Activities

Exercise 6-14 (20 minutes) a. Some transactions affect the determination of net income for accounting purposes in one reporting period and the computation of taxable income and income taxes payable in a different reporting period. In accordance with the matching principle, the appropriate income tax expense represents the income tax consequences of revenues and expenses recognized for accounting purposes in the current period, whether those income taxes are paid or payable in current, future, or past periods. Accordingly, a deferred income taxes account is setup to reflect such timing differences. b. When depreciation expense for machinery purchased this year is reported using the MACRS for income tax purposes and the straight-line basis for accounting purposes, a timing difference arises. Because more depreciation expense is reported for income tax purposes than for accounting purposes this year, pretax accounting income is more than taxable income. The difference creates a credit to deferred income taxes equal to the difference in depreciation multiplied by the appropriate income tax rate. When rent revenues received in advance this year are included in this year's taxable income but as unearned revenues (a current liability) for accounting purposes, a timing difference arises. Because rent revenues are reported this year for income tax purposes but not for accounting purposes, pretax accounting income is less than taxable income. The difference creates a debit to deferred income taxes equal to the difference in rent revenues multiplied by the appropriate income tax rate. c. The income tax effect of the depreciation (timing difference) is classified on the balance sheet as a noncurrent liability because the asset to which it is related is noncurrent. The income tax effect of the rent revenues received in advance (timing difference) is classified on the balance sheet as a current asset because the liability to which it is related is current. The noncurrent liability and the current asset should not be netted on the balance sheet because one is current and one is noncurrent. On the income statement, the income tax effect of the depreciation (timing difference) and the rent revenues received in advance (timing difference) should be netted. This amount is classified as a deferred component of income tax expense.

Chapter 06 - Analyzing Operating Activities

Exercise 6-15 (15 minutes) There are at least two earnings targets that are typically relevant for managers and investors. The first is the consensus earnings expectation of the analyst community. The second is the earnings in the same quarter of the previous fiscal year. (A third might be an earnings forecast previously released by management.) Beating these targets by even a penny is typically viewed as a sign of sustained profit growth and skilled leadership. This means that companies near these targets will use earnings management to meet or exceed these targets, even if only by a penny. Accordingly, earnings increases of $0.01 can be significant when the change pushes earnings equal to or above relevant earnings targets. Of course, a magnitude or scale issue can be relevant as well. A $0.01 change in an earnings per share figure that is approximately $0.05 per share in total can be quite relevant, whereas a $0.01 change for an earnings per share figure that is approximately $10.00 per share can be substantially less relevant.

Exercise 6-16 (20 minutes) a. The effects of dilutive stock options and warrants are not included in the computation of the number of shares for basic earnings per share. They are, however, included in diluted earnings per share computations. b. The effects of dilutive convertible securities are not included in the computation of the number of shares for basic earnings per share. They are, however, included in diluted earnings per share computations. c. Antidilutive securities are excluded from both basic and diluted earnings per share.

Chapter 06 - Analyzing Operating Activities

Exercise 6-17 (20 minutes) a. Basic earnings per share is the amount of earnings attributable to common shareholders (that is, net income less preferred dividends) divided by the weighted average number of common shares outstanding for that period. b. Diluted earnings per share is the amount of current earnings per share that reflects the maximum dilution that would result from the conversion of all convertible securities and the exercise of all warrants and options. The conversion of these securities individually would decrease earnings per share and in the aggregate would have a dilutive effect. The computation of diluted earnings per share should be based upon the assumption that all such issued and issuable shares are outstanding from the beginning of the period, or from their inception if after the beginning of the period. To summarize, whereas basic earnings per share does not reflect any securities convertible or exercisable into common shares, diluted earnings per share includes all such securities and considers their dilutive effect upon earnings per share, taking into account necessary adjustments to income resulting from the conversion process. (CFA Adapted)

Exercise 6-18 (15 minutes) 1. b. Shares outstanding after the stock dividend are 2 million shares outstanding entire year + 10% of 2 million shares outstanding for 9/12 of year, OR 2 mill + .2 mill(.75) = 2,150,000 shares. 2. a (potentially dilutive securities are not considered in basic earnings per share) 3. a (warrants are antidilutive because more shares are assumed bought back at the average market price with the proceeds than were issued)

Chapter 06 - Analyzing Operating Activities

PROBLEMS Problem 6-1 (45 minutes) a. Computation of earnings components as a percent of sales: 2011 Sales ........................................................................... 100% .....................................................................................

2010 100%

2009 100%

Cost of sales ..............................................................

42.7%

40.9%

41.2%

Selling, general, and administrative expenses .......

34.4%

34.8%

34.5%

Other (income) expense, net.....................................

-0.1%

1.9%

0.7%

Interest expense, net .................................................

0.3%

0.4%

0.5%

Provision for income taxes .......................................

7.4%

7.2%

7.4%

Net income attributable to non-controlling interest

0.7%

Cost of sales has remained fairly steady in each of the 3 years as a percentage of sales. This has accounted for the consistent level of pre-tax profits, as all other expense categories have also remained fairly constant across these years for Colgate. b. Sales and cost of sales are typically the most highly persistent income statement items, and reductions in COS as a percentage of sales are fairly rare in practice. SG&A costs are also typically highly persistent. However, the company may be able to find ways to cut some of these through operating efficiencies. However, a decision to cut these types of persistent expenses, along with expenses like R&D, can have severe ramifications for future profitability. Alternatively, if Colgate engaged in significant restructuring, these costs are generally viewed as transitory. c. Provision for taxes as a percent of earnings before income taxes: FY 2011 = $1,235/$3,789 = 32.6% FY 2010 = $1,117/$3,430 = 32.6% FY 2009 = $1,141/$3,538 = 32.2% Deviations from the statutory percentage of 35% commonly arise as a result of expenses that are recognized for financial reporting purposes that are not deductible for tax purposes. An example is a restructuring charge that must be recognized when incurred for financial reporting purposes, but cannot be deducted for tax purposes until paid. 6-32 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 06 - Analyzing Operating Activities

d. Colgate reports $ 256 and $ 262 in expenses related to research and development in 2010 and 2011, respectively. Advertising expenses are $ 1,656 and $ 1,734 for 2010 and 2011, respectively. Together these items represent 12% of net sales for Colgate in each year. Amounts spent on R&D and advertising are investments by the company designed to generate new profitable products and to improve sales of existing products. However, these investments are not recorded as assets in the balance sheet. Instead, the full amounts spent on R&D and advertising by Colgate in 2010 and 2011 are recognized as expenses in those years. The rationale for treating R&D and advertising amounts as expense rather than as assets is due to the uncertain nature of the benefits that relate to investments in R&D and advertising. e. Amounts spent on R&D and advertising benefit current and future periods. A company with low earnings in the current period may be tempted to reduce the amount spent on R&D and/or advertising in order to limit the amount of expense recognized. By lowering an expense, firms can increase net income in the current period. If analysts fail to recognize the potentially negative impact on future earnings of these reductions in investment, then forecasts of future earnings will be overly optimistic. This can lead to an over-valuation of the company.

Case 6-2 (60 minutes) a. Computation of earnings components as a percent of sales Year 11 Year 10 Sales ........................................................................... 100% 100%

Year 9 100%

Cost of products sold ................................................

66.0%

68.6%

70.5%

Marketing and selling expenses ...............................

15.4%

15.8%

14.4%

Administrative expenses...........................................

4.9%

4.7%

4.4%

Research and development expenses .....................

0.9%

0.8%

Interest expense ........................................................

1.9%

1.8%

1.7%

Interest income ..........................................................

-0.4%

-0.3%

-0.7%

Foreign exchange losses, net ...................................

0.0%

0.1%

0.3%

Other expense ............................................................

0.4%

0.2%

0.6%

Divestitures, restructuring and unusual charges ...

0.0%

5.5%

6.0%

b. Cost of products (goods) sold has declined in each of the 3 years as a percentage of sales. This has accounted for most of the change in pre-tax profits 6-33 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 06 - Analyzing Operating Activities

as all other expense categories have remained fairly constant aside from restructuring costs, which were not present in Year 11. c. Sales and cost of goods sold are typically the most highly persistent, and reductions on COGS as a percentage of sales such as we see in this example are rare. SG&A costs are also typically highly persistent. However, the company may be able to find ways to cut some of these through operating efficiencies. The R&D costs are also reasonably persistent. Again, the company can choose to increase or decrease these, but such a decision can have severe ramifications for future profitability. Restructuring costs are generally viewed as transitory. d. Provision for taxes as a percent of earnings before income taxes: Year 11 = $265.9/$667.4 = 39.8% Year 10 = $175.0/$179.4 = 97.5% Year 9 = $93.4/$106.5 = 87.7% Deviations from the statutory percentage of 35% commonly arise as a result of expenses that are recognized for financial reporting purposes that are not deductible for tax purposes. An example is a restructuring charge that must be recognized when incurred for financial reporting purposes, but cannot be deducted for tax purposes until paid. e. Campbell reports $339.1 million and $343.0 million in divestitures, restructuring and unusual charges in Years 10 and 9, respectively. Restructuring costs typically include asset write-downs and severance costs. Asset write-downs are non-cash charges that typically relate to reduced cash flows of those assets that likely have occurred over several prior years. Severance costs typically relate to accruals of costs that will not be paid until some future period. f.

Removal of costs relating to depreciable assets will reduce future depreciation expense. A cost is, therefore, recognized in the current period that would have been recognized in future periods, thus shifting income from the present into the future. Similarly, severance costs include the accrual of a liability for future costs. This liability is reduced in future periods instead of recording an expense, thus increasing future periods’ profitability.

Chapter 06 - Analyzing Operating Activities

Problem 6-3 (45 minutes) 1. Income Statement 2012 1481 1175 40 99

2011 1078 856 40 76

167

106

Discontinued Operations: Income from discontinued operations Gain from Sale

39 26

Net Income

232

132

2012

2011

Revenues Operating Expenses Net Interest Expense Tax Expense Income from continuing operations

Balance Sheet Cash Operating Assets Assets held for disposal Investment securities

600 3590 1200

3179 821 1200

Total Assets

5390

5200

Operating Liabilities Liabilities held for disposal Long Term Debt Deferred Tax Liability Equity

2344

2100 300 800

Liabilities & Equity

5390

800 14 2232

2000 5200

NOTES: Gain on Sale = 600 - (860-300) = $ 40. Of that 35% = $ 14 is a tax effect, which is reflected in the balance sheet as a deferred tax liability. The after tax gain reported in the income statement is $ 26. 2 As an analyst we should ignore the effects of the discontinued operation. That is because analysis is forward looking and so we need to analyze the company's continuing divisions. Therefore, it is important to calculate ratios for the present and past years for only continuing operations when doing trend analysis. In 2012, however it is important to exclude the cash of $ 600 from assets, when determining ROA.

Chapter 06 - Analyzing Operating Activities

Problem 6-4 (30 minutes) 1. a 2 b (40% of revenues and costs are recognized) 3. a 4. d 5 a 6. c 7. d [($120,000/30%) + ($440,000/40%)] Problem 6-5 (25 minutes) a. (1) Failing to timely record returned credit card purchases and membership cancellations: An accounts receivable analysis would be the focal point to identifying this problem. We would examine for either continual growth in accounts receivable or unusual (unexplained) write-offs of receivables. Ratios or techniques that compare cash collections to accounts receivable also could potentially identify a problem area or fraudulent behavior. (2) Improperly capitalizing and amortizing expenses related to attracting new members: This behavior would be difficult to uncover. The key is to understand the growth in reported intangible assets and deferred charges, and to assess its reasonableness. Unusual increases should be viewed as a potential red flag. (3) Recording fictitious sales: One key to uncovering fictitious sales is to monitor the joint behavior of sales and accounts receivable, simultaneously. Increasing sales should not necessarily lead to slower accounts receivable turnover. Increases in the accounts receivable turnover ratio should be investigated because this can be caused by, among other factors, the recognition of fictitious or uncollectible sales.

b. The external auditor must conduct the audit according to generally accepted auditing standards. The culpability of auditors in a fraud situation varies on a case by case basis. It is often difficult to detect a fraud if key client personnel are colluding and conspiring to cover up. However, in this case the fraud was so widespread that auditor negligence is part of the problem. From an economic perspective, this question will ultimately be answered via litigation.

Chapter 06 - Analyzing Operating Activities

Problem 6-6 (60 minutes) 1. Information to answer this question is found in Colgate’s 2011 income statement and in Note 10 to the financial statements:

EBT Statutory Tax Permanent Differences Tax Provision Deferrals Tax Payable

2011 $ % 3,789 1,326 35% 91 2% 1,235 33% (38) 1,273

2010 $ % 3,430 1,201 35% 84 2% 1,117 33% 71 1,046

2009 $ % 3,538 1,238 35% 97 3% 1,141 32% 19 1,122

Note: Negative numbers for taxes indicate tax credits (taxes that in principle are “receivable” from the government) The differences between the statutory taxes and the actual payments arise because of permanent and temporary differences. For example, in 2011 Colgate should have paid $ 1,326 in tax under the statutory rate, but ended paying $ 1,273 because of permanent differences of $ 91 million that reduced Colgate’s effective tax amounts (rates) from $ 1,326 (35%) to $ 1,235 (33%) and through temporary differences of $ (38) that created deferred tax adjustments which increased Colgate’s tax payment by $ 38 million more in taxes than it provided for in the income statement. 2. Colgate’s effective tax rates are 33% (2011), 33% (2010) and 32% (2009). Effective tax rates differ from statutory tax rates (35%) because of permanent differences. These permanent differences occur because there are provisions in the tax code that allow ColgatePalmolive Company to permanently pay less than 35% taxes on its income. For example, Colgate must pay state income taxes. After a credit on the federal income tax form, Colgate’s state income taxes create permanent differences of +0.4% (2011), +1.1% (2010) and +0.5% (2009). The amount obviously is not directly proportional to Colgate’s EBT and that is why the % changes over the years. If Colgate posts a loss in EBT, then the sign of these permanent differences will also change as a proportion of EBT. In the three years considered, the most significant permanent difference for Colgate is that of earnings taxed at other than the US statutory tax rate. Colgate does not recognize US income taxes on $ 3,500 of undistributed earnings of foreign subsidiaries. These foreign earnings are considered to be “indefinitely reinvested” in these foreign countries. As a result of this designation, Colgate does not recognize US taxes on the foreign earnings amounts. For countries where the statutory tax rate is lower than the US rate, this results in a permanent tax difference that lowers Colgate’s effective tax rate. 6-37 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 06 - Analyzing Operating Activities

3. Colgate’s tax provision (expense) and payments are: 2011 1,235 (38) 1,273

Tax Provision Deferrals Tax Payable

2010 1,117 71 1,046

2009 1,141 19 1,122

The difference between the tax provision and tax payable arises because of deferred tax accounting adjustments. These deferrals constitute temporary differences. The tax payable to government is based on the Colgate’s taxable income which depends on the tax codes at the various countries that Colgate operates in. The tax provision is based on Colgate’s earnings before tax which is computed using GAAP. The differences between taxable income (per tax books) and earnings before tax (per GAAP books) gives rise to temporary differences which are handled through deferred tax adjustments. 4. Many valuation books (and courses) teach us to use the statutory rate (35%) when forecasting a company’s income after taxes. This is fundamentally wrong. The statutory tax rate (35%) is the marginal tax rate and tells us how much of tax is payable for every additional dollar of earnings. In contrast, to make an earnings forecast one needs to estimate the average tax rate during the forecast period. It is clear that the average tax rate in a period is different from the statutory tax rate because of permanent differences. To ascertain the correct tax rate for the forecast one needs to estimate the effective tax rate during the forecast period. This is not an easy exercise. It is not clear that the current year’s effective tax rate will give us the best estimate of next year’s effective tax rate. This is because effective tax rates can be volatile on account of (1) differences in the magnitude of earnings before taxes and (2) non-recurring (one-time) permanent differences. For these reasons, one needs to estimate the “stable” effective tax rate. Colgate’s effective tax rates for 2011, 2010 and 2009 are 33%, 33% and 32%. This rate appears very stable over the three years considered. The table below shows the effective tax rates and tax payment of Colgate during the past 10 years: 2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

Income before taxes

3,789

3,430

3,538

3,005

2,564

2,059

2,134

2,050

2,087

1,912

1,709

Tax provision

1,235

1,117

1,141

968

759

648

728

675

621

582

522

Effective tax rate

33%

32%

30%

31%

34%

33%

30%

31%

It is clear that Colgate’s effective tax rate is very stable around 32%-33% during the last decade of profitability. Therefore, 33% is a good conservative estimate of the effective tax rate. However, note that Colgate’s effective tax rate in 2010 is 33% (in place of 30%) due to a hyperinflationary transition charge for Venezuela subsidiaries. This item is transitory and will not persist in the future. These types of transitory items could potentially skew an estimate of the persistent effective tax rate. A superior method is estimating the tax provision through regression analysis. A regression assumes that there are fixed (dollar) and variable (% of income before tax) components to the tax provision (i.e., to the permanent differences). 6-38 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 06 - Analyzing Operating Activities

Regress the tax provision on income before tax in the following manner: Tax Provision = a + b*Income before tax + e The estimation gives a (constant) of -49.57 and b (slope) of 0.3374. One can use this regression to estimate the tax provision directly. For example, if we estimate Colgate’s income before tax as $ 3,900 in 2013, then the estimated tax provision is -49.57 + 0.3374*(3,900) = 1,266. How well does the regression work? The graph below shows its fits the past data fairly well: 1,400 1,200 Tax Provision 1,000 800 Actual

600

Estimate 400 200 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

The regression’s slope estimate also suggests that our ad hoc estimate of 33% is not bad. At any rate, remember it is not 35%! Note that it is fairly simple to estimate the effective tax rates for Colgate. This is primarily because of the stable nature of Colgate’s income during the past decade. Effective tax rates are more stable and hence easier to forecast for firms with more stable income patterns. 5. Colgate’s deferred tax assets/liabilities in 2011 and 2010 are: 2011 2010 Deferred Tax Assets 988 1,017 Deferred Tax Liabilities (920) (923) Valuation Allowance (1) (1) Net 67 93 Deferred tax assets and liabilities arise because the tax provision made with respect to a particular item is different than the actual tax payable because of that item, i.e., accountants make deferrals in the GAAP books. These assets and liabilities arise because of temporary differences between the GAAP and tax accounting rules with respect to that item. For example, consider stock-based compensation which creates a deferred tax asset of $115 in 2011. This arises because, in its GAAP books, Colgate has recognized compensation expense for the grant-date fair value of stock options granted to employees in the current and prior years. Tax rules will not allow a deduction of this compensation expense until the stock option is actually exercised. This results in taxable income being higher than GAAP income 6-39 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 06 - Analyzing Operating Activities

in the current year, thus resulting in a deferred tax asset which suggests that tax payments could be lower in the future when the employee stock options are exercised, i.e., the temporary difference “reverses”. Tax rules further specify that the amount of compensation expense related to the options is different from the grant date fair value, which also gives rise to a permanent book-tax difference once the options are exercised. However, I would estimate that the bulk of the deferred tax asset represents a temporary difference that will reverse pretty soon, probably within a few years. An example of a deferred tax liability is that relating to depreciation and amortization. Colgate uses accelerated depreciation for tax purposes but straight-line depreciation under GAAP. As a result, taxable income in the past is lower than GAAP income. This suggests that tax payments in the future will be proportionally higher when the tax depreciation becomes smaller (and taxable income larger) than that under GAAP. The reversal of this is expected to be gradual and spread over a fairly long period, say 10 to 15 years (or whatever is the economic life of Colgate’s fixed assets). 6. Colgate’s deferred tax liabilities are fairly stable across 2010 and 2011, showing a net decrease of only $3 from 2010 to 2011. The deferred tax assets show a net decrease of $ 29. The most significant changes are: decrease of 24 in tax loss and tax credit carryforwards due to the offset of prior tax losses against 2011 income; an increase of 31 related to accrued liabilities that are recognized as expenses under GAAP before being recognized as tax expenses; a decrease of 52 related to other accruals that recognize GAAP expenses prior to tax expenses. Colgate does not recognize a significant valuation allowance for its deferred tax assets, meaning that the company expects to recognize almost the full value of these deferred tax assets by offsetting them against income in coming years. This makes sense, given Colgate’s past history of profitability. Because Colgate does not change its valuation allowance between 2010 and 2011, the net change in deferred tax assets/liabilities for Colgate is a decrease of $ 26 in the net deferred tax asset.

Chapter 06 - Analyzing Operating Activities

Problem 6-7 (45 minutes) STEAD CORPORATION Year 4

Year 5

Year 6

$10,000 $10,000

$10,000

($ in thousands)

a. Income Statement Sales .............................................................. Expenses *..................................................... Income before tax .........................................

9,000

$ 1,000 $ 1,000 $

10,400 (400)

Tax expense: Current ** ...................................................

—

300

500

Deferred .....................................................

500

200

(700)

Total tax expense ......................................

500 $

(200)

Net income (loss) ..........................................

500 $

(200)

* Includes unusual expense of $1,400 in Year 6. **Taxable income (loss): Before loss carryforward ..................................... $ (400) $ 1,000 $ 1,000 After deducting loss carryforward ...................... — 600 — Tax due (at 50%) .................................................... — 300 500 Note: The timing difference regarding deferred preoperating costs is $1,400 in Year 4. However, only $1,000 of this amount results in a reduction of Year 4 taxable income (the remaining $400 becomes a loss carryforward and reduces taxable income in Year 5). The tax effect (at 50 percent) of these differences is $500 in Year 4 and $200 in Year 5. The entire timing difference reverses in Year 6.

b. Balance Sheet Current tax payable ...................................... Deferred tax payable.....................................

—

$ 300

$ 500

500

700

—

Chapter 06 - Analyzing Operating Activities

Problem 6-8 (30 minutes) 1. c ($6,500,000 net income / 2,500,000 shares = $2.60) 2. b Diluted EPS =

Adjusted net income wtd. avg. of + wtd. avg. number common stock of common shares outstanding issuable from options and convertibles

Since average market price of stock exceeds exercise price of options, the options are dilutive. Using treasury stock method for options we obtain: i. 200,000 shares × $15 = $3,000,000 proceeds ii. $3,000,000 / 20 average price = 150,000 shares purchased in open market Thus, 50,000 additional shares would be issued. Are the convertible bonds dilutive? No. Assuming conversion of bonds, 100,000 additional shares would be issued. The net income adjustment would be: Interest expense related to bonds ............................ $500,000 Less taxes .................................................................... (200,000) Increase in net income ............................................... $300,000 Consequently: EPS = ($6,500,000+$300,000)/(2,500,000+100,000) = $2.62 Diluted EPS = $6,500,000/(2,500,000+50,000) = $2.55

Problem 6-9 (40 minutes) a. Basic EPS Computations: Basic EPS = $4,000,000 / 3,000,000 shares = $1.33 Diluted EPS Computations: Since average market price of stock exceeds exercise price of options and warrants, the options and warrants are dilutive. Using treasury stock method: i. 1,000,000 shares × $15 = $15,000,000 proceeds ii. $15,000,000 / $20 = 750,000 shares purchased in open market Thus, 250,000 additional shares would be issued. Diluted EPS = $4,000,000 / 3,250,000 shares = $1.23 b. Basic EPS Computations: Basic EPS = $3,000,000 / 3,000,000 shares = $1.00 Diluted EPS Computations: Since average market price of stock exceeds exercise price of options and warrants, the options and warrants are dilutive. Using treasury stock method: i. 1,000,000 shares × $15 = $15,000,000 proceeds ii. $15,000,000 / $18 = 833,333 shares purchased in open market Thus, 166,667 additional shares would be issued. Diluted EPS = $3,000,000 / 3,166,667 shares = $0.95 6-42 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 06 - Analyzing Operating Activities

CASES Case 6-1 (70 minutes)

Determination of core income Income from continuing operations (a) Pre-tax adjustments: Inventory write-off Restructuring charge Goodwill impairment Loss on early extinguishment of debt Gain/loss from sale of business units Gain/loss from sale of marketable securities Unrealized gain/loss on trading securities Early retirement charge Total pre-tax adjustments Tax effects (35%) Total after-tax adjustments (b) Core Income (a + b) Determination of comprehensive income Net income Other comprehensive income: Foreign currency translation gains Unrealized gain (loss) on available for sale securities Postretirement benefit adjustment Comprehensive income

2011 451

2010 (155)

45 0 23 13 (80) (122) (11) 34 (98) 34 (64) 383

0 0 0 0 (55) 6 0 (49) 17 (32) 419

765 0 0 0 11 (2) 0 774 (271) 503 348

2012 548

2011 497

2010 (100)

23 23 173 767

4 (33) 345 812

55 (40) (433) (518)

Estimating sustainable income A good starting point for estimating sustainable income is core income. The problem with stopping with core inocme, however, is that an analyst could end up entirely excluding legitimate business expenses. Take the restructuring charge of $ 765 million taken in 2010. This charge is going to reduce labor costs, lease rentals and depreciation over at least the next five years. If we ignore this charge by adding it back to determine core income, we will be overestimating the sustainable income of this company. Accordingly, to determine sustainable income we start with core income and then make appropriate amortization for restructuring charge taken in 2010. We amortize 1/5 of $ 765 = $ 153 million per year on a pre-tax basis, which works out to $ 99 miilion on an after-tax basis (assuming 35% tax rate). Therefore, sustainable income estimates are as follows:

Core Income less After-tax amortization of restructuring charge Sustainable income estimate 4.

2012 447

2012 383 (99) 284

2011 419 (99) 320

2010 348 (99) 249

Estimating economic income Starting point for estimating economic income is comprehensive income. But we must also include 6-43

Chapter 06 - Analyzing Operating Activities

(exclude) those expenses that represent changes in shareholder value not included (do not represent changes in shareholder value that are included), in the following manner: 2012 2011 2010 (a) Comprehensive income 767 812 (518) Add Compensation Expense 23 25 22 Less Option grants (70) Add Unrealized gain on office property 44 29 (b) Total Pre-tax adjustment 67 54 (48) less tax portion (35%) (23) (19) 17 (c) Total after-tax adjustment 44 35 (31) Economic income estimate (a +c) 810 848 (550) Determining unrealized gain on office property Fair-market value Amortized cost Difference Change in difference

2012 285 112 173 44

2011 245 116 129 29

2010 220 120 100

NOTES: 1. The effects of discontinued operation are included in economic income computation. It is also fine to exclude them. 2.

In sustainable income the effects of expected returns of the office property and the marketable securities have not been considered because of lack of information. In reality, one would need to also consider this. It must be noted that sustainable income is different from operating income and therefore even non-operating items that are recurring in nature must considered.

The entire restructuring charge is included in year of charge for economic income. Alternatively, the amount actually incurred during the year can be used.

Chapter 06 - Analyzing Operating Activities

Case 6-2 (50 minutes) a. Balance Sheets and Income Statements with Alternative Revenue Recognition: Shipment

Production b

Collection

Balance Sheet Cash ...................................................... Receivables ........................................... Inventory, at cost .................................. Inventory, at market .............................. Total assets ...........................................

$1,670 1,800 700 -$4,170

$1,670 1,800 -900 $4,370

$1,670 1,800 -790c $4,260

Accrued shipping cost ......................... Accrued sales commission .................. Deferred income.................................... Invested capital ..................................... Retained earnings ................................. Total liabilities and equity ....................

-$ 180 -3,000 990 $4,170

-$ 180 180a 3,000 810 $4,170

-$ 180 -3,000 1,080 $4,260

Income Statement Sales ........................................... $9,900 Costs and expenses: Cost of goods sold ........................... Selling expense ................................. Shipping expense ............................. Net income ............................................

$8,100 $10,800 7,700 990 220 $ 990

20 270 -3,000 1,080 $4,370

$9,900

6,300 8,400 810 1,080 180 240 $ 810 $ 1,080

7,610d 990 220 $1,080

Notes: a. Deferred income: Sales is $1,800 less costs of ($1,400 + $180 + $40) = $180. b. Time of production: Figures can be reflected gross as in left column or net as in right column. c. Inventory, at net realizable value $790 = $900 less $20 less $90. d. Cost of goods sold is a "to-balance" figure based on inventory (for example, Beg. $0 plus purchases $8,400 less End. $790 = COGS $7,610).

Chapter 06 - Analyzing Operating Activities

Case 6-2—continued b. The installment method delays the reporting of revenues and thereby delays the time for payment of taxes. The time value of money is a major motivation for delaying cash payments for taxes. c. Balance Sheet: Some analysts prefer the installment method because it is more conservative. However, the installment method attempts to value receivables (less deferred income) at the historical cost of the inventory. It would appear that the credit analyst should be future-oriented and view receivables at the expected future cash inflow. Income Statement: Some analysts prefer the installment method because it is more conservative. However, this method has two critical weaknesses: (i) Revenues and profits are not recognized when performance (earning) occurs; instead, recognition is delayed until cash is collected. (ii) Selling costs are mismatched (this is most dramatic in a period of rapid growth or decline in sales). The installment method does not show economic reality. Case 6-3 (75 minutes) 1. BREAK-DOWN OF RESTRUCTURING AND OTHER CHARGES

Description

Classific ation

Charge PrePostTax Tax

Utilized Balance Pre-Tax Pre-Tax

Lease Commitments ............................ Restruc.

Severance/Closing Costs .................... Restruc.

PP&E Write-Down................................. Restruc.

155

Other...................................................... Restruc.

Total Restructuring ..............................

294

164

130

Change in acctg estimate/legal SG&A provision ...............................................

3rd party claims/FTC ............................. SG&A

TOTAL ............................................

353

279

184

169

Markdown-Clear Excess Inventory ..... CGS

253

179

266

Chapter 06 - Analyzing Operating Activities

Markdown-Store Closedowns ............. CGS

Inventory Systems Refine/Change CGS in estimates ..........................................

TOTAL ............................................

345

229

238

107

GRAND TOTAL .....................................

698

508

422

276

2. RECAST INCOME STATEMENT AFTER REMOVING CHARGE

1998 Reported $ %

Net Sales ..................................................................... 11170 100% 11170

100%

11038

100%

Cost of goods sold ..................................................... 8191 73.3%

7846

70.2%

7710

69.8%

Gross Profit ................................................................ 2979 26.7%

3324

29.8%

3328

30.2%

Selling, general & administrative .............................. 2443 21.9%

2384

21.3%

2231

20.2%

Depreciation ............................................................... 255 2.3%

255

2.3%

253

2.3%

Restructuring Charge ................................................ 294 2.6%

0.0%

Interest Expense less Income ................................... 93 0.8%

0.8%

0.7%

Earnings before tax .................................................... (106) -0.9%

592

5.3%

772

7.0%

Tax Provision .............................................................. 26 0.2%

216

1.9%

282

2.6%

Earnings after tax ....................................................... (132) -1.2%

376

3.4%

490

4.4%

Total Charge ...............................................................

508

4.5%

EAT after charge......................................................... (132) -1.2%

(132)

-1.2%

490

4.4%

Reported $ %

1999 Recast $

Cost of goods sold is increasing, resulting in decreasing gross profit. Selling, general and administrative expense and interest expense are also increasing, resulting in a decrease in earnings before tax and a 1% drop in net profit margin on sales.

Chapter 06 - Analyzing Operating Activities

Case 6-3—continued 3. Elements of Restructuring Plan and Expected Economic Effects

Element Store Closing

C3 PlanStore Reformatti ng etc

Consolidati on of distribution centers and admin offices Legal Contingenc ies TOTAL

Description Close 50 international and 9 Toys “R” Us stores that do not meet strategic profitability objectives Close 31 US Kids “R” Us stores and convert 28 nearby Toys “R” Us stores into combo stores

Cost Leases Severance etc PPE Write down Markdown Acctg change & legal settlements Total

81 29 155 29

Reformat stores, expand product lines Supply chain reengineering

Markdown Systems Refined Total

253 63 316

Consolidate distribution centers/warehou ses Consolidate 6 admin offices FTC related 3rd party claim

Other

3rd party claims

39 333

698

Expected Economic Effects Sales reduction $ 322 MM, operating loss saving $ 5 MM pa 2600 employees terminated ($ 100-150 MM pa saving) Closings: Eliminate loss making stores/focus on more profitable opportunities Combo Stores: Release working capital, lower operating costs, increase productivity $ 580 (24%) reduction in stores inventory Enhanced customer experience Higher productivity/lower inventory/lower cost/heightened flexibility Improve SG&A efficiencies Flatten management and increase customer responsiveness

Expected savings $ 97 MM pa

Chapter 06 - Analyzing Operating Activities

Case 6-3—continued 4. The restructuring liability can be purposefully overstated to create a hidden reserve. This hidden reserve can be used to manage earnings in at least two ways. First, the company can charge some operating expenses of future periods to the restructuring liability. Second, the company can reverse a portion of the charge to create net income in the period of the reversal. In the case of Toys R Us it is unlikely that it is managing its earnings. Using charges to manage earnings is a form of “classificatory earnings management” (see Chapter 2). However, by burying various elements of the charge in different line items the very purpose of the charge, i.e., inducing users to ignore the entire charge is lost. Therefore it is not likely that the purpose of the restructuring charge was earnings management. 5. The following adjustments would be made to the financial statements to recast the restructuring charge as an investment to create future cost savings. First, the charge is recorded as an asset and amortized over 10 years. Second, 20x8 income is increased by reversing the charge. Income in fiscal 20x9 and the next 10 years will then be reduced by a pro-rata amount of the “investment.” 6. The relative success of restructuring activities can and must be assessed. The company should report higher return on assets and higher return on equity. Also, the company should report substantially lower costs such as selling and administrative costs. These costs should also decrease as a percentage of sales.

Chapter 06 - Analyzing Operating Activities

Case 6-4 (60 minutes) a. Basic Earnings Per Share Computations: Basic EPS = $1,500,000 / 900,000 shares = $1.67 Diluted Earnings Per Share Computations: The warrants are dilutive since the average market price of common stock ($13) exceeds the exercise price of the warrants ($10). i. 900,000 shares x $10 = $9,000,000 proceeds ii. $9,000,000 / $13 = 692,307 shares purchased in open market Thus, 207,693 additional shares would be issued. “As if” EPS = $1,500,000/(900,000+207,693) = $1.35 Are the subordinated convertible debentures dilutive? Yes. Assuming conversion, a total of 500,000 ($9,000,000/$18) additional common shares would be issued at June 30, Year 1. The net income adjustment would be: Interest expense for debentures.................... $270,000 Less taxes ....................................................... (135,000) Increase in net income ................................... $135,000 “As if” EPS = ($1,500,000+$135,000)/(900,000+250,000) = $1.42 Consequently: Diluted EPS = ($1,500,000+$135,000)/(900,000+207,693+250,000) = $1.20

b. Interest expense (Year 2): Debentures ($9,000,000 x 6%) ........................... Term loan: ($3,000,000 x 7%)/2 ......................... ($2,500,000 x 7%)/2 ......................... Interest expense.................................................

$540,000 105,000 87,500 $732,500

Earnings before interest and taxes (Year 2): Net income ......................................................... Taxes (50%) ........................................................ Interest expense................................................. Earnings before interest and taxes ..................

$1,500,000 1,500,000 500,000 $3,000,000

Times interest earned = $3,500,000/$732,500 = 4.78

Chapter 06 - Analyzing Operating Activities

Case 6-5 (45 minutes) I. a. Basic EPS = [$285,000- ($2.40 x 10,000 shares)] / 90,000 shares = $2.90 b. Diluted EPS: Are the convertible bonds dilutive? Yes. Assuming conversion, the net income adjustment would be: Interest expense for debentures .................................... Less taxes ........................................................................ Increase in net income ....................................................

$80,000 (40,000) $40,000

“As if” EPS = ($285,000+$40,000)/(90,000+30,000) = $2.71 Is the convertible preferred dilutive? Yes. Assuming conversion: “As if” EPS = $285,000/(90,000+20,000) = $2.59 Diluted EPS = ($285,000+$40,000)/(90,000+30,000+20,000 shares) = $2.32 II. Computation of Basic Earnings Per Share: Weighted average shares outstanding during Year 6: January 1 ............................................ 10,000 sh. July 1................................................... 2,000 sh.

1 yr. 10,000 sh. 1/2 yr. 1,000 sh. 11,000 sh.

Basic EPS = ($10,000 - $1,000) / 11,000 shares = $0.82

Chapter 06 - Analyzing Operating Activities

Case 6-6A (60 minutes) Range

1 (i)

Weighted

Year-End Price

Average

In-the-

Overhang

Price

Money

# shares Outstanding

1.50 – $11.48

310,542

8.08

$ 11.57 – $18.14

311,566

14.65

$ 19.34 – $23.48

302,259

21.52

$ 23.78 – $27.55

300,998

26.32

$ 28.13 – $34.75

304,110

30.91

$ 35.36 – $53.80

314,372

42.35

$ 58.23 – $75.00

308,609

67.04

$ 80.09 – $113.25

359,849

98.03

$134.91 – $237.19

298,455

196.19

$242.09 – $267.99

146,994

259.98

Current Price= In-the-

Overhang

Money

60.92 54.35 47.48 42.68 38.09 26.65 1.96 -

18,918,219 16,933,612 14,351,257 12,846,595 11,583,550 8,378,014 604,874 0 0 0

81.92

25,439,601

75.35

23,476,498

68.48

20,698,696

63.68

19,167,553

59.09

17,969,860

47.65

14,979,826

22.96 -

7,085,663 -

TOTAL Overhang

2,957,754

$83,616,120

$128,817,696

Market Cap

55,398,615

$3,822,504,435

$4,985,875,350

2.19%

2.58%

Overhang %

The overhang is $ 83.62 million when using the year-end market prices. This constitutes about 2.2% of the market capitalization. 1 (ii)

A more accurate estimate of the overhang at the year-end market price is provided by the company in the footnote: $ 84.482 million. It is called the aggregate intrinsic value. Our estimate of $ 83.62 million is close, but not perfectly accurate because we use the price ranges that the company provides to compute the overhang, while the company has information on each individual option grants.

1 (iii)

1 (iv)

The “overhang” is not a liability, in the sense that it is not money owed by the company to outsiders. However, it represents a transfer of wealth from the current shareholders to prospective shareholders (employees) and so is a reduction in the wealth of current shareholders. However, one should not subtract the amount from the market capitalization because the stock market usually adjusts for this amount when pricing the company’s stock.

Chapter 06 - Analyzing Operating Activities

2 (i)

Netflix grants employee stock options with an exercise price equal to the market price on the date of the grant. These options vest immediately. Earlier options could be exercised upto within some period after leaving the company. The latest options could be exercised upto 10 years regardless of employment status. The cost to Netflix is that the ESO are options, which even though granted at market price have a value that is approximately determined by the Black-Scholes formula. This value arises because (1) future exercise is possible at current price (interest cost) and (2) downside protection is available if the stock were to lose value (option cost). Netflix grants employees stock under the ESPP at 85% of current market price. The cost to the company is that these shares are given at a discount of 15% to the current market price.

2 (ii) (a) Total post-tax stock-based comp (b) Net income after compensation expense (c) Net income before compensation expense

2010

2011

$16,835

$38,735

$160,853

$226,126

$177,688

$264,861

Compensation Exp as % of ( c ) 9.5% 14.6% It can be seen that compensation expense has increased substantially over time both in $ terms and a % of income. The reason for the sustained increase in the ESO expense over time is largely due to changes in the number of options granted and in the assumptions that determine option fair values at date of grant. Netflix granted 725k options in 2011, representing an increase of more than 30% over that granted in 2010. This increase in the number of options granted will increase expense recognized in 2011. In addition, the value of each options granted in 2011 is much higher probably because of higher stock price volatility in 2011. This increase in the implied volatility used to value options will increase the fair value of options at the grant date. Finally, lower employee turnover prior to the end of the option exercise period will increase stock option expense as more employees are expected to exercise vested options. To the extent that the poor job market in 2011 influenced more Netflix employees to stay at the company, option expense could increase. 2 (iii)

2 (iv)

The major assumptions underlying the option values are: (1) risk-free interest rate (2) expected dividend yield (3) return volatility and (4) expected "term", i.e., average years before employees exercise. The values of these assumptions and their justification is provided in teh note information.

2 (v)

The compensation expense from ESOs is a “real” cost to the current shareholders and this expense is permanent in nature both because it is an amortized amount (although for Netflix it is amortized within a year) and because companies grant options on an ongoing basis. Thus I would consider the option expense when determining the “real” income of the company for valuing the stock. However see answer to (5), for how credit and equity analysts should use this information.

Chapter 06 - Analyzing Operating Activities

3 (i)

Net income for 2011 = Basic EPS for 2011 = # shares used for EPS determination

$226,126

Option Overhang reported by Netflix Stcok Price at year-end # treasury shares that can be purchased

84,482

Diluted # shares (52833 + 1224) Diluted EPS

$4.28 52,833

$69 1,224.38 54057 4.183103

The diluted EPS reported Netflix is $ 4.16. The difference between our estimate and the reported number could be due to the following factors: (1) other diluted securities, such as convertible bonds; (2) the dilution is estimated using the average options outstanding and the average stock price the year while we used those at the year end. Indeed other note information in Netflix’s 10K reveals that both these factors played a role.

3 (ii)

We can approximately determine the “overhang” by using the following formula: Overhang = Basic EPS – Diluted EPS * Market Capitalization Diluted EPS = (4.28 - 4.16) * $ 3,822 million = $ 110.3 million 4.16 Our number is larger than the overhang we estimated using the detailed information on weighted average exercise prices. Note that this number gives us the total “overhang” from all potentially dilutive securities, not just options. As long as options constitute a major component the total dilutive securities we are fine. Use this method only if you don’t have footnote information.

Overall, no changes need be made to the balance sheet. The option overhang need not be reflected on the balance sheet because it only a transfer between the current and potential shareholders. It is not a liability to the company. However, an equity analyst has to be aware of the extent potential through employee stock options, i.e., the option overhang. For an equity analysis, in principle, no changes need be made to reported income. However, many equity analysts prefer first estimating the value of the company’s equity WITHOUT considering the option compensation expense. Once they figure out this value, they then divide that by the total number of outstanding shares (without considering dilution) to arrive at a per-share fundamental value of the company. Then they apply this per-share fundamental value (rather than the market price) to arrive at the value of the option overhang. The option overhang is subtracted from the estimated fundamental value of the company to arrive at the value of the current shareholder’s equity. Such an approach will provide a very different value to the company than using the company’s income AFTER option expense in an earnings-multiple estimation of equity value. 6-54

Chapter 06 - Analyzing Operating Activities

Options expense and option overhang are both irrelevant for credit analysis. This is because employee stock options transfer wealth from current shareholders to employees. Therefore creditors are not affected by this. However, if a company has a consistent policy of buying back its shares to prevent dilution, this must be kept track of by a credit analyst because it is equivalent to a dividend payment.

Chapter 07 - Cash Flow Analysis

Chapter 7 Cash Flow Analysis REVIEW Cash is the residual of cash inflows less cash outflows for all prior periods of a company. Net cash flows, or simply cash flows, refer to the current period's cash inflows less cash outflows. Cash flows are different from accrual measures of performance. Cash flow measures recognize inflows when cash is received not necessarily earned, and outflows when cash is paid not necessarily incurred. The statement of cash flows reports cash flow measures for three primary business activities: operating, investing, and financing. Operating cash flows, or cash flows from operations, is the cash basis counterpart to accrual net income. Information on cash flows helps us assess a company's ability to meet obligations, pay dividends, increase capacity, and raise financing. It also helps us assess the quality of earnings and the dependence of income on estimates and assumptions regarding future cash flows. This chapter describes cash flows and their relevance to our analysis of financial statements. We describe current reporting requirements and their implications for our analysis of cash flows. We explain useful analytical adjustments to cash flows using financial data to improve our analysis. We direct special attention to transaction reconstruction, T-account, and conversion analyses.

Chapter 07 - Cash Flow Analysis

OUTLINE •

Statement of Cash Flows Relevance of Cash Reporting by Activities Constructing the Cash Flow Statement Special Topics

•

Reporting Cash Flows from Operations Indirect Method Direct Method Converting from Indirect to Direct Method Adjustments to Cash Flow Components Additional Disclosures and Adjustments

•

Analysis Implications of Cash Flows Limitations in Cash Flow Reporting Interpreting Cash Flows and Net Income Alternative Cash Flow Measures Company and Economic Conditions Free Cash Flow Cash Flows as Validators

•

Specialized Cash Flow Ratios Cash Flow Adequacy Ratio Cash Reinvestment Ratio

•

Appendix 7A Analytical Cash Flow Worksheets

Chapter 07 - Cash Flow Analysis

ANALYSIS OBJECTIVES •

Explain the relevance of cash flows in analyzing business activities.

•

Describe reporting of cash flows by business activities.

•

Describe the preparation and analysis of the statement of cash flows.

•

Interpret cash flows from operating activities.

•

Analyze cash flows under alternative company and business conditions.

•

Describe alternative measures of cash flows and their usefulness.

•

Illustrate an analytical tool in evaluating cash flows (Appendix 7A).

Chapter 07 - Cash Flow Analysis

QUESTIONS 1. The term cash flow was probably first coined by analysts. They recognized that the accrual system of income measurement permits the introduction of a variety of alternative accounting treatments and consequent distortions. The crude concept of cash flow—net income plus major noncash expenses (such as depreciation)—was derived to bypass these distortions and bring income measurement closer to the discipline of actual cash flows. This cash flow measure, still a popular surrogate for cash from operations (CFO), is crude because it falls short of reliably approximating in most cases the correct measure of CFO. Confusion with the term cash flow derives from several sources. One source of confusion stems from the initial and incorrect computation of the crude measure of cash flow as income plus major noncash expenses. The figure fails to reflect actual cash flows. Another and more serious confusion arises from the assertion by some, and particularly by managers dissatisfied by the level of their reported net income, that cash flow is a measure of performance superior to or more valid than net income. This assertion implicitly assumes that depreciation, and other noncash costs, are not genuine expenses. Experience shows that only net income is properly regarded as a measure of performance and can be related to the equity investment as an indicator of operating performance. If we add back depreciation to net income and compute the resulting return on investment, we are, in effect, confusing the return on investment with an element of return on investment in fixed assets. 2. While fragmentary information on the sources and uses of cash can be obtained from comparative balance sheets and from income statements, a comprehensive picture of this important area of activity can be gained only from a statement of cash flows (SCF). The SCF provides information to help answer questions such as: • What amount of cash is generated by operations? • What utilization is made of cash provided by operations? • What is the source of cash invested in new plant and equipment? • What use is made of cash from a new bond issue or the issuance of common stock? • How is it possible to continue the regular dividend in the face of an operating loss? • How is debt repayment achieved? • What is the source of cash used to redeem the preferred stock? • How is the increase in investments financed? • Why, despite record profits, is the cash position lower than last year? 3.

SFAS 95 requires that the statement of cash flows classify cash receipts and cash payments by operating, financing and investing activities. Operating activities encompass all the earning-related activities of the enterprise. They encompass, in addition to all the income and expense items found on the income statement, all the net inflows and outflows of cash that operations impose on the enterprise. Such operations include activities such as the extension of credit to customers, investment in inventories, and obtaining credit from suppliers. This means operating activities relate to all items in the statement of income (with minor exceptions) as well as to balance sheet items that relate to operations mostly working capital accounts such as accounts receivable, inventories, prepayments, accounts payable, and 7-4

Chapter 07 - Cash Flow Analysis

accruals. SFAS 95 also specifies that operating activities include all transactions and events that are not of an investing or financing nature. Financing activities include obtaining resources from owners and providing them with a return of or a return on (dividends) their investment. They also include obtaining resources from creditors and repaying the amounts borrowed or otherwise settling the obligations. Investing activities include acquiring and selling or otherwise disposing of both securities that are not cash equivalents and productive assets that are expected to generate revenues over the long-term. They also include lending money and collecting on such loans. 4. We can distinguish among three categories of adjustments that convert accrual basis net income to cash from operations: (i) Expenses, losses, revenues, and gains that do not use or generate cash such as those involving noncash accounts (except those in ii), (ii) Net changes in noncash accounts (mostly in the operating working capital group) that relate to operations—these modify the accrual-based revenue and expense items included in income, (iii) Gains and losses (such as on sales of assets) that are transferred to other sections of the SCF so as to show the entire cash proceeds of the sale. 5. The two methods of reporting cash flow from operations are: Indirect Method: Under this method net income is adjusted for noncash items required to convert it to CFO. The advantage of this method is that it is a reconciliation that discloses the differences between net income and CFO. Some analysts estimate future cash flows by first estimating future income levels and then adjusting these for leads and lags between income and CFO (that is, noncash adjustments). Direct (or Inflow-Outflow) Method: This method lists the gross cash receipts and disbursements related to operations. Most respondents to the Exposure Draft that preceded SFAS 95 preferred this method because this presentation discloses the total amount of cash that flows into the enterprise and out of the enterprise due to operations. This gives analysts a better measure of the size of cash inflows and outflows over which management has some degree of discretion. As the risks that lenders are exposed to relate more to fluctuations in CFO than to fluctuations in net income, information on the amounts of operating cash receipts and payments is important in assessing the nature of those fluctuations. 6. The function of the income statement is to measure the profitability of the enterprise for a given period. This is done by matching expenses and losses with the revenues and gains earned. While no other statement measures profitability as well as the income statement, it does not show the timing of cash flows and the effect of operations on liquidity and solvency. The latter is reported on by the SCF. Cash from operations (CFO) reflects a broader concept of operations relative to net income. It encompasses all earning-related activities of the enterprise. CFO is concerned not only with expenses and revenues but also with the cash demands of these activities, such as investments in customer receivables and in inventories as well as the financing provided by suppliers of goods and services. CFO focuses on the liquidity aspect of operations and is not a measure of profitability because it does not include important costs such as the use of long-lived assets in operations or important revenues such as the equity in the earnings of nonconsolidated subsidiaries or affiliates. 7-5 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 07 - Cash Flow Analysis

7. The SCF sheds light on (i) the effects of earning activities on cash resources, (ii) what assets are acquired, and (iii) how assets are financed. It also can highlight more clearly the distinction between net income and cash provided by operations. The ability of an enterprise to generate cash from operations on a consistent basis is an important indicator of financial health. No business can survive over the long run without generating cash from its operations. However, the interpretation of CFO figures and trends must be made with care and with a full understanding of all surrounding circumstances. Prosperous as well as failing entities can find themselves unable to generate cash from operations at any given time, but for different reasons. The entity caught in the "prosperity squeeze" of having to invest its cash in receivables and inventories to meet ever-increasing customer demand will often find that its profitability will facilitate financing by equity as well as by debt. That same profitability should ultimately turn CFO into a positive figure. The unsuccessful firm, on the other hand, will find its cash drained by slowdowns in receivable and inventory turnovers, by operating losses, or by a combination of these factors. These conditions usually contain the seeds of further losses and cash drains and also can lead to difficulties in obtaining trade credit. In such cases, a lack of CFO has different implications. The unsuccessful or financially pressed firm can increase its CFO by reducing accounts receivable and inventories, but usually this is done at the expense of services to customers that can further depress future profitability. Even if the unsuccessful firm manages to borrow, the costs of borrowing only magnify the ultimate drains of its cash. Thus, profitability is a key consideration, and while it does not insure CFO in the short run, it is essential to a healthy financial condition in the long run. Changes in operating working capital items must be similarly interpreted in light of attending circumstances. An increase in receivables can mean expanding consumer demand for enterprise products or it can mean an inability to collect amounts due in a timely fashion. Similarly, an increase in inventories (and particularly of the raw material component) can imply preparations for an increase in production in response to consumer demand. It also can imply (particularly if the finished goods component of inventories is increasing) an inability to sell due to, say, when anticipated demand did not materialize. 8. A valuable analytical derivative of the SCF is "free cash flow." As with any other analytical measure, analysts must pay careful attention to components of this computation. Here, as in the case of any cash flow measures, ulterior motives may sometimes affect the validity of the computation. One of the analytically most useful computations of free cash flow is: Cash from Operations (CFO) - Capital expenditures required to maintain productive capacity used in generating income - Dividends (on preferred stock and maintenance of desired payout on common stock) = Free Cash Flow (FCF)

Chapter 07 - Cash Flow Analysis

Positive FCF implies that this is the amount available for company purposes after provisions for financing outlays and expenditures to maintain productive capacity at current levels. Internal growth and financial flexibility depend on an adequate amount of FCF. Note that the amount of capital expenditures needed to maintain productive capacity at current levels is generally not disclosed by companies. It is included in total capital expenditures, which also can include outlays for expansion of productive capacity. Breaking down capital expenditures between these two components is difficult. The FASB considered this issue, but in SFAS 95 it decided not to require classification of investment expenditures into maintenance and expansion categories.

9. For financial statement analysis, the SCF provides clues to important matters such as:

• • • • • • • •

Feasibility of financing capital expenditures and possible sources of such financing. Sources of cash to finance an expansion in the business. Dependence of the firm on external sources of financing (such as debt or equity). Future dividend policies. Ability to meet future debt service requirements. Financial flexibility, that is, the firm's ability to generate sufficient cash so as to respond to unanticipated needs and opportunities. Insight into the financial habits of management and indications of future policies. Signals regarding the quality of earnings.

Chapter 07 - Cash Flow Analysis

EXERCISES Exercise 7-1 (20 minutes) The Year 11 CFO of Campbell is higher (by $403.7 million) than its Year 11 net income for two main reasons: 1. Some items decreased net income but did not use cash—specifically: a. Depreciation and amortization are expenses not requiring a cash outlay ($208.6). b. Deferred income taxes are an expense that has no present cash payment ($35.5). c. Several charges and expenses did not require outlays of cash ($63.2). d. A decrease in inventory implies that cost of sales are charged by reducing inventory levels rather than by making cash payments of $48.7. 2. Some items generated operating cash inflow did not enter into the determination of net income—specifically: a. The decrease in accounts receivable means that cash is collected beyond the amounts recognized as sales revenue in the income statement ($17.1). b. There are several other items that had a similar effect, amounting to $30.6.

Exercise 7-2 (40 minutes) a. SFAS 95 requires that the SCF classify cash receipts and payments by operating, financing, and investing activities. (1) Operating activities encompass all the earning-related activities of the enterprise. They encompass, in addition to all the income and expense items found on the income statement, all the net inflows and outflows of cash that operations impose on the enterprise. Such operations include activities such as the extension of credit to customers, investment in inventories, and obtaining credit from suppliers. This means operating activities relate to all items in the statement of income (with minor exceptions) as well as to balance sheet items that relate to operations mostly working capital accounts such as accounts receivable, inventories, prepayments, accounts payable, and accruals. SFAS 95 also specifies that operating activities include all transactions and events that are not of an investing or financing nature. (2) Financing activities include obtaining resources from owners and providing them with a return of or a return on (dividends) their investment. They also include obtaining resources from creditors and repaying the amounts borrowed or otherwise settling the obligations. (3) Investing activities include acquiring and selling or otherwise disposing of both securities that are not cash equivalents and productive assets that are expected to generate revenues over the long-term. They also include lending money and collecting on such loans. 7-8 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 07 - Cash Flow Analysis

Exercise 7-2—concluded b. SFAS 95 requires that all significant financing and investing activities be disclosed. For example, noncash transactions that include the conversion of debt to equity, the acquisition of assets through the issuance of debt, and exchanges of assets or liabilities, should be disclosed in a separate schedule of noncash investing and financing activities. c. (1) Net income is the starting point of the computation of CFO. SFAS 95 does not require the separate disclosure of extraordinary items in the SCF. (2) Depreciation is added back as an expense not requiring cash. (3) The write-off of uncollectible receivables does not affect cash. Similarly, the bad debt expense does not require an outlay of cash. Since this corporation uses the indirect method for presentation of CFO, no additional adjustment is needed beyond the adjustment for the change in the net accounts receivable, which includes the credit to the allowance for doubtful accounts. (4) The $140,000 increase in accounts receivable means that some sales have not been collected in cash and, accordingly, net income is reduced by $140,000 in arriving at CFO. The $60,000 decline in inventories means that cost of goods sold includes inventories paid for in prior years, and did not require cash this year. As such, net income is increased by $60,000 in arriving at CFO. (5) This $380,000 is an expense requiring cash—no adjustment is called for. This amount also must be disclosed as part of the supplemental disclosures. (6) A reconstructed analytical entry would appear as: Cash .............................................. 30,000 Accumulated Depreciation ......... 50,000 PPE .......................................... 75,000 Gain on sale of machine ........ 5,000 The $30,000 increase in cash is shown as a source from investing activities. The $5,000 gain is deducted from (removed from) net income so that the entire proceeds of the sale are shown as part of investment activities. (7) Only the cash payment of $100,000 is shown in the SCF as an investing activity outflow. In a separate schedule, the purchase of buildings and land for noncash considerations is detailed. (8) This is a noncash transaction that is disclosed in a separate schedule of noncash investing and financing activities. (9) The declaration of a cash dividend creates a current liability. During Year 8, no cash outflow occurs and there is nothing to report on the Year 8 SCF. (10) This event has no effect on cash nor need it be reported in conjunction with the SCF.

Chapter 07 - Cash Flow Analysis

Exercise 7-3 (30 minutes) a. Cash Flows from Operations Computation: Net income .................................................................. Add (deduct) items to convert to cash basis: Depreciation, depletion, and amortization............ Deferred income taxes ........................................... Amortization of bond discount .............................. Increase in accounts payable ................................ Decrease in inventories.......................................... Undistributed earnings of unconsolidated subsidiaries and affiliates ..................................... Amortization of premium on bonds payable ........ Increase in accounts receivable ............................ Cash provided by operations ....................................

$10,000 $8,000 400 50 1,200 850

(200) (60) (900)

10,500 $20,500

(1,160) $19,340

b. (1) The issuance of treasury stock for employee stock plans (as compensation) requires an addback to net income because it is an expense not using cash. (2) The cash outflow for interest is not included in expense and must be included as cash outflow in investing activities (as part of outlays for property.) (3) If the difference between pension expense and actual funding is an accrued liability, the unpaid portion must be added back to income as an expense not requiring cash. If the amount funded exceeds pension expense, then net income must be reduced by that excess amount.

Chapter 07 - Cash Flow Analysis

Exercise 7-4 (30 minutes) a. Beginning balance of accounts receivable ........ Net sales ................................................................ Total potential receipts ......................................... Ending balance of accounts receivable .............. Cash collected from sales ....................................

$ 305,000 1,937,000 $2,242,000 - 295,000 $1,947,000

b. Ending balance of inventory ................................ Cost of sales.......................................................... Total ....................................................................... Beginning balance of inventory........................... Purchases ..............................................................

$ 549,000 +1,150,000 $1,699,000 - 431,000 $1,268,000

Beginning balance of accounts payable ............. Purchases (from above) ....................................... Total potential payments ...................................... Ending balance of accounts payable .................. Cash payments for accounts payable.................

$ 563,000 1,268,000 $1,831,000 - 604,000 $1,227,000

c. Issuance of common stock .................................. Issuance of treasury stock ................................... Total nonoperating cash receipts........................

d. Increase in land ..................................................... Increase in plant and equipment ......................... Total payments for noncurrent assets ................

$ 150,000 18,000 $ 168,000

81,000 17,000 98,000

Exercise 7-5 (20 minutes) Source a. b. c. d. e. f. g. h. i. j.

Use X X

Adjustment X

X X X X X X

Category O F F I F NCN I NCS F O

Chapter 07 - Cash Flow Analysis

Exercise 7-6 (20 minutes) Source a. X b. c. d. e. f. g. X h. i. j.

Use

Adjustment X

X X

Category O F NCN I NCS NCN I NCS NE NE

Exercise 7-7 (30 minutes)

1. 2. 3. 4a. 4b. 4c. 5. 6. 7. 8. 9. 10. 11. 12. 13.

Net Income NE NE + NE(1) NE + +(3) NE + NE NE

Cash from operations NE NE + NE +(2) +(2) + + (long-run -) -(5) NE +(4) + + NE NE

Cash position + + + NE +(2) +(2) + + (long-run -) + NE +(4) + + + +

(1)

Deferred tax accounting. Depends on whether tax savings are realized in cash. (3) If profitable. (4) If accounts receivable collected. (5) Depends on whether interest is paid or accrued. (2)

Further explanations (listed by proposal number): 1. Substituting payment in stock for payment in cash for its dividends will not affect income or CFO but will increase cash position. 2. In the short run, postponement of capital expenditures will save cash but have no effect on income or CFO. In the long term, both income and CFO may suffer due to lower operating efficiency.

Chapter 07 - Cash Flow Analysis

Exercise 7-7—continued 3. Cash not spent on repair and maintenance will increase all three measures. However, the skimping on necessary discretionary costs will adversely impact future operating efficiency and, hence, profitability. 4. Managers advocating an increase in depreciation may have spoken in the mistaken belief that depreciation is a source of cash and that consequently increasing it would result in a higher cash inflow. In fact, the level of depreciation expense has no effect on cash flow—the same amount of depreciation deducted in arriving at net income is added back in arriving at CFO. On the other hand, increasing depreciation for tax purposes will in all cases result in at least a short-term savings. 5. Quicker collections will not affect income but will increase CFO because of lower accounts receivable. Cash will also increase by the speedier conversion of receivables into cash. In the longer run this stiffening in the terms of sale to customers may result in sales lost to competition. 6. Payments stretched-out will lower income because of lost discounts but does positively affect CFO by increasing the level of accounts payable. Cash conservation will result in a higher cash position. Relations with suppliers may be affected adversely. Note: Long-term cash outflow will be higher because of the lost discount. 7. Borrowing will result in interest costs that will decrease income and CFO. Cash position will increase. 8. This change in depreciation method will increase income in the early stages of an asset's life. The opposite may hold true in the later stages of the asset's life. 9. In the short term, higher sales to dealers will result in higher profits (assuming we sell above costs) and, if they pay promptly, both CFO and cash will increase. However, unless the dealers are able to sell to consumers, such sales will be made at the expense of future sales. 10. This will lead to less income from pension assets in the future which could cause future pension expense to increase. 11. The cost of funding inventory will be reduced in the future. In the current period net income may also be increased by a LIFO liquidation from reduced inventory levels. 12. The current period decline in the value of the trading securities has been reflected in current period income, as has the previous gain. Although the sale will increase cash, it will have no effect on current period income. If the current period decline is deemed to be temporary, the company is selling a potentially profitable security for a short-term cash gain. 13. Reissuance of treasury shares will increase cash, but will have no effect on current period income as any “gain” or “loss” is reflected in additional paid in capital, not income. If the stock price is considered to be temporarily depressed, the company is foregoing a future sale at a greater market price and is, thus, suffering current dilution of shareholder value.

Chapter 07 - Cash Flow Analysis

Exercise 7-8 (20 minutes) a. Depreciation is neither a source nor a use of cash. Instead, depreciation is an allocation of the cost of an asset over its useful life. b. A major cause of the belief that depreciation is a source of cash is the "add back" presentation in the SCF prepared using the indirect format. This presentation adds depreciation to net income and gives the erroneous impression that it increases cash from operations. c. There is one sense in which depreciation is a source of cash, and for this reason we must not overemphasize the idea that depreciation is not a source of cash. Namely, when selling prices are sufficient to recover the depreciation expense allocated to products sold, then revenues do provide management with a discretionary, even if temporary, inflow of cash (assuming no significant change in operating working capital). Normally, management will have to invest this cash in fixed assets replacements to continue in business on a long-term basis. However, in the event of a financial crisis or cash shortfall, management has the option of diverting such cash to uses that will avert a liquidity crisis. This is the one exception that may allow one to regard depreciation as a temporary “source of cash.”

Chapter 07 - Cash Flow Analysis

Exercise 7-9 (60 minutes) a. Cash Collections Computation: Accounts Receivable (Net) Beg [a] Sales [13]

564.1 6205.8 6145.4

End [33]

624.5

Cash collections [b]

Notes: [a] Balance at 7/29/Year 10 ............................................ Less: increase in Year 10 .........................................

$624.5 [33] (60.4) [61] $564.1 [b]This amount is overstated by the provision for doubtful accounts expense that is included in another expense category.

b. Cash Dividends Paid Computation: Dividends Payable Dividend paid [77]

137.5

32.3

Beg [43]

142.2

Dividend declared [a] [89]

37.0

End [43]

Note [a]: Item [89] represents dividends declared, not dividends paid (see also Item [77]).

Cost of Goods and Services Produced Computation: Inventories

Beg [34]

819.8

Amount to balance

3982.4

End [34]

706.7

4095.5

Cost of products sold [14]

d. The entry for the income tax provision for Year 11 is: Income tax expense [27] ...................................... 265.9 Deferred income tax (current) plug .................. 12.1 Income tax payable ............................................. 230.4 Deferred income tax (noncurrent) [a] ............... 23.4 Notes: (1) The entry increases current liabilities by $12.1 since deferred income tax (current) is credited by this amount. It also increases current liabilities by $230.4 [124A], the amount of income taxes payable. (2) The [a] is the difference in the balance of the noncurrent deferred income tax item [176] = $258.5 - $235.1 = $23.4. (3) Also, $23.4 + $12.1 = $35.5, which is total deferred tax [59] or [127A]

Chapter 07 - Cash Flow Analysis

Exercise 7-9—continued e. Depreciation expense has no effect on cash from operations. The credit, when recording the depreciation expense, goes to accumulated depreciation, a noncash account. f. These provisions are added back because they affect only noncash accounts, the charge to earnings must be removed in converting it to the cash basis. g. The “Effect of exchange rate changes on cash” represents translation adjustments (differences) arising from the translation of cash from foreign currencies to the U.S. dollar. h. Any gain or loss is reported under "other, net"—Item [60]. i. Free cash flows = Cash flow from operations – Cash used for capital additions – Dividends paid Year 11: $805.2 – $361.1 – $137.5 = $306.6 Year 10: $448.4 – $387.6 – $124.3 = $(63.5) Year 9: $357.3 – $284.1 – $86.7 = $(13.5) j. Start-up companies usually have greater capital addition requirements and lower cash inflows from operations. Also, start-ups rarely pay cash dividends. Free cash flow earned by start-up companies is usually used to fund the growth of the company, especially if successful. k. During the launch of a new product line, the statement of cash flows can be affected in several ways. First, cash flow from operations is lower because substantial advertising and promotion is required and sales growth has not yet been maximized. Second, substantial capital additions are usually necessary to provide the infrastructure for the new product line. Third, cash flow from financing can be affected if financing is obtained to launch this new product line.

Chapter 07 - Cash Flow Analysis

Exercise 7-10 (15 minutes) a. Revenues are, in certain instances, recognized before cash is received (that is, when earned). Expenses are, in certain instances, recognized after cash is paid (that is, matched with revenues). As a result, net income can be positive when operating cash flows are negative. Consider some examples: (1) If accounts receivable increase substantially during the year, this implies that revenues outpaced cash collections. (2) If a company builds up its inventory levels substantially, then cash is paid out but no expense is recognized. (3) If the company reduces its accounts payable balances substantially during the year, then cash flows can be negative when net income is positive. b. Operating cash flows can serve as one indicator of earnings quality because over a number of years, cash flows should approximate earnings. If cash flows from operations are consistently lower than earnings, it is possible that the reported earnings are not of high quality. (As with any broad guideline, one must look for corroborating evidence.)

Exercise 7-11 (15 minutes) a. During the growth stage, a company invests heavily in infrastructure growth and into advertising and promotion. As the company transitions into the “cash cow” stage, the company reduces the investment in both infrastructure growth and advertising and promotional activities. This transition would be manifested in the statement of cash flows by increased operating cash flows (less cash outflows for advertising and promotion, higher margins, so forth) and decreased use of cash for investing activities. b. The decline of a “cash cow” would be reflected in the statement of cash flows by declining cash flows from operations. The declining operating cash flows will result from declining sales of the fading “cash cow” products.

Chapter 07 - Cash Flow Analysis

PROBLEMS Problem 7-1 (60 minutes) WORKSHEET TO COMPUTE CASH FLOW FROM OPERATIONS (IN MILLIONS) DIRECT (INFLOW-OUTFLOW) PRESENTATION CAMPBELL SOUP — YEAR ENDED JULY 28, YEAR 11 Ref. Cash Receipts from Operations Net Sales ........................................................... 13 Other revenue and income ............................. 19 (I) D in current receivables ............................. 61 (I) D in noncurrent receivables ....................... = CASH COLLECTIONS ................................. Cash Disbursements for Operations Total expenses (include min. int. & taxes) a Less: Expenses & losses not using cash: - Depreciation and amortization ..................... - Noncurrent deferred income taxes .............. - Other, net ........................................................

Reported

Adjust.

Revised

$6,204.1 26.0 17.1

$7.5 C C

$6,211.6 26.0 17.1

$6,247.2

$7.5

$6,254.7

$5,831.0

$7.5

$5,838.5

57 59 60

(208.6) (35.5) (63.2)

Change in Current Assets and Liabilities related to Operations I (D) in inventories ......................................... 62 I (D) in prepaid expenses .............................. 35 (I) D in accounts payable .............................. 41 (I) D in taxes payable ..................................... 44 (I) D in accruals, payrolls, etc. b ................... 175 I or D in noncurrent accounts c .................... = CASH DISBURSEMENTS .............................

$ (48.7) (25.3) 42.8 (21.3) (26.8) 5.8 $5,450.2

$ (48.7) (25.3) 42.8 (21.3) (26.8) 5.8 $5,457.7

Dividends Received Equity in income of unconsolidated affiliates............................... 24 Distributions beyond equity in income of affiliates c .................................. = Dividends from unconsol. affiliates ........... 169A CASH FLOW FROM OPERATIONS ...............

0.0 $7.5

2.4 5.8 $ 8.2 $ 805.2

2.4 0.0 $0.0 $0.0

5.8 $ 8.2 $ 805.2

Total costs and expenses [22A] + Taxes on earnings [27] + Minority interests [25] + Interest income [19] = $5,531.9 + $265.9 + $7.2 + $26.0 = $5,831 b It is assumed that accruals, payrolls, etc., are part of item [175]. c A reconciling amount to tie in with the $8.2 dividends from affiliates (item 169A) versus equity in earnings of affiliates (item 24).

Chapter 07 - Cash Flow Analysis

Problem 7-2 (75 minutes) a. WORKSHEET TO COMPUTE CASH FLOW FROM OPERATIONS (IN MILLIONS) DIRECT (INFLOW-OUTFLOW) PRESENTATION CAMPBELL SOUP YEAR ENDED JULY 29, YEAR 10 Ref. Cash Receipts from Operations Net Sales ........................................................... Other revenue and income: (I) D in current receivables ............................. (I) D in noncurrent receivables Effect of translation adjustments ............... = Cash Collections ........................................... Cash Disbursements for Operations Total expenses (include interest & taxes) [22A] + [27] + [25] ............................... Less: Expenses & Losses not using cash - Depreciation & amortization ......................... - Noncurrent deferred income taxes .............. - Other provision for restructuring and writedowns .............................................. - Other * ............................................................. - Other Changes in Current Assets and Liabilities related to operations I (D) in inventories ......................................... I (D) in prepaid expense ................................ (I) D in accounts payable .............................. (I) D in taxes payable ..................................... (I) D in accruals, payrolls, etc. ...................... (I) D in dividends payable ............................. I or D other ** .................................................. I or D in noncurrent amounts ....................... = Cash Disbursements .............................

Reported

Adjust.

Revised

$6,205.8

$7.5

$6,213.3

(60.4)

0.0 $6,145.4

0.0 $7.5

0.0 $6,152.9

$6,214.9

$7.5

$6,222.4

57 59

(200.9) (3.9)

58 60

(339.1) (24.7)

(10.7)

68.8 0.0 $5,704.4

Dividends Received Equity in income of unconsolidated affiliates ........................................................... 24 - Undistributed equity in income of affiliates ........................................................... 169A = Dividends from unconsol. affils. ................. Cash Flow From Operations ........................... *

(60.4)

0.0 $7.5

68.8 0.0 $5,711.9

13.5 (6.1) 7.4 $ 448.4

13.5 0.0

(6.1) 7.4 $ 448.4

Other, net [60] $18.6 + [169A] $6.1 = $24.7 Campbell shows a combined figure instead of details of operating assets and liabilities.

Chapter 07 - Cash Flow Analysis

Problem 7-3 (75 minutes) a. Zett Company Statement of Cash Flows For the Year Ended December 31, Year 2 Cash flows from operating activities Net Income ............................................................ $7,000 Add (deduct) items to convert to cash basis Depreciation ..................................................... 5,000 Loss on sale of fixed assets ............................ 1,000 Gain on sale of investment .............................. (3,000) Decrease in inventory ...................................... 2,000 Increase in receivables .................................... (5,000) Decrease in accounts payables ...................... (7,000) Net cash provided from operating activities Cash flows from investing activities Sale of fixed assets .............................................. Sale of investments.............................................. Purchase of fixed assets ..................................... Net cash provided from investing activities Cash flows from financing activities Sale of unissued common stock......................... Purchase of treasury stock ................................. Net cash used by financing activities................. Net Increase in cash.............................................

Supplemental disclosure of Cash Flow information Cash paid during the year for: Interest ................................................................................ Income taxes ...................................................................... Schedule of noncash investing and financing activities: Acquisition of fixed assets by issue of bonds ..................... Conversion of bonds into common stock .............................

6,000 9,000 (4,000) 11,000

1,000 (11,500) (10,500) 500

4,000 6,000 30,000 10,000

Chapter 07 - Cash Flow Analysis

Problem 7-3—continued b. Zett Company Comparison of Accrual and Cash Reporting Income Statement Cash from operations Sales ..........................................

$70,000

$65,000

Gain on sale of investments ....

3,000

(a)

$73,000

$65,000

Purchases .................................

(40,000)

(47,000)

Decrease in inventory ..............

(2,000)

—

Depreciation .............................

(5,000)

(c)

Expenses paid ..........................

(18,000)

Loss on sale of fixed assets ....

(1,000)

(d)

Net income ................................

$ 7,000

Cash from operations ..............

Collection from customers

Payments to suppliers (b)

Notes: (a) Omitted because it is linked with proceeds from sale of investments (investing activities). (b) Purchase of $40,000 + Decrease in accounts payable of $7,000. (c) No cash required. (d) Linked with sales of fixed assets (investing activities).

c. The income statement prepared on the accrual basis is designed to reflect profitability. Cash from operations measures the effects on cash of operating activities, and is best for liquidity and solvency analyses.

Chapter 07 - Cash Flow Analysis

Problem 7-4 (75 minutes) a. Dax Corporation Statement of Cash Flows For the Year Ended December 31, Year 2 ($ thousands) Cash provided from (used for) operations Net Income ...................................................................... Add (deduct) items to convert to cash basis: Amortization .............................................................. Depreciation .............................................................. Inc. in accounts payable .......................................... Inc. in deferred income tax ...................................... Inc. in other current liabilities .................................. Inc. in accounts receivable ...................................... Inc. in inventories ..................................................... Inc. in prepaid expenses .......................................... Net cash used for operations ........................................ Cash provided from (used for) investing activities Purchase of patents ....................................................... Addition to plant and equipment .................................. Addition to other assets ................................................ Net cash used for investing activities .......................... Cash provided from (used for) financing activities Addition to long-term debt ............................................ Issuance of common stock ........................................... Dividends paid .............................................................. Net cash provided from financing activities ................ Net decrease in cash...................................................... Supplemental disclosure of cash flow information Cash paid during year for: Interest ................................................. Income taxes .......................................

$160 10 95 30 12 7 (310) (145) (25) $(166)

(140) (700) (25) (865)

800 200 (109) 891 $(140)

$28,000 $70,000

Chapter 07 - Cash Flow Analysis

Problem 7-4—continued b. The major reasons for the difference between net income of $160 and cash outflow for operations of $166 are the heavy investments in inventories of $145 and the increased level of financing of customers evidenced by a $310 higher receivables balance. Compared to these heavy investments in operating assets, accounts payable have increased very modestly. With rising sales and profits, the company is experiencing a prosperity squeeze. c. This situation must be addressed before the liquidity problem becomes more serious. The following actions are reasonable recommendations: 1. The larger volume of purchases justifies increased trade credit. The resulting expansion of accounts payable would increase cash from operations. 2. The company needs a larger equity capital base. With increasing profits and with the company being in a growth industry this may be a good time to sell stock without diluting earnings per share. 3. Issuance of equity will form a good base for further borrowing should business continue to expand rapidly. 4. After additional equity capital has been obtained the company should consider lowering the dividend payout. For a fast growing and profitable company such as Dax, a dividend payout ratio of 68% ($109/$160) is quite high. Given its current profit opportunities, more earnings should be retained in the business.

Chapter 07 - Cash Flow Analysis

Problem 7-5 (40 minutes) Niagara Company Statement of Cash Flows For Year Ended December 31, Year 9 Cash flows from operating activities Cash receipts from operations Sales [a] ................................................................... $980 Cash payments for operations Purchases of inventory [b] ..................................... (645) Selling and general expenses ............................... (100) Interest expense [c] ................................................ (40) Income tax expense [d] .......................................... (30) Cash flows from operations ........................................

$165

Cash flows from investing activities Purchase of fixed assets ........................................

(150)

Cash flows from financing activities Repayment of notes payable ................................. Issuance of long-term debt .................................... Cash dividends paid ............................................... Cash flows used in financing ...................................... Net increase in cash.....................................................

(25) 50 (30) (5) $ 10

Beginning cash balance .............................................. Ending cash balance.................................................... Notes: [a] Sales ................................................................................ Less increase in receivables ......................................... Cash collections ............................................................. [b] Cost of goods sold ......................................................... Add increase in inventories ........................................... Less increase in payables .............................................

50 $ 60

$1,000 (20) $980 $ (650) (20) 25 (645)

[c] Interest expense ............................................................. Less increase in interest payable .................................

(50) 10

[d] Income tax expense ....................................................... Less increase in deferred income tax ..........................

(40) 10

(40) (30) Note: Purchase of fixed assets is computed from depreciation expense plus change in fixed assets ($100+$50). Dividends paid is computed from net income and change in retained earnings ($60-$30). Supporting schedule for CFO: Net income ..................................................................................................... $ 60 Add depreciation ........................................................................................... 100 Increase in deferred tax ................................................................................ 10 Increase in receivables ................................................................................. (20) Increase in inventory ..................................................................................... (20) Increase in accounts payable ....................................................................... 25 Increase in interest payable ......................................................................... 10 Cash flows from operations ......................................................................... $165

Chapter 07 - Cash Flow Analysis

Problem 7-6 (35 minutes) Effects

Analytical Entries (Optional)

a. [-Y, 11,000] [CC, 11,000]

Bad Debt Expense ........................ Allowance for Bad Debt .........

11,000

b. [-Y, 16,000] [YA, 16,000]

Depreciation .................................. Accumulated Depreciation ....

16,000

c. [NAA, 100,000] [NDE, 100,000]

Building ......................................... Long-Term Note Payable .......

100,000

f. [+C, 10,000] [-Y, 2,000] [CC, 12,000]

Cash ............................................... Loss ............................................... Inventory .................................

10,000 2,000

g. [+C, 35,000] [DC, 5,000] [CC, 25,000] [+Y, 15,000]

Cash ............................................... Accounts Receivable .................... Inventory ................................. Gain..........................................

35,000 5,000

h. [CC, 3,000] [-Y, 3,000]

Allowance ...................................... Bad Debt Expense ........................ Accounts Receivable ..............

5,000 3,000

i. [AA, 100,000] [-C, 100,000] [-Y, 20,000] [YA, 20,000]

Assets ............................................ Cash ......................................... Depreciation expense ................... Accumulated Depreciation ....

100,000

j. [+C, 8,000] [AD, 8,000] [YA, 1,000] [-Y, 1,000]

Cash ............................................... Loss on Sale .................................. Machinery (net) .......................

8,000 1,000

11,000

16,000

100,000

d. None e. None

12,000

25,000 15,000

8,000

100,000 20,000 20,000

9,000

Chapter 07 - Cash Flow Analysis

Problem 7-7 (60 minutes) Part I. Effects a. [DL, 100,000] [-C, 100,000]

Analytical Entries (Optional) Current Portion of L-T Debt.......... Cash .........................................

b. [+C, 4,000] [AD, 4,000] [YA, 1,000] [-Y, 1,000]

Cash ............................................... Loss ............................................... Equipment ...............................

4,000 1,000

c. [-Y, 75,000] [CC, 75,000]

Loss ............................................... Inventory .................................

75,000

d. [+C, 28,000] [DE, 28,000]

Cash ............................................... Paid-In Capital ............................... Treasury stock ........................

28,000 2,000

e. [NAA, 300,000] [NDE, 300,000]

Plant Assets .................................. Mortgage Payable ................... Mortgage Payable—Current...

300,000

f. [+C, 6,000] [+Y, 30,000] [YS, 24,000]

Investment ..................................... Equity in NI of Subsidiary ...... Cash ............................................... Investment

30,000

g. [+C, 10,000] [+Y, 40,000] [DC, 10,000] [NC, 20,000]

Cash ............................................... Accounts Receivable, current...... Accounts Receivable, noncurrent Sales ........................................

10,000 10,000 20,000

h. [DC, 9,000] [+Y, 9,000]

Inventory ........................................ Cost of Goods Sold ................

9,000

i. [DC, 260,000] [CC, 160,000] [DE, 410,000] [-C, 360,000]

Current Assets .............................. Plant and Equipment .................... Current Liabilities. .................. Long-Term Debt ...................... Cash ($400-$40) ......................

260,000 670,000

j. [-Y, 60,000] [CC, 60,000]

Expense ......................................... 60,000 Allowance for doubtful accounts

100,000 100,000

5,000

75,000

30,000

250,000 50,000

30,000 6,000 6,000

40,000

9,000

160,000 410,000 360,000

60,000

Chapter 07 - Cash Flow Analysis

Problem 7-7—continued Part II. Effects

Analytical Entries (Optional)

a. [AA, 120,000] [-C, 120,000]

Investment ..................................... Cash .........................................

120,000

b. [YS, 7,500] [+Y, 7,500]

Investment ..................................... Equity in Earnings ..................

7,500

c. [+C, 3,000] [+Y, 9,000] [YS, 6,000]

Investment ..................................... Equity in Earnings…………….. Cash ............................................... Investment ...............................

9,000

d. [+C, 4,000] [AD, 4,000] [YS, 1,000] [+Y, 1,000]

Cash ............................................... Equipment (net) ...................... Gain on Sale ...........................

4,000

e. [+C, 60,000] [IL, 60,000]

Cash ............................................... Note Payable (current) ...........

60,000

f. [NDR, 9,000] [NDE, 9,000]

Bonds Payable .............................. Common stock ........................ Paid-In Capital .........................

9,000

g. [+C, 6,000] [DE, 6,000]

Cash ............................................... Treasury stock ........................ Paid-In Capital .........................

6,000

h1. [AA, 200,000] [DE, 100,000] [-C, 100,000] h2. [DC, 80,000] [AA, 180,000] [DE, 140,000] [-C, 60,000]

Investment ..................................... Common stock ........................ Cash ......................................... Current Assets ($120-$40)............ Plant and Equipment .................... Current Liabilities ................... Long-Term Debt ...................... Common stock ........................ Cash ($100-$40) ......................

200,000

i. [-Y, 4,000] [YA, 4,000]

Minority Interest Expense ............ Minority Interest ......................

4,000

120,000

7,500

9,000 3,000 3,000

3,000 1,000

60,000

2,000 7,000

4,000 2,000

100,000 100,000 80,000 180,000 60,000 40,000 100,000 60,000

4,000

Chapter 07 - Cash Flow Analysis

Problem 7-7—continued Part II. Effects

Analytical Entries (Optional)

j. [-Y, 50,000] [CC, 50,000]

Inventory Loss .............................. Inventory .................................

50,000

k. None

Allow. for doubtful accounts........ Accounts receivable

1,200

l. [NAA, 120,000] [NDE, 120,000]

Leased Equipment ........................ Long-Term debt ......................

120,000

m. None

Retained Earnings ........................ Common stock ....................... Paid-in Capital .........................

180,000

Bad Debts Expense ...................... Allow for Doubtful Accounts .

27,000

n. [-Y, 27,000] [CC, 27,000]

50,000

1,200

120,000

120,000 60,000

27,000

Chapter 07 - Cash Flow Analysis

Problem 7-8 (45 minutes) BIRD CORPORATION Balance Sheet As of January 1, Year 1 Assets Cash ............................................................................ Accounts receivable .................................................. Inventory ..................................................................... Current assets ............................................................ Property, plant, and equipment................................. Less: Accumulated depreciation .............................. Other noncurrent investments .................................. Total assets ................................................................

$ 50,000 90,000 110,000 $250,000 $465,000 235,000

Liabilities and Equity Accounts payable....................................................... Current portion of long-term debt............................. Current liabilities ........................................................ Long-term debt ........................................................... Common stock ........................................................... Retained earnings ...................................................... Total liabilities and equity .........................................

230,000 245,000 $725,000

$ 60,000 110,000 $170,000 185,000 290,000 80,000 $725,000

Note: T-Accounts for Reconstruction of Balance Sheet (Optional) Cash Beg ($100,000 Ending - $50,000 Incr.)

50,000 Operations

Net income (1) Depreciation expense (2) Loss on sale of equip (3) Increase in accounts payable (4)

150,000 85,000 5,000 40,000

50,000 30,000 20,000

(5) Gain on sale of investments (6) Increase in accounts receivable (7) Increase in inventory

Investing Sale of equipment (8) Sale of investments (9)

10,000 95,000

150,000 (10) Additions to property and equip.

Financing Issuance of common stock (11) Additions to long-term debt (12)

10,000 15,000

Ending

100,000

80,000 30,000

(13) Cash dividends (14) Decrease in current portion of long-term debt

Chapter 07 - Cash Flow Analysis

Problem 7-8—continued Retained Earnings (13)

80,000

Property, Plant, and Equipment

80,000 150,000

Beg (1)

Beg (10)

465,000 150,000

150,000

End

550,000

Other Noncurrent Investments Beg

245,000

End

200,000

45,000

65,000

(3),(8) & (a)

Accumulated Depreciation (5),(9)

(a)

Long-term Debt

50,000

235,000 85,000

Beg (2)

270,000

End

Common Stock

185,000 15,000

Beg (12)

290,000 10,000

Beg (11)

200,000

End

300,000

End

Accounts Receivable

Inventory

Beg (6)

90,000 30,000

Beg (7)

110,000 20,000

End

120,000

End

130,000

Accounts Payable

Current Portion of Long-Term Debt

60,000 40,000

Beg (4)

100,000

End

(14)

30,000

110,000

Beg

80,000

End

Chapter 07 - Cash Flow Analysis

Problem 7-9 (30 minutes) Current Ratio

Working Capital Effect Amount

Cash from Operations Effect Amount

a. b.c. d.NE e. f. g.+ h.+ i.

+ NE NE + + + -

NE $0 0 NE 70,000 0 + 100,000 NE 0 15,000 NE 90,000 NE 20,000

0 NE 8,000 NE NE 0 0 NE

50,000

k. l. m. n.NE

+ NE NE

NE NE 0

10,000 0 0 NE

NE NE NE 0

o.NE p.q.+ r. s. t. u.NE v. w.

NE NE NE NE NE + +

0 0 0 NE 0 + +

NE NE 20,000 15,000 0 NE* 28,000 90,000

0 0 20,000 NE NE 0 NE NE*

5,000

40,000

Analytical Entries (Optional) Dr. Cr.

$1,000 Wages Payable Cash Purchases Acct. Pay. 0 Loss Acct. Pay. Cash Acct. Rec. 0 Land Cash 0 Note Payable Cash Note Receivable Land Cash Paid-in Cap 0 Machine Cash S-T Liab. L-T Liab. 0 Bond Payable Cash Premium on B. Pay. Gain 0 Retained Earnings Div. Pay. 0 Dividend Payable Cash 0 Retained Earnings StkDivPay Stock Dividend Pay. Paid-in Cap CapitalStk No entry Cash Notes Pay. Accounts Payable Cash 0 Patent Cash 15,000 Loss MktbleSec 0 Loss Org. Exp. Depreciation Exp. Accum Dep 0 Accounts Receivable Sales 0 Cash Building Gain 0 Cash Machine Notes Receivable 0 Income Tax Expense IncTaxPay DefTax(LT)

*Transaction does not effect cash from operations. However, the computation of cash from operations is effected if it is calculated using the indirect method.

Chapter 07 - Cash Flow Analysis

Problem 7-10 (45 minutes) a. The two measures are summary performance metrics from two different statements (or portions of statements) that deal with operations—the income statement and the cash from operations (CFO) section of the statement of cash flows. There is considerable confusion among users of financial statements about both the concept of "operations" and about the different aspects of operations that these two measures are designed to portray. The function of the income statement is to measure the profitability of the enterprise for a given period. This is done by recognizing revenue when earned, and then matching expenses with those revenues. Moreover, costs incurred during a period that do not create future benefits must be charged to expense regardless of the availability of related revenues against which they can be matched. While no other statement measures profitability as well as the income statement, it does not show the timing of cash flows and the effect of operations on liquidity and solvency. Consequently, other specialized statements are needed to focus on the latter factors, which are different dimensions of earning-related activities. Cash from operations (CFO) encompasses the broader concept of operations compared with net income. It encompasses all earning-related activities of the entity and it is concerned not only with revenues and expenses but also with the cash demands of these activities such as investments in customer receivables and in inventories as well as the financing provided by suppliers of goods and services. We can arrive at operating cash receipts and disbursements by adjusting net income for items needed to convert it to the cash basis (indirect format). We must remember that CFO focuses on liquidity and is not a measure of profitability as it excludes important costs such as the use of long-lived assets in operations, nor important revenues such as equity in the earnings of nonconsolidated subsidiaries or affiliates. b. Analysis of Transactions Net Income

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22.

+ + NE NE NE NE NE NE NE + NE NE NE

Cash from Operations

NE NE NE NE + NE NE NE NE NE NE NE NE NE NE NE NE NE NE NE -

Chapter 07 - Cash Flow Analysis

Problem 7-11 (75 minutes) a. As an initial step, the effect of the Kraft acquisition must first be removed from the Philip Morris (PM) accounts. The resulting balance sheet changes are Philip Morris Unadjusted Year 7 Year 8 Change $

157

Kraft

PM Adj. Change

758

$ (601)

Accts. Recble.

$2,065

$ 2,222

Inventories ...

4,154

5,384

1,230

1,232

(2)

PP&E ............

6,582

8,648

2,066

1,740

326

Goodwill .......

4,052

15,071

11,019

10,361

658

S-T Debt ........

1,440

1,259

(181)

700

(881)

Accts. Pay. ...

791

1,777

986

578

408

Accrued liab.

2,277

3,848

1,571

530

1,041

L-T Debt ........

6,293

17,122

10,829

900

9,929

Chapter 07 - Cash Flow Analysis

Problem 7-11—continued This permits one to derive the statement of cash flows—indirect format PHILIP MORRIS COMPANIES, INC. Statement of Cash Flows For the Year Ended December 31, Year 8 ($ millions)

Cash flows from operating activities Net income .................................................................... Add (deduct) adjustments to cash basis Depreciation expense ............................................. Amortization of goodwill ........................................ Decrease in accounts receivable........................... Decrease in inventories .......................................... Decrease in deferred taxes .................................... Increase in accounts payable ................................ Increase in accrued liabilities ................................ Increase in income taxes payable ......................... Net cash flow from operating activities..................... Cash flows from investing activities Increase in property, plant & equipment (before depreciation)................................................. Increase in goodwill (before amortization) ............... Decrease in investments ............................................ Acquisition of subsidiary—Kraft * ............................. Net cash used by investing activities ........................ Cash flows from financing activities Decrease in short-term debt ....................................... Increase in long-term debt ......................................... Decrease in equity (repurchase) ** ............................ Dividends declared ..................................................... Increase in dividends payable ................................... Net cash provided by financing activities ................. Net increase in cash....................................................

$ 2,337 654 125 601 2 (325) 408 1,041 362 $ 5,205

(980) (783) 405 (11,383) (12,741) (881) 9,929 (540) (941) 47

Supplemental disclosure of cash flow information Interest paid during year ............................................................................ Income taxes paid during the year ............................................................

7,614 78

$ 670 $1,353

Notes: * Total of Kraft assets and liabilities removed from year to year changes and shown as cash outlay for investing activity. ** The net issuance or repurchase of equity is computed by reconciling the stockholders' equity account as follows: 12/31/Year 7 balance .............................................................................................. $6,823 Year 8 net income ................................................................................................... 2,337 Dividend declared ................................................................................................... (941) Total ......................................................................................................................... 8,219 12/31/Year 8 balance .............................................................................................. (7,679) Decrease in equity (repurchase) ........................................................................... $ 540

Chapter 07 - Cash Flow Analysis

Problem 7-11—continued b. Note: For the complete statement of cash flows, the following presentation (direct format) of the cash flows from operating activities section should replace the cash flows from operating activities section (using the indirect format) for the statement of cash flows in part a.

PHILIP MORRIS COMPANIES, INC. Cash Flow From Operations For Year Ended December 31, Year 8 ($ Millions) Cash flows from operating activities Cash receipts from operations Sales [a] ...................................................................

$32,343

Cash payments for operations Purchases of inventory [b] ..................................... Selling and administrative expenses [c] ............... Interest expense [d] ................................................ Income tax expense [e] ..........................................

(11,746) (13,369) (670) (1,353)

Cash flows from operations ........................................

$5,205

Notes [a]: Sales .................................................................................... Decrease in accounts receivable ..................................... Cash collections .................................................................

$31,742 601

[b]: Cost of goods sold ............................................................. Decrease in inventories ..................................................... Increase in accounts payable ...........................................

(12,156) 2 408

(11,746)

[c]: Selling and administrative expense ................................. Increase in accrued liabilities ...........................................

(14,410) 1,041

(13,369)

$32,343

[d]: Interest expense (as given) ............................................... [e]: Income tax expense ........................................................... Increase in income taxes payable .................................... Decrease in deferred income taxes ..................................

(670) (1,390) 362 (325)

(1,353)

Chapter 07 - Cash Flow Analysis

Problem 7-11—concluded c. Free cash flow can be defined in various ways. The starting point is cash flow from operating activities of $5,205 million. Students may want to remove interest expense from operating cash flow; if they do so, it should be on an after-tax basis. From operating cash flow, capital expenditures should be deducted. It would be proper to differentiate capital expenditures required to maintain existing business from those that generate growth. The simplest calculation would be operating cash flow less capital expenditures: $5,205-$980 = $4,225 million. Other variations are possible. Students should also subtract dividends paid of $894. This yields a free cash flow of $3,331. The implications of free cash flow for a company’s future earnings and financial condition can include the: 1. Repayment of debt resulting in lower interest cost and higher earnings. This would also reduce debt ratios and improves interest coverage, possibly leading to higher debt ratings. 2. Repurchase of equity. This may raise earnings per share and (if repurchased below stated book value per share) would increase this book value. 3. Increased ability to make acquisitions (such as Kraft), which can provide future growth, better diversification, and lower risk. 4. Increased funding of internal growth through capital spending, research and development, new product introduction costs, and so forth. 5. Increase in dividends, providing larger payout of earnings to equity investors. 6. Increased liquidity (financial flexibility), allowing the firm to respond to unexpected needs and opportunities.

Chapter 07 - Cash Flow Analysis

Problem 7-12 (60 minutes) a. ZETA CORPORATION WORKSHEET TO COMPUTE CASH FLOW FROM OPERATIONS DIRECT PRESENTATION (IN $000S) Year 6

Year 5

Operating Cash Receipts and Disbursements Cash Receipts from Operations Net sales [a] (186,000 + 18,000) (155,000 + 23,000) [A] ................................................... Other revenue and income ............................................ (I) D in current receivables ............................................ (I) D in non-current receivables [b] ............................... Other adjustments [c] ..................................................... = CASH COLLECTIONS ..................................................

1* 2* 3 4 5 6

Cash Disbursements for Operations Total expenses [a] [B] .................................................... 7* Less: Expenses and losses not using cash - Depreciation and amortization .................................... 8 - Noncurrent deferred income taxes ............................. 9 - Other minority interest ................................................. 10 - Other loss on discontinued operations ..................... 11 - Other............................................................................... 12

$204,000

$178,000

(3,000)

(2,400)

201,000

175,600

196,000

170,000

(6,000) (1,600) (200) (700)

(4,000) (1,000)

15,900

Changes in Current Assets and Liabilities related to Operations I (D) in inventories........................................................... 13 I (D) in prepaid expense ................................................. 14 (I) D in accounts payable and accruals ........................ 15 (I) D in taxes payable ...................................................... 16 (I) D in accruals ............................................................... 17 I or D other ....................................................................... 18 I or D other ....................................................................... 19 I or D in noncurrent accounts [b] .................................. 20 = CASH DISBURSEMENTS ............................................ 21

(2,500) (5,700)

6,000 200 (2,000) (1,000)

195,200

168,200

Dividends Received Equity in income of unconsolidated affiliates ............ 22* - Undistributed equity in income of affiliate ............... 23 = DIVIDENDS FROM UNCONSOL AFFILIATES .......... 24

2,000 (1,400) 600

(1,000) 1,300 300

Other Cash Receipts (Disbursements) ....................... 25* CASH FLOW FROM OPERATIONS [d] ......................... 26

$ 6,400

$ 7,700

Chapter 07 - Cash Flow Analysis

Problem 7-12—continued Notes: (*) These five lines must equal reported net income per income statement [Year 6 verification: $204,000 -$196,000 + $2,000 = $10,000]. (a) Including adjustments (grossing-up) of revenue and expense of discontinued operations reported in note. (b) Determined to relate to operations (described in footnotes). (c) Such as removal of gains included above (described in footnotes). (d) Reconcile to amount reported by company. If not reported, reconcile to change in cash for period. (A) Sales from discontinued operations (see Note 4)

(B) Expenses per income statement.................................................... Income taxes .................................................................................... Minority interest ............................................................................... Discontinued operations ................................................................ Loss on disposal ............................................................................. Cumulative effect of accounting change ...................................... Expenses of discontinued operations .......................................... Loss on discontinued operations ..................................................

Year 6 167,000 10,000 200 1,100 700 (1,000) 178,000 19,100 (1,100)* 196,000

Year 5 138,000 7,800 1,200 147,000 24,200 (1,200)** 170,000

* Replaced by sales of $18,000 (Note 4) - expenses $19,100. ** Replaced by sales of $23,000 (Note 4) - expenses $24,200. [Note: Due to the acquisition of TRO Company in Year 6, the operating working capital accounts include amounts so acquired and may distort cash inflows and outflows from operations.]

b. Year 6

Year 5*

Income tax expense ............................................................. $10,000 Taxes in “below line” items: + Tax on cumulative effect .................................................. 1,000 – Tax on discontinued operations ...................................... (1,100) – Tax on loss with disposal (700) 9,200 Increase in deferred income tax ......................................... (1,600) Increase in taxes payable .................................................... (5,000) Income taxes paid ................................................................ $ 2,600

$7,800 -(1,200) -6,600 (1,000) (1,000) $4,600

* Data for Year 5 not provided in financial statements.

Chapter 07 - Cash Flow Analysis

Problem 7-12—continued c. Change in balances of “Accounts Payable and Accruals”—per balance sheet ..................................... Less: Adjustment due to disposal [a] ........................... $ 300 Less: Adjustment due to TRO acquisition [b] .............. 3,200 Adjustment to net income to arrive at CFO ..................

$6,000 3,500 $2,500

Explanations: [a] Note 4 describes the loss on disposal—summarized as follows: Loss on disposal ........................................................................ 1,400 Property, plant & equipment ............................................... Inventories * .......................................................................... Accounts payable & accruals * ............................................ and Tax payable * ............................................................................. Loss on disposal ...................................................................

1,000 100 300

700 700

No cash is involved in this loss. However, if the operating working capital items (marked by *) involved in this entry are not adjusted, the operating cash flows will be distorted. Thus, the effect of this entry on these accounts must be eliminated. The balance sheet year-to-year change in the "Accounts Payable and Accruals" account shows an increase of $6,000. However, the change related to cash effects of operations is $300 less because a $300 credit to the account represents a noncash entry. Thus, the adjustment in the SCF is $5,700. The total adjustment from loss on disposal in the SCF can be summarized as: Inventories (increase) ................................................................ Accounts payable and accruals (decrease) .......................... Property, plant and equipment (increase) .............................. Loss on discontinued oper. (addback to income) ............ Taxes payable (increase) ......................................................

100 300 1,000 * 700 700

* The amount of $6,500 shown as additions to PP&E reflects this adjustment.

[b] Note 3 describes the acquisition of TRO Company. Zeta assumed accounts payables and accruals of $3,200. These must be removed from the determination of CFO to not distort this figure. The $3,200 is shown as part of the amount determining the acquisition price of TRO.

Chapter 07 - Cash Flow Analysis

CASES Case 7–1 (45 minutes) a. 1. Depreciation expense represents the allocation of the cost of fixed assets over the useful life of the asset. Amortization expense represents the allocation of the cost of intangible assets over the useful life of the asset. In each of these cases, the investing cash outflow occurs when the asset is acquired (and not when its cost is subsequently allocated to expense). 2. Changes in deferred taxes impact reported tax expense, but not taxes paid. Consequently, the statement of cash flows begins with net income (using reported tax expense) and adjusts for changes in deferred taxes in order to derive cash taxes paid. 3. Decreases in receivables cause operating cash flows to be greater than net income because cash has been collected relating to revenues recorded in a previous period. 4. Decreases in inventory cause operating cash flows to be greater than net income because cash was generated as inventories are sold and not replenished. b. Net income is much less than operating cash flows in 2005 primarily because of the add-back of depreciation and amortization, cash inflows arising from the tax benefits relating to employee stock options, and the reduction of operating working capital. c. Free cash flows = Cash flow from operations – Capital additions – Dividends 2005: $5,310 – $525 – $0 = $4,785 2004: $3,670 – $329 – $0 = $3,341 2003: $3,538 – $305 – $0 = $3,233 d. Dell has used free cash flows primarily to repurchase shares of its stock. The excess has been invested in marketable securities. e. Dell can return cash to shareholders via dividend payments and stock repurchases. Cash paid for dividends is zero, but stock repurchases have amounted to $8,509 million ($4,219+$2,000+$2,290) over the past 3 years.

Chapter 07 - Cash Flow Analysis

Case 7–2 (40 minutes) a. Analysis of the statement of cash flows suggests that this strategy was implemented during Year 8. Specifically, during that year the cash flows of Lands’ End to buildup its inventory to implement its new policy are very high — $104.545 million cash outflow to acquire additional inventory. b. 1. Depreciation expense represents the allocation of the cost of fixed assets over the useful life of the asset. Amortization expense represents the allocation of the cost of intangible assets over the useful life of the asset. In each of these cases, the investing cash outflow occurs when the asset is acquired (and not when its cost is subsequently allocated to expense). 2. Increases in receivables cause operating cash flows to be less than net income because revenues (reflecting receivables) are included in net income, but the related cash may not yet be received. Conversely, decreases in receivables cause operating cash flows to be greater than net income because cash is received for revenues recognized in prior periods. 3. Decreases in inventory cause net income to be higher than operating cash flows because sales revenue is recognized when earned but the inventory sold can be paid for in earlier periods. Increases in inventory cause operating cash flows to be less than net income because cash was used to increase inventory levels. When these inventories are subsequently sold, revenues will be earned and net income will be increased. However, this inventory will be expensed on the income statement in the period that it is sold. 4. Each year, Lands’ End establishes a reserve for sales returns. As a result, a reconciling item is created between net income and operating cash flows because the cash outflow to cover the reserve will occur in the next period when a portion of the sold items is actually returned. c. Free cash flows = Cash flow from operations – Capital additions – Dividends Year ended Year 9: $ 74,260 – $46,750 – $0 = $ 27,510 Year ended Year 8: $ (26,932) – $47,659 – $0 = $(74,591) Year ended Year 7: $121,795 – $18,481 – $0 = $103,314 d. Lands’ End appears to have recently used its free cash flow to repurchase shares. Assuming that management doesn’t have any positive net present value projects for expansion available, this is a reasonable use of free cash flow as it returns cash to shareholders. These shareholders can then invest these funds according to their risk and return preferences.

Chapter 07 - Cash Flow Analysis

Case 7-3 (30 minutes) a. Yahoo issued stock (common and preferred) to generate the necessary cash flows to finance its business activities and growth opportunities.

b. Net income (revenues and expenses) appears to be driving operating cash flows for Yahoo. As net income increases (decreases), operating cash flow increases (decreases).

c. Yahoo has substantial cash reserves generated via equity issuances. This equity capital is necessary to finance projected growth in the upcoming years. Until the company requires the cash, it is being invested in marketable securities in a desire to earn a higher than “normal” rate of return.

d. This amount represents cash received before revenue is recognized (that is, the service/product is not yet delivered). Most of this deferred revenue likely is related to prepaid advertising revenue received in advance.

Chapter 07 - Cash Flow Analysis

Case 7-4 (60 minutes) a. WYATT CORPORATION Statement of Cash Flows For the Year Ended December 31, Year 10 Cash flows from operating activities Net income * ............................................................................ $186,000 Add (deduct) adjustments to cash basis Depreciation expense ....................................................... 246,000 Gain on sale of equipment ** ........................................... (4,000) Increase in accounts receivable ..................................... (111,000) Increase in inventories ..................................................... (218,000) Increase in accounts payable .......................................... 103,000 Decrease in income taxes payable ................................. (25,000) Increase in other payables .............................................. 92,000 Net cash flow from operating activities .............................

$269,000

Cash flows from investing activities Proceeds from sale of equipment ......................................... Additions to plant and equipment ........................................ Net cash used by investing activities.................................

(178,000)

34,000 (212,000)

Cash flows from financing activities Issuance of stock .................................................................... Dividends ................................................................................. Reduction of debt ................................................................... Net cash provided by financing activities ......................... Net increase in cash .............................................................

17,000 (74,000) (17,000) (74,000) $ 17,000

Cash balance, December 31, Year 9 ................................... Cash balance, December 31, Year 10 ................................. Notes: * Determination of Year 10 net income: Retained earnings, 12/31/Year 10 ............................................ Retained earnings, 12/31/Year 9 .............................................. Plus: Dividends paid................................................................. Year 10 net income ................................................................... **Derivation of gain on sale of equipment: Accumulated depreciation, 12/31/Year 9 ................................ Depreciation expense ............................................................... Accumulated depreciation, 12/31/Year 10 .............................. Accumulated depreciation on equipment sold ...................... Original Cost ............................................................................. Accumulated depreciation on equipment sold ...................... Basis of equipment ................................................................... Proceeds from sale ................................................................... Gain on sale ...............................................................................

175,000 $192,000

$1,638,000 (1,526,000) 112,000 74,000 $ 186,000 $ 916,000 246,000 $1,162,000 (1,131,000) $ 31,000 $ $ $

61,000 (31,000) 30,000 34,000 4,000

Chapter 07 - Cash Flow Analysis

Case 7-4—continued

b.In Year 10, Wyatt Corporation generated cash from operations of $269,000 after considering operating working capital needs. Subtracting projected debt service of $300,000 per year and estimated capital spending of $325,000 per year from that figure leaves a decidedly negative number. That is, there is not sufficient cash to fund both the debt service and the expansion project for any extended period of time. Therefore, the leveraged buyout and the capital spending plan are mutually not compatible goals—at least not as currently proposed. Wyatt cannot do both. Moreover, it probably should not do either one if it wishes to maintain a reasonable margin of safety.

Chapter 07 - Cash Flow Analysis

Case 7-5 (75 minutes) DOVER CORP. Statement of Cash Flows For the Year Ended December 31, Year 8 Cash flows from operating activities Net income...................................................................................... Adjustments to reconcile net income to net cash provided by operating activities: Depreciation ................................................................................... Amortization of patent .................................................................. Loss on sale of equipment ........................................................... Equity in income of Top Corp. ..................................................... Gain on sale of marketable equity securities ............................ Decrease in allowance to reduce marketable equity securities to market ......................................................... Increase in accounts receivable .................................................. Decrease in inventories ................................................................ Decrease in accounts payable and accrued liabilities ............ Net cash provided by operating activities ................................. Cash flows from investing activities Sale of marketable equity securities ........................................... Sale of equipment ......................................................................... Purchase of equipment ................................................................. Net cash provided by investing activities ................................. Cash flows from financing activities Issuance of common stock .......................................................... Cash dividend paid ........................................................................ Payment on note payable ............................................................. Net cash used in financing activities .......................................... Net increase in cash ...................................................................... Cash at beginning of year ........................................................... Cash at end of year .......................................................................

$305,000

82,000 9,000 10,000 (30,000) (19,000) (15,000) (35,000) 80,000 (115,000) $272,000

119,000 18,000 (120,000) 17,000

260,000 (85,000) (300,000) (125,000) $164,000 307,000 $471,000

Chapter 07 - Cash Flow Analysis

Case 7-5—continued Feasibility Analysis of Management’s Proposal Cash from operations, Year 8 ................................................ Additional interest cost .......................................................... Annual equipment investments ............................................. Less Year 8 outlay ................................................................... Annual inventory buildup ....................................................... Projected cash shortfall..........................................................

$ 272,000 (200,000) (180,000) 120,000 (60,000) $ (48,000)

Other considerations in Assessing Management’s Proposal: Non-CFO cash flows in Year 8 are $(108,000) — a cash outflow. However, dividend payments can probably be reduced. A ultimate question is whether the investment in equipment will yield positive additions to CFO. The current analysis raises serious doubts about the feasibility of this proposal. NOTE: Supporting computations for the SCF draw on these T-accounts ($000s) Cash Beginning

307 Operating

(1) Loss on sale of equipment (4) Net income (b) Decrease in Inventory (e) Amortization of patents (f) Depreciation

10 305 80 9 82

34 30 35 115

(2) Gain on sale of securities (c) Equity in Top Corp. (a) Increase in accounts receivable (g) Decrease in accounts payable

34 30 35 115

120

(d) Additions to PP&E

120

300 85

(h) Increase in note payable (5) Dividends

Investing (1) Proceeds from sale of equipment (2) Proceeds from sale of securities

18 119 Financing

(3) Issue of common stock

260

Ending

471

Chapter 07 - Cash Flow Analysis

Case 7-5—continued Marketable Securities, at cost Beg

250

End

150

100

Allow. to Reduce Marketable Sec. to Market (2)

100

(2)

Accounts Receivable 515 35

Beg

890

End

550

End

810

Investment in Top Corp. (at equity) 390 30

Beg (d)

1,070 120

End

420

End

1,145

Patent

End

109

300

(e)

900

Beg

600

End

(b)

(1)

280 82

Beg (f)

345

End

(g)

115

960

Beg

845

End

Deferred Income Taxes

650 200

Beg (3)

190

Beg

850

End

190

End

Retained Earnings 85

Accounts Payable and Accrued Liabilities

Common Stock

(5)

End

Accum. Depreciation

Long-Term Note Payable (h)

PP&E

Beg (c)

118

Beg

Inventories

Beg (a)

Beg

Additional Paid-In Capital

365 305

Beg (4)

170 60

Beg (3)

585

End

230

End

Chapter 08 - Return on Invested Capital and Profitability Analysis

Chapter 8 Return on Invested Capital and Profitability Analysis REVIEW Return on invested capital is important in our analysis of financial statements. Financial statement analysis involves our assessing both risk and return. The prior three chapters focused primarily on risk, whereas this chapter extends our analysis to return. Return on invested capital refers to a company's earnings relative to both the level and source of financing. It is a measure of a company's success in using financing to generate profits, and is an excellent measure of operating performance. This chapter describes return on invested capital and its relevance to financial statement analysis. We also explain variations in measurement of return on invested capital and their interpretation. We also disaggregate return on invested capital into important components for additional insights into company performance. The role of financial leverage and its importance for returns analysis is examined. This chapter demonstrates each of these analysis techniques using financial statement data.

Chapter 08 - Return on Invested Capital and Profitability Analysis

OUTLINE •

Importance of Return on Invested Capital Measuring Managerial Effectiveness Measuring Profitability Measuring for Planning and Control

•

Components of Return on Invested Capital Defining Invested Capital Adjustments to Invested Capital and Income Computing Return on Invested Capital

•

Analyzing Return on Net Operating Assets Disaggregating Return on Net Operating Assets Relation between Profit Margin and Asset Turnover Profit Margin Analysis Asset Turnover Analysis

•

Analyzing Return on Common Equity Disaggregating Return on Common Equity Financial Leverage and Return on Common Equity Assessing Growth in Common Equity

Chapter 08 - Return on Invested Capital and Profitability Analysis

ANALYSIS OBJECTIVES •

Describe the usefulness of return measures in financial statement analysis.

•

Explain return on invested capital and variations in its computation.

•

Analyze return on net operating assets and its relevance in our analysis.

•

Describe disaggregation of return on net operating assets and the importance of its components.

•

Describe the relation between profit margin and turnover.

•

Analyze return on common shareholders' equity and its role in our analysis.

•

Describe disaggregation of return on common shareholders' equity and the relevance of its components.

•

Explain financial leverage and how to assess a company's success in trading on the equity across financing sources.

Chapter 08 - Return on Invested Capital and Profitability Analysis

QUESTIONS 1. The return that is achieved in any one period on the invested capital of a company consists of the returns (and losses) realized by its various segments and divisions. In turn, these returns are made up of the results achieved by individual product lines and projects. A well-managed company exercises rigorous control over the returns achieved by each of its profit centers, and it rewards the managers on the basis of such results. Specifically, when evaluating new investments in assets or projects, management will compute the estimated returns it expects to achieve and use these estimates as a basis for its decision to invest or not. 2. Profit generation is the first and foremost purpose of a company. The effectiveness of operating performance determines the ability of the company to survive financially, to attract suppliers of funds, and to reward them adequately. Return on invested capital is the prime measure of company performance. The analyst uses it as an indicator of managerial effectiveness, and/or a measure of the company's ability to earn a satisfactory return on investment. 3. If the investment base is defined as comprising net operating assets, then net operating profit (e.g., before interest) after tax (NOPAT) is the relevant income figure to use. The exclusion of interest from income deductions is due to its being regarded as a payment for the use of money from the suppliers of debt capital (in the same way that dividends are regarded as a payment to suppliers of equity capital). NOPAT is the appropriate amount to measure against net operating assets as both are considered to be operating. 4. First, the motivation for excluding nonproductive assets from invested capital is based on the idea that management is not responsible for earning a return on non-operating invested capital. Second, the exclusion of intangible assets from the investment base is often due to skepticism regarding their value or their contribution to the earning power of the company. Under GAAP, intangibles are carried at cost. However, if their cost exceeds their future utility, they are written down (or there will be an uncertainty exception regarding their carrying value in the auditor's opinion). The exclusion of intangible assets from the asset base must be based on more substantial evidence than a mere lack of understanding of what these assets represent or an unsupported suspicion regarding their value. This implies that intangible assets should generally not be excluded from invested capital. 5. The basic formula for computing the return on investment is net income divided by total invested capital. Whenever we modify the definition of the investment base by, say, omitting certain items (liabilities, idle assets, intangibles, etc.) we must also adjust the corresponding income figure to make it consistent with the modified asset base. 6. The relation of net income to sales is a measure of operating performance (profit margin). The relation of sales to total assets is a measure of asset utilization or turnover—a means of determining how effectively (in terms of sales generation) the assets are utilized. Both of these measures, profit margin as well as asset utilization, determine the return realized on a given investment base. Sales are an important factor in both of these performance measures.

Chapter 08 - Return on Invested Capital and Profitability Analysis

7. Profit margin, although important, is only one aspect of the return on invested capital. The other is asset turnover. Consequently, while Company B's profit margin is high, its asset turnover may have been sufficiently depressed so as to drag down the overall return on invested capital, leading to the shareholder's complaint. 8. The asset turnover of Company X is 3. The profit margin of Company Y is 0.5%. Since both companies are in the same industry, it is clear that Company X must concentrate on improving its asset turnover. On the other hand, Company Y must concentrate on improving its profit margin. More specific strategies depend on the product and industry. 9. The sales to total assets (asset turnover) component of the return on invested capital measure reflects the overall rate of asset utilization. It does not reflect the rate of utilization of individual asset categories that enter into the overall asset turnover. To better evaluate the reasons for the level of asset turnover or the reasons for changes in that level, it is helpful to compute the rate of individual asset turnovers that make up the overall turnover rate. 10. The evaluation of return on invested capital involves many factors. The inclusion/exclusion of extraordinary gains and losses, the use/nonuse of trends, the effect of acquisitions accounted for as poolings and their chance of recurrence, the effect of discontinued operations, and the possibility of averaging net income are just a few of many such factors. Moreover, the analyst must take into account the effects of price-level changes on return calculations. It also is important that the analyst bear in mind that return on invested capital is most commonly based on book values from financial statements rather than on market values. And finally, many assets either do not appear in the financial statements or are significantly understated. Examples of such assets are intangibles such as patents, trademarks, research and development activities, advertising and training, and intellectual capital. 11. The equity growth rate is calculated as follows: [Net income – Preferred dividends – Common dividend payout] / Average common equity. This is the growth rate due to the retention of earnings and assumes a constant dividend payout over time. It indicates the possibilities of earnings growth without resort to external financing. The resulting increase in equity can be expected to earn the rate of return that the company earns on its assets and, thus, further contribute to growth in earnings. 12. a. The return on net operating assets and the return on common stockholders' equity differ by the capital investment base (and its corresponding effects on net income). RNOA reflects the return on the net operating assets of the company whereas ROCE reflects the perspective of common shareholders. b. ROCE can be disaggregated into the following components to facilitate analysis: ROCE = RNOA + Leverage x Spread. RNOA measures the return on net operating assets, a measure of operating performance. The second component (Leverage x Spread) measures the effects of financial leverage. ROCE is increased by adding financial leverage so long as RNOA>weighted average cost of capital. That is, if the firm can earn a return on operating assets that is greater than the cost of the capital used to finance the purchase of those assets, then shareholders are better off adding debt to increase operating assets.

Chapter 08 - Return on Invested Capital and Profitability Analysis

13. a. ROCE can be disaggregated as follows: Net income - Preferred dividends Sales  Sales Average common equity This shows that “equity turnover” (sales to average common equity) is one of the two components of the return on common shareholders' equity. Assuming a stable profit margin, the equity turnover can be used to determine the level and trend of ROCE. Specifically, an increase in equity turnover will produce an increase in ROCE if the profit margin is stable or declines less than the increase in equity turnover. For example, a common objective of discount stores is to lower prices by lowering profit margins, but to offset this by increasing equity turnover by more than the decrease in profit margin. b. Equity turnover can be rewritten as follows: Net operating assets Sales  Net operating assets Average common equity The first factor reflects how well net operating assets are being utilized. If the ratio is increasing, this can signal either a technological advantage or under-capacity and the need for expansion. The second factor reflects the use of leverage. Leverage will be higher for those firms that have financed more of their assets through debt. By considering these factors that comprise equity turnover, it is apparent that EPS cannot grow indefinitely from an increase in these factors. This is because these factors cannot grow indefinitely. Even if there is a technological advantage in production, the sales to net operating assets ratio cannot increase indefinitely. This is because sooner or later the firm must expand its net operating asset base to meet rising sales or else not meet sales and lose a share of the market. Also, financing new assets with debt can increase the net operating assets to common equity ratio. However, this can only be pursued to a point—at which time the equity base must expand (which decreases the ratio). 14. When convertible debt sells at a substantial premium above par and is clearly held by investors for its conversion feature, there is justification for treating it as the equivalent of equity capital. This is particularly true when the company can choose at any time to force conversion of the debt by calling it in.

Chapter 08 - Return on Invested Capital and Profitability Analysis

EXERCISES Exercise 8-1 (35 minutes) a. First alternative: NOPAT = $6,000,000 * 10% = $600,000 Net income = $600,000 – [$1,000,000*12%](1-.40) = $528,000 Second alternative: NOPAT = $6,000,000 * 10% = $600,000 Net income = $600,000 – [$2,000,000*12%](1-.40) = $456,000 b. First alternative: ROCE = $528,000 / $5,000,000 = 10.56% Second alternative: ROCE = $456,000 / $4,000,000 = 11.40% c. First alternative: Assets-to-Equity = $6,000,000 / $5,000,000 = 1.2 Second alternative: Assets-to-Equity = $6,000,000 / $4,000,000 = 1.5 d. First, let’s compute return on assets (RNOA): First alternative: $600,000 / $6,000,000 = 10% Second alternative: $600,000 / $6,000,000 = 10% Second, notice that the interest rate is 12% on the debt (bonds). More importantly, the after-tax interest rate is 7.2% (12% x (1-0.40)), which is less than RNOA. Hence, the company earns more on its assets than it pays for debt on an after-tax basis. That is, it can successfully trade on the equity—use bondholders’ funds to earn additional profits. Finally, since the second alternative uses more debt, as reflected in the assets-to-equity ratio in c, the second alternative is probably preferred. The shareholders would take on additional risk with the second alternative, but the expected returns are greater as evidenced from computations in b.

Chapter 08 - Return on Invested Capital and Profitability Analysis

Exercise 8-2 (40 minutes) a. NOPAT = Net income = $10,000,000 x 10% = $1,000,000 b. First alternative: NOPAT = $1,000,000 + $6,000,000*10% = $1,600,000 Net income = $1,600,000 – ($2,000,000  5% x [1-.40]) = $1,540,000 Second alternative: NOPAT = $1,000,000 + $6,000,000*10% = $1,600,000 Net income = $1,600,000 – ($6,000,000  6% x [1-.40]) = $1,384,000 c. First alternative: ROCE = $1,540,000 / ($10,000,000 + $4,000,000) = 11% Second alternative: ROCE = $1,384,000 / ($10,000,000 + $0) = 13.84% d. ROCE is higher under the second alternative due to successful use of leverage— that is, successfully trading on the equity. [Note: Asset-to-Equity is 1.14=$16 mil./$14 mil. (1.60=$16 mil./$10 mil.) under the first (second) alternative.] The company should pursue the second alternative in the interest of shareholders (assuming projected returns are consistent with current performance levels).

Chapter 08 - Return on Invested Capital and Profitability Analysis

Exercise 8-3 (15 minutes) a. RNOA = 2 x 5% = 10% b. c.

ROCE = 10% + 1.786 x 4.4% = 17.86% RNOA Leverage advantage Return on equity

10.00% 7.86% 17.86%

Exercise 8-4 (30 minutes) a. Computation and Interpretation of ROCE: Year 5 0.112 0.46 3.25 0.570 9.54%

Year 9 0.109 0.44 3.40 0.556 9.07%

Pre-tax profit margin.......................................................... Asset turnover.................................................................... Assets-to-equity ................................................................. After-tax income retention * .............................................. ROCE (product of above) .................................................. * 1-Tax rate. ROCE declines from Year 5 to Year 9 because: (1) pre-tax margin decreases by approximately 3%, (2) asset turnover declines by roughly 4.3%, and (3) the tax rate increases by about 3.8%. The combination of these factors drives the decline in ROCE—this is despite the slight improvement in the assets-to-equity ratio.

b. The main reason EPS increases is that shareholders had a large amount of assets and equity working for them. Namely, the company grew while return on assets and return on equity remained fairly stable. In addition, the amount of preferred stock declined, as did the amount of preferred dividends. With this decline in the cost of carrying preferred stock, earnings available to common stock increased. (CFA Adapted)

Chapter 08 - Return on Invested Capital and Profitability Analysis

Exercise 8-5 (15 minutes) a. RNOA = 3 x 7% = 21% b. ROCE = RNOA + LEV x Spread = 21% + (1.667 x 8.4%) = 35% c. Net leverage advantage to common equity Return on net operating assets .................................. Leverage advantage .................................................... Return on common equity (rounding difference) .....

21% 14% 35%

Exercise 8-6 (30 minutes) a. At the present level of debt, ROCE = $157,500 / $1,125,000 = 14%. In the absence of leverage, the noncurrent liabilities would be substituted with equity. Accordingly, there would be no interest expense with all-equity financing. Consequently, in this case, net income would be as follows: Net income (with leverage) .................................. $157,500 Plus interest saved ($675,000  8%) .................... $54,000 Less tax effect of interest expense ..................... 27,000 27,000 Net income (without leverage) ............................. $184,500 ROCE without leverage = $184,500 / $1,800,000 = 10.25%. This means that leverage is beneficial to Rose's shareholders since ROCE is 14% with leverage but only 10.25% without leverage.

b. NOPAT = $157,500 + [$675,000 x 8% x (1-.50)] = $184,500 RNOA = $184,500 / ($2,000,000-$200,000) = 10.25%

c. The company is utilizing borrowed funds in its capital structure. Since the ROCE is greater than RNOA, the use of financial leverage is beneficial to stockholders. Specifically, the after cost of debt is 4% and the financial leverage (NFO/Equity) is $675,000 / $1,125,000 = 60%. Therefore, ROCE = RNOA + LEV x Spread = 10.25% + 0.60 x (10.25% - 4%) = 14%, as before. The favorable effect of financial leverage is given by the term [0.60 x (10.25% - 4%)] = 3.75%.

Chapter 08 - Return on Invested Capital and Profitability Analysis

Exercise 8-7 (10 minutes) 1. 2. 3.

c a c

Exercise 8-8 (20 minutes) (Assessments of profit margin and asset turnover are relative to industry norms.) a. Higher profit margin and lower asset turnover. b. Higher asset turnover and lower profit margin. c. Higher profit margin and similar/lower asset turnover. d. Higher asset turnover and similar/lower profit margin. e. Higher asset turnover and lower/similar profit margin. f. Higher asset turnover and similar/higher profit margin. g. Higher asset turnover and lower profit margin.

Exercise 8-9 (20 minutes) The memorandum to Reliable Auto Sales President would include the following points: • Both Reliable and Legend Auto Sales are perpetually investing $100,000 in automobile inventory. • Legend Auto Sales is able to generate more profit than Reliable because it is turning over its inventory (10 cars) more often. Specifically, Legend is turning its inventory over 10 times per year while Reliable is turning its inventory over only 5 times per year. Hence, given the same investment in automobile inventory, Legend is twice as profitable as Reliable. • Encourage Reliable to sacrifice some return on each sale to increase the inventory turnover. By slightly reducing price, relative to that charged by Legend, Reliable predictably will find that overall profitability increases. This is because while profit per sale declines, the number of units sold and, therefore, inventory turnover will increase. These factors predictably yield increased return on assets.

Chapter 08 - Return on Invested Capital and Profitability Analysis

Exercise 8-10 (20 minutes) Computation of Asset (PP&E) Turnover [computed as Sales / PP&E (net)]: Northern: $12,000 / $20,000 = 0.60 Southern: $6,000 / $20,000 = 0.30 This implies that Northern generates $0.60 in sales per year for each $1 investment in PP&E. In contrast, Southern generates $0.30 in sales per year for each $1 investment in PP&E. This shows that Northern is able to generate twice the return for each $1 invested in PP&E. Assuming equal profit margins, Northern will report a higher return on assets because of the volume of sales that the company is able to generate with its investment in PP&E (at least in the short run). Exercise 8-11 (15 minutes) Low volume operations mean that fixed costs, which in the case of automakers are substantial, must be absorbed by a low number of units produced. Since the lower of cost or market rule implies that inventory cannot be priced higher than expected sales price less costs of disposal plus a normal profit margin, much of that excess cost must be charged to the period incurred. In this case, that means the fourth quarter financial statements absorb much of this cost. This is probably the most likely accounting-based reason for the fourth quarter losses described in the news release.

Chapter 08 - Return on Invested Capital and Profitability Analysis

PROBLEMS Problem 8-1 (30 minutes) a. 1. Quaker Oats does not reveal its computation of this return. Accordingly, we make some simple computations and assumptions: (i) For simplicity, focus on one share, (ii) The dividend is $1.56 for Year 11, (iii) The average stock price is $55 and the price increase for Year 11 is $14—based on the beginning price of $48 and the ending price of $62. Using this information, we compute return to a share of stock as follows: = [Dividend per share + Price increase per share] / Average price per share = [$1.56 + $14] / $55 = 28.3% However, if we use the beginning price of $48 per share, we get closer to the company's 34% return: = [$1.56 + $14] / $48 = 32.4% 2. The return on common equity is based on the relation between net income and the book value of the equity capital. In contrast, Quaker Oats’ “return to shareholders” uses dividends plus market value change in relation to the market price per share (cost of investment to shareholders.) b. The company must have derived the 3.6% from price, market, and other factors that are not disclosed. Conceptually, this 3.6% should reflect the added risk of an investment in Quaker Oats’ stock vis-à-vis a risk-free security such as a U.S. Treasury bond. c. Quaker does not reveal its computations. It may disclose a variety of interest rates on long-term debt that it carries in the notes to financial statements. Based on data available to it, but not to the financial statement reader, it probably computed a weighted-average interest rate from which it deducted the tax benefit in arriving at the 6.4% cost of debt.

Chapter 08 - Return on Invested Capital and Profitability Analysis

Problem 8-2 (50 minutes) a. Computation of Return on Invested Capital Measures: As a first step, we construct the company’s income statement. Sales (500,000 units @ $10). ................................................ Fixed costs ....................................................................... Variable costs (500,000 units @ $4). ............................ Labor costs (20 employees x $35,000). ........................ Income before taxes .......................................................... Taxes (50% rate) ................................................................. Net income ..........................................................................

$5,000,000 1,500,000 2,000,000 700,000 800,000 400,000 $ 400,000

(1) RNOA = [$400,000 + ($2,000,000 x 7.5%)(1-0.50)] / ($8,000,000-$2,00,000) = $475,000 / $6,000,000 = 7.92% (2) ROCE = [$400,000 - ($1,000,000 x 6%)] / $3,000,000 = 11.33% b. Wage Rate Analysis to meet a Target Return on Invested Capital: Estimated Fiscal Year 9 Operations: Sales (550,000 units @ $10) ............................................................. $5,500,000 Fixed costs ($1,500,000 x 1.06).......................................................... 1,590,000 Variable costs ($550,000 units @ $4) .............................................. 2,200,000 Income before labor costs and taxes ............................................. $1,710,000 To obtain a 10% return on long-term debt and equity capital, Zear will need a numerator of $600,000 given an invested capital base of $6,000,000. The required operating income to yield this $600,000 amount is computed as: Net income + Interest expense x (1 - 0.50) = $600,000 Net income + ($2,000,000 x 7.5%) x (1-0.50) = $600,000 Net income = $525,000 Assuming taxes at a 50% rate, Zear needs pre-tax income of $1,050,000, computed as: Income before labor and taxes ............ $1,710,000 Labor costs ........................................... ? Pre-tax income ...................................... $1,050,000 This implies: Labor costs = $660,000 or Average wage per worker = $660,000 / 22 employees = $30,000 per employee Since the current salary level is $35,000, Zear cannot achieve its target return level and give a salary raise to its employees. (CFA Adapted)

Chapter 08 - Return on Invested Capital and Profitability Analysis

Problem 8-3 (30 minutes) a. ROCE = $1,650 / $3,860 = 42.7% b. NOPAT = ($2,550 + $10) x (1-0.35) = $1,664 NOA = $7,250-$3,290 = $3,960 RNOA (using year-end NOA balance) = $1,664 / $3,960 = 42% The effect of financial leverage, thus, is only 0.7% as NFO/NFE are insignificant. Most of Merck’s ROCE in this year is derived from operating results. Pre-tax income to sales

0.36

Net income to sales

0.23

Sales/current assets

1.47

Sales / fixed assets

2.97

Sales / total assets

0.98

Total liabilities / equity

0.88

L-T liabilities / equity

0.03

Chapter 08 - Return on Invested Capital and Profitability Analysis

Problem 8-4 (60 minutes) a. 1. RNOA = NOPAT Avg. NOA NOPAT = [$186,000 + $2,000 - $120,000 - $37,000 + $1,000] x 50% = $16,000 Note: we include income from equity investments under the assumptions that these are operating rather than financial investments. We also include the cumulative effect as operating in the absence of information to the contrary. Minority interest and discontinued operations are nonoperating (minority interest is therefore, treated as equity in the ROCE computation).

NOA Year 6 = $138,000 - $29,000 - $7000 - $3,600 = $98,400 NOA Year 5 = $105,000 - $23,000 - $2,000 - $2,000 = $78,000 RNOA = $16,000 / ([$98,400 + $78,000]/2) = 18.14% 2. ROCE = Net income - Preferred dividends Average common equity ROCE = ($10,000 –$0) /[($55,400* + $47,800*)/2]

= 19.38%

*Note: minority interest is treated as equity. If Minority interest is ignored, the ROCE is 19.8%

b. NFO = NOA - Equity Year 6: $43,000; Year 5: $30,200 LEV = Avg. NFO / Ave Equity = ([$43,000 + $30,200] / 2) / ([$55,400* + $47,800*] / 2) = 0.71 NFE = NOPAT – Net income Year 6: $6,000 NFR = NFE / Avg. NFO = $6,000 / ([$43,000 + $30,200] / 2) = 16.4% Spread = RNOA – NFR = 18.14% - 16.4% = 1.74% ROCE = RNOA + LEV x Spread = 18.14 + 0.71 x 1.74% = 19.38% 94% (18.14%/19.38%) of Zeta’s ROCE is derived form operating activities. The company is effectively using leverage, however, as indicated by the positive spread, but the leverage does not contribute significantly to Zeta’s return on equity and may not be worth the added risk.

Chapter 08 - Return on Invested Capital and Profitability Analysis

Problem 8-5 (40 minutes) a. ROCE = [Net income – preferred dividends] / stockholders’ equity* *end of year in this problem ROCE Year 5: [$14 – $0] / $125 = 11.2% ROCE Year 9: [$34 - $0] / $220 = 15.5% RNOA Year 5 = ($35 x 0.50) / ($52 + $123) = 10.0% RNOA Year 9 = ($68 x 0.50) / ($63 + $157) = 15.5% ROCE = RNOA + Leverage x Spread Year 5: 10.0% + 1.2% = 11.2% Year 9: 15.5% + 0 = 15.5% b. Texas Talcom’s ROCE has increased form years 5 to 9. The source is this increase, however, has been an increase in RNOA as the leverage effect is zero in Year 9 since its long-term debt has been retired. Given the RNOA increase, additional leverage might be explored as a way to increase shareholder returns.

Chapter 08 - Return on Invested Capital and Profitability Analysis

Problem 8-6 (75 minutes) Background Information: Product A Yr 7 Yr 6 Number of units sold ...................... 10,000 7,000 Selling price per unit ...................... $6.00 $5.00 Unit cost ........................................... $5.00 $4.00

Product B Yr 7 Yr 6 600 900 $50.00 $50.00 $32.50 $30.00

Johnson Corporation Analysis Statement of Changes in Gross Margin Year 2 versus Year 1 Analysis of Variation in Product A Sales

Increased quantity at Yr 6 prices (3,000 x $5)......................... Price increase at Yr 6 quantity (7,000 x $1) ........................... Quantity increase x price increase (3,000 x $1) .....................

$ 15,000 7,000 3,000

Analysis of Variation in Product A Cost of Sales

Increased quantity at Yr 6 cost (3,000 x $4) ........................... Increased cost at Yr 6 quantity (7,000 x $1) ........................... Cost increase x quantity increase (3,000 x $1) ...................... Net Variation (Increase) in Gross Margin for Product A .............

(12,000) (7,000) (3,000) $ 3,000

Analysis of Variation in Product B Sales

Decreased quantity at Yr 6 prices (300 x $50) .......................

$ (15,000)

Analysis of Variation in Product B Cost of Sales:

Decreased quantity at Yr 6 cost (300 x $30) .......................... Increased cost at Yr 6 quantity (900 x $2.50) ......................... Cost increase x quantity decrease (300 x $2.50) ................... Net Variation (Decrease) in Gross Margin for Product B ............ Summary of Net Variation in Margins for Products A and B Net increase from product A ......................................................... Net decrease from product B ........................................................ Net Decrease in Gross Margin ......................................................

9,000 (2,250) 750 (7,500)

3,000 (7,500) $ (4,500)

Chapter 08 - Return on Invested Capital and Profitability Analysis

Problem 8-7 (60 minutes) a. SPYRES MANUFACTURING COMPANY Comparative Common-Size Income Statements Year Ended December 31 Year 9 Year 8

Increase (Decrease)

Net sales .............................

100.0%

20.0%

Cost of goods sold ............

81.7

86.0

14.0

Gross margin on sales ......

18.3

14.0

57.1

Operating expenses...........

16.8

10.2

98.0

Income before taxes ..........

1.5

3.8

(52.6)

Income taxes ......................

0.4

1.0

(52.0)

Net income .........................

1.1

2.8

(52.9)

b. Performance in Year 9 is poor when compared with Year 8. One bright spot is the percentage of Cost of Goods Sold to Sales, which decreased in Year 9. However, Operating Expenses climbed sharply. This sharp climb in operating expenses is unexpected since there is usually a larger fixed cost component comprising these costs compared with that for Cost of Goods Sold. Management should further check operating expenses. If operating expenses had remained at the Year 8 level of 10.2%, income would have been up favorably for Year 9. Operating expenses may have included a future-directed component such as advertising or training costs. Also, management would want to follow up on the change in gross margin. The sharp improvement in gross margin may have been due to factors such as the liquidation LIFO inventory layers or, alternatively, to something more fundamental with the activities of the firm.

Chapter 08 - Return on Invested Capital and Profitability Analysis

Problem 8-8 (75 minutes) ZETA CORPORATION Statement of Variations in Income and Income Components Year 6 versus Year 5 Items tending to increase net income: Increase in net sales: Net sales, Year 6 ......................................... $186,000 Net sales, Year 5 ......................................... 155,000 $31,000 Deduct increase in cost of goods sold: Cost of goods sold, Year 6 ....................... 120,000 Cost of goods sold, Year 5 ....................... 99,000 21,000 Net increase in gross margin on sales: Gross margin, Year 6 ................................. 66,000 Gross margin, Year 5 ................................. 56,000 10,000 Increase in equity in income (loss) of assoc. co.: Equity in income, Year 6 ........................... 2,000 Equity in loss, Year 5 ................................. (1,000) 3,000 Decrease in loss of discont. oper. (net of taxes): Loss on disc. oper., Year 6 ....................... 1,100 Loss on disc. oper., Year 5 ....................... 1,200 100 Increase in cum. effect of accounting change: Cumulative effect, Year 6 .......................... 1,000 Cumulative effect, Year 5 .......................... 0 1,000 Total of items tending to increase income ... 14,100

Items tending to decrease net income: Increase in S&A expense: S&A, Year 6 ................................................. 37,000 S&A, Year 5 ................................................. 33,000 Increase in interest expense: Interest expense, Year 6 ............................ 10,000 Interest expense, Year 5 ............................ 6,000 Increase in income taxes: Income taxes, Year 6 ................................. 10,000 Income taxes, Year 5 ................................. 7,800 Increase in minority interest: Minority interest, Year 6 ............................ 200 Minority interest, Year 5 ............................ 0 Increase in loss on disposal of disc oper.: Loss on disposal, Year 6 ........................... 700 Loss on disposal, Year 5 ........................... 0 Total of items tending to decrease net income .................. Net increase in net income: Net income, Year 6 ..................................... Net income, Year 5 .....................................

10,000 7,000

20.0%

21.2

17.9

300.0

8.3

—

4,000

12.1

4,000

66.7

2,200

28.2

200

—

700 11,100

—

3,000

42.9

Chapter 08 - Return on Invested Capital and Profitability Analysis

Problem 8-8—continued Analysis and Interpretation: (1) ZETA has two "below the line" items--discontinued operations and a change in accounting principle. While net income increased by 42.9%, income from continuing operations increased by 31.7%. (Per note 1, the increase in Year 6 income from operations due to the change in inventory accounting is only $400.) (2) Per note 3, ZETA acquired most of TRO Company effective December 31, Year 6. As the acquisition was accounted for as a purchase, the Year 5 and 6 income statements do not reflect the results of TRO. Certain pro forma information is included in note 3. (3) The 21.2% increase in COGS slightly exceeds the 20% increase in sales, leading to a lower gross profit margin despite the accounting change. (4) The increase in equity in income of associated companies helped increase net income. The analyst should assess whether a dollar of income for associated companies is equivalent to a dollar of income for ZETA. (5) S&A expenses rose less than sales, contributing to increased income. (6) The increase in interest expense is matched by an increase in long-term debt.

Chapter 08 - Return on Invested Capital and Profitability Analysis

Problem 8-9 (75 minutes) a. 1. Data communications ........................... Time recording devices ........................ Hardware for electronics ...................... Home sewing products ......................... Corporate total .......................................

Inventory-to-Sales 1,897/6,890 = 27.5% 2,728/4,100 = 66.5% 287/1,850 = 15.5% 526/1,265 = 41.6% 5,438/14,105 = 38.6%

2. Inventory-to-Contribution Data communications ........................... 1,897/1,510 = 1.26 Time recording devices ........................ 2,728/412 = 6.62 Hardware for electronics ...................... 287/919 = 0.31 Home sewing products ......................... 526/342 = 1.54 Corporate total ....................................... 5,438/3,183 = 1.71 b. Data communications............ Time recording devices ......... Hardware for electronics ....... Home sewing products ......... Total ........................................

Year 1 44% 34% -22% 100%

Year 2 59% 21% -20% 100%

Year 3 48% 2% 37% 13% 100%

Year 4 47% 13% 29% 11% 100%

c. Desirability of Investment for Each Product Line (ranked): Data communications equipment seems to be the best candidate for investment. Its growth has been steady while the amount of inventory/sales (27.5%) and inventory/income contribution (1.26) is relatively low. The trend of income contribution of hardware for electronics is stable and both the amount of inventory/sales (15.5%) and inventory/income contribution (0.31) compares very well with others. Home sewing products also shows a stable income contribution trend; however, it should be noted that the amount of sales is decreasing every year and the inventory/sales (41.6%) and inventory/income contribution (1.54) do not compare favorably with others. The least desirable candidate for investment is time recording devices whose data compare very poorly with others in all the respects mentioned above.

Chapter 08 - Return on Invested Capital and Profitability Analysis

Problem 8-10 (30 minutes)

ROE RNOA ROA NBC FLEV PM NATO OLLEV ATO

Alpha 100/500=20% 120/700=17% 120/1000=12% 20/200=10% 200/500=0.40 120/2400=5% 2400/700=3.43 300/700=0.43 2400/1000=2.4

ROE=RNOA+FLEV(RNOA-NBC) 20%=17%+0.4(17%-10%) RNOA=ROA*(1+OLLEV) 17%=12%*(1 + 0.43) RNOA=PM*NATO 17.1%=5%*3.43

Beta 100/500=20% 108/600=18% 108/700=15.4% 8/100=8% 100/500=0.20 108/2160=5% 2160/600=3.6 100/600=0.17 2160/700=3.086 20%=18%+0.2(18%-8%) 18%=15.4%*(1+ 0.17) 18%=5%*3.6

Alpha is a much riskier company than Beta, as indicated by the higher financial and operating liability leverages and the lower spread (RNOA – NBC). Since risk affects cost of capital (Ke) and P/E ratio is proportional to 1/(Ke-g), the riskier company will have a lower P/E ratio, given equal growth rates. Beta also seems to be using assets more effectively with higher RNOA, ATO, and NATO. Therefore it is not necessary that Alpha is underpriced relative to Beta.

Chapter 08 - Return on Invested Capital and Profitability Analysis

CASES Case 8-1 (120 minutes) a. Computation of Return on Invested Capital Measures: 2005 (1) Return on net operating assets [a] ............. 73.9% (2) Disaggregated RNOA: Oper. Profit margin [a] ............................ 5.9% NOA turnover [a] ..................................... 12.49 (3) Return on common equity [b]...................... 47.7% (4) Disaggregated ROCE [c]: RNOA ................................................. 73.9 LEV ................................................. -38.3% Spread ...................................................... 68.6% Computation notes: [a] NOPAT Average net operating assets = ($4,254 x (1-[$1,402/$4,445])) / (($1,9301+$5,9502)/2) = 73.9% 1 2005: $23,215 - $5,060 - $14,136 - 2,089 = $1,930 2 2004: $19,311 - $835 - $10,896 - $1,630 = $5,950

Disaggregated: 2005 profit margin: ($4,254 x (1-[$1,402/$4,445])) / $49,205 = 5.9% 2005 net operating asset turnover: $49,205 / (($1,930+$5,950)/2) = 12.49

[b] Net income [11] - Preferred dividends Average common equity 2005: [$3,043 - $0] / [($6,485 + $6,280)/2] = 47.7%

[c] 2005 NFO = $505 - $5,060 = -$4,555 2004 NFO = $505 - $835 = -$330 LEV = Avg. NFO Avg. Equity

(-$4,555 - $330)/2 ($6,485 + $6,280)/2

-38.3%

NFE = NOPAT - Net income = $2,912 - $3,043 = -$131 NFR = NFE / Avg. NFO = $-131 / (-$4,555 - $330)/2 = 5.3% Spread = RNOA – NFR = 73.9% – 5.3% = 68.6%

Chapter 08 - Return on Invested Capital and Profitability Analysis

Case 8-1—continued b. Computation of Asset Turnover Ratios: 2005 (1) Accounts receivable turnover .................................

12.23

Average collection period ........................................

29.85

(2) Inventory turnover .....................................................

102.26

Average inventory days outstanding ......................

3.57

(3) Long-term operating asset turnover .......................

6.56

(4) Accounts payable turnover ......................................

4.96

Average payables days outstanding .......................

73.61

c. Dell achieves extraordinary returns (both on net operating assets and equity) due to its high turnover of net operating assets. Dell’s working capital management is legendary. The Accounts receivable turnover rate has decreased in recent years as the company expanded into more corporate sales, but remains high with an average collection period of only 29.9 days. Dell’s ability to operating with very little inventory and long-term operating assets, however, is the primary driver of its profitability. Inventories turn 102 times a year, with an average inventory days outstanding of only 3.57. This is extraordinary. Furthermore, the company turns its long-term operating assets 6.56 times a year, significantly greater than nearly every other publicly traded company. Finally, Dell is able to use its market power to delay payment to suppliers. Its accounts payable turnover rate is 4.96 times a year, for an average payable days outstanding of 73.61. Dell is, therefore, collecting cash in 28.85 days and paying its suppliers in 73.61 days. The cash generated by this relation is invested in marketable securities, $5 billion in 2005, resulting in a negative NFO. The fact that ROCE is lower than RNOA results from the use of relatively high cost equity capital to finance investment in marketable securities. The company could eliminate this “problem” by repurchasing stock with its marketable investments, and has, indeed, repurchased a considerable amount of stock over the past 3 years. Since it operates in a fast changing industry, the additional liquidity is probably warranted. Dell’s ROE of 47.7% is still considerably greater than the 12% median for publicly traded companies.

Chapter 08 - Return on Invested Capital and Profitability Analysis

Case 8-2 (75 minutes) a. Nike’s ROCE, currently at 21.6%, has been steadily increasing over the 5 year period, while Reebok’s has remained at a constant level for the past 3 years, and is currently 15.7%. ROCE = RNOA + LEV x Spread. The computation of ROCE, based on its disaggregated components is as follows: NIKE: 19.2% + 0.144 x 16.6% = 21.6% Reebok: 12.7% + 0.367 x 8.2% = 15.7% The recent 5-year trend in the ROCE components is as follows: NIKE (NKE) Reebok (RBK) Sales growth

NKE’s sales growth has increased significantly in the past 2 years

After suffering sales declines 5 and 4 years ago, RBK’s growth has improved and is significant in the current year

Gross Profit

NKE’s gross profit margin has increased by 3.5 percentage points in the past 3 years and is currently 4.5 percentage points higher than RBK’s.

RBK’s gross profit margin increased by 1.6 percentage points in year 4 and has leveled off.

SG&A exp %

NKE’s SG&A percentage has increased by 2.1 percentage points from its trough and is currently 0.5 percentage points higher than RBK’s.

RBK’s SG&A percentage is 3 percentage points lower than 5 years ago and has leveled off in the recent 2 years.

NOPAT/Sales

NKE’s NOPAT% has increased by 1 percentage point form 5 years ago and is currently 2.8 percentage points higher than RBK’s.

RBK’s NOPAT% has also increased over the 5 year period, and is currently 1.8 percentage points higher than in year 1. It is currently significantly lower than NKE’s.

TAX exp. %

NKE’s tax expense has been increasing and is currently higher than RBK’s.

RBK’s tax expense has been decreasing over the 5 year period.

NOA turnover

NKE’s NOA turnover has increased significantly over the 5 year period, but is currently lower than RBK’s.

RBK’s NOA turnover has decreased form its high in Year 3, but has leveled off in the past 2 years.

Receivables turnover

NKE’s receivables turn has fluctuated within a constant band over the past 5 years and the average collection period currently stands at 63 days.

RBK’s receivable turn is significantly higher than NKE’s, and has remained fairly constant during the past 3 years. Its average collections period is 50 days.

Inventory turnover

NKE turns its inventories 4.45 times a year, for an average inventory days outstanding of 82 days.

RBK turns its inventories 5.71 times a year for an average inventory days outstanding of 64 days.

L-T oper. asset turn

NKE has been turning its long-term operations assets more quickly over the past 5 years, but only half as fast as RBK does.

RBK’s long-term operating asset turnover rate is twice that of NKE and has been increasing steadily over the past 5 years.

Accts. Pay turn

NKE’s accounts payable turnover rate has slowed over the past 3 years, increasing its average payable days outstanding to 35 days.

RBK’s accounts payable turnover has increased over the past 3 years, reducing its average payable days outstanding to 27 days.

Chapter 08 - Return on Invested Capital and Profitability Analysis

Case 8-2—concluded b. NKE’s operating performance is better than RBK’s. Its NOPAT margin is 2.8 percentage points higher, driven by a significantly higher gross profit margin. It appears that NKE is able to use its brand recognition and effective advertising to command higher unit selling prices for its products. The NOA turnover is roughly comparable to the two companies. Most of the assets are current and NKE working capital turnover rate (not listed) is 3.89 times, compared with RBK’s of 3.14. The higher turnover of the more significant working capital accounts more than offsets NKE’s slower long-term operating assets turnover rate. Based on this analysis, NKE appears to exhibit superior operating performance. Whether the stock is a “buy” depends on two factors: 1. is NKE’s higher profit margin sustainable, and 2. has the market already impounded the superior operating performance into NKE stock price.

Chapter 08 - Return on Invested Capital and Profitability Analysis

Case 8-3 (75 minutes) a. Computation and Disaggregation of ROCE Year 13

Year 9

ROCE NOA NFOA Equity

13.34% 5,527 497 5,030

23.09% 3,243 199 3,044

LEVB

0.10

0.07

NOPAT NFEC Net income

654 17 671

677 26 703

11.82% -3.52% 15.34%

20.87% -13.17% 34.04%

RNOA NFRD SpreadE A NOA - Equity B NFO/Equity C Net income-NOPAT

D Negative amount indicates net income vs. expense E RNOA-NFR

Computations ROCE NOA NOPAT 1

Year 13 $671/$5,030 = .133 $363+$1,390+$609+5,228+$2,272$2,821-$1,514=$5,527 ($8,529-$6,968-$515)x(1($403/$1,074))=$654

Year 9 $703/$3,044=.231 $381+$224+$+909+3,397+$1,084$1,262-$1,490=$3,243 ($4,594-$3,484)x(1($450/$1,153)=$677

Ending assets are used because information is unavailable to compute average assets.

b. Disney’s profit margin on sales decreased substantially from Year 9 to Year 13. Some reasons for this change include: • Disney experienced above average growth in the film entertainment business, which has the lowest operating margin of any of its business segments. • Disney experienced deterioration in consumer product margins as the business mix shifted away from licensing and royalty income. • Euro Disney losses and reserve provision (write-off) hurt Year 13 results, as compared with no effect in Year 9. • Disney experienced deterioration in the theme park margins because of lower attendance—this, in turn, stemmed from a slower economy and more expensive admission prices. • The profit margin on sales is offset, to some extent, by the favorable effects of financial leverage as the return on financial assets (other current assets) exceeds borrowing costs.

Chapter 08 - Return on Invested Capital and Profitability Analysis

Case 8-4 (55 minutes) a. The level of sales would be affected by many factors, including the following: (i) the quality and popularity of products for the particular fashion season, (ii) the number of customers reached via the catalog or the internet, (iii) the prices at which goods are offered, and (iv) the state of the economy. The gross profit level would be affected by: (i) the quality of materials used in production, (ii) the costs of manufacturing products, (iii) the price of goods purchased for resale, and (iv) the prices at which goods are sold. b. In simple terms, the gross profit percent gives you a measure of how much of each dollar sold is available to cover the non-product costs. For Land's End in Year 9, the gross profit percent indicates that for every $1 of sales, there was $0.45 to cover selling, general, and administrative expenses, and all other expenses. c. The selling, general, and administrative expenses would be determined by all of the following: (i) the cost of paper, (ii) the cost of postage to mail the catalogs, (iii) the cost of the photography and catalog production, (iv) the number of pages per catalog, and (v) the number of catalogs mailed. The cost of paper is most likely directly related to the quality of the paper used. The quality of the paper used can impact sales by influencing the customer's opinion of the quality of the products (that is, if cheap paper is used, the products may be perceived as cheaply made, but if the catalog is made of heavy, glossy paper, the products may be expected to be of similar high quality). Limiting the size and weight of each catalog can control the cost of postage. However, limiting the size and weight of each catalog may mean lower sales because customers may not get enough information about the products available. By choosing a higher or lower quality production, the cost of the photography and the catalog production can be controlled. The expected impact on the sales level would be similar to the impact of the paper quality. The number of pages can be easily controlled. There is probably an optimum number of pages to maximize sales levels (that is, more is probably not absolutely better). The number of catalogs mailed can easily be controlled with proper address tracking (to avoid doubling or tripling up on some customers). Again, there is probably an optimum number of different addresses to target.

Chapter 08 - Return on Invested Capital and Profitability Analysis

Case 8-5 (95 minutes) a. Petersen Corporation (1) $ of Total (2) % of Divisional (3) Divisional Income Consolidated Revenue Income to Total Income as % of Revenue

Manuf. engin. products ...............

Engineering equipment .............. 28.1 18.3 16.8 17.0

Other equipment .........................

2.9

Parts, supplies & services.......... 27.5 18.4 17.3 17.2

Total .............................................. 61.1 40.4 37.6 37.1 52.5 30.7 43.5 40.7

5.7

5.5

3.7

Engin. & erecting services .........

International operations .............

3.5

6.3 14.3

5.8 12.0

-- 10.0

9.6

8.8

Systems Group ............................ 61.1 40.4 43.9 51.4 83.9 48.3 58.9 61.5

9.2

9.5 14.612.3

5.7

7.2

9.0 9.2

6.9

8.1 8.4

5.5 (1.8)

6.1

6.4 5.9

6.9

8.0 8.2

6.0 12.611.3

-- 31.4 17.6

8.7 --

Total Environmental

Graphics Group Frye Copy Systems ..................... 23.6 17.3 16.1 15.3 20.2 15.6 13.2 13.6 Sinclair and Valentine .................

-- 33.0 29.5 23.7

A. C. Garber ................................. 15.3

9.3 10.5

-- 28.9 21.8 19.4

9.6 (4.1)

7.2

6.1

Total Graphics Group ................. 38.9 59.6 56.1 48.6 16.1 51.7 41.1 38.5

2.8

Total rev. or div. income ............. 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

Chapter 08 - Return on Invested Capital and Profitability Analysis

Case 8-5—concluded b. The Environmental Systems Group has generally declined in its contribution to total consolidated revenue. The exception is in Year 3 when the decline was reversed due to a strong increase in the revenue of the engineering and erection services division. The Graphics Group markedly increased its dollar revenue share in Year 2. This increase is largely due to the acquisition of Sinclair and Valentine in Year 2. Accordingly, this increase has largely leveled off. Note that only income-related data are reported for international operations. In such a case, the analyst must carefully examine the related textual disclosures. In the case of Petersen Corp., these figures consist of royalty income and the Company's equity participation in the income before taxes of the international subsidiaries and affiliates of the group, neither of which are included in revenue. While the Environmental Systems Group has declined overall in its contribution to sales, it has grown in its contribution to income. Its income share is much larger than its share of revenues—this is due to greater profitability by the Environmental Systems Group and, particularly, the Manufactured Engineering Products where profitability (as measured by divisional income as a percent of revenues) has been growing. While this profitability has declined somewhat from Year 2 to Year 3, it remains at a level considerably higher than the company as a whole.

Chapter 08 - Return on Invested Capital and Profitability Analysis

Case 8-6 (150 minutes) 1. Sears and Wal-Mart-Recast Income Statement Sears

Wal-Mart

1999 OR

Operating Revenue Sales and Service Other Income Credit Revenues

1998

36728 6 4343

36957 28 4618 41077

Less Operating Expenses Cost of Sales Selling & General Admin Provision for Uncollectible Accounts Depreciation & Amortization Restructuring and Impairment Cumulative Effect of Acctg Change

27212 8418 871 848 41

Less Tax Expense Reported Provision Interest Tax Shield

Operating Income

NFE

Less Net Financial Expense Interest Expense Interest Interest on Capital Lease Extraordinary Loss on Debt Extinguishment

27444 8384 1287 830 352

MIN

Less Minority Interest

Net Income

1998

137634 1574 166809

129664 27040

139208 108725 22363

198

904 444

38297 766 498

156902 3338 358

131088 2740 279

1348

1264

3696

3019

2339

2042

6211

5101

1268

1423

756 266

529 268

1022

797

24 1268

Less Interest Income Less Int. Tax Shield (@ 35% tax rate)

165013 1796 41603

37390 TE

1999

1447

444

498

358

279

824

949

664

518

170

153

1453

1048

5377

4430

Chapter 08 - Return on Invested Capital and Profitability Analysis

Case 8-6—continued Sears and Wal-Mart—Recast Balance Sheet Sears 1998

1999 Net Operating Assets Operating Assets OA Cash and cash equivalents 729 Retained interest in transferred 3144 credit card receivables Net credit card receivables 18033 Trade Receivables 404 Merchandise inventories 5069 Prepaid exp & deferred charges 579 Deferred Taxes 1076 Property, Plant & Equipment, net 6450 Property under Capital Leases,net Goodwill and Intangibles Other Assets & Deferred Charges 1470

495 4294

612 3719

17972 397 4816 506 1363 6380

18003 401 4943 543 1220 6415

1452 36954

NOA

less Operating Liabilities Accounts Payable etc Accrued Liabilities Unearned Revenues Accrued Taxes Deferred Taxes Postretirement Benefits1

1461 37675

6732

6862

971 584

928 524

950 554

Net Operating Assets

2346 10727 26227

Financial Obligations and Equity Financial Liabilities FL Commercial Paper Short Term Borrowings 2989 Long-Term Debt Due within 1 year 2165 Capital Lease Obligations due within 1 year Long Term Debt 12884 Capital Lease Obligations

Ave.

1856

1879

1868

1341 19793 1366

1118 17076 1059

1230 18435 1213

32839 3130 9392 632

23674 2299 2538 353

28257 2715 5965 493

37315

6992

2180

Wal-Mart 1999 1998

Ave.

70349

49996

60173

13105 6161

10257 4998

11681 5580

1129 759

501 716

815 738

2263 10530 27145

21154 49195

26686

4624 1414

3807 1790

13631

13258

16472 33524

18813 41360

3323

1662

1964 121

900 106

1432 114

13672 3002

6908 2699

10290 2851

18038

19669

18854

22082

10613

16348

Net Financial Obligations Minority Interest Equity

18038 1350 6839

19669 1410 6066

18854 1380 6453

22082 1279 25834

10613 1799 21112

16348 1539 23473

Net Financing

26227

27145

26686

49195

33524

41360

less Financial Assets

NFO MIN E NFO +E

1 Including this as operating because the pension expense has been included with operating expenses. Part 6 of the case involves restating the balance sheet and income statement and redoing the analysis. At that stage it is necessary to classify interest cost, return on plan assets and the funded status of the pension plans as non-operating (financial). 8-33 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 08 - Return on Invested Capital and Profitability Analysis

Case 8-6—continued 2. 1999 BALANCE SHEET Net Operating Assets OA Operating Assets OL less Operating Liabilities NOA Net Operating Assets

Sears

Wal-Mart

37315 10629 26686

60173 18813 41360

18854

16348

18854 1380 6453 26686

16348 1539 23473 41360

41077 37390 1348 2339 824 62 1453

166809 156902 3696 6211 664 170 5377

Sears 22.52% 19.34% 1.16

Wal-Mart 22.91% 22.18% 1.03

RNOA ROA NFR

8.76% 6.27% 4.37%

15.02% 10.32% 4.06%

FLEV OLLEV

2.41 0.40

0.65 0.45

NATO ATO PM

1.54 1.10 5.69%

4.03 2.77 3.72%

Financial Obligations and Equity FL Financial Liabilities FA less Financial Assets NFO Net Financial Obligations MIN Minority Interest E Equity NFO+ Net Financing E

INCOME STATEMENT OR Operating Revenue OE Less Operating Expenses TE Less Tax Expense OI Operating Income NFE Less Net Financial Expense MIN Less Minority Interest NI Net Income

1ST STAGE RATIO ANALYSIS ROE (excl MI) ROE (incl MI) MI Sharing Factor

Chapter 08 - Return on Invested Capital and Profitability Analysis

Case 8-6—continued FIRST STAGE ANALYSIS ROEexcl MI 22.52% 22.91%

= = =

ROEincl MI 19.34% 22.18%

x MI Sharing Factor x 1.16 x 1.03

ROEexcl MI

RNOA

FLEV

Sears

19.34%

8.76%

2.41

Wal-Mart

22.18%

15.02%

0.65

Sears Wal-Mart

RNOA 8.76% 15.02%

= = =

ROA 6.27% 10.32%

x (1+OLLEV) x (1+0.40) x (1+0.45)

Sears Wal-Mart

(RNOA-NBC) <--Spread--> x (8.76%-4.37%) <--4.39%--> (15.02%x 4.06%) <--10.96%-->

SECOND STAGE ANALYSIS Sears Wal-Mart

RNOA 8.76% 15.02%

= = =

PM 5.69% 3.72%

x x x

NATO 1.54 4.03

Sears Wal-Mart

RNOA 8.76% 15.02%

= = =

PM 5.69% 3.72%

x x x

ATO 1.10 2.77

x x x

(1+OLLEV) (1+0.40) (1+0.45)

THIRD STAGE ANALYSIS----PROFIT MARGIN DRIVERS Sears Wal-Mart

PM 5.69% 3.72%

= = =

Pre-Tax PM = Sears 8.97% = Wal-Mart 5.94% =

Sears Wal-Mart

Pre-Tax Sales PM 9.07% 6.06%

Pre-Tax PM 8.97% 5.94%

Pre-Tax Sales PM +/9.07% 6.06% -

= Gross Margin = 29.56% = 22.26%

Tax Expense/OR 3.28% 2.22%

Other PM 0.10% 0.12%

SG&A/OR 20.49% 16.20%

Chapter 08 - Return on Invested Capital and Profitability Analysis

Case 8-6—continued THIRD STAGE ANALYSIS----TURNOVER DRIVERS First determine current and noncurrent portions of operating assets and operating liabilities (average) Sears Wal-Mart Operating Assets Current Non-Current Total Operating Liabilities Current Non-Current Total Operating WC

Sears

WalMart

1 NATO 1 1.54

237

183

1 4.03

28929 8386 37315

22746 37427 60173

8366 2263 10629 20563

18075 738 18813 4671

1 + OWCTO 1 = + 2

1 FATO 1 4.9

1 35.71

1 4.45

1 226

1 LOLTO 1 18.15 (days)

(days)

BREAK-UP OF OPERATING WORKING CAPITAL (Average) Inventory Receivables Other Current Assets Current Operating Assets

Sears 4943 22122 1864 28929

Wal-Mart 18434 1230 3082 22746

Payables Other Current Liabilities Current Operating Liabilities

6862 1504 8366

11681 6394 18075

Sears

WalMart

1 OWCTO 1 2

= =

1 ITO 1 8.3

1 1 + ARTO OTHCATO 1 1 + + 1.86 22

1 APTO 1 5.99

1 OTHCLTO 1 27.3

183

1 35.71

1 1 + + 9.04 135.62

1 54.12

1 14.28

1 26.09

196

(days)

Chapter 08 - Return on Invested Capital and Profitability Analysis

Case 8-6—continued 4. Recast Financial Statements of Sears’ Business Segments Income Statement Revenue Cost of Sales Depreciation Interest Expense Provision for uncollectible amounts Others (Balancing) Operating Income Allocated Corporate Other Income Income before taxes Tax Net Income before minority interest OR Operating Revenues OE Operating Expenses Tax Expense Interest Tax Debt Shield TE Tax Expense OI Operating Income Interest Interest Tax Debt Shield NFE Net Financial Expense NI Net Income

Credit 4085

Others 36986 27212

Total 41071 27212

792

848

1116 871

152

1268

737 1347 32

7442 1388 290 6 1104 413 691

1315 491 824

2413 322 6 2419 904 1515

4085 1654 491 391

36986 35730 413 53

41071 37384 904 444

882 1549 1116 391

466 790 152 53

1348 2339 1268 444

725 824

99 691

824 1515

Key Ratios for Sears Segments Compared with Wal-Mart Sears Total Credit ROE 19.34% 26.73% RNOA 8.77% 7.87% ROA 6.27% 7.08% NFR 4.37% 4.37% FLEV 2.41 5.39 OLLEV 0.40 0.11 PM 5.70% 37.92% NATO 1.54 0.21 ATO 1.10 0.19

Average Balance Sheet Operating Assets Retained Interest in Credit Card Recbles. Net Credit Card Receivables Trade Receivables Merchandise Inventory

Credit 3498

Others 221

Total 3719

16934

1069

18003

401 4943

5991 1915 14541 890 15431

6415 37315

6862 3767 10629

PP&E 106 Others (Balancing Amt.) 85 Sub-Total 20622 Allocated Corp. Assets 1262 Total 21884 OL

37315

Operating Liabilities Payables Others Total

2209 2209

6862 1558 8420

NOA

Net Operating Assets

19675

7011

26686

Financial Liabilities

16594

2260

18854

Financial Assets

NFO

Net Financial Obligations

16594

2260

18854

E+MIN Equity+Minority Interest

3081

4751

7832

Others 14.55% 11.27% 5.12% 4.37% 0.48 1.20 2.14% 5.28 2.40

WalMart Total 22.91% 15.02% 10.32% 4.06% 0.65 0.45 3.72% 4.03 2.77

Chapter 08 - Return on Invested Capital and Profitability Analysis

Case 8-6—continued 5. Although the ROCE’s are similar the source of the ROCE is very different. WalMart’s ROCE comes from business operations and, in particular, its ability to control costs of retail operations as evidenced by higher profit margins in its retail business. Sears, on the other hand, derives its ROCE from financial leverage, particularly through its finance subsidiary. That means Sears is much more risky and, therefore, is accorded a lower valuation.

Chapter 09 - Prospective Analysis

Chapter 9 Prospective Analysis REVIEW Prospective analysis is the final step in the financial statement analysis process. It includes forecasting of the balance sheet, income statement and statement of cash flows. Prospective analysis is central to security valuation. Both the free cash flow and residual income valuation models described in Chapter 1 require estimates of future financial statements. We provide a detailed example of the forecasting process to project the income statement, the balance sheet, and the statement of cash flows. We describe the relevance of forecasting for security valuation and provide an example utilizing forecasted financial statements to implement the residual income valuation model. We discuss the concept of value drivers and their reversion to long-run equilibrium levels. In the appendix, we provide a detailed example of short-term cash flow forecasting.

Chapter 09 - Prospective Analysis

OUTLINE •

The Projection Process Projecting Financial Statements Application of Prospective Analysis in the Residual Income Valuation Model Trends in Value Drivers

•

Short-term Forecasting (Appendix)

Chapter 09 - Prospective Analysis

ANALYSIS OBJECTIVES •

Describe the importance of prospective analysis.

•

Explain the process of projecting the income statement, the balance sheet and the statement of cash flows.

•

Discuss and illustrate the Importance of Sensitivity Analysis.

•

Describe the implementation of the projection process in the valuation of equity securities.

•

Discuss the concept of value drivers and their reversion to long-run equilibrium levels.

Chapter 09 - Prospective Analysis

QUESTIONS 1. Prospective analysis is central to security valuation. All valuation models rely on forecasts of earnings or cash flows that are, then, discounted back to the present to arrive at the estimated value of the security. Prospective analysis is also useful to examine the viability of companies’ strategic plans, that is, whether they will be able to generate sufficient cash flows from operations to finance expected growth or whether they will be required to seek external financing. In addition, prospective analysis is useful to examine whether announcing strategies will yield the benefits expected by management. Finally, prospective analysis can be used by creditors to assess companies’ ability to meet debt service requirements. 2. Prior to the forecasting process, financial statements can be recast to better portray economic reality. Adjustments might include elimination of transitory items or reallocating them to past or future years, capitalizing (expensing) items that have been expensed (capitalized) by management, capitalizing operating leases and other forms of off-balance sheet financing, and so forth. 3. In addition to trend analysis, analysts frequently incorporate external (non-financial) information into the prospective process. Some examples are the expected level of macroeconomic activity, the degree to which the competitive landscape is changing, any strategic initiatives that have been announced by management, and so forth. 4. The forecast horizon is the period for which specific estimates are made. It is usually 5-7 years. Forecasts beyond the forecast horizon are of dubious value since estimates are uncertain. 5. Since all valuation models are infinite horizon models, analysts frequently assume a steady state into perpetuity after the forecast horizon. A common assumption is that the company will grow at the long-run rate of inflation, that is, remaining constant in real terms. 6. The projection process begins with an expected growth in sales. Gross profit and operating expenses are, then, estimated as a percentage of forecasted sales using historical ratios and external information. Depreciation expense is usually estimated as a percentage of beginning gross depreciable assets under the assumption that depreciation policies will remain constant. Interest expense is usually estimated at an average borrowing rate applied to the beginning balance of interest bearing liabilities. Projections of expected interest rates are used for variable rate indebtedness and new borrowings. Finally, tax expense is estimated using the effective tax rate on pre-tax income. 7. In the first step, balance sheet items are projected using forecasted income sales (COGS) and relevant turnover ratios. Long-term assets are projected using forecasted capital expenditures. Long-term liabilities are projected from current maturities of longterm debt disclosed in the debt footnote, and paid-in-capital is assumed to be constant in this stage. Retained earnings are projected adding (subtracting) projected profits (losses) and subtracting projected dividends. Once total liabilities and equities are forecasted, total assets is set equal to this amount and forecasted cash is computed as the plug figure. 9-4 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 09 - Prospective Analysis

In the second step, long-term liabilities and equities are adjusted to yield the desired level of cash. The analyst must be careful to maintain the historical leverage ratio and adjust liabilities and equities proportionately. 8. The residual income model expresses stock price as the book value of stockholders’ equity plus the present value of expected residual income (RI). Residual income can be expressed in ratio form as, RI = (ROEt – k) * BVt-1 Where ROE=NIt/BVt-1. This form highlights the fact that stock price is only impacted so long as ROE  k. In equilibrium, competitive forces will tend to drive rates of return (ROE) to cost (k) so that abnormal profits are competed away. The estimation of stock price, then, amounts to the projection of the reversion of ROE to its long-run value for a particular company and industry. ROE is a value driver since it impacts our valuation of the stock price. Its components (asset turnover and profit margin) are also value drivers 9. We can make two observations regarding the reversion of ROE: a. ROEs tend to revert to a long-run equilibrium. This reflects the forces of competition. Furthermore, the reversion rate for the least profitable firms is greater than that for the most profitable firms. And finally, reversion rates for the most extreme levels of ROE are greater than those for firms at more moderate levels of ROE. b. The reversion is incomplete. That is, there remains a difference of about 12% between the highest and lowest ROE firms even after ten years. This may be the result of two factors: differences in risk that are reflected in differences in their costs of capital (k); or, greater (lesser) degrees of conservatism in accounting policies. The reversion of ROA and NPM are similar. While some reversion of TAT is evident, it is much less than that of the other value drivers.

10. Short-term cash forecasts are key to assessments of short-term liquidity. An asset is called "liquid" because it will or can be converted into cash within the current period. The analysis of short-term cash forecasts will reveal whether an entity will be able to repay short-term loans as planned. This also means such analysis is extremely important for a potential short-term credit grantor. Short-term cash forecasts often are relatively realistic and accurate because of the shortness of the time span covered. 11. A cash forecast, to be most meaningful, must be for a relatively short-term period of time. There are many unpredictable variables involved in the preparation of a reliable forecast for a highly liquid asset such as cash. Over a long period of time (that is, beyond the time span of one year), the difference in the degree of liquidity among items in the current assets group is usually insignificant. What is more important for long time spans are the projections of net income and other sources and uses of funds. The focus should be shifted to working capital (and other accrual measures), and away from cash flows, for longer forecast horizons of, say, thirty months—where the time required to convert current assets into cash is insignificant.

Chapter 09 - Prospective Analysis

12. Cash inflows and outflows are highly interrelated. These two flows are crucial to a company’s “circulation system." A deficiency in any part of the system can affect the entire system. For example, a reduction or cessation of sales affects the vital conversion of finished goods into receivables or cash, which in turn leads to a drop in the cash reservoir. If the system is not strengthened by "transfusion" (such as additional investment by owners or creditors), production must be curtailed or discontinued. Lack of cash inflows also will reduce other expenses such as advertising, promotion, and marketing expenses, which will further adversely affect sales. This can yield a vicious cycle leading to business failure. 13. Most would agree with this assertion. Cash is the most liquid asset and when management urgently needs to purchase assets or incur expenses, a cash exchange is the quickest and easiest means to execute a transaction. Moreover, unless management has a credit line established with a reliable outsider (such as a revolving account at a bank), lack of cash can mean a permanent loss of profitable opportunities. 14. Ratio analysis is a static measurement tool. Ratios measure relations among financial statement items as of a given moment and time. In contrast, funds flow analysis is a dynamic measure covering a period of time. A dynamic model of funds flow analysis uses the present only as a starting point and utilizes the best available estimates of future plans and conditions to forecast the future availability and disposition of cash or working capital. Analyzing funds flow also encompasses the projected operations of a company. Since one of the fundamental assumptions of accounting is the going-concern concept, some assert that the dynamic model is more realistic and is superior to static representations. However, care should be taken in placing too much reliance on funds flow analysis as it is primarily based on estimates, and not on realized observations. 15. Except for transactions involving the raising of money from external sources (such as through loans or additional investments) and the investments of money in long-term assets, almost all internally generated cash flows relate to and depend on sales. Accordingly, the usual first step in preparing a cash forecast is to estimate sales for the period under consideration. The reliability of any cash forecast depends on the accuracy of this forecast of sales. In arriving at the sales forecast, the analyst should consider: (1) past trends of sales volume, (2) market share, (3) industry and general economic conditions, (4) productive and financial capacity, and (5) competitive factors, among other variables.

Chapter 09 - Prospective Analysis

EXERCISES Exercise 9-1 (45 minutes) Projected Income Statement for Year 12 Quaker Oats Company Forecasted Income Statement For Year Ended June 30, Year 12 Revenues [given].................................................................

$6,000.0

Costs and expenses Cost of goods sold [a] ...................................................

$3,186.0

Selling, general, and administrative [b] .......................

2,439.4

Other expenses [c].........................................................

35.2

Interest, net [d] ...............................................................

91.4

Total costs and expenses ...................................................

5,752.0

Income from continuing operations .................................

248.0

Income taxes [e] ..................................................................

105.9

Income before discontinued operations ..........................

142.1

(Loss) on disposal of discontinued operations [given] ...

(2.0)

Net income ...........................................................................

$ 140.1

Notes: [a] Cost of sales is estimated to be at a level representing the average percentage of cost of sales to sales as prevailed in the four-year period ending June 30, Year 11, which is 53.1% (19,909.2 – 9,331.3)/19,909.2. Therefore, 6,000 x .531 = $3,186. [b] Selling, general & administrative expenses in Year 12 are expected to increase by the same percentage as these expenses increased from Year 10 to Year 11, which is 15%. Therefore, $2,121.2 x 1.15 = $2,439.4. [c] Other expenses are expected to be 8% higher in Year 12. Therefore, 32.6 x 1.08 = $35.2. [d] Interest expense (net of interest capitalized) and interest income will increase by 6% due to increased financial needs. Therefore, $86.2 x 1.06 = $91.4 [e] The effective tax rate in Year 12 will equal that of Year 11, which is 42.7% ($175.7/$411.5). Therefore, tax expense = $248 x .427 = $105.9.

Chapter 09 - Prospective Analysis

Exercise 9-2 (25 minutes) Spreadsheet to Compute Forecasts of Sales and Income

Date Dec-Y1 Mar-Y2 Jun-Y2 Sep-Y2 Dec-Y2 Mar-Y3 Jun-Y3 Sep-Y3 Dec-Y3 Mar-Y4 Jun-Y4 Sep-Y4 Dec-Y4 Mar-Y5 Jun-Y5 Sep-Y5 Dec-Y5 Mar-Y6 Jun-Y6 Sep-Y6 Dec-Y6 Mar-Y7 Jun-Y7 Sep-Y7 Dec-Y7 Mar-Y8 Jun-Y8 Sep-Y8 Dec-Y8 Mar-Y9 Jun-Y9 Average change for each quarter

Forecast Sep.Y9* Forecast Dec.Y9* Forecast Mar. Y0* Forecast Jun. Y0*

Sales

N.I.

$17,349 12,278 13,984 13,972 16,040 12,700 14,566 14,669 17,892 12,621 14,725 14,442 17,528 14,948 17,630 17,151 19,547 16,931 18,901 19,861 22,848 19,998 21,860 21,806 24,876 22,459 24,928 23,978 28,455 24,062 27,410

$1,263 964 1,130 996 1,215 1,085 656 1,206 1,477 1,219 1,554 1,457 1,685 1,372 1,726 1,610 1,865 1,517 1,908 1,788 2,067 1,677 2,162 2,014 2,350 1,891 2,450 2,284 2,671 2,155 2,820

Change In Dec. Sales

Change in Dec. NI

-$1,309

-$48

1,852

Change In March Sales

in March

Change

$422

$121

Change In June Sales

Change In June NI

$582

-$474

153

2,710

178

1,945

226

2,172

270

$1,667.67

$214.67

25,645.67

2,498.67

182

202 3,067

160 2,959

254

283 2,461

214 3,068

288

321 1,603

30,041.57

2,709

172

145 1,271

$1,586.57

251

180 1,983

3,579

-227

898

153 2,905

2,028

$210

208 2,327

3,301

$697 134 159

2,019

Change in Sept. NI

262 -79

-364

Change In Sept. Sales

$201.14 $1,683.43

264

$170.14

2,482

370

$1,918.00

$241.43

2,872.14 25,745.43

2,325.14 29,328.00

3,061.43

* Most recent actual quarter + average change for the quarter. Note: Reported quarterly sales and net income for General Electric are: Sales Net income Sep Y9 $27,200 $2,653 Dec Y9 32,855 3,089 Mar Y0 29,996 2,592

Chapter 09 - Prospective Analysis

Exercise 9-3 (40 minutes) a. To illustrate how predictions of market share and total market sales can be used in the forecasting process, consider the following example. If an analyst, for instance, predicts that (i) Cough.com will maintain its 0.08% share of the market for children's cough medicine and (ii) total Industry sales of children's cough medicine for year 2006 is $3.2 billion, then a reasonable estimate of Cough.com's year 2006 sales is $2.56 million. This is computed as 0.08% market share multiplied by the expected $3.2 billion of industry sales. b. All relevant data should be sought out, subject to cost-benefit considerations, in the prediction of sales. The importance of sales to predictions of financial performance and financial condition cannot be overemphasized. Accordingly, companies invest considerable research and effort in predicting sales. Regarding what types of data to seek and how to obtain them, let’s consider a retailer. To project the sales of a retailer, an analyst might consider visiting outlets that sell the retailers’ products and observe customer-buying patterns versus the patterns observed for key competing products. This activity can be done using anecdotal observation or using formal statistical sampling depending upon the analysts' perceived need for accuracy. Moreover, the analyst can seek information from insiders via interview or interpretation of formal or informal disclosures made by the company. The analyst can also review company strategies and industry trends. In sum, good predictions involve more than sophisticated models—they demand that the analyst take the perspective of a customer constrained by the economic environment predicted to exist. c. Relying on predicted year 2006 total industry sales of $3.2 billion, the sales of Cough.com are predicted to be as follows 2006 Market share is 5% greater [105% x .08%] x $3.2 billion = $2.688 million

2006 Market share is 5% worse [95% x .08%] x $3.2 billion = $2.432 million

d. What-If industry sales are 10% higher: [105% x .08%] x [110% x $3.2 billion] = $2.9568 million

[95% x .08%] x [110% x $3.2 billion] = $2.6752 million

What-If industry sales are 10% lower: [105% x .08%] x [90% x $3.2 billion] = $2.4192 million

[95% x .08%] x [90% x $3.2 billion] = $2.1888 million

Chapter 09 - Prospective Analysis

Exercise 9–4A (30 minutes) Lyon Corporation Cash Forecast For July, Year 6 Beginning cash balance .....................................................

$ 20

Cash collections Beginning accounts receivable ...............................

$ 20

Sales for month ........................................................

150 170

Less: Ending accounts receivable ..........................

Cash available .....................................................................

149 $169

Cash disbursements Beginning accounts payable ...................................

Purchases (note a) ...................................................

115 133

Ending accounts payable (25% of purchases).......

104

Miscellaneous outlays .............................................

Cash balance ............................................................

$ 54

Minimum cash balance desired...............................

Excess cash ..............................................................

$ 24

[a] Ending inventory ....................................................................................................... Cost of goods sold (5/6 of sales) ............................................................................. Less beginning inventory......................................................................................... Purchases ..................................................................................................................

$ 15 125 140 25 $115

Chapter 09 - Prospective Analysis

PROBLEMS Problem 9-1 (90 minutes) a. Coca-Cola Year 3 Estimate 20,297

Year 2 20,092

Year 1 19,889

Cost of goods

6,106

6,044

6,204

Gross profit

14,191

14,048

13,685

Selling general & administrative expense

7,972

7,893

9,221

Depreciation & amortization expense

863

803

773

Interest expense

-66

-308

292

Income before tax

5,422

5,660

3,399

Income tax expense

1,620

1,691

1,222

Net income

3,802

3,969

2,177

Outstanding shares

3,491

3,481

Sales growth

1.02%

Gross Profit Margin

69.92%

Selling General & Administrative Exp / Sales

39.28%

Depreciation (depn exp / pr yr PPE gross)

12.14%

INT (int / pr yr LTD)

-5.45%

Tax (Inc Tax / Pre-tax inc)

29.88%

INCOME STATEMENT Net sales

RATIOS

Chapter 09 - Prospective Analysis

Problem 9-1 — continued Year 3 Estimate 587 1,901 1,066 2,300 5,854

Year 2 1,934 1,882 1,055 2,300 7,171

Year 1 1,892 1,757 1,066 1,905 6,620

Property, plant & equipment Accumulated depreciation Net property & equipment Other assets Total assets

8,305 3,515 4,791 10,793 21,438

7,105 2,652 4,453 10,793 22,417

6,614 2,446 4,168 10,046 20,834

Accounts payable & accrued liabilities Short-term debt & cmltd Income taxes Total current liab

3,717 3,899 815 8,431

3,679 3,899 851 8,429

3,905 4,816 600 9,321

Deferred income, taxes & other Long term debt Total liabilities

1,403 1,219 11,053

1,403 1,219 2,622

1,362 835 2,197

Common stock Capital surplus Retained earnings Treasury stock Shareholder equity Total liabilities & net worth

873 3,520 19,674 13,682 10,385 21,438

873 3,520 20,655 13,682 11,366 22,417

870 3,196 18,543 13,293 9,316 20,834

RATIOS AR turn INV turn AP turn Tax Pay (Tax pay / tax exp) FLEV Div/sh

10.68 5.73 1.64 50.33% 2.06 $1.37

10.68 5.73 1.64 50.33% 1.97 $1.37

11.32 5.82 1.59 49.10% 2.24 $1.21

CAPEX CAPEX/Sales

1,200 5.91%

1188 5.91%

1165 5.86%

BALANCE SHEET Cash Receivables Inventories Other Total current assets

Chapter 09 - Prospective Analysis

Problem 9-1 — continued Year 3 Estimate

Statement of Cash Flows Net income

3,802

Depreciation

863

Accounts receivable

-19

Inventories

-11

Accounts payable

Income taxes

-36

Net cash flow from operations

4,636

CAPEX Net cash flow from investing activities

-1,200 -1,200

Long term debt Additional paid in capital Dividends Net cash flow from financing activities

0 0 -4,783 -4,783 _____ -1,347 1,934 587

Net change in cash Beginning cash Ending cash

b. Based on our initial projection of Coca-Cola’s balance sheet, it appears that the company will require approximately $1.5 billion of external financing in Year 3. This amount will yield a cash balance of approximately $2 billion, consistent with prior years.

Chapter 09 - Prospective Analysis

Problem 9-2 (95 minutes) a. Best Buy Year 3 Estimate

Year 2

Year 1

Net sales

18,800

15,326

12,494

Cost of goods

15,048

12,267

10,101

Gross profit

3,752

3,059

2,393

Selling general & administrative expense

2,761

2,251

1,728

Depreciation & amortization expense

304

167

103

Income before tax

688

641

562

Income tax expense

263

245

215

Net income

425

396

347

Outstanding shares

208

200

Sales growth

22.67%

Gross Profit Margin

19.96%

Selling General & Administrative Exp / Sales

14.69%

DEPRECIATION (depn exp / pr yr PPE gross)

15.28%

Tax (Inc Tax / Pre-tax inc)

38.22%

Income statement

RATIOS

Chapter 09 - Prospective Analysis

Problem 9-2 — continued Year 3 Estimate 196 384 2,168 102 2,850

Year 2 746 313 1,767 102 2,928

Year 1 751 262 1,184 41 2,238

Property, plant & equipment Accumulated depreciation Net property & equipment Other assets Total assets

3,249 847 2,403 466 5,719

1,987 543 1,444 466 4,838

1,093 395 698 59 2,995

Accounts payable & accrued liabilities Short-term debt & cmltd Income taxes Total current liab

3,034 114 136 3,284

2,473 114 127 2,714

1,704 16 65 1,785

Long term liabilities Long term debt Total long-term liabilities

122 67 189

122 181 303

100 15 115

Common stock Capital surplus Retained earnings Shareholder equity Total liabilities & net worth

20 576 1,650 2,246 5,719

20 576 1,225 1,821 4,838

20 247 828 1,095 2,995

RATIOS AR turn INV turn AP turn Tax Pay (Tax pay / tax exp) FLEV Div/sh

48.96 6.94 4.96 51.84% 2.55 $0.00

48.96 6.94 4.96 51.84% 2.66 $0.00

47.69 8.53 5.93 30.23% 2.74 $0.00

CAPEX CAPEX/Sales

1,262 6.71%

1029 6.71%

416 3.33%

BALANCE SHEET Cash Receivables Inventories Other Total current assets

Chapter 09 - Prospective Analysis

Problem 9-2 — continued Year 3 Estimate 425 304 -71 -401 561 9 827

Statement of Cash Flows Net income Depreciation Accounts receivable Inventories Accounts payable Income taxes Net cash flow from operations CAPEX Net cash flow from investing activities

-1,262 -1,262

Long term debt Additional paid in capital Dividends Net cash flow from financing activities

-114 0 0 -114 ____ -550 746 196

Net change in cash Beginning cash Ending cash

b. Based on our projection, it appears that Best Buy will require about $550 Million of external financing to yield a cash balance of approximately $750 million. Analysts must allocate this external financing between debt and equity so as to preserve the financial leverage level presently used by Best Buy.

Chapter 09 - Prospective Analysis

Problem 9-3 (90 minutes) a. Merck Year 3 Estimate

Year 2

Year 1

Net sales

56,435

47,716

40,343

Cost of goods

34,272

28,977

22,444

Gross profit

22,164

18,739

17,900

Selling general & administrative expense

7,725

6,531

6,469

Depreciation & amortization expense

1,661

1,464

1,277

Interest expense

237

342

329

Income before tax

12,541

10,403

9,824

Income tax expense

3,762

3,121

3,002

Net income

8,779

7,282

6,822

Outstanding shares

2,976

2,968

Sales growth

18.27%

Gross Profit Margin

39.27%

Selling General & Administrative Exp / Sales

13.69%

DEPRECIATION (depn exp / pr yr PPE gross)

8.76%

INT (int / pr yr LTD)

4.94%

Tax (Inc Tax / Pre-tax inc)

30.00%

INCOME STATEMENT

RATIOS

Chapter 09 - Prospective Analysis

Problem 9-3 — continued Year 3 Estimate 5,254 6,168 4,233 880 16,536

Year 2 3,287 5,215 3,579 880 12,961

Year 1 4,255 5,262 3,022 1,059 13,598

Property, plant & equipment Accumulated depreciation Net property & equipment Other assets Total assets

24,056 7,514 16,543 17,942 51,020

18,956 5,853 13,103 17,942 44,007

16,707 5,225 11,482 15,075 40,155

Accounts payable & accrued liabilities Short-term debt & cmltd Income taxes Total current liab

6,983 4,067 1,897 12,947

5,904 4,067 1,573 11,544

5,391 3,319 1,244 9,954

Deferred income, taxes and other Long term debt Total liabilities

11,614 4,787 29,347

11,614 4,799 27,957

11,768 3,601 25,323

Common stock Capital surplus Retained earnings Treasury stock Shareholder equity Total liabilities & net worth

30 6,907 37,123 22,387 21,673 51,020

30 6,907 31,500 22,387 16,050 44,007

30 6,266 27,395 18,858 14,832 40,155

RATIOS AR turn INV turn AP turn Tax Pay (Tax pay / tax exp) FLEV Div/sh CAPEX CAPEX/Sales

9.15 8.10 4.91 50.41% 2.35 $1.06 5,100 9.04%

9.15 8.10 4.91 50.41% 2.74 $1.06 4312 9.04%

7.67 7.43 4.16 41.45% 2.71 $0.98 3641 9.03%

BALANCE SHEET Cash Receivables Inventories Other Total current assets

Chapter 09 - Prospective Analysis

Problem 9-3 — continued Year 3 Estimate

Statement of Cash Flows Net income

$ 8,779

Depreciation

1,661

Accounts receivable

-953

Inventories

-654

Accounts payable

1,079

Income taxes

323

Net cash flow from operations

10,235

CAPEX

-5,100

Net cash flow from investing activities

-5,100

Long term debt

-12

Additional paid in capital

Dividends

-3,156

Net cash flow from financing activities

-3,168 _____

Net change in cash

1,967

Beginning cash

3,287

Ending cash

5,254

b. Based on our initial projections, it appears that Merck will have excess cash of approximately $2 billion in year 3. This excess cash should be used to reduce both debt and equity so as to maintain historical financial leverage.

Chapter 09 - Prospective Analysis

Problem 9-4 (90 minutes) Historical figures Year 2 Year 3 Sales growth Net profit Margin (Net income/Sales) NWC turn (Sales/avg NWC) FA turn (Sales/avg FA) Total operating assets/Total equity Cost of equity ($ Thousands) Sales Net income ($ Mil) Net working capital Fixed assets Total Operating assets L-T Liabilities Total Stockholder's Equity ($ Mil) Residual Income Computation Net Income Beginning Equity Required Equity Return Expected Earnings Residual Income Discount factor Present value of residual income Cum PV residual income Terminal value of abnormal earnings Beg book value of equity Value of equity - Abnormal Earnings Common shares outstanding (mil) per share

Forecast Year 6

Year 7

20x8

Terminal Year 20x8

8.50% 6.71% 8.98 1.67 1.96

10.65% 8.22% 9.33 1.64 2.01

10.65% 8.22% 9.33 1.64 2.01 12.5%

10.65% 8.22% 9.33 1.64 2.01

3.50% 8.22% 9.33 1.64 2.01

25,423 1,706 2,832 15,232 18,064 8,832 9,232

28,131 2,312 3,015 17,136 20,151 10,132 10,019

31,127 2,558 3,336 18,961 22,297 11,211 11,086

34,443 2,831 3,692 20,981 24,673 12,405 12,267

38,112 3,132 4,085 23,216 27,301 13,727 13,574

42,171 3,466 4,520 25,689 30,209 15,189 15,020

46,663 3,835 5,001 28,425 33,426 16,807 16,619

48,297 3,969 5,176 29,420 34,596 17,395 17,201

2,558 10,019 12.5% 1,252 1,306 0.89

2,831 11,086 12.5% 1,386 1,445 0.79

3,132 12,267 12.5% 1,533 1,599 0.70

3,466 13,574 12.5% 1,697 1,769 0.62

3,835 15,020 12.5% 1,877 1,958 0.55

3,969 16,619 12.5% 2,077 1,892

1,161 1,161

1,142 2,303

1,123 3,425

1,105 4,530

1,086 5,616 11,665 10,019 27,301 1,737 $15.72

Horizon Year 4 Year 5

Chapter 09 - Prospective Analysis

Problem 9-5 (90 minutes) a. Telnet Corporation Pro Forma Income Statement ($000s) Six Months Ended June 30, Year 2 Sales revenue ($250 x 6 mos.) ...................................................................

$1,500

Cost of goods sold (note [a]) .....................................................................

1,199

Gross margin ...............................................................................................

301

Selling and administrative expenses ($47.5 x 6 mos.) .............................

285

Expected pre-tax income ............................................................................

Estimated income taxes (at 50%) ...............................................................

Expected net income ..................................................................................

Note [a]: We use T-accounts to compute cost of goods sold ($ thousands) Raw Material Inventory Beginning (given) Material purchases ($125 x 6 mos.)

0 750

Ending (given)

715

To W.I.P. inventory [a] (plug)

Work in Process Inventory Beginning (given) From raw materials inventory [a] Labor ($30.5 x 6 mos.) Variable overhead ($22.5 x 6 mos.) Rent ($10 x 6 mos.) Depreciation ($35 x 6 mos.) Patent amortization ($.5 x 6 mos.) Ending (given)

0 715 183 135 60 210 3

7 1,299

Prepaid expenses (given) To F.G. inventory [b] (plug)

0 Finished Goods Inventory

Beginning (given) From W.I.P. inventory [b] Ending (given)

0 1,299

1,199

Cost of goods sold (plug)

100

Chapter 09 - Prospective Analysis

Problem 9-5 — continued b. Telnet Corporation Pro forma Balance Sheet ($000s) June 30, Year 2 ASSETS Cash ............................................................................... $

(minimum cash)

Accounts receivable .....................................................

375

(45 days' sales)*

Inventories ($35 + $100) ...............................................

135

(given)

Prepaid expenses .........................................................

(given)

Total current assets ...................................................

557

(subtotal)

Equipment .....................................................................

1,200

(given)

Less accumulated depreciation ..................................

210

($35 x 6 mos.)

Equipment, net ............................................................

990

(subtotal)

Patents ...........................................................................

(given)

Less amortization .........................................................

($500 x 6 mos.)

Patents, net..................................................................

(subtotal)

Total Assets................................................................... $1,584 LIABILITIES AND STOCKHOLDERS’ EQUITY Accounts payable ......................................................... $ 125

(30 days' purchases)**

Accrued taxes ...............................................................

(from Inc. Stmt.)

Stockholders' equity ....................................................

1,300

(given)

Retained earnings ........................................................

(from Inc. Stmt.)

Additional funds needed .............................................

143

"plug"

Total liabilities and equity ........................................... $1,584 * ($250,000 x 6) / 180 days = $8,333 per day x 45 days = $375,000 ** ($125,000 x 6) / 180 days = $4,166 per day x 30 days = $125,000

Chapter 09 - Prospective Analysis

Problem 9-5 — continued c. Telnet Corporation Forecasted Statement of Cash Flows For Six Months Ended June 30, Year 2 Cash balance, beginning .....................................................

60,000

Add collection of accounts receivable * .............................

1,125,000

$1,185,000

Less disbursements for Material purchases ** ......................................................

625,000

Labor .................................................................................

183,000

Rent ...................................................................................

60,000

Overhead ...........................................................................

135,000

Selling expense ................................................................

285,000

(1,288,000)

Tentative cash balance .........................................................

$ (103,000)

Minimum cash balance required .........................................

40,000

Additional borrowing required .............................................

$ 143,000

Ending cash balance ............................................................

Loan balance ..........................................................................

$ 143,000

40,000

* Collection of accounts receivable Sales .......................................................................... Collections ................................................................ Accumulated Collections .........................................

Jan. 250 0 0

Feb. 250 125 125

Mar. 250 250 375

Apr. 250 250 625

May 250 250 875

June 250 250 1,125

** Payment of accounts payable Purchases.................................................................. Payments ................................................................... Accumulated Payments ...........................................

Jan. 125 0 0

Feb. 125 125 125

Mar. 125 125 250

Apr. 125 125 375

May 125 125 500

June 125 125 625

Chapter 09 - Prospective Analysis

Problem 9-6 (95 minutes) Quaker Oats Forecasted Statement of Cash Flows For Year Ended June 30, Year 12 Cash provided by (used for) operations Net income (a) ................................................................................................

$ 238.8

Items in income not affecting cash Depreciation & amortization (b) .................................................................

196.6

Deferred income taxes (c) ..........................................................................

54.7

Provision for restructuring charges (given) ............................................

0.0

Increase in receivables (d) ...........................................................................

(8.9)

Increase in inventories (e) ............................................................................

(45.2)

Increase in other current assets (f) .............................................................

(25.6)

Increase in accounts payable (g) ................................................................

42.1

Increase in other current liabilities (h) ........................................................

24.5

Cash provided by operating activities ........................................................

$ 477.0

Cash provided by (used for) investment activities Capital expenditures, PP&E (given) ............................................................

$ (300.0)

Asset retirements (given) .............................................................................

20.0

Other changes (given)...................................................................................

(30.0)

Cash used for investing activities ...............................................................

$ (310.0)

Cash provided by (used for) financing activities Repayments of L-T debt (given) ..................................................................

$ (45.0)

Net decrease in S-T debt (given) .................................................................

(40.0)

Cash dividend paid (given) ...........................................................................

(135.0)

Additions to L-T debt—plug (i) ....................................................................

55.8

Cash provided by financing activities ........................................................

$(164.2)

Net increase in cash (j) .................................................................................

2.8

Cash, beginning balance ..............................................................................

30.2

Cash, balance at end of year ........................................................................

$ 33.0

Notes: (a) Average percent of income from continuing operations to sales, Years 9-11 ($235.8 +$228.9 + $148.9) / ($5,491.2 + $5,030.6 + $4,879.4) = 3.98% Net income in Year 12 = $6,000 x .0398 = $238.8

Chapter 09 - Prospective Analysis

Problem 9-6 – continued (b) Depreciation and amortization in Year 12 = $238.8 x .8233 = $196.6 (c) Average percent of deferred income taxes (noncurrent) and other items to income from continuing operations, Years 9-11: $140.4 / $613.6 = 22.9% Noncurrent deferred income tax in Year 12 = $238.8 x .229 = $54.7 (d) Ending accounts receivable = $6,000 x (42/360) = $700.0 For Year 12: Accounts receivable, beg $691.1 Accounts receivable, end 700.0 Increase $ 8.9 (e) Year 12 cost of sales = $6,000 x .51 = $3,060 Ending inventory = $3,060 x (55/360) = $467.5 For Year 12: Inventory, beg $422.3 Inventory, end 467.5 Increase $ 45.2 (f) ($13.7 + $14.1 + $48.9)/3 = $25.6 (g) Year 12 purchases = $2,807.2 x 1.12 = $3,144.1 Accounts payable, end = $3,144.1 x (45/360) = $393.0 For Year 12: Accounts payable, beg $350.9 Accounts payable, end 393.0 Increase $ 42.1 (h) ($43.2 + $83.4 - $53.1)/3 = $24.5 (i) Amount required to balance statement. (j) Percent of cash to revenues in Year 11 = $30.2 / $5,491.2 = 0.55% Year-end cash in Year 12 = $6,000 x 0.55% = $33 Increase in cash for Year 12 = $33 - $30.2 = $2.8

Chapter 09 - Prospective Analysis

CASES Case 9-1 (60 minutes) Kodak INCOME STATEMENT

20x7 Est

20x6

20x5

Net sales

12,515

13,234

13,994

Cost of goods

8,199

8,670

8,375

Gross profit

4,316

4,564

5,619

Selling general & administrative expense (except depreciation)

1,761

1,862

1,776

Depreciation expense

766

765

738

Research & development costs

737

779

784

Goodwill amortization

154

151

Restructuring costs (credits)

659

-44

1,052

345

2,214

Interest expense

208

219

178

Other expense (income)

-96

Income before tax

827

108

2,132

Income tax expense

245

725

Net income

582

1,407

Outstanding shares

290

-5.43% 34.49% 14.07% 5.90% 5.89% 6.49% 29.63%

Earnings from operations

RATIOS Sales growth Gross Profit Margin Selling General & Administrative Exp / Sales DEPRECIATION (depn exp / pr yr PPE gross) R&D/sales INT (int / pr yr STD and LTD) Tax (Inc Tax / Pre-tax inc)

Chapter 09 - Prospective Analysis

Case 9-1 – continued BALANCE SHEET Cash Receivables Inventories Other Total current assets

20x7 Est $ 17 2,210 1,075 761 4,064

Property, plant & equipment Accumulated depreciation Net property & equipment Other assets Total assets

13,972 12,982 12,963 (NOTE 4) 8,089 7,323 7,044 5,883 5,659 5,919 3,020 3,020 2,802 $12,967 $13,362 $14,212

20x6 448 2,337 1,137 761 4,683

20x5 246 2,653 1,718 874 5,491

Accounts payable & accrued liabilities Short-term debt Current maturities of l-t debt Income taxes Total current liab

3,098 1,378 13 544 5,033

3,276 1,378 156 544 5,354

3,403 2,058 148 (NOTE 8) 606 6,215

Long term debt Postemployment liabilities Other long-term liabilities Total liabilities

1,653 2,728 720 10,134

1,666 2,728 720 10,468

1,166 2,722 681 10,784

Common stock Capital surplus Retained earnings Treasury stock Shareholder equity Total liabilities & net worth

978 849 6,773 5,767 2,833 12,967

978 849 6,834 5,767 2,894 13,362

978 871 7,387 5,808 3,428 14,212

RATIOS AR turn INV turn AP turn FLEV Div/sh

5.66 7.63 2.65 4.58 $2.22

5.66 7.63 2.65 4.62 $2.22

5.27 4.87 2.46 4.15 $1.88

CAPEX CAPEX/Sales

990 7.91%

1047 7.91%

783 5.60%

Chapter 09 - Prospective Analysis

Case 9-1 – continued Statement of Cash Flows

20x7 Estim.

Net income

$ 582

Depreciation

766

Accounts receivable

127

Inventories

Accounts payable

(178)

Net cash flow from operations

1,359

CAPEX Net cash flow from investing activities

(990) (990)

Long term debt Dividends Net cash flow from financing activities

(156) (643) (799) _____ (431) 448 $ 17

Net change in cash Beginning cash Ending cash

Chapter 09 - Prospective Analysis

Case 9-2 (120 minutes) Miller Company Cash Forecast For Years Ended December 31, Years 2 through 4 Year 2 Year 3 Year 4 Cash balance at beginning of period .................. $ 0 $1,929,000 $254,500 Cash received from stockholders ....................... 100,000 0 0 Proceeds of loan (see [a]) .................................... 1,700,000 100,000 0 Cash receipts less cash payments (see [b]) ...... 129,000 125,500 146,500 Payments for construction .................................. 0 (1,700,000) (100,000) Payments on loan (see [a]) .................................. 0 (200,000) (200,000) Cash balance at end of period ............................. $1,929,000 $ 254,500 $101,000 Supporting Schedules for the Cash Forecast [a] Schedule of interest and commitment fees Amount of Loan Year 2: To be borrowed 1/1 .................................................................... To be borrowed 4/1 .................................................................... Commitment fee due 4/1 ($1,000,000 x 1% x 1/4) ................... To be borrowed 7/1 .................................................................... Commitment fee due 7/1 ($500,000 x 1% x 1/4) ...................... To be borrowed 12/31 ................................................................ Commitment fee due 12/31 ($200,000 x 1% x 1/2) .................. Interest due on loan: On $800,000 @ 5% ............................................................... On $500,000 @ 5% x 3/4 ...................................................... On $300,000 @ 5% x 1/2 ...................................................... Total at 12/31/Year 2 .................................................................. Year 3: To be borrowed 4/1 .................................................................... Commitment fee due 4/1 ($100,000 x 1% x 1/4) ...................... Repayment of loan: Due 6/30 ................................................................................ Due 12/31 .............................................................................. Interest due on loan: On $1,700,000 @ 5% x 1/4 ................................................... On $1,800,000 @ 5% x 1/4 ................................................... On $1,700,000 @ 5% x 1/2 ................................................... Total at 12/31/Year 3 .................................................................. Year 4: Repayment of loan: Due 6/30 ................................................................................ Due 12/31 .............................................................................. Interest due on loan: On $1,600,000 @ 5% x 1/2 ................................................... On $1,500,000 @ 5% x 1/2 ................................................... Total at 12/31/Year 4 ..................................................................

Interest or Fee

$ 800,000 500,000 $ 2,500 300,000 1,250 100,000 1,000

$1,700,000

40,000 18,750 7,500 $71,000

100,000 250 (100,000) (100,000)

$1,600,000

21,250 22,500 42,500 $86,500

(100,000) (100,000)

$1,400,000

40,000 37,500 $77,500

Chapter 09 - Prospective Analysis

Case 9-2 – continued [b] Schedule of Operating Results Year 2

Year 3

Year 4

Operating profit (at $.04 per ton handled) .................. $200,000

$212,000

$224,000

Results of operations Interest and commitment fees (above) .......................

71,000

86,500

77,500

Cash derived from operations ......................................

129,000

125,500

146,500

Depreciation (at $.03 per ton handled) ........................

150,000

159,000

168,000

Operating loss ................................................................

$ 21,000

33,500

21,500

Operating loss from prior year(s) ................................

21,000

54,500

Accumulated operating loss ........................................

$ 54,500

$ 76,000

Interpretation and Evaluation As revealed in note [b], reporting on the "results of operations," Miller Company is expected to record operating losses for each of the next three years under analysis. Nevertheless, the analysis also reveals that Miller is expected to generate sufficient cash flow to cover the various cash commitments.

Chapter 09 - Prospective Analysis

Case 9-3 (100 minutes) Royal Company Cash Forecast For Years Ending March 31, Years 6 and 7 Year 6

Year 7

Beginning balance of cash ......................................

75,000

Cash receipt from customers (see Schedule A) .... Cash disbursements Direct materials (see Schedule B)......................... Direct labor ............................................................. Variable overhead .................................................. Fixed costs ............................................................ Total cash disbursements ..................................... Operating cash receipts less disbursements ........

825,000

1,065,000

220,000 300,000 100,000 130,000 750,000 75,000

245,000 360,000 120,000 130,000 855,000 210,000

Cash from sale of receivables and inventories ..... Total cash available .................................................

90,000 $165,000

0 $ 285,000

Payments to general creditors ................................ Ending balance of cash ...........................................

90,000 $ 75,000 1

270,000 2 $ 15,000

This amount could have been used to pay general creditors or carried forward to the beginning of the next year. 2 Computed as: ($600,000 x 60%) - ($50,000 + $40,000).

Schedule A Cash Receipts from Customers Year 6 Sales ............................................................................................ $900,000 Beginning accounts receivable................................................ 0 Total ........................................................................................... 900,000 Less: Ending accounts receivable .......................................... 75,000 Cash receipts from customers ................................................. $825,000

Year 7 $1,080,000 75,000 1,155,000 90,000 $1,065,000

Schedule B Cash Disbursements for Direct Materials Year 6 Direct materials required for production .................... $200,000 Required ending inventory ........................................... 40,000 3 Total ............................................................................... 240,000 Less: Beginning inventory ........................................... 0 Purchases .................................................................... 240,000 Beginning accounts payable ........................................ 0 Total ............................................................................... 240,000 Less: Ending accounts payable ................................... 20,000 Disbursements for direct materials ............................. $220,000 3 4

Year 7 $240,000 50,000 4 290,000 40,000 250,000 20,000 270,000 25,000 $245,000

Computed as: 12,000 units x 2/12 = 2,000; 2,000 x $20 per unit = $40,000. Computed as: 15,000 units x 2/12 = 2,500; 2,500 x $20 per unit = $50,000.

Chapter 09 - Prospective Analysis

Case 9-4 (115 minutes) a. (1) Estimated Total Cash Receipts Sep. Oct. Total sales............................................. $40,000 $48,000 Credit sales (25%) ................................ 10,000 12,000 Cash sales ............................... $30,000 36,000 $45,000 Receipts of past month's credit sales 10,000 Total cash receipts ............................... $46,000

Nov. $60,000 15,000 $60,000 12,000 $57,000

Dec. $80,000 20,000 15,000 $75,000

(2) Estimated Cash Disbursements for Purchases Oct. Nov. Dec. Total Sales ....................................... $48,000 $60,000 $80,000 Purchases (70% next mo. sales) .... Less: 2% purchase discount .......... Cash disbursements .......................

$42,000 840 $41,160

$56,000 1,120 $54,880

Total —

$25,200 $123,200 504 2,464 $24,696 $120,736

(3) Estimated Cash Disbursements for Operating Expenses Oct. Nov. Dec. Sales ................................................. $48,000 $60,000 $80,000 Salaries and Wages (15%) .............. Rent (5%).......................................... Other Expenses (4%) ...................... Cash disbursements .......................

$ 7,200 2,400 1,920 $11,520

$ 9,000 3,000 2,400 $14,400

Total —

$12,000 4,000 3,200 $19,200

$28,200 9,400 7,520 $45,120

Estimated Total Cash Disbursements Oct. Nov. Dec. Purchases [part (2)]......................... $41,160 $54,880 $24,696 Operating expenses [part (3)] ........ 11,520 14,400 19,200 Plant and equipment (given) .......... 600 400 Total cash disbursements .............. $53,280 $69,680 $43,896

Total $120,736 45,120 1,000 $166,856

(4)

(5) Estimated Net Cash Receipts and Disbursements Oct. Nov. Dec. Total cash receipts .......................... $46,000 $57,000 $75,000 Total cash disbursements .............. 53,280 69,680 43,896 Net cash increase ............................ $31,104 Net cash decrease ........................... $ 7,280 $12,680

Total $178,000 166,856 $ 11,144

Chapter 09 - Prospective Analysis

Case 9-4 — continued (6) Estimated Financing Required Oct. Nov.

Beginning cash balance .................

$12,000

$ 8,720

Net cash increase ............................ Net cash decrease ...........................

7,280

12,680

Cash position before financing ......

$ 4,720

$(3,960)

Financing required ..........................

4,000

12,000

Dec.

Total

$ 8,040

$12,000

31,104

11,144

$39,144

$23,144 16,000

Interest expense 1............................

(180)

Financing retired .............................

(16,000)

$22,964

Ending cash balance....................... 1

$ 8,720

$ 8,040

Computed as: ($4,000 x .06 x 3/12) + ($12,000 x .06 x 2/12).

b. (1) Union Corporation Forecasted Income Statement For the Quarter Ended December 31, Year 6

Sales [see (1) in part a] ......................................................

$188,000

Deduct Cost of goods sold (70% of sales)...............................

$131,600

Less: Purchase discounts taken [see (2) in part a]....

2,464

Gross profit.........................................................................

129,136 58,864

Selling and administrative expenses Salaries and wages [see (3) in part a] .........................

28,200

Rent [see (3) in part a] ..................................................

9,400

Other expenses [see (3) in part a] ...............................

7,520

Depreciation ($750 x 3 months) ...................................

2,250

Total selling and administrative expenses ......................

47,370

Operating income ...............................................................

11,494

Interest expense .................................................................

180

Net income .......................................................................

$ 11,314

Chapter 09 - Prospective Analysis

Case 9-4 — continued (2) Union Corporation Forecasted Balance Sheet As of December 31, Year 6

ASSETS Current Assets Cash [see (6) in part a] .................................................

$ 22,964

Accounts receivable (25% of Dec. sales) ....................

20,000

Inventory [($30,000 + 70% of $36,000) x 98%] ............

54,096

Total current assets ...........................................................

$ 97,060

Plant and equipment ..........................................................

101,000

Less: Accumulated depreciation ......................................

2,250

Total assets ........................................................................

98,750 $195,810

LIABILITIES AND EQUITY Liabilities.............................................................................

Stockholders' equity ..........................................................

195,810

Total liabilities and equity .................................................

$195,810

Chapter 10 - Credit Analysis

Chapter 10 Credit Analysis REVIEW This chapter focuses on credit analysis. It is separated into two major sections: liquidity analysis and solvency analysis. Liquidity refers to the availability of resources to meet shortterm cash requirements. A company's short-term liquidity risk is affected by the timing of cash inflows and outflows along with its prospects for future performance. Our analysis of liquidity is aimed at companies' operating activities, their ability to generate profits from the sale of goods and services, and working capital requirements and measures. This chapter describes several financial statement analysis tools to assess short-term liquidity risk for a company. We begin with a discussion of the importance of liquidity and its link to working capital. We explain and interpret useful ratios of both working capital and a company's operating cycle for assessing liquidity. We also discuss potential adjustments to these analysis tools and the underlying financial statement numbers. What-if analysis of changes in a company's conditions or strategies concludes this section. The second part of this chapter considers solvency analysis. Solvency is an important factor in our analysis of a company's financial statements. Solvency refers to a company's longrun financial viability and its ability to cover long-term obligations. All business activities of a company—financing, investing, and operating—affect a company's solvency. One of the most important components of solvency analysis is the composition of a company's capital structure. Capital structure refers to a company's sources of financing and its economic attributes. This chapter describes capital structure and explains its importance to solvency analysis. Since solvency depends on success in operating activities, the chapter examines earnings and its ability to cover important and necessary company expenditures. Specifically, this chapter describes various tools of solvency analysis, including leverage measures, analytical accounting adjustments, capital structure analysis, and earningscoverage measures. We demonstrate these analysis tools with data from financial statements. We also discuss the relation between risk and return inherent in a company's capital structure, and its implications for financial statement analysis.

Chapter 10 - Credit Analysis

OUTLINE Section 1: Liquidity •

Liquidity and Working Capital Current Assets and Liabilities Working Capital Measure of Liquidity Current Ratio Measure of Liquidity Using the Current Ratio for Analysis Cash-Based Ratio Measures of Liquidity

•

Operating Activity Analysis of Liquidity Accounts Receivable Liquidity Measures Inventory Turnover Measures Liquidity of Current Liabilities

•

Additional Liquidity Measures Current Assets Composition Acid-Test (Quick) Ratio Cash Flow Measures Financial Flexibility Management's Discussion and Analysis

•

What-If Analysis

Section 2: Capital Structure and Solvency •

Importance of Capital Structure Characteristics of Debt and Equity Motivation for Debt Capital Concepts of Financial Leverage Adjustments for Capital Structure Analysis

•

Capital Structure Composition and Solvency Common-Size Statements in Solvency Analysis Capital Structure Measures for Solvency Analysis Interpretation of Capital Structure Measures Asset-Based Measures of Solvency

Chapter 10 - Credit Analysis

•

Earnings Coverage Relation of Earnings to Fixed Charges Times Interest Earned Analysis Relation of Cash Flow to Fixed Charges Earnings Coverage of Preferred Dividends Interpreting Earnings Coverage Measures

•

Capital Structure Risk and Return

Appendix 11A: Rating Debt Appendix 11B: Predicting Financial Distress

Chapter 10 - Credit Analysis

ANALYSIS OBJECTIVES •

Explain the importance of liquidity in analyzing business activities.

•

Describe working capital measures of liquidity and their components.

•

Interpret the current ratio and cash-based measures of liquidity.

•

Analyze operating cycle and turnover measures of liquidity and their interpretation.

•

Illustrate what-if analysis for evaluating changes in company conditions and policies.

•

Describe capital structure and its relation to solvency.

•

Explain financial leverage and its implications for company performance and analysis.

•

Analyze adjustments to accounting book values to assess capital structure.

•

Describe analysis tools for evaluating and interpreting capital structure composition and for assessing solvency.

•

Analyze asset composition and coverage for solvency analysis.

•

Explain earnings-coverage analysis and its relevance in evaluating solvency.

•

Describe capital structure risk and return and its relevance to financial statement analysis.

•

Interpret ratings of organizations' debt obligations (Appendix 11A).

•

Describe prediction models of financial distress (Appendix 11B).

Chapter 10 - Credit Analysis

QUESTIONS 1. Liquidity is an indicator of an entity's ability to meet its current obligations. An entity in a weak short-term liquidity position will have difficulty in meeting short-term obligations. This has implications for any current and potential stakeholders of a company. For example, lack of liquidity would affect users’ analysis of financial statements in the following ways: Equity investor: In this case, the company likely is unable to avail itself of favorable discounts and to take advantage of profitable business opportunities. It could even mean loss of control and eventual partial or total loss of capital investment. Creditors: In this case, delay in collection of interest and principal due would be expected and there is a possibility of the partial or total loss of the amounts due them. 2. A major limitation in using working capital (in dollars) as an analysis measure is its failure to meaningfully relate it to other measure for interpretive purposes. That is, working capital is much more meaningful when related to other amounts, such as current liabilities or total assets. In addition, the importance attached to working capital by various users provides a strong incentive for an entity (especially the ones in a weak financial position) to stretch the definition of its components. For example, some managers may “expand” the definition of what constitutes a current asset and a current liability to better present their current position in the most favorable light. Moreover, there are several opportunities for managers to stretch these definitions. For this reason, the analyst must use judgment in evaluating management’s classification of items included in working capital—and apply adjustments when necessary. 3. In classification of accounts as current or noncurrent, we look to both the intentions of management and the normal practice for the industry (beyond the “longer of the operating cycle or one-year” rule). In the case of fixed assets, there is the possibility of their inclusion in current assets under one condition. The condition is that management intends to sell these fixed assets and management has a definite contractual commitment from a buyer to purchase them at a specific price within the following year (or operating cycle, if longer). 4. Installment receivables derived from sales in the regular course of business are deemed to be collectible within the operating cycle of a company. Therefore, such installment receivables are to be included in current assets. 5. Inventories are not always reported as current assets. Specifically, inventory amounts in excess of current requirements should be excluded from current assets. Current requirements include quantities to be used within one-year or the normal operating cycle, whichever period is longer. Business at times builds up its inventory in excess of current requirement to hedge against an increase in price or in anticipation of a strike. Such excess inventories beyond the requirements of one year should be classified as noncurrent. 6. Prepaid expenses represent advance payments for services and supplies that would otherwise require the current outlay of funds during the succeeding one-year or a longer operating cycle.

Chapter 10 - Credit Analysis

7. Banks usually reserve the right not to renew the whole or part of a loan at their option when they sign a revolving loan agreement. The fact that a bank agrees informally to renew short-term notes does not make them noncurrent. The possibility that the company under analysis included such notes under long-term liabilities should be carefully assessed (and potentially reclassified if our analysis suggests otherwise). 8. Some of these industry characteristics, such as the absence of any distinction between current and noncurrent on the balance sheet in the real estate industry, can indeed require special treatment. However, even in such cases, analysts should be careful to consider whether these "special" characteristics change the relation existing between current obligations and the liquid funds available (or reasonably expected to become available) to meet them. Our analysis should adjust the classifications of any items not meeting our assessment of the current and noncurrent criteria. 9.

Identical working capital does not imply identical liquidity. The absolute amount of working capital has significance only when related to other variables such as sales, total assets, etc. The absolute amount only has, at best, a limited value for intercompany comparisons. A better gauge of liquidity when focusing on working capital is to relate its amount to either or both of current assets and current liabilities (or sales, assets, etc.).

10. The current ratio is the ratio of current assets to current liabilities. It is a static measure of resources available at a given point in time to meet current obligations. The reasons for its widespread use include: • It measures the degree to which current assets cover current liabilities. • It measures the margin of safety available to allow for possible shrinkage in the value of current assets. • It measures the margin of safety available to meet the uncertainties and the random shocks to which the flows of funds in a company are subject. 11. Cash inflows and cash outflows are not perfectly predictable. For example, in the case of a business downturn, sales can decline more rapidly than do outlays for purchases and expenses. The amount of cash held is in the nature of a precautionary reserve, which is intended to take care of short-term surprises in cash inflows and outflows. 12. There is a relation between inventories and sales. Specifically, as sales increase (decrease), the inventory level typically increases (decreases). However, inventories are a direct function of sales only in rare cases. Methods of inventory management exist, and experience suggests that inventory increments vary not in proportion to demand (sales) but rather with measure approximating the square root of demand. 13. Management’s major objectives in determining the amounts invested in receivables and inventories include the promotion of sales, improved profitability, and the efficient utilization of assets. 14. The current ratio is a static measure. The value of the current ratio as a measure of liquidity is limited for the following reasons: • Future liquidity depends on prospective cash flows and the current ratio alone does not indicate what these future cash flows will be. • There is no direct or established relationship between balances of working capital items and the pattern which future cash flows are likely to assume.

Chapter 10 - Credit Analysis

• Managerial policies directed at optimizing the levels of receivables and inventories are oriented primarily toward the efficient and profitable utilization of assets and only secondarily at liquidity considerations. 15. The limitations to which the current ratio is subject should be recognized and its use should be restricted to the type of analytical task it is capable of serving. Specifically, the current ratio can help assess the adequacy of current assets to discharge current liabilities. This implies that any excess (called working capital) is a liquid surplus available to meet imbalances in the flow of funds, shrinkage in value, and other contingencies. 16. Cash-based ratios of liquidity typically refer to the ratio of cash (including cash equivalents) to total current assets or to total current liabilities. The choice of deflator depends on the purposes of analysis. (i) The higher the ratio of cash to total current assets the more liquid the current asset group is. This means that this portion of the total current assets is subject only to a minimal danger of loss in value in case of liquidation and that there is practically no waiting period for conversion of these assets into usable cash. (ii) The ratio of cash to total current liabilities measures how much cash and cash equivalents are available to immediately pay current obligations. This is a severe test that ignores the revolving nature of current liabilities. It supplements the cash ratio to total current assets in that it measures cash availability from a somewhat different point of view. 17. An important measure of the quality of current assets such as receivables and inventories is their turnover. The faster the turnover—collections in case of receivables and sales in case of inventories—the smaller the likelihood of loss on ultimate realization of these assets. 18. The average accounts receivable turnover measures in effect the speed of their collection during the period. The higher the turnover figure, the faster the collections are, on average. 19. The collection period (or days' sales in accounts receivable) measures the number of days' sales uncollected. It can be compared to a company's credit terms to evaluate the quality of its collection activities. 20. Either one or all of the following are possible reasons for an increase in the collection period: • A relatively poorer collection job. • Difficulty in obtaining prompt payment for various reasons from customers in spite of diligent collection efforts. • Customers in financial difficulty, which in turn may imply a poor job by the credit department. • Change of credit policies or sales terms in a desire to increase sales. • Excessive delinquency of one or a few substantial customers.

Chapter 10 - Credit Analysis

21. (a) If the inventory level is inadequate, the sales volume may decline to below the level of sales otherwise attainable. A loss of potential customers can also occur. (b) Excessive inventories, however, expose the company to expenses such as storage costs, insurance, and taxes as well as to risks of loss of value through obsolescence and physical deterioration. Excessive inventories also tie up funds that can be used more profitably elsewhere. 22. The LIFO method of inventory valuation in times of increasing costs can render both the inventory turnover ratio as well as the current ratio practically meaningless. However, there is information regarding the LIFO reserve that is reported in financial statements. Use of the LIFO reserve enables the analyst to adjust an unrealistically low LIFO inventory value to a more meaningful inventory amount. Still, in intercompany comparative analysis, even if two companies use LIFO cost methods for their inventory valuations, the ratios based on such inventory figures may not be comparable because their respective LIFO inventory pools (bases) may have been acquired in years of significantly different price levels. 23. The composition of current liabilities is important because not all current liabilities represent equally urgent and forceful calls for payment. Some claims, such as for taxes and wages, must be paid promptly regardless of current financial difficulties. Others, such as trade bills and loans, usually do not represent equally urgent calls for payment. 24. Changes in the current ratio over time do not automatically imply changes in liquidity or operating results. In a prosperous year, growing liabilities for taxes can result in a lowering of the current ratio. Moreover, in times of business expansion, working capital requirements can increase with a resulting contraction of the current ratio—so-called "prosperity squeeze." Conversely, during a business contraction, current liabilities may be paid off while there is a concurrent (involuntary) accumulation of inventories and uncollected receivables causing the ratio to rise. Finally, advances in inventory practices (such as just-in-time) can lower the current ratio. 25. "Window dressing" refers to the adjustment of year-end account balances of current assets and liabilities to show a more favorable current ratio than is otherwise warranted. This can be accomplished, for example, by temporarily stepping up the efforts for collection, by temporarily recalling advances and loans to officers, and by reducing inventory to below the normal level and use the proceeds from these steps to pay off current liabilities. The analyst should go beyond year-end reported amounts and try to obtain as many interim readings of the current ratio as possible. Even if the year-end current ratio is very strong, interim ratios may reveal that the company is dangerously close to insolvency. More generally, our analysis must always be aware of the possibility of window dressing of both current and noncurrent accounts. 26. The rule of thumb regarding the current ratio is 2:1 — a value below that level suggests serious liquidity risk. Also, the rule of thumb suggests that the higher the current ratio be above the 2:1 level, the better. The following points, however, should be kept in mind so as not to expose our analysis to undue risks of errors in inferences: • A current ratio much higher than 2 to 1, while implying a superior coverage of current liabilities, can signal a wasteful accumulation of liquid resources. • It is the quality of the current assets and the nature of the current liabilities that are more significant in interpreting the current ratio—not simply the level itself.

Chapter 10 - Credit Analysis

• The need of a company for working capital varies with industry conditions as well as with the length of its own net trade cycle. 27. In an assessment of the overall liquidity of a company’s current assets, the trend of sales is an important factor. Since it takes sales to convert inventory into receivables and/or cash, an uptrend in sales indicates that the conversion of inventories into more liquid assets will be easier to achieve than when sales remain constant. Declining sales, on the other hand, will retard the conversion of inventories into cash and, consequently, impair a company’s liquidity. 28. In addition to the tools of analysis of short-term liquidity that lend themselves to quantification, there are important qualitative considerations that bear on short-term liquidity. These can be usefully characterized as depending on the financial flexibility of a company. Financial flexibility is the ability of a company to take steps to counter unexpected interruptions in the flow of funds. This refers to the ability to borrow from a variety of sources, to raise equity capital, to sell and redeploy assets, and to adjust the level and direction of operations to meet changing circumstances. The capacity to borrow depends on numerous factors and is subject to rapid change. It depends on profitability, stability, relative size, industry position, asset composition and capital structure. It will depend, moreover, on such external factors as credit market conditions and trends. The capacity to borrow is important as a source of funds in a time of need and is also important when a company must roll over its short-term debt. Prearranged financing or open lines of credit are more reliable sources of funds in time of need than is potential financing. Other factors which bear on the assessment of the financial flexibility of a company are the ratings of its commercial paper, bonds and preferred stock, restrictions on the sale of its assets, the degree of discretion with its expenses as well as the ability to respond quickly to changing conditions such as strikes, shrinking demand, and cessation of supply sources. The SEC requires a "Management's Discussion and Analysis of Financial Condition and Results of Operations" (MD&A). This requirement includes a discussion of liquidity factors—including known trends, demands, commitments or uncertainties likely to have a material impact on the company's ability to generate adequate amounts of cash. If a material deficiency in liquidity is identified, management must discuss the course of action it has taken or proposes to take to remedy the deficiency. In addition, internal and external sources of liquidity as well as any material unused sources of liquid assets must be identified and described. 29. The importance of projecting the effects of changes in conditions and policies on the cash resources of a company is to allow for proper planning and control. For example, if management decides to ease the credit terms to its customers, knowing the impact of the new policy on cash resources will help it make a more informed decision. It may seek improved terms from suppliers or make arrangements to obtain a loan. 30. Key elements in evaluating long-term solvency are: • Analysis of the capital structure of the firm. • Assessing different risks for different types of assets. • Measuring earnings, earning power, and earnings trend. • Estimating earnings coverage of fixed charges. • Assessing the asset coverage of loans. • Measuring protection afforded by loan covenants and collateral agreements. 10-9 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 10 - Credit Analysis

31. Analysis of capital structure is important because the financial stability of a company and the risk of insolvency depend on the financing sources as well as on the type of assets it holds and the relative magnitude of such asset categories. Specifically, there are essential differences between debt and equity, which are the two major sources of funds. Equity capital has no guaranteed return that must be paid out and there is no timetable for repayment of the capital investment. From the viewpoint of a company, equity capital is permanent and can be counted on to remain invested even in times of adversity. Therefore, the company can confidently invest equity funds in long-term assets and expose them to the greatest risks. On the other hand, debts are expected to be paid at certain specified times regardless of a company's financial condition. To the investor in common stock, the existence of debt contains a risk of loss of investment. The creditors would want as large a capital base as is possible as a cushion that will shield them against losses that can result from adversity. Therefore, it is important for the financial analyst to review carefully all the elements of the capital structure. 32. Financial leverage is the result of borrowing and incurring fixed obligations for interest and principal payments. The owners of a successful business that requires funds may not want to dilute their ownership of the business by issuing additional equity. Instead, they can "trade on the equity" by borrowing the funds required, using their equity capital as a borrowing base. Financial leverage is advantageous when the rate of return on total assets exceeds the net after-tax interest cost paid on debt. An additional advantage provided by financial leverage is that interest expense is tax deductible while dividend payments are not. 33. Leverage is a two-edged sword. In good times, net income benefit from leverage. In a recession or when unexpected adverse events occur, net income can be harmed by leverage. Therefore, the use of leverage is acceptable to the financial markets only up to some undefined level. Ninety percent is higher than that “acceptable” level. Specifically, at 90 percent debt to total capital, future financing flexibility would be extremely limited, lenders would not loan money, and equity financing may cost more than the potential returns on incremental investments. Also, a 90 percent debt level would make net earnings extremely volatile, with a sizable increase in fixed charges. The incremental cost of borrowing, including refunding of maturing issues, increases with the level of borrowing. A 90 percent debt level could pose the probability of default and receivership in the event that something goes wrong. The financial risk of such a company would be much too high for either stockholders or bondholders. 34. In an analysis of deferred income taxes, the analyst must recognize that under normal circumstances the deferred tax liabilities will “reverse” (become payable) only when a firm shrinks in size. Shrinkage in firm size is usually accompanied with losses instead of with taxable income. In such circumstances, the “drawing down” of the deferred tax account is more likely to involve credits to tax loss carryforwards or carrybacks, rather than to the cash account. To the extent that a future reversal is only a remote possibility, the deferred credit should be viewed as a source of long-term funding and be classifiable as part of equity. On the other hand, if the possibility of a drawing down of the deferred tax account in the foreseeable future is high, then the account, or a portion of it, is more in the nature of a long-term liability.

Chapter 10 - Credit Analysis

35. The accounting requirements for the capitalization of leases are not rigorous and definite enough to insure that all leases that represent, in effect, installment purchases of assets are capitalized. Consequently, the analyst must evaluate leases that have not been capitalized with a view to including them among debt obligations. Leases which cover most (say 75-80 percent) of the useful life of an asset can generally be considered the equivalent of debt financing. (See Chapter 3 for additional analysis and discussion.) 36. Off-balance-sheet financing are attempts by management to structure transactions in such a way as to exclude debt (and related assets) from the balance sheet. This is usually accomplished by emphasizing legal (accounting) form over substance. Examples of such transactions are take or pay contracts, certain sales of receivables, and inventory repurchase agreements. 37. Pension accounting recognizes that if the fair value of pension assets falls short of the accumulated pension benefit obligation, a liability for pensions exists. However, this liability normally does not take into consideration the projected benefit obligation that recognizes an estimate for future pay increases. When pension plans base their benefits on future pay formulas, the analysts, who judge such understatement as serious and who can estimate it, may want to adjust the pension liability for analysis purposes. 38. The preferred method of presenting the financial statements of a parent and its subsidiary is in consolidated format. This is also the preferred method from an analysis point of view. However, separate financial statements of the consolidated entities are necessary in some cases, such as when the utilization of assets of a subsidiary (such as an insurance company or a bank) is not subject to the full discretion of the parent. Information on unconsolidated subsidiaries is also important when bondholders of such subsidiaries must look only to a subsidiary’s assets as security. Moreover, bondholders of the parent company (particularly holding companies) may derive a significant portion of their fixed charge coverage from the dividends of the unconsolidated subsidiaries. Yet, in the event of the subsidiary's bankruptcy, the parent bondholders may be in a junior position to the bondholders of the subsidiary. 39. a. Generally, the minority interest is shown among liabilities in consolidated financial statements. However, the minority interest differs from debt in that it has neither mandatory dividend payment requirements nor principal repayment requirements. Therefore, for the purpose of capital structure analysis, it may be classified as equity rather than as a liability. b. The purpose of appropriating retained earnings is to "set aside" a certain portion of retained earnings to prevent them from serving as a basis for the declaration of dividends. There exists no claim by an outsider to such an appropriation until the contingency materializes. Therefore, unless the reason for the amount reserved is certain to occur, such appropriations should be considered a part of equity capital. c. A guarantee for product performance is the result of a definite contract with the buyer that commits the entity to correct product defects. Therefore, it is a potential liability and should be classified as such. d. Convertible debt is generally classified among liabilities. However, if the terms of conversion and the market price of the common stock are such that it is most likely to be converted into common stock, it should be considered as equity for the purpose of capital structure analysis.

Chapter 10 - Credit Analysis

e. Most preferred stock entails no absolute obligation for payment of dividends or repayment of principal—that is, it possesses characteristics of equity. However, preferred stock with a fixed maturity or subject to sinking fund requirements should, from an analysis point of view, be considered as debt. 40. a. The equity of a company is measured by the excess of total assets over total liabilities. Accordingly, any analytical revision of asset book values (from amounts reported at in the financial statements) yields a change in the amount of equity. For this reason, in assessing capital structure, the analyst must decide whether or not the book value amounts of assets are realistically stated in light of analysis objectives. b. The following are examples of the need for possible adjustments. Different or additional adjustments may be needed depending on circumstances: (1) Inventories carried at LIFO are generally understated in times of rising prices. The amount by which inventories computed under FIFO (which are closer to replacement cost) exceed inventories computed under LIFO is disclosed as the LIFO reserve. These disclosures should enable the analyst to adjust inventory amounts and the corresponding equity amounts to more realistic current costs. (2) For fiscal years beginning before 12/16/93, marketable securities were generally stated at cost, which may be below market value. Using parenthetical or footnote information, the analyst can make an analytical adjustment increasing this asset to market value and increasing owner's equity by an equal amount. (3) Intangible assets and deferred items of dubious value, which are included on the asset side of the balance sheet, have an effect on the computation of the total equity of a company. To the extent that the analyst cannot evaluate or form an opinion on the present value or future utility of such assets, they may be excluded from consideration, thereby reducing the amount of equity by the amounts at which such assets are carried. However, the arbitrary exclusion of all intangible assets from the capital base is an unjustified exercise in over-conservatism. 41. Long-term creditors are interested in the future operations and cash flows of a debtor (in addition to the short-term financial condition of the debtor). For example, a creditor of a three-year loan would want to make an analysis of solvency assuming the worst set of economic and operating conditions. For such purposes, an analysis of short-term liquidity is usually not adequate. However, such a dynamic analysis for the long term is subject to substantial uncertainties and requires assumptions for a much longer time horizon. The inevitable lack of detail and the uncertainties inherent in long-term projections severely limit their reliability. This does not mean that long-term projections are not useful. What it does mean is that the analyst must be aware of the serious limitations to which they are subject. 42. Common-size analysis focuses on the composition of the funds that finance a company. As such, it reflects on the financial risk inherent in the capital structure. Specifically, it shows the relative magnitudes of the financing sources of the company and allows the analyst to compare them with similar data of other companies. Instead, capital structure ratios reflect on the financial risk of a company by relating various components of the capital structure to each other or to total financing. An advantage of ratio analysis is that it can be used as a screening device and, moreover, can reflect on relations across more than one financial statement.

Chapter 10 - Credit Analysis

43. The difference between the book value of equity capital and its market value is usually due to a number of factors. One of these is the effect of price-level changes. These, in turn, are caused by at least two factors: change in the purchasing power of money and change in price due to economic factors such as the law of supply and demand. Therefore, with fluctuating prices, it is unlikely that historical cost will correspond to market value. Accounting methods in use can also significantly affect the book values of assets. For example, a particular depreciation method often is adopted for tax reasons rather than to measure the loss of value of an asset due to use or obsolescence. The analyst could potentially adjust for this distortion of current value by valuing the equity at market value. For actively traded securities this would not be too difficult. However, the stock market too is often subject to substantial overvaluation and undervaluation depending on the degree of speculative sentiment. Hence, in most cases, equity capital will not be adjusted to market—instead, the focus will be on valuing assets and liabilities, with equity as a residual value. 44. Since liabilities and equity reveal the financing sources of a company, and the asset side reveals the investment of these funds, we can generally establish direct relations between asset groups and selected items of capital structure. This does not, of course, imply that resources provided by certain liabilities or equity should be directly associated with the acquisition of certain assets. Still, it is valid to assume that the types of assets a company employs should determine to some extent the sources of resources used to finance them. Therefore, to help assess the risk exposure of a given capital structure, the analysis of asset distribution is one important dimension. As an example, if a company acquired long-term assets by means of short-term borrowings, the analyst would conclude that this particular method of financing involves a considerable degree of risk (and cost). 45. The earnings to fixed charges ratio measures directly the relation between debt-related and other fixed charges and the earnings available to meet these charges. It is an evaluation of the ability of a company to meet its fixed charges out of current earnings. Earnings coverage ratios are superior to other tools, such as debt-to-equity ratios, which do not focus on the availability of funds. This is because earnings coverage ratios directly measure the availability of funds for payment of fixed charges. Fixed charges are mainly a direct result of the incurrence of debt. An inability to pay their associated principal and interest payments represents the most serious risk consequence of debt. 46. Identifying the items to include in "fixed charges" depends on the purpose of the analysis. Fixed charges can be defined narrowly to include only interest and interest equivalents or broadly to include all outlays required under contractual obligations— specifically: (a) Interest and interest equivalents: i. Interest on long-term debt (including amortization of any discounts and premiums). ii. Interest element included in long-term lease rentals. iii. Capitalized interest. (b) Other outlays under contractual obligations: i. Interest on income bonds (assuming profitable operations—implicit assumption in such borrowings). ii. Required deposits to sinking funds and principal payments under serial bond obligations. iii. Principal repayments included in lease obligations. 10-13 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 10 - Credit Analysis

iv. Purchase commitments under noncancelable contracts to the extent that requirements exceed normal usage. v. Preferred stock dividend requirements of majority-owned subsidiaries. vi. Interest on recorded pension liabilities. vii. Guarantees to pay fixed charges of unconsolidated subsidiaries if the requirement to honor the guarantee appears imminent. (c) Other fixed charges—such as imputed interest in the case on non-interest or low interest-bearing obligations. These are not periodical fund drains. For each of the above categories, the corresponding income to be included in the ratio computation should be adjusted accordingly. Regarding fixed charges, those items not tax deductible must be tax adjusted. This is done by increasing them by an amount equal to the income tax that would be required to obtain an after-tax income sufficient to cover the fixed charges. The tax rate to be used should be based on the relation of the taxes on income from continuing operations to the amount of pre-tax income from continuing operations—the company's effective tax rate. 47. A company normally signs a long-term purchase contract to either insure that its supply of essential raw material is not interrupted or to get a favorable purchase discount, or both. In times of favorable economic conditions, the analyst need not worry about most such commitments (indeed, they are a positive factor). The only exception is when such commitments reflect amounts in excess of requirements given expected sales. Accordingly, if the analyst concludes that the purchase commitments represent the minimum required supplies, s/he can justifiably exclude the commitments from fixed charges. If the analyst includes the commitments in fixed charges, income should be adjusted to reflect the tax-deductible nature of the purchase that will eventually be recorded as cost of goods sold. Proceeds from the forced sale of excess supplies can also be deducted on an estimated basis. 48. Net income includes items of revenue that do not generate immediate cash. It also includes expenses that do not require the immediate use of cash. For a measure of cash available to meet fixed charges, the more relevant figure is "cash provided by operations" reported in the statement of cash flows. Net income can sometimes be used as a proxy of this more appropriate measure of cash availability. 49. Since Company B is under the control of Company A, the latter can siphon off funds from it to the detriment of B's creditors. Moreover, the customer-supplier relationship with Company A means that Company A has considerable discretion in the allocation of revenues, costs, and expenses among the two entities in such a way as to determine which company will show what portion of the total available income. This again can work to the detriment of Company B's creditors. As a lender to Company B, one would want to write into the lending agreement conditions that would prevent parent Company A from exercising its controlling powers to the detriment of the lender. 50. Debt can never be expected to carry the risks and returns of ownership because of the fixed nature of its rewards. Also, it cannot serve as the permanent risk capital of a company because it must be repaid with interest. Moreover, debt is incurred on the foundation of an equity base. Indeed, equity financing shields or at least reduces the risks of debt financing. Equity financing also absorbs the losses to which a company is exposed. Consequently, the assertion is basically accurate.

Chapter 10 - Credit Analysis

51. The advantages of convertible debt are that the company is able to potentially enlarge its equity base (and/or at a potentially lower cost) than it might otherwise be able to with pure equity financing. Also, it might be able to sell equity shares at a price in excess of the current market price and to obtain, in the interim, a lower interest cost because of the conversion feature of the debt. The disadvantages are that a subsequent decline in the market price of the stock can postpone conversion substantially and indefinitely. This would leave the company with a debt burden that it was not prepared to shoulder over the long term. Consequently, what may have been conceived of as temporary financing can, in fact, become long-term debt financing. 52. (a) Long-term indentures span such an extended period of time that they are subject to many uncertainties and imponderables. Consequently, long-term creditors often insist on the maintenance of certain ratios at specified levels and/or controls over specific managerial actions and policies (such as dividends and capital expenditures). However, no restrictive covenant or other contractual arrangement can prevent operating losses, which present the most serious risk to long-term creditors. (b) 1. Maintenance of a minimum degree of short-term liquidity. 2. Prevention of the dissipation of equity capital by retirement, refunding, or the payment of excessive dividends. 3. Preservation of equity capital for the safety of creditors. 4. Insure the ability of creditors to protect their interests in a deteriorating situation. 53.

The major reason why debt securities are rated while equity securities are not rest in the fact that there is a far greater uniformity of approach and homogeneity of analytical measures used in the evaluation of credit worthiness than there is in the evaluation of equity securities. This increased agreement on what is being measured in credit risk analysis has resulted in widespread acceptance of and reliance on published credit ratings in many sectors of the analyst community.

54. In rating an industrial bond issue, rating agencies focus on the issuing company's asset protection, financial resources, earning power, management, and the specific provisions of the debt security. Asset protection is concerned with measuring the degree to which a company's debt is covered by its assets. Financial resources encompass, in particular, such liquid resources as cash and other working capital items. Future earning power is a factor of great importance in the rating of debt securities because the level and the quality of future earnings determine importantly a company's ability to meet its obligations. Earnings power is generally a more reliable source of security than is asset protection. Management abilities, philosophy, depth, and experience always loom importantly in any final rating judgment. Through interviews, field trips and other analyses the raters probe into management's goals, the planning process as well as strategies in such areas as research and development, promotion, new product planning and acquisitions. The specific provisions of the debt security are usually spelled out in the bond indenture.

Chapter 10 - Credit Analysis

55. The analyst who can effectively execute financial statement analysis can also improve on the published bond ratings. Indeed, effective financial statement analysis is possibly even more valuable in the valuation of debt securities than in the case of equity securities. Bond ratings cover a wide range of characteristics and they present opportunities for those who can better identify key differences within a rating classification. Moreover, rating changes generally lag the market. This lag presents additional opportunities to an analyst who with superior skill and alertness can identify important changes before they become generally recognized. 56. Companies hire bond-rating agencies to rate their debt because these ratings are an externally generated, independent signal of the company's creditworthiness and quality. Investors would rely less on ratings if they were produced in-house because of management's incentives to report high quality and of management self-interest. In short, they act as independent signals of debt quality.

Chapter 10 - Credit Analysis

EXERCISES Exercise 10-1 (20 minutes) Current Ratio 1.* No change 2. No change 3. Increase 4. Decrease 5. Decrease 6. Decrease 7. Increase 8. Decrease 9. Increase 10. No change

Quick Ratio No change No change Increase No change Decrease Decrease Increase Decrease Increase Decrease

Working Capital No change No change Increase Decrease Decrease Decrease No change No change Increase No change

* Assumes a sufficient amount is provided for in the Allowance for Bad Debts.

Exercise 10-2 (30 minutes) 1.

(a) (b) NE NE

Journal Entry COGS 500 R.E. 500

Accts Recble Sales

Allow for Bad Debts Accts Recble

Bad Debt Expense Accts Recble

NE NE

COGS Inventory

NE NE

R.E. 500 COGS 500

Explanation Cost of goods sold increases by 500; average inventory increases by 250; ratio (c) decreases. Denominator will increase by half the amount of the numerator causing the (a) ratio to increase. Denominator of ratio (b) will increase causing the ratio to decrease. There is no effect on the components of ratio (c). The numerator in ratio (a) won't change and the denominator will decrease thus increasing the ratio. Because ratio (a) will increase, ratio (b) will decrease as the average accounts receivable turnover increases. Ratio (c) is unaffected. Ratio (a) will increase due to the decrease in the denominator. Ratio (b) will decrease due to the increase in the denominator, which is due to the increase in ratio (a). Ratio (c) is unaffected. Only ratio (c) is affected. The numerator increases while the denominator decreases. Neither ratio (a) nor (b) are affected. The average inventory will decrease by 50% of the decrease in the numerator in ratio (c) due to the averaging effect, thus increasing the ratio.

Chapter 10 - Credit Analysis

Exercise 10-3 (30 minutes) 1.

(a) (b) NE NE

Journal Entry Allow for Bad Debts Accts Recble

Explanation Since we use the net A.R. in computation of ratio, there is no effect.

NE NE

COGS R.E.

Neither ratio (a) nor (b) is affected. The cost of goods sold increases by $1,000, and average inventory will increase by $500 (due to the averaging effect), thus decreasing ratio (c).

NE NE

COGS Inventory

Only ratio (c) is affected. The numerator increases while the denominator decreases.

NE NE

Loss Inventory

Neither ratio (a) nor (b) is affected. Average inventory will decrease by $1,500 (half of $3,000), increasing ratio (c).

NE NE

R.E. COGS

Neither ratio (a) nor (b) is affected. The average inventory will decrease by half of the decrease in the numerator.

Sales Accts Recble

Denominator of ratio (a) decreases by half the amount the numerator decreases, causing ratio (a) to increase. Denominator of ratio (b) will increase, causing it to decrease. There is no effect on ratio (c).

Exercise 10-4 (45 minutes) a. Methods to window dress financial statements to improve the current and quick ratios: 1. Pay off accounts payable with cash. This would have the effect of reducing both current assets and current liabilities by the same amount, thus increasing the current ratio and quick ratio. 2.* Invest additional capital funds at year-end. This would increase cash without affecting current liabilities. 3.* Sell fixed assets for cash or short-term notes. This would increase current assets, but decrease only fixed assets. Thus, the current and quick ratios would improve. 4.* Borrow cash by incurring long-term liabilities (notes or bonds). This would increase cash, but would not affect current liabilities, since the purpose is to make them long-term liabilities. 5.* Defer incurring various expenses, such as advertising, research and development, and marketing, along with reducing capital expenditures. 6. Keep the cash receipts books open longer, in an effort to show higher receivables or collections. This method is a highly irregular and manipulative device. *

These procedures are normal business transactions that cannot usually be considered manipulative in character. They may become manipulative when they have no sound business justification and are undertaken solely to influence the measures used by outside analysts.

Chapter 10 - Credit Analysis

Exercise 10-4—concluded b. The analyst could, if all underlying evidence and documents were available, detect each of these methods. However, sufficient evidence, such as invoices and the books of original entry, will most likely not be available for inspection. Moreover, these methods may not be recognizable through the usual analysis of financial statements of the company. If sufficient evidence were available, the following are techniques that may be used to detect the methods described in a. 1. The analyst could determine the company's usual payment policies, and compare them with those employed at year-end. S/he could look at the terms of the liabilities, to see if they were paid at the most beneficial time—in other words, if any economic benefit was derived by paying them earlier than due or when normally paid. S/he could inspect the payments in the first month of the following year, to see if liabilities were paid disproportionately to year-end, taking into account due dates and normal requirements. An unusually low inventory at year-end might also indicate failure to purchase merchandise at year-end in an effort to improve the quick ratio. 2. The analyst could analyze the timing of investments and the use to which they were put. If s/he sees large capital infusions at year-end, and that these investments were represented by idle cash, or by marketable securities which are not related to operations, and where there is little probability of such funds being required for operations in the near future, the reason might be window dressing. 3. Contracts and invoices might be examined to see when they were entered into and when they were recorded. 4. The procedures for investigation of excessive borrowing at year-end are the same as those for excessive investments of equity funds (2. above). Also, the contracts should be studied to determine if they are bona fide loans. 5. The purchase journal and cash disbursements journal should be examined to compare expenses incurred towards the end of the year with expenses at the beginning of the following year, and the reasons for large differences. 6. To determine if the books are being kept open too long, the analyst would study such documents as the underlying invoices and canceled checks to determine their actual dates, and to compare this with the dates recorded. S/he might also confirm material accounts with customers as of the year-end.

Chapter 10 - Credit Analysis

Exercise 10-5 (30 minutes) A*

I/I=D

D/NE=D

D/D=I

I/NE=I

I/I=D

NE/I=D

I/I=D

D/NE=D

I/NE=I

I/I=D

D/D=I

D/I=D

10.

I/NE=I

Ratio codes and definitions: A. Total debt / Total equity B. Long-term debt / Total equity C. [Pre-tax earnings + Fixed charges (FC)] / FC D. [Pretax CFO + FC] / FC

Exercise 10-6 (25 minutes) I. b II. a III. b IV. b V. d

Chapter 10 - Credit Analysis

PROBLEMS Problem 10-1 (60 minutes) a. Short-term liquidity ratios for Campbell Soup: 1. [36] / [45] = $1,665.5 / $1,298.1 = 1.28 2. ($80.7 [31] + $22.5 [32] + $624.5 [33]) / $1,298.1 [45] = 0.56 3. $6,205.8 [13] / [($624.5 [33] + $564.1)/2] = 10.44 4. $4,258.2 [14] / [($819.8 [34] + $816.0)/2] = 5.21 5. $624.5 [33] / ($6,205.8 / 360) = 36.23 6. $819.8 / ($4,258.2 / 360) = 69.31 7. 36.23 + 69.31 = 105.54 8. ($80.7 + $22.5) / $1,665.5 = 0.062 9. ($80.7 + $22.5) / $1,298.1 = 0.0795 10. Ending inventory…………………… +Cost of goods sold…………………. - Beginning inventory.………………. - Depreciation…………………………. =Purchases.……………………………

$ 819.8 [34] 4,258.2 [14] 816.0 (given) 184.1 [187] $4,077.9

($525.2 [41] / ($4,077.9 / 360) = 46.36 11. 105.54 - 46.36 = 59.18 12. $448.4 [64] / $1,298.1 [45] = 34.54% b. Campbell’s liquidity position is excellent for a couple of reasons. First, the company has adequate current assets relative to current liabilities as evidenced by its current and acid-test ratios. Second, the company earns consistent sales and collects on receivables as evidenced by its receivables turnover. Consequently, the company generates abundant cash to supplement its current assets.

Chapter 10 - Credit Analysis

Problem 10-1—concluded c. Current assets using FIFO = $1,665.5 [36] + $84.6 [153] = $1,750.1 COGS (FIFO) = COGS (LIFO) + ΔLIFO reserve = $4,258.2 + [$84.6 - ($904 - $816)] = $4,254.8 1. $1,750.1 / $1,298.1 = 1.35 4. $4,254.8 / [($904.4 + $904)/2] = 4.71 5. $624.5 [33] / ($6,205.8 [13] / 360) = 36.23 6. $904.4 / ($4,258.2 / 360) = 76.46 7. 36.23 + 76.46 = 112.69 d. Disregarding, for purposes of this analysis, the prepaid expenses and similar unsubstantial items entering the computation of the current ratio, we are left with the four major elements that comprise this ratio—those are cash, accounts receivable, inventories, and current liabilities. If we define liquidity as the ability to balance required cash outflows with adequate inflows, including an allowance for unexpected interruptions of inflows or increases in outflows, we must ask: Does the relation of these four elements at a given point in time: 1. Measure and predict the pattern of future fund flows? 2. Measure the adequacy of future fund inflows in relation to outflows? Unfortunately, the answer to both of these questions is primarily no. The current ratio is a static concept of what resources are available at a given moment in time to meet the obligations at that moment. The existing reservoir of net funds does not have a logical or causal relation to the future funds that will flow through it. Yet it is the future flows that are the subject of our greatest interest in the assessment of liquidity. These flows depend importantly on elements not included in the ratio itself, such as sales, profits, and changes in business conditions. There are at least three conclusions that can be drawn: 1. Liquidity depends to some extent on cash or cash equivalents balances, but to a much more significant extent on prospective cash flows. 2. There is no direct or established relation between balances of working capital items and the pattern that future cash flows are likely to assume. 3. Managerial policies directed at optimizing the levels of receivables and inventories are mainly directed towards efficient and profitable asset utilization and only secondarily towards liquidity. These conclusions obviously limit the value of the current ratio as an index of liquidity. Moreover, given the static nature of this ratio and the fact that it consists of items that affect liquidity in different ways, we must exercise caution in using this ratio as a measure of liquidity.

Chapter 10 - Credit Analysis

Problem 10-1—concluded e. Accounts receivable turnover rates or collection periods can be compared to industry averages or to the credit terms granted by the company. When the collection period is compared with the terms of sale allowed by the company, the degree to which customers are paying on time can be assessed. In assessing the quality of receivables, the analyst should remember that a significant conversion of receivables into cash, except for their use as collateral for borrowing, cannot be achieved without a cutback in sales volume. The sales policy aspect of the collection period evaluation must also be kept in mind. A company may be willing to accept slow-paying customers who provide business that is, on an overall basis, profitable; that is, the profit on sale compensates for the extra use by the customer of the company funds. This circumstance may modify the analyst's conclusions regarding the quality of the receivables but not those regarding their liquidity. The current ratio computation views its current asset components as sources of funds that can, as a means of last resort, be used to pay off the current liabilities. Viewed this way, the inventory turnover ratios give us a measure of the quality as well as of the liquidity the inventory component of the current assets. The quality of inventory is a measure of the company's ability to use it and dispose of it without loss. When this is envisaged under conditions of forced liquidation, then recovery of cost is the objective. In the normal course of business, the inventory should, of course, be sold at a profit. Viewed from this point of view, the normal profit margin realized by the company assumes importance because the funds that will be obtained, and that would theoretically be available for payment of current liabilities, will include the profit in addition to the recovery of cost. In both cases, costs of sales will reduce net proceeds. In practice, a going concern cannot use its investment in inventory for the payment of current liabilities because any drastic reduction in normal inventory levels will surely cut into the sales volume. The turnover ratio is a gauge of liquidity in that it conveys a measure of the speed with which inventory can be converted into cash. In this connection, a useful additional measure is the conversion period of inventories.

Chapter 10 - Credit Analysis

Problem 10-2 (45 minutes) Future Technologies, Inc. Cash Forecast For Year Ended December 31, Year 2

Cash, January 1, Year 2

$ 42,000

Cash Collections Accounts receivable, Jan. 1,Year 2 Sales*

$ 90,000 472,500 562,500 (945) (72,188)

Less discount on sales [a] Less acct. rec., Dec. 31, Year 2 [b] Total cash available

489,367 531,367

Cash Disbursements Accounts payable, Jan 1., Year 2 Purchases [c] Less: Acct. pay., Dec. 31, Year 2 [d] Accrued taxes paid Other expenses—Cash [e] Cash available, Dec. 31, Year 2

78,000 356,760 (132,511)

302,249 10,800 116,550

Cash needed for equipment Cash balance desired Deficiency in Cash (need to borrow)

429,599 $ 101,768 (175,000) (30,000) $(103,232)

Sales: $450,000 x 1.05 = $472,500 Cost of goods sold $312,000 x .98 = $305,760

[a]

$472,500 x 10% x 2% = $945 (discount on sales)

[b]

$472,500 x 90% x (60/360) = $70,875 $472,500 x 10% x (10/360) = 1,313 $72,188 (Accounts receivable, Dec. 31, Year 2)

[c] Year 2 Cost of goods sold..…………... Ending inventory……………………….. Goods available for sale.……………... Beginning inventory…………………… Purchases………………………………..

$305,760 90,000 (given) $395,760 39,000 $356,760

[d]

Accounts Pay., 12/31/Year 2 = Yr 2 Purchases x (A.P., 12/31/Year 1 / Yr 1 Purchases) Accounts Pay., 12/31/Year 2 = $356,760 x ($78,000 / $210,000) = $132,511

[e]

Year 1 Sales………………………………… $ 450,000 Cost of goods sold………………. (312,000) Depreciation……………………….. (15,000) Net income…………………………. (12,000) Other expenses…………………… $ 111,000 Other expenses (Year 2) = $111,000 x 1.05 = $116,550

Chapter 10 - Credit Analysis

Problem 10-3 (45 minutes) RAM Corporation Cash Forecast before Policy Changes For Year Ended December 31, Year 2 Cash, January 1, Year 2……………………

$ 80,000

Cash Collections Accounts receivable, Jan. 1………… Sales (800,000 x 110%)………………. Less: Accounts recble., Dec. 31 [a].. Total cash available ………………………..

865,000 945,000

Cash Disbursements Accounts payable, Jan. 1……………. $130,000 Purchases [b]………………………….. 657,000 Less: Accounts pay., Dec. 31 [c]…... (244,000) Increase in notes payable…………... Accrued taxes…………………………. Cash expenses [d]…………………….

$150,000 880,000 (165,000)

543,000 (15,000) 20,000 258,500

Net cash flow………………………………...

806,500 $138,500

Cash balance desired……………………… Cash excess………………………………….

50,000 $ 88,500

Notes: [a] 360 days / ($800,000/$150,000) = 67.5 days Applied to Year 2 sales: $880,000 x (67.5/360) = $165,000 [b] Year 2 Cost of sales ($520,000 x 110%)……………… $572,000 Ending inventory (given)…………………………… 150,000 Goods available for sale…………………………… 722,000 Beginning inventory………………………………… 65,000 Purchases…………………………………………….. $657,000 [c]

Purchases x (Year 1 Accounts payable / Year 1 Purchases) = $657,000 x ($130,000 / $350,000) = $244,000

[d]

Gross profit ($880,000 - $572,000)…………………… $308,000 Less: NI (110% of $20,000 Year 1 NI) + (10% of Year 1 depreciation*) ($22,000 + $2,500)… $24,500 Depreciation noncash……………………………….. 25,000 49,500 Other cash expenses $258,500 * Depreciation expense is not expected to increase by 10%.

Chapter 10 - Credit Analysis

Problem 10-3—concluded a.

What-If Analysis of Proposed Credit Policy Change A.R., Dec. 31 [$880,000 (sales) x (90/360)]……. Less A.R. from forecast statement (above)..... Additional cash needed………………………… Cash excess (above)……………………...…….. Cash excess for this proposal…………………

$ 220,000 165,000 55,000 88,500 $ 33,500

b. What-If Analysis of Proposed Collection Period Change A.R., Dec. 31 [$880,000 (sales) x (120/360)]…… Less A.R. from statement (above)…………….. Additional cash needed…………………………. Cash excess (above)…………………………….. Cash to be borrowed…………………………….. c.

$ 293,000 165,000 128,000 88,500 $ 39,500

What-If Analysis of Proposed Payment Period Change A.P., Dec. 31 [$657,000 (purch.) x (60/360)]…. A.P. from statement (above)……………………... Additional cash needed………………………… Cash excess (above)……………………………. Cash to be borrowed…………………………….

$109,500 244,000 134,500 88,500 $ 46,000

Chapter 10 - Credit Analysis

Problem 10-4 (40 minutes)

Top Corporation Cash Forecast For Year Ended December 31, Year 6 Cash balance (1/1/Year 6)………………..

$ 35,000

Cash receipts Accounts receivable, Jan. 1..…...

$ 75,000

Sales………………………………….

412,500

Accounts receivable, Dec. 31 (Sales, $412,500 x 90/360)……..

(103,125)

Cash receipts….……………………

384,375

Total cash available……………………...

$419,375

Cash disbursements Accounts payable, Jan. 1 .……… $ 65,000 Purchases [1]……………………… 331,750 Accounts payable, Dec. 31 ……… (122,000)

274,750

Payment of notes payable……….

2,500

Accrued taxes………………………

9,000

Cash expenses [2]…………………

110,250

396,500

Estimated cash balance………………….

$ 22,875

Minimum cash balance desired……….

50,000

Required to borrow……………………….

$ 27,125

Notes: [1] Beginning inventory……………………. + Purchases (plug)……………………… Goods available for sale.………………. - Ending inventory………………………. Cost of sales ($412,500 x .70)………… [2] Gross profit (30% of sales)……………… Depreciation ($25,000 - $21,500)……….. Net income (excludes other expenses).. Other expenses (plug)………………….… Net income (given)………………………...

$ 32,000 331,750 363,750 75,000 $288,750 $123,750 3,500 120,250 110,250 $ 10,000

Chapter 10 - Credit Analysis

Problem 10-5 (60 minutes) a. Relevant information that probably can be derived from the notes to the financial statements includes: 1. Details of Gant's bank credit, including total line of credit, portion currently unused, interest rates, and terms of credit. 2. Impacts of any consolidated subsidiaries on the liquidity of the consolidated balance sheet of Gant. Subsidiaries usually maintain separate credit facilities; therefore, solvency of a subsidiary may not necessarily be accessible to the parent company's creditors. 3. Gant's pension funding obligations. Is there an unfunded liability? If so, what are the future financial obligations? Additional relevant information that you should attempt to obtain from Gant's management includes:

4. Prior years’ (and/or quarterly) statements of cash receipts and payments. 5. Forecasts statement (one or more years) of due dates and amounts for its receivables and payables. 6. Budget of planned capital expenditures. 7. Budget of planned long-term financing. b. Qualitative assessments that you would want to make regarding Gant Corporation and its industry include: 1. Financial flexibility of Gant in terms of its ability to liquidate assets without affecting profitability. 2. Level of inflation (prices changes) applicable to Gant and its industry (including those for raw materials, unionized labor, product price flexibility). 3. Gant's competitiveness in the domestic industry (that is, how up-to-date is its plant and equipment?). Also, will major capital expenditures be required in the near term? 4. How does the industry and Gant compete internationally? Are there adverse international industry developments beyond the control of Gant? In addition to these general qualitative assessments of Gant, you would want to consider the following more specific qualitative assessments:

5. Cost Control Program: How has the cost cutting program impacted its financial flexibility? How lean is its operations? Are there assets that can be disposed of without impacting productivity or profitability negatively? Has the program been too intense such that long-term opportunities are lost? 6. "Commodity" Orientation of Product Line: What has happened with commodity prices over the past several years? Are the markets for Gant's various product lines soft? 7. U.S. Plant Facilities: How has the strength/weakness in the U.S. dollar affected the company's competitive position over the past years? How competitive is Gant internationally? Will it be forced to diversify its operations internationally and/or upgrade plant productivity? How would a major sustained capital expenditure program affect solvency?

Chapter 10 - Credit Analysis

Problem 10-6 (60 minutes) a. Ratio 1. Current ratio Year 5: $61,000/$40,000………………. Year 6: $84,000/$54,000………………. 2. Days' sales in receivables 5: ($20,000 / ($155,000/360)…………... 6: ($25,000 / ($186,000/360)…………...

Year 5

Year 6

1.5 1.6

46 48

3. Inventory turnover 5: $99,000/[($32,000+$38,000)/2]…….. 2.83 6: $120,000/[($38,000+$56,000)/2]……

2.55

4. Days' sales in inventory 5: $38,000/($99,000/360)………………. 138 6: $56,000/($120,000/360)……………..

168

5. Days' purchases in accounts payable 5: $23,000/($105,000* /360)…………… 6: $29,000/($138,000* /360)…………… * Purchases Cost of sales……………………... + Ending inventory……………… Goods available for sale……….. - Beginning inventory…………... Purchases…………………………

79 76 Year 5 $ 99,000 38,000 137,000 32,000 $105,000

6. Cash flow ratio 5: $7,700 / $40,000………………….…. 6: $6,400 / $54,000………………….….

Year 6 $120,000 56,000 176,000 38,000 $138,000

0.19 0.12

b. Most of the liquidity measures of ZETA do not reveal any significant changes from Year 5 to Year 6. However, there is some deterioration in the inventory turnover. This deterioration is even more evident in the days' sales in inventory measures. Moreover, the liquidity index also suggests that the liquidity position of ZETA has deteriorated from Year 5 to Year 6. Also notice that because of a lower level of operating cash flows, the cash flow ratio shows a significant decline. Still, due to the short time span of this analysis, one would want to examine another year or two (say, Years 3 and 4) to see if these changes reflect a longer-term trend in liquidity.

Chapter 10 - Credit Analysis

Problem 10-7 (75 minutes) a. Computation of Year 10 capital structure and solvency ratios for Campbell requires that we determine the following component measures for Year 10: Long-term debt Notes payable .................................................................. $ 792.9 Capital lease obligations ................................................ 12.9 Long-term debt [172] ....................................................... 805.8 Deferred income taxes (50%) [176] ................................ 117.6 Other Liabilities [177] ...................................................... 28.5 Current Liabilities [45] ..................................................... 1,298.1 Total debt ......................................................................... $2,250.0 Equity Capital Owners' equity [54].......................................................... $1,691.8 Deferred income taxes (50%) [176] ................................ 117.6 Minority interests [178] ................................................... 56.3 Total equity ...................................................................... $1,865.7 1. $2,250.0 / $1,865.7 = 1.21 2. $2,250.0 / $4,115.6 = 0.55 3. ($805.8 + $117.6 + $28.5) / $1,865.7 = 0.51 4. $1,865.7 / $2,250.0 = 0.83 5. $1,717.7 [37] / $1,865.7 = 0.92 6. $1,298.1 / $2,250.0 = 0.58 7. Numerator

Pretax income [26] ................................................... Interest expense [100] ............................................. Int. with oper. leases (1/3 of $62.4 [143]) ............... Interest incurred [98] ............................................... Undistributed equity in earnings in nonconsolidated subs. [169A] ($13.0- $7.4) ..............

Denominator

179.4 111.6 20.8

--20.8 121.9

(5.6) 306.2

0.0 142.7

Ratio = $306.2 / $142.7 = 2.14 8. Numerator

Cash from ops before tax* ...................................... Interest expense ...................................................... Interest incurred ...................................................... Interest portion of op leases ..................................

619.5 111.6 -20.8 751.9

Denominator

--121.9 20.8 142.7

* CFO [64] $448.4 + Current tax expense $171.1 [124A] = $619.5

Ratio = $751.9 / $142.7 = 5.27 9. $367.4 / $2,250.0 = 0.16

Chapter 10 - Credit Analysis

Problem 10-7—concluded b. We would compute the total debt to total capitalization as follows: $805.8(a) [46] + $28.5(b) [177] + $235.1 (c) [176] = 38.0% $1,069.4(d) + $1,691.8(e) [54] + $56.3 (f) [178] (a) Long-term debt (b) Other liabilities (c) Deferred income taxes (assuming 100% considered as liabilities) (d) a + b + c (e) Total equity (f) Minority interests

It appears that Campbell management calculated the total debt to total capitalization ratio, item [12] as follows: Total borrowings (Notes Payable + Long-term debt) $1,008 Capitalization (Total borrowings + Total Equity + Minority Interest + Deferred Income Taxes) $2,991 Total debt to capitalization ratio

0.337 ($1,008/$2,991)

This computation omits other liabilities and deferred taxes from the computation of total debt.

Chapter 10 - Credit Analysis

Problem 10-8 (45 minutes) a. 1. Ratio of Earnings to Fixed Charges: Text reference

Numerator

(a) (b) (h) (d) (f) (g)

$4,600 400 -120 60 (300) $4,880

Pre-tax income .............................................. Interest expensed ......................................... Interest incurred............................................ Interest part of operating rental expense ... Amortization of prior capitalized interest ... Undistrib. inc. of <50% owned affiliates......

Denominator

--440 120 --$560

Ratio = $4,880 / $560 = 8.71

2. Ratio of Cash From Operations to Fixed Charges: Numerator

Pre-tax income ...................................................... Add (Deduct) adjustments: Depreciation .......................................................... Amortization of bond premium ............................ Share of minority interest in income ................... Undistributed income of affiliates ....................... Increase in accounts receivable .......................... Decrease in inventory ........................................... Increase in accounts payable .............................. Pre-tax cash provided by operations .................. Int. exp. ($400) + Bond premium amor ($300) ..... Interest incurred.................................................... Interest portion of capital leases .........................

Denominator

$4,600

$ --

600 (300) 200 (300) (900) 800 700 $5,400 700

---------440 120 $560

120 $6,220

Ratio = $6,220 / $560 = 11.11

3. Earnings Coverage of Preferred Dividends: $4,880 / {$560 + [$400/(1 - 0.40)] } = 3.98 b. The company's coverage ratios suggest the existence of sufficient earnings and cash flows to cover its fixed charges. There is no evidence of concern from any of these three coverage ratios. For a more complete analysis, we would want to collect values from other firms (competitors) and additional prior years for comparative analyses.

Chapter 10 - Credit Analysis

Problem 10-9 a. 1. Ratio of Earnings to Fixed Charges Pre-tax income ...................................................... Int. incurred – int. capitalized (880+340-120) ...... Amortization of bond discount ............................ Interest portion of rental expense ....................... Amortization of prior capitalized interest ........... Undistributed inc. of <50% owned affiliates ....... Share of minority interest ....................................

Numerator

Denominator

$5,800 1,100 100 400 100 (400) 600 $7,700

$ -1,220 100 400 ---$1,720

Ratio = $7,700 / $1,720 = 4.48

2. Ratio of Cash From Operations to Fixed Charges Numerator

Pre-tax income ...................................................... $ 5,800 Add back expenses not requiring cash: Depreciation (includes amortization of previously capitalized interest) ......................... 1,200 Amortization of bond discount ............................ 100 Share of minority interest .................................... 600 Deferred taxes—already added back .................. -Increase in inventories ......................................... (2,000) Decrease in accounts receivable......................... 1,600 Increase in accounts payable .............................. 2,000 Less Undistributed income of affiliates .............. (400) Pre-tax cash provided by operations .................. 8,900 Interest expensed—bond discount add back ..... 1,100 Interest portion of rental expense ....................... 400 Interest incurred.................................................... $10,400 Ratio = $10,400 / $1,720 = 6.04

Denominator

-100 --------400 1,220 $1,720

3. Earnings Coverage of Preferred Dividends: Ratio = $7,700 / {$1,720 + [$400/(1 - .40)] } = 3.23 b. The company's coverage ratios suggest the existence of sufficient earnings and cash flows to cover its fixed charges. There is no evidence of concern from any of these three coverage ratios. For a more complete analysis, we would want to collect values from other firms (competitors) and additional prior years for comparative analyses.

Chapter 10 - Credit Analysis

Problem 10-10 (40 minutes) a. 1. Ratio of Earnings to Fixed Charges Pre-tax income ...................................................... Interest expense (880 + 340 - 120) ....................... Interest incurred (880 + 340) ................................ Amortization of bond discount ............................ Interest portion of rental payments ..................... Amortization of capitalized interest .................... Undistributed income of <50% owned affiliates . Share of minority interest

Numerator

Denominator

$6,200 1,100 -100 400 80 (800) 600 $7,680

--1,220 100 400 --____ $1,720

Ratio = $7,680 / $1,720 = 4.47 2. Ratio of Cash From Operations to Fixed Charges Pre-tax income ...................................................... Add (deduct) items to convert to cash basis: Depreciation .......................................................... Amortization of bond discount ........................... Minority interest in income .................................. Undistributed income of affiliates ....................... Changes in: Accounts receivable ........................................... Inventories........................................................... Payable and accrued expenses ......................... Pre-tax cash from operations .............................. Interest incurred (880 + 340) ................................ Amortization of bond discount ............................ Interest expense (880 + 340 - 120) ....................... Interest portion of rental expense .......................

Numerator

Denominator

$6,200

1,200 100 600 (800) 600 (160) 120 7,860 --1,100 400 $9,360

------

---1,220 100 400 $1,720

Ratio = $9,360 / $1,720 = 5.44 3. Earnings coverage of preferred dividends: Ratio = $7,280 / {$1,720 + [$400/(1 - .40)] } = 3.05 b. Based on the calculations in part a, the supervisor's concerns about the coverage ratios are misplaced. Indeed, the company's coverage ratios suggest the existence of sufficient earnings and cash flows to cover its fixed charges. There is no evidence of concern from any of these three coverage ratios. For a more complete analysis, we would want to collect values from other firms (competitors) and additional prior years for comparative analyses.

Chapter 10 - Credit Analysis

Problem 10-11 (50 minutes) Interest incurred calculation First Mortgage Bonds: 5.0% of 7,500 = 375 6.0% of 17,500 = 1,050 Sinking Fund Debentures 6.5% of 10,000 = Total interest incurred

1,425 650 $2,075

a. Earnings Coverage Ratio on the First Mortgage Bonds (pre-tax basis) (1) 3.3 [based on Year 7 earnings, ($4,750 / $1,425)] (2) 3.1 [based on 5-year average, {($4,750+$4,500+$4,500+$4,250+$4,000)/5}/$1,425] Earnings Coverage Ratio on the Sinking Fund Debentures (pre-tax basis) (1) 7.3 [based on Year 7 earnings, ($4,750 / $650)] (2) 6.8 [based on 5-year average, {($4,750+$4,500+$4,500+$4,250+$4,000)/5}/$650] b. Long-Term Debt to Equity Ratio Ratio = $35/$47 = 0.74 → 74% of capital is debt Of equity capital, 42.6% ($20,000*/$47,000) is senior to common stock * $1.10 preferred (300,000 x $20) ..................................... Class A shares .................................................................

$ 6,000 14,000 $20,000

c. Earnings Coverage Ratio on the Cumulative Redeemable Preferred Interest requirements for long-term debt ......................................... $2,075 $1.10 preferred dividend—tax adjusted [(300,000)($1.1)]/(1-.50)..... 660 Required pre-tax ................................................................................. $2,735 (1) 1.7 = [based Year 7 earnings, ($4,750 / $2,735) (2) 1.6 = [based on 5-year average, ($4,400 / $2,735) d. Earnings per Share Computation Assuming Conversion $4,750 Year 7 earnings before interest and taxes (2,075) Interest expense $2,675 Pre-tax income (1,337) Taxes (50%) $1,338 After-tax income (330) $1.10 preferred dividends (300,000 shares x $1.10) $1,008 Available for common shareholders 1.8 mil $ 0.56

Common shares 1 mil. + 0.8 mil. (Class A Conversion) Earnings per share

Chapter 10 - Credit Analysis

Problem 10-12 (45 minutes) a. Computation of Income and EPS under Debt vs. Equity Financing Debt

Equity

Income before interest and taxes—pre-expansion.......... $20,000,000

$20,000,000

Additional income from expansion ...................................

4,000,000

Income before interest and taxes—post-expansion .......

24,000,000

Interest expense (6%)($20,000,000)+$1,000,000 ..............

(2,200,000)

(1,000,000)

Income before taxes ............................................................

21,800,000

23,000,000

Income taxes (40%) .............................................................

(8,720,000)

(9,200,000)

$13,080,000

$13,800,000

Common shares outstanding .............................................

2,000,000

2,400,000

Earnings per share ..............................................................

$6.54

$5.75

Net income

b. Computation of EPS Equality between Debt and Equity Financing (EBIT * - $2,200,000 )(1 - .40) (EBIT * - $1,000,000 )(1 - .40) = 2,000,000 2,400,000 * EBIT = Earnings Before Interest and Taxes.

Solving for EBIT yields: EBIT = $8,200,000 Interpretation: When income before interest and taxes is at $8,200,000, stockholders are indifferent between the debt or equity financing plans.

Chapter 10 - Credit Analysis

Problem 10-13 (55 minutes) a. 1. Guaranteed Subsidiary Debt. Add $250,000,000 to both long-term debt and to fixed assets. Rationale: Under the equity method of accounting for joint ventures, the debt incurred is not reported on the balance sheet of the partners and therefore, this debt should be reflected in the adjusted debt ratio since Lubbock has guaranteed the total indebtedness of the joint venture. 2. LIFO Reserve. Add $200,000,000 to both inventory and to retained earnings (ignoring potential tax effects). Rationale: Under LIFO accounting, Lubbock will report current costs for inventory transactions in its income statement but its balance sheet amount for ending inventory will reflect “first-in, still-here,” or FISH. Accordingly, the SEC requires companies using LIFO to disclose in notes to the financial statements the amounts by which LIFO inventories must be increased to reflect current costs. Lubbock reports that under FIFO, its inventories would have exceeded reported amounts by $200,000,000. Accordingly, to reflect current costs, inventories should be stated on the adjusted basis of FIFO; also, retained earnings (excluding tax effects) should be credited by the same amount that inventories are debited by. An alternative approach is to recognize a deferred tax liability of $200,000 x current marginal tax rate. 3. Operating Leases. These long-term operating leases could be capitalized. The present value of these long-term leases must be calculated using a discount rate. Assuming 10% is the interest rate implicit in the lease, the present value is approximately $750,000,000. The present value amount should be added to long term debt and to fixed assets.

b. Long-Term Debt to Long-Term Capitalization Before Adjustments ($ millions): Long-term debt Long-term debt + Minority interest + Shareholders' equity = $675 / ($675 + $100 + $400 + $1,650) = 23.9% Long-Term Debt to Long-Term Capitalization After Adjustments ($ millions): Long-term debt + Guaranteed debt + Leases Long-term debt + Minority interest + Shareholders' equity + Guaranteed debt + Inventory Adjustment + Leases = ($675+$250+$750) / ($675+$100+$400+$1,650+$250+$200+$750) = 41.6%

Chapter 10 - Credit Analysis

Problem 10-13—concluded c. 1. Two points: (i) For fiscal years beginning before 12/16/93, marketable securities were valued at the lower of cost or market under SFAS 12 (for marketable equity securities) and ARB 43 (for marketable debt securities). During this period the market value of securities were sometimes substantially higher than shown on the balance sheet, requiring analytical adjustment. Under current practice, all marketable securities (except held-to-maturity debt securities) are valued at market. Hence, only held-to-maturity debt securities are potentially subject to market adjustment. (ii) An analyst must realize that the longer the elapsed time since the balance sheet date the greater the likelihood that market values for marketable securities have changed. Hence, for comparative analysis spanning several years, adjustments to market may be necessary for investment securities. 2. Deferred income taxes are created when a company uses different accounting methods for income tax and financial reporting such that so-called timing differences in income occur. One school of thought argues that deferred taxes should be recognized as a liability. The presumption is that timing differences will reverse in the future and the taxes will become payable or that changes in the tax law could accelerate payment of such taxes. Opponents argue that deferred taxes should be included in shareholders' equity. The presumption here is that timing differences are unlikely to reverse and therefore the balance in deferred taxes will continue to grow and not become payable. This means that the longterm debt ratio of a company would be adversely affected if deferred taxes are considered long-term debt (first viewpoint); however, this ratio would be favorably impacted if such taxes are considered as part of shareholders' equity (second viewpoint).

Chapter 10 - Credit Analysis

Problem 10-14 (75 minutes) a. Ratio Computations 1. Year 5: $57,200a/ $105,000b = 0.55 Year 6: $82,600a/ $138,000b = 0.60 a

Includes: (1) Total current liabilities, (2) Long-term debt due after one year, and (3) Deferred income taxes b Includes: (1) All items in (a) above, as well as (2) Minority interest, and (3) Stockholders' equity

2. Year 5: $57,200 / $47,000 = 1.22 Year 6: $82,600 / $54,000 = 1.53 3. Year 5: $17,200a/ $47,800b = .36 Year 6: $28,600a/ $55,400b = .52 a

Including deferred taxes. Stockholders' equity + minority interest.

4. Year 5 $16,000 a + $4,000 b + $2,000 c + $16 d + $1,000 e + $1,000 f * = 3.42 $5,000 g + $2,000 c + $16 d * Loss per income statement (additional 300 added back in SCF represents dividends received).

Year 6 $21,000 a + $7,420 b + $2,500 c + $20 d + $1,200 e - $1,400 f * * $9,280 + $2,500 c + $20 g

= 2.61

**From the statement of cash flows (income minus dividends received). a Pre-tax income b Interest incurred - interest capitalized c Amortization of bond discount d Interest portion of operating rental expense e Amount of previously capitalized interest amortized in this period f Reversal of undistributed income (loss) of associated companies g Interest incurred

Chapter 10 - Credit Analysis

Problem 10-14—concluded 5. Cash from operations* + income tax expense (except deferred taxes)+ fixed charges** Fixed charges** * Depreciation added back already includes amortization of interest previously capitalized. **As computed in (4) above.

Year 5: [$7,700 + ($7,800-$1,000) + $7,016] / $7,016 = 3.07 Year 6: [$6,400+($10,000-$1,600)+$11,800]/ $11,800 = 2.25

b. Analysis and Interpretation The financial leverage index, which underwent only minimal change, is at a level suggestive of leverage benefits to ZETA's stockholders. There also has been a marked increase in leverage as is indicated by the total debt to equity and the long-term debt to equity measures. With total liabilities exceeding equity by over 50 percent, the level of liabilities is significant. The relation of long-term debt to equity is at a somewhat lower level. The earnings and cash flow coverage of fixed charges are low on an absolute basis and have declined from Year 5 to Year 6. This decline is primarily because fixed charges increased faster than net income. Finally, operating cash flows declined in Year 6 compared to Year 5.

Chapter 10 - Credit Analysis

Problem 10-15 (60 minutes) a. Ratios Based on Projected Year 7 Data 1. Operating income / Sales = 8.8%. 2. Earnings before interest and taxes / Total assets = 2.9%. 3. Times interest earned = Earnings before interest and taxes/ Interest = 1.01. 4. Long-term debt / Total assets = 55.5%.

b. Effect of Year 7 Merger on the Ratios and Creditworthiness of BRT 1. Operating income to sales: The creditworthiness of BRT Corporation, from the standpoint of operating profit margin, declines because of the merger. Operating margins for the combined company is weaker because of the inability to generate higher operating profits on the combined sales. Still, this ratio should be evaluated over a longer term to determine whether the operating efficiency of the company is improving. 2. EBIT/Total assets: The return on assets ratio declines. The company’s productive use of its assets has not improved, causing a continued decline in credit quality. The creation of a large intangible asset can affect this ratio. An analyst must determine whether, over time, management has the ability to generate higher earnings from the intangible asset. Still, this ratio value is weak—it suggests possible underutilization of the intangible rights. 3. Times interest earned: This interest coverage ratio markedly decreases, creating a credit concern regarding BRT’s ability to meet its fixed obligations. The earnings before interest and taxes of the merged company has not grown proportionally to the amount of interest owed per year. A declining interest coverage ratio indicates a lack of excess funds available for other capital expenditures. When a company’s times interest earned approaches 1.0, the creditworthiness of the company is likely reduced because of its potential inability to pay its fixed obligations. 4. Long-term debt to total assets: This leverage ratio remains flat. While a leverage ratio alone does not indicate a credit problem, the leverage ratio in combination with other ratios does. That is, BRT is unable to generate higher returns with the same amount of leverage, which affects operating performance. The issuance of additional stock allowed the companies to merge without incurring a larger increase in debt.

Chapter 10 - Credit Analysis

Problem 10-15—concluded c. Hold or Sell Analysis of BRT Bonds by Clayton Asset Management Currently, the BRT bonds are trading as BB-rated bonds. Prior to the merger, BRT’s ratios approximated a weak BB credit. After the merger, all the ratios declined below values representative of a BB credit rating except the ratio of debt to total assets, which maintained a BB credit quality. Several other factors may cause further deterioration in the financial strength of BRT. First, a large portion of assets is now intangible, which introduces the potential for overstating current values (or, at the very least, it increases uncertainty). The value of the intangibles is best measured by their ability to generate revenues. Recent results suggest that ability is suspect. Second, BRT is not generating sufficient income to cover interest expenses. This lack of sufficient income makes it difficult to provide for capital expenditures to maintain and build its current business. Third, with the weakening financial structure of BRT, the company has further reduced its flexibility to compete in a highly competitive environment. Additional contributing factors include management’s focus on aggressive expansion at the expense of bondholders’ interests and the competitive pressures created by government regulation of the industry. The cumulative effect of declining financial ratios, potentially overvalued assets, reduced ability to meet capital expenditure needs, and reduced financial flexibility to compete in a highly competitive industry, have a negative impact on BRT’s creditworthiness. It is recommended that Clayton sell the BRT bonds in anticipation of a widening spread between BRT bonds and U.S. Treasuries. This widening spread relative to Treasuries will cause the bonds to underperform as the market adjusts the values of the bonds in line with comparable lower-credit-quality bonds. (CFA adapted)

Chapter 10 - Credit Analysis

Problem 10-16 (50 minutes) Recommendation: Buy the Patriot Manufacturing bonds. Quantitative Support for Recommendation: The ratio information shows that Patriot is less risky than Sturdy Machines. First, the pre-tax interest coverage of Sturdy Machines is just over 1.0 versus Patriot’s 6.1. Second, Patriot’s cash flow to total debt is higher than Sturdy Machines and is improving. Third, Patriot’s total debt to capital ratio is lower than Sturdy Machines and it is decreasing. Qualitative Support for Recommendation: At least three qualitative factors support this recommendation. First, Patriot’s credit rating is improving as evidenced by its recent ratings upgrade. Sturdy Machines, on the other hand, is a deteriorating credit, as evidenced by its recent credit rating downgrade. Second, given that the recency of the credit-rating changes, one would expect no change (or continued increases) in the rating of the Patriot bonds and no change (or continued decreases) in the rating of the Sturdy Machines bonds. Third, we anticipate that the Patriot bonds will fall in yield (rise in price). Sturdy Machines’ bonds appear to be riskier than Patriots’ bonds. (CFA adapted)

Chapter 10 - Credit Analysis

CASES Case 10-1 (90 minutes) a. FAX Corporation Forecasted Statement of Cash Receipts and Payments For Year Ended December 31, Year 2 Beginning cash balance…………………… Add: Cash Receipts Beginning accounts receivable…. +Sales for Year 2 [1]………………. - Ending accounts receivable [2]... Cash collections……………………. Total cash inflows…………………………... Deduct: Cash disbursements Beginning accounts payable…… +Purchases for Year 2 [3]………... -Ending accounts payable [4]……. Payments to creditors…………….. Payments of cash expenses [5]…. Payment of notes payable Payment of long-term debt……….. Total cash disbursements…………………. Net cash flow………………………………… Less minimum cash balance……………… Cash borrowings expected……………

$ 30,000 $ 52,000 1,104,000 (276,000) 880,000 910,000 60,000 600,000 (75,000) 585,000 315,920 20,000 25,000 945,920 $(35,920) (20,000) $(55,920)

Notes [1] Sales for Year 2 = Sales for Year 1 x 115% = $960,000 x 1.15 = $1,104,000 [2] Ending A.R. = Average daily sales x Collection period = $1,104,000 x 90/360 = $276,000 [3] Purchases (Year 2) = COGS + Ending inventory - Beginning inventory COGS (Year 2) = COGS (Year 1) x 110% = $550,000 x 1.1 = $605,000 Average Inventory = COGS / Average inventory turnover = $605,000 / 5.5 = 110,000 Ending inventory = (Average inventory x 2) - (Beginning Inventory) = $110,000 x 2 - $112,500 = $107,500 Purchases (Year 2) = $605,000 + $107,500 - $112,500 = $600,000

Chapter 10 - Credit Analysis

Case 10-1—concluded Notes—continued [4] Ending A.P. = Purchases (Year 2) x (Beg. A.P. / Year 1 Purchases) = $600,000 x ($60,000 / $480,000) = $75,000 [5] Cash expenses (Year 2) = Selling and Admin. expenses + Taxes paid S&A (Year 2) = S&A (Year 1) x 110% = $160,000 x 1.1 = $176,000 Income tax expense for Year 2= [Sales - (COGS + Depreciation + S&A)] x .48 = [$1,104,000 - ($605,000 + ($30,000 x 1.05) + $176,000] x .48 = $139,920 Cash expenses (Year 2) = $176,000 + $139,920 = $315,920

b. From the analysis in part a, it is predicted that FAX will need to borrow $55,920 in Year 2.

Chapter 10 - Credit Analysis

Case 10-2 (90 minutes) a. Kopp Corporation Forecasted Statement of Cash Receipts and Payments For Year Ended December 31, Year 2 Beginning cash balance…………………… $ 30,000 Add: Cash receipts Beg. accounts receivable…………. $ 52,000 +Sales for Year 2 [1]……………….. 1,104,000 - Ending accounts receivable [2]... (276,000) Cash collections….…………………. 880,000 Total cash inflows…………………………... 910,000 Deduct: Cash disbursements Beg. accounts payable…………….. 60,000 +Purchases for Year 2 [3]…………. 582,667 - Ending accounts payable [4]……. (77,689) Payments to creditors……………… 564,978 Payments for cash expenses [5]…. 315,920 Payment of notes payable………… 20,000 Payment of long-term debt………... 25,000 Total cash disbursements………………… 925,898 Net cash flow………………………………... $ (15,898) Less: Minimum cash balance…………….. Cash borrowings expected………………..

(20,000) $ (35,898)

Notes [1] Year 2 Sales = Year 1 Sales x 115% = $960,000 x 1.15 = $1,104,000 [2] Ending A.R. = Average daily sales x Collection Period = ($1,104,000/360) x 90 = $276,000 [3] Year 2 Purchases = COGS + Ending inventory - Beginning inventory Year 2 COGS = Year 1 COGS x 110% = $550,000 x 1.1 = $605,000 Average inventory = COGS / Average inventory turnover = $605,000 / 6 = $100,833.33 Ending inventory = (Average inventory x 2) - (Beginning Inventory) = ($100,833.33 x 2) - $112,000 = $89,667 Year 2 Purchases = $605,000 + $89,667 - $112,000 = $582,667 [4] Ending A.P. = Year 2 Purchases x (Beg. A.P. / Year 1 Purchases) = $582,667 x ($60,000/$450,000) = $77,689 [5] Year 2 cash expenses: Year 1 selling and admin expense x 110% = $160,000 x 1.10 = $176,000 Year 2 income tax expense = [Sales - (COGS + Depr. + Selling & admin exp.)] x .48 = [$1,104,000 - ($605,000 + ($30,000 x 105%) + $176,000)] x .48 = $139,920 Cash expenses = $176,000 + $139,920 = $315,920

b. From the analysis in part a, it is predicted that FAX will need to borrow $35,898 in Year 2.

Chapter 10 - Credit Analysis

Case 10-3 (75 minutes) a. Year 5

Year 4

Working capital Current assets Current liabilities Working capital

342,000 177,800 164,200

198,000 64,800 133,200

Current ratio

1.92

3.06

Acid-test ratio [($12,000 + $183,000) / $177,800] [($15,000 + $80,000) / $64,800]

1.10

Accounts receivable turnover $1,684,000 / [($183,000 + $80,000) / 2] $1,250,000 / [($80,000 + $60,000) / 2]

12.81

Collection period of receivables 360 / 12.81 360 / 17.86

28.10

Inventory turnover ratio ($927,000 / [($142,000 + $97,000) / 2] ($810,000 / [($97,000 + $52,000) / 2]

7.76

Days to sell inventory 360 / 7.76 360 / 10.88

46.39

Debt-to-equity ratio (120 + 30 + 147.8) / (110 + 94.2) (73 + 14.4 + 50.4) / (110 + 60.2)

1.46

Times interest earned $87,000 / $12,000 $43,300 / $7,300

7.25

1.47

17.86

20.16

10.88

33.09

0.81

5.93

b. Index-number trend series

Year 5

Year 4 Year 3

Sales………………………………… 160.4

119.0

100.0

Cost of goods sold……………….. 181.1

158.2

100.0

Gross profit………………………… 140.7

81.8

100.0

Marketing and administrative….

143.2

84.8

100.0

Net income…………………………... 112.5

54.0

100.0

Chapter 10 - Credit Analysis

Case 10-3—concluded c. A loan should not be granted, as it appears that the overall financial position of the company is deteriorating. The following points should be noted: 1. The current ratio went down from 3.06 to 1.92. 2. A similar reduction occurred in the acid-test ratio, indicating the company is in a weaker position. 3. Accounts receivable turnover decreased while the collection period increased. This indicates a greater investment in receivables although the collection period of 28 days is still within the firm's terms of net 30 days. 4. The inventory turnover deteriorated from 10.88 to 7.76 and the days to sell inventory increased to 46 days from 33 days. This means that the firm is carrying a larger investment in inventories, which ties up its badly needed quick assets. In addition, the risk of obsolete inventory is increased. 5. Debt-to-equity ratio increased drastically. Both the short-term and long-term debt were affected. The firm will probably experience difficulty in meeting its current maturities (see current and acid-test ratio declines) because the firm is financing its increased working capital needs with debt instead of with equity. 6. Although sales increased dramatically, the firm incurred a greater proportional increase in its costs. In Year 4, the firm had a lower gross profit and a lower net income despite the increase in sales. In Year 5, gross profit increased, but at a slower rate than the increase in sales. This indicates that the firm is experiencing a cost/profit squeeze. Before any loans are made to the company, management must address the issues above and an improved financial condition must be demonstrated.

Chapter 10 - Credit Analysis

Case 10-4 (85 minutes) a. The following eight considerations are relevant for discussions with management and beginning the task of credit analysis: 1. Economic cyclicality. How closely do the tobacco, food, and beverage industries track GNP? Is tobacco consumption more tied to sociopolitical and regulatory factors than to economic ones? Cyclicality of an industry is the starting point an analyst should consider in reviewing an industry. A company's earnings growth should be compared against the growth trend of its industry, with significant deviations carefully analyzed. Industries may be somewhat dependent on general economic growth, demographic changes, and interest rates. In general, however, industry earnings are not perfectly correlated with any one economic statistic. Not only are industries sensitive to many economic variables, but often segments within a company or industry move with different lags in relation to the overall economy. 2. Growth prospects. Are the businesses that Altria is operating within growing at a steady pace, or is growth slipping? Will European consumption of cigarettes begin to slow as they have in the U.S. due to more no smoking regulations? Related to the issue of growth, is there consolidation going on in tobacco, food or beverages? Alternate growth scenarios have different implications for a company. With high-growth industries, the need for additional capacity and related financing is an issue. With low-growth industries, movements toward diversification and/or consolidation strategies are a possibility. As a general proposition, companies in high-growth industries have greater potential for credit improvement than companies operating in lower-growth industries. 3. Research & development. R&D activities are not large in the tobacco, food or beverage industries, although expenditures are directed at new product development. In general, it is safe to characterize these businesses as having a stable product line that will not vary much over time. For firms relying on such expenditures to maintain or improve market position, it is important to assess whether the company in question has the financial resources to maintain a leadership position or at least expend a sufficient amount of money to keep technologically current. 4. Competition. How competitive are these industries? Are there players who are out to gain market share at the expense of profits? Is the industry trending toward oligopoly, which would make small companies in the industry vulnerable to the economies of scale the larger companies bring to bear? Economic theory shows us how competition within an industry relates to market structure and has implications for pricing flexibility. An unregulated monopoly is in position to price its goods at a level that will maximize profits. Most industries, however, encounter free market forces and cannot price their goods/services without consideration of supply and demand as well as the price charged for substitute goods/services. Oligopolies often have a pricing leader. Analysts must be concerned about small companies in an industry that is trending toward oligopoly. In such an environment, the small company's production costs may exceed those of the industry leaders. If a small firm is forced to follow the pricing of the industry leaders, the firm may be driven out of business.

Chapter 10 - Credit Analysis

Case 10-4—concluded 5. Sources of supply. Are these businesses vulnerable to the cost of production inputs? Or is the market position of Altria such that it can easily pass on higher raw material costs? Industry market structure often has a direct impact on sources of supply. From a competitive standpoint, the company that controls its factors of production is in a superior position. 6. Degree of regulation. Tobacco has faced some regulatory hurdles in the past (especially the recent past), as has food and beverage to a lesser degree. What does the future hold in this area? The analyst should be concerned with the direction of regulation and its effect on future profitability. 7. Labor. Are these businesses heavily unionized? What is the status of labor-management relations? When the labor market is "tight," this is an important consideration in nonunionized companies. 8. Accounting. Do these businesses have any unique accounting practices that warrant special attention? As stressed throughout the text, an analyst must become familiar with industry accounting practices before proceeding with a company analysis. To assess whether a company is liberal or conservative in applying GAAP industry practices should be examined. b. 1a. Ratios for Altria for Year 9 before the acquisition of Kraft are: Pretax interest coverage = ($4,820+$500)/$500 = 10.64 LT debt as % of capitalization = $3,883/($3,883+$9,931) = 28.11% CF as % of total debt = ($2,820+$750+$100-$125)/($3,883+$1,100) = 71.14% 1b. Ratios for Altria for Year 9 pro forma for the acquisition of Kraft are: Pretax interest coverage = ($4,420+$1,600)/$1,600 = 3.76 LT debt as % of capitalization = $15,778/($15,778+$9,675) = 61.99% CF as % of total debt = ($2,564+$1,235+$390-$125)/($15,778+$1,783) = 23.14% 2. Relating these ratios to the median ratios for the various bond rating categories places Altria in the position shown below: Before Kraft Ratio Implied Rating Pretax interest coverage ................................. 10.64 AA LT debt as % of cap. ........................................ 28.11% A CF as % of total debt ....................................... 71.14% A+/AAAfter Kraft Ratio Implied Rating Pretax interest coverage ................................. 3.76 BBB LT debt as % of cap. ........................................ 61.99% B CF as % of total debt ....................................... 23.14% BB Recommendation: These ratios suggest that Altria bonds have deteriorated from a strong A rating to a BB rating, based on the median ratios for the various bond categories. Given that Altria is in relatively stable businesses (food and tobacco) that tend to be much less cyclical than the economy overall, an argument could be made that its bonds should be rated as a strong BB or even a BBB. 10-50 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 10 - Credit Analysis

Case 10-5 (90 minutes) a. Asset Protection

Year 7

Year 9

Net tangible assets to LT debt. ............................

52.0%

46.2%

Moderate deterioration, but nothing serious. The large increase in the goodwill account is evidently a factor. LT debt to total capitalization ..............................

64.0%

62.6%

2.31

1.83

Modest improvement. Debt to common equity ........................................

Good improvement due to more rapid growth in retained earnings. Total assets to total shareholders' equity ..........

3.33

3.40

Liquidity

Year 7

Year 9

Collection period................................................... Inventory turnover ................................................

68 12.0

90 4.7

Slight improvement.

Its petrochemicals acquisitions have increased ABEX's working capital requirements, particularly accounts receivable and inventories. Short-term debt to long-term debt.......................

5.8%

9.3%

The greater working capital requirements have evidently forced ABEX to rely more heavily on short-term debt.

Earning Power

Year 7

Year 9

Pretax interest coverage ...................................... Operating cash flow to long-term debt ...............

1.80 20.4%

1.84 22.1%

Pretax interest coverage is similar between Year 7 and Year 9, although it was significantly higher in Year 8 (2.54). Higher operating margins and improved cash flow helped in supporting the higher debt burden. This is especially evident in the operating cash flow to long-term debt ratio.

Chapter 10 - Credit Analysis

Case 10-5—concluded b. Among the more qualitative considerations that should be reviewed in assessing the risk of downgrade are: (1) Economic cyclicality: The petrochemical business is likely to be more cyclical than the pipeline business, which is regulated and generally more of a cost pass-through operation. (2) Growth prospects: Petrochemicals may have greater growth prospects than the pipeline business, but that growth is likely to be more erratic, due to economic cyclicality. (3) Competition: The lack of regulation and the commodity nature of most of its products makes the petrochemical business generally more competitive than the pipeline business. (4) Sources of supply: Both the petrochemical and the pipeline businesses have to deal with the problem of securing sufficient supplies of raw material. Again, the petrochemical business is probably more prone to disruption than the pipeline business. Other possible considerations include: (5) Management expertise. (6) Environmental concerns. (7) Debtor problems. (8) Quality of earnings. (9) Barriers to entry. (10) Benefits of diversification.

c. One might conclude from the qualitative considerations in part b that the shift toward petrochemicals makes ABEX more vulnerable to the vagaries of the economic cycle. If so, this will lead to a more volatile earnings stream going forward. To this extent, there is some pressure for a rating downgrade. Looking at the ratio analysis in part a, one might conclude that there is relatively little deterioration in credit quality. The modest deterioration in asset protection seems to be offset by higher cash flow margins, which allows the company to support the higher debt burden. However, the greater reliance on short-term debt to finance the increased working capital requirements is somewhat troublesome.

Chapter 11 - Equity Analysis and Valuation

Chapter 11 Equity Analysis and Valuation REVIEW Equity analysis and valuation is the focus of this chapter. This chapter extends earlier analyses to consider earnings persistence and earning power. Earnings persistence is broadly defined and includes the stability, predictability, variability, and trend in earnings. We also consider earnings management as a determinant of persistence. Earning power refers to the ability of the core operations of a company to operate profitably. Our valuation analysis emphasizes earnings and other accounting measures for computing company value. Earnings forecasting considers earning power, estimation techniques, and monitoring mechanisms for analysis. This chapter describes several useful tools for equity analysis and valuation. We describe recasting and adjustment of financial statements. We also distinguish between recurring and nonrecurring, operating and nonoperating, and extraordinary and nonextraordinary earnings components. Throughout the chapter we emphasize the application of earnings-based analysis with several illustrations.

Chapter 11 - Equity Analysis and Valuation

OUTLINE •

Earnings Persistence Recasting and Adjusting Earnings Determinants of Earnings Persistence Persistent and Transitory Items in Earnings

•

Earnings-Based Equity Valuation Relation between Stock Prices and Accounting Data Fundamental Valuation Multiples Illustration of Earnings-Based Valuation

•

Earning Power and Forecasting for Valuation Earning Power Earnings Forecasting Interim Reports for Monitoring and Revising Earnings Estimates

Chapter 11 - Equity Analysis and Valuation

ANALYSIS OBJECTIVES •

Analyze earnings persistence, its determinants and its relevance for earnings forecasting.

•

Explain recasting and adjusting of earnings and earnings components for analysis.

•

Describe earnings-based equity valuation and its relevance for financial analysis.

•

Analyze earning power and its usefulness for forecasting and valuation.

•

Explain earnings forecasting, its mechanics and its effectiveness in assessing company performance.

•

Analyze interim reports and consider their value in monitoring and revising earnings estimates.

Chapter 11 - Equity Analysis and Valuation

QUESTIONS 1. The significance and potential value of research and development costs are among the most important for financial statement analysis and interpretation. They are important not only because of their relative amount but also because of their significance for the projection of future performance. The analyst must pay careful attention to research and development costs and to the absence of such costs. In many companies they represent substantial costs, much of them of a fixed nature. We must make a careful distinction between what can be quantified in this area, and consequently analyzed, and what cannot be quantified and must consequently be evaluated in qualitative terms. While a quantitative measure of the amount of R&D expenses is not difficult, it is often difficult to evaluate the quality of research and development costs and their effect on future earnings. There seems to be no clear-cut definition of "research." Therefore, it may not be meaningful to compare the quality of the research and development costs of two companies. Still, the analyst should evaluate such qualitative factors as the caliber of the research staff and organization, the eminence of its leadership, as well as the commercial results of their efforts. One would also want to consider whether the research and development is government-sponsored or company-sponsored. 2. The reported values of most assets in the balance sheet ultimately enter the cost streams of the income statement. Therefore, whenever assets are overstated, then income is overstated because it has been relieved of charges needed to bring such assets down to realizable value. The converse should also hold true, that is, to the extent to which assets are understated, the income, current and cumulative, is also understated. Turning to the relation between liabilities and income, an overstatement of income can occur because income is relieved of charges required to bring the provision or the liabilities to their proper amounts. Conversely, an overprovision of present and future liabilities or losses results in the understatement of income or in the overstatement of losses. 3. The objective of recasting the income statement is so that the stable, normal, and continuing elements in the income statement can be separated and distinguished from random, erratic, unusual, or nonrecurring elements. Both sets of elements require separate analytical treatment and consideration. Moreover, recasting also aims at identifying those elements included in the income statement that should more properly be included in the operating results of one or more prior periods. 4. The analyst will find data needed for analysis of the results of operations and for their recasting and adjustment in: • The income statement and components such as: -Income from continuing operations -Income from discontinued operations -Extraordinary gains and losses -Cumulative effect of changes in accounting principles. • The other financial statements and the footnotes thereto. • Textual disclosures found throughout the published report, including MD&A. • The analyst may also find unusual items segregated within the income statement (generally on a pre-tax basis) but their disclosure is optional.

Chapter 11 - Equity Analysis and Valuation

•

The analyst will consult all the above-mentioned sources as well as, if possible, management in order to obtain the needed facts. These will include facts which affect the comparability and the interpretation of income statements, such as product-mix changes, production innovations, strikes, and raw material shortages which may or may not be included in management's mandatory discussion and analysis of the results of operations.

5. Once the analyst has secured as much information as is possible, several years’ income statements (generally at least five) are recast and adjusted in such a way as to facilitate their analysis, to evaluate the trend of earnings, and to aid in determining the average earning power of the company. While this procedure can be accomplished in one phase, it is simpler and clearer to subdivide it into two distinct steps: (1) recasting and (2) adjusting. The recasting process aims at rearranging the items within the income statement in such a way as to provide the most meaningful detail and the most relevant format needed by the analyst. At this stage the individual items in the income statement may be rearranged, subdivided, or tax effected, but the total must reconcile to the net income of each period as reported. The adjusting process of items within a period will help in the evaluation of the earnings level. For example, discretionary and other noteworthy expenses should be segregated. The same applies to items such as equity in income or loss of unconsolidated subsidiaries or associated companies, which are usually shown net of tax. Items shown in the pre-tax category must be removed together with their tax effect if they are to be shown below normal "income from continuing operations." Expanded tax disclosure enables the analyst to segregate factors that reduce taxes as well as those that increase them, enabling an analysis of the degree to which these factors are of a recurring nature. All material permanent differences and credits, such as the investment tax credit, should be included. The analytical procedure involves computing taxes at the statutory rate (currently 35 percent) and deducting tax benefits such as investment tax credits, capital gains rates or tax-free income, and adding factors such as additional foreign taxes, non tax-deductible expenses and state and local taxes (net of federal tax benefit). Immaterial items can be considered in one lump sum labeled as "other." Analytically recast income statements will contain as much detail as is needed for analysis and are supplemented by explanatory footnotes. 6. Based on data developed in the recast income statements as well as on other available information, certain items of income or loss are assigned to the period to which they most properly belong. This is a major part of the adjustment process. The reassignment of extraordinary items or unusual items (net of tax) to other years must be done with care. For example, the income tax benefit of the carryforward of operating losses should generally be moved to the year in which the loss occurred. The costs or benefits from the settlement of a lawsuit may relate to one or more preceding years. The gain or loss on disposal of discontinued operations will usually relate to the results of operations over a number of years. If possible, all years under analysis should be placed on a comparable basis when a change in accounting principle or accounting estimate occurs. If, as is usually the case, the new accounting principle is the desirable one, prior years should, if possible, be restated to the new method, or a notation made regarding a lack of comparability in certain respects. This procedure will result in a redistribution of the "cumulative effect of change in accounting principle" to affected prior years. Changes in estimates can be accounted for only prospectively and generally accepted accounting principles prohibit prior year restatements except in certain specified cases. The analyst's ability to place all years on a comparable basis will depend on availability of 11-5 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 11 - Equity Analysis and Valuation

information. Before the trend in earnings can be evaluated it is necessary to obtain the best approximation possible of the earnings level of each year. All items in the income statement must be considered and none can be excluded or "dropped by the wayside." For example, if it is decided that an item in the income statement does not properly belong in the year in which it appears it may be either: (i) Shifted (net of tax) to the result of one or a number of other years, or (ii) If it cannot be identified with another specific year or years, it must be included in the average earnings of the period under analysis. 7. Analysts must be alert to accounting distortions designed to affect trends. Some of the most common and most pervasive practices in accounting are designed to affect the presentation of earnings trends. These procedures are based on the assumptions that (i) the trend of income is more important than its absolute size, (ii) retroactive revisions of income already reported in prior periods have little, if any, market effect on security prices, and (iii) once a company has incurred a loss, the size of the loss is not as significant as the fact that the loss has been incurred. These assumptions and the propensities of some managers to use accounting as a means of improving the appearance of the earnings trend has led to techniques which can be broadly described as "earnings management." The earnings management process, so as to distinguish it from outright fraudulent reporting, must meet a number of requirements. This process is a rather sophisticated device. It does not rely on outright or patent falsehoods and distortions, but rather uses the leeway existing in accounting principles and their interpretation to achieve its ends. It is usually a matter of form rather than one of substance. Consequently, it does not involve a real transaction (such as postponing an actual sale to another accounting period in order to shift revenue) but only a redistribution of credits or charges among periods. The general objective is to moderate income variability over the years by shifting income from good years to bad years, by shifting future income to the present (in most cases presently reported earnings are more valuable than those reported at some future date) or vice versa. 8. Earnings management can take many forms. Here are some forms to which the analyst should be particularly alert: • Changing accounting methods or assumptions with the objective of improving or modifying reported results. For example, to offset the effect on earnings of slumping sales and of other difficulties, Chrysler Corp. revised upwards the assumed rate of return on its pension portfolio, thus increasing income significantly. Similarly, Union Carbide improved results by switching to a number of more liberal accounting alternatives. • Misstatements, by various methods, of inventories as a means of redistributing income among the years. • The offsetting of extraordinary credits by identical or nearly identical extraordinary charges as a means of removing an unusual or sudden injection of income that may interfere with the display of a growing earnings trend. 9. There are powerful incentives that motivate companies and their managers to engage in income smoothing. Companies in financial difficulties may be motivated to engage in such practices for what they see and justify as their battle for survival. Successful companies will go to great lengths to uphold a hard-earned and well-rewarded image of earnings growths by smoothing those earnings artificially. Moreover, compensation plans or other incentives based on earnings will motivate managers to accelerate the recognition of income by anticipating revenues or deferring expenses. Analysts must 11-6 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 11 - Equity Analysis and Valuation

appreciate the great variety of incentives and objectives that lead managers and, at times, second-tier management without the knowledge of top management, to engage in practices ranging from smoothing to the outright falsification of income. It has been suggested that smoothing is justified if it can help a company report earnings closer to its true "earning power" level. Such is not the function of financial reporting. As we have repeatedly argued, the analyst will be best served by a full disclosure of periodic results and the components that comprise these. It is up to the analyst to average, smooth, or otherwise adjust reported earnings in accordance with specific analytical purposes. The accounting profession has earnestly tried to promulgate rules that discourage practices such as the smoothing of earnings. However, given the powerful propensities of companies and of their owners and managers to engage in such practices, analysts must realize that, where there is a will to smooth or even distort earnings, ways to do so are available and will be found. Consequently, particularly in the case of companies where incentives to smooth are more likely to be present, analysts should analyze and scrutinize accounting practices to satisfy themselves regarding the integrity of the income-reporting process. 10. Managers are almost always concerned with the amount of net results of the company as well as with the manner in which these periodic results are reported. This concern is reinforced by a widespread belief that most investors accept the reported net income figures, as well as the modifying explanations that accompany them, as true indices of performance. Extraordinary gains and losses often become the means by which managers attempt to modify the reported operating results and the means by which they try to explain these results. Quite often these explanations are subjective and are slanted in a way designed to achieve the impact and impression desired by management. 11. The basic objectives in the identification and evaluation of extraordinary items by the analyst are: • To determine whether a particular item is to be considered "extraordinary" for purposes of analysis; that is, whether it is so unusual and nonrecurring in nature that it requires special adjustment in the evaluation of current earnings levels and of future earnings possibilities. • To decide what form the adjustment, for items that are considered as "extraordinary" in nature, should take. 12. Nonrecurring Operating Gains or Losses. By "operating" we usually identify items connected with the normal and usual operations of the business. The concept of normal operations is more widely used than understood and is far from clear and well defined. Nonrecurring operating gains or losses are, then, gains or losses connected with or related to operations that recur infrequently and/or unpredictably. Examples include: (1) foreign operations giving rise to exchange adjustments because of currency fluctuations or devaluations, and (2) an unusually severe decline in market prices requires a large write-down of inventory from cost to market. The analyst in considering how to treat nonrecurring operating gains and losses would do best to recognize the fact of inherent abnormality in business and treat them as belonging to the results of the period in which they are reported.

Chapter 11 - Equity Analysis and Valuation

Recurring Non-operating Gains or Losses. This category includes items of a nonoperating nature that recur with some frequency. Examples include recurring exchange adjustments, gains and losses on sales of fixed assets, interest income, and the rental received from employees who rent company-owned houses. While items in this category are often classified as "unusual" in published financial statements, the narrow definition of "non-operating" which they involve as well as their recurrent nature are good reasons why the analyst should not exclude them from current results. Nonrecurring, Non-operating Gains or Losses. Of the three categories, this one possesses the greatest degree of "abnormality." Not only are the events here not repetitive and unpredictable, but they do not fall within the sphere of normal operations. In many cases these events are not unintended or unplanned. However, they can rarely be said to be totally unexpected. Business is ever subject to the risk of sudden adverse events and to random shocks, be they natural or man-made. In the same manner, business transactions are also subject to unexpected windfalls. Examples in this category include substantial uninsured casualty losses unrelated to normal or expectable operating risks. It can be seen readily that while the above occurrences are, in most cases, of a nonrecurring nature, their relation to the operations of a business varies. All are occurrences in the regular course of business. Even the assets destroyed by acts of nature were acquired for operating purposes and thus were subject to all possible risks. Of the three categories, this one comes closest to meeting the criterion of being "extraordinary." Nevertheless, truly unique events are very rare. What looks at the time as unique may, in the light of experience, turn out to be the symptom of a new set of circumstances. The analyst must bear in mind such possibilities but, barring evidence to the contrary, he/she can regard items in this category as extraordinary in nature and thus omit them from the results of operations of a single year. They are, nevertheless, part of the longer term record of results of the company. Thus, they enter the computation of average earnings, and the propensity of the company to incur such gains or losses must be considered in the projection of future average earnings. 13. a. Whenever there is a gain (whether it is recorded as extraordinary or not), there is an increase in resources. Similarly, a loss results in a reduction of resources. In this sense, an extraordinary gain or loss is not different from a normal or ordinary gain or loss. Once an asset is written off as a result of extraordinary loss, that asset will not be available in the future to generate revenues. Conversely, an extraordinary gain will result in an addition of resources on which a future return can be expected. Therefore, the financial analyst should measure the potential effect of the extraordinary events on future earnings and evaluate the likelihood of the occurrence of events causing extraordinary items. b. One implication frequently associated with the reporting of extraordinary gains and losses is that they have not resulted from a "normal" or "planned" activity of management and that, consequently, they should not be used in the evaluation of management performance. The analyst should seriously question such a conclusion. What is "normal" activity in relation to management's deliberate actions? Whether we talk about the purchase or sale of securities, assets not used in operations, or divisions and subsidiaries that definitely relate to operations, we talk about actions deliberately taken by management with specific purposes in mind. Such actions require, if anything, more consideration or deliberation than ordinary everyday operating decisions because they are usually special in nature and involve 11-8 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 11 - Equity Analysis and Valuation

substantial amounts of money. The results of such activities always qualify or enhance the results of "normal" operations, thus yielding the final net results. 14. Most analysts probably would (should) disagree with this assertion. Management is entrusted with the control of all assets of an entity in every possible way, including extraordinary events. Their responsibility is not confined to "normal" operations, and we can generally assume that every action taken by the management has some specific purpose in mind, be it "normal operations" or "abnormal operations," to enhance company results. It is extremely rare to see a business event that can be termed completely unexpected or unforeseeable. When it comes to the assessment of results that really count and those that build or destroy value, the distinction of what is normal and what is not fades. 15. From a strictly mathematical point of view, the accounting-based equity valuation model is impervious to accounting manipulations under the clean surplus relation. Firms that overstate net income will have higher book values, which will reduce future residual income. Firms with conservatively measured net income will report lower book values, which will increase future residual income. On the other hand, projections of future profitability are based on current and past financial results. To the extent that accounting manipulations can affect net income forecasts by users, these manipulations will affect firm valuation. 16. a. The major determinants of the PB ratio are (1) future ROCE, (2) growth in book value, and (3) risk. The major determinants of the PE ratio are (1) the level of current earnings, (2) trend in future residual income, and (3) risk. b. As illustrated in a chart in the chapter, the joint values of the PB and PE ratios give important insights into the market's expectations regarding earnings growth and future ROCE. To the extent that the analyst can "outguess" the market, s/he will be able to identify mispriced securities. 17. Forecasting must be differentiated from extrapolation. The latter is based on an assumption of the continuation of an existing trend and involves a mechanical extension of the trend into the uncharted territory of the future. Forecasting, on the other hand, is based on a careful analysis of as many individual components of income and expense as is possible and a considered estimate of future level taking into consideration interrelations among the components as well as probable future conditions. Thus, forecasting requires as much detail as is possible to obtain. 18. The MD&A often contains a wealth of information on management's views and attitudes as well as on factors that can influence company operating performance and financial condition. Consequently, the analyst will likely find much information in these analyses to aid in the forecasting process. Moreover, while not requiring it, the SEC encourages the inclusion in these discussions of forward-looking information. 19. The best possible estimate of the average earnings of a company, which can be expected to be sustained and to repeat with some degree of regularity over a span of future years, is referred to as its earning power. Except in specialized cases, earning power is universally recognized as the single most important factor in the valuation of a company. Most valuation approaches entail in one form or another the capitalization of earning power by a factor or multiplier which takes into account the cost of capital as well as 11-9 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 11 - Equity Analysis and Valuation

future expected risks and rewards. The importance of earning power in such that most analyses of income and related financial statements have as one of their ultimate objectives the determination of earnings. Earning power is a concept of financial analysis, not of accounting. It focuses on stable and recurring elements and aims to arrive at the best possible estimate of repeatable average earnings over a span of future years. Accounting, as we have seen, can supply much of the essential information for the computation of earning power. However, the process is one involving knowledge, judgment, experience as well as a specialized investing or lending point of view. We know investors and lenders look ultimately to future cash flows as sources of rewards and safety. Accrual accounting, which underlies income determination, aims to relate sacrifices and benefits to the periods in which they occur. In spite of its known shortcomings, this framework represents the most reliable and relevant indicator of longer-term future probabilities of average cash inflows and outflows presently known. 20. Interim financial statements, most frequently issued on a quarterly basis, are designed to fill the reporting gap between the year-end statements. They are used by decision makers as means of updating current results as well as in the prediction of future results. If a year is a relatively short period of time in which to account for results of operations for many analytical purposes, then trying to confine the measurement of results to a three-month period involves all the more problems and imperfections. Generally, the estimating and adjustment procedures at interim financial statement dates are performed much more crudely than for year-end financial statements. The net result is that the interim reports are less accurate than year-end reports that are audited. Another serious limitation to which the interim reports are subject is the seasonality of activities to which most businesses are subject. Sales may be unevenly distributed over the year and this tends to distort comparisons among the quarterly results of a single year. It also presents problems in the allocation of many costs. Similar allocation problems are encountered with the extraordinary and other nonrecurring elements. Despite these limitations, interim reports can provide useful information if the analysts are fully aware of the possible pitfalls and use them with extreme care. The analyst can overcome some of the seasonality problem by considering in the analysis not merely the results of a single quarter but rather the year-to-date cumulative results. 21. The reporting of interim earnings is subject to limitations and distortions. The intelligent use of reported interim results requires that we have a full understanding of the possible problem areas and limitations. The following is a review of some of the basic reasons for these problems and limitations as well as their effect on the determination of reported interim results: Year-End Adjustments. The determination of the results of operations for a year requires many estimates, as well as procedures such as accruals and the determination of inventory quantities and carrying values. These procedures can be complex, time consuming, and costly. Examples of procedures requiring a great deal of data collection and estimation includes estimation of the percentage of completion of contracts, determination of cost of work in process, the allocation of under- or over-absorbed overhead for the period and the determination of inventory under the LIFO method. The complex, time-consuming, and expensive nature of these procedures can mean that they are performed much more crudely during interim periods and are often based on records that are less complete than their year-end counterparts. The result inevitably is a less accurate process of income determination which, in turn, may require year-end adjustments which can modify substantially the interim results already reported. 11-10 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 11 - Equity Analysis and Valuation

Seasonality. Many companies experience at least some degree of seasonality in their activities. Sales may be unevenly distributed over the year and so it may be with production and other activities. This tends to distort comparisons among the quarterly results of a single year. It also presents problems in the allocation of many budgeted costs, such as advertising, research and development, and repairs and maintenance. 22. The major disclosure requirements by the SEC with regard to interim reports are: • Comparative quarterly and year-to-date abbreviated income statement data—this information may be labeled "unaudited" and must also be included in annual reports to shareholders. • Year-to-date statements of cash flows; • Comparative balance sheets; • Increased pro forma information on business combinations accounted for as purchases; • Conformity with the principles of accounting measurement as set forth in the professional pronouncements on interim financial reports; • Increased disclosure of accounting changes with a letter from the registrant's independent public accounting firm stating whether or not it judges the changes to be preferable; • Management's narrative analysis of the results of operations, explaining the reasons for material changes in the amount of revenue and expense items from one quarter to the next. • Indications as to whether a Form 8-K was filed during the quarter reporting either unusual charges or credits to income or a change of auditors; • Signature of the registrant's chief financial officer or chief accounting officer. The objectives behind these disclosures are: • They will assist investors in understanding the pattern of corporate activities throughout a fiscal period. • Presentation of such quarterly data will supply information about the trend of business operations over segments of time that are sufficiently short to reflect business turning points. 23. While there have been some notable recent improvements in the reporting of interim results, the analyst must remain aware that accuracy of estimation and the objectivity of determinations are and remain problem areas which are inherent in the measurement of results of very short periods. Also, the limited association of auditors with interim data, while lending as yet some unspecified degree of assurance, cannot be equated to the degree of assurance which is associated with fully audited financial statements. SEC insistence that the professional pronouncements on interim statements be adhered to should offer analysts some additional comfort. However, not all principles promulgated on the subject of interim financial statements result in presentations useful to the analyst. For example, the inclusion of extraordinary items in the results of the quarter in which they occur will require careful adjustment to render them meaningful for purposes of analysis. While the normalization of expenses is a reasonable intra-period accounting procedure, the analyst must be aware of the fact that there are no rigorous standards or rules governing its implementation and that it is, consequently, subject to possible abuse. The shifting of costs between periods is generally easier than the shifting of sales; and, therefore, a close analysis of sales may yield a more realistic clue to a

Chapter 11 - Equity Analysis and Valuation

company's true state of affairs for an interim period. Some problems of seasonality in interim results of operations can be overcome by considering in the analysis, not merely the results of a single quarter, but also the year-to-date cumulative results that incorporate the results of the latest available quarter. This is the most effective way of monitoring the results of a company and bringing to bear on its analysis the latest data on operations that are available.

Chapter 11 - Equity Analysis and Valuation

EXERCISES Exercise 11-1 (45 minutes) a. Schedule of Maintenance and Repairs (scaled)

Year 9

Year 10

Total 2 years

Average 2 years

Year 11

Revenues [1] .............................

$4,879.4

$5,030.6

$9,910.0

$4,955.0

$5,491.2

PP&E (net) [66] ..........................

959.6

1,154.1

2,113.7

1,056.9

1,232.7

Maintenance & Repairs [155] ..

93.8

96.6

190.4

95.2

96.1

% of Maintenance & Repairs to Revenue ..................

1.92%

1.75%

% of Maintenance & Repairs to PP&E, net ................

9.77%

8.37%

9.01%

7.80%

b. The percentage of maintenance and repairs to revenues in Year 11 (1.75%) is lower than the same percentage scaled by the average of Years 9 and 10 (1.92%). Assuming that the 2-year average is representative of a longer period pattern, it would appear that management may have been saving on discretionary costs in Year 11 to prop up income. The percentage of maintenance and repairs to net PP&E exhibits the same pattern and also signals an effort by management to lower costs. For example, assume total savings equals the difference between the actual expenditure on maintenance and repairs in Year 11 and the amount of spending required to equate the rate of spending implicit in the average percentage to revenues for the preceding years: Implicit spending = $5,491.2 x 1.92% Actual spending in Year 11 ............ "Savings".........................................

= $105.4 = 96.1 = $ 9.3 (8.8% of implicit spending)

PPE (net) x Ave % = $1,232.7 x 9.01% Actual ............................................... "Savings".........................................

= $111.1 = 96.1 = $ 15.0 (13.5% of implicit spending)

Chapter 11 - Equity Analysis and Valuation

Exercise 11-2 (60 minutes) a. The president is correct in designating most of the items described as normal operating expenses that good managers should expect and anticipate. Many diverse views still prevail on how extraordinary items should be presented. They differ due to different conceptions regarding the purposes of the income statement and those of financial statement analysis. Basically, preparers of the income statement should recognize that they have a varied audience and that it is best to give the reader all the information that s/he may need to arrive at an income figure adjusted for his/her own purposes and abstain from built-in interpretations. The designation of an item of gain or loss as extraordinary carries with it an interpretative message. Consequently, only in those relatively rare cases when an item is both non-operating and nonrecurring may it be designated as extraordinary (based on firsthand knowledge of attending circumstances) and be useful to the user of financial statements. b. To qualify for the "extraordinary" presentation category in the income statement the item must be both unusual and non-recurring in nature. However, the classification of an item as extraordinary for accounting purposes is often dictated by considerations that are not relevant to the objectives of the analyst. Therefore, each analyst should establish his/her own criteria for the classification to suit his/her particular analytical purpose and, if so, how to adjust for it. Some of the frequently used guidelines are: (1) Nonrecurring operating gains and losses, (2) Recurring non-operating gains and losses, (3) Non-recurring, non-operating gains and losses.

Chapter 11 - Equity Analysis and Valuation

Exercise 11-2—concluded c. 1. No. This is an expected business event, although it may not be predictable. It is not different from events such as an increase of import duties and taxes. 2. No. It may be "nonrecurring," however, it is expected in business. 3. No. It indicates superior performance by competitors--a frequent occurrence. 4. No. Tax is legitimate, unavoidable business cost and any change in taxation should affect other companies in the industry as well. 5. No. Strikes may not be an annual event; however, they are a recurring operational possibility. 6. No. It is a "nonrecurring" cost of an operating nature. 7. No. It can occur in any business and it reflects management's planning and judgment. 8. No. This danger is always inherent in research and development. 9. No. This risk is part of software development. 10. No. It reveals a failure of credit policy. 11. No. Capital gains and losses resulting from rental cars should be regarded as operating items of a car rental company. 12. No. The analyst, however, should carefully analyze the circumstances in order to determine if it qualifies under "nonrecurring" and "nonoperating" event. 13. No. Amounts involved are generally minor and the operation of the houses should be viewed as a part of the whole operation. 14. Yes. However, it may inform the analyst that management is unprepared for such an event. 15. Yes. It may qualify as a "nonrecurring, nonoperating" event. 16. Yes. It appears to qualify as a “nonrecurring, nonoperating” event.

Chapter 11 - Equity Analysis and Valuation

Exercise 11-3 (30 minutes) a. Many views prevail on how extraordinary items should be presented. They differ with differing conceptions regarding the purposes of the income statement and those of financial statement analysis. Basically, preparers of the income statement should recognize that they have a varied audience and that it is best to give the reader all the information that he/she may need to arrive at an income figure adjusted for his/her own purposes. The designation of an item of gain or loss as extraordinary carries with it an interpretative message. Consequently, only in those relatively rare cases when an item is both nonoperating and nonrecurring may its designation as extraordinary (based on the preparer's firsthand knowledge of attending circumstances) be useful to the user of financial statements. b. The analyst must assess the importance of items presented as extraordinary— namely, the probability of their recurrence and the likelihood that they represent a symptom of operating conditions that are likely to be increasingly prevalent. On the basis of such an evaluation, s/he can decide how to consider them in the computation of average earnings, average coverage ratios, return on invested capital ratios, and other measures. The analyst also can determine their impact in the evaluation of management and in the forecasting of earnings. Generalizations, or preconceived classifications, are less useful in this area.

Chapter 11 - Equity Analysis and Valuation

Exercise 11-4 (40 minutes) a. Sales and other revenues should be recognized for interim financial statement purposes in the same manner as revenues are recognized for annual reporting purposes. This means normally at the point of sale or, in the case of services, at completion of the earnings process. In the case of industries whose sales vary greatly due to the seasonal nature of business, revenues should still be recognized as earned, but a disclosure should be made of the seasonal nature of the business in the notes. In the case of long-term contracts recognizing earnings on the percentage-of-completion basis, the current state of completion of the contract should be estimated and revenue recognized at interim dates in the same manner as at the normal year-end. b. For interim reporting purposes, product costs (costs directly attributable to the production of goods or services) should be matched with the product and associated revenues in the same manner as for annual reporting purposes. Period costs (costs not directly associated with the production of particular goods or service) should be charged to earnings as incurred or allocated among interim periods based on an estimate of time expired, benefit received, or other activity associated with the particular interim period(s). Also, if a gain or loss occurs during an interim period and is a type that would not be deferred at yearend, the gain or loss should be recognized in full in the interim period in which it occurs. Finally, in allocating period costs among interim periods, the basis for allocation must be supportable and may not be based on merely an arbitrary assignment of costs between interim periods. c. GAAP allow for some variances from the normal method of determining cost of goods sold and valuation of inventories at interim dates, but these methods are allowable only at interim dates and must be fully disclosed in a footnote to the financial statements. Some companies use the gross profit method of estimating cost of goods sold and ending inventory at interim dates instead of taking a complete physical inventory. This is an allowable procedure at interim dates, but the company must disclose the method used and any significant variances that subsequently result from reconciliation of the results obtained using the gross profit method and the results obtained after taking the annual physical inventory. At interim dates, companies using the LIFO cost-flow assumption may temporarily have a reduction in inventory level that results in a liquidation of base period inventory layers. If this liquidation is considered temporary and is expected to be replaced prior to year-end, the company should charge cost of goods sold at current prices. The difference between the carrying value of the inventory and the current replacement cost of the inventory is a current liability for replacement of LIFO base inventory temporarily depleted. When the temporary liquidation is replaced, inventory is debited for the original LIFO value and the liability is removed. Also, inventory losses from a decline in market value at in-

Chapter 11 - Equity Analysis and Valuation

Exercise 11-4—concluded terim dates should not be deferred but should be recognized in the period in which they occur. However, if in a subsequent interim period the market price of the written-down inventory increases, a gain should be recognized for the recovery up to the amount of the loss previously recognized. If a temporary decline in market value below cost can reasonably be expected to be recovered prior to year-end, no loss should be recognized. Finally, if a company uses a standard costing system to compute cost of goods sold and to value inventories, variances from standard should be treated at interim dates in the same manner as at year-end. However, if variances occur at an interim date that are expected to be absorbed prior to year end, the variances should be deferred instead of being immediately recognized. d. The provision for income taxes shown in interim financial statements must be based upon the effective tax rate expected for the entire annual period for ordinary earnings. The effective tax rate is, in accordance with previous APB opinions, based on earnings for financial statement purposes as opposed to taxable income that may consider timing differences. This effective tax rate is the combined federal and state(s) income tax rate applied to expected annual earnings, taking into consideration all anticipated investment tax credits, foreign tax rates, percentage depletion capital gains rates, and other available tax planning alternatives. Ordinary earnings do not include unusual or extraordinary items, discontinued operations, or cumulative effects of changes in accounting principles, all of which will be separately reported or reported net of their related tax effect in reports for the interim period or for the fiscal year. The amount shown as the provision for income taxes at interim dates should be computed on a year-to-date basis. For example, the provision for income taxes for the second quarter of a company's fiscal year is the result of applying the expected rate to year-to-date earnings and subtracting the provision recorded for the first quarter. There are several variables in this computation (expected earnings may change, tax rates may change), and the year-to-date method of computation provides the only continuous method of approximating the provision for income taxes at interim dates. However, if the effective rate or expected annual earnings change between interim periods, the change is not reflected retroactively but the effect of the change is absorbed in the current interim period.

Chapter 11 - Equity Analysis and Valuation

Exercise 11-5 (25 minutes) The suggested solution is a general one. It must be emphasized that the impact of these factors will be different depending on whether the company is in a growth, cyclical, and/or defensive phase. Still, these factors will have some effect on most companies. a. Factors deriving from the company that affect: (1) Earnings per Share • Accounting policy, particularly inventory and depreciation. • Sales volume, cost of goods sold, and operating expenses. • Quality of management and R&D. • Success of new product introduction. • Start-up expense, special items, nonrecurring gains or losses. • Expansion programs--internal or through acquisition. • Leverage. • Overall financial policies. (2) Dividends per share • Capital expenditure programs. • Volatility or stability of net income. • Overall financial condition. • Alternative uses of cash. • Replacement of fixed assets. • Stage of life cycle of company--youth, middle, mature. • Sinking fund requirements. (3) Market price per share • Quality of management. • Growth rate of net income and earnings per share. • Quality of earnings, profit margins, research, competitive environment. • Price-earnings ratio accorded. • Financial management. • Trading on equity, leverage. • New product development, general outlook. • Information disseminated by management so as to allow an intelligent analysis of projects.

Chapter 11 - Equity Analysis and Valuation

Exercise 11-5—concluded b. Factors deriving from the economy that affect: (1) Earnings per share • If the economy turns up or down, and a company makes products whose demand turns with the general economy, earnings will be variable compared to a company whose products are subject to stable or constantly growing demand. • Government intervention can influence EPS by preventing price rises or forcing uneconomic labor settlements. • Labor disturbances halting operations, lowering revenues and hence EPS. Companies with poor labor relation policies are subject to such variability in earnings. • Changes in consumer fads or styles of living can cause variance until the affected company catches up again. • Population shifts out of areas served. • Changes in tax laws. (2) Dividends per share • Tax laws. • Growth rate of economy encouraging reinvestment. • Of course, anything affecting EPS affects dividends also --not necessarily immediately, but at least in terms of dividend policy. (3) Market price per share • Investor confidence in the ability of the government to cope with problems. • Cyclical change in economy affecting investor confidence which is reflected in the stock market in general. Research indicates that over 50 percent of price movements for a typical stock are due to price movements of the general market.

Chapter 11 - Equity Analysis and Valuation

PROBLEMS Problem 11-1 (70 minutes) a. Quaker Oats Recast Income Statements ($ millions) For Years Ended Year 11, Year 10 and Year 9 Year 11

Year 10

Year 9

Net sales .....................................................................

5,491.2

5,030.6

4,879.4

Interest income ...........................................................

9.0

11.0

12.4

Total revenue ..............................................................

5,500.2

5,041.6

4,891.8

Cost of sales [a].......................................................

2,647.0

2,528.1

2,514.0

Selling, general and admin expenses [b] ..............

669.5

605.5

597.0

Repair and maintenance expenses [a] ..................

96.1

96.6

93.8

Depreciation expenses [a] ......................................

125.2

103.5

94.5

Advertising and merchandising expenses [b] ......

1,407.4

1,195.3

1,142.7

Research and development [b] ..............................

44.3

43.3

39.3

Interest expenses [c]...............................................

95.2

112.8

68.8

Foreign exchange (gains) losses ...........................

(5.1)

25.7

14.8

Amortization of intangibles ....................................

22.4

22.2

18.2

Losses (gains) from plant closing and ops sold ..

8.8

(23.1)

119.4

Miscellaneous expenses (income).........................

6.5

(8.4)

(2.8)

Total costs and expenses ..........................................

5,117.3

4,701.5

4,699.7

Income before taxes...................................................

382.9

340.1

192.1

Taxes (at 34%) ............................................................

130.2

115.6

65.3

Income from continuing operations .........................

252.7

224.5

126.8

Costs and expenses

See explanatory notes [a] through [c] on next page.

Chapter 11 - Equity Analysis and Valuation

Problem 11-1—concluded Notes:

[a] Cost of goods sold ........................................................... Less: Repair and maintenance expenses ...................... Less: Depreciation expense ............................................ Add: LIFO liquidation gain before tax* ...........................

2,839.7 (96.1) (125.2) 28.6 2,647.0

2,685.9 (96.6) (103.5) 42.3 2,528.1

2,655.3 (93.8) (94.5) 47.0 2,514.0

* LIFO liquidation gain (pre-tax): Year 11 = 18.9/(1 - .34) = 28.6; Year 10 = 27.9/(1 - .34) = 42.3; Year 9 = 31.0/(1 - .34) = 47.0

[b] Selling, General and Administrative expenses ............. Less: Advertising and merchandising expenses Less: Research and development ..................................

2,121.2 (1,407.4) (44.3) 669.5

1,844.1 (1,195.3) (43.3) 605.5

1,779.0 (1,142.7) (39.3) 597.0

[c] Interest expense ............................................................... Less: Interest allocated to disc ops ...............................

101.9 (6.7) 95.2

120.2 (7.4) 112.8

75.9 (7.1) 68.8

b. Analysis and Interpretation. Unlike reported net income, income from continuing operations has grown significantly over the three year period Year 9 – Year 11. Income (loss) from discontinuing operations had a marked effect on net results. Also, the LIFO liquidation gains decline over this three-year period. Moreover, advertising and merchandising expenses increased markedly, while repair and maintenance, as well as R & D expenses, remain stable.

Chapter 11 - Equity Analysis and Valuation

Problem 11-2 (75 minutes) a. Step 1: Compute Amount to be Allocated: Purchase price of Finex (given) .................................................. Book value of total equity 1 .......................................................... Payment in excess of book value ................................................ Add: Decrease in accounts receivable (5%)............................... Amount to be allocated to Land, Buildings and Equipment .... 1

$700,000 570,000 130,000 7,500 $137,500

Preferred stock + Common stock + Paid-In capital + Retained earnings.

Step 2: Allocate amount to individual assets: Land 1 .................................................................................................. Buildings 2 .......................................................................................... Equipment 3 ........................................................................................ Total .....................................................................................................

$ 10,377 93,396 33,727 $137,500

[40,000 / (40,000 + 360,000 + 130,000)] x 137,500. [360,000 / (40,000 + 360,000 + 130,000)] x 137,500. 3 [130,000 / (40,000 + 360,000 + 130,000)] x 137,500. 2

Step 3: Compute reported values to assign to individual assets: Land ($40,000 + $10,377) ........................................................ $ 50,377 Building ($360,000 + $93,396) ................................................ $453,396 Equipment ($130,000 + $33,727) ............................................ $163,727 b. Finex, Inc. Pro Forma Balance Sheet As of January 1, Year 2 ASSETS Cash ............................................................. U.S. government bonds ............................ Accounts receivable (net) ......................... Merchandise inventory ............................. Land ............................................................. Building ....................................................... Equipment .................................................. Total assets ................................................ LIABILITIES AND EQUITY Accounts payable ...................................... Notes payable ............................................. Bonds payable ........................................... Preferred stock ........................................... Common stock ........................................... Paid-in capital and retained earnings * ... Total liabilities and equity .........................

55,000 25,000 142,500 230,000 50,377 453,396 163,727 $1,120,000

(unchanged) (unchanged) (less 5%) (unchanged) (restated) (restated) (restated)

$ 170,000 50,000 200,000 100,000 400,000 200,000 $1,120,000

(unchanged) (unchanged) (unchanged) (unchanged) (unchanged) (increase of $130,000)

* Component amounts will vary with method of acquisition.

Chapter 11 - Equity Analysis and Valuation

Problem 11-2—concluded c. Finex, Inc. Pro Forma Income Statement For Year Ended December 31, Year 2 Net sales ........................................................ Cost of goods sold .......................................

$546,000

Add: Increased depreciation in COGS1.......

664

Gross profit..................................................... Selling & administrative expenses ..............

$860,000

100.0%

546,664

63.6

313,336

36.4

241,328

28.0

$ 72,008

8.4

240,000

Add: Increase in depreciation expense:1 Year 2 ($18,892 - $6,297=$12,595) Year 1 ($16,900 - $5,633=$11,267) .............

1,328

Net operating income ................................... 1 Depreciation rates before purchase:

Building: 7,900 / (360,000 + 35,000) Equipment: 9,000 / (130,000 + 20,000)

= 2% = 6%

Estimated depreciation expense in Year 2: Building: $453,396 x 2% Equipment: $163,727 x 6% Total

= $ 9,068 = 9,824 = $18,892

Estimated depreciation in COGS in Year 2 ($18,892 x 1/3) Estimated depreciation in COGS in Year 1 [($7,900+$9,000) x 1/3] Increase in depreciation expense

$6,297 5,633 $ 664

d. Yes, the pro forma net operating income is 8.4% of net sales.

Chapter 11 - Equity Analysis and Valuation

Problem 11-3 (60 minutes) Analysis of Credit Constraint from Bank America Step 1: Construct a Pro Forma Gross Profit Schedule Sales .......................................................... Less 10% sales returns ................................ 2% sales discount ............................... Net Sales ..................................................... Cost of goods sold Beginning inventory ($138,000/1.38) ... Purchases ............................................ $400,000 Less 2% purchases returned ........................ (8,000) 1% purchases discount ...................... (4,000) Less: Ending inventory ....................... Gross Profit ...............................................

$500,000 $ 50,000 10,000

60,000 440,000

100,000

388,000 488,000 138,000

350,000 $ 90,000

Step 2: Compute Gross Margin to Sales Gross margin to sales = $90,000 / $440,000 = 20.45% Step 3: Assess whether Aspero meets Credit Constraint Bank America would not extend a loan to Aspero (20.45% < 25% min.)

Analysis of Credit Constraint from Bank Boston Step 1: Compute Current Liabilities (Accounts Payable is its only current liability) Current liabilities = Purchases  Accounts payable turnover Accounts payable turnover = 360  90 = 4 Accounts payable = 388,000  4 = $97,000 Step 2: Compute Current Assets Current Assets Cash ...................................................................... Accounts receivable [a] ........................................ Inventory ................................................................ Total Current Assets.............................................

5,500 55,000 138,000 $198,500

[a] A.R. = Sales  A.R. turnover = 440,000  (360/45) = 55,000.

Step 3: Compute Current Ratio Current ratio = $198,500  $97,000 = 2.05 Step 4: Assess whether Aspero meets Credit Constraint Bank Boston would extend a loan to Aspero (2.05 > 2.0 min.)

Chapter 11 - Equity Analysis and Valuation

Problem 11-4 (60 minutes) a. Residual Income Computation Year 1: $12,500 - (.15)($50,000) Year 2: $11,700 - (.15)($56,500) Year 3: $11,420 - (.15)($63,845) Year 4: $11,860 - (.15)($72,145) Year 5: $10,820 - (.15)($72,145)

= $5,000 = $3,226 = $1,845 = $1,039 =$ 0

[5,000]* [3,225]* [1,843]* [1,038]* [ -2]*

*Note: Consistent with the example in the text, the figures are based on rounding ROCE to two digits. The figures without rounding are reported in parentheses.

b. Estimate of Equity Value 1/1/Year 2: $56,500 + $3,226/1.152 + $1,845/1.153 + $1,039/1.154 ....... 1/1/Year 3: $63,845 + $1,845/1.153 + $1,039/1.154 ............................... 1/1/Year 4: $72,145 + $1,039/1.154 ........................................................ 1/1/Year 5: ...........................................................................................

$60,747 $65,652 $72,739 $72,145

c. Conservative accounting principles tend to understate net income and book value. As long as the analyst's estimates of future profitability incorporate the eventual reversal of this conservatism under the clean surplus relation, value estimates will not be affected by conservative accounting. d. Estimate of PB 1/1/Year 2: 1 + (.2071-.15)/1.15 + [(.1789-.15)/1.152] x [$63,845/$56,500] + [(.1644-.15)/1.153] x [$72,145/$56,500] = 1.09 1/1/Year 3: 1 + (.1789-.15)/1.15 + [(.1644-.15)/1.152] x [$72,145/$56,500] = 1.04 1/1/Year 4: 1 + (.1644-.15)/1.15] = 1.01 1/1/Year 5: 1.00 e. Estimate of PE (Note: "Normal" PE = 1.15/.15 = 7.67): 1/1/Year 3: 7.67 + [7.67/$11,700] x [($1,845-$3,226)/1.15 + ($1,039-$1,845)/1.152 + ($0-$1,039)/1.153] - $4,355/$11,700 = 5.66 1/1/Year 4: 7.67 + [7.67/$11,420] x [($1,039-$1,845)/1.15 + ($0-$1,039)/1.152] - $3,120/$11,420 = 6.40 1/1/Year 5: 7.67 + [7.67/$11,860] x [($0-$1,039)/1.15] - $11,860/$11,860 = 6.08

Chapter 11 - Equity Analysis and Valuation

CASES Case 11-1 (90 minutes) a. Ferro Corporation Recast Income Statements ($000s) For Years Ended Year 5 and Year 6 Year 6

Year 5

Net sales .................................................................................. $376,485 Cost of sales [a] ...................................................................... 251,846 Selling & administrative expenses [b] ................................. 48,216 Repairs & maintenance [a] .................................................... 15,000 Advertising expense [b] ......................................................... 6,000 Employee training program [b] ............................................. 4,000 Research & development ....................................................... 9,972 335,034 Operating Income ................................................................... 41,451 Other income: [c] Royalties............................................................................. 710 Interest earned .................................................................. 1,346 Miscellaneous .................................................................... 1,490 Total other income ............................................................ 3,546 Other charges: [d] Interest expense ................................................................ 4,055 Miscellaneous .................................................................... 1,480 Total other charges ........................................................... 5,535 Income before taxes ............................................................... 39,462 Income taxes (at 48%, before items below) [e] ................... 18,942 Income from continuing operations ..................................... 20,520 Add (deduct) permanent tax differentials: Lower tax rate on earnings of consolidated subsidiaries (Year 6: 36,819 x 5.3%) [e] ........................ 1,951 Lower tax rate on equity in income of affiliated companies (Year 6: 36,819 x 1.4%) [e]........................... 516 Unrealized foreign exchange loss, not tax deductible (Year 6: 36,819 x 5.3%) [e] ............................................... (1,951) Added US taxes on dividends from subsidiaries, etc. (Year 6: 36,819 x .8%) [e] ................................................. (295) Investment tax credit (Year 6: 36,819 x 1.5%) [e] ............ 552 Miscellaneous tax benefits (Year 6: 36,819 x .4%) —rounded [e] ..................................................................... 135 Equity in earnings of affiliates (net of tax) (Year 6: 1,394 x .52) [c] .................................................... 725 Unrealized loss on foreign currency translation (net of tax) (Year 6: 4,037 x .52) [d] ................................ (2,099) Loss from disposal of chemicals division (net of tax) (Year 5: 7,000 x .52) [a] .................................................... Net income as reported .......................................................... $ 20,054

$328,005 210,333 42,140 20,000 7,000 5,000 8,205 292,678 35,327 854 1,086 1,761 3,701 4,474 1,448 5,922 33,106 15,891 17,215 1,312 198 (891) (248) 223 158 262 (963) (3,640) $ 13,626

Chapter 11 - Equity Analysis and Valuation

Case 11-1—concluded Notes: Notations [a], [b], etc., indicate related items in the statement. For example, repairs and maintenance is separated from cost of goods sold.

b. Factors causing the effective tax rate to be greater than the statutory rate include the (1) unrealized foreign exchange translation loss, and (2) additional taxes on dividends from subsidiaries and affiliates. Of these factors, changes in foreign exchange rates may be considered random. Dividend policy is under the control of management. The factors causing the effective tax rate to be less than the statutory rate include the: (1) earnings of consolidated subsidiaries taxed at rates less than the US rate, (2) equity in after-tax earnings of affiliates, (3) ITC, and (4) miscellaneous. Of these factors, the ITC is unstable as it depends on government policy. c. While Ferro's sales grew by only 14.8%, net income from continuing operations increased by 19.2%. The increase in the net income to sales ratio may have resulted from "savings" in repairs and maintenance (R&M), advertising, and employee training program expenses. The following analysis explains these "savings":

Year 5

Year 6

Actual Amount

Benchmark*

Difference (savings)

% R&M to Sales .............................

6.1

4.0

$15,000

$22,970

$ 7,970

% Advertising to Sales .................

2.1

1.6

6,000

7,910

1,910

% Employee Training to Sales ....

1.5

1.1

4,000

5,650

1,650

$25,000

$36,530

$11,530

The Year 6 % NI to Sales (on Year 5 basis) would be: Net income from continuing operations ........... ........................... $20,520 Less "savings" on discretionary items ($11,530 x .52) ............... Net income on adjusted basis **

5,995

.................. ........................... $14,525

% of net income to sales ($14,525/$376,485)*** ...........................

3.8%

Note: The disposal of the chemical division may have affected cost patterns. * Amount of spending required in Year 6 to equal the spending implicit in the Year 5 ratios. ** Adjusted to reflect discretionary costs at the same level as prevailed in Year 5. *** % of NI to Sales as reported is 5.3%.

Chapter 11 - Equity Analysis and Valuation

Case 11-2 (80 minutes) Reaction to Proposals 1 through 3 (1) The tonnage-of-production method provides an especially good matching of depreciation expense against revenues for Canada Steel's highly cyclical business. A unit-of-production method effectively makes depreciation a variable rather than a fixed cost and, therefore, tends to stabilize earnings. Casting metals is not a high technology business, and actual wear and tear on the equipment is more relevant to replacement need than technological obsolescence. A switch to straight-line would not eliminate the deferred tax liability as this difference is caused by accelerated methods and shorter lives rather than by the difference between the tonnage-of-production and straight-line methods. Moreover, Canada Steel should not attempt to extinguish this liability since it is an interest-free loan from the government, which may never have to be repaid as long as new assets are acquired. A switch to straight-line would leverage profits on any production increase (or decrease) because depreciation expense would be a direct function of time rather than units produced. However, the quality of earnings may be reduced by a switch to straight-line since this method would accentuate the highly cyclical nature of the business and result in increased income volatility.

(2) The reasons for adopting the LIFO method—reducing taxes and increasing cash flow—are still valid. Inflation usually declines during recessions, but this does not mean its recurrence is improbable. Maximizing cash flow remains important to the corporation and shareholders. A return to FIFO would relinquish the tax savings of prior years, although it is true that the balance sheet and income statement would be strengthened by the change. The quality of earnings is likely to be affected adversely by the lack of consistency in inventory method (two changes in a period of several years) and a perception that the motive in making the change was to increase book value per share, avoid two consecutive unprofitable years, and escape violation of a loan covenant. The $4 million upward adjustment in working capital is a result of increasing the inventory account by this amount, which has the effect of increasing the current ratio as shown below:

Current assets ................................................... Current liabilities ............................................... Current ratio ......................................................

LIFO $10.5 $ 4.5 2.3

FIFO $14.5 $ 4.5 3.2

The $0.5 million increment to net income will offset an operating loss of $0.4 million, which would not be unexpected on a sales decline of 31%. In addition, the $2.0 million addition to shareholders' equity from prior years' profits is likely to be far less significant than current profit trends (Canada Steel has had to disclose regularly in the notes to its financial statements the difference in inventory values resulting from the use of LIFO versus FIFO).

Chapter 11 - Equity Analysis and Valuation

Case 11-2—concluded (3) The inventory change will enable Canada Steel to meet the minimum current ratio requirements. However, the stock repurchase program should not be recommended for the following reasons: •

The proposed repurchase price of $100 per share is well above book value and recent market prices, suggesting dilution for remaining shareholders.

•

The potential dividend savings are outweighed by interest costs of $101,000 ($2.0 million x 11% x 0.46 marginal tax rate) to finance the purchase--in other words, leverage is negative.

•

The debt-to-equity ratio has increased significantly from 10% ($2.0 million long-term debt/$17.7 million equity + $2.0 million long-term debt) to 35% ($6.1 million long-term debt/$11.4 million equity + $6.1 million long-term debt). An additional $2.0 million of stock repurchased would raise this ratio to 41% ($8.1 million long-term debt/$11.5 million equity + $8.1 million long-term debt). The increased financial risk is particularly inappropriate for an industry with significant sensitivity to the business cycle. Shrinking shareholders' equity under present circumstances is prudent only by sale of fixed assets, not the incurring of additional debt.

In sum, each of the foregoing proposals 1-3 would have a negative impact on the quality of Canada Steel's earnings.

Chapter 11 - Equity Analysis and Valuation

Case 11-3 (75 minutes) a. Estimation of Equity Valuation 1

Net income........................ 1,034

1,130

1,218

1,256

1,278

1,404

1,546

Book value, beginning .... 5,308

5,292

5,834

6,338

6,728

7,266

7,856

Residual income [a] ..........

344

442

460

432

403

459

525

PV factor (at 13%) ............

.885

.783

.693

.613

.543

.480

.425

PV residual income ...........

304

346

319

265

219

221

223

[a] Residual income = NI - (13% x Beginning book value).

Value at 1/1/Year 1 = $5,308 +$304 +$346 + $319 + $265 + $219 + $221 + $223 = $7,205 b. Computation and Interpretation of PB: PB ratio = $7,205 / $5,308 = 1.36 Assuming accurate estimates, a market-based PB of 1.95 implies that Colin is overvalued. One might consider selling-short Colin stock. c. Computation and Interpretation of PE: PE ratio = $7,205 / $1,034 = 6.97 Assuming accurate estimates, a market-based PE of 10 implies that Colin is overvalued. One might consider selling-short Colin stock. d. Estimation of Equity Valuation 1

Net income ................ 1,034

1,130

1,218

1,256

1,278

1,404

1,546

Book value, beg ........ 5,308

5,292

5,834

6,338

6,728

7,266

7,856

8,506

344

442

460

432

403

459

525

440

PV factor (at 13%) ..... . .885

.783

.693

.613

.543

.480

.425

3.270 [b]

PV residual income ...... 304

346

319

265

219

221

223

1439

Residual income [a] .....

[a] Residual income = NI - (13% x Beginning book value). [b] To discount a perpetuity to beginning of Year 1: (1) Divide $1,439 by 0.13 to arrive at value as of 1/1/Year 8, and multiply by 7-year present value factor of 0.425 [0.425/0.13 = 3.270].

Value at 1/1/Year 1 = $5,308 +$304 +$346 +$319 +$265 +$219 +$221 +$223 +$1,439 = $8,644

Chapter 11 - Equity Analysis and Valuation

Case 11-4 (60 minutes) a. The revenue model was adopted since many of the firms initially did not have net income or cash inflows. While this may be an excuse for limitations in valuation models, the reality is that a revenue model directly values these companies based on their primary source of cash inflows. As the businesses mature, they will become profitable as they reach economies of scale with respect to their cost structures. The revenue model considers the companies’ prospects for such growth. The “non-financial’ metrics provide information on capacity and efficiency. For example, revenue per head is a measure of how well each firm is utilizing its personnel. Billable headcount is a measure of size and speaks to economies of scale issues. Billing rates reflect the value of the services provided. Firms that offer front- and back-end services have a higher average billing rate than firms that develop Web storefronts. Annual turnover speaks to each firm’s cost structure. Higher turnover means higher costs and lower utilization since new hires are sent to training programs and are billed to customers. Average utilization is the percentage of annual billable hours (2,080) per employee that are billed to clients. This measure excludes administrative and financial personnel. b. The revenue multiples reflect prospects for growth and the value of services provided. Those firms that provide both front- and back-end services trade at a higher revenue multiple since they have better prospects for sustained revenue streams. c. Headcount measures can be problematic in periods of high growth since new hires are included in the headcount measures upon hire. That means that revenue per head and average utilization are understated since the new hires are sent to training and do not initially generate revenue or work billable hours. Higher turnover measures have a similar effect. d. The revenue multiples are lower since a firm can only double in size so many times. In other words, growth rates slow over time so the prospects for growth also diminish. Lower multiples reflect this phenomenon. e. Razorfish was trading at nearly three times the revenue multiple that I-Cube was trading at when the deal was made. Analysts viewed the transaction as positive. There was a consensus among the analysts that follow Razorfish that value would come from operating improvement and not just financial engineering. The acquisition of I-Cube allowed Razorfish to add expertise it did not possess and allowed them to come closer to being able to offer complete front- and back-end services. In this case, the 18% premium appears to be a good buy for Razorfish.

Colgate's Summary Financial Data (In billions, except per share data) Net Sales Gross Profit Operating Income Net Income Restructuring charge (after tax) Net Income before restructuring Op Income before restructuring

2011 16.73 9.59 3.84 2.43 0.00 2.43 3.84

2010 15.56 9.20 3.49 2.20 0.06 2.26 3.55

2009 15.33 9.01 3.62 2.29 0.00 2.29 3.62

2008 15.33 9.01 3.33 1.96 0.11 2.07 3.44

2007 13.79 8.22 2.96 1.74 0.18 1.92 3.14

2006 12.24 7.21 2.57 1.35 0.29 1.64 2.86

2005 11.40 6.62 2.37 1.35 0.15 1.50 2.52

2004 10.58 6.15 2.20 1.33 0.06 1.39 2.26

2003 9.90 5.75 2.14 1.42 0.04 1.46 2.18

Total Assets Total Liabilities Long Tern Debt Sharehholder' Equity Treasury Stock at cost

12.72 10.18 4.43 2.07 12.81

11.17 8.36 2.82 2.68 11.31

11.13 7.88 2.82 3.12 10.48

9.98 7.94 3.59 1.92 9.70

10.11 7.72 3.22 2.29 8.90

9.14 7.62 2.72 1.41 8.07

8.51 7.05 2.92 1.35 7.58

8.67 7.21 3.09 1.25 6.97

7.48 6.38 2.68 0.89 6.50

Basic Earnings per share Cash Dividends per share Closing Stock Price Shares Outstanding (billions)

4.98 2.27 92.39 0.48

4.45 2.03 80.37 0.49

4.53 1.72 82.15 0.49

3.81 1.56 68.54 0.50

3.35 1.40 77.96 0.51

2.57 1.25 65.24 0.51

2.54 1.11 54.85 0.52

2.45 0.96 51.16 0.53

2.60 0.90 50.05 0.53

Kimberley Clark Summary Financial Data (In billions, except per share data) 2011 Net Sales 20.85 Gross Profit 6.15 Operating Income 2.44 Net Income 1.59 Restructuring charge (after tax) 0.29 Net Income before restructuring 1.88 Op Income before restructuring 2.73

2010 19.75 7.38 2.90 1.84 0.00 1.84 2.90

2009 19.12 7.27 3.07 1.88 0.09 1.98 3.16

2008 19.42 6.68 2.64 1.69 0.05 1.74 2.69

2007 18.27 6.60 2.75 1.82 0.10 1.92 2.84

2006 16.75 6.36 2.61 1.50 0.31 1.81 2.92

2005 15.90 6.12 2.57 1.57 0.17 1.74 2.73

2004 15.08 5.91 2.59 1.80 0.01 1.81 2.60

2003 14.35 5.66 2.52 1.69 0.00 1.69 2.52

Total Assets Total Liabilities Long Tern Debt Sharehholder' Equity Treasury Stock at cost

19.37 13.84 5.43 5.53 2.11

19.86 13.12 5.12 5.92 4.73

19.21 12.47 4.79 5.41 4.09

18.09 12.80 4.88 3.88 4.29

18.44 11.73 4.39 5.22 3.81

17.07 9.75 2.28 6.10 1.39

16.30 9.59 2.59 5.56 6.38

17.02 9.30 2.30 6.63 5.05

16.78 9.15 2.73 6.77 3.82

Basic Earnings per share Cash Dividends per share Closing Stock Price Shares Outstanding (billions)

4.02 2.76 73.56 0.40

4.47 2.58 63.04 0.41

4.53 2.38 63.71 0.42

4.08 2.27 52.74 0.41

4.13 2.08 69.34 0.42

3.27 1.92 67.95 0.46

3.33 1.75 59.65 0.46

3.58 1.54 65.81 0.48

3.34 1.32 59.09 0.50

R O

T T L P P D

COLGATE 2002 9.29 5.35 2.02 1.29 0.00 1.29 2.02

2001 9.43 5.46 1.86 1.15 0.00 1.15 1.86

Net Sales Gross Profit Operating Income Net Income Before restructuring: Net Income before restructuring Op Income before restructuring

2011 177% 176% 206% 212%

2010 165% 169% 188% 192%

2009 163% 165% 194% 200%

2008 163% 165% 179% 171%

2007 146% 151% 159% 152%

212% 206%

197% 191%

200% 194%

180% 185%

168% 169%

7.09 6.53 3.21 0.35 6.15

6.98 5.93 2.81 0.85 5.20

Total Assets Total Liabilities Long Tern Debt Sharehholder' Equity Treasury Stock at cost

182% 172% 158% 244% 246%

160% 141% 100% 316% 217%

159% 133% 100% 368% 201%

143% 134% 128% 227% 186%

145% 130% 115% 270% 171%

2.33 0.72 52.43 0.54

2.02 0.68 57.75 0.55

Basic Earnings per share Cash Dividends per share Closing Stock Price Shares Outstanding (billions)

247% 336% 160% 87%

220% 301% 139% 90%

224% 255% 142% 90%

189% 231% 119% 91%

166% 207% 135% 92%

2011 102% 32% 23% 57%

2010 76% 31% 22% 59%

2009 91% 34% 24% 59%

2008 93% 33% 22% 59%

2007 94% 31% 21% 60%

102% 32% 23%

78% 32% 23%

91% 34% 24%

98% 34% 22%

104% 33% 23%

1.40 4.92 2.14 18.55 21.43 46%

1.40 3.12 1.05 18.06 14.87 46%

1.45 2.53 0.91 18.13 13.03 38%

1.53 4.13 1.87 17.99 17.88 41%

1.43 3.37 1.41 23.27 17.36 42%

2011 76% 121% 116% 99%

2010 56% 117% 114% 102%

2009 67% 129% 120% 102%

2008 69% 124% 110% 102%

2007 69% 115% 109% 103%

76% 121% 116%

58% 119% 116%

67% 129% 120%

73% 128% 114%

77% 123% 115%

104% 70% 64% 65% 57% 136%

103% 45% 32% 63% 40% 137%

108% 36% 27% 63% 35% 114%

113% 59% 56% 63% 48% 123%

106% 48% 42% 81% 46% 125%

2011

2010

2009

2008

2007

COLGATE Return on equity Return on assets Operating profit margin Gross profit margin Before restructuring: Return on equity Return on assets Operating profit margin Total asset turnover Total liabilities to equity Long-term debt to equity Price to earnings Price to book Dividend Payout COLGATE Return on equity Return on assets Operating profit margin Gross profit margin Before restructuring: Return on equity Return on assets Operating profit margin Total asset turnover Total liabilities to equity Long-term debt to equity Price to earnings Price to book Dividend Payout COLGATE

Cum-Div Return (Gross)

1.18

1.00

1.22

0.90

1.22

2011 144% 92% 94% 99%

2010 136% 110% 111% 114%

2009 132% 108% 118% 117%

2008 134% 99% 101% 105%

2007 126% 98% 106% 113%

114% 104%

112% 110%

120% 120%

106% 102%

117% 108%

KIMBERLEY CLARK 2002 13.57 5.55 2.58 1.67 0.00 1.67 2.58

2001 14.52 6.71 2.60 1.61 0.04 1.65 2.64

Net Sales Gross Profit Operating Income Net Income Before restructuring: Net Income before restructuring Op Income before restructuring

15.59 9.13 2.84 5.65 3.35

15.01 8.51 2.42 5.65 2.75

Total Assets Total Liabilities Long Tern Debt Sharehholder' Equity Treasury Stock at cost

129% 163% 224% 98% 77%

132% 154% 211% 105% 172%

128% 146% 198% 96% 149%

121% 150% 201% 69% 156%

123% 138% 181% 93% 139%

3.26 1.18 47.47 0.51

3.04 1.11 59.80 0.52

Basic Earnings per share Cash Dividends per share Closing Stock Price Shares Outstanding (billions)

132% 249% 123% 76%

147% 232% 105% 78%

149% 214% 107% 80%

134% 205% 88% 79%

136% 187% 116% 81%

2011 28% 12% 12% 30%

2010 33% 15% 15% 37%

2009 41% 16% 16% 38%

2008 37% 14% 14% 34%

2007 32% 15% 15% 36%

33% 14% 13%

33% 15% 15%

43% 17% 17%

38% 15% 14%

34% 16% 16%

1.06 2.50 0.98 18.30 5.26 69%

1.01 2.22 0.87 14.10 4.34 58%

1.02 2.31 0.89 14.06 4.91 53%

1.06 3.30 1.26 12.93 5.62 56%

1.03 2.25 0.84 16.79 5.59 50%

2011 98% 72% 65% 64%

2010 114% 86% 82% 81%

2009 142% 95% 90% 82%

2008 130% 83% 76% 74%

2007 113% 89% 84% 78%

113%

112%

146%

131%

116%

KIMBERLEY CLARK Return on equity Return on assets Operating profit margin Gross profit margin Before restructuring: Return on equity Return on assets Operating profit margin Total asset turnover Total liabilities to equity Long-term debt to equity Price to earnings Price to book Dividend Payout KIMBERLEY CLARK Return on equity Return on assets Operating profit margin Gross profit margin Before restructuring: Return on equity

Return on assets Operating profit margin

79% 72%

84% 81%

96% 91%

84% 76%

91% 86%

Total asset turnover Total liabilities to equity Long-term debt to equity Price to earnings Price to book Dividend Payout

110% 166% 229% 93% 95% 188%

104% 147% 202% 72% 79% 158%

106% 153% 206% 71% 89% 144%

110% 219% 293% 66% 102% 152%

106% 149% 196% 85% 101% 138%

2011

2010

2009

2008

2007

1.21

1.03

1.25

0.79

1.05

KIMBERLEY CLARK

Cum-Div Return (Gross)

2006 130% 132% 138% 118%

2005 121% 121% 127% 118%

2004 112% 113% 118% 116%

2003 105% 105% 115% 124%

2002 99% 98% 109% 112%

2001 100% 100% 100% 100%

143% 154%

131% 135%

121% 121%

127% 117%

112% 109%

100% 100%

131% 128% 97% 167% 155%

122% 119% 104% 160% 146%

124% 122% 110% 147% 134%

107% 107% 95% 105% 125%

101% 110% 114% 41% 118%

100% 100% 100% 100% 100%

127% 185% 113% 93%

126% 164% 95% 94%

121% 142% 89% 96%

129% 133% 87% 97%

115% 107% 91% 97%

100% 100% 100% 100%

2006 98% 29% 21% 59%

2005 104% 28% 21% 58%

2004 124% 27% 21% 58%

2003 230% 29% 22% 58%

2002 215% 29% 22% 58%

2001 135% 27% 20% 58%

119% 32% 23%

115% 29% 22%

130% 28% 21%

236% 30% 22%

215% 29% 22%

135% 27% 20%

1.39 5.40 1.93 25.39 23.71 49%

1.33 5.22 2.16 21.59 20.97 44%

1.31 5.79 2.48 20.88 21.63 39%

1.36 7.19 3.03 19.25 30.11 35%

1.32 18.63 9.17 22.50 80.22 31%

1.35 7.01 3.32 28.59 37.58 33%

2006 72% 109% 106% 102%

2005 77% 104% 105% 100%

2004 92% 102% 105% 100%

2003 170% 110% 109% 100%

2002 159% 108% 110% 99%

2001 100% 100% 100% 100%

88% 122% 118%

85% 110% 112%

96% 105% 108%

174% 112% 111%

159% 108% 110%

100% 100% 100%

103% 77% 58% 89% 63% 146%

98% 75% 65% 76% 56% 131%

97% 83% 75% 73% 58% 117%

101% 103% 91% 67% 80% 104%

98% 266% 276% 79% 213% 92%

100% 100% 100% 100% 100% 100%

2006

2005

2004

2003

2002

2001 OVERALL

1.21

1.09

1.04

0.97

0.92

1.0692

2006 115% 95% 100% 93%

2005 109% 91% 99% 97%

2004 104% 88% 100% 112%

2003 99% 84% 97% 105%

2002 93% 83% 99% 104%

2001 100% 100% 100% 100%

110% 111%

105% 104%

110% 99%

103% 96%

102% 98%

100% 100%

114% 115% 94% 108% 51%

109% 113% 107% 98% 232%

113% 109% 95% 117% 184%

112% 107% 113% 120% 139%

104% 107% 117% 100% 122%

100% 100% 100% 100% 100%

108% 173% 114% 87%

110% 158% 100% 89%

118% 139% 110% 93%

110% 119% 99% 96%

107% 106% 79% 98%

100% 100% 100% 100%

2006 26% 16% 16% 38%

2005 26% 15% 16% 38%

2004 27% 15% 17% 39%

2003 27% 16% 18% 39%

2002 30% 17% 19% 41%

2001 29% 17% 18% 46%

31% 17% 17%

28% 16% 17%

27% 15% 17%

27% 16% 18%

30% 17% 19%

29% 18% 18%

1.00 1.60 0.37 20.78 5.08 59%

0.95 1.73 0.47 17.91 4.95 53%

0.89 1.40 0.35 18.38 4.79 43%

0.89 1.35 0.40 17.69 4.38 40%

0.89 1.62 0.50 14.56 4.29 36%

0.97 1.51 0.43 19.67 5.52 37%

2006 90% 90% 87% 82%

2005 90% 89% 90% 83%

2004 94% 89% 96% 85%

2003 96% 90% 98% 85%

2002 104% 97% 106% 89%

2001 100% 100% 100% 100%

107%

98%

93%

94%

102%

100%

100% 96%

93% 95%

88% 95%

89% 97%

96% 105%

100% 100%

104% 106% 87% 106% 92% 161%

99% 114% 109% 91% 90% 144%

92% 93% 81% 93% 87% 118%

92% 90% 94% 90% 79% 108%

92% 107% 117% 74% 78% 99%

100% 100% 100% 100% 100% 100%

2006

2005

2004

2003

2002

2001 OVERALL

1.17

0.93

1.14

1.27

0.81

1.0533

2011 16.73 9.59 3.84 2.43 0 2.43 3.84

2010 15.56 9.2 3.49 2.2 0.06 2.26 3.55

2009 15.33 9.01 3.62 2.29 0 2.29 3.62

2008 15.33 9.01 3.33 1.96 0.11 2.07 3.44

2007 13.79 8.22 2.96 1.74 0.18 1.92 3.14

Total Assets Total Liabilities Long Tern Debt Sharehholder' Equity Treasury Stock at cost

12.72 10.18 4.43 2.07 12.81

11.17 8.36 2.82 2.68 11.31

11.13 7.88 2.82 3.12 10.48

9.98 7.94 3.59 1.92 9.7

10.11 7.72 3.22 2.29 8.9

Basic Earnings per share Cash Dividends per share Closing Stock Price Shares Outstanding (billions)

4.98 2.27 92.39 0.48

4.45 2.03 80.37 0.49

4.53 1.72 82.15 0.49

3.81 1.56 68.54 0.5

3.35 1.4 77.96 0.51

Kimberley Clark Summary Financial Data (In billions, except per share data) Net Sales Gross Profit Operating Income Net Income Restructuring charge (after tax) Net Income before restructuring Op Income before restructuring

2011 20.85 6.15 2.44 1.59 0.29 1.88 2.73

2010 19.75 7.38 2.9 1.84 0 1.84 2.9

2009 19.12 7.27 3.07 1.88 0.09 1.98 3.16

2008 19.42 6.68 2.64 1.69 0.05 1.74 2.69

2007 18.27 6.6 2.75 1.82 0.1 1.92 2.84

Total Assets Total Liabilities Long Tern Debt Sharehholder' Equity Treasury Stock at cost

19.37 13.84 5.43 5.53 2.11

19.86 13.12 5.12 5.92 4.73

19.21 12.47 4.79 5.41 4.09

18.09 12.8 4.88 3.88 4.29

18.44 11.73 4.39 5.22 3.81

Basic Earnings per share Cash Dividends per share Closing Stock Price Shares Outstanding (billions)

4.02 2.76 73.56 0.4

4.47 2.58 63.04 0.41

4.53 2.38 63.71 0.42

4.08 2.27 52.74 0.41

4.13 2.08 69.34 0.42

2006 12.24 7.21 2.57 1.35 0.29 1.64 2.86

2005 11.4 6.62 2.37 1.35 0.15 1.5 2.52

2004 10.58 6.15 2.2 1.33 0.06 1.39 2.26

2003 9.9 5.75 2.14 1.42 0.04 1.46 2.18

2002 9.29 5.35 2.02 1.29 0 1.29 2.02

2001 9.43 5.46 1.86 1.15 0 1.15 1.86

9.14 7.62 2.72 1.41 8.07

8.51 7.05 2.92 1.35 7.58

8.67 7.21 3.09 1.25 6.97

7.48 6.38 2.68 0.89 6.5

7.09 6.53 3.21 0.35 6.15

6.98 5.93 2.81 0.85 5.2

2.57 1.25 65.24 0.51

2.54 1.11 54.85 0.52

2.45 0.96 51.16 0.53

2.6 0.9 50.05 0.53

2.33 0.72 52.43 0.54

2.02 0.68 57.75 0.55

2006 16.75 6.36 2.61 1.5 0.31 1.81 2.92

2005 15.9 6.12 2.57 1.57 0.17 1.74 2.73

2004 15.08 5.91 2.59 1.8 0.01 1.81 2.6

2003 14.35 5.66 2.52 1.69 0 1.69 2.52

2002 13.57 5.55 2.58 1.67 0 1.67 2.58

2001 14.52 6.71 2.6 1.61 0.04 1.65 2.64

17.07 9.75 2.28 6.1 1.39

16.3 9.59 2.59 5.56 6.38

17.02 9.3 2.3 6.63 5.05

16.78 9.15 2.73 6.77 3.82

15.59 9.13 2.84 5.65 3.35

15.01 8.51 2.42 5.65 2.75

3.27 1.92 67.95 0.46

3.33 1.75 59.65 0.46

3.58 1.54 65.81 0.48

3.34 1.32 59.09 0.5

3.26 1.18 47.47 0.51

3.04 1.11 59.8 0.52

Ratio Analysis (1998) Liquidity Current Ratio Solvency Total Debt to Equity Long Term Debt to Equity Times Interest Earned Return on Investment Return on Total Assets Return on Equity

1998

AMR

1997

1998

0.809

0.842

3.831 2.931 3.020

3.921 2.968 2.376

5.89% 18.69%

Delta

UAL

1997

1998

0.710

0.672

0.475

0.516

4.295 3.118 2.380

5.455 4.036 2.326

8.943 7.078 1.759

12.048 9.602 1.977

7.17% 23.20%

1997

4.47% 21.87%

Note: We treat preference share capital as debt and include preference dividend with interest. Sensitivity Analysis Drop in demand Revised Income Statement for 1998 Operating Revenue Operating Expenses Operating Income Other Income & Adjustments Interest Expense* Income before Tax Tax Provision Continuing Income % drop in Continuing Income Revised Ratios (1998) Liquidity Current Ratio Solvency Total Debt to Equity Long Term Debt to Equity Times Interest Earned Return on Investment Return on Total Assets Return on Equity

AMR

10%

18245 (16191) 2054 198 (996) 1256 (540) 716 41%

17285 (15986) 1298 198 (996) 501 (276) 225 81%

0.809

Delta

UAL

10%

13431 (11770) 1661 141 (991) 811 (358) 453 44%

12724 (11621) 1103 141 (991) 253 (162) 90 89%

16683 (15340) 1343 133 (1227) 248 (78) 170 72%

15805 (15146) 659 133 (1227) (436) 161 (275) 145%

0.809

0.710

0.475

3.831 2.931 2.261

3.831 2.931 1.503

4.295 3.118 1.818

4.295 3.118 1.255

8.943 7.078 1.202

8.943 7.078 0.645

4.33% 10.69%

2.77% 3.36%

5.39% 11.26%

3.61% 2.24%

3.07% 5.18%

1.66% -8.37%

1.3 Case 6-1 Ace Company's income statements for the three years 2012, 2011, 2010 are given below (All amounts in $ millions): Sales Cost of goods sold Gross profit Selling, general administration Restructuring Goodwill impairment Other income (expense) Tax Provision Income from continuing operations Income from discontinued operation Gain on discontinued operation Net income

2012 3,424 -1,604 1,820 -1,260

2011 3,036 -1,297 1,738 -1,099

2010 2,818 -1,157 1,661 -1,126 -765

-23 110

(201)

(222)

447 32 69 548

451 46

-155 55

497

-100

2011 173 -189

2010 194 -130

55 -6

-11 2

Note information from the annual report provided the following additional information: 1.

Other income (expense) comprised the following: Interest income Interest expense Loss on early extinguishment of debt Gain (loss) from sale of business units Gain (loss) from sale of marketable securities Unrealized gain (loss) on trading securities Early retirement charge

2012 159 -215 -13 80 122 11 -34 110

In 2012, cost of goods sold included inventory write-off of $ 45 million. This write-off pertained to obsolete inventory that was not sold for many years. Much of the written down inventory was unsold at the end of 2012. Selling, general administration included share compensation expense of $ 23, $ 25 and $22 million respectively for 2012, 2011 and 2010. This expense relates to option grants given to the new CEO in 2010, which was valued at around $ 70 million on the date of grant.

The restructuring charge in 2010 was taken to significantly downsize and streamline operations and close a number of underperforming businesses. Of the charge of $ 765 million, $ 312 million was in the form of asset impairments and the remaining $ 453 million was cash payments related to lease cancellations, employee retrenchment and reorganization costs. It was expected that this restructuring would lead to cost reductions and improved efficiency that would last at least five years.

The following items were reported in the statement of shareholder's equity: 2012 Foreign currency translation gains 23 Unrealized gain (loss) on available for sale securities 23 Postretirement benefit adjustment 173 219

2011 4 -33 345 316

2010 55 -40 -433 -418

The company has significant office property that is reported at amortized cost on the balance sheet. The fair market value of this property was considerably larger than its amortized cost, as shown in the table below: Amortized Cost Fair Market value

2012 112 285

2011 116 245

2010 120 220

Assume a marginal tax rate of 35% on all adjustments made to income. Required For all three years determine (1) core income (2) comprehensive income (3) sustainable income and (4) economic income. Explain the basis for your calculations.

Problem 6-1

2012 447

2011 451

2010 (155)

45 0 23 13 (80) (122) (11) 34 (98) 34 (64) 383

0 0 0 0 (55) 6 0 (49) 17 (32) 419

765 0 0 0 11 (2) 0 774 (271) 503 348

Determination of comprehensive income Net income Other comprehensive income: Foreign currency translation gains Unrealized gain (loss) on available for sale securities Postretirement benefit adjustment Comprehensive income

2012 548

2011 497

2010 -100

23 23 173 767

4 -33 345 812

55 -40 -433 -518

2011

2010

Core Income less After-tax amortization of restructuring charge Sustainable income estimate 4.

383 -99 284

419 -99 320

348 -99 249

Estimating economic income Starting point for estimating economic income is comprehensive income. But we must also include 2012 2011 2010 (a) Comprehensive income 767 812 -518 Add Compensation Expense 23 25 22 Less Option grants -70 Add Unrealized gain on office property 44 29 (b) Total Pre-tax adjustment 67 54 -48 less tax portion (35%) -23 -19 17 (c ) Total after-tax adjustment 44 35 -31 Economic income estimate (a +c) 810 848 -550 Determining unrealized gain on office property Fair-market value Amortized cost Difference Change in difference

2012 285 112 173 44

2011 245 116 129 29

2010 220 120 100

NOTES: 1. The effects of discontinued operation are included in economic income computation. It is also fine to exclude them. 2.

The entire restructuring charge is included in year of charge for economic income. Alternatively, the amount actually incurred during the year can be used.

1 (i)

Range

# shares Outstandi ng

Weighted

Year-End Price

Average

In-the-

Price

Money

69 Overhang

Current Price= In-the-

90 Overhang

Money

1.50 – $11.48

310,542

8.08

60.92

18,918,219

81.92

25,439,601

$ 11.57 – $18.14

311,566

14.65

54.35

16,933,612

75.35

23,476,498

$ 19.34 – $23.48

302,259

21.52

47.48

14,351,257

68.48

20,698,696

$ 23.78 – $27.55

300,998

26.32

42.68

12,846,595

63.68

19,167,553

$ 28.13 – $34.75

304,110

30.91

38.09

11,583,550

59.09

17,969,860

$ 35.36 – $53.80

314,372

42.35

26.65

8,378,014

47.65

14,979,826

$ 58.23 – $75.00

308,609

67.04

1.96

604,874

22.96

7,085,663

$ 80.09 – $113.25

359,849

98.03

$134.91 – $237.19

298,455

196.19

$242.09 – $267.99

146,994

259.98

TOTAL Overhang

2,957,754

$83,616,120

$128,817,696

Market Cap

#########

$3,822,504,435

$4,985,875,350

2.19%

2.58%

Overhang %

The overhang is $ 83.62 million when using the year-end market prices. This constitutes about 2.2% of the market capitalization. 1 (ii)

1 (iii)

At an estimated price of $ 90, the overhang is $ 128.82 million and constitutes 2.58% of market capitalization. The diluted market value of the existing shareholder's shares is $ 4.857 billion ($ 4.985 billion - $ 128.82 million) which works out to $ 87.67 per share. This number can also be arrived at using the % of overhang: $ 90 X (1 - 0.0258) = $ 87.67. The “overhang” is not a liability, in the sense that it is not money owed by the company to outsiders. However, it represents a transfer of wealth from the current shareholders to prospective shareholders (employees) and so is a reduction in the wealth of current shareholders. However, one should not subtract the amount from the market capitalization because the stock market usually adjusts for this amount when pricing the company’s stock.

1 (iv)

2 (i)

2 (ii)

2010 (a) Total post-tax stock-based comp (b) Net income after compensation expense (c) Net income before compensation expense

2011

$16,835

$38,735

$160,853

$226,126

$177,688

$264,861

2 (iii)

2 (iv)

Option compensation expense is not reported as a line item of the income statement. Using the details provided by Netflix, we see that the bulk of the option expense is allocated between two departments: Technology and development and General and administrative. Both of these departments account for a lower level of expense on the income statement relative to the marketing department. This suggests that R&D and admin personnel get more of the option grants relative to marketing staff, although it is also possible that marketing expense on the income statement does not reflect personnel expense. The major assumptions underlying the option values are: (1) risk-free interest rate (2) expected dividend yield (3) return volatility and (4) expected "term", i.e., average years before employees exercise. The values of these assumptions and their justification is provided in teh note information.

2 (v)

3 (i)

Net income for 2011 = $226,126 Basic EPS for 2011 = $4.28 # shares used for EPS determination 52,833 Option Overhang reported by Netflix 84,482 Stcok Price at year-end $69 # treasury shares that can be purchased 1,224.38 Diluted # shares (52833 + 1224) Diluted EPS

54057 4.18310302

3 (ii)

Note that this number gives us the total “overhang” from all potentially dilutive securities, not just options. As long as options constitute a major component the total dilutive securities we are fine. Use this method only if you don’t have footnote information. 4

$4,857,057,653.96 87.67 87.678

2012 3,424 -1,604 1,820 -1,260

2011 3,036 -1,297 1,738 -1,099

2010 2,818 -1,157 1,661 -1,126 -765

-23 110

(201)

(222)

447 32 69 548

451 46

-155 55

497

-100

2011 173 -189

2010 194 -130

55 -6

-11 2

Note information from the annual report provided the following additional information: 1.

2012 159 -215 -13 80 122 11 -34 110

2011 4 -33 345 316

2010 55 -40 -433 -418

2012 112 285

2011 116 245

2010 120 220

Problem 6-1

2012 447

2011 451

2010 (155)

45 0 23 13 (80) (122) (11) 34 (98) 34 (64) 383

0 0 0 0 (55) 6 0 (49) 17 (32) 419

765 0 0 0 11 (2) 0 774 (271) 503 348

2012 548

2011 497

2010 -100

23 23 173 767

4 -33 345 812

55 -40 -433 -518

2011

2010

Core Income less After-tax amortization of restructuring charge Sustainable income estimate 4.

383 -99 284

419 -99 320

348 -99 249

2012 285 112 173 44

2011 245 116 129 29

2010 220 120 100

NOTES: 1. The effects of discontinued operation are included in economic income computation. It is also fine to exclude them. 2.

The entire restructuring charge is included in year of charge for economic income. Alternatively, the amount actually incurred during the year can be used.

1 (i)

Range

# shares Outstandi ng

Weighted

Year-End Price

Average

In-the-

Price

Money

69 Overhang

Current Price= In-the-

90 Overhang

Money

1.50 – $11.48

310,542

8.08

60.92

18,918,219

81.92

25,439,601

$ 11.57 – $18.14

311,566

14.65

54.35

16,933,612

75.35

23,476,498

$ 19.34 – $23.48

302,259

21.52

47.48

14,351,257

68.48

20,698,696

$ 23.78 – $27.55

300,998

26.32

42.68

12,846,595

63.68

19,167,553

$ 28.13 – $34.75

304,110

30.91

38.09

11,583,550

59.09

17,969,860

$ 35.36 – $53.80

314,372

42.35

26.65

8,378,014

47.65

14,979,826

$ 58.23 – $75.00

308,609

67.04

1.96

604,874

22.96

7,085,663

$ 80.09 – $113.25

359,849

98.03

$134.91 – $237.19

298,455

196.19

$242.09 – $267.99

146,994

259.98

TOTAL Overhang

2,957,754

$83,616,120

$128,817,696

Market Cap

#########

$3,822,504,435

$4,985,875,350

2.19%

2.58%

Overhang %

The overhang is $ 83.62 million when using the year-end market prices. This constitutes about 2.2% of the market capitalization. 1 (ii)

1 (iii)

1 (iv)

2 (i)

2 (ii)

2010 (a) Total post-tax stock-based comp (b) Net income after compensation expense (c) Net income before compensation expense

2011

$16,835

$38,735

$160,853

$226,126

$177,688

$264,861

2 (iii)

2 (iv)

2 (v)

3 (i)

54057 4.18310302

3 (ii)

$4,857,057,653.96 87.67 87.678

Balance Sheets $ Millions Assets Current Assets Freehold Assets (Net) Leased Assets (Net) Intangibles & Other Total Liabilities Current Liabilities: Current Portion of Capital Lease Other Current Liabilities Long Term Liabilities: Lease Liability Long Term Debt Other Long Term Liabilities Preferred Stock Shareholder's Equity Contributed Capital Retained Earnings Treasury Stock Total Income Statement $ Millions Operating Revenue Operating Expenses Operating Income Other Income & Adjustments Interest Expense* Income before Tax Tax Provision Continuing Income * Includes preference dividends.

1998

AMR

1997

1998

4,875 12,239 2,147 3,042 22,303

4,986 11,073 2,086 2,714 20,859

154 5,485

Delta

UAL

1997

1998

3,362 9,022 299 1,920 14,603

2,867 7,695 347 1,832 12,741

2,908 10,951 2,103 2,597 18,559

2,948 9,080 1,694 1,742 15,464

135 5,437

63 4,514

62 4,021

176 5,492

171 5,077

1,764 2,436 5,766

1,629 2,248 5,194

249 1,533 4,046 175

322 1,475 3,698 156

2,113 2,858 3,848 791

1,679 2,092 3,493 615

3,257 4,729 -1,288 22,303

3,286 3,415 -485 20,859

3,299 1,776 -1,052 14,603

2,896 812 -701 12,741

3,518 1,024 -1,261 18,559

2,877 300 -840 15,464

1997

1998

1997

1998

18,184 -16,277 1,907 137 -420 1,624 -651 973

14,138 -12,445 1,693 141 -197 1,637 -647 990

13,594 -12,063 1,531 91 -216 1,406 -561 845

17,561 -16,083 1,478 133 -361 1,250 -429 821

1998 19,205 -16,867 2,338 198 -372 2,164 -858 1,306

AMR

Delta

UAL

1997

1997 17,378 -16,119 1,259 551 -291 1,519 -561 958

Excerpts from Lease Footnotes (1998) $ Millions MLP Due - 1999 - 2000 - 2001 - 2002 - 2003 - 2004 and after Total MLP Due Less Interest Present Value of MLP

Capital 273 341 323 274 191 1,261 2,663 -745 1,918

AMR Operating 1,012 951 949 904 919 12,480 17,215

Capital 100 67 57 57 48 71 400 -88 312

Delta Operating 950 950 940 960 960 10,360 15,120

Capital 317 308 399 341 242 1,759 3,366 -1,077 2,289

UAL Operating 1,320 1,329 1,304 1,274 1,305 17,266 23,798

Excerpts from Lease Footnotes (1997) $ Millions MLP Due - 1998 - 1999 - 2000 - 2001 - 2002 - 2003 and after Total MLP Due Less Interest Present Value of MLP

Capital 255 250 315 297 247 1,206 2,570 -806 1,764

AMR Operating 1,011 985 935 931 887 13,366 18,115

Capital 101 100 68 57 57 118 501 -117 384

Delta Operating 860 860 840 830 850 9,780 14,020

Capital 288 262 241 314 277 1,321 2,703 -853 1,850

UAL Operating 1,419 1,395 1,402 1,380 1,357 19,562 26,515