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73 Cards in this Set

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Types of Financial Statements (3)
1) Balance Sheet,
2) Income Statement, and
3) Summary of Cash Flows
Conservative Bias of Accountants
Counterweights individuals/firms to gravitate toward presenting financial conditions in the best possible light
Monetary Unit Concept
accountants must express all figures in a common monetary unit; i.e., be reluctant to record occurrences not easily convertible to monetary units
Market Value vs. Historic Cost
Preference for HISTORICAL costs over market values
Historic costs
are (1) more conservative, and
(2) tend to be based on actual transactions
Market value
1) more subjective,
2) more easily manipulated
3) Requires frequent recalculation
Setting Accounting Standards
o SEC (for public companies only) --> Requires GAAP compliance
o FASB --> Promulgates and regulates GAAP by issuing statements and interpretations
o AICPA --> Promulgates and regulates GAAS (for auditors)
o Public Company Accounting Oversight Board --> Congressionally created in the Enron/Worldcom wake
Balance Sheet (concept)
A series of snapshots of an entity’s financial position at specific times
- Typically two snapshots: one at the beginning of the period and one at the end
Balance Sheets (contents) (3)
1) Assets,
2) Liabilities, and
3) Owners’ Equity
Assets (concept)
Listing of a firm’s economic resources at a particular time
Assets (Definition)
Resources with probable future economic benefits obtained or controlled by an entity resulting from past transactions or events (i.e., something resulting from a past transaction that has a probable future benefit)
1) Must have a probable future benefit; merely a possible benefit doesn’t qualify
2) Must arise out of specific “past transactions or events” (e.g. inventions, reputation for good service, etc. do not count as assets)
Assets (components) (2)
1) Current Assets
2) Plant, Property and Equipment (PPE)
Current Assets (def + 4)
Def: Assets likely to be changed into cash within 1 year
List in the following order:
1) Cash (and cash equivalents),
2) A/R,
3) Inventory,
4) Prepaid Expenses
Plant, Property and Equipment (PPE)
e.g. land, goodwill, a tractor, etc.
Liabilities definition
- Claims of creditors
Owner's Equity
- Claims of owners of the company
Liabilities (components)
1) Current Liabilities
2) Other liabilities (long term)
Current Liabilities
- those likely to be reduced to cash payments w/in 1 year
- E.g., A/P, accrued expenses (incurred but not paid), income tax payable, short-term N/Ps, etc.
Liabilities (definition)
Probable future economic sacrifices of economic benefits arising from present obligations to transfer assets or render services in the future as a result of past transactions or events (i.e., a probable future economic sacrifice resulting from a past obligation)
Owners Equity (definition)
The residual interest in assets of an entity after subtracting its liabilities
Owners Equity (components)
for typical U.S. corporations where owners = SHs:
- owners’ equity = funds originally contributed by SHs + accumulated profits (retained earnings)
Fundamental Accounting Equation
Assets = Liabilities + Owners’ Equity
Income Statement (concept)
A summary of revenues and expenses during the accounting period
Income Statement (Function)
Compares revenues and expenses; determines whether there’s a profit or loss
Revenues
increases in equity resulting from asset increases and/or liability decreases from delivering goods or services or other activities constituting the entity’s ongoing major/central operations
Expenses
decreases in equity from asset decreases or liability increases from delivery of goods or services, or carrying out any activities constituting the entity’s ongoing major or central operations
Income Statements (components)
1) Gross Margin = Sales Revenue - COgs
2) Operating Earnings = Gross margin - operating expense - depreciation expense
3) Earnings Before Income Tax (EBIT) = Operating earnings - Interest expense
4) Net Income = EBIT - Income Tax expense
Gross Margin
Sales Revenue - COGs
- This is one measure of profitability
Operating Earnings
Gross margin - operating expense - depreciation expense
Earnings Before Income Tax (EBIT)
= Operating earnings - Interest expense
Net Income
= EBIT - Income Tax
- Added to the balance sheet as retaied earnings
= profits
Revenue Allocation
Revenue should be allocated to the period during which effort is expended in generating it
Expense Allocation
Expenses should be allocated to the period in which the benefit from it will contribute to income generation
LIFO
- Creates more net income when inventory prices are falling
- Better reflects expenses and net income
FIFO
- Creates more net income when inventory prices are rising
- Better reflects the true value of inventory
Capitalization and Depreciation (use)
Used when: inputs have readily determined costs that contribute to income over several accounting periods
Capitalization and Depreciation (procedure)
Capitalize certain expenditures as assets, then depreciate them as expenses over a fixed period of time that corresponds to the period during which the asset contributes to income generation
Capitalization and Depreciation (accounting procedure)
1. At Purchase: Credit Cash, Debit Equipment
2. Every Year for a Fixed Period: Credit Equipment, Debit Expenses
Summary of Cash Flows (concept)
- A summary of how a firm obtains and uses cash during the accounting period
- Information is largely derived from the other two financial statements
Summary of Cash Flows (function)
- Highlighting the entity’s changes in its cash position over time
a. E.g., buying an asset uses cash, and is therefore a negative entry on the Summary of Cash Flows, and vice versa
- Demonstrates an entities Liquidity
Boundary Problems types (3)
1) Intangible Assets
2) Contingent liabilities
3) Extraordinary and Unusual Items
Intangible Assets (generally)
- Type of boundary problem
- Economic resources that contribute to success BUT are not treated by the balance sheet as assets
- Not really a subject of abuse/manipulation
Intangible Assets (treatment)
- ONLY APPEAR to the extent that they are products of identifiable costs

Exception: Treated as assets IF they’re obtained through arms-length transactions (e.g., buying a trademark  record an asset (debit goodwill, e.g.) and amortize)
- I.e., extremely different effects on financial statements can occur from the same real world event depending on the situation
Contingent Liabilities (definition)
a.k.a. expected liability
- Liabilities contingent on future events; may or may not be incurred
Contingent Liabilities (treatment generally)
Depends on the probability the laibility will be incurred AND if the cost can be reasonably estimated
Contingent Liabilities (treatment - Probable AND estimatable)
- Credit liability account
- Debit expense account
Contingent Liabilities (treatment - Reasonably possible (less than probable) OR not estimatable)
disclose information about the contingency (w/ estimated cost or range of costs) in a footnote to the financial statements (and in other places necessary, e.g. SEC disclosures)
Contingent Liabilities (treatment - not reasonably probable)
Does not need to be disclosed at all
Extraordinary and Unusual Items
(Definition)
Costs associated w/ highly unusual events (e.g., a tornado, unexpected deterioration of business assets, etc.)
i. Unusual, not tied to the firm’s ordinary operations, nor likely to recur, etc.
ii. NO strict definition  discretionary
Extraordinary and Unusual Items
(Treatment)
- Distinguished from other expenses on the income statement on a separate line beneath a line labeled “net income before extraordinary and unusual items”
- Extraordinary INCOME is considered earned from primary operations (NOT extraordinary circumstances)
Types of Financial Statement Analysis (5)
1) Liquidity
2) Solvency
3) Managerial Efficiency
4) Profitability
5) Market value of a Firm
Liquidity Analysis
How quickly a firm can convert its assets to cash to satisfy its obligations
- Examine i) statement of cash flows, ii) amount of cash shown on balance sheet, etc.
Current Ratio
- Measures: What portion of current assets can be used to pay obligations coming due w/in the year
- Equation: (Current Assets / Short-Term (Current) Liabilities)
- Target: Can vary by industry
- Book: Current assets should always be greater than short-term liabilities; current ratio should always be greater than 1.5 and 2.0
- Typically analysts hope for a ratio > 2
Solvency Analysis
The relationship between assets and liabilities, but not necessarily in the short-term (contrasted w/ liquidity)
Solvency Ratios
- First perspective
1) Debt/Equity Ratio
2) Leverage Ratio
- Second Perspective
1) Interest Coverage Ratio
Debt/Equity Ratio
- Type of Solvency Ratio

Equation: (Total Liabilities / Total Equity)

Use: Seen in loan covenants requiring maintenance of a given ratio

Target: depends heavily on the industry
Leverage Ratio:
- Type of Solvency Ratio

Equation: (Total Liabilities / Total Assets)

Target: depends on the industry; typically analyze CHANGES in the ratio over time
Interest Coverage Ratio
- Type of Solvency Ratio

Equation: (EBIT [“operating earnings”] / Annual Interest Expense)

Measures: Comparing a firm’s annual interest expenses to the earnings it has available to make those payments
- The LARGER the ratio, the MORE likely a firm is able to pay its future interest obligations as they come due

Target: Varies by industry; look more for CHANGES rather than any particular level as an indicia of health
- Look for VERY high numbers; even a ICR = 2 means that half of your earnings are going toward interest payments
- Based on Income Statement figures
Managerial Efficiency Analysis
Often used to evaluated the performance of individual employees (can even be used to calculate compensation packages)
Managerial Efficiency (ratios) (3)
1) Receivables to Sales Ratio
2) Turnover Ratio
3) Interest Costs
Receivables to Sales Ratio
- Type of Managerial Efficiency Ratio
Equation: (A/R / Sales (gross) Revenue)

Measures: What % of sales are being purchased on credit
- Assuming sales revenue is generated evenly throughout the year, (52 * Ratio %) is the time it takes, on average, for a customer to pay off his account (Book: 5 weeks is a reasonable period  ratio = 0.096)

Target: Ratio > 15% may start to raise eyebrows, particular if the ratio is rising
Turnover Ratio
- Type of managerial efficiency ratio

Equation: (COGS / Inventory)
Measures: Estimates how many times a firm’s inventory is sold during the year (i.e., how often inventory is turning over)
- If Ratio = 10, then at the end of the year the inventory on hand is 10% of the value of all inventory sold during the year (i.e., inventory turned over 10 times during the year)
- HIGHER ratio indicates MORE EFFICIENT the firm’s inventory management is  items stay in inventory for less time and thus inventory maintenance costs are lower

Target: Varies by industry (high in grocery stores, low at Louis Vuitton)
Interest Costs
- Managerial efficiency ratio

Equation: (Interest Payments / Interest Bearing Debt)
- Interest Bearing Debt = Liabilities bearing interest

Measures: Shows the firm’s total interest rate for all notes payable
- IMPORTANT b/c bank’s charge higher i-rates for riskier ventures
- A higher firm i-rate can make it a riskier venture (also signals how other lending institutions judge the health and risk of the firm)
- Useful for evaluating a company’s health (e.g., APEX problem)
Profitability Ratio (ratios) (3)
1) Margin
2) Return on Assets (ROA)
3) Return on Equity (ROE)
Margin Ratio
- Profitability Ratio

Equation: (Operating Earnings (EBIT) / Sales (gross) Revenue)

Measures: Percentage of sales that remained after direct costs (COGS) and indirect costs (operating expenses) were deducted
- E.g., Margin = 0.125 means that every dollar of sales generated 12.5 cents of operating income

Target: Widely varied across industries  look for changes w/in a firm, or compare to other industry firms
- E.g., low margin for grocery stores, high for luxury car sales
Return on Assets (ROA)
- Type of profitability ratio

Equation: (Net Income / Total Assets)
i. Net Income = Earnings after interest and tax payments

Measures: Amount of income generated by each dollar of assets

- Often included in loan covenants
Return on Equity (ROE)
- Type of Profitability ratio

Equation: (Net Income / Total Owners’ Equity)

Measures: The return on the owners’ investment in a firm
Market Value of a Firm analysis (generally)
- Financial statements, b/c of GAAP, are based on historical costs  therefore, there’s no guarantee that accounting statement figures will accord w/ market values

- May not reflect: valuable intangible assets, certain appreciation or deterioration of certain long-lived assets, proper valuation of certain contingencies, etc.
Market Value of a firm Ratios (4)
1) Book value per share
2) Earnings per share
3) Price to earning ration (PE)
4) Tobin's Q ratio
Book Value Per Share
- Type of Market value ratio

Equation: (Owners’ Equity / # of shares of common stock outstanding)
i. Owners’ Equity ~ the value of the firm to SHs

- May or may not be a good estimate of the true market value of a firm or its shares (see qualification)
Earnings Per Share Ratio
- Type of Market value ratio

Equation: (Net Income / # of shares of common stock outstanding)

Measures: the amount of earnings (profit) attributable to each share
- Often used to evaluate the market price of a company’s stock
- E.g., ask how much you’d be wiling to pay to receive $4.00/year (EPS of 4) from a company of this type; if the income stream was expected to continue indefinitely at a 10% return, you might be willing to pay $40.00/share
- Often used to evaluate the market price of a company’s stock
Price to Earnings Ratio (PE)
- Type of Market value ratio

Equation: (Price of Common Stock / EPS)

Qualification: Only for companies whose securities trade in public markets (or otherwise have a readily obtainable market price)

Measures: EXPECTATIONS w/ respect to reality
1.JoShep: Often used to identify possible industry “bubbles”
iii.Book e.g.: for the fourth quarter, took the midpoint of the trading range for the price of the common stock
iv. a/k/a “Price-Earnings Multiple”
Tobin's Q Ratio
- Type of market value ratio

Equation: – (Market Value of Assets / Book Value of Assets)
i. Book Value of Assets – what’s listed on the balance sheet
ii. Market Value of Assets = Book Value of Assets + Market Value of the Common Stock – Book Value of the Common Stock

Measures: How much people vaue the firm for compared to what’s actually on the balance sheet

Target: Not sure
1. High figures in the financial services and telecommunication industries (no significant fixed asset investments (e.g., little PPE