Financial

Statement
Analysis
K R Subramanyam
John J Wild

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

4-2

Analyzing Investing Activities

CHAPTER

4-3

Current Asset Introduction

Classification
Current
Current (Short-term)
(Short-term)
Assets
Assets

Noncurrent
Noncurrent (Long(Longterm)
term) Assets
Assets

Resources
Resourcesor
orclaims
claimsto
to
resources
resourcesthat
that are
are
expected
expectedto
tobe
besold,
sold,
collected,
collected, or
orused
used within
within
one
oneyear
yearor
orthe
theoperating
operating
cycle,
cycle, whichever
whichever is
is
longer.
longer.

Resources
Resourcesor
orclaims
claimsto
to
resources
resourcesthat
that are
are
expected
expectedto
toyield
yield
benefits
benefitsthat
thatextend
extend
beyond
beyondone
oneyear
yearor
or the
the
operating
operating cycle,
cycle,
whichever
whicheveris
islonger.
longer.

4-4

Current Asset Introduction

Cash, Cash Equivalents and Liquidity
Cash
Cash
Currency,
Currency,coins
coins and
and amounts
amounts on
on deposit
deposit
in
in bank
bank accounts,
accounts, checking
checking accounts,
accounts, and
and
some
some savings
savings accounts.
accounts.

4-5

Current Asset Introduction

Cash, Cash Equivalents and Liquidity
Cash
Cash Equivalents
Equivalents
Short-term,
Short-term, highly
highly liquid
liquid investments
investments that
that are:
are:

Readily
Readily convertible
convertible to
to aa known
known cash
cash
amount.
amount.

Close
Close to
to maturity
maturity date
date and
and not
not
sensitive
sensitive to
to interest
interest rate
rate changes.
changes.

4-6

Current Asset Introduction

Analysis of Cash and Cash Equivalents
Companies
Companiesrisk
riskaareduction
reductionin
in liquidity
liquidityshould
shouldthe
the

market
market value
valueof
of short-term
short-terminvestments
investmentsdecline.
decline.
Cash
Cashand
andcash
cashequivalents
equivalentsare
aresometimes
sometimesrequired
required
to
tobe
bemaintained
maintainedas
ascompensating
compensatingbalances
balancesto
to
support
supportexisting
existing borrowing
borrowing arrangements
arrangementsor
or as
as
collateral
collateralfor
for indebtedness.
indebtedness.

4-7

Current Asset Introduction

Receivables
Receivables
Receivables are
are amounts
amounts due
due from
from others
others
that
that arise
arise from
from the
the sale
sale of
of goods
goods or
or services,
services,
or
or the
the loaning
loaning of
of money
money
Accounts
Accounts receivable
receivable refer
refer to
to oral
oral
promises
promises of
of indebtedness
indebtedness due
due from
from customers
customers
Notes
Notes receivable
receivable refer
refer to
to formal
formal written
written
promises
promises of
of indebtedness
indebtedness due
due from
from others
others

4-8

Current Asset Introduction

Valuation of Receivables
Receivables
Receivables are
are reported
reported at
at their
their net
net realizable
realizable
value
value
total
total amount
amount of
of receivables
receivables less
less an
an
allowance
allowance for
for uncollectible
uncollectible accounts
accounts
Management
Management estimates
estimates the
the allowance
allowance for
for
uncollectibles
uncollectibles based
based on
on experience,
experience, customer
customer
fortunes,
fortunes, economy
economy and
and industry
industry expectations,
expectations,
and
and collection
collection policies
policies

4-9

Current Asset Introduction

Analyzing Receivables
Assessment
Assessmentof
ofearnings
earningsquality
qualityisisoften
oftenaffected
affectedby
byan
ananalysis
analysisof
ofreceivables
receivablesand
andtheir
their
collectibility
collectibility
Analysis
Analysismust
mustbe
bealert
alertto
tochanges
changesin
inthe
theallowancecomputed
allowancecomputedrelative
relativeto
tosales,
sales,
receivables,
or
industry
and
market
conditions.
receivables, or industry and market conditions.
Two
Twospecial
specialanalysis
analysisquestions:
questions:
(1)
(1) Collection
Collection Risk
Risk
Review
Reviewallowance
allowancefor
foruncollectibles
uncollectiblesin
inlight
lightof
ofindustry
industryconditions
conditions
Apply
special
tools
for
analyzing
collectibility:
Apply special tools for analyzing collectibility:
Determining
Determiningcompetitors
competitorsreceivables
receivablesas
asaapercent
percentof
ofsalesvis--vis
salesvis--visthe
the
company
under
analysis
company under analysis
Examining
Examiningcustomer
customerconcentrationrisk
concentrationriskincreases
increaseswhen
whenreceivables
receivablesare
are
concentrated
in
one
or
a
few
customers
concentrated in one or a few customers
Investigating
Investigatingthe
theage
agepattern
patternof
ofreceivablesoverdue
receivablesoverdueand
andfor
forhow
howlong
long
Determining
Determiningportion
portionof
ofreceivables
receivablesthat
thatisisaarenewal
renewalof
ofprior
priorreceivables
receivables
Analyzing
Analyzingadequacy
adequacyof
ofallowances
allowancesfor
fordiscounts,
discounts,returns,
returns,and
andother
othercredits
credits
(2)
Authenticity
of
Receivables
(2) Authenticity of Receivables
Review
Reviewcredit
creditpolicy
policyfor
forchanges
changes
Review
return
policies
for
Review return policies forchanges
changes
Review
Reviewany
anycontingencies
contingencieson
onreceivables
receivables

4-10

Current Asset Introduction

Securitization of Receivables
Securitization
Securitization(or
(orfactoring)
factoring)is
iswhen
whenaacompany
companysells
sellsall
allor
oraa
portion
portionof
ofits
itsreceivables
receivablesto
toaathird
thirdparty
party
Receivables
Receivablescan
canbe
besold
soldwith
withor
orwithout
withoutrecourse
recourseto
toaabuyer
buyer
(recourse
(recourserefers
refersto
toguarantee
guaranteeof
ofcollectibility)
collectibility)
Sale
Saleof
ofreceivables
receivableswith
withrecourse
recoursedoes
doesnot
noteffectively
effectivelytransfer
transferrisk
risk
of
ofownership
ownership
For securitizations with any type of recourse, the seller
must record both an asset and a compensating liability
for the amount factored
For securitizations without any recourse, the seller
removes the receivables from the balance sheet

4-11

Current Asset Introduction

Prepaid Expenses
Prepaid
Prepaidexpenses
expensesare
areadvance
advancepayments
paymentsfor
forservices
servicesor
orgoods
goodsnot
not
yet
yetreceived
receivedthat
thatextend
extendbeyond
beyondthe
thecurrent
currentaccounting
accountingperiod
period
examples
examplesare
areadvance
advancepayments
paymentsfor
forrent,
rent,insurance,
insurance,utilities,
utilities,and
and
property
propertytaxes
taxes

Analysis of Prepaids
Two
Twoanalysis
analysisissues:
issues:
(1)
(1) For
Forreasons
reasonsof
ofexpediency,
expediency,noncurrent
noncurrentprepaids
prepaidssometimes
sometimes
are
areincluded
includedamong
amongprepaid
prepaidexpenses
expensesclassified
classifiedas
ascurrent-current-when
whentheir
theirmagnitude
magnitudeis
islarge,
large,they
theywarrant
warrantscrutiny
scrutiny
(2)
(2)Any
Anysubstantial
substantialchanges
changesin
inprepaid
prepaidexpenses
expenseswarrant
warrant
scrutiny
scrutiny

4-12

Inventories
Definitions
Inventories are goods held for sale, or goods
acquired (or in process of being readied) for
sale, as part of a companys normal
operations
Expensing treats inventory costs like period
costscosts are reported in the period when
incurred
Capitalizing treats inventory costs like product
costscosts are capitalized as an asset and
subsequently charged against future
period(s) revenues benefiting
from their sale

4-13

Inventories
Inventory Costing Method
Use of Inventory Methods in Practice

4-14

Inventories
First-In, First-Out (FIFO)

Oldest
Oldest
Costs
Costs

Costs
Costs of
of Goods
Goods
Sold
Sold

Recent
Recent
Costs
Costs

Ending
Ending
Inventory
Inventory

4-15

Inventories
Last-In, First-Out (LIFO)

Recent
Recent
Costs
Costs

Costs
Costs of
of
Goods
Goods Sold
Sold

Oldest
Oldest
Costs
Costs

Ending
Ending
Inventory
Inventory

4-16

Inventories
Average Cost
When
When aa unit
unit is
is sold,
sold, the
the
average
average cost
cost of
of each
each
unit
unit in
in inventory
inventory is
is
assigned
assigned to
to cost
cost of
of
goods
goods sold.
sold.
Cost of
Units
Goods
available on
Available for
the date of
Sale
sale

4-17

Inventories
Illustration of Costing Methods
Inventory
Inventoryon
onJanuary
January1,
1,Year
Year22 40
40@
@$500
$500
Inventories
Inventoriespurchased
purchased
during
60
duringthe
theyear
year
60@
@$600
$600
Cost
Costof
ofGoods
Goodsavailable
available
for
100
forsale
sale
100units
units

$$20,000
20,000
36,000
36,000
$$56,000
56,000

Note:
Note:30
30units
unitsare
aresold
soldin
inYear
Year22for
for$800
$800each
eachfor
fortotal
total
Revenue
Revenueof
of$24,000
$24,000

4-18

Inventories
Illustration of Costing Methods

FIFO
FIFO
LIFO
LIFO
Average
Average

Beginning
Beginning
Inventory
Inventory
$20,000
$20,000
$20,000
$20,000
$20,000
$20,000

++
++
++
++

Net
Net
Purchases
Purchases
$36,000
$36,000
$36,000
$36,000
$36,000
$36,000

==
==
==
==

Cost
Costof
of
Goods
GoodsSold
Sold
$15,000
$15,000
$18,000
$18,000
$16,800
$16,800

++
++
++
++

Ending
Ending
Inventory
Inventory
$41,000
$41,000
$38,000
$38,000
$39,200
$39,200

Assume
Assumesales
salesof
of$35,000
$35,000for
forthe
theperiodthen
periodthengross
grossprofit
profitunder
undereach
each
method
methodis:
is:
Sales
Cost
Gross
Sales
Costof
ofGoods
GoodsSold
Sold ==
GrossProfit
Profit
FIFO
$24,000
---- 15,000
==
$9,000
FIFO
$24,000
15,000
$9,000
LIFO
$24,000
---- 18,000
==
$6,000
LIFO
$24,000
18,000
$6,000
Average
$24,000
---- 16,800
==
$7,200
Average
$24,000
16,800
$7,200

4-19

Economic Profit vs. Holding Gain

In periods of rising prices, FIFO produces higher gross
profits than LIFO because lower cost inventories are
matched against sales revenues at current market
prices. This is sometimes referred to as FIFOs phantom
profits.
The FIFO gross profit is actually a sum of two
components: an economic profit and a holding gain:
Economic profit = 30 units x ($800 - $600) = $6,000
Holding gain = 30 units x ($600 - $500) = $3,000

4-20

Inventories
LIFO Liquidations
(1)
(1)Companies
Companiesmaintain
maintain LIFO
LIFOinventories
inventoriesin
in separate
separate
cost
costpools.
pools.
(2)
(2)When
Wheninventory
inventoryquantities
quantitiesare
arereduced,
reduced,each
eachcost
cost
layer
layer is
ismatched
matchedagainst
against current
current selling
selling prices.
prices.
(3)
(3)In
Inperiods
periodsof
of rising
rising prices,
prices,dipping
dipping into
intolower
lowercost
cost
layers
layerscan
caninflate
inflateprofits.
profits.

4-21

Inventories
Analyzing InventoriesRestatement of LIFO to
FIFO
Three
Threestep
stepprocess:
process:
(1)
(1) Reported
ReportedLIFO
LIFOInventory
Inventory++LIFO
LIFO reserve
reserve
(2)
(2) Deferred
Deferredtax
taxpayable
payable++ [LIFO
[LIFOreserve
reservexxTax
Taxrate]
rate]
(3)
(3) Retained
Retained earnings
earnings++[LIFO
[LIFOreserve
reservexx(1-Tax
(1-Taxrate)]
rate)]
LIFO
LIFO reserve
reserve is
isthe
the amount
amountby
bywhich
which current
current cost
cost
exceeds
exceedsreported
reportedcost
cost of
ofLIFO
LIFO
inventories
inventories

4-22

Long-Lived Asset Introduction

Definitions
Long-lived
Long-livedassetsresources
assetsresourcesthat
thatare
areused
usedto
togenerate
generaterevenues
revenues(or
(or
reduce
reducecosts)
costs)in
inthe
thelong
longrun
run
Tangible fixed assets such as
property, plant, and equipment
Intangible assets such as
patents, trademarks,
copyrights, and goodwill
Deferred charges such as
research and development
(R&D) expenditures, and natural
resources

4-23

Long-Lived Asset Introduction

Capitalization
Capitalizationprocess
Capitalizationprocessof
ofdeferring
deferringaacost
costthat
thatisisincurred
incurredin
inthe
the
current
currentperiod
periodand
andwhose
whosebenefits
benefitsare
areexpected
expectedto
toextend
extendto
toone
oneor
ormore
more
future
futureperiods
periods
For
Foraacost
costto
tobe
becapitalized,
capitalized,ititmust
mustmeet
meeteach
eachof
ofthe
thefollowing
followingcriteria:
criteria:
ItItmust
mustarise
arisefrom
fromaa
past
pasttransaction
transactionor
orevent
event
ItItmust
mustyield
yieldidentifiable
identifiableand
and
reasonably
reasonablyprobable
probablefuture
futurebenefits
benefits
ItItmust
mustallow
allowowner
owner(restrictive)
(restrictive)
control
controlover
overfuture
futurebenefits
benefits

4-24

Long-Lived Asset Introduction

Allocation
Allocationprocess
Allocationprocessof
ofperiodically
periodicallyexpensing
expensingaadeferred
deferred
cost
cost(asset)
(asset)to
toone
oneor
ormore
morefuture
futureexpected
expectedbenefit
benefitperiods;
periods;
determined
determinedby
bybenefit
benefitperiod,
period,salvage
salvagevalue,
value,and
andallocation
allocation
method
method
Terminology
Terminology
Depreciation
Depreciation for
fortangible
tangiblefixed
fixed
assets
assets
Amortization
Amortization for
forintangible
intangibleassets
assets

Depletion
Depletion for
fornatural
naturalresources
resources

4-25

Long-Lived Asset Introduction

Impairment
Impairmentprocess
Impairmentprocessof
ofwriting
writingdown
downasset
assetvalue
valuewhen
whenits
its
expected
expected(undiscounted)
(undiscounted)cash
cashflows
flowsare
areless
lessthan
thanits
itscarrying
carrying
(book)
(book)value
value
Two
Twodistortions
distortionsarise
arisefrom
fromimpairment:
impairment:
Conservative
Conservativebiases
biasesdistort
distort
long-lived
long-livedasset
assetvaluation
valuation
because
becauseassets
assetsare
arewritten
written
down
downbut
butnot
notwritten
writtenup
up
Large
Largetransitory
transitoryeffects
effectsfrom
from
recognizing
recognizingasset
assetimpairments
impairments
distort
distortnet
netincome.
income.

4-26

Plant Assets & Natural Resources

Plant Assets
Tangible
Actively Used in Operations
Expected to Benefit Future Periods
Property, Plant and Equipment

4-27

Plant Assets & Natural Resources

Plant Assets Costing Rule
Purchase
price
Acquisition
cost

Acquisition cost excludes

financing charges and
cash discounts.

All
expenditures
needed to
prepare the
asset for its
intended use

4-28

Plant Assets & Natural Resources

Valuation Analysis
Valuation emphasizes objectivity of historical cost, the
conservatism principle, and accounting for the money
invested
Limitations of historical costs:
Balance sheets do not purport to reflect market values
Not especially relevant in assessing replacement values
Not comparable across companies
Not particularly useful in measuring opportunity costs
Collection of expenditures reflecting different
purchasing power

4-29

Plant Assets & Natural Resources

Depreciation
Depreciation is the process of allocating the
cost of a plant asset to expense in the
accounting periods benefiting from its use.
Balance Sheet
Acquisition
Cost
(Unused)

Cost
Allocation

Income Statement
Expense
(Used)

4-30

Plant Assets & Natural Resources

Factors in Computing Depreciation
The calculation of depreciation requires
three amounts for each asset:
Cost.
Salvage Value.
Useful Life.
Depreciation Method

4-31

Plant Assets & Natural Resources

Comparing Depreciation Methods
Straight-Line Method
Depreciation
=
Expense per Year

Cost - Salvage Value

Useful life in periods

SL

4-32

Plant Assets & Natural Resources

Double-Declining-Balance Method
Step 1:
Straight-line
depreciation rate
Step 2:
Double-decliningbalance rate
Step 3:
Depreciation
expense

100 %
Useful life

= 2

Straight-line
depreciation rate

Double-decliningbalance rate
Ignores salvage value

Beginning period
book value

4-33

Plant Assets & Natural Resources

Activity (Units-of-Production) Method
Step 1:
Depreciation
Per Unit

Cost - Salvage Value

Total Units of Production

Depreciation
Per Unit

Step 2:
Depreciation
Expense

Units Produced
in Period

4-34

Plant Assets & Natural Resources

Natural Resources
Natural resources (wasting assets)rights to extract or consume natural resources

Total cost,
including
exploration and
development,
is charged to
depletion expense
over periods
benefited.

Extracted from
the natural
environment
and reported
at cost less
accumulated
depletion.

Examples: oil, coal, gold

4-35

Plant Assets & Natural Resources

Depletion of Natural Resources
Depletion is calculated using the
units-of-production method.
Unit depletion rate is calculated as follows:
Cost

Salvage Value

Total Units of Capacity

4-36

Plant Assets & Natural Resources

Depletion of Natural Resources
Total depletion cost for a period is:
Unit Depletion
Rate

Total
depletion
cost

Number of Units
Extracted in Period
Cost of
goods sold
Unsold
Inventory

4-37

Plant Assets & Natural Resources

Analyzing Depreciation and Depletion
Assess reasonableness of depreciable base, useful life, and allocation
method
Review any revisions of useful lives
Evaluate adequacy of depreciationratio of depreciation to total
assets or to other size-related factors
Analyze plant asset agemeasures include
Average total life span

Average age

Average remaining life

Average total life span

Gross plant and equipment assets /

Current year depreciation expense.
Accumulated depreciation / Current
year depreciation expense.
Net plant and equipment assets /
Current year depreciation expense.
Average age + Average remaining life

(these measures also reflect on profit margins and financing requirements)

4-38

Intangible Assets
Often
Oftenprovide
provide
exclusive
exclusiverights
rights
or
orprivileges.
privileges.

Noncurrent
Noncurrentassets
assets
without
withoutphysical
physical
substance.
substance.

Intangible
Assets
Useful
Usefullife
lifeis
is
often
oftendifficult
difficult
to
todetermine.
determine.

Usually
Usuallyacquired
acquired
for
foroperational
operational
use.
use.

4-39

Intangible Assets
Accounting for Intangible Assets
Record at cost,
including
purchase price,
legal fees, and
filing fees.

Patents
Copyrights
Leaseholds
Leasehold
Improvements
Goodwill
Trademarks and
Trade Names

4-40

Intangible Assets
Analyzing Intangibles and Goodwill
Search for unrecorded intangibles and
goodwilloften misvalued and
most likely exist off-balance-sheet
Examine for superearnings as
evidence of goodwill
Review amortization periodsany likely bias is in the
direction of less amortization and can call for
adjustments
Recognize goodwill has a limited useful life--whatever
the advantages of location, market dominance,
competitive stance, sales skill, or product
acceptance, they are affected by changes in business