Session 2, Sunday, April 2nd (1:30-5:00) v Association for Financial Professionals. All rights reserved. Session 3-1

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Session 2, Sunday, April 2nd (1:30-5:00) v2.

2 Chapters Covered Financial Accounting and Reporting: Part I, Domain B Chapter 7 Ratio Analysis: Part I, Domain B Chapter 8 Financial Statement Projections: Part II, Domain B Chapter 10 v Association for Financial Professionals. All rights reserved. Session 3-2

3 Key Accounting Concepts Elements Assets Liabilities Equity Revenues Expenses Accounts refer to the records within each element I recommend spending some time with Exhibit I.B.7-1 on page IB-50 Accrual accounting versus cash accounting Matching principle v Association for Financial Professionals. All rights reserved. Session 3-3

4 Accounting Standards Global Accounting Standards International Financial Reporting Standards (IFRS) as pronounced by the International Accounting Standards Board (IASB) U.S. Accounting Standards Generally Accepted Accounting Principles (GAAP) as pronounced by the Financial Accounting Standards Board (FASB) IFRS is focused more on principles, while GAAP is more rules based v Association for Financial Professionals. All rights reserved. Session 3-4

7 The Income Statement Revenue Cost of Goods Sold = Gross Profit Amounts earned from the sale of products or services to customers. The expense associated with providing the goods or services whose sale is recognized as revenue. Measures the profitability of the end product considering only the direct costs associated with creating the product. v Association for Financial Professionals. All rights reserved. Session 3-7

8 The Income Statement Gross Profit SG&A Expenses= EBITDA Includes: Payroll costs Marketing and advertising Promotion costs R&D Some taxes Office expenses and supplies Shipping and distribution expenses Rent, utilities, maintenance and insurance All costs (other than interest and income taxes) not directly connected to producing the goods or services the organization sells. v Association for Financial Professionals. All rights reserved. Session 3-8

9 The Income Statement EBITDA Depreciation and Amortization = EBIT Examples: Buildings Machinery Vehicles Furniture Technology items Assets that provide value over more than the operating cycle. Considered capital expenses. Cost Residual Value = Period Depreciation Useful Life v Association for Financial Professionals. All rights reserved. Session 3-9

10 Depreciation Expense Examples A machine has a depreciable basis of $1,000,000 and a useful life of 4 years. At the end of 4 years, it is expected that the machine will be sold for $100,000. It is also expected that the machine will produce 200,000 units of output per year over the 4 year period. S-L Dep Exp = ($1,000,000-$100,000)/4 = $225,000 DDB Dep Exp Year 1 = ($1,000,000)*(2/4) = $500,000 DDB Dep Exp Year 2 = ($1,000,000-$500,000)*(2/4) = $250,000 Units of Production Dep Exp Year 1 = [($1,000,000-$100,000)/800,000]*[200,000]= $225,000 It s purely a coincidence that S-L and Units of Production are equivalent v Association for Financial Professionals. All rights reserved. Session 3-10

11 The Income Statement EBIT Interest Expense = Net Income Before Taxes The interest an organization pays to bondholders, banks and private lenders, including revolving bank debt (plus interest on capital leases). This is a subtotal line. It is used to calculate the effective tax rate for the initial estimation of the provision for income taxes. v Association for Financial Professionals. All rights reserved. Session 3-11

12 The Income Statement ETR = Income Tax Income Before Tax Income Before Taxes Income Tax Expense + or Extraordinary Items = Net Income Events or transactions that are both highly abnormal for the particular operations, type of business, industry or geographic region and infrequent; they are not expected to occur often, given the particular environment. The Bottom Line v Association for Financial Professionals. All rights reserved. Session 3-12

13 More on the Income Statement Exam prep note: Be able to work through a simplified I/S from the top-down. However, watch out for the question s desired earnings or profitability measure. That is, the question may provide enough info to solve for net income, but the question may just ask for EBIT v Association for Financial Professionals. All rights reserved. Session 3-13

14 Forecasting with Common-Sized Income Statements With the information provided by the common-sized income statement, we can make forecasts for subsequent years Suppose that Revenues are expected to grow by 15% in What would be the effect on CGS and the Gross Profit Margin (in 2014)? v Association for Financial Professionals. All rights reserved. Session 3-14

16 Forecasting with Common-Sized Income Statements 1. Expected Revenue Growth is 15% Projected Revenues in 2014 = $56,206*1.15= $64, Project CGS in 2014 using the Common-Sized Income Statement CGS 2014 = $64,636.90*0.64 = $41, Projected GPM 2014 = $64, $41, =35.999% $64, There are many other applications that can work similarly. Be prepared for them. v Association for Financial Professionals. All rights reserved. Session 3-16

17 Earnings Per Share (EPS) A widely used measure of profitability and must be reported on the income statement if the company is publicly traded. Basic EPS Net Income Preferred Dividends Weighted Average Outstanding Shares v Association for Financial Professionals. All rights reserved. Session 3-17

18 Basics of the Balance Sheet Snapshot Most are classified The Swiss Army Knife of Financial Identities: Assets = Liabilities + Equity It can be used to think through many qualitative questions v Association for Financial Professionals. All rights reserved. Session 3-18

The Balance Sheet Assets Liabilities Shareholders Equity v2.

The Difference between Debt and Liabilities Liabilities are amounts owed, regardless of form Debt refers only to obligations that require interest

23 The Difference between Debt and Liabilities Liabilities are amounts owed, regardless of form Debt refers only to obligations that require interest payments Debts are a subset of liabilities Accounts Payable Liabilities Debt v Association for Financial Professionals. All rights reserved. Session 3-23

24 Liabilities Current Liabilities Accounts payable (A/P) Deferred revenue Accrued liabilities Income taxes payable Short-term debt Current maturities of long-term debt Noncurrent Liabilities Long-term debt Deferred income taxes Other noncurrent liabilities (pension obligations, health care, long-term compensation, other operating and administrative activities) v Association for Financial Professionals. All rights reserved. Session 3-24

26 The Statement of Cash Flows Where from? Income statement (bottom line) Income statement Change in ( ) balance sheet Change in ( ) balance sheet Change in ( ) balance sheet Supporting statements From prior period income statement To current period income statement v Association for Financial Professionals. All rights reserved. Session 3-26

27 Sources and Uses of Funds Source of funds: 1. Decrease in an asset 2. Increase in a liability Use of funds: 1. Increase in an asset 2. Decrease in a liability v Association for Financial Professionals. All rights reserved. Session 3-27

The Statement of Cash Flows Indirect method Direct method; provides more information

29 More on Statement of Cash Flows Know: The effects of changes in assets and liabilities How to calculate CF from Operations How to calculate the change in cash and equivalents if given CF from Operations, CF from Investments, and CF from Financing The linkages between the income statement and balance sheet; IB-107 through 110 v Association for Financial Professionals. All rights reserved. Session 3-29

31 Types of Ratios Type of Ratio Liquidity (Working Capital) Leverage Activity (Efficiency) Profitability Market Value What Is Measured An organization s ability to pay off its short-term debt obligations while still funding ongoing operations The types of force multipliers (i.e., financial and operational) an organization uses to increase its value and the extent to which it relies on them How efficiently an organization is able to turn its assets into sales or cash An organization s ability to generate earnings as compared to its expenses and other costs over a specified time-period. How an organization is valued by investors v Association for Financial Professionals. All rights reserved. Session 3-31

Currently-maturing long-term debt Accrued taxes and other expenses Current Ratio = Current Assets

32 Liquidity Ratios: Current Ratio Current assets may include: Cash Marketable securities Accounts receivable Inventories Current liabilities may include: Accounts payable Short-term notes payable Currently-maturing long-term debt Accrued taxes and other expenses Current Ratio = Current Assets Current Liabilities v Association for Financial Professionals. All rights reserved. Session 3-32

33 Liquidity Ratios Quick Ratio Cash Ratio Cash + Cash Equivalents + Short Term Investments + Accounts Receivable Current Liabilities OR Cash + Cash Equivalents + Marketable Securities Current Liabilities Current Assets Inventories Other Current Assets Current Liabilities v Association for Financial Professionals. All rights reserved. Session 3-33

34 More on Liquidity Ratios Note the relationship between the Current Ratio and the Quick Ratio CR >= QR When interpreting expected changes in liquidity ratios, the beginning value of the ratio is important to note, due to the nature of certain financial transactions. What is the impact on the Quick Ratio if an A/P is paid off with Cash from the B/S? v Association for Financial Professionals. All rights reserved. Session 3-34

35 An Example Suppose that your firm pays off an accounts payable with $20,000 in cash. Prior to the transaction the current ratio equals What effect will this transaction have the current ratio? v Association for Financial Professionals. All rights reserved. Session 3-35

36 Financial & Operational Leverage Financial leverage. This is the extent to which an organization uses debt rather than equity to finance its assets, or how much debt the company has in relation to its assets and/or to its shareholders equity. v Association for Financial Professionals. All rights reserved. Session 3-36

37 Leverage Ratios Debt to Total Assets Ratio Long-term Debt to Equity Ratio Total Debt Total Assets Long-Term Debt Shareholder s Equity v Association for Financial Professionals. All rights reserved. Session 3-37

Change in EBIT OR % Change in Net Income % Change in EBIT v2.

39 Leverage Ratios Degree of Operating Leverage Ratio % Change in EBIT % Change in Sales Degree of Financial Leverage Ratio % Change in EPS % Change in EBIT OR % Change in Net Income % Change in EBIT v Association for Financial Professionals. All rights reserved. Session 3-39

Leverage Ratios: Degree of Total Leverage v2.

41 Leverage Ratios: Coverage Ratios Interest Coverage = EBIT Interest Expense Cash Coverage = EBIT + Depreciation Interest Expense v Association for Financial Professionals. All rights reserved. Session 3-41

42 Activity Ratios Average Accounts Receivable Turnover Net Credit Sales Average Accounts Receivable Days Sales Outstanding (Average Accounts Receivable Days) Average Accounts Receivable Net Credit Sales x Number of Days in the Period v Association for Financial Professionals. All rights reserved. Session 3-42

43 Activity Ratios Average Inventory Turnover COGS Average Inventory Days Inventory Outstanding (Inventory Days) Average Inventory COGS* x Number of Days in the Period * or Cost of Sales v Association for Financial Professionals. All rights reserved. Session 3-43

44 Activity Ratios Average A/P Turnover Total Supplier Purchases Average Accounts Payable OR COGS Average Accounts Payable OR Period Purchases Accounts Ending Balance Days Payable Outstanding (Accounts Payable Days) Average Accounts Payable COGS* x Number of Days in the Period * or Cost of Sales v Association for Financial Professionals. All rights reserved. Session 3-44

45 Forecasting with Turnover Measures Suppose that revenues are expected to grow to $64, What would be the A/R impact? From ShopNow s 2013 Income Statement and Balance Sheet: Avg AR Turnover = 56,206 (5,083+6,082)/2 = v Association for Financial Professionals. All rights reserved. Session 3-45

46 Forecasting with Turnover Measures Holding the A/R T/O measure constant, a forecasted revenue level of $64, in 2014 implies a 2014 average A/R level of: $6, = 64, x v Association for Financial Professionals. All rights reserved. Session 3-46

47 Activity Ratios Cash Conversion Cycle DIO + DSO - DPO Where: DIO = Days Inventory Outstanding DSO = Days Sales Outstanding DPO = Days Payables Outstanding v Association for Financial Professionals. All rights reserved. Session 3-47

49 Activity Ratios Average Asset Turnover Average Fixed Asset Turnover Revenue Average Total Assets Revenue Average Fixed Assets OR Revenue Average Net PP&E v Association for Financial Professionals. All rights reserved. Session 3-49

51 Profitability Measures: The Margins Gross Margin = Revenues COGS Revenue EBITDA Margin = EBITDA Revenue EBIT Margin = EBIT Revenue Profit Margin = NI Revenue v Association for Financial Professionals. All rights reserved. Session 3-51

DuPont Analysis GOAL Operating Efficiency Asset Efficiency Financial Leverage METRIC Profit Margin Average Total Assets Turnover Average Equity Multiplier EQUATION

53 DuPont Analysis GOAL Operating Efficiency Asset Efficiency Financial Leverage METRIC Profit Margin Average Total Assets Turnover Average Equity Multiplier EQUATION Net Income Revenue Revenue Average Total Assets Average Total Assets Average Equity v Association for Financial Professionals. All rights reserved. Session 3-53

54 DuPont Example 1 If the profit margin is 0.157, total asset turnover is 0.64, and the Equity multiplier is 1.39, then ROE is? v Association for Financial Professionals. All rights reserved. Session 3-54

55 DuPont Example 2 Firm Z has a 7% profit margin, an ROE of 17%, and total asset turnover of What is the Equity Multiplier? v Association for Financial Professionals. All rights reserved. Session 3-55

56 DuPont Example 3 Firm W has sales of $9,980, total assets of $3,140, and a debt-to-equity ratio of If the return on equity is 16%, what is NI? v Association for Financial Professionals. All rights reserved. Session 3-56

57 Earnings per Share (EPS); warning see pg ib-164 Basic EPS = Net Income Preferred Dividends Weighted Average Outstanding Shares Diluted EPS = (Net Income Preferred Dividends) + (Conv. Preferred Dividends + After-Tax Interest) Weighted Average Outstanding Shares + Diluted Shares v Association for Financial Professionals. All rights reserved. Session 3-57

59 EVA Example A firm has an operating profit of $80,000. The firm s tax rate is 30% and the weighted average cost of capital is 9.0%. The company s capital structure consists of $250,000 in debt and $300,000 of equity. What is the firm s EVA? v Association for Financial Professionals. All rights reserved. Session 3-59

AFP Financial Planning & Analysis Learning System Session 2, Sunday, April 2nd (1:30-5:00)

AFP Financial Planning & Analysis Learning System Session 2, Sunday, April 2nd (1:30-5:00) Chapters Covered Financial Accounting and Reporting: Part I, Domain B Chapter 7 Ratio Analysis: Part I, Domain