FINANCIAL ECONOMIC ANALYSIS AND INTERPRETATION SECOND EDITION CHRIS HIGSON RIVINGTON

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1 FINANCIAL STATEMENTS ECONOMIC ANALYSIS AND INTERPRETATION SECOND EDITION CHRIS HIGSON RIVINGTON

2 Contents Chapter 1 Introduction Accounting 2 Return, Risk, Valuation 3 Using this book 4 Chapter 2 The Balance Sheet and Income Statement 9 Companies and GAAP 10 The elements of a balance sheet 11 Fixed assets and working capital 12 Financial versus non-financial 13 Shareholders'funds 13 Group accounts 14 Balance sheets in different businesses 15 The elements of an income statement 17 Operating profit 17 EBIT and earnings 18 Earnings per share 19 Comprehensive income 19 Income statements in different businesses 19 Measures of return on capital and financial structure 21 Leverage 21 Return on capital employed and return on equity 21 Equity ratio 22 Review 24 Technical Notes 25 Formatting Tiffany's balance sheet 25 Formatting Tiffany's income statement 28 Chapter 3 Assets 31 Asset recognition 32 Measuring asset cost 33 The cost of inventory 33 Exploration costs and successful efforts 35 Intangibles 36 The value, and risk, of intangibles 36 GAAP for intangibles 38 The effect of expensing intangibles 38 Research and development in GAAP 40 Purchase accounting 42 Pooling 43 What to do with intangibles in financial analysis 44 Adjusting the data 46 The argument for not recognising intangibles 47 i iii

3 Review 49 Technical Notes 50 The impact of inventory valuation on profit 50 Purchase accounting and pooling 51 Capitalising R&D 53 Chapter 4 Liabilities 55 Liability recognition 56 Liabilities must be unavoidable 57 Provisions 57 Pensions 59 Pension concepts and vocabulary 60 Balance sheet accounting for pensions 61 I ncome statement accounting for pensions 62 What to do with pensions in financial analysis 64 Tax 64 Deferred tax accounting 65 GAAP for deferred tax 67 Tax losses 67 GAAP for tax losses 68 What to do with deferred tax in financial analysis 70 Review 72 Chapter 5 The Entity 73 Consolidation 74 Equity accounting 74 The tests for consolidation 75 The effect of non-consolidation 76 Leasing 78 Accounting for a finance lease 78 Capitalising operating leases from outside 80 The debate about operating leasing 81 Receivables financing and derecognition 83 GAAP for financial asset derecognition 83 Securitisation 85 The effect of business model on asset structure 86 Netting and the right of offset 88 Review 89 Technical Note 90 Capitalising operating leases from outside 90 Chapter 6 Income 93 Revenue 94 GAAP for revenue recognition 94 Revenue timing 95 Deferred revenue 96 The gross/net game 97 Operating cost 99

4 Financing cost 102 Taxation 103 The drivers of the effective tax rate 105 Understanding the effective tax rate 106 Core income 108 The logic of core income 108 Pro forma earnings 109 Managing volatility 110 Review 113 Technical Notes 114 Understanding Telenor's tax rate 114 Stock option accounting 117 Chapter 7 Balance Sheet Valuation 121 Some value concepts 122 Measuring EV, RC and RV 123 Opportunity cost and deprival value 123 Valuation of operating assets in GAAP 126 Depreciation 127 Depreciation and the cult of EBITDA 128 Impairment 130 Goodwill impairment 131 How rigorous is GAAP for impairment? 132 The cash generating unit 132 The recoverable amount 134 Valuation of financial assets and liabilities 135 The fair value controversy 137 Review 139 Chapter 8 GAAP's Accounting Model 141 The balance sheet as the fundamental record 142 Hicksian income 142 The accounting identity 142 Government accounting 144 Property rights in developing economies 146 Accrual accounting 146 Some other accounting models 147 GAAP's model 150 Balance sheet completeness 150 Comprehensive income 150 Accounting conservatism 151 Comprehensive income and realised income 152 The historical-cost bias 153 Consequences of the historical-cost bias 156 Is GAAP converging? 157 The case against convergence 158 The threat to accountability 159 SME GAAP 159 Review 160 V

5 Chapter 9 Operating Performance 165 Entity return on capital 166 Core income or complete income? 167 The idea of capital employed 168 Netting cash 169 Unconsolidated investments 169 The bright line between operating and financing 170 Internal consistency 172 The profitability equation 173 What shapes the profitability equation 173 Forensic analysis of operating performance 174 Working capital metrics 175 Limitations of disclosure 176 Non-financial data 176 Segment data 177 How the business model affects the numbers 178 Vertical integration 179 Outsourcing 180 Business model innovation 181 The asset-light balance sheet 182 Review 185 Technical Notes 186 Estimating the tax on EBIT 186 Tiffany's operating performance 188 Chapter 10 Cash Flow 193 The logic of cash flow 194 Direct versus indirect cash flow 194 Free cash flow 195 EBITDA 1% Cash from operations 196 Operating free cash flow 196 Cash flow before financing 197 Equity free cash flow 197 Using GAAP cash flow 1 98 Extracting operating free cash flow 198 Disclosure issues 199 Interpreting the cash flow statement 200 The effect of growing and shrinking 202 The effect of business model 202 The effect of accounting policy on cash flow 205 Review 207 Technical Notes 208 Preparing a cash flow from the balance sheets and income statement 208 Formatting Asahi's cash flow statement 210 vi

6 Chapter 11 Leverage and Risk 215 Financial leverage 216 Book leverage 216 Hybrid securities 216 Interest cover 217 Market leverage 218 Debt multiples 219 The cost of capital 220 The cost of debt capital 220 The cost of equity capital 221 The weighted average cost of capital 221 Operating leverage and volatility 222 Financial leverage adds volatility 223 The equity strip 225 The risk of default 226 The drivers of return on equity 227 The love-hate relationship with debt 227 Review 230 Technical Note 231 The equity premium 231 Chapter 12 Failure 233 The anatomy of failure 234 Failure vocabulary 234 The vulnerability to failure 234 What happens in a recession 235 Predicting corporate failure 236 Solvency ratios 236 Failure prediction models 237 Credit scores 237 The equity ratio 238 Creative accounting, and how to spot it 240 Watch the balance sheet 242 Watch the effective tax rate 243 Do I understand this? 244 Financial governance 245 Fraudulent accounting 246 Enron's accounting 247 The financial governance system 248 Failures in financial governance 249 Review 251 Chapter 13 Value Metrics 253 The idea of value creation 254 Some related ideas 256 Accounting returns as measures of IRR 257 Tax consistency 257 Dealing with accounting bias in value metrics 258 VÜ

7 Spotting value destruction 260 EVA and economic profit 262 Countering the'maximise return'fallacy 263 Economic profit in financial analysis 264 Valuation using economic profit 265 Economic value added 266 Accounting returns versus stock returns 267 Accounting returns are better behaved than stock returns 268 Price to book as a measure of NPV 271 Review 273 Technical Note 274 Value metrics theory 274 Chapter 14 Modelling and Valuation 275 Valuation vocabulary and arithmetic 276 Simplifying free cash flow 277 Growth and return 277 Valuation 278 Using multiples in valuation 279 The financial model 280 The drivers of economic value 281 The analysis of growth 283 Organic growth 283 Volume and price 285 Dealing with inflation 286 Competitive advantage 287 Economies of scale and learning 287 The hockey stick at Amazon 288 Review 290 Technical Note 291 How inflation affects the results of international companies 291 Appendix Financial Arithmetic 295 Discounted cash flow 296 Present values and future values 296 Annuities 297 Net present value 298 Internal rate of return 298 Using Excel 299 Perpetuities 300 Derivation of the perpetuity formula 300 Economic profit valuation 302 Entity-level economic profit valuation 303 Derivation of the return on equity relationship 304 viii

Financial statements are the window through which the outside world

Chapter 1 Introduction Financial statements are the window through which the outside world views the economic performance of companies. This book explains the craft of reading and interpreting financial