SMART STARTER - · PDF fileSection A of CMA Part 2 Financial Decision Making. PART 2 Financial Decision Making. Introduction ... 2- Part 2: Financial Decision Making (4 hours

SMART STARTERSection A of CMA Part 2

Financial

Decision

Making

PART 2

Financial Decision Making

Introduction

Intro-2 © 2017 Powers Resources Corporation®. All rights reserved

Acknowledgements: PRC extends its appreciation to the Institute of Management Accountants and its team for their support in developing this material.

The CMA is a registered trademark owned by the IMA.

Introduction

© 2017 Powers Resources Corporation®. All rights reserved Intro-3

IMPORTANT NOTE

Dear Valued Candidate,

Please check our website regularly for downloads of any new supplemental updates of this material, or for other information provided to assist you in the preparation for your CMA examination. While every effort was made to ensure accuracy and minimize any errors in this 2nd edition of the PRC CMA Review, errors are an integral part of the publishing process. We continuously seek and value your feedback on how we can improve this material.

It is also critical to emphasize that this review material was prepared in accordance with the IMA’s disclosed Content Specification Outline, but due to the nature of the exam and the topics covered, a candidate is expected to apply reasoning and logic to a wide array of potential scenarios that may not be fully covered in review materials. Moreover, when considering the body of knowledge for the CMA exam, it is sometimes impractical to divide with clear lines between the various topics.

All information pertaining to the CMA examination was valid as of the time of printing this material. For more up to date information, log on to our Website at:

www.powersresources.com

Sincerely,

PRC Development Team

Introduction


NOTES

Introduction


INTRODUCTION TO THE CMA EXAM

1. Introduction ...................................................................................................................................... 7

2. Admission to the CMA Program .................................................................................................... 7

3. Content of the CMA Exam ............................................................................................................. 8

4. CMA Application and Exam Registration (IMA CMA Handbook) ................................................... 8 5. Identification Requirements ............................................................................................................. 9 6. Calculator Policy .............................................................................................................................. 9 7. Examinee Conduct .......................................................................................................................... 9 8. Exam Rules and regulations .......................................................................................................... 10

9. PRC’s Passing Tips for Taking The CMA Exam .......................................................................... 11

All Section Read this introduction about the CMA exam.

Make sure to read the exam section a couple of days before your exam.

Introduction


NOTES

Introduction


1. Introduction

To become Certified Management Accountant (CMA), you are required to sit and pass the two parts of the exam.

The exam is administered by The Institute of Management Accountants – IMA. CMA exams are offered through computer-based testing (CBT). This means that you will be able to take your exam in any one of Prometric’s available testing centers around the world (www.prometric.com/icma).

The exam consists of two parts multiple choice and writing questions as follows:

1- Part 1: Financial Reporting, Planning, Performance, and Control

(4 hours – 100 multiple-choice questions and two essay questions)

2- Part 2: Financial Decision Making

(4 hours – 100 multiple-choice questions and two essay questions)

2. Admission to the CMA Program

To become certified, you need to fulfill ALL the following requirements.

1. Active membership in the Institute of Management Accountants

2. Pay the CMA Entrance Fee

3. Satisfy the Education Qualification (A Bachelor’s or advanced degree, from an accredited college or university, or a professional certificate, such as CIA or CFA. A list of approved certifications is available in the CMA handbook)

4. Satisfy the Experience Qualification (two continuous years of professional experience in management accounting and/or financial management)

5. Complete all required examination parts

6. Comply with the IMA Statement of Ethical Professional Practice

You may sit for the CMA exam before fulfilling the education and experience requirements, but you must complete the CMA program within three years from the date of entry into the program (date of payment of CMA entrance fee).

Introduction


3. Content of the CMA Exam

1. Part 1 – Financial Reporting, Planning, Performance, and Control A. External Financial Reporting Decisions (15%) B. Planning, Budgeting and Forecasting (30%) C. Performance Management (20%) D. Cost Management (20%) E. Internal Controls (15%)

2. Part 2 – Financial Decision Making

A. Financial Statement Analysis (25%) B. Corporate Finance (20%) C. Decision Analysis (20%) D. Risk Management (10%) E. Investment Decisions (15%) F. Professional Ethics (10%)

The Board of Regents of the Institute of Certified Management Accountants (ICMA®) has overall responsibility for developing the CMA examinations.

The ICMA was created for the purpose of developing and administering the CMA program.

PRC is committed to continuously adjust the content of its materials and the level of concentration of each topic to keep abreast with the changes in the exam coverage.

4. CMA Application and Exam Registration (IMA CMA Handbook)

The CMA examination is given in a computer-based format, and is offered at Prometric Testing Centers located throughout the world. An up-to-date listing of all Prometric Testing Centers can be found at Prometric’s website (www.prometric.com/ICMA) Parts 1 and 2 are offered during the following three testing windows.

January/February

May/June

September/October

Exam registration steps:

1- IMA Membership application

2- CMA Entrance Fee

3- Exam scheduling

Introduction


DETAILED APPLICATION, REGISTRATION, AND SCHEDULING INSTRUCTIONS are available in the CMA handbook. You are kindly requested to go over them as they are an important guide for the online registration.

The handbook is available on the IMA’s website through the following link: https://www.imanet.org/cma-certification/

5. Identification Requirements

For admission to a Prometric Test Site, you must present proof of your identify. The name on your ID must match exactly with the name on your authorization letter. Following are the only acceptable forms of valid identification.

1. Valid, signed, non-expired Government-issued passport.

Or

2. Two original forms of non-expired identification, one with a photograph, both with your signature. Acceptable forms of ID include a drivers’ license, military ID, credit card or bank debit card with photo and signature, bank debit card with signature, or company ID.

Or

3. A Government-issued National country ID Card with a photograph (with or without a signature), and another acceptable valid form of ID with a signature as defined in #2 above.

6. Calculator Policy

Small battery or solar powered electronic calculators restricted to a maximum of six functions –addition, subtraction, multiplication, division, square root, and percentage are allowed. The calculator must not be programmable and must not use any type of tape. Candidates can also use the Texas Instrument’s BA II Plus, Hewlett- Packard 10BII, HP 12c, or HP 12c Platinum calculators when taking the exams. Candidates will not be allowed to use calculators that do not comply with these restrictions.

7. Examinee Conduct

All candidates are required to sign a statement agreeing not to disclose the contents of the examinations nor remove examination materials from the testing room. All candidates are also required to attest to the authenticity of their credentials and the accuracy of all statements made in their application. Cheating will not be tolerated, and all instances of suspected cheating will be fully investigated. Examinees who are caught cheating will have their grades invalidated and will be disqualified from future examinations. Cheating includes, but is not limited to, the following; copying answers from another candidate during the exam, using unauthorized materials during the exam, helping another candidate during the exam, removing exam materials from the testing room, divulging exam questions, and/or falsifying credentials.

For those already certified by the ICMA, failure to comply with the nondisclosure policy or the subsequent discovery of cheating will be considered a violation of the IMA Statement of Ethical Professional Practice and will result in revocation of the certificate.

Introduction


8. Exam Rules and regulations (www.prometric.com)

1. You will be continuously monitored by video, physical walk-throughs and the observation window during your test. All testing sessions are video and audio recorded.

2. You must present valid (unexpired) and acceptable ID(s) in order to take your test. Validity and number of IDs required is predetermined by your test sponsor.

3. You are required to sign out on the test center roster each time you leave the test room. You must also sign back in and show your ID to the Test Center Administrator (TCA) in order to be re-admitted to the test room.

4. You are prohibited from communicating, publishing, reproducing, or transmitting any part of your test, in any form or by any means, verbal or written, for any purpose.

5. You must not talk to other candidates or refer to their screens, testing materials, or written notes in the test room.

6. You must not use written notes, published materials, or other testing aids, except those allowed by your test sponsor. (The TCA will refer to the applicable client practice for allowances.)

7. You are allowed to bring soft ear plugs (with no wires/cords attached) or center-supplied tissues in the test room.

8. Any clothing or jewelry items allowed to be worn in the test room must remain on your person at all times. Removed clothing or jewelry items must be stored in your locker.

9. You will be scanned with a metal detector wand prior to every entry into the test room. If you refuse, you cannot test.

10. You will be asked to raise your slacks/pants legs above your ankles and pull your sleeves up (if long sleeves are worn) prior to every entry into the test room.

11. You will be asked to empty and turn your pockets inside out prior to every entry into the test room to confirm that you have no prohibited items.

12. You must not bring any personal/unauthorized items into the testing room. Such items include but are not limited to: outerwear, hats, food, drinks, purses, briefcases, notebooks, pagers, watches, cellular telephones, recording devices, and photographic equipment. Weapons are not allowed at any Prometric Testing Center.

13. You must return all materials issued to you by the TCA at the end of your test.

14. You must comply with the policy of your test sponsor regarding the use of phones during scheduled breaks in your test.

15. Your test may have either scheduled or unscheduled breaks which are determined by your test sponsor. The TCA can inform you what is specifically permitted during these breaks.

16. If a break is taken during the exam you must return to your original, assigned seat.

17. Repeated or lengthy departures from the test room for unscheduled breaks will be reported by the TCA.

18. If you need access to an item stored in the test center during a break such as food or medicine, you must inform the TCA before you retrieve the item. You are not allowed to access any prohibited item (as defined by the client practice applicable for the test you are taking).

Introduction


19. You must conduct yourself in a civil manner at all times when on the premises of the testing center. Exhibiting abusive behavior towards the TCA, or any other staff member of the test center, may result in criminal prosecution.

20. To protect the privacy of all testers, the TCA can neither confirm nor deny if any particular individual is present or scheduled at the test center.

21. Persons not scheduled to take a test are not permitted to wait in the test center. Note: Client practice policies applicable to individual exams may supersede any of these regulations.

9. PRC’s Passing Tips for Taking The CMA Exam

A. Preparing for the Exam

- Plan your study program.

- Periodically review, reassess, and revise your study program as to keep yourself within the time budget.

- Make sure to read through all the lectures and solve ALL multiple-choice questions (MCQs).

- Second attempts on solving the MCQs should be concentrated on questions answered incorrectly in previous attempts.

- Spend more time on topics that you are answering incorrectly.

- It is highly recommended to enroll in one of PRC’s live courses, or intensive seminars in your area.

- Utilize PRC’s essay writing support techniques. When practicing your essays, you can send us a sample essay that you answered and one of our lead instructors will provide you with customized support on what you need to do to improve you essay writing techniques.

B. Before you Go

- Have a good night’s sleep before the exam.

- Arrange for a light breakfast.

- Plan to arrive at the exam site at least half an hour before the exam.

- Remember to have the following items with you:

Authorization letter.

Valid photo identification.

C. During the Exam

- You have 180 minutes /3 hours to answer 100 questions, and 60 minutes to answer to essay questions.

- Read the exam instructions carefully.

- If you do not use all the 180 minutes allocated for the MCQ questions, the remaining time will be added to the time allocated for essay questions.

Introduction


- Use PRC’s Exam Answering Technique©:

Go through the questions answering only short and/or questions that you are familiar with. Do not attempt to answer long and/or questions pertaining to topics you are not familiar with or do not like. This step should give you more time on the more difficult questions in addition to building your confidence.

Make a second pass attempting to answer medium length and/or medium difficulty questions.

Repeat the process until you have completed the entire exam Session.

When you have exhausted all the questions you are able to answer, and there are still unanswered questions, attempt to guess the answers.

Be sure to choose only the appropriate checkbox. Budget your time and use PRC’s Exam Answering Technique to maximize your chances of passing.

Read the answer choices carefully.

If you do not know the correct answer, select the best possible choice.

Double check that you have answered all questions before submitting your exam.

Make sure to read and sign the nondisclosure agreement.

Maintain your positive attitude before and during the exam; do not panic if you encounter difficulties while studying or while doing the exam.

D. After Each Exam

- Do not discuss the exam with anyone as it may potentially violate the IMA’s exam non-disclosure clause.

- Contact PRC at [email protected] and let us know how we did and what we need to improve to help future candidates.

GOOD LUCK!

Section A

Financial Statement Analysis

All Section Financial statement analysis is a separate section of the Part 2 exam comprising 25% tested at all three Levels (A, B, and C).

Remember to read the answers of all questions whether solved correctly or incorrectly.

When reviewing the lecture before the exam, emphasize and concentrate on questions solved incorrectly in prior solving attempts.

Section A: Financial Statement Analysis

A-2 © 2017 Powers Resources Corporation®. All rights reserved

FINANCIAL STATEMENT ANALYSIS

(25% LEVELS A, B, AND C)

A.1 Basic Financial Statement Analysis ............................................................................................... 3

Common Size Financial Statements .............................................................................................. 3

A.2 Financial Ratios ........................................................................................................................... 12

Ratio Analysis .............................................................................................................................. 12

Liquidity Ratios ............................................................................................................................ 13

Leverage Ratios ........................................................................................................................... 15

Activity Ratios .............................................................................................................................. 20

Profitability Ratios ........................................................................................................................ 23

Market Ratios ............................................................................................................................... 26

Other Performance Ratios ........................................................................................................... 33

Limitations of Ratio Analysis ........................................................................................................ 34

A.3 Profitability Analysis ..................................................................................................................... 39

Income Measurement Analysis .................................................................................................... 39

Revenue Analysis ........................................................................................................................ 41

Cost of Sales Analysis ................................................................................................................. 45

Expense Analysis ........................................................................................................................ 46

Variation Analysis ........................................................................................................................ 46

Sustainable Equity Growth ........................................................................................................... 47

A.4 Special Issues .............................................................................................................................. 50

Impact of Foreign Operations ...................................................................................................... 50

Effects of Changing Prices and Inflation ...................................................................................... 55

Off-Balance Sheet Financing ....................................................................................................... 56

Impact of Changes in Accounting Treatment ............................................................................... 60

Accounting and Economic Concepts of Value and Income .......................................................... 61

Earnings Quality .......................................................................................................................... 61

A.5 Comprehensive Example ............................................................................................................. 66


© 2017 Powers Resources Corporation®. All rights reserved A-3

STUDY SESSION 1

A.1 Basic Financial Statement Analysis

1. Basic financial statement analysis a. Common size financial statements b. Common base year financial statements

Common Size Financial Statements

Financial statement analysis is the process of analyzing reported financial data in order to evaluate the risk and financial performance of a company, as well as identifying its financial strengths and weaknesses. Among the basic accounting tools used in this process are accounting ratios analysis and trend analysis.

A. Accounting Ratios Analysis – an accounting ratio measures the relationship between two or more items or accounts of the company’s financial statements based on the logical relationship among those accounts or items. Once calculated, accounting ratios provide deeper understanding of the financial aspects of the company and allow for comparing the financial performance of the company with other companies, with its industry average, and with the past performance of the same company. Accounting ratios can be grouped into categories based on the financial aspects of the business which the ratios are intended to measure.

B. Trend Analysis – trend and time series analysis can be used in analyzing financial statements. Elements of the financial statements or ratios are prepared for successive periods and then analyzed to identify the pattern (or trend) of the changes in those elements or ratios over time. Trend analysis shows the amount and direction of the changes and allows for investigating the reasons of those changes.

C. Common-Size Analysis – common-size format is an important tool that can help in financial statement analysis. Common-size statements are financial statements in which each element is presented as a percentage of a base amount. This presentation helps mainly in comparing the financial statements’ elements among companies with different sizes because each element is presented as a percentage regardless of its size. Common-size analysis can be vertical or horizontal.

1. Vertical Common-Size Analysis – in vertical common-size statements, the elements of the statement for one year are presented as a percentage of a base amount. The base amounts are generally total assets for the balance sheet and sales for the income statement. Vertical common-size statements are used in comparing the data of a company over two or more periods, comparing the data of two or more different companies, and comparing the data of a company with the industry’s average.

2. Horizontal Common-Size Analysis – in horizontal common-size statements, the elements of the financial statement for one year are presented as a percentage of base-year elements. This presentation allows for comparing data of a single company over several periods, showing the trends of the changes, and evaluating the overall performance. This is also called variation analysis or trend series analysis. This format allows for calculating the growth rate of individual line items on the financial statements. For example if the sales increased from 100% in the base-year to 125% in the next year, then the growth rate of sales would be 25%.



Comprehensive Example - Comparative Balance Sheets

Future Tech Company Balance Sheet

As of December 31,

2011 2012 2013

ASSETS

CURRENT ASSETS

Cash 9,819,206 7,329,405 6,052,754 Inventories 8,341,092 17,304,624 35,572,405 Accounts receivable 1,867,869 3,758,779 11,008,546 Other receivables 276,986 598,214 10,313,047 Advances and prepayments 143,587 340,823 17,921,150

Other debit balances 3,968,589 6,816,175 3,194,441

Total Current Assets 24,417,329 36,148,020 84,062,343

FIXED ASSETS 15,174,832 14,912,847 24,219,521

TOTAL ASSETS 39,592,161 51,060,867 108,281,864

LIABILITIES AND PARTNERS' EQUITY

CURRENT LIABILITIES

Accounts payable 626,402 189,984 26,592,825 Bank overdrafts 145,634 218,932 13,377,466

Current portion of long-term debt 3,599,980 3,937,690 4,307,080

Total Current Liabilities 4,372,016 4,346,606 44,277,371

LONG-TERM LIABILITIES 18,108,770 14,171,080 9,864,000

TOTAL LIABILITIES 22,480,786 18,517,686 54,141,371

SHAREHOLDERS’ EQUITY

Paid-in Capital 12,213,134 12,213,134 30,790,634

Retained Earnings 4,898,241 20,330,047 23,349,859

Total Shareholder's Equity 17,111,375 32,543,181 54,140,493

TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY 39,592,161 51,060,867 108,281,864



Comprehensive Example - Comparative Income Statements

Future Tech Company Income Statement

For the Year Ended December 31,

2011 2012 2013

Sales 95,217,059 246,867,314 267,621,574

Less: Cost of sales (71,737,302) (193,200,932) (218,060,917) Gross Margin 23,479,757 53,666,382 49,560,657

Selling Expenses (2,909,848) (12,386,993) (13,234,362) General and administrative expenses (3,187,398) (6,528,463) (18,636,785) Depreciation (1,845,800) (2,557,028) (3,200,034)

EBIT 15,536,711 32,193,898 14,489,476 Interest (2,116,430) (1,807,700) (2,941,511)

EBT 13,420,281 30,386,198 11,547,965

Tax (4,026,084) (9,115,859) (3,464,390)

Net Income for the period 9,394,197 21,270,339 8,083,576

Comprehensive Example - Comparative Statements of Changes in Equity

Future Tech Company Statement of Changes in Equity

For the Year Ended December 31, 2011 2012 2013

Beginning balance as of January 1, - 17,111,375 32,543,181

Prior period adjustment - - (400,000) Adjusted Beginning Balance - 17,111,375 32,143,181 Issuance of Shares 12,213,134 - 18,577,500 Net income for the period 9,394,197 21,270,339 8,083,576 Dividends (4,495,956) (5,838,532) (4,663,764)

Ending balance as of December 31, 17,111,375 32,543,181 54,140,493



Comprehensive Example - Comparative Statement of Cashflows

Future Tech Company Statement of Cash Flows

For the Year Ended December 31, 2011 2012 2013

CASH FLOWS FROM OPERATING ACTIVITIES

Net income 9,394,197 21,270,339 8,083,576 Adjustments to reconcile net income to net cash

flows from operating activities

Depreciation 1,845,800 2,557,028 3,200,034

Losses (Gains)

Operating gain (loss) before changes in assets and

liabilities used in operating activities 11,239,997 23,827,367 11,283,610

Net (increase) decrease in assets

Inventories (8,341,092) (8,963,532) (18,267,781)

Accounts receivable (1,867,869) (1,890,910) (6,310,730)Other Receivables (276,986) (321,228) (10,313,047)Advances and prepayments (143,587) (197,236) -17921150

Other debit balances (3,968,589) (2,847,586) 3,621,734 Net increase (decrease) in liabilities

Current liabilities 626,402 (436,418) 26,183,909

Bank overdrafts 145,634 73,298 13,377,466

Net cash provided by operating activities (2,586,090) 9,243,755 1,654,011

CASH FLOWS FROM INVESTING ACTIVITIES

Fixed assets (17,020,632) (2,295,043) (12,906,708)

Net cash used in investing activities (17,020,632) (2,295,043) (12,906,708)

CASH FLOWS FROM FINANCING ACTIVITIES

Issuance of Shares 12,213,134 - 18,577,500

Long-term Loan 25,000,000 - -

Repayment of long-term debt (3,291,250) (3,599,980) (3,937,690)

Dividends (4,495,956) (5,838,532) (4,663,764)

Net cash provided by financing activities 29,425,928 (9,438,512) 9,976,046

NET INCREASE IN CASH AND CASH EQUIVALENTS 9,819,206 (2,489,800) (1,276,652)

Cash and cash equivalents, January 1 - 9,819,206 7,329,406

CASH AND CASH EQUIVALENTS, DECEMBER 31 9,819,206 7,329,406 6,052,754



Illustration of Vertical Common-Size Analysis – Balance Sheet

Future Tech Company Vertical Common-Size Balance Sheet

As of December 31,

2011 2012 2013

ASSETS

CURRENT ASSETS

Cash 25 14 6 Inventories 21 34 33 Accounts receivable 5 7 10 Other receivables 1 1 10 Advances and prepayments 0 1 17

Other debit balances 10 13 3

Total Current Assets 62 71 78 FIXED ASSETS 38 29 22 TOTAL ASSETS 100 100 100


CURRENT LIABILITIES

Accounts payable 2 0 25 Bank overdrafts 0 0 12

Current portion of long-term debt 9 8 4

Total Current Liabilities 11 9 41

LONG-TERM LIABILITIES 46 28 9

TOTAL LIABILITIES 57 36 50


Paid-in Capital 31 24 28

Retained Earnings 12 40 22

Total Shareholder's Equity 43 64 50

TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY 100 100 100



Illustration of Horizontal Common-Size Analysis – Balance Sheet

Future Tech Company Horizontal Common-Size Balance Sheet

As of December 31, 2011 2012 2013

ASSETS

CURRENT ASSETS

Cash 100 74.64 61.64 Inventories 100 176.23 362.27 Accounts receivable 100 38.28 112.11 Other receivables 100 6.09 105.03 Advances and prepayments 100 3.47 182.51

Other debit balances 100 69.42 32.53

Total Current Assets 100 368.14 856.10 FIXED ASSETS 100 151.87 246.65 TOTAL ASSETS 100 520.01 1,102.76


CURRENT LIABILITIES

Accounts payable 100 1.93 270.82 Bank overdrafts 100 2.23 136.24

Current portion of long-term debt 100 40.10 43.86

Total Current Liabilities 100 44.27 450.93

LONG-TERM LIABILITIES 100 144.32 100.46

TOTAL LIABILITIES 100 188.59 551.38


Paid-in Capital 100 124.38 313.58

Retained Earnings 100 207.04 237.80

Total Shareholder's Equity 100 331.42 551.37 TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY 100 520.01 1,102.76

Note that the growth rate of inventory from 2011 to 2012 is 76.23% (176.23 – 100), and in 2013 is 262.27% (362.27 - 100). This increase may draw management attention to analyze its implications.



Illustration of Vertical Common-Size Analysis – Income Statement

Future Tech Company Income Statement


2011 2012 2013

Sales 100 100 100

Less: Cost of sales (75) (78) (81) Gross Margin 25 22 19

- - - Selling Expenses (3) (5) (5) General and administrative expenses (3) (3) (7) Depreciation (2) (1) (1)

EBIT 16 13 5 Interest (2) (1) (1)

EBT 14 12 4

Tax (4) (4) (1)

Net Income for the period 10 9 3

Illustration of Horizontal Common-Size Analysis – Income Statement

Future Tech Company Horizontal Common-Size Income Statement


2011 2012 2013

Sales 100 259.27 281.06

Less: Cost of sales 100 269.32 303.97 Gross Margin 100 228.56 211.08

Selling Expenses 100 425.69 454.81 General and administrative expenses 100 204.82 584.70 Depreciation 100 138.53 173.37

EBIT 100 207.21 93.26 Interest 100 85.41 138.98

EBT 100 226.42 86.05

Tax 100 226.42 86.05

Net Income for the period 100 226.42 86.05



Practice Questions – Session 1

1. Gordon has had the following financial results for the last four years.

Year 1 Year 2 Year 3 Year 4 Sales $1,250,000 $1,300,000 $1,359,000 $1,400,000

Cost of goods sold 750,000 785,000 825,000 850,000

Gross profit 500,000 515,000 534,000 550,000 Inflation factor 1.00 1.03 1.07 1.10

Gordon has analyzed these results using vertical common-size analysis to determine trends. The performance of Gordon can best be characterized by which one of the following statements?

a. The common-size gross profit percentage has decreased as a result of an increasing common-size trend in cost of goods sold.

b. The common-size trend in sales is increasing and is resulting in an increasing trend in the common-size gross profit margin.

c. The common-size trend in cost of goods sold is decreasing which is resulting in an increasing trend in the common-size gross profit margin.

d. The increased trend in the common-size gross profit percentage is the result of both the increasing trend in sales and the decreasing trend in cost of goods sold.

2. In assessing the financial prospects for a firm, financial analysts use various techniques. An example of vertical, common-size analysis is:

a. An assessment of the relative stability of a firm’s level of vertical integration.

b. A comparison of financial ratio between two or more firms in the same industry.

c. Advertising expense is 2% greater compared with the previous year.

d. Advertising expense for the current year is 2% of sales.

3. The major advantage of vertical analysis is

a. The ability to see trends within specific line items.

b. The ability to determine if a company is a going-concern.

c. The ability to compare companies of various sizes.

d. The ability to determine if the company’s strategic goals are being achieved.

4. When preparing a common-size balance sheet, the base amount is usually

a. Current assets

b. Long-term assets

c. Total assets

d. Sales



Feedback:

1. Answer (a) is correct. Gordon’s common-size gross profit percentage has decreased as a result of an increasing common-size trend in cost of goods sold as shown below.

Year 1 Year 2 Year 3 Year 4

Sales 100% 100% 100% 100% Cost of goods sold (÷ Sales) 60.0% 60.3% 60.7% 60.7% Gross profit (÷ Sales) 40.0% 39.6% 39.2% 39.2%

2. Answer (d) is correct. Vertical, common-size analysis compares the components within a set of financial statements. A base amount is assigned a value of 100%. For example, total assets on a common-size balance sheet and net sales on a common-size income statement are valued at 100%. Common-size statements permit evaluation of the efficiency of various aspects of operations. An analyst who states that advertising expense is 2% of sales is using vertical, common-size analysis.

3. Answer (c) is correct. Vertical analysis allows companies that vary in size to be compared since the absolute dollar amounts are ignored and a percentage is calculated from the total account.

Answer (a) is not correct because horizontal analysis allows trends to be identified from the base year to future years. Vertical analysis allows companies that vary in size to be compared since the absolute dollar amounts are ignored and a percentage is calculated from the total account.

Answer (b) is not correct because determining whether a company is a going-concern (which assumes that the company will have an indefinite life) is not determined from vertical analysis. Liquidity and solvency analysis is more likely to help determine if a company is not a going-concern. Vertical analysis allows companies that vary in size to be compared since the absolute dollar amounts are ignored and a percentage is calculated from the total account.

Answer (d) is not correct because determination of achieving strategic goals is done through comparison of goals and multiple financial analyses. Vertical analysis allows companies that vary in size to be compared since the absolute dollar amounts are ignored and a percentage is calculated from the total account.

4. Answer (c) is correct. The total assets amount is typically the base on the balance sheet.

Answer (a) is not correct because the current assets amount is not the base used when preparing a common-size balance sheet. The total assets amount is typically the base on the balance sheet.

Answer (b) is not correct because the long-term assets category is not the base used when preparing a common-size balance sheet. The total assets amount is typically the base on the balance sheet.

Answer (d) is not correct because sales revenue is the base used when preparing a common-size income statement. The total assets amount is typically the base on the balance sheet.



STUDY SESSION 2

A.2 Financial Ratios

2. Financial ratios a. Liquidity b. Leverage c. Activity d. Profitability e. Market

Ratio Analysis

A. Ratio calculations include the comparison of various numbers, amounts, percentages . . . etc. to calculate predetermined relationships. These relationships may then be tested for reasonableness, compared with each other, and/or compared with industry averages.

B. Financial ratio calculations are typically the most common and widespread use of ratio analysis, but the potential ratios that can be used by management accountants in the various areas include financial and non-financial ratios. For example:

3. Ratios of labor hour usage during production as a test for efficiency of production.

4. Financial ratios (discussed in more detail in Part III Section B.

5. Ratio of defects in various periods/processes.

C. Ratio analysis has its inherent problems and limitations that necessitate care and judgment. These limitations are discussed at the end of Section A-2.

For the purpose of the CMA exam, the following groups of ratios will be discussed:

Liquidity ratios

Leverage

Activity ratios

Profitability ratios

Market ratios

Liquidity

Leverage

Activity

Profitability

Market



Liquidity Ratios

Liquidity Ratios are ratios that measure the relationship of a firm’s cash and other current assets to its current liabilities. The liquidity of current assets is generally dictated by their type (cash, receivables, inventory . . . etc.). The liquidity of current liabilities is general a function of the firm’s creditworthiness, reputation, size, and capital levels. Larger, creditworthy organizations with high capital levels are generally able to obtain short term credit for longer periods and at relatively lower or no interest.

A. Current Ratio

1. Is calculated by dividing current assets by current liabilities.

2. It indicates the extent to which current liabilities are covered by those assets expected to be converted to cash in the near future.

3. It is the most commonly used measure of short-term solvency.

4. If the company’s current ratio is low, it may face a potential solvency problem. On the other hand, a significantly high current ratio may be due to excess current assets implying improper current asset management (excess cash, accounts receivable, and/or inventory).

Liquidity

Leverage

Activity

Profitability

Market

Current Ratio

Current Ratio = Current Assets

Current Liabilities

B. Quick (Acid test) Ratio

1. Is calculated by deducting inventories and prepayments from current assets and dividing the remainder by current liabilities.

2. It measures the ability to pay off short-term obligations without relying on the sale of inventories.

3. An increase in the quick ratio generally implies that a company is better able to meet its short-term financing needs and vice versa.

4. The quick ratio is a better indicator about the company’s ability to meet its short-term obligations than the current ratio as it excludes inventory. Inventory may require significant time for liquidation and therefore, may not be readily available to meet short-term obligations.

5. For example, a library or a retail department store maintain high inventory amounts that may indicate a healthy current ratio, however, because such inventories may not be readily convertible into cash to meet short-term obligations without a compromise on the sales value, the current ratio becomes misleading.

Quick Ratio

Quick Ratio = Current Assets – Inventories – Prepayments

Current Liabilities Or

Quick Ratio = Cash + Marketable Securities + Receivables

Current Liabilities



C. Cash Ratio

1. Is calculated by dividing cash and marketable securities by current liabilities.

2. The cash ratio is used to measure the company’s ability to pay off current liabilities if both inventory and accounts receivable are not liquid.

Cash Ratio

Cash Ratio = Cash + Marketable Securities

Current Liabilities

D. Cash Flow Ratio

1. Is calculated by dividing operating cash flow by average current liability.

2. Measures the company’s ability to meets its current debt obligations with cash generated from the normal operations of the company.

Cash Flow Ratio

Cash Flow Ratio = Cash flow from operations Average Current Liabilities

E. Working Capital (Net Working Capital)

1. The terms “Working Capital’ and “Net Working Capital” mean the same thing on the CMA exam

2. Is calculated by deducting current liabilities from current assets.

3. Working capital measures the company’s liquidity in absolute terms i.e. remaining working capital after paying all outstanding current liabilities.

Working Capital

Working Capital = Current Assets – Current Liabilities

F. The Liquidity of Current Liabilities – In addition to examining the above ratios, the analyst must examine the liquidity of current liabilities which is determined by the degree of how urgent current liabilities must be paid. In addition, any unrecorded current liabilities must be examined and considered because these unrecorded liabilities will be paid in the near future using the current assets and that affects the liquidity of the company. Examples of unrecorded current liabilities include expected insurance obligations, purchase commitments, and operating lease obligations.



Leverage Ratios

A. Capital Structure and Solvency - Leverage

1. Capital Structure - refers to a company’s combination of the two major sources of funds, debt capital and equity capital. Debt capital is funds obtained through borrowing. Equity capital is funds obtained mainly from stock issues to the general public. This combination affects the company’s risk and return. Increasing the debt percentage in the capital structure allows the company to generate more returns to owners and to take advantage of opportunities. On the other hand, increasing the debt level increases the risk of default and insolvency of the company due to the fixed charges (interests and principal payments) associated with debts. These charges and payments must be made regardless of the earnings or losses.

Liquidity

Leverage

Activity

Profitability

Market

2. Solvency - refers to the firm’s ability to meet its long term liabilities as they mature.

3. Leverage - in general, leverage is the ability to increase return to owners by using debts (financial leverage) or by using operating fixed cost (operating leverage).

A. Total Debt to Total Assets

1. Total debt includes both current liabilities and long-term debt. Creditors prefer lower debt ratios because the lower the debt ratio, the greater the cushion against creditors’ losses in the event of liquidation.

2. Debt ratio indicates the percentage of assets financed by creditors and measures the long-term debt paying ability

3. The owners on the other hand, may want more leverage because it magnifies earnings.

4. Generally, firms operating in cyclical industries tend to have lower debt ratios than those in non-cyclical industries.

Total Debt to Total Assets

Total Debt to Total Assets = Total Debt

Total Assets

B. Debt/Equity Ratio

1. Total debt includes both current liabilities and long-term debt. The optimal debt/equity ratio is that which minimizes the firm’s weighted average cost of capital (WACC).

Debt/Equity Ratio

Debt/Equity Ratio = Total Debt

Common Stockholders’ Equity

C. Long-Term Debt to Equity Ratio

1. Current liabilities are excluded in this case in order to compare long-term debt only with stockholder’s equity.

Long-Term Debt to Equity Ratio

Long-Term Debt to Equity Ratio = Total Debt – Current Liabilities Common Stockholders’ Equity



D. Times Interest Earned (Interest Coverage)

1. Measures the ability of the firm to meet its annual interest payments.

2. Creditors rely on TIE to measure a firm’s ability to meet its interest payment obligations. A high TIE ratio, even when coupled with a high debt ratio is considered more acceptable by lenders than a low TIE ratio with a relatively low debt ratio.

Times Interest Earned

Times Interest Earned (TIE) = Earnings Before Interest and Taxes (EBIT)

Interest Expense

E. Earnings to Fixed Charges Ratio (Fixed Charge Coverage Ratio)

1. It is the ratio of (earnings before interest and taxes + operating leases expenses) divided by (interest expenses on loans and capital leases + annual principal payments on loans and capital leases + operating leases expenses).

2. Measures the ability of the firm to meet its fixed-charge contractual obligations.

Earnings to Fixed Charges Ratio

Earnings to Fixed Charges Ratio = Earnings Before Fixed Charges and Taxes

Fixed Charges

Or

Earnings to Fixed Charges Ratio = EBIT + Operating Lease Payments

Interest + Principal Payments + Operating Lease Payments

F. Cash Flow to Fixed Charges Ratio

1. It is the ratio of (operating cash flow OCF + cash interest on loans and capital leases + operating leases expenses + taxes paid with cash) divided by (interest expenses on loans and capital leases + annual principal payments on loans and capital leases + operating leases expenses).

2. This ratio uses adjusted operating cash flow instead of adjusted earnings used in Fixed Charge Coverage Ratio. It measures the ability of the firm to meet its fixed-charge contractual obligations with its operating cash flow.

Cash Flow to Fixed Charges Ratio

Cash Flow to Fixed Charges = Earnings Before Fixed Charge and Taxes

Fixed Charges

Or

Cash Flow to Fixed Charges = OCF + Cash Interests + Cash Taxes + Operating Lease Payments

Interest + Principal Payments + Operating Lease Payments



G. Financial Leverage Ratio 1. Calculated by dividing the total assets by the common equity (preferred stocks are excluded from

equity).

2. Indicates the amount of assets that are financed by debts.

Financial Leverage Ratio

Financial Leverage Ratio = Total Assets

Common Stockholders’ Equity

H. Degree of Financial Leverage (DFL) is a measure of the ratio of debt to equity in a company. 1. Companies with a relatively higher debt to equity ratio will have a relatively high degree of

financial leverage.

2. DFL measures the percentage increase in net income as a result of a 1% increase in EBIT (Earnings Before Interest and Taxes).

Degree of Financial Leverage

Degree of Financial Leverage = Q(P – VC) – FC

= EBIT

Q(P – VC) – FC – Interest EBIT – I

Or

Degree of financial Leverage = % Change in Net income

% Change in EBIT

3. Higher DFL reduces a company’s cost of capital because interest on debt is tax deductible while dividends are not.

4. Higher DFL is associated with a higher financial risk due to the fixed interest payments that are payable whether the company has earned the interest or not.

Degree of Financial Leverage Example

The following is a comparison of two scenarios, one with relatively high interest costs and one with relatively low interest costs. Each scenario demonstrates the change in net income as a result of a 10% increase and 10% decrease in EBIT.

DFL

4.0 1.1 High Interest Costs Low Interest Costs

Base 10% ∆ in

EBIT (10%) ∆ in EBIT Base

10% ∆ in EBIT

(10%) ∆ in EBIT

EBIT 20,000 22,000 18,000 20,000 22,000 18,000 Less: Interest (15, 00) (15,000) (15,000) (2,000) (2,000) (2,000) EBT 5,000 7,000 3,000 18,000 20,000 16,000 Less: Taxes (20) (1,000) (1 400) (600) (3,600) (4,000) (3,200) Net income (NI) 4,000 5,600 2,400 14,400 16,000 12,800 % change in NI 40% -40% 11% -11%



I. Degree of Operating Leverage (DOL) is a measure of the fixed costs in operations as compared to the variable costs. 1. Companies with high fixed costs (typically associated with high investments in plant and

equipment) will have a relatively high degree of operating leverage.

2. DOL measures the % increase in EBIT as a result of a 1% increase in sales.

Degree of Operating Leverage

Degree of Operating Leverage = Q(P – VC)

= Contribution Margin

Q(P – VC) – FC Contribution Margin – Fixed Costs

Or

Degree of Operating Leverage = % Change in EBIT % Change in Sales

Degree of Operating Leverage Example

The following is a comparison of two scenarios, one with relatively high fixed costs and one with relatively low fixed costs. Each scenario demonstrates the change in EBIT (Earnings Before Interest and Taxes) as a result of a 10% increase and 10% decrease in sales.

DOL

4.5 1.3 High Fixed Costs Low Fixed Costs

Base 10% ∆ in

Sales (10%) ∆ in Sales Base

10% ∆ in Sales

(10%) ∆ in Sale

Sales 100, 00 110,000 90,000 100,000 110,000 90,000 Less: Variable Costs (10,000) (11,000) (9,000) (10,000 (11,000) (9,000) Contribution 90,000 99,000 81,000 90,000 99,000 81, 00 Less: Fixed Costs (70,000) (70,000) (70,000) (20,000) (20,0 0) (20,000) EBIT 20,000 29,000 11,000 70,000 79,000 61,000 % change in EBIT 45% -45% 13% -13%

Passing Tip: Companies with high fixed costs have higher operating leverage, and companies with

higher debt to equity ratios have higher financial leverage. J. Degree of Total (Combined) Leverage is a measure of the combined impact of operating and

financial leverage. 1. DTL measures the % increase in net income as a result of a 1% increase in sales.

Degree of Total Leverage

Degree of Total Leverage = Q(P – VC)

= Contribution Margin

Q(P – VC) – FC – I EBIT – I

2. Since a high DTL is associated with high risk, companies tend to mitigate the risk by attempting to stabilize the DTL. Since DTL is the combination of both the DOL and DFL, a company with a high DOL would tend to reduce its DFL and vice versa.



Degree of Total Leverage Example

The following is a comparison of four scenarios, with various combinations of relative fixed costs and interest costs. Each scenario demonstrates the change in net income as a result of a 10% increase and 10% decrease in sales.

DTL

18 5.0 High Fixed – High Interest High Fixed – Low Interest

Base 10% ∆ in


10% ∆ in Sales

(10%) ∆ Sales

Sales 100,000 110,000 90,000 100,000 110,000 90,000 Less: Variable Costs (10,000) (11,000) (9,000) (10,000) (11,000) (9,000) Contribution 90,000 99,000 81,000 90,000 99,000 81,000 Co ts (70,000) (70,000) (70,000) (70, 00) (70,000) (70,000) EBIT 20,000 29,000 11,000 20,000 29,000 11,000 Less: Interest (15,000) (15,000) (15,000) (2,000) (2,000) (2,000) EBT 5,000 14,000 (4,000) 18,000 27,000 9,000 Less: Taxes (20%) (1,000) (2,800) 800* (3,600) (5,400) (1,800) Net income (NI) 4,000 11,200 (3,200) 14,400 21,600 7,200 % change in NI 180% -180% 50% -50%

* Tax refund

DTL

1.6 1.3 Low Fixed – High Interest Low Fixed – Low Interest

Base 10% ∆ in


10% ∆ in Sales

(10%) ∆ in Sales

Sales 100,000 110,000 90,000 100,000 110,000 90,000 Less: Variable Costs (10,000) (1 ,000) (9,000) (10,000) (11,000) (9,000) Contribution 90,000 99,000 81,000 90,000 99,000 81,000 Less: Fixed Costs (20,000) (20,000) (20,000) (20,000) (20,000) (20,000) EBIT 70,000 79,000 61,000 70,000 79,000 61,000 Less: Interest (15,000) (15,000) (15,000) (2,000) (2,000) (2,000) EBT 55,000 64,000 46,000 68,000 77,000 59,000 Less: Taxes (20%) (11,000) (12,800) (9,200) (13,600) (15,400) (11,800) Net income (NI) 44,000 51,200 36,800 54,400 61,600 47,200 % change in NI 16% -16% 13% -13%

From the above four scenarios, it’s evident that when a company has relatively high fixed costs, it should aim to reduce its interest expense (by reducing its reliance on debt) if it intends to reduce its overall risk. If a company has relatively low fixed costs, it can tolerate relatively higher interest costs while still achieving a relatively lower risk. If companies have no control over their fixed costs, they should aim to control their interest charges when attempting to achieve an acceptable risk level. On the other hand, if companies have control over their fixed costs, then they could borrow and incur interest, and control their overall risk by controlling their fixed costs.



Activity Ratios

Activity Ratios are a set of ratios that measure how effectively a firm is managing its assets and resources.

A. Inventory Turnover Ratio

1. Is calculated by dividing cost of goods sold by inventories.

2. Measures the inventory turnover rate.

3. A higher turnover rate for inventory indicates that the firm is better utilizing its capital that

is invested in inventory. Successful companies can keep their inventory low with higher

turnovers while still meeting customer orders on a timely basis.

Liquidity

Leverage

Activity

Profitability

Market

Inventory Turnover Ratio

Inventory Turnover Ratio = Cost of Goods Sold Average Inventories

B. Days Sales in Inventory (Inventory Turnover days)

1. Is calculated by dividing 360 by the inventory turnover ratio.

2. Indicates the average length of time the firm must wait from the date of purchasing inventory to the date of selling it.

3. A shorter period indicates that management is better managing its inventory purchase functions, however, care should be taken to also measure any associated stock-out costs.

Days Sales in Inventory

Days Sales in Inventory = Average Inventory

Average Daily Cost of Goods Sold

Or

Days Sales in Inventory = 360

Inventory Turnover Ratio

C. Accounts Receivable Turnover Ratio

1. Is calculated by dividing the net credit sales by the average trade receivables.

2. Indicates the number of times average accounts receivable are collected during the period.

3. Measures the company's effectiveness in extending credit and collecting accounts receivable.

Accounts Receivable Turnover Ratio

Accounts Receivable Turnover = Net Credit Sales

Average Trade Receivables



D. Days Sales Outstanding in Receivables (DSO)

1. Is calculated by dividing accounts receivable by average sales per day.

2. Indicates the average length of time the firm must wait after making a sale before receiving cash.

3. A high ratio indicates deteriorating liquidity.

4. While a low ratio indicates better liquidity, a too low ratio indicates tight credit policy that could result in lost sales.

Days Sales Outstanding in Receivables

Days Sales Outstanding in Receivables = Average Trade Receivables

Average Daily Sales

Or

Days Sales Outstanding in Receivables = 360

Accounts Receivables Turnover Ratio

E. Accounts Payable Turnover Ratio

1. Is calculated by dividing the net annual credit purchases by the average accounts payable.

2. Indicates the number of times average accounts payable are paid during the period.

3. Measures the company's effectiveness in obtaining credit and paying off its accounts payable.

4. Generally, the increase in this ratio is more favorable as accounts payable are being paid more quickly. A decrease in this ratio implies that the company is paying off its suppliers more slowly.

Accounts Payable Turnover Ratio

Accounts Payable Turnover = Net Credit Purchases

Average Accounts Payable

F. Days Purchases in Accounts Payable

1. Indicates the average length of time between making the purchase and paying for it.

Days Purchases in Accounts Payable

Days Purchases in Accounts Payable = Average Accounts Payable Average Daily Purchases

Or

Days Purchases in Accounts Payable = 360




G. Operating Cycle (Net Operating Cycle)

1. It is the average time between the purchase of inventory goods and the receipt of cash from selling those goods. It is the number of days a company takes to convert its inventories into cash.

2. Measures the company’s operating efficiency and working capital management. A short operating cycle is favorable as it improves the company’s liquidity and reduces the amounts invested in working capital.


Operating Cycle

= Days Sales in

Inventory +

Days Sales in Receivables

H. Cash Cycle (Cash Conversion Cycle CCC)

1. It is the average number of days a company takes to convert cash used to purchase inventory into cash once again (Cash-To-Cash).

2. As purchases may be made on credit, Days Purchases in Accounts Payable are deducted from the operating cycle in order to calculate the time elapsed between when cash payments for inventory are made and when cash is received from selling that inventory.

Cash Cycle

Cash Cycle = Days Sales in

Inventory + Days Sales in Receivables –

Days Sales in Payables

I. Fixed Assets Turnover Ratio

1. Ratio of sales to average net fixed assets.

2. Measures how effectively the firm uses its plant and equipment.

Fixed Assets Turnover Ratio

Fixed Assets Turnover Ratio = Sales

Average Fixed Assets

J. Total Assets Turnover Ratio

1. Is calculated by dividing sales by average total assets.

2. Measures the turnover of all the firm’s assets.

Total Assets Turnover Ratio

Total Assets Turnover Ratio = Sales

Average Total Assets



Profitability Ratios

Profitability Ratios are a group of ratios that measure the combined effects of liquidity, asset management, and debt management on operating results.

A. Gross Profit Margin Percentage

1. Calculated by dividing gross profit (net sales – cost of goods sold) by net sales.

2. The increase in gross profit margin indicates an efficient management of cost of goods sold.

Liquidity

Leverage

Activity

Profitability

Market

Gross Profit Margin Percentage

Gross Profit Margin % = Gross Profit

Net Sales

B. Operating Profit Margin Percentage

1. Calculated by dividing operating income (income from the company’s core operations before interests and taxes) by net sales.

2. Comparing the changes in gross profit margin with the changes in operating profit margin provides insight about the company’s efficiency in managing its operating costs. The decrease in operating profit margin in relation to gross profit margin indicates an inefficient management of other operating costs, as the cost of goods sold exists in both ratios.

Operating Profit Margin Percentage

Operating Profit Margin % = Operating Income

Net Sales

C. Net Profit Margin on Sales

1. Calculated by dividing net income by sales.

2. Measures income per dollar of sales.

Net Profit Margin on Sales

Net Profit Margin = Net Income Net Sales



D. Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) Margin Percentage

1. EBITDA is revenues minus expenses (excluding interest, taxes, depreciation and amortization). EBITDA is calculated by adding back depreciation and amortization to EBIT.

2. EBITDA Margin is calculated by dividing EBITDA by net sales.

3. EBITDA Margin facilitates a comparison of operating profitability among different companies that use different accounting standards. Excluding interest, taxes, depreciation and amortization reduces the influence of using different accounting treatments.

EBITDA

EBITDA Margin = EBITDA

Net Sales

E. Basic Earning Power (BEP)

1. Calculated by dividing EBIT by average total assets.

2. Indicates the ability of the firm’s assets to generate operating income.

3. This ratio shows the raw earning power of the firm’s assets, before the influence of taxes and leverage, and it is useful for comparing firms with different tax situations and different degrees of financial leverage.

Basic Earning Power

Basic Earning Power = EBIT


F. Return on Total Assets

1. Is the ratio of the net income to the average total assets.

2. This ratio shows the net earning power of the firm’s assets after the influence of all expenses, taxes, and interest.

3. The higher ROA indicates a more efficient use of the total assets.

Return on Assets

Return on Assets (ROA) = Net Income




G. Return on Operating Assets

1. Calculated by dividing operating income by net operating assets.

2. Net operating assets is defined as total assets less any goodwill and/or assets not used for operations such as land purchased as an investment or equipment not currently used in operations.

Return on Operating Assets

Return on Operating Assets = Operating Income

Net Operating Assets

H. Return on Common Equity

1. Ratio of net income to common equity.

2. Measures the rate of return on common shareholders’ investment.

3. When ROE is greater than ROA, the firm is employing financial leverage effectively. That means the earnings on borrowed funds exceed the interest paid and the excess contributes to the income available to common shareholders.

Return on Common Equity

Return on Common Equity (ROE) = Net Income Available to Common Shareholders

Average Common Equity

Or

Return on Common Equity (ROE) = Net Income – Preferred Dividends

Average Common Equity



Market Ratios

Market Ratios give management an indication of what investors think of the company’s past performance and future prospects.

A. Basic Earnings Per Share

1. EPS is the most important measure for stockholders and potential investors in evaluating the profitability of a company. It measures the income earned per common share even if the company does not declare dividends. Companies with publicly traded shares are required to disclose EPS on their financial statements.

2. Basic EPS is the ratio of the net income available to common shareholders to the weighted average number of common shares outstanding.

Liquidity

Leverage

Activity

Profitability

Market

Basic Earnings Per Share

Basic Earnings Per Share (BEPS) = Net Income Available to Common Shareholders

Weighted Average # of Common Shares Outstanding

3. Net income available to common shareholders is net income minus preferred dividends. If the company has cumulative preferred shares, then the preferred dividends are earned at the end of each period and, therefore, must be subtracted from net income to reach net income available to common shareholders. If the company has noncumulative preferred shares, then the preferred dividends are not subtracted unless the company declared preferred dividends.

Net Income − Noncumulative preferred dividends declared − Cumulative preferred dividends earned = Net Income Available to Common Shareholders

4. The weighted average number of common shares outstanding during the period is computed by taking into account any shares issuance, shares reacquiring, stock dividends, or stock splits during the period. For shares issuance or reacquiring during the period, the shares must be weighted by the fraction of the period they are outstanding. On the other hand, stock dividends or stock splits are assumed to have occurred on the beginning of the period even though they occurred during the period.



Illustration of Basic Earnings Per Share

Selected data for Aurora Corporation is presented below:

Aurora Corporation has net income of $400,000 for the year just ended. At the beginning of the year, Aurora Corp. had 5,000 shares of 10% cumulative preferred stock, par

value $100. No dividends were declared at the year end. At the beginning of the year, Aurora Corp. had 100,000 shares of common stock outstanding. During

the year, the following transactions occurred. On April 1 of the current year, 25,000 shares of common stock were issued and sold. On July 1 of the current year, 10,000 shares of common stock were purchased. On September 1 of the current year, Aurora Corp. declared and distributed a 20% stock dividend. On November 1 of the current year, 12,000 shares of common stock were issued and sold.

Calculate the basic EPS for Aurora Corp. for the year just ended. Solution: 1. The first step is to calculate the net income available to common shareholders. The preferred shares are

cumulative. Therefore, the preferred dividends must be subtracted even though the preferred dividends were not declared:

Preferred dividends for the year = 0.10 × $100 × $5,000 = $50,000.

Net income available to common shareholders = $400,000 - $50,000 = $350,000.

2. The second step is to calculate weighted average number of common shares outstanding for the year. The table below shows the calculations:

Dates Outstanding Shares

Outstanding Fraction of The Year

Effect of Stock Dividend*

Weighted Number of Shares

January 1 – April 1 100,000 × 3/12 × 1.2 = 30,000

April 1 – July 1 125,000 × 3/12 × 1.2 = 37,500

July 1 – September 1 115,000 × 2/12 × 1.2 = 23,000

September 1 – November 1 138,000 × 2/12 = 23,000

November 1 – December 31 150,000 × 2/12 = 25,000

Weighted average number of common shares outstanding 138,500

* The stock dividend of 20% was treated as if it occurred at the beginning of the year. As a result, the shares outstanding before the stock dividend were restated based on the percentage of stock dividend.

3. The third step is to calculate BEPS:

Basic Earnings Per Share = Net Income Available to Common Shareholders

Weighted Average # of Common Shares Outstanding

Basic Earnings Per Share = $350,000

= $2.53 138,500



B. Diluted Earnings Per Share

1. When the company has a complex capital structure, the basic EPS fails to recognize the potential impact of its convertible securities on earnings per share. In diluted EPS, the number of common shares outstanding is adjusted to include the shares that may be issued as a result of exercising convertible or dilutive securities. Convertible and dilutive securities include convertible bonds, convertible preferred shares, and options and warrants that are outstanding at year end. These securities reduce (or dilute) earnings per share by increasing the number of outstanding shares if exercised by holders. Companies that have convertible or dilutive securities in their capital structures are required to disclose both basic and diluted earnings per share on their financial statements.

Diluted Earnings Per Share

Diluted Earnings Per Share (EPS) = Net Income Available to Common Shareholders

Diluted Weighted Average # of Common Shares Outstanding

2. Diluted EPS is always equal to or less than basic EPS. If the conversion or exercise of the security increases earnings per share then the security is antidilutive and its effect should be neglected in calculating diluted EBS. Therefore, companies will not report diluted EPS if the securities in their capital structure are antidilutive.

3. Convertible Bonds - When the company capital structure includes convertible bonds, the if-converted method is used to calculate the diluted EBS. This method assumes that the conversion of the bonds is at the beginning of the year (or, if issued during the year, at the time of issuance). This method also eliminates the related interests net of tax.

4. Convertible Preferred Stocks - The effect of convertible preferred stocks in computing the diluted EBS is the same as of the bonds except that instead of adding back the interest costs, the preferred dividends will not be deducted from the net income. That is because the preferred stocks are assumed to be converted into common shares at the beginning of the period and thus there would be no preferred dividends.



Illustration of Diluted Earnings Per Share – Convertible Bonds

A company has a $200,000 net income and a weighted average number of common shares outstanding during the year of 50,000 shares. The company also has two convertible classes of bonds outstanding. The first one is 5,000 bonds at 8% interest rate and $100 par value issued 2 years ago and convertible into 8,000 shares. The second one is 5,000 bonds at 6% interest rate and $100 par value issued on July 1 of the current year and convertible into 10,000 shares. The tax rate is 40%. Calculate the diluted EBS for this company.

Solution

The basic EPS for this company is:


= $4 50,000

1. The first step in calculating the diluted EBS for this company is to calculate the net income available to

common shareholders after converting the bonds. This requires adding back the interest on the bonds less the related tax effect:

Net income $200,000 Add: interest adjustments 8% bonds: 8% × $500,000 × (1 - .40) $24,000 6% bonds: 6% × $500,000 × (1 - .40) × (6/12) $9,000

Net income available to common shareholders $233,000

2. The second step is to calculate the diluted weighted average number of common shares outstanding:

Weighted average number of common shares outstanding 50,000 Add: shares to be issued if bonds were converted: 8% bonds: from the beginning of the year 8,000 6% bonds: from the issuance date (10,000 × 6/12) 5,000

Diluted weighted average number of common shares outstanding 63,000

3. The third step is to calculate diluted EPS:

Diluted Earnings Per Share = $233,000

= $3.7 63,000

5. Dilutive Options and Warrants - When the company has stock options or warrants outstanding, the treasury-stock method is used to calculate the diluted EBS. Under this method, the options or warrants are assumed to be exercised at the beginning of the year (or, if issued during the year, at the time of issuance), and that the company uses the proceeds from this exercising to purchase common stock for the treasury at the average market price of the common stock during the year. Then the remaining shares are added to the weighted average number of shares outstanding in order to calculate diluted EPS. The exercise of options and warrants is assumed to have occurred only if the average market price of the share is higher than the exercise price during the period. If the market price of the share is lower than the exercise price of the options or warrants, the options or warrants are then antidilutive because their exercise increases earnings per share.



Illustration of Diluted Earnings Per Share – Options

A company has a $100,000 net income and a weighted average number of common shares outstanding during the year of 20,000 shares. The company also has 4,000 options outstanding at an exercise price of $30 for a common share. The options were issued in a prior year. The common stock market price per share was $35 at the beginning of the year and $45 at the end of the year. Calculate the diluted EBS for this company.

Solution

The basic EPS for this company is:


= $5 20,000

1. Computing the diluted weighted average number of common shares outstanding:

Average market share price for the year: ($45 + $35) ÷ 2 $40 Proceeds from the exercise of 4,000 options: (4,000 × $30) $120,000 Shares issued upon the exercising of the options: 4,000 Treasury shares repurchased with proceeds: ($120,000 ÷ $40) (3,000)

Shares to be added to the weighted average number of shares outstanding 1,000 2. The diluted EBS for this company is:

Diluted Earnings Per Share = $100,000

= $4.76 21,000

C. Price/Earnings Ratio

1. Ratio of the price per share to earnings per share.

2. Shows the dollar amount investors will pay for $1 of current earnings.

3. Measures the stock market's assessment of the firm's earning quality.

Price/Earnings Ratio (P/E)

Price/Earnings Ratio (P/E) = Market Price Per Common Share

Earnings Per Share (EPS)



D. Price/EBITDA Ratio

1. Ratio of market price per common share to Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA).

2. EBITDA per common share is EBITDA divided by the weighted average number of common shares outstanding.

3. By adding back interest, taxes, depreciation and amortization to the earnings, Price/EBITDA Ratio facilitates the comparison among companies with different amounts of debts, or which require different upfront capital investments.

Price/EBITDA Ratio

Price/EBITDA Ratio = Market Price Per Common Share

EBITDA Per Share

E. Book Value per Share

4. Also called Net Asset Value per Share or Equity Per Share.

5. Book Value per Share represents the dollar value of the common stock after liquidating the company (liquidating all assets and paying all debts as stated on the balance sheet).

6. Book Value per Share uses balance sheet values of assets and liabilities. The potential difference between these recorded values and the market values represent the main limitation of using Book Value per Share.

Book Value Per Share

Book Value Per Share = Net Common Equity

Common Shares Outstanding

F. Market/Book Ratio

7. The ratio of a stock’s market price to its book value.

8. Companies with relatively high rates of return on equity generally sell at higher multiples of book value than those with low returns.

Market/Book Ratio

Market/Book Ratio = Market Price per Share Book Value per Share



G. Dividend Payout Ratio

1. Calculated by dividing the dividends declared to common shareholders by the net income available to common shareholders (or net income – preferred dividends), or by dividing the dividends per common share by the EPS.

2. The ratio shows the percentage of net income paid to the common shareholders in the form of dividends.

3. Growing companies tend to have low dividends payout ratios as they prefer to use earnings to finance the growth of the company.

Dividend Payout Ratio

Dividend Payout Ratio = Total Dividends to Common Shareholders

Income Available to Common Shareholders

H. Retention ratio

1. Is the percentage of net income retained by the company and not paid to the common shareholders in the form of dividends.

2. Calculated by deducting the dividend payout ratio from 1.

3. The retention ratio measures the company’s internal growth potential.

Retention Ratio

Retention Ratio = 1 – Dividend Payout Ratio

Passing Tip: A company with a higher dividend payout ratio will have a higher marginal cost of capital since the company is exhausting its retained earnings causing it to seek more costly external financing.

I. Earnings Yield

1. It is the inverse of P/E Ratio.

2. Measures the income-generating power of each dollar invested in the price of the share.

Earnings Yield

Earnings Yield = Earnings per Share (EPS)

Market Price per Common Share

J. Dividend Yield

1. Measures the dividends’ generating power of each dollar invested in the price of the share.

Dividend Yield

Dividend Yield = Dividends per Common Share

Market Price per Common Share



K. Shareholder Return

1. Shareholder Return Ratio includes dividend payments received during the year and the changes in the price of the stock in order to calculate total shareholder return for a given year.

Shareholder Return

Shareholder Return = End Stock Price – Beginning Stock Price + Annual Dividends/Share

Beginning Stock Price

Other Performance Ratios

A. Residual Income

1. Is the net income less the required rate of return on investment.

2. It measures the excess income above what is required by the company.

Residual Income

Residual Income = Income – (Required Rate of Return x Investment)

B. Economic Value Added (EVA®)

1. The EVA is similar to the residual income ratio, however, EVA uses the WACC (weighted average cost of capital discussed in Section B-2) rather than the required rate of return and total assets less the current liabilities rather than the invested amount.

2. EVA is considered a more reflective measure of a firm’s performance since the WACC is a more accurate measure of the actual cost of the firm’s capital. Any return in excess of the WACC is considered to have added real economic value.

Economic Value Added (EVA)

EVA = After-tax Operating Income – [WACC x (Total Assets – Current Liabilities)]

C. Market Value-Added (MVA)

1. Is calculated by deducting the invested capital from the market value of the firm.

2. MVA measures the amount of value that the firm’s operation has added in excess of its originally invested capital.

Market Value-Added (MVA)

Market Value Added = Market Value – Invested Capital



Limitations of Ratio Analysis

Inherent problems and limitations that necessitate care and judgment: 1. A financial ratio is not very useful by itself. It must be compared to something like prior period ratios,

ratios of other similar companies, industry averages, or predetermined benchmarks. Obtaining such information for comparison is not an easy task.

2. Many large firms operate a number of different divisions in different industries thus it is difficult to develop a meaningful set of industry averages. A reasonably good segment may be overshadowed by another poor performing one.

3. The reliability of ratios depends on the credibility of the numbers used in their calculation. Weak internal controls, or other factors, may affect the credibility of financial statements’ numbers and financial ratios’ analysis.

4. Ratios deal only with quantifiable items. Many items that are of financial value and should be considered when evaluating a company are ignored by ratio analysis because they cannot be recorded objectively. Examples of those items include human resources, employee morale, the company’s reputation, and customer loyalty.

5. Inflation may have an impact on ratio analysis. Inflation would impact financial statements’ accounts from year-to-year, and it may badly distort the firms’ balance sheets in the long-run. a. For example, a company that has been in business for some time, and that has land and property

acquired decades ago will report a relatively low amount for its assets since they are reported at historical cost. When comparing the performance figures to that of a newly setup company with exactly the same assets, but acquired recently, the ratios may be distorted. The older company will report lower depreciation, higher income, higher assets turnover, and higher debt to assets ratios.

b. Also, when comparing the results of several periods, a growth in revenues and/or expenses may be the result of rising prices rather than real growth in sales and/or expenditures.

6. Ratios are typically compared to industry averages, but most firms want to be better than average so attaining average is not good enough. Some firms aim to benchmark against the best-in-class.

7. Different accounting practices can distort comparisons. Different companies may use different accounting methods and practices which affect many financial statement items such as depreciation, cost of goods sold, inventory valuation, useful lives of an asset, salvage values, and bad debts. This affects comparability between companies.

8. Seasonal factors can distort ratio analysis. When comparing quarterly financial information, seasonal factors may significantly affect the ratios. For example, a ski resort will have significantly different figures between peek and off-peek seasons.

9. Most assets and liabilities are based on historical cost basis. Using historical cost in calculating ratios may reduce the relevancy of these ratios in evaluating the company’s performance and position.

10. Firms can employ window dressing techniques which will make their financials appear better than they actually are, thus distorting ratios.

11. It is difficult to generalize about whether a particular ratio is good or bad. For example, how good is a current ratio of 1? Or a debt ratio of 40%?

12. A firm may have some ratios that look good and others that look bad, making it difficult to tell whether the company is on balance, strong or weak.

Passing Tip: Inflation impacts financial ratio analysis for one firm over time, as well as comparative

analysis of firms of different ages.




1. The Liabilities and Shareholders’ Equity section of Mica Corporation’s Statement of Financial Position is shown below.

January 1 December 31 Accounts payable $ 32,000 $ 84,000 Accrued liabilities 14,000 11,000 7% bonds payable 95,000 77,000 Common stock ($10 par value) 300,000 300,000 Reserve for bond retirement 12,000 28,000 Retained earnings 155,000 206,000 Total liabilities and shareholders’ equity $608,000 $706,000

Mica’s debt/equity ratio is

a. 25.1%.

b. 25.6%.

c. 32.2%.

d. 33.9%.

2. At the end of its fiscal year on December 31, 2000, Merit Watches had total shareholders' equity of $24,209,306. Of this total, $3,554,405 was preferred equity. During the 2001 fiscal year, Merit's net income after tax was $2,861,003. During 2001, Merit paid preferred share dividends of $223,551 and common share dividends of $412,917. At December 31, 2001, Merit had 12,195,799 common shares outstanding and the company did not sell any common shares during the year. What was Merit Watch's book value per share on December 31, 2001?

a. $1.88.

b. $2.17.

c. $1.91.

d. $2.20.

3. Douglas Company purchased 10,000 shares of its common stock at the beginning of the year for cash. This transaction will affect all of the following except the

a. Debt-to-equity ratio.

b. Earnings per share.

c. Net profit margin.

d. Current ratio.



4. Garstka Auto Parts must increase its acid test ratio above the current 0.9 level in order to comply with the terms of a loan agreement. Which one of the following actions is most likely to produce the desired results?

a. Expediting collection of accounts receivable.

b. Selling auto parts on account.

c. Making a payment to trade accounts payable.

d. Purchasing marketable securities for cash.

5. When reviewing a credit application, the credit manager should be most concerned with the applicant’s

a. Profit margin and return on assets.

b. Price-earnings ratio and current ratio.

c. Working capital and return on equity.

d. Working capital and current ratio.

6. Globetrade is a retailer that buys virtually all of its merchandise from manufacturers in a country experiencing significant inflation. Globetrade is considering changing its method of inventory costing from first-in, first-out (FIFO) to last-in, first-out (LIFO). What effect would the change from FIFO to LIFO have on Globetrade’s current ratio and inventory turnover ratio?

a. Both the current ratio and the inventory turnover ratio would increase.

b. The current ratio would increase but the inventory turnover ratio would decrease.

c. The current ratio would decrease but the inventory turnover ratio would increase.

d. Both the current ratio and the inventory turnover ratio would decrease.

7. A financial analyst with Mineral Inc. calculated the company's degree of financial leverage as 1.5. If net income before interest increases by 5%, earnings to shareholders will increase by

a. 1.50%.

b. 3.33%.

c. 5.00%.

d. 7.50%.

8. A company has net income for the current year of $120,000 and pays $5,000 in dividends to its preferred shareholders and $20,000 in dividends to its common shareholders. The weighted average number of common shares outstanding for the year is 1,500, and the weighted average number of preferred shares outstanding for the year is 2,500. Earnings per share for this company for the current year, to the nearest cent, is:

a. $60.00.

b. $66.67.

c. $76.67.

d. $80.00.



Feedback:

1. Answer (c) is correct. Mica’s debt-to-equity ratio is 32.2% as shown below.

Debt-to-equity ratio = Total debt / Equity

= ($84,000 + $11,000 + $77,000) / ($300,000 + $28,000 + $206,000)

= $172,000 / $534,000

= 32.2%

2. Answer (a) is correct. Merit’s book value per share is $1.88 as calculated below.

Book value per share = (Total equity – Preferred equity) ÷ Common shares outstanding = ($26, 433,841* - $3,554,405) ÷ 12,195,799 = $22,879,436 ÷ 12,195,799 = $1.88

*$24,209,306 + $2,861,003 - $223,551 - $412,917

3. Answer (c) is correct. The only measure not affected by the purchase of its own common stock is Douglas’ net profit margin. Both the debt/equity ratio and the earnings per share are affected by the number of outstanding shares of common stock while the current ratio is affected by the amount of cash held.

4. Answer (b) is correct. To increase its acid test ratio, Gratska should sell auto parts on account. This transaction will increase accounts receivable and thus the numerator of the ratio. Inventory is not included in the ratio so the change in inventory will not affect the ratio.

5. Answer (d) is correct. A comparison of current assets with current liabilities gives an indication of the short-term debt-paying ability of a firm. Both working capital and the current ratio compare current assets with current liabilities and, therefore, measure credit worthiness.

6. Answer (c) is correct. Globetrade’s current ratio would decrease as a result of the change to LIFO because the value of ending inventory would be lower thus decreasing the firm’s current assets. Globetrade’s inventory turnover ratio would increase as a result of the change to LIFO because the cost of goods sold would increase.

7. Answer (d) is correct. Earnings to Mineral’s shareholders will increase by 7.5% as shown below.

Degree of financial leverage = % change in net income / % change in EBIT

1.5 = X / 5%

X = 7.5%



8. Answer (c) is correct. Earnings per share indicates the income earned by each share of common stock. The numerator is earnings available to common shareholders. The denominator is the weighted average number of common shares outstanding over the accounting period.

EPS = [net income - preferred dividends] / weighted number of common shares outstanding

= [$120,000 - $5,000]/1,500

= $76.67

Answer (a) is not correct because in this calculation preferred dividends are not netted out of the numerator and because the number of preferred shares should not be included in the denominator.

EPS = net income/weighted number of common and preferred shares

= $120,000 / [(1,500 + 2,500)/2] = $120,000/2,000

= $ 60

Answer (b) is not correct because in this calculation the common dividends are deducted from the

numerator, rather than the preferred dividends.

EPS = [net income common dividends]/ weighted number of common shares outstanding

= [$120,000 $20,000]/1,500

= $66.67

Answer (d) is not correct because this calculation does not subtract preferred shares from the

numerator.

EPS = net income/weighted number of common shares outstanding

= $120,000/1,500

= $80



STUDY SESSION 3

A.3 Profitability Analysis

3. Profitability analysis a. Income measurement analysis b. Revenue Analysis c. Cost of sales analysis d. Expense analysis e. Variation analysis

Profitability is a company’s ability to earn profits over a period of time by using its resources. In addition to calculating profitability ratios, analyzing profitability requires examining the elements of those ratios including the interrelationships among them.

Income Measurement Analysis

A. ROA, ROE and The DuPont Chart

1. As discussed earlier, ROA and ROE are tow profitability ratios intended to measure the rate of return on total assets and on common shareholders’ investment respectively.

2. The DuPont Chart is a chart designed to show the relationships among return on assets, asset turnover, profit margin, and leverage.

3. DuPont Equation is a formula that gives the rate of return on assets by multiplying the profit margin by the total assets turnover.

Return on Assets

ROA = Profit Margin x Total Assets Turnover

ROA = Net Income

x Sales

Sales Average Total Assets

a. Breaking down ROA into profit margin on sales and the total asset turnover shows that the level of ROA is a function of the amount of sales generated using the assets (Total Asset Turnover), and the profitability of the sales (Profit Margin).

4. DuPont Equation

DuPont Equation (ROE)

ROE = ROA x Equity Multiplier

ROE = Net Income

x Average Total Assets

Average Total Assets Average Common Equity



5. Extended DuPont Equation – breaking down ROE into its underling elements shows that the level of ROE is a function of the amount of sales generated using the assets (Total Asset Turnover), and the profitability of the sales (Profit Margin), and the financial leverage (Equity Multiplier).

Extended DuPont Equation

ROE = Profit margin x Total assets turnover x Equity multiplier

(Financial Leverage)

ROE = Net Income

x Sales

x Average Total assets

Sales Average Total assets Average Common equity

B. Equity, Assets, and Return - In calculating ROA and ROE, the amounts “Assets,” “Equity,” and “Return” may have different definitions.

1. Assets (Total Liabilities plus Total Equity) may be determined as:

a. Operating assets only, non-operating assets such as intangibles and other assets are excluded.

b. Productive assets only, idle or unproductive assets are excluded.

c. Accumulated depreciation may be excluded.

d. Debt and preferred stock are excluded to include only equity capital.

e. Current liabilities may be excluded in order to emphasize long-term capital.

f. Using market value instead of book value of Invested capital (debt and equity).

2. Equity may be determined as:

a. Total stockholders’ equity including preferred stock.

b. Common stockholders’ equity excluding preferred stock.

3. Return may be determined as:

a. Income before dividends and interest, if total assets are used in the denominator. That is because interest and dividends are payment to the suppliers of debt and equity.

b. Income available to common stockholder only. Preferred dividends are excluded in calculating return on common equity capital. When preferred dividends are cumulative, they are excluded even if not declared.



C. Factors to be Considered in Measuring Income

1. Estimates: Accountants make many estimates that affect the bottom line of the income statement. These estimates include useful life of fixed assets, salvage values, bad debt allowance and warranty costs. For example, extending the useful life of a fixed asset leads to decreasing the depreciation expense for the accounting period and therefore increasing the reported income.

2. Accounting methods: Accountants may use different accounting methods which have different impacts on the reported income. The analyst must understand the implications of using each accounting method in order to be able to adjust reported numbers as needed during the analysis. For example, different accounting methods that may be employed include depreciation methods (straight line, or declining balance), inventory valuation methods (FIFO, LIFO, or weighted average).

3. Disclosure incentives: If the company fully discloses its financial information, its stock price will accurately reflect its fair market value but at the same time, these disclosures may harm the competitive position of the company. The financial analyst should be aware of disclosure incentives of management when evaluating reported income.

4. Different needs of users: There are many different users with many different needs of the financial information. Creditors and suppliers concentrate on the strength of the company’s financial position and its ability to repay its debts and obligations, while the investors concentrate on the profitability and the future growth of the company. Management considers both sides of stakeholders and creditors. Analysts should address the specific needs of the users of their analysis.

Revenue Analysis

A. Revenues are inflows or other enhancements of assets of a company or settlement of its liabilities during a period from delivering or producing goods, or rendering services. In other words, revenues are resources that a company receives from its operations and dealing with customers. The owners and the creditors invest in a company because they expect that the company will sell products or services to customers and generate resources more than what was consumed in producing those products or performing the services. Revenue is a crucial measure of a company’s financial performance analysis as it directly affects the profitability and liquidity of the company. The financial analyst must consider the source, stability, and trend of revenue in order to better interpret the reported revenue and evaluate the financial position and profitability of the company.

B. The source of revenue relates to revenue recognition and to the origin of the revenue:

1. Revenues may be recognized by companies using different revenue recognition methods. Some companies are aggressive in their revenue recognition practices while others tend to be more conservative.

C. Origin – the financial analyst must distinguish between revenues that come from usual operations and revenues from non-core, or nonrecurring sources. Normal, and continuing operational revenues are of more importance in evaluating the profitability and financial position of the company. Revenues from non-core or nonrecurring sources are subject to fluctuation in the future and cannot be relied upon in evaluating the current financial position and predicting future performance. Examples of non-core and nonrecurring items that should be isolated during analysis are the effects of changes in accounting principles, the effects of discontinued operations, and other one-time events or extraordinary items.



D. Revenue Recognition – the Revenue recognition method used in preparing the financial statements affects the comparability and the accuracy of financial measures.

1. In comparing the financial measures of a company with related measures of other companies or with industry averages, the analyst must examine the consistency of revenue recognition methods used by the company and by the other companies in the comparison. If the recognition method used by the company is different, the analyst should be aware of the effects of this difference on the results of the comparison.

2. The timing of recognizing revenue must be appropriate in order to accurately determine the company’s financial results. Recognizing revenues before or after the appropriate time incorrectly affects the recorded income and the profitability and liquidity ratios of the related accounting periods. Revenue must be recorded when realized or realizable and earned. Revenues are realized when products are exchanged for cash or claims to cash. Revenues are realizable when assets received or held are readily convertible into cash or claims to cash. Revenues are considered earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues. The analyst must be aware of the following recognition rules when evaluating the revenue recognition method used by the company:

a. Revenues from selling products are recognized at the date of sale. Revenues from interest, rent, and royalties are recognized as time passes or as the assets are used.

b. Generally, revenues are recognized at point of sale when the price is substantially determinable at the date of sale, the obligation of the buyer to pay the seller is fixed and not contingent, the buyer has economic substance apart from that of the seller, the seller does not have significant obligations for future performance, and the amount of future returns can be reasonably estimated.

c. Revenues from long-term contracts are recognized with progress towards completion (percentage-of-completion method), or at the end of the contract (completed contract method).

d. Revenues are recognized at the completion of production for salable products with assured prices and an established market, e.g. precious metals, oil, or agricultural products.

e. Revenues are recognized after delivery when there is reasonable doubt about collectability, i.e. when the degree of collectability can’t be reasonably estimated. The recognition occurs either as the revenues are received (installment sale method) or after enough revenue has been received to recover the cost of the sale (cost recovery method).

E. Stability and Trend of Revenue

1. Investors and creditors are concerned not only about the company’s current level of return but also about the company’s ability to keep achieving the current level (i.e., stability) and exceed it in the future (i.e., trend). The stability of the return enhances its value in predicting future returns. As stated earlier, fluctuating revenues cannot be relied upon in evaluating the current financial position and predicting future performance. The trend of the revenue represents the rate and direction of the movement in the revenue levels from year to year. Persistent revenue levels with steady growth trend are indicators of a continuing healthy financial performance.



2. Revenue may fluctuate over time due to revenue from non-core or nonrecurring sources. Therefore, it is important to examine the source of revenue and isolate the effects of non-core or nonrecurring sources when analyzing financial statements. The analyst may recast income statements by excluding non-core and nonrecurring items in order to determine the persistent returns of the company over years and show their trend.

3. The analyst must consider the followings in evaluating the stability and trend of revenue:

a. Customer Concentration - the reliance on a single customer or on many diversified customers (bargaining power of buyers).

b. Distribution Channels - the reliance on single distributor or on many separate distributors.

c. Diversification of Markets - the reliance on one market or on many geographically diversified markets.

d. The price elasticity of the demand for the product.

e. The ability of anticipating the future demand on the current product and on new products.

f. Business conditions and competition level.

F. Relationship Between Revenue, Inventory, and Receivables

1. The company carries inventory to meet customers’ orders. When the company sells from its inventory to customers on credit it recognizes the sales in accounts receivable. Later, the accounts receivable are collected and the operating cycle is completed. This cycle, generally, dictates that in order to increase sales revenue the company has to increase its inventory and receivables levels. The company must balance between the benefits of increasing sales revenues and the costs and risks associated with increasing inventory and receivables levels. Higher levels of inventory lead to higher carrying costs and higher risks of obsolescence or damages. Similarly, higher levels of receivables mean higher costs of granting credit and higher risks of default.

2. The analyst should examine the relationships between the levels of sales, inventory, and receivables for validity and investigate the reasons behind any irregularities. The ratios that help in examining these relationships include receivable turnover ratio, inventory turnover ratio, days sales in inventory, and days sales in receivables. The increase in inventory without corresponding increase in sales indicates problems in selling inventory. The increase in receivables without corresponding increase in sales indicates problems in the collection process that may be associated with excessive extension of credit, accounts receivable collectability issues, and/or aggressive management incentives linked to sales only. a. A buildup in finished goods inventory with declining levels of raw materials and work-in-

process may indicate a potential decline in future sales as the company’s finished goods

would ultimately be depleted and not replenished due to lack of availability of raw materials.



Comparison of Revenue Recognition Practices Two companies are executing two similar long-term construction contracts. Both companies acquired the necessary materials at the inception of the contract and progress towards completion was measured at 25% by end of year 1, 75% by end of year 2, and both companies completed the contracts during year 3. Both companies use the percentage of completion method to account for the long-term contracts. Company 1 measures the percentage of completion using the cost-to-cost method while Company 2 measures the percentage of completion using the progress towards completion. Other pertinent information:

Contract revenues $1,000,000 Estimated total costs 800,000 Total materials 500,000 Construction costs incurred per year 100,000 Gross Profit 200,000 Gross Profit % 20%

Company 1 Revenue/Gross Profit Recognition (cost-to-cost approach)

Year 1 Year 2 Year 3 Total Costs to date 600,000 700,000 800,000 800,000 Total Costs 800,000 800,000 800,000 800,000 % of completion 75% 87.5% 100% 100% Revenue recognized 750,000 125,000 125,000 1,000,000 Gross Profit recognized 150,000 25,000 25,000 200,000

Company 2 Revenue/Gross Profit Recognition (Progress towards completion approach)

Year 1 Year 2 Year 3 Total % of completion 25% 75% 100% 100% Revenue recognized 250,000 500,000 250,000 1,000,000 Gross Profit recognized 50,000 100,000 50,000 200,000

As demonstrated above, while both companies will recognize the exact same total revenues and gross profits over the three-year period, and while both companies will use the percentage of completion method, using different methods to estimate the percentage of completion (both of which are GAAP), each will report a different amount of revenues and gross profit during each year of the period.



Cost of Sales Analysis

A. Analyzing cost of sales is an important part of profitability analysis as the cost of goods sold represents the largest expense in merchandizing and manufacturing companies. The following are the formulas for calculating profit margins which are the most common measures of profitability:

Cost of goods sold is beginning inventory plus net purchases minus ending inventory.

Gross profit margin is sales minus cost of goods sold.

Gross profit margin percentage is gross profit margin divided by net sales.

Operating profit margin percentage is operating profit divided by net sales.

Net profit margin percentage is net income divided by net sales.

B. Gross profit margin is the first measure of profitability. It is calculated by deducting only the cost of goods sold from sales revenue. Poor management of cost of goods sold leads to a decrease in gross profits as a result of the increase in cost of goods sold. The higher gross profit margin indicates higher profitability of the company without considering other expenses and revenues. Gross profit margin percentage represents the gross profit margin as a percentage of net sales. The analysis of gross profit margin should include comparing it with prior periods and/or with industry averages and determining the reasons of changes. The reasons that may explain the changes in gross profit margin include the changes in sales volume, selling price, and cost per unit.

C. Operating profit is the income from the company’s core operations before interests and taxes. It is calculated by deducting other operating expenses such as general and administration expenses from gross profit margin, and adding other operating incomes. Operating profit margin percentage represents the operating profit margin as a percentage of net sales. Comparing the changes in gross profit margin with the changes in operating profit margin provides insight about the company’s efficiency in managing its operating expenses. The decrease in operating profit margin in relation to gross profit margin indicates an inefficient management of other operating expenses as the cost of goods sold exists in both ratios. For example, if company A has a higher gross margin and a lower operating margin than company B, the reason could be that company A has a higher G&A expenses than company B.

D. Net income considers all revenue and expense items of the company. It measures income per dollar of sales. Examining the changes in net profit margin in relation to the changes in operating profit margin highlights the effects of changes in interests and taxes.

E. In analyzing the cost of goods sold, the analyst should consider the following areas as they affect the overall management of cost of goods sold:

1. The inventory storage policy.

2. The quality of raw materials.

3. The proficiency of the employed labor.

4. The level of automation.

5. Costing management system.



Expense Analysis

In addition to the cost of goods sold, the analyst should examine the other expenses of the company which include the following major categories:

A. Selling expenses include marketing, advertising, and sales commissions. Those expenses may have fixed and variable components.

B. Depreciation expense – tangible assets are depreciated over the periods that are expected to benefit from the use of those assets. The analyst should be aware that different companies use different depreciation methods which may affect the purpose of the analysis.

C. Amortization expense – intangible assets (except for goodwill) are amortized over their useful lives.

D. Repair and maintenance expenses – the analyst should recognize that some maintenance activities can be postponed by management to save costs temporarily and improve the reported results. That may shorten the useful life of the affected assets. Repair and maintenance expenses have fixed and variable components.

E. General and administrative expenses include administrative salaries, insurance, communication expenses, and rents.

F. Financing expenses include primarily interest expense on debts.

G. Income taxes – the analyst should calculate the effective tax rate and compare it with the statutory tax rate and identify the reasons for any differences. Effective tax rate is calculated by dividing total tax expenses by the firm's income before taxes.

Variation Analysis

A. Variation analysis was introduced earlier in Horizontal Common-Size financial statement analysis. Variation analysis is used as part of financial analysis to evaluate the percentage change of a financial item or measure over many periods in order to identify the trend of these changes.

B. Variation analysis shows the movement of an item over time by showing the increases or decreases in its value. This is performed by using a base year amount and assigning the value of 100% to it. The amounts of subsequent years are then presented as percentages of the base year amount.

Illustration of Variation Analysis

The following example illustrates the variation analysis of gross profits and net income for a company.

Year 1 Year 2 Year 3

Gross Profit $ 8,000 9,200 10,800 Gross Profit % 100% 115% 135% Net Income $ 4,000 4,400 4,800 Net Income % 100% 110% 120%

Examining the percentage changes in this analysis shows that, over the three years, the net income was growing at a rate lower than the growing rate of gross profit. This indicates that the expenses other than COGS are increasing and need to be managed.



Sustainable Equity Growth

A. The sustainable equity growth rate determines the growth rate a company can have based on its earnings only without using other means of financing. Growing beyond the sustainable growth rate requires additional capital from debt or equity which is not available always.

B. This ratio increases as a result of the increase in ROE, or by the increase in retention rate by keeping a larger portion of earnings to reinvest it again in the business.

Sustainable Equity Growth

Sustainable Equity Growth Rate = ROE x Retention Ratio

Sustainable Equity Growth Rate = ROE x (1 – Dividends payout ratio)

C. If the company pays out dividends at a rate of 40% of its earnings (income available to common shareholders), and its return on equity was 25%, then the sustainable growth rate for that company will be 15% (25% multiplied by 60%).




1. Company A has a higher rate of return on assets than Company B, the reason may be that Company A has a <List A> profit margin on sales, a <List B> asset turnover ratio, or both.

List A List B

a. Higher Higher

b. Higher Lower

c. Lower Higher

d. Lower Lower

2. When calculating ratios involving income, an adjustment is most likely to be made for

a. Gross profit.

b. Selling expenses.

c. Nonrecurring gains and losses

d. Fixed overhead costs.

3. The financial controller is comparing the financial statements of his company with the financial statements of a competitor in the same market, the revenue recognition method used by the competitor is different than the one adapted by the company. What would the controller do?

a. The controller must assess the impact of this difference during the analysis.

b. The controller shall stop the comparison as it is not relevant any more.

c. The controller shall ask for a meeting with the controller of the competitor to assess the impact of this difference.

d. The controller has to proceed with the comparison as revenue recognition has no relevance in the comparison process.

4. The sustainable equity growth rate determines the growth rate a company can have based on its:

a. Capability to get external loans.

b. Capability to issue new common shares.

c. Issue new preferred shares.

d. Earnings only without using other means of financing.



Feedback:

1. Answer (a) is correct. The DuPont model treats the return on assets as the product of the profit margin and the asset turnover:

(Net income ÷ Net sale) X (Net Sales ÷ Total assets)

If one company has a higher return on assets than another, it may have a higher profit margin, a higher asset turnover, or both.

2. Answer (c) is correct. Nonrecurring gains and losses are sometimes added to or subtracted from income to arrive at income from continuing operations. Because ratios are used to predict the future, nonrecurring items that are not likely to recur should not be considered.

3. Answer (a) is correct. The analyst should be aware of the effects of this difference on the result of the comparison.

4. Answer (d) is correct. The sustainable equity growth rate determines the growth rate the company can have based on its earnings only without using other means of financing (debt or equity).



STUDY SESSION 4

A.4 Special Issues

4. Special issues a. Impact of foreign operations b. Effects of changing prices and inflation c. Off-balance sheet financing d. Impact of changes in accounting treatment e. Accounting and economic concepts of value and income f. Earnings quality

Impact of Foreign Operations

Due to the rapid expansion of international business, companies are more involved in conducting abroad business which means more exposure to foreign currencies. There are two issues related to accounting for foreign currencies:

Accounting for foreign currency transactions which are transactions denominated in a currency other than the reporting currency of the company.

Accounting for a subsidiary of the company that keeps its records in a different currency from the parent company’s currency. The financial statements of this subsidiary must be converted to parent company reporting currency when preparing consolidated financial statements.

A. Foreign Currency Transactions – transactions denominated in foreign currencies include sales or purchases of goods, acquiring assets, and incurring liability in foreign currency.

B. Accounting for foreign currency transactions requires treatments at three different dates:

1. At the date of the transaction, the transaction is recorded at the current exchange rate.

2. At each financial statements date, the affected accounts (receivables or payables) are revalued using the current exchange rate to reflect the fair values. The gains or losses due to changes in the exchange rate are recorded in the income statement.

3. At the date of the settlement of the receivables or payables, the gains or losses are recognized to reflect the change in the exchange rate since the date of the last financial statements. The gains or losses are recorded in the income statement.



Illustration of Foreign Currency Transactions

On October 10, 2013 a US company sold products to a company in France for 6,000 euros, the payment was to be received on February 11, 2014. Exchange rates were as follows:

October 10 €1 = USD1.4

December 31 €1 = USD1.44

February 14 €1 = USD1.41

What are the journal entries relevant to the above transaction?

Solution:

a. October 10, 2013 – on the date of the transaction, the exchange rate was $1.4 for each euro:

Dr. Accounts Receivable 8 400 Cr. Revenue 8,400

(1.4 × 6,000 = 8,400)

b. On December 31, 2013 the date of preparing financial statements, the exchange rate was $1.44 for each euro:

Dr. Accounts Receivable 240 Cr. Foreign currency gain 240

(0.04 × 6,000 = 240)

c. On February 14, 2014, the date of receiving the payment and converting it, the exchange rate was $1.41

Dr. Cash 8,460 Dr. Foreign currency loss 180 Cr. Accounts Receivable 8,640

(1,41 × 6,000 = 8,460) (0.03 × 6,000 = 180)

C. Accounting for Subsidiaries With Foreign Currencies – preparing consolidated financial statements may require performing many adjustments on the foreign subsidiaries’ statements that are related to the differences in the applied accounting standards. These adjustments must be performed prior to the conversion of the statements of the subsidiary to parent company currency. For example, when the parent company is a US company, and the foreign subsidiary uses accounting standards other than GAAP, the financial statements of the subsidiary must be modified to confirm with US GAAP before converting these statements to US dollars.

1. There are three types of currencies related to converting financial statements currencies:

a. Currency of Records is the currency used by the foreign subsidiary to keep its records.

b. Reporting Currency is the currency of the parent company’s financial statements. It is the currency that the subsidiaries’ statements must be converted into in order to prepare the consolidated financial statements of the parent company and its subsidiaries.

c. Functional Currency is the currency of primary economic environment of the subsidiary. It is the currency of the majority of the subsidiary transactions. This currency may be the currency of the country in which the foreign subsidiary operates, the currency of the parent company, or another different currency. Functional currency should be determined based on several economic factors. The following table summarizes those factors.



Determining Functional Currency

Factor The Functional Currency is the

Foreign Currency When

The Functional Currency is the

Parent’s Currency When

Selling Price

Sales prices for the foreign entity’s products and services are not responsive to changes in exchange rates but are determined primarily by local competition or local regulations.

Sales prices for the foreign entity’s products and services are responsive to changes in exchange rates.

Market The foreign entity has an active local sales market for its products and services.

The sales market is primarily in the country of the parent entity.

Expense Foreign entity’s operating costs (labor, material, and other costs) are primarily local costs.

Foreign entity’s operating costs are primarily costs for importing components from the parent entity’s country.

Financing Foreign entity’s financing is primarily denominated in foreign currency.

Foreign entity’s financing is obtained primarily from the parent entity.

Cash Flow

The cash flows related to the foreign entity’s assets and liabilities are primarily in the foreign currency and do not directly affects the parent entity’s cash flows.

The cash flows related to the foreign entity’s assets and liabilities directly affect the parent entity’s cash flows.

Intra-entity Transactions

The volume of transactions between the foreign entity and the parent entity is low and the interrelationship between their operations is insignificant.

The volume of transactions between the foreign entity and the parent entity is high and the interrelationship between their operations is extensive.

2. Converting the financial statements of foreign subsidiaries involves two different methods, the temporal method and the current rate method. Appling one of those methods or both depends on the currency types used by the foreign subsidiary:

a. If the foreign subsidiary’s currency of records is NOT the functional currency and the functional currency is NOT the reporting currency, the financial statements of the subsidiary are first re-measured to its functional currency using the temporal method, and then translated from the functional currency to the reporting currency using the current rate method.

b. If the foreign subsidiary’s currency of records is the functional currency and the functional currency is NOT the reporting currency, the financial statements of the subsidiary are only translated from the functional currency to the reporting currency using the current rate method.

c. If the foreign subsidiary’s currency of records is the reporting currency, no conversion is needed even when the reporting currency is NOT the functional currency of the subsidiary environment. That is because the statements of the subsidiary are already in the reporting currency.



3. Re-measurement - Temporal Method: As stated above, the re-measurement is used in conversion from the currency of records to the functional currency using the temporal method. The temporal method is also called the monetary/non-monetary method. The exchange rates used in this method are the current rate, which is the rate at the date of preparing the consolidated financial statements, and the historical rate, which is the rate when the related transaction occurred, as well as the average rate:

a. Historical exchange rates are used to convert the following items

i. Non-monetary items such as fixed assets, intangible assets, and inventories

ii. Revenues and Expenses related to non-monetary items (e.g., cost of goods sold, depreciation, amortization)

iii. Equity items, except for changes in retained earnings from net income

iv. Dividends declared

b. Current exchange rate is used to convert monetary items which include cash, cash equivalents, accounts receivable, notes receivable, accounts payable, bonds payable, and notes payable.

c. Average exchange rates are used to convert other revenues and expenses that occur evenly throughout the period.

d. All gains and losses that arise from re-measurement are recognized in the income statement. That may lead to fluctuated reported net income over periods.



4. Translation – Current Rate Method: As stated above, the translation method is used in conversion from the functional currency to the reporting currency using the current rate method. In this method:

a. Current exchange rate is used to convert balance sheet amounts except for equity.

b. Historical exchange rates are used to convert equity items, except for changes in retained earnings from net income.

c. Average exchange rate is used to convert all revenues and expenses.

d. All gains and losses that arise from translation are NOT recognized in the income statement. These gains and losses are recognized in Other Comprehensive Income in stockholders’ equity. That results in a more stable reported net income over periods.

Passing Tip: Loss and gains from foreign transaction → Income Statement Loss and gains from re-measurement → Income Statement Loss and gains from translation → Other Comprehensive Income

D. Effects of Changes in Exchange Rates on Financial Analysis

1. Foreign Currency Transactions – conducting transactions in foreign currencies creates accounting items that are denominated in foreign currencies. These items are subject to changes in accordance to the changes in exchange rates which affects the related financial ratios. For example:

a. When purchases are dominated in foreign currencies it will generate accounts payable in foreign currencies. At the date of the balance sheet, an appreciation in the foreign currency will increase the accounts payable balance and decrease net income as a result of recognizing foreign exchange loss. This will has negative effects on the liquidity and profitability ratios. While the depreciation in the foreign currency will create the opposite results.

b. When sales are dominated in foreign currencies it will generate accounts receivable in foreign currencies. At the date of the balance sheet, an appreciation in the foreign currency will increase the accounts receivable balance and the net income as a result of recognizing foreign exchange gain. This will have positive effects on liquidity and profitability ratios. While depreciation in the foreign currency will create opposite results.

2. Re-measurement and Translation – converting the financial statements currency utilizes different exchange rates, historical, current, and average rates. This conversion changes the stated amounts of many items of the financial statements which alter the relative relationships among the accounts and, accordingly, the ratio analysis of those statements. As stability and steady growth in reported earnings are highly desirable by management and investor, companies try to mitigate the effects of fluctuations in foreign currencies’ rates on the reported earnings. The means used in managing foreign currency risks include currency futures, currency swaps, and currency options which are discussed in section B of this part.

Passing Tip: In the USA, FASB requires that if a foreign subsidiary is working in a country with a highly inflationary economy, the functional currency of that subsidiary must be the same as its reporting currency (i.e., US dollars). An economy is classified as highly inflationary if the inflation rate of that economy exceeds 100% over a period of three years.



Effects of Changing Prices and Inflation

A. Effect of inflation represents a major limitation of financial ratios analysis. The increase in price level impacts financial statements’ accounts from year-to-year, and significantly distorts account balances in the long-run. That is mainly because financial statements are based on historical cost which deteriorates their relevancy in high inflation environments. In addition, the increase in prices does not impact all accounts in the same way. Non-monetary accounts are affected more than current monetary accounts. That distorts the relative relationships among these accounts, and, therefore, the reliability and comparability of the related ratios. Similarly, the mix of assets, liabilities and equity differ from one company to another which negatively affects the validity of measuring the performance of one company in relation to another during high inflation periods. During inflation periods:

1. Depreciable assets with long useful lives tend to overstate net income due to computing the depreciation expense based on the historical lower cost.

2. Inventory with low turnover tends to overstate net income due to selling inventory items for current inflated prices while the cost of items sold is lower than current cost. This effect is magnified when FIFO method.

3. Holding monetary assets leads to purchasing power losses as the same amount of money can purchase lower amount of goods. While monetary liabilities cause purchasing power gains.

4. Debt acquired during high inflation periods will usually have higher interest rates, and interest rates

will be different between companies that acquired their debts at different times thus impacting their bottom line from factors other than their operational profitability.

B. In order to remove the impact of inflation, the analyst adjusts financial statements using different methods. One method that may be used is adjusting the affected items of financial statements to reflect the current fair amounts. Thus, the non-monetary assets and liabilities are adjusted for the change in the price index, while the monetary assets and liabilities are not adjusted. As for the revenues and expenses, the average price index during the period is applied.



Off-Balance Sheet Financing

Off balance sheet financing is any form of transaction that enables the company to use a resource without recording the related assets or liabilities in the company’s balance sheet. Typically, companies engage in such form of funding to improve their capital structure by lowering the debt to equity and debt to total assets ratios which reduce the cost of capital for the company. Off-balance sheet financing may also be used to avoid certain loan covenant restrictions on the total debts a company can carry. The most common forms of off-balance sheet financing are:

Operating leases

Special purpose entities

Sale of receivables

Joint ventures



A. Operating Leases

1. There are two types of leases the operating lease and the capital lease. The main difference between the two types of leases is that in the capital lease the leased asset and obligations are recorded on the balance sheet, while in the operating lease nothing is recorded on the balance sheet and the lease payments are treated as operating expenses. Companies can negotiate lease terms in a manner that lead to classify the lease contract as an operating lease which give the lessee the right to use the asset without recording any liabilities.

2. Using operating leases enables the company to use the leased asset without affecting its liquidity ratios or the debt to equity ratios. That is because without the lease the company would have to purchase the asset by using its cash, or by using long or short term financing.

a. If the company acquires the asset using cash, its liquidity ratios will be affected.

b. If the company acquires the asset using trade credit, its short-term liquidity ratios will be affected.

c. If the company acquires the asset using long-term debt, its debt and debt/equity ratios will be affected.

Operating Lease vs. Capital Lease vs. Asset Acquisition

Operating Lease Capital Lease Asset Acquisition

Fixed Assets No assets are recorded since the company is leasing the asset

An asset is recorded for the leased assets and amortized over the life of the lease

The asset is recorded as a fixed asset and depreciated over its useful life

Liabilities No liabilities are recorded since the company is leasing the asset

The company must report a liability equal to the present value of the minimum lease obligations under the lease

The company must present a liability for the remaining unpaid balance of any loans used to acquire the asset

Income Statement

The company records an annual lease payment as an expense

The company records an annual amortization expense

The company records an annual depreciation expense



B. Special Purpose Entities (SPE)

1. SPE is a legal entity created to carry out a specific purpose, activity, or series of transactions. Normally, companies create these entities to isolate financial risk and provide less-expensive financing. These entities may be used to finance a high risk project without putting the parent company at risk, to securitize loans or other receivables, to share risks with partners or investors, or to trade in financial derivatives. The company may benefit from SPEs in two ways: removing debts from the balance sheet, and providing protection from possible financial failure by its SPEs.

2. SPEs were used extensively by companies as a technique for hiding debts and improving the appearance of the financial statements. In the past, there was no requirement for a company without a controlling ownership interest in another entity to consolidate that entity’s financial statements. The company might create a large number of SPEs and benefit from the funds without recording any liability (as in the case of Enron Corporation). During recent years, accounting guidelines were improved to limit the illegitimate use of SPEs.

3. For example, a car manufacturer sets up a SPE to source engine parts and assemble them to create car engines. The car manufacturer signs a contract to acquire all of the SPE’s production, and against this contract, the SPE is in a position to obtain loans. The SPE acquires the necessary manufacturing assets against long-term loans that will reflect only on the SPE’s financials and not on the car manufacturer’s financials. The car manufacturer managed to indirectly produce and source its own engines without having to reflect the debt on its own financial statements.



C. Factoring of Receivables

1. Sale of receivables is typically a transfer of a company’s receivables to other entity named “factor”. Companies may use factoring to hide the fact that they are, in effect, using accounts receivable as a collateral for a loan received from the factor. If this transfer is accounted for as a sale, the company removes its accounts receivable from the balance sheet and raises its cash balance without recording any liability, thus it is a form of off-balance sheet financing. However, in order for this transfer to be accounted for as a sale, the following terms must be met:

a. The sold receivables are out of reach of the seller’s creditors.

b. The purchaser has the right to pledge the bought receivables.

c. The seller does not have control over the sold receivables.

2. If one of these terms does not hold, the sold receivables should not be derecognized from the seller’s records, thus the transaction should be recorded as a loan that is guaranteed by the receivables.

D. Joint Ventures

1. A joint venture is a type of entity with limited purpose that is owned by two or more companies. The purpose usually involves conducting a large or risky project. If the company owns more than 50% of the shares of the venture, or can exercise significant influence, the venture is accounted for as a subsidiary and its assets and liabilities are consolidated. However, companies usually manage to keep their shares in ventures under this threshold in order to avoid consolidation which allows the venture to serve as off-balance sheet financing for the parent company.

Illustration of Off-Balance Sheet Financing

The below example demonstrates the effect of off-balance sheet financing on debt-to-equity ratio:

Acquired Assets Leased Assets Current Assets 100,000 100,000 Fixed Assets 900,000 250,000 Total Assets 1,000,000 350,000 Current Liabilities 50,000 50,000 Long-term Liabilities 700,000 50,000 Total Liabilities 750,000 100,000 Equity 250,000 250,000 Total Liabilities and Equity 1,000,000 350,000 Debt-to-equity ratio 3 0.4 Debt-to-total assets 0.75 0.286



Impact of Changes in Accounting Treatment

If a company decided to change its inventory valuation method from LIFO to weighted average after periods of increasing prices, the company’s balances of retained earnings and inventory will probably change significantly. Thus the financial analysis and the related ratios will be affected as a result of this moving from one acceptable accounting method to another. Consequently, the comparability between periods for the same company and between companies is affected, as well as, the ability to extract meaningful trend data. Therefore, it is important for the analyst to understand the effects of any similar conditions that alters financial statements balances. There are three types of accounting changes that require adjusting the financial statement and require different accounting treatments:

A. Corrections of Accounting Errors – errors in prior financial statements must be corrected once discovered and the related adjustments must be conducted on the financial statements. These adjustments are accounted for and reported in the statement of retained earnings as “prior period adjustments” (net of tax). The charge is made directly to the opening balance of retained earnings for the current period. Therefore, they are excluded from the determination of net income for the current period. The company is required to correct and restate all affected prior periods statements. Examples include changing from the cash method of accounting (not GAAP) to the accrual method of accounting (GAAP) or discovering the failure to record a significant expense in a prior period.

B. Changes in Accounting Principle refer to changes from one accepted accounting principle to another. Changes in accounting principle are recognized by including the cumulative effect net of tax to adjust the beginning balance of retained earnings. Prior to 2006, the cumulative effect of changes in accounting principle was included in the current year’s income statement, but this is no longer acceptable. The cumulative effect is based on a retroactive computation of changing to the new accounting principle. The company is required to restate its previously issued financial statements to reflect the change in the principles. Examples of changes in accounting principle include a change in the method of accounting for long-term construction contracts (Completed contract, Percentage of completion) or a change in the method of inventory costing (FIFO, LIFO, Average).

C. Changes in Accounting Estimate are treated prospectively, which means that no adjustments should be made in the results of prior periods, and the financial statements of prior periods are not restated. Instead, the effects of changes in estimate are accounted for in the period of change and future periods. Prior to 2006, changes in depreciation, amortization or depletion methods were accounted for as changes in accounting principles. However, since 2006 these changes are considered changes in accounting estimates affected by changes in accounting principles. Therefore, no cumulative effect of the change will result from a change in depreciation method. Instead, the remaining balance will be depreciated over the remaining life of the assets using the new depreciation method. Examples of items that require estimates include depreciation, warranty claims, and bad debts.



Accounting and Economic Concepts of Value and Income

A. Economic and Accounting Profit

1. Accounting Profit is the net income appears on the income statement. It is calculated by deducting the company’s explicit cost from the revenues. Explicit costs are all business expenses that the company has to pay to others in the course of running a business. Explicit costs include items such as wages, rent, and materials. Calculating accounting profit follows the accounting guidelines such as GAAP or IFRS.

2. Economic Profit is calculated by deducting economic costs from revenues. Economic costs refer to the sum of all explicit and implicit (opportunity) costs of a business. Opportunity costs refer to the benefits foregone as a result of selecting one course of action rather than another. In other words, the opportunity cost is the foregone income that could be generated if the company had invested its resources in another alternative instead of its own business. Therefore, accounting profit is always greater than economic profit. The most common opportunity cost is “normal profit” that is expected to be generated from conducting business.

3. Analyzing economic profit helps the owners of the company in evaluating the current profitability of the company in relation to other possible alternatives. That is, determining whether the company should continue in its business or the owners could generate more profits by investing their resources in something else.

B. Book Value and Market Value – the value of a firm, an asset, or a liability may differ significantly according to the valuation method used.

1. Book Value is the value according to the accounting bookkeeping records. The book value for an asset is the historical cost minus accumulated depreciation, and the book value of a company is total assets minus liabilities.

2. Market value of a company (market capitalization) is the market price per common stock multiplied by the number of outstanding stocks. Market value of an asset is the price that would be received if the asset is sold in the market. Fair market value differs from market value by that fair value takes into consideration the conditions of the sale transaction and the efficiency of the market. Fair market value is the price that would be received if the asset is sold in an orderly transaction between market participants that are knowledgeable about the asset and are free of undue pressure to trade. Therefore, in case of forced liquidation, liquidation value is not fair value as it involves pressure.

3. The company may have in its records a mix of values, book values for fixed assets and inventories, fair market value for its financial securities investment that are quoted in the secondary market.

Earnings Quality

Earnings quality refers to the ability of the reported earnings to accurately represent current operating performance of the company and to aid in predicting future earnings. The followings are the basic determinants of earnings quality:

A. The Effect of Business Environment and Economic Forces – this includes analyzing the effects on earnings as a result of factors such as inflation, business cycle, competition, and regulatory or political environment. For example

1. Variability of earning levels in relation to business cycle reduces earnings quality.



2. Inflation artificially overstates revenues and understates some expense, like depreciation, which reduces earnings quality.

3. Companies with foreign operations are exposed to the possibility of difficulty in repatriating funds and to currency fluctuations which may reduce their earnings persistence and quality.

B. Management – management usually has the ability to make decisions that alter reported income. These decisions include for example choosing favorable accounting methods, or determining the timing of certain transactions such as repairs, maintenance, or other discretionary expenses. The analyst should examine the characters of the management in order to evaluate its incentives to influence earnings. For example, the earnings quality is lower for a subsidiary that its management compensation is based on the reported income. Available means for management to increase the earnings may include:

1. Overstating the assets by decreasing the allowances for doubtful debt or ignoring written off of obsolete inventories.

2. Reducing repair and maintenance expenses that lead to accumulate them to future periods and reducing the capacity of the assets.

3. Capitalizing research and development expenses without reaching the feasibility stage.

C. Selection of Accounting Principles – as stated earlier, the selection between acceptable accounting principles may have a great effect on the company’s reported earnings. If the company is using liberal (or aggressive) accounting policies, it will lead to higher earnings in the short term and that will be reflected negatively in the long term. In contrast, if the company is using conservative policies, it will lead to lower earnings during the short term but will increase earnings in future. Using conservative policies limits the possibility of overstating earnings thus enhances the quality of earnings. However, conservatism should not be used to the extent that deteriorates the integrity of financial information and misleads users. The following are some of liberal accounting policies that may reduce earnings quality in some cases:

1. Using FIFO during the inflationary periods and LIFO during the deflationary periods.

2. Using percentage of completion for long term contracts instead of completed contracts for long term contracts.

3. Using straight line method for fixed assets depreciation instead of declining methods and extending the useful life of the assets.

4. Accounting for a lease as an operating lease reduces the short term expenses and increases the long term expenses, while capital lease method has the adverse effect.

The financial analyst should examine the applied accounting policies and evaluate their effects on the quality of reported financial data.

D. Off balance sheet financing is another factor that affects the quality of earnings. Off balance sheet financing was discussed earlier in this section.




1. Which one of the following statements best reflects the relationship between the results of financial ratios calculated in a local currency versus those where a functional currency is used?

a. Financial ratio results are similar under translation and remeasurement, and ratios under translation are also often similar to those in the local currency.

b. Financial ratio results are similar under translation and remeasurement, but ratios under translation are often different from those in the local currency.

c. Financial ratio results are different under translation and remeasurement, but ratios under translation are often similar from those in the local currency.

d. Financial ratios results are different under translation and remeasurement, and ratios under translation are also often different from those in the local currency.

2. A firm’s functional currency should be

a. Selected on the basis of several economic factors including cash flow, sales price, and financing indicators.

b. The currency of the foreign environment in which the firm primarily generates and expends cash.

c. Selected on the basis of cost-benefit analysis and ease of preparing consolidated financial statements.

d. The currency of the parent organization as the firm operates as an extension of the parent’s operations.

3. Which of the following is true about the impact of price inflation on financial ratio analysis?

a. Inflation impacts only those ratios computed from balance sheet accounts.

b. Inflation impacts financial ratio analysis for one firm over time, but not comparative analysis of firms of different ages.

c. Inflation impacts financial ratio analysis for one firm over time, as well as comparative analysis of firms of different ages.

d. Inflation impacts comparative analysis of firms of different ages, but not financial ratio analysis for one firm over time.

4. Which of the following is not a form of off-balance sheet financing?

a. Operating leases

b. Joint ventures

c. Factoring receivables

d. Capital leases



5. A major difference between economic profit and accounting profit is that economic profit

a. Allows for more accurate expense accruals.

b. Minimizes the impact of accounting estimates.

c. Reduces profits by associated cost of capital.

d. Adjusts accounting profit by depreciation.

6. An example of a practice that would be least likely to negatively impact a company’s quality of earnings is the intentional

a. Purchase of inventory of an obsolete product at year-end to avoid a LIFO liquidation.

b. Offer to the sales staff of financial incentives for increasing year-end sales.

c. Estimate of uncollectible accounts as 2% of sales when the company’s records show the historical rate is 5% of sales.

d. Recording of an order from a reliable customer as a sale on December 31 when the cash is received even though the goods will not ship until January 2.



Feedback:

1. Answer (d) is correct. Financial ratios computed based on local currency will be different from financial ratios computed based on translation or remeasurment. Moreover, financial ratios computed based on translation will also differ since income statement items and balance sheet items are different from one to another.

2. Answer (a) is correct. A firm’s functional currency should be the currency of the primary economic environment in which the firm operates and should be selected on the basis of several economic factors including cash flow, sales price, and financing indicators.

3. Answer (c) is correct. Inflation impacts both aspects. Answer (a) is not correct because inflation also distorts depreciation charges, inventory costs, and profits. Answers (b) and (d) are not correct because inflation impacts both aspects.

4. Answer (d) is correct. Operating leases, joint ventures and factoring of receivables are all considered off-balance sheet financing. Capital leases are not off-balance sheet financing.

5. Answer (c) is correct since economic profit takes the implicit cost in addition to explicit cost into consideration.

Answer (a) is not correct since economic profit does not take accruals into consideration.

Answer (b) is not correct since there are additional estimates, which are the opportunity cost, normal profit and cost of capital.

Answer (d) is not correct since economic profit does not take depreciation into consideration.

6. Answer (b) is correct. All above choices will lead to lower earnings quality except for B since the sale staff will have actual sales in order to receive higher commissions.



A.5 Comprehensive Example Sales Analysis

Tribrand Co. is in the business of distributing major electric and electronic devices and appliances. From a summary of the 2013 figures, 75% of its sales were generated from three categories: Screen, Fridge, and A/C; and 90% when adding the Washing Machine and Range Ovens. Of the annual sales, 71% are generated from the Arzo brand.

Sales Analysis

Arzo Bito Cleo Total % of

Total Screen 7,653,420 2,436,982 0 10,090,402 33.12% Fridge 6,223,147 654,245 292,980 7,170,372 23.54% A/C 5,270,456 417,775 44,025 5,732,256 18.82% Washing Machine 154,009 71,431 2,116,935 2,342,375 7.69% Range Ovens 1,579,272 0 0 1,579,272 5.18% Freezer 0 16,446 563,502 579,948 1.90% Other 801,344 1,144,392 1,022,242 2,967,978 9.74% Total 21,681,648 4,741,271 4,039,683 30,462,603 100% % of total 71.17% 15.56% 13.26% 100%



Contribution Margin

Similar to sales, 75% of contribution is from the top three sales categories, and approximately 90% are from the top 5 sales categories. Also similar to the sales percentages, the highest % of contribution margin was from the Arzo Brand at 73% of the total contribution margin. From the below numbers, and purely from an accounting perspective, it is evident that management should focus its sales attention on the Arzo Fridge and AC over the other brands while concentrating on the Cleo Washing Machine over the other brands. Further, its focus on the miscellaneous items should be from the Bito and Cleo rather than from the Arzo items.

Contribution Margin

Arzo Bito Cleo Total

% of Total

Screen 728,339 288,102 0 1,016,441 23.07% Fridge 1,353,142 132,857 23,553 1,509,552 34.26% A/C 798,442 -12,590 -2,062 783,790 17.79% Washing Machine 9,424 6,106 327,057 342,587 7.77% Range Ovens 224,826 0 0 224,826 5.10% Freezer 0 3,045 32,101 35,146 0.80% Other 104,383 211,778 178,165 494,326 11.22% Total 3,218,556 629,298 558,814 4,406,668 100.00% % of total 73.04% 14.28% 12.68% 100.00%



Inventory December 31, 2013

In order to assess the management of inventory, inventory balances were quantified. It appears that while Arzo’s inventory is relatively well-managed, the inventory of both Bito and Cleo is not. Overall, Arzo’s inventory, in value, comprises 45% of total ending inventory while it is contributing more than 70% of both the sales and the contribution margin. On the other hand, Cleo's inventory comprises almost one third of the total ending inventory, while its sales and contribution are approximately 12%. The bulk of the Cleo inventory comes from the Freezers which comprise almost 15% of total inventory while their sales and contribution margin are less than 1%. Inventory management policies for both the A/C and the TV seem reasonable as their ending inventory is relatively low, while their contribution is relatively significant.

Inventory


Total Screen 1,017,958 753,213 1,771,171 25.67% Fridge 1,133,860 79594 415,822 1,629,276 23.61% A/C 61,999 87,687 34,928 184,614 2.68% Washing Machine 215,099 53,900 282,093 551,092 7.99% Range Ovens 68,087 68,087 0.99% Freezer 26,313 95,051 893,820 1,015,184 14.71% Other 560,777 489,034 631,720 1,681,531 24.37% Total 3,084,093 1,558,479 2,258,383 6,900,955 100.00% % of total 44.69% 22.58% 32.73% 100.00%



Average Inventory

To further analyze the inventory management process, and to avoid year-end inventory purchases that could mislead the analysis, the average inventory is more meaningful for the analysis. While some percentages did change, the overall trend is evident. Arzo’s inventory management still appears to be better than the other two brands, while Cleo balances are relatively high compared to the other brands, sales, and contribution margin. The average inventory for the Freezers reflects that the freezer issue initiated during this year.

Average Inventory


Total Screen 1,105,572 376,606 1,482,178 22.13% Fridge 1,729,691 39,797 513,912 2,283,400 34.10% A/C 475,643 43,844 60,180 579,667 8.66% Washing Machine 112,692 26,950 330,614 470,256 7.02% Range Ovens 66,694 66,694 1.00% Freezer 26,313 47,526 511,440 585,279 8.74% Other 396,894 244,517 587,449 1,228,860 18.35% Total 3,913,499 779,240 2,003,595 6,696,334 100.00% % of total 58.44% 11.64% 29.92% 100.00%



Inventory Turnover

The following table estimates the number of days that the inventory remains on hand at the 2013 sales rate. Overall, for the top five categories, the only relatively low turnover (highest days in inventory) is that of the Fridge. Within the Fridge category, the Cleo fridges are extremely slow moving. Almost 50% of inventory that also comprise 50% of sales, have an average inventory turnover of 60 days, while 25% of the inventory, that also comprise almost 25% of sales, have an average turnover of 4.5 months.

Generally, all items with inventory turnover of over 2 months require better management.

Inventory Turnover (Days)

Arzo Bito Cleo Total

Screen Turnover (days) 52 58 54 % of Total 26.79% 8.31% 35.10%

Fridge Turnover (days) 117 25 627 133 % of Total 18.84% 2.02% 1.04% 21.90%

A/C Turnover (days) 35 33 429 39 % of Total 17.30% 1.66% 0.18% 19.14%

Washing Machine Turnover (days) 256 136 61 77 % of Total 0.56% 0.25% 6.92% 7.74%

Range Ovens Turnover (days) 16 16 % of Total 5.24% 5.24%

Freezer Turnover (days) 1,165 316 353 % of Total 0.05% 2.06% 2.11%

Other Turnover (days) 212 85 241 173 % of Total 2.69% 3.62% 2.46% 8.77%

Total Turnover (days) 70 62 189 85 % of Total 71.42% 15.91% 12.67% 100.00%



Financial Statement Analysis - Comparative Balance Sheets

From looking at the Statement of Financial Position for the years ended December 31, 2012 and 2013, it is evident that there has been almost a 25% buildup in current assets primarily financed from current liabilities. Looking further into this buildup, it is evident that the buildup was mainly in accounts receivable, and orders and prepayments. The financing for this buildup was predominantly from banks. Loans from banks were even used to significantly reduce the balance of the Company's suppliers. This position is considered a relatively aggressive position since bank loans have been used to finance clients’ accounts receivable.

Annual Comparative Balance Sheets as of December 31, 2012 and 2013

2012 2013 Current Assets 20,955,234 28,035,360

Cash on hand and in banks 256,539 170,870 Accounts Receivables 11,725,403 15,803,398 Inventory 6,495,641 6,907,446 Order and Prepayments 2,454,516 5,079,657 Other debit balances 23,135 73,989

Fixed Assets 167,583 234,378 Cost 188,942 255,737 Accumulated Depreciation -21,359 -21,359

Total Assets 21,122,817 28,269,738

Currents liabilities 17,784,663 24,213,699 Suppliers 4,031,137 1,693,508 Bank overdrafts 8,989,813 17,483,958 Bank loans 1,271,626 448,809 Bills payable 1,554 3,892,301 Bank charge Accruals 0 176,266 Other Creditors 3,490,533 518,857

Equity 3,338,154 4,056,039 Capital 150,000 150,000 Additional Paid-In Capital 2,029,473 1,696,051 Retained Earnings 1,158,681 2,209,988

Total Liabilities and Equity 21,122,817 28,269,738



Quarterly Comparative Balance Sheets

Further analysis into the buildup reflects that the bulk was made during the second quarter of 2013. The buildup was partially as a result of increased accounts receivable and increased inventory during the first half of 2013, but the inventory levels were brought down while accounts receivable remained high throughout the end of the year. Financing the buildup was predominantly from banks.

2013 Quarterly Comparative Balance Sheets

Q1 2013 Q2 2013 Q3 2013 Q4 2013 Current Assets 22,037,328 28,554,862 28,691,701 28,035,360

Cash on hand and in banks 15,313 151,608 90,684 170,870 Accounts Receivables 12,338,272 13,793,210 15,627,485 15,803,397 Inventory 7,336,258 8,862,408 9,920,553 6,907,446 Order and Prepayments 2,330,359 5,714,849 3,021,647 5,079,657 Other debit balances 17,126 32,787 31,332 73,990

Fixed Assets 213,084 216,739 228,094 234,378 Cost 234,443 238,098 249,453 255,737 Accumulated Depreciation (21,359) (21,359) (21,359) (21,359)

Total Assets 22,250,412 28,771,601 28,919,795 28,269,738

Currents liabilities 19,205,894 25,024,726 24,838,668 24,213,699 Suppliers 657,486 1,538,256 1,627,813 1,693,508 Bank overdrafts 13,589,904 15,537,111 16,976,801 17,483,958 Bank loans 1,047,221 822,817 673,214 448,809 Bills payable 404 3,786,551 3,892,301 3,892,301 Bank Charge Accruals 134,952 418,222 369,483 176,266 Other Creditors 3,775,927 2,921,769 1,299,056 518,857

Equity 3,044,518 3,746,875 4,081,127 4,056,039 Capital 150,000 150,000 150,000 150,000 Additional Paid-In Capital 2,693,922 2,499,803 1,907,274 1,696,051 Retained Earnings 200,596 1,097,072 2,023,853 2,209,988



Comparative Income Statements for 2012 and 2013

An increase of almost 10% in sales reflected as almost 50% in contribution margin between both years while selling, general and administrative expenses remained the same, and interest and bank charges were cut in half. This reflected positively on the bottom line by almost quadrupling net income after eliminating the effect of reimbursements. However, it seems that these amounts appear misleading since the increase in sales, was associated with a significant buildup of both accounts receivable, and inventory. It appears that the Company's credit policy was relaxed, while the Company did not account for potential bad debts or allowance for obsolete/slow moving inventory which most likely will impact the Company's financials in future periods.


2012 2013 Sales 26,852,503 29,808,581

Cost of Sales -24,114,785 -25,854,384

Contribution Margin 2,737,718 3,954,197

Selling G&A Expenses -1,535,032 -1,470,657

Interest and Bank Charges -835,975 -418,974

Reimbursements 769,205 144,671

Other Revenues 22,764 750

Net Income 1,158,680 2,209,987



Quarterly Comparative Income Statements

The analysis of the quarterly numbers reflects a trend of a decreasing contribution margin probably as a result of higher competition.


Q1 2013 Q2 2013 Q3 2013 Q4 2013 2013

Sales 5,923,330 7,716,158 9,680,291 6,488,802 29,808,581

Cost of Sales -5,266,276 -6,372,685 -8,371,513 -5,843,910 -25,854,384

Contribution Margin 657,054 1,343,473 1,308,778 644,892 3,954,197

Selling G&A Expenses -325,071 -367,877 -395,419 -382,290 -1,470,657

Interest and Bank charges -153,373 -98,170 -40,578 -126,853 -418,974

Reimbursements 21,538 18,750 54,000 50,383 144,671

Other Revenues 450 300 0 0 750

Net Income 200,598 896,476 926,781 186,132 2,209,987



2013 Statement of Cash Flows

While bank overdrafts are treated as operating cash flows by some analysts, we believe it is more reflective if deemed as financing. Of the $10 million negative operating cash flows, $8.5 million were financed from banks in the form of short-term loans.

Statement of Cash Flows for the Year 2013

2013 Operating Cash Flows Net Income 2,209,987 Add: Gains and Losses 0 Change in Receivables -4,077,995 Change in Inventory -411,805 Change in Orders and Prepayments -2,625,140 Change in Other Debit Balances -50,854 Change in Suppliers -2,337,629 Change in Other Creditors -2,971,675 Net cash flow from operations -10,265,111

Investing Cash flows Purchase of Fixed Assets -66,795

Financing Cash Flows Change in Bank overdrafts 8,494,145 Change in Bank loans -822,817 Change in Bills Payable 3,890,747 Change in Bank Charge Accruals 176,266 Change in Equity -1,492,104

Net Cash flow from Financing Activates 10,246,237

Net Change in Cash -85,669

Beginning Cash 256,539

Ending Cash 170,870



Quarterly Comparative Cash Flow Statements

As reflected in the statement of financial position, the significant buildup was made in the first half of 2013, but except for the fourth quarter of 2013, the Company continued its reliance on cash flows from financing activities. This trend requires immediate and urgent management attention to reverse. This trend may be reversed by better management of accounts receivable, inventory, and accounts payable.

2013 Quarterly Comparative Cash Flow Statements

Q1 2013 Q2 2013 Q3 2013 Q4 2013 2013

Operating Cash Flows

Net Income 200,596 896,475 926,781 186,135 2,209,987

Add: Gains and Losses 0 0 0 0 0

Change in Receivables -612,870 -1,454,938 -1,834,275 -175,912 -4,077,995

Change in Inventory -840,616 -1,526,150 -1,058,145 3,013,106 -411,805 Change in Orders and Prepayments 124,157 -3,384,490 2,693,203 -2,058,010 -2,625,140

Change in Other Debit Balances 6,009 -15,661 1,456 -42,658 -50,854

Change in Suppliers -3,373,651 880,770 89,557 65,695 -2,337,629

Change in Other Creditors 285,395 -854,158 -1,622,713 -780,199 -2,971,675

Net Cash flow from Operations -4,210,980 -5,458,152 -804,136 208,157 -10,265,111

Investing cash flows

Purchase of Fixed Assets -45,501 -3,655 -11,355 -6,284 -66,795

Financing Cash Flows

Change in Bank Overdrafts 4,600,090 1,947,207 1,439,690 507,158 8,494,145

Change in Bank Loans -224,405 -224,405 -149,603 -224,404 -822,817

Change in Bills Payable -1,150 3,786,147 105,750 0 3,890,747

Change in Bank Charge Accruals 134,952 283,270 -48,739 -193,217 176,266

Change in Equity -494,232 -194,119 -592,529 -211,224 -1,492,104

Net Cash flow from Financing Activates 4,015,255 5,598,100 754,569 -121,687 10,246,237

Net Change in Cash -241,226 136,293 -60,922 80,186 -85,669

Beginning Cash 256,539 15,313 151,608 90,684 256,539

Ending Cash 15,313 151,608 90,684 170,870 170,870



Ratio Analysis – Liquidity Ratios

From analyzing the liquidity ratios of the Company, the aggressive management style is apparent and reflected in the ratios. The Company's current assets are only slightly bigger than its current liabilities with a current ratio of 1.14 to 1.18. However, if inventory is excluded and only cash and receivables are considered, the ratio drops to 0.56 to 0.68. Further, when the cash ratio is calculated, the ratio is almost 1%. While such ratios may generally be expected in a retail business, the Company's management is operating in an aggressive manner since any slow-down in sales and/or collections will either build-up interest expenses, thus erode potential profits and/or place the Company in a tough position with its creditors.

2013 Quarterly Ratio Analysis – Liquidity Ratios

2012 2013 Current Ratio 1.18 1.16 Quick Ratio 0.67 0.66 Cash Ratio 0.01 0.01 Working Capital 3,170,571 3,821,660

Q1 2013 Q2 2013 Q3 2013 Q4 2013 2013 Current Ratio 1.15 1.14 1.16 1.16 1.16 Quick Ratio 0.64 0.56 0.63 0.66 0.66 Cash Ratio 0.00 0.01 0.00 0.01 0.01 Working Capital 2,831,435 3,530,136 3,853,034 3,821,660 3,821,660



Ratio Analysis – Asset Management Ratios

The operating cycle (or cash-to-cash) is between 254 and 344 days. This is a relatively long cycle for a similar business especially in light of the aggressive liquidity position. It is strongly recommended that this cycle be reduced. Generally, the lower this cycle, the more effective is the Company in operating its assets, and thus the more profitable it will be.

2013 Quarterly Ratio Analysis – Asset Management Ratios

2012 2013 Inventory Turnover 3.71 3.86 Inventory Turnover - Days 97 93 Accounts Receivable Turnover 2.29 2.17 Accounts Receivable Turnover - Days 157 166 Total Assets Turnover 1.27 1.21 Accounts Payable Turnover 5.98 9.03 Accounts Payable Turnover - Days 60 40 Average Order Turnover - Days 60 60 Operating Cycle 254 280

Q1 2013 Q2 2013 Q3 2013 Q4 2013 2013 Inventory Turnover 0.76 0.79 0.89 0.69 3.86 Inventory Turnover - Days 118 114 101 130 93 Accounts Receivable Turnover 0.49 0.59 0.66 0.41 2.17 Accounts Receivable Turnover - Days 183 152 137 218 166 Total Assets Turnover 0.27 0.30 0.34 0.23 1.21 Accounts Payable Turnover 2.25 5.80 5.29 3.52 9.03 Accounts Payable Turnover - Days 40 16 17 26 40 Average Order Turnover - Days 60 60 60 60 60 Operating Cycle 321 311 281 382 280



Ratio Analysis – Debt Management Ratios

The Company's debt management ratios reflect the aggressive management style described earlier with 85% of the Company's assets financed by debt. The company is operating in a volatile economy and inventories that can easily become obsolete and should attempt to improve its debt-equity ratios. Such high ratios may impact its ability to initiate new financing.

2013 Quarterly Ratio Analysis – Debt Management Ratios

2012 2013 Debt/Equity 5.33 5.97 Debt to Assets 0.84 0.86 Times Interest Earned 2.33 5.62 Financial Leverage 0.70 0.85

Q1 2013 Q2 2013 Q3 2013 Q4 2013 2013 Debt/Equity 6.31 6.68 6.09 5.97 5.97 Debt to Assets 0.86 0.87 0.86 0.86 0.86 Times Interest Earned 1.45 9.33 24.17 1.86 5.62 Financial Leverage 0.59 0.90 0.96 0.65 0.85



Ratio Analysis – Profitability Ratios

The Company's profitability ratios are reasonable, however, because the income statement fails to consider allowances (bad debts, depreciation, and inventory), these ratios are not truly indicative of the Company's performance.

2013 Quarterly Ratio Analysis – Debt Management Ratios

2012 2013 Profit Margin on sales 10.20% 13.27%

Basic Earning Power 9.23% 9.45%

Return on Assets 5.49% 5.69%

Return on Equity 34.71% 59.78%

Residual Income - WACC 12% 758,102 1,723,263

Q1 2013 Q2 2013 Q3 2013 Q4 2013 2013 Profit Margin on sales 11.09% 17.41% 13.52% 9.94% 13.27%

Basic Earning Power 1.03% 3.59% 3.40% 0.83% 9.54%

Return on Assets 0.61% 2.25% 2.14% 0.44% 5.69%

Return on Equity 6.29% 26.40% 23.68% 4.57% 59.78%

Residual Income - WACC 12% -164,746 446,850 437,046 -300,590 1,723,263

Other Notes on the Analysis

From the numbers, it is obvious that there are no allowances that are being accounted for. In accordance with Generally Accepted Accounting Principles, the accounting process should account for the following allowances:

Allowance for doubtful debt Allowance for obsolete/slow-moving inventory Depreciation Maintenance/Warranty expenses



Liquidity Ratio Formula Answer

1. Current

2. Quick

3. Cash

4. Cash Flow

5. Working Capital



Leverage Ratio Formula Answer

1. Total Debt to Total Assets

2. Debt/Equity

3. Long-term Debt to Equity

4. Times Interest Earned

5. Earnings to Fixed Charges

6. Cash Flow to Fixed Charges

7. Financial Leverage Ratio

8. Degree of Financial Leverage



Activity Ratio Formula Answer

1. Inventory Turnover

2. Days Sales in Inventory

3. Accounts Receivable Turnover

4. Days Sales Outstanding

5. Accounts Payable Turnover

6. Days Purchases in Accounts Payable

7. Operating Cycle

8. Cash Cycle

9. Fixed Assets Turnover

10. Total Assets Turnover



Profitability Ratio Formula Answer

1. Gross Profit Margin

2. Operating Profit Margin

3. Net Profit Margin on Sales

4. Earnings Before Interest, Taxes, Depreciation, and Amortization %

5. Basic Earning Power

6. Return on Total Assets

7. Return on Operating Assets

8. Return on Common Equity



Market Ratio Formula Answer

1. Market

2. Basic Earnings Per Share

3. Diluted Earnings Per Share

4. Price/Earnings (P/E)

5. Price/EBITDA

6. Book Value Per Share

7. Market/Book

8. Dividend Payout



9. Retention

10. Earnings Yield

11. Dividend Yield

12. Shareholder Return

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