FINANCIAL STATEMENT ANALYSIS

Course Code: BI 408

JAHIDUL HASSAN JACKY

ID: 19306002
Department of Banking and Insurance, University of Chittagong
 Chapter 1
An Overview of Financial Statement Analysis
Summary:

Financial statement analysis and business analysis are critical components in evaluating
a company's economic prospects, risks, and decision-making processes. Here's a
summary of the key points from the provided text:
1. Business Analysis:
• Business analysis involves evaluating a company's environment, strategies,
financial position, and performance to make informed decisions.
• It aids in various decisions such as investment choices, credit extension, IPO
valuation, and restructuring evaluations.
• Business analysis is utilized by security analysts, investment advisors, fund
managers, and others.
• The goal of business analysis is to improve business decisions by evaluating
available information about
 a company’s financial situation,
 its management,
 its plans and strategies, and
 its business environment.

2. Types of Business Analysis:

• Credit Analysis: Assessing a company's creditworthiness and risk of default,
focusing on liquidity and solvency.
 Creditors lend funds to a company in return for a promise of repayment
with interest.
 This type of financing is temporary since creditors expect repayment of
their funds with interest.
Credit analysis focuses on downside risk instead of upside potential.
This includes analysis of both liquidity and solvency.

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  Liquidity is a company’s ability to raise cash in the short term to meet its
obligations. Liquidity depends on a company’s cash flows and the
makeup of its current assets and current liabilities.
 Solvency is a company’s long run viability and ability to pay long-term
obligations. It depends on both a company’s long-term profitability and
its capital (financing) structure.
With short-term credit, creditors are concerned with
 current financial conditions,
 cash flows, and
 the liquidity of current assets.
Long-term credit analysis includes
 projections of cash flows and
 evaluation of extended profitability (also called sustainable earning
power).
• Equity Analysis: Evaluating a company's value based on fundamental factors,
focusing on earnings quality and intrinsic value.
 Equity investors provide funds to a company in return for the risks and
rewards of ownership.
 Equity financing, also called equity or share capital, offers a cushion or
safeguard for all other forms of financing that are senior to it.
 This implies equity investors are the first to absorb losses when a
company liquidates, although their losses are usually limited to the
amount invested.
 Thus, unlike credit analysis, equity analysis is symmetric in that it must
assess both downside risks and upside potential. Because equity
investors are affected by all aspects of a company’s financial condition
and performance.
 Fundamental analysis, which is more widely accepted and applied, is the
process of determining the value of a company by analyzing and
interpreting key factors for the economy, the industry, and the
company.
A main part of fundamental analysis is evaluation of a company’s
financial position and performance.
 An investor’s strategy with fundamental analysis:
o buy when a stock’s intrinsic value exceeds its market value,
o sell when a stock’s market value exceeds its intrinsic value, and
o hold when a stock’s intrinsic value approximates its market value.

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 Other uses of business analysis include:
 Managers: Utilizing financial statements to guide strategic decisions and
analyzing competitors' financials for insight into their profitability and
risk.
 Mergers, Acquisitions, and Divestitures: Employing business analysis
during restructuring efforts such as mergers, acquisitions, divestitures,
and spin-offs.
 Financial Management: Evaluating the impact of financing decisions and
dividend policies on company value to ensure future profitability and
manage risk.
 Directors: Using business and financial statement analysis to oversee
company activities and protect shareholders' interests.
 Regulators: Applying financial statement analysis tools to audit tax
returns and verify reported amounts' reasonableness.
 Labor Unions: Utilizing financial statement analysis techniques in
collective bargaining negotiations.
 Customers: Employing analysis techniques to assess the profitability of
suppliers and estimate their profits from mutual transactions.

3. Components of Business Analysis:

• Prospective Analysis: Forecasting future payoffs to estimate company value.
• Business Environment and Strategy Analysis: Assessing economic and industry
conditions and evaluating competitive strategies.
Business environment and strategy analysis involve two key components:
1. Industry Analysis:
 Evaluates the prospects and structure of the industry, which significantly
influences a company's profitability.
 Often conducted using frameworks like Porter's Five Forces or value
chain analysis.
 Views the industry as a collection of competitors vying for bargaining
power with consumers and suppliers, facing threats from new entrants
and substitute products.
2. Strategy Analysis:
 Assesses a company's business decisions and its success in establishing a
competitive advantage.
 Involves evaluating strategic responses to the business environment and
their impact on future success and growth.
 Requires scrutiny of the company's competitive strategy regarding
product mix and cost structure.

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 • Accounting Analysis: Evaluating the quality of financial reporting and assessing
earnings quality and persistence.
1. Purpose: Evaluates how accurately a company's accounting reflects
economic reality.
2. Process: Studies transactions, assesses accounting policies' impact, and
adjusts statements for better analysis.
3. Reliability: Quality of financial analysis depends on the reliability of
financial statements.
4. Issues: Accounting standards may not always meet individual needs,
leading to comparability problems and accounting distortions.
5. Accounting Risk: Distortions create accounting risk, which accounting
analysis aims to reduce.
6. Factors Evaluated: Considers factors like business operations,
accounting policies, information disclosure, management performance,
and earnings persistence.

• Financial Analysis: Analyzing financial position, performance, profitability, risk,

and sources and uses of funds.
Financial analysis involves using financial statements to assess a company's
position, performance, and future prospects. It focuses on two main sets of
questions: future-oriented and track record-based. Key areas of financial
analysis include:
1. Profitability Analysis:
 Evaluates return on investment, sources of profits, margins, turnover,
and sustainability of earnings.
2. Risk Analysis:
 Assesses a company's ability to meet commitments, including solvency,
liquidity, earnings variability, and risk to creditors and equity holders.
3. Analysis of Sources and Uses of Funds:
 Evaluates how a company obtains and deploys its funds, providing
insights into future financing implications.

4. Business Activities:
• Planning Activities: Setting goals, strategies, and financial projections.
• Financing Activities: Raising funds through equity or debt.
• Investing Activities: Acquiring and maintaining assets for operations or
investments.
• Operating Activities: Carrying out the business plan and generating earnings.
5. Tools of Financial Statement Analysis:
• Comparative Financial Statement Analysis: Reviewing changes in financial
statements over time.

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 Comparative financial statement analysis, also known as horizontal analysis,
involves reviewing consecutive financial statements to identify changes over
time. Two popular techniques are:
1. Year-to-Year Change Analysis:
 Compares financial statements over short periods, typically two to three
years.
 Analyzes changes in individual account balances, presenting both
absolute dollar amounts and percentages.
2. Index-Number Trend Analysis:
 Useful for long-term trend comparisons.
 Involves selecting a base period with a preselected index number usually
set to 100, providing a frame of reference for comparisons.

• Common-Size Financial Statement Analysis: Expressing accounts as

percentages of total assets or sales.

Common-size financial statement analysis, also known as vertical analysis:

1. Balance Sheet Analysis:
 Total assets (or liabilities plus equity) are expressed as 100%.
 Accounts within these groupings are then expressed as a percentage of
their respective total.
2. Income Statement Analysis:
 Sales are typically set at 100%.
 Remaining income statement accounts are expressed as a percentage of
sales.

• Ratio Analysis: Assessing the mathematical relation between key financial

quantities.
A ratio expresses a mathematical relation between two quantities. A ratio of
200 to 100 is expressed as 2:1, or simply 2.
To be meaningful, a ratio must refer to an economically important relation.
• Cash Flow Analysis: Evaluating sources and uses of funds and cash flow
forecasting.
Cash flow analysis is primarily used as a tool to evaluate the sources and uses
of funds.
Cash flow analysis provides insights into how a company is obtaining its
financing and deploying its resources.
It also is used in cash flow forecasting and as part of liquidity analysis.
• Valuation Models: Estimating intrinsic value based on present value theory.
Valuation normally refers to estimating the intrinsic value of a company or its
stock.

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 The basis of valuation is present value theory.
This theory states the value of a debt or equity security is equal to the sum of
all expected future payoffs from the security that are discounted to the
present at an appropriate discount rate.
Present value theory uses the concept of time value of money
Overall, thorough analysis of financial statements and business conditions is essential
for making well-informed decisions in various aspects of business management and
investment.

BOOK Questions

1. Describe business analysis and identify its objectives. @

Ans:
Business analysis is the process of evaluating a company’s economic prospects and
risks. This includes analyzing a company’s
1. Business environment: (this refers to the external factors that can impact a
company's operations and performance. Such as market trends, regulatory
environment, industry competition, technological advancements, and economic
conditions.)
2. Strategies: (this involves assessing the plans and actions implemented by a company
to achieve its objectives. It includes evaluating the company's competitive positioning,
marketing strategies, product development plans, expansion strategies, and risk
management approaches.)
3. Financial position and performance: (This entails analyzing a company's financial
statements, including the balance sheet, income statement, and cash flow statement. It
involves assessing key financial metrics such as profitability, liquidity, solvency,
efficiency, and growth rates to understand the company's financial health and
performance over time.)

Business analysis is useful in a wide range of business decisions such as:

Investment Choices: It helps in determining whether to invest in equity (stocks) or debt

securities (bonds or loans).
Credit Extension: It assists in deciding whetherto extend credit through short- or long-
term loans.
Valuation for IPO: It assists in determining how to value a business in an initial public
offering (IPO), and
Restructuring Evaluations: It supports in deciding how to evaluate restructurings
including mergers, acquisitions, and divestitures.

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2. Explain the claim: Financial statement analysis is an integral part of business
analysis.@
Ans:
The claim that financial statement analysis is an integral part of business analysis is true
because financial statements provide crucial information about a company's financial
health and performance, which is essential for making informed business decisions.
Here's why:
a. Financial statement analysis reduces reliance on hunches, guesses,
and intuition for business decisions.
b. It decreases the uncertainty of business analysis.
3. It does not lessen the need for expert judgment but, instead, provides a
systematic and effective basis for business analysis.

3. Describe the different types of business analysis. Identify the category of users of
financial statements that applies to each different type of business analysis. @
Ans:
Financial statement analysis is an important and integral part of business analysis. The
goal of business analysis is to improve business decisions by evaluating available
information about a company’s financial situation, its management, its plans and
strategies, and its business environment.
These business decisions extend to
 equity and debt valuation,
 credit risk assessment,
 earnings predictions,
 audit testing,
 compensation negotiations, and
 countless other decisions
The major types of business analysis are:
Credit Analysis: YQ
Credit analysis is the evaluation of the creditworthiness of a company.
Creditworthiness is the ability of a company to honor its credit obligations.
The main focus of credit analysis is on risk, not profitability.
Credit analysis focuses on downside risk instead of upside potential.
This includes analysis of both liquidity and solvency.
Liquidity is a company’s
ability to raise cash in the short term to meet its obligations. Liquidity depends on a
company’s cash flows and the makeup of its current assets and current liabilities.

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Solvency is a company’s
long run viability and ability to pay long-term obligations. It depends on both a
company’s long-term profitability and its capital (financing) structure.

Equity Analysis:
Equity analysis involves evaluating a company's value as an investment opportunity for
shareholders. It assesses both downside risks and upside potential, considering factors
such as the economy, industry, and company performance. Fundamental analysis is a
key method, aiming to determine intrinsic value by forecasting earnings or cash flows
and assessing risk through a comprehensive analysis of the company's business
prospects and financial statements.

Other Uses of Business Analysis

Business analysis is utilized by various stakeholders for different purposes:
1. Managers use financial statement analysis to identify strategic changes and evaluate
competitors' profitability and risk.
2. During mergers, acquisitions, divestitures, and spin-offs, business analysis aids in
restructuring operations.
3. Financial management relies on business analysis to assess the impact of financing
decisions and dividend policies on company value.
4. Directors utilize business and financial statement analysis to oversee company
activities and protect shareholders' interests.
5. Regulators, like the IRS, apply financial statement analysis tools to audit tax returns
and ensure reported amounts are reasonable.
6. Labor unions use financial statement analysis techniques in collective bargaining
negotiations.
7. Customers utilize analysis techniques to determine the profitability of suppliers and
estimate mutual transaction profits.

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4. What are the main differences between credit analysis and equity analysis? How do
these impact the financial statement information that is important for each type of
analysis?
Ans:

The main differences between credit analysis and equity analysis lie in their objectives,
perspectives, and focus areas:
1. Objective:
• Credit analysis focuses on assessing the creditworthiness of a company,
primarily evaluating its ability to repay debts and meet financial obligations.
• Equity analysis aims to determine the intrinsic value of a company's stock,
focusing on assessing the potential for future growth and profitability.
2. Perspective:
• Credit analysis is primarily concerned with downside risk, emphasizing the
preservation of capital and the ability to meet debt obligations.
• Equity analysis considers both downside risks and upside potential, aiming to
identify opportunities for capital appreciation and maximizing returns on
investment.
3. Focus Areas:
• Credit analysis emphasizes factors such as liquidity (short-term cash
availability), solvency (long-term viability), and the ability to generate stable
cash flows to cover debt repayments.
• Equity analysis focuses on evaluating a company's growth prospects,
competitive position, management quality, and the sustainability of earnings
and cash flows.
These differences impact the financial statement information that is important for each
type of analysis:
• For credit analysis, financial statements provide crucial information on a company's
liquidity position (current assets vs. current liabilities), leverage ratios (debt-to-equity
ratio), cash flow generation, and debt service coverage ratios. Key financial ratios
such as the current ratio, quick ratio, and interest coverage ratio are essential
indicators of a company's ability to meet its debt obligations.
• In equity analysis, financial statements are analyzed to assess the company's revenue
growth, profit margins, return on equity (ROE), earnings per share (EPS), and other
performance metrics. Investors focus on understanding the drivers of future earnings
growth, evaluating the company's competitive advantages, and assessing the quality
of management. Additionally, balance sheet items such as retained earnings and
shareholder equity are crucial for estimating the company's intrinsic value.
Overall, while both credit analysis and equity analysis utilize financial statement
information, they interpret it differently based on their distinct objectives and

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 perspectives, emphasizing different aspects of a company's financial health and
performance.

5. What is fundamental analysis? What is its main objective?

Ans:
Fundamental analysis is a method used to determine the intrinsic value of a company's
stock by evaluating its financial health, business prospects, industry conditions, and
macroeconomic factors. Its main objective is to identify stocks that are undervalued or
overvalued relative to their intrinsic worth, helping investors make informed decisions
on buying, selling, or holding stocks.

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6. What are the various component processes in business analysis? Explain with
reference to equity analysis. @@
Ans:

Let’s delve into the various component processes in business analysis, particularly in
the context of equity analysis.
1. Business Environment and Strategy Analysis:
o This initial step involves evaluating the overall business landscape and the
specific strategies employed by a company.
o It helps understand how external factors (such as market conditions,
regulations, and economic trends) and internal plans (such as company goals
and competitive positioning) influence a company’s performance.
o Analysis of the business environment seeks to identify
and assess a company’s economic and industry circumstances. This includes
analysis of its product, labor, and capital markets.
o Analysis of business strategy seeks to identify and assess a company’s
competitive strengths and weaknesses along with its opportunities and
threats.
o Business environment and strategy analysis requires knowledge of
 both economic and industry forces.
 strategic management,
 business policy,
 production,
 logistics management,
 marketing, and
 managerial economics.

2. Industry Analysis:
o Here, we assess the industry in which a company operates. This includes:
 Analyzing industry trends.

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  Studying the competitive landscape.
 Understanding regulatory dynamics.
 Identifying growth opportunities and risks.
o Industry analysis provides context for evaluating individual companies within
the sector.
3. Accounting Analysis:
o In this process, we review and analyze a company’s financial statements to
ensure they are accurate and provide a true representation of the firm’s
financial health.
o Key aspects include assessing accounting policies, recognizing revenue, and
understanding cost structures.
4. Financial Analysis:
o Financial analysis encompasses evaluating a company’s financial data to assess
its performance and predict future trends. It includes:
 Profitability Analysis: Examining how profitable the company is.
 Analysis of Cash Flows: Assessing how cash is generated and used by the
business.
 Risk Analysis: Evaluating potential risks that could impact financial
performance.
o These analyses contribute to estimating the cost of capital, which helps
determine the intrinsic value of a company during equity evaluation.
5. Prospective Analysis:
o This step involves predicting future financial performance based on current
data and trends.
o Equity analysts use various models (such as discounted cash flow or
comparable company analysis) to estimate future earnings and growth
prospects.
6. Financial Statement Analysis:
o Here, we dive deeper into a company’s financial statements (income
statement, balance sheet, and cash flow statement).
o We analyze ratios, trends, and key financial metrics to gain insights into the
company’s financial health.
Remember, successful business analysis can generate more revenue, spur growth, and
streamline business operations. It’s a dynamic process that requires continuous review
and adaptation to stay effective.

7. Describe the importance of accounting analysis for financial analysis. @

Ans:
Accounting analysis plays a crucial role in financial analysis by providing a
comprehensive evaluation of a company's financial statements. Firstly, it helps in
assessing the reliability and accuracy of financial information, ensuring that the data

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 used for analysis is credible and transparent. Secondly, accounting analysis allows for
the adjustment of financial statements to better reflect the underlying economic
realities, reducing distortions and enhancing comparability across companies and time
periods. Additionally, it aids in identifying any potential accounting manipulations or
irregularities, thereby mitigating risks associated with misleading financial reporting.
Moreover, accounting analysis facilitates the evaluation of a company's earnings quality
and persistence, which are essential for understanding its long-term financial
performance and sustainability. Overall, accounting analysis acts as a foundation for
financial analysis, providing essential insights into a company's financial health and
enabling informed investment decisions.

8. Describe financial statement analysis and identify its objectives.

Ans:
Financial statement analysis involves examining a company's financial statements to
assess its financial performance, position, and potential for future growth. The primary
objectives of financial statement analysis are:
1. Assessing Financial Performance: Analyzing financial statements helps stakeholders
evaluate how well a company has performed over a specific period, typically
assessing profitability, efficiency, and liquidity.
2. Evaluating Financial Position: Financial statement analysis aids in understanding a
company's financial health by assessing its assets, liabilities, and equity. This
evaluation helps stakeholders gauge solvency, leverage, and overall financial stability.
3. Predicting Future Performance: By analyzing historical financial data, stakeholders
can make informed projections about a company's future performance and potential
growth prospects.
4. Comparing Performance: Financial statement analysis facilitates comparisons
between different companies, industries, or time periods, enabling stakeholders to
benchmark performance and identify trends or outliers.
5. Assessing Risk: Understanding a company's financial statements allows stakeholders
to assess various risks, including credit risk, operational risk, and market risk, which
are crucial for making investment or lending decisions.

9. Identify at least five different internal and external users of financial statements.
Ans:
Here are at least five different internal and external users of financial statements:
1. Internal Users:
• Management: Executives, managers, and internal departments within the
company use financial statements to assess the company's performance, make
strategic decisions, and plan for future operations.

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 • Employees: Employees may use financial statements to evaluate the
company's financial health, stability, and performance, which can impact
decisions related to employment, compensation, and career development.
• Board of Directors: The board of directors relies on financial statements to
monitor the company's financial performance, ensure compliance with
regulations, and provide oversight and strategic guidance to management.
• Investment Committees: In larger organizations or investment firms,
specialized committees responsible for making investment decisions may use
financial statements to evaluate potential investments, assess risks, and
allocate capital.
• Internal Auditors: Internal auditors review financial statements to ensure
accuracy, compliance with internal controls, and adherence to accounting
standards and company policies.
2. External Users:
• Investors: External investors, including individual investors, institutional
investors, and venture capitalists, use financial statements to assess the
company's financial health, growth prospects, and potential returns on
investment.
• Creditors: Banks, financial institutions, and other creditors analyze financial
statements to evaluate the company's creditworthiness, assess the risk of
lending money or extending credit, and determine appropriate interest rates
and terms.
• Regulators: Government agencies, regulatory bodies, and tax authorities rely
on financial statements to monitor compliance with laws and regulations,
assess the company's financial stability, and ensure transparency and
accountability.
• Suppliers and Vendors: Suppliers and vendors may review financial statements
to evaluate the company's ability to pay bills and fulfill contractual obligations,
which can impact decisions related to extending credit, negotiating terms, and
entering into agreements.
• Customers: Customers may use financial statements to assess the financial
stability and reliability of the company as a business partner, which can
influence purchasing decisions, long-term contracts, and brand loyalty.

10. Identify and discuss the four major activities of a business enterprise. @
Ans:
A business enterprise typically engages in four major activities:
1. Planning Activities:
A company’s goals and objectives are captured in a business plan that describes the
company’s purpose, strategy, and tactics for its activities.
Business Plan aids

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  Analysis of a company’s current and future prospects;
 Analysis of business environment and strategy
2. Financing Activities:
Financing activities refer to methods that companies use to raise the money.
There are two main sources of external financing –
• Equity investors (also called owners or shareholders);
• Creditors (lenders).

3. Investing Activities:
Investing activities refer to a company’s acquisition and maintenance of investments
 for purposes of selling products and providing services, and
 for the purpose of investing excess cash.
Investments in land, buildings, equipment, legal rights (patents, licenses, copyrights),
inventories, human capital, information systems, and similar assets are for the
purpose of conducting the company’s business operations.
Such assets are called operating assets.
Also, companies often temporarily or permanently invest excess
Cash in securities such as other companies’ equity stock, corporate and government
bonds, and money market funds.
Such assets are called financial assets.

 Investments in short-term assets are called current assets.

 Investments in long-term assets are called noncurrent assets.

4. Operating Activities:
Operating activities represent the “carrying out” of the business plan given its
financing and investing activities.
Operating activities involve at least five possible components: research and
development, procurement, production, marketing, and administration.
 Operating activities are a company’s primary source of earnings.
 Operating activities determine the company’s success or failure.

11. Explain how financial statements reflect the business activities of a company.
Ans:
Financial statements serve as a comprehensive summary of a company's business
activities, providing valuable insights into its financial performance, position, and cash
flows. Each component of the financial statements reflects different aspects of the
company's operations:
Income Statement: The income statement reflects the company's profitability over a
specific period by detailing revenues, expenses, and net income. Revenue represents

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 the amount earned from selling goods or services, while expenses encompass the costs
incurred in generating revenue, such as production costs, operating expenses, and
taxes. Net income indicates the company's overall profitability after accounting for all
expenses.
Balance Sheet: The balance sheet provides a snapshot of the company's financial
position at a given point in time, detailing its assets, liabilities, and equity. Assets
represent the resources owned or controlled by the company, including cash, inventory,
property, and equipment. Liabilities encompass the company's obligations, such as
debts, loans, and accounts payable. Equity reflects the company's ownership interests,
including common stock, retained earnings, and additional paid-in capital.
Cash Flow Statement: The cash flow statement tracks the inflows and outflows of cash
during a specific period, categorizing cash flows into operating, investing, and financing
activities. Operating activities represent the company's core business operations,
including cash received from customers and cash paid for expenses. Investing activities
involve the purchase or sale of long-term assets, while financing activities include
raising capital or repaying debts.
By analyzing these financial statements, stakeholders can gain a comprehensive
understanding of the company's business activities, financial health, and performance,
enabling informed decision-making and strategic planning.

12. Identify and discuss the four primary financial statements of a business.
Ans:

The four primary financial statements of a business provide a comprehensive overview

of its financial performance, position, and cash flows:
1. Income Statement: Also known as the profit and loss statement, the income
statement summarizes the company's revenues, expenses, and net income (or loss)
over a specific period, typically a month, quarter, or year. It showcases the
company's ability to generate profits from its core operations by detailing sales, cost
of goods sold, operating expenses, and taxes.
2. Balance Sheet: The balance sheet presents a snapshot of the company's financial
position at a specific point in time, usually the end of a reporting period. It consists of
three main sections: assets, liabilities, and shareholders' equity. Assets represent
what the company owns, including cash, inventory, property, and equipment.
Liabilities are the company's obligations, such as debts, loans, and accounts payable.
Shareholders' equity reflects the company's net worth, representing the difference
between assets and liabilities.
3. Cash Flow Statement: The cash flow statement tracks the inflows and outflows of
cash and cash equivalents during a specific period, categorizing cash flows into three
main activities: operating, investing, and financing. Operating activities include cash
receipts and payments related to the company's core business operations. Investing

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 activities involve cash flows from buying or selling long-term assets. Financing
activities include cash flows from issuing or repurchasing stock, issuing or repaying
debt, and paying dividends.
4. Statement of Changes in Equity: Also known as the statement of shareholders'
equity, this statement details changes in the company's equity over a specific period,
including changes in share capital, additional paid-in capital, retained earnings, and
other comprehensive income. It provides insights into how the company's equity
position has evolved over time due to factors such as net income, dividends, share
issuances, and stock repurchases.

13. Explain why financial statements are important to the decision-making process in
financial analysis. Also, identify and discuss some of their limitations for analysis
purposes. Y
Ans:
Financial statements are crucial in the decision-making process of financial analysis
because they provide valuable insights into a company's financial health, performance,
and prospects. Investors, creditors, and other stakeholders rely on financial statements
to assess profitability, liquidity, solvency, and growth potential, aiding in investment,
lending, and operational decisions. However, financial statements have limitations that
can hinder analysis. These include:
1. Comparability Problems: Differences in accounting standards and practices between
companies can lead to comparability problems. When companies adopt different
accounting methods for similar transactions, it becomes challenging to compare their
financial performance accurately. Moreover, changes in accounting methods over
time further complicate analysis, as historical data may not be directly comparable to
current information.
2. Accounting Distortions: Discretion and imprecision in accounting can distort financial
statement information, leading to discrepancies between reported figures and the
underlying economic reality. Managerial estimates are prone to errors or biases,
potentially skewing financial results. Additionally, managers may engage in earnings
management tactics, such as income smoothing or aggressive revenue recognition, to
manipulate financial statements for favorable presentation. Furthermore, accounting
standards may fail to capture economic realities accurately, resulting in distortions
that hinder meaningful analysis.

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14. Identify at least seven additional sources of financial reporting information (beyond
financial statements) that are useful for analysis.
Ans:
Beyond financial statements, additional sources of financial reporting information
useful for analysis include:
1. Management Discussion and Analysis (MD&A): Provides insights into management's
perspective on financial performance and future prospects.
2. Footnotes to Financial Statements: Offers detailed explanations and additional
information on accounting policies, assumptions, and contingent liabilities.
3. Annual Reports: Provides a comprehensive overview of the company's operations,
strategy, and performance.
4. Quarterly Earnings Releases: Offers interim updates on financial performance and
key metrics.
5. Auditor's Reports: Provides assurance on the accuracy and reliability of financial
statements.
6. Proxy Statements: Discloses executive compensation, governance practices, and
shareholder proposals.
7. Press Releases and News Articles: Offer market updates, company announcements,
and industry insights.

15. Identify and discuss at least two areas of financial analysis.

Ans:
Two areas of financial analysis are profitability analysis and liquidity analysis.
1. Profitability Analysis: Evaluates a company's ability to generate profits relative to its
expenses and investments. Key metrics include gross profit margin, net profit margin,
return on assets (ROA), and return on equity (ROE).
2. Liquidity Analysis: Assesses a company's ability to meet short-term financial
obligations. Common ratios include the current ratio and the quick ratio, which
measure the company's ability to cover current liabilities with its current assets,
excluding inventory.

16. Identify and describe at least five categories of financial analysis tools. @
Ans:
Analysis Tools
1. Comparative financial statement analysis
2. Common-size financial statement analysis
3. Ratio analysis
4. Cash flow analysis
5. Valuation

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1. Comparative Financial Statement Analysis
Individuals conduct comparative financial statement analysis by reviewing consecutive
balance sheets, income statements, or statements of cash flows from period to period.

 Comparative financial statement analysis also is referred to as horizontal analysis.

This usually involves a review of changes in individual account balances on a year-to-
year or multiyear basis.
 Two techniques of comparative analysis are especially popular:
i. Year-to-year change analysis and
ii. Index-number trend analysis.
Year-to-Year Change Analysis:
 Comparing financial statements over relatively short time periods –
two to three years.
 Analysis of year-to-year changes in individual accounts.
 It has the advantage of presenting changes in absolute dollar amounts as well as
in percentages.
Index-Number Trend Analysis:
 A useful tool for long-term trend comparisons is index- number
trend analysis.
 Trend analysis requires choosing a base period, for all items, with a preselected
index number usually set to 100.
 Because the base period is a frame of reference for all comparisons, it is best to
choose a normal year with regard to business conditions.

2. Common-Size Financial Statement Analysis/ vertical analysis

In analyzing a Balance Sheet,
 It is common to express total assets (or liabilities plus equity) as 100%.
 Then, accounts withinthese groupings are expressed as a
percentage of their respective total.
In analyzing an Income Statement,
 Sales are often set at 100%
 Remaining income statement accounts expressed as a percentage of sales.

3. Ratio Analysis
A ratio expresses a mathematical relation between two quantities. A ratio of 200 to
100 is expressed as 2:1, or simply 2.
To be meaningful, a ratio must refer to an economically important relation.

4. Cash Flow Analysis

Cash flow analysis is primarily used as a tool to evaluate the
sources and uses of funds.

JH JACKY 19
 Cash flow analysis provides insights into how a company is obtaining its financing and
deploying its resources. It also is used in cash flow forecasting and as part of liquidity
analysis.

5. Valuation Models
Valuation normally refers to estimating the intrinsic value of a company or its stock.
The basis of valuation is present value theory.
This theory states the value of a debt or equity security is equal to the sum of all
expected future payoffs from the security that are discounted to the present at an
appropriate discount rate.
Present value theory uses the concept of time value of money

17. Comparative analysis is an important tool in financial analysis.

a. Explain the usefulness of comparative financial statement analysis.
b. Describe how financial statement comparisons are effectively made.
c. Discuss the necessary precautions an analyst should take in performing
comparative analysis.
Ans:
a. Usefulness of Comparative Financial Statement Analysis: Comparative financial
statement analysis helps in understanding trends, changes, and performance over time.
By comparing financial data across multiple periods, analysts can identify patterns,
assess growth rates, and evaluate the effectiveness of management strategies. It
provides insights into areas of improvement, highlights potential risks, and aids in
making informed decisions regarding investment, lending, and strategic planning.
b. Effectively Making Financial Statement Comparisons: Financial statement
comparisons are effectively made by organizing data in a structured manner, using
common-size or percentage change formats, and focusing on key financial metrics.
Analysts should identify significant changes, outliers, and trends, and consider factors
such as seasonality, industry benchmarks, and economic conditions.
c. Precautions in Performing Comparative Analysis: Analysts should ensure consistency
in accounting methods, adjust for any extraordinary items or non-recurring events, and
consider the impact of inflation or currency fluctuations. It's essential to use reliable
and accurate data, verify the integrity of financial statements, and consider qualitative
factors that may influence performance. Additionally, analysts should avoid making
conclusions based solely on numerical changes and consider the broader context and
underlying reasons for observed trends.

JH JACKY 20
18. Common-size analysis is an important tool in financial analysis.
a. Describe a common-size financial statement. Explain how one is prepared.
b. Explain what a common-size financial statement report communicates about a
company.
Ans:
a. Common-Size Financial Statement: A common-size financial statement expresses
each line item as a percentage of a base figure, typically total revenue for the income
statement or total assets for the balance sheet. To prepare a common-size financial
statement, each line item is divided by the base figure and multiplied by 100 to obtain
the percentage representation. This standardizes the financial statement, making it
easier to compare the relative proportions of different components over time or across
companies.
b. Communication of Common-Size Financial Statement: A common-size financial
statement report highlights the relative composition of different line items within the
financial statements. It provides insights into the proportion of revenues, expenses,
assets, liabilities, or equity relative to the base figure, facilitating comparisons and
identifying trends or areas of concern in the company's financial structure or
performance.

JH JACKY 21
 Chapter 2
Analyzing Financing Activities
Chapter outline

Chapter Summary:

Introduction:
Business activities are financed with liabilities or equity. Liabilities are financing
obligations requiring future payment, typically senior to equity. They can be financing
(e.g., notes, bonds) or operating (e.g., trade creditors). Equity represents owners' claims
on net assets, subordinate to liabilities.

• Business activities are financed with liabilities or equity, or a combination of both.

• Liabilities represent financing obligations requiring future payment, whether in
money, services, or other assets.
• They represent outsiders' claims against a company's present and future assets and
resources.
• Liabilities can be categorized as either financing or operating, typically senior to
equity holders.
• Financing liabilities encompass credit financing forms like long-term notes, bonds,
short-term borrowings, and leases.
• Operating liabilities arise from operational activities such as trade creditors and
postretirement obligations.

Reporting Liabilities and Equity:

• Liabilities are commonly reported as current or noncurrent, based on their due date.
• Current liabilities are obligations due within one year, while noncurrent liabilities
extend beyond a year.
• Equity denotes owners' claims on the net assets of the company, junior to creditors
but entitled to residual returns.
Risk and Return:
JH JACKY 22
• Equity holders bear the maximum risk associated with a company but also enjoy all
residual returns.
This structure provides a clear overview of the distinctions between liabilities, equity,
and their respective roles in financing and ownership within a business.

Current Liabilities:
Settlement requires current assets or incurrence of another liability. Examples include
taxes payable, accounts payable, and short-term borrowings.

Definition and Settlement:

• Current liabilities are obligations that require the use of current assets or the creation
of another current liability for settlement.
• Settlement period is the longer of one year or the operating cycle.
• Recorded at maturity value, not present value, due to their short settlement period.
Types of Current Liabilities:
1. Operating Activities:
• Taxes payable: Taxes owed to governmental authorities.
• Unearned revenues: Revenue received in advance for goods or services not yet
provided.
• Advance payments: Payments received in advance for future deliveries or
services.
• Accounts payable: Amounts owed to suppliers for purchases of goods or
services on credit.
• Other accruals of operating expenses: Accrued expenses such as wages
payable, utilities payable, etc.
2. Financing Activities:
• Short-term borrowings: Loans or credit arrangements with maturity within one
year.
• Current portion of long-term debt: Portion of long-term debt due within one
year.
• Interest payable: Accrued interest on outstanding debt obligations.
These classifications help categorize current liabilities based on their origin and purpose
within the company's operations and financing activities.

Noncurrent Liabilities:
Mature in over one year (or operating cycle). Includes loans, bonds, with detailed
disclosure requirements.

Definition and Characteristics:

JH JACKY 23
• Noncurrent liabilities, also known as long-term liabilities, are obligations with a
maturity period exceeding one year or the operating cycle if longer.
• Examples include loans, bonds, debentures, and long-term notes.
Assessment and Measurement:
• Assessment and measurement of noncurrent liabilities involve disclosing all relevant
restrictions and covenants associated with these obligations.
• Common disclosures include details about interest rates, maturity dates, conversion
privileges, call features, and subordination provisions.
• These disclosures provide transparency and insight into the terms and conditions
governing the noncurrent liabilities, helping stakeholders understand the company's
long-term financial commitments and obligations.

Analyzing Liabilities:
Auditors and double-entry accounting assure liabilities recording accuracy. Important
features for analysis include terms, restrictions, and dilutive features.

1. Sources of Assurance:
• Auditors play a crucial role in verifying the identification and measurement of
liabilities through various techniques:
• Direct confirmation: Auditors directly confirm the existence and terms of
liabilities with relevant parties.
• Review of board minutes: Auditors review board meeting minutes to
identify any discussions or decisions related to liabilities.
• Reading of contracts and agreements: Auditors examine contracts and
agreements to understand the terms and conditions of liabilities.
• Questioning knowledgeable individuals: Auditors question individuals
familiar with company obligations to gain insights into liabilities.
2. Double-Entry Accounting:
• Double-entry accounting ensures that every asset, resource, or cost acquired
has a corresponding entry for the obligation or resource expended.
• While double-entry accounting provides a systematic approach to recording
transactions, it does not address commitments and contingent liabilities,
requiring reliance on other sources for analysis.
3. Analysis of Commitments and Contingent Liabilities:
• Analysis often relies on notes to financial statements and management
commentary in annual reports to assess commitments and contingent
liabilities.
• Accuracy and reasonableness of debt amounts can be verified by reconciling
them to disclosures for interest expense and interest paid in cash.
4. Impact of Understated Liabilities:

JH JACKY 24
 • Understated liabilities may lead to an overstatement in income due to lower or
delayed expenses, impacting the accuracy of financial statements.
• Descriptions of liabilities, along with their terms, conditions, and
encumbrances, should be analyzed to understand their implications fully.
5. Key Features in Analyzing Liabilities:
• Terms of indebtedness: Key terms include maturity, interest rate, payment
pattern, and amount.
• Restrictions on deploying resources: Understanding restrictions related to
pursuing business activities is essential.
• Ability and flexibility in pursuing further financing: Assessing the company's
capacity to obtain additional financing is crucial.
• Obligations for working capital and debt to equity: Analyzing these financial
figures provides insights into the company's financial health.
• Dilutive conversion features: Understanding features that may dilute
ownership or value of existing shares is important.
• Prohibitions on disbursements: Restrictions on dividend payments can impact
cash flow and shareholder returns.

Leases:
Leases involve lessor-lessee agreements, categorized as capital or operating leases.
Capital leases recognize assets and liabilities; operating leases don't.

A lease is a contractual agreement between a lessor (owner) and a lessee (user),

granting the lessee the right to use an asset owned by the lessor for a specified period.
In exchange, the lessee makes rental payments known as minimum lease payments
(MLP).
Alternative Methods for Lease Accounting:
1. Capital Lease:
• A capital lease transfers substantially all the benefits and risks of ownership
from the lessor to the lessee.
• For the lessee, a capital lease is treated as an asset acquisition and a liability
incurrence.
• Similarly, for the lessor, it's treated as a sale and financing transaction.
• Both the leased asset and the lease obligation are recognized on the lessee's
balance sheet if classified as a capital lease.
2. Operating Lease:
• In operating leases, the lessee accounts for the minimum lease payments as
rental expenses/revenue.
• No asset or liability is recognized on the lessee's balance sheet.

JH JACKY 25
 • Operating leases allow lessees to structure leases to appear as operating
leases, even if economically they resemble capital leases.
• This practice allows lessees to engage in off-balance-sheet financing, where
neither the leased asset nor its corresponding liability is recorded on the
balance sheet, despite the transfer of many ownership benefits and risks to the
lessee.
In summary, the choice between capital and operating leases affects how assets and
liabilities are recognized on the lessee's balance sheet. Capital leases result in
recognition of both assets and liabilities, while operating leases do not. Off-balance-
sheet financing can occur with operating leases, as assets and liabilities related to the
lease are not recorded on the lessee's balance sheet, potentially impacting financial
ratios and analysis.

Lease Classification and Reporting:

A lessee classifies and accounts for a lease as a capital lease if, at its inception, the lease
meets any of four criteria:
1. Transfer of Ownership: The lease transfers ownership of the property to the lessee
by the end of the lease term.
2. Bargain Purchase Option: The lease contains an option to purchase the property at a
bargain price.
3. Term Length: The lease term is 75% or more of the estimated economic life of the
property.
4. Present Value of MLPs: The present value of the minimum lease payments (MLPs) at
the beginning of the lease term is 90% or more of the fair value of the leased
property.
When a lease is classified as a capital lease:
• The lessee records both the asset and liability at an amount equal to the present
value of the minimum lease payments over the lease term (excluding executory costs
such as insurance, maintenance, and taxes paid by the lessor included in the MLP).
• The leased asset is depreciated following the lessee's normal depreciation policy.
• Interest expense is accrued on the lease liability, similar to any other interest-bearing
liability.
For an operating lease:
• The lessee charges rentals (MLPs) to expense as they are incurred.
• No asset or liability is recognized on the balance sheet.
The accounting rules mandate that all lessees disclose:
1. Future minimum lease payments separately for capital leases and operating leases
for each of the five succeeding years and the total amount thereafter.
2. Rental expense for each period that an income statement is reported.

JH JACKY 26
These disclosures provide transparency regarding a company's lease obligations and
their impact on future cash flows and financial performance.

Analyzing Leases:
Operating leases understate liabilities and assets, affecting solvency ratios. They delay
expense recognition, affecting income and liquidity ratios.

Impact of Operating Leases:

Accounting standards provide alternative methods to reflect differences in lease
transactions' economics effectively. However, lessees often classify lease contracts as
operating leases, which can have several impacts on financial statements:
1. Reduced Usefulness of Financial Statements:
• The prevalence of operating leases reduces the comparability of financial
statements across companies, affecting analysts' ability to assess performance
and financial position accurately.
2. Understated Liabilities:
• Operating leases keep lease financing off the balance sheet, resulting in
understated liabilities. This can distort the company's financial position and
leverage ratios.
3. Positive Impact on Solvency Ratios:
• The exclusion of operating lease liabilities from the balance sheet can
artificially improve solvency ratios like debt-to-equity, potentially leading to
misinterpretations of the company's financial health.
4. Understated Assets:
• Since operating lease assets are not recognized on the balance sheet, they
understate total assets. This inflation can affect metrics like return on
investment and asset turnover ratios, providing a skewed view of the
company's efficiency.
5. Delayed Expense Recognition:
• Operating leases delay expense recognition compared to capital leases. This
delay leads to an overstatement of income in the early stages of the lease but
results in an understatement of income in the later stages, affecting
profitability analysis.
6. Understated Current Liabilities:
• By excluding the current portion of lease payments from the balance sheet,
operating leases understate current liabilities. This inflation can distort liquidity
ratios such as the current ratio, potentially misleading stakeholders about the
company's short-term financial obligations.
7. Inflation of Interest Coverage Ratios:
• Operating leases include interest within lease rentals, understating both
operating income and interest expense. This inflation artificially boosts interest

JH JACKY 27
 coverage ratios like times interest earned, potentially masking the company's
true financial health.
Understanding these impacts is crucial for analysts to make informed decisions and
adjustments when assessing a company's financial statements and performance.

Postretirement Benefits:
Postretirement benefits come in two forms:
1. Pension benefits, where the employer promises monetary benefits to the employee
after retirement, and
2. Other postretirement employee benefits (OPEB), where the employer provides other
(usually nonmonetary) benefits after retirement – primarily health care and life
insurance.
Analyzing Postretirement Benefits:
A five-step procedure for analyzing postretirement benefits:
1. Determine and reconcile the reported and economic benefit cost and liability (or
asset),
2. Make necessary adjustments to financial statements,
3. Evaluate actuarial assumptions and their effects on financial statements,
4. Examine pension risk exposure, and
5. Consider the cash flow implications of postretirement benefit plans.

Contingencies:
Loss contingencies meeting probability and estimability conditions are recognized. Gain
contingencies are disclosed. Analysis requires scrutiny of estimates and note
disclosures.

Contingencies refer to potential gains and losses whose resolution depends on future
events. Loss contingencies, specifically, entail potential claims on a company's resources
and are commonly known as contingent liabilities. These liabilities can arise from
various situations such as litigation, threats of expropriation, collectibility issues with
receivables, product warranties or defects, performance guarantees, tax assessments,
self-insured risks, or catastrophic property losses.
For a loss contingency to be recognized as a liability, it must meet two conditions:
1. Probability of Loss: There must be a probability that an asset will be impaired or a
liability will be incurred. This probability implies that a future event will likely confirm
the loss.
2. Estimability of Loss: The amount of the potential loss must be reasonably estimable.
If a company fails to meet either of these conditions, it does not record the loss
contingency as a liability on its financial statements. Instead, the company discloses the
contingency in the notes to the financial statements.

JH JACKY 28
In financial reporting, companies adhere to conservatism principles. They do not
recognize gain contingencies in their financial statements but may disclose them in the
notes if there is a high probability of realization. This ensures that potential gains are
not overstated until they are realized.
Understanding contingencies and how they are disclosed in financial statements is
essential for stakeholders to assess the potential risks and liabilities faced by a company
and make informed decisions.

Analyzing Contingent Liabilities:

Analyzing contingent liabilities requires careful consideration of the underlying
estimates provided by companies, which are often based on prior experience or future
expectations. It's crucial to exercise caution when accepting management's estimates
for these liabilities, as they can significantly impact financial statements and decision-
making.
In addition to reviewing management's estimates, it's essential to analyze the note
disclosures accompanying the financial statements. These disclosures typically include:
1. Description of the Contingent Liability and Risk Degree: The disclosure provides a
detailed description of the contingent liability, including the nature of the risk
involved. Understanding the nature and extent of the risk is critical for evaluating its
potential impact on the company's financial position and performance.
2. Potential Amount of the Contingency and Risk Exposure: The disclosure may include
an estimate of the potential amount of the contingency. It also outlines how the
participation of other parties, such as insurance providers or co-defendants, is
considered in determining the overall risk exposure. This information helps
stakeholders assess the likelihood and magnitude of the potential loss.
3. Charges Against Income for Contingent Losses: Companies may disclose any charges
against income related to the estimates of contingent losses. This allows stakeholders
to understand the potential impact on the company's financial results and
profitability.
By carefully analyzing these disclosures and considering the underlying estimates,
stakeholders can gain insights into the nature, extent, and potential impact of
contingent liabilities on the company's financial health and make informed decisions
accordingly.

Shareholders' Equity:
Equity reflects owners' claims. Analyzing equity involves examining sources, rights, and
restrictions, including dividends and appropriations.
Equity refers to the financing provided by owners (shareholders) of a company. It
represents their ownership stake and claims on the net assets of the company. Equity
holders bear the highest risk associated with the company but also have the potential

JH JACKY 29
 for maximum returns, as they are entitled to the residual profits once creditors' claims
are settled.
Contributed Capital: Contributed capital, also known as paid-in capital, comprises the
total financing received from shareholders in exchange for capital shares. It is typically
categorized into two parts:
1. Common and/or Preferred Stock: Common stock represents ownership in the
company and often comes with voting rights. Preferred stock, on the other hand,
may offer specific privileges such as priority dividend distributions and liquidation
preferences.
2. Additional Paid-in Capital: This component represents the amount received from
shareholders in excess of the par value or stated value of the shares issued. It reflects
the premium paid by investors for acquiring shares.
Treasury Stock (Buybacks): Treasury stock refers to shares of a company's stock that
were previously issued and fully paid for but have been reacquired by the company. The
acquisition of treasury stock results in a reduction of both assets and shareholders'
equity on the balance sheet.
Preferred Stock Features: Preferred stock may possess various features that distinguish
it from common stock, including:
• Dividend Distribution Preferences: Preferred shareholders may have preferences
regarding dividend distributions, such as receiving dividends before common
shareholders or participating in dividends beyond a specified rate.
• Liquidation Priorities: In the event of liquidation, preferred shareholders may have
priority over common shareholders in the distribution of assets.
• Convertibility into Common Stock: Some preferred shares may be convertible into
common stock, allowing shareholders to exchange preferred shares for a specified
number of common shares.
• Call Provisions: Companies may have the option to repurchase preferred shares from
shareholders at predetermined prices, known as call provisions.
Understanding the various components of shareholders' equity and the features
associated with preferred stock is essential for investors and analysts to assess the
rights, privileges, and risks associated with different classes of equity securities.

Analyzing Shareholders’ Equity:

Analysis of shareholders’ equity would include:
 Classifying and distinguishing among major sources of equity financing.
 Examining rights for classes of shareholders and their priorities in liquidation.
 Evaluating legal restrictions for distribution of equity.
 Reviewing contractual, legal, and other restrictions on distribution of retained
earnings.
 Assessing terms and provisions of convertible securities, stock options, and other
arrangements involving potential issuance of shares.

JH JACKY 30
Retained Earnings:
Retained earnings are the earned capital of a company.
The retained earnings account reflects the accumulation of undistributed earnings or
losses of a company since its inception.
Retained earnings are the primary source of dividend distributions to shareholders.

Cash and Stock Dividends:

Dividends are rewards distributed by companies to shareholders. They can be in the
form of cash, property, or stock.
1. Cash Dividend:
• Common type, involves distributing cash to shareholders.
• Becomes a liability once declared.
• Shareholders receive cash per share owned.
2. Property Dividend (Dividend in Kind):
• Distribution of company assets, goods, or stock of another corporation.
• Valued at market value of assets distributed.
• Shareholders receive assets instead of cash.
3. Stock Dividend:
• Additional shares of company stock distributed to existing shareholders.
• Represents a capitalization of retained earnings.
• Shareholders receive more shares proportionally.
Key Points:
• Cash dividends provide immediate liquidity.
• Property dividends offer alternative forms of value.
• Stock dividends increase shares without altering total equity value.
• The decision to issue dividends is typically made by the board of directors based on
financial factors.

Restrictions and Appropriations:

Retained earnings can be restricted or appropriated for specific purposes, affecting
dividend distributions.

Retained earnings, while an essential source of funds for dividends and investments,
can face constraints due to contractual agreements or board decisions.
1. Contractual Agreements:
• Loan covenants or agreements may restrict the use of retained earnings.
• These agreements outline specific conditions, such as minimum retained
earnings levels, before dividends can be paid.
2. Board Decisions:
• Boards of directors may impose restrictions on the distribution of retained
earnings.

JH JACKY 31
 • Such decisions align with strategic goals or financial stability objectives.
Key Points:
• Restrictions on retained earnings ensure compliance with financial agreements.
• Loan agreements and bond indentures commonly dictate these limitations.
• Boards of directors wield authority in determining dividend payments based on
company needs and objectives.

Appropriations of Retained Earnings:

Appropriations of retained earnings involve setting aside funds for specific purposes
instead of distributing them to shareholders as dividends.
Key Points:
• Purposeful Allocation: Funds are earmarked for future needs or strategic initiatives.
• Financial Transparency: Provides clarity on how retained earnings will be used.
• Examples: Research and development, capital expenditures, debt repayment.
Impact on Financial Statements:
• Appropriations are disclosed in financial statements to inform stakeholders about
capital allocation decisions.

Spin-Offs and Split-Offs:

Spin-offs and split-offs are methods used by companies to divest subsidiaries, either
through distribution to shareholders or outright sale.
Key Points:
• Spin-Offs: Distribution of subsidiary stock to shareholders as a dividend.
• Split-Offs: Exchange of subsidiary stock owned by the company for shares owned by
shareholders.
• Impact on Financial Statements: Reduction of assets and retained earnings in the
case of spin-offs. Treatment of received stock as treasury stock in split-offs.
Purpose:
• To streamline operations or focus on core businesses.
• To unlock value for shareholders by providing ownership in separate entities.
Disclosure: Companies typically provide details of spin-offs or split-offs in financial
statements and related disclosures.

SHAREHOLDERS’ EQUITY:
Prior Period Adjustments:
• Corrections for errors in prior periods’ financial statements.
• Excluded from the income statement, reported as an adjustment to the beginning
balance of retained earnings (net of tax).
Book Value per Share:

JH JACKY 32
• Book value refers to the net asset value, calculated as total assets minus liabilities
and claims of securities senior to common stock.
• For common stock, book value equals total assets minus liabilities, and senior
securities, reported on the balance sheet.
Purpose:
• Reflects the true value of common stockholders' equity.
• Provides insights into the company's financial health and shareholder value.
Disclosure:
• Prior period adjustments are disclosed in financial statements, impacting the
beginning balance of retained earnings.
• Book value per share is often calculated and reported in financial reports for investor
analysis.

Conclusion:
Understanding liabilities, equity, and financial reporting involves analyzing various
components and their implications for a company's financial position and performance.
Effective analysis requires attention to detail and careful consideration of relevant
factors.

JH JACKY 33
 BOOK Questions

1. Explain major forms of financing and their characteristics. @

Ans:
The major forms of financing are liabilities and equity. Here's an explanation of each
with their characteristics:
1. Liabilities:
• Characteristics:
• Liabilities represent obligations that a company owes to external parties,
such as creditors and lenders.
• They typically involve a promise to repay money, provide services, or
transfer other assets in the future.
• Liabilities can be either current (short-term) or noncurrent (long-term)
depending on their maturity date.
• Examples of financing liabilities include long-term loans, bonds, short-
term borrowings, leases, and other forms of credit financing.
2. Equity:
• Characteristics:
• Equity represents the ownership stake in a company held by its
shareholders.
• It reflects the residual claim on the company's assets after all liabilities
have been satisfied.
• Equity holders are entitled to the company's profits through dividends
and capital appreciation, but they also bear the highest risk.
• Equity can be in the form of common stock, preferred stock, or
additional paid-in capital.

2. Explain the difference between operating and financing liabilities. @

Ans:
Operating and financing liabilities differ in their nature and origin within a company's
financial structure. Here's a breakdown of the differences between the two:
1. Operating Liabilities:
• Nature:
• Operating liabilities arise directly from a company's day-to-day business
operations.
• They are typically related to the purchase of goods or services necessary
for conducting business activities.
• Examples include trade payables (accounts payable), wages payable,
taxes payable, accrued expenses, unearned revenues, and other
obligations directly tied to operational activities.
JH JACKY 34
 • Purpose:
• Operating liabilities facilitate the ongoing functioning of a company by
providing necessary resources or services.
• They are essential for maintaining the smooth operation of the business
but do not involve external financing activities.
• Maturity:
• Operating liabilities can be both short-term and long-term, depending
on the nature of the obligation and when it is expected to be settled.
• Examples:
• Trade payables to suppliers for inventory purchases.
• Accrued expenses for utilities, rent, or wages.
• Taxes payable for income taxes owed to tax authorities.
2. Financing Liabilities:
• Nature:
• Financing liabilities arise from activities related to raising capital or
obtaining financing from external sources.
• They involve agreements to borrow money or acquire funds from
creditors, lenders, or investors to support the company's operations or
growth.
• Examples include long-term loans, bonds, leases, short-term borrowings,
and any other forms of credit financing.
• Purpose:
• Financing liabilities provide the company with external funds necessary
for investment in assets, expansion, or meeting financial obligations.
• They represent contractual obligations to repay borrowed funds over
time, typically with interest.
• Maturity:
• Financing liabilities can be both short-term and long-term, depending on
the duration of the borrowing or financing arrangement.
• Examples:
• Long-term loans used for capital investment or expansion projects.
• Bonds issued to raise funds from investors.
• Leases used to finance the acquisition of equipment or property.

3. What are the major forms of financing liabilities? Which are long term and which are
short term? @
Ans:
The major forms of financing liabilities include various instruments used by companies
to raise capital or obtain financing from external sources. These liabilities can be
categorized as either long-term or short-term based on their maturity dates. Here's a
breakdown of the major forms of financing liabilities and their typical classification:

JH JACKY 35
 Long-Term Financing Liabilities:
1. Long-Term Loans:
• These are borrowing arrangements with repayment terms extending beyond
one year.
• Long-term loans are typically used for large capital investments, such as
purchasing real estate or funding long-term projects.
• The repayment schedule spans several years, and interest payments are made
periodically.
2. Bonds:
• Bonds are debt securities issued by companies or governments to raise capital.
• They have a fixed maturity date, typically ranging from several years to
decades.
• Bondholders receive periodic interest payments until maturity, at which point
the principal amount is repaid.
• Bonds can be secured or unsecured and may offer various features such as
convertible or callable options.
3. Leases (Long-Term Portion):
• Leases are contractual agreements allowing the use of assets (such as
equipment or property) in exchange for rental payments.
• Leases with terms exceeding one year are classified as long-term financing
liabilities.
• Companies may enter into operating leases or capital leases, each with
different accounting and financial implications.
Short-Term Financing Liabilities:
1. Short-Term Borrowings:
• Short-term borrowings refer to funds borrowed for a period typically less than
one year.
• These borrowings are used to meet short-term financing needs, such as
working capital requirements or temporary cash flow shortages.
• Examples include lines of credit, bank overdrafts, and short-term loans from
financial institutions.
2. Current Portion of Long-Term Debt:
• The current portion of long-term debt represents the portion of long-term
loans or bonds that must be repaid within the next year.
• It is classified as a short-term liability on the balance sheet, reflecting the
upcoming repayment obligation.
• Companies may have to allocate funds from current assets or arrange for
refinancing to meet these obligations as they come due.
3. Interest Payable:
• Interest payable represents the accrued interest on outstanding debt
obligations that has not yet been paid.

JH JACKY 36
 • It is recorded as a short-term liability until it is settled.
• Interest payable typically accrues on a periodic basis, such as monthly or
quarterly, depending on the terms of the borrowing agreement.

4. Explain how bond discounts and premiums usually arise. Describe how they are
accounted for in the balance sheet and income statement.
Ans:
Bond discounts arise when the stated interest rate is lower than market rates, leading
investors to pay less than the bond's face value. Discounts are recorded as contra-
liabilities on the balance sheet, amortized to interest expense using the effective
interest method. Bond premiums occur when the stated rate exceeds market rates,
causing investors to pay more than face value. Premiums are added to the bond
payable, amortized to interest expense, reducing interest expense and increasing the
bond's carrying value over time.

5. Describe how fair value accounting for long-term debt works. How does it differ from
the current accounting using amortized cost?
Ans:
Fair value accounting for long-term debt involves reporting the debt at its current
market value, which may fluctuate over time due to changes in interest rates and credit
risk. This differs from the current accounting method using amortized cost, where debt
is initially recorded at its face value and subsequently adjusted for amortization of any
premiums or discounts. Fair value accounting provides users of financial statements
with more relevant and timely information about the value of the debt in the current
market environment.
6. How do we account for short-term debt? What is the logic for this approach?
Ans:
Short-term debt is typically accounted for at amortized cost on the balance sheet. The
logic behind this approach is to reflect the actual cost of borrowing over the short term,
which may include any interest expense incurred during the borrowing period. Since
short-term debt is usually repaid within a year, there is less need to mark it to market
like long-term debt.
7. Describe the major disclosure requirements for long-term debt.
Ans:
Disclosure requirements for long-term debt typically include details such as:
• Principal amount outstanding
• Interest rates and terms of repayment
• Maturity dates
• Collateral pledged, if any
• Any covenants or restrictions imposed by the lender
• Any significant events or changes in the debt arrangement

JH JACKY 37
8. Describe the usefulness and the problems with reporting long-term debt at (1) face
value, (2) amortized cost, and (3) fair values.
Ans:
• Face Value: Reporting long-term debt at face value provides a simple and
straightforward representation of the contractual obligation. However, it may not
reflect the debt's actual market value or risk.
• Amortized Cost: Reporting at amortized cost adjusts for premiums or discounts and
reflects the carrying value of the debt over time. However, it may not fully capture
changes in market interest rates or credit risk.
• Fair Value: Reporting at fair value provides a more accurate depiction of the debt's
current market value and risk. However, it may introduce volatility in financial
statements due to fluctuations in market conditions.

9. What are the various forms of protections that lenders incorporate into their debt
contracts?
Ans:
Lenders may incorporate various protections into debt contracts, including:
• Collateral: Assets pledged as security for the loan.
• Covenants: Restrictions or conditions imposed on the borrower to maintain certain
financial ratios or behaviors.
• Guarantees: Additional parties providing assurance of repayment.
• Priority of Payments: Specifying the order in which different classes of debt are
repaid in the event of default.

10. What do we mean by seniority of debt? What consideration should an analyst keep in
mind when analyzing debt seniority?
Ans:
Debt seniority refers to the order in which debts are repaid in the event of liquidation
or bankruptcy. Analysts should consider seniority when analyzing debt to assess the
relative risk and priority of repayment. Higher seniority debt holders have a greater
claim on assets and are more likely to be repaid in full compared to lower-ranking debt
holders.
11. What do we mean by secured debt? What consideration should an analyst keep in
mind when analyzing secured debt?
Ans:
Secured debt is backed by specific assets (collateral) pledged by the borrower to the
lender. In the event of default, the lender has the right to seize and sell the collateral to
recover the outstanding debt. Analysts should consider the quality and value of the
collateral when assessing the risk associated with secured debt, as it provides additional
protection for lenders compared to unsecured debt.

JH JACKY 38
12. Debt contracts usually place restrictions on the ability of a company to deploy
resources and to pursue business activities. These are often referred to as debt
covenants.
a. Identify where information about such restrictions is found.
b. Describe how covenants serve as an early warning mechanism for lenders to
protect their investments.
c. What is a technical default?
Ans:
a. Information about debt restrictions or covenants is typically found in the debt
agreement or contract between the borrower (company) and the lender. These
covenants are detailed in the loan documentation and may include financial covenants
(related to financial ratios), operating covenants (related to business operations), and
other restrictions on the company's activities.
b. Debt covenants serve as an early warning mechanism for lenders by providing them
with indicators of the borrower's financial health and performance. By monitoring
compliance with these covenants, lenders can assess the borrower's ability to meet its
obligations and take appropriate actions if there are signs of financial distress. If a
borrower breaches a covenant, it may trigger default provisions, allowing lenders to
demand immediate repayment or take other corrective actions to protect their
investments.
c. A technical default occurs when a borrower breaches a covenant or other terms of
the debt agreement, even if it does not result in an immediate financial crisis or inability
to repay the debt. It signifies a violation of the contractual terms and may prompt
lenders to take corrective actions or negotiate with the borrower to remedy the
situation before it escalates into a more serious default.

13. Define margin of safety as it applies to debt contracts and describe how the margin of
safety can impact assessment of the relative level of company risk.
Ans:
The margin of safety in debt contracts refers to the difference between a company's
actual performance or financial condition and the thresholds specified in the debt
covenants. A larger margin of safety indicates that the company has more room for
error or adverse events before breaching its debt covenants, thus reducing the risk of
default. Assessing the margin of safety allows lenders and investors to gauge the
relative level of risk associated with a company's debt and make informed decisions
about lending or investing in the company.
14. Companies often issue convertible debt or debt with attached warrants.
a. What is convertible debt?
b. What is debt issued with warrant? How does it differ from convertible debt?
c. Why do companies issue convertible debt?
d. How do we account for convertible debt?

JH JACKY 39
 e. What are the analysis implications of convertible debt?
Ans:
a. Convertible Debt: Convertible debt is a type of bond or loan that can be converted
into shares of common stock or other securities of the issuing company at a
predetermined conversion ratio and price. It gives bondholders the option to convert
their debt into equity, providing them with the potential for capital appreciation if the
company's stock price rises.
b. Debt Issued with Warrants: Debt issued with warrants includes additional warrants
or options attached to the debt securities, allowing the holder to purchase a certain
number of shares of the company's stock at a specified price within a predetermined
period. Unlike convertible debt, which involves automatic conversion, warrants give the
holder the choice to exercise them to acquire equity in the company.
c. Reasons for Issuing Convertible Debt: Companies may issue convertible debt to raise
capital at a lower interest rate than traditional debt or to attract investors who are
interested in potential equity upside. It offers flexibility for both the issuer and investors
by providing a combination of debt and equity features.
d. Accounting for Convertible Debt: Convertible debt is initially recorded as debt on the
balance sheet, with any proceeds received allocated between the debt and the
embedded conversion option. The debt and the conversion option are subsequently
accounted for separately, with changes in fair value recorded through the income
statement or equity.
e. Analysis Implications of Convertible Debt: Convertible debt can impact financial
analysis by potentially diluting existing shareholders' equity if and when the debt is
converted into equity. Analysts must consider the potential dilutive effect and the
impact on earnings per share, as well as the company's capital structure and financial
flexibility. Additionally, the presence of convertible debt may signal the company's
confidence in its future growth prospects and its ability to generate returns for
investors.

15. a. Describe the criteria for classifying leases by a lessee.

b. Prepare a summary of accounting for leases by a lessee.
Ans:
a. Criteria for Classifying Leases by a Lessee: The classification of leases by a lessee is
determined by the extent to which the lease transfers risks and rewards associated with
owning the underlying asset to the lessee. The criteria typically include:
1. Transfer of Ownership: If the lease transfers ownership of the asset to the lessee by
the end of the lease term, it is classified as a finance lease.
2. Bargain Purchase Option: If the lease contains a bargain purchase option (i.e., an
option to purchase the asset at a price significantly below its fair value), it is classified
as a finance lease.

JH JACKY 40
 3. Lease Term vs. Economic Life: If the lease term is for a major part of the economic
life of the asset (usually defined as 75% or more), it is classified as a finance lease.
4. Present Value of Lease Payments: If the present value of lease payments (excluding
executory costs) equals or exceeds substantially all of the fair value of the leased
asset, it is classified as a finance lease.
If none of the above criteria are met, the lease is classified as an operating lease.

b. Summary of Accounting for Leases by a Lessee:

Operating Lease:
• Initially, no asset or liability is recognized on the balance sheet.
• Lease payments are recognized as rental expenses on a straight-line basis over the
lease term, resulting in a consistent expense pattern over time.
• The total lease payments are disclosed in the footnotes of the financial statements.
Finance Lease:
• The lessee recognizes both an asset (the right to use the leased asset) and a liability
(the obligation to make lease payments) on the balance sheet at the commencement
of the lease term.
• The asset is initially measured at the present value of the minimum lease payments,
while the liability is measured at the same amount.
• Lease payments are apportioned between interest expense (reflecting the financing
cost) and reduction of the lease liability.
• The asset is depreciated over its useful life, and interest expense is recognized on the
lease liability using the effective interest method.
• Subsequent measurement involves periodic adjustments for interest expense and the
reduction of the lease liability.
• The lease liability is reduced as payments are made, and the interest expense
decreases over time.
• Any difference between the total lease payments and the initial liability is recognized
as a finance cost over the lease term.
This summary provides a basic understanding of the accounting treatment for leases by
a lessee, distinguishing between operating leases and finance leases.

16. a. Identify the different classifications of leases by a lessor. Describe the criteria for
classifying each lease type.
b. Explain the accounting procedures for leases by a lessor.
Ans:
a. Classifications of Leases by a Lessor and Criteria:
1. Sales-Type Lease:
• Criteria: A lease is classified as a sales-type lease if it meets any one of the following
criteria:

JH JACKY 41
 • The lease transfers ownership of the asset to the lessee by the end of the lease
term.
• The lease contains a bargain purchase option (BPO), allowing the lessee to
purchase the asset at a price significantly below its fair value.
• The lease term is for a major part of the economic life of the asset (usually
defined as 75% or more).
• The present value of lease payments equals or exceeds substantially all of the
fair value of the leased asset.
2. Direct Financing Lease:
• Criteria: A lease is classified as a direct financing lease if it does not meet any of the
criteria for a sales-type lease but meets one of the following criteria:
• The lease transfers ownership of the asset to the lessee by the end of the lease
term.
• The lease contains a bargain purchase option (BPO).
• The lease term is for a major part of the economic life of the asset.
• The present value of lease payments equals or exceeds substantially all of the
fair value of the leased asset.
3. Operating Lease:
• Criteria: A lease is classified as an operating lease if it does not meet any of the
criteria for a sales-type or direct financing lease.
b. Accounting Procedures for Leases by a Lessor:
Sales-Type Lease:
• The lessor recognizes the gross investment in the lease (the present value of lease
payments) and records a sales revenue equal to the fair value of the leased asset at
the commencement of the lease term.
• Any difference between the gross investment in the lease and the cost or carrying
amount of the leased asset is recognized as unearned interest income.
• Subsequent to lease commencement, the lessor recognizes interest income over the
lease term and reduces the unearned interest income.
• The leased asset is derecognized from the lessor's balance sheet, and any profit or
loss on the sale is recognized at lease commencement.
Direct Financing Lease:
• Similar to a sales-type lease, the lessor recognizes the gross investment in the lease
and records interest income over the lease term.
• However, the lessor does not recognize any profit or loss on the sale of the asset at
lease commencement.
Operating Lease:
• The lessor continues to recognize the leased asset on its balance sheet and
depreciates it over its useful life.

JH JACKY 42
 • Lease payments received are recognized as rental income over the lease term on a
straight-line basis unless another systematic basis is more representative of the time
pattern in which use benefit derived from the leased asset is diminished.
These accounting procedures provide a framework for lessors to recognize revenue and
income associated with leases based on the classification of the lease and the
underlying economic substance of the transaction.

17. Describe the provisions concerning leases involving real estate.

Ans:
Lease agreements for real estate detail terms like rent, duration, and maintenance
responsibilities. They address rent payment, lease term, property use, maintenance,
utilities, security deposit, insurance, subleasing, and dispute resolution. These
provisions ensure clarity, protect interests, and govern property usage, aiming to
prevent future disputes. Both lessors and lessees should thoroughly understand and
agree to these terms to avoid misunderstandings or conflicts.

18. Discuss the implications of lease accounting for the analysis of financial statements.
Ans:
Lease accounting changes, such as ASC 842 in the US, significantly impact financial
statement analysis:

1. Balance Sheet: Operating leases are now recognized, increasing assets and liabilities.
This affects leverage and asset turnover ratios.
2. Income Statement: Operating leases are straight-lined, while finance leases incur
interest and depreciation. These impacts operating and net income, as well as EBITDA.
3. Cash Flow: Cash flow classifications differ between operating and finance leases,
affecting free cash flow and operating cash flow.
4. Financial Ratios: Leverage ratios increase, ROA may decrease initially, and interest
coverage may decrease for companies with finance leases.
5. Disclosure: Enhanced disclosures detail lease terms, obligations, and impact on
financial statements.

In essence, these changes require analysts to adapt their assessments of a company's

financial health, performance, and cash flow dynamics.

19. When a lease is considered an operating lease for both the lessor and the lessee,
describe what amounts will be found on the balance sheets of both the lessor and the
lessee related to the lease obligation and the leased asset.
Ans:
For an operating lease, the treatment on the balance sheet of both the lessor and
lessee is as follows:

JH JACKY 43
 Lessee's Balance Sheet:
• Lease Obligation: The lessee does not recognize the lease obligation on the balance
sheet. Instead, lease payments are recognized as expenses on the income statement
over the lease term.
• Leased Asset: The lessee does not recognize the leased asset on the balance sheet.
Instead, the right to use the leased asset is disclosed in the footnotes of the financial
statements.
Lessor's Balance Sheet:
• Lease Receivable: The lessor does not recognize the lease receivable on the balance
sheet. Instead, lease receipts are recognized as revenue on the income statement
over the lease term.
• Leased Asset: The lessor recognizes the leased asset on the balance sheet as an asset
under property, plant, and equipment or investment property, depending on the
nature of the asset.

20. When a lease is considered a capital lease for both the lessor and the lessee, describe
what amounts will be found on the balance sheets of both the lessor and the lessee
related to the lease obligation and the leased asset.
Ans:
For a capital lease, the treatment on the balance sheet of both the lessor and lessee is
as follows:
Lessee's Balance Sheet:
• Lease Obligation: The lessee recognizes the lease obligation as a liability on the
balance sheet, equal to the present value of minimum lease payments. This
represents the present value of the future lease payments over the lease term.
• Leased Asset: The lessee recognizes the leased asset as an asset on the balance
sheet, equal to the present value of minimum lease payments or the fair value of the
leased asset, whichever is lower. This represents the right to use the leased asset
during the lease term.
Lessor's Balance Sheet:
• Lease Receivable: The lessor recognizes the lease receivable as an asset on the
balance sheet, equal to the present value of minimum lease payments. This
represents the future cash flows expected from the lease.
• Leased Asset: The lessor derecognizes the leased asset from its balance sheet if
ownership is transferred. If ownership is retained, the lessor continues to recognize
the leased asset on the balance sheet, and it may be classified as an asset under
property, plant, and equipment or investment property, depending on the nature of
the asset.
These treatments reflect the accounting standards for operating leases and capital
leases as per generally accepted accounting principles (GAAP) or international financial
reporting standards (IFRS).

JH JACKY 44
21. Discuss how the lessee reflects the cost of leased equipment in the income statement
for (a) assets leased under operating leases and (b) assets leased under capital leases.
Ans:
a. Operating Leases:
In an operating lease, the lessee reflects the cost of leased equipment on the income
statement as operating expenses. Lease payments are evenly spread out over the lease
term, expensed consistently, and classified as operating expenses. This reduces net
income but doesn't impact leverage ratios as the lease obligation isn't on the balance
sheet.

b. Capital Leases:
In a capital lease, the lessee recognizes both interest and depreciation expenses on the
income statement. Interest expense reflects borrowing costs for the lease liability, while
depreciation expense accounts for asset consumption. This reduces net income and
affects metrics like EBITDA, reflecting the lessee's ownership of the asset.

22. Discuss how the lessor reflects the benefits of leasing in the income statement under
(a) an operating lease and (b) a capital lease.
Ans:
Certainly!

a. Operating Lease:

• Rental Income Recognition: Lessors recognize rental income evenly over the lease
term, serving as operating revenue.
• Straight-Line Recognition: Rental income is typically recognized evenly each
period, ensuring a consistent revenue stream.
• Impact: Rental income boosts revenue without significant gains due to no
transfer of ownership or risks.

b. Capital Lease:

• Interest Income Recognition: Lessors recognize interest income over the lease
term, resembling loan interest.
• Gain on Sale (if applicable): Any profit from selling the leased asset upfront is
recognized immediately.
• Impact: Interest income contributes to revenue, potentially augmented by gains
from asset sales, showcasing profitability.

JH JACKY 45
 In essence, lessors reflect leasing benefits through rental income for operating leases
and interest income (with potential asset sale gains) for capital leases, providing insights
into their leasing-related financial performance.

23. Companies use various financing methods to avoid reporting debt on the balance
sheet. Identify and describe some of these off-balance-sheet financing methods.
Ans:
Off-balance-sheet financing refers to financing methods used by companies to avoid
reporting certain liabilities on their balance sheets. Some common off-balance-sheet
financing methods include:
1. Operating Leases: Companies may enter into operating leases instead of capital
leases to avoid recognizing leased assets and corresponding lease liabilities on their
balance sheets.
2. Joint Ventures: Forming joint ventures allows companies to share ownership and
control of assets and operations without consolidating the joint venture's financial
results on their balance sheets.
3. Special Purpose Entities (SPEs): Companies may establish SPEs, such as subsidiaries
or partnerships, to hold assets or undertake specific projects. If structured properly,
the liabilities of these entities may not be consolidated on the company's balance
sheet.
4. Sale and Leaseback Arrangements: Companies may sell assets to third parties and
lease them back under operating leases. This allows companies to access cash tied up
in assets without recognizing debt on their balance sheets.
5. Off-Balance-Sheet Financing Through Derivatives: Companies may use derivatives
such as forwards, swaps, or options to hedge risks or speculate without recognizing
the underlying assets or liabilities on their balance sheets.

24. a. Explain a loss contingency. Provide examples.

b. Explain the two conditions necessary before a company can record a loss
contingency against income.
Ans:
a. A loss contingency refers to a potential liability that may arise from past events and
whose outcome depends on uncertain future events. Examples of loss contingencies
include pending lawsuits, warranty claims, or environmental liabilities.
b. For a company to record a loss contingency against income, two conditions must be
met:
• It must be probable that an asset will be impaired or a liability incurred, meaning that
it is likely that a future event will confirm the loss.
• The amount of loss must be reasonably estimable, allowing the company to
determine a reliable estimate of the potential liability.

JH JACKY 46
25. Define a commitment and provide three examples of commitments for a company.
Ans:
A commitment is a binding agreement or promise that obligates a company to
undertake future actions or transactions. Examples of commitments for a company
include:
• Capital expenditure commitments for the purchase of property, plant, and
equipment.
• Operating lease commitments for the rental of office space or equipment.
• Contractual commitments to purchase goods or services from suppliers.

26. Explain when a commitment becomes a recorded liability.

Ans:
A commitment becomes a recorded liability on the balance sheet when it meets the
criteria for recognition as a liability under accounting standards. This typically occurs
when the commitment is legally enforceable, probable, and the amount can be reliably
estimated. Until then, the commitment may be disclosed in the footnotes to the
financial statements.

27. Define off-balance-sheet financing and provide three examples.

Ans:
Off-balance-sheet financing refers to financing activities that do not result in the
recognition of liabilities on a company's balance sheet. Examples include:
Operating leases
Joint ventures
Special purpose entities (SPEs)

28. Describe the required financial statement disclosures for financial instruments with
off-balance-sheet risk of loss. How might these disclosures be used to assist financial
analysis?
Ans:
Financial statement disclosures for financial instruments with off-balance-sheet risk of
loss typically include information about the nature, terms, and potential impact of these
instruments. They may also disclose the maximum potential exposure to loss and any
risk management strategies employed by the company. These disclosures assist
financial analysis by providing insight into the company's off-balance-sheet obligations
and the potential impact on its financial position and performance.

JH JACKY 47
29. Describe the criteria a company must meet before a transfer of receivables with
recourse can be booked as a sale rather than as a loan.
Ans:
Before a transfer of receivables with recourse can be booked as a sale rather than as a
loan, the company must meet certain criteria, including:
• The transferor surrenders control over the receivables.
• The transferor does not maintain effective control over the transferred receivables.
• The transferor does not have the obligation to repurchase the receivables except for
certain specified reasons.

30. Explain how off-balance-sheet financing items should be treated for financial analysis
purposes.
Ans:
Off-balance-sheet financing items should be carefully evaluated and adjusted for
financial analysis purposes to provide a more accurate picture of a company's financial
position and performance. Analysts may consider incorporating off-balance-sheet items
into financial ratios, such as debt-to-equity ratio, to assess leverage more
comprehensively. They may also evaluate the potential impact of off-balance-sheet
obligations on cash flow and liquidity. Additionally, disclosures related to off-balance-
sheet financing should be carefully reviewed to understand the nature and extent of
these obligations.

31. Identify types of equity securities that are similar to debt.

Ans:
Equity securities that are similar to debt include:
• Preferred stock with fixed dividend payments resembling interest payments on debt.
• Cumulative preferred stock where unpaid dividends accumulate and must be paid
before common dividends.
• Convertible preferred stock that can be exchanged for a fixed number of common
shares, akin to convertible bonds.
• Redeemable preferred stock that can be repurchased by the issuer at a
predetermined price, resembling callable bonds.

32. Identify and describe several categories of reserves, allowances, and provisions for
expenses and losses.
Ans:
Several categories of reserves, allowances, and provisions for expenses and losses
include:
• Allowance for doubtful accounts
• Reserve for inventory obsolescence
• Provision for income taxes

JH JACKY 48
 • Reserve for warranty expenses
• Provision for legal claims
• Reserve for restructuring costs
33. Explain why analysis must be alert to the accounting for future loss reserves.
Ans:
Analysis must be alert to the accounting for future loss reserves because they represent
potential future obligations that can impact a company's financial performance and
position. Changes in the estimation or recognition of loss reserves can affect reported
earnings and may indicate management's assessment of future risks or contingencies.

34. Distinguish between different kinds of deferred credits on the balance sheet. Discuss
how to analyze these accounts.
Ans:
Deferred credits on the balance sheet may include deferred revenue, deferred tax
liabilities, and deferred rent. Deferred revenue represents advance payments from
customers for goods or services not yet provided. Deferred tax liabilities arise from
temporary differences between accounting and tax treatment. Deferred rent represents
prepayments or accrued rent expenses yet to be recognized.

35. Identify objectives of the classifications and note disclosures associated with the
equity section of the balance sheet. Explain the relevance of these disclosures to
analysis of financial statements.
Ans:
The objectives of classifications and disclosures associated with the equity section of
the balance sheet include providing transparency and clarity regarding the composition
and rights of equity holders. These disclosures help analysts assess the company's
capital structure, ownership structure, dividend policies, and potential dilution effects
from convertible securities or stock options.

36. Identify features of preferred stock that make it similar to debt. Identify the features
that make it more like common stock.
Ans:
Preferred stock features that make it similar to debt include fixed dividend payments,
priority in liquidation, and cumulative dividends. Features that make it more like
common stock include voting rights, potential for capital appreciation, and non-fixed
dividends.

37. Explain the importance of disclosing the liquidation value of preferred stock, if
different from par or stated value, for analysis purposes.
Ans:

JH JACKY 49
 Disclosing the liquidation value of preferred stock, if different from par or stated value,
is important for analysis purposes as it provides insight into the potential recovery for
preferred shareholders in the event of liquidation. This information helps analysts
assess the relative safety and attractiveness of preferred stock investments.
38. Explain why the accounting for small stock dividends requires that market value,
rather than par value, of the shares distributed be charged against retained earnings.
Ans:
Accounting for small stock dividends requires charging the market value, rather than
par value, of the shares distributed against retained earnings to reflect the economic
substance of the transaction accurately. This ensures that the distribution of additional
shares is properly recognized as a reduction in retained earnings rather than as a
nominal transfer of value.

39. Many companies report “minority interests in subsidiary companies” between the
long-term debt and equity sections of a consolidated balance sheet; others present
them as part of shareholders’ equity.
a. Describe minority interest.
b. Indicate where on the consolidated balance sheet it best belongs. Discuss
what different points of view these differing presentations represent.
Ans:
a. Minority interest represents the portion of a subsidiary company's equity that is not
owned by the parent company. It reflects the equity interest held by outside investors
in the subsidiary.
b. Minority interests in subsidiary companies can be presented between long-term debt
and equity sections or as part of shareholders' equity on a consolidated balance sheet.
The differing presentations represent different perspectives on the ownership structure
and control of the subsidiary. Placing minority interests between long-term debt and
equity highlights the financial claim of minority shareholders, while including it in
shareholders' equity emphasizes the consolidated ownership structure under the
parent company.

JH JACKY 50
 Chapter 3
Analyzing Investing Activities

Summary:
1. Assets are resources controlled by companies for profit generation, classified into
current and noncurrent categories.
i. Current assets (cash, cash equivalents, receivables, inventories, and prepaid
expenses) are convertible to cash within the operating cycle, while
ii. Noncurrent assets (property, plant, equipment, intangibles, investments, and
deferred charges) benefit the company beyond the current period.
Assets can also be classified as: 1. financial assets 2. operating assets.
Financial assets mainly consist of marketable securities and investments, while
Operating assets are those used in day-to-day business operations.

2. An operating cycle is the amount of time from the commitment of cash for purchases
until the collection of cash resulting from sales of goods or services.

For a manufacturing company, this would entail purchasing raw materials, converting
them to finished goods, and then selling and collecting cash from receivables.

Cash represents the starting point, and the end point, of the operating cycle.

The operating cycle is used to classify assets (and liabilities) as either current or
noncurrent.

JH JACKY 51
3. Efficient management of current assets is crucial for optimizing profitability and cash
flow.
4. Methods like effective credit underwriting, receivables collection, and just-in-time
inventory management are employed to manage current assets.

5. Working Capital:
The excess of current assets over current liabilities, is vital for operations but can be
costly.
Many companies attempt to improve profitability and cash flow by reducing investment
in current assets through methods such as
i. effective credit underwriting,
ii. collection of receivables, and
iii. just-in-time inventory management.

In addition, companies try to finance a large portion of their current assets through
current liabilities, such as accounts payable and accruals, in an attempt to reduce
working capital.

7. Cash and cash equivalents are the most liquid assets, with cash equivalents (short-
term treasury bills, commercial paper, and money market funds.) being short-term
investments easily convertible to cash.

8. Liquidity provides flexibility to take advantage of changing market conditions and to

react to strategic actions by competitors. Q. how?

Analysts should also assess:

1. Allocation of cash equivalents into equity securities.
2. Obligations to maintain cash as compensating balances or collateral for debt.

9. Receivables represent amounts due from sales or advances and require careful
analysis for collection risk, return privileges, and contingencies.

Collection Risk:
To assess collection risk for receivables:
1. Compare competitors' receivables as a percentage of sales.
2. Check for customer concentration, especially if receivables are concentrated in few
customers.
3. Analyze trends in the average collection period compared to industry credit terms.
4. Determine the proportion of receivables that are renewals of prior accounts or notes
receivable.

JH JACKY 52
Return privileges:
Liberal return policies can impact the quality of receivables, as they allow customers the
right to return merchandise, affecting the reliability of sales transactions.

Contingencies:
Receivables can be affected by contingencies, which may impact their value. Analyzing
these contingencies helps determine if they affect the worth of receivables.

10. Securitization of Receivables:

Securitization involves a company selling its receivables to a third party, which finances
the purchase by issuing bonds to investors. The collected receivables serve as the
source of income for the bondholders. This practice is called securitization. When
receivables are sold to a bank or finance company, it's known as factoring. Receivables
can be sold with or without recourse, where recourse refers to the seller's guarantee of
collectibility. Selling receivables with recourse does not fully transfer the risk of
ownership from the seller.

11. Prepaid expenses are advance payments for services or goods.

12. Inventories are goods held for sale and require scrutiny due to their impact on
income and asset valuation.
Inventories consist of goods held for sale as part of a company's regular operations. We
focus on inventories because they are a significant part of operating assets and directly
influence income determination. The choice of costing methods for inventory valuation
is crucial as it impacts both net income and asset valuation. These methods are
essential for calculating the cost of goods sold and the value of ending inventory, thus
affecting income and asset measurements.

13. Long-term assets include tangible fixed assets and intangible assets like patents and
goodwill.
Long-term asset accounting involves three main activities: capitalization, allocation, and
impairment.
1. Capitalization: Defers costs incurred in the current period to future periods where
benefits are expected.
2. Allocation: Periodically expenses deferred costs to future benefit periods. This
includes depreciation for tangible assets, amortization for intangible assets, and
depletion for natural resources.
3. Impairment: Writes down the book value of assets when expected cash flows can't
recover the remaining cost on the balance sheet.

JH JACKY 53
Capitalization:

Capitalization involves recording hard assets at purchase price, while soft assets like
R&D and advertising are expensed immediately. However, software development costs
for internal use are capitalized and amortized over its useful life.
Effects of Capitalization:
1. Effects of Capitalization on Income:
Postpones expense recognition, resulting in higher income initially but lower in
subsequent periods.
2. Effects of Capitalization for Return on Investment:
Smoothes income series and decreases volatility in return on investment ratios by
affecting both numerator and denominator.
3. Effects of Capitalization on Solvency Ratios:
Immediate expensing of asset costs understates equity, impacting solvency ratios
like debt to equity.
4. Effects of Capitalization on Operating Cash Flows
Immediate expensing overstates operating cash outflows and understates
investing cash outflows.

14. Plant Assets and Natural Resource:

Plant assets, also known as property, plant, and equipment (PPE), are noncurrent
tangible assets used for generating revenue and cash flows over multiple periods. They
have useful lives, are intended for operational use, and are not acquired for sale. PPE
includes real estate (property), buildings and structures (plant), and machinery
(equipment). These assets, often the largest in a company's holdings, depreciate over
time due to use. They are also referred to as fixed assets or capital assets.

Valuing Property, Plant, and Equipment

When valuing property, plant, and equipment, the historical cost principle is used,
which means assets are initially recorded at their purchase cost. This includes expenses
like freight, installation, taxes, and setup.
For natural resources, also known as wasting assets, companies report them at
historical cost plus costs of discovery, exploration, and development. Costs are
allocated over the estimated reserves available.

15. Depreciation, depletion, and amortization methods allocate costs over useful lives.

Depreciation:
Depreciation is the allocation of the costs of assets over their
useful lives.
The rate of depreciation depends on factors:

JH JACKY 54
 Cost of assets
 Useful life,
 Salvage value, and
 Pattern of use.

Depletion:
Depletion is the allocation of the cost of natural resources on the basis of rate of
extraction or production.
Depletion depends on:
 production – more production yields more depletion expense.

16. Analyzing Plant Assets and Natural Resources:

Analyzing plant assets and natural resources highlights the emphasis on historical cost
for valuation, but this approach has limitations:
• Historical costs aren't particularly relevant for assessing replacement values or future
operational needs.
• They lack comparability across different companies' reports.
• They're not useful for measuring opportunity costs of disposal or assessing
alternative fund uses.
• During changing price levels, historical costs reflect a collection of expenditures with
varying purchasing power.

17. Analyzing Depreciation and Depletion:

Analyzing depreciation and depletion involves considering factors like the depreciable
base, useful life, and allocation method, which can significantly impact depreciation
charges. Our analysis should incorporate this information to assess earnings effectively.
One key aspect to focus on is any revisions to the useful lives of assets.

18. Analyzing Impairments:

Three analysis issues arising with impairment are:
- evaluating the appropriateness of the amount of the impairment,
- evaluating the appropriateness of the timing of the impairment, and
- analyzing the effect of the impairment on income.

19. Intangible Assets:

Intangible assetsare rights, privileges, and benefits of ownership
or control.
Characteristics of intangibles:
 high uncertainty of future benefits,

JH JACKY 55
 lack of physical existence,
 inseparable from a company or its segment,
 have indefinite benefit periods, and
 experience large valuation changes based on competitive circumstances.

20. Amortization of Intangibles:

Intangible assets must be amortized over the benefit periods for these assets.
The length of a benefit period depends on
 the type of intangible,
 demand conditions,
 competitive circumstances, and
 any other legal, contractual, regulatory, or economic limitations.

21. Historical cost valuation is standard but has limitations in assessing replacement
values and future needs.
22. Intangible assets, like goodwill, require cautious evaluation as they may be
misvalued.
23. Analyzing assets involves understanding liquidity, profitability, and risk implications,
as well as the methods and principles governing their valuation and management.
24. Analyzing Intangibles:
We encourage caution and understanding when evaluating intangibles as they are
often seriously misvalued.
Goodwill is eventually reflected in super-earnings. If super- earnings are not evident,
then goodwill is of little or no value.
Since less amortization increases reported earnings, management might amortize
intangibles over periods exceeding their benefit periods.
Our analysis must be alert to the composition, valuation, and disposition of
intangibles.

The operating cycle is a business process that converts inventory into cash. Here are
the key stages:
1. Cash: Represents the initial funds available to the business.
JH JACKY 56
 2. Purchases of Goods or Services: Cash is used to buy goods or services.
3. Holding or Manufacturing Interval: During this phase, goods are either stored or
processed.
4. Inventory: The goods acquired are held in inventory.
5. Sales: Inventory is sold, resulting in receivables (sales made on credit).
6. Receivables: Represent the amount owed by customers.
7. Collection Interval: Receivables are collected, converting them back into cash.

1. a. Explain the concept of a company’s operating cycle and its meaning.

b. Discuss the significance of the operating cycle to classification of current versus
noncurrent items in a balance sheet. Cite examples.
c. Is the operating cycle concept useful in measuring the current debt-paying ability of
a company and the liquidity of its working capital components?
Ans:

a. The operating cycle of a company refers to the time it takes to convert cash into
inventory, sell the inventory, and then collect the resulting receivables from sales. In
simpler terms, it represents the period from when a company invests cash in its
operations to when it receives cash from the sale of goods or services. For example, in a
manufacturing company, the operating cycle involves purchasing raw materials,
converting them into finished goods, selling those goods, and finally collecting cash
from customers. Understanding the operating cycle is crucial for assessing the efficiency
of a company's operations and its ability to generate cash flow.

b. The operating cycle is significant for the classification of current versus noncurrent
items in a balance sheet because it helps determine the timing of when assets are
expected to be converted into cash. Current assets are resources expected to be
converted into cash or used up within one operating cycle or one year, whichever is
longer. Examples include cash, accounts receivable, and inventory. Noncurrent assets,
on the other hand, are resources expected to benefit the company for periods beyond
the current operating cycle or year. Examples include property, plant, and equipment,
as well as long-term investments. Understanding the operating cycle aids in
distinguishing between assets that will be utilized in the short term versus those that
will provide long-term benefits to the company.

c. Yes, the operating cycle concept is useful in measuring the current debt-paying ability
of a company and the liquidity of its working capital components. A shorter operating
cycle generally indicates that a company can more quickly convert its assets into cash,
which can be used to meet its short-term debt obligations. Additionally, analyzing the
components of the operating cycle, such as receivables turnover and inventory
turnover, provides insights into the efficiency of cash conversion and working capital

JH JACKY 57
 management. By understanding the operating cycle and its components, investors and
creditors can assess the liquidity and financial health of a company more effectively.

2. Identify the main concerns in analysis of accounts receivable.

Ans:
1. Collection Risk: Assessing the risk associated with collecting receivables is crucial. It
involves evaluating the creditworthiness of customers and the likelihood of timely
payment. Companies need to ensure that they have effective credit policies in place
to mitigate collection risk.
2. Quality of Receivables: Analyzing the quality of receivables involves examining the
composition of accounts receivable, including aging schedules, concentrations of
credit risk, and any allowances for doubtful accounts. Receivables that are overdue or
concentrated in a few customers pose higher risks.
3. Return Privileges: Liberal return policies can impact the authenticity of receivables.
Companies need to assess the likelihood of returns and allowances, as they can affect
the ultimate collectability of receivables.
4. Contingencies: Receivables may be subject to various contingencies, such as
disputes, discounts, or allowances. Analyzing these contingencies is essential to
determine their impact on the value of receivables and the company's financial
health.
5. Securitization: Companies may opt to securitize receivables by selling them to third
parties. Assessing the terms of such arrangements, including recourse provisions and
the impact on liquidity, is important for understanding the true risk exposure related
to receivables.

3. Many companies attempt to improve profitability and cash flow by reducing

investment in current assets through methods such as
i. effective credit underwriting,
ii. collection of receivables, and
iii. just-in-time inventory management.
Ans:
Absolutely, companies employ various strategies to optimize their profitability and cash
flow by reducing their investment in current assets. Here's how each of the mentioned
methods contributes to achieving this goal:
1. Effective Credit Underwriting: By conducting thorough credit underwriting,
companies can minimize the risk of extending credit to customers who may default
on payments. This involves evaluating the creditworthiness of potential customers
before offering them credit terms. By extending credit only to reliable customers,
companies can reduce the amount tied up in accounts receivable and mitigate the
risk of bad debt. This, in turn, improves cash flow by ensuring a higher percentage of
receivables are collected on time.

JH JACKY 58
 2. Collection of Receivables: Prompt and efficient collection of receivables is essential
for maintaining healthy cash flow. Companies implement robust collection policies
and procedures to ensure that outstanding receivables are collected promptly. This
may involve sending timely reminders, offering discounts for early payments, or
implementing stricter credit terms for delinquent customers. By accelerating the
collection of receivables, companies can convert accounts receivable into cash more
quickly, thereby improving liquidity and cash flow.
3. Just-in-Time Inventory Management: Just-in-time (JIT) inventory management is a
strategy aimed at minimizing inventory holding costs by synchronizing inventory
levels with production and sales requirements. Instead of maintaining large
inventories, companies only procure inventory as and when needed to fulfill
customer orders. This helps reduce the amount of capital tied up in inventory, freeing
up cash for other purposes. Additionally, JIT reduces the risk of obsolete inventory
and minimizes storage costs. By optimizing inventory levels, companies can improve
cash flow and profitability.

4. a. What is meant by the factoring or securitization of receivables?

b. What does selling receivables with recourse mean? What does it mean to sell them
without recourse?
c. How does selling receivables (particularly with recourse) potentially distort the
balance sheet?
Ans:
a. Factoring or Securitization of Receivables:
• Factoring or securitization of receivables involves selling accounts receivable to a
third party, typically a financial institution, at a discount. The third party, known as a
factor or securitizer, assumes responsibility for collecting the receivables from the
debtors. In return, the selling company receives immediate cash, thereby improving
its liquidity. Factoring often involves the outright sale of receivables, while
securitization involves bundling receivables into securities that can be sold to
investors.
b. Selling Receivables with Recourse vs. Without Recourse:
• Selling Receivables with Recourse: Selling receivables with recourse means that a
company sells its accounts receivable to a third party but retains some degree of
responsibility or liability for the collection of those receivables. If the debtor fails to
pay the receivable, the company selling the receivable with recourse may be
obligated to repurchase the receivable or compensate the buyer for any losses
incurred.
• Selling Receivables without Recourse: Selling receivables without recourse means
that a company sells its accounts receivable to a third party without any recourse or
responsibility for the collection of those receivables. Once the receivables are sold,

JH JACKY 59
 the buyer assumes full responsibility for collecting payment from the debtors, and
the selling company is not liable for any defaults or non-payments.
c. How Selling Receivables (Particularly with Recourse) Potentially Distorts the
Balance Sheet:
• Off-Balance Sheet Financing: Selling receivables with recourse allows a company to
remove these receivables from its balance sheet, potentially improving apparent
liquidity and reducing debt-to-equity ratios. However, the company may still retain
significant risks associated with non-payment by debtors, leading to understatement
of risk exposure on the balance sheet.
• Retention of Risk: Even though receivables are sold with recourse, the selling
company may still retain a portion of the risk associated with non-payment by
debtors. However, if this risk is not adequately disclosed, the balance sheet may not
accurately reflect the true level of risk exposure.
• Impact on Financial Ratios: Selling receivables with recourse can affect various
financial ratios, such as the current ratio and debt-to-equity ratio. While the sale of
receivables may initially improve liquidity and reduce debt levels, the potential
obligation to repurchase or compensate for defaulted receivables could impact these
ratios negatively in the future.
• Recognition of Liabilities: If the likelihood of recourse obligations is significant,
accounting standards may require the recognition of liabilities on the balance sheet
to reflect the potential obligation to repurchase or compensate for defaulted
receivables. Failure to accurately account for these obligations can distort the
company's financial position and performance.

5. Discuss the consequences for each of the acceptable inventory methods in recording
costs of inventories and in determination of income.
Ans:

The method chosen for recording costs of inventories can have significant
consequences for a company's financial statements and income determination. Here's a
discussion of the consequences for each of the acceptable inventory methods:
1. FIFO (First-In, First-Out):
o Matches oldest inventory costs with revenue first.
o Higher net income during rising prices.
o Results in higher reported inventory values.
2. LIFO (Last-In, First-Out):
o Assumes recent inventory costs are sold first.
o Lower net income during rising prices.
o Leads to lower reported inventory values.
3. Weighted Average Cost:

JH JACKY 60
 o Recording Costs of Inventories: Average costs of all units available for sale are
used for both cost of goods sold (COGS) and ending inventory. This method
smooths out cost fluctuations.
o Determination of Income: Moderately affects net income, providing
intermediate values between FIFO and LIFO. Suitable for industries with price
fluctuations.

6. Discuss current disclosures for inventory valuation methods and describe how these
disclosures are useful in our analysis. Identify additional types of inventory
disclosures that would be useful for analysis purposes.
Ans:
Current disclosures for inventory valuation methods typically include descriptions of the
specific inventory costing methods used by the company, such as FIFO (First-In, First-
Out), LIFO (Last-In, First-Out), or weighted average cost. These disclosures are usually
found in the notes to the financial statements or within the accounting policies section.
Here's how these disclosures are useful in our analysis:
1. Transparency: Disclosures help investors understand how inventory costs are
determined and reported.
2. Comparability: Allows for industry-wide comparisons of inventory management
practices.
3. Risk Assessment: Helps assess risk levels associated with inventory methods (e.g.,
LIFO vs. FIFO).
4. Financial Ratio Analysis: Impacts key ratios, influencing performance assessments.

Additional types of inventory disclosures that would be useful for analysis purposes
include:
1. Inventory Aging: Breakdown by age categories reveals liquidity and obsolescence
risks.
2. Inventory Composition: Details by product lines or regions aid turnover assessment.
3. Inventory Impairment: Transparency on losses and valuation methods.
4. Inventory Footnotes: Context on policies, adjustments, and management judgments.

7. Comment on the following: Depreciation accounting is imperfect for analysis

purposes.
Ans:
Depreciation accounting, while essential for allocating the cost of tangible assets over
their useful lives, has several imperfections that can affect its usefulness for analysis
purposes. Firstly, depreciation methods and estimates involve a degree of subjectivity,
leading to potential variations in reported depreciation expenses among companies.
Additionally, depreciation accounting may not accurately reflect the actual decline in
value of assets over time, particularly for assets with uncertain future benefits or

JH JACKY 61
 rapidly changing market conditions. Moreover, depreciation accounting does not
consider the impact of technological advancements or changes in market demand,
which can render assets obsolete or less valuable before the end of their estimated
useful lives. Finally, depreciation accounting may not fully capture the economic reality
of asset utilization, as it relies on historical cost rather than market value. Overall, while
depreciation accounting provides a systematic way to allocate asset costs, its limitations
should be considered when conducting analysis.
8. Identify analytical tools useful in evaluating deprecation expense. Explain why they
are useful.
Ans:
b. Analytical Tools for Evaluating Depreciation Expense:
• Comparison to Industry Benchmarks: Analyzing depreciation expense relative to
industry benchmarks allows for comparisons with peer companies or industry
averages. Significant deviations from industry norms may indicate differences in asset
utilization, depreciation methods, or asset management strategies.
• Trend Analysis: Examining trends in depreciation expense over time provides insights
into changes in asset usage, maintenance practices, or capital expenditure patterns.
Significant fluctuations or trends in depreciation expense can signal shifts in business
operations or asset management strategies.
• Asset Turnover Ratios: Asset turnover ratios, such as fixed asset turnover or total
asset turnover, measure the efficiency of asset utilization relative to revenue
generation. Changes in depreciation expense can impact asset turnover ratios,
highlighting shifts in asset productivity or capital efficiency.
• Cash Flow Analysis: Assessing the relationship between depreciation expense and
operating cash flow helps evaluate the impact of non-cash expenses on cash flow
generation. Significant disparities between depreciation expense and cash flow from
operations may indicate underlying issues in asset management or capital
expenditure planning.
• Discounted Cash Flow (DCF) Analysis: DCF analysis involves estimating the present
value of future cash flows generated by assets. Depreciation expense is a key
component in calculating cash flows for DCF analysis, as it affects future earnings and
cash flow projections. Evaluating the reasonableness of depreciation assumptions
and estimates is crucial for accurate DCF valuations.

9. Distinguish between a “hard asset” and a “soft asset.” Cite several examples.
Ans:
Hard Asset: Hard assets refer to tangible, physical assets with a definite physical
presence and measurable value. These assets are typically used in production or
operations and have a relatively long useful life. Examples of hard assets include
machinery, equipment, real estate, vehicles, and infrastructure.

JH JACKY 62
 Soft Asset: Soft assets, also known as intangible assets, are non-physical assets that lack
a definite physical presence but have value to the business. These assets are often
intellectual or legal in nature and provide long-term benefits to the company. Examples
of soft assets include patents, trademarks, copyrights, goodwill, brand recognition,
customer relationships, and proprietary technology. Soft assets are typically more
difficult to quantify and value compared to hard assets.

10. “Liquidity provides flexibility to take advantage of changing market conditions and to
react to strategic actions by competitors.” But how?
Ans:
Liquidity provides flexibility to take advantage of changing market conditions and to
react to strategic actions by competitors in several ways:
1. Ability to Seize Opportunities: When a company has sufficient liquidity, it can quickly
capitalize on opportunities that arise in the market. This could include acquiring
distressed assets at favorable prices, purchasing inventory in bulk at discounted
rates, or investing in growth initiatives such as expansion into new markets or the
development of new products or services.
2. Timely Response to Market Trends: Liquidity enables companies to respond swiftly
to changing market trends and consumer preferences. For example, having cash on
hand allows a retailer to adjust its inventory mix in response to shifting consumer
demand, while a technology company with ample liquidity can invest in research and
development to stay ahead of competitors and adapt to emerging technologies.
3. Flexibility in Financing Options: A company with high liquidity has greater flexibility
in choosing its financing options. It can opt for debt financing when interest rates are
favorable or choose to raise equity capital when market conditions are conducive to
an initial public offering (IPO) or secondary offering. This flexibility reduces reliance
on a single financing source and enhances the company's ability to fund its
operations and growth initiatives.
4. Competitive Response: Liquidity provides companies with the ability to respond
strategically to actions taken by competitors. For example, in industries with intense
competition, a company with ample cash reserves may lower prices or increase
marketing spending to gain market share or defend its position against aggressive
competitors. Similarly, liquidity can be used to launch new marketing campaigns,
offer discounts or incentives, or invest in product innovation to differentiate from
competitors.
5. Mergers and Acquisitions: Liquidity facilitates strategic acquisitions or mergers,
allowing companies to consolidate market share, expand into new geographic
regions, or enter new lines of business. Cash-rich companies have the advantage of
being able to negotiate favorable terms in acquisition deals and may even use their
liquidity as a bargaining tool to secure better pricing or conditions.

JH JACKY 63
 Chapter 4
Analyzing Operating Activities

Chapter Summary:
 Income Statement Basics:
• Income is the net result of revenues minus expenses, determined using accrual
accounting.
• The income statement summarizes a company's financial performance over a
period.

 Income Analysis Objectives:

• Assessing company performance and risk.
• Predicting future cash flows and their uncertainty.
 Alternative Concepts of Income:
• Economic income: Reflects changes in shareholder wealth, considering cash
flows and future cash flow present value changes.
• Permanent income: Represents stable average income a business is expected
to earn over its lifetime.
 Accounting Income Components:
• Revenues and gains: Inflows of cash from ongoing business activities.
Revenues are earned inflows of cash that arise from a company’s ongoing
business activities.
Gains are earned inflows of cash arising from transactions and events
unrelated to a company’s ongoing business activities.
• Expenses and losses: Outflows or allocations of cash related to ongoing
business operations.

JH JACKY 64
 Expenses are incurred outflows of cash that arise from a company’s ongoing
business operations.
Losses are decreases in a company’s net assets arising from peripheral or
incidental operations of a company.
 Income Classification:
• Operating vs. Non-operating Income:
Operating Income: Arises from core business activities, like sales of goods or
services.
Non-operating Income: Derives from peripheral activities, such as investments
or one-time gains.
• Recurring vs. Nonrecurring Income:
Recurring Income: Regularly generated from ongoing operations, providing a
stable income stream.
Nonrecurring Income: Occurs irregularly or infrequently, often from
extraordinary events or one-time transactions.
 Alternative Income Measures:
• Net Income: Represents the bottom line of the income statement, computed
by subtracting expenses from revenues. It includes both operating and non-
operating items.
• Comprehensive Income: Goes beyond net income by incorporating other
comprehensive income items like unrealized gains/losses on investments,
foreign currency translation adjustments, etc. It provides a more inclusive view
of changes in shareholders' equity.
• Continuing Income: Excludes extraordinary items, cumulative effects of
accounting changes, and effects of discontinued operations from net income. It
focuses on ongoing, recurring earnings to assess the sustainable earning power
of a business.
 Operating Income:
There are three important aspects of operating income:
First, Operating income pertains only to income generated from operating activities.
Second, Operating income focuses on income for the company as a whole rather
than for debt and equity holders.
This means that operating income is a measure that focuses on the income
generated from the company’s core business operations, excluding any income or
expenses from non-core business activities.
Third, Operating income pertains only to ongoing business activities.

JH JACKY 65
 This means any income or loss pertaining to discontinued operations is excluded
from operating income.
 Comprehensive Income:
• Clean Surplus: The bottom-line income reflects all changes in shareholders’
equity arising from other than owner transactions. This adjustments in income
statement is called clean surplus.
• Dirty Surplus: Nevertheless, standard setters have over time allowed certain
components of comprehensive income to bypass the income statement as
direct adjustments to equity. These adjustments are called dirty surplus.
 Non-Recurring Items:
• Extraordinary items: Unusual and infrequent events reported separately in the
income statement.
• Discontinued operations: Income/loss from divested segments, reported
separately.
 Accounting Changes:
• Companies can change accounting methods and assumptions to:

 Comply with a new accounting standard,

 Better reflect changing business activities or conditions.
 Window-dress financial statements, particularly for managing earnings.
Four types of accounting changes:
• A change in accounting principle,
• A change in accounting estimate,
• A change in reporting entity, and
• Correction of an error.
 Four types of accounting changes encompass various alterations in accounting
practices:
Change in Accounting Principle: Occurs when a company shifts from one generally
accepted accounting principle (GAAP) to another. For instance, changing from FIFO to
LIFO inventory valuation method. Typically requires retrospective application,
restating prior period financial statements.
Change in Accounting Estimate: Involves adjusting estimates used in financial
reporting, such as useful lives of assets or allowance for doubtful accounts.
JH JACKY 66
 Prospectively applied in the period of change and future periods; no restatement of
prior period financial statements required.
Change in Reporting Entity: Arises when there's a change in the composition of
entities included in financial statements, like merger, acquisition, or disposal of a
subsidiary. Requires restatement of prior period financial statements to reflect the
change in reporting entity.
Correction of an Error: Involves rectifying an error in previously issued financial
statements. Correction is applied retrospectively by restating prior period financial
statements to correct the error. It ensures financial statements are presented
accurately and fairly.

 Analyzing Accounting Changes:

• Consider cosmetic nature, economic reality reflection, and potential earnings
management.
• Assess impact on comparisons across time and on economic vs. permanent
income.
An analyst must consider:
First, recognize that they often have no direct impact on cash flows, only on reported
earnings.
Second, consider whether the change better aligns with economic reality, such as
adjusting depreciation methods to match asset usage.
Third, Be vigilant for potential earnings management, particularly through changes in
accounting estimates.
Fourth, Guard against earnings manipulation, which occurs when practices deviate
from accepted norms.
Fifth, ensure comparability across time periods by evaluating changes consistently.
Finally, Evaluate the impact on both economic and permanent income, using
reported numbers for permanent income and considering both current and
cumulative effects for economic income estimation.

JH JACKY 67
 BOOK Questions
1. Companies typically report compensating balances that are required under a loan
agreement as unrestricted cash classified within current assets.
a. For purposes of financial statement analysis, is this a useful classification? Explain.
b. Describe how you would evaluate compensating balances.
Ans:
a. Usefulness of Classification:
• This classification may not be entirely useful for financial statement analysis because
it can overstate the liquidity position of the company. Compensating balances,
although reported as unrestricted cash, are actually tied up as collateral for loans.
They cannot be freely used for operational purposes. Therefore, relying solely on this
classification may lead to a misconception about the company's actual liquidity
position.
• Explanation: It's important for financial analysts to understand the true nature of
unrestricted cash and distinguish it from cash that is encumbered by loan
agreements. This misclassification can distort liquidity ratios and mislead
stakeholders about the company's ability to meet short-term obligations.
b. Evaluation of Compensating Balances:
• Analyze loan agreements and related documents to determine the nature and extent
of compensating balances.
• Assess the impact of compensating balances on liquidity ratios and financial health.
• Consider the company's ability to meet short-term obligations after accounting for
the encumbrance of cash.

2. a. Explain the concept of a company’s operating cycle and its meaning.

b. Discuss the significance of the operating cycle to classification of current versus
noncurrent items in a balance sheet. Cite examples.
c. Is the operating cycle concept useful in measuring the current debt-paying ability of a
company and the liquidity of its working capital components?
Ans:
a. Operating Cycle:
• The operating cycle represents the time it takes for a company to convert its
resources into cash through operational activities. It includes the process of acquiring
inventory, selling goods or services, and collecting cash from customers.

JH JACKY 68
b. Significance of Operating Cycle to Balance Sheet Classification:
• The operating cycle influences the classification of current versus noncurrent items
on the balance sheet. Items related to the operating cycle, such as inventory and
accounts receivable, are typically classified as current assets because they are
expected to be converted into cash or consumed within the operating cycle period.
• Examples: Inventory, accounts receivable, and prepaid expenses are examples of
current assets directly linked to the operating cycle. Conversely, long-term
investments or assets held for sale are typically classified as noncurrent assets as
they are not expected to be converted into cash within the operating cycle.
c. Usefulness of Operating Cycle in Measuring Current Debt-Paying Ability and Working
Capital Liquidity:
• Yes, the operating cycle concept is useful in assessing a company's current debt-
paying ability and the liquidity of its working capital components. By understanding
the length of the operating cycle, analysts can gauge how efficiently a company
manages its working capital and the speed at which it can convert assets into cash to
meet short-term obligations.
• Explanation: A shorter operating cycle indicates faster turnover of assets and
efficient management of working capital, which positively impacts liquidity and the
ability to pay off current debts. Conversely, a longer operating cycle may raise
concerns about liquidity and working capital management.
• Example: If a company has a short operating cycle, it suggests that it can quickly
convert inventory into sales and collect cash from customers, enhancing its ability to
meet short-term debt obligations. Conversely, a longer operating cycle may indicate
slower cash conversion and potential liquidity challenges.
3. a. Identify the main concerns in analysis of accounts receivable.
b. Describe information, other than that usually available in financial statements, that we
should collect to assess the risk of noncollectibility of receivables.
Ans:
a. Main Concerns in Analysis of Accounts Receivable:
• Assessing the quality of receivables: Determine the likelihood of collection and
potential for bad debts.
• Analyzing aging schedules: Reviewing the age of receivables helps in identifying
overdue accounts and potential collection issues.
• Evaluating allowance for doubtful accounts: Assessing the adequacy of the provision
for bad debts.

JH JACKY 69
 • Understanding credit policies: Examining the terms and conditions for extending
credit to customers.
b. Additional Information to Assess Noncollectibility Risk:
• Customer creditworthiness: Obtaining credit reports or conducting credit checks on
customers.
• Industry trends: Understanding the economic conditions and industry-specific factors
that may impact customer solvency.
• Customer payment history: Reviewing historical payment patterns and any past
delinquencies.
• Customer relationships: Assessing the nature of the relationship between the
company and its customers, including communication and responsiveness.

4. a. What is meant by the factoring or securitization of receivables?

b. What does selling receivables with recourse mean? What does it mean to sell them
without recourse?
c. How does selling receivables (particularly with recourse) potentially distort the balance
sheet?
Ans:
a. Factoring or Securitization of Receivables:
• Factoring: Involves selling accounts receivable to a third-party (factor) at a discount in
exchange for immediate cash.
• Securitization: Involves pooling receivables and selling them as securities to investors,
with the receivables serving as collateral.
b. Selling Receivables with Recourse vs. Without Recourse:
• With Recourse: The seller retains some responsibility for non-payment by the debtor.
If the debtor defaults, the seller may be required to repurchase the receivables from
the buyer.
• Without Recourse: The buyer assumes full responsibility for non-payment by the
debtor. The seller has no further obligation if the debtor defaults.
c. Potential Distortion of Balance Sheet by Selling Receivables:
• Selling receivables with recourse may lead to the need for the seller to retain a
portion of the receivable amount as a contingent liability, potentially understating
the true level of liabilities on the balance sheet.

JH JACKY 70
 • Selling receivables without recourse may result in the transfer of both assets and
liabilities off the balance sheet, which can distort the financial position and leverage
ratios of the seller.
5. a. Discuss the consequences for each of the acceptable inventory methods in recording
costs of inventories and in determination of income.
b. Comment on the variation in practice regarding the inclusion of costs in inventories.
Give examples of at least two sources of such cost variations.
Ans:
a. Consequences of Acceptable Inventory Methods on Recording Costs and Income:
• FIFO (First-In, First-Out): Generally results in higher ending inventory and lower cost
of goods sold (COGS) during inflationary periods. This leads to higher reported
income due to lower expenses.
• LIFO (Last-In, First-Out): Typically leads to lower ending inventory and higher COGS
during inflationary periods, resulting in lower reported income due to higher
expenses.
• Weighted Average Cost: Blends the costs of all units available for sale, resulting in a
cost per unit. This method falls between FIFO and LIFO in terms of impact on
inventory valuation and income determination.
b. Variation in Practice Regarding Inclusion of Costs in Inventories:
• Direct Costs vs. Indirect Costs: Some companies include only direct costs (direct
materials, direct labor) in inventories, while others also include indirect costs
(manufacturing overhead).
• Allocation Methods: Differences in how companies allocate overhead costs to
inventories, such as using traditional costing or activity-based costing, can result in
variations in inventory valuation.

6. a. Describe the importance of the level of activity on the unit cost of goods produced
by a manufacturer.
b. Allocation of overhead costs requires certain assumptions. Explain and illustrate cost
allocations and their links to activity levels with an example.
Ans:
a. Importance of Activity Level on Unit Cost of Goods Produced:
• The level of activity directly affects the unit cost of goods produced by a
manufacturer. Higher activity levels typically result in lower unit costs due to

JH JACKY 71
 economies of scale, as fixed costs are spread over more units of production.
Conversely, lower activity levels may lead to higher unit costs as fixed costs are
spread over fewer units.
b. Allocation of Overhead Costs and Links to Activity Levels:
• Overhead costs need to be allocated to products to determine their total production
costs. This allocation involves certain assumptions, such as the choice of allocation
base (e.g., direct labor hours, machine hours) and the predetermined overhead rate.
• Example: A manufacturing company allocates overhead costs based on machine
hours. If the company produces more units during a period, it will require more
machine hours, resulting in a higher allocation of overhead costs to each unit
produced. Conversely, if the company produces fewer units, the overhead costs
allocated to each unit will be higher due to fewer machine hours used. This illustrates
the link between activity levels and overhead cost allocation.

7. Explain the major objective(s) of LIFO inventory accounting. Discuss the consequences
of using LIFO in both measurement of income and the valuation of inventories for the
analysis of financial statements.
Ans:
Major Objectives of LIFO Inventory Accounting:
• Matching Principle: LIFO (Last-In, First-Out) aims to match the most recent costs of
inventory with current revenues. This theoretically reflects the current cost of goods
sold (COGS) more accurately by using the most recent costs.
• Tax Minimization: LIFO may help minimize taxable income during periods of rising
prices because it assigns the highest costs to COGS, thereby reducing taxable profits.
Consequences of Using LIFO:
• Measurement of Income: LIFO often results in lower reported income during periods
of rising prices. This is because the COGS reflects higher, more recent costs compared
to FIFO or weighted average methods.
• Valuation of Inventories for Financial Statement Analysis: LIFO tends to undervalue
inventories on the balance sheet during inflationary periods. This can distort financial
ratios such as gross profit margin and inventory turnover ratio, leading to potential
misinterpretation of a company's financial health.

JH JACKY 72
8. Discuss current disclosures for inventory valuation methods and describe how these
disclosures are useful in our analysis. Identify additional types of inventory disclosures
that would be useful for analysis purposes.
Ans:
Current Disclosures for Inventory Valuation Methods:
• Companies typically disclose their inventory valuation method (FIFO, LIFO, weighted
average) in the footnotes to the financial statements.
• These disclosures provide transparency to investors and analysts regarding the
method used to value inventories.
Usefulness of Disclosures in Analysis:
• Knowing the inventory valuation method helps analysts understand the potential
impact on financial ratios and profitability measures.
• It allows for more accurate comparison between companies and industries, as
different valuation methods can lead to variations in reported financial figures.
Additional Inventory Disclosures for Analysis:
• Inventory Turnover: Disclosure of inventory turnover ratios over multiple periods can
provide insights into inventory management efficiency.
• Inventory Aging Schedule: Details on the age of inventory, such as how much
inventory is classified as slow-moving or obsolete, can help assess the quality and
potential liquidity issues related to inventory.
• Impact of Inventory Valuation Methods: Quantitative disclosures showing the
potential impact of using different inventory valuation methods on financial
statements can aid analysts in adjusting financial ratios for comparability.
9. Companies typically apply the lower-of-cost-or-market (LCM) method for inventory
valuation.
a. Define cost as it applies to inventory valuation.
b. Define market as it applies to inventory valuation.
c. Discuss the rationale behind the LCM rule.
d. Identify arguments against the use of LCM.
Ans:
a. Cost in Inventory Valuation: Cost refers to the expenses incurred in acquiring, producing,
and bringing inventory to its current condition and location. It includes direct costs such as

JH JACKY 73
purchase price, freight, and handling charges, as well as indirect costs such as storage and
insurance.
b. Market in Inventory Valuation: Market refers to the replacement cost of inventory,
which is the current cost of purchasing or producing the same inventory items. It is
determined by comparing the current market price to the original cost of inventory.
c. Rationale behind LCM Rule:
• The LCM rule ensures that inventories are not overstated on the balance sheet by
requiring companies to value inventory at the lower of its cost or market value.
• This rule aims to provide conservative and realistic valuation of inventories to reflect
potential declines in market value or obsolescence.
d. Arguments against the Use of LCM:
• LCM can lead to inconsistency and subjectivity in valuation, as determining market
value may be subjective and prone to manipulation.
• It may not accurately reflect the future selling price of inventory, especially in
industries with volatile market prices.
• LCM can result in volatility in reported earnings due to write-downs of inventory
values, which may distort financial performance.

10. Compare and contrast the effects of LIFO and FIFO inventory costing methods on
earnings in an inflationary period.
Ans:
Comparison of LIFO and FIFO in Inflationary Period:
• LIFO (Last-In, First-Out): During inflation, LIFO tends to result in higher cost of goods
sold (COGS) as it assigns the most recent, higher costs to inventory, leading to lower
reported earnings.
• FIFO (First-In, First-Out): FIFO, on the other hand, tends to result in lower COGS as it
assigns the older, lower costs to inventory, leading to higher reported earnings.
Contrast:
• LIFO matches recent costs with revenue, which may better reflect current economic
conditions but can lead to inventory undervaluation on the balance sheet.
• FIFO may better match historical costs with revenue, providing a more accurate
representation of inventory value on the balance sheet but potentially overstates
earnings during inflationary periods.

JH JACKY 74
11. Manufacturers report inventory in the form of raw materials, work-in-process, and
finished goods. For each category, discuss how an increase might be viewed as a positive
or a negative indicator of future performance depending on the circumstances that led to
the inventory build up.
Ans:
Raw Materials:
• Positive Indicator: An increase in raw materials may indicate anticipation of
increased production, reflecting confidence in future demand and growth
opportunities.
• Negative Indicator: However, an excessive build-up of raw materials may suggest
inefficient inventory management, tying up working capital and increasing holding
costs.
Work-in-Process (WIP):
• Positive Indicator: An increase in WIP may indicate higher production levels and
progress towards completing products, signaling operational efficiency and meeting
customer demand.
• Negative Indicator: Conversely, a sudden surge in WIP may signal production
bottlenecks, inefficiencies, or delays in completing products, potentially impacting
profitability and customer satisfaction.
Finished Goods:
• Positive Indicator: An increase in finished goods may indicate successful production
and fulfillment of customer orders, suggesting strong sales and revenue growth.
• Negative Indicator: However, excessive finished goods may signal overproduction,
potentially leading to inventory obsolescence, discounting, or write-offs, impacting
profitability and liquidity.
12. Comment on the following: Depreciation accounting is imperfect for analysis
purposes.
Ans:
Comment on Depreciation Accounting Imperfection: Depreciation accounting, while
necessary for allocating the cost of assets over their useful lives, has inherent limitations for
analysis purposes. It relies on estimates of asset useful lives, salvage values, and
depreciation methods, which can vary and impact the accuracy of financial statements.
Additionally, depreciation methods may not always reflect the true economic wear and tear
of assets, leading to potential distortions in financial ratios and performance metrics.

JH JACKY 75
13. Analysts cannot unequivocally accept the depreciation amount. One must try to
estimate the age and efficiency of plant assets. It is also useful to compare depreciation,
current and accumulated, with gross plant assets, and to make comparisons with similar
companies. While an analyst cannot adjust earnings for depreciation with precision, an
analyst doesn’t require precision. Comment on these statements.
Ans:
Comment on Estimating Depreciation: While depreciation amounts are reported in
financial statements, analysts should assess the age and efficiency of plant assets to
understand the reasonableness of depreciation expenses. Comparing depreciation to gross
plant assets and benchmarking against industry peers provides context for evaluation.
Although precision in adjusting earnings for depreciation may be challenging, the goal is to
obtain a reasonable approximation rather than exact precision, allowing for meaningful
analysis and decision-making.
14. Identify analytical tools useful in evaluating deprecation expense. Explain why they
are useful.
Ans:
Analytical Tools for Evaluating Depreciation Expense:
• Ratio Analysis: Comparing depreciation expense to gross plant assets or revenues
helps assess the efficiency of asset utilization and the impact on profitability.
• Trend Analysis: Examining changes in depreciation expense over time provides
insights into asset aging, maintenance practices, and potential investment needs.
• Benchmarking: Comparing depreciation metrics with industry averages or peer
companies helps identify outliers and assess relative performance.
• Cash Flow Analysis: Evaluating the impact of depreciation on cash flows, such as
through cash flow from operating activities, helps understand the cash-generating
ability of the business.
These tools are useful because they provide insights into the efficiency of asset utilization,
the adequacy of depreciation policies, and potential implications for financial performance
and future investments.

15. Analysts must be alert to what aspects of goodwill in their analysis of financial
statements?
Ans:
Aspects of Goodwill Analysts Must Be Alert To:

JH JACKY 76
 • Impairment: Goodwill is subject to impairment testing, and analysts should assess
whether any impairment charges have been recorded and the potential impact on
reported earnings.
• Valuation: Analysts should scrutinize the valuation of goodwill recorded on the
balance sheet, ensuring it accurately reflects the value of intangible assets acquired.
• Acquisition Strategy: Understanding the rationale behind goodwill arising from
acquisitions helps assess management's strategic decisions and potential future
performance expectations.
• Disclosure: Analysts should review disclosures related to goodwill, including the
method used for impairment testing and any significant assumptions made, to
evaluate the reliability of reported financial information.
16. Explain when an expenditure should be capitalized versus when it should be
expensed.
Ans:
Capitalization vs. Expense of Expenditures:
• Capitalization: Expenditures should be capitalized when they result in the
acquisition, improvement, or enhancement of an asset that will provide future
economic benefits beyond the current period. Capitalized costs are recorded as
assets on the balance sheet and depreciated or amortized over their useful lives.
• Expense: Expenditures should be expensed when they are incurred to maintain or
repair existing assets, do not extend the useful life or enhance the asset's capabilities,
or are consumed within the current accounting period. Expensed costs are recorded
as expenses on the income statement and reduce net income for the period.

17. Distinguish between a “hard asset” and a “soft asset.” Cite several examples.
Ans:
Distinction between Hard Assets and Soft Assets:
• Hard Asset: Hard assets refer to tangible assets with physical substance and lasting
value. They are typically used in operations or production and are included on the
balance sheet as property, plant, and equipment (PP&E) or fixed assets.
• Examples: Machinery, equipment, land, buildings, vehicles.
• Soft Asset: Soft assets, also known as intangible assets, lack physical substance but
hold value for the business. They are typically recorded on the balance sheet and
amortized over their useful lives.

JH JACKY 77
 • Examples: Intellectual property (patents, trademarks), goodwill, copyrights,
software licenses.

18. The net income of companies that explore for natural resources can sometimes bear
little relation to the asset amounts reported on the balance sheet for natural resources.
a. Explain how the lack of a relation between income and natural resource assets can
occur.
b. Describe circumstances when a more economically sensible relation is likely to exist.
Ans:
a. Lack of Relation between Income and Natural Resource Assets:
• Exploration costs for natural resources are often expensed as incurred, leading to
little reflection of these expenditures in the asset amounts reported on the balance
sheet.
• Additionally, natural resource assets may be undervalued on the balance sheet if
exploration costs are not reflected, leading to a disconnect between reported income
and asset amounts.
b. Circumstances for a More Economically Sensible Relation:
• When exploration costs are capitalized and added to the cost of natural resource
assets, providing a more accurate representation of the resources' value.
• When natural resource assets are revalued periodically to reflect changes in market
prices, reserves, or technological advancements, aligning the balance sheet with the
economic reality of the assets.

19. From the view of a user of financial statements, describe objections to using historical
cost as the basis for valuing tangible assets.
Ans:
Objections to Using Historical Cost for Valuing Tangible Assets:
• Historical cost may not reflect the current fair value or market value of assets,
especially during periods of inflation or deflation.
• It does not account for changes in the asset's condition, technological advancements,
or market conditions over time.
• Using historical cost may result in understating or overstating the true economic
value of assets, impacting decision-making and financial analysis.

JH JACKY 78
 • Historical cost does not provide users with relevant information about the current
worth or potential future cash flows associated with tangible assets.
20. a. Identify the basic accounting procedures governing valuation of intangible assets.
b. Distinguish between accounting for internally developed and purchased goodwill (and
intangibles).
c. Discuss the importance of distinguishing between identifiable intangibles and
unidentifiable intangibles.
d. Explain the principles underlying amortization of intangible assets.
Ans:
a. Basic Accounting Procedures for Valuation of Intangible Assets:
• Intangible assets are initially recorded at cost, which includes all costs necessary to
acquire or develop the asset.
• Subsequent to initial recognition, intangible assets are typically amortized over their
useful lives, reflecting the consumption of economic benefits over time.
• Intangible assets with indefinite useful lives are not amortized but are subject to
impairment testing at least annually.
b. Accounting for Internally Developed and Purchased Goodwill and Intangibles:
• Internally Developed Intangibles: Costs incurred internally to develop intangible
assets are generally expensed as incurred, except for certain development costs that
meet specific criteria for capitalization.
• Purchased Goodwill and Intangibles: Goodwill and intangible assets acquired in a
business combination are recognized at their fair values at the acquisition date.
Goodwill is recorded as the excess of the purchase price over the fair value of
identifiable assets acquired and liabilities assumed.
c. Importance of Distinguishing between Identifiable and Unidentifiable Intangibles:
• Identifiable Intangibles: These are assets with identifiable characteristics and
separable from the business, such as patents or trademarks. They are recorded on
the balance sheet and subject to amortization or impairment testing.
• Unidentifiable Intangibles: These are assets without identifiable characteristics, such
as goodwill or brand reputation. They are not separately recognized on the balance
sheet unless acquired in a business combination and are subject to annual
impairment testing.
d. Principles Underlying Amortization of Intangible Assets:

JH JACKY 79
 • Amortization of intangible assets reflects the systematic allocation of their cost over
their useful lives.
• The amortization period is based on the estimated economic benefits derived from
the intangible asset, considering factors such as technological obsolescence, legal or
contractual limitations, and expected market demand.
• Intangible assets with finite useful lives are amortized over their expected useful lives
using a systematic and rational method.

21. Describe analysis implications for goodwill in light of current accounting procedures.
Ans:
Analysis Implications for Goodwill:
• Goodwill represents the premium paid for acquiring a business and is subject to
impairment testing at least annually.
• Analysts should evaluate the carrying amount of goodwill relative to its recoverable
amount to assess whether impairment may be necessary.
• Changes in goodwill impairment charges can signal changes in the underlying
performance or value of the acquired business, impacting future cash flows and
financial performance.

22. Identify five types of deferred charges and describe the rationale of deferral for each.
Ans:
Types of Deferred Charges and Rationale of Deferral:
1. Prepaid Expenses: Costs paid in advance that benefit future periods, such as
insurance premiums or rent. These are deferred to match expenses with related
revenues.
2. Deferred Tax Assets: Tax benefits that will be realized in future periods due to
temporary differences between accounting and tax rules. Deferred to reflect future
tax benefits.
3. Deferred Revenue: Payments received in advance for goods or services that will be
delivered in the future. Deferred until revenue recognition criteria are met.
4. Deferred Financing Costs: Fees and expenses associated with obtaining financing,
deferred and amortized over the term of the financing.

JH JACKY 80
 5. Deferred Compensation: Compensation paid to employees that will be recognized as
an expense over the service period. Deferred to match expense with related benefits.

23. a. Describe at least two assets not recorded on the balance sheet.
b. Explain how an analyst evaluates unrecorded assets.
Ans:
a. Assets Not Recorded on the Balance Sheet:
• Brand Reputation: While valuable, brand reputation is often not recorded on the
balance sheet unless acquired through a business combination.
• Human Capital: The skills, knowledge, and experience of employees are not typically
recorded on the balance sheet.
b. Evaluation of Unrecorded Assets:
• Analysts assess the impact of unrecorded assets on the company's value and
performance through qualitative analysis, considering factors such as brand
recognition, employee expertise, and customer relationships.
• Comparisons with industry peers and historical performance can provide insights into
the significance of unrecorded assets and their potential impact on future earnings
and cash flows.

JH JACKY 81
 Chapter 5
Profitability Analysis

Chapter Summary:

Return on Invested Capital (ROIC):

• ROIC measures a company’s earnings relative to its financing.
• It reflects a company's success in using financing to generate profits.
Importance of ROIC:
• Provides a comprehensive measure of company performance.
• Allows comparison of companies based on capital efficiency and risk.
• Assesses return relative to capital investment risk.
• Indicates a company's ability to attract financing, repay creditors, and reward
owners.
• Assesses managerial effectiveness, profitability, and aids in planning and control.
1. Measuring Managerial Effectiveness:
• ROIC reflects the effectiveness of management in decision-making and execution.
• Management's skill, resourcefulness, and motivation influence ROIC significantly.
2. Measuring Profitability:
• ROIC is a crucial indicator of a company's long-term financial strength.
• It assesses profitability using both income statement and balance sheet data.
• Offers advantages over other solvency measures by incorporating various financing
perspectives.
3. Measure for Planning and Control:
• ROIC plays a vital role in planning, budgeting, and controlling business activities.
• Helps in evaluating returns at different levels such as segments, divisions, and
product lines.
• Guides strategic decisions and action plans based on expected returns.
Components of ROIC:
Return on invested capital is computed as:
Return on Invested Capital = (income/invested capital)

JH JACKY 82
 Two different measures of invested capital:
(i) Net Operating Assets
(ii) Common Equity Capital
1. Net Operating Assets (NOA):
• Operating assets are comprised of total assets less financial assets such as
investments in marketable securities.
• Operating liabilities are comprised of total liabilities less interest-bearing debt.
• NOA Computed as (Operating Assets - Operating Liabilities)
𝑁𝑁𝑁𝑁𝑁𝑁 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑇𝑇𝑇𝑇𝑇𝑇 (𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁)
• Return on NOA =
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑁𝑁𝑁𝑁𝑁𝑁

• Net operating income after tax (NOPAT) = Revenue-Operating Expenses

2. Common Equity Capital:
• Return On Common Equity (ROCE) = (Net Income - Preferred Dividends) /
Average Common Equity.
• Common Equity = Total Shareholders’ Equity - Preferred Stock
or Common Equity = Total Assets - Debt and Preferred Stock.
Disaggregating RNOA:
• RNOA = Net Operating Profit Margin x Net Operating Asset Turnover.
• Net Operating Profit Margin measures a company’s operating profitability relative to
sales.
• Net Operating Asset Turnover measures a company’s effectiveness in generating
sales from net operating assets.
Effect of Operating Leverage:
• Alternate decomposition of RNOA includes Operating Liability Leverage Ratio.
• Increasing Operating Liability Leverage Ratio enhances RNOA.
Disaggregation of Profit Margin (PM):
• Pretax PM is divided into Pretax sales PM and Pretax other PM.
• Provides insight into gross margin, selling expenses, administrative expenses, and
other factors affecting profitability.

JH JACKY 83
 BOOK Questions
1. How is return on invested capital used as an internal management tool?
Ans:
Return on invested capital (ROIC) is used as an internal management tool in various ways:
1. Performance Evaluation: It assesses the effectiveness of capital allocation decisions
and overall business performance.
2. Resource Allocation: ROIC guides decisions on where to allocate resources based on
their potential to generate high returns.
3. Incentive Alignment: It can be used to align managerial incentives with the
company's financial objectives.
4. Strategic Planning: ROIC helps in evaluating strategic initiatives and investment
opportunities.
5. Continuous Improvement: It serves as a benchmark for driving operational efficiency
and enhancing profitability over time.

2. Why is return on invested capital one of the most relevant measures of company
performance? How do we use this measure in our analysis of financial statements?
Ans:

Return on invested capital (ROIC) is highly relevant due to its comprehensive assessment of
profitability and capital efficiency:
1. Comprehensive Performance Measure: It integrates both income and balance sheet
data, offering a holistic view of financial performance.
2. Capital Efficiency Indicator: ROIC reflects how effectively a company generates
profits from its invested capital, highlighting management's resource allocation skills.
In financial statement analysis:
• Comparative Analysis: ROIC facilitates comparisons across companies and industries.
• Trend Analysis: Monitoring changes in ROIC over time helps identify financial
performance trends.
• Strategic Decision Making: ROIC guides strategic decisions such as capital allocation
and investment prioritization.
• Risk Management: ROIC aids in assessing the risk-return profile of investments.

JH JACKY 84
3. Why is interest expense ignored when computing return on net operating assets
(RNOA)?
Ans:
Interest expense is ignored when computing Return on Net Operating Assets (RNOA)
because:
1. Focus on Operational Performance: RNOA aims to evaluate the profitability of a
company's core business operations, excluding the impact of financing decisions.
2. Isolating Operating Income: By excluding interest expense, RNOA provides a clearer
picture of the operating income generated solely from the company's operating
assets.
3. Comparability: Ignoring interest expense ensures comparability across companies
with varying capital structures, allowing for a more accurate assessment of
operational efficiency.

4. Discuss the motivation for excluding “nonproductive” assets from invested capital
when computing return. What circumstances justify excluding intangible assets from
invested capital?
Ans:
Excluding "nonproductive" assets from invested capital when computing return:
1. Focus on Efficiency: Emphasizes assets actively contributing to revenue generation
and operational activities, providing a clearer picture of operational efficiency.
2. Enhanced Comparability: Facilitates comparison across companies and industries by
ensuring return calculations reflect performance from assets actively deployed in
revenue-generating activities.
Excluding intangible assets may be justified when:
1. Lack of Tangibility: Intangible assets may not directly contribute to revenue and are
challenging to value accurately.
2. Strategic Considerations: Companies strategically invest in intangible assets for
competitive advantage, but excluding them allows focus on tangible assets while
separately evaluating intangible impacts.

5. Why must income used in computing return on invested capital be adjusted to reflect
the capital base (denominator) used in the computation?
Ans:
JH JACKY 85
Income used in computing return on invested capital (ROIC) must be adjusted to reflect the
capital base (denominator) used in the computation because:
1. Consistency: It ensures alignment between earnings and the capital employed,
maintaining consistency in the ROIC calculation.
2. Comparability: Adjusting income allows for meaningful comparisons of ROIC across
companies with different capital structures.
3. Reflecting Opportunity Cost: This adjustment accounts for the opportunity cost of
capital, reflecting the return relative to the cost of capital.
4. Accurate Performance Measurement: It provides a more accurate measure of the
company's performance in generating returns from its invested capital.

6. What is the relation between return on net operating assets and sales? Consider both
NOPAT sales and sales to net operating assets in your response.
Ans:
The relation between return on net operating assets (RNOA) and sales is twofold:
1. NOPAT to Sales Ratio: Indicates operational profitability relative to total sales. Higher
ratio signifies better efficiency in converting sales into profits.
2. Sales to Net Operating Assets Ratio: Reflects how efficiently sales are generated
from net operating assets. A higher ratio suggests effective asset utilization.
Together, these ratios illustrate the company's ability to turn sales into profits while
efficiently utilizing operational assets.

7. Company A acquires Company B because the latter has a NOPAT margin exceeding the
industry norm. After acquisition, a shareholder complains that the acquisition lowered
return on net operating assets. Discuss possible reasons for this occurrence.
Ans:

The acquisition of Company B by Company A, despite Company B having a higher NOPAT

margin, could lower return on net operating assets (RNOA) due to:
1. Integration Challenges: Difficulty in effectively integrating operations, leading to
inefficiencies in asset utilization.
2. Increase in Asset Base: Addition of Company B's assets may not align proportionately
with profit increases, resulting in lower RNOA.

JH JACKY 86
 3. Profitability Dilution: If Company A's profitability is lower than Company B's pre-
acquisition, it could dilute the overall RNOA.
4. Financial Structure Changes: Changes in financial structure post-acquisition could
affect cost of capital and RNOA.
5. Strategic Objectives: Strategic reasons for the acquisition might impact short-term
financial metrics like RNOA.

8. Company X’s NOPAT margin is 2% of sales. Company Y has a net operating asset
turnover of 12. Both companies’ RNOA are 6% and are considered unsatisfactory by
industry norms. What is the net operating asset turnover of Company X? What is the
NOPAT margin for Company Y? What strategic actions do you recommend to the
managements of the respective companies?
Ans:
To calculate the missing metrics and provide strategic recommendations:
Given Data:
• Company X:
• NOPAT Margin = 2%
• RNOA = 6%
• Company Y:
• Net Operating Asset Turnover = 12
• RNOA = 6%
Calculations:
1. Net Operating Asset Turnover for Company X:
• RNOA = NOPAT Margin * Net Operating Asset Turnover
• 6% = 2% * Net Operating Asset Turnover
• Net Operating Asset Turnover for Company X = 6% / 2% = 3
2. NOPAT Margin for Company Y:
• RNOA = NOPAT Margin * Net Operating Asset Turnover
• 6% = NOPAT Margin * 12
• NOPAT Margin for Company Y = 6% / 12 = 0.5%
Strategic Recommendations:

JH JACKY 87
 1. For Company X:
• Increase Efficiency: Improve asset turnover to boost RNOA. This could involve
optimizing inventory management, enhancing production processes, or
divesting underperforming assets.
• Cost Control: Focus on reducing operating expenses to increase profitability
without relying solely on sales growth.
• Productivity Enhancement: Implement measures to enhance workforce
productivity and operational efficiency to achieve higher returns on assets.
2. For Company Y:
• Enhance Profitability: Increase NOPAT margin by improving cost management,
pricing strategies, or product mix to generate higher profits from sales.
• Asset Utilization: Optimize asset utilization to increase net operating asset
turnover. This could involve streamlining operations, reducing idle assets, or
investing in technology to improve efficiency.
• Strategic Investments: Consider strategic investments in areas with potential
for high returns, such as research and development, innovation, or market
expansion, to drive overall profitability and return on assets.

9. What is the purpose of measuring asset turnover for different asset categories?
Ans:
Measuring asset turnover for different asset categories serves to:
1. Identify efficient asset utilization and areas for improvement.
2. Compare performance across asset categories for better resource allocation.
3. Optimize operations, streamline processes, and enhance productivity.
4. Guide strategic planning and decision-making.
5. Manage risks associated with underutilized or overinvested assets.

10. What factors (limitations) enter into our evaluation of return on net operating assets?
Ans:

Several factors or limitations enter into our evaluation of return on net operating assets
(RNOA):

JH JACKY 88
 1. Accounting Practices: Differences in accounting methods or standards can affect the
calculation of net operating assets and thus impact the accuracy of RNOA
comparisons between companies or over time.
2. Asset Valuation: Variability in asset valuation methods, such as historical cost or fair
market value, can distort RNOA calculations and make comparisons less meaningful.
3. Asset Utilization: RNOA may not accurately reflect the efficiency of asset utilization if
assets are underutilized, idle, or obsolete. In such cases, RNOA may overstate
operational efficiency.
4. Capital Structure: RNOA can be influenced by a company's capital structure,
including the use of debt financing. Changes in capital structure can affect the cost of
capital and thus impact RNOA.
5. Industry Norms: RNOA benchmarks may vary across industries due to differences in
business models, asset intensity, or market dynamics. Comparisons should consider
industry-specific factors.
6. Macroeconomic Factors: External economic conditions, such as interest rates,
inflation, or currency fluctuations, can impact asset values, profitability, and
ultimately RNOA.
7. Timing of Investments: RNOA may be affected by the timing of asset acquisitions or
disposals, leading to fluctuations in performance that may not accurately reflect long-
term operational efficiency.
8. Non-operating Items: RNOA may be distorted by the inclusion of non-operating
items in net operating assets or NOPAT, such as investment income or one-time
gains/losses.
9. Intangible Assets: RNOA may not fully capture the value or impact of intangible
assets, such as brand reputation, intellectual property, or customer relationships,
which can be critical drivers of profitability.
10.Inflation: Inflation can distort the purchasing power of assets and earnings over time,
affecting the accuracy of RNOA as a measure of operational performance.
In summary, while RNOA is a useful metric for evaluating operational efficiency, it is
essential to consider these limitations and employ additional measures or contextual
information to ensure a comprehensive assessment of a company's performance.

JH JACKY 89
11. How is the equity growth rate computed? What does it measure?
Ans:
The equity growth rate is computed by comparing the equity value at the end of a period
with the equity value at the beginning of that period. It's typically calculated using the
following formula:
(𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸−𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸)
Equity Growth Rate = ( )×100%
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸

This formula expresses the change in equity as a percentage of the initial equity value.
The equity growth rate measures the rate at which a company's equity, or net worth
attributable to shareholders, is growing over a specific period. It provides insights into the
company's ability to generate shareholder value and the effectiveness of management in
growing the equity base. A higher equity growth rate indicates faster growth in shareholder
wealth, while a lower or negative growth rate may signal stagnation or decline in
shareholder value.

12. a. How do return on net operating assets and return on common equity differ?
b. What are the components of return on common shareholders’ equity? What do the
components measure?
Ans:
a. Difference between Return on Net Operating Assets (RNOA) and Return on Common
Equity:
• RNOA: Measures return from operational assets, excluding non-operating items.
• Return on Common Equity: Reflects return earned by common shareholders,
including all income available to them.
b. Components of Return on Common Shareholders' Equity:
• Net Income: Profit after deducting all expenses.
• Preferred Dividends: Dividends paid to preferred shareholders.
• Average Common Equity: Average value of common shareholders' equity,
representing their ownership stake.

13. a. Equity turnover is sales divided by average shareholders’ equity. What does equity
turnover measure? How is it related to return on common equity? (Hint: Look at the
components of ROCE.)

JH JACKY 90
b. “Growth in earnings per share from an increase in equity turnover is unlikely to
continue indefinitely.” Do you agree or disagree with this assertion? Explain your answer
and discuss the components of equity turnover for their impact on earnings.
Ans:
a. Equity Turnover:
• Measurement: Measures how efficiently a company generates sales relative to
shareholders' equity.
• Relation to ROCE: Reflects sales generated per unit of equity, influencing ROCE if
profitability is maintained or improved.
b. Assertion on EPS Growth from Increase in Equity Turnover:
• Agreement: Agree that EPS growth from increased equity turnover is unlikely to
continue indefinitely.
• Explanation: Initial EPS growth may result from increased sales or reduced equity,
but sustaining it long-term requires maintaining profitability and careful
management of equity.

14. What circumstances justify including convertible debt as equity capital when
computing return on shareholders’ equity?
Ans:
Including convertible debt as equity capital when computing return on shareholders' equity
may be justified under certain circumstances, such as:
1. Conversion Likely: If the convertible debt is highly likely to be converted into equity
within the relevant timeframe, treating it as equity capital provides a more accurate
representation of the company's capital structure and shareholders' interests.
2. Significant Impact: If the convertible debt represents a significant portion of the
company's capital structure or has a substantial impact on shareholders' equity,
including it as equity capital provides a more comprehensive picture of the
company's financial position and performance.
3. Transparent Reporting: Including convertible debt as equity capital enhances
transparency and clarity in financial reporting, especially when communicating with
investors or stakeholders who may consider the potential dilution effect of
convertible securities on shareholders' equity.
4. Consistency: If the company consistently treats convertible debt as equity capital in
its financial reporting and analysis, maintaining this approach ensures consistency
and comparability over time.
JH JACKY 91
 5. Economic Substance: If the convertible debt serves a similar economic function to
equity, such as providing long-term financing or aligning interests between debt
holders and equity holders, treating it as equity capital reflects the economic
substance of the transaction more accurately.
In summary, including convertible debt as equity capital in computing return on
shareholders' equity is justified when it aligns with the company's capital structure, reflects
economic substance, enhances transparency, and provides a more accurate representation
of shareholders' interests and financial performance.

JH JACKY 92
 Chapter 6
Credit Analysis

Chapter Summary:
Liquidity:
• The ability to convert assets into cash to meet short-term obligations.
• Short term is typically within a year or the company's normal operating cycle.
• Lack of liquidity:
• Prevents taking advantage of opportunities.
• Reflects inability to cover current obligations.
• Can lead to insolvency and bankruptcy.
• Endangers personal assets of owners in sole proprietorships.
• Affects creditors, customers, and suppliers.
• Force a company to sell investments and other assets at reduced prices;
Working Capital:
• Excess of current assets over current liabilities.
• Measures liquidity and provides a safety cushion to creditors.
• Important for meeting contingencies and uncertainties in cash flow.
• Working Capital Analysis Concerns:
 Contingent liabilities: Evaluate likelihood of loan guarantee contingencies impacting
working capital.
 Future lease payments: Consider minimum rental obligations from non-cancelable
leases.
 Long-term asset contracts: Account for progress payments in contracts for
construction or acquisition reported as commitments, not liabilities, in balance
sheets. Include these commitments in working capital analysis.

Current Ratio Measure of Liquidity:

• Measures current liability coverage, buffer against losses, and reserve of liquid funds.
 Current liability coverage: The higher the amount (multiple) of current assets to
current liabilities, the greater assurance we have that current liabilities will be
paid.

JH JACKY 93
  Buffer against losses: Current ratio indicates the margin of safety to cover
potential decreases in noncash current asset values during disposal or liquidation.
A larger buffer reduces risk, as it provides more protection against asset
devaluation.
 Reserve of liquid funds: The current ratio serves as a measure of safety against
uncertainties and unexpected events affecting cash flows. It indicates the
company's ability to withstand shocks like strikes or losses that could disrupt cash
flow temporarily. Higher current ratio implies better preparedness for such
events.
• Current ratio = Current assets / Current liabilities.
• Limitations: Doesn't predict future cash flows or adequacy of future inflows, static
measure.
 The current ratio is a static measure of resources available at a point in time to meet
current obligations.
 The current reservoir of cash resources does not have a logical or causal relation to
its future cash inflows.
 Cash inflows depend on factors excluded from the ratio, including sales, cash
expenditures, profits, and changes in business conditions.

Using the Current Ratio for Analysis:

1. Liquidity primarily relies on prospective cash flows, with cash levels playing a
secondary role.
2. Balances of working capital accounts don't directly predict future cash flows.
3. Managerial focus on receivables and inventories aims for efficient asset utilization,
with liquidity as a secondary consideration.
Analysis of Current Ratio - Caution:
• Changes in current ratio may not reflect changes in liquidity or operating
performance, as seen during economic fluctuations.
• Management may manipulate the current ratio through actions like accelerating
receivable collections or delaying purchases.
• Interim analysis is important to prevent window dressing and understand seasonal
effects.
• The "2:1" rule of thumb for financial soundness is questionable due to varying quality
of assets and liabilities and differing industry conditions.
• Working capital requirements vary with industry conditions and trade cycle length,
making simplistic evaluations inadequate.
Cash-Based Ratio Measures of Liquidity:
JH JACKY 94
 • Cash to Current Assets Ratio: Measures liquidity of near-cash assets.

• Cash to Current Liabilities Ratio: Measures cash available to pay obligations.

Operating Activity Analysis of Liquidity:

• Accounts Receivable Liquidity Measures: Assess quality and speed of receivables
turnover.
• Inventory Turnover Measures: Assess quality and liquidity of inventory turnover.
• Liquidity of Current Liabilities: Judged based on urgency of payment.
Accounts Receivable Liquidity Measures:
• Quality and liquidity of receivables are crucial for liquidity assessment.
• Quality: Likelihood of collection without loss.
• Liquidity: Speed of converting receivables to cash, measured by turnover rate.
Accounts Receivable Turnover:
• Ratio: Net sales on credit / Average accounts receivable.
• Indicates how efficiently receivables are collected.
Days’ Sales in Receivables:
• Measures average time to collect receivables based on year-end balance.
• Calculation: Accounts receivable / Average daily sales.
Interpretation of Receivables Liquidity Measures:
• Compare turnover rates and collection periods with industry averages or credit
terms.
• Assess if customers are paying on time based on comparison with credit terms.
• For example, if credit terms are 40 days and collection period is 75 days, it suggests
poor collection efforts, delays, or customer financial distress.

JH JACKY 95
Inventory Turnover Measures:
1. Inventory Turnover:
• Measures the average rate at which inventories move through the company.
• Ratio: Cost of goods sold / Average inventory.
• Indicates efficiency in managing inventory.
2. Days’ Sales in Inventory:
• Measures the number of days it takes for inventory to be sold.
• Calculation: Inventory / (Cost of goods sold / 360).
• Assesses purchasing and production policies.
Interpreting Inventory Turnover:
• Reflects both quality and liquidity of inventory.
• Quality: Company's ability to use and dispose of inventory effectively.
• Liquidity: Ability to convert inventory into cash.
• Note: Inventory is not used to pay current liabilities, but a reduction can impact sales
volume.

Liquidity of Current Liabilities:

Current liabilities are important in computing both working capital and the current ratio for
two related reasons:
1. Current liabilities are used in determining whether the excess of current assets over
current liabilities affords a sufficient margin of safety.
2. Current liabilities are deducted from current assets in arriving at working capital.
Quality of Current Liabilities:
• Vital for working capital and current ratio analysis.
• Not all current liabilities are equally urgent for payment.
• Some, like tax obligations, require immediate payment irrespective of financial
conditions.
• Others, like liabilities to long-standing suppliers, may offer flexibility.
• Quality assessed based on urgency of payment, impacting liquidity and financial
stability evaluations.

JH JACKY 96
Financial Flexibility:
• Ability to counter unexpected interruptions in cash flow.
It can mean the ability
 to borrow from various sources,
 to raise equity capital,
 to sell and redeploy assets, or
 to adjust the level and direction of operations to meet changing circumstances.
• Factors affecting borrowing capacity: profitability, stability, industry position, etc.
• Other factors: credit ratings, asset sale restrictions, discretionary expenses, ability to
respond to changes.
Conclusion:
• Liquidity and working capital are crucial for a company's financial health.
• Analysis involves various ratios and measures, but caution is needed due to
limitations and potential management manipulations.
• Financial flexibility is essential for adapting to changing conditions and maintaining
stability.

JH JACKY 97
 BOOK Questions
1. Why is liquidity important in analysis of financial statements? Explain its importance
from the viewpoint of more than one type of user.
Ans:
Liquidity holds paramount importance in financial statement analysis for various
stakeholders:
1. Investors:
• Assess liquidity to gauge the company's ability to meet short-term obligations.
• Lack of liquidity may lead to losses and difficulty in selling holdings swiftly.
2. Creditors:
• Evaluate liquidity to determine repayment capacity and assess default risk.
• Liquidity influences lending terms and interest rates.
3. Management:
• Relies on liquidity to ensure smooth operations and execute strategic
initiatives.
• Adequate liquidity is crucial for day-to-day expenses and growth projects.
4. Suppliers and Customers:
• Evaluate liquidity to gauge the risk of non-payment and maintain strong
business relationships.
• Customers prefer financially stable companies for long-term commitments.
In essence, liquidity is essential for financial stability, meeting obligations, and fostering
trust among stakeholders.

2. Working capital equals current assets less current liabilities. Identify and describe
factors impairing the usefulness of working capital as an analysis measure.
Ans:
Factors impairing the usefulness of working capital as an analysis measure include:
1. Seasonality and Cyclical Trends: Fluctuations in working capital due to seasonal or
industry cycles can distort its interpretation.
2. Accounting Policies: Variations in inventory valuation methods and other accounting
practices can affect working capital calculations.

JH JACKY 98
 3. Quality of Assets and Liabilities: Working capital doesn't distinguish between high-
quality and low-quality assets or liabilities.
4. Timing of Payments and Receipts: It doesn't consider the timing of cash flows, which
can impact liquidity despite apparent working capital adequacy.
5. Capital Expenditures: Working capital doesn't reflect the need for future investments
in growth or maintenance.
6. Debt Structure: It overlooks differences in debt maturity and repayment schedules,
which can affect short-term liquidity despite sufficient current assets.
Considering these limitations, it's essential to use working capital alongside other metrics
for a comprehensive financial analysis.

3. Are fixed assets potentially includable in current assets? Explain. If your answer is yes,
describe situations where inclusion is possible.
Ans:
Fixed assets are generally not included in current assets because they're intended for long-
term use. However, in specific cases, they might be included if:
1. Assets Held for Sale: If a fixed asset is intended for sale within a year, it may be
included in current assets.
2. Assets Held for Investment: Fixed assets held for short-term investment purposes
may be classified as current assets if they're expected to be converted into cash
within a year.
3. Assets Under Construction: Fixed assets under construction may be included if
they're expected to be completed and used within the operating cycle of the
business.
4. Assets Held for Trading: Fixed assets held for trading purposes may be classified as
current assets if they're expected to be sold within a year.
In such cases, inclusion is based on short-term liquidity or the asset's expected realization
within the normal operating cycle. However, careful review of financial statements is
necessary to understand the nature and implications of these assets.

4. Certain installment receivables are not collectible within one year. Why are these
receivables sometimes included in current assets?
Ans:

JH JACKY 99
Installment receivables may be included in current assets despite not being collectible
within one year due to:
1. Materiality: If their portion collectible within a year is significant relative to total
current assets.
2. Operating Cycle: In industries with extended operating cycles.
3. Management Intent: If there's an intention to convert them into cash within a year.
4. Normal Business Practices: In industries where it's customary to include them in
current assets.
Their inclusion provides a more complete picture of short-term liquidity, but clear
disclosure is crucial for transparency.

5. Are all inventories included in current assets? Why or why not?

Ans:
Not all inventories are included in current assets. Some inventories, such as those held for
long-term purposes or not expected to be converted into cash within a year, are classified
as non-current assets. Inventories held for sale or expected to be sold within a year are
included in current assets. However, specific accounting policies and the expected timing of
completion and sale determine whether work in progress inventory is classified as current
or non-current.
6. What is the justification for including prepaid expenses in current assets?
Ans:
Prepaid expenses are included in current assets because they represent future benefits
already paid for. This aligns with the matching principle, ensures short-term liquidity, and
provides a complete picture of the company's assets.
7. Assume a company under analysis has few current liabilities but substantial long-term
liabilities. Notes to the financial statements report the company has a “revolving loan
agreement” with a bank. Is this disclosure relevant to your analysis?
Ans:
Yes, the disclosure of a "revolving loan agreement" with a bank is relevant to the analysis
for several reasons:
1. Debt Structure: Provides insights into the company's borrowing terms, maturity
dates, and covenant requirements.
2. Liquidity Management: Indicates the company's ability to address short-term
financing needs and manage working capital fluctuations.

JH JACKY 100
 3. Financial Flexibility: Shows the company's access to funds when needed, aiding in
navigating economic challenges.
4. Risk Assessment: Helps assess credit risk and ability to manage debt obligations
effectively.
Understanding these aspects is crucial for evaluating the company's financial health and
performance.

8. Certain industries are subject to peculiar financing and operating conditions calling for
special consideration in drawing distinctions between current and noncurrent. How
should analysis recognize this in evaluating short-term liquidity?
Ans:
Analysis should recognize industry-specific financing and operating conditions by
considering:
1. Industry Norms: Understand typical practices and working capital requirements.
2. Seasonality: Account for seasonal revenue and expense fluctuations.
3. Regulatory Environment: Consider industry regulations impacting cash flow.
4. Capital Expenditures: Evaluate investment patterns and their impact on liquidity.
5. Supply Chain Dynamics: Assess dependencies and potential disruptions.
6. Access to Financing: Understand industry-specific financing options.
This tailored approach ensures a more accurate evaluation of short-term liquidity and
identifies industry-specific risks.

9. Your analysis of two companies reveals identical levels of working capital. Are you
confident in concluding their liquidity positions are equivalent?
Ans:
No, I wouldn't confidently conclude their liquidity positions are equivalent based solely on
identical working capital levels because:
1. Composition Differences: Variances in current assets and liabilities may affect
liquidity differently.
2. Operating Efficiency: Differences in operational effectiveness can impact liquidity
despite similar working capital levels.
3. Industry Variances: Industries have diverse working capital requirements, influencing
liquidity assessments.
JH JACKY 101
 4. External Factors: Economic conditions and market dynamics can affect liquidity
differently for each company.
5. Cash Flow Dynamics: Working capital alone doesn't provide insights into cash flow
patterns or meeting short-term obligations.

10. What is the current ratio? What does the current ratio measure? What are reasons for
using the current ratio for analysis?
Ans:
The current ratio is a financial metric used to assess a company's short-term liquidity. It
measures the company's ability to cover its current liabilities with its current assets within
the next year. Reasons for using the current ratio for analysis include evaluating current
liability coverage, providing a buffer against losses, and serving as a measure of reserve
liquid funds.
11. Since cash generally does not yield a return, why does a company hold cash?
Ans:
A company holds cash for several reasons, despite it generally not yielding a return:
1. Liquidity Needs: Cash provides immediate access to funds to meet short-term
obligations, such as paying bills, salaries, or unexpected expenses.
2. Operational Flexibility: Having cash on hand allows a company to seize opportunities
quickly, such as investing in promising ventures, acquiring assets, or pursuing
strategic initiatives.
3. Emergency Funds: Cash reserves act as a financial safety net during economic
downturns, crises, or unexpected events, ensuring the company can continue
operations even in adverse conditions.
4. Cushion Against Uncertainty: Holding cash provides a buffer against uncertainties in
cash flows, helping to manage fluctuations in revenue, expenses, or market
conditions.
5. Avoiding Financial Distress: Maintaining adequate cash reserves reduces the risk of
financial distress or insolvency, providing stability and confidence to stakeholders,
including investors, creditors, and employees.

12. Is there a relation between level of inventories and sales? Are inventories a function
of sales? If there is a relation between inventories and sales, is it proportional?
Ans:

JH JACKY 102
Yes, there is a relationship between inventories and sales. Typically, inventories are a
function of sales, meaning they fluctuate based on expected demand. While the
relationship is generally proportional, it can vary based on factors such as industry,
seasonality, and company strategy.
13. What are management’s objectives in determining a company’s investment in
inventories and receivables?
Ans:
Management aims to:
1. Optimize working capital.
2. Meet customer demand.
3. Minimize stockouts.
4. Maximize inventory turnover.
5. Manage credit effectively.
6. Improve cash flow.
7. Reduce financing costs.

14. What are the limitations of the current ratio as a measure of liquidity?
Ans:
The limitations of the current ratio as a measure of liquidity include:
1. Static Measure: The current ratio provides a snapshot of liquidity at a specific point
in time and may not reflect changes in liquidity over time.
2. Composition Differences: It doesn't consider the composition of current assets and
liabilities, which may vary in quality and liquidity.
3. Timing of Cash Flows: The current ratio doesn't account for the timing of cash flows,
such as when receivables will be collected or when liabilities will be due.
4. Inclusion of Non-Cash Assets: It includes non-cash assets like prepaid expenses and
inventory, which may not be readily convertible into cash.
5. Industry Variability: Industry norms and working capital requirements vary, making it
difficult to compare current ratios across different industries.
6. Manipulation: Companies can manipulate the current ratio through window dressing
techniques, such as delaying payables or accelerating receivables collection, to make
their liquidity appear stronger than it actually is.

JH JACKY 103
 7. No Consideration of Cash Flow Adequacy: It doesn't assess whether current assets
are sufficient to cover operating cash flow needs or whether current liabilities can be
met with available cash.
8. Overlooking Future Obligations: It doesn't consider future obligations like long-term
debt or future capital expenditure requirements.
Understanding these limitations is crucial for a comprehensive analysis of a company's
liquidity position.

15. What is the appropriate use of the current ratio as a measure of liquidity?
Ans:
The appropriate use of the current ratio as a measure of liquidity involves:
1. Relative Comparison: Comparing the current ratio of a company to industry
benchmarks or historical trends to assess its liquidity position relative to peers.
2. Trend Analysis: Monitoring changes in the current ratio over time to identify trends
and potential liquidity issues.
3. Supplemental Analysis: Using the current ratio alongside other liquidity ratios and
cash flow metrics for a more comprehensive assessment of liquidity.
4. Considering Industry Variability: Recognizing industry-specific working capital
requirements and comparing the current ratio within the context of the industry.
5. Understanding Composition: Understanding the composition of current assets and
liabilities to interpret the current ratio accurately.

16. What are cash-based ratios of liquidity? What do they measure?

Ans:
Cash-based ratios of liquidity measure a company's ability to meet short-term obligations
using cash and cash equivalents. These ratios focus specifically on the availability of cash to
cover current liabilities. Common cash-based ratios include:
1. Cash Ratio: This ratio measures the proportion of cash and cash equivalents to
current liabilities, providing a more stringent assessment of liquidity than the current
ratio.
2. Operating Cash Flow Ratio: This ratio compares operating cash flow to current
liabilities, indicating how well operating cash flow covers short-term obligations.

JH JACKY 104
These ratios help assess the adequacy of a company's cash reserves to meet its immediate
financial commitments and provide insights into its short-term liquidity position.

17. How can we measure “quality” of current assets?

Ans:
• Assessing the quality of current assets involves evaluating their liquidity, reliability,
and potential for conversion into cash without significant loss.
• One way to measure the quality of current assets is to analyze their composition,
focusing on the proportion of highly liquid assets like cash and marketable securities
compared to less liquid assets such as inventory or prepaid expenses.
• Additionally, assessing the age and collectibility of accounts receivable and the
marketability of inventory can provide insights into the quality of current assets.

18. What does accounts receivable turnover measure?

Ans:
• Accounts receivable turnover measures how effectively a company manages its
credit sales and collects payments from customers during a specific period.
• It is calculated by dividing net credit sales by the average accounts receivable
balance.
• A high turnover ratio indicates that the company efficiently collects payments from
customers, while a low ratio suggests that accounts receivable are not being
collected quickly.
• This metric is essential for evaluating the efficiency of credit and collection policies,
as well as assessing the company's liquidity and cash flow.

19. What is the days’ sales in receivables? What does it measure?

Ans:
• Days' sales in receivables, also known as the average collection period, measures the
average number of days it takes for a company to collect its accounts receivable.
• It is calculated by dividing the ending accounts receivable balance by the average
daily credit sales.

JH JACKY 105
20. Assume a company’s days’ sales in receivables is 60 days, compared to 40 days for the
prior period. Identify at least three possible reasons for this change.
Ans:
• Changes in Credit Policies: If the company tightens its credit policies, it may take
longer for customers to pay their outstanding balances, resulting in a longer
collection period.
• Economic Conditions: Economic downturns or financial difficulties faced by
customers could lead to delays in payments, thereby increasing the days' sales in
receivables.
• Changes in Sales Mix: If the company experiences a shift in sales toward customers
with longer credit terms or slower payment habits, it could result in a longer
collection period.

21. What are the repercussions to a company of (a) overinvestment and (b)
underinvestment in inventories?
Ans:
• Overinvestment:
• Higher Carrying Costs: Overinvestment in inventories leads to higher carrying
costs such as storage, insurance, and obsolescence expenses.
• Reduced Liquidity: Excessive inventory ties up capital, limiting the company's
ability to invest in other opportunities and potentially impacting liquidity.
• Increased Risk of Obsolescence: Over time, excess inventory may become
obsolete, resulting in inventory writedowns and losses.
• Underinvestment:
• Stockouts: Inadequate inventory levels may lead to stockouts, causing
disruptions in production and sales, and potentially resulting in lost revenue
and dissatisfied customers.
• Missed Opportunities: Insufficient inventory may prevent the company from
capitalizing on sales opportunities, especially during peak demand periods.
• Increased Ordering Costs: Frequent replenishment orders for low inventory
levels can result in higher ordering and transportation costs.

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22. What problems are expected in an analysis of a company using the LIFO inventory
method when costs are increasing? What effects do price changes have on the (a)
inventory turnover ratio and (b) current ratio?
Ans:
• Understated Inventory Value: LIFO (Last In, First Out) method results in the valuation
of inventory at older, lower-cost prices, leading to an understatement of inventory
value on the balance sheet.
• Lower Profit Margins: During periods of increasing costs, using LIFO can result in
higher cost of goods sold (COGS), reducing gross profit margins and potentially
impacting profitability.
• Distorted Financial Ratios: LIFO can distort financial ratios such as inventory turnover
and current ratio by understating inventory value, affecting the accuracy of financial
analysis.
• Effects of Price Changes on Ratios:
• Inventory Turnover Ratio: Increasing costs under LIFO can lead to a lower
inventory turnover ratio as higher COGS is divided by average inventory,
resulting in a longer time to sell inventory.
• Current Ratio: Rising prices can decrease the current ratio as the value of
inventory decreases relative to current liabilities, potentially indicating lower
liquidity.

23. Why is the composition of current liabilities relevant to our analysis of the quality of
the current ratio?
Ans:
• The composition of current liabilities is relevant to current ratio analysis because not
all current liabilities have the same urgency or forceful payment demands.
• Urgent liabilities like taxes must be paid promptly regardless of financial pressures,
while liabilities to long-standing suppliers may allow more flexibility.
• Assessing the composition helps gauge the true liquidity position and the ability to
meet short-term obligations effectively.

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24. A seemingly successful company can have a poor current ratio. Identify possible
reasons for this result.
Ans:
• Overstated Receivables: Inflated accounts receivable balances due to lenient credit
policies or difficulties in collecting payments can lower the current ratio.
• Excessive Inventory Levels: Holding excessive inventory beyond what is necessary for
operations can reduce the current ratio.
• High Levels of Short-Term Debt: Heavy reliance on short-term borrowing or
revolving credit facilities can inflate current liabilities, decreasing the current ratio.
• Seasonal Variations: Companies with significant seasonal fluctuations in revenue
may experience temporary dips in the current ratio during off-peak periods.
• Capital Expenditures: Large investments in long-term assets may divert funds away
from short-term liquidity, impacting the current ratio negatively.
25. What is window-dressing of current assets and liabilities? How can we recognize
whether financial statements are window-dressed?
Ans:
• Window-dressing refers to the manipulation of financial statements to create a more
favorable impression of a company's financial position than is actually the case.
• In the context of current assets and liabilities, window-dressing may involve actions
such as accelerating the collection of receivables or delaying payment of liabilities
shortly before the end of a reporting period to artificially inflate liquidity ratios like
the current ratio.
• Recognition of Window-Dressing:
• Abrupt Changes: Sudden and significant fluctuations in current assets or
liabilities near the end of a reporting period may indicate window-dressing.
• Consistency Checks: Comparing financial statement figures with historical
trends or industry benchmarks can reveal inconsistencies that suggest
manipulation.
• Scrutinizing Footnotes: Footnotes accompanying financial statements may
provide insights into unusual transactions or timing differences, hinting at
potential window-dressing activities.

26. What is the rule of thumb governing the expected level of the current ratio? What
risks are there in using this rule of thumb for analysis?

JH JACKY 108
Ans:
• The rule of thumb suggests that a current ratio of 2:1 or higher indicates financial
soundness, while a ratio below 2:1 suggests increasing liquidity risks.
• Risks in Using the Rule of Thumb:
• Industry Variability: Different industries have varying working capital
requirements, making a universal benchmark like the 2:1 ratio less applicable.
• Composition Differences: The quality and composition of current assets and
liabilities can significantly impact the current ratio's interpretation, rendering a
simplistic rule of thumb inadequate.
• Ignoring Context: The rule of thumb overlooks factors such as business cycles,
seasonality, and growth stages, which can influence the appropriate level of
liquidity for a company.

27. Describe the importance of sales in assessing a company’s current financial condition
and the liquidity of its current assets.
Ans:
• Sales Revenue: Sales generate cash inflows, which are essential for meeting short-
term obligations and maintaining liquidity.
• Revenue Stability: Consistent and growing sales indicate a healthy business
operation and provide assurance of future cash inflows to support liquidity.
• Accounts Receivable: Sales drive accounts receivable balances, and the efficiency of
receivables collection impacts liquidity by influencing cash flow timing.
• Inventory Turnover: Sales volume affects inventory turnover, with higher sales
typically leading to faster inventory turnover and improved liquidity.
• Cash Flow Generation: Ultimately, sales revenue is a primary driver of cash flow,
which is critical for sustaining operations and supporting liquidity needs.

28. Identify important qualitative considerations in the analysis of a company’s liquidity.

What SEC disclosures help our analysis in this area?
Ans:
• Management's Strategy: Assessing management's approach to liquidity
management, including its ability to anticipate and address short-term funding
needs.

JH JACKY 109
 • Market Perception: Considering how stakeholders, including creditors and investors,
perceive the company's liquidity position and management's ability to maintain it.
• Industry Dynamics: Understanding industry-specific liquidity challenges and
benchmarks, which may vary based on factors like seasonality, supply chain
dynamics, and competitive pressures.
• Regulatory Environment: Monitoring regulatory disclosures, such as those required
by the Securities and Exchange Commission (SEC), to gain insights into material risks,
contingencies, and liquidity concerns.
SEC Disclosures for Liquidity Analysis:
• Management's Discussion and Analysis (MD&A): Provides management's perspective
on liquidity risks, significant changes, and future outlook, offering valuable qualitative
insights.
• Financial Statement Footnotes: Disclose information on significant accounting
policies, contingent liabilities, contractual obligations, and other factors impacting
liquidity.
• Risk Factors: Disclosures outlining potential risks, including liquidity risks, that could
materially affect the company's financial condition or results of operations.

29. What is the importance of what-if analysis on the effects of changes in conditions or
policies for a company’s cash resources?
Ans:
• Helps Evaluate Resilience: Conducting what-if analysis allows companies to assess
their ability to withstand adverse scenarios or unexpected events that could impact
cash resources.
• Supports Decision-Making: By modeling different scenarios and their potential
effects on cash flows, management can make informed decisions regarding capital
allocation, financing strategies, and risk management.
• Enhances Contingency Planning: Identifying potential liquidity gaps or vulnerabilities
through what-if analysis enables proactive contingency planning and the
implementation of mitigation strategies.
• Facilitates Stress Testing: By stress-testing various scenarios, companies can identify
weaknesses in liquidity management practices and strengthen their resilience to
adverse conditions.

JH JACKY 110
30. Identify several key elements in the evaluation of solvency.
Ans:
• Debt Coverage Ratios: Assessing the company's ability to service its debt obligations
through metrics like the debt service coverage ratio and interest coverage ratio.
• Asset Quality: Evaluating the quality and liquidity of assets relative to liabilities,
considering factors such as asset impairments, depreciation, and contingent
liabilities.
• Cash Flow Adequacy: Analyzing cash flow generation and sustainability to ensure the
company can meet its financial commitments over the long term.
• Long-Term Viability: Considering the company's ability to generate sustainable profits
and cash flows to support continued operations and growth while meeting long-term
debt obligations.

31. Why is analysis of a company’s capital structure important?

Ans:
• Financial Risk Assessment: Analyzing the composition of a company's capital
structure helps assess its financial risk exposure, including leverage levels, interest
rate sensitivity, and refinancing risks.
• Cost of Capital Determination: Evaluating the mix of debt and equity financing aids in
determining the company's weighted average cost of capital (WACC), a crucial factor
in investment decisions and capital budgeting.
• Strategic Decision-Making: Understanding the company's capital structure assists
management in making strategic decisions regarding capital allocation, dividend
policy, and financing options.
• Investor Perception: Investors often assess a company's capital structure to gauge its
financial health, risk profile, and alignment with shareholder interests.

32. What is meant by financial leverage? Identify one or more cases where leverage is
advantageous.
Ans:
• Financial leverage refers to the use of debt financing to amplify returns or magnify
risks associated with investment or business operations.
• Advantages of Leverage:

JH JACKY 111
• Tax Benefits: Interest payments on debt are typically tax-deductible, reducing
the company's overall tax liability and increasing after-tax profits.
• Return Amplification: By using debt to finance investments, companies can
amplify returns on equity, potentially increasing shareholder value.
• Enhanced Flexibility: Debt financing provides companies with additional
financial resources without diluting ownership or control, offering flexibility in
capital structure management.
• Risk Diversification: Leveraged capital structures allow companies to diversify
their funding sources, reducing reliance on equity financing and enhancing
financial stability.

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 Chapter 7
Equity Analysis and Valuation

*No Math For this chapter.

Chapter Summary:
This chapter starts with the analysis of
 Earnings persistence;
 Valuation; and
 Forecasting.
Earnings Persistence:
• Earnings stability, predictability, variability, and trend are crucial for financial analysis,
separating recurring from irregular components.
• A good financial analysis identifies components in earnings that exhibit stability and
predictability – that is, persistent components.
• Analysis also must be alert to earnings management and income smoothing.
Recasting And Adjusting Earnings:
• Income statements are adjusted to isolate stable earnings from one-time events or
accounting changes.
• Equity analysis involves separating stable, recurring earnings from irregular, one-time
elements. This process identifies and reallocates items that should belong to prior
periods, ensuring a clear distinction between ongoing and non-recurring earnings
components.
Information on Earnings Persistence:
Major sources of this information include the:
• Income statement, including its components:
 Income from continuing operations.
 Income from discontinued operations.
 Extraordinary gains and losses.
 Cumulative effect of changes in accounting principles.
• Other financial statements and notes.
• Management discussion and analysis.

JH JACKY 113
Adjusting Earnings and Earnings Components:
By recalculating and modifying income statements spanning multiple years, usually five, we
evaluate the consistency of earnings over time. This process helps gauge the company's
ability to generate consistent profits, which is crucial in understanding its long-term earning
potential.
Determinants of Earnings Persistence:
Following the recasting and adjustment of earnings, our analysis shifts to assessing earnings
persistence. Key factors influencing this persistence include:
1. Earnings Management: Practices such as manipulating accounting methods impact
the stability of earnings.
2. Variability: Fluctuations in earnings can affect their long-term predictability.
3. Trends: Consistent patterns in earnings growth or decline provide insights into future
performance.
4. Incentives: Management motivations, such as compensation plans, may influence
the manipulation or maintenance of earnings stability.

Earnings Trend and Persistence:

• Steady earnings growth is desirable, but accounting distortions must be considered.
• Steady growth trends are favorable indicators.
• Trends are assessed through statistical methods or trend statements.
• They offer insights into both current and future company performance and reflect
management quality.
• Accounting distortions must be monitored, especially regarding changes in
accounting principles and the impact of business combinations, necessitating
adjustments.

Earnings Management and Persistence:

• Earnings management is distinct from misrepresentations and distortions and is
conducted within acceptable accounting principles.
• It involves discretion in applying accounting principles to achieve specific results,
often superficially rather than substantively.
• Key methods of earnings management include:

JH JACKY 114
 1. Changes in Accounting Methods or Assumptions: Altering these can impact
revenues positively or negatively.
2. Offsetting Extraordinary Gains and Losses: This masks unusual earnings
effects that could affect trends negatively.
3. Big Baths: Recognizing future costs in the current period to alleviate poor
performance.
4. Write-downs: Adjusting asset values downwards during poor operating results.
5. Timing Revenue and Expense Recognition: Adjusting recognition timing to
manipulate earnings, including revenue, asset sales, research expenses, and
more.

Management Incentives:
• Managers may distort earnings for personal gain, influenced by compensation plans.
• Managers, owners, and employees may manipulate earnings for personal gain,
affecting reported earnings.
• Successful companies may seek to maintain a reputation for earnings growth through
management practices.
• Compensation plans and other incentives tied to accounting metrics provide
additional motivation for managers to engage in earnings management.

Earnings-Based Equity Valuation:

• Traditional equity valuation methods often utilize the Discounted Cash Flow (DCF)
method.
• In the DCF approach, the company's equity value is determined by forecasting future
cash flows available to equity investors.
• These projected cash flows are then discounted back to present value using the
company's cost of equity capital.
Equity Valuation:
Discounted cash flow (DCF) methods are used, considering future profitability and earnings
quality.

JH JACKY 115
Relation between Stock Prices and Accounting Data:
• Earnings quality impacts valuation models, with criticism for potential manipulation.
• Accurate estimates of stock prices are contingent upon assessing the quality and
persistence of a company's earnings and earning power.
• However, accounting-based valuation methods face criticism due to the susceptibility
of earnings to manipulation and distortion by management.
• Managers may prioritize personal objectives and interests tied to reported
accounting numbers, potentially affecting the reliability of accounting-based
valuations.

Fundamental Valuation Measures:

Price-to-book (PB) and price-to-earnings (PE) ratios are commonly used.
Two widely used valuation metrics are:
(i) Price-to-Book (PB) Ratio:
• Calculated as the market value of equity divided by the book value of equity.
• Offers insights into how the market values a company relative to its net asset value.
(ii) Price-to-Earnings (PE) Ratio:
• Derived from dividing the market value of equity by net income.
• Indicates how much investors are willing to pay for each unit of earnings generated
by the company.
Insights from the equations:
• PE Ratio and Cost of Capital: There exists an inverse relationship between the PE
ratio and the cost of equity capital. Higher cost of equity results in a lower PE ratio,
and vice versa.
• PE Ratio and Expected Growth: The PE ratio is positively correlated with the
expected growth in earnings per share (EPS) relative to normal growth. Higher
expected growth typically leads to a higher PE ratio.

Earning Power and Forecasting:

Earning power, reflecting stable future earnings, is essential for valuation models. Time
horizons for measurement vary.

JH JACKY 116
• Earning Power Definition: Earning power represents the level of earnings a company
is expected to sustain over the long term.
• Importance in Valuation: Earning power is a primary factor in determining a
company's value.
• Capitalization of Earning Power: Accounting-based valuation models capitalize
earning power by considering factors such as the cost of capital, future expected
risks, and returns.
• Measuring Earning Power: Focuses on the stability and persistence of earnings and
their components, with earnings being the most reliable measure for valuation.
• Time Horizon: A one-year period is often insufficient for accurate measurement.
Instead, earnings power is typically assessed using average or cumulative earnings
over several years, with a preferred horizon of 5 to 10 years depending on industry
and other factors.

JH JACKY 117
 BOOK Questions
1. Why is analysis of research and development expenses important in assessing and
forecasting earnings? What are some concerns in analyzing research and development
expenses?
Ans:
Importance of Analyzing Research and Development (R&D) Expenses:
1. Innovation and Growth: R&D expenses often indicate a company's commitment to
innovation and future growth. Higher R&D spending may suggest potential for new
products or services, which could lead to increased earnings in the future.
2. Long-Term Performance: R&D investments can have a significant impact on a
company's long-term performance and competitiveness. Analyzing these expenses
helps assess the company's ability to generate sustainable earnings over time.
3. Earnings Potential: R&D activities can lead to the development of new technologies,
processes, or products, which may contribute to increased revenues and earnings in
the future. By understanding R&D expenses, analysts can better forecast potential
future earnings growth.
4. Competitive Positioning: Comparing R&D spending across companies within the
same industry provides insights into their relative competitive positioning and
potential for future earnings growth.
Concerns in Analyzing Research and Development Expenses:
1. Timing of Benefits: The benefits of R&D investments may not materialize
immediately and could take several years to generate positive returns. This delay in
realizing returns can complicate earnings forecasting.
2. Risk of Failure: Not all R&D projects succeed, and investments in unsuccessful
projects may result in wasted expenses. Analysts need to consider the risk of failure
associated with R&D activities when assessing their impact on earnings.
3. Accounting Treatment: The accounting treatment of R&D expenses can vary
between companies and may affect reported earnings. Some companies capitalize
certain R&D costs, which can distort earnings figures and make comparisons
challenging.
4. Capital Allocation: Excessive R&D spending without commensurate returns can
indicate poor capital allocation decisions by management. Analysts should assess
whether R&D investments are generating sufficient returns relative to their costs.
5. Competitive Environment: In industries with intense competition and rapidly
evolving technologies, companies may feel pressured to increase R&D spending to

JH JACKY 118
 remain competitive. Analysts need to consider the competitive environment when
evaluating R&D expenses and their impact on earnings forecasting.
2. What is the relation between the reported values of assets and reported earnings?
What is the relation between the reported values of liabilities, including provisions, and
reported earnings?
Ans:
The reported values of assets and liabilities, including provisions, can have a significant
impact on reported earnings. Here's how:
Reported Values of Assets and Reported Earnings:
1. Depreciation and Amortization: The reported values of tangible assets such as
equipment and buildings, as well as intangible assets like patents and trademarks,
are subject to depreciation and amortization. These accounting practices allocate the
cost of assets over their useful lives, reducing reported earnings over time.
2. Impairment Charges: If the value of an asset declines significantly and is no longer
recoverable, impairment charges may be recorded. These charges reduce reported
earnings for the period in which they are recognized.
3. Asset Sales or Dispositions: Gains or losses from the sale or disposal of assets affect
reported earnings. Selling assets at a gain increases earnings, while selling at a loss
decreases earnings.
4. Investment Income: Assets such as investments in securities or interest-bearing
instruments generate income, which contributes to reported earnings.
5. Inventory Valuation: The value of inventory affects the cost of goods sold (COGS)
and, consequently, gross profit and earnings. Changes in inventory valuation
methods or write-downs can impact reported earnings.
Reported Values of Liabilities, including Provisions, and Reported Earnings:
1. Interest Expense: Liabilities such as loans and bonds generate interest expense,
which reduces reported earnings.
2. Restructuring and Other Provisions: Provisions for restructuring costs, legal
settlements, or other liabilities are recorded when a company has a present
obligation that is likely to result in an outflow of resources. These provisions reduce
reported earnings in the period they are recognized.
3. Changes in Fair Value: Liabilities measured at fair value through profit or loss (e.g.,
derivative liabilities) are subject to changes in fair value, which impact reported
earnings.

JH JACKY 119
 4. Income Taxes: Changes in reported values of liabilities such as deferred tax liabilities
affect income tax expense, which impacts reported earnings.
5. Dividend Payments: Liabilities such as dividends payable represent obligations to
shareholders. Dividend payments reduce reported earnings and retained earnings.
In summary, changes in the reported values of assets and liabilities, including provisions,
directly affect reported earnings through various accounting mechanisms and transactions.

3. What is the purpose in recasting the income statement for analysis?

Ans:
The purpose of recasting the income statement for analysis is to provide a clearer
understanding of a company's financial performance by adjusting for certain non-recurring
or irregular items. Recasting involves separating out one-time or unusual expenses,
revenues, gains, or losses from the core operating activities of the business. This process
helps in several ways:
1. Isolating Core Operating Performance: Recasting helps analysts focus on the
company's ongoing, recurring operations by removing the noise caused by non-
recurring or irregular items. By isolating these core earnings, analysts can better
assess the company's ability to generate profits from its primary business activities.
2. Comparability: Recasting allows for more accurate comparisons of financial
performance over time or across companies within the same industry. By removing
non-recurring items, the income statement becomes more comparable across
different reporting periods or companies, facilitating better trend analysis and
benchmarking.
3. Enhanced Decision Making: Recasting provides decision-makers with a more
accurate picture of the company's financial health and performance. By identifying
and adjusting for non-recurring items, management can make more informed
strategic decisions regarding resource allocation, investment opportunities, and
operational improvements.
4. Improved Forecasting: By removing non-recurring or irregular items, recasting helps
analysts make more accurate forecasts of future financial performance. This allows
investors, creditors, and other stakeholders to make better-informed decisions about
the company's future prospects and valuation.
Overall, the purpose of recasting the income statement is to provide stakeholders with a
clearer, more accurate representation of the company's underlying financial performance,
which in turn supports better decision-making and analysis.

JH JACKY 120
4. Where do we find the data necessary for analysis of operating results and for their
recasting and adjustment?
Ans:
The necessary data for analyzing operating results and performing recasting and
adjustments are typically found in a company's financial statements, primarily the income
statement. Additional information may be obtained from footnotes to the financial
statements, management discussion and analysis (MD&A) sections, and other relevant
disclosures in the annual report or quarterly filings.
5. Describe the recasting process. What is the aim of the recasting process in analysis?
Ans:
1. Identifying Non-Recurring Items: The first step in the recasting process is to identify
non-recurring or irregular items on the income statement. These may include one-
time gains or losses, restructuring charges, asset write-downs, or changes in
accounting methods.
2. Adjusting for Non-Recurring Items: Once identified, non-recurring items are adjusted
or removed from the income statement. This involves adding back one-time gains or
losses and excluding them from the analysis to isolate the core operating
performance of the company.
3. Normalizing Earnings: After removing non-recurring items, adjustments are made to
normalize earnings. This may involve smoothing out fluctuations in earnings over
time, such as deferring or accelerating recognition of revenues or expenses to better
reflect the company's ongoing operations.
4. Comparing Adjusted Results: Finally, the adjusted earnings are compared to the
reported earnings to assess the impact of non-recurring items on the company's
financial performance. Analysts may also compare the adjusted results to industry
benchmarks or historical performance to evaluate trends and identify areas of
improvement.
Aim of the Recasting Process in Analysis:
The aim of the recasting process is to provide a clearer and more accurate picture of the
company's underlying financial performance. By removing non-recurring or irregular items
from the income statement, analysts can focus on the core operating earnings of the
business. This enables better comparisons of financial performance over time and across
companies within the same industry, facilitates more accurate forecasting of future
earnings, and helps investors make more informed decisions about the company's valuation
and investment potential. Overall, the recasting process aims to enhance the quality and
reliability of financial analysis by eliminating distortions and providing a more realistic
assessment of the company's earnings power.
JH JACKY 121
6. Describe the adjustment of the income statement for financial statement analysis.
Ans:
The adjustment of the income statement for financial statement analysis involves
identifying and removing non-recurring or irregular items that distort the true operating
performance of the company. This may include excluding items such as extraordinary gains
or losses, restructuring charges, or changes in accounting methods to present a more
accurate representation of the company's ongoing earnings.
7. Explain earnings management. How is earnings management distinguished from
fraudulent reporting?
Ans:
Earnings management involves strategically manipulating financial results to achieve
specific goals, such as meeting earnings targets or presenting a favorable image of the
company's performance. This can include practices like income smoothing, big bath
accounting, and classification shifting.
Distinguishing Earnings Management from Fraudulent Reporting:
• Intent: Earnings management is typically motivated by managerial discretion and
incentives, within legal boundaries, to meet financial objectives. In contrast,
fraudulent reporting involves intentionally deceiving stakeholders for personal gain
or to conceal financial problems.
• Legality: Earnings management may stay within accounting rules, whereas fraudulent
reporting involves illegal activities like fabricating transactions or falsifying
documents.
• Materiality and Transparency: Earnings management adjustments may be immaterial
or transparent, while fraudulent reporting often involves significant efforts to hide
material financial information.
In essence, while both involve manipulating financial results, earnings management
operates within legal boundaries and managerial discretion, whereas fraudulent reporting
involves deliberate deception and illegal actions.
8. Identify and explain at least three types of earnings management.
Ans:
Three Types of Earnings Management:
1. Income Smoothing:
• Explanation: Income smoothing aims to even out fluctuations in reported
earnings over time by strategically timing the recognition of revenues and

JH JACKY 122
 expenses. This practice involves shifting income between reporting periods to
create a more consistent pattern of earnings.
• Example: A company might defer recognizing revenue from a highly profitable
project in one period to future periods when earnings are expected to be
lower, thereby smoothing out fluctuations in reported profits.
2. Big Bath Accounting:
• Explanation: Big bath accounting involves taking significant write-downs or
provisions in a single reporting period to artificially reduce reported earnings.
By recognizing large losses or expenses in a single period, companies can
create a "clean slate" for future periods, where earnings are expected to
improve.
• Example: A company experiencing a downturn may take large write-downs on
assets or record hefty provisions for future expenses, such as restructuring
costs, in one period to lower reported earnings. This allows the company to
present stronger earnings in subsequent periods.
3. Classification Shifting:
• Explanation: Classification shifting involves reclassifying certain expenses or
revenues to manipulate reported earnings. By categorizing items as non-
operating or extraordinary, companies can adjust earnings from core
operations without actually changing their underlying business performance.
• Example: A company might reclassify certain operating expenses as non-
recurring or one-time charges, such as litigation costs or asset impairments, to
artificially improve reported earnings from core operations.
These types of earnings management practices allow companies to influence reported
financial results to meet internal or external expectations, manage investor perceptions, or
enhance executive compensation. However, they can distort the true financial performance
of the company and mislead investors and stakeholders.
9. What factors and incentives motivate companies (management) to engage in earnings
management? What are the implications of these incentives for financial statement
analysis?
Ans:
Factors and Incentives for Earnings Management:
• Meeting earnings targets set by analysts or investors.
• Enhancing executive compensation tied to financial performance metrics.

JH JACKY 123
 • Maintaining or improving stock prices to attract investors or avoid negative market
reactions.
Implications for Financial Statement Analysis:
• Earnings management can distort the true financial performance of a company,
making it challenging for analysts to accurately assess its health and profitability.
• It may lead to misinterpretation of financial ratios and trends, affecting investment
decisions and valuation models.
• Analysts must critically evaluate financial statements and consider potential
manipulation when performing analysis and making investment recommendations.
10. Why is management interested in the reporting of extraordinary gains and losses?
Ans:
Management is interested in the reporting of extraordinary gains and losses for several
reasons:
1. Impact on Financial Performance: Extraordinary gains and losses can significantly
affect a company's reported earnings for a particular period. Management closely
monitors these items as they can influence investor perceptions of the company's
financial health and performance.
2. Effect on Shareholder Confidence: Reporting extraordinary gains can enhance
shareholder confidence by signaling successful one-time events or achievements.
Conversely, losses may prompt management to take corrective actions or provide
explanations to reassure stakeholders.
3. Strategic Decision-Making: Management's decisions regarding business strategies,
resource allocation, and capital investments may be influenced by the occurrence of
extraordinary gains or losses. Understanding the nature and impact of these items
helps management make informed decisions about future operations and
investments.
4. Compliance and Disclosure Requirements: Management has a legal obligation to
accurately report extraordinary gains and losses in accordance with accounting
standards and regulatory requirements. Failure to do so can result in penalties, fines,
or reputational damage.
Overall, management's interest in reporting extraordinary gains and losses stems from their
significant impact on financial performance, shareholder confidence, strategic decision-
making, and compliance obligations.

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11. What are the analysis objectives in evaluating extraordinary items?
Ans:
The analysis objectives in evaluating extraordinary items are to assess their impact on
reported earnings, understand the nature and cause of these items, and determine
whether they are likely to recur in the future.
12. What three categories can unusual or extraordinary items be usefully subdivided into
for purposes of analysis? Provide examples for each category. How should an analysis
treat items in each of these categories? Is a certain treatment implied under all
circumstances? Explain.
Ans:
Extraordinary items can be subdivided into:
1. Non-Recurring Events: Such as restructuring charges or asset write-downs.
2. Unusual Events: Such as natural disasters or litigation settlements.
3. Changes in Accounting Principles: Such as the adoption of new accounting
standards.
Each category should be analyzed separately to assess its impact on reported earnings and
to determine whether it is likely to recur in the future. The treatment of these items may
vary depending on their nature and materiality, and there is no one-size-fits-all approach to
their analysis.

13. Describe the effects of extraordinary items on:

a. Company resources.
b. Management evaluation.
Ans:
a. Company resources: Extraordinary items can impact company resources by affecting
reported earnings, which may influence investor perceptions and access to capital.
b. Management evaluation: Extraordinary items can influence management evaluation by
distorting reported financial performance metrics used for executive compensation or
performance evaluation.

14. Comment on the following statement: “Extraordinary gains or losses do not result
from ‘normal’ or ‘planned’ business activities and, consequently, they should not be used
in evaluating managerial performance.” Do you agree?

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Ans:
I partially agree with the statement. While it is true that extraordinary gains or losses are
not typically derived from normal or planned business activities, their exclusion from
evaluating managerial performance may not always be appropriate. Here's why:
Agreement:
• Extraordinary gains or losses are often the result of non-recurring events or
circumstances outside management's control, such as natural disasters, legal
settlements, or significant asset impairments.
• Including these items in evaluating managerial performance may distort the
assessment by attributing outcomes beyond management's influence to their
performance.
Partial Disagreement:
• However, some extraordinary gains or losses may stem from management decisions
or actions, albeit not as part of routine operations. For instance, gains from asset
sales or strategic divestitures may reflect management's successful execution of
business strategies.
• Excluding all extraordinary items from managerial evaluation might overlook
instances where management's decisions or actions have influenced the occurrence
or magnitude of such events.
Conclusion: While it's essential to recognize that extraordinary gains or losses are not
indicative of routine managerial performance, a nuanced approach is needed. Assessing the
circumstances surrounding these items and their relation to management's decisions can
provide valuable insights into their role in overall performance. Therefore, while
extraordinary items should be considered cautiously in evaluating managerial performance,
a blanket exclusion may not capture the full picture of management's effectiveness.

15. Can accounting manipulations influence earnings-based estimates of company

valuation? Explain.
Ans:
Yes, accounting manipulations such as earnings management can influence earnings-based
estimates of company valuation by distorting reported earnings. This can lead to inaccurate
assessments of a company's financial health and performance, potentially affecting its
valuation multiples and stock price.
16. a. Identify major determinants of PB and PE ratios.

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b. How can the analyst use jointly the values of PB and PE ratios in assessing the merits of
a particular stock investment?
Ans:
a. Identify major determinants of PB and PE ratios.
Major determinants of price-to-book (PB) and price-to-earnings (PE) ratios include:
• Growth prospects
• Risk profile
• Interest rates
• Market sentiment
• Industry dynamics
b. How can the analyst use jointly the values of PB and PE ratios in assessing the merits of
a particular stock investment?
The analyst can use PB and PE ratios together to gain a comprehensive understanding of a
company's valuation relative to its earnings and book value. A low PB ratio may indicate
that the stock is undervalued relative to its book value, while a low PE ratio may suggest
that the stock is undervalued relative to its earnings. By considering both ratios, the analyst
can assess whether the stock represents a good investment opportunity based on its
fundamentals and market valuation.

17. What is the difference between forecasting and extrapolation of earnings?

Ans:
Difference between Forecasting and Extrapolation of Earnings:
1. Forecasting:
• Definition: Forecasting involves predicting future earnings based on a
comprehensive analysis of various factors, including historical financial
performance, industry trends, market conditions, and management
projections.
• Methodology: Forecasting typically utilizes qualitative and quantitative
techniques, such as financial modeling, regression analysis, scenario analysis,
and expert judgment, to generate forward-looking estimates of earnings.
• Purpose: The primary objective of forecasting is to provide a reasoned and
systematic estimate of future earnings that can guide decision-making,
strategic planning, and financial analysis.

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 2. Extrapolation of Earnings:
• Definition: Extrapolation involves extending past earnings trends into the
future without considering external factors or changes in business conditions.
• Methodology: Extrapolation relies solely on historical earnings data to project
future earnings, assuming that past trends will continue unchanged.
• Limitations: Extrapolation may overlook important factors that could impact
future earnings, such as changes in market dynamics, shifts in consumer
preferences, technological advancements, or regulatory developments.
• Risk: Extrapolation carries a higher risk of inaccuracy, especially if underlying
conditions change significantly or if historical trends are not representative of
future performance.
Key Differences:
• Scope: Forecasting considers a wide range of factors and employs various analytical
methods to generate forward-looking estimates, whereas extrapolation relies solely
on historical data.
• Flexibility: Forecasting allows for adjustments and revisions based on changing
circumstances or new information, whereas extrapolation assumes that historical
trends will continue unchanged.
• Accuracy: Forecasting tends to produce more accurate and reliable estimates by
incorporating diverse inputs and analytical techniques, whereas extrapolation may be
less accurate due to its reliance on past trends alone.
• Insight: Forecasting provides deeper insights into the drivers of earnings and
potential future scenarios, while extrapolation offers a simple, but potentially
oversimplified, projection based on historical data alone.
In summary, while both forecasting and extrapolation involve predicting future earnings,
forecasting is a more comprehensive and rigorous process that considers a broader range
of factors and analytical methods, whereas extrapolation relies solely on historical data and
may be less reliable in dynamic or uncertain environments.

18. How do MD&A disclosure requirements aid in earnings forecasting?

Ans:
MD&A (Management Discussion and Analysis) disclosure requirements provide valuable
insights into a company's operating performance, financial condition, and future prospects.
By analyzing MD&A disclosures, analysts can better understand management's views on the
company's earnings outlook and key factors influencing future earnings performance.

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19. What is earning power? Why is earning power important for financial statement
analysis?
Ans:
Earning power refers to the sustainable level of earnings that a company is expected to
generate over the long term. It is important for financial statement analysis because it
provides insights into the company's ability to generate consistent profits and create value
for shareholders over time. By assessing earning power, analysts can evaluate the
company's profitability, growth potential, and overall financial health.
20. How are interim financial statements used in analysis? What accounting problems
with interim statements must we be alert to in an analysis?
Ans:
Interim Financial Statements in Analysis:
• Usage: Interim financial statements are utilized in analysis to provide insights into a
company's financial performance and position between annual reporting periods.
Analysts use interim statements to assess trends, evaluate performance, make
comparisons with prior periods, and adjust forecasting models.
• Accounting Problems to Be Alert To:
1. Seasonality: Interim financial statements may not fully reflect the seasonality
of a company's operations, leading to fluctuations in revenue and expenses
that may not accurately represent the underlying performance.
2. Timing of Transactions: Interim statements may not capture all transactions
occurring throughout the reporting period, especially those happening near
the end of the period, which could distort the financial results if significant
transactions are omitted or delayed.

21. Interim financial reports are subject to limitations and distortions. Identify and discuss
at least two reasons for this.
Ans:
• Incompleteness: Interim financial reports cover shorter periods and may not provide
a comprehensive view of a company's performance, omitting certain material events
or transactions that occur outside the reporting period.
• Estimations and Projections: Interim financial reports often involve estimations and
projections for items such as revenue recognition, allowances for doubtful accounts,
or inventory valuation, which may be less reliable or subject to change compared to

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 annual financial statements. These estimations can introduce uncertainties and
inaccuracies into the interim reports.
22. What are major disclosure requirements for interim reports? What are the objectives
of these requirements?
Ans:
Major Disclosure Requirements for Interim Reports:
1. Financial Statements: Include condensed balance sheet, income statement, cash
flow statement, and statement of changes in equity.
2. Management's Discussion and Analysis (MD&A): Provide insights into financial
condition, results of operations, and significant trends.
3. Segment Information: Disclose performance metrics for different business segments.
4. Significant Accounting Policies: Explain changes in accounting policies and their
impact.
5. Events and Transactions: Report significant events like acquisitions, disposals, or
impairments.
Objectives of These Requirements:
1. Transparency: Ensure timely and relevant information for investor trust.
2. Informed Decision-Making: Enable investors to make educated investment decisions.
3. Comparison: Facilitate performance comparison with past periods and peers.
4. Risk Assessment: Help investors evaluate potential risks and uncertainties.
5. Regulatory Compliance: Ensure adherence to standards and promote financial
integrity.

23. What are the implications of interim reports for financial analysis?
Ans:
Implications of Interim Reports for Financial Analysis:
1. Timely Updates: Interim reports offer timely insights into a company's financial
performance between annual reports, aiding analysts in tracking progress and
identifying trends promptly.
2. Performance Evaluation: Analysts can use interim reports to assess financial health,
profitability, and operational efficiency over shorter periods, facilitating performance
evaluation.

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 3. Trend Identification: Comparison with previous periods helps identify trends and
patterns, assisting analysts in gauging the company's trajectory and areas for
improvement.
4. Strategic Insights: Interim reports provide insights into management strategies and
initiatives, helping analysts assess effectiveness and impact on financial performance.
5. Forecasting Aid: Analysts can adjust forecasting models based on actual results and
management guidance provided in interim reports, enhancing accuracy in predicting
future performance.
6. Risk Assessment: Interim reports help identify and assess risks that may affect
financial stability, supporting informed decision-making by investors.
7. Market Influence: Interim reports can influence market sentiment and stock prices,
necessitating accurate interpretation by analysts to anticipate market reactions
effectively.
In summary, interim reports serve as valuable tools for financial analysis, offering timely
updates, aiding performance evaluation, identifying trends, providing strategic insights,
aiding forecasting, assessing risks, and influencing market sentiment.

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 Chapter 8
Cashflow Statement

Chapter Summary:

Statement of Cash Flows:

The statement of cash flows details cash inflows and outflows, categorized into operating,
investing, and financing activities. It helps in understanding cash generation, expenditure,
and financing sources, addressing various questions about cash management.
Questions such as:
 How much cash is generated from or used in operations?
 What expenditures are made with cash from operations?
 How are dividends paid when confronting an operating loss?
 What is the source of cash for debt payments?
 How is the increase in investments financed?
 What is the source of cash for new plant assets?
 Why is cash lower when income increased?
 What is the use of cash received from new financing?
Reporting by Activities:
1. Operating Activities:
• Operating activities are the earning-related activities of a company.
• It Involves revenue, expenses, and cash flows related to day-to-day operations.
• It Includes transactions like extending credit, inventory investments, and
supplier credits.
• Its related to income statement items and balance sheet items relating to
operations.
2. Investing Activities:
• It Covers acquisition and disposal of non-cash assets and investments.
• It Involves
 Assets, expected to generate income for a company;
 Lending funds and collecting the principal, on these loans.
3. Financing Activities:
• {Focuses on funding sources and uses, including borrowing, owner
contributions, and dividends.}

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 • Financing activities are means of contributing, withdrawing, and servicing
funds to support business activities.
• They include –
 Borrowing and repaying funds with bonds and other loans;
 Contributions and withdrawals by owners and
 Return (dividends) on investment.

Limitations in Cash Flow Reporting:

• Separate disclosure not required for extraordinary items or discontinued operations.
• Interest and dividends received are classified as operating cash flows, while interest
paid is considered a financing outflow. Some users may view interest and dividends
received as investing inflows.
• Income taxes are categorized as operating cash flows, potentially distorting analysis if
significant tax benefits or costs are disproportionately attributed to operating
activities.
• Removing pretax gains or losses on sales of plant or investments from operating
activities can distort analysis of both operating and investing activities.
ANALYSIS OF CASH FLOWS:
Analysis Implications:
• Identify major past sources and uses of cash.
• Aggregate cash flows over several years for meaningful trend analysis.
• Focus on questions regarding asset financing, expansion sources, dependence on
external financing, investing demands, and managerial policies.
• questions like:
 Are asset replacements financed from internal or external funds?
 What are the financing sources of expansion and business acquisitions?
 Is the company dependent on external financing?
 What are the company’s investing demands and opportunities?
 What are the requirements and types of financing?
 Are managerial policies (such as dividends) highly sensitive to cash flows?

Inferences from Analysis:

• Evaluate management’s decision quality and its impact on operations and financial
position.
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 • Gain insights into management’s adaptability to changing business conditions and its
ability to capitalize on opportunities and overcome challenges.
• Analyze resource allocation, investment reduction, cash sources, and reduction of
claims against the company.
• Assess earnings disposition and discretionary cash flow investment.
• Infer the size, composition, pattern, and stability of operating cash flows.
Free Cash Flow:
• Calculated as cash flows from operations minus capital expenditures and dividends.
• Positive free cash flow indicates financial flexibility and growth potential.
Specialized Cash Flow Ratios:
1. Cash Flow Adequacy Ratio:
• Measures a company’s ability to cover capital expenditures and dividends from
operations.
• Ratio of cash from operations to capital expenditures and dividends over three
years.
• The cash flow adequacy ratio is calculated as:

2. Cash Reinvestment Ratio:

• Indicates the percentage of operating cash retained for asset replacement and
growth.
• Computed as operating cash flow minus dividends divided by total assets.

Interpretation:
• Ratios provide insights into a company’s ability to meet cash needs and reinvest for
growth.
• Ratios below 1 indicate potential reliance on external financing.

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 BOOK Questions
1. What is the meaning of the term cash flow? Why is this term subject to confusion and
misrepresentation?
Ans: Cash flow refers to the movement of cash into and out of a business over a specific
period. It represents the net change in a company's cash position resulting from operating,
investing, and financing activities. This term is subject to confusion and misrepresentation
because it can be influenced by various factors, including non-cash transactions, timing
differences, and accounting policies.
2. What information can a user of financial statements obtain from the statement of cash
flows?
Ans: Information from Statement of Cash Flows: Users of financial statements can obtain
crucial information from the statement of cash flows, including:
• Operating, investing, and financing activities that affect the company's cash position.
• Sources and uses of cash, providing insights into liquidity, solvency, and financial
flexibility.
• Changes in cash and cash equivalents during the reporting period.
3. Describe the three major activities the statement of cash flows reports. Cite examples
of cash flows for each activity.
Ans: Three Major Activities Reported in Statement of Cash Flows: The statement of cash
flows reports:
1. Operating Activities: Cash flows from core business operations, such as revenue from
sales and payments to suppliers.
• Example: Cash received from customers, payments to suppliers for inventory.
2. Investing Activities: Cash flows from the purchase and sale of long-term assets or
investments.
• Example: Cash spent on acquiring property, plant, and equipment; cash
received from selling investments.
3. Financing Activities: Cash flows related to borrowing, repaying debt, and equity
transactions.
• Example: Cash received from issuing bonds, cash paid for dividends.

4. Explain the three categories of adjustments in converting net income to cash flows
from operations.

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Ans: Categories of Adjustments in Converting Net Income to Cash Flows from Operations:
The three categories of adjustments are:
1. Non-cash Expenses: Adjustments for expenses recorded in the income statement but
not involving cash outflows, such as depreciation and amortization.
2. Changes in Working Capital: Adjustments for changes in current assets and liabilities,
such as accounts receivable, inventory, accounts payable, and accrued expenses.
3. Other Adjustments: Includes items like interest expense, income taxes, and gains or
losses on the sale of assets.
5. Describe the two methods of reporting cash flow from operations.
Ans: Methods of Reporting Cash Flow from Operations: Two methods are used:
1. Direct Method: Reports actual cash inflows and outflows from operating activities,
such as cash received from customers and paid to suppliers.
2. Indirect Method: Adjusts net income for non-cash items and changes in working
capital to derive cash flow from operations.
6. Contrast the purpose of the income statement with that of cash flow from operations.
Ans: Purpose Contrast between Income Statement and Cash Flow from Operations:
The income statement shows profitability over a specific period, indicating revenues,
expenses, and net income. In contrast, the cash flow from operations focuses on the actual
cash inflows and outflows related to core business activities, excluding non-cash
transactions and changes in working capital.
7. Discuss the importance to analysis of the statement of cash flows. Identify factors
entering into the interpretation of cash flows from operations.
Ans: Importance of Statement of Cash Flows to Analysis:
The statement of cash flows is crucial for analysis because it provides insights into a
company's liquidity, solvency, and financial flexibility. Key factors for interpreting cash flows
from operations include understanding the company's operating efficiency, working capital
management, and cash flow sustainability.
8. Describe the computation of free cash flow. What is its relevance to financial analysis?
Ans: Computation of Free Cash Flow and Relevance to Financial Analysis:
Free cash flow is calculated by subtracting capital expenditures and dividends from cash
flow from operations. It indicates the cash available for discretionary purposes, such as
debt repayment, dividends, or investments in growth opportunities. Understanding free
cash flow is essential for assessing a company's financial health and evaluating its ability to
generate value for shareholders.

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9. List insights that the statement of cash flows can provide to our analysis.
Ans: Insights Provided by Statement of Cash Flows to Analysis: Insights from the
statement of cash flows include understanding cash generation and usage, evaluating the
company's ability to meet financial obligations, assessing investment and financing
decisions, and analyzing cash flow trends over time.

- Best of Luck -

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