Analyzing Financing Activities

Topic 3
Where are we?
Part I Part II Part III
Introduction and Overview Accounting Analysis Financial Analysis
To understand the business & To understand the numbers To analyze the past
the financial statements (and adjust them, if any) performance
Topic 1 Topic 3 Topic 6
– Overview of Financial – Analyzing Financing Activities – Profitability Analysis
Statement Analysis
Topic 4 Topic 7
Topic 2 – Analyzing Investing Activities – Credit Risk Analysis
– Financial Reporting & Analysis
Topic 5 Topic 8
– Analyzing Operating Activities – Cash Flow Analysis

To forecast the future

performance & make decision
Topic 9
– Forecasting and Valuation

2
Lesson Plan
• Financing Activities: Debt Financing / Equity Financing

• Analyzing Trade Debt: Accounts Payable

• Analyzing Non-Trade Debt: Note Payable

• Analyzing Equity: Book Value per Share

3
Financing Activities
Sources of funding are required for acquiring assets and conducting business
activities.

Financing activities ( 融資活動 ) could be in the form of debt financing (i.e.

raise / repay debts) and/or equity financing (i.e. issue / buy back shares).

An asset is a present economic resource controlled by the entity as a result of

past events. An economic resource is a right with the potential to produce
economic benefits.

A liability is a present obligation of the entity to transfer an economic

resource as a result of past events.

Equity is the residual interest in the assets of the entity after deducting all its
liabilities. 4
Debt Financing
Cash inflows
• Cash proceeds from issuing debentures, loans, notes, bonds, mortgages
and other short-term or long-term borrowings to the debt holders.

Date of borrowing
Dr. Cash
Cr. Note Payable ( 應付票據 )

Cash outflows
• Cash repayments of amounts borrowed; and
• Cash payments by a lessee for the reduction of the outstanding liability
relating to a finance lease. (HKAS 7.17)
Date of repaying the principal / interest
Dr. Note Payable
Dr. Interest Expense / Payable
Cr. Cash 5
Debt Financing
Current / Non-current
• Current liabilities ( 流動負債 / 短期負債 ) (payable within 12 months)
• Non-current liabilities ( 長期負債 ))
 Impact: Current ratio?

Financing / Operating
• Financing liabilities (arising from financing activities)
• e.g. long-term debt; note payable; bank loan; lease obligation

• Operating liabilities (arising from operating activities)

• e.g. accounts payable; unearned revenue; other accruals

6
Equity Financing
Cash inflows
• Cash proceeds from issuing shares to the shareholders

Date of issuing shares

Dr. Cash
Cr. Share Capital – Ordinary ( 普通股股本 )
Cr. Share Capital – Preference ( 優先股股本 )

Cash outflows
• Cash dividends paid to the shareholders
• Cash paid to repurchase shares (treasury shares)

Date of declaring cash dividends Date of paying cash dividends

Dr. Retained Earnings ( 保留盈利 ) Dr. Dividends Payable
Cr. Dividends Payable ( 應付股息 ) Cr. Cash
7
Equity Financing
Where to look for the information?

Issue shares Declare/pay Repurchase

dividends shares
Statement of Cash Flows Y (Note 1) Y (Note 1) Y
Statement of Financial Position Y Y Y
Statement of Changes in Equity Y Y Y
Statement of Profit or Loss (Note 2) N/A N/A N/A

Note 1
An entity might issue shares to suppliers / employees for goods or services received in a share-based
payment transaction. No cash flow is involved in such transactions. (HKFRS 2)

Similarly, issuance of new shares in share dividends / stock splits has no cash flow impact.

Note 2
Unlike debt financing, all transactions with shareholders are not recognized in profit or loss. 8
Lesson Plan
• Financing Activities: Debt Financing / Equity Financing

• Analyzing Trade Debt: Accounts Payable

• Analyzing Non-Trade Debt: Note Payable

• Analyzing Equity: Book Value per Share

9
Analyzing Trade Debt: Accounts Payable
Where do they come from?
Statement of Financial Position
• Credit purchase
Current assets
Date of credit purchase Inventory
Dr. Inventory Cash
Cr. Accounts Payable ( 應付帳款 )
Current liabilities
Accounts Payable

Date of repayment
Dr. Accounts Payable Date of selling inventory
Cr. Cash Dr. Cash / Accounts Receivable
Cr. Sales Revenue

Dr. Cost of Goods Sold (COGS)

Cr. Inventory
10
Analyzing Trade Debt: Accounts Payable
What issues to consider?
• How quickly did the firm settle the trade debt (during the period)?
 Average payable days outstanding ( 平均欠款日數 )

• How long had the accounts payable been overdue (at the period-end)?
 Ageing analysis of accounts payable ( 應付帳款帳齡分析 )

They could be an indicator of the firm’s (improving/worsening) ability to

meet its debt when due.

11
Average Payable Days Outstanding

Average payable days outstanding

= (Average Accounts payable / COGS) * 360

Opening Inventory
+ Purchase – COGS
Note
= Closing Inventory
Accounts payable arises from credit purchase.

Since credit purchase is not required to be publicly disclosed, either “total

purchase” or COGS is usually adopted as a replacement.

For this module, COGS is adopted for the calculation above. 12

Average Payable Days Outstanding
Example 1
ACY Limited had below in the recent years:

31 December
Year 3 Year 2 Year 1
$ $ $
Accounts Payable 33,000 29,000 27,000

Year 3 Year 2 Year 1

$ $ $
Cost of Goods Sold 318,858 315,000 300,000 Class
Exercise
Required:
(i) Calculate the average payable days outstanding in Year 2 and Year 3.
(ii) Analyze the indication to ACY Limited’s liquidity in these two years . 13
Average Payable Days Outstanding
Average payable days outstanding in Year 2
= (Average Accounts payable in Year 2 / COGS in Year 2) * 360
= { [ ($27,000 + $29,000) / 2 ] / $315,000 } * 360
= 32 days

Average payable days outstanding in Year 3

= (Average Accounts payable in Year 3 / COGS in Year 3) * 360
= { [ ($29,000 + $33,000) / 2 ] / $318,858 } * 360
= 35 days

This indicates that ACY Limited on average took 3 days more in Year 3 (35 days) to repay its
accounts payable than in Year 2 (32 days). [observed result]

This might signal the firm’s worsening ability to pay debt promptly [possible reason].
Alternatively, this could also be due to a longer credit period was obtained from the
suppliers [another possible reason]. 14
Ageing Analysis of Accounts
Payable
An ageing analysis of accounts payable is required for listed entities in
Hong Kong (Paragraph 4.2(b), Appendix 16, MBLRs).

This provides a comparison to the “average payable days outstanding”.

15
Ageing Analysis of Accounts
Payable
Example 2
Further information is available regarding ACY Limited:

31 December
Year 3 Year 2
$ $
Accounts Payable 33,000 29,000

Ageing analysis
Within 1 month from invoice date 28,000 26,000
1 to 3 months 3,000 2,200
Over 3 months but within 6 months 2,000 800
33,000 29,000

Required: Class
(i) Comment on the ageing analysis information above. Exercise
16
Ageing Analysis of Accounts
Payable
In Year 2, more than 89% of accounts payable were aged within 1
month ($26,000 / $29,000 = 89.7%).
Observed
results
In Year 3, only around 85% of payables were aged within 1 month
($28,000 / $33,000 = 84.8%); while the remaining 15% debt were
aged over 1 month (Year 2: 10%).

This indicates that ACY Limited had taken a longer period of time The trend
to pay debt after the invoice dates in Year 3 than in Year 2.

Again, this might signal the firm’s worsening ability to pay debt
promptly; or simply that a longer credit period was bargained Likely
from the suppliers. Further information is needed to determine reason(s)
the likely underlying reason.
17
Lesson Plan
• Financing Activities: Debt Financing / Equity Financing

• Analyzing Trade Debt: Accounts Payable

• Analyzing Non-Trade Debt: Note Payable

• Analyzing Equity: Book Value per Share

18
Analyzing Non-Trade Debt: Note Payable
Where do they come from?
• Bank loan borrowing / Issuing note payable

Date of borrowing Date of repaying the principal

Dr. Cash Dr. Note Payable
Cr. Note Payable ( 應付票據 ) Cr. Cash

Interest accrued at each period-end date

Dr. Interest Expense / Finance Cost ( 利息費用 )
Cr. Interest Payable ( 應付利息 )
Similar instruments:
- Bonds payable
- Long-term debt
Date(s) of repaying the interest
Dr. Interest Payable … etc.
Cr. Cash 19
Analyzing Non-Trade Debt: Note Payable
Where do they come from?
• Bank loan borrowing / Issuing note payable

Statement of Financial Position Statement of Profit or Loss

(At each period-end date) (for each accounting period)

Current assets Income

Cash …

Current liabilities Expense

Note Payable (current portion) Interest Expense / Finance Cost

Non-current liabilities
Note Payable (non-current portion)

20
Measuring Note Payable
Long-term Debt / Note / Bank Borrowing
A liability with a contractual obligation to deliver cash or another financial
asset to another entity shall be classified as a financial liability ( 金融負債 ) in
the financial statements. (HKAS 32.11)

At each period-end, a liability like above is measured at amortized cost (i.e.

applying the effective interest method), except for those measured at fair value
through profit or loss (only for those held for trading / as designated upon
initial recognition).
(HKFRS 9.4.2)
Consider the basic features of a bond issued:
(i) Principal / Face value ( 本金 )
(ii) Coupon rate ( 名義票面利率 )
(iii) Discount rate / Effective interest rate ( 實際利率 )
(iv) Maturity ( 還款期 ) 21
Financial liability at amortized cost
If a financial liability is measured at amortized cost, you can simply
prepare an amortization schedule to calculate the interest payment &
interest expense for each period, and the amortized cost of the liability at
the end of each period.

The idea of amortized cost is based on the reasoning that the same
discount rate shall be applied throughout the loan period (regardless of
the subsequent changes in interest rate that the market would require shall
a similar loan be re-issued again by the borrower at each period-end).

Alternatively, you can also re-calculate the present value of the liability at
each subsequent year-end, using the original discount rate, for the
remaining unpaid interest payments and the principal. You will get the
same answers.

22
Financial liability at amortized cost
Example 3
On 1 January 20X1, ACY Limited issued a 3% bond with face value of
$100,000, due in 3 years (i.e. 31 December 20X3) with interest payable, in
arrears, annually on each 31 December.

The market yield was 3% for similar bonds on 1 January 20X1, and
increased to 5% on 31 December 20X1.

For the year ended 31 December 20X1:

(i) How much liability was reported?
(ii) How much cash shall be paid in the future?
(cash flows forecast) Class
Exercise
23
 Amortization Schedule
Annual Interest Payments
3-Year, 3% Bonds Sold to Yield 3%

All in $ Amortized cost Amortized cost

at 1 Jan Interest payment Interest expense at 31 Dec
[a] [b = $100,000 * 3% [c = a * 3% [a – b + c]
coupon rate] discount rate]
Year 20X1 100,000 (3,000) 3,000 100,000
Year 20X2 100,000 (3,000) 3,000 100,000
Year 20X3 100,000 (3,000) 3,000 100,000

Annual interest payment = Principal $100,000 * Coupon rate 3% = $3,000

Cash flows shall be discounted at 3% discount rate:

Present value on 1 Jan 20X1

= (3,000 / 1.03) + (3,000 / 1.03^2) + (3,000 / 1.03^3) + (100,000 / 1.03^3)
= $100,000

As at 31 Dec 20X1, the new market interest rate of 5% is ignored in calculating the amortized
cost of the financial liability. Instead, the original discount rate of 3% is still applicable. 24
Financial liability at fair value
If a financial liability is measured at fair value, it shall be re-measured at the
latest effective interest rate for the remaining unpaid cash outflows (i.e. the
unpaid interest and the principal).

Despite using a different discount rate, the total cash flows and expenses
throughout the loan period shall remain unchanged.

Total expense in each year = Change in reported liability + Interest paid

Regarding financial liability at fair value, you are NOT required to split the
expenses between “Interest Expense” and “Unrealized gain/loss due to change
in fair value” (in the Statement of Profit or Loss) in this module.

However, you shall calculate the fair value at each period-end date (in the
Statement of Financial Position); the total expenses (in the Statement of Profit
or Loss); as well as the interest payments (in the Statement of Cash Flows). 25
Financial liability at fair value
Example 4
On 1 January 20X1, ACY Limited issued a 3% bond with face value of
$100,000, due in 3 years (i.e. 31 December 20X3) with interest payable, in
arrears, annually on each 31 December.

The market yield was 3% for similar bonds on 1 January 20X1, and
increased to 5% on 31 December 20X1.

For the year ended 31 December 20X1:

(i) How much liability shall be reported?

Class
Exercise
26
Financial liability at fair value
Fair value at 1 Jan 20X1 (i.e. the present on the issue date)
= (3,000 / 1.03) + (3,000 / 1.03^2) + (103,000 / 1.03^3)
= $100,000

Amortized Cost at 31 Dec 20X1 (based on the original 3% discount rate)

= (3,000 / 1.03) + (103,000 / 1.03^2)
= $100,000

Fair Value at 31 Dec 20X1 (based on the latest 5% market rate)

= (3,000 / 1.05) + (103,000 / 1.05^2)
= $96,281 27
Financial liability at fair value
Restrictions from HKFRS 9
Paradoxically, increase in discount rate leads to decrease in fair value of a
financial liability in the borrower’s book (given the same contractual cash
outflows).

For financial liabilities designated (by management) as measured at fair

value, gain/loss from change in fair value shall, in general, be recognized in
other comprehensive income, rather than in profit or loss, if this is due to
worsening/improving of the entity’s credit risk. (See HKFRS 9.5.7.7)

Remember: Interest rate = Risk-free rate + Risk premium

28
Evaluating the Terms of Debt & Borrowing
In analyzing an entity’s debt, see below from the Notes to Financial
Statements:

• Maturity (Short-term or long-term funding? Future cash outflows.)

• Seniority (Senior debts are paid before junior debts, shall the borrower
be liquidated.)

• Security (Secured debt is backed by collateral: borrower’s assets.)

• Covenants (If the terms are violated, the debt becomes repayable on
demand.)

29
Evaluating the Terms of Debt & Borrowing
For example, Champion REIT ( 冠君產業信託 ) (2778.HK) obtained debt
financing from the market and reported some financial liabilities as at 31
December 2020.

Try to read pages 133, 149, 150, 171, 172, and 185 in the annual report to
look for below:
• Current / Non-current? Maturity?
• Measured at amortized cost? At fair value through profit or loss?
• Secured / Unsecured? What were the collateral?
• Timing & amounts of the (undiscounted) future cash outflows?

30
Lesson Plan
• Financing Activities: Debt Financing / Equity Financing

• Analyzing Trade Debt: Accounts Payable

• Analyzing Non-Trade Debt: Note Payable

• Analyzing Equity: Book Value per Share

31
Common Types of Shares
Share Capital – Ordinary ( 普通股股本 )
(i.e. common stock)
This is the class of shares with ownership interest and bearing the ultimate risks
and rewards (residual interests) of the company’s performance.

Share Capital – Preference ( 優先股股本 )

(i.e. preferred stock)
This is a class of shares with features not possessed by common stock. For example*:
• Dividend distribution preferences
• Liquidation priorities
• Convertibility (redemption) into common stock
• Call provisions
• Non-voting rights

* These features are subject to the specific terms in each case. 32

Book Value per Share
Book Value per Share ( 每股賬面資產淨值 )
= Net assets value (as reported) at period-end
/ Number of shares at period-end*

This represents the net assets value available to shareholders (at the
reported amounts in the Statement of Financial Position) if the company
was liquidated at the period-end.

This can be further divided into: (i) book value per preferred stock; and (ii)
book value per common stock

* Number of shares at period-end

= Total number of shares issued – Treasury shares (share buyback)
33
Book Value per Share
Book value of common stock can be calculated as follows:

Items
Total assets – Total Liabilities = Net assets X (as reported)
Less: Those attributable to preference shares (X) (if applicable) *
Less: Those attributable to non-controlling interest (X) (if applicable)
Book value attributable to the ordinary shares X

Share Capital – Preference ( 優先股股本 )

Share Premium – Preference ( 股份溢價 – 優先
股)

* This includes the book value of preference shares, but can also include any
unrecorded claims of senior securities, such as unrecorded dividends to
preferred shares for the year (i.e. those dividends in arrears but not yet
declared at year-end). 34
Why dividends in arrears
might get unrecorded at the period-end?
A company has a present obligation to pay interest and principal to
creditors (due to contractual obligations), and thus a liability is recorded
once accrued.

However, dividends only become payable to preference / ordinary

shareholders when the company declares to pay.

As such, any dividends declared after the year-end date, even attributable
to that year, shall not be recognized in the financial statements for that
year (since the present obligation did not exist at year-end).
(See HKAS 10.12)

*This could lead to preference shares dividends that are in arrears for the
year, but get unrecorded in the financial statements for the same year.
35
 Book Value per Share
Equity items, Balance Sheet

Assuming that
Dividends for Year 5 are in
arrears (and also unrecorded)
= $360,281,100 * 7%
= $25,219,677

This $25m is then

not reflected in the
Balance Sheet;
while it can be
deducted for
calculating book
value of common
stock (page 172,
Textbook)
Calculation of book value per share Page 173, Subramanyam (2014) 36
 Class
Book Value per Share Exercise
Example 5
(Extract of) Statement of Financial Position – ACY Limited

31.12.20X1
$
 Total Assets 2,600

 Total Liabilities 500

Equity
Share Capital – Ordinary (300 shares @ $3) 900
Share Capital – Preference (100 shares, 10% cumulative, $2 par) 200
Retained Earnings 1,000
 Total equity 2,100

Assuming that dividends for

Calculate below as at 31.12.20X1:
20X1 were declared to
(i) Book value per preference share holders of preference share
(ii) Book value per ordinary share on 10 December 20X1. 37
Book Value per Share
Answer 5.1
Net assets value (as reported) at 31.12.20X1 that are attributable to the
preference shares
= Preference shares in equity
= $200

Number of preference shares at 31.12.20X1

= 100 share

Book value per preference share as at 31.12.20X1

= $200 / 100 shares
= $2
38
Book Value per Share
Answer 5.2
Net assets value (as reported) at 31.12.20X1 that are attributable to the
ordinary shares
= Net assets – Those attributable to the preference shares
= $2,100 – $200
= $1,900

Number of ordinary shares at 31.12.20X1

= 300 shares

Book value per ordinary share as at 31.12.20X1

= $1,900 / 300 shares
= $6.33 39
Book Value per Share
Example 6
Same data from Example 5, but assuming that dividends for 20X1 were not
yet declared to preference share holders before the end of 20X1.

Calculate below as at 31.12.20X1:

(i) Book value per preference share
(ii) Book value per ordinary share

40
Book Value per Share
Answer 6.1
Net assets value (as reported) at 31.12.20X1 that are attributable to the
preference shares
= Preference shares in equity + Dividends in arrears
= $200 + (100 shares * $2 * 10%)
= $220

Number of preference shares at 31.12.20X1

= 100 shares

Book value per preferred stock as at 31.12.20X1

= $220 / 100 shares
= $2.2 41
Book Value per Share
Answer 6.2
Net assets value (as reported) at 31.12.20X1 that are attributable to the
ordinary shares
= Net assets – Those attributable to the preference shares
= $2,100 – $220
= $1,880

Number of ordinary shares at 31.12.20X1

= 300 shares

Book value per ordinary share as at 31.12.20X1

= $1,880 / 300 shares
= $6.27 42
Book Value per Share
Relevance of Book Value
Book value per share provides a measure of the asset coverage for each share
held.

The concept of book value is particularly relevant to assets like financial assets
and investment property, since they are usually measured at fair value, and can
be more easily realized for distribution to creditors / shareholders.

Constraint of Book Value

However, measurement (and even non-recognition) of some other items might
limit the usefulness of book value per share:
(i) Property, plant and equipment (Cost – Accumulated Depreciation?)
(ii) Human capital? Internally developed technical know-how?
(iii) Contingent assets / Contingent liabilities / Commitment?
(iv) The market’s expectation on the firm’s future growth potential? 43
Textbook Reading & Exercise
Textbook Reading
• Chapter 3. Financial Statement Analysis. International Edition (11th
edition). Subramanyam (2014). McGraw-Hill.

Textbook Exercise
• Question 3-1, and 3-2
• Exercise 3-8
• Problem 3-4
• Case 3-3

44