Transcript 3_AFPLST_Slides_Chapters_4_5

Session 3, Module Two:
Corporate Financial Management


Chapter 4:
Financial
Accounting and
Reporting
Chapter 5:
Financial Planning
and Analysis
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Session 3: Module 2, Chapter 4 - 1
Chapter 4: Financial Accounting
and Reporting
Outline:
 Accounting Concepts and Standards
 Financial Reporting Statements
 Accounting for Derivatives, Hedges and
FX Translation
 Accounting for U.S. Governmental and
Not-for-Profit (G/NFP) Organizations
 Impact of Pension Plans and Deferred
Compensation on Financial Statements
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Session 3: Module 2, Chapter 4 - 2
Insights Gained from Financial
Statement Analysis





How well the company has managed its
liquidity position
How effectively it used and financed its
assets
Whether it had a proper balance between
debt and equity financing
How well it controlled operating and
financing costs
Whether the profit it earned was
satisfactory in relation to revenue and
asset investments supporting operations
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Session 3: Module 2, Chapter 4 - 3
Discussion Question
Discuss global accounting standards, who
issues them, how they differ from U.S. GAAP,
and how they are being adopted.
Answer:
 International Accounting Standards Board
(IASB) pronouncements are International
Financial Reporting Standards (IFRS)
 More high level, less detailed than
U.S. GAAP
 2015-2016 worldwide adoption or
convergence to resolve differences
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Session 3: Module 2, Chapter 4 - 4
U.S. Generally Accepted
Accounting Principles (GAAP)
Four basic
principles
underlying
GAAP:
Historical
cost
Full
disclosure
Revenue
recognition
Matching
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Session 3: Module 2, Chapter 4 - 5
Cash vs. Accrual Accounting
Cash accounting:



Records cash as it is
received/disbursed.
Records expenses as
they are paid.
Directly relates all
entries to a cash inflow
or outflow.
Accrual accounting:





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Recognizes revenues as
they are earned.
Recognizes expenses
when the associated
revenue is recognized.
Makes entries regardless
of when the related cash
flow occurs.
Earnings management
Earnings manipulation—
intentionally distorting
estimates or making
judgments that influence
reported income.
Session 3: Module 2, Chapter 4 - 6
ASC Codification Topics


Accounting for cash, cash equivalents and overdrafts
Accounting for short-term investments (Topic 320)



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Other-than-temporary impairment (OTTI) (Topic 325)
1.
2.
3.

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Trading securities
Held-to-maturity (HTM) securities
Available for sale (AFS) securities
Impaired: fair value less than cost
Impairment temporary or OTTI? Fair value in sale?
For OTTI, recognize entire impairment loss in earnings
Classification of debt (current/noncurrent)
Accounting for goodwill and other acquired intangible
assets (Topic 350)
SOX improvements in OBSA reporting
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Session 3: Module 2, Chapter 4 - 7
Auditor Opinions





Standard unqualified
Unqualified with
explanatory
paragraph or
modified unqualified
Qualified
Adverse
Disclaimed
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Session 3: Module 2, Chapter 4 - 8
Discussion Question
What is the impact of SOX and the PCAOB on
the audit process?
Answer:
 Requires PCAOB to register, monitor, inspect and
discipline public accounting firms.
 PCAOB acquired responsibility for establishing
auditing standards.
 Requires companies to evaluate and disclose
internal financial controls.
 Auditors must attest to, or confirm, these
controls.
 Requires CEOs and CFOs to certify financial
statements (specifies fines and jail time).
 Public firms must maintain independent audit
committees.
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Session 3: Module 2, Chapter 4 - 9
Discussion Question
What are the financial statements
required by SEC Regulation S-X in the
U.S., and what additional information is
required?
Answer:
 Statement of financial position (balance
sheet)
 Income statement
 Reconciliation of changes in
shareholders’ equity
 Statement of cash flows
 Accompanying notes
 Management discussion and analysis (MD&A)
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Session 3: Module 2, Chapter 4 - 10
Sample Balance
Sheet (see book)


Reports financial
condition at point in
time
Assets:
Current assets
Fixed assets
(depreciable fixed
assets)
 Intangible assets



Liabilities:




Current liabilities
Long-term liabilities
Equity
Assets = Liabilities +
Shareholders’ Equity
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Session 3: Module 2, Chapter 4 - 11
Discussion Question
How are liabilities and debt
different? Give an example of each.
Answer:


Liability refers to an amount that is owed,
regardless of the form. Example: Accounts
payable is a liability but not a debt.
Debt refers only to obligations that
require interest payments and is
considered a subset of liabilities. Example:
Notes payable are both a liability and a
debt.
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Session 3: Module 2, Chapter 4 - 12
Sample Income
Statement



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
Revenues earned
Expenses incurred
Gains and losses
arising from
conversions of
assets and liabilities
over an accounting
period
Measured over a
span of time
Costs and
earnings




See book
COGS
EBITDA
EBIT
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Session 3: Module 2, Chapter 4 - 13
Discussion Question
Comprehensive income is net income adjusted
for what types of gains and losses not
reported on the income statement?
Answer:
 Unrealized gains and losses, from OTTI
investments (Topics 320 and 325)
 Minimum pension liability adjustments
(Topic 715)
 Foreign currency translation adjustments
(Topic 830)
 Changes in the market values of certain
futures contracts qualifying as hedges
(Topic 815)
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Session 3: Module 2, Chapter 4 - 14
Discussion Question
Identify whether changes in each of the
following balance sheet accounts is a source
or use of funds on the statement of cash
flows.
Answers:
Use of funds
Increase in an asset
Source of funds
Decrease in an asset
Source of funds
Increase in a liability
Use of funds
Decrease in a liability
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Session 3: Module 2, Chapter 4 - 15
Discussion Question
Describe the basic differences between
using the direct and indirect methods to
prepare a statement of cash flows.
Answer:
 Indirect method begins with net income from
the income statement; adjusts net income by
any changes in balance sheet accounts
from the prior period.
 Direct method reports the source of cash
inflows and outflows without relying on
adjustments to net income; total cash flow
for each activity is computed; accrual
accounts are converted to a cash amount.
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Session 3: Module 2, Chapter 4 - 16
Sample Statement
of Cash Flows


Shows sources and
uses of cash.
Sections:





Operating
Investing
Financing


See book
Must be able to
construct!
Cash from
operations
calculated by
adding back noncash charges (e.g.,
depreciation).
Cash, not earnings,
repays debt.
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Session 3: Module 2, Chapter 4 - 17
Discussion Question
According to ASC Topics 815, 820 and 825,
how are gains and losses arising from changes
in a derivative’s fair value accounted for and
what are some types of qualifying hedges?
Answer:
 If not hedge instruments—reported in current income.
 Fair value hedges—hedge specific asset or
liability on balance sheet—recognize as income
together with offsetting gains and losses of
hedged item.
 Hedges to minimize variability in the cash
flow values of a forecasted transaction—
reported in comprehensive income:


Cash flow hedges
FX transaction hedges
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Session 3: Module 2, Chapter 4 - 18
FX Translation Accounting


Translation to home currency: determine
correct exchange rate for each foreign
financial statement line item.
Topic 830:


Determine the functional currency.
Determine whether the functional currency of the
subsidiary is also its home currency.


If so, current method translates all assets and liabilities
at the current spot rate (date of translation). Retained
earnings are translated at weighted average rate. Other
equity translated at transaction date spot rates.
If not, temporal (historical) method remeasures
nonmonetary balance sheet accounts and related income
statement accounts at historical exchange rates.
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Session 3: Module 2, Chapter 4 - 19
Chapter 5: Financial Planning
and Analysis
Outline:
 Basic Financial Concepts
 Decision Evaluation
 Developing Operating
and Financial Budgets
 Financial Statement
Analysis
 Performance
Measurement
 Financial Analysis and
Rating Agencies
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Session 3: Module 2, Chapter 5 - 20
Time Value of Money


A dollar today is
worth more than a
dollar tomorrow.
The value of cash
flow is determined
by:
Amount of the cash
flow
 Appropriate
interest rate
 At what future
period the cash
flow is expected to
occur

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Session 3: Module 2, Chapter 5 - 21
Future Value

What is the future value of $100 if it
can be invested for two years,
compounded annually, at a rate of
10% per year?
n
Future Value = PV × (1 + i)
Where:
FV = Future value
PV = Present value or value today
i= Periodic interest rate
n = Number of periods
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= $100 (1 + .10)2
= $100 (1.21) = $121
Session 3: Module 2, Chapter 5 - 22
Present Value

What is the present value of $2,382 to
be received after three years,
discounted at a rate of 6.00%
annually?
Present Value =
Where:
FV = Future value
i = Periodic interest rate
n = Number of periods
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$2,382
FV
=
n
3
1 + i 1 + 0.06
$2,382
=
= $2,000
1.191
Session 3: Module 2, Chapter 5 - 23
Operating Leverage
High fixed
costs and low
variable costs
Profits will expand rapidly
after the company earns
enough to cover its fixed
costs.
■ Volume of business does not
Low fixed
need to be as great to cover
costs and high
fixed costs.
variable costs
■ Additional business volume
will not cause profits to rise
as rapidly because variable
costs are high.
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Session 3: Module 2, Chapter 5 - 24
Break-Even Analysis (CTP sure)

Break-even point: Level of activity for
an operation at which costs equal
benefits
Unit Break -Even Point =
=
Fixed Costs
Selling Price Per Unit  Variable Cost Per Unit
$10,000
$10  $6
= 2,500 Units
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Session 3: Module 2, Chapter 5 - 25
Capital Budgeting

Developing strategic plans for a company’s
proposed large-dollar investments

For example, purchase of new equipment,
replacement of existing equipment,
introduction of a new product line or
acquisition of another firm or division

Form of C/B analysis using models:




Payback period
Net present value
Profitability index
Internal rate of return
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Session 3: Module 2, Chapter 5 - 26
Net Present Value (NPV)

Evaluates the PV of all inflows and outflows
of a project using WACC as a discount rate
NPV = PV of Cash Inflows  PV of Cash Outflows

If the only cash outflow is in the present:
NPV = PV of Cash Inflows  Cash Cost
C3
C1
C2
Cn
=
+
+
+ ... +
 Cost
1
2
3
n
(1+ i) (1+ i)
(1+ i)
(1+ i)
Where C = net cash flow; i = discount rate; n = number of
periods; subscript indicates time period (1, 2, etc.);
exponent indicates compounding
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Session 3: Module 2, Chapter 5 - 27
Profitability Index (PI)

Ratio of the PV gained to the cost required to obtain
that value; shows value gained per dollar of
investment:
Profitability Index =

Present Value of Cash Inflows
Present Value of Cash Outflows
If the only cash outflow is in the present (period 0):
PIA =
$951.57
= 0.952
$1,000.00
PIB =
$2,124.98
= 2.125
$1,000.00
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Session 3: Module 2, Chapter 5 - 28
Internal Rate of Return (IRR)

Discount rate (i) that makes NPV = 0
or, equivalently, PV of cash inflows =
PV of cash outflows
NPV = PV of Cash Inflow  Cost = 0
NPVA =
$300
$300
$400
$100
$100
+
+
+
+
 $1,000 = 0  i = 7.7%
1
2
3
4
5
(1 + i) (1 + i) (1 + i) (1 + i)
(1 + i)
NPVB =
$300
$300
$400 $1,000 $1,000
+
+
+
+
 $1,000 = 0  i = 38.1%
1
2
3
4
5
(1 + i) (1 + i) (1 + i)
(1 + i)
(1 + i)
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Session 3: Module 2, Chapter 5 - 29
Capital Expenditure Analysis Summary
Project
Acceptance
Criterion
Project A
Project B
Net present
value (NPV)
NPV > 0
$–48.43
$1.124.98
Profitability
index (PI)
PI > 1
0.952
2.2125
Internal rate
of return
(IRR)
IRR >
WACC*
7.7%
38.1%
Method
* Weighted average cost of capital (WACC) = 10% in the example
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Session 3: Module 2, Chapter 5 - 30
Investment Risk Analysis and RiskAdjusted Discount Rate (RADR)
Risk analysis
 Scenario analysis



How much is NPV
influenced by
changes in single
variable?
Simulation


What-if analysis of
best and worst cases
(NPV)
Sensitivity analysis

RADR
Monte Carlo
simulation
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
Essentially requires
high-risk endeavors
to earn a higher rate
of return to justify the
investment
Risk adjustment
factor, e.g., ±2% if
WACC is 10%
Low-risk: WACC = 8%
Medium-risk: WACC =
10%
 High-risk: WACC =
12%


Session 3: Module 2, Chapter 5 - 31
Constructing Pro Forma Financial
Statements From Budgets
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Session 3: Module 2, Chapter 5 - 32
Financial Statement Analysis





Suppliers determine whether to make sales
on credit.
Trading partners assess the financial ability
of a counterparty to meet contractual
obligations.
Lenders determine whether to enter into or
maintain credit relationships.
Rating agencies assess credit risks of issues.
Investors make decisions about purchasing
and selling corporate debt and equity.
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Session 3: Module 2, Chapter 5 - 33
Financial Statement Analysis Ratios

Liquidity or working capital ratios

Efficiency or asset management
ratios

Debt management ratios

Performance ratios
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Session 3: Module 2, Chapter 5 - 34
Discussion Question
How do common-size statements
facilitate direct comparisons of
financial data for firms of different
sizes?
Answer:
 Expenses as a percentage of revenues
reveal which firm has the best expense
controls in various areas.
 Asset categories expressed as a percentage
of total assets can similarly be compared
across companies, as can liability categories
expressed as a percentage of total assets.
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Session 3: Module 2, Chapter 5 - 35
Liquidity or Working Capital:
Current Ratio


Measures the degree to which current
obligations are covered by current
assets.
Example: Firm has a stock of $2.35 in
cash and assets that it expects to convert
into cash during the next year.
Total Current Assets
$8,000
Current Ratio =
=
= 2.35
Total Current Liabilities $3,400
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Session 3: Module 2, Chapter 5 - 36
Liquidity or Working Capital:
Quick Ratio


Measures the degree to which a
company’s current liabilities are covered
by its most liquid current assets.
Example: Firm has a stock of $1.32 for
each $1 of short-term liabilities.
Quick Ratio =
=
(Cash) + (Short-Term Investments) + (Accounts Receivable)
Total Current Liabilities
($1,500 + $1,300 + $1,700)
= 1.32
$3,400
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Session 3: Module 2, Chapter 5 - 37
Liquidity or Working Capital:
Cash Flow to Total Debt Ratio




Measures ability to repay debt
Low ratio indicates a weak ability to
repay debt
Reliable predictor of financial failure
Higher ratio implies more safety
Cash Flow to Total Debt Ratio =
=
Net Income + Depreciation
 Short-Term Debt + Long-Term Debt 
 $850 + $200 
 $1,800 + $3,900 
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=
$1,050
= 0.184
$5,700
Session 3: Module 2, Chapter 5 - 38
Liquidity or Working Capital:
Working Capital


Indicates the dollar amount by which
current assets exceed current liabilities
(not a ratio).
Example: If all current assets convert to
cash, the firm would have $4,600 above
what is needed to pay off short-term
liabilities.
Working Capital = Current Assets  Current Liabilities
= $8,000  $3,400 = $4,600
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Session 3: Module 2, Chapter 5 - 39
Efficiency and Asset Management:
Total Asset Turnover


Measures how many times the asset base
is turned over with the flow of revenue.
Example: Firm generated $0.968 of
revenue per $1 of investment in assets.
Revenues
Total Asset Turnover =
Total Assets
$15,000
=
= 0.968 Times
$15,500
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Session 3: Module 2, Chapter 5 - 40
Efficiency and Asset Management:
Fixed Asset Turnover


Focuses on how efficiently fixed assets,
or plant and equipment, are used.
Example: Firm generated $2 revenue for
each $1 invested in fixed assets.
Revenues
Fixed Asset Turnover =
Net Property, Plant, Equipment
$15,000
=
= 2.0 Times
$7,500
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Session 3: Module 2, Chapter 5 - 41
Efficiency and Asset Management:
Current Asset Turnover


Measures how many times the firm has
turned over the stock of its most liquid
assets with the flow of revenue.
Example: The firm generated $1.88 of
revenue per $1 invested in current asset
accounts.
Revenues
Current Asset Turnover =
Current Assets
$15,000
=
= 1.88 Times
$8,500
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Session 3: Module 2, Chapter 5 - 42
Efficiency and Asset Management:
Cash Conversion Efficiency


Measures the efficiency with which a
company converts sales into cash.
Example: $0.037 of cash was carved out
of each revenue dollar.
Cash Conversion
Efficiency
Cash Flow from Operations
=
Revenues
$550
=
$15,000
= 0.037 or 3.7%
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Session 3: Module 2, Chapter 5 - 43
Discussion Question
Which three of the following ratios could help
determine the extent to which a company was
leveraged?
a) Total liabilities to total assets
b) Times interest earned ratio
c) Long-term debt to capital
d) Debt to tangible net worth
e) Fixed charge coverage ratio
Answer: a, c, d. These ratios measure degree of
indebtedness. The higher the ratio, the greater
the relative indebtedness.
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Session 3: Module 2, Chapter 5 - 44
Debt Management:
Total Liabilities to Total Assets


Measures the percentage of all
liabilities to total investments or total
assets.
Example: Some form of debt supplies
$0.471 of each $1 of assets.
Total Liabilities to Total Assets =
=
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Total Liabilities
Total Assets
$7,300
= 0.471 or 47.1%
$15,500
Session 3: Module 2, Chapter 5 - 45
Debt Management:
Long-Term Debt to Capital


Measures what percentage of a
company’s capitalization is provided by
long-term debt.
Example: Long-term (L/T) debt supplied
32.2% of total capital.
L/T Debt to Capital =
Long-Term Debt
Long-Term Debt + Equity 
$3,900
=
= 0.322 or 32.2%
 $3,900 + $8,200 
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Session 3: Module 2, Chapter 5 - 46
Debt Management:
Debt to Tangible Net Worth


Measures a company’s debt as a percentage
of its tangible net worth. Intangibles include
goodwill, patents, trademarks, copyrights.
Example: The sum of short- and long-term
interest-bearing debt is 69.5% of tangible
net worth (total equity in this case).
Total Debt
Debt to Tangible Net Worth =
 Total Equity  Intangible Assets 
=
 $1,800 + $3,900  =
 $8,200  $0 
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0.695 or 69.5%
Session 3: Module 2, Chapter 5 - 47
Debt Management:
Times Interest Earned (TIE) Ratio


Measures a firm’s ability to service debt
through interest payments.
Example: The firm has 5.33 times the
funds available to pay interest as the
amount of interest that was paid.
TIE =
Operating Profit
EBIT
=
Interest Expense Interest Expense
$1,600
=
= 5.33 Times
$300
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Session 3: Module 2, Chapter 5 - 48
Performance: Profit Margins
Percentage of
revenues remaining
after deductions:
 Gross: COGS
 Operating: COGS
+ operating
expenses
 EBITDA: same as
operating
but add back
depreciation and
amortization
 Net: all expenses
and taxes
Gross
Profit Margin
Operating
Profit Margin
Gross Profit
=
Revenues
EBIT
=
Revenues
EBITDA
EBITDA Margin =
Revenues
Net Profit
Net Income
Margin
=
Revenues
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Session 3: Module 2, Chapter 5 - 49
Performance:
Return on Total Assets (ROTA)


Measures net income in relation to the level
of total assets.
Example: Every $1 in total assets generates
$0.055 in net income.
Net Income
Return on Total Assets =
Total Assets
$850
=
$15,500
= 0.055 or 5.5%
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Session 3: Module 2, Chapter 5 - 50
Performance:
Return on Common Equity


Measures earnings available to common
shareholders expressed as a percentage of
common equity.
Example: Firm earned $0.104 of accounting net
profit for each $1 of common equity investment.
Return on Common Equity =
=
=
Earnings Available to Common Shareholders
Common Equity
Net Income  Preferred Dividends 
 Total Equity  Preferred Stock 
 $850  $0 
 $8,200  $0 
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= 0.104 or 10.4%
Session 3: Module 2, Chapter 5 - 51
Integrated Ratio Analysis:
DuPont Equation

Looks at the return on total assets as
a product of the return on sales and
total asset turnover.
Return on Total Assets = Return on Sales  Total Asset Turnover
Net Income
Total Revenues
=

Total Revenues
Total Assets
= 0.057  0.968 = 0.055 or 5.5%
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Session 3: Module 2, Chapter 5 - 52
Strengths and Limitations
of Ratio Analysis
Advantages:



Easily computed
and widely used
Information easily
obtained
Facilitate
comparison
between
companies
Disadvantages:





Express historical data at fixed
points, not intra-period, may
not indicate future performance
Should not use in isolation
(comparative or trend)
Summarize accounting
information and may not reflect
economic value
Cannot reflect qualitative value
(strategies, talent)
Different accounting methods
may reduce the validity of firm
comparisons
v3.0 © 2011 Association for Financial Professionals. All rights reserved.
Session 3: Module 2, Chapter 5 - 53
Performance Measurement CTPYes

Return on investment (ROI)



ROI over a partial period may be misleading.
ROI does not include cost of capital.
Positive NPV project can be rejected if it lowers firm’s ROI.
ROI =

Net Income
Net Income
=
Invested Capital Long-Term Debt + Equity
Residual income (RI)


Assigns charge to the invested capital.
If profit exceeds charge for capital, then RI is a profit.
RI = Net Income  Invested Capital  Cost of Capital

Free cash flow (FCF)
FCF = Net Income  Depreciation and Amortization
 Change in Working Capital  Capital Expenditures
v3.0 © 2011 Association for Financial Professionals. All rights reserved.
Session 3: Module 2, Chapter 5 - 54
Economic Value Added (EVA) CTP


Shows that value is created only if the firm earns
a rate of return that exceeds its WACC
Example: EVA of a company with:




Long-term debt of $3,900,000, equity of $8,200,000
Marginal tax rate of $450,000/$1,300,000
WACC of 10%
Operating income (EBIT) of $1,600,000
EVA = EBIT (1  Tax Rate)  (WACC)(Long-term Debt + Equity)
= $1,600,000 (1  0.34615)  (.10)($3,900,000 + $8,200,000)
= $1,046,160  (.10)($12,100,000)
= $1,046,160  $1,210,000 = -$163,840
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Session 3: Module 2, Chapter 5 - 55
Discussion Question
What possible scenarios could increase EVA?
Answer:
 Improve operating efficiency so that
more EBIT is generated on the existing
asset base.
 Invest additional capital in assets that
earn a rate of return that exceeds the
cost of capital.
 Eliminate assets that earn a rate of
return that is less than the cost of
capital.
v3.0 © 2011 Association for Financial Professionals. All rights reserved.
Session 3: Module 2, Chapter 5 - 56
End of Session 3
Assignment:
 Complete the following
tasks for Module Three,
Chapters 6 and 7:

Review each chapter.

Complete the test-your-understanding
questions at the end of each chapter.

Complete the online module-specific test.

Complete the Exam Practice (Describe and
Differentiate) questions (located at the end of
the module).
v3.0 © 2011 Association for Financial Professionals. All rights reserved.
Session 3: Module 2, Chapter 5 - 57