Archive for the 'Financial Statement Analysis' Category

General Requirements for Financial Statements

International Accounting Standard (IAS) No. 1, Presentation of Financial Statements, sets out the following general requirements.

Required Financial Statements

A complete set of financial statements includes a balance sheet, an income statement, a statement of changes in shareholders’ equity, a cash flow statement, and notes summarizing significant accounting policies and other explanatory notes.

Fundamental Principles of Preparation

Fair presentation requires faithful representation of the effects of transactions, events and conditions in accordance with the definitions and recognition criteria for assets, liabilities, income and expenses set out in the Framework.

Financial statements are prepared on the basis of the firm being an ongoing entity (going concern). If the firm is being liquidated or will cease business, this must be disclosed.

Financial statements will be prepared on the accrual basis of accounting.

Presentations and classifications should be consistent from one period to the next.

Omissions or misstatements are material if they could influence the economic decisions taken by financial statement users. Material items should be presented separately.

Presentation Requirements

Each material class of similar items is presented separately, as are dissimilar items unless they are immaterial.

Assets and liabilities, or income and expenses, shall not be offset unless specifically required or permitted by an IFRS.

The balance sheet should distinguish between current and non-current assets and liabilities unless a liquidity-based presentation provides more relevant and reliable information.

IAS No. 1 outlines the minimum information that must be presented on each financial statement and in the notes.

All amounts reported in a financial statement should have comparable information for the prior period.

Posted on 1st November 2008
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Barriers to Developing Universally Accepted Accounting Standards

International accounting standards are developed by the IASB, while U.S. GAAP is developed by FASB. In 2002, both standard-setting bodies committed to developing high-quality, compatible accounting standards. In the “Norwalk Agreement,” both standard setters agreed to make best efforts to:

  1. make their existing standards fully compatible as soon as practical
  2. coordinate future development of standards

Since 2004, any significant new standard should be developed cooperatively. Existing differences may take longer to reconcile, as in many cases they represent differences in principles. In addition, industry lobbies and politicians exert pressure on the standard-setters, and these groups may have different motivations in different countries.

Posted on 1st October 2008
Under: Accounting, Financial Statement Analysis, International Investing | No Comments »

How Non-Cash Investing and Financing Transactions are Treated on the Statement of Cash Flows

Companies occasionally engage in non-cash transactions. Examples include asset exchanges, acquisitions made in exchange for stock of the parent company, or the exchange of convertible bonds into shares.

Since such transactions do not involve cash, they are not reported on the face of the statement of cash flows. However, significant non-cash transactions must be disclosed in the financial statement notes or a supplement to the cash flow statement.

Posted on 2nd July 2008
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Dilutive and Antidilutive Securities

When a company has issued securities that can be exchanged for common shares, converting the securities into common shares would potentially dilute the ownership stake of existing shareholders. When calculating earnings per share, companies must consider the potential dilution.

For securities that pay a dividend or periodic interest payment, the after-tax payments would be added back to earnings (since those payments would no longer be necessary if the securities were converted.) Then, the number of shares into which the securities are converted is added to the shares outstanding.

Diluted EPS = (Earnings + After tax payments on convertible securities)/(Shares outstanding plus shares issued on conversion)

In some cases, securities would be antidilutive, or increase earnings per share if they were assumed to be converted. Such securities are not included in the diluted EPS calculation, as it is intended to represent the maximum possible dilution.

Posted on 2nd June 2008
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The Income Statement: Operating versus Non-Operating Components

On the income statement, accounting standards encourage separate treatment of operating and non-operating items. Operating items are those relating to the day-to-day management of the enterprise: sales, cost of sales, selling, general and administrative expense, research and development costs, etc. Often the net of these items is presented as a subtotal, operating income.

Non-operating items include investing and financing activities, which are reported separately from operating income (unless pertaining to a financial services firm, for which such items are operational.) Non operating items include the interest, dividends and profits on investments made in the securities of other companies; interest expense; etc.

Some investments in other companies are made for strategic reasons, such as access to raw materials. In these cases, investors and analysts may wish to classify the investments as operating.

While taxes are a normal operating expense, they are also affected by non-operating items. Often, analysts will adjust operating profit by the tax rate to arrive at NOPAT (net operating profit after tax.)

Posted on 2nd May 2008
Under: Adjusting Reported Financial Statements, Financial Statement Analysis, Fundamental Analysis, Investing in Stocks | No Comments »

Using Futures to Alter Risk in Fixed Income Portfolios

Compared to cash markets, futures offer a number of advantages for controlling duration in a fixed income portfolio. These include:

  • Cost effectiveness
  • Liquidity
  • Deep markets
  • Ability to shorten duration by shorting futures contracts

To alter the duration of a portfolio using futures contracts it is necessary to know how many contracts to buy or sell.

Target duration = Current dollar duration + Dollar duration of the futures contracts

Dollar duration of the futures contracts = Dollar duration per contract X the number of contracts

The number of contracts = the difference between the target duration and the initial duration, multiplied by the portfolio value, all divided by the dollar duration per futures contract.

Posted on 24th April 2008
Under: Active Management, Financial Statement Analysis, Investing in bonds, Investment Returns, Portfolio Management | No Comments »

Asset Turnover

Working capital items such as inventory, accounts receivable and accounts payable represent the day-to-day financing requirements a company faces. Without inventory there can be no sales, etc. Most of the activity ratios focus on these working capital needs.

However, simply having working capital is not enough. Wal Mart could have all the inventory in the world, but without the store to put it in it would still have no business. Although the store does not constantly have to be replaced, it is essential to conducting business and requires ongoing support in the form of renovation, repairs, etc.

The final activity ratios measure how efficiently a company puts these longer-term assets to use. In other words, how much sales can the company generate given a certain amount of assets in place. The resulting ratio, asset turnover, can be expressed using solely long-term assets or by using total assets. The latter measure incorporates working capital efficiency as well. In either case, the numerator is sales and the denominator is the average asset value (long-term or total) during the period being measured.

Below is the data used to calculate both long-term asset turnover and total asset turnover for Plantronics, Inc.

2006 2005
Sales
750,394

559,995
Current assets
328,349

406,694
Non-current assets 283,900 81,235
Total assets
612,249

487,929
Sales/Average non-current assets 4.11
Sales/Average total assets 1.36

Posted on 19th April 2008
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Best and Worst Situations for Applying Residual Income Models

When used to value stocks, the residual income model separates value as the sum of two components:

  • The current book value of equity (BV)
  • The present value of expected future residual income [sum from time t=1 to infinity(RI/(1+r)^t)]

The model can be used to value the firm (based on total book value and residual income) or a share, using book value and residual income per share.

Like any model, residual income models are more appropriate at some times than others. They are most appropriate when:

  • The subject company is non-dividend paying
  • Free cash flow is unstable or negative over a reasonable forecast horizon
  • Other approaches result in greater sensitivity to terminal value than the investor finds comfortable

The are less appropriate when:

  • the company’s accounting practices result in significant dirty surplus
  • the components of residual income (book value, ROE) are not predictable

Posted on 30th December 2007
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What are Deferred Taxes?

Deferred tax assets represent taxes that have been paid (or often the carryforward of losses) but which have not yet flowed through the income statement. A deferred tax liability represents tax payments that have appeared on the income statement but not yet been paid. They usually arise when accounting standards and tax authorities recognize the timing of taxes due at different times. For example, when a company uses accelerated depreciation when reporting to the tax authority (to increase expense and lower tax payments in the early years) but uses the straight-line method on the financial statements. Since these differences will correct over the course of the asset’s depreciable life, they are called “temporary differences.”

Under IAS 12 and US GAAP (SFAS 109), deferred taxes are accounted for under the liability method. Under this method, deferred tax assets and liabilities are recognized when there is a temporary difference between the stated value of an asset or liability for tax purposes and the value for financial reporting purposes. The deferred tax is also contingent upon the expectation that future revenue and income will be sufficient to offset the deferred tax.

To determine the deferred tax treatment under various circumstances:

  • An asset whose carrying value exceeds its tax basis will result in a deferred tax liability.
  • An asset whose carrying value is less than its tax basis will result in a deferred tax asset.
  • A liability whose carrying value exceeds its tax basis will result in a deferred tax asset.
  • A liability whose carrying value is less than its tax basis will result in a deferred tax liability.

 

Posted on 2nd December 2007
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Strengths and Weaknesses of the Residual Income Model

When used to value stocks, the residual income model separates value as the sum of two components:

  • The current book value of equity (BV)
  • The present value of expected future residual income [sum from time t=1 to infinity(RI/(1+r)^t)]

The model can be used to value the firm (based on total book value and residual income) or a share, using book value and residual income per share.

Strengths of the model include:

  • Less sensitivity to estimated terminal value than other models
  • Rely on readily available accounting data
  • Can be used to value stocks that do not have stable dividends or cash flow
  • Focus on economic, rather than accounting, profitability

Weaknesses include:

  • Relies on accounting data (which can be manipulated)
  • May require adjustments based on accounting methods, particularly in cases of a dirty surplus.

Posted on 30th November 2007
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