FIN 658 :: FINANCIAL STATEMENT ANALYSIS
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Chapter 6 :: Analyzing Operating Activities
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• Analyze the item involved in operating activities under
business activities.
• Explain revenue and expense recognition and its risks for
financial statement analysis.
• Discuss the function of cost of sold with three inventory
valuation methods (average costing, FIFO and LIFO)
• Identify the role of taxation.
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OPERATING ACTIVITIES
To analyze operating activities, it involved analyzing:
•
Revenue and gains
•
Cost of a good sold
•
Expenses
•
Interest Expense
•
Income taxes
•
Net income after tax
Revenue and Gains
Revenue recognition refers to a set of accounting rules that governs how a company
accounts for its sales. Revenues must be presented at accrual basis in the income
statement; and it can be identified as simple and complex.
Below are the
characteristics of Revenue.
Aspects of
Companies
1. Revenue Type
Type Associated with
Simple Revenue
Product
Type Associated with
Difficult Revenue
Service (architecture,
legal, etc. ) construction,
2. Ownership
Type
Company is the
owner/seller
Company is an agent,
distributor or franchisor (or
products are sold on
consignment)
3. Type of Sales
Cycle
Sales are made at
delivery or "point of
sale"
Stand-alone products
Sales are made via longterm service, subscription
or membership contracts
Bundled products and
services (that is, multiple
deliverable arrangements
(MDAs))
4. Degree of
Product
Complexity
Examples of
"Difficult" Revenue
Extended service
warranty contract is
sold with consumer
electronics or building
highway or apartments
Auction site sells airline
tickets (should it report
"gross" revenue or "net"
fee received?) Or a
restaurant boosts
revenue by collecting
franchise fees
Fitness facility operator
sells long-term gym
memberships
Software publisher
bundles installation and
technical support with
product
Simple revenue:
•
•
•
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It owns its product,
Gets paid fairly quickly after delivery and
The product is not subject to overly complex bundling arrangements.
FIN 658 :: FINANCIAL STATEMENT ANALYSIS
Even the most honest companies in this business cannot avoid making revenue‐
reporting judgments and must therefore be scrutinized. Financial Accounting
Standard Board (FASB) required revenue to be declared at accrual as deemed received
for the particular year.
Below is an example of Cash Revenue vs. Accrual
JKL Industries
From BALANCE SHEET:
2007
2006
Cash
RM77,012
RM384,514
Receivables
6,679,907
8,982,854
2007
2006
RM204,647,364
RM200,839,393
Cost of sales
181,606,051
178,114,150
Gross profit
23,041,313
22,725,243
Assets
Current assets:
From INCOME STATEMENT:
Sales
How To Calculate “Cash Received from Customers:”
(1) Net Sales
(2) + Decrease (or – Increase)
RM204,647,364
2,302,947
= 8,982,854 – 6,679,907
(3) + Increase In Cash Advances
= Cash Received from customers
N/A
RM206,950,311
We add the decrease in accounts receivable because it signifies cash received to
pay down receivables. 'Cash advances from customers' represents cash received for
services not yet rendered; this is also known as unearned or deferred revenue and is
classified as a current liability on the balance sheet.
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We calculate 'cash received from customers' to compare the growth in cash received
to the growth in reported revenues. If the growth in reported revenues jumps far
ahead of cash received, we need to ask why.
For example, a company may induce revenue growth by offering favorable
financing terms - like the advertisement you often see for consumer electronics
that offer "0% financing for 18 months." A new promotion such as this will
create booked revenue in the current period, but cash will not be collected until
future periods. And of course, some of the customers will default and their cash
will not be collected. So the initial revenue growth may or may not be good
growth, in which case, we should pay careful attention to the allowance for
doubtful accounts.
What is Allowance for Doubtful Accounts?
Allowance for Doubtful Accounts
Of course, many sales are offered with credit terms: the product is sold and
an accounts receivable is created. Because the product has been delivered
(or service has been rendered) and payment is agreed upon, known and
reasonably assured, the seller can record it as a revenue.
However, the company must estimate how much of the receivables will not be
collected. For example, it may book RM100 in gross receivables but, because
the sales were on credit, the company might estimate that RM7 will ultimately
not be collected. Therefore, a RM7 allowance is created and only RM93 is
booked as revenue. As you can see, a company can report higher revenues
by lowering this allowance.
Therefore, it is important to check that sufficient allowances are made. If the
company is growing rapidly and funding this growth with greater accounts
receivables, then the allowance for doubtful accounts should be growing too.
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Revenue recognition is a hot topic and the subject of much post-mortem
analysis in the wake of multiple high-profile restatements. We cannot directly
guard against fraud; that is a job for a company's auditor and the audit
committee of the board of directors. But we can do the following:
•
Determine the degree of accounting risk posed by the company's business
model.
•
Compare growth in reported revenues to cash received from customers.
•
Parse organic growth from the other sources and be skeptical of any one-time
revenue gains not tied directly to cash (quality of revenues). Scrutinize any
material gains due to acquisitions. And finally, omit currency gains.
Reported on the income statement, it is the sum of all direct and indirect selling
expenses
and
all
general
and
administrative
expenses
of
a
company.
Cost of a Good Sold
The direct costs attributable of the goods sold to the production by a company. This
amount includes the cost of the materials used in creating the good along with the
direct labor costs used to produce the good. It excludes indirect expenses such as
distribution costs and sales force costs.
COGS appear on the income statement and can be deducted from revenue to
calculate a company's gross margin.
Also referred to as "cost of sales".
COGS are the costs that go into creating the products that a company sells;
therefore, the only costs included in the measure are those that are directly tied to
the production of the products.
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For example, the COGS for an automaker would include the material costs for the
parts that go into making the car along with the labor costs used to put the car
together. The cost of sending the cars to dealerships and the cost of the labor used to
sell the car would be excluded.
The exact costs included in the COGS calculation will differ from one type of
business to another.
The costs of goods attributed to a company’s products are expensed as the company
sells these goods.
There are several ways to calculate COGS but one of the more basic ways is to start
with:
9 The beginning inventory for the period and
9 Add the total amount of purchases made during the period then
9 Deducting the ending inventory.
This calculation gives the total amount of inventory or, more specifically, the cost of
this inventory, sold by the company during the period. Therefore, if a company starts
with RM10 million in inventory, makes RM2 million in purchases and ends the period
with RM9 million in inventory, the company's cost of goods for the period would be
RM3 million (RM10 million + RM2 million - RM9 million).
Current Purchase, Inventory brought forward from previous year and inventory not
fully utilized until the end of the year are the measurement of COGS. Therefore part
of the operating activity analysis involved monitoring purchase or materials,
beginning inventory and ending inventory. The common method used to purchase
and produced can be either using FIFO, LIFO or average costing methods
1. Applying Three Inventory Valuation Methods
In all three case, the same beginning inventory, purchases and ending inventory
will be used for a one-month accounting period in March.
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Three inventory purchases were made during the month:
March 1
100 unit at RM10
March 15
200 unit at RM11
March 25
200 unit at RM12
The beginning inventory value was 100 items at RM9 each.
Average costing
Averaging costing methods is an evaluation in which the costs of inventory
were averaged to determine cost per unit. Before using the average-costing
inventory system, you need to calculate the average cost per unit.
100 at RM9
= RM900 (Beginning inventory)
Plus purchases:
100 at RM10
= RM1,000 (March 1purchase)
200 at RM11
= RM2,200 (March 15 purchase)
200 at RM12
= RM2,400 (March 25 purchase)
Cost of goods available for sale = RM6,500
Average cost per unit:
RM6,500 (cost of goods available for sale) ÷ 600 (number of units)
= RM10. 83 (Average cost per unit)
After knowing the average cost per unit, calculate the cost of goods sold and
the ending inventory value by using the average-costing inventory system:
Cost of goods sold
500 at RM10.83 = RM5,415
Ending inventory
100 at RM10.83 = RM1,083
So, the value of cost of goods sold using the average-costing method is
RM5,415. This is the figure as the cost of goods sold line item on the income
statement. The value of the inventory left on hand, or the ending inventory is
RM1,083. This is the number as the inventory item on the balance sheet.
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First In, First Out – FIFO
FIFO is a valuation method in which the assets produced or acquired first are
sold, used or disposed. FIFO is the most commonly used.
For taxation purposes, FIFO assumes that the assets that are remaining in
inventory are matched to the assets that are most recently purchased or
produced. Because of this assumption, there is a number of tax minimization
strategies associated with using the FIFO asset-management and valuation
method.
To find the costs of goods sold, add the beginning inventory to the purchases
that took place during the reporting period. The remaining 100 units at RM12
are the value of ending inventory. Here’s the calculation:
Beginning inventory: 100 at RM9
=
RM900
March 1 purchase: 100 at RM10
=
RM1,000
March 15 purchase: 200 at RM11
=
RM2,200
March 25 purchase: 100 at RM12
=
RM1,200
Cost of goods sold
=
RM5,300
=
RM1,200
Ending inventory:
From March 25: 100 at RM12
In this example, the cost of goods sold includes the value of the beginning
inventory plus the first two purchases on March 1 and 15 and part of the
purchases on March 25. Those units remaining on the shelf are from the last
purchase on March 25. The cost of goods sold is RM5,300 and the value of
the inventory on hand, or the ending inventory is RM1,200.
Last In, First Out - LIFO
LIFO is a valuation method that assumes that assets produced or acquired
last are the ones that are firstly used sold or disposed.
LIFO assumes that an entity sells, uses or disposes first of its newest
inventory. If an asset is sold for less than it is acquired for, then the difference
is considered a capital loss. If an asset is sold for more than it is acquired for,
the difference is considered a capital gain. Using the LIFO method to evaluate
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and manage inventory can be tax advantageous, but it may also increase
tax liability.
To calculate LIFO, start with the last units purchased and work backward to
calculate the cost of goods sold. The first 100 units at RM9 in the beginning
inventory end up being the same 100 at RM9 for the ending inventory. Here’s
the calculation:
March 25 purchase: 200 at RM12
=
RM2,400
March 15 purchase: 200 at RM11
=
RM2,200
March 1 purchase: 100 at RM10
=
RM1,000
Cost of goods sold
=
RM5,600
=
RM900
Ending inventory:
From beginning inventory: 100 at RM9
So, the cost of goods sold line item on the income statement is RM5,600 and
the value of the inventory line item on the balance sheet is 900.
2. Comparing inventory methods and financial statements
Looking at the results of each method side by side shows the impact that the
inventory valuation method has on the net income statements:
Income Statement Line Item
Averaging
FIFO
LIFO
Sales
RM10,000
RM10,000
RM10,000
Cost of goods sold
RM5,415
RM5,300
RM5,600
Income
RM4,585
RM4,700
RM4,400
LIFO gives the lowest net income figure and the highest cost of goods sold.
Companies that use the LIFO system have higher costs to write off on their taxes,
so they pay less in income taxes. FIFO gives companies the lowest cost of goods
sold and the highest net income, so companies that use this method know their
bottom lines look better to investors.
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Results for the inventory number on the balance sheet will also differ using these
different methods:
Ending inventory
Averaging
FIFO
LIFO
RM1,083
RM1,200
RM900
LIFO users are likely to show the lowest inventory balances because their
numbers are based on the oldest purchases, which are in many industries, also
the lowest cost. This situation is exactly opposite if investors are looking at an
industry in which in the cost of goods is dropping in price. Then the oldest goods
can be the most expensive.
For example, computer companies carrying older, outdated equipment can have
more expensive units sitting on the shelves if they try to use the Last In, First Out
method, even though the units may not be worth anywhere near what the
company paid for them.
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Other cost flow assumptions (rising prices)
During periods of rising prices (inflation), the LIFO inventory cash flow method
reports a higher cost of sales, a lower amount for ending inventory than FIFO.
Therefore a change from FIFO to LIFO during this period would result in a decrease
of net income and a decrease in ending inventory. As a general rule, amount-value
LIFO uses a double-extension method to compute:
1. The value of the ending inventory in terms of base year prices, and
2. The value of the ending inventory at current prices. The ratio of 2 over 1
provides the specific price index for valuing any layers of inventory added in
the period.
This characteristic is unique to this method of inventory. None of the other inventory
methods require estimate of price-level changes for specific inventories.
In using LIFO, the cost of the last goods is used in pricing the costs of goods sold. In
using FIFO, the costs of the last goods in are used in pricing the ending inventory.
Therefore the LIFO method will result in having cost of goods sold most closely
approximate current cost and the FIFO method will result in having ending inventory
most closely approximate current cost.
COGS LIFO = COGS FIFO + (R% x Inventory Beginning)
Expenses
Selling, General & Administrative Expense - SG&A
Direct selling expenses are expenses that can be directly linked to the sale of a
specific unit such as credit, warranty and advertising expenses. Indirect selling
expenses are expenses which cannot be directly linked to the sale of a specific unit,
but which are proportionally allocated to all units sold during a certain period, such as
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telephone, interest and postal charges. General and administrative expenses include
salaries of non-sales personnel, rent, heat and lights.
High SG&A expenses can be a serious problem for almost any business. Examining
this figure as a percentage of sales or net income compared to other companies in
the same industry can give some idea of:
9 Whether management is spending efficiently or
9 Wasting valuable cash flow.
For example, in the television industry businesses that depend on a great
deal of advertising must carefully monitor their marketing expenses. A good
management team will often attempt to keep SG&A expenses under tight
control and limited to a certain percentage of revenue by reducing corporate
overhead (i.e. cost-cutting, employee lay-offs).
Operating expense
Operating expense is a category of expenditure that a business incurs as a result of
performing its normal business operations. One of the typical responsibilities that
management must contend with is determining how low operating expenses can be
reduced without significantly affecting the firm's ability to compete with its
competitors.
Also known as "OPEX".
For example, the payment of employees' wages and funds allocated toward research
and development are operating expenses. In the absence of rising prices or finding
new markets or product channels in order to raise profits, some businesses attempt
to increase the bottom line purely by cutting expenses.
While laying off employees and reducing product quality can initially boost earnings
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and may even be necessary in cases where a company has lost its competitiveness,
there are only so many operating expenses that management can cut before the
quality of business operations is damaged.
Non-operating expense
An expense incurred by activities not relating to the core operations of the business.
Accountants may remove non-operating expenses or revenues in order to examine
the performance of the business, ignoring effects of financing or irrelevant issues.
Non-operating expenses may take a variety of forms. The most common type relate
to interest charges or other costs of borrowing. A firm may also categorize any costs
incurred from restructuring or reorganizing, currency exchange, charges on
obsolescence of inventory, as non-operating expenses. Expenses relating to
employee benefits, such as pension contributions would also be considered as a
non-operating cost.
Interest Expense
The amount reported by a company or individual as an expense for borrowed money.
It is sometimes called "interest payable".
Interest is calculated as a percentage of the amount of debt for each period of time.
Points paid for a mortgage are a form of prepaid interest.
Net Income
Net income is a company's total earnings (or profit). Net income is calculated by:
9 Taking revenues and adjusting for the cost of doing business
depreciation,
interest, taxes and other expenses.
This number is found on a company's income statement and is an important measure
of how profitable the company is over a period of time. The measure is also used to
calculate earnings per share.
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Often referred to as "the bottom line" since net income is listed at the bottom of the
income statement. Net income is also known as "profit attributable to shareholders".
Accounting Profit vs. Economic Profit (or Loss)
The difference between the revenue received from the sale of an output and the
opportunity cost of the inputs used. This can be used as another name for "economic
value added" (EVA).
Don't confuse this with 'accounting profit', which is what most people generally mean
when they refer to profit.
In calculating economic profit, opportunity costs are deducted from revenues earned.
Opportunity costs are the alternative returns foregone by using the chosen inputs. As
a result, you can have a significant accounting profit with little to no economic profit.
For example, say you invest RM100,000 to start a business, and in that year you
earn RM120,000 in profits. Your accounting profit would be RM20,000. However, say
that same year you could have earned an income of RM45,000 had you been
employed. Therefore, you have an economic loss of RM25,000 (120,000 - 100,000 45,000).
Income Tax / Taxation
Income tax is a tax that governments impose on financial income generated by all
entities within their jurisdiction. By law, businesses and individuals must file an
income tax return every year to determine whether they owe any taxes or are eligible
for a tax refund. Income tax is a key source of funds that the government uses to
fund its activities and serve the public.
BASIS OF TAXATION
Income tax is generally imposed on a territorial basis in that only income accruing in
or derived from Malaysia is liable to tax. However, resident individuals and other noncorporate entities are also taxed on foreign-sourced income remitted into Malaysia.
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Foreign-sourced income received by resident companies are not subject to tax even
if such income is remitted to Malaysia.
Sources of Income Liable to Tax
Sources of income which are liable to income tax are as follows:
•
Gains and profits from trade, profession and business
•
Salaries, remunerations, gains and profits from an employment
•
Dividends, interests or discounts
•
Rents, royalties or premiums
•
Pensions, annuities or other periodic payments/li>
•
Other gains or profits of an income nature not mentioned above.
Chargeable income is arrived at after adjusting for expenses incurred wholly and
exclusively in the production of the income. Specific provisions or reserves for
anticipated losses or contingent liabilities are not tax deductible. No deduction for
book depreciation is allowed although capital allowances are granted. Unabsorbed
losses may be carried forward indefinitely to offset against future income.
Corporate tax
Tax rate
Tax rate for a limited and unlimited company residence in Malaysia is
For example in Malaysia, for year assessment 2008, with an income tax
rate of 26%, for every RM100,000 that the firms makes, RM26,000
(RM100,000 x 0.26) must be paid as tax.
Net Income after Tax
An individual’s income after deductions, credits and taxes are factored into gross
income. Deductions and credits are subtracted from gross income to arrive at
taxable income, which is used to calculate income tax. Net income is income tax
subtracted from taxable income.
1. Net income is calculated by starting with a company's total revenue.
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2. From this, the cost of sales, along with any other expenses that the
company incurred during the period, is removed to reach earnings before
tax.
3. Tax is deducted from this amount to reach the net income number.
4. Net income, like other accounting measures, is susceptible to
manipulation through such things as aggressive revenue recognition or by
hiding expenses.
5. When basing an investment decision on net income numbers, it is
important to review the quality of the numbers that were used to arrive at
this value.
For example, suppose that your gross income is RM50,000 and you have
RM20,000 in deductions. This leaves you with a net income before tax
(NIBT)of RM30,000. Then, your tax deductible (30,000 @ 26%) of
RM7,800 will be subtracted from NIBT ; the remaining RM22,200 will be
your net income after tax.
Net Income after tax
The amount of money that an individual or company has left over after all federal,
state and withholding taxes have been deducted from taxable income. After-tax
income represents the amount of disposable income that a consumer or firm has
to spend on future investments or on present consumption.
Also known as "income after taxes"
When analyzing or forecasting personal or corporate cash flows, it is important to
use an estimated after-tax net cash flow. This is a more appropriate measure
because after-tax cash flows are what the entity has available for consumption.
This is not to say that all investments are purchased with after tax income; some
companies offer salary deferral retirement plans that deduct money on a pretax
basis. The money will be taxed once the employee decides to withdraw the
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amount (such as for retirement). However, because most people have less
income during their retirement years compared to their prime earning years, the
amount of tax paid will be less.
SUMMARY
Revenue is the most important source of cash for a company. To survive, a company
must have its sources of revenue sustainable and grow. Thus, scrutinizing the sources of
the revenue is important as it will tell us the sources of revenue growth.
SELF-TEST WITH SOLUTIONS
Question
Sales of Kukuh Industries Sdn. Bhd are approximately RM750,000 per year. Kukuh
requires a short term financing of RM150,000 to finance its working capital
requirements SIM Bank is considering Kukuh,s financing request but requires certain
minimum conditions be satisfied. The following information is available for Kukuh for
the current year:
•
Beginning inventory is RM105,000
•
Ending inventory is RM145,000
•
Credit terms to Kukuh’s customers are 35 days
•
Credit terms from its suppliers are 75 days
•
Purchases for the years are RM450,000
•
Purchase returns and allowances are 3% of purchases
•
Purchase discounts are 1% of purchases
•
Accounts payable is only current liability
•
Cash is 10% of accounts receivable
•
Sales return and allowances are 10% of sales
•
Sales discounts are 2% of sales
You are required to compute current liabilities and current assets.
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Solution:
Compute Current Liabilities (A/c Payable)
Beginning inventory
+ Net Purchases – COGS = Ending Inventory
COGS = Beginning inventory + Net Purchases - Ending Inventory
= RM105,000 + (0.97 x RM450,000) – RM145,000
= RM396,500
Days’ purchase in a/c payable = (a/c payable / COGS) x 360
75 days = (a/c payable / RM396,500) x 360
A/c payable = (75 x RM396,500) / 360 = RM82,604
Compute Current Assets
Current Assets
Cash
RM
Account receivable *
Inventory
Total Current Assets
6,417
64,167
145,000
215,584
*ACP = A/c receivable / Sales
35 days = A/c receivable ÷ (0.88 x RM750,000) x 360
A/c receivable = (35 x RM660,000) / 360 = RM64,167
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Question
NM and NI Corporation are involved in the same business segment; boutique and
fashion. However, NM and NI are using different accounting method for their
inventory costing. NM used FIFO inventory method where as NI used LIFO inventory
method.
i)
Show the effect of FIFO and LIFO method for inventory costing during the
inflationary period for NM and NI.
ii) Determine which corporation would be beneficial during deflationary period.
iii) Determine which method, FIFO or LIFO is preferable for analysis.
Solution:
i)
ii)
Effect
NM (FIFO)
NI (LIFO)
Cost of materials
Lower
Higher
Gross income
Higher
Lower
Ending inventory
Higher
Lower
Taxes
Higher
Lower
In long term, as long as the costing method used is consistent, no
company would be better off than another. In short period, which company
would be beneficial is depending on tax environment. During deflationary
period, NI should earn greater profits because the cost is expense based
on recent cost which is cheaper. However, if the tax bracket is high NI
needs to pay more than NM as it record higher profit for the year
iii)
For analysis purpose, LIFO is preferable method as its give the most
recent COGS but it also leads to less recent balance sheet than often
understate the inventory value.
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EXERCISES
Question 1
Below is the income statement and balance sheet of PQR Corporation. From this
information prepare a statement of cash flows for the year ended June 30, 2007.
Income Statement for year ended June
(In thousands)
2006(RM)
2007 (RM)
500,000
512,000
Cost of sales
(395,000)
(404,480)
Gross margin
105,000
107,520
Selling and Administrative
(60,000)
(61,440)
Income before interest and taxes
45,000
46,080
Interest expense
(9,900)
(12,320)
Income before income taxes
35,100
33,760
Income tax
(12,812)
(12,322)
Net income
22,288
21,438
Revenues
Balance Sheet as of June
(In thousands)
Assets
2006 (RM)
2007 (RM)
Change
Cash and equivalents
10,000
10,240
240
Accounts receivable
40,000
48,640
8,640
Inventories
39,500
56,627
17,127
Prepaid expenses
10,000
11,000
1,000
Total current assets
99,500
126,507
27,007
Property, plant and equipment
390,000
411,000
21,000
(233,000)
(250,000)
(17,000)
PPE, net
157,000
161,000
4,000
Other assets, net amortization
27,000
26,000
(1,000)
Current assets
Accumulated depreciation
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Total assets
283,500
313,507
30,007
Current portion of long-term debt
12,000
13,000
1,000
Notes payable
30,000
31,000
1,000
Accounts payable
39,500
42,450
2,950
Accrued liabilities
21,569
18,000
(3,569)
Income taxes payable
8,900
9,500
600
Total Current Liabilities
111,969
113,950
1,981
Long-term debt
87,000
99,000
12,000
Non-current deferred income tax
10,000
9,070
(30)
Other non-current liabilities
4,340
5,000
660
Common stock – Class A
3,000
3,500
500
Capital in excess of par
21,000
26,000
5,000
Retained earnings
46,191
56,087
9,896
Total Shareholders’ Equity
70,191
85,587
15,396
Total Liabilities and Equity
283,500
313,507
30,007
Liabilities and Shareholders’ Equity
Shareholders’ Equity
Question 2
Briefly explain four (4) advantages for companies using FIFO as compared to LIFO
inventory accounting method during period of rising prices and stable economy.
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FIN 658
Chapter 6 :: Analyzing Operating Activities
Question 3
The Jacob Corporation has released the following year-end financial data (RM):
Pretax income
60000
Net income
42000
Interest expense
Sales
Total Assets
Common equity
Based on the information above, calculate:
1. Operating profit margin
2. Asset turnover
3. Interest expense rate
4. Tax retention
5. Financial leverage
6. Return on Equity
172 | F I N
658
7200
300 000
80000
160000
FIN 658 :: FINANCIAL STATEMENT ANALYSIS
Study Notes
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FIN 658
Chapter 6 :: Analyzing Operating Activities
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658