Introduction to Financial
Statement Analysis
P.V. Viswanath
Functions of Financial Statements
 They provide information to the owners and
creditors of the firm about the company’s current
status and past financial performance
 Financial statements provide a convenient way for
owners and creditors to set performance targets and
to impose restrictions on the managers of the firm.
 Financial statements provide convenient templates
for financial planning.
P.V. Viswanath
2
The Balance Sheet
The balance sheet is a snapshot of the firm’s
assets and liabilities at a given point in time
Assets are listed in order of liquidity, i.e. ease
of conversion to cash without significant loss
of value
Liabilities are listed in order of time to
maturity
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Assets
 Assets are divided into current assets and long-term
assets. Current assets are:




Cash and marketable securities
Accounts receivable
Inventories
Other current assets, such as prepaid expenses
 Long-term assets include net property, plant and
equipment (net PP&E).

This consists of the original cost of PP&E reduced each
year by an amount called depreciation that is intended to
account for wear-and-tear and obsolescence.
P.V. Viswanath
4
Assets
 When a firm acquires another firm, it will acquire a set of
assets that must be listed on its balance sheet. Often it will
pay more for these assets than their book value on the
acquired firm’s balance sheet.
 The difference is listed as goodwill.
 Trade-marks, patents and other such assets, along with
goodwill are called intangible assets.
 If their value decreases over time, they will be reduced by an
amortization charge.
 Amortization, like depreciation is not a cash expense.
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Liabilities
 Liabilities are divided into current and long-term liabilities.
 Liabilities that will be satisfied in one year are known as
current, and include:



Accounts payable,
Notes payable, short-term debt and all repayments of debt that will
occur within the year.
Items such as salary or taxes that are owed but have not yet been
paid.
 The difference between current assets and current liabilities
is known as (net) working capital.
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Long-term liabilities
 Long-term debt is any loan or debt obligation with a maturity of more
than one year.
 Capital leases are long-term lease contracts that obligate the firm to
make regular payments in exchange for the use of an asset.
 Deferred taxes are taxes that are owed but not yet paid. Firms keep two
sets of books – one for financial reporting and one for tax purposes.
Deferred tax liabilities arise when the firm’s financial income exceeds its
income for tax purposes. If a firm depreciates assets faster for tax
purposes than for reporting purposes, its tax paid will be less than tax
due according to reported income. Hence it will look as if the firm has
not paid taxes that it owes.
 Over time, the discrepancy will disappear and the tax due will be “paid.”
Hence deferred tax is recorded as a liability.
P.V. Viswanath
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Stockholder’s Equity
 The sum of current liabilities and long-term liabilities is total
liabilities. The difference between the firm’s asset and its
liabilities is Stockholders’ Equity or the book value of
equity.
 This number often does not provide us with an accurate
assessment of the firm’s equity because book values are
based on historical quantities and not on market values.
 The market price of a share times shares outstanding is
called market capitalization; this reflects what investors
expect the firms assets to produce in the future that can be
distributed to shareholders.
P.V. Viswanath
8
Market Value vs. Book Value
Example
According to Generally Accepted Accounting Principles
(GAAP), your firm has equity worth $6 billion, debt worth
$4 billion, assets worth $10 billion. The market values your
firm’s 100 million shares at $75 per share and the debt at $4
billion.
Q: What is the market value of your assets?
A: Since (Assets=Liabilities + Equity), your assets must have a
market value of $11.5 billion.
P.V. Viswanath
9
Market Value vs. Book Value
Example
Book Value Balance Sheet
Assets = $10 bil
Debt = $4 bil
Equity = $6 bil
Market Value Balance Sheet
Assets = $11.5 bil
Debt = $4 bil
Equity = $7.5 bil
P.V. Viswanath
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The Balance Sheet Identity

Current Liabilities
Payables
Short-term Debt
Current Assets
Cash & Securities
Receivables
Inventories
+
=
Fixed Assets
Tangible Assets
Intangible Assets
+
Long-term Liabilities
+
Shareholders’ Equity
P.V. Viswanath
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Pepsico Inc. Balance Sheet (in mil. $)
Assets
Current Assets Cash And
Cash
Short Term
Investments
Net
Receivables
Inventory
Other Current Assets
Total Current Assets
Long Term Investments
Property Plant and Equipment
Goodwill
Intangible Assets
Other Assets
Total Assets
28-Dec-02
1,638
207
2,531
1,342
695
6,413
2,611
7,390
3,631
1,588
1,841
23,474
29-Dec-01 Liabilities
28-Dec-02
6,052
Current Liabilities
683
Accounts Payable
5,490
966
562
Short/Current Long Term Debt
2,142
Other Current Liabilities
1,310 Total Current Liabilities
6,052
752 Long Term Debt
2,187
5,853 Other long-term liabilities
5,937
2,871 Total Liabilities
14,176
6,876 Common Stock & Other Paid-up Capital
30
3,374 Retained Earnings
9,268
1,467 Total Stockholders' Equity
9,298
1,254
21,695 Tot Liabs & Shareholders' Equity
23,474
P.V. Viswanath
29-Dec-01
4,998
3,484
354
1,160
4,998
2,651
5,398
13,021
43
8,605
8,674
21,695
12
Income Statement
The income statement is like a video of the
firm’s operations for a specified period of
time.
You report revenues first and then deduct any
expenses for the period.
Matching principle – GAAP requires the
income statement to show revenue when it
accrues and match the expenses required to
generate the revenue.
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Earnings Calculations
 Gross Profit

The difference between sales revenues and the costs incurred to make and sell the
products.
 Operating Expenses
 Expenses in the ordinary course of running the business, but not directly related to
producing the goods; includes administrative expenses, marketing expenses, R&D
 Earnings before Interest and Taxes (EBIT)

Includes other sources of income or expenses that arise from activities that are not the
central part of the business, e.g. investment income.
 Pretax Income and Net Income (NI)


From EBIT, we deduct interest paid and corporate taxes to determine Net Income.
EPS = NI/Shares Outstanding
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Income Statement
Pepsico Inc. (in mil. $)
As of year ending
Dec 02
Dec 01
Revenue
25,112
26,935
Cost of Goods Sold
10,523
9,837
Gross Profit
14,589
17,098
SG&A Expense
8,523
11,608
Depreciation & Amortization
1,112
1,082
Operating Income
4,954
4,408
316
227
5046
4248
178
219
Income Before Taxes
4,868
4,029
Income Taxes
1,555
1,367
Nonoperating Income
EBIT
Interest
P.V. Viswanath
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Accounting vs Economic Measures of
Income
 The return to a stockholder of investing in a stock is simply
the rate of return on his investment:
r 
Ending
Price of Share - Beginning
Beginning
Price  Cash Dividend
Price of Share
 Accountants often measure corporate performance using the
return on equity (ROE):
ROE 
Net Income
Shareholde
rs' Equity
 A big difference between the two is that the ROE does not
incorporate the impact on the share price of future expected
superior (or inferior) returns
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Ratio Analysis
 Ratios also allow for better comparison through
time or between companies
 As we look at each ratio, ask yourself what the ratio
is trying to measure and why is that information
important
 Ratios are used both internally and externally
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Categories of Financial Ratios
 Liquidity ratios

Short-term solvency or how easily the firm can lay its hands on cash.
 Financial leverage ratios

Show long-term solvency; how heavily the firm is in debt.
 Efficiency or turnover ratios

Indicate how productively the firm is using its assets
 Profitability ratios

Used to measure the firm’s return on its investments
 Market value ratios
P.V. Viswanath
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Computing Profitability Measures
 Profit Margin = Net Income / Sales

3313/ 25112 = 0.1319 times or 13.19%
 Operating Profit Margin = (Operating Income) / Sales

(4954) / 25112 = 0.1973 times or 19.73%
 Return on Assets (ROA) = (Net Income) / Av TA

(3313) / [(23474+21695)/2] = 0.1467 times or 14.67%
 Return on Equity (ROE) = Net Income / Average Equity

3313 / [(9298+8674)/2] = 0.3687 times or 36.87%
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Computing Leverage Ratios for 2002
 Total Debt Ratio = (Total Debt) / TA



Total debt, here, is usually interpreted to mean all debt-like
obligations, which is effectively total liabilities
(14176) / 23,474 = .6039 times or 60.39%
The firm finances almost 60% of their assets with debt.
 Debt/Equity = Tot Debt / Tot Eq

14,176 / 9,298 = 1.5246 times
 These numbers can also be computed for long-term debt (i.e.
long-term liabilities):
 Long Term Debt Ratio = LT Debt/ Total Assets = (2,187 +
5,937)/ 23,474 = 0.3461
 Long Term Debt/Equity = (2,187 + 5,937)/9,298 = 0.87375
P.V. Viswanath
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Computing Coverage Ratios
 Determinants of the riskiness of a firm’s debt
 Times Interest Earned = EBIT / Interest

(4868 + 178) / 178 = 28.35 times
 Cash Flow Coverage = (EBIT + Depreciation) /
Interest

(4868 + 178 + 1112) / 178 = 34.60 times
P.V. Viswanath
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Computing Liquidity Ratios
 Current Ratio = CA / CL

6413 /6052 = 1.06 times
 Quick Ratio = (CA – Inventory) / CL

(6413 – 1342) / 6052 = 0.838 times
 Cash Ratio = Cash / CL

1,638 / 6,052 = .276 times
 Net Working Capital to TA Ratio = NWC/TA

(6413-6052)/ 23474 = 0.154
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Computing Inventory Ratios
 Inventory Turnover = Cost of Goods Sold /
Average Inventory

10523 / [(1342+1310)/2] = 7.94 times
 Days’ Sales in Inventory = 365 / Inventory
Turnover = Av Inv/(COGS/365)
365 / 7.94 = 45.99 days
 When you have ratios with Income Statement numbers in
the numerator and Balance Sheet numbers in the
denominator, use average of year beginning and year end
quantities.

P.V. Viswanath
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Computing Receivables Ratios
 Receivables Turnover = Sales / Av Accounts
Receivable

25112 / [(2531+2142)/2] = 10.75 times
 Average Collection Period = Days’ Sales in
Receivables = 365 / Receivables Turnover = Av
Receiv/ (Av Sales)

365 / 10.75 = 33.96 days
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Computing Total Asset Turnover
 Total Asset Turnover = Sales / Av Total Assets

25112 / [(23474+21695)/2] = 1.11 times
 Measure of asset use efficiency
 Not unusual for TAT < 1, especially if a firm has a
large amount of fixed assets.
 What is a reasonable value for TAT will depend on
the industry in question
P.V. Viswanath
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Computing Market Value Measures
 Market Price (end of 2002) = $42.22 per share
 Shares outstanding = 1753 million
 P/E Ratio = Price per share / Earnings per share

42.22 / 1.89 = 22.34 times
 Market-to-book ratio = mkt value per share / book value per share

42.22 / (9298 / 1753) = 7.96 times
 Enterprise Value


The value of the underlying business assets – computed as Mkt Value of
Equity + Debt – Cash = 42.22(1,753) + 14,176 - 1,638 = 86,549.66m.
This can be interpreted as the cost to take over the entire business.
P.V. Viswanath
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Payout and Retention Ratios
 Dividend payout ratio = Cash dividends / Net
income


Cash dividend equals common dividend + preferred divs
1041 / 3313 = .3142 or 31.42%
 Plowback ratio = Retention ratio = 1 – payout ratio

1 – 0.3142 = 0.6858 = 68.58%
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Benchmarking
 Ratios are not very helpful by themselves; they need
to be compared to something
 Time-Trend Analysis


Used to see how the firm’s performance is changing
through time
Internal and external uses
 Peer Group Analysis


Compare to similar companies or within industries
SIC and NAICS codes
P.V. Viswanath
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Standardized Financial Statements
 Common-Size Balance Sheets

Compute all accounts as a percent of total assets
 Common-Size Income Statements

Compute all line items as a percent of sales
 Standardized statements make it easier to compare financial
information, particularly as the company grows
 They are also useful for comparing companies of different
sizes, particularly within the same industry
P.V. Viswanath
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Statement of Cashflows
 A firm’s cashflows can be quite different from its
net income. For example:


The income statement does not recognize capital
expenditures as expenses in the year that the capital
goods are paid for. Those expenses are spread over time
as a deduction for depreciation.
The income statement recognizes revenues and expenses
when sales are made, even though the money may not
have been collected (revenues) or paid out (expenses).
P.V. Viswanath
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The Statement of Cashflows
 The statement of cashflows shows the firm’s cash
inflows and outflows from



Operations
Investments and
Financing
 The form of this statement is determined by
accounting standards.
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Statement of Cash Flows:
Operating Activities
 Operating activities are earnings-related
activities. Generally these relate to Income Statement
activities, and items included in working
capital. Included are:







Sales and expenses necessary to obtain sales
Related operating activities, such as extending credit to
customers
investing in inventories
obtaining credit from suppliers
payment of taxes
insurance payments
Other activities that don't easily fit into the other two
categories, such as settlements in lawsuits.
P.V. Viswanath
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Statement of Cash Flows:
Investing and Financing Activities
 Investing activities relate to the acquisition
and disposal of noncash assets: assets which
are expected to generate income for the
company over a period of time. These include
lending funds and collecting on these loans.
 Financing activities relate to the contribution,
withdrawing and servicing of funds to support
business activities.
P.V. Viswanath
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Pepsico Inc. (in mil. $)
Statement of Cash Flows 2002
3 ,3 13
N e t Inc o m e
O pe ra t ing A c t iv it ie s , C a s h F lo ws P ro v ide d B y o r Us e d In
1,112
Depreciatio n
A djustments To Net Inco me
-390
Changes In A cco unts Receivables
-260
Changes In Liabilities
704
Changes In Invento ries
-53
Changes In Other Operating A ctivities
201
T o t a l C a s h F lo w F ro m O pe ra t ing A c t iv it ie s
4 ,6 2 7
Inv e s t ing A c t iv it ie s , C a s h F lo ws P ro v ide d B y o r Us e d In
-1,437
Capital Expenditures
Investments
757
Other Cashflo ws fro m Investing A ctivities
153
T o t a l C a s h F lo ws F ro m Inv e s t ing A c t iv it ie s
-527
F ina nc ing A c t iv it ie s , C a s h F lo ws P ro v ide d B y o r Us e d In
-1,041
Dividends P aid
-1,734
Sale P urchase o f Sto ck
-404
Net B o rro wings
T o t a l C a s h F lo ws F ro m F ina nc ing A c t iv it ie s
Effect Of Exchange Rate Changes
C ha nge In C a s h a nd C a s h E quiv a le nt s
P.V. Viswanath
- 3 ,17 9
34
$ 955
34
Notes to Financial Statements
 The Notes to the Financial Statements are
frequently very useful in assessing the financial
health of the firm. They often contain:

An explanation of accounting methods used




Straight-line versus accelerated depreciation
LIFO vs FIFO
Restatement of results from prior years using the new standards
Greater details regarding certain assets and liabilities

Conditions and expiration dates of long- and short-term debt,
leases, etc.
P.V. Viswanath
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Notes to Financial Statements

Information regarding the equity structure of the firm


Documentation of changes in operations


Conditions attached to the ownership of shares; these can be
particularly useful to assess the firm’s vulnerability to takeovers.
Acquisitions and Divestitures and their impact
Off-balance sheet items

Forward contracts, swaps, options and other derivative contracts,
which do not appear in the balance sheet, but which can affect a
firm greatly. A lot of Enron’s problems had to do with such offbalance sheet items.
P.V. Viswanath
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Determinants of Growth




Profit margin – operating efficiency
Total asset turnover – asset use efficiency
Financial leverage – choice of optimal debt ratio
Dividend policy – choice of how much to pay to
shareholders versus reinvesting in the firm
P.V. Viswanath
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The Du Pont Identity
 ROA = NI/ TA


ROA = (NI/ Sales)*(Sales / TA)
ROA = (Net Profit Margin)*(Asset Turnover)
 ROE = NI / TE


ROE = (NI/Sales)*(Sales/TA)*(TA/TE)
= Net Profit Margin*Asset Turnover*Equity Multiplier
 Net Profit margin is a measure of the firm’s operating efficiency
– how well it controls costs
 Total asset turnover is a measure of the firm’s asset use
efficiency – how well it manages its assets
 Equity multiplier is a measure of the firm’s financial leverage
P.V. Viswanath
38
Determinants of Earnings Growth Rate
 Earnings in any period depends on the investment base, as well as
the rate of return that the firm earns on that investment base:
 Et+1 = (TEt)ROE
= (TEt-1 + DTEt)(ROE), where DTEt is the increment in total
equity in period t over and above that in period t-1.
= (TEt-1)ROE + (DTEt)(ROE)
= Et + (DTEt)(ROE);
 Hence Et+1 - Et = (DTEt)(ROE)
 Dividing both sides by Et , we get gt = (DTEt/Et)(ROE)
 We have assumed that ROE does not change, i.e. that the debtequity ratio will be kept constant, as we can see from the DuPont
identity.
 Hence debt must be increased and equity decreased in such a way as
to keep the debt ratio constant, assuming that the assets side of the
business maintains a constant profitability.
P.V. Viswanath
39
Sustainable Growth
 The sustainable growth rate tells us how fast the firm can grow, without
increasing financial leverage and without any additional outside equity.
 We have already seen that gt = (DTEt/Et)(ROE)
 If only internal funds are used, then DTEt is simply retained earnings.
 Hence, sustainable growth rate (of earnings) = retention ratio x ROE


0.6858 x 0.3687 = 0.2528 or 25.28%
If the firm can continue to earn 36.87% on its equity and can plow back 68.58%
of earnings into operations, its earnings and equity should both grow at 25.28%
p.a.
 As discussed above, ROE is assumed to be constant, i.e. that the debt-equity
ratio will be kept constant.
 However, if the firm will not have access to new debt financing, the
business can only grow at a lower rate.
P.V. Viswanath
40
Internal Growth Rate
The rate at which the business as a whole, i.e. the total assets of the firm can
grow without additional external financing is called the internal growth rate.
Internal

retained
growth rate

retained
earnings
total assets
earnings
x
net income
net income
Internal
growth rate


equity
Sustainabl
e
Growth Rate
x
x
equity
total assets
equity
total assets
0.2169 x (9298+8674) /(23474+21695) = 0.2528 x 0.3979 = 0.1006
or 10.06%
P.V. Viswanath
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Questions we would like answered…
As financial analysts…
Ass ets
What are the assets in place?
How valuable are these assets?
How risky are these assets?
What are the growth assets?
How valuable are these assets?
Liabilities
Assets in Place
Debt
Growth Assets
Equity
What is the value of the debt?
How risky is the debt?
What is the value of the equity?
How risky is the equity?
However, the information we have comes from
the firm’s financial statements which are
generally prepared by accountants…
P.V. Viswanath
42
The Accountant’s Balance Sheet
Figure 4.1: The Balance Sheet
Assets
Liabilities
Fixed Assets
Current
Liabilties
Current Assets
Debt
Debt obligations of firm
Investments in securities &
assets of other firms
Financial Investments
Other
Liabilities
Other long-term obligations
Assets which are not physical,
like patents & trademarks
Intangible Assets
Equity
Equity investment in firm
Long Lived Real Assets
Short-lived Assets
Short-term liabilities of the firm
This is what we can see from the firm’s balance sheet…
P.V. Viswanath
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Growth Assets
 In a financial balance sheet, we are much less concerned with recording
what a firm paid for what it owns and much more concerned about how
much it is worth and how the nature of the asset affects the firm’s
decision-making and risk.
 There is therefore a greater emphasis on growth assets and the market
values of equity and debt.
 Growth assets represent the capitalized value of net cashflows to be
generated from assets that the firm does not currently own, but has the
ability to acquire and/or is expected to acquire.
 Thus a firm might have the capabilities to expand --whether such
capabilities represent organic growth or inorganic growth (through
mergers). The NPV from such future growth – to the extent the market
recognizes it – is already included in the market value of a firm and
should be recognized in the financial balance sheet as an asset.
P.V. Viswanath
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Growth Assets
 The characterization of an asset as a growth asset is
important for several reasons:



One, the valuation of the firm is incomplete without the
inclusion of such assets. Valuation of such assets may also
require option techniques as opposed to simply expected
cashflow methods.
Two, growth assets represent future discretionary expenditure
and represent a higher level of risk for the investor –
furthermore, such risk can be asymmetric; growth assets may
have a higher upside beta than the corresponding downside
beta (since the firm does not own the asset, it can decide to
forgo the option to acquire it in bad states of the economy).
Two, growth assets are more susceptible to agency costs of
debt and must be financed by equity
P.V. Viswanath
45
Desirable Modifications to Income
Statement
 In addition to the failure to inclued growth assets, there are a
few expenses that are consistently mis-categorized in
financial statements. In particular,


Operating leases are considered as operating expenses by
accountants but they are really, partly, financial expenses
R&D expenses are considered as operating expenses by accountants
but they are really capital expenses.
 The degree of discretion granted to firms on revenue
recognition and extraordinary items is used to manage
earnings and provide misleading pictures of profitability.
P.V. Viswanath
46
Dealing with Operating Leases
 A Lease is a long-term rental agreement
 Leases can either be capital leases or operating leases


A capital lease is often for as long as the life of the equipment, or there
may be an option for the lessee to buy the equipment at the end of the
contract period. Capital leases have to be capitalized and shown on the
balance sheet.
In an operating lease, typically, the contract period is shorter than the
life of the equipment, and the lessor pays all maintenance and servicing
costs. Operating leases do not have to be shown on the balance sheet.
However, operating leases also represent expected fixed periodic
payments, and thus function similar to debt.
As such, a financial analyst would want to see operating leases
capitalized as well
P.V. Viswanath
47
Dealing with Operating Lease
Expenses
 How do we do this?

First, we compute the “debt” value of the operating lease
as the PV of the operating lease expenses, using the pretax cost of debt as the discount rate.
This now creates an asset - the value of which is equal to
the debt value of operating leases. This asset now has to
be depreciated over time.

Second, the operating income has to be adjusted to
reflect these changes.
P.V. Viswanath
48
Dealing with Operating Leases:
Adjusting Operating Income
 Note that the operating lease expense has two components


an operating expense component, i.e. the reduction in the value of
the asset being used, represented by the depreciation, and
a financing component, i.e. the cost of financing the asset.
 Using this model, we assume that
Interest expense on the debt created by converting operating
leases = Operating lease expense - Depreciation on asset created
by operating lease. Then,
Adjusted Operating Income
= Operating Income - Depreciation on operating lease asset +
operating lease expenses
= Operating Income + Imputed Interest expense on operating leases.
= Operating Income + Debt value of Operating leases x Cost of debt
P.V. Viswanath
49
Example: Capitalizing Operating
Leases at Maxwell Shoe
From the 10-K filing made by the company with the SEC on 1/29/2001:
The Company leases equipment and office and warehouse space under long-term
non-cancelable operating leases which expire at various dates through January
31, 2007. At October 31, 2000, future minimum payments under such leases were
as given below (in ‘000s).
Minimum Payments Present Value at 7%
2001
1488
1390.65
2002
1008
880.43
2003
917
748.55
2004
650
495.88
2005
600
427.79
Later Years
750
498.08
Minimum payments are capitalized using an assumed pre-tax cost of debt of
7% p.a. This will be the value of the Lease Asset/Liability on the Oct. 31,
2000 balance sheet. Later years refer to 2006 and 2007.
P.V. Viswanath
50
Example: Capitalizing Operating
Leases at Maxwell Shoe
I assume that payments are made at the end of the fiscal year, ending in
October.
Since the figure for "Later Years," $750, is larger than the declining sequence
of amounts for previous years, I assume that this reflects the amounts for
both 2006 and 2007.
Since the leases expire in January 2007, which is 3 months past the fiscal
year end, I have prorated the amounts for 2006 and 2007, viz. $600 for 2006
(payable at the end of October 2006) and $150 for 2007 (payable at the end
of January 2007).
Hence the $498.08 computed as the present value for the row “Later Years”
equals 600/(1.07)6 + 150/(1.07)6.25.
The present value of the minimum payments (as of Oct. 31, 2000) works out
to $4441.38.
P.V. Viswanath
51
Imputed Interest Expenses on
Operating Leases
Lease payments in 2000 were $1024. Hence the PV of operating leases
as of end 1999 would be (PV of Op. Leases as of end 2000 + Lease
expenses for 2000)/1.07 = (4441.38+1024)/1.07 = $5107.83.
The imputed interest expense is the Debt Value of Operating Leases x
Interest rate.
PV(Operating Leases) as of Oct. 31, 1999
Interest rate on debt
Imputed Interest expense on PV of operating leases
5107.83
7%
357.55
Adjusted Operating Income = Operating Income + Imputed Interest
Payment
= $13,489 + $357.55 = $13,846.55
Net Income is not affected because the imputed interest expense will be
subtracted from Operating Income, just as any other interest expense
would be.
P.V. Viswanath
52
The Effects of
Capitalizing Operating Leases
 Debt: will increase, leading to an increase in debt ratios used
in the cost of capital and levered beta calculation
 Operating income: will increase, since operating income will
now be before the imputed interest on the operating lease
expense
 Net income: will be unaffected since it is after both
operating and financial expenses anyway
 Return on Capital will generally decrease since the increase
in operating income will be proportionately lower than the
increase in book capital invested
P.V. Viswanath
53
R&D Expenses: Operating or Capital
Expenses
 Accounting standards require us to consider R&D as an
operating expense even though it is designed to generate
future growth. It is more logical to treat it as capital
expenditures.
 An approach to capitalizing R&D (cost-based),



Specify an amortizable life for R&D (2 - 10 years)
Collect past R&D expenses for as long as the amortizable life
Sum up the unamortized R&D over the period. (Thus, if the
amortizable life is 5 years, the research asset can be obtained by
adding up 1/5th of the R&D expense from four years ago, 2/5th of
the R&D expense from four years ago...:
P.V. Viswanath
54
Capitalizing R&D Expenses: Boeing
Assuming a ten year life; thus, R&D expenses for
1998 will be amortized over the 1999-2008 period.
Year
R&D Outlay
Unamortized Portion at
end 1998
Amortization for
1998
Value
1988
751
0
0
75.1
1989
754
0.1
75.4
75.4
1990
827
0.2
165.4
82.7
1991
1417
0.3
425.1
141.7
1992
1846
0.4
738.4
184.6
1993
1661
0.5
830.5
166.1
1994
1704
0.6
1022.4
170.4
1995
1300
0.7
910
130
1996
1633
0.8
1306.4
163.3
1997
1924
0.9
1731.6
192.4
1998
1895
1
1895
0
Capitalized value of R&D for 1998 =
9100.2
Total R&D Amortization Expense for 1998 =
P.V. Viswanath
1381.7
55
Boeing’s Corrected Operating Income
For 1998
Operating Income*
$1,720.00
+ Research and Development Expenses**
$1,895.00
- Amortization of Research Asset**
$1,381.70
= Adjusted Operating Income
$2,233.30
* Data obtained from Income Statement
** Data obtained from Income Statement; see also previous slide
In principle, it could be argued that R&D capitalized values should
be restated in 1998 dollars, instead of using the raw unamortized
portions of R&D outlays in past years; however, the current
procedure may be defended on the grounds of conservatism.
P.V. Viswanath
56
Boeing’s Corrected Balance Sheet
 There will be the following modifications on the
balance sheet:



There will be a new asset, R&D, that will show on the
assets side. If one wants to show the gross value of R&D
and accumulated amortization, however, that will require
computation of the amortization in each year for as many
years as the amortizable life of the R&D.
Corresponding to that, the value of stockholder’s equity
will be higher by the same amount.
In our example, this amount will be $9,100.
P.V. Viswanath
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The Effect of Capitalizing R&D
 Operating Income will generally increase, though it depends
upon whether R&D is growing or not. If it is flat, there will be
no effect since the amortization will offset the R&D added
back. The faster R&D is growing the more operating income
will increase.
 Net income will increase proportionately, depending again
upon how fast R&D is growing. Adjusted Net Income will
also have to take the tax deductibility of R&D into account.
 Book value of equity (and capital) will increase by the
capitalized Research asset
 Capital expenditures will increase by the amount of R&D;
Depreciation will increase by the amortization of the research
asset; for all firms, the net cap ex will increase by the same
amount as the after-tax operating income.
P.V. Viswanath
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