FI N A NC I A L AN A LY SI S
95-711
FALL 2002
LECTURE NOTES
SESSION ONE
Prof. L. A. Pastor
F I N A N C I A L S TAT E M E N TS
INTERPRETATION
 Managers’ decisions affect financial statements
 Financial Statements are designed to report performance consistently
 External users need financial statements to evaluate management decisions
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)
 Guidelines and rules, that govern the preparation financial statements
 Accrual (vs. Cash) Basis of Accounting
 “Promulgated” by FASB
 Required by the SEC
FINANCIAL STATEMENTS
 Balance Sheet
 Income Statement
 Statement of Cash Flows
 Statement of Changes in Owner Equity
BOOK VS. MARKET
V a lu e o f E q u ity
R a tio , M a rk e t
($ m illio n s
C om pany
Book
A M F B o w ling Inc .
B o is e C a s c a d e C o rp .
C a s tle & C o o k e Inc .
C o c a -C o la Inc .
D o w J o ne s & C o . Inc .
V a lu e to
M a rk e t
B o o k V a lu e
530
306
0 .6
1 ,3 4 3
1 ,7 4 6
1 .3
537
251
0 .5
8 ,4 0 3
1 6 5 ,1 9 0
1 9 .7
509
4 ,4 2 6
8 .7
F o rd M o to r C o .
2 3 ,4 0 9
7 1 ,7 1 7
3 .1
H e w le tt-P a c k a rd C o .
1 6 ,9 1 9
6 9 ,3 6 5
4 .1
L TV C o rp .
1 ,6 2 7
575
0 .4
S a fe c o C o rp .
5 ,5 7 6
5 ,8 5 2
1 .0
Tim b e rla nd C o m p a ny
266
506
1 .9
U g ly D uc k ling C o rp .
163
73
0 .5
Ya ho o Inc .
536
2 3 ,5 7 8
4 4 .0
ACCRUAL VS. CASH
 GAAP Preferred
 Not for Taxes
 Matches Revenues with Expenses
ACCRUAL BASIS
 Simultaneous
Cash flows and revenue and expense recognition (Same for Cash Basis)
 Accruals
Revenues and expense recognition preceding cash in flow and out flow
 Deferrals
Cash flows precedes revenue and expense recognition
EXAMPLES
 John began working at XYZ Co. in December and got paid $5,000 on the first of
January for the preceding month. What is the salary expense for John in the month
of December using:
 the accrual basis of accounting?
 the cash basis of accounting?
EXAMPLE
 In December ABC Co. purchased and received $20,000 worth of XYZ’s services
on 30 day terms. What is the revenue related to this sale for XYZ in December
using
 the accrual basis of accounting?
 the cash basis of accounting?
EXAMPLE
 If John was the only cost related to the services received by ABC in Decembe r
what was the profits related to this job for XYZ in December and January using
 the accrual basis of accounting?
 the cash basis of accounting?
EXAMPLE
 XYZ received a deposit of $10,000 in December from ABC for a new project
which is to start in the new year? What is the Revenue for December using
 the accrual basis of accounting?
 the cash basis of accounting?
ACCOUNTING CONVENTIONS
 Conservatism
Although accuracy is paramount, it is preferable to err on the side of conservatism
 Measurement
Consistent Currency Unit
Consistent Time Periods
 Going Concern
 Reliability
Objective
 Cost
COST
 Historical cost
Amount originally paid for the asset
 Net realizable value (NRV)
Amount expected to be realized
 Replacement cost
Current cost to replace (e.g., certain marketable securities).
 Present value
Amount of estimated future cash flows (e.g., monetary assets and liabilities)
 Fair Market value (or FMV)
What the market will bear
TYPES OF BUSINESS ORGANIZATIONS
 Sole Proprietorships
Limited Partnerships
 Partnerships
LLP
 Corporations
LLC
 Hybrids
PC
ORGANIZING A BUSINES S
Sole
Proprietorship
Partnership
Corporation
Ownership
The Manager
Partners
Shareholders
Owners are
managers
Yes
Yes
Usually Not
Liability
Unlimited
Unlimited
(exceptions)
Limited
Taxes
Personal
Personal
Corporate
GOALS OF THE CORPORATION
 Shareholders desire wealth maximization
 Do managers maximize shareholder wealth?
 Managers have many constituencies “stakeholders”
 “Agency Problems” represent the conflict of interest between management and
owners
MANAGING CORPORATIONS
 Shareholder
Elects Board of Directors
Shareholder Votes vs. Proxy
 Board of Directors
Hires Management
Oversight of Management
 Management makes decision
Authorizes Dividends to Shareholders
Usually Approved by the Board
BA L A N C E S H E E T
PERFORMANCE CORPORATION
Balance Sheet
At December 31, 19A
Assets:
Cash
Merchandise inventory (for resale)
Supplies inventory (for use in rendering services)
Accounts receivable (from customers)
Service vehicles
Less accumulated depreciation
Total assets
$ 32,000
42,000
15,000
13,000
50,000
(10,000)
$142,000
Liabilities:
Accounts payable (to suppliers)
Note payable (to bank)
Total liabilities
Stockholders' equity:
Contributed capital, 6,500 shares
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
$22,000
25,000
47,000
$65,000
30,000
95,000
$142,000
BALANCE SHEET FORMAT
Current Assets
Current Liabilities
Non Current Liabilities
Non Current Assets
Total Liabilities
Total Equity
Total Assets
Total Liabilities & Equity
VALUE OF ASSETS
 Record the asset at either the FMV of what is received or the FMV of what is
given up, whichever is more clearly determinable.
 Cash, value of services, other assets
 If unclear, emphasize the asset received
ACQUISITION OF ASSET S
 Paying cash
 Issuing debt
Notes payable, leases
 Issuing equity
Common stock, preferred stock
 By self-construction
CURRENT ASSETS (SHORT TERM)
 Cash and equivalents
 Short-term investments
 Receivables (net of allowance for doubtful accounts)
 Inventories
 Prepaid expenses
 Notes receivable
 Deferred income taxes
NON CURRENT ASSETS ( LONG TERM ASSETS)
Property, plant and equipment
Natural resources
Intangible assets
FIXED ASSETS
 Property, plant and equipment (PP&E)
Land
Buildings
Furniture, vehicles and equipment
Leasehold improvements
Less:
allowance for accumulated depreciation
PROPERTY PLANT & EQU IPMENT
 Tangible
 Used in the operations of the business
 Relatively long-lived
 Not intended for resale
“COSTS” CAPITALIZED
 Transportation
 Installation
 Additions
 Maintenance is not Capitalized
NATURAL RESOURCES
 Acquisition costs (capitalized)
 Exploration costs – two methods
Successful efforts (capitalize costs related only to successful completion)
Full costing (capitalize costs related to all exploration)
INTANGIBLE ASSETS
 Patents
 Copyrights
 Trademarks and Trade names
 Organization costs
 Goodwill
 Capitalized R&D
 Cost Allocation through “Amortization”
RESEARCH & DEVELOPME NT
 Expensed as incurred until feasibility is established
 Capitalized as an Asset after feasibility point
COST ALLOCATION
 Method is Management’s Decision
 Depreciation & Amortization
Long Term Assets
Matches Use of Asset to related Revenue
 Depletion
Natural Resources
Cost of Resources Extracted
RELATED DEPRECIATION EXPENSE
 Reduce the Value of the asset on the Balance Sheet
 Accumulated Depreciation is a “contra asset” account
 Increase in Accumulated Depreciation results in a corresponding increase in
Depreciation Expense on the Income Statement
LIABILITIES
 Current liabilities
Accounts payable
Accrued expenses payable
Short term Notes
Current portion of
long-term debt
 Long-term liabilities
Long Term Notes and Bonds Payable
Capital Leases
Mortgages
LIABILITIES (OBLIGAT IONS) ARISE FROM:
 Using or taking possession of resources in the course of operations before paying
for them
 Receive payment in advance of delivery of service or products
 Raise Cash from Financial Institutions or Other Debt holders
 Promises that obligate the company in the future like warranties
REQUIREMENT OF LIABILITIE S
 An obligation has been incurred
 Amount of obligation can be measured with reasonable certainty
 Determine when the debt will be due and payable with reasonable certainty
Time value of
money
IS THIS A LIABILITY
 ABC Company has placed an order for 200 units to be delivered in 30 days
Is this a liability?
Why or why not?
IS THIS A LIABILITY
 All of ABC Company’s products come with a one year warranty. Costs are
incurred when repairs are made under the warranty.
Is this a Liability?
Why or why not?
IS THIS A LIABILITY
 ABC Company has been notified that it is being sued for discrimination.
Is this a liability?
What do you need to know?
Would a shareholder want to know about this?
IS THIS A LIABILITY
 Hilton Hotels has a frequent visitor program which award points and allows
redemption for free stays.
Is this a liability?
What do you need to know?
Would a shareholder want to know about this?
SHORT TERM OR CURREN T LIABILITIES
 Expected to be paid within 1 year (or business cycle)
 May also incur Interest Expense
 Include:
Accounts Payable
Short Term Portion of Long Term Debt
Accrued Expenses
•Payroll not yet paid out
•Utilities
LONG TERM OR NON CUR RENT LIABILITIES
 Do not expect to pay off within the next year
 Include
Long Term Loans
Bonds
Mortgages
LONG TERM DEBT
 Obligation to Repay
Unlike Stocks
 Interest Rate
Even if not stated
Gives Rise to Interest Expense
 Security
Claims against specific asset (secured)
General claims against all assets (unsecured)
 Maturity
Have a definite maturity date
May be callable earlier at the borrower’s discretion
INTEREST
 Principal x Interest Rate x Time
 Interest Rate always stated on an annual basis
 Ex. On a 10% loan the monthly interest equals
Principal x 10% x 1/12
LEASES
 Operating leases
Like renting an apartment
Risks and benefits of ownership is not transferred to Lessee (renter)
Payments are recorded as an Expense only
Leased Asset is not recorded on the Balance Sheet
LEASES
 Capital Lease
Economic Benefits and Risks are transferred to Lessee
Lease is for 75% of assets useful life or
Present value of the lease payments equals 90% of the value of the Asset or
Lease has a bargain purchase option
Asset must be recorded on the books
Lease is recorded as a Liability
Interest has to be calculated for each payment on the lease
IS THIS A LIABILITY
 ABC Company takes a 4 year lease on a vehicle that has a useful life of 5 years
IS THIS A LIABILITY
 ABC Company takes a 2 year lease on a vehicle that has a useful life of 5 years. At
the end of the second year, ABC can purchase the car for less than its Fair Market
Value.
IS THIS A LIABILITY
 ABC Company takes a 3 year lease on a vehicle that has a useful life of 5 years.
The sticker price on the car is $20,000. The present value of all the lease is
$19,000.
 How will this affect the financial statements?
ANSWER
 Increase in Assets
 Increase in Liabilities
 Must Depreciate Asset
 Must “break out” Interest Expense when lease payment is made
CAPITAL LEASE
 ABC makes an annual payment on the lease of $7,911 on this 3 year Capital
Lease.
 What is the effect on the Financial Statements?
CALCULATE INTEREST E XPENSE AND PRINCIPAL PAYMENT
 Interest Expense
$19,000 x 12% = $2,280
 Principal Pay Down
$7,911 - $2,280 = $5,631
 Principal Balance
$19,000 - $5,631 = $13,369
AMORTIZATION TABLE
Loan Principal Amount
Annual Interest Rate
Year
2001
2002
2003
Balance
$19,000.00
$13,369.00
$7,062.28
Monthly Payments
Interest Over Term of Loan
Sum of All Payments
$19,000.00
12.00%
Payments
$7,911.00
$7,911.00
$7,911.00
Principal
$5,631.00
$6,306.72
$7,063.53
Interest
$2,280.00
$1,604.28
$847.47
Cummulative
Principal
$5,631.00
$11,937.72
$19,001.25
$7,911.00
$4,731.75
$23,733.00
Cummulative
Interest
$2,280.00
$3,884.28
$4,731.75
 To get Payment amount, use the Excel Function: =PMT(.12, 3, 19000)
CALCULATE DEPRECIATI ON
 Use Straight line Depreciation
Historical Cost = $19,000
Lease (proxy for useful life) = 3
Annual Depreciation Expense
•$19,000/3 = $6,333
Corresponding Accumulated Depreciation
Ending
Balance
$13,369.00
$7,062.28
($1.25)
STOCKHOLDERS’ EQUITY
 Contributed capital
Common stock
Preferred stock
Additional contributed capital
 Retained earnings
EQUITY
 Residual Rights
 Assets = Liabilities + Equity
 Difference between Assets and Liabilities
SOURCES OF EQUITY
 Sales of Stock
Stock = Par Value x Shares sold
Additional Paid in Capital
 Retention of Profits (earnings)
TYPES OF STOCK
 Common
Voting rights
Last to get anything in a liquidation
 Preferred
No voting rights
Has preference over Common Shareholders if dividends are declared
Has preference over Common Shareholder in a liquidation
May include a Preferred Stock Dividend which is based on the Par Value of the Preferred
Stock
COMMON STOCK
 Authorized
In the Charter
 Issued
Sold to Investors
 Outstanding
Still in Investors hands
 Treasury
Bought back by the Company for future Reissue
 Retired
Bought back by the Company and “disposed” of
ISSUE STOCK FOR CASH
 ABC Company is authorized to issue 1,000,000 shares of $2 par value common
stock. The company issues, 100,000 shares at $10 per share.
 If it costs ABC $50,000 to issue the shares how are the financial statements
affected
ANSWER
Assets
Cash
Total Effect on Assets
$950,000
$950,000
Stockholders’ Equity
Common stock, $2 par
Additional paid-in capital
Total Effect on Equity
$200,000
750,000
$950,000
ISSUE STOCK FOR SERV ICE
 ABC Company issues 5,000 shares of $2 par common stock, in exchange for
services quoted at $20,000.
 How are the financial statements affected?
ANSWER
(NOT INCLUDING THE E ARLIER TRANSACTION)
Income Statement
Professional Services
Balance Sheet
Stockholders’ Equity
Common stock $2 par
Additional paid-in capital
$20,000
$10,000
10,000
$20,000
DIVIDENDS
 Management is under no obligation to declare dividends on Common Stock
 Management can declare dividends but not pay them out right away (in arrears)
 Not included in calculating profit
 Deducted from profit to calculate Retained Earnings
DECLARING DIVIDENDS
 At the end of the fiscal year, ABC Company had a profit of $2 mil lion.
Management with consent of the Board of Directors declares a $.50 dividend per
share. Remember, ABC has 105,000 shares outstanding.
 How are the financial statements affected?
ANSWER
Income Statement
Profit
$2,000,000
Statement of Shareholder Equity
Dividends
$52,500
Balance Sheet (Equity)
Retained Earnings
$1,947,500
DILUTION
 When more shares are issued, the % of the company that existing stockholder
own is reduced.
In public companies shareholders may not care
In closely held companies shareholders may care a whole lot!
 Stock rights for common stock
Gives shareholder preemptive right to buy new share
Allows shareholders to maintain a proportional ownership in the corporation when
additional shares are issued
Rights are usually for a few weeks
Like a warrant which can be for years
STOCK DIVIDENDS
 A company may declare a stock dividend to reward shareholders without paying
out cash
 Shareholders do not pay anything for these shares
 Total Value of Equity Section does not change
STOCK SPLIT
 Doubles the number of shares each stockholder owns
 Reduces Par Value by half
 Does not affect Additional Paid in Capital or Retained Earnings
 Total Equity stays the same
 Does not increase the number of shares not yet issued by the com pany
ASSET?
 Since Advertising should result in future sales and therefore future benefits, is
advertising an Asset?
BEEN ON PETS.COM LATELY?
 Seventeen dot-coms, as Internet companies are known, were among about three
dozen advertisers who paid a record average of $2.2 million for a 30-second
commercial on the ABC telecast which saw the St. Louis Rams beat the Tennessee
Titans, 23-16.
 Pets.com: "Don't Go" (30 Seconds)
The company's sock puppet dog sings a woeful tale of a pet's life when his or her
owner leaves home to buy pet food.
PETS.COM IS GONE
 Still think it’s a good idea to capitalize advertising and marketing cost?