US GAAP vs. IFRS

Difference in the treatment of dividend and interest
Under U.S. GAAP, SFAS 95:

• Dividends paid by a company to its shareholders are classified on the cash flow statement under cash flow from financing.
• The dividends received by a company from its investments are classified as cash flow from operations.
• All interests received and paid by or to a company are classified as cash flow from operations.
  
  Under IFRS:
  Dividends paid by a company to its shareholders, dividends received by a company from its investments and all interests received and paid by or to a company can be classified as either cash flow from financing or cash flow from operations.
  
  

	IFRS	U.S. GAAP
Dividends paid by a company to shareholders	Cash Flow from Financing or Operations	Cash Flow from Financing
Dividends received by a company from investments	Cash Flow from Financing or Operations	Cash Flow from Operations
All interest received and paid by or to a company	Cash Flow from Financing or Operations	Cash Flow from Operations

Other Difference between IFRS and US GAAP

	IFRS	U.S. GAAP
Inventory	LIFO is allowed	LIFO is allowed
Inventory	LIFO is allowed; Recovery of value is allowed if certain criteria are met.	LIFO is allowed; Recovery of value is NOT allowed
Property and Equipment	Upward revaluation is allowed; The increase in value is reported in the income statement to the extend of previous downward valuation. Otherwise it is reported as a direct adjustment to equity.	Reported on balance sheet at original cost less accumulated depreciation; Upward revaluation is NOT allowed.
Intercorporate investment	Use voting control % to determine the need of consolidation: Less than 20% (no significant influence)=> market method; 20%-50% (Significant influence) => Equity method; More than 50% (Control) => Consolidation; Shared (Joint control) =>Proportionate consolidation* or equity method; *Proportionate consolidation - report pro-rata share of the assets, liabilities and net income of the investee.	Use voting control % and economic control to determine the need of consolidation Less than 20% (no significant influence) => market method; 20%-50% (Significant influence) => Equity method; More than 50% (Control) => Consolidation; Shared (Joint control) => equity method; Proportionate consolidation is not permitted.
Goodwill	Not systematically amortized but subject to an impairment test at least annually. The timing of impairment judgment of goodwill can be used to mange earnings Analyst can make adjustments: Deduct goodwill when computing ratios; Exclude goodwill impairment charges ; from income statement when analyzing trends; Evaluate acquisitions in terms of the price paid relative to the earning power of the acquired assets.
Identification intangible assets	Reported on the balance sheet at acquisition cost less accumulated amortization; The costs of internally developed intangibles are generally expensed as insured; Do allow upward revaluations.	Same reporting as IFRS. Do NOT permit upward revaluations
Provision	Non-financial liabilities that are uncertain about their timing and amount.	Use “contingency” instead of “provision”

Common financial statements adjustments for comparison

· Difference in depreciation methods and assumptions
· Difference in inventory cash flow assumptions and methods
· Difference in the treatment of the effect of exchange rate changes
· Difference in classification of investment securities
· Sales of receivable with recourse
· Operating lease
· Take-or-pay contracts
· Capitalization decisions
· Goodwill

General screening criteria for potential equity investments

· Low P/E,P/CF,P/S
· High ROE, ROA, growth rate of sales and earnings
· Low leverage

Role of financial statement analysis in assessing credit quality

Credit analysis
Character – firm’s management reputation and history of debt repayment
Collateral – ability to pledge collateral can reduce lender’s risk
Capacity – for debts longer than 30 days, need to monitor the financial statement closely

Credit rating agencies
· Moody’s
· Stand and Poor’s

Categories to assess firm creditworthiness
· Scale and diversification – the greater, the better
· Operational efficiency – the larger, the better
· e.g. ROA, operating margin, EBITDA margin
· Margin Stability – indicate the probability of debt repayment
· Leverage – The greater earnings relative to debt and interest expense, the better credit risk

Forecast Financial Performance of a Firm

Usually based on top-down approach.

Single period forecast:
1. Forecast GDP growth (supplied by in-house or outside party)
2. Use historical relationship to estimate relationship between GDP growth and the growth of industry sales
3. Determine the firm's market share and multiply by industry sales to forcast the firm's sales
4. Forcast earnings by using simple forecasting model - historical average or trend-adjusted measure of profitability, e.g. operating maring, EBT maring or net margin. Or, forcast earnings by using complex forecasting models - each financial statment items are estimated on separate assumptions.

Multi-period forecast:
· Usually employ a single estimates of sales growth which is expected to continue indefinitely

Estimate cash flow:
· Make assumptions on future source and use of cash, especially on the changes in working capital, capital expenditure on new fixed assets, issuance or repayment of debts, stock issuance and repurchase.
· Assumption on noncash working capital as a % of sales remain constant

Ways to examine the variability of financial outcomes

Sensitivity analysis
Based on "What if" questions.

Scenario analysis
Based on specific scenaros

Simulation
Select probability distributions for key variables and use computer to generate distribution of outcomes based on repeated random selection.

Pro-forma Financial Statement

Both common-size financial statements and ratio analysis can be used to prepare pro-forma financial statement.

Pro forma statements are based on specific assumptions on future business condition and firm performance., as an integral part of business planning and control. Financial managers use them in the decision-making process when constructing an annual budget, developing long-range plans, and choosing among capital expenditures.

Change in sales
· A common assumption that drive the changes in balance sheet and income statement.

Construct sales-drive pro-forma financial statements:
· Estimate sales driven relationship
· Estimate future tax rate, interest rate
· Forecast sales
· Estimate fixed operating costs and fixed financial costs
· Construct pro-forma statements

Estimate sales
· Use the average compound growth rate of sales over 5 or 10-year period
· Use regression analysis to estimate the relation between GDP growth and sales growth
· Incorporate economic cycles and seasonality of sales
· Incorporate specific events such as changes in regulation, new product development, etc.

Relative Financial Ratios

Single ratio is meaningful only relative to:

• industry norms (most common, if wide variations within industry, use median instead of mean, better not to use all the firms but use cross-sectional analysis-subset of firms with similar size and characteristics),
• overall economy norms( important when overall business condition are changing, the company’s own historical performance (very common, often conduct time-series analysis , consider trends in ratio)
• The company's past performance – This is a very common analysis. It is similar to a time-series analysis, which looks mostly for trends in ratios.

Goodness of ratios: some desirable to close the industry norms; some the higher, the better eg return on asset, profit margin; some depends on the context eg high ROE resulted from high profit margins or asset turnover is good but resulted from high leverage met with a great deal of skepticism

Usefulness and Limitations of Ratios analysis

Usefulness of Ratios analysis
· to forecast furture earings and cash flows
· understand the financial flexibility of the firm
· evaluate management's performance

Examples:
· Premium and custom products is at higher gross maring
· Higher proportion spent on research and development leads to our expectation of products with cutting-edge features and high quality.
· Larger ratio of gross profits to operating profits if spend more in R&D and/or advertising expenditures.
· Examine if the company has implement their claimed strategies such as cutting cost

Limitations of ratios analysis
· cannot useful if viewed in isolation;
· difficult comparison due to different accounting treatment;
· difficult to find comparable industry ratios for multi-operations company;
· All ratio but not only one set of ratios must be viewed relative to others for conclusion
· Difficult to find a meaningful set of industry-average ratio for multi-operations company
· Seasonal factors distort ratio analysis
· Different accounting practices
· Difficult to generalized about wheter a ratio is good or not
· Difficult to tell if the company is good or weak due to the combination of good and bad ratios
· Require to judge some range of acceptable values

External liquidity

External liquidity
· Total market value of o/s securities (no of common stocks o/s x market price per share)
· no of shareholders-more shareholders translates to greater liquidity
· Trading turnover (no of shares traded in a year / total no of shares o/s)

Traditional car dealership against internet-based dealership:
· lower asset turnover (due to larger capital tied up in physical facilities);
· higher gross profit margin ( due to keen competitive over internet)

DuPont and sustainable growth

Used to determine what the company is worth, and allows creditors to estimate the company’s ability to pay its existing debt and evaluate their additional debt application.

ROE = net income /equity
(reminders: 1) not subtract preferred dividend 2) use end of year equity but no average)

ROE = (net income/sales) x (sales/equity) = profit margin x equity turnover

Basic DuPont:

ROE = Net margin x Asset turnover x Equity multiplier = (Net income/Sales) x (Sales/Assets) x (Assets/Equity).
(equity multiplier- measure if a company is leveraged)

Extended DuPont:
ROE = [(EBIT/Sales) x (Sales/Assets) - (Interest expense/Assets)] x (Assets/ Equity) x (1 - Tax rate). = {(operating profit margin x total asset turnover – interest expense rate) x financial leverage multiplier x tax retention rate}

As leverage rises, so does the interest expense rate, +ve effects of leverage can be mitigated by the higher interest payments. Higher taxes leads to lower ROE; High profit margin & asset turnover leads to high ROE

Retention rate = 1 - Dividend payout.
(dividend payout = dividends declared / operating income after taxes = Dividend per share / earnings per share)

Sustainable growth rate = ROE x RR = Return on equity x Retention rate.

Earnings and cash flow ratios

Interest coverage = EBIT / Interest expense.
(ability to repay its debt obligations)

Fixed financial cost coverage = EBIT /(interest expense +1/3 lease payment)
(1/3 derived from a bond rating agency guideline that suggests 1/3 of lease payments represent the effective int component of borrowing)

Fixed charge coverage = EBIT / [Interest expense + Lease payments + Preferred dividends / (1-t)].

Total charge coverage ratio
(ability to make good on all of obligations), as preferred dividends are paid from after-tax dollars and need to be adjusted to a pretax basis)

Cash flow to interest expense = (net income + depreciation expense + increase in deferred taxes)/ interest expense
(use traditional cash flow instead of income in numerator, a different type of coverage ratio. Some use CFO or free cash flow)

Cash flow coverage of fixed financial cost coverage = {(traditional CF+ Interest Expense +1/3 lease payments)/(interest expense + 1/3 lease payments)}

Cash flow to LT debt= (net income + depreciation expense + increase in deferred taxes ) / Book value of LT debt
(denominator either with or without deferred taxes, If low->difficult to meet LT debt payments)

Cash flow to total debt = (net income + depreciation expense + increase in deferred taxes) / total debt)

Risk Measures

Business risk: – related to the company’s income variance

Business risk = coefficent of variation = standard deviation of operating income / mean operating income (use 5-10 yrs data as too short-> not reliable; If too long->not relevant)

sales volatility= SD of sales / mean sales
(use 5-10 yrs data as too short-> not reliable; If too long->not relevant)

Operating leverage =mean [absolute value (% change in operating earning/%change in sales)
(how much the production costs are fixed as opposed to variable. If greater use of fixed costs, greater impact of a change in sales on operating income of a company-> greater the risk will be

Financial risk: - related to the company’s financial structure (use of debt).

Debt to equity = LT debt / Total equity.
(measure of fixed cost financing, the analyst has a choice of whether to include deferred taxes as part of debt; If deferred taxes resulted from accelerated & SL depreciation difference, should not be included; If result from income recognition on LT contracts, taxes will have to paid at some point,->include)

LT debt to total capital = LT debt / LT capital.
(may or may not include deferred taxes)

Total debt ratio = Total interest bearing debt / (Total capital - Non interest bearing liabilities).

Operating Performance

The measurement of operating performance is used to analyze and determine how well management operates a company.

Operating efficiency - revealed if the company’s assets were utilized efficiently.

Total asset turnover = Sales / Average total net assets.
(Differene across industries; manufacturing business that are capital intensive, near 1; Retail business- near 10; If too low->capital tied up; If too high-> too few assets for potential sales or asset base is outdated)

Fixed asset turnover = Sales / Average net fixed assets.
(utilization of fixed asset, If low,->means too much capital tied up in its asset base; If too high-> has obsolete equipment)

Equity turnover = Sales / Average equity.
(measure of employment of owner’s capital, include preferred/common stock, paid-in-capital & retained earning; about capital structure as co can increase this ratio by using more debt financing)

Working capital turnover = Revenue / average working capital

Operating profitability - related to the company’s overall profitability

Gross margin = Gross profit / Sales = (Sales - COGS) / Sales.
(concerned if too low)

Operating margin = Operating profit / Sales = EBIT / Sales.
concerned if too low)

Net margin = Net income / Sales
(concerned if too low)

Return on total capital (ROTC) = EBIT / Average total capital.
(should add back gross interest expense as total capital includes debt. Do Not use net interest expense,i.e. gross interest expense – interest income; total capital is the same as total asset, concerned if too low)

Return on total equity (ROE) = NI / Average total equity
= (net income /sales) (Sales / total assets) (total assets / equity)
(concerned if too low, include preferred stock)

Return on owners’ equity = (NI - Preferred dividends) / (Average total equity – Preferred stock) (concerned if too low)

Profitability ratios

Profitability ratios - The higher, the better

Gross profit margin
Can increase by raising sales prices or lowering per unit cost

Gross profit margin = gross profit/ revenue

Net profit margin
Can increase by raising sales prices or cutting costs

Others profit ratios:
Net profit margin = net income / revenue
Operating profit margin = operating income / revenue
Pre-tax margin = pre-tax earning / revenue

Liquidity ratios

Liquidity ratios are used to analyze and determine a company’s financial ability to meet short-term liabilities.

Current ratio = Current assets / Current liabilities.
(If <1,> liquidity crisis. If higher-> better the ability to pay ST liability.)

Quick ratio = (Cash + Marketable securities + Receivables) / Current liabilities.
(more stringent measure of liquidity- not incl inventories & other not very liquid asset)

Cash ratio = (Cash + Marketable securities) / Current liabilities.
(most conservative measures)

Receivables turnover = Sales / Average receivables. {ave = (beg + End)/2}
(desirable to have figures close to the industry norm)

Inventory turnover = COGS / Average inventories.
(desirable to have figures close to the industry norm. If the stock level is too low, it is probably to lose sales, if too high, too much cash is tied up.

Payables turnover = COGS / Average payables.

Receivables period = 365 / Receivables turnover.
(no of days receivables ,desirable to have figures close to the industry norm; If too high-> too much capital tied up in assets; If too low-> too rigorous credit policy)

Inventory processing period = 365 / Inventory turnover
(no. of days inventory ,desirable to have figures close to the industry norm, If too high->capital tied up & obsolete inventory; If too low->inadequate stock->adversely impact sales)

Payables period = 365 / Payables turnover.
(no. of days of payables, paying too early is costly unless the firm can take advantage of discounts; Postponing the payment is costly due to the discount foregone, late payment penalties/interest, deterioration of credit rating and business relationship)

Operating Cycle = days of inventory + days of receivable

Cash conversion cycle = days of inventory + days of receivable – days of payable
(if too high-> not desirable, excessive amt of capital investment in the sales process)

Common-sized financial statements

Common-sized financial statements:
· Express all in % of sale to allow easy comparison of different sized firms.
· Useful for time-series and cross-sectional analysis and facilitate the comparison for firms of different size

Income statement:
Income statement items as a % of sales,

% value of income statement account = Income statement account / Total Sales (Revenues)

Note:
· It is more meaningful to present income tax expenses as an effective rate than as a % of sales. Effective rate = income tax / pre-tax income

Balance Sheet:
Balance sheet items as a % of assets

% value of balance sheet account = Balance sheet account / Total Assets

Effects of change in interest rate on debts and Early Retirement of Debt

Effects of changei n interest rate on debts
Changes in bond value due to changes in interest rates are not reflected in the value of bond liability.

Analysts should:
· Consider the market value of debt in the financial analysis.

Early Retirement of debt
At bond’s maturity: decrease in cash and LT liability, market value = book value

Early retirement of debt:
· The carrying value of debt liability minus the price at which it is purchased back is recorded as an extraordinary item (below the operating line, net of tax), because:
· This gain/loss is not due to the firm’s performance,
· The cause behind the gain/loss (change in interest rates) could have occurred in a different period. The gain or loss may signal an earnings change in opposite direction, that is
· If the company generate gain by retiring old low interest debt at a market price well below bookvalue (bought back at price below book value), but if it raises the proceeds by borrowing at current higher interest rate =>increase interest expense.;
· If the company generate loss by retiring old high interest debt =>can borrow at low current interest rate debt.

Zero Coupon Bond, Convertible bond, Bond with warrant, Redeemable Preferred Stock

Zero Coupon Bond
Also know as pure discount instrument.

For an extreme case of a discounted bond issue, the coupon rate is 0, so the entire interest expense goes towards amortization of the bond discount.

The carrying value of the bond grows towards par over the life of the bond. Recognized interest expense for each period by applying discount rate to book value (i.e. effective interest method or PV amortization method)

Convertible Bond:
The conversion option is ignored in accounts upon issuance and the bond is booked in the same way as non-convertibles. Option is undetachable and the interest expense of the convertible is lower {due to the conversion option the firm gives to bondholders, which is not reflected in liabilities}.

Upon conversion, reclassified from debt to equity in balance sheet.

Bond with warrant:
Option is detachable and as a sweetener , proceeds from issuance of bonds should be split into 1) pure bond valued treated as debt 2) options is treated as equity.

GAAP requires the issuer to calculate the fair value and report the warrant separately in stockholders’ equity. Accounting for bonds with warrants is closer to economic reality than that of convertible bonds.

How should an analyst treat convertibles:
· If current stock price < conversion price, treat like an ordinary bond (debt).
· If current stock price > conversion price, treat like equity.
· If current stock price is close to the conversion price, choose the more conservative treatment.

Alternatively, use option-adjusted yield as the true cost of debt.

Redeemable preferred stock:
Often recorded as a separate item between equity and debt.

Analyst should
· treated as debt and its dividends as interest payments for purpose of analysis.

Cash flow adjustment

Premium bonds:
higher cash coupon ->CFO is understated;

Discount bonds:
lower cash coupon -> CFO is overstated;

zero coupon bond:
the coupon understated the cash components of interest expense & CFO is overstated
i.e. no coupon =>CFO has no interest expense deducted =>severely understate interest expense and overstate CFO;

Analyst should:
· make adjustment which is positive for premium & negative for discount bond.