Investment Tools Financial Statement Analysis Assets.doc

九 Investment Tools: Financial Statement Analysis: Assets1.A: Analysis of Inventoriesa: Compute ending inventory balances and cost of goods sold using the LIFO, FIFO, and average cost methods to account for product inventory.Example: Given the following inventory data:January 1 (beginning inventory):2 units $2 per unit = $ 4January 7 purchase:3 units $3 per unit = $9January 19 purchase:5 units $5 per unit = $25 Cost of goods available (BI + P):10 units = $38 Units sold during January:7 units FIFO cost of goods sold (value the 7 units sold at unit cost of last units purchased). Start at the top and work down:From beginning inventory:2 units $2 per unit = $4From first purchase:3 units $3 per unit = $ 9 From second purchase: 2 units $5 per unit = $10 FIFO cost of goods sold:7 units = $23 Ending inventory: 3 units $5 = $15 LIFO cost of goods sold (value the 7 units sold at unit cost of first units purchased). Start at the bottom and work up:From second purchase: 5 units $5 per unit = $25 From first purchase:2 units $3 per unit = $6 LIFO cost of goods sold:7 units = $31 Ending inventory:2 $2 + 1 $3 = $7 Average cost of goods sold (value the 7 units sold at the average unit cost of goods available).Average unit cost = $38 / 10 = $3.80 per unitWeighted average cost of goods sold = 7 $3.80 = $26.60Ending inventory = 3 $3.80 = $11.40b: Explain the usefulness of inventory and cost-of-goods-sold data provided by the LIFO, FIFO, and average cost methods when prices are 1) stable, or 2) rising.Balance sheet: Inventories based on FIFO are preferable since these values most closely resemble current cost and hence current economic value. GAAP requires that firms use the lower of cost or market when valuing inventory. Applying the lower-of-cost-or-market to the inventory calculated under any cost flow assumption would decrease income and inventory on the balance sheet if market is lower than cost. If assigned costs to ending inventory using one of the cost flow assumptions (LIFO, FIFO, or average cost) is greater than the replacement market cost of that inventory, then that ending inventory must be written-down to market. This rule is applied individually to each major classification of inventory. Inventory is not changed if market price is greater than cost. This potentially increases cost of goods sold and decreases net income and current assets.Income statement: LIFO allocates the most recent prices to the cost of goods sold. For income statement purposes, LIFO is the most informative accounting method and provides a better measure of current income. The quandary, FIFO provides the best balance sheet measure and LIFO the best income statement measure. From an analysts perspective there is often information available to permit restatement of one method to another to provide a better analysis. The discussion above assumes the value for purchases is known but this too may be affected by management choice.c: Discuss the impact of LIFO and FIFO (in periods of rising prices and stable or increasing inventory quantities) on a companys cost of goods sold, income, cash flow, and working capital.In periods of rising prices and stable or increasing inventory quantities:LIFO results in:FIFO results in:higher COGSlower COGSlower taxeshigher taxeslower net income (EBT & EAT)higher net income (EBT & EAT)lower inventory balanceshigher inventory balanceslower working capitalhigher working capitalhigher cash flows (less taxes paid out)lower cash flows (more taxes paid out)d: Describe the effects of adjustment from LIFO to FIFO on inventory balances, cost of goods sold, and income.Adjustment for inventory balances: Add the LIFO reserve to LIFO inventory. This transforms LIFO inventory to FIFO. Now, since you changed inventory on the left side of the balance sheet to current cost, the left side of the balance sheet doesnt balance with the right side. So, you must then: increase retained earnings by the LIFO reserve times (1 t). Retained earnings increases, because accumulated FIFO profits would be greater than LIFO profits. Increase deferred tax liability by the LIFO reserve times the tax rate, t. This deferred tax liability would exist if LIFO were used for taxes and FIFO for the financial statements.Adjustment of cost of goods sold The next step is to adjust the LIFO income statement to an approximation of a FIFO income statement. The COGS adjustment uses the difference in the beginning and ending LIFO reserves. The change in the LIFO reserve between two years represents the impact of using LIFO during that year. During periods of rising prices, LIFO COGS will be greater than FIFO COGS. So, to convert LIFO COGS to FIFO COGS you must reduce the LIFO COGS by the current years increase in the LIFO reserve. This will, in turn, cause after tax income to increase by the change in the LIFO Reserve times 1 - the tax rate. Note, if the LIFO reserve should fall, then the analysis above would be reversed. Change in LIFO Reserve = LIFO ReserveENDING LIFO ReserveBEGINNING.e: Compute and describe the effects of the choice of inventory method on profitability, liquidity, activity, and solvency ratios.Let beginning inventory be one unit at $10. One more unit was purchased for cash during the year at $20. One of the two units available for sale was sold for $30. At year end the replacement cost of inventory is $30. Ending current assets other than inventory is $40, current liabilities is $25, and long-term liabilities is $50. Cash expenses other than cost of goods sold is $5 and the income tax rate is 40%. Beginning stockholders equity is $100 and no dividends were paid. The statement above summarizes the financials given the three inventory accounting methods. The statement below summarizes financial results:FIFOLIFOCost of goods sold1020Net income93Ending inventory2010Beginning inventory1010Average inventory1510Ending Stockholders Equity109103Beginning Stockholders Equity100100Average Stockholders Equity104.5101.5Total Current Assets20+40 =6010+40 =50Current Ratio60/25 =2.450/25 =2.0Debt to Equity Ratio75/109 =0.68875/103 =0.728Inventory turnover67%200%Return on Equity8.6%3.0%f: Discuss the reasons why a LIFO reserve might decline during a given period and discuss the implications of such a decline for financial analysis.Remember, if prices are falling or there is a LIFO liquidation, the LIFO reserve and the change in LIFO reserve will be negative, reflecting that LIFO results in lower COGS, higher earnings, higher taxes and lower cash flows. The table below indicates the summaries the implications for financial analysis caused by falling prices.LIFO results in.FIFO results in.lower COGShigher COGShigher taxeslower taxeshigher net income (EBT & EAT)lower net income (EBT & EAT)higher inventory balanceslower inventory balanceshigher working capitallower working capitallower cash flows (more taxes paid out)higher cash flows (less taxes paid out)1.B.: Analysis of Long-Lived Assets, Pt I: The Capitalization Decisiona: Compute and describe the effects to capitalizing versus expensing on income, variability, profitability, cash flow from operations, and leverage ratios.Financial Statement Effects: Although it may make no operational difference, the choice between capitalization or expensing will affect reported income, cash flow from operations, and ratios.CapitalizingExpensingIncome VariabilityLowerHigherProfitability-Early Years (ROA&ROE)HigherLowerProfitability-Later Years (ROA&ROE)LowerHigherTotal Cash FlowsSameSameCash Flow from OperationsHigherLowerCash Flow from InvestingLowerHigherLeverage Ratios (Debt/Equity & Debt/Assets)LowerHigherb: Explain the effects on financial statements of capitalizing interest costs. During the current year capitalized interest decreases interest expense and increases net income. For analysis purposes capitalized interest should be added to interest expense and taken out of the fixed asset. When the capitalized interest is removed from fixed assets, depreciation expense will be reduced when that asset is placed in operations. Capitalized interest also distorts the classification of cash flows. Interest capitalized as part of fixed assets is not reported as a CFO outflow, but rather as a CFI outflow. So CFO is overstated and CFI is understated. Cash flows should thus be adjusted by adding the capitalized interest back to the investment cash flows and deducting it with the other interest payments from cash flow from operations. The interest coverage ratio should also be adjusted. Capitalized interest should be included in interest expense (EBIT/I) so the interest coverage ratio will fall. For firms in an expansion phase, capitalization of interest may result in a gain in earnings over an extended period of time because the amount of interest amortized will not catch up with the amount of interest capitalized in the current period. Thus, net income will be overstated. c: Discuss the circumstances under which intangible assets, including software development costs, are capitalized.Research & development: Although risky, R&D expenditures are clearly economic assets lasting on the average 7 to 10 years. However, under GAAP (SFAS 2), requires that research & development expenditures are expensed when incurred. Outside the U.S., R&D expenditures may be capitalized if various conditions are met.Patents and copyrights costs (except legal fees of registering) incurred in developing patents and copyrights are expensed. However, if the patent or copyright is purchased then the cost is capitalized.Franchise and license costs can be capitalized by the purchasing firm.Brands and trademarks: If acquired in arms-length transactions the cost can be capitalized.Advertising costs like R&D expenditures are expensed when incurred. However, direct-response advertising costs are capitalized.Goodwill is an intangible asset representing the difference between the amount paid for an acquired firm and the fair market value of its net assets. Goodwill can be recognized and capitalized only in purchase transactions.Computer software development costs: SFAS 86 requires that all costs incurred to establish the technological or economic feasibility of software are expensed (like R&D). Subsequent costs can be capitalized as part of inventory. Disparate accounting for software development costs (e.g., Microsoft expenses all software costs) requires the analyst to evaluate and eliminate the impact of capitalization.1.C: Analysis of Long-Lived Assets, Pt II: Analysis of Depreciation and Impairmenta: Compute and describe how changing depreciation methods or changing the estimated useful life or salvage value of an asset affects financial statements and ratios.A change in depreciation method is considered a change in accounting principles and the cumulative effect must be reported net of taxes. If the change in depreciation method applies only to newly acquired assets, then there is no cumulative effect and the effect of the change is gradual. A company can change the method for newly acquired assets without any specific disclosure. If the change applies to all assets, then the cumulative effect may be significant and the effect on depreciation expense is immediate. Such a change is made retroactively and the company must disclose the cumulative effect separately and net of taxes. A company can change the asset lives and salvage value, but because this is considered a change in an accounting estimate (as opposed to an accounting principle), disclosure is not required. Reading the financial statement footnotes to see if any changes in these estimates have been made is important.b: Explain the role of depreciable lives and salvage values in the computation of depreciation expenses.Depreciation lives and salvage values: Depreciation is a significant expense that must be subject to critical (if not skeptical) analysis. Why? Because, while useful life, salvage value, and the depreciation method must be disclosed, management chooses them. This allows for the possibility of income manipulation. Management could estimate a useful life longer than that warranted and then write-down the overstated assets in a restructuring process. Management might also write-down assets, taking an immediate charge against income, and then record less future depreciation expense based upon the written-down assets. This results in higher future net incomes in exchange for a one-time charge to current income.Impact of depreciation methods on financial statements: Depreciation is an allocation of past investment cash flows and has no impact on the statement of cash flows. It is important for the analyst to consider the capital expenditures to better understand the impact of the choice of depreciation methods. In the early years of an assets life, accelerated methods tend to depress net income and retained earnings and result in lower return measures (ROE & ROA). At the end of the assets life the effect reverses.c: Discuss how inflation affects the measurement of economic depreciation.Inflation has the effect of reducing the ability of depreciation expenses to reflect replacement costs. If the replacement cost of an asset is increasing, then depreciation based on historical cost will not be sufficient to replace the asset. In these cases of rising prices, reported incomes and taxes are too high. This is a difficult but important consideration for analysis. The two key issues are the correct useful life of the asset and the correct rate of economic depreciation. Depreciation based on the current cost of the asset (as opposed to its historical cost) is superior in predicting future cash flow.Example: If an asset with a three-year life is purchased for $3,000 and depreciated using straight line at $1,000 a year. After three years the asset is replaced at a cost of $5,000 (inflation). Total depreciation expense is an insufficient measure of replacement cash outflow. Depreciation based on current cost would measure the 3 year expense at $5,000 which is cash required for replacement.d: Compute the average age and average depreciable life of fixed assets.Several measures relating to plant age for firms using straight line are useful for interperiod and interfirm comparisons are shown below. For illustrative purposes assume that current year depreciation expense is $10,000, gross plant and equipment is $200,000, and accumulated depreciation of $50,000.Average age % or relative age is: accumulated depreciation / ending gross investment = $50,000 / $200,000 = 25%. The average depreciable life is: gross plant and equipment / current years depreciation expense = $200,000 / $10,000 = 20 year average life of P&E.The average age of plant and equipment is: accumulated depreciation / current years depreciation expense = $50,000 / $10,000 = 5 year average age of P&E.If a firms relative age of plant and equipment is high, then the firm has not been adding to its capital stock and is probably a less efficient and competitive producer that will have to invest in PP&E in the future. However, the measure is sensitive to estimated life and salvage value used (the shorter estimated life, the greater depreciation and the higher average age percentage).e: Explain circumstances under which valuation impairment leads to a write-down.Assets carried at more than the recoverable amounts are considered impaired. For impaired assets retained by the firm, the issue is how to report the firms inability to recover fully their carrying amount. Since management largely controls the timing and amount of impairment recognition, it is difficult to compare the impact of impairment and the resulting ratios over time and across companies. Impairments are reported pretax as a component of income from continuing operations. Impairment losses are sometimes reported as a component of restructuring which also includes elements that affect cash flows (e.g., severance pay). It is therefore important of separate write-downs of assets that do not affect cash flow from those components of restructuring which do affect cash flow. Loss from the impairment of assets must be recognized when there is evidence of a lack of recoverability of the carrying amount. Lack of recoverability may be signaled by a significant decrease in the market value or use of the asset, changes in the legal or business climate, significant cost overruns, or a forecast of a significant decline in the long-term profitability of the asset. The impairment of an asset cannot be restored. If an asset is held for disposition, it is carried on the balance sheet at the lower of cost and net realizable value.f: Compute and describe the effects on financial statements and ratios of an impairment write-down.Financial statement impact of impairments: A write-down of assets affects the balance sheet categories of assets (PP&E), liabilities (deferred taxes) and stockholders equity (retained earnings). During the year of write-down, the loss from impairment decreases income from continuing operations. This decreases retained earnings. The assets and its associated deferred taxes are reduced. Cash flow is not affected. Recognition of the impairment leads to a deferred tax asset not a current refund. In future years, less depreciation expense is recognized on the written-down asset, resulting in higher net income. The following table relates the effects of impairments:Impairment EffectsCash FlowNo effectAssets (PP&E)DecreaseDeferred TaxesDecreaseStockholders EquityDecreaseCurrent Ne