Financial

Statement
Analysis

K.R. Subramanyam

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
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Analyzing Financing Activities

3
CHAPTER
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Overview of Chapter

Companies operations are

financed by various sources:
• Liabilities
• Capital (Stockholders’ Equity)
• Off balance sheet transactions
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Companies’ Financing Sources

Liabilities
Capital (Stockholders’ Equity)
Off balance sheet transactions
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Liabilities

What are the two major types of

liabilities?
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Liabilities
Alternative Classification
Obligations that arise from operating
activities--examples are accounts
Operating payable, unearned revenue, advance
Liabilities payments, taxes payable,
postretirement liabilities, and other
accruals of operating expenses

Obligations that arise from financing

activities--examples are short- and
Financing long-term debt, bonds, notes, leases,
Liabilities and the current portion of long-term
debt
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Liabilities

What are some key features in

analyzing liabilities?
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Liabilities
Important Features in Analyzing Liabilities
• Terms of indebtedness (such as maturity, interest
rate, payment pattern, and amount).
• Restrictions on deploying resources and pursuing
business activities.
• Ability and flexibility in pursuing further financing.
• Obligations for working capital, debt to equity, and other
financial figures.
• Dilutive conversion features that liabilities are
subject to.
• Prohibitions on disbursements such as dividends.
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Liabilities

How are liabilities classified in

the financial statements?
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Liabilities
Classification
Current (short-term) Noncurrent (Long-Term)
Liabilities Liabilities

Obligations whose Obligations not

settlement requires use of payable within one
current assets or the year or the operating
incurrence of another cycle, whichever is
current liability within one longer.
year or the operating
cycle, whichever is
longer.
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Companies’ Financing Sources

Liabilities
Capital (Stockholders’ Equity)
Off balance sheet transactions
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Shareholders’ Equity

What are the basic

characteristics of Shareholders’
Equity?
How is Shareholders’ Equity
analyzed?
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Shareholders’ Equity
Basics of Equity Financing
Equity — refers to owner (shareholder)
financing; its usual characteristics include:
• Reflects claims of owners (shareholders) on
net assets
• Equity holders usually subordinate to
creditors
• Variation across equity holders on seniority
• Exposed to maximum risk and return

Equity Analysis — involves analyzing equity characteristics, including:

• Classifying and distinguishing different equity sources
• Examining rights for equity classes and priorities in liquidation
• Evaluating legal restrictions for equity distribution
• Reviewing restrictions on retained earnings distribution
• Assessing terms and provisions of potential equity issuances

Equity Classes — two basic components:

• Capital Stock
• Retained Earnings
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Shareholders’ Equity

What are the five major

elements of Shareholders’
Equity?
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Elements of Shareholders’ Equity

The five key elements:

• Preferred stock
• Common Stock
• Paid in capital
• Retained earnings
• Treasury stock
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Shareholders’ Equity

Classification of Capital Stock

Preferred Stock — stock with features not possessed by
common stock; typical preferred stock features include:
• Dividend distribution preferences
• Liquidation priorities
• Convertibility (redemption) into common stock
• Call provisions
• Non-voting rights

Common Stock — stock with ownership interest and

bearing ultimate risks and rewards (residual interests) of
company performance
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Shareholders’ Equity
Components of Capital Stock
Contributed (or Paid-In) Capital — total financing received from
shareholders for capital shares; usually divided into two parts:

• Common (or Preferred) Stock — financing equal to par or

stated value;if stock is no-par, then equal to total financing

• Contributed (or Paid-In) Capital in Excess of Par or Stated

Value — financing in excess of any par or stated value

Treasury Stock (or buybacks) - shares of a company’s stock

reacquired after having been previously issued and fully paid for.
• Reduces both assets and shareholders’ equity
• contra-equity account (negative equity).
• typically recorded at cost
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Shareholders’ Equity
Basics of Retained Earnings
Retained Earnings — earned capital of a company; reflects
accumulation of undistributed earnings or losses since inception;
retained earnings is the main source of dividend distributions

Cash and Stock Dividends

• Cash dividend — distribution of cash (or assets) to shareholders
• Stock dividend — distribution of capital stock to shareholders

Prior Period Adjustments — mainly error corrections of prior periods’

statements

Appropriations of Retained Earnings — reclassifications of retained

earnings for specific purposes

Restrictions (or Covenants) on Retained Earnings — constraints or

requirements on retention of retained earnings
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Shareholders’ Equity

What are the sources of

increases and decreases in
shareholders’ equity?
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Shareholders’ Equity
Reporting Capital Stock

Sources of increases in capital stock outstanding:

• Issuances of stock
• Conversion of debentures
• Issuances of stock in acquisitions and mergers
• Issuances pursuant to stock options and warrants exercised

Sources of decreases in capital stock outstanding:

• Purchases and retirements of stock
• Stock buybacks
• Reverse stock splits
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Shareholders’ Equity

What is a spin off compared to

a split off?
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Shareholders’ Equity

Spin-Offs and Split-Offs

• Spin-off, the distribution of subsidiary stock to

shareholders as a dividend; assets (investment in
subsidiary) are reduced as is retained earnings.

• Split-off, the exchange of subsidiary stock owned by

the company for shares in the company owned by the
shareholders; assets (investment in subsidiary) are
reduced and the stock received from the shareholders is
treated as treasury stock.
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Companies’ Financing Sources

Liabilities
Capital (Stockholders’ Equity)
Off balance sheet transactions
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Off balance sheet Financing

What are the basic?

What are the motivation for
off balance sheet
financing?
What are examples?
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Off Balance Sheet Financing

Special purpose subsidiaries:

• Trust preferred subsidiaries
• Real estate subsidiaries
• Mortgage securitizations
• Enron utilization
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Off-Balance-Sheet Financing
Illustration of SPE Transaction to Sell
Accounts Receivable
• A special purpose entity is formed by the sponsoring
company and is capitalized with equity investment,
some of which must be from independent third
parties.
• The SPE leverages this equity investment with
borrowings from the credit markets and purchases
earning assets from or for the sponsoring company.
• The cash flow from the earning assets is used to
repay the debt and provide a return to the equity
investors.
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Off-Balance-Sheet Financing

Illustration of SPE Transaction to Sell

Accounts Receivable
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Off-Balance-Sheet Financing

Benefits of SPEs:

1. SPEs may provide a lower-cost financing alternative

than borrowing from the credit markets directly.
2. Under present GAAP, so long as the SPE is properly
structured, the SPE is accounted for as a separate
entity, unconsolidated with the sponsoring
company.
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Off-Balance-Sheet Financing
Basics of Off-Balance-Sheet Financing
Off-Balance-Sheet Financing is the non-recording of financing obligations

Motivation
To keep debt off the balance sheet—part of ever-changing landscape, where as one
accounting requirement is brought in to better reflect obligations from a specific off-
balance-sheet financing transaction, new and innovative means are devised to take
its place

Transactions sometimes used as off-balance-sheet financing:

• Operating leases that are indistinguishable from capital leases
• Through-put agreements, where a company agrees to run
goods through a processing facility
• Take-or-pay arrangements, where a company guarantees to pay GAAP
for goods whether needed or not
• Certain joint ventures and limited partnerships
• Product financing arrangements, where a company sells and agrees to
either repurchase inventory or guarantee a selling price
• Sell receivables with recourse and record them as sales rather than liabilities
• Sell receivables as backing for debt sold to the public
• Outstanding loan commitments
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Off-Balance-Sheet Financing
Analysis of Off-Balance-Sheet Financing
Sources of useful information:
Notes and MD&A and SEC Filings

Companies disclose the following info about financial instruments with

off-balance-sheet risk of loss:
• Face, contract, or principal amount
• Terms of the instrument and info on its credit and market risk, cash
requirements, and accounting Loss incurred if a party to the
contract fails to perform
• Collateral or other security, if any, for the amount at risk
• Info about concentrations of credit risk from a counterparty or
groups of counterparties

Useful analyses:
• Scrutinize management communications and press releases
• Analyze notes about financing arrangements
• Recognize a bias to not disclose financing obligations
• Review SEC filings for details of financing arrangements
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Related Financing Issues

Commitments

Contingencies
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Commitments and Contingencies

What are the basic and

differences between
Commitments and Contingencies?
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Contingencies and Commitments

Basics of Contingencies
Contingencies -- potential losses and gains whose resolution depends on one or
more future events.

Contingent liabilities -- contingencies with potential claims on resources

-- to record a contingent liability (and loss) two
conditions must be met:
(i) probable i.e. an asset will be impaired or a
liability incurred, and
(ii) the amount of loss is reasonably estimable;
-- to disclose a contingent liability (and loss) there
must be at least a reasonable possibility of
incurrence

Contingent assets -- contingencies with potential additions to resources

Contingencies -- a contingent asset (and gain) is not recorded until
should be . . .
the contingency is resolved
-- a contingent asset (and gain) can be disclosed if
probability of realization is very high
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Contingencies and Commitments

Analyzing Contingencies
Sources of useful information:
Notes, MD&A, and Deferred Tax Disclosures

Useful analyses:
• Scrutinize management estimates
• Analyze notes regarding contingencies, including
•Description of contingency and its degree of risk
•Amount at risk and how treated in assessing risk exposure
•Charges, if any, against income
• Recognize a bias to not record or underestimate contingent liabilities
• Beware of big baths — loss reserves are contingencies
• Review SEC filings for details of loss reserves
• Analyze deferred tax notes for undisclosed provisions for future losses

Note: Loss reserves do not alter risk exposure,

have no cash flow consequences, and do not
provide insurance
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Contingencies and Commitments

Basics of Commitments
Commitments -- potential claims against a company’s resources due
to future performance under contract

Analyzing Commitments
Sources of useful information:
Notes and MD&A and SEC Filings

Useful analyses:
• Scrutinize management communications and press releases
• Analyze notes regarding commitments, including
•Description of commitment and its degree of risk
•Amount at risk and how treated in assessing risk exposure
•Contractual conditions and timing
• Recognize a bias to not disclose commitments
• Review SEC filings for details of commitments
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Leases

Leasing Facts
Lease – contractual agreement between a
lessor (owner) and a lessee (user or renter)
that gives the lessee the right to use an asset
owned by the lessor for the lease term.

MLP – minimum lease payments

(MLP) of the lessee to the lessor
according to the lease contract
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Leases
Lease Accounting and Reporting
(1) Capital Lease Accounting For leases that transfer substantially all benefits
and risks of ownership—accounted for as an asset acquisition and a liability
incurrence by the lessee, and as a sale and financing transaction by the lessor
A lessee classifies and accounts for a lease as a capital lease if,
at its inception, the lease meets any of four criteria:
(i) lease transfers ownership of property to lessee by end of the lease
term
(ii) lease contains an option to purchase the property at a bargain price
(iii) lease term is 75% or more of estimated economic life of the
property
(iv) present value of rentals and other minimum lease payments at
beginning of lease term is 90% or more of the fair value of leased
property

(2) Operating Lease Accounting For leases other than capital leases—the lessee
(lessor) accounts for the minimum lease payment as a rental expense (income)
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Leasing – Illustration

Leased assets have an expected life of

5 years.
Depreciation is straight line.
Annual lease payment is $2,505.
Interest rate is 8%.
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Leasing
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Leases
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Leases
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Leases
Effects of Lease Accounting
Impact of Operating Lease versus Capital Lease:
• Operating lease understates liabilities—improves solvency ratios
such as debt to equity
• Operating lease understates assets—can improve return on
investment ratios
• Operating lease delays expense recognition—overstates income
in early term of the lease and understates income later in lease
term
• Operating lease understates current liabilities by ignoring current
portion of lease principal payment—inflates current ratio & other
liquidity measures
• Operating lease includes interest with lease rental (an operating
expense)—understates both operating income and interest
expense, inflates interest coverage ratios,
understates operating cash flow, & overstates
financing cash flow
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Postretirement Benefits
Two kinds of Retirement Plans

Defined Pension Plan -- Employer-promises

monetary benefits to employees after retirement, e.g.,
monthly stipend until death.

Defined Contribution Plan – Plan specify the amount

of pension contribution that the employer makes to the
plan.
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Postretirement Benefits
Elements of the Pension Process

Employer Pension Employee

Fund
Benefits
Contributions
(Disbursements)

Investment and returns

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Postretirement Benefits
Pension Basics
Pension Plan – agreement by the employer to provide pension benefits involving
3entities: employer-who contributes to the plan; employee-who derives benefits; and
pension fund
Pension Fund – account administered by a trustee, independent of employer,
entrusted with responsibility of receiving contributions, investing them in a proper
manner, & disbursing pension benefits to employees
Vesting – specifies employee’s right to pension benefits regardless of whether
employee remains with the company or not; usually conferred after employee has
served some minimum period with the employer

Pension Plan Categories

Defined benefit – a plan specifying amount of pension benefits that employer promises
to provide retirees; employer bears risk of pension fund performance

Defined contribution – a plan specifying amount of pension contributions that

employers make to the pension plan; employee bears risk of pension fund performance

Focus of Pension Analysis

Defined benefit plans constitutes the major share of pension plans and are
the focus of analysis given their implications to future company
performance and financial position