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.
 3-2

Analyzing Financing Activities

3
CHAPTER
 3-3

Overview of Chapter

Companies operations are

financed by various sources:
•Liabilities
•Capital (Stockholders’ Equity)
•Off balance sheet transactions
 3-4

Companies’ Financing Sources

Liabilities
Capital (Stockholders’ Equity)
Off balance sheet transactions
 3-5

Liabilities

What are the two major types of

liabilities?
 3-6

Liabilities
Alternative Classification
Obligations
Obligationsthat
thatarise
arisefrom
fromoperating
operating
activities--examples
activities--examplesareareaccounts
accounts
Operating
Operating payable,
payable,unearned
unearnedrevenue,
revenue,advance
advance
Liabilities
Liabilities payments,
payments,taxes
taxespayable,
payable,
postretirement
postretirementliabilities,
liabilities,and
andother
other
accruals
accrualsofofoperating
operatingexpenses
expenses

Obligations
Obligationsthat
thatarise
arisefrom
fromfinancing
financing
activities--examples
activities--examplesare
areshort-
short-and
and
Financing
Financing long-term
long-termdebt,
debt,bonds,
bonds,notes,
notes,leases,
leases,
Liabilities and
andthe
thecurrent
currentportion
portionofoflong-term
long-term
Liabilities debt
debt
 3-7

Liabilities

What are some key features in

analyzing liabilities?
 3-8

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.
 3-9

Liabilities

How are liabilities classified in

the financial statements?
 3-10

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.
 3-11

Companies’ Financing Sources

Liabilities
Capital (Stockholders’ Equity)
Off balance sheet transactions
 3-12

Shareholders’ Equity

What are the basic

characteristics of
Shareholders’ Equity?
How is Shareholders’ Equity
analyzed?
 3-13

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
 3-14

Shareholders’ Equity

What are the five major

elements of Shareholders’
Equity?
 3-15

Elements of Shareholders’ Equity

The five key elements:

•Preferred stock
•Common Stock
•Paid in capital
•Retained earnings
•Treasury stock
 3-16

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
 3-17

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
 3-18

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
 3-19

Shareholders’ Equity

What are the sources of

increases and decreases in
shareholders’ equity?
 3-20

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
 3-21

Shareholders’ Equity

What is a spin off compared to

a split off?
 3-22

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.
 3-23

Companies’ Financing Sources

Liabilities
Capital (Stockholders’ Equity)
Off balance sheet transactions
 3-24

Off balance sheet Financing

What are the basic?

What are the motivation for
off balance sheet
financing?
What are examples?
 3-25

Off Balance Sheet Financing

Special purpose subsidiaries:

• Trust preferred subsidiaries
• Real estate subsidiaries
• Mortgage securitizations
• Enron utilization
 3-26

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.
 3-27

Off-Balance-Sheet Financing

Illustration of SPE Transaction to Sell

Accounts Receivable
 3-28

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.
 3-29

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
 3-30

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
 3-31

Related Financing Issues

Commitments

Contingencies
 3-32

Commitments and Contingencies

What are the basic and

differences between
Commitments and Contingencies?
 3-33

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
should be . . .
-- a contingent asset (and gain) is not recorded until
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
 3-35

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
 3-36

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
 3-37

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)