Sen Finance Sen Finance Sen Finance Sen Finance: CFA® Level I

SenFinance.
com June 2010

© Jayanta Sen 2010
Sen Finance
CFA® Level I
1
Dec 2010
FRA Additional Notes for
First 35% Free Portion of
Curriculum (R 29 to R 36)
These notes cover remaining exam material (for
the FRA section) not covered in the FRA videos.
1
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1
SenFinance.com June 2010
Financial Statements: (R 29)

The primary financial statements are:
1) Balance Sheet: The RHS lists assets of the firm and the LHS liabilities
and owners’ equity (who owns how much). It’s a stock statement, that is
values at a point in time, say Dec 31, 20X0.
2) Income Statement: How much did the firm earn during a particular
period? It is a flow statement, not a snapshot at a point in time, but rather
what happened over a period of time.
3) Statement of Cash Flows, the 3 important components of which are
Cash Flows from Operating Activities, Cash Flows from Investing, and
Cash Flows from Financing.
There is a fourth financial statement, the Statement of Owners' Equity,

also called “Statement of Changes in Earned Surplus” or “Retained
Earnings Statement” or “Statement of Stockholders’ Equity”.
Financial statements also have Financial Notes and Supplementary

Schedules. These provide information on items such as:
Legal issues facing the firm
Acquisitions made by the firm
Important customers
Segments of the firm
Quarterly data
Outlook based on known trends and disclosures about contractual

obligations and commercial commitments (off balance sheet
arrangements) should be discussed in the Management Discussion and
Analysis (MD&A) section.
In most countries it is legally necessary for firms (especially those who

have sold shares to the public) to have their financial statements audited
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by independent accounting firms. The Auditor’s Report describes the
statements audited and the audit process. It may issue an unqualified
opinion (“clean”, everything in order), or a qualified opinion (one or more
things in the financial statements not in keeping with accounting
standards).
In the US, firms subject to SEC regulations (that is, those who have sold
securities) need to file the form 10-K (domestic firms) or 20-F (foreign
firms). Domestic firms are also required to file 10-Q quarterly, and foreign
firms 6-K semi-annually.
Most firms provide an “annual report” to their shareholders (though it is

not required by SEC).
The Accounting Equation: (R 30)

The Accounting Equation is:
Assets = Liabilities + Contributed Capital + Beginning Retained Earnings

+ (Revenue - Expenses - Dividends)
Retained Earnings = Beginning Retained Earnings + (Revenue – Expenses

– Dividends)
One way to think of the above is that the Assets of the firm were
purchased/created by issuing debt (Liabilities), or issuing equity
(Contributed Capital), or by profits made by the firm (Retained Earnings)
Ownership of the Assets of the firm are distributed among those who paid
to purchase debt (Liabilities), and those who paid to purchase equity
(Contributed Capital + Retained Earnings)
Statement of Owner’s Equity: (R 30)
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The “Statement of Owners' Equity” has Beginning Retained Earnings, Net

Income (from the Income Statement), and also accounts for items like
Dividends. It may appear in the B/S, in a combined Income and Retained
Earnings Statement or separately.
Items such as “Treasury Stock Repurchase” and “Additional Paid in

Capital” would appear in the “Statement of Owners' Equity”.
Management Discussion and Analysis (MD&A)

Section: (R 30)
The MD&D section discusses issues such as:
1) Results of Operations
2) Capital Resources and Liquidity
It is optional (not binding) for management to discuss forward-looking

data that anticipate trends or events in the MD and A section.
International Financial Reporting Standards

(IFRS): (R 31)
The International Accounting Standards Board (IASB) develops
international accounting standards which were earlier titled International
Accounting Standards (IAS) and are now titled International Financial
Reporting Standards (IFRS).
The 5 factors identified by IFRS for reliability of financial statements are:
Faithful representation; Neutrality; Substance over form; Prudence; and
Completeness.
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US GAAP (Generally Accepted Accounting
Principles): (R 31)
The corresponding body to the IASB in the US, is the Financial
Accounting Standards Board (FASB), which is the highest authority in
establishing US GAAP (Generally Accepted Accounting Principles).
In the US firms issuing securities are subject to the rules and regulations
of the Securities and Exchange Commission created by the Securities
Exchange Act of 1934. The Public Company Accounting Oversight Board
(PCAOB) was established by the Sarbanes-Oxley Act of 2002, and is
overseen by the SEC. This act also increased the responsibility of the
management in matters of the accuracy of financial statements.
Convergence and the Framework: (R 31)

“The Norwalk Agreement” between IASB and FASB in 2002 committed
them to 1) making their standards fully compatible 2) coordinating in the
future so that the standards remained compatible.
The Framework for the Preparation and Presentation of Financial

Statement developed by the IFRS identifies 4 principal desirable
qualitative characteristics: Understandability; Relevance; Reliability; and
Comparability. There are 5 principles: Fair presentation; Going concern
(financial statements should be prepared with continuity through time);
Accrual Basis of accounting; Consistency; and Materiality
Income Statement Formats: (R 32)

An income statement that shows the subtotal “gross profit” has a
multi-state format rather than a single-step format.
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An income statement may have “grouping by nature” (for example
grouping depreciation in all different kinds of assets into one item), or
“grouping by function” (for example grouping expenses such as salaries,
raw material costs, depreciation etc. into COGS).
Revenue Recognition: (R 32)

Revenue recognition is important as investors and other economic agents
who seek information from financial statements pay particular attention to
revenues. A firm may want to inflate revenues to mislead investors into
believing that its future prospects are better than actual. Accordingly the
IASB asks that revenues be recognized by a firm when:
1) the buyer bears the risks and benefits of ownership of the good sold by
the firm
2) the firm does not continue management of the good in a manner
associated with ownership
3) revenues and costs can be measured reliably
The FASB requires that revenue be recognized when “realized or

realizable and earned” according to the following criteria:
1) Evidence of contract between buyer and seller (not just, for example
some notion that this sale will be completed next period)
2) Item sold has been delivered or service has been provided.
3) Price is determined or can be determined.
4) Buyer is unlikely default on payment.
The different methods of revenue recognition are:
A) Sales-basis recognizes revenues when a sale is made. If the payment is

deferred (sale made on credit), then Accounts Receivable will increase.
Even though cash has not been received, the revenue is still recognized.
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B) When a firm has a contract that takes multiple periods to complete, the
question arises, in which periods should the revenues from the contract be
recognized? This could happen, for example with engineering projects like
building a bridge that will take many years to complete.
Percentage of Completion recognizes revenue on a pro-rata basis based on
how much of the contract has been completed (as measured by costs
incurred). An alternative to using costs incurred are milestones.
Under the percentage-of-completion method accounts billed to customers

are recorded as a liability (advance billings) and an asset (accounts
receivable).
Under the percentage-of-completion method costs incurred are

accumulated in a asset account titled Construction-in-Progress. It has to
be an asset account, because without it the B/S would show lower LHS
than RHS (think of cash falling due to costs, but corresponding decrease in
RHS).
When using the Percentage-of-Completion if estimates of revenue or costs

change then earnings of prior periods are not restated.
C) Also for a contract stretching over multiple accounting periods,

revenue may be recognized by the Completed Contract method, that waits
till the end of the contract to recognize both revenues and expenses.
During the contract the accounts net construction in progress (asset) and
net advance billing (liability) are updated.
The Completed Contract Method is generally used when no contract

exists, or estimates of the selling price are not reliable.
The Completed Contract Method is recommended for short term projects.
The percentage-of-completion method provides better information about

operating activities than completed-contract method.
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D) Barter transactions occur when a firm exchanges a product with
another firm, for example an internet firm can provide advertising to
another firm, in exchange for advertising. The IFRS requires measuring
revenues from barter transactions based on similar non-barter
transactions with other parties.
E) Gross versus Net is an issue for firms that purchase goods from
suppliers and re-sell. For Gross (rather than Net) Revenues to be reported,
US GAAP requires that the firm must be the primary obligor under the
contract. The firm is really acting as if the product was its own, rather
than just re-selling. The firm bears inventory risk and has reasonable
latitude to establish price. For example Buy.com selling a Canon camera
(where the price is largely out of Buy.com’s control) would not qualify for
Gross Revenues to be reported.
F) Installment sales method recognizes as profits the percentage of total

profits from a contract equal to the percentage of cash received from total
sales. For example, suppose a real estate developer has built and sold
houses for $100 million, but has received payment of only $35 million, then
the profits recognized should be only 35% of total profits.
G) Cost-recoverability method has the firm not recognizing any profit till
costs have been recovered.
Example: A firm receives a contract that will pay it a total of $100 million
over years. The total expected expense of the contract will be $75 million.
The expenses incurred, and payments received by the firm are as follows
($ millions):
Year 1 Year 2 Year 3 Year 4

Payments Received 15 25 30 30
Expenses 25 20 15 15
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a) What will be the revenues for year 2 if the firm follows the percentage
of completion?
b) What will be expenses for year 2 if the firm follows the completed
contract method?
Answer:
a) Revenues = (25/75) * 100 = fraction of expense for the year * total
payments = $33.33 M
b) In the completed contract method, both revenues and expenses are
recognized at the end when the contract is completed. So both revenues
and expenses are zero for year 2.
Example: The firm has billed its client for less than what it has delivered.
How will Net Income and Cash be different if the firm was using
“completed contract method” rather than “percentage of completion
method” for revenue recognition?
Answer: If the firm was using “completed contract method” rather than
“percentage of completion method” for revenue recognition, it would
result in lower Net Income but not lower Cash.
Percentage of completion recognizes the revenue earlier than completed

contract, leading to higher Net Income (as project is profitable).
Percentage of completion and completed contract give the same balance
sheet entries (which includes Cash), except for the Net construction in
progress (asset) and net advance billing (liability) accounts. In any case,
Cash will be whatever cash (and equivalents) the firm has, it can’t be
changed due to accounting practices followed by a firm.
Expense Recognition: (R 32)

The “matching principle” is generally the basis for expense recognition.
Costs are to be matched with revenues.
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Nonrecurring and Nonoperating items: (R 32)
A “Discontinued” operation is an operation that the firm has disposed of,
or planned to dispose of. In the Income Statement the impact of the
disposal is reported separately as “Discontinued” operations. The idea is
that an analyst should be able to disentangle the rest of the firm from the
discontinued operations, and make estimates for the future performance of
the firm (which will be missing the discontinued operations).
IAS and US GAAP differ in their treatment of “Extraordinary Items”,

with IAS not allowing the classification whereas US GAAP permitting the
classification. According to US GAAP, the necessary conditions for
“Extraordinary Items” are unusual in nature and infrequent in
occurrence. The firm decides if an item is “extraordinary” based on these
criteria. Items that are unusual or infrequent, but not both, cannot be
classified as “extraordinary”.
If there is a change in accounting standards (for example due to some

pronouncement of FASB), then a firm should apply the new standards to
all fiscal years reported in the financial statements. This will require
“retrospective application” of the new standards to some prior years. The
reason to do so is to enable comparison across years.
If a firm makes a change in an “accounting estimate” (for example the life

of an equipment) no changes are necessary for prior period statements.
Nonoperating income arises from activities that are not the related to the
business of the firm. For example, for a car manufacturing company the
income from investments in equity and debt of another firm would be
nonoperating income. This income is generally disclosed separately in the
Income Statement.
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Calculating EPS: Dilutive and Antidilutive
Securities: (R 32)
Earnings Per Share = EPS = Earnings for the firm / Number of Shares
Calculating the Earnings Per Share (EPS) for a firm may require
adjustments to Earnings (the numerator) and the number of shares (the
denominator) the earning.
In this section we will discuss the impact of: Preferred Shares; Stock
dividends, splits, and issues; Convertible Securities
Preferred shares
The simplest adjustment if for preferred shares. Remember that preferred
shares do not share in increases in dividends, so they are rather like debt
(without the tax advantage) rather than equity. Hence they are to be
removed while calculating basic EPS:
Basic EPS = (Net Income – Preferred Dividends) / Number of shares
The number of shares in the above equation do not include preferred

shares.
When you are asked to calculate EPS, it is the EPS of common stock.
Hence ignore any preferred stock and dividends paid to preferred stock.
Stock dividends, splits, and issues

During a year a firm may issue new shares, so we have to determine what
is the correct number of shares for calculating EPS. It is not necessarily
the number of shares at the end of the year.
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The following rules should be followed for determining the number of
shares:
1) If the shares are sold, then the number of shares should be pro-rated
according to the time they were sold. For example, if the firm sells the
shares on Sep 1, then the sold shares have 4 months till Dec 31, in which
case the pro-rated number of shares should be found by multiplying the
number of shares by 4/12. The idea here is that the firm had 4 months to
invest the money received from selling the shares and earn a profit, rather
than the entire 12 months.
2) If the shares are given to the shareholders for no payment (that is, due
to a stock dividend, or a stock split) then the entire number of shares at the
end of the period should be counted. That is, if the shares are free, no pro-
rata reduction in number of shares.
Example: Firm QXS starts with 50,000 shares on Jan 1, 20X5. It issues
30,000 shares for cash on March 1, 20X5, and 15,000 shares for cash on
July 1, 20X5. The number of shares to be used for calculating EPS will be:
Answer: Number of shares = Initial number + Number issued on March 1

* (10/12) + Number issued on July 1 * (6/12) = 50,000 + 30,000 * (10/12) +
15,000 * (6/12) = 82,500
Example: A firm had 2 million shares of common stock outstanding on Jan

1, 20X2. It sold 1 million new shares for cash on March 1, 20X2. It had Net
Income of $20M during the year. It paid $4M as dividends to common
stock, $6M interest expense on debt and $3M as dividend to preferred
stock. What is its EPS for 20X2?
Answer: Number of shares outstanding = Number of shares on Jan 1 +

(10/12) * Number of shares on March 1 = 2 M + 1 M * (10/12) = 2.833 M
EPS = (Net Income - Dividends to Preferred) / # of shares outstanding
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= ($20M - $3M) / 2.833M = $6
Convertible Securities
There are three types of convertible securities we will cover: Convertible
Preferred Stock and Convertible Debt; and Stock Options and Warrants.
Convertible securities may be dilutive or antidilutive. If the conversion

reduces the EPS, the security is dilutive, and if it increases the EPS the
security is antidilutive.
In the calculation of fully diluted EPS, the antidilutive securities are

ignored (not converted). Basic ESP is calculated without converting any of
the securities that may be converted to stock (like convertible debt,
warrants etc.).
For convertible bonds and convertible preferred stock, we use the if-
converted method:
To calculate the denominator we convert at the beginning of the year if the
convertible debt existed at the beginning of the year. Otherwise we convert
at issuance date (whenever it occurred during the year).
For the numerator we add the related interest expense (net of tax) for the
convertible debt to Net Income. For convertible preferred stock we do not
have to add back the associated preferred dividends, as preferred
dividends haven’t been deducted from Net Income to start with.
For calculating the diluted EPS in the presence of options and warrants we
use the treasury-stock method:
We assume that the options and warrants were exercise occurred at the
beginning of the year (if they existed at the beginning of the year) or issue
date (if they were issued during the year).
If there are proceeds from the exercise of options or warrants, then these
proceeds are assumed to purchase common stock for treasury stock.
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The security is dilutive if exercise price is less than the market price of
stock.
If exercise price is greater than the market price the security is anti-
dilutive. The diluted EPS calculation should ignore this security.
Example: An analyst has the following information about a firm:

B/S at Dec 31, 20X5
B/S at Dec 31, 20X5

Notes Payable 600,000
8% cumulative, convertible preferred stock, par
value $10. 1,000,000 shares authorized, 500,000
shares issued and outstanding 5,000,000
Common Stock, par value $10. 4,500,000 shares
authorized 2,000,000 issued and outstanding 20,000,000
Additional Paid in Cap 4,000,000
Retained Earnings 5,000,000
Net Income for 20X5 24,000,000
Notes and Assumptions

8% convertible preferred stock each convertible into 0.4
shares of common stock.
No preferred dividends declared in 20X5
The 2,000,000 common stock were outstanding for all of 20X5
Average Income Tax Rate is 40%
What is the EPS taking into account the dilutive effect of 8% convertible
preferred stock (by the If-converted Method)?
Answer: 500,000 preferred stocks convert to 200,000 common stock.

Denominator = 2,000,000 + 200,000 = 2.2M
The income to common stock holders (now that preferred dividends do not
have to be paid as preferreds have been converted to common stock) is the
entire $24,000,000.
Diluted EPS = $24 M / 2.2M = $10.91
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B/S at Dec 31, 20X5
B/S at Dec 31, 20X5

7% convertible bonds, par value $1,000. 3,000
bonds issued 3,000,000

7% convertible bonds are each convertible into 100 shares of
common stock.
What is the EPS taking into account the dilutive effect of 7% convertible
bonds (by the If-converted Method)?
Answer: The bonds will convert to 3,000 * 100 = 300,000 shares.

Denominator = 3,000,000 + 300,000 = 3.3M
The interest paid on the debt = $3,000,000 * 7% = $210,000
On an after-tax basis the interest savings to the firm from conversion of

the debt = $210,000 * (1 – 0.40) = $126,000
Numerator = $5,000,000 + $126,000 = $5.126M
Diluted EPS = $5.126M / 3.3M = $1.55
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B/S at Dec 31, 20X5
B/S at Dec 31, 20X5

The firm has outstanding 1,000,000 options with an exercise price of $50
and no other potentially dilutive securities. The firm’s market price has
averaged $80 during the year.
What is the firm’s basic and diluted EPS (using the Treasury Stock
method)?
Answer: For basic EPS we have the numerator (net income) to be $10M
and denominator (shares outstanding) to be 3M.
Basic EPS = $10M / 3M = $3.33
For diluted EPS, first note that the firm would receive $50 * 1M = $50M.
This can be used to repurchase $50M / $80 = 0.625M shares
So adjusted denominator for diluted EPS = 3M + 1M – 0.625M = 3.375M
The numerator does not change as the options do not receive any
dividends or suchlike.
Diluted EPS = $10M / 3.375M = $2.96

B/S at Dec 31, 20X5
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B/S at Dec 31, 20X5

16% cumulative, convertible preferred stock,
par value $10. 1,000,000 shares authorized,
500,000 shares issued and outstanding 5,000,000

8% convertible preferred stock each convertible into 0.5
shares of common stock.
Besides the convertible stock, there are no other potentially
dilutive securities
No preferred dividends declared in 20X5
What is the basic and dilutive EPS(by the If-converted Method)?
Answer: Preferred Dividends = $5,000,000 * 16% = $800,000

The basic EPS calculation has the:
Numerator = Net Income – Preferred Dividends = $4M - $0.8M = $3.2M
Denominator = 2,000,000
Basic EPS = $3.2M / 2M = $1.6
500,000 preferred stocks convert to 500,000 * 0.5 = 250,000 common stock.

Denominator = 2,000,000 + 250,000 = 2.25M
The income to common stock holders (now that preferred dividends do not
have to be paid as preferreds have been converted to common stock) is the
entire $4,000,000.
EPS with preferred conversion = $4M / 2.25M = $1.78
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As the conversion increases the EPS, the convertible preferreds are anti-
dilutive. Hence they are ignored in the calculation of the diluted EPS
(which remains at $1.6).
Type of EPS Numerator Denominator

Basic Net Income – Preferred Weighted shares
Dividends outstanding
Diluted Net Income – Preferred Weighted shares
(Convertible Debt) Dividends + Interest to outstanding + Shares on
Debt * (1 – T) converting debt
Diluted Net Income Weighted shares
(Convertible outstanding + Shares on
Preferred Shares) converting preferred shares
Diluted (Options Net Income – Preferred Weighted shares
and Warrants) Dividends outstanding + Shares on
converting debt – Shares
that can be repurchased
from proceeds of
conversion
Notes: 1) If shares are issued during the period they are A) taken for the
entire period if there was no money received by the firm (stock split or
dividend). B) if new shares are sold, then pro-rated by the time for which it
existed during the period.
2) If a convertible security is antidilutive, then it is ignored for the purpose
of calculating diluted EPS.
Comprehensive Income: (R 32)

SFAS defines “Comprehensive Income” as “the change in equity [net
assets] of a business enterprise during a period from transactions and
other events and circumstances from non-owner sources. It includes all
changes in equity during a period except those resulting from investments
of owners and distributions to owners”.
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“Other Comprehensive Income” are items that add to income for the
owners of the firm, but however are not included in the Net Income
calculation. These items are however included in “Comprehensive
Income”. These items are:
1) Foreign currency translation adjustments
2) Deferred gains and losses on cash flow hedges
3) Unrealized loss or gain on available-for-sale securities
4) Gain or loss due to change in funded status of retirement plans
Comprehensive income reporting is mandatory under US GAAP, but

optional under IFRS.
Balance Sheet Formats: (R 33)

A single column for assets, liabilities and owners’ equity is the “report
format”. The “account format” has assets on the left and liabilities and
owners’ equity on the right.
In a “classified” B/S various classes of items are grouped together to

reduce the number of items and make it easier to read.
Statement of Changes in Shareholders’ Equity:

(R 33)
The Statement of Changes in Shareholders’ Equity has changes in the
firm’s net assets or wealth. Present in it are items reported in
Comprehensive Income (R 32).
Land and Building Accounts: (R 33)

In addition to the purchase price, commissions to real estate agents should
be debited to the Land account.
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The cost (as recorded in the Building account) of an existing building
includes purchase price plus all repairs and other expenditures. When a
firm constructs a building for itself, architects’ and lawyers fees are
included in cost (Building account).
Suppose land and building are purchased together, and it is not specified
in the purchase contract how much is paid for each separately. An
appraisal has to be done and the purchase price has to be proportionately
divided into the land and building accounts. Whereas land is a non-
depreciating asset, building is not.
Improvements to real estate, such as landscaping, fencing, driveways etc.

are temporary hence they should be recorded in a separate account Land
Improvements which depreciates. These improvements are unlike Land
which is non-depreciating.
Freight and installation costs are included in the cost of Equipment.
Direct and Indirect Methods (formats) for the

Cash Flow Statement: (R 34)
In the “indirect method” for calculating cash flows, you start with Net
Income, add back non-cash expenses like Depreciation and Amortization,
subtract non-cash revenues (increase in Current Assets) etc.
In the “direct method” you add cash inflows and subtract cash outflows,
that is start with Sales and other cash inflows, then subtract cash outflows
etc. This is not the preferred method for firms as it requires more
information.
Example: SG and A would be an account title in a cash flow statement

prepared by the direct method but not in the indirect method for it has
already been taken out of Net Income (the starting point for the indirect
method)
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Cash Flow Statement Items: (R 34)

It is important to remember what the different items are in the Cash Flow
Statement. For the US GAAP:
Direct Method CFO = Sales - Increase in A/C Receivables – Increase in

Working Capital - COGS + Increase in A/C Payable – Increase in
Inventories – Operating Expenses – Increase in Prepaid Expenses +
Increase in Accrued Liabilities – Interest Paid on Debt + Interest Received
from Investments + Dividends Received from Equity Investments +
Increase in Interest Payable – Amortization of Bond Premium – Income
Tax + Increase in Income Tax Payable
Some intuitions for the above:

Increase in Inventories means that more purchases are being made, and
therefore more cash has to be paid.
Income Tax – Increase in Income Tax Payable = Cash Paid for Income
Tax
Increase in Prepaid Expenses is the extra cash paid for Prepaid Expenses
over the amount that is accounted in Expenses.
Note: If there is a Decrease in Accounts Payable, then the sign would flip
to a negative etc.
Indirect Method CFO = Net Income + Non-cash Expenses + Losses on Sale

of Assets – Increases in Non-Cash Current Assets + Increases in Current
Liabilities (except Notes Payable and Dividends Payable)
Some intuitions for the above:

Non-cash expenses like Depreciation and Amortization have to be added
back as no cash exits the firm to pay for these expenses
Losses on Sale of Assets would end up in CFI, but are present in NI. So to
get CFO starting from NI, we have to add this back.
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Increase in Current Liabilities means that the firm is not paying out
money it owes, so less cash is exiting the firm than what the NI would have
you believe, hence add back. However Notes Payable and Dividends
Payable are CFF items, not CFO.
CFI = - Capital Expenditures - Acquisitions
CFF = Long term Debt Issued - Long term Debt Repaid + Common Stock
Issued - Dividends Paid - Treasury Stock Repurchased
Increase in Cash and Equivalents = CFO + CFI + CFF
For IFRS, the firm has flexibility in classifying Dividends Paid, Interest
Paid, Dividends Received, and Interest Received (see table of differences
between GAAP and IFRS).
Free Cash Flow to Firm: (R 34)

FCFF = Net Income + NCC + Interest * (1 – T) – FCInv – WCInv
Where NCC = Non-cash charges such as depreciation and amortization, T

= Tax Rate, FCInv = Capital Expenditures, and WCInv = Working
Capital Expenditures
Equivalently, FCFF = CFO + Interest * (1 – T) – FCInv
Where CFO = Cash Flow from Operating Activities = Net Income + NCC -
WCInv
Example: An analyst has the following information for the firm Genmax
Corp ($ millions):
Cash Flow from Operating Activities $598
Interest Paid to Debt $210
Cash Paid for Purchase of Equipment $112
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Cash Received from Sale of Equipment $63
Cash Paid to Retire Long Term Debt $42
Cash Received from Issue of Long Term Debt $54
Cash Dividends Paid $14
Income tax rate is 36%
What is the FCFF of Genmax?
Answer: FCFF = $598 + $210 * (1 – 0.36) + $63 - $112 = $683.4
Money paid to retire or received from issue of long term debt does not
figure in CFO, it is counted in CFF. So it does not need to be subtracted
etc.
Free Cash Flow to Equity: (R 34)

Free cash flow to Equity (rather than the firm) takes out the cash flow to
debt.
FCFE = CFO – FCInv + Net Borrowing – Net Debt Repayment
Example: An analyst has the following information for the firm Genmax
Corp ($ millions):
Cash Flow from Operating Activities $598
Interest Paid to Debt $210
Cash Paid for Purchase of Equipment $112
Cash Received from Sale of Equipment $63
Cash Paid to Retire Long Term Debt $42
Cash Received from Issue of Long Term Debt $54
Cash Received from sale of Short Term Debt $18
Cash for Repayment of Short Term Debt $12
Cash Dividends Paid $14
Income tax rate is 36%
23
What is the FCFE of Genmax?
Answer: FCFE = $598 + $63 - $112 + $54 - $42 = $561
Money paid to retire or received from issue of long term debt does not
figure in CFO, it is counted in CFF. As net money from sale/repurchase of
long-term is not present in CFO, it has to be added separately.
Money paid to retire or received from issue of short term debt does figure
in CFO. So the net impact of issue/repurchase of short-term debt is
already present in CFO, and it does not have to be accounted for
separately.
One thing to note here is that money begin received from borrowing (debt)
or used in repayment of debt is being counted in FCFE. This is an
important manner in which FCFE conceptually differs from Net Income.
FCFE is just the cash that is available to equity owners, whether it is from
the firm making profits or from the firm borrowing money.
Common Size B/S, Income, and Cash Flow

Statements: (R 35)
A common-size balance sheet lists all balance sheet accounts as a
percentage of total assets.
A common-size income statement lists all income statement accounts as a

percentage of sales. Net Income is not suitable as a scale factor as it could
be small, negative or even zero.
A common-size cash-flow statements can either:

1) divide all cash flow items by net revenues
2) divide all cash inflows (outflows) by total inflows (outflows).
Cross Sectional and Trend Analysis: (R 35)
24
In cross-sectional analysis we compare a firm to other similar firms
(possibly same industry).
In trend analysis we compare the firm to itself across time, that is, we
analyze how the numbers for the firm (ratios etc.) are changing through
time.
Activity, liquidity, solvency, profitability, and

valuation, cash flow and other ratios: (Rs 33, 34,
35 etc.)
Current Ratio = Current Assets / Current Liabilities
Quick Ratio = (Cash + Marketable Securities + Receivables)/Current

Liabilities
Cash Ratio = (Cash + Marketable Securities)/Current Liabilities
Interest Coverage = (Net Income + Income Taxes + Interest Expense) /

Interest Expense
Debt Coverage = CFO / Total Debt
Times Interest Earned = EBIT / interest expense
Average Number of Days Payables Outstanding = 365 / Payable Turnover
Inventory Turnover = Cost of goods sold / Average Inventory
Average Inventory Processing Period = 365 * (Average Inventory/COGS)
Payable turnover = Annual purchases / Average Payables
25
Receivables Turnover Ratio = Net Sales / Average Receivables
Financial Leverage = Total Assets / Total Equity
Fixed-charge Coverage = earnings before fixed charges and taxes / fixed

charges
Cash conversion cycle = average collection period + average number of

days in stock - average age of payables
Defensive interval = 365 * (cash + marketable securities + accounts

receivable) / projected expenditures
Capital Expenditure Ratio = CFO / capital expenditures
Return on Total Capital = (Net Income + Gross Interest Expense)/Average

Total Capital
Return on Total Equity = Net Income / Average Total Equity
Return on Owner’s (common) Equity = (Net Income - Preferred Dividend/

Average Common Equity
Equity Turnover = Net Sales / Average Equity
Gross Profit Margin = Gross Profit / Net Sales
Net Profit Margin = Net Income / Net Sales
P/E = Price / Earnings
P/S = Price / Sales
P/BV = Price / Book Value
26
Dividend Payout Ratio = Dividends / Earnings
Retention Ratio = 1 – Dividend Payout Ratio

= (Earnings – Dividends) / Earnings
DuPont Equation: (R 35)

Different forms of the DuPont Equation
ROE = Net Profit Margin * (Sales/Total Assets) * (Total Assets / Equity)
= Return on Total Assets * (Total Assets / Equity)
The above follows from:
Net Profit Margin = Net Profit / Sales
and ROE = Net Profit / Equity
The DuPont Equation can be re-written as:
Net Profit Margin = ROE / ((Total Asset Turnover) * (Financial Leverage

Multiplier))
Where:
Total Asset Turnover = Sales / Total Assets
and Financial Leverage Multiplier = Total Assets / Equity
Example: A firm has Net Profit Margin of 3%, Sales to Total Assets Ratio
of 0.8, Total Assets to Equity of 5. What is its ROE?
Answer: ROE = 3% * 0.8 * 5 = 12%
27
Another form of the DuPont equation is:
ROE = (Net Profit / Pretax Profit) * (Pretax Profit / EBIT) * (EBIT / Sales)
* (Sales / Assets) * (Assets / Equity)
Inventories: (R 36)
Both US GAAP and IFRS value inventory by LCM (lower of cost or
market).
Firms that use LIFO are required to report LIFO Reserve by the US
GAAP, and this reserve is found in the footnotes.
Standards Convergence: (R 31, 37 etc.)

IASB and FASB have been working to bring about the convergence IFRS
and US GAAP.
Qualitative characteristics stressed by IAS for increasing usefulness of

financial statements: relevance (avoid unnecessary information);
predictive value (should aid in making decisions); faithful representation;
neutrality; and verifiability.
Differences between IFRS and US GAAP: (R 31,

37, 43 etc.)
In this section we will list the differences between International Financial
Reporting Standards (IFRS) and US GAAP:
LIFO is not permitted under IFRS, but permitted under US GAAP.
28
IFRS and U.S. GAAP differ significantly in the revaluation of fixed assets.
Impairment test for goodwill is a one step process in IFRS and a two step
process in US GAAP.
Impairment may be reversed under IFRS, but not under US GAAP. In

IFRS an impairment loss recognized in prior periods for an asset (other
than goodwill) can be reversed only if estimates used to determine the
asset’s recoverable amount have changed (since the last impairment loss
was recognized).
In US GAAP goodwill is tested for impairment on a reporting-unit

(business segment) level whereas in IFRS it is tested at the cash-generating
unit (CGU) or group of CGUs.
Upward revaluation of PP&E is not allowed in US GAAP, but allowed in

IFRS.
Reversal of inventory write-downs is not allowed in US GAAP, but allowed

in IFRS if certain conditions are met.
Dividends received by a firm from its investments are classified under

CFO in US GAAP, and either CFF or CFO under IFRS.
Dividends paid by a firm to its shareholders are classified under CFF in

US GAAP, and either CFF or CFO under IFRS.
Extraordinary items are allowed under US GAAP but not under IFRS.
Comprehensive income reporting is mandatory under US GAAP, but

optional under IFRS.
For long term investments in other firms, the need for consolidation is
determined by voting control in IFRS and voting and economic control in
US GAAP.
29
A liquidity based balance sheet would normally be used by a financial
institution under IFRS.
Issue US GAAP IFRS

LIFO Allowed Not Allowed
B/S for financial Normally liquidity
institution based
Impairment Not reversible Reversible
Goodwill Impairment Tested on “reporting Tested on “cash-
unit” generating unit”
Goodwill Impairment Two-step process One-step process
Upward Revaluation of Not allowed Allowed
PP&E
Reversal of Inventory Not Allowed Allowed
Write-downs
Extraordinary Items Allowed Not Allowed
Comprehensive Income Mandatory Optional
Reporting
Consolidation of Long- Voting and Economic Voting Control
term Investments Control
LCM Write-downs Aggregates for similar
items not allowed
Dividends Paid CFF CFF or CFO
Dividends Received CFO CFI or CFO
Interest Paid CFO CFF or CFO
Interest Received CFO CFI or CFO
Tax Cash Flows Must be disclosed
separately
Interest and Taxes Paid Disclosed either in
Cash Flow Statement
or footnotes
30
Value of Asset Historical Cost Historical Cost or
Fair Value
End of Chapter Questions

Do the following end of chapter questions and answers in the curriculum
books. Answers are provided in the curriculum books. If you are short of
time, try to at least read the questions and answers.
R 29: 1, 2, 4, 5, 6, 8
R 30: 2 to 4, 6, 7, 9 to 13, 15 to 20
R 31: 1, 4 to 15
R 32: 1 to 13, 16 to 20
R 33: 3 to 6, 9 to 18, 20 to 24
R 34: 4 to 18, 20 to 23
R 35: 2, 4 to 19
R 36: 1 to 19, 21
31

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com June 2010

Financial Statements: (R 29)

There is a fourth financial statement, the Statement of Owners' Equity,

Financial statements also have Financial Notes and Supplementary

Outlook based on known trends and disclosures about contractual

In most countries it is legally necessary for firms (especially those who

Most firms provide an “annual report” to their shareholders (though it is

The Accounting Equation: (R 30)

Assets = Liabilities + Contributed Capital + Beginning Retained Earnings

Retained Earnings = Beginning Retained Earnings + (Revenue – Expenses

Statement of Owner’s Equity: (R 30)

The “Statement of Owners' Equity” has Beginning Retained Earnings, Net

Items such as “Treasury Stock Repurchase” and “Additional Paid in

Management Discussion and Analysis (MD&A)

It is optional (not binding) for management to discuss forward-looking

International Financial Reporting Standards

Convergence and the Framework: (R 31)

The Framework for the Preparation and Presentation of Financial

Income Statement Formats: (R 32)

Revenue Recognition: (R 32)

The FASB requires that revenue be recognized when “realized or

The different methods of revenue recognition are:

A) Sales-basis recognizes revenues when a sale is made. If the payment is

Under the percentage-of-completion method accounts billed to customers

Under the percentage-of-completion method costs incurred are

When using the Percentage-of-Completion if estimates of revenue or costs

C) Also for a contract stretching over multiple accounting periods,

The Completed Contract Method is generally used when no contract

The Completed Contract Method is recommended for short term projects.

The percentage-of-completion method provides better information about

F) Installment sales method recognizes as profits the percentage of total

Year 1 Year 2 Year 3 Year 4

Percentage of completion recognizes the revenue earlier than completed

Expense Recognition: (R 32)

IAS and US GAAP differ in their treatment of “Extraordinary Items”,

If there is a change in accounting standards (for example due to some

If a firm makes a change in an “accounting estimate” (for example the life

Basic EPS = (Net Income – Preferred Dividends) / Number of shares

The number of shares in the above equation do not include preferred

Stock dividends, splits, and issues

Answer: Number of shares = Initial number + Number issued on March 1

Example: A firm had 2 million shares of common stock outstanding on Jan

Answer: Number of shares outstanding = Number of shares on Jan 1 +

EPS = (Net Income - Dividends to Preferred) / # of shares outstanding

Convertible securities may be dilutive or antidilutive. If the conversion

In the calculation of fully diluted EPS, the antidilutive securities are

Example: An analyst has the following information about a firm:

B/S at Dec 31, 20X5

Notes and Assumptions

Answer: 500,000 preferred stocks convert to 200,000 common stock.

Example: An analyst has the following information about a firm:

B/S at Dec 31, 20X5

Notes and Assumptions

Answer: The bonds will convert to 3,000 * 100 = 300,000 shares.

The interest paid on the debt = $3,000,000 * 7% = $210,000

On an after-tax basis the interest savings to the firm from conversion of

Diluted EPS = $5.126M / 3.3M = $1.55

Example: An analyst has the following information about a firm:

B/S at Dec 31, 20X5

So adjusted denominator for diluted EPS = 3M + 1M – 0.625M = 3.375M

Diluted EPS = $10M / 3.375M = $2.96