Section 1

1. Financial statements – refresher

a. Balance sheet
The balance sheet is a picture of the company at a point in time
- Financial situation (what the company owns and owes)
- Asset = Liabilities + Shareholders’ equity
o Assets are classified in function of their liquidity
o Assets are separated between current and non-current assets
- Liabilities are separated between current and non-current liabilities
o Liabilities are classified in function of their maturity
- Current assets – Current liabilities = Working capital
o The level of working capital provides information about the ability of an entity to
meet liabilities as they fall due

b. Income statement,
- Financial result of the company over an entire period
- Revenues + Other income – Expenses – Other expense = Net Income
- Expenses may be grouped together either by their nature or function
o Example of grouping by nature: grouping depreciation on manufacturing
equipment and depreciation on administrative facilities into a single line item
called “depreciation”
o Example of grouping by function: cost of goods sold, which may include labour
and material costs, depreciation, and some other salaries.
Gross profit = Revenue – Cost of sales
- Operating profit (or EBIT) = Gross profit – Operating expenses (e.g., SG&A, R&D)

c. Cash-flow statement
- Focus on inflows and outflows of cash
- Three categories: operating, investing, financing
- Explains the cash variation over a given period of time
- Some differences in cash flow statements prepared under IFRS and US GAAP
- The operating cash flow can be reported with either the direct or the indirectmethod
o the indirect method starts with net income and makes adjustments
o the direct method shows the specific cash inflows and outflows

2. A crucial accounting
a. Income measurement – key concepts
- Revenues are recorded (recognized) when earned:
- when the seller has performed a service or conveyed an asset to the buyer which
entitles the seller to the benefits represented by the revenues, and the value to be
received for that service or asset is reasonably assured and can be measured with a
high degree of reliability.
- Expenses are recorded when incurred:
o expired costs or assets that are used up in producing those produce revenues.
o expense recognition is tied to revenue recognition – commonly referred to as the
“matching principle”
o expenses are recorded in the same accounting period in which the related
revenues are recognized.

b. Cash flow versus crural income measurement

- Accrual accounting decouples measured earnings (i.e., revenues minus expenses)
from the amount of cash generated from operations.
 o Accrual accounting revenues generally do not correspond to cash receipts for the
period, nor do accrual expenses always correspond to cash outlays for the
period.
o Accrual accounting can produce large discrepancies between measured earnings
and the amount of cash generated from operations (cash-basis earnings).
- Accrual accounting better matches economic benefit with economic effort
o More realistic picture of past economic activities.

3. Sources of capital
a. Financial options

b. Introduction to capital
- Raising capital is a fundamental business activity.
- Working capital management: the management of short-term assets and liabilities
o To ensure that the firm has adequate and quick access to the funds necessary for
day-to-day operations, while at the same time making sure that the company’s
assets are invested in the most productive way.
- Other debt and equity obligations used to finance the business longer term are
considered part of the firm’s capital structure.
- Goal of capital structure management: balance the risks and costs of the firm’s long-
term finances.

c. Internal financing
- Companies can generate internal financing and liquidity from shorter- term operating
activities in several ways:
o generating more after-tax operating cash flow
o increasing working capital efficiency, such as extending company’s payables
period, reducing its receivables period, or shortening its asset conversion cycle
o converting liquid assets such as receivables, inventories, and marketable
securities to cash

d. External financing
- Businesses are generally financed longer term using a combination of debt and
equity securities.
 - However, there are key differences between debt and equity obligations:
o Legal agreement (contractual obligation to debtholders)
o Claim priority (interest and principal payments have priority)
o Distributions (contractual, periodic payments to debtholders)
o Taxation (interests are tax-deductible expenses)
o Term (stated term to maturity for debt)
o Voting rights (no voting rights for debt)
o Cost to company (debt has lower cost in general)
o Investor risk (debt is generally less risky)

e. Financing choices
- Depend on the nature of the firm’s needs and business, the general economic
environment, and market conditions.
- Major firm-specific factors influencing financing choices:
o Size, Riskiness of assets, Assets for collateral, Public vs private equity, Currency
risk, Bankruptcy and agency costs
- Major economic factors:
o Taxation, Inflation, Government policy, Monetary policy

4. Revenue recognition
a. Revenue recognition principles
- Similar across US GAAP and IFRS (IFRS 15 and ASC Topic 606)
- Income definition (IASB):
Income is increases in economic benefits during the accounting period in the form of
inflows or enhancements of assets or decreases of liabilities that result in increases
in equity, other than those relating to contributions from equity participants.
- Gains and losses arise from peripheral activities rather than from core business.
o Ex.: Sale of surplus restaurant equipment for more than its carrying value.
o Gains and losses may be considered as operating activities (e.g., a loss due to a
decline in inventory value) or as non-operating activities (e.g., the sale of non-
trading investments)

b. The five step revenue recognition model

- The revenue recognition model provides a five-step method for evaluating contracts
with customers to determine when revenue may be recognized.
- The five steps:
1. Identify the contract(s) with a customer.
2. Identify the distinct performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations in the contract.
5. Recognize revenue when (or as) the entity satisfies a performance obligation

c. Identify the contract with the customer

- All of the following conditions must be met for a firm to account for a contract with a
customer:
o All parties to the contract have approved the contract and are legally obligated to
perform their obligations under the contract.
o Each party’s rights regarding the goods or services being exchanged can be
identified.
o Payment terms can be identified.
o The contract has commercial substance.
o Collection is probable.

d. Recognise revenue when (or as), the entity satisfies a performance obligation
 - A performance obligation is considered satisfied when control over the goods and
services that comprise the performance obligation is transferred to the customer.
Control has transferred when:
o The customer has a legal obligation to pay the firm.
o The customer has physical possession (in the case of goods).
o The customer is subject to the risks and rewards generally associated with
ownership.
o The customer has indicated its acceptance of the goods and services.
- Percentage-of-completion calls for recognition of revenue on long- term construction
contracts as work is completed (rather than at conclusion of the work):
o Revenue can be recognized over time as a performance obligation is satisfied if
any of the following criteria is met:
o The customer simultaneously receives and consumes the goods and services
provided by the firm as it satisfies its performance obligation.
o The firm’s performance creates or enhances an asset under the customer’s
control.
o The firm’s performance does not create an asset with an alternative use.

e. Gift cards
- Gift cards represent a particular type of prepayment.
- Amounts received for the purchase of gift cards are not recognized as revenue when
the cards are sold.
- A portion of gift card balances will go unused; the unused portion is referred to as
“breakage.”
o Estimated breakage may be recognized as revenue in proportion to the usage of
the gift cards.
o However, breakage can be recognized only to the extent that it is probable a
reversal will not be necessary.

5. Receivables
a. Account receivable
- Accounts receivable are generally reflected in the balance sheet at net realizable
value.
- Two things must be estimated to determine the net realizable value of receivables:
- Credit losses—the amount that will not be collected because customers are unable
to pay.
- Returns and allowances—the amount that will not be collected because customers
return the merchandise for credit or are allowed a reduction in the amount owed

b. Approaches to estimating uncollectible accounts

- Sales Revenue Approach
o Estimate the bad debt provision as a percentage of sales.
DR Credit loss expense X
CR Allowance for credit losses X
- Gross Receivables Approach
o Estimate the required allowance account balance as a percentage of gross
receivables and then adjust the allowance to this figure.
DR Credit loss expense X
CR Allowance for credit losses X

c. Writing off credit losses

- When a specific account receivable is known to be definitely uncollectible, the
amount must be removed from the books:
DR Allowance for credit losses X
 CR Accounts receivable – Ralph Company X
- Notice that the entry has no effect on income:
o The specific account receivable (Ralph Company) is eliminated from the books
and the allowance contra-account is reduced, but no credit loss expense is
recorded.
o This is consistent with the accrual accounting philosophy of recording estimated
uncollectibles when the sale is made rather than at a later date when the
nonpayment is identified.

d. Existing receivables represents real sales ?

- Generally, the growth rates in sales and in accounts receivable should be roughly
equal.
- Receivables might grow faster than sales for the following reasons:
- Deliberate change in ( loosening of) sales terms to attract new customers.
- Deteriorating credit worthiness among existing customers.
- Firm has changed its financial reporting procedures, which determine when sales are
recognized (that is, accelerated revenue
- recognition).
- Large increases in accounts receivable relative to sales frequently represent a
danger signal

e. Sale of receivables and collateralized borrowing

- Companies might want to accelerate cash collection for the following reasons:
- Competitive conditions require credit sales but the company is unwilling to bear the
cost of processing and collecting receivables.
- There may be an imbalance between the credit terms of the
- company’s suppliers and the time required to collect customer receivables.
- The company may have an immediate need for cash but be short of it.

f. Factorising receivables
- Pros of factoring receivables:
o Immediate cash
o No need of significant assets as collateral (invoices are the collaterals)
o Available to any size business
- Cons of factoring receivables:
o Only solves the issue of limited cash flow due to slow-paying clients
o More costly than usual credit lines (1-4% per month)
o Financial institution may contact your customers (reputation)

6. Inventories
a. Inventory accounts
b. Inventory issues

c. Perpetual inventory system

- Two different methods for determining inventory quantities: perpetual and periodic.
- A perpetual inventory system keeps a running (or “perpetual”) record of the amount
of inventory on hand.
- Usually, inventory records are maintained in both physical units and dollars.

d. Costs included in inventory

- All costs required to obtain physical possession of the inventory and to make it
saleable.
o Purchase cost
o Sales taxes and transportation paid by the buyer
o Insurance costs
o Storage costs
 o Production costs (for a manufacturer) that are included in making a finished
salable product
- In principle, inventory costs should also include the costs of the purchasing
department and other general and administrative costs associated with the
acquisition and distribution of inventory.
e. GAAP and cost flow assumptions
- Types of cost flow assumptions allowed by GAAP:
o First-in, first-out; Last-in, first-out ; Weighted average cost; Specific identification
- GAAP does not require the cost flow assumption to conform to the actual physical
flow of the goods.
- Different cost flow assumptions can be used for different types of inventory.
- GAAP requires all firms to disclose their inventory cost flow assumptions and
methods in their notes (usually in the significant accounting policies or inventory
notes).

f. Inventory impairment
- When market prices drop below the inventory’s original cost, GAAP requires firms to
use the lower of cost or net realizable value (LCNRV) method.
- The lower of cost or net realizable value method can be applied to:
o Individual inventory items
o Classes of inventory
o The inventory as a whole
- Net realizable value equals the estimated selling price of the inventory in the ordinary
course of business less the reasonably predictable costs of completing, disposing of,
and transporting the inventory.

g. Inventories with IFRS

- Much of the IFRS guidelines for inventory are similar to U.S. GAAP . However, there
are important nuances:
o IAS 2 does not permit the use of LIFO.
o IAS 2 allows inventory reductions to be reversed if the market recovers, but the
inventory carrying amount cannot exceed the original cost.
o Under U.S. GAAP, once the carrying value of an item is reduced, it cannot be
increased to its original cost.

7. Long live assets

a. Long live assets
- Long-lived assets: Assets expected to yield their economic benefits (or service
potential) over a period longer than one year.
- Long-lived assets may be tangible, intangible, or financial assets.
- The initial balance sheet carrying amount of a long-lived asset is governed by two
rules:
o All costs necessary to acquire the asset and make it ready for use are included in
the asset account (capitalized costs).
o Joint costs incurred in acquiring more than one asset are apportioned among the
acquired assets.

b. Intangible assets
- Intangible assets are long-lived assets that do not have physical substance.
- The category includes the following types of assets:
o Patents, Copyrights, Trademarks, Brand names, Customer lists, Licenses,
Technology, Franchises…
- The accounting for acquired intangible assets is straight-forward:
o The acquired intangible asset is first recorded at the transaction price.
 o Most acquired intangible assets are amortized (depreciated) on a straight- line
basis over their expected useful economic lives and reviewed for impairment.
o Some intangible assets, known as indefinite-lived intangible assets, have
indefinite lives and are not amortized. Instead, they are evaluated annually for
impairment.

c. R&D definitions
- Research: “original and planned investigation undertaken with the prospect of
gaining new scientific or technical knowledge and understanding.
o The “research phase of an internal project” refers to the period during which a
company cannot demonstrate that an intangible asset is being created (e.g., the
search for alternative materials or systems to use in a production process).
- Development: “the application of research findings or other knowledge to a plan or
design for the production of new or substantially improved materials, devices,
products, processes, systems or services before the start of commercial production
or use.

d. Depreciation
- The costs of productive assets must be apportioned to the periods in which they
provide benefits.
- The cost to be allocated to periods is the asset’s original historical cost minus its
expected salvage value.
- Computing depreciation requires the reporting entity to estimate three things:
o The expected useful life (in years or units) of the asset.
o The depreciation pattern that will reflect the asset’s declining service potential.
o The expected salvage value that will exist at the time the asset is retired.

e. Disposition of long lived assets

- When individual long-lived assets are disposed of before their useful lives are
completed, any difference between the net book value of the asset and the
disposition proceeds is treated as a gain or loss.
o Gain (loss) = Disposition proceeds – Book Value
o Gain (loss) = Disposition proceeds – (Cost – Accumulated Depreciation)
- Ex.: An asset is being depreciated using the accelerated method and is sold at the
end of Year 2 for $5,000 when its book value is $3,780 (historical cost = $10,500,
accum. depr. = $ 6,720).
- The entry to record the disposition removes the asset and its accumulated
deprecation from the books

f. Comparison of IFRS and GAAP long lived asset accounting

IFRS allows more choice in valuation models and has different specific guidance for
issues such as depreciation and impairments.
Tangible Long-Lived Assets:
- IAS 16 allows two different models for tangible long-lived assets:
o Cost Method (same as U.S. GAAP)
o Revaluation Method: Asset is carried at a revalued amount reflecting fair market
value at the revaluation date.
> Subsequent depreciation is based on fair value, not original cost.
> The amount of the write-up is credited to an owners’ equity account called
Revaluation Surplus (equivalent to Accumulated other comprehensive
income)
8. Long-term debt
a. Overview of liabilities
 - Liabilities are defined as probable future sacrifices of economic benefits arising from
present obligations of a particular entity to transfer assets or to provide services to
other entities in the future as a result of past transactions or events.
- This means a financial statement liability is:
o An existing obligation arising from past events, which calls for payment of cash,
delivery of goods, or provision of goods and services to some other entity at
some future date.

b. Bonds terminology
- A bond is a financial instrument that represents a formal promise to repay both the
amount borrowed as well as the interest on the amount borrowed.
o Debentures, the most common type of corporate bond, are backed only by the
company’s general credit.
o Secured bonds are backed by collateral.
o Mortgage bonds use real estate as collateral for repayment of the loan.
o Serial bonds require periodic payment of interest and a portion of the principal
(for example, an equal amount each year to maturity).

c. Bonds key feature

- Face value: the amount of cash payable by the company to the bondholders when
the bonds mature.
- Coupon rate: the interest rate promised in the contract (used to calculate the periodic
interest payments)
- Market rate: the rate demanded by purchasers of the bonds given the risks
associated with future cash payment obligations of the particular bond issue.
- Effective rate: the market rate at the time of issuance that the company incurs on the
debt. It is the discount rate that equates the present value of the two types of
promised future cash payments to their selling price.
- If MR>CR: bond issued at a discount. If MR<CR: bond issued at a premium.

d. Accounting for bonds

- Most companies report the historical cost (sales proceeds) of the bonds after
issuance, and amortize any discount or premium over the life of the bond.
o The rationale for reporting the bonds at amortized historical cost is the company’s
intention to retain the debt until it matures.
o For the company, changes in the underlying economic value of the debt are not
relevant
- The amount reported on the balance sheet for bonds is thus the historical cost plus
or minus the cumulative amortization, which is referred to as amortized cost.
- Companies also have the option to report the bonds at their current fair values.
- The amount at which bonds are reported on the company’s balance sheet is referred
to as the carrying amount, carrying value, book value, or net book value.
- If the bonds are issued at par, the initial carrying amount will be identical to the face
value:
o Periodic interest expense = Periodic interest payment to bondholders.
- If the market rate differs from the coupon, the premium or discount is amortized over
the life of the bonds as a component of interest expense.
o For bonds issued at a premium: the carrying amount of the bonds is initially
greater than the face value. As the premium is amortized, the carrying amount of
the bonds will decrease to the face value.
Reported interest expense < coupon payment
o For bonds issued at a discount: the carrying amount of the bonds is initially less
than the face value. As the discount is amortized, the carrying amount of the
bonds will increase to the face value.
Reported interest expense > coupon payment
 - The accounting treatment for bonds issued at a discount (premium) reflects the fact
that the company essentially paid (received a reduction) some of its borrowing costs
at issuance by selling its bonds at a discount (premium).
o Rather than there being an actual (reduced) cash transfer in the future, this
“payment” (reduction) was made in the form of accepting less (receiving more)
than the face value for the bonds at the date of issuance.
o The total interest expense reflects both components of the borrowing cost: the
periodic interest payments plus the amortization of the discount.
When the bonds mature: carrying amount = face value for bonds issued at face value, a
discount, or a premium.

e. Amortising the premium / discount

- Two methods for amortizing premiums and discounts:
o the effective interest rate method  required under IFRS
> applies the market rate in effect when the bonds were issued to the current
carrying amount of the bonds to obtain interest expense for the period.
> the difference between the interest expense (based on the effective interest
rate and amortized cost) and the interest payment (based on the coupon rate
and face value) is the amortization of the discount or premium.
o the straight-line method  preferred under US GAAP (better reflects the
economic substance of the transaction)
> evenly amortizes the premium or discount over the life of the bond

f. Bonds at fair value

- The amortized historical costs reflects the market rate at issuance.
- As market interest rates change, the bonds’ carrying amount diverges from the
bonds’ fair market value.
- When market interest rates decline (increase), the fair value of a bond with a fixed
coupon rate increases (decreases).
o Consequently, a company’s economic liabilities may be higher (lower) than its
reported debt based on amortized historical cost.
o Using financial statement amounts based on amortized cost may underestimate
leverage ratios.
- Companies have the option to report financial liabilities at fair value.
- IFRS and US GAAP require fair value disclosures in the financial statements unless
the carrying amount approximates fair value or the fair value cannot be reliably
measured.
- A firm reporting a liability at fair value will report decreases in the liability’s fair value
as income and increases as [Link]
- It is mostly firms in the financial sector that report using bonds fair value (they
already report financial investments and derivatives at fair value).

g. Derecognition of debt
- Once bonds are issued, a company may:
o keep the bonds outstanding until maturity
o redeem the bonds before maturity either by calling them (if call provision) or by
purchasing them in the open market
- If a company decides to redeem bonds before maturity:
o the bonds payable account is reduced by the carrying amount of the redeemed
bonds.
o the difference between the cash required to redeem the bonds and the carrying
amount of the bonds is a gain or loss on the extinguishment of debt.

h. Callable Bond
 - A callable bond is a bond that the issuer may redeem before maturity.
- Allows the issuing company to pay off their debt early.
- A bond may be called if market interest rates move lower, allowing the company to
re-borrow at a better rate.
- Callable bonds typically offer a more attractive interest rate or coupon rate to
compensate for their callable nature.

i. Debt covenants
- Borrowing agreements often include restrictions called covenants
o protect creditors by restricting activities of the borrower.
o benefit borrowers as they lower the risk to the creditors
- Affirmative covenants: restrict the borrower’s activities by requiring certain actions.
o Ex.: covenants may require to maintain certain ratios above a specific level or
perform regular maintenance on real assets used as collateral.
- Negative covenants: require that the borrower not take certain actions.
o Ex.: restrict the borrower’s ability to invest, pay dividends, or make other
operating and strategic decisions that might adversely affect the company’s ability
to pay interest and principal.
- A covenant violation is a breach of contract.
o Potential consequences: penalty payment, , increase interest rate, renegotiation,
call for repayment.

9. Financial reporting quality

a. Introduction
- Ideally, financial reports should be based on sound financial reporting standards, and
free from manipulation.
- In practice, the quality of financial reports can vary greatly.
- High-quality financial reporting provides information that is useful in assessing a
company’s performance and prospects.
- Low-quality financial reporting contains inaccurate, misleading, or incomplete
information.

b. Unusual or in frequently occurring items

- Unusual or infrequently occurring items
- Gains and losses (usually losses) that arise from a firm’s continuing operations, but
that are not typical, recurring costs.
- Reported as separate line items in the continuing operations section of the income
statement.
- Examples:
o Write-downs or write-offs of receivables, inventory, equipment leased to others,
and intangibles
o Gains or losses from the exchange or translation of foreign currencies
o Gains or losses from the sale or abandonment of property, plant or equipment
o Special one-time charges from corporate restructurings
o Gains or losses from the sale of investments
o Losses from floods, fires, or other disasters

c. Discontinued operations
- Transactions related to certain operations the firm intends to discontinue or has
already discontinued are separated from other income statement items.
- Discontinued operations will not generate future operating cash flows.
- Classification on income statement:
o The operating results of discontinued operations are excluded from continuing
operations in the current period when the decision to discontinue was made.
 o In addition, they are excluded from continuing operations in any prior years for
which comparative data are provided.
o Net income for those prior years are the same as originally reported; the amounts
removed from continuing operations are reclassified to discontinued operations.

d. Earnings management
- Making intentional choices that create biased financial reports.
- Earnings management represents “deliberate actions to influence reported earnings
and their interpretation” (Ronen and Yaari, 2008).
- Earnings can be “managed” upward (increased) by taking real actions, such as
- deferring research and development (R&D) expenses into the next reporting period.
o They can be increased by accounting choices, such as changing accounting
estimates.
o Ex.: the amount of estimated product returns, bad debt expense, or asset
impairment could be decreased to create higher earnings.

Section 2

1. Cost functions estimation

a. Major cost, classifications schemes
- Direct and indirect costs:
o With respect to a cost object
- Variable, fixed and mixed costs:
o In function of activity
- Product and period costs:
o Product costs are inventoriable (e.g., direct materials, direct labour,
manufacturing overhead)
o Period costs are expensed as incurred

b. Determining cost functions and cost behaviour

- A cost function takes the following form: Y = a + bX
- To approximate a firm’s cost function, we will use two methods:
o High-low method
> Simple / easy to use / rough approximation
o Regression analysis
> More sophisticated / statistical approach

2. CVP analysis
a. Introduction
- A key metric tracked by airline companies is the break-even load factor:
o Percentage of seats that must be sold to achieve a profit of 0.
- For a quick glimpse of how well an airline is doing, we can compare the actual load
factor (percentage of seats actually sold) to the break-even load factor!
- Which elements may affect the break-even load factor?
o The level of fixed costs (aircraft maintenance, insurance, depreciation, the wages
of administrative staff, etc..)
o The average price per ticket the airline is able to charge its customers.
o The variable costs incurred for each flight (fuel expense, complimentary on-
board drinks and snacks, newspapers, and charges related to processing each
ticket sold).

b. Contribution margin
 - The Contribution Margin (CM) is the amount remaining from sales revenue after
variable expenses have been deducted.
- It can be represented in monetary or percentage terms:
CM = Sales – VC
CMR = CM / Sales
- To estimate the impact on profit of a given change in sales level, it is useful to
present the income statement using the contribution margin format.
- This format emphasizes cost behaviours and therefore is extremely helpful to
managers who need to evaluate the impact on profits of changes in selling price,
cost, or volume.

c. Breakeven point
- • BEP is the level of sales (volume of sales, quantity or turnover) at which the profit is
equal to zero at BEP: Profit = Total Revenues - Total Expenses = 0
- BEP is the point when the total sales revenue (turnover) equals total expenses
(variable costs + fixed costs) at BEP: Total Revenues = Total Expenses
- The point where total contribution margin equals total fixed expenses at BEP:
Contribution Margin = Fixed Expenses

d. CVP graphical analysis

- Relationships between revenue, cost, volume and profit can be expressed
graphically by preparing a cost-volume-profit (CVP) graph.
- In a CVP graph (sometimes called a break-even chart), unit volume is commonly
represented on the horizontal x-axis and dollar values on the vertical y-axis.
- Preparing a CVP graph involves three steps:
1. Plot the line parallel to the volume axis that represents total fixed expenses.
2. Plot the line representing total expenses (fixed plus variable) at various activity
levels.
3. Plot the line representing total sales dollars at various activity levels.

e. Leverage
- Leverage is created using fixed costs in a company.
- Fixed costs that are operating costs (e.g., depreciation or rent) create operating
leverage. Fixed costs that are financial costs (e.g., interest expense) create financial
leverage.
- Firms often have some latitude in trading off between fixed and variable costs.
o E.g., fixed investments in automated equipment can reduce variable labour costs.
- Which cost structure is better—high variable costs and low fixed costs, or the
opposite?
o No single answer to this question is correct: either structure has its advantages.

f. Understanding the firms use of leverage

- Analysts need to understand a company’s use of leverage because:
o The degree of leverage is an important component in assessing a company’s risk
and return characteristics.
o It may help discern information about a company’s business and future prospects
from management’s decisions about the use of operating and financial leverage.
o The valuation of a company requires forecasting future cash flows and assessing
the risk associated with those cash flows

g. Operating leverage
- The operating leverage helps managers calculate the incidence of sales variations
on operating income.
- Firms with a higher proportion of fixed costs compared to variable costs are said to
have high operating leverage.
 Operating leverage = Contribution margin / Operating profit
= [Q * (P-VCu)] / [Q * (P-VCu) – FC]
- The concept of operating leverage is based on the idea that sales will increase or
decrease without any changes in the cost structure. Is it realistic?
- If a company is near its break-even point, then even small percentage increases in
sales can yield large percentage increases in profits.
o Explains why management often work very hard for only small increases in sales
volume.
o If OL=5, a 2% increase in sales translates into a 10% increase in profits!
- Both sales risk and operating risk influence a company’s business risk.
- Both sales risk and operating risk are determined in large part by the type of
business the company is in.
- However, management has more opportunity to manage and control operating risk
than sales risk.
- Example: A company is deciding which equipment to buy to produce a particular
product. The sales risk is the same no matter what equipment is chosen to produce
the product. But the available equipment may differ in terms of the fixed and variable
operating costs of producing the product. Financial analysts need to consider how
the operating cost structure of a company affects the company’s risk.

Section 3

1. The financial analysis process, tools, and techniques

a. The financial analysis, process, tools, and techniques
- Variety of reasons for performing financial analysis
- Important to know where to find relevant data, how to process and analyze the data
- Various steps:
o Determine the purpose of the analysis
o Collect data
o Process data
o Analyze and interpret the data
o Develop conclusions

b. Ratio Analysis
- Ratios are a useful way of expressing relationships:
o Among financial accounts
o From one point in time to another
- Financial statement ratios are effective in selecting investments and in
- predicting financial distress
- The ratio is not the answer, it is an indicator of some aspect of a company’s
performance
o Tells what happened but not why it happened
- Formulas and even names of ratios often differ from one source to the other.

c. Common size balance sheets and income statements

- Common-size analysis: expressing financial data, including entire financial
statements, in relation to a single financial statement item.
o Items used most frequently as the bases are total assets or revenue.
o Creates a ratio between every financial statement item and the base item.
- Vertical common-size balance sheet highlights the mix of assets.
- Horizontal common-size balance sheet computes the increase/decrease in % of
each balance sheet item from the prior year
 - Vertical common-size income statement divides each income statement item by
revenue
2. Financial Ratios
a. Ratio Categories
- Activity ratios: measure how efficiently a company performs day-to-day tasks (e.g.,
collection of receivables, management of inventory).
- Liquidity ratios: measure the company’s ability to meet its short-term obligations.
- Solvency ratios: measure a company’s ability to meet long-term obligations. Subsets
of these ratios are also known as “leverage” and “long-term debt” ratios.
- Profitability ratios: measure the company’s ability to generate profits from its
resources (assets).
- Valuation ratios: measure the quantity of an asset or flow (e.g., earnings) associated
with ownership of a specified claim (e.g., a share or ownership of the enterprise).

b. Accounting for context

Ratios should be compared and put in context of:
- Company goals and strategy
- Industry norms
o Companies may have several lines of business
o Companies may use different accounting standards
o Different business strategies
- Economic conditions
o Cyclical companies see their ratios improve in a strong economic context (and
vice versa)

3. Activity Ratios
a. Also known as asset utilization ratios or operating efficiency ratios.
- Measure how assets are efficiently managed:
o For working capital
o For long-term assets
o Sometimes also useful in assessing liquidity

b. Inventory, turnover, and DOH

- Indicates the resources tied up in inventory
o Can be used to indicate inventory management effectiveness
- A higher inventory turnover ratio implies a shorter period that inventory is held, and
thus a lower DOH.
- A high inventory turnover ratio relative to industry norms might indicate:
o An effective inventory management
 o Or that the company does not carry adequate inventory, so shortage could hurt
revenue
o Need to compare revenue growth with the industry
 Slower growth with higher inventory turnover could indicate inadequate
inventory levels
 Revenue growth above the industry’s average might mean that higher
turnover reflects greater inventory management efficiency

c. Receivables turnover and DSO

- The number of DSO = time between a sale and cash collection
o reflects how fast the company collects cash from customers to whom it offers
credit
- A high receivables turnover ratio (and low DSO) might indicate:
o Highly efficient credit and collection
o Or, that the company’s credit/collection policies are too strict, which might lead to
loss of sales being due to competitors offering more lenient terms
- Low receivables turnover ratio raises questions about the efficiency of the company’s
credit and collections policies.
- Comparing the firm’s sales growth to the industry can help assess whether sales are
being lost due to stringent credit policies.

d. Payable turnover and number of days payables

- Number of days of payables: the average number of days the company takes to pay
its suppliers.
- Payables turnover: how many times per year the company theoretically pays off its
creditors.
- Assumption: all purchases made on credit
- If purchases not directly available: COGS + Change in inventory = Purchases
- High payables turnover might mean that:
o the company is not making full use of available credit facilities
o the company is taking advantage of early payment discounts
- A very low turnover ratio (high days payable) could indicate:
o trouble making payments on time (need to check also for liquidity)
o exploitation of lenient supplier terms

e. Fixed asset turnover and total assets turnover

- Measure how efficiently the company generates revenues from its investments in
(fixed) assets.
- A higher (fixed) asset turnover ratio indicates more efficient use of (fixed) assets in
generating revenue.
- A low ratio can indicate inefficiency, a capital-intensive business environment, or a
new business not yet operating at full capacity.
o Can reflect strategic decisions (being labor-intensive vs capital-intensive)
- The (fixed) asset turnover ratio would be lower for a company whose assets are
newer (less depreciated).
- Fixed and total assets turnover at Dell:
o TA turnover = 101,197 / 108,075 = 0.94
o FA turnover = 101,197 / 5,124 = 19.75
4. Liquidity ratios
a.  Ability to meet short-term obligations:
- how quickly assets are converted into cash.
- ability to pay off short-term obligations.
 b. Liquidity ratios
Current ratio (CA/CL)
- A high current ratio (>1) indicates higher levels of liquidity.
- A low current ratio (<1) indicates lower liquidity and greater reliance on outside
financing and operating cash flows to meet short-term obligations.
- The current ratio implies that inventories and receivables can be quickly turned into
cash.
Quick ratio ((CA-INV)/CL)
- The quick ratio is more conservative as it only includes very liquid assets.
- Reflects the fact that in some companies, the inventory might not be easily converted
into cash (and also that the firm would not be able to sell it at its carrying value in
emergency)
Cash ratio (CASH/CL)
- Even more conservative. Reliable measure of liquidity in a crisis period.

c. Cash conversion cycle

- Time between when the firm invests in WC and it collects cash.
- Normal cycle:
o Purchase inventory on credit  sell it on credit  pay suppliers  collect
o cash from clients
- A shorter cash conversion cycle indicates:
o greater liquidity
o that the company only needs to finance its inventory and accounts receivable for
a short period of time.
- A longer cash conversion cycle indicates:
o lower liquidity
o that the company must finance its inventory and accounts receivable for a longer
period of time (potential need for a higher level of capital to fund current assets)

5. Solvability Ratios
a. Solvability/Solvency refers to a company’s ability to fulfill its long-term debt obligations
- Solvency ratios provide information about:
o the proportion of debt in the company’s capital structure
o the adequacy of earnings and cash flow to cover interest expenses and other
fixed charges
- Use of debt  Fixed charges  Financial leverage
o Interest are fixed expenses, so a given variation in EBIT leads to a greater
variation in EBT for firms with higher leverage.
- If the company can earn more on capital than the interests it pays, leverage is
beneficial
o lowers the cost of capital
o magnifies the return to shareholders
 b. Solvency ratios
- Debt-to-Assets: percentage of total assets financed with debt. A higher ratio indicates
weaker solvency.
- Debt-to-Equity: amount of debt capital relative to equity capital. A higher ratio
indicates weaker solvency.
- Interest Coverage: number of times a company’s EBIT could cover its interest
payments. A higher interest coverage ratio indicates stronger solvency.
- Fixed Charge Coverage: number of times a company’s earnings (before interest,
taxes, and lease payments) can cover the company’s interest and lease payments. A
higher fixed charge coverage ratio implies stronger solvency.

c. Financial ratios and default risk

- A firm defaults when it fails to make principal or interest payments.
- Lenders can then:
o Adjust the loan payment schedule.
o Increase the interest rate and require loan collateral.
o Seek to have the firm declared insolvent.
- Financial ratios play two roles in credit analysis:
o They help quantify the borrower’s credit risk before the loan is granted.
o Once granted, they serve as an early warning device for increased credit risk.
- Companies with lower business risk and steady cash flows are better positioned to
take on more leverage.
o A higher proportion of debt financing poses less risk of non-payment of interest
and debt principal to a company with steady cash flows than to a company with
volatile cash flows.
6. Profitability
a. .
b. Return on sales.
- Gross profit margin: % of revenue available to cover operating and other expenses
and to generate profit.
o Higher gross profit margin = higher product pricing and/or lower product costs
o Gross profits are affected by competition and competitive advantages (superior
branding, better quality, or exclusive technology)
- Operating profit margin:
o An operating profit margin increasing faster than the gross profit margin can
indicate improvements in controlling operating costs (and vice versa)
- Pretax margin: indicate the effects on profitability of leverage and other (non-
operating) income and expenses.
- Net Profit Margin: Most of the time, the net income used in calculating the net profit
margin is adjusted for non-recurring items to better understand the company’s
potential future profitability

c. ROA
- ROA = NI / Average assets
- Return earned by a company on its assets.
- Issue with the usual ratio: net income is the return to shareholders, but assets are
financed by both shareholders and creditors.
- Interest expense (the return to creditors) has already been subtracted in the
numerator.
- The operating ROA uses EBIT (operating income) as numerator, which reflects the
returns on all assets invested in the company.
- Given that various formulas can be applied, it is important to use the same formula
consistently in comparisons to other companies or time periods.
- In contrast, ROE is the return earned by a company on equity capital.

d. Dupont Analysis
- Useful technique to understand what drives a company’s ROE
- Breaks down ROE into its components indicating distinct aspects of the firm
- ROE = NI / Average SOE
- ROE = (NI / Average TA) * (Average TA / Average SOE) = ROA * Leverage
o ROE is a function of ROA and the use of debt.
o As long as a company can borrow at a rate lower than the marginal rate it can
earn investing in its business, the company makes an effective use of leverage
and ROE increases with leverage.
- ROE = (NI / Revenue) * (Revenue / Average TA) * (Average TA / Average SOE)
= Net profit margin * Asset turnover * Leverage
- Net profit margin can be further decomposed into:
NI / Average SOE =
(NI/EBT)*(EBT/EBIT)*(EBIT/Revenue)*(Revenue/Average TA)*(Average TA/Average
SOE)
- Which is equal to:
ROE = Tax burden * Interest burden * EBIT margin * Asset turnover * Leverage
o The tax burden reflects: 1 – Tax rate, the higher the percentage, the less the firm
pays taxes.
o The interest burden: the smaller the percentage, the higher the interest burden.
o This decomposition can be used to understand what is driving ROE.
e. Linking ROA, ROE, and leverage
- Economic assets = Shareholders’ equity + Financial debts = SOE + FD
- Cost of debt = rd = Financial charges / Financial debts
- Economic profit = Net income + Financial expenses
- ROA = Economic profit / Economic assets
- ROE = NI / SOE
ROE = ROA + (ROA – rd) * (FD/SOE) = ROA + Leverage
- If no debt (FD = 0): ROA = ROE
- If ROA > rd  Financial leverage positively impacts performance  ROE>ROA
- If ROA < rd  Financial leverage negatively impacts performance  ROE<ROA
-