CFA Level 1 (2009) - 3

Sllldy Session 10

Cross-Refcrcncc to CFA Institute Assigncd Rcading #41 - Accounting Shenanigans on the Cash Flow Statcment

receivables as collateral, the inflow of cash is n:poned as a financing activity in the cash flow statemenr.

\X!hen receivables are securitized, they are usually transferred ro a bankruptcy remote srrucrure known as a special purpose emity (SPE). The SPE pools the receivables rogerher and sells securities represeming an interest in the poo!. A securitiIation is treated jusr like a collection; rhat is, the inflow of cash is reported as an operating activity in the cash !low starement because the transaction is reponed as a sale. So, by securitizing its accounts receivable, rather than wairing to collect from the cusromer, a firm can accelerate operating cash Row into the current period.

Accelerating operating cash flow by securitizing receivables is not sustainable because the firm only has a limited amount of accounts receivable.

Securitizing accounts receivable may also affect earnings. When the receivables are securitized. the firm can recognize a gain in some cases. This gain is the result of differences between the book value and fair value of the receivahles at the time of securitization. The gain can be affecred hy a numher of cst imales including the expc((L'd default rate, the expected prepayment rate, and the discount rate used.

GAAP is silent on where the gains from securitizations should be reponed in the income statemenr. Some firms take a more aggressive approach and include the gains as revenue. Other firms reduce operating expenses by the amount of the gains. Some firms repon the gains as a pan of nonoperating income.

Repurchasing Stock to Offset Dilution

When a firm's srock options are exercised, shares must be issued. The higher the srock price relative to the exercise price, the more shares that must be issued by the finn. As the shares are issued, earnings per share are diluted (reduced).

Firms often repurchase srock to offset the dilutive effeCts of stock option exercise. The cash received from the exercise of the option and the outflow of cash from the share repurchase are both reponed as financing activities in rhe cash flow statement. Because there is a tax benefit when options are exercised, exercise increases operating cash flow.

For analytical purposes, the net cash outflow for share repurchases to avoid dilution should be reclassified from financing activities to operating activities to better reflect the substance of the transaction. Since employee stock options are part of compensation, an analyst should subtract the cash outflow from operating cash flow to recognize the true cash cost of options-based compensation.

Study Session 10 Cross-Reference to CFA Institute Assigned Reading #41 - Accounting Shenanigans on the Cash Flow Statement

[OS Ii I

Srretching aCCOUllls payable by delaying payment is not a sustainable source of operating cash How. Suppliers may refuse lO extend additional credil because of the slower paymcnts. Stretching accoullls payable can be identified hy increases in the nUll1hn o( days in payables.

Arranging for a third party (0 finance (pay) a firm's payables in one period, so that the firm can account for repayment as a hnancing (rather than operating) cash flow in a later period, is a method to decrease operating cash flows in a period of seasonally high CFO, and increase them in a subsequent period.

Securitizing accounts receivable accelerales operating cash flow into the currelll period, but this sourCe of cash is not sustainable and artificially increases receivables (Url10VCr.

Securilizing receivablcs m:l)'also allow the firm to immcdiately recognii.e gains in the

Illcome st:1ten1ent.

Some firms repurchase srock to offset the dilutive effect of the exercise of employee stock options. The analyst must determine whether the increase in operating cash flow resulting from the income tax benefits of the exercise of employee stock options is sustainable. For analysis, the net cash outflow to repurchase srock should be considered an operating acrivity instead of a hnancing activity, since it is essentially a compensation expense.

5wdy Session 10

Cross-Reference to CFA Institute Assigned Reading #41 - Accounting Shenanigans on the Cash Flow Statement

CONCEPT CHECKERS

1.Decreasing accounts payable turnover by delaying payments to suppliers is most likely to cause cash now from financing activities to:

A.increase.

R.decrease.

C.remain unchanged.

2.As parr of its working capital management program, Rotan Corporation has an accounts payable financing arrangement with the First National Bank. The bank pays Rotan's vendors within 30 days of the invoice date. Rotan reimburses the bank 90 days after the invoice is due. Ignoring interest, what is the must likely effect on Rotan's operating cash flow and financing cash Aow when the bank is repaid?

A.Both will decrease.

B.Neither will decrease.

C. Only one will decrease.

4.Over the past two years, a firm reporred higher operating cash Row as a result of securitizing its accounts receivable and from increasing income tax benefits from employee stock options. The tax benefits are solely the result of higher tax rates. Should an analyst conclude that these two sources of operating cash flow are sustainable?

A.Both sources are sustainable.

B.Neither source is sustainable.

C.Only one of these sources is sustainable.

Study Session 10

Cross-Reference to CFA Institute Assigned Reading #41 - Accounting Shenanigans on the Cash Flow StatemclI!

]. C Decreasing accoulHs payable turnover by delaying payments «) suppliers is a source of operating cash, not a source of financing cash. Decreasing accounts payable turnover is !lot a sustainable source of clsh flow because suppliers may eventually refuse to extend credit because of the slower payments.

2.C When the bank is repaid, the cash oudlow is reponed as a flnancing activity. Operating cash flow is not affected when payment is made.

3.B The cash received from securitizing receivables is reponed ;lS an operating activity. The cash received from borrowing against accounts receivable is teported as a financing activi ty.

4.B Accelerating operaling cash How by securitizing receivables is nOl sustainable because the firm only has a limited amoul1t of accounts receivable. An increase in tax benefits as a result higher of t'lX rates is nOl sustainable. 'bx rates could also decrease in the future.

The following is a review of the financial Reporting and Analysis principles designed to address rhe learning outcome statements set forth by CI:A Institute"'. This topic is also covercd in:

I

FINANCIAL STATEMENT ANALYSIS:

ApPLICATIONS

StuJy Session 10

EXAM FOCUS

!.OS tiLa: Evaluate a company's past financial performance and explain how a company's str;llcgy is reflected in past /111;:ncial pl'l'forl11ancl'.

In the previous review. we introduced a number of financial ratios that can be used to assess a company's profitability, kvcrage, solvency, and operational efficiency. The analyst can evaluate (rends in these ratios, as well as their levels, to evaluate how the company has performed in these areas.

Trends in financial ratios and differences between a firm's financial ratios and those of its competitors or industry averages can indicate important aspects of a hrm's business strategy. Consider two finns in the personal computer business. One builds relatively high-end computers with cutting-edge features, and one competes primarily on price and produces compurers with various configurations using readily available technology. \X;'hat differences in their financial starcments would we expect (0 find?

Premium products are usnally sold at higher gross margins rhan less differentiated commodity-like products, so we should expect cost of goods sold to be a higher proportion of sales for the latter. We might also expect the company with curringedge features and high quality to spend a higher proportion of sales on research and

development, which may be quite minimal for a firm purchasing improved components from suppliers rather than developing new features and capabilities in-house. The

ratio of gross pro(1ts to operaring profits will be larger for a firm that spends highly on research and development or on advertising.

In general, it is important for an analyst to understand a subject firm's business strategy. If the firm claims it is going to improve earnings per share by cutting costs, examination of operating ratios and gross margins over time will reveal whether the firm has actually been able to implement such a strategy and whether sales have suffered as a result.

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A forccasl of futlllc nl'l inCOllll: and cash How oflen hegins wilh :1 foreclsl of fUlure sales. Over sllOren horizons, the "lOp down" :lpproach to forecasting sales is used. The analyst hegins widl a forecast of CD]> glOwrh, orrcn supplicli hy outside resc:\Ich or an inhouse economics group" Historicd rC!:llionships Cln bl" uSl,d to ('stinLllC thl' rl'htionship bl:twn:n CUP growth and thl: growth of induslty saks. If dw subjl:u Ilrm's market sharl' is expeCled to rl:main till: same, the growth of firm sales will be (he saml: as rhe growth in industry sales. If the analyst has reason [0 believe rhe /ln11's market share will incrl:ase or decrease nexr pcriod, rhe market sharl: can be adjllSred r()[" rhis change and rhen lllulriplied by esrimared industry saks for rhe nl:xr period 10 gl:r rhe forecasl of Iin11 sales for rhe period.

In a sinl[)le forecasling model. some historical avnage or rrend-adjusted mL':ISlltT of prorllahility (opn:llillg m,rrgin, I~BT mal gin, or IIl'l nl:llgill) C:lII he IISl'll to fora:l\l earnings. In C01Ilplex I~JreC:Jsring mOlkls, l'alh ilClll Oil :In incollle Slarl'lucnl :lIld b:ll:lIl\l shcl'l CUI he cSlin\:lred hased Oil sq),lI:IlC :ISSllll1]>tioIlS ahollt its growrh in rcbrioll

to ITVenUl: growth. For mulri-pniod furecasrs, rhe analyst rypically CJl1I)lo)'s a single estimate of sales growrh at some point that is expected 10 conrinue indefinitely.

"l() esrimate cash flows, rhe an:dyst musr make assumprions abour future sources and uses of cash. The most imporralll of these will be increases in \'vorking capiral. capital expendirures on llew fixed assets, issuance or repayments of deht, and issuance or

repurchase of stock. A typical assumption is rhat noncash working capiral as a percclIlage of sales remains COnSClnl. A first-pass model might indicate a need for cash in future periods, and these cash requircme11ls can then be 11Il:( hy projecting nccessary borrowing in future periods. r:or consistency, interesr expense in future periods llIust also be adjusted for any increase in deht.

Figure 1 il1ustrates this method. This projection assumes the company's sales increase 5% per year, its cost of goods sold is 35% of sales, and operating expenses are 55% of sales. Ir also assumcs noncash working capiral stays constanr at 85% of sales and fixed capital requiremcnrs will be 5%) of sales in each year. Net incomc is projl:cred to increase over rhe forecast period, bur the analysis reveals thar cash is expected to decrease, suggesting ;] need for financing.

Study Session 10

Cross-Reference to Ci'/\ Institute Assigned Reading #42 - Financial Statement Analysis: Applications

Figure 1: Income and Cash Flow Projection

Traditionally, credit analysts have spoken of the "three C's," "[our C's," or even the "five C's" of credit analysis. One version of the three C's includes: Character, Collateral, and Capacity to repay. Character refers lO firm management's professional reputation and the firm's history of debt repayment. The ability to pledge specific collateral reduces lender risk. It is the third C, the capacity to repay, that requires close examination o[ a firm's financial statemenrs and ratios. Since some debt is fot periods of 30 years or longer, the credit analyst must take a very long-rcrm view of the firm's prospects.

Credit rating agencies such as Moody's and Standard and Poor's employ formulas that arc essentially weighted averages of several specific accounting ratios and business characteristics. The specific items used in the formula and their weights vary from industry to industry, but the types of items considered can be separated into four general categories:

1.Scale and dilJersijication. Larger companies and those with more different product lines and greater geographic diversification arc better credit risks,

2.Operational efficiency. Such items as operating ROA, operating margins, and EBITDA margins fall into this category. Along with greater vertical diversification, high operating efficiency is associated with better debt ratings.

Swdy Sl:SSiOll 10

Cross-Reference to CF/\ Institute Assigned Reading #42 - Financial Statement Analysis: Applkations

3.Mmgin stability. Stability of the relevant profitabiliry margins indicarcs J higher

probhbility of repayml'lH (le;lds to J bl'trer dl'bt rating and J lower interesr rate). Highly variable operJting ITStdts mJke lenders nl'rvous.

4. Leverage. Ratios of operating earnings, EBITDA, or some meaSllrl' of free cash Aow lO interl:st t'xpl'nse or total deht make up the most important parr of the credit rJting formula. Firms with grearer eJrnings in relation to their ddH and in relarion to their inr<:rest expense are bl'trer credit risks.

lOS 42.<1: Discuss the lise of Ilnancial statement analvsis In screening for potential equity investments.

In many cases an analyst must sdecr portfolio stocks from the large universe of potenlial equity investments. Whether the objeer is to select growth stocks, income stocks, or value srocks, accounting items and ratios can be used to identiCy a manageable subscl of a\'~lil:lble stocKS Cor furrher analysis.

Some invcstmcnl srrattgies even have financial ratios in their names, such as low prictlcJrnings and low pricelsalc:s investing. Multiple criteria arc uscd because J scrun based on a single factor can include hrms with other undesirable characteristics. For example, a company wirh a low PIE nuy also have operating losses, declining sales prospecrs, or very high leverage.

Analysts should be Jware that their equity screens wililikdy include and exclude many or all of the firms in particular industries. A screen to identify hrms with low PIE ratios willlikC'ly exclude growth compJnies from the sample. A low price-to-book or high dividend screen willlikcly include an inordinate proportion of Jinancial services companles.

Backtestil7g refers to lIsing a specific set of criteria to screen historical data to determine how portfolios based on those criteria would have performed. There is, of course, no guarantee that screening criteria that have identified stocks that outperformed in the past will continue ro do so. Analysts must also pay special attention to the potenrial effeers

of survivorship bias, data-mining bias, and look-ahead bias (sec the topic review on Sampling and Estimation) when evaluating rhe results of backtesting.

1.0.'1;j 2.e: Determine and jl,siify appropriate ,malyst adjllstments 10 ,I

COl1lpal1Y's financial statements to facilitate comparison with another company.

Because different companies choose different accounting methods, an analyst must be prepared to adjust the financial statements of one company to make them comparable

to those of another company or group of companies. Differences in accounting methods chosen by firms subject to the same standards, as well as differences in accounting methods due to differences in local accounting standards, can make comparisons between companies problematic.

Consider two companies in the same industry that have different depreciation schedules. One company has selected straight-line depreciation even though physical assets in its

Srudy Session I(J

Cross-Reference to eFA Institute Assigned Reading #42 - Financial Statement Analysis: Applications

industry lend to lose most oC their productive value early in their economic lives. The analyst would need to adjust the depreciation of that firm so that the net income l-igures ror the firms are comparable. A change in a firm's f-inancial sratement depreciation would lead to changes in gross profir, operating profit, and so on down to nel profir and earnings per share.

Differences between U.S. C;AAP and IFRS relJuire an ;jnalysr to adjust the financial SI~lteI11entsof firtlls from different countries before comparing rheir financial results. Important differences between rhe rwo include their treatments of the dTeet of exchange rate changes, cerrain securities held by the firm, and inventory cost Hows. Differences in accounting standards are covered in more derail in the next topic review.

We have already covered other ~ldjusrI11enIS for certain accounting methods and estimates. The analyst may need to convert fln:lltcial starements for Ll FO-hased firms to FIH), or vicc-vers~l. AnalYSIS would likely innease both liahiliries and assets for a t1rm wirh signitlcanl lll1l'r:lling leases, or f<JI" one wirh take-or-pay COIHraets.

Study 5t:ssioll 1()

Cross-Refercllcc to eFA Institutc Assigncd Reading 1/42 - Financial Statt:menl Analysis: Applications

lOS 'J2,a

'Ii'cnds in a company's linanL'ial ratios and diHncnu:s bctwL'L'n its linanld ratio; :Ind I!JOSL' of its ulm\Wtilors or industry avnagL' ratios can revc,t! imjlOI't;lI\l as!KLIS of' ils husi ness s t ];llcg)'.

[ (lSi.?, h

A cOlllpany's future inCUlllC and clsh flows can be projL'ctCLI by I()recasting s;dl's gmwth and using esrim:llcs of proflt margins and the incrcases in working capiLlI and fixcd assets necessary to suppOrt the fon:casl salcs growlh,

I ( i:, i) _,

Crcdit analysis uses a firm's financial slatelllcntS to aSSl'SS ils credit quality, Indicators of';1 firm's LTnlill\ortllillL'SS illLlude ils sl,de :lllei divnsiliL;ili'lll. 0[1n:llillll;J! l-ffilicnLI", nLlIgin Sl,lhiliIY, ,11lL1 lISe ld lin:llllial kl'l'Llgl',

Potenrially artraerive equity investments can be identified by screening a univLTse of srocks llsing minimum or maximumvalucs of onc or morc ralios, \X/hich (alld

how mallY) ratios to usc, what minimum or IllilXinllllll values 10 usc, and how much imporLllllc 10 givc cileh ratio all present challenges to thc analys\.

\X!hcll companies usc differem accounting mcthods or estimates relating to areas such

,IS illVl'lllnrv ilccollnling. llcprccialion, capitalization, i\lld olf-haLlllce-shcu lln:lI1cing, analySIS lllust adjust thc financial slatel11ems for comparability.