AFP - Treasury4 - Session CHP 18 Amd 19

Financial Management
Session 10, Module Five:

Chapter 18:
Financial Accounting
and Reporting
Chapter 19:
Financial
Planning and
Analysis
Session 10, Module Five:
Financial Management
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Overview - 2
Outline:
Introduction
Accounting Concepts and Standards
Financial Reporting Statements
Accounting for Derivatives, Hedges and FX
Translation
Accounting for U.S. Governmental and Not-For-
Profit Organizations
Chapter 18: Financial Accounting and
Reporting
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 18 - 3
Audit objectives
Generally accepted
auditing standards
Scope
Relevance
Completeness
Accuracy
Not financial fitness,
but fair reflection
Process
Study business
Internal controls for
reliability
Reconcile accounting
entries with evidence
Sampling
Materiality
Accounting methods
Proper and complete
Audit Process
Auditor Opinions
Standard unqualified
Unqualified with
explanatory
paragraph or
modified unqualified
Qualified
Adverse
Disclaimed

Balance Sheet
Financial condition
at point in time
Assets = Liabilities +
Shareholders Equity
Assets:
Current assets
Fixed assets (depreciable
fixed assets)
Intangible assets
Liabilities:
Current liabilities
Long-term liabilities
Equity
Discussion Question
How are liabilities and debt different?
a) Debt refers to an amount that is owed, regardless of
the form.
b) Accounts payable is a liability but not a debt.
c) Liability refers only to obligations that
require interest payments and is
considered a subset of liabilities.
d) Notes payable is a liability but not a
debt.
Answer: b (a and c have labels reversed;
notes payable is both a liability and a debt.)
(p.5-15)
Income Statement
Revenues earned
Expenses incurred
Gains and losses from
conversions of assets
and liabilities over
accounting period
Measured over a span
of time
Costs and
earnings
COGS
EBITDA
EBIT
Discussion Question
Answer: c (p.5-18)

Net income adjusted for the following gains and losses
not reported on the income statement is called what?

Unrealized gains, losses,
from OTTI investments
(Topics 320 and 325)
Minimum pension liability
adjustments (Topic 715)
Foreign currency translation
adjustments (Topic 830)
Changes in market values of
futures contracts qualifying
as hedges (Topic 815)

a) Operating income
b) Other income and
expenses
c) Comprehensive
income
d) Retained earnings

Discussion Question
Identify whether changes in each of the balance sheet
accounts is a source or use of funds on the statement
of cash flows.

Increase in an asset
Decrease in an asset
Increase in a liability
Decrease in a liability
Answers: (p. 5-19)
Source of funds
Use of funds
Source of funds
Use of funds
Indirect method
Start: net income from the income statement
Adjust by changes in balance sheet accounts from
prior period
Direct method
Source of cash inflows and outflows without relying
on adjustments to net income
Total cash flow for each activity computed
Accrual accounts converted to cash amount

Preparing the Statement of Cash Flows
Statement of Cash Flows
Sources and uses
of funds
Sections:
Operating
Investing
Financing
Cash from
operations: add
back non-cash
charges (e.g.,
depreciation)
Cash, not
earnings, repays
debt
Discussion Question
How are gains and losses arising from changes in
a derivatives fair value accounted for in ASC
Topics 815, 820 and 825?
a) If not hedge instrumentsreport in current income.
b) Fair value hedgeshedge specific asset or
liability on balance sheetrecognize as income but omit
hedged item offsetting gains/losses.
c) Cash flow hedges are reported in current
income.
d) FX transaction hedges are reported in
current income.

Answer: a (b recognizes offsetting gains and losses;
c and d are reported in comprehensive income)
(p.5-24)
IAS 21/ASC Topic 830:
Determine functional currency
Is subsidiarys functional currency also its home
currency?
Yes Current method
Translate all assets and liabilities at current spot rate (date of
translation).
Translate retained earnings at weighted average rate.
Translate other equity at transaction date spot rates.
No Temporal method
Remeasure nonmonetary balance sheet accounts and related
income statement accounts at historical exchange rates.
FX Translation Accounting
Serve collective group/constituencies
Taxes or fees
Goods/services as resources allow
Net worth (not equity)
Compliance, accountability (not profit)
IFRS or GAAP for not-for-profits
GASB (FAF) for U.S. government
Accounting for G/NFP Organizations
Outline:
Cost Behavior
Decision Evaluation
Developing and Operating Financial Budgets
Financial Statement Analysis
Performance Measurement
Financial Analysis and Rating Agencies
Chapter 19: Financial Planning and Analysis
Cost Behavior
High fixed costs
and low variable
costs

Profits will expand rapidly after
company earns enough to cover
fixed costs.
Low fixed costs
and high
variable costs
Volume need not be as great to
cover fixed costs.
Added volume will not cause
profits to rise as rapidly due to
high variable costs.
Operating Leverage
Discussion Question
Which factor should be considered relevant
data for decision evaluation? (pick two)
a) Sunk costs
b) Costs that affect future cash flows
c) Revenues that will be earned with either alternative
d) Costs that will be incurred with one alternative but
not the other

Answer: b and d (p.5-44)
Break-even point: Level of activity for
operation at which costs = benefits
Break-Even Analysis
Fixed Costs
Unit Break-Even Point =
Selling Price Per Unit Variable Cost Per Unit
$10,000
=
$10 $6
= 2,500 Units
Capital Budgeting
Strategic plans for
proposed large-dollar
investments
Examples:
New/replacement
equipment
New product line
Acquire firm or
division
C/B analysis using
models:
Payback period
Net present value
Profitability index
Internal rate of return

Evaluates the PV of all inflows and outflows of
a project using WACC as a discount rate

Net Present Value (NPV)
Where: C = net cash flow; i = discount rate; n = number of
periods; subscript indicates time period (1, 2, etc.); exponent
indicates compounding
If the only cash outflow is in the present:
NPV = PV of Cash Inflows PV of Cash Outflows

3 1 2 n
1 2 3 n
NPV = PV of Cash Inflows Cash Cost
C C C C
= + + +... + Cost
(1+i) (1+i) (1+i) (1+i)

A
1 2 3 4 5
B
1 2 3 4 5
$300 $300 $400 $100 $100
NPV = + + + + $1,000 = $ 48.43
(1 + .10) (1 + .10) (1 + .10) (1 + .10) (1 + .10)
$1,000 $1,000 $300 $300 $400
NPV = + + + + $1,00
(1 + .10) (1 + .10) (1 + .10) (1 + .10) (1 + .10)
0= $1,124.98
Net Present Value (NPV)
If WACC = 10%, two projects NPVs are:
Ratio of PV gained to cost to obtain that value;
value gained per dollar of investment:

If only cash outflow is in present (period 0):
Profitability Index (PI)
Present Value of Cash Inflows
Profitability Index =
Present Value of Cash Outflows
A
B
$951.57
PI = = 0.952
$1,000.00
$2,124.98
PI = = 2.125
$1,000.00
Discount rate (i) that makes NPV = 0
PV of cash inflows = PV of cash outflows
Internal Rate of Return (IRR)

=

A
1 2 3 4 5
B
1 2 3 4
NPV = PV of Cash Inflow Cost = 0
$300 $300 $400 $100 $100
NPV = + + + + $1,000 0 i = 7.7%
(1 + i) (1 + i) (1 + i) (1 + i) (1 + i)
$1,000 $1 $300 $300 $400
NPV = + + + +
(1 + i) (1 + i) (1 + i) (1 + i)
=
5
,000
$1,000 0 i = 38.1%
(1 + i)

Method
Acceptance
Criterion

Project A

Project B
NPV NPV > 0 $48.43 $1.124.98
PI PI > 1 0.952 2.2125
IRR IRR > WACC* 7.7% 38.1%
Capital Expenditure Analysis Summary
* WACC = 10% in the example
Risk analysis
Sensitivity analysis
How do changes in
single variable influence
NPV?
Scenario analysis
What-if analysis of best
and worst cases (NPV)
Monte Carlo simulation
RADR
High-risk endeavors:
higher rate of return to
justify investment
Risk adjustment factor,
e.g., 2% if WACC is
10%
Low-risk: 8%
Medium-risk: 10%
High-risk: 12%
Investment Risk Analysis and RADR
Risk-Adjusted Return
on Capital (RAROC)
Originally for FI
project evaluation
Uses risk estimate to
adjust return on
capital calculations
Comparable
Expected loss (EL)
Nonfinancial issues
Market ready?
Technology ready?
Regulatory mandate?
Other Cost/Benefit Analyses
Discussion Question
How do treasurys plan assessments affect
projected cash flow streams in budgeting?
a) Calculates adequate funds and liquidity
b) Determines impact on debt covenants and credit
ratings
c) Manages financing of long-term assets through
debt and equity issues
d) Treasury is not directly or indirectly
responsible for budgeting

Answer: b (p.5-58)
Budgets Pro Forma Financial Statements
Suppliers: Sales on credit?
Trading partners: Can counterparty meet
contractual obligations?
Lenders: Initiate/maintain credit relationships?
Rating agencies: Credit risks?
Investors: Purchase/sell corporate debt and
equity?
Financial Statement Analysis
Financial Statement Analysis Ratios
Liquidity or working
capital ratios
Efficiency or asset
management ratios
Debt management
ratios
Performance ratios

Discussion Question
How do common-size statements enable direct
financial comparisons of different size firms?
a) Expenses as % of profit reveal who has the best
expense controls
b) Asset categories as a % of revenues can be
compared
c) Liability categories as a % of total assets can
be compared
d) Cash flow elements as a % of net income
can be compared
Answer: c (p.5-63)
How many times asset base is used (turned
over) with flow of revenue.
Example: Firm generated $0.968 of revenue per
$1 of investment in assets.
Total Asset Turnover
Revenues
Total Asset Turnover =
Total Assets
$15,000
= = 0.968 Times
$15,500
How efficiently fixed assets, or property, plant
and equipment, are used.
Example: Firm generated $2 revenue for each
$1 invested in fixed assets.
Fixed Asset Turnover
Revenues
Fixed Asset Turnover =
Net Property, Plant, Equipment
$15,000
= = 2.0 Times
$7,500
How many times firm turned over stock of
most liquid assets with flow of revenue.
Example: Firm generated $1.88 of revenue per
$1 in current asset accounts.

Current Asset Turnover
Revenues
Current Asset Turnover =
Current Assets
$15,000
= = 1.88 Times
$8,500
Efficiency with which company converts sales
into cash.
Example: $0.037 of cash was carved out of
each revenue dollar.
Cash Conversion Efficiency
Cash Conversion
Cash Flow from Operations
Efficiency =
Revenues
$550
=
$15,000
= 0.037 or 3.7%
Discussion Question
Which three ratios help determine the extent to
which a company was leveraged?
a) Total liabilities to total assets
b) Times interest earned ratio
c) Long-term debt to capital
d) Debt to tangible net worth
e) Fixed charge coverage ratio
Answer: a, c, d. Degree of indebtedness
ratios: The higher the ratio, the greater the
relative indebtedness. (p.5-68)

Percentage of all liabilities to total investments
or total assets.
Example: Some form of debt supplies $0.471 of
each $1 of assets.
Total Liabilities to Total Assets
Total Liabilities
Total Liabilities to Total Assets =
Total Assets
$7,300
= = 0.471 or 47.1%
$15,500
What percentage of capitalization is provided
by long-term debt.
Example: Long-term (L/T) debt supplied 32.2%
of total capital.
Long-Term Debt to Capital

-
-
Long Term Debt
L/T Debt to Capital =
Long Term Debt +Equity
$3,900
= = 0.322 or 32.2%
$3,900 + $8,200
Debt as a percentage of tangible net worth.
Intangibles: goodwill, patents, trademarks, and
copyrights.
Example: Sum of short- and long-term interest-
bearing debt is 69.5% of tangible net worth.
Debt to Tangible Net Worth

Total Debt
Debt to Tangible Net Worth =
Total Equity Intangible Assets
$1,800 + $3,900
= = 0.695 or 69.5%
$8,200 $0
Ability to service debt via interest payments.
Example: Firm has 5.33 times more funds
available to pay interest than interest that was
paid.
Times Interest Earned (TIE) Ratio
Operating Profit EBIT
TIE = =
Interest Expense Interest Expense
$1,600
= = 5.33 Times
$300
Performance: Profit Margins
Percentage of
revenues remaining
after deductions:
Gross: COGS
Operating: COGS +
operating expenses
EBITDA: same as
operating
but add back
depreciation and
amortization
Net: all expenses
and taxes

Gross
Gross Profit
Profit Margin =
Revenues
Operating
EBIT
Profit Margin =
Revenues
EBITDA
EBITDA Margin =
Revenues
Net Profit
Net Income
Margin =
Revenues
Net income relative to level of total assets.
Example: Every $1 in total assets generates
$0.055 in net income.
Return on Total Assets (ROTA)
Net Income
Return on Total Assets =
Total Assets
$850
=
$15,500
= 0.055 or 5.5%
Earnings available to common shareholders
expressed as a percentage of common equity.
Example: Firm earned $0.104 of accounting net
profit for each $1 of common equity
investment.
Return on Common Equity

Earnings Available to Common Shareholders

Return on Common Equity =
Common Equity
Net Income Preferred Dividends
=
Total Equity Preferred Stock
$850 $0
= = 0.104 or 10.4%
$8,200 $0
Return on total assets as product of return on
sales and total asset turnover.
Integrated Ratio Analysis: DuPont Equation

Return on Total Assets = Return on Sales Total Asset Turnover
Net Income Total Revenues
=
Total Revenues Total Assets
= 0.057 0.968 = 0.055 or 5.5%
Discussion Question
Why do service industry ratios differ from
manufacturing industry ratios?
a) Balance sheets have higher current assets,
especially A/R
b) Service firms have higher debt
c) Supply costs are always low
d) Asset turnover is more
important than profit margin
Answer: a (p.5-74)
Advantages:
Easily computed and
widely used
Information easily obtained
Easy comparison between
companies
Disadvantages:
Historical data at fixed points,
not intra-period
No future performance
promise
Not best in isolation
(comparative or trend)
Accounting information not
economic value
Not qualitative value
(strategies, talent)
Accounting methods may
reduce comparison validity
Strengths and Limitations of Ratio Analysis
Return on investment (ROI)
Partial period may be misleading.
Does not include cost of capital.
Positive NPV project rejected if it lowers firms ROI?

Net Income Net Income
ROI = =
Invested Capital Long-Term Debt + Equity
Residual income (RI)
Assigns charge to the invested capital.
If profit exceeds charge for capital, then RI is a
profit.

Free cash flow (FCF)

FCF = Net Income Depreciation and Amortization
Change in Non-Cash Working Capital Capital Expenditures

RI = Net Income Invested Capital Cost of Capital
Value created only if firm earns a rate of return
that exceeds its WACC
Example: EVA of a company with:
Long-term debt of $3,900, equity of $8,200
Marginal tax rate of $450/$1,300
WACC of 10%
Operating income (EBIT) of $1,600
Economic Value Added (EVA)

EVA = EBIT (1 Tax Rate) (WACC)(Long-term Debt + Equity)

= $1,600 (1 0.34615) (.10)($3,900 + $8,200)
= $1,600 (0.65385) (.10)($12,100)
= $1,046 $1,210 = -$164
Discussion Question
What possible scenario could increase EVA?
a) Rating agencies re-evaluate creditworthiness of an
issue.
b) Improve operating efficiency so less EBIT is
generated on the existing asset base.
c) Invest additional capital in assets that earn a rate of
return less than the cost of capital.
d) Eliminate assets that earn a rate of return
less than the cost of capital.
Answer: d (p.5-80)
End of Session 10
Assignment:
Complete the following tasks
for Module Five, Chapter 20:
Review the chapter.
Complete the test-your-understanding questions at
the end of the chapter.
Review the module flashcards.
Complete the online calculations.
Complete the online module-specific test.
Complete the Exam Practice (Describe and
Differentiate) questions (located at the end of the
module textbook).

AFP - Treasury4 - Session CHP 18 Amd 19

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Financial Management

Session 10, Module Five:

Earnings Available to Common Shareholders

EVA = EBIT (1 Tax Rate) (WACC)(Long-term Debt + Equity)

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