Download Operating activities section starts with net income and

Module D
How External Users
Assess Management’s
Operating Decisions
How External Users Assess
Management’s Operating Decisions
• Topics
– Statement of cash flows operating activities
section, indirect method
– Operating activities and profitability ratios
– Operating activities and risk ratios
– Common financial statement analysis issues
related to operating items
Statement of Cash Flows: Operating
Activities, Indirect Method
• Under the indirect method:
– Operating activities section starts with net
income and uses reconciling items to arrive at
cash flow from operating activities.
This SCF tells
them WHAT?
Indirect Method Format
• Net Income
• Add (Deduct)
– Non-cash expenses: depreciation, depletion,
amortization (1)
– (Non-cash revenues) e.g., investment income for
securities accounted for under the equity method (1)
– Losses (gains) on sale (2)
– Decreases (increases) in operational current assets
and deferred income tax assets(3)
– Increases (decreases) in operational current
liabilities and deferred income tax liabilities(3)
• Net cash flows from operating activities
Notes:
(1)Non-cash
expenses and revenues affect net
income, but not cash
(2)Gains and losses are non-operational in
nature for most companies
(3)These reconciling items adjust from accrual
basis effects, which are reflected in net
income, to cash basis effects
As with all targets, financial and
otherwise, management should state in
advance exactly what we are shooting
for … because, if we aim for nothing
we are likely to hit it!
Operating Activities and
Profitability Ratios
Return on Assets (ROA)
ROA =
net profit margin ratio x asset turnover
ratio
Net profit margin ratio =
[net income + (1-t) interest expense  sales
Asset turnover ratio =
sales  average total assets
• Effect on ROA
– Successful operations increase sales, which
should increase ROA!
– Increases in receivables and inventory decrease
ROA.
Inventory turnover ratio =
Cost of goods sold  Average inventory
All other things being equal, an increased ratio
is good news!
Increases in inventory decrease the ratio
Increases in cost of goods sold increase the ratio
If gross profit percentage is dropping,
an increase may not be good news!
Operating Activities and Risk Ratios
Operating cash flow to capital expenditures ratio =
Operating cash flow  Capital expenditures
A ratio greater than 1.0 likely means that
a company is generating enough cash flow
from operations to meet demand for
capital investments.
An increased ratio means less risk!
Operating cash flow to total liabilities ratio =
Operating cash flow  Average total liabilities
Successful operations increase the ratio.
Interest coverage ratio =
(Income before income taxes + Interest expense)
Interest expense
Successful operations increase cash flow, which
decreases the need to borrow to finance
operations;therefore, increases the ratio and
decreases risk!
A ratio of 1.0 means that the company is
generating enough pretax profit to [barely]
meet the carrying costs of debt financing.
Sometimes called the “thin ice ratio.”
Common Financial Statement Analysis
Issues Related to Operating Items
•
•
•
•
Inventory
Bad debts expense
Deferred income taxes
Pensions and other
post-employment benefits
Financial Statement Analysis: Inventory
• Companies may use different inventory methods
(e.g., LIFO, FIFO, average).
– Financial analysts wanting to compare
companies may “restate” financial statements
and use a single method across companies.
– Companies that use LIFO present information
about the “LIFO Reserve” in notes to the
financial statements.
The “LIFO Reserve” = the difference, if any
(during inflation), between LIFO inventory and
another inventory method, usually FIFO.
“LIFO Reserve” Example: Pharmacia
Upjohn’s 1998 Annual Report
• Note 1: Summary of Accounting Policies
– Inventories are costed at the lower of cost or
market.
– Cost is determined by the LIFO method for
substantially all U.S. inventories and the FIFO
method for substantially all non-U.S.
inventories.
Upjohn’s Note 8
(In part; amounts in millions)
Inventories (FIFO basis)
Less reduction to LIFO cost
1998
1997
$1,186
$1,118
(154)
(160)
$1,032
$ 958
• Financial Statement Data Adjustment
– The balance sheet adjustment information is
shown in note (e.g., in 1998, ending inventory is
changed from $1,186,000 to $1,032,000).
– Income statement adjustment is the change in
the “LIFO Reserve” (e.g., in 1998 from 160 to
154).
• After adjustment, financial statement ratios
are calculated using adjusted [pro forma]
numbers.
Financial Statement Analysis:
Bad Debts
• Analysts track the following amounts over
time
– Ratio of bad debts expense to sales
– Ratio of allowance for bad debts to accounts
receivable
• These ratios can raise red flags if they
increase without appropriate explanation
Financial Statement Analysis:
Deferred Income Taxes
• Deferred income taxes liabilities
– For companies in the introduction and growth
stage, deferred income tax liabilities may be
viewed as (reclassified as) equity.
– For companies in the maturity or decline stage,
classification as a liability is appropriate.
Financial Statement Analysis: Pensions and
Other Post-Employment Benefits
• Three adjustments are possible
– Adjust from the balance sheet amount to
the economic status of the plan if the
economic status of the plan is a liability
and a larger liability than the balance
sheet liability amount (a conservative
approach). A very common approach!
– Adjust from the balance sheet amount to
the economic status of the plan regardless
of whether the economic status is an asset
or liability.
– Consolidate the pension plan with the
company:
• Treat plan obligations as liabilities and
plan assets as investments on the
balance sheet.
• Treat service costs, interest cost, and
expected return on plan assets as line
items on the income statement.
Observation on Goals
“Dreams without deadlines, tend
to remain dreams.”
- H. O. Wilson
End of Module D