Analyzing operating activities Week 6 – October 23 – 27/2016 FINA321 Abdullah Al Shukaili

Learning objectives Income analysis and measurement Revenue and gains Expenses and losses Income classification Discontinued operation Asset impairment Revenue recognition

What do you mean by “ operating activities”? Operating activities are the functions of a business related to the provision of its offerings. These are the company's core business activities, such as manufacturing, distributing, marketing and selling a product or service. Operating activities should generally provide the majority of a company’s cash flow and largely determine whether a company is profitable.

Income analysis Income is the net of revenues and gains less expenses and losses. Income is one measure of operating activities Why analyze income and its components? to assess company performance and risk exposures, and to predict the amounts, timing, and uncertainty of future cash flows

Income measurement The main purpose of the income statement is to explain how income is determined. Economic income measures the net change in shareholder’s wealth during a period is typically equal to a period’s cash flows plus change in present value of expected future cash flows. measures change in shareholder value Permanent income is an estimate of the stable average income that a business is expected to earn over its lifetime, given the current state of its business. Permanent income also called sustainable income permanent income is proportional to value.

Revenues and Gains Analyzing revenue recognition practices is crucial in financial statement analysis. Revenues are earned inflows or prospective earned inflows of cash that arise from a company’s ongoing business activities. These include cash inflows such as cash sales & credit sales. Gains are earned inflows or prospective earned inflows of cash arising from transactions and events unrelated to a company’s ongoing business activities.

Expenses and Losses Expenses are incurred outflows, prospective outflows, or allocations of past outflows of cash that arise from a company’s ongoing business operations. Losses are decreases in a company’s net assets arising from peripheral or incidental operations of a company.

Alternative Income Classifications and Measures It is important for an analyst to appreciate the differences between:- (1) operating versus non-operating income (2) recurring versus nonrecurring income Recurring and Nonrecurring Income determine the permanent and transitory components of income Operating and Non-operating Income Operating income is a measure of company income from ongoing operating activities. Such as income that is generated from operating activities. Therefore, any revenues (and expenses) not related to business operations are not part of operating income This means that financing revenues and expenses (mainly interest expense) are excluded when measuring operating income

Alternative Income Classifications and Measures Non-operating income includes all components of income not included in operating income. Such as income generated from finance activities. What is the difference between net income and comprehensive income?

Discontinued Operations A company reports gains or losses from discontinued operations in two categories: (1) operating income or loss from discontinued operations until the management commits to the disposal and (2) gains and losses on disposal, including operating income or loss during the phase-out period. all effects of discontinued operations must be removed from current and past income With regard to a company’s financial condition, an analyst must remove the assets and liabilities of the discontinued operations from the balance sheet

Asset Impairments (write off) A long-lived asset is said to be impaired when its fair value (market value or value from use within the company) is below its carrying value (book value in the balance sheet). Asset impairments occur for many reasons, these include a decline in the asset market value, a decline in market demand for the output from the asset, technological obsolescence, and changes in the company’s business strategy.

Asset Impairments In a disposal, a company sells one or more assets, or a business segment, and stop to operate the disposed assets. In contrast, an impaired asset, while it can be sold or disposed of in any manner, is often retained in the company and operated at a reduced level, made idle, or abandoned.

Revenue Recognition Revenues resulting from a company’s “ongoing major or central operations” or resulting from continue operations. Gains resulting from marginal or external or uncontained operations. It is also important to understand when a company recognizes revenues and gains. Generally, revenue is recognized when it is both realized (or realizable) and earned. Revenue is usually recognized at the point of sale Recording of revenue is a critical event in income determination. Analysis must take aim at the accounting methods to ascertain whether revenue is properly reflected economic reality.

Exercises Explain why an analyst attaches great importance to evaluation of the income statement. Define income. Distinguish income from cash flow. What are the two basic economic concepts of income? What implications do they have for analysis? Explain how accountants measure income. Distinguish between net income and comprehensive income. Distinguish between operating and non-operating income. Give examples of items that are typically included in each category

Reading Chapter 6 in the text book