Course Title:Financial Statement Analysis Course Code:MGT-537 Course Instructor: Dr. Hafiz Muhammad Ishaq Total Lectures:32

Previous Lecture Summary Long Term Debt-Paying Ability Income Statement Consideration when Determining Long-Term Debt-Paying Ability, Times Interest Earned Fixed Charge Coverage Practical Exercises

Today's Lecture Topics  Long Term Debt-Paying Ability Joint Ventures Contingencies Financial Instruments with Concentrations of Credit Risk, Disclosures About Fair Value of Financial Instruments Practical Exercises Profitability Profitability Measures Net Profit Margin

Joint Ventures New firm formed to achieve specific objectives of a partnership like temporary arrangement between two or more firms. JVs are advantageous as a risk reducing mechanism in new-market penetration, and in pooling of resource for large projects. They however, present unique problems in equity ownership, operational control, and distribution of profits or losses. An association of two or more businesses established for a special purpose. Consolidation means combining assets, equity, liabilities and operating accounts of a parent firm and its subsidiaries into one financial statement. See also consolidated financial statement. –Parent firm has control

Carry as an investment Parent firm has significant influence Analysis Review footnote for commitments relating to the joint venture Off-balance sheet commitments represent potential liabilities Banking: Paying off two or more old loans with a new loan. See also consolidation loan Law: Combining two actions (involving the same parties and the same issues) into one action on court orders. Consolidation may or may not result in single judgment. Joint Ventures

Contingencies Existing situation whose result is unknown or unpredictable. Possible event that must be prepared for. Condition that must be satisfied before an action is activated, an agreement is effected, a contract is performed, a plan is executed, or a provision is enforced. Loss contingencies that are not accrued are footnoted if it is reasonably possible that an asset has been impaired or a liability has been incurred Review contingency note for possible liabilities not disclosed on the balance sheet Gain contingencies are not accrued

Financial Instruments with Off-Balance-Sheet Risk An asset or debt that does not appear on a company's balance sheet. Items that are considered off balance sheet are generally ones in which the company does not have legal claim or responsibility for. Disclosure is required of –Contract face amount –Nature and terms of the instrument –Amount of the potential loss –Entity’s collateral policy and description of the collateral Risk: Potential loss if –The co-party fails to perform –Changes in market make instrument less valuable

Financial Instruments with Concentrations of Credit Risk Disclosure is required of –The extent of risk from exposures to individuals or groups of counterparties in the same industry or region Small companies are particularly liable to concentration risk

Disclosures About Fair Value of Financial Instruments Disclosure of financial instrument fair value is required –On-balance sheet assets and liabilities –Off-balance sheet assets and liabilities If estimation of fair value is not practicable –Descriptive information pertinent to estimating fair value is provided

Practical Exercise Bonds payable, 12% $1,000,000 Stockholders' equity 1,800,000 Current assets 1,870,000 Tangible assets, net 1,600,000 Intangible assets 40,000 Investments 120,000 Other assets 90,000 Sales 4,000,000 Operating expenses 3,620,000 You have been asked to evaluate the long-term borrowing position of Client, Inc. However, you were given only the following limited information. Required: Assuming that this is the only information you will receive, estimate the following ratios:

Practical Exercise (cont’d) a.Times interest earned ratio b.Debt ratio c.Debt/equity ratio d.Debt to tangible net worth ratio

Current assets $ 2,731,020 $ 2,364,916 Property and equipment, net 10,960,286 8,516,833 Intangible assets, at cost less applicable amortization 294, ,919 $13,986,081 $11,137,668 Current liabilities $ 3,168,123 $ 2,210,735 Deferred federal income taxes 160,000 26,000 Mortgage note payable 456,000 — Stockholders' equity 10,201,958 8,900,933 $13,986,081 $11,137,668 Net sales $33,410,599 $25,804,285 Cost of goods sold (30,168,715)(23,159,745) Selling and administrative expense (2,000,000)(1,500,000) Interest expense (216,936)(39,456) Income tax expense (400,000) (300,000) Net income $ 624,948 $ 805, The following information is computed from Fast Food Chain’s annual report for 2010.

Practical Exercise (cont’d) Note: One-third of the operating lease rental charge was $100,000 in 2010 and $50,000 in Capitalized interest totaled $30,000 in 2010 and $20,000 in a.Based on the above data for both years, compute: 1.Times interest earned 2.Fixed charge 3.Debt ratio 4.Debt/equity ratio 5.Debt to tangible net worth Required: b.Comment on the firm's long-term borrowing ability based on the analysis.

Practical Exercise (cont’d) Comment on Long-Term Borrowing Ability In 2010, this firm had a substantial rise in debt. This included current liabilities, deferred taxes, and a new mortgage note payable. This increased debt and the related increased interest expense caused a decline in interest coverage and a rise in the debt, debt/equity, and debt to tangible net worth ratios. In addition, operating lease rental charges went up, which lowered the fixed charge coverage.

Balance Sheet (in thousands) Current assets $ 449,195 $ 433,049 Investments 32,822 55,072 Deferred charges 4,905 12,769 Property, plant, and equipment, net 350, ,128 Trademarks and leaseholds 45,031 47,004 Excess of cost over fair market value of net assets acquired 272, ,639 Assets held for disposal 6,062 10,247 $ 1,161,082 $1,237,908 Total liabilities $ 689,535 $ 721,149 Total stockholders' equity 471, ,759 $ 1,161,082 $1,237,908 Income Statement Net sales $ 2,020,526 $1,841,738 Cost of goods sold (2,018,436)(1,787,126) Selling and administrative (300,000)(250,000) Interest expense (40,000) (30,000) Net income (loss) $ (337,910)$ (225,388) The following financial information is excerpted from the 2010 annual report of Retail Products, Inc.

Practical Exercise (cont’d) a.1.Times interest earned 2.Debt ratio 3.Debt/equity ratio 4.Debt to tangible net worth ratio b.Comment on the results. c.Does a times interest earned ratio of less than 1 to 1 mean that the firm cannot pay its interest expense? Required: For each year compute :

No, a times interest earned ratio of less than 1 to 1 does not mean, in the short run, that the firm cannot meet its interest payments. Some of the expenses, such as depreciation, do not require current funds, but they do reduce the interest coverage. Also, in the short run, the outlay can come from sources of funds other than income. Results Interpretation

Lecture Summary Contingencies Financial Instruments with Concentrations of Credit Joint Ventures Risk, Disclosures About Fair Value of Financial Instruments Practical Exercises Profitability