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) $1,186$1,118 Less reduction to LIFO cost (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