Financial Statement Analysis - Understanding Income Statements, CFA Level 1

Level I - Financial Reporting and Analysis Understanding Income Statements 1 Contents 1. 2. 3. 4. 5. 6. 7. 8. Introduction Components and Format of the Income Statement Revenue Recognition Expense Recognition Non-Recurring items and Non-Operating items Earnings Per Share Analysis of the Income Statement Comprehensive Income 2 1. Introduction • Income Statement, Profit and Loss Statement, P&L, Statement of Earnings • The income statement provides financial results of a company’s business activities over a period • Net Income = Revenue - Expenses ak al i 11 • Income statements is an important input for valuation models mod dels 3 2. Components and Format of the Income Statement 2011 • Revenue and Net Revenue • Cash vs. Non-Cash Expenses • Single Step vs. Multi step Format Revenue $1,100,000 Net Revenue $1,000,000 Cost of Goods Sold 500,000 SG&A 250,000 Depreciation 80,000 Operating Profit (EBIT) $170,000 Interest $30,000 00 Earnings Before Taxes Taxes (.40) Net Income 11 li B o ah 158 ok a / C • Revenue, Sales, Turnover $140,000 0,000 $56,000 $ 6,000 $84,000 $84 000 4 Single-Step Format versus Multi-Step Format 2011 2011 $1,000,000 Cost of Goods Sold 500,000 Gross Profit $500,000 80,000 SG&A 250,000 Operating Profit (EBIT) $170,000 Depreciation 80,000 Interest $30,000 Operating Profit (EBIT) $170,000 Earnings Before Taxes $140,000 Interest $30,000 Taxes (.40) $56,000 Earnings Before Taxes $140,000 Net Income $84,000 Taxes (.40) $56,000 6,000 $1,000,000 Cost of Goods Sold 500,000 SG&A 250,000 Depreciation Net Income ha 4 ali Net Sales Net Sales $84,000 $84,0 00 5 3. Revenue Recognition • In IFRS, the term “income” includes revenue and gains. • If a company sells goods for $100 cash in Period 1 and has a no refund policy, can it recognize revenue in Period 1? • What if the company sells goods on credit in Period 1 and will receive cash in Period 2. Can revenue be recognized in Period 1? ok C 82 0 • What if an advance payment is received in Period 1 but goods and servicess are a e to be delivered in Period 2. When will the revenue be recognized? 6 Accounting Standards for Revenue Recognition Core principle: Revenue should be recognized to “depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in an exchange for those goods or services.” Five steps in recognizing revenue: Identify the contract(s) with a customer Identify the performance obligations in the contract Determine the transaction price Allocate the transaction price to the performance obligations in the contract Recognize revenue when (or as) the entity satisfies a performance obligation ak al i 11 Bo 58 o / • Capitalize incremental costs of obtaining a contract and certain costs incurred to fulfill a contract • Disclose information about contracts with customers disaggregated into different categories of contracts contra tss • Disclose balances of any contract-related assets and liabilities and significant changes in thosee ba balances, alances remaining performance obligations and transaction price allocated to those obligations, and d anyy significant signi cant judgments and changes in judgments related to revenue 7 4. Expense Recognition • Expenses are “decreases in economic benefit during the accounting period in the form of outflows or depletion of assets or incurrence of liabilities that result in decreases in equity.” • Matching Principle: Expenses to generate revenue are recognized in the same period as revenue. • Period costs (or period expenses) are reflected in the period when the expense is incurred. 8 Issues in Expense Recognition • Doubtful Accounts ƒ Some credit customers will default ƒ When revenue is recognized estimate uncollectible amount • Warranties ƒ Estimate future warranty expense ƒ Recognize as estimated warranty expense during period of sale • Depreciation and Amortization ƒ Allocate cost over useful life of a long-lived asset 9 Implications For Financial Analysis Estimates for doubtful accounts Estimates for warranty expense Net Income Expenses Depreciation methods and estimates Early recognition of expenses Æ conservative ak al 11 15 An analyst should recognize whether a company’s expense recognition policy iss conservative or not; this can be determined from the footnotes rentt expense It is possible that two companies in the same industry have very different recognition polices 10 5. Non-Recurring Items and Non-Operating Items Analysts are generally trying to estimate future earnings. Hence, reporting standards require firms to separate income and expense items which are likely to continue from items which are not likely to continue. Discontinued Operation: An operation which a company has disposed or plans to dispose. Net income from discontinued operations is shown net of tax after net income from continuing operations. en te Unusual or Infrequent Items: Examples include restructuring charges and gains/losses from sale of equipment. These items are highlighted but still shown wn as operating expenses. 11 Non-Operating Items • Non-operating items are typically reported separately from operating income because they are material and/or relevant to the understanding of the company’s financial performance. • Under IFRS, there is no definition of operating activities. Companies need to use judgment. ƒ Interest or dividends received would be operating items for a financial services firm ƒ Interest expense would be an operating item for a bank but non-operating for a manufacturing firm • Generally investing and financing activities are disclosed on a net basis ƒ Example: net interest expense for a manufacturing firm ƒ Components disclosed in the notes 12 Visual Depiction of an Income Statement Manufacturing Company using U.S. GAAP Revenue or Income Operating Expenses Cost of Goods Sold SG&A Depreciation Unusual or Infrequent Items Operating Income Non-Operating Expenses Interest Expense EBT (continuing operations ) Taxes NI (continuing operations) Earnings from discontinued operations net of taxes Extraordinary items net of taxes Net Earnings or Net Income 13 Changes in Accounting Policies New standards might require companies to change accounting policies. Companies may be allowed to adopt standards prospectively or retrospectively • Changes in accounting principle require retrospective application ƒ Examples: LIFO ÆFIFO, new revenue recognition rules Bo 8 o 9 • Changes in accounting estimates require prospective application ƒ Example: change in useful life of depreciable assets Correction of an error for a prior period requires a restatement of the four ur major maajo or financial statements 14 6. Earnings Per Share EPS is an important metric and must be shown on the face of the income statement. It depicts the earnings per ordinary share. Ordinary shares are subordinate to all other types of equity. Also referred to as common stock or common shares. EPS = income available to ordinary shareholders / number of ordinary shares li 15 8 What if a company has issued securities which are convertible to ordinary shares? Convertible bonds, convertible preferred stock, employee stock options. These securities might be potentially dilutive. ka When a company has securities which are convertible to ordinary shares es it is said to have a complex capital structure. 15 Basic EPS Basic EPS = Net Income – Preferred Dividend Weighted Average Outstanding Shares 16 Example For 2010, Giggly Ltd. had net income of $200,000. The company paid $50,000 dividends to preferred shareholders and $25,000 dividends to common shareholders. The common stock information is as follows. Shares as at January 1, 2010: 75,000 Shares issued on July 1, 2010: 15,000 What is the basic earnings per share for the company? Answer: 1.82 17 Example For 2011, Giggly Ltd. had net income of $300,000. The company paid $50,000 dividends to preferred shareholders and $25,000 dividends to common shareholders. The common stock information is as follows. Shares as at January 1, 2011: 90,000 Shares issued on April 1, 2011: 15,000 Shares repurchased on October 1, 2011: 30,000 2-for-1 stock split on December 1, 2011 What is the basic earnings per share for the company? Answer: 1.33 18 Diluted EPS Compute diluted EPS using the if-converted method Diluted EPS = (Net income) Weighted average shares + New shares if convertible shares are converted 19 Example The estimated net income of Jamming Studios for 2013 is $750,000. The capital structure for the company is as follows: Common stock outstanding 50,000 shares Convertible preferred stock 10,000 shares Each share of preferred stock pays $4 dividend and is convertible into 4 shares of common stock. What is the estimated basic and diluted EPS for the company? Basic EPS: 14.20 Diluted EPS: 8.33 20 Example AA Ltd reported net income of $500,000 for 2011. The capital structure of the company was as follows: Weighted average common stock outstanding for 2011 = 45,000 200 convertible bonds each with $100 par value and 10% coupon; convertible to 20 shares 15,000 non-convertible preferred shares, each paying $2 dividend The tax rate for the company is 40%. What is the basic and diluted EPS? Basic EPS = 10.44 Diluted EPS = 9.62 21 Example Travelling Trains Ltd reported net income of $600,000 for the year 2009 and had a weighted average of 150,000 common shares. On January 1, 2009, the company had issued10,000 employee stock options with an exercise price of $40. Over the year, the average market price for the company’s share was $50. What is the basic and diluted EPS for Travelling Trains Ltd? Basic EPS = 4.00 Diluted EPS = 3.95 22 Antidilutive Securities Some convertible securities could be antidilutive. Antidilutive securities are not included in the calculation of diluted EPS. Diluted EPS reflects maximum potential dilution. In 2010 XYZ Ltd had net income of $1,750,000. On average 500,000 common shares were outstanding. 20,000 convertible preferred shares, each paying $10 dividend and convertible to three shares of common stock, were also outstanding. Compute the basic and diluted EPS. Basic EPS = 3.10 Diluted EPS = 3.10 23 7. Analysis of the Income Statement Time series versus cross sectional analysis 2012 % Net Sales $1,000,000 100% $1,110,000 100% Cost of Goods Sold 500,000 50% 650,000 58.5% Gross Profit $500,000 50% $460,000 41.5% SG&A 250,000 25% 265,000 23.9% Depreciation 80,000 8% $110,000 10% Operating Profit (EBIT) $170,000 17% $85,000 7.6% Interest $30,000 3% $40,000 3.6% 3.6 % Earnings Before Taxes $140,000 14% $45,000 4% Taxes (.40) $56,000 5.6% Net Income $84,000 8.4% k / 9 Ce al 8 n i 20 te 6 r Ratios: Gross Profit Margin Operating Profit Margin Net Profit Margin % a 04 kal 11 i B Example of a common sized income statement. 2011 $18,000 18,000 1.6% .6% $27,000 $27 ,000 2.4% 2 24 8. Comprehensive Income Comprehensive Income = Net Income + Other revenue and expense items which are excluded from the net income calculation Also called other comprehensive income or OCI. Part of shareholder equity. 41 li 11 Bo ah 58 o ak / al 98 ib 2 ok Four types of items are treated as other comprehensive income 1. Unrealized gain/losses from a certain category of investment security (available for sale) 2. Foreign currency translation adjustments Note: Avail Availablee for sale ale 3. Unrealized gains/losses on derivative contracts used for hedging FS) is a US GAA (AFS) GAAP term term. 4. Certain costs of a company’s defined benefit post-retirement plans TThe he ccorresponding rresp po ding IF IFRS ter termss is “fa “fair valu value hrough other ther through com ehens income”. comprehensive 25 OCI Illustration XYX Company Balance Sheet on 1 Jan 2001 XYX Company Income Statement for 2001 AFS Security PP&E 100 1,000 Revenue Expenses 300 100 Equity 1,100 Net Income 200 Assets = Liability + Equity Entire net income is retained and AFS security increases in value to 120 XYX Company Balance Sheet on 31 Dec 2001 Cash AFS Security PP&E 200 120 1,000 Equity 1,320 26 Example The beginning shareholder’s equity for Panama Papers Ltd is $2,200,000. The net income reported for the year is $1,600,000. The cash dividends paid amounted to $800,000. The ending shareholder’s equity is $3,200,000. Calculate the other comprehensive income. OCI= 200,000 27 Summary • Revenue Recognition • Expense Recognition • Non-Recurring Items and Non-Operating Items • Earnings Per Share • Common Size and Ratio Analysis • Comprehensive Income 28 Conclusion • Read summary • Review learning objectives • Examples • Practice problems: good but not enough • Practice questions from other sources 29