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Financial Analysis

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Fourth Edition

Financial Statement
Analysis & Valuation
Peter D. Easton

University of Notre Dame

Mary Lea McAnally

Texas A&M University

Gregory A. Sommers

Southern Methodist University

Xiao-Jun Zhang

University of California, Berkeley

Cambridge

Business Publishers

To my daughters, Joanne and Stacey
—PDE

To my husband Brittan, and my children Loic, Maclean, Quinn and Kay
—MLM

To my wife Susan, and my children Christian, Peter and Philip
—GAS

To my wife Sharon, my daughter Jasmine, and my parents 滕惠清 and 张祥林
—XZ

Financial Statement Analysis & Valuation, Fourth Edition, by Peter D. Easton, Mary Lea McAnally,
Gregory A. Sommers, and Xiao-Jun Zhang.
COPYRIGHT © 2015 by Cambridge Business Publishers, LLC. Published by Cambridge
Business Publishers, LLC. Exclusive rights by Cambridge Business Publishers, LLC for manufacture and export.
ALL RIGHTS RESERVED. No part of this publication may be reproduced, distributed, or stored in a database or retrieval system in any form or by any means, without prior written consent of
Cambridge Business Publishers, LLC, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Student Edition ISBN 978-1-61853-104-9

Bookstores & Faculty: to order this book, call 800-619-6473 or email customerservice@cambridgepub.com. Students: to order this book, please visit the book’s Website and order directly online.
Printed in the United States of America.
10 9 8 7 6 5 4 3 2 1

About the Authors

Peter D. Easton is an expert in accounting and valuation and holds the Notre Dame Alumni Chair in Accountancy in the Mendoza College of Business. ­rofessor
P
Easton’s expertise is widely recognized by the academic research community and by the legal community. Professor Easton frequently serves as a consultant on accounting and valuation issues in federal and state courts.
Professor Easton holds undergraduate degrees from the University of Adelaide and the University of South
Australia. He holds a graduate degree from the University of New England and a PhD in Business Administration
(majoring in accounting and finance) from the University of California, Berkeley.
Professor Easton’s research on corporate valuation has been published in the Journal of Accounting and Economics, Journal of Accounting Research, The Accounting
Review, Contemporary Accounting Research, ­ eview of
R
Accounting Studies, and Journal of Business Finance and
Accounting. Professor Easton has served as an associate editor for 11 leading accounting journals and he is currently an associate editor for the Journal of Accounting
Research, Journal of Business Finance and Accounting, and Journal of Accounting, Auditing, and Finance. He is an editor of the Review of Accounting ­ tudies.
S
Professor Easton has held appointments at the University of Chicago, the University of California at Berkeley,
Ohio State University, Macquarie University, the Australian Graduate School of Management, the University of
Melbourne, Tilburg University, National University of
Singapore, Seoul National University, and Nyenrode
University. He is the recipient of numerous awards for excellence in teaching and in research. Professor Easton regularly teaches accounting analysis and security valuation to MBAs. In addition, Professor Easton has taught managerial accounting at the graduate level.

Mary Lea McAnally is the Philip Ljundahl Professor of Accounting and Associate Dean for Graduate Programs at the Mays Business School. She obtained her PhD from
Stanford University and B. Comm. from the University of Alberta. She worked as a Chartered Accountant (in
Canada) and is a Certified Internal Auditor. Prior to arriving at Texas A&M in 2002, Professor McAnally held positions at University of Texas at Austin, Canadian National
Railways, and Dunwoody and Company.
Her research interests include accounting and disclosure in regulated environments, executive compensation, and accounting for risk. She has published articles in the leading academic journals including Journal of Accounting and Economics, Journal of Accounting Research, The
Accounting Review, Review of Accounting Studies, and
Contemporary Accounting Research. Professor McAnally received the Mays Business School Research Achievement
Award in 2005. She is Associate Editor at Accounting
Horizons and serves on the editorial board of Contemporary Accounting Research and is Guest Editor for the
MBA-teaching volume of Issues in Accounting Education
(2012). She is active in the American Accounting Association and its FARS section.
At Texas A&M, Professor McAnally teaches financial reporting, analysis, and valuation in the full-time and
Executive MBA programs. Through the Mays Center for
Executive Development, she works with corporate clients including Halliburton, AT&T, and Baker Hughes. She has also taught at University of Calgary, IMADEC (in Austria) and at the Indian School of Business, in Hyderabad. She has received numerous faculty-determined and studentinitiated teaching awards at the MBA and executive levels.
Those awards include the Beazley Award, the Trammell
Foundation Award, the MBA Teaching Award (multiple times), the MBA Association Distinguished Faculty Award
(three times), the Award for Outstanding and Memorable
Faculty Member, and the Distinguished Achievement
Award.

iii

iv  Authors
A
 bout the

Gregory A. Sommers is Director of the Master of
Science in Accounting program and Professor of Practice in Accounting in the Edwin L. Cox School of Business at
Southern Methodist University. He holds an undergraduate degree in accounting from Fresno Pacific University and a
PhD in Accounting and Management Information Systems from The Ohio State University. Professor Sommers is a
Certified Public Accountant who practiced in and continues to be licensed in California.
Professor Sommers’ research focuses on market-based empirical studies of the relations between currently available accounting data, expectations of future accounting data, expected cost of capital and valuation. His research has been published in Journal of Accounting Research and
Journal of Business, Finance, and Accounting. Professor Sommers serves on the editorial board of Review of
Accounting Studies.
Professor Sommers teaches financial accounting, including international accounting, in the undergraduate and graduate programs as well as in executive education at Southern Methodist University. He has taught financial statement analysis and valuation for over ten years at the graduate level and his teaching materials were previously utilized as resources for another textbook in this area.
Professor Sommers’ teaching has earned him numerous awards including Outstanding MBA Teaching as well as recognition from student organizations.
Professor Sommers is an active member of the American Accounting Association and its Financial Accounting and Reporting Section. He has served as chairman of the
Trueblood Seminar for Professors sponsored by Deloitte.
Professor Sommers is recognized as an expert in the areas of financial reporting, financial analysis, estimation of cost of capital, and business valuation.

Xiao-Jun Zhang is the E. R. Niemela Associate

Professor of Accounting at the Haas School of Business,
University of California, Berkeley. He has served as Chair of the accounting group and the Director of the Center for
Financial Reporting and Management at the University of
California, Berkeley.
Professor Zhang holds an undergraduate degree from
Renmin University, and masters degrees from the University of Maryland and Columbia University. Professor
Zhang received his PhD from Columbia University.
Professor Zhang’s research focuses on financial statement analysis and security valuation. His work has been published in highly respected research journals including The
Accounting Review, Journal of Accounting and Economics,
Journal of Accounting Research, and Review of Accounting
Studies. Professor Zhang has served on the editorial board of several journals, and has been a reviewer for many others top journals in the fields of finance and accounting.
Professor Zhang teaches undergraduate, MBA, and
PhD courses in accounting and analysis. He is consistently ranked among the best instructors by students at the University of California, Berkeley. Professor Zhang is a respected consultant having performed consulting services for several hedge funds. He has also served as an advisor to the Investment Club at the University of California, Berkeley.

Preface
Welcome to the Fourth Edition of Financial Statement Analysis & Valuation. Our main goal in writing this book was to address the needs of today’s instructors and students interested in financial analysis and valuation by providing the most contemporary, engaging, and user-oriented textbook available. This book is the product of extensive market research including focus groups, market surveys, class tests, manuscript reviews, and interviews with faculty from across the country. We are grateful to students and faculty whose insights, suggestions and feedback greatly benefited this
Fourth Edition.

TARGET AUDIENCE
Financial Statement Analysis & Valuation is intended for use in a financial statement analysis and/or valuation course in which profitability analysis and security valuation are emphasized.
This book accommodates mini-courses lasting only a few days as well as extended courses lasting a full semester.

INNOVATIVE APPROACH
Financial Statement Analysis & Valuation is applications oriented and focuses on the most salient aspects of accounting, analysis, and valuation. It teaches students how to read, analyze, and interpret financial statement data to make informed business decisions. This textbook makes financial statement analysis and valuation engaging, relevant, and contemporary. To that end, it consistently incorporates real company data, both in the body of each module and throughout the assignment material.

FLEXIBLE STRUCTURE
The curricula, instructor preferences, and course lengths vary across colleges. Accordingly and to the extent possible, the 15 modules that make up Financial Statement Analysis & Valuation were designed independently of one another. This modular presentation enables each college and instructor to “customize” the book to best fit their needs. Our introduction and discussion of financial statements constitute Modules 1 and 2. Module 3 presents the analysis of financial statements with an emphasis on analysis of operating profitability. Module 4 introduces credit risk analysis. Modules 5 through 10 offer an analysis of accounting numbers and disclosures. The aim of those modules is to help us better interpret financial statements and to adjust those statements as necessary to improve our financial statement analysis. Modules 11 through 15 describe forecasting, cost of capital estimation, and company valuation.

Flexibility for Courses of Varying Lengths
Many instructors have approached us to ask about suggested class structures based on courses of varying length. To that end, we provide the following table of possible course designs. For instructors desiring greater emphasis on accounting analysis, additional time can be spent on

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Modules 1 through 10. For instructors desiring greater emphasis on analysis and valuation, additional time can be spent on Modules 11 through 15.
15 Week
Semester‑Course
Module 1
Framework for Analysis and Valuation

10 Week
Quarter‑Course

6 Week
Mini‑Course

1 Week
Intensive‑Course

Week 1
Week 1

Week 1

Day 1

(Modules 1 and 2)

(Modules 1 and 2)

(Modules 1 and 2)

Week 3

Week 2

Week 2

Day 2

Week 4

Week 3

Optional

Optional

Week 5

Week 4

Week 3

Module 2
Review of Business Activities and Financial
Statements

Module 3
Profitability Analysis and Interpretation

Module 4
Credit Risk Analysis and Interpretation

Weeks 1 and 2

Module 5
Revenue Recognition and Operating
Income

Day 3
(Modules 5 and 6 )

Module 6

Week 6

Week 5

Skim

Week 7

Optional

Optional

Optional

Week 8

Optional

Optional

Optional

Week 9

Week 6

Optional

Optional

Week 10

Asset Recognition and Operating Assets

Week 7

Skim

Optional

Week 11

Week 8

Week 4

Module 7
Liability Recognition and Nonowner
Financing

Module 8
Equity Recognition and Owner Financing

Module 9
Incorporate Entities

Module 10
Off-Balance-Sheet Financing

Module 11
Forecasting Financial Statements

Module 13
Cash-Flow-Based Valuation

Week 9

Week 5

Weeks 9 and 10

Weeks 5 and 6

Day 5
(Modules 13 and 14)

Module 14

Week 14

Week 10

Week 6

Week 15

Operating-Income-Based Valuation

Market-Based Valuation

Week 12
Week 13

Cost of Capital and Valuation Basics

Module 15

Day 4
(Modules 11 and 12)

Module 12

Optional

Optional

Optional

INNOVATIVE PEDAGOGY
Financial Statement Analysis & Valuation includes special features specifically designed for the student with a keen interest in analysis and valuation.

Focus Companies for Each Module
Each module’s content is explained through the reporting activities of real companies. To that end, each module incorporates a “focus company” for special emphasis and demonstration. The enhanced instructional value of focus companies comes from the way they engage students in real

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analysis and interpretation. Focus companies were selected based on the industries that business students typically enter upon graduation.

Focus Company by Module
Module 1

Berkshire Hathaway

Module 10

Southwest Airlines

Module 2

Apple

Module 11

Procter & Gamble

Module 3

Walmart

Module 12

Southern Company

Module 4

Home Depot

Module 13

Nike

Module 5

Pfizer

Module 14

Nike

Module 6

Cisco

Module 15

Family Dollar

Module 7

Verizon

Appendix B

Starbucks

Module 8

IBM

Appendix C

Kimberly-Clark

Module 9

Google

Real Company Data Throughout
Market research and reviewer feedback tell us that one of instructors’ greatest frustrations with other financial statement analysis and valuation textbooks is their lack of real, contemporary company data. We have gone to great lengths to incorporate real company data throughout each module to reinforce important concepts and engage students. We engage nonaccounting students specializing in finance, marketing, management, real estate, operations, and so forth, with companies and scenarios that are relevant to them. For representative examples, SEE PAGES 3-11; 5-5; 6-12.
6-13
Module 6 | Asset Recognition
Analyst Adjustments and Operating Assets

anaLysis DeCision you are are incorporated
New to the fourth edition, Analyst Adjustmentsthe receivables Manager throughout most of the modules.
You are analyzing your receivables turnover report for the period and you are concerned to accounting
These boxed elements explain and illustrate the types of adjustments analysts make that the average collection period is lengthening. What specific actions can you take to reduce the averinformation to make it more collection period? [Answer, p. 6-43] age useful in their assessment of a firm.

anaLyst aDJustMents 6.1

adjusting for allowances on accounts receivable

Returning to Cisco, assume the analyst wishes to adjust the allowance for doubtful accounts so that it is consistent across periods; for example, assume the analyst wants the ratio of the allowance to accounts receivable (gross) to be the same. To illustrate, let’s apply this approach to the recent three years for Cisco. There are at least two ways to achieve this: one focused on the balance sheet, the other on the income statement. For the balance sheet method, we determine the “average percent” for 2012–2010 as follows: Allowance for doubtful accounts
Accounts receivable, gross

2012, 2011, 2010

2012, 2011, 2010

5

$207 1 $204 1 $235
$4,576 1 $4,902 1 $5,164

5

$646
$14,642

5 4.412%

Then, we estimate the allowance for doubtful accounts using the average percent computed above for 2012, 2011 and 2010:
2010 allowance for doubtful accounts: 4.412% 3 $5,164 5 $228 (instead of $235; a decrease of 2$7).
2011 allowance for doubtful accounts: 4.412% 3 $4,902 5 $216 (instead of $204; an increase of 1$12).
2012 allowance for doubtful accounts: 4.412% 3 $4,576 5 $202 (instead of $207; a decrease of 2$5).

Reformulations for the 2010 through 2012 balance sheets follow (assume a 30% tax rate):
2010 assets: Deduct $7 from the allowance (debit it), which increases the net accounts receivable asset $7.
2010 liabilities: Add $2.1 to deferred tax liabilities ($7 3 30%).
2010 equity: Add $4.9 to retained earnings ($7 3 [1230%]).
2011 assets: Add $12 (2011), deduct $7 (2010) from the allowance which increases the net accounts receivable asset $5.
2011 liabilities: Deduct $3.6 (2011), and add $2.1 (2010) to deferred tax liabilities; thus, deduct $1.5, computed as 2($12 3 30%) 1 $2.1.
2011 equity: Deduct $8.4 (2011), and add $4.9 (2010) to retained earnings; thus, deduct $3.5, computed as 2($12 3 [1230%]) 1 $4.9.
2012 assets: Deduct $5 (2012), add $12 (2011), and deduct $7 (2010) from the allowance (credit it), which impacts net accounts receivable asset by $0.
2012 liabilities: Add $1.5 (2012), deduct $3.6 (2011), and add $2.1 (2010) to deferred tax liabilities; thus, $0 change, computed as
($5 3 30%) 2 $3.6 1 $2.1.
2012 equity: Add $3.5 (2012), deduct $8.4 (2011), and add $4.9 (2010) to retained earnings; thus, $0 change, computed as
($5 3 [1 2 30%]) 2 $8.4 1 $4.9.

Reformulations for the 2010 through 2012 income statements follow:
2010 bad debts expense: Deduct $7 from bad debts expense.
2010 income tax expense: Add $2.1 to income tax expense ($7 x 30%).
2010 revenue: Add $4.9 to net income ($7 x [1230%]).

vii

eXhiBit 4.6

S&P Rating Distribution—2013

14.0%
12.0%

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10.0%
8.0%

Decision Orientation
6.0%

anaLysis DeCision

D

B
B
C −
C
C
+
C
C
C C
C
C

C
C

BB
BB

B+

A
A
BB −
B+
BB
BB B
B−
BB
+

AA
AA

A+

AA
A
AA
+

One primary goal 4.0%a financial statement analysis and valuation course is to teach students of 2.0% the skills needed to apply their accounting knowledge to solving real business problems and
0.0%
making informed business decisions. With that goal in mind, Analysis Decision boxes in each module encourage students to apply the material presented to solving actual business scenarios. you are the Vice President of Finance

Your company is currently rated B1/B1 by the Moody’s and S&P credit rating agencies, respectively. You are considering possible financial and other restructurings to increase your company’s credit rating. What types of restructurings might you consider? What benefits will your company receive from those restructurings? What costs will your company incur to implement such restructurings? [Answer, p. 4-33]

how Credit ratings are Determined each credit rating agency has its own unique approach to credit rating. recall that credit rating agencies have access to information not available to other lenders because regulation FD does
Research Insights agencies. Typically the agencies create analyst teams that comprise a prinot apply to credit rating mary analyst (team leader) and other analysts and specialists. During the rating process, members
Academicof this team often meet face to face with managers of the businessbeingconducted,meetings research plays an important role in the way company is rated. such accounting and analysis are performed, and students expectations about future demand for industry conditions as can provide insight into managers’ are taught. It is important and students to recognize how well as detailed information on operating and investment Therefore, we periodically incorporate modern research and modern business practice interact.plans. each rating agency has understand the analytical models and methodologies but these relevant research to help studentsits own proprietary,important relation between research and modern models all include at least three types of inputs: macroeconomic statistics, industry data, and business. For representative examples, SEEnot be surprising that credit rating agencies employ company-specific information. it should PAGES 3-19; 5-37. macroeconomists as economy-wide changes can have a considerable impact on the financial position of individual companies. These economists monitor
Financial Statement Effects Template unemployment statistics, consumer confidence metrics, Federal reserve Bank announcements (about interest rates and adjustments), regulatory pronouncements, and related events. These macroeconomic valuation course is not
As instructors, we recognize that the financial statement analysis and events are common across directed individual issue and issuer ratings. solely toward accounting majors. Financial Statement Analysis & Valuation embraces this reality.
The analyst team analyzes industry level data in a manner as previously discussed. each
This bookrating agency tailors existing frameworks (such as Porter’s five forces or a sWOT analysis) and highlights financial reporting, analysis, valuation, interpretation, applications and decision making. their analysis with in-house quantitativefinancial statement agencies have indus- to train augments We incorporate the following (statistical) models. The effects template try experts; that is, the economic ramifications of transactions and their students in understanding analysts who have deep understanding of particular industries. impacts on financial
The analyst team gathers great resource data to compute and analyze financial ratios statements. This analytical tool is a financial statementfor students in learning analysis and applying it such as those we described earlier. A list of the ratios that s&P uses, together with median averto their future courses and careers. is in exhibit 4.7. in examining the ratios, recall that debt is increas- Then,
Each transaction is identified in the “Transaction” column. ages for various risk classes, the dollar amounts (positive or negative) of therow Aaa, to the last, C. effects are recorded in the approingly more risky as we move from the first financial statement priate balanceThe team also seeks statement columns. The template also reflects the statement of cash sheet or income firm-specific qualitative information such as the company’s history, executives’ cash column) of the statement of governance structure, employee (via flow effects (via thereputation, numberandemployees, corporate stockholders’ equity effects turn- the conover, and customer satisfaction. As part of this evaluation, analysts do on-site visits and speak tributed capital and earned capital columns). The earned capital account is immediately updated to directly with managers and executives. importantly, the analyst team must determine whether and reflect anyhow historic company-specific information will change(denoted byAfterarrow line fromare income income or loss arising from each transaction in the future. the all, credit ratings net to earned forward-looking assessments is instructive ability reveals timely debt payments. To that end, capital). This template of a company’s as it to make the financial impacts of transactions, analysts project into the effects and ratios under choices. For those desiring a more traditional and it provides insights financial statementsof accounting a number of scenarios and perform sensitivity analysis on their numbers.

analysis, journal entries and T-accounts are shown in the margin.
Balance Sheet

Transaction
Dr. Acct.
#

Cr. Acct

Cash
Asset

1

Noncash
5
Assets

Liabilities

1

Income Statement
Contrib.
Earned
1
Capital
Capital

RevExpenNet
2
5 enues ses
Income

#

Account
Account

In the margin next to the financial statement effects template are shown the related journal entry and T-account effects.

=
The statement of cash flow effects are reflected via the Cash
Asset column.

2

The statement of stockholders’ equity effects are reflected via the Contributed
Capital and Earned Capital columns.

=

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Mid-Module and Module-End Reviews
Financial statement analysis and valuation can be challenging—especially for students lacking business experience or previous exposure to finance, management, and other business courses.
To reinforce concepts presented in each module and to ensure student comprehension, we include mid-module and module-end reviews that require students to recall and apply the financial statement analysis and valuation techniques and concepts described in each module. To aid students in developing their comparative analysis skills, most of those review problems center on a company or companies that compete with the focus company of that module. For representative examples,
SEE PAGES 3-8; 8-15; 11-39.

Experiential Learning
Students retain information longer if they can apply the lessons learned from the module content.
To meet this need for experiential learning, we conclude each module with a hands-on analysis project. A series of questions guides students’ inquiry and helps students synthesize the material in the module and integrate material across modules. For representative examples, SEE PAGES
1-37; 3-52; 13-28.

Excellent, Class-Tested Assignment Materials
Excellent assignment material is a must-have component of any successful textbook (and class).
We went to great lengths to create the best assignments possible from contemporary financial statements. In keeping with the rest of the book, we used real company data extensively. We also ensured that assignments reflect our belief that students should be trained in analyzing accounting information to make business decisions, as opposed to working on mechanical tasks. Assignments encourage students to analyze accounting information, interpret it, and apply the knowledge gained to a business decision or in a valuation context. There are six categories of assignments: Questions,
Mini Exercises, Exercises, Problems, International Applications, and Discussion Points.

Fourth Edition Changes
Based on classroom use and reviewer feedback, a number of substantive changes have been made in the fourth edition to further enhance the students’ experiences:
■■ Analyzing Cash Flows: To help students better understand cash flows, we have included

■■

■■
■■

■■

■■

a new appendix on the analysis of cash flows (Appendix B). This new appendix includes a discussion of the cash flow cycle and interpretation of cash flow patterns.
Analyst Adjustments: New to the fourth edition, Analyst Adjustments are incorporated throughout most of the modules. These boxed elements explain and illustrate the types of adjustments analysts make to accounting information to make it more useful in their assessment of a firm. See example on Preface page vii.
Ongoing Analysis Project: We have added a project component to each module. See the description above in Experiential Learning.
Updated Financial Data: We have updated all Focus Company financial statements and disclosures to reflect each company’s latest available filings. We also explain the SEC’s EDGAR financial statement retrieval software and how to download excel spreadsheets of financial statements from 10-K filings.
Updated Assignments: We have updated all assignments using real data to reflect each company’s latest available filings and have added many new assignments that also utilize real financial data and footnotes. We have expanded the IFRS Applications to include more companies from Canada and Australia.
International Financial Reporting Standards (IFRS): We have updated the IFRS Insight boxes and IFRS Alert boxes on the similarities and differences between U.S. GAAP and
IFRS. Each module concludes with a Global Accounting section and an expanded IFRS assignments section, which brings in reports and disclosures from around the globe.

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■■ New Focus Companies: We have changed a number of the focus companies: Module 3 now

■■

■■

■■

■■

■■

■■
■■

■■

■■

uses Walmart, Module 8 focuses on IBM, Module 10 uses Southwest Airlines, and Modules
13 and 14 highlight Nike.
Accounting Quality: We augmented the section on accounting quality in Module 5. It describes measures of accounting quality and factors that mitigate accounting quality. We also provide a check list of items in financial statements that should be reviewed when analyzing financial statements.
Intercorporate Investments: Consistent with recent changes in accounting standards, we have revised Module 9 to emphasize investors’ control of securities and deemphasize the percentage of ownership as the determining factor in selecting the method used for financial reporting.
Credit Ratings: This edition expands discussion of credit ratings. This includes trends in credit ratings, current credit rating statistics, and rating procedures implemented by companies such as Moody’s and Standard and Poor’s.
Noncontrolling Interest: We added expanded discussion of noncontrolling interest, how it is reported in financial statements, and the interpretation of its disclosure. The book distinguishes the ROE disaggregation with and without controlling interest and explains how to handle noncontrolling interest for analysis, forecasting, and equity valuation. In Module 9, we also expand our discussion of consolidation to illustrate the allocation of consolidated net income to the noncontrolling interest and to the controlling (parent) interest.
Revised Forecasting Module: We have expanded our discussion of the forecasting of revenues and expenses to distinguish between forecasting using publicly-available databases and forecasting with proprietary databases. For the latter, we continue to utilize analyst reports and spreadsheets provided to us by Morgan Stanley.
Enhanced R&D Analysis: We have developed a new discussion of R&D costs in Module 5 focusing on the analysis and interpretation of R&D.
Expanded Analysis of Allowance Accounts: We have developed a new appendix to Module
6 to illustrate the accounting for sales returns and analysis. We also present a discussion of the analysis of the allowance accounts in Schedule II (Valuation and Qualifying Accounts) of the 10-K or similar disclosures in other types of annual reports.
Pension Accounting: We have expanded our discussion of analysis of pension disclosures, including the change that many companies now immediately recognize actuarial gains and losses in operating results.
New Regulations: We highlight pending and proposed accounting standards and their likely effects, if passed. These include the recently adopted standard on Revenue Recognition. This edition also reflects all accounting standards in effect since our last edition, including the new business combination and consolidation standard and goodwill impairment testing.

Online Instruction and Homework
Management System
: A web-based learning and assessment program intended to complement your textbook and faculty instruction. This easy-to-use program grades homework automatically and provides students with access to narrated demonstrations and eLecture videos. Assignments with in the margin are available in myBusinessCourse. Access is free with new copies of this the textbook (look for a page containing the access code near the front of the book). If you buy a used copy of the book, you can purchase access at www.mybusinesscourse.com.

Supplement Package
For Instructors
: A web-based learning and assessment program intended to complement your textbook and instruction.
Solutions Manual: Created by the authors, the Solutions Manual contains complete solutions to all the assignments in the textbook.

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PowerPoint: Created by the authors, the PowerPoint slides outline key elements of each module.
Test Bank: Written by the authors, the test bank includes multiple-choice items, exercises, short essay questions, and problems.

Computerized Test Bank: This computerized version of the test bank enables you to add and edit questions; create up to 99 versions of each test; attach graphic files to questions; import and export ASCII files; and select questions based on type or learning objective. It provides password protection for saved tests and question databases and is able to run on a network.

Website: All instructor materials are accessible via the book’s Website (password protected) along with other useful links and information. www.cambridgepub.com

For Students
: A web-based learning and assessment program intended to complement your textbook and instruction.
Website: Useful links are available to students free of charge on the book’s Website.

Acknowledgments
All four editions of this book benefited greatly from the valuable feedback of focus group attendees, reviewers, students, and colleagues. We are extremely grateful to them for their help in making this project a success.
Khaled Abdou, Penn State University
Kristian Allee, University of Wisconsin
Teri Allen, Southwest Oklahoma State University
Rihab Alzubaidi, Westfield State College
Paul Bahnson, Boise State University
Gerhard Barone, Gonzaga University
Progyan Basu, University of Maryland
Sudipta Basu, Temple University
Hilary Becker, Carlton University
Frank Beil, University of Minnesota
Joy Begley, University of British Columbia
Richard Bernstein, University of Toledo
William Black, Case Western Reserve University
Kelsey Brasel, University of Alabama—Tuscaloosa
James Briley, Northeastern State University
Philip Brown, Harding University
Jeffrey Byrne, Indiana University Southeast
Michael Calegari, Santa Clara University
Charles Caliendo, University of Minnesota
Shelly Canterbury, George Mason University
Jian Cao, Florida Atlantic University
Dan Carraher, Dominican University
Judson Caskey, University of Texas—Austin
Jack Cathey, University of North Carolina—Charlotte
Agnes Cheng, Louisiana State University
Mei Cheng, University of Arizona
Bob Churchman, Harding University
Michael Clement, University of Texas—Austin
Daniel Cohen, University of Texas—Dallas
John Copley, University of Texas—Dallas
Erin Cornelsen, University of South Dakota
Steve Crawford, Rice University
Akash Dania, Alcorn State University
Hemang Desai, Southern Methodist University

Timothy Dimond, Northern Illinois University
Michael Drake, Brigham Young University
Ellen Engel, University of Chicago
Patricia Fairfield, Georgetown University
Lucille Faurel, University of California—Irvine
Mary Fischer, University of Texas—Tyler
Karen Foust, Tulane University
Joe Foy, CUNY-Brooklyn College
Ed Furticella, Purdue University
Carl Gabrini, College of Coastal Georgia
Margaret Gagne, Marist College
Kelly Gamble, University of Alabama—Huntsville
Waqar Ghani, Saint Joseph’s University
Don Giacomino, Marquette University
John Giles, North Carolina State University
Jianxin Gong, University of Illinois
Maurice Gosselin, University of Laal
Jeffrey Gramlich, University of Southern Maine
Tony Greig, University of Wisconsin
Umit Gurun, University of Texas—Dallas
Robert Halsey, Babson College
John Hand, University of North Carolina
Trevor S. Harris, Columbia University
Charles Harter, Georgia Southern University
Robert Holtfreter, Central Washington University
James A Howard, University of Maryland
James Irving, Clemson University
Ronald Jastrzebski, Purdue University
Kurt Jesswein, Sam Houston State University
Gun Joh, San Diego State University
Stephen John, Kean University
Marilyn Johnson, Michigan State University
Rick Johnston, Purdue University
Christopher Jones, George Washington University

xi

xii 
P
 reface

William Kamas, University of Texas—Dallas
Jocelyn Kauffunger, University of Pittsburgh
Elizabeth Keating, Harvard University
Marve Keene, Coastal Carolina University
Myung-Sun Kim, SUNY University of Buffalo
Sungsoo Kim, Rutgers University—Camden
Bonnie Klamm, North Dakota State University
John Kostolansky, Loyola University
Gopal Krishnan, George Mason University
Cynthia Krom, Franklin & Marshall University
Lisa Kutcher, Colorado State University
Ron Lazer, University of North Carolina
Reuven Lehavy, University of Michigan
Siyi Li, University of Illinois—Chicago
Steve Lim, Texas Christian University
Haijin Lin, University of Houston
Philip Little, Coastal Carolina University
Dennis Lopez, University of Texas—San Antonio
Yoshie Lord, Eastern Illinois University
Barbara Lougee, University of San Diego
Henock Louis, Penn State University
Ron Mano, Westminster College
Stanimir Markov, Southern Methodist University
Maureen Mascha, University of Wisconsin—Oshkosh
Karen McDougal, St. Joseph University
Michael McLain, Hampton University
Krishnagopal Menon, Boston University
Norman Meonske, Kent State University
Bill Mesa, Colorado Christian University
Birendra Mishra, California State University- Riverside
Debra Moore, Dallas Baptist University
Erin Moore, Westfield State University
Mark Moore, Texas Tech University
Haim Mozes, Fordham University
Belinda Mucklow, University of Wisconsin
R.D. Nair, University of Wisconsin
Alex Nekrasov, University of California—Irvine
Michael Neugent, University of Cincinnati
Christopher Noe, Massachusetts Institute of Technology
Emeka Nwaeze, University of Texas—San Antonio
Donald Pagach, North Carolina State University
Shailendra Pandit, University of Illinois—Chicago
Aaron Pennington, York College of Pennsylvania
Ray Pfeiffer, Texas Christian University
Brandis Phillips, North Carolina A&T University
Chris Prestigiacomo, University of Missouri

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Richard Price, Utah State University
Larry Prober, Rider University
Rama Ramamurthy, College of William & Mary
KK Raman, University of Texas—San Antonio
Ken Reichelt, Louisiana State University
Jay Rich, Illinois State University
Edward Riedl, Harvard University
Byung Ro, Purdue University
Andrea Roberts, University of Virginia
Darren Roulstone, Ohio State University
Marc Rubin, Miami University
Anwar Salimi, CSU Pomona
Carol Sargent, Georgia State University
Bill Schwartz, Oklahoma State University
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Andreas Simon, Cal Poly—San Luis Obispo
Praveen Sinha, Cal State—Long Beach
Nancy Snow, University of Toledo
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Victor Stanton, University of California—Berkeley
John J. Surdick, Xavier University
Eric Sussman, UCLA
Diane Tanner, University of North Florida
Gary Taylor, University of Alabama
Teresa Thamer, Brenau University
Randy Thomas, Upper Iowa University
Dorothy Thompson, University of North Texas
Russell Tietz, Kent State University
Jack Trifts, Bryant University
Mark Trombley, University of Arizona
Carmelita Troy, Andrews University
Andrew Van Buskirk, Ohio State University
William Walsh, Syracuse University
Charles Wasley, University of Rochester
Ralph Welton, Clemson University
Clark Wheatley, Florida International University
Billy Wi, Wesleyan College
Matt Wieland, University of Georgia
Jeffrey Wong, University of Nevada—Reno
Lee Yao, Loyola University—New Orleans
Susan Young, Fordham University
Yong Yu, University of Texas—Austin
Lin Zheng, Mercer University

In addition, we are extremely grateful to George Werthman, Lorraine Gleeson, Beth Nodus, Jocelyn Mousel, Jill
Fischer, Debbie McQuade, Terry McQuade, and the entire team at Cambridge Business Publishers for their encouragement, enthusiasm, and guidance.

Peter Mary Lea Greg Xiao-Jun

August 2014

Brief Contents
Preface v

1

Framework for Analysis and Valuation 1-1

2

Review of Business Activities and Financial Statements 2-1

3

Profitability Analysis and Interpretation 3-1

4

Credit Risk Analysis and Interpretation 4-1

5

Revenue Recognition and Operating Income 5-1

6

Asset Recognition and Operating Assets 6-1

7

Liability Recognition and Nonowner Financing 7-1

8

Equity Recognition and Owner Financing 8-1

9

Intercorporate Entities 9-1

10

Off-Balance-Sheet Financing 10-1

11

Forecasting Financial Statements 11-1

12

Cost of Capital and Valuation Basics 12-1

13

Cash-Flow-Based Valuation 13-1

14

Operating-Income-Based Valuation 14-1

15

Market-Based Valuation 15-1

Appendix A: Compound Interest Tables

A-1

Appendix B: Constructing and Analyzing the Statement of Cash Flows B-1 Appendix C: Comprehensive Case C-1 Appendix D: Chart of Accounts with Acronyms D-1

Glossary G-1

Index I-1

xiii

Contents
About the Authors iii

Exercises 1-30

Preface v

Problems 1-31
IFRS Applications 1-36

Module

1

Discussion Points 1-36
Ongoing Analysis Project 1-37
Solutions to Review Problems 1-38

Framework for Analysis and Valuation 1-1
Step 1— usiness Environment and Accounting Information 1-5
B
Reporting on Business Activities 1-5
Demand for and Supply of Accounting Information 1-6
Demand for Information 1-7
Supply of Information 1-7
International Accounting Standards and Convergence 1-9
Review of Financial Statements 1-10
Balance Sheet 1-10
Income Statement 1-12
Statement of Stockholders’ Equity 1-14
Statement of Cash Flows 1-15

Module

2

Review of Business Activities and Financial Statements 2-1
Interpreting a Balance Sheet 2-3
Assets 2-4
Liabilities and Equity 2-6
Interpreting an Income Statement 2-11
Recognition of Revenues and Expenses 2-12
Reporting of Transitory Items 2-13

Financial Statement Linkages 1-16

Interpreting a Statement of Stockholders’ Equity 2-15

Information Beyond Financial Statements 1-16

Interpreting a Statement of Cash Flows 2-15

Analyzing the Competitive Business Environment 1-16
SWOT Analysis of the Business Environment 1-19
Analyzing the Broader Business Environment 1-19
Mid-Module Review 1-20
Step 2—Adjusting and Assessing Financial Information 1-20
Choices in Financial Reporting 1-20
Analysis of Financial Statements 1-22
Step 3—Forecasting Financial Numbers 1-23
Step 4—Company Valuation 1-24
Financial Statement Analysis in an
Efficient Capital Market 1-25

Statement Format and Data Sources 2-16
Cash Flow Computations 2-18
Mid-Module Review 1 2-19
Articulation of Financial Statements 2-20
Retained Earnings Reconciliation 2-20
Financial Statement Linkages 2-20
Mid-Module Review 2 2-22
Analyzing Transactions and Adjustments 2-22
Transaction Analysis 2-23
Adjusting Accounts 2-24

Analyzing Global Reports 1-26

Constructing Financial Statements from
Transactions and Adjustments 2-28

Module-End Review 1-26

Closing Process 2-32

Appendix 1A: Accessing SEC Filings 1-26

Analyzing Global Reports 2-32

Guidance Answers . . . Analysis Decision 1-28

Module-End Review 2-33

Questions 1-28

Appendix 2A: Additional Information Sources 2-34

Mini Exercises 1-29

xiv

Form 10-K 2-34
Form 20-F and Form 40-F 2-35

C
 ontents
Form 8-K 2-35

Derivation of Nonoperating Return Formula 3-27

Analyst Reports 2-35

xv

Special Topics 3-28

Credit Services 2-36

Appendix 3B: DuPont Disaggregation Analysis 3-29

Data Services 2-36

Basic DuPont Model 3-29

Guidance Answers . . . Analysis Decision 2-37

Return on Assets 3-29

Questions 2-37

Productivity 3-30

Mini Exercises 2-38

Financial Leverage 3-30
ROA Adjustment in the Basic DuPont Model 3-31

Exercises 2-39

Illustration of DuPont Disaggregation 3-31

Problems 2-43

Guidance Answers . . . Analysis Decision 3-32

IFRS Applications 2-48

Questions 3-32

Discussion Points 2-50
Ongoing Analysis Project 2-51
Solutions to Review Problems 2-52

Mini Exercises 3-32
Exercises 3-36
Problems 3-40
IFRS Applications 3-49

Module

3

Profitability Analysis and
Interpretation 3-1

Discussion Points 3-52
Ongoing Analysis Project 3-52
Solutions to Review Problems 3-53

Return on Equity (ROE) 3-4
Operating Return (RNOA) 3-5
Operating Items in the Income Statement—NOPAT 3-5
Mid-Module Review 1 3-8
Operating Items in the Balance Sheet—NOA 3-8
Computing Return on Net Operating Assets (RNOA) 3-12
RNOA Disaggregation into Margin and Turnover 3-13

Module

4

Credit Risk Analysis and
Interpretation 4-1
Demand for and Supply of Credit 4-3
Demand for Credit 4-3
Supply of Credit 4-5

Net Operating Profit Margin 3-13

Mid-Module Review 1 4-7

Net Operating Asset Turnover 3-14

Credit Risk Analysis Process 4-7

Trade-Off between Margin and Turnover 3-15

Analyzing Credit Risk 4-8

Mid-Module Review 2 3-16
Further RNOA Disaggregation 3-17
Nonoperating Return 3-18
Financial Leverage Across Industries 3-20
Limitations of Ratio Analysis 3-20
Analyzing Global Reports 3-22
Module-End Review 3-23
Appendix 3A: Nonoperating Return Component of ROE 3-23
Nonoperating Return Framework 3-23
Nonoperating Return—With Debt Financing, but Without Nonoperating Assets 3-23

Chance of Default 4-8
Mid-Module Review 2 4-18
Loss Given Default 4-20
Credit Ratings 4-22
Why Companies Care About Their Credit Rating 4-23
How Credit Ratings Are Determined 4-25
Predicting Bankruptcy Risk 4-28
Altman Z-Score 4-28
Application of Z-Score 4-28
Bankruptcy Prediction Errors 4-29
Module-End Review 4-30
Appendix 4:  redit Risk Analysis at Two Major NRSROs 4-30
C

Nonoperating Return—With Debt Financing and Nonoperating Assets 3-24

Guidance Answers . . . Analysis Decision 4-33

Nonoperating Return—Without Debt Financing, but With Nonoperating Assets 3-26

Mini Exercises 4-34

Nonoperating Return—With Debt Financing, Nonoperating
Assets, and Noncontrolling Interest 3-26

Questions 4-34

Exercises 4-35
Problems 4-38

xvi 
C
 ontents
IFRS Applications 4-44

Analysis Implications 6-9

Ongoing Analysis Project 4-48

Mid-Module Review 1 6-14

Discussion Points 4-48

Analysis of Inventory 6-14

Solutions to Review Problems 4-49

Capitalization of Inventory Cost 6-15
Inventory Costing Methods 6-15
Lower of Cost or Market 6-18

Module

5

Revenue Recognition and
Operating Income 5-1
Operating Income Components 5-5
Revenue and its Recognition 5-5
Research and Development (R&D) Expenses 5-12
Restructuring Expenses and Incentives 5-15
Mid-Module Review 1 5-20
Income Tax Expenses and Allowances 5-20
Mid-Module Review 2 5-29
Foreign Currency Translation Effects 5-29
Operating Components Below-The-Line 5-30
Discontinued Operations 5-31

Footnote Disclosures 6-19
Financial Statement Effects of Inventory Costing 6-20
Tools of Inventory Analysis 6-22
LIFO Liquidations 6-26
Mid-Module Review 2 6-27
Analysis of Property, Plant and Equipment (PPE) 6-28
Capitalization of Asset Costs 6-28
Depreciation 6-29
Asset Sales and Impairments 6-32
Footnote Disclosures 6-35
Analysis Implications 6-36
Analyzing Global Reports 6-40
Module-End Review 6-41
Appendix 6A: Sales Returns and Allowances 6-41
Analysis of Allowance Accounts 6-42

Extraordinary Items 5-32

Guidance Answers . . . Analysis Decision 6-43

Earnings Per Share 5-33

Questions 6-44
Mini Exercises 6-44

Accounting Quality 5-34
Assessing and Remediating Accounting Quality 5-37

Exercises 6-47

Analyzing Global Reports 5-38

Problems 6-52

Module-End Review 5-40

IFRS Applications 6-56

Appendix 5A:  hanges to Revenue Recognition Standard 5-40
C

Discussion Points 6-60

Appendix 5B: Expanded Explanation of
Deferred Taxes 5-42

Ongoing Analysis Project 6-60
Solutions to Review Problems 6-61

Questions 5-44
Mini Exercises 5-44
Exercises 5-47
Problems 5-52

Module

IFRS Applications 5-62

7

Liability Recognition and
Nonowner Financing 7-1

Discussion Points 5-66
Ongoing Analysis Project 5-66
Solutions to Review Problems 5-68

Analyzing Current Liabilities 7-4
Accounts Payable 7-5
Accounts Payable Turnover (APT) 7-5

Module

6

Asset Recognition and
Operating Assets 6-1
Analysis of Accounts Receivable 6-4
Allowance for Uncollectible Accounts 6-5
Footnote and MD&A Disclosures 6-8

Mid-Module Review 1 7-6
Accrued Liabilities 7-6
Mid-Module Review 2 7-11
Current Nonoperating Liabilities 7-11
Mid-Module Review 3 7-12
Analyzing Long-Term Nonoperating Liabilities 7-13
Pricing of Debt 7-13
Effective Cost of Debt 7-15

C
 ontents
Analyzing Debt Financing 7-16

xvii

Sell-Offs 8-25

Financial Statement Effects of Debt Issuance 7-16

Spin-Offs 8-26

Effects of Discount and Premium Amortization 7-18

Split-Offs 8-27

Financial Statement Effects of Bond Repurchase 7-20
Financial Statement Footnotes 7-20
Credit Ratings and the Cost of Debt 7-22

Analysis of Equity Carve-Outs 8-27
Mid-Module Review 4 8-28
Convertible Securities 8-28

What Are Credit Ratings? 7-23

Analyzing Global Reports 8-29

What Determines Credit Ratings? 7-24

Guidance Answers . . . Analysis Decision 8-30

Any Trends with Credit Ratings? 7-25
Financial Ratios Across Industries 7-26
Analyzing Global Reports 7-27
Module-End Review 7-28
Appendix 7A: Compound Interest 7-28
Present Value Concepts 7-28
Future Value Concepts 7-33

Module-End Review 8-30
Questions 8-31
Mini Exercises 8-31
Exercises 8-34
Problems 8-39
IFRS Applications 8-46

Appendix 7B: Economics of Gains and Losses on Bond Repurchases 7-33

Discussion Points 8-51

Guidance Answers . . . Analysis Decision 7-35

Solutions to Review Problems 8-52

Ongoing Analysis Project 8-51

Questions 7-35
Mini Exercises 7-35
Exercises 7-38
Problems 7-42
Module

IFRS Applications 7-46

9

Intercorporate Entities 9-1

Discussion Points 7-53
Ongoing Analysis Project 7-53
Solutions to Review Problems 7-54

Analyzing Passive Investments 9-5
Acquisition and Sale 9-5
Fair Value Versus Cost 9-6
Investments Marked to Market 9-7

Module

8

Equity Recognition and
Owner Financing 8-1
Analyzing Contributed Capital 8-4

Financial Statement Disclosures 9-8
Investments Reported at Cost 9-10
Mid-Module Review 1 9-11
Analyzing Investments with Significant Influence 9-12
Accounting for Investments with Significant Influence 9-12
Equity Method Accounting and ROE Effects 9-14

Classes of Stock 8-5

Mid-Module Review 2 9-17

Analyzing Stock Transactions 8-7

Analyzing Investments with Control 9-18

Analyzing Stock-Based Compensation 8-10

Accounting for Investments with Control 9-18

Mid-Module Review 1 8-15

Analyzing Global Reports 9-29

Analyzing Earned Capital 8-15

Module-End Review 9-30

Cash Dividends 8-16
Mid-Module Review 2 8-17
Stock Dividends and Splits 8-17
Mid-Module Review 3 8-19
Accumulated Other Comprehensive Income 8-20
Analyzing Noncontrolling Interest 8-22
Analysis and Interpretation of Noncontrolling Interest 8-23
Summary of Stockholders’ Equity 8-24
Analyzing Equity Carve-Outs and Convertibles 8-25

Appendix 9A: Analyzing Derivatives 9-31
Disclosures for Derivatives 9-32
Guidance Answers . . . Analysis Decision 9-35
Questions 9-35
Analysis of Derivatives 9-35
Mini Exercises 9-36
Exercises 9-37
Problems 9-46

xviii 
C
 ontents
IFRS Applications 9-51
Discussion Points 9-55
Ongoing Analysis Project 9-55
Module

Solutions to Review Problems 9-56

Module

10

Off-Balance-Sheet
Financing 10-1
Analyzing Leases 10-4
Lessee Reporting of Leases 10-4
Footnote Disclosure of Leases 10-6
Capitalization of Operating Leases 10-7
Mid-Module Review 10-11
Analyzing Pensions 10-12
Reporting of Defined Benefit Pension Plans 10-13
Balance Sheet Effects 10-13
Income Statement Effects 10-15
Footnote Disclosures—Components of
Plan Assets and PBO 10-16
Footnote Disclosures and Future Cash Flows 10-18
Footnote Disclosures and Profit Implications 10-19
Analysis Implications 10-20
Other Post-Employment Benefits 10-21
Analyzing Global Reports 10-23
Module-End Review 10-24
Appendix 10A: Amortization Component of
Pension Expense 10-25
Appendix 10B: Special Purpose Entities (SPEs) 10-26
Applying SPEs as Financing Tools 10-27
Reporting of SPEs Designated as VIEs 10-28
Analysis Implications of SPEs 10-28
Appendix 10C:  ease Capitalization Using a Calculator
L
and Present Value Tables 10-29
Lease Capitalization Using Present Value Tables 10-31
Guidance Answers . . . Analysis Decision 10-31
Questions 10-32
Mini Exercises 10-32
Exercises 10-36
Problems 10-42
IFRS Applications 10-47
Ongoing Analysis Project 10-53
Solutions to Review Problems 10-54

11

Forecasting Financial
Statements 11-1
Forecasting Process 11-3
Overview of Forecasting Process 11-4
All-Important Revenues Forecast 11-5
Identifying the Forecasting Steps 11-7
Forecasting Process: Procter & Gamble 11-7
Step 1: Forecasting Revenues 11-8
Factors Impacting Revenue Growth 11-9
Forecasting Revenue Growth 11-13
Step 2: Forecasting Expenses 11-21
Forecasting Operating Expenses 11-21
Forecasting Nonoperating Expenses 11-21
Forecasting Expenses for P&G Using
Public Information 11-21
Forecasting Expenses for P&G Using
Proprietary Databases 11-24
Step 3: Forecasting Assets, Liabilities and Equity 11-25
Process of Forecasting Balance Sheet Items 11-26
Forecasting Balance Sheet Items 11-28
Step 4: Adjust Forecasted Statements 11-33
Adjust Forecasted Balance Sheet 11-34
Forecasting Statement of Cash Flows 11-35
Additional Forecasting Issues 11-36
Reassessing Financial Statement Forecasts 11-36
Multiyear Forecasting of Financial Statements 11-37
Mid-Module Review 11-39
Parsimonious Multiyear Forecasting 11-41
Parsimonious Method for Forecasting 11-41
Multiyear Forecasting with Parsimonious Method 11-42
Analyzing Global Reports 11-42
Module-End Review 11-43
Appendix 11A:  organ Stanley’s Forecast Report
M
on Procter & Gamble 11-43
Questions 11-59
Mini Exercises 11-59
Exercises 11-62
Problems 11-70
IFRS Applications 11-77
Discussion Points 11-79
Ongoing Analysis Project 11-81
Solutions to Review Problems 11-82

C
 ontents

xix

Discounted Cash Flow (DCF) Model 13-5
DCF Model Structure 13-5

Module

12

Cost of Capital and
Valuation Basics 12-1
Basics of Valuation 12-3

Steps in Applying the DCF Model 13-7
Illustrating the DCF Model 13-7
Extending the DCF Model 13-9
Analyzing Global Reports 13-11
Module-End Review 13-11
Appendix 13A: Nike Financial Statements 13-12

Payoffs from Equity and Debt Instruments 12-4
Steps in Stock Valuation 12-4
Intrinsic Value 12-5
Review of Time Value of Money 12-6
Valuation of a Debt Instrument 12-9
Valuation of an Equity Instrument 12-9
Estimating Cost of Capital 12-10

Appendix 13B: RBC Capital Markets Valuation of
Procter & Gamble 13-14
Guidance Answers . . . Analysis Decision 13-16
Questions 13-16
Appendix 13C:  erivation of Free Cash Flow Formula 13-16
D
Mini Exercises 13-17

Diversifiable and Non-Diversifiable Risk 12-11

Exercises 13-17

Cost of Equity Capital Using the Capital
Asset Pricing Model 12-11

Problems 13-20

Cost of Equity Capital Using a Multi-Factor Model 12-13

Ongoing Analysis Project 13-28

Cost of Debt Capital 12-13
Weighted Average Cost of Capital 12-15

IFRS Applications 13-27

Solutions to Review Problems 13-29

Mid-Module Review 12-16
Dividend Discount Model 12-17
Recursive Process of Valuation 12-17
Module

Framework of the Dividend Discount Model 12-18
Dividend Discount Model with Constant Perpetuity 12-18
Dividend Discount Model with Increasing Perpetuity 12-19

14

Operating-IncomeBased Valuation 14-1

Issues in Applying the Dividend Discount Model 12-19
Equity Valuation Models 14-4

Module-End Review 12-22
Appendix 12A: Estimating Cost of Equity Capital 12-22
Guidance Answers . . . Analysis Decision 12-27
Questions 12-27

Residual Operating Income (ROPI) Model 14-5
ROPI Model Structure 14-5
Steps in Applying the ROPI Model 14-6
Illustrating the ROPI Model 14-7

Mini Exercises 12-27

Extending the ROPI Model 14-8

Exercises 12-28

Steady State in Valuation 14-9

Problems 12-30

Forecast Sources Determining Valuation 14-9

Discussion Points 12-33

Achieving Steady State 14-10

Solutions to Review Problems 12-36

Forcing Steady State—An Illustration 14-11
Managerial Insights from the ROPI Model 14-11
Assessment of Valuation Models 14-13

Module

13

Cash-Flow-Based
Valuation 13-1
Equity Valuation Models 13-4
Dividend Discount Model 13-4
Discounted Cash Flow Model 13-4
Residual Operating Income Model 13-5
Model Equivalency 13-5

Analyzing Global Reports 14-14
Module-End Review 14-14
Appendix 14A: Nike Financial Statements 14-15
Guidance Answers . . . Analysis Decision 14-17
Questions 14-17
Mini Exercises 14-17
Exercises 14-18
Problems 14-22
IFRS Applications 14-28

xx 
C
 ontents
Discussion Points 14-30

A

Ongoing Analysis Project 14-30

Appendix

Solutions to Review Problems 14-31

Compound Interest Tables A-1

Module

15

Market-Based
Valuation 15-1
Valuation Model using Market Multiples 15-3
Application of the Model Using Market Multiples 15-4
Valuation Using Balance Sheet Multiples 15-6

Appendix

B

Constructing and
Analyzing the Statement of Cash Flows B-1
Framework for Statement of Cash Flows B-5

Valuation Using a Net Operating Asset (NOA) Multiple 15-6

Operating Activities B-7

Valuation Using a Book Value (BV) Multiple 15-7

Investing Activities B-7

Mid-Module Review 1 15-8
Valuation Using Income Statement Multiples 15-9
Valuation Using a Net Operating Profit
After Tax (NOPAT) Multiple 15-9
Valuation Using a Net Income (NI) Multiple 15-10
Valuation Using Industry-Based Multiples 15-11
Combining Estimates from Differing Multiples 15-12
Mid-Module Review 2 15-13
Selecting Comparables for Market Multiples 15-13
Deriving Price-to-Book from Residual
Operating Income Model 15-13
PB Ratios in Relation to Profitability, Growth, and Risk 15-14
Mid-Module Review 3 15-17
Deriving Price-to-Earnings from Residual
Operating Income Model 15-17
PE Ratios in Relation to Profitability, Growth, and Risk 15-18
Mid-Module Review 4 15-19
Interpreting and Reverse Engineering of Market Multiples 15-20
Interpreting and Reverse Engineering the PB Ratio 15-20
Interpreting and Reverse Engineering the PE Ratio 15-21
Perspective on Valuation Multiples and
Fundamental Analysis 15-22

Financing Activities B-8
Cash Flows From Operating Activities B-8
Steps to Compute Net Cash Flow from
Operating Activities B-9
Java House Case Illustration B-10
Cash Flows from Investing Activities B-14
Analyze Remaining Noncash Assets B-14
Java House Case Illustration B-14
Cash Flows from Financing Activities B-15
Analyze Remaining Liabilities and Equity B-15
Java House Case Illustration B-15
Summary of Net Cash Flow Reporting B-16
Supplemental Disclosures for Indirect Method B-17
Java House Case Illustration B-17
Analysis of Cash Flow Information B-19
Cash Flow Patterns B-19
Usefulness of the Statement of Cash Flows B-23
Ratio Analyses of Cash Flows B-23
Appendix-End Review 1 B-25
Appendix B1:  irect Method Reporting for the
D
Statement of Cash Flows B-26
Cash Flows from Operating Activities B-27
Cash Flows from Investing and Financing B-29

Module-End Review 15-23

Appendix-End Review 2 B-29

Guidance Answers . . . Analysis Decision 15-24

Guidance Answers . . . Analysis Decision B-30

Questions 15-24

Questions B-31

Mini Exercises 15-24

Mini Exercises B-32

Exercises 15-26

Exercises B-34

Problems 15-30

Problems B-38

Discussion Points 15-34

IFRS Applications B-47

Solutions to Review Problems 15-37

Solutions to Review Problems B-49

C
 ontents

Appendix

Appendix

C

Comprehensive Case C-1
Introduction C-3
Reviewing The Financial Statements C-4
Income Statement Reporting and Analysis C-4
Balance Sheet Reporting and Analysis C-12
Off-Balance-Sheet Reporting and Analysis C-23
Statement of Cash Flows Reporting and Analysis C-26
Independent Audit Opinion C-27
Assessing Profitability and Creditworthiness C-28
ROE Disaggregation C-29
Disaggregation of RNOA—Margin and Turnover C-29
Disaggregation of Margin and Turnover C-29
Credit Analysis C-30
Summarizing Profitability and Creditworthiness C-30
Forecasting Financial Statement Numbers C-31
Valuing Equity Securities C-34
Parsimonious Forecast C-34
Discounted Cash Flow Valuation C-34
Residual Operating Income Valuation C-35
Sensitivity Analysis of Valuation Parameters C-35
Assessment of the Valuation Estimate C-36
Summary Observations C-36

D

Chart of Accounts with Acronyms D-1
Assets D-1
Liabilities D-1
Equity D-1
Revenues and Expenses D-1
Closing Account D-1

Glossary G-1
Index I-1

xxi

2. Identify and explain the four financial statements, and define the accounting equation. (p. 1-10)

3. Describe business analysis within the context of a competitive environment. (p. 1-16)
4. Explain and apply the basics of profitability analysis. (p. 1-22)

© Getty Images

Learning
Obj e c t i v e s

1. Identify and discuss the users and suppliers of financial statement information. (p. 1-6)

M o d u l e

Framework for Analysis and Valuation

1

B e rk s hire H a t h a w a y owns numerous businesses that pursue diverse activities. The legendary Warren Buffett, the
“Sage of Omaha,” manages the company. Buffett’s investment philosophy is to acquire and hold companies over the long run. His acquisition criteria, taken from Berkshire Hathaway’s annual report, follow:
1. Large purchases (and large pretax earnings).

Berkshire Hathaway

2.  emonstrated consistent earning power (future projections are of no
D
interest to us, nor are ‘turnaround’ situations).
3.  usinesses earning good returns on equity while employing little or
B
no debt.

4. Management in place (we can’t supply it).
5. Simple businesses (if there’s lots of technology, we won’t understand it).
6. An offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).
At least three of Buffett’s six criteria relate to financial performance. First, he seeks businesses with large and consistent earning power. Buffett is not only looking for consistent earnings, but earnings that are measured according to accounting policies that closely mirror the underlying economic performance of the business.
Second, Buffett focuses on “businesses earning good returns on equity,” defined as income divided by average stockholders’ equity: “Our preference would be to reach our goal by directly owning a diversified group of businesses that generate cash and consistently earn above-average returns” (Berkshire Hathaway annual report). For management to earn a good return on equity, it must focus on both income (financial performance) and equity (financial condition).
Third, Buffett values companies based on their ability to generate consistent earnings and cash. He focuses on intrinsic value, which he defines in each annual report as follows:
Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.
The discounted value Buffett describes is the present (today’s) value of the cash flows the company expects to generate in the future. Cash is generated when companies are well managed and operate profitably and efficiently.
Warren Buffett provides some especially useful investment guidance in his Chairman’s letter from a prior period’s
Berkshire Hathaway annual report:
(continued on next page) 1-2

(continued from previous page)

Three suggestions for investors: First, beware of companies displaying weak accounting. . . . When managements take the low road in aspects that are visible, it is likely they are following a similar path behind the scenes. There is seldom just one cockroach in the kitchen.
Second, unintelligible footnotes usually indicate untrustworthy management. If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to.
Finally, be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, nosurprise environment, and earnings simply don’t advance smoothly (except, of course, in the offering books of investment bankers).
This book will explain Buffett’s references to earnings projections, growth expectations, and return on equity as well as a host of other accounting issues that affect interpretation and valuation of companies’ financial performance. We will analyze and interpret the footnotes, which Buffett views as crucial to quality financial reporting and analysis. Our philosophy is simple: we must understand the intricacies and nuances of financial reporting to become critical readers and users of financial reports for company analysis and valuation.
Sources: Berkshire Hathaway 10-K Reports, Berkshire Hathaway Annual Reports; The Wall Street Journal, January 2014.

MODule
O r g a n i z at i o n

Framework for Analysis and Valuation

Business Environment and
Accounting Information

Adjusting and Assessing
Financial Information

n Reporting on Business Activities

n Choices in Financial Reporting

n Demand for and Supply of

n Analysis of Financial Statements

Accounting Information

n Return on Assets Disaggregation

n Review of Financial Statements n Analyzing the Competitive

Business Environment

n Profitability and Productivity

Forecasting and Valuation n Forecasting Financial

Performance and Financial
Condition
n Company Valuation for Business

Decisions n Financial Statement Analysis in

an Efficient Capital Market

Financial statement analysis is the process of extracting information from financial statements to better understand a company’s current and future performance and financial condition. Financial statements serve many objectives. Management uses financial statements to raise financing for the company, to meet disclosure requirements, and to serve as a benchmark for executive bonuses. Investors and analysts use financial statements to help decide whether to buy or sell stock. Creditors and rating agencies use financial statements to help decide on the creditworthiness of a company’s debt and lending terms. Regulatory agencies use financial statements to encourage enactment of social and economic policies and to monitor compliance with laws.
Legal institutions use financial statements to assess fines and reparations in litigation. Various other decision makers rely on financial statements for purposes ranging from determining demands in labor union negotiations to assessing damages for environmental abuses.
Valuation is the process of drawing on the results of financial statement analysis to estimate a company’s worth (enterprise value). A company’s worth can be viewed as a collection of assets, and those assets have claims on them. Owner claims are reflected in equity shares
(securities) of a company. Nonowner claims are reflected in obligations and debt shares (securities) of the company. The valuation process seeks to assess the worth of equity shares or debt shares, or both.
Financial statement analysis and valuation is the joint process of scrutinizing a company’s financial statements and valuing its equity and debt. The relations between the company (its assets) and the market claims on the company are depicted here:
1-3

Module 1 | Framework for Analysis and Valuation
Company

=
Value
of the
Company

Market
Stock
Stock
Stock
Stock
Stock

Owner
Claims

Shareholders
(equity market)

Nonowner
Claims

Creditors
(debt market)

+
Claims
on the
Company

We see that company value equals owner and nonowner claims, where those claims are valued by the equity and debt markets.
This book provides a framework and several tools to help us analyze companies and value their securities. To this end, it is helpful to imagine yourself as a specific user of financial statements. For example, imagine you are a stock investor—how do you identify a stock to buy or whether to sell a stock you own? Imagine you are a bond trader—how do you identify a bond to acquire or whether to dispose of a bond you own? Imagine you are a manager—how do you decide whether to acquire another company or divest of a current division? Imagine you are an equity or credit analyst—how do you assess and communicate an investment appraisal or credit risk report? This focused perspective will enhance your learning process and makes it relevant.
This module begins with an overview of the demand for and supply of accounting information. We then review financial statements and explain what they convey about a company.
We provide an introduction to analysis of the business environment, which is a crucial part of understanding the context in which we draw inferences from financial statements. Profitability is described next as it frames much of our analysis of financial statements. In concluding the module, we discuss the application of information garnered from financial statement analysis and business analysis to produce forecasts that are used in valuation. We include (in the appendix) a discussion of accessing SEC filings, which are required for all companies traded publicly in the U.S.
The remainder of the book is organized around four key steps in financial statement analysis and valuation. These steps are portrayed graphically at the top of the next page. Step 1 consists of Modules 1 and 2 where we develop an understanding of the business environment and company-reported accounting information, including the statement of cash flows in Appendix B. This helps answer the question: What is the setting in which the company operates? Step 2 consists of Modules 3 and 4, which introduce both profitability and credit risk analysis, and Modules 5 through 10, which provide tools for adjusting and assessing financial statement information. This step is the core of financial statement analysis, allowing us to adjust financial statements as necessary to improve our analysis and better reflect business performance and financial condition. The adjustments and assessments answer the question: What is the company’s current financial performance and condition? Step 3 consists of Module 11, which applies our knowledge of the business environment and company’s current status to form predictions about future financial performance and condition.
Forecasting reflects our beliefs of where the company is heading. Step 4 consists of Modules 12 through 15 and utilizes the forecasted information in a variety of valuation methods. The valuation estimates based on forecasted numbers help answer the question: What is the company worth? Implicit to all decision making in a business context should be an analysis of value or the change in value. This book explains the explicit connections that allow us to estimate company value from financial information. All four steps are repeated in
Appendix C, which examines Kimberly-Clark as a case analysis.

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1-5

Module 1 | Framework for Analysis and Valuation

Step 1—Understanding the Business Environment and Accounting Information
Modules 1 and 2 and Appendix B

Where does the firm operate?

Step 2—Adjusting and Assessing Financial Information and Accounting Information
Profitability Analysis—Module 3 Investing—Modules 6, 9, and 10
Credit Analysis—Module 4
Financing—Modules 7 and 8
Operations—Module 5

Where is the firm currently?

Step 3—Forecasting Financial Information
Module 11

Where is the firm going?

Step 4—Using Information for Valuation
Cost of Capital and Valuation Basics—Module 12
Cash-Flow-Based Valuation—Module 13
Operating-Income-Based Valuation—Module 14
Market-Based Valuation—Module 15

What is the firm worth?

Step 1— usiness Environment and
B
Accounting Information
Reporting on Business Activities
To effectively analyze a company or infer its value, we must understand the company’s business activities. Financial statements help us understand these business activities. These statements report on a company’s performance and financial condition, and reveal executive management’s privileged information and insights.
Financial statements seek to satisfy the needs of a diverse group of users. The functioning of the accounting information system involves application of accounting standards to produce financial statements. Effectively using this information system involves making judgments, assumptions, and estimates based on data contained in the financial reports. The greatest value we derive from this information system as users of financial reports is the insight we gain into the business activities of the company under analysis.
To effectively analyze and use accounting information, we must consider the business context in which the information is created—see Exhibit 1.1. Without exception, all companies plan business activities, finance those activities, invest in those activities, and then engage in operating activities.
Companies conduct all these activities while confronting business forces, including market constraints and competitive pressures. Financial statements provide crucial input for strategic planning.
They also provide information about the relative success of previously implemented plans, which can be used to take corrective action or make new operating, investing, and financing decisions.
Exhibit 1.1 depicts the business activities for a typical company. The outer (green) ring is the planning process that reflects the overarching goals and objectives of the company within which strategic decisions are made. Those strategic decisions involve company financing, asset management, and daily operations. Apple Inc., the focus company in Module 2, provides the following description of its business strategy in its annual report:
Business Strategy The Company is committed to bringing the best user experience to its customers through its innovative hardware, software, peripherals, and services. The Company’s business strategy leverages its unique ability to design and develop its own operating systems, hardware, continued Module 1 | Framework for Analysis and Valuation

1-6

continued from prior page

application software, and services to provide its customers new products and solutions with superior ease-of-use, seamless integration, and innovative design. The Company believes continual investment in research and development, marketing and advertising is critical to the development and sale of innovative products and technologies. As part of its strategy, the Company continues to expand its platform for the discovery and delivery of third-party digital content and applications through the iTunes Store . . . The Company also supports a community for the development of third-party software and hardware products and digital content that complement the Company’s offerings. The
Company’s strategy also includes expanding its distribution network to effectively reach more customers and provide them with a high-quality sales and post-sales support experience.

A company’s strategic (or business) plan reflects how it plans to achieve its goals and objectives. A plan’s success depends on an effective analysis of market demand and supply. Specifically, a company must assess demand for its products and services, and assess the supply of its inputs (both labor and capital). The plan must also include competitive analyses, opportunity assessments, and consideration of business threats.
Historical financial statements provide insight into the success of a company’s strategic plan thus far, and are an important input to the planning process. These statements highlight portions of the strategic plan that proved profitable and, thus, warrant additional capital investment. They also reveal areas that are less effective, and provide information to help managers develop remedial action.
Once strategic adjustments are planned and implemented, the resulting financial statements provide input into the planning process for the following year; and this process begins again.
Understanding a company’s strategic plan helps focus our analysis of financial statements by placing them in proper context.
EXHIBIT 1.1

Business Activities
Fo
rc es es rc Fo

Pla

g

nin

an
Pl
Prior financial statements are inputs into planning
Balance sheet
Income statement
Statement of stockholders' equity Statement of cash flows

Investing
Activities

Pla es rc
Fo

ing

St
Certi ock ficat e

Current financial statements reflect performance and condition

St
Certi ock ficat e

Financing
Activities

Operating
Activities

nn

Reports prepared

nn

Stock
Certificate

ing

g

nin

an

Pl

Balance sheet
Income statement
Statement of stockholders' equity Statement of cash flows

Fo rc es

Period of time

Reports prepared

Demand for and Supply of Accounting Information
Demand for financial statements has existed for centuries as a means to facilitate efficient contracting and risk-sharing. Decision makers and other stakeholders demand information on a company’s past and prospective returns and risks. Supply of financial statements is driven by companies that wish to lower their costs of financing and less obvious costs such as political, contracting, and labor. Managers decide how much financial information to supply

L O 1 Identify and discuss the users and suppliers of financial statement information.

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Module 1 | Framework for Analysis and Valuation

by weighing the costs of disclosure against the benefits of disclosure. Regulatory agencies intervene in this process with various disclosure requirements that establish a minimum supply of information. Demand for Information
The following broad classes of users possess a demand for financial accounting information:
■■ Managers and employees

■■ Shareholders and directors

intermediaries
■■ Creditors and suppliers

■■ Regulators and tax agencies

■■ Investment analysts and information

■■ Customers and strategic partners
■■ Voters and their representatives

For their own well-being and future earnings potential, managers and employees demand accounting information on the financial condition, profitability, and prospects of their companies as well as comparative financial information on competing companies and business opportunities. Investment analysts and other information intermediaries, such as the financial press and business commentators, are interested in predicting companies’ future performance.
Banks and other lenders demand financial accounting information to help determine loan terms, loan amounts, interest rates, and required collateral. Shareholders and directors demand financial accounting information to assess the profitability and risks of companies. Customers (both current and potential) demand accounting information to assess a company’s ability to provide products and/or services as agreed and to assess the company’s staying power and reliability.
Regulators (such as the SEC, the Federal Trade Commission, and the Federal Reserve Bank) and tax agencies demand accounting information for antitrust assessments, public protection, price setting, import-export analyses, and establishing tax policies. Voters and their representatives to national, state, and local governments demand accounting information for policy decisions. To satisfy these varying demands for and uses of financial information, companies prepare general-purpose financial statements, which refer to financial statements aimed to satisfy informational needs of a generic user.
IFRS Insight

Development of International Standards

The accounting standards explained in this book are consistent with U.S. generally accepted accounting principles (GAAP), which are primarily developed by the Financial Accounting Standards Board (FASB). A similar organization, the International Accounting Standards Board (IASB), develops a global set of International Financial Reporting Standards (IFRS) for preparation of financial statements. To increase comparability of financial statements and reduce reporting complexity, the Securities and Exchange Commission (SEC), the FASB, and the IASB are committed to a process of convergence to one set of world accounting standards. As we progress through the book, we will provide IFRS Insight boxes like this to identify differences between GAAP and IFRS.

Supply of Information
In general, the quantity and quality of accounting information that companies supply are determined by managers’ assessment of the benefits and costs of disclosure. Managers release information provided the benefits of disclosing that information outweigh the costs of doing so. Both regulation and bargaining power affect disclosure costs and benefits and thus play roles in determining the supply of accounting information. Most areas of the world regulate the minimum levels of accounting disclosures. In the U.S., publicly traded firms must file financial accounting information with the
Securities and Exchange Commission (SEC). The two main compulsory SEC filings are:
■■ Form 10-K: the audited annual report, which provides a comprehensive overview of the com-

pany for the past year; includes the four financial statements, discussed below, with explanatory notes and the management’s discussion and analysis of financial results along with other important disclosures and for periods in addition to the past year.

Module 1 | Framework for Analysis and Valuation

■■ Form 10-Q: the quarterly report, which provides an interim view of a company’s financial

position and performance; includes summary versions of the four financial statements and limited additional disclosures.

Additional common SEC financial filings are:

■■ Form 10-K/A or 10-Q/A: the “A” refers to an amended previously filed Form 10-K or 10-Q,

respectively, usually due to an accounting change or error correction.
■■ Form 20-F: submitted by “foreign private issuers” to reconcile accounting statements to U.S.
GAAP standards.
Forms 10-K (which must be filed within 60 [90] days of the year-end for larger [smaller] companies) and 10-Q (which must be filed within 40 [45] days of the quarter-end for larger [smaller] companies, except for the fourth quarter when it is part of the 10-K) are available electronically from the SEC Website (see Appendix 1A). The minimum, regulated level of information is not the standard level of disclosure observed in practice. Both the quantity and quality of information differ across companies and over time. We need only look at several annual reports to see considerable variance in the amount and type of accounting information supplied. For example, differences abound on disclosures for segment operations, product performance reports, and financing activities. Further, some stakeholders possess ample bargaining power to obtain accounting information for themselves directly from the company. These typically include private lenders and major suppliers and customers.
The information that companies make public is a rich source from which we perform our financial statement analysis. Our understanding of that information provides the basis for evaluating how the company has chosen to operate in its business environment, where the company is currently, and what it plans for the future. This analysis then shapes our expectations of the company’s future (our forecasts). Still, as we use the information provided by the company, we must consider the benefits and costs that influence the company’s disclosures and their desire to shape perception.

Benefits of Disclosure
The benefits of supplying accounting information extend to a company’s capital, labor, input, and output markets. Companies must compete in these markets. For example, capital markets provide debt and equity financing; the better a company’s prospects, the lower is its cost of capital (as reflected in lower interest rates or higher stock prices). The same holds for a company’s recruiting efforts in labor markets and its ability to establish superior supplier-customer relations in the input and output markets.
A company’s performance in these markets depends on success with its business activities and the market’s awareness of that success. Companies reap the benefits of disclosure with good news about their products, processes, management, and so forth. That is, there are real economic incentives for companies to disclose reliable (audited) accounting information enabling them to better compete in capital, labor, input, and output markets.
What inhibits companies from providing false or misleading good news? There are several constraints. An important constraint imposed by stakeholders is that of audit requirements and legal repercussions associated with inaccurate accounting information. Another relates to reputation effects from disclosures as subsequent events either support or refute earlier news.
Costs of Disclosure
The costs of supplying accounting information include its preparation and dissemination, competitive disadvantages, litigation potential, and political costs. Preparation and dissemination costs can be substantial, but many of these costs are unavoidable because managers need similar information for their own business decisions. The potential for information to yield competitive disadvantages is high. Companies are concerned that disclosures of their activities such as product or segment successes, strategic alliances or pursuits, technological or system innovations, and product or process quality improvements will harm their competitive advantages. Also, companies are frequently sued when disclosures create expectations that are not met. Highly visible companies often face political and public pressure, which creates “political costs.” These companies often try to appear as if

1-8

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Module 1 | Framework for Analysis and Valuation

they do not generate excess profits. For example, government defense contractors, large software conglomerates, and oil companies are favorite targets of public scrutiny. Disclosure costs are higher for companies facing political costs.
The SEC adopted Regulation FD, or Reg FD for short, to curb the practice of selective disclosure by public companies (called issuers by the SEC) to certain shareholders and financial analysts. In the past, many companies disclosed important information in meetings and conference calls that excluded individual shareholders. The goal of this rule is to even the playing field for all investors. Reg FD reads as follows: “Whenever an issuer discloses any material nonpublic information regarding that issuer, the issuer shall make public disclosure of that information . . . simultaneously, in the case of an intentional disclosure; and . . . promptly, in the case of a nonintentional disclosure.” Reg FD increased the cost of voluntary financial disclosure and led some companies to curtail the supply of financial information to all users.

International Accounting Standards and Convergence
The International Accounting Standards Board (IASB) oversees the development of accounting standards for a vast number of countries outside the U.S. More than 100 countries, including those in the European Union, require use of International Financial Reporting Standards
(IFRS) developed by the IASB. For many years, IASB and the FASB operated as independent standard-setting bodies. In the early 2000s, pressure mounted for these two standard-setting organizations to collaborate and create one set of internationally acceptable standards. At a joint meeting in 2002, the FASB and the IASB each acknowledged their commitment to the development of high-quality, compatible accounting standards that could be used for both domestic and cross-border financial reporting.
The original intent of the two boards was to create one set of standards that companies across the globe would adopt. However, resistance from U.S. companies, investors, and legislators thwarted that effort. Instead, a new approach has emerged and has the support of the
SEC staff. Under this method, labeled the endorsement method, FASB would remain the U.S. standard setter and endorse new IFRS into the U.S. financial reporting system. Additionally, the FASB will consider how to conform current U.S. standards to existing IFRS. During 2013,
FASB and IASB made progress on projects concerning revenue recognition, financial instruments, and leases. At present, the two boards have the following additional projects on their agendas: loan impairment, insurance contracts, and investment entities.
On July 13, 2012, the staff of the SEC’s Office of the Chief Accountant published a report on an IFRS Work Plan. The report did not include a final policy decision, or even a recommendation, as to whether or how IFRS should be incorporated into the U.S. financial reporting system.
Thus, as of early 2014, there is no formal plan for U.S. companies to transition to IFRS. For now, the endorsement method prevails. Interestingly, foreign companies that are listed on U.S. stock exchanges are permitted to file IFRS financial statements with the SEC and many do.
Are financial statements issued under IFRS substantially different from those issued under
U.S. GAAP? At a broad level, the answer is no. Both are prepared using accrual accounting and utilize similar conceptual frameworks. Both require the same set of financial statements: a balance sheet, an income statement, a statement of cash flows, a statement of stockholders’ equity, and a set of explanatory footnotes. That does not mean that no differences exist.
However, the differences are typically technical in nature, and do not often differ on broad principles discussed in this book. Indeed, recent accounting standards issued by the FASB and the IASB, such as the accounting for acquisitions of companies, were developed jointly and issued simultaneously to minimize differences as the two standard-setting bodies work toward harmonization of international standards.
At the end of each module, we summarize key differences between U.S. GAAP and IFRS.
Also, there are a variety of sources that provide more detailed and technical analysis of similarities and differences between U.S. GAAP and IFRS. The FASB, the IASB, and each of the “Big
4” accounting firms also maintain websites devoted to this issue. Search under IFRS and PwC,
KPMG, EY and Deloitte; the two standard-setting bodies also provide useful information, see:
FASB (www.fasb.org/intl/) and IASB (www.ifrs.org).

Module 1 | Framework for Analysis and Valuation

1-10

business Insight Accounting Quality
In the bear market that followed the bursting of the dot-com bubble in the early 2000s, and amid a series of corporate scandals such as Enron, Tyco, and WorldCom, Congress passed the
Sarbanes-Oxley Act, often referred to as SOX. SOX sought to rectify perceived problems related to accounting, including weak audit committees and deficient internal controls. Increased scrutiny of financial reporting and internal controls has had some success. A report by Glass, Lewis and Co., a corporate-governance research firm, shows that the number of financial restatements by publicly traded companies surged to a record 1,295 in 2005—which is one restatement for each 12 public companies, and more than triple the 2002 total, the year SOX passed. The Glass, Lewis and Co. report concluded that “when so many companies produce inaccurate financial statements, it seriously calls into question the quality of information that investors relied upon to make capital-allocation decisions” (CFO.Com). Bottom line: we must be critical readers of financial reports.

Review of Financial Statements
Companies use four financial statements to periodically report on business activities. These statements are the: balance sheet, income statement, statement of stockholders’ equity, and statement of cash flows. Exhibit 1.2 shows how these statements are linked across time. A balance sheet reports on a com­ any’s financial position at a point in time. The income statement, statement of stockp holders’ equity, and the statement of cash flows report on performance over a period of time. The three statements in the middle of Exhibit 1.2 (period-of-time statements) link the balance sheet from the beginning to the end of a period.
Exhibit 1.2

Financial Statement Links across Time
Statement of
Cash Flows

Balance Sheet
(beginning-ofperiod)

Statement of
Stockholders’
Equity

Balance Sheet
(end-ofperiod)

Income
Statement

A one-year, or annual, reporting period is common and is called the accounting, or fiscal, year. Of course, firms prepare financial statements more frequently; semiannual, quarterly, and monthly financial statements are common. Calendar-year companies have reporting periods beginning on
January 1 and ending on December 31. Berkshire Hathaway is a calendar-year company. Some companies choose a fiscal year ending on a date other than December 31, such as when a high sales period ends and inventory is low. For example, Target’s fiscal year ends on the Saturday nearest January 31, after the busy holiday season.

Balance Sheet
A balance sheet reports a company’s financial position at a point in time. The balance sheet reports the company’s resources (assets), namely, what the company owns. The balance sheet also reports the sources of asset financing. There are two ways a company can finance its assets.

L O 2 Identify and explain the four financial statements, and define the accounting equation.

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Module 1 | Framework for Analysis and Valuation

It can raise money from shareholders; this is owner financing. It can also raise money from banks or other creditors and suppliers; this is nonowner financing. This means that both owners and nonowners hold claims on company assets. Owner claims on assets are referred to as equity and nonowner claims are referred to as liabilities (or debt). Since all financing must be invested in something, we obtain the following basic relation: investing equals financing. This equality is called the accounting equation, which follows:
Investing

Assets

5

‫؍‬

Nonowner
Financing
Liabilities

1

؉

Owner Financing

Equity

The accounting equation works for all companies at all points in time.
The balance sheet for Berkshire Hathaway is in Exhibit 1.3 (condensed). Refer to this balance sheet to verify the following amounts: assets 5 $427,452 million; liabilities 5 $235,864 million; and equity 5 $191,588 million. Assets equal liabilities plus equity, which reflects the accounting equation: investing equals financing.

Investing Activities
Balance sheets are organized like the accounting equation. Investing activities are represented by the company’s assets. These assets are financed by a combination of nonowner financing (liabilities) and owner financing (equity).
EXHIBIT 1.3

Balance Sheet ($ millions)
Berkshire Hathaway
Balance Sheet*
December 31, 2012

Report amounts at a point in time

Assets
Cash ������������������������������������������������������������������������������������������������
Noncash assets��������������������������������������������������������������������������������

$ 46,992
380,460

Total assets��������������������������������������������������������������������������������������

$427,452

Total resources

$235,864

Financing

Liabilities and equity
Total liabilities ����������������������������������������������������������������������������������
Equity
Contributed capital (common stock and paid-in capital)������������ Retained earnings������������������������������������������������������������������������ Other equity �������������������������������������������������������������������������������� Berkshire Hathaway equity���������������������������������������������������������� Noncontrolling interest����������������������������������������������������������������

Investing

37,238
124,272
26,137

Nonowner claim on resources

187,647
3,941

Berkshire
Hathaway
owners’ claim on resources Total equity† ��������������������������������������������������������������������������������

191,588

Total liabilities and equity ����������������������������������������������������������������

$427,452

Financial statement titles often begin with the word consolidated. This means that the financial statement includes a parent company and one or more subsidiaries, companies that the parent company controls.
*

All owners’ claim on resources

Components of equity are explained as part of Exhibit 1.5. For Berkshire Hathaway, other equity includes accumulated other comprehensive income and treasury stock.



For simplicity, Berkshire Hathaway’s balance sheet in Exhibit 1.3 categorizes assets into cash and noncash assets. Noncash assets consist of several asset categories (Module 2 explains the composition of noncash assets). These categories are listed in order of their nearness to cash. For example, companies own a category of assets called inventories. These are goods that the company intends to sell to its customers. Inventories are converted into cash when they are sold, which typically occurs within a short period of time. Hence, they are classified

Module 1 | Framework for Analysis and Valuation

1-12

st

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co

is

C

G

em s oo
St
gl ar e b C uck at er s pi lla r In te l
Ta
So rg ut e hw
A t
Pr es pp oc t A le te r & irlin
G es
M am cD bl on e al d’ s as short-term assets. Companies also report a category of
Relative Proportion of Short-Term and Long-Term Assets assets called property, plant and equipment. This category
Short-Term
100% includes a company’s office buildings or manufacturing
90%
Assets facilities. Property, plant and equipment assets will be held
80%
Long-Term
70%
for an extended period of time and are, therefore, generally
Assets
60% classified as long-term assets.
50%
40%
The relative proportion of short-term and long-term
30%
assets is largely determined by a company’s business
20%
model. This is evident in the graph to the side that depicts
10%
0% the relative proportion of short- and long-term assets for several companies that we feature in this book. Companies such as Cisco and Google require little investment in longterm assets. On the other hand, Procter & Gamble and
McDonald’s require a large investment in long-term assets.
Although managers can influence the relative amounts and proportion of assets, their flexibility is somewhat limited by the nature of their industries.

C s is
Pr co In te oc S te yst l r & em s G
M am
So
ut cD ble hw on es ald t A ’s irl in e Ta s
C rge at er t pi lla r ck

e

St

ar

bu

pl

Ap

G

oo

gl

e

Financing Activities
Assets must be paid for, and funding is provided by a combination of owner and nonowner financing. Owner (or equity) financing includes resources contributed to the company by its owners along with any profit retained by the company.
Nonowner (creditor or debt) financing is borrowed money.
Relative Proportion of Liabilities and Equity
We distinguish between these two financing sources for a reason: borrowed money entails a legal obligation to repay
100%
amounts owed, and failure to do so can result in severe
90%
80% consequences for the borrower. Equity financing entails no
70%
such legal obligation for repayment.
60%
The relative proportion of nonowner (liabilities) and
50%
40% owner (equity) financing is largely determined by a com30% pany’s business model. This is evident in the graph to the
20%
side, again citing many of the companies we feature as focus
10%
0% companies in this book. Google’s and Apple’s revenues and expenses are more volatile, which means that these companies face greater operating risk than do more established companies that operate in relatively stable markets. On the other hand, Caterpillar’s cash flows are relatively stable. They can operate with more nonowner financing.
IFRS Insight Balance Sheet Presentation and IFRS
Balance sheets prepared under IFRS often classify accounts in reverse order of liquidity (lack of nearness to cash), which is the opposite of what U.S. companies do. For example, intangible assets are typically listed first and cash is listed last among assets. Also, equity is often listed before liabilities, where liabilities are again listed in order of decreasing liquidity. These choices reflect convention and not IFRS requirements.

Income Statement
An income statement reports on a company’s performance over a period of time and lists amounts for revenues (also called sales) and expenses. Revenues less expenses yield the bottomline net income amount. Berkshire Hathaway’s income statement is in Exhibit 1.4. Refer to its income statement to verify the following: revenues 5 $162,463 million; expenses 5 $147,151 million; and net income 5 $15,312 million. Net income reflects the profit (also called earnings) to owners for that specific period.

Equity
Liabilities

Module 1 | Framework for Analysis and Valuation

EXHIBIT 1.4

Income Statement ($ millions)
Berkshire Hathaway
Income Statement
For Year Ended December 31, 2012

Report amounts over a period of time

Revenues���������������������������������������������������������������������������������������������� $162,463
Expenses���������������������������������������������������������������������������������������������� 147,151

Goods or services provided to customers

Net income������������������������������������������������������������������������������������������ $ 15,312
Less: Earnings attributable to noncontrolling interest��������������������������
488

Costs incurred to generate revenues

Net income attributable to Berkshire Hathaway stockholders������ $ 14,824

Manufacturing and merchandising companies typically include an additional expense account, called cost of goods sold (or cost of sales), in the income statement following revenues.
It is also common to report a subtotal called gross profit (or gross margin), which is revenues less cost of goods sold. The company’s remaining expenses are then reported below gross profit. This income statement layout follows:
Revenues
2 Cost of goods sold

Cost of materials, labor and overhead

5 Gross profit
2 Expenses

Revenues less cost of goods sold

5 Net income (loss)

Expenses other than cost of goods sold

C

e

cD el on is al co d’ Pr s Sy oc st te em r& s
G
am bl St e ar bu ck
C
s at er pi lla
So
r ut hw Ta es rge t tA irl in es In t M

gl

oo

G

pl

e

Operating Activities
Operating activities use company resources to produce, promote, and sell its products and services. These activities extend from input markets involving suppliers of materials and labor to a company’s output markets involving customers of products and services. Input markets generate most expenses (or costs) such as inventory, salaries, materials, and logistics. Output markets generate revenues (or sales) to customers. Output markets also generate some expenses such as marketing and distributing products and services to customers. Net income arises when revenues exceed expenses. A loss occurs when expenses exceed revenues.
Differences exist in the relative profitability of companies across industries. Although effective management can increase the profitability of a company, business models play a large part in determining company profitability. These differences are illustrated in the graph (to the side) of net income as a percentage of sales for several companies.
Net Income as a Percent of Sales
Target operates in a mature industry with little ability to differentiate its merchandise
30%
from competitors. Hence, its income as a per25% cent of sales is low. Southwest Airlines faces
20%
a different kind of problem: having competi15% tors that are desperate and trying to survive.
10%
Profitability will not return to the transporta5% tion industry until weaker competitors are no longer protected by bankruptcy courts. At the
0%
other end of the spectrum are Apple, Google, and Intel. All three are dominant in their industries with products protected by patent laws.
Their profitability levels are more akin to that of monopolists.
Ap

1-13

Module 1 | Framework for Analysis and Valuation

Analyst Adjustments 1.1

1-14

Adjusting for Noncontrolling Interest

The income statement shows net income separated into two parts; one portion attributable to noncontrolling interest and a second portion attributable to Berkshire Hathaway stockholders. When you buy stock in Berkshire Hathaway, you are a stockholder of that company. Berkshire Hathaway owns stock in other companies, and the companies that Berkshire Hathaway (the parent) owns are called subsidiaries. Most of Berkshire Hathaway’s subsidiaries are owned entirely (100%) by Berkshire Hathaway. These are called “wholly-owned subsidiaries.” However, some Berkshire Hathaway subsidiaries are owned jointly by Berkshire Hathaway and other outside stockholders. If Berkshire
Hathaway owns more than 50% of the common stock of a given subsidiary, Berkshire has de facto control over the operating, investing, and financing activities of the subsidiary. In this case,
Berkshire Hathaway includes all of the revenues and all of the expenses of such a subsidiary in its own consolidated income statement. Then, Berkshire Hathaway separates the total consolidated net income into the portion that it owns (income attributable to Berkshire Hathaway stockholders) and the portion owned by outside stockholders (income attributable to noncontrolling interest). The portion is determined by the percent of outstanding common stock that Berkshire Hathaway owns
(if Berkshire Hathaway owns 60% of the stock, 60% of the subsidiary’s income is attributable to
Berkshire Hathaway stockholders and 40% is attributable to the noncontrolling interest). So, which income number should we use in an analysis of Berkshire Hathaway? Because analysis is usually performed from the standpoint of a stockholder of Berkshire Hathaway, we focus on the net income attributable to Berkshire Hathaway stockholders.

Statement of Stockholders’ Equity
The statement of stockholders’ equity reports on changes in key types of equity over a period of time. For each type of equity, the statement reports the beginning balance, a summary of the activity in the account during the year, and the ending balance. Berkshire Hathaway’s statement of stockholders’ equity is in Exhibit 1.5. During the recent period, its equity changed due to share issuances and income reinvestment. Berkshire Hathaway classifies these changes into four categories:
■■ Contributed capital, the stockholders’ net contributions to the company

■■ Retained earnings, net income over the life of the company minus all dividends ever paid
■■ Other, consists of amounts that we explain later in the book
■■ Noncontrolling interest, the equity of outside stockholders
EXHIBIT 1.5

Statement of Equity ($ millions)
Berkshire Hathaway
Statement of Stockholders’ Equity
For Year Ended December 31, 2012
Contributed
Capital

December 31, 2011 . . . . . . . . . .
Stock issuance (repurchase) . . .
Net income . . . . . . . . . . . . . . . .
Dividends . . . . . . . . . . . . . . . . . .
Other . . . . . . . . . . . . . . . . . . . . .

$37,815
118

December 31, 2012 . . . . . . . . . .

$37,238

Retained
Earnings
$109,448

Other
Equity
$17,587
(1,296)

Report amounts over a period of time
Noncontrolling
Interest

9,846

(658)

$168,961
(1,178)
15,312
(0)
8,493

$26,137

$3,941

$191,588

488b

14,824a
(0)
(695)
$124,272

$4,111

Total

a

This is income attributable to Berkshire Hathaway stockholders, see Exhibit 1.4

b

This is income attributable to noncontrolling interest, see Exhibit 1.4

Beginning period amounts Change in balances over a period
Ending period amounts 1-15

Module 1 | Framework for Analysis and Valuation

Exhibit 1.5 reconciles the activity in each of the equity accounts from the balance sheet in Exhibit
1.3. We briefly discuss each of these accounts here and explain the accounts in depth in Module 8.
■■ Contributed capital represents assets the company received from issuing stock to stockhold-

ers (also called shareholders). The balance of this account at the beginning of the year was
$37,815 million. During the year, Berkshire Hathaway sold additional shares for $118 million and recorded miscellaneous adjustments of $(695) million to yield a year-end balance of $37,238 million.
■■ Retained earnings (also called earned capital or reinvested capital) represent the cumulative total amount of income that the company has ever earned and that has been retained in the business; that is, not distributed to stockholders in the form of dividends. The change in retained earnings links consecutive balance sheets via the income statement: Ending retained earnings 5 Beginning retained earnings 1 Net income for the period 2 Dividends for the period. For Berkshire Hathaway, its retained earnings increases from $109,448 million to
$124,272 million. This increase of $14,824 million is explained by its net income of $14,824 million as Berkshire Hathaway paid no dividends in 2012.
■■ Other equity for Berkshire Hathaway consists of accumulated other comprehensive income
(AOCI) and Treasury stock (TS). We defer discussion of AOCI to Module 8. For now, view
AOCI as income that has not been reflected in the income statement and is, therefore, excluded from retained earnings. Treasury stock is the cost of the shares that Berkshire Hathaway has repurchased and not reissued. It can be seen as the opposite of contributed capital. Treasury stock decreases equity when shares are repurchased (hence, the negative sign).
■■ Noncontrolling interest represents the equity of noncontrolling stockholders who own stock

in Berkshire Hathaway’s subsidiaries. As with equity for Berkshire Hathaway’s stockholders, the equity of noncontrolling interest increases by income attributable to noncontrolling interest and decreases by any dividends paid or losses attributable to the noncontrolling interest
(there were none in 2012). We defer discussion of this account to Modules 8 and 9.

business Insight Warren Buffett on Financial Reports
“When Charlie and I read reports, we have no interest in pictures of personnel, plants or products.
References to EBITDA [earnings before interest, taxes, depreciation and amortization] make us shudder—does management think the tooth fairy pays for capital expenditures? We’re very suspicious of accounting methodology that is vague or unclear, since too often that means management wishes to hide something. And we don’t want to read messages that a public relations department or consultant has turned out. Instead, we expect a company’s CEO to explain in his or her own words what’s happening.” —Berkshire Hathaway Annual Report

Statement of Cash Flows
The statement of cash flows reports the change (either an increase or a decrease) in a company’s cash balance over a period of time. However, the change in cash is not what matters as that can be found from the balance sheet. The useful information this statement reports is the detailed cash inflows and outflows from operating, investing, and financing activities over a period of time.
Berkshire Hathaway’s statement of cash flows is in Exhibit 1.6. Its cash balance increased by
$9,693 million in the recent period: operating activities generated a $20,950 million cash inflow, investing activities reduced cash by $10,574 million, and financing activities yielded a cash outflow of $683 million.
Berkshire Hathaway’s operating cash flow of $20,950 million does not equal its $14,824 million net income. Generally, a company’s net cash flow for a period does not equal its net income for the period. This is due to timing differences between when revenue and expense items are recognized on the income statement and when cash is received and paid. (We discuss this concept further in subsequent modules.)

Module 1 | Framework for Analysis and Valuation

EXHIBIT 1.6
Report amounts over a period of time
Net cash inflow from operating

Statement of Cash Flows ($ millions)

Berkshire Hathaway
Statement of Cash Flows
For Year Ended December 31, 2012

Net cash outflow from investing

Operating cash flows . . . . . . . . . . . . . . . . . . . . . . .
Investing cash flows . . . . . . . . . . . . . . . . . . . . . . . .
Financing cash flows . . . . . . . . . . . . . . . . . . . . . . . .

$20,950
(10,574)
(683)*

Net cash outflow from financing

Net increase in cash . . . . . . . . . . . . . . . . . . . . . . . .
Cash, December 31, 2011 . . . . . . . . . . . . . . . . . . . .

9,693
37,299

Cash, December 31, 2012 . . . . . . . . . . . . . . . . . . . .

$46,992

Cash amounts per balance sheet
*

Includes $(123) relating to foreign currency exchange rate changes.

Both cash flow and net income numbers are important for business decisions. Each is used in security valuation models, and both help users of accounting reports understand and assess a company’s past, present, and future business activities.

Financial Statement Linkages
The four financial statements are linked within and across periods—consider the following:
■■ The income statement and the balance sheet are linked via retained earnings. For Berkshire

Hathaway, the $14,824 million increase in retained earnings (reported on the balance sheet) equals its net income (reported on the income statement) the updated balance. Berkshire
Hathaway did not pay dividends in 2012.
■■ Retained earnings, contributed capital, and other equity balances appear both on the statement of stockholders’ equity and the balance sheet.
■■ The statement of cash flows is linked to the income statement as net income is a component of operating cash flow. The statement of cash flows is also linked to the balance sheet as the change in the balance sheet cash account reflects the net cash inflows and outflows for the period.
Items that impact one financial statement ripple through the others. Linkages among the four financial statements are an important feature of the accounting system.

Information Beyond Financial Statements
Important financial information about a company is communicated to various decision makers through means other than the four financial statements. These include the following:
■■ Management Discussion and Analysis (MD&A)
■■ Independent Auditor Report

■■ Financial statement footnotes

■■ Regulatory filings, including proxy statements and other SEC filings

We describe and explain the usefulness of these additional information sources throughout the book.

Analyzing the Competitive Business Environment
To understand a company we must “know the business.” A way to formalize that knowledge is through use of Porter’s value-chain model (see Porter, Competitive Advantage: Creating and Sustaining Superior Performance, 1985, and the followin graphic). Analysis using the value-chain seeks to identify and understand the activities that create a company’s profit margin.

L O 3 Describe business analysis within the context of a competitive environment. 1-16

1-17

Module 1 | Framework for Analysis and Valuation

Primary Activities

Support Activities

Primary activities are:
■■ Inbound logistics

Firm infrastructure

Legal, accounting, financial management

Human resource management

Personnel, recruitment, training, staff planning

Technology/product development

Product and process design, production engineering, market testing, R&D

Procurement

Supplier management, funding, subcontracting, specification

■■ Operations

■■ Outbound logistics

■■ Marketing and sales
■■ Servicing

INBOUND OPERATIONS OUTBOUND MARKETING SERVICING
LOGISTICS
LOGISTICS & SALES
Examples:
Quality control; receiving; raw materials control; supply schedules

Examples:
Manufacturing;
packaging; production control; quality control; maintenance

Examples:
Finishing goods; order handling; dispatch; delivery; invoicing Examples:
Customer
management; order taking; promotion; sales analysis; market research

Value added less Cost =
Profit margin

Support activities are:
■■ Firm infrastructure
■■ Human resource

Examples:
Warranty;
maintenance; education; training; upgrades management

■■ Technology/product

development
■■ Procurement

The results of these activities manifest themselves in a company’s financial statements and the supporting documents.
A company’s primary and support activities are not carried out in isolation but are, instead, influenced by five important forces that confront the company and determine its competitive intensity: (A) industry competition, (B) buyer power, (C) supplier power, (D) product substitutes, and (E) threat of entry (for further discussion, see Porter, Competitive Strategy: Techniques for
Analyzing Industries and Competitors, 1980 and 1998).
EXHIBIT 1.7

Competitive Forces within the Broader Business Environment
Stock
Certificate
S
Certtock ifica te

S
Certtock
ifica te Creditors
Government

Shareholders
Suppliers C

Global Forces

Regulators
Entrants E
Competitors A
Substitutes D
Tax Authorities

Voters and Public

Buyers B
Board of s Director dit ee
Au mitt m Co

Labor Forces
Investors

rs

ito

ed
Cr

Distribution

Governance

These five forces are depicted graphically in Exhibit 1.7 and are key determinants of profitability. A Industry competition Competition and rivalry raise the cost of doing business as companies must hire and train competitive workers, advertise products, research and develop products, and engage in other related activities. B Bargaining power of buyers Buyers with strong bargaining power can extract price concessions and demand a higher level of service and delayed payment terms; this force reduces both profits from sales and the operating cash flows to sellers.

Module 1 | Framework for Analysis and Valuation

C Bargaining power of suppliers Suppliers with strong bargaining power can demand higher prices and earlier payments, yielding adverse effects on profits and cash flows to buyers. D Threat of substitution As the number of product substitutes increases, sellers have less power to raise prices and/or pass on costs to buyers; accordingly, threat of substitution places downward pressure on profits of sellers. E Threat of entry New market entrants increase competition; to mitigate that threat, companies expend monies on activities such as new technologies, promotion, and human development to erect barriers to entry and to create economies of scale.
The broader business environment affects the level of profitability that a company can expect to achieve. Global economic forces and the quality and cost of labor affect the macroeconomy in which the company operates. Government regulation, borrowing agreements exacted by creditors, and internal governance procedures also affect the range of operating activities in which a company can engage. In addition, strategic plans are influenced by the oversight of equity markets, and investors are loathe to allow companies the freedom to manage for the longer term. Each of these external forces affects a company’s strategic planning and expected level of profitability.
The relative strength of companies within their industries, and vis-à-vis suppliers and customers, is an important determinant of both their profitability and the structure of their balance sheets.
As competition intensifies, profitability likely declines, and the amount of assets companies need to carry on their balance sheet likely increases in an effort to generate more profit. Such changes are revealed in the income statement and the balance sheet.

Applying Competitive Analysis
We apply the competitive analysis framework to help interpret the financial results of McLane Company. McLane is a subsidiary of Berkshire Hathaway and was acquired several years ago. Berkshire describes McLane’s business in the following note to the Berkshire Hathaway 2012 annual report:
McLane Company—McLane Company, Inc. (“McLane”) provides wholesale distribution and logistics services in all 50 states and internationally in Brazil to customers that include convenience stores, discount retailers, wholesale clubs, drug stores, military bases, quick service restaurants, and casual dining restaurants. Prior to Berkshire’s acquisition in 2003, McLane was an integral part of the Wal-Mart Stores, Inc. (“Wal-Mart”) distribution network. McLane continues to provide wholesale distribution services to Wal-Mart, which accounts for approximately 28% of McLane’s revenues. McLane’s business model is based on a high volume of sales, rapid inventory turnover, and tight expense control.

McLane is a wholesaler of food products; it purchases food products in finished and semifinished form from agricultural and food-related businesses and resells them to grocery and convenience food stores. The extensive distribution network required in this business entails considerable investment. Our business analysis of McLane’s financial results includes the following observations:

■■ Industry competitors McLane has many competitors with food products that are difficult
■■

■■
■■
■■

to differentiate.
Bargaining power of buyers The note above reveals that 28% of McLane’s sales are to WalMart, which has considerable buying power that limits seller profits; also, the food industry is characterized by high turnover and low profit margins, which implies that cost control is key to success.
Bargaining power of suppliers McLane is large ($37 billion in annual sales), which implies its suppliers are unlikely to exert forces to increase its cost of sales.
Threat of substitution Grocery items are usually not well differentiated; this means the threat of substitution is high, which inhibits its ability to raise selling prices.
Threat of entry High investment costs, such as warehousing and logistics, are a barrier to entry in McLane’s business; this means the threat of entry is relatively low.

Our analysis reveals that McLane is a high-volume, low-margin company. Its ability to control costs is crucial to its financial performance, including its ability to fully utilize its assets. Evaluation of McLane’s financial statements should focus on that dimension.

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Module 1 | Framework for Analysis and Valuation

SWOT Analysis of the Business Environment
As an alternative to Porter-based competitive analysis, some prefer a SWOT analysis of a company. SWOT is an acronym that stands for Strength, Weakness, Opportunities and Threats. This analysis can be applied to almost any organization. This approach is universally applicable and easy to apply, and can be graphically portrayed as follows:
Internal
Factors

External
Factors

SWOT
Analysis

Strengths

Opportunities

Positive
Factors

Weaknesses

Threats

Negative
Factors

SWOT analysis has two parts. Looking internally, we review a company’s Strengths and Weaknesses, while for external purposes we review the Opportunities of and Threats to the company.
SWOT analysis tries to understand particular Strengths and Weaknesses that give rise to specific
Opportunities (to exploit the Strengths) and Threats (caused by the Weaknesses). When used as part of an overall strategic analysis, SWOT can provide a good review of strategic options.
However, SWOT is sometimes criticized as too subjective. Two individuals can identify entirely different factors from a SWOT analysis of the same company. This is partly because SWOT is intuitive and allows varying opinions on the relevant factors.

Analyzing the Broader Business Environment
Quality analysis depends on an effective business analysis. Before we analyze a single accounting number, we must ask questions about a company’s business environment such as the following:
■■ Life cycle At what stage in its life is this company? Is it a startup, experiencing growing pains?

■■
■■
■■
■■

■■

Is it strong and mature, reaping the benefits of competitive advantages? Is it nearing the end of its life, trying to milk what it can from stagnant product lines?
Outputs What products does it sell? Are its products new, established, or dated? Do its products have substitutes? How complicated are its products to produce?
Buyers Who are its buyers? Are buyers in good financial condition? Do buyers have substantial purchasing power? Can the seller dictate sales terms to buyers?
Inputs Who are its suppliers? Are there many supply sources? Does the company depend on a few supply sources with potential for high input costs?
Competition In what kind of markets does it operate? Are markets open? Is the market competitive? Does the company have competitive advantages? Can it protect itself from new entrants? At what cost? How must it compete to survive?
Financing Must it seek financing from public markets? Is it going public? Is it seeking to use its stock to acquire another company? Is it in danger of defaulting on debt covenants? Are there incentives to tell an overly optimistic story to attract lower cost financing or to avoid default on debt?

Module 1 | Framework for Analysis and Valuation

■■ Labor Who are its managers? What are their backgrounds? Can they be trusted? Are they com-

petent? What is the state of employee relations? Is labor unionized?
■■ Governance How effective is its corporate governance? Does it have a strong and independent board of directors? Does a strong audit committee of the board exist, and is it populated with outsiders? Does management have a large portion of its wealth tied to the company’s stock?
■■ Risk Is it subject to lawsuits from competitors or shareholders? Is it under investigation by regulators? Has it changed auditors? If so, why? Are its auditors independent? Does it face environmental and/or political risks?
In sum, we must assess the broader business context in which a company operates as we read and interpret its financial statements. A review of financial statements, which reflect business activities, cannot be undertaken in a vacuum. It is contextual and can only be effectively undertaken within the framework of a thorough understanding of the broader forces that impact company performance. We should view the above questions as a sneak preview of those we will ask and answer throughout this book when we read and interpret financial statements for purposes of forecasting and valuation.

M i d- M odul e R eview
The following financial information is from AXA Equitable Life Insurance Company, a competitor of Berkshire Hathaway’s GEICO Insurance, for the year ended December 31, 2012 ($ millions).
Cash, ending year���������������������������������������������������������������������
Cash flows from operations �����������������������������������������������������
Revenues�����������������������������������������������������������������������������������
Net income attributable to AXA stockholders���������������������������
AXA stockholders’ equity ���������������������������������������������������������
Cash flows from financing���������������������������������������������������������
Total liabilities ���������������������������������������������������������������������������
Expenses�����������������������������������������������������������������������������������
Noncash assets�������������������������������������������������������������������������
Cash flows from investing���������������������������������������������������������
Net income �������������������������������������������������������������������������������
Noncontrolling interest (equity)�������������������������������������������������
Cash, beginning year�����������������������������������������������������������������

$ 3,162
(780)
9,160
121
15,436
3,407
158,913
8,944
173,681
(2,692)
216
2,494
3,227

Required 1. Prepare an income statement, balance sheet, and statement of cash flows for AXA at December
31, 2012. 2. Compare the balance sheet and income statement of AXA to those of Berkshire Hathaway in Exhibits 1.3 and 1.4. What differences do we observe?
The solution is on page 1-38.

Step 2—Adjusting and Assessing Financial
Information
Choices in Financial Reporting
Some people mistakenly assume that financial accounting is an exact discipline—that is, companies select the one proper accounting method available to account for a transaction, and then follow the rules. The reality is that GAAP allows companies choices in preparing financial statements. The choice of methods often yields financial statements that are markedly different from one another in terms of reported income, assets, liabilities, and equity amounts.
People often are surprised that financial statements comprise numerous estimates. For example, companies must estimate the amounts that will eventually be collected from customers, the length

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Module 1 | Framework for Analysis and Valuation

of time that buildings and equipment will be productive, the value impairments of assets, the future costs of warranty claims, and the eventual payouts on pension plans. Following are examples of how some managers are alleged to have abused the latitude available in reporting financial results.
Company

Allegations

Adelphia Communications
(ADELQ)

Founding Rigas family collected $3.1 billion in off-balance-sheet loans backed by
Adelphia; it overstated results by inflating capital expenses and hiding debt.

Time Warner
(TWX)

As the ad market faltered and AOL’s purchase of Time Warner loomed, AOL inflated sales by booking revenue for barter deals and ads it sold for third parties.
These questionable revenues boosted growth rates and sealed the deal. AOL also boosted sales via “round-trip” deals with advertisers and suppliers.

Enron

Created profits and hid debt totaling over $1 billion by improperly using offthe-books partnerships; manipulated the Texas power market; bribed foreign governments to win contracts abroad; manipulated California energy market.

Global Crossing (GLBC)

Engaged in network capacity “swaps” with other carriers to inflate revenue; shredded documents related to accounting practices.

Qwest Communications
International (Q)

Inflated revenue using network capacity “swaps” and improper accounting for long-term deals.

Tyco (TYC)

Ex-CEO L. Dennis Kozlowski indicted for tax evasion; Kozlowski and former CFO
Mark H. Swartz, convicted of taking unauthorized loans from the company.

WorldCom

Overstated cash flow by booking $11 billion in operating expenses as capital costs; loaned founder Bernard Ebbers $400 million off-the-books.

Autonomy Corp.

Engaged in aggressive revenue recognition (“round-trip transactions”) where it bought goods from customers and failed to fully record costs; its overstated results allegedly led Hewlett-Packard to overpay when acquiring Autonomy stock.

Accounting standard setters walk a fine line regarding choice in accounting. On one hand, they are concerned that choice in preparing financial statements will lead to abuse by those seeking to gain by influencing decisions of financial statement users. On the other hand, standard setters are concerned that companies are too diverse for a “one size fits all” financial accounting system.
Enron exemplifies the problems that accompany rigid accounting standards. A set of accounting standards relating to special purpose entities (SPEs) provided preparers with guidelines under which those entities were or were not to be consolidated. Unfortunately, once the SPE guidelines were set, some people worked diligently to structure SPE transactions so as to narrowly avoid the consolidation requirements and achieve off-balance-sheet financing. This is just one example of how, with rigid standards, companies can adhere to the letter of the rule, but not its intent. In such situations, the financial statements are not fairly presented. When financial statements are not fairly presented, it frustrates our attempt at determining where the company is currently. This leads to reductions in our ability to accurately determine where the company is going and impacts our estimate of what the company is worth.
For most of its existence, the FASB has promulgated standards that were quite complicated and replete with guidelines. This invited abuse of the type embodied by the Enron scandal. In recent years, the pendulum has begun to swing away from such rigidity. Now, once financial statements are prepared, company management is required to step back from the details and make a judgment on whether the statements taken as a whole “fairly present” the financial condition of the company as is asserted in the company’s audit report (see below).
Moreover, since the enactment of the Sarbanes-Oxley Act, the SEC requires the chief executive officer (CEO) of the company and its chief financial officer (CFO) to personally sign a statement attesting to the accuracy and completeness of the financial statements. This requirement is an important step in restoring confidence in the integrity of financial accounting. The statements signed by both the CEO and CFO contain the following declarations:
■■ Both the CEO and CFO have personally reviewed the annual report.
■■ There are no untrue statements of a material fact that would make the statements misleading.

Module 1 | Framework for Analysis and Valuation

1-22

■■ Financial statements fairly present in all material respects the financial condition of the

company.
■■ All material facts are disclosed to the company’s auditors and board of directors.
■■ No changes to its system of internal controls are made unless properly communicated.

The Sarbanes-Oxley Act also imposed fines and potential jail time for executives. Presumably, the prospect of personal losses is designed to make these executives more vigilant in monitoring the financial accounting system. In addition, Congress passed The Wall Street Reform and Consumer
Protection Act of 2010 (or the Dodd-Frank Act). Among the provisions of the act were rules that strengthened SOX by augmenting “claw-back” provisions for executives’ ill-gotten gains.

Analysis of Financial Statements
This section previews the financial statement analysis framework of this book. This framework is used extensively by market professionals who analyze financial reports to evaluate company management and value the company’s debt and equity securities. Analysis of financial performance is crucial in assessing prior strategic decisions and evaluating strategic alternatives.

Return on Assets
Suppose we learn that a company reports a profit of $10 million. Does the $10 million profit indicate that the company is performing well? Knowing that a company reports a profit is certainly positive as it indicates that customers value its goods or services and that its revenues exceed expenses. However, we cannot assess how well it is performing without considering the context. To explain, suppose we learn that this company has $500 million in assets. We now assess the $10 million profit as low because relative to the size of its asset investment, the company earned a paltry 2% return, computed as $10 million divided by $500 million. A 2% return on assets is what a much lower-risk investment in government-backed bonds might yield. The important point is that a company’s profitability must be assessed with respect to the size of its investment. One common metric is the return on assets
(ROA)—defined as net income for that period divided by the average assets for that period.
Components of Return on Assets
We can separate return on assets into two components: profitability and productivity. Profitability relates profit to sales. This ratio is called the profit margin (PM), and it reflects the net income (profit after tax) earned on each sales dollar. Management wants to earn as much profit as possible from sales.
Productivity relates sales to assets. This component, called asset turnover (AT), reflects sales generated by each dollar of assets. Management wants to maximize asset productivity, that is, to achieve the highest possible sales level for a given level of assets (or to achieve a given level of sales with the smallest level of assets).
Exhibit 1.8 depicts the disaggregation of return on assets into these two components. Profitability (PM) and productivity (AT) are multiplied to yield the return on assets (ROA). Average assets are commonly defined as (beginning-year assets 1 ending-year assets)/2.
EXHIBIT 1.8

Return on Assets Disaggregation
Return on assets
Net income
Average assets

Profitability (profit margin)

؋

Productivity (asset turnover)

Net income
Sales

؋

Sales
Average assets

L O 4 Explain and apply the basics of profitability analysis.

Module 1 | Framework for Analysis and Valuation

Profitability and Productivity
There are an infinite number of combinations of profit margin and asset turnover that yield the same return on assets. To illustrate, Exhibit 1.9 graphs actual combinations of these two components for companies that we highlight in this book (each is identified by its ticker symbol).
Retailers, such as Home Depot (HD), Target (TGT), and Starbucks (SBUX) are characterized by relatively low profit margins and a high turnover of their assets. The business models for other companies such as 3M (MMM), Johnson & Johnson (JNJ), and McDonald’s (MCD) require a larger investment in assets. These companies must earn a higher profit margin to yield an acceptable ROA. We might be surprised to see technology companies such as Apple (AAPL), Google
(GOOG), and Cisco (CSCO) in the group with high asset investments. Technology companies typically maintain a high level of cash and short-term investments on their balance sheets, which allows them to respond quickly to opportunities. The solid line represents those profitability and productivity combinations that yield a 10.5% return on assets.
EXHIBIT 1.9

Profitability and Productivity Across Companies

2.00

HD

1.80
1.60
Asset Turnover

1-23

SBUX
TGT

1.40

CL

DELL

1.20
1.00

LUV

0.80

MMM

GIS

MCD

CAT
PG

0.60
0.40

JNJ

CMCSA

AAPL

INTC
GOOG
CSCO

0.20
0.00
0%

5%

10%

15%

20%

25%

30%

Profit Margin

Return on Equity
Another important analysis measure is return on equity (ROE), which is defined as net income divided by average stockholders’ equity, where average equity is commonly defined as (beginningyear equity 1 ending-year equity)/2. In this case, company earnings are compared to the level of stockholder (not total) investment. ROE reflects the return to stockholders, which is different from the return for the entire company (ROA).
Analysis DECISION

You Are the Chief Financial Officer

You are reviewing your company’s financial performance for the first six months of the year and are unsatisfied with the results. How can you disaggregate return on assets to identify areas for improvement? [Answer, p. 1-28]

Step 3—Forecasting Financial Numbers
Forecasting is a step where we proceed from our understanding of the company’s current environment (Step 1) and what has occurred with the company (Step 2) to a prediction of what will occur next. This step is crucial to decision making and valuation, and it is arguably a very difficult task.
When we formalize predictions and state them in the form of financial projections, the quality of our forecasts is dependent on at least two factors. First, the quality of our analysis performed in Steps 1 and 2 in understanding the business environment and in adjusting and assessing financial information is crucial. If we fail to effectively understand the context in which a company

Module 1 | Framework for Analysis and Valuation

1-24

operates, we will not be able to make appropriate estimates going forward. The quality of our adjustments made to the company’s financial information drives the quality of our forecasts. For example, if we fail to adjust for any off-balance-sheet financing, leverage is likely understated and future financing needs are inaccurately forecasted. Another example would be not recognizing the negative implications for future operations of growing inventory levels combined with flat or declining sales. Second, the quality of our forecasts is dependent on our assumptions being realistic and achievable. For example, is a company, which has recently experienced sales declines, likely to become the industry leader? Can a company increase sales when confronting a new entrant in the industry? Part of our task is to objectively examine what evidence supports, or challenges, the forecast assumptions we make. In sum, the importance of forecast quality cannot be overemphasized as it is vital to our estimates of where a company is going, which are direct inputs to valuation.
Research Insight Knowledge of Future Earnings Yields Excess Returns
20%
15%
Cumulative excess returns

Evidence shows that knowledge of future earnings is valuable and useful to investors and others. The theoretical linkage between earnings and stock prices is as follows: current earnings predict future earnings, and future earnings help determine expected future dividends, and these future dividends, when discounted, determine current stock price.
Numerous large-sample empirical studies provide evidence consistent with a linkage between earnings and prices. A subset of these studies finds a link between earnings changes and excess stock returns. In general, studies find excess annual returns of around 10-25% for earnings increases, and 10-25% negative returns for earnings decreases. It is no wonder that investors, analysts, and others devote so much time and effort to forecasting earnings.

Firms with good news earnings

10%
5%
0%
-5%

-10%

Firms with bad news earnings

-15%
-20%

-12 -11 -10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0

1

2

3

4

Months relative to annual earnings announcement

Step 4—Company Valuation
When we embark on financial statement analysis, we are motivated by the need to make a financial decision. This could be from an external standpoint such as whether to buy or sell shares as an investor or from an internal standpoint such as evaluating a potential acquisition or change in scope of operations. All financial decisions involve valuation at some level. In making these decisions, we attempt to predict the future. The key to good valuation estimates is accurate forecasts of future cash flows. And, the key to forecasting is having a good understanding of where the firm currently is and the business environment in which it competes.
One method for determining value is to directly examine the worth of the company’s assets and liabilities. However, in most cases, we instead think of the worth of a company as the current value of expected payoffs. In Modules 12 to 14, we describe how to compute value using dividends, cash flows, and earnings as the payoffs. We often hear the adage “cash is king,” which some then interpret as cash being best for valuation instead of, say, dividends or earnings. However, like earnings, cash reporting is subject to managerial biases and accounting limitations—no more, no less. Yet, there are situations where cash or earnings or dividends can work better for valuation purposes. We must develop the skills to understand where those situations are and where one, or a combination of different metrics, is best for valuation.

5

6

1-25

Module 1 | Framework for Analysis and Valuation

Module 15 tackles market-based valuation, which is probably the most frequently used valuation technique in the world today. At first glance, this method appears not to require the analysis performed in Steps 1, 2, and 3, as it generally utilizes market multiples determined from comparable firms. However, this is deceiving. Understanding where the company operates, where the company currently is, and where the company is going also drives valuation using multiples. That is, our financial analysis influences the choice of market multiple, the choice of comparables, and interpretation of the valuation estimate.
Research Insight Are Earnings Important?
A study asked top finance executives of publicly traded companies to rank the three most important measures to report to outsiders. The study reports that:
“[More than 50% of] CFOs state that earnings are the most important financial metric to external constituents . . . this finding could reflect superior informational content in earnings over the other metrics. Alternatively, it could reflect myopic managerial concern about earnings. The emphasis on earnings is noteworthy because cash flows continue to be the measure emphasized in the academic finance literature.”

The study also reports that CFOs view year-over-year change in earnings to be of critical importance to outsiders. Why is that? The study provides the following insights.
“CFOs note that the first item in a press release is often a comparison of current quarter earnings with four quarters lagged quarterly earnings . . . CFOs also mention that while analysts’ forecasts can be guided by management, last year’s quarterly earnings number is a benchmark that is harder, if not impossible, to manage after the 10-Q has been filed with the SEC . . . Several executives mention that comparison to seasonally lagged earnings numbers provides a measure of earnings momentum and growth, and therefore is a useful gauge of corporate performance.”

Thus, are earnings important? To the majority of finance chiefs surveyed, the answer is a resounding yes. (Source: Graham, et al., Journal of Accounting and Economics, 2005)

Financial Statement Analysis in an Efficient Capital Market
Some question the value of financial statement analysis if capital markets are efficient. The idea of market-efficiency is that security prices reflect available information and respond rapidly to new information when it is available. Some people incorrectly believe that this implies there is no gain to engaging in financial statement analysis. However, if our expectations differ from those of other investors there exists an opportunity to make trades based on those beliefs.
Market-efficiency requires effort from people to gather information, interpret it, and then make trades creating supply or demand pressures such that market prices adjust to a new equilibrium. This task of information gathering and processing is the task of financial analysts and investors. In the U.S., the existence of a well-functioning capital market, particularly for the largest firms, allows for buy-side and sell-side analysts, institutional investors, and others to fill this role to potentially render prices efficient. For other firms where there is infrequent coverage in the financial press and little following from investors, prices can be less efficient. Nonetheless, academic research has found many anomalies where markets appear to not fully reflect information or reflect it with a lag.
Another facet of this discussion is management incentives. Management often has an incentive to report favorable financial information due to compensation agreements and a desire to maximize share price. While U.S. GAAP and IFRS put some restrictions on what is reported, the financial data can be biased, misleading, or obscuring of reality. Our analysis attempts to recognize and adjust for such possibilities. However, our estimates of value are only as good as the accounting numbers that underlie them. If we are able to perform effective analysis and gain a thorough understanding of where the firm operates, is currently situated, and is going, then even in an efficient market there are gains available through financial statement analysis.

Module 1 | Framework for Analysis and Valuation

1-26

Analyzing Global Reports
As we discussed earlier, the U.S. is among only a few economically developed countries (such as India,
Singapore, and Taiwan) that do not use IFRS (a list is at http://www.iasplus.com/en/resources/use-ofifrs/#totals). While laws and enforcement mechanisms vary across countries, the demand and supply of accounting information are governed by global economic forces. Thus, it is not surprising that IFRS and
U.S. GAAP both prescribe the same set of financial statements. While account titles and note details differ, the underlying principles are the same. That is, U.S. GAAP and IFRS both capture, aggregate, summarize, and report economic activities on an accrual basis.
Given the global economy and liquid transnational capital markets, along with the fact that many non-U.S. companies file IFRS financial statements with the SEC, it is critical that we be conversant with both U.S. GAAP and IFRS. For this purpose, the final section of each module includes a summary of notable differences between these two systems of accounting for topics covered in that module. Also, each module has assignments that examine IFRS companies and their financial statements. By using a wide array of financial information, we will speak the language of accounting in at least two dialects.

M o d u le- En d R eview
Following are selected data from Progressive Corporation’s 2012 10-K.
$ millions

2012

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income . . . . . . . . . . . . . . . . . . . . . . .
Average assets . . . . . . . . . . . . . . . . . . . .
Average stockholders’ equity . . . . . . . . .

$17,084
902
22,270
5,907

Required a. Compute Progressive’s return on assets. Disaggregate the ROA into its profitability and productivity components. b. Compute Progressive’s return on equity (ROE).
The solution is on page 1-38.

A p p e n d ix 1 A : Accessing SEC Filings

All publicly traded companies are required to file various reports with the SEC, two of which are the 10-Q (quarterly financial statements) and the 10-K (annual financial statements). Following is a brief tutorial to access these electronic filings. The SEC’s Website is http://www.sec.gov. 1. Following is the opening screen. Click on “Filings”
(highlighted below).

2. In Company name, type in the name of the company we are looking for. In this case, we are searching for
Berkshire Hathaway. Then click search.

1-27

Module 1 | Framework for Analysis and Valuation

3. Several references to Berkshire appear. Click on the
Central Key Index, CIK (the SEC’s numbering system) next to Berkshire Hathaway, Inc.

4. Enter the form number under “filing type” that we want to access. Click the Search button. In this case we are looking for the 10-K.

5. Click on the document link for the year that we want to access. 6. Exhibits relating to Berkshire Hathaway’s 10-K filing appear; click on the 10-K document.

7. The Berkshire Hathaway 10-K will open up; the file is searchable. 8. Download an Excel file of the financial statement data by clicking on “Interactive Data.”

9. Click on “View Excel Document” to view or download as a spreadsheet.

Module 1 | Framework for Analysis and Valuation

1-28

Guidance Answers . . . Analysis Decision
You Are the Chief Financial Officer Financial performance is often measured by return on assets, which can be disaggregated into the profit margin (profit after tax/sales) and the asset turnover (sales/average assets). This disaggregation might lead you to review factors affecting profitability (gross margins and expense control) and to assess how effectively your company is utilizing its assets (the turnover rates). Finding ways to increase profitability for a given level of investment or to reduce the amount of invested capital while not adversely impacting profitability contributes to improved financial performance.

Superscript A denotes assignments based on Appendix 1A.

Questions
Q1-1.

A firm’s planning activities motivate and shape three types of business activities. List the three activities.
Describe how financial statements can provide useful information for each activity. How can subsequent financial statements be used to evaluate the success of each of the activities?

Q1-2.

The accounting equation (Assets 5 Liabilities 1 Equity) is a fundamental business concept. Explain what this equation reveals about a company’s sources and uses of funds and the claims on company resources. Q1-3.

Companies prepare four primary financial statements. What are those financial statements and what information is typically conveyed in each?

Q1-4.

Does a balance sheet report on a period of time or at a point in time? Explain the information conveyed in the balance sheet.

Q1-5.

Does an income statement report on a period of time or at a point in time? Explain the information conveyed in the income statement.

Q1-6.

Does a statement of cash flows report on a period of time or at a point in time? Explain the information and activities conveyed in the statement of cash flows.

Q1-7.

Explain how a company’s four primary financial statements are linked.

Q1-8.
Q1-9.

Financial statements are used by several interested stakeholders. List three or more potential external users of financial statements. Explain how each constituent on your list might use financial statement information in their decision making process.
What ethical issues might managers face in dealing with confidential information?

Q1-10. Access the 2012 10-K for Procter & Gamble at the SEC’s database of financial reports (www.sec. gov). Who is P&G’s auditor? What specific language does the auditor use in expressing its opinion and what responsibilities does it assume?
A

Q1-11.

Describe a decision that requires financial statement information, other than a stock investment decision. How is financial statement information useful in making this decision?

Q1-12. Users of financial statement information are vitally concerned with the company’s strategic direction.
Despite their understanding of this need for information, companies are reluctant to supply it. Why?
In particular, what costs are companies concerned about?
Q1-13. One of Warren Buffett’s acquisition criteria is to invest in businesses “earning good return on equity.”
The return on equity (ROE) formula uses both net income and stockholders’ equity. Why is it important to relate net income to stockholders’ equity? Why isn’t it sufficient to merely concentrate on companies with the highest net income?
Q1-14. One of Warren Buffett’s acquisition criteria is to invest in businesses “earning good return on equity, while employing little or no debt.” Why is Buffett concerned about debt?

Procter &
Gamble
(PG)

1-29

Module 1 | Framework for Analysis and Valuation

Assignments with the logo in the margin are available in
See the Preface of the book for details.

.

Mini Exercises
Dell Inc.

M1-15. Relating Financing and Investing Activities (LO2)
In a recent year, the total assets of Dell Inc. equal $47,540 million and its equity is $10,701 million.
What is the amount of its liabilities? Does Dell receive more financing from its owners or nonowners?
What percentage of financing is provided by Dell’s owners?

Best Buy

M1-16. Relating Financing and Investing Activities (lo2)
In a recent year, the total assets of Best Buy equal $16,787 million and its liabilities equal $13,072 million. What is the amount of Best Buy’s equity? Does Best Buy receive more financing from its owners or nonowners? What percentage of financing is provided by its owners?

(DELL)

(BBY)

M1-17. Applying the Accounting Equation and Computing Financing Proportions (LO2)
Use the accounting equation to compute the missing financial amounts (a), (b), and (c). Which of these companies is more owner-financed? Which of these companies is more nonowner-financed? Discuss why the proportion of owner financing might differ across these three businesses.

HewlettPackard
(HPQ)

General Mills
(GIS)

Target

(TGT)

($ millions)
Hewlett-Packard������������������������������������������������������
General Mills ������������������������������������������������������������
Target������������������������������������������������������������������������

Assets

5

Liabilities

1

Equity

$108,768
$ 22,658
$ (c)

5
5
5

$85,935
$ (b)
$31,605

1
1
1

$ (a)
$ 8,096
$16,558

(SBUX)

M1-18.A Identifying Key Numbers from Financial Statements (lo2)
Access the September 30, 2012, 10-K for Starbucks Corporation at the SEC’s database for financial reports (www.sec.gov). What did Starbucks report for total assets, liabilities, and equity at September
30, 2012? Confirm that the accounting equation holds. What percent of Starbucks’ assets is financed by nonowners?

E. I. DuPont de
Nemours

M1-19.A Verifying Linkages Between Financial Statements (lo2)
Access the 2012 10-K for DuPont at the SEC’s database of financial reports (www.sec.gov). Using its December 31, 2012, consolidated statement of stockholders’ equity, prepare a table to reconcile the opening and ending balances of its retained (reinvested) earnings for 2012 by showing the activity in the account during the year.

Starbucks

(DD)

M1-20. Identifying Financial Statement Line Items and Accounts (lo2)
Several line items and account titles are listed below. For each, indicate in which of the following financial statement(s) we would likely find the item or account: income statement (IS), balance sheet (BS), statement of stockholders’ equity (SE), or statement of cash flows (SCF). a. Cash asset
d. Contributed capital
g. Cash inflow for stock issued b. Expenses
e. Cash outflow for capital expenditures h. Cash outflow for dividends c. Noncash assets f. Retained earnings
i. Net income
M1-21. Identifying Ethical Issues and Accounting Choices (lo1)
Assume that you are a technology services provider and you must decide on whether to record revenue from the installation of computer software for one of your clients. Your contract calls for acceptance of the software by the client within six months of installation. According to the contract, you will be paid only when the client “accepts” the installation. Although you have not yet received your client’s formal acceptance, you are confident that it is forthcoming. Failure to record these revenues will cause your company to miss Wall Street’s earnings estimates. What stakeholders will be affected by your decision and how might they be affected?

Module 1 | Framework for Analysis and Valuation

1-30

Exercises
E1-22.

Composition of Accounts on the Balance Sheet (lo2)
Answer the following questions about the Target balance sheet. a. b. c.

E1-23.

Briefly describe the types of assets that Target is likely to include in its inventory.
What kinds of assets would Target likely include in its Property and Equipment?
Target reports about two-thirds of its total assets as long-term. Given Target’s business model, why do we see it report a relatively high proportion of long-term assets?

Target

(TGT)

Applying the Accounting Equation and Assessing Financial Statement Linkages (lo2)
Answer the following questions. (Hint: Apply the accounting equation.) a. b. c.

Intel had assets equal to $84,351 million and liabilities equal to $33,148 million for a recent yearend. What was Intel’s total equity at year-end? Why would we expect a company like Intel to report a relatively high proportion of equity vis-à-vis liabilities?
At the beginning of a recent year, JetBlue ’s assets were $7,071 million and its equity was $1,757 million. During the year, assets decreased $1 million and liabilities decreased $132 million. What was JetBlue’s equity at the end of the year?
What balance sheet account provides the link between the balance sheet and the income statement?
Briefly describe how this linkage works.

E1-24.

Applying Financial Statement Relations to Compute Dividends (lo2)
Colgate-Palmolive reports the following dollar balances in its retained earnings account.

JetBlue

(JBLU)

Specifying Financial Information Users and Uses (lo1)
Financial statements have a wide audience of interested stakeholders. Identify two or more financial statement users that are external to the company. For each user on your list, specify two questions that could be addressed with financial statement information.

E1-25.

Intel

(INTC)

($ millions)
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2012

2011

$16,953

ColgatePalmolive

$15,649

(CL)

During 2012, Colgate-Palmolive reported net income of $2,472 million. What amount of dividends, if any, did Colgate-Palmolive pay to its stockholders in 2012? What percent of its net income did ColgatePalmolive pay out as dividends in 2012?
E1-26.

Computing and Interpreting Financial Statement Ratios (lo4)
Following are selected ratios of Colgate-Palmolive for 2012 and 2011.
Return on Assets (ROA) Component

E1-27.

2011

Profitability (Net income/Sales) . . . . . . . . . . . . . . . . . . . . . . . .
Productivity (Sales/Average net assets) . . . . . . . . . . . . . . . . .

a. b. c.

2012
14%
1.3

15%
1.4

Computing Return on Assets and Applying the Accounting Equation (lo4)
Nordstrom, Inc. , reports net income of $735 million for its fiscal year ended February 2013. At the

Assessing the Role of Financial Statements in Society (lo1)
Financial statement information plays an important role in modern society and business. a. b.

(CL)

Was the company profitable in 2012? What evidence do you have of this?
Is the change in productivity (asset turnover) a positive development? Explain.
Compute the company’s return on assets (ROA) for 2012 (show computations).

beginning of that fiscal year, Nordstrom had $8,491 million in total assets. By fiscal year-end 2013, total assets had decreased to $8,089 million. What is Nordstrom’s return on assets (ROA)?
E1-28.

ColgatePalmolive

Identify two or more external stakeholders that are interested in a company’s financial statements and what their particular interests are.
What are generally accepted accounting principles? What organizations have primary responsibility for the formulation of GAAP?

Nordstrom, Inc.
(JWN)

1-31

Module 1 | Framework for Analysis and Valuation

c. d.
E1-29.

Starbucks
(SBUX)

What role does financial statement information play in the allocation of society’s financial resources? What are three aspects of the accounting environment that can create ethical pressure on management?

Computing Return on Equity (L04)
Starbucks reports net income for 2012 of $1,383.8 million. Its stockholders’ equity is $4,387.3 million and $5,114.5 million for 2011 and 2012, respectively. a. b. c.

Compute its return on equity for 2012.
Starbucks repurchased over $501 million of its common stock in 2012. How did this repurchase affect Starbucks’ ROE?
Why do you think a company like Starbucks repurchases its own stock?

Problems
P1-30.

Wal-Mart
Stores, Inc.

Computing Return on Equity and Return on Assets (lo4)
The following table contains financial statement information for Wal-Mart Stores, Inc.
($ millions)

(WMT)

Total Assets

2013 . . . . . . . . . . . . . . . . . . . . . . .
2012 . . . . . . . . . . . . . . . . . . . . . . .
2011 . . . . . . . . . . . . . . . . . . . . . . .

$203,105
193,406
180,782

Net Income
$16,999
15,699
16,389

Sales
$469,162
446,950
421,849

Equity
$81,738
75,761
71,247

Required

a. b.

c.
P1-31.

General Mills,
Inc.

Compute the return on equity (ROE) for 2012 and 2013. What trend, if any, is evident? How does
Wal-Mart’s ROE compare with the approximately 21.5% median ROE for companies in the Dow
Jones Industrial average for 2012?
Compute the return on assets (ROA) for 2012 and 2013. What trends, if any, are evident? How does Wal-Mart’s ROA compare with the approximate 6.7% median ROA for companies in the Dow
Jones Industrial average for 2012?
What factors might allow a company like Wal-Mart to reap above-average returns?

Formulating Financial Statements from Raw Data (lo2, 4)
Following is selected financial information from General Mills, Inc. , for its fiscal year ended May
26, 2013 ($ millions).

(GIS)

Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash from operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash, beginning year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Noncash assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash from financing activities* . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total expenses (other than cost of goods sold) . . . . . . . . . . . . . .
Cash, ending year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash from investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . .
*

Required

$17,774.1
2,926.0
471.2
8,096.0
21,916.6
(1,140.4)
11,350.2
4,568.7
741.4
14,562.0
(1,515.4)

Cash from financing activities includes the effects of foreign exchange rate fluctuations.

Prepare the income statement, the balance sheet, and the statement of cash flows for General Mills for the fiscal year ended May 26, 2013. b. Do the negative amounts for cash from investing activities and cash from financing activities concern us? Explain. c. Using the statements prepared for part a, compute the following ratios (for this part only, use the year-end balance instead of the average for assets and stockholders’ equity): i. Profit margin ii. Asset turnover iii. Return on assets iv. Return on equity a.

Module 1 | Framework for Analysis and Valuation

P1-32.

Formulating Financial Statements from Raw Data (lo2, 4)
Following is selected financial information from Abercrombie & Fitch for its fiscal year ended February 2, 2013 ($ millions).
Noncash assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total expenses (other than cost of goods sold) . . . . . . . . . . . . . .
Cash from investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash, ending year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash from operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash from financing activities* . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash, beginning year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
*

$2,343
2,580
(247)
644
4,511
1,169
684
(377)
1,694
584
1,818

1-32

Abercrombie &
Fitch
(ANF)

Cash from financing activities includes the effects of foreign exchange rate fluctuations.

Required

Prepare the income statement, the balance sheet, and the statement of cash flows for Abercrombie
& Fitch for the fiscal year ended February 2, 2013. b. Do the negative amounts for cash from investing activities and cash from financing activities concern us? Explain. c. Using the statements prepared for part a, compute the following ratios (for this part only, use the year-end balance instead of the average for assets and stockholders’ equity): i. Profit margin ii. Asset turnover iii. Return on assets iv. Return on equity a.

P1-33.

Formulating Financial Statements from Raw Data (lo2, 4)
Following is selected financial information from Cisco Systems, Inc. , for the year ended July 27, 2013
($ millions).
Cash, ending year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash from operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash from financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total expenses (other than cost of goods sold) . . . . . . . . . . . . . .
Noncash assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash from investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash, beginning year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Required

$ 7,925
12,894
48,607
59,128
19,167
(3,000)
42,063
19,457
93,266
(11,768)
9,983
9,799

Prepare the income statement, the balance sheet, and the statement of cash flows for Cisco Systems for the fiscal year ended July 27, 2013. b. Do the negative amounts for cash from investing activities and cash from financing activities concern us? Explain. c. Using the statements prepared for part a, compute the following ratios (for this part only, use the year-end balance instead of the average for assets and stockholders’ equity): i. Profit margin ii. Asset turnover iii. Return on assets iv. Return on equity a.

Cisco Systems,
Inc.
(CSCO)

1-33

Module 1 | Framework for Analysis and Valuation

P1-34.

Formulating a Statement of Stockholders’ Equity from Raw Data (lo2)
Crocker Corporation began calendar-year 2013 with stockholders’ equity of $150,000, consisting of contributed capital of $120,000 and retained earnings of $30,000. During 2013, it issued additional stock for total cash proceeds of $30,000. It also reported $50,000 of net income, and paid $25,000 as a cash dividend to stockholders.
Required

Prepare the 2013 statement of stockholders’ equity for Crocker Corporation.
P1-35.

Gap, Inc.

Formulating a Statement of Stockholders’ Equity from Raw Data (lo2)
Gap, Inc. , reports the following selected information at February 2, 2013 ($ millions).

(GPS)

Contributed capital, February 2, 2013 . . . . . . . . . . . . . . . . . . . . . . . $ 2,919
Treasury stock, February 2, 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . (13,465)
Retained earnings, February 2, 2013 . . . . . . . . . . . . . . . . . . . . . . . 13,259
Accumulated other comprehensive income, February 2, 2013 . . .
181

During fiscal year 2013, Gap reported the following:
1
. Issuance of stock . . . . . . . . . . . . . . . . 3
$
2 . Repurchase of stock . . . . . . . . . . . . . 705 3. Net income . . . . . . . . . . . . . . . . . . . . 1,135 4. Cash dividends . . . . . . . . . . . . . . . . . 240
5
. Other comprehensive income (loss) . (48)
Required

Use this information to prepare the statement of stockholders’ equity for Gap, Inc., for fiscal year 2013.
P1-36.

Kimberly-Clark
(KMB)

Computing, Analyzing, and Interpreting Return on Equity and Return on Assets (lo4)
Following are summary financial statement data for Kimberly-Clark for 2010 through 2012.
Kimberly-Clark Corporation (KMB)
($ millions)
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2012

2011

2010

$21,063
1,750
19,873
4,985

$20,846
1,591
19,373
5,249

$19,746
1,843
19,864
5,917

Required

a.

b. c.
P1-37.

Nordstrom, Inc.
(JWN)

Compute the return on assets and return on equity for 2011 and 2012 (use average assets and average equity), together with the components of ROA (profit margin and asset turnover). What trends do we observe?
Which component appears to be driving the change in ROA over this time period?
KMB repurchased a large amount of its common shares in recent years at a cost of almost $4.9 billion. How did this repurchase affect its return on equity?

Computing, Analyzing, and Interpreting Return on Equity and Return on Assets (LO4)
Following are summary financial statement data for Nordstrom, Inc. , for 2011 through 2013.
($ millions)
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Required

a. b.

2013

2012

2011

$11,762
735
8,089
1,913

$10,497
683
8,491
1,956

$9,310
613
7,462
2,021

Compute return on assets and return on equity for each year 2012 and 2013 (use average assets and average equity), together with the components of ROA (profit margin and asset turnover). What trends, if any, do we observe?
Which component, if any, appears to be driving the change in ROA over this time period?

Module 1 | Framework for Analysis and Valuation

P1-38.

Computing, Analyzing, and Interpreting Return on Equity (lo4)
Canadian Tire Corporation, Limited operates retail stores in Canada that sell general merchandise, clothing, and sporting goods. Total stockholders’ equity for Canadian Tire (in Canadian dollars) is
$4,763.6 in 2012 and $4,409.0 in 2011. In 2012, Canadian Tire reported net income of $499.2 on sales of
$11,427.2.

1-34

Canadian Tire
Corporation,
Limited

Required

a. b. c.
P1-39.

What is Canadian Tire’s return on equity for 2012?
What are total expenses for Canadian Tire for 2012?
Canadian Tire used cash to repurchase a large amount of its common stock during the period 2009 through 2012. What motivations might Canadian Tire have for repurchasing its common stock?

Comparing Abercrombie & Fitch and TJX Companies (lo4)
Following are selected financial statement data from Abercrombie & Fitch (ANF—upscale clothing retailer) and TJX Companies (TJX—value-priced clothing retailer including TJ Maxx)—both dated
2013.
($ millions)

Company

Total Assets

2012
2013
2012
2013

TJX Companies Inc. . . . . . . . . . .
TJX Companies Inc. . . . . . . . . . .
Abercrombie & Fitch . . . . . . . . . .
Abercrombie & Fitch . . . . . . . . . .

$8,282
9,512
3,117
2,987

Net Income

$1,907

237

Sales

$25,878

4,511

Abercrombie &
Fitch
(ANF)

TJX Companies
(TJX)

Required

a. b. c.

P1-40.

Compute the return on assets for both companies for the year ended 2013.
Disaggregate the ROAs for both companies into the profit margin and asset turnover.
What differences are observed? Evaluate these differences in light of the two companies’ business models. Which company has better financial performance?

Computing and Interpreting Return on Assets and Its Components (lo4)
McDonald’s Corporation (MCD) reported the following balance sheet and income statement data for 2010 through 2012.
($ millions)
2010 . . . . . . . . . . . . . . . . . . . . . . . . . .
2011 . . . . . . . . . . . . . . . . . . . . . . . . . .
2012 . . . . . . . . . . . . . . . . . . . . . . . . . .

Total Assets
$31,975.2
32,989.9
35,386.5

Net Income

$5,503.1
5,464.8

Sales

McDonaldÕs
Corporation
(MCD)


$27,006.0
27,567.0

Required

a. b.
P1-41.

What is MCD’s return on assets for 2011 and 2012? Disaggregate MCD’s ROA into its net profit margin and its asset turnover.
What factor is mainly responsible for the change in MCD’s ROA over this period?

Disaggregating Return on Assets over Multiple Periods (lo4)
Following are selected financial statement data from 3M Company for 2009 through 2012.
($ millions)
2009 . . . . . . . . . . . . . . . . . . . . . . . . . .
2010 . . . . . . . . . . . . . . . . . . . . . . . . . .
2011 . . . . . . . . . . . . . . . . . . . . . . . . . .
2012 . . . . . . . . . . . . . . . . . . . . . . . . . .

Total Assets

Net Income

Sales

$27,250
30,156
31,616
33,876

$3,193
4,085
4,283
4,444

3M Company
(MMM)

$23,123
26,662
29,611
29,904

Required

a. b.
P1-42.

Compute 3M Company ’s return on assets for 2010 through 2012. Disaggregate 3M’s ROA into the profit margin and asset turnover for 2010 through 2012. What trends do we observe?
Which ROA component appears to be driving the trend observed in part a? Explain.

Reading and Interpreting CEO Certifications (lo1)
Following is the CEO Certification required by the Sarbanes-Oxley Act and signed by Apple CEO
Timothy D. Cook. Apple’s Chief Financial Officer signed a similar form.

Apple Inc.

(AAPL)

1-35

Module 1 | Framework for Analysis and Valuation

CERTIFICATIONS
I, Timothy D. Cook, certify that:
1.

Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.

Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.

The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and
15d-15(f)) for the registrant and have:

(a)  esigned such disclosure controls and procedures, or caused such disclosure controls and
D
procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b)  esigned such internal control over financial reporting, or caused such internal control over
D
financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c)  valuated the effectiveness of the registrant’s disclosure controls and procedures and preE sented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d)  isclosed in this report any change in the registrant’s internal control over financial reporting
D
that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5.

The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a)  ll significant deficiencies and material weaknesses in the design or operation of internal conA trol over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize, and report financial information; and

I have reviewed this annual report on Form 10-K of Apple Inc.;

2.

(b) 
Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: October 31, 2012

By: /s/ Timothy D. Cook

Timothy D. Cook

Chief Executive Officer

Required

a. b. c.
P1-43.

General
Electric
(GE)

Summarize the assertions that Timothy D. Cook made in this certification.
Why did Congress feel it important that CEOs and CFOs sign such certifications?
What potential liability do you believe the CEO and CFO are assuming by signing such certifications?

Assessing Corporate Governance and Its Effects (lo1)
Review the corporate governance section of General Electric ’s Website http://www.ge.com. Find and click on: “investor relations”; then, find and click on: “governance” and open the “Governance
Principles” PDF.
Required

a. b.

In your words, briefly describe GE’s governance structure.
What is the main purpose of its governance structure?

Module 1 | Framework for Analysis and Valuation

1-36

IFRS Applications
I1-44.

Applying the Accounting Equation and Computing Financing Proportions (LO2)
The following table contains fiscal 2012 information for three companies that use IFRS. Apply the accounting equation to compute the missing financial amounts (a), (b), and (c). Which of these companies is more owner-financed? Which of these companies is more nonowner-financed? Discuss why the proportion of owner financing might differ across these three companies.
(Amounts in millions)

Assets

OMV Group (Austria)�����������������������������������������
Ericsson (Sweden)�������������������������������������������
BAE Systems (UK)�������������������������������������������

I1-45.

Liabilities

5

€ 13,888
SEK 274,996
(c)

€ 6,034
(b)
£18,500

Equity

1

(a)
SEK 138,483
£3,774

Computing Return on Equity and Return on Assets (LO4)
The following table contains financial statement information for AstraZeneca , which is a global biopharmaceutical company focused on discovery, development, manufacturing and commercialization of medicines and is headquartered in London, UK.
($ millions)

Total Assets

Net Income

Sales

$8,106
9,470
6,405

$33,269
33,591
27,973

AstraZeneca

Equity

$56,127
52,830
53,534

OMV Group
Ericsson
BAE Systems

$23,410
23,472
23,952

2010��������������������
2011��������������������
2012��������������������
Required

a.

b. c.
I1-46.

Compute the return on equity (ROE) for 2011 and 2012. What trend, if any, is evident? How does
AstraZeneca’s ROE compare with the approximately 21.5% median ROE for companies in the
Dow Jones Industrial average for 2012?
Compute the return on assets (ROA) for 2011 and 2012. What trends, if any, are evident? How does
AstraZeneca’s ROA compare with the approximate 6.7% median ROA for companies in the Dow
Jones Industrial average for 2012?
What factors might allow a company like AstraZeneca to reap above-average returns?

Computing and Interpreting Return on Assets and Its Components (LO4)
Tesco PLC , which is one of the world’s largest retailers and is headquartered in Cheshunt, U.K., reported the following balance sheet and income statement data for 2011 through 2013.
(£ millions)
2011�����������������������������
2012�����������������������������
2013�����������������������������

Total Assets
£12,039
12,863
13,096

Net Income
£2,671
2,814
120

Sales
£60,455
63,916
64,826

Required

a. b. c.

What is Tesco’s return on assets for 2012 and 2013?
Disaggregate Tesco’s ROA metrics from part a into profit margin and asset turnover.
What factor is mainly responsible for the change in Tesco’s ROA over this period?

Discussion Points
D1-47. Strategic Financing (LO2)
You and your management team are working to develop the strategic direction of your company for the next three years. One issue you are discussing is how to finance the projected increases in operating assets. Your options are to rely more heavily on operating creditors, borrow the funds, or to sell additional stock in your company. Discuss the pros and cons of each source of financing.

Tesco PLC

1-37

Module 1 | Framework for Analysis and Valuation

D1-48. Statement Analysis (LO4)
You are evaluating your company’s recent operating performance and are trying to decide on the relative weights you should put on the income statement, the balance sheet, and the statement of cash flows. Discuss the information each of these statements provides and its role in evaluating operating performance.
D1-49. Analyst Relations (LO2)
Your investor relations department reports to you that stockholders and financial analysts evaluate the quality of a company’s financial reports based on their “transparency,” namely the clarity and completeness of the company’s financial disclosures. Discuss the trade-offs of providing more or less transparent financial reports.
D1-50. Ethics and Governance: Management Communications (lo1)
The Business Insight box on page 1-15 quotes Warren Buffett on the use of accounting jargon. Many companies publicly describe their performance using terms such as “EBITDA” or “earnings purged of various expenses” because they believe these terms more effectively reflect their companies’ performance than GAAP-defined terms such as net income. What ethical issues might arise from the use of such terms and what challenges does their use present for the governance of the company by stockholders and directors?

Ongoing Analysis Project
An important part of learning is application. To learn accounting, we must practice the skills taught and apply those skills to real world problems. To that end, we have designed a project to reinforce the lessons in each module and apply that to real companies. The goal of this project is to complete a comprehensive analysis of two (or more) companies in the same industry. We will then create a set of forecasted financial statements and a valuation of the companies’ equity. This is essentially what financial analysts and many creditors do. We might not aspire to be an analyst or creditor, but by completing a project of this magnitude, we will have mastered financial reporting at a sufficient level to be able to step into any role in an organization. The goal of Module 1’s assignment is to obtain and begin to explore the financial reports for two publicly traded companies that compete with each other.
■■ Select two publicly traded companies that compete with each other. They must be publicly traded as private company financial statements will not be publicly available. While the two companies do not need to be head-to-head competitors, their main lines of business should broadly overlap.
■■ Download the annual reports for each company and peruse them. At this stage, choose companies that are profitable (net income is positive) and that have positive retained earnings and stockholders’ equity. Select companies whose financial statements are not overly complicated. (Probably avoid the automotive, banking, insurance, and financial services industries. Automotive companies have recently reported large losses, which complicates the analysis. Banking, insurance, and financial services have operations that differ drastically from the usual industrial companies common in practice. While these companies can be analyzed, they present challenges for the beginning analyst.)
■■ Use the SEC EDGAR Website to locate the recent Form 10-K (or other annual report such as 20-F or 40-F). Download a spreadsheet version of financial statements. Use Appendix 1A as a guide.
■■ Use the annual report and the financial statements along with any online sites to assess the companies’ business environment. Use Porter’s Five Forces or a SWOT analysis to briefly analyze the competitive landscape for the two companies. (Originated by Albert S. Humphrey, SWOT
Analysis provides a useful way to assess an organization’s Strengths, Weaknesses, Opportunities, and Threats.) Our aim is to understand the competitive position of each company so that we can assess their financial statements in a broader business context.
■■ Explore the financial statements and familiarize yourself with the company basics. The following give an indication of some questions that guide us as we look for answers.
• What accounting standards are used, U.S. GAAP, IFRS, or other?
• What is the date of the most recent fiscal year-end?
• Determine the relative proportion of short-term and long-term assets.
• Determine the relative proportion of liabilities and equity.
• Calculate the return on assets (ROA) for the most recent year.
• 
Disaggregate ROA into the two component parts as shown in Exhibit 1.8. Compare the numbers/ratios for each company.
• 
Find the companies’ audit reports. Who are the auditors? Are any concerns raised in the reports?
• Do the audit reports differ significantly from the one for Berkshire Hathaway in this module?

Module 1 | Framework for Analysis and Valuation

Solutions to Review Problems
Mid-Module Review
Solution

1.

AXA Equitable Life Insurance Company
Income Statement
For Year Ended December 31, 2012
Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 9,160
8,944

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income attributable to noncontrolling interest . . . . . . . . . . . . . . . . .

216
95

Net income attributable to AXA stockholders . . . . . . . . . . . . . . . . . . . . .

$ 121

AXA Equitable Life Insurance Company
Balance Sheet
December 31, 2012
Cash . . . . . . . . . . . . .
Noncash assets . . . . .

$176,843

Liabilities . . . . . . . . . . . . . . . . .
Equity
AXA stockholders’ equity . . . .
Noncontrolling interest . . . . . .

$158,913

Total stockholders’ equity . . . .
Total assets . . . . . . . .

$ 3,162 173,681

$ 17,930

Total liabilities and equity . . . .

$176,843

15,436 2,494

AXA Equitable Life Insurance Company
Statement of Cash Flows
For Year Ended December 31, 2012
Cash flows from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash flows from investing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash flows from financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ (780)
(2,692)
3,407

Net increase (decrease) in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash, beginning year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

(65)
3,227

Cash, ending year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$3,162

Berkshire Hathaway is a larger company; its total assets are $427,452 million compared to AXA’s
2.
assets of $176,843 million. The income statements of the two companies are markedly different. Berkshire Hathaway reports nearly eighteen times as much revenue ($162,463 million compared to $9,160 million). The difference in net income attributable to the parent stockholders is also large; Berkshire
Hathaway earned $14,824 million whereas AXA reported net income of only $121 million.

Module-End Review
Solution

a. ROA 5 Net income/Average assets 5 $902/$22,270 5 4.1%. The profitability component is Net income/Sales 5 $902/$17,084 5 5.3%, and the productivity component is Sales/Average assets 5 $17,084/$22,270 5 0.77. Notice that 5.3% 3 0.77 5 4.1%. Thus, the two components, when multiplied, yield ROA. b. ROE 5 Net income/Average stockholders’ equity 5 $902/$5,907 5 15.3%.

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