Players in the Accounting Communication Process

Management Preparation CFO, CEO, Accounting Staff Guided by GAAP (IFRS) Independent Auditors Verification Partners, Managers, Staff Guided by GAAS (ISA) Information Intermediaries Analysis and Advice Financial analysis, Information services Government Regulators Verification

Ensuring the Integrity of Financial Information Communication Process

Regulators
Standard Setting and Verification

IFAC
Auditing Standards

IASB
Accounting Standards

Stock Exchanges
Corporate Governance Standards

Management
Primary Responsibility CFO, CEO, Accounting staff

Communicating and Interpreting Accounting Information

Auditors (CPAs)
Users Analysis and Decision Investors, Lenders, etc.

Directors
Oversight Audit Committee (Independent directors)

Public companies only

2

Verification Partners, Managers, Staff

Users: Institutional and Private Investors, Creditors, and Others

Management Primary Responsibility CFO, CEO, Accounting Staff

Guiding Principles for Communicating Useful Information

Primary Objective of External Financial Reporting To provide economic information to external users for decision making.

Guiding Principles for Communicating Useful Information

Primary Objective of External Financial Reporting To provide economic information to external users for decision making.
Primary Qualitative Characteristics

The full-disclosure principles require . . . 1. Relevance: Timely and Predictive and Feedback Value A complete set of financial statements, and Reliability: Accurate, Unbiased, and Verifiable 2.Notes to the financial statements
Secondary Qualitative Characteristics Comparability: Across businesses Consistency: Over time
5 6

Information Intermediaries Analysis and Advice Financial analysts, Information services

Users Analysis and Decision Institutional and private investors, Lenders, Suppliers, Customers, etc.

Primary Qualitative Characteristics Relevance: Timely and Predictive Feedback Value Reliability: Accurate, Unbiased, and Verifiable

Secondary Qualitative Characteristics Comparability: Across businesses Consistency: Over time

4

International Accounting Standards Board and Global Differences in Accounting Standards

Annual Reports

Annual Reports

International Financial Reporting Standards

Difference in Accounting Standards Extraordinary items LIFO for inventory Reversal of inventory write-downs Basis of property, plant, and equipment US GAAP Permitted Permitted Prohibited Historical cost IFRS Prohibited Prohibited Required Fair Value or Historical cost

For privately held companies, annual reports are simple documents that include:
1. Four basic financial statements. 2. Related notes (footnotes). 3. Report of independent accountants (auditors

For public companies, annual reports are elaborate due to reporting requirements:
1. A Nonfinancial Section

opinion) if the statements are audited.

A letter to the stockholders, a description of managements philosophy, products, successes, etc. See next slide for a detailed listing . . .
9

2. A Financial Section

7 8

Annual Reports
1. Summarized financial data for a number of years. 2. Management Discussion and Analysis (MD&A). 3. The four basic financial statements. 4. Notes (footnotes). 5. Independent Accountants Report and the Management Certification.

Quarterly Reports
Usually begin with short letter to stockholders Condensed unaudited (but reviewed) income statement and balance sheet for the quarter. Often, cash flow statement and statement of stockholders equity are omitted. Some notes to the financial statements also may be omitted.

Classified Balance Sheet

Callaway Golf Company Consolidated Balance Sheet
(in thousands, except share data and per share data)

December 31, 2006 2005

6. Recent stock price information. 7. Summaries of the unaudited quarterly financial data. 8. Lists of directors and officers of the company and relevant addresses.

ASSETS Current assets: Cash and cash equivalents Accounts receivable, net Inventories, net Other current assets Total current assets Property, plant and equipment, net Intangible assets, net Other assets

46,362 $ 118,133 265,110 63,595 493,200 131,224 175,159 46,364 845,947 $

49,481 98,082 241,577 49,450 438,590 127,739 175,191 22,978 764,498

10

11

12

Classified Balance Sheet

Callaway Golf Company Consolidated Balance Sheet
(in thousands, except share data and per share data)

Classified Balance Sheet

Callaway Golf Company Consolidated Balance Sheet
December 31,
(in thousands, except share data and per share data)

Classified Income Statement

Contributed capital is normally shown in two accounts:
1.Common Stock 2.Additional Paid-in Capital

Income statements may contain three sections:

1. Continuing operations 2. Nonrecurring Items
A. Discontinued operations B. Extraordinary items (not in Europe)

December 31, 2006 2005

2006

2005

LIABILITIES & STOCKHOLDERS" EQUITY Current Liabilities: Accounts payable and accrued expenses $ Notes payable, current portion Total current liabilities Long-term liabilities: Other liabilities Minority interest Commitment and contingencies (Note13) 143,455 $ 80,000 223,455 43,388 1,987 140,184 21 140,205 28,245

SHAREHOLDERS' EQUITY Shareholders' equity: Common stock, $.01 par value, 85,096,782 and 84,950,694 issued and outstanding at December 31, 2006 and 2005, respectively Additional paid-in capital Retained earnings Total shareholders' equity Total liabilities and shareholders' equity

3. Earnings per share

851 $ 141,192 435,074 577,117

850 164,202 430,996 596,048

$ 845,947 $ 764,498

13

14

15

Classified Income Statement

General Format for the Classified Income Statement

Earnings Per Share

Net Income* Average Number of Shares of Common Stock Outstanding During the Period

Common-Size Income Statement

Matrix, International Income Statement Month Ended January 31, 2009 Revenues: Sales revenue $ Rental income Total revenues Costs and expenses: Cost of sales Salaries & benefits expense General & administrative expenses Depreciation expense Total costs and expenses Operating income Other revenues and gains (expenses and losses) Investment income Interest expense Gain on sale of land Income before income taxes Income tax expense Net income $ Earnings per share $

Net sales Cost of goods sold Gross profit Operating expenses Income from operations Nonoperating revenues/expenses and gains/losses Income before income taxes Income tax expense Net income

EPS =

66,000 3,800 69,800 36,000 16,000 8,100 2,500 62,600 7,200 1,000 (60) 3,000 11,140 3,899 7,241 0.40

94.56% 5.44% 100.00% 51.58% 22.92% 11.60% 3.58% 89.68% 10.32% 1.43% -0.09% 4.30% 15.96% 5.59% 10.37%

Total revenue is equal to 100%.

Basic EPS *If there are preferred dividends, the

amount is subtracted from the Net Income in the numerator.
16 17

18

Statement of Cash Flows

The Statement of Cash Flows is divided into three major sections. 1. Cash flows from operating activities. 2. Cash flows from investing activities. 3. Cash flows from financing activities. We will examine the indirect method of preparing the statement. This format begins with a reconciliation of accrual income to cash flows from operations.
CALLAWAY GOLF COMPANY Consolidated Statement of Cash Flows For the Year Ended December 31 (in thousands) 2006 Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation & amortization Other non-cash items Changes in assets and liabilities, net of effects from acquisitions: Accounts receivable, net Inventories, net Other assets Accounts payable and accrued expenses Income taxes payable Other liabilities Net cash provided by operating activities $ 23,290
CALLAWAY GOLF COMPANY Consolidated Statement of Cash Flows For the Year Ended December 31 (in thousands) Change in Account Balance During Year 2006 Increase Decrease Cash flows from operating activities: Current Net income Subtract from net Add $to net income. 23,290 Assets Adjustments to reconcile net income to net cash income. Current provided by operating activities: Add to net income. Subtract from net Depreciation & amortization 32,274 Liabilities income. Other non-cash items 14,035 Changes in assets and liabilities, net of effects from acquisitions: Accounts receivable, net (12,128) Inventories, net (16,842) Other assets (4,475) Accounts payable and accrued expenses (10,803) Income taxes payable (6,936) Other liabilities (1,128) Net cash provided by operating activities $ 17,287

32,274 14,035

(12,128) (16,842) (4,475) (10,803) (6,936) (1,128) 17,287

19

20

21

Notes to Financial Statements

Consolidated Statement of Cash Flows 2006 Cash flows from investing activities Capital expenditures Acquisition, net of cash acquired Investment in marketable securities Proceeds from sale of assets Net cash used in investing activities Cash flows from financing activities: Issuance of common stock Acquisition of treasury stock Proceeds from line of credit (net) Other financing activities Dividends paid, net Net cash used in financing activities Effect of exchange rate changes on cash Net decrease in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year $ (32,453) 374 (10,008) 469 (41,618) 9,606 (52,872) 80,000 2,549 (19,212) 20,071 1,141 (3,119) 49,481 46,362
22

Return on Equity (ROE) Analysis

Return on = Equity Net Income Average Stockholders Equity1

Descriptions of the key accounting rules that apply to the companys statements. Additional detail supporting reported numbers. Relevant financial information not disclosed on the statements.

ROE measures how much the firm earned for each dollar of stockholders investment.
1(beginning
23

equity + ending equity) 2

24

ROE Profit Driver Analysis

ROE

Profit Drivers and Business Strategy

Asset Turnover

Chapter Supplement: Nonrecurring Items

In addition, companies may have nonrecurring Net sales items. These nonrecurring items may include: 1. Discontinued operations, Gross profit Operating items, 2. Extraordinaryexpenses These items are reported separately because Nonoperating revenues/expenses and gains/losses they areIncome before income taxes not useful in predicting future income Income tax of the company. expense
Net income Income from operations Cost of goods sold
General Format for the Classified Income Statement

Net Profit Margin

Financial Leverage

Rely on R&D and product promotion to convince customers of the superiority of your product.

High-value or product-differentiation.

Net Income Average Stockholders Equity

Net Income Net Sales

Net Sales Average Total Assets

Average Total Assets Average Stockholders Equity

Rely on efficient management of accounts receivable, inventory and productive assets to produce high asset turnover.

Low-Cost.

25

26

27

Discontinued Operations Sale or abandonment of a segment of a business.

Extraordinary Items

Unusual
Income or loss on segments operation for the period. Gain or loss on disposal of the segment.

Infrequent

Analyzing Financial Statements

Show net of applicable taxes.

28

Show net of applicable taxes.

29

Understanding The Business

Individual Company Factors

Understanding The Business

Return on an equity security investment
Dividends Increase in share price

Understanding a Companys Strategy

I need to know the companys policies on product differentiation, pricing, and cost control to make my financial analysis more meaningful.

Industry Factors

Economy-wide Factors

Invest? No Yes

Business Strategy

Operating Decisions Transactions Financial Statements

33

Investors

Financial Statement Analysis

FINANCIAL STATEMENT USERS
EXTERNAL DECISION MAKERS

Financial Statement Analysis

THREE TYPES OF FINANCIAL STATEMENT INFORMATION
Past Performance Present Condition Future Performance

Financial Statement Analysis

Financial statement analysis is based on comparisons.

MANAGEMENT

Time series analysis . . . uses accounting data to make product pricing and expansion decisions. . . . use accounting data for investment, credit, tax, and public policy decisions.
34

Comparison with similar companies Provides insights concerning a companys relative performance.
36

Income, sales volume, cash flows, returnon-investments, EPS.

Assets, debt, inventory, various ratios.

Sales and earnings trends are good indicators of future performance.

Examines a single company to identify trends over time.

35

Component Percentages Express each item on a particular statement as a percentage of a single base amount.
Net sales on the income statement Total assets on the balance sheet

The comparative income statements of Home Depot for 2007 and 2006 appear on the next slide. Prepare component percentage income statements where net sales equal 100%.
37

HOME DEPOT Comparative Income Statements (Condensed) Amounts in Millions Except Per Share Data 2007 Percent 2006 Percent Net Sales $ 90,837 100.0% $ 81,511 100.0% Cost of Merchandise Sold 61,054 67.2% 54,191 66.5% Gross Profit 29,783 27,320 Operating Expenses 20,110 17,957 Operating Income 9,673 9,363 Interest and Investment Income 27 62 Interest Expense (392) (143) 2007 Cost 2007 Sales Earnings Before Income Taxes 9,308 9,282 Income Taxes 3,547 3,444 Net Earnings $ 5,761 $ 5,838 Basic Earnings Per Share $ 2.80 $ 2.73 Weighted-Average Number of Common Shares Outstanding 2,062 2,147 Diluted Earnings Per Share $ 2.79 $ 2.72
38

HOME DEPOT Comparative Income Statements (Condensed) Amounts in Millions Except Per Share Data 2007 Percent 2006 Percent Net Sales $ 90,837 100.0% $ 81,511 100.0% Cost of Merchandise Sold 61,054 67.2% 54,191 66.5% Gross Profit 29,783 32.8% 27,320 33.5% Operating Expenses 20,110 22.1% 17,957 22.0% Operating Income 9,673 10.6% 9,363 11.5% Interest and Investment Income 27 0.0% 62 0.1% Interest Expense (392) -0.4% (143) -0.2% Earnings Before Income Taxes 9,308 10.2% 9,282 11.4% Income Taxes 3,547 3.9% 3,444 4.2% Net Earnings $ 5,761 6.3% $ 5,838 7.2% Basic Earnings Per Share $ 2.80 $ 2.73 Weighted-Average Number of Common Shares Outstanding 2,062 2,147 Diluted Earnings Per Share $ 2.79 $ 2.72
39

Commonly Used Ratios The 2007 and 2006 balance sheets for Home Depot are presented next. We will be referring to these financial statements throughout the ratio analyses.

HOME DEPOT Comparative Balance Sheets (Condensed) Amounts in Millions

HOME DEPOT Comparative Balance Sheets (Condensed) Amounts in Millions

2007 Assets Cash and Cash Equivalents Short-Term Investments Receivables, net Merchandise Inventories Other Current Assets Total Current Assets Property and Equipment, at cost Less Accumulated Depreciation Net Property and Equipment Other Assets Total Assets
40

2006

2007 Liabilities Current Liabilities Noncurrent Liabilities Total Liabilities Stockholders' Equity Common Stock, $.05 par Paid-in Capital Retained Earnings Accumulated Other Comprehensive Income Total Less: Treasury Stock Total Stockholders' Equity Total Liabilities & Stockholders' Equity

2006

Home Depot

600 $ 793 14 14 3,223 2,396 12,822 11,401 1,341 665 18,000 15,269 34,358 31,530 7,753 6,629 26,605 24,901 7,658 4,235 $ 52,263 $ 44,405

$ 12,931 $ 12,706 14,302 4,790 27,233 17,496 121 7,930 33,052 310 41,413 (16,383) 25,030 $ 52,263 $ 120 7,149 28,943 409 36,621 (9,712) 26,909 44,405

Continued
41 42

Test of Profitability Return on Equity

Profitability is a primary measure of the overall success of a company.
Return on Equity = Net Income Average Stockholders Equity

Test of Profitability Return on Assets

Return on Assets Return on Assets = Net Income + Interest Expense (net of tax) Average Total Assets $5,761 + ($392 (1 - .34)) = 12.5% ($52,263 + $44,405) 2 Corporate tax rate is 34%. This ratio is generally considered the best overall measure of a companys profitability.
43 44

Test of Profitability Financial Leverage Percentage

Financial Leverage = Return on Equity Return on Assets

9.7%

22.2% 12.5%

Return on Equity =

$5,761
($25,030 + $26,909) 2

= 22.2%

This measure indicates how much income was earned for every dollar invested by the owners.

Financial leverage is the advantage or disadvantage that occurs as the result of earning a return on equity that is different from the return on assets.
45

Test of Profitability Earnings per Share (EPS)

EPS = Net Income* Average Number of Shares Outstanding for the Period

Test of Profitability Quality of Income

Quality = of Income Cash Flow from Operating Activities Net Income
$ 5,761 1,886 96 531 46 297 178 (123) (563) (172) (225) (51) $ 7,661
47

Test of Profitability Quality of Income

Quality = of Income Cash Flow from Operating Activities Net Income

Cash Flow from Operating Activities Net Income Add: Depreciation and Amortization Decrease in Receivables, net Increase in Accounts Payable Increase in Deferred Income Taxes Stock-based Compensation Expense Other Deduct: Increase in Deferred Revenue Increase in Merchandise Inventories Decrease in Income Taxes Payable Decrease in Other Current Assets Decrease in Other Long-term Liabilities Cash Flow from Operating Activities

*If there are preferred dividends, the amount is subtracted from net income.

EPS =

$5,761 (1,970 + 2124) 2

= $2.81

Quality = of Income

$7,661 $5,761

= 1.33

Average number of shares based on the number of shares at the beginning and end of the year. Earnings per share is probably the single most widely watched financial ratio.
46

A ratio higher than 1 indicates high-quality earnings.

48

Test of Profitability Profit Margin

Profit = Margin Profit = Margin Net Income Net Sales $5,761 $90,837

Test of Profitability Fixed Asset Turnover

Fixed = Asset Turnover Net Sales Revenue Average Net Fixed Assets

Tests of Liquidity Cash Ratio

Tests of liquidity focus on the relationship between current assets and current liabilities.
Cash Ratio Cash Ratio = Cash + Cash Equivalents Current Liabilities $600 $12,931

= 6.3%

Fixed $90,837 = = 3.53 Asset ($26,605 + $24,901) 2 Turnover

0.05 to 1

This ratio tells us the percentage of each sales dollar that is income.
49

This ratio measures a companys ability to generate sales given an investment in fixed assets.

This ratio measures the adequacy of available cash.

50 51

Tests of Liquidity Current Ratio

Current Ratio Current Ratio Current Assets Current Liabilities $18,000 $12,931 = 1.39 to 1

Tests of Liquidity Quick Ratio (Acid Test)

Quick Ratio Quick Ratio = Quick Assets Current Liabilities $3,837 $9,554 =
$

Tests of Liquidity Receivable Turnover

Receivable Turnover Receivable Turnover Net Credit Sales Average Net Receivables $90,837 = 32.3 Times ($3,223 + $2,396) 2

0.40 to 1
600 3,223 14 $ 3,837

This ratio measures the ability of the company to pay current debts as they become due.
52

Cash & Cash Equivalents Receivables, net Short-term Investments Quick Assets

This ratio is like the current ratio but measures the companys immediate ability to pay debts.
53

This ratio measures how quickly a company collects its accounts receivable.

54

Tests of Liquidity Average Age of Receivables

Average Age of Receivables Days in Year Receivable Turnover

Tests of Liquidity Inventory Turnover

Inventory Turnover

Tests of Liquidity Average Days Supply in Inventory

Average Days Supply in Inventory Average Days Supply in Inventory Days in Year Inventory Turnover 365 5.0

Cost of Goods Sold Average Inventory

Average Age of Receivables

365 32.3

= 11.3 Days

Inventory Turnover

$61,054 = 5.0 Times ($12,822 + $11,401) 2

73 Days

This ratio measures the average number of days it takes to collect receivables.

This ratio measures how quickly the company sells its inventory.

This ratio measures the average number of days it takes to sell the inventory.
56 57

55

Tests of Liquidity Accounts Payable Turnover

Accounts Payable Turnover Accounts Payable Turnover

Tests of Liquidity Average Age of Payables

Average Age of Payables Days in Year Accounts Payable Turnover 365 9.1

Tests of Solvency Times Interest Earned

Tests of solvency measure a companys ability to meet its long-term obligations.
Times Interest Earned Times Interest Earned Net Interest Income Tax + + Income Expense Expense Interest Expense

Cost of Goods Sold Average Accounts Payable

$61,054 ($7,356 + $6,032) 2

= 9.1 Times

Average Age of Payables

40.1 Days $5,761 + $392 + $3,547 $392

This ratio measures how quickly the company pays its accounts payable.

= 24.7 Times

This ratio measures the average number of days it takes to pay its suppliers.

This ratio indicates a margin of protection for creditors.

58 59 60

Tests of Solvency Cash Coverage

Cash = Coverage Cash Flow from Operating Activities Before Interest and Taxes Paid Interest Paid
Cash Flow from Operating Activities Net Income Add: Depreciation and Amortization Decrease in Receivables, net Increase in Accounts Payable Increase in Deferred Income Taxes Stock-based Compensation Expense Other Deduct: Increase in Deferred Revenue Increase in Merchandise Inventories Decrease in Income Taxes Payable Decrease in Other Current Assets Decrease in Other Long-term Liabilities Cash Flow from Operating Activities $ 5,761 1,886 96 531 46 297 178 (123) (563) (172) (225) (51) $ 7,661
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Tests of Solvency Cash Coverage

Cash = Coverage Cash = Coverage Cash Flow from Operating Activities Before Interest and Taxes Paid Interest Paid $7,661 + $270 + $3,963 $270
Cash interest paid Income tax paid $ 270 3,963

Tests of Solvency Debt-to-Equity Ratio

Debt-to-Equity Ratio Debt-to-Equity Ratio Total Liabilities Stockholders Equity $27,233 $25,030

44.0

1.09

From Statement of Cash Flows

This ratio compares the cash generated with the cash obligations of the period.
62

This ratio measures the amount of liabilities that exists for each $1 invested by the owners.
63

Market Tests Price/Earnings (P/E) Ratio

Market tests relate the current market price of a share of stock to an indicator of the return that might accrue to the investor. P/E Ratio = Current Market Price Per Share Earnings Per Share $34 $2.80 A recent price for Home Depot stock was $34 per share.

Market Tests Dividend Yield Ratio

Dividend Yield Dividend Yield = Dividends Per Share Market Price Per Share $0.675 $34

Interpreting Ratios Ratios may be interpreted by comparison with ratios of other companies or with industry average ratios. Ratios may vary because of the companys industry characteristics, nature of operations, size, and accounting policies.

2%

P/E Ratio

12.1

Home Depot paid dividends of $.675 per share when the market price was $34 per share. This ratio is often used to compare the dividend-paying performance of different investment alternatives.
64 65

This ratio measures the relationship between the current market price of the stock and its earnings per share.

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Other Financial Information

In addition to financial ratios, special factors might affect company analysis: Rapid growth. Uneconomical expansion. Subjective factors.

A securities market in which prices fully reflect available information is called an efficient market.
In an efficient market, a companys stock reacts quickly when new, relevant information is released about the company.
67