Lecture 4 and 5: Recap

and Introduction to
Accounting Analysis
BITS Pilani By Gaurav Nagpal
Pilani|Dubai|Goa|Hyderabad

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Concepts covered till now

 Lemons Problem
 Business Analysis, Accounting Analysis, Prospective
Analysis, Financial Analysis
 Michael Porter Forces, Value Net Model
 Competitive Strategies
 Corporate strategies: Directional, Portfolio, Parenting

 Integration: Forward, Backward, Full, Quasi, Taper

 Licensing vs Franchising
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 BITS Pilani
Pilani|Dubai|Goa|Hyderabad

Overview of financial statements and

ratios: Recap
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Financial Statements

Balance Sheet: a financial statement that reports a company's

assets, liabilities and shareholders' equity at a specific point in
time, and provides a basis for computing rates of return and
evaluating its capital structure.

Income Statement: A summary of a company's revenues

(sales) and expenses, periodically for its fiscal year. 

Cashflow Statement shows how changes in balance sheet

accounts and income affect cash and cash equivalents, and
breaks the analysis down to operating, investing, and financing
activities.
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BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

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BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Accounting vs Finance

The difference between finance and accounting is

that accounting focuses on the day-to-day flow of money
in and out of a company or institution, whereas finance is
a broader term for the management of assets and
liabilities and the planning of future growth.

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Liquidity Analysis

Current Ratio Formula = Current Assets / Current Liability

Acid Test Formula or Quick Ratio = (Current Assets

-Inventory)/(Current Liability)
= Quick Assets / Current Liabilities

Cash Ratio Formula = (Cash + Marketable Securities) /

Current Liability

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Productivity Analysis
Inventory Turnover Ratio Formula = Cost of Goods Sold / Average Inventory

Receivable Turnover Ratio Formula = Net Credit Sales / Average Accounts

Receivable

Capital Turnover Ratio Formula = Net Sales (Cost of Goods Sold) / Capital
Employed

Asset Turnover Ratio Formula = Turnover / Net Tangible Assets

Net Working Capital Turnover Ratio Formula = Net Sales / Net Working Capital

Cash Conversion Cycle Formula = Receivable Days + Inventory Days –

Payable Days

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Profitability Analysis

Earning Margin formula = Net Income / Turnover * 100

Return on Investment formula = Profit Before Interest

and Tax / Total Capital Employed

Return on Equity Formula = Profit After Taxation –

Preference Dividends / Ordinary Shareholder’s Fund
* 100

Earnings Per Share Formula = (Earnings After Taxation

– Preference Dividends) / Number of Ordinary Shares
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Business Risk Analysis

Operating Leverage Formula = % change in EBIT / %

change in Sales

Financial Leverage formula = % change in Net Income /

% change in EBIT

Total Leverage Formula = % change in Net Profit / %

change in Sales

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Financial Risk Analysis

Debt Equity Formula = Long Term Debts /

Shareholder’s Fund

Interest Coverage Formula = EBITDA / Interest Expense

Debt Service Coverage Formula = Operating Income /

Debt Service

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Stability Ratios

Fixed Asset Ratio Formula = Fixed Assets / Capital

Employed

Ratio to Current Assets to Fixed Assets = Current

Assets / Fixed Assets

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BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

 BITS Pilani
Pilani|Dubai|Goa|Hyderabad

Accounting Analysis

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 Key Concepts

The Importance of Accounting Analysis

Understanding accounting allows the business analyst to effectively use the financial
information disclosed by companies.

Doing accounting analysis requires:

Identifying places where there is accounting flexibility
Evaluating effectiveness of firm’s accounting policies and estimates
Adjusting a firm’s accounting numbers using cash-flow and footnote information to undo
the distortions

Key Concepts
Various factors influence the quality of accounting-based financial reports.
Managers have some discretion in accounting choices used in financial reporting.
Incentives for the management of financial reporting items must be considered by the
analyst. 16

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 Key Concepts

Accrual Accounting

Revenues are economic resources earned during a period. Expenses are economic
resources used up in a time period.
Revenue Recognition---------Realization Principle
Expense Recognition--------- Conservatism and Matching Principles
Profit= Revenue - Expenses

Assets are economic resources owned by a firm that are likely to produce future
economic benefits and measurable with a reasonable degree of certainty
Liabilities are economic obligations of a firm arising from benefits received in the past that
are required to be met with a reasonable degree of certainty and whose timing is
reasonably well-defined.
Assets= Liability + Equity
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 Key Concepts

Delegation of Reporting to Management

– Preparation of financial statements requires complex
judgements
– Corporate managers entrusted the primary task of making these
judgements
– Accounting discretion allows them to reflect inside information in
the financial statements
– Managers have incentive to use their accounting discretion to
distort reported profits by making biased assumptions
– This management of earnings makes the financial statements
less valuable to external users
– Accounting rules, audit mechanisms, legal system
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Fair Value Accounting

Which assets to be recorded at fair values and which ones at historical cost?
– Marketable securities are required to be valued at fair values

How to record unrealized gains and losses from using fair values?
– If marketable securities are not held for hedging purposes, unrealized gains and
losses to be included in net income

How to measure fair values?

– Reporting at fair value requires subjectivity, depending on the liquidity and
transparency of asset market
– Level one, Level two and Level three securities

Lessons from Financial Crisis of 2008 on Mortgage-backed securities (Subprime

mortgage-backed securities, comprised entirely from pools of loans made 19
to subprime borrowers, were riskier, but they also offered higher dividends)
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
 US GAAP/ IFRS CONVERGENCE

 Local accounting standards had little regard for cross-border consistency

 Economic integration and improved capital flows post World War- II
 Demand for comparability of financial information
 In 2007, SEC eliminated the requirement to reconcile the books with US
GAAP
 By 2011, all major economies had established timelines and programs to
converge with IFRS

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Factors Influencing Accounting Quality

High quality accounting data are free of bias and noise.

Three potential sources of noise and bias in accounting data:

1. Noise/bias from accounting rules One-size-fits-all problem
2. Forecast errors
3. Managers accounting choices

Role of external auditors

Role of legal liabilities

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 Potential sources of noise and bias

Reported accounting number = True number + noise/bias from

accounting rules + noise/bias from forecast error + noise/bias from
managers accounting choice

True number is what would be reported if accounting rules were

tailored to conform to the unique circumstances of the firm AND
management had perfect foresight of the future AND management
reported in an unbiased manner without consideration of the
resulting economic consequences.

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Potential sources of noise and bias

One-Size-Fits-All Problem
Accounting standards often specify uniform accounting for all firms (one size fits all). The fit between accounting
standards and the nature of the firms transactions may introduce some distortion in the reported financial statements.
Example: required expensing of R&D expenditures.

Forecast Errors
Accrual accounting requires that management make a host of forward-looking estimates. These estimates are inevitably
inaccurate because management doesn’t have perfect foresight of the future. Example: estimate of future bad-debts

Managers Accounting Choices

Managers have a number of incentives to choose accounting disclosures that are biased: Debt covenants,
Compensation contracts, Contests for corporate control,

Tax considerations, Regulatory considerations,

Capital market and stakeholder considerations, Competitive considerations

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Steps in Accounting Analysis

Step 1: Identify Principal Accounting Policies

Step 2: Assess Accounting Flexibility
Step 3: Evaluate Accounting Strategy
Step 4: Evaluate the Quality of Disclosure
Step 5: Identify Potential Red Flags
Step 6: Undo Accounting Distortions

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BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Step 1: Identify Principal
Accounting Policies
What are the key business success factors?

What accounting policies are used to measure the effect of

these success factors?

Example 1: credit risk is a big success factor in banking, and the

loan loss reserve (allowance for doubtful accounts) is the
account that reports on this success factor.

Example 2: warranty claims is a big success factor in

manufacturing and the warranty reserve is the account that
reports on this success factor.
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Step 2: Assess Accounting
Flexibility
Accounting flexibility can be a strength or a weakness, depending
upon how management uses that flexibility.

Example 1: R&D is a big success factor in biotechnology industry,

but GAAP imposes one-size-fits-all accounting on this factor (all
non-software R&D is expensed). No flexibility.

Example 2: Similar activity in software development industry

(software R&D), but GAAP allows firms latitude in deciding when
to start capitalizing software development costs. Managers can
use this flexibility in an unbiased manner or to opportunistically
achieve some desired financial reporting objective (e.g., make the
numbers).
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Step 3: Evaluate Accounting
Strategy
Flexibility in accounting choices allows managers to strategically
communicate economic information or hide true performance.

Issues to consider include:

– Norms for accounting policies with industry peers
• In case it is different, is it because of different strategy by the firm?
– Incentives for managers to manage earnings
• Is the firm close to violating a bond covenant?
• Does management own significant stock?
– Changes in policies and estimates and the rationale for doing so
– Whether transactions are structured to achieve certain accounting
objectives

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Step 4: Evaluate the Quality of
Disclosure
Managers have considerable discretion in disclosing certain
accounting information

Issues to consider include:

– Does the firm provide adequate disclosures to assess the business strategy and
its economic consequence?
– Adequacy of footnotes to the financial statements
– Whether MD&A sufficiently explains and is consistent with current performance
– Whether GAAP restricts the appropriate measurement of key measures of
success
– Adequacy of segment disclosure
– How forthcoming is the management w.r.t. bad news?
– How good is the firm’s investor relations program?

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Step 5: Identify Potential Red
Flags
Some issues that warrant gathering more information
include:
– Unexplained changes in accounting especially when performance is poor
– Unexplained transactions that boost profits
– Unusual increases in inventory or A/R in relation to sales
– Increases in the gap between net income and cash flows from operating
activities
– Increases in the gap between reported income and its tax income
– Unexpected large asset write-offs Large fourth-quarter adjustments
– Qualified audit opinions or auditor changes
– Related-party transactions
– Large fourth quarter adjustments
– Unexpected large asset write-offs

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Step 6: Undo Accounting
Distortions
If numbers appear distorted, recast the numbers to eliminate
the distortion.

Use cashflow statement to reconcile the firm’s performance

based on accrual accounting and cash accounting. For eg:
aggressive capitalization can be uncovered by cashflow
statement

Footnotes capture changes in accounting policies, accrual

estimates and the differences between the firm’s accounting
policies for shareholder reporting and tax reporting

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Accounting Analysis Pitfalls

Avoid assuming that conservative accounting = good

accounting. Conservative accounting may also be
misleading. For example:
– Accounting for intangible assets
– Income Smoothing
– Discounting by investors over a period of time

Avoid assuming that unusual accounting practices = earnings

management. Not all unusual accounting practices are
questionable. It might be justified if the firm’s business is
unusual. Also, there can be changed business
circumstances like new product launch, change in sales
strategy or change in customer focus
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Concluding Comments

Accounting analysis is an essential step in analyzing

corporate financial reports.

A methodology consisting of six steps in analyzing

accounting data is presented in this chapter.

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