MBA_620_Project 1_Analyzing Financial Statements

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Project 1: Analyzing Financial Statements MBA620 Project 1 Introduction In project 1, assume you are a free-lance consultant for Maryland Creative Solutions, a fictional company. The assignment will require you to examine the firm's declining financial health and find ways to reverse this trend. During the course of this project, analyze the firm’s balance sheet, income statements, and cash flows to form strategies for a successful future for the firm. Regularly review your syllabus and class announcements to submit your project on time and meet the grading criteria. If at any point during your project you need clarity, reach out to your course instructor. We want you to do well and utilize all your available resources. Best of luck on project 1. Scenario You have been chosen to join a team of consultants at Maryland Creative Solutions (MCS). Congratulations on your hiring! The group you will be working with has a history of helping transform troubled companies into profitable enterprises with a promising future. Your team is assigned to a client firm, Largo Global Inc. (LGI). LGI's operational efficiency has declined over the past three years. The company's board of directors has hired MCS to uncover the underlying issues and make recommendations to turn things around. What's New 2: The Financial System and the Level of Interest Rates 3: Financial Statements, Cash Flows, and Taxes 4: Analyzing Financial Statements Financial Statements, Cash Flows, and Taxes Learning Objectives Discuss generally accepted accounting principles (GAAP) and their importance to the economy. Explain the balance sheet identity and why a balance sheet must balance. Describe how market-value balance sheets differ from book-value balance sheets. Identify the basic equation for the income statement and the information it provides. Understand the calculation of cash flows from operating, investing, and financing activities required in the statement of cash flows. Explain how the four major financial statements discussed in this chapter are related. Identify the cash flow to a firm's investors using its financial statements. Discuss the difference between average and marginal tax rates. 1

On July 20, 2010, after the close of U.S. financial markets, Apple Inc. announced that its corporate earnings for the quarter ended June 26, 2010 were $3.253 billion, or $3.51 per common share outstanding. This was considerably greater than the $3.08 per share that financial analysts covering Apple were expecting. As a result, Apple's stock price jumped at the news, trading from a low of $240.65 per share on July 20 to a high of $265.22 the next morning. Apple attributed its strong earnings during the period to higher than expected sales of its products, including the newly released iPhone 4 and iPad devices. This example illustrates the relation between the information contained in a firm's accounting statements and its stock performance. Public corporations in the U.S. communicate their financial performance to their investors through their financial statements, leading to Wall Street's virtual obsession with accounting earnings. Analysts estimate how much firms should earn in a particular reporting period, and firms that fail to meet these estimates can be punished by falling stock prices. If a firm consistently fails to meet these estimates, its CEO can be out of a job. Pressure to meet analyst expectations has occasionally led managers to misstate accounting results in efforts to mislead analysts and investors. In the wake of several especially large-scale accounting frauds, involving firms such as Enron and WorldCom, Congress and federal regulators tightened accounting standards and oversight of the accounting profession in the early 2000s. Passage of the SarbanesOxley Act, discussed in Chapter 1 , is an example of these steps. Clearly, the correct preparation of financial statements is crucial for investors. In this chapter and the next, we focus on the preparation, interpretation, and limitations of financial statements. The concepts that we discuss in these chapters provide an important foundation for the material discussed in the rest of this book. CHAPTER PREVIEW In Chapter 1 we noted that all businesses have owners and stakeholders—managers, creditors, suppliers, and the government, among others—who have claims on the firms' cash flows. The owners and stakeholders in a firm need to monitor the firm's progress and evaluate its performance. Financial statements enable them to do this. The accounting system is the framework that gathers information about the firm's business activities and translates the information into objective numerical financial reports. Most firms prepare financial statements on a regular basis and have independent auditors certify that the financial statements have been prepared in accordance with generally accepted accounting principles and contain no material misstatements. The audit increases the confidence of the owners and stakeholders that the financial statements prepared by management present a “fair and accurate” picture of the firm's financial condition at a particular point in time. In fact, it is difficult to get any type of legitimate business loan without audited financial statements. This chapter reviews the basic structure of a firm's financial statements and explains how the various statements fit together. It also explains the relation between accounting earnings and cash flow to investors. We examine the preparation of the balance sheet, the income statement, the statement of retained earnings, and the statement of cash flows. As you read through this part of the chapter, pay particular attention to the differences between (1) book value and market value and (2) accounting 2

income and cash flow to investors. Understanding the differences between these concepts is necessary to avoid serious analytical and decision-making errors. The last part of the chapter discusses essential features of the federal tax code for corporations. In finance we make most decisions on an after-tax basis, so understanding the tax code is very important. 3.1 FINANCIAL STATEMENTS AND ACCOUNTING PRINCIPLES  Before we can meaningfully interpret and analyze financial statements, we need to understand some accounting principles that guide their preparation. Thus, we begin the chapter with a discussion of generally accepted accounting principles, which guide firms in the preparation of financial statements. First, however, we briefly describe the annual report. The Annual Report The annual report is the most important report that firms issue to their stockholders and make available to the general public. Historically, annual reports were dull, black-and-white publications that presented audited financial statements for firms. Today some annual reports, especially those of large public companies, are slick, picture-laden, glossy “magazines” in full color with orchestrated media messages. Annual reports typically are divided into three distinct sections. First are the financial tables, which contain financial information about the firm and its operations for the year, and an accompanying summary explaining the firm's performance over the past year. For example, the summary might explain that sales and profits were down because of declining consumer demand in the wake of the 2008 financial crisis. Often, there is a letter from the chairman or CEO that provides some insights into the reasons for the firm's performance, a discussion of new developments, and a high-level view of the firm's strategy and future direction. It is important to note that the financial tables are historical records reflecting past performance of the firm and do not necessarily indicate what the firm will do in the future. To find annual reports and other corporate filings for U.S. corporations, visit the EDGAR search page maintained by the U.S. Securities and Exchange Commission (SEC) at http://www.sec.gov/edgar.shtml . The second part of the report is often a corporate public relations piece discussing the firm's product lines, its services to its customers, and its contributions to the communities in which it operates. The third part of the annual report presents the audited financial statements: the balance sheet, the income statement, the statement of retained earnings, and the statement of cash flows. Overall, the annual report provides a good overview of the firm's operating and financial performance and states why, in management's judgment, things turned out the way they did. Generally Accepted Accounting Principles 3

In the United States, accounting statements are prepared in accordance with generally accepted accounting principles (GAAP) , a set of widely agreed-upon rules and procedures that define how companies are to maintain financial records and prepare financial reports. These principles are important because without them, financial statements would be less standardized. Accounting standards such as GAAP make it easier for analysts and management to make meaningful comparisons of a company's performance against that of other companies. generally accepted accounting principles (GAAP) a set of rules that defines how companies are to prepare financial statements You can find more information about FASB at http://www.fasb.org . Accounting principles and reporting practices for U.S. firms are promulgated by the Financial Accounting Standards Board (FASB), a not-for-profit body that operates in the public interest. FASB derives its authority from the Securities and Exchange Commission (SEC). GAAP and reporting practices are published in the form of FASB statements, and certified public accountants are required to follow these statements in their auditing and accounting practices. Fundamental Accounting Principles To better understand financial statements, it is helpful to look at some fundamental accounting principles embodied in GAAP. These principles determine the manner of recording, measuring, and reporting company transactions. As you will see, the practical application of these principles requires professional judgment, which can result in considerable differences in financial statements. The Assumption of Arm's-Length Transactions Accounting is based on the recording of economic transactions that can be quantified in dollar amounts. It assumes that the parties to a transaction are economically rational and are free to act independently of each other. To illustrate, let's assume that you are preparing a personal balance sheet for a bank loan on which you must list all your assets. You are including your BMW 325 as an asset. You bought the car a few months ago from your father for $3,000 when the retail price of the car was $15,000. You got a good deal. However, the price you paid, which would be the number recorded on your balance sheet, was not the market price. Since you did not purchase the BMW in an arm's- length transaction, your balance sheet would not reflect the true value of the asset. The Cost Principle Generally, the value of an asset that is recorded on a company's “books” reflects its historical cost. The historical cost is assumed to represent the fair market value of the item at the time it was acquired and is recorded as the book value . Over time, it is unlikely that an asset's book value will be equal to its market value because market values tend to change over time. The major exception to this principle is 4

marketable securities, such as the stock of another company, which are recorded at their current market value. book value the net value of an asset or liability recorded on the financial statements—normally reflects historical cost It is important to note that accounting statements are records of past performance; they are based on historical costs, not on current market prices or values. Accounting statements translate the business's past performance into dollars and cents, which helps management and investors better understand how the business has performed in the past. The Realization Principle Under the realization principle, revenue is recognized only when the sale is virtually completed and the exchange value for the goods or services can be reliably determined. As a practical matter, this means that most revenues are recognized at the time of sale whether or not cash is actually received. At this time, if a firm sells to its customers on credit, an account receivable is recorded. The firm receives the cash only when the customer actually makes the payment. Although the realization principle concept seems straightforward, there can be considerable ambiguity in its interpretation. For example, should revenues be recognized when goods are ordered, when they are shipped, or when payment is received from the customer? The Matching Principle Accounting tries to match revenue on the income statement with the expenses incurred to generate the revenue. In practice, this principle means that revenue is first recognized (according to the realization principle) and then is matched with the costs associated with producing the revenue. For example, if we manufacture a product and sell it on credit (accounts receivable), the revenue is recognized at the time of sale. The expenses associated with manufacturing the product—expenditures for raw materials, labor, equipment, and facilities—will be recognized at the same time. Notice that the actual cash outflows for expenses may not occur at the same time the expenses are recognized. It should be clear that the figures on the income statement more than likely will not correspond to the actual cash inflows and outflows during the period. The Going Concern Assumption The going concern assumption is the assumption that a business will remain in operation for the foreseeable future. This assumption underlies much of what is done in accounting. For example, suppose that Kmart has $4.6 billion of inventory on its balance sheet, representing what the firm actually paid for the inventory in arm's-length transactions. If we assume that Kmart is a going concern, the balance sheet figure is a reasonable number because in the normal course of business we expect Kmart to be able to sell the goods for its cost plus some reasonable markup. 5

However, suppose Kmart declares bankruptcy and is forced by its creditors to liquidate its assets. If this happens, Kmart is no longer a going concern. What will the inventory be worth then? We cannot be certain, but 50 cents on the dollar might be a high figure. The going concern assumption allows the accountant to record assets at cost rather than their value in a liquidation sale, which is usually much less. You can see that the fundamental accounting principles just discussed leave considerable professional discretion to accountants in the preparation of financial statements. As a result, financial statements can and do differ because of honest differences in professional judgments. Of course, there are limits on honest professional differences, and at some point, an accountant's choices can cross a line and result in “cooking the books.” International GAAP Accounting is often called the language of business. Just as there are different dialects within languages, there are different international “dialects” in accounting. For example, the set of generally accepted accounting principles in the United Kingdom is called U.K. GAAP. Given the variation in accounting standards, accountants must adjust financial statements so that meaningful comparisons can be made between firms that utilize different sets of accounting principles. The cost of making these adjustments represents an economic inefficiency that adds to the overall cost of international business transactions. By the end of the 1990s, the two predominant international reporting standards were the U.S. GAAP and the International Financial Reporting Standards, also known as IFRS. Both FASB and the International Accounting Standards Board (IASB) have been working toward a convergence of these rules in an effort to provide a truly global accounting standard. Consistent with these efforts, the U.S. SEC is reviewing proposals for U.S. corporations to adopt IFRS for financial reporting by as early as 2015. Today most international jurisdictions already utilize IFRS or some close variant of those standards. You can read more about IFRS at http://www.ifrs.com . Illustrative Company: Diaz Manufacturing In the next part of the chapter, we turn to a discussion of four fundamental financial statements: the balance sheet, the income statement, the statement of retained earnings, and the statement of cash flows. To more clearly illustrate these financial statements, we use data from Diaz Manufacturing Company, a fictional Houston-based provider of petroleum and industrial equipment and services worldwide. 1 Diaz Manufacturing was formed in 2003 as a spin-off of several divisions of Cooper Industries. The firm specializes in the design and manufacturing of systems used in petroleum production and has two divisions: (1) Diaz Energy Services, which sells oil and gas compression equipment, and (2) Diaz Manufacturing, which makes valves and related parts for energy production. In 2011 Diaz Manufacturing's sales increased to $1.56 billion, an increase of 12.8 percent from the previous year. A letter to stockholders in the 2011 annual report stated that management did not expect earnings in 2012 to exceed the 2011 earnings. The reason for caution was that Diaz's earnings are very 6

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