Module D How External Users Assess Management’s Operating Decisions

1. Module DHow External Users Assess Management’s Operating Decisions

2. How External Users Assess Management’s Operating Decisions • Topics • Statement of cash flows operating activities section, indirect method • Operating activities and profitability ratios • Operating activities and risk ratios • Common financial statement analysis issues related to operating items

3. Statement of Cash Flows: Operating Activities, Indirect Method • Under the indirect method: • Operating activities section starts with net income and uses reconciling items to arrive at cash flow from operating activities. This SCF tells them WHAT?

4. Indirect Method Format • Net Income • Add (Deduct) • Non-cash expenses: depreciation, depletion, amortization (1) • (Non-cash revenues) e.g., investment income for securities accounted for under the equity method (1) • Losses (gains) on sale (2) • Decreases (increases) in operational current assets and deferred income tax assets(3) • Increases (decreases) in operational current liabilities and deferred income tax liabilities(3) • Net cash flows from operating activities

5. Notes: (1)Non-cash expenses and revenues affect net income, but not cash (2)Gains and losses are non-operational in nature for most companies (3)These reconciling items adjust from accrual basis effects, which are reflected in net income, to cash basis effects

6. As with all targets, financial and otherwise, management should state in advance exactly what we are shooting for … because, if we aim for nothing we are likely to hit it!

7. Operating Activities and Profitability Ratios

8. Effect on ROA • Successful operations increase sales, which should increase ROA! • Increases in receivables and inventory decrease ROA.

10. Operating Activities and Risk Ratios

13. Common Financial Statement Analysis Issues Related to Operating Items • Inventory • Bad debts expense • Deferred income taxes • Pensions and other post-employment benefits

14. Financial Statement Analysis: Inventory • Companies may use different inventory methods (e.g., LIFO, FIFO, average). • Financial analysts wanting to compare companies may “restate” financial statements and use a single method across companies. • Companies that use LIFO present information about the “LIFO Reserve” in notes to the financial statements. • The “LIFO Reserve” = the difference, if any (during inflation), between LIFO inventory and another inventory method, usually FIFO.

15. “LIFO Reserve” Example: Pharmacia Upjohn’s 1998 Annual Report • Note 1: Summary of Accounting Policies • Inventories are costed at the lower of cost or market. • Cost is determined by the LIFO method for substantially all U.S. inventories and the FIFOmethod for substantially all non-U.S. inventories.

16. Upjohn’s Note 8 (In part; amounts in millions)

17. Financial Statement Data Adjustment • The balance sheet adjustment information is shown in note (e.g., in 1998, ending inventory is changed from $1,186,000 to $1,032,000). • Income statement adjustment is the change in the “LIFO Reserve” (e.g., in 1998 from 160 to 154). • After adjustment, financial statement ratios are calculated using adjusted [pro forma] numbers.

18. Financial Statement Analysis: Bad Debts • Analysts track the following amounts over time • Ratio of bad debts expense to sales • Ratio of allowance for bad debts to accounts receivable • These ratios can raise red flags if they increase without appropriate explanation

19. Financial Statement Analysis: Deferred Income Taxes • Deferred income taxes liabilities • For companies in the introduction and growth stage, deferred income tax liabilities may be viewed as (reclassified as) equity. • For companies in the maturity or decline stage, classification as a liability is appropriate.

20. Financial Statement Analysis: Pensions and Other Post-Employment Benefits • Three adjustments are possible • Adjust from the balance sheet amount to the economic status of the plan if the economic status of the plan is a liability and a larger liability than the balance sheet liability amount (a conservative approach). A very common approach!

21. Adjust from the balance sheet amount to the economic status of the plan regardless of whether the economic status is an asset or liability.

22. Consolidate the pension plan with the company: • Treat plan obligations as liabilities and plan assets as investments on the balance sheet. • Treat service costs, interest cost, and expected return on plan assets as line items on the income statement.

23. Observation on Goals “Dreams without deadlines, tend to remain dreams.” - H. O. Wilson

24. End of Module D