ROCE
What item do you look at to answer the question 'is the amount of debt in the capital structure increasing or decreasing'?
Capital structure leverage indicator
What are the two ways common shareholders will benefit from ownership?
dividend income
appreciation in value of the company's stock
What is the balance sheet and why is it the most important financial statement?
rolling history of a company's financial condition
single statement that carries over from one year to the next
What financial statements does restating from LIFO to FIFO have the greatest impact on? (hint: balance sheet and income statement)
Balance sheet -> MAJOR impact
Income statement -> some impact
When valuing inventory on the balance sheet, what is cost?
determined by applying LIFO, FIFO, or Averaging Costing
one method for determining the cost of ending inventory and used on a consistent basis
(in terms of lower of cost or market, it is typically cost)
What item do you look at to answer the question 'is the amount of earnings available to common shareholders increasing or decreasing'?
Common earnings leverage
Definition of financial leverage
capital structure of the company that includes debt and/or preferred stock
What are the financial resources of a business entity and how do companies finance their acquisition?
creditors (liabilities)
owners contributions (contributed capital)
prior years earnings (retained earnings)
How can you tell if LIFO liquidation is occurring?
Look at LIFO ending inventory
- if the number is increasing, it means they purchased more than they sold and LIFO liquidation did not occur
- if the number decreases at all, it means you sold more than you purchased, your earnings will be artificially boosted (LIFO liquidation occurred)
When valuing inventory on the balance sheet, what is market?
how much would it cost to replace our existing inventory
another way of saying the fair market value of the balance sheet date
replacement cost
What party benefits from positive financial leverage?
common shareholders
- means there is more income going to benefit the common shareholders
Definition of positive financial leverage
rate of return on assets exceeds the cost of capital provided by creditors and/or preferred shareholders
Two concerns that the financial analyst "may have" about the valuation of specific individual assets on the balance sheet
Inventory
- shown at the lower cost or market (typically cost)
- If a company used LIFO to determine cost, number on the balance sheet for inventory is probably undervalued
PP&E
- shown on the balance sheet at historical cost (very reliable, but not relevant)
Use of LIFO in periods of rising prices - normal expectations (LIFO)
- cost of goods sold is greater under LIFO
- net income is lower under LIFO
What is ending inventory made up of under FIFO?
Ending inventory is made up of the merchandise most recently acquired
cost of goods sold is made up of the oldest merchandise included in the company's inventory records
How does negative financial leverage affect the common shareholders?
rate of return on assets is less than the cost of capital provided by creditors and/or preferred shareholders
Two general questions related to the general valuation of assets on the balance sheet
Are assets being shown on the balance sheet at fair market value?
If not, are assets being shown on the balance sheet at a decent surrogate of fair market value?
Use of FIFO in periods of rising prices - normal expectations (FIFO)
- cost of goods sold is less under FIFO
- net income is more under FIFO
What is ending inventory made up of under LIFO?
Ending inventory is made up of the oldest merchandise included in the company's inventory records
cost of goods sold is made up of the merchandise most recently acquired
What four questions do you need to answer for an ROCE interpretation problem?
Is the company using financial leverage positively or negatively?
Is the amount of debt in the capital structure increasing or decreasing?
Is the amount of earnings available to the common shareholders increasing or decreasing?
Please explain the observed behavior of ROCE.
Describe a quick and easy way to determine if financial leverage is being used positively or negatively
If ROCE > ROA, financial leverage is being used positively.
If ROCE < ROA, financial leverage is being used negatively.
What are the 3 largest assets on the balance sheet made up of?
Accounts Receivable, Inventory, and PP&E
2 of the 3 are problematic to the financial analyst (inventory and PP&E)
If a company uses LIFO, the financial analyst has two concerns:
How much is the inventory undervalued on the balance sheet?
Did the company use LIFO liquidation to artificially boost earnings?
Does the balance sheet reflect inventory at current fair market value or at a good surrogate for fair market value?
(3 observations of a financial analyst)
if the company is using FIFO, then it is perfect (reflects current market value of ending inventory)
if the company is using average costing, then it is a decent surrogate for fair market value
if the company is using LIFO, the ending inventory would be undervalued (grossly undervalued)