© CFA Institute For candidate use only Not for distribution FINANCIAL STATEMENT ANALYSIS AND CORPORATE ISSUERS CFA® Program Curriculum 2022 • LEVEL I • VOLUME © CFA Institute For candidate use only Not for distribution © 2021, 2020, 2019, 2018, 2017, 2016, 2015, 2014, 2013, 2012, 2011, 2010, 2009, 2008, 2007, 2006 by CFA Institute All rights reserved This copyright covers material written expressly for this volume by the editor/s as well as the compilation itself It does not cover the individual selections herein that first appeared elsewhere Permission to reprint these has been obtained by CFA Institute for this edition only Further reproductions by any means, electronic or mechanical, including photocopying and recording, or by any information storage or retrieval systems, must be arranged with the individual copyright holders noted CFA®, Chartered Financial Analyst®, AIMR-PPS®, and GIPS® are just a few of the trademarks owned by CFA Institute To view a list of CFA Institute trademarks and the Guide for Use of CFA Institute Marks, please visit our website at www.cfainstitute.org This publication is designed to provide accurate and authoritative information in regard to the subject matter covered It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service If legal advice or other expert assistance is required, the services of a competent professional should be sought All trademarks, service marks, registered trademarks, and registered service marks are the property of their respective owners and are used herein for identification purposes only ISBN 978-1-950157-44-0 (paper) ISBN 978-1-950157-68-6 (ebk) 10 © CFA Institute For candidate use only Not for distribution CONTENTS How to Use the CFA Program Curriculum Background on the CBOK Organization of the Curriculum Features of the Curriculum Designing Your Personal Study Program CFA Institute Learning Ecosystem (LES) Prep Providers Feedback xi xi xii xii xiii xiv xv xvi Financial Statement Analysis Study Session Financial Statement Analysis (2) Reading 17 Understanding Income Statements Introduction Components and Format of the Income Statement Revenue Recognition General Principles Accounting Standards for Revenue Recognition Expense Recognition: General Principles General Principles Issues in Expense Recognition: Doubtful Accounts, Warranties Doubtful Accounts Warranties Issues in Expense Recognition: Depreciation and Amortization Implications for Financial Analysts: Expense Recognition Non-Recurring Items and Non-Operating Items: Discontinued Operations and Unusual or Infrequent items Discontinued Operations Unusual or Infrequent Items Non-Recurring Items: Changes in Accounting Policy Non- Operating Items Earnings Per Share and Capital Structure and Basic EPS Simple versus Complex Capital Structure Basic EPS Diluted EPS: the If-Converted Method Diluted EPS When a Company Has Convertible Preferred Stock Outstanding Diluted EPS When a Company Has Convertible Debt Outstanding Diluted EPS: the Treasury Stock Method Other Issues with Diluted EPS and Changes in EPS Changes in EPS Common-Size Analysis of the Income Statement Common-Size Analysis of the Income Statement Income Statement Ratios indicates an optional segment 6 12 13 14 18 18 22 22 22 23 27 28 28 29 30 33 34 35 36 37 38 39 40 43 44 44 45 47 ii © CFA Institute For candidate use only Not for distribution Comprehensive Income Summary Practice Problems Solutions Contents 49 52 55 60 Reading 18 Understanding Balance Sheets 63 Introduction and Components of the Balance Sheet 64 Components and Format of the Balance Sheet 64 Balance Sheet Components 65 Current and Non-Current Classification 67 Liquidity- Based Presentation 68 Current Assets: Cash and Cash Equivalents, Marketable Securities and Trade Receivables 69 Current Assets 69 Current Assets: Inventories and Other Current Assets 74 Other Current Assets 74 Current liabilities 75 Non-Current Assets: Property, Plant and Equipment and Investment Property 79 Property, Plant, and Equipment 80 Investment Property 81 Non-Current Assets: Intangible Assets 81 Identifiable Intangibles 82 Non-Current Assets: Goodwill 84 Non-Current Assets: Financial Assets 87 Non-Current Assets: Deferred Tax Assets 91 Non- Current Liabilities 91 Long-term Financial Liabilities 93 Deferred Tax Liabilities 93 Components of Equity 94 Components of Equity 94 Statement of Changes in Equity 97 Common Size Analysis of Balance Sheet 98 Common-Size Analysis of the Balance Sheet 98 Balance Sheet Ratios 106 Summary 108 Practice Problems 111 Solutions 116 Reading 19 Understanding Cash Flow Statements Introduction Classification Of Cash Flows and Non-Cash Activities Classification of Cash Flows and Non-Cash Activities indicates an optional segment 119 120 121 121 Contents Reading 20 © CFA Institute For candidate use only Not for distribution iii Cash Flow Statement: Differences Between IFRS and US GAAP Cash Flow Statement: Direct and Indirect Methods for Reporting Cash Flow from Operating Activities Cash Flow Statement: Indirect Method Under IFRS Cash Flow Statement: Direct Method Under IFRS Cash Flow Statement: Direct Method Under US GAAP Cash Flow Statement: Indirect Method Under US GAAP Linkages of Cash Flow Statement with the Income Statement and Balance Sheet Linkages of the Cash Flow Statement with the Income Statement and Balance Sheet Preparing the Cash Flow Statement: The Direct Method for Operating Activities Operating Activities: Direct Method Preparing the Cash Flow Statement: Investing Activities Preparing the Cash Flow Statement: Financing Activities Long-Term Debt and Common Stock Dividends Preparing the Cash Flow Statement: Overall Statement of Cash Flows Under the Direct Method Preparing the Cash Flow Statement: Overall Statement of Cash Flows Under the Indirect Method Conversion of Cash Flows from the Indirect to Direct Method Cash Flow Statement Analysis: Evaluation of Sources and Uses of Cash Evaluation of the Sources and Uses of Cash Cash Flow Statement Analysis: Common Size Analysis Cash Flow Statement Analysis: Free Cash Flow to Firm and Free Cash Flow to Equity Cash Flow Statement Analysis: Cash Flow Ratios Summary Practice Problems Solutions 123 Financial Analysis Techniques Introduction The Financial Analysis Process Analytical Tools and Techniques Financial Ratio Analysis The Universe of Ratios Value, Purposes, and Limitations of Ratio Analysis Sources of Ratios Common Size Balance Sheets and Income Statements Common-Size Analysis of the Balance Sheet Common-Size Analysis of the Income Statement Cross-Sectional, Trend Analysis & Relationships in Financial Statements Trend Analysis Relationships among Financial Statements The Use of Graphs and Regression Analysis Regression Analysis 175 176 177 181 183 184 186 187 188 189 189 191 192 194 195 197 indicates an optional segment 125 126 129 131 133 135 135 137 138 142 144 144 145 145 146 149 150 150 155 160 162 164 165 171 iv © CFA Institute For candidate use only Not for distribution Contents Common Ratio Categories & Interpretation and Context Interpretation and Context Activity Ratios Calculation of Activity Ratios Interpretation of Activity Ratios Liquidity Ratios Calculation of Liquidity Ratios Interpretation of Liquidity Ratios Solvency Ratios Calculation of Solvency Ratios Interpretation of Solvency Ratios Profitability Ratios Calculation of Profitability Ratios Interpretation of Profitability Ratios Integrated Financial Ratio Analysis The Overall Ratio Picture: Examples DuPont Analysis: The Decomposition of ROE Equity Analysis and Valuation Ratios Valuation Ratios Industry-Specific Financial Ratios Research on Financial Ratios in Credit and Equity Analysis Credit Analysis The Credit Rating Process Historical Research on Ratios in Credit Analysis Business and Geographic Segments Segment Reporting Requirements Segment Ratios Model Building and Forecasting Summary Practice Problems Solutions 197 198 199 199 201 205 206 207 210 211 212 215 215 216 218 219 221 226 226 229 231 232 233 234 234 235 236 238 239 241 247 Study Session Financial Statement Analysis (3) 251 Reading 21 Inventories Introduction Cost of inventories Inventory valuation methods Specific Identification First-In, First-Out (FIFO) Weighted Average Cost Last-In, First-Out (LIFO) Calculations of cost of sales, gross profit, and ending inventory Periodic versus perpetual inventory systems Comparison of inventory valuation methods The LIFO method and LIFO reserve LIFO Reserve 253 254 255 256 257 257 258 258 258 260 263 265 266 indicates an optional segment Contents © CFA Institute For candidate use only Not for distribution LIFO liquidations Inventory method changes Inventory adjustments Evaluation of inventory management: Disclosures & ratios Presentation and Disclosure Inventory Ratios Illustrations of inventory analysis: Adjusting LIFO to FIFO Illustrations of inventory analysis: Impacts of writedowns Summary Practice Problems Solutions Reading 22 v 266 274 275 282 282 283 284 288 294 297 313 Long-Lived Assets 321 Introduction & Acquisition of Property, Plant and Equipment 322 Introduction 322 Acquisition of Long-Lived Assets 323 Property, Plant, and Equipment 323 Acquisition of Intangible Assets 326 Intangible Assets Purchased in Situations Other Than Business Combinations 326 Intangible Assets Developed Internally 327 Intangible Assets Acquired in a Business Combination 328 Capitalization versus Expensing: Impact on Financial Statements and Ratios 330 Capitalisation of Interest Costs 335 Capitalisation of Interest and Internal Development Costs 338 Depreciation of Long-Lived Assets: Methods and Calculation 342 Depreciation Methods and Calculation of Depreciation Expense 343 Amortisation of Long-Lived Assets: Methods and Calculation 351 The Revaluation Model 352 Impairment of Assets 356 Impairment of Property, Plant, and Equipment 357 Impairment of Intangible Assets with a Finite Life 359 Impairment of Intangibles with Indefinite Lives 359 Impairment of Long-Lived Assets Held for Sale 359 Reversals of Impairments of Long-Lived Assets 360 Derecognition 360 Sale of Long-Lived Assets 360 Long-Lived Assets Disposed of Other Than by a Sale 361 Presentation and Disclosure Requirements 363 Using Disclosures in Analysis 370 Investment Property 374 Summary 377 Practice Problems 380 Solutions 392 indicates an optional segment vi Reading 23 Reading 24 © CFA Institute For candidate use only Not for distribution Contents Income Taxes Introduction Differences Between Accounting Profit and Taxable Income Current and Deferred Tax Assets and Liabilities Deferred Tax Assets and Liabilities Determining the Tax Base of Assets and Liabilities Determining the Tax Base of an Asset Determining the Tax Base of a Liability Changes in Income Tax Rates Temporary and Permanent Differences Between Taxable and Accounting Profit Taxable Temporary Differences Deductible Temporary Differences Examples of Taxable and Deductible Temporary Differences Exceptions to the Usual Rules for Temporary Differences Business Combinations and Deferred Taxes Investments in Subsidiaries, Branches, Associates and Interests in Joint Ventures Unused Tax Losses and Tax Credits Recognition and Measurement of Current and Deferred Tax Recognition of a Valuation Allowance Recognition of Current and Deferred Tax Charged Directly to Equity Presentation and Disclosure Comparison of IFRS and US GAAP Summary Practice Problems Solutions 397 398 398 399 400 403 404 405 407 408 409 410 410 412 413 413 413 414 415 415 418 424 426 428 433 Non-Current (Long-Term) Liabilities 435 Introduction 436 Bonds Payable & Accounting for Bond Issuance 436 Accounting for Bond Issuance 436 Accounting for Bond Amortisation, Interest Expense, and Interest Payments 440 Accounting for Bonds at Fair Value 445 Derecognition of Debt 448 Debt Covenants 451 Presentation and Disclosure of Long-Term Debt 453 Leases 456 Examples of Leases 457 Advantages of Leasing 457 Lease Classification as Finance or Operating 457 Financial Reporting of Leases 459 Lessee Accounting—IFRS 459 Lessee Accounting—US GAAP 461 Lessor Accounting 463 Introduction to Pensions and Other Post-Employment Benefits 465 Evaluating Solvency: Leverage and Coverage Ratios 469 indicates an optional segment Contents © CFA Institute For candidate use only Not for distribution vii Summary Practice Problems Solutions 472 475 480 Study Session Financial Statement Analysis (4) 487 Reading 25 Financial Reporting Quality Introduction & Conceptual Overview Conceptual Overview GAAP, Decision Useful Financial Reporting GAAP, Decision-Useful, but Sustainable? Biased Accounting Choices Within GAAP, but “Earnings Management” Departures from GAAP Differentiate between Conservative and Aggressive Accounting Conservatism in Accounting Standards Bias in the Application of Accounting Standards Context for Assessing Financial Reporting Quality: Motivations and Conditions Conducive to Issuing Low Quality Financial Reports Motivations Conditions Conducive to Issuing Low-Quality Financial Reports Mechanisms That Discipline Financial Reporting Quality Market Regulatory Authorities Auditors Private Contracting Detection of Financial Reporting Quality Issues: Introduction & Presentation Choices Presentation Choices Accounting Choices and Estimates and How Accounting Choices and Estimates Affect Earnings and Balance Sheets How Accounting Choices and Estimates Affect Earnings and Balance Sheets How Choices that Affect the Cash Flow Statement Choices that Affect Financial Reporting Warning Signs 1) Pay attention to revenue 2) Pay attention to signals from inventories. 3) Pay attention to capitalization policies and deferred costs. 4) Pay attention to the relationship of cash flow and net income. 5) Other potential warnings signs. Summary Practice Problems Solutions 489 490 491 492 493 494 503 503 505 506 507 Applications of Financial Statement Analysis Introduction & Evaluating Past Financial Performance Application: Evaluating Past Financial Performance 561 562 563 Reading 26 indicates an optional segment 508 509 509 510 510 512 516 518 519 525 526 537 540 544 544 545 546 546 546 549 552 556 viii © CFA Institute For candidate use only Not for distribution Application: Projecting Future Financial Performance as an Input to Market Based Valuation Projecting Performance: An Input to Market-Based Valuation Projecting Multiple-Period Performance Application: Assessing Credit Risk Screening for Potential Equity Investments Framework for Analyst Adjustments & Adjustments to Investments & Adjustments to Inventory A Framework for Analyst Adjustments Analyst Adjustments Related to Investments Analyst Adjustments Related to Inventory Adjustments Related to Property, Plant, and Equipment Adjustments Related to Goodwill Summary Practice Problems Solutions Contents 566 567 572 576 578 581 582 582 582 586 588 590 592 594 Corporate Issuers Study Session Corporate Issuers (1) Reading 27 Introduction to Corporate Governance and Other ESG Considerations 599 Introduction and Overview of Corporate Governance 600 Corporate Governance Overview 600 Stakeholder Groups 602 Stakeholder Groups 602 Principal–Agent and Other Relationships in Corporate Governance 605 Shareholder and Manager/Director Relationships 606 Controlling and Minority Shareholder Relationships 606 Manager and Board Relationships 607 Shareholder versus Creditor Interests 607 Other Stakeholder Conflicts 608 Overview and Mechanisms of Stakeholder Management 608 Overview of Stakeholder Management 609 Mechanisms of Stakeholder Management 609 Mechanisms to Mitigate Associated Stakeholder Risks 613 Employee Laws and Contracts 614 Contractual Agreements with Customers and Suppliers 615 Laws and Regulations 615 Company Boards and Committees 615 Composition of the Board of Directors 616 Functions and Responsibilities of the Board 617 Board of Directors Committees 617 Relevant Factors in Analyzing Corporate Governance and Stakeholder Management 620 Market Factors 620 Non- Market Factors 622 Risks and Benefits of Corporate Governance and Stakeholder Management 623 Risks of Poor Governance and Stakeholder Management 623 indicates an optional segment 597 © CFA Institute For candidate use only Not for distribution Managing and Measuring Liquidity liquidity management is important to ensure solvency Unfortunately, this recognition comes too late for some companies, with bankruptcy and possible liquidation representing the companies’ final choice 3.1 Defining Liquidity Management Liquidity management refers to an organization’s ability to generate cash when and where it is needed Liquidity refers to the cash balances, borrowing capacity, and ability to convert other assets or extend other liabilities into cash for use in keeping the entity solvent (i.e., being able to pay bills and continue in operation) For the most part, we associate liquidity with short-term assets and liabilities, yet longer-term assets such as marketable securities can be converted into cash to provide liquidity In addition, longer-term liabilities can also be renegotiated to reduce the drain on cash, thereby providing liquidity by preserving the limited supply of cash Of course, these last two methods might come at a price because they tend to reduce the company’s overall financial strength The challenges of managing liquidity include developing, implementing, and maintaining a liquidity policy To this effectively, a company must manage all its key sources of liquidity efficiently These key sources can vary from company to company, but they generally include primary sources of liquidity, such as cash balances, and secondary sources of liquidity, such as selling assets 3.1.1 Primary Sources of Liquidity Primary sources of liquidity represent the most readily accessible resources available They can be held as cash or as near-cash securities Primary sources include the following: ■■ Free cash flow, which is the firm’s after-tax operating cash flow less planned short- and long-term investments For a profitable firm, free cash flow provides substantial liquidity A rapidly growing firm has less free cash flow because of the investments required to facilitate the firm’s growth ■■ Ready cash balances, which is cash available in bank accounts, resulting from payment collections, investment income, liquidation of near-cash securities (i.e., those with maturities of fewer than 90 days), and other cash flows ■■ Short-term funds, which can include items such as trade credit, bank lines of credit, and short-term investment portfolios ■■ Cash flow management, which is the company’s effectiveness in its cash management system and practices, and the degree of decentralization of the collections or payments processes The more decentralized the system of collections, for example, the more likely the company will be to have cash tied up in the system and not available for use These sources represent liquidity that is typical for most companies They represent funds that are readily accessible at relatively low cost 3.1.2 Secondary Sources of Liquidity The main difference between primary and secondary sources of liquidity is that using a primary source is not likely to affect the normal operations of the company, whereas using a secondary source might result in a change in the company’s financial and operating positions Secondary sources include ■■ negotiating debt contracts, relieving pressures from high interest payments or principal repayments, and negotiating contracts with customers and suppliers; 681 682 © CFA Institute For candidate use only Not for distribution Reading 29 ■ Sources of Capital ■■ liquidating assets, which depends on the degree to which short-term and/or long-term assets can be liquidated and converted into cash without substantial loss in value; and ■■ filing for bankruptcy protection and reorganization The use of secondary sources might signal a company’s deteriorating financial health and provide liquidity at a high price—the cost of giving up a company asset to produce emergency cash This last source, reorganization through bankruptcy, can also be considered a liquidity tool because a company under bankruptcy protection that generates operating cash will be liquid and generally able to continue business operations until a restructuring has been devised and approved However, this option is likely to be at a significant cost, or disadvantage, to existing equityholders Example 2 shows the net proceeds from the primary and secondary sources of liquidity for a company in a financial crisis The example also shows the liquidation costs incurred by the company when using these sources to raise funds These costs can include the fees and commissions involved with the asset sale as well as any discount in asset value due to illiquidity issues EXAMPLE 2 Estimating Costs of Liquidity for OM Distributors One of the companies in your portfolio, OM Distributors (OM), is having a liquidity crisis You have identified four potential actions that OM could take to raise funds You have estimated, in local currency, the fair value of the assets and the liquidation costs OM might incur Source of Funds Fair Value (Local, millions) Liquidation Cost (%) Sell short-term marketable securities 10 Sell select inventories and receivables 20 10 Sell excess real estate property 50 15 Sell a subsidiary of the firm 30 20 The liquidation costs include the fees and commissions of selling an asset as well as any reduction in the value of the asset, because it is an illiquid asset being sold quickly In this case, liquidation costs for marketable securities are rounded to 0% Net of liquidation costs how much liquidity can OM raise if all four sources of funds are used, and what are the total liquidation costs incurred by OM? In local currency, these amounts are: A 110 million, 9.5 million B 94.5 million, 15.5 million C 125.5 million, 15.5 million Solution: The costs and net funds raised are summarized in this table: © CFA Institute For candidate use only Not for distribution Managing and Measuring Liquidity Liquidation Costs Net Proceeds (local, millions) Fair Value (local, millions) % (local, millions) Marketable securities 10 0 10 Inventories & receivables 20 10 18 Real estate property 50 15 7.5 42.5 Subsidiary of the firm 30 20 24 Source of Funds Total 15.5 94.5 B is correct Shown in the table above in local currency terms, the total net proceeds are 94.5 million, and the total liquidation costs incurred are 15.5 million 3.1.3 Drags and Pulls on Liquidity Cash flow transactions—that is, cash receipts and disbursements—have significant effects on a company’s liquidity position We refer to these effects as drags and pulls on liquidity A drag on liquidity is when receipts lag, creating pressure from the decreased available funds; a pull on liquidity is when disbursements are paid too quickly or trade credit availability is limited, requiring companies to expend funds before they receive funds from sales that could cover the liability Major drags on receipts involve pressures from credit management and deterioration in other assets and include the following: ■■ Uncollected receivables The longer these are outstanding, the greater the risk that they will not be collected at all They are indicated by the large number of days of receivables and high levels of bad debt expenses Just as the drags on receipts might cause increased pressure on working capital, pulls on outgoing payments could have similar effects ■■ Obsolete inventory If inventory stands unused for long periods, it might be an indication that it is no longer usable Slow inventory turnover ratios can also indicate obsolete inventory Once identified, obsolete inventory should be attended to as soon as possible to minimize storage and other costs ■■ Tight credit When economic conditions make capital scarcer, short-term debt becomes more expensive to arrange and use Attempting to smooth out peak borrowings can help blunt the impact of tight credit, as can improving the company’s collections In many cases, drags can be alleviated by stricter enforcement of credit and collection practices However, managing the cash outflows might be as important as managing the inflows If suppliers and other vendors who offer credit terms perceive a weakened financial position or are unfamiliar with a company, they might restrict payment terms so much that the company’s liquidity reserves are stretched thin Major pulls on payments include the following: ■■ Making payments early By paying vendors, employees, or others before the due dates, companies forgo the use of funds Effective payment management means not making early payments Payables managers typically hold payments until they can be made by the due date 683 684 © CFA Institute For candidate use only Not for distribution Reading 29 ■ Sources of Capital ■■ Reduced credit limits If a company has a history of making late payments, suppliers might cut the amount of credit they will allow to be outstanding at any time, which can squeeze the company’s liquidity Some companies try to extend payment periods as long as possible, disregarding the possible impact of reduced credit limits ■■ Limits on short-term lines of credit If a company’s bank reduces the line of credit it offers the company, a liquidity squeeze might result Credit line restrictions can be government mandated, market related, or simply company specific Many companies try to avert this situation by establishing credit lines far in excess of what they are likely to need This “overbanking” approach is often commonplace in emerging economies or even in more-developed countries when the banking system is not sound and the economy is shaky ■■ Low liquidity positions Many companies face chronic liquidity shortages, often because of their particular industry or from their weaker financial position The major remedy for this situation is, of course, to improve the company’s financial position, perhaps by issuing additional equity or hybrid securities If not, the company could be heavily affected by interest rates and credit availability, in which case it might have to turn to secured borrowing to obtain working capital funds Therefore, these companies must identify ahead of time the assets that can be used to help support their short-term borrowing activities Identifying these drags and pulls as soon as possible is critical, including before they happen or when they have just arisen In Example 3, an analyst is trying to identify changes in the firm that are affecting the its liquidity position EXAMPLE 3 Drags and Pulls on Liquidity Arya Rajavade’s firm is experiencing liquidity challenges Several things might be contributing to this Rajavade is reviewing three notable changes that have been suggested to her as drags or pulls on liquidity: ■■ The increasing days in receivables are a drag on liquidity ■■ Lower inventory turnover is a drag on liquidity ■■ Increased credit limits by lenders is a pull on liquidity Which of these does not contribute to the firm’s tight liquidity situation? A The change in days in receivables B The change in inventory turnover C The change in credit limits Solution: C is correct The increase in credit limits is not a pull on liquidity but is in fact the opposite; it provides liquidity 3.2 Measuring Liquidity c compare a company’s liquidity position with that of peer companies © CFA Institute For candidate use only Not for distribution Managing and Measuring Liquidity Liquidity contributes to a company’s creditworthiness Creditworthiness allows the company to obtain lower borrowing costs and better terms for trade credit and contributes to the company’s investment flexibility, enabling it to exploit profitable opportunities The less liquid the company, the greater the risk it will suffer financial distress or, in the extreme case, insolvency or bankruptcy Because debt obligations are paid with cash, the company’s cash flows ultimately determine solvency Immediate sources of funds for paying bills are cash on hand, proceeds from the sale of marketable securities, and the collection of accounts receivable Additional liquidity comes from inventory that can be sold and thus converted into cash, either directly through cash sales or indirectly through credit sales (i.e., accounts receivable) At some point, however, a company might have too much invested in low- and non-earning assets Cash, marketable securities, accounts receivable, and inventory represent a company’s liquidity, but these investments are low earning relative to the long-term, capital investment opportunities that companies might have available Various financial ratios can be used to assess a company’s liquidity as well as its management of assets over time Here we will look at some of these ratios in a little more detail Introduced in the coverage of Financial Reporting and Analysis, several liquidity and activity ratios are summarized in Exhibit 4 Exhibit 4 Ratios Used for Assessing Company Liquidity Liquidity Ratios Current ratio = Quick ratio = Cash ratio = Current assets Current liabilities Cash + Short-term marketable instruments + Receivables Current liabilities Cash + Short-term marketable instruments Current liabilities Activity Ratios Accounts receivable turnover = Inventory turnover = Credit sales Average receivables Cost of goods sold Average inventory Number of days of receivables = = Number of days of inventory = = Average accounts receivable Average day's sales on credit Average accounts receivable Sales on credit/365 Average inventory Average day's cost of goods sold Average inventory Cost of goods sold/365 (continued) 685 686 © CFA Institute For candidate use only Not for distribution Reading 29 ■ Sources of Capital Exhibit 4 (Continued) Number of days of payables = = Average accounts payable Average day's purchases Average accounts payable Purchases/365 Cash conversion cycle = Days of inventory + Days of receivables – Days of payables We calculate liquidity ratios to measure a company’s ability to meet short-term obligations to creditors as they mature or come due This form of liquidity analysis focuses on the relationship between current assets and current liabilities and the rapidity with which receivables and inventory can be converted into cash during normal business operations The levels of these ratios, trends or changes in the ratios over time, and comparisons with competitors or the industry are used to judge a firm’s liquidity position In addition to looking at the relationships among these balance sheet accounts, we can also estimate activity ratios, which measure how well key current assets are managed over time These ratios use information from the income statement and the balance sheet to help tell the story of how well a company is managing its liquid assets Some of the major applications of this type of analysis include performance evaluation, monitoring, creditworthiness assessment, and financial projections But ratios are useful only when they can be compared The comparison should be done in two ways: comparisons over time for the same company and over time for the company compared with its peer group Peer groups can include competitors from the same industry as the company as well as other companies of comparable size with comparable financial situations Consider Daimler AG, a producer of cars, trucks, and vans We can see the change in the company’s current, quick, and cash ratios over a decade, the fiscal years 2010 through 2019, in Exhibit 5, Panel A Here, we see that the current ratio and the quick ratio increased over the time period The cash ratio, over the decade, did not show the upward trend that the quick and current ratios exhibited We can see what is driving these trends in the calculation of the cash conversion cycle in Panel B of the exhibit Over the 10 years, the cash conversion cycle increased by more than 40 days The slight increase in days of payables outstanding would have decreased the cash conversion cycle slightly The days of inventory increased by approximately days, and the days of receivables increased by approximately 37 days Although the increase in inventory certainly puts a demand on liquidity, for Daimler, the impact of the increase in receivables was more dramatic Over the decade, however, based on the liquidity and activity ratios, this company seemed to have good control of its liquidity position Exhibit 5 Liquidity Analysis of Daimler AG, 10 Years Ending December 2019 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 Panel A: Current, Quick, and Cash Ratios, December 2010–2019 Current Ratio 1.21 1.24 1.22 1.21 1.19 1.15 1.19 1.15 1.11 1.07 Quick Ratio 0.93 0.94 0.93 0.91 0.88 0.84 0.90 0.85 0.80 0.80 Cash Ratio 0.25 0.25 0.26 0.25 0.23 0.23 0.30 0.26 0.20 0.25 © CFA Institute For candidate use only Not for distribution Managing and Measuring Liquidity Exhibit 5 (Continued) 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 Panel B: Days of Inventory, Receivables, Payables, and Cash Conversion Cycle, December 2010–2019 Days of Inventory on Hand 75.2 74.9 + Days of Receivables 136.8 127.9 118.8 118.4 104.6 102.6 105.5 104.6 104.2 100.0 − Days of Payables Outstanding 34.1 = Cash Conversion Cycle 177.9 167.6 156.8 159.5 142.4 137.7 139.2 138.7 137.9 135.0 35.2 71.6 73.9 33.6 32.8 69.1 31.3 68.5 33.4 69.2 35.5 71.5 37.4 71.2 37.5 66.6 31.6 Now consider Walmart, Target Corporation, Kohl’s Corporation, and Costco Wholesale Corporation Selected ratios for these large US discount retailers are shown in Exhibit 6 The data are from the fiscal year ending January 2020, except for Costco, whose fiscal year ended in August 2019 We see some differences among these four competitors These differences can be explained, in part, by the retailers’ different product mixes (e.g., Walmart and Costco have more sales from grocery lines than the other two), as well as their different inventory management systems and different inventory suppliers None of the four firms invests heavily in accounts receivable, and customers generally pay with credit cards The different need for liquidity can also be explained, in part, by the companies’ different operating cycles The most striking difference is for Kohl’s Walmart, Target, and Costco have investments in inventory that are largely matched and paid for by accounts payable Kohl’s, notably, has the highest investment in inventory, which is not financed by payables Because it includes more of such items as clothing, Kohl’s inventory is also more seasonal than that of the other companies Hence, Kohl’s has the highest current ratio because much of its inventory must be financed by non-current liabilities Exhibit 6 Liquidity Ratios among Discount Retailers Company Ratio for January 2020 Fiscal Year Walmart Target Kohl’s Costco Current ratio 0.79 0.89 1.68 1.01 Quick ratio 0.22 0.27 0.40 0.52 Days of inventory on hand Days of receivables Days of payables outstanding Cash conversion cycle 41.0 59.1 98.0 30.8 4.4 4.5 0.4 3.8 43.5 56.2 33.3 31.4 1.9 7.4 65.1 3.2 687 © CFA Institute For candidate use only Not for distribution Reading 29 ■ Sources of Capital 688 EXAMPLE 4 Measuring Liquidity Given the following ratios, how well has the company been managing its liquidity? Current Fiscal Year Ratio Current ratio Quick ratio Average for the Previous Five Fiscal Years Company Industry Company Industry 1.9 2.5 1.1 2.3 0.7 1.0 0.4 0.9 Days of receivables 39.0 34.0 44.0 32.5 Days of inventory on hand 41.0 30.3 45.0 27.4 Days of payables outstanding 34.3 36.0 29.4 35.5 Solution: The ratios should be compared in two ways: over time (the trend over time would typically be examined) and with the trend in the industry In all ratios shown here, the current year shows improvement over the previous years in terms of increased liquidity In each case, however, the company remains behind the industry average in terms of liquidity A brief snapshot such as this example could be the starting point in assessing management’s ability to deliver future improvement and reach or beat the industry standards EVALUATING SHORT-TERM FINANCING CHOICES d evaluate choices of short-term funding Because so many short-term financing alternatives are available, the company must know how various financing instruments and markets can affect its liquidity position and risks The costs of the financing alternatives can also be crucial When companies not explore their options sufficiently, their liquidity might be inadequate, and they might not take advantage of cost savings that some forms of borrowing offer This situation can arise if a company’s treasurer is not familiar with the common forms of short-term borrowing or has not formulated an effective borrowing strategy Given the various forms of short-term borrowing, having a planned strategy is essential for a borrower to avoid getting stuck in an uneconomical situation If a company spends too little time establishing a sound strategy for its short-term borrowing, in a crisis, it might not be able to borrow at all, from any source The major objectives of a short-term borrowing strategy include the following: ■■ Ensuring that sufficient capacity exists to handle peak cash needs ■■ Maintaining sufficient sources of credit to be able to fund ongoing cash needs ■■ Ensuring that rates obtained are cost-effective and not substantially exceed market averages © CFA Institute For candidate use only Not for distribution Evaluating Short-Term Financing Choices In addition, several factors will influence a company’s short-term borrowing strategies, such as the following: ■■ Size and creditworthiness A borrower’s size can dictate the options available Larger companies can take advantage of economies of scale to access commercial paper, banker’s acceptances, and so on The lender’s size is also an important criterion, because larger banks have higher house or legal lending limits The borrower’s creditworthiness will determine the rate, compensation, or even whether the loan will be made at all ■■ Legal and regulatory considerations Some countries impose constraints on how much a company can borrow and under what terms it can borrow Structure is usually greater for companies operating in developed countries with well- defined legal systems than for those operating in countries with emerging economies Also, in developed countries, some industries are strongly regulated Regulated companies, such as utilities and banks, might be restricted in how much they can borrow and the kind of borrowing they can engage in Utilities typically have steady and predictable income streams and are often allowed to borrow larger amounts Banks in the United States have come under greater scrutiny since the financial crisis and recession of 2007–2009 They are now required to have a greater amount of equity capital ■■ Sufficient access Borrowers should diversify to have adequate alternatives and not be too reliant on one lender or form of lending if the amount of their borrowing is very large Even so, using one alternative primarily, but often with more than one provider, is typical for borrowers Borrowers should be ready to go to other sources and know how to so Borrowers should not stay too long with just one source or with the lowest rates Many borrowers are usually prepared (somewhat) to trade rates for certainty Market power can help a company dictate more favorable terms for accounts payable, allowing it to delay payments without having to forgo discounts Having marketable securities on hand that can be quickly sold to meet short-term needs is also helpful ■■ Flexibility of borrowing options Flexibility means the ability to manage maturities efficiently; that is, there should not be any “big” days, when significant amounts of loans mature To effectively manage loan maturities, borrowers need active maturity management, awareness of the market conditions (e.g., knowing when the market or certain maturities should be avoided), and the ability to pre-pay loans when unexpected cash receipts occur Borrowing strategies, like investment strategies, can be either passive or active Passive strategies usually involve minimal activity, with one source or type of borrowing and with little (if any) planning A passive strategy is often reactive in responding to immediate needs for liquidity Passive strategies are characterized by steady, often routine rollovers of borrowings for the same amount of funds each time, without much comparison shopping Passive strategies might also arise when borrowing is restricted, such as when borrowers are limited to one or two lenders by agreement (e.g., in a secured loan arrangement) Active strategies are usually more flexible and reflect planning, reliable forecasting, and comparison pricing With active strategies, borrowers are more in control and not fall into the rollover “trap” that is possible with passive strategies Many active strategies are matching strategies Matching borrowing strategies function in a manner similar to matching investment strategies: loans are scheduled to mature when large cash receipts are expected These receipts can pay back the loan, so the company does not have to invest the funds at potentially lower rates than the borrowing cost, thereby creating unnecessary costs 689 690 © CFA Institute For candidate use only Not for distribution Reading 29 ■ Sources of Capital EXAMPLE 5 Evaluating Short-Term Choices When contemplating the possibilities for short-term financing needs, a company should consider which of the following items? A Cost of the funds borrowed B The flexibility offered by the source C The ease with which the funds can be accessed D Any legal or regulatory constraints that might favor one source over another E All of the above Solution The correct answer is E Cost of funds is the most obvious item to consider, but borrowing at a slightly higher cost sometimes makes sense when taking all the other items into consideration EXAMPLE 6 Meeting Short-Term Financing Need The Keown Corp has accounts payable of €2 million with terms of 2/10, net 30 Accounts receivable also stands at €2 million In addition, the company has €5 million in marketable securities Keown has a short-term need of €200,000 to meet payroll Which of the following options makes the most sense for raising the €200,000? A The company should issue long-term debt B The company should issue common stock C The company should delay paying accounts payable and forgo the 2% discount D The company should sell some of its accounts receivable to a factor at a 10% discount E The company should sell some of its marketable securities at a 0.5% brokerage cost Solution: A and B would not be appropriate for raising €200,000 for a short-term need These options take time to arrange, and they are more appropriate for long-term capital needs and for much larger financing amounts C, D, and E are all appropriate options for meeting short-term financing needs However, C and D are costly The options for raising €200,000 are summarized in this table: Summary © CFA Institute For candidate use only Not for distribution Liquidation Costs Source of Funds Action % € C Accounts payable (2/10, net 30) Delay €200,000 in payment, and forgo 2% discount 2.0 4,000 D Accounts receivable Sell €222,222 in value at 10% discount to raise €200,000 10.0 22,222 E Marketable securities Sell €200,000 in value 0.5 1,000 Choosing C means forgoing a 2% discount, which on €200,000 amounts to a cost of €4,000 To net €200,000 using option D, the company would have to sell €222,222 of accounts receivable to a factor, representing a cost of €22,222 E appears to be the best choice Marketable securities are liquid and can be easily sold for market value, less the relatively minor brokerage cost of €1,000 SUMMARY In this reading, we considered key aspects of capital alternatives and short-term financial management: the financing choices available to a company and effective liquidity management Both are critical in ensuring a company’s solvency and ability to remain in business If done improperly, the results can be disastrous for the company This reading covered the following: ■■ Describing internal and external sources of capital and the considerations that lead to their selection ■■ Describing primary and secondary sources of liquidity and factors that can enhance a company’s liquidity position ■■ Understanding how to evaluate a company’s liquidity position and comparing it to peer companies ■■ Evaluating the short-term financing choices available to a company based on their characteristics and their effective costs 691 692 © CFA Institute For candidate use only Not for distribution Reading 29 ■ Sources of Capital PRACTICE PROBLEMS Two analysts are discussing the costs of external financing sources The first states that the company’s bonds have a known interest rate but that the interest rate on accounts payable and the interest rate on equity financing are not specified They are implicitly zero Upon hearing this, the second analyst advocates financing the firm with greater amounts of accounts payable and common shareholders equity Is the second analyst correct in his analysis? A He is correct in his analysis of accounts payable only B He is correct in his analysis of common equity financing only C He is not correct in his analysis of either accounts payable or equity financing A company has arranged a $20 million line of credit with a bank, allowing the company the flexibility to borrow and repay any amount of funds as long as the balance does not exceed the line of credit These arrangements are called: A convertibles B factoring C revolvers SOA Company needs to raise 75 million, in local currency, for substantial new investments next year Specific details, all in local currency, are as follows: Investments of 10 million in receivables and 15 million in inventory Fixed capital investments of 50 million, including 10 million to replace depreciated equipment and 40 million of net new investments Net income is expected to be 30 million, and dividend payments will be 12 million Depreciation charges will be 10 million Short-term financing from accounts payable of 6 million is expected The firm will use receivables as collateral for an 8 million loan The firm will also issue a 14 million short-term note to a commercial bank Any additional external financing needed can be raised from an increase in long-term bonds If additional financing is not needed, any excess funds will be used to repurchase common shares What additional financing does SOA require? A SOA will need to issue 19 million of bonds B SOA will need to issue 26 million of bonds C SOA can repurchase 2 million of common shares Kwam Solutions must raise €120 million Kwam has two primary sources of liquidity: €60 million of marketable securities (which can be sold with minimal liquidation/brokerage costs) and €30 million of bonds (which can be sold with 3% liquidation costs) Kwam can sell some or all of either of these portfolios Kwam has a secondary source of liquidity, which would be to sell a large piece of real estate valued at €70 million (which would incur 10% liquidation costs) If Kwam sells the real estate, it must be sold entirely (a fractional sale is not possible) What is the lowest cost strategy for raising the needed €120 million? A Sell €60 million of the marketable securities, €30 million of the bonds, and €34.3 million of the real estate property B Sell the real estate property and €50 million of the marketable securities © 2021 CFA Institute All rights reserved Practice Problems © CFA Institute For candidate use only Not for distribution C Sell the real estate property and €57 million of the marketable securities A company increasing its credit terms for customers from 1/10, net 30, to 1/10, net 60, will most likely experience: A an increase in cash on hand B a lower level of uncollectible accounts C an increase in the average collection period Paloma Villarreal has received three suggestions from her staff about how to address her firm’s liquidity problems Suggestion Reduce the firm’s inventory turnover rate Suggestion Reduce the average collection period on accounts receivable Suggestion Accelerate the payments on accounts payable by paying invoices before their due dates Which suggestion should Villarreal employ to improve the firm’s liquidity position? A Suggestion B Suggestion C Suggestion Selected liquidity ratios for three firms in the leisure products industry are given in the table below The most recent fiscal year ratio is shown, along with the average of the previous five years Company H Company J Most recent Five- year average Current ratio 5.37 Quick ratio Cash ratio Company S Most recent Five- year average Most recent Five-year average 2.51 3.67 3.04 3.05 2.53 5.01 2.19 2.60 2.01 1.78 1.44 3.66 0.97 1.96 1.28 0.96 0.67 Relative to their peers and relative to their own prior performance, which company is in the most liquid position? A Company H B Company J C Company S An analyst is examining the cash conversion cycles and their components for three companies that she covers in the leisure products industry She believes that changes in the investments in these working capital accounts can reveal liquidity stresses on a company 2021 2020 2019 2018 2017 2016 Days of Inventory on Hand 68.4 70.5 60 57.8 59.8 59.8 + Days of Receivables 101.8 103.4 95.6 92.4 94.7 93.3 52.1 54.6 48 41.9 36.8 35.9 118.1 119.3 107.6 108.3 117.7 117.2 Company H – Days of Payables Outstanding = Cash Conversion Cycle Company J (continued) 693 694 © CFA Institute For candidate use only Not for distribution Reading 29 ■ Sources of Capital 2021 2020 2019 2018 2017 2016 Days of Inventory on Hand 105.6 101.4 96.3 105.2 103.2 101.4 + Days of Receivables 27.7 29.4 32.9 36.3 37.8 38 – Days of Payables Outstanding 36.6 38.5 35.3 39.3 37.8 40.2 = Cash Conversion Cycle 96.7 92.3 93.9 102.2 103.2 99.2 118.9 69.2 63.4 81.7 Company S Days of Inventory on Hand 135.8 + Days of Receivables 49.1 42.5 54.2 36.2 29.1 38.3 – Days of Payables Outstanding 30.9 27.9 34.6 29.8 31.8 35.9 154.0 145.6 138.5 75.6 60.7 84.1 = Cash Conversion Cycle 131 Which company’s operating cycle appears to have caused the most liquidity stress? A Company H’s B Company J’s C Company S’s Solutions © CFA Institute For candidate use only Not for distribution SOLUTIONS C is correct Although accounts payable not charge an explicit interest rate, the cost of accounts payable is reflected in the costs of the services or products purchased and in the costs of any discounts not taken Accounts payable can have a very high implicit cost Similarly, equity financing is not free A required return is expected on shareholder financing just as on any other form of financing C is correct A revolver is a short-term borrowing facility in which a bank allows the firm to borrow and repay loans during the life of the line of credit A is correct SOA must issue 19 million of bonds Source Amount (local, millions) Accounts payable Bank loan against receivables Short-term note 14 Net income + depreciation – dividends 28 Total sources 56 The firm requires 75 million of financing in local currency terms Given the planned sources (before bond financing or repurchases) total 56 million, SOA will need to issue 19 million of new bonds C is correct Kwam must sell the entire real estate property because the two primary sources (marketable securities and bonds) will not raise the needed €120 million A is incorrect because it assumes a fractional real estate sale The real estate sale will raise a net of €63 million (€70 million minus 10% liquidation expenses) To raise the rest of the funds needed (€120 million - €63 million = €57 million), Kwam can sell €57 million of marketable securities, which have minimal liquidation/brokerage costs C is correct A longer average collection period will certainly occur Higher cash balances and a lower level of uncollectible accounts will not occur B is correct Reducing the average collection period would speed up receipts and improve the firm’s liquidity position The other two suggestions would worsen the firm’s liquidity position A is correct Relative to peers, Company H has the highest set of ratios Relative to historical average ratios, Company H’s recent ratios show the greatest increases The cash ratio is the most relevant for judging liquidity, and Company H’s cash ratio is quite high C is correct Company S’s cash conversion cycle nearly doubled over recent years, while the cash conversion cycles for Companies H and J are nearly unchanged The days of inventory on hand and days of receivables both increased substantially for Company S, and its days of payables outstanding decreased very slightly The net effect was the large increase in the cash conversion cycle Although changes occurred in the components of the cash conversion cycles for Companies H and J, the net effect on their cash conversion cycles was small 695 ... Statement Ratios indicates an optional segment 6 12 13 14 18 18 22 22 22 23 27 28 28 29 30 33 34 35 36 37 38 39 40 43 44 44 45 47 ii © CFA Institute For candidate use only Not for distribution... Problems Solutions 39 7 39 8 39 8 39 9 400 4 03 404 405 407 408 409 410 410 412 4 13 4 13 4 13 414 415 415 418 424 426 428 433 Non-Current (Long-Term) Liabilities 435 Introduction 436 Bonds Payable... Liquidity 669 669 670 671 672 6 73 676 676 680 681 684 indicates an optional segment 626 627 627 628 629 629 630 630 632 632 633 634 636 637 638 640 642 644 x © CFA Institute For candidate use