DuPont analysis decomposes a firm’s ROE to better analyze a firm’s performance. Start with ROE Traditional DuPont equation is: Extended DuPont equation is: An analyst has gathered the following information about a company: Operating profit margin = 12% Average tax rate = 30% Asset turnover ratio = 2 times Financial leverage multiplier = 1.5 times Interest burden = 0.6 times Calculate the company’s ROE. Solution: Tax burden = 1 – tax rate = 1 – 0.3 = 0.7 ROE = 0.7 x 0.6 x 0.12 x 2 x… Read More
The four inventory valuation methods are: FIFO The cost of the first item purchased is assumed to be the cost of the first item sold. Ending inventory is based on the cost of the most recent purchases. LIFO The cost of the last item purchased is assumed to be the cost of the first item sold. Ending inventory is based on the cost of the earliest purchases. Weighted average cost Each item in the inventory is valued using an average cost of all items in the inventory. COGS and inventory values are between their FIFO and LIFO values. Specific identification… Read More
LIFO reserve is the difference between LIFO inventory reported and the amount that would have been reported in inventory if the FIFO method had been used. Under US GAAP, companies that use the LIFO method must disclose the LIFO reserve in their financial notes. This information can be used to adjust reported ending inventory and COGS in order to compare this company with a company using the FIFO method. LIFO liquidation occurs when the number of units in ending inventory is less than the number of units in the beginning inventory (i.e. the firms sells more than it purchases during… Read More
Depreciation methods are: Straight line – The cost of an asset is evenly distributed over the asset’s useful life. Accelerated – A higher depreciation expense is recorded in the early years and lower depreciation expense is recorded in the later years of an asset’s life. Double declining balance (DDB) is one example of an accelerated depreciation method. Units of production – Cost allocated is based on the actual use of an asset in a particular period. Straight line depreciation expense = depreciable cost / estimated useful life DDB depreciation expense = 2 x straight-line rate x beginning book value Units… Read More
Lessor (entity lending the asset) perspective Operating lease The asset remains on the balance sheet and is depreciated. The lease payments are recorded as rental income. Finance lease The asset is removed from the balance sheet and replaced with a lease receivable. The interest portion of the lease payment is recorded as interest income and the principal repayment portion decreases the lease receivable on the balance sheet. Lessee (entity using the asset) perspective Operating lease No asset or liability is recorded on the balance sheet. The entire lease payment is reported as a rental expense on the income statement and… Read More
Accounting profit is the pretax income from the income statement. It is based on accounting standards. Taxable income is income subject to tax. It is based on the tax returns. The accounting profit and taxable income are different because of differences between the accounting standards and the tax returns. For example, Accounting profit is usually calculated using straight line depreciation. While taxable income is usually calculated using accelerated depreciation. Accounting profit is usually based on accrual basis of accounting. While taxable income is usually based on cash-basis accounting. Deferred tax assets are created when income tax payable is greater than… Read More
Under the effective interest rate method, interest expense = book value of the bond liability at the beginning of the period x market interest rate at issuance. The interest expense includes amortization of any discount or premium at issuance. Premium bond: The yield < coupon rate, therefore interest expense < coupon payment. The difference is subtracted from the bond liability on the balance sheet, which leads to amortization of the premium. Discount bond: The yield > coupon rate, therefore interest expense > coupon payment. The difference is added to the bond liability on the balance sheet, which leads to amortization… Read More
Solvency refers to a company’s ability to meet its long-term debt obligations. In evaluating solvency: Leverage ratios focus on the balance sheet and measure the amount of debt financing relative to equity financing. Leverage Ratio Numerator Denominator Debt to assets Total debt Total assets Debt to capital Total debt Total debt + shareholder’s equity Debt to equity Total debt Total shareholder’s equity Financial leverage Average total assets Average total equity Coverage ratios focus on the income statement and cash flows and measure the ability of a company to cover its interest payments. Coverage Ratio Numerator Denominator Interest coverage EBIT Interest… Read More
A board of directors is the central pillar of corporate governance. The board of directors is elected by shareholders to act in their interest. Executive (internal) directors are typically members of senior management employed by the company. Nonexecutive (external) directors have no other relationship with the company. They are also called independent directors. A board primarily has these two duties – duty of care and duty of loyalty towards the shareholders. A company’s board of directors can have several committees that are responsible for specific functions. For example, audit committee governance committee remuneration committee nomination committee risk committee investment committee
Decisions should be based on incremental cash flows (not on accounting income as it is based on accrual basis): Exclude sunk costs For example, already incurred costs like preliminary consulting fees should not be included in the analysis. Include externalities – Both positive/negative externalities should be considered in the analysis. For example, negative impact of a new diet soda product launch on the sales of existing soda products. (Note: In a conventional cash flow, the sign of cash flows changes only once during the life of the project; while an unconventional cash flow has more than one sign change.) Timing… Read More
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