UNIVERSITY OF NAIROBI
SCHOOL OF BUSINESS
PROGRAMME: MSC FINANCE
IN PARTIAL FULFILLMENT OF DAC 511 IN MSC FINANCE YEAR 2013
GROUP ASSIGNMENT – ANALYSING INVESTING ACTIVITIES
LECTURER: HERICK ONDIGO
JANUARY 2013
PRESENTED BY: GROUP TWO
1. DEVRAJ A SANGHANI D63/60293/2013
2. RACHEL MWALILI D63/60284/2013
3. ALUNDA JACKLINE D63/60011/2013
4. WINFRED MUTERO D63/60482/2013
5. MICHAEL KINYANJUI D63/60249/2013
6. SIMON M NDUNG’U D63/60853/2013
7. CHURCHILL ADIKA D63/80213/2012
8. YASIN HASSAN D63/60531/2013
9. RENNOX ASILIGWA D63/60005/2013
10. RUTH BOYANI D63/61595/2013
11. PETE LUKE OCHIENG D63/60102/2013
TABLE OF CONTENTS
1.10 ANALYZING INVESTING ACTIVITIES…………………………………………………………………………1
1.11 Analysis Objective……………………………………………………………………………………………1
1.12 Managing operating assets……………………………………………………………………………..1
1.13 Introduction to current assets………………………………………………………………………..1
1.14 Cash and Cash Equivalents……………………………………………………………………………..3
1.15 Analyzing receivables……………………………………………………………………………………..5
1.16 Prepaid expenses…………………………………………………………………………………………..8
2.00 INVENTORIES………………………………………………………………………………………………………..8
2.10 Inventory costing – Effects on profitability……………………………………………………9
2.11 Inventory costing – Effects on balance sheet………………………………………………..10
2.12 Inventory costing – Effects on cash flows……………………………………………………..10
2.13 Other issues in inventory valuation………………………………………………………………10
3.00 LONG-TERM ASSETS……………………………………………………………………………………………14
3.10 Introduction to long-term assets………………………………………………………………….14
3.11 Accounting for Long-Term Assets…………………………………………………………………14
3.12 Capitalizing versus Expensing……………………………………………………………………..18
4.00 PLANT ASSETS AND NATURAL RESOURCES…………………………………………………………20
4.10 Valuing Plant Assets and Natural Resources………………………………………………20
4.11 Valuing Property, Plant, and Equipment……………………………………………………20
4.12 Valuing Natural Resources…………………………………………………………………………20
4.13 Analyzing Plant Assets and Natural Resources……………………………………………24
4.14 Analyzing Depreciation and Depletion……………………………………………………….25
4.15 Analyzing Impairments………………………………………………………………………………28
5.00 INTANGIBLE ASSETS…………………………………………………………………………………………..29
5.10 Accounting for intangibles………………………………………………………………………….30
5.11 Identifiable Intangibles ……………………………………………………………………………..30
5.12 Unidentifiable Intangibles………………………………………………………………………….30
5.13 Unrecorded intangibles……………………………………………………………………………..31
(i)
1.10 ANALYZING INVESTING ACTIVITIES.
1.11Analysis Objective
1. Define current assets and their relevance for analysis.
2. Explain cash management and its implications for analysis.
1.12 Managing operating assets
Effective management of operating assets is key to achieving high performance.
1.13 Introduction to current assets
Assets are resources controlled by a company for the purpose of generating profit. Theycan be categorized into two groups—current and noncurrent.
Current assets are resources readily convertible to cash within the operating cycle of the company. Major classes of current assets include cash, cash equivalents, receivables, inventories, and prepaid expenses.
Long-term (or noncurrent) assets are resources expected to benefit the company for periods beyond the current period. Major long-term assets include property, plant, equipment, intangibles, investments, and deferred charges. An alternative distinction often useful for analysis is to designate assets as either financial assets or operating assets.
Financial assets consist mainly of marketable securities and other investments in nonoperating assets. They usually are valued at fair (market) value and are expected to yield returns equal to their risk-adjusted cost of capital.
Operating assets constitute most of a company’s assets. They usually are valued at cost and are expected to yield returns in excess of the weighted-average cost of capital.
Current assets include cash and other assets that are convertible to cash, usually withinthe operating cycle of the company.
An operating cycle (shown in exhibit 4.1 below ) is the amount of time from commitment of cash for purchases until the collection of cash resultingfrom sales of goods or services.
It is the process by which a company convertscash into short-term assets and back into cash as part of its ongoing operating activities.
For a manufacturing company, this would entail purchasing raw materials, convertingthem to finished goods, and then selling and collecting cash from receivables.
Cashrepresents the starting point, and the end point, of the operating cycle. The operatingcycle is used to classify assets (and liabilities) as either current or noncurrent.
Current assetsare expected to be sold, collected, or used within one year or the operating cycle,whichever is longer. Typical examples are cash, cash equivalents, short-term receivables,short-term securities, inventories, and prepaid expenses.
The excess of current assets over current liabilities is called working capital. Workingcapital is a double-edged sword—companies need working capital to effectivelyoperate, yet working capital is costly because it must be financed and can entail otheroperating costs, such as credit losses on accounts receivable and storage and logistics costs for inventories.
Many companies attempt to improve profitability and cash flow by reducing investment in current assets through methods such as effective credit underwriting and collection of receivables, and just-in-time inventory management. In addition, companies try to finance a large portion of their current assets through current liabilities, such as accounts payable and accruals, in an attempt to reduce working capital. Because of the impact of current assets (and current liabilities) on liquidity and profitability, analysis of current assets (and current liabilities) is very important in both credit analysis and profitability analysis.
222 Financial
1.14 Cash and Cash Equivalents
Cash, the most liquid asset, includes currency available and funds on deposit.
Cashequivalents are highly liquid, short-term investments that are
(1) Readily convertible into cash
(2) So near maturity that they have minimal risk of price changes due tointerest rate movements.
These investments usually carry maturities of three monthsor less. Examples of cash equivalents are short-term treasury bills, commercial paper,and money market funds. Cash equivalents often serve as temporary repositories ofexcess cash.
The concept of liquidity is important in financial statement analysis.
By liquidity, wemean the amount of cash or cash equivalents the company has on hand and the amountof cash it can raise in a short period of time. Liquidity provides flexibility to take advantageof changing market conditions and to react to strategic actions by competitors.
Liquidity also relates to the ability of a company to meet its obligations as they mature.Many companies with strong balance sheets (where there exists substantial equity capitalin relation to total assets) can still run into serious difficulties because of illiquidity.
Companies differ widely in the amount of liquid assets they carry on their balancesheets. As the graphic indicates, cash and cash equivalents as a percentage of total assetsranges from 2% (Target) to 22% (Dell). These differences can result from a numberof factors. In general, companies in a dynamic industry require increased liquidity totake advantage of opportunities or to react to a quickly changing competitive landscape.er Four | Analyzing Investing Activities 223
In addition to examining the amount of liquid assetsavailable to the company, analysts must also consider thefollowing:
1. To the extent that cash equivalents are investedin equity securities, companies risk a reduction inliquidity should the market value of those investmentsdecline.
2. Cash and cash equivalents are sometimes requiredto be maintained as compensating balances tosupport existing borrowing arrangements or as collateralfor indebtedness.
1.15 Analyzing receivables
Analysis of receivables must recognize the possibility of error in judgment as to their ultimate collection. We must be alert of management’s incentives in reporting higher levels of income and assets. Due to this, two important questions confront analysis of receivables.
Collection Risk
Most provisions for uncollectible accounts are based on past experience, although they make allowance for current and emerging economic, industry, and debtor circumstances. Full information to assess collection risk for receivables is not usually included in financial statements. Useful information must be obtained from other sources or from the company.
Analysis tools for investigating collection include:
Ø Comparing competitors’ receivables as a percentage of sales with those of the company under analysis
Ø Examining customer concentration—risk increases when receivables are concentrated in one or a few customers
Ø Computing and investigating trends in the average collection period of receivables compared with customary credit terms for the industry
Ø Determining the portion of receivables that are renewals of prior accounts or notes receivables
Authenticity of Receivables
The description of receivables in financial statements or notes is usually insufficient to provide reliable clues as to whether receivables are genuine, due, and enforceable. Knowledge of industry practices and supplementary sources of information are used for added assurance.
One factor affecting authenticity is the right of merchandise return. Our analysis must allow for return privileges. Liberal return privileges can impair quality of receivables.
Receivables also are subject to various contingencies. Analysis can reveal whether contingencies impair the value of receivables. A note to the financial statements of Sanford & Sons reveals several contingencies:
Accounts receivable: Accounts receivable are stated net after allowances for returns and doubtful accounts of $472,000. Accounts receivable include approximately $4,785,000 for shipments made under a deferred payment plan whereby title to the merchandise is transferred to the dealer when shipped; however, the company retains a security interest in such merchandise until sold by the dealer. Payment to the Company is due from the dealer as the merchandise is sold at retail. The amount of receivables of this type shall at no time exceed $11 million under terms of the loan and security agreement.
Receivables like these often entail more collection risk than receivables without contingencies.
Securitization of Receivables
Analysis issue also arise when a company sells all or a portion of its receivables to a third party which finances the sale by selling bonds to the capital markets. The collection of those receivables provides the source for the yield on the bond. This practice is called securitization. The sale of receivables to a bank or commercial finance company is called factoring.
Recourse refers to guarantee of collectibility. Receivables can be sold with or without recourse to a buyer. Sale of receivables with recourse does not effectively transfer risk of ownership of receivables from the seller.
Receivables can be kept off the balance sheet only when the company selling its receivables surrenders all control over the receivables to an independent buyer of sufficient financial strength. As long as a buyer has any type of recourse or the selling company has any degree of retained interest in the receivables, the company selling receivables has to continue to record both an asset and a compensating liability for the amount sold.
The securitization of receivables is often accomplished by establishing a special purpose entity (SPE). See below how to purchase the receivables from the company and finance the purchase via sale of bonds into the market. The consumer finance company has sold $42 billion of its $80 billion loan portfolio and acknowledges that securitization is a significant source of its financing.
Sync Co. securitizes its entire receivables of $400 million with no recourse by selling the portfolio to a trust that finances the purchase by selling bonds. As a result, the receivables are removed from the balance sheet and the company receives $400 million in cash. The balance sheet and key ratios of Sync are shown below with three alternative scenarios:
(1) Before securitizing the receivables;
(2) After securitizing receivables with off-balance-sheet financing (as reported under GAAP)
(3) After securitizing receivables butreflecting the securitization as a borrowing (reflecting the analyst’s adjustments).
Notice how scenario 2, compared to the true economic position of scenario 3, window-dresses the balance sheet by not reporting a portion of current liabilities.
Balance Sheet
Before After Adjusted
Assets
Cash $ 50 $ 450 $ 450
Receivables 400 0 400
Other Current Assets150 150 150
Total Current Assets 600 600 1000
Noncurrent Assets900 900 900
Total Assets $ 1500 $ 1500 $1900
Liabilities
Current Liabilities $ 400 $ 400 $ 800
Noncurrent Liabilities 500 500 500
Equity 600 600 600
Total liabilities and equity $ 1500 $1500 $1900
Securitization often involves lenders that package loans and sell them to investors, then use the freed-up capital to make new loans. Yet lenders often retain the riskiest piece of the loans because it is the hardest to sell—meaning they could still be on the hook if the loans go bad.
1.16 Prepaid expenses
Prepaid expenses are advance payments for services or goods not yet received. Examples are advance payments for rent, insurance, utilities, and property taxes. Prepaid expenses usually are classified in current assets because they reflect services due that would otherwise require use of current assets.
2.00 INVENTORIES
Definition – inventories are goods held for sale as part of a company’s normal business operations.
They are major component of operating assets and directly affect determination of income.
Why is inventory costing important?
Assigning costs to inventory affects both income and asset measurement.
The importance of inventory equation
Opening inventories + purchases – cost of goods sold = closing inventories
The above equation highlights the flow of costs within the company. The cost of inventory is initially recorded on the balance sheet and as the goods are sold, they flow into the income statement as cost of goods sold (COGS). In accordance to the Accruals concept, cost cannot be in two places; either they remain on the balance sheet (future expense) or are recognized currently in the income statement and reduce profitability to match against sales revenue.
There are several options to determine the order in which costs are removed from the balance sheet and recognized as COGS in the income statement.
1. First in, first out (FIFO) – a method in which first unit purchased is first unit sold.
2. Last in, first out (LIFO) - a method in which last unit purchased is the first to be sold.
3. Average costing – a method where units are sold without regard to the order in which they are purchased and computes COGS and ending inventories as a simple weighted average.
2.10 Inventory costing – Effects on profitability
Each of the above methods will result in different COGS and ending inventories. This implies that each of the method will yield different net income and asset figures.
In periods of rising prices, FIFO produces higher gross profits than LIFO because lower cost inventories are matched against sales revenues at current market prices. This is referred to as FIFO’s phantom profits as the gross profit is actually a sum of two components; an economic profit and a holding gain.
The economic profit = no. of units sold x (sales price – replacement cost)
Holding gains = no. of units sold x (replacement cost – acquisition cost)
Example:-
No of units sold = 30
Sales price = $800
Replacement cost = $600
Acquisition cost = $500
Gross profit = (30 x $800) – (30 x $500) = $9,000
Economic profit = 30 x ($800- 600) = $6,000
Holding gains = 30 x ($600-500) = $3000
Of the $9,000 reported profit, $3,000 relates to inflationary gains realized by the company on holding stocks it purchased some time ago at prices lower than current prices.