Income Statement

Inventory valuation
 FIFO: Inventory reflects cost of most recent purchases; COGS reflects cost of oldest purchases.
 LIFO: COGS reflects cost of most recent purchases; inventory reflects cost of oldest purchases.
 Average cost: Unit cost equals cost of goods available for sale divided by total units available and is used for
both COGS and inventory.
 Specific identification: Each item in inventory is identified and its historical cost is used for calculating COGS
when the item is sold.

Intangible assets with limited lives should be amortized using a method that reflects the low over time of their
economic bene its. Intangible assets with indefinite lives (e.g., goodwill) are not amortized.

Users of financial data should analyse the reasons for any changes in estimates of expenses and compare these
estimates with those of peer companies.

Balance sheet
Balance Sheet Ratio
1. Liquidity Ratios - Measure the ability to meet short-term obligations:
 Current Ratio = Current Assets / Current Liabilities.
 Quick Ratio = (Current Assets – Inventory) / Current Liabilities.
 Cash Ratio = (Cash + Marketable Securities) / Current Liabilities.

2. Solvency Ratios - Measure the ability to meet long-term obligations:

 Long-term Debt-to-Equity = Total Long-term Debt / Total Equity.
 Debt-to-Equity = Total Debt / Total Equity.
 Financial Leverage = Total Assets / Total Equity.

Cash Flow
Direct Method
Direct method of CFO identifies actual cash inflows and outflows. CFO = CFF + CFI
1. Cash collected from customers:
 Cash received from customers = Revenue - Increase in accounts receivables
Ex: Corporation reported accounts receivable of $66 million at the end of its second fiscal quarter. MC had revenues of $72
million for its third fiscal quarter and reported accounts receivable of $55 million at the end of its third fiscal quarter. Based
on this information, the amount of cash MC collected from customers during the third fiscal quarter is?
Cash from customers = 100 million – 10 million = 90 million

 Ending accounts receivable = Beginning accounts receivable + Revenue - Cash received from customers
Ex: Corporation reported accounts receivable of $66 million at the end of its second fiscal quarter. MC had revenues of $72
million for its third fiscal quarter and reported accounts receivable of $55 million at the end of its third fiscal quarter. Based
on this information, the amount of cash MC collected from customers during the third fiscal quarter is?
55 = 66 + 72 - Cash received from customers = 83 million

2. Cash paid to suppliers:

 Cash paid to suppliers = COGS + Increase in inventory = Purchase from suppliers - Increase in Acc. Payables
Ex: Corporation reported cost of goods sold for the year of $80 million. Total assets increased by $55 million, including an
increase of $5 million in inventory. Total liabilities increased by $45 million, including an increase of $2 million in accounts
payable. The cash paid by the company to its suppliers is most likely closest to:
Cash paid to suppliers = 80 + 5 - 2 = 83 million
 Ending inventory = Beginning inventory + Purchases – COGS
Ex: Corporation reported cost of goods sold for the year of $100 million. Total assets increased by $60 million, including an
increase of $5 million in inventory. MC had revenues of $20 million for its third fiscal quarter. Total liabilities increased by
$45 million, including an increase of $4 million in accounts payable Based on this information, the amount of cash MC paid
to suppliers during the third fiscal quarter is?
20 + 5 = 20 + Cash received from customers - 100 = 105 million

 Ending accounts payable = Beginning acc. Payable + Purchases - Cash paid to suppliers

3. Cash paid to employees:

 Cash paid to employees = Salary - Increase in salary
Ex: Corporation reported salaries expense of $500,000, and the increase in salaries payable was $50,000. How much cash
did the company pay in salaries?
Cash paid to employees = 500,000 – 50,000 = 450,000

 Ending salary = Beginning salary + Salary - Cash paid to employees

Ex: Corporation reported salaries expense of $20 million. The beginning balance of salaries payable was $3 million, and the
ending balance of salaries payable was $1 million. How much cash did the company pay in salaries?
1 = 3 + 20 – Cash paid to employees = 22

4. Cash paid for other operating expenses:

 Cash paid for other operating expenses = Other operating expenses + Increase in prepaid expenses -
Increase in other accrued liabilities
Ex: Corporation reported other operating expenses of $200,000. The prepaid expenses increased from $5,000 at the
beginning of the year to $25,000 at the end of the year, and other accrued liabilities increased from $10,000 to $20,000
during the year. How much cash did the corporation pay for other operating expenses?
Cash paid for other operating expenses = 200,000 + (25,000 – 5,000) – (20,000 – 10,000) = 210,000

5. Cash paid for interest:

 Cash paid for interest = Interest expense + Decrease in interest payable
Ex: Corporation reported interest expense of $19 million. Interest payable increased by $3 million over the period. How
much cash did the company pay for interest?
Cash paid for interest = 19 – 3 = 16 million

 Ending interest payable = Beginning interest payable + Interest expense - Cash paid for interest
Ex : A corporation reported interest expense of $19 million. The interest payable account increased by $3 million over the
period. The beginning interest payable was $5 million.
(5 + 3) = 5 + 19 - Cash paid for interest = 16 million

6. Cash paid for income taxes:

 Cash paid for income tax expense = Income tax expense - Increase in Income tax payable - Deferred tax
liability + Deferred tax assets
Ex: A corporation reported taxes expense of $6 million. Taxes payable decreased by $4 million over the period. The deferred
tax liability increased by $2 million, and the deferred tax assets increased by $1 million. How much cash did the company
pay for taxes?
Cash paid for tax = 6 + 4 – 2 + 1 = 9 million
Direct method of CFI (investing activities) is calculated by examining changes in the gross asset account that
result from investing activities. CFI = cash paid for new asset - cash inflow from the sale of equipment
 Cash paid for new asset = (ending gross assets – beginning gross assets) + gross cost of old assets sold
OR
 Ending gross assets = beginning gross assets + cash paid for new asset - paid for new asset
 Cash inflow from the sale of equipment = historical cost – depreciation + gain (-loss) on a sale of asset
 Book value = Historical cost – Depreciation
 Cash inflow – Book value = Gain (or loss)
Ex: A corporation reported a loss on the sale of equipment of $2 million in 2018. The company’s income statement also
shows depreciation expense of $8 million, and the cash flow statement shows capital expenditures of $10 million, all of
which was for the purchase of new equipment. From the comparative balance sheets, the equipment account increased
from $100 million on December 31, 2017, to $105 million on December 31, 2018, reflecting a net increase of $5 million. The
accumulated depreciation on equipment also increased from $40 million at the end of 2017 to $46 million at the end of
2018, a change of $6 million. How much cash did the company receive from the equipment sale?
Cash paid for new asset = (120 - 100) + 5 = 25 million
Cash inflow = 5-2 = 3 (estimated depreciation)
Cash inflow = 5 (historical cost) – 3 (estimated depreciation) -2 (loss) = 0
CFI = 25 – 0 = 25

Direct method of CFF (financing activities) is calculated by examining changes between the firm and the supplier
of capital (equity or debt). CFF = net cash flow from creditors + net cash flow from shareholders
 Net cash flow from creditors = new borrowings – principal amount repaid
+
 Net cash flow from shareholders = new equity issued – share repurchased – cash dividends paid
Ex: A corporation reported net income of $25 million. The company has no outstanding debt. At the end of 2017, the
corporation reported the following balances: Common stock at $100 million, additional paid-in capital on common stock at
$100 million and retained earnings at $100 million. The total stockholders’ equity was $300 million. By the end of 2018,
these amounts had changed. The common stock increased by $2 million, bringing its balance to $102 million. The additional
paid-in capital on common stock increased by $40 million, reaching $140 million. The retained earnings increased by $15
million, bringing the balance to $115 million. As a result, the total stockholders’ equity rose by $57 million to $357 million.
What should the company report in the financing section of the statement of cash flows in 2018?
New borrowings = 0
Principal amount repaid = 0
New equity issued = 2 + 40 = 42 million
Share repurchased = 0
Cash dividends paid = 25 – 15 = 10 million
Net cash flow from shareholders = 42 – 0 - 10 = 32 million = CFF

FCFE/FCFF
Free cash flow to the firm is cash available to all investors, both equity owners and debt holders.
 FCFF = (Net income + non-cash charges – working capital investments + (Interest expense x (1-tax rate)) –
fixed capital investment.
 FCFF = CFO + (Interest expense x (1-tax rate)) – fixed capital investment.

Free cash flow to the equity is cash flow that would be available for distribution to common shareholders.
 FCFE = CFO − fixed capital investment + net borrowing.

Other free cash flow ratios:

1. Performance ratios
 Cash flow-to-revenue ratio = CFO / net revenue
 Cash return-on-assets ratio = CFO / average total
 Cash return-on-equity ratio = CFO / average total equity
 Cash to-income ratio = CFO / operating income
 Cash flow per share ratio = (CFO - preferred dividends) / weighted average number of common shares

2. Coverage ratios
 Debt coverage ratio = CFO / total debt
 Interest coverage ratio = CFO + interest paid + taxes paid / interest paid
 Reinvestment ratio = CFO / cash paid for long-term assets
 Debt payment ratio = CFO / cash long-term debt payment
 Dividends payment ratio = CFO / dividends paid
 Investing and financing ratio = CFO / cash outflows from investing and financing activities

Indirect method