2 Cfa l1 2023 Fsa Corporate Issuers Fintree Juice Notes

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JuiceNotes 2023
Financial Statement Analysis |Corporate Issuers
Chartered Financial Analyst - Level I

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INDEX
Financial Statement Analysis
Name of Reading
15 Financial Statement Analysis:Introduction 6
16 Financial Reporting Standards 8
17 Understanding Income Statement 11
18 Understanding Balance Sheet 20
19 Understanding Cash Flow Statement 26
20 Financial Analysis Techniques 29
21 Inventories 33
e
22 Long-Lived Assets 39
23 Income Taxes 44
24 Long Term Liabilities 47
re
25 Financial Reporting Quality 53
26 Financial Statement Analysis:Applications 56
Corporate Issuers
nT
27 Corporate Structures and Ownership 60

28 Introduction to Corporate governance & other ESG 64
29 Business Models 69
30 Capital Investments 74
31 Sources of Capital
Fi
78
32 Cost of Capital - Foundational Topics 81
33 Capital Structure 84
34 Measures of Leverage 87
Financial Statement
Analysis
© 2023 FinTree Education Pvt. Ltd.
6
It is an independent review of an entity’s financial statements

Conducted by public accountants
To provide an opinion on fairness and reliability of financial statements
Auditor examines the company’s accounting and internal control systems, confirms
assets and liabilities, and tries to determine the financial statements are free of any
material errors
Unqualified opinion (Clean opinion) - Issued when financial statements are free from
material omissions and errors
Qualified opinion - Issued when financial statements deviate from accounting principles
Adverse opinion - Issued when financial statements are not presented fairly or are
materially nonconforming with accounting standards
Disclaimer of opinion - Issued when auditor is unable to express an opinion
Company’s management is responsible for maintaining an effective internal control
system to ensure the accuracy of its financial statements, not the auditor
All queries/doubts about this reading can be posted on Watch video with important
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7
● The SEC has the responsibility of enforcing the act (SOX).

● The act prohibits a company’s external auditor from providing
certain additional paid services to the company
● The act requires a company’s executive management to certify
that the financial statements are presented fairly management
is required to include a statement about the effectiveness of
company’s internal controls of financial reporting.
● Additionally, the external auditor must provide a statement
confirming the effectiveness of the company’s internal controls.
● In the European Union, each member state has its own
securities regulations, but all countries in the EU are required to
report using IFRS.
8
9
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testable concepts here
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10
= Gross Profit
= EBITDA
COGS = EBIT
= EBT
Interest = EAT
Depreciation
(+) Unrealised Losses/
Salaries
Total
11
Receiving cash from Accounts Receivable in future
Note : Sales is recorded after revenue earning activity (delivery of goods) is complete.
Note : Since goods are delivered now the liability is settled.
12
During the first year of construction, the builder incurs $60 million of costs.
13
14
15
16
17
also called
Stock split and Bonus Shares examples as stock dividend
18

Forum Link
Video Link
19
20
21
22
23
Debt Securities acquired

with intent to sell
Debt Securities
No intent to sell No intent

in near term to hold
24
25
26
27
Forum Link
Video Link
28
29
30
31
32
33
34
+
+
35
36
37
38
39
40
41
42
PAT, assets, equity Upward revaluation Incase of loss PAT

and ROE and ROA will increase assets and assets will
will decrease and equity decrease
Asset turnover ( ) Asset turnover ( ) Asset turnover ( )
Subsequent periods; Debt-to-assets and in case of gain PAT
PAT and ROE and debt-to-equity will and assets will
ROA will increase decrease increase

Forum Link
43
Video Link
44
45
Forum Link
Video Link
46
47
48
Lease is treated as capital lease for tax purposes

and operating lease for accounting purposes
49
50
Recognise “right of use”

(ROU) assets & lease
liability
Recognise “right of use”

(ROU) assets & lease
liability
inf low
51
Forum Link
Video Link
52
53
54
55
Forum Link
Video Link
56
57
Corporate Issuers
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Corporate Structures and Ownership

LOS a
Business Legal Operated Liability Profits Risks Business
Structure Identity by Growth
Sole No Owner Owner has Owner Owner Limited owner’s

Proprietorship unlimited ability to
liability finance and
personal risk
appetite
General No Partners Partners Shared by Shared by Limited by partners

Partnership have partners partners ability to
unlimited finance and
liability their risk appetite
Limited No Partners GP has Shared by Shared by Limited by partners

Partnership unlimited partners partners ability to
liability; LP finance and
has limited their risk appetite
liability
Corporation Separate Owner Limited by In Limited by Unlimited potential

equity proportion equity and
investment of equity investment access to capital
investment
US LLC US
Corporation
Taxation Personal Level Personal &

Corporate
Level
60
Business Liability
· Limited Liability: maximum loss is the amount invested
· Unlimited Liability: in case of insolvency, personal assets are also at stake
Public For-Profit
- Listed on
stock exchange
For-Profit
Private For-Profit
- not listed on
stock exchange
Types of
Corporations
Non-Profit -main objective is not

to earn profits
-no shareholders
-no dividends
-exempt from paying taxes
Capital
Ownership Capital Equity
· Shareholders
· Earn Dividends (Non tax deductible)
Borrowed Capital Debt

· Bondholders
· Earn Interest (Tax deductible)
61
LOS b
· Market Capitalization = Current Stock Price x Total Shares Outstanding

· Market Capitalization is the market value of the shares
· Enterprise Value = Market Value of Shares (+) Market Value of Debt (-) Cash
IPO, DL, Acquisition
Private Public
LBO, MBO
IPO DL
Underwriting Yes No
New Capital Yes No
ŸSpecial Purpose Acquisition Company (SPACs) is a means of acquiring a company. A SPAC is a shell
company (or blank check company), because it exists solely for the purpose of acquiring an unspecified
private company sometime in the future. SPACs raise money through IPOs, which is then kept in a
Trust A/c. SPACs have 18 months to complete the acquisition or else the money has to be returned to
the investors
Leveraged Buyout (LBO): Investors are not affiliated with the company
Management Buyout (MBO): Investors are members of the company (usually the management of the
company)
62
Life Cycle Start Up Growth Maturity Decline

Stages
Revenues Low to none Increasing Positive and Predictable Deteriorating
Cash Flow Negative Increasing Positive and Predictable Deteriorating
Business Risk High Moderate Low Increasing
Financial Need Proof Of Scale Business as usual Shortfalls

Concept
Financing Very High Very High to Moderate to low Increasing

Difficulty High
Financial Claims:
Debt Vs Equity Claim Difference
Legal recourse Lender
Contractual Lender
obligation
Claim priority
Lender
Corporation
No legal recourse Shareholder Shareholder Shareholder
Residual claim to net assets Shareholder Shareholder Shareholder
Shareholder Shareholder Shareholder
Debt Vs Equity
Debt Equity
Cheaper Costlier
Riskier Less risky
63
Corporate Governance and ESG

LOS a
1 Corporate governance System of internal controls and procedures by which individual
companies are managed.
A framework that defines rights, roles and responsibilities of

various groups
Arrangement of checks and balances a company needs to

minimize and manage the conflicting interests between insiders
and external shareowners.
2 Corporate governance theories
Shareholder Stakeholder
theory theory
Primary focus is the interest of Focus under this theory is

firm’s shareholders broader
firm’s common equity
e
Maximization of MV (not BV) of
CG is concerned with the conflict

of interest between managers
and owners
It considers conflict of interest
among several groups such as
shareholders, employees,
suppliers, customers and others.
re
LOS b Primary stakeholders of a
company
Shareholders Ÿ Voting rights

Ÿ Residual interest
nT
Ÿ Ongoing interest in profitability and growth, both increasing the value of their shares
BOD Ÿ Responsibility to protect the interest of shareholders
Ÿ To hire, fire and set the compensation of the firm’s senior managers
Ÿ Monitor financial performance and other ongoing activities.
Ÿ Firm’s executives (most-senior managers) serve on BOD along with directors who are
not otherwise employed by the firm.
Ÿ One-tier - Both executive and non-executive board members serve on a single BOD
Ÿ Two-tier - Non-executive board members serve on a supervisory board that oversees a
Fi
management board, made up of company executives.

Senior managers Ÿ Compensation - salary, bonus and perquisites
Ÿ Executive bonuses are tied to same measure of firm performance, giving them a strong
interest in financial success of the firm.
Employees Ÿ They have interest in the pay, opportunities for career advancement, training and
working conditions
Creditors Ÿ Providers of debt capital
Ÿ Do not have voting rights
Ÿ Do not participate in the firm’s growth beyond their promised interest and principal
payment
Suppliers Ÿ Ongoing relationship with the firm
Ÿ Typically short-term creditors
Ÿ They have interest in the firm’s solvency and ongoing financial strength
64
LOS c Conflict of interest
Principal-agent ª It arises because an agent is hired to act in the interest of the principal but
the agent’s interest may not coincide exactly with those of the principal.
Shareholders ª Shareholders are principals and board members are their agents
and managers ª Managers and directors are dependent on firm for employment
ª They may choose lower level of business risk than the shareholders would
or BOD
since their employment is dependant on firm’s performance.
ª There is an information asymmetry between shareholders and managers
because managers have more and better understanding of the functioning
of the firm. This decreases the ability of the shareholders or non-executive
directors to monitor and evaluate whether managers are acting in the best
interest of the shareholders.
Groups of ª A single shareholder or a group of shareholders may hold a majority of the

votes and act against the minority shareholders.
shareholders ª Some firms have different classes of shares, some with more voting power
than others.
ª In the event of an acquisition, controlling shareholders may be in a
position to get better terms for themselves than minority shareholders.
Creditors and ª Shareholders may prefer more risk than creditors do because creditors
shareholders have a limited upside from good result.
ª The company may raise prices or reduce product quality to increase
Shareholders
profits to the detriment of customers.
and other ª The company may employ strategies that significantly reduce taxes they
stakeholders pay to the government.
ee
LOS d Stakeholder management - Management of company relations with stakeholders
Infrastructures
Legal Contractual Organizational Governmental

infrastructure infrastructure infrastructure infrastructure
r
Legal recourse of Contract that spell out Company’s CG Comprises
stakeholders when rights and responsibilities procedures regulations to
nT
their rights are of company and the including its which companies
violated stakeholders internal systems are subject
LOS e Mechanism to manage stakeholder relationships
Ordinary Requires majority of Majority Candidate with most

resolution votes. Eg. approval voting votes for each single
Voting by Assigning one’s right of auditors, election board position is
Fi
proxy to vote to another of directors elected
Proxy is often a Special May require a Cumulative Shareholders can

director, member of resolution supermajority vote. voting cast all their votes to
management or Typically 2/3rd or one single board
shareholder’s 3/4thof votes Eg. candidate or divide
investment advisor mergers, takeovers. them among others.
Such special This can result in
resolutions can also greater minority
be addressed at EGMs shareholder
representation on
the board compared
to majority voting
65
LOS f 1 Board
structure
One-tier Two-tier
board board
Single BOD Two BODs
Internal directors / External directors / Supervisory board Management board

Executive directors Non executive directors
Excludes executive Made up of executive
Senior managers No other relationship directors directors
employed by the firm with the company. Also
termed as independent
Led by company’s CEO
directors
Chairman of the board is
sometimes the CEO
Lead independent director - Ability

to call meetings of independent
directors, separate from meetings
of the full board
ee
Staggered board - Elections for some board positions are held each year, thus limiting the ability of
shareholders to replace board members in any one year
2 Board responsibilities
ª Selecting senior management, setting their compensation, evaluating their performance

and replacing them as needed.
ª Setting strategic direction.
ª Approving capital structure changes, acquisitions and large investment expenditures.
r
ª Reviewing company performance and taking necessary corrective steps.
ª Planning for continuity of management and succession of the CEO.
ª Establishing, monitoring and overseeing firm’s internal controls and risk management
nT
system.
ª Ensuring the quality of the firm’s financial reporting and internal audit.
3 Board committees
Audit Governance Nominations Compensation Risk Investment

committee committee committee committee committee committee
Fi
Ÿ Implementation Ÿ CG code Ÿ Proposes qualified Ÿ Recommends to Ÿ Informs the board Ÿ Reviews and
of accounting Ÿ Implementing code of candidates for the board the about appropriate reports to the
policies ethics and policies election to the amounts of risk policy and board on
Ÿ Effectiveness of regarding conflict of board compensation to risk tolerance of management
internal controls interest be paid to the organization proposals for
Ÿ Recommending Ÿ Monitoring changes in directors and Ÿ Oversees large
external auditor laws and regulations senior managers. enterprise-wide acquisitions, sale
Ÿ Proposing Ÿ Ensuring company is risk management or disposal of
remedies based complying with all process company assets
on audits. laws and regulations or segments
66
LOS g Factors that affect stakeholder relationships and CG
1 Activist They pressure companies in which they

shareholders hold significant number shares for changes
Hedge funds have engaged in shareholder activism to
increase the MV of firms in which they hold significant stakes
Proxy fight can be initiated by the group by seeking the proxies of

shareholders to vote in favour of their alternative proposals and policies
An activist group may make a tender offer for specific no.

of shares to gain enough votes to take over the company
A threat of hostile takeover (the one not supported by management) can act as
an incentive thus influencing management and board to pursue policies more in
alignment with the interests of shareholders
2 Legal
environment
Common-law system Civil law system
Judges’ rulings become law Judges are bound to rule

in some instances based only on enacted laws
ee
Interests of creditors and
shareholders are
considered to be more
Rights of creditors are
more clearly defined than
those of shareholders.
protected in countries with Therefore not difficult to
this system enforce through the courts
LOS h Risks of poor CG and benefits of effective CG

r
When governance is weak and managers are not monitored, they may choose
lower-than-optimal risk, reducing company value
Risk is that, some stakeholders can gain an advantage to the disadvantage

nT
of other shareholders
Poor compliance procedures with respect to regulation and reporting can
easily lead to legal and reputational risks
Effective CG can improve operational efficiency by ensuring that management

and board member incentives align their interests with those of shareholders
Alignment of management interests with those of shareholders leads to better
Fi
financial performance and greater company value
LOS i Factors relevant to the analysis of CG
Elements of CG that analysts è Ownership and voting structure

1 è Board composition
have found to be relevant - è Management remuneration
è Composition of shareholders
è Strength of shareholder rights
è Management of long term risks
67
Dual class One class of shares may be entitled to several votes per share, while another
2
structure - class of shares is entitled to one vote per share
On average, companies with a dual class share structure have traded at a
discount to comparable companies with a single class of shares
LOS j Environmental and social considerations in investment analysis
ESG integration/investing - The use of environmental, social and governance factors in

making investment decisions
Also termed as sustainable investing, responsible investing

and socially responsible investing
LOS k 1 Usage of ESG in investment analysis
Negative Certain companies and certain sectors are excluded from portfolios.
screening - Eg. mining and oil production sector.
Positive No specific sectors are excluded from portfolios but investors identify
screening - best practices across environmental sustainability.
2
Impact
investing
ee
Investing in order to promote specific social or environmental goals.
Investors seek to make profit while at the same time having a

positive impact on the environment
Thematic Refers to investing based on a single goal. Eg.

investing development of clean water resources
r
nT
Fi
Forum Link
Video Link
68
Business Models
Business model types
Business Model : Helps analysts understand businesses
Channels :
Wholeseller Retailer
Manufacturer End-Customer
Direct Sales
Drop Shipping : Goods delivered directly from manufacturer to consumer without taking goods
into inventory
Omnichannel : Digital + Physical channels
Pricing and Revenue Models
Value Based Cost Based
Based on value Based on costs

received by customer incurred
Pricing discrimination : • Different prices for different customers

• Tiered pricing: based on volume
• Dynamic pricing: off-peak, surge, congestion
• Auction/ reverse auction: through bidding
69
Pricing for Multiple Products
Bundling Razors and Blades Optional Product

Pricing Pricing
Combining multiple Low price on an Customer buys

products so that equipment + High additional products or
customers are margin on repeat services either at the
incentivized. purchase time
Eg. Hotel rooms with consumable of purchase or
free breakfast Eg. Printer and printer afterwards
ink
Pricing for Rapid Growth
Penetration Freemium Hidden Revenue

Pricing Pricing Business Models
Firm willingly Customers get certain Services to users at no

sacrifices margins to level of usage at no charge and generate
build scale cost revenues
Eg. Netflix Eg. News apps elsewhere.
Eg. Online
marketplaces
70
Alternatives to Ownership
Recurring revenue/
Fractionalization Leasing Licensing Franchising
Subscription Pricing
Customers can rent selling assets in Shifting ownership Access to Franchiser gives
a product/ service smaller units of an asset from intangible assets franchisee right to
for as long as they Eg. Co-working the firm using it to sell or distribute
want the one that has its product or
lower costs for service
capital and
maintenance
Value Proposition : Product / service attributes valued by the firm’s target customers
Value chain : Systems / processes that create value for customers
Supply chain : Sequence of processes involved in the creation of a product
Unit economics : Revenues and costs explained on a per unit bases
Business Model Variations

• Private label / Contract
: Produce goods that are marketed by others
manufacturers
Licensing : Produce goods using other’s brand name in return for a royalty
Value added resellers : Distribute and handle complex aspects of product installation,
customization
Franchise models : Retailers have tightly defined and exclusive relationship with the parent
company
E-Commerce Business Model

Affiliate marketing : Generates commission revenue for sales generated on others website
Marketplace businesses : Creating network of buyers and sellers without taking ownership
of goods. Eg. Alibaba
Aggregators : Re-markets products/ services under its own brand

Network Effects and Platform Business Models
Network effects : Increase in value of a network to its users due to which more users join.
Eg. LinkedIn
Platform Business : Value is created in the network outside the firm.
Crowdsourcing and Business Models
Crowdsourcing : Users contribute directly to a product/ service/ online content.

Eg. Wikipedia
Firm Specific Factors
Asset-light business models : Shift in ownership of high-cost assets to other firms
Pay-in-advance : Reduce/ eliminate need for working capital
Explain and Classify types of Business and Financial Risks for a Company
Macro Risk :
Risk from political, economic, legal and other institutional factors. These affect all businesses
Business risk :
Risk that the firm’s operating results will be different from the expectations. It includes both industry
risk and company-specific risk
Financial risk :
Risk arising from company’s capital structure
Company-specific risk :
Ÿ Competitive risk: risk of a loss of market share or pricing power to competitors. Also arises from
potential disruption
ŸProduct market risk: risk that the market for a new product will fall short of expectations
72
Components of Leverage
Contribution
Operating
Leverage
EBIT
Total
Leverage
EBIT
Financial
Leverage
EBIT
73
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Capital Investments
LOS a Describe the capital allocation process and basic principles of capital allocation
1 Capital budgeting process 2 Categories of capital

budgeting projects
Idea generation
Replacement Replacement
projects to maintain projects for cost
the business reduction
Analyzing project Without detailed Fairly detailed
proposals analysis analysis
New product or
Expansion Projects market
development
Create the firm- wide
Very detailed Detailed analysis
capital budget
analysis
Other projects
Mandatory Projects such as R&D
Monitoring decisions and
conducting a post-audit
e Without detailed
analysis
2 Externalities
re
1 Basic principles of capital
budgeting
4Decisions are based on cash flows, not

Positive Negative
accounting income.
4Consider opportunity costs.

Positive effect on Negative effect on
nT
4Timing of cash flows is important. sales of a firm’s sales of a firm’s

other product lines. other product lines.
4Consider cash flows after tax.
4Ignore financing cost as a cash outflow.

Eg. Sales of cars will Cannibalization - New
increase business of project taking sales from
4Ignore sunk cost as it is irrelevant for
auto components in an existing product. Eg.
decision making Coke Vs Diet coke
future.
Fi
3 Conventional Unconventional
cash flow cash flow
pattern pattern
Sign on the cash flows Sign on the cash flows Problem of no IRR
changes only once changes more than once or multiple IRR
0 1 2 3 0 1 2 3
- 1000 500 500 500 - 1000 800 -600 300

74
LOS b Demonstrate the use of net present value (NPV) and internal rate of return (IRR) in allocating
capital and describe the advantages and disadvantages of each method
Selection of capital projects
Unlimited Capital
funds rationing
Independent Mutually exclusive
´ Unlimited access ´ Constraints on

select all select only one to capital raising capital
projects, if NPV project (with the ´ Firm can ´ Undertake
>0 highest NPV) undertake all projects with
profitable projects highest NPV
Project sequencing - Investment in a project today creates opportunity to invest in projects in future
Discounted
Payback Profitabilit
NPV IRR payback
period y index
period
PV of inflows −
PV of outflows
ee
Rate at which NPV
=0
Time taken to
recover initial
Time taken to
recover initial
© 20 23 FinTree Education Pvt. Ltd.
investment investment
PV of inflows
PV of outflows
PV of inflows = PV considering TVM

NPV = +ve PI > 1 = Accept
of outflows Shorter the
[Accept] PI < 1 = Reject
better Poor measure of
IRR > WACC = profitability
NPV = -ve Accept PI > 1 = +ve
Poor measure of NPV
[Reject] Good measure of
profitability
r
IRR < WACC = PI < 1 = −ve
liquidity
Reject NPV
Good measure
of liquidity DPB > PB
nT
Doesn’t
consider TVM &
CFs after PB
Fi
75
LOS c Describe expected relations among a company's investments, company value, and
share price
The NPV criterion is the criterion most directly related to stock prices.
+ NPV Increase company value

- NPV Decrease company value
Effect of inflation on capital budgeting analysis
Nominal cash flow Real cash flow
Nominal discount rate Real discount rate
If inflation is higher than expected Value of the project will be lower than expected
Inflation reduces tax savings from depreciation
Inflation decreases the value of bond payment to bondholders
Inflation will affect revenues and costs differently
LOS d
ee
Describe types of real options relevant to capital investment
Real options
Timing Abandonment Expansion/growth Flexibility Fundamental

r
options options options options options
nT
Give managers
Allow management choices regarding Whole investment
to abandon a the operational is an option.
project if PV of aspects of a Payoffs from the
Allow company to
incremental CFs project investment are
make additional
from abandoning a dependant on the
investment in a
Allow company to project exceeds Price-setting underlying asset,
project if doing so
delay making an the PV of options: just like financial
creates value
investment incremental CFs Demand > Supply options
Fi
from continuing a
Similar to call
project Production- Eg. Value of gold
options
flexibility options: mine is dependent
Similar to put Using different on the price of
options inputs/producing gold
different outputs
Real options: Options arising in capital budgeting decisions
76
LOS e
Common capital budgeting pitfalls
Not incorporating economic responses into the investment analysis
Misusing standardized project evaluation templates
Having overly optimistic assumptions for pet projects of senior management
Basing long-term investment decisions on short-term EPS or ROE
Using IRR to make investment decision

Poor estimation of cash flows
Overestimation/undersestimation of overhead costs
Using a discount rate that does not accurately reflect the project’s risk
Spending the entire capital budget
Failure to consider investment alternatives
Handling sunk costs and opportunity costs incorrectly

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77
Sources of capital
LOS a Describe types of financing methods and considerations in their selection
Internal and external Funding Sources
Internal External
Financial Capital
Other
Intermedlarles Markets
► After-tax operating ► Uncommitted lines of ► Commercial paper ► Leasing

cash flows credit ► Public and private
► Accounts payable ► Committed lines of debet
► Accounts receivable credit ► Hybrid securities
► Inventory & ► Revolving credit Preferred equity
marketable securities ► Secured loans Convertibles
► Factoring ► Common equity
Financing Considerations
Firm Specific Macroeconomic
► Company Size
► Taxation
► Riskiness of assets
► Inflation
► Assets for collateral
► Government policy
► Public versus private equity
► Monetary policy
► Asset liability management
► Debt maturity structure
► Currency risks
► Agency costs
► Bankruptcy cost
► Flotation costs
78
LOS b Primary and secondary sources of liquidity and factors that influence a
company's liquidity position
1 Sources of liquidity 2 Factors that influence a

company’s liquidity position
Primary Secondary DI PO
sources sources Drag on Inflows Pull on Outflows
Used in normal day to Used in deteriorating Eg. Uncollected Eg. Paying vendors
day operations financial conditions receivables, sooner than is
obsolete inventory optimal
è Selling good è Selling assets
è Collecting from AR è Negotiating debts Delay/reduce CF Accelerating cash
è Short-term funding (restructuring) or increase outflows
è Trade credit
è Line of credit
borrowing cost
LOS c Compare a company's liquidity position with that of peer companies
Liquidity Activity Higher the better

Ratios Ratios
4ARTR = Credit Sales / Avg Accounts Receivable

4Current ratio = CA / CL
4ITR = COGS / Avg Inventory
4Quick ratio (acid test ratio) = CA − Inventory/CL
4WCTR = Sales / Working Capital
4Cash ratio = Cash + Marketable Sec. / CL
4APTR = Purchases / Avg Accounts Payable
Lower the better
Accounts payable - 50
0 30 50 70
Inventory AR Cash
30 40
Operating cycle (70) = No. of days in Inventory (30) + No. of days in AR (40)
Cash conversion/Net operating cycle (20) = Operating cycle (70) − No. of days in AP (50)
79
LOS d Evaluate choices of short-term funding

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 do not substantially exceed market
averages
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80
Cost of Capital - Foundational Topic
LOS a 1 Calculation and interpretation of WACC
Capital Amount Weight Weighted

component average
Equity 1000 20% 20% 4%
2000 15% 40% 6%
Debt 2000 10% 40% 4%
Total 5000 100% 14%
Marginal cost of capital = Weighted average cost of capital WACC
ee 2 Costs
Equity Preferred Debt Tax Shield of

stock Interest
Kce Kps Kd x (1-t)

r
LOS b Impact of taxes on cost of capital
Interest paid on corporate debt is tax deductible
nT
No tax deduction is allowed for payments to common or preferred stockholders
LOS c Calculate and interpret the cost of debt capital using the yield-to-maturity
approach and the debt-rating approach
1. YTM of the bond is the cost of debt and not the coupon rate.
Fi
a. Kd = YTM*(1-t)
2. If market price of bond is not available, we use the following approach:

a. Debt rating approach - estimate the before tax cost of debt by
using the YTM on comparable rated bonds for maturities that
closely match that of company's existing debt
81
LOS d
Cost of Preferred Stock = Annual Preferred Dividends / Market Price of Preferred stock
LOS e Calculate and interpret the cost of equity capital using the capital asset pricing
model approach and the bond yield plus risk premium approach
Cost of equity
Capital Asset Gordon Growth Bond yield +

Pricing Model Model / Dividend Risk Premium
discount model
D1 + g PAT Ad hoc approach

Kce = RFR + (Rm - RFR) x β Kce =
P0 Equity
Analysts add a risk

Market Risk Premium Retention Ratio × ROE
premium to the
(MRP) market yield on
firm’s long term debt
DPS
1 − Payout ratio
EPS
ee
LOS f Explain and demonstrate beta estimation for public companies, thinly traded public
companies, and non public companies
1
Y = a + bx
r
Covariance (s,m)
Beta =
Dependant variable Variance (m)
nT
Independent variable
Intercept Slope/beta
2 Pure-play method
Fi
(Unlever) (Relever) Project beta

Beta of a comparable
Asset beta
company Divide Multiply (Equity beta)
D/E of D/E of
comparable our
company company
1 + D/E ratio
(1 − t)
82
3 Challenging issues with beta
Ê Beta is estimated using historical returns data. The estimate is sensitive to the length of
time used and frequency.
Ê Betas exhibit mean reversion tendency (aka beta drift).
Ê Beta of the entire market is 1, therefore all betas have a tendency to move toward 1 and
estimate may need to be adjusted.
Ê The estimate is affected by index chosen.
Ê Beta may need to be adjusted upward for small firms to reflect inherent risk in them.
LOS g Treatment of floatation cost
The correct method to account for floatation costs is to calculate the dollar amount of cost
and increase the initial cash outflow by this amount.
It should not be incorporated directly into the cost of equity because it is not an ongoing
expense and it would lead to increase in WACC which in turn will reduce the NPV

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83
Capital Structure
LOS a Capital structure and company life-cycle
+
Revenue
Cash flow
0 Time
Stage of life cycle
Revenue growth
ee
Start-up Growth
Financial management
Beginning Rising
Mature
Slowing
Cash flow Negative Improving Positive / Predictable
Business risk High Medium Low
Debt capital/leverage
r
Availability Very limited Limited/improving High
nT
Cost High Medium Low

Secured (by receivables Unsecured (bank
Typical cases N/A
fixed assets) and public debt)
Typical % of capital
Close to 0% 0%-20% 20%+
structure
1
Note: These ratios are calculated based on the market values of equity and debt
Fi
84
LOS b Explain the Modigliani–Miller propositions regarding capital structure

1 MM propositions
MM proposition I MM proposition I
No taxes With taxes

Value
Value of a firm is unaffected Value is maximized at

by its capital structure 100% debt
VL = VU VL = VU + (t × d)
MM proposition II MM proposition II
No taxes With taxes
Ke increases linearly as the WACC is minimized at 100%

Cost
company increases its debt debt
Ke = Ko + D/E (Ko − Kd) Ke = Ko + D/E (Ko − Kd) (1 − t)
Assumptions:
Œ No taxes, no transaction costs and no bankruptcy costs
Investors have same expectations with respect to CFs
Ž Borrowing and lending at RFR
No agency costs
Operating income is unaffected by changes in capital
LOS c Trade-Off Theory with Taxes and Costs of Financial Distress. Firm Value and the Debt-to-Equity
Ratio
Marketed value of the firm

Value of
levered firm
PV of costs
of financial
distress
PV of interest Value of levered firm

tax shields with financial distress
Value of
unlevered firm
Optimal debt/equity ratio
85
LOS d Explain factors affecting capital structure decisions
Corporate governance theories

2
Shareholder Stakeholder
theory theory
Primary focus is the interest of Focus under this theory is

firm’s shareholders broader
Maximization of MV (not BV) of It considers conflict of interest
firm’s common equity among several groups such as
shareholders, employees,
suppliers, customers and others.
Primary stakeholders of a
company
Shareholders
ee
Ÿ Voting rights
Ÿ Residual interest
Ÿ Ongoing interest in profitability and growth, both increasing the value of their shares
Senior managers Ÿ Compensation - salary, bonus and perquisites
Ÿ Executive bonuses are tied to same measure of firm performance, giving them a strong
interest in financial success of the firm.
Employees Ÿ They have interest in the pay, opportunities for career advancement, training and
working conditions
r
Creditors Ÿ Providers of debt capital
Ÿ Do not have voting rights
Ÿ Do not participate in the firm’s growth beyond their promised interest and principal
nT
payment
Suppliers Ÿ Ongoing relationship with the firm
Ÿ Typically short-term creditors
Ÿ They have interest in the firm’s solvency and ongoing financial strength
Fi
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86
Measures of Leverage
LOS a
1 Variable
Variable cost
cost
Fixed
Fixed cost
cost
Low leverage High leverage
2 Leverage refers to the amount of 3 Risks

fixed costs a firm has.
Financial risk Business risk
Operating fixed Financing fixed
cost (OFC) cost (FFC)
Sales risk Operating risk
Degree of
Operating
Leverage
ee
Degree of
Financial
Leverage
Uncertainty about
firm’s sales
Additional
uncertainty
about operating
earning
Additional risk borne

∆ operating ∆ net income
by shareholders
r
earnings > ∆ sales > ∆ operating
because of debt
earnings
financing
nT
LOS b
1 Degree of operating Degree of financial Degree of combined
leverage (DOL) leverage (DFL) leverage (DCL)
Fi
% ∆ EBIT
% ∆ sales
% ∆ EPS
DOL × DFL
% ∆ EBIT
Sales − VC
EBIT % ∆ EPS
EBIT
% ∆ sales
EBT
Highest at low level of
sales Sales − VC
If there’s no FFC,
EBT
DFL=1
If there’s no OFC,
DOL=1
87
+10% +10%
2 Sales 1000
Variable 400
cost
Contribution 600 Contribution % ∆ EBIT
1.5 DOL = Or
EBIT % ∆ Sales
Operating
200
fixed cost
DTL = DOL × DFL 3
+15%
EBIT 400
+15%
Interest 200
EBIT % ∆ EAT
EBT 200 2 DFL = Or
% ∆ EBIT
EBT
Taxes 100
EAT 100
+30% +30%
% ∆ Sales = % ∆ Contribution
% ∆ EBT = % ∆ EAT
% ∆ Net income = % ∆ PAT = % ∆ EPS
LOS c
ee
Effect of financial leverage on ROE
ROE = Net income Use of financial leverage increases the risk of default but also
Equity increases the potential return for equity shareholders
LOS d LOS e
r
Operating Operating fixed cost
Breakeven Level of sales a
breakeven
= Contribution per unit
firm must generate
nT
quantity - to cover its FC & VC

Total OFC + Interest
Sales = FC + VC breakeven = Contribution per unit
Breakeven
sales -
Net income = 0 Units to be sold OFC + Desired EBIT
Contribution - Sales − VC
to generate =
Contribution per unit
desired EBIT
Fi
Units to be sold OFC + Interest + Desired EBT

to generate =
desired EBT
To calculate units to be sold to generate desired EAT,
convert EAT to EBT then use the above formula
Fixed cost
Breakeven point (in amount) =
Contribution ratio
Contribution
Contribution ratio =
Sales
88
Eg. Operating fixed cost = 10,000 Financing fixed cost = 20,000 Tax rate = 50%
Selling price = 100 Variable cost = 60 Desired EBT = 30,000 Desired EBIT = 10,000 Desired EAT = 50,000
Contribution per unit = Selling price − Variable cost

= 100 − 60
= 40

Contribution ratio =
Sales per unit
40
=
100
= 40%
OFC
Operating breakeven =
10,000
=
40
= 250
OFC + FFC
Total breakeven (quantity) =
10,000 + 20,000
=
40
ee = 750
OFC + FFC
Total breakeven (in amount) =
Contribution ratio
10,000 + 20,000
=
40%
= 75,000
r
OFC + FFC + Desired EBT
Units to be sold to generate desired EBT =
nT
10,000 + 20,000 + 30,000

=
40
= 1,500
OFC + Desired EBIT

Units to be sold to generate desired EBIT =
10,000 + 10,000
Fi
=
40
= 500
89
OFC + FFC + (Desired EAT/1 − t)

Units to be sold to generate desired EAT =
10,000 + 10,000 + (50,000/1 − 0.5)
=
40
= 3,250

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Financial Statement Analysis |Corporate Issuers

Chartered Financial Analyst - Level I

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27 Corporate Structures and Ownership 60

It is an independent review of an entity’s financial statements

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● The SEC has the responsibility of enforcing the act (SOX).

All queries/doubts about this reading can be posted on

Receiving cash from Accounts Receivable in future

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Debt Securities acquired

No intent to sell No intent

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PAT, assets, equity Upward revaluation Incase of loss PAT

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Lease is treated as capital lease for tax purposes

Recognise “right of use”

Recognise “right of use”

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A normal person spends about two-three hours travelling

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Corporate Structures and Ownership

Sole No Owner Owner has Owner Owner Limited owner’s

General No Partners Partners Shared by Shared by Limited by partners

Limited No Partners GP has Shared by Shared by Limited by partners

Corporation Separate Owner Limited by In Limited by Unlimited potential

Taxation Personal Level Personal &

Non-Proﬁt -main objective is not

Borrowed Capital Debt

· Market Capitalization = Current Stock Price x Total Shares Outstanding

IPO, DL, Acquisition

New Capital Yes No

Life Cycle Start Up Growth Maturity Decline

Revenues Low to none Increasing Positive and Predictable Deteriorating

Cash Flow Negative Increasing Positive and Predictable Deteriorating

Business Risk High Moderate Low Increasing

Financial Need Proof Of Scale Business as usual Shortfalls

Financing Very High Very High to Moderate to low Increasing

Legal recourse Lender

No legal recourse Shareholder Shareholder Shareholder

Residual claim to net assets Shareholder Shareholder Shareholder

Shareholder Shareholder Shareholder

Riskier Less risky

Corporate Governance and ESG

A framework that defines rights, roles and responsibilities of

Arrangement of checks and balances a company needs to

2 Corporate governance theories

Primary focus is the interest of Focus under this theory is

firm’s common equity

CG is concerned with the conflict

Shareholders Ÿ Voting rights

management board, made up of company executives.