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Financial Analysis Chapter 7 Page 1 of 15
Financial Analysis: A User Approach
Chapter 7
An Accounting Analysis Perspective
Earnings
Revenue Recognition
Accounting to FASB Concept Statement No. 5 states that two
criteria must be satisfied before revenue can be recognized –
the revenue must be realized and earned
Realized (or realizable) – Revenues are realized when
products (goods or services), merchandise, or other assets
are exchanged for cash or claims to cash. Revenues and
gains are realizable when related assets received or held
are readily convertible to known amounts of cash or claims
to cash.
Earned - Revenues are not recognized until earned.
Revenues are considered to have been earned when the
entity has substantially accomplished what it must do to
be entitled to the benefits represented by the revenues.
Financial Analysis Chapter 7 Page 2 of 15
Concepts Statement 5 continues and provides the following
additional detail related to revenue recognition:
1. The two conditions are usually met by the time product or
merchandise is delivered or services are rendered to
customers, and revenues from manufacturing and selling
activities are commonly recognized at time of sale (usually
meaning delivery)
2. If sale or cash receipt (or both) precedes production and
delivery, revenues may be recognized as earned by
production and delivery.
3. If product is contracted for before production, revenues
may be recognized by a percentage-of completion method
as earned—as production takes place—provided
reasonable estimates of results at completion and reliable
measures of progress are available.
4. If services are rendered or rights to use assets extend
continuously over time, reliable measures based on
contractual prices established in advance are commonly
available, and revenues may be recognized as earned as
time passes.
5. If products or other assets are readily realizable because
they are salable at reliably determinable prices without
significant effort, revenues and some gains or losses may
be recognized at completion of production or when prices
of the assets change.
Financial Analysis Chapter 7 Page 4 of 15
SAB 101 and 104
In 1999, SEC Staff Accounting Bulletin was issued because
there were substantial concerns about aggressive revenue
recognition practices among registrants
SAB 104 was subsequently issued in 2003 as an
amendment of 101
SAB 101/104 did not change any of the revenue
recognition concepts or methods that previously existed, it
simply “reminded” registrants what the concepts and
methods were
SAB 101/104 did introduce a four criteria test used to
evidence that revenue is both realized or realizable and
earned:
o Persuasive evidence of an arrangement exists. The use of
the term "arrangement" is meant to identify the final
understanding between the parties as to the specific nature
and terms of the agreed-upon transaction.
o Delivery has occurred or services have been rendered.
o The seller's price to the buyer is fixed or determinable,
which means that the amount to be paid is a set amount
that is not subject to refund or adjustment.
o Collectibility is reasonably assured.
Hundred of registrants restated their financial statements
and revised their revenue recognition polices in response
to SAB 101/
Financial Analysis Chapter 7 Page 5 of 15
Expense Recognition
Generally expenses are the cost incurred to produce
revenues, so expense recognition is linked to revenue
recognition
The general name for this approach is the “matching
principle” in that expenses are matched to revenues
Product costs are cost that can be directly related to
revenues
Period costs have no cause and effect relationship to
revenues but are consumed during the period
Allocated costs are costs that benefit more than one
accounting period
Revenue and Expense Recognition Policy Disclosures
Firms report their revenue and expense policies in the
financial statements, typically this information is included
in a footnote, often the first one
Financial Analysis Chapter 7 Page 7 of 15
The Company establishes certain distributor and OEM sales programs aimed at increasing customer
demand. For the distribution channel, these programs typically involve rebates related to a distributor’s
level of sales, order size, advertising or point of sale activity and price protection adjustments. For OEM
sales, rebates are typically based on an OEM customer’s volume of purchases from the Company or
other agreed upon rebate programs. The Company provides for these obligations at the time that
revenue is recorded based on estimated requirements. The Company estimates these contra-revenue
rebates and adjustments based on various factors, including price reductions during the period
reported, estimated future price erosion, customer orders, distributor sell-through and inventory levels,
program participation, customer claim submittals and sales returns. The Company’s estimates reflect
contractual arrangements but also the Company’s judgment relating to variables such as customer claim
rates and attainment of program goals, and inventory and sell-through levels reported by the
Company’s distribution customers. During periods in which the Company’s distributors’ inventories of its
products are at higher than historical levels, the Company’s sales programs estimates are subject to a
greater degree of subjectivity and the potential for actual results to vary is accordingly higher. Currently,
the Company’s distributors’ inventories are within the historical range. Significant actual variations in
any of the factors upon which the Company bases its contra-revenue estimates could have a material
effect on the Company’s operating results. In addition, the Company’s failure to accurately predict the
level of future sales returns by its distribution customers could have a material impact on the Company’s
financial condition and results of operations.
The Company estimates probable product warranty costs at the time revenue is recognized. The
Company generally warrants its products for a period of three to five years. The Company’s warranty
provision considers estimated product failure rates and trends (including the timing of product returns
during the warranty periods), estimated repair or replacement costs and estimated costs for customer
compensatory claims related to product quality issues, if any. The Company uses a statistical model to
help with its estimates and the Company exercises considerable judgment in determining the underlying
estimates. Should actual experience in any future period differ significantly from its estimates, or should
the rate of future product technological advancements fail to keep pace with the past, the Company’s
future results of operations could be materially affected. The Company’s judgment is subject to a
greater degree of subjectivity with respect to newly introduced products because of limited experience
with those products upon which to base its warranty estimates. The Company continually introduces
new products.
The actual results with regard to warranty expenditures could have a material adverse effect on the
Company’s results of operations if the actual rate of unit failure, the cost to repair a unit, or the actual
cost required to satisfy customer compensatory claims are greater than that which the Company has
used in estimating the warranty accrual. The Company also exercises judgment in estimating its ability to
sell certain repaired disc drives. To the extent such sales fall below the Company’s forecast, warranty
cost will be adversely impacted.
Financial Analysis Chapter 7 Page 8 of 15
EBIT and EBITDA
EBIT is earnings before interest and taxes (a/k/a operating
earnings)
EBITDA is earnings before interest, taxes, depreciation,
and amortization. EBITDA is somewhat similar to the cash
flow from operating activities, but with smoothing related
to accruals.
EBIT and EBITDA will be different from net income when:
o There are large nonrecurring items
o The company has a lot of debt or a lot of cash
o The company owns a lot of depreciable assets and
limited-life intangibles
Financial Analysis Chapter 7 Page 10 of 15
SEAGATE TECHNOLOGY
CONSOLIDATED STATEMENTS OF OPERATIONS
(In millions, except per share data)
Fiscal Year Ended June 27,
2008
June 29,
2007
June 30,
2006
Revenue $ 12,708 $ 11,360 $ 9, Cost of revenue 9,503 9,175 7, Product development 1,028 904 805 Marketing and administrative 659 589 447 Amortization of intangibles 54 49 7 Restructuring and other 88 29 4 Total operating expenses 11,332 10,746 8, Income from operations 1,376 614 874 Interest income 57 73 69 Interest expense (126) (141) (41) Other, net 22 15 22 Other income (expense), net (47) (53) 50 Income before income taxes 1,329 561 924 Provision for (benefit from) income taxes 67 (352) 84 Net income $ 1,262 $ 913 $ 840
2008 2007 2006
Net Income 1,262 913 840
Interest & Taxes 114 (299) 34
EBIT 1,376 614 874
Deprec. & Amort.* 844 851 612
EBITDA 2,220 1,465 1,
- From Statement of Cash Flows
Net Income
EBIT
EBITDA
Financial Analysis Chapter 7 Page 11 of 15
Comprehensive Income
Recall that companies must report both Net Income and
Comprehensive Income
The most common differences are:
o Translation Gains and Losses Related to Foreign
Operations
o Unrealized Holding Gains and Losses on Available for
Sale Securities
o Fair Value Gains and Losses Related to Derivatives
Used as Cash Flow Hedges
Comprehensive Income is most commonly reported in the
Statement of Changes in Stockholders’ Equity
Other Earnings Concepts
Many companies compute pro forma earnings
Pro forma earnings are computed as if certain items
included in net income are treated differently
A/K/A EBBS – Earnings Before the Bad Stuff
In 2003, the SEC adopted a rule which requires that when
a company reports any “non-GAAP financial measure”
(SEC’s term for pro forma amounts) it must be reconciled
to the reported GAAP measure
S&P has its own earnings measure called “Core Earnings”
Financial Analysis Chapter 7 Page 13 of 15
SEAGATE TECHNOLOGY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In millions)
Fiscal Year Ended June 27,
2008
June 29,
2007
June 30,
OPERATING ACTIVITIES^2006 Net income $ 1,262 $ 913 $ 840 Adjustments to reconcile net income to net cash from operating activities: Depreciation and amortization 844 851 612 Stock-based compensation 113 128 90 Deferred income taxes 10 (365) 23 Allowance for doubtful accounts receivable, net of recoveries (3) 40 — Redemption charges on 8% Senior Notes due 2009 — 19 — In-process research and development 4 4 — Tax benefit from stock options (6) — (44) Non-cash portion of restructuring and other 2 19 — Other non-cash operating activities, net (12) 17 12 Changes in operating assets and liabilities: Accounts receivable (67) 34 (190) Inventories (151) 106 (113) Accounts payable 351 (391) 91 Accrued expenses, employee compensation and warranty 154 (465) 120 Accrued income taxes 13 8 54 Other assets and liabilities 24 25 (38) Net cash provided by operating activities 2,538 943 1, INVESTING ACTIVITIES Acquisition of property, equipment and leasehold improvements (930) (906) (1,008) Proceeds from sale of fixed assets 29 55 — Purchases of short-term investments (486) (322) (3,220) Maturities and sales of short-term investments 460 997 3, Net cash and cash equivalents acquired from Maxtor — — 297 Acquisitions, net of cash and cash equivalents acquired (78) (178) (28) Other investing activities, net 14 (48) (130) Net cash used in investing activities (991) (402) (561) FINANCING ACTIVITIES Net proceeds from issuance of long-term debt — 1,477 — Repayment of long-term debt (34) (5) (340) Redemption of 8% Senior Notes due 2009 — (400) — Redemption premium on 8% Senior Notes due 2009 — (16) — Proceeds from exercise of employee stock options and employee stock purchase plan 178 219 118 Dividends to shareholders (216) (212) (155) Tax benefit from stock options 6 — 44 Repurchases of common shares (1,479) (1,526) (399) Net cash used in financing activities (1,545) (463) (732) Increase in cash and cash equivalents 2 78 164 Cash and cash equivalents at the beginning of the period 988 910 746 Cash and cash equivalents at the end of the period $ 990 $ 988 $ 910 Supplemental Disclosure of Cash Flow Information Cash paid for interest $ 121 $ 88 $ 38 Cash paid for income taxes, net of refunds 34 38 15
Financial Analysis Chapter 7 Page 14 of 15
CFO 2,538 943 1,
CFI (991) (402) (561)
CFF (1,545) (463) (732)
Inc/(Dec) in Cash 2 78 164
FCF 1,547 541 896
Total Liabilities 5,534 4,735 4,
CFO/TL .46 .20.
# Shares (Basic) 542 558 495
EPS 2.46 1.64 1.
CFOPS 4.68 1.68 2.
CapEx 930 906 1,
Inventory Inc/(Dec) 151 (106) 113
Cash Dividends 216 212 155
CFA =
