For equity research and investment roles, a very good understanding of accounting is required to parse through financial statements and figure out what does and does not matter.
Understanding how things flow through the three statements and how foreign operations affect company profits and cash flow is especially important for companies that are exposed to multiple countries.
Foreign exchange questions are usually not asked unless the candidate has an accounting degree or is interviewing for an equity research position that focuses on companies that have very global operations – multinationals for one (such as Coca Cola or Procter & Gamble) or international supply chain operations that see their revenues in USD (for example, suppliers for the global smartphone market).
These topics will all be covered by intermediate accounting courses (300 level) and CFA Levels I & II – which is a reason why investment analyst and equity/credit research positions stress the CFA designation.
Walk through the three statements
On December 31, 2017, Company A announces it will be increasing its planned capex in 2018 by $10.
Income statement – no change
Cash flow statement – Cash flow from operations (CFO) is unchanged, $10 of cash is used in investing activities so (CFI) is -$10, and cash flows from financing (CFF) are unchanged. Net change in cash is -$10.
Balance sheet – Cash decreases by $10 while property, plant and equipment rise by $10. Assets are unchanged, liabilities are unchanged and shareholder’s equity is unchanged.
On December 31, 2017, Company A issues a bond worth $20 with a 5% coupon.
Income statement – Throughout the year, interest is 5% of $20 is $1. Interest expense goes up by $1, net income falls by $1.
Cash Flow statement – net income is $1 lower, so CFO is $1 lower. CFI is unchanged. Issuing the bond means that $20 is raised so CFF goes up by $20. Cash goes up by $19.
Balance sheet – Cash goes up by $19, so assets rise by $19. Debt goes up by $20, so liabilities are up by $20. Lower net income means retained earnings are $1 lower, so A + 19, L + 20, SE – 1; change in A = change in L + SE.
What is a better indicator of profitability?
EBITDA or NPAT?
EBITDA is earnings before interest, taxes, depreciation and amortization while NPAT is net profit after tax. NPAT is a better indicator of profitability because it is profitability whereas EBITDA is a pre-leverage and pre-tax metric that also strips out depreciation. These are dependent on capital structure and capital spending, so EBITDA does not tell the whole story.
Cash flow vs EBITDA
Cash flow is a better measure of profitability because cash flow is post tax and post interest. Also, for a firm with finite life, capex should eventually equal depreciation less a salvage – capex is a reality for most operating companies, so EBITDA will not capture all of the cash that is available to stakeholders.
What are possible scenarios for the following:
Company A and B both trade at 15x Price-to-Earnings, however Company A trades at 10x EV/EBITDA versus 6x for Company B.
EV/EBITDA is pre-leverage while Price/Earnings is after capital structure. It could be that company A and B are in different industries and have different levels of debt but end up both trading at 12x P/E.
Company A and B have ROE of 25%; however, Company A has a net profit margin of 15% while company B has a net profit margin of 10%.
They could be different companies in different industries – or company B is more levered than Company A, so while the profit is smaller for the revenue, it ends up being a match for the amount of equity that shareholders have put in versus other capital providers.
Foreign Operations and Accounting
For a Canadian company with large USD revenues, how will a depreciating USD affect earnings, margins and capex?
If sales are in USD (like an oil company), a lower USD will result in lower sales. If costs are in USD (like an airline, which buys fuel that will be based off a USD traded commodity), a depreciating USD will result in lower operating expenses. How this affects earnings is based on whether there is a net inflow or outflow of USD. If you have more USD revenues than costs, this means a depreciating dollar is bad and vice versa – likewise for margins.
For capex, if it is denominated in USD, a depreciating dollar will result in lower capital expenditures and accordingly lower depreciation assuming that the PP&E was constructed on domestic soil and capitalized in the book value.
For financial assets such as accounts receivable denominated in a foreign currency, what happens when the exchange rate changes?
Changes in monetary assets are run through profit and loss.
A foreign currency transaction should be recorded initially at the rate of exchange at the date of the transaction (use of averages is permitted if they are a reasonable approximation of actual). [IAS 21.21-22]
At each subsequent balance sheet date: [IAS 21.23]
- foreign currency monetary amounts should be reported using the closing rate
- non-monetary items carried at historical cost should be reported using the exchange rate at the date of the transaction
- non-monetary items carried at fair value should be reported at the rate that existed when the fair values were determined
Exchange differences arising when monetary items are settled or when monetary items are translated at rates different from those at which they were translated when initially recognised or in previous financial statements are reported in profit or loss in the period, with one exception. [IAS 21.28] The exception is that exchange differences arising on monetary items that form part of the reporting entity’s net investment in a foreign operation are recognised, in the consolidated financial statements that include the foreign operation, in other comprehensive income; they will be recognised in profit or loss on disposal of the net investment. [IAS 21.32]
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