BEC Flashcards
What is internal control?
(ORC - 3 objectives of COSO framework)
Process designed and implemented by an organization’s management, Board and employees to provide reasonable assurance that the organization will achieve its operating, reporting and compliance objectives.
How does COSO framework assist management and the board?
- Effective application of internal controls
- Determine requirements of an effective system of internal control
- Allows for judgment + flexibility in design and implementation within all operational and functional areas
- Identify + analyze risks to develop acceptable actions to mitigate or minimize risks to an acceptable level
- Eliminate redundant, ineffective, or inefficient controls
- Extend internal control application beyond financial reporting. Main focus: Efficient & effective: Operations + Compliance with laws/ regulations
What does the COSO cube illustrate?
COSO cube links all 5 (five) components with all three (3) objectives categories and ALL levels of the organizational structure, everything is interrelated, which is illustrated by the cube itself.
What is the COSO cube?
COSO cube depicts relationship between entity objectives, integrated internal control components and organizational structure.
Includes three (3) objectives “ORC”:
* Operations
* Reporting
* Compliance
Includes five (5) internal control components “CRIME”:
* Control environment
* Risk assessment
* Information & Communication
* Monitoring activities
* Existing control activities
Includes four (4) levels of organizational structure:
* Entity level
* Division
* Operating unit
* Function
How can COSO framework provide value to stakeholders?
COSO framework enables external stakeholders to gain greater understanding and/or confidence on:
- What constitutes as an “effective” system of internal controls
- Management will be able to eliminate ineffective, redundant or inefficient controls
- Board has effective oversight of organization’s internal controls
- Organization will achieve its stated objectives and is capable of identifying, analyzing and responding to risks
What are the three (3) categories of objectives in the COSO framework?
(ORC numenoic)
- Operations - relates to effectiveness and efficiency and ensuring that organization assets are adequately safeguarded.
- Reporting (focus of COSO) - pertain to reliability, timeliness, and transparency of entity’s external + internal financial and non-financial reporting established by regulators.
- Compliance - ensures entity is adhering to laws + regulations.
What are the components of Internal Control?
(CRIME nemonic)
CRIME applies to all three (3) “ORC” categories. It represents the five (5) integrated components of internal control.
CRIME + seventeen (17) related fundamental principles are needed to achieve the three (3) objectives of internal control.
- Control environment - tone at the top (ethics)
- Risk assessment- FS misstated, not efficient, breaking the law
- Information and communication - fair, accurate, complete, and timely “FACT nemonic”
- Monitoring - effectiveness of controls & report deficiencies
- Existing Control Activities - Policies/procedures to mitigate risks
What is control environment?
- Component of internal controls
- EBOCA nemonic
Control environment includes processes, structures and standards that provide the foundation for entity to establish a system of internal control through “tone at the top” approach. It includes the following:
- Ethics - establish standards of conduct
- Board independence - oversight responsibilities
- Organizational structure - establish reporting lines and ensure authority and responsibility are appropriate
- Commitment to competence - hire, develop, retain competent EE’s
- Accountability - establish performance measures, incentives and rewards
What is risk assessment?
- Component of internal controls
- SAFR nemonic
Risk assessment makes entity “SAFR”
Risk assessment is an entity’s identification and analysis of risks to achievement of objectives. Four (4) principles related to risk assessment are:
- Specify objectives - identification and assessment of risks
- Analyze risks - how risks should be managed
- Potential for Fraud - assessing incentives, pressures, opportunities, attitudes and rationalizations
- Assess changes - in external environment, business model and leadership
What is information and communication?
- Component of internal controls
- OIE and FACT nemonic
Information and communication is between internal and external parties. Three (3) principles “OIE” relate to this internal control component:
- Obtain or generates and uses relevant high quality information that is fair, accurate, complete and timely “FACT”
- Internally communicate information to internal audit, audit committee and management. Information flows up, down and across organization
- Communication with external parties such as CPA firm and consultants. Management has two-way external communication channels using various methods and channels.
What are monitoring activities?
- Component of internal controls
- SO D nemonic
Monitoring is process of assessing quality of internal control performance by assessing design + operating effectiveness of controls.
Monitor “SOD” or grass wont grow. Two (2) principles related to monitoring activities are:
- Ongoing + separate evaluations performed to determine whether the components of internal control are present + functioning. Frequency of testing dictated by risk.
- Communication (reporting) of internal control deficiencies in timely manner for corrective action.
What are control activities?
- Component of internal controls
- CA TP nemonic
Control activities are established in entity’s P&P’s to mitigate risks. These may be detective or preventative + includes segregation of duties. Three (3) principles related to control activities are:
- Select + develop control activities to mitigate risks.
- Select + develop technology controls to support achievement of objectives.
- Deploy and put P&P’s into action
What are the seventeen (17) principles within each of the five (5) components of internal controls that are associated with the COSO objectives (operations, reporting and compliance)?
Five (5) components of internal control = CRIME
- Control Environment “EBOCA”
* Commitment to ethical values + integrity
* Board independence + oversight
* Organizational structure
* Commitment to competence
* Accountability - Risk assessment “SAFR”
* Specify objectives
* Identify + assess changes
* Consider potential for fraud
* Identify + analyze risks - Information and communication “OIE”
* Obtain and use info
* Internally communicate information
* Communicate w/external parties - Monitoring activities “SO D”
* Ongoing and/or separate evaluations
* Communication of deficiencies - (Existing) Control activities “CA T P”
* Select + develop control activities
* Select + develop technology controls
* Deploy through P&P’s
The five (5) components of internal controls and seventeen (17) principles within the components are said to be relevant (flexible) as well as present and functioning.
What does present and functioning mean?
Present (Design) - components and relevant principles are included in the design and implementation of the internal control system.
Functioning (Operating Effectively) - demonstrates that the components and relevant principles are operating as designed in the internal control system.
What is COSO definition of risk?
Risk is the possibility that events will occur and affect the achievement of strategy and business objectives.
What is the underlying premise of ERM?
Entities exist to provide value for stakeholders and face risk in the pursuit of value. Management decisions affect the development of value including its creation, preservation, erosion, and realization.
How is value defined within ERM?
Value is defined by entity type:
For-profit commercial entities - shaped by strategies that balance market opportunities against risks pursuing those opportunities.
NFP/ Governmental entities - shaped by delivering goods/services that balance opportunity to serve broader community against associated risks.
What are the components of value creation within ERM?
(CPER nemonic)
Develop value to make it “CPER”
- Value created when benefits > costs of resources used.
- Value erosion - costs > benefits, stock price decrease, ROIC < cost, -NPV. Erosion created due to faulty strategy + inefficient/ ineffective operations.
- Value realization - realized from benefits created by organization received by stakeholders [dividends/ SP > cost “capital gain”] that are monetary or nonmonetary (customer satisfaction, brand and leadership) form.
What does mission, vision and core values mean within ERM?
These define what an entity strives to be (successful) and how it wants to conduct business (ethically)
- Mission (objectives) - core purpose + why entity exists
- Vision (strategy) - what entity hopes to achieve
- Core values - “How” to achieve goals with ethics, culture and core values. Represents beliefs and ideas about what is good/ bad
What is Enterprise Risk Management?
(CCPIS nemonic)
ERM is the culture, capabilities, and practices with strategy-setting and performance that organizations rely on to manage risk in creating, preserving and realizing value.
CCPIS - to manage risk and create value
Culture - core values, collective thinking and shaping decisions.
Capabilities- competitive advantage and exploitation.
Practices - continually applied at all levels of the entity.
Integration w/strategy-setting and performance that aligns with mission and vision:
* Why do you exist - mission
* What’s your strategy/mission
Mission and values correlate w/strategy and business objectives.
What is risk appetite?
Risk appetite is an entity willingness to assume risk. It is expressed as a range and provides guidance on whether an entity should pursue or not pursue:
- Mission aligns with an entity “why” which is impacted by industry
- Vision aligns with “how” (an entity strategy - aggressive/ conservative)
- Risk appetite varies and is flexible
What is the relationship between value and risk appetite?
Both are directly related:
* Risk assumed
* Expected return
What are the components of ERM?
(GO PRO nemonic)
ERM has five (5) components and twenty (20) risk management principles. They are similar to the COSO cube for internal control but address broader issues of risks.
- Governance and culture
* Tone at the top, core values, EBOCA
* Control environment from CRIME nemonic - Strategy and Objective-setting
* Mission/vision - defines risk appetite
* Risk assessment and control activities from CRIME nemonic
* SAFR nemonic - Performance
* Evaluate, ID and respond to risk using ARTS nemonic
* Risk assessment and control activities from CRIME nemonic
* SAFR nemonic - Review and revision - assess substantial changes and pursue improvements
* Monitoring from CRIME nemonic - Information (IT), Communication (risk info) and Reporting Ongoing (performance)
* Information and communication from CRIME nemonic
* OIE nemonic
* CATP and SOD nemonic blended in: obtain info (FACT), internal and external communications
What are the twenty (20) principles within each of the five (5) components ERM?
Five (5) components of ERM = GO PRO
- Governance and Culture “DOVES”
* Defines desired culture
* Exercises board oversight
* Demonstrates commitment to core values - tone at the top
* Attracts, develops, and retains EE’s
* Establishes operating structure - Strategy and Objective setting “SOAR”
* Evaluates alternative strategies - what is the vision?
* Formulates business objectives - why do we exist (mission)?
* Analyzes business context
* Defines risk appetite - Performance “VAPIR”
* Develops portfolio view - Parent level
* Assesses severity of risk
* Prioritizes risk
* Identifies risks (events)
* Implements risk responses - using “ARTS” nemonic - Review and Revision “SIR”
* Assesses substantial change
* Pursue improvement in ERM
* Reviews risk and performance - How did we do with managing risk? Did we use the right hedge? - Information, Communication, and Reporting Ongoing “TIP”
* Leverages information and technology
* Communicates risk information
* Reports on risk, culture and performance
What is governance and culture?
- Component of ERM
- DOVES nemonic
Governance and culture is an entity tone at the top and culture of the organization. The five (5) principles are:
- Defines desired culture - spectrum that progresses from risk adverse to risk neutral and extends to risk aggressive.
* How conservative or aggressive do we want to be? - Exercises board oversight - entity strategy + business objectives
- Demonstrates commitment to core values - support from the top of the organization, adopt a code of conduct
- Attracts, develops and retain EE’s - Board selection of executive leadership and HR assisting management to staff competent + capable individuals
- Establishes operating structure - How an entity carry out day-to-day operations
* Centralized vs. Decentralized
* Degree of operating leverage - FC (salary) and/or versus VC (commission)
The ability of an organization to successfully achieve its strategy and business objectives is impeded when the behaviors and decisions of the organization (culture) do not align with its core values.
What is strategy and objective-setting?
- Component of ERM
- SOAR nemonic
Strategy and objective-setting is how an entity sets its risk appetite with strategy-setting. Objectives enable strategy to be put into place. The four (4) principles are:
- Evaluates alternative strategies - more equity/less debt, more VC/less FC, low risk but low return
- Formulates business objectives that are specific, measurable or observable and attainable. They relate to financial performance, customer aspirations, and operational efficiency.
* Must be realistic given risk assumed - Analyze business context external and internal.
- Defines risk appetite in qualitative terms (goal based- how critical) and quantitative (standard deviation). Expressed in ranges with a ceiling and floor.
* Must be suitable for entity
What is performance?
- Component of ERM
- VAPIR nemonic
Performance is the identification and assessment of risk prioritization based on severity. Risk responses are selected and monitored “ARTS nemonic”. Similar to a risk assessment in COSO internal control framework. The five (5) principles are:
- Develops portfolio view and evaluates from an entity-wide view (parent level)
- Assesses severity of risk at multiple levels. Risks deemed severe at the operating level may be less of a concern at division or entity level b/c well diversified. Entity identifies triggers to reassessed severity of risk
Risks can be the following:
* Inherent - cyclical demographics
* Target residual - entity prefers to assume in pursuit of strategy (DOL/ DFL)
* Actual residual risk after management has taken action - pay low for insurance, high deductible - helps entity prioritize risk
- Prioritizes risk - interest rate, currency, competition
- Identify risks
- Implement risks “ARTS” nemonic
- Avoid - leaving a line of business (get out). High-High for Frequency/likelihood & Severity impact
- Reduce - hedging to reduce severity of risk (security alarms, use derivatives). High-Low for Frequency/likelihood & Severity impact
- Transfer - sharing to reduce severity of risk (buy insurance). Low-High for Frequency/likelihood & Severity impact
- Self-insure - Acceptance of risks most appropriate when risk is within entity risk appetite - inherent in industry (self-insure). Low-Low for Frequency/likelihood & Severity impact
- Entity can also pursue risk to amplify return (DOL/ DFL). Management would do this when they understand the nature and extent of changes
What is review and revision?
- Component of ERM
- SIR nemonic
Review and revision is reviewing an entity risk management capabilities/practices relative to targets. The three (3) principles are:
- Assesses substantial change - Internal (change in officers) and External (threat substitute product)
- Pursue improvement in ERM (efficiency and usefulness)
- Reviews risk and performance (was hedge effective?)
What is information, communication and reporting ongoing?
- Component of ERM
- TIP nemonic
Information, communication, and reporting ongoing is the iterative process of obtaining relevant information (internal and external) and sharing it throughout the entity. The three (3) principles are:
- Leverages information and technology relevant information that is fair, accurate, complete and timely which is a competitive advantage. Data management is integral to risk-aware decisions. Similar to “OIE” nemonic.
- Communicates risk information (MDA) to internal and external stakeholders.
- Reports on risk, culture and performance (MDA) from a portfolio view of risk at the entity level (parent level) as well as at different levels (subsidiary/ product line).
What does the revenue process entail?
- Sales order
- Delivery of services/ goods
- Customer billing
- Payment collections
What are key revenue process documents?
- Sales order - list details of customer order (items/ services ordered, quantity, prices, and agreed upon timing & delivery).
- Pick ticket - list provided to warehouse or inventory function detailing items and quantities to be picked/ packaged and sent to shipping department.
- Packing slip - details items, quantities and included in shipment for verification.
- Bill of lading - accompanies shipment that provides contract concerning allocation of responsibilities b/t seller, carrier and customer.
- Sales invoice - sent to customer detailing goods, services ordered, total cost and payment instructions.
- Receipt - document that acknowledges receipt of payment.
- Remittance advice - notice of payment sent by customer to company.
What does the expenditure process entail?
- Placing order for goods/ services
- Goods delivered/ services rendered
- Receipt and approval of billing (3-way match)
- Bill payment
What are key expenditure process documents?
- Purchase requisition - request generated for goods/ services to be purchased by purchasing function.
- Purchase order - sent by buyer to seller indicating goods/ services desired, quantities, timing needs and agreed upon price.
- Receiving report - indicates goods/ services received, quantity received, timing of receipt and corresponding PO (if applicable).
- Supplier invoice - sent to company from supplier detailing goods/ services ordered, total order cost and payment instructions.
- Voucher - PO, receiving report, supplier invoice to match what was ordered + received (3-way match).
What are the five (5) manufacturing steps?
- Product design & engineering
- Product development
- Manufacturing forecasting & scheduling
- Manufacturing operations
- Manufacturing and fixed asset accounting & reporting
What are the finance and reporting activities?
- Treasury - manage cash flow and financial activities.
- G/L updates
- Report generation (F/S and managerial)
What are processing controls?
Processing controls protect organization against processed data incomplete or inaccurate.
- Data matching
- Input validation
- Sequence check
- Cross-footing
What are standing data controls?
Master files or general data files that contain long-term data that does not change often.
- Access & authorization control
- Read-only rights
- Change control
- Regular backups
- Periodic reconciliation of changes to data
- Review of employee access, authorization, and rights
What are input edit checks?
Input edit checks (constraints) are preventative controls that assist in protecting integrity of information + only allowing complete transactions to be submitted for processing:
- Consistent forms
- Completeness check
- Reasonableness check
- Field check
- Size check
- Limit or range check
- Sign check
- Referential check (Validity) check
- Closed-loop verification
What is transaction exposure?
(Exchange rate risk)
Transaction exposure is the potential that an organization could suffer economic loss or gain upon settlement of individual transactions as a result of changes in exchange rates.
The following are risks for exporters and importers:
Export:
* A/R denominated in FC DECREASES; thus A/R DECREASES (Loss)
Import:
A/P denominated in FC INCREASES; thus
A/P INCREASES (Loss)
What is economic exposure?
(Exchange rate risk)
Economic exposure is the potential that the PV of an organization cash flows could increase or decrease as a result of changes in exchange rates.
- Domestic currency appreciation - domestic goods relatively more expensive now; thus exports DECREASE; thus FC DECREASES:
- A/R DECREASES, PV of cash-in DECREASES (Loss)
- A/P DECREASES, PV of cash-out DECREASES (Gain)
PV cash in/out = economic exposure
Loss/ gain = transaction exposure
Also, foreign imports become LESS expensive; thus imports INCREASE.
- Domestic currency depreciation - domestic goods relatively cheap now thus exports INCREASE; thus FC INCREASES:
- A/R INCREASES; PV of cash-in INCREASES (Gain)
- A/P INCREASES; PV of cash-out INCREASES (Loss)
Also, foreign imports become MORE expensive; thus imports DECREASE.
What are the results of measuring specific net transaction exposure?
- Exporter:
- A/R > A/P; net asset risk is that FC DECREASES.
- Net asset export risk is that FC DECREASES, thus A/R DECREASES = Loss
- Mitigate transaction exposure = BUY put options or SELL future contracts. If FC DECREASES, use profit on derivative to offset loss or sell contracts.
- Concern for exporter is that domestic currency (US dollar) will strengthen, which means when the foreign buyer pays the exporter in the foreign currency, it will translate into a lower amount received when its converted to the domestic currency.
- Importer:
- A/P > A/R; net liability risk is that FC INCREASES.
- Liabilities in FC: risk is FC INCREASES, which INCREASES liability = Loss
- Mitigate transaction exposure = BUY call option or forward (large) / futures (small) contract.
- If FC INCREASES, use profit on derivative to offset loss.
What are circumstances that impact exchange rates?
- Trade-related factors
- Relative inflation rates, relative income levels and government controls (trade restrictions) impacts demand for goods + demand/supply for currency.
- Financial factors
- Relative to interest rates + cash flow impacts demand for securities + demand/supply of currency.
What are ways an entity can mitigate exposure to long-term transactions?
- LT forward contracts - set up to stabilize transaction exposure over long periods.
- Currency swaps (swap borrowings):
- Two firms
- Financial intermediaries
- Parallel loan
What is translation exposure?
(Exchange rate risk)
Represents risk that assets, liabilities, equity, or income of consolidated organization that includes foreign subsidiaries will change as a result of changes in exchange rates.
- Translation exposure INCREASES as the proportion of foreign involvement by subsidiaries INCREASES.
What is cross rate?
Cross rate is the exchange rate between two (2) currencies derived by using two exchange rate quotes that have a common currency.
What is weighted average interest rate?
= Effective annual interest payments / Debt outstanding
(Outflow/ Net inflow)
What is cost of preferred stock?
Cost of pref. Stk. = Pref. stock dividends (par x rate) / Net proceeds of pref. stock
Net proceeds = Selling price - cost of issuance
Net proceeds = Mkt value of pref. stock
(Outflows / Inflows)
What is the cost of R/E?
- CAPM
- DCF
- Bond yield risk premium
- CAPM:
= Risk-free rate + Risk premium
= Risk-free rate + (Beta x Mkt risk prem)
= Risk-free rate + [Beta x (Mkt return - Risk-free rate)]
- DCF:
= D1 (Divd today x 1 + g)/ Mkt value C/S
= [Divd per share / Mkt price] + growth rate
- Bond yield risk premium:
= Pretax cost of LT debt + Mkt risk prem
What effect does current assets have on an entity’s asset structure?
As current assets INCREASE, liquidity INCREASES, risk of distress DECREASES, but ROA DECREASES.
- Cash + cash equivalents DECREASE ROA
What effect does Non-current assets have on an entity’s asset structure?
As non-current assets INCREASE, liquidity DECREASES, risk of distress
INCREASES, but ROA INCREASES.
- LT investments + PP&E INCREASES ROA
What is return on sales?
= Income before int income, int exp + taxes */ Net sales
- = Net income - interest income + interest expense + tax expense
Both interest income and expense adjusted for: Subtract income and add back expense.
What is return on investment?
Provides an assessment of an entity’s % return relative to its capital investment risk. Expressed as income divided by invested capital in simplistic form. Also expressed as a product of Profit Margin and Investment Turnover:
- ROI = Net income / Average invested capital
- Avg. Invested capital = Assets - operating liabilities
- ROI = Profit Margin x Investment Turnover
- ROI = [Income/ Sales] x [Sales/ Invested Capital]
What is return on assets?
Similar to ROI, except ROA uses average total assets in the denominator rather than invested capital:
ROA = Net income/ Average total assets
What is return on equity?
Measure for determining an entity’s effectiveness:
ROE = Net income/ Average total equity [Assets - Liabilities]
What is Economic Order Quantity?
(ESOC nemonic)
EOQ inventory model attempts to minimize total ordering and carrying cost:
E = sqrt 2 x SO/ C
E = Order size (EDQ)
S = Annual sales (units)
O = Cost per PO
C = Annual carrying cost/ unit
Assumptions:
* Demand is known + constant
* Carrying cost/ unit are fixed
* Does NOT consider stock out costs
* Does NOT account for costs of safety stock
What is APR of quick payment discount?
= [360 / Pay period - Discount period]
x
[Discount % / 100% - Discount %]
Example: 2/10, net/30:
APR Discount = [360/ 30 - 10] x [2%/ 100% - 2%]
What is the Supply Chain Operations Reference (SCOR) model?
SCOR model developed to create a generic model for supply chain analysis. Four (4) key management processes or activities:
- Plan - determining demand (sales forecast + talking to suppliers)
- Source - procure required resources (select vendors)
- Make - turn RM to finish goods to meet demand (manage production process - manufacturing, testing and packaging)
- Deliver - activities to get finished product to customers
What are characteristics of Plan?
(SOCR)
Planning to properly balance demand and supply:
- Demand requirements (sales forecasts)
- Ability of suppliers to supply resources
- Inventory levels
What are characteristics of Source?
(SCOR)
Procure the measures required to meet it:
- Selecting vendors
What are characteristics of Make?
(SOCR)
Activities that turn raw materials into finished products that are produced to meet a planned demand:
- Production process
- Manufacturing
- Testing
- Packaging
What are characteristics of Deliver?
(SOCR)
Activities of getting finished product into hands of consumers to meet planned demand:
- Managing of orders
- Forecasting
- Pricing
- Transportation
- Shipping
- Labeling
Ex: Managing A/R and collections from customers
What are working capital techniques that accelerate the flow of cash?
- Concentration banking
- Lock-box system
- Use of local post office
A/R turnover
= Net Sales/ Average A/R (net)
- If Avg A/R DECREASES, Sales INCREASES, will result in INCREASE in A/R turnover
Days sales in A/R
= 365 / Accounts receivable turnover
A/R turnover = Net Sales/ Avg. A/R (net)
What are items that impact level of safety stock?
Safety stock levels are affected by the following:
- Uncertain sales forecasts - greater uncertainty means a higher level of safety stock should be carried.
- Dissatisfaction of customers - if customers are dissatisfied with back orders (which occur when there are stock outs), then more safety stock should be carried to prevent stock outs.
- Uncertain lead times - greater uncertainty means a higher level of safety stock is needed.
What is Just-in-time inventory model?
- JIT inventory model was developed to reduce the lag time between inventory arrival and inventory use.
- Reduces need of manufacturers to carry large inventories BUT requires considerable degree of coordination between manufacturer and supplier.
- JIT is a pull approach inventory model.
What is the Kanban inventory control technique?
- Kanban inventory control technique give visual signals (time to order) that component in production needs to be replenished.
- Prevents oversupply or interruption of entire manufacturing process as a result of lacking component.
How do you evaluate the decision to use a lock box system?
Compare cost of implementing a
lock-box to investment income that can be earned by investing funds.
Lock-box system cost
Investment income:
(1) divide # of days lock-box system will reduce collection time by year (I.e. 360 days).
(2) Multiply #1 by annul sales x investment percentage (return rate)
(3) Compare investment income to cost of lock-box system.
What is price-to-sales ratio?
Price-to-sales ratio can be used to estimate current stock price. Ratio can provide meaningful information when net earnings data is not available:
Price-to-sales = P0/ S1
P0 = Stock price or value today
P0 = Market capitalization/ Shares outstanding
S1 = Expected (per share) sales in one year S1 = Sales1/ # CSO
Sales1 = Sales0 x (1 + Growth rate)
- Ratio is not as volatile as P/E ratio.
- Sales are always positive (can’t use negative earnings for a P/E multiple).
- Ratio is a good multiple for analyst to use in valuing a new company.
What is the PEG ratio?
PEG ratio is a measure that shows the effect of earnings growth on a company’s P/E assuming a linear relationship between P/E and growth:
PEG = (P0 / E1) / G
P0 = Stock price or value today
E1 = Expected EPS (forward)
G = Growth rate = 100 x Expected growth rate
Stocks with lower PEG ratios are more attractive to investors than high ratios. If P0/ E1 is low and growth rate is high, then the ratio is low and if it’s LESS than peers, relatively undervalued which means “buy it”.
How do you value equity using the PEG ratio?
PEG ratio calculates the P/E ratio per unit of growth. PEG ratio can be multiplied by both forecasted future earnings + growth rate to determine current (or projected) price of stock:
P0 = PEG x E1 x G
P0 = Stock price or value today
E1 = Expected EPS (forward)
G = Growth rate = 100 x Expected growth rate
What is the zero growth model?
(Preferred stock)
Zero growth model is a perpetuity (zero growth stock). Cash flow paid by an annuity last forever. When a company is expected to pay the SAME dividend each period, the perpetuity can be used to determine stock value:
PV of a perpetuity = Stock value per share
P = D/ R
P = Stock price
D = Dividend (Par x fixed %)
R = Required return (Not 1 + R)
Assumptions: dividend will be specified and it never changes. Required rate of return will be specified.
What is price-earnings (P/E) ratio?
P/E ratio is the most widely used multiple when valuing equity securities. Measures amount that investors are willing to pay for each dollar of EPS. Rationale is that earnings are a key driver of investment value (stock price):
P/E ratio = P0/ E1
P0 = Stock price or value today
P0 = Market capitalization/ Shares outstanding
E1 = EPS expected in one year (next 4 quarters)
E1 = E0 x (1 + G)
E1 = NI1 / # CSO
- Higher P/E ratios generally indicate investors are anticipating more growth and are bidding up price per share in advance of performance.
- P/E ratio is where P0 “should be” E1 x “justified multiple”. Also, the P/E ratio is termed “forward P/E” as the denominator is based on expected earnings over the next 4 quarters.
What is the Constant (Gordon) growth dividend discount model?
(DDM)
Dividend discount model (DDM) assumes that the intrinsic value of a company’s stock is the PV of expected future dividends:
Economic return = change in price “growth” + Dividend income/ Beginning price
Price = Dividend/ (Return - Growth)
What is the value (price) of equity formula (Dividend growth model)?
Pt = Dt * (1 + G)/ (R - G)
Pt = Current price (price at period “t”)
D (t + 1) = Dividend one year after period “t”
R = Required return
G = (Sustainable) Growth rate
P0 = Div1/ (R - G)
P1 = Div2/ (R - G)
Div1 = Div0 x (1 + G)
How do you calculate free cash flow?
Free cash flow is the amount of cash that a business generates after taking into account reinvestments in non-current assets:
Net income or Net operating profit AFTER taxes
+ non cash expenses
- INCREASE in working capital
- capital expenditures
= Free cash flow
How do you calculate the price-to-cash flow ratio?
P/CF ratio may be used to calculate current stock price. Rationale for using this price multiple is that cash flow is harder for companies to manipulate than earnings.
P/CF is a more stable measure of P/E.
Changes in a company’s P/CF ratios over time are positively related to changes in a company’s LT stock returns:
P/CF = P0/ CF1
P0 = Stock price or value today
CF1 = Expected cash flow in 1 year
= CF1/ # CSO
= CF0 x (1 + G)
= Operating CF x (1 + G)/ # CSO
How do you value equity using the price-to-cash flow ratio?
Value of equity can be calculated as follows:
P0 = [P0/ CF1] x CF1
P0 = Stock price or value today
CF1 = Expected cash flow in 1 year
How do you determine the required rate of return?
Capital asset pricing model (CAPM) is often used to determine required rate of return for dividend discount model:
Rce = Rf + B1 * [E(Rm) - Rf]
Rce = Required rate of return on CE security
Rf = Risk-free rate of return
B1 = Beta on security
E(Rm) = Expected return on market (portfolio)
[E(Rm) - Rf] = Equity risk premium
Assumptions:
- Dividends one year beyond year which price is determined
- Constant growth rate of dividends “Exponential” - Div4 = Div0 x (1 + G) to the 4th power
- Stock price will grow at same rate as dividend
- Required rate of return is GREATER THAN dividend growth rate
What is prime cost?
Prime cost = DL + DM
- Direct labor is “directly related” to production of a product or performance of a service + expected ‘downtime’ for labor.
- Direct raw material are costs of materials purchased + freight-in (net of purchase discounts) + normal scrap.
What is conversion cost?
Conversion cost = DL + Manufacturing overhead
- Direct labor is “directly related” to production of a product or performance of a service + expected ‘downtime’ for labor.
- MOH includes indirect costs that are NOT easily traceable to cost pool or cost object. Includes indirect materials (I.e., cleaning supplies for shop floor and machines), indirect labor (forklift drivers, maintenance workers, shift mangers, engineers, etc.) and other “in factory” indirect costs (depreciation, rent, maintenance, property taxes, insurance and utilities).
What is cost of goods manufactured?
COGS
+ Ending FG
- Beg. FG
= COGM
COGM accounts for manufacturing costs of products COMPLETED during the period:
Step 1: Calculate AFU
Beg. RM
+ Purchases
= Available for use (AFU) *
- Has to go in either two (2) places: EI or Used (meaning RM was used)
Step 2: Calculate COGM
Beg WIP
+ DM (per step 1)
+ DL
+ MOH APPLIED
= Total manufacturing cost incurred
- Ending WIP
= COGM
Note 1: Current manufacturing cost = DM + DL + MOH applied
Note 2: If no beg. WIP, then current mfg. cost is same as COGM
Step 3: Calculate COGS
Beg. FG
+ COGM (per step 2)
= COGAS
- Ending FG
= COGS
Note 3: COGS statement for manufacturer similar to retailers, except COGM used in place of purchases.
What is the internal rate of return?
IRR is the expected rate of return on a project.
- IRR is a time-adjusted rate of return from an investment
- Focuses decision maker on discount rate at which the PV of a project’s cash inflows = PV of cash outflows
- IRR determines the PV factor and related interest rate that yields NPV = 0
What are inputs of the Black-Scholes option pricing model?
Black-Scholes model inputs include the following:
- Common stock price (of underlying stock)
- Option exercise price
- Risk-free interest rate
- Time to expiration
- Measure of risk tied to underlying stock
How do you calculate the debt ratio?
Debt ratio = Total Debt/ Total Assets
How do you calculate expected after-tax cash flows used to evaluate a capital investment?
After-tax cash flows are relevant to capital budgeting decisions and are computed using one of two methods. Operating cash flows differs from net income b/c noncash expenses (i.e., deprecation) must be ADDED back to net income to get to cash flow
After-tax CFs = Pretax CF (EBT) x (1-T) = Inflow
- Cash inflows = Sales - Variable costs
- Cash inflows x tax rate = cash inflows net of tax
- Initial investment divided by UL = Depreciation expense
- Depreciation expense x TR = Noncash expense ADDED to cash inflow net of tax
What are key assumptions of the Black-Scholes option pricing model?
Black-Scholes option pricing model assumptions:
- European-style options
- Can ONLY be exercised at maturity
- Risk-free rate and volatility of stock prices are constant over option life
- No taxes or transaction costs exist
- Stock prices behave in a random manner
- Stock pays no dividends
How is the optimal capitalization for an organization determined?
Determined by the lowest total weighted-average cost of capital (WACC). Capitalization of WACC maximizes shareholder’s equity.
WACC is internally used as a hurdle rate for capital investment decisions. The lower the hurdle, the easier it is to expect positive spread where ROIC > WACC.
What are product costs?
Product costs = DM + DL + Factory (Manufacturing) overhead applied.
Examples include the following:
* Wages & fringe benefits for factory employees
* Raw materials purchased
* Plant utilities (overhead)
* Rent costs on manufacturing plant (overhead)
* Plant worker costs
How do you calculate applied (estimated) overhead under the traditional costing method?
With traditional costing, all indirect costs (total manufacturing overhead) costs are allocated to a “single” cost pool:
Step 1: Overhead rate (single) = “All” Budgeted overhead costs / (single) Estimated cost driver (i.e., DL $, DL hrs., Machine hrs.)
Step 2: Applied overhead = Actual cost driver x Overhead rate
Applied O/H = Actual output x Standard per unit
What is the behavior of a variable cost?
As volume INCREASES, total cost INCREASES, but is fixed or constant per unit. This behavior is only within the revelvant range.
What is the flow of inventory for Raw Materials?
Beg. RM
+ RM purchases
= RM available for use
- RM used
= Ending RM (Balance Sheet)
What is the flow of inventory for Work-in-Process?
Beg. WIP
+ RM used
+ DL [DL rate * Act. Hrs.]
+ OH used
= WIP available to be finished
- Inv. transferred to FG
= Ending WIP (Balance Sheet)
Another way to reflect the flow of WIP inventory:
Beg. WIP
+ RM used
+ DL [DL rate * Act. Hrs.]
+ OH applied
- Ending WIP
= COGM
Note: To calculate OH used, calculate the OH rate, then applied OH
Step 1: OH rate = Budgeted OH / Budgeted cost driver
Step 2: OH rate x Actual cost driver
What is the flow of inventory for Finished Goods?
Beg. FG
+ Inv. transferred from WIP
= FG available for sale
- COGS (Income Statement)
= Ending FG (Balance Sheet)
Another way to reflect the flow of FG:
Beg. FG
+ COGM
- Ending FG
= COGS
What are the steps to calculating equivalent units using the FIFO method?
Equivalent units under the FIFO method is composed of three (3) parts:
- Completion of units on hand at beg. of period:
[Beg. WIP x (1 - % already complete)]
- Units started and completed during period:
[Units completed - Beg. WIP]
- Units partially completed at end of period:
[Ending WIP x % complete]
What is a process costing inventory system?
Method of product costing that averages costs and applies them to a large number of homogeneous items using the following steps:
- Summarize flow of physical units
- Calculate “equivalent unit” output
- Accumulate total costs to be accounted for
- Calculate average unit costs based on total cost and equivalent units
- Apply average costs to units completed and remaining in Ending WIP
How do you calculate cost per equivalent unit using the weighted average cost method?
Cost per equivalent unit = Beg. cost + Current cost/ Equivalent units
Units completed (Beg. WIP + units started and completed during the month)
+ Ending WIP x % completed
= Equivalent units
How do you calculate cost per equivalent unit using the FIFO cost method?
Cost per equivalent unit = Current cost ONLY/ Equivalent units
Beg. WIP x (1 - % already complete)
+ Units completed - Beg. WIP
+ Ending WIP x % complete
= Equivalent units
What are the steps to calculating equivalent units using the Weighted Average method?
Equivalent units under the Weighted Average method is composed of two (2) parts:
- Units completed: Beg WIP + units started and completed during the month
- Ending WIP x % completed
How do you calculate the amount of over/ underapplied overhead?
Need to calculate the difference between actual OH and applied OH:
- Compute the standard rate per driver (i.e., machine hour):
Application rate per hour = Total standard costs/ Total standard hours
- Compute amount applied:
Total applied OH = Total ACTUAL hours x Application rate per hour
- Determine amount of over/ underapplied OH:
Over/ underapplied OH = Total applied OH - ACTUAL OH
