Exam 1 Flashcards
ROA
NI+Int Exp(1-tax)/Avg Total Assets
-Measures firm’s performance in using assets to generate earnings
ROE
NI - Preferred Div/Avg Common Equity
-Firm’s ability to use and finance assets to generate earnings for common shareholders
Profit Margin
NI+Int Exp(1-tax)/Revenue
-Firm’s ability to control level of expenses
Expense over Revenue
Cogs Exp+SG&A+R&D+Other/Revenue
Asset Turnover
Revenues/Avg Total Assets
-How efficient is company at using its assets; how much in revenue is generated by each dollar of assets
AR Turnover
Net Credit Sales/Average AR
-Rate at which firm collects AR
Inventory Turnover
COGS/Avg Inventory
-Number of times inventory is complete sold
Plant Asset Turnover
Net Credit Sales/Net PPE
-Revenue generated by each dollar of plant assets
Operating Cycle
Day Sales’ Outstanding+ Days’ Inventory on Hand
- Costco has a (-) operating cycle, meaning it acquires, sells, and collects on inventory before they have to pay for the inventory (very efficient)
- Include or exclude Days Payable subtracted from OC
- How long a $ is stuck inside the company
Debt to Asset Ratio
Total Debt/Total Assets
- Leverage
- Percentage of firm’s assets that are financed through debt
Interest Coverage Ratio
EBIT/Int Exp
- How many times earnings covers the interest charges
- High ICR is good as debt holder, could be concerning as equity holder (they should be taking on more debt and buy more assets to make more money for shareholders)
Current Ratio
Current Assets/Current Liabilities
-Sufficient current assets to cover its current liabilities
Quick Ratio
Cash+Market Securities+Receivables/Current Liabilities
-Enough assets that can be converted QUICKLY to cash to meet current liabilities? (Quickly means much less than 1 year)
Cash Flow Statement
Change in Cash = CF Operations + CF Investing + CF Financing
Debit increase accounts
- Assets
- Expenses
- Dividends
Vital signs of a company
- Profitability
- Risk
Price to Book
- How much the market is willing to pay for $1 of assets
- Market sees more growth potential if this number is higher (valued higher)
Valuation Models
- Whichever model we choose is where “value” lies for specific user
- Do not have inputs, based on forecasting
- Given a set of consistent financial statements, all of these will generate the SAME value
Dividend Discount Model (DDM)
- Based on value distributed to shareholders
- Expresses firm value directly from financial statements
Discounted Cash Flow Model (DCM)
-Based on firm’s ability to create value
Residual Income Model (RIM)
- Based on firm’s ability to create value, earnings over cost of capital
- Focus on value creation rather than distribution
Mispricing
- = Value - Price
- Value is estimated using a valuation model
- Positive mispricing: purchase security
- negative mispricing: sell or short security (hold position until mispricing is corrected)
- Before you buy, figure out the reasoning for the mispricing
Market efficiency
- How quickly prices reflect all available information about a particular stock
- Under efficient market hypothesis, no investor has an advantage in predicting stock returns because no one has access to info not readily available to anyone else
Forms of market efficiency
- Weak form
- Semi-strong form
- Strong form
US Market is…
Semi-strong! Stock prices reflect stock price history, all public information and all private information
Post-earnings announcement drift
- Theory is that these prices continue to drift in the general direction post-earnings announcement
- In reality, numbers are all over the board so averages are almost meaningless and do not reflect what is really going on
Market inefficiencies
- Research shows that earnings are predictable based on past earnings and stock returns do not always reflect this
- Market does not reflect info in the footnotes or in the components of earnings
Market sum up:
- Markets are reasonably efficient
- Making money in the market requires costly information acquisition and interpretation
- To get into the market, what skill or advantage do I have that market doesn’t?
Standard Setting Influences
- Manager/Companies (more flexibility, look more profitable, fewer required disclosures)
- Investors/Users (More disclosures, transparent info, cost is less important)
- Congress (Constituents happy)
- Auditors (bright lines in standards, guidance from standard setters, reduce liability to investors)
Bond indenture
- Bond contract
- Includes covenants to protect lender and borrower
Investors through public offering
- Primary bond market (money paid for the bonds goes to the issuer)
- Secondary bond market ( Reselling of bonds by investors, money goes to investors not the issuer)
Private placement
- Selling un-registered securities to qualified institutional investors ( investment companies, pension plans, etc)
- Less costly than public offering because no SEC registration is required
- Bonds CANNOT be re-sold
Stated rate
interest rate that the ISSUER chooses
Nominal rate, coupon rate, face rate, etc.
Term bonds
mature on a single date
Serial bonds
Mature in installments
Zero Coupon (Deep Discount)
Provide no interest until maturity
Variable Rate
Interest rate varies over time
Callable bond
Company has the right to pay off the bond in advance (payment usually higher than original principal)
Putable bond
Gives owner the right to sell the bond back to the issuer at pre-specified price
Convertible bond
Investor has right to trade in the bond for common stock of the company
IMPORTANT
Interest payments are calculated at the stated rate, present values are calculated using effective rate
Effective rate
rate the market assigned to the bond when it was initially sold
Why does stated rate not equal effective rate?
- Market moves, can’t change
- Strategic reasons
- If equal, issued AT PAR
- Stated rate Effective; AT PREMIUM
In effective interest method, what does the interest expense represent?
Interest payment plus allocation of the discount/premium
Adjusting entries
Reflect economic activity when there has been no change of cash
If we do not adjust to accrue interest:
- Int expense & payment are UNDERstated
- Income is OVER stated
Accounting gain/loss =
Book value of bonds - cash paid to retire bonds
- Cash paid to retire bonds depends on Market rate (the day extinguished)
- Book value of bonds depends on Effective rate the day it was initially sold
Gain or loss when extinguishing debt?
Effective rate > market rate = LOSS (price greater than carrying value)
Effective rate
Why might market rate have increased?
- Feds could have increased rates
- Company is more risky, market is accounting for this increased risk
Accounting effect:
- One time loss, later on lower interest expense and lower bonds payable
- One time gain, but higher interest expense in the future
- Choose when you want to show the loss
Callable bonds
- Bonds are callable at a certain price (often above face value)
- Allow the issuer the option to redeem the bond early by paying a set price
- Investors will realize that the bonds will likely be called if interest rates fall, so callable bonds should be valued less than non-callable bonds
Conversion of bonds to stocks
- Bondholders will trade bonds for stocks if they believe the stock price will increase
- Debit bonds payable, credit capital stock
Long-term debt disclosures
- Note will include lots of info including, maturity dates, nature of liability, restrictions imposed by creditors and assets designated or pledged as a security (need to know other existing debt)
- MUST disclose future payments for sinking fund requirements and maturity amounts of long-term debt during each of the next 5 years
Debt covenant
Agreement between companies and creditors that the company should operate within certain limits
- Breach of covenant allows creditor to demand immediate payment
- Generally only leads to a renegotiation of the terms of the debt
- Only have disclose debt covenants if there has been a previous violation
Fair Value Option
- Mitigate volatility in reported earnings
- Greater convergence with IFRS
- Price is the price you would get in an orderly market transaction
Debt: Historical cost v. Fair Value
- Effect of fair value changes on the income statement is counterintuitive
- If credit rating falls, market rate will rise, value of bond will fall and gain is reported
- If credit rating rises, market rate for bond will fall, value of bond will rise, loss is reported
- More relevant than hc because reflects current market rates, consistent with fair value
- Better for equity holders
