FAR SEC 15 Flashcards
1
Q
What is a derivative (basic definition)?
A
A derivative is a bet on whether the value of something will go up or down. The purpose is either to speculate (incur risk) or to hedge (avoid risk). The value of a derivative changes as the value of the specified variable changes. For example, a corn farmer can guarantee the price of his annual corn production using a derivative. In this case, the derivative is a hedge against the changes in the price of corn (to avoid risk).
2
Q
Define call option.
A
A call option is the right (but not an obligation) to purchase an asset at a fixed price (i.e., the exercise price or the strike price) on or before a future date (i.e., expiration date).
3
Q
Define put option.
A
A put option is the right (but not an obligation) to sell an asset at a fixed price (i.e., the exercise price or the strike price) on or before a future date (i.e., expiration date).
4
Q
Define exercise price (strike price).
A
The exercise or strike price is the agreed-upon price of exchange in an option contract.
5
Q
Define expiration date.
A
The expiration date is the date when the option may no longer be exercised.
6
Q
Define underlying.
A
An underlying is the price, rate, or other variable (e.g., security price, commodity price, foreign exchange rate, etc.) specified in a derivative instrument.
7
Q
Define notional amount.
A
A notional amount is the number of units (e.g., number of securities, tons of commodity, etc.) specified in a derivative instrument.
8
Q
Define embedded.
A
Embedded means that a derivative is contained within either (1) another derivative or (2) a financial instrument.
-For example, a mortgage has an embedded option. The mortgagor (the debtor) generally has the option to refinance the mortgage if interest rates decrease.
9
Q
Define spot price/rate.
A
The spot price/rate is the rate for immediate settlement of currencies, commodities, securities, etc.
10
Q
Define forward price/rate
A
The forward price/rate is the rate for settlement of currencies, commodities, securities, etc., at some definite date in the future.
11
Q
What are the three characteristics of a derivative?
A
1) A derivative is a financial instrument that has at least one underlying and at least one notional amount or payment provision, or both.
2) No initial net investment, or one smaller than that necessary for contracts with similar responses to the market, is required.
3) A derivative’s terms require or permit net settlement or provide for the equivalent.
i) Net settlement means that the derivative can be readily settled with only a net delivery of assets. Thus, neither party must deliver (a) an asset associated with its underlying or (b) an asset that has a principal, stated amount, etc., equal to the notional amount.
12
Q
For derivatives, what is net settlement?
A
Net settlement means that the derivative can be readily settled with only a net delivery of assets. Thus, neither party must deliver (a) an asset associated with its underlying or (b) an asset that has a principal, stated amount, etc., equal to the notional amount.
13
Q
What is the benefit of a call option to the purchase?
A
A call option allows the purchaser to benefit from an increase in the price of the underlying asset. The gain is the excess of the market price over the exercise price. The purchaser pays a premium for the opportunity to benefit from this appreciation.
14
Q
What is the benefit of a put option to the purchaser?
A
A put option allows the purchaser to benefit from a decrease in the price of the underlying asset. The gain is the excess of the exercise price over the market price. The purchaser pays a premium for the opportunity to benefit from the depreciation in the underlying.
15
Q
What are the two components of the price of an option?
A
The price of an option (option fair value) consists of two components: the intrinsic value and the time value.
16
Q
What is the option price formula?
A
Option price = Intrinsic value + Time value
17
Q
What is a forward contract? (4 elements)
A
1) A forward contract is an agreement for the purchase and sale of a stated amount of a commodity, foreign currency, or financial instrument at a stated price. Delivery or settlement is at a stated future date.
2) Forward contracts are usually specifically negotiated agreements and are not traded on regulated exchanges. Accordingly, the parties are subject to default risk (i.e., that the other party will not perform).
3) A forward contract to buy or sell foreign currency is called a forward exchange contract.
4) The fair value of this contract, both on the initial recognition date and the balance sheet date, is measured based on the forward exchange rate on those dates.
18
Q
What is a futures contract?
A
A futures contract is a forward-based agreement to make or receive delivery or make a cash settlement that involves a specified quantity of a commodity, foreign currency, or financial instrument during a specified time interval.
19
Q
What is an interest rate swap? (2 elements)
A
1) An interest rate swap is an exchange of one party’s interest payments based on a fixed rate for another party’s interest payments based on a variable rate. Moreover, most interest rate swaps permit net settlement because they do not require delivery of interest-bearing assets with a principal equal to the contracted amount.
2) An interest rate swap is appropriate when one counterparty prefers the payment pattern of the other. For example, a firm with fixed-rate debt may have revenues that vary with interest rates. It may prefer variable-rate debt so that its debt service will correlate directly with its revenues.
20
Q
When is it appropriate to use an interest rate swap?
A
An interest rate swap is appropriate when one counterparty prefers the payment pattern of the other. For example, a firm with fixed-rate debt may have revenues that vary with interest rates. It may prefer variable-rate debt so that its debt service will correlate directly with its revenues.
21
Q
Which financial instruments ARE NOT derivatives?
A
Certain financial instruments, e.g., accounts receivable, notes receivable, bonds, preferred stock, and common stock, are not derivatives. However, any of these instruments may be an underlying asset (security) in a derivative.
22
Q
What is the accounting treatment for derivatives? (5 elements)
A
1) Derivatives should be recognized as assets or liabilities depending on the terms of the contract.
2) Fair value is the only relevant measure for derivatives.
3) The accounting for changes in fair value of a derivative depends on
i) The reasons for holding it,
ii) Whether the entity has elected to designate it as part of a hedging relationship, and
iii) Whether it meets the qualifying criteria for the particular accounting.
4) Derivatives not designated as a hedging instrument are measured at fair value through net income (i.e., gains or losses on the remeasurement to fair value are recognized directly in earnings).
5) Derivatives designated as a hedging instrument are measured at fair value through net income or at fair value through OCI, depending on whether the hedge is
i) A fair value hedge,
ii) A cash flow hedge, or
iii) A foreign currency hedge.
23
Q
The accounting for changes in fair value of a derivative depends on which three elements?
A
The accounting for changes in fair value of a derivative depends on
1) The reasons for holding it,
2) Whether the entity has elected to designate it as part of a hedging relationship, and
3) Whether it meets the qualifying criteria for the particular accounting.
24
Q
Derivatives designated as a hedging instrument are measured at fair value through net income or at fair value through OCI, depending on whether the hedge is_________________ (3 elements).
A
Derivatives designated as a hedging instrument are measured at fair value through net income or at fair value through OCI, depending on whether the hedge is
1) A fair value hedge,
2) A cash flow hedge, or
3) A foreign currency hedge.
25
What are the characteristics of hedge accounting? (3 elements)
1) The purchase or sale of a derivative or other instrument is a hedge if it is expected to neutralize the risk of (1) a recognized asset or liability, (2) an unrecognized firm commitment, or (3) a forecasted (anticipated) transaction.
i) For example, a flour company buys and uses wheat in its product. It may wish to guard against increases in wheat costs when it has committed to sell at a price related to the current cost of wheat. If so, the company will purchase wheat futures contracts that will result in gains if the price of wheat increases (offsetting the actual increased costs).
2) To qualify for hedge accounting, the hedging relationship must be highly effective. It should result in offsetting changes in the fair value (or cash flows) attributable to the hedged risk during the term of the hedge.
i) When the hedge is determined to be highly effective, hedge accounting is applied to the entire change in the fair value of the hedging instrument.
3) A fully effective (perfect) hedge results in no net gain or loss. It occurs when the gain or loss on the hedging instrument exactly offsets the loss or gain on the hedged item.
26
Under what three conditions is a derivative or other instrument a hedge?
The purchase or sale of a derivative or other instrument is a hedge if it is expected to neutralize the risk of (1) a recognized asset or liability, (2) an unrecognized firm commitment, or (3) a forecasted (anticipated) transaction.
27
What condition is necessary for a derivative or other instrument to qualify for hedge accounting?
1) To qualify for hedge accounting, the hedging relationship must be highly effective. It should result in offsetting changes in the fair value (or cash flows) attributable to the hedged risk during the term of the hedge.
-When the hedge is determined to be highly effective, hedge accounting is applied to the entire change in the fair value of the hedging instrument.
28
What is a perfect hedge?
A fully effective (perfect) hedge results in no net gain or loss. It occurs when the gain or loss on the hedging instrument exactly offsets the loss or gain on the hedged item.
29
Are all hedges derivatives?
No, not all hedges are derivatives, e.g., diversifying a portfolio is a form of hedging that doesn't involve derivatives. Simply taking a position that is negatively correlated other assets would be a non-derivative hedge.
30
What are the three attributes of fair value hedges?
1) A fair value hedge mitigates the exposure to changes in the fair value of a recognized asset or liability or of an unrecognized firm commitment that are attributable to a specified risk.
2) Examples of hedged items are
i) Fixed-rate investments and debt and
ii) Firm commitments to purchase or sell assets or incur liabilities.
3) Gains and losses in relation to a fair value hedge must be accounted for as follows:
i) Gains or losses from changes in the fair value of the hedging instrument (derivative) are recognized immediately in earnings.
ii) Gains or losses from changes in the fair value of the hedged item attributable to the hedged risk are recognized immediately in earnings.
-The gain or loss from the change in the fair value of the hedging instrument is reported in the same income statement line item as the earnings effect of the hedged item.
31
How are gains and losses in relation to a fair value hedge accounted for? (3 elements)
Gains and losses in relation to a fair value hedge must be accounted for as follows:
1) Gains or losses from changes in the fair value of the hedging instrument (derivative) are recognized immediately in earnings.
2) Gains or losses from changes in the fair value of the hedged item attributable to the hedged risk are recognized immediately in earnings.
3) The gain or loss from the change in the fair value of the hedging instrument is reported in the same income statement line item as the earnings effect of the hedged item.
32
What are two examples of hedged items?
Examples of hedged items are
1) Fixed-rate investments and debt and
2) Firm commitments to purchase or sell assets or incur liabilities.
33
What are the attributes of cash flow hedges? (3 elements)
1) A cash flow hedge mitigates the exposure to variability in the cash flows of a recognized asset or liability or of a forecasted transaction that is attributable to a specified risk.
i) A forecasted transaction is probable, i.e., expected to occur, although no firm commitment exists. It does not (a) provide current rights or (b) impose a current obligation because no transaction or event has occurred.
ii) An example is an anticipated purchase or sale of inventory or item of property, plant, and equipment (a forecasted transaction).
2) Gains or losses from changes in the fair value of the hedging instrument (derivative) are recognized in OCI.
3) The amounts recognized in OCI (the gains or losses on the hedging instrument) are reclassified to earnings only when the hedged item affects earnings.
i) After the reclassification of these gains or losses from accumulated OCI to earnings, they are reported in the income statement in the same line item as the earnings effect of the hedged item.
34
For cash flow hedges, what is a forecasted transaction?
A forecasted transaction is probable, i.e., expected to occur, although no firm commitment exists. It does not (a) provide current rights or (b) impose a current obligation because no transaction or event has occurred.
-An example is an anticipated purchase or sale of inventory or item of property, plant, and equipment (a forecasted transaction).
35
What are the three attributes of foreign currency hedges?
1) Certain foreign currency exposures also may qualify for hedge accounting.
2) A derivative may hedge the foreign currency exposure to variability in a foreign currency (exchange rate fluctuations) in different foreign currency transactions.
3) A derivative may hedge the foreign currency exposure of net investments in a foreign operation. The accounting for gains and losses on the hedging instrument in a net investment hedge is accounted for similar to a cash flow hedge.
i) Gains and losses on the change in the fair value of the hedging instrument are recognized in the currency translation adjustment section of OCI.
ii) Those amounts are reclassified from accumulated OCI to earnings only when the hedged item affects earnings.
36
What are the attributes of embedded derivatives? (2 elements)
1) A common example is the conversion feature of convertible debt. It is a call option on the issuer’s stock. Embedded derivatives must be accounted for separately from the host if
i) The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics of the host;
ii) The hybrid instrument is not remeasured at fair value under otherwise applicable GAAP, with changes in fair value reported in earnings; and
iii) A freestanding instrument with the same terms as the embedded derivative is subject to the guidance on derivative instruments and hedging.
2) If an embedded derivative is accounted for separately, the host contract is accounted for based on the accounting standards that apply to instruments of its type. The separated derivative should be accounted for under the guidance on derivative instruments and hedging.
i) If the embedded derivative to be separated is not reliably identifiable and measurable, the entire contract must be measured at fair value, with gains and losses recognized in earnings.
ii) It may not be designated as a hedging instrument because nonderivatives usually do not qualify as hedging instruments.
37
Which three conditions are individually sufficient for embedded derivatives to be accounted for separately from their hosts?
Embedded derivatives must be accounted for separately from the host if
1) The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics of the host;
2) The hybrid instrument is not remeasured at fair value under otherwise applicable GAAP, with changes in fair value reported in earnings; and
3) A freestanding instrument with the same terms as the embedded derivative is subject to the guidance on derivative instruments and hedging.
38
If the embedded derivative is accounted for separately, which three conditions apply?
1) If an embedded derivative is accounted for separately, the host contract is accounted for based on the accounting standards that apply to instruments of its type. The separated derivative should be accounted for under the guidance on derivative instruments and hedging.
2) If the embedded derivative to be separated is not reliably identifiable and measurable, the entire contract must be measured at fair value, with gains and losses recognized in earnings.
3) It may not be designated as a hedging instrument because nonderivatives usually do not qualify as hedging instruments.
39
To which things to the guidance for disclosures about derivatives instruments and hedging activities apply?
The guidance for disclosures about derivative instruments and hedging activities applies to all entities and all derivatives and hedged items.
40
What are the specific disclosures required for derivatives and hedging? (4 elements)
The following are some of the disclosures for every reporting period for which a statement of financial position is issued:
1) Objectives of holding derivative instruments; their context, including each instrument’s primary risk exposure; and the entity’s related strategies.
i) A distinction must be made between instruments (whether or not hedges) used for (1) risk management and (2) other purposes. The entity must disclose which hedging instruments are hedges of fair value, cash flows, or the net investment in a foreign operation. If derivatives are not hedges, their purpose must be described.
2) Information about the volume of derivatives.
3) Location and gross fair values of reported derivatives.
i) These amounts are separately reported as assets and liabilities and classified as hedges and nonhedges. Within these classes, amounts are separately reported by type of derivative.
4) Location and amounts of gains and losses on derivatives and hedged items.
i) This information includes separate disclosures for (1) fair value hedges (hedging instruments and hedged items), (2) gains and losses on cash flow hedges and hedges of net investments that are currently recognized in OCI or reclassified from accumulated OCI, and (3) derivatives that are not used as hedges.
ii) The information is separately reported by type of derivative, with identification of line items.
41
Which four elements are reported for the location and amounts of gains and losses on derivatives and hedged items?
This information includes separate disclosures for
(1) fair value hedges (hedging instruments and hedged items), (2) gains and losses on cash flow hedges and hedges of net investments that are currently recognized in OCI or reclassified from accumulated OCI, and
(3) derivatives that are not used as hedges.
(4) The information is separately reported by type of derivative, with identification of line items.
42
For foreign currency issues, what is the reporting currency?
The reporting currency is the currency in which an entity prepares its financial statements.
43
For foreign currency issues, what is the definition of functional currency?
1) The functional currency is the currency of the primary economic environment in which the entity operates. Normally, that environment is the one in which it primarily generates and expends cash.
2) For example, the functional currency of a foreign subsidiary might be the parent’s currency if its cash flows directly and currently affect the parent’s cash flows.
44
For foreign currency issues, what are foreign currency transactions? What are the three events that can trigger foreign currency transactions?
Foreign currency transactions are fixed in a currency other than the functional currency. They result when an entity
1) Buys or sells on credit;
2) Borrows or lends; or
3) For other reasons, acquires or disposes of assets, or incurs or settles liabilities, fixed in a foreign currency.
45
For foreign currency issues, what is a foreign currency?
A foreign currency is any currency other than the entity’s functional currency.
46
For foreign currency issues, what is the current exchange rate?
The current exchange rate is the rate used for currency conversion.
47
For foreign currency issues, what is the transaction date?
The transaction date is the date when a transaction is recorded under GAAP.
48
For foreign currency issues, what is a transaction gain (loss)?
A transaction gain (loss) results from a change in exchange rates between the functional currency and the currency in which the transaction is denominated. It is the change in functional currency cash flows
i) Actually realized on settlement and
ii) Expected on unsettled transactions.
49
For foreign currency issues, what are the three steps of the process of foreign currency translation?
Foreign currency translation is the process of expressing in the reporting currency amounts that are (1) denominated in (fixed in units of) a different currency or (2) measured in a different currency.
50
How does foreign currency translation relate to consolidated entities?
A consolidated entity may consist of separate entities operating in different economic and currency environments. Translation is necessary in these circumstances so that consolidated amounts are presented in one currency (the reporting currency of the parent company).
51
What are the two attributes of foreign currency transactions?
1) The terms of a foreign currency transaction are stated in a currency different from the entity’s functional currency.
i) For example, if an entity whose functional currency is the U.S. dollar purchases inventory on credit from a German entity, payment is to be in euros.
2) The initial measurement of the transaction must be in the reporting entity’s functional currency.
i) The exchange rate used is the rate in effect on the date the transaction was initially recognized.
ii) A foreign currency transaction gain or loss results from a change in the exchange rate between the date the transaction was recognized, the date of the financial statements, and the date the transaction is settled.
-This gain or loss is included in the income statement in the period the exchange rate changes. If the monetary aspect of the transaction has not yet occurred at the end of the reporting period, monetary items (accounts payable and accounts receivable) are measured at the period-end exchange rate.
52
For foreign currency transactions, how are the terms stated?
The terms of a foreign currency transaction are stated in a currency different from the entity’s functional currency.
For example, if an entity whose functional currency is the U.S. dollar purchases inventory on credit from a German entity, payment is to be in euros.
53
How is initial measurement done for foreign currency transactions?
The initial measurement of the transaction must be in the reporting entity’s functional currency.
The exchange rate used is the rate in effect on the date the transaction was initially recognized.
54
What are the four elements of foreign currency translation?
1) The method used to convert foreign currency amounts into units of the reporting currency is the functional currency translation approach (current-rate method).
2) It is appropriate for use in accounting for and reporting the financial results and relationships of foreign subsidiaries in consolidated statements. This method
i) Identifies the functional currency of the entity (the currency of the primary economic environment in which the foreign entity operates),
ii) Measures all elements of the statements in the functional currency, and
iii) Uses a current exchange rate for translation from the functional currency to the reporting currency.
3) Assets and liabilities are translated at the exchange rate at fiscal year end.
4) Revenues, expenses, gains, and losses are translated at the rates in effect when they were recognized. However, a weighted-average rate for the period may be used for these items.
55
What method is used for foreign currency translation?
The method used to convert foreign currency amounts into units of the reporting currency is the functional currency translation approach (current-rate method).
56
How are translation adjustments reported? (3 elements)
1) Foreign currency translation adjustments for a foreign operation (translation gains and losses) are reported in other comprehensive income (OCI).
2) When the investment in a foreign entity is sold, the amount of translation gains or losses attributable to this foreign operation is (1) removed from accumulated other comprehensive income and (2) recognized in measuring the gain or loss on the sale.
3) When only part of the investment in a foreign entity is sold, a pro rata portion of the translation gains or losses is reported as part of a gain or loss on the sale.
57
What are the six attributes of remeasurement?
1) If the books of a foreign entity are maintained in a currency not the functional currency, foreign currency amounts must be remeasured into the functional currency using the temporal method. They are then translated into the reporting currency using the current-rate method.
2) Nonmonetary balance sheet items and related revenue, expense, gain, and loss amounts are remeasured at the historical rate.
-Examples are (a) equity securities carried at cost; (b) inventories carried at cost; (c) cost of goods sold; (d) prepaid expenses; (e) property, plant, and equipment; (f) depreciation; (g) intangible assets; (h) amortization of intangible assets; (i) deferred income; (j) common stock; (k) preferred stock carried at its issuance price; and (l) any noncontrolling interest.
3) Monetary items are remeasured at the current rate.
Examples of monetary items are
Receivables,
Payables,
Inventories carried at market, and
Marketable securities carried at fair value.
4) Any gain or loss on remeasurement of monetary assets and liabilities is recognized in current earnings as part of continuing operations. This accounting treatment was adopted because gains or losses on remeasurement affect functional currency cash flows.
5) The financial statements of a foreign entity in a highly inflationary economy are remeasured into the reporting currency using the temporal method. Thus, the reporting currency is treated as if it were the functional currency.
6) Transaction gains and losses on the following are excluded from earnings and are reported in the same way as translation adjustments, i.e., in OCI:
i) Transactions that are designated and effective as economic hedges of a net investment in a foreign entity
ii) Transactions that are in effect long-term investments in foreign entities to be consolidated, combined, or accounted for by the equity method
58
For remeasuerment in foreign currency issues, what methods are used?
If the books of a foreign entity are maintained in a currency not the functional currency, foreign currency amounts must be remeasured into the functional currency using the temporal method. They are then translated into the reporting currency using the current-rate method.
59
For remeasuerment in foreign currency issues, how are nonmonetary balance sheet items treated?
Nonmonetary balance sheet items and related revenue, expense, gain, and loss amounts are remeasured at the historical rate.
60
For remeasuerment in foreign currency issues, how are monetary items remeasured?
Monetary items are remeasured at the current rate.
-Examples of monetary items are
Receivables,
Payables,
Inventories carried at market, and
Marketable securities carried at fair value.
61
For remeasuerment in foreign currency issues, how is any gain or loss on remeasurement treated?
Any gain or loss on remeasurement of monetary assets and liabilities is recognized in current earnings as part of continuing operations. This accounting treatment was adopted because gains or losses on remeasurement affect functional currency cash flows.
62
For remeasuerment in foreign currency issues, what is done in a highly inflationary economy?
The financial statements of a foreign entity in a highly inflationary economy are remeasured into the reporting currency using the temporal method. Thus, the reporting currency is treated as if it were the functional currency.
63
For remeasuerment in foreign currency issues, what are the three attributes of the treatment of transaction gains and losses?
1) Transaction gains and losses on the following are excluded from earnings and are reported in the same way as translation adjustments, i.e., in OCI:
2) Transactions that are designated and effective as economic hedges of a net investment in a foreign entity
3) Transactions that are in effect long-term investments in foreign entities to be consolidated, combined, or accounted for by the equity method
64
For foreign currency issues, what are the tax effects of changes in exchange rates? (2 elements)
1) Interperiod tax allocation is necessary when transaction gains and losses result in temporary differences. Moreover, the tax consequences of translation adjustments are accounted for in the same way as temporary differences.
2) Intraperiod tax allocation is also required. For example, taxes related to transaction gains and losses and translation adjustments reported in OCI should be allocated to those items.
65
What is the most common form of financial statement analysis?
The most common form of financial statement analysis is ratio analysis, in which two financial statement measures are compared.
66
What is liquidity? (2 elements)
1) Liquidity is a firm’s ability to pay its current obligations as they come due and thus remain in business in the short run. Liquidity measures the ease with which assets can be converted to cash.
2) Liquidity ratios measure this ability by relating a firm’s liquid assets to its current liabilities.
67
What is shown on the resources & capital structure diagram?
68
What are the liquidity ratios?
The current ratio and the quick (acid-test) ratio.
69
What is the current ratio?
The current ratio (also called the working capital ratio) is the most common measure of liquidity.
Current Ratio = Current assets/Current liabilities
70
What is the current ratio formula?
Current Ratio = Current assets/Current liabilities
71
What is the quick (acid-test) ratio?
The quick (acid-test) ratio excludes inventories and prepaids from the numerator, recognizing that those assets are difficult to liquidate at their stated values. The quick ratio is thus a more conservative measure than the basic current ratio.
Quick Ratio = (Cash and equivalents + Marketable securities + Net receivables)/(Current liabilities)
72
What is the formula for the quick ratio?
Quick Ratio = (Cash and equivalents + Marketable securities + Net receivables)/(Current liabilities)
73
What are the effects of transactions on the liquidity ratios? (3 elements)
1) If a ratio is less than 1.0, the numerator is lower than the denominator.
-A transaction that causes equal changes in the numerator and denominator will thus have a proportionally greater effect on the numerator, resulting in a change in the ratio in the same direction.
2) If a ratio is equal to 1.0, the numerator and denominator are the same.
-A transaction that causes equal changes in the numerator and denominator results in no change in the ratio.
3) If a ratio is greater than 1.0, the numerator is higher than the denominator.
-A transaction that causes equal changes in the numerator and denominator will thus have a proportionally greater effect on the denominator, resulting in a change in the ratio in the opposite direction.
74
What is shown on the transaction effects for liquidity ratios table?
75
What are the activity ratios?
These are receivables ratios, inventory ratios, and ratios for the operating cycle, cash conversion cycle, and asset turnover.
76
What is the accounts receivable ratio?
The accounts receivable turnover ratio is the number of times in a year the total balance of receivables is converted to cash.
Accounts receivable turnover = (Net credit sales)/(Average balance in receivables)
77
What is the accounts receivable ratio formula?
Accounts receivable turnover = (Net credit sales)/(Average balance in receivables)
78
What is the average collection period ratio (also called the days' sales in receivables)?
The average collection period (also called the days’ sales in receivables) measures the average number of days that pass between the time of a sale and receipt of the invoice amount.
Days’ sales in receivables = (Days in year)/(Accounts receivable turnover ratio)
79
What is the formula for average collection period ratio (days' sales in receivables)?
Days’ sales in receivables = (Days in year)/(Accounts receivable turnover ratio)
80
What is the inventory turnover ratio?
Inventory turnover measures the number of times in a year the total balance of inventory is converted to cash or receivables.
-Generally, the higher the inventory turnover rate, the more efficient the inventory management of the firm. A high rate may imply that the firm is not carrying excess levels of inventory or inventory that is obsolete.
Inventory turnover = (Cost of goods sold)/(Average balance in inventory)
81
What is the formula for the inventory turnover ratio?
Inventory turnover = (Cost of goods sold)/(Average balance in inventory)
82
What is the inventory turnover ratio (days' sales in inventory)?
Days’ sales in inventory measures the average number of days that pass between the acquisition of inventory and its sale.
Days’ sales in inventory = (Days in year)/(Inventory turnover ratio)
83
What is the formula for the inventory turnover ratio?
Days’ sales in inventory = (Days in year)/(Inventory turnover ratio)
84
What is the operating cycle?
A firm’s operating cycle is the amount of time that passes between the acquisition of inventory and the collection of cash on the sale of that inventory.
Operating cycle = Days’ sales in receivables + Days’ sales in inventory
85
What is the operating cycle formula?
Operating cycle = Days’ sales in receivables + Days’ sales in inventory
86
What is the cash conversion cycle? (4 elements)
1) A firm’s cash conversion cycle is the amount of time that passes between the actual outlay of cash for inventory purchases and the collection of cash from the sale of that inventory.
Average collection period
+
Days’ sales in inventory
–
Average payables period
=
Cash conversion cycle
2) The accounts payable turnover ratio is the number of times during a period that the firm pays its accounts payable.
Accounts payable turnover = (Cost of goods sold)/(Average balance in accounts payable)
3) The average payables period (also called payables turnover in days, or payables deferral period) is the average time between the purchase of inventories and the payment of cash.
Average payable period = (Days in year)/(Accounts payable turnover)
4) A difference between the operating cycle and the cash conversion cycle exists because the firm’s purchases of inventory are made on credit. Thus, the cash conversion cycle is equal to the operating cycle minus the average payables period.
87
What is the accounts payable turnover ratio?
The accounts payable turnover ratio is the number of times during a period that the firm pays its accounts payable.
Accounts payable turnover = (Cost of goods sold)/(Average balance in accounts payable)
88
What is the formula for the accounts turnover ratio?
Accounts payable turnover = (Cost of goods sold)/(Average balance in accounts payable)
89
What is the average payables period (also called payables turnover in days or payables deferral period)?
The average payables period (also called payables turnover in days, or payables deferral period) is the average time between the purchase of inventories and the payment of cash.
Average payable period = (Days in year)/(Accounts payable turnover)
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What is the formula for the average payable period?
Average payable period = (Days in year)/(Accounts payable turnover)
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What are the other turnover ratios?
The total assets turnover and fixed assets turnover are broader-based ratios that measure the efficiency with which assets are used to generate revenue.
Both cash and credit sales are included in the numerator.
Total assets turnover = (Net total sales)/(Average total assets)
Fixed assets turnover = (Net total sales)/(Average net fixed assets)
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What is the total assets turnover ratio?
Total assets turnover = (Net total sales)/(Average total assets)
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What is the fixed assets turnover ratio?
Fixed assets turnover = (Net total sales)/(Average net fixed assets)
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What are the ratios for solvency and leverage? (2 elements)
1) Solvency is a firm’s ability to pay its noncurrent obligations as they come due and thus remain in business in the long run (contrast with liquidity).
i) Leverage in this context refers to the use of a high level of debt relative to equity in the firm’s capital structure.
ii) An overleveraged firm risks insolvency.
Debt-to-equity ratio = (Total liabilities)/(Total equity)
2) The ability to service debt out of current earnings is a key aspect of the successful use of leverage.
Times-interest-earned ratio = (Earnings before interest and taxes)/(Interest expense)
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What is solvency?
Solvency is a firm’s ability to pay its noncurrent obligations as they come due and thus remain in business in the long run (contrast with liquidity).
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What is leverage?
Leverage in this context refers to the use of a high level of debt relative to equity in the firm’s capital structure.
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What is the risk of excess leverage?
An overleveraged firm risks insolvency.
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What is the formula for the Debt-to-equity Ratio?
Debt-to-equity ratio = (Total liabilities)/(Total equity)
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How is the Times-interest-earned ratio interpreted?
The times-interest-earned ratio measures the ability to service debt out of current earnings, which is a key aspect of the successful use of leverage.
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What are the profitability ratios?
Profitability ratios measure how effectively the firm is using its resource base to generate a return.
Profit margin on sales = Net income/Sales
Return on assets = (Net income)/(Average total assets)
Return on equity = (Net income)/(Average total equity)
Return on common equity = (Net income – Preferred dividends)/(Average common equity)
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What are the corporate valuation ratios?
These ratios reflect and shape the stock market’s assessment of a firm’s current standing and future prospects.
Basic earnings per share = (Income available to common shareholders)/(Weighted-average common shares outstanding)
Book value per common share = (Net assets available to common shareholders)/(Ending common shares outstanding)
Price-to-earnings ratio = (Price per common share)/(Basic EPS)
