Finance Flashcards
Short-term solvency or liquidity
Current ratio = Current assets / current liabilities
Quick ratio = (Current assets − inventory − prepaid expenses) / current liabilities
Activity or asset management
Asset turnover = Sales / avg. total assets
Receivables turnover = Credit sales / avg. A/R
Average collection period = Days in the period / A/R turnover OR average A/R / (credit sales / 365)
Inventory turnover = Cost of goods sold / avg. inventory
Days in inventory (or Inventory Period) = Days in the period / inventory turnover OR average Inventory / (cost of
goods sold / 365)
Financial leverage or debt service
Debt ratio = Total liabilities / total assets
Debt-to-equity ratio = Total liabilities / total equity
Equity multiplier ratio (leverage ratio) = Total assets / total equity
Times interest earned (or interest coverage) = EBIT / interest expense
Profitability intro
Profitability ratios compare income statement accounts to evaluate the company’s ability to generate income against expenses and returns on balance sheet investments.
Profitability
Profit margin = Net income / sales
Return on assets (ROA) — net return = Net income / avg. total assets
ROA — gross return = EBIT / avg. total assets
ROA — DuPont model = Profit margin × total asset turnover
Return on equity (ROE) = (Net income – preferred dividends declared) / avg. total common equity
ROE — DuPont model = Profit margin × total asset turnover × equity multiplier
Dividend payout ratio (A) = Dividends declared / net income
Sustainable growth rate = ROE (DuPont model) × retention ratio
Retention ratio = 1 – dividend payout ratio
Value or market value
Price earnings (P/E) ratio = Market price of shares / EPS (earnings per share)
Dividend yield = Dividend declared per share / market price of shares
Dividend payout ratio (B) = Dividend declared per share / EPS (earnings per share) OR dividends / net income
Efficiency intro
Efficiency ratios measure a company’s ability to use assets and manage liabilities effectively. Accounts receivable turnover (and days in accounts receivable) and inventory turnover (days in inventory) are both good measures of efficiency.
Liquidity intro
Liquidity ratios measure a company’s ability to meet its short-term financial obligations.
Leverage intro
Leverage ratios measure how much debt a company has relative to assets, and the ability a company has to meet both short- and long-term debt obligations.
Price (commodity price) risk exposure
PPPI faces price risk exposure as a seller of newsprint in a market where prices of newsprint change with market conditions. Currently, the company’s customer contracts are priced to fluctuate with the market rates for newsprint rather than being fixed. This causes the company’s revenues to fluctuate with newsprint prices in the market.
PPPI may also face price risk exposure as a consumer of various commodities in its manufacturing operations, including chemicals, additives, fuel oil, natural gas, and electricity costs. Similar to above, expenses will fluctuate when the various commodity prices change.
Recommendation
Since PPPI is exposed to fluctuations in the price of newsprint, as well as various commodities, it should consider hedging against this risk by using either futures or forward contracts. PPPI could also use options to hedge against commodity risk.
Foreign currency risk exposure
Analysis
PPPI has financial risk exposure to fluctuating foreign exchange rates, as 70% of its external sales are denominated in U.S. dollars. In addition to this, PPPI’s inputs of chemicals and additives are purchased in U.S. dollars.
The risk is slightly mitigated by the fact that fluctuations in the revenue are offset by the same fluctuations in costs of chemicals and additives, and thus the foreign currency risk exposure has a type of natural hedge because of the payment of some expenses in U.S. dollars.
Recommendation
Although the U.S. dollar revenues and expenses help to offset PPPI’s foreign exchange risk, it could consider further hedging alternatives by using futures, forward, or options contracts for the net amount of exposure.
Interest rate risk exposure
Analysis
PPPI is exposed to fluctuating interest rates on its short-term line of credit at a rate of prime plus 2%. As the prime rate of interest changes, the interest rate paid on the line of credit will also change, making financing charges from one period to another less predictable.
Recommendation
Since PPPI is exposed to fluctuations in interest rates, it should consider hedging against this risk by using an interest rate swap.
Forward contracts
A forward contract is a commitment by one party to deliver a specified quantity of an asset, by a specified date, and for a counterparty to accept it and pay a specified amount. The item in this case is a specified amount of U.S. dollars.
Forward contracts adv. vs disadv.
Advantages
* There is no upfront premium payable to enter into the contract.
* There is protection against unfavourable movements in the respective exchange rate — in other words, the exchange rate is locked in, giving certainty.
* If there is high correlation between the contract and the underlying cash flow (for example, the U.S. dollar sales), then it can be very effective in mitigating the risk.
Disadvantages
* Using forward contracts forgoes any favourable movement in the respective exchange rate — that is, if the spot exchange rate is more favourable for PPPI, the company has lost the opportunity to benefit from the exchange gain at this rate.
* A physical forward contract creates an obligation to deliver the quantity of U.S. dollars specified, which increases operational risk if PPPI is unable to deliver for whatever reason.
* Entering into a forward contract may require a separate hedging line of credit, which may be included in the existing credit facility or conflict with terms of the existing credit facility or other debt.
Leverage intro
Leverage ratios measure how much debt a company has relative to assets, and the ability a company has to meet both short- and long-term debt obligations.
