Financial Management & Capital Budgeting Flashcards
Financial Management
An aspect of managing an entity that consists of 5 functions:
- Financing (Raising Capital)
- Capital Budgeting (Long-term projects to invest in)
- Financial Management (Cash Flows and Capital Structure)
- Corporate Governance (Ethical Behavior)
- Risk Management (Managing Exposure)
Cash Conversion Cycle
The average number of days from when a firm pays for purchases to the time it collects cash from the sale of goods, calculated as:
CCC=ICP+RCP-PDP.
Inventory Conversion Period (ICP) - average number of days to convert inventory to sales, calculated as (Average inventory / Cost of Goods Sold)365
Receivables Collection Period (RCP) - Average number of days to collect accounts receivable, calculated as
(Average accounts receivable / Credit Sales)365
Accounts Payable Deferral Period (PDP) - Average number of days between the purchase of inventory and payment for it calculated as
(Average Accounts Payable / Purchases) * 365
Cash Management
Making certain that there is adequate cash for operations, compensating balance requirements, the ability to take advantage of trade opportunities, the ability to take advantage of unexpected opportunities, and the ability to deal with an emergency.
Economic Order Quantity (EOQ)
The amount of inventory that should be ordered each time a purchase is made to minimize the combined cost of placing the order, receiving, and processing; and maintaining inventory balances on hand, including the costs of insurance and space, as well as interest on the investment in inventory, calculated as the square root of 2AP/S with A equal to annual demand for inventory, P equal to the cost of placing an order, and S equal to the annual cost of storing a unit in inventory for 1 period.
Reorder Point
The minimum amount of inventory that should remain on hand when an order is placed equal to:
Average Daily Demand * Average Lead Time + Any Safety Stock
Safety Stock
The amount of inventory that will be included in the reorder point to protect the company from running out of inventory as a result of higher than normal demand or a longer than normal lead time for delivery, equal to :
Minimum Daily Demand * Maximum Lead Time) - (Average Daily Demand * Average Lead Time)
Just-in-Time (JIT)
An inventory management system consisting of ordering as little inventory as possible and as late as possible to keep costs down, but requiring an excellent relationship with reliable suppliers to avoid running out of inventory.
Backflush Approach
An inventory management system appropriate when minimal inventories are maintained, involving charging all merchandise related costs directly to costs of goods sold with an adjustment to recognized inventories on hand at financial statement date, measured at standard cost.
Capital Budgeting
The process used to determine how and when an entity will use its cash for long-term purposes, such as making equipment purchases, acquiring long-term investments, or entering into long-term projects, and how it will finance those projects.
Payback Period
A method for evaluating a capital budgeting opportunity by determining the length of time it will take to recover the amount invested and comparing that to guidelines established by the entity. measured with the formula:
Payback Period in Years = Investment / Annual Cash Flows
Internal Rate of Return (IRR)
A method for evaluating a capital budgeting opportunity by determining the effective return that is expected to be earned and comparing it to guidelines established by the entity, measured in a two-step process, which involves first calculating a present value (PV) factor and then using that factor to determine the effective interest rate.
- PV factor = Investment / Annual Cash Flows (same as payback period)
- Using PV tables, find the interest rate at which the PV factor for the appropriate number of periods is equal to the one calculated
Accounting Rate of Return (ARR) or Return on Investment (ROI)
The rate of return earned on a capital budgeting opportunity calculated on the basis of changes in accounting net income rather than cash flows and compared to guidelines established by the entity calculated with the formula:
ROI = Accounting Income / Average Investment
Net Present Value
The difference between the present value of all cash flows that will result from investing in a capital budgeting opportunity, calculated at the entity’s desired rate of return, and the amount of the initial investment, with a positive amount indicating that the return on the investment exceeds the entity’s minimum desired return, calculated by the formula:
Net PV = PV of future cash flows - Current cash outflows
Annual Financing Costs
The effective interest rate being paid as a result of not taking advantage of a trade discount, calculated using a 2 step process, which first involves measuring the discount as a percentage of the net amount paid had the discount been taken and then, based on the length of time that discount relates to, calculating the annual rate:
- Discount as a % of Net Amount = (Discount % / 100% - Discount %)
- Result is multiplied by / (Period for payment in full - Discount Period)
Compensating Balance
An arrangement with a lender requiring the borrower to maintain demand deposit balances with the lending institution in an amount equal to a percentage of the amount borrowed, increasing the effective interest rate on the loan since only a portion of the borrowed funds are actually available for use. The actual Effective Rate is the annual interest amount, calculated as:
Principle * Stated Rate, divided by the net funds available, calculated as Principle - Loan Origination Fees - Compensating Balances
