Mid Term Study Guide

Question 1

Cost of Supplier’s Financing

Answer 1

Referred to as costly trade credit in the text, this is the credit taken – in excess of free trade credit – whose cost is equal to the discount lost.

=[(% discount)/(1-%discount)] * [(365)/(Net days to pay - days to get discount)]

Question 2

Depreciation

Answer 2

Depreciation is a non-cash charge against tangible assets, such as buildings or machines. It is taken for the purpose of showing an asset’s estimated dollar cost of the capital equipment used up in the production process. From an accounting perspective, using depreciation expenses on the I/S helps match the cost of fixed goods to the value they help create. (Note: accumulated depreciation may also show on the B/S, but this is a cumulative total appreciation – essentially the sum taken out each year on the I/S. Typically the B/S shows net PPE, which = gross PPE - accumulated depreciation)

Question 3

Valuation of Intangibles

Answer 3

First, an intangible is an asset like a patent, a copyright, a trademark, or simply goodwill. The accounting treatment of intangibles is similar to that of tangible assets. For example, a patent at cost X is good for 20 years. You would most likely amortize this over the course of 20 years (X / 20 each year) (note: this is the straight line depreciation approach).

Question 4

Multiple Scenario Analysis and Percentage of Sales Planning Method

Answer 4

Scenario analysis is a process of analyzing possible future events by considering alternative possible outcomes (sometimes called “alternative worlds”). Thus, the scenario analysis, which is a main method of projections, does not try to show one exact picture of the future. Instead, it presents consciously several alternative future developments. // The Percentage of Sales Method is a financial forecasting approach that is based on the premise that most balance sheet and income statement accounts vary with sales. Therefore, the key driver of this method is the sales forecast and based upon this, pro-forma financial statements (i.e., forecasted) can be constructed and the firms needs for external financing can be identified. Note: certain items on the B/S may not increase in line with sales – the key to using % of sales method is to determine whether the item’s growth will be in proportion to sales growth. If so, use % sales. If not, find an assumption in the case or from what you know to estimate that item’s growth (or lack of growth).

Question 5

Operating and Financial Leverage

Answer 5

Operating leverage measures the extent to which a company or specific project requires some aggregate of both fixed and variable costs. Fixed costs are those not altered by an increase or decrease in the total number of goods or services a company produces. Variable costs are those that vary in direct relationship to a company’s production – variable costs rise when production increases and fall when production decreases. Businesses with higher ratios of fixed costs to variable costs are characterized as using more operating leverage, while businesses with lower ratios of fixed costs to variable costs use less operating leverage. Utilizing a higher degree of operating leverage increases the risk of cash flow problems resulting from errors in forecasts of future sales. The degree of financial leverage (DFL) measures a percentage change of earnings per share for each unit’s change in EBIT that result from a company’s changes in its capital structure. Earnings per share become more volatile when the DFL is higher. Financial leverage magnifies earnings per share and returns because interest is a fixed cost. When a company’s revenues and profits are on the rise, this leverage works very favorably for the company and for investors. However, when revenues or profits are pressured or falling, the exponential effects of leverage can become problematic.

Question 6

Paid-Up Capital, Excess of Par and Retained Earnings

Answer 6

x

Question 7

Retained Earnings

Answer 7

Retained earnings are profits remaining after paying dividends to shareholders. It falls in the owners equity portion of the balance sheet.

Question 8

Factoring Account Receivables

Answer 8

Also known as A/R Financing, factoring A/R refers to selling A/R or invoices to a third party commercial financial company, also known as a “factor.” This is done so that the business can receive cash more quickly than it would by waiting 30 to 60 days for a customer payment.

Slight alternate definition from Investopedia: A type of asset-financing arrangement in which a company uses its receivables - which is money owed by customers - as collateral in a financing agreement. The company receives an amount that is equal to a reduced value of the receivables pledged. The age of the receivables have a large effect on the amount a company will receive. The older the receivables, the less the company can expect.

http: //www.investopedia.com/terms/a/accountsreceivablefinancing.asp#ixzz3pL0SHre0
http: //www.rtsfinancial.com/guides/what-factoring

Question 9

Pro-Forma Financial Statements

Answer 9

Many companies issue pro-forma financial statements in addition to generally accepted accounting principles (GAAP) -adjusted statements as a way to provide investors with a better understanding of operating results. In legitimate cases, pro forma financial statements take out one-time charges to smooth earnings. However, companies can also manipulate their financial results under the guise of pro-forma financial statements to provide a picture that is rosier than reality.

Read more: Pro Forma Financial Statements - Complete Guide To Corporate Finance | Investopedia http://www.investopedia.com/walkthrough/corporate-finance/4/capital-investment-decisions/pro-forma.aspx#ixzz3pKD6pij4

Question 10

Cost of Bank Financing

Answer 10

x

Question 11

EPS, Stock Valuation and Market Efficiency

Answer 11

EPS = (net income - dividends on preferred stock) / avg. outstanding shares

Question 12

Credit Risk and Liquidity Ratios for Seasons Sales

Answer 12

Liquidity ratios:

• Current ratio = (current assets) / (current liabilities)
  
  • preferred to be over 2
• Acid or quick ratio = (current assets - inventory) / (current liabilities)
  
  • preferred to be over 1 Acid/quick is better to use in industries where inventory may quickly use value or is less liquid (e.g., super fashionable clothes, fresh food products)

Question 13

Sustainable Rate of Growth

Answer 13

The maximum growth rate that a firm can sustain without having to increase [external] financial leverage. (think this is without having to raise additional funds from either debt or equity). Calculated as: ROE x (1 - dividend-payout ratio) Change in equity * Equity at beginning of period

Question 14

Cash Conversion Cycle

Answer 14

The length of time between the firm’s actual cash expenditures on productive resources (labor and materials) and its own cash receipts from the sale of products (that is, the length of time between paying for labor and materials and collecting on receivables). Thus, the CCC equals the length of time the firm has funds tied up in current assets. = inventory conversion period + Avg. Collection period - payables deferrable period

Question 15

Payables Deferral Period vs. Inventory Conversion Period

Answer 15

These are two of the three periods (receivables collection) within the cash conversion cycle. The inventory conversion period = inventory / (sales / 360). The payables deferral period is the average length of time between the purchase of materials and labor and the payment of cash for them. The formula is payables / (COGS / 360).

Note: if data available is monthly, sub 30 for 360!

Question 16

Accrual Principle

Answer 16

This is the concept that you should record accounting transactions in the period in which they actually occur rather than the period in which the cash flows related to them occur.

Question 17

Cash-Flows and Depreciation

Answer 17

Depreciation expenses included on the I/S are non-cash transactions, meaning that net income at the bottom of the I/S does not accurately reflect cash on hand at the end of the period. When determining cash flows, among other things, you need to add depreciation expenses back to net income.

Question 18

ROE

Answer 18

The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested.

ROE is expressed as a percentage and calculated as: Return on Equity = Net Income/Shareholder’s Equity

Per the DuPont equation:

ROE = profit margin * asset turn * leverage

Question 19

Inventory Valuation

Answer 19

Inventory valuation is the dollar amount associated with the items contained in a company’s inventory. Initially the amount is the cost of those items. Inventory valuation includes all of the costs to get the inventory items in place and ready for sale. The inventory valuation excludes the costs of selling and administration. A manufacturer’s inventory valuation will include the costs of production, namely direct materials, direct labor, and manufacturing overhead. Inventory valuation is important in that it affects the cost of goods sold reported on the company’s income statement, and thus gross margin [(revenue - COGS)] / Revenue.

Inventory is also an important component of a company’s current assets, working capital, and current ratio.

Finally, a buildup of inventory has implications for a firm’s cash conversion cycle – if the firm produces mroe than it sells consistently, cash will be tied up in inventory.

Question 20

Net Cash Flows and Retained Earnings

Answer 20

x

Question 21

Estimation of Financing Requirements

Answer 21

Additional Funds Needed (AFN):

AFN = Required increase in assets - increase in liabilities - addition to retained earnings

Question 22

Financial Planning and Variance Analysis

Answer 22

x

Question 23

Working Capital Requirement and Short Term Financing

Answer 23

x

Question 24

Ratio Analysis

Answer 24

Ratio analysis is a form of financial statement analysis that is used to obtain a quick indication of a firm’s financial performance in several key areas. The ratios are categorized as short-term solvency ratios (liquidity), debt management ratios, asset management ratios, profitability ratios, and market value ratios.

Question 25

The Three Levers of ROE

Answer 25

ROE includes asset turnover (sales/assets), net profit margin (earnings/sales, expressed as a percentage), and financial leverage (assets/equity). If you multiply the three levers together, you get a company’s ROE, or the return the company is making on its shareholders’ equity. Studying a company’s ROE levers, and seeing which lever contributes most strongly to ROE, can be helpful in forming a picture of that company’s business–its sources of strength and its potential risks.

Question 26

Income Statement and NOCF

Answer 26

x

Question 27

Stock Buy-Backs vs. Stock Split

Answer 27

A buyback takes place when a company uses its cash to repurchase stock from the market. A company cannot be a shareholder in itself so when the shares are repurchased, they are either canceled or made in to treasury shares. Either way, this lowers the amount of shares in circulation, which increases the value of each share, at least temporarily. If you had a $10 bill and somebody offered to give you two $5 dollar bills, would you feel a little richer? A stock split doesn’t add any value to a stock. Instead, it takes one share of a stock and splits it in to two shares, reducing its value by half. Current shareholders will hold twice the shares at half the value for each, but the total value doesn’t change.

A stock split is usually done by companies that have seen their share price increase to levels that are either too high or are beyond the price levels of similar companies in their sector. The primary motive is to make shares seem more affordable to small investors even though the underlying value of the company has not changed.

Likewise, a buyback may take place to either increase the value of individual shares or eliminate any threats by shareholders who may be looking for a controlling stake.

Question 28

Acid Test vs. Current Ratio

Answer 28

The current ratio indicates the extent to which current liabilities are covered by those assets expected to be converted to cash in the near future (current ratio = current assets / current liabilities). The acid test goes one simple step further in measuring liquidity by subtracting out inventory from current assets (acid test = (current assets - inventory) / current liabilities).

Question 29

Amortization

Answer 29

A non-cash charge against intangible assets such as goodwill or IP. An amortization schedule is a table that breaks down the periodic fixed payment of an installation loan into its principle and interest components. Finally, an amortization loan is a loan that is repaid in equal period payments (or “killed off”) over time.

Question 30

Depletion

Answer 30

Depletion is similar to both depreciation and amortization, except that it applies to resources, such as minerals, oil in wells, etc.

A resource-based asset is depleted similar to how a fixed asset is depreciated as it creates value.

Question 31

Dividends

Answer 31

A sum of money paid regularly (usually quarterly) by a company to its shareholders from its profits. Note that profits - dividends = retained earnings (equity) that can be plowed back into the company.

Dividend payout ratio = % of net income distributed as dividends

Question 32

Is it better to have a long or short cash conversion cycle?

Answer 32

You would prefer a shorter cash conversion cycle. The longer the cash conversion cycle, the greater the need for external financing.

Question 33

Why should a firm maintain a sufficient amount of cash?

Answer 33

There are a few reasons to maintain a sufficient amount of cash. One is to take advantage of trade discounts. Another is to maintain a solid credit rating. Yet another reason is to meet any unexpected needs.

Other reasons include signaling competitors or potential market entrants that you may purchase them if they attempt to compete with you. Finally, in an example, Apple holds large cash (or cash equivalent) balances to cover potential losses if a new product fails to meet sales targets (e.g., if the iphone 8 and 9 fail, they have the cash to get them through to the iphone 10).

Question 34

For what purpose does a firm hold cash?

Answer 34

There are two basic purposes. One is for every day business operations and transactions. The other is for compensation to financial institutions (compensating balances).

Question 35

What is float?

Answer 35

it is time that elapses relating to mailing, processing, and clearing checks. Modern technologies have greatly shortened the time it takes to move monies between entities.

Float, or free float, refers to the number of a firm’s shares trading freely on the market.

Question 36

What is a lockbox system?

Answer 36

A customer’s payments are sent to a Post Office box maintained by a bank. Bank personnel retrieve the payments and deposit them into the firm’s bank account.

Question 37

What are the major types of short-term investments?

Answer 37

Treasury bills, Treasury notes, certificates of deposit (CDs), commercial paper, etc.

Question 38

What are important considerations with regard to short-term investments?

Answer 38

Liquidity and safety because these investments must be available to meet the current cash needs of the firm.

Question 39

Current Ratio

Answer 39

Current Assets / Current Liabilities

The current ratio indicates the extent to which the claims of ST creditors are covered by assets that can quickly be converted to cash. The creditor will want to see a high current ratio, and the shareholder may want to see a low current ratio.

Question 40

Quick Ratio (Acid Test)

Answer 40

(Current Assets - Inventories) / Current Liabilities

Inventory is the least liquid of current assets. The quick ratio is a measure of the firm’s ability to pay off ST obligations without relying on the sale of inventory. If the quick ratio is less than 0, it means you probably have to sell inventory in order to pay off the current liabilities.

Question 41

Total Assets Turnover Ratio

Answer 41

Sales / Total Assets

Measures the dollars generated for each dollar tied up in assets. In other words, it measures how effectively a firm is managing its assets. If there is too much invested in assets, it means operating capital is very high. If there is too little invested in assets, it means the firm may lose sales.

Question 42

Fixed Asset Turnover Ratio

Answer 42

Sales / Net Fixed Assets

This speaks to how efficiently the firm is using its fixed assets.

Question 43

Days Sales Outstanding (DSO) Ratio

Answer 43

Receivables / (Sales / 365)

The average amount of time that a firm must wait after making a sale before receiving cash.

Question 44

Inventory Turnover Ratio

Answer 44

COGS / Inventory

This ratio roughly approximates the number of times per year that the inventory sells out. Notice that this ratio uses COGS vice sales. Inventory is usually reported at cost, so it is better to compare inventory with costs vice sales.

Question 45

Debt Ratio

Answer 45

Total Debt / Total Assets

Total debt usually includes notes payable and LT debt.

Question 46

Debt-to-Equity Ratio

Answer 46

Total Debt / Total Common Equity

Total debt usually includes notes payable and LT debt.

Question 47

Interest Coverage Ratio

Answer 47

EBIT / Interest Expense

Measures the extent to which operating income can decline before the firm is unable to meet its annual interest costs. Interest is paid with pre-tax dollars, so the firm’s ability to pay current interest is not affected by taxes.