Midterm

Question 1

Current Ratio

Answer 1

CA/CL

Question 2

Quick Ratio

Answer 2

CA - Inventory/CL

Question 3

ROA

Answer 3

Net Income/Total Assets

Question 4

ROE

Answer 4

Net Income/Total Shareholder’s Equity

• Increasing any one of components of ROE (net margin, asset turnover or financial leverage) will increase ROE.

Question 5

Shareholder’s Equity

Answer 5

Total Liabilities - Total Assets

Question 6

Dupont Equation (extended)

Answer 6

ROE = Profit Margin x Total Asset Turnover X Financial Leverage

= Net Income/Sales x Sales/Total Assets x Total Assets/Shareholder’s Equity

DuPont analysis tells us that ROE is affected by three things:

• Operating efficiency, which is measured by profit margin
• Asset use efficiency, which is measured by total asset turnover
• Financial leverage, which is measured by the equity multiplier

Question 7

External Financing Required

Answer 7

Total Assets - (Liabilities + Owners Equity)

Question 8

Sustainable Growth Rate

Answer 8

= Profit Margin x Retention Rate x Asset Turnover Ratio x Assets to Equity Ratio

= Net Income/Sales x (1-Dividend Payout Ratio) x Net Income/Total Assets x Total Assets/Total Equity

Question 9

Net Cash Flows from Operating Activities

Answer 9

Net Income … Taken from I/S

Make adjustments to NI:

1. ) Depreciation and amortisation … +
2. ) Taxes .. -

Add in changes in assets/liabilities:

1. ) Increase in A/R … -
2. ) Increase in A/P … +
3. ) Increase in accruals … +
4. ) Increase in inventory… -

Add all together: NET CASH FROM OPERATING ACTIVITIES

Question 10

Free Cash Flow

Answer 10

= NOPAT - Net Investment in Operating Capital

NOPAT = EBIT(1-Tax Rate)

Net Investment in Operating Capital = Net operating capital 1 - net operating capital 2

Net Operating Capital = NOWC + Operating long-term assets

NOWC = Operating current assets - operating current liabilities

==> (EBIT(1-Tax Rate)) - [ [(Operating current assets - operating current liabilities) + operating long-term assets] 1 - [(Operating current assets - operating current liabilities) + operating long-term assets] 2 ]

o Free cash flows (FCFs) are the cash flows available for distribution to all firm investors (shareholders and creditors) after the company has paid all expenses (including taxes) and made the required investments in operations to support growth.

Question 11

NOPAT

Answer 11

EBIT(1-Tax Rate)

Question 12

Net Investment in Operating Capital

Answer 12

Net operating capital 1 - net operating capital 2

Question 13

Net Operating Capital

Answer 13

NOWC + Operating long-term assets

Question 14

NOWC

Answer 14

Operating current assets - operating current liabilities

Question 15

Retained Earnings

Answer 15

= Beginning Retained Earnings + Net Income - Dividends

Retained earnings are reinvested in the firm and over time represent the owners share or equity value of the firm; retained earnings + dividends = earnings after tax EBT

Question 16

Pro Forma Financial Statements

Answer 16

Financial statements that show what finances would be like if certain assumptions are realised

• Helps them assess whether firms performance is in line with their targets and investors expectations
• Can help them do what if analyses
• Helps figure out future financing needs –> future free cash flows –> company’s value

Question 17

Calculation of Pro Forma

Answer 17

Percentage of Sales or Additional Funds Needed

Question 18

Percentage of Sales for Pro Forma Statement Calculation

Answer 18

Most items on income statement/balance sheet calculated as a percentage of sales.

HOWEVER, dividend policy, debt and equity financing are not part of sales. NEEDS TO BE EDITED

Question 19

Additional Funds Needed for Pro Forma Statement Calculation

Answer 19

Required Increase in Assets - Spontaneous Increase in Liabilities - Increase in Retained Earnings

• AFN = (A* /S0)ΔS – (L*/S0) ΔS – MS1(RR)

= [(FA/S)(S%increase in S)] - [(A/P+Accr)(S%increase in S)] - [(S(1+%increase in S))(NI/S)*(1-(Dividends/NI))]

Question 20

The 3 C’s: Cost of Bank Financing

Answer 20

Cost - interest rate on the loan
Collateral - the firm backs its loan with assets (inventory or A/C) in case they default
Covenants - conditions borrower must comply with in order to adhere to agreement terms.

Question 21

Times Interest Earned

Answer 21

EBIT/Interest Expense

Calculates how many times a company can pay interest expense with its pre-tax income; creditors favour a higher ratio.

Question 22

EPS

Answer 22

Net Income/Average Outstanding Shares

Typically higher when debt financing is used in favour of equity

Increases are good, decreases are bad

Issuing more equity will initially dilute it, but over time, EPS will rise

Growth in dividends results as a result of a growth in EPS

Question 23

P/E Ratio

Answer 23

Price per share/EPS

Question 24

Dividend Payout Ratio

Answer 24

Dividends/Net Income

The percentage of earnings paid to shareholders in dividends/how well earnings support dividend payments. More mature companies have higher payment ratios.

Question 25

When Sustainable Growth Rate Exceeds Actual Growth...

Answer 25

A firm may be underperforming. To grow faster: improve operating efficiency by 1.) increasing profit margin OR asset turnover --> increase retained earnings or 2.) Alter financial policies by increasing revenue --> reduce dividends --> increase RE OR increase lev --> increase debt financing and growth capacity If there is too little growth, a firm may: a. Pay dividends b. Ignore the problem c. Amass cash d. Reducing financial leverage e. Repurchase shares f. Introduce new product lines/diversification of product line

Question 26

When Actual Growth Rate Exceeds Sustainable Growth...

Answer 26

(1) Firm may run into trouble with unrestrained growth (2) If its temporary growth, take out short term loans → once the growth decreases, pay off debts with any leftover cash (3) If its long term growth, do one of the following: a. Sell Equity – Increases cash, increases borrowing capacity, may be hard in some countries b. Increase financial leverage – Raises cash, raises risk of bankruptcy c. Reduce payout of dividends – Saves cash which can be used to build up equity, can also anger shareholders who may sell stock d. Prune marginal activities - gets rid of products with no synergy, generates cash from sales of assets e. Outsourcing – increases asset turnover and therefore, ROA f. Increase prices – Higher prices may reduce growth Merger – cash cow with deep pockets

Question 27

Payables Deferral Period

Answer 27

Part of CCC. Average length of time between a firms purchase of materials/labour and the payment of cash for them. = accounts payable/(COGS/365)

Question 28

Inventory Conversion Period

Answer 28

Part of CCC. Average length of time to convert materials into finished goods and sell them. = Inventory/(Sales/365)

Question 29

Accrual Principle

Answer 29

Costs should be matched to the revenue they generate. --> Revenues/expenses are recorded when earned/incurred and not when cash is received for them.

Question 30

Cash Flows

Answer 30

Cash inflows: arise from financing, operations or investing • It means you are getting cash which implies a decrease in asset accounts and increase in liability accounts * Cash outflows result from expenses or investments * It means you are using cash which implies an increase in asset accounts and decrease in liability accounts * Types of cash flows: operating, investing and financing * They are essential for solvency o Firms increase cash flows by creating value for customers, suppliers, and employees. The value of a firm depends on the size of the firm’s free cash flows, the timing of those flows (sooner, the better), and their risk (ceteris paribus, will pay more for a stock with less risky cash flows).

Question 31

Depreciation

Answer 31

o The reduction in the value of a long-lived asset (buildings, machines) from use or obsolescence. The decline is recognised in accounting by a periodic allocation of the original cost of the asset to current operations

Question 32

Net Cash Flow

Answer 32

Net Profit + Depreciation + Amortisation

Question 33

Financial Planning

Answer 33

1) Project financial statements using financial statement forecasting methods and use these forecasts to analyze operating plans. 2) Determine the funds needed to achieve operating objectives. 3) Forecast funds available for the duration of the operating plan and plan financing accordingly. 4) Establish a performance-based management compensation system.

Question 34

Working Capital

Answer 34

CA-CL - If it's positive, firms can pay off ST Liabilities; if negative, firms can't cover their CL with their CA

Question 35

Debt Ratio

Answer 35

Total Liabilities/Total Assets - How the firm is financed

Question 36

Basic Earnings Power (BEP)

Answer 36

EBIT/Total Assets

Question 37

Stock Buy Back

Answer 37

Company buys back some of its outstanding stock to initiate cash distributions to shareholders.

Question 38

Average Collection Period

Answer 38

Receivables/(Sales/365)