Midterm Flashcards
Current Ratio
CA/CL
Quick Ratio
CA - Inventory/CL
ROA
Net Income/Total Assets
ROE
Net Income/Total Shareholder’s Equity
- Increasing any one of components of ROE (net margin, asset turnover or financial leverage) will increase ROE.
Shareholder’s Equity
Total Liabilities - Total Assets
Dupont Equation (extended)
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
External Financing Required
Total Assets - (Liabilities + Owners Equity)
Sustainable Growth Rate
= 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
Net Cash Flows from Operating Activities
Net Income … Taken from I/S
Make adjustments to NI:
- ) Depreciation and amortisation … +
- ) Taxes .. -
Add in changes in assets/liabilities:
- ) Increase in A/R … -
- ) Increase in A/P … +
- ) Increase in accruals … +
- ) Increase in inventory… -
Add all together: NET CASH FROM OPERATING ACTIVITIES
Free Cash Flow
= 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.
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
Retained Earnings
= 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
Pro Forma Financial Statements
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
Calculation of Pro Forma
Percentage of Sales or Additional Funds Needed
Percentage of Sales for Pro Forma Statement Calculation
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
Additional Funds Needed for Pro Forma Statement Calculation
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))]
The 3 C’s: Cost of Bank Financing
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.
Times Interest Earned
EBIT/Interest Expense
Calculates how many times a company can pay interest expense with its pre-tax income; creditors favour a higher ratio.
EPS
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
P/E Ratio
Price per share/EPS
Dividend Payout Ratio
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.
When Sustainable Growth Rate Exceeds Actual Growth…
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
When Actual Growth Rate Exceeds Sustainable Growth…
(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
Payables Deferral Period
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)
Inventory Conversion Period
Part of CCC.
Average length of time to convert materials into finished goods and sell them.
= Inventory/(Sales/365)
Accrual Principle
Costs should be matched to the revenue they generate. –> Revenues/expenses are recorded when earned/incurred and not when cash is received for them.
Cash Flows
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).
Depreciation
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
Net Cash Flow
Net Profit + Depreciation + Amortisation
Financial Planning
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.
Working Capital
CA-CL
- If it’s positive, firms can pay off ST Liabilities; if negative, firms can’t cover their CL with their CA
Debt Ratio
Total Liabilities/Total Assets
- How the firm is financed
Basic Earnings Power (BEP)
EBIT/Total Assets
Stock Buy Back
Company buys back some of its outstanding stock to initiate cash distributions to shareholders.
Average Collection Period
Receivables/(Sales/365)
