SEC A 2 Flashcards
1
Q
- Vertical Analysis:
A
- Income items as % of Sales (e.g., Selling Expense = 10% of Sales).
- Balance Sheet items as % of Assets (e.g., Cash = 5% of Total Assets).
2
Q
- Horizontal Analysis:
A
- Base Year Analysis: Compare year-over-year growth rates as %.
- Variation Analysis: Calculate yearly % change.
3
Q
Statement of Financial Position (Balance Sheet)
A
- Assets: Current ( Cash and Cash Equivalents (Short-term investments ≤ 90 days), Marketable Securities (Current), Accounts Receivable (Net) ,Inventories ,Other Current Assets) + Non-Current (PPE, intangible assets).
- Liabilities: Current (payables) + Non-Current (long-term debt).
- Equity: Includes common stock, preferred stock, and retained earnings.
Liquidity Ratios:
4
Q
Liquidity Ratios:
A
- Current Ratio = CA / CL (Ideal: 2:1).
- Quick Ratio = (CA - Inventory) / CL (Ideal: 1:1). Measures liquidity without including inventory and Prepaid Exp, focusing on the most liquid assets.
- Cash Ratio = (Cash + Cash Equivalents) / CL (Conservative: 0.5:1). includes Current Marketable Securities
- Operating Cash Flow Ratio = Operating Cash Flow / CL.
- Net Working Capital Ratio = NWC / Total Assets.
5
Q
Quick Ratio
A
- Quick Ratio = (CA - Inventory) / CL (Ideal: 1:1). Measures liquidity without including inventory and Prepaid Exp, focusing on the most liquid assets.
6
Q
- Cash Ratio = (Cash + Cash Equivalents) / CL (Conservative: 0.5:1). includes Current Marketable Securities
A
- Cash Ratio = (Cash + Cash Equivalents) / CL (Conservative: 0.5:1). includes Current Marketable Securities
7
Q
- Operating Cash Flow Ratio =
A
Operating Cash Flow / CL.
8
Q
- Net Working Capital Ratio
A
= NWC / Total Assets.
9
Q
Impact of Sales on Liquidity & Cash Flow
A
Factor Increase in Sales Volume Decrease in Sales Volume
Current Assets Increase due to receivables/inventory. Decrease as collection/purchases slow.
Current Liabilities Increase from payables and wages. Decrease with fewer obligations.
Cash Flow Decrease if working capital rises. Improve temporarily with reduced receivables/inventory.
10
Q
Solvency Ratios
A
Impact of Debt on Solvency
* Solvency: Ability to meet long-term obligations.
* More Debt: Lowers solvency, increases default risk.
11
Q
- Financial Leverage Ratio (FLR)
A
- Formula: Total Assets / Total Shareholders’ Equity.
- Purpose: Shows asset financing through equity vs. debt.
- Key Points:
- FLR = 2: Debt equals equity.
- FLR > 2: High debt, high risk.
- FLR < 2: Low debt, low risk.
12
Q
- Degree of Financial Leverage (DFL)
A
- Formula: % Change in Net Income / % Change in EBIT.
- When using single year = DFL = EBIT / EBT
- Purpose: Measures profit sensitivity to EBIT changes.
- Key Points:
- DFL > 1: Magnifies both profits and losses.
- High DFL: High risk, amplified earnings changes.
13
Q
- Degree of Operating Leverage (DOL)
A
- Formula: % Change in EBIT / % Change in Sales.
- DOL = Contribution Margin / EBIT
- Purpose: Shows impact of fixed costs on EBIT changes.
- Key Points:
- High DOL: High fixed costs, amplified profit/risk.
- Low DOL: Lower earnings variability.
14
Q
- Degree of Total Leverage (DTL)
A
- DTL = DOL * DFL
- % Change in Net Income / % Change in Sales
- DTL = Contribution Margin / Earnings Before Taxes (EBT)
15
Q
- Debt-to-Equity Ratio
A
- Formula: Total Liabilities / Shareholders’ Equity.
- Purpose: Measures reliance on debt vs. equity.
- Key Points:
- High ratio = high leverage and risk.
- Low ratio = conservative financing.
16
Q
- Debt- Ratio or Debt to Asset Ratio
A
Total Liabilities / Total Asset
17
Q
Interest Coverage Ratio:
A
- Interest Coverage Ratio: EBIT / Interest Expense.
- Purpose: Assesses ability to meet interest obligations.
- High Ratio: Indicates strong debt servicing abili
18
Q
- Fixed Charge Coverage:
A
(EBIT + Lease Payments) / Total Fixed Charges.
* Purpose: Measures coverage of all fixed obligations.
19
Q
- Cash Flow to Fixed Charges:
A
Adjusted Cash Flow / Fixed Charges.
* Purpose: Focuses on cash available for fixed charges.
20
Q
Study Unit 5: A.2. Activity Ratios
A
Purpose: Activity ratios assess a company’s efficiency in managing current assets (e.g., receivables, inventory) and liabilities.
1. General Guidelines:
* Annualized Data: Adjust for periods shorter than a year.
* Gross vs. Net Receivables: Use gross receivables in ratios.
* Average Figures: Use average balance sheet items for ratios.
21
Q
- Receivables Turnover Ratio: Measures how efficiently receivables are collected.
A
- Formula: Net Credit Sales / Average Gross Receivables
22
Q
- Average Collection Period (ACP): Indicates days to collect receivables.
A
- Formula: 365 / Accounts Receivable Turnover Ratio or (Average Accounts Receivable / Net Credit Sales) * 365. 0r Average Accounts Receivable / Credit Sale Per Day
23
Q
- Inventory Turnover Ratio: Measures days inventory is held before being sold.
A
- Formula: COGS / Average Inventory
24
Q
- Days Inventory Outstanding (DIO): Shows average days inventory stays in stock.
A
- Formula: 365 /ITR or (Average Inventory /Annual COGS) * 365. Or Average Inventory / COGS Per Day
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* Accounts Payable Turnover Ratio: Measures payment frequency to suppliers.
* Formula: Credit Purchases / Average Accounts Payable
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* Days Payable Outstanding (DPO): Indicates days taken to pay off suppliers.
* Formula: 365 / Accounts Payable Turnover Ratio or (Average Accounts Payable / Annual Credit Purchases) * 365 Or Average Accounts Payable / Average Credit Purchases Per Day
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Estimating Purchases (When Not Given):
* Purchases = COGS + Closing FG - Opening FG
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* Total Asset Turnover: Measures how effectively assets generate sales.
* Formula: Net Sales / Average Total Assets
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* Fixed Asset Turnover: Measures fixed asset efficiency in generating sales.
* Formula: Net Sales / Average Fixed Assets
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2. Operating and Cash Cycles:
* Operating Cycle: Time to purchase, sell, and collect cash from inventory.
* Formula: Inventory Period + Receivables Period
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* Cash Cycle: Time to convert inventory to cash.
* Formula: Operating Cycle - Payable Period
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1. Book Value Per Share (BVPS): reflects the residual equity available to common shareholders after settling all liabilities.
Formula: (Total Equity - Preferred Equity) / Number of Common Shares Outstanding
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Total Stockholders' Equity:
Total Stockholders' Equity: The overall equity of the company, including common stock, retained earnings, and additional paid-in capital (all items in equity - preferred equity )
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2. Market to Book Ratio (PRICE TO BOOK RATIO)
Calculation: Market Price per Share / Book Value per Share
* > 1.0: Market confidence and future growth expectations. < 1.0: Possible undervaluation or distress.
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3. Price-Earnings (P/E) Ratio: The P/E ratio shows what investors are willing to pay for each dollar of earnings. It reflects the market's view of a company's future earnings potential.
P/E Ratio = Market Price per Share / Basic Earnings per Share (Annual)
* High P/E indicates growth optimism, Low P/E suggests undervaluation or declining growth expectations.
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4. Earnings Yield : Represents earnings return per dollar invested, It’s the inverse of the P/E ratio.
Earnings Yield = Basic Earnings per Share Annaul / Market Price per Share
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5. Dividend Yield :Reflects dividend income relative to stock price.
Dividend Yield = Annual Dividend per Common Share / Current Market Price Per Share
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6. Dividend Payout Ratio
Per-Share Formula
Dividend Payout Ratio = Annual Dividends per Common Share / Basic Earnings per Share
Whole Company Formula
Dividend Payout Ratio = Total Common Dividend (Annual) / Income Available For Common Shares (IAC)
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6. Dividend Payout Ratio
another formula
Dividend Yield = Dividend payout ratio / Price EARNING RATIO
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7. Total Shareholder Return (TSR) : Combines capital appreciation and dividends.
TSR = [(Ending Stock Price - Beginning Stock Price) + Dividends per Share] / Beginning Stock Price
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8. Basic EPS (BEPS): Reflects earnings per common share considering weighted shares during the period.
Basic EPS = INCOME AVAILABLE FOR COMMON SHARE HOLDERS (IAC) / Weighted Average Common Shares Outstanding
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IAC
=Net Income−Cumulative Preferred Dividends Earned−Noncumulative Preferred Dividends Declared
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KeyKey Point: Only the net income for the current year is considered in EPS calculation, not the retained earnings balance.
Point: Only the net income for the current year is considered in EPS calculation, not the retained earnings balance.
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9. Diluted EPS (DEPS):
Steps: 1.Calculate Basic EPS (BEPS): For companies with a complex structure, both BEPS and DEPS must be presented on the income statement with equal prominence.
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2.Calculate the EPS Effect of warrants and options(Treasury Stock Method)
If average market price > exercise price of the option then its DILUTIVE (net shares increase).
1. Assumes options/warrants are exercised at the beginning of the year or issue date. Proceeds from the exercise are used to repurchase shares at the average market price. net share increase : of mkt price and exercise price * share) / mkt price)
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3.Impact on EPS: No impact on numerator (income), increases denominator (shares outstanding).
4.Calculate EPS Effects of Convertible Securities (If-Converted Method):
* Rank From most dilutive (lowest EPS Effect)to least dilutive. Assumes conversion occurs at the beginning of the year or issue date.
* EPS Effect: Measures the impact of conversion on EPS. Lower EPS Effect means more dilutive.
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EPS Effect of Bond = Interest (1-tax rate) / No of converted common shares
EPS Effect of Preference Shares = Dividend declared for non cumulative + Dividend Earned for Cumulative / No of share the preference shares converted into
Note
* Anti-dilutive securities are excluded from DEPS calculation but disclosed in notes.
* EPS Effect is used for ranking, not direct impact on DEPS.
* Options/warrants are always added first if dilutive(market price> exercise price), without calculating EPS Effect.
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10. Gross Profit Margin Percentage: Measures the proportion of sales revenue remaining after deducting COGS
Calculation: (Gross Profit / Net Sales Revenue) * 100
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11. Operating Profit Margin Percentage: Measures the proportion of Net Sales Revenue retained as Operating Income after covering SG&A expenses.
Calculation: (Operating Income / Net Sales Revenue) * 100
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12. Net Profit Margin Percentage Indicates the percentage of Sales Revenue that converts into Net Income, reflecting total profitability.
Represents the impact of financial income/expenses (e.g., interest and dividend income, interest expense), non-operating gains/losses, and tax provisions.
Calculation: (Net Income / Net Sales Revenue) * 100
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13. EBITDA Margin Percentage: EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) as a percentage of net sales revenue.
Calculation: (EBITDA / Net Sales Revenue) * 100
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14. Return on Assets (ROA) : Evaluates a company's ability to generate income relative to its assets, indicating profitability and efficiency in using resources.
Calculation: (Income / Average Total Assets) * 100
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15. Return on Equity (ROE) :Measures the return a business generates on the stockholders' equity. Indicates how effectively company uses equity financing to generate profits.
Calculation: (Net Income / Average Equity) * 100
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16. Return on Common Equity (ROCE)
(Calculation: (Net Income - Preferred Dividend)/ Average common Equity) * 100
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Impact of Stock Dividends vs. Issuance:
* Stock dividends increase the weighted average shares for the entire year, reducing BEPS.
* Issuance mid-year results in a partial-year weight, leading to a higher BEPS. (Increase numerator and denominator)
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DuPont Model
ROA = Total Asset Turnover * Net Profit Margin : ROA: Efficiency of asset utilization.
* Total Asset Turnover: Efficiency in using assets to generate sales, Net Profit Margin: Profitability of sales.
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ROE
= Total Asset Turnover * Net Profit Margin * Financial Leverage Ratio (Equity Multiplier)
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Strategies to Improve ROA & ROE:
* Increase Sales with Existing Assets: ↑ Total Asset Turnover → Higher ROA & ROE
* Reduce Operational Costs: ↑ Net Profit Margin → Higher ROA & ROE
* Increase Prices Without Losing Customers: ↑ Net Profit Margin → Higher ROA & ROE
* Increase Leverage (Debt): ↑ Financial Leverage Ratio → Higher ROE
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Factors Affecting ROA & ROE:
* Accounting Policies: Inventory methods, depreciation affect profitability.
* Revenue Recognition: Timing impacts financial comparisons.
* Receivables & Inventory: Higher sales → Higher risk; Manage receivables/inventory.
* Revenue and Receivables: High sales increase receivables, impacting credit risk and ROA/ROE.
* Revenue and Inventory: Increased inventory risks obsolescence and reduces liquidity, affecting profitability.
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Key Considerations:
1. Segment Analysis: Identifies strong and weak business areas.
2. Revenue Stability: Predictable revenue leads to higher ROA/ROE.
3. Earnings Consistency: Stable earnings increase market value and ROA/ROE.
4. Liquidity Ratios: Effective management of receivables and inventory improves cash flow and profitability.
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Impact on ROA and ROE:
* FIFO increases ROA/ROE during rising prices, while LIFO reduces them.
* Accelerated depreciation lowers ROA/ROE early but improves later.
* Capitalized assets improve ROA/ROE in the short term.
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Revenue Recognition (ASC 606):
* Over Time: For gradual performance, like construction projects.
* At a Point in Time: For immediate control transfer, like home sales.
* Analysts need to understand methods for proper comparisons.
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Sustainable Equity Growth (SEG):
Formula: SEG = (1 - Dividend Payout Ratio) × Return on Equity (ROE).
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* From this formula we can find out ROE
ROE = SEG / (1 - Dividend Payout Ratio). * SEG indicates how much a company can grow without external financing.
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Ratio Analysis:
Benefits, Limitations
* Benefits: Helps with financial understanding, comparisons, and performance evaluation.
* Limitations: Relies on context, data quality, and consistent reporting.
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1. Foreign Currency Gains/Losses:
* Occurs in foreign currency transactions.
* Unrealized gains/losses recorded in the income statement; realized gains/losses upon settlement.
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2. Foreign Currency Translation and Re-measurement:
* Multinational companies must translate subsidiary financials, leading to translation/re-measurement gains/losses.
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1. Restatement:
Foreign entity statements adjusted to U.S. GAAP before conversion.
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Functional Currency:
* Primary operating currency. (The functional currency cannot be changed unless there is a significant change in economic circumstances.)
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Re-measurement vs. Translation Purpose
Purpose : Convert currency of record to functional currency
Convert functional currency to reporting currency
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Re-measurement vs. Translation Method Used
Method Used Monetary/Non- Monetary -
Temporal method Current Rate Method
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Re-measurement vs. Translation Balance
Balance Sheet - Monetary items: Current rate(A bond investment classified as held-to-maturity is a monetary )
- Non-monetary items: Historical rate All items: Current rate
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Re-measurement vs. Translation Stockholders’ Equity
Stockholders’ Equity Historical rates Historical rates
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Re-measurement vs. Translation Income Statement
Income Statement - Items related to non-monetary balance sheet: Historical rate
- Other items: Weighted average rate All items: Weighted average rate
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Re-measurement vs. Translation Gains/Losses
Gains/Losses Recognized in income statement (continuing operations) Recorded as equity (Accumulated Other Comprehensive Income)
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Impact of Inflation on Financial Statements and Ratios
* Historical Costs: Assets recorded at outdated prices, distorting the balance sheet.
* Monetary Assets/Liabilities: Assets lose value, liabilities gain value.
* Net Income: Overstated due to outdated depreciation and FIFO inventory.
* Debt Financing: Fixed rate debt benefits, floating rate debt worsens with inflation.
* Cash Flow/Risk: Increased cash demand and business risk.
Conclusion: Inflation distorts financial data and ratios, requiring careful analysis.
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Retrospective Application:
1. Retrospective Application: Adjusts prior periods and equity for changes in principle and reporting entity.
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2. Restatement:
Corrects errors, adjusts assets, liabilities, and retained earnings.(retrospective only but with "restated")
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3. Prospective Adjustment:
Applies changes only to the current or future periods without adjusting prior periods.
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* Impact on Ratios:
* Changes in principles or estimates affect net income, assets, liabilities, and equity.
* Ratios like ROA and ROE may change depending on adjustments
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1. Changes in Accounting Principles –
Retrospective Adjustment: * A switch between GAAP methods (e.g., FIFO to LIFO) is treated as a change in accounting principle.
* Retrospective Application: Adjust prior periods to reflect the new method and adjust opening retained earnings.
* Impracticability: If prior data is unavailable, apply changes only to current and future periods.
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2. Changes in Reporting Entity –
*Retrospective Adjustment: Occurs when the reporting entity changes (e.g., consolidation of subsidiaries).
* Financial statements for prior periods are adjusted as if the new entity structure existed then.
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3. Changes in Accounting Estimates –
Prospective Adjustment : * Adjustments to assumptions (e.g., useful life of an asset) are treated prospectively.
* No prior period adjustments: Changes affect only current and future periods.
* Example: Adjust depreciation based on a revised useful life, impacting only future depreciation.
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4. Error Corrections –
Restatement
* Errors or misapplications are corrected retrospectively, with "restated" financial statements.
* Adjust prior period balances, including retained earnings, and recalculate financial ratios.
* Example: Correcting a non-GAAP to GAAP transition.
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Impact on Financial Ratios
*
Changes in principles or corrections affect financial ratios (e.g., profitability, liquidity).
* Steps: Calculate ratios before the change, Adjust account balances based on changes, Recalculate ratios using updated balances.
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Retained Earnings Adjustments:
retrospective changes reflected in the Retained Earnings section in Equity. where they adjust the beginning balance of Retained Earnings.
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* Book Value:
Value based on financial statements (assets - liabilities, recorded at historical cost). representing what was paid for the assets.
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* Market Value:
Worth based on market price of shares (price per share × outstanding shares). based on the price of its equity securities (shares) - reflects investors' expectations
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* Fair Value:
price an asset or liability would sell for in an orderly market transaction under current conditions. used for valuing investments.
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* Liquidation Value:
Value if assets are sold quickly, usually lower than book and market values.
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* Accounting Profit:
Profit from subtracting explicit costs from total revenue.
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* Economic Profit:
Profit from subtracting both explicit and implicit (opportunity) costs from total revenue. * Economic profit is more useful for decisions, as it includes opportunity costs.
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Economic Depreciation:
Decline in market value of an asset over time.
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Accounting Depreciation:
Spreading an asset’s cost over its useful life, shown as an expense
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Earnings Quality
reflects how sustainable a company’s profits are. Higher-quality earnings come from consistent growth or cost control, not manipulation. rofits derived from increased sales or improved cost control are considered higher quality
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Key Determinants
1. Business Environment: External factors like competition and inflation impact earnings.
2. Accounting Principles:
* Conservative Accounting: Slower income recognition leads to more reliable earnings.
* Aggressive Accounting: Faster income recognition can inflate short-term earnings.
* Inventory :LIFO: Conservative inventory method than FIFO
* Fixed Assets: :Accelerated Depreciation: More conservative than straight-line.
* Intangible Assets amortization: Shorter amortization periods - More conservative
3. Management’s Character:
1. Asset Valuation: Overstating assets inflates earnings.
2. Sales Tactics: Aggressive promotions inflate short-term sales.
3. Inventory & Liabilities: Overstating inventory or understating provisions impacts earnings.
4. Expenditure Manipulation: Timing of expenses affects earnings quality.
5. Risks: Over-reliance on customers/suppliers lowers quality.
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Earnings Persistence
Earnings persistence reflects the stability of a company’s earnings over time and is essential for evaluating long-term performance. Analysts recast and adjust earnings to isolate stable components from unusual items, ensuring accurate analysis.
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Steps to Recast and Adjust Earnings:
1. Segregate Discretionary Expenses: Separate expenses like advertising or R&D.
2. Treat Unusual Items: Adjust unusual gains/losses and shift to the correct period.
3. Reclassify Earnings: Reallocate items like lawsuit settlements to the correct period.
4. Tax Adjustments: Shift tax benefits to the correct year.
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Determinants (causes or reasons) of Earnings Persistence:
1. Earnings Variability: Measure fluctuations; lower variability is better.
2. Earnings Trend: A consistent upward trend is desirable.
3. Management Incentives: Incentives may lead to earnings manipulation.
4. Earnings Management: Practices like smoothing or changing assumptions may artificially stabilize earnings.
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vertical analysis
common size, Different company, different size, single period
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horizontal analaysis
common base, trend analysis, single company, different period comparison
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Most dilutive EPS (for ranking)
Lowest EPS effect is most dilutive
104
Least dilutive EPS (for ranking)
higetst EPS Effect
105
overstating Assest means
understating COGS (inflates earings)
106
Deferred tax is not a
Current Liability,
Deferred Tax?
Deferred tax arises due to the temporary differences between accounting profit (reported in financial statements) and taxable profit (calculated as per tax laws). These differences create a timing mismatch in recognizing income or expenses for tax purposes.
Generally, deferred tax is a non-current asset or liability because it arises from long-term timing differences.
However, if a portion of Deferred Tax Asset (DTA) is expected to be used within one year, it can be classified as a current asset.
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when ending inventory is overstated
then COGS is understated
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