Section 3 Financial Management Flashcards
Economic Order Quantity
The economic order of quantity is the purchase order size that minimizes the total inventory order cost and inventory carrying costs.
EOQ = √(2 ×Ordering Cost ×Annual Demand / Carrying Cost)
Reorder Point
A reorder point is the inventory unit on hand that triggers the purchase of a predetermined amount of replenishment inventory. The formula for the reorder point is to multiply the DAILY usage for an inventory item by the lead time in days to replenish it and add the minimum amount of inventory required.
Reorder Point = Lead Time (In Days) * Average Sales per Day + Safety Level of Inventory
Cash Conversion Cycle
= Inventory Conversion Period + Receivables Collection Period - Payables Deferral Period
Inventory Conversion Period = 365 / Inventory Turnover Ratio
Receivables Collection Period = 365 / AR Turnover Ratio
Payables Deferral Period = 365 / AP Turnover Ratio
The Cash Conversion Cycle (also called Net Operating cycle) is the amount of time between the date of cash expenditures for production of inventory to the date of cash collection from customers (i.e., receivables). It is the sum of the inventory conversion cycle (60 days) plus the receivables collection period (15 days) less the payables deferral period (30 days) = 45 days.
Interest Coverage Ratio
When a company has a fixed obligation of servicing debts through interest payments, the “times interest earned ratio” measures the number of times that the firm can pay its interests from EBIT. It can be calculated as follows: (Earnings before interest and taxes / Interest obligation)
Capital Asset Pricing Model (CAPM) - Cost of Retained Earnings
CAPM is a model that evaluates the relationship between risk and expected return for assets, but usually stocks.
CAPM uses 1) the risk-free rate of return and 2) Beta.
The risk-free rate of return is the hypothetical rate for return for “no risk” and is based on the rate for a 3-month U.S. treasury bill.
Beta (β) is a measure of how volatile an investment is compared to the rest of the market, or comparable items. A beta of 1 means it’s equal, a beta of 0.5 means it is half as volatile as comparable items, and a beta of 2 means it is twice as volatile as comparable items.
Capital Asset Pricing Model (CAPM) uses formula below to compute the cost of retained earnings:
Required Rate of Return: RFR + Beta(ERR - RFR)
RFR = Risk Free Rate
ERR = Expected Rate of Return
Payback period
Payback period = Initial investment / Annual after-tax cash inflows
IRR = Initial Investment / PRESENT VALUE of Annual After-tax cash inflows
Profitability Index = Present Value of Total Cash Flows / Initial Investment
- Salvage Value is only included if the payback period extends that long.
- Can’t include salvage if Investment has already been covered
The company’s after-tax operating cash inflows (or Money Generated After Tax) = After-tax operating inflows + Depreciation tax shields
= (110,000 x 60%) + (80,000 x 40%)
= $98,000
Simply:
Payback Period = What you Paid / What It’s Making
Return on Assets
Return on Assets = Profit Margin on Sales x Asset Turnover
Asset Turnover = Net Sales / Average total assets
Net Present Value
Net Present Value is equal to the discounted future value less the initial investment
Inventory Turnover, Receivable Turnover, Payables Turnover
Inv Turnover = COGS / Avg Inventory
Rec Turnover = Net Credit Sales / Avg AR
Payables Turnover = Purchases / Avg Payables
Asset Turnover = Net Sales / Avg Total Assets
Internal Rate of Return
By definition, the internal rate of return is the rate which would exactly equate the present value of a project’s expected cash inflows to the present value of the project’s expected costs.
- Uses the Rate of Return Earned by the Initial Investment
Price-to-Sales ratio
Current Market Price per Share / Sales per Share
Price-to-Sales ratio is a comparison of the company’s share price with its revenues, i.e., sales.
It can be calculated as P0/Sales per share, where P0 is the current share price and Sales is the sales per share in the most recent year.
In this example, Sales per share = 6,500,750/500,000 = 13.0015
Price-to-Sales ratio = 70/13.0015 = 5.38 times
Weighted Average Cost of Capital
Calculates the true cost of Capital. refers to the opportunity cost of using capital in a project or investment compared to another.
WACC =
(%Cost of Equity * % of Capital that is financed through equity) + (%Cost of Debt * % of Capital that is financed through debt)
If tax rate is involved include the inverse in the calculation of cost of debt. EG 30% Tax Rate
= %Debt * .7 * %Cost of Debt
Cost of Debt
You are figuring out the cost percent of the debt taken.
(Interest Expense - Tax Benefit) / Carrying Value of Debt
Average Collection Period
= 365 / Net credit Sales / Avg AR
Pay Off Formula
What you Owe / Income *365 = Pay off in Days
Debt Ratio
= Total Liabilities / Total Assets
Also known as Financial Leverage
% of Debt that makes up Liabilities and Equity
Cost of Forgoing a Discount
The cost of not taking advantage of a discount = [360 / (Pay period – Discount period)] x [Discount / (100 – Discount%)]
In other words:
360 / (Excess Days Allowed) * (Discount / Percent of amount that would have been paid)
Operating Leverage vs Financial Leverage
Operating leverage measures a companies fixed costs as a percent of its total costs. Higher OL = Lower Fixed Costs
OL = Net Operating Income / Contribution Margin
Financial Leverage measure how much a company is financing its assets with debt. Too little is inefficient and too much is too risky.
FL = Total Debt / Total Assets
Accounting Rate of Return
Net Income / Average Investment
Net Present Value VS Internal Rate of Return
NPV gives the actual cost or benefit of the project at present value.
IRR give the rate at which the present value of expected cashflows meets the present value of the cost of the project.
PV Factor
IRR PV Factor = Investment / After Tax Annual Cashflow
Remember it’s annual because you are trying to find the rate of return
You are trying to find which PV factor to use in the table to calculate the present value of the cashflows.
Inventory Reorder Point
AVG Daily Demand * AVG Lead Time
Residual Income
= Operating Income - (Required Rate of Return * Invested Capital)
Rate of return is also called the Cost of Capital or Cost of Equity.
RoR is the number used for the cost of equity in the WACC formula
Financial Spread
= ROI - Cost of Capital
Days Sales In AR
= (Ending AR / Net Credit Sales) * 365
Profitability Index
= Present value of cash flows / Initial Investment
Inverse of Payback Period and PV Factor
Price Earnings Ratio & PEG
P/E Ratio = Share Price / Earnings per Share
EPS = NI / Average Shares Outstanding
PEG = P/E Ratio / EPS Growth
Cost of Retained Earnings (Equity)
CRE = (Dividends per share / Current Market Price of Stock) + %Constant Rate of Growth of Dividends
= (Div/Price) + %Growth Rate
Cost of Capital
= Dividend / (Market Price per Share - costs to issue)
Growth Rate
(End Value - Beg Value) / Beg Value * 100
