Ch 1 Flashcards

Question

Overview of Financial Objectives in Public Sector Orgs

Answer 1

Quoted company objective is max sh/h wealth, measurable through share price and dividends Public sector org is run in interests of society of whole, thus we should try to measure the gap between costs of operation (easily measured) and benefits provided (incredibly difficult) benefits are intangible / impossible to quantify – govt orgs use low discount rate and/or attempt to quantify non-fin benefits in standard NPV – but overall very tricky

Answer 2

Regulation to ensure public are not victims of monopoly that these orgs enjoy eg. capping of sales prices, taxing of super profits, or limit on permitted profit levels

Answer 3

historically, public sector growth entirely funded by govt now, government has imposed cash limits, and public sectors orgs are turning to capital markets for funds, thus beginning to face the same choices as for-profit entities

Answer 4

value added to an entity's products by its own effort problem = comparability with other industries or entities in same industry public sector entities (e.g. health) are publishing information on their own value-add

Answer 5

true concept of profit absent from most of the public sector however a different measure of output may be used = e.g. surplus after all costs (input) to capital investment (output)

Answer 6

although profit concept is absent, not unrealistic to expect entities to use donated assets with maximum efficiency Interpretation of ROA in public sector affected by: - difficulty determining value - no resale value - assets are for use by community at large - dep'n charge may have "double taxation" effect on taxpayer

Answer 7

increasingly important - e.g. universities an dhealth care health providers must now "sell" services to trusts established to "buy" from them - and risk losing market share (within limits) if customers decide to buy elsewhere

Answer 8

Public sector increasingly in competition with other public and private bodies providing same service e.g. hospitals are competing for health trust funds, advantage here is that getting access to competitor data is easier than in private sector (presumably b/c services are in "public interest")

Answer 9

Public sector entities are risk averse because of: - political repercussions of failure - taxpayers do not have alternative options to down-risk their investments (unlike sh/h)

Answer 10

Performance of an activity in such a way as to simultaneously achieve ECONOMY, EFFICIENCY, EFFECTIVENESS making optimum use of available rscs to achieve intended outcome

Answer 11

ECONOMY - minimizing cost of resources used/req'd (inputs) - spending less EFFICIENCY - relationship between output from gds/svcs and rscs to produce them - spending well EFFECTIVENESS - relationship between intended and actual results (outcomes) - spending wisely newcomer - EQUITY - extent to which svcs are available to reach intended audience - spending fairly

Answer 12

very difficulty to measure in practice a relative measure \> absolute

Answer 13

Definition: Investigation into whether proper arrangements have been made to secure 3Es in use of resources Purpose: seeks to determine whether VFM has been achieved in a specific area of expenditure / whether rsc use to achieve intended outcome was optimal intention not to question policy objecties, but provide independent and rigorous analysis on how money was spent to achieve these objectives

Answer 14

Mix of quant and qual methods: - financial analysis - analysis of mgmt info - interview / focus groups with dept/other staff - general research - surveys of practitioners or serice users - benchmarking with other orgs / countries

Answer 15

Typical focus is EITHER on effectiveness OR on economy and efficiency - they are often in partial conflict better service (effectiveness) requires more spending (economy) cheaper service (economy) means lower quality (effectiveness)

Answer 16

COMPETITION may be weaker overseas, thus attractive to firm facing competition at home COUNTRY FACTORS cheaper sources of raw mat and labor, plus govt grants and cheap loans to attract inward investment CUSTOMER BENEFITS reduced delivery times and improved relationships by locating closer to existing customers (plus ability to gain others) ECONOMIES OF SCALE RISK MANAGEMENT reduced exposure to a single economy - interest rates, inflation, govt policy, FX

Answer 17

POSITIVE NPV Gain in sh/h wealth IMPACT ON F/S translation risk = assets denominated in foreign currency giving rise to unrealized gains/losses upon conversion to domestic currency IMPACT ON COC international investments often riskier than domestic, thus COC likely to increase

Answer 18

Profitability Ratios Lender Ratios Investor Ratios

Answer 19

GROSS PROFIT Sales less Cost of Sales High Gross Profit Margin indicative of good performance OPERATING PROFIT Profit from trading activities Sales less operating costs, but before finance costs and tax NET PROFIT Profit after deduction of finance costs and tax

Answer 20

Earnings Before Interest, Tax, Depreciation, and Amortization has become increasingly widely used in recent years – sceptics say because it gives a higher measure of earnings than profit from operations EBITDA makes sense as it excludes dep'n and amort'n, both accounting adjustments and not CF – but for this reason EBITDA often mistakenly regarded as CF measure, whereas no accrual or working cap adjustments are made

Answer 21

(1) Return on Capital Employed (ROCE) (2) Return on Equity (ROE)

Answer 22

ROCE shows the overall perf of the org, expressed as a % return on total investment – thus mgmt efficiency in generating profits from available rscs { Operating Profit / Capital Employed } \* 100 Capital Employed = total funds investment = sh/h funds + l/t debt (or total assets less CL)

Answer 23

ROE gives indication of how well org has performed in relation to sh/h { Net Profit / Equity } \* 100 Equity = book value of sh/h funds useful to compare ROE to ROCE to measure how much of business's return pertains to sh/h – but they are not directly comparable: ROE uses net, ROCE uses operarting profit

Answer 24

Revenue / Capital Employed shows how much revenue is produced per $ of investment in capital employed

Answer 25

ROCE = Operating Profit Margin \* Asset Turnover { op prof / cap emp } = { op prof / rev } \* { rev / cap emp } ROCE fall could thus be b/c org is: generating lower sales from capital (lower asset turnover), and/or generating lower profit margin on sales (lower op prof mgn)

Answer 26

generally, high levels are desirable entity with high profit margins and high ROCE perceived as doing well – and increases over time are viewed positively "ideal" values vary between industries, so comparisons between years and competitors is key

Answer 27

The relationship between an org's borrowings (both prior charge capital and l/t debt) and shareholder funds the mix of debt to equity within a firm's permanent capital

Answer 28

Capital Gearing - SOFP Measure Interest Cover - SOPL Measure

Answer 29

{ debt / (debt + equity ) } \* 100 Debt = redeemable pref shares, bank borrowings, bong (incl overdrafts if l/t finance sources) Equity = ordinary and irredeemable pref shares (plus rsvs if valued at book value)

Answer 30

Market Values should be used over Book Values in Capital Gearing Ratio If using book values, must include any reserves/retained profits attributable to ordinary sh/h: Book Value = ordinary share cap + reserves If using market values, reserves must be excluded as considered as included in share price: Market Value = # shares \* share price

Answer 31

indicates the number of times profits will cover the interest charge Profit before interest and tax / Interest Payable used by lenders to determine vulnerability of interest payments to a drop in profit EBITDA often used as numerator b/c better approximation of cash generated by business / available to pay interest

Answer 32

Total l/t debt / Total assets measures availability of assets in the business in relation to total debt

Answer 33

Market price used in ratio formulae is ex-div market price Ex-div price = Cum-dividend price less upcoming dividend per share

Answer 34

investor ratio earnings / # ordinary shares in issue earnings = profit distributable to ordinary sh/h, i.e. after interest, tax, and pref dividends EPS is a historical figure and can be manipulated by changes to a/c policies, mergers/acquisitions - although obsessed upon by analysts and execs, future earnings are of greater concern to investors (and are harder to predict)

Answer 35

investor ratio measure of growth – compares market value (measure of future earnings) to current earnings current share price / EPS or: Total Market Cap / Total Earnings higher P/E ratio = higher market expectation of future earnings growth (aka "market potential")

Answer 36

investor ratio reciprocal of P/E ratio: EPS / current share price or total earnings / total market cap market price incorporates expectations of all buyers and sellers of entity shares, thus earnings yield is indication of future earning power of entity

Answer 37

Dividend per Share / EPS or: Total Dividend / Total Earnings usually, entity with high P/E ratio has low dividend payout ratio b/c high growth entities require more resources // stable entities have lower P/E ratio and higher dividend-payout ratios consider investor objectives – do they want high growth/risk or lower risk with fixed dividends and lower capital growth?

Answer 38

investor ratio dividend per share / current share price or: Total Dividend / Total market Capitalization however, dividend only part of overall return - capital gain from increase in value may far outweigh dividend

Answer 39

investor ratio EPS / Dividend per share or: Total Earnings / Total Dividend Higher dividend cover = more likely that dividend yield can be maintained Also indicates level of profits retained by entity for reinvestment, by considering how mnay times this year's dividend is covered by this year's earnings

Answer 40

Investor Ratios { (CY figure / PY figure) – 1 } \* 100% Over n years: { n√ (year n figure / earliest year figure) – 1 } \* 100%

Answer 41

SPENDING FALLS higher interest rates raise cost of credit and deter spending assuming stable incomes, higher credit cards/mortgage payments mean less free cash fall in spending =\> reduced aggregate demand =\> unemployment ASSET VALUES FALL value of bonds will fall b/c of fixed lower interest rate driving reduced demand people's wealth reduced =\> turn to saving to protect wealth this reduces expenditure in economy even further FOREIGN FUNDS ATTRACTED foreign speculators can earn higher rate of return cf overseas these funds could then be loaned out to businesses EXCHANGE RATE RISES demand for domestic currency increases =\> exchange rate increases import prices lowered and domestic inflation driven down but exports more expensive / harder to sell longer-term effect on balance of payments depends on elasticity of demand/supply for traded goods INFLATION FALLS less demand in economy =\> producers lower prices by squeezing margins or wages new borrowing is postponed by high interest thus demand will fall (thus price will too) higher exchange rate raises export prices, this threatens sales and requires cost/wage cuts – workers laid off =\> total demand reduced =\> inflation falls

Answer 42

Definition = rising prices low inflation may benefit an economy // however, getting inflation to 0% may result in higher unemployment there is agreement that 5%+ inflation is harmful

Answer 43

DISTORTS CONSUMER BEHAVIOR front-loading purchases in fear of price hikes =\> unstable markets and unnecessary shortages REDISTRIBUTES INCOME unfair lowering of purchasing power of those on fixed incomes or lacking bargaining power AFFECTS WAGE BARGAINERS trade unions will push for higher claims, especially if they previously underestimated price increases if employers accept, wage-price spiral which exacerbates inflation issue UNDERMINES BUSINESS CONFIDENCE planning and prod'n difficult when impossible to predict economic future and/or accurately calculate prices and investment returns WEAKENS COUNTRY COMPETITIVE POSITION if inflation here is higher, exports less attractive and imports more competitive leading to fewer of our goods selling here and abroad =\> bigger trade deficit RESTRIBUTION OF WEALTH real value of savings eroded when rate of interest \< inflation redistribution from saveers to borrowers, from payables to receivables government is largest borrower via national debt =\> it gains the most

Answer 44

Shows impact of interest rates on expected exchange rate – more specifically, shows that the forward rate of exchange can be found by adjusting the spot rate to reflect the differential in interest rates between the two countries F₀ = S₀ \* { (1+r_var) / (1+r_base) } S₀ = spot rate of exchange F₀ = forward rate of exchange r_var / r_base = interest rates for variable and base currencies (base being USD in $1 = ¥100 or ¥105)

Answer 45

changes in interest rates / exchange rates / inflation can effect org ability to meet objectives e.g. exchange rate change could impact sales prices and thus profitability ratios, may prevent achieving an earnings objective

Answer 46

change in margins and volumes of activity can also impact org ability to meet objectives e.g. fall in sales volume can hit profitability ratios =\> missing earnings growth target

Answer 47

HISTORICAL RECORDS, NOT FORWARD-LOOKING however, many countries require additional disclosures re. prospects, environmental data, market information, etc. in keeping with drive towards integrated reporting ACCRUALS VS CASH SOPL on accruals basis =\> difficult to relate to cash position inclusion of SOCF in accounts gives impression of cash position FINANCIAL INFORMATION ONLY historically the case - although in recent years env and social issues have been reported upon so that users of accounts can have a fuller view of entity performance