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Flashcards in CMA 2 Deck (17):

Vertical Analysis (also called
common-size financial statements)

Makes it possible to compare the performance of companies of different sizes during the same period of time. Covers one year’s operating results and expresses each component as a percentage of a total


Horizontal (or trend analysis)

Enables comparison of data for a single company or a single industry over a period of time.


Two rules should always be followed when calculating ratios that include both balance sheet and income statement items:

1) Average balances of balance sheet items are used instead of ending balances whenever a ratio calculation is relating an income statement amount to a balance sheet amount. The average balance amount should be the average balance of the balance sheet item during the same period of time as is covered by the income statement item.
2) When the time period represented by an income amount in a ratio is less than one year, the income
amount should be annualized to present the amount as if the same income level had been attained
for a full year. To annualize an income amount that is for less than a full one-year period, annualize it
as follows.

If the income amount is for one quarter, multiply it by 4 to annualize it.

If the income amount is for one month, multiply it by 12 to annualize it.

If the income amount is for five months, divide it by 5 months and then multiply the result (one
month’s income) by 12 months.

If the income amount is for an uneven number of days, for example 54 days, divide the income amount by the number of days and then multiply the result (one day’s income) by 365 days.



Reflects the ability of a firm to meet its SHORT-TERM obligations by using assets that are most readily
converted into cash without significant loss in value or the necessity of making significant price concessions.
Assets that can be converted into cash within a SHORT period of time without significant loss are referred to as
LIQUID ASSETS, and they are identified in financial statements as current assets. CURRENT ASSETS may also be referred to as WORKING CAPITAL, since they represent the resources needed for the day-to-day operations of the firm's long-term, capital investments. CURRENT ASSETS should be used to satisfy CURRENT liabilities


Quick Ratio (or Acid Test Ratio)

Cash + Marketable Securities + Net Accounts / Receivable Current Liabilities


Cash Ratio

Cash & Cash Equivalents + Marketable Securities /
Current Liabilities


Cash Flow Ratio

Operating Cash Flow / Period-End Current Liabilities


Net Working Capital Ratio

Net Working Capital
(Current Assets – Current Liabilities) / Total Assets


Liquidity of Current Liabilities

1) Tax liabilities must be paid when due
2) unrecorded liabilities i.e. purchase commitments or operating lease obligations



Refers to the potential to earn a HIGH LEVEL of return relative to the amount of cost expended.


Financial Leverage Ratio (or Equity Multiplier)

Total Assets / Total Equity


The financial leverage ratio indicates

The amount of debt a firm is using to finance its assets. The more debt the company has, the higher its financial leverage ratio will be. The company’s financial
leverage ratio will increase as more money is borrowed to finance additional assets.


Trading on the equity

A term that means the company is using financial leverage (debt) in an effort to achieve increased returns.


Degree of Financial Leverage (DFL)

% [of future] Change in Net Income / % [of future] Change in EBIT (Earnings Before Interest and Taxes


Degree of Financial Leverage
(DFL) When only one period of financial information is available

Earnings Before Interest and Taxes (EBIT) /
Earnings Before Taxes (EBT)

The DFL predicts the effect on the future EBT of a given future percentage increase in EBIT



Total operating revenue
− Total operating expense
= Operating income
+ Interest and dividend income
+/− Non-operating gains/(losses)
+/− Gains/(losses) on discontinued operations
= Earnings before interest and taxes (EBIT)
− Interest expense
= Earnings before taxes (EBT)
− Taxes
= Net income



- Variable costs
=Contribution margin
- Fixed costs
= Operating income
+ Non-operating gains/(losses)
+ Interest income
- Interest expense
- Taxes
= Net income