Finals Flashcards

Question

Limitations of Financial Ratios

Answer 1

- To make ratios meaningful… Need to “benchmark” Look at trends Compare financial performance with other businesses or industry averages - Only give signals— do not answer questions relating to why, what, or how - Ensure that numbers used are similar – different accounting methods and ratio calculations - Business size may make a difference - Nature of the operations may also be different (new plant versus worn-out plant)

Answer 2

1. High operating leverage A large proportion of the company’s costs are fixed costs. In this case, the firm earns a large profit on each incremental sale, but must attain sufficient sales volume to cover its substantial fixed costs. If it can do so, then the entity will earn a major profit on all sales after it has paid for its fixed costs. Larger fluctuation of profit with changes in revenue - more risky 2. Low operating leverage A large proportion of the company’s sales are variable costs, so it only incurs these costs if there is a sale. In this case, the firm earns a smaller profit on each incremental sale, but does not have to generate much sales volume in order to cover its lower fixed costs. It is easier for this type of company to earn a profit at low sales levels, but it does not earn outsized profits if it can generate additional sales. Smaller fluctuation of profit with changes in revenue

Answer 3

Volume of production Prices Costs (fixed & variable) Changes in product mix

Answer 4

Controllable / non-controllable Direct / indirect Committed fixed / discretionary fixed

Answer 5

Contribution Margin = Revenue – Variable Expenses (Variable Direct Materials, Variable Labour & Variable Overhead) Could also be per product = Sale price – Variable Direct Material (per unit of product) – Variable Labour (per unit of product) – Variable overhead (per unit of product)

Answer 6

- The more debt financing a company uses, the higher its financial leverage - A high degree of financial leverage results higher risk to shareholders - The less financing a company uses, the lower its financial leverage - A low degree of financial leverage results in lower risk to shareholders

Answer 7

- Solvency Ratios: Net income + depreciation / Short term Liabilities + Long term Liabilities - Interest Coverage Ratio: Operating Income (EBIT) + Interest Expense / Interest Expense - Debt/Total Assets: percentage of company’s assets financed by debt. Higher the ratio, greater degree of leverage. - Debt/Equity: degree of financial leverage being used. The higher the ratio, it implies a higher amount of debt and higher interest expense. A capital structure of equal parts debt and equity would result in a debt/equity ratio of 1. Above 1, a company has more debt; below 1, the company has more equity.

Answer 8

First: Sales projections with Sensitivity Analysis! Then: Production/Merchandising projections; Sales and Administrative expenses projections; Capital expenses projections Then: Cash Flow projections Identify short-term financing needs Then: Pro-forma Income Statement Finally: Pro-forma Balance Sheet

Answer 9

``` Buy property, plant, and equipment Additional investments in research and development Promote the launch of a new product Acquire a new business Additional working capital ```

Answer 10

``` 1. Internal financing Cash flow from the operations Profit for the year Add back: depreciation Deduct: dividends paid = Total funds generated by the business Working capital Inventories Trade receivables ``` 2. External financing Shareholders (equity) Lenders (long- and short-term) Leasing

Answer 11

``` Risk/return of financing options - Business risk Built-into the firm’s operations Uncertainty in the marketplace - Financial risk Related to the firm’s capital structure Debt versus equity - Instrument risk Quality of security Secured versus unsecured loans ```

Answer 12

- Lender’s Criteria - The matching principle - Matching strategy (matching maturities) - Short-term funds finance – temporary working capital - Creditworthiness

Answer 13

Some are more restrictive or focus on different priorities than others. Relationship and reputation matters either as much or more than technical requirements.

Answer 14

The matching principle requires that revenues and any related expenses be recognized together in the same period. Thus, if there is a cause-and-effect relationship between revenue and the expenses, record them at the same time. If there is no such relationship, then charge the cost to expense at once. This is one of the most essential concepts in accrual basis accounting, since it mandates that the entire effect of a transaction be recorded within the same reporting period.

Answer 15

is the acquisition of investments whose payouts will coincide with an individual or firm's liabilities. Under a matching strategy, each investment is chosen based on the investor’s risk profile and cash flow requirements. The payout might consist of dividends, coupon payments or principal repayment.

Answer 16

are met with short-term debts and long-term requirements with long-term debts. The underlying principal is that each asset should be compensated with a debt instrument having almost the same maturity. - Long-term funds finance – fixed assets and permanent working capital - Short-term funds finance – temporary working capital

Answer 17

How safe you are as a borrower in the perspective of the lender. How likely you are to make your payments on time and pay a loan in full. Cs - of credit (Factors that investors look at to assess the creditworthiness of a business) ``` Character Collateral Capacity Capital Circumstances Coverage ```

Answer 18

Poor earnings record Questionable management ability Collateral of insufficient quality or quantity Slow and past due in trade or loan payments Poor accounting system New firm with no established earnings record Poor moral risk (character)

Answer 19

Equity Financing - Raising capital through the sale of shares of an enterprise - The sale of an ownership interest to raise funds for business purposes ``` - Common shares Voting rights Dividends if available - Preferred shares Preferential access to dividends May have voting rights ```

Answer 20

Conventional Intermediate and Long-term Financing - Term loan Financing amount depends on what can be offered as security and is determined by lender Banks, trust companies, insurance companies, and pension funds - Conditional sales contract Agreement made between a buyer and a seller for the purchase of an asset (e.g., truck) by installments - Bonds Long-term loans that could be secured or unsecured (20 to 30 years) - Mortgages Long-term loan to finance real property, land, and buildings

Answer 21

``` Supplier financing - Trade credit - Consignment sales Chartered banks and trust companies - Line of credit - Interim (bridge) financing Asset-based financing - Accounts receivable factoring - Inventory financing ```

Answer 22

- Capital cost allowance - Tax effects of capital cost allowance represent an advantage to ownership - Obsolescence - Makes leasing more attractive - Operating and maintenance charges - Represent an expense to ownership and make leasing more attractive - Salvage or residual value- Advantage to ownership - Tax effects - Lease payments are fully tax deductible and make leasing more attractive

Answer 23

Future Value of a Single Sum Present value of a future lump sum Future value of an annuity Present value of an annuity

Answer 24

The Rule of 72 is a simplified way to determine how long an investment will take to double, given a fixed annual rate of interest. By dividing 72 by the annual rate of return, investors can get a rough estimate of how many years it will take for the initial investment to duplicate itself.

Answer 25

STEP 1: Calculate the payment per period STEP 2: Determine the interest in Period t STEP 3: Compute principal payment in Period t STEP 4: Determine ending balance in Period t STEP 5: Start again at Step 2 and repeat

Answer 26

1. Accounting methods - Use financial statement information - Do not consider time value of $ 2. Payback method - Simple technique that considers time risk only 3. NPV 4. IRR or Discounted Cash Flow (DCF) 5. Profitability Index (PI)

Finals Flashcards

(50 cards)