Accounting Exam 4

What are the two standards ratio analysis should be compared with?

past history of company industry averages

Cash outflows in operating activities come from Cash inflows in operating activities come from

payment for operating cost collection of sales revenues

Return on Sales

percent of each sales dollar that is left over as net income after all expenses have been subtracted Net income/ Sales

The discount factor is a function of

period numbers minimum required rate of return aka discount rate is used to calculate

Sources of cash include

profitable operations issuance of long term debt sale of long term assets issuance of capital stock

What is the criteria that long term assets have to meet?

Long life expectancy; typically greater than 1 year Large monetary value; large is determined by top management

Capital Investment decisions involve the purchase of

Long term assets

What is the difference between the type of measure and cash flow reinvestment assumption with net present value and IRR?

NPV: absolute dollars at required rate of return IRR: relative percentage at internal rate of return

What is present value equation?

P= F/(1+i)^n

What are the pros and cons of Net present value?

Pros: incorporates the time value of money provides method for screening projects or investments Cons: Calculations can be complicated Measures cannot be used to rank because projects of different sizes are not comparable

What are the pros and cons of profitability index?

Pros: incorporates time value of money provides excellent basis for rank ordering investments of difficult sizes Cons: calculations can be complicated not as widely recognized as NPV or IRR

What are the pros and cons of internal rate of return?

Pros: incorporates time value of money provides excellent rank ordering also be used in screening tools Cons: calculations are more complicated that NPV or PI assumes cash flows are reinvested at IRR

The difference between beginning and ending cash balances shown on the balance sheet serves as

a control figure for the statement of cash flows

What is a postaudit?

a follow-up analysis of a capital project once it is implemented

Statement of cash flows is required by

all firms registered with the United States Securities and Exchange Commission

an increase in accounts receivable is deducted from net income to obtain operating cash flows because

cash collections from customers were less than revenues reported

Direct Method

computes operating cash flows by adjusting each line on the income statement to reflect cash flows

Indirect Method

computes operating cash flows by adjusting net income for items that do not affect cash flows such as losses and accruals Most widely used method

Cash

currency and cash equivalents

Earnings per share

earnings generated per share of common stock (Net income - preferred dividends)/ Average common shares

the payback period is used to assess

financial risk, impact of investment on liquidity, obsolescence risk, impact of investment on performance measures

What are cash inflows and outflows?

inflows: sources; activities that increase cash outflows: uses; activities that decrease cash

Noncash exchanges

investing and financing activity that doesn't affect cash ex: land exchanged for common stock

What is the primary benefit of a postaudit?

leads to more goal-congruent decisions by managers

What are the three ratio classifications?

liquidity, leverage, and profitability

Liquidity ratios: name the 4

measures ability to meet short-term or current obligations 1. current ratios 2. quick or acid-test ratio 3. Accounts receivable turnover 4. inventory turnover

A dollar today is worth __________ a dollar received in some ___________ period of time.

more than; future

Using NPV, a project is rejected if it is A project is accepted if it is

negative; positive

What are considered nondiscounting models? discounting?

nondiscounting: payback period and accounting rate of return discounting: net present value, profitability index, and internal rate of return

What are the three sources of cash?

operating, investing, and financing activities

Statement of cash flows

provides information regarding the sources and uses of cash. distinguishes the importance of cash and cash flow

an increase in inventories is deducted from net income to arrive at operating cash flow because

purchases are larger than COGS by the amount inventories are increased

Pedee Company inventory turnover is 80 days. ______________ would help improve that ratio.

reducing average inventory

The Statement of cash flows replaced the

statement of changes in financial position based on the working capital concept in 1988

What is an advantage of common size analysis?

the effects of size are eliminated

Capital Investment Decisions involve comparing

the large investment being made now with dollar benefits that will occur in a future period

Capital Budgeting

the process of making capital investment decisions

Capital investment decisions should earn back

their original capital outlay plus a reasonable return

Luke Company's current-period income statement, Research and Development expenses are 62% sales revenue. Luke has most likely provided

vertical analysis using sales as base

Investing activities

- activities that involve the acquisition or sale of long-term assets - includes productive assets (acquiring new equipment) and long-term investments (acquiring stock in another company) - ex: purchase land

Financing activities

- activities that raise cash from creditors and owners - raise cash by issuing private stock - ex: issuance of a mortgage

What is the formula when cash flows are uniform for internal rate of return?

- calculate the payback period, round 5 integers to right of decimal - locate F on table with life of investment - IRR is percent corresponding - if it doesn't exist then interpolate

What is net present value?

- difference between present value of future cash flows (FCFs) and the initial investment (II) and other outflows if any - NPV= PV of FCFs - II - Unfiorm CF: Annual CF x Discount factor - Non-uniform CF: (CFyear1 x DF) + (CFyear2 x DF) + ...

What is the Internal rate of returns?

- interest rate where net present value = 0 - if IRR > required rate of return, accepted - if IRR< required ror , rejected

quick ratio

- measure of liquidity that compares only the most liquid assets with current liabilities - (cash + marketable securities + A/R)/ current liabilities

current ratios

- measure of the ability of a company to pay its short-term liabilities - current ratio= current assets/current liabilities - low current ratio = liquidity problems - high current ratio = excessive investment in current resources

Profitability Ratios

- measure the earning ability of a company - allow investors, creditors, lenders, and managers to evaluate the extent to which invested funds are being used efficiently 1. Return on Sales 2. Earnings per Share

Accounts Receivable Turnover

- number of times company has turned over the A/R balance in the form of sales - measure of company's ability to collect its account receivables - Net Sales/ Average A/R

Inventory Turnover

- number of times inventory has been turned over in the form of sales - measure of company's ability to move/ manage its inventory - cost of goods sold/average inventory

Operating activities

- ongoing, day to day, revenue generating activities - involve increase or decrease in either current assets and current liabilities - includes interest payments, interest and dividend income

What is the profitability index?

- ratio of the present value (PV) of FCFs to initial investment (II) - PI = PV of FCF/II - If PI is >= 1 then it is acceptable - If mutually exclusive, highest PI that is > 1

What is the accounting rate of return?

- return on project measured in terms of net income - average income/ initial investment - must be >= minimum required

What is the payback period?

- the amount of time required for an investment to generate cash flows sufficient to recover its initial cost - original investment/annual cash flow - decision rule: shorter paybacks are preferred

Debt Ratio

- total liabilities/total assets - percent of assets financed by creditors -creditors often impose restrictions on the percent of liabilities allowed.

ratio analysis

- using fractions or percents to identify financial strengths and weaknesses - ratio should be compared with a standard

Debt to Equity Ratio

-compares total debt to total equity - total liabilities/ total stockholders equity

Leverage Ratios

-measure the ability of a company to meet its long and short term obligations - ratios provide a measure of the degree of protection provided to a co. creditors 1. Debt Ratio 2. Debt-to-Equity Ratio

What are the key features of a post audit?

1. comparison of actual benefits with the estimated benefits 2. a comparison of actual operating costs with estimated operating costs 3. an evaluation of the overall outcome of investment 4. propose corrective action

To make a capital investment decision, a manager must

1. estimate quantity and timing of cash flows 2. assess risk of investment 3. consider impact of investment on firm's profits 4. choose a decision criterion to assess viability of investment

What are the two forms of common size analysis?

1. horizontal analysis: line item on financial statement expresses as a percent of some prior-period amount (base period) - if more than 2 periods involved then trend analysis 2. vertical analysis: a line item on a financial statement expressed as a percent of some other line item for the same period

Describe the two types of capital investments.

1. independent projects: projects, if accepted or rejected, do not affect the cash flow of other projects 2. mutually exclusive projects: projects that, if accepted, preclude the acceptance of all other competing projects

Describe the two capital investment decision models?

1. nondiscounting: ignore the time value of money 2. discounting: explicitly consider the time value of money

If NPV is positive

1. present value of cash inflows is > initial capital outlay 2. internal rate of return is > discount rate used in NPV calculation 3. profitability index is > 1

What are the time value of money factors?

1. principal (investment) amount (P): simple lump sum, multiple different amounts, multiple different amounts, or annuity 2. number of periods: life of investment (n) 3. interest rate: compound interest assumed (i) 4. cash flows: uniform annuity and uneven (F)

Capital Investment Decisions

Decisions that determine which projects a business will invest in, how the investment(s) will be financed, and whether or not to pay dividends to shareholders.

Common size analysis

Expresses line items or accounts in the financial statements as percentages.

What are the pros and cons of accounting rate of return?

Pros: incorporates familiar concept of profitability provides comparative measure that can be used to rank alternatives Cons: ignores time value of money net income can be manipulated by managers encourages short-term orientation by managers

What are the pros and cons of the payback period?

Pros: simple measure of risk used to choose Cons: ignores cash flows beyond the payback period ignores the time value of money

cash equivalents

Short-term, highly liquid investments that can be readily converted to a specific amount of cash and which are relatively insensitive to interest rate changes.