WGU C214 Financial Mngt
20x2 20x1 Gross PP&E $22,500 $????? Less: Acc. Depr $7,100 $????? Net PP&E $15,400 $15,200 Using the data above and assuming no asset disposals, what is the firm's CFI for the year 20x2? Assume that the firm claims $1,600 in depreciation expense during the period.
$1,800 With the assumption of no asset disposals, CFI will be equal to 1) change in Gross PP& E, or 2) Change in Net PP&E plus depreciation expense. The change in Net PP&E of $200 plus $1,600 in depreciation expense equals CFI of $1800.
20x2 20x1 Gross PP&E $22,500 $20,600 Less: Acc. Depr $????? $5,400 Net PP&E $????? $15,200 What is the firm's CFI?
$1,900 With the assumption of no asset disposals, CFI will be equal to 1) change in Gross PP&E, or 2) change in Net PP&E plus depreciation expense. The change in Gross PP&E is $1,900.
Balken, Inc. reports the following on their most recent financial statements: Change in accounts payable: $50 Change in notes payable: $100 Change in long-term debt: $200 Change in retained earnings: -$120 Net income: $170 What is Balken's CFF for the period?
$10
Balken Inc. reports the following on their most recent financial statements: · Change in accounts payable: $50 · Change in notes payable: $100 · Change in long-term debt: $200 · Change in retained earnings: -$120 · Net income: $170 What is Balken's CFF for the period?
$10 CFF = change in notes payable + change in long-term debt - dividends (assuming no other relevant changes); hence, CFF = 100 + 200 -Dividends. The change in RE = net income - dividends; so, -120 = 170 - dividends; thus, dividends = 290. Finally, CFF = 100 +200 - 290 = 10.
BackJack reports retained earnings of $15,225 for 20x2. The firm paid dividends of $4000 and $2,025 in 20x1 and 20x2, respectively. Additionally, the firm reported net income of $8,000 and $5,000 in 20x1 and 20x2, respectively. What were BackJack's reported retained earnings for 20x1?
$12,250 Solution: New RE = Old RE + NI - Div; 15225 = Old RE + 5000 - 2025; Old RE = 12,250
A firm reported retained earnings of $305 in 20x2. For 20x3, the firm reports retained earnings of $400 and pays dividends of $25. What was net income in 20x3?
$120 Solution: New RE = Old RE + NI - Div; 400 = 305 + NI - 25; NI = 120
U&I Inc. recorded retained earnings of $2,000 last year and $2,500 this year. Net income of U&I Inc. is $500 and $650 for last year and this year, respectively. This year, U&I Inc. must have paid dividends of:
$150 Solution: Change in RE = NI -dividends. Rearranging: Dividends = NI - Change in RE. Therefore: Dividends = 650 - (2500 - 2000) = $150.
Balken Inc. reports the following on their most recent financial statements: · Change in accounts payable: $50 · Change in notes payable: $100 · Change in long-term debt: $200 · Change in retained earnings: -$120 · Dividends declared: $160 What is Balken's net income for the period?
$40 Change in RE = net income - dividends; -120 = net income - 160.
A firm purchased equipment three years ago for $500,000. The equipment is the only fixed asset the firm has ever owned. If the firm claimed depreciation of $20,000 the first year, $35,000 the second year and $32,500 the third year, the Gross Fixed Assets should be equal to:
$500,000 Solution: GROSS fixed assets represent the original cost of the firm's fixed assets before accumulated depreciation.
TellAll reports retained earnings of $1122 and $1402 for 20x1 and 20x2, respectively. Additionally, the firm paid dividends of $200 and $225 in 20x1 and 20x2, respectively. What was TellAll's net income for 20x2?
$505 Solution: New RE = Old RE + NI - Div; 1402 = 1122 + NI - 225; NI = 505
Last year a firm recorded Net PP&E of $4,600 while this year the same firm recorded Net PP&E of $4,500. If the depreciation expense for last year and this year are $500 and $800 respectively, what is the CFI of the company? (assume no asset disposals)
$700 Solution: CFI = (Change in Net PP&E + Depreciation Exp) = (4500 - 4600 + 800) = $700
A firm recorded Gross PP&E of $5,000 in 20x1 and $6,300 in 20x2. Further, accumulated depreciation was $2,000 and $2,400 in 20x1 and 20x2, respectively. Assuming no asset disposals, CFI is closest to which of the following?
($1,300) Solution: CFI = (Change in Gross PP&E) = (6300 - 5000) = ($1,300).
Quick Ratio
(Current Assets - Inv) / Current Liab
DuPont Decompistion (DuPont Equation)
(Net Income / Sales) × (Sales / Total Assets) × (Assets / Equity) Net Margin x TAT x FLR
Dividends =
(Old RE + Net Income) - New RE
Gross Margin percent of revenue remaining after the cost of the goods sold
(Sales - COGS) / Sales
Steps of Firm Analysis
1. Basic Data - Identify comparison group, Gather/scrub data, calculate ratio 2. Differences - Target v standard, Red Flags, Integrated analysis 3. Deepen Analysis - Broaden data sources, Evaluate competitive landscape, Internal/external threats 4. Report Cause & Cure - Identify sources of weakness, consider competitive response, prepare recommendations
The DuPont Equation: Three Tools for ROE
1. Higher Margins: decrease costs relative to sales (higher net margin) 2. Greater Efficiency: Increase sales relative to assets (higher TAT) 3. Lever Up: Increase debt relative to equity (higher FLR)
Kyoto Restaurant has total asset turnover of 1.50, ROE of 18.00%, and net profit margin of 6.00%. What is Kyoto's financial leverage ratio?
2.0 FLR = ROE / (Net Margin x TAT) = 0.18 / (0.06 x 1.50) = 2.00.
Average collection period (ACP)
365 / AR Turnover
Days on Hand
365 / Inventory Turnover
Suppose a firm has a financial leverage ratio of 2.50. What percentage of the firm's assets are financed by equity?
40% The correct answer is 40%. We know that Assets (100%) = Liabilities (X%) + Equity (Y%). So Financial leverage ratio = 2.5 = 100% / Y% = Assets/Equity; thus Y = 100 / 2.5 = 40%.
If a firm's financial leverage ratio is 2.50, what percentage of assets are financed by debt?
60% Solution: We know that Assets (100%) = Liabilities (X%) + Equity (Y%). So, Financial leverage ratio = 2.5 = 100%/Y% = Assets/Equity; thus Y = 40%, so X = 60% = percent financed by debt.
Macrosoft's average collection period is closest to which of the following? (Assume 365 days in a year.)
90 days Solution: AR Turnover = credit sales/AR = 15000/3700 = 4.055. Average Collection Period = 365/AR Turnover = 90.0 days. (Note: in the absence of other information, all sales are assumed to be on credit).
Which of the following statements is NOT correct with respect to using ratios to analyze a firm or firms?
A change in a ratios reveals the economic character of the firm.
The timing of a firm's fiscal year end would be most relevant to which of the following firms:
A snowboard shop.
Which of the following represent operating asset accounts considered in the calculation of CFO?
Accounts receivable and inventory
While looking at XYZ Corp's two most recent balance sheets, you notice inventory decreased by $100,000. The firm has a tax rate of 40%. To calculate Cash Flow from Operations, you will:
Add $100,000 to CFO A decrease in an operating asset represent a cash inflow associated with CFO. The tax rate does not impact the question.
When calculating CFO, which of the following is correct?
Add an increase in accrued wages
Which of the following will decrease CFO?
An increase in accounts receivable and a decrease in accounts payable
Which of the following is true with respect to CFO?
An increase in inventory indicates a reduction in CFO An increase in an operating liability (like A/P) will increase CFO. An increase in notes payable will increase CFF. An increase in cash is the result of operations, investment, and financing.
The flexibility aspect of ratios and ratio analysis refers to which of the following?
Analysts can create new ratios if needed.
Given the following data, calculate CFF for 20X3. 20X2 20X3 Retained Earnings 3,400 3,600 Accounts Payable 2,100 1,900 Notes Payable 1,200 1,300 Common Stock 4,200 4,500 Accounts Receivable 3,200 3,700 Net Income 400 500 Long-Term Debt 4,500 4,500
Answer: $100 ·CFF = Change in N/P + Change in LTDebt + Change in CS - Dividends o Change in LTDebt = 4500-4500 = 0 o Dividends = NI - change in retained earnings = 500 - [3600-3400] = 300
Borrowing and ROE
Borrowed money carries an explicit interest rate. If it costs a firm 10% to borrow and the firm earns 10% on the debt-financed assets, ROE will be unchanged. However, if the firm earns more than 10% on the assets, ROE will increase. Unfortunately, this works in both directions. If earnings fall below 10%, ROE will decrease.
Which of the following best describes the simplified calculation of CFO:
CFO = NI + Depreciation expense + changes in operating accounts CFO is calculated for a single period, so we need depreciation expense for that period and not total accumulated depreciation. Additionally, while changes in accounts receivable are included in the calculation of CFO we need to examine all operating accounts not just this one.
Inventory Turnover
COGS / Inventory
Which of the following are current asset or current liability accounts that are not included in the calculation of CFO?
Cash & notes payable
Which one of the following is NOT a part of the statement of cash flows?
Cash flows from liquidating activities
CFI =
Change in Gross PP&E or Change in Net PP&E + Depreciation
Which one of the following items should NOT be included in the calculation of CFF?
Change in Retained Earnings
The evolution of retained earnings is best described by:
Change in retained earnings = net income - dividends The change in retained earnings = net income - dividends. Remember, there are only two things you can do with net income: 1) pay it out as dividends and 2) retain it within the firm.
AR Turnover
Credit Sales / AR
Current Ratio
Current Assets/Current Liab
Brighton and DarkTec are identical companies: both companies sell computers to identical clients, recognize the same amount of revenue, and purchased the same capital equipment at the same cost at the beginning of this year. However, Brighton's sales are 1/3 on credit while 2/3 of DarkTec's sales are on credit. In addition, while both companies use straight-line depreciation, Brighton calculates depreciation of the new equipment based on an 8-year useful life while DarkTec calculates depreciation based on 10-year life (i.e. Depreciation Expense = Cost of Machine/Life of the Machine). Assume both companies had exactly the same balance sheets at the beginning of the year. Which of the following statements is most likely correct?
DarkTec has a higher net income than Brighton. Brighton should have lower account receivables than DarkTec since it has lower credit sales (and presumably the same collection rate since both firms have identical clients). There is nothing in the problem to indicate that interest expense will be different for the two firms. All else equal, DarkTec's net income will be higher because of lower depreciation expense stemming from the longer assumed asset life.
Depreciation expense is a significant source of difference between net income and CFO because:
Depreciation expense is non-cash expense on the income statement associated with the acquisition of long-lived assets.
On the income statement, Cost of Goods Sold includes
Direct materials and direct labor associated with production
Net Income =
Dividends + Change in RE
FCFF =
EBIT (1-tax rate) + depreciation - CAPEX - Increases in NWC Tax rate = percent of earnings a firm pays in tax Depreciation = Depreciation expense EBIT = Earnings before interest and taxes CAPEX = Capital expenditure on PP&E; frequently measured as CFI NWC = Net working capital (current assets − current liabilities) changes EBIT (1-tax rate), is referred to as Net Operating Profit After Taxes (NOPAT)
Times interest earned (TIE) this ratio tells us how many times a company covers (or can pay) interest expense given operating profit
EBIT / Interest expense
Operating Margin percent of sales remaining after covering the cost of the goods sold AND operating expenses.
EBIT / Sales
Operating Income Return on Investment (OIROI) the relationship between operating profit (EBIT) and the company's asset base tells us how much pre-tax, pre-financing profit the company generates per dollar of assets
EBIT / Total Assets
Assume that the industry average ROE is 12%. For Eastern Family, which of the following best describes their ROE:
Eastern Family is generating lower return to owners than the industry. ROE for Eastern Family is 8.94% (474/5300 = 8.9%) which is less than the industry average.
If the industry average debt ratio is 60%, then:
Eastern Family is more aggressively financed by debt than the industry. Eastern Family's debt ratio is 67.28% (= total liabilities/total assets = 10,900 / 16200; remember, total liabilities equals current liabilities [$3,900] + long-term liabilities [$7,000]). Since the industry average is only 60%, Eastern Family finances a higher portion of its assets with debt than the industry norm. Thus, Eastern is more aggressively financed than the industry. Having a higher debt ratio does not necessarily mean that the company's debt is lower quality.
The industry has the following ratios: · Current ratio = 2.15 · Quick ratio = 1.5 · Inventory turnover = 1.95 · AR turnover = 4.5 Which one of the following statements is the most accurate about Eastern Family?
Eastern Family takes longer to collect receivables than the industry. The accounts receivable turnover for Eastern Family is lower than the industry norm suggesting that it takes the company longer to collect receivables than the industry average. You cannot assess the company's liquidity based on ONLY current ratio. Also, since Eastern Family's inventory turnover ratio is lower than the industry this would imply it is NOT better at managing its inventory. Eastern Family's Current Ratio = 9700/3900 = 2.49; Quick Ratio = (9700-4000)/3900 = 1.46; Inventory turnover = 5890/4000 = 1.47; accounts receivable turnover = 10000/3000 = 3.33.
If a competitor of Eastern Family has a Total Asset Turnover (TAT) of 1.10, then:
Eastern Family's asset utilization success cannot be assessed by the TAT alone. Looking only at TAT for Eastern and a competitor will not allow us to judge whether Eastern is doing good or bad. We have to consider issues such as technology investment and cost structure.
The basic equation for the balance sheet is:
Equity = Assets - Liabilities The equation is usually introduced as Assets = Liabilities + Equity. Commonly, we solve for Equity as is the case for this questions (E=A-L).
Which of the following accurately describes the calculation of Free Cash Flow to the Firm?
FCFF = EBIT*(1-tax rate) + Depreciation - CAPEX - Increases in NWC
A firm can sustain negative CFO indefinitely by borrowing, selling equity, and/or by selling assets.
False
An income statement always provides an accurate measure of a firm's cash flows.
False
Cash accounting offers a superior method of analyzing a company
False
Dividing CFO among the owners of a firm is a sustainable policy.
False
Increases in operating balance sheet accounts will decrease CFO.
False
The Statement of Cash Flows is not useful when assessing the financial health of a firm due to the impact of accrual accounting.
False
The ratios used in financial analysis are defined by GAAP.
False
When calculating CFF, most of the data can be located at the bottom of the asset side of the balance sheet.
False
When calculating CFO, you generally include the changes in all current assets and current liabilities.
False
For visualizaiton purposes, it is correct to think of balance sheet accounts relevant to CFI as being on the bottom of the financing side.
False CFI accounts are generally non-current assets (i.e., bottom of the asset side of the balance sheet).
Cash flow from operations cannot be managed.
False CFO can be dramatically impacted by managerial discretion in the financial reporting process.
The Statement of Cash Flows categorizes cash flow into cash flow from operations, cash flow from production, and cash flow from financing.
False Cash flow from production is not a category. The three cash flow areas are from operations, investing, and financing.
The income statement represents a snapshot of the firm at one point in time.
False False. The income statement represents the result of operations over a period of time.
Tax expense as shown on the income statement is the amount of cash the firm paid to the taxing authority during the period.
False False; Income tax expense (aka provision for taxes) is rarely the actual amount of tax paid during the period. The tax provision on the income statement is calculated as if the tax code is identical to financial accounting standards. In reality, the tax code differs in many ways from financial accounting. Hence, the actual tax liability can be higher or lower than the reported income tax expense
The firm in an industry with the largest CFO is the industry's top performer.
False Having the largest CFO might merely be a function of size. Best" is multi-dimensional. The firm reporting the largest CFO might be historically successful but now be struggling/shrinking because of a lack of innovation, market dynamics, etc. Further, having the largest CFO in the buggy whip industry does not reveal much about performance.
Inventory is the most liquid component of current assets.
False Of the major components comprising current assets (i.e., cash, marketable securities, accounts receivable, and inventory), inventory is usually the least liquid.
A firm with positive CFO should be considered healthy.
False Positive CFO is usually a key component in firm health, but positive CFO by itself says little about a firm.
A firm can use retained earnings to pay bills if needed.
False Retained earnings isn't a box of cash. To pay bills, the firm must have cash in the bank as represented by the cash account in current assets. The earnings retained by the firm have already been used to finance the firm's assets (recall: A = L + E). If a firm has a large retained earnings balance and small debt load (relative to assets), it may have significant borrowing capacity. But, borrowing capacity is not the same as a cash reserve. Retained earnings definitely is NOT a cash reserve.
A change in notes payable will impact CFO.
False Solution: A change in notes payable will NOT impact CFO (Note: notes payable is a financing variable; hence, changes in notes payable impact CFF).
Assuming no asset disposals, CFI is equal to the change in Net PP&E.
False Solution: Assuming no asset disposals, CFI is the change in GrossPP&E. Equivalently, CFI is equal to the change in Net PP&E plus depreciation expense.
If you want to understand a firm's operations, cash accounting is a superior tool.
False Solution: False. Accrual accounting is superior for understanding the operations of a firm. The cash accounting system may lead you to an inaccurate view of the firm since the receipt and disbursement of cash is frequently not synchronized with operating variables.
Unlike net income, CFO is not subject to managerial discretion or manipulation.
False Solution: While gross cash flows are difficult to manage/manipulate, it is relatively easy to shift cash flows between the activity categories (e.g., shifting between CFO and CFI). Hence, the analyst must still be careful to understand the assumptions/estimates/decisions made in the reported data.
Income Statement is the most easily interpreted of the basic financial statements
False - The income statement is usually regarded as the most difficult to analyze and interpret.
The basic balance sheet equation states that Assets are equal to Liabilities plus Owner's equity. This is because all assets are:
Financed either by other people's money or by the firm's owners' money. Solution: All assets must be financed. The only two sources of financing are: 1) other people's money (liabilities) and 2) owner's money (owner's equity).
Which one of the following is NOT included in the DuPont calculation?
Fixed asset turnover
Which of the following best describes the problem associated with GAAP accounting standards when performing ratio analysis?
GAAP accounting standards allow for significant managerial discretion in reported financial statements.
Net PP&E =
Gross PP&E - Accumulated Depreciation; accumulated depreciation is the total of all depreciation claimed against the firm's assets
Revenues minus cost of goods sold is:
Gross Profit. Revenues - COGS = Gross Profit - Operating Expenses = EBIT/Operating Profit - Interest Expenses = EBT - Tax Expenses = Net Income/Earnings
Consider Kyoto Restaurant. Kyoto's ROE is lower than the industry average. However, Kyoto's total asset turnover and financial leverage ratio are identical to the industry. The industry average net margin must be:
Higher than Kyoto's net margin.
Consider two companies, Hoogle and Mapple. They are economically identical. However, for reporting purposes Hoogle uses the managerial discretion that is required with accrual accounting to increase net income relative to Mapple (assume any balance sheet effects are inconsequential). Which of the following is correct:
Hoogle's OIROI is higher than Mapple's but Hoogle is NOT more efficient. Using the accrual accounting system to increase net income is known as earnings management. Since the firms are economically identical, Hoogle's use of accruals to increase net income and OIROI is just a ruse.
Which of the following would not be considered an operating expense?
Interest expense Recall the income statement format: Revenues - cost of goods sold - operating expense = EBIT (Earnings Before INTEREST and Taxes; a frequent proxy for operating profit). Interest is NOT an operating expense as it is deducted after the calculation of EBIT.
Depreciation expense is added back when calculating Free Cash Flow (FCF) because depreciation expense:
Is a non-cash expense Solution: Depreciation expense is added back since it is non-cash expense.
Big-Tokyo Inc. has a financial leverage ratio of 2.00, total asset turnover of 1.50 and ROE of 18.00%. For Big-Tokyo's industry, the average ROE is 16.00% and the industry average total asset turnover (TAT) and financial leverage ratio (FLR) are the same as Big-Tokyo. The industry average net margin must be:
Lower than Big-Tokyo's.
The industry average current ratio and quick ratio are 2.64 and 1.88 respectively. Which of the following would be the most plausible inference about Macrosoft's liquidity?
Macrosoft has higher inventory relative to current liabilities than the industry average. · Current ratio = CA/CL = 12,550/4260 = 2.95 Macrosoft has a higher current ratio while the quick ratio is lower. This means that the company must be carrying a large amount of inventory (i.e., when we take inventory out of the numerator, the ratio falls significantly).
If the industry average ROE is 4.12% and ROA is 2.09%, the most plausible conclusion about Macrosoft's profitability is:
Macrosoft is more profitable than the industry. For Macrosoft: ROE = NI/Equity = 462/8300 = 5.56%; ROA = 462/20900 = .0221 = 2.21%. Hence, Macrosoft is generating higher ROA and ROE than the industry.
Suppose that Macrosoft decides to increase the estimated life over which fixed assets are depreciated. Which of the following is most likely?
Macrosoft's OIROI will increase. Macrosoft's depreciation expense will be lower as a result of extending the estimated life of its assets (recall depreciation expense = (cost-salvage value)/estimated life). Lower depreciation expense leads to higher EBIT. Higher EBIT results in higher OIROI. (Note: the change in depreciation expense will increase EBIT and increase total assets; however, the change in EBIT will likely dominate).
In Macrosoft's industry, the average current ratio is 2.76, the average quick ratio is 1.56, the average inventory turnover is 1.68 and the industry average collection period is 54.3 days. When comparing Macrosoft to the industry, which one of the following statements is the most accurate?
Macrosoft's higher current ratio and quick ratio could be due to the build up of illiquid current assets. For Macrosoft: 1) Current ratio = CA/CL = 12550/4260 = 2.94, 2) Quick ratio = (CA-Inv)/CL = (12550 - 5300)/4260 = 1.70, 3) Inventory turnover = Cost of goods sold/inventory = 8930/5300 = 1.68, and 4) AR Turnover = credit sales/AR = 15000/3700 = 4.055; Therefore, Average Collection Period = 365/AR Turnover = 90.0 days. A common mistake is to interpret Macrosoft's higher current and quick ratios as evidence the company is more liquid than the typical firm in the industry. Liquidity requires a broader view of the firm that can be gained by looking only at the current ratio and quick ratio. Macrosoft has the same level of the inventory turnover as the industry implying that inventories are NOT less liquid. What about the other current assets? Notice that Macrosoft takes 90 days to collect receivables compared to only 54.3 for the industry. The very long ACP relative to the industry indicates the Macrosoft's AR are low quality (i.e., the firm has slow paying customers or they are failing to write-off uncollectable receivables). Hence, the high level of both the current and quick ratio is likely due to the build up of low quality receivables. The build-up of uncollectable/low-quality accounts receivable does nothing to provide liquidity for the firm. Hence, the current and quick ratios, in isolation, are misleading for Macrosoft.
When a firm purchases short-term U.S. Treasury securities, they are generally included on the balance sheet as:
Marketable Securities
Current liabilities are reported in order of:
Maturity (shortest first) Current liabilities are reported in order of shortest to longest maturity.
FCFE =
NI + Depreciation - CAPEX - Increase in NWC + Increases in Debt Increases in debt = new borrowings minus any repayment of old debt
Return on Equity (ROE)
NI / Owner's Equity
Net Margin percent of revenue that drops to the bottom line
NI / Sales
Return on Assets (ROA)
NI / Total Assets
CFO (Simplified) =
Net Income + Non-cash expenses (depreciation exp) + Decrease in Operating Asset Accounts (other than cash) - Increase in Operating Asset Accounts (other than cash) + Increase in Operating Liab Accts (other than notes pay) - Decrease in Op Liab Accts (other than notes pay)
CFO =
Net Income + depreciation expense ± changes in operating assets (Note: add decreases and subtract increases) ± changes in operating assets (Note: add decreases and subtract increases) ± changes in operating liability accounts (Note: add increases and subtract decreases)
Which of the following is not a reason for the difference between CFO and net income?
Net income doesn't account for the change in cash While technically true (i.e., net income doesn't account for the change in cash), this is not a reason for the difference in CFO and net income. Neither net income nor CFO "accounts" for the change in cash.
New RE =
Old RE + Change in RE
New RE =
Old RE + Net Income - Dividends
Which one of the following is NOT part of the common ratio categories?
Operating
Which one of the following ratios is NOT part of the common ratio categories?
Operating
Earnings Before Interests and Taxes (EBIT) is also called:
Operating Income
CFO implications of changes in:
Operating asset accounts (e.g., AR and inventory) are: Increases = an outflow of cash Decreases = an inflow of cash Operating liability accounts (e.g., accounts payable and accrued wages) are: Increases = an inflow of cash Decreases = an outflow of cash
Increased Assets =
Outflow of cash
Which one of the following is not an element of the DuPont decomposition?
Percentage of net income paid out as dividends.
Firm B should have higher debt ratio than Firm A.
Recall the DuPont equation: ROE = net margin x TAT x FLR. Both firms have the same net profit margin, but Firm A has a higher TAT (total asset turnover) than Firm B. Thus, the equal ROEs for both firms imply that Firm B has a higher debt ratio (resulting in a higher FLR; FLR = Assets/Equity) than Firm A. Both firms have the same current ratio, but firm A has a higher quick ratio than firm B implying Firm B's inventory is NOT more liquid than Firm A's. Hence, firm A has relatively less inventory than firm B. The equal gross margin for both firms and the higher quick ratio (lower inventory) suggests that inventory turnover is higher for firm A than for firm B. Thus, if anything, firm A's inventory appears more liquid than firm B's inventory. Firm A's Sales/Current Assets is higher than Firm B's and both companies have the same fixed asset turnover. So, Firm A should have higher total asset turnover than Firm B.
Which one of the following is NOT an example of the use of meaningful comparison standards for ratio analysis?
Reporting ratios in annual financial statements.
Free Cash Flow (FCF) is different from Cash Flows from Operations (CFO) because FCF:
Represents cash flow after required investment FCF allows for required reinvestment (i.e., FCF is after reinvestment cash). Conceptually, FCF is distributable cash.
Which of the following represent potential uses of net income under the accrual accounting system:
Retain within the firm and dividends There are only two things a company can do with its net income: 1) pay it out as dividends to shareholders, or 2) retain it within the firm.
Which of the following best describes the guiding principle for revenue recognition within accrual accounting system
Revenue is reported when the earnings process is complete With accrual accounting, revenue is recognized when the earnings process is complete. Indicators that the earnings process is complete include the transfer of the risk of ownership and assurance of payment.
The basic equation of an income statement is:
Revenues - expenses = net income Income statement equation: Revenues - expenses = net income
The matching principle in accrual accounting requires that:
Revenues are matched to the expenses incurred to generate the revenues Once revenues are recognized, the firm should also report the expenses incurred in generating the revenues.
A high-quality customer just purchased $500,000 worth of product from your company. The contract calls for immediate delivery of the product with a cash payment of $300,000 today and $200,000 to be paid 60 days. The expense associated with the product is $300,000, of which $100,000 has not been paid to your supplier. Under accrual based accounting system, you will most likely report:
Revenues of $500,000 and expenses of $300,000. Solution: Under accrual accounting system, you record the revenues when the earnings process is complete and match the expense with the revenues. In this case, we delivered the product and have a contract for payment with a high-quality firm. Hence, the earnings process is complete (including reasonable assurance of payment) so the firm will recognize $500,000 in revenue. The matching principle requires expense recognition for revenues recognized. The fact that our firm hasn't paid the supplier doesn't impact the expenses incurred to generate the $500,000 in revenue. Hence, the firm will recognize $300,000 in expense associated with the sale.
Accrual accounting recognizes:
Revenues when the earnings process is complete and matches expenses to revenues recognized.
Fixed Asset Turnover (FAT) calculates sales generated per dollar of fixed assets
Sales / Fixed Assets
Total Asset Turnover (TAT) measures how many dollars in sales the firm generates per dollar of assets
Sales / Total Assets
Lower interest expense than the competitor.
Since Eastern Family has higher gross margin (41.10%), COGS is relatively low. Eastern Family has higher operating expenses since the drop in operating margin (drop from net margin to operating margin) is bigger than the competitor. You cannot tell dollar amount of sales with the given ratios. Given the other three answers can't be right, lower interest expense than competitor (as a percent of sales) must be correct. We can see this is the ratios. The difference between operating margin and net margin is driven by Interest and Taxes (recall operating margin is EBIT/Sales). As such, the change from operating to net margin indicates the percentage of revenues consumed by interest and taxes. For Eastern, the change is 8.76% (= operating margin - net margin = 13.5% - 4.47%). The equivalent change for the competitor is 10.7%. Given that both firms pay the same percentage in taxes (i.e., 40% of EBT), the smaller change for Eastern Family is likely due to small interest expense on a relative basis. Gross Margin = 4110/10000 = 41.1%; operating margin = 1350/10000 = 13.5%, net margin = 474/10000 = 4.74%
Suppose an analyst is reviewing the profitability ratios for a firm. Which of the following statements represents the most valid insight for the analyst?
Since the profitability ratios of the firm declined, the analyst devotes additional effort to understanding revenues and costs.
Ratio Analysis popular tool 3 reasons:
Standardization, Flexibility, Focus Ratios don't answer questions about the company; ratios tell you what questions to ask
Accounts payable represents money a firm owes to:
Suppliers due to purchases made on credit
The use of the historical cost principle on the balance sheet means:
That most assets are stated at the original cost less depreciation While there are some exceptions, most assets on the balance sheet are reported as the historical acquisition cost less any depreciation claimed against the assets.
Assuming no asset disposals, depreciation expense is equal to:
The change in accumulated depreciation
Suppose a firm shows an increase in accounts receivable of $100 during a period. Considered in isolation, which of the follow best describes the impact of this change on the Statement of Cash Flows?
The change will decrease CFO by $100 An increase in an asset account indicates an outflow of cash. Since A/R is an operating account, the $100 increase will decrease CFO by $100.
Retained earnings represents:
The cumulative amount of the firm's earnings not distributed to shareholders
Suppose the inventory turnover of a company is higher than the industry. Based on this one ratio, which of the following is most likely to be correct?
The firm has too little inventory resulting in lost sales or stock-outs.
A firm reports the following cash flow data: o CFO = $1mm o CFI = -$750k o CFF = -$100k Which of the following is most reasonable assessment given the data?
The firm is sustainable in its current state
Current assets are listed in order of:
The most liquid to the least liquid.
Net Fixed Assets represents:
The original cost of the firm's assets held for use less accumulated depreciation Net Fixed Assets is the cost of the firm's non-current assets less the total amount of depreciation claimed against the assets (aka accumulated depreciation).
On the balance sheet, Gross Fixed Assets represent:
The original cost of the fixed assets currently owned by the firm. Solution: Gross fixed assets represent the original cost of the fixed assets currently owned by the firm. In general, market values are not relevant to fixed assets (note: there are times when market values are reported on the balance sheet; these exceptions are not included in the discussion for this learning resource).
Thirty years ago, your firm purchased a parcel of land for $100,000. You still own the land. The current market price of the land is $1,000,000. Under accrual accounting, which of the following adjustment should be made to recognize the current value of the land?
There is no adjustment to be made. Solution: Under the historical cost principle, the book value of the land is not changed.
Debit Ratio more precise measure of a firm's financial structure. Interest-bearing debt carries explicit interest costs
Total Liab / Total Assets
An increase in inventory will decrease CFO.
True
Current liabilities represent money owed by a firm that requires payment within one year.
True
FCFF can sustainably be distributed to the providers of capital.
True
Generally speaking, the operating accounts relevant to the calculation of CFO are located at the top of both the asset and financing side of the balance sheet.
True
Increases in operating assets and decreases in operating liabilities will decrease CFO.
True
Ratios help identify the areas of a firm that need investigation.
True
Retained earnings represent the accumulated net income of the firm less dividends paid.
True
The calculation of FCFF uses NOPAT instead of Net Income because FCFF is the cash available to both debt holders and equity holders.
True
Notes Payable carry an explicit interest cost
True Notes payable represent a formal lending arrangement and carry an explicit or stated interest component
Which one of the following is NOT an example of meaningful ratio analysis?
Using GAAP rules to calculate standard ratios.
If the current ratio of a company is higher than the industry, then:
You cannot tell without looking at other liquidity ratios.
If the current ratio of a company is higher than the industry, then:
You cannot tell without looking at other liquidity ratios. You cannot tell a company's liquidity compared to the industry just by looking at one ratio.
The sum of CFO + CFI + CFF is equal to:
he change in cash during the period
Interest-bearing debt to total capital (IBDTC) =
interest-bearing debt/total capital
FCFE measures
the cash distributable to equity holders after all obligations (including interest and principle to debt holders) and required reinvestment are satisfied. As we will see later in this course, FCF is one of the most important concepts in finance.
Financial leverage ratio (FLR) In a very simplistic firm, 40% debt implies the other 60% must be financed with equity. Thus, 60% equity financing (or equity/assets) implies an FLR of 1.67 (assets/equity).
total assets/equity
