Chapter 1: Economics & Analysis - Fundamental Analysis
Which of the following represents "leverage"? A. Current Assets - Current Liabilities B. Debt/Equity C. Sales - Expenses D. Operating Income/Bond Interest
Debt/Equity "Leverage" is the amount of debt used in the company's long-term capital base (long term capital consists of debt, preferred stock, and common stock). It is called "leverage" because the use of debt in a company's asset base allows it to "leverage" its EPS as its income rises (as income rises, once fixed debt interest cost is covered, all of the increase flows through to the shareholders - the bondholders to do not share in this). Current Assets/Current Liabilities is the Current Ratio and measures liquidity. Sales - Expenses is operating income and measures profitability. Operating Income/Bond Interest is the "Times Interest Earned" ratio and measures a company's ability to cover its fixed bond interest cost.
A company's current assets double. Its current liabilities quadruple. The company's current ratio will: A. Increase by 50% B. Decrease by 50% C. Increase by 100% D. Decrease by 100%
Decrease by 50% Assume that a company has $1 of current assets and $1 of current liabilities. The current ratio is $1 current assets/ $1 current liabilities = 1. If the current assets double, they will now be $2. If the company's current liabilities quadruple, the will now be $4. The current ratio is $2 current assets/$4 current liabilities = 0.50. The current ratio has fallen from 1 to 0.50, a decline of 50%
All of the following are included in the footnotes to a corporation's financial statements EXCEPT: Estimated unrealized losses on investments Estimated legal liabilities Deferred tax liabilities Open contractual commitments
Estimated unrealized losses on investments Explanation: The type of investment will determine how it is valued on a company's financial statements. Securities investments are valued at current market value. Any gain or loss is reflected in the market value. Long term investments in assets are valued at book value less depreciation. Unrealized gains or losses on investments are not detailed in the footnotes. Included in the footnotes are significant accounting policies, upcoming debt repayments; open contractual commitments; outstanding lease obligations; future pension obligations; estimated legal liabilities; deferred tax liabilities and details of discontinued operations charges.
A research firm that employs fundamental analysis would examine: I. Price Earnings Ratio II. Cash Flow III. Bar Charts IV. Point and Figure Charts A. I and II only B. III and IV only C. II and III only D. II and IV only
I and II only A fundamental analyst examines the "fundamentals" of a company, including its market share, product line, management, earnings, profitability, and balance sheet. In contrast, a technical analyst examines technical factors such as the stock's price movements and trading volumes. Technical analysts are often called "chartists" because they examine charts that map out trading and volume patterns, looking for "signals" to buy or sell based on these.
Which of the following are components of common stockholder's equity? I. Common at Par II. Capital in Excess of Par III. Retained Earnings IV. Intangibles
I, II, III If a corporation sells stock at a price above par value, the par value, the par value received is shown on the balance sheet as "par value," while the excess funds are credited to the corporation's capital surplus account. Retained earnings and earned surplus are different names for the same account - corporate earnings that are not paid out as dividends are credited annually to RE; this is technically owned by the common shareholders. Intangibles are assets of a corporation, such as the value of copyrights, patents or trademarks. They are not a component of common stockholders' equity.
When looking at the Price/Book Value ratio of a corporation, which statements are TRUE? I. The numerator on the equation is based on liquidation value II. The numerator in the equation is based on market value III. The denominator in the equation is based on liquidation value IV. The denominator in the equation is based on accounting value
II & IV The Price/Book Value Ratio of a corporation is the company's Market Price (per share)/Common Stockholders' Equity (per share). While the "price" is the market value per share, book value is simply the accounting value of common stockholders' equity. Common stockholders' equity is based on accounting as of the date each transaction happened, which could be years in the past. Thus, if the market values of those assets or liabilities booked years in the past have moved dramatically, then "book value" really has little meaning.
Arrange the following in priority of claim in a corporate liquidation: I. Unpaid Wages II. Secured Bondholders III. Subordinated Bondholders IV. Debenture Bondholders
II, I, IV, III In a corporate liquidation, secured bondholders are paid first; then unpaid wages and taxes; then debenture holders; then subordinated bondholders; then preferred stockholders; and finally, common stockholders.
A corporation has reported quarterly earnings of $3 per share. The corporation retained $9 of earnings at year end. The corporation's dividend payout ratio is: A. 25% B. 33% C. 66% D. 75%
If the company retained $9 of its $12 of earnings per share (4 quarters at $3 = $12 annual earnings), then it paid out the other $3. The dividend payout ratio is: $3/$12 = 25%
The Current Ratio measures: A. Debt service coverage B. Liquidity C. Leverage D. Profitability
Liquidity The current ratio is: current assets/current liabilities. It is a measure of liquidity, because it looks at whether the company can pay its current bills as they come due.
Fundamental analysts would evaluate which of the following?
Liquidity Ratios Fundamental analysts select investments based on fundamentals such as earnings trends, balance sheet strength (liquidity ratios), management, etc. Technical analysts select investments based on chart movements, trading volumes, advance-decline ratios, etc.
Balance Sheet of a Company: Cash: $20K A/R: $20K Inventory: $30K Marketable Securities: $60K Trade Payables: $15K Taxes Payable: $30K Long Term Debt: $25K What is the net working capital of the company? A. $25K B. $55K C. $85K D. $115K
$85K NWC: $130K - $45K NWC: Current assets - current liabilities. Current assets are those assts that are turned into cash within a year; current liabilities are those bills that must be paid within a year. The current assets in this example are: cash, a/r, inventory, and marketable securities, totaling $130K. Current liabilities are: trade payables and taxes payable, totaling $45K
What is ABC Corp's Quick Ratio?
1.25 to 1 Note: There are $60M of Current Assets, but the $10M of inventory is not liquid, it is deducted to arrive at "Quick Assets". (Current Assets - Illiquid Assets)/Current Liabilities
What is XYZ Corp's Quick Ratio? Total Current Assets: $283M $117M of inventory $21 million of prepaid expenses Total Current Liabilities: $90M
1.61:1 $283M - ($117M + $21M) = $145M $145M/$90M = 1.61
A corporation shows the following in its capital structure: Long Term Debt: $20M Common at Par: $10M Capital in Excess of Par: $50M RE: $40M The corporations D/E Ratio is: A. 2:01 B. 1:03 C. 1:05 D. 1:06
1:05 $20M/$100M = 1:05 The D/E Ratio measures the corporation's use of debt (leverage) in its capital base. Stockholders' Equity consists of Common at Par ($10M) + Capital in Excess of Par ($50M) + RE ($40) = $100M The D/E Ratio is: Long Term Debt/Stockholders' Equity
A consumer goods company has a D/E ratio of 10. Which statement is TRUE? A. This company might not be able to generate enough cash to pay its debts B. A high ratio is preferred by investors because it shows that the company is investing in itself C. This company is at lower risk if there is an economic downturn D. The ratio correlates with the P/E ratio of the company
A The D/E ratio examines how leveraged the company is. Leverage is the use of debt in a company's capital structure. Because interest on debt is typically fixed rate and must be paid in both good times and bad times, if the company runs into a rough patch, it might not be able to pay the interest on its bonds if it has a large amount of debt. A D/E ratio of 10:1 is extremely high. Capital intensive industries (like utilities) use a lot of debt in their capital base because the interest is deductible and their earnings are fairly stable. However, their ratios rarely exceed 2:1. So this company is in real trouble and probably won't be able to pay the interest and principal on its debt.
Following is the balance sheet of a company: What is the net working capital of the company? Cash: $40,000 A/R: $70,000 Inventory: $30,000 Long Term Assets: $100,000 Trade Payables: $25,000 Long Term Payables: $50,000 Long Term Debt: $60,000
Net working capital of a company is current assets - current liabilities. Current assets are those assets taht are turned into cash within a year; current liabilites are those bills that must be paid within a year. The current assets in this example are cash, accounts receivable, and inventory, totaling $140,000. The only current liability is trade payables, at $25,000. Thus, net working capital is $140,000 - $25,000 = $115,000
A corporation reports Earnings Per Common Share of $8, of which $6 was retained by the company. The dividend payout ratio is: A. 25% B. 50% C. 75% D. 100%
The dividend payout ratio is: $2/$8 = 25% If the company retained $6 of its $8 of earnings per share, then it paid out the other $2.
A Debt/Equity Ratio of 1 means that: A. The company will be able to pay all of its debt in the upcoming year B. Shareholders and creditors have an equal stake in the company's assets C. The company has not used any leverage in its capital base D. The company's interest payments to bondholders equals the company's dividend payments to shareholders
Shareholders and creditors have an equal stake in the company's assets The D/E ratio measures a company's leverage - the use of borrowed funds in the company's capital base. Companies borrow long-term funds for capital expenditures when it is cheaper to do so, meaning interest rates are low. The company can deduct the interest payments. The risk is a business decline, where the company might not be able to cover its fixed interest expense. If a company has borrowed $10M and it has $10M of stockholders' equity, it has long-term capital of $20M. Its D/E ratio is $10M debt/$10M equity = 1. This means that both creditors and shareholders have an equal stake in the company. Notice that the ratio has nothing to do with interest payments or dividend payments made.
To calculate a company's Debt/Equity ratio, the needed information is found on the: A. Income statement B. Statement of financial condition C. Both the income statement and statement of financial condition D. Footnotes to the company's financial statements
Statement of financial condition A company's Debt/Equity Ratio is the ratio of Long Term Debt to Common Stockholders' Equity. Both of these are found on the company's balance sheet, also called the company's statement of financial condition.
The Price/Book Value ratio of a company is used to measure: A. A company's ability to pay any bills coming due B. The relative value of the bondholders' stake to the equity holders' stake in the company C. The relative value of the stock's market price to the fundamental value of the company's net assets D. The profitability of the company excluding any intangible assets
The relative value of the stock's market price to the fundamental value of the company's net assets The Price to Book Value ratio is the market price per share dived by the book value per share. It compares the price paid in the market to the theoretical value of what is being purchased. A high Price to Book Value Ratio would be the case for a young rapidly growing company, since investors are bidding up the price based on future growth expectations. A lower ratio is typical for mature companies with limited growth prospects.